Financial Statement Analysis

PAPER NO.
CI33
SECTION THREE
CERTIFIED INVESTMENT
AND FINANCIAL ANALYSTS
(CIFA)
FINANCIAL STATEMENT ANALYSIS
STUDY NOTES
August 2015 www.fb.com/kasnebcsia

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PAPER NO. 9 FINANCIAL STATEMENT ANALYSIS
GENERAL OBJECTIVES
This paper is intended to equip candidate with knowledge, skills and attitude that will enable
him/her to analyse and interpret the financial statements of a firm
9.0 LEARNING OUTCOMES
On successful completion of this paper, the candidate should be able to:
 Evaluate the various alternative sources of financial information

 Apply the various financial statement analytical tools and techniques in analyzing
financial statements
 Demonstrate an understanding of accounting measurements and recognition
 Compare the financial reporting and accounting treatments of assets and liabilities
 Comply with the requirements of IASs, IFRSs and IPSASs
 Evaluate the financial performance of a firm
CONTENT
9.1 Overview of financial statement analysis………………………………………...…………5
- Definition of financial statement analysis

- Different reporting environment frameworks
- Steps in analyzing financial statements
- Importance and challenges of financial statement analysis
- Sources of information for analysis (Financial Statements, Auditors report, Management
commentary, Filing with regulatory authorities and press reports)
- Approaches to analyzing financial statements (Macro, industry and Firm-Either to down
or bottom up)
9.2 Financial reporting on assets and liabilities……………………………...……………….15
- Investment properties; presentation and disclosure

- Accounting policies, changes in accounting estimates and errors (prior period errors)
- Events after the reporting period
- Non-current items and non operating items; discounted operations (Exclude disposal of
subsidiaries), extraordinary items, unusual or infrequent items, changes in recognition
and disclosures and impairment)
- Non-current assets held for sale
- Intangible assets
- Leases (finance and operating, presentation disclosure, recognition), off balance sheet
leverage from operating leases.

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- Income taxes: accounting profit and taxable income, deferred tax assets and liabilities tax
base of assets and liabilities, temporary and permanent differences, recognition and
measurement of current and deferred tax, presentation and disclosure
- Employee benefits (Post-employment benefits): types of post employment benefits;
impact of the assumption used such as discount rates, return on plan assets and salary
growth on the defined benefit obligation and periodic expense; pension plan footnote
disclosure, effect on underlying economic liability (assets) of a company‘s pension and
other post employment benefits; share based compensation
- Multinational operations: foreign currency transactions; translation of foreign currency in
the financial statements, effects of changing prices and inflation
9.3 Quality of earnings and earnings management……………………………………….….72
- Categories of earnings: earnings before interest, tax depreciation and armotization

(EBITDA), operating earnings, net income among others
- Measures of the accrual components of earnings and earnings quality
- Earnings Per Share (EPS); Basic EPS, diluted EPS, using EPS to value firms, criticism of
EPS
- Segment reporting; disclosure requirements, geographical segments, segment ratios
9.4 Other Inter-corporate Investments……………………………………………………......86
- Subsidiaries
- Associate companies
- Jointly controlled entities
- Evaluating the effect of the inter-corporate investments on financial statements given the
different accounting treatment
9.5 Analysing the financial statements………………………………………………….……132
- Income statement: components and format of the income statement, revenue recognition
and expenses recognition; analysis of the income statement; common size analysis, ratio
analysis
- Statement of financial position; components and format of statement of financial position
(assets, liabilities and equity), off balance sheet items; analysis of the statement of
financial position; common size analysis, cross sectional analysis, ratio analysis
- Statement of changes in equity; components of equity, equity valuation ratios
- Cash flow statements; components and format of the cash flow statement, categories of
cash flow items, direct and indirect methods for preparing cash flow statements; cash
flow statement analysis; evaluation and uses of cash, common size analysis, free cash
flow to the firm and free cash flow to equity, cash flow ratios, quality of earnings.

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9.6 Financial statement analytical tools……………………………………………………196
- Financial analysis techniques; financial analysis framework/process; computation and

analysis
- Profitability analysis: desegregation and interpreting return on assets (ROA), return on
capital employed (ROCE), relating ROA to ROCE, DuPont analysis.
- Analysis of growth and sustainable earning: growth analysis, analysis of changes in
profitability and sustainable earnings, analysis of growth in shareholder‘s equity growth,
sustainable earnings and the evaluation of price to book-P/B ratios and price earnings-P/E
ratios.
- Analytical tools and techniques; ratio analysis, common size analysis, graphs, regression
analysis.
- Model building and forecasting; sensitivity analysis, scenario analysis, simulation,.
- Application of ratio analysis-cross sectional analysis, trend analysis, forecast financial
statements, credit analysis and rating
9.7 Qualitative and other current issues in analysis of financial statements………………228
- Qualities of useful financial statements

- Red flag and accounting warning signs that may indicate financial statements are of poor
quality
- Accounting scandals
- Accounting shenanigans on the cash flow statement; Creative accounting and
manipulating financial statements
- Mispresentation in the financial statements
- Adjustments that may be required to make financial statements comparable
9.8 Emerging issues and trends
Summaries of IFRS and IAS……………………………………….…………………………237

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CHAPTER ONE
OVERVIEW OF FINANCIAL STATEMENT ANALYSIS

INTRODUCTION
Financial statement analysis is defined as the process of identifying financial strengths and
weaknesses of the firm by properly establishing relationship between the items of the balance
sheet and the profit and loss account.
There are various methods or techniques that are used in analyzing financial statements, such as
comparative statements, schedule of changes in working capital, common size percentages, funds
analysis, trend analysis, and ratios analysis.
Financial statements are prepared to meet external reporting obligations and also for decision
making purposes. They play a dominant role in setting the framework of managerial decisions.
But the information provided in the financial statements is not an end in itself as no meaningful
conclusions can be drawn from these statements alone. However, the information provided in the
financial statements is of immense use in making decisions through analysis and interpretation of
financial statements.
DIFFERENT REPORTING ENVIRONMENTAL FRAMEWORK
Accounting conceptual framework

An accounting conceptual framework is a coherent system of inter-related objectives and
fundamentals that should lead to consistence standards that prescribe the nature, function and
limits of financial accounting and financial statements.
The main reason for developing an agreed conceptual framework is that it provides:
 A framework for setting accounting standards

 A basis for solving accounting disputes
 Fundamental principles which then do not have to be repeated in accounting standards
The IFRS framework describes the basic concepts that underlie the preparation and presentation
of financial statements for external users. The IFRS framework serves as a guide to the board in
developing future IFRSs and as a guide to resolving accounting issues that are not addressed
directly in an international Financial Reporting Standard or interpretation.
The IFRS frame work addresses
1. The objectives of financial reporting

2. The qualitative characteristics of useful financial information
3. The reporting entity
4. The definition, recognition and measurement of the elements from which financial
statements are constructed
5. Concepts of capital and capital maintenance

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Fundamental accounting concepts
i. Going concern – The enterprise will continue operations for the foreseeable future
ii. Accruals – Revenues and costs are accrued as they are earned and not incurred
iii. Consistency – consistent application of principles from one period to the next
iv. Prudence – Revenues and profits are recognized when realized but all anticipated
liabilities and expenses are recognized
Different reporting framework
As much accounting information is desired to be comparable, it is worth noting that accounting

conceptual framework differ from environment to environment:
1. Not-for-profit organizations which use cash accounting instead of accrual.
2. Public sector accounting which uses fund accounting instead of income statement and
statement of financial position
3. Small and medium enterprises which require fewer disclosures than other publicly quoted
companies
4. Frameworks can also differ from country to country or region to region
Advantages
Financial statement analysis is an important business practice because it facilitates senior

management to reassess a corporation's balance sheet and income statement to estimate levels of
monetary position and success. Financial statement analysis may be essential for management to
recognize levels of cash receipts and disbursements in business operations. A statement of cash
flows lists cash flows related to operating activities, investments and financing transactions. A
statement of owners' equity may facilitate an investor to recognize a company's shareholders.
Major characteristics to improve the financial statements:
1. Intelligibility
This indicates that the information contained in financial statements should be accessible in such
a way that users can comprehend it, so they could communicate the intended meaning. Will
statements be understandable or not depends on how they are compiled by accountants, and how
they are used by the users (decision makers), who should have the basic knowledge to interpret
information and to use them for adoption and implementation of certain business activities.
2. Comparability:
To decide the trend of changes in financial situation and to determine productivity of business
enterprises, it is imperative through consistent adherence to evaluation and measurement of the
effects of business events from period to period. This characteristic should allow investors,
creditors and others to identify and appreciate financial statements of entities in the flow of time,
and to compare the financial statements of different entities. At last, comparability of financial

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statements is provided if the users are timely informed about the changes in accounting policy in
the same or in different companies.
3. Timeliness:
It entails that if company want that instruments of financial reporting had a great use value,
especially for decision-makers they must be submitted to a reasonable time.
4. Verifiability:
The information is confirmable in the sense that it should ensure credibility and objectivity. It
necessitates that independent observers reach the same or similar conclusions that is not biased
or contains material errors and recognition of the chosen method of assessment is applied free
from material error and subjectivity
Limitations of Financial Statement Analysis

1. It is just study of temporary reports.
2. It checks just financial aspect of company's performance and position but it ignores non-
monetary characteristic of company.
3. It does not investigate the changes in price level of different items of financial statements.
4. Many accounting theories and conventions are used to prepare financial statement and
these concepts and conventions are established for analysis. So, analysis is totally
affected with these accounting concepts.
5. Analysis of financial statements is just source but not conclusion or result because
reviewer or evaluator, who writes its analysis, may also affect the analysis. So, different
interpretation by different person may become its restraint.
It can be said that in financial statements, there is lack of Precision, lack of Exactness,
Incomplete Information, hiding of Real Position or Window Dressing, lack of Comparability,
and there is historical cost.
To summarize, financial statement analysis is helpful in appraising the operational competence
of the management of a company. The actual performance of the company which are divulged in
the financial statements can be compared with some standards set earlier and the any difference
between standards and actual performance can be used as the marker of effectiveness of the
management. Briefly, financial statement analysis is the analysis, interpretation and comparison
of monetary data in order to accomplish desired results.
SOURCES OF INFORMATION FOR ANALYSIS
Additional information about a company‘s apart from the above information on financial
statements.
1. Management discussion and analysis (M.D.A)
MDA reviews a company‘s financial position in result of operation. Management must highlight
any unfavorable and favorable events affecting the company‘s operations and identify significant
events and uncertainties surrounding the company and its effects on liquidity, capital resources
and results of operations.

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2. Management report
This sets out responsibilities of management in preparing financial statements. Its purpose is to
reinforce.
- Senior managements‘ responsibilities for the company‘s financed internal control system
- Shared roles of management, directors and the auditor in preparing financial statements.
3. Auditor‘s report
An external auditor is an independent certified public accountant hired by shareholders to
provide an opinion on whether or not the company‘s financial statements prepared in conformity
with the general accounting provision. There are 4 types of auditor‘s opinion.
- Unqualified (clean) opinion

Financial statements present fairly a company‘s financial position and performance.
- Qualified opinion
This unqualified opinion except for the items relating to the qualification
- Adverse opinion
It indicates that a company‘s financial statements are mis-presented, misstated, and do not
accurately reflect its financial performance and health.
- Disclaimer opinion
Here the audit is insufficient in scope to render an opinion. This may be due to its unavailability
of sufficient collaborating evidence to make an opinion.
Financial statement analysis requires a review of the auditor‘s report to ascertain whether the
company received an unqualified opinion. Anything less than an unqualified opinion increases
the risk of analysis
4. Explanatory notes
Notes are meant for communicating additional information regarding items included or excluded
from the body of statements. The technical nature of notes creates a need or a certain level of
accounting knowledge on the part of the financial analyst. Explanatory notes include information
on:
- Accounting principles and methods employed
- Detailed disclosure regarding individual financial statement items.
- Commitments and contingencies
- Business combinations
- Stock option plans
- Transactions with related parties.
- Legal proceedings
- Significant customers
5. Supplementary information
Certain supplementary information required by accounting regulatory agencies to appear in
either notes to the financial statements or in the cause of companies with publicly traded

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securities, reports with capital markets authority. The supplemental schedules includes
information on
- Business segment data
- Export sales
- Marketable securities
- Valuation accounts
6. Social responsibility report

The regulation of social responsibility often translates into meaningless financial benefits.
Funding relates to managers commitment to employees, the environment, society, human
resource developments and non-quantifiable analysis factors.
7. Proxy statements
A proxy is a means whereby a shareholder authorizes another person to act for him or her at a
meeting of shareholders. A proxy statement contains information necessary for shareholders in
voting on matters for which the proxy is solicited.
Proxy statements contain pertinent information regarding a company including:-
i. The identity of shareholders owning 5% or more of the outstanding shares.
ii. Biography information on the BOD
iii. compensation arrangement with officers and directors
iv. Employees benefit plans and certain transactions with officers and directors related
parties.
v. Voting procedures and information
vi. Background information about the company‘s nominated directors
vii. Executive compensation
8. Letters to share holders

Just like MDA, this is a letter communicating to shareholders pertinent issues including market
outlook and business plans which may not be depicted in financial statements.
It indicates and describes management outlook for organizations growth trajectory and often
details such as challenges in the environment. It may also inform of awards and social
responsibility activities undertaken by the organization.
9. Footnotes
These are additional notes in financial statement which describes and explains further how
details in the financial statement are arrived and their meaning.
10. Annual report to shareholders

These are reports which are mandatory required by regulatory authorities such as CMA in Kenya
and include information such as:-
i. Composition of directors
ii. Financial reports and other pertinent information that the public should be made aware
of.
Other regulatory authorities are RBA, KRA etc.

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11. Corporate press release
These are news that follows within the publishing requirements of a company. They includes:-
i. Recent financial statements released and key performances
ii. Any new important information like change of management, new products or strategies
12. Annual report to shareholders

These should include:-
i. Mergers, consolidation, acquisition and similar matters
ii. Financial statements
iii. Audited accounts and reports
Demand for financial information.
Parties demanding financial information include.
1) Shareholders, investors and security analysts

The decision made by these parties include not only which shares to buy, retain or sell but also
the timing of the purchases or sale of those shares.
Typically these decisions will have either an investment focus or a stewardship focus.
- investors focus
The emphasis is choosing a portfolio of securities which is consistent with preferences of the
investor for risk, returns, dividend yield liquidity etc.
- stewardship focus
The concern of shareholders is monitoring management and attempting to affect its behavior in a
way deemed appropriate. Management has considerable discretion concerning use and
disposition of resources.
2) Managers
Managers‘ use financial statement information in many of the financing and operating decisions
e.g. debt-equity ratio or interest coverage ratio is frequently important in deciding how much
long term debt to be raised up.
3) Employees
Employees have a vested interest in the construed and profitable operations of their firms.
Employees can also demand financial statements to monitor the viability of their pension plans
4) Lenders and other suppliers

Many banks have standard evaluation procedures that stipulate that information relating to
liquidity, leverage, profitability etc to be considered when determining amounts of loan to
authorize.
5) Customers
Customers have a vested interest in monitoring financial viability of the firm‘s with which they
have long term relationship. This interest is likely to increase when constants develop about
possible bankruptcy.

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6) Government/regulatory agencies
Demand for financial statements information by this group can arise in diverse areas such as
- Revenue raising e.g. income tax
- Government contracting e.g. for reimbursing supplies a paid on a government bases or
for monitoring when the companies is engaged in government business are earning
excess profit.
- Rate determination e.g. deciding the allowable rate of return that an electricity company
can earn.
APPROACHES TO ANALYZING FINANCIAL STATEMENTS
BUSINESS ANALYSIS AND MACRO ENVIRONMENT

The PESTEL model
We have here another acronym of a useful tool, and framework, to understand either the growth
or downturn of a market, doing a scan of the external macro-environment of your company. The
PESTEL Analysis stands for:
 P-political
 E-economic
 S-social
 T-technological
 E-ecological/environment
 L-legal
Whereas SWOT Analysis will help to measure a business unit, idea or project; PESTEL
Analysis will help you measure a market or a contextual environment.
There are variations for the PESTEL acronym, being very common STEEP, PESTELI, PEST,
adding factors like Ethical, Environmental, Ecologic, Legal, International, etc. It is an
unnecessary job, because all of them can be assigned to one of those PESTEL factors – Political,
Economic, Social, Technological and Legal.
See figure below with some important factors that you can consider, as well as others can be
added.
Political
Regulatory bodies and processes, Funding, grants and initiatives, Lobbying/pressure groups,
International pressure groups, Wars and conflict, Political stability
Economic
Economic growth/downturn, Home economy situation, Home economy trends, Overseas
economies and trends, Inflation rates, General taxation issues, Seasonality/weather issues,
Market and trade cycles, Specific industry factors, Market routes and distribution trends,
Customer/end-user drivers, Interest and exchange rates: , International trade/monetary issues,
unemployment

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Social
Lifestyle trends, Income distribution, Demographics, Social mobility and labor, Work/career and
leisure attitudes , Entrepreneurial spirit, Consumer attitudes and opinions, Media views, Law
changes affecting social factors, Brand, company, technology image, Consumer buying patterns,
Fashion and role models, Major events and influences, Buying access and trends,
Ethnic/religious factors, Advertising and publicity, Ethical issues, Living conditions
Technological
Competing technology development, Research funding, Associated/dependent technologies,
Replacement technology/solutions, Maturity of technology, Manufacturing maturity and
capacity, , Information and communications, Consumer buying, Mechanisms/technology,
Technology legislation, Innovation potential, Technology access, licensing, patents, Intellectual
property issues, Global communications, Energy uses and costs, Total Cost of Ownership,
Changes in Information Technology, Changes in Internet, Changes in Mobile Technology, Rate
of technology transfer.
Legal
Taxation, Unemployment policies, General taxation issues, Contract enforcement law,
International trades and regulations, Legislation to the industry, Environmental regulations and
protection, Government policies:, Government term and change, Trading policies.
PESTEL factors are important role, however they are beyond the control of the company,
normally must be considered as either threats or opportunities, which can be applied in the
SWOT Analysis. They are macro-economic factors, so they usually differ per continent, country
or region. They are virtually unlimited. The firm must prioritize and monitor those factors that
influence its industry/company. Below an example for a car rental company in a country in the
American continent, outside Brazil and USA

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Michael porter‘s FIVE FORCES model
Porter looked at the structure of industries. In particular, he was interested in assessing industry
attractiveness by which he meant how easily it would be to make average profits (for
shareholders and to fund adequate investment). He concluded that industry attractiveness
depends on five factors or forces
1. Competitive rivalry between existing firms
This is intense if large numbers of industries exist; there is low industry growth, high fixed cost,
low switching costs and high strategic stakes among other factors
2. Threat of new entrants/or are there barriers to entry

Factors to consider are economies of scale, product differentiation, capital requirement,
switching costs, vertical integration, cost advantage independent of scale and legal barriers.
3. Threat of substitute products

Look at relative price/performance substitutes and switching
4. Power of suppliers
This is worse if the industry is dominated by a few large firms and if suppliers have
differentiated products
5. Power of customers
This is worse if buyers power is concentrated, products undifferentiated, buyers are aware of
other suppliers‘ price and switching costs are low

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CHAPTER TWO
FINANCIAL REPORTING ON ASSETS AND LIABILITIES
ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES

AND ERRORS
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors is applied in selecting
and applying accounting policies, accounting for changes in estimates and reflecting corrections
of prior period errors.
The standard requires compliance with any specific IFRS applying to a transaction, event or
condition, and provides guidance on developing accounting policies for other items that result in
relevant and reliable information. Changes in accounting policies and corrections of errors are
generally retrospectively accounted for, whereas changes in accounting estimates are generally
accounted for on a prospective basis.
IAS 8 was reissued in December 2005 and applies to annual periods beginning on or after 1
January 2005.
SUMMARY OF IAS 8
Key definitions [IAS 8.5]
 Accounting policies are the specific principles, bases, conventions, rules and practices
applied by an entity in preparing and presenting financial statements.
 A change in accounting estimate is an adjustment of the carrying amount of an asset or
liability, or related expense, resulting from reassessing the expected future benefits and
obligations associated with that asset or liability.
 International Financial Reporting Standards are standards and interpretations adopted
by the International Accounting Standards Board (IASB). They comprise:
o International Financial Reporting Standards (IFRSs)
o International Accounting Standards (IASs)
o Interpretations developed by the International Financial Reporting Interpretations
Committee (IFRIC) or the former Standing Interpretations Committee (SIC) and
approved by the IASB.
 Materiality. Omissions or misstatements of items are material if they could, by their size
or nature, individually or collectively; influence the economic decisions of users taken on
the basis of the financial statements.

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Prior period errors are omissions from, and misstatements in, an entity's financial statements
for one or more prior periods arising from a failure to use, or misuse of, reliable information that
was available and could reasonably be expected to have been obtained and taken into account in
preparing those statements. Such errors result from mathematical mistakes, mistakes in applying
accounting policies, oversights or misinterpretations of facts, and fraud
Selection and application of accounting policies

Accounting policies are the specific assumptions, bases, principles and practices that are adopted
by firms in preparing financial statements. The standard requires that companies follow the
policies consistently from one financial period to the next.
A company should be guided by accounting standards or the current practices in choosing and
applying accounting policies. The standard allows firms to change their accounting policies
when;
i) There is new standard
ii) The change is required by the law
iii) The new change will result in a fair presentation of the financial performance and position.
When a company changes its policies, then the change should be accounted for respectively i.e.
the previously reported financial statements should be adjusted/restated to reflect the new policy
for comparison purposes.
Example:
A Ltd. has decided to change its policy of writing off borrowing costs to capitalizing the same.
As at 31st December, 2003, the company had written off borrowing costs amounting to £200,000.
During the year ended 31/12/04. The company reported profit for the period of £450,000 but
after charging borrowing costs of £50,000. As at 31/12/03 the retained profits were £1,500,000.
Other transactions were:-
 Transfer from revaluation reserve on sale of PPE - £40,000
 Transfer from retained profits to general reserve - £50,000
 Interim dividends paid - £200,000
Required: Prepare the statement of changes in equity extract for the year-ended 81/12/04

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Retained profits
£
Balance as at 1.1.2004 1,500,000
Change in accounting policy 200,000
Balance as restated 1,700,000
Transfer from revaluation reserve on sale of PPE 40,000
Profit for the period (450,000 + 50,000) 500,00
Transfer to general reserve (50,000)
Interim dividends paid (200,000)
Balance as at 31/12/2004 1,990,000
Changes in accounting estimates
In preparing financial statements, it may be difficult to arrive at exact values for certain items to
be presented in the financial statements and thus estimates are normally used.
Examples of estimates: Depreciation, provision for doubtful debts and other provisions in
relation to contingent liabilities e.g. pending court cases (suits)
These estimates are based on the available information as at the time of preparing financial
statements.
However, in subsequent financial periods, changes may be required on these estimates because
of new information becoming available. IAS 8 requires that a change in accounting estimate
should be accounted for in the period in which the change arises and where relevant, in other
subsequent financial period. E.g. an increase or decrease in provision for doubtful debts will be
adjusted for in the current year‘s income statement whereas depreciation will not only be
adjusted for in the current year but also in the subsequent financial periods. i.e. the remaining
Net Book Value of the assets will be depreciated over the remaining useful life starting with the
current financial period.
Example:
B Ltd., bought an item of plant at a total cost of £100,000. The estimated useful life
commencing from 1st January 2000 was 10 years. At the start of the 4th year it was discovered
that the actual estimated useful life of the plant was 8 years and not 10 years.
Required: Compute the depreciation charge for each of the eight years on the plant.

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Initial depreciation = 100,000
10
=£10,000 each for 3 years
Net Book Value at beginning of year 4

= 10,000 x 3 years = 30,000
= 100,000 – 30,000 = 70,
Depreciation for rest of the 5 years
= 70,000
5
=£ 14,000
Errors
An error is an error discovered in the current financial period but it relates to one or more
previous financial periods. Such errors arise due to mathematical mistakes, misapplication of
accounting policies, oversights and fraud.
The statement requires that if such an error is material i.e. the previously reported financial
statements were materially misstated or misrepresented, then, the opening balances of the current
financial period must be restated and if practical, the previous financial statements should be
restated.
Therefore an error requires retrospective application.
Example:
ABC Ltd., reported the following transactions during the year ended 31/12/2004
Retained profits b/d £100,000

Transfer from revaluation reserve £20,000
Transfer to general reserve £15,000
Profit for the period £60,000
Interim dividends paid £20,000
After the above balances were extracted, new information came to light that the opening
inventory was overstated by £10,000 due to double counting of some stock items.
Required: Prepare the statement of changes in equity extract for the year ended 31 st December
2004.

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Retained profits £
Balance as at 1.1.04 100,000
Error (10,000)
Balance restated 90,000
Transfer from revolutions reserve 20,000
Profit for the period (60,000 + 10,000) 70,000
Interim dividends paid (20,000)
Balance as at 31.12.04 145,000
Question:
The following trial balance relates to Venus ltd as at 31st march 2010
Sh‖000‖ Sh‖000‖
Sales 236 200
Purchases 127 850
Distribution costs 8 000
Administration expenses 4 400
Loan interest paid 2 400
Preference dividend paid 1 000
Land and buildings (at valuation) 130 000
Plant and equipment (cost) 84 300
Software (at cost) 10 000
Available for sale investments 12 000
Depreciation (1 April 2009):Plant and equipment 24 300
Software 6 000
Loss on cash stolen 32 000
Trade receivables 23 000
Inventory (1 April 2009) 19 450
Bank 350
Trade payable 15 200
Ordinary share capital 60 000
10% preference shares (redeemable) 20 000
12% loan stock 40 000
Deferred tax 3 000
Available for sale investment reserve 5 000
Revaluation reserve (property, plant and equipment) 40 000
Retained profit - 4 350
454 400 454 400
Additional information:
1. Sales include an amount of sh.8 million for goods sold to a customer who was meant to confirm
acceptance of the goods by 31 March 2010. The customer had not confirmed his acceptance of
the goods by 31 March 2010. The goods were sold at a gross profit margin of 25%.
2. The closing inventory as at 31 March 2010 was valued at cost at sh. 8.5 million. However, goods
costing sh.500 000 were damaged and could only be sold for sh.300 000
3. On 1 April 2009, Venus ltd. revalued the land and buildings. The details are as follows:

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Cost Valuation
1 April 2005 1 April 2009
Sh‖000‖ Sh‖000‖
Land 20 000 25 000
Buildings 80 000 105 000
The buildings had an estimated useful life of 40 years when they were acquired and this has not
changed. The relevant entries in the revaluation reserve have already been passed.
4. Plant and equipment depreciated at 20% per annum on the reducing balance basis, software is
depreciated using the sum of digits methods over 5 years
5. The available for sale (AFS) investment had a decline in market value of sh.1.2million which was
not reflected in the accounts before the current year‘s revaluations.
6. The cash loss of sh.32 million was discovered during the current financial year but was traced to a
senior employee who left in the year ended 31 March 2009. This money cannot be recovered and
is to be written off
7. The estimated current year‘s tax is sh.11.3 millions. The taxable temporary differences as at 31
March 2010 amounted to sh.16 million
8. Corporation tax rate is 30%
Required:
Prepare the following statements for publication purposes:
a) The statement of comprehensive incomes for the year ended 31 March 2010. (8 marks)
b) The statement of changes in equity as at 31 march 2010. (4 marks)
c) The statement of financial position as at march 2010 (8 marks)
Suggested solution:
Workings:
1. Sales 236 200-8 000 228 200
2. Cost of sales
Opening stock 19 450
Purchases 127 850
Available for sale 147 300
Closing stock (8 500+6000) (14 500)
Cost of goods sold 132 800
Depreciation
Buildings (105 000/36) 2 917
PPE (84 300-24 300) 12 000
Software (3/15*10 000) 2 000
Cost of sales 149 717
3. Administration costs
Reported 4 400
Write down value in stock 200
Cash loss 32 000
36 600

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4. Finance costs
10% preference dividends 2 000
6 800
5. Accruals
Loan interest (4 800-2 400) 2 400
Preference dividend (2 000-1 000) 1 000
3 400
6. Tax expense
Estimate 11 300
Increase in deferred liability* 1 800
13 100
Deferred tax liability
Taxable timing difference of 16 000
Deferred tax liability (30%*16 000) 4 800

Deferred tax liability b/f 3 000
Increase in deferred tax liability* 1 800
7. AFS investment
Reported 12 000
Decline in value (1 200)
New balance* 3 800
Revaluation reserve on AFS
Balance b/f 5 000
Decline in value (1 200)
New balance 3 800
8. Receivables
Reported 23 000
Sale or return (8 000)
15 000
9. Closing inventory to SOFP
T.B + sale or return-write down (8 500+6 000-200) 14 300

21
Statement of comprehensive income
Revenue 228 200
Cost of sales (149 717)
Distribution costs (8 000)
Administration expenses (36 600)
Operating profit 33 883
Finance cost (6 800)
Income before tax 27 083
Income tax expense (13 100)
Profit after tax 13 983
Other comprehensive income

Decrease in AFS assets (1 200)
Total comprehensive income 12 783
Statement of changes in equity

Ordinary share capital Retained earnings revaluation
1.04.09 60 000 4 350 45 000
Comprehensive income 13 983 (1 200)
Balance 31.03.10 60 000 18 333 43 800
Statement of financial position
Non-current assets
Land and buildings (130,000-2 917) 127 083
Pand E (23 000-8 000) 48 000
Software (10 000-8 000) 2 000
AFS assets 10 800
187 883
Current assets
Inventory (8 500+6 000-200) 14 300
Receivables (23 00-8 000) 15 000
Total assets 217 183
Liabilities and shareholders‘ funds

Current liabilities
Accrued loan interest payable 2 400
Accrued preference dividends payable 1 000
Bank overdraft 350
Trade payables 15 200
Tax payable 11 300
Long-term liabilities and equity

Deferred tax liability 4 800
10% preference shares 20 000
AFS assets revaluation 3 800
PPE revaluation reserve 40 000
Retained profit 18 333
Total liabilities and equity 217 183

22
Question:
The authorized share capital of Shirika Jipya Limited consists of 75,000 redeemable preference
shares of Sh.10 each and 1,500,000 ordinary share of Sh.25 each. The former are to be redeemed
during 2005.
The trial balance of Shirika Jipya Limited as at 30 June 2000 was as follows:
Sh. ‗000‘ Sh. ‗000‘

Ordinary Share capital (shares fully paid) 15,375
6% redeemable preference share capital 750
Share premium account 3,150
Profit and loss account (1 July 1999) 21,600
10% convertible loan stock 8,000
Deferred tax 1,080
Inventories (1 July 1999) 25,073
Trade receivable 34,979
Trade payables 25,425
Provision for doubtful debts 90
Wages and salaries payable 473
Value added tax payable 681
Interim dividend paid 430
Freehold land, at cost 848
Building at cost 5,100
Plant at cost 30,750
Provision for depreciation on building 398
Provision for depreciation on plant 12,059
Long-term investment quoted 3,525
Interest paid 450
Purchases 141,450
Preferred dividend paid 32
Profit on sale of plant 173
Bad debts 23
Sales 179,100
Dividend received from investments (gross) 300
Installment tax and withholding tax paid 738
Wages and salaries 24,450
Bank 806
268,654 268,654
1. The 10% convertible loan stock is secured against the plant.
2. (i.) During the year fixed assets were purchased as follows

23
Buildings Sh.750,000 and plant Sh.4,050,000.
(ii). Plant with an original cost of Sh.1,500,000.
3. Depreciation is to be charged as to buildings Sh.53,000 and plant Sh.690,000.
4. The quoted investments had a market value at 30 June 2000 of Sh.6,750,000.
5. The wages and salaries figure includes the following:
Directors Salaries 122,00

General Manager 33,000
Company Secretary 23,000
6. The firm had signed a contract for Sh.23,243,000 being the lower of cost and net realisable
value.
7. Sh.75,000 needs to be transferred from the deferred tax account.
8. The stock as at 30 June 2000 was Sh.23,243,000 being the lower cost and net realisable
value.
9. The following provisions need to be made:
(i). Audit fees of Sh. 53,000

(ii). A final dividend on ordinary shares of Sh.35 per share. This had been proposed
before the year end.
(iii) The provision of doubtful debts is to be adjusted to Sh.120,000.
(iv). Corporate tax of the year‘s profit is estimated at Sh. 4,290,000. Last year‘s tax was
Overestimated by Sh.15, 000: this figure had been netted off against the installment and
with-holding tax paid.
10. After payment of the preference dividend in March 2000, the company decided to redeem
these shares and this was done in June 2000. No entries have been made in the books in
respect of the same. The shares were redeemed at a premium of 5% and this is to be written –
off in the share premium account.
Required:
(a) An Income Statement (using the cost of sales method: do not attempt to classify expenses
according to their functions). (8 marks)
(b) A statement of Changes in Equity for the year ended 30 June 2000. (8 marks)

24
(c) A Statement of financial position as at that date in a form suitable for publication and
conforming (as far as the information permits) with the requirements of the Companies Act
and International Accounting Standards. (9 marks)
(Total: 25 marks)
Solution
Shirika Jipya
Income statement for the year ended 30 June 2000
Sh.000 Sh.000
Turnover 179,100
Cost of sales (W1) (143,023)
Gross profit 35,077
Other operating income: Profit on disposal 173
Investment income 300 473
Expenses 35,550
Other expenses (W) 24556
Finance cost 832 (25,388)
Profit before tax 10,162
Income tax expense (4,200)
Profit for the period 5,962
Shirika jipya
Statement of changes in equity for the year ended 30 june 2000
Ordinary Share Capital Investment Retained

share Premiu redemption revaluation Profits Total
capital m reserve Sh.‘000‘
Sh.‘000‘ Sh.‘000‘ Sh.‘000‘ Sh.‘000
Sh.‘000‘ ‘
Bal as at 1.7.99 15,375 3,150 - 21,600 40,125
Gain on revaluation 3225 -3225
Purchase of shares (37.5) (37.5)
Transfer to CRR 750 (750) -
Profit for year 5,962 5,962
Dividends: (430) (430)
Interim (W4)
15,375 3,112.5 750 3225 26362 48844.
5

25
Shirika Jipya
Statement of financial position as at 30 June 2000
Sh.000 Sh.000
Non Current Assets

Plant, property and equipment (Note 4) 23,498
Investments 6750
30248
Current Assets
Inventory 23,243
Receivables (W6) 34,859
Bank (W7) 18.5 58,120.5
88368.5
Financed by:
Authorized share capital 37,500
1.5m ordinary shares @ Sh.29 750
75,000 preference shares @ Sh.10 38,250
Issued and Paid up
Ordinary share capital 15,375
Capital redemption reserve 750
Share premium 3,112.5
Investment revaluation 3,225 7,087.5
Retained profits 26,382
Shareholders‘ funds 48,844.5
Non Current Liabilities
Loan stock 8,000
Deferred tax 1,005 9,005
Current liabilities
Creditors 25,425
Accruals (W8) 1,557
Accrued tax (W9) 4,537
30,519
88368.5
Notes to the Financial Statements
1. The above financial statements have been prepared under the historical basis of
accounting which is modified to accommodate revaluation of certain assets. They
are in compliance with the applicable IFRSs and the Company‘s Act.
2. The profit for the period has been arrived at after charging:
Sh.000
Directors fee 122
Depreciation 743
Auditors remuneration 53
Staff costs 24328

26
3. The tax expense for the year is arrived at by applying the corporate rate of tax in
Kenya of 30% to the adjusted profit for the year.
4. Property, plant and Equipment
Land Buildings Plant Total

Sh.‘000‘ Sh.‘000‘ Sh.‘000‘ Sh.‘000‘
Cost/valuation
Bal b/d 848 28,200 4,350 33,398
Additions - 4,050 750 4,800
Disposal - (1,500) - (1,500)
Bal c/d 848 30,750 5,10 46,698
Depreciation
Bal b/d - 13,214 398 13,612
Eliminated and disposed - (1,155) - (1,155)
Charge for year - 690 53 743
Bal c/d = 12,749 451 13,200
NBV c/a 848 18,001 4,649 23,498
NBV b/d 848 14,986 3,952 19,786
5. The 10% loan stock is secured against the plant.
6. The firm has signed a contract of Sh.8.775m for the construction of a warehouse for
storage of goods.
Workings
1.
25,073
Cost of sales 141,450
Opening stock 166,523
Purchases (23,243)
Closing stock
143,280
Add: Depreciation on:
 Buildings 53
690
 Plant 144023

27
Finance cost
2. Debenture interest (10% x 8,000) 800
Paid 450
Accrued 350
800
Add: Preference share dividend paid 32
832
3.
30
Other expenses 53
Increased provision (bad debts) 24,450
Audit fee 23
Wages and salaries 24556
Bad debts
4. Interim dividends
Ordinary share capital 430
Preference share capital 32
462
5 Income tax expense
Current years estimate 4,290
Less previous years overprovision (15)
Transfer from deferred tax (75)
4,200
Note: Under IAS 32 redeemable preference shares are treated as a non current liability.
Therefore any dividends paid thereon are finance costs and it will not appear as part of
shareholders funds.
Sh.000
5.  15,375  21,525
Final dividends  35x 
 25 
Preference share capital (6% x 750 – 32) 13
21,538
6. Receivables = (34,979 – 120) 34,859

28
7. Bank: As per TB 806
Paid for redemption (787.5)
18.5
8. Accruals
Wages 473
VAT 681
Interest 350
Audit fee 53
1,557
9. Accrued tax
Estimated for year 4,290
Overestimated (15)
Paid
(738)
3,537
Deferred Tax A/c

Sh.000
Sh.000
Profit & Loss 75
C/d 1,005 Bal b/d 1,080
1,080 1,080
Example Four
Viatu Ltd, which manufactures footwear, makes up its accounts to 31 March each year. The company has
an authorized share capital of Sh. 600,000,000 divided into 15,000,000 6.5% preference shares of Sh. 20
each and 30,000,000 ordinary shares of Sh. 10 each. The following trial balance was extracted as at 31
March 2002.
Trial balance as at March 2002

Sh000 Sh000
Cost of Sales 699,992
Motor vehicle expenses 59,684
Selling and distribution costs 78,840
Depreciation of motor vehicles – for the year 12,580
Administration expenses 11,492
Audit fees 1,400
Sales
Discounts received 1,191,864
Investment income – trade investments 812
- others 1,072
1,608
13,000
Preference dividends paid 1,600
Debenture interest 8,615
29
Corporation tax paid – installment 8,500
Compensation to director for loss of office 1,040
Depreciation of fixtures for the year)
8% debentures 3,000 20,000
Cash in hand
Ordinary share capital issued and paid-up) 11,745 200,000
Bank balance
Preference share capital issued and paid-up) 204,132 200,000
Inventory 31 March 2002) 336,440
Debtors/creditors
102,000
Deferred tax 24,800 3,000
Motor vehicles net book value)
Provision for doubtful debts
11,300 14,400
Fixtures and fittings net book value)
Profit and loss account 1 April 2001)
General reserves 110,848
Share premium 60,000
Freehold land and building cost) 270,000 40,000
Investments – trade market value Sh.35,000,000) 30,000
Others market value Sh.62,000,000) 61,610
_______
1,945,604 _______
1,945,604
1. Wages and salaries include salary paid to Managing Director of Sh. 30,000,000 and salary paid to
Sales Director of Sh. 25,000,000.
2. Provision is due to be made for directors‘ fees Sh. 150,000,000.
3. Provision for doubtful debts is to be adjusted to Sh. 16,822,000.
4. Timing differences of Sh. 4,000,000 are expected to reverse in the near future.
5. The directors recommended an ordinary dividend of Sh.1.35 per share.
6. Corporation tax for the year is Sh.11; 820,000.The corporation tax rate is 30%on adjusted profit.
7. Land and buildings were professionally valued at Sh.300,000,000 at the year end. The directors wish
to incorporate the valued amount in the financial statements.
8. Information about other fixed asset is as follows:

30
Motor Fixtures &
vehicles fittings
Sh
Sh
Cost (including additions during the year) 51,200,000 20,800,000
Additions during the year 2,240,000 1,600,000
Cost of assets disposed of during the year (No entry made yet) 2,800,000 1,455,000
Accumulated depreciation of asset disposed of during the year 2,150,000 905,000
Proceeds of asset disposed of (including in sales in the trial 715,000 500,000
balance)
Required
(a)Income statement for the year ended 31 March 2002 (13 marks)
(b)Statement of financial position as at 31 March 2002 (12 marks)
(The above two statement should be presented in the form suitable for publication in accordance with the
requirements of International Accounting Standards .IASs)
Solution
Viatu Ltd
Income statement for the year ended 31 March 2003
Sh.‘000‘ Sh.‘000‘
Turnover (W1) 1,190,694
Cost of sales (699,922)
Gross profit 490,657
Other Incomes : Discount received 812
Profit on disposal 15
Investment income 2,680 3,507
494,164
Selling and distribution expenses 176,104
Administrative expenses 245,688
Finance costs 1,600 (423,392)
Income tax expense: Current 11,820
Deferred (1,800) (10,020)
Profit for the period 60,752

31
Viatu Ltd
STATEMENT OF CHANGES IN EQUITY AS AT 31.03.02
Ordinary Preference Share General F.ARev. Retained Total
share share premium reserve Reserve earnings
capital capital
Sh.‘000‘ Sh.‘000‘ Sh.‘000‘ Sh.‘000‘ Sh.‘000‘ Sh.‘000‘ Sh.‘000‘
Bal b/f 200,000 200,000 400,000 600,000 - 110,848 610,848
Prior adjustment - - - - - - -
Restated 200,000 200,000 400,000 600,000 - 110,848 610,848
Rev. gain on - - - - 30,000 - 30,000
NCA
Rev. gain on - - - - 390 - 390-
investment
Rev. gain on - - - - - - -
foreign - - - - - 60,752 60,752
Net profit: year
Dividends: - - - - -
Interim - - - - - (13,000) (13,000)
-
Bal b/d 200,000 200,000 40,000 60,000 30,390 158,600 68,8990
(b) Viatu Ltd

Statement of financial position as at 31 March 2002
Sh.‘000‘ Sh.‘000‘
Non Current Assets
Plant, property and equipment 334,900
Investments( Other ) 62000
396900
Current Assets
Inventory 204,132
Receivables (336,440 – 16,822) 319,618
Trade investments 30,000
Cash and bank (11,745 + 3,000) 14,745 568,495
965395
FINANCED BY:
Authorised share capital
15m shares 6.5% preference @ Sh.20
300,000
50m share ordinary @ Sh.10
300,000
600,000
Issued and fully paid
10m 6.5% preference shares @ Sh.20
200,000
20m Ordinary shares @ Sh.10
200,000
400,000
Reserves
Share premium
Revaluation reserve 40,000
General reserve 30,390
Retained profit 130,390
60,000
Shareholders‘ funds 158,600

32
Noncurrent liabilities 158,600 688,990
8% debentures
Deferred tax
20,000 21,200
1,200 710190
Current liabilities
Trade creditors 102,000
Tax payable (11,820 – 8,615) 3,205
Accrued directors‘ fee 150,000 255,205
TOTAL EQUITY AND LIABILITIES 965395
Workings
1. Turnover Sh.‘000‘
As per trial balance 1,191,864
Less proceeds and disposals (1,215)
1,190,649
2. Selling and distribution costs

As per TB 78,840
Motor vehicle expenses 59,864
Wages 25,000
Depreciation: Motor vehicle 12,580
176,104
3. Administrative expenses
As per TB 11,492
Audit fees 1,400
Depreciation: fixtures 1,040
Compensation of director for loss of office 8,500
Provision for doubtful debts (16,822 – 14,400) 2,422
Director‘s fee 150,000
245,688
4. Profit on assets disposed

Motor vehicles Fixtures & Total
Cost 2,800 Fittings 4,255
Acc. Dep. 2,150 1,455 3,055
NBV 650 905 1,200
Proceeds 715 550 1,215
Profit & Loss 500
6,500

33
Deferred tax a/c
Sh.‘000‘ Sh.‘000‘
Profit U Loss 1,800
Bal c/d (30% x 4,000) 1,200 Bal b/d 3,000
3,000 3,000
Notes to the accounts
Note 1 Accounting policies
These financial statements have been prepared under the historical cost basis of accounting, which is
modified to accommodate the revaluation of certain properties and in accordance with the applicable
IFRSs.
Property plant and equipment is shown at cost or revalued amount less the total accumulated depreciation
which is based on the estimated useful life of the assets.
Inventory has been stated at the lower of cost and net realisable value.
Note 2 Profit before tax
The profit before tax has been arrived at after charging the following expenses
Sh.‘000‘
Directors fee 205,000
Compensation to director for loss of office 8,500
Depreciation 13,650
Auditors fee 1,400
Staff costs 40,834
Note 3 Taxation
Corporation tax is based on the adjusted profits for tax purpose at a corporation tax rate of 30%
Note 4 Property plant and equipment
Freehold land Motor Fixtures &

COST/VALUATION & Buildings vehicles Fittings Total
Sh.‘000‘ Sh.‘000‘ Sh.‘000‘ Sh.‘000‘
Bal as at 01.04.01 270,000 48,960 19,200 338,160
Additions - 2,240 1,600 3,840
Disposals - (2,800) (1,455) (4,255)
Revaluations 30,000 - - 30,000
Bal as at 31.03.02 300,000 48,400 19,345 367,745
Accumulated Depreciation
Bal as at 01.04.01 - 13,820 8,460 22,280
Eliminated on disposal - (2,150) (905) (3,055)
Charge for the year - 12,580 1,040 13,650
Bal as at 31.03.02 - 24,250 8,595 32,845
NBV as at 31.03.02 300,000 24,150 10,750 315,880
NBV as at 01.04.01 270,000 35,140 10,740 315,880

34
Note 5 Dividends
During the year the company paid a dividend of sh.1.30 on the preference shares outstanding. The
directors are now proposing a dividend of sh.1.35 per s share on the number of ordinary shares
outstanding at the end of the year.
EVENTS AFTER REPORTING PERIOD (IAS10)

Events after the reporting period are those events, both favourable and unfavourable which occur
between the reporting date and the date on which financial statements are approved for issue by
board of directors.
Adjusting and non-adjusting events
Adjusting events are events after the reporting date which provides additional evidence of the
conditions existing at the reporting date.
Non-adjusting events are events after the reporting date which concern conditions that arose after
reporting date.
Examples of adjusting events:
i. Irrecoverable debts arising after the reporting date, which may help qualify the allowance
for receivables as at the reporting date
ii. Allowance for inventories due to evidence of the net realizable value
iii. Amount received in respect of insurance claims which were being negotiated at the
reporting date
iv. The discovery of fraud or errors
Examples of non-adjusting events:

i. A major business combination after the reporting date
ii. The destruction of a major production plant by fire after the reporting date
iii. Abnormally large changes after the reporting date in asset prices of foreign exchange
Accounting for adjusting and non-adjusting events

Adjusting events require the amounts to be recognized in the financial statements. Disclosure
would affect the ability of users of the financial statements to make proper evaluation and
decisions
Illustration:
Shortly after the reporting date, a major credit customer of the company went into liquidation
because of heavy trading loss and it‘s expected that little or none of the ksh.1, 250,000 debts will
be recoverable. Ksh.1, 000,000 of the debt relates to the sales made prior to the year ended 31 st

35
December 2012. The ksh.250, 000 relates to sales made in the first two days of the new financial
year.
In 2012 financial statements the whole debt has been written off, but one of the directors has
pointed out that, as the liquidation is an even after the reporting date, the debt should not in fact
be written off but disclosure should be made by note to this year‘s financial statements, and the
debt written off in 2013 financial statements.
Required:
Advise whether the director is right?
Solution:
 Under IAS 10 an event after the reporting date is an event which occurs between the
financial period and the date on which financial statements are approved by the board of
directors
 Ksh.1,000,000 of the receivable existed at the reporting date and the liquidation of the
major customer provides more information about receivables
 In accordance with IAS 10, this is an adjusting event which would require the debt
existing at the reporting date to be written off in the 2012 financial statements
 The remaining receivable did not exist at the reporting date and should therefore be
written off in 2013 financial statements.
Non-current assets held for sale and discontinued operations. (IFRS 5)
The objectives of IFRS 5 are to:

1. Classify, measure and present non-current assets held for sale, in particular requiring that
such assets should be presented separately on the face of statement of financial position
2. Present separately the results of discontinued operations.
Classification as held for sale.

A non-current asset should be classified as held for sale if its carrying amount will be recovered
principally through a sale transaction rather than through continued use. The following
conditions should apply:
1. The asset must be available for sale in its present condition
2. The sale must be highly probable meaning that
(a) Management are committed to a plan to sell the assets
(b) There is an active plan to locate buyer
(c) The asset is being actively marketed
3. The sale is expected to be completed with 12 months of its classification as held for sale
4. It is highly unlikely that the plan will be significantly changed or withdrawn
Measurement and presentation of non-current assets held for sale.

36
i. Non-current assets held for sale should be measured at the lower of their carrying amount
and fair value less cost to sell.
ii. Held for sale non-current assets should be presented separately on the face of statement
of financial position and should not be depreciated
iii. On presentation on statement of financial position, they will qualify as current assets
under rules of IAS 1
Illustration 1:
On 1st January 20x1, john‘s pizza company bought a chicken processing machine for ksh.200,
000. It has an expected useful life of 10 years and a nil residual value. On December 20x2, after
2 years of using the assets, john‘s company decides to sell the machine and starts action to locate
a buyer. The machines are in short supply so john‘s is confident that the machine to dismantle
the machine and market it available to the buyer.
Required:
At what value should the machine be stated in john‘s company statement of financial position?
Solution:
Carrying amount = 8 x 200,000 = 160,000

or
200,000 − 0
200,000 − 𝑥2 = 160,000
10
Fair value
= 150,000 − 5,000
= 145,000
The machine qualifies as held for sale, so it should be stated at lower of ksh. 160,000 which is
ksh 145,000
The impairment loss of ksh.15, 000 incurred in writing down the machine to fair value less costs
to sell will be charged to the income statement.
Illustration 2:
On January 20x0, XYZ purchased a machine for ksh.100, 000. It was expected that it would have
a useful life of 8 years and a residual value ksh.20.000. However, during 20x1 December, the
directors decided to sell the machine. The company removes the machine from the farm in
readiness for quick disposal and prepares the machine for viewing by potential purchasers. They
appoint an agent to assist with marketing and advertising. The agent advises that the disposal
may take two to six months but should be sold for ksh. 45,000.

37
Required:
Show the movement on the machine during the year ended 31 st 20x1. And describe how the asset
should be disclosed on the statement of financial position at year end.
Solution:
Machine
Opening balance 90,000
Depreciation (10,000)
Closing 80,000
Balance impairment (35,000)
Recoverable amount 45,000
A discontinued operating is a component of an entity that has either been disposed of or is

classified as held for sale and
 Represent a separate major line of business or geographical area of operations
 Is part of single co-ordinated plan to dispose of a separate major line of business or
geographical area of operation or
 Is a subsidiary acquired exclusively for resale
Discontinued operations are required to be shown separately in order to help users to predict
future performance.
Presentation of operations in the financial statement
An entity must disclose a single amount on the face of income statement, comprising a total of:
 The post-tax profit/loss of discontinued operations.
 The post-tax gain or loss recognized on the measurement of fair values less costs to sell
on disposal, of the assets constituting the discontinued operations.
An analysis for this single amount must be presented, either in the notes on the face of income
statement.
The analysis must disclose:

 The revenue, expenses and pretax profit or loss of the discontinued operations
 The related income expense
 The gain or loss recognized on the measurement to fair value less cost to sell, or on the
disposal, of the assets constituting the discontinued operations.
Illustration:
Valentine produced cards and sold roses. However, halfway through the year ended 31 st march
20x6, the rose business was closed and assets sold of incurring losses on disposal of non-current
assets of $76,000 and redundancy costs of $37,000. The directors reorganized the continuing
business at a cost of $98,000. Trading results may be summarized as follows:

38
$ ‗000‘ $‘000‘
Turnover 650 320
Cost of sales 320 150
Administration 120 110
Distribution 60 90
Other trading information is as follows:
Interest payable 17
Tax 31
Required:
Draft the income statement for the year ended 31st march 20x6.
Income statement for valentine for the year ended 31 st march 20x6
$‘000‘
Continuing operations 650
Cost of sales (320)
Gross profit 330
Administration costs (120)
Distribution costs (60)
Operating profit 150
Reorganization costs (98)
52
Finance costs(interest payable) (17)
Profit before tax 35
Income tax (31)
Profit for the period from continuing operations 4
Discontinued operations
Loss for the period from total operations (143)
Loss for the period from total operations (139)
In the notes to the accounts disclose analysis of the discontinued operations figure
$‘000‘

39
Revenue 320
Cost of sales (150)
Gross profit 170
Distribution costs (90)
Operating loss (30)
Loss on disposal (76)
Redundancy costs (37)
Overall loss (143)
Current and deferred tax

Deferred taxes is a tax that is payable in future.
Current tax
This is the corporation tax payable by companies based on trading results for given period. Tax
is mainly from profits but a company may have a taxable business which means a company
doesn‘t have a tax liability in the current period, but carries the taxable loss to the subsequent
period to be offset against future profits. Once the corporation tax has been estimated, IAS 12
requires the following accounting treatment and presentation.
1) The total corporation tax liability for the period is shown as a separate item in the income
statement to be referred to as income tax expense.
2) If part of the total liability is unpaid by the end of the financial period then the unpaid
amount is to be presented as part of the current liabilities in the statement of financial
position (SOFP) and referred to as current tax.
3) Companies often use estimates to compute corporations before tax for a given financial
period. In the subsequent financial period, the tax initially estimated may either be more
or less than what is actually paid. This is referred to as under provision of the previous
year‘s tax. If actual tax paid is more than what was provided then this is called
overprovision.
𝐴𝑐𝑡𝑢𝑎𝑙 > 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒 – 𝑢𝑛𝑑𝑒𝑟𝑝𝑟𝑜𝑣𝑖𝑠𝑖𝑜𝑛
𝐴𝑐𝑡𝑢𝑎𝑙 < 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒 – 𝑜𝑣𝑒𝑟𝑝𝑟𝑜𝑣𝑖𝑠𝑖𝑜𝑛
IAS 12 recommends that an under provision of previous year‘s tax should be added to the current
year tax expense while an overprovision should be deducted.
Example:
During the year ended31/12/2008, A Ltd. had estimated the corporation tax for the year to be
£100,000. The amount was still outstanding as at 31/12/08. During the year ended 2009, on
30th June the actual amount payable was agreed with the tax authorities and eventually paid.
Meanwhile during the year 2009, the company paid additional investment taxes of £80,000.
As at the end of the year the company the company estimated that he payable for year 2009
will be £120,000.
40
Required:
Compute the income tax expense and the balance sheet liability for year 2009 assuming that;
a) The actual tax paid for year 2008 was £90,000
b) The actual tax paid for year 2008 was £110,000.
a) Tax for 2008 (£90,000) – Over provision of previous year‘s tax
Income statement change in 2009

Current year‘s tax estimate 120,000
Less overprovision of previous year‘s tax (100 – 90) (10,000)
‗000‘
Income tax expense 110,000
Statement of financial position liability

Less installment taxes paid (80,000)
Current tax 40,000
b) Tax for 2008 (£110,000) – Under provision of previous year‘s tax
Income statement change in 2009

Add: under provision of previous year‘s tax (100-110) 10,000
Income tax expense 130,000
Deferred tax
This is the tax that is payable or that would be saved in future. If it is payable then it is called a
deferred tax liability and if it will be saved then it is called deferred tax asset. Deferred tax arises
because of the differences in the way traditions are treated in accounting and the way they are
treated after tax. Deferred tax is the basis of allocating tax charges to particular accounting
periods. The key to deferred taxation lies in two quite different concepts of;
1) Accounting profit (reported profit)
- This is the figure of profit before tax reported to the shareholders in the published
accounts.
2) Taxable profits
- This is the figure of profit on which the taxation authorities base their calculation
The difference between accounting profit and taxable profit is caused by permanent differences
and temporary differences
41
Permanent differences
i. One difference between accounting profit and taxable profit is caused by certain items
not being taxable/allowable
ii. Differences which only impact on tax computation of one period
iii. Differences which do not have deferred tax consequences whatsoever
Temporary differences
These are sometimes called timing differences. These are differences between the carrying
amount of an asset and for tax purposes
Examples:
i. Certain types of incomes and expenditures that are taxed on cash rather than on accrual
basis e.g. provisions which can be used by a company but which tax authorities don‘t
recognize.
ii. The difference between depreciation charged on a non current asset that qualifies for tax
allowances and the actual allowance tax depreciation) given.
A temporary difference arises when an expense is allowed for both tax and accounting purposes
but the timing of the allowance differs e.g. if relief for capital expenditure is given at a faster rate
for tax purposes than depreciation in the financial estimates, the tax charged will be lower in the
first years than it could have been if based on accounting profit but in the subsequent years the
tax charge will be higher.
Example;
A firm bought an item of plant at a total amount of £50,000. During the first year, the firm
provided for depreciation of 10,000. The item of plant has a capital allowance of`£15,000 for the
first year.
Required: Compute the carrying amount of the asset, the tax base and hence the temporary
difference.
Carrying amount = cost – depreciation

=50,000-10,000 =40,000
Tax base = cost – capital allowance

=50,000-15,000 =35,000
Temporary differences = carrying amount – tax base

=40,000-35,000 =£5,000

IAS 12 requires deferred tax liability to be recognized for all temporary differences with minor
expectations. A taxable temporary difference arises where the carrying value of an asset is
greater than its tax base.

