INSTITUTE OF CERTIFIED

PUBLIC ACCOUNTANTS
OF RWANDA

CPA

I1.2
FINANCIAL REPORTING

Study Manual

2nd edition February 2020,

 © ICPAR

All copy right reserved

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in
any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written
permission of ICPAR.

Acknowledgement

We wish to officially recognize all parties who contributed to revising and updating this Manual, Our thanks are extended
to all tutors and lecturers from various training institutions who actively provided their input toward completion of this
exercise and especially the Ministry of Finance and Economic Planning (MINECOFIN) through its PFM Basket Fund
which supported financially the execution of this assignment
INSTITUTE OF CERTIFIED PUBLIC
ACCOUNTANTS OF RWANDA

Intermediate Level
I1.2 FINANCIAL REPORTING

2nd Edition February 2020

This Manual has been fully revised and updated in accordance with the current syllabus/
curriculum. It has been developed in consultation with experienced tutors and lecturers.

.
TABLE OF CONTENTS

Unit
title page

Syllabus: 11

1. Conceptual framework for financial reporting 14

The qualitative characteristics of financial information 15

2. Relevant international accounting standards &

international Financial reporting standards: 21

Presentation of financial statements IAS 1 22

Introduction 22
Objective 22
Purpose of financial statements 22
Components of financial statements 22
Financial review by management 23
Structure, content and reporting 23
Sundry matters 23
Statement of financial position format 25
Statement of comprehensive income 27
Information to be presented either on the Face
of the income statement or in the notes 29
Statement of changes in equity 30
Disclosure of significant accounting policies 31
Question/solution 31
Property, plant & equipment IAS 16 33
Objective 33
Definition 33
Recognition 34
Initial measurement 34
Subsequent expenditure 36
Measurement after recognition 37
Derecognition 41

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 Depreciation 41

Disclosure 42
Accounting government grants & disclosure of government Assistance IAS 20 43
Introduction 43
Definitions 44
Recognition 44
Accounting treatment 45
Leases IFRS 16 47
IFRS 16 leases 47
Investment property IAS 40 59
Objective 59
Exclusions 59
Definition 59
Recognition and initial measurement 60
Subsequent measurement 60
Cost model 60
Fair value model 60
Cost model vs. Fair value model 61
Transfers 62
Owner-occupied property and investment property 64
Disposals 64

Disclosure requirements: fair value model and cost model 65

Intangible assets IAS 38 66
Objective 66
Exclusions 66
Definition 66
Accounting treatment 67
Acquisition by government grant 68
Exchange of assets 68
Internally generated goodwill 68
Internally generated intangible assets 68
Research 69
Development 69
Measurement of intangible assets after recognition 70

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 Cost model 70
Revaluation model 70
Useful life 72
Disposals and retirements 72

Disclosure requirements 73
Assets with both tangible and intangible elements 74
Website development costs 74

Questions 74
Inventories IAS 2 76
Objective 76
Definitions 77
Measurement 77
Valuation methods 79
Disclosure 79
Repayment of government grants 80
Disclosure 81

Sundry matters 81
Provisions, contingent liabilities & contingent assets IAS 37 81
Objective 81
Provisions 82
Definitions 82
Restructuring 84
Onerous contract 85
Contingent liabilities 85
Contingent assets 85

Disclosures 86
Events after the reporting period IAS 10 87
Objective 87
Definition 87
Dividends 88
Updating disclosures 89
Disclosure 89

Going concern considerations 89

Accounting policies, changes in accounting estimates & Errors IAS 8 89

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 Introduction 89
Definitions 89
Accounting policies 90
Changes in accounting policies 91
Disclosures 92
Limitations of retrospective application 92
Changes in accounting estimates 92
Correction of prior period errors 93

Questions 94
The effects of changes in foreign exchange rates IAS 21 95
Introduction 95
Functional and presentation currencies 95
Accounting for individual transactions 96

Translating the financial statements of foreign operation 101

Cash flow statements IAS 7 115
Objective 115
Definitions 115
Operating activities 115
Investing activities 116
Financing activities 116
Reporting cash flows from operating activities 116
Worked examples 118
Disposal of a tangible non-current asset 123
Taxation 124
Dividends 124
Worked example 125
Consolidated cash flow statements 127

Limitations of the cash flow statement 136

Revenue from contracts with customers IFRS 15 136
IFRS 15– revenue from contracts with customers 136
Introduction 136
IFRS 15 137
Definitions 137
Earnings per share IAS 33 142

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 Scope 143
Definitions 143
Number of shares 144
Measurement of basic earnings per share 144
Changes in capital structure 145
Presentation and disclosure 150

Retrospective adjustments 150

Borrowing cost IAS 23 151
Definition 151
Accounting treatment 151
Borrowing costs eligible for capitalisation 151
Commencement of capitalisation 152
Cessation of capitalisation 152
Suspension of capitalisation 152
Interest rates 152

Disclosure 154
Income taxes IAS 12 154
Introduction 154
Current tax 155
Deferred tax 156
Calculation of deferred tax 157
Why account for deferred tax? 159
Deferred tax liabilities and assets 160
Tax rate 160
Further specific examples 161

Disclosure requirements 164

Financial instruments (IAS 32, IFRS 9, IFRS 7) 164
IAS 32 – financial instruments: presentation 164
IFRS 9 – financial instruments: recognition And measurement 168

IFRS 7 – financial instruments: disclosures 171

First time adoption of international financial reporting Standards IFRS 1 173
Introduction 173
Accounting policies 173
Exemptions and exceptions 174

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 Comparative information 175

Disclosures in the first IFRS accounts 178

Interim financial reporting IAS 34 179
Introduction 179
Minimum components of an interim financial report 179
Selected explanatory notes 180
Periods for which interim financial statements are required to be presented 180
Materiality 180

Seasonal or uneven revenue and costs 181

Agriculture IAS 41 181
Introduction 181
Definitions 182
Recognition and measurement 182
Gains and losses 184
Government grants and assistance. 185

Disclosure 185
Operating segments IFRS 8 186
Introduction 186
Definition 187
Reportable segments 187
Disclosing segmental information 188
Drawbacks to segmental reporting 189
Non current assets held for sale and discontinued Operation (IFRS 5) 191
Objective 191
Assets held for sale - definition 192
Assets held for sale - measurement 193
Assets held for sale- presentation in the statement of financial position 193
Assets held for sale – miscellaneous points 193
Assets held for sale - examples 194
Discontinued operations – definition 194
Discontinued operations - presentation 195

3. Company accounts 197

Branch accounts 198

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 Goods sent at cost price 211
Accounting for independent branches 216
Consignment accounts 229
Insurance companies accounts 249
Bankruptcy and liquidation of companies 265
Overview of insolvency and bankruptcy 265
Introduction to financial distress 265
Meaning of financial distress 265

Company liquidation 266

4. Group accounts and business combinations 271

Definitions 272
Control 273
Exemptions from the requirement to prepare consolidated financial statements 273
Accounting dates 274
Accounting policies 274
Cessation of control 274
Disclosure 275
Acquistion costs 275
Contingent consideration 275
Mechanics and techniques 277
Consolidated financial statements 2 – advanced consolidated
statement of financial position 285
Determining the fair value of net assets 285
Inter-company inventory profit 287
Inter-company profit on sale of a non-current asset 287
Inter-company debts 288
Preference shares in a subsidiary company 292
Loan notes in a subsidiary company 292
Inter-company dividends 293

Acquisitions of subsidiary during the year 297

Consolidated financial statements 3 – associates and joint ventures
investments in associates and interests in joint ventures 309
Equity method of accounting 309

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 Disclosure requirements 310
Mechanics and techniques 311
Transactions between group and associate 312
Interests in joint ventures 318

Disclosure 321
Consolidated financial statements 4 – consolidated statement of
comprehensive incomes 325
Introduction 325
Non-controlling interest 326
Profit and loss - balance forward in subsidiary 327
Inter company profits 330
Transfers to reserves 337
Debit balance on statement of comprehensive income at acquisition 338
Sales and cost of sales 339
Debenture interest 340
Acquisition of subsidiary during the year 341
Associate companies in the statement of comprehensive ncome 343

Goodwill on acquisition of an associate 345

5. Interpretation of financial statements 352

Introduction 352
Interested parties 353
Profitability ratios 355
Liquidity ratios 358
Investment ratios 362
Limitations of ratio analysis 365
Other measures of business operations 365
Worked example 366
Accounting for consignments background to consignments 370
Accounting for banks 373
Insurance companies 374
Liquidation & bankruptcies 375
IPSAS 377
Cash flow statements – IPSAS 2 379

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 Inventories - IPSAS 12 379
Accounting policies, changes in accounting estimates and errors - IPSAS 3 380
Property , plant and equipment - IPSAS 17 382
Intangible assets – IPSAS 31 384
Investment property – IPSAS 16 385
Provisions, contingent liabilities and contingent assets – IPSAS 19 386
Accounting for revenues in the public sector (IPSASs 9 and 23) 387
IPSAS 9 – exchange transactions 387
IPSAS 23 – non-exchange transactions 388
Disclosures 391
Borrowing costs – IPSAS 5 392
Leases – IPSAS 13 392
Consolidated financial statements and other connected situations – IPSAS 6,
7 and 8 393
Investments in associates - IPSAS 7 396
Interests in joint ventures – IPSAS 8 397

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Subject Title: I1.2 Financial Reporting
Aim
The aim of this subject is to ensure that students have the technical knowledge and understanding
of how to account for transactions and prepare financial statements for both single entities and
groups, in accordance with international financial reporting standards.
Financial reporting as an Integral Part of the Syllabus
Financial reporting develops the concepts covered in Financial Accounting and provides students
with the appropriate context to develop their technical skills. It is an essential underpinning for
the later study of Advanced Financial Reporting and Audit Practice & Assurance Services.

Learning Outcomes
On successful completion of this subject students should be able to:

• Prepare the financial statements of companies and groups of companies in accordance with
current international financial reporting standards and national legislation, including:

• Statements of Comprehensive Income,

• Statements of Financial Position
• Statements of Changes in Equity, and
• Statements of Cash flow.
• Prepare notes to financial statements in accordance with current international financial
reporting standards and national legislation.
• Discuss, explain and apply the methods of accounting for business combinations; and
• Interpret financial statements and prepare reports tailored to each user group’s technical
knowledge and understanding of such statements.

Syllabus:
1. Conceptual framework for financial reporting

• Objectives of financial statements

• Qualitative characteristics of financial information
• Financial statements and reporting entity
• Elements of financial statements
• Recorginition and derecognition
• Measurements
• Presentation and disclosure
• Concept of capital ,capital mentainance and determination of profit

2. Relevant International Accounting Standards & International Financial Reporting

Standards:

• Presentation of Financial Statements IAS 1

• Property, Plant & Equipment IAS 16
• Accounting Government Grants & Disclosure of Government Assistance IAS 20
• Leases IFRS 16
• Investment Property IAS 40

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 • Intangible Assets IAS 38
• Inventories IAS 2
• Provisions, Contingent Liabilities & Contingent Assets IAS 37
• Events after the Reporting Period IAS 10
• Accounting Policies, Changes in Accounting Estimates & Errors IAS 8
• The effects of changes in Foreign Exchange Rates IAS 21
• Cash Flow Statements IAS 7
• Revenue from contracts with customers IFRS 15
• Earnings Per Share IAS 33
• Borrowing cost IAS 23
• Income Taxes IAS 12
• Financial Instruments (IAS 32,IFRS 9 ,IFRS 7)
• First time adoption of International Financial Reporting Standards IFRS 1
• Interim Financial Reporting IAS 34
• Agriculture IAS 41
• Operating Segments IFRS 8
• Impairment of assets IAS 36

3. Company Accounts
Preparation and presentation of financial statements to comply with the relevant Rwandan
legislation and IFRS, this should focus on both accounting for:

• Large Listed Entities

• Branch Accounts
• Co-Operatives and small businesses
• Accounting for Banks & Other Financial Institutions
• Accounting for Insurance Companies
• Accounting for Agri-business (Farm Accounts)
• Accounting for Consignments & Other Agency Selling
• Accounting for bankruptcies and liquidations

4. Group Accounts and Business Combinations

• Applicable standards (IAS 27,IAS 28 IFRS 3 ,IFRS 10 ,IFRS 11and IFRS 13)
• Consolidated statements of financial position, consolidated statements of comprehensive
income, including reserve reconciliations, consolidated statements of cash flow, acquisition
and disposal of subsidiaries and associates (both domestic and overseas) during the year.
• Takeover of sole traders.
• Accounting treatements of associate and joint ventures

5. Interpretation of Financial Statements

• Ratio analysis, cash flow analysis, and the preparation of reports thereon.

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 6. Public sector financial reporting
The broad reporting requirements of the Rwandan government in accordance with
the relevant Rwandan law (this should include recent developments such as the evolution
of an Organic Law on Finances and Asset which is in preparation if completed in time for
the syllabus).

• Broad understanding of the content of the Finance & Accounting

• Regulations Manual
• The international standard setting process and IPSAS

7. Emerging issues in financial reporting

Tutors will prepare and deliver this topis according to the new current trends at the time of delivery.
(Eg. New Accounting standards and prouncements)

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STUDY UNIT1:
CONCEPTUAL FRAMEWORK FOR FINANCIAL REPORTING

• Objectives of financial statements

• Qualitative characteristics of financial information
• Financial statements and reporting entity
• Elements of financial statements
• Recorginition and derecognition
• Measurements
• Presentation and disclosure
• Concept of capital ,capital mentainance and determination of profit

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THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION

The Conceptual Framework states that qualitative characteristics are the attributes that make
the information provided in financial statements useful to users.
The two fundamental qualitative characteristics are relevance and faithful representation. Enhancing
qualitative characteristics are comparability, verifiability, timeliness and understandability
‘Relevance.

Relevant financial information is capable of making a difference in the decisions made by users…
Financial information is capable of making a difference in decisions if it has predictive value,
confirmatory value or both’
The predictive and confirmatory roles of information are interrelated. Information on financial
position and performance is often used to predict future position and performance and other
things of interest to the user, e.g. likely dividend, wage rises. The manner of showing information
will enhance the ability to make predictions, e.g. by highlighting unusual items. The relevance of
information is affected by its nature and materiality.
Materiality ‘Materiality. Information is material if omitting it or misstating it could influence decisions
that the primary users of general-purpose financial reports make on the basis of those reports
which provide financial information about a specific reporting entity’

Information may be judged relevant simply because of its nature. In other cases, both the nature
and materiality of the information are important. An error which is too trivial to affect anyone’s
understanding of the accounts is referred to as immaterial. In preparing accounts, it is important
to assess what is material and what is not, so that time and money are not wasted in the pursuit
of excessive detail. Determining whether or not an item is material is a very subjective exercise.
There is no absolute measure of materiality. It is common to apply a convenient rule of thumb (for
example, material items are those with a value greater than 5% of net profits). However, some
items disclosed in the accounts are regarded as particularly sensitive and even a very small
misstatement of such an item is taken as a material error. An example, in the accounts of a limited
liability company, is the amount of remuneration (salaries and other rewards) paid to directors
of the company. The assessment of an item as material or immaterial may affect its treatment
in the accounts. For example, the statement of profit or loss of a business shows the expenses
incurred grouped under suitable captions (administrative expenses, distribution expenses etc);
but in the case of very small expenses it may be appropriate to lump them together as ‘sundry
expenses’, because a more detailed breakdown is inappropriate for such immaterial amounts. In
assessing whether or not an item is material, it is not only the value of the item which needs to
be considered. The context is also important.

a. If a statement of financial position shows non-current assets of RWF2,000 million

and inventories of RWF30 million an error of RWF200,000 in the depreciation calculations
might not be regarded as material. However, an error of RWF20 million in the inventory
valuation would be material. In other words, the total of which balance the error forms,
must be considered.

b. If a business has a bank loan of RWF50 million and a RWF55 million balance on
bank deposit account, it will be a material misstatement if these two amounts are netted
off on the statement of financial position as ‘cash at bank RWF5 million’. In other words,
incorrect presentation may amount to material misstatement even if there is a very small
or even no monetary error.

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Faithful representation
‘Faithful representation. Financial reports represent economic phenomena in words and numbers.
To be useful, financial information must not only represent relevant phenomena but must faithfully
represent the substance of the phenomena that it purports to represent’
To be a faithful representation, information must be complete, neutral and free from error. A
complete depiction includes all information necessary for a user to understand the phenomenon
being depicted, including all necessary descriptions and explanations.
A neutral depiction is without bIAS in the selection or presentation of financial information. A
neutral depiction is not slanted, weighted, emphasized, de-emphasized or otherwise manipulated
to increase the probability that financial information will be received favorably or unfavorably by
users. Neutrality is supported by the exercise of prudence. Prudence is the exercise of caution
when making judgements under conditions of uncertainty. Free from error means there are no
errors or omissions in the description of the phenomenon and the process used to produce the
reported information has been selected and applied with no errors in the process. In this context
free from error does not mean perfectly accurate in all respects.

Prudence was removed from the 2010 Conceptual Framework as it was deemed to be implied
within the depiction of neutrality, and that the term was being interpreted in different ways.
However, it was felt that the exercise of prudence, along with understanding the substance of
the transitions, rather than the pure legality of them, was required to be explicitly stated in the
2018 revisions to the Conceptual Framework. Furthermore, the Conceptual Framework 2018
revision included a clear definition of the term in order to clarify any potential areas of confusion
Substance over form

This is a characteristic of faithful representation. To be useful, financial information must…faithfully

represent the substance of the phenomena that it purports to represent. In many circumstances
the substance of an economic phenomenon and its legal form are the same. If they are not the
same, providing information only about the legal form would not faithfully represent the economic
phenomenon. For example, a business may have entered into a leasing agreement for some
equipment. However, the terms are such that the business is really buying the equipment. The
equipment should therefore be included in the statement of financial position as an asset of the
business and the leasing agreement should be treated as a financing arrangement.
Enhancing qualitative characteristics

Comparability
Comparability. Comparability is the qualitative characteristic that enables users to identify and
understand similarities in, and differences among, items’ (Conceptual Framework: para. 2.25).
‘Information about a reporting entity is more useful if it can be compared with similar information
about other entities and with similar information about the same entity for another period or date’
(Conceptual Framework: para. 2.24).
‘Consistency, although related to comparability, is not the same. Consistency refers to the use
of the same methods for the same items (ie consistency of treatment) either from period to
period within a reporting entity or in a single period across entities’ (Conceptual Framework:
para. 2.26). The disclosure of accounting policies is particularly important here. Users must
be able to distinguish between different accounting policies in order to be able to make a valid
comparison of similar items in the accounts of different entities. Comparability is not the same
as uniformity. Entities should change accounting policies if those policies become inappropriate.
Corresponding information for preceding periods should be shown to enable comparison to be
made over time.

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Verifiability
Verifiability. Verifiability helps assure users that information faithfully represents the economic
phenomena it purports to represent. It means that different knowledgeable and independent
observers could reach consensus, although not necessarily complete agreement, that a particular
depiction is a faithful representation’ Conceptual Framework: para. 2.30).

Information that can be independently verified is generally more decision-useful than information
that cannot.

Timeliness
Timeliness. Timeliness means having information available to decision-makers in time to be
capable of influencing their decisions. Generally, the older information is the less useful it is’
(Conceptual Framework: para. 2.33).
Information may become less useful if there is a delay in reporting it. There is a balance between
timeliness and the provision of reliable information. If information is reported on a timely basis
when not all aspects of the transaction are known, it may not be complete or free from error.
Conversely, if every detail of a transaction is known, it may be too late to publish the information
because it has become irrelevant. The overriding consideration is how best to satisfy the economic
decision-making needs of the users.
Understandability
Understandability. Classifying, characterizing and presenting information clearly and concisely
makes it understandable’ (Conceptual Framework: para. 2.34).

Financial reports are prepared for users who have a reasonable knowledge of business and
economic activities and who review and analyses the information diligently. Some phenomena
are inherently complex and cannot be made easy to understand. Excluding information on those
phenomena might make the information easier to understand, but without it those reports would
be incomplete and therefore misleading. Therefore, matters should not be left out of financial
statements simply due to their difficulty, as even well-informed and diligent users may sometimes
need the aid of an adviser to understand information about complex economic phenomena.

The elements of financial statements

Transactions and other events are grouped together in broad classes and in this way their
financial effects are shown in the financial statements. These broad classes are the elements of
financial statements.
Financial position. The elements affecting financial position are assets, liabilities and equity
• Asset is a present economic resource controlled by the entity as a result of past events. An
economic resource is a right that has the potential to produce economic benefits’
• Liability is a present obligation of the entity to transfer an economic resource as a result of
past events’
• Equity is the residual interest in the assets of the entity after deducting all its liabilities’

Whether an item satisfies any of the definitions above will depend on the substance and economic
reality of the transaction, not merely its legal form.

Asset
We can look in more detail at the components of the definitions given above. Potential to produce
economic benefits. An economic resource is a right that has the potential to produce economic
benefits (Conceptual Framework, para. 4.14).

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Assets are usually employed to produce goods or services for customers; customers will then
pay for these. Cash itself renders a service to the entity due to its command over other resources.
The economic benefits can come in various forms, including x Cash flows, such as returns on
investment sources x Exchange of goods, such as by trading, selling goods, provision of services
x Reduction or avoidance of liabilities, such as paying loans.

Liabilities
Again, we can look more closely at some aspects of the definition of a liability as per the
Conceptual Framework: For a liability to exist, three criteria must all be satisfied:

• The entity has an obligation

• The obligation is to transfer an economic resource
• The obligation is a present obligation that exists as a result of past events

An essential characteristic of a liability is that the entity has an obligation. Obligation. ‘A duty or
responsibility that the entity has no practical ability to avoid’ (para. 4.29).

A present obligation exists as a result of past events if the entity has already obtained economic
benefits or taken an action, and as a consequence, the entity will or may have to transfer an
economic resource that it would not otherwise have had to transfer (para. 4.43). (Conceptual
Framework) It is important to distinguish between a present obligation and a future commitment.
A management decision to purchase assets in the future does not, in itself, give rise to a present
obligation.

EXAMPLE
Consider the following situations. In each case, do we have an asset or liability within the
definitions given by the Conceptual Framework? Give reasons for your answer.

(a) Mucyo Ltd has purchased a patent for RWF20,000,000. The patent gives the company sole
use of a particular manufacturing process which will save RWF3,000,000 a year for the next
five years.

(b) Kalisa Ltd paid René Gatera RWF10,000,000 to set up a car repair shop, on condition that
priority treatment is given to cars from the company’s fleet.

(c) Deals on Wheels Ltd provides a warranty with every car sold.

ANSWER
(a) This is an asset, albeit an intangible one. There is a past event, control and future economic
benefit (through cost savings).

(b) This cannot be classified as an asset. Kalisa Ltd has no control over the car repair shop and
it is difficult to argue that there are ‘future economic benefits’.

(c) The warranty provided constitutes a liability; the business has taken on an obligation. It
would be recognized when the warranty is issued rather than when a claim is made

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Equity
Equity is defined above as a residual, but it may be sub-classified in the statement of financial
position. This will indicate legal or other restrictions on the ability of the entity to distribute or
otherwise apply its equity. Some reserves are required by statute or other law, eg for the future
protection of creditors. The amount shown for equity depends on the measurement of assets and
liabilities. It has nothing to do with the market value of the entity’s shares.

Performance
The elements affecting financial performance are income and expenses.
Profit is used as a measure of performance, or as a basis for other measures (e.g. earnings per
share). It depends directly on the measurement of income and expenses, which in turn depend
(in part) on the concepts of capital and capital maintenance adopted. The elements of income
and expense are therefore defined. x Income. ‘Increases in assets, or decreases in liabilities,
that result in increases in equity, other than those relating to contributions from holders of equity
claims.’ x Expenses. ‘Decreases in assets, or increases in liabilities, that result in decreases in
equity other than those relating to distributions to holders of equity claims.

Income and expenses can be presented in different ways in the statement of profit or loss and
other comprehensive income, to provide information relevant for economic decision making. For
example, income and expenses which relate to continuing operations are distinguished from the
results of discontinued operations.

Income. Revenue arises in the course of ordinary activities of an entity. ‘Increases in assets’
include those arising on the disposal of non-current assets. The definition of income also includes
unrealized gains, e.g. on revaluation of marketable securities.
Expenses As with income, expenses include losses as well as those expenses that arise in the
course of ordinary activities of an entity. Losses will include those arising on the disposal of
non-current assets. The definition of expenses will also include unrealized losses, e.g. the fall in
value of an investment.

Recognition of the elements of financial statements

Recognition. ‘The process of capturing for inclusion in the statement of financial position or
statement(s) of profit or loss and other comprehensive income an item that meets the definition
of one of the elements of financial statements – an asset, a liability, equity, income or expenses’
(Conceptual Framework: para. 5.1).

An asset or liability should be recognized if it will be both relevant and provide users of the
financial statements with a faithful representation of the transactions of that entity, The Conceptual
Framework takes these fundamental qualitative characteristics along with the definitions of the
elements of the financial statements as the key components of recognition. Previously, recognition
of elements would have been affected by the probability of whether the event was going to
happen and the reliability of the measurement. The IASB has revised this as they believed
this set too rigid a criterion as entities may not disclose relevant information which would be
necessary for the user of the financial statements because of the difficulty of estimating both the
likelihood and the amount of the element. Even if an item is not recognized, then the preparers
of the financial statements should consider whether, in order to meet the faithful representation
requirement, there should be a description in the notes to the financial statements. Derecognition
is the removal of all or part of a recognized asset or liability from an entity’s statement of financial
position. Derecognition normally occurs when that item no longer meets the definition of an asset
or liability. (Conceptual Framework: para. 5.26)

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The Conceptual Framework considers derecognition to be a factor when the following occurs:

(a) Loss of control or all or part of the recognized asset; or

(b) The entity no longer has an obligation for a liability. The IASB has brought these concepts
of recognition and derecognition into the Conceptual Framework so that they can be revisited
when visiting new standards or revising existing ones

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STUDY UNIT 2:
RELEVANT INTERNATIONAL ACCOUNTING STANDARDS &
INTERNATIONAL FINANCIAL REPORTING STANDARDS:

• Presentation of Financial Statements IAS 1

• Property, Plant & Equipment IAS 16
• Accounting Government Grants & Disclosure of Government Assistance IAS 20
• Leases IFRS 16
• Investment Property IAS 40
• Intangible Assets IAS 38
• Inventories IAS 2
• Provisions, Contingent Liabilities & Contingent Assets IAS 37
• Events after the Reporting Period IAS 10
• Accounting Policies, Changes in Accounting Estimates & Errors IAS 8
• The effects of changes in Foreign Exchange Rates IAS 21
• Cash Flow Statements IAS 7
• Revenue from contracts with customers IFRS 15
• Earnings Per Share IAS 33
• Borrowing cost IAS 23
• Income Taxes IAS 12
• Financial Instruments (IAS 32,IFRS 9 ,IFRS 7)
• First time adoption of International Financial Reporting Standards IFRS 1
• Interim Financial Reporting IAS 34
• Agriculture IAS 41
• Operating Segments IFRS 8
• Impairment of assets IAS 36

CPA EXAMINATION I1.2 FINANCIAL REPORTING 21

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PRESENTATION OF FINANCIAL STATEMENTS IAS 1

INTRODUCTION
IAS 1 (Revised) was published in September 2007. It introduced a number of changes, the main
ones being as follows:

• The titles of the main financial statements were amended to Statement of Changes in
Position, Statement of Comprehensive Income and Statement of Cash Flows
• To present all non-owner changes in equity (comprehensive income) either in one statement
of comprehensive income or a separate income statement and statement showing other
comprehensive income
• To present a statement of financial position at the beginning of the earliest comparative period
when the entity applies a prior period adjustment.

The intention of the revision is to improve the quality of the information provided to users by
aggregating information in the financial statements on the basis of shared characteristics.

B. OBJECTIVE
The objectives of IAS 1 are to:

• Provide the formats for the presentation of Financial Statements, such as Statement of
Comprehensive
• Income and Statement of Financial Position.
• Ensure that the Financial Statements are comparable year on year for the entity and
comparable to competitors.
• Set out the disclosure required by management relating to the judgements they have made in
selecting the entity’s accounting policies.
• Set out the disclosure to be made in relation to estimating uncertainty at the Statement of
Financial Position date, in particular where there is a significant risk of causing a material
adjustment to the carrying amounts at which assets and liabilities will be presented in the next
financial year.

C. PURPOSE OF FINANCIAL STATEMENTS

The objective of general purpose financial statements is to provide information about the financial
position of an entity. General purpose financial statements are those intended to serve users
who do not have the authority to demand financial reports tailored for their own needs.

Financial statements also show the results of management’s stewardship of the entity’s resources.

D. COMPONENTS OF FINANCIAL STATEMENTS

A complete set of financial statements should include:
• A statement of financial position at the end of the period
• A statement of comprehensive income for the period
• A statement of changes in equity for the period
• Statement of cash flows for the period, and
• Notes comprising a summary of accounting policies and other explanatory notes.

22 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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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 as at the beginning of the earliest comparative
period.

An entity may use titles for the statements other than those stated above. For example, an entity
may continue to use the previous title of Statement of Financial Position and cash flow statement.

E. FINANCIAL REVIEW BY MANAGEMENT

In addition to the Financial Statements identified in Section D above, management may present
a Financial Review outside the Financial Statements. The Financial Review explains the main
features of the entities financial performance and financial position as well as the main areas of
uncertainty. This Financial Review typically includes:

• An outline of the main factors affecting performance including changes in the business
environment in which the entity operates. How the entity has reacted to those changes and
the effect.
• Entity’s policy for investment and its dividend policy.
• How the entity is financed.
• Any resources that the entity uses that are not disclosed on the Statement of Financial
Position in accordance with IFRSs.

Other reports which may be included are:

• Environmental Reports – Particularly in industries where environmental issues are of
significance.
• Value Added Statements.

Any reports provided in addition to the Financial Statements are outside the scope of the IASs.

F. STRUCTURE, CONTENT AND REPORTING

The financial statements shall be identified clearly and distinguished from other information.
The financial statements should show:

• The name of the reporting entity

• The Statement of Financial Position date or the period covered by the Statement of
Comprehensive Income
• The currency in which the financial statements are presented
• The level of rounding used in presenting amounts e.g. RWF’000, RWFm or the like.
• The financial statements shall be presented at least annually.

G. SUNDRY MATTERS
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,

CPA EXAMINATION I1.2 FINANCIAL REPORTING 23

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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.

Accruals 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.

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.

Materiality has been defined as follows: “Omissions or misstatements of items are material if
they could, individually or collectively, influence the economic decisions of users taken on the
basis of the Financial Statements. Materiality depends in the size and nature of the omission or
misstatement judged in the circumstances. The size or nature of the item, or a combination of
both, could be the determining factor.”

24 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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Offsetting
Assets and liabilities, and income and expenses, may not be offset unless required or permitted
by a Standard or an Interpretation.
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 on the face of financial statements and
notes, unless another Standard Requires otherwise.

If comparative amounts are changed or reclassified, various disclosures are required.

H. STATEMENT OF FINANCIAL POSITION FORMAT

It is important before attempting a Statement of Financial Position to clearly understand the split
between current and non-current assets and liabilities

Current Assets
An asset shall be classified as current when it satisfies any of the following criteria:
• It is expected to be realised or is intended for sale or use in the entity’s normal operating
cycle;
• It is held primarily for the purpose of being traded;
• It is expected to be realised within 12 months after the Statement of Financial Position date,
or
• It is cash or a cash equivalent (as defined by IAS 7 Cash Flow Statements) All other assets
shall be classified as non-current.

Current Liabilities
A liability shall be classified as current when it satisfies any of the following criteria:
• It is expected to be settled in the entity’s normal operating cycle;
• It is held primarily for the purpose of being traded;
• It is due to be settled within 12 months after the Statement of Financial Position date. All other
liabilities shall be classified as non-current liabilities.

EXAMPLE OF A STATEMENT OF FINANCIAL POSITION

ABC LTD
STATEMENT OF FINANCIAL POSITION AS AT 31ST DECEMBER 2010

RWFm RWFm

Assets
Non-Current Assets
Property 150
Plant and Equipment 78
Intangible Assets 22
Investments 30
280
Current Assets

CPA EXAMINATION I1.2 FINANCIAL REPORTING 25

STUDY MANUAL
 Inventories 81
Trade Receivables 76
Prepayments 4
Cash and Cash Equivalents 22
183
Total Assets 463

Equity and Liabilities

Shareholders’ Equity
Share Capital 100
Share Premium 20
Revaluation Reserve 35
Retained Earnings 97
Total Equity 252

Non-Current Liabilities
Long-Term Borrowings 150

Long-Term Provisions 10
Total Non-Current Liabilities 160

Current Liabilities
Trade Payables 35
Accruals 4
Income Tax Payable 12
Total Current Liabilities 51
Total Equity and Liabilities 463

Example 1 – Statement of Financial Position

The following information is available about the balances of ALP, a limited

liability company.

Balances at 31st May 2011 RWF

Non-Current Assets - Cost 500,000

- Accumulated Depreciation 100,000

Cash at Bank 95,000
Issued Share Capital – Ordinary Shares of RWF1 each 200,000
Inventory 125,000
Trade Payables 82,000
Retained Earnings 292,500
10% Loan Notes 150,000
Trade Receivables 112,000
Loan Note Interest Owing 7,500
26 I1.2 FINANCIAL REPORTING CPA EXAMINATION
STUDY MANUAL
REQUIREMENT:
Prepare the Statement of Financial Position of ALP as at 31st May 2011 using the format IAS
1 – Presentation of

Financial Statements.

ALP Limited
Statement of Financial Position as at 31st May 2011
Assets RWF RWF
Non-Current Assets:
Cost 500,000
Less Accumulated Depreciation (100,000)
400,000
Current Assets
Inventory 125,000
Trade Receivables 112,000
Cash at Bank 95,000
332,000
Total Assets 732,000

Equity and Liabilities

Shareholders’ Equity Share
Capital 200,000
Retained Earnings 92,500
492,500
Non-Current Liabilities
10% Loan Notes 150,000
Current Liabilities
Trade Payables 82,000
Accruals 7,500 89,500
Total Current Liabilities 239,500
Total Liabilities
Total Equity and Liabilities 732,000

I. STATEMENT OF COMPREHENSIVE INCOME

IAS 1 allows a choice of two presentations of comprehensive income:
• A statement of comprehensive income showing total comprehensive income; OR
• An Statement of Comprehensive Income showing the realised profit or loss for the period
PLUS a statement showing other comprehensive income.

Total comprehensive Income is the realised profit or loss for the period, plus other comprehensive
income.
Other comprehensive income is income and expenses that are not recognised in profit or loss.
That is, they are recorded in reserves rather than as an element of the realised profit for
the period. For example, other comprehensive income would include a change in revaluation
surplus.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 27

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Statement of Comprehensive Income
The recommended pro-forma layout is as follows:

PQR
Statement of Comprehensive Income for the Year Ended 31st December 2010

RWF000
Revenue X
Cost of sales (X)
Gross profit X
Administrative expenses (X)
Profit from operations X
Finance costs (X)
Investment income X
Profit before tax X
Income tax expense (X)
Profit for the year X
Other Comprehensive Income
Gain/Loss on revaluation of PPE X
Gain/Loss on available for sale investments X
Total comprehensive income for the year X

Income Statement Plus Statement of Comprehensive Income

The recommended pro-forma layout is as follows:

PQR
Statement of PLfor the year ended 31ST December 2010

RWF000
Revenue X
Cost of sales (X)
Gross profit X
Administrative expenses (X)
Profit from operations X
Finance costs (X)
Investment income X
Profit before tax X
Income tax expense (X)
Profit for the year X

A recommended format for the presentation of other comprehensive income is as follows:

PQR
Other Comprehensive Income for the year ended 31st December 2010

RWF000
Profit for the Year X
Other comprehensive income
Gain/Loss on revaluation of PPE X
Gain/Loss on available for sale investments X
Total comprehensive income for the year X

28 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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J. INFORMATION TO BE PRESENTED EITHER ON THE FACE OF THE INCOME
STATEMENT OR IN THE NOTES

When items of income and expense are material, their nature and amount shall be disclosed
separately. Examples of these would include:

• The write down of inventories to net realisable value

• The write down of property, plant and equipment to recoverable amount
• Gains/losses on disposal of property, plant and equipment
• Gains/losses on disposal of investments
• Legal settlements

An entity shall not present any items of income or expense as extraordinary items. The
description extraordinary items were used in the past to represent income and expenses arising
from events outside the ordinary activities of the business. IAS 1 has therefore abolished this
classification of items.

Example – Income Statement Function of Expenditure Method

Set out below are details from the financial records of Watt Limited:

Distribution Costs 5,470

Interest Costs 647
Cost of Sales 18,230
Sales Revenue 44,870
Income Tax Expense 1,617
Administration Expenses 9,740

REQUIREMENT:
Prepare the Income Statement

SOLUTION:

Watt Limited - Income Statement for the year ended 31st March 2010

RWFm

Sales Revenue 44,870

Cost of Sales (18,230)
Gross Profit 26,640
Administration Expenses (9,740)
Distribution Costs (5,470)
Profit from Operations 11,430
Interest Costs (647)
Profit Before Tax 10,783
Income Tax Expense (1,617)
Net Profit for the Year 9,166

CPA EXAMINATION I1.2 FINANCIAL REPORTING 29

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K. STATEMENT OF CHANGES IN EQUITY
An entity shall present a statement of changes in equity showing on the face of the statement:

• Profit or loss for the period

• Each item of income and expense for the period that is recognised directly in equity e.g. a
revaluation surplus on the revaluation of property
• The effects of changes in accounting policies and correction of errors recognised in
accordance with IAS8
• The amounts of transactions with equity holders e.g. issue of shares, any premium thereon
and dividends to equity holders.
• The balance of retained earnings (accumulated profit) at the start of the year, changes during
the year and the balance at the end of the year.
• The balance on each reserve account at the start of the year, changes during the year and the
balance at the end of the year.

Therefore, the statement of changes in equity provides a summary of all changes in equity
arising from transactions with owners, including the effect of share issues and dividends. Other
non-owner changes in equity are disclosed in aggregate only.

Statement of Changes in Equity

Essentially the statement of changes in equity presents in a columnar format all the changes
which have affected the various equity balances of share capital and reserves.

Share Share Revaluation Retained Total

Capital Premium Reserve Earnings Equity
RWF RWF RWF RWF

RWF

Balance at 1.1.10 X X X X X
Change in
accounting policy _ (X) (X)

XX
Restated Balance XX XX X XXX
Issue of shares
Revaluation gain
Transfer (X) X -
Profit for the year _ X (X) X (X)
Dividends

Balance at 31.12.10 X X X X X
_

30 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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L. DISCLOSURE OF SIGNIFICANT ACCOUNTING POLICIES

An entity shall disclose the significant accounting policies used in preparing the financial
statements.
M. QUESTION/SOLUTION
Question – XYZ
The following items have been extracted from the trial balance of XYZ, a limited liability
company, as at 30th September 2010.

Ref. To Notes RWF RWF

Opening Inventory 186,400
Purchases 1,748,200
Carriage Inwards 38,100
Carriage Outwards 2 47,250
Sales Revenue 3,210,000
Trade Receivables 318,000
Wages & Salaries 2 and 3 694,200
Sundry Administrative Expenses 2 381,000
Allowance for doubtful debts, as at 1st 4 18,200
October 2009
Bad Debts written off during the year 4 14,680
Office Equipment as at 1st October 2009:

Cost 5 214,000
Accumulated Depreciation 5 88,700
Office Equipment: Additions during the year 5 48,000
Proceeds of sale of items during the year 5 12,600
Interest paid 2 30,000

Notes:
1. Closing inventory amounted to RWF219,600
2. Prepayments and accruals:

Prepayments Accruals
RWF RWF

Carriage Outwards 1,250

Wages & Salaries 5,800

Sundry Administrative Expenses 4,900 13,600
Interest Payable 30,000

CPA EXAMINATION I1.2 FINANCIAL REPORTING 31

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 3. Wages and salaries cost is to be allocated:
Cost of Sales 10%

Distribution Costs 20%

Administrative Expenses 70%

4. Further bad debts totalling RWF8,000 are to be written off, and the closing allowance for doubtful
debts is to be equal to 5% of the final trade receivables figure. The bad and doubtful debt
expense is to be included in administrative expenses.

5. Office equipment:
Depreciation is to be provided at 20% per annum on the straight-line basis, with a full year’s
charge in the year of purchase and none in the year of sale.
During the year office equipment, which had cost RWF40,000 with accumulated
depreciation ofRWF26,800 was sold for RWF12,600.
All office equipment is used for administrative purposes.

6. Income Tax of RWF22,000 is to be provided for.

REQUIREMENT:
Prepare the company’s Income Statement for the year ended 30th September 2010 in
accordance with IAS 1

Presentation of Financial Statements.

SOLUTION:

XYZ Limited
Income Statement for the year ended 30th September 2010

RWF RWF
Sales Revenue 3,210,000
Cost of Sales (W1) (1,823,100)
Gross Profit 1,386,900
Distribution Costs (W1) (188,500)

Administrative Expenses (W1) (944,680) (1,133,180)

Profit from operations 253,720
Interest payable (30,000 + 30,000)
(60,000)
Profit before Tax 193,720
Income Tax 22,000
Profit for the Year 171,720

32 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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Working1
Cost of Distribution Administrative

Sales Costs Expenses

RWF RWF RWF
Opening Inventory 186,400
Purchases 1,748,200
Carriage Inwards 38,100
Carriage Outwards (47,250 48,500
+1,250)
Wages and Salaries
694,200
5,800
700,000 70,000 140,000 490,000

Sundry administrative expense (381,000 + 13,600 – 4,900) 389,700

Bad and doubtful debts (14,680 + 8,000 – 2,700) 19,980

Depreciation of office equipment

20% x (214,000 – 40,000 + 48,000) 44,400
Loss on sale 600
Closing inventory (219,600)
1,823,100 188,500 944,680

PROPERTY, PLANT & EQUIPMENT IAS 16

OBJECTIVE
The objective of IAS 16 is to prescribe the accounting treatment for property, plant and equipment,
so that users of the financial statements can understand the nature of the entities investment in
such assets and any changes that have occurred in that investment.

The standard indicates that the main issues to be dealt with are:

• The recognition of assets

• The determination of their carrying amount
• Depreciation and impairment losses
• Disclosure requirements

The standard does not apply to:

• Property, plant and equipment classified as held for sale under IFRS 5
• Mineral rights and reserves
• Biological assets
B. DEFINITION
Property, plant and equipment are tangible items that:

• Are held for use in the production or supply of goods or services, for rental to others or for
administration purposes; and
• Are expected to be used during more than one period.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 33

STUDY MANUAL
The carrying amount refers to the amount at which an asset is recognised after deducting
accumulated depreciation and accumulated impairment losses, i.e. its net book value.

C. RECOGNITION
An item of property, plant and equipment should be recognised as an asset in the Statement of
Financial Position if, and only if:

• It is probable that future economic benefits associated with the item will flow to the entity; and
• The cost of the item can be measured reliably.

The Framework for the Preparation and Presentation of Financial Statements also states that
having control over as asset is an important feature in the recognition of that asset in the accounts
(for example, legal ownership of an asset is not essential in establishing the existence of the
asset, as long as the entity can show that it controls the benefits which are expected to flow from
that asset, e.g. Finance Lease).

An entity controls an asset if it has the power to obtain the future economic benefits flowing from
that asset and also restrict the access of others to those benefits.

D. INITIAL MEASUREMENT
If an asset qualifies for recognition, then it should initially be measured at its cost.

Cost is the amount of cash or cash equivalents paid or the fair value of other consideration given
to acquire an asset at the time of acquisition or construction.

The cost of an asset comprises:

The Purchase Price less trade discounts and rebates

• Import duties and non-refundable purchase taxes

• Any costs that are directly attributable to bringing the asset to the location and condition
necessary for the asset to be used as intended, for example:

• Site preparation costs

• Initial delivery and handling costs
• Installation and assembly costs
• Professional fees
• Costs of testing whether the asset is functioning properly (after deducting the sales
proceeds of any samples produced during testing)

• The initial costs of dismantling and removing the item and restoring the site, if such an
obligation is placed on the entity (legally or constructively)

Administration and other general overheads are not included in the cost of the asset.
Likewise, the following are also excluded: training costs, advertising and promotional costs and
costs incurred while an asset, capable of being used as intended, is yet to be brought into use,
is left idle or is operating below full capacity.

[Note that in the case of self-constructed assets, the following are excluded from the cost of the

34 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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asset:
• Internal profits
• Abnormal amounts of wasted material, labour or other resources]

In certain circumstances, IAS 23 allows part of the borrowing cost to be capitalised.

If an asset is acquired in exchange for another asset, the acquired asset is measured at its fair
value unless the exchange lacks commercial substance or the fair value cannot be measured
reliably. If this is the case, the acquired asset should be measured at the carrying value of
the asset given up (carrying amount being equal to cost less accumulated depreciation and
impairment losses).

Question:
T.s Limited has recently acquired an item of plant. The details of this acquisition are:

RWF RWF
List price of plant 40,000
Trade discount applicable to T. Ltd 12.5%
Ancillary costs:
Shipping and handling costs 2,750
Pre-production testing 12,500
Maintenance contract for three years 24,000
Site preparation costs:
Electrical cable installation 14,000
Concrete reinforcement 4,500
Own labour costs 7,500 26,000

T.Ltd paid for the plant (excluding the ancillary costs) within four weeks and thus received a 3%
early settlement discount.

An error was made in installing the electrical cable. This error cost RWF6,000 and is
included in the RWF14,000 figure.

The plant is expected to last for 10 years. At the end of this period, there will be compulsory
costs of
RWF18,000 to dismantle the plant and restore the site. (Ignore discounting).

What is the initial cost of the plant that should be recognised in the Statement of Financial
Position?

Solution:
RWF RWF
List price of plant 240,000
Less trade discount (12.5%) (30,000)

210,000
Shipping and handling costs 2,750

CPA EXAMINATION I1.2 FINANCIAL REPORTING 35

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 Pre-production testing
Site preparation costs: 12,500
Electrical cable (14,000 – 6,000) 8,000
Concrete reinforcement 4,500
Own labour costs 7,500
20,000
Dismantling and restoration 18,000
Initial cost of plant 263,250

Note:
Early settlement discount is a revenue item
Maintenance cost is also a revenue item
The electrical error must be charged to the income statement

E. SUBSEQUENT EXPENDITURE
The cost of day-to-day servicing of an asset is not included in the carrying amount of an asset.
This expenditure is referred to as “repairs and maintenance” and should be charged to the
income statement in the period it is incurred.

However, if part of an asset is replaced, e.g. new engine in a plane or new lining in a furnace,
then the cost of this replacement can be capitalised if the recognition criteria mentioned earlier
are met.

The part of the asset that is replaced must then be derecognised (with any resulting profit or loss
on disposal being calculated and recognised).

Some assets require ongoing and substantial expenditure for overhauling and restoring
components of an asset, for example:

• Overhaul of Airplane, to keep it airworthy

• Dry docking of a ship

A provision for this expenditure cannot be made. Rather, the cost is capitalised and depreciated
separately over its individual useful economic life. It is important to note that this variety of
subsequent expenditure can only be treated in this way if the asset is treated as separate
components for depreciation purposes.

If the asset is not accounted for as several different components, this kind of subsequent
expenditure must be treated as normal repairs and renewals and charged to the income statement
as it is incurred.

Example
S. Limited purchases a plane that has an expected useful life of 20 years, and has no residual
value. The plane requires a substantial overhaul every 5 years (i.e. at the end of years 5, 10, and
15). The plane cost RWF45 million and RWF5 million of this figure is estimated to be attributable

36 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
to the economic benefits that are restored by the overhauls.

The annual depreciation charge would be calculated as follows:

• The plane is treated as two separate components for depreciation purposes:

• The RWF5 million is depreciated over 5 years (i.e. RWF1 million per annum)
• The balance of RWF40 million is depreciated over 20 years (i.e. RWF2 million per annum).
• The total annual depreciation charge is RWF3 million.

When the first overhaul is carried out at the end of year 5 at a cost of, say, RWF10 million, this
cost is capitalised and depreciated to the date of the next overhaul.

This means that total depreciation for years 6 to 10 will be RWF4 million (RWF10m/5 years +
RWF40m/20 years).

F. MEASUREMENT AFTER RECOGNITION

IAS 16 provides two options when accounting for property, plant and equipment after their
initial recognition:
(a) Cost Model
After recognition, the asset should be carried in the Statement of Financial Position at:
• Cost
• Less Accumulated Depreciation
• Less Accumulated Impairment Losses

(b) Revaluation Model

After recognition, an asset, whose fair value can be measured reliably, should be carried at a
revalued amount.
The revalued amount is the fair value of the asset at the date of revaluation less subsequent
accumulated depreciation and impairment losses.

The fair value of property is based on its market value, as assessed by a professionally qualified
valuer. The fair value of plant and equipment is usually their market value, determined by
appraisal.
If there is no market based evidence of fair value because the asset is of a specialised nature
and is rarely sold, then the fair value of that asset will have to be estimated using an income or
a depreciated replacement cost approach.

All revaluations should be made at such a frequency that the carrying amount does not differ
materially from the fair value at the Statement of Financial Position date.

If an item of property, plant and equipment is revalued, then the entire class of property, plant and
equipment to which the asset belongs shall be revalued.

If an asset is revalued upwards:

CPA EXAMINATION I1.2 FINANCIAL REPORTING 37

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 • Debit Asset
• Credit Revaluation Surplus
• With the amount of the increase

However, if the revaluation gain reverses a previous revaluation loss, which was recognised as
an expense, then the gain should be recognised in the income statement (but only to the extent
of the previous loss of the same asset). Any excess over the amount of the original loss goes to
the Revaluation Surplus.

Example:
GJ Limited has land in its books with a carrying value of RWF14 million. Two years ago the land
was worth RWF16 million. The loss was recorded in the Income Statement. This year the land
has been valued at RWF20 million.

Thus:
RWFm RWFm
Debit Land 6
Credit Income Statement 2
Credit Revaluation Surplus 4

If an asset is revalued downwards:

• Debit Income Statement
• Credit Asset

With the amount of the decrease

However, the decrease should be debited directly to the revaluation surplus to the extent of any
credit balance existing in the revaluation surplus in respect of that asset.

Example:
G J Limited has land in its books with a carrying value of RWF20 million. Two years ago the
land was worth RWF15 million. The gain was credited to the Revaluation Surplus. This year
the land has been valued at RWF13 million. Thus:
RWFm RWFm
Debit Revaluation Surplus 5
Debit Income Statement 2
Credit Land 7

[Note that the Revaluation Surplus is part of owners’ equity.]

If however, the asset is subject to depreciation, then the treatment of revaluation surpluses
becomes a little more complicated.
If an asset is revalued upwards, then the annual depreciation charge will be greater. This will
reduce profits to lower than they would be if no revaluation took place. Consequently, the
accumulated reserves will also be lower.

The revaluation surplus will be realised if and when the asset is sold or disposed of in the
future. But, it can be argued that the surplus is also being realised when the asset is being

38 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
used, i.e. over its remaining useful life.

