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Financial accounting ABE diplopma in business management

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Business Management Study Manuals Diploma in Business Management FINANCIAL ACCOUNTING The Association of Business Executives 5th Floor, CI Tower  St Georges Square  High Street  New Malden Surrey KT3 4TE  United Kingdom Tel: + 44(0)20 8329 2930  Fax: + 44(0)20 8329 2945 E-mail: info@abeuk.com  www.abeuk.com © Copyright, 2008 The Association of Business Executives (ABE) and RRC Business Training All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form, or by any means, electronic, electrostatic, mechanical, photocopied or otherwise, without the express permission in writing from The Association of Business Executives Diploma in Business Management FINANCIAL ACCOUNTING Contents Unit Title The Nature and Purpose of Accounting The Scope of Accounting Users of Accounting Information Rules of Accounting (Accounting Standards) Accounting Periods The Main Characteristics of Useful Information The Twelve Traditional Accounting Concepts Important Accounting Terms Different Types of Business Entity Auditing in Business 14 14 17 20 22 25 Business Funding Capital of an Enterprise Dividends Debentures Types and Sources of Finance Management of Working Capital 31 33 40 41 44 48 Final Accounts and Balance Sheet 53 55 55 57 59 62 67 69 71 75 75 The Trial Balance Trading Account Manufacturing Account Profit and Loss Account Allocation or Appropriation of Net Profit The Nature of a Balance Sheet Assets and Liabilities in the Balance Sheet Distinction between Capital and Revenue Preparation of Balance Sheet Presentation of Financial Statements Introduction The UK Companies Act 1985 and Accounting Requirements The Balance Sheet The Income Statement IAS 1: Statement of Changes in Equity Summary of Statements Required by IAS Narrative Statements Required in Published Financial Statements Appendix 1: Example of Statement of Accounting Policies Appendix 2: Example of Independent Auditors' Report Appendix 3: Example of Directors' Report Page 81 83 83 87 93 97 99 99 102 110 111 Unit Title Page Profit and Cash Flow Availability of Profits for Distribution Cash Flow Statements Funds Flow Statements 115 116 119 130 Valuation of Non-Current Assets and Inventories Valuation of Inventories Valuation of Long-Term Contracts The Importance of Inventory Valuation Depreciation Methods of Providing for Depreciation Borrowing Costs and IAS 23 Leased Assets and IAS 17 IAS 36: Impairment of Assets IAS 40: Investment Properties 135 137 143 146 149 153 154 154 156 157 Further Accounting Standards and Concepts Introduction IAS 33: Earnings Per Share IAS 20: Accounting for Government Grants IAS 12: Income Taxes Accounting for Research and Development Expenditure IAS 10: Events after the Balance Sheet Date IAS 37: Provisions, Contingent Liabilities and Contingent Assets IAS 38: Intangible Assets IAS 18: Revenue IAS 24: Related Party Transactions Accounting for Inflation 165 167 167 168 169 170 171 173 176 178 179 180 Assessing Financial Performance Interpretation of Accounts Ratio Analysis Profitability Ratios Liquidity Ratios Efficiency Ratios Capital Structure Ratios Investment Ratios Limitations of Accounting Ratios Worked Examples Issues in Interpretation 189 191 193 196 198 200 202 203 205 207 214 Unit Title Page Sources and Costs of Finance Introduction Finance and the Smaller Business Finance and the Developing Business Finance for the Major Company The London Money Market The Cost of Finance Cost of Equity Cost of Preference Shares Cost of Debt Capital Weighted Average Cost of Capital (WACC) Cost of Internally Generated Funds Management of Factors Affecting Share Prices Factors Determining Capital Structure Advantages and Disadvantages of the Principal Financial Alternatives 225 227 227 230 233 239 240 241 243 243 244 245 247 249 253 10 Financial Reconstruction Introduction Redemption of Shares Accounting Treatment Example of Redemption of Preference Shares Example of Redemption of Ordinary Shares Redemption of Debentures 257 258 258 259 