A2 Accounting Revision Kit

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Contents
MANUFACTURING ACCOUNTS..................................................................................................................... 3
NON-PROFIT ORGANISATIONS (NPO) ....................................................................................................... 11
PARTNERSHIP ............................................................................................................................................. 17
RATIO ANALYSIS ......................................................................................................................................... 53
CASH FLOW STATEMENTS .......................................................................................................................... 62
COMPUTERISED ACCOUNTING SYSTEM .................................................................................................... 66
INTERNATIONAL ACCOUNTING STANDARDS (IAS) ................................................................................... 68
ETHICS ......................................................................................................................................................... 98
BUDGETING; PLANNING OF FUTURE OF BUSINESS USING ACCOUNTING ............................................. 101
STANDARD COSTING AND VARIANCE ANALYSIS..................................................................................... 110
INVESTMENT APPRAISAL ......................................................................................................................... 120
SENSITIVITY ANALYSIS.............................................................................................................................. 128
ACTIVITY-BASED CONSTING (ABC)........................................................................................................... 131
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MANUFACTURING ACCOUNTS
Some businesses do not involve just in trading activities but instead they manufacture their
own products. Such businesses are called Manufacturing businesses. For such businesses, in
order to calculate profitability, we have to calculate the cost of production. Thus, it is very
important to understand the cost structure of the business, which comprises of the following:
1) FIXED COSTS: Fixed Costs are those costs which do not vary as output varies. Whether
output is zero or is in large quantities, the fixed costs remain same. They are also known as
‘Indirect Costs’ or ‘Factory Overheads’. For example, rent, supervisor salary, depreciation and
so on.
It is very important to realize that as output increase, the ‘fixed cost per unit’ keeps on falling
(spreads over the output).
2) VARIABLE COSTS: Variable Costs are costs which vary as output varies. When output is
zero, variable costs do not exist. But as output starts rising, variable costs starts increasing.
They are also known as ‘Direct Costs’ or ‘Prime Cost’. For example, cost of material, wages of
labour, etc.
The ‘variable cost per unit’ is always fixed.

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3) SEMI-VARIABLE COSTS: Semi-Variable Costs are those costs which have a certain
element of variable cost and some portion of fixed cost. For example, Utility Bills in which line
rent is fixed and other cost depends on the units consumed. There are 3 situations in which
semi-variable costs can be applied:
Utility bills Call packages

Rent a car
4) STEPPED COSTS: Stepped Costs are those costs which are fixed over a range of output
and then fixed again over another range of output. Thus, the cost increases in the form of steps.
For example, Warehousing cost.
5) SUNK COSTS: Sunk Costs are those costs which are irrelevant from the decision-making
perspective, and hence are not drawn as a graph. For example, Market research cost (which is
irrelevant to the cost of production), and when making manufacturing account, our only
concern is the cost of production.
6) TOTAL COST: is the sum of fixed costs and

variable costs. When output is zero, total cost is equals
to the fixed costs because at the instant, variable cost
does not exist. But as output starts increasing, total
costs start increasing because of increase in variable
costs.
The increase in total cost is because of the variable cost
and thus total cost and variable costs graphs are always
parallel and the vertical distance between these two graphs is the fixed cost.
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WHY IS THERE A NEED TO MANUFACTURE GOODS?

 To earn higher profits
 To produce high-quality products
 To maintain brand image
 To remove dependency from suppliers
 Availability of raw materials (If raw material is available, then instead of buying finished
products, the business tries to convert those raw materials into finished goods itself)
 Learning by doing
 Diversification
 If the business has better manufacturing skills than trading skills.
 To introduce the product not available in the market.
NOTE:
When making manufacturing account, we try to identify what is the cost of production and
whether it is feasible to manufacture goods or to buy it from an outside vendor. If it is cheaper
to produce than to buy a product, then manufacturing should be done and the difference
between the manufacturing cost and the purchase price is manufacturing profit.
It is extremely important that manufacturing profit and trading profit should be
calculated separately, so that the performance of the manufacturing department and the
trading department could be identified individually. This is also important because of the fact
that the performance of each department manager is judged by the performance of his
department.
The accounting treatment of questions involving manufacturing business comprise of

preparation of
 Manufacturing Account
 Computation of Un-realised Profit
 Preparation of Un-realised Profit Account
 Income Statement
 Statement of Financial Position
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AQ INDUSTRIES
MANUFACTRING ACCOUNT FOR THE YEAR ENDED 31 DEC 2016
$ $ $
Cost of Raw Materials Consumed
Opening Inventory of Raw Materials xxx
Purchases of Raw Materials xxx
Less: Purchases Returns of Raw Materials (xx) xxx
Carriage Inwards of Raw Materials xxx
Cost of Raw Materials Available for sale xxx
Less: Closing Inventory of Raw Materials (xx) xxx
Add: Other Direct Costs
Direct Labour xx
Variable Overheads xx
Royalties xx xxx
Prime Cost xxx
Add: Indirect Costs/ Factory Overheads
Depreciation xx
Rent and Rates xx
Supervisor Salary xx
Indirect Material xx
Indirect Labour xx xxx
Cost of Production xxx
Add: Opening Inventory of Work-in-Process xxx
Less: Closing Inventory of Work-in-Process (xx) xxx
Manufacturing Cost xxx
Add: Factory Profit xxx
Transfer to Income Statement xxx
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AQ INDUSTRIES
INCOME STATEMENT FOR THE YEAR ENDED 31 DEC 2016
$ $ $
Sales xxx
Less: Sales Returns (xx) xxx
Less: Cost of Goods Sold
Opening Inventory of Finished Goods xxx
Transfer from Manufacturing Account xxx
Purchases of Finished Goods xxx
Less: Purchases Returns of Finished Goods (xx) xxx
Cost of Goods Available for sale xxx
Less: Closing Inventory of Finished Goods (xx) (xxx)
Gross Profit xxx
Add: Other Incomes
Discount Received xx
Rent Received xx
Sale of raw material/work in process xx xxx
xxx
Less: Expenses
All expenses associated to Selling and Office only xx
Bad Debts xx
Selling Royalties xx
Office salaries xx (xx)
Net Trading Profit xxx
Add: Factory Realized Profit xxx
Total Net Profit xxx
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AQ INDUSTRIES
STATEMENT OF FINANCIAL POSITION AS AT 31 DEC 2016
$ $ $
Tangible Non-Current Assets
Goodwill xxx (xxx) xxx
Intangible Non-Current Assets
Factory Assets xxx (xxx) xxx
Office Assets xxx (xxx) xxx
xxx
Current Assets
Closing Inventory (RM + WIP + FG) xxx
Less: Provision for unrealized profit (x) xxx
Receivables (Net) xx
Less: Provision for bad debts (x)
Less: Provision for discount allowed (x) xx
Prepayments xx
Bank xx
Cash xx xxx
Total Assets xxx
Equity
Opening Capital xxx
Add: Net Profit xxx xxx
Less: Drawings (xx) xxx
Current Liabilities
Payables xxx
Accruals xxx
Total Current Liabilities xxx
Non-Current Liabilities
Loan from XYZ xxx
xxx
Total Liabilities and Equity xxx
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PROVISION FOR UNREALISED PROFIT

When a business manufactures goods, it charges factory profit on it. This factory profit will
actually be earned if this product is sold. The existence of closing inventory of finished goods is
an indication that all the products manufactured are not yet sold; hence all factory profit is not
yet realized. Thus, there is a need to compute how much factory profit is actually realized. Thus,
we apply the formula:
Computation of Realized Profit
Opening Provision for unrealized profit xxx
Add: Factory Profit xxx
Less: Closing Provision for unrealized profit (xxx)
Factory Realized Profit xxx
Computation of Provision for Unrealized Profit
Opening Provision for unrealized profit =
Closing Provision for unrealized profit =
NOTE:
If provision for unrealized profit is given in the Trial Balance, then there is no need to calculate
the opening provision for unrealized profit. This is because there is a possibility that last year’s
factory profit is different from current year’s factory profit and hence if we will calculate it
ourselves, then the answer that we obtain might be different from the answer given in the trial
balance.
The closing inventory given in the Statement of Financial Position is at Cost whereas the
closing inventory given in the Income Statement is at Transfer Price (Cost + Profit)
Manufacturing Royalties Direct Cost (Manufacturing Account)
Selling Royalties Expenses (Income Statement)
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How to prepare Provision for unrealized Profit Account?

Provision for unrealized profit like any other provision is an expected loss as well as contra asset
and its accounting treatment is exactly same as that of provision for doubtful debts and hence
ledger account of provision for unrealized profit is made as follows:
Provision for unrealized profit
I/S (Decrease in provision) xx Opening Balance xxx
Closing Balance xxx I/S (Increase in provision) xx
xxx xxx
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NON-PROFIT ORGANISATIONS (NPO)
Some organizations come into existence not to make profits but to provide facilities to their
members. Such organizations do not have owners. They have members, who elect one of the
members for running the NPO. Since there are no owners, there is no concept of capital,
drawings or profits. Such organizations exist in the form of clubs, or housing societies and thus
NPOs are also referred to as Club Accounting.
Since in clubs, there is no concept of Capital, therefore instead of capital Account, we make
‘Accumulated Funds Account’. Moreover, instead of Bank Account, we make ‘Receipts and
Payments Account’, and since there is no concept of profit and loss account, we make ‘Income
and Expenditure Account’ to find out whether the club has more incomes or expenses.
The major source of Income for the club is Subscriptions. Subscriptions are payments made by
the members to the NPO in order to avail the facilities of the club. Sometimes, the clubs also
involve in trading activities and once again the motive is not profit making but to facilitate the
members.
The accounting treatment of a NPO comprises of the following steps. If the requirement of the
question is to prepare Income and Expenditure Account and Statement of Financial Position, all
the following steps must be applied:
1) Preparation of Accumulated Funds

Accumulated Funds are similar to Capital Account and is achieved when opening liabilities are
deducted from opening assets.
ACCUMULATED FUNDS
Assets xxx Liabilities xxx
xxx xxx
xxx xxx
xxx xxx
xxx
Accumulated Funds xxx
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2) Preparation of Receipts and Payments Account

Receipts and Payments Account is similar to Bank Account and is based on cash concept. When
cash comes into the business, it is recorded as Receipts and when cash goes out of the business,
it is recorded as Payments. The Receipts and Payments Account can either have debit balance
or a credit balance. Debit balance of Receipts and Payments Account is Current Assets and
credit balance of Receipts and Payments Account is Current Liabilities. Receipts and Payments
Account is made as follows:
RECEIPTS AND PAYMENTS ACCOUNT

Receipts Payments
Balance b/d xxx Balance b/d xxx
xxx xxx
xxx xxx
xxx xxx
Balance c/d xxx Balance c/d xxx
3) Preparation of Trading Account

If clubs involve into trading activities, then we need to prepare Trading account. If receivables
and payables are given in the question, then we must prepare SLCA and PLCA to find out sales
and purchases. The terminology used for sales in questions involving NPO is ‘Takings’. The
trading account is made as follows:
TRADING ACCOUNT FOR THE YEAR ENDED 31 DEC 2013

Sales/Takings xxx
Opening Inventory xxx
Purchases xxx
Less: Closing Inventory (xx) (xxx)
Gross Profit xxx
Less: Expenses associated to Trading only

Wages xx
Other Expenses xx (xxx)
Profit / (Loss) from trading xxx
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4) Preparation of Subscription Account

Subscriptions are weekly, monthly or annual payments made by the members to the NPO in
order to avail the facilities of the club.
Subscriptions in Arrears:
Subscriptions in arrears means subscriptions earned but yet not received. They are accrued
subscriptions which are accrued incomes and hence current assets for the club.
Subscriptions in Advance:
Subscriptions in advance are the subscriptions received but yet not earned. They are unearned
income or pre-received income and hence current liabilities for the club.
The subscription account is made as follows:
SUBSCRIPTIONS ACCOUNT
Accrued b/d xxx Prepaid b/d xxx

Cash Refund xxx Receipts and Payments Account xxx
Income and Expenditure Account xxx Bad Debts xxx
Prepaid c/d xxx Accrued c/d xxx
xxx xxx
5) Adjustment of Expenses and Revenues

The revenues and expenses can be adjusted through PAAP and APPA. If the question is silent
regarding depreciation of NCA in questions involving NPO, then it does not mean that no
depreciation will be charged. Instead, it is an indication that revaluation method of depreciation
is to be applied, as follows:
Opening value of asset xxx

Add: Purchase of asset xxx
Less: Sale of Asset (xxx)
Less: Closing value of asset (xxx)
Depreciation for the year xxx
6) Preparation of Income and Expenditure Account

Income and Expenditure Account takes into consideration the earning capacity of the club as to
how much income is generated and through what sources and how much expenses are made
and by what means. If gift/donation/legacy received by the club is without any purpose, then it
is to be treated as an Income. The life membership which is capitalized during the accounting
period is also to be treated as an Income. Thus, Income and Expenditure Account is made as
follows:
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INCOME AND EXPENDITURE ACCOUNT FOR THE YEAR ENDED 31st DEC 2016
Incomes $ $
Subscription xxx
Profit from Trading xxx
Gift/Donation/Legacy (Not for specific purposes) xxx
Gain on Disposal xxx
Entrance fees xxx xxx
Less: Expenses
Rent xxx
Loss from trading xxx
Depreciation xxx
Loss on Disposal xxx
Wages xxx
Utility Bills xxx
Any other expense associated to club xxx (xxx)
SURPLUS / (DEFICIT) OF INCOME OVER EXPENDITURE xxx
7) Preparation of Statement of Financial Position

Statement of Financial Position will be made normally. The only important thing is to take into
consideration the ‘Capital Receipts’. The life membership which has not been capitalized and
gift/donation/legacy for specific purposes are examples of Capital Receipts, and hence are not
to be included in Income and Expenditure Account; instead are to be part of “Financed By”
section of Statement of Financial Position. Statement of Financial Position is to be made as
follows:
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$ $ $
Non-Current Assets
Motor Vehicle xxx (xxx) xxx
Fixtures and Fittings xxx (xxx) xxx
Total Non-Current Assets xxx
Current Assets
Inventory xx
Receivables xx
Prepayments xx
Arrears (Subscriptions) xx
Receipts and Payments Account xx xxx
Total Assets xxx
Equity and Liabilities

Accumulated Funds xxx
Add: Surplus / (Deficit) xxx
Add: Life Membership xxx
Add: Gift/Donation/Legacy (for specific purposes) xxx xxx
Current Liabilities
Payables xx
Advance (Subscriptions) xx
Accruals xx
Receipts and Payments Account (Overdraft) xx xxx
Loan/Debentures xxx
Loan from member xxx xxx
Total Liabilities xxx
Total Liabilities and Accumulated Funds xxx
GIFT/DONATION/LEGACY:
If gift/donation/legacy is not for specific purpose, it will be treated as Income, and will be
recorded in the Income and Expenditure Account. But if gift/donation/legacy is for a specific
purpose, then it will be recorded in the “Financed By” section of the Balance Sheet.
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HOW TO CAPITALISE LIFE MEMBERSHIP?

Some clubs provide the facility of life membership in which the members do not have to pay
monthly or annually. Instead they pay a lump sum amount at the time of joining the club. The
question will always tell over how many years this amount will spread over. The spreading of
life membership over its life is called Capitalization of Life Membership. Each year, the amount
of life membership is capitalized and transferred to the Income Statement, and the amount not
capitalized remains in the “Financed By” section of the Balance Sheet.
Example: Life membership of $20000 paid which will expire over next 10 years.
Income and Balance Sheet

Expenditure Account
1st Year 2000 18000
2nd Year 2000 16000
3rd Year 2000 14000
COMMON ERRORS MADE BY STUDENTS IN QUESTIONS INVOLVING NPO:

1. Students forget to write opening bank balance figure in accumulated funds because it is
usually written separately.
2. Students consider bank balance as always debit balance whereas the bank balance can
also be a credit balance.
3. Students forget to make Control Accounts for calculation of sales and purchases.
4. Students do not calculate depreciation when question is silent regarding depreciation.
5. Students do not adjust other expenses and revenues for accruals and prepayments.
6. Students do not take into consideration the appropriate treatment of life membership.
7. Gift/Donation/Legacy is not properly accounted for.
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PARTNERSHIP
Partnership is an agreement between two to twenty people who join together with an
intention of sharing profits and bearing losses. When the partnership is formed, a partnership
agreement is made in which it is decided how much will be the interest on capital, interest on
drawings, salary to partners, bonus or commissions and whether any partner will be a dormant
partner or not. And if the partner has provided loan how much will be the interest.
In absence of partnership agreement, Partnership Act 1890 will come under consideration and
the contents of Partnership Act 1890 are:
i. No interest on capital
ii. No interest on drawings
iii. No salary to partners
iv. No bonus to partners
v. No commission to partners
vi. No partner to be treated as dormant partner
vii. Interest on loan by the partner at the rate of 5%
viii. Residual profits to be distributed amongst partners equally.
INTEREST ON CAPITAL: It is given to the partner as an incentive to invest more into partnership.
Usually this interest rate is equal to the market rate of interest so as to attract the partners so
that by joining the partnership not only will they earn the normal interest but they will also
reap benefits of partnership.
INTEREST ON DRAWINGS: It is charged to the partners as a restriction to withdraw
unnecessarily, otherwise the partners will withdraw huge amounts causing liquidity crisis of
partnership.
SALARY TO PARTNERS: It is given to the partners as a compensation for the services they have
performed for the partnership. Instead of hiring an employee the partner does the work and is
paid the salary.
BONUS TO PARTNERS: It is given to the partners against the organizations performance. The
better the partnership performs the higher the bonuses are distributed amongst the partners.
COMMISSION TO PARTNERS: It is given to the partners against their individual performance in
order to keep them motivated and perform even better.
INTEREST ON LOAN BY THE PARTNERS: When the partners provide loans to the partnership,
they are not considered to be the partner for that amount of loan. Instead, they are a liability of
the partnership and hence interest on loan is not the distribution of profit, instead it is an
expense of the business. If it is not pre-decided than loan interest would be 5%.
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RESIDUAL PROFITS: Once the profits are distributed in the forms of interest, salary, bonus and
commission, the remaining profits are called residual profits which are to be distributed
amongst the partners in their predetermined rates decided in the partnership agreement. If no
profit and loss sharing ratio is given then in accordance to Partnership Act 1890 it is to be
distributed equally.
DORMANT PARTNER: It is also known as 'Sleeping Partner', such a partner is not actively
involved in the running of the partnership. His role is restricted to investing in the partnership
but is not part of decision making process. Since the dormant partner is not actively involved his
liability is limited.
LIMITED LIABILITY: it means that incase of bankruptcy or insolvency, the maximum amount
that can be snatched from a partner is his investment. His personal belongings will not be
affected.
In a partnership, all partners cannot be sleeping partners there has to be at least one active
partner who will be responsible for the running of the business. The liability of the active
partner is unlimited. Unlimited liability means that incase of bankruptcy or insolvency, the
personal belongings of the partner will be at stake.
The accounting treatment of partnership involves preparation of:
I. Income statement
II. Profit and Loss Appropriation account
III. Partners' Current account
IV. Partners' Capital account
V. Statement of Financial Position
INCOME STATEMENT is made as normally like any other business. The only thing to be taken
into consideration is Interest on Loan by partners and it will be treated as an expense and
hence is not the distribution of profits.
PROFIT AND LOSS APPROPRIATION ACCOUNT shows the distribution of profits amongst the
partners in the form of interest, salary, bonus and commission. It also identifies the figure of
residual profits and the way it is distributed amongst the partners.
CURRENT ACCOUNTS are also known as Fluctuating Capital Account and shows movement in
Capital because of distribution of profits and drawings. The current account can have either a
credit or a debit balance. If the distribution of profits is more than drawings, the current
account will have a credit balance whereas if the drawings are more than the distribution of
profits, the current account will have debit balance. The credit balance in the current account is
a positive balance and the debit balance in the current account is a negative balance.
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PARTNERS’ CAPITAL ACCOUNT is also known as Fixed Capital Account because it usually does
not change and the changes in the capital account only occurs when:
 The partner introduces additional capital
 When no separate current accounts are maintained (in this case, all entries regarding
current account are passed through the capital account)
 When there is a partnership change (in case of a partnership change, we have to
prepare and adjust Goodwill account and Revaluation accounts into the capital
accounts)
At AS Level, the partnership change can only occur because of the following reasons:
i. Admission of a partner
ii. Retirement of a partner
iii. Change in the profit and loss sharing ratio
iv. Amalgamation of partnership
v. Sale of partnership
vi. Conversion of partnership into Limited Company
vii. Business Takeover
STATEMENT OF FINANCIAL POSITION is made as normally except for the Financed By section in
which we have to take into consideration the closing capital and current account balances.
Moreover, if there is any goodwill maintained in the books, it has to be incorporated in the
Statement of Financial Position as Intangible Non-Current Asset.
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SIMON, RAJ AND KULJEET