Thus, the revaluation surplus being realised is the difference between:

• The new depreciation charge on the revalued amount of the asset; and
• The old depreciation charge on the cost of the asset.

Example:
S. Limited bought an item of machinery for RWF100,000 at the start of 2007. The asset had an
estimated useful life of 5 years, with no residual value.

At the start of 2009, the asset was revalued to RWF120,000. There was no change in its
expected useful life.

Solution:
RWF
At 1st January 2009:
Carrying amount of asset 60,000
Revalued to 120,000
Revaluation surplus 60,000

Thus:
RWF RWF
Debit Machinery 60,000
Credit Revaluation Reserve 60,000

The new annual depreciation charge, after revaluation will be:

120,000
= RWF40,000 per annum
3 years
This represents an increase of RWF20,000 per annum over the old depreciation charge.

To compensate for this, S. Limited can “release” from the revaluation reserve to the accumulated
reserves an amount to reflect the “realisation” of the revaluation reserve. The revaluation surplus
is released on a straight- line basis over the remaining life of the machine, i.e.
RWF60,000
= RWF20,000 per annum
3 years
Thus:
RWF RWF
Debit Revaluation Reserve 20,000
Credit Accumulated Reserves 20,000

[This would occur in the Statement of Changes in Equity and is not part of the profit or loss.]
The depreciation charge changes from the date of the revaluation onwards.

Example:
On the 31st December 2008, S.B. Limited had the following shown in its Statement of Financial

CPA EXAMINATION I1.2 FINANCIAL REPORTING 39

STUDY MANUAL
Position:
Buildings RWF
Cost 5,000,000
Accumulated depreciation 1,000,000
Carrying amount 4,000,000

Depreciation on buildings has been charged at the rate of 2% per annum.

[Note: this means that the annual charge is RWF100,000 per annum and thus, the buildings were
acquired 10 years previously. At the end of December 2007, the buildings had an estimated
useful life of 40 years remaining.]
The building is revalued to RWF5,925,000 on the 30th June 2009. There is no change in its
remaining estimated useful life.

Show the extracts from the financial statements for the year ended 31st December 2009.
Solution:
Depreciation charge for year:
RWF RWF
5,000,000 x 2% x 6/12 =

50,000+ 5,925,000 x 6/12 = 39.5 years

75,000 125,000

The asset is depreciated as normal up to the date of the revaluation. Thereafter, the revalued
amount is written off over the remaining life of the asset.

Thus:
Income Statement
RWF
Depreciation 125,000
Statement of Financial Position
Valuation at 30th June 2009 5,925,000
Accumulated depreciation 75,000
Carrying amount 5,850,000

At the date of revaluation a revaluation surplus would have been create

RWF
Carrying amount 3,950,000
Revalued amount 5,925,000
Revaluation surplus 1,975,000

The revaluation surplus can be “released” to accumulated reserves over the remaining life of
the asset, i.e.
RWF1,975,000
= RWF50,000 per annum
39.5yeas

[In 2009, RWF50,000 x 6/12 = RWF25,000 would be released.]

40 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
In 2010 onwards, the annual depreciation charge will be RWF150,000 per annum.

As an alternative to releasing the revaluation surplus over the assets remaining useful life,
the surplus could instead be transferred in its entirety to retained earnings when the asset is
eventually derecognised.

G. DERECOGNITION
If an asset is sold, scrapped or withdrawn from use (so that no future economic benefits are
expected) then the asset must be removed from the Statement of Financial Position.
Any gain or loss arising on disposal must be calculated and included as part of profit or loss for
period. The gain or loss on disposal is the difference between:

• The carrying amount of the asset; and

• The net sales (disposal) proceeds.

[Note: any consideration receivable on disposal of an item of property, plant and equipment is
measured at its fair value.]

H. DEPRECIATION
Each part of an item of property, plant and equipment that has a cost that is significant in relation
to the total cost of the item should be depreciated separately.

This means that an entity should allocate the amount initially recognised in respect of an item of
property, plant and equipment and each part should be separately depreciated.

For example, a company acquires a property at a cost of RWF100 million. For depreciation
purposes, the asset has been separated into the following elements:

Separate Asset Cost

Life Land RWF25m
Freehold Buildings RWF50m
50 years Lifts RWF15m
15 years Electrical and wiring System RWF10m
10 years

Thus, each asset should be depreciated accordingly.

The depreciation charge for a period should be recognised in the profit or loss for the period. It
is usually an expense item. But if the asset is used in the process of producing goods for sale,
then the depreciation of that asset is included in the cost of sales.

There are situations however, when the depreciation of any asset should be included in the
carrying amount of another asset. For example, under IAS 38 Intangible Assets, depreciation
of assets used for development purposes may be included in the cost of the intangible asset
(development costs) capitalised in the Statement of Financial Position.

So, if the future economic benefits embodied in an asset are absorbed in producing other assets,
then the depreciation charge constitutes part of the cost of the other asset and thus is included
in its carrying amount.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 41

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The depreciable amount of an asset should be allocated on a systematic basis over its useful
life. The method of depreciation should reflect the pattern in which the asset is used in the entity.
Whichever method is chosen by the entity, it should be applied consistently from period to period
unless there is a change in the expected pattern of consumption of the assets future economic
benefits.

The entity should review both the residual value of the asset and its expected useful life on an
annual basis. If necessary, these should be revised (as a change in estimate, in accordance
with IAS 8).
Because an asset is being repaired or maintained does not mean it should avoid depreciation.
Depreciation begins when the asset is available for use and ceases at the earlier date of:

• When it is classified as held for resale under IFRS 5; and

• When the asset is derecognised.

Land, with some exceptions, has an unlimited useful life and so it is not subject to depreciation.
Buildings have a useful life and, thus, are depreciated.

If an asset is revalued, the revalued amount should be depreciated over its remaining useful life,
starting at the date of its revaluation.

If the useful life of an asset is revised, the carrying value of the asset should be written off over
the remaining life, starting with the period in which the change is made.

Example:
S. Limited purchased an asset on 1st January 2008. It had an expected useful life of 5 years. Its
residual value is immaterial. Its cost was RWF500,000. At 31st December 2010, the remaining
useful life is revised to 7 years.

Thus the depreciation charge in the accounts for 2010 will be as follows:
Net Book Value at 31st December 2009 RWF 300,000
Remaining useful life at the start of the year 2010 (i.e. 7 years from the end of this year + this
year) 8 years

Depreciation charge RWF37,500

(Note, the estimated useful life at the year 2010 is 7 years, but this information is used to compute
this year’s depreciation charge too.)

I. DISCLOSURE
For each class of property, plant and equipment, the following information must be disclosed:

• The measurement bases for calculating the gross carrying amount

• Depreciation method used
• The useful lives or the depreciation rates used
• The gross carrying amount and the accumulated depreciation at the beginning of the period
• A reconciliation of the carrying amount at the beginning and end of the period showing:

42 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
 • Additions
• Assets held for sale in accordance with IFRS 5
• Acquisitions through business combinations
• Increases or decreases arising from revaluations
• Impairment losses
• Reversals of impairment losses
• Depreciation
• Other changes, including foreign currency exchange differences

The following, if they arise, should also be disclosed:

• Existence of restrictions on title and whether assets have been pledged as security for
liabilities and the amounts involved
• Amount of expenditure recognised in the course of the assets construction

• Amount of contractual commitments to acquire property, plant and equipment

• The amount of compensation from third parties for assets that were impaired, lost or given up
included in profit or loss (if not disclosed separately on the face of the income statement)

If assets have been revalued, the following should be disclosed:

• Date of revaluation
• Whether an independent valuer was used
• Methods and assumptions used in estimating the fair value
• The extent to which estimates were based on active markets or other techniques which were
used
• The carrying amount of the asset if the cost model had been used
• The revaluation surplus

IAS 16 encourages the disclosure of:

• The carrying amount of idle property, plant and equipment

• The gross carrying amount of fully depreciated assets still in use
• The carrying amount of assets retired from active use and not classified as held for sale
• If the cost model is used, then disclose the fair value of the assets.

ACCOUNTING GOVERNMENT GRANTS & DISCLOSURE OF GOVERNMENT ASSIS-

TANCE IAS 20

A. INTRODUCTION

IAS 20 sets out the accounting procedures to be followed when dealing with government grants.
It also outlines the disclosure requirements necessary upon receipt of such grants.

The standard recognises that government assistance can come in a variety of forms and may be
motivated by different government objectives. Indeed some or all of the grant aid may become

CPA EXAMINATION I1.2 FINANCIAL REPORTING 43

STUDY MANUAL
repayable if certain conditions are not met. IAS 20 also outlines the action to be taken in this
situation.

IAS 20 sets out to achieve two main objectives:

• Outline an appropriate accounting treatment for the resources received by the entity from
government sources.
• Provide an indication of the extent to which an entity has benefited from such
assistance in the accounting period.

B. DEFINITIONS
Government refers to government, government agencies and similar bodies whether local,
national or international.

Government assistance is action by government designed to provide an economic benefit

specific to an entity or range of entities qualifying under certain criteria. For the purposes of
IAS 20, government assistance does not include benefits provided only indirectly through action
affecting general trading conditions, such as the provision of infrastructure in development areas
or the imposition of trading constraints on competitors.

Government Grants are assistance by government in the form of transfers of resources to an entity
in return for past or future compliance with certain conditions relating to the operating activities of
the entity. They exclude those forms of government assistance which cannot reasonably have a
value placed upon them and transactions with government which cannot be distinguished from
the normal trading transactions of the entity. (See Section G).

Grants related to assets are government grants whose primary condition is that an entity qualifying
for them should purchase, construct or otherwise acquire long-term assets. Subsidiary conditions
may also be attached restricting the type or location of the assets or the periods during which
they are to be acquired or held.

Grants related to income are government grants other than those related to assets.

Forgivable loans are loans which the lender undertakes to waive repayment of under
certain prescribed conditions.

C. RECOGNITION
Government grants should not be recognised in the financial statements until there is
reasonable assurance that:

• The entity will comply with the conditions attaching to them; and
• The grants will be received.

The standard states that the manner in which the grant is received will not affect the accounting
treatment. For example, an entity may receive cash or alternatively the government may reduce
a liability owed to it by the entity. Both constitute government grants and must be treated as such.

Note that a forgivable loan from government is also treated as a government grant when there is
reasonable assurance that the entity will meet the terms for forgiveness of the loan.

44 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
If the grant takes the form of a non-monetary asset, then the fair value of that asset is assessed
and both the asset and the grant are treated at this value.

Example:
The Ministry of Infrastructure transfer title of a building to B. Limited, as part of an overall package
to encourage the development of a research and development facility to aid the mining industry.
The building has a fair value of RWF100,000.

Solution:
This constitutes a government grant. Thus in the books of B. Limited:

RWF RWF
DR Land and Buildings Account 100,000

CR Grant Account 100,000

Note that in circumstances where a non-monetary asset is transferred, an alternative sometimes

used is to record both the asset and the grant at a nominal amount.

D. ACCOUNTING TREATMENT
Government grants should be recognised as income over the periods necessary to match them
with the related costs which they are intended to compensate, on a systematic basis.

1. For grants related to income the grant can be:

• Presented as a credit in the Statement of Comprehensive Income, either separately

or under a general heading such as “other income”; or
• They are deducted in reporting the related expense e.g. a labour cost subsidy could
be deducted from the cost of labour to be shown in the Statement of Comprehensive
Income.
Both methods are acceptable. However, in either case disclosure of the grant, and the effects
of the grant must be made.

Example
FG. Ltd. obtained a grant of RWF30 million to compensate it for costs incurred in planting trees
and hedgerows over a period of 3 years. FG. ltd. will incur costs as follows:

Year 1 RWF5 million Year 2 RWF5 million Year 3 RWF10 million

(Thus total costs expected to be incurred come to RWF20 million and grant aid of RWF30 million
has been received).

Applying IAS 20, the grant will be recognised as income over the period which matches the cost,
using a systematic and rational basis. As a result, the total grant recognised per annum will be:

Year 1 RWF30 x 5/20 = RWF7.5 million

Year 2 RWF30 x 5/20 = RWF7.5 million
Year 3 RWF30 x 10/20 = RWF10 million

2. For grants related to assets, there are two allowable accounting treatments:

CPA EXAMINATION I1.2 FINANCIAL REPORTING 45

STUDY MANUAL
 • Show the grant as a deferred credit in the Statement of Financial Position, amortising it to the
Statement of Comprehensive Income over the life of the asset to which it relates; or
• Deduct the grant in arriving at the carrying amount of the asset. In this way, the grant is
recognised over the life of the asset by way of a reduced depreciation charge in the Statement
of Comprehensive Income.

Note that regardless of which method is used the cash flow statement would normally show the
purchase of an asset and the receipt of a grant as two separate cash flows.

Example:
S. Limited receives a 50% grant towards the cost of a machine, which has a cash price of
RWF100,000. The machine has an estimated useful life of five years and its residual value is
expected to be immaterial.

Solution:
The asset cost is RWF100,000 and the grant is RWF50,000. Thus, the net cost to the company
is RWF50,000.

Option 1:
On acquiring the asset:

RWF RWF
DR Machine Account 100,000
CR Bank Account 100,000
On receiving the grant:

RWF RWF
DR Bank Account 50,000
CR Government Grant Account 50,000
Thus, the annual depreciation charge is: RWF100,000 = 20,000
5yeas
The annual amortisation of grant is:

RWF50,000 = 5 years

(this is credited to the Statement of RWF10,000 Comprehensive Income)

Option 2:
On acquiring the asset:

RWF RWF
DR Machine Account 100,000
CR Bank Account 100,000
On receiving the grant:

RWF RWF
DR Bank Account 50,000
CR Machine Account 50,000

Thus, the annual depreciation charge is: RWF50,000 =

46 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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LEASES IFRS 16

IFRS 16 Leases
It is a contract between the lessee and the lessee where the lessor offers an asset to the lessee
which he pays for in installment

Objective
This Standard sets out the principles for the recognition, measurement, presentation
and disclosure of leases. The objective is to ensure that lessees and lessors provide
relevant information in a manner that faithfully represents those transactions. This
information gives a basis for users of financial statements to assess the effect that
leases have on the financial position, financial performance and cash flows of an entity.
An entity shall consider the terms and conditions of contracts and all relevant
facts and circumstances when applying this Standard. An entity shall apply
this Standard consistently to contracts with similar characteristics and in
similar circumstances.

Scope
An entity shall apply this Standard to all leases, including leases of right-of-use assets in a
sublease, except for:

• leases to explore for or use minerals, oil, natural gas and similar nonregenerative resources;
• leases of biological assets within the scope of IAS 41 Agriculture held by a lessee;
• service concession arrangements within the scope of IFRIC 12 Service Concession
Arrangements
• licences of intellectual property granted by a lessor within the scope of IFRS 15 Revenue from
Contracts with Customers; and
• rights held by a lessee under licensing agreements within the scope of IAS 38 Intangible
Assets for such items as motion picture films, video recordings, plays, manuscripts, patents
and copyrights.
A lessee may, but is not required to, apply this Standard to leases of intangible asset

Recognition exemptions

A lessee may elect not to apply the requirementsto:

• short-term leases; and

• leases for which the underlying asset is of low value

Lessee
For a contract that contains a lease component and one or more additional
lease or non-lease components, a lessee shall allocate the consideration in the contract to each
lease component on the basis of the relative stand-alone price of the lease component and the
aggregate stand-alone price of the non-lease components.

Lessee Recognition
At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 47

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Measurement
Initial measurement

Initial measurement of the right-of-use asset

At the commencement date, a lessee shall measure the right-of-use asset at
cost. The cost of the right-of-use asset shall comprise:

• the amount of the initial measurement of the lease liability, as described in paragraph 26;
• any lease payments made at or before the commencement date, less any lease incentives
received;
• any initial direct costs incurred by the lessee; and
• an estimate of costs to be incurred by the lessee in dismantling and removing the underlying
asset, restoring the site on which it is located or restoring the underlying asset to the condition
required by the terms and conditions of the lease, unless those costs are incurred to
produce inventories. The lessee incurs the obligation for those costs either at the
commencement date or as a consequence of having used the underlying asset during a
particular period

Initial measurement of the lease liability

At the commencement date, a lessee shall measure the lease liability at the present value of
the lease payments that are not paid at that date. The lease payments shall be discounted
using the interest rate implicit in the lease, if that rate can be readily determined. If that rate
cannot be readily determined, the lessee shall use the lessee’s incremental borrowing rate.
At the commencement date, the lease payments included in the measurement of the lease
liability comprise the following payments for the right to use the underlying asset during the lease
term that are not paid at the commencement date:

• fixed payments (including in-substance fixed payments as described less any lease incentives
receivable;
• variable lease payments that depend on an index or a rate, initially measured using the index
or rate as at the commencement date (as described in paragraph 28);
• amounts expected to be payable by the lessee under residual value
guarantees;
• the exercise price of a purchase option if the lessee is reasonably certain to exercise that
option and
• payments of penalties for terminating the lease, if the lease term reflects the lessee exercising
an option to terminate the lease.

Subsequent measurement
Subsequent measurement of the right-of-use asset
After the commencement date, a lessee shall measure the right-of-use asset
applying a cost model, unless it applies either of the measurement models

Cost model
To apply a cost model, a lessee shall measure the right‑of‑use asset at cost:

• less any accumulated depreciation and any accumulated impairment losses; and
• adjusted for any remeasurement of the lease liability specified in
paragraph 36
• A lessee shall apply the depreciation requirements in IAS 16 Property, Plant and Equipment in
depreciating the right-of-use asset,
48 I1.2 FINANCIAL REPORTING CPA EXAMINATION
STUDY MANUAL
Other measurement models
If a lessee applies the fair value model in IAS 40 Investment Property to its
investment property, the lessee shall also apply that fair value model to rightof-use assets that
meet the definition of investment property in IAS 40.
If right-of-use assets relate to a class of property, plant and equipment to which the lessee
applies the revaluation model in IAS 16, a lessee may elect to
apply that revaluation model to all of the right-of-use assets that relate to that class of property,
plant and equipment.

Subsequent measurement of the lease liability

After the commencement date, a lessee shall measure the lease liability by:

• increasing the carrying amount to reflect interest on the lease liability;

• reducing the carrying amount to reflect the lease payments made; and
• re-measuring the carrying amount to reflect any reassessment or lease modifications specified
in or to reflect revised in-substance fixed lease payments
Interest on the lease liability in each period during the lease term shall be the
amount that produces a constant periodic rate of interest on the remaining
balance of the lease liability.

The periodic rate of interest is the discount rate described in if

After the commencement date, a lessee shall recognise in profit or loss, unless
the costs are included in the carrying amount of another asset applying other applicable
Standards, both:

• interest on the lease liability; and

• variable lease payments not included in the measurement of the lease
liability in the period in which the event or condition that triggers those payments occurs.

Reassessment of the lease liability

After the commencement date, a lessee re-measure the lease liability to reflect changes to
the lease payments. A lessee shall recognise the amount of the remeasurement of the lease
liability as an adjustment to the right-of-use asset. However, if the carrying amount of the right-
of-use asset is reduced to zero and there is a further reduction in the
measurement of the lease liability, a lessee shall recognise any remaining amount of the re-
measurement in profit or loss.
A lessee shall remeasure the lease liability by discounting the revised lease payments using a
revised discount rate, if either:

• there is a change in the lease term, A lessee shall determine the revised lease payments on
the basis of the revised lease term; or
• there is a change in the assessment of an option to purchase the underlying asset, assessed
considering the events and circumstances described in the context of a purchase option. A
lessee shall determine the revised lease payments to reflect the change in amounts payable
under the purchase option.

A lessee shall remeasure the lease liability by discounting the revised lease payments, if either:

• there is a change in the amounts expected to be payable under a residual value guarantee. A
lessee shall determine the revised lease payments to reflect the change in amounts expected
to be payable under the residual value guarantee.
• there is a change in future lease payments resulting from a change in an index or a rate used

CPA EXAMINATION I1.2 FINANCIAL REPORTING 49

STUDY MANUAL
 to determine those payments, including for example a change to reflect changes in market
rental rates following a market rent review.

The lessee shall remeasure the lease liability to

reflect those revised lease payments only when there is a change in the cash flows (ie when
the adjustment to the lease payments takes effect).
A lessee shall determine the revised lease payments for the remainder of the lease term based
on the revised contractual payments.

Lease modifications
A lessee shall account for a lease modification as a separate lease if both:

• the modification increases the scope of the lease by adding the right to use one or more
underlying assets; and
• the consideration for the lease increases by an amount commensurate with the stand-alone
price for the increase in scope and any appropriate adjustments to that stand-alone price to
reflect the circumstances of the particular contract.

For a lease modification that is not accounted for as a separate lease, at the effective date of
the lease modification a lessee shall:

• allocate the consideration in the modified contract

• determine the lease term of the modified lease and
• remeasure the lease liability by discounting the revised lease payments using a revised
discount rate. The revised discount rate is determined as the interest rate implicit in the lease
for the remainder of the lease term, if that rate can be readily determined, or the lessee’s
incremental borrowing rate at the effective date of the modification, if the interest rate implicit
in the lease cannot be readily determined.

For a lease modification that is not accounted for as a separate lease, the lessee shall account
for the re-measurement of the lease liability by:

• decreasing the carrying amount of the right-of-use asset to reflect the partial or full termination
of the lease for lease modifications that decrease the scope of the lease. The lessee shall
recognise in profit or loss any gain or loss relating to the partial or full termination of the
lease.
• making a corresponding adjustment to the right-of-use asset for all other lease modifications.

Presentation
A lessee shall either present in the statement of financial position, or disclose in the notes:

• right-of-use assets separately from other assets. If a lessee does not present right-of-use
assets separately in the statement of financial position, the lessee shall:

• include right-of-use assets within the same line item as that within which the
corresponding underlying assets would be presented if they were owned; and
• disclose which line items in the statement of financial position include those right-of-
use assets. lease liabilities separately from other liabilities.

If the lessee does not present lease liabilities separately in the statement of financial position,
the lessee shall disclose which line items in the statement of financial position include those
liabilities.
In the statement of profit or loss and other comprehensive income, a lessee shall present

50 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
interest expense on the lease liability separately from the depreciation charge for the right-
of-use asset. Interest expense on the lease liability is a component of finance costs, In the
statement of cash flows, a lessee shall classify:

• cash payments for the principal portion of the lease liability within financing activities;
• cash payments for the interest portion of the lease liability applying the requirements in IAS 7
Statement of Cash Flows for interest paid; and
• short-term lease payments, payments for leases of low-value assets and variable lease
payments not included in the measurement of the lease liability within operating activities

Disclosure
The objective of the disclosures is for lessees to disclose information in the notes that, together
with the information provided in the statement of financial position, statement of profit or loss
and statement of cash flows, gives a basis for users of financial statements to assess the effect
that leases have on the financial position, financial performance and cash flows of the lessee.

A lessee shall disclose information about its leases for which it is a lessee in a single note or
separate section in its financial statements. However, a lessee need not duplicate information
that is already presented elsewhere in the financial statements, provided that the information is
incorporated by cross reference in the single note or separate section about leases.

A lessee shall disclose the following amounts for the reporting period:

• depreciation charge for right-of-use assets by class of underlying asset;

• interest expense on lease liabilities;
• the expense relating to short-term leases accounted
• the expense relating to variable lease payments not included in the measurement of lease
liabilities;

• income from subleasing right-of-use assets;

• total cash outflow for leases;
• additions to right-of-use assets;
• gains or losses arising from sale and leaseback transactions; and
• the carrying amount of right-of-use assets at the end of the reporting

Lessor
Classification of leases
A lessor shall classify each of its leases as either an operating lease or a finance lease.
A lease is classified as a finance lease if it transfers substantially all the risks and rewards
incidental to ownership of an underlying asset. A lease is classified as an operating lease if it
does not transfer substantially all the risks and rewards incidental to ownership of an underlying
asset. Whether a lease is a finance lease or an operating lease depends on them substance of
the transaction rather than the form of the contract. Examples of situations that individually or in
combination would normally lead to a lease being classified as a finance lease are:

• the lease transfers ownership of the underlying asset to the lessee by the end of the lease
term;
• the lessee has the option to purchase the underlying asset at a price that is expected to be
sufficiently lower than the fair value at the date the option becomes exercisable for it to be
reasonably certain, at the inception date, that the option will be exercised;

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STUDY MANUAL
 • the lease term is for the major part of the economic life of the underlying asset even if title is
not transferred;
• at the inception date, the present value of the lease payments amounts to at least substantially
all of the fair value of the underlying asset; and
• the underlying asset is of such a specialised nature that only the lessee can use it without
major modifications.

Indicators of situations that individually or in combination could also lead to a lease being
classified as a finance lease are:

• if the lessee can cancel the lease, the lessor’s losses associated with the cancellation are
borne by the lessee; eriod by class of underlying as gains or losses from the fluctuation in
the fair value of the residual accrue to the lessee (for example, in the form of a rent rebate
equaling most of the sales proceeds at the end of the lease); and
• the lessee has the ability to continue the lease for a secondary period at
Finance leases

Recognition and measurement

At the commencement date, a lessor shall recognize assets held under a finance lease in its
statement of financial position and present them as a receivable at an amount equal to the net
investment in the lease.

Initial measurement
The lessor shall use the interest rate implicit in the lease to measure the net investment in
the lease. In the case of a sublease, if the interest rate implicit in the sublease cannot be
readily determined, an intermediate lessor may use the discount rate used for the head
lease (adjusted for any initial direct costs associated with the sublease) to measure the net
investment in the sublease.
Initial direct costs, other than those incurred by manufacturer or dealer lessors, are included
in the initial measurement of the net investment in the lease and reduce the amount of income
recognised over the lease term. The interest rate implicit in the lease is defined in such a way
that the initial direct costs are included automatically in the net investment in the lease; there is
no need to add them separately.

Initial measurement of the lease payments included in the net investment in the lease At the
commencement date, the lease payments included in the measurement of the net investment
in the lease comprise the following payments for the right to use the underlying asset during
the lease term that are not received at the commencement date: t that is substantially lower
than market rent.

Manufacturer or dealer lessors

At the commencement date, a manufacturer or dealer lessor shall recognise the following for
each of its finance leases:

• revenue being the fair value of the underlying asset, or, if lower, the present value of the lease
payments accruing to the lessor, discounted using a market rate of interest;
• the cost of sale being the cost, or carrying amount if different, of the underlying asset less the
present value of the unguaranteed residual value; and
• selling profit or loss (being the difference between revenue and the cost of sale) in accordance
with its policy for outright sales to which IFRS 15 applies. A manufacturer or dealer lessor shall
52 I1.2 FINANCIAL REPORTING CPA EXAMINATION
STUDY MANUAL
 recognise selling profit or loss on a finance lease at the commencement date, regardless of
whether the lessor transfers the underlying asset as described in IFRS 15.

Subsequent measurement
A lessor shall recognise finance income over the lease term, based on a pattern reflecting a
constant periodic rate of return on the lessor’s net investment in the lease. A lessor aims to
allocate finance income over the lease term on a systematic and rational basis. A lessor shall
apply the lease payments relating to the period against the gross investment in the lease to
reduce both the principal and the unearned finance income.

A lessor shall apply the derecognition and impairment requirements in IFRS 9 to the net
investment in the lease. A lessor shall review regularly estimated unguaranteed residual
values used in computing the gross investment in the lease. If there has been a reduction
in the estimated unguaranteed residual value, the lessor shall revise the income allocation
over the lease term and recognise immediately any reduction in respect of amounts accrued.
A lessor that classifies an asset under a finance lease as held for sale (or includes it in a disposal
group that is classified as held for sale) applying IFRS 5 Non-current Assets Held for Sale and
Discontinued Operations shall account for the asset in accordance with that Standard.

Lease modifications
A lessor shall account for a modification to a finance lease as a separate lease if both:

• the modification increases the scope of the lease by adding the right to
use one or more underlying assets; and
• the consideration for the lease increases by an amount commensurate with the stand-alone
price for the increase in scope and any appropriate adjustments to that stand-alone price to
reflect the circumstances of the particular contract.

For a modification to a finance lease that is not accounted for as a separate lease, a lessor
shall account for the modification as follows:

• if the lease would have been classified as an operating lease had the modification been in
effect at the inception date, the lessor shall:

• account for the lease modification as a new lease from the effective date of the
modification; and
• measure the carrying amount of the underlying asset as the net investment in the
lease immediately before the effective date of the lease modification.
• (b) otherwise, the lessor shall apply the requirements of IFRS 9.

Operating leases
Recognition and measurement
A lessor shall recognise lease payments from operating leases as income on either a straight-
line basis or another systematic basis. The lessor shall apply another systematic basis if that
basis is more representative of the pattern in which benefit from the use of the underlying asset
is diminished.
A lessor shall recognise costs, including depreciation, incurred in earning the lease income as
an expense.
A lessor shall add initial direct costs incurred in obtaining an operating lease to the carrying
amount of the underlying asset and recognise those costs as an expense over the lease term
on the same basis as the lease income.

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The depreciation policy for depreciable underlying assets subject to operating leases shall
be consistent with the lessor’s normal depreciation policy for similar assets. A lessor shall
calculate depreciation in accordance with IAS 16 and IAS 38.
A lessor shall apply IAS 36 to determine whether an underlying asset subject to an operating
lease is impaired and to account for any impairment loss identified.
A manufacturer or dealer lessor does not recognise any selling profit on entering into an
operating lease because it is not the equivalent of a sale.

Lease modifications
A lessor shall account for a modification to an operating lease as a new lease from the effective
date of the modification, considering any prepaid or accrued lease payments relating to the
original lease as part of the leasepayments for the new lease.

Presentation
A lessor shall present underlying assets subject to operating leases in its statement of financial
position according to the nature of the underlying asset.

Disclosure
The objective of the disclosures is for lessors to disclose information in the notes that, together
with the information provided in the statement of financial position, statement of profit or loss
and statement of cash flows, gives a basis for users of financial statements to assess the effect
that leases have on the financial position, financial performance and cash flows of the
lessor. A lessor shall disclose the following amounts for the reporting period:

• for finance leases:

• selling profit or loss;

• finance income on the net investment in the lease; and
• income relating to variable lease payments not included in the
measurement of the net investment in the lease.
• for operating leases, lease income, separately disclosing income relating to variable lease
payments that do not depend on an index or a rate.

Sale and leaseback transactions

If an entity (the seller-lessee) transfers an asset to another entity (the buyerlessor) and leases
that asset back from the buyer-lessor, both the seller-lessee and the buyer-lessor shall account
for the transfer contract lease
Assessing whether the transfer of the asset is a sale An entity shall apply the requirements for
determining when a performance obligation is satisfied in IFRS 15 to determine whether the
transfer of an asset is accounted for as a sale of that asset.

Transfer of the asset is a sale

If the transfer of an asset by the seller-lessee satisfies the requirements of IFRS 15 to be
accounted for as a sale of the asset:

• the seller-lessee shall measure the right-of-use asset arising from the leaseback at the
proportion of the previous carrying amount of the asset that relates to the right of use retained
by the seller-lessee. Accordingly, the seller-lessee shall recognise only the amount of any
gain or loss that relates to the rights transferred to the buyer-lessor.

54 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 • the buyer-lessor shall account for the purchase of the asset applying
applicable Standards, and for the lease applying the lessor accounting requirements in this
Standard.

Calculation of Minimum Lease Payments

Company X Limited acquires an asset under a finance lease. The asset, with an expected useful
life of 5 years,
has a cash price of RWF10,900. The lease is for five years, with an annual payment of RWF3,000
in arrears. The implicit rate of interest in the lease is 12%.

Calculate the value at which the asset will be initially recorded in the accounts.

Solution
First, calculate the present value of the minimum lease payments.
Year Lease Payment 12% Discount Factor Present Value
1 3,000 0.893 2,679

2 3,000 0.797 2,391

3 3,000 0.712 2,136
4 3,000 0.636 1,908
5 3,000 0.567 1,701
10,815

Second, compare to the fair

value.

RWF
Fair Value (cash price) 10,900
PV of lease payments 10,815

Thus:
Dr Leased Asset Account 10,815

Cr Leasing Obligation 10,815

Therefore, at the start of the lease:

Dr Non-Current Assets
Cr Leasing Obligation
With fair value of the leased asset (or the present value of the minimum lease payments, if lower)
The leased asset is subsequently depreciated over the shorter of:

• The useful economic life of the asset; or

• The lease term

[Note: The lease term may comprise both a primary period and a secondary period. The
secondary period is included in the lease term if it is reasonably certain at the beginning of the
lease that this period will be exercised]

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As the lease progresses, the finance charge included in the lease payments must be calculated
and charged to the
Statement of Comprehensive Income.

This means that the lease payment must be split into its component parts:

Finance cost, charged to Statement of
Comprehensive Income
Lease Payment

Capital portion, reducing balance sheet

liability

Thus, for each lease payment under a finance lease:

Dr Statement of Comprehensive Income (interest element)

Dr Leasing obligation in balance sheet (capital element)
Cr Bank

In calculating the amount of the finance charge, there are two main methods:

• The actuarial method

• The sum of digits method, also known as the Rule of 78

The aim of each method is to allocate the finance cost in such a way as to produce a reasonably
constant periodic rate of return on the outstanding balance of the leasing obligation.
[
Example 1
Company Y Limited acquires a machine under a finance lease agreement. The machine has a
cash price of
RWF6,000.

The terms of the lease are:

Deposit RWF900 followed by three annual payments of RWF2,100 per annum in arrears. The
implicit rate of interest is 11.35%.

Using the Actuarial Method:

This method apportions the interest as it actually accrues, using the rate of interest implicit in the
contract.

Thus,
RWF
Cash price 6,000
Deposit 900
Amount financed by leasing 5,100

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 Consequently, the initial recording of the lease will be:
RWF RWF
Dr Leased machinery 6,000
Cr Bank account 900
Cr Leasing obligation 5,100
Then in each year of the lease:

Year Opening Balance Interest Lease Rentals Closing

Balance
1 5,100 *579 2,100 **3,579
2 3,579 406 2,100 1,885
3 1,885 215 2,100 -
* 5,100 x 11.35% = 579
** (5,100 + 579) – 2,100 = 3,579
In year one, extracts from the financial statements would show: Statement of Comprehensive
Income:
RWF
Finance charge 579
RWF6,000
Depreciation 2,000
3 years

Balance Sheet:
Leased assets (6,000 – 2,000) 4,000

Non-current liabilities
Leasing obligations 1,885

Current liabilities Total 3,579

Leasing obligations (3,579 – 1,885) 1,694

Using the Sum-of-Digits Method:

There are 3 years in the lease
Thus, the sum-of-digits is: 3+2+1 = 6

n(n+1)
Note: An alternative, quicker way to calculate the sum-of-digits is to use the formula:
2

3(4)
Where n = number of years in the lease. In the above example, this becomes: =6
2
Next, calculate the total interest payable over the life of the lease:

RWF
Total amount financed 5,100
Total repayments (RWF2,100 x 3) 6,300
Total interest 1,200

Thus, the interest charge each year will be:

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 Year 1 1,200 x 3/6 = 600
Year 2 1,200 x 2/6 = 400
Year 3 1,200 x 1/6 = 200
The extracts from the accounts will be in year one: Statement of Comprehensive Income:

RWF
Finance charge 600
Depreciation (as before) 2,000

Balance Sheet:
Leased assets 4,000
Non-current liabilities
Leasing obligations 1,900 Total 3,600 i.e.

Current liabilities (5,100 + 600) – 2,100

Leasing obligations 1,700

Note: There is a slight difference in the finance charge, and therefore also in the closing
balance of the liability, between the two methods.

Example 2
Company Z Limited acquired a machine by way of a lease agreement. The fair value of the
machine was RWF15,850. Estimated life of the machine is 4 years.

The terms of the lease are:

Annual lease rental of RWF5,000 payable in arrears each year for 4 years.

The implicit interest rate is 10%.

Solution
Is this lease a finance lease?

RWF
PV of minimum lease payments = 15,850
Cash price (fair value) = 15,850
It is a finance lease

Initially,
RWF RWF
Dr Leased machinery 15,850
Cr Leasing obligation 15,850

Then, to calculate the finance charge and the closing balance of the liability (using the actuarial
method):
Year Opening Balance Lease Rentals Closing
10% Interest Balance
1 15,850 1,585 5,000 12,435
2 12,435 1,243 5,000 8,678

58 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 3 8,678 868 5,000 4,546
4 4,546 454 5,000 -
In year one, the extracts from the financial statements would show: Statement of Comprehensive
Income:

RWF
Finance charge 1,585
RWF15,850
Depreciation 3,962
4 years

INVESTMENT PROPERTY IAS 40

A. OBJECTIVE
To outline the accounting treatment for investment properties and the disclosure requirements.

B. EXCLUSIONS
The standard does not apply to:

• Biological assets related to agricultural activity

• Mineral rights and reserves

C. DEFINITION
Investment property is property (land or buildings or part of a building) held to earn rental or for
capital appreciation or both, rather than for:

• Use in the production or supply of goods or services or for administrative purposes or

• Sale in the ordinary course of business.

Note that the standard says it is “property held”. This means that the entity does not have to own
title to the property. Investment property held under a finance lease is included in the definition.

Recent changes to IAS 40 have seen the possible inclusion in the definition of property held
under an operating lease. Property held by a lessee under an operating lease shall qualify
as an investment property if, and only if, the property would otherwise meet the definition of
an investment property and the lessee uses the “fair value” model for the asset recognised.
It should be noted, however, that once this model is selected for one property held under an
operating lease, all property classified as investment property should be accounted for using the
“fair value” model.

This aspect of recognising investment property was included in the Standard in response to the
situation in some countries where properties are held under long leases that provide rights that
are broadly similar to those of a purchaser. The inclusion in the Standard of such interests allows
the lessee to measure such assets at fair value.

The nature of investment properties is different from other types of land and buildings and
consequently the accounting treatment will be different also. By earning rentals or capital
appreciation (or both), investment properties generate cash flows that are mostly independent of
other assets held by the entity.

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D. RECOGNITION AND INITIAL MEASUREMENT
Investment property should be recognised as an asset when, and only when:

• It is probable that future economic benefits will flow to the entity from the property, and
• The cost of the property can be measured reliably.

Such are the normal requirements for the recognition of assets.

An investment property should be measured initially at its cost. Transaction costs should be
included in the cost of the property.
The cost of a purchased investment property includes its purchase price and any other directly
attributable expenditure, for example:

• Legal fees
• Other transaction costs

The cost of a self-constructed investment property is its cost at the date when the construction
is completed. (Up to the date of completion, the property would be accounted for using IAS 16).

If the property is held under a lease, then the asset should be measured initially at the lower of
the:

• Fair value of the property, and

• Present value of the minimum lease payments (including any premium paid for lease).

E. SUBSEQUENT MEASUREMENT
IAS 40 allows the entity to choose from two different options when accounting for the subsequent
measurement of its investment properties. These options are:

• Cost model, or
• Fair Value Model

F. COST MODEL
Using this approach, all investment properties are treated like other properties under IAS 16
Property, Plant and
Equipment i.e. shown at: Cost
Less Accumulated Depreciation

Less Accumulated Impairment Losses

[Note, that if the investment property is held for sale as defined in IFRS 5 Non-Current Assets
Held For Sale and Discontinued Operations, the investment property should be measured in
accordance with that standard.]

G. FAIR VALUE MODEL

This model requires the entity to revalue all of its investment property at fair value.
[As stated earlier, if the property is held by the lessee under an operating lease, the fair value
model must be applied.]

60 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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Any gain or loss that arises from revaluing to fair value should be treated as part of the profit or
loss for the period (i.e. in the Statement of Comprehensive Income).

The fair value is the price at which property could be exchanged between knowledgeable,
willing parties in an arm’s length transaction.

This fair value should reflect market conditions at the Statement of Financial Position date.
Thus, the fair value is usually calculated by comparing current prices for similar properties in
an active market.

In estimating fair value, the entity should consider a number of factors and sources:

• Current prices in an active market for properties of a different nature, condition or location,
adjusted to reflect those differences
• Recent prices of similar properties on less active markets, adjusted to reflect changes in
economic conditions
• Discounted cash flow projections based on reliable estimates of future cash flows.

[In exceptional circumstances, if the fair value of the property cannot be estimated reliably on a
continuing basis, the property should be measured using the cost model in IAS 16. This policy
should be applied until the property is disposed of.]

There is a major difference between the fair value policy allowed in IAS 40 and the revaluation
policy allowed under IAS 16.

In IAS 40, all gains and losses on revaluation to fair value go to the Statement of Comprehensive
Income. In IAS 16, if an asset is revalued to fair value, gains are credited to a revaluation reserve.
The IASB take the view that the fair value model is appropriate for investment properties as this
is consistent with accounting for financial assets held as investments require by IAS 39 Financial
Instruments: Recognition and Measurement.

H. COST MODEL vs. FAIR VALUE MODEL

The following model demonstrates the potential impact on the financial statements of the two
options.

Example:
XYZ purchases a property in Kigali for RWF10m on 1st June 2010. The property was purchased
for both rental income and capital appreciation. The building has a useful life of 50 years.

Estimates of the market value of the building on 31st May 2011 show a value of RWF12m.

What is the impact on the financial statements for the year ended 31st May 2011 if the company
uses:

• Fair Value Model

• Cost Model

Permitted under IAS 40.

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Solution:
(a) Fair Value Model

RWF RWF
Dr Investment Property 2m
Cr Statement of Comprehensive Income 2m

Thus, there is a gain in the Statement of Comprehensive Income of RWF2m, increasing profit
for the period.

In the Statement of Financial Position, the investment property is shown at RWF12m.

(b) Cost Model

Here, the asset is depreciated annually.

RWF10m
= RWF200,000 per annum
50 years

In the Statement of Comprehensive Income, there will be a depreciation expense of RWF200,000,

decreasing profit.

In the Statement of Financial Position, the investment property will have a carrying
amount of RWF10,000,000 - RWF200,000 = RWF9,800,000

Once an entity chooses a method of accounting for investment properties, it must be consistent
in that choice.

A change in method is considered to be a change in accounting policy under IAS 8. Such a

change should only occur if it would result in a more appropriate presentation of transactions,
other events or conditions in the entity’s financial statements.

IAS 40 goes on to state that it considers a change from the fair value to the cost model resulting
in a more appropriate presentation as “highly unlikely”.

Furthermore, an entity is “encouraged but not required” to use the services of an experienced
independent valuer with recognised relevant professional qualifications when determining the
fair value of its investment properties.

[All entities must determine the fair value of investment property, regardless of the accounting
treatment. If an entity uses the cost model, it must still disclose the fair value of the property in
the notes to the financial statements.]

I. TRANSFERS
Transfers to or from investment property can only be made when there is a change in use.
There are a number of possibilities:

• Transfer from investment property to owner-occupied property i.e. commencement of owner

occupation. The fair value of the property at the date of change is determined and used for
subsequent accounting under IAS 16.
• Transfer from investment property to inventories i.e. commencement of development with a
view to sale. The fair value of the property at the date of change is determined and used for
62 I1.2 FINANCIAL REPORTING CPA EXAMINATION
STUDY MANUAL
 subsequent accounting under IAS 2 Inventories.
• Transfer from owner occupied property to investment property i.e. end of owner occupation.
If the investment property is to be carried at fair value, the entity should apply IAS 16 up to the
date of change in use.
Any difference at that date, between the carrying amount of the property under IAS 16 and
its fair value, is treated in the same way as a revaluation in accordance with IAS 16. That is,
gains will be credited to a revaluation reserve and losses will be charged to the Statement of
Comprehensive Income.
[Please refer to IAS 16 for treatment of such gains and losses where there have been
previous revaluations.]

• Transfer from inventories to investment property through the commencement of an operating

lease to another party. Here, any difference between the fair value of the property and its
carrying amount at that date should be recognised in profit or loss.
• Transfer from property in the course of construction or development (covered by IAS 16) to
investment property i.e. end of construction/development. As with (d), any difference between
the fair value of the property and its carrying amount at that date should be recognised in profit
or loss.

Example
W. Ltd purchased a property on 1st January 2009 for RWF3,000,000. W.Ltd intended to renovate
the property and let the building to a government department, due to locate in the area under
its decentralisation programme. A further RWF600,000 was spent over the next 11 months in
getting the building ready for letting. No lease had been signed by the government department.
The building was ready for tenant occupation on 1st December
2009.

The valuation of the completed property on 31st December 2009 was RWF4,000,000.
However, due to unforeseen budgetary difficulties, the government shelved its decentralisation
plan and the property remained unoccupied.

In February 2010, the property was valued at RWF4,200,000 and W.Ltd decided immediately
to relocate its head office to this property. W Ltd secured tenants for its old headquarters. The
book value of that head office was RWF3,000,000 and the market value at the date of letting in
February 2010 was RWF3,600,000.

The valuations of both properties were provided by independent qualified valuers.

How should W Ltd account for these property movements under IAS 40 and IAS 16, assuming
the company implements the Fair Value Model and the Revaluation Model, respectively?

When the property was acquired in 2009, it was the intention of W Ltd to let the property out to
a government department. The property was held to acquire rentals and thus, qualifies as an
investment property under IAS 40. The acquisition cost, together with the cost of renovation,
which totalled RWF3,600,000, should be included as investment property in the Statement of
Financial Position.

At 31st December 2009, the property is revalued to its fair value of RWF4,000,000 and the gain
of RWF400,000 should be recognised in the Statement of Comprehensive Income for that year.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 63

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In February 2010, the property was valued at RWF4,200,000 and W Ltd decided to relocate its
head office to this property. Since the property is now owner occupied (see Section J below),
it no longer meets the definition of an investment property. It is no longer held for rentals (or
capital appreciation) but for use in the business. Its changed in status means that from the date
of change, it will now be dealt with under IAS 16.

At the time of the transfer from investment property to PPE, the fair value is deemed to be the “cost”
of the property under its new classification. The increase from its book value of RWF4,000,000 to
its fair value of RWF4,200,000 (i.e. RWF200,000) should be recorded in the calculation of profit
for the period.
In addition, W Ltd secured tenants for its old Head Office building. Again, there is a change in the
status of that building as it is now meets the definition of an investment property, and is no longer
PPE. Thus, it will now be dealt with under IAS 40.

IAS 16 applies up to the date of the transfer from PPE to investment property. Any difference
arising between the carrying value under IAS 16 at that date and the fair value is accounted for
as a revaluation under IAS 16.

The carrying value of the property was RWF3,000,000 and the market value in February 2010
was RWF3,600,000. Therefore, the increase of RWF600,000 is recorded as a revaluation surplus
prior to reclassification. It is not included in the profit calculation for the period.

J. OWNER-OCCUPIED PROPERTY AND INVESTMENT PROPERTY

This is property held for use in the production or supply of goods or services or for administrative
purposes, and thus is not investment property.

IAS 40 points out, however, that some properties comprise a portion that is held for rentals and/
or capital appreciation and another portion that is owner-occupied.

If these portions could be sold separately, (or leased out separately under a finance lease) an
entity accounts for the portions separately. If the portions cannot be sold separately, the property
is an investment property only if an insignificant portion is held for use in the production or supply
of goods or services or for administration purposes.

The term “insignificant” is not defined and is left to subjective judgement. However, in other
Standards, indications are that 2% may be an applicable level.

In the case of groups of companies, where one group member leases a property to another
group member, then at group or consolidation level, the property is classified as owner occupied.
However, at an individual company level, the owner of the property should treat it as an investment
property. Thus, appropriate adjustments would need to be made in the group accounts.

K. DISPOSALS
Gains or losses on disposal are calculated in the usual way, i.e.
• Net Disposal Proceeds
• Less Carrying Amount of the Asset

Such gains or losses should be recognised in the Statement of Comprehensive Income, in the
period of the disposal, (unless IAS 17 requires otherwise on a sale or leaseback).

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L. DISCLOSURE REQUIREMENTS: FAIR VALUE MODEL AND COST MODEL
The following must be disclosed:

• Whether the fair value model or cost model has been applied.
• If it applies the fair value model, whether, and in what circumstances, property held under
operating leases are classified and accounted for as investment property.

• If classification is difficult, the criteria used to distinguish investment property from owner
occupied property.
• The methods and assumptions applied in determining fair value.
• The extent to which the fair value is based on a valuation by an independent, qualified,
experienced valuer. If there has been no such valuation, this fact must be disclosed.
• The amounts recognised in profit or loss for:

• Rental income from investment property

• Direct expenses arising from investment property that generated rental income for
the period
• Direct expenses from investment property that did not generate rental income for
the period
• The existence and amounts of restrictions on the realisability of investment property or the
remittance of income and proceeds of disposal
• Contractual obligations to purchase, construct or develop investment property or for repairs,
maintenance or enhancements.

Fair Value Model

In addition to the disclosures required above, if the fair value model is being applied the entity
must also
disclose a reconciliation between the carrying amount of investment property at the beginning
and end of the period, showing:
• Additions
• Additions resulting from acquisitions through business combinations
• Assets classified as held for sale
• Net gains or losses from fair value adjustments
• Net exchange differences on translating foreign investment property
• Transfers to and from inventories and owner-occupied properties
• Other changes

Cost Model
If the cost model is being applied, the entity must disclose, in addition to other disclosures
mentioned above:
• The depreciation methods used
• The useful lives or depreciation rates used
• The gross carrying amount and the accumulated depreciation (including any impairment
losses) at the beginning and end of the period
• A reconciliation of the carrying amount at the beginning and end of the period, showing:

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 • Additions
• Additions resulting from acquisitions through business combinations
• Assets classified as held for sale
• Depreciation
• Impairment losses
• Net exchange differences on translating foreign investment property

• Transfers to and from inventories and owner occupied property

• Other changes
• The fair value of investment property. If it cannot determine fair value reliably, it must disclose

• A description of the investment property

• An explanation of why fair value cannot be determined reliably
• If possible, the range of estimates within which fair value is highly likely to lie

INTANGIBLE ASSETS IAS 38

A. OBJECTIVE
To outline the accounting treatment for intangible assets that are not dealt with specifically in
another standard.

B. EXCLUSIONS
IAS 38 does not apply to:

• Intangible assets that are within the scope of another standard

• Financial assets, as defined in IAS 39 Financial Instruments: Recognition and Measurement
• Mineral rights and expenditure on the exploration and extraction of oil, gas, minerals, etc.

C. DEFINITION
An intangible asset is an identifiable non-monetary asset without physical substance. Examples
of such assets, which come within the scope of IAS 38 are:

• Brand Names
• Mastheads and Publishing Titles
• Computer Software
• Licences and Franchises
• Copyrights and Patents

To be considered identifiable, the intangible asset:

• Must be separable, i.e. it is capable of being separated or divided from the entity and sold,
transferred, licensed, rented or exchanged, either individually or together with a related
contract, asset or liability;

66 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 or
• Arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations

In addition, the ability of the entity to control an asset is important in determining whether to
recognise that asset in the accounts. An entity controls an asset if it has the power to obtain the
future economic benefits flowing from that asset and also restrict the access of others to those
benefits.
Usually, the ability to control these benefits derives from enforceable legal rights, but IAS 38
recognises that there are potentially other ways to control these benefits, though admittedly it
is more difficult to demonstrate control in the absence of legal rights. An example given in the
Framework for the Preparation and Presentation of Financial Statements of such a situation is
know-how obtained from a development activity which may meet the definition of an asset when,
by keeping that know-how secret, an entity controls the benefits that are expected to flow from it.