259 262 265 11 Group Accounts 1: Regulatory and Accounting Framework Introduction IAS 27: Consolidated and Separate Financial Statements IFRS 3: Business Combinations IAS 28: Investments in Associates IFRS 3: Fair Values in Acquisition Accounting Alternative Methods of Accounting for Group Companies Merger Accounting 269 270 270 272 274 276 277 280 12 Group Accounts 2: The Consolidated Accounts Introduction The Consolidated Balance Sheet The Consolidated Income Statement Group Accounts – Example 283 284 284 298 306 13 Financial Accounting Examination – The Compulsory Question The Financial Accounting Examination December 2007 Compulsory Question Specimen Examination Compulsory Question 323 324 325 330 Study Unit The Nature and Purpose of Accounting Contents Page A The Scope of Accounting The Purpose of Accounting Financial Accounting and Management Accounting Money as the Common Denominator The Business Entity 3 3 B Users of Accounting Information Main Categories of Users Interests of Principal Users 4 C Rules of Accounting (Accounting Standards) Development of UK Accounting Standards International Accounting Standards Statements of Standard Accounting Practice 6 D Accounting Periods 14 E The Main Characteristics of Useful Information Underlying Assumptions Qualitative Characteristics of Financial Statements 14 15 16 F The Twelve Traditional Accounting Concepts Prudence Going Concern Consistency Money Measurement Duality Matching Cost Materiality Objectivity Realisation 17 17 18 18 18 18 19 19 19 19 19 (Continued over) © ABE and RRC The Nature and Purpose of Accounting Business Entity Concept Separate Valuation IAS 1: Presentation of Financial Statements 19 20 20 G Important Accounting Terms The Accounting Equation or Basic Formula Assets and Liabilities Capital v Revenue Expenditure 20 20 21 22 H Different Types of Business Entity The Sole Trader Partnerships Limited Companies in the UK Accounting Differences Between Companies and Unincorporated Businesses Principle of Limited Liability Promoters and Legal Documents 22 22 23 23 24 24 24 I Auditing in Business What is an Audit? Types of Audit UK Law and External Audit External Audit Report External Audit Process Expectations Gap 25 25 25 26 27 28 28 Answers to Questions for Practice 30 © ABE and RRC The Nature and Purpose of Accounting A THE SCOPE OF ACCOUNTING The Purpose of Accounting A business proprietor normally runs a business to make money He or she needs information to know whether the business is doing well The following questions might be asked by the owner of a business:  How much profit or loss has the business made?  How much money I owe?  Will I have sufficient funds to meet my commitments? The purpose of conventional business accounting is to provide the answers to such questions by presenting a summary of the transactions of the business in a standard form Financial Accounting and Management Accounting Accounting may be split into Financial Accounting and Management Accounting (a) Financial Accounting Financial accounting comprises two stages: (b)  book-keeping, which is the recording of day-to-day business transactions; and  preparation of accounts, which is the preparation of statements from the bookkeeping records; these statements summarise the performance of the business – usually over the period of one year Management Accounting Management accounting is defined by the Chartered Institute of Management Accountants (CIMA) as follows: "The application of professional knowledge and skill in the preparation and presentation of accounting information in such a way as to assist management in the formulation of policies and in the planning and control of the operations of the undertaking" Management accounting, therefore, seeks to provide information which will be used for decision-making purposes (e.g pricing, investment), for planning and control Money as the Common Denominator Accounting is concerned with money measurement – it is only concerned with information which can be given a monetary value We put money values on items such as land, machinery and stock, and this is necessary for comparison purposes For example, it is not very helpful to say: "Last year we had four machines and 60 items of stock, and this year we have five machines and 45 items of stock." It is the money values which are useful to us There are, though, limitations to the use of money as the common denominator (a) Human Asset and Social Responsibility Accounting We have seen that accounting includes financial accounting and management accounting Both of these make use of money measurement However, we may want further information about a business: ©  Are industrial relations good or bad?  