$ $ $
Sales xxx
Purchases xxx
Less: Purchases Returns (xx) xxx
Costs Associated to Purchases xxx
Gross Profit xxx
Add: Other Incomes
Discount Received xx
Gain on Disposal xx
Bad Debts Recovered xx
Decrease in provision xx
Commission Received xx
Rent Received xx xxx
xxx
Less: Expenses
Rent xx
Utility xx
Depreciation xx
Discount Allowed xx
Loss on Disposal xx
Increase in provision xx
Carriage outwards xx
All Expenses associated to partnership xx
Interest on loan by partner xx (xxx)
Profit / (Loss) for the year xxx
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PROFIT AND LOSS APPROPRIATION ACCOUNT

$ $ $
Profit / (Loss) for the year xxx
Add: Interest on Drawings
Simon xx
Raj xx
Kuljeet xx xx xxx
Less: Interest on Capital
Simon xx
Raj xx
Kuljeet xx (xx)
Less: Salary
Simon xx
Raj xx (xx)
Less: Commission
Kuljeet (xx)
Less: Bonus
Simon xx
Raj xx
Kuljeet xx (xx) (xxx)
RESIDUAL PROFIT xxx

Less: Share of Profit
Simon xx
Raj xx
Kuljeet xx (xx)
-
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CURRENT ACCOUNT
SIMON RAJ KULJEET SIMON RAJ KULJEET
Balance b/d - - Xx Balance b/d Xx Xx -
Share of Loss xx Xx Xx Interest on Xx Xx xx

Capital
Drawings xx Xx Xx Salary Xx Xx -
Interest on xx Xx Xx Bonus Xx Xx xx
Drawings
Commission - - xx
Share of Xx Xx xx
Profit
Interest on Xx Xx xx
Loan *
Balance c/d xx xx - Balance c/d - - xx
xxx Xxx Xxx Xxx Xxx xxx
Bal b/d - - Xx Bal b/d Xx Xx -
*If interest on loan by the partner is already paid to the partner, then it will not be included in the
current account. If it is not yet paid, then only it will be part of Partner’s current account but will
not be part of Accruals, Current Liabilities in the Statement of Financial Position. Whatsoever, it
will be always part of Income Statement as an expense.
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CAPITAL ACCOUNT
SIMON RAJ KULJEET SIMON RAJ KULJEET
Goodwill xx Xx Xx Balance b/d Xx Xx xx

written off
Loss on xx Xx Xx Cash - Xx -
Revaluation
Loss on xx Xx Xx Goodwill Xx Xx xx
Realization recorded
Balance c/d xx Xx Xx Profit on Xx Xx xx

Revaluation
Profit on Xx Xx xx
Realization
xxx Xxx Xxx Xxx Xxx xxx
Bal b/d Xx Xx xx
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SIMON, RAJ AND KULJEET

$ $ $

Goodwill xxx
Plant and Machinery xxx (xxx) xxx
xxx
Current Assets
Inventory xxx
Receivables (Net) xxx
Less: Provision for bad debts (x)
Less: Provision for discount allowed (x) xx
Prepayments xx
Bank xx
Cash xx xxx
Total Assets xxx
EQUITY AND LIABILITIES

Capital Accounts:
Simon xx
Raj xx
Kuljeet xx xxx
Current Accounts:
Simon xx
Raj xx
Kuljeet (x) xxx xxx
Current Liabilities
Payables xxx
Accruals xxx
Bank Overdraft xxx
Debentures xxx
Loan from Simon xxx
Total Non-Current Liabilities xxx

Total Equity and Liabilities xxx
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GOODWILL
Goodwill is the good reputation of the business. It is the worth of the business over and above
the fair value of its net assets and hence it is an Intangible Non-Current Asset.
Goodwill = Purchase Price – Fair Value of Net Assets Acquired
When there is any partnership change, it is a compulsion to value Goodwill so that the existing
partners can realize the true worth of the business and receive their due share. When at the
time of partnership change, goodwill is recorded, it is recorded amongst the old partners in
their old profit and loss sharing ratio, and hence the double-entries to record Goodwill are
Goodwill DR
Partners’ Capital Account CR:
A
B Amongst old partners in
C old profit and loss sharing ratio
If the question states that the Goodwill is to be maintained in the books, then it will be shown
in the books as Intangible Non-Current Assets, and each year we will have to check whether this
Goodwill is having any fall in its value. Fall in the value of Goodwill occurs either because of
Amortization (Depreciation of Goodwill) or Impairment (Drastic fall in the value of Goodwill)
and the fall in the value of Goodwill will be treated as an expense in the Income Statement, and
the double entries are
Income Statement DR (Expense)

Goodwill CR
If at the time of partnership change, the question indicates that Goodwill is not to be
maintained in the books, or Goodwill is to be written off, or Goodwill is not to be recorded, it all
indicates that Goodwill will be written off after recording it, and will not come in the Statement
of Financial Position. Goodwill is written off amongst new partners in their new Profit and Loss
sharing ratio, and hence the double-entries are:
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Partners’ Capital Account DR:

A
B Amongst new partners in their
C new profit and loss sharing ratio
Goodwill Account CR
Example: A, B and C are partners sharing Profit and Loss equally. C retires and D is admitted and
now partners are sharing profit and loss in the ratio 3:2:1.
If goodwill which is not be maintained in the books is valued at $18000, pass double-entries and
make goodwill account.
Recording of GW: Writing-off Goodwill:

Goodwill DR 18000 A (3/6 * 18000) DR 9000
A CR 6000 B (2/6 * 18000) DR 6000
B CR 6000 D (1/6 * 18000) DR 3000
C CR 6000 Goodwill CR 18000
GOODWILL ACCOUNT
A 6000 A 9000
B 6000 B 6000
C 6000 D 3000
18000 18000
REVALUATION
At the time of partnership change, it is also necessary to make the Revaluation Account. All
assets and liabilities must be checked for revaluation. Any movement in any asset or liability at
the time of partnership change will pass through Revaluation Account. A credit balance in the
Revaluation Account means Profit on Revaluation and the debit balance on the Revaluation
account means Loss on Revaluation.
Any profit or loss on Revaluation will be distributed amongst the old partners in their old profit
and loss sharing ratio because any change in any asset or liability is because of the existing
partners. Hence, the double-entries are:
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Profit on Revaluation:
Revaluation Account DR
Partners’ Capital Account CR:
A
B Amongst old partners in
C old profit and loss sharing ratio
Loss on Revaluation:
Partners’ Capital Account DR:
A
B Amongst old partner
old profit and loss sharing ratio
Revaluation Account CR
The Revaluation Account is made as follows:

REVALUATION ACCOUNT
Downward Revaluation Of Assets xxx Upward Revaluation Of Assets xxx
Downward Revaluation Of Assets xxx Upward Revaluation Of Liabilities xxx
Profit on Revaluation xxx Loss on Revaluation xxx
xxxx xxxx
HOW TO REVALUE ASSETS AND LIABILITES?

UPWARD REVALUATION OF ASSETS:
Asset DR
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Example: Inventory $12000 Revalued to $15000
Inventory DR 3000
Revaluation Account CR 3000
If the Non-current assets which involve depreciation are being re-valued, then we will first write
off its depreciation and then perform revaluation. Hence, the double-entries are
Provision for Depreciation DR

Asset DR
Example:
Case 1 Case 2 Case 3) Case 3

Cost: 50000 Cost: 50000Cost: 50000
Cost: 50000 Cost: 50000
Depreciation: (30000) Depreciation: (30000) Depreciation: (30000)
Depreciation: (30000) Depreciation: (30000)
Net Book Value: 20000 Net Book Value: 20000 Net Book Value: 20000
Net Book Value: 20000 Net Book Value: 20000
Revalued to $75000 Revalued to $40000 Revalued to $50000
Prov. for Depreciation Dr 30000 Prov. for Depreciation Dr. 30000 Prov. for Depreciation Dr. 30000
Asset Dr. 25000 Asset Dr. 10000 Revaluation Cr. 3000
Revaluation Cr. 55000 Revaluation Cr. 20000
Case 4
Cost: 50000
Depreciation: (30000)
Net Book Value: 20000
Revalued by $50000
Prov. for Depreciation Dr. 30000

Asset Dr. 20000
Revaluation Cr. 50000
Page 29 of 132
DOWNWARD REVALUATION OF ASSETS:

If the assets are downward revalued, it occurs when the value of asset falls below its NBV,
hence the double-entries are:
Asset CR
If the Non-current assets which involve depreciation are being re-valued, then we will first write
off its depreciation and then perform revaluation. Hence, the double-entries are
Provision for Depreciation DR

Asset CR
Example:
Cost: 50000
Depreciation: (30000)
Net Book Value: 20000
Revalued to $12000
Provision for Depreciation DR 30000
Revaluation Account DR 8000
Asset CR 38000
UPWARD REVALUATION OF LIABILITIES:

If the liabilities agree to accept lesser amount than they owe, it is referred to as Upward
Revaluation of Liabilities and hence the double-entries are:
Liabilities DR
Example: Payables $12000 they agreed to accept $10000 in full settlement
Payables DR 2000
Revaluation Account CR 2000
DOWNWARD REVALUATION OF LIABILITIES:

If liabilities ask for more amount than they owe at the time of partnership change, it is referred
to as Downward Revaluation of Liabilities, and hence the double-entries are:
Liabilities CR
Page 30 of 132
Example: Payables $12000 they ask for $15000 in full settlement

Revaluation Account DR 3000
Payables CR 3000
ADMISSION OF A PARTNER
When a new partner is admitted to the partnership, he brings with him either cash or assets. At
the time of admission, the accounting treatment comprises of preparation of
 Goodwill Account
 Revaluation Account
 Partners’ Capital Account
 Statement of Financial Position after the admission
NOTE: At the time of admission of partners, the current account balances are NOT transferred
to the capital account.
RETIREMENT OF A PARTNER
When a partner retires, he takes with him his due share from the partnership either in the form
of cash or any other asset and hence at the time of retirement, the current account balances of
the retiring partner only are transferred to the capital account so that the true belongings of
the retiring partner could be identified. If the retiring partner plans to take with him cash from
the partnership and there are insufficient funds in the business’s bank account then we will
create Bank Overdraft but give the retiring partner his due share. The retiring partner can also
leave loan to the partnership at the time of his retirement but this loan will not be considered
as a loan from partner instead it will be treated just like any other loan from an outsider
because retiring partner is no more a partner. At the time of retirement the accounting
treatment comprises of preparation of
 Goodwill Account
 Revaluation Account
 Partner’s Capital Account
 Statement of Financial Position after the retirement
Page 31 of 132
FORMATION OF PARTNERSHIP
When two sole traders merge together to form a partnership, we will take into consideration all
those assets and liabilities which the partnership is taking over at the revalued amount. Hence,
at the time of formation of partnership, revaluation account will NOT be made.
CHANGE IN THE PROFIT AND LOSS SHARING RATIO
When the profit and loss sharing ratio changes amongst the partners during an accounting
period, then two possible varieties of questions can be tested.
In the first variety of question, the accounting treatment comprise of preparation of
 Goodwill account
 Revaluation account
 Statement of Financial Position after the partnership change.
In the second variety of questions, the accounting treatment comprise of preparation of
 Columnar Income Statement taking into consideration the duration before the
partnership change and after partnership change
 Columnar Profit and Loss Appropriation Account taking into consideration all aspects
before partnership change and after partnership change
 Combined Partner’s Current Account taking into consideration the total effect of all the
changes that have taken place during the partnership.
NOTE: When the profit and loss sharing ratio changes, the current account balances are NOT
transferred to the capital account.
SALE OF PARTNERSHIP
When a partnership business is sold or disposed off all assets and liabilities of a partnership
needs to be sold and the accounting treatment comprise of preparation of
 Realization Account
 Partner’s Capital Account
 Bank Account
When the partnership business is disposed off Current Account Balances of ALL partners are
transferred to the Capital Account and all books must be closed and there should remain no
balance in any of the accounts.
Page 32 of 132
REALISATION ACCOUNT is also called Dissolution Account. When a partnership business is

being sold or disposed off it is necessary to prepare the Realization Account. It is called
Realization Account because it helps us in identifying how much amount is realized from sale of
partnership or the assets and liabilities of partnership. If the Realization Account has a credit
balance it is called Profit on Realization and if it has a debit balance it is called Loss on
Realization. Profit or Loss on Realization is distributed amongst old partners in their old profit
and loss sharing ratio Realization Account is made as follows
REALISATION ACCOUNT
All Assets at Net Book Value All Liabilities except NCL and Bank O/D xxx
except Bank xxx
Bank (Amount Realized from Sale of
Bank ( Amount paid to Liabilities) xxx
Assets) xxx
Dissolution Expenses xxx
Partner’s Capital Account( If Partner takes
Profit on Realization xxx over any asset) xxx
xxxx
Loss on Realization xxx
xxxx
Page 33 of 132
INSOLVENT PARTNERS
When at the time of partnership dissolution, one of the partners who has to pay to the
partnership refuses to pay back the amount he owes by declaring himself insolvent, then the
question falls under the category of Insolvent Partners and has to be solved in accordance with
GARNER VS MURRAY Case. As per the Garner VS Murray Case, if the partner becomes insolvent,
then his obligation in the partnership will be met by the remaining partners as per the ratio of
their last agreed Capital account balances (i.e. opening capital balances)
PARTNERSHIP SALE TO LIMITED COMPANY /
CONVERSION OF PARTNERSHIP TO LIMITED COMPANY
When a partnership is sold to the limited company or converts itself into limited company, its
accounting treatment is same which comprises of preparation of
 Realization Account
 Purchase Consideration Account
In case of conversion to limited company or sale to limited company, the realization account is
made as follows:
REALIZATON ACCOUNT
All assets at NBV ‘including’ Bank xxx All liabilities except long term loan by partner xxx
Dissolution Expenses xxx Purchase Consideration xxx
Partners’ Capital Account xxx
Gain on Realization xxx Loss on Realization xxx
xxx xxx
If partner takes over any asset (at valuation)
Gain or Loss on Realization will be distributed amongst old partners in their old profit and loss
sharing ratio.
Purchase Consideration means for how much amount the partnership business has been taken
over by the limited company and through what sources. Usually the partnership business is
taken over by limited company by issuing shares to the partners, by giving them debentures or
sometimes by giving them cash. If at the time of conversion of a partnership into a limited
company, each partner does not get at least one new share in the new partnership, the
question does not fall under the category of partnership conversion to limited company; then it
is just a normal sale.
If the question is silent as to how the purchase consideration will be distributed amongst the
partners, then it will be distributed as follows:
Page 34 of 132
 Ordinary Shares will be distributed amongst the partners in their profit and loss sharing
ratio
 Debentures will be given to the partner who has provided the loan to the partnership in
such a manner that he will receive the same interest that he was receiving when he had
provided loan to the partnership.
 Preference Share or Cash will be given to those partners in whose Capital Account there is
still remains a balance.
Example:
A partner has given loan to the partnership of Rs. 10000 bearing interest @8% per
annum
i.e. he used to earn interest of 10000 * 8% = 800 each year
If rate of debenture interest is 10%, then