D. ACCOUNTING TREATMENT
IAS 38 requires that intangible assets be recognised at cost in the financial statements if:

• It is probable that future economic benefits attributable to the asset will flow to the
organisation, and
• The cost of the asset can be measured reliably.

The cost of the asset refers to the amount of cash or cash equivalents paid or the fair value of
other consideration given (e.g. equity shares) to acquire an asset at the time of its acquisition.

The cost of separately acquired intangible assets comprises:

• Purchase price (including irrecoverable taxes / duties less discounts and rebates) and
• Directly attributable costs of preparing the asset for use (these can include items such as
professional fees, costs of testing and employees’ benefits)

However, the following costs cannot be included:

• Costs of introducing new products / services such as advertising

• Costs of conducting new business
• Administration costs
• Costs incurred while an asset that is ready for use is awaiting deployment
• Initial operating losses incurred from an operation.

[Note: if the intangible asset is acquired in an acquisition, then the fair value of the asset at the
date of acquisition is used in accounting for the business combination.]

The fair value of an asset is the amount for which that asset could be exchanged between
knowledgeable, willing parties in an arm’s length transaction.

The fair value is easy to determine if there is an active market for the asset type. If an active
market does not exist, then the fair value will have to be estimated. In determining this amount
the entity should consider the outcome of recent transactions for similar assets. An active

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market is a market in which all the following conditions exist:

• The items traded in the market are homogenous

• Willing buyers and sellers can normally be found at any time
• Prices are available to the public

E. ACQUISITION BY GOVERNMENT GRANT

There may be situations where an intangible asset may be acquired free of charge through a
government grant, e.g. licences for Radio/TV stations.
The entity may choose to recognise both the intangible asset and the grant initially at fair value.
This would be in accordance with IAS 20.

Alternatively, the entity can recognise the asset initially at a nominal amount plus any expenditure
that is directly attributable to preparing the asset for its intended use.

F. EXCHANGE OF ASSETS
An intangible asset may be acquired for a non-monetary asset or assets, or by way of a
combination of monetary and non-monetary assets.

The cost of such an intangible asset is measured at fair value unless:

• The exchange lacks commercial substance, or

• The fair value of neither the asset given or received can be measured reliably

If the acquired asset is not measured at fair value, its cost is measured at the carrying amount
of the asset given up.

G. INTERNALLY GENERATED GOODWILL

[There will be a fuller description of the treatment of goodwill elsewhere in this book.] Internally
generated goodwill should not be recognised in the financial statements.
This is because it is not an identifiable resource controlled by the company that can be measured
reliably at cost.

H. INTERNALLY GENERATED INTANGIBLE ASSETS

IAS 38 points out that the recognition of internally generated intangible assets may be problematic
because of difficulties in:

• Determining whether and when the asset will generate future economic benefits, and
• Determining the cost of the asset reliably

The standard does not prohibit, per se, the recognition of internally generated intangible assets
but it does specifically mention that internally generated brands, publishing titles, customer lists
and items similar in substance shall not be recognised as intangible assets.

This is because expenditure on these items cannot be distinguished from the cost of developing
the business as a whole.
To determine whether an internally generated intangible asset should be recognised, IAS 38
says that the entity should classify the generation of the asset into:

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 • research phase, and
• A development phase.

Research and development activities are aimed at the development of knowledge. Therefore,
although these activities may result in an asset with physical substance (e.g. a prototype),
the physical element of the asset is secondary to its intangible component, i.e. the knowledge
embodied in it.

I. RESEARCH
Research is original and planned investigation undertaken with the prospect of gaining new
scientific or technical knowledge and understanding.

Research expenditure must be recognised as an expense in the Statement of Comprehensive

Income when it is incurred, i.e. it cannot be capitalised. This is because, in this phase of a
project, it cannot be demonstrated that an intangible asset exists that will generate probable
future economic benefits.

IAS 38 provides examples of research activities:

• Activities aimed at obtaining new knowledge

• The search for alternatives for materials, devices, products, processes, systems or services
• The design or evaluation of possible alternatives for new or improved materials, devices,
products, processes, systems or services.

J. DEVELOPMENT
Development is the application of research findings or other knowledge to a plan or design for the
production of new or substantially improved materials, devices, products, processes, systems or
services before the start of commercial production or use.

An intangible asset arising from development shall be recognised if, and only if, an entity can
demonstrate all of the following:

• Probable future economic benefits will be generated by the asset

• Intention to complete and use or sell the asset
• Resources exist to complete the development and to use/sell the asset
• Ability to use or sell the asset
• Technical feasibility of completing the asset so that it will be available for use or sale
• Expenditure attributable to the development of the asset can be measured reliable

The cost of an internally generated intangible asset is the total expenditure incurred from the
date when the intangible asset first meets the recognition criteria.

This cost includes all directly attributable costs necessary to create, produce and prepare the
asset to be capable of operating in the manner intended by management. For example:

• Costs of materials/services uses

• Fees to register a legal right
• Amortisation of patents and licences used to generate the intangible asset

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Note that expenditure on an intangible item that was initially recognised as an expense cannot
be recognised as part of the cost of an intangible asset at a later date, i.e. such an expense
cannot be re-instated as an asset at a later date.

IAS 38 provides examples of development activities:

• Design, construction and testing of prototypes and models

• Design of tools, moulds and dies involving new technology
• Design, construction and testing of a chosen alternative for new or improved materials,
devices, products, processes, systems or services.

If the two phases cannot be distinguished, then the entire expenditure is classified as research.

A project can very often commence with a research phase and subsequently evolve into a
development phase. In this situation, it will be necessary to determine at what point in time
the project has entered into this development stage. Expenditure incurred up to this point must
be expensed in the Statement of Comprehensive Income and expenditure after this point can be
capitalised as an intangible asset (assuming the afore-mentioned conditions apply).

Using hindsight to capitalise the entire expenditure in not allowed. Research expenditure must
be expensed when incurred and IAS 38 does not allow the re-instatement of previously written
off costs. In addition, it is not permissible to accumulate costs in an account and then consider
the nature of the entire project only when preparing the year end financial statements.

K. MEASUREMENT OF INTANGIBLE ASSETS AFTER RECOGNITION

After initial recognition, an intangible asset should be valued using either:

• Cost Model, or
• Revaluation Model

L. COST MODEL
The intangible asset should be carried at: Cost
Less Accumulated Amortisation

Less Accumulated Impairment Losses

M. REVALUATION MODEL
The intangible asset should be carried at:

• Revalued Amount (i.e. fair value at date of revaluation)

• Less Any Subsequent Accumulated Amortisation
• Less Any Subsequent Accumulated Impairment Losses

The “fair value” should be determined by reference to an active market. If there is no active
market for the asset, it cannot be revalued. Thus, the revaluation model would be inappropriate
in this case.
An active market is one in which:
• The items traded are homogenous
• Willing buyers and sellers can be found at any time
• Prices are available to the public.
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As a result of this definition of an active market, the revaluation model is not a realistically usable
model. Intangible assets such as brands, trademarks, film titles, copyright etc. are unique and
cannot be considered homogenous.

If a revaluation policy is used, the revaluation should be carried out regularly so that the fair value
of the asset does not differ materially from its carrying amount at the Statement of Financial
Position date.

This means that the frequency with which an intangible asset is revalued depends on the volatility
of the fair values of the asset. Accordingly, some intangible assets will be revalued on an annual
basis while others may show only insignificant movements in fair value, thereby necessitating
less frequent revaluations.

If an intangible asset shows a revaluation gain, that gain should be credited to reserves.
However, if the gain reverses a previous revaluation loss of the same asset, and that loss was
recognised in the Statement of Comprehensive Income, then the present gain shall be credited
to the Statement of Comprehensive Income, with any excess going to reserves.

If the intangible asset shows a revaluation loss, that loss shall be recognised in the Statement of
Comprehensive Income. However, if the loss reverses a previous revaluation gain of the same
asset, and that gain was credited to reserves, the loss should be debited to reserves to the extent
of any credit balance in the revaluation surplus in respect of that asset.

[The cumulative revaluation surplus included in equity may be transferred directly to retained
earnings on disposal or retirement of the asset. Alternatively, some of the surplus may be realised
as the asset is used by the entity.

The transfer from revaluation surplus to retained earnings is not made through the Statement of
Comprehensive Income but through the Statement of Changes in Equity.]

Example
T. Cabs Ltd. owns a freely transferable taxi operators licence, which it acquired on 1st January
2009, at an initial cost of RWF20,000. The useful life of the licence is 5 years (its valid life).
Straight line amortisation is used. Licences such as these are traded frequently between both
existing operators and new entrants to the industry. At the year end 31st December 2010, the
traded value of a licence was now 240,000 as a result of an increase in taxi fares announced by
the Taxi Regulator.

The journal entries to be recorded are as follows: RWF RWF

Debit Accumulated Amortisation 8,000

Credit Intangible Asset 8,000

(Being the elimination of accumulated depreciation against the cost of the asset)
Debit Intangible asset – cost 12,000
Credit Revaluation reserve 12,000
(Being uplift of net book value to revalued amount)
The asset now has a revised carrying amount of RWF24,000 (20,000 – 8,000 + 12,000)

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N. USEFUL LIFE
IAS 38 states that an entity should assess the useful life of an intangible asset. In particular,
whether that useful life is:

• Finite, or
• Indefinite

All relevant factors must be considered in assessing the lifespan of an intangible asset, for
example:

• Product life cycles

• Industry stability
• Likely actions by competitors
• Legal restrictions
• Whether the useful life is dependent on the useful life of other assets

Note that “indefinite” does not mean “infinite”.

An intangible asset with a finite life should be amortised over its estimated useful life. Such
amortisation is usually on a straight-line basis and no residual value is provided for unless:

• There is a commitment by a third party to purchase the asset at the end of its useful life, or
• There is an active market for the asset and:

• The residual value can be determined by reference to that market and

• It is probable that such a market will exist at the end of the asset’s useful life.

Amortisation of an intangible asset with a finite life commences when the asset is available for
use and will cease when the asset is derecognised or when the asset is classified as held for
sale, whichever is earlier.
The amortisation of an intangible asset is usually recognised in the profit or loss for
the period. The amortisation period and method should be reviewed on an annual basis, and
changed if necessary.
If an intangible asset is deemed to have an indefinite life, that asset should not be amortised.
However, it should be tested for impairment annually and whenever there is an indication that
the asset may be impaired.

The asset is said to have an indefinite life if there is no foreseeable limit to the periods over which
the asset is expected to generate net cash inflows.

If a change occurs, resulting in an intangible asset with a heretofore indefinite life becoming an
asset with a finite life, such an alteration is considered to be a change in estimate (IAS 8) and
thus does not require a prior year adjustment.

O. DISPOSALS AND RETIREMENTS

An intangible asset should be derecognised:

• On disposal, or
• When no future economic benefits are expected.

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Any gain or loss on de-recognition should be calculated and included in the profit or loss for
period.

P. DISCLOSURE REQUIREMENTS
The disclosure requirements for intangible assets are extensive.

The entity must disclose the following for each class of intangible assets, distinguishing between
internally generated intangible assets and other intangible assets:

• Whether the useful lives are indefinite or finite and, if finite, the useful lives or the amortisation
rates used.
• The amortisation methods used for intangible assets with finite useful lives.
• The gross carrying amount and any accumulated amortisation (aggregated with accumulated
impairment losses) at the beginning and end of the period
• The line item(s) of the Statement of Comprehensive Income in which any amortisation of
intangible assets is included
• A reconciliation of the carrying amount at the beginning and end of the period showing:

• Additions, indicating separately those from internal development, those acquired

separately and those acquired through business combinations
• Assets classified as held for resale under IFRS 5
• Increases or decreases in the period arising from revaluations and impairment
losses recognised or reversed directly in equity under IAS 36
• Impairment losses recognised in profit or loss during the period under IAS 36
• Impairment losses reversed in profit or loss during the period under IAS 36
• Any amortisation recognised in the period
• Exchange differences (net) arising on the translation of the financial statements of a
foreign operation
• Other changes during the period

An entity must also disclose:

• For an asset assessed as having an indefinite useful life, the carrying amount of that asset
and reasons supporting the assessment of an indefinite useful life
• The amount of contractual commitments for the acquisition of intangible assets
• The aggregate amount of research and development expenditure recognised as an expense
during the period
• Details of revaluations
• The existence and carrying amounts of assets whose title is restricted and the carrying
amounts of assets pledged as security for liabilities

The entity is encouraged, but not required, to disclose:

• A description of any fully amortised intangible asset that is still in use, and
• A brief description of significant intangible assets controlled by the entity but not recognised as
assets because they did not meet the recognition criteria in the standard or because they were
acquired or generated before the version of IAS 38 issued in 1998 was effective.
CPA EXAMINATION I1.2 FINANCIAL REPORTING 73
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Q. ASSETS WITH BOTH TANGIBLE AND INTANGIBLE ELEMENTS
IAS 38 recognises that some intangible assets may be contained in or on a physical substance
such as a compact disc (in the case of computer software), legal documentation (in the case of
a licence or patent) or film.

It must then be determined whether an asset that incorporates both intangible and tangible
elements should be treated under IAS 16 Property, Plant and Equipment or under IAS 38
Intangible Assets. In order to resolve this issue, the entity must use judgement to assess which
element is more significant.

For example, computer software for a computer-controlled machine tool that cannot operate
without that specific software is an integral part of the related hardware and it is treated as
Property, Plant and Equipment. The same applies to the operating system of a computer.

But when the software is not an integral part of the related hardware, computer software is
treated as an intangible asset.

R. WEBSITE DEVELOPMENT COSTS

In most modern business environments, websites now exist which introduce the products /
services of the entity to the market. A website has many of the features of both a tangible and
intangible asset and SIC 32 Intangible Assets – Website Costs was issued to deal with the
accounting issues surrounding web site costs.

SIC 32 states that a website that has been developed for the purposes of promoting and
advertising an entity’s products and services does not meet the criteria for the capitalisation of
costs under IAS 38. Therefore, costs incurred in setting up such websites should be expensed.

S. QUESTIONS
Example 1
H. Ltd. develops and manufactures exhaust systems. The company has 3 projects in hand on
30th June 2010; A1, B2 & C3. The details for each are as follows:
A1 B2 C3
RWF’000 RWF’000 RWF’000
Deferred development expenditure at 1st July 1,080 1,500 -
2009
Development expenditure incurred in year ended
30th June 2010:
Wages and Salaries 180 - 120
Material 30 - 24
Overheads 9 - 18

Project A1
All expenditure on this project was capitalised until 30th June 2009 as the conditions necessary
for capitalisation, as laid down by IAS 38, were present. However, during the current year, the
future profitability of the project became doubtful due to previously unforeseen competitive
pressures.

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Project B2
All expenditure on this project was incurred and deferred prior to the current year. Commercial
production began in September 2009. Actual and estimated sales from year end 30th June 2010
to 30th June 2013 are as follows:
30th June 2010 800,000 units
30th June 2011 2,400,000 units
30th June 2012 3,600,000 units
30th June 2013 400,000 units
The directors believe it to be imprudent to defer any expenditure beyond 30th June 2013.

Project C3
This project only commenced in the year under review and appears to satisfy the criteria for
deferral.

REQUIREMENT:
Show how the above 3 projects would affect the financial statements of H. Ltd. for the year ended
30th June 2010

SOLUTION
Project A1
The balance brought forward at the start of the year and all the expenditure incurred during the
year ended 30th
June 2010 must be written off, as the conditions for deferral no longer apply. Thus, write off
RWF1,299,000.

Project B2
Since commercial production has commenced and revenue is now flowing from the sale of the
units, it is now appropriate to amortise the deferred development expenditure too. This means
that costs and revenues from the project will be “matched”. IAS 38 states that development
expenditure should be amortised on a systematic basis to reflect the pattern in which the assets
future economic benefits are expected to be consumed by the entity (or on a straight line basis
if no consumption pattern is evident).

Units Development expenditure to I/S

30th June 2010 800,000 1,500 x (800/7,200) = 167

30th June 2011 2,400,000 1,500 x (2,400/7,200) = 500
30th June 2012 3,600,000 1,500 x (3,600/7,200) = 750
30th June 2013 400,000 1,500 x (400/7,200) = 83
Total 7,200,000

Project C3
The expenditure incurred during the year ended 30th June 2010 can be capitalised. Thus,
show RWF162,000 as an intangible asset in the financial statements.

STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 30TH JUNE 2010
RWF
Amortisation of development expenditure 167,000
Development Expenditure written off 1,299,000

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STATEMENT OF FINANCIAL POSITION AT 30TH JUNE 2010

Non-Current Assets RWF

Development Expenditure (1,500 + 162 – 167) 1,495,000

Example 2
In a major shift in the focus of operations, OFA.Ltd plans to sell its products through the internet.
During 2009,
the company purchased a domain name for RWF30,000 from an individual who had previously
registered it.

How should the cost of acquiring the domain name be accounted for in the financial statements
for the year ended 31st December 2009?

SOLUTION
The issue to be resolved here is whether the cost of acquiring the domain name should be
capitalised as an asset
or written off as an expense. One argument is that since the payment was made with the
expectation that the organisation would generate future economic benefits from conducting its
business through the new website, it qualifies as an asset and should therefore be capitalised.
However, similar arguments apply to other costs such as advertising and marketing expenditure,
which are not allowed to be capitalised.

The payment is certainly not an identifiable asset in its own right, since the payment made by
OFA Ltd. was solely to facilitate carrying out its own business, albeit through the internet. OFA
Ltd. could choose not to acquire its domain name, but this in itself would not prevent the company
from trading through the net, as it could always register another name.

The only advantage of trading through the internet using the same name is to enable OFA Ltd.
to exploit its existing presence in the marketplace. The real economic benefit to the organisation
comes not from the name registration but from the internally generated brand that OFA Ltd has
already developed. It is also doubtful that the name could be separately marketable, since it is
unlikely to have any value to a third party.

On this basis, the payment for the name is effectively a one-off cost that OFA Ltd. has incurred to
remove an obstacle to conducting business through the internet. An analogy would be a payment
to the Office of Registrar General for registering the OFA Ltd name.
It is, therefore, very much in the nature of a pre-operating cost that should be written off to the
Statement of Comprehensive Income in the year it is incurred.

INVENTORIES IAS 2
OBJECTIVE
IAS 2 sets out the accounting treatment for inventories. For many entities, closing inventory can
be a highly significant figure and is used in the calculation of profit and also shown as a current
asset in the Statement of Financial Position.

Thus, the main issue addressed in IAS 2 is the establishing of the amount of cost that should be
recognised in the accounts.

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The standard applies to all inventories with the exception of:

• Work in progress arising under construction contracts

• Financial instruments
• Biological Assets related to agricultural activity

B. DEFINITIONS
Inventories are assets:

• Held for sale in the ordinary course of business; or

• In the process of production for such sale; or
• In the form of materials or supplies to be consumed in the production process or in the
rendering of services.

C. MEASUREMENT
Inventories should be measured at the lower of cost and net realisable value.
Cost should comprise:
Costs of purchase + Costs of conversion + Other costs incurred in bringing the inventories to
their present location and condition

Net Realisable Value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.

The costs of purchase include the purchase price, import duties (and other taxes not recoverable
by the entity), transport and handling costs and any other directly attributable costs. However,
note that trade discounts, rebates and other similar items must be deducted.

The costs of conversion include costs that are directly related to the units of production e.g. direct
labour, direct expenses, work subcontracted to third parties. They also include a systematic
allocation of fixed and variable overheads. When allocating such overheads, the overheads must
be based on normal level of activity.

The other costs mentioned above are any other costs incurred in bringing the inventory to its
present condition and location.

The standard mentions other costs which must be excluded from the cost of inventories.
These are:

• Abnormal amounts of wasted materials, labour and other production costs

• Storage costs (unless necessary in the production process before a further production stage)

• Administration overheads which do not contribute to bringing inventories to their present

condition and location
• Selling costs

Instead, these costs are to be charged as expenses in the period they are incurred. In relation
to Net Realisable Value, the standard makes the following points:

• Inventories may have to be written down below cost to NRV if the item becomes damaged,
obsolete or if the selling price has declined

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 • Inventories are normally written down to NRV, in such circumstances, on an item-by-
item basis, although it may be appropriate to group similar or related items, in some cases
• Estimates of the NRV are based on the most reliable estimate, at the time estimates are
made, of the amount the inventory is expected to realise
• A new assessment of NRV is made in each subsequent period

If the circumstances which caused inventories to be written down below cost no longer apply,
the amount of the write-down is reversed.

Example:
Value the following items of inventory (each relating to separate entities)

(a) A consignment of goods purchased three weeks before the year-end for RWF20,000 was
subsequently damaged in an accident. The original estimated selling price of these goods was
RWF27,000. However, in order to make the goods ready for sale, remedial work costing RWF4,500
needs to be carried out, after which the goods will be sold for RWF23,000.

(b) Materials were purchased for RWF18,000. Since these items were purchased, a new competitor
has entered the market, forcing down the cost of supplies. The cost price of the goods has fallen
to RWF15,000. The goods are expected to be sold for RWF25,000.

(c) For operational reasons, an entity could not carry out its annual stocktake until five days after the
year-end.
At this date, stock on the premises was RWF20 million at cost. Between the year-end and the
stocktake, the following transactions were identified:

• Normal sales at a mark-up on cost of 30%, RWF1,560,000

• Sales on a sale or return basis at a margin of 20%, RWF930,000
• Goods received at cost, RWF780,000

Solution:

(a) Cost of goods RWF20,000

NRV (RWF23,000 – RWF4,500) RWF18,500
Goods should be included in inventory at RWF18,500

(b) Cost of goods RWF18,000

NRV RWF25,000

Goods should be included in inventory at RWF18,000

Note that the new replacement cost of RWF15,000 is irrelevant. ment cost is ignored.
The replace

(c) RWF
Cost of goods per stocktake 20,000,000
Add: Cost of items sold between year end and stocktake
Normal sales 1,200,000

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 Sale or return 744,000

Less: Cost of items purchased between year end and stocktake (780,000)
Cost of goods 21,164,000
If the cost is less than the NRV, value at RWF21,164,000

D. VALUATION METHODS
IAS 2 states that the cost of inventories should be arrived at using:

• First In First Out (FIFO); or

• Weighted Average Cost

The same cost formula should be used for all inventories having a similar nature and use.
If the inventories are not interchangeable, they should be valued using specific identification of
their individual costs.

E. DISCLOSURE
The following should be disclosed:

• The accounting policy

• The total carrying amount of inventories, classified as appropriate
• Carrying amount of inventories carried at fair value less costs to sell
• Amount of any write-downs
• Amount of any write-down reversals

• Details of the reasons why the reversal occurred

• Carrying amount of any inventories pledged as security for liabilities

Example
CD Ltd. Manufactures bicycles and in its most recent financial year, the costs associated with
this were as follows:

RWF
Materials 15,000
Labour 10,000
Machinery depreciation 5,000
Factory rates 5,000
Sundry Factory Expenses 12,000
Selling expenses 4,000
Head Office expenses 18,000
Total 69,000

At the end of the year, there are 500 bicycles in stock. The value placed on these should be as
follows:
Materials 15,000
Labour 10,000
Machinery depreciation 5,000

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 Factory rates 5,000
Sundry factory expenses 12,000
47,000
20,000 units were produced.
Thus, the cost per unit is RWF47,000/20,000, i.e. €2.35. Closing Inventory is 500 units x
RWF2.35 = RWF1,175.
Example
SD Ltd. manufactures footballs. The following information is available regarding the cost of its
finished goods, currently in inventory.

Direct Materials RWF1.50 per unit

Direct Labour RWF1.00 per unit
Direct expenses RWF0.75 per unit
Production overhead for the year RWF800,000
Administration overhead for the year RWF200,000
Selling Overhead for the year RWF400,000
Interest for the year RWF100,000

There are 10,000 units in inventory at the year end. Normal production is 1,000,000 units per
year, but due to ongoing industrial unrest during the year, actual production was only 500,000
units.
Therefore, the goods in inventory at the year end should be valued at:

Direct materials RWF1.50

Direct labour RWF1.00
Direct expenses RWF0.75
Prime cost RWF3.25
Production overhead (RWF800,000/1,000,000) RWF0.80
Cost per unit RWF4.05

Thus, 10,000 units x RWF4.05 = RWF405,000 should be shown in the accounts as closing
inventory. RWF10,000
Note that both options have the same impact on the profit or loss for the period.

E. REPAYMENT OF GOVERNMENT GRANTS

If the grant becomes repayable, for example its prescribed conditions are not subsequently met
by the entity, then it should be treated as a revision of an accounting estimate.

Repayment of a grant related to an asset should be recorded by increasing the carrying amount
of the asset or reducing the deferred income balance by the amount repayable. The total extra
depreciation that would have been recognised to date as an expense, if the grant had not been
received, should be recognised immediately as an expense.
Repayment of a grant related to income should be first set against any unamortised deferred
credit in relation to the grant. If the repayment exceeds the amount of that deferred credit, or
if no deferred credit existed in the first place, the excess should be recognised as an expense
immediately.

Example:
F.Ltd. qualified for a grant of RWF80 million to construct and manage a windmill in an
economically
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disadvantaged area near Butare. It is estimated that the windmill would cost RWF150 million
to build. The grant stipulates that F.Ltd must employ labour from the locality in the construction
and going forward, must maintain a 1:1 ratio of local to outside labour for the next 7 years. The
windmill will be depreciated on a straight line basis over 10 years.

Therefore, the grant received by F.Ltd will also be recognised over a 10 year period. In each of
the 10 years, the grant will be recognised in proportion to the annual depreciation of the windmill.
This means that RWF8 million per annum will be recognised as income in each of the 10 years.

Additionally, the condition to maintain the local workforce at the levels stipulated needs to be
disclosed. This contingency would have to be disclosed for the next 7 years (during which period
the condition is in force). This will also meet the requirements of IAS 37.

F. DISCLOSURE
The following must be disclosed:
• The accounting policy adopted for government grants, including the methods of presentation
adopted in the financial statements.
• The nature and the extent of government grants recognised in the financial statements and
an indication of other forms of government assistance from which the entity has directly
benefited.
• Unfulfilled conditions and other contingencies attaching to government assistance that
has been recognised.
G. SUNDRY MATTERS
Examples of government assistance that cannot reasonably have a value placed upon them are:

• Free technical advice

• Free marketing advice
• Provision of guarantees

Thus, these are excluded from the definition of government grants and should not be treated
as such. Furthermore, entities may receive government assistance which is not specifically
related to their operatingactivities. For example, transfers of resources to entities operating in an
underdeveloped area.

SIC 10 states that such forms of assistance do constitute grants and should be accounted for in
accordance with IAS 20. This is because the grants received are conditional upon the recipient
operating in a particular industry or area.
Finally, if a grant is received in relation to an asset that is not depreciated, then the grant should
be amortised over the period in which the cost of meeting the obligations or conditions attached
to the grant is incurred.

PROVISIONS, CONTINGENT LIABILITIES & CONTINGENT ASSETS 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.

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B. PROVISIONS
The IASB recognised the need for detailing specific rules regarding the creation of provisions.
Without such rules, it would be possible for entities to mislead the users of accounts, whether
unintentionally or deliberately.

For example, an entity might engage in profit-smoothing. It might create a provision in years
where profits are high (thereby artificially reducing profits) and subsequently reverse those
provisions in years where profits are low (thereby artificially increasing profits).

Thus, IAS 37 states that provisions can only be made where there are valid grounds for their
creation.

C. DEFINITIONS
A provision is a liability of uncertain timing or amount.
A liability is a present obligation arising from past events, the settlement of which is expected to
result in an outflow from the entity of resources embodying economic benefits.

Provisions differ from other liabilities because of their uncertainty.

In order for a provision to be recognised in the financial statements, all the following conditions
must be met:

• There is a present obligation as a result of a past event. [This obligation can be legal or
constructive.]
• It is probable that a transfer of economic benefits will be required to settle the obligation.
• A reliable estimate can be made of the obligation.

If all three conditions are met, then a provision can be created. Generally this is done by:

• Dr Expense (in Statement of Comprehensive Income)

• Cr Provision (liability in the Statement of Financial Position)

When the obligation is discharged in the future, the liability is removed from the Statement of
Financial
Position, or indeed, more information may become available requiring the provision to be
adjusted.

It is necessary to take a closer look at the conditions for creating a provision, and in particular
the terminology used.

Firstly, an obligation is a past event that creates a legal or constructive obligation that results in
an enterprise having no realistic alternative to settling that obligation.
The absence of a realistic alternative is critical in determining the validity of the provision. As
stated above, the obligation can be legal or constructive.

A legal obligation is an obligation that derives from:

• A contract
• Legislation
• Other operation of law

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A constructive obligation is one that derives from an entity’s actions where:

• By an established pattern of past practice, published policies or a sufficiently current

statement, the entity has indicated to other parties that it will accept certain responsibilities;
and
• As a result, the entity has created a valid expectation on the part of those other parties that it
will discharge those responsibilities.

In relation to the transfer of economic benefits, such a transfer is considered probable if it is more
likely than not to occur, i.e. there is a greater than 50% chance of such a transfer will arise.

IAS 37 states that the amount recognised as a provision should be the best estimate of the
expenditure required to settle the present obligation at the Statement of Financial Position date.

Such estimates are determined by the judgement of management, who will use their experience
of similar transactions and, if necessary, reports from independent experts.

In cases where there is a range of possible outcomes, management can use the “expected
value” statistical method.

Risks and uncertainties surrounding events and circumstances should be considered in arriving
at the best estimate of a provision.
If a group of items is being measured, it is the “expected value”.
If a single obligation is being measured, it is the “most likely outcome”.

Example:
A company sells goods with a warranty for parts and labour after sales, for any manufacturing defects.
Past experience indicates the following:
75% of goods had no defect
20% of the goods had a minor defect
5% of the goods had a major defect

The average cost of repairing items has been:

RWF30 for a minor defect
RWF150 for a major defect

Management expect past trends and costs to continue. They sold 100,000 units in the period.
Can a provision be created for the cost of repairs?
Is there a present obligation as a result of a past event? Yes, there is a legal contract as a result
of the warranty given to customers.

Is it probable that a transfer of economic benefits will be required to settle the obligation? Yes,
repairing items have a cost that must be met.

Can a reliable estimate be made of the obligation? Yes, using expected value it can be calculated
as follows:

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 RWF
100,000 units x 75% x RWF0 = Nil
100,000 units x 20% x RWF30 = 600,000
100,000 units x 5% x RWF150 = 750,000
1,350,000

Thus the company should create a provision in the amount of RWF1,350,000 for the estimated
future cost of repairing items.

In calculating the amount of a provision, where the effect of the time value of money is material,
the provision should be the present value of the expenditure required to settle the obligation.

The discount rate in calculating the present value should be appropriate to the company, i.e.
reflect current market assessments of the time value of money and the risks specific to the
liability.

The discount rate to be used in calculating the present value should be the pre-tax discount rate
that reflects current market assessments of time value of money and the risks specific to the
liability.

Note that gains from the expected disposal of assets should not be taken into account in
measuring a provision.

If some or all of the expenditure required to settle a provision is expected to be reimbursed

by another party (for example, through insurance contracts, indemnity clauses or suppliers
warranties), this reimbursement should be recognised when and only when it is virtually certain
to be received.

The reimbursement should be treated as a separate asset in the Statement of Financial Position,
but may be netted against the related provision expense in the Statement of Comprehensive
Income.

Provisions should be reviewed at each Statement of Financial Position date and adjusted if
necessary. If it is no longer appropriate for the provision to continue, then it should be reversed.

Provisions should not be created for future operating losses. This is because they do not meet
the definition of a liability, as set out earlier. [However, expected future losses may suggest that
assets are impaired and so the entity should test the assets for impairment under IAS 36.]

D. RESTRUCTURING
If the entity is to embark on a restructuring programme (for example, closure of business locations,
sale of a business division, changes in management structure) expected future costs of that
restructuring can be provided for if the entity:

• Has a detailed formal plan

• Has communicated the plan to those affected by it, thus creating a valid expectation that the
restructuring will be carried out.

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This plan should outline at least:

• The business or part of the business being restructured

• The principal locations affected by the restructuring
• The location, function and approximate number of employees who will be compensated for
terminating their employment
• When the plan will be implemented
• The expenditure that will be undertaken.

E. ONEROUS CONTRACT
An onerous contract is a contract in which the unavoidable costs of meeting the obligations
under the contract exceed the economic benefits expected to be received under it.

The unavoidable costs are the lower of the cost of fulfilling the contract and any penalties arising
from failure to fulfil it.

Onerous contracts should be recognised and treated as a provision.

F. CONTINGENT LIABILITIES
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 recognised because:

• It is not probable that a transfer of economic benefits will be required to settle the
obligation; or
• The amount of the obligation cannot be measured reliably.

An entity should not recognise a contingent liability in the financial statements. However, it should
disclose the following:

• Description of the contingent liability

• An estimate of its financial effect
• An indication of the uncertainties relating to the amount or timing of the liability
• The possibility of any reimbursement

However, the position of a contingent liability is often fluid. Thus the entity should continually
assess the situation to determine if the status of the contingency should be changed to a provision
or removed altogether from the notes to the financial statements.

G. CONTINGENT ASSETS
A contingent asset is a possible asset that arises from past events and whose existence will be
confirmed only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the entity.

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An example of a contingent asset is a claim that the entity is pursuing through the courts, where
the outcome is uncertain.
Contingent assets should not be recognised in the financial statements. Furthermore, it is only
disclosed in the notes if an inflow of benefits is probable.

However, if the realisation of income is virtually certain, the asset is not a contingent asset any
longer and should be recognised.
Again, contingent assets should be continually reviewed and any change in status should
be recorded appropriately.
In relation to the disclosure of information surrounding provisions, contingent assets and
contingent liabilities, IAS 37 does provide a “let-out” clause.

Paragraph 92 states that where disclosure of such information might seriously prejudice the
position of the entity in a dispute with other parties on the subject matter of the provision,
contingent asset or contingent liability, then the entity need not disclose the information.
In that case, the entity should disclose the nature of the dispute as well as the fact and reason
why the information has not been disclosed.
But Paragraph 92 suggests that such cases will be “extremely rare”.

H. DISCLOSURES
For each class of provision, the following must be disclosed:

• The carrying amount at the beginning and end of the period

• Additional provisions made in the period
• Amounts used (i.e. incurred and charged against the provision) during the period
• Unused amounts reversed during the period
• The increase during the period in the discounted amount arising from the passage of time and
the effect of any change in the discount rate.

Additionally for each class of provision:

• A brief description of the nature of the obligation and the expected timing of any resulting
outflows of economic benefits
• An indication of the uncertainties about the amount or timing of those outflows
• The amount of any expected reimbursement

In relation to contingent liabilities, unless the possibility of settlement is remote, the entity must
disclose:

• A brief description of the nature of the contingent liability

• An estimate of its financial effect
• An indication of the uncertainties relating to the amount or timing of the outflow
• The possibility of a reimbursement

In relation to contingent assets, where an inflow is probable, the entity must disclose:

• A brief description of the nature of the contingent asset; and

• Where practicable, an estimate of their financial effect

In extremely rare cases, disclosures required for provisions, contingent liabilities and contingent

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assets may prejudice seriously the position of the entity in a dispute with other parties on the
subject matter of the provision, contingent asset or contingent liability. In such cases, an entity
need not disclose the information. Instead, it should disclose the general nature of the dispute,
together with the fact that, and the reason why, the information has not been disclosed.

Note in rare cases, it is not clear if there is a present obligation. In these 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 Statement of Financial Position date.

EVENTS AFTER THE REPORTING PERIOD IAS 10

A. OBJECTIVE
It is a fundamental principle of accounting that all available information must be considered when
preparing financial statements. This must include information on relevant events which occur
right up to the date on which the financial statements are authorised for issue.

The purpose of IAS 10 is to outline the circumstances when an entity should adjust its financial
statements for events that occur after the Statement of Financial Position date and also the
disclosures necessary after these events have occurred.

The standard also indicates that if these events after the reporting date suggest that
the going concern assumption is no longer appropriate, then the entity should not prepare its
accounts on the going concern basis.

That is, if management determines that it will liquidate the entity or to cease trading or that it has
no other realistic alternative, then the financial statements should not be prepared on a going
concern basis. Instead, the Statement of Financial Position should be adjusted onto a break-up
basis.

B. DEFINITION
Events after the reporting date are those events, both favourable and unfavourable, that occur
between the reporting date and the date the financial statements are authorised for issue.

Events which occur between these dates may provide information which may help in the
preparation of the statements.
The standard distinguishes between two types of such events.

(a) Adjusting Events

These are events that provide evidence of conditions that existed at the Statement of Financial
Position
date. As their title suggests, the financial statements should be adjusted to reflect these events.

IAS 10 gives examples of what it considers to be adjusting events:

The settlement, after the Statement of Financial Position date, of a court case that confirms that
the entity had a present obligation at the Statement of Financial Position date: The entity will
accordingly adjust any previously recognised provision or create a new one.

The receipt of information after the Statement of Financial Position date indicating that an asset
was impaired at the Statement of Financial Position date, for example:

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 • The bankruptcy of a customer after the Statement of Financial Position date
• The sale of inventories after the Statement of Financial Position date may give evidence about
their net realisable value at the Statement of Financial Position date

The determination after the Statement of Financial Position date of the cost of assets purchased,
or proceeds of assets sold, before the year-end.

The discovery of fraud or errors that show the financial statements are incorrect.

(b) Non-Adjusting Events

These are events that are indicative of conditions that arose after the Statement of Financial
Position date.
As their title would suggest, the entity should not adjust its financial statements to reflect these
events. However, the standard recognises that these events may be relevant to users of the
accounts i.e. the events
could influence the economic decisions that the users make. Thus, if the events are material,
they should be disclosed in the notes to the accounts. The note should detail:

• The nature of the event; and

• An estimate of its financial effect, or a statement that such an estimate cannot be made

IAS 10 gives examples of what it considers to be non-adjusting events:

• A major business combination after the year end or the disposal of a major subsidiary
• Announcing a plan to discontinue an operation
• Major purchases of assets, disposals of assets, expropriation of major assets by
government or classification of assets as held for sale
• Destruction of a major production plant by fire
• Announcing or commencing a major restructuring
• Major ordinary share transactions after the year-end (other than bonus issues, share splits or
reverse share splits, which must be adjusted for)
• Abnormally large change in asset prices or foreign exchange rates after the year-end
• Changes in tax rates/laws
• Commencing major litigation arising solely out of events that occurred after the Statement of
Financial Position date

C. DIVIDENDS
If an entity declares dividends to holders of equity shares after the Statement of Financial Position
date, these dividends cannot be included as a liability at the Statement of Financial Position date.

However, such a declaration is a non-adjusting subsequent event and footnote disclosure is

required, unless immaterial.

This is because the dividends do not meet with the criteria of a present obligation in IAS 37. The
International Accounting Standards Board also discussed whether or not an entity’s past practice
of paying dividends could be considered a constructive obligation and concluded that such
practices do not give rise to a liability to pay dividends. However, the dividends are disclosed in
the notes in accordance with IAS 1.

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D. UPDATING DISCLOSURES
If an entity receives information after the Statement of Financial Position date about conditions
that existed at the Statement of Financial Position date, then the disclosures should be updated
to reflect the new information.

For example, if further information is received concerning a contingent liability that existed at the
Statement of Financial Position date, the disclosures regarding that item as required under IAS
37 will have to be updated.

E. DISCLOSURE
The entity must disclose the date when the financial statements were authorised for issue and
who gave that authorisation. If the financial statements can be amended after issue, this fact
must be disclosed.

F. GOING CONCERN CONSIDERATIONS

If the entity’s financial position deteriorates after the year end to an extent that doubt is cast
on the entity’s ability to continue as a going concern, IAS 10 requires that the entity should not
prepare its financial statements on a going concern basis. If it is management’s intention to
liquidate or cease trading, or that no realistic alternative exists, the accounts should be prepared
on a “break-up basis”. In addition, disclosures prescribed by IAS 1 under such circumstances
should
 also be complied with.

ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES & ER-
RORS IAS 8
A. INTRODUCTION
The Framework for the Preparation and Presentation of Financial Statements, published by
the IASB, identifies “comparability” as one of the four qualitative characteristics of financial
statements. The Framework recognises the importance of comparing both the financial statements
of an entity from one period to another as well as the financial statements of other entities. This
comparison is needed in order to compare and contrast financial performance, financial position
and changes in financial position.

IAS 8 deals with selecting and changing accounting policies, accounting estimates and
errors. Its main objectives are to:

• Enhance the relevance and reliability of financial statements

• Ensure comparability of the financial statements of an entity over time as well as with
financial statements of other entities.

B. DEFINITIONS
Accounting policies are the specific principles, bases, conventions, rules and practices adopted
by an entity in preparing and presenting financial statements.

A change in accounting estimate is an adjustment to the carrying amount of an asset or liability

or the amount of the periodic consumption of an asset that results from the assessment of
the present status of, and expected future benefits and obligations associated with assets and
liabilities. Changes in accounting estimates result from new information or new developments
and, accordingly, are not correction of errors.

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Prior period errors are omissions from, and misstatements in, the entities financial statements
from one or more periods arising from a failure to use, or the misuse of, reliable information that:

• Was available when financial statements for those periods were authorised for issue, and
• Could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of those financial statements

These errors include:

• Effects of mathematical mistakes

• Mistakes in applying accounting policies
• Misinterpretation of facts

Fraud
Retrospective application is applying a new accounting policy to transactions, other events and
conditions as if the policy had always been applied

Retrospective restatement is correcting the recognition, measurement and disclosure of amounts

of elements of financial statements as if a prior period error had never occurred

Prospective application of a change in accounting policy and of recognising the effect of a change
in accounting estimate, respectively, is:
• Applying the new accounting policy to transactions, other events and conditions occurring
after the date as at which the policy is changed, and
• Recognising the effect of the change in the accounting estimate in the current and future
periods affected by the change.

C. ACCOUNTING POLICIES
The existence and proper application of accounting policies are central to the proper understanding
of the information contained in the financial statements, as prepared by management. A clear
outline of all significant accounting policies used in the preparation of financial statements should
be provided in all cases. This is especially important in situations where alternative treatments,
permissible under certain IFRS, are possible. Failure to outline the accounting policy pursued by
the entity in such a situation would compromise the ability of users of the financial statements to
make relevant comparisons with other entities.

Accounting policies are determined by applying relevant IFRS or IFRIC and considering
any relevant implementation guidance issued by the IASB.

Where there is no IFRS or Interpretation that addresses a specific transaction, event

or condition, then management should exercise judgement in developing and applying an
accounting policy that results in information that is relevant and reliable.

Reliable information should:

• Represent faithfully the financial position, financial performance and cash flows
• Reflect the economic substance of transactions, other events and conditions neutral
• Be prudent
• Be complete in all material respects
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In this regard, when exercising such judgement, management should refer to (in this order):-

• The requirements and guidance of the IFRS’s and IFRIC’s dealing with similar and related
issues
• The definitions, recognition criteria and measurement concepts for assets, liabilities and
expenses in the framework

Furthermore, management can also consider (to the extent that they do not conflict with IASB
standards and the Framework):
Recent pronouncements of other standard setting bodies that use a similar conceptual framework
to develop standards,

• Other accounting literature

• Accepted industry practices

D. CHANGES IN ACCOUNTING POLICIES

It is important for users of financial statements to be able to compare the financial statements
of an entity over a period of time in order to identify trends and patterns in its financial position,
financial performance and cash flows. Thus, it is important that there is consistency in the
treatment of items from period to period. To help facilitate this, the same accounting policies are
adopted in each period unless a change in these policies is merited.

The IAS restricts the instance in which a change in accounting policy is permissible. An entity
should change an accounting policy only if the change

• Is required by a Standard or an interpretation; or

• Results in a more appropriate presentation of events or transactions in the financial
statements, that is the financial statements will provide relevant and more reliable information
to the user of the accounts

The standard highlights two types of event that do not result in the change of an accounting
policy:

• The application of an accounting policy for transactions, other events or conditions that
differs in substance from those previously occurring
• The application of a new accounting policy for transactions, other events or conditions that did
not occur previously or were immaterial.

In the case of non-current tangible fixed assets, a move to revaluation accounting will not result
in a change of accounting policy under IAS 8 but a revaluation as per IAS 16.

If a change in accounting policy is required by a Standard or Interpretation, then any transitional

arrangements contained therein must be followed. If no such transitional arrangements are
provided or an accounting policy is being changed voluntarily, the change in accounting policy
must be adopted “retrospectively”. This means that the new policy is applied to transactions,
other events and conditions as if the policy had always been applied.

(Prospective application is not allowed unless it is impracticable to determine the cumulative

effect).

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This consequently means that the comparatives presented in the financial statements must also
be restated, as if the new policy had always been applied. The impact of the new policy on
retained earnings prior to the earliest period presented should be adjusted against the opening
balance of retained earnings.

E. DISCLOSURES
The following disclosures are required for a change in an accounting policy:-

• Reason for the change

• Amount of the adjustment for the current period and for each period presented
• Amount of the adjustments required for the periods prior to those disclosed in the financial
statements
• The fact that comparative information has been restated
The entity should also disclose the impact of new IFRS that have been issued but have not yet come into force.
F. LIMITATIONS OF RETROSPECTIVE APPLICATION
If it is considered impracticable to determine either the period-specific effects or the cumulative
effects of a change in accounting policy, then retrospective application of the change need not
be made.

The Standard defines the term “impracticable” to mean the entity cannot apply it after making
every effort to do so. For a particular period, it is impracticable to apply a change in accounting
policy if:
• The effects of the retrospective application are not determinable
• The retrospective application requires assumptions about what management’s intentions
would have been at the time; or
• The retrospective application requires significant estimates of amounts and it is impossible to
distinguish objectively, from other information, information about those estimates that:

• Provides evidence of circumstances that existed at that time; and

• Would have been available at that time.

Therefore, when it is impracticable to apply a change in policy retrospectively, the entity applies
the change to the earliest period to which it is possible to apply the change.

G. CHANGES IN ACCOUNTING ESTIMATES

Because of the uncertainties that form part of everyday business, there are many items contained
in the financial statements that cannot be measured precisely and thus estimates are used for
these items. This is due to uncertainties inherent in business activities. In arriving at an estimate,
careful consideration is made of the latest reliable information that is available at the time.

Examples of accounting estimates include among other things:

• Useful lives of property, plant and equipment (and therefore depreciation)

• Inventory obsolescence
• Fair values of financial assets / liabilities
• Bad debts Some provisions, e.g. provision for warranty obligations

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It is acknowledged that the use of reasonable estimates is an essential part of the preparation
of financial statements and consequently does not undermine their reliability. By their nature,
these estimates may have to be revised periodically if the circumstances on which the estimate
is based have changed. Alternatively, new information may come to light or more experience
may be acquired which may necessitate a change in previous estimates in order to preserve the
reliability and relevance of the financial statements.
It is important, then, to realise that the revision of an estimate is not an error nor does it relate to
prior periods. The effect of a change in an accounting estimate should be included 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. Any corresponding changes in assets and liabilities, or to
an item of equity, are recognised by adjusting the carrying amount of the asset, liability or equity
item in the period of change.

So, the effect of a change in accounting estimate is recognised prospectively. Prospective

recognition means that the change is applied from the date of change in estimate. Previous
financial statements remain unaltered. For example, a change in the estimate of bad debts
affects only the current period and therefore is recognised in the current period. But a change in
the useful life of a depreciable asset affects the depreciation expense for the remainder of the
current period and for the future periods during the assets remaining useful life.

The nature and the amount of the change in an accounting estimate should be disclosed, unless
it would involve undue cost or effort. If this is the case, then this fact should be disclosed.

Note also that it can be difficult to distinguish between a change in an accounting policy and a
change in an accounting estimate. In a case where such a distinction is problematical, then the
change is treated as a change in accounting estimate, with appropriate disclosure.

H. CORRECTION OF PRIOR PERIOD ERRORS

It is also important to recognise the difference between the correction of an error and a change
in an accounting estimate.

Errors can arise in recognition, measurement, presentation or disclosure of items in financial

statements. If financial statements contain errors (material errors or intentional immaterial errors
that achieve a particular presentation), then they do not comply with IFRS.

Remember, estimates are approximations that may need revision as more information becomes
known. For example, the gain or loss on the outcome of a contingency that could not previously
have been estimated reliably does not constitute an error.

A material prior period error is corrected retrospectively in the first set of financial statements
authorised for issue after its discovery. The comparative amounts for the prior period(s) presented
in which the error occurred are restated. This simply means that material errors relating to prior
periods shall be corrected by restating comparative figures in the financial statements for the
year in which the error is discovered, unless it is “impracticable” to do so (the strict definition of
“impracticable”, mentioned earlier, applies).

IAS 1 (Revised) also requires that where a prior period error is corrected retrospectively, a
statement of financial position must be provided at the beginning of the earliest comparative
period.

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Errors can normally be corrected through the Statement of Comprehensive Income of the
period when uncovered unless the errors are material. In the event that the errors uncovered
relate to a previous period and they are classed as material, then it is necessary to correct them
as a prior period adjustment.

Only where it is impracticable to determine the cumulative effect of an error on prior periods can
an entity correct the error prospectively.
The following disclosures are required for errors uncovered:-

• Nature of the prior period error

• For each period, the amount of the correction (for each line item affected and, where applicable,
the basic and diluted earnings per share)
• The amount of the error at the beginning of the earliest prior period presented

• In retrospective restatement is impracticable for a particular prior period, the circumstances that
led to the existence of that condition and a description of how and from when the error has been
corrected. Subsequent periods need not repeat these disclosures.

I. QUESTIONS
RT. Ltd. changed its accounting policy in the year ended 31st December 2010 with respect to the
valuation of its inventories. Up to 2010, inventories were valued using a weighted average (AVCO)
cost method. But in 2010, the method was changed to first-in first-out (FIFO). The change
occurred as it was considered to more accurately reflect the usage and flow of inventories in
the economic cycle. The impact on inventory valuation was determined to be:

At 31st December 2008 an increase of RWF30,000

At 31st December 2009 an increase of RWF45,000
At 31st December 2010 an increase of RWF60,000

Assume the retained earnings of RT. ltd. on the 1st January 2009 were RWF900,000.
The Statement of Comprehensive Incomes prior to
adjustment are:
2010 2009
RWF RWF
Revenue 750,000 600,000
Cost of sales 300,000 240,000
Gross Profit 450,000 360,000
Administration Costs 180,000 150,000
Selling and distribution costs 75,000 45,000
Net profit 195,000 165,000

Show how the change in accounting policy impacts upon the Statement of Comprehensive
Income and the
Statement of Changes in Equity in accordance with the requirements of IAS 8.

SOLUTION
After adjusting, the Statement of Comprehensive Incomes would be as follows:

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 2010 2009(restated)
RWF RWF
Revenue 750,000 600,000
Cost of sales 285,000 225,000
Gross Profit 465,000 375,000
Administration Costs 180,000 150,000
Selling and distribution costs 75,000 45,000
Net profit 210,000 180,000

In each year, the cost of sales will be reduced by RWF15,000 (as the increase in closing inventory
exceeds the increase in opening inventory). As the cost of sales falls, the net profit rises.