42
Deferred tax asset
IAS 12 requires that;
i. Deferred tax asset should be recognized for all temporary differences
ii. A deductible temporary difference arises where the tax base of an asset exceeds its
carrying value.
iii. To the extent that it is probably taxable profit will be available against which deductible
temporary differences can be utilized than deferred tax asset can be recognized especially
in regard to tax losses carried forward.
iv. No discounting is allowed.
Application scenario
a) Revaluation of non-current assets
- Deferred tax should be recognized on revaluation gain even when there is no intention to
sell the asset or roll over relief available on the gain.
- The revaluation of noncurrent assets results in taxable temporary differences and so its
liability. This is charged as a component of other comprehensive income (alongside the
revaluation gain reserve). It is therefore disclosed either in the statement of cash inflow
(SOCI) or in a statement showing other comprehensive incomes.
b) Tax loses-
- When used tax losses are carried forward a deferred tax asset can be recognized to the
extent taxable profit will be available in the future to offset the losses against.
- If an entity doesn‘t expect to have taxable profits in future, it cannot recognize an asset in
its own account. If however the entity is part of a group and many surrender the tax losses
to other groups and companies, a deferred tax asset may be recognized in the
consolidated accounts.
- The asset is equal to the losses expected to be utilized multiplied by the tax rate.
Changes in tax rates
The corporation tax may change from one period to the next e.g. the tax rate for 2010 may be
33% and 2011 35%. The question is which tax rate should be used in computing deferred tax for
the current year (assuming the current year is 2010) if a company uses the current year‘s tax rate
then it is called the deferral method.
If a company uses the subsequent years tax rate i.e. 35%, in this case unless the subsequent tax
rate is not known in which case the firm can use the deferral method.
Further points on deferral tax

IAS 12 explains that there are two main types of temporary differences notably
- Taxable temporary difference (TTD)
- Deductible temporary difference (DDT)
Taxable temporary difference- These are differences that lead to a future payment of tax i.e.
deferred tax liability. They arise when the carrying amount of an asset is greater than the tax
base.

43
Deductible temporary difference – These are temporary differences that lead to a future tax
saving, i.e. deferred tax asset. They arise when the carrying amount is less than the tax base. A
deferred tax asset may also arise where the company has future taxable losses (tax losses carried
forward) or if the company has a tax refund or credit.
Disclosure requirements
The tax expense (income) should be presented on the face of income statement. The major
components of tax expense (income) should be disclosed separately in a note.
Current and deferred charged/credited directly to equity (taxes out of main event e.g.
revaluation) should be disclosed separately in a note.
Current and deferred tax charged/credited directly to equity should be disclosed. An explanation
of the relationship between tax expense (income) and accounts profit in either or both of the
following forms.
1. Reconciliation between tax expense and product of account profit multiplied by the
applicable rate, disclosing also the basis on which the applicable rates are computed
2. A numerical reconciliation between average effective tax rate and applicable tax rate,
disclosing also the basis on which applicable tax rate is computed.
3. Amount of deferred tax asset/liability and nature of evidence supporting its recognition.

44
QUESTIONS:
QUESTION ONE
1. Distinguish between “deferred tax liabilities” and deferred tax assets”
Deferred tax assets are the amounts of income taxes recoverable in future periods in respect of:
- Deductible temporary differences
- The carry forward of unused tax loses
- The carry forward of unused tax credits
2. As at January Thames Ltd had a current tax liability of ksh 3,000,000. During the year ended
31st December 2010, the company estimated that the corporation tax liability after adjusting its
profits for tax papooses is at Ksh 12,000,000. The company made installment tax payment
specifically for the year 2010 amounting to ksh 10,000,000.
Required:
a) Compute the income tax expense for the year 2010 assuming that:
i. The current tax as at 1st January 2010 was paid during the year at Ksh
2,800,000 in addition to 2010 installment
ii. The current tax rates as 2010 was paid at ksh 3,400,000 in addition to
installment of the year 2010
b) The income tax liability that would be presented in the statement of financial position
Solution:
Tax expense composition
Provision 12 000 000
Over/under subscription 200 000 (3M-2.8M)
Deferred tax
a) i) Tax expense
Current estimate 12 000 000
Less: overprovision (3M-2.8) (200000)
11 800 000
ii)
Current estimate 12 000 000
Add: under provision (3.4M-3M) 400 000
12 400 000
b)
Current years estimate 12 000 000
Less: installments payment 10 000 000
Current tax liability 2 000 000

45
QUESTION TWO:
Speedo has estimated its income tax liability for the year ended 31st December 20x8 at ksh
180,000,000, Based on taxable profits of ksh 600,000. The tax rate is 30%. Extract from the trial
balance as at December 20x8
Dr (Kshs) Cr. (Kshs)
Sales 1,500,000
Operating costs 900,000
Income tax 3,000
Show the income statement for the year ended 31st December 20x8 and the liability for income
taxes in the statement of financial position at that date.
Solution:
Revenue 1 500 000
Operating costs 900 000
Profit before tax 600 000
Tax estimate (30%) 180 000
Over provision (3 000)
Income tax expense 177 000
Net income after tax 423 000
Statement of financial position (Extract)

Current liability 180 000
Unless otherwise you are told about new balances of timing differences, assume they are
taxable timing differences and write about your assumption.
QUESTION THREE:
Noel is preparing accounts for the year ended 31 st December 2011. The deferred tax provision
was $78,000 and past cumulative timing differences of $180,000, have accumulated at the year
end. Tax at 30% is estimated at $254,000
Required:
Prepare statement of financial position and income statement extracts for the year ended 31 st
December 2011
Income tax expense 240 000 Balance b/f 78 000
Balance c/f (0.3× 180 000) 54000
An increase in deferred tax liability increases income tax expense for the year
A decrease in deferred tax liability decreases income tax expense for the year
An increase in deferred tax asset decreases income tax expense for the year
A decrease in deferred tax asset increases income tax expense for the year

46
Deferred tax (statement of financial position)
$ 000
Opening balance 78
Decrease (balancing figure) (24)
Closing balance 54
The closing balance of 54 is posted to statement of financial position as a deferred tax

liability.
Income statement (extract)

Current tax 254
Less: decrease in tax liability (24)
Income tax expense 230
QUESTION FOUR:
As at 30th September 2011, Grace has non-current assets with a carrying value of ksh 1,100,000
but a tax written down value of Ksh 700,000. The brought forward balance on the deferred tax
account is ksh 300,000. Assume a tax rate of 30%.
Compute the effect of deferred tax on the financial statement for the year ended 30th
September 2011.
Solution:
Step 1: Determining timing difference
Carrying value of assets 1 100 000

Tax base of assets 700 000
Timing difference (TTD) 400 000
Step 2: Determine the new figure for deferred tax liability
Tax debt × Tax rate

400 000 × 30% = 120 000
Step 3: Determine movement in deferred tax liability account
Deferred tax a/c

Balance (income tax expense) 180 000 Balance b/f 300 000
Balance c/f 120 000
300 000 300 000
Step 4: Effects on financial statements.
a) Statement of financial position

Deferred tax liability 120 000
b) Income statement
Effect is to decrease income tax expense by 180 000

47
QUESTION FIVE:
Busy man of London has the following trial balance and other details for his company.
Dr (£) Cr. (£)
Sales 100,000
Operating costs 55,000
Dividends received 18,000
Deferred tax 19,000
Prior year overprovision on tax 4,000
A taxable temporary difference of £125,000 has accumulated at the year. Income tax 20% is
estimated at £30,000.
a) Prepare the deferred tax note
b) Prepare the income statement and tax note.
Solution:
a) Deferred tax
£
Opening balance 19 000
Increase 6 000
Closing balance(0.2x125000) 25 000
b) Income statement
Revenue 100 000

Operating cost (55 000)
Operating profit 45 000
Investment income 53 000
Tax (working below) (32 000)
Working for tax expense

Provision (Estimate for the year) 30 000
Over provision (4 000)
Deferred tax 6 000
QUESTION SIX:
A company has provided the following information regarding tax, during the year ended 31 st
December 2008.
i. As at 2008 the balance brought down on the current tax account and deferred tax (all
liabilities) was $20,000 and $40,000 respectively
ii. The current tax brought forward was finally settled at $25,000
48
iii. Current years‘ tax estimate is $150,000 with installment payment of $120,000 having
been made
iv. The following items are considered for the purpose of computing the deferred tax
balances as at December 2008
 Property, plant and equipment had a carrying value of $200,000 and tax base of
$100,000
 Intangible assets amounted to $10,000 but this had already been allowed as an
expense in full for tax purpose
 Inventory was valued at cost of $120,000 and had a net realizable value of
$115,000. The actual cost is normally used for tax purpose
 Receivables amounted to $100,000 after making a general allowance of $10,000.
The general allowance is not allowed for tax purpose
 Corporation tax is 30%
Required:
Compute the income tax expense, the current and deferred tax liabilities to the statement of
financial position.
Solution:
Working 1:
C.V T.B Type of

difference
PPE 200 100 TTD 100
intangibles 10 0 TTD 10
inventory 115 120 DTD (5)
receivables 100 110 DTD (10)
Net timing difference TTD 95
Deferred tax liability 0.3×95 = 28.5

Balance c/f on deferred tax liability 40.0
Decrease in deferred tax liability 11.5
Income tax expense

Current year‘s estimate 150 000
Add: under provision 5 000
Decrease in deferred tax liability (11 500)
143 000
Current tax liability
Current year‘s estimate 150 000
Less: installment paid (120 000)
Current tax liability 30 000

49
Journal:
Dr. deferred tax liability 40 000
Cr. Deferred tax liability 28 500
Cr. Tax liability 11 500
In statement of financial position we will have a deferred tax liability of 28 500 replacing the b/f
of 40 000, the difference of 11 500is credited to income tax expense a/c.
Sometimes, IAS requires a company to adjust increase or decrease in deferred tax a/c in the
reserve and not in income statement (or through the income tax expense)
This happens when temporary differences arise as a result of some devaluation whose gain/loss
has been reported in reserves e.g. revaluation reserve.
QUESTION SEVEN:
Assume that a firm bought some building at a total cost of $100,000 on January 1 2008. The
depreciation charge is straight line based on 50 years while capital allowance for the first year is
3% on cost. As at December 31st 2008 the buildings were valued to $100,000.
Required:
a) Compute the carrying amount, the tax base and the temporary difference of the
building indicating the temporary differences arising due to revaluation
b) Assuming a corporation tax of 30%, give the relevant journal entry to record
revaluation and the deferred tax effects as at 31-12-2008.
Solution:
Jan 2008 = 100 000
Depreciation straight line for 50 years
Capital allowance = 3%
Revaluation = 100 000
i) $000
Cost as at 1.1.2008 100
Depreciation for the year (2)
Carrying amount before revaluation 98
Revaluation gain (100-98) 2
Carrying amount after revaluation 100
Tax base 97
Taxable timing difference 3
Taxable timing difference to revaluation 2
ii) To record revaluation of a building

Dr. Building a/c 2 000
Cr. reserve 2 000
To record deferred tax effects

Dr. Revaluation reserve (2 000×30%) 600
Cr. Income statement (1 000×30%) 300
Cr. Deferred tax a/c (30%×3000) 300
50
Item Condition Nature of timing difference result
Asset C.V>T.B TTD Deferred tax liability
Asset C.V<T.B DTD Deferred tax asset
Liability C.V>T.B DTD Deferred tax asset
liability C.V<T.B TTD Deferred tax liability
QUESTION EIGHT:
The following statements of financial position relates to elgonltd, a public limited company, as at
30 September 2010:
Sh.‖ 000‖
Non-current assets at cost:
Plant, property and equipment 10 000
Goodwill 6 000
Other intangible assets 5 000
Financial assets (cost) 9 000
30 000
Current assets:
Other receivables 4 600
Cash and bank balances 6 700
Total assets 48 300
Equity and liabilities:
Other reserves 5 000
Retained Earnings 9 630
Total equity 29 630
Non-current liabilities:
Deferred tax 3 600
Employee benefits 4 000
7 600
Current liabilities:
Current tax 4 070
Trade and other payables 7 000
11 070
Total equity and liabilities 48 300
The following information is relevant to the above financial statement:

1. The financial assets are classified as ―available for sale‖. Their market value as at 30
September 2010 was sh.10.5 million. Tax is payable on their sale
2. The company has not accounted for an increase in the present value of past service cost
of sh.520 000
3. Goodwill is not allowable for tax purposes

51
4. The tax base of the assets and liabilities are the same as their carrying amounts in the
statement of financial position as at 30 September 2010 except for the following:
Sh‖000‖
Property, plant and equipment 2 400
Other receivables 5 000
Employee benefits 5 000
Other intangible assets were software development costs which were all allowed for tax
purposes when the costs were incurred in 2008
Trade and other payables include an accrual for compensation to be paid to employees.
This amounts to sh.1 500 000 and is allowed for tax when paid
5. Assume a corporation tax rate of 30% in the current year and 32% in the previous years
6. Property was revalued downward by sh.2 000 000 during year
Required:
Calculate the provision for deferred tax as at 30 September 2010 after any necessary adjustment
showing how the provision for deferred tax would be dealt with in the financial statements
Suggested solution:
item Asset/li C.V per Adjustment Adjusted Tax base Timing

ability SOFP C.V difference
PPE Asset 10 000 (2 000) 8 000 2 400 5 600 TTD
Other intangibles Asset 5 000 - 5 000 0 5 000 TTD
Financial asset Asset 9 000 1 500 10 500 9 000 1 500 TTD
Trade receivables Asset 7 000 - 7 000 7 500 (500) DTD
Other receivables Asset 4 600 - 4 600 5 000 (400) DTD
Employees benefits liability 4 000 520 4 520 5 000 480 TTD
trade &other payables liability 7 000 - 7 000 5 500 (1 500) DTD
10 180
Net taxable timing difference

Deferred tax liability 10 180×30%=3054

52
Balance b/f 3 600
Income tax expense 546
Balance c/f 3 054
3 600 3 600
The deferred tax liability of the 3054 is posted to statement of financial position.
The decrease in deferred tax liability is credited to income tax expense SOCI (3 600-3 054)=546
QUESTION NINE
(a) (i) Explain the rationale behind providing deferred tax based on temporary differences (4 marks)
(ii) Polytech Limited has a deferred tax liability of sh.100 million as at 1 October 2011. During the year
ended 30 September 2012, the following information was available for computation of deferred tax:
1. Property, plant and equipment had a carrying amount of sh. 1,200 million and a tax base of
sh.1,000 million. Some land and building were revalued upwards by sh.50 million during the year
ended 30 September 2012
2. Intangible assets consisting of trade licenses being amortized over five years had a carrying
amount of sh.60million. this has been allowed for tax purposes
3. The company has available for sale financial assets with a carrying amount of sh.20 millions and
financial assets at fair value through profit and loss of shillings 10 million. Both financial assets
reported losses in fair value of sh.2 million each as at 30th September 2012
4. Inventory is shown at the lower of cost and net realizable value. The cost is sh.800 million while
net realizable value is sh.780 million
5. Trade receivables had a carrying amount of sh.500 million (unrealized). Both the allowance and
exchange gain are not allowed for tax purposes
6. Trade and other payables are stated at sh.900 million after making a provision for discount of
sh.10 million
Assume a tax rate of 30%.
Required:
Temporary differences for the year ended 30 September 2012. (6 marks)
Suggested solution:
a) (i)
Deferred tax arises because of differences in the way the government and accountants treat some income
and expense items. In order to comply with the matching concept, then it is important to report the
possible tax that will be paid or settled in the future in the current financial statements.
(ii) Computation of temporary differences.

53
Carrying Tax base Temporary Taxable/
amount difference Deductible
Sh. ‗million‘ Sh. ‗million‘ Sh. ‗million‘ Sh. ‗million‘

Property, plant and equipment 1,200 1,000 200 Taxable
Intangible assets 60 0 60 Taxable
Available for sale financial assets 20 22 (2) Deductible
Fair value through profit and loss 10 12 (2) Deductible
Inventory 780 800 (20) Deductible
Trade receivables 500 480 20 Taxable
Trade and other payables (900) (910) (10) Taxable
Deferred tax balance c/d at 30% 79.8
Deferred tax balance b/f 100
Decrease in deferred tax 20.2
QUESTION TEN:
Jenga ltd. had a deferred tax liability balance forward of sh.2 million. As at 31 December 2008,
the firm hand the following assets:
Assets Carrying amount Tax Base
Sh‖000‖ Sh‖000‖
Property, plant and equipment 20, 000 10, 000
Receivables 8, 000 8, 500
Inventory 7, 500 8, 000
Temporary difference due to revaluation of buildings in the year was sh.1, 000, 000
Required:
Compute the deferred tax liability as at December 2008 and show the relevant journal entry
Suggested solution:
Jenga Ltd
Deferred tax
Sh‖000‖ Sh‖000‖
Balance b/f 2 000
Balance c/d (30%x9 000) 2 700 Increase in def. tax liability 700
2 700 2 700
Journal entries:
Sh‖000‖ sh‖000‖
Dr. Revaluation reserve 300
Dr. Income statement 400
Cr. Deferred tax liability 700

54
WORKINGS
CA TB TD
PPE 20000 10000 10000-ttd
Receivables 8000 8500 50dtd
Inventory 7500 8000 50-dtd
900
EMPLOYMENT BENEFITS
Employment benefits form a very important constituent of an entity‘s expenses. Employers offer
benefits that can be enjoyed by employees during the period commencing from the completion of
the employee‘s service. These benefits are offered as part of the remuneration package.
Post-employees benefits are employee‘s benefits payable after the completion of employment.
They include retirement benefits, such as pensions, post-employment life insurance and post
employment medical care. Arrangements whereby an entity provides post-employment benefits
are known as post-employment plan.
Post-employment benefits plans are either:
 Defined contribution plans; or
 Defined benefit plans
Defined contribution plans

These are post-employment benefit plans under which an entity pays fixed contributions into a
separate entity (a fund) and will have no legal or constructive obligation to pay further
contributions if the fund does not hold sufficient assets to pay all employees benefits relating to
employees service in the current and prior periods.
The amount of the liability towards post retirement benefit is restricted to the fixed contributions
to a separate entity fund.
The amount of post-employment benefit received by the employee depends on the contribution
paid by the entity and the employee (if any) to a post-employment benefit plan or to an insurance
company., together with any investment returns arising from the contributions made. Therefore
the actuarial risk and investment risks rest fully with the employee. There is no way to know how
much the plan will ultimately give the employee upon retirement.
Discounting
Usually contributions are not discounted since they represent the current expenditure to be paid
immediately. However, where contributions to a defined contribution do not fall due wholly
within twelve months after the end of the period in which the employees render the related
service, they shall be discounted.
Defined benefit plan

Defined benefit plans are post-employment benefit plans other than defined contribution plans.
Under this plan:
1. The entity‘s obligation is to provide the agreed benefits to current and former employees.
2. Actuarial risks and investment risk fall, in substance on the entity. If actuarial or
investment experience is worse than expected, the entity‘s obligation may be increased.

55
This basically means that employers agree to give their employees for example, a defined
benefit when they retire e.g. pension payable after they retire, of 30% of their final salary.
3. Generally, the amount of retirement benefits is calculated using a formula which includes
the earnings of the employee and the number of years of service of the employee.
4. The amount of promised retirement benefits depends on:
 The financial position of the plan (The value of assets in the fund or plan)
 The ability of contributors to make future contributions
 Investment performance and efficiency of the plan
5. The periodic advice of an actuary will be needed to assess the financial condition of the
plan, review the assumptions and recommend future contribution levels.
6. The financial statements will contain either
 A statement of the net assets available for benefits
 The actuarial present value of promised retirement benefits
 The resulting excess or deficit Or
 A statement of the net assets available for benefits including either:
 A note disclosing the actuarial present value of the promised retirement benefits
or
 If an actuarial valuation has been prepared at the date of the financial statements,
the most recent valuation shall be used as a base and the date of valuation
disclosed
7. The financial statements should also explain the relation between:
 The actuarial present value of the promised retirement benefits and the net assets
available for benefit; and
 The policy for the funding of the promised benefits
Funded defined benefit obligations

Defined benefits plans may be unfunded, or they may be wholly or partly funded. Funded plans
are pension plans which have assets allocated assets cover the future obligation fully. Partly
funded plans are pension plans which have assets allocated, but such assets do not cover future
obligations fully.
Major difference between a defined contribution plan and a defined benefit plan
Features Defined contribution Defined benefit plan
plan
Fixed Contribution by Benefits to the employees
employer
Liability of the Restricted to the fixed Not restricted to contribution but linked to the
employer contribution benefits payable
Risk Lies with employees Lies with employer – may have to pay more if
present contribution is not sufficient to pay
the fixed benefit
Presentation in the No liability unless Liability is shown net of plan asset
financial statement contribution is unpaid

56
Multi-employer plans
Multi-employer plans are defined contribution plans (other than state plans) or defined plans
(other than sate plans that:
a) Pool the assets contributed by various entities that are not under common control
b) Use those assets to provide benefits to employees of more than one entity, on the basis
that contribution and benefits levels are determined without regard to the identity of the
entity that employees concerned.
ACCOUNTING FOR POST EMPLOYMENT BENEFITS (PENSIONS)

An entity is to recognize the following amounts as expenses or incomes in the statement of
comprehensive income:
 Current serve cost
 Interest cost
 Expected return on any plan assets and on any reimbursement rights
 Actuarial gains and losses
 Past service costs
 Effects of any curtailment or settlement
The following table summarizes the impact on the SOCI
present value of fair value of Impact on SOCI

defined benefit plan assets
obligation
1 Current service Increase liability Expense
cost
2 interest cost Increase liability Interest expense
3 Return on plan Increase asset Recognize the expected
assets return on assets as income
4 Contributions paid Increase asset
5 Retirement and Decrease liability Decrease asset
benefits paid
Statement of financial position presentation

The SOFP recognizes the following:
 The present value of the defined benefit obligation on the settlement of financial position
date
 Plus any unrecognized actuarial gains (less any actuarial losses)
 Less any unrecognized past service cost
 Less the fair values at the statement of financial position date of plan asset ( if any) out of
which the obligations are to be settled directly
 The result represents net plan obligation or net plan asset to present in the statement of
financial position
57
EXPLANATION OF THE COMPONENTS OF PENSION EXPENSE
I. Current service cost

This is the expense caused by the increase in pension benefits payable (projected benefit
obligation) to employees because of their services rendered during the current year.
Actuaries compute service cost as the present value of the new benefits earned by
employees during the year. Service cost is therefore determined as the actuarial present
value of benefits (attributed by the pension benefit formula) to employees due to service
rendered during the year
II. Past service cost

This is the increase in present value of the defined benefit obligation for the employee
service in prior periods, resulting in the current period from the introduction of changes
to, post employment benefits or other long-term employee benefits. Past service cost may
either be positive (where benefits are introduced or improved) or negative (existing
benefits are reduced)
III. Interest on the liability

Because a pension is a deferred compensation arrangement, there is a time value of
money factor. Therefore the pension (projected obligation) is recorded on a discounted
basis. Interest expense accrues each year on the projected benefit obligation just as it does
on any discounted debt. To record the interest expense the accountant receives help from
the actuary in selecting the interest rate, called for this purpose settlement rate.
As stated above, a pension is a deferred compensation arrangement under which an
element of wages is a deferred and a liability is created. Because the liability is not paid
until maturity, it is recorded on a discounted basis and accrues interest over the life of the
employee. The interest component is the interest for the period on the projected benefit
obligation outstanding during the period.
The interest rate (discounted rate) used is a rate that reflects the rates at which pension
benefits could be effectively settled.
IV. Return on plan assets

The return on plan assets is interest, dividends, and other revenues derived from the plan
assets, together with realized and unrealized gains or losses on the plan assets less any
costs of administering the plan and less any tax payable by the plan itself.
 The actual returns from plan assets i.e. interest, dividends and so on
 Add realized/unrealized gains/loss on plan assets
 Less costs of administering the plan
 Less tax payable by the plan
The income statement recognizes the expected return and not the actual return on plan assets.
The difference between the actual return and the expected return is the actuarial gain/loss
The expected return on plan assets is based on market expectations, the begging of the period, for
returns over the entire life of the related obligation. It is usually calculated by applying the
expected rate of return to the opening balance of the plan assets (at fair value)

58
Calculating actual return on plan assets
Ksh.
Fair value of plan assets at the end of the period xxx
Less: Fair value of plan assets at the beginning of the period (xx)
Less: contribution received (xx)
Add: benefits paid xxx
Actual return on plan assets xxx
V. Actuarial gains/losses
The actuarial gains/losses arise due to annual valuation of obligation and plan assets
comprising:
 Actuarial gain or loss on obligation arises due to difference between the actual
and assumptions.
Determination of actuarial loss/gain arising from obligations
Present value of obligation at beginning of period (according to actuarial report) xxx

Add: interest costs (to increase obligation) xxx
Add: current and past service costs xxx
Less: benefits paid (xx)
Actual gain/loss (balancing figure) xxx
PV of obligation at end of period (according to actuarial report) xx
If the actual present value of future obligation is less than assumptions, there is actuarial gain and
vice versa.
 Actuarial gain/loss on the plan asset arises due to differences in the actual and
expected returns
If the actual return on plan assets is more than the expected then there is actuarial gain and vice
versa.
The actuarial gain or loss is determined by adding the effects of the above differences.
Experience adjustments are another term for effects or differences between the previous actuarial
assumptions and what has actually occurred.
VI. The effects of any curtailment or settlement
Gains or losses on settlement or curtailments of a defined benefit plan should comprise:

 Any resulting change in the present values of the defined obligation
 Any resulting change in the fair value of plan assets
 Any related actuarial gain or losses and past service cost that had not been
previously recognizes

59
Before determining the effects of a curtailment or settlement an enterprise should measure the
obligation and the related plan assets (if any) using current actuarial assumptions (including
current market interest rates and other current market prices)
A curtailment occurs when an enterprise either:

 Is demonstrably committed to make a material reduction in the number of employees
covered by a plan: or
 Amends the terms of a defined benefit plan such that a material element of qualify only
for reduced benefits
A curtailment may arise from an isolated event, such as the closing of a plan, discontinuance of
an operation or termination or suspension of a plan
A settlement occurs when an enterprise enters into a transaction that eliminates all further legal
or consecutive obligation for part or all of the benefits under a defined benefit plan, for example,
when a lump-sum cash payment is made to, or on behalf of, plan participants in exchange for
their rights to receive specified post employment benefits.
CORRIDOR AMORTIZATION
Due to off-setting of the assets gains and losses and the liability gains and losses the accumulated
total unrecognized net gain or loss may not grow too large. It is however possible and offsetting
may not occur and the balance in the unrecognized net gain or loss account may grow to a large
amount. In order to limit its growth some amount of it may be amortized when it gets large.
The amount to be amortized would usually be the excess of the net unrecognized gain or loss
above some specified level. International Accounting Standard No 19 recommends that
enterprises amortize the gain or loss above (i.e. the excess) 10% of the LARGER of the
beginning balances of the projected benefit obligation or the market-related value of the plan
asset. The amount of excess unrecognized gain or loss to be amortized is determined as follows.
Net cumulative unrecognized actuarial gains (losses) at begging of year xxx

Less: limits of corridor at beginning of the year (xx)
Excess amount to be amortized xxx
The amortization for a period is calculated by dividing the excess by the average remaining
service period of active employees expected to receive benefits under the plan. Any other
systematic method of amortization of the unrecognized gains and losses may be used.
The limits of ‗corridor‘ is simply the larger or the greater of the 10% of
a) The present value of the obligation before deducting plan assets at the beginning of the
year and
b) 10% of the fair value of plan asset at the beginning of the year

60
Gains and losses that arise from a single occurrence not directly related to the operation of
pension plan and not in the ordinary course of the employer‘s business should be recognized
immediately and reported in the period. A gain or loss that is directly related to plant closing, a
disposal of a segment or a similar event that is greatly affects the size of the employee workforce
should be recognized as part of the gain or loss associated with that event and therefore not
treated as a pension gain or loss.
PENSION OBLIGATION LIABILITY

Pension obligation is the amount of the employer‘s liability and the pension obligation should be
reported in the financial statements. An employer‘s pension obligation is the deferred
compensation obligation it has to its employees for their service under the terms of the pension
plan.
There are three alternatives of measuring the liability as explained below:
a) Vested benefit
These are benefits that the employee is entitled to receive even if the employee renders
no additional service under the plan. Under most pension plans, a certain minimum
number of years of service to the employer are required before an employee achieves
vested benefits status. The vested benefits pension obligation is computed using current
salary levels and includes only vested benefits
b) Accumulated benefit obligation
Under this method the measure of obligation is based on the computation of the deferred
compensation amount on all years of service performed by employees under the plan,
both vested and non-vested using current salary levels.
c) Projected benefits obligation
Under this method, the obligation measure is based on the computation of deferred
compensation amount on both vested and non-vested service using future salaries.
Because future salaries are expected to be higher than current salaries, the method results
in the highest measurement of the benefit obligation. The choice between the above
measures of pension obligation is critical because it affects the amount of pension
liability and the pension expense reported.
MINIMUM LIABILITY
Minimum liability is a liability that occurs when the accumulated benefit obligation exceeds the
fair value (not market value) of plan assets.

61
The purpose of the minimum liability is to ensure that if a significant plan amendment or
actuarial loss occurs a liability will be recognized at least to the extent of the unfunded portion of
the accumulated benefit obligation.
In calculating minimum liability the plan assets are compared with the smaller accumulated
benefit obligation instead of the larger projected obligation. The rationale for using the
accumulated benefit obligation is that if the liability was to be settled immediately, then it would
be settled on the basis of present salary rates and non future salary rates.
If a liability for accrued pension cost is already reported in the accounts then only additional
liability to equal the minimum liability (unfunded accumulated benefit) is recorded.
OTHER CONCEPTS
 If the amount funded (paid in cash) by the employer to the pension trust is less than the
annual expense (pension expense) the difference is accrued as a liability and treated as a
non-current liability. It may be described liability for pension expense not funded or due
to pension fund or accrued pension cost. The liability would be classified as current when
it requires the disbursement of cash in the next year.
 If the amount funded (paid) to the pension trust during the period is greater than the
amount charged as expense, the difference is treated as assets. The asset reported as
prepaid pension cost or deferred pension expense is the current assets section if it is
current in nature.
 If the accumulated benefit obligation exceeds the fair value of the pension plan assets, an
additional liability is recorded. The debt is either to an intangible asset account called
deferred pension cost or to a contra account to shareholders equity. If the debt is greater
than the unrecognized prior service cost, it is reported as intangible asset. If the debt is
greater than the unrecognized prior service cost, the excess debit is recorded as contra
equity and described as excess of additional pension liability over unrecognized prior
service cost.
Asset ceiling test
Ordinarily the SOFP recognizes the following;

- PV of the defined benefit obligation on SOFP date (year end)
- Plus, any unrecognized actuarial gains (less any actuarial losses)
- Less, any unrecognized past service cost
- Less, FV on the statement of financial position date of plan asset (if any) out of which
the obligations are to be settled directly

62
For the net amount determined above may be –ve (asset) in such situations, the entity has to
apply the asset ceiling test.
The standard (IAS 19) specifies the ceiling on the defined benefit asset that can be recognized.
An entity shall measure the resulting asset at the lower of;
a) The amount defined
b) The total of;
i) Any cumulative unrecognized net actuarial loss and past services
ii) PV of any economic benefits available in the form of refunds from the plan or
reductions in future contribution to the plan. The PV of these economic benefits shall
be determined using the discounting rate method.
This indicates that there is a ceiling on carrying value of the asset.
EAXMPLE:
A defined benefit obligation has the following characteristics.
Ksh ‗millions‘
PV of obligation 880
FV of plan asset 952
Unrecognized actuarial losses 88
Unrecognized past service cost 56
Unrecognized liability 40
PV of the available refunds and Reductions in future contribution 72
Determine liability to be recognized in SOFP.

Solution:
Present value of liability 880
Less: unrecognized actuarial loss (88)
Past service cost (56)
Unrecognized increase in liability (40)
Adjusted PV of obligation 696
Less: FV of plan asset (952)
(256)
Since the amount is negative, the asset needs to be recognized as follows using asset ceiling test.
Unrecognized actuarial loss 88

Unrecognized past service cost 56
PV of available refunds and reductions
In future contribution 72
216

63
In the SOFP recognize 216 being lower than 256 as the net asset in employee benefits.
The difference of 40M coming out of the ceiled amount is not charged to statement of cash
inflow, but it is disclosed in the notes of accounts indicating a reduction of 40M in the value of
net plan assets.
Corridor amortization approach
Step 1:
Determine net accumulative unrecognized service gain/loss at the beginning of year.
Step 2:
Determine corridor which is the greater of;
- 10% of PV of defined benefit obligation at the beginning
- 10% of FV of plan assets.
Step 3:
If step2 is greater than step 1, the amount is within the corridor and there is no need to recognize
any amortization.
If step 1 is greater than step 2 then the excess of 1 over 2 is dividend by the remaining work life
of employees in the plan and is recognized as the gain or loss in the statement of cash inflow.
In the corridor approach the actuarial gains/losses are recognized as follows.

Amount within the corridor
Deferral and hence includes as liability in statement of financial position.
Amount in excess of ‗corridor‘ amount,

Recognize in income statement over the remaining work lives of employees or shorter periods.
Alternatives to corridor amortization
An entity may apply systematic methods to actuarial gains/losses even if they are within the
limits specified in the corridor concept. An entity adopting any systematic method will achieve
faster recognition of actuarial gains and losses in income statement.
The amount recognized in statement of cash inflow should be transferred to retained earnings
immediately. Reclassification of this amount from other accounts to income statement in the
subsequent years is not allowed.
Key issues in the determination of the method of accounting for retirement benefits in
respect of defined benefits plan.
i. Valuation of plan assets.
It is always questionable in law or economic reality whether assets should be recognized

as if they belong to company in the statement of financial position.

64
ii. Measurement of plan liability.
The difference in use of actuarial or market values brings in confusion as to which

method should be preferred.
iii. Frequency of actuarial valuations.
If actuarial valuations are not frequent enough the figures for PV of benefit of obligations
and FV of plan assets may not be current enough to capture reality.
iv. Recognition of actuarial losses/gains.
The question arises as to whether these gains/losses should be recognized immediately or

over the service life of employees.
EXERCISE
QUESTION ONE
From the information below calculate the pension expense for the year 20x0
Plan asset 1st January 200 540,000

Projected benefit obligation 1st January 200 600,000
Annual pension cost 84,000
Contributions (funding) 60,000
Actual return on plan assets 90,000
Benefits paid to retirees 45,000
Settlement rate (expected rate) 8%
Solution:
Workings)
Pension expense for the year ended 20X0
Pension cost 84 000

Interest on liability (8%×600 000) 48 000
Expected return of plan asset (8%×600 000) (48 000)
Actuarial gain on Plan assets (90 000-48 200) (42 000)
Net pension expense 42 000
Statement of comprehensive income (extract)

Actuarial cost: employee benefit expense 42 000

65
QUESTION TWO
From the information given below compute the pension expense for the year 20x1
Service cost 105,000
Contribution plan 240,000
Prior service cost amortization 10,000
Actual and expected return on the assets 80,000
Benefits paid 50,000
Accrued pension cost 1st Jan 20x1 8,000
Plan assets on Jan 20x1 843,000
Projected benefit obligation 1 st Jan 20x1 1,150,000
Unrecognized prior service cost balance at Jan 20x1 240,000
Interest/discount (settlement rate) 10%
Solution:
Service cost 105 000

Prior service cost amortization 10 000
Expected return on the assets (80 000)
Interest on liability (0.1x1 150 000) 115 000
150 000
QUESTION THREE
From the following information, calculate actuarial gain or loss arising:
Present value of obligation at beginning of period 2,000,000

Interest costs for the period 20,000
Current and past service costs 260,000
Benefits paid during the year 300,000
PV of obligation at end of period) 2,200,000
Solution:
PV of obligation at beginning 2 000 000

Add: interest cost for period 20 000
Service cost 260 000
Less: benefits paid (300 000)
Actual present value of plan obligation 1 980 000
Gain on actuarial assumption 220 000
PV of obligation at end of year 2 200 000

66
QUESTION FOUR
Calculate actuarial gain or loss from the following information
Contribution received 600,000

Benefits paid 3,800,000
Fair value of plan assets 31/12/20x6 10,000,000
Fair value of plan assets31/12/20x5 7,000,000
Expected return on plan assets 4,000,000
Solution:
Fair value of plan asset at end 10 000 000

Less: fair value plan asset at the beginning (7 000 000)
Contributions received (600 000)
Add: benefits paid 3 800 000
Actual returns on plan assets 6 200 000
Actuarial gain 2 200 000
Expected return on plan asset 4 000 000
QUESTION FIVE
The following information relates to a company‘s defined benefit pension plan as at 1 st January
20x6
Present value of defined benefit obligation 2,250,000

Fair value of plan assets 1, 800,000
Unrecognized actuarial gains (presented as a liability in the SOFP) 285,000
Average remaining working lives of employees participating in the plan is 10 years
Determine the amount of actuarial gains to be recognized in the income statement for the year
ended 31st December 20x6.
Solution:
Corridor amortization
Unrecognized actuarial gains/losses = 200 000 (determine this first)
Compare with 10% PV obligation at start 10% of plan asset beginning
10% of PV of obligation 225 000

10% of PV of plan asset 180 000
Unrecognized actuarial gain 285 000
(285 000- 225 000)=60 000

67
60 000
𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑒𝑑 =
10
= 6 000
If unrecognized gains = 210 000(less than both)
=225 000+210 000
=246 000 (to be posted to SOFP)
QUESTION SIX
Tedcomp Limited prepares its financial statements on 30 September each year. The company makes
contribution to a defined plan for its employees. The company accounts for actuarial gains and losses
arising on these arrangements using the 10% corridor method.
1. At 1 October 2011, the plain obligation was sh.42 million and the fair value of the plan assets was
sh.36 million
Unrecognized actuarial losses at that date totaled sh.7.8 million.
2. The actuary advised that the current service cost for the year ended 30 September 2012 was sh.4.8
million. Tedcomp Limited paid contribution of sh.3.84 million to the plan on 30 September 2012.
These were the only contribution paid in the year.
3. The expected annual rate of return on plan assets at 1 October 2011 was 5%. They actuary revised
this estimate to 4% at 30 September 2012
4. The appropriate annual rate at which to discount the plan liabilities was 6% on 1 October 2011
and 5.5% on 30 September 2012
5. The plan paid our benefits totaling sh.2.4 million to retired members on 30 September 2012
6. At 30September 2012 the plan obligation was sh.49.8 millions and the fair value of the plan asset
was sh.39 million
7. The average remaining service life of plan members still in employment was estimated to be 20
years.
Tedcom Limited policy is to recognize the excess of the limits over the average service life of
employees.
Required:
(i) Income statement (extract) for the year ended 30 September 2012 (5 marks)
(ii) Statement of financial position (extract) as at 30 September 2012 (5 marks)
(Total: 10 marks)
Solution:
Extracts of the income statement and statement of financial position

68
According to actuary:
PV of obligations at beginning 42 000 000
PV of obligations at end 49 800 000
FV of plan assets at beginning 36 000 000
FV of plan assets at beginning 39 000 000
Current service cost 4 800 000
Expected return (5%x36 000 000) 1 800 000
Interest expense (6%x42 000 000) 2 520 000
Settlement rate 6%
Expected return 5%
Obligation:
PV of obligation at beginning 42 000 000
Add: Service cost 4 800 000
Interest cost for period 2 520 000
Less: benefits paid (2 400 000)
Actual present value of plan obligation 46 920 000
Gain on actuarial assumption (balancing figure) 2 880 000
PV of obligation at end of year 49 800 000
Fair value of plan asset at end 39 000 000

Less: fair value plan asset at the beginning (36 000 000)
Contributions received (3 840 000)
Add: benefits paid 2 400 000
Actual returns on plan assets 1 560 000
Actuarial loss (balancing figure) 240 000
Expected return on plan asset 1 800 000
Corridor amortization:
Unrecognized actuarial gains/losses 7 800 000
Compare with:
10% of PV of obligation at the start (10%x36) 3 600 000
10% of PV of plan asset at beginning (10%x42) 4 200 000 4 200 000
Unrecognized actuarial gain 3 600 000
3 600 000
Out of corridor amortization = = 180 000 (to be posted to income statement)
20
Tedcomp Limited
income statement (extract) for the year ended 30 September 2012
Sh.‘000‘
Current service cost 4,800
Interest cost (6% x 42,000) 2,520
Recognized actuarial losses 180
Less: Expected return on plan assets (5% x 36,000) (1,800)
5,700
69
Tedcomp Limited
statement of financial position (extract) for the year ended 30 September 2012
Sh.‘000‘
Estimated benefit obligation 49,800
Estimated plan assets 39,000
Unrecognized losses (10,740)
Net benefit obligation 60
Problems associated with accounting for pensions.

- Actuarial assumptions
- Different companies employ different policies
- Incorrect data
- Incomplete data
QUESTION SEVEN
Given below are the beginning balances of respective years‘ present for the projected benefit
obligation and market-related values for the pension plan assets.
Projected benefit obligation Plan asset value
1999 1,200,000 1,900,000
2000 2,400,000 2,800,000
2001 2,900,000 2,600,000
2002 3,900,000 3,000,000
The average remaining service per employee in 1999 and 2000 was 10 years and in 2001 and
2002 was 12years. The unrecognized net gain or loss that occurred during each year is as follows
1999 280,000 loss

2000 90,000 loss
2001 12,000 loss
2002 25,000 gain

70
In working the solution, the unrecognized gains and losses must be aggregated to arrive at each
year‘s balances.
Required: using the corridor approach, compute the amount of unrecognized net gain or loss
amortized and charge to pension expenses in each of the four years
QUESTION EIGHT
From the following information concerning the pension fund of some company, calculate the
amounts to be reported in the balance sheets as the end of each of the three years.
Assets and obligations 20x1 20x2 20x3

Market related value 1,300,000 1,650,000 1,800,000
Plan assets (fair value) 1,300,000 1,670,000 1,850,000
Accumulated benefit obligation 1,150,000 1,480,000 2,050,000
Projected benefit obligation 1,600,000 1,910,000 2,500,000
Unfunded accumulated benefits 200,000
Over funded accumulated benefits 150,000 190,000
Amounts to be recognized 25,000 22,000
(accrued) prepaid pension cost at begging of year
Pension expense (250,000) (268,000) (310,000)
Contribution 275,000 265,000 265,000
accrued/prepaid pension cost at end of the year 25,000 22,000 (13,000)
The company‘s unrecognized prior service cost is 637,000 at end of 20x2

71
CHAPTER THREE
QUALITIES OF EARNINGS AND EARNINGS MANAGEMENT
EARNINGS PER SHARE
EPS is the average of earnings attributed to every individual shareholder by equity holder
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑎𝑏𝑙𝑒 𝑡𝑜 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑕𝑜𝑙𝑑𝑒𝑟𝑠

𝐵𝑎𝑠𝑖𝑐 𝐸𝑃𝑆 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠𝑕𝑎𝑟𝑒𝑠 𝑖𝑛 𝑖𝑠𝑠𝑢𝑒
For the purpose of calculating basic EPS, the profit or loss for the period should be the profit or
loss attributable to shareholders in the present company less dividends on the irredeemable
preference shares and any shares with a prior claim. (Dividends on redeemable/convertible
preference shares are classified as part of finance charges and deducted in arriving at the profit
before tax)
Earnings should be apportioned over the weighted average equity shares capital (i.e. taking
account of the date any new shares are issued during the year)
Bonus issue
A bonus issue (or capitalization issue or scrip issue) does not provide additional resources to the
issuer and it means the shareholder owns the same proportion of the business before and after the
issue.
In calculating EPS, the bonus shares are deemed to have been issued at the start of the year and
comparative figures are restated to allow for the proportional increase in share capital caused by
the bonus issue.
Example:
A company makes a bonus issue of one new share for every five existing shares held on 1 st July
2012.
2012 2011
s
Profit attributable to ordinary shareholders for year ending 31 December 550,000 460,000
Number of ordinary shares in issue at 31st 1,200,000 1,000,000
Calculate EPS in year 2012 accounts?

72
Solution:
EPS calculation
2011
460,000
= 38.3
1,200,000
2012
550,000
= 45.8
1,200,000
For comparison purposes the number of shares in 2011 is adjusted to 1,200,000
Rights issue
A rights issue is an issue of new shares to existing shareholders a price below the current market
value.
Rights issue contributes additional resources and its normally priced below full market price. To
arrive at figures for EPS when rights issue is made, we need to calculate first of all the
theoretical ex-rights price
Example:
Suppose that Egghead Company has 10,000 shares in issue. It is now proposed to make a 1 for 4
rights issue at a price of ksh.3 per share. The market value of existing shares on the final day
before the issue is made is ksh.3.50 (this is the ―cum rights‖ value). What is the theoretical ex-
rights price per share?
Kshs
Before issue 4 shares, value ksh 3.50 14
Rights issue 1 share, value 3 3
Theoretical value of 5 share 17
17
Theoretical ex-rights price ksh share = Kshs 3.40 per share
5
Procedure for calculating EPS for current year and corresponding figure for the previous year in
rights issue
a) The EPS for corresponding previous period should be multiplied by the fraction
𝑇𝑕𝑒𝑜𝑟𝑒𝑡𝑖𝑐𝑎𝑙 𝑒𝑥 − 𝑟𝑖𝑔𝑕𝑡𝑠 𝑝𝑟𝑖𝑐𝑒

𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑛 𝑙𝑎𝑠𝑡 𝑑𝑎𝑦 𝑜𝑓 𝑞𝑢𝑜𝑡𝑎𝑡𝑖𝑜𝑛 (𝑐𝑢𝑚 𝑟𝑖𝑔𝑕𝑡𝑠)

73
b) To obtain the EPS for the current year
i. Multiply the number of shares before the rights issue by the fraction of the year
before the date of issue and by fraction
𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑛 𝑙𝑎𝑠𝑡 𝑑𝑎𝑦 𝑜𝑓 𝑞𝑢𝑜𝑡𝑎𝑡𝑖𝑜𝑛 (𝑐𝑢𝑚 𝑟𝑖𝑔𝑕𝑡𝑠)

𝑇𝑕𝑒𝑜𝑟𝑒𝑡𝑖𝑐𝑎𝑙 𝑒𝑥 − 𝑟𝑖𝑔𝑕𝑡𝑠 𝑝𝑟𝑖𝑐𝑒
ii. Multiply the number of shares after the rights issue by the fraction of the year
after the date of issue and add to the figure arrived in (i).
The total earnings should then be dividend by the total number of shares so calculated.
Example:
Brains Company had 100,000 shares in issue, and then makes a 1 for 5 rights issue on October 1st
20x2 at a price $1. The market value on the last day of quotation cum rights $1.60. Calculate the
EPS for 20x2 and the corresponding figure for 20x1 given total earnings of $50,000 in 20x2 and
$ 40,000 in 20x1. Assume December 31st year end.
Before issue 5 shares, value x $1.6 8.00

Rights issue 1 share, value x 1.00 1.00
Theoretical value of 6 share 9.00
Theoretical ex-rights price = $9/6 =$1.5
EPS for 20x1:

Calculated before taking into account the rights issue = 40cts ($40,000 divided by 100,000
shares)
1.50𝑥40𝑐𝑡𝑠
𝐸𝑃𝑆 = = 37.5𝑐𝑡𝑠
1.60
(This is the corresponding value for 20x1 which will be shown in the income statement for brains
co. at the end of 20x2)
EPS for 20x2:

Number of shares before rights issue was 100,000. 20,000 were issued.
Shares
9 1.6
Step 1, 100,000𝑥 12 𝑥 1.50 = 80,000
3
Step 2, 120,000 𝑥 = 30,000
12
Total number of shares 110,000

74
550,000
𝐸𝑃𝑆 = = 45.5𝑐𝑒𝑛𝑡𝑠
110,000
Diluted earnings per share

Equity share capital may change in the future owing to circumstances which exist now-known as
dilution. The provision of diluted EPS figure attempts to alert shareholders to the potential
impact of EPS. Examples of dilutive factors are:
 The conversion terms for convertible bonds
 The conversion terms for convertible preference shares
 The exercise price for options and the subscription price for warrants
Basic principles of calculating diluted earnings per share

To deal with potential ordinary shares, adjust basic earnings and number of shares assuming
convertibles, options etc. had converted to equity shares on the first day of the accounting period,
or on the date of issue, if later.
DEPS is calculated as follows:
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒𝑠 + 𝑛𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝑒𝑥𝑡𝑟𝑎 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠𝑕𝑎𝑟𝑒𝑠 + 𝑛𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝑒𝑥𝑡𝑟𝑎 𝑠𝑕𝑎𝑟𝑒𝑠
Convertibles
The principles of convertible bonds and convertible preference shares are similar.
If the convertible bonds/preference shares have been converted:
 The interest/dividend would be saved therefore earnings would be higher
 The number of shares would increase.
Options and warrants to subscribe for shares

An option or warrant gives the holder the right to buy shares at some time in the future at a
predetermined price.
Cash does not enter the entity at the time option is exercised, and the DEPS calculation must
allow for this.
The total number of shares in issue on the exercise of the option or warrant is split in to two:
 The total number of shares that would have been issued if the cash received had been
used to buy shares at fair value (using the average price the shares during the period)
 The remainder, which are treated like a bonus issue (i.e. as having been issued for that
consideration)

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The number of shares issued for no consideration is added to the number of shares when
calculating the DEPS.
Example of diluted earnings per share with options
A company had 8.28 million shares in issue at the start of the year and made no issue of shares
during the year ended 31 st December 20x4, but on that date there were outstanding options to
purchase 920, 000 ordinary $1share at $1.70 per share. The average fair value of ordinary share
was $1.80. Earnings for the year ended 31 st December was $2,208,000.
Calculate the fully diluted EPS for the Year ended 31st December 20x4.
Solution:
Steps
a) Determine how much the shareholders will pay for at the option price.
b) Determine how many shares the shareholder will receive if the shares were bought at
market price (fair value)
c) Determine the shares issued for free and add this to existing shares to arrive at total
assumed shares hence calculate diluted earnings per share.
Calculations:
1) Options 920,000𝑥1.70 = $1,564,000
1,564 ,000
2) At fair value, the shares bought with $1,564,000 are = 868,889
1.80
3) Number of shares issued free 920,000 − 868,889
4) Total shares for calculating DEPS 8,280,000 + 51,000 = 8,331,111
2,208 ,000
5) DEPS=8,331 ,111 = 26.5 𝑐𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒
Disclosure of EPS
The following information should be disclosed for both basic and diluted EPS:
 The profit or loss used as numerator and reconciliation of those amounts to the net profit
or loss for the period
 The weighted average number of ordinary shares used as the denominator and a
reconciliation of the denominator to each other
Importance of basic earnings per share

1. The figure EPS is used to compute the major stock market indicator of performance, the
price earnings ratio (P/E ratio). The calculation is as follows:
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑕𝑎𝑟𝑒

𝑃 𝐸 𝑟𝑎𝑡𝑖𝑜 =
𝐸𝑃𝑆
2. EPS shows the amount of earnings available to each ordinary shareholder. It indicates the
potential return on individual investments.
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Importance of diluted earnings per share
1. It shows what the current years EPS would be if all the dilutive potential ordinary shares
in issue had been converted.
2. It can be used to asses trends in the past performance
3. In theory, it serves as a warning to equity share holders that the return on their investment
may fall in future periods
Limitations of EPS
(a) It does not take into account of inflation. Apparent growth in earnings may not be real.
(b) It is based on historical information therefore does not necessarily have predictive value
(c) An entity‘s earnings are affected by the choice of the accounting policies. Therefore it
may not always be appropriate to compare EPS of different companies
(d) DEPS is only an additional measure of past performance despite looking at future
potential shares.
IFRS 8 — Operating Segments
Many entities produce and market a variety of products and services and also operate in many
geographical areas of the world. Each of these products and geographical areas are naturally
subject to different rates of profitability, risks, opportunities etc.
The objective of IFRS 8 is to establish principles for reporting financial information by the
segment. An example of a company operating segment is General electric which has the
following segments: commercial finance, healthcare products, industrial products, infrastructure,
NBC universal etc
IFRS8 operating segment requires particular classes of entities (essentially those with publicly
traded securities) to disclose information about their operating segments, products and services,
the geographical areas in which they operate, and their major customers. Information is based on
internal management reports, both in the identification of operating segments and measurement
of disclosed segment information.
Scope of IFRS 8
IFRS 8 applies to the separate or individual financial statements of an entity (and to the
consolidated financial statements of a group with a parent):
 whose debt or equity instruments are traded in a public market or

 That files, or is in the process of filing, its (consolidated) financial statements with a
securities commission or other regulatory organization for the purpose of issuing
any class of instruments in a public market

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However, when both separate and consolidated financial statements for the parent are presented
in a single financial report, segment information need be presented only on the basis of the
consolidated financial statements
Operating segments
An operating segment is a component of an entity:
 That engages in business activities from which it may earn revenues and incur expenses
(including revenues and expenses relating to transactions with other components of the
same entity)
 whose operating results are reviewed regularly by the entity's chief operating decision
maker to make decisions about resources to be allocated to the segment and assess its
performance and
 for which discrete financial information is available
Reportable segments
An entity is required to report financial and descriptive information about its reportable
segments. Reportable segments are operating segments or aggregations of operating segments
that meet specified criteria for determining reportable segment
Determination of Reportable segments
IFRS does not set on the number of reportable segment an entity should report on.
In order to establish whether a segment is reportable segment, the standard suggests using a
quantitative threshold. A reporting segment may come up applying aggregation criteria.
a) Quantitative threshold
Segments must be reported on separately if they meet any of the following criteria
i. Reported revenue (internal and external) is more than 10 % of the combined revenue
(internal and external) of all operating segments.
ii. The absolute measure of its reported profit or loss is 10 % or more of the greater, in
absolute amount, of
 the combined reported profit of all operating segments that did not report a loss and
 the combined reported loss of all operating segments that reported a loss; or
iii. Assets are 10 % or more of the combined assets of all operating segments.
The reportable segment should report at least 75% of the entity‘s revenue.

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If the total external revenue reported by operating segments constitutes less than 75 per cent of
the entity's revenue, additional operating segments must be identified as reportable segments
(even if they do not meet the quantitative thresholds set out above) until at least 75 per cent of
the entity's revenue is included in reportable segments.]
IFRS 8 does not define ―Total revenue‖. However, the total entity revenue should be interpreted
as the entity‘s external revenue; the additional segments are required to be reported until 75%
criteria is fulfilled.
b) Aggregation criteria
Operating segments can be combined if they have similar economic characteristics. Two or more
operating segments can be aggregated into one single operating segment if aggression is
consistent with the core principles of IFRS 8, the segments have similar characteristics, and the
segments are similar in each of the following characteristics:
 The nature of products and services

 The types or class of customers for their products and services
 The methods used to distribute their product or provide their services
 The nature of the regulatory environment e.g. banking, insurance or public utilities
Segments that do not individually exceed the 10% threshold limit may be aggregate:
i. If the operating segments have similar characteristics and

ii. Share a majority of the features of aggregation criteria
Usefulness of segment information
1) Comparative assessment of segment risk and returns

It offers critical yardsticks for comparison of performance across divisions and it is a very
useful tool for decision making
2) Enables more informed judgements about the entity as a whole

It is possible to derive the profitability of each segment
3) Investors are aided in forecasting consolidated sales and net income
Investors can make investment decisions on the basis of future growth of the company.
Investors can identify the most profitable segment of the company and the future
prospects of the product and the company
4) Comparative analysis of the company and its competitors

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The disclosures with respect to segment information will enable the compilation of
industry data. This enables the company to compare its performance with that of the
competitors.
5) It is also valuable to employees, creditors and government

Just like other financial statements, employees, creditors and the government are
stakeholders in information depicted in segments
Problems with segment reporting
i. Risk of information being passed to competitors especially if too much information is

revealed in segment reports
ii. Inconsistency in determination of segments. Not all companies follow a similar method
for determining segments
iii. Burden for smaller companies. The type of information required by IFRS 8 may be too
time consuming for small organizations
iv. Problem faced by auditors: if the auditor discloses too much information, the client may
play into the hands of competitors, if the auditor discloses too little information; this
might raise the ire of the regulatory authorities
v. Difficulty in allocating revenue and expenses to different segments. The basis of
allocation which is chosen can have a material effect on the segment result. Therefore,
the financial statements of different entities may not be comparable
Disclosure requirements
Suggested information prepared should contain the following.
1. general information
This should contain:
 The various factors used to identify the reportable segments. For example geographical
area or differences in products
 The types of products and services from which each operating segment derives its
revenues
2. Information about the reported segment profit or loss, including certain specified
revenues and expenses included in segment profit or loss, segment assets and segment
liabilities, and the basis of measurement

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3. Reconciliations of the totals of segment revenues, reported segment profit or loss,
segment assets, segment liabilities and other material items to corresponding items in the
entity's financial statements
4. some entity-wide disclosures that are required even when an entity has only one
reportable segment, including information about each product and service or groups of
products and services
5. analyses of revenues and certain non-current assets by geographical area – with an
expanded requirement to disclose revenues/assets by individual foreign country (if
material), irrespective of the identification of operating segments
6. information about transactions with major customers

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QUESTIONS:
Earnings per share
Question one:
Bridgeview had the following capital and reserves on 1st January 2009
Ksh
Share capital (Kshs 1 Ordinary shares) 7,000,000
Revaluation reserve 500,000
Retained earnings 9,000,000
Shareholders‘ funds 17,400,000
Bridgeview issues 2 Millions Kshs 1 ordinary share on 1st April 2009. Bridgeview‘s results are
as follows:
Profit after tax for 2009 was Kshs 1,150,000
Calculate basic earnings per share for 2009.
Question two:
On December 31st 20x1, the issued share capital of Rafiki enterprises consisted of 4,000,000
ordinary shares of Kshs 25 each and the shares were quoted at ksh.50 per share. Its trading
results for the last two years were as follows:
Profit after tax for 20x1 was Kshs 3,200,000 and 4,250,000 for 20x2
Show the calculation of the basic EPS to be presented in the financial for the year ended 31st
December 20x2, including comparative figures.
Question three:
A company had 8.28 million shares in issue at the start of the year and made no issue of shares
during the year ended 31 st December 20x4, but on that date it had in issue $2,300,000. 10%
convertible loan stock 20x6 – 20x9. Assume a corporation tax rate of 30%. The earning for the
year was $2,208,000. The loan stock will be convertible into ordinary $1 share as follows.
20x6 90 $1 shares for $100 nominal value loan stock

Calculate the fully diluted EPS for the year ended 31st December 20x4.
Question four:
On 31st December 20x0 a company had in issue 8,000,000 ordinary shares of Kshs 10 each, On
January 1st of 20x1, the company issued 10%, 10,000,000 preference shares of Kshs 10 each.