Is staff morale high?  Is the management team effective? ABE and RRC The Nature and Purpose of Accounting  What is the employment policy?  Is there a responsible ecology policy? These questions will not be answered by conventional business accounting in money terms but by "human asset accounting" and "social responsibility accounting" These subjects have not yet been fully developed and are outside the scope of your syllabus (b) Devaluation The value of money does not remain constant, and there is normally some degree of inflation in the economy We will look at the steps that have been taken to attempt to adjust accounting statements to the changing value of money later in the course The Business Entity The business as accounting entity refers to the separate identities of the business and its owners  The Sole Trader There must always be a clear distinction between the owner of the business and the business itself For example, if Mr X owns a biscuit factory, we are concerned with recording the transactions of the factory We are not concerned with what Mr X spends on food and clothes If Mrs Y, works at home, setting aside a room in her house, an apportionment may have to be made  Partnership Similarly, the partners in a business must keep the transactions of the business separate from their own personal affairs  Companies In UK law, a company has a distinct "legal personality" This means that a company may sue or be sued in its own right The affairs of the shareholders must be distinguished from the business of the company The proprietor of a limited company is therefore distinct from the company itself We shall return to the issue of business entities later in the unit B USERS OF ACCOUNTING INFORMATION We need to prepare accounts in order to "provide a statement that will meet the needs of the user, subject to the requirements of statute and case law and the accounting bodies, and aided by the experience of the reception of past reports" So if we prepare accounts to meet the needs of the user, who is the user? Main Categories of Users The main users of financial accounts are:  Equity investors (shareholders, proprietors, buyers)  Loan creditors (banks and other lenders)  Employees  Analysts/advisers  Business contacts (creditors and debtors, competitors)  The government (The Inland Revenue) © ABE and RRC 308 Group Accounts 2: The Consolidated Accounts Workings (a) Goodwill calculations £000 S Ltd: Purchase consideration £000 600 80% ordinary share capital 80% pre-acquisition reserves 80% revaluation reserve (fair value) (1,200 – 1,000) × 80% 320 80 160 Goodwill on acquisition (560) 40 Impairment: £6,000 £000 A Ltd: Purchase consideration 140 25% of ordinary share capital 25% pre-acquisition reserves 50 20 Goodwill on acquisition (b) £000 (70) 70 Minority interest in S Ltd £000 20% ordinary shares 20% reserves 20% revaluation 80 160 40 280 (c) Investment in associated company £000 Cost of investment Group share of post-acquisition retained profits (25% × (280 – 80)) 140 50 190 Equals: 25% of A Ltd net assets at 31.12 Year (i.e 480 × 25%) plus Goodwill 120 70 190 (d) Group reserves (using a "T" account) GROUP RESERVES £000 S Ltd pre-acquisition reserve Minority interests £000 80 H Ltd 2,200 160 S Ltd 800 Impairment Balance c/d 2,804 A Ltd (share) 50 3,050 3,050 © ABE and RRC Group Accounts 2: The Consolidated Accounts Group Income Statement for the Year ended 31 December Year £000 Profit before tax (1,320 + 260 + (180 × 25%)) Taxation (400 + 60 + (40 × 25%)) Profit after tax 1,625 (470) 1,155 Impairment of