The Statement of Changes in equity will reflect the impact on the retained earnings of RT. Ltd. as
follows: RWF

At 1st January 2009 as originally stated 900,000

Change in Accounting Policy for valuation of inventory 30,000
At 1st January 2009as restated 930,000
Net profit for year as restated 180,000
At 31st December 2009 1,110,000
Net profit for year 210,000
At 31st December 2009 1,320,000

THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATES IAS 21

INTRODUCTION
The purpose of IAS 21The Effects of Changes in Foreign Exchange Rates is to outline the
following issues:

• The definition of functional and presentation currencies

• Accounting for an entities individual transactions in a foreign currency
• Translation of the financial statements of a foreign subsidiary

B. FUNCTIONAL AND PRESENTATION CURRENCIES

The functional currency is the currency of the primary economic environment where the entity
operates. In most cases, the functional currency is the currency of the country in which the entity
is situated and in which it carries out most of its transactions. In essence, it is the currency an
entity uses in its day-to-day transactions.

IAS 21 states that the following factors should be considered when determining the functional
currency of an entity:

• The currency that mainly influences sales prices for goods and services (i.e. the currency in
which prices are denominated and settled)
• The currency of the country whose competitive forces and regulations mainly determine the
sales price of goods and services

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 • The currency that mainly influences labour, material and other costs of providing goods and
services
• The currency in which funding from issuing debt and equity is generated
• The currency in which receipts from operating activities are usually retained

The first three points are seen as the primary factors in determining an entities functional currency.

Furthermore, if an entity is a foreign operation (i.e. a subsidiary, associate, joint venture or branch
whose activities are based in a country or currency other than those of the reporting entity), the
following factors must also be considered:

• Whether the activities of the foreign operation are carried out as an extension of the parent,
rather than with a significant measure of autonomy/independence.
• Whether transactions with the parent are a high or low proportion of the foreign operations
activities
• Whether cash flows from the foreign operation directly affect the cash flows of the parent and
are readily available for remittance to it
• Whether cash flows from the activities of the foreign operation are sufficient to service existing
debt obligations without funds being made available by the parent

Where the indicators are mixed, management must exercise its judgement as to the functional
currency to adopt that best reflects the underlying transactions.

Putting the above into context, if an entity operates abroad as an independent operation
(generating income and expenses and raising finance, all in its own local currency), then its
functional currency would be its local currency. On the other hand, if the entity was merely an
overseas extension of the parent and only sells goods imported from the parent and remits all
profits back to the parent, then the functional currency should be the same as the parent. In this
case, the foreign entity would record its transactions in the currency of the parent and not its
local currency.

Once the functional currency has been determined, it is not subsequently changed unless there
is a change in the underlying circumstances that were relevant when determining the original
functional currency.

The presentation currency is the currency in which the financial statements are presented. IAS
21 states that, whereas an entity is constrained by the above factors in determining its functional
currency, it has a completely free choice as to the currency in which it presents its financial
statements.

If the presentation currency is different from the functional currency, then the financial statements
must be translated into the presentation currency. Therefore, if a parent entity has
subsidiaries whose functional currencies are different from that of the parent, then these must
be translated into the presentation currency so that the consolidation process can take place.

C. ACCOUNTING FOR INDIVIDUAL TRANSACTIONS

When an entity enters into a contract where the consideration is denominated in a foreign
currency, it will be necessary to translate that foreign currency into the entity’s functional currency

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for inclusion in its accounts. Examples of such foreign transactions include:

• Importing of raw materials

• Importing non-current assets
• Exporting finished goods
• Raising an overseas loan
• Investment in foreign shares / debt instruments

When translating the foreign currency transaction, the exchange rate used should be either:
• The spot exchange rate on the date the transaction occurred (the spot rate is the exchange
rate for immediate delivery); or
• For practical reasons, an average rate over a period of time, providing the exchange rate
has not fluctuated significantly

When cash settlement occurs, the settled amount should be translated using the spot rate
on the settlement date. If the exchange rate has altered between the transaction date and the
settlement date, there will be an exchange difference.

These exchange differences must be recognised as part of the profit or loss for the period in
which they arise.

Example
MSH Ltd has a year end of 31st December. On the 16th November, MSH purchased goods from
an American supplier for $125,000. On the 5th December, MSH paid the American supplier in
full.

The relevant exchange rates are:

16th November RWF1 = $1.35
5th December RWF1 = $1.31

At the date of the transaction:

$125,000 / $1.35 = RWF92,593

Debit Purchases RWF92,593

Credit Payables RWF92,593

At the date of settlement:

$125,000 / $1.31 = RWF95,420

Debit Payables RWF92,593

Debit FX Loss (I/S) RWF2,827
Credit Cash RWF95,420

The treatment of any foreign items remaining in the statement of financial position will depend on
whether they are classified as monetary of non-monetary items.

Monetary Items are defined as money /cash and assets and liabilities to be received or paid in
fixed or determinable amounts. Examples include cash, receivables, payables, loans, deferred
tax, pensions and provisions.
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The main characteristic of non-monetary items is the absence of a right to receive a fixed or
determinable amount of money. They represent other items in the statement of financial position
that are not monetary items and include things like property plant and equipment, inventory,
investments, prepayments, goodwill, intangibles and inventory.

The rule for the treatment of these foreign items at the reporting date is as follows:
Monetary items: Re-translate using the closing rate of exchange (i.e. the spot exchange rate at
the reporting date)

Non-monetary items: Do not re-translate

Non-monetary items measured at cost less depreciation are translated and

recorded at the exchange rate at the date of their acquisition
Items measured at fair value less depreciation should be translated and recorded at the
exchange rate at the date of revaluation

Exchange differences arising on the re-translation of monetary items at the reporting date must
be recognised as part of the profit or loss for the period in which they arise.

Similarly, exchange differences arising on the subsequent settlement of these monetary items
after the reporting date should be recognised as part of the profit or loss for the period in which
they arise.

Example:
Pot Ltd. purchases specialised machinery for use in its production process from a foreign supplier
on 18th
September. The machine cost US$300,000 and was paid for in full one month later. The year
end is 31st
December.

The relevant exchange rates are:

18th September RWF1 = US$4.0
5th December RWF1 = US$4.8

At the date of the transaction:

US$300,000 / 4 = RWF75,000

Debit PPE RWF75,000

Credit Payables RWF75,000

At the date of settlement:

US$300,000 / 4.8 = RWF62,500

Debit Payables RWF75,000

Credit FX Gain (I/S) RWF12,500
Credit Cash RWF62,500
No further translation will occur. All depreciation charged on this asset will be based on RWF75,000.

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Example:
DB Ltd entered into the following foreign transactions with United States suppliers and customers
during the year ended 31st December 2010:

Date Details Amount US$

31st January Purchase of PPE 300,000
9th April Payment for the PPE 300,000
Purchases on credit 150,000
30th June Sales on credit 400,000
23rd Payment for the 150,000
September purchases
5th December 10 year loan taken out 500,000
The relevant exchange rates were:

Date US$ : RWF

31st January 1.5 : 1
9th April 1.8 : 1
30th June 1.6 : 1
23rd September 1.2 : 1
5th December 1.3 : 1
31st December 1.4 : 1

Prepare Journal Entries to record the above transactions.

31st January 2010

US$300,000 / 1.5 = RWF200,000

Debit PPE RWF200,000
Credit Payables RWF200,000

9th April 2010

US$ 300,000 / 1.8 = RWF166,667

US$ 150,000 / 1.8 = RWF 83,333
Debit Payables RWF200,000 RWF166,667
Credit Cash
Credit FX Gain (I/S) RWF33,333

Debit Purchases RWF83,333

Credit Payables RWF83,333

30th June 2010

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US$400,000 / 1.6 = RWF250,000
Debit Receivables RWF250,000
Credit Sales RWF250,000
23rd September 2010

US$150,000 / 1.2 = RWF125,000

Debit Payables RWF83,333
Debit FX Loss (I/S) RWF41,667
Credit Cash RWF125,000
5th December 2010

US$500,000 / 1.3 = RWF384,615

Debit Cash RWF384,615
Credit Loan RWF384,615

In addition, at the year ended 31st December 2010, any outstanding monetary items must be
re-translated at the closing rate. In this example, there are two such monetary items remaining:

• The Receivables arising from the sale of goods on 30th June

• The Loan taken out on 5th December

31st December 2010

US$400,000 / 1.4 = RWF285,714 (Re-state the receivable to this amount) US$500,000 / 1.4 =
RWF357,143 (Re-state the loan to this amount)

Debit Receivables RWF35,714

Credit FX Gain (I/S) RWF35,714

Debit Loan RWF27,472

Credit FX Gain (I/S) RWF27,472

Summary of FX Gains / Losses for the year ended 31st December 2010:

RWF
9th April Gain 33,333
23rd September Loss (41,667)
31st December Gain 35,714
31st December Gain 27,472

Net Gain to I/S for year 54,852

Note that when the Receivable is received in 2011, a further exchange gain or loss will need to
be calculated upon settlement and included as part of the profit or loss for the year ended 31st
December 2011.

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D. TRANSLATING THE FINANCIAL STATEMENTS OF FOREIGN OPERATION
Where a subsidiary entity’s functional currency differs from the presentation currency of its
parent, its financial statements must be translated into the parent’s presentation currency prior
to consolidation.

There are a number of different methods that can be used to deal with the translation of a foreign
subsidiary. The method below outlines one such approach.

The following exchange rates should be used in the translation:

Income Statement / Statement of Comprehensive Income:

Income: average rate for the year

Expenses: average rate for the year

Note that the average rate for the year is used for expediency. Ideally, each item of income and
expenditure should be translated at the rate in existence for each transaction. But if there has
been no significant variance over the period, the average rate can be used.

Statement of Financial Position:

Assets & Liabilities: closing rate (i.e. the rate at the reporting date)
Share Capital: historic rate (i.e. the rate at the date of acquisition)
Pre-Acquisition reserves: historic rate
Post –Acquisition reserves: Balancing figure

Exchange differences arise because items are translated at different points in time at different
rates of exchange, for example, the profit or loss for the year forms part of the entity’s overall
retained earnings in the Statement of Financial Position. But, the profit or loss for the year is
arrived at by using the average rate, whereas the reserves figure as a whole in the Statement of
Financial Position does not use the average rate at all.

The exchange difference arising on translation of foreign currency accounts arises as follows:

Opening net assets + Profit for the year = Closing net assets

In the previous year’s Revenue and expenses are

financial translated within
statements, these were the Statement of Comprehensive
translated at last year’s Income at the average rate.
closing rate.
However, the profit is included
For the purposes of this within this year’s closing net
year’s accounts, they are assets at the closing rate
included within
closing net assets at this
year’s closing
rate

Therefore, the calculation of the exchange difference can be calculated as follows:

Opening net assets at this year’s closing rate X
Opening net assets at last year’s closing rate (X)

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 Profit for year at closing rate X
Profit for year at average rate (X)

X/(X)
X/(X)
Total exchange gain / loss (multiplied by Group Share) X/(X)

Goodwill on consolidation
Goodwill is calculated in the normal way, e.g. if using the proportion of net assets method:

Fair Value of consideration X

Less: share of net assets acquired (X) X
Alternatively, if goodwill and NCI are to be arrived at using the fair value method,
calculate:
Parents Share of Goodwill X
NCI Share of Goodwill X
Total Goodwill X

However, either way, the goodwill is initially calculated in foreign currency.

Goodwill is then translated twice:

• At the rate existing at the date of acquisition

• At the rate existing at the reporting date

The exchange difference arising will form part of the total exchange difference disclosed
as other comprehensive income and accumulated in other components of equity.

Non-Controlling Interest

Income Statement / Statement of Comprehensive Income:

NCI is the share of the subsidiary’s profit as translated for consolidated purposes

Statement of Financial Position:

NCI is calculated by reference to either the net assets of the subsidiary or the fair value at
acquisition plus the
share of post acquisition profits.

In either case, the NCI is translated at the closing rate at the reporting date.

QUESTION 1 – Home & Faraway

On 1st June 2010, Home Limited acquired 80% of Faraway Inc., whose functional currency is the
US $. The financial statements at 31st May 2011 are as follows:

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Statement of Comprehensive Income
Revenue Home Faraway
RWF US$
25,000 35,000

Operating Costs -15,000 -26,250

Profit before tax 10,000 8,750

Tax 8,000 -7,450
Profit for the year 2,000 1,300

Statement of Financial Position

Home Faraway
RWF US$
Investment in Faraway 5,000
Non-current assets 10,000 3,000
Current assets 5,000 2,000
20,000 5,000

Share capital 6,000 1,500

Retained earnings 4,000 2,500
10,000 4,000
Liabilities 10,000 1,000
20,000 5,000

Neither entity recognised any components of other comprehensive income in their individual
accounts in the period.

The following information is applicable:

• At the date of acquisition, the fair value of the net assets of Faraway were US$6,000. The
increase in the fair value is attributable to land that remains carried by Faraway at its historical
cost.
• Goodwill is translated at the closing rate.
• During the year, Home sold goods on cash terms for RWF1,000 to Faraway.
• On the 1st May 2011, Home lent Faraway RWF400. The liability is measured by Faraway at
the historic rate.
• The non-controlling interest is valued using the proportion of net assets method.
• Exchange rates to the RWF:

US$
1st June 2010 1.50
Average rate 1.75
1st May 2011 1.90
31st May 2011 2.00

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REQUIREMENT:
Prepare the group statement of financial position, income statement and statement of
comprehensive income at
31st May 2011.

SOLUTION:
Step 1: Establish Group Structure
Faraway
Group
80% NCI
20%
Subsidiary
1 year
Step 2: Adjustments
2.1 Inter Company Loan
Faraway has recorded the loan at its historic amount. The monetary liability must be translated
at the closing rate, with any gain/loss arising being included in the I/S for the year.
Initially, the loan would have been recorded at RWF400 x 1.9 = US$760
At year end, the loan is retranslated at RWF400 x 2 = US$800

Thus, there is a loss of US$40

US$ US$
Debit I/S Faraway 40
Credit Loan 40
Any gain or loss arising must be adjusted for in Faraway’s Statement of Comprehensive Income,
before translation.
Remember to eliminate the inter company loan on consolidation.

2.2 Revaluation at the Date of Acquisition

At acquisition, the fair value of Faraway’s net assets was US$6,000

At that date:
US$
Share capital 1,500

Pre-Acq. Reserves 1,200 (2,500 less 1,300 profit for

the year)
2,700
Fair Value 6,000
Increase 3,300
The increase is in respect of land.
Thus, US$
Debit PPE 3,300
Credit Revaluation 3,300
Reserve

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Step 3: Translate the Statement of Comprehensive Income of Faraway, at the average
rate for the year
US$ Rate RWFm
Revenue 35,000 1.75 20,000

Operating Costs -26,250 1.75 -15,000

FX loss on loan -40 1.75 -23
Profit before tax 8,710 4,977
Tax -7,450 1.75 -4,257
Profit for the year 1,260 720

Step 4: Calculate Goodwill Arising on Acquisition

• Calculate goodwill in foreign currency

• Translate goodwill at the spot rate at acquisition
• Translate goodwill at the closing rate at year end
• The difference represents either a gain or loss and is shown in reserves

US$
Cost of investment RWF5,000 x 1.5 7,500
Less:
Net assets (given in question)
6,000
Group share 80% 4,800

Goodwill in foreign currency 2,700

Translate at acquisition 2,700/1.5 1,800

Translate at reporting date 2,700/2 1,350
Loss (to reserves)
450

There is no impairment of goodwill in the question.

Step 5: Translate the SOFP of Faraway
US$ Rate RWF
Non-current assets 6,300 2 3,150
Current assets 2,000 2 1,000
8,300 4,150

Ordinary share capital 1,500 1.5 1,000

Revaluation reserve 3,300 1.5 2,200
Reserves: Pre-Acq 1,200 1.5 800
Post-Acq (bal fig) 1,260 (bal fig) -370
7,260 3,630
Liabilities 1,040 520
8,300 4,150

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Step 6: Prepare the Consolidated Statement of Comprehensive Income and SOFP

Statement of Comprehensive Income

Home Faraway Adjust. Total
RWFm RWFm RWFm RWFm
Revenue 25,000 20,000 -1,000 44,000
Operating costs -15,000 -15,000 1,000 -29,023
FX Loss -23
Profit before tax 10,000 4,977 14,977
Tax -8,000 -4,257 -12,257
Profit after tax 2,000 720 2,720
NCI: RWF720 x 20% = RWF144

Home Group
Consolidated Statement of Comprehensive Income for the year ending 31st May 2011

RWF

Revenue 44,000
Operating costs -29,023
Profit before tax 14,977
Tax -12,257
Profit after tax 2,720

Other Comprehensive Income

Loss on retranslation of Goodwill -450
Exchange loss on translation of financial statements (see below) 1,090
Total Comprehensive Income 1,180
Profit attributable as follows:
Equity holders of parent 2,576
NCI 144
2,720

Total Comprehensive Income attributable as follows:

Equity holders of parent (2,576 – 872 – 450) 1,254.0
NCI (144 –218)
-74.0 1,180.0

Home Group
9,254

9,980
Note 1: NCI in SOFP
On translation of Faraway’s SOFP in Step 5 earlier, the net assets (capital and reserves) were
translated as
RWF3,630 in total.

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Thus, NCI is RWF3,630 x 20% = RWF726
Note 2: Consolidated Reserves

Home:
RWFm RWFm
Per SOFP 4,000.0
Loss on retranslation of goodwill -450.0
Faraway:
Group share of post-acq reserves
80% x -370 = -296 (the post-acq reserves were calculated as a balancing figure
3,550.0
in the translation of the SOFP of Faraway in Step 5)
-296.0
3,254.0
Note 3: Exchange Difference
In the Consolidated Accounts, the exchange difference will comprise:

• Exchange difference on translation of the financial statements

• Exchange difference on retranslation of goodwill

The total exchange difference shall be disclosed as other comprehensive income.

There are two ways in which the exchange difference arising on the translation of the financial
statements can be calculated.

Method 1:
RWFm
Opening reserves 800.0
Profit for year 720.0
1,520.0
Closing reserves 430.0
Exchange difference 1,090.0

Group share RWF1,090 x 80% = RWF872

NCI share RWF1,090 x 20% = RWF218

Method 2:
Opening net assets (1,500 + 3,300 + 1,200) = US$6,000

RWFm
Opening net assets at last year’s closing rate (1.5) 4,000
Opening net assets at this year’s closing rate (2) 3,000
Loss 1,000
Profit for year = US$1,260

RWFm
Profit for year at average rate (1.75) 720
Profit for year at closing rate (2) 630
Loss 90
Total Net Loss 1,000 + 90 + 1,090
Group share RWF1,090 x 80% = RWF872
NCI share RWF1,090 x 20% = RWF218

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QUESTION 2 – Memo
Memo, a public limited company, owns 75% of the ordinary share capital of Random, a public
limited company which is situated in a foreign country. Memo acquired Random on 1st May
20X3 for 120 millionUS$, when the retained profits of Random were 80 million US$ Random has
not revalued its assets or issued any share capital
since its acquisition by Memo. The following financial statements relate to Memo and Random.

Statements of financial position at 30th April 20X4

Memo Random
Property, plant and equipment RWFm US$m
297 146
Investment in Random 48 -
Loan to Random 5 -
Current assets 355 102
705 248
Capital and reserves
Ordinary shares of RWF1/1US$ 60 32
Share premium account 50 20
Retained earnings 360 95
470 147
Non-current liabilities 30 41
Current liabilities 205 60
705 248

Statements of Comprehensive Income for year ended

30th April 20X4 Memo Random

RWFm US$m
Revenue 200 142
Cost of sales (120) (96)
Gross profit 80 46
Distribution and administrative expenses (30) (20)
Operating profit 50 26
Interest receivable 4 -
Interest payable - (2)
Profit before taxation 54 24
Income tax expense (20) (9)
Profit for the year 34 15

The following information is relevant to the preparation of the consolidated financial statements
of Memo:
(a) During the financial year Random has purchased raw materials from Memo and
denominated the purchase in US$ in its financial records. The details of the transaction are set
out below:
Date of Transaction Purchase Price Profit Percentage
on
Selling Price
RWFm
Raw materials 1st February 20X4 6 20%

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 At the year-end, half of the raw materials purchased were still in the inventory of Random. The
inter- company transactions have not been eliminated from the financial statements and the
goods were recorded by Random at the exchange rate ruling on 1st February 20X4. A payment
of RWF6 million was made to Memo when the exchange rate was 2.2 US$ to RWF1. Any
exchange gain or loss arising on the transaction is still held in the current liabilities of Random.

(b) Memo had made an interest free loan to Random of RWF5 million on 1st May 20X3. The loan
was repaid on 30th May 20X4. Random had included the loan in non-current liabilities and had
recorded it at the exchange rate at 1st May 20X3.
(c) The fair value of the net assets of Random at the date of acquisition is to be assumed to be the same
as the carrying value. Goodwill is to be calculated using the traditional method of only calculating
goodwill acquired by the parent i.e. the non-controlling interest is calculated as a proportionate
share of the subsidiary’s net assets with no goodwill allocated.

(d) Random operates with a significant degree of autonomy in its business

operations.
(e) The following exchange rates are relevant to the financial statements:

US$ to RWF
30th April/1st May 20X3 2.5
1st November 20X3 2.6
1st February 20X4 2
30th April 20X4 2.1
Average rate for year to 30th April 20X4 2

(f) Memo has paid a dividend of RWF8 million during the financial year.

REQUIREMENT:
Prepare a consolidated statement of comprehensive income for the year ended 30th
April 20X4 and a consolidated statement of financial position at that date in accordance with
International Financial Reporting Standards.

SOLUTION:

Step 1: Establish Group Structure

Random
Group
75% NCI
25%

Subsidiary
1 year

Step 2: Adjustments
2.1 Inter Company Purchases
Random purchased goods from Memo and paid for them prior to the year end. The FX rate
between the date of purchase and date of settlement changed, giving rise to a gain or loss. This
exchange gain or loss is still held in the current liabilities of Random, according to the question.
Thus, calculate the FX gain/loss arising and treat it properly in the
accounts. Initially, the transaction was recorded at RWF6m x 2 = 12
million US$.

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 The cost of settlement was RWF6m x 2.2 = 13.2 million US$.
Thus, Random suffered a loss of 1.2 million US$. Adjust its Statement of Comprehensive Income
to reflect this loss before translating the financial statements.
US$ m US$ m
Debit I/S (Random) 1.2
Credit Current Liabilities 1.2

2.2 Inter Company Loan

The loan was made by Memo to Random on the 1st day of the accounting period and repaid by
Random after the year end.
Thus, this monetary liability existed at the year end and as such, needs to be retranslated at the
closing rate. Any gain or loss arising must be adjusted for in Random’s Statement of Comprehensive
Income, again, before translation.
Initially, the loan would have been recorded at RWF5m x 2.5 = 12.5 million
US$. At year end, the loan is retranslated at RWF5m x 2.1 = 10.5 million
US$.
Thus, there is a gain of 2 million US$.
US$ m US$ m
Debit Loan Account 2
Credit I/S (Random) 2

Remember to eliminate the inter company loan on consolidation.

RWFm RWFm
Debit Non-Current Liabilities 5
Credit Loan to Random 5
Therefore, Random has generated a net FX gain of 2m – 1.2m = 0.8m US$, in respect of both
the loan and the purchases. This is adjusted for in its Statement of Comprehensive Income, and
subject to translation.

2.3 Inter Company Profit on Inventory

Memo sold RWF6m goods to Random. Includes margin of 20%. At year end, ½ the goods
remain. RWF6m x 20% x ½ = RWF0.6m

RWFm RWFm
Debit I/S (reserves) Memo 0.6
Credit Inventory 0.6
Eliminate inter company sales and cost of sales of RWF6m in the consolidated Statement
of Comprehensive Income.

Step 3: Translate the Statement of Comprehensive Income of Random, at the average rate for
the year
US$ m Rate RWFm
142.0 2 71.0
Revenue
Cost of sales -96.0 2 -48.0
Gross profit 46.0 23.0
Distribution and -20.0 2 -10.0
Administration
Interest payable -2.0 2 -1.0

110 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
 Net Foreign Exchange 0.8 2 0.4
gain
Profit before tax 24.8 12.4

Income tax expense -9.0 2 -4.5

Profit after tax 15.8 7.9
Step 4: Calculate Goodwill arising on acquisition
• Calculate goodwill in foreign currency
• Translate goodwill at the spot rate at acquisition
• Translate goodwill at the closing rate at year end
• The difference represents either a gain or loss and is shown in reserves

US$ m
Cost of investment 120
Less:
Share capital 32
Share premium 20
Reserves at acquisition 80
132
Group share 75%
-99
Goodwill in foreign currency 21

RWFm
Translate at acquisition 21/2.5 8.4
Translate at reporting date 21/2/1 10.0
Gain (to reserves) 1.6

Goodwill at the Reporting Date in the Consolidated SOFP is RWF10m

Step 5: Translate the SOFP of Random

US$ m Rate RWFm

Tangible non current assets 146.0 2.1 69.50

Current assets 102.0 2.1 48.60

248.0 118.10

Ordinary share capital 32.0 2.5 12.80

Share premium 20.0 2.5 8.00
Reserves: Pre-Acq 80.0 2.5 32.00
Post-Acq (bal fig) 15.8 (bal fig) 17.60
147.8 70.40

Non-Current liabilities (41 – 2) 39.0 2.1 18.60

Current liabilities (60 + 1.2) 61.2 2.1 29.10
248.0 118.10

CPA EXAMINATION I1.2 FINANCIAL REPORTING 111

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Step 6: Prepare the Consolidated Statement of Comprehensive Income and SOFP

Statement of Comprehensive Income

Memo Random Adjust. Total
RWFm RWFm RWFm RWFm
Revenue 200.0 71.0 -6.0 265.0
Cost of sales -120.0 -48.0 6.0 -162.6
Inventory profit -0.6
Gross profit 79.4 23.0 102.4
Admin & Distribution -30.0 -10.0 -40.0
Interest receivable 4.0 4.0
Interest payable -1.0 -1.0
FX gain 0.4 0.4

NCI: RWF7.9m x 25% = RWF1.975m, say RWF2m

Memo Group
Consolidated Statement of Comprehensive Income for the year ending 30th April 20X4

RWFm
Revenue 265.0
Cost of sales -162.6
Gross profit 102.4
Administration & Distribution expenses -40.0
Interest receivable 4.0
Interest payable -1.0
FX gain 0.4
Profit before tax 65.8
Tax -24.5
Profit for the year 41.3

Other Comprehensive Income

Gain on retranslation of Goodwill 1.6

Exchange gain on translation of financial statements (see below) 9.7

Total Comprehensive Income 52.6

Profit attributable as follows:

Equity holders of parent 3.3
NCI 2.0
41.3

Total Comprehensive Income attributable as follows:

Equity holders of parent (39.3 + 1.6 + 7.3) 48.2
NCI (2 + 2.4) 4.4
52.6

112 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
assets

Non Current Assets

Memo Group
Consolidated Statement of Financial Position at 30th April 20X4

RWFm RWFm
Intangibles:
Goodwill 10.0
Tangibles (297 + 69.5) 366.5
Current Assets (355 + 48.6 – 0.6) 403.0
779.5

Equity and Liabilities RWFm RWFm

Equity
Share capital 60.0
Share premium 50.0
Reserves (see below)
374.2
484.2
NCI (see below)
17.6
501.8
Non Current Liabilities (30 + 18.6 – 5) 43.6
Current liabilities (205 + 29.1)
234.1
779.5
Note 1: NCI in SOFP
On translation of Random’s SOFP in Step 5 earlier, the net assets (capital and reserves) were
translated as
RWF70.4m in total.

Thus, NCI is RWF70.4m x 25% = RWF17.6m

Note 2: Consolidated Reserves

Memo:

RWFm RWFm
Per SOFP 360.0
Inventory profit 0.6
Gain on retranslation of goodwill 1.6

Random:
Group share of post-acq reserves 361.0
75% x 17.6 (17.6 was calculated in the retranslated SOFP of Random in Step 5) 13.2
374.2

CPA EXAMINATION I1.2 FINANCIAL REPORTING 113

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Note 3: Exchange Difference
In the Consolidated Accounts, the exchange difference will comprise:

• Exchange difference on translation of the financial statements

• Exchange difference on retranslation of goodwill

The total exchange difference shall be disclosed as other comprehensive income.

There are two ways in which the exchange difference arising on the translation of the financial
statements can be calculated.

Method 1:
RWFm
Opening reserves 32.0
Profit for year 7.9
39.9
Closing reserves 49.6
Exchange difference 9.7

Group share RWF9.7m x 75% = RWF7.275m, say RWF7.3m

NCI share RWF9.7m x 25% = RWF2.425m, say RWF2.4m

Method 2:

Opening net assets (32 + 20 + 80) = 132m US$

RWFm
Opening net assets at last year’s closing rate (2.5) 52.8
Opening net assets at this year’s closing rate (2.1) 62.9
Gain 10.1
Profit for year = 15.8m US$

RWFm
Profit for year at average rate (2.0) 7.9
Profit for year at closing rate (2.1) 7.5
Loss 0.4

Total Net Gain 10.1 – 0.4 = 9.7

Group share RWF9.7m x 75% = RWF7.275m, say RWF7.3m

NCI share RWF9.7m x 25% = RWF2.425m, say RWF2.4m

The exchange difference arising in respect of goodwill was calculated earlier.

114 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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CASH FLOW STATEMENTS IAS 7

OBJECTIVE
The objective of IAS 7 is to require the provision of information about the historical changes in
cash and cash equivalents of an entity by means of a cash flow statement, which classifies cash
flow into:
• Operating Activities
• Investing Activities
• Financing Activities

The standard requires the cash flow statement to be presented as an integral part of the financial
statements.

All entities need cash to conduct their operations, discharge their obligations and provide returns
to their investors.

The cash flow statement, taken together with the other financial statements, helps users to
evaluate the position and performance of the entity.

Cash flow statements assist in assessing the ability of an entity to generate cash and cash
equivalents. Also, cash flows generated in the past are often used as an indicator of future cash
flows.

B. DEFINITIONS
Cash comprises cash on hand and demand deposits. Bank overdrafts, because they can be
repayable on demand, are often included as a component of cash.

Cash equivalents are short term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value. They
are held to meet short-term cash commitments rather than for investments and usually have a
maturity of three months or less.

Cash flows do not include movements in cash and cash equivalents. It is considered that such
items are part of the cash management of an entity rather than part of its operating, investing
and financing activities.

C. OPERATING ACTIVITIES
These are the main revenue producing activities of the entity. The cash flow from operating
activities is a key indicator of the extent to which the operations of the entity has generated cash
to:
• Repay loans
• Maintain the operating capability
• Pay dividends
• Make new investments

Without using external sources of finance.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 115

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Examples of Cash Flows from Operating Activities
• Cash receipts from sale of goods and the rendering of services
• Cash payments to suppliers
• Cash payments to employees
• Cash payments/refunds of income tax
• Cash receipts from royalties, fees, commissions and other revenue

D. INVESTING ACTIVITIES
These are the acquisition and disposals of long-term assets and other investments. It is important
to disclose the cash flows from investing activities separately because these represent the extent
to which expenditures have been made for resources intended to generate future income and
cash flows.

Examples of Cash Flows from Investing Activities

• Cash payments to acquire property, plant and equipment and intangibles
• Cash receipts from sales of property, plant and equipment and intangibles
• Cash payments to acquire an investment in shares or loans in other entities
• Cash receipts from sale of investments
• Cash advances and loans made to other parties (non-financial institutions)
• Cash receipts from the repayment of advances and loans made to other parties (again non-
financial institutions)

E. FINANCING ACTIVITIES
These are activities that result in changes in the size and composition of the contributed equity
and borrowings of the entity. The disclosure of cash flows arising from financing activities is
useful in predicting claims on future cash flows by providers of capital.

Examples of Cash Flows from Financing Activities

• Cash proceeds from issuing shares

• Cash payments to owners to buy back shares
• Cash proceeds from issuing debentures, loans, notes, bonds, mortgages, etc. (d) Cash
repayments of amounts borrowed
• Cash payment reducing the liability relating to a finance lease

F. REPORTING CASH FLOWS FROM OPERATING ACTIVITIES

The reporting of cash flows from operating activities can be either by:

• The Direct Method, whereby major classes of gross cash receipts and gross cash payments
and cash receipts from customers, and cash payments to suppliers are disclosed
Or
• The Indirect Method, whereby profit or loss is adjusted for the effects of transactions of a non-
cash nature and the accrual or deferral of past or future operating cash receipts or payments
e.g. profit adjusted for depreciation and any increase in trade payables and accruals.

116 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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The standard encourages the use of the direct method as it provides information which may be
useful in estimating future cash flows.

Interest and Dividends

Cash flows from interest and dividends received and paid should each be disclosed separately.
IAS 7 does not
specify the classification of these under either operating investing or financing activities.
However, each should be classified in a consistent manner.

Taxes on Income
Cash flows from taxes on income should be separately disclosed and classified under operating
activities unless
they can be specifically identified with financing and investing activities.
Indirect Method – Cash Flow Statement

Cash Flow from Operating Activities

RWFm RWFm
Profit before taxation 3,450
Adjustments for:
Depreciation 470
Investment income (400)
Interest expense 350
3,870
Increase in Trade Receivables (600)

Increase in Inventory (1,120)

Increase in Trade Payables 400
Cash generated from Operations 2,550
Interest paid (270)

Income Tax paid (900)

Net Cash from Operating Activities 1,380

Cash Flow from Investing Activities

Purchase of Property, Plant and (900)
Equipment

Proceeds from Sale of Plant and 20

Equipment
Interest received 200
Dividends received 200
Net Cash used in Investing Activities (480)

Cash Flow from Financing Activities

Proceeds from Issue of Shares 250

Proceeds from Long Term Borrowing 160

CPA EXAMINATION I1.2 FINANCIAL REPORTING 117

STUDY MANUAL
 Dividend paid (1,200)
Net Cash used in Financing Activities (790)
Net Increase in Cash and Cash 110
Equivalents
Cash and cash Equivalents at Start of Year 120

Cash and Cash Equivalents at End of Year 230

Direct Method Cash Flow Statement

Cash Flow from Financing Activities

RWFm RWFm
Cash received from Customers 30,150
Cash paid to Suppliers and Employees (27,600)
Cash generated from Operations 2,550
Interest paid (270)
Income Taxes paid (900)
Net Cash Flow Operating Activities 1,380

The remainder of the cash flow statement is the same as the indirect method.

G. WORKED EXAMPLES
A cash flow statement essentially links together the opening Statement of Financial Position, the
Statement of
Comprehensive Income and the closing Statement of Financial Position.

Example 1
Z Limited’s opening SOFP had cash of RWF60,000 and ordinary shares of RWF60,000. Its
trading activities for the year ended 31st December 20X1are as follows:

RWF RWF
Cash sales 100,000
Cash purchases 70,000
Closing inventory Nil
Cost of sales 70,000
Gross profit 30,000
Cash expenses (12,000)
Profit 18,000

118 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
The SOFP at the year-end, and at the start of the year are set out below:

SOFP
Year End Start

RWF’ RWF’
000 000
Non-Current assets Nil Nil
Cash (60 + 18) 78 60
78 60
Shareholders’ Equity
Ordinary shares 60 60
Retained earnings 18 -
78 60
Cash Flow Statement – Indirect Method

RWF’000
Profit 18,000
Adjusted for depreciation and changes in inventory etc Nil
Net cash from operating activities 18,000

Net increase in cash 18,000


Cash at start of year 60,000
Cash at end of year 78,000
Cash Flow Statement – Direct Method

RWF’000
Cash received from customers 100,000
Cash paid to suppliers (70,000)
Cash paid to employers and other cash payments (12,000)
Net cash from operating activities 18,000

Net increase in cash 18,000


Cash at start of year 60,000
Cash at end of year 78,000

Example 2
In the year ended 31st December 20X2 Z Limited borrowed RWF40,000 on a long-term basis.
It bought equipment for RWF20,000. It’s trading activities for the year ended 31st December
19X2 are as follows:

CPA EXAMINATION I1.2 FINANCIAL REPORTING 119

STUDY MANUAL
 Net Increase in Cash 44,000
Cash at Start of Year 78,000
Cash at End of Year 122,000
Cash Flow Statement – Direct Method
RWF’000
Cash received from customers 130
Cash paid to suppliers (90)
Cash paid to employees and other cash payments (14)
Interest paid (2)
Net Cash Inflow from Operating Activities 24

Investing and Financing Activities as above.

Example 3
In the year ended 31st December 20X3 Z Limited had the
following trading activities:
RWF’000 RWF’000
Sales 175
Opening inventory Nil
Purchases 16
Closing inventory (25)
Cost of sales (91)
Gross profit 84
Cash expenses (22)
Depreciation (5)
Operating profit 57
Interest paid (4)
Profit before taxation 53
Income tax paid (14)
Profit after taxation 39

The opening and closing SOFPs are as follows:

SOFP
Year End Start
RWF’000 RWF’000
Non-Current assets 10 15
Inventory 25 -
Receivables 18 -
Bank* 139 122
182 122

Total assets 192 137

Liabilities
Trade payables 16 -
Tax payable - -
16 -
Loan 40 40
Total liabilities 56 40

120 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
Shareholders Equity
Ordinary shares 60 60
Retained earnings 76 37
Total shareholders equity 136 97

Total liabilities and shareholders equity 192 137

*Bank at start 122

Received from customers (175 –18) 157

Paid to suppliers (116 – 16) (100)

Cash expenses (22)
Interest paid (4)
Tax paid (14)
139

Cash Flow Statement – Indirect Method

Cash Flows from Operating Activities
RWF’000 RWF’000

Profit before taxation 53

Adjustments for: Depreciation
5

Interest expense 4
62
Increase in inventory (25)
Increase in trade receivables (18)
Increase in trade payables 16
Cash generated from operations 35
Interest paid (4)
Income tax paid (14)
Net cash from Operating Activities 17

Cash Flows from Investing Activities -

Cash Flows from Financing Activities -

Net increase in cash 17

Cash at start of year 122
Cash at end of year 139

Cash Flow Statement – Direct Method

Cash Flows from Operating Activities
RWF’000 RWF’000
Cash receipts from customers (175 – 18) 157
Cash paid to suppliers (116 – 18) (100)
Cash paid to employees and other cash (22)
payments
Interest paid (4)
Income tax paid (14)
Net Cash from Operating Activities 17

CPA EXAMINATION I1.2 FINANCIAL REPORTING 121

STUDY MANUAL
Example 4
In the year ended 31st December 20X4 Z Limited had the following trading activities:
RWF’000 RWF’000
220
Sales 25
Opening inventory
Purchases 127
Closing inventory (34)
Cost of sales (118)
Gross profit 102
Cash expenses (28)
Depreciation (5)
Operating profit 69
Interest expense (4)
Profit before taxation 65
Income tax (22)

Profit after taxation 43

Dividend paid (10)
Retained for year 33

The opening and closing SOFPs are as follows:

SOFP
Year End Start

RWF’000 RWF’000
Non-Current assets 5 10
Inventory 34 25
Trade receivable 23 18
Bank 186 153
243 196
Total assets 258 206
Liabilities
Trade payables 25 16
Interest accrued 2 -
Income tax payable 22 14
49 30
Loan 30 40
Total liabilities 79 70
Shareholders Equity
Ordinary shares 60 60
Retained earnings 109 76
169 136
Total Liabilities and Shareholders Equity 248 206

Cash Flow Statement – Indirect Method

Cash Flows from Operating Activities
RWF’000 RWF’000
Profit before taxation 65
Adjustments for: Depreciation
5

122 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 Interest expense 4
74
Increase in inventory (9)
Increase in trade receivables (5)
Increase in trade payable 9
Cash generated from operations 69
Interest paid (4 – 2) (2)
Income tax paid (14)
Net Cash from Operating Activities 53

Cash Flow from Investing Activities -

Cash Flow from Financing Activities

Loan repaid (10)
Dividend paid (10)
Net Cash Used in Financing Activities (20)
Net Increase in Cash 33
Cash at start of year 186
Cash at end of year 186

H. DISPOSAL OF A TANGIBLE NON-CURRENT ASSET

The disposal of a tangible non-current asset has two implications for a cash flow statement:
• Adjust the profit before taxation for any profit or loss on disposal, if a loss add to profit before
taxation and if a profit deduct from profit before taxation
And
• The sale proceeds will be included under the heading “investing activities”.

Example
Year 1 Year 2
RWF’000 RWF’000
Plant - cost 1,000 800
- depreciation 400 480

During the year plant costing RWF200,000, which had been depreciated by RWF120,000,
was sold for
RWF90,000.

The depreciation charge and profit/loss on disposal can be ascertained using “T” accounts.

Plant - Depreciation
RWF’000 RWF’000
Balances b/f 400
Disposal 120 P & L (bal. 200
figure)
Balance c/f 480
600 600

CPA EXAMINATION I1.2 FINANCIAL REPORTING 123

STUDY MANUAL
 RWF’000 RWF’000
Plant – cost 200 Plant – 120
depreciation
Profit on disposal 10 Bank 90
(bal. figure)
210 210
Cash Flow Statement (Extracts)
Cash Flows from Operating Activities

RWF’000
Profit before taxation X
Adjustments for:
Depreciation 200
Profit on disposal of plant (10)

Cash Flows from Investing Activities

Proceeds from sale of plant 90

I. TAXATION
The taxation paid figure in the cash flow statement is calculated as follows:

Taxation Account

RWF’000 RWF’000
Balance b/d 135 Balance b/d 120
Bank tax paid 120 Statement of Comprehensive 135
Income
255 255

J. DIVIDENDS
The dividends paid figure in the cash flow statement is calculated in a similar fashion to the
taxation paid:
Dividend Account

RWF’000 RWF’000
Balance c/d 100 Balance b/d 80
Bank Dividend 80 Statement of Comprehensive 100
paid Income
180 180

124 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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K. WORKED EXAMPLE
The financial statements of E Ltd are set out below:
E Ltd Statement of Comprehensive Income for the year ended 31st December Year 2

RWF’000
Sales 2,553
Cost of sales 1,814
Gross profit 739
Distribution costs 125
Administrative
expenses 264
Operating profit 350
Interest received 25
Interest paid 75
Profit before taxation 300
Taxation 140
Profit after taxation 160
Dividends 100
Retained profit for the year 60

Non-Current Assets
SOFPs as at 31st December

Year 2 Year 1
RWF’000 RWF’000
Tangible 380 305
Intangible 250 200
Investments 25
630 530
Current
assets
Inventory 150 102
Trade receivables 390 315
Investments 50 -
Cash in hand 2 1
592 418
Total assets 1,222 948
Liabilities
Trade payables 127 119
Bank overdraft 85 89
Income tax payable 190 160
Dividend payable 100 80
502 448
Long term loan 100 -
Total liabilities 602 448
Shareholders Equity
Share capital 200 150
Share premium 160 150
Retained earnings 260 200

CPA EXAMINATION I1.2 FINANCIAL REPORTING 125

STUDY MANUAL
 620 500
Total liabilities and 1,222 948
shareholders’ equity
Notes:

• Non-current asset investments were sold in Year 2 for RWF30,000

• Non-current assets (cost RWF85,000, net book value RWF45,000) were sold for RWF32,000
in Year 2
• The following information relates to the fixed assets:

31/12/Yr 2 31/12/Yr 1
RWF’ RWF’
000 000
Cost 720 595
Depreciation 340 290
Net book value 380 305
• 50,000 ordinary RWF1 shares were issued at a premium of RWF0.20 per share during Year 2
• The current asset investments are readily disposable.

Required:
Prepare a cash flow statement for the year ended 31st December Year 2 using the indirect
method to comply with the provisions of IAS 7 Cash Flow Statements.

Solution

E Ltd Cash Flow Statement for the year ended 31st December Year 2
RWF’000 RWF’000

Cash and cash equivalents at end of year (33)

Cash and Cash Equivalents at End of Year

Investments 50
Cash 2
Bank Overdraft (85) (33)

Working 1

Tangibles
RWF’000 RWF’000
Opening 595 Closing 720
Additions 210 Disposal 85
805 805

Accumulated Depreciation
RWF’000 RWF’000
Closing 340 Opening 290
Disposal 40 Depreciation 90
380 380

126 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 Disposal

RWF’000 RWF’000

Cost 85 Accumulated 40
depreciation
Bank 32
Loss 13
85 85

Working 2

Income Tax

RWF’000 RWF’000
Closing 190 Opening 160
Bank 110 Statement of Comprehensive 140
Income
300 300

Working 3
Dividends
RWF’000 RWF’000
Closing 100 Opening 80
Bank Statement of Comprehensive 100
80 Income
180 180

L. CONSOLIDATED CASH FLOW STATEMENTS

In addition to the usual cash flow items indicated earlier, when the consolidated cash flow
statement of a group of companies is being prepared, there are potentially three other entries
required in the statement:

(a) Dividends received from associate companies and/or joint ventures

(b) Dividends paid to non-controlling interest
(c) Purchase of subsidiary undertakings

(a) Dividends Received from Associates or Joint Ventures

Such dividends, net of any tax on them if applicable, are included under the heading of “Net
Cash Flows from Investing Activities”.
If the figure for these dividends is not given in the question, it can be calculated by
reconstructing the “T”
account, for example:

Investment in Associate Account

CPA EXAMINATION I1.2 FINANCIAL REPORTING 127

STUDY MANUAL
 Balance b/d (per opening b/s) X Share of tax (per i/s) X
Share of profit (per i/s) X Dividend received (bal. fig) X
X Balance c/d X
X
Balance b/d (per closing b/s) X

(b) Dividends Paid to Non-Controlling Interest

These dividend payments are included under the heading of “Net Cash Flows from Financing
Activities”.

If the figure for these dividends is not given in the question, it can be calculated by
reconstructing the minority interest “T” account, for example:

Non-Controlling Interest Account X

Dividend received (bal. fig) X Balance b/d (per opening b/s)
Balance c/d X

Share of profit of NCI (per i/s) X Balance b/d (per closing b/s) X


(c) Purchase of Subsidiary Undertakings

Where a subsidiary is acquired during the period, the acquisition is recognised in the cash flow
statement
if there is a cash element of the purchase consideration.

Any non-cash element of the consideration, e.g. shares, loan stock, etc is excluded from the cash
flow statement.

The cash consideration included will be:

• Cash paid to acquire subsidiary
• Cash holding of subsidiary at acquisition (or + bank overdraft of subsidiary at acquisition)

The total net cash cost of acquiring the subsidiary is included in the heading “Cash Flows from
Investing Activities”.
On disposal of a subsidiary the cash inflow will be:

• Cash received on disposal

• - Cash holding of subsidiary on disposal (or + bank overdraft of subsidiary at acquisition)

Again, only the cash element of any consideration received is included in the cash flow statement.
[Note, however that receivables, payables and inventories of the subsidiary that exist at the
date of acquisition must be excluded when calculating the increase or decrease of receivables,
payables and inventories in the cash flow statement. Furthermore, other relevant balances
at acquisition must be taken into account in preparing the cash flow statement for the year of
acquisition]

Consider the following comprehensive example of a consolidated cash flow statement.

SH.Limited is a long established company operating in the hotel and leisure industry. In recent
years, it has diversified into other areas, achieving its corporate expansion by the acquisition of
other companies.

128 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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Following the successful acquisition of four companies in the previous six years, as well as
obtaining an associate interest in another, SH. Ltd acquired a 75% shareholding in BK Limited
on the 1st January 20X7. This was the only acquisition in the current financial year.

The consolidated financial statements, in draft form, are as follows:

SH Limited Draft Consolidated Statement of Comprehensive Income for the year ended 31st
December 20X7

RWF’000 RWF’000
4,455
Operating profit
Share of associate profits 1,485
Investment income 600
Interest payable (450)
Profit before tax 6,090
Tax (2,055)
Profit for period 4,035

Attributable to:
Equity holders of the parent 3,735

Non-Controlling Interest 300

4,035

SH Limited Draft Consolidated SOFP as at 31st December 20X7

20X7 20X6
RWF’000
RWF’000 RWF’000 RWF’000
Assets
Non-Current Assets
Property, plant and equipment 11,625 7,500
Goodwill 300 -
Investments in associates 3,300 3,000
Long term investments 1,230 1,230
16,455 11,730
Current assets
Inventories 5,925 3,000
Receivables 5,550 3,825
Cash 13,545 5,460
25,020 12,285
41,475 24,015
Equity and Liabilities
Capital and Reserves
Ordinary 11,820 6,000

Share premium 8,649 6,285

Retained earnings 10,335 7,500
30,804 19,785
Non-Controlling Interest 345 -

CPA EXAMINATION I1.2 FINANCIAL REPORTING 129

STUDY MANUAL
 Non-Current Liabilities
Finance lease obligations 2,130 510
Loans 4,380 1,500
Deferred tax 90 39
6,600 2,049
Current liabilities
Trade payables 1,500 840
Finance lease obligations 720 600
Income tax 1,386 651
Accrued interest 120 90
3,726 2,181
41,475 24,015
Notes:
1. Non-current assets comprise:

20X7 20X6
RWF’000 RWF’000
Buildings at book value 6,225 6,600
Machinery: Cost 9,000 4,200
Accumulated
(3,600) (3,300)
Depreciation
NBV 5,400 900
11,625 7,500

There were no acquisition or disposals of buildings during the year.

Machinery that had originally cost RWF1.5m was sold for RWF1.5m, resulting in a profit of
RWF300,000. New machinery was acquired in 20X7, including additions of RWF2.55m acquired
under finance leases.

2. The tax charge in the Statement of Comprehensive Income comprises:

RWF’000
Group income tax 1,173
Deferred
tax 312
Share of associate company tax 435
Tax attributable to investment income 135
2,055

3. Loans were issued at a discount in 20X7 and the carrying amount of the loans at 31st
December 20X7 included RWF120,000 representing the finance cost attributable to the discount
and allocated in respect of the current period.

567

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4. Information relating to the acquisition of BK Limtied:
RWF’000
Machinery 495
Inventories 96
Trade receivables 84
Cash 336
Trade payables (204)
Income tax (51)
756
Non-Controlling Interest (25%) (189)
Goodwill 300
867

Consideration paid: 2,640,000

shares 825
Cash 42
867

Required
Prepare a draft consolidated cash flow statement for SH. Group for the year ended 31st
December 20X7, in accordance with the indirect method laid out in IAS 7.