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The preference shares are convertible to ordinary shares at a rate of 1 ordinary share for 100
preference shares in future. The after tax earnings were ksh 3,000,000.
Calculate the fully diluted earnings per share at end of December 20x1.
QUESTION
The following information is extracted from the books of Viwanda for the year ended 31
ended March 2004:
Sh‖Million‖ Sh‖Million‖
Sales:
Food products 5 650
Plastic and packaging 625
Pharmaceutical 345
Others 162 6 782
Expenses:
Food products 3 335
Pharmaceutical 222
Others 200 4 182
Other items:
General operating expenses 562
Income from investments 132
Interest expenses 65
Identifiable assets:
Food products 7 320
Plastic and packaging 1 320
Pharmaceutical 1 050
Others 665 10 355
General assets: 722
1. Inter-segment sales for the year ended 31 March 2004, were as follows:
Sh‖Million‖
Food products 55
Pharmaceutical 21
Others 7
2. Operating profit includes sh. 33 000 000 on intersegment sales
3. Information about intersegment expenses is not available

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Required:
Segmental financial information, in conformity with the requirements if IAS 14 (segment

reporting), for the year ended 31 March 2004.
Viwanda ltd
Segment report for the year ended 31st march 2004
Food Plastics & Pharma- others Interseg- Consolidated
products packaging ceuticals mentation figures
Sh `m` Sh `m` Sh `m` Sh `m` Sh `m` Sh `m`
Revenues:
Sales to unaffiliated customer 5 595 553 324 155 6 627
Intersegment sales 55 72 21 7 155
Total revenue 5 650 625 345 162 155 6 627
Segment expenses (3 335) (425) (222) (200) (122) (4 060)
Operating profit 2 315 200 123 (38) 33 2 567
Other items:
General corporate expenses (562)
Income from investments 132
Interest expenses (65)
Income:continuing operation 2 072
Identifiable assets 7 320 1 320 1 050 665 10 355
General corporate assets 722
Total assets 11 077
Adjustments that may be necessary to make financial statements comparable
One of the qualitative characteristics of useful financial statement is comparability; however,

sometimes it may not be easy to compare results of companies owing to size. In this case there
are two measures which can be taken to compare two companies of different sizes:
1) Use of common size financial statements where all the accounts heading are expressed in
terms of percentages.
2) Use of ratios will also make even financials of companies of different sizes comparable.
There is however adjustments which are necessary owing to different accounting policies of
companies or practices which may emanate from the management and directors deliberate
attempt to manipulate accounts.
3) Revaluation of assets may be necessary to reflect their true value and the same time
reflect the true year‘s depreciation. For comparison is made possible.
4) Allowance need to be made for uncollectible accounts to reflect the true value of
collectible accounts

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5) In case inventory was kept in the books at cost, then it may be imperative to adjust the
value of inventory to the lower of cost or net realizable value.
6) Unrecognized provisions and contingencies should be included so as to capture the entire
expenses attendant to the business.
7) Incase accounts were prepared strictly on cash basis, adjustments should be made to
restate accounts to reflect accrual concept since accrual method of accounting is the only
one that shows results of past operations accurately.

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CHAPTER FOUR
OTHER INTER-CORPORATE INVESTMENTS
A strong understanding of accounting rules and treatments is the backbone of quality financial
analysis. Whether you're an established analyst at a large investment bank, working in a
corporate finance advisory team, just starting out in the financial industry or still learning the
basics in school, understanding how firms account for different investments, liabilities and other
such positions is a key in determining the value and future prospects of any business. In this
article we will examine the different categories of intercorporate investments and how to account
for them on financial statements.
Intercorporate investments are undertaken when companies invest in the equity or debt of other
firms. The reasons behind why one company would invest in another are many, but could
include:
1. the desire to gain access to another market

2. increase its asset base
3. Gain a competitive advantage or simply increase profitability through an ownership (or
creditor) stake in another company.
A company can have investments in other companies in the form of: ordinary shares, preference
shares and loan stock. The investment in ordinary shares leads to ownership and therefore
requires further consideration. The investment in the ordinary shares can be summarized
diagrammatically as follows;
> 50% O.S.C

A
50% O .S. C
B
THE FIRM
<50% but>=20% O.S.C
<20% O. S. C
D
NOTE;
1. Company A is referred to as a subsidiary company and is accounted as per the requirements

of 1AS 27 ―subsidiary company and separate financial statements.‖
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2. Company B is a jointly controlled entity and is accounted for according to the requirements
of 1AS 31 ―joint ventures‖.
3. Company C is an Associate company and is accounted for as per requirements of 1AS/28

―Associate companies‖.
4. Company D is a pure investment accounted for as per requirements of 1AS 32 and 39

―financial instruments.
Jointly controlled entities and pure investments are beyond scope.
Investments in Financial Assets

An investment in financial assets is typically categorized as having ownership of less than
20% in an investee. Such a position would be considered a "passive" investment because in
most cases an investor would not have significant influence or control over an investee.
At acquisition, the assets (investment in investee) are recorded on the investing firm's
(investor) balance sheet at fair value. As time elapses and the fair value of the assets
changes, the accounting treatment will be dependent upon the classification of the assets.
Assets are classified as:
 Held-to-Maturity
These are debt securities intended to be held till maturity. Long-term securities will be
reported at amortized cost on the balance sheet, with interest income being reported on
the investee's income statement.
 Held-for-Trading
Equity and debt securities held with the intent to be sold for a profit (hopefully) within a
short time-horizon, typically three months. They are reported on the balance sheet at fair
value, with any fair value changes (realized and unrealized) being reported on the income
statement, along with any interest or dividend income.
 Available-for-Sale
These are neither held-to-maturity nor held-for-trading. Available-for-sale securities are
similar to held-for-trading securities, however only realized changes in fair value are
reported on the income statement (along with dividend and interest income), with all
unrealized changes being reported as a component of shareholders' equity on the balance
sheet.
The choice of classification is an important factor when analyzing financial asset investments. A
firm that classifies securities as held-for-trading would report higher earnings if the fair value of
the investment rises than if it had classified the investment as held-for-sale, since unrealized fair
value changes in held-for-trading securities are reported on the firm's income statement, while a
similar change in held-for-sale securities would be reported in shareholders' equity. Additionally,
GAAP does not allow firms to reclassify investments which have been originally classified as
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held-for-trading or designated as fair value investments. So the accounting choices made by
investing companies when making investments in financial assets can have a major effect on its
financial statements.
Investments in Associates
An investment in an associate is typically an ownership interest of between 20-50%. Although
the investment would generally be regarded as non-controlling, such an ownership stake would
be considered influential, due to the investor's ability to influence the investee's managerial team,
corporate plan and policies along with the possibility of representation on the investee's board of
directors.
An influential investment in an associate is accounted for using the equity method of

accounting. In this method original investment is recorded on the balance sheet at cost (fair
value). Subsequent earnings by the investee are added to the investing firm's balance sheet
ownership stake (proportionate to ownership), with any dividends paid out by the investee
reducing that amount. The dividends received from the investee by the investor however are
recorded on the income statement.
The equity method also calls for the recognition of goodwill paid by the investor at acquisition,
with goodwill defined as any premium paid over and above the book value of the investee's
identifiable assets. Additionally, the investment must also be tested periodically for impairment.
If the fair value of the investment falls below the recorded balance sheet value (and is considered
permanent), the asset must be written-down. A joint venture, whereby two or more firms share
control of an entity, would also be accounted for using the equity method.
A major factor that must also be considered for the purpose of investments in associates is
intercorporate transactions. Since such an investment is accounted for under the equity method,
transactions between the investor and the investee can have a significant impact on both
companies' financials. For, upstream (investee to investor) and downstream (investor to
investee), the investor must account for its proportionate share of the investee's profits from any
intercorporate transactions.
Keep in mind that these treatments are general guidelines and not hard rules. A company that
exhibits significant influence over an investee with an ownership stake of less than 20% should
be classified as an investment in an associate. While a company with a 20-50% stake that does
not show any signs of significant influence could be classified as only having an investment in
financial assets.

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Business Combinations
Business combinations are categorized as one of the following:
 Merger – The acquiring firm absorbs the acquired firm, which from acquisition will
cease to exist.
 Acquisition – The acquiring firm along with the newly acquired firm continue to exist,
typically in parent-subsidy roles.
 Consolidation – The two firms combine to create a completely new company.
 Special Purpose Entities – An entity typically created by a sponsoring firm for a single
purpose or project.
When accounting for business combinations the acquisition method is used. Under the
acquisition method, both the companies' assets, liabilities, revenues and expenses are combined.
If the ownership stake of the parent company is less than 100%, it is necessary to record a
minority interest account on the balance sheet to account for the amount of the subsidiary not
controlled by the acquiring firm.
The purchase price of the subsidiary is recorded at cost on the parent's balance sheet, with any
goodwill (purchase price over book value) being reported as an unidentifiable asset. In a case
where the fair value of the subsidiary falls below the carrying value on the parent's balance sheet,
an impairment charge must be recorded and reported on the income statement.
Conclusion
when examining the financial statements of companies with intercorporate investments, it is
important to watch for accounting treatments or classifications that do not seem to fit the
actualities of the business relationship. While such instances shouldn't automatically be looked at
as "tricky accounting," being able to understand how the accounting classification effects a
company's financial statements is an important part of financial analysis.
SUBSIDIARY COMPANIES (1AS 27)
A subsidiary company is a company in which the investing company (also called parent or parent
company) controls the financial and operating policies of the subsidiary company.
In most cases, control is evidenced (but not limited) to owning more than 50% of the ordinary
share capital of the subsidiary company. Control may also be exercised in the following ways;
i) The parent company owning more than 50% or the voting rights in the company or
subsidiary company.
ii) The parent company being able to appoint majority of the directors in the board of directors.
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iii) The parent company carrying out favourable transactions with the subsidiary e.g. sale and
purchase of goods at a price below the market value.
The substance of the relationship between parent company and subsidiary company is the
effectively, the parent company controls the subsidiary company. This means that the parent
company controls the assets of the subsidiary company and is liable to the debts of the subsidiary
company.
1AS 27 therefore requires that the parent a company should include the financial results of the
subsidiary company in its own financial statements. The process involves adding the assets,
liabilities and incomes and expenses of the subsidiary company to those of the parent company
while excluding inter-company transactions and balances. This process is called consolidation
and the combined financial statements are called Group accounts or consolidated accounts.
1AS 27/IAS 1 requires the parent company to present the following in its published financial
statements.
i) A consolidated income statements

ii) A consolidated statement of changes in equity
iii) A consolidated statement of financial position
iv) A consolidated statement of cash flow
v) Group notes to the accounts.
1AS 27 also requires the parent company to present its own financial statements separately i.e.
excluding the subsidiary company.
The purpose of consolidated accounts is to:

1. Present financial information about a parent undertaking and its subsidiary undertakings
as a single economic unit.
2. Show the economic resources controlled by the group
3. Show obligations of the group and
4. Show the results the group achieves with its resources.
GROUP STRUCTURES
A group structure is the relationship between the parent company and its subsidiaries. There are
normally four main types of group structures (apart from the parent company and one subsidiary)
i.e.
i) parent company with more than one subsidiary company,

ii) parent company with a subsidiary company that has a subsidiary company (Sub-subsidiary),
iii) parent company with direct investment in sub-subsidiary company,
iv) Multiple group structures

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Consolidated financial statements under the entity concept
Consolidated financial statements are prepared by replacing the cost of investments with the
individual assets and liabilities underlying the investment. If the subsidiary is partly owned, all
assets and liabilities of subsidiaries are consolidated, but the non-controlling shareholders
interest in those net assets is presented.
Definition:
IAS 27 consolidated and separate financial statements use the following definitions:
Subsidiary – An entity that is controlled by another entity (known as parent)
Control – the power to govern the financial operating policies of an entity so as to benefit from
its activities.
Control is usually based on ownership of more than 50% of voting power, but other forms of
control are possible.
Other forms include:

According to IAS 27 four other situations where control can exist are when the parent has power
to:
1. Over more than half the voting rights by virtue of an agreement with other investors.
2. To govern the financial and operating policies of an entity under statute or an agreement
3. To appoint or remove the majority of the members of the board of directors
4. To cast the majority of votes at a meeting of the board of directors
Example:
Z is considering an investment on west, the capital structure of which is as follows 10,000 A
voting ordinary shares 10,000 B non-voting ordinary shares. Both classes of shares have the
same dividend rights:
Describe the appropriate group accounting for west if
i. Z purchases 6,000 of A ordinary shares.__(60%)
ii. Z purchases 10,000 B and 4,000 A ordinary shares__(associate)
Answer to Example
i. It is the voting share that gives Z the influence on west. Z should control west in this
case. West will therefore be treated as a subsidiary because Z owns 60% of the voting
shares in west.
ii. As Z has less than 50% of the voting shares this time Z will not probably nor be able to
control west therefore west will not be treated as a subsidiary
IAS 27 requires that consolidated financial statements shall include all subsidiary of the parent.
The two exceptions to these rules are:
1. Lack of effective control – the excluded should be accounted for as an investment in
accordance with IAS 39
Subsidiary held for resale – held for resale subsidiary is treated as a current asset investment
and valued at lower of the carrying amount and fair value less cost to sell
Principles of consolidation

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1. Non-conterminous
Some companies in the group may have differing accounting dates in practice; such companies
will often prepare financial statements up to the group accounting date for consolidation
purposes.
For purpose of consolidation, IAS allows use of financial statements made up to date not more
than three months earlier or later than the parent reporting date, with due adjustment for
significant transactions or other events between the dates.
2. Uniform accounting policies

All groups companies should have the same accounting policies. If the group member uses
different accounting policies, its financial statements must be adjusted to achieve consistency
before they are consolidated
3. Eliminating intra-group transactions

This must be eliminated on consolidation in order to achieve the main objective of group
financial statements, i.e. to show the position of the group as if it were a single economic entity.
A group cannot trade with itself, nor can it make a profit out of itself. In a similar way cannot
increase its sales or its net assets by transferring assets and liabilities between members of the
group
Related parties
Two parties are considered related if
1. One party has the ability to control the other party or
2. One party has the ability to exercise significant influence over the other party or
3. The parties are under common control. Therefore
1. A company that is a subsidiary is a related party of its parent company
2. This means that the financial statement may have been affected by related party
transactions
Types of transactions that may occur between the parent and subsidiary (related parties) and their
impact on the financial statements of the individual company and the group are:
Transactions Potential impact

Sales and purchases Favourable prices, affecting profits, advantageous
settlement terms, affecting receivables and payables
Finance Favourable rates of interest, affecting profits
Non-current assets Favourable terms for cost financing
Promotion services At minimal or no cost, affecting profits
Guarantees for loans and overdrafts Without which they wouldn‘t have been granted

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Even when related party transactions are at arm‘s length, it‘s important to realize that they are
related party transactions. This is because it is quite possible that they would not have occurred
but for the relationship.
IAS 24 Related Party Disclosures
IAS 24 Related Party Disclosures requires disclosures about transactions and outstanding
balances with an entity's related parties. The standard defines various classes of entities and
people as related parties and sets out the disclosures required in respect of those parties,
including the compensation of key management personnel.
IAS 24 was reissued in November 2009 and applies to annual periods beginning on or after 1
January 2011.
Summary of IAS 24
Objective
The objective of IAS 24 is to ensure that an entity's financial statements contain the disclosures
necessary to draw attention to the possibility that its financial position and profit or loss may
have been affected by the existence of related parties and by transactions and outstanding
balances with such parties.
Who are related parties?
A related party is a person or entity that is related to the entity that is preparing its financial
statements (referred to as the 'reporting entity') [IAS 24.9].
(a) A person or a close member of that person's family is related to a reporting entity if
that person:
(i) Has control or joint control over the reporting entity;
(ii) Has significant influence over the reporting entity; or
(iii) Is a member of the key management personnel of the reporting entity or of a

parent of the reporting entity.
(b) An entity is related to a reporting entity if any of the following conditions applies:
(i) The entity and the reporting entity are members of the same group (which
means that each parent, subsidiary and fellow subsidiary is related to the others).

93
(ii) One entity is an associate or joint venture of the other entity (or an associate or
joint venture of a member of a group of which the other entity is a member).
(iii) Both entities are joint ventures of the same third party.
(iv) One entity is a joint venture of a third entity and the other entity is an
associate of the third entity.
(v) The entity is a post-employment defined benefit plan for the benefit of
employees of either the reporting entity or an entity related to the reporting entity.
If the reporting entity is itself such a plan, the sponsoring employers are also
related to the reporting entity.
(vi) The entity is controlled or jointly controlled by a person identified in (a).
(vii) A person identified in (a)(i) has significant influence over the entity or is a
member of the key management personnel of the entity (or of a parent of the
entity).
(viii) The entity, or any member of a group of which it is a part, provides key
management personnel services to the reporting entity or to the parent of the
reporting entity*.
* Requirement added by Annual Improvements to IFRSs 2010–2012 Cycle, effective for annual
periods beginning on or after 1 July 2014.
The following are deemed not to be related:
 two entities simply because they have a director or key manager in common
 two venturers who share joint control over a joint venture
 providers of finance, trade unions, public utilities, and departments and agencies of a
government that does not control, jointly control or significantly influence the reporting
entity, simply by virtue of their normal dealings with an entity (even though they may
affect the freedom of action of an entity or participate in its decision-making process)
 a single customer, supplier, franchiser, distributor, or general agent with whom an entity
transacts a significant volume of business merely by virtue of the resulting economic
dependence
What are related party transactions?
A related party transaction is a transfer of resources, services, or obligations between related

parties, regardless of whether a price is charged.

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Disclosure
Relationships between parents and subsidiaries. Regardless of whether there have been
transactions between a parent and a subsidiary, an entity must disclose the name of its parent
and, if different, the ultimate controlling party. If neither the entity's parent nor the ultimate
controlling party produces financial statements available for public use, the name of the next
most senior parent that does so must also be disclosed. [IAS 24.16]
Management compensation. Disclose key management personnel compensation in total and for
each of the following categories: [IAS 24.17]
 short-term employee benefits

 post-employment benefits
 other long-term benefits
 termination benefits
 share-based payment benefits
Key management personnel are those persons having authority and responsibility for planning,
directing, and controlling the activities of the entity, directly or indirectly, including any directors
(whether executive or otherwise) of the entity. [IAS 24.9]
If an entity obtains key management personnel services from a management entity, the entity is
not required to disclose the compensation paid or payable by the management entity to the
management entity‘s employees or directors. Instead the entity discloses the amounts incurred by
the entity for the provision of key management personnel services that are provided by the
separate management entity*. [IAS 24.17A, 18A]
* These requirements were introduced by Annual Improvements to IFRSs 2010–2012 Cycle,

effective for annual periods beginning on or after 1 July 2014.
Related party transactions. If there have been transactions between related parties, disclose the
nature of the related party relationship as well as information about the transactions and
outstanding balances necessary for an understanding of the potential effect of the relationship on
the financial statements. These disclosure would be made separately for each category of related
parties and would include: [IAS 24.18-19]
 the amount of the transactions

 the amount of outstanding balances, including terms and conditions and guarantees
 provisions for doubtful debts related to the amount of outstanding balances
 expense recognised during the period in respect of bad or doubtful debts due from related
parties

95
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
Its basic principle is to show all assets and liabilities of the parent and subsidiary. The
consolidated statement of financial position involves adding assets and liabilities of the
subsidiary to those of the parent company while excluding inter-company balances
Method of preparing consolidated SOFP

1) The investment in the subsidiary(s) shown in the parent‘s statement of financial position
is replaced by the net assets of the subsidiary
2) The cost of investment in subsidiary is effectively cancelled with ordinary shares capital
and reserves of the subsidiary. This leaves a consolidated statement of financial position
showing
4. Net assets of the whole group
5. The share capital of the group which always equals the share capital of the parent only.
6. The retained profits comprising profits made by the group (i.e. all parent‘s historical
profits plus the profits made by the subsidiary post-acquisition)
Example:
Statements of financial position as at 31st

20x4
Parent(P) Subsidiary(S)‘000‖
$‘000‘
Non- 60 50
current
assets
Investment 50 -
in S at cost
Current 40 40
assets
150 90
Ordinary 100 40
share
capital
Retained 30 10
earnings
Current 20 40
liabilities
150 90
P acquired all shares of S on 31 December 20x4 for a cost of $50,000. Prepare consolidated
SOFP

96
Suggested Answer:
Parent Ltd consolidated SOFP

$‘000‘
Non-current assets (60+50) 110
Investment in S at cost (40+40) 80
190
Ordinary share capital 100
Retained earnings 30
Current liabilities 60
190
Good will on consolidation
Good will on consolidation arises when the purchase consideration paid by the holding company
is different from the value of the net assets acquired in the subsidiary company.
If purchase consideration is more than net assets acquired, then the difference is positive
goodwill and if purchase considered is less than net assets acquired, then the difference is
negative goodwill.
Goodwill will thus be computed in the following two ways;
Method1.
Partial Goodwill (old method)
£
Cost of investment in subsidiary xx
Less: share of net assets acquired (on date of acquisition) (x)
xx/(xx)
Method 2
Full goodwill (new method)
£ £
Cost of investment in subsidiary xx
less: Ordinary share capital of subsidiary xx
Goodwill-parents share xx
Fair value of NCI xx
less: Non-controlling share of net assets of acquisition (xx)
Goodwill - NCI xx
Total goodwill xx

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This method is known as full goodwill method as it results in 100% of the goodwill being shown
in the group SOFP that belongs to the shareholders of the parent and that belonging to the NCIS
Positive goodwill is presented as a non-current asset on the face of the consolidated SOFP of the
SOFP and is subject to impairment and reviews to assess whether its value has fallen.
NOTE: Total assets less total liabilities i.e. net assets are the same as shareholders funds. The
most common approach used in computing goodwill is by preparing an account called cost of
control whereby the cost of investment is posted on the debit side and the parent company share
of the ordinary share capital, capital reserves and revenue reserves on the date of acquisition in
the subsidiary company are posted on the credit side. The balancing figure in that account is
goodwill.
Example:
Mzalendo acquired 80% of the ordinary share capital of KANU on 31December 20x7 for
$78,000. At this date, net assets of KANU were $85,000. What is the goodwill that arose on the
acquisition?
i. If the NCI is valued using the proportion of net assets mentioned
ii. If the NCI is valued using the full goodwill method and the fair value of NCI on the
acquisition dates is $21,000
Answer:
i) Purchase consideration 78,000
Share of subsidiaries assets (80%x85,000) (68,000)
Goodwill arising 10,000
ii) Cost of investment 78,000

80% of net assets at acquisition (80%x85,000) (68,000)
Goodwill-parent share 10,000
Fair value of NCI at acquisition 21,000
NCI net asset after acquisition (20%x85,000) (17,000)
Goodwill NCI 4,000
Total goodwill 14,000
Steps in consolidation:
i) Establish the groups structure i.e. the percentage ownership by the parent company.
ii) Establish subsidiary‘s net assets at date of acquisition and net asset at reporting date
iii) Calculate goodwill
iv) Establish non-controlling interest
v) Establish parent retained earnings and parent share of subsidiary past acquisition retained
earnings.

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Pre-requisition profit and group reserves
Retained profits ideally should be the amounts that can be distributed as dividends.
Therefore, in arriving at group retained profits, careful attention should be paid to the profits
of the subsidiary company. All the profits of the parent company can be distributed or are
distributable.
However, the subsidiaries profits belong to both the parent company and the Non-controlling
interest. Thus the share that belongs to the Non-controlling interest will be transferred to the
Non-controlling interest‘s account.
The remaining profits that belong to the parent company should be split between pre-
acquisition profits and post acquisition profits.
The pre acquisition profits are the profits in the subsidiary company on the date of
acquisition and are thus used in computing goodwill.
The post acquisition profits relate to the period after acquisition and can thus be distributed
or can be paid out to the shareholders of the parent company. They should thus form part of
the group retained profits.
In summary, the group-retained profit is made up of: -
£
Parent company‘s retained profits x
Add: Parent company‘s share of post acquisition retained profits In x
subsidiary company
xx
Non-controlling interest (NCI)
When the parent company owns less than 100% of the ordinary share capital of the
subsidiary company then the other balance is held by Non-controlling interest. Therefore if
the parent company owns 80% of the ordinary share capital of the subsidiary then the Non-
controlling interest owns 20%. The Non-controlling interest (NCI) should be shown
separately in the consolidated statement of financial position but as part of shareholders
funds and the figure to appear in the statement of financial position will be made up of the
following.
-Non-controlling interest share of the ordinary share capital in subsidiary on statement of

financial position date
-Non-controlling interest share of capital reserves in subsidiary company on statement of
-Non-controlling interest share of revenue (retained profits) in subsidiary company on
statement of financial position date.

99
Alternatively, the total due to the Non-controlling interest can be prepared by opening the
Non-controlling interest account whereby the Non-controlling interest‘s share of the ordinary
share capital, capital reserves and retained profits in subsidiary company is posted to the
credit side.
Intra-group trading
The potential problem that arise when the parent and subsidiary trade with each other are:
i. Current accounts between subsidiary and parents
ii. Unrealized profit on sale of inventory
iii. Unrealized profit on sale of non-current assets
iv. Loan stock held by one company in the other
v. Dividends and loan interest
Current accounts
Sometimes the parent and subsidiary will trade with each other on credit, leading to a receivable
(current), in one company‘s SOFP and payables, (current) in the other company‘s SOFP
These amounts owed in the group rather than outside the group and therefore they must not
appear in the consolidated statement of financial position. They are therefore cancelled against
each other on consolidation.
Cash/goods in transit
At the year end, current accounts may not agree owing to the existence of goods in transit items
such as goods or cash.
The accounting treatment is as follows:
i. If the goods or cash are in transit between parent and subsidiary make the adjusting entry
to the SOFP of the recipient.
Dr. Cash in transit

Cr. Receivable current account
ii. If the goods were in transit make the adjustment to the recipient account
Dr. Inventory
Cr. Payable current account
Once in agreement, the current accounts may be crossed and cancelled as part of the process of
cross costing the assets and liabilities
This means therefore those reconciled current accounts are removed from both receivables and
payables in the consolidated statement of financial position.

100
IFRS 3: Position on goodwill
Goodwill is calculated as the excess of the consideration transferred and amount of any non-
controlling interest over the net of the acquisition date identifiable assets acquired and liabilities
assumed.
Treatment of Goodwill
Positive goodwill:
i. Goodwill is capitalized as an intangible non-current asset
ii. Goodwill is tested annually for possible impairment
iii. Amortization of goodwill is not permitted by the standard
Negative goodwill:
It arises when the cost of the investment is less than the value of net assets purchased.
Most likely reasons for negative goodwill is misstatement of the fair values of assets and
liabilities and accordingly the standard requires that the calculation be reviewed.
After such review any negative goodwill remaining is credited directly to statement of
comprehensive income.
Calculation of cost of acquisition
The cost of acquisition includes the following elements

7. Cash paid
8. Fair value of any other consideration
Fair value of net assets required
IFRS 3 revised, requires that subsidiary‘s assets and liabilities be recorded at their fair value for
the purpose of the calculation of goodwill and production of consolidated accounts.
Adjustments will therefore be required where the subsidiary‘s accounts themselves do not reflect
fair value
Question:
ABC purchased 60% of the ordinary share in sasha on 31 st December 2009 for Ksh.10,000,000
cash. At the date the SOFP of sasha showed net assets of Ksh.9,000,000 further investigations
revealed that the land held at cost of Ksh.1,700,000 had a market value of Ksh.4,000,000
What is the goodwill arising on acquisition using the proportion of net assets method?
Solution:
Cost of investment 10,000,000

Less: 60% of net assets at acquisition (60%x(9M+4M-1.7M) 6,780,000
Goodwill on acquisition 3,220,000
Unrealized profit

101
Profits made by members of the group on transactions with other group members are:
i. Recognized in the accounts of the individual companies concerned but
ii. In terms of the group as whole such profits are unrealized and must be eliminated from
the consolidated accounts.
Intra-group trading and unrealized profits in inventory
When goods have been sold by one Group Company at a profit and some of the goods are still in
purchaser‘s inventory at year end, then the profit arising on these goods is unrealized from the
view point of the group as a whole, because the group is treated as a single entity. Until the
goods are sold to an outsider party there is no realized profit from the group perspective.
Adjustment for unrealized profit in inventory
The process to adjust is:

i. Determine value of closing inventory included in an individual company‘s accounts
which have been purchased from another company in the group
ii. Use mark-up or margin to calculate how much of that value represents profit earned by
the selling company
iii. Make the adjustment: This will depend on who the seller is
(a) If the seller is the current company:

- The profit elimination included in the holding company accounts relates entirely to the
group. The adjustment required is:
Dr. Group retained earnings (Deduct the profit)

Cr. Group inventory (Deduct profit when consolidating inventory)
(b) Accounts and relates partly to the group and partly to NCI (if any)
Adjustments are:
Dr. Subsidiary retained earnings (deduct the profit)

Cr. Group inventory (deduct profit when consolidating inventory)
Example:
Suppose P owns 90% of S. During the year S sold goods to P at a cost plus 25%, at year
end closing inventory of P includes 800,000 of goods at invoice value acquired originally
from S. what adjustment are required in the consolidation working papers.
Answer:
Unrealized profit is 25/125 x 800,000 = 160,000
Journal entry is
Dr. Consolidated retained earnings 144,000
Dr. NCI 16,000
Cr. Consolidated inventory 160,000

102
Non-current assets
If one group member sells non-current assets to another group member the adjustment must be
made to recreate the situation that would have existed if the sale had not occurred (there would
have been no profit on the sale and depreciation would have been based on the original cost of
the assets of the group)
Adjustment for unrealized profit in the non-current assets
The easiest way to calculate the adjustment requires is to compare the carrying value (CV) of the
assets now with the CV that it would have held had the transfer not occurred:
Carrying Value at reporting date xx

CV at reporting date if intragroup transfer had not occurred (xx)
Adjustment required xx
The calculated amount should be

1. Deducted when adding across parent and subsidiaries non-current assets
2. Deducted in retained earnings of the seller
Acquisition During the year
If the parent company acquires the subsidiary during the year, the net assets of the date of
acquisition must be calculated based at the start of the subsidiaries financial year plus the profit
of up to the date of acquisition. It is normally assumed that the subsidiary profit after tax accrues
evenly over time.
CONSOLIDATED INCOME STATEMENT

Principles of consolidated income statement (CIS)
Basic principles
i) From the revenue to profit after tax include all parent income and expenses plus all of the
subsidiary incomes expenses reflecting control of the subsidiary
ii) After profit after tax deduct share due to non-controlling system (to reflect ownership)
Consolidation schedules
Parent Subsidiary Adjustment Total

(time apportioned)
Revenue xx xx (xx) xx
Cost of sales (xx) (xx) (xx) (xx)
Operating expenses (xx) (xx) (xx) (xx)
Finance cost (xx) (xx) (xx)
Income taxes (xx) (xx) (xx)
xx xx

103
Impairment of goodwill
Once any impairment has been identified during the year, the charge for the year will be passed
through the consolidated income statement. This will usually be through operating expenses
Total impairment to date is an adjustment in retained earnings in the consolidated statements of
financial position.
Non-controlling interest
This is calculated as NCI% x subsidiary profit after tax (taken from subsidiary column of
consolidation schedule)
Dividends
- A payment of a dividend by subsidiary to a parent need to be cancelled
- Only dividends paid by parents to its own shareholders appear in the consolidated
- Any dividend income shown in the consolidated income statement must arise from
investment in other than those in subsidiary associates
- The non-controlling interest in the subsidiary is calculated on the profit after tax and
before dividends. The figure therefore includes the NCI share of subsidiary dividends and
subsidiary earnings.
Fair values
If a depreciating non-current asset is revalued as part of fair value exercise when calculating
goodwill, these will result in an adjustment to the consolidated income statement.
The consolidated income statement income statement must include a depreciation charge based
on the fair value of the asset, included in the consolidated statement of financial position.
Extra depreciation must therefore be calculated charged to an appropriate cost category within
the consolidation schedule.
Sales, purchases and inventories

The effect of intra-group trading must be eliminated from the consolidated income statement.
𝐶𝑜𝑛𝑠𝑜𝑙𝑖𝑑𝑎𝑡𝑒𝑑 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑝𝑎𝑟𝑒𝑛𝑡 ′ 𝑠𝑟𝑒𝑣𝑒𝑛𝑢𝑒 + 𝑠𝑢𝑏𝑠𝑖𝑑𝑖𝑎𝑟𝑦 ′ 𝑠 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑖𝑛𝑡𝑟𝑎𝑔𝑟𝑜𝑢𝑝 𝑠𝑎𝑙𝑒𝑠
𝐶𝑜𝑛𝑠𝑜𝑙𝑖𝑑𝑎𝑡𝑒𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠 = 𝑝𝑎𝑟𝑒𝑛𝑡 ′ 𝑐. 𝑜. 𝑠 + 𝑠𝑢𝑏𝑠𝑖𝑑𝑖𝑎𝑟𝑦 ′ 𝑠 𝑐. 𝑜. 𝑠 − 𝑖𝑛𝑡𝑟𝑎𝑔𝑟𝑜𝑢𝑝 𝑠𝑎𝑙𝑒𝑠
The deductions of intragroup sales in both cases should be shown in the adjustments column of
the consolidation schedules
Inventory
- If any goods sold intragroup are included in closing inventory, their values must be
adjusted to the lower of cost and net realizable value (NRV)
- The adjustment for unrealized profit should be shown as an increase to the cost of sales in
the sellers column in the consolidation schedule

104
- If the unrealized profit originally arose in the subsidiary, the NCI must be adjusted for its
share in the unrealized profit
Interests
If loans are outstanding between two group companies, intragroup loan interest will be paid and
received.
Both the loan and interest must be excluded from the consolidated results. The relevant amount
of interest should be deducted from group investment income and group finance cost through the
adjustments column of the consolidated schedule
Transfer of Non-current assets within the group

Adjustments required are:
i) Any profit or loss arising on transfer must be deducted from the appropriate category
within the sellers column in the consolidation schedule
ii) The depreciation charge must be adjusted (in the sellers column of the schedule) so that it
is based on the cost of the asset to the group
iii) If the selling price of an asset between group members is the same as the carrying value
in the books of the sellers at the time of sale, then no adjustment is necessary.
Acquisitions during the year

If a subsidiary is acquired part way through the year, then the subsidiary results should only be
consolidated from the date of acquisition i.e. the date on which the control is obtained. This will
require:
a. Identification of the net assets of the subsidiary at the date of acquisition in order to
calculate goodwill
b. Time apportionment of the results of subsidiary in the year of acquisition, assuming
revenue and expenses accrue evenly
c. After apportionment, deduction of intra-group transaction (post acquisition) follows.
Circumstances under which a subsidiary company can be excluded from consolidation

Consolidated financial statements shall include all subsidiaries of the parent
A parent need not present consolidated financial statements if and only if;
(a) The parent is itself a wholly owned subsidiary, or is a partially-owned subsidiary of
another entity and its other owners, including those not otherwise entitled to vote,
have been informed about, and do not object to, the parent not presenting
consolidated financial statements.
(b) The parent‘s debt or equity instruments are not traded in a public market (a domestic
or foreign stock exchange or an over-the-counter market, including local and regional
markets).

105
(c) The parent did not file, nor is it in the process of filling, its financial statements with
securities commission or other regulatory organization for the purpose of issuing any
class of instruments in a public market.
(d) The ultimate or any intermediate parent of the parent produces consolidated financial
statements available for public use that comply with international financial reporting
standards.
Note:
 The standard does not require consolidation of a subsidiary acquired when there is
evidence that the control is intended to be temporary. However there must be evidence
that the subsidiary is acquired with the intention to dispose of it within twelve months
and that management is actively seeking a buyer. When a subsidiary previously excluded
from consolidated is not disposed of within twelve months it must be consolidated as
from the date of acquisition unless narrowly specified circumstances apply.
 An entity is not permitted to exclude from consolidated an entity it continues to control
simply because that entity is operating under severe long-term restrictions that
significantly impair its ability to transfer funds to the parent. Control must be lost for
exclusion to occur.
 A subsidiary is not excluded from consolidated simply because the investor is a venture
capital organization, mutual fund, unit trust or similar entity.
 A subsidiary is not excluded from consolidated because its business activities are
dissimilar from those of the other entities within the group. Relevant information is
provided by consolidating such subsidiaries and disclosing additional information in the
consolidated financial statements about the different business activities of subsidiaries.
For example, the disclosure required by IAS 14 (segment reporting) help to explain the
significance of different business activities within the group.
Some of the reasons for exclusion are given under the companies Act but are now prohibited by
the standard.
CONSOLIDATED STATEMENTS CASHFLOW (IAS 7)
In addition to the items discussed in topic one when we were preparing a statement of cash flow,
the following points need to be noted about preparation of consolidated cash flow statements.
i) Goodwill impaired for the year is a non-cash expense that should be added back to the group
profit before the tax.
ii) Where the group has investments in associate company then dividends received from
associate should be reported as a separate item under investing activities. The dividend to
be reported can be determined as follows.

106
Investment in associate account
£ £
Balance b/d x Share of tax in associate
company
Share of profit before tax in associate Dividends balance figure x
company
Balance c/d x
x x
The dividends paid to Minority interest (NCI) should also be disclosed separately from those of the holding
company and classified under financing activities
Dividends paid to Minority interest (NCI) may be determined as follows:
Minority interest (NCI) account

£ £
Dividends balance figure x Balance b/d
Balance c/d x Share of profits in subsidiary x
x x

107
REVISON QUESTIONS
Question one:
The following SOFP have been prepared as at December 20x8
Dickens Jones
Noncurrent assets 85,000 18,000
Investment in Jones shares 60,000
145,000 18,000
Current assets 160,000 84,000
305,000 102,000
Capital and reserves
Called up share capital 65,000 20,000
Share premium 35,000 10,000
Retained earnings 70,000 25,000
170,000 55,00
Current liabilities 135,000 47,000
305,000 102,000
Dickens acquired its 80% holding in Jones on January 1st 20x8 when Jones retained earnings
stood at $20,000. On this date, the fair value of 20% non-controlling interest shareholding was
$12,500.
Prepare the consolidated statement of financial position of dickens as at 31 st December 20x8.
Suggested Solution:
i. net assets
At acquisition At reporting
Share capital 20,000 20,000
Share premium 10,000 10,000
50,000 55,000
ii. Goodwill
Cost of investment 60,000

Less: 80% of net assets at acquisition 80%of50000) 40,000
Fair value of NCI at acquisition 12,500
Less: 20% of net asset after acquisition (10,000)
Goodwill NCI 2,500

108
iii. NCI at reporting date
20% of NA at reporting date (20% x55,000) 11,000
NCI share of goodwill 2,500
13,500
iv. Retained earnings:
Parent as per statement 70,000

Parent share of outstanding post acquisition profit (80%x5,000) 4,000
74,500
Dickens consolidated statement of financial position

$‘000‘
Goodwill 22,500
Tangible (85+18) 103,000
Current assets (160+84) 244,000
369,000
share capital 65,000
Retained earnings 74,000
NCI 13,500
187,500
Current liabilities (135,000+47,000) 182,000
369,000
Question two:
Health ltd bought 90% of equity share capital of safety ltd at the begging of the year on January
1st 20x2 when the retained earnings of safety ltd stood at $5,000. Statement of financial position
at the year ended of 31 st December 20x3 is as follows (thousands of dollars)
Health ltd Safety ltd

Non-current assets
Property plant and equipment(PPE) 100 30
Investment 34
Current assets
inventory 90 20
Receivables 110 25
Bank 10 5
344 80

109
Equity and liabilities
share capital 15 31
Retained earnings 159 5
Non-current liabilities 120 28
Current liabilities 50 16
344 80
S transferred goods to H at transfer price of $18,000 and mark-up of 50%. Two thirds of the
goods remained in inventory at the year end. The current account in the subsidiary and the parent
stood at $22,000 on that day. Goodwill has suffered an impairment of $10,000.
Prepare the consolidated statement of financial position on December 31 st 20x3. The non-
controlling interest is valued using the proportion of net assets method.
Suggested solution:
i. Net assets of safety
Share capital 5,000 31,000
10,000 36,000
ii. Goodwill (proportionate method)

Less: 90% of net assets at acquisition (90%x10, 000) 9,000
Less: impairment 10,000
Goodwill at reporting date 15,000
iii. Unrealized profit in inventory
Sales 18,000 150%

C.O.S 100%
Gross profit 50%
2/3 of goods remaining unrealized profit

2/3 of 6,000=4,000
Group share of unrealized profit
4,000x90%=3,600
Journal entry:
Dr. R/E (group) 3,600
Dr. NCI 400
Cr. Inventory 4,000

110
iii. NCI at reporting
10% of NA at reporting date 3,600

Less: provision for unrealized profit 400
3,200
iv. Group reserve:

100% Health ltd 159,000
90% post acquisition profit 23,400
Goodwill impairment (1000)
Provision for unrealized profit (3,600)
168,800
Health group ltd statement of financial ltd.

‗000‘ of ‗000‘ of
dollars dollars
Noncurrent assets (100+30) 130
Goodwill 15 145
Current assets
Inventory (90+20-4) 106
Receivables (110+25-22) 113
Bank (10+5) 15 234
379
share capital 15.0
Reserves (R/E) 168.8
NCI 3.2
Non-current liabilities (120+28) 148.0
Current liabilities (50+16-22) 44.0
379
Question three:
Hazelnut (H) acquired 80% of the share capital of peppermint (P) at the beginning of the year
where the reserve of P stood at $125,000. Hazelnut paid initial cash consideration of $1 million.
Additionally, H issued 200,000 shares with a nominal value of $1 and a current market value of
$1.8. It was agreed that H would pay a further $500,000 in three years time. Current interest rates
are 10% p.a. the appropriate discount factor for $1 receivable three years from now is 0.751. The
shares and contingent consideration have not yet been recorded.
Below are the statements of financial position of hazelnut (H) and peppermint (P) as at 31 st
December 20x4.
111
Hazelnut (H) Peppermint (P)
‗000‘ of dollars ‗000‘ of dollars
Investment in peppermint at cost 1,000
Non-current assets 5,500 1,500
Current assets
Inventory 550 100
Receivables 400 200
Cash 200 50
7,650 1,850
share capital 2,000 500
Reserves (R/E) 1,400 300
Non-current liabilities 3,000 400
Current liabilities 1,250 650
7,650 1,850
At acquisition the fair value of peppermint‘s non-current assets exceeded their book value by
$200,000. They had a remaining useful life of 5 years at this date. The consolidated goodwill has
been impaired by one fifth of its value.
The Hazelnut group values the non-controlling interest using the full goodwill method. At the
date of acquisition the fair value of the 20% non-controlling interest was $380,000.
Prepare the consolidated statement of the financial position as at 31 st December 20x4.
Workings:
i. group structure
80% ownership (parent)

20% NCI
ii. Net assets of peppermint
Share capital 500 500
FV adjustment 200 200
Depreciation adjustment (140)
825 960

112
iii. Journal entries to record consideration in kind
Dr. Investment in P (shares) 360,000

Dr. Investment in P (deferred compensation) 376,000
Cr. Share capital 200,000
Cr. Share premium 160,000
Cr. Deferred compensation 376,000
Remember to record the credit side of the journal entries in SOFP.
iv.
Cash 1,000
Shares (200x1.8) 360
Deferred payment 376
1,736
For 80% of P is investment (80% of 825) 660
Goodwill parents share 1076
FV of NCI at acquisition 380
Less: 20% of NA at acquisition (165)
Goodwill NCI share 215
Impairment 20% or 1/5 258
Carrying goodwill 1,033
v. journal entry to record goodwill impairment
Dr. retained earnings 206.4

Dr. NCI 51.6
Cr. Goodwill 258
vi. NCI value to CSOFP at reporting date
20% of NA of P at reporting date 192

NCI share of goodwill at acquisition 215
Less: NCI share of goodwill at impairment (516)
3,554
vii. Unwinding of discount

PV of deferred payment at acquisition 376
PV of deferred payment at reporting date 413
Increase in PV of deferred payment due to passage of time 37

113
ix. Group R/E
Hazelnut (1,400-37) 1,363
Peppermint (80 %( 300-40-125)) 108
Impairment of goodwill (206.4)
1,264.6
Hazelnut Group statement of financial position

‗000‘ of
dollars
Non-current assets
goodwill 1,033
Other non-current assets (5,500+1,500+200-40) 7,160
8,193
Current assets
Inventory (550+100) 650
Receivables (400+200) 600
Cash (200+50) 250
9693
share capital (2,000+200) 2,200
Share premium 160
Retained earnings 1,264.60
Non-controlling interest 355.40
Non-current liabilities (3,000+400) 3,400
Current liabilities (1250+650) 1,900
Deferred compensation 413
9693
IAS 31 — INTERESTS IN JOINT VENTURES
OVERVIEW
IAS 31 Interests in Joint Ventures sets out the accounting for an entity's interests in various forms of joint
ventures: jointly controlled operations, jointly controlled assets, and jointly controlled entities. The
standard permits jointly controlled entities to be accounted for using either the equity method or by
proportionate consolidation.
IAS 31 was reissued in December 2003, applies to annual periods beginning on or after 1 January 2005,
and is superseded by IFRS 11 Joint Arrangements and IFRS 12 Disclosure of Interests in Other Entities
with effect from annual periods beginning on or after 1 January 2013.

114
SUMMARY OF IAS 31
IAS 31 applies to accounting for all interests in joint ventures and the reporting of joint venture assets,
liabilities, income, and expenses in the financial statements of venturers and investors, regardless of the
structures or forms under which the joint venture activities take place, except for investments held by a
venture capital organization, mutual fund, unit trust, and similar entity that (by election or requirement)
are accounted for as under IAS 39 at fair value with fair value changes recognized in profit or loss. [IAS
31.1]
Key definitions
Joint venture: a contractual arrangement whereby two or more parties undertake an economic activity
that is subject to joint control.
Venturer: a party to a joint venture and has joint control over that joint venture.
Investor in a joint venture: a party to a joint venture and does not have joint control over that joint
venture.
Control: the power to govern the financial and operating policies of an activity so as to obtain benefits
from it.
Joint control: the contractually agreed sharing of control over an economic activity. Joint control exists
only when the strategic financial and operating decisions relating to the activity require the unanimous
consent of the venturers.
Jointly controlled operations
Jointly controlled operations involve the use of assets and other resources of the venturers rather than the
establishment of a separate entity. Each venturer uses its own assets, incurs its own expenses and
liabilities, and raises its own finance.
IAS 31 requires that the venturer should recognize in its financial statements the assets that it controls, the
liabilities that it incurs, the expenses that it incurs, and its share of the income from the sale of goods or
services by the joint venture. [IAS 31.15]
Jointly controlled assets
Jointly controlled assets involve the joint control, and often the joint ownership, of assets dedicated to the
joint venture. Each venturer may take a share of the output from the assets and each bears a share of the
expenses incurred. [IAS 31.18]
IAS 31 requires that the venturer should recognize in its financial statements its share of the joint assets,
any liabilities that it has incurred directly and its share of any liabilities incurred jointly with the other
venturers, income from the sale or use of its share of the output of the joint venture, its share of expenses
incurred by the joint venture and expenses incurred directly in respect of its interest in the joint venture.
[IAS 31.21]

115
Jointly controlled entities
A jointly controlled entity is a corporation, partnership, or other entity in which two or more venturers
have an interest, under a contractual arrangement that establishes joint control over the entity. [IAS 31.24]
Each venturer usually contributes cash or other resources to the jointly controlled entity. Those
contributions are included in the accounting records of the venturer and recognized in the venturer's
financial statements as an investment in the jointly controlled entity. [IAS 31.29]
IAS 31 allows two treatments of accounting for an investment in jointly controlled entities – except as
noted below:
 proportionate consolidation [IAS 31.30]

 equity method of accounting [IAS 31.38]
Proportionate consolidation or equity methods are not required in the following exceptional
circumstances: [IAS 31.1-2]
 An investment in a jointly controlled entity that is held by a venture capital organization

or mutual fund (or similar entity) and that upon initial recognition is designated as held
for trading under IAS 39. Under IAS 39, those investments are measured at fair value
with fair value changes recognized in profit or loss.
 The interest is classified as held for sale in accordance with IFRS 5.
 A parent that is exempted from preparing consolidated financial statements by paragraph
10 of IAS 27 may prepare separate financial statements as its primary financial
statements. In those separate statements, the investment in the jointly controlled entity
may be accounted for by the cost method or under IAS 39.
 An investor in a jointly controlled entity need not use proportionate consolidation or the
equity method if all of the following four conditions are met:
1. the venturer is itself a wholly-owned subsidiary, or is a partially-owned subsidiary
of another entity and its other owners, including those not otherwise entitled to
vote, have been informed about, and do not object to, the venturer not applying
proportionate consolidation or the equity method;
2. the venturer's debt or equity instruments are not traded in a public market;
3. the venturer did not file, nor is it in the process of filing, its financial statements
with a securities commission or other regulatory organization for the purpose of
issuing any class of instruments in a public market; and
4. the ultimate or any intermediate parent of the venturer produces consolidated
financial statements available for public use that comply with International
Financial Reporting Standards.
Proportionate consolidation
Under proportionate consolidation, the balance sheet of the venturer includes its share of the assets that it
controls jointly and its share of the liabilities for which it is jointly responsible. The income statement of
the venturer includes its share of the income and expenses of the jointly controlled entity. [IAS 31.33]

116
IAS 31 allows for the use of two different reporting formats for presenting proportionate consolidation:
[IAS 31.34]
 The venturer may combine its share of each of the assets, liabilities, income and expenses
of the jointly controlled entity with the similar items, line by line, in its financial
statements; or
 The venturer may include separate line items for its share of the assets, liabilities, income
and expenses of the jointly controlled entity in its financial statements.
Equity method
Procedures for applying the equity method are the same as those described in IAS 28 Investments in
Associates.
Separate financial statements of the venturer
In the separate financial statements of the venturer, its interests in the joint venture should be: [IAS 31.46]
 accounted for at cost; or

 Accounted for under IAS 39 Financial Instruments: Recognition and Measurement.
Transactions between a venturer and a joint venture
If a venturer contributes or sells an asset to a jointly controlled entity, while the assets are retained by the
joint venture, provided that the venturer has transferred the risks and rewards of ownership, it should
recognize only the proportion of the gain attributable to the other venturers. The venturer should
recognize the full amount of any loss incurred when the contribution or sale provides evidence of a
reduction in the net realizable value of current assets or an impairment loss. [IAS 31.48]
The requirements for recognition of gains and losses apply equally to non-monetary contributions unless
the gain or loss cannot be measured, or the other venturers contribute similar assets. Unrealized gains or
losses should be eliminated against the underlying assets (proportionate consolidation) or against the
investment (equity method). [SIC-13]
When a venturer purchases assets from a jointly controlled entity, it should not recognize its share of the
gain until it resells the asset to an independent party. Losses should be recognized when they represent a
reduction in the net realizable value of current assets or an impairment loss. [IAS 31.49]
Financial statements of an investor
An investor in a joint venture who does not have joint control should report its interest in a joint venture
in its consolidated financial statements either: [IAS 31.51]
 in accordance with IAS 28 Investments in Associates – only if the investor has significant
influence in the joint venture; or
 in accordance with IAS 39 Financial Instruments: Recognition and Measurement.

117
Partial disposals of joint ventures
If an investor loses joint control of a jointly controlled entity, it derecognizes that investment and
recognizes in profit or loss the difference between the sum of the proceeds received and any retained
interest, and the carrying amount of the investment in the jointly controlled entity at the date when joint
control is lost. [IAS 31.45]
Disclosure
A venturer is required to disclose:
 Information about contingent liabilities relating to its interest in a joint venture. [IAS
31.54]
 Information about commitments relating to its interests in joint ventures. [IAS 31.55]
 A listing and description of interests in significant joint ventures and the proportion of
ownership interest held in jointly controlled entities. A venturer that recognizes its
interests in jointly controlled entities using the line-by-line reporting format for
proportionate consolidation or the equity method shall disclose the aggregate amounts of
each of current assets, long-term assets, current liabilities, long-term liabilities, income,
and expenses related to its interests in joint ventures. [IAS 31.56]
 The method it uses to recognize its interests in jointly controlled entities. [IAS 31.57]
IAS 28 — INVESTMENTS IN ASSOCIATES AND JOINT VENTURES (2011)
The summary below applies to IAS 28 Investments in Associates and Joint Ventures, issued in
May 2011 and applying to annual reporting periods beginning on or after 1 January 2013. For
earlier reporting periods, refer to our summary of IAS 28 Investments in Associates.
Objective of IAS 28
The objective of IAS 28 (as amended in 2011) is to prescribe the accounting for investments in associates
and to set out the requirements for the application of the equity method when accounting for investments
in associates and joint ventures. [IAS 28(2011).1]
Scope of IAS 28
IAS 28 applies to all entities that are investors with joint control of, or significant influence over, an
investee (associate or joint venture). [IAS 28(2011).2]

118
Key definitions
[IAS 28.3]
Associate An entity over which the investor has significant influence

Significant The power to participate in the financial and operating policy decisions of the
influence investee but is not control or joint control of those policies
Joint
An arrangement of which two or more parties have joint control
arrangement
The contractually agreed sharing of control of an arrangement, which exists
Joint control only when decisions about the relevant activities require the unanimous
consent of the parties sharing control
A joint arrangement whereby the parties that have joint control of the
Joint venture
arrangement have rights to the net assets of the arrangement
Joint venturer A party to a joint venture that has joint control of that joint venture
A method of accounting whereby the investment is initially recognised at cost
and adjusted thereafter for the post-acquisition change in the investor's share of
Equity method the investee's net assets. The investor's profit or loss includes its share of the
investee's profit or loss and the investor's other comprehensive income
includes its share of the investee's other comprehensive income
Significant influence
Where an entity holds 20% or more of the voting power (directly or through subsidiaries) on an investee,
it will be presumed the investor has significant influence unless it can be clearly demonstrated that this is
not the case. If the holding is less than 20%, the entity will be presumed not to have significant influence
unless such influence can be clearly demonstrated. A substantial or majority ownership by another
investor does not necessarily preclude an entity from having significant influence. [IAS 28(2011).5]
The existence of significant influence by an entity is usually evidenced in one or more of the following
ways: [IAS 28(2011).6]
 representation on the board of directors or equivalent governing body of the investee;

 participation in the policy-making process, including participation in decisions about
dividends or other distributions;
 material transactions between the entity and the investee;
 interchange of managerial personnel; or
 provision of essential technical information
The existence and effect of potential voting rights that are currently exercisable or convertible, including
potential voting rights held by other entities, are considered when assessing whether an entity has
significant influence. In assessing whether potential voting rights contribute to significant influence, the
entity examines all facts and circumstances that affect potential rights [IAS 28(2011).7, IAS 28(2011).8]

119
An entity loses significant influence over an investee when it loses the power to participate in the
financial and operating policy decisions of that investee. The loss of significant influence can occur with
or without a change in absolute or relative ownership levels. [IAS 28(2011).9]
The equity method of accounting
Basic principle. Under the equity method, on initial recognition the investment in an associate or a joint
venture is recognized at cost, and the carrying amount is increased or decreased to recognise the investor's
share of the profit or loss of the investee after the date of acquisition. [IAS 28(2011).10]
Distributions and other adjustments to carrying amount. The investor's share of the investee's profit
or loss is recognized in the investor's profit or loss. Distributions received from an investee reduce the
carrying amount of the investment. Adjustments to the carrying amount may also be necessary for
changes in the investor's proportionate interest in the investee arising from changes in the investee's other
comprehensive income (e.g. to account for changes arising from revaluations of property, plant and
equipment and foreign currency translations.) [IAS 28(2011).10]
Potential voting rights. An entity's interest in an associate or a joint venture is determined solely on the
basis of existing ownership interests and, generally, does not reflect the possible exercise or conversion of
potential voting rights and other derivative instruments. [IAS 28(2011).12]
Interaction with IFRS 9. IFRS 9 Financial Instruments does not apply to interests in associates and joint
ventures that are accounted for using the equity method. Instruments containing potential voting rights in
an associate or a joint venture are accounted for in accordance with IFRS 9, unless they currently give
access to the returns associated with an ownership interest in an associate or a joint venture. [IAS
28(2011).14]
Classification as non-current asset.
An investment in an associate or a joint venture is generally classified as non-current asset, unless it is

classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued
Operations. [IAS 28(2011).15]
Application of the equity method of accounting
Basic principle.
In its consolidated financial statements, an investor uses the equity method of accounting for investments
in associates and joint ventures. [IAS 28(2011).16] Many of the procedures that are appropriate for the
application of the equity method are similar to the consolidation procedures described in IFRS 10.
Furthermore, the concepts underlying the procedures used in accounting for the acquisition of a
subsidiary are also adopted in accounting for the acquisition of an investment in an associate or a joint
venture. [IAS 28.(2011).26]
Exemptions from applying the equity method.
An entity is exempt from applying the equity method if the investment meets one of the following
conditions:

120
 The entity is a parent that is exempt from preparing consolidated financial statements
under IFRS 10 Consolidated Financial Statements or if all of the following four
conditions are met (in which case the entity need not apply the equity method): [IAS
28(2011).17]
o the entity is a wholly-owned subsidiary, or is a partially-owned subsidiary of
another entity and its other owners, including those not otherwise entitled to vote,
have been informed about, and do not object to, the investor not applying the
equity method
o the investor or joint venturer's debt or equity instruments are not traded in a public
market
o the entity did not file, nor is it in the process of filing, its financial statements with
a securities commission or other regulatory organization for the purpose of
issuing any class of instruments in a public market, and
o the ultimate or any intermediate parent of the entity produces consolidated
financial statements available for public use that comply with International
Financial Reporting Standards.
 When an investment in an associate or a joint venture is held by, or is held indirectly
through, an entity that is a venture capital organization, or a mutual fund, unit trust and
similar entities including investment-linked insurance funds, the entity may elect to
measure investments in those associates and joint ventures at fair value through profit or
loss in accordance with IFRS 9. [IAS 28(2011).18] When an entity has an investment in
an associate, a portion of which is held indirectly through a venture capital organization,
or a mutual fund, unit trust and similar entities including investment-linked insurance
funds, the entity may elect to measure that portion of the investment in the associate at
fair value through profit or loss in accordance with IFRS 9 regardless of whether the
venture capital organization, or the mutual fund, unit trust and similar entities including
investment-linked insurance funds, has significant influence over that portion of the
investment. If the entity makes that election, the entity shall apply the equity method to
any remaining portion of its investment in an associate that is not held through a venture
capital organization, or a mutual fund, unit trust and similar entities including investment-
linked insurance funds. [IAS 28(2011).19]
Classification as held for sale. When the investment, or portion of an investment, meets the criteria to be
classified as held for sale, the portion so classified is accounted for in accordance with IFRS 5. Any
remaining portion is accounted for using the equity method until the time of disposal, at which time the
retained investment is accounted under IFRS 9, unless the retained interest continues to be an associate or
joint venture. [IAS 28(2011).20]
Discontinuing the equity method.
Use of the equity method should cease from the date that significant influence or joint control ceases:
[IAS 28(2011).22]
 If the investment becomes a subsidiary, the entity accounts for its investment in
accordance with IFRS 3 Business Combinations and IFRS 10
 If the retained interest is a financial asset, it is measured at fair value and subsequently
accounted for under IFRS 9

121
 Any amounts recognized in other comprehensive income in relation to the investment in
the associate or joint venture are accounted for on the same basis as if the investee had
directly disposed of the related assets or liabilities (which may require reclassification to
profit or loss)
 If an investment in an associate becomes an investment in a joint venture (or vice versa),
the entity continues to apply the equity method and does not re-measure the retained
interest. [IAS 28(2011).24]
Changes in ownership interests.
If an entity's interest in an associate or joint venture is reduced, but the equity method is continued to be
applied, the entity reclassifies to profit or loss the proportion of the gain or loss previously recognized in
other comprehensive income relative to that reduction in ownership interest. [IAS 28(2011).25]
Equity method procedures.
 Transactions with associates or joint ventures. Profits and losses resulting from upstream
(associate to investor, or joint venture to joint venturer) and downstream (investor to
associate, or joint venturer to joint venture) transactions are eliminated to the extent of
the investor's interest in the associate or joint venture. However, unrealized losses are not
eliminated to the extent that the transaction provides evidence of a reduction in the net
realizable value or in the recoverable amount of the assets transferred. Contributions of
non-monetary assets to an associate or joint venture in exchange for an equity interest in
the associate or joint venture are also accounted for in accordance with these
requirements. [IAS 28(2011).28-30]
 Date of financial statements. In applying the equity method, the investor or joint venturer
should use the financial statements of the associate or joint venture as of the same date as
the financial statements of the investor or joint venturer unless it is impracticable to do
so. If it is impracticable, the most recent available financial statements of the associate or
joint venture should be used, with adjustments made for the effects of any significant
transactions or events occurring between the accounting period ends. However, the
difference between the reporting date of the associate and that of the investor cannot be
longer than three months. [IAS 28(2011).33, IAS 28(2011).34]
 Accounting policies. If the associate or joint venture uses accounting policies that differ
from those of the investor, the associate or joint venture's financial statements are
adjusted to reflect the investor's accounting policies for the purpose of applying the
equity method. [IAS 28(2011).35]
 Losses in excess of investment. If an investor's or joint venturer's share of losses of an
associate or joint venture equals or exceeds its interest in the associate or joint venture,
the investor or joint venturer discontinues recognizing its share of further losses. The
interest in an associate or joint venture is the carrying amount of the investment in the
associate or joint venture under the equity method together with any long-term interests
that, in substance, form part of the investor or joint venturer's net investment in the
associate or joint venture. After the investor or joint venturer's interest is reduced to zero,
a liability is recognized only to the extent that the investor or joint venturer has incurred
legal or constructive obligations or made payments on behalf of the associate. If the
associate or joint venture subsequently reports profits, the investor or joint venturer
122
resumes recognizing its share of those profits only after its share of the profits equals the
share of losses not recognized. [IAS 28(2011).38, IAS 28(2011).39]
Impairment. After application of the equity method an entity applies IAS 39 Financial Instruments:
Recognition and Measurement to determine whether it is necessary to recognize any additional
impairment loss with respect to its net investment in the associate or joint venture. If impairment is
indicated, the amount is calculated by reference to IAS 36 Impairment of Assets. The entire carrying
amount of the investment is tested for impairment as a single asset, that is, goodwill is not tested
separately. The recoverable amount of an investment in an associate is assessed for each individual
associate or joint venture, unless the associate or joint venture does not generate cash flows
independently. [IAS 28(2011).40, IAS 28(2011).42, IAS 28(2011).43]
Separate financial statements
An investment in an associate or a joint venture shall be accounted for in the entity's separate financial
statements in accordance with IAS 27 Separate Financial Statements (as amended in 2011).
Disclosure
There are no disclosures specified in IAS 28. Instead, IFRS 12 Disclosure of Interests in Other Entities
outlines the disclosures required for entities with joint control of, or significant influence over, an
investee.