goodwill S Minority interest (20% × 200) Profit after tax and minority interest Dividend Group retained profit for the year (6) (40) 1,109 (100) 1,009 Group Balance Sheet as at 31 December Year £000 Non-current assets Intangible (40  6) Tangible (including revaluation) 34 3,200 Investment in associated undertaking 190 Net current assets 900 4,324 Creditors: amounts falling due after more than year (440) 3,884 Share capital Reserves Minority interest 800 2,804 280 3,884 Note that only the unimpaired goodwill in relation to S appears under intangibles © ABE and RRC 309 310 Group Accounts 2: The Consolidated Accounts Questions for Practice Bold plc purchased 75% of the ordinary share capital of Surf Ltd several years ago when Surf Ltd's retained earnings were £200,000 Bold plc has also owned 25% of Tide Ltd since 31 December Year At that date Tide Ltd's reserves were £40,000 The income statements for the three companies for the year ended 31 December Year were as follows: Bold plc £000 Sales Tide Ltd £000 800 500 (600) (450) (200) 400 350 300 (200) (200) (100) 200 150 200 60 – – Profit before tax 260 150 200 Taxation (70) (48) (60) Profit after tax 190 102 140 (100) (60) (60) 90 42 80 Retained profit b/f 1,200 800 400 Retained profit c/f 1,290 842 480 Cost of sales Gross profit Expenses Operating profit Dividends receivable Dividends proposed Retained profit for year 1,000 Surf Ltd £000 Prepare a consolidated income statement and analysis of retained profits for the year ended 31 December Year for the Bold group Show also how these profits would be reflected in reserve movements © ABE and RRC Group Accounts 2: The Consolidated Accounts 311 This final question for practice is taken from the December 2007 examination paper On October 2005, Helman enterprise acquired million of Sabine enterprises' ordinary shares paying £4.50 per share At the date of acquisition, the retained earnings of Sabine were £4,200,000 The draft balance sheets of the two enterprises as at 30 September 2007 were as follows: Helman £000 £000 Sabine £000 £000 11,000 10,225 9,000 6,000 5,110 30,225 11,110 Assets Non-current assets Property Plant and equipment Investment in Sabine Current assets Inventory Trade receivables Cash 4,925 5,710 495 Total assets 3,295 1,915 11,130 5,210 41,355 16,320 5,000 25,920 2,500 8,290 30,920 10,790 6,000 2,000 Equity and liabilities Equity Ordinary shares £1 Retained earnings Non-current liabilities 10% loans Current liabilities Trade payables Bank overdraft Tax 3,200 1,235 Total equity and liabilities 4,435 41,355 2,255 285 990 3,530 16,320 Extracts from the income statement of Sabine enterprise before inter-group adjustments for the year ended 30 September 2007 are: £000 Profit before tax Taxation Profit after tax 2700 800 1900 The following information is also relevant: © ABE and RRC 312 Group Accounts 2: The Consolidated Accounts (a) During the year, Sabine sold goods to Helman for £0.9 million Sabine adds a 20% mark-up on cost to all its sales Goods with a transfer price of £240,000 were included in Helman's inventory as at 30 September 2007 (b) The fair value of Sabine's land and plant and equipment at the date of acquisition was £1 million and £2 million respectively in excess of the carrying values Sabine's balance sheet has not taken account of these fair values Group depreciation policy is land not depreciated, plant and equipment depreciated 10% per annum on fair value (c) An impairment review has been carried out on the consolidated goodwill as at 30 September 2007 and it has been found that the goodwill has been impaired by £400,000 during the year Required Prepare the consolidated balance sheet of the Helman group as at 30 September 2007 Now check your answers with those provided at the end of the unit © ABE and RRC Group Accounts 2: The Consolidated Accounts ANSWERS TO QUESTIONS FOR PRACTICE H plc Consolidated Balance Sheet as at 31 December Year £000 Tangible non-current assets (1,000 + 1,400 + 200) 2,600 (i.e including revaluation) Net current assets (500 + 400) 900 3,500 Represented by: £1 Ordinary shares 100 Profit & loss account 2,960 3,040 Minority