Accounts Notes

CAPE
ACCOUNTING
Unit 1 FINANCIAL
ACCOUNTING
MODULE 1: ACCOUNTING THEORY, RECORDING AND
CONTROL SYSTEMS
The Nature and Scope of Financial Accounting
The Development of Accounting
Roman Empire-
 Early form of Journalising
o Res Gestae Divi Augusti (Deeds of the Divine Augustus)
o Wooden tablets of Fort Windowlanda
 Transactions recorded by military of Roman Army
 Cash
 Commodities
 Transaction
o Heroninos Archive- papyrus documents named after heroninos.
 Complex Standardized Accounting System for running
private estates.
Medieval and Renaissance Periods
 Double-entry bookkeeping
o Pioneered in the Jewish community of the early-medieval Middle
East
 Medieval Europe- 13th century
o Transactions financed by bank loans
o Accounting Terms
 Debitum (Debit)- What is due
 Creditum (Credit)- something entrusted to another”
 Earliest evidence of full-double entry bookkeeping
o Farolfi ledger (1299-1300)
 Giovanno Farolfi and Company
 Money Lenders of Archbishop of Aries
 Oldest complete double entry system
o Messari accounts
 City of Genoa in 1340
 Messari is Italian for Treasurer’s
 Luca Pacioli’s work
o Summa de Arithmetica, Geometrica, Proportioni et Proportionalita
(Review of Arithmetic, Geometry, Ratio and Proportion)
 Published in 1494
 Include a 27-page treatise on bookkeeping
- Particularis de Computis et Scripturis (Details of
Calculation and Recording)
o Recommends the Venetian method of double-entry bookkeeping
 Memoriale (Memorandum)
 Giornale (Journal)
 Quaderno (Ledger)
o This system minimizes the merchants’ risk of theft by their
employees and agents
Modern Professional Accounting
 Two Concepts
o Development of the double entry bookkeeping system in the 14 th
to 15th century
o Professionalization in the 19th and 20th centuries
 Chartered Accountants
o Originated in Scotland in 19th century
 Institute of Accounts in Glasgow
o July 1854
o Petitioned Queen Victoria for a Royal Charter
 Signed by 49 Glasgow accountants
o Edinburgh Society of Accountants (1854)
o Glasgow Institute of Accountants and Actuaries (1854)
o Aberdeen Society of Accountants (1867)
 London became the financial center of the world
o Accountants became an integral part of the business and financial
system.
o Institute of Chartered Accountants in England and Wales (1880)
 FCA (Fellow Chartered Accountant)- firm partner
 ACA (Associate Chartered Accountant)- qualified staff
 American Institute of Certified Public Accountants (1887)
In 1494, Luco Pacioli, an Italian, described the double entry system of debit
(Dr) and credit (Cr) to be recorded in journals and ledgers. That system has
remained basically the same today.
‘Financial accounting deals with recording, summarising and communicating
economic events of entities based on established principles, standards and
legislation.’ (Caribbean Examination Council, 2012, p. 1)
These established principles, standards and legislation (unique to each

jurisdiction) are referred to as Generally Accepted Accounting Principles
(GAAP).
Significance of Accounting Information

The focus of financial accounting is to report to external users a summary of
past economic events of the recently concluded financial period, reflecting the
entity’s financial performance and financial position. This should be done in a
timely manner to allow the users to make effective economic decisions. These
reports are called general purpose financial statements.
Limitations of Accounting Information
- Assumptions, subjective judgements and estimates are required in the

measurement and reporting of business activity.
- Non-financial events or factors may contribute to the entity’s success but
cannot be measured monetarily; for example, good working employees or suitable
distribution location.
- Reports are based on historic cost and not the fair market value (current value).
Users of Accounting
User Need for Accounting Information

Shareholders  Assess management’s stewardship
 Determine distributable profits and dividends
Potential  Determine whether to make equity payments
Investors
Trade  Assess the company’s ability to pay employees for effective
Unions/Employees Negotiation
Banks and other  Assess the security of money lent or to be lent to the
financial lending company
institutions
Government  Determine tax to be levied on the company
 Determine taxation policies
 Include in the country’s national income statistics
Security  Regulate activities of enterprises
Exchange
Commission
Financial Analysts  Analyse the company in relation to other companies
Trade Creditors  Assess the company's ability to pay its short-term
obligations
Managers  Assess their own stewardship and for planning ahead
Journalise all
transactions
chronologically
Prepare a
Post to ledger
closing trial
accounts
balance
Journal all Prepare a trial

closing entries balance
Prepare a full Make end of

set of financial period
statements adjustments
Prepare an
adjusted trial
balance
Accounting Methods
Accrual Basis
This is a method in which revenue is recorded when it is earned and expenses are
recorded when they are incurred rather than when cash is received or disbursed.
Accrual basis accounting is required in the preparation of general purpose financial
statements as it takes into account all the economic activity of the entity that has
occurred during the financial period under review. This gives a true and fair view of
the entity’s performance, allowing for greater ability to predict future cash flows.
Cash Basis
This is a method in which revenue is recorded when cash is received, and expenses
are recorded when cash payments are made.
Accounting Standards
ACCOUNTING STANDARDS ARE GUIDELINES OF BEST ACCOUNTING PRACTICE IN THE TREATMENT OF

ACCOUNTING INFORMATION AND FOR FINANCIAL REPORTING. They are not rules. The IASB
(International Accounting Standards Board) is the standard-setting body of the IASC
(International Accounting Standards Committee), an independently run private-sector
organisation. The IASB consists of 14 members, of which 3 may be part-time. The
IASB consists of representatives from four basic groups:
1. preparers of general-purpose financial statements

2. users of general-purpose financial statements
3. the auditing profession
4. academia.
The IASB is responsible for the approval of IFRSs (International Financial Reporting
Standards) and related documents. The standard-setting process called ’Due Process‘ is
as follows:
1. The IASB sets up a steering committee.

2. The steering committee identifies issues.
3. The steering committee studies national and regional requirements and practice
in relation to the issues.
4. The steering committee prepares and presents a Point Outline to IASB.
5. The Point Outline is converted to an Exposure Draft and sent out to member
organisations for discussion/ feedback.
6. After comments are received and revisions are approved by the IASB, the
revised Exposure Draft is adopted and issued as an IFRS.
The International Financial Reporting Standard for Small and Medium-sized

Entities (IFRS for SMEs)
This was developed giving consideration to, complying with and borrowing from current
IASs and IFRSs and is in line with the IASB’s Conceptual Framework of Accounting. As
the development of this standard had gone through due process, on 09 July 2009 the
IASB issued the IFRS for SMEs.2 Most businesses in the Caribbean are SMEs and
jurisdictions have adopted the IFRS for SMEs as part of their GAAP.
Issuing the IFRS for SMEs:
 makes it simpler for SMEs to comply with the requirements of the one standard
than adhering to the full set of IFRSs and IASs and many national GAAPs
requirements
 reduces the cost associated with meeting the requirements of the full set of
IFRSs and IASs
 simply meets the needs and capabilities of SMEs.
Conceptual Framework of Accounting
Purpose of the conceptual framework
To assist the IASB in developing and revising IFRSs that are based on consistent
concepts, to help preparers to develop consistent accounting policies for areas that are
not covered by a standard or where there is choice of accounting policy, and to assist
all parties to understand and interpret IFRS.
Contents of the Conceptual Framework
Objectives of Financial Reporting
- The primary users of general-purpose financial reporting are present and

potential investors, lenders and other creditors, who use that information to
make decisions about buying, selling or holding equity or debt instruments,
providing or settling loans or other forms of credit, or exercising rights to vote
on, or otherwise influence, management’s actions that affect the use of the
entity’s economic resources.
- The primary users need information about the resources of the entity not only
to assess an entity's prospects for future net cash inflows but also how
effectively and efficiently management has discharged their responsibilities to
use the entity's existing resources.
- The IFRS Framework notes that other parties, including prudential and market
regulators, may find general purpose financial reports useful.
- The objectives of financial reporting are to provide
o Useful in credit and investment decisions
o Useful or helpful in assessing cash flows
o About enterprise resources, claims on resources, use of resources and
change in resources.
Qualitative characteristics of Accounting Information
- In between the why and the how are the qualities that make information useful.
These are used to define the elements of financial statements
- Fundamental/Primary
o Relevance: if it can influence the user’s decisions, thereby making a
difference. Relevant information must possess the following attributes:
 Predictive value: it can be used to help project future outcomes of
the entity.
 Feedback or confirmatory value: it confirms or corrects
information on past expectations.
 Be timely: it is given to the user in a time that can help in making a
reliable decision.
 Materiality: if the economic decisions of the user are affected by
the omission or misstatement of it, then it is material.
o Faithful Representation: means representation of the substance of an
economic phenomenon instead of representation of its legal form only. A
faithful representation seeks to maximise the underlying characteristics
of completeness, neutrality and freedom from error. A neutral depiction
is supported by the exercise of prudence. Prudence is the exercise of
caution when making judgements under conditions of uncertainty.
- Enhancing/Secondary
o Comparability- information about a reporting entity is more useful if it
can be compared with a similar information about other entities and with
similar information about the same entity for another period or another
date. Comparability enables users to identify and understand similarities
in, and differences among, items. In order to compare, they must be in
the same industry.
o Verifiability helps to assure users that information represents faithfully
the economic phenomena it purports to represent. Verifiability means
that different knowledgeable and independent observers could reach
consensus, although not necessarily complete agreement, that a
particular depiction is a faithful representation.
o Timeliness means that information is available to decision-makers in time
to be capable of influencing their decisions.
o Understandability- classifying, characterising and presenting information
clearly and concisely makes it understandable. While some phenomena are
inherently complex and cannot be made easy to understand, to exclude
such information would make financial reports incomplete and potentially
misleading. Financial reports are prepared for users who have a
reasonable knowledge of business and economic activities and who review
and analyse the information with diligence.
o Consistency: similar items such as, for example, inventory valuation and
depreciation of fixed assets must be treated in the same way in the
accounting period and from one period to the next. If there is a change in
accounting method or policy, then the company must disclose it with
justification by way of notes to the financial statements.
Elements of Financial Statements
The entities full set of financial statements consist of statement of financial position,
comprehensive income, changes in equity and cash flow and notes to financial
statements. This is a reflection of the effects of the transactions in other events.
 Elements relating to financial position (balance sheet)

o Asset is a resource controlled by the entity as a result of past events
and from which future economic benefits are expected to flow to the
entity.
o Liability is a present obligation of the entity arising from past events,
the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits.
o Equity is the residual interest in the assets of the entity after deducting
all its liabilities.
 Definitions of the elements relating to performance
o Income is increases in economic benefits during the accounting period in
the form of inflows or enhancements of assets or decreases of liabilities
that result in increases in equity, other than those relating to
contributions from equity participants.
o Expenses are decreases in economic benefits during the accounting
period in the form of outflows or depletions of assets or incurrences of
liabilities that result in decreases in equity, other than those relating to
distributions to equity participants.
Level III: Recognition, measurement and disclosure principles
Assumptions
 Economic, separate or business entity concept: the activities of the owner and
the company are separate and must be so reflected in the accounts.
 Going concern: the business will continue for the foreseeable future. As a
result, financial statements are prepared and presented in that way. If the
business will not continue for the foreseeable future then it must be recorded
at liquidation value (selling price less cost of disposal).
 Monetary unit: this is also known as unit of measure or money measurement
concept. This states that financial statements should be prepared in one stable
monetary unit and that non-monetary items may not be recorded.
 Objectivity: financial statements must be free from bias.
 Periodicity: this is also known as the time period assumption, which states that
financial information is needed by users periodically; therefore, financial
statements are prepared and presented in artificial time periods.
Principles
 Historic cost concept: all transactions are recorded at cost at the time they
occur.
 Revenue recognition: revenue should be recognised when there is an inflow of
net assets from a sale of goods or services.
 Matching: the expenses that were incurred in the period are matched against
the revenue of the same period.
 Accruals: the effects of transactions and other events are recognised when
they occur, rather than when cash or cash equivalent is received or paid, and
they are reported in the financial statements for the period to which they
relate.
 Duality: every transaction must be entered twice – once as a debit (Dr) and once
as a credit (Cr).
 Separate valuation: where two transactions occur such as buying from and selling
to a supplier with no agreement to set-off the amounts, the debtor and creditor
must be shown separately.
 Full disclosure: circumstances and situations that make a difference to the
users of financial statements should be disclosed. This can be done by data in
the financial statements or by way of notes to the financial statements.
Constraints
 Cost-benefit to the company. Will the benefits of including certain information

in the financial statements outweigh the costs, or vice versa?
 Materiality: the information is material if it influences the decision of the user;
if not it is considered immaterial and can be summarised.
 Industry practice: the peculiar nature of some industries and business concerns
sometimes requires departure from basic accounting theory.
 Conservatism (prudence): when in doubt, choose the solution that will be least
likely to overstate assets and income and understate expenses and liabilities.
Recording Financial Information
Recording Transactions
a. 1 June 2015: a sole trader, Naija Celestine started a business called Basketball
Gamers with $8000 cash
Date Details Debit Credit
2015
1 June Cash 8000
Capital 8000
Owner’s initial investment
b. 2 June 2015: deposited $6000 cash into the bank

2015
2 June Bank 6000
Cash 6000
Deposited 6000 cash into the bank
c. 5 June 2015: purchased a photocopier on credit for office use from Fax Us Ltd.
2015
5 June Office Equipment 6000
Fax Us Ltd 6000
Purchased photocopier from Fax Us Ltd
d. 9 June 2015: purchased goods for resale from J. Morgan paying $1500 cash.
2015
9 June Purchases 1500
Cash 1500
Purchased goods for resale
Adjusting Entries
Inventory
Example: John Swimmers has a business called Splash-a-lot and at 01 April 2014
beginning inventory was $4000 and at 31 March 2015 ending inventory was $5000.
Record the general journals to close off beginning inventory to the income statement
and closing inventory.

2015
31 Mar Income Statement 4000
Inventory 4000
To close off opening inventory account

2015
31 Mar Inventory 5000
Income Statement 5000
To record closing inventory
Accounting for consumables such as office supplies and small tools

Example: G. Chambers Company Ltd. Started the year 2015 with an office supply
inventory of $7600 and at the end of the year had $3300 of office supplies inventory.
Record the general journal to show the office supplies expense for 2015.
Office Supplies expense= opening inventory-closing inventory
= $7600-$3300
= $4300
2015
31 Dec Office supplies expense 4300
Office supplies inventory 4300
To expense office supplies used during 2015
Closing off an expense account

Example: The trial balance as at 31 December 2015 indicates that the rent expense for
the year was $18000. Close off the rent expense account.

2015
31 Dec Income statement 18000
Rent expense 18000
To close off rent expense account
Closing off a revenue account

Bel Bell company sells cell phones on behalf of Digicel Ltd. Its revenue is generated
from the commission on the sale of cell phones. Its total commission revenue for the
year 2015 was $405000.

2015
31 Dec Commission revenue 405000
To close off the commission revenue account
Recording depreciation calculated for the period

Example: The cost of machinery at the end of the year 2015 was 76000 and the
allowance for depreciation as at 1 January 2015 was $16000. Calculate depreciation for
the year using the reducing balance method at 10% per annum and show the relevant
journal entry for this adjustment.
Reducing balance method formula: net book value* x given percentage
*fixed asset at cost – accumulated depreciation
Depreciation for the year= (76000-16000) x 10%
= $6000

2015
31 Dec Income Statement 6000
Allowance for Depreciation 6000
Depreciation for machinery for 2015
Deferrals (prepayments) and accruals (amounts owing, outstanding or due)

Example: Max Enterprises paid $15000 for the year for rent in 2015. The monthly rent
is 1000. Prepare the necessary journal to close off the rent expense account.

2015
December Income Statement 12000
Prepaid Rent Expense 3000
Rent Expense 15000
To close off the rent expense account and
record prepayment.
Example: Max Enterprises paid $15000 for 2015 in rent expenses. The monthly rent is
$1500. Prepare the necessary journal to close off the rent expense account

2015
December Income Statement 18000
Rent Expense 15000
Accrued rent expense 3000
To close off rent expense account and to record
accrual
Example: Max Enterprises collects commission for the sale of cell phones. The monthly
revenue is $2000. For the year 2015, 30000 was received.

2015
December Commission Revenue 30000
Income Statement (2000 * 12 months) 24000
Prepaid commission revenue 6000
To close off the commission revenue account and
record prepayment
Example: Max Enterprises collects commission for the sale of cell phones. The monthly
revenue is $3000. For the year 2015 $30000 was received.

2015
December Commission Revenue 30000
Accrued Commission Revenue 6000
To close off the commission revenue account and
record accrual
Equity
Shares are units of stocks issued by a corporation that represent ownership. Equity is
the residual interest in the assets of an entity after deducting all its liabilities.
Issue of shares:
 Authorized- the value of shares that the corporation has permission to sell.
o Registered
o Nominal
 Issued- the value of shares offered for sale to the public.
o Application- the amount that shareholders pay when applying for shares
o Allotment- the value of shares that are assigned to shareholders by the
corporation
o First & Final Capital- the request for shareholders to pay any amounts
owing for shares
 Called-Up- the amount shareholders have been asked to pay by a particular date
 Paid-Up Capital- the actual amount collected from the shareholders at a
particular date.
o Share Capital Account- sale of shares at par or slated value
o Premium Account- sale of shares in excess of par or slated value
Shares
 Common Stock- capital that forms the backbone of the corporation and yields a
variable rate of return
 Bonds issue- increase in the number of shares decrease in the value per share
 Rights Issue- increase in the number of shares at the expense of the
shareholders
Preferred Stock
Capital that carries a fixed rate of return. These individuals cannot vote.
 Cumulative- guaranteed fixed rate of return on the investment. If not paid in

current year is carried forward.
 Non-Cumulative- guaranteed a fixed rate of return only when dividend is
declared.
 Redeemable- agreement that the corporation can purchase at a later date
 Non-redeemable- no agreement for the corporation to buy back
Valuation Definitions and Examples Journal Entries

NO PAR Stock with no assigned value at DR. Cash/Bank 5000
incorporation CR. Common Stock 5000
E.g., Issued 1000 shares at $5 each.
These are no par shares and have no
slated value
PAR Stock that have assigned a value at DR. Cash 40000
incorporation CR. Common Stock 40000
E.g., Issued at 20000 shares at $2 par
value common stock and received cash
ABOVE Stock issued at a value above that which DR. Cash 40000
PAR was given at incorporation. CR. Common Stock 16000
(Premium) E.g., Issued 8000 shares of $2 par value CR. Premium 24000
common stock at $5 each and received
cash
BELOW Stock issued at a value below that which DR. Bank 3000
PAR was given at incorporation. DR. Premium 1000
E.g., Issued 2000 shares at $2 par value CR. Common Stock 4000
common stock at $1.50 and received
cheque
STATED This is the value that the board of DR. Cash 50000
VALUE directors may assign to no-par stock. CR. Common Stock 30000
E.g., Blue Jays Corporation has $3 stated CR. Premium 20000
value no par stock and issued 10000
shares at $5 per share for cash
For Organisational Expenses in setting up a DR. O. Expenses 80000
services corporation paid for through the issuance CR. Common Stock 70000
of shares. CR. Premium 10000
E.g., Lawyer and consultants frees were
settled by using 15000 shares at $3.50
each
For Non- Buying assets by using an issue of shares DR. Office Building 75000
Cash E.g., Office Building value at $100000 CR. Common Stock 45000
Assets were bought using 15000 shares at $5, CR. Premium 30000
having a par value of $3
Capital Reduction
This is reducing the legal capital of a company it must go through all the necessary legal
formalities. In the first step in reducing the legal capital is by the company passing a
special resolution effect.
Reasons for capital reduction:
 Where capital is not represented by assets

 Where some of the assets are no longer needed
 To reduce a liability in respect to an amount unpaid on a share
Sometimes a company may have a large deficit in its retained earnings, which may be
the result of accumulated losses over a number of years or other significant debit to
the account. The company may therefore seek to offer its invested capital accounts to
reflect a more favourable financial position as long as the law provides for it.
In preparing the capital reduction the following journal entries could be used.
1. To write down the assets

DR. Capital reduction
CR. Various assets
2. To reduce the liabilities
DR. liabilities
CR. Capital reduction
3. To reduce share capital
DR. Share capital
CR. Capital reductio
4. If a credit balance remains on the capital reduction
DR. capital reduction
CR. Capital reserves
Where some of the assets are no longer needed
There are times when the asset of a company exceed. This may be due to firms
activities resulting in. As long as all legal formalities are observed in the company may
return surplus capital to shareholders. This is done by debiting the share capital and
credit.
Dividends
This is distributed to the company’s shareholders. This reduces the retained earnings
of the company. They are not expenses and most companies don’t pay cash dividends
since these funds are retained for financing future growth. There are three important
dividend dates:
Declaration Date- board of directors announce its intention to pay dividends to.
Record Date- this is the date where the ownership of shares is determined, that is,
determine the different class of shareholders and the amount each will receive.
Payment Date- this is when actual payment to shareholder is recorded.
Journal Entry for Dividends
i. Declaration Date
DR: Dividends Declare
CR. Dividend Payable
ii. Record Date
No Entry
iii. Payment Date
DR: Dividend Payable
CR: Cash/Bank
iv. Closing of the Dividend a/c
DR: Retained Earnings
CR: Dividend declared
Example #1: Joan’s Cooperation had 15000 common shares outstanding on September
15, 2017 when it declared 112000 cash dividends to shareholders on record Oct. 1
payable Oct. 10, 2017. Prepare the journal entries to record the activity relating to the
dividends and to close the dividends declared on December 31, 2014.

2017
Sept. 15 Dividend Declare 112000
Dividend Payable 112000
Oct. 10 Dividend Payable 112000
Cash/Bank 112000
Dec 31 Retained Earnings 112000
Dividend Declared 112000
Example 2: Simpson Company is authorized by its Articles of Incorporation to issue

80000 shares of $50 10% non-cumulative non-participating preference shares and
500000 no par shares. The following transaction occurred during April 1 2023:
- April 1- sold 3000 preference shares for cash at par value

- April 15- sold preference shares at $315000 cash
- April 20- exchanged $20000, 14% note payable plus 6 months accrued interest
payable for 300 preference shares.
Prepare the journal entries to record the following transactions:
a) Sale of $30000 preference shares at par

b) The sale of 5000 preference shares for 375000
c) The exchange of note payable plus accrued interest payable for preference
share

2023
April 1 Cash 150000
10% preference shares (3000 @ $50) 150000
April 15 Cash 375000
10% Preference share 250000
Share premium 125000
April 20 Note Payable 20000
Interest 14% 20000 2800
10% Preference shares 15000
Share Premium 7800
Rights Issue
This is an issue of shares to current shareholders. The value of the share is usually
above par but discounted to the market value of the share. These shareholders are in
no way duty-bound to purchase these shares.
Example: Timothy Ltd issues 20 000 shares of common stock to its existing
shareholders with par value $4.00 per share and market value of $6.00 on 04 February
2015. The company is offering a 10 per cent discount on the market value to its current
shareholders. The issue was fully subscribed.