123
QUESTIONS:
International accounting standards (IAS) 28’ investment in associates prescribes the use of
the equity method of accounting for investments in associates over which the investor has
significant influence
Required:
i) Describe the term “significant influence” in the context of IAS 28.
Suggested answer:
Where an investor holds directly or indirectly, 20% or more of the voting power of the investee,
it is presumed to have significant influences, unless it can be clearly demonstrated otherwise.
The existence of significant influence is usually evidenced in one or more of the following
ways:
- Representation on the board of directors
- Participation in policy-making process, including participation in decision about
dividends
- Material transactions between investor and investee
- Interchange of managerial personnel
- Provision of essential technical information
ii) Explain four circumstances under which the investor is exempted from use of
the equity method
Suggested answer:
- The investment is classified as held for sale
- The parent company is exempted from use of equity method
- the investment is wholly owned subsidiary, or it is a partially owned subsidiary of
another entity whose owners do not object to the investor not applying the equity method
and the following also apply:
 The investor‘s debt or equity instrument are not traded in a public market
 The investor did not file, nor is it in the process of filling its financial statements
with the stock exchange for purpose of issuing instruments in a public market
 The intermediate or ultimate parent of the investor produces consolidated
financial statements which are available for public use and comply with
international finance reporting standards

124
Question:
The following statements of financial position were extracted from the books of accounts of
panther Ltd. And its investee companies star ltd, and Able ltd. As at 31 December 2011:
Panther ltd Star ltd Able ltd
Non-current assets at cost: Sh.‖ Sh.‖million Sh.‖
million‖ ‖ million‖
Plant, property and equipment 10,000 4,250 8,250
Investments 13,000 - 750
23,000 4,250 9,000
Current assets:
Inventories 2,400 1,250 1,500
Receivables 3,800 2,000 2,750
Cash and bank balances 1,300 750 1,250
7,500 4,000 5,500
Total assets 30,500 8,250 14,500
Ordinary share capital(sh.10 each) 5,000 1,500 2,000
Retained profits 18,500 4,000 10,000
23,000 5,500 12,000
8% Loan notes 2,000 - -
10% Loan notes - 1,000 -
2,000 1,000 -
Trade payables 4,250 1,250 1,800
Current tax 750 500 70
5,000 1,750 2,500
Total equity and liabilities 30,500 8,250 14,500
1. Panther ltd. Acquired 80% of the ordinary shares of star ltd for sh.6, 800,000 on 1 July 2011.
Panther ltd also acquired 50% of the 10% loan notes of the company on the same date. The fair
value of the non-controlling interest was sh.1, 280,000.
2. On 1 July 2011, panther ltd. Further acquires 80,000 shares of the able ltd. At sh.55 per share.
3. The profit after tax of star ltd and able ltd. For the year ended 31 December 2011was
sh.1,000,000 and sh.6,00,000 respectively
4. On the date of acquisition, the fair values of the assets of star ltd. Were equal to their carrying
amounts except for the land and plant whose fair values were sh.200, 000 and sh.800, 000 in
excess of their carrying amounts respectively. Plant is to be depreciated on a prorate basis over
the remaining useful life of four years.
5. Panther ltd. Sold goods to star ltd. For sh.3, 000,000 at a mark-up of 50% in October 2011. Half
of these goods were included in the inventory of star ltd. as at 31 December 2011.
6. As at 31 December 2011. Star ltd. Owed Panther ltd. Sh.750,000
7. During the year Panther ltd. Sold goods to samba ltd, a company domiciled in Nigeria. The goods
were invoiced in Naira (Nr.) currency. The total value was shillings (ksh) 500,000 and the
exchange rate as at 31 December 2011 was 1 Ksh.=12.5Nr

125
8. None of the three companies paid dividends during the year
9. As at December 2011, the goodwill of star ltd. And Able ltd. Is estimated to be impaired by
sh.200, 000 and sh.100, 000 respectively.
Assume profits accrued evenly throughout the year.
Required:
Group statement of financial position as at 31 December 2011
Suggested solution:
Panther Ltd.
Group Statement of financial position as at 31 December2011
Sh.‖000‖ Sh.‖000‖
Property, plant and equipment
15,150
Goodwill
1,880
Investment in associate company
5,500
Other investments(13 000-6 800-4 400-500)
1,300
23,830
Current assets:
Inventory (2 400+1 250-500) 3,150
Receivables (3 800+2 000-750-100) 4,950
Cash and bank balances (1 300+750) 2,050 10,150
Total assets 33,980

Ordinary share capital(sh.10 each) 5 ,000
Shareholders‘ funds attributable to parent 24,180
Shareholders‘ funds attributable to NCI 1,320
25,480
8% loan notes 2,000
10% loan notes 500 2,500
Trade payables (4 250+1 250-750) 4,750
Current tax (750+500) 1,250 6,000
Total equity and liabilities
33,980

126
Workings:
i. Property, plant and equipment

Sh‖000‖
Panther limited (2560+1420) 10 000
Star limited (1400+900) 4 250
Fair value gain (200+800) 1 000
Additional depreciation (800/4𝑥 6 12) (100)
15 150
ii. Good will in star limited sh‖000‖ sh‖000‖
Fair value of consideration -panther ltd 6 800

-Non-controlling interest 1 280
8 080
Net assets 1 500
Pre-acquisition net profits 3 500
Fair value adjustment 1 000 (6 000)
Goodwill 2 080
Less goodwill impairment (200)
1 880
iii. Investment in Associate (Able ltd) sh‖000‖

Cost (800 000x55%) 4 400
Addition depreciation (600 x 6 12 x 40%) 1 200
5 600
Impairment of goodwill (100)
5 500
iv. Retained profit sh‖000‖
Panther limited 18 500

Less: unrealized profit closing inventory (500)
Exchange loss (100)
Impairment of goodwill: -star ltd (160)
-Able ltd (100)
Profit and loss shares in Star ltd (80 %( 4000-3000-500-100) 320
Profit and loss shares in Able ltd (40 %( 10000-4000-300) 1 200
19 160
v. Non-controlling interest ( shareholders funds in star ltd +goodwill. Fair value on
acquisition (1 280+sharing post depreciation (20%x400) less impairment of goodwill
40=sh.1 320 000

127
Question:
Differentiate between full consolidation and equity method of accounting for subsidiaries and
associate companies.
Suggested answer:
Full consolidation:
The main reason for consolidating a subsidiary is because the subsidiary‘s assets are controlled
by the holding company and meanwhile, the holding company is also liable to the subsidiary‘s
liability. The substance is that the assets and liabilities of a subsidiary belongs to the holding
company
Equity method:
The investor is able to influence but not control the associate company therefore, it is not proper
to report the associate as a mere investments nor consolidate and hence the use of equity method.
Question:
H ltd. acquired 80% of the ordinary share capital of S ltd. on October 2009 for sh.2, 500 million.
One year later on 1 October 2010. H ltd. acquired 40% of the ordinary share capital of A ltd. for
sh.800 million. The statements of financial position of the three companies as at 30 September
2011 were as follows:
H ltd S ltd A ltd
Non-current assets at cost: Sh.‖ 000‖ Sh.‖000‖ Sh.‖ 000‖
Freehold property 2,560 1,400 800
Plant 1,420 900 540
Patents 250 420 -
Investments 3,450 200 60
7,680 2,920 1,400
Current assets:
Inventories 570 400 300
Receivables 420 380 400
Cash and bank balances - 150 120
990 930 820
8,670 3,850 2,220
Ordinary share capital(sh.10 each) 2,000 1,000 500
Share premium 1.000 500 100
Retained profits 4,500 1,900 1,200
7,500 3,400 1,800
Deferred tax 200 - 80
Bank overdraft 80 - -
Trade payables 750 450 280
Current tax 140 - 60
970 4 50 340
Total equity and liabilities 8,670 3,850 2,220

128
1. The retained earnings of H ltd. and Able ltd. as at 1 October 2009 and 1 October 2010
were as follows:
H ltd S ltd A ltd
Sh‖million‖ Sh‖million‖ Sh‖million‖
October 2009 2, 000 1, 200 500
1 October 2010 3, 000 1, 500 800
2. O 1 October 2009, the fair values of assets of S ltd. were equal to their book values
except for an item of plant whose fair value was sh.200 million more than its book value
3. During the year, M ltd. sold goods to A ltd. at a selling price of sh.140 million reporting a
profit of 40% on cost. A ltd‘s inventories as at 30 September 2011 included half of the
goods purchased from H ltd.
4. Included in the trade receivables of H ltd. is sh.120 million due from S ltd. included only
70 millions of this amount in its trade payables. The difference was due to some
administrative expenses charges to S ltd. by H ltd. which had not been accounted for by S
ltd.
5. As at 30 September 2011, 40% of the goodwill arising from arising of S ltd. had been
impaired. No impairment loss had arisen in A ltd. the group accounts for goodwill using
the partial method.
Required:
Group statement of financial position as at 30 September 2011

129
Suggested solution:
H Ltd.
Consolidated statement financial position as at 3 September
2011
Sh.‖000‖ Sh.‖000‖
Property, plant and equipment 6,480
Goodwill 108
Patents (250+420) 670
Investment in associate 952
Other investments(150+200) 350
8,560
Current assets:
Inventory (570+400) 970
Trade Receivables (42+380-70-50) 680
Cash and cash equivalents 150 1,800
Total assets 10,360
Share capital 2,000
Share premium 1,000
Retained profits 5,100
8,100
Non-Controlling interest 20% x(3 400+200- 710
50)
8,810
Deferred tax 200
Bank overdraft 80
Trade payables (750+450-70) 1,130
Current tax 140 1,350
Total equity and liabilities 10,360
Workings:
i. Property, plant and equipment
Sh‖000‖
H limited (2560+1420) 3 980
S limited (1400+900) 2 300
Fair value gain 200
6 480

130
ii. Goodwill in S limited
sh‖million‖ sh‖million‖
Cost of purchase 2 500
Less:
Share capital 1 000
Share premium 500
Retained profit 1 200
For adjustment 200
2 900
Share of H ltd @80% (2 300)

180
Less impairment @40% 170
108
iii. Investment in Associate A ltd
Cost of purchase 800
Share of post acquisition:

Retained profit balance c/d 1 200
Retained profit acquisition (800)
400
Unrealized profit (20)
380
Share of H limited @40% 152
952
iv. Retained profit

H ltd. S ltd. A ltd
sh‖million‖ sh‖million‖ sh‖million‖
Balance b/d 4 500 1 900 1 200

Administration expenses (50)
Unrealized profit (inventory) (8)
Pre-acquisition (1 200) (1 800)
4 492 650 400
Goodwill loss (72) - -
4 420 650 400
Share of H limited 5 100 520 160

131
CHAPTER FIVE
ANALYSING THE FINANCIAL STATEMENTS
PRESENTATION OF FINANCIAL STATEMENTS

Sixth schedule to the Companies Act: Accounts
IFRSs Gives the guideline on the content and the accounting statements of certain events and
transactions in the financial statements. The following IFRSs are relevant for the purpose of
preparing published financial statements;
IAS 1: - Presentation of Financial Statements

IAS 7: - Cashflow statements
IAS 8: - Accounting policies, changes in accounting estimates and errors
IAS 10: - Events after the balance sheet date
IAS 12: - Income Tax
IFRS 5 - Non-current assets held for sale and discontinued operations.
IAS 1 — Presentation of Financial Statements
OVERVIEW
IAS 1 Presentation of Financial Statements sets out the overall requirements for financial
statements, including how they should be structured, the minimum requirements for their content
and overriding concepts such as going concern, the accrual basis of accounting and the
current/non-current distinction. The standard requires a complete set of financial statements to
comprise a statement of financial position, a statement of profit or loss and other comprehensive
income, a statement of changes in equity and a statement of cash flows.
IAS 1 was reissued in September 2007 and applies to annual periods beginning on or after 1
January 2009.
SUMMARY OF IAS 1
Objective of IAS 1
The objective of IAS 1 (2007) is to prescribe the basis for presentation of general purpose
financial statements, to ensure comparability both with the entity's financial statements of
previous periods and with the financial statements of other entities. IAS 1 sets out the overall
requirements for the presentation of financial statements, guidelines for their structure and
minimum requirements for their content. Standards for recognizing, measuring, and disclosing
specific transactions are addressed in other Standards and Interpretations.

132
Scope
Applies to all general purpose financial statements based on International Financial Reporting
Standards
General purpose financial statements are those intended to serve users who are not in a position
to require financial reports tailored to their particular information needs.
Objective of financial statements
The objective of general purpose financial statements is to provide information about the
financial position, financial performance, and cash flows of an entity that is useful to a wide
range of users in making economic decisions. To meet that objective, financial statements
provide information about an entity's:
 assets
 liabilities
 equity
 income and expenses, including gains and losses
 contributions by and distributions to owners
 cash flows
That information, along with other information in the notes, assists users of financial statements
in predicting the entity's future cash flows and, in particular, their timing and certainty.
Components of financial statements
A complete set of financial statements should include:
 a statement of financial position (balance sheet) at the end of the period

 a statement of comprehensive income for the period (or an income statement and a
statement of comprehensive income)
 a statement of changes in equity for the period
 a statement of cash flows for the period
 notes, comprising a summary of accounting policies and other explanatory notes
When an entity applies an accounting policy retrospectively or makes a retrospective restatement

of items in its financial statements, or when it reclassifies items in its financial statements, it
must also present a statement of financial position (balance sheet) as at the beginning of the
earliest comparative period.
An entity may use titles for the statements other than those stated above.

133
Reports that are presented outside of the financial statements – including financial reviews by
management, environmental reports, and value added statements – are outside the scope of
IFRSs.
Fair presentation and compliance with IFRSs
The financial statements must "present fairly" the financial position, financial performance and
cash flows of an entity. Fair presentation requires the faithful representation of the effects of
transactions, other events, and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in the Framework. The application of
IFRSs, with additional disclosure when necessary, is presumed to result in financial statements
that achieve a fair presentation.
IAS 1 requires that an entity whose financial statements comply with IFRSs make an explicit and
unreserved statement of such compliance in the notes. Financial statements shall not be described
as complying with IFRSs unless they comply with all the requirements of IFRSs (including
Interpretations).
Inappropriate accounting policies are not rectified either by disclosure of the accounting policies
used or by notes or explanatory material.
IAS 1 acknowledges that, in extremely rare circumstances, management may conclude that
compliance with an IFRS requirement would be so misleading that it would conflict with the
objective of financial statements set out in the Framework. In such a case, the entity is required
to depart from the IFRS requirement, with detailed disclosure of the nature, reasons, and impact
of the departure.
Going concern
An entity preparing IFRS financial statements is presumed to be a going concern. If management

has significant concerns about the entity's ability to continue as a going concern, the uncertainties
must be disclosed. If management concludes that the entity is not a going concern, the financial
statements should not be prepared on a going concern basis, in which case IAS 1 requires a series
of disclosures.
Accrual basis of accounting
IAS 1 requires that an entity prepare its financial statements, except for cash flow information,
using the accrual basis of accounting.
Consistency of presentation
The presentation and classification of items in the financial statements shall be retained from one
period to the next unless a change is justified either by a change in circumstances or a
requirement of a new IFRS.

134
Materiality and aggregation
Each material class of similar items must be presented separately in the financial statements.
Dissimilar items may be aggregated only if they are individually immaterial.
Offsetting
Assets and liabilities, and income and expenses, may not be offset unless required or permitted
by an IFRS.
Comparative information
IAS 1 requires that comparative information shall be disclosed in respect of the previous period
for all amounts reported in the financial statements, both face of financial statements and notes,
unless another Standard requires otherwise.
If comparative amounts are changed or reclassified, various disclosures are required.
Structure and content of financial statements in general
Clearly identify:
 the financial statements

 the reporting enterprise
 whether the statements are for the enterprise or for a group
 the date or period covered
 the presentation currency
 The level of precision (thousands, millions, etc.)
Reporting period
There is a presumption that financial statements will be prepared at least annually. If the annual
reporting period changes and financial statements are prepared for a different period, the entity
must disclose the reason for the change and a warning about problems of comparability.
Statement of Financial Position (Balance Sheet)
An entity must normally present a classified statement of financial position, separating current
and non-current assets and liabilities. Only if a presentation based on liquidity provides
information that is reliable and more relevant may the current/non-current split be omitted. In
either case, if an asset (liability) category combines amounts that will be received (settled) after
12 months with assets (liabilities) that will be received (settled) within 12 months, note
disclosure is required that separates the longer-term amounts from the 12-month amounts.

135
Current assets are cash; cash equivalent; assets held for collection, sale, or consumption within
the entity's normal operating cycle; or assets held for trading within the next 12 months. All other
assets are non-current.
Current liabilities are those expected to be settled within the entity's normal operating cycle or
due within 12 months, or those held for trading, or those for which the entity does not have an
unconditional right to defer payment beyond 12 months. Other liabilities are non-current.
When a long-term debt is expected to be refinanced under an existing loan facility and the entity
has the discretion the debt is classified as non-current, even if due within 12 months
If a liability has become payable on demand because an entity has breached an undertaking
under a long-term loan agreement on or before the reporting date, the liability is current, even if
the lender has agreed, after the reporting date and before the authorization of the financial
statements for issue, not to demand payment as a consequence of the breach. However, the
liability is classified as non-current if the lender agreed by the reporting date to provide a period
of grace ending at least 12 months after the end of the reporting period, within which the entity
can rectify the breach and during which the lender cannot demand immediate repayment.
Minimum items on the face of the statement of financial position
(a) property, plant and equipment

(b) investment property
(c) intangible assets
(d) financial assets (excluding amounts shown under (e), (h), and (i))
(e) investments accounted for using the equity method
(f) biological assets
(g) Inventories
(h) trade and other receivables
(i) cash and cash equivalents
(j) assets held for sale
(k) trade and other payables
(l) Provisions
(m) financial liabilities (excluding amounts shown under (k) and (l))
(n) liabilities and assets for current tax
(o) deferred tax liabilities and deferred tax assets
(p) liabilities included in disposal groups
(q) non-controlling interests, presented within equity and
(r) issued capital and reserves attributable to owners of the parent
Additional line items may be needed to fairly present the entity's financial position.

136
IAS 1 does not prescribe the format of the balance sheet. Assets can be presented current then
non-current, or vice versa, and liabilities and equity can be presented current then non-current
then equity, or vice versa. A net asset presentation (assets minus liabilities) is allowed. The long-
term financing approach used in UK and elsewhere – fixed assets + current assets - short term
payables = long-term debt plus equity – is also acceptable.
Regarding issued share capital and reserves, the following disclosures are required:
 numbers of shares authorized, issued and fully paid, and issued but not fully paid
 par value
 reconciliation of shares outstanding at the beginning and the end of the period
 description of rights, preferences, and restrictions
 treasury shares, including shares held by subsidiaries and associates
 shares reserved for issuance under options and contracts
 a description of the nature and purpose of each reserve within equity

137
Format for statement of financial position
Example:
ABC LTD
STATEMENT OF FINANCIAL POSITION AS AT 31/12/
NON-CURRENT ASSETS £ £
Property, plant and equipment x
Goodwill x
Other intangible assets x
Investment Long-term x
x
CURRENT ASSETS
Inventory x
Accounts receivables and prepayments x
Short-term investment x
Cash at bank and in hand x x
TOTAL ASSETS xx
EQUITY AND LIABILTIES
Preference share capital x
Ordinary share capital x
x
RESERVES
Share premium x
Revaluation reserve x
General reserve x x
Retained profits x
Shareholders‘ funds x
NON-CURENT LIABILITIES
Loan stock/debentures x
Redeemable preference shares x
Deferred tax x
Other long-term provisions x x
CURRENT LIABILITIES
Bank overdraft x
Trade and other payables (accruals) x
Current tax (tax payable) x
Current portion of loan stock x
Prepared dividends (and shares or preference shares) x x
TOTAL EQUITY AND LIABILITY xx

138
Statement of Comprehensive Income
Comprehensive income for a period includes profit or loss for that period plus other
comprehensive income recognized in that period. As a result of the 2003 revision to IAS 1, the
Standard is now using 'profit or loss' rather than 'net profit or loss' as the descriptive term for the
bottom line of the income statement.
All items of income and expense recognized in a period must be included in profit or loss unless
a Standard or an Interpretation requires otherwise. [IAS 1.88] Some IFRSs require or permit that
some components to be excluded from profit or loss and instead to be included in other
The components of other comprehensive income include:
 changes in revaluation surplus (IAS 16 and IAS 38)

 actuarial gains and losses on defined benefit plans recognized in accordance with IAS 19
 gains and losses arising from translating the financial statements of a foreign operation
(IAS 21)
 gains and losses on re-measuring available-for-sale financial assets (IAS 39)
 The effective portion of gains and losses on hedging instruments in a cash flow hedge
(IAS 39).
An entity has a choice of presenting:
 a single statement of comprehensive income or

 two statements:
o an income statement displaying components of profit or loss and
o a statement of comprehensive income that begins with profit or loss (bottom line
of the income statement) and displays components of other comprehensive
income
Minimum items on the face of the statement of comprehensive income should include:
 revenue
 finance costs
 share of the profit or loss of associates and joint ventures accounted for using the equity
method
 tax expense
 a single amount comprising the total of (i) the post-tax profit or loss of discontinued
operations and (ii) the post-tax gain or loss recognized on the disposal of the assets or
disposal group(s) constituting the discontinued operation
 profit or loss
 each component of other comprehensive income classified by nature

139
 share of the other comprehensive income of associates and joint ventures accounted for
using the equity method
 total comprehensive income
The following items must also be disclosed in the statement of comprehensive income as
allocations for the period:
 profit or loss for the period attributable to non-controlling interests and owners of the
parent
 total comprehensive income attributable to non-controlling interests and owners of the
parent
Additional line items may be needed to fairly present the entity's results of operations. No items
may be presented in the statement of comprehensive income (or in the income statement, if
separately presented) or in the notes as 'extraordinary items'.
Certain items must be disclosed separately either in the statement of comprehensive income or in
the notes, if material, including:
Write-downs of inventories to net realizable value or of property, plant and equipment to

recoverable amount, as well as reversals of such write-downs
 restructurings of the activities of an entity and reversals of any provisions for the costs of
restructuring
 disposals of items of property, plant and equipment
 disposals of investments
 discontinuing operations
 litigation settlements
 other reversals of provisions
Expenses recognized in profit or loss should be analyzed either by nature (raw materials, staffing
costs, depreciation, etc.) or by function (cost of sales, selling, administrative, etc). If an entity
categorizes by function, then additional information on the nature of expenses – at a minimum
depreciation, amortization and employee benefits expense – must be disclose

140
Example:
By function
ABC LTD
INCOME STATEMENT FOR THE YEAR ENDED 31/12/
£ £
Revenue x
Cost of sales (x)
Gross profit x
Other incomes (e.g. investment income) x
x
Expenses
Distribution costs x
Administration costs x
Other expenses x
Finance costs x (x)
Profit before x
Income tax expense (x)
Profit for the period xx
By Nature
ABC LTD
INCOME STATEMENT FOR THE YEAR ENDED 31/12/
£ £
Revenue x
Other incomes x
x
Expenses
Raw materials consumed x
Changes in finished goods and work in progress x
Depreciation and amortization x
Employee benefits x
Other expenses x
Finance costs x (x)
Profit before tax x
Income tax expenses (x)
Profit for the period xx

141
Statement of Cash Flows
Rather than setting out separate standards for presenting the cash flow statement, IAS 1.111
refers to IAS 7 Statement of Cash Flows
Statement of Changes in Equity
IAS 1 requires an entity to present a statement of changes in equity as a separate component of

the financial statements. The statement must show:
 total comprehensive income for the period, showing separately amounts attributable to
owners of the parent and to non-controlling interests
 the effects of retrospective application, when applicable, for each component
 reconciliations between the carrying amounts at the beginning and the end of the period
for each component of equity, separately disclosing:
o profit or loss
o each item of other comprehensive income
o transactions with owners, showing separately contributions by and distributions to
owners and changes in ownership interests in subsidiaries that do not result in a
loss of control
The following amounts may also be presented on the face of the statement of changes in equity,
or they may be presented in the notes:
 amount of dividends recognized as distributions, and

 the related amount per share

142
Example:
The format of the statement of changes in equity is given as follows:
Prefere Ordinar Share Revaluatio General Retained TOTA

nce y share premiu n reserve reserve profits L
share capital m
capital
£ £ £ £ £ £ £
Balance at 1.1 x x x x x x x
Changes in a/c
policy/correction of - - - - - (x) (x)
error
Balance as restated (i x x x x x x x
+ii)
Gain/losses on
revaluation PPE - - - x - - x
Transfer to retained
profits on sale of PPE - - - (x) - x -
Gain losses on
investment revaluation - - - x - - x
Foreign currency
exchange gain/losses - - - x - - x
Net gains/losses
directly reported in
equity (iv + v +vi + vii) - - - x - x x
Profit for the period - - - - - x x
Total gains/losses
recognized during the
year (viii + ix) - - - x - x x
Issue of shares x x x - - - x
Transfer to general
reserve - - - - x (x) -
Dividends: interim paid - - - - - (x) (x)
Final proposed (If prop
before year end) - - - - - (x) (x)
Balance as at 31.12 ( x
+ xi + xii + xiii) x x x x x x x

143
The final value of the total should be the same as the shareholder funds in the balance sheet.
Notes to the financial statements
The notes must:
 present information about the basis of preparation of the financial statements and the
specific accounting policies used
 disclose any information required by IFRSs that is not presented elsewhere in the
financial statements and
 provide additional information that is not presented elsewhere in the financial statements
but is relevant to an understanding of any of them
Notes should be cross-referenced from the face of the financial statements to the relevant note.
IAS 1.114 suggests that the notes should normally be presented in the following order:
 a statement of compliance with IFRSs

 a summary of significant accounting policies applied, including
o the measurement basis (or bases) used in preparing the financial statements
o the other accounting policies used that are relevant to an understanding of the
 supporting information for items presented on the face of the statement of financial
position (balance sheet), statement of comprehensive income (and income statement, if
presented), statement of changes in equity and statement of cash flows, in the order in
which each statement and each line item is presented
 other disclosures, including:
o contingent liabilities (see IAS 37) and unrecognized contractual commitments
o non-financial disclosures, such as the entity's financial risk management
objectives and policies (see IFRS 7)
Disclosure of judgments
New in the 2003 revision to IAS 1, an entity must disclose, in the summary of significant
accounting policies or other notes, the judgements, apart from those involving estimations, that
management has made in the process of applying the entity's accounting policies that have the
most significant effect on the amounts recognized in the financial statements.
Examples cited in IAS 1.123 include management's judgements in determining:
 whether financial assets are held-to-maturity investments

 when substantially all the significant risks and rewards of ownership of financial assets
and lease assets are transferred to other entities

144
 whether, in substance, particular sales of goods are financing arrangements and therefore
do not give rise to revenue; and
 whether the substance of the relationship between the entity and a special purpose entity
indicates control
Disclosure of key sources of estimation uncertainty
Also new in the 2003 revision to IAS 1, an entity must disclose, in the notes, information about
the key assumptions concerning the future, and other key sources of estimation uncertainty at the
end of the reporting period, that have a significant risk of causing a material adjustment to the
carrying amounts of assets and liabilities within the next financial year. These disclosures do not
involve disclosing budgets or forecasts.
The following other note disclosures are required by IAS 1.126 if not disclosed elsewhere in
information published with the financial statements:
 domicile and legal form of the entity

 country of incorporation
 address of registered office or principal place of business
 description of the entity's operations and principal activities
 if it is part of a group, the name of its parent and the ultimate parent of the group
 if it is a limited life entity, information regarding the length of the life
OTHER DISCLOSURES
Disclosures about dividends
In addition to the distributions information in the statement of changes in equity (see above), the
following must be disclosed in the notes: " the amount of dividends proposed or declared before
the financial statements were authorized for issue but not recognized as a distribution to owners
during the period, and the related amount per share and " the amount of any cumulative
preference dividends not recognized.
Capital disclosures
An entity should disclose information about its objectives, policies and processes for managing
capital. To comply with this, the disclosures include:
 qualitative information about the entity's objectives, policies and processes for managing
capital, including>
o description of capital it manages

145
o nature of external capital requirements, if any
o how it is meeting its objectives
 quantitative data about what the entity regards as capital
 changes from one period to another
 whether the entity has complied with any external capital requirements and
 If it has not complied, the consequences of such non-compliance.
Disclosures about puttable financial instruments

A requires the following additional disclosures if an entity has a puttable instrument that is
classified as an equity instrument:
 summary quantitative data about the amount classified as equity

 the entity's objectives, policies and processes for managing its obligation to repurchase or
redeem the instruments when required to do so by the instrument holders, including any
changes from the previous period
 the expected cash outflow on redemption or repurchase of that class of financial
instruments and
 Information about how the expected cash outflow on redemption or repurchase was
determined

146
Terminology
The 2007 comprehensive revision to IAS 1 introduced some new terminology. Consequential
amendments were made at that time to all of the other existing IFRSs, and the new terminology
has been used in subsequent IFRSs including amendments. IAS 1.8 states: "Although this
Standard uses the terms 'other comprehensive income', 'profit or loss' and 'total comprehensive
income', an entity may use other terms to describe the totals as long as the meaning is clear. For
example, an entity may use the term 'net income' to describe profit or loss." Also, IAS 1.57(b)
states: "The descriptions used and the ordering of items or aggregation of similar items may be
amended according to the nature of the entity and its transactions, to provide information that is
relevant to an understanding of the entity's financial position."
Term before 2007 revision of IAS 1 Term as amended by IAS 1 (2007)

balance sheet statement of financial position
cash flow statement statement of cash flows
statement of comprehensive income (income statement
income statement
is retained in case of a two-statement approach)
recognized in the income statement recognized in profit or loss
recognized [directly] in equity (only for
recognized in other comprehensive income
OCI components)
recognized [directly] in equity (for recognized outside profit or loss (either in OCI or
recognition both in OCI and equity) equity)
removed from equity and recognized in reclassified from equity to profit or loss as a
profit or loss ('recycling') reclassification adjustment
Standard or/and Interpretation IFRSs
on the face of in
equity holders owners (exception for 'ordinary equity holders')
balance sheet date end of the reporting period
reporting date end of the reporting period
after the balance sheet date after the reporting period
June 2011: IASB issued amendments to IAS 1

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Amendments to IAS 1 Presentation of Financial Statements
 Preserve the amendments made to IAS 1 in 2007 to require profit or loss and OCI to be
presented together, i.e. either as a single statement of comprehensive income, or separate
income statement and a statement of comprehensive income — rather than requiring a
single continuous statement as was proposed in the exposure draft
 Require entities to group items presented in OCI based on whether they are potentially
reclassifiable to profit or loss subsequently. i.e. those that might be reclassified and those
that will not be reclassified
 Require tax associated with items presented before tax to be shown separately for each of
the two groups of OCI items (without changing the option to present items of OCI either
before tax or net of tax)
 Applicable to annual periods beginning on or after 1 July 2012, with early adoption
permitted.
INTRODUCTION:
Companies report a statement of stockholders‘ equity, which includes retained earnings. The
statement of stockholders‘ equity is formatted like a statement of retained earnings but with a
column for each element of stockholders‘ equity. The statement of stockholders‘ equity thus
reports the reasons for all the changes in equity during the period.
Components of Shareholder's Equity

Also known as "equity" and "net worth", the shareholders' equity refers to the shareholders'
ownership interest in a company.
Usually included are:
 Preferred stock - This is the investment by preferred stockholders, which have priority
over common shareholders and receive a dividend that has priority over any distribution
made to common shareholders. This is usually recorded at par value.
 Additional paid-up capital (contributed capital) - This is capital received from
investors for stock; it is equal to capital stock plus paid-in capital. It is also called
"contributed capital".
 Common stock - This is the investment by stockholders, and it is valued at par or stated
value.
 Retained earnings - This is the total net income (or loss) less the amount distributed to
August 2015
the shareholders in the form of a dividend since the company'swww.fb.com/kasnebcsia
initiation.
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 Other items - This is an all-inclusive account that may include valuation allowance and
cumulative translation allowance (CTA), among others. Valuation allowance pertains to
noncurrent investments resulting from selective recognition of market value changes.
Cumulative translation allowance is used to report the effects of translating foreign
currency transactions, and accounts for foreign affiliates.
Stockholders' Equity Statement

Instead of presenting a detailed stockholders' equity section in the balance sheet and a retained
earnings statement, many companies prepare a stockholders' equity statement.
This statement shows the changes in each type of stockholders' equity account and the total
stockholders' equity during the accounting period. This statement usually includes:
 Preferred stock
 Common stock
 Issue of par value stock
 Additional paid-in capital
 Treasury stock repurchase
 Cumulative Translation Allowance (CTA)
 Retained earning
The financial statement that follows below is the 20X9 statement of stockholders‘ equity for
Allied Electronics Corporation.
Study its format.
There is a column for each element of equity, starting with Common Stock on the left. The far-
right column reports the total.
The top row (line 1) reports beginning balances, taken from last period‘s balance sheet. The rows
then report the various transactions that affected equity, starting with Issuance of stock (line 2).
The statement ends with the December 31, 20X9, balances (line 10).
All the amounts on the bottom line appear on the ending balance sheet, given in the statement of
financial position

149
Statement of stock holders‘ equity:
Allied Electronics Corporation
Statement of Stockholders‘ Equity
Year Ended December 31, 20X9

Accumulated Other
Comprehensive Income
Common Additional Retained Treasury Unrealized Foreign- Total
Stock Paid-in Earnings Stock Gain Currency Stockholders‘
$1 Par Capital (Loss) on Translation Equity
Investment Adjustment
1.Balance, $10,000 $160,000 $130,000 (25,000) $6,000 $(10,000) $271,000
December 31,
20X8
2. Issuance of 20,000 500,000 520,000
stock..
3. Net income 69,000 69,000
4 .Cash (21,000) (21,000)
dividends
5 Stock 3,000 72,000 (75,000) 0
dividend—10%
6 .Purchase of (9,000) (9,000)
treasury stock
7 .Sale of 7,000 4,000 11,000
treasury stock
8. Unrealized 1,000 1,000
gain
on investments
9.Foreign- 3,000 3,000
currency
translation
adjustment
10. Balance, $33,000 $739,000 $103,000 (30,000) $7,000 $ (7,000) $845,000
December 31,
20X9.
Let‘s examine Allied Electronics‘ stockholders‘ equity during 20X9.

150
Issuance of Stock (Line 2)
During 20X9, Allied issued common stock for $520,000. Of this total, $20,000 (par value) went
into the Common Stock account, and $500,000 increased Additional Paid-in Capital. Total
equity increased by $520,000.
Net Income (Line 3)
During 20X9, Allied Electronics earned net income of $69,000, which increased Retained
Earnings. The net income is from the income statement.
Declaration of Cash Dividends (Line 4)
Allied Electronics declared cash dividends of $21,000. The statement of shareholders‘ equity
reports the decrease in retained earnings from the declaration of the cash dividends.
Distribution of Stock Dividends (Line 5)
During 20X9, Allied Electronics distributed a stock dividend to its stockholders. Prior to the
stock dividend, Allied‘s Common Stock account had a balance of $30,000 (beginning balance of
$10,000 + new issue of $20,000). The 10% stock dividend then added 3,000 shares of $1-par
common stock, or $3,000, to the Common Stock account.
Allied decreased (debited) Retained Earnings for the market value of this ―small‖ stock dividend.
The difference between the market value of the dividend ($75,000) and its par value ($3,000)
was credited to Additional Paid-in Capital ($72,000)
Purchase and Sale of Treasury Stock (Lines 6 and 7)
Treasury stock is recorded at cost. During 20X9, Allied Electronics paid $9,000 to buy treasury
stock (line 6). This transaction decreased stockholders‘ equity.
Allied later sold some treasury stock (line 7). The sale of treasury stock brought in $11,000 cash
and increased total stockholders‘ equity by $11,000. The treasury stock that Allied sold had cost
the company $4,000, and the extra $7,000 was added to Additional Paid-in Capital. At year end
(line 10), Allied still owned treasury stock that cost the company $30,000. The parentheses
around the treasury stock figures in the statement of shareholders‘ equity means that treasury
stock is a negative element of stockholders‘ equity. Trace treasury stock‘s ending balance to the
statement of financial position in Allied electronics shown below.

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Allied Electronic Corporation
statement of financial position (Partial)
December 31, 20X9

Total assets $1,500,000
Total liabilities $ 655,000
Stockholders‘ equity:
Common stock, $1 par, shares issued—33,000 $ 33,000
Additional paid-in capital 739,000
Treasury stock (30,000)
Accumulated other comprehensive income:
Unrealized gain on investments 7,000
Foreign-currency translation adjustment (7,000)
Total stockholders‘ equity 845,000
Total liabilities and stockholders‘ equity $1,500,000
Accumulated Other Comprehensive Income (Lines 8 and 9)
Two categories of other comprehensive income are unrealized gains and losses on available for-
sale investments and the foreign-currency translation adjustment.
At December 31, 20X8, Allied Electronics held available-for-sale investments with an unrealized
gain of $6,000. This explains the beginning balance. Then, during 20X9, the market value of the
investments increased by another $1,000 (line 8)
At December 31, 20X9, Allied‘s portfolio of investments had an unrealized gain of $7,000 (line
10). An unrealized loss on investments would appear as a negative amount. At December 31,
20X8, Allied had a negative foreign-currency translation adjustment of $10,000 (line 1). During
20X9, the foreign-currency translation adjustment increased by $3,000 (line 9), and at December
31, 20X9, Allied‘s cumulative foreign-currency translation adjustment stood at $7,000—a
negative amount that resembles an unrealized loss (line 10).
Minority interest (MI)
When the parent company owns less than 100% of the ordinary share capital of the subsidiary
company then the other balance is held by minority interest. Therefore if the parent company
owns 80% of the ordinary share capital of the subsidiary then the minority interest owns 20%.
The minority interest (M.I) should be shown separately in the consolidated statement of financial
position but as part of shareholders funds and the figure to appear in the statement of financial

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position will be made up of the following.
1. Minority interest share of the ordinary share capital in subsidiary on statement of

2. Minority interest share of capital reserves in subsidiary company on statement of
3. Minority interest share of revenue (retained profits) in subsidiary company on
statement of financial position date.
Alternatively, the total due to the minority interest can be prepared by opening the Minority
Interest account whereby the Minority interest‘s share of the osc, capital reserves and retained
profits in subsidiary company is posted to the credit side.
Leases
Lease is an agreement between two parties i.e. the lessor and the lessee where the lessor who is
the owner of the asset transfers to the lessee the right to use the asset in return of periodic
payment called lease rentals
A lease contract enables the lessee to obtain the use of property without making initial payment
of the asset it is therefore a financing strategy as the property can be used in generating cash for
payment of the lease rentals.
IAS 17 recognize two types of lease
1. Finance lease
2. Operating lease
QUESTION
The following trial balance relate to Ziwani Limited as at October 2011:
Sh.‖000‖ Sh.‖000‖
Ordinary share capital(sh.10 each) 56,000
Retained earnings (1 November 2010) 1,400
8% convertible loan stock 30,000
Freehold property at cost 1 November 2010:
(land element sh.25 million) 75,000
Plant and equipment (at cost) 74,500
Accumulated depreciation (1 November 2010):
Building 10,000

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Plant and equipment 24,500
Current tax 800
Deferred tax 2,600
Inventory: 4 November 2011 36,000
Trade receivables 47,100
Bank loan 11,500
Trade payables 24,500
Revenues 339,650
Cost of sales 207,750
Distribution costs 27,500
Administrative expenses 30,700
Interest paid on convertible loan stock 2,400
500,950 500,950
1. The inventory of Ziwani limited was not counted until 4 November 2011 due to operation
reasons. At this date, the cost of this inventory was sh.36million and this figure had been used in
the cost of sales calculation above. Between the year ended 31 October 2011 and 4 November,
Ziwani limited received a delivery of goods at a cost of sh.2.7 million and made sales of sh.7.8
million at a markup on cost of 30%. Neither the goods delivered nor the sales made in this period
were included in Ziwani limited‘s purchases (as part of cost of sales) or revenues in the above
trial balance.
2. On 1 November 2010, Ziwani limited decided, for the first time, to value its freehold property.
A qualified property valuer reported that the market value of the freehold property on this date
was sh.80million of which sh.30million related to the land. At this date, the remaining estimated
life of the building was 20 years. Plant is depreciated at 20% per annum on a reducing balance
method.
3. The bank loan is being repaid in ten equal installments which commenced on 1 November
2006.
4. Provision for doubtful debts of 5% of the trade receivables is to be made.
5. The balance on current tax represents the under/over provisions of the tax liability for the year
ended 31 October 2011. The required provision for income tax for the year ended 31 October
2011 is sh. 19.4 million. The net temporary differences during the year were determined as
sh.19.8 million.
6. Income tax and deferred tax are provided at a rate of 30% on all items giving rise to tal
7. Provision is to be made for the following items:

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Interest on bank loan sh.1.84 million
Proposed dividends of 10%
Required:
(a) Statement of comprehensive income for the year ended 31 October 2011 (8
marks)
(b) Statement of changes in equity for the year ended 31 October 2011 (4
marks)
(c) Statement of financial position 31 October 2011 (8 marks)
(Total: 20 marks)
Suggested solution:
Closing stock-reported 36 000
Less: Inventory received 31/10/2011 to 1/4/2011 (2 700)
Add: Sales made 31/10/2011 to 1/4/2011 6 000
(100 130 𝑥7 800) Current value of closing stock 39 300
Stocks were understated by 3 300 (39 300-36 000)
Revaluation surplus:
NBV Revaluation Surplus
Land 25 000 30 000 5 000
Building 40 000 50 000 10 000

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To SOFP and SOCI
Depreciation expense for the year:
50 000
Building = 2 500
20
Depreciation on building = 0.2𝑥50 = 10
50 − 10 = 40
Plant (74 500-24 500) x20% =10 000
Bank loan repayment:
11 500
Current = 2 300 current liabilities
5
Long term (11 500-2 300) 9 200 Non current liability
11 500
Bad debts expense:
5% (47 000) 2 355
Accounts receivable balance (47 100-2 355) 44 745
47 100
Admin expense:
Reported 30 700
Bad debts 2 355
33 055

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Income tax expense:
Provision 19 400
Deferred tax b/f 2 600
Deferred tax c/f 5 940
Increase in deferred tax liability 3 340
Finance cost:
Interest on bank loan 1 840
Interest on convertible loan 2 400
4 240
a)
Statement of comprehensive Income:
Revenue 339 650
Cost of sales (219 950)
Distribution costs (27 500)
Administration costs (33 055)
Finance costs (4 240)
Income tax expense (22 740)
Profit for the year 35 165
Other comprehensive income:

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Revaluation reserve (L&B) 15 000
Total comprehensive income 50 165
b)
Statement of changes in equity:
R/E Revaluation reserve Share capital
1.11.2010 1 400 - 56 000
Profit for the year 35 165 - -
Proposed dividend (5 600) - -
Revaluation (SOCI) - 15 000 -
30 965 15 000 56 000
c)
Statement of financial position:
Non-current assets:
Freehold property (50 000-2 500) +30 000 77 500
PPE (74 000-34 500) 40 000
Current assets:
Inventory 39 300
Receivables 44 754
Liabilities and equity:
Current tax provision 20 200

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Bank loan payable 2 300
Proposed dividends 5 600
Interest payable 1 840
Deferred tax 5 940
Bank loan 9 200
8% convertible loan 30 000
Revaluation reserve 15 000
201 545
Question:
Distinguish between a finance lease and an operating lease.
A finance lease transfers substantially all the risks and rewards incidental to ownership of an
asset to the lease while an operating lease is any other than a finance lease.
Question:
On 1 January 2009, Kamulu limited leased a machine from general machines ltd. under a finance
lease agreement. Kamulu limited was to make installment lease payments of sh.14, 000, 000
every six months on 30 June and 31 December in arrears. The first payment was made on 30
June 2009. The fair value of the machine was sh.60, 000, 000 with an estimated useful life of 3
years. The first interest rate implicit in the lease was 10% per six months.
Required:
i. Extracts of the statement of comprehensive income for the years ended 31 December
2009 and 2010.
ii. Extracts of the statement of financial position as at December 2009 and 2010.

159
Suggested solution:
Year Balance b/d interest@10% Lease rental Principal paid Bal c/d
Sh‖000‖ Sh‖000‖ Sh‖000‖ Sh‖000‖ Sh‖000‖

2009 (i) 60 000 6 000 14 000 8 000 52 000
(ii) 52 000 4 200 14 000 8 800 43 200
2010 (i) 43 200 4 320 14 000 9 680 33 520
(ii) 33 520 3 352 14 000 10 648 22 872
2011 (i) 22 872 2 287 14 000 11 713 11 159
(ii) 11 159 1 116 14 000 11 159
Depreciation=sh.60 000/3=sh.20 000 per annum
Income statement extract
2009 2010
Sh‖000‖ Sh‖000‖
Expenses:
Finance lease 10 200 7 672
Depreciation 20 000 20 000
Statement of financial position extract
2009 2010
Sh‖000‖ Sh‖000‖
Assets:

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Non-current assets
PPE (machine) NBV 40 000 20 000
Liabilities:
Non-current liabilities
Obligation under finance lease 22 872
current liabilities
Obligation under finance lease 20 328 22 872
Question:
Outline the four main categories of financial instruments in the context of International
Accounts Standard (IAS) 39.
Financial instruments are contracts that give rise to financial assets of one entity and financial
liability or equity instruments of another entity.
The main categories of financial assets are:
- Financial assets at a fair value through profit and loss (FVPL). - These are financial
assets which are acquired with the intention of resale. Include share and loan stocks
which are traded on a stock exchange and derivative having a net cash inflow
- Held to maturity (HTM)-these are financial assets that are acquired with the intention to
be held till the maturity or settlement date. Include the loan stock traded in the stock
exchange with the intention to hold till they mature
- Loans and receivables (L/R)- these are financial assets which are acquired with the
intention to be held till maturity date although no active market is involved
- Available for sale (AFS)- this is normally a default category for other financial assets
that the firm may wish to classify as available for sale. Include shares and loan stocks not

161
traded in the stock exchange, loans and shares issued by private companies
Question:
With respect of International Accounts Standard (IAS) 37, Provisions, Contingent liabilities
and Contingent assets
i. Distinguish between “provisions” and Contingent liabilities”
A provision is a liability of uncertain timing or amount ( a liability being a present obligation of

the entity arising from past events, the settlement of which is expected to result in an outflow
from the entity of resource embodying economic benefit)
A contingent liability is a possible obligation that arises from past events and whose existence
will be confirmed only by the occurrence or non-occurrence of one or more uncertain future
events not wholly within the control of the entity or a present obligation that arises from past
events but is not recognized because:
 It is not probable than an outflow of resources embodying economic

benefits will be required to settle the obligation or
 The amount of the obligation cannot be measured with sufficient
reliability
ii. Identify the three circumstances under which a provision should be recognized
in the financial statements
1. An entity has a present obligation as a result of past event

2. It is probable that an outflow of resources embodying economic benefit
will be required to settle the obligation
3. A reliable estimate can be made of the amount of the obligation
iii. Describe the accounting treatment of contingent liabilities in the financial

statements
An entity shall not recognize a contingent liability unless the possibility of any outflow in
settlement is remote, an entity should disclose for each class of contingent liability at the end of
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reporting period a brief description of the nature of the contingent liability and where,
practicable.
 An estimate of its financial effect

 An indication of the uncertainties relating to the amount of timing of any
outflow; and
 The possibility of any reimbursement
Question:
In the context of IAS 16 property, plant and equipment
i. Explain when the cost of an item of property ,plant and equipment should be
recognized as an asset
It should be recognized if and only if:
 It is probable that the future economic benefits associated with the item
will flow to entity
 The cost of the item can be measured reliably
ii. Briefly describe the accounting treatment with respect to the increase in the
carrying amount of an asset as a result of revaluation
If an asset‘s carrying amount is increased as a result of revaluation, the increase shall be

recognizes in other comprehensive income and accumulation in equity under revaluation surplus.
However, to the extent that the increase reverses a revaluation decrease of the same asset
previously recognized in profit and loss then the increase shall be recognized in profit and loss. If

163
an assets carrying amount is decreased as a result of revaluation, the decrease shall be recognized
in profit and loss. However the decrease shall be recognized in other comprehensive income to
the extent of any credit balance existing in the revaluation surplus in respect of that asset.
iii. Outline any two disclosure requirement for items of property, plant and
equipment which are stated at revalued amounts
 The effective date of revaluation

 Whether an independent valuer was involved
 The method and significant assumption applied in estimating the items fair
values
 The extent to which the items fair values were determined directly by
reference to observable prices in an active market transaction on arms
length term
 The carrying amount that would have been recognized had the asset been
carried under the cost model
 The revaluation surplus indicating the change for the period and any
restriction on the distribution of the balance to shareholders
IAS 7 — Statement of Cash Flows
IAS 7 Statement of Cash Flows requires an entity to present a statement of cash flows as an
integral part of its primary financial statements. Cash flows are classified and presented into
operating activities (either using the 'direct' or 'indirect' method), investing activities or financing
164
activities, with the latter two categories generally presented on a gross basis.
IAS 7 was reissued in December 1992, retiled in September 2007, and is operative for financial
statements covering periods beginning on or after 1 January 1994.
SUMMARY OF IAS 7
Objective of IAS 7
The objective of IAS 7 is to require the presentation of information about the historical changes
in cash and cash equivalents of an entity by means of a statement of cash flows, which classifies
cash flows during the period according to operating, investing, and financing activities.
Fundamental principle in IAS 7
All entities that prepare financial statements in conformity with IFRSs are required to present a
statement of cash flows.
The statement of cash flows analyses changes in cash and cash equivalents during a period. Cash
and cash equivalents comprise cash on hand and demand deposits, together with short-term,
highly liquid investments that are readily convertible to a known amount of cash and that are
subject to an insignificant risk of changes in value. Guidance notes indicate that an investment
normally meets the definition of a cash equivalent when it has a maturity of three months or less
from the date of acquisition. Equity investments are normally excluded, unless they are in
substance a cash equivalent (e.g. preferred shares acquired within three months of their specified
redemption date). Bank overdrafts which are repayable on demand and which form an integral
part of an entity's cash management are also included as a component of cash and cash
equivalents.
Presentation of the Statement of Cash Flows
Cash flows must be analyzed between operating, investing and financing activities.
Key principles specified by IAS 7 for the preparation of a statement of cash flows are as follows:
 operating activities are the main revenue-producing activities of the entity that are not
investing or financing activities, so operating cash flows include cash received from
customers and cash paid to suppliers and employees
 investing activities are the acquisition and disposal of long-term assets and other
investments that are not considered to be cash equivalents
 financing activities are activities that alter the equity capital and borrowing structure of
the entity
 interest and dividends received and paid may be classified as operating, investing, or
financing cash flows, provided that they are classified consistently from period to period

165
 cash flows arising from taxes on income are normally classified as operating, unless they
can be specifically identified with financing or investing activities
 For operating cash flows, the direct method of presentation is encouraged, but the indirect
method is acceptable
the direct method shows each major class of gross cash receipts and gross cash
payments. The operating cash flows section of the statement of cash flows under the
direct method would appear something like this:
Cash receipts from customers xx,xxx

Cash paid to suppliers xx,xxx
Cash paid to employees xx,xxx
Cash paid for other operating expenses xx,xxx
Interest paid xx,xxx
Income taxes paid xx,xxx
Net cash from operating activities xx,xxx
 The indirect method adjusts accrual basis net profit or loss for the effects of non-cash
transactions. The operating cash flows section of the statement of cash flows under the
indirect method would appear something like this:
Profit before interest and income taxes xx,xxx

Add back depreciation xx,xxx
Add back amortization of goodwill xx,xxx
Increase in receivables xx,xxx
Decrease in inventories xx,xxx
Increase in trade payables xx,xxx
Interest expense xx,xxx
Less Interest accrued but not yet paid xx,xxx
Interest paid xx,xxx
Income taxes paid xx,xxx
Net cash from operating activities xx,xxx
 the exchange rate used for translation of transactions denominated in a foreign currency
should be the rate in effect at the date of the cash flows
 cash flows of foreign subsidiaries should be translated at the exchange rates prevailing
when the cash flows took place
 as regards the cash flows of associates and joint ventures, where the equity method is
used, the statement of cash flows should report only cash flows between the investor and
166
the investee; where proportionate consolidation is used, the cash flow statement should
include the venture‘s share of the cash flows of the investee
 Aggregate cash flows relating to acquisitions and disposals of subsidiaries and other
business units should be presented separately and classified as investing activities, with
specified additional disclosures. The aggregate cash paid or received as consideration
should be reported net of cash and cash equivalents acquired or disposed of.
 cash flows from investing and financing activities should be reported gross by major
class of cash receipts and major class of cash payments except for the following cases,
which may be reported on a net basis:
o cash receipts and payments on behalf of customers (for example, receipt and
repayment of demand deposits by banks, and receipts collected on behalf of and
paid over to the owner of a property)
o cash receipts and payments for items in which the turnover is quick, the amounts
are large, and the maturities are short, generally less than three months (for
example, charges and collections from credit card customers, and purchase and
sale of investments)
o cash receipts and payments relating to deposits by financial institutions
o cash advances and loans made to customers and repayments thereof
 investing and financing transactions which do not require the use of cash should be
excluded from the statement of cash flows, but they should be separately disclosed
elsewhere in the financial statements
 the components of cash and cash equivalents should be disclosed, and a reconciliation
presented to amounts reported in the statement of financial position
 the amount of cash and cash equivalents held by the entity that is not available for use by
the group should be disclosed, together with a commentary by management
IAS 8 — Accounting Policies, Changes in Accounting Estimates and Errors
IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors is applied in selecting
and applying accounting policies, accounting for changes in estimates and reflecting corrections
of prior period errors.
The standard requires compliance with any specific IFRS applying to a transaction, event or
condition, and provides guidance on developing accounting policies for other items that result in
relevant and reliable information. Changes in accounting policies and corrections of errors are
generally retrospectively accounted for, whereas changes in accounting estimates are generally
accounted for on a prospective basis.