interest 440 3,500 Note that "negative goodwill", in accordance with IFRS 3, is written off to retained profits Workings COST OF CONTROL £000 Investment in S Ltd 700 Negative goodwill (bal fig.) 20 £000 Shares (80%) 80 Pre-acquisition profit and loss (80% × 600) 480 Revaluation (80% × 200) 160 720 720 GROUP RESERVES £000 Minority interest (20% × 1,650) 330 H plc 2,100 Pre-acquisition profit and loss 480 S Ltd 1,650 CBS (balancing figure) 2,940 3,750 © £000 ABE and RRC 3,750 313 314 Group Accounts 2: The Consolidated Accounts MINORITY INTEREST £000 CBS (balancing figure) 440 £000 Shares (20%) 20 Preference shares (100%) 50 Revaluation (20%) 40 Profit and loss (20%) 330 440 440 The figure for "profit and loss" included in the minority interest working at £330,000 represents 20% of the total profit and loss a/c of S Ltd There is no distinction drawn between the pre- and post- acquisition profits as far as the minority interest is concerned, whereas the cost of control account includes only the group share of the pre-acquisition profits This is a common area for mistakes and you must be sure that you fully understand it To clarify: £000 S profit and loss account 1,650 This has been disposed of as follows: Taken to cost of control: 80% of pre-acquisition profit (80% × 600) 480 Taken to group profit and loss: 80% of post-acquisition profit i.e 80% × (1,650 – 600) 840 Taken to minority interest: (20% × 1,650) 330 1,650 H plc Consolidated Balance Sheet as at 31 December Year £000 Intangible non-current asset: goodwill Tangible non-current assets (800 + 900) Net current assets (520 + 360 + 20) 42.75 1,700.00 900.00 2,642.75 Represented by: £1 Ordinary shares Retained profits 100.00 2,252.75 2,352.75 Minority interest 290.00 2,642.75 © ABE and RRC Group Accounts 2: The Consolidated Accounts 315 Workings COST OF CONTROL £000 Investment 420.00 £000 Shares (75%) 150.00 Pre-acquisition reserves (75% × 300) 225.00 Goodwill 420.00 45.00 420.00 Goodwill is impaired by £2,250 GROUP RESERVES £000 Minority interest (25% × 960) 240.00 Pre-acquisition reserves 225.00 Goodwill written off CBS (balancing figure) £000 H plc 1,760.00 S Ltd 960.00 2.25 2,252.75 2,720.00 2,720.00 MINORITY INTEREST £000 CBS (balancing figure) 290.00 £000 Shares (25%) Reserves (25% × 960) 290.00 50.00 240.00 290.00 Notes © (a) The minority interest could also have been calculated by taking 25% of S Ltd's net assets, i.e 25% × 1,160 = 290 (b) The inter-company accounts cancel on consolidation and an adjustment of £20,000 is made to net current assets to include the cash in transit at year-end, which increases recorded group liquid assets ABE and RRC 316 Group Accounts 2: The Consolidated Accounts X plc Consolidated Balance Sheet as at 31 December Year £000 Tangible non-current assets (1,200 + 700) 1,900 Net current assets (260 + 350) 610 Debenture stock (50 – 10) (40) 2,470 Represented by: £1 Ordinary shares 100 Share premium 100 Retained profits 1,810 2,010 Minority interest 460 2,470 Workings COST OF CONTROL £000 Investment Negative goodwill 250 £000 Shares (60%) 60 Share premium (60% × 80) 48 Pre-acquisition reserves (60% × 240) 144 252 252 COST OF DEBENTURES £000 Cost of investment 10.5 £000 Nominal value of stock 10.0 Premium on acquisition 0.5 10.5 10.5 © ABE and RRC Group Accounts 2: The Consolidated Accounts 317 GROUP RESERVES £000 £000 Minority interest (40% × 720) 288.0 X plc 1,520.5 Pre-acquisition reserves 144.0 Y Ltd 720.0 Premium on acquisition of debentures CBS (balancing figure) 0.5 1,808.0 2,240.5 2,240.5 MINORITY INTEREST £000 CBS 460 £000 Shares (40%) Preference shares (100%) Share premium (40%) Reserves (40%) 460 40 100 32 288 460 Note that negative goodwill is written off to retained profits in accordance with IFRS Consolidated Balance Sheet as at 30 June Year £000 Intangible asset (goodwill) 387.6 Plant & machinery 4,106.0 Inventory (1,120 + 480 – 10) 1,590.0 Debtors 1,560.0 Bank Creditors 250.0 (1,430.0) 6,463.6 Represented by: £1 Ordinary shares 2,000.0 Reserves 3,839.6 5,839.6 Minority interest 624.0 6,463.6 © ABE and RRC 318 Group Accounts 2: The Consolidated Accounts Workings (a) Plant & Machinery and Inventory Unrealised Profits (i) £000 Hold plc £000 3,200 Sub Ltd 960 less Profit on sale (60) plus Excess depreciation 906 4,106 The excess depreciation is calculated as follows: £ 10% Depreciation on the asset transferred (cost £300,000) in Sub's books 30,000 10% Depreciation on the cost of the asset to the group 24,000 Thus increase in group reserves (ii) (b) 6,000 Stock from Sub in Hold's books: £30,000 Unrealised profit element (mark-up 50%) allocated to group reserves: £10,000 Goodwill This calculation is merely the normal cost of control a/c done using a memorandum format: £000 Investment in Sub Ltd £000 1,200 Shares (60% × 200) 120 Pre-acquisition reserves (60% × 1,040) 624 Goodwill 744 456 Annual amortisation over 20 years: £22,800 (c) Minority Interest £000 40% ordinary shares in Sub 40% Sub profit and loss 80 544 624 © ABE and RRC Group Accounts 2: The Consolidated Accounts (d) 319 Consolidated reserves Again, done using a memorandum format instead of a "T" account: £000 Hold £000 3,780.0 Unrealised profit in machinery cost Sub (60.0) 1,360.0 Unrealised profit in stock Excess depreciation (10.0) 6.0 1,356.0 Pre-acquisition profits 60% × 1,040 (624.0) Minority interest 40% × 1,360 (544.0) Group share of Sub post-acquisition profits 188.0 3,908.0 less Goodwill (3 years at £22,800 pa) Balance to CBS 68.4 3,839.6 Tide is treated as an associated company and is consolidated using the equity method Bold plc Group Consolidated Income Statement for the Year ended 31 December Year £000 £000 Sales (1,000 + 800) 1,800.0 Cost of sales (600 + 450) 1,050.0 Gross profit 750.0 Expenses (200 + 200) 400.0 350.0 Share of associated company profit before tax (200 × 25%) 50.0 400.0 Taxation: Group (70 + 48) Associate (25% × 60) Profit after tax Minority interest (25% × 102) © 118.0 15.0 133.0 267.0 25.5 Profit after tax attributable to the group 241.5 Dividend 100.0 Retained profit for year 141.5 ABE and RRC 320 Group Accounts 2: The Consolidated Accounts Note that the marks allocated within the answer are also shown here Marks Helman Group Consolidated Balance Sheet as at 30 September 2007 £000 Assets Non-current assets Land and property (11,000 + 6,000 + 1,000) 18,000 Plant and equipment (see workings) 16,935 840 Intangible assets (see workings) 35,775 Current assets Inventory (see workings) 8,180 Trade receivables (5,710 + 1,915) 7,625 ½ Cash 495 Total assets 16,300 ½ 52,075 Equity and liabilities Equity Ordinary share capital Retained earnings (see workings) Minority interest (see workings) Total equity 5,000 28,440 2,670 36,110 Non-current liabilities 10% loans (6,000 + 2,000) 8,000 ½ Current liabilities Trade payables (3,200 + 2,255) Bank overdraft Tax (1,235 + 990) 5,455 ½ 285 ½ 2,225 Total equity and liabilities 7,965 ½ 52,075 Presentation Workings Plant and equipment: 10,225 + 5,110 + 2,000 – 400 (depreciation) Intangible assets: 1,240 (goodwill) – 400 (impairment) Inventory: 4,925 + 3,295 – 40 (unrealised profit) Retained earnings: 25,920 + 80%(8,290 – 4,200 (preacq) – 400 (dep) –40 (urp)) – 400 (impairment) Minority interest: 20%(10,790 – 400 – 40 + 3,000 (revaluation)) © ABE and RRC Group Accounts 2: The Consolidated Accounts Calculation of goodwill: £000 Paid: 2m x £4.50 Bought: 2m £1 shares 80% revaluation of assets £3m 80% retained earnings at date of acquisition £4.2m Goodwill © ABE and RRC £000 9,000 2,000 2,400 3,360 (7,760) 1,240 321 322 Group Accounts 2: The Consolidated Accounts © ABE and RRC ... Accounting may be split into Financial Accounting and Management Accounting (a) Financial Accounting Financial accounting comprises two stages: (b)  book-keeping, which is the recording of day-to-day... business accounting is to provide the answers to such questions by presenting a summary of the transactions of the business in a standard form Financial Accounting and Management Accounting Accounting... permission in writing from The Association of Business Executives Diploma in Business Management FINANCIAL ACCOUNTING Contents Unit Title The Nature and Purpose of Accounting The Scope of Accounting

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