Solution

 SH Limited Draft Consolidated Cash Flow Statement for the year ended 31st December 20X7
RWF’000 RWF’000

Cash Flows from Operating Activities 6,090

Net profit before tax
Adjustments for:
Depreciation (W1) 975
Profit on sale of plant (300)
Share of associates profit (1,485)
Investment income (600)
Interest payable 450
Operating profit before working capital 5,130
changes
Increase in receivables (W2) (1,641)
Increase in inventories (W2) (2,829)
Increase in payables (W2) 456
Cash generated from operations 1,116
Interest paid (W3) (300)
Income tax paid (W4) (750)
Net cash from operating activities 66

Cash Flows from Investing Activities

Purchase of subsidiary undertaking (W5) 294

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 Purchase of property, plant and equipment (3,255)
(W6)
Proceeds from sale of plant 1,500
Dividends from investment (600 – 135) 465
Dividends from associate (W7) 750
Net cash used in investing activities (246)

Cash Flows from Financing Activities

Issue of ordinary share capital (W8) 7,359
Issue of loan stock (W9) 2,760
Capital payments under finance leases (W10) (810)
Dividends paid (W11) (900)
Dividends paid to non-controlling interest (144)
(W12)
Net cash flows from financing activities 8,265

Net increase in cash and cash equivalents 8,085

Cash and cash equivalents at 1/1/20X7 5,460
Cash and cash equivalents at 31/12/20X7 13,545

Note 1: Cash and Cash Equivalents

31st December
20X7 20X6
Cash 5,460 13,545

Workings
(W1) Depreciation

(a) Buildings
RWF’000 RWF’000
NBV 20X6 6,600
NBV 20X7 6,225
Depreciation 375
(Note: there was no disposal of buildings during the year)

(b) Machinery
Provision for Depreciation on Machinery

Depreciation on disposal (see 300 Balance b/d 3,300

below)
Balance c/d 3,600 Charge for year 600
(bal. fig.)
3,900 3,900
Balance b/d 3,600

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Disposal Account

Machinery account (cost) 1,500 Bank (sales proceeds) 1,500

Profit on disposal (given) 300 Depreciation on disposal (bal. fig.) 300
1,800 1,800

Total Depreciation charged for year:

Buildings 375
Machinery 600
975

(W2) Working Capital Changes

Receivables Inventories Payables

RWF’000 RWF’000 RWF’000
Opening balance 3,825 3,000 840
Closing balance 5,550 5,925 1,500
Increase/(decrease) 1,725 2,925 660
Balance at date of acquisition of (84) (96) (204)
subsidiary
1,641 2,829 456

(W3) Interest Paid

Interest Account
Discount 120 Balance b/d 90
Interest paid (bal. fig.) 300 Charge for year (per i/s) 450
Balance c/d 120
540 540
Balance b/d 120

(W4) Income Tax Paid

Income Tax Account

Tax paid (bal. fig.) 750 Balance b/d (651 + 39) 690

Statement of 1,485
Comprehensive Income
(1,173 + 312)

Balance c/d 1,476 Tax at acquisition 51

Balance b/d (1,386 + 90) 1,476

2,226 2,226

(W5) Purchase of Subsidiary Undertaking

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 RWF’000
Cash paid (42)
+ Cash acquired on acquisition 336
Net cash flow 294

(W6) Purchase of Property, Plant and Equipment

Machinery Account

Balance b/d 4,200 Disposal 1,500

Finance lease obligations 2,550
Acquired on acquisition 495
Purchased (bal. fig.) 3,255 Balance c/d 9,000
10,500 10,500
Balance b/d 9,000

There was no acquisition or disposal of buildings during the year.

(W7) Dividends from Associate

Investment in Associate

Balance b/d 3,000 Share of tax 435

Share of profits 1,485 Dividend received (bal. fig.) 750
Balance c/d 3,300
4,485 4,485
Balance b/d 3,300

(W8) Issue of Ordinary Share Capital

Ordinary Share Capital

Balance b/d 6,000

Balance c/d 11,820 Issued as consideration for 660
acquisition

Issued for cash 5,160

11,820 11,820
Share Premium Account

Balance b/d 6,285

Consideration for 165
acquisition
Balance c/d 8,649 Cash received 2,199
8,649 8,649
Balance b/d 8,649

Total cash received for shares = 5,160 + 2,199 = 7,359

Note: 2,640,000 shares issued as consideration for BK Ltd

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 RWF’000 RWF’000
Dr Investment in BK Ltd
Cr Share capital (2,640 x .25rwf) 660
Cr Share premium (balance) 165

(W9) Issue of Loan Stock

RWF’000

Opening balance 1,500

Closing balance 4,380
Increase 2,880
Less discount (120)
Net increase for cash 2,760

(W10) Capital Payments under Finance Leases


Balance b/d (510 + 600) 1,110

New leases 2,550

Payments made 810 3,660

Balance c/d 2,850 Balance b/d (2,130 + 720) 2,850
3,660

(W11) Dividends Paid

RWF’000

Opening retained earnings 7,500

Add: Profit for year (group) share 3,735

11,235

Less: Closing retained earnings 10,335

Dividends Paid 900

No dividends outstanding at year-end. Thus, they have been paid in full.

(W12) Dividends Paid to Minority Interest

Non-Controlling Interest Account

Balance b/d -

Dividends paid 144 Share of profit 300

Balance c/d 345 On acquisition of BK Ltd 189
489 489
Balance b/d 345

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M. LIMITATIONS OF THE CASH FLOW STATEMENT
Where users of the financial statements are assessing the extent of future cash flows, then cash
flow statements, though useful, should not be considered in isolation. Information from income
statements and Statement of Financial Positions, together with the cash flow statements, give
an overall indication of the company’s performance and financial position.

The cash flow statement suffers from a number of drawbacks which may hinder its usefulness.

• It is based on historical information. Past performance might not be a reliable indicator of

future performance.
• Cash flow statements are open to manipulation of cash flows, for example delaying payment
to creditors beyond the year-end has a positive, but short-term impact on cash.
• While cash flow is important for a business to survive, so too is its ability to
generate profit.

Concentrating on short-term cash generation may be detrimental to investment in longer term

projects which may be very profitable.

REVENUE FROM CONTRACTS WITH CUSTOMERS IFRS 15

IFRS 15– REVENUE FROM CONTRACTS WITH CUSTOMERS

IFRS 15 Revenue from Contracts with Customers replaces IAS 18 Revenue (effective for annual
reporting periods beginning on or after 1 January 2018).
For straightforward transactions of sales of goods, the change to IFRS 15 from IAS 18 will
have little, if any, effect on the amount and timing of revenue recognition. For contracts such
as long-term service contracts it could result in changes either to the amount or to the timing of
revenue recognized. However, the only significant area in which the FA syllabus will be affected
is the recognition of revenue for sales where a cash/settlement discount allowed is offered to the
customer.
IFRS 15 is concerned with reporting the nature, amount, timing and uncertainty of revenue and
cash flows resulting from contracts with customers.
Revenue from contracts with customers arises from fairly common transactions:

• The sale of goods

• The rendering of services

Generally, revenue is recognized when the entity has transferred control of goods and services
to the buyer. Control of an asset is described in the standard as ‘the ability to direct the use of,
and obtain substantially all of the remaining benefits from, the asset.’ (IFRS 15)

Introduction
Accruals accounting is based on the matching of costs with the revenue they generate. It is
crucially important under this convention that we establish the point at which revenue is
recognized, so that the correct treatment can be applied to the related costs. For example, the
costs of producing an item of finished goods should be carried as an asset in the statement of
financial position until such time as it is sold; they should then be written off as a charge to the
trading account. Which of these two treatments should be applied cannot be decided until it is
clear at what moment the sale of the item takes place? The decision has a direct impact on
profit since it would not be prudent to recognise the profit on sale until a sale has taken place, in

136 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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accordance with the criteria of revenue recognition.
Revenue is generally recognized as earned at the point of sale, because at that point four criteria
will generally have been met.

• The product or service has been provided to the buyer.

• The buyer has recognized his liability to pay for the goods or services provided. The converse
of this is that the seller has recognized that ownership of goods has passed from himself to
the buyer.
• The buyer has indicated his willingness to hand over cash or other assets in settlement of his
liability.
• The monetary value of the goods or services has been established.

However, there are situations where revenue is recognized at other times than at the point of
sale, for example, the sale of a cell phone contract. This is a long-term service contract which
may involve multiple services and goods delivered at different points over the contract. In this
scenario, revenue is recognized upon the fulfilment of various performance obligations of each
distinct good and service. IFRS 15 applies to long-term service contracts as well as simpler
sales transactions involving single products and services. However, revenue recognition of long-
term service contracts is beyond the scope of this syllabus.

IFRS 15
IFRS 15 governs the recognition of revenue arising from contracts with customers. Revenue is
income arising in the ordinary course of an entity’s activities, such as sales and fees.
The key principle of IFRS 15 is that revenue is recognized to depict the transfer of promised
goods or services to customers at an amount that the entity expects to be entitled to in exchange
for those goods or services. This is achieved by applying a five-step model:

• Identify the contract(s) with a customer

• Identify the performance obligations in the contract
• Determine the transaction price
• Allocate the transaction price to the performance obligations in the contract
• Recognise revenue when (or as) the entity satisfies a performance obligation

Definitions
The following definitions are given in the standard.
b is income arising in the course of an entity’s ordinary activities.
Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in an increase in equity, other than
those relating to contributions from equity participants.
A contract is an agreement between two or more parties that creates enforceable rights and
obligations.

A customer is a party that has contracted with an entity to obtain goods or services that are an
output of the entity’s ordinary activities in exchange for consideration.
A performance obligation is a promise in a contract with a customer to transfer to the customer
either: a good or service (or a bundle of goods or services) that is distinct; or a series of distinct
goods or services that are substantially the same and that have the same pattern of transfer
to the customer. Transaction price is the amount of consideration to which an entity expects to
be entitled in exchange for transferring promised goods or services to a customer, excluding

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amounts collected on behalf of third parties.
Revenue does not include sales taxes, value added taxes or goods and service taxes which are
only collected for third parties, because these do not represent economic benefits flowing to the
entity. The same is true for revenues collected by an agent on behalf of a principal. Revenue for
the agent is only the commission received for acting as agent.

Measurement of revenue
This is the transaction price, as defined above in the standard, allocated to each performance
obligation. This will take account of any trade discounts and volume rebates. At Foundation
level, this is simply the amount at which the goods/services are sold to the customer, with one
exception; where a sale involves a cash (or settlement) discount.

Cash/settlement discounts allowed

IFRS 15 refers to ‘variable consideration’. This means the variable element of the payment a
business expects to receive for a sale. A cash/settlement discount allowed for payment by cash/
prompt payment is one such variable consideration. IFRS 15 requires a business to estimate
the amount of variable consideration it expects to receive and reflect this in the transaction price
(IFRS 15: para 50).
This gives rise to the following accounting treatment of cash/settlement discounts allowed:

• If a customer is expected to take up a cash/settlement discount allowed, the discount is

deducted from the invoiced amount when recording the revenue.
• If the customer subsequently does not take up the discount, the discount is then recorded as
revenue. x If the customer is not expected to take up the discount, the full invoiced amount is
recognized as revenue when recording the sale. If the customer subsequently does take up
the discount, revenue is then reduced by the discount.

EXAMPLE
In this example, the five-step model is applied to a simple sales transaction involving the sale of
a single product.
TDF is a company that manufactures office furniture. A customer placed an order on 22 December
20X4 for an office desk at a price of RWF300,000 plus sales tax at 20% of RWF60,000. The desk
was delivered to the customer on 25 January 20X5, who accepted the goods as satisfactory by
signing a delivery note. TDF then invoiced the customer for the goods on 1 February 20X5. The
customer paid RWF360,000 to TDF on 1 March 20X5.

Required
How should TDF account for revenue?

ANSWER
Applying the five-step model:

• Identify the contract(s) with a customer:

A customer placed an order for a desk. This represents a contract to supply the desk.
• Identify the performance obligations in the contract:
There is one performance obligation, the delivery of a satisfactory desk.
• Determine the transaction price:
This is the price agreed as per the order, i.e. RWF300,000. Note that sales tax is not included
since transaction price as defined by IFRS 15 does not include amounts collected on behalf of third
parties.

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 • Allocate the transaction price to the performance obligations in the contract:
There is one performance obligation, therefore the full transaction price is allocated to the
performance of the obligation of the delivery of the desk.
• Recognise revenue when (or as) the entity satisfies a performance obligation:
Since the customer has signed a delivery note to confirm acceptance of the goods as satisfactory,
this is evidence that TDF has fulfilled its performance obligation and can therefore recognise
RWF300,000 in January 20X5.
Note. The timing of payment by the customer is irrelevant to when the revenue is recognized.
For most simple transactions with a single performance obligation, the full transaction price will be
recognized when control of goods or services has transferred to the customer.
It gets more complex however when there are multiple performance obligations, e.g., as mentioned
in the previous topic, the sale of a cell phone contract. This often involves a ‘free’ phone and
monthly network service bundled together as a single monthly fee. In this scenario there are two
performance obligations; the delivery of the phone at the start of the contract and the network
service. The transaction price of the monthly fee would need to be apportioned between these two
performance objectives and recognized thereon.
Don’t worry about learning this particular example, since long-term contracts are beyond scope
of this syllabus. However, it is shown here to demonstrate how the standard is applied to more
complex revenue arrangements.

EXAMPLE
Now work through this example to give you practice in preparing financial statements in
accordance with IAS 1. Note that very little detail appears in the statement of profit or loss – all
items of income and expenditure are accumulated under the standard headings. Write out the
standard proformas and then go through the workings, inserting figures as you go.
USB Ltd, a limited liability company, has the following trial balance at 31 December 20X9.

RWF’000 RWF’000
Cash at bank 100
Inventory at 1 January 20X9 2,400
Administrative expenses 2,206
Distribution costs 650
Non-current assets at cost:
Buildings 10,000
Plant and equipment 1,400
vehicles 320
Suspense 1,500
Accumulated depreciation
Buildings 4,000
Plant and equipment 480
Motor vehicles 120
Retained earnings 560
Trade receivables 876
Purchases 4,200
Dividend paid 200
Sales revenue 11,752
Sales tax payable 1,390

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 Trade payables 1,050
Share premium 500
RWF1 ordinary shares 1,000
22,352 22,352

The following additional information is relevant.

(a) Inventory at 31 December 20X9 was valued at RWF1,600,000. While doing the inventory count, errors
in the previous year’s inventory count were discovered. The inventory brought forward at the beginning of
the year should have been RWF2.2m, not RWF2.4m as above.
(b) Depreciation is to be provided as follows.
(i) Buildings at 5% straight line, charged to administrative expenses
(ii) Plant and equipment at 20% on the reducing balance basis, charged to cost of sales
(iii) Motor vehicles at 25% on the reducing balance basis, charged to distribution costs
(c) No final dividend is being proposed.
(d) A customer has gone bankrupt owing RWF76,000. This debt is not expected to be recovered and an
adjustment should be made. An allowance for receivables of 5% is to be set up.
(e) 1m new ordinary shares were issued at RWF1.50 on 1 December 20X9. The proceeds have been left
in a suspense account.

Required
Prepare the following.
(a) Statement of profit or loss for the year ended 31 December 20X9 (3 marks)
(b) Statement of changes in equity for the year ended 31 December 20X9 (4 marks)
(c) Statement of financial position as at 31 December 20X9 (8 marks)
All statements are to be prepared in accordance with the requirements of IFRSs. Ignore taxation.
(Total: 15 marks)
ANSWER

USB LTD
STATEMENT OF PROFIT OR LOSS
FOR THE YEAR ENDED 31 DECEMBER 20X9

RWF’000
Revenue 11,752
Cost of sales (W2) (4,984)
Gross profit 6,768
Administrative expenses (W3) (2,822 )
Distribution costs (650 + 50 (W1)) (700 )
Profit for the year 3,246

140 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 (b)
USB LTD
STATEMENT OF CHANGES IN EQUITY
FOR THE YEAR ENDED 31 DECEMBER 20X9

Share capital Share premium Retained earnings

Total RWF’000 RWF’000 RWF’000 RWF’000
Balance at 1 January 20X9 1,000 500 560 2,060
Prior period adjustment – – (200) (200)

Restated balance 1,000 500 360 1,860

Total comprehensive income for the year – – 3,246 3,246
Dividend paid – – (200) (200)
Share issue 1,000 500 – 1,500
Balance at 31 December 20X9 2,000 1,000 3,406 6,406

(c)
USB LTD
STATEMENT OF FINANCIAL POSITION
AS AT 31 DECEMBER 20X9
RWF’000 RWF’000
Non-current assets
Property, plant and equipment (W4) 6,386
Current assets
Inventory 1,600
Trade receivables (876 – 76 – 40) 760
Cash 100
2,460
Total assets 8,846

Equity and liabilities

Equity
Share capital (1000 + 1000) 2,000
Share premium (500 + 500) 1,000
Retained earnings (W5) 3,406
Current liabilities
Sales tax payable 1,390
Trade payables 1,050
2,440
Total equity and liabilities 8,846

Workings
1 Depreciation

RWF’000
Buildings (10,000 u 5%) 500
Plant (1,400 – 480) X20% 184
Motor vehicles (320 – 120) 25% 502

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 Cost of sales

RWF’000
Opening inventory 2,200
Purchases 4,200
Depreciation (W1) 184
Closing inventory (1,600)
4,984
3 Administrative expenses RWF’000
Per T/B 2,206
Depreciation (W1) 500
Irrecoverable debt 76
Receivables allowance ((876 – 76) X5%) 40
2,822
4 Property, plant and equipment
Cost Acc. dep Dep. chg. Carrying amount
RWF’000 RWF’000 RWF’000 RWF’000
Buildings 10,000 4,000 500 5,500
Plant 1,400 480 184 736
Motor vehicles 320 120 50 150
11,720 4,600 734 6,386
5 Retained earnings
RWF’000
B/f per T/B 560
Prior period adjustment (inventory) (200)
Profit for period 3,246
Dividend paid (200)
3,406

EARNINGS PER SHARE IAS 33

EXPLANATORY NOTE

The need for the disclosure of Earnings Per Share (EPS) is based on the increasing use of the
Price/Earnings
(P/E) ratio as a standard stock market indicator. The formula for the calculation of the P/E ratio is:
Market Price of Share
EPS
Therefore, the P/E ratio can be seen as a “purchase of a number of year’s earnings” but
perhaps more significantly, for many investors it also represents the future prospects of the
share. A higher P/E ratio is believed to indicate a faster growth in the company’s EPS in the
future. Conversely, the lower the P/E ratio, the lower the expected future growth.

The continued use of P/E ratios requires that the EPS, on which that ratio is based, should be
calculated and disclosed on a comparable basis as between one company and another and as
between one financial period and another, so far as this is possible.

In addition to this, the trend shown by a comparison of a company’s profits over time is a rather
crude measure of performance and can be misleading without careful interpretation of all the
events that the company has experienced. Particularly, this would be the case where a company

142 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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is enlarged by amalgamation or issues of shares for cash. Profits can be expected to increase
as the resources of the company increase. Earnings Per Share will show whether profits are
increasing less, equally or more than the company’s resources. As new shares are issued, a
company may well show rising profits without reflecting a corresponding growth in EPS.

IAS 33 Earnings Per Share outlines the principles for the determination and presentation of EPS,
in order to improve comparisons between different companies in the same reporting period and
between different reporting periods for the same company.

B. SCOPE
IAS 33 applies to entities whose ordinary shares (or potential ordinary shares) are publicly traded
and to entities that are in the process of issuing shares (or potential ordinary shares) in public
securities markets.

C. DEFINITIONS

• Ordinary Share
An equity instrument that is subordinate to all other classes of equity instruments. It is an instrument
that falls under the definition of “equity shares” in IAS 32, i.e. a contract that evidences a residual
interest in the assets of an entity after deducting all of its liabilities. Ordinary shares participate in the
net profit for the period only after other types of shares, such as preference shares. An entity may
have more than one class of ordinary shares.

• Earnings
The earnings should be the after-tax net profit / loss after deducting preference dividends and
other appropriations for non-equity shares. All items of income and expense that are recognised in
a period, including exceptional items and non-controlling interests, are included in the determination
of net profit or loss for the period.

Therefore, the calculation of the earnings figure effectively becomes:

Profit
Less Tax
Less Non-Controlling Interest (in the case of group accounts)
Less Preference dividends (or other non-equity appropriations)

EPS is normally expressed in Rwandan francs (RWF).

The amount of preference dividends that is deducted from the net profit for the period is:

(a) The amount of any preference dividends on non-cumulative preference shares declared in
respect of the period;
OR

(b) The full amount of the required preference dividends for cumulative preference shares for the period,
whether or not the dividends have been declared, as the undeclared amount is still deductible as
an appropriation. The amount of preference dividends for the period does not include the amount
of any preference dividends for Cumulative Preference Shares paid or declared during the current
period in respect of previous periods.
Where an entity has more than one class of ordinary shares, the earnings for the period are
apportioned over different classes of shares in accordance with their dividend rights or other
rights.
CPA EXAMINATION I1.2 FINANCIAL REPORTING 143
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D. NUMBER OF SHARES
For the purpose of calculating basic earnings per share, the number of shares should be the
weighted average number of ordinary shares outstanding during the period.

The weighted average number of ordinary shares outstanding during the period reflects the fact
that the amount of shareholders capital may be varied during the period as a result of a larger
or lesser number of shares being outstanding at any time. It is the number of ordinary shares
outstanding at the beginning of the period, adjusted by the number of ordinary shares bought
back or issued during the period multiplied by a time weighting factor.

The time weighting factor is the number of days that the specific shares are outstanding as a
proportion of the total number of days in the period (a reasonable approximation of the weighted
average is adequate in many circumstances).

E. MEASUREMENT OF BASIC EARNINGS PER SHARE

EPS = Profit – Tax – Non-Controlling Interest – Preference Dividends
Weighted average number of Ordinary Shares in issue during the period
IAS 33 says that the entity must calculate the EPS amounts for profit or loss attributable to
ordinary equity holders of the parent entity and , if presented, profit or loss from continuing
operations attributable to those equity holders.

EXAMPLE 1
Company X has 1,000,000 ordinary RWF1 shares and 500,000 RWF1 10% Cumulative
preference shares

Statement of Comprehensive Income (Extract)

RWF RWF

Operating Profit 750,000

Tax (300,000) 450,000
Dividends Paid
Ordinary 75,000
Preference 40,000
115,000
Retained Profit 335,000

Solution
450,000 – 50,000
EPS is: = .40rwf
1,000,000
Note that if the preference shares were non-cumulative, the EPS would be
450,000 – 40,000
EPS is: = .41rwf
1,000,000

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EXAMPLE 2
X plc made a profit after tax of RWF1.5 million, out of which a preference dividend of
RWF200,000 was paid.
There are 10 million ordinary shares in issue.

RWF
Earnings are: Profit after tax 1,500,000
Preference dividend (200,000)
1,300,000
Number of Ordinary Shares: 10,000,000
EPS: 13rwf

EXAMPLE 3
A company’s capital structure at 31st December 2010 comprised:

RWF1,250,000 8% Cumulative Preference Shares of RWF1 each

RWF1,800,000 Ordinary Shares of RWF1 each

Profits before tax were RWF1,000,000. Assume corporation tax 50%

of Profits.

Solution
RWF1,000,000 - RWF500,000 -RWF100,000*
EPS = = 22..22rwf
1,800,000 shares

* RWF1,250,000 x 8% = RWF100,000

Example 4
CDE Ltd. reported profit before tax in the year ended 31st March 2010 of RWF95,000. Tax for
the year amounted to RWF40,000 and the company paid the preference dividend of RWF8,000.
The number of ordinary shares in issue at that date was 500,000.

Solution
RWF95,000 - RWF40,000 - RWF8,000
EPS = = .094rwf
500,000 shares

F. CHANGES IN CAPITAL STRUCTURE

When a firm’s capital structure changes, the denominator of the EPS fraction changes also.
There are a number of possible causes for such a change. The most common are:

1. Issue of shares at their full market price

2. A Capitalisation or Bonus issue
3. A Rights Issue
4. Share Exchange

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1. Issue Of Shares At Full Market Price
Rule = New shares should be included in the EPS calculation, weighted on a time
basis
Do not adjust previous year’s EPS

The rationale of this approach is that cash or other assets are introduced into the business during
the year as a result of the share issue. These assets should generate additional earnings for that
portion of the year for which they are issued. Therefore, in order to compare like with like, the
denominator should include the additional shares only for that portion of the year in which shares
are issued.

EXAMPLE
Company X issued 450,000 shares for RWF1 each on the 1st July 2010. This was in addition
to the
3,600,000 shares already in issue.

Earnings for the year 2010 were RWF396,000

What is the EPS for the year ended 31st December 2010?

Solution
Number of Shares for EPS purposes:
3,600,000 x 6/12 = 1,800,000
+
4,050,000 x 6/12 = 2,025,000
Total 3,825,000

RWF396,000
EPS = = 0.1035 rwf
3,825,000 shares
2. Bonus or Capitalisation Issue
This is also sometimes referred to as a scrip issue. In this type of issue, ordinary shares are issued
to
existing shareholders for no additional consideration, i.e. for free. Therefore the number of shares
in issue is increased without an increase in resources.

Rule = Bonus shares are deemed to be issued on the 1st day of the earliest period being
reported (usually, the 1st day of the comparative year). The effect will be as if the bonus
shares had always been in issue.
Thus, no time weighting
Adjust previous years EPS

EXAMPLE
Company Y had earnings for EPS purposes of RWF75,000 in 2010.

There were 500,000 shares in issue at the start of the year.

The company issued a bonus issue of 1 for 5 half way through the year

What is the EPS for 2010?

Solution
A 1 for 5 bonus issue means 100,000 free shares were issued.
RWF75,000
EPS = = 0.125rwf
(500,000 + 100,000)
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 EXAMPLE
Et Ltd. had earnings in 2009 and 2010 of RWF360,000 and RWF396,000 respectively. At the start
of
2010, there were 3,600,000 ordinary shares in issue. In 2010, Et Ltd. made a 1 for 9 bonus issue.

Solution
2010 EPS Earnings 396,000
Shares 4,000,000
EPS .099rwf
2009 EPS (comparative) Earnings 360,000
Shares 4,000,000
EPS .09rwf
As an alternative to adjusting the 2009 EPS in the method shown above, it is also acceptable to
multiply the previous year’s EPS by a ‘bonus factor’. This bonus factor depends on the terms of
the bonus issue itself. In the question above, the bonus issue was a 1 for 9. Thus, the bonus factor
is 9/10th (a 1 for 2 issue would have a bonus factor of 2/3rd, a 1 for 3 issue would have a bonus
factor of 3/4th etc.).
In 2009, the EPS would have been calculated as .10rwf (RWF360,000/3,600,000). Thus, the
adjusted
2008 figure in the accounts for 2010 would be .10rwf x 9/10th =
.09rwf.
Note that even though the bonus shares were not issued until 2010, the comparative EPS figure
for 2009 is then recalculated to include the bonus shares as if they had existed back then. This is
done to preserve comparability between the periods.

3. Rights Issue
A rights issue is an issue of shares, pro rata, to existing shareholders. The exercise price is often
less than
the fair value of the shares. Therefore, such a rights issue includes a bonus element an in
calculating EPS, this has to be taken into consideration.
Rule = Calculate the “Theoretical Ex Rights Price”
Weight shares on a time basis
Adjust previous years EPS

The Theoretical Ex Rights Price is the price the shares will have, in theory, after the rights issue
occurs. The market price of the shares immediately before the rights issue takes place is often
referred to as the
“Cum Rights Price”.
Both the Theoretical Rx Rights Price and the Cum Rights Price are used in the calculation of EPS
and in the adjusting of the previous year’s EPS.

EXAMPLE
Company A had earnings (for EPS) of RWF396,000 in 2010 and RWF360,000 in
2009

At the start of 2010, it had 3,600,000 shares in issue

On the 1st July 2010, the company made a 1 for 4 for .50rwf rights issue. The “cum rights” price
was
RWF1. What is the EPS for 2010?

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 Solution
Calculate the T.E.R.P.
RWF
4 shares x RWF1.00 = 4.00
1 share x RWF0.50 = 0.50
5 shares 4.50
T.E.R.P. = 0.90
RWF396,000
(3,600,000 x 1.00 / .90 x 6/12) + (4,500,000 x 6/12)

RWF396,000
=.0931rwf
4,250,000

Adjust previous years EPS (10rwf as previously reported)

.10rwf x 0.90 / 1.00 = .09rwf

4. Share Exchange
Shares issued to acquire a subsidiary are deemed to be issued on the first day of the period for
which profits of new subsidiary are included in group earnings

This is because the results of the new subsidiary are only included in the consolidated accounts
from that date onwards.

EXAMPLE
Company X has 1 million shares in issue on 1st January 2010. On 30th September, Company X
acquired
80% of the Ordinary shares of Y Ltd.

As part of the consideration, Company X issued 600,000 ordinary shares with a market value of
RWF4 each

What is the number of shares to be included in the EPS calculation?

Solution
For the EPS calculation in 2010, the number of shares is:

(1,000,000 x 9/12) + (1,600,000 x 3/12)

= 1,150,000 shares
Comprehensive Example involving more than one change in the capital structure of a company
Extracts from the Statement of Financial Position of RDN as at 1st April 2010 are:

RWF’000 RWF’000
Ordinary shares of .25rwf each 4,000
8% Preference shares 1,000
Reserves
Share premium 700
Capital redemption reserve 1,300
Revaluation reserve 90
Retained earnings 750

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 2,840
7,840
10% convertible loans 2,000

The following draft Statement of Comprehensive Income has been prepared for the year to 31st
March
2011:
RWF’000 RWF’000
Profit before interest and tax 1,800
Loan interest (200)
Profit before tax 1,600
Taxation
Provision for 2011 300
Deferred tax 390

Dividends paid: Ordinary

320
80 Preference
(690)
910

(400)
510

(i) A bonus issue of 1 new share for every 8 ordinary shares held was made on 7th September
2010

(ii) A fully subscribed rights issue of 1 new share for every 5 ordinary shares held at a price of .50
rwf’s each was made on 1st January 2011. Immediately prior to the issue, the market price of
RDN’s ordinary shares was RWF1.40 each

(iii) The EPS was correctly reported in last year’s accounts at .08 rwf’s
Solution
Earnings (910 – 80) RWF830,000
Number of Shares 01/04/10
Opening Balance 16,000,000
07/09/10
Bonus Issue (1 for 8) 2,000,000
1/1/11
Rights Issue (1 for 5) 3,600,000
31/3/11Closing Balance 21,600,000

Calculate the T.E.R.P.

RWF
5 shares x RWF1.40 = 7.00
1 share x RWF0.50 = 0.50
6 shares 5.50
T.E.R.P. = 1.25
RWF830,000
EPS
(18,000,000 x 1.40 / 1.25 x 9/12) + (21,600,000 x 3/12)

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 RWF830,000
20,520,000

.0404rwf

Adjust previous years EPS

.08rwf x 8/9* x 1.25 / 1.40 = .0635rwf

* This fraction represents the ‘bonus factor’ and is used to factor in the effect of the bonus issue.
The bonus issue terms were 1 for 8, thus the bonus factor is 8/9.

G. PRESENTATION AND DISCLOSURE

The entity must present, on the face of the Statement of Comprehensive Income, the EPS in
respect of the profit or loss from continuing operations, attributable to the ordinary equity holders.

If the entity reports a discontinued operation, it must disclose the EPS for the discontinued
operation either on the face of the Statement of Comprehensive Income or in the notes to the
financial statements.

The entity must disclose the following:

• The amount used as the numerator in calculating EPS, together with a reconciliation of those
amounts to the net profit or loss for the period
• The weighted average number of ordinary shares used as the denominator in calculating
the EPS, together with a reconciliation of these denominators to each other.

If the entity makes a net loss for the period, the EPS is still calculated using the net loss (as
adjusted) as the numerator. Thus, the EPS will be a negative figure. Disclosure is still mandatory
when the EPS is negative.

H. RETROSPECTIVE ADJUSTMENTS
If the number of ordinary shares increases as a result of:

• A capitalisation / bonus / scrip issue; or

• A share split

The calculation of EPS for all periods must be adjusted retrospectively.

If these changes occur after the Statement of Financial Position date but before the financial
statements are authorised for issue, the EPS calculations for those and any prior period financial
statements presented must be based on the new number of shares. The fact that the EPS
calculation reflects such changes in the number of shares must be disclosed.

In addition, the EPS of all periods presented in the financial statements must be adjusted for
the effects of errors and adjustments arising from changes in accounting policies accounted for
retrospectively.

[Note that other major share transactions after the Statement of Financial Position date are Non-
Adjusting Events according to IAS 10 and so are not applied retrospectively. However, they must
be disclosed in the notes to the financial statements]

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BORROWING COST IAS 23

DEFINITION
Borrowing costs are interest and other costs incurred by an entity in connection with the
borrowing of funds. They may include, for example:

• Interest on bank overdrafts, short-term and long-term loans

• Amortisation of discounts or premiums related to borrowing
• Finance charges in respect of finance leases
• Exchange differences arising from foreign currency borrowings to the extent that they are
regarded as an adjustment to interest costs.

The Standard only applies to borrowing costs related to external borrowings and not to equity.
Therefore, the Standard does not deal with the imputed or actual cost of equity, including
preference share capital not classified as equity.

B. ACCOUNTING TREATMENT
IAS 23 Borrowing Costs regulates the extent to which entities are allowed to capitalise borrowing
costs incurred on money borrowed to finance the acquisition of certain assets.

Borrowing costs must be capitalised as part of the cost of an asset when:

• It is probable that the costs will result in future economic benefits and the costs can be
measured reliably; and
• They are directly attributable and they would have been avoided if the asset was not bought,
constructed or produced.

Note that this is a departure from the previous position which existed up to 1st January 2009,
where a benchmark treatment and an allowed alternative were available to entities.

Other borrowing costs are recognised as an expense in the period they were incurred. A qualifying
asset is an asset that takes a substantial period of time to get ready for its intended use or sale.
Examples of such assets include:
• Inventories that require substantial time periods to bring them to saleable condition
• Manufacturing plants
• Investment properties
C. BORROWING COSTS ELIGIBLE FOR CAPITALISATION
When an entity borrows funds specifically to acquire a qualifying asset, the borrowing costs
relating to that asset should be readily identifiable. Such costs are directly attributable since they
would have been avoided if the asset had not been acquired, constructed or produced.

However, if the financing activity of an entity is centrally co-ordinated, it may be difficult to identify
the relationship between particular borrowings and a qualifying asset. In this case, IAS 23 says
that judgement must be exercised.

If funds are borrowed generally and used to obtain a qualifying asset, the amount of funds
eligible for capitalisation is calculated by applying a “capitalisation rate” to the cost of the asset.
This rate is the weighted average of the borrowing costs that are applicable to the borrowings of

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the entity that are outstanding during the period.

On the other hand, if the funds have been specifically borrowed to acquire the asset, the amount
of funds that can be capitalised is calculated as follows:

• Actual borrowing costs incurred on that borrowing

• Less: Any investment income on the temporary investment of those borrowings*
• *Borrowed funds are sometimes temporarily invested pending their expenditure on qualifying
assets.

D. COMMENCEMENT OF CAPITALISATION
The capitalisation of borrowing costs shall commence when:

• Expenditures for the asset are being incurred

• Borrowing costs are being incurred and
• Activities that are necessary to prepare the asset for its intended use or sale are in
progress. This includes not only physical work constructing the asset but also technical and
administration work prior to the commencement of construction.

E. CESSATION OF CAPITALISATION
The capitalisation of borrowing costs shall cease when substantially all the activities necessary
to prepare the qualifying asset for its intended use or sale are complete.
An asset is normally ready for use or sale when the physical construction of the asset is complete.
F. SUSPENSION OF CAPITALISATION
The capitalisation of borrowing costs should be suspended during extended periods in which
active development is interrupted.

Thus, for example, borrowing costs incurred during builders’ holidays would continue to be
capitalised, whereas borrowing costs incurred during prolonged industrial disputes would not be
capitalised.

G. INTEREST RATES
Where assets are financed by specific borrowings, IAS 23 requires that the cost of this specific
borrowing, related to the financing, be capitalised.

However, where the general borrowings of the company are used to finance qualifying assets,
then a weighted average cost of capital (excluding any specific borrowings) should be applied to
the average investment in the asset.

In addition, any interest from the temporary investment of any surplus funds relating to the
financing of the assets is treated as a reduction of the borrowing cost.

Example 1
On the 1st June 2010, SH. Limited commenced construction of a new factory that is expected
to take 3 years to complete. It is being financed entirely by a 3-year term loan of RWF6 million
(taken out at the start of construction).

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The loan carries a fixed interest rate of 9% per annum and issue costs of 1.5% of the loan value
were incurred on the loan. During the year, RWF57,000 had been earned from the temporary
investment of these borrowings.

The company’s year-end is 31st December.

How much interest must be capitalised under IAS 23 for the year ended 31st December 2010?
(You may use the straight-line method to amortise issue costs)
Solution
RWF
Interest* 315,000
PLUS
Issue costs** 17,500
LESS
Interest earned from temporary investment of funds (57,000)
Amount to be capitalised 275,500

* Interest

RWF6 million x 9% x 7/12 = 315,000

*Issue Costs
RWF6 million x 1.5% = RWF90,000
Amortised over three years, RWF30,000 per annum
Thus, for this year, RWF30,000 x 7/12 = RWF17,500

Example 2
S. Company Limited is constructing an investment property. Due to the poor state of the property
letting market, construction of this property was halted for the first three months of the year.
On the 30th September 2010, the company completed the property. Despite attempts to let the
property, it remained empty at the year end.

The average carrying value of the property, before the inclusion of the current years borrowing
cost, is RWF15 million.

The investment property has been financed out of funds borrowed generally for the purpose of
financing qualifying assets. The company’s weighted average cost of capital is 12% including
all borrowings. However, if a specific loan acquired to fund a different specific asset is excluded,
then the weighted average cost of capital is 10.5%.

The company’s year end is 31st December.

How much interest must be capitalised under IAS 23 for the year ended 31st December 2010?

Solution
RWF15 million x 10.5% x 6/12 = RWF787,500
Note that borrowing costs should not be capitalised during periods when no construction or
development occurs. In addition, capitalisation should cease when the asset is ready for
use. In this example, this excludes capitalisation for the first 3 months and the last 3 months
of the year.

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Example 3:
T. C Limited commenced the construction of a new manufacturing plant on 1st March 2010.
Construction of the building cost RWF18 million. The plant was completed on 1st December
2010 and brought into use on 1stFebruary 2011.

T. C Limited borrowed RWF12 million to help finance the construction of the plant. Interest on the
loan is 8% per annum.

What is the total cost of the building to be capitalised?

Solution:
RWF
Cost of building 18,000,000
Borrowing costs RWF12m x 8% x 9/12 720,000
18,720,000
Example 4:
On 1st January 2009, H. Ltd began construction of a toll bridge. The construction is expected to
take 3.5 years. It is being financed by issuing bonds for RWF7 million at 12% per annum. The
bonds were issued at the beginning of the construction. The costs of issuing the bonds are 1.5%.
The project is also partly funded by the issue of share capital, with a 14% cost of capital. H. Ltd
has opted to capitalise borrowing costs, under IAS 23.

The company’s year end is 31 December.

How much must be capitalised in the first year?

RWF
Interest on the bond = RWF7 million x 12% = 840,000
Amortisation of issue costs = (RWF7 million x 1.5%)/3.5 years = 30,000
Total to be capitalised = 840,000 + 30,000 = 870,000

H. DISCLOSURE
The financial statements must disclose:

• The accounting policy adopted

• The amount of borrowing costs capitalised during the period
• The capitalisation rate used to determine the amount of borrowing costs eligible for
capitalization

INCOME TAXES IAS 12

INTRODUCTION
IAS 12 deals with the accounting treatment of tax liabilities. In this chapter, it is assumed that
the tax liability for the period has already been computed, and the entity now must deal with the
treatment of tax in the financial statements.

The title of the standard suggests that it deals with Income Tax only, but the standard deals with
any tax on company profits, regardless of what the tax is actually called (e.g. corporation tax).

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This chapter looks at the following issues:

• Current tax
• Deferred tax

B. CURRENT TAX
Current tax is the amount of tax payable (or recoverable) in respect of taxable profit (or allowable
loss) for the period. IAS 12 states that current tax for the current and prior periods should be
recognised as a liability in the Statement of Financial Position to the extent that it has not yet
been settled. To the extent that the amounts already paid exceed the amount due, than an asset
should be recognised.

In addition, a tax asset should be recognised in the event that the benefit of a tax loss can be
carried back to recover current tax of a prior period.

Current tax liabilities should be measured at the amount expected to be paid to the tax authorities.
Likewise, current tax assets should be measured at the amounts expected to be recovered from
the tax authorities. This means, in both situations, the amounts involved should be calculated
using the rates / laws that have either been enacted or substantially enacted at the reporting
date.

Current tax assets and liabilities should be shown separately in the financial statements. They
can only be offset if there is a legally enforceable right to do so and it is the entity’s intention to
offset them.

Any adjustments required to reflect any under or over provisions for tax in previous years should
be included in the tax charge (or credit) in the statement of comprehensive income for the current
period. It is, after all, merely the correction of an estimate, and is accounted for as such (i.e. it
does not necessitate a retrospective adjustment)

Example
FS Limited is preparing its financial statements for the year ended 30th June 2010. The following
information is relevant to the tax expense / liability at the year end:

• The current tax due is RWF2,500,000. This reflects the proposed new tax rates announced by
the government in an emergency budget in April 2010, which are to be enacted from August
2010 onwards. If the old rates are applied, the tax liability would be RWF2,100,000.
• During the year ended 30th June 2010, payments on account to the tax authorities
amounted to RWF1,100,000 in respect of current tax for 2010.
• Current tax for 2009 was over estimated by RWF125,000.

What is the tax expense and end-of-year liability to be shown in the financial statements for the
year ended 30thJune 2010?

Since the new tax rate is “substantially enacted” at the year end, the current tax for 2010 is
RWF2,500,000. The over-estimate in the previous year must also be factored in and this will result
in a tax expense in the statement of comprehensive income of RWF2,375,000 (RWF2,500,000
- RWF125,000).

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In the Statement of Financial Position, the tax liability shown in Current Liabilities will be the amount
actually outstanding at the year end, i.e. RWF2,500,000 - RWF1,100,000 = RWF1,400,000.

C. DEFERRED TAX
Deferred tax is the estimated future tax consequences of transactions and events recognised
in the financial statements of the current and previous periods. The need for deferred tax arises
because the profit for tax purposes may differ from the profit shown in the financial statements.

The difference between accounting profit and taxable profit is caused by:

• Temporary differences
• Permanent differences

Deferred tax is a means of “ironing out” the tax inequalities arising from temporary differences.

Temporary Differences
These are differences between the carrying amount of an asset or liability in the statement of
financial position
and the tax base of the asset or liability. The tax base is the amount attributed to that asset or
liability for tax purposes (often known as the Tax Written Down Value).

A temporary difference arises when an item is allowable for both accounting and tax purposes,
but there is a difference in the timing of when the item is dealt with in the accounts and when it
is dealt with in the tax computations.

A common example of such a difference is capital expenditure. In the financial statements, the
expenditure will be depreciated over the life of the asset and this depreciation will be deducted
in arriving at accounting profit. However, in the tax computation, depreciation is not deductible. It
is added back and capital allowances (or tax depreciation) are granted instead. If the accounting
depreciation and capital allowances are calculated at a different rate, there will be a difference
between the accounting profit and the taxable profit.
This is a temporary difference because eventually, the cause of the difference will disappear
entirely. That is, the asset will eventually be fully depreciated and no further depreciation expense
in respect of that asset will appear in future Statement of Comprehensive Incomes and all capital
allowances will also have been claimed, leaving no further deductions in future tax computations
in respect of the asset.

Permanent Differences
Some income and expenses may not be chargeable / deductible for tax and therefore there will
be a permanent
difference between accounting and taxable profits. That is, the difference will not reverse in the
future

Therefore, permanent differences are:

One-off differences between accounting and taxable profits caused by certain items not being
taxable /allowable

Differences which only impact on the tax computation of one period

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An example of a permanent difference would be fines or penalties, such as interest imposed on
the late payment of tax. Such an expense would appear in the financial statements but would not
be allowable for tax purposes.

Deferred tax arises in respect of temporary differences only. Deferred tax is not concerned with
permanent differences.

D. CALCULATION OF DEFERRED TAX

Deferred tax is calculated using the liability method. Under this method, deferred tax is calculated
by reference to the tax base of an asset (or liability) compared to its book value. IAS 12 requires
full provision for all taxable temporary differences (except goodwill).

The following steps should be followed:

• Calculate the temporary difference

• Apply the tax rate to the temporary difference
• The resulting tax liability (or asset) is shown in the Statement of Financial Position and the
increase or decrease on the previous period is reflected in the statement of comprehensive
income, as part of the tax figure (unless it relates directly to a gain or loss that has been
recognised in equity, e.g. revaluations, in which case the deferred tax is also recognised in
equity)

Example 1
BT Ltd. purchased an item of machinery for RWF2,000,000 on 1st January 2008. It had an
estimated life of eight years and an estimated residual value of RWF400,000. The machine is
depreciated on a straight line basis. The tax authorities do not allow depreciation as a deductible
expense. Instead, a tax expense of 40% of the cost of
this type of asset can be claimed against income tax in the year of purchase and 20% per annum
(on a reducing

balance basis) of its tax base thereafter. The rate of income tax can be taken as 25%.

In respect of the above item of machinery, calculate the deferred tax charge / credit in BT Ltd
statement of comprehensive income for the years ended 31st December 2008, 2009 and 2010
and the deferred tax balance in the statements of financial position at those dates.

Work to the nearest RWF’000.

Solution
2,000,000 – 400,000
Annual accounting depreciation: = 200,000 per annum
8 years

Y/E 31st December 2008

RWF’000

Carrying value (2,000 – 200) 1,800

Tax Base (2,000 – 800) 1,200

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 Temporary Difference 600
Tax rate 25%
Deferred Tax liability 150

Debit Tax (I/S) 150

Credit Deferred Tax (SOFP) 150

Extract from Statement of Comprehensive Income Tax

RWF’000 RWF’000
Current Tax X
Deferred Tax 150
Total X

Extract from Statement of Financial Position

Non-Current Liabilities
Deferred Tax 150

Y/E 31st December 2009

RWF’000

Carrying value 1,600

Tax Base (1,200 – 240) 960
Temporary Difference 640
Tax rate 25%
Deferred Tax liability 160

Thus, the deferred tax liability has increased by RWF10,000

Debit Tax (I/S) 10

Credit Deferred Tax (SOFP) 10

Extract from Statement of Comprehensive Income Tax

RWF’000 RWF’000
Current Tax X
Deferred Tax 10
Total X

Extract from Statement of Financial Position

Non-Current Liabilities
Deferred Tax 160

Y/E 31st December 2010

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 RWF’000
Carrying value 1,400
Tax Base (960 - 192) 768
Temporary Difference 632
Tax rate 25%
Deferred Tax liability 158

The deferred tax liability has decreased by RWF2,000. It is beginning to “reverse”.

Debit Deferred Tax (SOFP) 2

Credit Tax (I/S) 2

Extract from Statement of Comprehensive Income Tax

RWF’000 RWF’000
Current Tax X
Deferred Tax (2)
Total X

Extract from Statement of Financial Position

Non-Current Liabilities
Deferred Tax 158

A similar process will be followed over the remaining useful life of the asset. By the end of
the assets life, the deferred tax liability will have fully reversed and there will be no remaining
balance in the Statement of Financial Position.

E. WHY ACCOUNT FOR DEFERRED TAX?

An explanation of why deferred tax is provided lies in the understanding that accounting profit (as
reported in a company’s financial statements) differs from the profit figure used by the tax
authorities to calculate a company’s income tax liability for a given period.

If deferred tax was ignored, a company’s tax charge for a particular period might bear little
resemblance to the reported profit. For example, if a company makes a large profit in a particular
period, but because of high levels of capital expenditure, it is entitled to claim large capital
allowances for that period, this would reduce the amount of tax it had to pay. The result of this
could be that the company reports a large profit and a small tax charge. This situation is usually
reversed in subsequent periods as tax charges appear to be much higher than the reported profit
suggests they should be.

It is argued that such a reporting system is misleading because the profit after tax, which is used
to calculate the company’s EPS, may appear disconnected from the pre-tax profit. This may
mean that a government’s fiscal (taxation) policy may distort a company’s profit trends.

Providing for deferred tax reduces this anomaly or inconsistency but it can never be entirely
eliminated due to items in the profit and loss that may never be allowed for tax purposes
(permanent differences).

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Where capital allowances (tax depreciation) is different from the related accounting depreciation
charges, this leads to the tax base of an asset being different from the carrying value in the
Statement of Financial Position. This is referred to as a temporary difference and a provision for
deferred tax is created.

This “liability approach” is the general principle on which IAS 12 bases the calculation of deferred
tax. The effect of this is that it usually brings the total tax charge (i.e. the provision for the current
year’s income tax plus the deferred tax) into proportion with to the profit reported to shareholders.

The main debate in the area of providing for deferred tax is whether the provision meets the
definition of a liability. If the liability is likely to crystallise (actually develop), then it is a liability.
However, if it will not crystallise in the foreseeable future, then arguably it is not a liability and
should not be provided for. The standard setters take a prudent approach and the standard does
not accept the latter argument.

The main benefits, therefore, of providing for deferred tax are as follows:

• Profit after tax, used to calculate EPS, may bear little resemblance to the pre-tax profit. If the
tax charge is fluctuating because of the way in which certain items are treated for tax, the EPS
will fluctuate too. Thus, providing for deferred tax reduces the fluctuation caused by temporary
differences.
• The EPS is used in the calculation of the Price Earnings (P/E) ratio, which in turn can impact
on share price. Without providing for deferred tax, the share price may be adversely affected
by government fiscal policy.
• Over-statement of profit, by not allowing for deferred tax, can lead to demands for
consequently over- optimistic dividends.
• Shareholders may be misled in relation to the performance of the company.
• Accounting for deferred tax satisfies the accruals concept in that the cost of the asset is
matched with the benefit of that asset over its useful life.
F. DEFERRED TAX LIABILITIES AND ASSETS
Liabilities:
IAS 12 requires that a deferred tax liability must be recognised for all taxable temporary differences
(with minor exceptions). A taxable temporary difference arises where the carrying value of an
asset is greater than its tax
base.

Assets:
IAS 12 requires that deferred tax assets should be recognised for all deductible temporary
differences. A
deductible temporary difference arises where the tax base of an asset exceeds its carrying
value. The deferred tax asset will be recognised to the extent that taxable profit will be available
against which the deductible temporary difference can be utilised.

G. TAX RATE
The tax rate in force (or expected to be in force) when the asset is realised or the liability is
settled should be used to calculate deferred tax.

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This rate must be based on tax rates and legislation that have been enacted or substantively
enacted by the reporting date.

Deferred tax assets and liabilities should not be discounted to present value.

H. FURTHER SPECIFIC EXAMPLES

1. Revaluation of non-current assets:

Deferred tax should be recognised on revaluation gains (even where there is no intention to sell the
asset or rollover relief is available on the gain).

The revaluation of non-current assets results in taxable temporary differences and therefore a
liability. This is charged as a component of Other Comprehensive Income alongside the revaluation
gain itself. It is therefore disclosed either in the statement of comprehensive income or in a separate
statement showing other comprehensive income.

Example
At 31st December 2010, the carrying value of property plant and equipment was RWF88 million
and its tax base was RWF54 million. The carrying value of RWF88 million includes a surplus
of RWF12 million that arose as a result of a property revaluation on 31st December 2010. This
revaluation had no effect on
the tax base of the property. The property had not previously been revalued. The tax rate
is 25%.