167
SUMMARY OF IAS 8
KEY DEFINITIONS
 Accounting policies are the specific principles, bases, conventions, rules and practices
applied by an entity in preparing and presenting financial statements.
 A change in accounting estimate is an adjustment of the carrying amount of an asset or
liability, or related expense, resulting from reassessing the expected future benefits and
obligations associated with that asset or liability.
 International Financial Reporting Standards are standards and interpretations adopted
by the International Accounting Standards Board (IASB). They comprise:
o International Financial Reporting Standards (IFRSs)
o International Accounting Standards (IASs)
o Interpretations developed by the International Financial Reporting Interpretations
Committee (IFRIC) or the former Standing Interpretations Committee (SIC) and
approved by the IASB.
 Materiality. Omissions or misstatements of items are material if they could, by their size
or nature, individually or collectively; influence the economic decisions of users taken on
the basis of the financial statements.
 Prior period errors are omissions from, and misstatements in, an entity's financial
statements for one or more prior periods arising from a failure to use, or misuse of,
reliable information that was available and could reasonably be expected to have been
obtained and taken into account in preparing those statements. Such errors result from
mathematical mistakes, mistakes in applying accounting policies, oversights or
misinterpretations of facts, and fraud.
Selection and application of accounting policies

When a Standard or an Interpretation specifically applies to a transaction, other event or
condition, the accounting policy or policies applied to that item must be determined by applying
the Standard or Interpretation and considering any relevant Implementation Guidance issued by
the IASB for the Standard or Interpretation.
In the absence of a Standard or an Interpretation that specifically applies to a transaction, other

event or condition, management must use its judgement in developing and applying an
accounting policy that results in information that is relevant and reliable. In making that
judgement, management must refer to, and consider the applicability of, the following sources in
descending order:
 the requirements and guidance in IASB standards and interpretations dealing with similar
and related issues; and
 The definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses in the Framework.

168
Management may also consider the most recent pronouncements of other standard-setting bodies
that use a similar conceptual framework to develop accounting standards, other accounting
literature and accepted industry practices, to the extent that these do not conflict with the sources.
Consistency of accounting policies
An entity shall select and apply its accounting policies consistently for similar transactions, other
events and conditions, unless a Standard or an Interpretation specifically requires or permits
categorization of items for which different policies may be appropriate. If a Standard or an
Interpretation requires or permits such categorization, an appropriate accounting policy shall be
selected and applied consistently to each category.
Changes in accounting policies
An entity is permitted to change an accounting policy only if the change:
 is required by a standard or interpretation; or

 Results in the financial statements providing reliable and more relevant information about
the effects of transactions, other events or conditions on the entity's financial position,
financial performance, or cash flows.
Note that changes in accounting policies do not include applying an accounting policy to a kind
of transaction or event that did not occur previously or were immaterial.
If a change in accounting policy is required by a new IASB standard or interpretation, the change
is accounted for as required by that new pronouncement or, if the new pronouncement does not
include specific transition provisions, then the change in accounting policy is applied
retrospectively.
Retrospective application means adjusting the opening balance of each affected component of
equity for the earliest prior period presented and the other comparative amounts disclosed for
each prior period presented as if the new accounting policy had always been applied.
 However, if it is impracticable to determine either the period-specific effects or the

cumulative effect of the change for one or more prior periods presented, the entity shall
apply the new accounting policy to the carrying amounts of assets and liabilities as at the
beginning of the earliest period for which retrospective application is practicable, which
may be the current period, and shall make a corresponding adjustment to the opening
balance of each affected component of equity for that period.
 Also, if it is impracticable to determine the cumulative effect, at the beginning of the
current period, of applying a new accounting policy to all prior periods, the entity shall
adjust the comparative information to apply the new accounting policy prospectively

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from the earliest date practicable.
Disclosures relating to changes in accounting policies
Disclosures relating to changes in accounting policy caused by a new standard or interpretation

include:
 the title of the standard or interpretation causing the change

 the nature of the change in accounting policy
 a description of the transitional provisions, including those that might have an effect on
future periods
 for the current period and each prior period presented, to the extent practicable, the
amount of the adjustment:
o for each financial statement line item affected, and
o for basic and diluted earnings per share (only if the entity is applying IAS 33)
 the amount of the adjustment relating to periods before those presented, to the extent
practicable
 If retrospective application is impracticable, an explanation and description of how the
change in accounting policy was applied.
Financial statements of subsequent periods need not repeat these disclosures.
Disclosures relating to voluntary changes in accounting policy include:
 the nature of the change in accounting policy

 the reasons why applying the new accounting policy provides reliable and more relevant
information
 for the current period and each prior period presented, to the extent practicable, the
amount of the adjustment:
 the amount of the adjustment relating to periods before those presented, to the extent
practicable
 if retrospective application is impracticable, an explanation and description of how the
change in accounting policy was applied.
Financial statements of subsequent periods need not repeat these disclosures.
If an entity has not applied a new standard or interpretation that has been issued but is not yet
effective, the entity must disclose that fact and any and known or reasonably estimable
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information relevant to assessing the possible impact that the new pronouncement will have in
the year it is applied.
Changes in accounting estimates
The effect of a change in an accounting estimate shall be recognized prospectively by including

it in profit or loss in:
 the period of the change, if the change affects that period only, or
 The period of the change and future periods, if the change affects both.
However, to the extent that a change in an accounting estimate gives rise to changes in assets and
liabilities, or relates to an item of equity, it is recognized by adjusting the carrying amount of the
related asset, liability, or equity item in the period of the change.
Disclosures relating to changes in accounting estimates
Disclose:
 The nature and amount of a change in an accounting estimate that has an effect in the
current period or is expected to have an effect in future periods
 If the amount of the effect in future periods is not disclosed because estimating it is
impracticable, an entity shall disclose that fact. [IAS 8.39-40]
Errors
The general principle in IAS 8 is that an entity must correct all material prior period errors
retrospectively in the first set of financial statements authorized for issue after their discovery by:
 restating the comparative amounts for the prior period(s) presented in which the error
occurred; or
 If the error occurred before the earliest prior period presented, restating the opening
balances of assets, liabilities and equity for the earliest prior period presented.
However, if it is impracticable to determine the period-specific effects of an error on

comparative information for one or more prior periods presented, the entity must restate the
opening balances of assets, liabilities, and equity for the earliest period for which retrospective
restatement is practicable (which may be the current period).

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Further, if it is impracticable to determine the cumulative effect, at the beginning of the current
period, of an error on all prior periods, the entity must restate the comparative information to
correct the error prospectively from the earliest date practicable.
Disclosures relating to prior period errors
Disclosures relating to prior period errors include:
 the nature of the prior period error

 for each prior period presented, to the extent practicable, the amount of the correction:
 the amount of the correction at the beginning of the earliest prior period presented
 If retrospective restatement is impracticable, an explanation and description of how the
error has been corrected.
INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS

(IPSAS)
International Public Sector Accounting Standards (IPSAS) are a set of accounting standards
issued by the IPSAS Board for use by public sector entities around the world in the preparation
of financial statements. These standards are based on International Financial Reporting Standards
(IFRS) issued by the International Accounting Standards Board (IASB).
Objective
IPSAS aims to improve the quality of general purpose financial reporting by public sector
entities, leading to better informed assessments of the resource allocation decisions made by
governments, thereby increasing transparency and accountability.
Scope
IPSAS are accounting standards for application by national governments, regional (e.g., state,
provincial, territorial) governments, local (e.g., city, town) governments and related
governmental entities (e.g., agencies, boards and commissions). IPSAS standards are widely
used by intergovernmental organizations. IPSAS do not apply to government business
enterprises.
Due process

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IPSAS are issued by IPSASB (International Public Sector Accounting Standards Board), an
independent organ of IFAC (International Federation of Accountants). The IPSASB adopts a due
process for the development of IPSAS that provides the opportunity for comment by interested
parties including auditors, preparers (including finance ministries), standard setters, and
individuals. IPSASB meetings to discuss the development and to approve the issuance of IPSAS
or other papers are open to the public. Agenda papers, including the minutes of the meetings of
the IPSASB, are published on the IPSASB's website: www.ipsasb.org. Observers on the IPSASB
meetings include ADB, EU, IASB, IMF, INTOSAI, OECD, UN, UNDP and the World Bank.
Convergence of IPSAS with IFRS
IPSAS are based on the International Financial Reporting Standards (IFRS), formerly known as
IAS. IFRS are issued by the International Accounting Standards Board (IASB). IPSASB adapts
IFRS to a public sector context when appropriate. In undertaking that process, the IPSASB
attempts, wherever possible, to maintain the accounting treatment and original text of the IFRS
unless there is a significant public sector issue which warrants a departure.
IFRS 4 INSURANCE CONTRACTS
IFRS 4 Insurance Contracts applies, with limited exceptions, to all insurance contracts
(including reinsurance contracts) that an entity issues and to reinsurance contracts that it holds.
In light of the IASB's comprehensive project on insurance contracts, the standard provides a
temporary exemption from the requirements of some other IFRSs, including the requirement to
consider IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors when
selecting accounting policies for insurance contracts.
IFRS 4 was issued in March 2004 and applies to annual periods beginning on or after 1 January
2005.
Summary of IFRS 4
Background
IFRS 4 is the first guidance from the IASB on accounting for insurance contracts – but not the
last. A Second Phase of the IASB's Insurance Project is under way. The Board issued IFRS 4
because it saw an urgent need for improved disclosures for insurance contracts, and some
improvements to recognition and measurement practices, in time for the adoption of IFRS by
listed companies throughout Europe and elsewhere in 2005.
Scope
IFRS 4 applies to virtually all insurance contracts (including reinsurance contracts) that an entity
issues and to reinsurance contracts that it holds. [IFRS 4.2] It does not apply to other assets and
liabilities of an insurer, such as financial assets and financial liabilities within the scope of IAS
39 Financial Instruments: Recognition and Measurement. [IFRS 4.3] Furthermore, it does not
address accounting by policyholders. [IFRS 4.4(f)]

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In 2005, the IASB amended the scope of IAS 39 to include financial guarantee contracts issued.
However, if an issuer of financial guarantee contracts has previously asserted explicitly that it
regards such contracts as insurance contracts and has used accounting applicable to insurance
contracts, the issuer may elect to apply either IAS 39 or IFRS 4 to such financial guarantee
contracts. [IFRS 4.4(d)]
Definition of insurance contract
An insurance contract is a "contract under which one party (the insurer) accepts significant
insurance risk from another party (the policyholder) by agreeing to compensate the policyholder
if a specified uncertain future event (the insured event) adversely affects the policyholder."
[IFRS 4.Appendix A]
Accounting policies
The IFRS exempts an insurer temporarily (until completion of Phase II of the Insurance Project)
from some requirements of other IFRSs, including the requirement to consider IAS 8 Accounting
Policies, Changes in Accounting Estimates and Errors in selecting accounting policies for
insurance contracts. However, the standard: [IFRS 4.14]
 prohibits provisions for possible claims under contracts that are not in existence at the
reporting date (such as catastrophe and equalisation provisions)
 requires a test for the adequacy of recognised insurance liabilities and an impairment test
for reinsurance assets
 requires an insurer to keep insurance liabilities in its balance sheet until they are
discharged or cancelled, or expire, and prohibits offsetting insurance liabilities against
related reinsurance assets and income or expense from reinsurance contracts against the
expense or income from the related insurance contract
Changes in accounting policies
IFRS 4 permits an insurer to change its accounting policies for insurance contracts only if, as a
result, its financial statements present information that is more relevant and no less reliable, or
more reliable and no less relevant. [IFRS 4.22] In particular, an insurer cannot introduce any of
the following practices, although it may continue using accounting policies that involve them:
[IFRS 4.25]
 measuring insurance liabilities on an undiscounted basis

 measuring contractual rights to future investment management fees at an amount that
exceeds their fair value as implied by a comparison with current market-based fees for
similar services
 using non-uniform accounting policies for the insurance liabilities of subsidiaries

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Re-measuring insurance liabilities
The IFRS permits the introduction of an accounting policy that involves remeasuring designated
insurance liabilities consistently in each period to reflect current market interest rates (and, if the
insurer so elects, other current estimates and assumptions). Without this permission, an insurer
would have been required to apply the change in accounting policies consistently to all similar
liabilities. [IFRS 4.24]
Prudence
An insurer need not change its accounting policies for insurance contracts to eliminate excessive
prudence. However, if an insurer already measures its insurance contracts with sufficient
prudence, it should not introduce additional prudence. [IFRS 4.26]
Future investment margins
There is a rebuttable presumption that an insurer's financial statements will become less relevant
and reliable if it introduces an accounting policy that reflects future investment margins in the
measurement of insurance contracts. [IFRS 4.27]
Asset classifications
When an insurer changes its accounting policies for insurance liabilities, it may reclassify some
or all financial assets as 'at fair value through profit or loss'.
Other issues
The standard:
 clarifies that an insurer need not account for an embedded derivative separately at fair
value if the embedded derivative meets the definition of an insurance contract
 requires an insurer to unbundle (that is, to account separately for) deposit components of
some insurance contracts, to avoid the omission of assets and liabilities from its balance
sheet
 clarifies the applicability of the practice sometimes known as 'shadow accounting'
 permits an expanded presentation for insurance contracts acquired in a business
combination or portfolio transfer
 addresses limited aspects of discretionary participation features contained in insurance
contracts or financial instruments
Disclosures
The standard requires disclosure of:

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 information that helps users understand the amounts in the insurer's financial statements
that arise from insurance contracts:
o accounting policies for insurance contracts and related assets, liabilities, income,
and expense
o the recognised assets, liabilities, income, expense, and cash flows arising from
insurance contracts
o if the insurer is a cedant, certain additional disclosures are required
o information about the assumptions that have the greatest effect on the
measurement of assets, liabilities, income, and expense including, if practicable,
quantified disclosure of those assumptions
o the effect of changes in assumptions
o reconciliations of changes in insurance liabilities, reinsurance assets, and, if any,
related deferred acquisition costs
 Information that helps users to evaluate the nature and extent of risks arising from
insurance contracts:
o risk management objectives and policies
o those terms and conditions of insurance contracts that have a material effect on
the amount, timing, and uncertainty of the insurer's future cash flows
o information about insurance risk (both before and after risk mitigation by
reinsurance), including information about:
 the sensitivity to insurance risk
 concentrations of insurance risk
 actual claims compared with previous estimates
o the information about credit risk, liquidity risk and market risk that IFRS 7 would
require if the insurance contracts were within the scope of IFRS 7
o information about exposures to market risk arising from embedded derivatives
contained in a host insurance contract if the insurer is not required to, and does
not, measure the embedded derivatives at fair value
Rating agency analysis of IFRS 4
Fitch Ratings – a leading global fixed income rating agency – has analysed the implications of
IFRS 4 Insurance Contracts and has concluded that Fitch "does not expect any rating actions as
a direct result of the move to IFRS. However, Fitch cannot rule out the possibility that the
additional disclosure and information contained in the accounts could lead to rating changes due
to an improved perception of risk based on the enhanced information available." The special
report Mind the GAAP: Fitch's View on Insurance IFRS provides an overview of IFRS 4 and the
issues being addressed in Phase II of the IASB's insurance project; assesses the implications
including increased volatility, greater use of discounting and fair values, changes to income
recognition, and enhanced disclosures; and discusses how the changes affect ratings analysis. An
excerpt:

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Fitch welcomes the progress made by the IASB towards standards that will be more transparent
and comparable across regions. The agency recognises the significant limitations of phase 1 but
believes that the enhanced disclosure and greater consistency at phase 1 of the insurance
accounting project (set out in IFRS 4) will aid in the analysis of insurers and is a useful stepping
stone to the more valuable phase 2.
CASH FLOW STATEMENT
Definition
"A statement of changes in the financial position of a firm on cash basis is called a cash
flow statement."
The cash flow statement describes the inflow (sources) & outflow (uses) of cash. It
summarizes the causes of changes in cash position of a business enterprise between two balance
sheets.
Classification of Cash Flows

1) Cash flows from operating activities
2) Cash flows from investing activities
3) Cash flows from financing activities
Cash flows from Operating Activities

Operating activities are the basic revenue producing activities of the enterprise. The amount of
cash flows arising from operating activities is an indicator of a firm's operating capability to
generate sufficient funds to meet its operating needs, pay dividends, repay loans, etc. without
depending on external sources of finance.
Examples of cash flow from operating activities
1) Cash receipts from sale of goods & rendering of services

2) Cash receipts from royalties, fees, commissions, etc
3) Cash payment to suppliers of goods & services
4) Cash payment to & on behalf of employees
5) Cash receipts & payments of an insurance company for premiums, claims, annuities and
other policy benefits
6) Cash payments or refunds of income tax relating to operating activities
7) Cash receipts and payments from contracts held for dealing or trading purposes.
Cash flows from Investing Activities

Investing activities are the acquisition & disposal of long term assets & investments. A separate
disclosure of cash flows arising from investing activities is important because cash flows
represent the extent to which expenditure have been made for resources to generate future
incomes.

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Examples of cash flow from investing activities
1) Cash payments to acquire fixed assets (including intangibles).
2) Cash receipts from disposal of fixed assets (including intangibles)
3) Cash receipts from disposal of shares, warrants, debt instruments, etc
4) Cash advances & loans made to third parties.
5) Cash receipts from the repayment of advances & loans made to third parties.
Cash flows from Financing Activities

Financing activities are activities that result in changes in the size & composition of the owners'
capital (including preference share capital in the case of a company) & borrowings of the
enterprise.
Examples of cash flows from financing activities

1) Cash proceeds from issuing shares or other similar instruments
2) Cash proceeds from issuing debentures, loans, bonds & other short or long term
borrowings
3) Cash repayments of amounts borrowed such as redemption of debentures, bonds,
preference shares.
Uses & Significance of Cash Flow Statement

Cash Flow Statement is of vital importance to the financial management & short term
financial planning. Its various uses are as follows:
1. Cash Flow Statement is prepared on cash basis hence it is useful in evaluating the cash
position of an enterprise.
2. A projected cash flow statement can be prepared so that it can enable the firm to plan &
co – ordinate its financial operations efficiently.
3. A comparison of historical & projected cash flow statements will reveal variations in the
performance so that the firm can take immediate effective action.
4. It indicates whether a firm's short term paying capacity is improving or deteriorating over
a period of time by preparing cash flow statements for a number of years.
5. It helps in planning the repayment of loans, replacement of fixed assets etc. It is also
significant for making capital budgeting decisions.
6. It clearly indicates the causes for poor cash position in spite of substantial profits in a
firm by throwing light on various applications of cash made by the firm.
7. Cash Flow Statement provides information of all activities classified under operating,
investing & financing activities.

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Limitations of Cash Flow Statement
Despite of a number of uses, cash flow statement also suffers from the following limitations:
i) As cash flow statement is based on cash basis of accounting, it ignores the basic
accounting concept of accrual basis.
ii) Cash Flow statement is not suitable for judging the profitability of a firm as non – cash
charges are ignored while calculating cash flows from operating activities.
iii) Funds flow statement presents a more complete picture than Cash flow statement.
iv) It is difficult to define the term "cash". There are no controversies over a number of items
like cheques, stamps, postal orders etc whether they are to be included in cash.
Note:
i. An increase in liability is a source of cash or cash inflow e.g. increase in creditors implies
purchase of goods on credit. Although no cash is received we can say that creditors have
given us loans which we have utilized to purchase goods from them.
ii. A decrease in liability is an application of cash or cash outflow e.g. sundry creditors are
paid off.
iii. An increase in asset is an outflow of cash e.g. goods sold on credit.
iv. A decrease in asset is an inflow or source of cash e.g. sale of stock, cash received from
debtors.
Actual flow of cash

It is the movement of cash that results in actual inflow or outflow of from the firm e.g. When
shares are issued for cash or when loan is repaid or when assets are sold for cash.
Notional flow of cash

It refers to delayed receipts & payments. Increase in current liabilities like trade creditors, bills
payable, etc results in notional inflow of cash as here cash inflow is implied.
Usually increase in long term liabilities generate actual cash & increase in current liabilities
generate notional cash.
REPORTING CASHFLOW FROM OPERATING ACTIVITIES
An enterprise should report cash flow from operating activities using either:
 The direct method, whereby major classes of gross cash payments are disclosed ;or

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
The indirect method, whereby net profit or loss is adjusted for the effects of transactions
of a non-cash nature, any deferrals or accruals of post or future operating cash receipts or
payments, and items of income or expense associated with investing or financing cash
flows.
DIRECT METHOD
Enterprises are encouraged to report cash flows from operating activities using the direct method.
Under the direct method information about major classes of gross cash receipts and gross cash
payments may be obtained either:
a. From the accounting records of the enterprise; or

b. By adjusting sales, cost of sales (interest and similar income and interest expense and
similar charges for a financial institution) and other items in the income statement for:
i. Changes during the period in inventories and operating receivables and payables
ii. Other non-cash items and
iii. Other items for which the cash effects are investing or financing cash flows.
INDIRECT METHOD
under the indirect method, the net cash flow from operating activities is determined by adjusting
a net profit or loss for the effects of:
a) changes during the period in inventories and operating activities receivables and payables
b) non-cash items such as depreciation, provisions, deferred taxes, unrealized minority
interest
c) All other items for which the cash effects are investing or financing cash flows.
Alternatively, the net cash flow from operating activities may be presented under the indirect
method by showing the revenue and expenses disclosed in the income statement and the changes
during the period in inventories and operating receivables and payable.
REPORTING CASH FLOWS FROM INVESTING AND FINANCIAL ACTIVITIES
An enterprise should report separately major classes of gross cash receipts and gross cash
payments arising from investing and financing activities, except to the extent that cash flows
described below are reported on a net basis.
REPORTING CASH FLOWS ON NET BASIS
Cash flow arising from the following operating, investing or financing activities may be reported
on a net basis:
a) Cash receipts and payments on behalf of customers when the cash flow reflect the
activities of the customer rather than those of the enterprise; and
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b) Cash receipts and payments for items, in which the turnover is quick, the amounts are
large, and the maturities are short.
Examples of cash receipts and payments referred to in (a) above are:
1. The acceptance and repayment of demand deposits of a bank

2. Funds held for customers by an investment enterprise
3. Rents collected on behalf of and paid over to the owners of properties
Examples of cash receipts and payments referred to in (b) above are advances made for, and
repayment of:
1. Principal amount relating to credit card customers

2. The purchase and sale of investments
3. Other short-term borrowing for example, those which have a maturity period of three
months or less
Cash flows arising each of the following activities of a financial institution may be reported on a
net basis:
a) Cash receipts and payments for the acceptance and repayment of deposits with fixed
maturity date.
b) The placement of deposits with and withdrawal of deposits from other financial
institutions
c) Cash advances and loans made to customers and repayment of those advances and loans
FOREIGN CURRENCY CASH FLOWS
Cash flows arising from transactions in a foreign currency should be recorded in an enterprises
reporting currency by applying to the foreign currency amount to the exchange rate between the
reporting currency and the foreign currency at the date of the cash flow.
The cash flow of a foreign subsidiary should be translated at the exchange rate between the
reporting currency and the foreign currency at the dates of cash flow
Unrealized gains and losses arising from changes in foreign currency exchange rates are not cash
flows. However, the effects of exchange rates changes on cash equivalents held or due in a
foreign currency is reported in the cash flow statement in order to reconcile cash and cash
equivalent at the beginning and the end of the period. This amount is presented separately from
cash flow from operating activities and financing activities and includes the differences, if any,
had those cash flows been reported at end of period exchange rates.
REPORTING EXTRAORDINARY ITEMS
The cash flow associated with extraordinary items should be classified as arising from operating,
investing or financing activities as appropriate and separately disclosed

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INTEREST AND DIVIDENDS
Cash flows from interest and dividends received and paid should each be disclosed separately.
Each should be classified in a consistent manner from period to period either as operating,
investing or financing activities
The total amount of interest paid during a period is disclosed in the cash flow statement whether
it has been recognized as an expense in the income statement or capitalized
Interest paid and interest and dividend received are usually classified as operating cash flows for
a financial institution. However, there is no consensus on the classification of these cash flows
for other enterprises. Interest paid and interest and dividends received may constitute operating
cash flow because they enter into the determination of net profit or loss alternatively, interest
paid and interest dividends received may be classified as financing cash flow and investing cash
flows respectively, because they are costs of obtaining financial resources or returns on
investment.
Dividends paid may be classified as a financing cash flow because they are a cost of obtaining
financial resources. Alternatively, dividends paid may be classified as a component of cash flow
from operating activities in order to assist users to determine the ability of an enterprise to pay
dividends out of operating cash flows.
TAXES ON INCOME
Cash flows arising from taxes on income should be separately disclosed and should be classified
as cash flow from operating activities unless they can be specifically identified with financing
and investing activities
Taxes on income arises on transactions that give rise to cash flow that are classified as operating
,investing or financing activities in a cash flow statement. While tax expense may be readily
identifiable with investing or financing activities the relating tax cash flow are often
impracticable to identify and may arise in a different period from the cash flows of the
underlying transaction. Therefore, taxes paid are usually classified as cash flow from operating
activities. However, when it is practicable to identify the tax cash flows with an individual
transaction that gives rise to cash flows that are classified as investing or financing activities the
tax cash flow is then classified as an investing or financing activity as appropriate. When tax
cash flows are allocated over more than one class of activity, the total amount of taxes paid is
disclosed.
INVESTMENTS IN SUBSIDIARIES, ASSOCIATES AND JOINT VENTURES.
When accounting for an investment in an associated or a subsidiary for by use of the equity or
cost method, an investor restricts its reporting in the cash flow statement to the cash flow
between itself and the investee, for example, to dividends and advances
An enterprise that reports its interests in a jointly controlled entity using proportionate

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consolidation includes in its consolidated cash flow statement its proportionate share of the
jointly controlled entity‘s cash flow. An enterprise, which reports such an interest using the
equity method, includes its cash flow statement the cash flows in respect of its investments or
receipts between it and jointly controlled entity.
ACQUISITIONS AND DISPOSALS OF SUBSIDIARIES AND OTHER BUSINESS

UNITS
The aggregate cash flows arising from acquisition and from disposals of subsidiaries or other
business units should be presented separately and classified as investing activities.
An enterprise should disclose, in aggregate, in respect of both acquisition and disposals of

subsidiaries or other business acquired during the period each of the following;
a) The total purchases or disposal consideration

b) The portion of the purchase or disposal consideration discharged by means of cash and
cash equivalent
c) The amount of cash and cash equivalent in the subsidiary or business unit acquired or
disposed of and
d) The amount of the assets and liabilities other than cash or cash equivalents in the
subsidiary or business unit acquired or disposed of, summarized by each major category.
INVESTMENT IN SUBSIDARIES, ASSOCIATES AND JOINT VENTURES
The separate presentation of the cash flow effects of acquisitions and disposals of subsidiaries
and other business units as single line items, together with the separate disclosure of the amounts
of assets and liabilities acquired or disposed of, helps to distinguish those cash flows from the
cash flows arising from the other operating, investing and financing activities. The cash flow
effects of disposals are not deducted from those of acquisitions.
The aggregate amount of the cash paid or received as purchase or sale consideration is reported
in the cash flow statement net of cash and cash equivalent acquired or disposed of.
NON-CASH TRANSACTIONS
Investing and financing transactions that do not require the use of cash or cash equivalents
should be excluded. From a cash flow statement, such transactions should be disclosed elsewhere
in the financial statements in a way that provides all the relevant information about these
investing and financing activities.
Many investing and financing activities do not have a direct impact on current cash flows
although they do affect the capital and asset structure of a company. The exclusion of non-cash
transactions from the cash flow statement is consistent with the objective of a cash flow
statement as these items do not involve cash flows in the current period. Examples of non-cash
transactions are :
a) The acquisition of asset or assets either by assuming directly related liabilities or by

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means of a finance lease:
b) The acquisition of a company by means of an equity issue; and
c) The conversion of debt to equity.
COMPONENTS OF CASH AND CASH EQUIVALENTS
An enterprise should disclose the components of cash and cash equivalents and should present a
reconciliation of the amounts in its cash flow statement with the equivalent items reported in the
balance sheet.
OTHER DISCLOSURES
A company should disclose, together with a commentary by management, the amount of

significant cash and cash equivalent balances held by the company.
Additional information may be relevant to users in understanding the financial position and
liquidation of a company. Disclosure of this information, together with a commentary by
management, is encouraged and may include:
a) The amount of undrawn borrowing facilities that may be available for future operating
activities and to settle capital commitments, indicating any restrictions on the use of these
facilities.
b) The aggregate amounts of cash flows that represent increase in operating capacity
separately from those cash flows that are require maintaining operating capacity.
The separate disclosure of cash flows that represent increases in operating capacity and cash
flows are required to maintain operating capacity is useful in enabling the user to determine
whether the company is investing adequately in the maintenance of its operating capacity. A
company that does not invest adequately in the maintenance of its operating capacity may be
prejudicing future profitability for the use of current liquidity and distribution to owners.

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On 16 June 2011, the IASB published amendments to IAS 1 Presentation of Financial
Statements. The amendments to IAS 1 retain the 'one or two statement' approach at the option of
the entity and only revise the way other comprehensive income is presented: requiring separate
subtotals for those elements which may be 'recycled' (e.g. cash-flow hedging, foreign currency
translation), and those elements that will not (e.g. fair value through OCI items under IFRS 9).
FORMAT OF CASH FLOW STATEMENT FOR NON-FINANCIAL INSTITUTION

ENTERPRISE
Direct method:
Sh sh
Cash flows from operating activities
Cash receipts from customers XX
Cash paid to suppliers (of goods and services) XX
Cash paid to and on behalf of employees XX
Cash generated from operations XX
Interest paid XX
Income tax paid XX
Cash flow before extraordinary item XX
Extraordinary item XX
Net cash from operating XX
Cash flow from investing activities
Purchase of property, plant and equipment XX
Proceeds from sale of equipment XX
Interest received XX
Dividends received XX
Net cash from or used in investing activities XX
Cash flow from financing activities
Proceeds from issuance of share capital XX
Proceeds from long term borrowing XX
Payment of finance lease liability XX
Dividends paid XX
Net cash from or used in financing activities XX
Net increase in cash and cash equivalent XX
Cash and cash equivalents at beginning of period XX
Cash and cash equivalent at end of period XX
Indirect method:

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sh sh
Net profit before taxation and extraordinary item XX
Adjustments for:
Depreciation XX
Amortization XX
Foreign exchange loss/gain XX
Investment income/loss XX
Interest expense XX
Operating profit before working capital XX
Increase/decrease in debtors XX
Increase/decrease inventories XX
Increase/decrease in trade creditors XX
Cash generated from operations XX
Interest paid XX
Income tax paid XX
Cash flow before extraordinary item XX
Extraordinary item (specify) XX
Net cash from operating activities XX
Cash flows from investing activities
Proceeds from sale of equipment XX
Net cash from or used in investing activities XX
Proceeds from issuance of share capital XX
Proceeds from long-term borrowing XX
Payment of finance lease liability XX
Dividends paid XX
Net cash from or used in financing activities XX
Net increase in cash and cash equivalents at the beginning of period XX
cash and cash equivalents at the beginning of period XX

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FORMAT OF CASH FLOW STATEMENT FOR A FINANCIAL INSTITUTION
ENTERPRISE
sh Sh
interest and commission receipts XX
interest payments XX
Recoveries on loans previously written off XX
Cash payments of employees and supplies XX
Operating profit before charges in operating assets XX
Increase or decrease in operating assets;
Short term funds XX
Extraordinary item XX
Deposits held for regulatory or monetary control purposes XX
Funds advanced to customers
Net increase in credit and receivables XX
Other short term negotiable securities XX
Increase or decrease in operating liabilities;
Deposit from customers XX
Negotiable certificates of deposit XX
Net cash from operating activities income tax XX
Income tax paid XX
Net cash from operating activities XX
Disposal from subsidiary Y XX
Proceeds from sale of non-dealing securities XX
Purchase of non-dealing securities XX
Net cash from investing activities XX
Issue of loan capital XX
Issue of preference shares by subsidiary undertaking XX
Repayment of long-term borrowing XX
Net decrease in other borrowing XX
Net cash from financing activities XX
Effects of exchange rate changes on cash and cash equivalents XX
Net increase in cash and cash activities XX
Cash and cash equivalents at begging of period XX
Example:
187
The chief accountant of Gucci Ltd availed the following financial statement for the financial
years ended 30th April 2011 and 2010
Income statement for the year ended 30th April 2011

Sh. Sh.
sales 4,395,000
Opening stock 190,000
purchases 2,980,000
3,170,000
Closing stock (240,000)
Cost of sales 2,930,000
Gross profit 1,465,000
Profit on sale of equipment 30,000
1,495,000
Expenses:
Depreciation 190,000
interest 25,000
(1,175,000)
Tax (120,000)
Profit after tax 200,000
Dividends
Interim paid 20,000
Dividend proposed 50,000
(70,000)
Retained profit for the year 80,000
Statement of financial position as at 30th April 2010

2011 2010
Sh.‖000‖ Sh.‖000‖
Non-current assets
Land 600,000 450,000
Motor vehicle 400,000 370,000
Equipment 200,000 300,000
Furniture 160,000 200,000
1,360,000 1,320,000
Current assets
inventory 240,000 190,000
Trade receivables 210,000 230,000
Bank balance and cash in hand 90,000 60,000
188
540,000 480,000
Total assets 1,900,000 1,800,000

Capital reserves:
ordinary share capital 600,000 500,000
share premium 150,000 100,000
general reserve 150,000 80,000
retained profits 320,000 240,000
1,220,000 920,000
Non-current liabilities
Debentures 200,000 300,000
Current liabilities
Trade payables 210,000 250,000
Taxation 90,000 70,000
Accrued wages and salaries 145,000 210,000
Accrued debenture interest 5,000 10,000
Proposed dividend 30,000 40,000
480,000 580,000
Total equity and liability 1,900,000 1,800,000
1. The purchase of land was financed by the issue of new ordinary shares at premium
2. An old piece of equipment was sold during the financial year ended 30th April 2011 at a profit
sh. 30,000,000.
Depreciation was provided as follows in the year:
Sh‖000‖
Motor vehicle 100,000
Equipment 50,000
Furniture 40,000
Required:
Statement of Cash flow in accordance with IAS 7 for the year ended 30th April 2011. Using
direct method.
Suggested solution:
Gucci statement of cash flows (workings)
Sh. ‗000‘
1. Receipts from customers
Accounts receivable balance b/f 230,000
Sales for 2013 4,395,000 4,395,000
Accounts receivables balance c/f (210,000)
Cash collected from customers 4,415,000
2. cash paid to suppliers

Accounts payable b/f 250,000
Purchases 2,980,000

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Accounts payable c/f (210,000)
Cash paid to customers 3,020,000
3. cash paid for wages and salaries

Wages and salaries accrued b/f 210,000
Expense for the year 960,000
Wages and salaries c/f (145,000)
Cash paid for wages and salaries 1,025,000
4. Cash paid on interest

Interest accrued b/f 10,000
Expense for the year 25,000
Interest accrued c/f (5,000)
Cash paid on interest 30,000
5. cash paid on tax

Tax payable bal b/f 70,000
Charge for the year 120,000
Tax payable c/f (90,000)
Cash paid on tax 100,000
6. cash paid for land purchases

Increase in share capital and premium
(600,000+150,000)-(500,000-100,000) 150,000
7.cash received from equipment sale

Balance b/f on equipment 300,000
Less depreciation (50,000)
250,000
Balance c/f on equipment 200,000
Disposal (carrying amount) 50,000
Add: profit on disposal 30,000
Cash received from disposal 80,000
8.cash paid on purchase of motor vehicle

Bal b/f carrying amount of motor vehicle 370,000
Depreciation for the year (100,000)
Carrying amount suntotal 270,000
Bal c/f carrying amount of motor vehicle 400,000
Cash paid for addition on motor vehicle 130,000
9. cash from issue of shares 150,000
10. cash paid for dividends

Proposed b/f 40,000
Current year‘s paid and proposed 50,000
Proposed c/f (30,000)
Cash paid for dividends 60,000
11. redemption of debentures(300,000-200,000) 100,000

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Statement of cash flow for the year ended 30th April 2011
Sh sh
Cash receipts from customers 4,415,000
Cash paid to suppliers (3,020,000)
Cash paid for wages and salaries (1,025,000)
Interest paid (30,000)
Tax paid (100,000)
Net cash from operating 240,000
Purchase of land (150,000)
Proceeds from sale of equipment 80,000
Purchase of motor vehicle (130,000)
Net cash from or used in investing activities (200,000)
issuance of shares at premium 150,000
Redemption of debentures (100,000)
Dividends paid (60,000)
Net cash from or used in financing activities (10,000)
Net cash generated during the year 30,000
Cash and cash equivalents at beginning of period 60,000
Cash and cash equivalent at end of period 90,000
Question:
a) In recent years, many financial analysts have commented on a growing disillusionment
with the usefulness and reliability of the information contained in some companies‘
income statements.
Required:
Discuss the extent to which a company‘s statement of cashflows may be more useful and reliable
than its income statement. (6marks)
b) The following information has been extracted from the financial statements of Texco
limited:
Income statement for the year ended 30 September 2010

2010
Sh.‖000‖
Revenue 15,000
Cost of sales (9,000)
Gross profit 6,000
Other operating expenses (2,300)
3,700
Finance cost (124)
Income tax expense (1,040)
Profit after tax 2,536
dividends (1,100)
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1,436
Statement of financial position as at 30 September

2010 2009
Assets: Sh.‖000‖ Sh.‖000‖
Non-current assets 18,160 14,500
Current assets:
Inventories 1,600 1,100
Trade receivables 1,500 800
Bank balance 150 3,250 1,200 3,100
Total assets 21,410
17,600

Capital and reserve:
Issued capital 10,834 7,815
Accumulated profits 5,836 4,400
16,670 12,215
Non-Current liabilities:
Interest bearing borrowings 1,700 2,900
Deferred tax 600 2,300 400 3,300
Proposed dividend 700 600
Tax 1,040 2,440 685
2,085
21,410
17,600
1. Non-current assets:
Property Plant Total
Sh‖000‖ Sh‖000‖ Sh‖000‖
At 30 September2009
Cost 8,400 10,800 19,200
Depreciation 1,300 3,400 4,700
Net book value 7,100 7,400 14,500
At 30 September 2010
Cost 11,200 13,400 24,600
Depreciation 1,540 4,900 6,440
Net book value 9,660 8,500 18,160

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2. Plant disposed of during the year ended 30 September 2010 had an original cost of
sh.2,600,000 and accumulated depreciation of sh.900,000. The cash received on disposal
was sh.730,000.
3. All additions to non-current assets during the year ended 30 September 2010 were
purchased for cash.
4. Dividends were declared before the balance sheet dates.
Required:
Statement of cash flows (in conformity with IAS 7, Statement of cash flows) and associated
notes, for the year ended 30 September 2010.
(14 marks)
Suggested solution:
a) Preference of cash flow statement over income statement.
Cash flow statement explicitly indicates how a firm sources for funds and also how it is
used. Income statement on the other hand does not clearly indicate sources and
application of funds.
As opposed to income statement, statement of cash flow may guard against creative
accounting with income statement, especially using basis of accounting, companies may
overstate revenues e.g. By including gains on disposal as part of revenue when in fact this
forms part of other comprehensive income.
Some corporations fail due to poor working capital management. There is no deliberate
effort in income statement to indicate in working capital items. This is well covered in
statement of cash flows especially using the indirect method in presenting statement of
cashflows.
Ordinarily, items not involving movement of cash e.g. depreciation; amortization and
effect of deferred tax would loosely part of sunk cost. Income statement takes into
account cognizance of such items before matching principle However, such items
especially depreciation and amortization may not have any bearing on future planning.
b)
i. Gain/loss from disposal of NCA plant

Cash received 730
NBV (2600-900) 1 700
Loss on disposal 970
ii. Depreciation for the year.

193
Accumulated depreciation a/c
Disposal Balance b/d 4
900 700
Balance c/d 6 Charge for period 2
440 640
7 7
340 340
iii. Additions to NCA
NCA (cost)
Balance b/d 19 Disposal 2
200 600
Addition 8 Balance c/d 2
000 4600
27 27
200 200
iv. tax paid for the year
Tax payable a/c

C/B (paid) Balance b/d
485 685
Balance c/d 1 Expense I/c
040 840
1 1
525 525
*Expense I/c 1 040 Less: effect of deferred tax

liability (200) =840
v. dividends paid
Dividends payable a/c

Cash 1 Balance b/d
000 600
Balance c/d Proposed 1
700 100
1 1
700 700
Statement of cashflows

194
Cash flow from operating activities:
Sh‖000‖ Sh‖000‖ Sh‖000‖
Adjustments:
Add:
Depreciation 2 640
Loss on disposal 970
Interest expense 124 3 734
Changes in working capital items:

Increase in debtors (700)
Increase in inventory (500)
Decrease in payables (100) (1 300)
Tax paid (485)

Interest paid (124) (609)
Net cash from Operating activities 5 401
Cash flow from investing activities:

Purchase of NCA (8 000)
Disposal of plant 730
Net cash flow from investing (7 270)
Cash flow from Financing activities:
Redemption of long term debt (1 200)
Issue of shares 3 019
Dividends paid (1 000)
Net cash flow from financing 819
(1 050)
Cash and cash equivalent at the start of the year 1 200
Cash and cash equivalent at the end of the year 150

195
CHAPTER SIX
FINANCIAL STATEMENT ANALYTICAL TOOLS
Introduction
Financial statement analysis is the application of analytical tools and techniques to ‗general
purpose ‗financial statements and related data to derive estimates and be useful in business
analysis.
Financial statement analysis is an integral part of business analysis. Business analysis is the
process of evaluating a company‘s economic prospect and risk.
Components of business analysis
a) Business environmental strategy/analysis

-analysis of business environment seeks to identify and asses a company economic and industry
circumstances. This includes analysis of capital, labour and capital markets, Economic and
regulatory setting. It also assesses its strengths, weaknesses, opportunities and threats. Business
environment and strategy analysis consists of:-
i. Industry analysis
It assesses industry prospect and degree of actual and potential competition facing a company.
ii. Strategy analysis

Its evaluation of both a company‘s business decision and its success at establishing a competitive
advantage
b) Accounting analysis
This is the process of evaluating the extent to which a company‘s accounting reflects economic
reality.
b) Financial analysis
It‘s the Use of financial statements to analyze a company‘s financial position in performance and
to assess future financial performance. Financial statement analysis consists of three broad areas.
- Profitability analysis
This is the evaluation of a company‘s return on investment. It focuses on a company‘s sources
and level of profits and involves identifying and measuring impact of various profitability
avenues.
- Risk analysis
This is the evaluation of a company‘s ability to meet its commitments. Risk analysis involves
assessing solvency and liquidity of a company along with its earnings variability.
- Analysis of sources and uses of funds.

196
This is the evaluation of how a company is obtaining and deploying funds. This analysis
provides insight into a company‘s future financing implication
d) Prospective analysis
It‘s the forecasting of future payoffs typically earnings, cashflows etc. this analysis draws on
accounting analysis, financial analysis and business environmental and strategy analysis. The
output of prospective analysis is a set of expected future payoffs used to estimate company‘s
value.
Financial statements- basics of analysis
A company‘s financial statements and related disclosures give information about four major
activities.
1) Planning activities
A company‘s goals and objectives are captured in a business that describes the purpose, strategy
and tactics for its activities. The business plan assists managers in focusing the efforts in
identifying expected opportunities and obstacles
2) Financing activities
A company requires financing to carry out its business plan. Financing activities refer to methods
that companies use to raise funds to pay for these things.
There are two main sources of external financing.
- Lenders (creditors)
- Shareholders (investors)
Out of the sources of finance comes payment to lenders (interest) and dividends to shareholders.
3) Investing activities
This refers to a company‘s acquisition and maintenance of investments for purposes of selling
products and providing services for the purpose of investing cash.
Investments in land , buildings, equipments, legal rights, inventory and human capital,
information systems and similar assets are the purpose of conducting company‘s business
operations and as such they are called operating assets.
Financial assets on the other hand are the assets such as bonds, equity stock and money market
funds which the company invests in when it has excess cash.
Investments in short term assets are called current assets. These assets are expected to be
converted to cash in short term. Investment in long term assets is called Net current assets.
4) Operating activities
They represent the carrying out of business plan given the company‘s financing and operating
activities involve at least 5 key components that is research in depth, procurement, production,
marketing and administration.
Financial statements

197
Typically 4 financial statements are prepared
1. Statement of financial position

This is the basis of accounting system showing the company‘s net worth. It‘s a statement of
assets and liabilities at a given point in time. It shows what the company owes, what it is owed
and the capital structure.
2. Statement of comprehensive income
It shows the result of operations of a company in an accrual basis. Under accrual basis of
accounting revenues are recognized when or as sells goods or renders services independent of
receiving cash. Similarly expenses are matched to these recognized revenues independent of
paying cash.
3. Statements of changes in equity
These reports changes in accounting that make up equity. This statement is useful in identifying
reasons for changes in equity holders claims on the assets of a company.
4. Statement of cashflows
The statement of cashflows reports cash inflows and cash out flows separately for a company‘s
operating, investing and financing activities over a period of time.
Financial statement analysis presents
1. Comparative financial statement analysis

Individuals conduct comparative financial statement analysis by reviewing consecutive
statements of financial position, statement of comprehensive income etc from period to period.
This usually involves a review of changes in individual accounts balances on a year to year basis.
The most important information often revealed from Comparative financial statements is trend.
Horizontal analysis
This is another term for comparative financial analysis given the right-left or left-right analysis
of account balances. Two techniques of comparative analysis are
a. year to year change
This compares financial statements over a relatively short time period e.g. 2-3yrs and is usually
performed with analysis of year to year changes in individual‘s accounts.
b. Index no. trend analysis
This is useful in comparing financial statements covering more than 2 or 3 years. This method
involves choosing a base period for all times with preselected index no. usually set to 100 e.g.
ABC cash balance as at 31/12 year 1 (base periods is $12000). Its cash balance as at 31/12 year 2
is $8000 dollar using 100 as an index no. for year 1. The index no. for year 2 is 150 and is
computed as
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
× 100
𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑏𝑎𝑙𝑎𝑛𝑐𝑒

198
18000
× 100 = 150
12000
2. Common size financial statement analysis.
This procedure is also called vertical analysis given the up-down or down-up evaluation of
accounts in common size statements. Common financial statement analysis is useful in
understanding the internal make up of financial statements e.g. in analyzing a business. A
common size analysis stresses two factors.
i. Sources of financing-including distribution of financing across current liabilities, net
current liabilities and equity.
ii. Composition of assets including amount for individual and current assets.
Common size statements are especially important for inter-comparisons because financial
statements of different companies are recast in common size format.
Comparison of a company‘s common size statements with those of competitors or industry
averages can highlight the account make up and distribution.
Example of a common size income statement,
XYZ Company.
1998(%) 1999(%)
Sales 100 100
Cost of goods sold 54.4 54.9
Gross profit 45.6 45.1
Selling and distribution cost 26.4 26.9
rent and other costs 6.9 8.4
Restructuring cost 0.0 8.9
Earnings from 14.1 0.9
Interest expense 0.8 0.7
Other income 2.4 0.1
Earnings before income Taxes 15.7 0.3
Provision for income tax 5.3 0.3
Net earnings 10.4 0.0
3. Ratio analysis
A ratio expresses a mathematical relation between two quantities. The important areas of
financial statements where ratios are applied are:-
a) Liquidity-represents credit risk analysis
b) Capital structure -represents credit risk analysis
c) Return on investment
d) Asset utilization
4. Cashflow analysis
This is primary tool used to evaluate sources and uses of funds. Cashflow analysis provides
insight into how a company is obtaining its financing and deploying its resources.
199
It is also used in cashflows forecasting and as a part of liquidity analysis.
Specialized analytical tools
Beyond the usual multi-purpose tools of financial analysis are a variety of special purpose tools.
These includes those directed at specific financial statements or segments or at a particular
industry e.g. occupancy capacity analysis in hospitals, hostels, hotels or airlines analysis. Special
purpose tools also include some types of cash forecasting analysis, statement of valuation of
gross profit and earnings power analysis.
Limitations of financial statement information

i. Timeliness
Financial statements are prepared as often as every quarter and are typically released from 3-6
weeks after the periods end. In contrasts analysts update their forecasts and recommendation on a
yearly real time basis as soon as information about a company is available to them,
ii. Frequency
Financial statements are prepared periodically, typically each quarter. However, alternative
information sources including analyst‘s reports are released to the market whenever business
events demand their revision.
iii. Forward looking
Alternative information sources particularly analyst‘s reports and forecasts utilize much forward
looking information
Financial statements contain limited forecasts. Further, historical cost based accounting usually
yields recognition lags, where certain business activities are recorded at a lag.
iv. Income Vs. cash
Income is an economic concept that is distinct from cashflows and capital appreciation and its
determined on an accrual concept e.g. in investment in shares one gains income in share price
appreciation and cash in the name of dividend.
But cash is only dividend actually received in the cash.
Measuring and analyzing business performance.
There are typically two methods of comparing performance of a company.

- Industry analysis
- Trend analysis
Industry analysis
This is a situation where within a specific period, the performance of the company compared
against other companies in the same industry.
Trend analysis
This analysis the performance of a company‘s over time.
A useful way of studying financial statements is to express income statement and statements of
financial position figures as a % of subtotals e.g. gross profit as a % of sales or fixed asset as a %
of total assets. This method is called common size statement approach.

200
Ratio analysis
Financial ratios are relationships determines from a firms financial information and used for
comparison purposes. There are basically 5 components of performance and measurements.
Ratios can be classified into:

a) Liquidity ratios.
b) Leverage or gearing ratios.
c) Activity ratios.
d) Profitability ratios.
USERS OF RATIOS
There are a vast number of parties interested in analyzing financial statements including
shareholders, lenders, customers, employees, government, and competitors. In many occasions,
they will be interested in different things therefore there is no any definite, all-encompassing list
of points for analysis that would be useful to all these stakeholders. However, it is possible to
construct a series of ratios that together will provide all of them with something that they find
relevant and from which they can investigate further if necessary.
Ratio category Examples of interested parties

Profitability Shareholders, management, employees,
creditors, potential investors
Liquidity Shareholders, suppliers, creditors, competitors
Efficiency Shareholders, potential purchasers, competitors
Shareholder Shareholders, potential investors
Capital structure Shareholders, lenders, creditors, potential
investors
UDYTEXT
1. Liquidity ratios
These measure firm‘s ability to meet its short-term maturing obligations as and when they fall
due. The lower the ratio, the higher the liquidity risk and vice versa. Failure to meet short term
liabilities due to lack of liquidity may lead to poor credit worthiness, litigation by creditors and
insolvency.
2. Leverage or gearing ratios
These measure extent to which a company uses its assets which have been financed by non
owner supplied funds. They measure financial risk of the company. The higher the ratio, the
higher the financial risk. Gearing refers to the amount of debt finance a company uses relative to
its equity finance.
3. Activity ratios
These measure the efficiency with which a firm uses its assets to generate sales. They are also
called turnover ratios as they indicate the rate at which assets are converted into sales.

201
4. Profitability ratios
They measure the management‘s effectiveness as shown by returns generated on sales and
investment. They indicate how successful management has been in generating profits of the
company.
5. Investment or equity ratios

These are used to evaluate the overall performance of a company. E.g. in determining company‘s
dividend policy, determining theoretical value of company‘s securities and predicting effects of
rights issue.
1. LIQUIDITY RATIOS
Current ratio
This is computed by dividing total current assets by total current liabilities:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Current ratio of more than one means that a company has more current assets than current
liabilities.
Acid test or quick ratio
This is calculated by dividing total current liabilities excluding stock by current liabilities. A firm
with a satisfactory current ratio may actually be in a poor liquidity position when inventories
form most of the total current assets.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑠𝑡𝑜𝑐𝑘

𝐴𝑐𝑖𝑑 𝑡𝑒𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
ATEMENT ANALYSIS
220 FINANCIAL ACCOUNTING
STUDYTEXT
2. GEARING OR LEVERAGE RATIOS
3.
Debt ratio or capital gearing ratio
This measures the proportion of debt finance to capital employed by a company. A company is
highly geared if the ratio is greater than 50%.
𝑇𝑜𝑡𝑎𝑙 𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡

𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑥100
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Debt equity ratio
This measures the proportion of non owner supplied funds to owner‘s contribution to the
company. A company is highly geared if the debt equity ratio is greater than 100%.

202
𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝑒𝑞𝑢𝑖𝑡𝑦 𝑜𝑟 𝑛𝑒𝑡𝑤𝑜𝑟𝑡𝑕
Times interest cover
This shows number of times earnings by a company cover its current payments. The higher the
ratio, the lower the gearing position and thus the lower the financial risk.
Earnings before interest and tax + Depreciation

Times interest cover =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑕𝑎𝑟𝑔𝑒𝑑
3. PROFITABILITY RATIOS
Return on capital employed (ROCE)

This measures the efficiency with which a company uses long term funds or permanent assets to
generate returns to shareholders.
Profit before interest and tax or operating profit

ROCE =
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Capital employed consists of shareholders funds (ordinary share capital, preference share capital,
share premium and retained earnings) and long term debts. Capital employed can also be
calculated as fixed assets plus net working capital.
221
STUDYTEXT
Gross profit margin
This ratio shows how well cost of production has been controlled in relation to distribution and
administration costs.
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑥100
𝑆𝑎𝑙𝑒𝑠
Net profit margin

This measures firm‘s ability to control its production, operating and financing costs
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑥100
Net assets turnover

This gives a guide to productive efficiency i.e. how well assets have been used in generating
sales.
𝑠𝑎𝑙𝑒𝑠
𝑁𝑒𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
203
Operating profit/margin ratio
This indicates efficiency with which costs have been controlled in generating profit from sales.
𝑃𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥 𝑜𝑟 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑥100
Operating expenses ratio

This indicates a firm‘s ability to control production and operating costs to generate a given level
of sales.
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑟𝑎𝑡𝑖𝑜 = 𝑥100
Return on investment
These measures the efficiency with which a company uses its total funds in capital employed to
generate returns to owner‘s funds.
Net profit after tax
Return on investment = 𝑥100
Capital employed
Return on equity. (ROE)

This measures the efficiency with which a company other supplier‘s funds to generate returns to
shareholders.
Earnings attributable to equity shareholders
Return on equity = 𝑥100
Equity
Equity comprises of ordinary share capital, share premium and reserves.