Debentures * 10% = 800 (so that he earns same interest)
Debentures = 800/0.1
hence, Debentures of Rs. 8000 will be issued.
AMALGAMATION/TAKE OVER/BUSINESS PURCHASE
Types of Questions:
1) When two sole traders merge together to form a partnership (Formation of a
Partnership)
2) When a partnership takes over a sole trader (Admission of a partner)
3) When two partnerships merge together to form another partnership by a new name
(Amalgamation of Partnership)
4) When a partnership is taken over a limited company or converts itself into a limited
company (Conversion of Partnership into Limited Company)
5) When a partnership and sole trader merge together to form a company, or are taken
over by the company, then the question falls under the category of Business Purchase.
6) When two or more partnerships join together to form a new company or are taken over
by the existing company, once again the question falls under the category of Business
Purchase.
NOTE: When amalgamation, take over or business purchase takes place, the most important
task is to calculate Goodwill. If goodwill is not clearly given, then it has to be calculated using
the formula:
Once Goodwill is recorded, it will be written off as normal.
Page 35 of 132
AMALGAMATION OF A PARTNERSHIP
When a partnership business amalgamates, the accounting treatment comprises of preparation
of:
 Combined Goodwill account
 Individual Revaluation account
 Individual Realization accounts (if the partners have disposed off anything)
 Capital Accounts
 Statement of Financial Position after amalgamation has taken place
NOTE: At the time of amalgamation, current account balances of all partners will be transferred
to capital account.
When the partnership business amalgamates, it is decided that what amount of capital will
each partner takeover to the new partnership. Any balance remaining on the capital account of
partners will be balanced off in the form of cash given to the partner or taken from the partner.
NOTE: If the requirement of the question is to prepare separate capital accounts for old and
new partnership, then always remember that the capital account of the old partnership will
comprise of opening balance, transfer of current account to capital account if necessary,
goodwill recorded, gain or loss on revaluation and any asset taken over by the partner. The new
capital account comprises of opening balance brought forward from previous partnership,
goodwill written off, closing balance of the partners’ capital account indicating the capital taken
over by the partner to the new partnership and any balance settled through cash.
In short, all those things that are distributed amongst old partners in their old profit and loss
sharing ratio will be part of old capital account, and all those things which are distributed
amongst new partners in their new profit and loss sharing ratio will be part of new capital
account.
BUSINESS PURCHASE
When the partnership and a sole trader is taken over by a company and when 2 partnerships
merge together to form a limited company, the accounting treatment of preparing the
Realization account is a combination of Realization account of normal sale and Realization
account of conversion to limited company. Some assets will be taken over by the company,
some assets will be taken over by the partner and some assets have to be disposed off. Thus,
when making realization account, always remember the bank balance will NOT be taken over.
NOTE: When closing entries are required, you have to prepare Realization account, purchase
consideration and partners’ capital accounts. But when opening entries of new company is
required, then don’t waste your time in preparing closing entries. Just make the purchase
consideration, goodwill account, adjustments and Statement of Financial Position.
Page 36 of 132
NOTE: When a business takes over another business, then the goodwill of the business being
taken over is to be ignored by the company which is taking over and hence the new goodwill is
to be calculated, using the formula:
Page 37 of 132
LIMITED COMPANIES
Limited companies are incorporated businesses. They are owned by the shareholders and
controlled by the directors, appointed by the shareholders at the Annual General meeting.
When the company comes into existence, it has to be registered through the registrar of the
company which if accepted will be incorporated into Limited Liability Company. When the
company comes into existence it has to prepare two documents:
 Memorandum of association.
 Articles of association.
Memorandum of Association is the relation of the company to the outside world and the
contents of memorandum of association are as follows:
1) Name Clause: Name of the company ending either PLC or Ltd.
2) Liability Clause: A statement that the liability of the company is Ltd.
3) Capital Clause: The amount of Authorized Share Capital.
4) Address Clause: The address of registered office
5) Activity Clause: The principle activities that the company will involve in.
Articles of association are the internal rules governing the rights of the members and the
running of the company. The contents are as follows:
1) It defines rights and the duties of the shareholders.
2) It defines rights and the duties of the directors.
3) It contains the regulations as to how the meetings may be called.
4) It defines the rules regarding the voting rights.
5) It contains rules regarding the members who fail to pay the amount due upon them.
6) The minimum qualification to be a director.
7) The minimum number of share that a director must hold.
A company is divided into two categories:
 Private Limited companies.
 Public Limited companies.
Private Limited Companies are usually family owned business. They can't have Authorized
Share Capital of more than $ 50,000. They can't issue share to the general public, nor are their
shares traded in the stock exchange. Private Limited companies always have Ltd attached to its
name.
Public Limited Companies can issue their share to the general public and their shares can be
traded in the stock exchange. Their Authorized Share Capital has to be more than $ 50,000.
They work under the policy of IAS Companies Act 2006 and Companies Act 1985. They usually
have the word PLC attached to its name.
Page 38 of 132
The capital structure of a company comprises of Ordinary Share Capital, Preference Share
Capital, Debentures, Convertible Loan Stocks and Reserves.
Ordinary Shareholders are the real owners of the company and have a voting right with which
they take active part in the running of the business, by appointing the directors and hence they
are the risk bearers. At the time of distribution of dividends, the ordinary shareholders are
given the last priority and even in the case of insolvency they rank last after the payments have
been made to the creditors, long term liabilities and preference shareholders. The amount of
dividends that they receive is not fixed and varies as per the profitability of the company. In
years of low or no profit, they are not given any dividends at all.
The priorities in which the company distributes its assets in case of insolvency are as follows:
i) Short-term debts (creditors, accruals, bank overdraft)
ii) Secured Long-term debts
iii) Unsecured Long-term debts
iv) Preference Share Capital
v) Ordinary Share Capital
Preference Shareholders are given preference over ordinary shareholders both at the time of
distribution of dividends and incase of insolvency. They usually don’t have a voting right and
they receive a fixed rate of dividends and are divided into four categories:
 Cumulative Preference Shares.
 Non-cumulative Preference Shares.
 Participating Preference Shares.
 Non-participating Preference Shares
Cumulative Preference Shares are those shares who will receive the dividends whether the
company is making good profits or not. In case the company is not able to pay dividends in one
year because of low profitability, then the amount that is not paid is to be compensated in the
next year, and until it is compensated, it is treated as Current Liability.
Non-cumulative Preference Shares are those which will receive a fixed rate of dividends only in
the year when the company is making good profits. In years of low profits, they will only receive
the dividends which the company will be able to pay and the right over the remaining dividends
will be lapsed and will not be compensated in the future years.
Participating Preference Shares are those preference shares which have a voting right and they
take part in running of the business by choosing the directors at the Annual General Meeting
(AGM). Amongst the Preference Shares they rank last both at the time of distribution of
dividends and in case of insolvency.
Page 39 of 132
Non-participating Preference Shares are those preference shares who neither have voting
rights nor are cumulative.
Besides the above-mentioned 4 categories, preference shares are broadly classified as
Redeemable and Non-Redeemable.
Debentures are the “I Owe You” certificates of the company, they are the long-term liabilities
on which a fixed rate of interest is given and the amount owed by the company is to be
returned on maturity. The interest on debentures are not the distribution of profits, instead are
the expense of the company.
Convertible Loan Stocks are the long-term liability of the company on which a fixed rate of
interest is to be given. On maturity, the convertible loan stock holders are given an option to
convert the loan into shares. Thus, the convertible loan stock holder becomes the shareholders
from the creditors of the company. The rate of conversion, the maturity date and the option to
convert are all pre-decided at the time when the convertible loan stocks are issued.
If the conversion is equal to the number of shares issued then the double entry is as follows:
Convertible Loan Stock DR
Ordinary Share Capital CR
If more amount of shares are issued compared to the amount of convertible loan stocks then
the double entry are as follows:
Share Premium DR
If less amount of shares are issued compared to the amount of convertible loan stocks, then it
indicates that the shares are issued at higher price or in other words shares are issued at
premium. The double entries are as follows:
Share Premium CR
Page 40 of 132
RESERVES
There are two types of reserves,
 Revenue Reserves
 Capital Reserves
Revenue Reserves are the amounts set aside by the company from the trading activities of the
business, i.e. from the profits for the future prospects of the company. The revenue reserves of
the company comprise of:
1. General Reserves
2. Asset Replacement Reserves
3. Retained Profits
General Reserves are the amounts that the company set aside for the purpose of expansion or
to combat a problem that might arise in future.
Asset Replacement Reserves is the amount set aside by the company so that it has sufficient
funds to buy a new asset when the old one is disposed off.
Retained Profits are the left-over profits which are ploughed back into the company to finance
the running of the company in an effective manner.
Capital Reserves are those which are generated through non-trading activities and they
comprise of:
 Share Premium
 Revaluation Reserves
 Capital Redemption Reserves
 Debenture Redemption Reserve Fund
Share Premium is the amount that is generated by selling a share at higher price than its face
value.
Revaluation Reserve is the amount that is generated when the assets are revalued over and
above its Net Book Value.
Capital Redemption Reserves (Not part of syllabus) are the reserves which might be created
when the shares are redeemed.
Debentures Redemption Reserve Funds (Not part of syllabus) are the reserves which might be
created when the debentures are redeemed.
Page 41 of 132
Limited companies are also called Limited Liability companies because the liability of the
shareholders is limited, i.e. they are not personally liable for the debts of the company in case
of insolvency or bankruptcy. In case of insolvency the maximum amount that can be snatched
from them is limited to their investment.
Authorized Share Capital is the maximum amount of shares that the company is allowed to
issue.
Issued Share Capital is the part of authorized share capital which the company has already
issued to the general public.
Called-up Share Capital is the part of issued share capital that the company has asked to pay.
Uncalled-up Share Capital is that part of issued share capital that the company has yet not
asked to pay.
Paid-up Share Capital is that part of called-up share capital which has already been paid.
Unpaid Share Capital comprises of Uncalled Share Capital and the unpaid part of Called up
Share Capital.
Face Value is also known as nominal or par value. It is that amount of share which is written on
the face of the shares.
Issue Price is the amount of shares at which the shares are offered to the general public.
Share Premium is the difference between issue price and the face value of the share.
Formula: Share Premium = Issued Price – Face Value
Market Value is the price at which the share is being traded at the stock exchange.
Authorized Share Capital ($100000)
Issued Share Capital ($70000)
Called Up Share Capital Uncalled Share Capital

$0.6 $0.4
Paid up Share Capital $0.15

$0.45 Unpaid Share Capital
Page 42 of 132
Dividends are the distribution of profits which is paid to the shareholders if the dividends are
paid during the year, they are called Interim Dividends and if dividends are paid at the end of
the year then they are called Final Dividends. If the dividends are declared but yet not paid,
they are known as Proposed Dividends.
Proposed Preference Dividends are Current Liabilities of the business whereas Proposed
Ordinary Dividends are neither part of Income Statement nor Statement of Financial Position
they are just mentioned in Notes to Accounts.
Preference Shares are always subject to fixed rate of dividends whereas ordinary shares can
receive varying amount of dividends each year either in the form of dividend per share or a rate
of dividend.
DIVIDENDS
Dividends per share (DPS) Rate of Dividends
DPS is applied on the ‘Number of Shares’ Rate of Dividends are applied on the
‘Amount of Shares’
Example: If a company has 100000 Ordinary

shares of $0.5 each and it decided to pay a Amount = Number of Shares x Face Value
dividend of $0.05 per share, then the
dividends will be
Example: If a company has 100000 Ordinary
shares of $0.5 each and it decided to pay a
100000 x 0.05 = $5000 dividend of 10%, then
100000 x 0.5 = 50000
Rate 10% of 50000 = $5000
 Preference Dividends are only subject to Rate of Dividends because they receive fixed
rate of dividends which is applicable to the Amount of Shares.
Page 43 of 132
Example: If a company has 80000 12% Preference Shares of $0.6 each, then the total dividends
applicable is
80000*0.6=48000
Rate of 12% = 12% of 48000 = $5760
Since preference shares receive fixed rate of dividend, if some amount is paid as Interim
Dividends them only the remaining amount is paid as Final.
INTERIM FINAL TOTAL
2000 3760 5760
2880 2880 5760
5000 760 5760
0 5760 5760
5760 0 5760
This is not applicable for ordinary shares because they are the real owners of the business and
can receive as much interim and as much final dividend as possible.
INTERIM FINAL TOTAL
5000 10000 15000
8000 12000 20000
0 0 0
0 8000 8000
7000 2000 9000
The accounting treatment of questions involving companies comprises of the preparation of:
I. Income statement
II. Statement of recognized gains and losses
III. Statement of Changes in Equity
IV. Statement of Financial Position
V. Cash flow Statements
VI. Notes to Accounts
Page 44 of 132
Income Statement is made as normally and shows the profitability position of the business. In
companies, it is compulsory to divide expenses into 3 categories:
1. Selling and Distribution Expenses: These include all those expenses which are associated
to promote sales. Example; Discount allowed, advertising, bad debts, provision for bad
debts, depreciation of delivery van, carriage outwards and so on.
2. Administrative Expenses: These include expenses which are incurred in managing the
day to day affairs of the business such as wages and salaries, rent, depreciation of
property/plant/equipment and utility bills.
Sum of Selling and Distribution expenses and Administrative expenses are called
Operating Expenses.
3. Financial Expenses: are those expenses that are associated to cost of financing a debt
such as interest and dividends on redeemable preference shares.
Moreover if taxes are incurred they will also be part of Income Statement of Companies,
so that distributable profits could be achieved.
Statement of Changes in Equity comprises of Ordinary share Capital, Preference Share Capital,
Revaluation Reserves, General Reserves, Asset-replacement reserve and Retained earnings. Any
movement in any of these things such as profits made, dividends paid, transfer to reserves, and
revaluation of assets and issue of shares are all part of Statement of Changes in Equity.
Proposed Preference dividends are although part of Statement of Changes in Equity but
proposed Ordinary Dividends are not part of Statement of Changes in Equity.
Statement of Financial Position is made as normally except for the fact that there is no
Financed By section in companies. Instead, there is a ‘Share Capital and Reserves Section’.
Notes to Accounts are the supplementary documents attached to financial statements in order
to make financial statements understandable in a better way.
NOTE: If the question is silent, the preference shares will be considered as Non-Redeemable
Preference Shares.
Page 45 of 132
TYPES OF SHARES
Ordinary Shares Preference Shares
Non-Redeemable Preference Redeemable Preference

Shares Shares
 are part of Shareholder’s

 IS NOT part of
Fund  are part of Shareholder’s
Shareholder’s Funds;
 Their dividends are part of Fund
instead are Non-current
distribution of profits  Their dividends are part of
liabilities of the company.
 Ordinary dividends paid distribution of profits
 Their dividends are NOT
only are part of Statement  Preference dividends paid
the distribution of profits
of Changes in Equity and proposed are part of
 Dividends on Redeemable
 Proposed Ordinary Statement of Changes in
Preference Shares are part
dividends are neither part Equity
of Expenses of the
of Statement of Changes in  Proposed Preference
company
Equity, nor are part of Dividends are Current
 Both dividends paid and
Current Liabilities Liabilities of the company.
proposed are part of
 Proposed Ordinary
financial expenses
dividends are mentioned
 Proposed preference
in the Notes to Accounts
dividends are Current
Liabilities of the company
Page 46 of 132
AQ LTD.
$ $ $
Sales xxx

Purchases xxx
Less: Purchases Returns (xx) xxx
Carriage Inwards xxx
Gross Profit xxx
Add: Other Incomes xx
Less: Selling and Distribution Expenses

Advertising xx
Bad Debts xx
Provision for Bad Debts xx
Discount Allowed xx
Commission xx
Depreciation of Delivery van xx
Carriage outwards xx xx
Less: Administrative Expenses
Wages and Salaries xx

Rent xx
Utility Bills xx
Depreciation xx
Loss on Disposal xx xx
Operating Expenses (xx)
Operating Profit/Profit before Interest and Tax xxx
Less: Financial Expenses
Interest xx
Dividends on Redeemable Preference Shares xx (xx)
Profit After Interest before Tax xxx
Less: Corporation Tax (xx)
Distributable Profits xxx

Page 47 of 132
Statement of Comprehensive Incomes: If statement of recognized gains and losses are part of
Income Statement, it results in Statement of Comprehensive Income.
STATEMENT OF RECOGNIZED GAINS AND LOSSES
Add: Surplus on Revaluation of NCA xx

Add/(Less): Capital Gains and Losses xx
Recognized Profit xxx
AQ LTD
STATEMENT OF CHANGES IN EQUITY
Ordinary Preference Revaluation Share General Asset Retained Total
Share Share Reserve Premium Reserve Replacement Profit
Capital Capital Reserve
Opening X X X X x x X xx
Balance
Distributable - - - - - - Xx xx
Profits
Transfer to - - - - xx xx (xx) -
any reserve
Issue of
shares at
Xx Xx - X - - - xx
premium
Preference
Dividends
- - - - - - (xx) (xx)
(Paid +
Proposed)
Ordinary
Dividends
- - - - - - (xx) (xx)
(Paid only)
Closing Xx Xx Xx Xx xx xx Xx xxx
Balance
Page 48 of 132
AQ LTD.
$ $ $
Cost Depreciation NBV
Goodwill xxx
Property, Plant and Equipment xxx (xxx) xxx
xxx
Current Assets
Inventory xxx
Less: Provision for bad debts (x) xx
Prepayments xx
Cash and Cash Equivalents xx xxx
Total Assets xxx
Share Capital and Reserves

Ordinary Share Capital xxx
Preference Share Capital xxx
Revaluation Reserve xxx
Share Premium xxx
General Reserve xxx
Asset Replacement Reserve xxx
Retained Profits xxx xxx
Current Liabilities
Payables xxx
Accruals xxx
Proposed Taxation xxx
Proposed Preference Dividends xxx
Debentures xxx
Redeemable Preference Shares xxx
Convertible Loan Stock xxx
NOTES TO ACCOUNTS
The company proposed ordinary dividends of $x/share or y% amounting to $____
Page 49 of 132
ISSUE OF SHARES
The first time when the company issue shares it is called IPO (Initial Public Offering). When the
company issues shares, it offers it to general public either at par value or at premium, and
hence cash is received against issue of shares. Thus, the double-entries to record issue of shares
are:
Bank DR
Ordinary Share Capital CR If issued at a premium
Share Premium CR
Bank DR
Ordinary Share Capital CR If issued at Par
RIGHTS ISSUE
The existing shareholders have a pre-emptive right that whenever new shares are issued, they
should be offered to the existing shareholders first before offering it to general public because
if this is not done, then the shareholding of the existing shareholders will be diluted which will
cause their economic decision making authority to fall.
So, in order to avoid dilution of shares, this pre-emptive right is given to existing shareholders.
The rights issue is usually made at a premium but they can also be issued at par. But the issue
price should always be less than the market value and hence the double-entries to record rights
issue are:
Bank DR
Ordinary Share Capital CR If issued at a premium
Share Premium CR
Bank DR
Ordinary Share Capital CR If issued at Par
BONUS ISSUE/ SCRIP ISSUE/ STOCK DIVIDENDS

If the company has made good profits but is suffering from liquidity crisis, then it will not be in a
position to distribute dividends in the form of cash, and hence in order to satisfy the
shareholders, the company will give dividends in the form of shares, known as Scrip Issue/
Bonus Issue/Stock Dividends. These dividends which are in the form of shares are financed
through the reserves of the company, and when the question is silent, the priorities in which
the bonus issue will be financed are:
i. Share Premium
ii. General Reserves
iii. Asset Replacement Reserves
iv. Retained Profits
Page 50 of 132
And hence, the double-entries are:

Bonus Shares DR
Share Premium DR
General Reserves DR
Retained Profits DR
Bonus Shares CR
If the question says bonus issues are made in such a manner that the reserves are to be left in
the most flexible form, and hence the priorities will be given as follows:
i. Share Premium
ii. Revaluation Reserve
iii. General Reserve
iv. Asset-Replacement Reserve
v. Retained Profits
Most flexible form means that the company wishes to keep as many Revenue Reserves as
possible, and utilize the Capital reserves to finance the Bonus Issue, and hence the double-
entries are:
Bonus Shares DR
Share Premium DR
Revaluation Reserve DR
General Reserves DR
Asset-Replacement Reserve DR
Retained Profits DR
Bonus Shares CR
NOTE: The bonus issue of shares is always made at Par.
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Example: The Share Capital and Reserves section of the Statement of Financial Position of Raj
Industries is as follows:
Ordinary Share Capital 80
Share Premium 20
Revaluation Reserve 30
General Reserves 25
Asset Replacement Reserve 15
Retained Profits 30 200
Although Raj Industries has a good profitability, it had a bank overdraft of $5000, and thus was
not in a position to pay cash dividends. Hence, Raj Industries decided to make a bonus issue of
1 share for every 4 shares held. You are required to pass the double-entries and prepare
Statement of Financial Position after the bonus issue.
80 x = 20
Bonus Shares DR 20
Ordinary Share Capital CR 20
Share Premium DR 20
Bonus Shares CR 20
Share Capital and Reserves:
Ordinary Share Capital (80+20) 100
Share Premium (20-20) 0
General Reserves 25
Example: The Share Capital and Reserves section of the Statement of Financial Position of
TickTock Ltd. is as follows:
Ordinary Share Capital 150
Share Premium 20
General Reserves 25
Page 52 of 132
The company decided to make a bonus issue of 7 shares for every 10 shares held leaving the
resources in the most flexible form. You are required to pass the double-entries and prepare
Statement of Financial Position after the bonus issue.
150 x 7=105
10
Bonus Shares DR 105
Ordinary Share Capital CR 105
Revaluation Reserve DR 30
Share Premium DR 20
General Reserves DR 25
Asset Replacement Reserve DR 15
Retained Profits DR 15
Bonus Shares CR 105
Share Capital and Reserves:
Ordinary Share Capital (150+105) 255
Share Premium (20-20) 0
General Reserves 0
Page 53 of 132
RATIO ANALYSIS
Once the Income Statement and Statement of Financial Position are prepared, it is extremely
important to analyze the business performance so that it could be found whether the
performance of the business has improved, deteriorated or remained constant. Not only this,
the ratios also help in analyzing that what caused the changes in business performance. If the
performance improved, what caused the improvement? If the performance deteriorated, what
went wrong? And if the performance remained constant, why was there no improvement?
Moreover, with the help of ratios, it can also be analyzed as to what measures can be taken to
further improve the performance and what steps should be followed to avoid deterioration.
For the purpose of analysis, the ratios are divided into the following categories:
 Profitability Ratios
 Resource Utilization Ratios
 Liquidity Ratios
 Investment Ratios
 Cash Flow Ratios
Profitability Ratios
Profitability ratios identify the earning capacity of the business, as to how much revenue is
earned and through what sources, and how much expenses are incurred and by what means
and thus what is the profitability. It helps in identifying whether the business is able to control
its expenses effectively and efficiently or not. Thus, the profitability ratios are as follows:
 Net Sales/ Turnover = Sales – Sales Returns
 Cost of Goods Sold = Opening Inventory + Net Purchases – Closing Inventory
 Owner’s Capital = Total Assets – Total Liabilities