The deferred tax liability at 31st December 2009 was RWF4 million. This liability related to taxable
temporary differences for property, plant and equipment.

At the year end 31st December 2010, the deferred tax calculation is as follows:

RWF’000
Carrying value 88,000
Tax base 54,000
Temporary difference 34,000
Tax rate 25%
Deferred Tax Liability 8,500
But, part of the difference is caused by the revaluation.

Thus, the deferred tax on the revaluation is: RWF12 million x 25% = RWF3 million. This
goes directly to equity (and Other Comprehensive Income).

At the 31st December 2010:

Deferred Tax Liability 8,500

Balance brought forward 4,000

RWF’000
Increase in liability 4,500
The required journal entries are:

RWF’000 RWF’000

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 Debit Revaluation Reserve 3,000
Debit Statement of Comprehensive Income (tax charge) 1,500
Credit Deferred Tax Account 4,500

2. Impairment Losses:
An impairment loss gives rise to a reduction in the carrying amount of an asset and a consequent
change in the deferred tax provision.

Example
Property with a carrying value of RWF100,000 is impaired by RWF20,000 at the end of the
financial year. The tax base of RWF60,000 is unaffected by the impairment. The tax rate is 25%.

Before Impairment After impairment

RWF RWF
Carrying amount 100,000 Carrying amount 80,000
Tax base 60,000 Tax base 60,000
Temporary Difference 40,000 Temporary Difference 20,000
Tax rate 25% Tax rate 25%
Deferred Tax Liability 10,000 Deferred Tax Liability 5,000

Thus, the deferred tax provision is reduced by RWF5,000 (i.e. RWF20,000 x 25%)

The required journal entries are:

RWF RWF

Debit Deferred Tax Account 5,000

Credit Statement of Comprehensive Income (tax charge) 5,000

3. Leasing:
A finance lease transaction can give rise to deferred tax implications. This is caused by the
temporary
differences arising on the treatment of the lease for accounting and tax purposes. The Statement
of Comprehensive Income will include a finance cost and depreciation expense. However, it is the
lease payment itself that may be allowable for tax purposes for the period.

Example
ST Limited entered into a finance lease arrangement on 1st January 2010. The lease rental for the
year was RWF6,000. The Statement of Comprehensive Income was charged with depreciation of
RWF2,910 and a finance cost of RWF2,274. The tax rate is 25%.

There is a temporary difference arising of RWF6,000 compared to RWF5,184 (RWF2,910 +

RWF2,274), which amounts to RWF816.
When multiplied by the tax rate of 25%, this gives rise to a deferred tax asset of RWF204.

The required journal entries are:

RWF RWF

Debit Deferred Tax Account 204

Credit Statement of Comprehensive Income (tax charge) 204

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4. Development Expenditure:
If development costs are capitalised in the Statement of Financial Position, this situation can give
rise to
deferred tax implications. This is caused by the temporary differences arising on the treatment of
the development expenditure for accounting and tax purposes. The expenditure is capitalised and
amortised over future periods, whereas the expenditure is allowable for tax purposes immediately.

Example:
Since July 2009, ELN Limited has been carrying out a project to develop a more efficient production
process. On the 1st April 2010, the project was assessed and found to be at a stage that justified
capitalising future costs incurred on the project. Accordingly, an intangible asset of RWF900,000
was included in the draft Statement of Financial Position at 31st December 2010. Amortisation is
expected to begin sometime in the year ended 31st December 2012. All expenditure on the project
qualifies for tax relief as the expenditure is incurred. The tax rate is 25%.

RWF
Carrying amount 900,000
Tax base 0
Temporary Difference 900,000
Tax rate 25%
Deferred Tax Liability 225,000
The required journal entries are:
RWF RWF
Debit Statement of Comprehensive Income (tax charge) 225,000

Credit Deferred Tax Account 225,000

5. Unrealised inventory profit:

In consolidated accounts, an unrealised inventory profit has deferred tax implications. An unrealised
inventory profit adjustment reduces the consolidated profit but has no effect on taxable profit.
A temporary difference arises, which will reverse in the next year as the inventory is sold and the
unrealised profit is realised.

Example
On 1st December 2010, A. Limited sold goods to one of its subsidiaries for RWF4,000,000. The
goods cost A Ltd RWF3,000,000 to manufacture. Prior to the year end 31st December 2010, the
subsidiary sold 40% of the goods to a non-group company for RWF2,200,000. The tax rate is
25%.

The profit on the inter company sale was RWF1,000,000. 60% of the goods remain in inventory
at the year end; therefore 60% of the profit remains also. Thus, in the consolidated accounts, an
adjustment must be made for RWF600,000.
This RWF600,000 is a temporary difference, as it treated in different periods for accounting and
tax purposes.

Thus, the deferred tax calculation is: RWF600,000 x 25% =RWF150,000

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 This is a deferred tax asset.

The required journal entries are:

RWF RWF
Debit Deferred tax account 150,000

Credit Statement of Comprehensive Income (tax charge) 150,000

I. DISCLOSURE REQUIREMENTS
There are extensive disclosure requirements in relation to tax. The main disclosures are:
The tax expense (income) should be presented on the face of the Statement of Comprehensive
Income.

The major components of the tax expense (income) should be disclosed separately in a note.

Current and deferred tax charged / credited to equity

The amount of income tax relating to each component of other comprehensive income

An explanation of the relationship between tax expense (income) and accounting profit in either
or both of the following forms:

• A numerical reconciliation between tax expense (income) and the product of accounting profit
multiplied by the applicable tax rate, disclosing also the basis on which the applicable tax rate
is computed
• A numerical reconciliation between the average effective tax rate and the applicable tax rate,
disclosing also the basis on which the applicable tax rate is computed.

FINANCIAL INSTRUMENTS (IAS 32,IFRS 9 ,IFRS 7)

A. IAS 32 – FINANCIAL INSTRUMENTS: PRESENTATION
The objective of IAS 32 is ‘to enhance financial statement users’ understanding of the significance
of on Statement of Financial Position and off Statement of Financial Position financial instruments
to an entity’s financial position, performance and cash flows’

The standard should be applied to the presentation of all types of financial instruments, whether
recognised or unrecognised. Certain items are excluded including subsidiaries, associates,
joint ventures and insurance contracts.

Definitions

Financial Instrument: any contract that gives rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity.

Financial asset: any asset that is

1. Cash
2. An equity instrument of another entity
3. A contractual right to receive cash or another financial asset from another entity; or to exchange

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 financial instruments with another entity under conditions that are potentially favourable to the
entity; or

4. A contract that will or may be settled in the entity’s own equity instruments and is:
4.1. A non derivative for which the entity is or may be obliged to receive a variable number of the
entity’s own equity instruments; or
4.2. A derivative that will or may be settled other than by the exchange of a fixed amount of cash
or other financial asset for a fixed number of the entity’s own equity instruments

Financial Liability: any liability that is:

1. A contractual obligation:
1.1. To deliver cash or another financial asset to another entity; or
1.2. To exchange financial instruments with another entity under conditions that are potentially
unfavourable; or
2. A contract that will or may be settled in the entity’s own equity instruments and is:

2.1. A non derivative for which the entity is or may be obliged to deliver a variable number of the
entity’s own instruments, or
2.2. A derivative that will or may be settled other than by exchange of a fixed amount of cash or another
financial asset for a fixed number of the entity’s own equity instruments.

Equity instrument: any contract that evidences a residual interest in the assets of an entity after
deducting its liabilities

Fair value: the amount that an asset could be exchanged, or a liability settled, between informed and
willing parties, in an arm’s length transaction, other than in a forced or liquidation sale

Derivative: a financial instrument or other contract with all three of the following characteristics:

1. Its value changes in response to the change in a specified interest rate, financial instrument
price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index,
or other variable

2. It requires no initial net investment or an initial net investment that is smaller than would be required
for other types of contracts that would be expected to have a similar response to changes in market
factors, and

3. It is settled at a future date

Liabilities and Equity
Financial Instruments should be presented according to their substance and not merely their legal form.
Entities that issue financial instruments should classify them as either equity or financial liabilities.

The classification depends on the following:-

• The substance of the contractual arrangement on initial recognition
• The definitions of a financial liability and an equity instrument.

The main difference between a liability and an equity instrument is the fact that an equity instrument has
no obligation to transfer economic benefits.
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 Compound Financial Instruments
Some financial instruments contain both a liability and an equity element. IAS 32 requires the financial
instrument to be split between the component parts and separately presented on the statement of
financial
position.

One of the most common types of component financial instruments is convertible debt. This contains a
primary financial liability for the entity but also gives the holder an option to convert to equity. Basically
this is identical to a liability and a warrant to issue equity.

IAS 32 requires the following for compound financial instruments

• Calculate the value of the liability component

• Deduct this from the instrument as a whole to leave a residual value for the equity element

Example:
On the 1st January 2006, FB Ltd issued RWF80 million 8% convertible loan stock at par. The stock
is convertible into equity shares, or redeemable at par, on the 31st December 2010, at the
option of the stockholders. The terms of conversion are that each RWF100 of loan stock will be
convertible into 50 equity shares of FB Ltd. A finance consultant has advised that if the option to
convert to equity had not been included in the terms of the issue, then a coupon rate of 12% would
have been required to attract subscribers for the stock.

The value of RWF1 receivable at the end of each year at a discount rate of
12% can be taken as:
RWF
Year
1 0.89
2 0.80
3 0.71
4 0.64
5 0.57

Show the initial journal entry to record the issue of the convertible debt and the statement of
comprehensive income finance charge for the year 31st December 2006 and the SOFP extracts
at the same date in respect of the issue of the convertible debt.

Solution
Calculate the liability component first. This is valued at the Present Value of cash flows associated
with the
convertible debt, discounted at the market rate for similar bonds with no conversion rights.

The difference between this Present Value and the net proceeds constitute the equity element.

Year Payment Discount Factor Present Value

RWF’000 RWF’000
1 6,400 0.89 5,696
2 6,400 0.80 5,120
3 6,400 0.71 4,544
4 6,400 0.64 4,096
5 86,400 0.57 49,248
Total Liability Component 68,704

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 Equity Component (bal. fig.) 11,296
Net proceeds 80,000

Therefore, to record the initial issuance of the convertible debt:

RWF’000 RWF’000
Debit Bank 80,000
Credit Equity (share options) 11,296
Credit 8% Convertible Debt (non current 68,704
liability)

At the end of the year, the liability value will have changed:
Year Opening Balance (12%) Finance Closing
Charge Payments Balance
RWF’000 RWF’000 RWF’000 RWF’000
1 68,704 8,244 6,400 70,548
2 70,548 8,466 6,400 72,614
3 72,614 8,714 6,400 74,928
4 74,928 8,991 6,400 77,519
5 77,519 9,302 86,400 -

(The difference at the end is due to rounding of figures)

(The closing balance for year 1 will be the opening balance for year 2, and so on)
Thus:
Statement of Comprehensive Income Extracts

Loan Stock interest paid 6,400

Required accrual of finance cost 1,844
Total finance cost for loan stock (RWF68,704,000 x 12%) 8,244

Statement of Financial Position Extracts

Non Current Liabilities

8% Loan Stock 2010 68,704
Accrual of finance costs 1,844

Equity and Liabilities70,548

Share options 11,296

Interest, Dividends, Losses and Gains

IAS 32 also considers how financial instruments affect the statement of comprehensive income.
The effect
depends on whether interest, dividends, losses or gains relate to the instrument.
a. Interest, dividends, losses or gains relating to a financial instrument classified as a financial
liability should be recognised as income or expense in profit and loss
b. Distributions to holders of a financial instrument classified as an equity instrument should be
debited directly to equity by the issuer
c. Transaction costs of an equity transaction shall be accounted for a deduction from equity (unless
they are directly attributable to the acquisition of a business, in which case they are accounted
for under IFRS 3)
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Disclosure of Financial Instruments
‘The purpose of the disclosure required by this standard is to provide information to enhance
understanding of the significance of financial instruments to an entity’s financial position,
performance and cashflows and assist in assessing the amounts, timing and certainty of future
cashflows associated with those instruments’ (IAS32)

In addition to monetary disclosures, narrative disclosures are also required.

Terms
Market risk – one of currency, interest or price risk

Currency risk – is the risk that the value of a financial instrument will fluctuate to changes in foreign
exchange rates

Interest rate risk – is the risk that the value of a financial instrument will fluctuate due to changes in
market interest rates

Price risk – is the risk that the value of a financial instrument will fluctuate as a result of changes in
market prices whether those changes are caused by factors specific to the individual instrument or its
issuer or factors affecting all securities traded on the market

Credit risk – is the risk that one party to a financial instrument will fail to discharge an obligation and
cause the other party to incur a financial loss

Liquidity risk – is the risk that an entity will encounter difficulty in raising funds to meet commitments
associated with financial risk. Liquidity risk may result from an inability to sell a financial asset quickly at
close to its fair value

Information to be Disclosed
Information must be disclosed about the following:-
• Risk management policies and hedging strategies
• Terms, conditions and accounting policies
• Interest rate risk
• Credit risk
• Fair value

Material items of income, expense, gains and losses resulting from financial assets and
liabilities.

B. IFRS 9 – FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT

IAS 39 applies to all entities and to all types of financial instruments except those specifically
excluded, as listed below, for example most investments in subsidiaries, associates and joint
ventures.
Example of initial recognition
An entity has entered into two separate contracts:

• A firm commitment to buy a specific amount of copper

• A forward contract to buy a specific quantity of copper an a firm date at a specified price

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 Contract A is a normal trading contract and contract B is a financial instrument.

For contract A, the entity does not recognise a liability for the copper until the goods have been
delivered. The contract is not a financial instrument as it involves a physical asset as opposed to a
financial asset.

For contract B, the entity recognises a financial liability (obligation) on the commitment date, rather
than waiting for the closing date in which the exchange takes place.

Derecognition
An entity should derecognise a financial asset when:

• The contract rights to the cashflows from the asset expire; or

• It transfers substantially all the risks and rewards of ownership of the financial asset to another
party

An entity should derecognise a financial liability when it is extinguished, ie when the obligation specified
in the contract is discharged, cancelled or expires. A financial liability may be partially derecognised if
only part of the obligation is removed.

Measurement of Financial Instruments

Financial instruments are initially measured at the fair value of the consideration given or received,
plus/minus transactions costs directly attributable to the acquisition or issue of the financial
instrument.

The exception to this is where the financial instrument is designated as at fair value through profit or
loss. In this case transaction costs are not added/subtracted from or to fair value at initial recognition.

If the fair value is not readily available at recognition date it must be estimated using an appropriate
technique.

Subsequent Measurement
After initial recognition all financial instruments should be re-measured to fair value without any
deduction for transaction costs that may be incurred on sale of or other disposal, except for:
• Loans and receivables
• Held to maturity investments
• Investments in equity instruments that do not have a quoted market price in an actively traded
market and whose fair value cannot be reliably measured and derivatives thatare linked to and
must be settled by delivery of such unquoted equity instruments.

Loans and receivables and held to maturity investments should be measured at amortised cost
using the effective interest method.

Investments whose fair value cannot be reliably measured should be measured at cost.

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Classification
Any financial instrument can be designated at fair value through profit or loss. This however is a
one off choice and has to be made on initial recognition. Once classified in this way, a financial
instrument cannot be re- classified.

For a financial instrument to be held to maturity it must meet certain criteria. These criteria are
not met if:-
• The entity intends to hold the financial asset for an undefined time
• The entity stands ready to sell the asset in response to changes in interest rates or risks,
liquidity needs and similar factors
• The issuer has a right to settle the financial asset at an amount significantly below its
amortised cost
• It does not have the resources available to continue to finance the investment until maturity
• It is subject to an existing legal or other constraint that could frustrate its intention to hold the
financial asset to maturity
• There is a penalty for selling or reclassifying an asset that was designated as held to maturity.
If this has occurred during the current financial year or during the two preceding financial
years then no asset can be classed as held to maturity.

Subsequent Measurement of Financial Liabilities

After initial measurement all financial liabilities must be measured at amortised cost, with the
exception of financial liabilities at fair value through the profit and loss. These should be measured
at fair value but if the fair value cannot be reliably measured they should be shown at cost.

Gains and Losses

Instruments held at fair value through profit or loss: gains are recognised through profit and loss.

Available for sale financial assets: gains and losses are recognised in reserves and on disposal
of the asset the balance in equity is transferred to the profit and loss account to allow the profit/
loss on disposal be calculated.

Financial instruments carried at amortised cost: gains and losses are recognised in profit and
loss as a result of the amortisation process and when the asset is derecognised.

Financial assets and financial liabilities that are hedged items: special rules apply.

Impairment and Uncollectability of Financial Assets

At each Statement of Financial Position date the entity must assess whether there is any objective
evidence that a financial asset or group of assets is impaired. Where there is objective evidence
of impairment, the entity should determine the amount of impairment loss.

Financial Assets Carried At Amortised Cost

Recognise the impairment in the profit and loss account

Financial Assets at Cost

Recognise the loss in the profit and loss account. Such impairments cannot be reversed.

Available For Sale Financial Assets

Impairments should also be recognised in the profit or loss.

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C. IFRS 7 – FINANCIAL INSTRUMENTS: DISCLOSURES
Objectives
The objectives of the standard are:

• Add certain new disclosures about financial instruments to those currently required by IAS 32
• Puts all financial instruments disclosures in a new standard. (The remaining parts of IAS 32
deal only with presentation matters).

Disclosure Requirements
An entity must group its financial instruments into classes of similar instruments and make
disclosures by class (when disclosures are required).

IFRS 7 identifies two main categories of disclosures:

• Information about the significance of financial instruments

• Information about the nature and extent of risks arising from financial instruments.

Information about the Significance of Financial Instruments

Statement of financial Position:
• Disclosure of the significance of financial instruments for an entity’s financial position and
performance

• Special disclosures about financial assets and financial liabilities designated to be measured
at fair value through profit and loss
• Reclassifications of financial instruments from fair value to amortised cost or vice versa
• Information about financial assets pledged as collateral (or held as collateral)
• Reconciliation of the allowance account for credit losses (bad debts)
• Information about compound financial instruments with multiple embedded derivatives
• Breaches of terms of loan agreements
• Disclosures about de-recognitions

Statement of Comprehensive Income and Equity:

• Items of income, expense, gains and losses

• Interest income and interest expense for those financial instruments that are not measured at
fair value through profit and loss
• Fee income and expense
• Amount of impairment losses on financial assets
• Interest income on impaired financial assets

Other disclosures:

• Accounting policies for financial instruments

• Information about hedge accounting
• Information about the fair values of each class of financial asset and financial liability, together

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 with:

• comparable carrying amounts

• description of how fair value was determined
• detailed information if fair value cannot be reliably measured

(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).

Information About The Nature And Extent Of Risks Arising From Financial Instruments.
Qualitative disclosures:
These describe:

• risk exposures for each type of financial instrument

• managements objectives, policies and processes for managing those risks
• 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 include:

• summary quantitative data about exposure to each risk at the reporting date
• disclosures about credit risk, liquidity risk and market risk
• concentrations of risk

Credit Risk:
Includes:
• maximum amount of exposure, description of collateral, information about credit quality of
financial assets that are neither past due or impaired for financial assets that are past due
or impaired, analytical disclosures re required

Liquidity Risk:
Includes:
• a maturity analysis of financial liabilities
• description of approach to risk management

Market Risk:
This 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

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FIRST TIME ADOPTION OF INTERNATIONAL FINANCIAL REPORTING
STANDARDS IFRS 1

A. INTRODUCTION

IFRS 1 was issued to ensure that an entity’s first IFRS financial statements, and any interim
financial reports for part of the period covered by those financial statements, contain high quality
information that:

• Is transparent for users and comparable over all periods presented;

• Provides a suitable starting point for accounting under International Financial Reporting
Standards; and
• Can be generated at a cost that does not exceed the benefits to users.

IFRS 1 applies to all entities adopting IFRS for the first time on or after 1st January 2004.

A first time adopter is an entity that presents its first IFRS financial statements. The entity must
make an explicit or unreserved statement that the annual financial statements comply with all
relevant IFRS’s.

The date of transition to IFRS’s is the beginning of the earliest period for which an entity
presents full comparative information under IFRS’s in its first IFRS financial statements.

IFRS 1 states that the starting point for the adoption of IFRS’s for the year ended 31st December
2005 is to prepare an opening IFRS balance sheet at 1st January 2004 (or the beginning of the
earliest comparative period).

The general rule is that this balance sheet will need to comply with each IFRS effective at 31st
December 2005 (the reporting date).

As a result, the opening balance sheet should:

• Recognise all assets and liabilities whose recognition is required by IFRS’s

• Not recognise items as assets or liabilities if the IFRS’s do not permit such recognition
• Reclassify items that the entity recognised under previous GAAP as one type of asset, liability
or component of equity but are a different type of asset, liability or component of equity under
IFRS’s
• Apply IFRS’s in measuring all recognised assets and liabilities

The opening balance sheet need not be published. Its main function is to provide opening
balances in order that future financial statements can be prepared in accordance with IFRS.

B. ACCOUNTING POLICIES
The entity must use the same accounting policies in its opening IFRS balance sheet and
throughout all periods presented in its IFRS financial statements.

Those accounting policies must comply with each IFRS effective at the reporting date for its first
IFRS financial statements (except with exemptions apply).

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This requirement can cause a number of practical difficulties:

• At the effective date of transition, it is not totally clear which IFRS’s will be in force two years
later.
Thus, the originally prepared balance sheet may have to be amended several times prior to the
publication of the first IFRS financial statements.

The entity cannot apply different versions of IFRS’s that were effective at earlier dates. However,
an entity may apply a new IFRS that is not yet mandatory if it permits early application.

• The costs of retrospectively applying the recognition and measurement principles of IFRS’s
might be considerable. IFRS 1 grants a limited number of exemptions from the general
requirements where the cost of complying with them would be likely to exceed the benefits to
users.

• The accounting policies used in the opening IFRS Statement of Financial Position may differ
from those that it used for the same date using previous GAAP. The resulting adjustments
arise from events and transactions before the date of transition to IFRS’s.
The entity must recognise those adjustments in retained earnings (or, if appropriate, another
category of equity) at the date of transition to IFRS’s.
The entity must explain how the transition from previous GAAP to IFRS’s affected its reported
financial position, financial performance and cash flows.

Thus, the entity’s first IFRS financial statements should include:

• Reconciliations of its equity reported under previous GAAP to its equity under IFRS’s for both
of the following dates:

• The date of transition to IFRS’s; and

• The end of the latest period presented in the equity’s most recent annual financial
statements under previous GAAP.
• A reconciliation of the profit or loss reported under previous GAAP for the latest period in the
entity’s most recent annual financial statements to its profit or loss under IFRS’s for the same
period.
• If the entity recognised or reversed any impairment losses for the first time in preparing its
opening IFRS Statement of Financial Position, the disclosures that IAS 36 Impairment of
Assets would have required if the entity had recognised those impairment losses or reversals
in the period beginning with the date of transition to IFRS’s.

C. EXEMPTIONS AND EXCEPTIONS

In general, the transitional provisions in other IFRS’s do not apply to first time adoption. However,
IFRS 1 does not allow full retrospective application of IFRS’s in the following areas:

• Assets classified as held for sale and discontinued operations

• Derecognition of financial assets and financial liabilities
• Estimates
• Hedge accounting

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In addition, the following exemptions may be elected:

• Previous business combinations do not have to be restated

• Past currency translation gains/losses included in revenue reserves need not be separated
out into the currency translation reserve
• An entity may elect to measure an item of property, plant and equipment at the date of
transition to IFRS’s at its fair value and use that fair value as its deemed cost at that date.
• Under IAS 32 part of the proceeds of convertible debt is classified as equity. If the debt
component is no longer outstanding at the date of transition, there is no need to
separate the liability and equity components.

If a subsidiary adopts IFRS’s later than the parent, the subsidiary may value its assets/liabilities
either:
• At its own transition date; or
• Its parents.

D. COMPARATIVE INFORMATION
To comply with IAS 1 Presentation of Financial Statements, an entity’s first IFRS financial
statements must include at least one year of comparative information under IFRS’s.

Question
“One issue that will involve significant changes in accounting policy and have corresponding
disclosure issues
is the rules on first-time adoption of IFRS. Many companies are starting to transfer their financial
statements from a previous GAAP into IFRS and are therefore having to restate those accounts”

IFRS 1 First time adoption of International Financial Reporting Standards addresses the issues
in completing this conversion.

Requirement
Draft a memo to the finance director of a client company explaining how IFRS 1 details the
manner in which his
company should implement a change from local accounting standards to international
standards, making specific reference to the following:

• Selection of accounting policies that comply with IFRS

• Preparation of an opening Statement of Financial Position at the date of transition to IFRS
• Making estimates under IFRS for both the opening IFRS Statement of Financial Position and
other periods presented
• Disclosures in the first IFRS financial statements

Tutorial Comment
This question focuses the candidate on the transition guidance from accounting under
local GAAP to accounting under international standards.
The candidate is specifically asked to explain the guidance relating to four key areas:

• Selection of accounting policies that comply with IFRS

• Preparation of an opening Statement of Financial Position at the date of transition to IFRS

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 • Making estimates under IFRS for both the opening IFRS Statement of Financial Position and
other periods presented
• Disclosures in the first IFRS financial statements

The candidate should be aware of the steps which must be taken when implementing IFRS for
the first time and should also be familiar with the additional disclosures that are required in the
initial reporting period.

Solution

To: Mr Kimuda, Finance Director, Client Company

From: Mr Nzomo, CPA Accountants
Date: 27th April 2005
Re: International Financial Reporting Standard – First-time adoption of International
Financial Reporting Standards

I refer to our recent telephone conversation and hereby outline the issues discussed concerning
the first time adoption of IFRS.
IFRS 1 was introduced to help ensure that an entity’s first IFRS financial statements will contain
high quality financial information that allows transparency and comparability for all periods
presented and that these financial statements can be generated in a cost efficient manner.

(i) Selection of accounting policies that comply with IFRS

An entity must select accounting policies that comply with IFRS at the reporting date. These
accounting policies must then be used to prepare the financial statements as at Statement of
Financial Position date and the comparative financial statements. This also means that the
selected accounting policies will have to be applied to the entity’s opening Statement of Financial
Position date of the comparative figures i.e. full retrospective application to comparatives.

In the case of excessive cost of restatement, certain exemptions are permitted under the standard.
These exemptions are independent of each other and are optional. They include the following:

• Property, Plant and Equipment

In cases where it is difficult to measure the historic cost of previously revalued assets, a first-time
adopter may measure such an item at its fair value at the transition date and use the fair value
as the deemed cost. An entity may also use a previous GAAP valuation as the deemed cost at
transition date so long as the revaluation is broadly comparable to the fair value or depreciated
replacement cost at the date of valuation.
In certain instances, these valuation methods may also apply to investment properties (under
the cost model in IAS 40 Investment Property) and to intangible assets that meet the recognition
criteria and the criteria for revaluation in IAS 38 Intangible assets.

• Business Combinations
An entity need not apply IFRS 3 Business Combinations retrospectively to business combinations
recognised under previous GAAP. However, if an entity wishes to avail of this exemption, it must
ensure that all combinations keep the same classification as in previous GAAP financial
statements; if an entity restates any business combinations to comply with IFRS 3, it must also
restate all later business combinations. For example, if a first-time adopter elects to restate a

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 business combination that occurred on 1st January 2004, it must restate all business combinations
that occurred on or after that date.
Some adjustments will still be required for business combinations which are not restated,
predominantly regarding goodwill. Any positive goodwill on the Statement of Financial Position at
the transition date should, from the start of the earliest comparative period, be subject to annual
impairment reviews; if negative, it should be written back to retained earnings.
Otherwise, all acquired assets and liabilities must be recognised insofar as is permitted under IFRS.
Items which do not qualify for recognition must be excluded from the opening IFRS Statement of
Financial Position but reclassified into relevant line items if appropriate.

• Defined Benefit Fund Schemes

At variance to IAS 19 Employee Benefits, a first-time adopter may elect to recognise all
cumulative actuarial gains or losses at the transition date and spread those that arise after this
date. If a first-time adopter elects to do so, it must apply to all such pension schemes.

• Cumulative Translation Differences

Cumulative exchange differences arising on foreign entities should be presented as a separate
reserve under IAS 21 The Effects of Changes in Foreign Exchange Rates and on disposal of the
foreign entity to offset this reserve against the disposal proceeds.
However, on transition to IFRS, it is acceptable now to separate exchange differences arising before
transition date and the subsequent gain/loss on disposal of that foreign entity would include only
those exchange differences arising after transition date.

• Financial Instruments
IAS 32 Financial Instruments: Disclosure and Presentation requires an entity to split a compound
financial instrument at inception in to separate liability and equity components. Under IFRS 1,
first-time adopter is not required to separate these two portions as the liability component is no
longer outstanding at the date of transition.

• Designation of Previously Recognised Financial Instruments

IAS 39 Financial Instruments: Recognition and Measurement permits a financial instrument to be
designated on initial recognition as a financial asset or financial liability at fair value through “profit
or loss” or as “available for sale”. A first-time adopter may make such a designation at date of
transition.
(Other exemptions also apply re share-based payment transactions, insurance contracts, and
assets and liabilities of subsidiaries, associates and joint ventures also acceptable)

(ii) Preparation of an opening Statement of Financial Position at the date of transition

to IFRS
This should be restated using recognition and measurement criteria in IFRS. This involves
restating the Statement of Financial Position prepared under the previous GAAP to ensure
compliance with the IFRS i.e. an entity will have to restate its Statement of Financial Position
as at 1st January 2004 if it is a first time adopter as at 31st December 2005.

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This means that an entity must:

• Recognise all assets and liabilities whose recognition is required by IFRS

• Cease to recognise some assets and liabilities that cannot be recognised under IFRS
• Reclassify items as different types of assets, liability and equity under IFRS
• Apply IFRS in measuring recognised assets and liabilities

The accounting policies that an entity uses in its opening IFRS Statement of Financial Position
may differ from those it used for reporting under the previous GAAP. Any adjustment to the
opening net assets should be recognised against retained earnings.

(iii) Making estimates under IFRS for both the opening IFRS Statement of Financial
Position and other periods presented

Estimates on transition should be consistent with estimates made at the same date under previous
GAAP (after any adjustments to reflect differences in accounting policies) unless there is objective
evidence that those estimates were in error.
An entity may also need to make new estimates under IFRS at the date of transition if no such
amount was recognised by previous GAAP.
(iv) Disclosures in the first IFRS accounts

An entity must include at least one year of comparative financial information. There are however
certain exemptions regarding the provision of comparative for financial instruments. If an entity
avails of such an exemption it may apply its previous GAAP and disclose this fact, together with the
nature of the main adjustments what would make the information comply with the IFRS guidance
on financial instruments.
An entity must also explain the effect of the transition from previous GAAP to IFRS on financial
performance, financial position and cashflows.
It must do so by providing reconciliations of (i) equity at date of transition and at Statement of
Financial Position date and (ii) reported profit and loss highlighting values under previous GAAP to
those under IFRS. These reconciliations must provide the readers with sufficient detail to understand
the material adjustments to the Statement of Financial Position, the Statement of Comprehensive
Income and to the cashflow statement, if prepared under previous GAAP.
If an entity recognised or reversed any impairment losses for the first time in preparing its opening
IFRS Statement of Financial Position, the first IFRS Financial Statements must include the
disclosures that IAS
36 Impairment of Assets would have required if the entity had recognised those impairment losses
or reversals in the period beginning with the date of transition to IFRS.

If an entity corrects any errors made under previous GAAP the reconciliations must distinguish the
correction of errors from changes in accounting policies.

Where fair value has been used as deemed cost, the entity’s first IFRS financial statements shall
disclose for each line item in the opening IFRS Statement of Financial Position the aggregate of
those fair values and the aggregate adjustment to the carrying amounts reported under previous
GAAP.

I trust that my response will clarify the issues raised if you have any further queries please
contact me.
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INTERIM FINANCIAL REPORTING IAS 34

INTRODUCTION
IAS 34 recognises the usefulness of timely and reliable interim financial reporting in improving the
ability of investors, creditors and others to understand an entity’s capacity to generate earnings
and cash flows and its financial condition and liquidity.

The standard does not oblige entities to publish interim financial reports. However, entities
whose debt or equity securities are publicly traded are often required by governments, stock
exchanges, accountancy bodies, etc to publish interim financial reports.
If interim financial reports are published and purport to comply with IFRSs, then IAS 34 governs
their content. Each financial report, annual or interim, is evaluated on its own for conformity to
IFRSs. If an entity’s interim
financial report is described as complying with IFRSs, it must comply with all of the requirements
of IAS 34.

The interim period is a financial period shorter than a full financial year. The interim financial
report means a financial report containing either a full set of financial statements (in accordance
with IAS 1) or a set of condensed financial statements (as outlined in IAS 34) for an interim
period.

B. MINIMUM COMPONENTS OF AN INTERIM FINANCIAL REPORT

An interim report may consist of a condensed version of the full financial statements and should
include an explanation of the events and transactions that are significant to an understanding of
the interim financial statements.
At a minimum, they should include:

• Condensed statement of financial position

• Condensed statement of comprehensive income
• Condensed statement showing either:

• All changes in equity; or

• Changes in equity other than those arising from capital transactions with owners
and distributions to owners
• Condensed cash flow statement; and
• Selected explanatory notes

If the entity publishes a set of condensed financial statements in its interim financial report, those
condensed statements should include, at a minimum each of the headings and subtotals that
were included in its most recent annual financial statements, together with selected explanatory
notes as outlined by IAS 34.
The recognition and measurement principle should be the same as those used in the main
financial statements. Additional line items or notes should be included if their omission would
render the interim reports misleading. Basic and diluted earnings per share should be presented
on the face of an Statement of Comprehensive Income for an interim period.
If, however, an entity chooses to publish a complete set of financial statements in its interim
financial report, the form and content of those statements must conform to IAS 1 for a complete
set of financial statements.

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C. SELECTED EXPLANATORY NOTES
The following information must be included, as a minimum, in the notes to the interim accounts
(assuming they are material and not included elsewhere in the interim financial statements):

• A statement that the same accounting policies used for the interim report were used for the
most recent annual financial statements. If the policies have changed a description of the
nature and effect of the change must be given.
• Explanatory comments about the seasonality or cyclicality of interim operations.
• The nature and amount of items that are unusual because of their nature, size or incidence.
• The nature and amount of changes in estimates of amounts reported in prior interim periods
of the current financial year and if those changes have a material effect in the current interim
period.
• Issuances, repurchases and repayments of debt and equity securities.
• Dividends paid.
• Segment revenue and segment results for business or geographical segments, whichever is the
primary basis of segment reporting (only disclose segment reporting in interim accounts if it is
required in the full annual accounts).
• Material events after the end of the interim period that have not been reflected in the interim
accounts.
• The effect of changes in the composition of the entity during the interim period e.g.
business combinations.
• Changes in contingent liabilities or contingent assets since the last annual statement of financial
position date.

If an entity’s interim financial report is in compliance with IAS 34, this fact should be disclosed.
To be in compliance, it must comply with all of the requirements of IFRSs.

D. PERIODS FOR WHICH INTERIM FINANCIAL STATEMENTS ARE

REQUIRED TO BE PRESENTED
Interim reports should include interim financial statements as follows:
• Statement of Financial Position at the end of the current interim period and a comparative
Statement of Financial Position at the end of the immediately preceding financial year.
• Statement of Comprehensive Income for the current interim period, and the cumulative year-
to-date figures with comparative Statements of Comprehensive Income for the comparable
interim periods (current and year-to-date) of the immediately preceding financial year.
• Statement showing changes in equity cumulatively for the current financial year-to-
date, with a comparative statement for the comparable year-to-date period of the immediately
preceding financial year.
• Cash flow statement cumulatively for the current financial year-to-date, with a comparative
statement for the comparable year-to-date period of the immediately preceding financial year.

E. MATERIALITY
In recognising, measuring, classifying or disclosing items for the interim report, materiality for the
interim period must be assessed. But, in assessing materiality, it must be recognised that interim
statements may rely on estimates to a greater extent than measurements of annual financial
data.

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F. SEASONAL OR UNEVEN REVENUE AND COSTS
In measuring income and expenditure for the purposes of interim reports IAS 34 adopts an
approach where:

• Revenue received and costs incurred seasonally or unevenly should not be anticipated
or deferred when preparing interim financial statements unless that treatment would be
appropriate at the end of the year.
• If there is a change in accounting policy during a financial year, figures for prior interim periods
of the current financial year should be adjusted for the change, so that the same accounting
policies are in force throughout the year.

Thus, if a company is preparing interim accounts for six months, it will report actual figures for
those six months. This is the case even if the business is seasonal in nature, with only, say 30%
of its sales being made in those six months.

Tax is the only exception to this rule. Tax is computed for the period by charging the expected
rate of tax for the year to the profits of the interim period.

AGRICULTURE IAS 41
A. INTRODUCTION
Agriculture is fundamentally different from other types of business. Instead of wearing out or being
consumed over time, many agricultural assets actually grow. It can be argued that depreciation is
irrelevant in this situation. Hence, biological assets are measured at fair value and any changes
in fair value are reported as part of net profit for the period.

As a result, not only will a farmer’s profit on sales be recorded but so too will increases in the
value of the farms productive assets as a whole.

At first glance, this may appear counter-intuitive as it departs from the traditional accounting
realisation concept, where a profit is not recognised before a sale has been made. In the case
of forestry for example, IAS
41 allows profits to be recognised years before the products are even ready for sale. In fact, IAS
41 particularly impacts upon agricultural activities where the income-producing biological
assets are expected to have economic lives that extend beyond one accounting period.

However, the rationale is that by requiring all changes in the value of a farm to be reported openly
and transparently, farm managers will be unable to boost profits by selling off an unsustainable
amount of produce. An example of this would be where a forestry company could show large
short-term profits by cutting down and selling all trees without replacing them. The profit would
reflect the sales but ignore the fall in the value of the forest.

The change in the fair value of biological assets has two dimensions:

• There can be physical change in the asset through growth

• There can be a price change

Separate disclosure of these two elements is encouraged but not required. Where biological
assets are harvested, then fair value measurement ceases at the time of harvest and after that,
IAS 2 Inventories applies.

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The main issues addressed by IAS 41 are:

• When should a biological asset or agricultural produce be recognised in the statement of

financial position?
• At what value should a recognised biological asset or agricultural produce be measured?
• How should the difference in value of a recognised biological asset or agricultural produce
between two Statement of Financial Position dates be accounted for?

B. DEFINITIONS
Agricultural activity: the management by an entity of the biological transformation of biological
assets for sale into agricultural assets or into additional biological assets.

Agricultural produce: the harvested product of the entity’s biological assets, for example, milk,
apples, coffee beans.

A biological asset: a living animal or plant

Biological transformation: comprises the processes of growth, degeneration, production, and

procreation that cause qualitative or quantitative changes in a biological asset

Harvest: is the detachment of produce from a biological asset or the cessation of a biological
asset’s life processes.

Active Market: a market where the items traded are homogenous, willing buyers and sellers can
be found at any time and prices are available to the public.

Fair Value: the amount for which an asset can be exchanged or a liability settled in an arm’s
length transaction between knowledgeable and willing parties. The fair value of an asset is based
on its present condition and location.

This standard shall be applied to account for the following when they relate to agricultural activity:
• Biological assets
• Agricultural produce at the point of harvest
• Government grants related to agricultural activities

C. RECOGNITION AND MEASUREMENT

An entity should recognise a biological asset or agricultural produce, when and only when

• The entity controls the asset as a result of past events; and

• It is probable that future economic benefits associated with the asset will flow to the entity; and
• The fair value or cost of the asset can be reliably measured

A biological asset shall be measured on initial recognition and at each subsequent Statement of
Financial Position date at fair value less point of sale costs, except where the fair value cannot
be estimated reliably.

Agricultural produce harvested from biological assets shall be measured at fair value less point
of sale costs at the point of harvest. Unlike a biological asset, there is no exception in cases in

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which fair value cannot be measured reliably. IAS 41 states that agricultural produce can always
be measured reliably. Fair value, less estimated point of sale cost at the point of harvest, forms
“cost” for the purposes of IAS 2.

The point of sale costs include commissions payable to brokers and dealers, levies by regulatory
agencies and commodity exchanges, transfer taxes and duties. Point of sale costs exclude
transport and other costs necessary to get assets to markets.

If an active market does not exist which would allow the assessment of fair value then the
company may employ some of the following to assist in determining fair value:-

• Assess the most recent market price, provided there has not been a significant change in
economic circumstances between the date of that transaction and the Statement of Financial
Position date
• Consider market prices for similar assets with adjustments to reflect differences and
• Use sector benchmarks such as the value of an orchard expressed per tray, bushel,
kilogramme or hectare and the value of beef-cattle expressed per kg of meat

If an entity has access to different markets, then the entity should choose the most relevant and
reliable price that is the one at which it is most likely to sell the asset.

In some cases, market prices or values may not be available for an asset in its present condition.
In these cases, the entity can use the present value of the expected net cash flow from the asset,
discounted at a current market pre-tax rate. In some circumstances, costs may be an indicator
of fair values, especially where little biological transformation has taken place or the impact of
biological transformation on the price is not expected to be significant.

The standard specifically requires that fair value is not determined by reference to a future
sales contract. Contract prices are not necessarily relevant in determining fair value, because
fair value reflects the current market value in which a willing buyer and seller would enter into
a transaction. Consequently, the fair value of the biological asset or agricultural produce is not
adjusted because of the existence of a contract.

The difficulty in establishing the fair value of a biological asset increases when the asset is a
“bearer asset”. This is an asset which itself will not eventually become agricultural produce. The
problem is exacerbated the more long-lived the asset is.
Coffee bushes - they take 3-4 years to mature then may live and produce fruit/beans for a further
10 years or more. The standard does not require external independent valuations but, in such
cases where fair values are otherwise difficult to determine, it may be possible and appropriate to
apply IAS 36 Impairment to determine both the value in use and the net selling price of the asset
and to use the higher of these two amounts to represent valuation.

When the presumption that fair value can be established can be rebutted, and until such time as
a fair value becomes measurable with reliability, the asset is carried on the statement of financial
position at cost less any accumulated depreciation and any accumulated impairment losses. All
the other biological assets of the entity must still be measured at fair value. IAS 41 also contains
additional disclosure requirements in such a situation.

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EXAMPLE
At 31st December 2009, a plantation consists of 100 trees that were planted 10 years ago.
These trees take 30 years to mature and will ultimately be processed into building material for
housing and furniture. The weighted average cost of capital is 6% per annum.

Only mature trees have established fair values by reference to a quoted price in an active market.
The fair value (inclusive of transport costs to get 100 logs to market) for a mature tree of the
same grade as in the plantation is:
As at 31st December 2009: RWF171
As at 31st December 2010: RWF165

Thus at 31st December 2009, the mature plantation would have been valued at RWF17,100,
while the following year, the mature plantation would have been valued at RWF16,500.

Assuming immaterial cash flow between now and the point of harvest, the fair value (and
therefore the amount reported as an asset in the statement of financial position) of the plantation
is estimated as follows:
31st December 2009 Present value of RWF17,100 discounted at 6% for 20 years = RWF5,332

31st December 2010

Present value of RWF16,500 discounted at 6% for 19 years = RWF5,453

D. GAINS AND LOSSES

At initial recognition, the fair value (less estimated point of sale costs) of a biological asset
is reported as a gain or loss in the statement of comprehensive income. A loss may arise on
initial recognition when the estimated point of sale costs exceed the fair value of the asset in its
present state.

The change in fair value (less estimated point of sale costs) of a biological asset between two
period end dates is reported as a gain or loss in the statement of comprehensive income.

A gain or loss arising on initial recognition of agricultural produce at fair value less estimated
point of sale costs is included in net profit or loss for the period.

In the example above, the difference in fair value of the plantation between 31st December 2009
and 2010is RWF121 (5,453 – 5,332). This will be reported in the Statement of Comprehensive
Income as a gain (irrespective of the fact that it has not yet been realised). The aggregate gain
of RWF121 is attributed to two factors:
• The effect of change in market price; and
• The physical change (growth) of the trees in the plantation. The aggregate gain is analysed as
follows:

• The price change, which, at the biological asset’s state as at the previous
accounting year end,
represents:
The value of the biological asset at prices prevailing as at the current accounting
year end less the value of the biological asset at prices prevailing as at the previous
accounting year end.

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 (16,500 x .3118) – (17,100 x .3118) = 5,145 – 5,332 = 187 (loss)
That is, 16,500 discounted at 6% for 20 years less 17,100 discounted at 6% for 20
years.

• The physical change, which, at current prices, represents:

The value of the biological asset in its state as at the current year end less the value of the
biological asset in its state as at the previous year end
(16,500 x .3305) – (16,500 x .3118) = 5,453 – 5,145 = 308 (gain)

That is, 16,500 discounted at 6% for 19 years less 16,500 discounted at 6% for 20 years.
Thus, the aggregate is: 187 (loss) + 308 (gain) = 121 net gain.

E. GOVERNMENT GRANTS AND ASSISTANCE.

The government grants are as defined in IAS 20 Accounting for Government Grants and
Disclosure of Government Assistance.

A government grant that is related to a biological asset measured at fair value less estimated point
of sale costs should be recognised as income when the government grant becomes receivable.
If there are conditions attached to the grant, then the entity will only recognise the government
grant when the conditions attaching thereto are complied with.

IAS 20 is applied only to a government grant that is related to a biological asset which has been
measured at cost less accumulated depreciation and impairment losses.

IAS 41 does not deal with grants related to agricultural produce. These grants may include
subsidies. Subsidies are normally payable when the produce is sold and would therefore be
recognised as income on the sale.

F. DISCLOSURE
IAS 41 requires extensive disclosures, including:

• The aggregate gain or loss arising during the current accounting period on initial recognition of
biological assets and agricultural produce and from the change in fair value less point of sale
costs of biological assets

• A description of each group of biological assets

• The methods and significant assumptions applied in determining the fair value of each
group of agricultural produce at the point of harvest and each group of biological asset

• The fair value less estimated point of sale costs of agricultural produce harvested during the
period, determined at the point of harvest
• The existence and carrying amounts of biological assets whose title is restricted, and the
carrying amounts of biological assets pledged as security for liabilities;
• The amount of commitments for the development or acquisition of biological assets
• Financial risk management strategies related to agricultural activity
• A reconciliation of the changes in carrying value of biological assets between the beginning
and end of the current period including

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 • The gain or loss from the changes in fair value less point of sale costs
• Increases due to purchases
• Decreases due to sales and biological assets held for sale in accordance with IFRS 5
• Decreases due to harvest
• Increases resulting from business combinations
• Net exchange differences from foreign current transactions
• Other changes

OPERATING SEGMENTS IFRS 8

A. INTRODUCTION
Large companies can often operate within several different business sectors and/or in different
geographical locations. Each of these sectors/locations can involve risks and opportunities that
can differ significantly from each other. For example, while an entity’s toy division might be facing
stiff competition from imports, its food division might be performing very well and expanding
market share rapidly.

If the results of all divisions of the company are amalgamated into a single set of financial
statements without any analysis of divisional performance, it would be very difficult for users of
these statements to engage in a meaningful measure of company performance for the period.

Thus, IFRS 8 requires entities within the scope of the standard to disclose information that will
allow users to evaluate the nature and financial effects of the business activities in which it
engages and the economic environments in which it operates.

IFRS 8 Operating Segments applies only to organisations whose equity or debt securities are
publicly traded and to organisations that are in the process of issuing equity or debt securities
in public securities markets. Should other organisations opt to disclose segment information
in financial statements that comply with international financial reporting standards, they must
comply fully with the requirements of IFRS 8.

According to the core principle of IFRS 8, an entity should disclose information to enable users
of its financial statements to evaluate the nature and financial effects of the types of business
activities in which it engages and the economic environments in which it operates.
The emphasis is now on disclosing segmental information for external reporting purposes based
on internal reporting within the entity to its “chief operating decision maker”. The IASB believes
that the requirement to report segmental information using the approach adopted by IFRS 8 (that
is, a “management approach”) allows the users of the financial statements to review segmental
information from the “eyes of management”, as opposed to a “risks and rewards” approach under
the old IAS 14.

In addition, the cost and time needed to produce such segmental information is greatly reduced
since most, if not all, of this information is already available within the entity, which is a distinct
advantage in the case of public companies that are required to report on a quarterly basis.

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B. DEFINITION
IFRS 8 defines an operating segment as a component of an entity:

• That engages in business activities from which it may earn revenues and incur expenses
Whose operating results are regularly reviewed by the entity’s chief operating decision maker
to make decisions about resources to be allocated to the segment and assess its performance
For which discrete financial information is available.

Segmental reports are designed to reveal significant information that might otherwise be hidden
by the process of presenting a single statement of comprehensive income / income statement
and statement of financial position for the entity.

C. REPORTABLE SEGMENTS
An entity should report financial and descriptive information about its reportable segments. Not
all operating segments would automatically qualify as reportable segments. IFRS 8 requires
segmental information to reflect the way that the entity is actually managed. The operating
segments are those that are used in its internal management reports. Consequently, management
identifies the operating segments.

The standard prescribes the criteria for an operating segment to qualify as a reportable segment
and must separately report information about an operating segment that meets any of the
following thresholds (the “alternative quantitative thresholds”):

• Its reported revenue, from both external customers and intersegment sales or transfers, is 10%
or more of the combined revenue (internal and external) of all operating segments; OR
• 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

• Its assets are 10% or more of the combined assets of all operating segments.

Furthermore, if the total revenue attributable to all operating segments (as identified by applying
the alternative quantitative thresholds criteria, above) constitutes less than 75% of the entity’s
total revenue as per its financial statements, the entity should look for additional operating
segments until it is satisfied that at least 75% of the entity’s revenue is captured through such
segmental reporting.

In identifying the additional operating segments as reportable segments (for the purposes of
meeting the 75% threshold); the Standard has relaxed its requirements of meeting the “alternative
quantitative thresholds” criteria. In other words, an entity has to keep identifying more segments
even if they do not meet the “alternative quantitative thresholds” test until at least 75% of the
entity’s revenue is included in reportable segments.

There is no precise limit to the number of segments that can be disclosed, but if there is more
than ten, the resulting information may become too detailed. Information about other business
activities and operating segments that are not reportable are combined into “all other segments”
category.

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It is important to note that even though IFRS 8 defines a reportable segment in terms of size, size
is not the only criterion taken into account. There is some scope for subjectivity.

EXAMPLE
FG carries out a number of different business activities. The summarised information regarding
these activities
is below:

Revenue Profit Before Total Assets

RWFm Tax RWFm
RWFm
Manufacture and sale of 249 69 102
computer hardware

Development and supply of

software:
To users of company’s hardware 66 36 18
products
To other users 15 9 3
Technical support and training 30 6 12

Contract work on IT products 90 30 30

Total 450 150 165

Which of the company’s activities should be identified as separate operating segments?

Manufacture and sale of computer hardware and contract work on IT products are clearly
reportable segments by virtue of size. Each of these two operations exceeds all three “10%
thresholds”.

On the face of it, it appears that the development of software is a third segment. It would make
intuitive sense for both parts of this operation to be reported together, as supply to users of other
hardware forms only 3% of total revenue and 6% of total profit before tax.