2015
Feb 4 Cash (200000 shares @ $6 * 90%) 108 000
Common stock (20 000 share @ par 80000
$4.00
Paid-in capital in excess of par 28000
(108 000 − 80 000)
To record rights issue
Bonus Issue
This is a gift of shares to current shareholders, usually given to them in place of cash
dividend.
Example: Williams Ltd has 20 000 shares of common stock at par value $2.00 per share
outstanding at 31 December 2015. The company gave a bonus issue of one for every
five stocks held on 31 December 2015 as dividends for 2015.
Details Details Debit Credit

2015
31 Dec Retained earnings (20000 shares/5) * $2 8000
Common stock 8000
To record a bonus issue
Bonds
These are long-term liabilities issued by a company to raise additional funds/capital. It

is also issued by government. By buying a bond, you are giving the issuer a loan and they
agree to pay you back the face value of the loan on a specific date and to pay you
periodic interest payment usually twice a year.
a. D. Corporation issued 100 5 years 10% bond at a $1000 par value dated January
1, 2007.
2007
Jan 1 Bank 100000
Bond Payable (100 * $1000) 100000
To record the issue of a bond at par
b. The interest payable annually on January 1st on the bond of D. Corporation is

accrued on December 31, 2007. Calculate the bond interest.
2007
Dec 31 Bond Interest Expense 10000
Bond Interest Payable ((100 * $1000) * 10%) 10000
To record the accrued interest of bond

2008
Jan 1 Bond Interest Payable 10000
Bank 10000
To record the payment of bond interest
Bond Issue at Premium
The sale of bond/debenture above face value cause the total cost of borrowing to be
less than the bond interest paid, because the borrower is not required to pay the bond
premium at the maturity date of the bond. Thus, the premium is considered to be
reduction in the cost of borrowing that reduces the bond interest expense over the
life of the bond.
Example: On the 1st of January 2022, Johnson’s corporation issued 50 million 5 years
7.5% bonds at $1.02 with a par value of $1. On June 30, 2022, Johnson paid interest on
the bond. You are required to prepare the journal entry to record.
a) The issues of bond

b) Semi-annual interest payment

2002
Jan 1 Cash 51000000
Bond payable 50000000
Bond premium 1000000
To record the issue of bond
June 30 Bond interest expense 1775000
Bond premium ((1000000/5) / 2) 100000
Cash (50000000 * 7.5% * ½) 1875000
Bond Issued at Discount
The issue of bond below face value causes the total cost of borrowing to differ from
the bond interest paid, that is, the issuing corporation not only must pay the
contractual interest rate over the terms of the bond but also must pay the face value
at maturity, that is the difference between the issued price and face value of the bond
is an additional cost of borrowing.
April 1, 2003, Ashton corporation issued 150000 five year 8% bonds at 0.96 with a
face value of 1. These bonds pay interest semi-annually on September 30, 2003.
Prepare the journal entry to record the issue of bonds and interest payment.

2003
April 1 Cash (0.96 *150000) 144000
Bond discount (0.04 * 150000) 6000
Bond payable (1 * 150000) 150000
To record the issue of bond
April 30 Bond interest expense 6600
Bond discount ((6000/5)/2) 600
Cash (150000 * 8% * ½) 6000
Redemption of Bonds Before Maturity
Bonds may be redeemed before it matures. A company may decide to retire bonds
before maturity in order to reduce the interest cost and remove the debt from its
balance sheet. A company should retire debt only if it has sufficient cash reserves or
resources.
The process:
1. Eliminate the carrying value of the bond at the redemption date (the carrying
value of the bond is the face value of the bond less unamortized bond discount
or add unamortized bond premium at the redemption date)
2. Record the cash paid.
3. Recognize the gain/loss on redemption
a. To find a loss on redemption- if cash paid is greater than the carrying
value. The converse is true.
Example: At the end of the 4th period, Candle Stick Corporation having sold its bond at
a premium, retires the bond at $1.03 after paying the annual interest. Assuming that
the carrying value of the bond on redemption date is 100400. Record the redemption of
bond at January 2000. Bond payable is 100000 while premium is 400.

2000
Jan 1 Bond payable 100000
Bond premium 400
Loss on redemption of bond 2600
Cash 103000
To record the redemption of the bond
Reserves
Capital reserves are gains or profits made on such transactions as:
 revaluation of non-current assets (revaluation reserve)

 issue of shares (share premium or paid-in capital in excess of par).
Revenue reserves are the setting aside of profits from the normal operations of
business (undistributed profits). It can be specific such as a:
 currency fluctuation reserve

 education and training reserve.
Or general such as:
 general reserve
 retained profits (retained earnings).
Recording assets
An asset is a resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity (IFRS for SMEs
2009 Section 2.15 (a)).
Investments
Example: Sale of a short-term investment with a book value of $4 000 for $3 500 on
06 May 2015.

2015
6 May Cash 3500
Income Statement: loss on sale of short-term 500
investment
Short-term investment 4000
Sale of short-term investment
Example: Jack Company decided to sell its investment in WITCO of 3 000 shares (long-
term investment) with a book value of $12 000 for $20 000 on 01 September 2015.

2015
1 Sept. Cash 20000
Short-term investment 12000
Income statement: Gain on sale of long-term. 8000
investment
Sale of long-term investment in WITCO shares
Basket Purchase
This involves the purchase of a group of non-current assets at a special price (called
basket price) for the group below that of the sum of the individual value of the assets.
The value of each asset is prorated based on its value in relation to the value of the
basket price.
Example: Ward Co. purchased a group of non-current assets from DVAK Ltd. With a
cheque for $600 000 on 1 April 2015. The fair market values of the assets were as
follows:
Land 350000
Plant 150000
Furniture and fixtures 225000
Machinery 200000
Motor vehicle 75000
Details Fair market Prorating basket price calculation Prorated

value price of
asset
Land 350000 350000 ÷ 1000000 × 600000 210000
Plant 150000 150000 ÷ 1000000 × 600000 90000
Furniture and 225000 225000 ÷ 1000000 × 600000 135000
fixtures
Machinery 200000 200000 ÷ 1000000 × 600000 120000
Motor Vehicles 75000 75000 ÷ 1000000 × 600000 45000
Total 1000000 600000
General Journal

2015
April 1 Land 210000
Plant 90000
Furniture and fittings 135000
Machinery 120000
Motor Vehicles 45000
Cash 600000
To record basket purchase
Recording liabilities
A liability is a present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying
economic benefits. Examples of non-current liabilities include a loan/note payable from
a financial institution for more than one year, a mortgage or debenture bonds.
Example: Penco Company received proceeds of a 10 per cent note payable for $175 000
from Belmont Bank Ltd on 01 March 2015 payable in 10 years.

2015
Mar 1 Bank
10% note
payable (Belmont
Bank Ltd)
Proceeds from note
payable
Instalment/payment on loan
On 31 December 2015, the end of the financial period for Penco Company, the interest
on the l0 per cent note payable for 175 000 is to be recorded in the financial
statements of the company. Record the journal to accrue for the outstanding interest
expense.
Accrued interest: 175 000 × 10% × 10 months = $14 583

2015
31 Dec Income Statement 14583
Accrued interest 14583
To record accrued interest for 10 months
ending 31 December 2015
Internal Control Systems
These are the whole system of controls put in place by management. They are divided
into two categories:
1. accounting controls, and

2. administrative controls.
Objectives
The major objectives of internal control, as espoused by the Institute of Internal

Auditors, are to:
 ensure the accurate and reliable recording and reporting of financial information
 promote compliance with management’s policies and procedures
 safeguard the assets of the organisation from wastage, theft and fraud
 encourage the efficient use of the organisation’s resources
 promote the accomplishment of the organisation’s goals and objectives.
Principles
1. Establishment of responsibility (proper authorisation): in applying this

principle, employees selected by management must be competent, reliable and
ethical. The organisation must offer suitable salaries to attract employees that
meet these criteria. There must also be a clear assignment of responsibility and
authority to every employee.
2. Segregation of duties: there must be the segregation (separation) of duties
within the organisation in an attempt to limit fraud, theft and wastage of
resources, thereby safeguarding the assets of the organisation. Segregation of
duties should occur in two areas.
a. Separation of accounting from the other functional areas of the
business; production, marketing, human resources and research and
development. Cash is the ’life blood‘ of any organisation and accounting
departments provide independent information for management in all
areas.
b. Separation of custody of assets from the maintenance of the accounting
records. For example, the person who collects inventory when delivered
to the organisation must not be the person who maintains the receipt and
disbursement of the inventory. Or the person who prepares the purchase
order must not be the person who receives the goods and maintains
inventory balances. Accountants must not handle cash and cashiers must
not have access to accounting records.
3. Independent internal verification: this is mainly for the purpose of validation
and is done by employees of the organisation such as:
a. Managers and supervisors, on a day-to-day basis, check work done by
subordinates to ensure company policies and procedures are followed and
that the organisation’s goals and objectives are being met.
b. Internal auditors are employees of the organisation and usually fall under
the Finance Department but report directly to the Audit Committee of
the Board of Directors. Their main responsibility is to ensure that
employees comply with policies and procedures. They do this by doing
regular or spot (surprise) checks on employees anywhere in the
organisation. These checks need not be of an accounting nature but in
relation to any functional area of business. Therefore, internal auditors
need not possess accounting qualifications but the technical skills in the
area they are auditing.
c. External auditors are independent to the company and are hired to
express an opinion as to whether the financial statements agree with
General Accepted Accounting Principles (GAAP) of the jurisdiction. Both
types of auditors do not only identify errors but make helpful
suggestions for improvement to the organisation’s systems.
4. Documents procedures or documentation: all documents used in the
organisation in relation to the use of its assets such as cash, inventory or any
other resource should be pre-numbered. This will make it a lot easier to account
for gaps and to clearly assign responsibility for the missing documents. It is also
useful for recording the documents, as the numbers can serve as references.
5. Physical, mechanical and electronic controls: with the advances in technology
there is a dwindling difference between these three groups. This is why they
are grouped together. They include such things as:
a. Physical walls and fences at the workplace.
b. Locks on gates, doors, drawers and having safes to restrict access by
unauthorised personnel.
c. Security guards, fi reproof cabinets and vaults, and safety deposit boxes.
d. Cameras for monitoring the movement of customers and employees.
e. Sensors attached to products to deter theft. The sensor usually sounds
an alarm if it is removed by an unauthorised person.
f. Various levels of access via passwords into offices and using computer
software, including smart cards for different levels of employees.
g. Point of sale terminals for use by credit and debit cards to reduce the
amount of cash held on the organisation’s premises, minimising losses
should cash be stolen.
6. Other controls include the following:
a. Fidelity bond (insurance): this is an insurance policy taken out by the
company against the theft of cash by the organisation’s employees which
allows for reimbursement of any losses.
b. Job rotation: allowing employees to function in other areas of the
organisation from time to time.
c. Mandatory vacation: demand that employees take annual vacation leave.
Internal control procedures can be applied to the main areas of business:
- Cash is one asset that is easily converted into other types of assets. It is easily
hidden and have no mark of ownership. It is therefore highly susceptible to
improper use and misappropriation. To safeguard cash, effective internal control
are very important.
o Receipts
 Only designated persons such as cashier and cashier department
individuals should be authorized to handle/have access to cash
receipts.
 There should be different persons assigned to the duties of
receiving cash, recording the cash receipt transaction and having
custody of the cash
 There should be documents to give evidence to the receipt of
cash. Evidence such as cash receipts, cash register tapes and
deposit slips from the bank.
o Disbursements
 Only designated persons such as the accountant, financial
controller or senior administrative staff should be authorized to
sign a cheque.
 Persons from different departments should be assigned duties of
approving an item for payment and making the payment.
 Pre-numbered cheques should be used. Cheques should be used in
sequence and all cheques accounted for.
 Before cheques are signed, supporting documentation such as
approved invoices should be presented to the cheque signer.
- Inventory- in many firms, stock is one of the most accessible assets. This makes
it a prime target for thieves. In addition, the percentage of inventory shrinkage
is quite high, with shoplifting by customers and embezzlement. Therefore, the
business must look at ways of protecting inventory from shoplifters ad
dishonest persons. To achieve this, the business can:
o Have an alert employee at the Point of Sale
o Use sensitized tags on merchandize that if not detected/neutralised by a
sales clerk will trigger an alarm
o Use surveillance cameras
o Scrutinize employees
o Limit access to store rooms and use physical controls such as locks and
vaults to secure inventory.
- Accounts Receivables
o The person who keeps the account receivable subsidiary ledger should
not have access to cash.
o The person who handles cash receipts should not issue credit notes.
o The person who handles cash receipts should not have the authority to
write off bad debts.
- Accounts Payables
o The person who keep a/c payable subsidiary ledger should not sign
cheques
o The person who signs the cheque should not receive goods or sign good
received notes
o The person who signs the cheque should not initiate purchase requisition.
o On a monthly basis, the individual accounts payable should be reconciled
with the supplier’s statement and the total compared with the general
ledger balances.
- Electronic Document Preparation Environment
o When a system is computerized, it must be properly documented. One of
the requirements of good internal control in the EDP environment is that
procedures for handling a transaction should be recorded. This is done by
using flow charts. It is important to ensure that document which passes
from one individual to another for approval does not return to a former
individual and also that there is little chance of figures for information
being changed on a document that has already been approved. To prevent
unauthorized access, the system will require that password being entered
and personal questions correctly answered before access to the system is
allowed.
o It is suggested that the password should be changed frequently and that
they should not be shared/disclosed to friend/ workers
o Security issues- control must be in place in the computer to prevent
unauthorized or intentional tampering with the programs.
o Disaster recovery – in the case, the computer hardware or software
breaks down it must be possible to construct and recover the data.
Auditors
- A N AUDITOR IS SOMEONE WHO EVALUATES THE EFFECTIVENESS OF THE COMPANY’ S SYSTEM INTERNAL
CONTROLS.
- The presence of internal and external auditors both lends credibility to figures
which appears on the financial statements.
Internal Auditor External Auditor

How appointed? By management By directors
Who do they report to? Board of Directors Shareholders
Relationship with the Employee Independent to
business management & board
of directors
What rules do they Responsibilities decided by Responsibilities fixed
follow? management by company law or by
any other regulation
governing the type of
business. E.g. Banking
Act
Scope of the work Consider whatever financial and Express an opinion on
covered operational issue management the fair
determines i.e. accounting representation of
efficiency & effectiveness financial statements
What type of report is Letter highlighting weakness and Standard format
presented strengths and making
recommendations for improving
area of weakness
How often is report As often as possible or as At the end of the
issued necessary fiscal period (once a
year)
Qualification/Education Experience in the type of business. Must be an
Need to be an accountant . BSc in accountant holding a
Business profession
Administration/Accounting/Finance designation i.e. CPA,
ACCA, CMA, CGA, CA
Types of Audits
- Operations Audit- is a review of any part of an entity’s operating procedures

and methods for the purpose of evaluating efficiency and effectiveness. In an
operational audit, the reviews are not only of an accounting nature but extended
to areas such as organisational structure, computer operation, production
methods and marketing. The purpose of this audit is to examine with a view of
improving the performance of an operation.
- Compliance Audit- this is to determine whether the entity is following specific
procedures/rules set out by higher authority.
- Audit of Financial Statement- is an examination of the transaction and financial
statement to determine whether the over financial statement are in accordance
with the GAAP. This audit includes test of accounting record, test of internal
control system and other audit procedures as being necessary.
Audit Committee
Is a committee of the board of directors that oversee the internal accounting control,
financial statements and financial affairs of the organisation. The committee provides
contact and communication among the board, the internal auditor, operating and
financial executives. The committee is typically composed of members inside and
outside the committee.
Module 2
Forms of Business Organisations
Sole Traders
 A business owned and operated by one individual.

 Simplicity of formation (has few to no legal requirements)
 The owner is control of the business
 Requires little start-up capital
 The owner and the business (the same legal entity)
 Lack of continuity (if owner dies or backs out, the business is done)
 The owner may gain capital from personal savings, family and friends.
 It is difficult to acquire loans because of the risks involved or lack of collateral.
 Capital is composed of capital and profit (or subtract losses)
Advantages Disadvantages
Simplicity of formation (has Unlimited Liability for owner
few to no legal requirements)
Quick Decision Making Lack of Continuity
The owner enjoys all profits Great demand on the owner’s
time and attention
Can be suitable where capital is
scarce
Partnerships
 Is defined as a business where two to twenty people work together towards a

common goal of making profits.
 Must register its trading name.
 Governed by the agreement that was drafted at its outset, known as a
partnership deed. This is a legal document which amounts to a binding contract
among the partners. The document stipulates how profits or losses should be
shared; the rights of each partner; rules for taking in new partners and
dissolution of the partnership; and the capital to be contributed by each
partner, among other things.
 If a partnership deed is not drafted up, the partnership is governed by
Partnership 1890 and 1907. The 1890 act stipulates that: al profits/losses
should be shared equally, each partner may take part in the management of the
business, no partner should receive a salary for working in the business and no
partner is entitled to any interest on his/her capital. The 1907 Act further
states that:
 A limited partnership shall not consist of more than 20 people, called
“general partners,” who shall be liable for all debts and obligations of the
firm, one or more people to be called “Limited partners”
 A limited partner shall not, during the continuance of the partnership, either
directly or indirectly, draw out or receive any part of his contribution
 A limited partner shall not take part in the management of the business, and
shall not have the power to bind the firm.
 Sleeping Partner is a partner that invests in the business but does not want to
participate in the day-to-day operations.
 Profit and losses are shared
 Capital is composed of Partner’s Capital + Current Accounts Balances
 No separation between business and partners.
Easy to form as there are few or no Partners have unlimited liability (except limited
legal requirements partner)
Each partner contributes to the Slow and tedious decision making
capital of the business
Responsibilities shared among Likeliness of conflict among partners
partners
Division of labour (specialised skills) Lack of continuity (one a partner leaves the
partnership it has to be dissolved)
Privacy of affairs (not compulsory to
publish accounts)
Limited Liability Companies
 This is a business unit that is regarded by law as an artificial person, distinct

and separate from its members, i.e. its owners.
 There are certain legal requirements that must be met before a company is
incorporated and starts trading. These are stipulated in a Companies Act. Two
documents must be drawn up: a memorandum of association and articles of
association. In Jamaica, under the Companies Act 2004, the articles of
incorporation include these two documents.
 The Act also stipulates that ‘One or more people may form acompany by signing
and sending articles of incorporation to the Registrar’. In some other countries,
however, individuals who want to form a company must submit both documents to
the Companies Office.
 The memorandum of association should outline:
 The name of the company, including the abbreviation
 ‘Ltd’ or ‘plc’
 The address of the registered office of the company
 The objects of the company and the scope of its operations
 Details of the company’s capital, i.e. both authorised and issued share
capital.
 This list is not exhaustive, as other clauses may be included, depending on the
type of company. The articles of association outline the internal running of the
company and should include:
 The number of directors, the procedures for their appointment and their
powers
 The rights of the shareholders
 Procedures for meetings
 Tenure of the directors before re-election
 The process for transferring shares
 A company’s main source of finance is from the shares that it issues (equity
capital). However, the company may also be financed by debt capital (loans). The
shares are issued to shareholders who become the owners of the company upon
purchase. The number of shares will determine the level of control of each
shareholder. Shareholders may not necessarily be the managers of the company,
but at an annual general meeting (AGM) may vote for directors to carry out that
role. These directors sit on a board which is headed by a chairperson. The board of
directors is accountable to the shareholders and may be dismissed or voted out if
its performance is below par. The company also has a secretary, who is entrusted
with the responsibility of maintaining a register of shareholders, notifying them of
AGMs and preparing the company’s annual reports.
 Capital= Ordinary shares (par or no-par value) + Preference shares (par or no-par
value) + Share premium + Reserves
Private Limited Company
 This is an incorporated business venture which is separate and distinct from its
owners that is owned by private individuals.
 Usually small in size and family owned
 The name of the company must be registered
 Shares cannot be traded on the stock exchange
 Shareholders cannot sell their shares without the
 agreement of the other shareholders
 Limited liability
 Involve two to fifty people.
Each shareholder has limited Raising of capital may be hampered since shares
liability cannot be traded publicly
Continuity of existence Profits have to be shared among a larger group of
people
There is a greater capital A copy of the audited financial statement must be
potential, as shares can be submitted to the Companies Office (so a lesser degree
sold to family members of privacy than for partnerships and sole traders)
Lower possibility of loss of Transfer of shares is limited by the approval of
control to outsiders existing members
The company has a legal Legal requirements may be time consuming and costly
identity separate from that to implement.
of its owners
Public Limited Company

 A public limited company is the legal status of any firm which has offered shares to
members of the general public and in turn owns a limited amount of its own shares.
 May be listed on the country’s stock exchange, where capital is raised.
 Company may advertise its shares to prospective investors in a document called a
prospectus.
 Managed by a board of directors elected by shareholders.
Shareholders have limited liability Many legal requirements which are costly and
time consuming to implement.
Continuity of Existence Higher risk of takeover bids as shares can be
easily purchased on the stock exchange
Easier to raise capital Public accounts can be view publicly, including
competitors
Freedom to transfer shares via the Can become large, impersonal and difficult to
stock exchange manage
Benefits from economies of scale due
to size and lower production costs
Better credit rating, easier to secure
loans
Cooperatives
 A form of business that consists of a group of people who have come together to
perform a business venture that is more efficient being done collectively rather
than individually.
 This form of business is expected to be registered with a Registrar of Cooperative
Societies. It is owned and controlled by its members, who exercise their control by
using their votes at annual general meetings.
 The business is financed by the members who purchase shares. They may seek
funding from banks and other lending institutions.
 Shares cannot be transferred.
 Activities are regulated by the Co-operatives Act
 Some cooperatives may have tax exemption; others may have to pay corporation tax
 The capital is composed of: ordinary shares, reserves and undistributed surplus
while members receives dividends and patronage refund.
 Democratic- each member has a say.
 Profits are distributed equally.
 Each member has one vote.
 Membership is voluntary.
 There are many types of cooperatives:
 Consumer cooperative
 Producer cooperative
 Workers’ cooperative
 Financial cooperative
Members have limited liability Profits may be minimal or even non-
existent
Profit is shared among members There is a possibility of conflict among
members
Members have equal say in the operation of Longer decision making
the business
Economies of scale Capital deficiency might impede growth
Public Sector Organisations includes businesses that are owned and controlled by the
government or local authorities of a country. The main purpose of these businesses is
to provide some form of benefit to society and not to make profits.
Public Corporations
 Are owned and controlled by the government.