= Capital Employed – Non-Current Liabilities
 Capital Employed = Net Assets

= Non Current Assets + Current Assets – Current Liabilities
= Non Current Assets + Working Capital
= Total Assets – Current Liabilities
= Owner’s Capital + Non-Current Liabilities
= Opening Capital + Net Profit – Drawings + Additional Capital +
Non Current Liabilities
 Gross Profit= Sales – Cost Of Goods Sold

 Net Profit= Gross Profit – Expenses
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 Gross Profit Markup: Gross profit as a percentage of Cost

= Gross Profit x 100
Cost
 Gross Profit Margin: Gross profit as a percentage of Sales
= Gross Profit x 100
Sales
 Net Profit Margin: Gross profit as a percentage of Sales
= Net Profit x 100
Sales
 Expenses to Sales ratio: Expenses as a percentage of Sales
= Expenses x 100
Sales
 Expenses to Sales ratio = Gross Profit Margin - Net Profit Margin
 Return on Capital Employed (ROCE) = Net Profit before Interest and Tax x 100
Capital Employed
 Return on Net Assets (RONA) = Net Profit before Interest and Tax x 100
Net Assets
 Return on Total Assets (ROTA) = Net Profit before Interest and Tax x 100
Total Asset
 Return on Investment (ROI) = Net Profit before Interest and Tax x 100
Investment
 Return on Current Assets (ROCA) = Net Profit before Interest and Tax x 100
Current Assets
 Return on Equity (ROE) = Net Profit after Interest and Tax x 100
Equity
 Return on Shareholder’s Fund (ROSHF) = Net Profit after Interest and Tax x 100
Shareholder’s Fund
 Equity = Owner’s Capital

=Ordinary Share Capital + All Reserves
 Shareholder’s Fund = Ordinary Share Capital + Preference Share Capital + All Reserves
= Equity + Preference Share Capital
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An increase in all Profitability ratios except for expenses to sales ratio depicts an improvement
in business performance and vice versa.
An increase in expense to sales ratio depicts deterioration as expenses have increased and
business is unable to control them.
Resource Utilization Ratios
Resource Utilization ratios identify how effectively and efficiently is the resources being utilized.
Resource utilization ratios are calculated in ‘times’ and the greater the resource utilization
ratio, the better the company’s performance is considered to be. Resource utilization ratios are
as follows:
 Utilization of Capital Employed = Sales
Capital Employed
 Utilization of Net Assets / Net Assets Turnover = Sales
Net Assets
 Utilization of Fixed Assets / Fixed Assets Turnover = Sales
Fixed Assets
 Utilization of Total Assets / Total Assets Turnover = Sales
Total Assets
 Utilization of Working Capital = Sales
Working Capital
Liquidity Ratios
Liquidity Ratios identifies how much cash is available within the business. It helps in identifying
whether the business has enough assets to pay off its debts and meet its obligations. It is the
ability of the business to convert its assets into cash. It must always be kept in mind that there
is a difference between profitability and liquidity of the business. If the business is earning good
profits, it does not necessarily mean that it is also generating good cash because when
calculating profits, we also take into consideration some cash and non-cash expenses whereas
when considering liquidity, we are only interested in cash inflows and outflows. Some non-cash
expenses and revenues taken into consideration are credit sales, credit purchases, discount
allowed, discount received, gain or loss on disposal, bad debts, depreciation and so on.
It is extremely important to realize that it is never the lack of profit which causes the company
to shut down. It is always the lack of liquidity or shortage of cash and inability to meet their
obligations and pay off the debts which causes the company to become bankrupt or to go into
liquidation. Thus, having a good liquidity is extremely essential for the survival or the going
concern of the business. Liquidity ratios are as follows:
Page 56 of 132
 Working Capital = Current Assets – Current Liabilities

Working Capital should always be positive at any period in time because if working capital is
negative, it indicates that the business is unable to meet its obligations and is on the verge of
the bankruptcy.
Positive Working Capital is known as Net Current Assets.
Negative Working Capital is known as Net Current Liabilities.
 Current Ratio = Current Assets Ideal Ratio = 1.5:1 – 2:1
Current Liabilities
 Quick Ratio = Current Assets – Closing Inventory Ideal Ratio = 1:1

Current Liabilities
The current and quick ratio must be close to or equal to the ideal ratio because if they are less
than ideal ratio, it is an indication that the company is suffering from financial crunch and
liquidity crisis. Similarly, if the current and quick ratios are above the ideal ratio, it indicates that
the business is not utilizing resources appropriately and is in-efficient. The amount which
should be invested elsewhere is stuck into the business.
 Average Inventory = Opening Inventory + Closing Inventory
2
 Rate of Inventory Turnover = Cost of Goods Sold
Average Inventory
It indicates the number of times the business is able to sell its stock completely. The higher the
rate of inventory turnover, the better the performance is. It helps in finding the rapidity with
which inventory is sold.
 Inventory Turnover (Days): This indicates how many days the business takes to
completely sell the inventory.
= Average Inventory x 365
Cost of Goods Sold
= 1 x 365
Rate of Inventory Turnover
Unless otherwise states, we have to give answer in ‘days’.
 Receivables Collection Period (Days) = Receivables x 365
Credit Sales
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It indicates how long the receivables take to pay back the amount that they owe.
 Payables PaymentPeriod (Days) = Payables x 365
Credit Purchases
It indicates how long the business takes to pay back the amount that is owed by them.
 Working Capital Cycle

= Inventory Turnover (Days) + Receivables Collection Period (Days) - Payables Payment
Period (Days)
Working Capital cycles indicate the number of days the business takes to recover the working
capital. The shorter the working capital cycle is, the better the liquidity of the business is. If we
delay payments to our creditors, then although working capital cycle will improve but at the
expense of adverse relationship with the payables and the discount which will have to be
forgone on early payments.
 Interest Cover = Net Profit before Interest and Tax Ideal Ratio >3
Interest Charges
Investment Ratios
They are also known as Stock-Exchange ratios and help the investor in deciding which company
to invest in , and hence useful for all stakeholders of the company. All these investment ratios
are from the perspective of investment in ordinary shares.
 Dividends per share (DPS):
It reflects the performance of the business. Any business with a high DPS is always preferred by
the shareholders.
Dividends per share (DPS) = Ordinary Dividends paid
Number of issued ordinary shares
 Earnings per share (EPS):
Earnings are the profits attributable to the ordinary shareholders and are considered as profits
after interest, tax and preference dividends.
Earnings per share (EPS) = Total Earnings
Total number of ordinary shares
Page 58 of 132
EPS is a true measure of company’s performance. The higher the EPS, the better the
performance of the company is considered to be.
 Dividend Cover indicates the company’s dividend policy as to how much dividend is
being distributed to the shareholders in comparison to the earnings of the business.
Dividend Cover = EPS = Dividends available to pay ordinary shareholders
DPS Ordinary Dividends paid
A high dividend cover reflects conservative dividend policy i.e. the business is only distributing a
small part of what is available to be distributed. Moreover, this conservative dividend policy is a
good strategy because if in future, profitability of the business falls, the business will still have
enough profits available saved from past years that it will be able to maintain its present level
of dividends.
If there is a low dividend cover, it is an indication of spend-thrift dividend policy which means
that majority of the dividends that is available is already paid to the shareholders. This is a bit
risky position because if in the future, the business is unable to achieve the present level of
dividends, then dividends to the shareholders will fall down.
 Dividends Yield = DPS x 100
MPS
Market Price per share
 Earnings Yield = EPS x 100
MPS
Market Price per share
Dividends Yield and Earnings Yield act as Returns on Investment. The higher the dividends yield
and earnings yield, the better the performance of the company is, because all investors always
expect as much dividends as possible. If we are aware of both dividends yield and earnings
yield, we will base our decision of investment on Earnings yield, because Earnings are a better
measure of company’s performance compared to dividends. Some companies mislead the
investors by paying high dividends in comparison to the earnings they have. Thus, it is
extremely vital that we judge the true potential of the company by deciding on the basis of
earnings.
 Price Earnings Ratio (PER) compares the market price of shares against the earnings
that are being generated. It also indicates the number of years’ earnings that the
shareholder is willing to sacrifice in order to buy the shares of the company. The higher
the PER, the greater the confidence of the shareholder in the company’s future.
Price Earnings Ratio (PER) = MPS
EPS
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 Interest Cover indicates the ability of the company to pay the interest out of its profits.
The higher the interest cover, the better the performance of the company is. The
minimum level of acceptable interest cover is at least 3 times. A low interest cover is a
warning to the shareholders that their dividends might be endangered if the profitability
of the company falls.
Interest Cover = Net Profit before Interest and Tax
Interest Charges
 Income Gearing determines the burden of financing the debt in comparison to the
profits earned. Income Gearing should always be as low as possible.
Income Gearing = Interest Charges x 100 (i.e. reciprocal of Interest Cover)
Profit before Interest and Tax
 Gearing Ratio:
Gearing indicates the relationship of outsider’s investment into the company. It helps in
assessing the risk of the business. It shows the ratio of borrowing to owner’s investment.
Gearing = Fixed Cost Capital x 100
Total Capital
Fixed Cost Capital = Debentures + Preference Share Capital + Convertible Loan Stocks
+Any other interest-bearing loan
Equity = Ordinary Share Capital + All Reserves
Total Capital = Equity + Fixed Cost Capital
Gearing should always be as low as possible (should not be more than 50% generally) because
highly geared companies have 2 problems:
 Most of the profits are consumed in financing the debts i.e. interest payments
 The risk increases significantly because in case of insolvency or bankruptcy, the
first priority is given to the debts of the business.
 Debt to Equity Ratio is an alternative measure of calculating the risk position of the
business and is similar to Gearing. The lower the debt to equity ratio, the better the
performance of the business is (should not be more than 100% generally).
Debt to Equity Ratio = Fixed Cost Capital x 100
Equity
Page 60 of 132
LIMITATIONS OF RATIOS:
 Ratios only show the results of a particular year. It does not indicate the causes of those
results.
 The accuracy of ratios depends on accuracy of the financial statements from which the
ratios are being prepared.
 Ratios are only used to compare like-to-like businesses (similar businesses)
 Ratios do not take into consideration the seasonal changes in the products.
 Ratios can be misleading if they do not take into consideration the effect of inflation.
 People who do not possess complete accounting knowledge cannot derive meaningful
information from the ratios.
 Ratios are only useful if they are calculated as soon as the accounting year ends.
Delayed calculation of ratios and analysis will be insignificant for the business as it will
be of no use.
Page 61 of 132
Commenting on Ratios
Whenever we have to comment on ratios, we will never do so in a haphazard manner; instead,
whatever the sequence of calculation of ratios, we will first comment on all profitability ratios, then on
all resource utilization ratios, then on liquidity ratios and finally on all investment ratios, followed by a
short conclusion. Not only this, it is extremely important to realize that we are not supposed to tell
whether the ratio has increased or decreased, instead we have to identify whether the performance of
the business has improved or deteriorated and what caused the improvement or deterioration. We also
need to suggest what steps should be taken to further improve the performance. When some ratios
increase, they show improved performance. When some ratios decrease, it shows improved
performance.
Sample Comment:
The gross profit margin of Najim has deteriorated by 3%. This could be because of the fact that either
his selling price has fallen or his cost of goods sold has increased. Despite fall in the GP margin, the NP
margin has improved by more than 2% which is quite commendable. This is because of the fact that
Najim has been able to control his expenses in an amazing manner and his expenses to sales ratio fell
from 22.5% to 17.4% which is worth appreciating. This, in turn, has caused the ROCE to increase by more
than 2%. Overall, his profitability has improved.
The current and quick ratios of Najim are almost equal to the ideal ratios, with slight deterioration in
current ratio and slight improvement in quick ratio. The inventory turnover days has improved by 3 days
indicating that Najim is able to sell his inventory earlier and much easily. This could be supported by the
fact that he might have reduced his selling price in order to attract sales which might have caused his GP
margin to fall. Najim is facing difficulty in collecting money from his receivables and they are paying 6
days late compared to last year. In turn, Najim is paying his suppliers 6 days late which is not a good
strategy. By paying 6 days late, he is deteriorating his relationship with the suppliers and might be
foregoing the discounts which he would have otherwise achieved if he would have paid on time. Overall,
his working capital cycle has improved by 3 days indicating an improved liquidity in comparison to last
year.
The NCA Turnover has slightly deteriorated identifying that Najim has not been able to utilize his
resources effectively and efficiently as he should have, which if he would have done would have further
improved his profitability and liquidity.
The interest cover of the company has fallen by 1.5 times which could be because of the fact the
interest charges have increased or profitability has fallen. It is more likely that interest charges have
increased because the gearing ratio have almost increased by 6% indicating that the risk of the business
has increased and the dependency of outsiders have increased. The dividend cover of the business has
fallen indicating that in order to maintain the current level of dividends; most of the earnings are being
used to pay the dividends. The PER has also fallen indicating that the investors are now less confident
about the company’s future. Overall, there is a downturn in company’s performance and compared to
last year, the investors will be reluctant to invest in such a company.
Overall, there is an improvement in Najim’s performance when comparing 2011 with 2010 as far as
profitability and liquidity ratios are concerned and there is still a margin of improvement as far as
resource utilization ratios and investment ratios are concerned.
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CASH FLOW STATEMENTS
As per IAS 7, preparation of Cash Flow Statements is the mandatory requirement of the
published company accounts. Cash flow statements acts as the third tier to Income Statement
and Statement of Financial Position. While Income Statement shows the profitability position of
the business, Statement of Financial Position shows the financial position of the business, Cash
Flow Statement shows the liquidity position of the business. It helps in identifying how much
cash came into the business and through what sources and how much cash went out of the
business and by what means. It is also extremely important to understand the difference
between profitability and liquidity of the business. If a company makes profits, it does not
necessarily mean that there will be availability of cash because the company might have
generated profits by making plenty of credit sales. Similarly, a company making losses does not
necessarily mean that the company will have bank overdraft or cash deficit. There is a
possibility that the company has incurred non-cash expenses resulting in losses. Thus, by
making cash flow statements, the availability of cash during the year and the difference
between profitability and liquidity becomes clear. The Cash Flow Statements must be prepared
in accordance to the format provided by IAS 7. As per IAS 7, four things must be shown in the
Cash Flow Statements:
1) Cash Flows from Operating Activities:

Cash Flows from Operating Activities means how much cash has been generated by the
company from the profits earned. In order to find the cash flow from operating activities, we
have to convert accounting profits to cash generated from these profits. In other words, we can
say that we have to convert profit from accrual concept to profit from cash concept.
2) Cash Flows from Investment Activities:

Investment activities refer to purchase and sale of tangible and intangible non-current assets. It
also means investment in other companies which are not immediately realizable. E.g. money
kept in bank which cannot be withdrawn before a particular time period, or debentures of 5
years, etc. Capital expenditures will be part of investment activities.
3) Cash Flows from Financing Activities

Financing activities means how has the business been financed and through what means.
Usually, businesses are financed by issue of shares, by obtaining loan and by issuing debentures
or convertible loan stocks. When the shares or loans are issued, cash comes into the business
and when the shares are redeemed or loans are repaid, cash goes out of the business. The
payment of dividends as per IAS 7 is part of financing activities.
4) Cash and Cash Equivalents

Cash and Cash Equivalents mean cash, bank, short term deposits and anything convertible into
cash within 3 months.
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STEPS TO PREPARE CASH FLOW STATEMENTS:
I. Calculation of Operating Profits

II. Conversion of Operating profits to cash generated through those profits
III. Preparation of cash flow statement as per the format provided by IAS 7
IV. Reconciliation of cash and cash equivalents
Sales xxx
Less: Cost of Goods Sold (xx)
Gross Profit xxx
Add: Other Incomes xxx
xxx
Less: Selling and Distribution Expenses (xx)
Less: Admin Expenses (xx)
Operating Expenses (xx)
Operating Profits xxx
Less: Financial Expenses (xx)
xxx
Less: Taxation (xx)
Less: Transfer to any reserves (xx)
xxx
Less: Ordinary Dividends (x)
Retained Profits xxx
Add: Retained Profit brought forward xxx
Retained Profit carried forward xxx
Therefore,
Operating Profits = Retained Profit carried forward - Retained Profit brought forward +
Preference Dividends + Ordinary Dividends + Transfer to any reserves + Taxation + Interest paid
– Interest Received
Page 64 of 132
Cash Generated from Operating Activities

Operating Profit xxx
Add: Goodwill written off xx
Add: Depreciation xx
Add: Loss on Disposal xx
Less: Gain on Disposal (xx)
Less: Increase in Inventory (xx)
Less: Increase in Receivables (xx)
Less: Increase in Prepayments (xx)
Add: Increase in Payables xx
Add: Increase in Accruals xx
Less: Tax paid (xx)
Less: Interest paid (xx)
Add: Interest received xxx
Cash Flow from Operating activities xxx
 Increase in current assets except bank: Less

Decrease in current assets except bank: Add
 Increase in current liabilities: Add

Decrease in current liabilities: Less
Page 65 of 132
CASH FLOW STATEMENT FOR THE YEAR ENDED 31st DEC 2016
$ $
Cash Flow from Operating Activities xxx
Cash Flows from Investment Activities
Purchase of Tangible and Intangible Non-Current Assets (xx)
Sale of Tangible and Intangible Non-Current Assets xxx
Investments in other sources/businesses (xx)
Return on investments xxx xxx
Cash Flows from Financing Activities
Issue of shares at premium xx
Redemption of shares (x)
Issue of loans or debentures xx
Repayment of loan (x)
Redemption of debentures (x)
Drawings (in case of a sole trader) (x)
Dividends paid (x)
*Dividends received xx xxx
Net Cash Inflow / (Outflow) xxx
Add: Opening Cash and Cash Equivalents xxx
Closing Cash and Cash Equivalents xxx
*Dividends received and interest received can also be part of Investment Activities.
NOTE: Bonus share is not part of Cash Flow Statements because cash is not involved.
 When the requirement of the question is to prepare Cash flow Statements the question
will provide us two Statement of Financial Positions (one of previous year and the other
of current year),Income Statement extract and some Notes to Accounts.
Page 66 of 132
COMPUTERISED ACCOUNTING SYSTEM

With the advent of computers, the manual accounting has been replaced by computerized
accounting software. Doing so has had both advantages and disadvantages, but since
advantages exceeds/supersedes the disadvantages, the usage of computers is preferred. Like all
computer software, even accounting software are categorized as input, process and output.
INPUT PROCESS OUTPUT
 Transactions  Double-entry system  Ledgers

 Amendments  Accounting concepts  Trial Balance
 Adjustments  IAS  Income Statement
 Statement of Financial Position
 Cash Flow Statements
 Ratios
ADVANTAGES OF ADOPTING COMPUTERISED ACCOUNTING SYSTEMS:

 Speed: By using computerized system, the data can be processed quickly.
 Accuracy: By using computerized system, chances of human error are almost negligible.
 Large quantity of data can be managed and processed very easily.
 Number of people required to manage accounting data are reduced.
 Storage of data becomes very easy as relevant can be easily saved in USBs.
 Easy access to data: When the transactions were performed manually, it was very
difficult to access data on time. But with advent of computers, the relevant data is just
one click away.
 Flexibility and Compatibility: It is very easy to carry accounting data from one place to
another, and older versions are always compatible to newer versions of accounting
software.
 Easy to edit: It is relatively easy to make amendments and changes in case any mistake
is made in entering accounting transactions, as just one amendment will change all
relevant entries.
 Errors affecting trial balance will not be possible and some errors not affecting trial
balance will also be avoided.
 Easy to audit: Checking of accounting data becomes easier as any forgery,
embezzlements or white-collar crimes are easily detectible.
 Management decisions such as inventory re-order level, invoicing, credit worthiness of
debtors can all be done by computerized accounting system.
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DIS-ADVANTAGES OF ADOPTING COMPUTERISED ACCOUNTING SYSTEMS:

 Security threats: It is easy to rob accounting data from computer systems compared to
manual systems.
 Viruses: Because of viruses, important data might be lost or damaged.
 Hacking: Hacking can not only cause business to lose data but it can also result in others
to access data.
 Data Protection Act can be violated causing violation to human right laws.
 A typo error might be very difficult to locate and will result in misleading financial
statements
 Some errors not affecting trial balance cannot be located easily
 Training cost is very high and professional software is very expensive to buy.
 Existing employees might not be acceptable for computerized accounting system and
hence cause redundancies.
 Strong IT department needs to be set up in order to ensure proper and smooth running
of computerized accounting system
HOW TO ENSURE THAT THERE WILL BE NO MANIPULATION IN ACCOUNTING DATA WHEN
SHIFTING FROM MANUAL TO ACCOUNTING COMPUTERIZED SYSTEMS:
 Only authorized person should be allowed to access data.
 An independent person must be responsible to ensure that the authorized person is
fulfilling his task with due diligence.
 Data should be obtained fairly and lawfully.
 Data kept must be accurate and up-to-date.
 Data user must have appropriate security against unauthorized access.
 Data Protection Acts and regulations must be ensured.
 Users of sensitive data must not be allowed to work from home.
 The hardware should not be allowed to be taken outside the office premises.
 All computer systems must have tracking device installed.
 The transfer of data should only be made from secured portals.
 The head of each department must have access to all his subordinates.
 Job rotation must be promoted in the organization.
 Forced vacations must be implied on all IT department workers.
Page 68 of 132
INTERNATIONAL ACCOUNTING STANDARDS (IAS)
Q1. What are IAS? Why are they prepared and what is its significance?
IAS are international accounting standards prepared by IASB (International accounting standard
board). In order to ensure the following:
1. That all companies prepare financial statements in a similar manner.
2. Comparison between the financial statements becomes easier.
3. White collar crimes, window dressing and creative accounting can be prevented,
detected and hence avoided.
4. Understanding of financial statements can become more relevant.
Q2. What is window dressing?