Although, technical support and training falls below all three 10% thresholds, it should be
disclosed as a fourth reportable segment because it has different characteristics from the rest of
the business.

D. DISCLOSING SEGMENTAL INFORMATION

IFRS 8 prescribes extensive segmental reporting disclosures. These include:

• General information about how the entity identified its operating segments and the types of
products and services from which each operating segment derives its revenues.
• 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; and
• 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.

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The standard makes clear that certain entity-wide disclosures are required even when an entity
has only one reportable segment. These disclosures include information about each product and
service or groups of products and services.

Additional disclosures include:

• Analyses of revenues and certain non-recurrent assets by geographical area, with an

expanded requirement to disclose revenues / assets by individual foreign country (if material),
irrespective of identification of the operating segments, and
• Information about transactions with “major customers”, that is, those customers that
individually account for revenues of 10% or more of the entity’s revenues.

IFRS 8 also expands considerably the disclosure of segment information at interim reporting
dates.

E. DRAWBACKS TO SEGMENTAL REPORTING

Despite the usefulness of the information provided by segmental reports, there are limitations
which must be borne in mind.
IFRS 8 states that segments should reflect the way in which an entity is managed. This means
that segments are defined by directors. This may lead to too much flexibility. It also means that
segmental information is useful only for comparing the performance of the same entity over time,
not for comparing the performance of different entities.

Common costs may be allocated to different segments on whatever basis the director is
reasonable. This can lead to the arbitrary allocation of these costs.

A segment’s operating results can be distorted by trading with other segments on non-commercial
terms.

These limitations have applied to most systems of segmental reporting, regardless of the
accounting standard being applied. IFRS 8 requires disclosure of some information about the
way in which common costs are allocated and the basis for inter-segment transactions.

EXAMPLE
EPN is a listed entity. You are the financial controller of the entity and its consolidated financial
statements for
the year ended 31 March 2010 are being prepared. The board of directors is responsible for all
key financial and operating decisions, including the allocation of resources. Your assistant is
preparing the first draft of the statements. He has a reasonable general accounting knowledge
but is not familiar with the detailed requirements of all relevant financial reporting standards. He
has sent you a note as shown below:

“We intend to apply IFRS 8 – Operating Segments – in this year’s financial statements. I am
aware that this standard has attracted a reasonable amount of critical comment since it was
issued in November 2006. The board of directors receives a monthly report on the activities of
the five significant operational areas of our business. Relevant financial information relating to
the five operations for the year to 31 March 2010, and in respect of our Head Office, is as follows:

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 Operational area Revenue for year Profit/ (loss) for Assets at
to 31 March 2010 year to 31 March 2010 31 March 2010
RWF’000 RWF’000
RWF’000
A 23,000 3,000 8,000
B 18,000 2,000 6,000
C 4,000 (3,000) 5,000
D 1,000 150 500
E 3,000 450 400
––––––– ––––––– –––––––
Sub-total 49,000 2,600 19,900
Head office Nil Nil 6,000
––––––– ––––––– –––––––
Entity total 49,000 2,600 25,900
––––––– ––––––– –––––––
I am unsure of the following matters regarding the reporting of operating segments:

• How do we decide on what our operating segments should be?

• Should we report segment information relating to Head Office?
• Which of our operational areas should report separate information? Operational areas A,
B and C exhibit very distinct economic characteristics but the economic characteristics of
operational areas D and E are very similar.
• Why has IFRS 8 attracted such critical comment?” Draft a reply to the questions raised by
your assistant.

SOLUTION
Following your recent memorandum here is a response to the queries you raised:

IFRS 8 – Operating Segments – states that an operating segment is a component of our business:
• That engages in activities from which it may earn revenues and incur expenses; Whose
operating results are regularly reviewed by the chief operating decision maker (CODM).
For which discrete financial information is available.

The term ‘CODM’ identifies a function, and not necessarily a manager with a specific title. The
key function is allocation of resources and assessment of performance. The CODM can be an
individual or a group of directors. In our case the board of directors is the CODM.

In order to be an operating segment a business unit must be producing revenue. Therefore,

despite the relative materiality of its assets to the assets of the entire entity, Head Office is not
an operating segment.

Once an operating segment is identified it is necessary to report separate information about the
segment if it exceeds any one of three quantitative thresholds:

Its reported revenue is 10% or more of the combined revenue of all operating segments.
The absolute amount 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.

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Its assets are 10% or more of the combined assets of all operating segments.
If, having applied these tests to individual operating segments, the external revenue of the
reportable segments is less than 75% of the external revenue of the combined entity, more
operating segments should be designated as reportable until the 75% threshold is reached.

Where two or more segments exhibit similar long term financial performance it is necessary to
aggregate them for the purposes of the size tests.

Therefore we will consider areas D and E together for these tests.

Segments A and B are separately reportable because in each case their revenue is more than
10% of the total revenue of the business. There is no need for any further consideration.

Segment C is reportable despite its revenue being less than 10% of the total revenue. Its assets
are more than
10% of the total of the assets of all operating segments. There is no need for any further
consideration.

Segments D and E are considered as a single segment. They fail both the revenue and the
assets tests but their profit (150 + 450 = 600) is more than 10% of the total profit of the segments
that report a profit (3,000 + 2,000
+ 600 = 5,600).Therefore the segments are reportable together as a single segment.

The reasons the standard has attracted such critical comment are:

• The identification of operating segments, and the segment information that is provided, is based
around the internal business organisation. Therefore the reports are potentially vulnerable to
management discretion in terms of what is reported and intercompany comparison may be
difficult or even impossible.
• The standard was issued as a part of the convergence project with the US FASB and is based
very much on the equivalent US standard. Some commentators are concerned that the reason
for the issue of the standard was based on pragmatism, rather than on sound theoretical
principles.
• The standard does not require entities to follow the measurement principles of IFRS in its
segment reports, but rather the measurement principles that are used internally.

NON CURRENT ASSETS HELD FOR SALE AND DISCONTINUED OPERA-

TION (IFRS 5)

A. OBJECTIVE
The objective of IFRS 5 is to outline:
• Accounting for assets classified as “Held-For-Sale”; and
• The presentation and disclosure of “Discontinued Operations”

IFRS 5 requires non-current assets and groups of assets (disposal groups”...see below) that are
‘Held-For-Sale’ to be presented separately on the face of the Statement of Financial Position
and the results of ‘Discontinued Operations’ to be presented separately in the Statement of
Comprehensive Income.

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IFRS 5 does not apply to the following:

• Deferred tax assets

• Assets arising from employee benefits
• Financial assets
• Investment properties accounted for in accordance with the fair value model
• Agricultural and biological assets
• Insurance contracts

B. ASSETS HELD FOR SALE - DEFINITION

A non-current asset shall be classified as held for sale if its carrying amount will be recovered
principally through a sale transaction rather than through continuing use.

A “Disposal Group” is a group of assets to be disposed of, by sale or otherwise, together as

a group in a single transaction, and liabilities directly associated with those assets that will be
transferred in the transaction.

In order for a non-current asset or disposal group to be classified as ‘Held-For-Sale”, a number

of detailed criteria must be met:-
• The asset must be available for immediate sale
• The sale must be highly probable

• Management must be committed to the sale

• There must be an active program to locate a buyer

• The asset must be marketed at a price that is reasonable in relation to its current fair value
• The sale should be expected to be completed within a twelve month period from the date of
classification
• It is unlikely that significant change to the plan will take place or that the asset will be
withdrawn from its availability for sale.

If the asset is not sold within the 12 month stipulated period, it can still be classified as held for
sale as long as any delay is beyond the control of the board and they are still committed to sell.

If the criteria for ‘Held-For-Sale’ are no longer met, the entity must cease to classify the assets
or disposal group as ‘held-For-Sale’. The assets or the disposal group must be measured at the
lower of:
• Its carrying amount before it was classified as held for sale adjusted for the depreciation that
would be charged if it were never classed as held for sale
• Its recoverable amount at the date of the decision not to sell

Any adjustment to the value should be shown in income from continuing operations for the
period.
If the assets are to be abandoned or gradually wound down, then they cannot be classified as
‘Held-For-Sale’ since their carrying amounts will not be recovered principally through a sale
transaction. They might, however, qualify as discontinued operations once they have been
abandoned.

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C. ASSETS HELD FOR SALE - MEASUREMENT
A non-current asset or a disposal group that is held for sale should be carried at the lower of
its:
• carrying value; or
• fair value less sales costs.

An impairment loss should be recognised when the carrying value is greater than the fair value
less sales costs. When a disposal group is being written down to fair value less costs to sell, the
impairment loss reduces the
carrying amount of assets in the order outlined by IAS 36 Impairment of assets That is, write
down goodwill
first and then allocate the remaining loss to the assets on a pro-rata basis (based on their
carrying amount). Non-current assets held for sale should not be depreciated, even if they are
still being used by the entity.
Where a non-current asset has previously been revalued and is now classified as being ‘Held-
for-Sale’, it should be revalued to fair value immediately before it is classified as ‘Held-For-Sale’.
It is then revalued again at the lower of the carrying amount and the fair value less costs to sell.
The difference is the selling costs and these should be charged against the profits for the period.

D. ASSETS HELD FOR SALE - PRESENTATION IN THE STATEMENT OF FINAN-

CIAL POSITION
IFRS 5 states that assets classified as ‘Held-For-Sale” should be presented separately from
other assets in the statement of financial position. The liabilities of a disposal group classified
as held for sale should be presented separately from other liabilities in the statement of financial
position.

Assets and liabilities held for sale should not be offset.

The major classes of assets and liabilities classified as ‘Held-For-Sale’ must be separately
disclosed either on the face of the statement of financial position or in the notes.

E. ASSETS HELD FOR SALE – MISCELLANEOUS POINTS

On occasion, entities can acquire non-current assets exclusively for resale. In these cases, the
non-current asset must be classified as ‘Held-For-Sale’ at the date of the acquisition only if it is
anticipated that it will be sold within a one year period and it is highly probable that the held-for-
sale criteria will be met within a short period of the acquisition date (normally no more than three
months).

If the criteria for classification of an asset as ‘Held-For-Sale’ occur after the year end, the non-
current asset should not be shown as ‘Held-For-Sale’. However, certain relevant information
should be disclosed about the asset in question. This is a non-adjusting event after the reporting
date.

Exchanges of non-current assets between entities can be treated as ‘Held-For-Sale’ when

such an exchange has a commercial substance, in accordance with IAS 16 Property Plant and
Equipment.

A non-current asset that has been temporarily taken out of use or service cannot be classified
as being abandoned.

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Assets classified as held for sale at the statement of financial position date are not
reported retrospectively. Therefore, comparative statements of financial position are not restated.

F. ASSETS HELD FOR SALE - EXAMPLES

Example 1
On 1st January 2007, CX Ltd. acquired a building for US $600,000. The building had an expected
useful life of
50 years. On 31st December 2010, CX Ltd. put the building up for sale. The criteria necessary
for classification as “Held-For-Sale” are deemed to be met.

On 31st December 2010, the building has an estimated market value of US$660,000 and selling
costs of
US$45,000 will be payable on disposal (including aUS $15,000 tax charge).

How should this building be accounted for?

SOLUTION
Until 31st December 2010, the normal rules of IAS 16 apply. The carrying value of the building
is US$552,000 (US$600,000 – (12,000 x 3)). At this date, the building is reclassified as a non-
current asset held for sale. It is measured at the lower of:
• Carrying Amount of US$552,000
• Fair Value Less costs to sell US$630,000

The building will therefore be measured at US $552,000 at 31st December 2010. (Note that any
applicable tax expense is excluded from the calculation of ‘costs to sell’).

Example 2
FL Ltd. has an asset that has been designated as ‘Held-For-Sale’ in the financial year to 31st
December 2010. During the financial year to 31st December 2011, the asset remains unsold.
The market conditions have deteriorated significantly, but the directors of Filo believe that the
market will improve and have therefore not reduced the price of the asset, which continues to be
classified as held for sale.

The fair value of the asset is US$15 million and the asset is being marketed atUS $21 million.

Should the asset be classified as ‘Held-For-Sale’ in the financial statements for the year
ending 31st
December 2011?

SOLUTION
Because the price is in excess of the current fair value, this means that the asset is not available
for immediate sale. Consequently, it should not be classified as held for sale.

G. DISCONTINUED OPERATIONS – DEFINITION

An entity should present and disclose information that enables users of the financial statements
to evaluate the financial effects of discontinued operations and disposals of non-current assets
or disposal groups.

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A discontinued operation is a component of an entity that has either been disposed of or is
classified as ‘Held- For-Sale’ and:
• Represents a separate major line of business or geographical area of operations
• Is part of a single coordinated plan to dispose of separate major line of business or
geographical area of operations; or
• Is a subsidiary acquired exclusively with a view to resale.

A component of an entity can be a business, geographical or reportable segment, a cash-

generating unit or a subsidiary.

If the operation has not already been sold, then it will only be a discontinued operation if it is held
for sale.

H. DISCONTINUED OPERATIONS - PRESENTATION

The entity should disclose a single amount on the face of the statement of comprehensive
income comprising the total of:-

• The post tax profit or loss of discontinued operations and

• The post tax gain or loss on the measurement to fair value less costs to sell or on the disposal
of the assets or disposal group constituting the disposal group

The above-mentioned single amount must be analysed, either in the notes or on the face of the
Statement of Comprehensive Income, into:

• The revenue, expenses and pre-tax profit or loss of discontinued operations

• The related income tax expense
• The gain or loss recognised on the re-measurement to fair value less costs to sell or on the
disposal of the assets of the discontinued operation
• The related income tax expense

The entity should disclose the net cash flows attributable to the operating, investing and financing
activities of discontinued operations. These disclosures may be presented either on the face of
the cash flow statement or in the notes.

If the decision to sell an operation is taken after the year end, but before the financial statements
are authorised, this is treated as a non-adjusting event after the reporting date and is disclosed
in the notes. The operation does not qualify as a discontinued operation at the reporting date and
separate presentation is not appropriate.

Discontinued Operations - Example

On the 1st July 2010, CCL Limited closed its software division. The software divisions operating
results from
the start of the financial year to the date of closure are as follows:

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 RWF’000
Sales revenue 50,000
Cost of sales 27,000

Operating expenses (34,000)

Operating loss (11,000)

The tax relief attributable to the operating loss is RWF3,500,000

In addition, the net assets of the division were sold off at a profit of RWF7,300,000. The tax
attributable to this profit is RWF2,300,000

Show the extract from the Statement of Comprehensive Income in relation to the discontinued
operation

Solution
First, make sure the figures have not been included as part of other figures.
For example, if the sales have been included in the sales from all divisions for the year, sales
from the software division must be deducted from total sales to avoid double-counting

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STUDY UNIT 3
Company Accounts
• Preparation and presentation of financial statements to comply with the relevant Rwandan
legislation and IFRS, this should focus on both accounting for:

• Large Listed Entities

• Branch Accounts
• Co-Operatives and small businesses
• Accounting for Banks & Other Financial Institutions
• Accounting for Insurance Companies
• Accounting for Agri-business (Farm Accounts)
• Accounting for Consignments & Other Agency Selling
• Accounting for bankruptcies and liquidations

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BRANCH ACCOUNTS
Nature and objectives of Branch accounting
The aim of every business is to grow and increase its sales volume so as to earn more and more
profits. To achieve this objective the strategy is to make market its products/services over a large
territory, which is possible only if the business decides to split its business into certain divisions
or parts. These are called Branches. For example, the Bank of Kigali Limited (BK Ltd) with its
registered head office in Kigali-Nyarugenge has opened up its Branches in different sectors of
Kigali City as well as in different towns all over Rwanda. Likewise, Kenya Commercial Bank
Limited (KCB Ltd) has many Branches all over the country of Kenya as well as in the countries
of the East African Community.

Definitions

• A Branch is a unit of a business enterprise located some distance from the Home Office (HO).
The merchandise of a Branch may be obtained exclusively from the HO, or a portion may be
purchased from outside suppliers. A Branch generally caries a stock of merchandise obtained
from the home office, makes sales, approves customers’ credit, and makes collections on
Trade A/cs receivable.
• Certain units or segments of a business enterprise may be operated as divisions. A division
may consist of either a series of Branches or one or more corporations. When a segment is
operated as a corporation, it is known as a subsidiary of the parent company.
• Branch accounting is an accounting system in which separate accounts are maintained for
each Branch of a corporate entity. The primary objectives of Branch accounting are better
accountability and control, since profitability and efficiency can be closely tracked at the
Branch level.
• Branch accounts are accounts relating to different Branches and are used to ascertain the
trading result of each Branch separately.

Need or objectives of Branch account

The various objects of maintaining Branch account are:

• To assess the progress and performance of each Branch

• To ascertain the profit or loss and financial position of each Branch.
• To have a better control over the Branches by the Head Office
• To enable the head office to know the requirements of goods, stock and cash for each Branch.
• To ascertain whether the Branch should be expanded or closed
• Formulate further programs and policies relating to the Branches.

Branch accounts and Departmental accounts compared

Departmental accounts are accounts relating to different departments of the business and are
used to ascertain the trading results of each department separately. Such accounts disclose not
only the profits of each of the department but also the profits of the whole business.
The difference between Branch and department can be summarized as follows:

• Branches are separated from the main organization while Departments are attached with the
main organization under a single roof.
• Branches are the outcome of tough competition and expansion of business. Departments are
the result of fast human life.
• Branches are geographically separated. Departments are not separated rather existed under
a same roof.

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 • Branches are of different types: dependent, independent and foreign. There is no such
classification in department because all are common under the same roof.
• Allocation of the Branch common expenses does not arise. Allocation of the departmental
common expenses is a tough job.
• To find out the net result of the organization, reconciliation of different Branch a/c is a main
job. In departmental accounting, no reconciliation is necessary because there is a central
account division.

Types of Branches and accounting records

Types of Branches
For accounting purposes Branches are classified as (1) Home Branches and (2) Foreign
Branches:

• Home/Domestic Branch

• Dependent Branch (taken as profit centre)

• Independent Branch (taken as an investment centre)
• Foreign branch: foreign branches are the branches which are located in a foreign country
(i.e. in a country other than in which the company is incorporated and registered). The foreign
branches keep their accounts not in home currency but in the respective foreign currency
when head office receives their trial balance, the values will be expressed in foreign currency,
now the same has to be converted into home currency.

Difference between independent and dependent branch

Basis (distinctive Independent Branch Dependent Branch

features)
Decision making Branch manager of an The Branch manager of a
independent Branch is dependent Branch is not given
given certain powers for decision making powers, the
decision making regarding manager acts according to
procurement, selling, the instruction and policies
advertising, staffing, pricing, directed by the Head Office.
and even for purchasing of
non-current assets.
Accounting System Independent branch keeps The accounts of branches are
full system of accounting at maintained at the Head Office
their place. level. At branch only Cash
Register and Debtors Register
are maintained. (Branches
keep only some memorandum
records.)

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 Sale of Goods These branches sell goods These branches sell only those
received from head office as goods which are supplied
well as from the purchases by the Head office. They are
made by them. normally not allowed to make
own purchases.

Point of Payment of Branches keep the required All branch expenses of

Expenses cash to meet the expenses regular nature like salary,
of regular nature with Rent normally paid directly by
themselves. head office. Branch managers
are allowed to incur petty
expenses only.

Remittance of Cash Independent Branches are All the daily cash sale and
not required to remit all the collection from debtors will
cash daily to Head Office. be deposited at local bank or
remitted to H.O
Trial Balance A trial balance has been Trial Balance is not required to
extracted from the ledger be extracted as accounts are
maintained at branch level. maintained at Head Office.

Reconciliation Reconciliation between There is no need of

branch Account in books of reconciliation as accounts are
head office and head office maintained at Head Office
Account in the books of level itself.
Branch is to be made before
finalising the Accounts.

Methods of Accounting is done on the Accounting under Dependent

Preparing Final double entry system basis, branches can be made by
Account so Trading/P&L A/c has been three different methods are
prepared in normal way. Debtors system, Final Account
system and Stock and Debtors
system.
Wholesale dependent Branch

Accounting records for Branches

When we look at accounting records to show transactions at the Branches of an organisation, we
have a choice of two main methods:

• the head office keeps all the accounting records; or

• each Branch has its own full accounting system.

If the Head Office maintains all the ledgers

The ledgers are used for three main purposes:

• To record transactions showing changes in assets, liabilities and capital;

• To ascertain the profitability of each Branch; and, if possible,
• To check whether anyone at the Branches is stealing goods or cash.

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This third purpose is very important for firms that have many Branches. The people who manage
or work in these Branches are receiving and paying out large sums of money. In addition they may
be handling large amounts of stocks of goods. The Branch may be at a considerable distance
away from the H.O and so manager, or any of the staff, may think that they can steal things
without being caught.

If each Branch maintains full accounting records

Branches rarely maintain full accounting records. When they do, it is usually in a business with
just a few Branches, and is normally done only when a Branch is large enough to warrant
employing its own accounting staff.

10 Retail dependent Branch

There are three methods to calculate the profits of a retail dependent Branch. Any of these can
be used to calculate Branch profits but the selection of method will depend upon the nature of
operations, size and level of complexity of the transaction.

• Debtors system
• Stock and debtors system
• Final account system (Income statement system)

20 Wholesale dependent Branch

A Branch may be operated both under the retail profit basis as well as under wholesale profit
basis. In the latter case, the head office sells goods to actual consumers through its retail
branches. The Head Office sends goods to the Branches at wholesale prices which is a cost
plus a percentage of profit. The Branch is likely to sell those goods at retail prices which are more
than the wholesale prices. Thus, under this system, Branch is treated as the wholesale Branch.

ACCOUNTING FOR DEPENDENT BRANCHES

Debtors System
This system is adopted in case of Branches of small size. Under this system, the head office
opens only one account for each Branch called Branch account. Its purpose is to ascertain the
profit or loss made by each Branch. Such Branch A/c is nominal in nature.
Goods may be invoiced to a Branch at cost or at selling price (called invoice price). Accordingly,
there are two methods of preparing the Branch Account:

• Cost price method, and

• Invoice price method or in case of retail Branches, at wholesale price.

Goods invoiced to branch at cost

When goods are invoiced at cost, the following journal entries are passed in the books of the
head office to record various transactions relating to the Branch. Accounting entries are

(1) To record opening balances of Branches Dr Branch account

assets Cr Branch assets (individually)

(2) To record opening balances of Branch Dr Branch liabilities (individually)

liabilities Cr Branch account

(3) For goods sent to the Branch Dr Branch a/c

Cr Goods sent to Branch a/c

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 For goods sent by Branch to another Dr Goods sent to Branch a/c
Branch at instructions from head Office Cr Branch (treated at par with goods
returned by Branch to head office)
(5) For goods returned by the Branch to Dr Goods sent to Branch A/c
head office Cr Branch A/c
(6) For goods returned by Branch debtors Dr Goods sent to Branch A/c
to H.O directly (same as returns from Cr Branch A/c
Branch to HO)
(7) For expenses at Branch paid by the Dr Branch a/c
head office Cr Bank a/c

(8) For remittances received from the Dr Bank a/c

Branch (cash remitted by the Branch to Cr Branch a/c
Head Office)
(9) For closing goods sent to Branch Dr Goods sent to Branch a/c
account Cr Purchases a/c / Trading a/c

(10) For closing balances of assets at the Dr Branch assets (individually)

Branch Cr Branch a/c

(11) For closing balances of liabilities at the Dr Branch a/c

Branch Cr Branch liabilities (individually)
(12) For closing Branch A/c into the P&L (a) If profit (i.e Total credits>Total
A/c debits)
Dr Branch A/c
Cr General profit and loss a/c
(b) If loss (i.e. Total credits <Total
debits)
Dr General profit and loss a/c
Cr Branch A/c

For abnormal loss

Dr Abnormal loss a/c (at cost)
Cr Branch a/c
Dr Insurance claim a/c (claim admitted)
Dr Profit & loss a/c (balance if not admitted by the insurance company)
Cr Abnormal loss a/c (cost of the abnormal loss)
Note: Abnormal loss should always be accounted for at cost. No entry is required for normal
losses
The specimen of a Branch account is given below:

202 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 Branch Account
To Balance (opening assets): By Balance (opening liabilities): xx
Stock xx Creditors xx
Debtors xx Outstanding expenses
Petty cash xx By Bank (Remittance to H.O): xx
Non-current assets xx by Branch xx
Prepaid expenses xx by Branch Debtors directly to H.O
To Goods sent to Branch: By Goods sent to Branch:
Goods sent by H.O. xx Returned by Branch xx
Goods sent by other Branches xx Returned by Branch debtors xx
To Bank (payment by HO on behalf of directly to HO xx
Branch): Sent to other Branches
For expenses xx
Petty cash xx

To Balance (closing liabilities): By Balance (closing assets):

Creditors xx Stock xx
Outstanding expenses xx Debtors xx
To General P&L (profit transferred) xx Petty cash xx
Non-current assets xx
Prepaid expenses xx
To General P&L (loss transferred) xx

xx xx
Note: To ascertain any missing figure relating to cash remitted, stock and/or debtors, a
memorandum Branch cash account, Branch stock account and Branch debtors account has to
be prepared.

Treatment of some peculiar items in Branch account

(1) Petty cash expenses: No entry is made in respect of petty cash expenses incurred by the Branch and
paid out of its petty cash. The Branch Account is debited with the opening balance of petty cash as
to bank account and the amount of petty cash sent by head office, and it is credited with the closing
balance of petty cash. This amounts to a net debit to Branch Account which is equal to the amount of
petty expenses incurred by Branch. If petty cash is maintained on the imprest system, actual expenses
incurred will be reimbursed and appear on the debit side of Branch A/c.

(2) Credit sales, sales return, bad debts, discount allowed to debtors: All these items relate to Branch
debtors and will not be shown in the Branch Account. The reasoning is similar to that of petty cash
expenses. When the Branch Account is debited with the opening balance of Branch debtors and
credited with cash received from debtors and the closing balance of Branch debtors, the amount of
credit sales etc. automatically stand accounted for.

(3) Shortage or surplus of stock: It is possible that, at the time of checking the stock of a Branch, certain
amount of shortage or surplus is detected. These are not to be shown in the Branch Account because
the closing stock credited to the Branch Account is the actual amount of stock and thus the shortage
or surplus is automatically covered.

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(4) Depreciation on non-current assets: It is also not shown in the Branch account because, as per practice,
the amount of depreciation is the difference between the amount debited (opening balance) and the
amount credited (closing balance) to the Branch A/c.

(5) Purchase of non-current assets by the Branch: The non-current assets purchased by the Branch should
be treated as closing Branch non-current asset and should be credited to the Branch account. If it is
purchased for cash, it should also be deducted from the remittance on the credit side of the Branch
account. If it is purchased on credit, it should also be treated as a closing Branch liability and appear
on the debit side of Branch account.

(6) Sale of non-current assets: The effect of this is to reduce the value of Branch assets at close and
increase the remittance from the Branch in case the sale is for cash. If the sale is for credit it will
increase the debtors balance instead of increase in remittance.

(7) Amount received from insurance company: in case insurance company admits a claim in respect of
stock or any other property damaged at the Branch, the amount received by the Branch from insurance
company will be remitted to the Head Office. In case the claim admitted is outstanding till the date of
the closing of the accounting period, the amount will be shown as an asset at the Branch on the credit
side of the Branch account.

Goods invoiced to branch at selling price

The Head Office may send goods to its Branches at a price higher than the ‘cost’. This inflated
price is termed ‘invoice price’. The difference between the invoice and the cost price is the
loading. This is done primarily to have an effective control over stock with Branches and keep the
margin of profit secret from the Branch manager. In such a situation, all entries relating to goods
are made in the Branch Account at invoice price and necessary adjustments for loading (Invoice
price minus Cost price) are recorded at the end of year by passing the following additional journal
entries:

1) For adjustment of loading (to remove loading) in opening stock at Branch

• Dr Stock reserve A/c

• Cr Branch A/c

2) For adjustment of loading (to remove loading) in goods sent to Branch less returns

• Dr Goods sent to Branch A/c

• Cr Branch A/c

3) For adjustment of loading (to remove loading) in closing stock at Branch

• Dr Branch account A/c

• Cr Stock reserve A/c

Stock and Debtors System

When there are large number of transactions at Branch, the Head Office does not open a
Branch A/c in its books. In such a case, the stock and debtors method is particularly maintained
by the Head Office to make efficient control over the branches. These control accounts include
the following:

204 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 • Branch Stock Account (at invoice price);
• Branch Debtors Account;
• Goods Sent to Branch Account.
• Branch Adjustment Account (for recording loading for goods and for ascertaining gross profit)
• Branch Profit and Loss Account (for ascertaining branch net profit)
• In addition to above, there are certain accounts which may also be opened:
• Branch Cash Account;
• Branch Expense Account;
• Abnormal Loss / Lost-in-Transit Account, etc.
• Branch Non-current asset Account

1. Branch stock account is the most important account which helps the Head Office to have an effective
control over the Branch stock. While preparing the Branch Stock Account, you will show the actual
stock with Branch as the balance in this account, and then if the totals of both sides do not tally, you
will show the difference as shortage or surplus as the case may be. If it is found that the actual stock
with the Branch is less than the balance shown by the Branch Stock Account, it means that there is a
‘shortage’ in the stock with the Branch. Similarly, if the actual stock with the Branch is more than the
balance shown by the Branch Stock Account, it would reflect ‘surplus’.
2. Goods sent to Branch account: This account is prepared to ascertain the net value of goods sent to the
Branch. Goods sent to the Branch, goods returned by the Branch, and loading included in them are
recorded in this account.

3. Branch debtors account is maintained to keep a record of all transactions relating to the Branch debtors
and ascertaining the balance of the debtors at the end of the accounting period.

4. Branch adjustment account, like a Trading A/c of the Branch, it is prepared to ascertain the gross profit
or gross loss made at the Branch. All shortage/surplus of stock and loading in the goods sent to the
Branch, in opening and closing stocks at the Branch, etc. are recorded in this account.

5. Profit and loss account is prepared to ascertain the net profit/loss made at the Branch. The gross profit
or loss from the Branch Adjustment Account is transferred to this account. It is debited with Branch
expenses as per the Branch Expenses Account and the loss on account of shortage being the cost of
such shortage. In case the Branch Stock Account reveals some surplus, the amount equal to the cost
of such surplus will be shown on the credit side of the Branch Profit & Loss A/c

6. Branch cash account is maintained to record all cash transactions of the Branch. It is particularly
helpful in those cases where a Branch is not required to remit immediately all collections of cash made
by it but use it for Branch expenses and remit the balance to the HO at regular intervals. Normally, a
dependent Branch is not allowed the freedom to retain cash collections. However, this account helps
the head office to keep control over Branch cash.

7. Branch non-current assets accounts: a separate account for each of the Branch non-current assets is
maintained to record all transactions relating to each of these non-current assets. The depreciation on
Branch non-current assets however, is debited to Branch Expenses A/c and credited to the respective
account.

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8. Branch expenses account is prepared to give to the Head Office a summary picture of different
expenses, bad debts, discounts, etc. incurred at the Branch.

9. Branch stock reserve account is contra to branch stock account. In this account opening and closing
balance of loading on branch stock is maintained.

Sale of goods by the branch at invoice price

The journal entries passed in the Head Office books to record the transactions at Branches
are:

(1) For goods sent to the Branch (at invoice price)

• Dr Branch stock A/c

• Cr Goods sent to the Branch A/c

(2) For goods returned by the Branch to Head Office (at invoice price)

• Dr Goods sent to Branch A/c

• Cr Branch stock A/c

(3) For goods sent/received by one Branch to/from another Branch

For example, if Branch X sends goods to Branch Y, the following entries will be passed:

• Dr Goods sent to X Branch A/c (as if the Branch has first returned goods to the Head Office)

Cr X Branch stock A/c

• Dr Y Branch stock A/c

Cr Goods sent to Y Branch A/c (and then the Head Office has sent goods to another
Branch)

(4) For cash sales made by the Branch (at invoice price)
• Dr Branch cash/bank A/c
• Cr Branch stock A/c

(5) For credit sales made by the Branch (at invoice price)

• Dr Branch debtors A/c

• Cr Branch stock A/c

(6) For cash received from Branch debtors to the Branch

• Dr Branch Cash Account

• Cr Branch Debtors Account

(7) For cash received from debtors and remitted to Head Office

• Dr Main Cash/bank A/c

• Cr Branch debtors A/c

(8) For goods returned by Branch debtors to the Branch

206 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 • Dr Branch stock A/c
• Cr Branch debtors A/c

(9) For goods returned by Branch debtors directly to the Head Office (at invoice price)

• Dr Goods sent to Branch A/c

• Cr Branch debtors A/c

(10) For bad debts, discounts allowed to debtors, etc.

• Dr Branch expenses A/c

• Cr Branch debtors A/c

(11) For expenses at Branch paid in cash

• Dr Branch expenses A/c

• Cr Cash/bank A/c

Closing entries at the end of the year:

(12) For closing Branch stock A/c including loading
For abnormal shortage or loss or pilferage of stock

• Dr Branch adjustment A/c (with amount of loading)

• Dr Branch profit & loss A/ c (with shortage at cost)
• Cr Branch stock A/c

No entry is required for a normal loss of stock. The branch stock balance (net) is shown as
found by physical verification. If insured, any amount received from insurance company for
abnormal loss of stock will be recorded as follows:

• Dr Branch cash A/c

• Cr Branch P&L A/c

If claim is accepted but not yet paid

• Dr Insurance claim recoverable A/c

• Cr Branch P&L A/c

For surplus of stock

• Dr Branch stock A/c

• Cr Branch adjustment A/c (with amount of loading)
• Cr Branch profit & loss A/ c (with shortage at cost)

(13) For adjustment of loading in opening stock

• Dr Stock reserve A/c

• Cr Branch Adjustment A/c

(14) For adjustment of loading in closing stock

• Dr Branch adjustment A/c

• Cr Stock reserve A/c

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(15) For adjustment of loading in net goods sent to Branch A/c (Goods sent less returns by
branch)

• Dr Goods sent to Branch A/c (with the amount of loading)

• Cr Branch adjustment A/c

(16) For closing Net Goods sent to the Branch A/c

• Dr Goods sent to Branch A/c

• Cr Purchases or Trading A/c (with the net amount at cost)

(17) For closing Branch expenses A/c

• Dr Branch profit & loss A/c

• Cr Branch expenses A/c

(18) For transfer of gross profit shown by the Branch adjustment A/c (to close)

• Dr Branch adjustment A/c

• Cr Branch P&L A/c

(19) For transfer of gross loss shown by the Branch adjustment A/c (to close)

• Dr Branch P&L A/c

• Cr Branch adjustment A/c

(20) For transfer of Net Profit at the Branch to General Profit & Loss A/c

• Dr Branch Profit and loss A/c

• Cr General Profit and loss A/c

(20) For transfer of Net Loss at the Branch to General Profit & Loss A/c
• Dr General Profit and loss A/c
• Cr Branch Profit and loss A/c

LEDGER ACCOUNTS IN THE MAIN LEDGER OF HEAD OFFICE

GOODS SENT TO BRANCH ACCOUNT

Branch stock (goods returned by xx Branch stock (goods sent at invoice xx
branch) price)
Branch adjustment (loading) xx
Purchases or Trading A/c (balancing xx
figure)

BRANCH STOCK ACCOUNT

Balance b/f (at invoice price) xx Branch debtors (credit sales, at selling xx
price)
Goods sent to Branch (at invoice xx Branch cash (cash sales, at selling xx
price) price)

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Branch debtors (sales return) xx Goods sent to Branch (return to the xx
HO)
Branch adjustment (loading on xx Branch adjustment (loading on xx
closing) opening)
Branch Profit and Loss (surplus of Branch Profit and Loss (shortage of xx
stock) stock)
Closing balance c/f (at invoice price)

BRANCH DEBTORS ACCOUNT

Opening balance b/f xx Main or Branch cash/bank (amount xx
received)
Branch stock (credit sales) xx Branch stock (sales return) xx
Branch expense: bad debts, discount, xx
allowance

Closing balance c/f xx

BRANCH EXPENSES ACCOUNT
Cash (expense) xx Branch Profit and Loss A/c (to close) xx

Branch debtors (discount, bad debt, xx

allowance)

BRANCH ADJUSTMENT ACCOUNT

Branch stock reserve (loading on closing xx Branch stock reserve (loading on op. xx
stock) stock)
Balance transferred to P&L A/c (gross xx Net Goods sent to Branch (loading) xx
profit)
Balance transferred to P&L A/c (gross xx
loss

BRANCH PROFIT AND LOSS ACCOUNT

Branch adjustment (gross loss) xx Branch adjustment (gross profit) xx

Branch expense (closed) xx Branch stock (surplus of stock) xx

Branch stock (shortage of stock) xx Other gains xx
Other losses xx Net loss transferred to General P &L xx
a/c
Net profit transferred to General P &L a/c xx

Sale of goods by the Branch at a price higher or lower than the invoice price
A Branch may be allowed to sell goods at a price higher than the invoice price. Since the Branch
stock account is prepared at invoice price, in case of stock and debtors system, an adjustment
entry will be required for the excess price charged by Branch in order to ascertain the closing

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STUDY MANUAL
stock at the Branch. The adjustment entry will be as follows:

• Dr Branch stock A/c

• Cr Branch adjustment A/c

Similarly, if a Branch is compelled to sell goods at a price lower than invoice price on account
of goods being spoiled or their being a defective in nature, an adjustment entry on the above
pattern will also be required. The entry will be as follows:

• Dr Branch adjustment A/c

• Cr Branch stock A/c

Adjustments for cash and goods in transit

In case of a dependent branch where the accounts are maintained according to debtors system
or stock and debtors system, the following adjustments may be required:

(1) Goods in transit

Sometimes goods sent by the Head Office may not have been received by a Branch or goods
returned by the Branch may not have been received by the Head Office by the end of the
accounting year. On account of these reasons, amount of goods sent to the Branch as shown by
the Head Office books may be different from that shown by then Branch returns. The following
adjustment entry will have to be passed for reconciling such differences in the Head Office books:

(i) In case of debtors system:

• Dr Goods sent to the Branch A/c*

• Cr Branch A/c

Or
• Dr Goods in transit A/c
• Cr Branch A/c

(ii) In case of stock and debtors system:

• Dr Goods sent to the Branch A/c*

• Cr Branch stock A/c

OR
• Dr Goods in transit A/c
• Cr Branch stock A/c

Note: * The goods in transit should be added up with the closing stock figure of the Head Office for
the purpose of Trading and Profit and Loss A/c in case this entry is passed instead of alternative
entry.

(2) Cash in transit

In case cash settlements between the Head Office and Branch are not accounted at any of the
either at the end of the accounting period, the Head Office should, therefore, pass the following
adjustment entry for such cash in transit:

(i) In case of debtors system:

• Dr Cash in transit A/c

• Cr Branch A/c

210 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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(ii) In case of stock and debtors system:

• Dr Cash in transit A/c

• Cr Branch cash A/c

Note: The goods in transit and Cash in transit will appear as assets in the balance sheet of the
H.O.

Final Accounts System

Under final accounts system (income statement system), the profit or loss of the Branch is
ascertained by preparing the Branch Trading and Profit and Loss Account. Apart from Profit &
Loss A/c, the H.O also maintains the Branch A/c but this Branch A/c is in the nature of a personal
account which shows only the mutual transactions between H.O and Branch. The balance of
Branch A/c, therefore, represents the net assets of Branch.

The only reason for preparing the statement is to have full information of all transactions which
are ignored in Debtor System (already discussed in the previous section).
We know very well that in the ‘Income Statement’ incomes and expenses are measured on the
basis of accrual concept and the profits are measured according to the matching concept. So
the cost of goods sold will be determined keeping in view that the goods sent to Branch are
equivalent to purchases of Branch and should be included at cost. Obviously the opening and
closing stocks cannot be measured at a value that is above its cost. So, we will consider both
situations at cost price and at invoice price.

2.2.3.1. Goods sent at cost price

Branch Trading and Profit & Loss Account

Particulars Amount Particulars Amount

FRw FRw
To Opening Stock at Branch (at xx By Branch Sales (net of returns)
Cost) Cash xx
To Goods sent from Head Office, xx Credit xx
cost xx xx By Closing Stock at Branch (at xx
Less : Goods returned to H.O, cost xx Cost)
xx xx
To Purchases (made directly by
Branch)
To Direct Expenses at Branch (if
any)
To Gross profit c/d
XX XX
To Various expenses incurred at xx By Gross profit b/d xx
Branch xx By Other incomes xx
To General P&L Account (Net
Profit)
XX XX
Goods sent at invoice price
If goods are invoiced above cost, the loading (i,e, profit element) on opening stock, goods sent
from Head Office (net of returns) and closing stock are reversed, to ascertain the true profits.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 211

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Wholesale Branch System
Sometimes, the Head Office (specifically dealing the manufacturing activities) sells goods to the
actual consumers through its retail branches or outlets when a branch is operated both under the
retail profit basis as well as under the wholesale profit basis.
Wholesale and Retail profit at Branch
In this case, the H.O sends goods to the branches at wholesale prices which cost plus a
percentage of profit. The branch is likely to sell those goods at retail prices which are more than
the wholesale prices. The real profit earned by the branch is the difference between the retail
selling price and the wholesale price.

For example the cost price of an article is $100, the wholesale price, $160 and the retail selling
price, $180. Under retail profit basis, where an article is sold by the Branch at retail price/list
price, the actual profit is $180 – $100 = $80 but if it is sold under wholesale basis, the amount of
profit will be $60 (i.e $160-$100, therefore the Branch’s real profit is $180 – $160 = $20.

In wholesale price system, the real cost of the Branch is the wholesale price of the goods sent.
But, we must remember that wholesale prices are fixed above cost. For this purpose, Branch
Stock Account or the Trading Account is debited with:

(a) the value of opening stock at the Branch; and

(b) price of goods sent during the year at wholesale price.
It is credited by:
(a) sales effected at the branch; and
(b) closing stock of goods valued at wholesale price.

The value of goods lost due to accident, theft etc. also is credited to the Branch Stock Account
or Trading Account calculated at the wholesale price. At this stage, the Branch Stock or Trading
Account will reveal the amount of gross profit (or loss). It is transferred to the Branch Profit and
Loss Account. On further being debited with the expenses incurred at the branch (including any
allowance that may have been made in favour of a customer after sales being recorded) and the
wholesale price of goods lost, the Branch Profit and Loss Account will disclose the net profit (or
loss) at the branch.

2. Creation of reserve for unrealized profit on unsold stock at the branch

If all the goods that have been sent to the branch are sold, no problem is created. However,
when part of the stock remains unsold, it includes profit margin of the Head Office which is the
difference between wholesale prices (the prices at which goods are sent to the Branch) and the
actual cost price of the goods to the Head Office. The Head Office must create suitable reserve
on closing stock at the branch at the end of the year because this stock is valued at wholesale
price and profit on it is still unrealized. The following journal entry is passed at the year-end:

• Dr H.O Profit and Loss A/c

• Cr Stock Reserve A/c (Amount of difference between wholesale price and cost price)

Note: Closing stock of branch includes goods directly purchased from suppliers will not be
concerned in the calculation of the provision of unrealized profit
In the Balance sheet, Branch stock is shown at cost i.e. after deducting stock reserve. At the
beginning of the next year, a reserve entry is passed for this profit will be realized.

212 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 • Dr Stock Reserve A/c                                        
• Cr H.O Profit and Loss A/c

Financial statements including dependent branches

Joyce Ltd has a HO in Central and two branches, one in Shishoza and the other in Tsindaneza.
Branch accounts are maintained by the head office. Goods are invoiced to Shishoza at cost plus
20%. This is the selling price. Joyce Ltd sent goods at cost plus 25% to Tsindaneza. The selling
price in this branch was cost plus 30%. The HO books showed the following balances related
to transactions between the Head Office and its two branches for the year ended 31 December
2017:

Shishoza Tsindaneza
$ $
Opening stock at cost 100,000 56,000

Credit sales by branches 800,000 476,840

Goods sent to branches at cost 806,000 400,000

Goods returned by branches at cost 80,000 --

Stock lost in transit at cost 64,000 --

Reduction in selling price 13,500 --

Cash received from debtors 340,200 345,320

Discount allowed 2,000 3,000

Bad debts written off 500 800

Returns by debtors 2,400 --

Branch transfer at selling price from Shishoza to

960
Tsindaneza
--
Closing stock at selling price 91,680 117,000

Goods in transit from head office to Shishoza at selling

4,800
price

Expenses 26,800 34,500

Any stock unaccounted for may be regarded as pilferage and normal wastage.
Required: (a) Compute the net profit earned at each branch

The following trial balance was extracted from the books of Joyce Ltd:

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STUDY MANUAL
 Trial Balance as at 31 December as at 31 Dec 2017
$ $
Share Capital 1,656,000
Profit and loss account 300,900

Non-current assets 800,000

Stock at Head Office, 1 January

250,000
2017

Debtors/Creditors 774,600 950,000

Provision for depreciation 200,000
Purchases 3,800,000
Sales 3,463,200
Administrative expenses 225,000
Selling expenses 108,000
Bank and cash 456,500

Branch stock 1 Jan 2017: Shishoza 120,000

Tsindaneza 72,800
Branch adjustment Account: 20,000
Shishoza
Tsindaneza 16,800
6,606,900 6,606,900

Additional information:

1) On 31 Dec 2017, stock in the H.O was valued at $180,000

2) The branches paid local expenses and remitted all the remaining cash received from debtors to the
H.O. No entry had been made about the remittances from the branches.
3) Depreciation is to be charged on the non-current asset at 10% per annum on cost.
(b) Prepare the final accounts for Joyce Ltd for the year ended 31 December 2017

Solution

Joyce Ltd
Trading and Profit and Loss Account for the year ended 31 December 2017
$ $
Sales 3,463,200
Opening Stock
250,000
Add: Purchases 3,800,000
Less: Goods sent to Branch 1,126,000
($725,200+$400,800) 2,924,000

214 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
Less: Closing Stock
180,000
Cost of Goods Sold 2,744,000
Gross Profit 719,200
3,463,200 3,463,200
Provision for Depreciation 80,000 Gross Profit
719,200
Administrative Expenses 225,000 Branch Profit:

Selling expenses 108,000 Shishoza 23,500

Net Profit for the year 401,440 Tsindaneza 71,740
814,440 814,440
Joyce Ltd
Balance Sheet as at 31 December 1997
$ $
Fixed Assets 800,000 Share Capital 1,656,000

Profit & Loss A/c

Less Provision for Depreciation 280,000 702,340
($300,900+$401,440)
520,000
Current Assets Current Liabilities
Stock (W1): 350,400 Creditors 950,000
Debtors ($774,600
1,357,220
+$454,900+$127,720)
Bank and Cash (W2) 1,080,720
3,308,340 3,308,340

Total Stock at cost (W1): $

HO 180,000

Shishoza 91,680
Tsindaneza 117,000

Goods in transit 4,800

Provision for Unrealized Profit -43,080

350,400

Branch Cash Account (W2)

Particulars Shishoza Tsindaneza Particulars Shishoza Tsindaneza
($) ($) ($) ($)

Branch 340,200 345,320 Expenses 26,800 34,500

Debtors

CPA EXAMINATION I1.2 FINANCIAL REPORTING 215

STUDY MANUAL
 Remittances 313,400 310,820
to HO
340,200 345,320 340,200 345,320

ACCOUNTING FOR INDEPENDENT BRANCHES

Independent home branches
Transactions between Head Office and its independent home branches

• In H.O books: Branch Current A/c is opened to record transactions between the H.O and
Branch;
• In Branch books: H.O Current A/c is opened to record transactions between the Branch and
H.O.

Accounting entries:

Transaction H.O Books Branch Books

Goods sent by H.O. to Branch Branch A/c Goods received from H.O. A/c
To Goods sent to Branch To H.O. A/c
A/c

Goods returned by Branch to Goods sent to Branch A/c H.O A/c

H.O. To Branch A/c To Goods received from H.O
A/c
Branch expenses incurred at — Expenses A/c
Branch Office To Cash / Bank A/c
Branch expenses paid for by Branch A/c Expenses A/c
the Head Office To Cash/Bank A/c To H.O A/c
Purchases made from parties — Purchases A/c
other than H.O. by Branch To Bank/ Creditors A/c
Sales effected by the Branch — Cash/Debtors A/c
To Sales A/c
Collection from debtors Cash/Bank A/c H.O. A/c
received directly by the H.O. To Branch A/c To Sundry Debtors A/c
Payment by H.O. for Branch A/c Purchases/Creditors A/c
Purchase made by the Branch To Bank A/c To H.O. A/c
Purchase of Asset by Branch — Sundry Assets A/c
To Bank/Liability
Asset purchased by Branch Branch Asset A/c H.O. A/c
but asset a/c is to be kept in To Branch A/c To Bank/Creditors A/c
H.O
Depreciation on the above Branch A/c Depreciation A/c
asset To Branch Asset A/c To H.O. A/c

Remittance of cash by H.O. to Branch A/c Bank A/c

Branch To Bank A/c To H.O. A/c

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Remittance of cash to H.O. by Bank A/c Ho A/c
Branch To Branch A/c To Bank A/c

Transfer of goods between Recipient Branch A/c Supplying Branch A/c

different branches To Supplying Branch A/c To Goods received from H.O.
A/c
OR Goods received from H.O.
A/c
To H.O. A/c
Charging the Branch service Branch (Expenses) A/c Expense A/c
charges by H.O. To Service charges A/c To H.O. A/c

Preparing the independent home branches accounts

10 Reconciliation
It has already been stated that the balance shown by the Branch A/c in the Head Office books
may not tally with the balance as shown by the Head Office A/c in the Branch books. The two
balances might be different because of following reasons:
• Goods-in-transit (not yet received by the end of year either by Branch or by the Head Office)
• Cash-in-transit (not yet received by the end of year either by Branch or by the Head Office)
• Mistakes

In all these cases, a reconciliation of the balance of Head Office A/c appearing in the books
of Branch with the balance of Branch A/c appearing in the books of Head Office is needed.
Accounting entry for reconciliation will be passed in the books of either party as follows:

Transaction In the HO Books In the Branch Books

Cash-in-transit Cash-in-transit A/c Cash-in-transit A/c
To Branch A/c To H.O. A/c
Goods-in-transit Goods-in-transit A/c Goods-in-transit A/c
To Branch A/c To H.O. A/c
Mistakes committed by either party Account to be rectified Account to be rectified
To Branch A/c To Head office A/c
OR OR
Branch A/c Head office A/c
To Account to be rectified To Account to be rectified

20 Adjustments
Besides reconciliation entries, adjustments entries may have to be passed at the end of the
accounting year for certain transactions between the Head Office and the Branch. These include:

• Inter branch transfers

• Depreciation on branch assets
• Allocation of Head Office expense

(a) Inter branch transfers

In the Books of Head Office
Receiving Branch A/c

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To Transferring Branch A/c
In the Books of Transferring Branch
Head office A/C
To Goods returned to Head Office A/c
In the Books of Receiving Branch
Goods received from head office
To Head Office A/c

(b) Depreciation on branch non-current asset, accounts maintained by the Head Office
Sometimes accounts of non-current assets at Branch are maintained by the Head Office. The
following entries will, therefore, be required for depreciation on such noncurrent assets:
In the books of the Head Office:
Branch A/c
To Branch non-current asset A/c
In the books of the Branch:
Depreciation A/c
To Head Office A/c

(c) Expenses incurred by the Head Office for the Branch

The Head Office may like to charge the Branch for the services rendered by it from time to time
to the Branch. As a matter of fact, a part of the time of Head Office employee is taken only in
doing the work for the Branch. The Branch A/c is thus charged with that proportionate amount
of expense incurred by the Head Office. The Head Office will account in its Profit and Loss A/c
that part of expense deemed to be assertive. The necessary adjustment entry will, therefore, be
passed as follows:

In the books of the Head Office:

Branch A/c
To Branch expenses A/c (for that part of expense charged)
In the books of the Branch:
Head Office expenses A/c (for expenses incurred by the Head Office)
To Head Office A/c

30 Incorporation of Branch Trial Balance in the Head Office Books

While discussing independent branch in the previous paragraphs it has been stated that branch
prepares its own trial balance and the same is sent to the H.O. for incorporation. Naturally, after
receiving the trial balance from branch H.O. incorporates with its own accounts the same to
prepare and ascertain the net result of the concern. Incorporation of branch trial balance into the
Head Office books means ‘consolidation’. The accounting entries for incorporation are passed
in the books of head office only. There are two methods for incorporating branch trial balance in
H.O. Book.