FINANCIAL STATEMENT ANALYSIS
222 FINANCIAL ACCOUNTING
STUDYTEXT
4. ACTIVITY RATIOS
Fast forward - These measure the efficiency with which a firm uses its assets to generate sales
Debtor‘s turnover
This shows the number of times debtors pay within the year. It indicates how efficient the firm is
in management of credit. The higher the ratio, the more efficient management is in managing its
credit policy.
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
𝐷𝑒𝑏𝑡𝑜𝑟’𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠
Debtor‘s days or ratio
This is also called the average collection period. It shows the average period of credit taken by
customers who buy on credit. It is compared the company‘s allowed credit period by suppliers to
give an indication of credit administration efficiency.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠
𝐷𝑒𝑏𝑡𝑜𝑟’𝑠 𝑑𝑎𝑦𝑠 𝑜𝑟 𝑟𝑎𝑡𝑖𝑜 = 𝑥𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠

204
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
=
𝐷𝑒𝑏𝑡𝑜𝑟’𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Creditor‘s turnover
This indicates the number of times creditors are paid by a company during a year.
𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐𝑕𝑎𝑠𝑒𝑠
𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟’𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
Creditor‘s days or ratio

This is also called the average deferral period. It indicates the average time that suppliers allow
a company to settle its dues.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟’𝑠 𝑑𝑎𝑦 𝑟𝑎𝑡𝑖𝑜 = 𝑥𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐𝑕𝑎𝑠𝑒𝑠

=
𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟’𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Stock or inventory turnover

This indicates the efficiency of a firm in selling its products so as to generate sales. It shows the
times stock is turned over or converted into sales within a year. It shows how rapidly stock is
being turned into cash through sales.
Cost of sales
Stock or inventory turnover =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘
STUDYTEXT
Stock days/inventory conversion period
This indicates the number of days it takes to convert inventory into sales. The fewer the number
of days, the more efficient a company is in converting stock into sales.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘
S𝑡𝑜𝑐𝑘𝑑𝑎𝑦𝑠 𝑜𝑟 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝑥 𝑁𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑖𝑛 𝑎 𝑦𝑒𝑎𝑟
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠𝑠

=
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Cash working cycle/Working capital cycle/Operating cycle

This is the period for which working capital financing is needed. The higher the working capital
cycle, the higher the investment in working capital. It is the period of time that elapses between
the point at which cash is spent on production or purchase of raw materials/stock to time stock is
converted into cash or cash is collected from a customer.
Average collection period xxx

Add inventory conversion period xxx
Less average deferral period (xxx)
Working capital cycle xxx

205
Calculation of Operating Cycle
The length of the operating cycle of a manufacturing firm is the sum of:
i) Inventory conversion period
ii) Receivables/debtors‘ conversion period
The inventory conversion period is the total time needed to produce and sell the product. It
includes:
a) Raw material conversion period.
b) Work-in-Process conversion period.
c) Finished goods conversion period.
The debtors‘ conversion period is the time required to collect the outstanding amount from
customers.
A firm may acquire resources on credit and defer payments. Payables may thus arise. The
payables deferral period is the length of time the firm is able to defer payments on purchase of
resources. The difference between the payables deferral period and the sum of the inventory
conversion period and receivable conversion period is referred to as the operating/cash
conversion cycle.
1. Inventory conversion period.
It is the sum of raw material conversion period, working in progress conversion period and
finished goods conversion period.
Raw material conversion period. - It is the average time period taken to convert raw
material into work in Process.
Raw material conversion period = Raw material inventory / (Raw material consumption/
360)
Working in process conversion period. - It is the average time taken to complete the semi-
finished or work in process.
𝑤𝑖𝑝 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑝𝑟𝑜𝑐𝑒𝑠𝑠 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 / (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 /360)
Finished goods conversion period.- It is the time taken to sale the finished goods .
Finished goods conversion period = Finished goods inventory/ (cost of sales/ 360)

206
Debtors conversion period.
It is the time taken to convert the debtors to cash. It represents the aver age collection period.
𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 / (𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠/360)
Payables deferral period.
It is the average time taken by the firm to pay its suppliers / creditors.
𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟 𝑑𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 / (𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐𝑕𝑎𝑠𝑒/ 360)
Summary
Inventory conversion period + Debtors conversion period – Creditors deferral period =Net
operating cycle
Example
The following information relates to Mutongoi Limited.
Sh.000
Purchase of raw material 6,700
Usage of raw material 6,500
Sale of finished goods (all on credit) 25,000
Cost of sales(Finished goods) 18,000
Average creditors 1,400
Average raw materials stock 1,200
Average work in progress 1,000
Average finished goods stock 2,100
Average debtors 4,700
Assume a 365 days year.
Required:
The length of the operating cash cycle.
Solution.
Raw material conversion period = Raw material inventory / (Raw material consumption/ 360)
= (1,200/6,500) × 365
= 67days
Work in process conversion period = Working process inventory / (Cost of production /360)
207
= (1000/18000) × 365
=20 days
𝐹𝑖𝑛𝑖𝑠𝑕𝑒𝑑 𝑔𝑜𝑜𝑑𝑠 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐹𝑖𝑛𝑖𝑠𝑕𝑒𝑑 𝑔𝑜𝑜𝑑𝑠 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦/ (𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠/ 360)
= (2100/18000) × 365
=43 days
𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 / (𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠/360)
= (4700/25000) × 365
=69 days
𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟 𝑑𝑒𝑓𝑒𝑟𝑟𝑎𝑙 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 / (𝐶𝑟𝑒𝑑𝑖𝑡 𝑝𝑢𝑟𝑐𝑕𝑎𝑠𝑒/ 360)
= (1400/6700) × 365
= 76 days
Length of operating cycle.
Inventory conversion period.
Raw material conversion period 67
Work in process conversion period 20
Finished goods conversion period 43 130
Debtors conversion period 69
Gross working capital cycle 199
Less: Creditor deferral period (76)
Net Cash Operating cycle 123
Cash turnover/Operating turnover

This shows number of times a company needs to replenish its working capital in a year.
Number of days in a year
𝐶𝑎𝑠𝑕 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑜𝑟 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑐𝑦𝑐𝑙𝑒
Fixed assets turnover

This indicates level of sales generated by fixed asset base of a company. It shows the efficiency
with which a company utilizes its assets to generate sales.
Sales
Fixed assets turnover =
𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
224 FINANCIACCOUNTING
STUDYTEXT
208
5. INVESTMENT OR EQUITY RATIOS
Fast forward - These are used to evaluate the overall performance of a company
Earnings Per Share (EPS)
This indicates the amount shareholders expect to generate in form of earnings for every share
invested. It shows profitability of a company on a per share basis.
Earnings attributable to equity shareholders

𝐸𝑃𝑆 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠𝑕𝑎𝑟𝑒
Dividend per Share (DPS)

This represents the amount of cash dividend that shareholders expect to receive for every share
invested in the company.
Total ordinary dividends

Dividend Per Share =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠𝑕𝑎𝑟𝑒
Dividend pay out ratio

This indicates proportion of earnings attributable to equity shareholders that are paid out to
common shareholders as dividends. It is used in analysis of dividend policy of the firm.
Total common dividends

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑃𝑎𝑦 𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝑥100
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠𝑕𝑎𝑟𝑒𝑕𝑜𝑙𝑑𝑒𝑟𝑠
Dividend per share

= 𝑥100
𝐸𝑎𝑟𝑛𝑖𝑛𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒
Dividend retention ratio
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 = 𝑥100
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑡𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠𝑕𝑎𝑟𝑒𝑕𝑜𝑙𝑑𝑒𝑟𝑠
Dividend cover
Earnings per share (EPS)
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑐𝑜𝑣𝑒𝑟 =
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒 (𝐷𝑃𝑆)
Earnings yield
This measures the potential return that shareholders expect to earn for every share invested in a
company. It evaluates the shareholders returns in relation to the market value of a share.

209
Earnings per share (EPS)
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑑 𝑌𝑖𝑒𝑙𝑑 = 𝑥100
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒 (𝑀𝑃𝑆)
STUDYTEXT
Dividend yield
This ratio measures how much an investor expects to receive from cash dividends for every share
purchased or invested in a company.
Dividend per share (DPS)
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 = 𝑥100
Price earnings ratio

This indicates how much an investor is prepared to pay for a company‘s share given its current
earnings per share. The higher the price earnings ratio, the more confident investors are that the
company will perform well in future.
𝑃𝑟𝑖𝑐𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑠 𝑝𝑒𝑟 𝑠𝑕𝑎𝑟𝑒 (𝐸𝑃𝑆)
LIMITATIONS OF RATIOS
Subjectivity
Ratios are subjective to accounting information that depends on the accounting policies adopted
by a particular organization hence making it impossible for cross sectional analysis if a company
uses different accounting policies. It is difficult to categorize firms due to diversifications i.e.
some companies have more than one line of business and thus will fall into several industries
thus difficult in ratio comparison.
Irrelevance
Ratios are historical figures which may irrelevant in making future decisions.
Qualitative aspects are ignored

Qualitative aspects such competent management, experience and motivation of employees are
not captured in computation of ratios.
Ambiguity
Different people will use different stances to describe financial information e.g. including
preference share capital in equity or return on capital being referred to as gross capital employed.
Usefulness
Ratios are computed at a specific point in time. By the time they are analyzed for decision
making, circumstances may have changed thus ratios are only useful in the short term
Monopoly
For a company without competitor, it may not be .possible to analyze its performance with other
companies in the same industry.

210
1. Short term solvency or liquidity measure
Here the primary concern is the firm‘s ability to pay its bills over the short term without undue
stress. Consequently this ratios focus on current assets and liabilities.
Illustration for business performance analysis
The following two financial statements will be used in calculation of ration to determine business
performance. The figures are in millions.
BRIDGEVIEW COMPANY LTD

STATEMENT OF FINANCIAL POSITION AS AT 31st DECEMBER
2010 2011
Non-current Assets
Net plan and equipment 2731 2880
Current assets
Cash 84 98
Accounts receivables 165 188
Inventory 393 422
Total 642 708
Liabilities and owners equity
Current liabilities
Accounts payable 312 344
Notes payable 231 196
Total 543 540
Long term debt 531 457
Owners equity
Common stock and paid-in surplus 500 550
Total 2299 2591
Total liabilities and equity 3373 3588
Income statement for 2011
Sales 2311
Cost of goods sold 1344
Depreciation 276
Earnings before interest and Tax 691
Interest paid 141
Taxable income 550
Taxes (34%) 187
Net income 363
Dividends 121
Retained earnings 242

211
Assume also that 33 million shares were outstanding at the end of 2010 and 2011. Market price
per share is ksh 88.
Required: calculate the key ratios the financial statements above and state the importance of the
ratios calculated.
Solution:
a) Current ratio.
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
708
= 1.31 𝑡𝑖𝑚𝑒𝑠
540
The higher the current ratio, the better the company is in covering current liabilities. But
at the same time it may mean an inefficient use of assets such as having excess inventory.
b) Quick (acid test ratio)
Base inventory is the least record of current assets, the acid test ratio doesn‘t take consideration
of inventory and therefore this ratio is written as
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
708 − 422
540
In this case the company has fewer current assets covering current liabilities.
c) Cash ratio
A very short term creditor may be interested in the cash inventory.
𝑐𝑎𝑠𝑕
98
540
d)
e) Net working capital to total assets
𝑛𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
708 − 540
× 100 = 4.7%
3588
Since net working capital is frequently viewed as a ratio of short term liquidity of a firm, it is
measured relative to total assets. A relatively low value may indicate relatively low liquidity
levels.
f) Interval measure
This assumes operations were disrupted but the company is still compelled to pay some short-
term obligations. It tries to find out how much will current assets cover daily operating costs.

212
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝑖𝑛𝑡𝑒𝑟𝑣𝑎𝑙 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 =
𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑎𝑖𝑙𝑦 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
Average daily operating cost from our illustration assumed to be
𝑐𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 1344
= = 3.68
365 365
Therefore IM
708
𝑖𝑛𝑡𝑒𝑟𝑣𝑎𝑙 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 = = 192 𝑑𝑎𝑦𝑠
3.68
2. Long term solvency measures

This group of ratios is intended to measure the firm‘s long run ability to meet its obligations or
more generally it‘s financial. These are sometimes called financial leverage ratios or leverage
ratios.
i. Total debt ratio
It takes into account all debts of all maturities to all creditors.
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
3588 − 2591
3588
ii. Debt-equity ratio
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
=
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦𝑡
540 + 457
2591
iii. Equity multiplier
=
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦𝑡
3588
= = 1.38 𝑡𝑖𝑚𝑒𝑠
2591
iv. Long term debt ratio
This ratio takes into account only long term debt and not short term obligation. The formula is
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡

=
𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡 + 𝑒𝑞𝑢𝑖𝑡𝑦
457
= = 0.15 𝑡𝑖𝑚𝑒𝑠
457 + 2591
The long term debt + equity is sometimes called firms capitalization.

v. Times interest earned
This ratio measures how well a company has its interest obligation covered.
𝐸𝐵𝐼𝑇
𝑇𝑖𝑚𝑒𝑠 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

213
691
= = 4.9 𝑡𝑖𝑚𝑒𝑠
141
vi. Cash coverage
The difference between cash coverage and times interest earned is that depreciation not being an
item involving movement of cash is added back to EBIT.
𝐸𝐵𝐼𝑇 + 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝑐𝑎𝑠𝑕 𝑐𝑜𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
691 + 276
= = 6.9 𝑡𝑖𝑚𝑒𝑠
141
3. Asset management/turnover ratio
Sometimes called asset neutralization ratios, the ratios in this category are intended to describe
how efficiently or intensely a firm uses its assets to generate sales.
a) Inventory turnover and Day sales in inventory
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
1344
= = 3.2 𝑡𝑖𝑚𝑒𝑠
422
Inventory was turned 3.2 times. It may also be imperative to use average inventory figures if they
are available.
b) Day sales inventory
365
=
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
365
= = 114 𝑡𝑖𝑚𝑒𝑠
32
It tells that on average inventory sits in store for 114 days before it is sold.
c) Receivables turn over
This measures how fast receivables are collected.
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
2311
188
This means that outstanding credit were collected and reloaded 12.3 times during the years.
d) Day sales and receivables/ average collection period

365
=
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
365
= = 29.67 𝑡𝑖𝑚𝑒𝑠
12.3
On average credit sales were collected in 30 days.
e) Networking capital ratio or sales

214
Ratios measures how much would we get out of our working capital.
𝑁𝑒𝑡 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
2311
(708 − 540)
f) Fixed asset turnover
𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
2311
2880
g) Total asset turnover
2311
3588
For every shilling invested in assets we generate sh.0.64 sales
4. Profitability measures
These measures are intended to measure how efficiently the firm uses its assets and how
efficiently the firm manages its operations. The focus in the group is on the bottom line i.e.
income
a. Profit margin
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
363
= 15.7%
2311
b. Return on assets
363
= 10.12%
3588
c. Return on equity
𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
363
= 14%
2591
5. Market value measures

These ratios are crucial when comparing the earning power of an organization and its distribution
(of dividend) policy with other organizations.
i. Price Earnings ratio
𝑀𝑃𝑆
𝐸𝑃𝑆
215
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 363
𝐸𝑃𝑆 = = = 11
𝑁𝑜 𝑜𝑓 𝑠𝑕𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 33
88
11
= 8 𝑡𝑖𝑚𝑒𝑠
We can interprete this to mean that Bridgeview‘s shares sell for 8 times to earning.
ii. Market-Book ratio
𝑀𝑃𝑆
=
𝐵𝑃𝑆
88
= = 1.2 𝑡𝑖𝑚𝑒𝑠
2591
33
Book value in this case is total equity, not just common stock divided by no. of shares
outstanding. The better if the ratio is more than one meaning share is doing well in the market.
iii. Dividend payout ratio
This measures amount of cash paid out to shareholders
𝐶𝑎𝑠𝑕 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
=
121
= = 0.33
363
iv. Retention/plough back ratio

= 1 − 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜
Because everything paid is retained.
v. Capital intensity ratio
𝑓𝑖𝑟𝑚𝑠 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

=
It‘s the reciprocal of assets turnover ratio .
Du-Pont identity
This was developed by du-Pont Company of USA. Du-Pont identity asserts that R.O.E is
affected by 3 things
- Operating efficiency (as measured by profit margin)
- Assets use efficiency (as measured by total assets turn over)
- Financial leverage (as measured by equity multiplier)
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

𝑅𝑂𝐸 = × × =
𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
Decomposing Du-Point multiplier further (5way Du-Point multiplier)
The 5 way Du-Point decomposition is the one found in financial data bases such as Bloomberg.
According to this formula

216
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝐸𝐵𝑇 𝐸𝐵𝐼𝑇 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐸 = × × × × =
𝐸𝐵𝑇 𝐸𝐵𝐼𝑇 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝑞𝑢𝑖𝑡𝑦
a.
= 𝑡𝑎𝑥 𝑏𝑢𝑟𝑑𝑒𝑛
𝐸𝐵𝑇
It measures how much of a company‘s pre-tax profit it gets to keep.
b.
𝐸𝐵𝑇
= 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑢𝑟𝑑𝑒𝑛
𝐸𝐵𝐼𝑇
It captures the effects of interest on ROE
c.
𝐸𝐵𝐼𝑇
= 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑚𝑎𝑟𝑔𝑖𝑛
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Measures effect of operating profitability on ROE
d.
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
= 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛 𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜
Indication of overall efficiency of the company
e.
= 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑟𝑎𝑡𝑖𝑜
𝐸𝑞𝑢𝑖𝑡𝑦
It‘s the total amount of a company‘s assets relative to its equity capital.
Simply put the decomposition of Du-Point identity into 5 components expresses a company‘s
ROE as a function of its tax rate, interest burden, operating profitability efficiency, efficiency
and leverage. An analyst uses this framework to determine what factors are driving the
companies ROE.
Limitations of financial ratios

1. Different companies use different accounting policies making comparisons is unrealistic.
2. Ratios do not take of inflation tendencies
3. Different companies use different calendar financial years therefore making comparison
difficult.
4. Unusual or transient events such as one time profit from sale of an asset may affect
performance and give misleading results.
5. Inaccuracies from financial statements would affect the ratios.
Long term financial planning and growth

Dimensions of financial planning
1. Planning horizon-it is the long range time period financial planning process. Focuses on
usually the next 2-5 years.
2. Aggregation- it is the process by which smaller investment proposals of the firms
operational units are added up and treated as one major project.

217
Benefits of planning
1. Interactions - The financial plan makes explicit linkages between investment proposals
for the different operating activities of the firm and the financing sources available to the
firm.
2. Options - The financial plan provides the opportunity for the firm to develop, analyze and
compare many different scenarios and does viability of options.
3. Avoiding surprises – Financial plan identifies what may happen to the firm if different
events take place, financial plan does employ anticipatory approach as a tool for risk
management.
4. Feasibility and consistency- To generate a coherent plan, goals and objectives will have
to be modified and priorities will have to be established.
Long term financial planning and growth

Financial planning establishes guidelines for change and growth in a firm. It formulates the way
the financial goals are to be achieved.
Ingredients of financial planning
- Sales
- Pro-forma statements
i). Sales forecast
Sales forecasts will frequently be given as the growth rate in sales rather than as explicit sales
figure.
The sales figure will be the ‗driver‘ meaning that the users of the planning model will supply
these values and most other values will be calculated based on it.
ii). Asset requirement

The plan will describe capital spending at a minimum the project of financial position will
contain changes in total fixed assets and net working capital‘ those changes are effectively the
firms total capital budget. Proposed capital spending in different areas must therefore be
reconciled with overall increase contained in the long range plan.
iii) pro-forma statements
Are basically income statement, statement of financial position and statement of cash flows
iv). Financial requirement
The plan will include a section on the planning arrangement that is necessary. This plan must
also discuss debt policy and dividend policy. Sometimes firms will expect to raise cash by selling
new shares of stock or by borrowing.
v) The ‗plug‘
After the firm has a sales forecast and an estimate of required spending on assets, some amount
of new financing will be necessary i.e. the statement of financial position will no longer balance.
Since new financing will be necessary to cover all of the projected capital spending, a financial
plug valuable must be selected. The plug is the designated source or sources of external
financing needed to deal with any shortfall 9 or surplus) in financing and therefore the SOFP in
to balance.
vi) The plan will have to state explicitly the economic environment in which the firm expects to
reside over the life of the project.
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EXTERNAL FINANCING AND GROWTH
External financing needs and growth are obviously related. All other things are the same. The
higher the growth rate in sales/assets, the greater will be the need for external financing.
Financial policy and growth

 Internal growth rate
This is the maximum growth rate that can be achieved with no extra financing of any kind.
𝑅𝑂𝐴 × 𝑏
𝑖𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑔𝑟𝑜𝑤𝑡𝑕 𝑟𝑎𝑡𝑒 =
1 − 𝑅𝑂𝐴 × 𝑏
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐴 =
Where, ROA=return on assets and

b= retention ratio.
Example:
Assume net income is sh.66M. Total assets are 500M and of the 66M, 44M was retained.
Calculate internal growth rate or the maximum growth rate that can be attained with no external
financing?
66
𝑅𝑂𝐴 = = 0.132
500
44
𝑏= = 0.69
66
0.132 × 0.67
𝑖𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑔𝑟𝑜𝑤𝑡𝑕 𝑟𝑎𝑡𝑒 = = 0.0097
1 − 0.132 × 0.67
= 9.7%
Therefore the company can expand at a maximum rate of 9.7% per year without external
financing
.
 Sustainable growth rate

In the previous example, if the company wishes to grow more rapidly than 9.7%, the external
finance must be arranged. The sustainable growth rate is the maximum growth rate a firm can
achieve without external equity financing while maintaining constant debt: equity ratio.
It is the maximum rate of growth a firm can attain without increasing its financial leverage. No
issue of equity.

219
𝑅𝑂𝐸 × 𝑏
𝑆𝐺𝑅 =
1 − 𝑅𝑂𝐸 × 𝑏
Example:
If net income is 66M and total equity is 250M and the plough back ratio is 0.67.
66
𝑅𝑂𝐸 = = 0.264
250
0.264 × 0.67
𝑆𝐺𝑅 =
1 − 0.264 × 0.67
= 21.36%
The company can expand at a maximum rate of 21.36% per year without external equity
financing. The company wills most likely increase its equity through retained earnings.
However, if the company doesn‘t have sufficient R/E it will have to borrow to finance growth
but still not use external equity. In the above example ROE, plough back ratio i.e. 0.67 is the
same as in the earlier illustration.
Determinants of growth
1. Profit margin
-An increase in profit margin will increase the firm‘s ability
2. Dividend policy
-A decrease in the percentage of net income paid out as a dividend will increase the retention
ratio. This increases the internally generated equity and therefore increases sustainability.
3. Financial policy
-An increase in D: E ratio increases the firm‘s financial leverage. Since this makes additional
debt financing available, it increases the sustainable growth rate.
4. Total asset turnover
-An increase in the firms total asset turnover increases the sales generated for each dollar in
asset. This increases the firms need for new assets as sales growth and thereby increases SGR
Financial distress
Financial distress indicates a condition when promises to creditors of a company are broken or
honored with difficulty. Sometimes it leads to bankruptcy.
Cost of financial distress
 Bankruptcy cost
Includes audit fees, legal fees and management fees
 Reduction in management efficiency
Financial distress in companies leads to problems that can reduce efficiency of management.
This is due to the shift of focus from long term to short term gains among managers, principally
due to diminished commitment. Also good staff leaves the firm for better opportunities.
 Conflict of interest between shareholders and creditors
As the firms liquidation values slips below its debt, its shareholders interest that the company
invests in risky projects which increases the probability of the firm‘s value to go below debt.
Risky project are not in the interest of creditors, since they increase the probability of the firms
value to decrease further, leaving them with even less. Since these projects do not necessarily
220
have a positive NPV, costs may rise from lost profits. Management may also choose to distribute
to save money from the creditors.
 High cost of capital
With financial distress of a company short term loans from creditors and banks will be given to
the firm at higher interest rates because of poor credit standing.
Options for relieving financial distress

- Debt restructuring
This is a process that allows a public company or sovereign entity facing cash flow problems and
financial distress to reduce and negotiate its deluges in order to improve or restore liquidity
rehabilitate so that it can continue its operation.
- Bankruptcy
If promises to creditors cannot be kept,, bankruptcy becomes an option for both companies and
individuals
Predicting business failure

Business failure can be predicted using linear discriminant model. Linear discriminant models
divide firms into high or low bankruptcy classes based on their financial characteristics. The
widely used model is the Altman‘s Z-score.
Altman‘s Z-score
It is a quantitative method of determining a company‘s financial health and likehood of
bankruptcy.
The Z-score model is the 1960‘s brain child of professor Edward Altman of NYU. It uses 8
variables that are EBIT, total assets, and net sales, market value of equity, total liabilities, current
assets, current liabilities and retained earnings.
The formula for the Z-score:
𝑍 − 𝑠𝑐𝑜𝑟𝑒 = 1.2𝑥1 + 1.4𝑥2 + 3.3𝑥3 + 0.6𝑥4 + 1.0𝑥5
𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑤𝑕𝑒𝑟𝑒, 𝑥1 =
𝑥2 =
𝐸𝐵𝐼𝑇
𝑥3 =
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

𝑥4 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡
𝑥5 =
221
Interpretation of Altman‘s Z-score
Z-score above 3 means a company is considered safe based on financial figures only.
Z-score between 2.7 and 2.99 means this is the zone where one should exercise caution. It could
mean the performance of the company is at risk.
Z-score between 1.8 and 2.7 means there is a good chance of a company going bankruptcy
within 2 years of operations from the date of financial statement/figures.
Z-score below 1.8 means the probability of financial embarrassment is very high and chances of
the firm surviving are minimal.
Question:
Using the financial statement of 2011 of Bridgeview Company, Calculate the Z-score for the
company and interprete the results.
Solution
𝑍 − 𝑠𝑐𝑜𝑟𝑒 = 1.2𝑥1 + 1.4𝑥2 + 3.3𝑥3 + 0.6𝑥4 + 1.0𝑥5
𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝐶𝐴 − 𝐶𝐿
𝑥1 = =
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
708 − 540
= = 0.047
3588
𝑥2 =
2041
= = 0.569
3588
𝐸𝐵𝐼𝑇
𝑥3 =
691
= = 0.193
3588
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

𝑥4 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 = 𝐿𝐷𝑇 + 𝐶𝐿
= 457 + 540 = 997
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 33 × 88 = 2904

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2904
= = 2.91
997
𝑥5 =
2311
= = 0.64
3588
𝑍 − 𝑠𝑐𝑜𝑟𝑒 = 1.2𝑥1 + 1.4𝑥2 + 3.3𝑥3 + 0.6𝑥4 + 1.0𝑥5

𝑍 − 𝑠𝑐𝑜𝑟𝑒 = 1.2 0.047 + 1.4 0.569 + 3.3 0.193 + 0.6𝑥4 + 1.0 0.64
= 3.5799
QUESTION
(a) Outline two types of information which could be obtained from the following sources:
i. Proxy statement (2 marks)
ii. Corporate press release (2 marks)
iii. Annual reports to regulators (2 marks)
(b) The top management of Zedrock Limited has provided you with the following financial statements
relating to its two divisions, alpha and beta, for the year ended 30 June 2012
Income statement for the year ended 30 June 2012
Alpha Division Beta Division
Sh.‖millions‖ Sh.‖millions‖
Revenue 4,000 6,000
Cost of sales (3,000) (4,800)
Gross profit 1,000 1,200
Expenses:
Distribution costs 200 150
Administrative expenses 290 250
Interest paid 10 (500) 400 (800)
Income tax expense (120) (90)
Dividend paid (150) (100)
Retained profit for the year 230 210
Retained profit brought forward 220 2,480
Retained profit carried forward 450 2,6900
Statement of financial position as at 30 June 2012:

Sh.‖millions‖ Sh.‖millions‖
Land and buildings 1,200 5,000
Furniture and motor vehicles 600 1,000
1,800 6,000
Current assets:
Inventory 400 800
Financial assets 100 230
Cash at bank - 1,350 100 1,880
Total assets 3,150 7,880

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Ordinary share capital(sh.1 par value) 1,000 1,600
Retained profits 450 2,690
1,450 4,290
Bank loan 500 3,000
Accounts payable 1,080 590
Bank overdraft 120 1,200 - 590
3,150 7,880
1. The two divisions sell goods on both cash and credit terms. On average, the credit sales account for
80% of the total sales while purchases account for 90%
2. The cash flow from operating activities for the two divisions are sh.750 millions and sh.800 million
respectively.
3. The division deal with electronic goods.
Required:
(i) Common size income statement for the year ended 30th June 2012 (6 marks)
(ii) Common size statement of financial position as at 30th June 2012 (6 marks)
(iii)Comment on the performance of the two divisions and state which division and state is better
(2 marks)
(Total: 20 marks)
Suggested solution:
a) Proxy statements
A proxy is a means whereby a shareholder authorizes another person to act for him or her at a meeting of
shareholders. A proxy statement contains information necessary for shareholders in voting on matters for
which the proxy is solicited.
Proxy statements contain pertinent information regarding a company including:-
viii. The identity of shareholders owning 5% or more of the outstanding shares.
ix. Biography information on the BOD
x. compensation arrangement with officers and directors
xi. Employees benefit plans and certain transactions with officers and directors related parties.
xii. Voting procedures and information
xiii. Background information about the company‘s nominated directors
xiv. Executive compensation
Corporate press release
These are news that follows within the publishing requirements of a company. They includes:-
iii. Recent financial statements released and key performances
iv. Any new important information like change of management, new products or strategies
Annual report to Regulators
These should include:-
iv. Mergers, consolidation, acquisition and similar matters
v. Financial statements
vi. Audited accounts and reports

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b)
Zedrock Limited
Common size Income statement for the year ended 30 June 2112

% % % %
sales 100 100
Cost of sales (75) (80)
Gross profit 25 20
Expenses:
Distribution costs 5 2.5
Administrative expenses 7.25 4.16
Finance cost 0.25 (12.5) 6.67 (13.33)
Gross Profit 12.5 6.67
Income tax expense (3) (1.50)
Profit after tax 9.5 5.17
Dividend paid (3.75) (1.67)
Retained profit for the year 5.75 3.50
Zedrock Limited
Statement of financial position as at 30 June 2012:
% % % %
Land and buildings 38 63.5
Furniture and motor vehicles 19 12.6
57 76.1
Current assets:
Inventory 12.8 10.2
Trade receivables 27.0 9.5
Financial assets 3.2 2.9
Cash at bank - 43 1.3 23.9

Ordinary share capital(sh.1 par value) 31.7 20.3
Retained profits 14.3 34.1
46 54.4
Bank loan 15.9 38.1
Accounts payable 34.3 7.5
Bank overdraft 3.8 38.1 - 7.5
100 100
Based on the income statement, Alpha division appears to be better than Beta division in terms of gross
profit, net profit margin and profits retained.
Based on the statement of financial position, Beta division seems to be better because it has more capital
than alpha and its non-current asset base is better.

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CREDIT RATING
This is the classification of a company‘s credit risk based on investigation of a customer‘s or
potential customer‘s financial resources, prior payment pattern and personal history or degree of
personal responsibility for debts incurred
Credit score:
This is a statistically derived numeric expression of a person‘s creditworthiness that is used by

lenders to access the likelihood that a person will repay his/her debt.
Example of credit score: these vary from country to country or from agency to agency. For
example for standard and poor‘s rating for corporations are:
AAA - best, very stable, reliable companies
AA - a very good rating. Company is reliable, but with a bit more risk than AAA.
The list goes on to A‘S….All the way to B‘s and lastly to NR which is not rated. There are also
ratings for individuals by companies.
Criticism of credit rating agencies
1. Credit rating agencies do not downgrade companies promptly enough. For example,
Enron‘s grading remained at investment grade four days before the company went into
bankruptcy
2. Large corporate rating agencies have been criticized for having too familiar relationship
with company management, possibly opening themselves to undue influence or
vulnerable of being misled
3. While often accused of being too close company management of their existing clients,
CRA‘s have been accused of engaging in heavy-handed ―blackmail‖ tactics in order to
solicit business from new clients, and lowering ratings for those firms.
4. Agencies are sometimes accused of being oligopolists, because barriers to market entry
are high and agency business is itself reputation-based (and the finance industry pays
little attention to an agency that is not widely recognized)
Improving business credit rating
i. Being aware of the factors that can improve business credit rating. There are several
factors that influence a business credit including paying credit in time.
ii. Make sure your suppliers including lenders are reporting your credit because good
information about your organization could be missing
iii. Repair the damage by paying of delinquent debts and paying other debts in time
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iv. Improve your statement of financial position by first analyzing your credit score and
working on the ratios which may indicate poor credit standing
v. Set a goal: having your ideal credit score written down will give you something concrete
to strive for.
DETERMINING WHO TO GRANT CREDIT
Which customers should revive credit?
This is determined by the following guidelines (summarized as the 5C‘s)

Capital: is the customer financially sound given and past performance?
Capacity: The customer should have the capacity to repay
Collateral: Does the customer have security to cover against credit default?
Conditions: What is the state of the industry in which the customer operates?
Character: asses the customers character even if it is a company – who are the directors, their
background (business or otherwise)
Concept of capital and capital maintenance
 This is an accounting concept bases on the principle that income is only recognized after
capital has been maintained or there has been a full recovery of cost
 Capital maintenance has been reached if the amount of the company‘s capital at the end
of the period is unchanged from that at the beginning of the period
 The two basic definitions of capital maintenance are financial capital maintenance and
physical capital maintenance.
 According to IFRS, under definition of capital maintenance, a profit is earned only if the
amount of the net asset at the end of the period exceeds the amount at the beginning of
the period, excluding any inflow from or outflows to owners, such as contributions and
distributions.
 It can be measured either in nominal monetary units are constant purchasing power units
 The definition of physical capital maintenance according IFRS implies that a profit is
earned only if the enterprise‘s productive or operating capacity at the end of the period
exceeds the capacity at the beginning of the period excluding any owners‘ contribution or
distribution.

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CHAPTER SEVEN
QUALITATIVE AND OTHER CURRENT ISSUES IN THE

ANALYSIS OF FINANCIAL STATEMENTS
Qualities of useful financial information
For financial information to be useful, it should possess the fundamental decision-specific

qualities of:
RELEVANCE
Relevance in the context of financial reporting means that the information must possess
predictive value confirmation of investor expectations about future cash-generating ability.
It should be both predictive and confirmative. For example, if net income and its components
confirm investor expectations about a company's future cash-generating ability, then net income
has confirmatory value for investors. This confirmation also can be useful in predicting the
company's future cash-generating ability as expectations are revised.
FAITHFUL REPRESENTATION
Faithful representation exists when there is agreement between a measure or description and the
phenomenon it purports to represent. For example, assume that the term inventory in the balance
sheet of a retail company is understood by external users to represent items that are intended for
sale in the ordinary course of business. If inventory includes, say, machines used to produce
inventory, then it lacks faithful representation.
To break it down further, faithful representation requires that information be complete, neutral,
and free from material error. A depiction of an economic phenomenon is complete if it includes
all information that is necessary for faithful representation of the economic phenomena that it
purports to represent. Omitting a portion of that information can cause the depiction to be false
or misleading and thus not helpful to the users of the information.
NEUTRALITY
The information being relied on should be free from bias. In that regard, neutral with respect to
parties potentially affected. It is highly related to the establishment of accounting standards.
Changes in accounting standards can lead to adverse economic consequences for certain
companies, their investors and creditors, and other interest groups. Accounting standards should
be established with overall societal goals and specific objectives in mind and should try not to
achieve particular social outcomes or favor particular groups or companies.

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COMPARABILITY
It‘s the ability to help users see similarities and differences among events and conditions. it is
import for investors and creditors to compare information among companies to make their
resource allocation decisions.
CONSISTENCY
It permits valid comparisons between different periods of accounting practices over time. The
predictive and confirmatory value of information is enhanced if users can compare the
performance of a company over time. In the Dell financial statements and disclosure notes,
notice that disclosure Note 1 includes a summary of significant accounting policies. If Dell were
to change one of these policies, new numbers might not be comparable to numbers measured
under a previous policy. To be sure readers are aware of the change; Dell would need to provide
a full disclosure in the notes to the financial statements.
VERIFIABILITY
It implies a consensus among different measurers. For example, the historical cost of a piece of
land to be reported in a company's balance sheet usually is highly verifiable. The cost can be
traced to an exchange transaction, the purchase of the land. However, the fair value of that land
is much more difficult to verify. Appraisers could differ in their assessment of fair value. The
term objectivity often is linked to verifiability. The historical cost of the land is objective and
easy to verify, but the land's fair value is subjective, influenced by the measurer's past experience
and prejudices. A measurement that is subjective is difficult to verify, which makes it less
reliable to users.
TIMELINESS
Information should be available to users early enough to allow its use in the decision process.
Information is timely when it is available to users early enough to allow them to use it in their
decision process. The need for timely information requires that companies provide information
to external users on a periodic basis. To enhance timeliness, the SEC requires its registrants to
submit financial statement information on a quarterly as well as on an annual basis for each fiscal
year.
UNDERSTANDABILITY
It means that users must understand the information within the context of the decision being
made. This is a user-specific quality because users will differ in their ability to comprehend any
set of information. The overriding objective of financial reporting is to provide comprehensible
information to those who have a reasonable understanding of business and economic activities
and are willing to study the information.

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Factors that may indicate that financial statements are of poor quality
1) Quality of accounting
Accounting information, for usefulness should be free of bias and errors (of commission
and omission). By large, the quality of accounting information will depend on the
qualification and experience of accounting staff employed to keep the books and prepare
the accounts
2) Management decision
Management decision may be influenced by their relationship with stakeholders of the
organization. They may engage in transactions that are not of the benefit of the
shareholders or which are not in tandem with goal congruence
3) Quality of external government mechanism

History has evidenced that the practices and professional conduct of the external auditor
has a bearing on the quality of financial statements produced by an organization. For
example, Arthur Andersen, a once globally re-known company swept manipulative
practices by Enron under the carpet
4) Quality of internal governance

A higher caliber and fairly independent internal audit team will keep managers ‗on toes‘
and prohibit manipulative accounting. The same will apply to a strict board of directors
5) Regulation as to the accounting reporting

A poor regulatory framework by the regulatory authorities may be an inducement to
creative accounting and vice versa
ACCOUNTING SCANDALS
Accounting scandals are political or business scandals which arise with the disclosure of
financial misdeeds by trusted executives of corporations or governments. Such misdeeds
typically involve complex methods for misusing or misdirecting funds, overstating revenues,
understating expenses, overstating the value of corporate assets or underreporting the existence
of liabilities, sometimes with the cooperation of officials in other corporations or affiliates.
In public companies, this type of "creative accounting" can amount to fraud, and investigations
are typically launched by government oversight agencies

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CREATING ACCOUNTING AND MANIPULATING FINANCIAL STATEMENTS
Creative Accounting
Creative Accounting, also called aggressive accounting, is the manipulation of financial

numbers, usually within the letter of the law and accounting standards, but very much against
their spirit and certainty not providing the true and fair view of a company that accounts are
supposed to. A typical aim of creative accounting will be to increase profit figures. Typical
creative accounting tricks include off balance sheet financing, over optimistic revenue
recognition and the use of exaggerated non- recurring items.
The technique of Creative accounting has changed over time. As accounting standards change,
the techniques that will work will also change. Many changes in accounting standards are meant
to block particular ways of manipulating accounts, which means that intent on creative
accounting need to find new ways of doing things. At the same time, other well mentioned
changes in accounting standards open up new opportunities for creative accounting.
According to critic David Ehrenstein, the term Creative Accounting was first used in 1968 in
the film The Producers by Mel Brooks. Many creative accounting techniques change the main
numbers show in the financial statements, but make themselves evident elsewhere, most often in
the notes to the accounts. The term creative accounting as generally understood refers to
systematic misrepresentation of the true income and assets of corporations and other
organizations. Creative accounting is at the root of a number of accounting scandals.
The term ―Window Dressing‖
The term window dressing has similar meaning when applied to accounts, but is a broader term
that can be applied to other areas. it is often used to describe the manipulation of investment
portfolio performance numbers. In the context of accounts, window dressing is more likely than
creative accounting to imply illegal or fraudulent practices
Earnings Management
Earnings management occurs when managers use judgment in financial reporting and in
structuring transactions to alter financial reports to either mislead some stakeholders about the
underlying economic performance of a company of influence contractual outcomes that depend
on reported accounting numbers. Earnings management involves the artificial increase of
revenues, profits or earnings per share figures through aggressive accounting tactics.
Aggressive earnings management is a form of fraud and differs from reporting error. The main
forms of earnings management are:
 unsuitable revenue recognition

 inappropriate accruals and estimates of liabilities
 Excessive provisions and generous reserve accounting

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 Intentional minor breaches of financial reporting requirements that aggregate to a
material breach.
Motives for creative accounting
i. Personal incentives
ii. Bonus related pay
iii. Benefits from shares and share options
iv. Job security
v. Personal satisfaction
vi. Cover-up fraud
vii. Tax management
viii. Management Buy outs
DESCRIPTION AND CHARACTERISTICS OF FRAUD

Fraud is a broad legal concept and auditors do not make legal determinations of whether fraud
has occurred. Rather, the auditor's interest specifically relates to acts that result in a material
misstatement of the financial statements. The primary factor that distinguishes fraud from error is
whether the underlying action that results in the misstatement of the financial statements is
intentional or unintentional. Therefore, fraud is an intentional act that results in a material
misstatement in financial statements that are the subject of an audit.
Two types of misstatements are relevant to the auditor's consideration of fraud—misstatements

arising from fraudulent financial reporting and misstatements arising from misappropriation of
assets.
 Misstatements arising from fraudulent financial reporting are intentional misstatements

or omissions of amounts or disclosures in financial statements designed to deceive
financial statement users where the effect causes the financial statements not to be
presented, in all material respects, in conformity with generally accepted accounting
principles, Fraudulent financial reporting may be accomplished by the following:
o Manipulation, falsification, or alteration of accounting records or supporting
documents from which financial statements are prepared
o Misrepresentation in or intentional omission from the financial statements of
events, transactions, or other significant information
o Intentional misapplication of accounting principles relating to amounts,
classification, manner of presentation, or disclosure
Fraudulent financial reporting need not be the result of a grand plan or conspiracy. It may
be that management representatives rationalize the appropriateness of a material
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misstatement, for example, as an aggressive rather than indefensible interpretation of
complex accounting rules, or as a temporary misstatement of financial statements,
including interim statements, expected to be corrected later when operational results
improve.
 Misstatements arising from misappropriation of assets (sometimes referred to as theft or

defalcation) involve the theft of an entity's assets where the effect of the theft causes the
financial statements not to be presented. Misappropriation of assets can be accomplished
in various ways, including
o Embezzling receipts
o stealing assets, or
o Causing an entity to pay for goods or services that have not been received.
Misappropriation of assets may be accompanied by false or misleading records or documents,
possibly created by circumventing controls. The scope of this section includes only those
misappropriations of assets for which the effect of the misappropriation causes the financial
statements not to be fairly presented.
Examples of situations where accounts are manipulated
1. Revenue
Revenues can be misstated by for example recording deferred revenue and unearned
revenue as part of the current revenue already earned. For example recording rent
received in advance as income instead of liability.
Revenue can also be accelerated by for example recognizing service agreements tied to
sales as part of revenue even before actual service is carried on non-current assets.
Further, non operating revenue such as the gain on disposal of non-current assets may be
lumped together with operating revenue when in effect it should be part of other
Revenue can also be understated if the objective is to evade tax.
2. Expenses
Depending on what the manipulators are bent on achieving, the expenses may be
overstated or understated. For example, with a view to delay expenses and hence
understate them, an organization may choose to capitalize some purchases instead of
expensing them. Understating closing stock may also help overstate cost of sales and
hence ―depress‖ net income.
3. Statement of financial position

Items may also be misstated or misclassified. For example, a company may decide to
report a finance lease as an operating lease and hence avoid reporting both a non-current
asst and non-current liability and hence at the same time avoid reporting depreciation
expense associated with the asset. Still on the statement of financial position a company
233
may deliberately understate liabilities so as to overstate its net assets: one way of
accomplishing this is by not recognizing provisions and contingencies
4. Cashflow statement
A company may ―park‖ long term investment under cash and cash equivalent so as to
apparently overstate the cash balances
MECHANISMS TO DETER STRATEGIC MANIPULATION
There are a number of mechanisms designed to prevent strategic manipulation such as:
a) An independent audit
The auditor expresses an opinion as to whether the financial statements conform GAAP,
the estimates are reasonable, and the data includes no material errors. The auditor also
examines the firm‘s internal control and reports any weaknesses to the audit committee of
the board of directors
b) The board of directors

Though the audit committee and the firms internal auditors, the board can discourage
unwanted behavior
c) Certification of senior management

The Chief Executive Officer (CEO) and Chief Finance Officer (CFO) must certify the
financial statements, which increase their personal risk.
d) Class action litigation

Law suits serve as deterrent to manipulating results
e) Regulators
Regulators can use fines as well as criminal prosecution as a deterrent.
f) General market scrutiny
Business journalists, financial analysts, short sellers, and unions are constantly trying to
identify manipulative behavior.
QUESTION:
a) With reference to IAS 36 (Impairment of assets), identify any four circumstances that
may indicate that an asset has been impaired.
 There has been significant decrease in the market value of the asset in excess of
the normal process of depreciation

234
 There has been a significant adverse change in either business or the market in
which the asset is involved
 Evidence is available that indicates that the performance of the asset will be worse
than expected
 When an asset is valued in terms of value in use and the actual cash flows are less
than the estimated flows before discounting
 Market interests or other market rates of return have increased during the period
and the increases are likely to decrease materially and assets recoverable amount
b) In the context of the International Accounting Standards Board’s framework for the
preparation and presentation of financial statements, identify and briefly explain any
four qualitative characteristics of financial statements
Qualitative characteristics are the attributes that make the information provided in financial
statements more useful to users. The major qualitative characteristics are:
i) Understability
An essential quality of the information provided bin financial statements is that it is readily
understandable by users, for those purpose, users are assumed to have reasonable knowledge of
business and economic activities and accounting and a willingness to study information with
reasonable diligence however information should not be excluded merely on the ground that it‘s
too difficult for certain users to understand
ii. Relevance
To be useful, information must be relevant to the decision making needs of users information has
the quantity of relevance when it influences the economic decisions of users by helping them to
evaluate past, present of future events or continuing or collecting the past evaluations
iii. Materiality
The relevance of information is affected by its nature and materiality; in some cases the nature of
information alone is sufficient to determine its relevance. For example the reporting of a new
segment may affect the assessment of the risks and opportunities facing the entity irrespective of
materiality of the results achieved by the new segment in the reporting period. Information is
material if its omission or n=misstatement could be influence the economic decisions of users
taken on the basis of the financial statements
iv. Reliability
To be useful information has to be reliable. Information has the quality of reliability when its
free from material error and bias and can be depended upon by users to represent t faithfully that
which is either purports to represent or could reasonably be expected to represent
v. Comparability
Users must be able to c0pompare the financial statement of an entity through time in order to
identify trends in its financial position and performance. Users must also be able to compare the

235
financial statement of different entities in order to evaluate their relative financial position,
performance and changes in financial position
v. Faithful representation
To be reliable, information must represent faithfully the transaction and other events it‘s either
purports to represent or could reasonably be expected to represent. Thus for example a balance
sheet should represent faithfully the transactions and other events that results in assets, liabilities
and equity of the entity at the reporting date which meets the recognition criteria
Other includes
vi. Substance over form
vii. Neutrality
viii. Completeness

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SUMMARIES OF INTERNATIONAL FINANCIAL REPORTING STANDARDS
(IFRSs)/ INTERNATIONAL ACCOUNTING STANDARDS (IASs)
Statements of International Accounting Standards issued by the Board of the International

Accounting Standards Committee (IASC) between 1973 and 2001 are designated "International
Accounting Standards" (IAS).
The International Accounting Standards Board (IASB) announced in April 2001 that its
accounting standards would be designated "International Financial Reporting
Standards" (IFRS). Also in April 2001, the IASB announced that it would adopt all of
the International Accounting Standards issued by the IASC.
IFRS 3 Business Combinations (revised January 2008)
It outlines the accounting when an acquirer obtains control of a business (e.g. an acquisition or
merger). Such business combinations are accounted for using the 'acquisition method', which
generally requires assets acquired and liabilities assumed to be measured at their fair values at
the acquisition date.
A revised version of IFRS 3 was issued in January 2008 and applies to business combinations
occurring in an entity's first annual period beginning on or after 1 July 2009.
Background
IFRS 3 (2008) replaced IFRS 3 (2004). IFRS 3 (2008) resulted from a joint project with the US
Financial Accounting Standards Board. FASB issued a similar standard in December 2007
(SFAS 141(R)). The revisions result in a high degree of convergence between IFRSs and US
GAAP in these areas, although some potentially significant differences remain.
Summary of IFRS 3:
Scope
Definition of a business combination. A business combination is a transaction or event in

which an acquirer obtains control of one or more businesses. A business is defined as an
integrated set of activities and assets that is capable of being conducted and managed for the
purpose of providing a return directly to investors or other owners, members or participants.
[IFRS 3.Appendix A]
Acquirer must be identified. Under IFRS 3, an acquirer must be identified for all business
combinations. [IFRS 3.6]
Scope changes from IFRS 3(2004). IFRS 3(2008) applies to combinations of mutual entities
and combinations without consideration (dual listed shares). These are excluded from IFRS
3(2004).

237
Scope exclusions. IFRS 3 does not apply to the formation of a joint venture*, combinations of
entities or businesses under common control. The IASB added to its agenda a separate agenda
project on common control transactions in December 2007. Also, IFRS 3 does not apply to the
acquisition of an asset or a group of assets that do not constitute a business. [IFRS 3.2]
* Annual Improvements to IFRSs 2011–2013 Cycle, effective for annual periods beginning on or
after 1 July 2014, amends this scope exclusion to clarify that is applies to the accounting for the
formation of a joint arrangement in the financial statements of the joint arrangement itself.
Method of accounting for business combinations
Acquisition method. The acquisition method (called the 'purchase method' in the 2004 version
of IFRS 3) is used for all business combinations. [IFRS 3.4]
Steps in applying the acquisition method are: [IFRS 3.5]
1. Identification of the 'acquirer' – the combining entity that obtains control of the acquiree
[IFRS 3.7]
2. Determination of the 'acquisition date' – the date on which the acquirer obtains control of
the acquiree [IFRS 3.8]
3. Recognition and measurement of the identifiable assets acquired, the liabilities assumed
and any non-controlling interest (NCI, formerly called minority interest) in the acquiree
4. Recognition and measurement of goodwill or a gain from a bargain purchase
Measurement of acquired assets and liabilities. Assets and liabilities are measured at their
acquisition-date fair value (with a limited number of specified exceptions). [IFRS 3.18]
Measurement of NCI. IFRS 3 allows an accounting policy choice, available on a transaction by

transaction basis, to measure NCI either at:
 fair value (sometimes called the full goodwill method), or

 the NCI's proportionate share of net assets of the acquiree (option is available on a
transaction by transaction basis).
Example: P pays 800 to purchase 80% of the shares of S. Fair value of 100% of S's
identifiable net assets is 600. If P elects to measure non-controlling interests as their
proportionate interest in the net assets of S of 120 (20% x 600), the consolidated financial
statements show goodwill of 320 (800 +120 - 600). If P elects to measure non-controlling
interests at fair value and determines that fair value to be 185, then goodwill of 385 is
recognised (800 + 185 - 600). The fair value of the 20% non-controlling interest in S will
not necessarily be proportionate to the price paid by P for its 80%, primarily due to
control premium or discount as explained in paragraph B45 of IFRS 3. [IFRS 3.19]
Acquired intangible assets. Must always be recognised and measured at fair value. There is no
'reliable measurement' exception.
Goodwill

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Goodwill is measured as the difference between:
 the aggregate of (i) the acquisition-date fair value of the consideration transferred, (ii) the
amount of any NCI, and (iii) in a business combination achieved in stages (see Below),
the acquisition-date fair value of the acquirer's previously-held equity interest in the
acquiree; and
 the net of the acquisition-date amounts of the identifiable assets acquired and the
liabilities assumed (measured in accordance with IFRS 3). [IFRS 3.32]
If the difference above is negative, the resulting gain is recognised as a bargain purchase in profit
or loss. [IFRS 3.34]
Business combination achieved in stages (step acquisitions)
Prior to control being obtained, the investment is accounted for under IAS 28, IAS 31, or IAS 39,
as appropriate. On the date that control is obtained, the fair values of the acquired entity's assets
and liabilities, including goodwill, are measured (with the option to measure full goodwill or
only the acquirer's percentage of goodwill). Any resulting adjustments to previously recognised
assets and liabilities are recognised in profit or loss. Thus, attaining control triggers
remeasurement. [IFRS 3.41-42]
Measurement period
If the initial accounting for a business combination can be determined only provisionally by the
end of the first reporting period, the business combination is accounted for using provisional
values. Adjustments to provisional amounts, and the recognition of newly identified asset and
liabilities, must be made within the 'measurement period' where they reflect new information
obtained about facts and circumstances that were in existence at the acquisition date. [IFRS
3.45] The measurement period cannot exceed one year from the acquisition date and no
adjustments are permitted after one year except to correct an error in accordance with IAS 8.
[IFRS 3.50]
Cost of an acquisition
Measurement. Consideration for the acquisition includes the acquisition-date fair value of
contingent consideration. Changes to contingent consideration resulting from events after the
acquisition date must be recognised in profit or loss. [IFRS 3.58]
Acquisition costs. Costs of issuing debt or equity instruments are accounted for under IAS 32
and IAS 39. All other costs associated with the acquisition must be expensed, including
reimbursements to the acquiree for bearing some of the acquisition costs. Examples of costs to be
expensed include finder's fees; advisory, legal, accounting, valuation and other professional or
consulting fees; and general administrative costs, including the costs of maintaining an internal
acquisitions department. [IFRS 3.53]

239
Contingent consideration. Contingent consideration must be measured at fair value at the time
of the business combination. If the amount of contingent consideration changes as a result of a
post-acquisition event (such as meeting an earnings target), accounting for the change in
consideration depends on whether the additional consideration is classified as an equity
instrument or an asset or liability: [IFRS 3.58]
 If the contingent consideration is classified as an equity instrument, the original amount is

not remeasured
 If the additional consideration is classified as an asset or liability that is a financial
instrument, the contingent consideration is measured at fair value and gains and losses are
recognised in either profit or loss or other comprehensive income in accordance with
IFRS 9 Financial Instruments or IAS 39 Financial Instruments: Recognition and
Measurement
 If the additional consideration is not within the scope of IFRS 9 (or IAS 39), it is
accounted for in accordance with IAS 37 Provisions, Contingent Liabilities and
Contingent Assets or other IFRSs as appropriate.
Note: Annual Improvements to IFRSs 2010–2012 Cycle changes these requirements for business
combinations for which the acquisition date is on or after 1 July 2014. Under the amended
requirements, contingent consideration that is classified as an asset or liability is measured at fair
value at each reporting date and changes in fair value are recognised in profit or loss, both for
contingent consideration that is within the scope of IFRS 9/IAS 39 or otherwise.
Where a change in the fair value of contingent consideration is the result of additional
information about facts and circumstances that existed at the acquisition date, these changes are
accounted for as measurement period adjustments if they arise during the measurement period
(see above). [IFRS 3.58]
Pre-existing relationships and reacquired rights
If the acquirer and acquiree were parties to a pre-existing relationship (for instance, the acquirer
had granted the acquiree a right to use its intellectual property), this must must be accounted for
separately from the business combination. In most cases, this will lead to the recognition of a
gain or loss for the amount of the consideration transferred to the vendor which effectively
represents a 'settlement' of the pre-existing relationship. The amount of the gain or loss is
measured as follows:
 for pre-existing non-contractual relationships (for example, a lawsuit): by reference to

fair value
 for pre-existing contractual relationships: at the lesser of (a) the favourable/unfavourable
contract position and (b) any stated settlement provisions in the contract available to the
counterparty to whom the contract is unfavourable. [IFRS 3.B51-53]
However, where the transaction effectively represents a reacquired right, an intangible asset is
recognised and measured on the basis of the remaining contractual term of the related contract

240
excluding any renewals. The asset is then subsequently amortised over the remaining contractual
term, again excluding any renewals. [IFRS 3.55]
Other issues
In addition, IFRS 3 provides guidance on some specific aspects of business combinations

including:
 business combinations achieved without the transfer of consideration [IFRS 3.43-44]

 reverse acquisitions [IFRS 3.B19]
 identifying intangible assets acquired [IFRS 3.B31-34]
 the reassessment of the acquiree's contractual arrangements at the acquisition date [IFRS
3.15]
Parent's disposal of investment or acquisition of additional investment in subsidiary
Partial disposal of an investment in a subsidiary while control is retained. This is accounted

for as an equity transaction with owners, and gain or loss is not recognised.
Partial disposal of an investment in a subsidiary that results in loss of control. Loss of

control triggers remeasurement of the residual holding to fair value. Any difference between fair
value and carrying amount is a gain or loss on the disposal, recognised in profit or loss.
Thereafter, apply IAS 28, IAS 31, or IAS 39, as appropriate, to the remaining holding.
Acquiring additional shares in the subsidiary after control was obtained. This is accounted
for as an equity transaction with owners (like acquisition of 'treasury shares'). Goodwill is not
remeasured.
Disclosure
Disclosure of information about current business combinations
The acquirer shall disclose information that enables users of its financial statements to evaluate
the nature and financial effect of a business combination that occurs either during the current
reporting period or after the end of the period but before the financial statements are authorised
for issue. [IFRS 3.59]
Among the disclosures required to meet the foregoing objective are the following: [IFRS 3.B64-
66]
 name and a description of the acquiree

 acquisition date
 percentage of voting equity interests acquired

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IAS 1 Presentation of Financial Statements (revised 2007)
*covered in the notes*
IFRS 4 — Insurance Contracts (issued in March 2004)
IFRS 7 — Financial Instruments: Disclosures (issued in August 2005)
Summary of IFRS 7
Overview of IFRS 7
 adds certain new disclosures about financial instruments to those currently required by
IAS 32;
 replaces the disclosures previously required by IAS 30; and
 puts all of those financial instruments disclosures together in a new standard on Financial
Instruments: Disclosures. The remaining parts of IAS 32 deal only with financial
instruments presentation matters.
Disclosure requirements of IFRS 7
IFRS requires certain disclosures to be presented by category of instrument based on the IAS 39
measurement categories. Certain other disclosures are required by class of financial instrument.
For those disclosures an entity must group its financial instruments into classes of similar
instruments as appropriate to the nature of the information presented. [IFRS 7.6]
The two main categories of disclosures required by IFRS 7 are:
1. information about the significance of financial instruments.