Window dressing refers to actions taken prior to issuing financial statement in order to improve
the appearance of financial statements. These are techniques in accounting that can be used to
portray the financial position of the company better than it actually is. For example:
I. Reducing the ratios of depreciation
II. Failure to write down any decrease in the value of non-current assets.
III. Anticipating profits on long term contracts.
IV. Including unrealized profits in the income statement.
Q3. What is included in the Annual reports? Or what are the Contents of Annual reports?
1. Financial statements: Cash flow statement, Income statement, Statement of Financial
Position
2. Accounting Policies.
3. Notes to accounts.
4. Director’s report.
5. Auditor’s Report.
Page 69 of 132
IAS #1 (Representation of Financial Statements):

This IAS indicates that following statements must be prepared by all companies and must be
part of published companies’ accounts.
1. Statement of Comprehensive Income
2. Statement of Changes in Equity.
3. Statement of Financial Position.
Income Statement: Similar to normal income statement but expenses are divided into
Operating expenses and Financial Expenses.
Operating expenses are those which include Selling & distribution expenses and Admin
Expenses. If statement of recognized gains and losses is attached to the income statement then
it becomes statement of comprehensive income.
Statement of Recognized Gains and Losses: is part of ‘Statement of Comprehensive income’.

The purpose of preparation of statement recognized gains and losses is to ensure that the
profits that have been recognized but not realized must be taken into consideration so that the
users of financial statements are aware of the true worth of the business for example
revaluation surplus and capital gains.
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Statement of comprehensive income for the year:

$ $
Sales x
Less: Cost of sales (x)
Gross Profit x
Less: selling and distribution expense (x)
Less: Administrative Expense (x)
Operating Expenses (x)
Profits before interest and tax/operating profit x
Less: Financial expenses. (x)
Interest (x)
Dividends on redeemable preference shares (x) (x)
Profit after interest before tax x
Less: corporation tax (x)
Profits available to pay equity holders xx
Statement of recognized gains and losses
Surplus on revaluation x
Capital gains and losses x
Comprehensive income xx
Page 71 of 132
Statement of changes in Equity

Ordinary PS G.R ARR Revaluation Share CRRF DRRF Ret.
Shares Reserve Premium Profit
Bal b/d x x x x x x x x x
Bonus Issue x (x) (x)
Redemption (x) (x) x

of Shares
Right issues
x X
Transfer to
xx (xx)
G.R
Preference
Dividends (x)
(paid +
proposed)
Ordinary
Dividends (x)
(Paid only)
Bal c/d xx xx xx xx xx Xx xx xx Xx
Statement of changes in Equity for the year ended 31st March 2009
$000 $000 $000 $000 $000
Equity Share Revaluation Retained Total

shares premium reserves earnings
Balance b/d 8 000 500 2 500 15 800 26 800
Share issue 8 600 4 300 12 900
Comprehensive income 5 000 7 000 12 000
Dividends paid (4 000) (4 000)
Balance c/f 16 600 4 800 7 500 18 800 47 700

Page 72 of 132
AQ LTD.
$ $ $
Cost Depreciation NBV
Goodwill xxx
Property, Plant and Equipment xxx (xxx) xxx
xxx
Current Assets
Inventory xxx
Less: Provision for bad debts (x) xx
Prepayments xx
Cash and Cash Equivalents xx xxx
Total Assets xxx
Share Capital and Reserves

Ordinary Share Capital xxx
Preference Share Capital xxx
Revaluation Reserve xxx
Share Premium xxx
General Reserve xxx
Asset Replacement Reserve xxx
Retained Profits xxx xxx
Current Liabilities
Payables xxx
Accruals xxx
Proposed Taxation xxx
Proposed Preference Dividends xxx
Debentures xxx
Redeemable Preference Shares xxx
Convertible Loan Stock xxx
Page 73 of 132
1. Ordinary Shares.
 Part of Equity
 Dividends paid only are part of Statements of changes in equity
 Proposed Ordinary Dividends is neither part of Statement of changes in equity nor
Statement of financial position; instead they will be only mentioned in notes to
accounts.
2. Preference Shares:
I. Redeemable Preference shares:
 Are not part of equity, instead are part of Non-Current Liability
 Dividends paid and proposed are part of financial expenses
 Proposed dividends are part of Current Liability
 These dividends are not part of distribution of profits instead are
expenses to business.
II. Non- Redeemable Preference Shares:
 Non-redeemable shares are part of equity
 Dividends paid and proposed are part of statement of changes in equity
 Proposed dividends are part of Current liability in Statement of financial
position.
 Dividends on Non-Redeemable preference share are part of distribution
of profits.
Q. At the start of financial year Equity section of a limited company’s statement of Financial
Position is:
$000
Share Capital ($1 shares) 2000
Share Premium 500
General Reserve 1200
Retained Earnings 1000
During the year the following took place:

1. The company made a profit attributable to equity holders of $800 000.
2. The company paid a final dividend from last year of $400 000.
3. An interim dividend of $0.01 per share on shares held at the start of the year was paid.
4. 500 000 additional shares were issued at $1.50 each.
5. The directors revalued land from $1 000 000 to $1 500 000.
6. The directors transferred $300 000 to general reserves.
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7. The directors proposed a final dividend of $0.25 per share.
REQUIRED: Prepare the statement of changes in Equity.
Q. A company is preparing its statement of changes in equity for the year ended 31 August.
The following information is available.
$000
balance of retained earnings (profits) at start
350
of year
net profit for the year 140
final dividend paid in respect of previous year 60
interim dividend paid 30
proposed final dividend for the current year 70
transfer to capital redemption reserve 100
What is the balance of retained earnings (profits) to transfer to the balance sheet at 31 August?
(A) $230 000 (B) $290 000
(C) $300 000 (D) $390 000
Q. A company is preparing its statement of changes in equity. It produces the following

information.
$000
retained earnings at start of year 40
profit for the year attributable to equity 30
holders
transfer to reserves 15
dividends paid during the year 10
proposed dividends 5
What is the retained earnings figure at the end of the year?
(A) $40 000 (B) $45 000
(C) $55 000 (D) $60 000
Page 75 of 132
Q A company’s year- end is 31 May. The following table shows dividends paid and proposed by
it.
$
proposed final dividend for year ended 31 May 2009, payable 100 000
September 2009
interim dividend for year ended 31 May 2010, payable March 2010 50 000
proposed final dividend for year ended 31 May 2010, payable 120 000
September 2010
Which figure will be shown as dividends in the notes to the accounts for the year ended 31 May
2010?
(A) $120 000 (B) $150 000
(C) $170 000 (D) $270 000
Q. What would not appear in the Income Statement of a limited company?

1. Finance costs
2. Revenue
3. Ordinary dividends paid
4. Ordinary dividends payable
A. 1 and 2
B. 1 and 4
C. 2 and 3
D. 3 and 4
Page 76 of 132
IAS #2 (Inventories):
As per prudence concept inventories should be valued at lower of cost or net realizable value.
Cost = Purchase Price + All costs associated to purchases.
NRV = Net Realizable Value = Selling Price – (All costs associated to sales)
There are three cash flow assumptions of valuing inventory and two methods of doing so:
1. LIFO: IAS2 does not allow the use of LIFO
2. FIFO
3. AVCO
The two ways in which these three methods can be applied are Perpetual and Periodic.
1. Perpetual means that the inventories will be valued after every transaction.
2. Periodic means that inventories will be valued at end of the period.
Types of Inventories:
i) Inventory of raw material i.e., the cost of raw material and cost associated to
purchase of raw material.
ii) Inventory of work in progress
iii) Inventory of finished goods
As per IAS 2 inventory of WIP & FG, comprises of direct material, direct labor, direct expenses
and other overheads associated to production of finished goods and work in progress.
Direct labor + Direct Expense = Conversion Cost

Inventory of F.G & Inventory of WIP = Conversion cost + Direct Material
Q. What is Conversion Cost?

Conversion cost is all cost which is incurred in bringing the inventory to its present location and
condition as per IAS2.
IAS 2 specially excludes the following cost to be included in inventories. They are:
1) Storage cost
2) Selling cost
3) Admin cost (NOT related to production e.g. salary of guard)
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Q. A company values inventory in line with IAS2. For month 1 the following costs were incurred:
 Direct materials $8840
 Direct Labor $6630
 Factory overheads $4420
 Selling and distribution costs of $11050
There was no opening inventory. During the month, the company produced and sold 2000 fully
completed units. At the end of the month 200 finished unites were in stock 20 units part
finished units were also in stock. They were 50% complete in respect of direct materials, labor
and factory overheads.
The finished goods could be sold for $20 each.
REQUIRED:
1. Calculate the cost per unit of production.
2. Calculate the value of work in progress and finished goods to be included in final
accounts.
Q. A company has the following costs for an item of inventory.

$
purchase cost 12 000
carriage inwards 2 000
conversion costs 18 000
storage costs 8 000
What should the inventory be valued at?

(A) $12 000 (B) $14 000
(C) $32 000 (D) $40 000
IAS # 7 (CASHFLOW Statements):

Cash flow statements act as a third tier to Income Statement and Statement of Financial
Position and is compulsory part of published company accounts. It includes three headings:
1) Cash flow from operating activities.
2) Cash flow from investing activities.
3) Cash flow from financing activities
Page 78 of 132
Steps involved in preparation of cash flow statement are:

1) Calculation of operating profits
2) Calculation of cash flow from operating activities
3) Preparation of Cash flow statement as per IAS 7
4) Reconciliation of cash and cash equivalent.
As per IAS 7, Cash and cash equivalent are cash, bank and short-term deposits and anything
convertible into cash within three months.
Q. Which of the following items is not considered as cash or cash equivalent?

a) Cash
b) Bank
c) Short term investments convertible into cash after 8 months
d) Short term investments convertible into cash within 2 months
IAS # 8 (Accounting Policies/ Changes in accounting estimates and errors):

This IAS deals with accounting concepts such as prudence, accruals, going concern, consistency
concept, business entity, materiality, matching, dual aspect concept, historical cost concept,
money measurement concept.
All these concepts are designed to ensure that the information provided in the financial
statement is useful to the users with four objectives in mind.
1) Relevance: The information in the financial statements has the ability to influence
decision making.
2) Reliability: The information in the financial statements is reliable and free from any
material biasness and must be prepared with utmost faith.
3) Comparability: The financial statements must be prepared in such a manner that
comparison between different firms must be possible and make sense.
4) Understandability: The information in the financial statements must be understandable
by all those who have some knowledge of accounting.
IAS # 10 (Events after the reporting period)
1) Adjusting events: If the existence of an event can be related to previous year, it is and
adjusting event. There are two types of adjusting events:
i. Material Impact: Financial statement must be adjusted to amount of it.
ii. Immaterial Impact: Must be disclosed to notes to accounts.
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2) Non-Adjusting events: If the existence of an event cannot be related to previous year,

that is, it has occurred after the accounting year end then it is a non-adjusting event.
There are two types of non-adjusting events:
i. Material: Disclosed to notes to accounts
ii. Immaterial: Ignored.
Note: If something which is to be disclosed to notes to accounts is not disclosed, then it will
result in the reliability of financial statements to be hampered.
Examples of adjusting events are:

 Purchase of fixed asset before accounting year ended invoiced later.
 Major debtor becoming bankrupt.
 Significant fall in value of non-current assets not recorded. (Impairment)
 Discovery of fraud or error which have material impact on financial statements.
 If the cost of the Inventory is greater than NRV.
Examples of Non-adjusting events:

 Purchase or sale of fixed asset after Statement of Financial Position’s date.
 Destruction of Inventory because of natural calamity
 Major share transaction.
 Changes In tax rates.
 Contingent assets and liabilities.
There are three situations which must be mentioned in the notes to accounts and hence are
non-adjusting events.
1. Proposed Ordinary dividends.
2. If after the financial year ends, the director discloses or determines that the business
will cease trading in future then the financial statement cannot be prepared based on
going concern concept.
3. It must be disclosed that what is the authorization date of the financial statements and
who authorizes it and after authorization if financial statements can be amended who
has the power to do so and how.
Page 80 of 132
Q) A Company’s year-end is 30 June 1997. On 27 July 1997, a major fire took place at the
company’s factory. On 8 August 1997, a major trade receivable at 30 June 1997 went
into liquidation.
In accordance with Accounting for Post- Statement of Financial Position’s Events, how
should the two events be treated in the financial statements?
Fire Liquidation
(A) Accrued in accounts accrued in accounts
(B) Accrued in accounts disclosed in notes
(C) Disclosed in notes accrued in accounts
(D) Disclosed in notes disclosed in notes
Q) Certain post Statement of Financial Position’s events must be disclosed in the notes to the
financial statements.
To which of the following does this rule apply?
(A) Insolvency of a trade receivable, existing at Statement of Financial Position date.
(B) Destruction of factory by fire after the year-end, resulting in no production.
(C) Sale of inventory after the year-end at a material loss.
(D) Valuation of property, providing evidence of permanent diminution in value at
year-end
Q. Events occurring after a Statement of Financial Position classified as either adjusting events
or non-adjusting events. An adjusting event is one, which requires a change in the financial
accounts.
Which of the following is an adjusting event?
(A)Changes in rates of foreign exchange

(B)The issue of shares
(C)The insolvency of a major trade receivable
(D) The purchase of a new vehicle
Page 81 of 132
Q. A business makes a profit for the financial year to 31 March 2010 of $100000.
After the Statement of Financial Position date, the following three events
occurred:
an adjusting event of $40 000 profit
a non-adjusting event of $30000 profit
a dividend declared of $20 000.
What is the adjusted profit?
(A) $140 000 (B) $160 000
(C) $170 000 (D) $190 000
IAS # 16 (Property, Plants and Equipment/ Tangible Non-Current Assets):

As per IAS 16 assets must be shown at their historical cost less accumulated depreciation.
Historical cost refers to the original cost of asset plus all costs associate to purchase, i.e. all
capital expenditure. This IAS also distinguishes between capital expenditure and revenue
expenditure and all capital expenditure must be part of fixed assets. This IAS also indicates that
each class of assets must be distinguished separately. Same rate of depreciation must be
applied in each class of asset.
Every year each class of asset must be checked for revaluation, if a particular asset is revalued
then all assets of such class shall be revalued and any surplus or revaluation should be shown is
statement of gains and losses. This IAS also emphasizes that schedule of Fixed asset must also
be made.
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Schedule of Fixed Asset
Cost Fixture &Fittings Plant and Machinery Land and Building
Opening Balance x x x
Additions x x x
Disposal (x) (x) (x)
Revaluation x
Closing Balance xx xx xx
Deprecation
Opening Balance x x x
Charge for year x x x
Disposal (x) (x) (x)
Closing depreciation xx xx xx
NBV xxx xxx xxx
Once the assets are revalued, depreciation is charged on the revalued amount from the date
of revaluation.
Q. The accounts of limited companies must disclose changes in methods of providing for
depreciation of non-current assets. Why is this important to users of corporate reports?
(A) It allows the market value of assets to be shown
(B) It enables comparison with previous year’s accounts
(C) It helps to assess company’s liquidity
(D) It helps to assess future dividends.
IAS # 17 (LEASE):
Finance Lease: If the assets which are bought on lease, becomes property of the person who
has bought it on lease, at the end of lease term, is called finance lease. Assets bought on
finance lease are treated as the Non-current asset of the business and amount yet not paid is
treated as liabilities.
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Operating Lease: If the asset bought on lease has to be returned to the original owner at the
end of lease term then it is operating lease. Assets bought on operating lease are not the fixed
asset of the business so any amount paid on lease term will be treated as rent and will be
charged to the income statement of the current year.
This IAS also deals with the concept of substance over form which states that if an asset is
bought on lease then it will be treated as the non-current asset of the business and amount not
yet paid will be treated as the liability.
IAS # 18 (Revenues)
This IAS recognizes revenues as sales. Sales are considered to be made as soon as title is
transferred from the seller to the buyer, irrespective of the fact whether the invoice is received
or not and whether goods are delivered or not. Once the risk and rewards are transferred, sale
is considered to be made.
Q. When is revenue recognized?