 They are usually formed by an Act of Parliament as a separate legal entity.
 The capital outlay and financing for these corporations come from government
funds acquired mainly through taxation.
 Unlike private sector organisations, public corporations are not aimed at making
profits but rather at providing an efficient public service at the lowest possible
price.
 Funding comes mostly from grants
 Annual accounting records are sent to the Auditor General
 Managed by directors appointed by the state.
 Public corporations are controlled by a Minister of Government who will appoint a
board of directors to deal with the day-to-day operations.
 The business has unlimited liability and the state has to bear its debts.
 State corporations are often found in areas of transportation, telecommunication,
postal services and utilities companies, e.g. electricity and water.
Financed by the government Might be inefficient
Loss-making firms may still be kept functional if Little incentive to be efficient as
the benefit to society is greater than cost of the state provides the funding
production
Prices tend to be low Members of the Board may be
politically affiliated
qThey provide services not offered by profit- There may be too much
maximising organisations government interference
Resources of the state are used for the economy
as a whole
Nationalised Industries
 Are enterprises that have been taken over by the government from private-sector
organisations.
 In order to nationalise an industry, the government will purchase the majority of
the company’s shares.
 The government will then appoint a board of directors which will deal with the
management of the company.
They provide services not offered by Government interference
profit-maximising organisations
Natural monopolies- may be efficient for There is no need to be efficient since
one firm to provide the service and reap government will cover losses
the benefits of economies of scale
Advanced technology- a firm in the There is no competition so little is done
private sector may not take the risk to for research and development
purchase the technology which would be
expensive
Strategic industries might be controlled The government wants and the firm’s
by the state to ensure supply of output objectives may conflict each other
even during war
Employment
Statutory Boards
 These are controlled by the state but operate with a board of directors partially
appointed by central government.
 Each board is answerable to a particular ministry in the government.
 Each entity is given specific responsibility for some aspect of the country.
Government Departments
 These are divisions or ministries of the government that facilitate interaction

with local authorities and nationalised industries.
 Each department is headed by a Minister who is appointed by the Prime
Minister. These departments are created to carry out various services, such as:
 Implementation of government policies
 Monitoring operations within the country and ensuring that there is
compliance with the law
 Performing the duties and responsibilities stipulated by the state.
 These departments are non-profit organisations and are funded from the tax
revenue of the country – for example, the Auditor General’s Department.
Local Authority and Municipal Undertakings
 This type of public-sector organisation deals with the affairs of government at the
local or community level.
 The functions, powers and duties of local authorities are determined by an Act of
Parliament.
 Local authorities are controlled and managed by councillors who are elected by the
local citizens. These councillors form the council which is headed by a mayor.
 They make and implement policy decisions on the management of the town or city.
Some of their responsibilities include:
 Construction and maintenance of drains
 Cleaning of gullies
 Garbage disposal
 Water supply
 Maintenance of parks and markets.
 Local authorities and municipal undertakings are financed by grants from central
government, rents, council taxes, business rates and trading activities.
Non-profit organisations
- Run by a group of private individuals or groups of organisations

- Separate legal entity
- Its motive for operating is to help people
- Ownership cannot be transferred
- The business is continuous since the firm has separate legal entity
- Operations managed by a board of directors
- Investments made by partners is how this organisation acquires capital
- Rules relating to the Partnership Act
- Each partner pays personal income tax
- The equity/capital is composed of accumulated fund and surpluses
- Members do not receive dividends. The income is used to further enhance the
organisation’s objectives.
Statement of Comprehensive Income Preparation
Revenues
These are the gross inflow of economic benefits during the period arising in the course
of ordinary activities of an entity. Revenue does involve the sale of shares or the sale
of non-current assets will not be considered revenue. The revenue is measured at the
fair value of the consideration received or receivable.
The conditions to be satisfied for recognising revenue are as follows:
 Significant risks and rewards of ownership of the goods transferred to the

buyer.
 Neither continual managerial involvement nor effective control over the goods
sold by the seller.
 Revenue can be measured reliably.
 Economic benefits associated with the transaction will fl ow to the entity.
 The costs incurred or to be incurred in respect of the transaction can be
measured reliably.
The four main categories of revenue are:
1. Sale of goods
2. Rendering of services
3. Franchise fees
4. Interest, royalties and dividends earned.
Revenue for the sale of goods format:
Sales XXXX
Less: Sales returns and allowances (XXXX)
Less: Sales discounts (XXXX)
Revenue (Turnover/net sales) XXXX
Inventories
Inventories are assets:
held for sale in the ordinary course of business
in the process of production for such sale, or

in the form of materials or supplies to be consumed in the production process or in the
rendering of services.
The cost of inventories shall include all costs of purchase, costs of conversion and
other costs incurred in bringing the inventories to their present location and condition.
Inventory valuation methods are as follows:
1. Specific identification
2. FIFO
3. LIFO (not an acceptable format for IAS 2 (IFRS for SMEs Section 13)
4. Weighted average
a. × 𝑇𝑜𝑡𝑎𝑙 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑢𝑛𝑖𝑡𝑠
The lower of cost and net realisable value (NRV)
An entity shall measure inventories at the lower of cost and NRV; that is, the
estimated selling price less costs to complete and sell. The cost to complete and sell
includes all further costs to completion and the costs that would be incurred in
marketing, selling and distribution of the inventory.
Note Briefly
When inventories are sold Record as expense in the period in which
related revenue is recognised
Goods on consignment Seller is the owner
Goods FOB- shipping point Buyer is the owner while in transit
Goods FOB- destination Seller is the owner while in transit
Statement of Comprehensive Income for a Partnership/Sole Trader
Sales xxx
Less Return Inwards (xxx)
Net Sales xxx
Less Cost of Goods Sold

Opening Inventory x
Add: Purchases x
Add: Carriage Inwards x
xxx
Less: Return Outwards x
xx
Less Closing Inventory x xx
Gross Profit xxx
Less Expenses
Bad debts (written off) x
Wages and salaries x
Rates x
Insurance x
Rent x
General expenses x
Postage x
Stationery x
Carriage outwards x
Discounts allowed x
Heating x
Electricity x
Depreciation x
Increase in provision for doubtful debts x xx
xxx
Add Revenue/Income
Discounts + Interests received x
Reduction in provision for bad debts x xx
Net Profit xxx
Profit and Loss Appropriation Account

$ $ $
Net Profit xxx
Add Interest on Drawings
A x
B x xx
xxx
Less Interest on capital
A x
B x xx
Salary
A x x (xxx)
xxx
Share of Profits
A xx
B xx
xxx
Cost Total Net Book

Depreciation Value
Non-current assets
Premises x x x
Motor Vehicle x x x
Furniture x x x
Office Equipment x x x
Machinery x x x
xx xx xx
Current assets
Inventory (closing) x
Accounts receivable (Less: Provision for x
doubtful debts)
Prepayment x
Cash at bank x
Cash in hand x xx
Less Current liabilities
Accounts payable x
Expenses owing x
Bank overdraft x xx
Net Current Assets xx
xx
Less Non-Current liabilities
Long-term loan x
Net Assets xxx
Financed by
Capital xxx
Add Profit xx
xxx
Less Drawings xx
xxx
$ $ $
Financed by:
Capital Accounts A B Total
Balance xx xx xxx
Current Accounts
Balance b/d xx xx
Add Share of profit x x
Salary- A x -
Interest on capital x x
xx xx
Less Drawings (x) (x)
Interest on drawings (x) (x)
xx xx
xxx
xxxx
COMPANIES
Statement of Comprehensive Income
$ $ $
Sales xxx
Less Returns Inwards x
xxx
Less Cost of Goods Sold
Opening inventory xxx
Add: Purchases xxx
Add: Carriage Inwards xx
xxx
Less: Returns Inwards xx xxx
xxx
Less: Closing Inventory xx (xxx)
Gross Profit xxx
Less Expenses:
Salaries and wages xx
Directors’ remuneration xx
General expenses xx
Rates and insurance xx
Motor expenses xx
Debenture interest xx
Bad debts written off xx
Depreciation: Motors xx
Equipment xx (xxx)
Net Profit xxx
Add Retained profits b/f from last year xxx
xxx
Less Appropriations:
Transfers to general reserve xx
Interim dividends paid:
Preference shares xx
Ordinary shares xx
Final dividends paid:
Preference shares xx
Ordinary shares xx (xxx)
Retained Profits c/f to next year xxx
Cost Total NBV

Depreciation
$ $ $
Plant, property and equipment
Goodwill xxx x xx
Buildings xxx x xxx
Equipment/Machinery xxx x xxx
xxx xx xxx
Current assets
Inventory xx
Accounts receivable xx
Bank xx
Cash xx xxx
Less Current liabilities
Accounts payable xx
Bank overdraft xx
Dividends owing xx
Debenture interest owing xx xxx
Net Current Assets xxx
Total assets less current liabilities xxx
Less Non-Current Liabilities
Debentures xx
xxx
Financed by:
Share capital Authorized Issued
Preference shares xxx xxx
Ordinary shares xxx xxx
xxx xxx
Reserves
Share Premium xxx
General reserve xxx
Profit and loss xxx xxx
xxx
Preparation of Financial Statement from Incomplete Records

Control Accounts
Control accounts are type of trial balance for each ledger that assist in locating errors
in the books especially in large businesses.
There are two types:
Sales Ledger Control Account

Purchases Ledger Control Account
Advantages of control accounts
 Location of error – By preparing control accounts, any arithmetical errors that

may have occurred are identified. Also, if a clerk has inadvertently omitted
entering an invoice or payment in the personal accounts, these too would be
identified since the control account acts as a mini trial balance. However, it
must be pointed out that there are other errors that may still be contained in
the ledgers such as mis postings or compensating errors.
 Prevention of fraud – Normally the control accounts are under the supervision of
a senior member of the accounting team or accounts manager. This makes fraud
more difficult since any transaction entered into a ledger account must also be
included in the control account, and since a different member of staff would be
responsible for maintaining the ledgers from the member supervising the control
account, it would be more difficult to carry out fraudulent transactions.
Therefore the supervisor or manager provides an internal check on the
procedures.
 Information for management – For management purposes, the balances on the

control accounts can always be taken to equal accounts receivable and accounts
payable without waiting for an extraction of individual balances. Management
control is thereby aided because the speed at which information is obtained is
one of the prerequisites of efficient control.
Statement of Affairs
When records of transactions are insufficient to enable a income statement to be
prepared, the profit or loss of a business for a given period may be calculated if the
assets and liabilities of the business at both the start and end of the period are know.
This is based on two principles:
1. The accounting equation = capital = assets – liabilities

2. Profit increases capital: losses reduce capital
The difference between the opening and closing capitals, after making adjustments for
new capital introduced and the owner’s drawings in the period, will reveal the profit or
loss. Capital is calculated by listing the assets and liabilities in a statement of affairs.
Statement of Affairs is a statement of assets and liabilities prepared to ascertain the

amount of change in the capital.
Receipts and Payments Account (basically the cashbook)
Correction of errors
Errors that do not affect the trial balance.
1. errors of commission – where a correct amount is entered, but in the wrong

person’s account
Example 1: D. Long paid us $50 by cheque on 18 May 2017. The transaction is
correctly entered in the cash book, but it was entered by mistake in the account
for T. Lee. This means that there had been both a debit of $50 and a credit of
$50. It has appeared in the personal account as:
2. Errors of principle – where an item is entered in the wrong type of account, for
example a non-current asset entered in an expense account.
Example 2: The purchase of a motor car for $5,500 by cheque on 14 May 2017
has been debited in error to a motor expenses account. In the cash book it is
shown correctly. This means that there has been both a debit of $5,500 and a
credit of $5,500.
3. errors of original entry – where an item is entered, but both debit and credit
entries are of the same incorrect amount
Example 3: Sales of $150 to T. Marley on 13 May 2017 have been entered as
both a debit and a credit of $130. The accounts would appear thus:
4. Errors of omission – where a transaction is completely omitted from the books.
We purchased goods from C. Richards for $250 on 13 May 2017 but did not
enter the transaction in the accounts. So there were nil debits and nil credits.
We found the error on 31 May 2017. The entries to correct it will be thus:
5. Compensating errors – where two errors of equal amounts but on opposite sides
of the accounts cancel out each other.
Let us take a case where incorrect totals had purchases of $7,900 and sales of
$9,900. The purchases day book adds up to be $100 too much. In the same
period, the sales day book also adds up to be $100 too much.
6. complete reversal of entries – where the correct amounts are entered in the
correct accounts, but each item is shown on the wrong side of each account.
We pay a cheque for $200 on 28 May 2017 to D. Charles. We enter it as follows
in accounts with the letter (A). There has, therefore, been both a debit and a
credit of $200.
Bank Reconciliation
A bank reconciliation statement reveals the correct balance on a bank account. The
statement ensures that the correct balance is shown in the statement of financial
position. Usually, for effective internal controls in a business, the reconciliation is
prepared by somebody other than the cashier, to minimise fraud or stealing of funds.
Bank reconciliation identifies the reasons why the bank account’s (in the cash book)
ending balance does not agree with the bank statement ending balance.
The reasons are:
1. Errors made by the firm and items not recorded in the bank account.
Process: use these items to update the bank account. Start with bringing down
the balance carried (opposite side of the account).
Examples include:
a. bank charges (Cr)
b. standing orders (Cr)
c. direct debit (Cr)
d. direct credit (Dr)
e. NSF cheques (Cr)
2. Errors made by the bank and items not recorded in the bank statement.
Process: use these to prepare the bank reconciliation statement
Examples include:
a. bank lodgments or unrecorded deposits
b. unpresented cheques
Steps to follow when preparing a bank reconciliation statement
1. Compare the entries in the cash book with bank statements. Tick items that
appear in both the cash book and the bank statement.
2. Enter in the cash book any items that remain unticked in the bank statements.
Calculate the new cash book balance.
3. Prepare the reconciliation statement. Begin with the final balance in the new
cash book and adjust it for any items that remain unticked in the cash book. The
result should equal the balance on the bank statement.
Dishonoured Cheques
Income and Expenditure Accounts

Non-profit organisations exist to provide facilities for their members. Examples are:
sports and social clubs, dramatic societies, music clubs, etc. Making a profit is not their
main purpose, although many carry-on fund-raising activities to provide more or better
facilities for the members. The organisation is ‘owned’ by all of its members and not by
just one person or partnership. Records of money received and spent are usually kept
by a club member who is not a trained bookkeeper or accountant.
Special features of non-profits

- An Income and Expenditure account takes the place of the profit and loss
account
- The words surplus of income over expenditure are used in place of ‘net profit’
- The words excess of expenditure over income are used in place of ‘net loss’.
- The term accumulated fund is used in place of ‘capital account’.
Subscriptions
The amount credited to the Income and Expenditure Account should be equal to the
annual subscription per member multiplied by the number of members. Subscriptions in
arrears and subscriptions in advance should normally be treated as accruals and
prepayments. However, each club has its own policy for treating subscriptions in
arrears or in advance. The two possible policies are as follows:
- Cash Basis—the amount received in the year is credited to the Income and
Expenditure Account. This may include subscriptions for a previous year or paid
in advance for the next year.
- Accrual Basis- all subscriptions due for the year, including those not received
yet are credited to the Income and Expenditure Account. It will usually be the
club’s policy to write off, as bad debts, subscriptions that are not received in
the year after they were due.
Life Subscriptions and entry fees
These are received as lump sums but should not be credited in full to the Income and
Expenditure Account when received. The club should have a policy of spreading this
income over a period of, say, five years. The amounts received should be credited to
the Deferred Income Account and Income and Expenditure Account in equal annual
instalments over a period determined by the club committee.
Donations
Donations and legacies to a club are usually made for particular purposes, for example
towards the cost of a new pavilion or a piece of equipment. Such donations should be
credited to an account opened for the purpose, and expenditure on it debited to the
account. Money received for special purposes should be placed in a separate bank
account to ensure that it is not spent on other things.
Ancillary activities
These are incidental to a club’s main purpose. They raise money to supplement income
from subscriptions. If the involve some sort of trading, a trading account should be
prepared for them as apart of the annual accounts, and the profit or loss should be
transferred to the Income and Expenditure Account.
Non trading activities, such as socials, outings and dinner-dances, may be dealt with in
the IEA with the income and costs being group together.
Accounting for Changes in Partnership
Admission
Acquiring interest of
Investing Activities
partner (payment
(payment recorded)
unrecorded)
Bonus Method Goodwill Method
Recorded Not Recorded
Reasons for Admission of Partners
 For additional funds/resources

 For expansion/reduction of operations
 To inherit a large customer based operations
 To share risks
 To share decision-making
Admission by Interest Acquisition (direct payment to partners not recorded)
1. Calculate the interest acquired by each partner
2. Record the interest acquired (by the journal)
3. Adjust the balance sheet
NB. Amount actually paid not shown on the books
Example: C&H are in partnership sharing profit and losses in the ratio 2:3 respectively.
Capital balances are:
C- $50000
H- $75000
D has approached C to purchase 25% of interest for 25000. Record the admission of D
into the partnership.
C’s Capital (25% of 50000) 12 500

D’s Capital (25% of 50000) 12500
Admission of D into partnership by
purchasing 25% interest from C
CHD
Balance Sheet Extracted
Financed By:
C Capital 37500
H Capital 75000
D Capital 12500 125000
Example 2: John and James are in partnership. Their capital are as follows:
John $40000
James $60000
Jones is interested in joining the partnership and made direct payment of 20000 to
each partnership for 25% of their interest.
General Journal

John’s Capital (25% * 40000) 10000
James’s Capital (25% of 60000) 15000
Jones’ Capital (25%(60000) (40000)) 25000
Admission of Jones into partnership by
purchasing 25% interest from John &
James
John, James & Jones

Balance Sheet Extracted
Financed By:
John Capital 30000
James Capital 45000
Jones Capital 25000 100000
Goodwill Method
To Calculate Goodwill: Market Value – Book Value
Reason for not recording goodwill
1. Value may change with business condition.

2. Valuation was negotiated or derived from a formula.
3. No charge to reduce profit.
4. Opinion divided on its amortization.
N.B. Payment with goodwill not recorded (the effect on goodwill only reflected in the
capital a/c)
Goodwill Method
Recorded
Salt and Peppa are in partnership sharing profit and loss 6:4. Their balances are as
follows:
- Fixed Assets- 13000

- Current Assets- 145000
- Liabilities- 80000
- Salt’s Capital- 120000
- Peppa’s Capital- 80000
Onion acquired 20% interest in capital for 70000 in cash. Prepare the journal entry to
record the admission of Onion under the goodwill method being recorded. Show the
balance sheet of the new partner.
1. Capital invested by new partner is recorded

Cash 70000
Onion’s Capital 70000
Admission of a new partner
2. Calculate the implied capital of the business

Capital Implied = 70000 * (100/20) = 350000
3. Calculate the book value of capital after admission of the new partner(s)
120000 + 80000 + 70000 = 270000
4. Calculate goodwill
350000-270000 = 80000
5. Record goodwill

Goodwill 80000
Salt’s Capital (6/10 * 80000) 48000
Peppa Capital (4/10 * 80000) 32000
Goodwill distributed between existing
partners
$ $ $
Fixed Assets 135000
Add: Goodwill 80000 215000
Current Assets 145000

Cash (Invested by Onion) 70000
215000
Less: Current Liabilities 80000
Working Capital 135000
Net Assets 340000
Financed by:
Salt Capital 168000
Pepper Capital 112000
Onion Capital 70000
350000
Not recorded
Ram and Jam are in partnership sharing profit/loss in the ratio 6:4 respectively. After
admitting Singh, the ratio changed to 5:3:2 respectively. Singh introduced capital of
38000 of which 16000 was for goodwill. If Ram’s 36000 and Jam’s 32000.
Steps:
1.
Cash 38000
Singh’s Capital (25%(60000) (40000)) 38000
Cash invested in the business by Singh
2. Calculate value of Goodwill= (10/2) * 16000 = $80000

3. Distribute Goodwill in the old profit sharing ratio:
a. Ram = 80000 * (6/10) = $48000
b. Jam = 80000 * (4/10) = $32000

Goodwill 80000
Ram Capital 48000
Jam Capital 32000
Distribution of goodwill to existing partners
4. Redistribute Goodwill in the new profit sharing ratio

Ram’s Capital 40000
Jam Capital 24000
Singh Capital 16000
Goodwill 80000
Distribution of goodwill in news partners ratio
Capital a/c
Date Details Jam Ram Singh Date Details Jam Ram Singh
Goodwill 40000 24000 16000 Balance b/f 36000 32000
Balance 44000 40000 22000 Cash 38000
c/d
Goodwill 48000 32000 -
84000 64000 38000 84000 64000 38000
Balance b/d 44000 40000 22000
$
Ram’s Capital 48000 Ram’s Capital 40000
Jam’s Capital 32000 Jam’s Capital 24000
Singh’s Capital 16000
80000 80000
Change in Profit Sharing Ratio
On January 1, 2002 C, M, P are in partnership with capital $160000, $90000 and

$60000 respectively. The agreement states that C, M and P share profit and losses in
the ratio 40:30:30. The partner amend their partnership to read effectively April 1,
2002 the profit & loss will be 45:30:25 respectively. The net income for the partners
was $100000. Calculate the profit & loss for each partner for Dec 31, 2002.
C M P
Share of Profit (Jan-Mar)- 3/12 *100000= 25000 10000 7500 7500
Share of Profit (Apr-Dec)- 9/12*100000 = 75000 33750 22500 18750
Total income earned by partner 43750 30000 26250
Retirement of Partners
Partners Cynthia, Val and Pam has capital balances $60000, 75000 and $30000
respectively. All assets are valued freely. They share profit and loss in the ratio 5:3:2.
Pam decides to retire from the partnership. Prepare the journal to record Pam’s
withdrawal under the following situation:
a. Pam sells her interest to Val for 25000