2. information about the nature and extent of risks arising from financial instruments
Information about the significance of financial instruments
Statement of financial position
 Disclose the significance of financial instruments for an entity's financial position and
performance. [IFRS 7.7] This includes disclosures for each of the following categories:
[IFRS 7.8]
o financial assets measured at fair value through profit and loss, showing separately
those held for trading and those designated at initial recognition
o held-to-maturity investments
o loans and receivables

242
o available-for-sale assets
o financial liabilities at fair value through profit and loss, showing separately those
held for trading and those designated at initial recognition
o financial liabilities measured at amortised cost
 Other balance sheet-related disclosures:
o special disclosures about financial assets and financial liabilities designated to be
measured at fair value through profit and loss, including disclosures about credit
risk and market risk, changes in fair values attributable to these risks and the
methods of measurement.[IFRS 7.9-11]
o reclassifications of financial instruments from one category to another (e.g. from
fair value to amortised cost or vice versa) [IFRS 7.12-12A]
o information about financial assets pledged as collateral and about financial or
non-financial assets held as collateral [IFRS 7.14-15]
o reconciliation of the allowance account for credit losses (bad debts) by class of
financial assets[IFRS 7.16]
o information about compound financial instruments with multiple embedded
derivatives [IFRS 7.17]
o breaches of terms of loan agreements [IFRS 7.18-19]
Statement of comprehensive income
 Items of income, expense, gains, and losses, with separate disclosure of gains and losses
from: [IFRS 7.20(a)]
o financial assets measured at fair value through profit and loss, showing separately
those held for trading and those designated at initial recognition.
o held-to-maturity investments.
o loans and receivables.
o available-for-sale assets.
o financial liabilities measured at fair value through profit and loss, showing
separately those held for trading and those designated at initial recognition.
o financial liabilities measured at amortised cost.
 Other income statement-related disclosures:

o total interest income and total interest expense for those financial instruments that
are not measured at fair value through profit and loss [IFRS 7.20(b)]
o fee income and expense [IFRS 7.20(c)]
o amount of impairment losses by class of financial assets [IFRS 7.20(e)]
o interest income on impaired financial assets [IFRS 7.20(d)]
Other disclosures
 Accounting policies for financial instruments [IFRS 7.21]

 Information about hedge accounting, including: [IFRS 7.22]
o description of each hedge, hedging instrument, and fair values of those
instruments, and nature of risks being hedged

243
o for cash flow hedges, the periods in which the cash flows are expected to occur,
when they are expected to enter into the determination of profit or loss, and a
description of any forecast transaction for which hedge accounting had previously
been used but which is no longer expected to occur
o if a gain or loss on a hedging instrument in a cash flow hedge has been recognised
in other comprehensive income, an entity should disclose the following: [IAS
7.23]
o the amount that was so recognised in other comprehensive income during the
period
o the amount that was removed from equity and included in profit or loss for the
period
o the amount that was removed from equity during the period and included in the
initial measurement of the acquisition cost or other carrying amount of a non-
financial asset or non- financial liability in a hedged highly probable forecast
transaction
Note: Where IFRS 9 Financial Instruments (2013) is applied, revised disclosure
requirements apply. The required hedge accounting disclosures apply where the
entity elects to adopt hedge accounting and require information to be provided in
three broad categories: (1) the entity‘s risk management strategy and how it is
applied to manage risk (2) how the entity‘s hedging activities may affect the
amount, timing and uncertainty of its future cash flows, and (3) the effect that
hedge accounting has had on the entity‘s statement of financial position, statement
of comprehensive income and statement of changes in equity. The disclosures are
required to be presented in a single note or separate section in its financial
statements, although some information can be incorporated by reference.
 For fair value hedges, information about the fair value changes of the hedging instrument
and the hedged item [IFRS 7.24(a)]
 Hedge ineffectiveness recognised in profit and loss (separately for cash flow hedges and
hedges of a net investment in a foreign operation) [IFRS 7.24(b-c)]
 Information about the fair values of each class of financial asset and financial liability,
along with: [IFRS 7.25-30]
o comparable carrying amounts
o description of how fair value was determined
o the level of inputs used in determining fair value
o reconciliations of movements between levels of fair value measurement hierarchy
additional disclosures for financial instruments whose fair value is determined
using level 3 inputs including impacts on profit and loss, other comprehensive
income and sensitivity analysis
o information if fair value cannot be reliably measured
The fair value hierarchy introduces 3 levels of inputs based on the lowest level of input
significant to the overall fair value (IFRS 7.27A-27B):
 Level 1 – quoted prices for similar instruments

 Level 2 – directly observable market inputs other than Level 1 inputs
 Level 3 – inputs not based on observable market data

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Note that disclosure of fair values is not required when the carrying amount is a reasonable
approximation of fair value, such as short-term trade receivables and payables, or for instruments
whose fair value cannot be measured reliably. [IFRS 7.29(a)]
Nature and extent of exposure to risks arising from financial instruments
Qualitative disclosures [IFRS 7.33]
 The qualitative disclosures describe:

o risk exposures for each type of financial instrument
o management's objectives, policies, and processes for managing those risks
o changes from the prior period
Quantitative disclosures
 The quantitative disclosures provide information about the extent to which the entity is
exposed to risk, based on information provided internally to the entity's key management
personnel. These disclosures include: [IFRS 7.34]
o summary quantitative data about exposure to each risk at the reporting date
o disclosures about credit risk, liquidity risk, and market risk and how these risks
are managed as further described below
o concentrations of risk
Credit risk
 Credit risk is the risk that one party to a financial instrument will cause a loss for the
other party by failing to pay for its obligation. [IFRS 7. Appendix A]
 Disclosures about credit risk include: [IFRS 7.36-38]
o maximum amount of exposure (before deducting the value of collateral),
description of collateral, information about credit quality of financial assets that
are neither past due nor impaired, and information about credit quality of financial
assets whose terms have been renegotiated [IFRS 7.36]
o for financial assets that are past due or impaired, analytical disclosures are
required [IFRS 7.37]
o information about collateral or other credit enhancements obtained or called
[IFRS 7.38]
Liquidity risk
 Liquidity risk is the risk that an entity will have difficulties in paying its financial
liabilities. [IFRS 7. Appendix A]
 Disclosures about liquidity risk include: [IFRS 7.39]
o a maturity analysis of financial liabilities
o description of approach to risk management
Market risk [IFRS 7.40-42]

245
 Market risk is the risk that the fair value or cash flows of a financial instrument will
fluctuate due to changes in market prices. Market risk reflects interest rate risk, currency
risk and other price risks. [IFRS 7. Appendix A]
 Disclosures about market risk include:
o a sensitivity analysis of each type of market risk to which the entity is exposed
o additional information if the sensitivity analysis is not representative of the
entity's risk exposure (for example because exposures during the year were
different to exposures at year-end).
o IFRS 7 provides that if an entity prepares a sensitivity analysis such as value-at-
risk for management purposes that reflects interdependencies of more than one
component of market risk (for instance, interest risk and foreign currency risk
combined), it may disclose that analysis instead of a separate sensitivity analysis
for each type of market risk
Transfers of financial assets [IFRS 7.42A-H]
An entity shall disclose information that enables users of its financial statements:
a. to understand the relationship between transferred financial assets that are not
derecognised in their entirety and the associated liabilities; and
b. to evaluate the nature of, and risks associated with, the entity's continuing involvement in
derecognised financial assets. [IFRS 7 42B]
Transferred financial assets that are not derecognised in their entirety
 Required disclosures include description of the nature of the transferred assets, nature of
risk and rewards as well as description of the nature and quantitative disclosure depicting
relationship between transferred financial assets and the associated liabilities. [IFRS
7.42D]
Transferred financial assets that are derecognised in their entirety
 Required disclosures include the carrying amount of the assets and liabilities recognised,
fair value of the assets and liabilities that represent continuing involvement, maximum
exposure to loss from the continuing involvement as well as maturity analysis of the
undiscounted cash flows to repurchase the derecognised financial assets. [IFRS 7.42E]
 Additional disclosures are required for any gain or loss recognised at the date of transfer
of the assets, income or expenses recognise from the entity's continuing involvement in
the derecognised financial assets as well as details of uneven distribution of proceed from
transfer activity throughout the reporting period. [IFRS 7.42G]
Application guidance
An appendix of mandatory application guidance (Appendix B) is part of the standard.

246
There is also an appendix of non-mandatory implementation guidance (Appendix C) that
describes how an entity might provide the disclosures required by IFRS 7.
IFRS 8 Operating Segments
IFRS 10 — Consolidated Financial Statements (issued in May 2011)
Summary of IFRS 10
Objective
The objective of IFRS 10 is to establish principles for the presentation and preparation of
consolidated financial statements when an entity controls one or more other entities. [IFRS 10:1]
The Standard: [IFRS 10:1]
 requires a parent entity (an entity that controls one or more other entities) to present
consolidated financial statements
 defines the principle of control, and establishes control as the basis for consolidation
 set out how to apply the principle of control to identify whether an investor controls an
investee and therefore must consolidate the investee
 sets out the accounting requirements for the preparation of consolidated financial
statements
 defines an investment entity and sets out an exception to consolidating particular
subsidiaries of an investment entity*.
* Added by Investment Entities amendments, effective 1 January 2014.
Key definitions
[IFRS 10:Appendix A]
Consolidated The financial statements of a group in which the assets, liabilities, equity,
financial income, expenses and cash flows of the parent and its subsidiaries are
statements presented as those of a single economic entity
An investor controls an investee when the investor is exposed, or has rights,
Control of an
to variable returns from its involvement with the investee and has the ability
investee
to affect those returns through its power over the investee
An entity that:
Investment entity*
1. obtains funds from one or more investors for the purpose of
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providing those investor(s) with investment management services
2. commits to its investor(s) that its business purpose is to invest funds
solely for returns from capital appreciation, investment income, or
both, and
3. measures and evaluates the performance of substantially all of its
investments on a fair value basis.
Parent An entity that controls one or more entities
Power Existing rights that give the current ability to direct the relevant activities
Rights designed to protect the interest of the party holding those rights
Protective rights
without giving that party power over the entity to which those rights relate
Relevant activities Activities of the investee that significantly affect the investee's returns
* Added by Investment Entities amendments, effective 1 January 2014.
Control
An investor determines whether it is a parent by assessing whether it controls one or more

investees. An investor considers all relevant facts and circumstances when assessing whether it
controls an investee. An investor controls an investee when it is exposed, or has rights, to
variable returns from its involvement with the investee and has the ability to affect those returns
through its power over the investee. [IFRS 10:5-6; IFRS 10:8]
An investor controls an investee if and only if the investor has all of the following elements:
[IFRS 10:7]
 power over the investee, i.e. the investor has existing rights that give it the ability to
direct the relevant activities (the activities that significantly affect the investee's returns)
 exposure, or rights, to variable returns from its involvement with the investee
 the ability to use its power over the investee to affect the amount of the investor's returns.
Power arises from rights. Such rights can be straightforward (e.g. through voting rights) or be
complex (e.g. embedded in contractual arrangements). An investor that holds only protective
rights cannot have power over an investee and so cannot control an investee [IFRS 10:11, IFRS
10:14].
An investor must be exposed, or have rights, to variable returns from its involvement with an
investee to control the investee. Such returns must have the potential to vary as a result of the
investee's performance and can be positive, negative, or both. [IFRS 10:15]
A parent must not only have power over an investee and exposure or rights to variable returns
from its involvement with the investee, a parent must also have the ability to use its power over
the investee to affect its returns from its involvement with the investee. [IFRS 10:17].

248
When assessing whether an investor controls an investee an investor with decision-making rights
determines whether it acts as principal or as an agent of other parties. A number of factors are
considered in making this assessment. For instance, the remuneration of the decision-maker is
considered in determining whether it is an agent. [IFRS 10:B58, IFRS 10:B60]
Accounting requirements
Preparation of consolidated financial statements
A parent prepares consolidated financial statements using uniform accounting policies for like
transactions and other events in similar circumstances. [IFRS 10:19]
However, a parent need not present consolidated financial statements if it meets all of the
following conditions: [IFRS 10:4(a)]
 it is a wholly-owned subsidiary or is a partially-owned subsidiary of another entity and its

other owners, including those not otherwise entitled to vote, have been informed about,
and do not object to, the parent not presenting consolidated financial statements
 its debt or equity instruments are not traded in a public market (a domestic or foreign
stock exchange or an over-the-counter market, including local and regional markets)
 it did not file, nor is it in the process of filing, its financial statements with a securities
commission or other regulatory organisation for the purpose of issuing any class of
instruments in a public market, and
 its ultimate or any intermediate parent of the parent produces consolidated financial
statements available for public use that comply with IFRSs.
Furthermore, post-employment benefit plans or other long-term employee benefit plans to which
IAS 19 Employee Benefits applies are not required to apply the requirements of IFRS 10. [IFRS
10:4(b)]
Consolidation procedures
Consolidated financial statements: [IFRS 10:B86]
 combine like items of assets, liabilities, equity, income, expenses and cash flows of the
parent with those of its subsidiaries
 offset (eliminate) the carrying amount of the parent's investment in each subsidiary and
the parent's portion of equity of each subsidiary (IFRS 3 Business Combinations explains
how to account for any related goodwill)
 eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows
relating to transactions between entities of the group (profits or losses resulting from
intragroup transactions that are recognised in assets, such as inventory and fixed assets,
are eliminated in full).
A reporting entity includes the income and expenses of a subsidiary in the consolidated financial
statements from the date it gains control until the date when the reporting entity ceases to control

249
the subsidiary. Income and expenses of the subsidiary are based on the amounts of the assets and
liabilities recognised in the consolidated financial statements at the acquisition date. [IFRS
10:B88]
The parent and subsidiaries are required to have the same reporting dates, or consolidation based
on additional financial information prepared by subsidiary, unless impracticable. Where
impracticable, the most recent financial statements of the subsidiary are used, adjusted for the
effects of significant transactions or events between the reporting dates of the subsidiary and
consolidated financial statements. The difference between the date of the subsidiary's financial
statements and that of the consolidated financial statements shall be no more than three months
[IFRS 10:B92, IFRS 10:B93]
Non-controlling interests (NCIs)
A parent presents non-controlling interests in its consolidated statement of financial position

within equity, separately from the equity of the owners of the parent. [IFRS 10:22]
A reporting entity attributes the profit or loss and each component of other comprehensive
income to the owners of the parent and to the non-controlling interests. The proportion allocated
to the parent and non-controlling interests are determined on the basis of present ownership
interests. [IFRS 10:B94, IFRS 10:B89]
The reporting entity also attributes total comprehensive income to the owners of the parent and
to the non-controlling interests even if this results in the non-controlling interests having a deficit
balance. [IFRS 10:B94]
Changes in ownership interests
Changes in a parent's ownership interest in a subsidiary that do not result in the parent losing
control of the subsidiary are equity transactions (i.e. transactions with owners in their capacity as
owners). When the proportion of the equity held by non-controlling interests changes, the
carrying amounts of the controlling and non-controlling interests area adjusted to reflect the
changes in their relative interests in the subsidiary. Any difference between the amount by which
the non-controlling interests are adjusted and the fair value of the consideration paid or received
is recognised directly in equity and attributed to the owners of the parent.[IFRS 10:23, IFRS
10:B96]
If a parent loses control of a subsidiary, the parent [IFRS 10:25]:
 derecognises the assets and liabilities of the former subsidiary from the consolidated
statement of financial position
 recognises any investment retained in the former subsidiary at its fair value when control
is lost and subsequently accounts for it and for any amounts owed by or to the former
subsidiary in accordance with relevant IFRSs. That fair value is regarded as the fair value
on initial recognition of a financial asset in accordance with IFRS 9 Financial

250
Instruments or, when appropriate, the cost on initial recognition of an investment in an
associate or joint venture
 recognises the gain or loss associated with the loss of control attributable to the former
controlling interest.
Investment entities consolidation exemption
[Note: The investment entity consolidation exemption was introduced by Investment Entities,
issued on 31 October 2012 and effective for annual periods beginning on or after 1 January
2014.]
IFRS 10 contains special accounting requirements for investment entities. Where an entity meets
the definition of an 'investment entity', it does not consolidate its subsidiaries, or apply IFRS 3
Business Combinations when it obtains control of another entity. [IFRS 10:31]
An entity is required to consider all facts and circumstances when assessing whether it is an
investment entity, including its purpose and design. IFRS 10 provides that an investment entity
should have the following typical characteristics [IFRS 10:28]:
 it has more than one investment

 it has more than one investor
 it has investors that are not related parties of the entity
 it has ownership interests in the form of equity or similar interests.
The absence of any of these typical characteristics does not necessarily disqualify an entity from
being classified as an investment entity.
An investment entity is required to measure an investment in a subsidiary at fair value through

profit or loss in accordance with IFRS 9 Financial Instruments or IAS 39 Financial Instruments:
Recognition and Measurement. However, an investment entity is still required to consolidate a
subsidiary where that subsidiary provides services that relate to the investment entity‘s
investment activities. [IFRS 10:31-32]
Because an investment entity is not required to consolidate its subsidiaries, intragroup related
party transactions and outstanding balances are not eliminated [IAS 24.4, IAS 39.80].
Special requirements apply where an entity becomes, or ceases to be, an investment entity.
[IFRS 10:B100-B101]
The exemption from consolidation only applies to the investment entity itself. Accordingly, a
parent of an investment entity is required to consolidate all entities that it controls, including
those controlled through an investment entity subsidiary, unless the parent itself is an investment
entity. [IFRS 10:33]
Disclosure

251
There are no disclosures specified in IFRS 10. Instead, IFRS 12 Disclosure of Interests in Other
Entities outlines the disclosures required.
Applicability and early adoption
Note: This section has been updated to reflect the amendments to IFRS 10 made in June 2012
and October 2012.
IFRS 10 is applicable to annual reporting periods beginning on or after 1 January 2013 [IFRS
10:C1].
Retrospective application is generally required in accordance with IAS 8 Accounting Policies,

Changes in Accounting Estimates and Errors [IFRS 10:C2]. However, an entity is not required
to make adjustments to the accounting for its involvement with entities that were previously
consolidated and continue to be consolidated, or entities that were previously unconsolidated and
continue not to be consolidated at the date of initial application of the IFRS [IFRS 10:C3].
Furthermore, an entity is not required to present the quantitative information required by

paragraph 28(f) of IAS 8 for the annual period immediately preceding the date of initial
application of the standard (the beginning of the annual reporting period for which IFRS 10 is
first applied) [IFRS 10:C2A-C2B]. However, an entity may choose to present adjusted
comparative information for earlier reporting periods, any must clearly identify any unadjusted
comparative information and explain the basis on which the comparative information has been
prepared [IFRS 10.C6A-C6B].
IFRS 10 prescribes modified accounting on its first application in the following circumstances:
 an entity consolidates an entity not previously consolidated [IFRS 10:C4-C4C]

 an entity no longer consolidates an entity that was previously consolidated [IFRS 10:C5-
C5A]
 in relation to certain amendments to IAS 27 made in 2008 that have been carried forward
into IFRS 10 [IFRS 10:C6].
An entity may apply IFRS 10 to an earlier accounting period, but if doing so it must disclose the
fact that is has early adopted the standard and also apply:
 IFRS 11 Joint Arrangements

 IFRS 12 Disclosure of Interests in Other Entities
 IAS 27 Separate Financial Statements (as amended in 2011)
 IAS 28 Investments in Associates and Joint Ventures (as amended in 2011).
The amendments made by Investment Entities are applicable to annual reporting periods
beginning on or after 1 January 2014 [IFRS 10:C1B]. At the date of initial application of the
amendments, an entity assesses whether it is an investment entity on the basis of the facts and
circumstances that exist at that date and additional transitional provisions apply [IFRS 10:C3B–
C3F].

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IAS 7 Cash Flow Statements (reissued in December 1992, retiled in September 2007 )
IAS 8 Accounting Policies, Changes in Accounting Estimates, and Errors (revised 2003)
IAS 10 Events After the Statement of financial position Date (revised 2003)
IAS 12 Income Taxes (revised 2000)
Summary of IAS 12
Objective of IAS 12
The objective of IAS 12 (1996) is to prescribe the accounting treatment for income taxes.
Temporary difference: a difference between the carrying amount of an asset or liability and its
tax base.
Taxable temporary difference: a temporary difference that will result in taxable amounts in the
future when the carrying amount of the asset is recovered or the liability is settled.
Deductible temporary difference: a temporary difference that will result in amounts that are
tax deductible in the future when the carrying amount of the asset is recovered or the liability is
settled.
Current tax
Current tax for the current and prior periods is recognised as a liability to the extent that it has
not yet been settled, and as an asset to the extent that the amounts already paid exceed the
amount due. [IAS 12.12] The benefit of a tax loss which can be carried back to recover current
tax of a prior period is recognised as an asset. [IAS 12.13] Current tax assets and liabilities are
measured at the amount expected to be paid to (recovered from) taxation authorities, using the
rates/laws that have been enacted or substantively enacted by the balance sheet date. [IAS 12.46]
Recognition of deferred tax liabilities

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The general principle in IAS 12 is that deferred tax liabilities should be recognised for all taxable
temporary differences. There are three exceptions to the requirement to recognise a deferred tax
liability, as follows: [IAS 12.15]
 liabilities arising from initial recognition of goodwill for which amortisation is not
deductible for tax purposes;
 liabilities arising from the initial recognition of an asset/liability other than in a business
combination which, at the time of the transaction, does not affect either the accounting or
the taxable profit; and
 liabilities arising from undistributed profits from investments where the entity is able to
control the timing of the reversal of the difference and it is probable that the reversal will
not occur in the foreseeable future. [IAS 12.39]
Recognition of deferred tax assets
A deferred tax asset should be recognised for deductible temporary differences, unused tax losses
and unused tax credits to the extent that it is probable that taxable profit will be available against
which the deductible temporary differences can be utilised, unless the deferred tax asset arises
from: [IAS 12.24]
 the initial recognition of an asset or liability other than in a business combination which,
at the time of the transaction, does not affect the accounting or the taxable profit.
Deferred tax assets for deductible temporary differences arising from investments in subsidiaries,
associates, branches and joint ventures should be recognised to the extent that it is probable that
the temporary difference will reverse in the foreseeable future and that taxable profit will be
available against which the temporary difference will be utilised. [IAS 12.44]
The carrying amount of deferred tax assets should be reviewed at the end of each reporting
period and reduced to the extent that it is no longer probable that sufficient taxable profit will be
available to allow the benefit of part or all of that deferred tax asset to be utilised. Any such
reduction should be subsequently reversed to the extent that it becomes probable that sufficient
taxable profit will be available. [IAS 12.37]
A deferred tax asset should be recognised for an unused tax loss carryforward or unused tax
credit if, and only if, it is considered probable that there will be sufficient future taxable profit
against which the loss or credit carryforwards can be utilised. [IAS 12.34]
Measurement of deferred tax assets and liabilities
Deferred tax assets and liabilities should be measured at the tax rates that are expected to apply
to the period when the asset is realised or the liability is settled (liability method), based on tax
rates/laws that have been enacted or substantively enacted by the end of the reporting period.
[IAS 12.47] The measurement should reflect the entity's expectations, at the balance sheet date,
as to the manner in which the carrying amount of its assets and liabilities will be recovered or
settled. [IAS 12.51]

254
Deferred tax assets and liabilities should not be discounted. [IAS 12.53]
Recognition of tax expense or income
Current and deferred tax should be recognised as income or expense and included in profit or
loss for the period, except to the extent that the tax arises from: [IAS 12.58]
 a transaction or event that is recognised directly in equity; or

 a business combination accounted for as an acquisition.
If the tax relates to items that are credited or charged directly to equity, the tax should also be
charged or credited directly to equity. [IAS 12.61]
If the tax arises from a business combination that is an acquisition, it should be recognised as an
identifiable asset or liability at the date of acquisition in accordance with IFRS 3 Business
Combinations (thus affecting goodwill).
Tax consequences of dividends
In some jurisdictions, income taxes are payable at a higher or lower rate if part or all of the net
profit or retained earnings is paid out as a dividend. In other jurisdictions, income taxes may be
refundable if part or all of the net profit or retained earnings is paid out as a dividend. Possible
future dividend distributions or tax refunds should not be anticipated in measuring deferred tax
assets and liabilities. [IAS 12.52A]
IAS 10 Events after the Reporting Period, requires disclosure, and prohibits accrual, of a
dividend that is proposed or declared after the end of the reporting period but before the financial
statements were authorised for issue. IAS 12 requires disclosure of the tax consequences of such
dividends as well as disclosure of the nature and amounts of the potential income tax
consequences of dividends. [IAS 12.82A]
Presentation
Current tax assets and current tax liabilities should be offset on the balance sheet only if the
entity has the legal right and the intention to settle on a net basis. [IAS 12.71]
Deferred tax assets and deferred tax liabilities should be offset on the balance sheet only if the
entity has the legal right to settle on a net basis and they are levied by the same taxing authority
on the same entity or different entities that intend to realise the asset and settle the liability at the
same time. [IAS 12.74]
Disclosure
In addition to the disclosures required by IAS 12, some disclosures relating to income taxes are
required by IAS 1, as follows:

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 IAS 1 requires disclosures on the face of the statement of financial position about current
tax assets, current tax liabilities, deferred tax assets, and deferred tax liabilities [IAS
1.54(n) and (o)]
 IAS 1 requires disclosure of tax expense (tax income) on the face of the statement of
comprehensive income [IAS 1.82(d)].
 IAS 12 requires disclosure of tax expense (tax income) relating to ordinary activities on
the face of the statement of comprehensive income [IAS 12.77].
 IAS 12 requires that if an entity presents a statement of income, in addition to a statement
of comprehensive income, tax expense (income) from ordinary activities should be
presented in the statement of income. [IAS 12.77A]
IAS 12.80 requires the following disclosures:
 major components of tax expense (tax income) [IAS 12.79] Examples include:
o current tax expense (income)
o any adjustments of taxes of prior periods
o amount of deferred tax expense (income) relating to the origination and reversal
of temporary differences
o amount of deferred tax expense (income) relating to changes in tax rates or the
imposition of new taxes
o amount of the benefit arising from a previously unrecognised tax loss, tax credit
or temporary difference of a prior period
o write down, or reversal of a previous write down, of a deferred tax asset
o amount of tax expense (income) relating to changes in accounting policies and
corrections of errors
IAS 12.81 requires the following disclosures:
 aggregate current and deferred tax relating to items reported directly in equity
 tax relating to each component of other comprehensive income
 explanation of the relationship between tax expense (income) and the tax that would be
expected by applying the current tax rate to accounting profit or loss (this can be
presented as a reconciliation of amounts of tax or a reconciliation of the rate of tax)
 changes in tax rates
 amounts and other details of deductible temporary differences, unused tax losses, and
unused tax credits
 temporary differences associated with investments in subsidiaries, associates, branches,
and joint ventures
 for each type of temporary difference and unused tax loss and credit, the amount of
deferred tax assets or liabilities recognised in the statement of financial position and the
amount of deferred tax income or expense recognised in the income statement
 tax relating to discontinued operations
 tax consequences of dividends declared after the end of the reporting period
Other required disclosures:

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 details of deferred tax assets [IAS 12.82]
 tax consequences of future dividend payments [IAS 12.82A]
IAS 16 — Property, Plant and Equipment
Summary of IAS 16
Objective of IAS 16
The objective of IAS 16 is to prescribe the accounting treatment for property, plant, and
equipment. The principal issues are the recognition of assets, the determination of their carrying
amounts, and the depreciation charges and impairment losses to be recognised in relation to
them.
Scope
IAS 16 does not apply to
 assets classified as held for sale in accordance with IFRS 5

 exploration and evaluation assets (IFRS 6)
 biological assets related to agricultural activity (see IAS 41) or
 mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative
resources
The standard does apply to property, plant, and equipment used to develop or maintain the last
two categories of assets. [IAS 16.3]
Recognition
Items of property, plant, and equipment should be recognised as assets when it is probable that:
[IAS 16.7]
 it is probable that the future economic benefits associated with the asset will flow to the
entity, and
 the cost of the asset can be measured reliably.
This recognition principle is applied to all property, plant, and equipment costs at the time they
are incurred. These costs include costs incurred initially to acquire or construct an item of
property, plant and equipment and costs incurred subsequently to add to, replace part of, or
service it.

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IAS 16 does not prescribe the unit of measure for recognition – what constitutes an item of
property, plant, and equipment. [IAS 16.9] Note, however, that if the cost model is used (see
below) each part of an item of property, plant, and equipment with a cost that is significant in
relation to the total cost of the item must be depreciated separately. [IAS 16.43]
IAS 16 recognises that parts of some items of property, plant, and equipment may require
replacement at regular intervals. The carrying amount of an item of property, plant, and
equipment will include the cost of replacing the part of such an item when that cost is incurred if
the recognition criteria (future benefits and measurement reliability) are met. The carrying
amount of those parts that are replaced is derecognised in accordance with the derecognition
provisions of IAS 16.67-72. [IAS 16.13]
Also, continued operation of an item of property, plant, and equipment (for example, an aircraft)
may require regular major inspections for faults regardless of whether parts of the item are
replaced. When each major inspection is performed, its cost is recognised in the carrying amount
of the item of property, plant, and equipment as a replacement if the recognition criteria are
satisfied. If necessary, the estimated cost of a future similar inspection may be used as an
indication of what the cost of the existing inspection component was when the item was acquired
or constructed. [IAS 16.14]
Initial measurement
An item of property, plant and equipment should initially be recorded at cost. [IAS 16.15] Cost
includes all costs necessary to bring the asset to working condition for its intended use. This
would include not only its original purchase price but also costs of site preparation, delivery and
handling, installation, related professional fees for architects and engineers, and the estimated
cost of dismantling and removing the asset and restoring the site
If payment for an item of property, plant, and equipment is deferred, interest at a market rate
must be recognised or imputed. [IAS 16.23]
If an asset is acquired in exchange for another asset (whether similar or dissimilar in nature), the
cost will be measured at the fair value unless (a) the exchange transaction lacks commercial
substance or (b) the fair value of neither the asset received nor the asset given up is reliably
measurable. If the acquired item is not measured at fair value, its cost is measured at the carrying
amount of the asset given up. [IAS 16.24]
Measurement subsequent to initial recognition
IAS 16 permits two accounting models:
 Cost model. The asset is carried at cost less accumulated depreciation and impairment.
[IAS 16.30]
 Revaluation model. The asset is carried at a revalued amount, being its fair value at the
date of revaluation less subsequent depreciation and impairment, provided that fair value
can be measured reliably. [IAS 16.31]

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The revaluation model
Under the revaluation model, revaluations should be carried out regularly, so that the carrying
amount of an asset does not differ materially from its fair value at the balance sheet date. [IAS
16.31]
If an item is revalued, the entire class of assets to which that asset belongs should be revalued.
[IAS 16.36]
Revalued assets are depreciated in the same way as under the cost model (see below).
If a revaluation results in an increase in value, it should be credited to other comprehensive

income and accumulated in equity under the heading "revaluation surplus" unless it represents
the reversal of a revaluation decrease of the same asset previously recognised as an expense, in
which case it should be recognised in profit or loss. [IAS 16.39]
A decrease arising as a result of a revaluation should be recognised as an expense to the extent

that it exceeds any amount previously credited to the revaluation surplus relating to the same
asset. [IAS 16.40]
When a revalued asset is disposed of, any revaluation surplus may be transferred directly to
retained earnings, or it may be left in equity under the heading revaluation surplus. The transfer
to retained earnings should not be made through profit or loss. [IAS 16.41]
Depreciation (cost and revaluation models)
For all depreciable assets:
The depreciable amount (cost less residual value) should be allocated on a systematic basis over
the asset's useful life [IAS 16.50].
The residual value and the useful life of an asset should be reviewed at least at each financial
year-end and, if expectations differ from previous estimates, any change is accounted for
prospectively as a change in estimate under IAS 8. [IAS 16.51]
The depreciation method used should reflect the pattern in which the asset's economic benefits
are consumed by the entity [IAS 16.60];
The depreciation method should be reviewed at least annually and, if the pattern of consumption
of benefits has changed, the depreciation method should be changed prospectively as a change in
estimate under IAS 8. [IAS 16.61]
Depreciation should be charged to profit or loss, unless it is included in the carrying amount of
another asset [IAS 16.48].

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Depreciation begins when the asset is available for use and continues until the asset is
derecognised, even if it is idle. [IAS 16.55]
Recoverability of the carrying amount
IAS 36 requires impairment testing and, if necessary, recognition for property, plant, and
equipment. An item of property, plant, or equipment shall not be carried at more than
recoverable amount. Recoverable amount is the higher of an asset's fair value less costs to sell
and its value in use.
Any claim for compensation from third parties for impairment is included in profit or loss when
the claim becomes receivable. [IAS 16.65]
Derecognition (retirements and disposals)
An asset should be removed from the statement of financial position on disposal or when it is
withdrawn from use and no future economic benefits are expected from its disposal. The gain or
loss on disposal is the difference between the proceeds and the carrying amount and should be
recognised in profit and loss. [IAS 16.67-71]
If an entity rents some assets and then ceases to rent them, the assets should be transferred to
inventories at their carrying amounts as they become held for sale in the ordinary course of
business. [IAS 16.68A]
Disclosure
For each class of property, plant, and equipment, disclose: [IAS 16.73]
 basis for measuring carrying amount

 depreciation method(s) used
 useful lives or depreciation rates
 gross carrying amount and accumulated depreciation and impairment losses
 reconciliation of the carrying amount at the beginning and the end of the period, showing:
o additions
o disposals
o acquisitions through business combinations
o revaluation increases or decreases
o impairment losses
o reversals of impairment losses
o depreciation
o net foreign exchange differences on translation
o other movements
Also disclose: [IAS 16.74]
 restrictions on title

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 expenditures to construct property, plant, and equipment during the period
 contractual commitments to acquire property, plant, and equipment
 compensation from third parties for items of property, plant, and equipment that were
impaired, lost or given up that is included in profit or loss
If property, plant, and equipment is stated at revalued amounts, certain additional disclosures are
required: [IAS 16.77]
 the effective date of the revaluation

 whether an independent valuer was involved
 the methods and significant assumptions used in estimating fair values
 the extent to which fair values were determined directly by reference to observable prices
in an active market or recent market transactions on arm's length terms or were estimated
using other valuation techniques
 for each revalued class of property, the carrying amount that would have been recognised
had the assets been carried under the cost model
 the revaluation surplus, including changes during the period and any restrictions on the
distribution of the balance to shareholders
IAS 17 — Leases
Summary of IAS 17
Objective of IAS 17
The objective of IAS 17 (1997) is to prescribe, for lessees and lessors, the appropriate accounting
policies and disclosures to apply in relation to finance and operating leases.
Scope
IAS 17 applies to all leases other than lease agreements for minerals, oil, natural gas, and similar
regenerative resources and licensing agreements for films, videos, plays, manuscripts, patents,
copyrights, and similar items. [IAS 17.2]
However, IAS 17 does not apply as the basis of measurement for the following leased assets:
[IAS 17.2]
 property held by lessees that is accounted for as investment property for which the lessee
uses the fair value model set out in IAS 40
 investment property provided by lessors under operating leases (see IAS 40)
 biological assets held by lessees under finance leases (see IAS 41)
 biological assets provided by lessors under operating leases (see IAS 41)
Classification of leases

261
A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incident to ownership. All other leases are classified as operating leases. Classification is made at
the inception of the lease. [IAS 17.4]
Whether a lease is a finance lease or an operating lease depends on the substance of the
transaction rather than the form. Situations that would normally lead to a lease being classified as
a finance lease include the following: [IAS 17.10]
 the lease transfers ownership of the asset to the lessee by the end of the lease term
 the lessee has the option to purchase the asset at a price which is expected to be
sufficiently lower than fair value at the date the option becomes exercisable that, at the
inception of the lease, it is reasonably certain that the option will be exercised
 the lease term is for the major part of the economic life of the asset, even if title is not
transferred
 at the inception of the lease, the present value of the minimum lease payments amounts to
at least substantially all of the fair value of the leased asset
 the lease assets are of a specialised nature such that only the lessee can use them without
major modifications being made
Other situations that might also lead to classification as a finance lease are: [IAS 17.11]
 if the lessee is entitled to cancel the lease, the lessor's losses associated with the
cancellation are borne by the lessee
 gains or losses from fluctuations in the fair value of the residual fall to the lessee (for
example, by means of a rebate of lease payments)
 the lessee has the ability to continue to lease for a secondary period at a rent that is
substantially lower than market rent
When a lease includes both land and buildings elements, an entity assesses the classification of
each element as a finance or an operating lease separately. In determining whether the land
element is an operating or a finance lease, an important consideration is that land normally has
an indefinite economic life [IAS 17.15A]. Whenever necessary in order to classify and account
for a lease of land and buildings, the minimum lease payments (including any lump-sum upfront
payments) are allocated between the land and the buildings elements in proportion to the relative
fair values of the leasehold interests in the land element and buildings element of the lease at the
inception of the lease. [IAS 17.16] For a lease of land and buildings in which the amount that
would initially be recognised for the land element is immaterial, the land and buildings may be
treated as a single unit for the purpose of lease classification and classified as a finance or
operating lease. [IAS 17.17] However, separate measurement of the land and buildings elements
is not required if the lessee's interest in both land and buildings is classified as an investment
property in accordance with IAS 40 and the fair value model is adopted. [IAS 17.18]
Accounting by lessees
The following principles should be applied in the financial statements of lessees:

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 at commencement of the lease term, finance leases should be recorded as an asset and a
liability at the lower of the fair value of the asset and the present value of the minimum
lease payments (discounted at the interest rate implicit in the lease, if practicable, or else
at the entity's incremental borrowing rate) [IAS 17.20]
 finance lease payments should be apportioned between the finance charge and the
reduction of the outstanding liability (the finance charge to be allocated so as to produce
a constant periodic rate of interest on the remaining balance of the liability) [IAS 17.25]
 the depreciation policy for assets held under finance leases should be consistent with that
for owned assets. If there is no reasonable certainty that the lessee will obtain ownership
at the end of the lease – the asset should be depreciated over the shorter of the lease term
or the life of the asset [IAS 17.27]
 for operating leases, the lease payments should be recognised as an expense in the
income statement over the lease term on a straight-line basis, unless another systematic
basis is more representative of the time pattern of the user's benefit [IAS 17.33]
Incentives for the agreement of a new or renewed operating lease should be recognised by the
lessee as a reduction of the rental expense over the lease term, irrespective of the incentive's
nature or form, or the timing of payments.
Accounting by lessors
The following principles should be applied in the financial statements of lessors:
 at commencement of the lease term, the lessor should record a finance lease in the
balance sheet as a receivable, at an amount equal to the net investment in the lease [IAS
17.36]
 the lessor should recognise finance income based on a pattern reflecting a constant
periodic rate of return on the lessor's net investment outstanding in respect of the finance
lease [IAS 17.39]
 assets held for operating leases should be presented in the balance sheet of the lessor
according to the nature of the asset. [IAS 17.49] Lease income should be recognised over
the lease term on a straight-line basis, unless another systematic basis is more
representative of the time pattern in which use benefit is derived from the leased asset is
diminished [IAS 17.50]
Incentives for the agreement of a new or renewed operating lease should be recognised by the
lessor as a reduction of the rental income over the lease term, irrespective of the incentive's
nature or form, or the timing of payments.
Manufacturers or dealer lessors should include selling profit or loss in the same period as they
would for an outright sale. If artificially low rates of interest are charged, selling profit should be
restricted to that which would apply if a commercial rate of interest were charged. [IAS 17.42]
Under the 2003 revisions to IAS 17, initial direct and incremental costs incurred by lessors in
negotiating leases must be recognised over the lease term. They may no longer be charged to

263
expense when incurred. This treatment does not apply to manufacturer or dealer lessors where
such cost recognition is as an expense when the selling profit is recognised.
Sale and leaseback transactions
For a sale and leaseback transaction that results in a finance lease, any excess of proceeds over
the carrying amount is deferred and amortised over the lease term. [IAS 17.59]
For a transaction that results in an operating lease: [IAS 17.61]
 if the transaction is clearly carried out at fair value - the profit or loss should be
recognised immediately
 if the sale price is below fair value - profit or loss should be recognised immediately,
except if a loss is compensated for by future rentals at below market price, the loss it
should be amortised over the period of use
 if the sale price is above fair value - the excess over fair value should be deferred and
amortised over the period of use
 if the fair value at the time of the transaction is less than the carrying amount – a loss
equal to the difference should be recognised immediately [IAS 17.63]
Disclosure: lessees – finance leases [IAS 17.31]
 carrying amount of asset

 reconciliation between total minimum lease payments and their present value
 amounts of minimum lease payments at balance sheet date and the present value thereof,
for:
o the next year
o years 2 through 5 combined
o beyond five years
 contingent rent recognised as an expense
 total future minimum sublease income under noncancellable subleases
 general description of significant leasing arrangements, including contingent rent
provisions, renewal or purchase options, and restrictions imposed on dividends,
borrowings, or further leasing
Disclosure: lessees – operating leases [IAS 17.35]
 amounts of minimum lease payments at balance sheet date under non cancellable
operating leases for:
o the next year
o beyond five years
 total future minimum sublease income under noncancellable subleases
 lease and sublease payments recognised in income for the period
 contingent rent recognised as an expense

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 general description of significant leasing arrangements, including contingent rent
provisions, renewal or purchase options, and restrictions imposed on dividends,
borrowings, or further leasing
Disclosure: lessors – finance leases [IAS 17.47]
 reconciliation between gross investment in the lease and the present value of minimum
lease payments;
 gross investment and present value of minimum lease payments receivable for:
o the next year
o beyond five years
 unearned finance income
 unguaranteed residual values
 accumulated allowance for uncollectible lease payments receivable
 contingent rent recognised in income
 general description of significant leasing arrangements
Disclosure: lessors – operating leases [IAS 17.56]
 amounts of minimum lease payments at balance sheet date under noncancellable

operating leases in the aggregate and for:
o the next year
o beyond five years
 contingent rent recognised as in income
 general description of significant leasing arrangements
IAS 18 — Revenue
Summary of IAS 18
Objective of IAS 18
The objective of IAS 18 is to prescribe the accounting treatment for revenue arising from certain
types of transactions and events.
Key definition
Revenue: the gross inflow of economic benefits (cash, receivables, other assets) arising from the
ordinary operating activities of an entity (such as sales of goods, sales of services, interest,
royalties, and dividends). [IAS 18.7]

265
Measurement of revenue
Revenue should be measured at the fair value of the consideration received or receivable. [IAS
18.9] An exchange for goods or services of a similar nature and value is not regarded as a
transaction that generates revenue. However, exchanges for dissimilar items are regarded as
generating revenue. [IAS 18.12]
If the inflow of cash or cash equivalents is deferred, the fair value of the consideration receivable
is less than the nominal amount of cash and cash equivalents to be received, and discounting is
appropriate. This would occur, for instance, if the seller is providing interest-free credit to the
buyer or is charging a below-market rate of interest. Interest must be imputed based on market
rates. [IAS 18.11]
Recognition of revenue
Recognition, as defined in the IASB Framework, means incorporating an item that meets the
definition of revenue (above) in the income statement when it meets the following criteria:
 it is probable that any future economic benefit associated with the item of revenue will
flow to the entity, and
 the amount of revenue can be measured with reliability
IAS 18 provides guidance for recognising the following specific categories of revenue:
Sale of goods
Revenue arising from the sale of goods should be recognised when all of the following criteria
have been satisfied: [IAS 18.14]
 the seller has transferred to the buyer the significant risks and rewards of ownership
 the seller retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold
 the amount of revenue can be measured reliably
 it is probable that the economic benefits associated with the transaction will flow to the
seller, and
 the costs incurred or to be incurred in respect of the transaction can be measured reliably
Rendering of services
For revenue arising from the rendering of services, provided that all of the following criteria are
met, revenue should be recognised by reference to the stage of completion of the transaction at
the balance sheet date (the percentage-of-completion method): [IAS 18.20]
 the amount of revenue can be measured reliably;

 it is probable that the economic benefits will flow to the seller;
 the stage of completion at the balance sheet date can be measured reliably; and

266
 the costs incurred, or to be incurred, in respect of the transaction can be measured
reliably.
When the above criteria are not met, revenue arising from the rendering of services should be
recognised only to the extent of the expenses recognised that are recoverable (a "cost-recovery
approach". [IAS 18.26]
Interest, royalties, and dividends
For interest, royalties and dividends, provided that it is probable that the economic benefits will
flow to the enterprise and the amount of revenue can be measured reliably, revenue should be
recognised as follows: [IAS 18.29-30]
 interest: using the effective interest method as set out in IAS 39

 royalties: on an accruals basis in accordance with the substance of the relevant agreement
 dividends: when the shareholder's right to receive payment is established
Disclosure [IAS 18.35]
 accounting policy for recognising revenue

 amount of each of the following types of revenue:
o sale of goods
o rendering of services
o interest
o royalties
o dividends
o within each of the above categories, the amount of revenue from exchanges of
goods or services
Implementation guidance
Appendix A to IAS 18 provides illustrative examples of how the above principles apply to
certain transactions.
IAS 19 — Employee Benefits (2011)
Summary of IAS 19 (2011)

Amended version of IAS 19 issued in 2011
IAS 19 Employee Benefits (2011) is an amended version of, and supersedes, IAS 19 Employee
Benefits (1998), effective for annual periods beginning on or after 1 January 2013. The summary
that follows refers to IAS 19 (2011).
Changes introduced by IAS 19 (2011) as compared to IAS 19 (1998) include:

267
 Introducing a requirement to fully recognise changes in the net defined benefit liability
(asset) including immediate recognition of defined benefit costs, and require
disaggregation of the overall defined benefit cost into components and requiring the
recognition of remeasurements in other comprehensive income (eliminating the 'corridor'
approach)
 Introducing enhanced disclosures about defined benefit plans
 Modifications to the accounting for termination benefits, including distinguishing
between benefits provided in exchange for service and benefits provided in exchange for
the termination of employment, and changing the recognition and measurement of
termination benefits
 Clarification of miscellaneous issues, including the classification of employee benefits,
current estimates of mortality rates, tax and administration costs and risk-sharing and
conditional indexation features
 Incorporating other matters submitted to the IFRS Interpretations Committee.
Objective of IAS 19 (2011)
The objective of IAS 19 is to prescribe the accounting and disclosure for employee benefits,
requiring an entity to recognise a liability where an employee has provided service and an
expense when the entity consumes the economic benefits of employee service. [IAS 19(2011).2]
Scope
IAS 19 applies to (among other kinds of employee benefits):
 wages and salaries

 compensated absences (paid vacation and sick leave)
 profit sharing and bonuses
 medical and life insurance benefits during employment
 non-monetary benefits such as houses, cars, and free or subsidised goods or services
 retirement benefits, including pensions and lump sum payments
 post-employment medical and life insurance benefits
 long-service or sabbatical leave
 'jubilee' benefits
 deferred compensation programmes
 termination benefits.
IAS 19 (2011) does not apply to employee benefits within the scope of IFRS 2 Share-based
Payment or the reporting by employee benefit plans (see IAS 26 Accounting and Reporting by
Retirement Benefit Plans).
Short-term employee benefits
Short-term employee benefits are those expected to be settled wholly before twelve months after
the end of the annual reporting period during which employee services are rendered, but do not

268
include termination benefits.[IAS 19(2011).8] Examples include wages, salaries, profit-sharing
and bonuses and non-monetary benefits paid to current employees.
The undiscounted amount of the benefits expected to be paid in respect of service rendered by
employees in an accounting period is recognised in that period. [IAS 19(2011).11] The expected
cost of short-term compensated absences is recognised as the employees render service that
increases their entitlement or, in the case of non-accumulating absences, when the absences
occur, and includes any additional amounts an entity expects to pay as a result of unused
entitlements at the end of the period. [IAS 19(2011).13-16]
Profit-sharing and bonus payments
An entity recognises the expected cost of profit-sharing and bonus payments when, and only
when, it has a legal or constructive obligation to make such payments as a result of past events
and a reliable estimate of the expected obligation can be made. [IAS 19.19]
Types of post-employment benefit plans
Post-employment benefit plans are informal or formal arrangements where an entity provides
post-employment benefits to one or more employees, e.g. retirement benefits (pensions or lump
sum payments), life insurance and medical care.
The accounting treatment for a post-employment benefit plan depends on the economic
substance of the plan and results in the plan being classified as either a defined contribution plan
or a defined benefit plan:
 Defined contribution plans. Under a defined contribution plan, the entity pays fixed
contributions into a fund but has no legal or constructive obligation to make further
payments if the fund does not have sufficient assets to pay all of the employees'
entitlements to post-employment benefits. The entity's obligation is therefore effectively
limited to the amount it agrees to contribute to the fund and effectively place actuarial
and investment risk on the employee
 Defined benefit plans These are post-employment benefit plans other than a defined
contribution plans. These plans create an obligation on the entity to provide agreed
benefits to current and past employees and effectively places actuarial and investment
risk on the entity.
Defined contribution plans
For defined contribution plans, the amount recognised in the period is the contribution payable in
exchange for service rendered by employees during the period. [IAS 19(2011).51]
Contributions to a defined contribution plan which are not expected to be wholly settled within
12 months after the end of the annual reporting period in which the employee renders the related
service are discounted to their present value. [IAS 19.52]

269
Defined benefit plans
Basic requirements
An entity is required to recognise the net defined benefit liability or asset in its statement of
financial performance. [IAS 19(2011).63] However, the measurement of a net defined benefit
asset is the lower of any surplus in the fund and the 'asset ceiling' (i.e. the present value of any
economic benefits available in the form of refunds from the plan or reductions in future
contributions to the plan). [IAS 19(2011).64]
Measurement
The measurement of a net defined benefit liability or assets requires the application of an
actuarial valuation method, the attribution of benefits to periods of service, and the use of
actuarial assumptions. [IAS 19(2011).66] The fair value of any plan assets is deducted from the
present value of the defined benefit obligation in determining the net deficit or surplus.
[IAS 19(2011).113]
The determination of the net defined benefit liability (or asset) is carried out with sufficient
regularity such that the amounts recognised in the financial statements do not differ materially
from those that would be determined at end of the reporting period. [IAS 19(2011).58]
The present value of an entity's defined benefit obligations and related service costs is
determined using the 'projected unit credit method', which sees each period of service as giving
rise to an additional unit of benefit entitlement and measures each unit separately in building up
the final obligation. [IAS 19(2011).67-68] This requires an entity to attribute benefit to the
current period (to determine current service cost) and the current and prior periods (to determine
the present value of defined benefit obligations). Benefit is attributed to periods of service using
the plan's benefit formula, unless an employee's service in later years will lead to a materially
higher of benefit than in earlier years, in which case a straight-line basis is used
[IAS 19(2011).70]
Actuarial assumptions used in measurement
The overall actuarial assumptions used must be unbiased and mutually compatible, and represent
the best estimate of the variables determining the ultimate post-employment benefit cost.
[IAS 19(2011).75-76]:
 Financial assumptions must be based on market expectations at the end of the reporting
period [IAS 19(2011).80]
 Mortality assumptions are determined by reference to the best estimate of the mortality of
plan members during and after employment [IAS 19(2011).81]
 The discount rate used is determined by reference to market yields at the end of the
reporting period on high quality corporate bonds, or where there is no deep market in
such bonds, by reference to market yields on government bonds. Currencies and terms of

270
bond yields used must be consistent with the currency and estimated term of the
obligation being discounted [IAS 19(2011).83]
 Assumptions about expected salaries and benefits reflect the terms of the plan, future
salary increases, any limits on the employer's share of cost, contributions from employees
or third parties*, and estimated future changes in state benefits that impact benefits
payable [IAS 19(2011).87]
 Medical cost assumptions incorporate future changes resulting from inflation and specific
changes in medical costs [IAS 19(2011).96]
* Defined Benefit Plans: Employee Contributions (Amendments to IAS 19 Employee Benefits)

amends IAS 19(2011) to clarify the requirements that relate to how contributions from
employees or third parties that are linked to service should be attributed to periods of service. In
addition, it permits a practical expedient if the amount of the contributions is independent of the
number of years of service, in that contributions, can, but are not required, to be recognised as a
reduction in the service cost in the period in which the related service is rendered. These
amendments are effective for annual periods beginning on or after 1 July 2014.
Past service costs
Past service cost is the term used to describe the change in a defined benefit obligation for
employee service in prior periods, arising as a result of changes to plan arrangements in the
current period (i.e. plan amendments introducing or changing benefits payable, or curtailments
which significantly reduce the number of covered employees) .
Past service cost may be either positive (where benefits are introduced or improved) or negative
(where existing benefits are reduced). Past service cost is recognised as an expense at the earlier
of the date when a plan amendment or curtailment occurs and the date when an entity recognises
any termination benefits, or related restructuring costs under IAS 37 Provisions, Contingent
Liabilities and Contingent Assets. [IAS 19(2011).103]
Gains or losses on the settlement of a defined benefit plan are recognised when the settlement
occurs. [IAS 19(2011).110]
Before past service costs are determined, or a gain or loss on settlement is recognised, the net
defined benefit liability or asset is required to be remeasured, however an entity is not required to
distinguish between past service costs resulting from curtailments and gains and losses on
settlement where these transactions occur together. [IAS 19(2011).99-100]
Recognition of defined benefit costs
The components of defined benefit cost is recognised as follows: [IAS 19(2011).120-130]

Component Recognition
Service cost attributable to the current and past periods Profit or loss
Net interest on the net defined benefit liability or asset,
determined using the discount rate at the beginning of the Profit or loss
period
271
Remeasurements of the net defined benefit liability or asset,
comprising:
Other comprehensive income
(Not reclassified to profit or loss
 actuarial gains and losses
in a subsequent period)
 return on plan assets
 some changes in the effect of the asset ceiling
Other guidance
IAS 19 also provides guidance in relation to:
 when an entity should recognise a reimbursement of expenditure to settle a defined

benefit obligation [IAS 19(2011).116-119]
 when it is appropriate to offset an asset relating to one plan against a liability relating to
another plan [IAS 19(2011).131-132]
 accounting for multi-employer plans by individual employers [IAS 19(2011).32-39]
 defined benefit plans sharing risks between entities under common control [IAS 19.40-
42]
 entities participating in state plans [IAS 19(2011).43-45]
 insurance premiums paid to fund post-employment benefit plans [IAS 19(2011).46-49]
Disclosures about defined benefit plans
IAS 19(2011) sets the following disclosure objectives in relation to defined benefit plans
[IAS 19(2011).135]:
 an explanation of the characteristics of an entity's defined benefit plans, and the

associated risks
 identification and explanation of the amounts arising in the financial statements from
defined benefit plans
 a description of how defined benefit plans may affect the amount, timing and uncertainty
of the entity's future cash flows.
Extensive specific disclosures in relation to meeting each the above objectives are specified, e.g.
a reconciliation from the opening balance to the closing balance of the net defined benefit
liability or asset, disaggregation of the fair value of plan assets into classes, and sensitivity
analysis of each significant actuarial assumption. [IAS 19(2011).136-147]
Additional disclosures are required in relation to multi-employer plans and defined benefit plans
sharing risk between entities under common control. [IAS 19(2011).148-150].
Other long-term benefits
IAS 19 (2011) prescribes a modified application of the post-employment benefit model described
above for other long-term employee benefits: [IAS 19(2011).153-154]

272
 the recognition and measurement of a surplus or deficit in an other long-term employee
benefit plan is consistent with the requirements outlined above
 service cost, net interest and remeasurements are all recognised in profit or loss (unless
recognised in the cost of an asset under another IFRS), i.e. when compared to accounting
for defined benefit plans, the effects of remeasurements are not recognised in other
Termination benefits
A termination benefit liability is recognised at the earlier of the following dates: [IAS 19.165-
168]
 when the entity can no longer withdraw the offer of those benefits - additional guidance
is provided on when this date occurs in relation to an employee's decision to accept an
offer of benefits on termination, and as a result of an entity's decision to terminate an
employee's employment
 when the entity recognises costs for a restructuring under IAS 37 Provisions, Contingent
Liabilities and Contingent Assets which involves the payment of termination benefits.
Termination benefits are measured in accordance with the nature of employee benefit, i.e. as an
enhancement of other post-employment benefits, or otherwise as a short-term employee benefit
or other long-term employee benefit. [IAS 19(2011).169]
IAS 21 The Effects of Changes in Foreign Exchange Rates (revised 2003)
IAS 24 — Related Party Disclosures (reissued in November 2009)
Summary of IAS 24
Objective of IAS 24
The objective of IAS 24 is to ensure that an entity's financial statements contain the disclosures
necessary to draw attention to the possibility that its financial position and profit or loss may
have been affected by the existence of related parties and by transactions and outstanding
balances with such parties.
Who are related parties?
A related party is a person or entity that is related to the entity that is preparing its financial
statements (referred to as the 'reporting entity') [IAS 24.9].
 (a) A person or a close member of that person's family is related to a reporting entity if
that person:
o (i) has control or joint control over the reporting entity;