(A)When goods are delivered and title has passed
(B)When goods for sale are purchased less cash discount
(C)When goods sold on credit are paid for
(D)When the cost of goods sold has been determined
IAS # 23 (Borrowing Cost and Qualifying assets):

Borrowing cost is finance cost and hence includes interest. As per IAS 1, dividends on
redeemable preference shares are also part of borrowing cost.
This IAS also emphasizes on the fact that if the rate of interest is varying from year to year then
average of all years’ interest is to be recorded for example, a debenture worth $100,000 has
interest rate of 10% per annum for the first three years and has interest rate of 12% for the
next two years, the interest to be charged each year will be:
1. 100,000 x 10% = 10,000
2. 100,000 x 10% = 10,000
3. 100,000 x 10% = 10,000
4. 100,000 x 12% = 12,000
5. 100,000 x 12% = 12,000
54,000/5 = 10,800 / year
This IAS also deals with qualifying assets. These are those assets which take a substantial period
of time to come under usable condition, so all expenses incurred on such assets till they
become usable are part of cost of asset and hence called qualifying assets. All costs incurred on
an asset to qualify an asset in usable condition are part of cost of the asset.
Page 84 of 132
Q. a) When should a non-current asset be recognized for inclusion in the final accounts?
b) State the two methods of valuing non-current asset for inclusion of final accounts.
c) A company borrows $50 000 to build a new warehouse. In the first year the company pays
interest on the money borrowed of $5000. The warehouse is completed and in use after 6
months. State how the interest should be treated in final accounts.
Q. X Plc incurred the following costs as a result of purchasing a new machine.
$
purchase price 7 000
installation cost 5 000
testing the machine before use 1 000
manufacturer’s list price 10 000
advertising the new products to be made by the 4 000
machine
What is the maximum initial cost of the machine that would be recognized as an asset of the
company?
(A) $13 000 (B) $16 000
(C) $17 000 (D) $20000
IAS # 33 (Earnings per share):
AS per IAS 33, earnings per share must be shown at the face of the financial statement because
it acts a decisive factor whether to invest in a company or not. When two businesses are being
compared the business with higher earnings per share is preferred.
Earning are the profits after interest, tax and preference dividends.
Earnings per Share (EPS): Profits after interest, tax and preference dividends
No. of shares issued
IAS # 36 (Impairment of Assets):
Impairment of Assets refers to drastic fall in the value of assets. All assets must be checked for
impairment on regular basis. This IAS identifies four terminologies:
1. Carrying amount i.e. Net book value (Cost - Depreciation)
2. Recoverable amount: Higher of fair value or value in use.
3. Fair value: Market value of the assets if they are sold immediately. Fair value is the
amount obtained from a sale of an asset less any cost associated to the sale of that
asset.
4. Value in use: The present value of future cash flows if the asset is continued to be
used.
Page 85 of 132
Impairment is the difference between carrying amount and value of asset; it is the amount by
which carrying amount of an asset exceeds its recoverable amount.
Double entry to record impairment is:
Income Statement DR
Impairment Loss Cr
Value of Asset:
Lower of Carrying amount or Recoverable amount.
Recoverable amount is higher of value in use or fair value.
Q. A company carries out an impairment review on its non-current assets. Details of digger are
as follows:
 Cost $80 000, less accumulated depreciation $30 000
 If the company sold the digger it would realize $45 000. There would be costs to sell of
$2000.
 The present value of future cash flows from digger are as follows:
Year 1 $15 000
Year 2 $12 000
Year 3 $10 000
Year 4 $9 000
The company’s cost of capital is 10%.
REQUIRED:
Calculate the value of digger for inclusion in the final accounts and also identify if there is any
impairment loss.
Q. The following data relates to a company at 31 December.

Details of a non-current asset $ million
Historic cost 15
Accumulated depreciation 10
Value in use 4
Fair value less costs to sell 3
What would be the impairment loss for the non-current asset to be recognized at 31
December?
A$1 million B$3 million
C$4 million D$5 million
Page 86 of 132
Q. At the start of the year a company has plant and machinery valued at $20 000.
Depreciation policy is to depreciate plant and machinery at 25 % using the reducing balance
method.
Following an impairment review the fair value of plant and machinery is $16 000 and its value in
use is $25 000.
At which value should plant and machinery be shown in the year end statement of financial
position?
A$15 000 B$16 000 C$20 000 D $25 000
IAS # 37 (Contingencies and Liabilities and Provisions):

Liabilities are the owing of the business with a certain amount and specified timings. Liability is
a present obligation based on past event.
Provisions are the expected losses. Provision is a liability of uncertain amount and timing.
Contingencies are those events whose existence and non-existence or whose occurrence and
non-occurrence depend on the occurrence or non-occurrence of future events for example
warranties.
Page 87 of 132
Contingencies
↙ ↘
Contingent Assets Contingent Liability.
This IAS defines four events:

1.Highly likely: The event with more than 90% chance of occurrence.
2. Probable: The event with 50% to 90% chance of occurrence.
3. Possible: The event with chance of 10% to 50% chance of occurrence.
4. Remote: The event with less than 10% chance of occurrence.
Contingent Assets Contingent Liabilities
Highly Likely Adjusted in the final Adjusted in the final

statement statement
Probable Notes to Accounts Adjusted in the final

statement
Possible Ignore Notes to Accounts
Remote Ignore Ignore
Q a) Define the term ‘Provision’ and ‘Liability’ as set out in IAS37.
b) Define the term ‘Contingent Liability’ as set out in IAS37.
c) State how provisions and contingent liabilities should be treated in the annual accounts.
Page 88 of 132
IAS # 38 (Intangible assets & Goodwill):

Intangible assets are those assets which cannot be seen or touched but have a monetary value
for e.g. goodwill, patents, trademarks, etc. But we are concerned with only Goodwill.
Goodwill is the good reputation of the business and is divided into two categories:
Goodwill
↙ ↘
Purchased Goodwill Inherent good will
↙ ↘
Positive Negative
IAS # 38 states that inherent goodwill is NOT recorded in books of accounts.
Purchased Goodwill = Purchase Price – Fair value of Net assets acquired.

Goodwill can be positive or negative. As per IAS 38 negative goodwill should be recorded on the
face of Statement of Financial Position as a negative item.
Positive goodwill is shown at the face of Statement of Financial Position as intangible fixed
asset. Every year, positive goodwill has to be checked for amortization (Depreciation). When
the question is silent
Goodwill has life of 20 years and has it be amortized over this period on straight line basis.
Page 89 of 132
IAS 38 allows revaluation of goodwill but maximum revaluation possible is to the extent that
revaluation reaches its original amount.
NOTES TO ACCOUNTS:
It is the supplementary document which is used to analyze and understand the financial
statement, since numbers do not speak for themselves. Notes to accounts are the key to read
the financial statements. Certain things must be mentioned in the notes to accounts.
1. Authorized share capital
2. Issued share capital
3. Share transaction during the year
4. Immaterial adjusting events
5. Material non-adjusting events
6. Reason for issue of shares and debentures
7. Any change in accounting policies
8. Exceptional items: Some events or expenses do not normally occur. They are
exceptional items such as cost of reconstruction, profit or loss from a sale of an
operation, profit or loss from sale of fixed assets.
9. Basis on which goodwill is valued
10. Basis on which goodwill is amortized
11. Details of impairment of goodwill.
12. Details of impairment of assets.
13. Method of depreciation
14. Estimated useful life of asset.
15. Total depreciation charge of the year
16. Any change in depreciation method
17. Contingencies.
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Directors’ Report:
Directors are the stewards of the company who are responsible for running the business on
behalf of shareholder. The directors’ report is the compulsory part of financial statement and
the directors’ report directly to the shareholders. The contents of Directors’ report are as
follows:
1. A review of activities of the business over the past year, together with any development
in future.
2. A statement of principle activities of company together with any significant changes in
those activities.
3. The names of directors along with their shareholdings in the company.
4. Proposed dividends paid by the company.
5. Political and charitable donations made by the company.
6. Company’s policies on the employment of disabled people
7. Health and safety at work for employees
8. Company’s policies on the payment of suppliers
9. Information about research and development carried by the company
10. Indication of future development in company’s business.
Auditor’s Report
Auditors are the guards of the company who are responsible to ensure that the directors are
performing their duties with due diligence and utmost good faith. Auditors must also ensure
that there are no material errors in the financial statements and the financial statements are
reliable, relevant and give a true and fair view of the company’s performance. They also
validate that the director’s report is also reliable. The contents of auditor’s reports are:
1) They indicate whether proper books of accounts have been kept.

2) The annual financial statements are in agreements with the books of account.
3) They indicate that in their opinion the statement of financial position gives a true and
fair view of the financial position of the company and income statement gives a true
profitability position of the company.
4) A statement that financial statements are prepared in accordance with IAS and the
Company’s Act.
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It is the responsibility of the auditors to point out if the financial statements are misleading or if
the going concern of the company is becoming void.
Auditors must be qualified accountants and must be independent in their decisions; their
decisions must not be biased and hence the auditor’s report directly to the shareholders and
not the directors.
If auditors give a qualified report it is an indication that they are not satisfied and either the
financial statements are incorrect or the director's report is misleading or the directors are not
reflecting a true and fair view of the company's performance.
The auditors also qualify the reports if they feel proper books of accounts are not maintained or
financial statements are not maintained in accordance with Books of Accounts.
If the auditors have given a qualified audit report the directors need to prepare the financial
statements all over again and get its auditing done again.
An unqualified audit report is an indication that the auditors are satisfied by the company's
financial representation and have not found any misstatement or material error worth
disclosing.
Auditors must be qualified accountants who should be independent from the business. If there
exists any kind of relationship between the auditor and the company being audited, then audit
report will be considered unacceptable. Thus auditors should not be employees of the
company. Furthermore, the major source of income of the audit company should not be a
particular company; else the element or biasness might be there.
What does the term stewardship means?

Stewardship reflects the principal agent relationship where the directors and auditors are the
agents of the company, while the shareholders are the principal and thus the directors and
auditors are answerable to the shareholders.
Q. What is not included in directors’ report?

 Director’s salary or remuneration (Because it is included in notes to accounts)
 Details of export sales
 Accounting policies (Because it is separately disclosed in the company accounts)
Q. What is not included at all in annual report?

 Scrap value of asset
 Basic of calculation of provision for bad debts.
 Any day to day expense.
Page 92 of 132
Q. Which of the following must be included in the Report of the Directors of a company?
(A)Accounting policies
(B)Amount recommended to be paid as dividends
(C)Directors’ remuneration (salary)
(D)Inventory valuation policy
Q. The Companies Act 1985 requires the disclosure of certain items in the Income statement.
Which of the following must be disclosed?
(A) Advertising expenditure (B)Auditor’s remuneration
(B) Bad debts written off (D) Rent and rates payable
Q. What must be disclosed in the Report of the Directors?

(A) Accounting policies (B) Directors’ interests in shares
(C) Overdraft facility (D) Segmental analysis of turnover
Q. Certain information must be disclosed in the notes to the financial statements.

To which of the following does this rule not apply?
(A)Estimated useful life of asset
(B) Method of depreciation used
(C) Scrap value of asset
(D) Total depreciation for the period
Q. Which item is not required in the Report of Directors of a limited company?

(A) Details of export sales
(B) Future developments for the business
(C) The names of the directors
(D) The proposed dividend details
Q. Which of the following is not required to be disclosed in published company accounts?

(A) Accounting policies (B)Auditors’ fees
(C) Directors’ remuneration (D) Rent paid for premises
Q. How a company can improve its profit by window dressing?

(A) Writing off goodwill
(B) Making a provision for redundancy
(C) Increasing the bad debts provision
(D) Reducing the rates of depreciation
Page 93 of 132
Q. A company wishes to present its financial statements in the most favorable light.
What will achieve this?
(A) first-in first-out inventory valuation
(B) Provision for bad debts
(C) Revaluation of non-current assets
(D) Window dressing
Q. What is found in the Directors’ Report of a limited company?

1 basis of depreciation of non-current assets
2 directors’ names
3 details of dividends
4 statement of the principal activities of the company
(A) 1 only (B) 1 and 2 only
(C) 1, 2 and 3 only (D) 2, 3 and 4 only
Q. In published accounts, where will the details of directors’ pay and benefits be found?
(A) Accounting policies (B) Income statement
(C) Statement of cash flows (D) none of the above
Q. What is the main purpose of Accounting Standards?

(A) To prevent unqualified accountants from preparing company accounts
(B) To provide useful information for shareholders
(C) To reduce the range and variety of financial accounting practices
(D) To set out uniform accounting bases
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A complete question covering ALL IAS in detail
The income statement of Saya Plc is as follows:
$ $
Revenue (Sales) 2500,000
Less: Cost of Sales (1200,000)
Gross Profit 1300,000
Less: Selling & distribution expenses 300,000
Less: Administrative Expenses 400,000 (700,000)
Profit before interest and tax 600,000
Less: Finance Cost
Interest 50,000
Redeemable Preference Dividends 40,000 (90,000)
510,000
Less: Taxation (110,000)
Distributable Profits 400,000
Extract of Statement of Changes in equity
$ $
Distributable profits 400,000
Add retained profits b/d 100,000
Less: Transfer to general reserves (100,000)
Less: Preference dividends paid and proposed (30,000)
Less: Ordinary dividends paid (70,000) (100,000)
Retained profit c/d 300,000

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Statement of Financial position
$ $ $
Intangible Non-current Assets
Goodwill 250,000
Tangible Non-current Assets
Freehold premises 4,500,000
Plant and Machinery 700,000 (200,000) 500,000
Office Equipment 150,000 (50,000) 100,000
5,350,000
Current assets
Inventory 120,000
Accounts Receivable 85,000
Cash and Cash Equivalents 105,000 310,000
Total Assets 5660,000
Equity and Liabilities
Ordinary shares 3000,000
6% Preference Shares 500,000
Share Premium 50,000
Revaluation Reserve 400,000
General Reserve 350,000
Retained Profits 300,000 4600,000
Current and Non Current Liabilities
Accounts Payable 60,000
10% Debentures 500,000
8% Redeemable Preference Shares 500,000 1,060,000
5,660,000
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The above financial statements are prepared by an inexperienced accountant. Though there are
no flaws in preparation of these Financial Statements but they are not suitable to be published
as company account because:
IAS has not been properly applied. When the chief accountant looked into the details, he
identified the following:
1. The life of goodwill is 5 years and it has to be amortized over its life. Amortization for
the current year has not been charged.
2. Freehold premises should be revalued to $5 million. This has not been considered.
3. It is company’s policy to check for impairment every 2 years. But the inexperienced
accountant forgot to take it into consideration. This year the following information is
available:
Plant and Machinery
Market Value $450,000
Present value of future cash flows/ value in use $430,000
Office Equipment
Fair Value $85,000
Value in use $120,000
4. When inventory’s cost and NRV were separately valued it was identified that cost was
$120000, NRV was $ 130000. The accountant was not aware of how to deal with it and
just took cost into consideration.
5. After a month of preparation of these final accounts $20000 worth of stock was
destroyed by fire. This was also not considered by the accountant.
6. Accounts receivable includes provision of bad debts of $5000. Which the accountant
forgot to take into consideration.
7. Cash + Cash Equivalent included $25000 investments which can be converted into cash
after 9 months.
8. The company can also suffer litigation to be sued for $40000. The company is not sure if
the suit will be filled but it is highly likely that the company will pay this $40000.
9. The company has issued 10% debentures because it is considering purchase of
equipment which will become usable in 3 years’ time. The accountant could not
understand the implication and treated debentures as non-current liability and its
interest as finance cost.
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10. The company has bought $100000 worth of vehicle on finance lease. No payment of this
finance lease has yet been made and hence the accountant did not include it in the
financial statements at all.
11. The accountant was also not aware of the differences between ordinary share,
especially preference share capital and redeemable preference shares but managed to
post them in Statement of Financial Position looking at past year’s Statement of
Financial Position and is happy his Statement of Financial Position has balanced off.
12. Sales include sales invoice of $50,000, which indicates goods that were sent on sale or
return basis. The customer returned the goods before the accounting year ended and
the goods were included in the closing inventory.
13. To publish company account, there are other certain prerequisites to support income
statement and Statement of Financial Position which this accountant has not prepared.
You are chief accountant of the company and are furious at what this new accountant has
done. Being the senior most person of the finance department it is your responsibility to make
him learn from his mistakes. Hence you decide to redraw income statement, Statement of
Financial Position and statement of changes in equity. You will also identify each IAS applied or
not applied when you identify the flaws of the new accountant. Also tell him what other
documents are to be prepared in order to publish company accounts.
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ETHICS
Ethics are generally accepted good practices. Usually when people, businesses and
professionals are ethical, it is considered a good sign but sometimes, ethics has a dilemma
attached to it. What is good for someone might not be good for others.
Organizations adopt ethical practices because of one of the following reasons:
i) First movers advantage
ii) Because competitors are adopting ethical practices
iii) Requirement of the law (CSR – Corporate Social Responsibility)
iv) Businesses are actually ethical
Along with the organizations, professionals also need to be ethical. Professionals will be ethical
by not performing white collar crimes, by not cheating, by not preparing misleading financial
statements, by avoiding window dressing or creative accounting, by working in the best
interests of all stakeholders etc.
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A2 LEVEL
COST
ACCOUNTING
Page 100 of 132
ACCOUNTING
FINANCIAL ACCOUNTING COST ACCOUNTING
 Is done to report the performance of the  Is done to help the business in Decision
company making
 Is the mandatory requirement of  To do cost accounting is NOT compulsory
published company accounts
 Fixed formats are applied when doing  No fixed formats are available
Financial accounting
 International Accounting Standards are  No International Accounting Standards
associated to it are associated to it
 For external use by general public and all  For internal use by the management of
relevant stakeholders the company is hence sometimes
referred to as Managerial Accounting.
A2 LEVEL COST ACCOUNTING:

 Budgets
 Standard Costing
 Investment Appraisal
 Activity Based Costing (ABC)
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BUDGETING; PLANNING OF FUTURE OF BUSINESS USING ACCOUNTING
Budgets are the future forecasts of the company’s performance and help the business in
foreseeing its future as to how the business should perform to achieve its targets. Budgets act a
benchmark for the business so that if the business is not performing in line of budgets it can be
rectified and brought back on track.
Budget also acts as a means of performance appraisal so that the actual performance of the
business could be compared with the expected performance and areas of improvement could
be identified. Budgets at any point in time should be SMART i.e.
SPECIFIC
MEASURABLE
ACHIEVABLE/ACCURATE
REALISTIC
TIME BOUND
Different organizations use different strategies to prepare budgets and all these strategies have
their own pros and cons.
1) Top-down Budgeting: In this strategy top management makes budget and implements it on
all other departments down the hierarchy. Although this is the most controlled budget but
since the top management is not aware of the day to day problems of the front line staff and
managers down the line these budgets tend to be unrealistic.
2) Bottom-Up Budgeting: Each department makes their own budget and sends it to top
management for approval. Although the front line managers keep their reservations in mind
when making these budgets still they tend to mis-communicate their problems to the top
management and usually sets low budget which are easily achievable. Thus the organization’s
true potential is not achieved.
3) Incremental Budgeting: Some organizations do not make budgets from scratch each year
instead they just make relevant changes to the past year's budgets. Although such budgets are
quickly made but they still contain the problems present in the last year's budget.
4) Zero Based Budgeting: In this strategy all budgets are made from the scratch. This is the
most time consuming budget methodology which aims at accurate budgeting and if not
properly implemented it is a waste of time, money and resources.
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5) Management by exception: In this strategy only those budgets are made again whose actual
results varied more than the expectations. Budgets are the future forecasts and are usually
different from the actual performance but there is a limit of inaccuracy involved. If the variation
in budgets is exceptionally higher than the expectation then management by exception is done.
6) Budgets by budget committee: The preparation of budgets with the help of budget
committee is the best strategy to prepare budgets as such budgets are most accurate and
realistic.
A budget committee comprises of managers and representatives from all levels of hierarchy
and they all give their input in identifying the short comings and strengths of their respective
departments so as to prepare a budget which is achievable at all levels. This type of budgeting
is preferred.
Budgetary Control is the process by which budgets are prepared for the foreseeable future and
are then compared with the actual performance to find out any variations between the
budgeted results and actual results which help the management to take any corrective actions
immediately. The main objective of the budgetary control are :
1.defining the objectives of the organizations
2.providing plans for achieving those objectives
3.coordinating the activities of various departments by ensuring that managers are working
towards the same common goal
4.operating all departments most effectively, efficiently and economically
5.increasing profitability by eliminating wastage and deadlocks between different departments
6.centralising the control system
7.take corrective measures where necessary
8.deligating responsibilities to different members of the organization in order to ensure more
ownership towards the organization and the budget
Advantages of Budgetary Control System