Pam’s Capital 25000
Val’s Capital 25000
Transfer of interest from Pam to Val
b. Pam sells her interest to the partnership for 25000 using the bonus method
30000 (pam capital) – 25000 (new capital) = 5000

Cynthia Capital (5/8 * 5000) 3125
Val Capital (3/8 * 5000) 1875
Cash 25000
Pam’s withdrawal from the partnership
c. Pam sells her interest to the partnership for 40000. Goodwill attributed to the
existing partners is recorded. Pam’s interest 20%.
Pam’s Goodwill = 40000-30000 = 10000
Goodwill of the company = 10000 * (100/20) = 50000

Goodwill 10000
Cash 40000
Pam’s withdrawal from partnership

Goodwill 50000
Cynthia Capital (5/10 * 50000) 25000
Val Capital (3/10 * 50000) 15000
Pam Capital (2/10 * 50000) 10000
Goodwill distributed among existing
partners
Dissolution of Partnership
This means the process during which the affairs of the partnership wound up. In this
case, all liabilities are finally settled by selling of assets in transferring them to a
particular partner, selling all accounts that existed with the partnership firm.
Reasons for Dissolution
 Bankruptcy
 Partner found guilty of misconduct
 Death of a partner
 Retirement of partner (when they are two)
Types of Dissolution of Partnership
- Non-judicial dissolution occurs when there is no need to apply to the courts for
an order. Example: when a partnership has been entered into for a fixed period
of time and the period has ended
- Judicial dissolution is when a partner applies to the courts to end partnership.
Example: when one of the partners has been found guilty of misconduct and
likely to prejudice the carrying on of the business
-
Steps in Dissolving a Partnership
1. Open a Realisation a/c to dispose of your assets. (transfer all assets except
cash and bank to realisation account a/c)
DR. Realisation a/c
CR. Assets a/c
2. Sell assets individually
DR. Cash/Bank
CR. Realisation a/c
3. Share profit/loss in the partner’s sharing ratio. If the credit side of the
realisation account is more than the debit, it is gain on realisation. The converse
is true.
Jill and James are partners and shared profits and losses equally. They agreed to
dissolve the partnership. The balance sheet book value are as follows:
Cash Balance- $250000
Non-Cash Assets- $400000
Other Liabilities- $150000
Capital Jill- $200000
Capital James- $300000
Liquidation Expense- $10000
Sale on Non-Cash Items $300000
Liabilities Settled $100000
Prepare the realisation a/c and capital a/c
Realisation a/c
Non Cash Items 400000 Non-Cash Assets 300000
Realisation Expense 10000 Liabilities 50000
Loss on realisation
Jill Capital 30000
James Capital 30000
Bank a/c
Balance b/f 250000 Liquidation Expense 10000
Non-Cash Assets 300000 Liabilities 100000
Capital Jill 170000
Capital James 270000
Liabilities a/c
Cash 100000 Balane b/d 150000
Realisation a/c 50000
Capital a/c
John James John James
Loss on realisation 30000 30000 Balance b/d 200000 300000
Cash 170000 270000
200000 300000 300000 300000
Incorporation of an Unincorporated Business
Sale (conversion) of partnership to a limited liability company (corporation)
A partnership business may be sold to a limited liability company, or the partners may
convert the business to a corporation in order to obtain the benefits as a limited
liability company (corporation). When a corporation retains the partnership books, the
assets and liabilities are adjusted to fair market values and a valuation adjustment
(realisation) account is created to accumulate the gains and losses.
Books of the buyer (that is, the limited liability company)
1. Identify all the assets and liabilities required.

2. Use the fair value for all assets and liabilities required.
3. Calculate the value of goodwill (purchase consideration less the fair value of net
assets [assets less liabilities] acquired).
4. Calculate the share premium (fair value of net assets acquired less par value of
shares issued).
Books of the seller (that is, the partnership)
1. Prepare a realisation (valuation adjustment/capital adjustment) account to

calculate the gain or loss on sale or conversion of partnership:
a. Debit all assets (at book value) sold or transferred.
b. Debit loss on assets taken over by partners.
c. Debit any dissolution expenses paid.
d. Credit all liabilities (at book value) sold or transferred.
e. Credit gain on liabilities settled by the partnership.
f. Credit the amount of the purchase consideration (amount paid for the
partnership). The purchase consideration may be a combination of cash,
loan or shares, the accounts of which must be debited.
g. The balance is shared among partners using the profit sharing ratios.
2. Make entry to record the shared loss or gain on realisation to partners’ capital
account
a. Debit: the shared loss on realisation to partners’ capital account, or
b. Credit: the shared gain on realisation to partners’ capital account
3. Make entry to record the value of assets taken over:
a. Debit: capital account with the value of any assets taken over
4. Make journal entry to transfer current accounts of the partners’ capital
accounts
a. Debit: current account with a positive/credit balance.
b. Credit: capital account of partners. (Entries will be reversed if the
balance of the current account is a negative/debit balance.)
Sale of partnership (ONLY)

1. Prepare a realisation (valuation adjustment/capital adjustment) account to
calculate the gain or loss on sale or conversion of partnership:
a. Debit all assets (at book value) sold or transferred
b. Debit loss on assets taken over by partners
c. Debit any dissolution expenses paid
d. Credit all liabilities (at book value) sold or transferred
e. Credit gain on liabilities settled by partnership
f. Credit the amount of the purchase consideration
g. The balance is shared among partners using the profi t sharing ratios
Note: All the above are the same elements of the sale or conversion of a
partnership company.
2. Make entry to record the shared loss or gain on realisation to partners’ capital
account
a. Debit the shared loss on realisation to partners’ capital account, or
b. Credit the shared gain on realisation to partners’ capital account.
Note: If any partner ends up with a debit balance, he or she must introduce
cash to close off his or her account. However, if this partner is insolvent, the
remaining solvent partners must share the debit balance in the ratio of their
fixed capitals.
3. Close off remaining partners’ capital accounts with cash.
Accounting for changes in corporations (private and public)
Module 3
Disclosure requirements relating to social and ethical issues in financial reporting
Inflation and Accounting
Current cost accounting
In current cost accounting, assets are valued at their current replacement cost rather
than at the price originally paid for them, the approach taken by historical cost
accounting. Current cost accounts are drawn up by adjusting the historical cost for
inflation and the usual adjustments such as those for depreciation. Current cost
accounting is usually used in economies with hyperinflation.
Fair value measurement
1. IFRS 13 Fair Value Measurement applies to IFRSs that require or permit fair
value measurements or disclosures and provides a single IFRS framework for
measuring fair value and requires disclosures about fair value measurement. The
standard defines fair value on the basis of an ‘exit price’ notion and uses a ‘fair
value hierarchy’, which results in a market-based, rather than entity specific,
measurement.
2. Exit price: the price that would be received on selling an asset or paid to
transfer a liability.
3. Fair value hierarchy has three levels:
a. Level 1: which is the most reliable is based on observable inputs such as
market prices for identical assets and liabilities.
b. Level 2: this is less reliable than Level 1 and is based on market prices for
similar assets and liabilities.
c. Level 3: which is the least reliable uses unobservable inputs such as
company data and assumptions.
4. Fair value as defined by the IFRS for SMEs (Section 2:34b) is the amount for
which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm’s length transaction. These include:
a. investments in non-convertible and non-puttable preference shares, and
b. non-puttable ordinary shares that are publicly traded or whose fair value
can otherwise be measured reliably, which are measured at fair value.
5. Changes in fair value are recognised in profit or loss.
IFRS for SMEs (Section 2.50)
1. For the following types of non-financial assets, this IFRS permits or requires
measurement at fair value:
a. investments in associates and joint ventures that an entity measures at
fair value
b. investment property that an entity measures at fair value
c. agricultural assets (biological assets and agricultural produce at the point
of harvest) that an entity measures at fair value less estimated costs to
sell
2. The use of the fair value hierarchy is also complied with under this IFRS.
Contingencies and Events after the end of the reporting period
IAS 37 outlines the accounting for provisions, together with contingent assets and
contingent liabilities. Provisions are measured at the best estimate (including risks and
uncertainties) of the expenditure required to settle the present obligation, and
reflects the present value of expenditures required to settle the obligation where the
time value of money is material.
Objective of IAS 37
To ensure that appropriate recognition criteria and measurement bases are applied to
these and that sufficient information is disclosed in the notes to the financial
statements to enable users to understand their nature, timing and amount.
Key principle of IAS 37

A provision should be recognised only when there is a liability, i.e. a present obligation
resulting from past events. Planned future expenditure, even where authorised by the
board of directors or equivalent governing body, is excluded from recognition.
Provisions
1. A liability of uncertain timing or amount. An entity must recognise a provision if,

and only if a present obligation (legal or constructive) has arisen as a result of a
past event (the obligating event), payment is:
a. probable (‘more likely than not’), and
b. the amount can be estimated reliably.
2. An obligating event is an event that creates a legal or constructive obligation
and, therefore, results in an entity having no realistic alternative but to settle
the obligation. [IAS 37.10] A constructive obligation arises if past practice
creates a valid expectation on the part of a third party, for example, a retail
store that has a long-standing policy of allowing customers to return
merchandise within, say, a 30-day period. [IAS 37.10] The amount recognised as
a provision should be the best estimate of the expenditure required to settle
the present obligation at the balance sheet date.
3. Provisions for one-off events (restructuring, environmental clean-up, settlement
of a lawsuit) are measured at the most likely amount. [IAS 37.40] Provisions for
large populations of events (warranties, customer refunds) are measured at a
probability-weighted expected value. [IAS 37.39]
4. Both measurements are at discounted present value using a pre-tax discount
rate that reflects the current market assessments of the time value of money
and the risks specific to the liability. [IAS 37.45 and 37.47] In reaching its
best estimate, the entity should take into account the risks and uncertainties
that surround the underlying events. [IAS 37.42]
5. If some or all of the expenditure required to settle a provision is expected to
be reimbursed by another party, the reimbursement should be recognised as a
separate asset, and not as a reduction of the required provision, when, and only
when, it is virtually certain that reimbursement will be received if the entity
settles the obligation. The amount recognised should not exceed the amount of
the provision. [IAS 37.53]
6. In rare cases, for example in a lawsuit, it may not be clear whether an entity has
a present obligation. In those cases, a past event is deemed to give rise to a
present obligation if, taking account of all available evidence, it is more likely
than not that a present obligation exists at the balance sheet date. A provision
should be recognised for that present obligation if the other recognition
criteria described above are met. If it is more likely than not that no present
obligation exists, the entity should disclose a contingent liability, unless the
possibility of an outflow of resources is remote. [IAS37.15]
7. In measuring a provision consider future events as follows:
a. Forecast reasonable changes in applying existing technology. [IAS 37.49]
b. Ignore possible gains on sale of assets. [IAS 37.51]
c. Consider changes in legislation only if virtually certain to be enacted.
[IAS 37.50]
d. Remeasurement of provisions. [IAS 37.59]
Use of provisions
Provisions should only be used for the purpose for which they were originally
recognised. They should be reviewed at each balance sheet date and adjusted to
reflect the current best estimate. If it is no longer probable that an outflow of
resources will be required to settle the obligation, the provision should be reversed.
[IAS 37.61]
Disclosures for provisions
1. Reconciliation for each class of provision: [IAS 37.84]

a. opening balance additions used (amounts charged against the provision)
b. unused amounts reversed
c. unwinding of the discount, or changes in discount rate closing balance.
2. A prior year reconciliation is not required. [IAS 37.84]
3. For each class of provision, a brief description of nature, timing, uncertainties,
assumptions and reimbursement, if any. [IAS 37.85]
Circumstances for recognising a provision
Restructuring by sale of an Only when the entity is committed to a sale, i.e.

operation there is a binding sale agreement [IAS 37.78]
Restructuring by closure or Only when a detailed form plan is in place and the
organisation entity has started to implement the plan, or
announced its main features to those affected. A
Board decision is insufficient [IAS 37.72]
Warranty When an obligating event occurs (sale of product
with a warranty and probable warranty claims will be
made)
Land contamination As contamination occurs for any legal obligations of
clean-up, or for constructive obligations if the
company’s published policy is to clean-up even if
there is no legal requirement to do so (past event is
the contamination and public expectation created by
the company’s policy)
Customer Refunds If the entity’s established policy is to give refunds
(past event is the sale of the product together with
the customer’s expectation, at time of purchase,
that a refund would be available)
Offshore oil rig must be For removal costs arising from the construction of
removed and sea bed restored the oil rig as it is constructed, add to the cost of the
asset. Obligations arising from the production of oil
are recognised as the production occurs
Abandoned leasehold, four For the unavoidable lease payments
years to run, no re-letting
possible
Onerous (loss-making) contract Recognise a provision
Circumstances when a provision is not recognized
Stadd training for recent No provision is recognised (there is no obligation to

changes in tax provide the training, recognise a liability if and when
the re-training occurs)
Major overhaul or repairs No provision is recognized (no obligation)
Future operating losses No provision is recognized (no liability)
Contingent liability
This is a possible obligation depending on whether some uncertain future event occurs,
or a present obligation but payment is not probable or the amount cannot be measured
reliably. A possible obligation (a contingent liability) is disclosed by way of notes to the
financial statements but not accrued. However, disclosure is not required if payment is
remote. [IAS 37.86] For example, at the date of its Balance Sheet, a company may be
involved in a legal action of which the outcome is uncertain. It is possible that the
company may be liable to pay substantial compensation if it loses the case, but this and
the amount of compensation, will not be known until later.
Contingent asset
This is a possible asset that arises from past events, and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity. Contingent assets should not be
recognised – but should be disclosed where an inflow of economic benefits is probable.
When the realisation of income is virtually certain, then the related asset is not a
contingent asset and its recognition is appropriate. [IAS 37.31–35]
The purpose of this is to ensure that contingencies are recognized in a company’s

financial statements and are quantified on appropriate bases. Companies must disclose
sufficient information in notes to financial statements to enable users to understand
the nature, timing and amounts of the contingencies.
Accounting for Post Balance Sheet Events

Post Balance Sheet events are those events, both favourable and unfavourable, which
occur between the Balance Sheet date and the date at which the financial statements
are approved by the board of directors.
Adjusting events are events which provide additional evidence of conditions existing at
the Balance Sheet date. Such events, if material, require amounts included in the
financial statements to be adjusted; they may indicate that the going concern concept
is not appropriate to the financial statements.
Examples:
- The purchase price or proceeds of sale of assets purchased or sold before the
year ended are not known until after the Balance Sheet date.
- The valuation of property after the
There are two types of
events:
1. Adjusting events are events occurring after the reporting date that provide
evidence of conditions that existed at the end of the reporting period. Examples
of adjusting events include: •
a. events that indicate that the going concern assumption in relation to the
whole or part of the entity is not appropriate;
b. settlements after reporting date of court cases that confirm the entity
had a present obligation at reporting date;
c. receipt of information after reporting date indicating that an asset was
impaired at reporting date;
d. bankruptcy of a customer that occurs after reporting date that confirms
a loss existed at reporting date on trade receivables;
e. sales of inventory after reporting date that give evidence about their net
realisable value at reporting date;
f. discovery of fraud or errors that show the financial statements are
incorrect.
2. Non-adjusting events are events occurring after the reporting date that do
NOT provide evidence of conditions that existed at the end of the reporting
period. Examples of non-adjusting events, that would generally result in
disclosure, include:
a. major business combinations or disposal of a major subsidiary;
b. major purchase or disposal of assets, classification of assets as held for
sale or expropriation of major assets by government;
c. destruction of a major production plant by fire after reporting date;
d. announcing a plan to discontinue operations;
e. announcing a major restructuring after reporting date;
f. major ordinary share transactions;
g. abnormally large changes, after the reporting date. in asset prices or
foreign exchange rates;
h. changes in tax rates or tax law;
i. entering into major commitments such as guarantees;
j. commencing major litigation arising solely out of events that occurred
after the reporting date.
Standard accounting practice for post balance sheet events
1. Financial statements should be prepared on the basis of conditions existing at

the statement of financial position date.
2. A material post-statement of financial position event requires changes in the
amounts to be included in the financial statements, where it is either an
adjusting event, or it indicates the application of a going concern concept to the
whole or material part of the company is not appropriate.
3. A material post-statement of financial position event should be disclosed where:
a. It is a non-adjusting event of such materiality that its nondisclosure
would affect the ability of the users of financial statements to reach a
proper understanding of the financial position, or
b. It is the reversal or maturity after the year end of a transaction
entered into before the year end, the substance of which was primarily
to alter the appearance of the company’s statement of financial position.
4. The disclosure should state, in note form, the nature of the event and the
estimate of the financial effect, or a statement that it is not practicable to
make such an estimate.
5. The estimate of the financial effect should be disclosed before taking into
account taxation, and the taxation implications should be explained, where
necessary, for a proper understanding of the financial position.
6. The date on which the financial statement are approved by the board of
directors should be disclosed in the financial statements.
Published Financial Statement
Preparation of Statement of Cash Flows (indirect method only)
IAS 7 Statement of Cash Flows requires an entity to present a statement of cash
flows as an integral part of its primary financial statements. Cash flows are classified
and presented with the following subheads: operating activities (either using the
‘direct’ or ‘indirect’ method), investing activities, or financing activities.
Objective of IAS 7 (IFRS for SMEs 7.1)
The objective of IAS 7 and the IFRS for SMEs Section 7 is to require the
presentation of information about the historical changes in cash and cash equivalents
of an entity by means of a statement of cash flows, which classifies cash flows during
the period according to operating, investing, and financing activities. The statement of
cash flows provides this information. Under the IFRS for SMEs Section 7.2, cash
equivalents are short-term, highly liquid investments held to meet short-term cash
commitments rather than for investment or other purposes. An investment normally
qualifies as a cash equivalent only when it has a short maturity, less than one year from
the date of acquisition. Bank overdrafts are normally considered financing activities
similar to borrowings. However, if they are repayable on demand and form an integral
part of an entity’s cash management, bank overdrafts are a component of cash and cash
equivalents. Some examples of cash and cash equivalents are:
 cash in hand
 cash at bank
 short-term investment
 marketable securities
 short-term fixed deposits
 bank overdraft.
All entities that prepare financial statements in conformity with IFRSs are required to
present a statement of cash flows. [IAS 7.1and IFRS for SMEs Section 7.3] The
statement of cash flows analyses changes in cash and cash equivalents during a period.
Guidance notes to the financial statements will indicate if an investment meets the
definition of a cash equivalent. An investment that has a maturity of three months or
less from the date of acquisition is considered a short-term investment. Equity
investments are normally excluded, unless they are in substance a cash equivalent (e.g.
preferred shares acquired within three months of their specified redemption date).
[IAS 7.7–8]
Presentation of the statement of cash flows
Operating activities are the main revenue-producing activities of the entity that are
not investing or financing activities, so operating cash flows include cash received from
customers and cash paid to suppliers and employees [IAS 7.14]. This will include the
organisation’s cash inflows and outflows from normal operations (found in the income
statement) and changes in working capital (found in the balance sheet).
Investing activities are the acquisition and disposal of long-term assets and other
investments that are not considered to be cash equivalents. [IAS 7.6]
Financing activities are activities that alter the equity capital and borrowing structure
of the entity [IAS 7.6]; interest and dividends received and paid may be classified as
operating, investing, or financing cash flows, provided that they are classified
consistently from period to period [IAS 7.31]; cash flows arising from taxes on income
are normally classified as operating, unless they can be specifically identified with
financing or investing activities [IAS 7.35].
Non-cash transactions (IAS 7.43 and IFRS for SMEs Section 7:18 and 7:19)
An entity shall exclude from the statement of cash flows investing and financing
transactions that do not require the use of cash or cash equivalents. An entity shall
disclose such transactions elsewhere in the financial statements in a way that provides
all the relevant information about those investing and financing activities. The exclusion
of non-cash transactions from the statement of cash flows is consistent with the
objective of a statement of cash flows because these items do not involve cash flows in
the current period. Examples of non-cash transactions are:
 the acquisition of assets either by assuming directly related liabilities or by

means of a finance lease
 the acquisition of an entity by means of an equity issue
 the conversion of debt to equity.
Other disclosures IAS 7.21
An entity shall disclose, together with a commentary by management, the amount of

significant cash and cash equivalent balances held by the entity that are not available
for use by the entity. Cash and cash equivalents held by an entity may not be available
for use by the entity because of, among other reasons:
 foreign exchange controls, or

 legal restrictions (statutory requirements).
The limitations of the statement of cash flows are as follows:
 Cash flow information is historical in nature and therefore not a prediction of

the future.
 Cash flows can be manipulated.
 Much of the detailed information is disclosed in the notes and therefore the
notes must be reviewed carefully.
 It may not always be so easy to distinguish between cash and cash equivalent.
Cash flows: Operating activities

Net income before interest and tax xxx
Adjustments:
Add: Depreciation xxx
Add: Loss on sale of non-current asset xxx
Less: Gain on sale of non-current asset (xxx)
Add: Impairment of non-current assets xxx
xxx
Changes in working capital
Add: Decrease in current assets xxx
Less: Increase in current assets xxx
Add: Increase in payable accounts (except interest payable and tax payable) xxx
Less: Decrease in payable accounts (except interest payable and tax payable) xxx
Interest expense xxx
Less: Interest accrued (xxx)
Less: Interest paid (xxx)
Less: Taxes paid (xxx)
Net cash flows from operating activities xxx
Cash flows: Investing activities

Proceeds from sale of non-current assets xxx
Purchase of non-current asset (xxx)
Net cash flows from investing activities xxx
Cash flows: Financing activities

Proceeds from general or rights issue of common stock (ordinary shares) xxx
Proceeds from issue of preference shares xxx
Redemption of shares (Treasury Stock) (xxx)
Issue of Treasury Stock xxx
Proceeds from sale of debentures /bonds xxx
Redemption of debentures /bonds (xxx)
Proceeds from note payable xxx
Repayment of note payable (xxx)
Dividends paid (xxx)
Net cash flow from investing activities xxx
Net increase/ (decrease) in cash xxx
Opening cash and cash equivalents balance (as seen in the previous year balance xxx
sheet)
Closing cash and cash equivalents balance (as seen in the current year’s Balance xxx
Sheet)
Ratio Analysis
Liquidity ratios
Current Ratio measures the firms ability to cover its short-term obligations. Current
international standard 1:5:1.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Acid test (Quick Ratio) measures the ability of the firm to pay its short-term
obligations should creditors demand payment immediately
𝐶𝑎𝑠ℎ + 𝐵𝑎𝑛𝑘 + 𝑆ℎ𝑜𝑟𝑡 − 𝑡𝑒𝑟𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 + 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 + 𝑆ℎ𝑜𝑟𝑡 − 𝑡𝑒𝑟𝑚 𝑛𝑜𝑡𝑒𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Benefits of strong liquidity ratios Demerits of weak liquidity ratios