273
o(ii) has significant influence over the reporting entity; or
o(iii) is a member of the key management personnel of the reporting entity or of a
parent of the reporting entity.
 (b) An entity is related to a reporting entity if any of the following conditions applies:
o (i) The entity and the reporting entity are members of the same group (which
means that each parent, subsidiary and fellow subsidiary is related to the others).
o (ii) One entity is an associate or joint venture of the other entity (or an associate or
joint venture of a member of a group of which the other entity is a member).
o (iii) Both entities are joint ventures of the same third party.
o (iv) One entity is a joint venture of a third entity and the other entity is an
associate of the third entity.
o (v) The entity is a post-employment defined benefit plan for the benefit of
employees of either the reporting entity or an entity related to the reporting entity.
If the reporting entity is itself such a plan, the sponsoring employers are also
related to the reporting entity.
o (vi) The entity is controlled or jointly controlled by a person identified in (a).
o (vii) A person identified in (a)(i) has significant influence over the entity or is a
member of the key management personnel of the entity (or of a parent of the
entity).
o (viii) The entity, or any member of a group of which it is a part, provides key
management personnel services to the reporting entity or to the parent of the
reporting entity*.
* Requirement added by Annual Improvements to IFRSs 2010–2012 Cycle, effective for annual
periods beginning on or after 1 July 2014.
The following are deemed not to be related: [IAS 24.11]
 two entities simply because they have a director or key manager in common
 two venturers who share joint control over a joint venture
 providers of finance, trade unions, public utilities, and departments and agencies of a
government that does not control, jointly control or significantly influence the reporting
entity, simply by virtue of their normal dealings with an entity (even though they may
affect the freedom of action of an entity or participate in its decision-making process)
 a single customer, supplier, franchiser, distributor, or general agent with whom an entity
transacts a significant volume of business merely by virtue of the resulting economic
dependence
What are related party transactions?
A related party transaction is a transfer of resources, services, or obligations between related

parties, regardless of whether a price is charged. [IAS 24.9]
Disclosure

274
Relationships between parents and subsidiaries. Regardless of whether there have been
transactions between a parent and a subsidiary, an entity must disclose the name of its parent
and, if different, the ultimate controlling party. If neither the entity's parent nor the ultimate
controlling party produces financial statements available for public use, the name of the next
most senior parent that does so must also be disclosed. [IAS 24.16]
Management compensation. Disclose key management personnel compensation in total and for
each of the following categories: [IAS 24.17]
 short-term employee benefits

 post-employment benefits
 other long-term benefits
 termination benefits
 share-based payment benefits
Key management personnel are those persons having authority and responsibility for planning,
directing, and controlling the activities of the entity, directly or indirectly, including any directors
(whether executive or otherwise) of the entity. [IAS 24.9]
If an entity obtains key management personnel services from a management entity, the entity is
not required to disclose the compensation paid or payable by the management entity to the
management entity‘s employees or directors. Instead the entity discloses the amounts incurred by
the entity for the provision of key management personnel services that are provided by the
separate management entity*. [IAS 24.17A, 18A]
* These requirements were introduced by Annual Improvements to IFRSs 2010–2012 Cycle,

effective for annual periods beginning on or after 1 July 2014.
Related party transactions. If there have been transactions between related parties, disclose the
nature of the related party relationship as well as information about the transactions and
outstanding balances necessary for an understanding of the potential effect of the relationship on
the financial statements. These disclosure would be made separately for each category of related
parties and would include: [IAS 24.18-19]
the amount of the transactions

the amount of outstanding balances, including terms and conditions and guarantees
provisions for doubtful debts related to the amount of outstanding balances
expense recognised during the period in respect of bad or doubtful debts due from related
parties
Examples of the kinds of transactions that are disclosed if they are with a related party
 purchases or sales of goods
 purchases or sales of property and other assets
 rendering or receiving of services
 leases

275
 transfers of research and development
 transfers under licence agreements
 transfers under finance arrangements (including loans and equity contributions in cash or
in kind)
 provision of guarantees or collateral
 commitments to do something if a particular event occurs or does not occur in the future,
including executory contracts (recognised and unrecognised)
 settlement of liabilities on behalf of the entity or by the entity on behalf of another party
A statement that related party transactions were made on terms equivalent to those that prevail in
arm's length transactions should be made only if such terms can be substantiated. [IAS 24.2
IAS 28 Investments in Associates (reissued in May 2011)
IAS 32 — Financial Instruments: Presentation (reissued in December 2003)
Summary of IAS 32
Objective of IAS 32
The stated objective of IAS 32 is to establish principles for presenting financial instruments as
liabilities or equity and for offsetting financial assets and liabilities. [IAS 32.1]
IAS 32 addresses this in a number of ways:
 clarifying the classification of a financial instrument issued by an entity as a liability or as

equity
 prescribing the accounting for treasury shares (an entity's own repurchased shares)
 prescribing strict conditions under which assets and liabilities may be offset in the
balance sheet
IAS 32 is a companion to IAS 39 Financial Instruments: Recognition and Measurement and

IFRS 9 Financial Instruments. IAS 39 deals with, among other things, initial recognition of
financial assets and liabilities, measurement subsequent to initial recognition, impairment,
derecognition, and hedge accounting. IAS 39 is progressively being replaced by IFRS 9 as the
IASB completes the various phases of its financial instruments project.
Scope

276
IAS 32 applies in presenting and disclosing information about all types of financial instruments
with the following exceptions: [IAS 32.4]
 interests in subsidiaries, associates and joint ventures that are accounted for under IAS 27
Consolidated and Separate Financial Statements, IAS 28 Investments in Associates or
IAS 31 Interests in Joint Ventures (or, for annual periods beginning on or after 1 January
2013, IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial
Statements and IAS 28 Investments in Associates and Joint Ventures). However, IAS 32
applies to all derivatives on interests in subsidiaries, associates, or joint ventures.
 employers' rights and obligations under employee benefit plans (see IAS 19 Employee
Benefits)
 insurance contracts(see IFRS 4 Insurance Contracts). However, IAS 32 applies to
derivatives that are embedded in insurance contracts if they are required to be accounted
separately by IAS 39
 financial instruments that are within the scope of IFRS 4 because they contain a
discretionary participation feature are only exempt from applying paragraphs 15-32 and
AG25-35 (analysing debt and equity components) but are subject to all other IAS 32
requirements
 contracts and obligations under share-based payment transactions (see IFRS 2 Share-
based Payment) with the following exceptions:
o this standard applies to contracts within the scope of IAS 32.8-10 (see below)
o paragraphs 33-34 apply when accounting for treasury shares purchased, sold,
issued or cancelled by employee share option plans or similar arrangements
IAS 32 applies to those contracts to buy or sell a non-financial item that can be settled net in cash
or another financial instrument, except for contracts that were entered into and continue to be
held for the purpose of the receipt or delivery of a non-financial item in accordance with the
entity's expected purchase, sale or usage requirements. [IAS 32.8]
Financial instrument: a contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity.
Financial asset: any asset that is:
 cash
 an equity instrument of another entity
 a contractual right
o to receive cash or another financial asset from another entity; or
o to exchange financial assets or financial liabilities with another entity under
conditions that are potentially favourable to the entity; or
 a contract that will or may be settled in the entity's own equity instruments and is:
o a non-derivative for which the entity is or may be obliged to receive a variable
number of the entity's own equity instruments

277
o a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity's own
equity instruments. For this purpose the entity's own equity instruments do not
include instruments that are themselves contracts for the future receipt or delivery
of the entity's own equity instruments
o puttable instruments classified as equity or certain liabilities arising on liquidation
classified by IAS 32 as equity instruments
Financial liability: any liability that is:
 a contractual obligation:
o to deliver cash or another financial asset to another entity; or
o to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or
 a contract that will or may be settled in the entity's own equity instruments and is
o a non-derivative for which the entity is or may be obliged to deliver a variable
number of the entity's own equity instruments or
o a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entity's own
equity instruments. For this purpose the entity's own equity instruments do not
include: instruments that are themselves contracts for the future receipt or
delivery of the entity's own equity instruments; puttable instruments classified as
equity or certain liabilities arising on liquidation classified by IAS 32 as equity
instruments
Equity instrument: Any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities.
Fair value: the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm's length transaction.
The definition of financial instrument used in IAS 32 is the same as that in IAS 39.
Puttable instrument: a financial instrument that gives the holder the right to put the instrument
back to the issuer for cash or another financial asset or is automatically put back to the issuer on
occurrence of an uncertain future event or the death or retirement of the instrument holder.
Classification as liability or equity
The fundamental principle of IAS 32 is that a financial instrument should be classified as either a
financial liability or an equity instrument according to the substance of the contract, not its legal
form, and the definitions of financial liability and equity instrument. Two exceptions from this
principle are certain puttable instruments meeting specific criteria and certain obligations arising
on liquidation (see below). The entity must make the decision at the time the instrument is
initially recognised. The classification is not subsequently changed based on changed
circumstances. [IAS 32.15]

278
A financial instrument is an equity instrument only if (a) the instrument includes no contractual
obligation to deliver cash or another financial asset to another entity and (b) if the instrument will
or may be settled in the issuer's own equity instruments, it is either:
 a non-derivative that includes no contractual obligation for the issuer to deliver a variable
number of its own equity instruments; or
 a derivative that will be settled only by the issuer exchanging a fixed amount of cash or
another financial asset for a fixed number of its own equity instruments. [IAS 32.16]
Illustration – preference shares
If an entity issues preference (preferred) shares that pay a fixed rate of dividend and that have a
mandatory redemption feature at a future date, the substance is that they are a contractual
obligation to deliver cash and, therefore, should be recognised as a liability. [IAS 32.18(a)] In
contrast, preference shares that do not have a fixed maturity, and where the issuer does not have
a contractual obligation to make any payment are equity. In this example even though both
instruments are legally termed preference shares they have different contractual terms and one is
a financial liability while the other is equity.
Illustration – issuance of fixed monetary amount of equity instruments
A contractual right or obligation to receive or deliver a number of its own shares or other equity
instruments that varies so that the fair value of the entity's own equity instruments to be received
or delivered equals the fixed monetary amount of the contractual right or obligation is a financial
liability. [IAS 32.20]
Illustration – one party has a choice over how an instrument is settled
When a derivative financial instrument gives one party a choice over how it is settled (for
instance, the issuer or the holder can choose settlement net in cash or by exchanging shares for
cash), it is a financial asset or a financial liability unless all of the settlement alternatives would
result in it being an equity instrument. [IAS 32.26]
Contingent settlement provisions
If, as a result of contingent settlement provisions, the issuer does not have an unconditional right
to avoid settlement by delivery of cash or other financial instrument (or otherwise to settle in a
way that it would be a financial liability) the instrument is a financial liability of the issuer,
unless:
 the contingent settlement provision is not genuine or

 the issuer can only be required to settle the obligation in the event of the issuer's
liquidation or
 the instrument has all the features and meets the conditions of IAS 32.16A and 16B for
puttable instruments [IAS 32.25]

279
Puttable instruments and obligations arising on liquidation
In February 2008, the IASB amended IAS 32 and IAS 1 Presentation of Financial Statements
with respect to the balance sheet classification of puttable financial instruments and obligations
arising only on liquidation. As a result of the amendments, some financial instruments that
currently meet the definition of a financial liability will be classified as equity because they
represent the residual interest in the net assets of the entity. [IAS 32.16A-D]
Classifications of rights issues
In October 2009, the IASB issued an amendment to IAS 32 on the classification of rights issues.
For rights issues offered for a fixed amount of foreign currency current practice appears to
require such issues to be accounted for as derivative liabilities. The amendment states that if such
rights are issued pro rata to an entity's all existing shareholders in the same class for a fixed
amount of currency, they should be classified as equity regardless of the currency in which the
exercise price is denominated.
Compound financial instruments
Some financial instruments – sometimes called compound instruments – have both a liability and
an equity component from the issuer's perspective. In that case, IAS 32 requires that the
component parts be accounted for and presented separately according to their substance based on
the definitions of liability and equity. The split is made at issuance and not revised for
subsequent changes in market interest rates, share prices, or other event that changes the
likelihood that the conversion option will be exercised. [IAS 32.29-30]
To illustrate, a convertible bond contains two components. One is a financial liability, namely
the issuer's contractual obligation to pay cash, and the other is an equity instrument, namely the
holder's option to convert into common shares. Another example is debt issued with detachable
share purchase warrants.
When the initial carrying amount of a compound financial instrument is required to be allocated
to its equity and liability components, the equity component is assigned the residual amount after
deducting from the fair value of the instrument as a whole the amount separately determined for
the liability component. [IAS 32.32]
Interest, dividends, gains, and losses relating to an instrument classified as a liability should be
reported in profit or loss. This means that dividend payments on preferred shares classified as
liabilities are treated as expenses. On the other hand, distributions (such as dividends) to holders
of a financial instrument classified as equity should be charged directly against equity, not
against earnings. [IAS 32.35]
Transaction costs of an equity transaction are deducted from equity. Transaction costs related to
an issue of a compound financial instrument are allocated to the liability and equity components
in proportion to the allocation of proceeds.

280
Treasury shares
The cost of an entity's own equity instruments that it has reacquired ('treasury shares') is
deducted from equity. Gain or loss is not recognised on the purchase, sale, issue, or cancellation
of treasury shares. Treasury shares may be acquired and held by the entity or by other members
of the consolidated group. Consideration paid or received is recognised directly in equity. [IAS
32.33]
Offsetting
IAS 32 also prescribes rules for the offsetting of financial assets and financial liabilities. It
specifies that a financial asset and a financial liability should be offset and the net amount
reported when, and only when, an entity: [IAS 32.42]
 has a legally enforceable right to set off the amounts; and

 intends either to settle on a net basis, or to realise the asset and settle the liability
simultaneously. [IAS 32.48]
Costs of issuing or reacquiring equity instruments
Costs of issuing or reacquiring equity instruments (other than in a business combination) are
accounted for as a deduction from equity, net of any related income tax benefit. [IAS 32.35]
Disclosures
Financial instruments disclosures are in IFRS 7 Financial Instruments: Disclosures, and no

longer in IAS 32.
The disclosures relating to treasury shares are in IAS 1 Presentation of Financial Statements and
IAS 24 Related Parties for share repurchases from related parties. [IAS 32.34 and 39]
IAS 33 — Earnings Per Share (December 2003)
Summary of IAS 33
Objective of IAS 33
The objective of IAS 33 is to prescribe principles for determining and presenting earnings per
share (EPS) amounts to improve performance comparisons between different entities in the same
reporting period and between different reporting periods for the same entity. [IAS 33.1]
Scope

281
IAS 33 applies to entities whose securities are publicly traded or that are in the process of issuing
securities to the public. [IAS 33.2] Other entities that choose to present EPS information must
also comply with IAS 33. [IAS 33.3]
If both parent and consolidated statements are presented in a single report, EPS is required only
for the consolidated statements. [IAS 33.4]
Ordinary share: also known as a common share or common stock. An equity instrument that is
subordinate to all other classes of equity instruments.
Potential ordinary share: a financial instrument or other contract that may entitle its holder to
ordinary shares.
Common examples of potential ordinary shares
 convertible debt
 convertible preferred shares
 share warrants
 share options
 share rights
 employee stock purchase plans
 contractual rights to purchase shares
 contingent issuance contracts or agreements (such as those arising in business
combination)
Dilution: a reduction in earnings per share or an increase in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised, or
that ordinary shares are issued upon the satisfaction of specified conditions.
Antidilution: an increase in earnings per share or a reduction in loss per share resulting from the
assumption that convertible instruments are converted, that options or warrants are exercised, or
that ordinary shares are issued upon the satisfaction of specified conditions.
Requirement to present EPS
An entity whose securities are publicly traded (or that is in process of public issuance) must
present, on the face of the statement of comprehensive income, basic and diluted EPS for: [IAS
33.66]
 profit or loss from continuing operations attributable to the ordinary equity holders of the
parent entity; and
 profit or loss attributable to the ordinary equity holders of the parent entity for the period
for each class of ordinary shares that has a different right to share in profit for the period.
If an entity presents the components of profit or loss in a separate income statement, it presents
EPS only in that separate statement. [IAS 33.4A]
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Basic and diluted EPS must be presented with equal prominence for all periods presented. [IAS
33.66]
Basic and diluted EPS must be presented even if the amounts are negative (that is, a loss per
share). [IAS 33.69]
If an entity reports a discontinued operation, basic and diluted amounts per share must be
disclosed for the discontinued operation either on the face of the of comprehensive income (or
separate income statement if presented) or in the notes to the financial statements. [IAS 33.68
and 68A]
Basic EPS
Basic EPS is calculated by dividing profit or loss attributable to ordinary equity holders of the
parent entity (the numerator) by the weighted average number of ordinary shares outstanding
(the denominator) during the period. [IAS 33.10]
The earnings numerators (profit or loss from continuing operations and net profit or loss) used
for the calculation should be after deducting all expenses including taxes, minority interests, and
preference dividends. [IAS 33.12]
The denominator (number of shares) is calculated by adjusting the shares in issue at the
beginning of the period by the number of shares bought back or issued during the period,
multiplied by a time-weighting factor. IAS 33 includes guidance on appropriate recognition dates
for shares issued in various circumstances. [IAS 33.20-21]
Contingently issuable shares are included in the basic EPS denominator when the contingency
has been met. [IAS 33.24]
Diluted EPS
Diluted EPS is calculated by adjusting the earnings and number of shares for the effects of
dilutive options and other dilutive potential ordinary shares. [IAS 33.31] The effects of anti-
dilutive potential ordinary shares are ignored in calculating diluted EPS. [IAS 33.41]
Guidance on calculating dilution
Convertible securities. The numerator should be adjusted for the after-tax effects of dividends
and interest charged in relation to dilutive potential ordinary shares and for any other changes in
income that would result from the conversion of the potential ordinary shares. [IAS 33.33] The
denominator should include shares that would be issued on the conversion. [IAS 33.36]
Options and warrants. In calculating diluted EPS, assume the exercise of outstanding dilutive
options and warrants. The assumed proceeds from exercise should be regarded as having been
used to repurchase ordinary shares at the average market price during the period. The difference
between the number of ordinary shares assumed issued on exercise and the number of ordinary
shares assumed repurchased shall be treated as an issue of ordinary shares for no consideration.
[IAS 33.45]

283
Contingently issuable shares. Contingently issuable ordinary shares are treated as outstanding
and included in the calculation of both basic and diluted EPS if the conditions have been met. If
the conditions have not been met, the number of contingently issuable shares included in the
diluted EPS calculation is based on the number of shares that would be issuable if the end of the
period were the end of the contingency period. Restatement is not permitted if the conditions are
not met when the contingency period expires. [IAS 33.52]
Contracts that may be settled in ordinary shares or cash. Presume that the contract will be
settled in ordinary shares, and include the resulting potential ordinary shares in diluted EPS if the
effect is dilutive. [IAS 33.58]
Retrospective adjustments
The calculation of basic and diluted EPS for all periods presented is adjusted retrospectively
when the number of ordinary or potential ordinary shares outstanding increases as a result of a
capitalisation, bonus issue, or share split, or decreases as a result of a reverse share split. If such
changes occur after the balance sheet date but before the financial statements are authorised for
issue, the EPS calculations for those and any prior period financial statements presented are
based on the new number of shares. Disclosure is required. [IAS 33.64]
Basic and diluted EPS are also adjusted for the effects of errors and adjustments resulting from
changes in accounting policies, accounted for retrospectively. [IAS 33.64]
Diluted EPS for prior periods should not be adjusted for changes in the assumptions used or for
the conversion of potential ordinary shares into ordinary shares outstanding. [IAS 33.65]
Disclosure
If EPS is presented, the following disclosures are required: [IAS 33.70]
 the amounts used as the numerators in calculating basic and diluted EPS, and a
reconciliation of those amounts to profit or loss attributable to the parent entity for the
period
 the weighted average number of ordinary shares used as the denominator in calculating
basic and diluted EPS, and a reconciliation of these denominators to each other
 instruments (including contingently issuable shares) that could potentially dilute basic
EPS in the future, but were not included in the calculation of diluted EPS because they
are antidilutive for the period(s) presented
 a description of those ordinary share transactions or potential ordinary share transactions
that occur after the balance sheet date and that would have changed significantly the
number of ordinary shares or potential ordinary shares outstanding at the end of the
period if those transactions had occurred before the end of the reporting period. Examples
include issues and redemptions of ordinary shares issued for cash, warrants and options,
conversions, and exercises [IAS 34.71]

284
An entity is permitted to disclose amounts per share other than profit or loss from continuing
operations, discontinued operations, and net profit or loss earnings per share. Guidance for
calculating and presenting such amounts is included in IAS 33.73 and 73A.
IAS 37 — Provisions, Contingent Liabilities and Contingent Assets (issued in September

1998)
Summary of IAS 37
Objective
The objective of IAS 37 is to ensure that appropriate recognition criteria and measurement bases
are applied to provisions, contingent liabilities and contingent assets and that sufficient
information is disclosed in the notes to the financial statements to enable users to understand
their nature, timing and amount. The key principle established by the Standard is that a provision
should be recognised only when there is a liability i.e. a present obligation resulting from past
events. The Standard thus aims to ensure that only genuine obligations are dealt with in the
financial statements – planned future expenditure, even where authorised by the board of
directors or equivalent governing body, is excluded from recognition.
Scope
IAS 37 excludes obligations and contingencies arising from: [IAS 37.1-6]
 financial instruments that are in the scope of IAS 39 Financial Instruments: Recognition
and Measurement (or IFRS 9 Financial Instruments)
 non-onerous executory contracts
 insurance contracts (see IFRS 4 Insurance Contracts), but IAS 37 does apply to other
provisions, contingent liabilities and contingent assets of an insurer
 items covered by another IFRS. For example, IAS 11 Construction Contracts applies to
obligations arising under such contracts; IAS 12 Income Taxes applies to obligations for
current or deferred income taxes; IAS 17 Leases applies to lease obligations; and IAS 19
Employee Benefits applies to pension and other employee benefit obligations; and .
Provision: a liability of uncertain timing or amount.
Liability:
 present obligation as a result of past events

 settlement is expected to result in an outflow of resources (payment)
Contingent liability:

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 a possible obligation depending on whether some uncertain future event occurs, or
 a present obligation but payment is not probable or the amount cannot be measured
reliably
Contingent asset:
 a possible asset that arises from past events, and

 whose existence will be confirmed only by the occurrence or non-occurrence of one or
more uncertain future events not wholly within the control of the entity.
Recognition of a provision
An entity must recognise a provision if, and only if: [IAS 37.14]
 a present obligation (legal or constructive) has arisen as a result of a past event (the
obligating event),
 payment is probable ('more likely than not'), and
 the amount can be estimated reliably.
An obligating event is an event that creates a legal or constructive obligation and, therefore,
results in an entity having no realistic alternative but to settle the obligation. [IAS 37.10]
A constructive obligation arises if past practice creates a valid expectation on the part of a third
party, for example, a retail store that has a long-standing policy of allowing customers to return
merchandise within, say, a 30-day period. [IAS 37.10]
A possible obligation (a contingent liability) is disclosed but not accrued. However, disclosure is
not required if payment is remote. [IAS 37.86]
In rare cases, for example in a lawsuit, it may not be clear whether an entity has a present
obligation. In those cases, a past event is deemed to give rise to a present obligation if, taking
account of all available evidence, it is more likely than not that a present obligation exists at the
balance sheet date. A provision should be recognised for that present obligation if the other
recognition criteria described above are met. If it is more likely than not that no present
obligation exists, the entity should disclose a contingent liability, unless the possibility of an
outflow of resources is remote. [IAS 37.15]
Measurement of provisions
The amount recognised as a provision should be the best estimate of the expenditure required to
settle the present obligation at the balance sheet date, that is, the amount that an entity would
rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party.
[IAS 37.36] This means:
 Provisions for one-off events (restructuring, environmental clean-up, settlement of a

lawsuit) are measured at the most likely amount. [IAS 37.40]

286
 Provisions for large populations of events (warranties, customer refunds) are measured at
a probability-weighted expected value. [IAS 37.39]
 Both measurements are at discounted present value using a pre-tax discount rate that
reflects the current market assessments of the time value of money and the risks specific
to the liability. [IAS 37.45 and 37.47]
In reaching its best estimate, the entity should take into account the risks and uncertainties that
surround the underlying events. [IAS 37.42]
If some or all of the expenditure required to settle a provision is expected to be reimbursed by

another party, the reimbursement should be recognised as a separate asset, and not as a reduction
of the required provision, when, and only when, it is virtually certain that reimbursement will be
received if the entity settles the obligation. The amount recognised should not exceed the amount
of the provision. [IAS 37.53]
In measuring a provision consider future events as follows:
 forecast reasonable changes in applying existing technology [IAS 37.49]

 ignore possible gains on sale of assets [IAS 37.51]
 consider changes in legislation only if virtually certain to be enacted [IAS 37.50]
Remeasurement of provisions [IAS 37.59]
 Review and adjust provisions at each balance sheet date

 If an outflow no longer probable, provision is reversed.
Some examples of provisions

Circumstance Recognise a provision?
Restructuring by sale Only when the entity is committed to a sale, i.e. there is a binding sale
of an operation agreement [IAS 37.78]
Only when a detailed form plan is in place and the entity has started to
Restructuring by
implement the plan, or announced its main features to those affected. A
closure or
Board decision is insufficient [IAS 37.72, Appendix C, Examples 5A &
reorganisation
5B]
When an obligating event occurs (sale of product with a warranty and
Warranty
probable warranty claims will be made) [Appendix C, Example 1]
A provision is recognised as contamination occurs for any legal
obligations of clean up, or for constructive obligations if the company's
Land contamination published policy is to clean up even if there is no legal requirement to do
so (past event is the contamination and public expectation created by the
company's policy) [Appendix C, Examples 2B]
Recognise a provision if the entity's established policy is to give refunds
(past event is the sale of the product together with the customer's
Customer refunds
expectation, at time of purchase, that a refund would be available)
[Appendix C, Example 4]

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Recognise a provision for removal costs arising from the construction of
Offshore oil rig must
the the oil rig as it is constructed, and add to the cost of the asset.
be removed and sea
Obligations arising from the production of oil are recognised as the
bed restored
production occurs [Appendix C, Example 3]
Abandoned leasehold,
A provision is recognised for the unavoidable lease payments [Appendix
four years to run, no
C, Example 8]
re-letting possible
CPA firm must staff No provision is recognised (there is no obligation to provide the training,
training for recent recognise a liability if and when the retraining occurs) [Appendix C,
changes in tax law Example 7]
Major overhaul or
No provision is recognised (no obligation) [Appendix C, Example 11]
repairs
Onerous (loss-making)
Recognise a provision [IAS 37.66]
contract
Future operating losses No provision is recognised (no liability) [IAS 37.63]
Restructurings
A restructuring is: [IAS 37.70]
 sale or termination of a line of business

 closure of business locations
 changes in management structure
 fundamental reorganisations.
Restructuring provisions should be recognised as follows: [IAS 37.72]
 Sale of operation: recognise a provision only after a binding sale agreement [IAS 37.78]
 Closure or reorganisation: recognise a provision only after a detailed formal plan is
adopted and has started being implemented, or announced to those affected. A board
decision of itself is insufficient.
 Future operating losses: provisions are not recognised for future operating losses, even
in a restructuring
 Restructuring provision on acquisition: recognise a provision only if there is an
obligation at acquisition date [IFRS 3.11]
Restructuring provisions should include only direct expenditures necessarily entailed by the
restructuring, not costs that associated with the ongoing activities of the entity. [IAS 37.80]
What is the debit entry?
When a provision (liability) is recognised, the debit entry for a provision is not always an
expense. Sometimes the provision may form part of the cost of the asset. Examples: included in
the cost of inventories, or an obligation for environmental cleanup when a new mine is opened or
an offshore oil rig is installed. [IAS 37.8]

288
Use of provisions
Provisions should only be used for the purpose for which they were originally recognised. They
should be reviewed at each balance sheet date and adjusted to reflect the current best estimate. If
it is no longer probable that an outflow of resources will be required to settle the obligation, the
provision should be reversed. [IAS 37.61]
Contingent liabilities
Since there is common ground as regards liabilities that are uncertain, IAS 37 also deals with
contingencies. It requires that entities should not recognise contingent liabilities – but should
disclose them, unless the possibility of an outflow of economic resources is remote. [IAS 37.86]
Contingent assets
Contingent assets should not be recognised – but should be disclosed where an inflow of
economic benefits is probable. When the realisation of income is virtually certain, then the
related asset is not a contingent asset and its recognition is appropriate. [IAS 37.31-35]
Disclosures
Reconciliation for each class of provision: [IAS 37.84]
 opening balance
 additions
 used (amounts charged against the provision)
 unused amounts reversed
 unwinding of the discount, or changes in discount rate
 closing balance
A prior year reconciliation is not required. [IAS 37.84]
For each class of provision, a brief description of: [IAS 37.85]
 nature
 timing
 uncertainties
 assumptions
 reimbursement, if any
IAS 39 — Financial Instruments: Recognition and Measurement
IAS 39 was reissued in December 2003, applies to annual periods beginning on or after 1
January 2005, and will be superseded by IFRS 9 not earlier than 2017

289
Summary of IAS 39
Deloitte guidance on IFRSs for financial instruments
Scope exclusions
IAS 39 applies to all types of financial instruments except for the following, which are scoped
out of IAS 39: [IAS 39.2]
 interests in subsidiaries, associates, and joint ventures accounted for under IAS 27
Consolidated and Separate Financial Statements, IAS 28 Investments in Associates, or
IAS 31 Interests in Joint Ventures (or, for periods beginning on or after 1 January 2013,
IFRS 10 Consolidated Financial Statements, IAS 27 Separate Financial Statements or
IAS 28 Investments in Associates and Joint Ventures); however IAS 39 applies in cases
where under those standards such interests are to be accounted for under IAS 39. The
standard also applies to most derivatives on an interest in a subsidiary, associate, or joint
venture
 employers' rights and obligations under employee benefit plans to which IAS 19
Employee Benefits applies
 forward contracts between an acquirer and selling shareholder to buy or sell an acquiree
that will result in a business combination at a future acquisition date
 rights and obligations under insurance contracts, except IAS 39 does apply to financial
instruments that take the form of an insurance (or reinsurance) contract but that
principally involve the transfer of financial risks and derivatives embedded in insurance
contracts
 financial instruments that meet the definition of own equity under IAS 32 Financial
Instruments: Presentation
 financial instruments, contracts and obligations under share-based payment transactions
to which IFRS 2 Share-based Payment applies
 rights to reimbursement payments to which IAS 37 Provisions, Contingent Liabilities and
Contingent Assets applies
Leases
IAS 39 applies to lease receivables and payables only in limited respects: [IAS 39.2(b)]
 IAS 39 applies to lease receivables with respect to the derecognition and impairment
provisions
 IAS 39 applies to lease payables with respect to the derecognition provisions
 IAS 39 applies to derivatives embedded in leases.
Financial guarantees
IAS 39 applies to financial guarantee contracts issued. However, if an issuer of financial

guarantee contracts has previously asserted explicitly that it regards such contracts as insurance
contracts and has used accounting applicable to insurance contracts, the issuer may elect to apply

290
either IAS 39 or IFRS 4 Insurance Contracts to such financial guarantee contracts. The issuer
may make that election contract by contract, but the election for each contract is irrevocable.
Accounting by the holder is excluded from the scope of IAS 39 and IFRS 4 (unless the contract
is a reinsurance contract). Therefore, paragraphs 10-12 of IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors apply. Those paragraphs specify criteria to use in developing
an accounting policy if no IFRS applies specifically to an item.
Loan commitments
Loan commitments are outside the scope of IAS 39 if they cannot be settled net in cash or
another financial instrument, they are not designated as financial liabilities at fair value through
profit or loss, and the entity does not have a past practice of selling the loans that resulted from
the commitment shortly after origination. An issuer of a commitment to provide a loan at a
below-market interest rate is required initially to recognise the commitment at its fair value;
subsequently, the issuer will remeasure it at the higher of (a) the amount recognised under IAS
37 and (b) the amount initially recognised less, where appropriate, cumulative amortisation
recognised in accordance with IAS 18. An issuer of loan commitments must apply IAS 37 to
other loan commitments that are not within the scope of IAS 39 (that is, those made at market or
above). Loan commitments are subject to the derecognition provisions of IAS 39. [IAS 39.4]
Contracts to buy or sell financial items
Contracts to buy or sell financial items are always within the scope of IAS 39 (unless one of the
other exceptions applies).
Contracts to buy or sell non-financial items
Contracts to buy or sell non-financial items are within the scope of IAS 39 if they can be settled
net in cash or another financial asset and are not entered into and held for the purpose of the
receipt or delivery of a non-financial item in accordance with the entity's expected purchase, sale,
or usage requirements. Contracts to buy or sell non-financial items are inside the scope if net
settlement occurs. The following situations constitute net settlement: [IAS 39.5-6]
 the terms of the contract permit either counterparty to settle net

 there is a past practice of net settling similar contracts
 there is a past practice, for similar contracts, of taking delivery of the underlying and
selling it within a short period after delivery to generate a profit from short-term
fluctuations in price, or from a dealer's margin, or
 the non-financial item is readily convertible to cash
Weather derivatives
Although contracts requiring payment based on climatic, geological, or other physical variable
were generally excluded from the original version of IAS 39, they were added to the scope of the
revised IAS 39 in December 2003 if they are not in the scope of IFRS 4. [IAS 39.AG1]

291
Definitions
IAS 39 incorporates the definitions of the following items from IAS 32 Financial Instruments:
Presentation: [IAS 39.8]
 financial instrument
 financial asset
 financial liability
 equity instrument.
Note: Where an entity applies IFRS 9 Financial Instruments prior to its mandatory application
date (1 January 2015), definitions of the following terms are also incorporated from IFRS 9:
derecognition, derivative, fair value, financial guarantee contract. The definition of those terms
outlined below (as relevant) are those from IAS 39.
Common examples of financial instruments within the scope of IAS 39
 cash
 demand and time deposits
 commercial paper
 accounts, notes, and loans receivable and payable
 debt and equity securities. These are financial instruments from the perspectives of both
the holder and the issuer. This category includes investments in subsidiaries, associates,
and joint ventures
 asset backed securities such as collateralised mortgage obligations, repurchase
agreements, and securitised packages of receivables
 derivatives, including options, rights, warrants, futures contracts, forward contracts, and
swaps.
A derivative is a financial instrument:
 Whose value changes in response to the change in an underlying variable such as an

interest rate, commodity or security price, or index;
 That requires no initial investment, or one that is smaller than would be required for a
contract with similar response to changes in market factors; and
 That is settled at a future date. [IAS 39.9]
Examples of derivatives
Forwards: Contracts to purchase or sell a specific quantity of a financial instrument, a
commodity, or a foreign currency at a specified price determined at the outset, with delivery or
settlement at a specified future date. Settlement is at maturity by actual delivery of the item
specified in the contract, or by a net cash settlement.
Interest rate swaps and forward rate agreements: Contracts to exchange cash flows as of a
specified date or a series of specified dates based on a notional amount and fixed and floating
rates.

292
Futures: Contracts similar to forwards but with the following differences: futures are generic
exchange-traded, whereas forwards are individually tailored. Futures are generally settled
through an offsetting (reversing) trade, whereas forwards are generally settled by delivery of the
underlying item or cash settlement.
Options: Contracts that give the purchaser the right, but not the obligation, to buy (call option)
or sell (put option) a specified quantity of a particular financial instrument, commodity, or
foreign currency, at a specified price (strike price), during or at a specified period of time. These
can be individually written or exchange-traded. The purchaser of the option pays the seller
(writer) of the option a fee (premium) to compensate the seller for the risk of payments under the
option.
Caps and floors: These are contracts sometimes referred to as interest rate options. An interest
rate cap will compensate the purchaser of the cap if interest rates rise above a predetermined rate
(strike rate) while an interest rate floor will compensate the purchaser if rates fall below a
predetermined rate.
Embedded derivatives
Some contracts that themselves are not financial instruments may nonetheless have financial
instruments embedded in them. For example, a contract to purchase a commodity at a fixed price
for delivery at a future date has embedded in it a derivative that is indexed to the price of the
commodity.
An embedded derivative is a feature within a contract, such that the cash flows associated with
that feature behave in a similar fashion to a stand-alone derivative. In the same way that
derivatives must be accounted for at fair value on the balance sheet with changes recognised in
the income statement, so must some embedded derivatives. IAS 39 requires that an embedded
derivative be separated from its host contract and accounted for as a derivative when:
[IAS 39.11]
 the economic risks and characteristics of the embedded derivative are not closely related
to those of the host contract
 a separate instrument with the same terms as the embedded derivative would meet the
definition of a derivative, and
 the entire instrument is not measured at fair value with changes in fair value recognised
in the income statement
If an embedded derivative is separated, the host contract is accounted for under the appropriate
standard (for instance, under IAS 39 if the host is a financial instrument). Appendix A to IAS 39
provides examples of embedded derivatives that are closely related to their hosts, and of those
that are not.
Examples of embedded derivatives that are not closely related to their hosts (and therefore must
be separately accounted for) include:

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 the equity conversion option in debt convertible to ordinary shares (from the perspective
of the holder only) [IAS 39.AG30(f)]
 commodity indexed interest or principal payments in host debt
contracts[IAS 39.AG30(e)]
 cap and floor options in host debt contracts that are in-the-money when the instrument
was issued [IAS 39.AG33(b)]
 leveraged inflation adjustments to lease payments [IAS 39.AG33(f)]
 currency derivatives in purchase or sale contracts for non-financial items where the
foreign currency is not that of either counterparty to the contract, is not the currency in
which the related good or service is routinely denominated in commercial transactions
around the world, and is not the currency that is commonly used in such contracts in the
economic environment in which the transaction takes place. [IAS 39.AG33(d)]
If IAS 39 requires that an embedded derivative be separated from its host contract, but the entity
is unable to measure the embedded derivative separately, the entire combined contract must be
designated as a financial asset as at fair value through profit or loss). [IAS 39.12]
Classification as liability or equity
Since IAS 39 does not address accounting for equity instruments issued by the reporting
enterprise but it does deal with accounting for financial liabilities, classification of an instrument
as liability or as equity is critical. IAS 32 Financial Instruments: Presentation addresses the
classification question.
Classification of financial assets
IAS 39 requires financial assets to be classified in one of the following categories: [IAS 39.45]
 Financial assets at fair value through profit or loss

 Available-for-sale financial assets
 Loans and receivables
 Held-to-maturity investments
Those categories are used to determine how a particular financial asset is recognised and
measured in the financial statements.
Financial assets at fair value through profit or loss. This category has two subcategories:
 Designated. The first includes any financial asset that is designated on initial recognition
as one to be measured at fair value with fair value changes in profit or loss.
 Held for trading. The second category includes financial assets that are held for trading.
All derivatives (except those designated hedging instruments) and financial assets
acquired or held for the purpose of selling in the short term or for which there is a recent
pattern of short-term profit taking are held for trading. [IAS 39.9]

294
Available-for-sale financial assets (AFS) are any non-derivative financial assets designated on
initial recognition as available for sale or any other instruments that are not classified as as (a)
loans and receivables, (b) held-to-maturity investments or (c) financial assets at fair value
through profit or loss. [IAS 39.9] AFS assets are measured at fair value in the balance sheet. Fair
value changes on AFS assets are recognised directly in equity, through the statement of changes
in equity, except for interest on AFS assets (which is recognised in income on an effective yield
basis), impairment losses and (for interest-bearing AFS debt instruments) foreign exchange gains
or losses. The cumulative gain or loss that was recognised in equity is recognised in profit or loss
when an available-for-sale financial asset is derecognised. [IAS 39.55(b)]
Loans and receivables are non-derivative financial assets with fixed or determinable payments
that are not quoted in an active market, other than held for trading or designated on initial
recognition as assets at fair value through profit or loss or as available-for-sale. Loans and
receivables for which the holder may not recover substantially all of its initial investment, other
than because of credit deterioration, should be classified as available-for-sale.[IAS 39.9] Loans
and receivables are measured at amortised cost. [IAS 39.46(a)]
Held-to-maturity investments are non-derivative financial assets with fixed or determinable

payments that an entity intends and is able to hold to maturity and that do not meet the definition
of loans and receivables and are not designated on initial recognition as assets at fair value
through profit or loss or as available for sale. Held-to-maturity investments are measured at
amortised cost. If an entity sells a held-to-maturity investment other than in insignificant
amounts or as a consequence of a non-recurring, isolated event beyond its control that could not
be reasonably anticipated, all of its other held-to-maturity investments must be reclassified as
available-for-sale for the current and next two financial reporting years. [IAS 39.9] Held-to-
maturity investments are measured at amortised cost. [IAS 39.46(b)]
Classification of financial liabilities
IAS 39 recognises two classes of financial liabilities: [IAS 39.47]
 Financial liabilities at fair value through profit or loss

 Other financial liabilities measured at amortised cost using the effective interest method
The category of financial liability at fair value through profit or loss has two subcategories:
 Designated. a financial liability that is designated by the entity as a liability at fair value
through profit or loss upon initial recognition
 Held for trading. a financial liability classified as held for trading, such as an obligation
for securities borrowed in a short sale, which have to be returned in the future
Initial recognition

295
IAS 39 requires recognition of a financial asset or a financial liability when, and only when, the
entity becomes a party to the contractual provisions of the instrument, subject to the following
provisions in respect of regular way purchases. [IAS 39.14]
Regular way purchases or sales of a financial asset. A regular way purchase or sale of
financial assets is recognised and derecognised using either trade date or settlement date
accounting. [IAS 39.38] The method used is to be applied consistently for all purchases and sales
of financial assets that belong to the same category of financial asset as defined in IAS 39 (note
that for this purpose assets held for trading form a different category from assets designated at
fair value through profit or loss). The choice of method is an accounting policy. [IAS 39.38]
IAS 39 requires that all financial assets and all financial liabilities be recognised on the balance
sheet. That includes all derivatives. Historically, in many parts of the world, derivatives have not
been recognised on company balance sheets. The argument has been that at the time the
derivative contract was entered into, there was no amount of cash or other assets paid. Zero cost
justified non-recognition, notwithstanding that as time passes and the value of the underlying
variable (rate, price, or index) changes, the derivative has a positive (asset) or negative (liability)
value.
Initial measurement
Initially, financial assets and liabilities should be measured at fair value (including transaction
costs, for assets and liabilities not measured at fair value through profit or loss). [IAS 39.43]
Measurement subsequent to initial recognition
Subsequently, financial assets and liabilities (including derivatives) should be measured at fair
value, with the following exceptions: [IAS 39.46-47]
 Loans and receivables, held-to-maturity investments, and non-derivative financial

liabilities should be measured at amortised cost using the effective interest method.
 Investments in equity instruments with no reliable fair value measurement (and
derivatives indexed to such equity instruments) should be measured at cost.
 Financial assets and liabilities that are designated as a hedged item or hedging instrument
are subject to measurement under the hedge accounting requirements of the IAS 39.
 Financial liabilities that arise when a transfer of a financial asset does not qualify for
derecognition, or that are accounted for using the continuing-involvement method, are
subject to particular measurement requirements.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between
knowledgeable, willing parties in an arm's length transaction. [IAS 39.9] IAS 39 provides a
hierarchy to be used in determining the fair value for a financial instrument: [IAS 39 Appendix
A, paragraphs AG69-82]
 Quoted market prices in an active market are the best evidence of fair value and should
be used, where they exist, to measure the financial instrument.

296
 If a market for a financial instrument is not active, an entity establishes fair value by
using a valuation technique that makes maximum use of market inputs and includes
recent arm's length market transactions, reference to the current fair value of another
instrument that is substantially the same, discounted cash flow analysis, and option
pricing models. An acceptable valuation technique incorporates all factors that market
participants would consider in setting a price and is consistent with accepted economic
methodologies for pricing financial instruments.
 If there is no active market for an equity instrument and the range of reasonable fair
values is significant and these estimates cannot be made reliably, then an entity must
measure the equity instrument at cost less impairment.
Amortised cost is calculated using the effective interest method. The effective interest rate is the
rate that exactly discounts estimated future cash payments or receipts through the expected life of
the financial instrument to the net carrying amount of the financial asset or liability. Financial
assets that are not carried at fair value though profit and loss are subject to an impairment test. If
expected life cannot be determined reliably, then the contractual life is used.
IAS 39 fair value option
IAS 39 permits entities to designate, at the time of acquisition or issuance, any financial asset or
financial liability to be measured at fair value, with value changes recognised in profit or loss.
This option is available even if the financial asset or financial liability would ordinarily, by its
nature, be measured at amortised cost – but only if fair value can be reliably measured.
In June 2005 the IASB issued its amendment to IAS 39 to restrict the use of the option to
designate any financial asset or any financial liability to be measured at fair value through profit
and loss (the fair value option). The revisions limit the use of the option to those financial
instruments that meet certain conditions: [IAS 39.9]
 the fair value option designation eliminates or significantly reduces an accounting

mismatch, or
 a group of financial assets, financial liabilities or both is managed and its performance is
evaluated on a fair value basis by entity's management.
Once an instrument is put in the fair-value-through-profit-and-loss category, it cannot be

reclassified out with some exceptions. [IAS 39.50] In October 2008, the IASB issued
amendments to IAS 39. The amendments permit reclassification of some financial instruments
out of the fair-value-through-profit-or-loss category (FVTPL) and out of the available-for-sale
category – for more detail see IAS 39.50(c). In the event of reclassification, additional
disclosures are required under IFRS 7 Financial Instruments: Disclosures. In March 2009 the
IASB clarified that reclassifications of financial assets under the October 2008 amendments (see
above): on reclassification of a financial asset out of the 'fair value through profit or loss'
category, all embedded derivatives have to be (re)assessed and, if necessary, separately
accounted for in financial statements.
IAS 39 available for sale option for loans and receivables

297
IAS 39 permits entities to designate, at the time of acquisition, any loan or receivable as
available for sale, in which case it is measured at fair value with changes in fair value recognised
in equity.
Impairment
A financial asset or group of assets is impaired, and impairment losses are recognised, only if
there is objective evidence as a result of one or more events that occurred after the initial
recognition of the asset. An entity is required to assess at each balance sheet date whether there is
any objective evidence of impairment. If any such evidence exists, the entity is required to do a
detailed impairment calculation to determine whether an impairment loss should be recognised.
[IAS 39.58] The amount of the loss is measured as the difference between the asset's carrying
amount and the present value of estimated cash flows discounted at the financial asset's original
effective interest rate. [IAS 39.63]
Assets that are individually assessed and for which no impairment exists are grouped with
financial assets with similar credit risk statistics and collectively assessed for impairment.
[IAS 39.64]
If, in a subsequent period, the amount of the impairment loss relating to a financial asset carried
at amortised cost or a debt instrument carried as available-for-sale decreases due to an event
occurring after the impairment was originally recognised, the previously recognised impairment
loss is reversed through profit or loss. Impairments relating to investments in available-for-sale
equity instruments are not reversed through profit or loss. [IAS 39.65]
Financial guarantees
A financial guarantee contract is a contract that requires the issuer to make specified payments to
reimburse the holder for a loss it incurs because a specified debtor fails to make payment when
due. [IAS 39.9]
Under IAS 39 as amended, financial guarantee contracts are recognised:
 initially at fair value. If the financial guarantee contract was issued in a stand-alone arm's
length transaction to an unrelated party, its fair value at inception is likely to equal the
consideration received, unless there is evidence to the contrary.
 subsequently at the higher of (i) the amount determined in accordance with IAS 37
Provisions, Contingent Liabilities and Contingent Assets and (ii) the amount initially
recognised less, when appropriate, cumulative amortisation recognised in accordance
with IAS 18 Revenue. (If specified criteria are met, the issuer may use the fair value
option in IAS 39. Furthermore, different requirements continue to apply in the specialised
context of a 'failed' derecognition transaction.)

298
Some credit-related guarantees do not, as a precondition for payment, require that the holder is
exposed to, and has incurred a loss on, the failure of the debtor to make payments on the
guaranteed asset when due. An example of such a guarantee is a credit derivative that requires
payments in response to changes in a specified credit rating or credit index. These are derivatives
and they must be measured at fair value under IAS 39.
Derecognition of a financial asset
The basic premise for the derecognition model in IAS 39 is to determine whether the asset under
consideration for derecognition is: [IAS 39.16]
 an asset in its entirety or

 specifically identified cash flows from an asset or
 a fully proportionate share of the cash flows from an asset or
 a fully proportionate share of specifically identified cash flows from a financial asset
Once the asset under consideration for derecognition has been determined, an assessment is
made as to whether the asset has been transferred, and if so, whether the transfer of that asset is
subsequently eligible for derecognition.
An asset is transferred if either the entity has transferred the contractual rights to receive the cash
flows, or the entity has retained the contractual rights to receive the cash flows from the asset,
but has assumed a contractual obligation to pass those cash flows on under an arrangement that
meets the following three conditions: [IAS 39.17-19]
 the entity has no obligation to pay amounts to the eventual recipient unless it collects
equivalent amounts on the original asset
 the entity is prohibited from selling or pledging the original asset (other than as security
to the eventual recipient),
 the entity has an obligation to remit those cash flows without material delay
Once an entity has determined that the asset has been transferred, it then determines whether or
not it has transferred substantially all of the risks and rewards of ownership of the asset. If
substantially all the risks and rewards have been transferred, the asset is derecognised. If
substantially all the risks and rewards have been retained, derecognition of the asset is precluded.
[IAS 39.20]
If the entity has neither retained nor transferred substantially all of the risks and rewards of the
asset, then the entity must assess whether it has relinquished control of the asset or not. If the
entity does not control the asset then derecognition is appropriate; however if the entity has
retained control of the asset, then the entity continues to recognise the asset to the extent to
which it has a continuing involvement in the asset. [IAS 39.30]
These various derecognition steps are summarised in the decision tree in AG36.
Derecognition of a financial liability

299
A financial liability should be removed from the balance sheet when, and only when, it is
extinguished, that is, when the obligation specified in the contract is either discharged or
cancelled or expires. [IAS 39.39] Where there has been an exchange between an existing
borrower and lender of debt instruments with substantially different terms, or there has been a
substantial modification of the terms of an existing financial liability, this transaction is
accounted for as an extinguishment of the original financial liability and the recognition of a new
financial liability. A gain or loss from extinguishment of the original financial liability is
recognised in profit or loss. [IAS 39.40-41]
Hedge accounting
IAS 39 permits hedge accounting under certain circumstances provided that the hedging
relationship is: [IAS 39.88]
 formally designated and documented, including the entity's risk management objective
and strategy for undertaking the hedge, identification of the hedging instrument, the
hedged item, the nature of the risk being hedged, and how the entity will assess the
hedging instrument's effectiveness and
 expected to be highly effective in achieving offsetting changes in fair value or cash flows
attributable to the hedged risk as designated and documented, and effectiveness can be
reliably measured and
 assessed on an ongoing basis and determined to have been highly effective
Hedging instruments
Hedging instrument is an instrument whose fair value or cash flows are expected to offset
changes in the fair value or cash flows of a designated hedged item. [IAS 39.9]
All derivative contracts with an external counterparty may be designated as hedging instruments
except for some written options. A non-derivative financial asset or liability may not be
designated as a hedging instrument except as a hedge of foreign currency risk. [IAS 39.72]
For hedge accounting purposes, only instruments that involve a party external to the reporting
entity can be designated as a hedging instrument. This applies to intragroup transactions as well
(with the exception of certain foreign currency hedges of forecast intragroup transactions – see
below). However, they may qualify for hedge accounting in individual financial statements.
[IAS 39.73]
Hedged items
Hedged item is an item that exposes the entity to risk of changes in fair value or future cash
flows and is designated as being hedged. [IAS 39.9]

300
A hedged item can be: [IAS 39.78-82]
 a single recognised asset or liability, firm commitment, highly probable transaction or a

net investment in a foreign operation
 a group of assets, liabilities, firm commitments, highly probable forecast transactions or
net investments in foreign operations with similar risk characteristics
 a held-to-maturity investment for foreign currency or credit risk (but not for interest risk
or prepayment risk)
 a portion of the cash flows or fair value of a financial asset or financial liability or
 a non-financial item for foreign currency risk only for all risks of the entire item
 in a portfolio hedge of interest rate risk (Macro Hedge) only, a portion of the portfolio of
financial assets or financial liabilities that share the risk being hedged
In April 2005, the IASB amended IAS 39 to permit the foreign currency risk of a highly probable
intragroup forecast transaction to qualify as the hedged item in a cash flow hedge in consolidated
financial statements – provided that the transaction is denominated in a currency other than the
functional currency of the entity entering into that transaction and the foreign currency risk will
affect consolidated financial statements. [IAS 39.80]
In 30 July 2008, the IASB amended IAS 39 to clarify two hedge accounting issues:
 inflation in a financial hedged item

 a one-sided risk in a hedged item.
Effectiveness
IAS 39 requires hedge effectiveness to be assessed both prospectively and retrospectively. To

qualify for hedge accounting at the inception of a hedge and, at a minimum, at each reporting
date, the changes in the fair value or cash flows of the hedged item attributable to the hedged risk
must be expected to be highly effective in offsetting the changes in the fair value or cash flows of
the hedging instrument on a prospective basis, and on a retrospective basis where actual results
are within a range of 80% to 125%.
All hedge ineffectiveness is recognised immediately in profit or loss (including ineffectiveness

within the 80% to 125% window).
Categories of hedges
A fair value hedge is a hedge of the exposure to changes in fair value of a recognised asset or
liability or a previously unrecognised firm commitment or an identified portion of such an asset,
liability or firm commitment, that is attributable to a particular risk and could affect profit or
loss. [IAS 39.86(a)] The gain or loss from the change in fair value of the hedging instrument is
recognised immediately in profit or loss. At the same time the carrying amount of the hedged

301
item is adjusted for the corresponding gain or loss with respect to the hedged risk, which is also
recognised immediately in net profit or loss. [IAS 39.89]
A cash flow hedge is a hedge of the exposure to variability in cash flows that (i) is attributable to
a particular risk associated with a recognised asset or liability (such as all or some future interest
payments on variable rate debt) or a highly probable forecast transaction and (ii) could affect
profit or loss. [IAS 39.86(b)] The portion of the gain or loss on the hedging instrument that is
determined to be an effective hedge is recognised in other comprehensive income. [IAS 39.95]
If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or a

financial liability, any gain or loss on the hedging instrument that was previously recognised
directly in equity is 'recycled' into profit or loss in the same period(s) in which the financial asset
or liability affects profit or loss. [IAS 39.97]
If a hedge of a forecast transaction subsequently results in the recognition of a non-financial

asset or non-financial liability, then the entity has an accounting policy option that must be
applied to all such hedges of forecast transactions: [IAS 39.98]
 Same accounting as for recognition of a financial asset or financial liability – any gain or
loss on the hedging instrument that was previously recognised in other comprehensive
income is 'recycled' into profit or loss in the same period(s) in which the non-financial
asset or liability affects profit or loss.
 'Basis adjustment' of the acquired non-financial asset or liability – the gain or loss on the
hedging instrument that was previously recognised in other comprehensive income is
removed from equity and is included in the initial cost or other carrying amount of the
acquired non-financial asset or liability.
A hedge of a net investment in a foreign operation as defined in IAS 21 The Effects of

Changes in Foreign Exchange Rates is accounted for similarly to a cash flow hedge.
[IAS 39.102]
A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair
value hedge or as a cash flow hedge.
Discontinuation of hedge accounting
Hedge accounting must be discontinued prospectively if: [IAS 39.91 and 39.101]
 the hedging instrument expires or is sold, terminated, or exercised

 the hedge no longer meets the hedge accounting criteria – for example it is no longer
effective
 for cash flow hedges the forecast transaction is no longer expected to occur, or
 the entity revokes the hedge designation

302
In June 2013, the IASB amended IAS 39 to make it clear that there is no need to discontinue
hedge accounting if a hedging derivative is novated, provided certain criteria are met. [IAS 39.91
and IAS 39.101]
For the purpose of measuring the carrying amount of the hedged item when fair value hedge
accounting ceases, a revised effective interest rate is calculated. [IAS 39.BC35A]
If hedge accounting ceases for a cash flow hedge relationship because the forecast transaction is
no longer expected to occur, gains and losses deferred in other comprehensive income must be
taken to profit or loss immediately. If the transaction is still expected to occur and the hedge
relationship ceases, the amounts accumulated in equity will be retained in equity until the hedged
item affects profit or loss. [IAS 39.101(c)]
If a hedged financial instrument that is measured at amortised cost has been adjusted for the gain
or loss attributable to the hedged risk in a fair value hedge, this adjustment is amortised to profit
or loss based on a recalculated effective interest rate on this date such that the adjustment is fully
amortised by the maturity of the instrument. Amortisation may begin as soon as an adjustment
exists and must begin no later than when the hedged item ceases to be adjusted for changes in its
fair value attributable to the risks being hedged.
Disclosure
In 2003 all disclosures about financial instruments were moved to IAS 32, so IAS 32 was
renamed Financial Instruments: Disclosure and Presentation. In 2005, the IASB issued IFRS 7
Financial Instruments: Disclosures to replace the disclosure portions of IAS 32 effective 1
January 2007. IFRS 7 also superseded IAS 30 Disclosures in the Financial Statements of Banks
and Similar Financial Institutions

303

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PAPER NO.

FINANCIAL STATEMENT ANALYSIS

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9.0 LEARNING OUTCOMES

On successful completion of this paper, the candidate should be able to:

 Evaluate the various alternative sources of financial information

9.1 Overview of financial statement analysis………………………………………...…………5

- Definition of financial statement analysis

9.2 Financial reporting on assets and liabilities……………………………...……………….15

- Investment properties; presentation and disclosure

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9.3 Quality of earnings and earnings management……………………………………….….72

- Categories of earnings: earnings before interest, tax depreciation and armotization

9.4 Other Inter-corporate Investments……………………………………………………......86

9.5 Analysing the financial statements………………………………………………….……132

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- Financial analysis techniques; financial analysis framework/process; computation and

9.7 Qualitative and other current issues in analysis of financial statements………………228

- Qualities of useful financial statements

9.8 Emerging issues and trends

Summaries of IFRS and IAS……………………………………….…………………………237

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OVERVIEW OF FINANCIAL STATEMENT ANALYSIS

DIFFERENT REPORTING ENVIRONMENTAL FRAMEWORK

Accounting conceptual framework

 A framework for setting accounting standards

The IFRS frame work addresses

1. The objectives of financial reporting

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Different reporting framework

As much accounting information is desired to be comparable, it is worth noting that accounting

Financial statement analysis is an important business practice because it facilitates senior

Major characteristics to improve the financial statements:

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Limitations of Financial Statement Analysis

SOURCES OF INFORMATION FOR ANALYSIS

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- Unqualified (clean) opinion

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6. Social responsibility report

8. Letters to share holders

10. Annual report to shareholders

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12. Annual report to shareholders

1) Shareholders, investors and security analysts

4) Lenders and other suppliers

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APPROACHES TO ANALYZING FINANCIAL STATEMENTS

BUSINESS ANALYSIS AND MACRO ENVIRONMENT

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2. Threat of new entrants/or are there barriers to entry

3. Threat of substitute products

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FINANCIAL REPORTING ON ASSETS AND LIABILITIES

ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES

Key definitions [IAS 8.5]

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Selection and application of accounting policies

i) There is new standard