1. It defines the goals, plans and policies of the organization on both short term and long term
basis.
2. Each department is given a realistic target which is mandatory for them to achieve and
performance related pays are attached to it.
3. It secures better communication and coordination amongst different departments.
4. In case the performance is below expectations budgetary control helps in identifying the
problems.
5. It helps in reducing costs by eliminating wastage and dead locks.
6. Since everything is already pre-planned it helps in smooth running of the organization.
7. It helps in providing the organization with the problem solving techniques.
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Disadvantages of Budgetary Control System

1.It is practically impossible to setup 100% accurate budgets.
2. Budgeting during inflationary conditions is very difficult.
3. Budgets involve heavy expenditure which small business cannot usually afford.
4. If budgets are prepared but not implemented it is an unworthy exercise.
5. Since budgets are prepared on the basis of future expectations and future is uncertain then
any foreseen event or uncertainty can upset the budget.
6. Budgetary Control is just a tool which helps the management in the decision making process
and take corrective actions but it cannot replace management as a whole.
7. Budgetry Control will only be successful if the top management supports it and monitors it
closely.
Thus, in order to forecast future performance, the budgets are made as follows, in the following
priority:
 Sales Budget
 Production Budget
 Purchases Budget
 Labor Budget
 Receivable Budget
 Payables Budget
 Expense Budget
 Cash Budget (followed by Budgeted Income Statement and Statement of Financial
Position)
1) Sales Budget: When making sales budget, we forecast units that the business will sell,
the price at which these units will be sold, and the total sales made.
SALES BUDGET
Units Selling Price Total Sales

January 500 10 5000
February 1000 10 10000
March 800 10 8000
April 1200 12 14400
Total Sales for the period 37400
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2) Production Budget: Production Budget is based on Sales Budget, as the number of units
produced will be dependent upon the number of units that the business will be able to sell.
PRODUCTION BUDGET (IN UNITS)
January February March April

Closing Inventory (Finished Goods) x x x x
Sales (Finished Goods) x x x x
Less: Opening Inventory (Finished Goods) (x) (x) (x) (x)
Units Produced x x x x
3) Purchase Budget: Units purchased will depend upon the number of units that the
business plans to produce, and hence we will convert production in units to production in terms
of raw material and then make the purchase budget.
PRODUCTION BUDGET (IN RAW MATERIAL)

Closing Inventory (Finished Goods) x x x x
Sales (Finished Goods) x x x x
Less: Opening Inventory (Finished Goods) (x) (x) (x) (x)
Units Produced x x x x
x kg/unit x x x x
Production (in kg) x x x x
PURCHASE BUDGET
Closing Inventory (Raw Material) x x x x
Production (in kg) x x x x
Less: Opening Inventory (Raw Material) (x) (x) (x) (x)
Purchases in kg x x x x
x $/kg x x x x
Purchases (in value) x x x x
Production = Closing Inventory (Finished Goods) + Sales (Finished Goods) – Opening Inventory
(Finished Goods)
Purchases = Closing Inventory (Raw Materials) + Production (in kg) – Opening Inventory (Raw
Materials)
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In case of a trading business only i.e. no production, then:
Purchases (Units) = Closing Inventory (Units) + Sales (Units) – Opening Inventory (Units)
Derived from:
Sales (Units) = Opening Inventory (Units) + Purchases (Units) – Closing Inventory (Units)
Example: X Ltd. Plans to sell 400 units of a product in January at $5 each. Sales will increase by
100 units in March and a further 10% in April. Selling price will increase by $1 each month.
Units are produced in such a manner that closing inventory each month us 10% of next months’
sales. Each unit requires 2 kg of raw material, and each kg of raw material costs $3. Raw
material is purchased in such a manner that the closing inventory is equal to next month’s
production. You are required to prepare:
1) Sales Budget (Jan-June)

2) 2) Production Budget (Jan-May)
3) 3) Purchase Budget (Jan-April)
SALES BUDGET
Units Selling Price Total Sales

January 400 5 2000
February 400 6 2400
March 500 7 3500
April 550 8 4400
May 550 9 4950
June 550 10 5500
Total Sales for the period 22750
PRODUCTION BUDGET
January February March April May

Closing Inventory 40 50 55 55 55
Sales (in units) 400 400 500 550 550
Less: Opening Inventory (40) (40) (50) (55) (55)
Production (in units) 400 410 505 550 550
x kg/unit 2 2 2 2 2
Production (in kg) 800 800 1010 1100 1100
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PURCHASE BUDGET
Closing Inventory 820 1010 1100 1100
Production (in kg) 800 820 1010 1100
Less: Opening Inventory (800) (820) (1010) (1100)
Purchases in kg 820 1010 1100 1100
x $/kg 3 3 3 3
Purchases (in value) 2460 3030 3300 3300
4) Labor Budget: Labor Budget is prepared by manufacturing business in order to identify

the number of hours that the labor will spend on making the product and the wage rate per
hour. Hence, then total labor cost will be identified.
Example: X Ltd. has 5 employees working 150 hours each month at the rate of $5 per hour. The
number of hours spent by each employee increased by 15 in February. In March, another
employee was hired at the same rate who will also work the same number of hours the other
employees are working. Wage rate increased by $1 in April. You are required to prepare the
labor budget from January to April.
LABOR BUDGET
Hours Rate Total Wages

January 5x150=750 5 3750
February 5x165=825 5 4125
March 6x165=990 5 4950
April 6x165=990 6 5940
5) Receivable Budget: are prepared to identify when would the receivable pay the amount
that they owe and how much.
Example: The sales budget of a business shows the following results:
SALES BUDGET
Total Sales
December 8000
January 9000
February 12000
March 15000
April 20000
Page 107 of 132
50% of the sales are cash sales. Of the credit sales, 20% will be received in the month following
sales and the remainder will be received 2 months after sales. You are required to prepare the
Receivable Budget.

1 month Receivable 3200 3600 4800 6000
2 month Receivable 4500 6000 7500 10000
7700 9600 12300 16000
6) Payables Budget: is similar to Receivables Budget and is made to identify the amount of
payables generated because of credit purchases.
Example: The purchase budget of a business indicates the following results:
PURCHASE BUDGET
Total Purchases
January 8000
February 10000
March 15000
April 9000
May 5000
40% are credit purchases and 60% are cash purchases. Of the credit purchases, 50% will be paid
in the month following purchases and the remaining within 2 months following purchase. You
are required to prepare the payables budget.
February March April May

1 month Payable 1600 2000 3000 1800
2 month Payable 4000 6000 3600 2000
Total Payables 5600 8000 6600 3800
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7) Expense Budget: is based on accrual concept. As soon as expenses are incurred,

whether cash expenses or non-cash expenses, and whether paid or not, will be part of Expense
Budget.
EXPENSE BUDGET
Depreciation x x x x
Bad Debts x x x x
Discount Allowed x x x x
Utility Bills x x x x
x x x x
8) Cash Budget: is based on Cash concept. When cash is expected to come into the
business, it will be recorded as Receipts and the cash which is expected to go out of the
business will be recorded as Payments.
The difference between the two will be the Net Cash Inflow/ (Outflow) for the year. Previous
years’ balance will be added to it to find the balance which will be carried forward.
CASH BUDGET
Jan Feb March April
RECEIPTS
Cash Sales x x x x
Receipts from Receivables x x x x
Sale of non-current asset - x - -
Other incomes - - x -
Total Receipts x x x x
PAYMENTS
Cash Purchases x x x x
Payments to Payables x x x x
Purchase of Non-current Assets - x - x
Expenses paid x x x x
Repayment of loan x x x -
Dividends paid x x - x
Drawings x - x x
Total Payments x x x x
Receipts – Payments x x x x
Add: Previous balance x x x x
Balance c/d xx xx xx xx
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NOTE: Reserves of a company are non-cash items i.e. any transfer to General Reserve does not
affect cash budget. (It is transferred as profit, not cash)
9) Master Budget: Budgeted Income Statement and Statement of Financial Position. It is

prepared based on accrual concept and is made as normally. Master Budget is prepared to
assess how profitable will the business be in future and what will be the financial position of
the business on a certain future date.
NOTE: When making budgets, selling expenses will be associated to the number of units sold,
while labor, variable overheads and other production expenses will be associated to
production.
Page 110 of 132
STANDARD COSTING AND VARIANCE ANALYSIS

When the business prepares budgets, it is based on expected performance of the company, and
usually the expected performance is different from the actual performance. Therefore, it is very
important to identify how much the actual results are varying in comparison to the budgeted
results. The budgeted results are the benchmark for the company and are the currently
attainable standards and are thus referred to as Standard Costing. The actual cost is compared
with the Standard Cost and the difference between the two is referred to as Variance. There
can either be a favorable variance or an adverse variance, and when we analyze whether the
variance is favorable or adverse, and what caused the variance, we are in reality doing the
Variance Analysis.
PURPOSE: The purpose of Standard Costing is to help management in the planning and control
of the business and links with the budgetary control system. It provides a benchmark to
measure actual performance and identifies areas where savings could be made.
The actual results and the budgeted results of the business can vary because of the following:
Sales Price Variance
1) Sales Variance Sales Volume Variance
Material Price Variance
2) Material Variance Material Usage Variance
Labor Rate Variance
3) Labor Variance Labor Efficiency Variance
Variable Overhead
4) Overhead Variance Fixed Overhead
Whenever the above mentioned four things will be compared, the comparison has to be made
between the actual results and the budgeted results, but the comparison will be misleading
until and unless the budgeted information that is being compared has the same number of
units as actual units produced/sold. In order to ensure that the actual and budgeted
comparison is based on the same units, we have to flex the budgets and convert the budgeted
data available in budgeted units to budgeted data in actual units. The process of converting
budgeted cost at budgeted activity level to budgeted cost at actual activity level is called Flexing
the Budgets. Then these budgeted costs at actual activity level are compared with actual cost at
actual activity level to achieve the Variance Analysis.
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In order to flex the budgets, the first task is to identify whether cost is Variable Cost, Fixed cost
or semi-variable cost, and then flexing will be done accordingly as follows:
i) Variable Cost:
If cost per unit is fixed at different activity level, it is an indication that it’s a Variable
Cost.
ii) Fixed Cost:
If total cost is constant at different activity levels, it is an indication that the cost
involved is the fixed cost.
iii) Semi-Variable Cost:

If neither cost per unit is same nor total cost is same, then it is an indication that is a
Semi-Variable Cost. In order to identify the fixed part and the variable part, we have
to apply the High-Low method as follows:
Variable Cost per unit = Highest Cost – Lowest Cost
Highest Output – Lowest Output
Example: Cost Data for two activity levels are given below:
12000 Units 25000 Units
Direct Material 36000 75000
Direct Labor 6000 12500
Production Overhead 30000 56000
Admin Costs 50000 50000
Selling Costs 20000 33000
IF Actual production is 30000 units, find the cost of production.

We need to flex the budget first, i.e.
Direct Material = 36000 = $3 we're finding per 75000 = $3 Hence, is a Variable Cost
12000 unit costs here 25000
so we can find
Direct Labor = 6000 = $0.5 the cost for 30k 12500 = $0.5 Hence, is a Variable Cost
units of actual pro
12000 25000
Production Overhead (variable cost per unit) = 56000 – 30000 = $2 per unit
25000 - 12000
(12000 x 2) + Fixed Cost = $30000 Hence, Fixed Cost = 30000 – 24000 = $6000
for 30000 Units: (2 x 30000) + 6000 = $66000
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Selling Costs (variable cost per unit) = 33000 – 20000 = $1 per unit
25000 - 12000
(12000 x 1) + Fixed Cost = $20000 Hence, Fixed Cost = 20000 – 12000 = $8000
for 30000 Units: (1 x 30000) + 8000 = $38000
30000 Units
Direct Material 90000
Direct Labor 15000
Production Overhead 66000
Admin Costs 50000
Selling Costs 38000
259000
The difference in the budgeted results and actual results is either because actual revenue is
different from budgeted revenue or actual cost is different from budgeted cost.
Flexed Budget – Actual Result bec if we budgted our revenue to be > it actually is,
means we didnt perform well which may be bec
If positive; Adverse Variance Revenue Variance we budgeted a higher SP then wht e actually sold
If negative; Favorable Variance @
e.g actual units 30k
If positive; Favorable Variance Cost Variances bud SP= 8
actual SP= 5
If negative; Adverse Variance (30*8) - (30*5) = 90
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Page 114 of 132
SALES VARIANCE
Indicates whether the business is able to sell as many units as it planned to sell and at the price
the business was expecting to sell. If the business has managed to sell the expected number of
units at expected price, there will be no variance. But if the actual results are different from
budgeted results, the variance will exist. The difference in sales variance could either be
because of sales price variance or sales volume variance.
If the business sells its products at a price lower than expected, there will be an Adverse Sales
Price Variance but if the selling price of the business is higher than the expected selling price,
then there will be a positive Sales Price Variance.
If more units are sold than expected, then the results will be a positive Sales Volume Variance,
but if lesser units are sold, it would result in Adverse Sales Volume Variance.
As per the law of demand, if the selling price rises, quantity demanded falls, and if the selling
price falls, quantity demanded rises, thus there is an inverse relationship between sales price
and sales volume and usually a positive price variance will accompany adverse volume variance,
and vice versa. But at times, the business can charge higher prices and even sell more goods,
resulting in both positive price and volume variance. Similarly, there is also a possibility that the
business charges lower prices and is yet unable to sell the desired quantity, thus resulting in
adverse price as well as volume variances. Thus, whatsoever the situation is, the aim of the
business should be No variance or Favorable Variance.
MATERIAL VARIANCE
Indicates whether the business is able to purchase material at the expected price and whether
as many units are being produced from the material bought as are desired. Material variance
could exist either because of Material Price Variance or Material Usage Variance.
If the material is bought at a higher price than the expected price, it will result in adverse Price
Variance, but if low priced material is obtained, then it will result if Favorable Material Price
Variance. At the same time, the quantity of material bought is also very important. If a poor
quality of material is bought, more material will be required to produce the desired output,
thus resulting in adverse material usage variance, but if a good-quality material is bought, and
less material is being used to make the desired output, then it will result in a Favorable Material
Usage Variance.
Usually, there exists an inverse relationship between material price variance and material usage
variance. A high-priced material is usually of good quality thus resulting in adverse price
variance but a favorable usage variance. Similarly, a low-priced material is usually of poor
quality, thus resulting in favorable price but adverse usage variance. The best achievement
would be both favorable price and usage variance.
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LABOR VARIANCE
Indicates whether the business is able to hire labor at the expected rate, or do they need to pay
a higher amount in order to attract desired labor, or is the labor efficient enough to fulfill the
task with the desired time or more hours are spent on the work than expected.
A favorable labor rate variance indicates that the labor is being hired at a lower rate than
expected, and adverse rate variance indicates more amount is being spent on hiring the labor.
Similarly, an efficient labor will be able to perform the duties within the specified time frame
indicating a favorable labor efficiency variance, whereas if more hours are spent on the work,
then the labor is unskilled resulting in adverse efficiency variance.
There is an inverse relationship between labor efficiency variance and labor rate variance
because usually a highly efficient labor is expensive to hire.
OVERHEAD VARIANCE
Whether fixed or variable, if the overheads are higher than expected, they will result in adverse
variances, or vice versa.
FIXED OVERHEAD VOLUME VARIANCE
Fixed Overhead Volume Variance quantifies the difference between budgeted and absorbed
fixed production overheads. The formula to calculate Fixed Overhead Volume Variance is
= (Budgeted Production – Actual Production) x Overhead Absorption Rate (OAR)
If positive; Adverse Variance
If negative; Favorable Variance
Fixed Overhead Volume Variance is the difference between fixed production costs which are
budgeted and the fixed production costs that are flexed during the period, hence the variance
arises due to a change in the level of output attained compared to level of output budgeted. It
has two sub-variances:
i) FIXED OVERHEAD CAPACITY VARIANCE
= (Budgeted Production Hours – Actual Production Hours) x Overhead Absorption Rate (OAR)
If positive; Adverse Variance

If negative; Favorable Variance
Fixed Overhead Capacity Variance calculates the variation in absorbed fixed overheads
attributable to a change in number of manufacturing hours, e.g. labor hours or machine
hours as compared to the budget.
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ii) FIXED OVERHEAD EFFICIENCY VARIANCE

= (Flexed Production Hours – Actual Production Hours) x Overhead Absorption Rate (OAR)
If positive; Favorable Variance
If negative; Adverse Variance
Fixed Overhead Efficiency Variance calculates the variation in absorbed fixed overheads
attributable to a change in manufacturing efficiency during the period.
Fixed Overhead Volume Variance is necessary if the profit statements are prepared on the basis
of absorption costing rather than marginal costing. This variance is only used to balance the
reconciliation statement if profits are calculated on the basis of absorption costing because
when Quantity Variance is calculated, it already takes into consideration fixed overhead
expenditure variances, whereas when we calculate fixed overhead variance, it implies that the
difference between budgeted and flexed fixed cost is included twice and hence to avoid
duplication, we have to use Fixed Overhead Volume Variance.
Example:
Actual Production 275000 units
Budgeted Production 250000 units
OAR $2000/unit
Standard Machine Hours per unit 10 hours
Actual number of Machine hours 3,000,000
OAR/hour = 2000 = $200/hour
10
Fixed Overhead Volume Variance = (250,000 – 275,000) x 2000 = (50,000,000) Favorable
(We will use OAR/unit here as Budgeted production and Actual production ‘in units’ is used)
Fixed Overhead Capacity Variance = (250,000x10 – 3,000,000) x 200 = (100,000,000) Favorable
(We will use OAR/hour here as Budgeted and Actual ‘hours’ are used)
Fixed Overhead Efficiency Variance = (2750,000 – 3,000,000) x 200 = (50,000,000) Adverse
Page 117 of 132
RELATIONSHIP BETWEEN DIFFERENT VARIANCES

All variances are inter-connected and an effect on one will have repercussions on all.
A poor-quality material might be less costly resulting in favorable price variance, but at the
same time, they will adversely affect not only material usage variance, but even hinder the
efficiency of labor thus adversely affecting labor efficiency variance.
Similarly, an unskilled labor will not only affect labor efficiency but will also damage the
material, adversely affecting material usage variance, although there might be a favorable labor
rate variance.
TYPES OF STANDARDS:
1) Ideal Standards
2) Current Standards (Standard Costing is based on this)
3) Attainable Standards
NOTE:
When Standard Output is achieved, i.e. Actual Output = Budgeted Output, then Flexing is not
required.
There is no need to flex the budgets for sales variances (only cost variances)
VARIANCE CONTROLLED BY
Material Price Variance Purchase Manager
Material Usage Variance Production Manager
Labor Rate Variance HR Manager
Labor Efficiency Variance Production Manager
Sales Price Variance Marketing and Sales Manager
Sales Volume Variance Marketing and Sales Manager
Variable Overhead Variance Production Manager
Fixed Overhead Variance Production Manager

Page 118 of 132
WHAT IS QUANTITY VARIANCE?