1. More liquid assets available for use 1. Lack of cash to:
by the firm for: a. pay short or even long-term
a. purchase of non-current assets for obligations as they become due
future revenue and cash generation b. meet running expenses/overheads
b. turning it into stronger interest- of the firm
bearing short-term investments for c. pay cash dividends
further revenue and cash d. meet expansion plans of the
generation organisation.
c. paying dividends 2. Poor liquidity may result in:
d. redeeming shares (treasury stock) a. loss of creditor confidence
e. paying off debts. resulting in reduced or no lines of
2. Increased shareholders’ confidence credit and balance due being
due to: demanded
a. potential cash dividends b. loss of shareholder/potential
b. funds to replace assets and investor confidence as cash may
further investment for greater not be available for payment of
future returns. dividends
3. Increased confidence by potential c. insolvency and resulting bankruptcy
investors:
a. a sign of excess liquidity
provides potential cash
dividends
4. Increased confidence by creditors
as there is the possible payment of
short-term debt on-time or earlier,
which may result in:
b. willingness to extend lines of
credit
c. willingness to offer new lines of
credit.
Profitability Ratios
 Gross margin percentage is the percentage profit that the firm makes before
period costs (administrative, selling and finance costs) are deducted.
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
× 100
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
The business would want to improve its gross profit margin, especially where it
has a number of expenses. In our example above, while a gross profit of 33.3 per
cent is acceptable, firms would want to push that figure closer to 50 per cent.
Higher gross profit suggests that management has been able to use the available
resources to generate high profits. A firm earning higher profit could plough
back some of that profit into research and development, which should improve
its operations. Improving gross profit should be the desire of most, if not all,
firms but what are the options available for doing so? Some of the steps that
firms could take to improve their gross profit margin would include:
 Increasing sales revenue – this could be done by either selling more or
increasing prices
 Buying material in bulk in order to benefit from discounts
 Sourcing a cheaper supplier without sacrificing the quality of the
materials
 Reducing the cost associated with the production of the goods
 Net income percentage/Net margin percentage- the percentage profit the
business makes for the year after all costs are deducted. It gives a good idea of
how the firm controls its expenses or overheads – that is, whether or not its
overheads are too high and are depleting the gross profit earned. It also shows
the firm’s level of efficiency.
𝑁𝑒𝑡 Pr 𝑜 𝑓𝑖𝑡
× 100
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
The firm would want to keep its net profit margin and gross profit margin close
to each other. This will show investors that the firm is not incurring huge selling
and distribution and administrative expenses. A net profit margin that is close
to a gross profit margin suggests that overheads or expenses are low, which is
desirable as the firm would be converting its revenue into actual profit. Where
the firm may have a high gross profit margin but low net profit margin it is
indicating that the overheads are too high. This can be dangerous, as a decline in
sales could see the firm making net losses. The net profit margin can be
improved in one of two main ways: reducing costs or increasing revenues.
 Return on assets measures the firm’s return from its investment assets,
indicating the measures of efficiency of the assets
[ ×( )]
= 𝑐%
 Return on capital employed- shows the efficiency of the use of capital employed
in the accounting period. This is the return to current investors in the firm.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 × 100
= 𝑑%
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
While the ROCE may vary, depending on the industry, the general rule is that
the higher it is, the better it is. Potential investors will use this ratio to assess
whether their investment will be feasible. The aim of investors is to have
sufficient or high returns and so they will refrain from investing if the firm is
falling below expectations. The ROCE should be above the rate at which the
company borrows money. This will ensure that shareholders can receive some
form of return on their investment. Where the firm is not making a sufficient
return on its capital employed it can take the following steps to improve it:
• Cutting costs, as this will improve its profits
• Reducing the amount of capital employed
• Seeking a cheaper source of raw materials.
 Earnings per share- shows the potential earnings (maximum possible dividend)
that the shareholders (stockholders) can receive from the net income.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒 ∗
= $𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
∗ (𝑜𝑝𝑒𝑛𝑖𝑛𝑔 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑠𝑠𝑢𝑒𝑑 𝑠ℎ𝑎𝑟𝑒𝑠 + 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑠𝑠𝑢𝑒𝑑 𝑠ℎ𝑎𝑟𝑒𝑠) ÷ 2
EPS is a good indicator of the profitability of the company and its ability to pay
out dividends to existing shareholders. Potential investors will tend to gravitate
to companies that have increasing earnings per share. The higher the EPS, the
more attractive it is for investors who may want to make an investment.
 Price earnings ratio (stock market ratio) - show the relationship between
potential dividend and market price per share. If the P/E ratio is high then the
company may experience growth in the demand for its shares, as investors feel
that they will get better returns on their investment.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ∗
=𝑒
𝐸𝑃𝑆
∗ 𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒
 Dividend pay out ratio- Measures the percentage of net income that has been
paid out to shareholders.
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 × 100
= 𝑓%
(𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
 Dividend per share shows the amount of dividend each share gets
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒
Results of strong profitability ratios
 increased investor (shareholders and potential investors) confidence in the

management of the resources of the organisation
 company ranking increased
 increase in the price of the share in the market
 increased creditor confidence in the longevity of the company, which may result
in willingness to provide debt funding.
Solvency Ratios
Solvency measures the firm’s financial health in relation to its debt, therefore
measuring its ability to remain in business over the long term.
 Debt to total assets- reflects the level of control creditors have on the
business’s assets. This can be easily compared to the level of control by the
owners.
𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 × 100
= ℎ%
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
 Debt to equity or gearing- indicates how many times that creditors have
control in relation to stockholders
𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
= 𝑖 𝑡𝑖𝑚𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
 Time interest earned or interest cover- shows the firm’s ability to meet the
current year’s interest payments out of current year’s earnings.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥 ∗
= 𝑗 𝑡𝑖𝑚𝑒𝑠
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
∗ 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 + 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
Activity Ratios
Inventory turnover- shows the average holding of inventory over the accounting period
therefore measuring the efficiency of inventory management.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠
= 𝑘 𝑡𝑖𝑚𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Average payables or payment period measures the length of time that the business
takes to pay its creditors.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠 × 365
= 𝑙 𝑡𝑖𝑚𝑒𝑠
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
Average receivables or collection period measures the average length of time a

business must wait before being paid by debtors.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 × 365
= 𝑚 𝑑𝑎𝑦𝑠
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
Significance and Limitations of Financial Statements
Analysis of Performance
Ratio analysis gives senior management and other stakeholders a better picture of the
business’s performance over a given period of time. The ratios that are calculated will
foster comparison of:
 The business’s performance with that in previous years

 Budgeted and actual performance or targets for the financial year
 The business and other businesses of the same nature in the industry.
While accounting ratios are good, it should not be misconstrued that analysis ends with
the calculation and comparison of these ratios. The figures and the comparison thereof
may just highlight trends in the final accounts of the business. However, interpretation
and analysis of these accounts lie in the reasons given for the trends and features
identified by doing ratio analysis.
Advantages of ratio analysis:

 Provides the framework and information to compare a business’s performance
with other businesses in the same industry or of the same nature.
 Can produce vital information about the performance of the firm
 A good tool to use to assess the financial position of the business
 Can be used to identify possible weaknesses within a business which would not
have been detected from simply drafting final accounts
 Helps management to formulate future plans and policies regarding the firm
 Can be used as a guide in making investment decisions
 Gives meaning, clarity and perspective to the accounting data presented in the
final accounts.
Limitations or disadvantages of ratio analysis:
 Ratio analysis is predominantly quantitative and hardly focuses on quality,

customer service and the morale of employees
 Ratio analysis focuses on historical data, with little emphasis on the future,
though it can be used to make projections
 Any ratio that is calculated is only as accurate and reliable as the information
that was used in its calculation – that is, if the financial report is not credible,
then the ratio cannot be either
 Its usefulness is dependent on the skill of the user. It requires experience to
interpret properly and place in context
 Ratios can only be used to compare similar companies and present with previous
data
 If the ratios are not adjusted for inflation, they might be misleading.
Vertical Analysis
Vertical analysis is the analysis of financial statements in one accounting period,

whereas horizontal analysis compares financial statements over two or more periods, or
two or more organisations. Vertical analysis has some inherent weaknesses:
1. There is a lack of comparison to indicate whether the company has improved, or

its status has weakened in relation to a previous period.
2. There is a lack of comparison to industry benchmarks and in relation to other
companies to identify the position in the industry.
Receivership and liquidation

Terminology
Bankrupt: a person or business against whom the court has issued a receiving order, as
a result of a creditor filing that the debtor has committed an act of bankruptcy.
Illiquid: the inability of a firm to meet its short-term obligations.
Insolvent: this is a firm that:

o is bankrupt and unable to meet its obligations as they become due
o has ceased paying its current obligations in the ordinary course of business as
they become due
o has property, plant and equipment with a total value, at fair valuation, which if
disposed of would be insufficient to enable the payment of all its obligations due
and accruing due. This results in a negative net worth, that is, assets are less
than liabilities.
Liquidity: a firm’s ability to meet its short-term obligations (current payments).
Receiver: a person appointed by the court when a firm is considered to commit an act
of bankruptcy.
Secured creditor: a person or business that a debt is owed to by a firm that is tied to
a specific asset or assets of that firm.
Security agreement: a contract for a creditor to get the assigned asset, or the
proceeds from the sale of an assigned asset, as payment of a debt, if the debtor is
unable to pay.
Solvency: the firm’s ability to generate enough cash to cover long-term debts as they
mature.
Bankruptcy
Bankruptcy is an action that's usually taken to protect a debtor from collection actions
by creditors. Bankruptcy courts and rules are primarily aimed at shielding the
borrower, not the lender. A company may file for bankruptcy when it wants time to
solve its financial problems while maintaining business operations. On the other hand,
when a company files for bankruptcy, it's generally for the purpose of liquidating and
closing a business.
There are several reasons why firms
 Changes in the economy such as inflation causing major increased prices in

inputs, or recession causing a major fall in selling prices
 Difficulty in sourcing finance or financiers to continue
 Poor planning
 Being indecisive
 Loss of key employees
 Overwhelmed by competition
 Lack of ability to change to suit current demand or advances in technology

 Unforeseen circumstances such as floods, storms and fi res
 Fraudulent activity.
Liquidation
LIQUIDATION IN FINANCE AND ECONOMICS IS THE PROCESS OF BRINGING A BUSINESS TO AN END AND
DISTRIBUTING ITS ASSETS TO CLAIMANTS . It is an event that usually occurs when a company is
insolvent, meaning it cannot pay its obligations when they are due. As company
operations end, the remaining assets are used to pay creditors and shareholders, based
on the priority of their claims. General partners are subject to liquidation.
The term liquidation may also be used to refer to the selling of poor-performing goods
at a price lower than the cost to the business or at a price lower than the business
desires.
Assets are distributed based on the priority of various parties’ claims, with a trustee
appointed to oversee the process. The most senior claims belong to secured creditors
who have collateral on loans to the business. These lenders will seize the collateral and
sell it—often at a significant discount, due to the short time frames involved. If that
does not cover the debt, they will recoup the balance from the company’s remaining
liquid assets, if any.
Next in line are unsecured creditors. These include bondholders, the government (if it
is owed taxes), and employees (if they are owed unpaid wages or other obligations).
Finally, shareholders receive any remaining assets, in the unlikely event that there are
any. In such cases, investors in preferred stock have priority over holders of common
stock. Liquidation can also refer to the process of selling off inventory, usually at steep
discounts. It is not necessary to file for bankruptcy to liquidate inventory
Receivership
A receivership is a court-appointed tool that can assist creditors in recovering funds in

default and can help troubled companies avoid bankruptcy. Having a receivership in
place makes it easier for a lender to obtain the funds that are owed to them if a
borrower defaults on a loan. A receivership may also occur as a step in a company's
restructuring process that is initiated to return a company to profitability. Moreover, a
receivership could arise as a result of a shareholder dispute over completing a project,
liquidating assets, or selling a business.
1. An act of bankruptcy is allegedly committed by a debtor, as the debtor is not

meeting its obligation as they mature (become due).
2. The creditor verifies the petition by an affidavit and fi les it with a court of
law.
3. The court dismisses the petition, then the action ends.
4. If the court allows the petition, then a receiving order is made and a receiver
appointed. The receiver is limited by the receiving order in his or her
management of the business. Generally, under the control of the receiver by law
usually are: the inventory, accounts receivable and other property of the
debtors. One of the highest priorities of the receiver is the statutory
obligations of the bankrupted firm.
5. A receiver informs all the debtors and creditors of the firm of his appointment.
6. The receiver takes custody of the assets.
7. The receiver opens a bank account to facilitate receipts and payment under his
or her management.
8. The receiver continues the business and disposes of assets where necessary.
9. The receiver assesses the claims made by the creditor.
10. The receiver prepares a monthly statement of affairs (balance sheet at market
values).
11. The receiver, in an effort to carry out the instruction of the court, carries on
the business by:
a. safeguarding assets
b. monitoring company activities
c. disposing of assets
d. discharging the firm’s indebtedness.
12. If the business is successful then it is returned to the owners by the receiver
as per the terms of the court. If not, then the business is liquidated by
disposing of the assets in a commercial manner.
Unit 2: Cost and Management Accounting

Module 1: Costing Principles
Introduction to Cost and Management Accounting
A. The important and role of Management Accounting
 Aids in the creation of plans
 Measure the performance of the business
 Customers receive better service
 Enhance productivity
 Increases profitability
 Assists with Operations Coordination
B. The role of Cost Accounting in manufacturing and service
industries
 Comparing Costs over time of a specific product
 Showing profitable and non-profitable activities
 Determine the total per-unit cost
 Controlling costs
Cost and Management Accounting Vs. Financial Accounting
 Management Accounting focuses on the accounting tools managers can use
internally to run a business. These tools can help managers to control day-to-day
operations by comparing the performance of actual results with budgeted
results.
 Cost Accounting provides information for day-to-day control of operations. It
shows information such as inefficiencies and wastage of materials. Costing
analysis losses from plant & machinery breakdowns in addition to recording
actual cost that are compared with estimated or standard cost.
 Financial Accounting focuses on preparing financial records or reports for the
use of external persons, shareholders, suppliers, banks and government
agencies.
Table: Differences between management and financial accounting
Management Accounting Financial Accounting

Users of Internal users such as External users such as investors,
accounting managers at all levels and creditors, and government agencies
information employees
Purpose of Help managers and Help investors, creditors and others
accounting employees to plan and make investments, give credit and
information control business operations make other decisions.
Freedom of No constraints, Constrained by Generally Accepted

choice with information prepared Accounting Principles (GAAP).
reference to contain both monetary and Information prepared contains mostly
accounting non-monetary transactions monetary transactions. Public
measures companies must be audited by an
independent auditor.
Timing focus Usage of both historical Use of historical information ONLY>
for the and future information The information evaluates a firm’s
preparation of such as formal use of yearly performance. The information
financial budgets as well as financial used in the preparation of the reports
reports records. In addition, the contain characteristics such as
information used must be relevance, faithful representation, and
relevant. must be reliable and objective.
Time span of Time span of financial Time span is less flexible, it can be
financial reports is flexible and may quarterly or yearly
reports vary from, for example,
hourly, daily or maybe
yearly
Types of Detailed reports and may Summarised reports on an entire
reports include details about business.
products, departments or
territories.
Manufacturing Accounts and Labour Costs

Costs Associated with Manufacturing Accounts
There are several different costs that are calculated when preparing manufacturing
accounts. These costs include:
 Product Cost
 Prime Costs
 Overheads
 Work-in Process
 Cost of goods manufactured
 Cost of goods sold
Production Cost= Prime Cost/Direct Cost + Factory

Overhead expenses/Indirect Cost
Prime Cost Components

.
Manufacturing Account
It shows the cost of production or the transfer price of goods completed during the
accounting period.
1. Direct Materials
 Costs of the materials used during the period
 Include the purchase price of the raw materials and the acquisition costs
related to the purchase.
 Examples: Purchases of raw materials
Carriage Inwards/freight charges on raw materials
2. Direct labour
 Wages paid to the people who are directly involved in the manufacturing
process.
 Example: Direct labour, direct wages, factory wages manufacturing and
production wages
3. Direct Expenses
 They refer to the expenses paid according to each unit of production.
 Examples: royalties (an amount paid by one party to another party that
owns a particular asset, for the right to ongoing use of that asset. E.g.,
music, book, brand etc.)
4. Factory Overhead Expenses/ Indirect Costs
 Cost incurred in the manufacturing process, but they cannot be traced directly
to the goods being produced.
 Include indiect materials, indirect labour and indirect expenses.
 Examples:
 Indirect materials
 Lubricants
 Loose Tools (opening balance + purchase - closing balance)
 Indirect Labour
 Wages and salaries
 Bonus or commission to cleaners, crane drivers, foremen, supervisors and
production manager
 Indirect expenses related to the factory, machinery and vehicles
 Rent and rates
 Depreciation
 Insurance
 Repairs and Maintenance
 Factory power/electricity
 Internal Transport
 Loss on disposal
5. Work in Progress- it refers to the semi-finished goods, which should be
included in the cost of goods manufactured
Trading Account
 This account shows the gross profit or loss resulted from the trading of
manufactured and other purchased goods.
 The accounts includes:
 Sales
 Cost of Goods Sold
 Manufactured goods
 Other goods
Profit and Loss Account

 Profit or loss of the whole business during the accounting period.
 Includes all the expenses and income related to the office and the running of the
whole business such as:
 Gross Profit/loss from the trading account
 Manufacturing profit/loss
 Administrative Expenses
 Selling and Distribution expenses
 Financial Expenses
 Increase/decrease in the provision of unrealised profit
 Net Abnormal loss
 Cash misappropriated
 Losses of raw materials
 Losses of finished goods
 Some expenses are related to both the manufacturing process and the
administration of the office such as:
 Rent Rates
 Electricity
 Insurance
 Depreciation on premises
 Motor Vehicles
 Motor Vehicles expenses
 These expenses should be allocated to the factory and office and debited to the
manufacturing account and the profit and loss account respectively.
 The bases of allocation are usually given in the examination questions.
FORMATS FOR FINANCIAL STATEMENTS MANUFACTURING INDUSTRIES
Manufacturing, Trading and Profit and Loss Account for the year ended 31 Dec
XXXX
$ $
Opening Stock of Raw Materials X
Add: Purchases of raw materials X
Carriage Inwards X
Less: Closing Stock of Raw Materials (X)
Cost of Raw Materials Consumed X
Direct Labour X
Royalties X
Prime Cost X
Factory Overhead Expenses:
Loose Tools (opening bal. +purchases- closing balance) X
Rent X
Production Manager’s salaries X
Factory Power X
Maintenance of plant & machinery X
Depreciation of plant & machinery X
X
X
Add: Opening Work in progress X
X
Less: Closing Work in Progress (X)
Production Cost of Goods Completed X
Factory Profit/loss X
Transfer of Goods Completed X
Sales X
Less: Returns Inwards (X)
Net Sales X
Less: Cost of Goods sold
Opening stock of finished goods X
Production Cost/Transfer Price of Goods Completed X
X
Less: Returns outwards (X)
X
Fire Loss X
X
Less: Closing Stock of finished goods (X)
(X)
Gross Profit X
Add: Factory Profit X
Add: Discount received X
X
Less: Expenses
Carriage Outwards X
Rent X
Discount Allowed X
Distribution Expenses X
Administration Expenses X
Selling Expenses X
Depreciation of Delivery Van X
Provision for unrealised profit X
Fire Loss X
(X)
Net Profit X
Production Cost vs Transfer Price of Goods Completed

 Stock of raw materials, work in progress and other finished goods are valued at
cost.
 However, the stock of manufactured goods can be valued at production cost or
the transfer price of goods completed.
 Provision of unrealized profit of stock should be made if closing stock of
manufactured goods is valued at transfer price
 Be made on the closing stock valued at production cost plus a percentage of
factory profit.
%
 Provision for unrealised profit = stock (transfer price) X
% (%)
Stock Loss
1. Normal Loss
Normal losses refer to losses related to the ordinary activities of the business.
Examples: damaged/spoiled stock, obsolete stock
No entry is required for normal loss
2. Abnormal Loss
Refers to losses not related to the ordinary activities of the business.
Examples: Fire loss, burglary loss
Impact of labour due to technology changes

Many manufacturing companies have more fixed costs and fewer variable costs
including labour. This trend results in fewer persons being employed and therefore, a
decrease in direct labour costs (variable costs). On the other hand, because there are
more fixed costs, there is an increase in automation and, as a result, depreciation and
lease charges (fixed costs) increase.
Renumeration
Renumeration is the compensation for work done or the reward for labour and services.
Time Wages System

 Flat Time Rate- operates by paying labour for the time worked; the payment
is by the hour, day or week. Wages are calculated by multiplying the total hours
worked by the rate per hour. The total number of hours worked is recorded on
clock cards or time sheets. Overtime premiums due to workers are paid in this
system.
Favoured where a worker is learning a All workers (skilled and unskilled) are paid
job the same regardless of their quality of work
or trade
Workers are guaranteed a fixed wage There is no incentive offered to workers
each week for the agreed hours worked. for making extra efforts.
Quality of work is maintained Workers may decide to work at a slower
throughout pace during normal working hours in
(And not sacrificed for increased order to work overtime for increased
earnings) rates of pay
 High Day Rate- This method pays a much higher day rate to workers than
flat time. Most firms make this payment to attract good employees, whose
output will continuously be productive and performance will be of a high
standard.
Payments are much higher than Problems occur when the target for production
other is not met
firms and will attract labour (and
the firm
is able to choose a better class of
worker)
Simple to understand and Standards must be continuously
administer maintained and closely monitored
Firms benefit from high
performance
through lower unit costs
 Measured Day Rate- employees are paid above the time rate. The workers’
output is measured over a period of time and they are paid on the basis of their
performance and efficiency during that time. The advantages of fi rms using
this system are listed below:
 It reduces paperwork.
 Although payment is based on the output for a period, the employee
receives a regular rate per hour for a long period.
 Graduated Time Rate- the rates of wages are linked up with the cost-of-
living index. Thus, the rate per hour or day fixed initially goes on changing with
the changes in the cost-of-living index.
Differential Time Rate-
Piece Rates
 Straight Piece Rate- is the payment of a fixed sum per fixed unit produced,
per standard time.
It is simple to understand and No payment or allowance is normally
calculate. made for unsuitable materials, variations
in the efficiency of tools and machinery
or production delays, which are matters
outside the control of the worker.
There is a direct incentive to Varying rates of output between different
increase workers may result in labour troubles
output (because the system (Trade unions may be contentious over
encourages fixing of piece rates)
greater efficiency)
Individual output can be easily and May not be suitable for all workers (only
quickly determined workers with specialised skills)
Unit costs are reduced System may leave opening for spoilt
production, lead to substandard work
or unacceptable wastage of materials
because of lack of monitoring and control
Wages are paid proportionate to
production
The work is completed more
quickly and
time wastage is not encouraged
 Taylor’s Differential Piece Rate- This scheme offers incentives to

employees as an encouragement to increase their output by paying higher rates
for increased levels of production.
Provides a very strong incentive to The beginner or slow learner is penalised
fast
workers
It is simple to understand and The quality of work may suffer as workers strive
work to reach a high output
Only the best workers are
attracted to the firm
 Merrick Multiple Piece Rate- ordinary piece rate is given to workers whose
level of performance is between of the standard output. Worker's producing
less than 83% of the standard output is paid at a basic piece rate. Those
produced from 83% to 100% of the standard output are paid 110% of the basic
piece rate.
 Group Piece Rate- the number of man-hours it takes a team to collectively
produce a single unit that meets quality standards and is saleable.
Plan
 Halsey Premium Plan- the time wages are guaranteed even if the output of a
worker is below the standard. In case, the worker completes the works in less than
the standard time, then he/she will be paid according to the actual time, i.e., time-
rate plus the bonus calculated at a specified percentage of the saved time.
 Rowan Premium Plan- the standard time for the completion of a job and the rate
per hour is fixed. If the time taken by the worker is more than the standard time,
then he is paid according to the time rate, i.e., time taken multiplied by the rate per
hour. In case, the worker completes the work in less than the standard time; then
he is entitled to a bonus along with the time wages
 Halsey Weir System-
 Barth Premium-which the time-rate is not guaranteed and the earnings of the
worker are ascertained by taking the square root of the standard hour multiplied by
the number of hours actually taken for the completion of the job and then
multiplying it by the worker’s rate per hour.
 Gantt Task and Bonus Plan- a wage incentive method of rewarding the
employees who outperform the expected set output by the organization.
 Emersons Efficiency Bonus Plan- The standard output in this plan is fixed to
represent 100% efficiency A bonus is paid to a worker whose efficiency exceeds
67%. As efficiency increases, the bonus also increases gradually in steps at a stated
rate so that at 100% efficiency, bonus would rise to 20% of wages.
Cost Classification
Cost is defined as the monetary exchange of resources given up to acquire a product or
service.
Cost classification is dependent on its purpose, inventory valuation and income

determination, decision making, and planning and control
Inventory Valuation
Product Cost Period Cost
Definition Costs that are incurred to Non-manufacturing costs that are expensed
create a product that is within an accounting period. They are not
intended for sale to incurred to manufacture a product
customers
Comprises Manufacturing and Non-manufacturing costs
production costs
Examples Raw materials, direct labour,  Financial- discount allowed, bank
direct expenses, factory charges
utilities, factory manager’s  Selling and Distribution- carriage
wages outwards, salesman’s charges,
marketing costs
 Administrative- telephone and office
expenses
Cost Behaviour is the way in which costs respond to changes in the volume of output or
activity.
Fixed Cost does not change within the relevant range of activity (that is, total cost
does not increase or decrease in the level of activity). Examples include building rental,
salary of director and straight-line depreciation. The unit cost is constant.
Variable Cost changes in proportion to changes in the volume of activity. Examples

include direct materials and labour and sales commission that varies with t he volume of
sales. The unit cost is fixed.
Mixed Costs refer to the combination of fixed and variable costs. Examples include
electricity and telephone bills. The fixed cost- minimum amount while the variable cost-
based on usage.
Traceable costs assigned to one or more objects are known as:
 Direct Costs- assigned to one specific cost object. For example, raw materials
and labour related to the manufacture of one product
 Indirect Costs- assigned to more than one specific cost object. For example,
factory rent, light and heat
Decision Making
 Relevant Costs- are costs that will be affected by a managerial decision.
 Future Cash Flows- cash expense which will be incurred in future because of
a decision.
 Avoidable Costs- only costs that can be avoided if a particular decision is not
implemented for decision making.
 Opportunity Costs- cash in flows which have to be sacrificed as a result of a
decision.
 Incremental Costs- only incremental or differential costs related to
different alternatives are relevant costs. Incremental cost is the extra cost
that a company incurs if it manufactures an additional quantity of units.
 Irrelevant Costs- costs are those that will not change in the future when you
make one decision versus another.
 Sunk Costs- is a cost already incurred and therefore cannot be changed by
any current or future action. If a new machine is to replace an old one. The
cost of the old one is a sunk cost. Sunk costs also include costs such as
insurance that has already been paid and therefore cannot be affected by
any future decision.
 Committed costs are those which the company will incur regardless of the
decision it makes. Examples include depreciation on existing plant and
machinery.
 Non-Cash Expenses- these are items such as depreciation that are irrelevant
as they do not affect the cash flows of a firm.
 Overheads- general and administrative overheads that are not affected by
the alternative decision.
Similarities Differences
Play apart in Irrelevant costs are usually long-term while relevant costs are
estimates short term.
Usually, variable Irrelevant costs are major expenses while relevant costs are
costs operational expenses.
Planning and Control

Planning and controlling requires firms’ personnel to predict costs and then compare
them to actual costs incurred.
Controllable costs are costs that are under the control of management. Examples
include controlling daily expenses such as supplies, maintenance and overtime, or large
investments in land, buildings and equipment.
Non-controllable costs are costs that are not under the control of management such
as depreciation and write-offs.
Costs Curves
The graph of total fixed cost (TFC) is simply a horizontal line since total fixed cost is
constant and not dependent on output quantity.
The graph for total variable cost (TVC) starts at the origin because the variable cost
of producing zero units of output, by definition, is zero.
The total cost (TC) curve is upward sloping (i.e., increasing in quantity). This simply
reflects the fact that it costs more in total to produce more output. Graph starts from
the fixed cost.
TC= TFC + TVC
As shown above, the average fixed cost (AFC) has a downward-sloping hyperbolic
shape, since average fixed cost is just a constant number divided by the variable on the
horizontal axis. Intuitively, an average fixed cost is downward sloping because, as
quantity increases, fixed cost gets spread out over more units.
Average Variable Cost
25
20
15
10
0
10 20 30 40 50 60 70 80
Material Control
What is procurement?
Procurement is a vital business function encompassing a range of activities for an
organisation to obtain goods and services. The purpose of procurement is to obtain
competitive prices for supplies, delivering the most value.
Not all organisations define procurement the same. Some define the function to encompass
a range of activities from sourcing suppliers to updating payment terms, while others are
narrower with activities such as issuing purchase orders and making payments.
Procurement helps organisations to find reliable suppliers, with competitive prices, and
services that match their needs. “Minimising cost is one important aspect of improving your
procurement processes. But it’s also vital to identify suppliers that provide the quality of
goods and services that the company needs and have the capacity to deliver reliably and a
track record of doing so.”
What are the types of procurement?
Procurement can be categorised in multiple ways, starting with goods procurement and
services procurement, which can then be both direct and indirect.
 Goods procurement: Commonly refers to procuring physical items, in order

to be effective with goods procurement organisations need good supply
chain management practices. (Goods procurement can be both direct and
indirect).
 Services procurement: This kind of procurement is commonly for people-
based services such as contractors, contingent labour, law firms etc. (Services
procurement can be both direct and indirect.
 Direct procurement: This refers to the procurement of anything used to
produce an end product (i.e. for manufacturing raw materials and
components).
 Indirect procurement: This is typically the procurement of essential items for
day-to-day operations (i.e. office supplies, furniture, advertising etc.).
What are the stages of procurement?
Sourcing stages
 Identifying the goods and services a company needs
 Submitting purchase requests
 Assessing and selecting vendors
Purchasing stages
 Negotiating prices and terms
 Creating a purchase order
 Receiving and inspecting the delivered goods
Payment stages
 Conducting three-way matching, comparing purchase orders, order receipts,
and invoices
 Approving the invoice and arranging payment
 Recordkeeping
Disposal of Hazardous Materials
These hazards impact emergency responders and effected communities. In some cases,
hazardous substances may irritate the skin or eyes, make it difficult to breathe, cause
headaches and nausea, or result in other types of illness
Waste material can be defined by one or more of the following:
• ignitability- antifreeze, brake fluid, gasoline, kerosene, diesel fuel, pesticides and
repellents, varnish, fluorescent bulbs
• corrosivity- acid and alkaline cleaning solutions, rust removers, battery acid, hot tank
waste
• reactivity- cyanide plating wastes, waste concentrated bleaches, pressurized aerosol cans
• toxicity- painting wastes, oily wastes
Inventory or Stock Valuation Methods
The method for valuing inventory depends on how the stock is tracked by the business over
time. A business must value inventory at cost. Since inventory is constantly being sold and
restocked and its price is continually changing, the business must make a cost flow
assumption that it will use frequently.
There are four accepted methods of inventory valuation.
 Specific Identification
 First-In, First-Out (FIFO)
 Last-In, First-Out (LIFO)
 Weighted Average Cost
Specific Identification
Under this method, every item in your inventory is tracked from the time it is stocked to
when it is sold. It is usually used for large items that can be easily identified and have widely
different features and costs associated with these features.
FIFO
This method is based on the premise that the first inventory purchased is the first to be sold. The
remaining assets in inventory are matched to the assets that are most recently purchased or
produced. During inflation, the FIFO method yields a higher value of the ending inventory, lower cost
of goods sold, and a higher gross profit.
Receipts Issues Balance
Date Qty Price Amount Qty Price Amount Qty Price Amount
LIFO
Under this inventory valuation method, the assumption is that the newer inventory is sold first while
the older inventory remains in stock. This method is hardly used by businesses since the older
inventories are rarely sold and gradually lose their value. This results in significant loss to the
business.
The only reason to use LIFO is when businesses expect the inventory cost to increase over time and
lead to a price inflation. By moving high-cost inventories to cost of goods sold, the reported profit
levels businesses can be lowered. This allows businesses to pay less tax.

Weighted Average Method
Under the weighted average cost method, the weighted average is used to determine the amount
that goes into the cost of goods sold and inventory. Weighted average cost per unit is calculated as
follows:
Weighted Average Cost Per Unit = Total Cost of Goods in Inventory / Total Units in Inventory
This method is commonly used to determine a cost for units that are indistinguishable from one
another and it is difficult to track the individual cost.

Economic Order Quantity
Economic Order quantity is a technique that is used to determine the most economic quantity of
inventory that should be purchased. This model attempts to determine the order size that will
minimize total inventory costs based on six assumptions. These are:
 The demand is uniformed and known

 The item cost does not vary with the order size
 All orders are delivered at the same time
 The lead time is known well in advanced so that the order can be timed to arrive when
inventory is exhausted.
 The cost to place and receive an order is the same regardless of the amount ordered
 The cost of holding inventory is a linear function of the number of items held.
Terms associated with Calculating EOQ
Buffer stock (minimum stock or safety stock): the lowest quantity of inventory kept on hand by a
company in the event of fluctuating usage or unusual delays in lead time.
Safety stock of inventory is allowed to act as a buffer to protect the company against errors such as
possible stock outs.
Lead or procurement time: the period of time between ordering and the time the goods arrive for
usage or are produced by the company.
Maximum level: a stock level calculated as the maximum desirable which is used as an indicator to
management to show when stocks have risen too high.
Reorder point: the level of inventory that triggers the placement of an order for additional units. It is
determined by usage, lead time and safety stock.
Usage: refers to the quantity of inventory used or sold each day.
Costs involved in Calculating EOQ
Purchasing Cost of inventory is the quoted purchase price of inventory, less any sales discount, plus
shipping (freight) charges.
Inventory ordering costs are the variable costs associated with preparing, receiving and paying for an
order. Some examples of costs are:
• the administrative cost in preparing the order
• the communication cost involved in placing the order – telephone, email of delivery of purchase
order costs
• the cost of ordering excess or too little inventory called Total Stocking Cost
• the cost of inspection of the received batches
Inventory carrying cost is the total variable cost of carrying one unit of inventory in stock for one
year. It includes storage costs, handling costs, property taxes, insurance and the opportunity cost of
the capital invested in stocks.
• storage charges (rent, lighting, air conditioning and heating)
• stores – wages, equipment, maintenance and running costs
• material handling costs
• audit – stocktaking and stock recording costs
• insurance and security
• deterioration and obsolescence or pilferage
• evaporation and vermin damage
Costs of not carrying sufficient inventory (stock-out costs)
Costs of not carrying sufficient inventory include:
• lost income through the loss of sales
• loss of future sales because customers may go elsewhere, or
• extra costs associated with expediting urgent orders.
Computing the EOQ: how much to order

Formula Approach
√2𝑆𝑂
𝑄=
𝐶
Where:
S = total demand in units
O= the costs of placing one order and
C = the cost of carrying one unit of inventory per annum
Tabular
Order size (this Carrying cost (average Order cost (number of Total relevant
column shows the inventory multiplied orders multiplied by (carrying cost plus
order in lots) by carrying cost per the ordering cost) ordering cost)
unit)
Computing reorder point: when to order
Constant usage during lead time
The formula below will be used when the rate of usage during lead time is known with certainty.
Reorder point = lead time × average daily or weekly usage
Variable usage during the lead time
The formula below will be used when companies experience problems in demand, delivery or
processing of orders and place a buffer to guard against stock outs.
Reorder point = (Lead time × Average daily or weekly usage) + Safety stock
Overhead Costs
A cost centre is any activity that incurs cost in the business. Overheads refer to all the costs outside
of direct materials and labour.
Predetermined overhead rate is a simple way of allocating manufacturing overheads to products.

This rate is simply calculated by the budgeted overhead cost by a n activity base
𝑃𝑂𝐻𝑅 =
The activity base can be in terms of hours, units or cost.
Example 1
Sade company has budgeted $100000 as overhead costs for 2017. The company uses direct labour
hours as its activity base. The budgeted activity level for 2017 is 5000 hours.
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑

𝑃𝑂𝐻𝑅 =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑎𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑙𝑒𝑣𝑒𝑙 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
10000
𝑃𝑂𝐻𝑅 = = $2
5000
Desk uses 20 labour hours

Fan uses 50 labour hours
Cost to be allocated to:
Cost Centre Labour Hours Consumed Cost Allocated

Desk 20 $40
Fan 50 $100
Example 2
Estimated Costs and operating data for 3 companies are shown below
Company
A B C
Direct Labour Hours 50000 30000 40000
Machine Hours 25000 60000 20000
Manufacturing Overheads $450000 360000 240000
Computer the following POHR for each company
1. Direct Labour Hours

A. 𝑃𝑂𝐻𝑅 = = =
$9.00 𝑝𝑒𝑟 𝑑𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟
B. 𝑃𝑂𝐻𝑅 = = =
C. 𝑃𝑂𝐻𝑅 = = =
2. Machine Hours
A. 𝑃𝑂𝐻𝑅 = = =
B. 𝑃𝑂𝐻𝑅 = = =
C. 𝑃𝑂𝐻𝑅 = = =
C. Company A and B use direct labour hours to allocate overhead costs while company C
uses machine hours. During the period the following activities were recorded.
Company
A B C
Employee 1 400 DLH 450 DLH 200 MH
A. 400 + 100 + 50 = 550

550 DLH * 9 = $4950
B. 450 + 75 + 50 = 575
575 DLH * 12= $6900
C. 200 + 300 + 100 = 600
600 MH * 12 = $7200
Methods of Service Cost Allocation

Direct Allocation
Each service department cost (support) is allocated directly to the production departments ONLY
based on the support it makes to the production cost.
Example
Belmont Company has two service departments and two production departments. The following
information is provided in the table below:
Service Departments Production Departments

Finance Administration Moulding Finishing
Total Overhead 75000 100000 260000 130000
Cost
Overhead
Allocation
Finance 10% 50% 40%
Administration 20% 30% 50%
Answer:
Supplied by Used by
Moulding Finishing Total
Finance 50% 40% 90%

$ $ $ $
Cost 75000 100000 260000 130000
Allocation of (75000) - 41,667 33,333
Finance Cost
Recalculation of 0 100000 301,667 163,333
Costs
Allocation of (100000) 37500 62500
Admin Costs
Recalculation of 0 0 339,167 225, 883
Costs
Calculations=
Finance Allocation- Moulding = (50/90) *75000= $41,667
Finance Allocation- Finishing = (40/90) *75000= $33,333
Admin Allocation- Moulding = (30/80) *100000= $37500
Admin Allocation- Finishing = (50/80) *100000= $62, 500
Step Down Allocation
This method allows for partial recognition of service rendered by support departments to toher
services department. It requires support departments to be ranked with the highest percentage of
its total services to other departments in the order of allocation
Example
Total Overhead 75000 100000 260000 130000
Cost
Overhead
Allocation
Finance 10% 50% 40%
Answer:

Administration Finance Moulding Finishing
$ $ $ $
Cost 100000 75000 260000 130000
Allocation of (100000) 20000 30000 50000
Finance Cost
Recalculation of 0 95000 290000 180000
Costs
Allocation of (95000) 52,778 42,222
Admin Costs
Recalculation of 0 0 342,778 222, 222
Costs
Calculations=
Admin Allocation- Finishing = (50/100) *100000= $50000
Admin Allocation- Finance = (20/100) *100000= $20000
Finance Allocation- Moulding = (50/90) *95000= $52,778
Finance Allocation- Finishing = (40/90) *95000= $42,222
Reciprocal Method
Service Departments are opened to receive costs from other service departments. It requires:
1. Use simultaneous equations to rework new overhead costs for service departments
2. Allocation of costs using the new overhead costs to all departments
Example
Answer:
Total Overhead 75000 100000 260000 130000
Cost
Overhead
Allocation
Finance 10% 50% 40%

$ $ $ $
Cost 75000 100000 260000 130000
Allocation of (96,939) 9694 48469 38,776
Finance Cost
Recalculation of (21,939) 109694 308,469 168,776
Costs
Allocation of (109694) 41,135 68,559
Admin Costs
Recalculation of 0 0 349, 604 237,335
Costs
Calculations=
Equation 1- Finance Equation 2- Administration
F= 75000 + (0.2A) A= 100000 + (0.1F)
Solve for equation 1 Solve equation 2
F= 75000 + 0.2(109694) A= 100000 + 0.2(96,939)
F=75000 + 21,939 A= 100000 + 19,388
F= 96, 939 A= $119,388
Substitute equation 1 in 2: Substitute eq 1 in 2:
F= 75000 + 0.2(100000 + 0.1F) A= 100000 +0.1 (75000 + 0.2A)
75000 + 20000 + 0.2F A= 100000+7500 + 0.02A
F-0.02F=95000 A-0.02A= $107,500
0.98F=95000 0.98A=$107500
F= 95000/0.98 0.98A/0.98= 107500/0.98
F= $96,939 A= 109,694
Finance Allocation
Administration= 0.1 * 96939= $9694
Moulding= 0.5 * 96939 = $48, 469
Finishing= 0.4 * 96939 = $38,776
Administration Allocation
Moulding= 30/80 * 109,694 = $41,135
Finishing= 50/80 * 109,694 = $ 68,559
Repeated Distribution Method

This method allows service departments to be opened to receive costs from other service
departments. It employs the step-down method in deciding the allocation process. It requires
support departments to be ranked with the highest percentage of its total services to other
departments in the order of allocation until the amount is minimal. The minimal amount is then
allocated ONLY to the production departments.
Example
Answer:
Total Overhead 75000 100000 260000 130000
Cost
Overhead
Allocation
Finance 10% 50% 40%

Administration Finance Moulding Finishing
$ $ $ $
Cost 100000 75000 260000 130000
Allocation of (100000) 20000 30000 50000
Administration
Cost
Costs
Allocation of 9500 (95000) 38000 47500
Finance Costs
Costs
Allocation of (9500) 1900 2850 4750
Admin Costs
Costs
Allocation of 190 (1900) 950 760
Finance Costs
Recalculation of 190 0 331,800 233,010
Costs
Allocation of (190) 71 119
Admin Costs
Recalculation of 0 331,871 233,129
Costs
Calculations=
Admin Allocation- Finishing = (50/100) *100000= $50000
Admin Allocation- Finance = (20/100) *100000= $20000
Finance Allocation- Administration- (10/100) * 95000= $9500
Finance Allocation- Moulding = (50/100) *95000= $47500
Finance Allocation- Finishing = (40/100) *95000= $38000
Module 1: Costing System
Job Costing
Job costing involves the accumulation of the costs of materials, labour, and overhead for a specific
job.
Characteristics of job costing

Direct materials (source documents)
 Material Requisition Form- a source document that contains the type and quantity of
materials to be used to complete a task.
 Purchase Requisition Form- a source document that is issued by the production department
requesting that material be ordered.
 Purchase Order- a source document issued by purchasing department to supplier.
 Receiving Report- the source document used to record the types and quantity of materials
received.
Material Control
+ when received - When issued
To record:
a) Purchase of raw materials

[Name of business] General Journal
2020
Apr-30 Purchase of Raw Materials 6000
Accounts payable 6000
Purchase of raw materials during the
period
b) The issue of these materials (direct and indirect)
2020
Apr-30 Work in process (direct materials) 40000
M. Overheads (indirect materials) 5000
Raw Materials 45000
Entry to record the dispatch of raw
materials
c) Labour Costs
2020
Apr-30 Direct Labour 6000
Indirect Labour 1000
Wages payable 7000
Entry to record labour cost used in
production
d) Manufacturing Overheads
2020
Apr-30 Manufacturing Overheads 6000
Accounts payable 6000
Entry to record Manufacturing overheads
for the period
Manufacturing Overheads
Acc. Depreciation
Job cost sheets

A job cost sheet is a document detailing all the costs incurred for the completion of a project. These
costs can be documented during the project or after the job is complete. Usually, the accounting
department compiles this record to: verify that expenses fell within the allocated budget. cost
estimate for future jobs.
Components of Job Cost Sheets
 manufacturing overheads
 direct material costs
 direct labour cost
Customer Name: Job#:

Address: Job Description:
Contract:
Price:
CUTTING DEPARTMENT
Direct Materials Direct Labour Overhead Applied
Date Source $ Date Source $ Date Source $
ASSEMBLY DEPARTMENT
FINISHING DEPARTMENT
SUMMARY
Cutting Dept. Assembly Dept. Finishing Dept.
Direct Materials Direct Materials Direct Materials
Direct Labour Direct Labour Direct Labour
Overheads Overheads Overheads
Total Total Total
FINAL COST
Direct Materials
Direct Labour
Overheads
Total
Flow of costs
Materials Work in progress
Beginning Used Beginning Cost of goods
Purchases DM (transferred to WIP Direct Materials manufactured
Carriage Inwards as direct materials) Direct Labour (transferred to
IM (transferred to OH finished goods)
overheads)
Wages Payable
Direct Labour Overheads
(transferred to WIP) Actual Applied/Allocated
Indirect Labour Indirect Materials XXX (transferred to
(transferred to Indirect Labour WIP)
overheads Other Overheads
Finished Goods
Beginning Cost of Goods Cost of Goods Sold
Cost of Goods Sold (transferred Cost of Goods
manufactured to cost of goods Sold
sold) Pre-determined Overhead Rates
These rates are used to calculate the amount of overhead to be attributed to each cost unit in each
cost centre. This method of using one activity or base to determine the OAR is referred to as the
traditional method of overhead allocation. Overhead absorption rates are calculated for future
periods because the cost of production must be known in advance to enable selling prices to be
fixed. Calculations are based on two areas: planned volumes of output and budgeted overhead
expenditure. You will notice in this review that the amount of overhead by a cost unit is usually
calculated by reference to the time taken to produce it.
Overhead absorption rates are calculated on planned levels of production and budgeted overhead
expenditure. At times (even in job costing which you will review in later chapters) the actual volume
of goods produced and the actual overhead expenditure will turn out to be different from the
budgeted amounts. Those results will show that overhead expenditure will either be under-
absorbed or over-absorbed.
Under-absorption (applied) of overheads
Under-absorption occurs when the actual expenditure is more than the budgeted and planned levels
of production. This means that not enough overheads were charged to production.
Over-absorption (applied) of overheads
Over-absorption occurs when the actual expenditure is less than the budgeted and planned levels of
production. This means that too many overheads were charged to production.
Activity Based Cost System (ABC System)
In contrast to traditional/absorption costing system, ABC system first accumulates the overhead
costs for each organisational activity, and then assigns the cost of activities to the products, services,
or customers (cost objects) causing the activity.
Important Terms
 ABC is a cost of attribution to cost units on the basis of benefit received from indirect
activities.
 An activity is an event that incurs costs.
 A cost object is defined as anything for which a separate measure of cost is
desired/required.
 An activity cost pool is the overhead costs allocated to a distinct type of activity or related
activities.
 A cost driver is any factor or activity that has a direct cause and effect relationship with
resources consumed.
 Cost unit is an item of production or a service for which it is useful to have cost information.
 Cost accounting is the process of identifying, analysing, summarising, recording and
reporting costs associated with business operations.
 Direct Costs are those costs that are directly associated with manufacturing process.
 Indirect/Overhead costs are those costs that are not directly identifiable with a unit of
production.
Related Concepts
 Direct Costing System is a system of costing the products where direct costs (variable costs)
are assigned to product only. It reflects the contribution to indirect costs. The system is
considered appropriate for decision making process. It is recommended in the circumstances
where indirect costs are a low proportion of a company’s total costs.
 Traditional/Absorption Costing System reflects full cost pertaining to a product. It is easy to
use and therefore is practiced widely. The allocation of overhead costs under this system is
based on a rate determined by either a percentage of direct labour cost or number of labour
hours worked or another. Therefore, the reported allocation of overheads for a given
product may be incorrect. It is the main defect of absorption costing.
 Activity Based Costing System also reflects full cost pertaining to a product; however,
establishes relationships between overhead costs and activities so that we can better
allocate overhead costs. It reflects a more accurate use of overhead costs based on their
recent activity levels achieved. Hence, it eliminates the defects of traditional/absorption
costing system.
Steps in ABC System
1. Identify cost objects (Product A,B, C)

2. Identify direct costs (direct labour/expenses/materials)
3. Selection of cost allocation bases to be used for overheads (# of set ups, units etc.)
4. Identify the overheads associated with the bases selected.
5. Compute the rate per unit
6. Compute overheads cost for allocation to products
7. Compute cost of products
Types of Cost
Drivers
Transaction Drivers Intensity Drivers

Duration Drivers
# of purchase orders Each overseas purchase
# of set up hours
# of customer orders order should be weighed
Inspection hours 1.5 times of local purchase
processed
Labour hours order
# of inspections
performed Production hours Each overtime hour shall
be charges as twice of the
# of set-ups undertaken Loading hours normal wage hour
Cost Pools and Cost Drivers
Activity Cost Pools Activity Cost Drivers

Production  Number of units
 Number of set ups
 Number of electricity units consumed
Marketing  Number of sales personnel
 Number of sales orders
Research & Development  Number of research projects
 Personnel hours spend on projects
 Technical complexities of the projects
Customer Service  Number of products serviced
 Number of service calls
 Hours spend on servicing products
Purchasing  Number of purchase orders
Material Handling  Number of material requisitions
Levels of activities
1. Unit Level activities

The costs of direct materials, direct labour and machine maintenance are examples
of unit level activities
2. Batch-level activities
Are costs incurred every time a group (batch) of units is produced. Purchase orders,
machine set-up, and quality tests are examples of batch-level activities.
3. Product-line activities
Examples of product line activities are engineering changes made in the assembly
line, product designer changes, and warehousing and storage costs for each product
line.
4. Facility support activities
The costs relating to the activities are administered in nature and include building
depreciation, property taxes, plant security, insurance, accounting, outside
landscape and maintenance, and plant management’s and support staff’s salaries
Process Costing
Nature of Process Costing
Process costing is a costing system used in manufacturing organisations, where units are
continuously mass produced through various processes. In the mass production system, the product
is a single homogeneous product and the output (finished goods) of one process becomes the input
for the next process until the last process. Examples may include the production of oil, natural gas,
sugar, flour, cement and bricks. The costing of a unit of product remains the same, consisting of
direct materials, direct labour and applied manufacturing overhead. These organisations are usually
highly capital intensive (more machinery in production than labour).
Terms Associated with Process Costing
Term Description
Abnormal These are losses that occur above that of the normal loss. This can be due to
Loss pilferage, employee negligence and faulty equipment. Reflected as a loss in the
income statement.
Normal Loss The normal expected wastage under usual operating conditions. This may be due to
evaporation or expected rejects. This cost is not accounted for by the business. The
cost of these units are absorbed by the other units in production.
Abnormal This occurs when the actual loss is less than the normal loss. This may result from
Gain worker efficiencies, improved technology and more efficient controls in the use of
direct material and direct labour and a more effective application of overheads.
Reflected as a gain in the income statement.
WIP (Work-in The number of units that are incomplete in that process at the end of the period.
process) Opening WlP refers to uncompleted units at the beginning of the process and ending
WIP refers to uncompleted units at the end of the process.
Equivalent This refers to units fully (100% complete) or partly (less than 100% complete)
Units completed, converted to an equivalent number of fully completed goods. For
example, 1500 units of which 1000 units are 100% complete and 500 are 60%
complete:
1000 units 100% complete = 1000 equivalent units
500 units 60% complete = 300 equivalent units
Total equivalent units = 1300 equivalent units.
Scrap Value In some cases, the units that are part of the normal or abnormal loss can be sold.
This is referred to as the scrap value. This is shown as revenue to the company.
Process Costing Report
At each process or department, a product report or worksheet is prepared to account for the units
received and complete and their related cost. One of two approaches is used to prepare the report;
FIFO (first-in, first-out) or weighted average.
Weighted Average method
Total Direct Direct Manufacturing

Materials Labour Overheads
Units to account for:
Beginning WIP (w% complete) xxx
Started in the period xxx
Total units to account for xxx
Units accounted for/Equivalent Units
Units completed and transferred out xxx xxx xxx Xxx
(100% complete
Ending WIP (y% complete) xxx xxx xxx xxx
Total units accounted for/ total xxx xxx xxx xxx
equivalent units (a)
Cost to account for:
Beginning WIP (w% complete) xxx xxx xxx xxx
Costs added during the period xxx xxx xxx xxx
Total cost to account for (b) xxx xxx xxx xxx
Equivalent cost (b) / (a)
Cost Reconciliation/Cost accounted for: r+s+t r s t
Units completed and transferred out [(r+s+t) * #
(100% complete) of units
completed]
xxx
Ending WIP
Direct materials (unit cost * equivalent xxx
units)
Direct labour (unit cost * equivalent xxx
units)
Manufacturing Overheads (unit cost * xxx
equivalent units)
Total ending WIP xxx
Total cost accounted for xxx
FIFO Method
Total Direct Materials Direct Labour Manufacturing

Overheads
Units to account
for:
Opening WIP xxx
(w% complete
Started in the xxx
period
Total units to xxx
account for
Units accounted
for/Equivalent
Units
Beginning WIP xxx xxx xxx xxx
(100% – w%
complete)
Units started and xxx xxx xxx xxx
completed in this
period (100%
complete)
Units transferred xxx xxx xxx xxx
out (100%
complete)
Ending WIP (y% xxx xxx xxx xxx
complete )
Total units xxx xxx xxx xxx
accounted for /
Total equivalent
units (a)
Cost to account
for:
Beginning WIP xxx xxx xxx xxx
(w% complete)
Cost added xxx xxx xxx xxx
during the period
(b)
Total cost to xxx xxx xxx xxx
account for
Equivalent unit r+s+t r s t
cost (b) ÷ (a)
Cost
reconciliation /
Cost accounted
for:
Beginning WIP xxx xxx xxx
(w% complete)
Beginning WIP xxx
(100% – w%
complete) Direct
materials
Beginning WIP xxx
(100% – w%
complete) Direct
labour
Beginning WIP xxx
(100% – w%
complete)
Manufacturing
overheads
Total beginning xxx xxx xxx xxx
WIP
Units started and xxx
completed during
the period (100%
complete)
Units completed xxx
and transferred
out
Ending WIP:
Direct materials xxx
(unit cost ×
equivalent units )
Direct labour xxx
(unit cost ×
equivalent units )
Manufacturing xxx
overheads (unit
cost × equivalent
units)
Total ending WIP xxx xxx xxx xxx
Total cost xxx
accounted for
Marginal Costing and Absorption Costing

The marginal costing method helps a company in key decisions such as operational efficiency and
control measures. The absorption method allocates full production costs and offers accurate final
pricing information.
WHAT IS MARGINAL COSTING?
Marginal costing is the method of allocating variable costs of production to products. It is the
measure of change in cost with respect to the change in quantity produced.
A product incurs two types of costs; fixed costs and variable costs. Fixed costs remain the same
regardless of the production output. In contrast, variable costs change with a change in the
production output.
Variable costs of production include direct material, direct labour, and direct equipment costs. Some
overheads such as utilities for production can also be considered variable costs of production.
For instance, if a particular machine is used for the production facility, the energy cost that varies
with the production level can be included in the total marginal cost of production.
CALCULATION FORMULA OF MARGINAL COSTING
The marginal cost can be calculated through the contribution margin formula. The contribution
margin is the sales less variable cost of production. The profit is contribution margin less fixed costs
of production.
Another way of calculating the marginal cost is to record the change in production related to the
change in quantity.
Marginal Cost = Change in Cost/Change in Quantity
A change in cost comes through the changing level of variable costs. The fixed costs will remain
constant up to a certain production level.
EXAMPLE OF MARGINAL COSTING
Suppose a company ABC produces eyeglass frames. The following data is available for its production
facility.
Units Produced in month 1= 10,000
Units produced in month 2 = 15,000
Variable Costs in month 1= $ 50,000
variable costs in month 2 = $ 80,000
Marginal Cost = Change in cost/change in quantity
Marginal Cost = (80,000 – 50,000)/ (15,000 – 10,000)
Therefore, Marginal Cost = 30,000/5,000 = $ 6 per unit.
Let us consider another example using a different approach. ABC company sells electric gadgets. The
following data is available for the current month-end.
Units Produced = 2,000
Units sold = 1,700
Selling price per Unit = $ 80
Unit Costs: Direct Material = $30 and Direct Labour = $15

Variable production Overheads= $5
Fixed production Overheads = $5
Fixed Costs = $ 50,000
Total Variable Cost per unit = $ 55
Sales (1700*80) 136 000

Cost of Goods Sold:
Opening Inventory
Variable Costs(1700*55) (93500)
Closing Inventory(300*55) 16500
Contribution margin 59000
Fixed Production Costs (50000)
Profit 9000
Sales xxxx
Less: Cost of Goods Sold
Opening Stock xxxx
Add: Cost of Goods Manufactured xxxx
Cost of Goods Available for sale xxxx
Less: Closing Inventory (xxxx)
Cost of Goods Sold xxxx
Add: Variable non-manufacturing xxxx (xxxx)
Contribution Margin xxxx
Less: Fixed Costs
Fixed manufacturing Overheads xxxx
Fixed Non-Manufacturing Overheads xxxx
Total Fixed Costs (xxxx)
Net Income xxxx
PROS AND CONS
Marginal costing is a useful approach that keeps the contribution margin at the same level
regardless of the production changes. It helps management in decision-making regarding product
costs and pricing.
Marginal costing differentiates between the direct and indirect costs of production. It considers
direct costs of production (variable costs) that affect the pricing strategy of the product.
Fixed costs are considered periodic costs in the marginal costing approach. The concept argues that
fixed costs incur regardless of the production level changes. Thus, should be allocated for the
production instead of cost per unit.
The disadvantage of the marginal costing approach is that it is not in accordance with accounting
standards such as GAAP. Public companies cannot adopt marginal costing against compliance rules.
Another drawback of marginal costing is that it considers fixed costs in full for the complete
production period. That can distort the unit selling pricing of products. Also, it can result in
inaccurate inventory costing.
ABSORPTION COSTING
Absorption costing is a costing method that includes all direct costs of production including variable
costs and fixed overhead costs.
Marginal costing includes all variable costs of production plus direct fixed overheads. Variable costs
include direct material, direct labour, and other direct production costs.
Some fixed costs are direct product costs as well. For example, if machinery is leased to produce a
specific product its lease payment is a direct production overhead cost. Thus, it should be included in
the absorption costing method.
Unlike the marginal costing method, absorption costing allocates full costs of production to the per
unit analysis. Hence, it is also called the full costing method.
The ending inventory amount will be different for a company using absorption costing than by using
marginal costing that only considers variable costs.
EXAMPLE
Sales xxxx
Less: Cost of Goods Sold
Opening Stock xxxx
Add: Cost of Goods Manufactured xxxx
Cost of Goods Available for sale xxxx
Less: Closing Inventory (xxxx)
Cost of Goods Sold (xxxx)
Gross Profit xxxx
Less: Expenses
Variable Non-manufacturing Overheads xxxx
Fixed Non-Manufacturing Overheads xxxx
Total Expenses xxxx
Net Income xxxx
PROS AND CONS
The absorption costing method of inventory is in accordance with the accounting standards such as
US GAAP. It means all public companies must implement this rule; thus, compliance is its foremost
advantage.
The absorption costing also includes fixed overheads that are direct costs of production. It reduces
the profits but offers a realistic approach.
The full costing approach helps a company find appropriate and competitive product pricing. Then,
there is an adjustment for any over and under absorption of fixed overheads. Thus, there is little left
after considering the full costs of production.
The biggest disadvantage of the absorption method is it does not help management in the decision-
making process. It is difficult to calculate actual production costs that are direct and variable to
product only.
Another drawback of the full costing method is that it may hide fixed costs from the income
statement. The fixed costs are allocated as production costs that means shifting fixed costs from the
income statement to the balance sheet.
Reconciliation Statement
Net Income: Marginal Costing xxx

Add: Fixed manufacturing overhead in closing xxx
inventory (closing inventory absorption costing
less closing inventory marginal costing)
xxx
Less: Fixed manufacturing overhead in closing (xxx)
inventory (opening inventory absorption
costing less opening inventory marginal costing)
xxx
OR
Absorption Costing Income xxx

Less: Fixed Production Costs in Closing Stock (xxx)
Marginal Costing Income xxx
Will the net income under absorption costing be higher, lower or the same as marginal costing?
1. If units produced >units sold then, absorption costing net income > marginal costing net income
2. If units produced < unit sold then, absorption costing net income < marginal costing net income
3. If units produced =units sold then, absorption costing net income = marginal costing net income
Module 3: Planning and Decision Making

Budgeting
A budget is a future financial plan expressed in quantitative terms. It is the process of formulating an
organisation’s plan.
The objectives of budgeting
 serves to motivate staff in achieving the goals and objectives of the business
 facilitates the communication of management’s plans throughout the organisation
 facilitates the allocation of resources to parts of the organisation where they can be used
effectively
 provides authority for action
 integrates the goals and objectives of departments by facilitating the coordination and
communication of the activities of businesses
 assists management with their planning functions
 uncovers bottlenecks in an organisation’s operations and alerting management of resource
constraints
 provides data/references as benchmarks from which comparisons can be made.
The role of the budget committee
The budget committee is made up of a group of key managerial persons from each department
within an organisation whose job is to coordinate and review their departmental budgets.
o Sets policies for budgets

o Approves budgets and revisions
o Coordinates departmental budgets with master budgets
o Analyses and reviews budget reports for each department periodically.
o Recommends corrective action
Budgetary Control
This is a system that uses the budgets for planning and controlling a firm’s business activities. This is
done periodically by comparing a fi rm’s actual results with its budgeted results, then taking
corrective action to achieve the required targets. The system just described is one of the functions of
the budget committee.
Master Budget
A master budget is a comprehensive set, made up of budgets, schedules and budgeted financial
statements of an organisation. It sets the targets for sales, production, distribution and financing
activities and ends with budgeted financial statements.
Sales budget and cash collection schedule
The sales budget shows the expected sales for the period. It is expressed in both dollars and units of
the product for sale. The sales budget starts the budgeting process in the master budget
preparation. It is the key to the entire budgeting process. The budget determines the inventory
levels, purchases and operating expenses. Thus, when the process continues, the production budget
becomes the key factor in the determination of the other budgets such as the direct materials
budget, the direct labour budget and the manufacturing budgets. Then these budgets, in turn, are
needed to construct a cash budget. It is essential therefore, that organisations prepare accurate and
reliable sales budgets.
In some organisations, the sales budget is followed by the preparation of a cash collection schedule.
This schedule is needed to prepare the cash budget. Expected receipts consist of collections on
credit to customers from the previous period and both cash and credit sales collections made in the
current budget period.
Production Budget
The production budget is prepared after the sales budget. It is important that sufficient goods are
available to meet the sales needs and provide for the desired ending inventory. A portion of these
goods already exist in the beginning inventory and the remainder will have to be produced by the fi
rm. The production budget lists the number of units that must be produced each period, based on
the expected sale and the fi rm’s inventory policy. To determine the production needs the following
formula is used:
Production budget = expected sales (units) + desired ending inventory (units) – beginning
inventory (units)
Direct (raw) materials purchases budget and expected schedule of expected cash
disbursements for raw materials.
The direct materials purchases budget will be prepared based on goods produced. The
budget details the raw materials that must be purchased to fulfill the production budget and
to provide adequate inventories. This budget is shown in units or dollars. The formula for the
direct materials budget is:
Production requirements (units) + desired ending inventory (units) – beginning

inventory (units)
The direct materials budget is usually accompanied by a schedule of expected cash
disbursements for raw materials. This computation is needed to prepare the cash budget.
The schedule consists of payments for purchases on account in the previous period plus any
payments for purchases in the current budget period.
Cash Budget
A cash budget is prepared for short periods of time to the expected fl ow of cash during the
budgeted period. Information obtained in the cash budget is useful in making decisions such as the
need for external financing during critical cash flow traps in an organisation.
To prepare the cash budget, the opening cash balance, cash receipts and cash payments must be
known and shown separately in the document.
Important points to remember when preparing this document are:
• Record only cash paid and received.
• Exclude non-cash items such as depreciation and provision (allowance) for doubtful debts.
• Include capital expenditure payments such as non-current (fi xed/tangible) assets.
Preparation of the cash budget
The cash budget comprises the following sections:
• cash receipts
• cash payments
• the cash excess or deficiency section, and
• financing.
The cash receipts include all estimated cash receipts from cash sales and receipts from accounts
receivables. Other receipts may include interest income, rental income, dividends, and sale of
investments, non-current assets or capital stocks.
Cash payments include all estimated cash payments such as direct materials, direct labour, and
manufacturing, selling and administrative expenses paid during the budget period. Other payments
include income taxes, dividends, investments and the purchase of non-current assets.
The financing section contains cash receipts from financing activities such as investment by owners,
receipt of loans from creditors and cash payments made by the firm to reduce loan payments,
interest paid on loans and other creditors. Whenever there is a cash flow deficit (cash trap),
arrangement is estimated for temporary financing, and is reflected in this section as well.
Cash Budget Format
Month Month Month Total

Beginning cash
xxxx xxxx xxxx xxxx
balance
Add: Receipts
xxxx xxxx xxxx xxxx
Cash sales
xxxx xxxx xxxx xxxx
Credit sales
xxxx xxxx xxxx xxxx
Other receipts
(itemise)
Total cash
xxxx xxxx xxxx xxxx
available
Less: Payments
Raw materials xxxx xxxx xxxx xxxx
Direct labour xxxx xxxx xxxx xxxx
Manufacturing xxxx xxxx xxxx xxxx
cost (excluding
depreciation)
Other payments xxxx xxxx xxxx xxxx
(itemise)
Total cash xxxx xxxx xxxx xxxx
payments
Excess
(deficiency) of
xxxx xxxx xxxx xxxx
receipts over
payments
Financing
Loan
xxxx xxxx xxxx xxxx
Loan payment
xxxx xxxx xxxx xxxx
Interest
xxxx xxxx xxxx xxxx
Ending cash
xxxx xxxx xxxx xxxx
balance
Standard Costing
Standard costing allows a business to plan its cost according to the level that favours management
in optimal usage of resources and minimum price.
Difference between standards and budgets
Standards ensure that the overall quality of a product is high. In concept, it is essentially the same as
budgets; both predetermined costs contribute to management planning and control. The difference
lies in the way the terms are expressed; for example, a standard is the budgeted cost (process cost)
per unit of product. In other words, in standard costing, a budget is prepared for each unit (each
process) instead of just for each particular department.
Standard costing system
A standard costing system is a product costing system that determines product cost by using
standards or norms for quantities and prices of the various components. These standards are
compared against actual costs for cost control purposes. A standard cost is an estimated or
budgeted cost (benchmark) to produce a single unit of product or perform a single service. Standard
costing oversees each individual cost component that makes up an entire budget. Standards costs
are planned unit costs of products, components or services produced in a period.
 Management can focus on problem  Standards are loosely determined as
areas. too vigorous; tight standards may be
 Problems can be spotted on time and ineffective
remedial actions taken promptly.  Standards which are changed
 Standards can be used to motivate constantly produce elastic criteria.
employees to performance  It is difficult in practice to assign
improvement. responsibility for variances to specific
 Standards are yardsticks for measuring individuals.
efficiency and are predetermined costs  Too much attention is focused on the
for control purposes ‘exception’ resulting in insufficient time
 Standard costs facilitate cash planning given to setting realistic standards.
and inventory planning  Difficulty in determining which
 Useful in setting selling prices. variances are ‘material’ or significant in
amount.
The Standard-Setting Process.