Quantity Variance is the additional profit arising from increased production and hence the
formula to calculate quantity variance is
Quantity Variance = Original Budget Profit – Flexed Budget Profit
If answer is positive; Adverse variance
If answer is negative; Favorable variance
RECONCILIATION STATEMENT TO RECONCILE THE BUDGETED PROFITS WITH ACTUAL PROFITS

$ $
Budgeted Profit xxx
Add: Favorable Variances
Sales Price Variance xx
Material Usage Variance xx
Labor Rate Variance xx
Variable Overheads Variance xx xx
Less: Adverse Variances
Quantity Variance xx
Material Price Variance xx
Labor Efficiency Variance xx (xx)
Actual Profit xxx
RECONCILIATION STATEMENT TO RECONCILE THE BUDGETED COSTS WITH ACTUAL COSTS
$ $
Budgeted Cost xxx
Add: Adverse Variances
Material Usage Variance xx
Variable Overheads Variance xx xx
Less: Favorable Variances
Fixed Overheads Variance xx
Material Price Variance xx
Labor Efficiency Variance xx (xx)
Actual Cost xxx
Page 119 of 132
NOTE: In order to reconcile, the following two things must be kept in mind:
i) We will only use sub-variances and not the total variances.
ii) We will take into consideration the Quantity variance instead of sales volume
variance. This is because sales volume variance is already part of Quantity variance,
and if sales volume variance will be considered, it will result in double counting.
Page 120 of 132
INVESTMENT APPRAISAL
Investment Appraisal is a method of assessing investment projects whether it is feasible to

invest huge amount of money in some projects. Since investment in a project requires big
capital investment, a wrong decision will not only result in huge losses but will also damage the
goodwill and might even affect the existence of the business.
In order to take the right decision, so as to maximize the profits, the tools and techniques of
investment appraisal are used which are as follows:
1) Payback period
2) Discounted Payback period
3) Net Present Value (NPV)
4) Profitability Index (PI)
5) Internal Rate of Return (IRR)
6) Average / Accounting Rate of Return (ARR)
PAYBACK PERIOD
Payback Period identifies the risk position of the business. It indicates how long does it take for
the initial investment to be recovered. The shorter the payback period, the less risky the
investment is as the initial investment will be recovered soon. When two or more projects are
being compared, the project with a shorter payback period will be selected.
Example: Project A Project B
Year 0 (100000) (100000)
Year 1 50000 30000
Year 2 40000 30000
Year 3 30000 30000
Year 4 20000 30000
Year 5 10000 30000
PAYBACK PERIOD: 2 Years 4 months 3 Years 4 months
DECISION: Based on Payback period, Project A must be selected because it has a shorter
payback period.
TIME VALUE OF MONEY
With the advent of time, the purchasing power of money falls because of the effect of inflation.
The worth of $1 today is not the same as worth of $1 after few years, and hence there arises
the need to identify the difference between real value of money and nominal value of money.
Real value of money means the true worth of money after taking onto consideration the effect
of inflation.
Page 121 of 132
When an investment decision is taken, the return of that decision covers a span of years, and
hence in order to calculate the true returns, we should base our calculations not on nominal
cash flows, instead we should base our calculations on real cash flows. These real cash flows are
termed as DCF (Discounted Cash Flows) and the nominal cash flows are termed as NCF (Net
Cash Flows). In order to convert Nominal Cash Flows into real cash flows, we have to multiply
the nominal cash flows by the Discount Factor. Discount Factor means what will be the worth of
$1 in future years and the formula to calculate discount factor is
Discount Factor = 1 where, i is the Cost of Capital (Rate of Inflation)
(1 + i)n and n is the number of years after the start of the project.
Discounted Cash Flows = Nominal Cash Flows x Discount Factor
Since the investment decisions are so important that decisions should be taken on real cash
flows rather than nominal cash flows and hence we multiply the cash flows by the discount
factor in order to achieve discounted or real cash flows.
DISCOUNTED PAYBACK PERIOD
Discounted Payback Period indicates how long will it take for the project to recover the initial
investment in real terms.
Example: Project A
NCF DF 10% DCF
Year 0 (100000) 1 (100000)
Year 1 50000 0.909 45450
Year 2 40000 0.826 33040
Year 3 30000 0.751 22530
Year 4 20000 0.683 13660
Year 5 10000 0.621 6210
DISCOUNTED PAYBACK PERIOD: 2 years 11.4 months i.e. 3 years
Project B
NCF DF 10% DCF
Year 0 (100000) 1 (100000)
Year 1 30000 0.909 27270
Year 2 30000 0.826 24780
Year 3 30000 0.751 22530
Year 4 30000 0.683 20490
Year 5 30000 0.621 18630
DISCOUNTED PAYBACK PERIOD: 4 years 3.7 months i.e. 4 years 4 months
DECISION: Project A must be selected based on discounted payback period because it has a
shorter payback period in real terms.
Page 122 of 132
NET PRESENT VALUE (NPV)

NPV helps in identifying the feasibility of the project. It shows the present value of the future
cash flows. The project which on face seems acceptable is actually acceptable or not if
discounted cash flows are used is identified through NPV.
A project will only be accepted if it has a positive NPV. When two projects are being compared,
the project with a higher positive NPV will be selected because that project is more profitable
to invest in. The formula to calculate NPV is
NPV = Discounted Net Receipts – Initial Investment
Example: Project A
NCF DF 10% DCF
Year 0 (100000) 1 (100000)
Year 1 50000 0.909 45450
Year 2 40000 0.826 33040
Year 3 30000 150000 0.751 22530 120890
Year 4 20000 0.683 13660
Year 5 10000 0.621 6210
50000 20890 NET PRESENT VALUE
Project B
NCF DF10% DCF
Year 0 (100000) 1 (100000)
Year 1 30000 0.909 27270
Year 2 30000 0.826 24780
Year 3 30000 150000 0.751 22530 113700
Year 4 30000 0.683 20490
Year 5 30000 0.621 18630
50000 13700 NET PRESENT VALUE
DECISION: Project A must be selected because it has a higher positive NPV.
(On face, both projects appear equally profitable, i.e. 50000 but A has a higher NPV than B)
PROFITABILITY INDEX (PI)
PI is an alternative method of calculating the feasibility of the project. It is similar to NPV except
for the fact that the formula to calculate Profitability Index is
Profitability Index = Discounted Net Receipts
Initial Investment
Page 123 of 132
Example: Project A Project B

PI 120890 = 1.21 113700 = 1.14
100000 100000
When two projects are being compared the project with a higher PI will be selected.
NOTE:
NPV at any point must be positive and PI at any point must be greater than 1.
When NPV is positive, PI is greater than 1.
When NPV is negative, PI is less than 1.
If NPV is negative or PI is less than 1, the project will be rejected.
If NPV is zero or PI is 1, it indicates that Break-Even is achieved.
INTERNAL RATE OF RETURN (IRR)
IRR indicates the rate at which the cost of capital will give NPV of zero or PI of 1. Hence, IRR acts
as the Break-Even point. In order to calculate IRR, we need NPVs at two different rates or cost
of capital, and the formula to calculate IRR is
IRR = X + Y ab
ab – cd
Where, X is a percentage with the higher NPV
Y is a difference between the rates of higher and lower NPV
ab is the value of higher NPV
cd id the value of lower NPV
Example: Project A
NCF Df 10% DCF NCF Df 18% DCF
Year 0 (100000) 1 (100000) (100000) 1
(100000)
Year 1 50000 0.909 45450 50000 0.842 42350
Year 2 40000 0.826 33040 40000 0.718 28720
Year 3 30000 0.751 22530 30000 0.609 18270
Year 4 20000 0.683 13660 20000 0.516 10320
Year 5 10000 0.621 6210 10000 0.437 4370
NPV 20890 NPV 4030
IRR = 10 + 8 20890 =19.9%
20890 – 4030
Page 124 of 132
Project B
Year 0 (100000) 1 (100000) (100000) 1
(100000)
Year 1 30000 0.909 27270 30000 0.842 25410
Year 2 30000 0.826 24780 30000 0.718 21540
Year 3 30000 0.751 22530 30000 0.609 18270
Year 4 30000 0.683 20490 30000 0.516 15480
Year 5 30000 0.621 18630 30000 0.437 13110
NPV 13700 NPV (6190)
IRR = 10 + 8 13700 = 15.5%
13700 – (-6190)
NOTE: The project with the higher IRR will be selected, and IRR will always be greater than cost
of capital.
ACCOUNTING / AVERAGE RATE OF RETURN (ARR)

ARR identifies the return on investment of the project. In order to calculate ARR, we have to
convert investments into profits and in order to do so, we will deduct depreciation from NCF to
achieve profits.
Profit = NCF – Depreciation
When the question is silent, depreciation is calculated on the basis of straight-line method and
the formula to calculate ARR is
ARR = Average Profit x 100
Average Investments
Average Profit = Sum of all years’ profit
Life in years
Average Investment = Initial Investment + Scrap Value + Working Capital
2
Page 125 of 132
Example: Project A
Depreciation = 100000 – 0 = 20000
5
NCF – Depreciation = Profit
50000 – 20000 = 30000
40000 – 20000 = 20000
30000 – 20000 = 10000
20000 – 20000 = 0
10000 – 20000 = (10000)
Sum of all years’ profit = 50000
Average Profit = 50000 = 10000
5
Average Investment = (10000 + 0) + 0 = 50000
2
ARR = 10000 x 100 = 20%
50000
Example: Project B
NCF – Depreciation = Profit
30000 – 20000 = 10000
(Since NCF and Depreciation are same each year for this project, profit of one year is the
average profit).
Average Profit = 10000
Average Investment = 10000 + 0 + 0 = 50000
2
ARR = 10000 x 100 = 20%
50000
When two projects are being compared, the project with a higher ARR will be selected.
At any point in time, the ARR of the project must be greater than the cost of capital, and it
should also be greater than IRR.
Page 126 of 132
POINTS TO REMEMBER:
1) If an inflow or outflow occurs at the end of the year, it is considered to have been
incurred in the same year.
2) If an inflow or outflow occurs at the start of the year, it is considered to have been
incurred in the previous year.
3) Except for ARR, all other tools of investment appraisal are based on cash flows. Only
ARR is based on profits.
4) If scrap value is given in the question, it will always be added as an inflow in the last year
of the project BUT it does not affect the profit.
5) If working capital is given in the question, it will act as an outflow in year 0 and as an
inflow in the last year of the project while calculating NCF but it will not affect the
profitability.
6) The investment decision that the business takes can be investment in a project,
investment in an employee, investment in assets and so on.
7) When making investment decisions, our NCF are not based on absolute inflows and
outflows, they are based on incremental inflows and outflows.
Page 127 of 132
ADVANTAGES AND DISADVANTAGES OF EACH TOOL OF INVESTMENT APPRAISAL:

PAYBACK PERIOD:
ADVANTAGES:
1) Identifies when the initial investment will be recovered.
2) Helps in understanding the risk position of the business.
DIS-ADVANTAGES:
1) Does not take time value of money into consideration.
2) Cash Flows achieved after the payback are ignored.
DISCOUNTED PAYBACK PERIOD:
ADVANTAGES:
1) Identifies when the initial investment will be recovered.
2) Helps in understanding the risk position of the business.
3) It takes into consideration the time value of money.
DIS-ADVANTAGE:
1) Cash Flows achieved after the payback are ignored.
NPV / IRR / PI:
ADVANTAGES:
1) Shows the true worth of the project
2) Identifies the overall earnings of the project
3) Takes time value of money into consideration
DIS-ADVANTAGES:
1) Does not take into consideration the profits.
2) Timings of cash flows are not taken into consideration.
ARR:
ADVANTAGES:
1) It takes into consideration the profits.
2) It helps in identifying the returns on investment of the business.
DIS-ADVANTAGES:
1) It does not take into consideration the time value of money
2) Timings of cash flows are not taken into consideration.
Page 128 of 132
SENSITIVITY ANALYSIS
When a business takes a decision based on Marginal Costing or takes an investment decision
based on Investment Appraisal, all of it is based on forecasts/expectations. Forecasts for
profitability of a product are based upon estimates of future revenues and costs. The profit will
be dependent on the accuracy of the forecast information. Hence, it is extremely important to
identify how sensitive are the Revenues and Costs to inaccuracies in the expected results.
Moreover, good decisions concerning the under-taking of investment projects depend upon
realistic assessments of receipts and costs. The long time span involved in investment projects
makes reliable forecasts difficult, and hence risk involved in taking the wrong decision is
considerably high, and hence it is important to decide how sensitive the outcome of the project
is to variation in costs and receipts.
SENSITIVITY ANALYSIS
SENSITIVITY ANALYSIS APPLIED TO SENSITIVITY ANALYSIS APPLIED TO

MARGINAL COSTING INVESTMENT APPRAISAL
 Sensitivity of planned profit to variation  Sensitivity of the project applied to Initial

in selling price Outlay
 Sensitivity of planned profit to variation in  Sensitivity of the project applied to Net
variable cost Receipts
 Sensitivity of planned profit to variation in  Sensitivity of the project applied to Cost
fixed cost of Capital
 Sensitivity of planned profit to variation in
units produced / sales volume.
SENSITIVITY ANALYSIS APPLIED TO MARGINAL COSTING

Example: A business expects to sell 16000 units at $25 per unit. The Variable cost per unit is
assumed to be $8/unit and Fixed Overheads are assumed to be $200000. Calculate the
sensitivity of the planned profit to variations in sales volume, sales price, marginal cost and
fixed cost.
Page 129 of 132
Sales (16000 x 25) 400000

Variable Cost (16000 x 8) (128000)
Total Contribution 272000
Less Fixed Cost (200000)
Profit 72000
Break-Even (in units) = 200000 = 11765 Units
25 – 8
i) Sensitivity in sales volume :16000 – 11765 = 4235 4235 x 100 = 26.5%

16000
ii) Sensitivity in sales price : 72000 x 100 = 18%
400000
iii) Sensitivity in marginal cost : 72000 x 100 = 56.25%
128000
iv) Sensitivity in fixed cost : 72000 x 100 = 36%
200000
Sales Price is most sensitive because it has least margin of accuracy.

Page 130 of 132
SENSITIVITY ANALYSIS APPLIED TO INVESTMENT APPRAISAL

Example: A project requires an initial outlay of $1 million. The Net Receipts for each of the 5
years of the project are estimated to be $300000. The company’s cost of capital is 10% and for
the purpose of IRR, cost of capital is 18%. Show how the acceptability of the project is sensitive
to changes in initial outlay, net receipts and cost of capital.
Year 0 (1000000) 1 (100000) (1000000) 1 (100000)
Year 1 300000 0.909 272700 300000 0.842 254100
Year 2 300000 0.826 247800 300000 0.718 215400
Year 3 300000 0.751 225300 300000 0.609 182700
Year 4 300000 0.683 204900 300000 0.516 154800
Year 5 300000 0.621 186300 300000 0.437 131100
NPV 137000 NPV (61900)
IRR 10 + 8 137000 = 15.5%
137000 – (-61900)
i) Sensitivity to initial outlay : 137000 x 100 = 13.7%
1000000
ii) Sensitivity to net receipts : 137000 x 100 = 12.05%
1137000
iii) Sensitivity to cost of capital : 15.5 – 10 = 5.5% 5.5 x 100 = 55%
10
Changes in Net Receipts is most sensitive as it has least margin of inaccuracy.
Page 131 of 132
ACTIVITY-BASED CONSTING (ABC)
Activity-based Costing is an accounting method that identifies the activities that a firm performs
and then assigns indirect costs to product. Activity-based costing system is better than
traditional system of absorption costing as this method recognizes the relationship between
cost, activities and products.
When we refer to marginal costing, it is best suited for decision making and only takes into
consideration the Variable costs. When we refer to absorption costing, although it takes into
consideration the full costs pertaining to a product but the allocation of overheads is based on
direct wages, direct labor, or machine hours and hence the fixed overhead allocation might be
misleading, hence making absorption costing defective.
Activity-based Costing is used to overcome flaws of both marginal and absorption costing. It
reflects the more accurate use of overheads based on their relevant activity levels. ABC system
establishes their relationships between overheads costs and activities so that we can better
allocate overhead costs in order to eliminate the defects of marginal and absorption costing.
Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical
manner than the traditional approach of simply allocating costs on the basis of machine hours.
Activity based costing first assigns costs to the activities that are the real cause of the overhead.
It then assigns the cost of those activities only to the products that are actually demanding the
activities.
Let's discuss activity based costing by looking at two products manufactured by the same
company. Product 124 is a low volume item which requires certain activities such as special
engineering, additional testing, and many machine setups because it is ordered in small
quantities. A similar product, Product 366, is a high-volume product—running continuously—
and requires little attention and no special activities. If this company used traditional costing, it
might allocate or "spread" all of its overhead to products based on the number of machine
hours. This will result in little overhead cost allocated to Product 124, because it did not have
many machine hours. However, it did demand lots of engineering, testing, and setup activities.
In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those
machine hours), but it demanded little overhead activity. The result will be a miscalculation of
each product's true cost of manufacturing overhead. Activity based costing will overcome this
shortcoming by assigning overhead on more than the one activity, running the machine.
Page 132 of 132
Activity based costing recognizes that the special engineering, special testing, machine setups,
and others are activities that cause costs—they cause the company to consume resources.
Under ABC, the company will calculate the cost of the resources used in each of these activities.
Next, the cost of each of these activities will be assigned only to the products that demanded
the activities. In our example, Product 124 will be assigned some of the company's costs of
special engineering, special testing, and machine setup. Other products that use any of these
activities will also be assigned some of their costs. Product 366 will not be assigned any cost of
special engineering or special testing, and it will be assigned only a small amount of machine
setup.

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Page 1 of 132

The ‘variable cost per unit’ is always fixed.

Utility bills Call packages

For example, Warehousing cost.

6) TOTAL COST: is the sum of fixed costs and

WHY IS THERE A NEED TO MANUFACTURE GOODS?

The accounting treatment of questions involving manufacturing business comprise of

PROVISION FOR UNREALISED PROFIT

Closing Provision for unrealized profit =

How to prepare Provision for unrealized Profit Account?

NON-PROFIT ORGANISATIONS (NPO)

1) Preparation of Accumulated Funds

2) Preparation of Receipts and Payments Account

RECEIPTS AND PAYMENTS ACCOUNT

3) Preparation of Trading Account

TRADING ACCOUNT FOR THE YEAR ENDED 31 DEC 2013

Gross Profit xxx

Less: Expenses associated to Trading only

4) Preparation of Subscription Account

Accrued b/d xxx Prepaid b/d xxx

5) Adjustment of Expenses and Revenues

Opening value of asset xxx

6) Preparation of Income and Expenditure Account

7) Preparation of Statement of Financial Position

STATEMENT OF FINANCIAL POSITION AS AT 31 DEC 2016

Fixtures and Fittings xxx (xxx) xxx

Total Non-Current Assets xxx

Total Assets xxx

Equity and Liabilities

Loan from member xxx xxx

Total Liabilities xxx

Total Liabilities and Accumulated Funds xxx

HOW TO CAPITALISE LIFE MEMBERSHIP?

Income and Balance Sheet

COMMON ERRORS MADE BY STUDENTS IN QUESTIONS INVOLVING NPO:

SIMON, RAJ AND KULJEET

PROFIT AND LOSS APPROPRIATION ACCOUNT

RESIDUAL PROFIT xxx

SIMON RAJ KULJEET SIMON RAJ KULJEET

Balance b/d - - Xx Balance b/d Xx Xx -

Share of Loss xx Xx Xx Interest on Xx Xx xx

Balance c/d xx xx - Balance c/d - - xx

xxx Xxx Xxx Xxx Xxx xxx

Bal b/d - - Xx Bal b/d Xx Xx -

SIMON RAJ KULJEET SIMON RAJ KULJEET

Goodwill xx Xx Xx Balance b/d Xx Xx xx

Balance c/d xx Xx Xx Profit on Xx Xx xx

xxx Xxx Xxx Xxx Xxx xxx

SIMON, RAJ AND KULJEET

Intangible Non-Current Assets

Plant and Machinery xxx (xxx) xxx

Total Assets xxx

EQUITY AND LIABILITIES

Total Current Liabilities xxx

Total Non-Current Liabilities xxx

Total Liabilities xxx

Goodwill = Purchase Price – Fair Value of Net Assets Acquired

Income Statement DR (Expense)