The types of information required (and source) to produce standard costs are:
 Direct materials (types, quantities and price); document – bill of materials

 Direct labour (grades, number and rates of pay); document – wages records
 Variable overhead (the total variable overhead costs analysed into various categories such as
employee and general costs)
 Fixed overhead (the total overhead analysed into various categories such as employee costs,
building costs and general administration expenses.
Setting Direct Materials Standards
The standards set for direct raw material are price and quantity. The direct materials price standards
the cost per unit of direct materials that should be incurred. This standard is based on current
purchase prices at times. The standard price per unit for materials purchased reflects the final cost,
net of discounts taken and handling charges. In addition, the price reflects the grade (namely good
quality), quantity and method of delivery. The information for setting standard price can be
prepared as shown below:
Purchase price (indicate grade) x

Freight (indicate type and from where) x
Receiving and handling x
Less purchase discount (x)
Total cost x
Units (divided) (÷) x
Standard price per pound x
The standard quantity per unit for direct materials reflects the amount of material going into each
unit of finished product including allowances for unavoidable waste, spoilages and other normal
inefficiencies. In setting the standard, management considers both the quality and quantity of
materials required to make products. This standard is expressed as a physical measure such as
pounds, barrels or board feet. The documentation prepared should contain some of the information
below:
Material requirements as specified in the bill of materials in pounds x

Allowance for waste and spoilage in pounds x
Allowance for rejects in pounds x
Standard quantity in pounds x
When the price and quantity standards have been set the standard cost of materials per unit of the
finished product will be computed and entered in the standard cost card. The information should be
shown in the cost card as follows:
X pounds per unit × $ per pound =$per unit
Setting direct labour standards
Direct labour price and quantity standards are expressed as labour rate and labour hours. Direct
labour price standard is the rate per hour that should be incurred for direct labour. This standard is
based on current wage rates, adjusted for anticipated changes such as cost of living allowance
(COLA). The standard labour rate per hour would include not only wages earned, but also employer
payroll taxes, an allowance for fringe benefits such as paid holidays and vacations and other labour
costs. A company determining the standard rate per hour should include the following:
Basic wage rate per hour x

Income tax (PAYE) x
NIS/Social Security x
Fringe benefits x
Total cost per worker x
Divided by total hours per week ( ÷) x
Standard rate per direct labour hour x
Standard Hours per unit
This is the determination of the standard direct labour time (quantity or efficiency) required
to make one unit of product especially in labour-intensive companies. The standard time
should include allowances for coffee breaks, employees’ personal washroom breaks, clean-
ups and machine setup and machine breakdown. The documentation when prepared should
contain the following:
Basic labour, time per unit in hours x

Allowance for breaks and personal needs x
Allowance for clean-up and preparation x
Allowance for machine breakdowns x
Allowance for rejects (or spoilage) x
Standard labour hours per unit of product x
Setting manufacturing overhead standards
A predetermined overhead rate is used to set manufacturing overhead standards. This rate is
determined by dividing budgeted overhead costs by an expected standard activity base such as
standard machine hours and standard direct labour hours.
Total standard cost per unit

The total standard cost per unit is the sum of the standard costs of direct materials, direct labour
and manufacturing overheads. The information will be shown as follows on a standard cost card:
Standard cost card

Inputs Standard quantity or Standard price or rate Standard cost
hours $ (standard quantity or
hours × standard price
or rate)
$
Direct Materials X pounds x x
Direct labour X pounds x x
Variable X pounds x x
manufacturing x
overhead
Total standard cost
per unit ($)
Types of standards
1. Ideal standard is a standard which is attainable under the most favourable conditions and where
no allowance is made for normal losses, wastage and machine breakdowns or work interruptions.
The major problem, however, is that employees may not strive to meet the standard because they
are demotivated.
2. Practical standard is stringent but attainable. The standards allow for normal machine downtime
and employee rest period. This is where the overall lowest price is used for costing and allows for
normal inefficiencies or delays in production. When these standards are used by companies, they
provide positive motivation to their employees.
Difference between static budgets and flexible budgets
A static budget is a budget prepared at the beginning of a budget period for a single planned output.
A flexible budget is a series of static budgets at different levels of activity adjusted (flexed) to
recognise the actual output level for a budgeted period. This particular type of budget gives
managers a clearer picture into the causes of variances in static budgets.
Flexible budget
Steps in constructing a flexible budget are set out below:
1. Identify the actual quantity of output.

2. Calculate the flexible budget revenues based on the budgeted selling price and actual
quantity of output.
3. Calculate the flexible budget for costs based on budgeted variable costs per output unit,
actual quantity of output, and the budgeted fixed costs
Variance Analysis
Material variances (price and usage)
Price = (actual price per unit − standard price per unit) × total actual quan ty used
Usage = (total actual quantity used – standard quantity for actual production) × standard price
Total = actual quantity used × (actual price per unit – standard price per unit) –standard price per
unit × (actual quantity used – standard quantity for actual production)
Causes of materials variances
1. Price paid for raw materials:

a. Internal:
i. delivery method used
ii. availability of quantity
iii. availability of cash discounts
iv. quality of the materials requested
v. rush order forces the company to pay a higher price for materials.
b. External:
i. Prices may rise faster than expected, for example oil price increases.
2. Materials quantity used:
a. inexperienced workers
b. faulty machinery or carelessness
c. inferior quality
Labour variances (wage rate and efficiency)
Rate = (actual hourly rate per unit – standard hourly rate per unit) × total actual hours worked
Efficiency = (total actual hours worked – standard hours for actual production) × standard hourly
rate
Total = (actual hourly rate per unit × actual hours) – (standard hourly rate per unit × standard hours
for actual production)
Causes of labour variances
Labour price variance:
a. paying workers higher wages than expected

b. misallocation of workers (such as using skilled workers instead of unskilled, or the reverse)
Labour efficiency:
a. poor training of workers

b. worker fatigue
c. faulty machinery or carelessness.
Variable overhead variances (efficiency and expenditure)
Expenditure(spending) = (actual variable overhead expenditure rate per unit – variable production
overhead absorption rate) × actual hours worked
Efficiency = (standard hours for actual production – actual hours worked) × variable production
overhead absorption rate
Total = (actual variable overhead) – (standard hours for actual production) × variable production
overhead absorption rate
Fixed overhead variances (expenditure and volume)
Expenditure (spending or fixed overhead flexible budget) = (actual expenditure – total budgeted
expenditure)
Efficiency = (standard hours of production – actual hours worked) × fixed absorption rate
Productivity (denominator or output level) = (actual hours worked (denominator hours) – standard
hours for actual production) × fixed overhead absorption rate
Volume = budgeted expenditure – (actual hours for production × fixed absorption rate)
Total = (actual overhead) – (standard hours of production) × fixed overhead absorption rate
Causes of manufacturing overhead variances
a. higher than expected use of indirect materials, indirect labour and factory supplies
b. increases in indirect manufacturing costs such as fuel and maintenance costs
c. inefficient use of direct labour or machine breakdowns
d. lack of sales orders.
Accounting entries for variances
The rules are as follows:
1. Open an account for each type of variance.

2. Debit adverse variances.
3. Credit favourable variances.
Cost volume profit (CVP) analysis

This is a management accounting tool used to evaluate the shifts in costs and volume and their
resulting effects on profits. In evaluating the shifts, managers focus on interactions between
elements such as prices of products, volume or level of activity, per unit variable costs, total fixed
costs and mix of products sold.
Cost Behaviour Analysis
Variable costs are costs that vary in total directly and change in proportion to the activity level, that
is, if the level increases by a percentage, the total variable costs will also increase by that
percentage. Variable cost per unit is assumed to remain constant within the relevant range.
Fixed costs are costs that remain the same (within the relevant range) in total regardless of changes
in the activity level. Remember also that a lot of manufacturing firms now use more technology
(fixed costs such as automation) and make less use of employee labour (variable costs). The change
in use in each case results in depreciation and lease charges (fixed costs) increasing, and direct
labour costs (variable costs) decreasing.
Relevant range is the range over which a company expects to operate during a year (or short term).
The relevant range is the range of activity over which a variable cost remains constant on a per-unit
basis and a fixed cost remains constant in total.
Mixed costs are costs that contain both variable and fixed elements. These costs change in total but
not proportionately with changes in the activity level.
CVP Analysis
CVP analysis considers the effects (interrelationships) among five basic components: volume or
activity, unit selling prices, variable cost per unit, total fixed costs and sales mix. The following
assumptions underlie each CVP analysis.
1. The behaviour of costs and revenues are linear throughout the relevant range of volume,
and they can be divided into variable and fixed elements (using the high-low method for
mixed costs). The variable element is constant per unit, and the fixed element is constant in
total over the entire relevant range.
2. Selling price is constant throughout the entire relevant range. The price of a product or
service will not change as volume changes. Changes in activity are the only factors that
affect costs.
3. In manufacturing companies, inventories do not change. The number of units produced
equals the number of units sold.
4. When more than one type of product is sold, the sales mix will remain constant (that is, the
percentage that each product represents of total sales will stay the same).
5. Changes in the level of revenues and costs arise only because of changes in the number of
products units produced and sold.
6. Efficiency will remain constant; that is, during the period there are no productivity gains or
losses.
Concepts/computations used in CVP
Operating income
Operating income = Total revenues from operations (cost of goods sold + operating costs)
Net income = Operating income – income taxes
Contribution
Contribution is the difference between selling price and variable cost (which is the amount
remaining after the deduction of variable costs). It is computed as follows:
Contribution = Sales – variable costs
Contribution margin per unit
Contribution margin per unit = Unit selling price – unit variable costs
Contribution margin ratio
Contribution margin ratio = Contribution margin per unit ÷ unit selling price
Computing break-even point
Break-even analysis
Break-even analysis is the process of finding break-even point. This analysis is useful in helping
managers in making decisions such as whether to introduce new product lines, change sales prices
on established products, or enter new market areas.
Break-even point
Break-even point is the level of activity at which total revenues equal total costs (both fixed and
variable) and net income is zero. Break-even point can be computed from a mathematical equation,
using contribution margin, or derived from a cost volume graph. The break-even point can be
expressed either in sales units or sales dollars.
Mathematical equation (equation method or income statement approach)
This method represents the contribution approach (variable costing) income statement and shows
the relationships among revenue, fixed cost, variable cost, volume and profit. The formula to express
break-even point is as follows:
Sales (x) – (variable expenses (x) – fixed expenses) = Net income
When rearranged the above equation produces the following expression (causing break-even profit
to be zero):
Sales = (variable expenses + fixed expenses) + operating profits
The formula for the sales break-even point in dollars is:
Break even in units × unit selling price
Contribution margin (unit contribution approach) technique
This approach centres on the idea that each unit sold provides a certain amount of contribution
margin to cover fixed costs. The formula to calculate the breakeven point in units is:
Fixed expenses ÷ unit contribution margin (which is selling price – variable cost)
The formula to calculate break-even point in total sales dollars is:
Fixed expenses ÷ contribution margin ratio (which is contribution margin per unit ÷ selling price per
unit × 100)
Margin of safety
The margin of safety is the excess of budgeted (or actual) sales over break-even volume of sales. It
states the amount by which sales can drop before losses begin to be incurred. The formula for
margin of safety in dollars is as follows:
Total sales – break-even sales
Margin of safety can also be expressed in percentage form. The percentage is obtained by:
Margin of safety in dollars ÷sales ×100

Target net income (profit or target net profit analysis)
This is the income objective fi rms set for individual product lines. It indicates the sales necessary to
achieve a specified level of income. The three approaches (equation method, contribution margin
method and through graphicpresentations) can be used to determine the required sales (either in
sales units or sales dollars).
Equation method
The formula for this method has an amount for target net income added to the equation. Required
sales are determined as follows:
Variable costs + fixed costs + target net income
Contribution margin technique
The sales required to meet a target net income can be computed in either units or dollars. The
formula using the contribution margin per unit is as follows:
(Fixed costs + target net income) ÷ contribution margin per unit
The formula for the contribution margin ratio is:
(Fixed costs + target net income) ÷ contribution margin ratio
Capital Budgeting Techniques
Capital budgeting is the process of generating, evaluating, selecting and following up on capital
expenditures. Capital expenditures are expenditures incurred in obtaining, producing or enhancing
assets (capital assets) that are expected to benefit t (generate revenue) the firm for a period (usually
longer than one year). These assets are tangible or intangible assets acquired for the purpose of
providing a service to the business and not held for resale.
Capital investment decisions play a significant part in the capital budgeting process, which is
concerned with decision-making in areas such as determining:
 which specific investment projects the firm should accept

 the total amount of capital expenditure which the fi rm should undertake
 how projects should be financed
Initial Investment on Project
Initial investment = (cost of new project + installation cost) – (proceeds from sale or disposal of
existing assets + taxes on sale of assets [if it is a tax saving])
The effect of depreciation on initial investment
Depreciation is a non-monetary expense charged against the profits of a firm. It is a tax shield for
capital budgeting decisions. The tax benefit is calculated as follows:
Amount of depreciation deductible for tax purposes × tax rate

Payback period(PBP) or Payback time
An investment’s payback period is the expected time period to recover the cash invested in a
project. Companies desire a short payback period to increase return and reduce risk. The more
quickly a company receives cash, the sooner it is available for other uses and the less time it is at risk
of loss. A shorter payback period also improves the company’s ability to respond to unanticipated
changes and lowers its risk of having to keep an unprofitable investment.
Computing payback period with even cash flows
The payback period is expressed in years. Net cash inflow is the same every year. The formula for
computing the payback period of an investment for even cash flows is:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
Computing payback period with uneven cash flows
Uneven cash flows refer to cash flows that are not all equal in amount. For this method, the payback
period is computed using the cumulative total of net cash flow (which is the addition of each
period’s net cash flows). Year 0 refers to the period of initial investment in which the cash
outflowoccurs at the end of year 0 to acquire the asset.
Period Expected Net Cash Flows Cumulative Net Cash Flows

Year 0 (xxxx) (xxxx)
Year 1 xxxx (xxxx)
Year 2 xxxx (xxxx)
Payback period= 2 years
- The payback method is simple to use - The method ignores the time value of
and understand. money.
- The project with the shortest payback - It ignores longer-term profitability of
period is chosen because it reduces projects (can encourage short-term
risk. thinking rather than long-term
- The method is easy to calculate. planning).
- It considers the timings of cash flows. - Ignores revenues and costs that occur
- The method is useful for firms after payback has been achieved.
operating in markets that undergo fast
change.
Accounting rate of return

Accounting rate of return (ARR) (known as return on average investment) expresses a project’s
return on investment. It is also an indicator of profitability. ARR is the average annual net income
from an investment expressed as a percentage of the average amount invested. When the expected
ARR exceeds required rate of return, the investment can be accepted. However, when the expected
ARR doesn’t exceed the required rate of return.
- It is simple to use and understand. - It ignores the time value of money.
- Takes into account the total earnings - Ignores the timing of the cash flow
(measures profitability) of the project. - Ignores the accrual concept of
- Considers the whole life of the project. accounting
- Easy to compare returns of different - More difficult to calculate than
options. payback.
Net present value
In this method, the present value of all cash inflows compared to the present value of all cash
outflows that are associated with an investment project. The difference between the present values
of cash flows and investment is called the net present value (NPV). Net present value determines
whether the project is an acceptable investment.
Salvage value affects net present value analysis; in computing NPV, salvage values should be
considered as an additional cash inflow and shown as such at the end of the final year of the asset’s
life, or as a reduction in the required investment.
In addition, some businesses may expand their working capital. Such needs should be treated as part
of the initial investment in a project. Furthermore, projects requiring additional outlays for repairs
and other additional operating costs should be treated as cash outflows. On the other hand, when a
project is terminated, working capital released (example from the sale of inventory, receipt from
receivables) should be treated as cash inflow.
NPV calculations do not include deductions for depreciation. They are based on inflows and outflows
of cash and not on the accounting concepts of revenues and expenses. Depreciation is not a cash
flow; it is a critical concept in computing net income for financial statements. It is a way of allocating
the cost of a non-tangible asset to different periods.
Format
Years Amount of cash (x%) factor Present Net

flow Value
Annual Net Cash 1- Number $x Annuity $x
Inflow of years
Initial Investment Now $(x) 1.00 $(x)
Net Present $x
Value
The formula to compute NPV is:
Net present value = Present value of discounted cash flows – amount invested
Accept Project Reject Project

When an asset’s expected cash flows are When an asset’s expected cash flows are
discounted and yield a positive (greater) net discounted and yield a negative (lower) net
present value. present value.
When an asset’s expected cash flows are
discounted and equals zero.
- Considers the time value of money - Difficulty in estimating the initial cost of
- Recognises income over the entire life the project and the time periods in
of the project which instalments must be paid back
- Deals with risk by discounting future - Difficult to estimate accurately the net
cash flow more heavily. cash flow for each year of the project’s
life
- Time-consuming to calculate
- Based on an arbitrary interest rate
- Difficult to understand.
Internal Rate of Return
The return can be defined as the interest yield promised by an investment project over its useful life.
IRR equals the rate that yields an NPV of zero for an investment. This technique is used to evaluate
the risk of an investment (project) and assess the uncertainty of future cash flows. To do this, a
predetermined hurdle rate is selected by management to compare and evaluate capital investment.
Acceptance or rejection of projects will depend on the actual returns from the comparison of
projects.
The firm computes the total present value of a project’s net cash flows using the IRR as the discount
rate and then subtracts the initial investment from this total present value to get a zero NPV.
Even cash flows IRR for even cash flows can be computed in a two-step process. The steps are as
follows:
1. Compute the present value factor for the investment project. The formula is as follows:
𝐴𝑚𝑜𝑢𝑛𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑
𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠
2. Identify the discount rate (IRR) yielding the present value factor. The process is as follows:
Search the interest table for a present value or annuity factor equal to the amount
calculated in 1 above in the relevant year row. (The discount rate implies that the IRR is
approximately (x%).)
Years Amount of cash (x%) factor Present Net

flow Value
Annual Net Cash 1- Number of $x Annuity $x
Inflow years
Initial Investment Now $(x) 1.00 $(x)
Net Present $x
Value
Uneven cash flows
When cash flows are uneven, a trial-and-error approach is used to compute the IRR. This is done by
selecting any reasonable discount rate to compute the NPV.
Note: The NPV result must end in different signs (positive and negative) because using IRR, the NPV
is zero and IRR lies between two discount rates. Assume that the amounts result in positive
(negative), re-compute until the results end differently (positive and negative).
Accept Project Reject Project

If IRR is higher (greater) than the hurdle rate. If IRR is lower(lesser) than the hurdle rate.
• If IRR is equal to zero.
- Recognises the time value of money - Assumes that earnings are re-invested
- Recognises income over the whole life at the IRR
of the project - Difficult to determine which of two
- Expressed as a percentage return, suitable rates to adopt unless a
which is useful in ranking alternative computer is used
projects - It gives an approximate rate of return
- Emphasis is placed on liquidity only.

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Medieval and Renaissance Periods

Modern Professional Accounting

These established principles, standards and legislation (unique to each

Significance of Accounting Information

Limitations of Accounting Information

- Assumptions, subjective judgements and estimates are required in the

User Need for Accounting Information

Journal all Prepare a trial

Prepare a full Make end of

ACCOUNTING STANDARDS ARE GUIDELINES OF BEST ACCOUNTING PRACTICE IN THE TREATMENT OF

1. preparers of general-purpose financial statements

1. The IASB sets up a steering committee.

The International Financial Reporting Standard for Small and Medium-sized

Issuing the IFRS for SMEs:

Contents of the Conceptual Framework

Objectives of Financial Reporting

- The primary users of general-purpose financial reporting are present and

Qualitative characteristics of Accounting Information

Elements of Financial Statements

 Elements relating to financial position (balance sheet)

Level III: Recognition, measurement and disclosure principles

 Cost-benefit to the company. Will the benefits of including certain information

Recording Financial Information

b. 2 June 2015: deposited $6000 cash into the bank

Date Details Debit Credit

Date Details Debit Credit

Accounting for consumables such as office supplies and small tools

Office Supplies expense= opening inventory-closing inventory

Closing off an expense account

Date Details Debit Credit

Closing off a revenue account

Date Details Debit Credit

Recording depreciation calculated for the period

Reducing balance method formula: net book value* x given percentage

*fixed asset at cost – accumulated depreciation

Depreciation for the year= (76000-16000) x 10%

Date Details Debit Credit

Deferrals (prepayments) and accruals (amounts owing, outstanding or due)

Date Details Debit Credit

Date Details Debit Credit

Date Details Debit Credit

Date Details Debit Credit

 Cumulative- guaranteed fixed rate of return on the investment. If not paid in

Valuation Definitions and Examples Journal Entries

Reasons for capital reduction:

 Where capital is not represented by assets

1. To write down the assets

Where some of the assets are no longer needed

Payment Date- this is when actual payment to shareholder is recorded.

Journal Entry for Dividends

Date Details Debit Credit

Example 2: Simpson Company is authorized by its Articles of Incorporation to issue

- April 1- sold 3000 preference shares for cash at par value

Prepare the journal entries to record the following transactions:

a) Sale of $30000 preference shares at par

Date Details Debit Credit

Date Details Debit Credit