• Detailed incorporation
• Abridged incorporation

(a) Detailed incorporation

For the purpose of preparing consolidated balance sheet in the Books of H.O, all items relating to
Branch Trading and Profit and Loss Account are incorporated in the Head Office books besides
assets and liabilities. The Trading and Profit and & Loss Account is prepared in the usual way in
the books of the Head Office. The following incorporation entries are passed:

(1) For incorporating items which are shown on the debit side of the Trading Account:
218 I1.2 FINANCIAL REPORTING CPA EXAMINATION
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Dr Branch Trading A/c
Cr Branch A/c
(with total amount of expenses which are debited to Trading Account: opening stock, purchases,
return inwards, wages and other manufacturing expenses, etc.)

(2) For incorporating items shown on the credit side of the Trading Account:
Dr Branch A/c
Cr Branch Trading A/c
(with total amount of revenues which are credited to Trading Account: sales, closing stock and
return outwards and other items that appear in the credit side)

(3) For transferring gross profit to Branch P&L A/c:

Dr Branch Trading A/c
Cr Branch P&L A/c

(3) For transferring loss profit to Branch P&L A/c:````````````````````````````````````````````````````````

````````````````````````````````````` qqqq1
Cr Branch P&L A/c
Dr Branch Trading A/c

(4) For incorporating expenses related to P&L A/c:

Dr Branch P&L A/c
Cr Branch A/c
(with the total amount of the items appearing on the debit side of the Branch P&L A/c such as
salary, rent, commission, depreciation, discount, bad debts, etc.)

(5) For incorporating the revenues related to P&L A/c:

Dr Branch A/c
Cr Branch P&L A/c
(with the total amount of items that appear in the credit side of the P&L A/c such as interest
received, discount received, commission earned, etc.)
(6) For transferring the net profit as shown by the Branch A/c:
Branch P&L A/c
To General P&L A/c

(6) For transferring the net loss as shown by the Branch A/c:
Dr General P&L A/c (H.O P&L A/c)
Cr Branch P&L A/c

(7) For incorporating Branch assets (after adjustments, if any):

Dr Branch Assets A/c (each asset to be debited individually)
Cr Branch A/c

(8) For incorporating Branch liabilities (after adjustments, if any):

Dr Branch A/c
Cr Branch Liabilities A/c (each liability to be credited individually)

Note: as a result of these incorporation entries, the Branch Account in the Head Office books will
be completely closed. In other words, after passing the accounting entries for incorporation, the
Branch Account appearing in the Trial balance of Head Office will give Nil Balance.

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In the beginning of the next year, the various assets and liabilities will be transferred back to
Branch Account by means of the following entries:

(1) For transfer of assets:

Dr Branch A/c
Cr Branch assets A/c (individually)

(2) For transfer of assets:

Dr Branch liabilities A/c (individually)
Cr Branch A/c

(b) Abridged incorporation

This method is applicable only when net profit/ net loss is given instead of detailed information
about all expense and income. Under this method, only net profit/net loss will be transferred to
Branch A/c.
The following entries will be passed in the books of the Head Office:

(1) For incorporating Branch net profit

Dr Branch A/c
Cr General Profit & Loss A/c

(1) For incorporating Branch net loss

Dr General Profit & Loss A/c
Cr Branch A/c
It may be seen that this entry replaces the first six entries passed in case of detailed incorporation
method:

(2) For incorporating Branch assets

Dr Branch assets A/c (debit each asset individually)
Cr Branch A/c

(3) For incorporating Branch liabilities:

Dr Branch A/c
Cr Branch liabilities A/c (credit each individually)

It should be noted that in case entries are passed only for transfer of items relating to Trading
and Profit & Loss Account or for incorporating only the balance as shown by the Branch Profit
and Loss Account (and not for incorporation of Branch Assets and Liabilities), the balance in the
Branch A/c at any time will show the Net assets. In other words, Branch Assets and Liabilities
will not appear in Branch A/c and this account will show a balance which must be equal to the
difference between assets and liabilities, i.e., in other words, net worth of the business.
Entries in the books of the Branch
The Branch books have also to be closed at the end of the accounting period. The entry for
closing the books of the Branch may also be passed according to any of the two methods
discussed above.

A. Detailed incorporation method

According to this method, each item of Trading and P&L A/c will be transferred to the Head Office
A/c besides items of assets and liabilities. The following entries will be passed:

220 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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(a) For transfer of items appearing on the debit side of the Branch Trading and P&L A/c
Dr Head Office A/c
Cr Opening Stock A/c
Cr Purchase A/c (actual amount)
Cr Goods received from Head Office A/c
Cr Direct manufacturing expenses A/c
Cr Rent A/c
Cr General expenses A/c (all other expenses related to debit of Trading and P&L Account)

(b) For transfer of items appearing on the credit side of the Branch Trading and P&L A/c
Dr Sales A/c
Dr Closing stock A/c (actual amount)
Dr Discount received A/c
Dr Interest received A/c
Cr Head Office A/c

(c) For transfer of Branch assets:

Dr Head Office A/c (actual amount)
Cr Branch Assets A/c (each asset to be credited individually)

(d) For transfer of Branch liabilities:

Dr Branch Liabilities A/c (actual amount)
Cr Head Office A/c
As a result of these entries, the Head Office A/c in the books of the Branch will be completely
closed.

B. Abridged incorporation method

In case of this method, the Branch Trading and Profit and Loss Account is prepared and the Net
Profit or Net Loss is transferred to Head Office Account. But treatment of branch assets and
branch liabilities will remain the same. The following entries will be passed in the books of the
Branch:
(a) In case of Net Profit:
Dr Profit & Loss A/c (with the amount of net profit)
Cr Head Office A/c

(b) In case of Net Loss:

Dr Head Office A/c
Cr Profit & Loss A/c (with the amount of net loss)

Example: The Head Office of a business and is Branch keep their own books and each prepares
its own Profit and Loss account. The following are the balances appearing on the two sets of the
books as on 31st Dec. 2015 after calculating profits and after making adjustments except those
referred to below:

Particulars Head Office Branch

Dr ($) Cr ($) Dr ($) Cr ($)
Capital – 100,000 – –
Noncurrent assets 36,000 – 16,000 –
Stock 34,200 – 10,740 –

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 Debtors and Creditors 7,820 3,960 4,840 1,920
Cash 10,740 – 1,420 –
Profit and Loss – 14,660 – 3,060
Branch Office Current Account 29,860 – – –
Head Office Current Account – – – 28,020
Total 118,620 118,620 33,000 33,000
Required:
Set out the balance sheet of the business as on 31st December 2015 and pass the journal
entries (in both sets of books) to record the adjustments dealing with the following:

(a) On 31st December 2015, the Branch had sent a cheque for $1,000 to the Head Office, but was not
received by them nor credited to the Branch till next month;
(b) Goods valued at $440 had been forwarded by the Head Office to the Branch and invoiced on 30th
December 2015, but were not received by the Branch nor dealt with in their books till next month;
(c) Stock stolen on the way to the branch are charged to the branch by the head office but not credited to
the head office in the branch books as the branch manager declined to admit any liability, $400 (not
covered by insurance);
(d) It was agreed that the Branch should be charged with $300 for administration services rendered by the
Head Office during the year;
(e) Depreciation of Branch assets, of which accounts are maintained by the Head Office not provided for
$250;
(f) The balance of profit shown by the Branch is to be transferred to the Head Office books.

Solution
When attempting a question on Independent Branch, we are advised to check whether the
balance as shown by the H.O A/c in branch books and the Branch A/c in the head office Books
reconcile with each other or not.

In the present question, there is a difference of $1,840. The difference is due to treatment required
for adjustments (a), (b) and (d) as mentioned in the question.
The reconciliation entries will have to be passed for these adjustments. Moreover, adjustment
entries have to be passed for other adjustments and transfer of branch profit.

Head Office Journal

Particulars $ $
(a) Cash in transit A/c (asset) 1,000
To Branch account 1,000
(Cash sent by Branch not yet received by the Head Office till 31st
December)
(b) Goods in transit A/c (asset) 440
To Branch A/c 440
(Goods invoiced on 30th December, not yet received by the Branch)

(c) Branch A/c (expense for Branch) 300

To Profit and Loss A/c (of H.O) 300
(Administrative services rendered by the H.O to the Branch)

222 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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(d) Profit and Loss A/c (of H.O) 400
To Branch A/c 400
(Uninsured stock stolen on the way to Branch)
(e) Branch A/c (expense for Branch) 250
To Branch assets A/c 250
(Depreciation on branch assets, accounts for which are maintained by
the H.O)
(F) Branch A/c 2,510
To General Profit and Loss A/c 2,510
(Profit shown by the Branch P&L A/c transferred to General P&L A/c)

Branch Journal

Particulars $ $

Profit and Loss A/c 300

To Head Office A/c 300
(Administrative services rendered by the H.O)

Profit and Loss A/c 250

To Head Office A/c 250
(Depreciation on branch assets, accounts for which are maintained by the
H.O)
Profit and Loss A/c 2,510
To Head Office A/c 2,510
(Transfer of profit to General P&L A/c)

Balance sheet as at 31st December 2015

ASSETS $
Noncurrent 36,000+16,000-250 51,750
Current assets
Stock (on hand and in-transit) 45,380
34,200+10,740+440

Debtors: 7,820+4,840 12,660

Cash (on hand and in-transit) 13,160

10,740+1,420+1,000
122,950
EQUITY AND LIABILITIES
Equity
Capital 100,000
Liabilities
Creditors 3,960+1,920 5,880
Profit and Loss A/c 14,560+2,510 17,070
122,950
Workings:
1. Calculation of Net Profit

CPA EXAMINATION I1.2 FINANCIAL REPORTING 223

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Branch P&L A/c
To H.O expenses 300 By Profit (as given) 3,060
To Depreciation 250
To Profit transferred to General 2,510 3,060
P&L A/c
3,060

General (H.O) P&L A/c

To Branch P&L A/c (stock 400 By Profit (as given) 14,660
stolen)
To Profit c/d 14,560 By Branch A/c (administrative 300
services)
14,960 14,960
By Profit b/d 14,560
By Branch A/c (profit made by 2,510
Branch)
17,070 17,070
2. Head Office Current Account and Branch Current Account

Branch A/c in the books of Head Office

To balance b/d 29,860 By goods in transit 440
To P&L A/c (admin expense) 300 By P&L A/c 400
To Branch Assets (depreciation) 250 By cash in transit 1,000
To General P&L A/c 2,510 By balance c/d 31,080
32,920 32,920
H.O A/c in the books of Branch
To balance c/d 31,080 By balance b/d 28,020
By H.O expense account 300
By Depreciation 250
By P&L A/c 2,510
31,080 31,080

The balance in the Branch A/c represents the net assets at Branch. This can be verified as
follows:

Noncurrent assets at 16,000

Branch
Stock at Branch 10,740
Debtors at Branch 4,840
Cash at Branch 1,420
33,000
Less: Creditors at Branch 1,920
31,080

224 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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3. In the consolidated balance sheet, the balance in the Branch A/c in the books of the Head
Office and the balance in the Head Office A/c in the books of the Branch will not appear as if
they are contrary to each other. This can be verified by passing entries for incorporating Branch
assets and liabilities in the Head Office books. Such entries are as follows:

Dr Cr
Brach noncurrent assets 16,000
Branch stock 10,740
Branch debtors 4,840
Branch cash 1,420
To Branch A/c 33,000
(Incorporation of Branch assets in the H.O
books)
Branch A/c 1,920
To Branch creditors A/c 1,920
Incorporation of Branch liabilities in the H.O
books)

2.3.2. Independent foreign branches

Foreign branches generally maintain independent and complete record of business transacted
by them in currency of the country in which they operate. Since the accounts are maintained in
foreign currency they have to be translated into reporting currency i.e. the currency in which the
head office transacts.

2.3.2.1. Nature of foreign branch operations

For the purpose of accounting, the accounting standards classify the foreign branches into two
types:

• Integral Foreign Operation;

• Non- Integral Foreign Operation.

(a) Integral Foreign Operation (IFO)

An IFO is a foreign operation, the activities of which are an integral part of those of the reporting
enterprise. The business of IFO is carried on as if it were an extension of the reporting enterprise’s
operations. Generally, IFO carries on business in a single foreign currency, i.e of the country
where it is located. For example, sale of goods imported from the reporting enterprise and
remittance of proceeds to the reporting enterprise.

(b) Non-Integral Foreign Operation (NFO)

A NFO is a foreign operation that is not an Integral Foreign Operation. The business of a NFO is
carried on in a substantially independent way by accumulating cash and other monetary items,
incurring expenses, generating income and arranging borrowing in its local currency. An NFO
may also enter into transactions in foreign currencies, including transactions in the reporting
currency. An example of NFO may be production in a foreign currency out of the resources
available in such country independent of the reporting enterprise.

2.3.2.2. Conversion rules and profit or loss on translation

(a) Conversion rules

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The following points should be borne in mind while converting trial Balance items of a foreign
branch.
If the rate of exchange is not subject to wide and frequent fluctuations, all the items in the
trial balance (other than remittances and Head Office A/c) can be converted at a fixed rate of
exchange.
If the rate of exchange is subject to wide and frequent fluctuations (exchange rate of reporting
currency in not stable in relation to foreign currencies due to international demand and supply
effects on various currencies), then, different rates are adopted for different transactions and
balances upon translation. They are:

1. (a) Noncurrent assets at the exchange rate ruling when the assets were bought – temporal method.
If fixed assets have been bought on different dates, then different rates will have to be used for each
separate purchase.
(b) Depreciation on the Noncurrent assets - at the same rate as the fixed assets concerned.
2. Current assets and current liabilities – at the rate ruling at the trial balance date. This is known as the
closing method.
3. Opening stock in the trading account – at the rate ruling at the previous balance sheet date (op bal).
4. Goods sent by the head office to the branch, or returns from the branch – at the actual figures shown
in the Goods Sent to Branches Account in the Head Office books.
5. Trading and profit and loss account items, other than depreciation, opening and closing stocks, or
goods sent to or returned by the branch – at the average rate for the period covered by the accounts.
6. The Head Office Current Account – at the same figures as shown in the Branch Current Account in the
Head Office books.

(b) Conversion of trial balance figures

When the conversion of the figures into your currency is completed, the totals of the debit and
credit sides of your currency trial balance will not normally be equal to one another. This is due
to different exchange rates being taken for conversion purposes. A balancing figure will therefore
be needed to bring about the equality of the totals.
For this purpose, a difference on exchange account will be opened in which a debit entry
will be made if the lesser total is on the debit side of the trial balance. When the head office
redrafts the profit and loss account any debit balance on the difference on exchange account
should be transferred to it as an expense. A credit balance on the difference on exchange
account should be transferred to the credit of the profit and loss account as a gain.
Profit in exchange:
Dr Difference in Exchange A/c
Cr Branch Profit & Loss A/c
Loss in exchange:
Dr Branch Profit & Loss A/c
Cr Difference in Exchange A/c

(c) IAS 21 The effects of changes in foreign exchange rates

In consolidated accounts, special rules are applied for foreign exchange conversion. Under IAS
21, at each balance sheet date:

• closing rate is used to translate foreign currency monetary items

• non-monetary items measured using historical cost in a foreign currency are translated using
the transaction date exchange rate
• other non-monetary items are translated using the exchange rate at the date their fair value
was determined

226 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 • exchange rate differences on the settlement of monetary items are generally recognised in
profit or loss
• when translating a foreign operation, assets and liabilities are translated at closing rate.
Income and expenses are translated at transaction date exchange rates. All resulting
exchange differences are recognised as a separate component of equity.

Example: Carlin & Co. has Head Office at New York (USA) and branch at Mumbai (India). Mumbai
branch is an integral foreign operation of Carlin & Co. Mumbai branch furnishes you with its trial
balance as on 31st March, 2016 and the additional information given thereafter:

Dr Cr
(Rs. 000) (Rs. 000)
Stock on 1st April, 2015 300 –

Purchases and sales 800 1,200

Sundry debtors and creditors 400 300

Bills of exchange 120 240

Wages and salaries 560 –

Rent, rates and taxes 360 –

Sundry charges 160 –

Computers 240 –
Bank balance 420 –

New York Office A/c – 1,620

3,360 3,360

Additional information:
(a) Computers were acquired from a remittance of US $6,000 received from New York Head Office and
paid to the suppliers. Depreciate computers at 60% for the year.
(b) Unsold stock of Mumbai branch was worth Rs. 420,000 on 31st March, 2016.
(c) The rates of exchange may be taken as follows:

• on 1.4.2015 @ Rs. 40 per US $

• on 31.3.2016 @ Rs. 42 per US $
• average exchange rate for the year @ Rs. 41 per US $
• conversion in $shall be made upto two decimal accuracy.

Required:
Prepare in US dollars the revenue statement for the year ended 31st March, 2016 and the
balance sheet as on that date of Mumbai branch as would appear in the books of New York Head
Office of Carlin & Co. You are informed that Mumbai branch account showed a debit balance of
US $39,609.18 on 31.3.2006 in New York books and there were no items pending reconciliation.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 227

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Solution

Carlin & Co. Ltd

Mumbai Branch Trial Balance in (US $) as on 31st March, 2016
Conversion Dr Cr
rate per US $ US $ US $

(Rs.)
Stock on 1.4.05 40 7,500.00 –

Purchases and sales 41 19,512.20 29,268.29

Sundry debtors and creditors 42 9,523.81 7,142.86

Bills of exchange 42 2,857.14 5,714.29

Wages and salaries 41 13,658.54 –
Rent, rates and taxes 41 8,780.49 –

Sundry charges 41 3,902.44 –

Computers – 6,000.00 –
Bank balance 42 10,000.00 –
New York office A/c – – 39,609.18
81,734.62 81,734.62

Trading and Profit & Loss Account for the year ended 31st March, 2016

US $ US $
To Opening Stock 7,500.00 By Sales 29,268.29
To Purchases 19,512.20 By Closing stock 10,000.00
To Wages and salaries 13,658.54 By Gross Loss c/d 1,402.45
40,670.74 40,670.74
To Gross Loss b/d 1,402.45 By Net Loss 17,685.38
To Rent, rates and taxes 8,780.49
To Sundry charges 3,902.44

To Depreciation ($6,000×0.6) 3,600.00

17,685.38 17,685.38

Balance Sheet of Mumbai Branch as on 31st March, 2016

ASSETS US $ LIABILITIES US $

New York Office A/c

39,609.18
Noncurrent assets

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Computers Less : Net Loss
6,000 17,685.38 21,923.80
Less: Depreciation
Sundry creditors 7,142.86
3,600
Net NCA
2,400.00 Bills payable 5,714.29
Current assets
Closing stock 10,000.00
Sundry debtors
9,523.81
Bills receivable
2,857.14
Bank balance
10,000.00
34,780.95 34,780.95

CONSIGNMENT ACCOUNTS
Nature and features of a consignment
In some cases, the manufacturers or wholesalers deliver goods but retain title to the goods
until they are sold. This specialised method of marketing certain types of products makes use
of a device known as a consignment. Consignment is a fairly common commercial transaction,
perhaps more common than many people may think. A typical example is that of a manufacturer
who supplies stock of a new product on consignment to a local distributor.
Consignment is defined as an arrangement whereby goods owned by one party called consignor
are sold by another party called consignee on a commission basis. The consignor is the principal
while the consignee is the agent.
It is important to understand this agency relationship. The ownership of the goods does not
transfer to the consignee. The consignee is entitles to a commission for selling the goods; the
expenses may be incurred by both parties; and periodically or on completion of the consignment,
settlement is effected between the parties. If any goods remain unsold then they are generally
returned to the consignor.

3.1.1.2. Features of a consignment

The following are the salient features of consignment:

1. Objects: Goods are forwarded by the consignor to the consignee with an objective of sale at a profit.
2. Ownership: In consignment, the consignee does not buy the goods. He merely undertakes to sell them
on behalf of the consignor. Hence, the ownership in the goods remains with consignor till it is sold by
the consignee.
3. Relationship: The relationship between the consignor and the consignee is that of a principal and an
agent, and not of a debtor and creditor. An agent becomes in debited for amounts realized on behalf
of the principal.
4. Risk: the consignor should bear all the risks connected with the goods until they are sold.
5. Expenses: as consignment is not a sale, whatever the consignee does is on behalf of the consignor.
Thus, the consignor should reimburse all legitimate expenses incurred by the consignee for selling and
receiving the goods.
6. Stock of goods: Any stock remaining unsold with the consignee belongs to the consignor.
7. Commission: the consignee agrees to sell the goods for an agreed rate of commission. He or she is
therefore, allowed to deduct his commission due from the sale proceeds.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 229

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8. Possession: goods will be in the possession of consignee until they sold on behalf of the consignor.
9. Repossession: the consignor can repossess the goods from the consignee at any time.
10. Profit or loss: since the consignee acts on behalf of the consignor, the profit or loss on sale of goods
belongs to the consignor.

3.1.1.3. Difference between sale and consignment

1. In sale the property in goods is transferred to the buyer immediately whereas in consignment the
property is transferred to the buyer only when goods are sold by the consignee. The ownership of
goods remains with the consignor when goods are transferred to the consignee by the consignor.
2. In sale, the risk attached to the goods passes with ownership to the buyer. In case of a consignment,
the risk attaching to the goods does not pass to the consignee who acts as an agent. If there is any
damage or loss to the goods it is borne by consignor provided the consignee has taken reasonable
care of the goods and the damage or loss is not due to his negligence.
3. The relationship of consignor and consignee is that of a principal and an agent as in a contract of
agency whereas the relationship of buyer and seller is governed by the Sale of Goods Act.

4. Unsold goods on consignment are the property of the consignor and may be returned if not saleable in
the market whereas goods sold on sale basis are normally not returnable unless there is some defect
in them.

Main terms of consignment trade

Consignment: this is the transfer of goods by one party called a consignor, to another party called
the consignee, to be sold by the latter on behalf of the former. The ownership of the goods is
retained by the consignor while the possession of the goods is transferred to the consignee.
Outward and Inward consignment: the consignment is termed outward consignment for the
person who sends the goods and inward consignment for the person who receives the goods for
sale.
Consignor: the party who sends the goods to agents for sale (manufacturer or whole seller)
Consignee: the party to whom the goods are sent for sale.
Ordinary commission: this is a fee payable by the consignor to the consignee for the sale of
goods when the consignee does not guarantee the collection of money from ultimate customers.
In this case, the percentage of the consignee’s remuneration of such commission is generally
lower.
Del Credere Commission: additional commission payable to the consignee for taking over
additional responsibility of collecting money from customers. In case, the customers do not pay
of the consignee takes over the loss of bad debts in his books. Although it’s paid for taking over
risk of bad debts that arise out of credit sales only, this commission is calculated on total sales
and not on credit sales.
Overriding commission: this type of commission is allowed to the consignee in addition to normal
commission. The idea seems to be to provide addition incentive to the consignee for the purpose
of creating market for new products (to promote sales at higher prices). It is an extra commission
allowed over and above the normal commission is generally offered for the following reasons:

• When the agent is required to put in hard work in introducing a new product in the market.
• Where he is entrusted with the work of supervising the performance of other agents in a
particular area.
• For effecting sales at prices higher than the price fixed by the consignor.

Advance against consignment: Until the goods are sold by the consignee, he is not indebted to

230 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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the consignor and is not expected to pay for them. This results in a part of the consignor’s capital
being locked up for a period. To overcome this difficulty, the consignee often remits a sum of
money in advance to the consignor. This may be done in the form of a simple bank draft or an
acceptance of a bill of exchange drawn by the consignor on the consignee. Normally, an advance
is readily sent against consignment by the consignee to the consignor when the consignment
goods have become popular in the consignee’s place.
Pro-forma Invoice: when goods are consigned to an agent they are generally accompanied
by a document called a ‘Pro-forma invoice’ giving indication of price of the goods at which the
consignee ought to sell the goods. Pro-Forma Invoice is a statement which is similar to that of
an invoice, but it is called proforma because it does not make the consignee responsible to pay
the amount named therein.

PRO-FORMA INVOICE

The Bhalodia International Company

Kalawad Road, Rajkot
Invoice for the goods sent for consignment to you M/s. Kansagara Bros., Kalawad Road,
Rajkot at our own risk.
Units Particulars of Goods Rate per unit Total
100 Mobile Phone MB. No. 5544 $6,000 $600,000
200 Mobile Phone MB. No. 4455 $3,000 $600,000
$1,200,000
Add: Expenses paid
Labour $10,000
Insurance $20,000
Miscellaneous expenses $5,000 $35,000
$1,235,000

E. & O.E.
Rajkot
Date: 11/2/2011 Navin Barcha
Sales Manager
Gujarat Zone

CPA EXAMINATION I1.2 FINANCIAL REPORTING 231

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CONSIGNMENT INVOICE

Efy Tal Jewelry Design Invoice

858-395-3398
[email protected]
www.efytal.com

Consignment invoice, pay by November 13th or return to Mitzi. Good luck!

Mail Payment To Address:

Please make check Payable to: Efy Tal
Efy Tal
930 Via Mil Cumbres Dr #10
Solana Beach, CA 92075

Mail Order To Address:

Post61
61 A Victory Lane
Los Gatos, CA 95030
1(408) 399-4472

Item# Description Price Qty Total

4M Small flower necklace $34 1 $34

2C Tree of life necklace $34 1 $34

7A Straw textured circle earrings hanging from $38 1 $38

coins.

13A Large cutout leaf earrings with stone $33 1 $33

(Ocean Quarts)

Total: $139

Account Sales: This is a summary of the transactions of the consignee. It is a means of conveying
information to the consignor and shows the gross proceeds of sale of the goods, expenses
incurred by the consignee, commission due and the net amount owing to the consignor.

Difference between Invoice and Account sales

Account sales Invoice

Prepared by the consignee Prepared by the seller

All expenses and commission are deducted All expenses incurred by the consignee are
in account sales borne by the consignor

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In invoice, expenses are added but After sale, expenses are paid by the buyer
discount and commission are deducted

The relationship between two parties The relationship between two parties is that of
remains as principal and agent debtor and creditor

Account Sales as received from ... of ... for the sales made on consignment for the period from
... to ...

Particulars FRw FRw

Gross sale proceeds:
Cash sales xx
Credit sales xx
Total sale proceeds xx
Other receipts xx
Total receipts xx
Less: Amounts to be deducted
Advances sent xx
Expenses paid to be reimbursed xx
Commissions receivable xx
Total deductions (xx)
Gross amount due xx
Less: Bad debts (Consignor’s responsibility) (xx)
Net amount due xx
Less: Amounts still to be collected (balance due (xx)
from consignment debtors)
Cash due xx
Less: Amounts sent (along with Account sales) (xx)

Net cash due xx

NOTES:
Other receipts: Amount to be paid by consignee may include the amounts received on account
of sale of abnormal loss stocks, insurance realisations and sale of salvaged stock. These
realisations would not form revenue for consignment business. Hence, they cannot be included
in the normal sale proceeds. But since the consignee has to account for these realisations also
he includes them in the account sales.

Bad debts: If the consignee has to bear the bad debt loss (del credere commission) such a
deduction cannot be made since the amount is to be given by the consignee and he cannot
reduce the amounts due saying someone did not pay up.

Balance due from consignment debtors: The amount due to be received by the consignor would
be the amount left over after setting off the advances, commissions, expenses to be reimbursed,
from the total receipts. The total receipts includes both cash receipts as well as collections in
relation to credit sales. This implies that the Net amount due to be sent to the consignor may not
be available with the consignee in cash.
CPA EXAMINATION I1.2 FINANCIAL REPORTING 233
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Consignee collects his dues first: If you notice the working in the account sales, you will be able
to ascertain that the consignee is paying cash to the consignor only after he has collected it from
the consignment debtors. From the initial sale proceeds he would be recovering the advances
he paid, the expenses he paid, the commission due to him (on all sales). If there is any amount
remaining after this, and that too if it is not locked up in consignment debtors only he would be
paying the consignor.

EXAMPLE OF ACCOUNT SALE

Account sales of 75 cases of fancy goods received from and sold

on account and risk of Messers A & Co.

$ $
35 case of fancy goods at $150 per case 5,250
40 cases of fancy goods at $200 per case 8,000 13,250

Less Charges and Expenses:

Freight & Cartage 50
Brokerage 10
Insurance 150
Storage 200
Commission at 10 per cent of sales 1,325
1,735
11,515
Less Amount of our acceptance given in advance 10,000
Bank draft now enclosed 1,515

E.&O.E.
Signed………
New York, 26 December 2009

Accounting and reporting of consignment business

Accounts and Expenses related to consignment
10 Accounts related to consignment arrangement

The objective of consignor in making accounts relating to consignment is two-fold:

• To ascertain the results (profit/loss) of consignment and incorporate them in his P&L Account.
• To make final settlement with the consignee.

To achieve these objectives, he prepares respectively two accounts:

• ‘Consignment Account’ and

• ‘Consignee Account’

The consignor and the consignee keep their own books of accounts. The consignor may send
goods to many consignees. Also, a consignee may act as agent for many consignors. Therefore, it
is appropriate that a separate consignment account as well as consignee account be prepared in
respect of every consignment to enable both of them to know profit or loss on each consignment.

234 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 • When goods are dispatched on consignment no entry can be made in the Sales A/c as this is
not a sale, and, until the goods are sold, they remain the legal property of the consignor. For the
same reason the consignee’s personal account cannot be debited with the value of the goods
consigned. He is not a debtor until the goods are sold.
• As an agent, the consignee is not liable to pay for the goods received on consignment. Therefore,
he makes no entry in his financial books on such receipts. As, however, he is liable to account for
the goods received, he keeps as adequate record in an appropriate memorandum book. Apart
from this his only concern is to record the expenses he has incurred, the sales, his commission
and his financial relationship with the consignor.

20 Expenses on consignment
(a) Non-recurring expenses
Non-recurring expenses are the expenses which do not arise repeatedly for a particular
consignment. They are incurred for bringing goods to the warehouse of the consignee. Such
expenses are generally incurred on the consignment as a whole, partly by the consignor and
partly by the consignee. The consignor usually incurs expenses, such as packing, cartage,
loading charges, freight, etc., on sending the goods to the consignee. But the consignee usually
incurs expenses, such as customs duty, clearing charges, etc., on receiving the goods from the
consignor.

(b) Recurring expenses

Recurring expenses are the indirect expenses incurred repeatedly on the same consignment.
They are incurred after the goods have reached the consignee’s place or warehouse. Advertising,
discount on bills, commission on collection of cheques, travelling expenses of salesman, bad
debts, etc., are some examples of recurring expenses incurred by the consignor whereas
warehouse rent and insurance, sales promotion, etc., are the examples of recurring expenses
incurred by the consignee.

3.1.2.2. Entries for goods sent on consignment at cost price

10 Journal entries in the books of the consignor

Transactions Double entries

Dr Consignment
Cr Goods sent on
Goods sent on consignment
consignment
Dr Goods sent on
Goods returned by the consignee consignment
Cr Consignment
Dr Consignment
Expenses incurred by the consignor while dispatching
Cr Bank
goods
Dr Consignment
Expenses incurred by consignee Cr Consignee
Dr Consignment
Commission payable to the consignee Cr Consignee

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Recording Account sales (del credere commission is paid Dr Consignee
to consignee or if in contract he agrees to collect the credit Cr Consignment
sales
Dr Consignment Trade
Recording Account sales (del credere commission is not
receivable
paid to consignee or in contract he can’t collect the credit
Cr Consignment account
sales)
No entry
Normal loss [normal loss of stock of consignment
(damaged stock, obsolete stock) which was not insured]
Insurance claim received for normal stock loss Dr Bank
Cr Consignment
Abnormal loss [abnormal stock loss credited to Dr Bank/Insurance company
consignment A/c (fire loss, burglary loss, stolen in transit] Dr Profit and Loss
Cr Consignment (Total loss)
Bad debts borne by consignor Dr Consignment
Cr Consignee
Bad debts borne by consignee No entry in the consignor’s
books
Remittance by (Payment from) consignee in full settlement Dr Bank/Bills receivable
by cheque or accepting Bill Cr Consignee
When Bill Receivable is discounted by Consignor Dr Bank a/c (Bills minus
discount
Dr Consignment a/c
(discount)
Cr Bills Receivable a/c (Total
bills
Profit on the consignment is transferred to the P&L A/c Dr Consignment
Cr Profit and loss

Loss on the consignment is transferred to the P&L A/c Dr Profit and loss
Cr Consignment
For closing stock on consignment Dr Consignment stock a/c
Cr Consignment a/c
For closing goods sent for consignment sale account Dr Goods sent on
consignment
To Trading a/c

Note: The discount on bills may be accounted for in one of two ways:

• As a normal operating expenses item and charged against the profit and loss account; or
• As a special expense item related to the consignment and therefore charged to consignment
a/c.

The method of accounting depends on whether the advance is interpreted as a method of

financing the business generally or whether it is regarded as a transaction particularly related to
consignment activity.

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Consignee A/c
To: By:
Consignment A/c: Consignment a/c (expenses of
consignee)
Cash sales Bills receivable a/c (full of bills)
Credit sales Bank/Cash a/c (advance paid to
consignor)
Own purchases Consignment a/c (consignee’s
commission

Consignment a/c (if any bad debts)

Balance c/f Bank/Cash a/c (for final payment)

Consignment A/c

To: Opening stock By:

Goods sent on consignment Consignee A/c:
Cash (expenses of consignor) Cash sale

Consignee a/c ( expenses of Credit sale

consignee)
Consignee a/c (commission) Own purchase
Consignee a/c (bed debts) Closing stock

P&L A/c ( if profit) P&L A/c ( if loss)

Goods sent on consignment A/c

To Trading a/c By Consignment a/c

20 Journal entries in the books of the consignee

Transactions Double entries

No entry (the property still
Goods sent form consignor belongs to the consignor)

Expenses paid by the consignor No entry

Dr Consignor
Commissions received Cr Commission received
Dr Consignor
Expenses paid on behalf of the consignor Cr Bank
Dr Consignor
Discounts allowed to customers Cr Debtors
Dr Consignor
Bad debts borne by consignor Cr Debtors

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 Dr Bad debts (Profit and Loss)
Bad debts borne by the consignee personally (when a
Cr Debtors
del credere commission was paid to the consignee)
Dr Cash/ Bank
Cash sales Cr Consignor
Dr Debtors
Credit sales Cr Consignor

Dr Consignor
Payment to the consignor by cheque or bill Cr Bank/Bill payable

Example 1:
Wills of London, whose financial year ends on 31 December, consigned goods to Adams, his
agent in Canada. All transactions were started and completed in 19X8.

(a) January 16: Wills consigned goods costing £500 to Adams

(b) February 28: Wills paid carriage to Canada, £50
Adams, the consignee, sends an account sales on 31 July when all goods have been sold. It shows:
(c) Sales amounted to £750
(d) Adams’s expenses were: Import duty, £25
Distribution expenses, £30
(e) Commission had been agreed at 6 per cent of sales. This amounted to £45
(f) Adams paid balance owing £650.

Solution: Entries in the books of the consignor (Wills’ books)

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The account sales sent by Adams to Wills would appear as follows:

The double entry accounts in the books of the consignee (Adams) are as follows:

CPA EXAMINATION I1.2 FINANCIAL REPORTING 239

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Entries for goods sent on consignment at a price higher than cost
For a number of reasons, the consignor may send the goods at a price higher than cost (invoice
price) so that the consignee gets no knowledge of real cost of goods which is confidential for the
consignor.
Invoice price is not the same thing as selling price. Invoice price is the price at which the
consignor sends the goods to the consignee. On the contrary selling price is the price at which
the consignee sells the goods to the customers. It is to be observed that SP>IP>CP.
However, if the consignor directs the consignee to sell the goods at invoice itself, then the SP =
IP. The amount of profit which is added to the cost in order to arrive at the invoice price is known
as loading. In other words, Loading = IP – CP or Number of units x (IP per unit – CP per unit)
It means, certain amount of profit is added to the cost price of goods. Profit/ Loading is calculated
after charging certain percentage either on Cost or Sale/ Invoice price.

Naturally, for finalization of accounts, such loading should be adjusted accordingly:

1. Opening stock: It is always shown on debit side of consignment account. The difference
between invoice price and cost price of the stock will be shown on credit side of consignment
account:
Stock reserve A/c…………………….Dr
To Consignment A /c………………………….Cr

2. Goods sent on consignment: Such goods are shown on the debit side of the consignment
account at invoice price. The difference between invoice price and cost price of goods sent on
consignment will be shown on the credit side of the consignment account:
Goods sent on consignment…………Dr
To Consignment A /c…………………………Cr

3. Goods returned by the consignee: The return of goods is shown on credit side of the consignment
account. The adjustment for loading will be made on the debit side of consignment account:
Consignment A /c……………………Dr
To Goods sent on consignment…….………..Cr

4. Closing stock (unsold stock): it is shown on the credit side of consignment account. Hence, the
adjustment for the loading will be made on the debit side of consignment account:
Consignment A /c…………………………………..Dr
To Stock reserve A/c Stock Suspense A/c ………………………… Cr

In practice, the loading done at a fixed percentage of profit on cost, bears a fixed relation with the
profit on invoice price of the goods.

5. Loading on abnormal loss (with the amount of loading on abnormal loss):

Consignment A/c …………………………Dr
To Abnormal Loss A/c ……………………………………Cr

Note: Other entries to be recorded in the books of consignor are as usual.

Example: Rashid of city A sends 100 sewing machines on consignment to Malik of city B. The cost
of each machine is $130 but the invoice price is at the rate of $160 each. Rashid spends $400
on packing and dispatch. Malik receives the consignment and immediately accepts Rashid’s
draft for $8,000. Subsequently, Malik informs Rashid that 80 machines have been sold at $175
each. Expenses paid by Malik are freight $600, warehouse rent $50, and insurance $100. Malik

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is entitled to a commission of 6 per cent on sales and 1.5 per cent as del credere commission.
Required: Give journal entries in the books of Rashid. Also prepare necessary ledger accounts:

Journal (amounts in $)
Consignment to Malik account 16,000
To Goods sent on consignment account 16,000
(100 machines at $160 each sent on consignment, at invoice
price)
Consignment to Malik account 400
To Cash account 400
(Expenses incurred on consignment)
Bills receivable account 8,000
To Malik 8,000
(Malik’s acceptance received)
Malik 14,000
To Consignment to Malik account 14,000
(80 machines sold by Malik at $175 each)
Consignment to Malik account 750
To Malik 750
(Expenses incurred by Malik)
Consignment to Malik account 1,050
To Malik 1,050

(Commission at 6% plus 1.5% on sales)

Consignment to Malik account 600
To Stock reserve account 600
(Difference in closing stock adjusted)
Stock on consignment account 3,400
To Consignment to Malik account 3,400
(Value of 20 machines in the hands of Malik)
Goods sent on consignment account 3,000
To Consignment to Malik account 3,000
(The difference in the invoice value and cost, $30 per
machine adjusted)

Goods sent on consignment account 13,000

To Trading account 13,000
(Transfer of goods sent on consignment to Trading account)

Consignment to Malik account 1,600

To Profit and loss account 1,600

(Transfer of profit on consignment)

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Closing stock and losses on consignment
Incomplete consignments: Unsold stock at balance sheet date
The main difference between a completed consignment at the balance sheet date and an
uncompleted one is that the unsold stock has to be to enable the profit on consignment up to
balance sheet date to be ascertained and included with revenue from other trading activities, and
carried down to the following period. This is to appear in the balance sheet of the consignor as
a current asset. The entry is:

Consignment Stock A/c ……………..Dr

Consignment A/c………………………….…. Cr

The basis for valuation of this stock is cost price unless deterioration or obsolescence requires
the adoption of net realizable value.

• Determination of cost price involves a consideration not only of the original purchase price of
the goods but also all direct expense or all expenses made whether by the consignor or by the
consignee in placing the goods in a saleable condition (till the goods reach the warehouse of
the consignee such as carriage and freight, loading charges, customs duty, clearing charges,
carriage paid up to warehouse and unloading charges).
Thus it is proper to include the following in valuing unsold stock:
Take Purchase price
Add Proportion of the total relevant expenses of the whole consignment:

• Inward charges to the consignor’s place of business

• Outward charges related to the dispatch to the consignee
• Inward charges incurred by the consignee
• Expenses incurred by the consignee in selling the goods such as advertisement, salesman’s
salaries and commission, storage, insurance against fire or theft are not included in the
valuation of unsold stock. These expenses do not relate to the goods unsold and are recorded
as marketing expenses.

At the commencement of next financial period, consignment stock is transferred to the consignment
account, as a debit to enable the profit/loss on sale of the remainder of consignment to be
determined as follows:
Consignment A/c……………………Dr
Consignment Stock A/c ……………………..Cr

Note: If the pro-forma invoice was made out at a price higher than the cost, stock will also be
valued at invoice and not at cost. But it is wrong to show unsold stock in Balance Sheet at a
figure higher than the cost. Hence for the difference (i.e., difference between value of stock at
invoice price and value of stock at cost) reserve must be created, entry is as follows:
Consignment A/c ……………………..Dr
Stock Reserve A/c……………………….….. Cr

Example 2: Suppose the Consignor sends to the Consignee, 2,000 Samsung mobile at $40 per
unit and pays customs duty, $3,000; marine insurance, $1,500. The Consignee pays, at the time
of taking delivery, unloading charges of $500. The Consignee also pays storage rent $450 and
advertisement $1,500. If we assume that 400 Samsung mobile remain unsold, the value will be
calculated as follows:

242 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 $
400 Samsung mobile (1/5th of 2000); i.e., 400 @ $40 16,000

1/5th of $3,000, Customs duty 600

1/5th of $1,500, Marine Insurance 300
1/5th of $500, unloading charges paid by the 100
Consignee
Total value of unsold Stock 17,000
The rule regarding valuation is cost or market price whichever is lower. This means that if the market price of the
unsold stock is more than $17,000, it will be valued at $17,000. If however, the market price is less than $17,000, it
will be valued at the market price. Any loss or depreciation of stock should be duly taken into account.
Example 1:
(a) Farr of Chester consigns 10 cases of goods costing £200 per case to Moore in Nairobi on July 19X7.
(b) Farr pays £250 for carriage and insurance for the whole consignment on 1 July 19X7. Farr receives an interim
account sales with a bank draft from Moore on 28 December 19X7. It shows (in £ sterling):

Farr now wishes to balance off his consignment account at his financial year end, 31 December
19X7, ad to transfer the profit to date to his P&L A/c. The consignee account will appear as
follows:

CPA EXAMINATION I1.2 FINANCIAL REPORTING 243

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Final completion of consignment: unsold stock at the beginning of the year, now sold

Taking the completion of the above consignment as an example, the following details were
obtained from the final account sales dated 3 March 19X8:

244 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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Farr’s books, the consignment account can now be shown as follows:

Losses on consignment
In case the goods sent on consignment are lost or damaged in transit or otherwise, the loss is
that of the consignor and not of the consignee. Accordingly the consignor will have to make the
entries for such loss. There are two types of losses which may arise in case of a consignment
transaction: normal loss and abnormal loss.

Normal loss
Normal loss is natural, unavoidable and inherent in the nature of goods or commodities sent
on consignment (due to evaporation, leakage & breaking the bulk into pieces). This type of
loss is a part of the cost of consignment, so the consignor does not make separate entry for
such a loss. However, the normal loss has to be taken into consideration while valuating unsold
consignment stock in the hand of the consignee. Since normal loss is a charge against gross
profit. No additional adjustment is required for this purpose. Moreover, the same is a part of cost
of goods, when valuation unsold stock is made in case of consignment account the quantity of
such loss (not the amount) should be deducted from the total quantity of the goods received by
the consignee in good condition.
Accounting treatment of normal loss is to charge the total cost of the goods to the remaining goods
after the normal loss. In other words, the value of the unsold stock is calculated in proportion to
the total cost of the goods consigned.

OR

Example: From the following particulars ascertain the value of unsold stock on consignment.

$
Goods sent (1,000 kgs) 20,000
Consignor’s expenses 4,000
Consignee’s non-recurring expenses 3,000
Sold (800 kgs) 40,000
Loss due to natural wastage (100
kgs)

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Solution
Value of unsold stock $
Total cost of goods sent 20,000
Add: Consignor’s expenses 4,000
Non-recurring expenses 3,000
Cost of 900 kgs (1,000 kgs – 100 27,000
kgs)

(b) Abnormal Losses -

Abnormal Losses arises as a result of negligence/ accident etc., e.g., theft, fire etc. Before
ascertaining the result of the consignment, value of abnormal loss should be adjusted. The
method of calculation is similar to the method of calculating unsold stock. Sometimes insurance
company admits the claim in part or in full. The same should also be adjusted against such
abnormal loss. This loss is calculated by adding proportionate direct expenses incurred by the
consignor and the consignee as the case may be to the original cost of the goods. The accounting
entry is:

Treatment of Abnormal Loss

(i) For abnormal loss:

Dr Abnormal Loss A/c
Cr Consignment A/c

(ii) If goods are not insured:

Profit & Loss A/c Dr
To Abnormal Loss A/c

(iii) If goods are insured and admitted or covered by Insurance Company:

Dr Insurance Company/Bank A/c
Cr Abnormal Loss A/c

(iv) For the balance (i.e. which is not covered/ admitted by Insurance Co.):
Dr Profit & Loss A/c
Cr Abnormal Loss A/c
Summary of the procedure for calculating the abnormal loss and valuation of the remaining
stock:
(i) Calculation of abnormal loss:

Cost of goods lost xx

Add: Proportionate expenses of the goods lost xx
Less: Any amount of claim (if any received from the insurance company) (xx)

XX

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(ii) Valuation of closing stock

Cost of the goods (1) xx

Add: Proportionate Non-recurring (direct) expenses incurred before the xx
loss (2)
Add: Proportionate expenses (Direct only) incurred after the loss (3) xx

Where

Example: Aju smart of Jaffna dispatched 1,000 shirts at $700 each to Mohan Bros of Colombo,
the consignors paid freight $7,500, cartage $500 and insurance $2,500. Mohan Bros received
only 900 shirts and incurred the following expenses.

Freight and other expenses ($) 100,000

Cartage ($) 5,000

Sales expenses ($) 6,000

The consignee sold 600 shirts only. You are required to calculate the value of closing stock.

Solution
Calculation of the value of unsold stock

Shirts received 900- shirts sold 600 = unsold stock 300

(i) Cost of unsold stock 300 × 700 = 210,000
(ii) Add: Proportionate expenses paid by consignor: (7,500+500+2,500) = 10,500*3/10
= 3,150
(iii) Add: Proportionate expense paid by consignee: Freight 100,000
5,000
Cartage = 35,000
105,000 (105,000*300/900
248,150
Normal and abnormal losses on the same consignment
In this case, the computation of the value of closing stock involves the following procedures:

1. Take the total cost of goods consigned and add all the non-recurring expenses (incurred by the
consignor and consignee).
2. Deduct the quantity and cost of abnormal loss from the total number of goods consigned and the
cost as obtained in (1) above, respectively.
3. Deduct the quantity of normal loss from the quantity worked out in (2) above without making any
adjustment in cost.
4. Calculate cost per unit of goods units by dividing the cost (remaining after deducting the cost of
abnormal loss) by the number of goods units.

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 5. Multiply the number of unsold units with the cost per unit obtained in (4) above to arrive at the value
of unsold stock.
3.1.2.5. Financial reporting for consignment in the books of consignor

Trading and Profit and Loss Account

FRw FRw
Opening Stock N Sales N
Add Purchases N
Less Goods on Consignment (C)
Less Closing stock (N)
Cost of goods sold N
Gross profit N
N N
Expenses N Gross profit N
Stock Loss of Consignment C Consignment profit C
Net profit T
T T
N=figure from Normal trading; C=figure from Consignment; T= Total figures

Balance Sheet (Extract)

Current Assets Current Liabilities
Stock (N+C) T
Consignee account (if a debit C Consignee account (if a credit C
balance) balance)

3.1.2.6. Financial reporting for consignment in the books of consignee

Trading and Profit and Loss Account

FRw FRw
Opening Stock N Sales N
Add Purchases N

Less Closing stock (N)

Cost of goods sold N
Gross profit N
N N
Expenses N Gross profit N
Bad debts N Commission received C
(from consignor)
Bad debts (for del credere C
commission)
Net profit T
T T

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 Balance Sheet (Extract)
Current Assets Current Liabilities
Stock (N+C) N
Consignor account (if a debit C Consignee account (if a credit C
balance) balance)

INSURANCE COMPANIES ACCOUNTS

Meaning of insurance and insurance contract
Insurance
Insurance is a social device for spreading the chance of financial loss among a large number of
people. By purchasing insurance, a person shares risk with a group of others, thereby reducing
the individual potential for disastrous financial consequences. An insurance risk is a risk created
by a contract and that cannot be covered without making reference to the original contract.

Insurance contract
As per IFRS 17, insurance contract is a “contract under which one party (insurer) accepts significant
insurance risk from another party (policyholder) by agreeing to compensate the policyholder if a
specified uncertain future event (insured event) adversely affects the policyholder.
Some contracts having the legal form of insurance may not meet that definition. Insurance
contracts transfer insurance risks (rather than only financial risks).

In other words, an insurance company (insurer) agrees, in return for a premium, to pay a sum of
money to a person or company (insured) on the happening of a certain event or to indemnify the
insured party against loss caused by risk insured against.
Insurance contract technically called ‘insurance policy’, is a written agreement between an
insurance company and a person who wants insurance which states the rules of the agreement.
An insurance policy has a lot of data. Besides the basic contact and billing information, a policy
might have premium, dividend, policy loan, agent’s commission, valuation and claims records.
Each of these records will interface with the general ledger over time. For instance, when a policy
is sold, a premium is received, a commission paid and a reserve for future claims is setup.

Insurance claim
An insurance claim is a formal request to an insurance company asking for a payment based on
the terms of the insurance policy. Insurance claims are reviewed by the company for their validity
and then paid out to the insured or requesting party (on behalf of the insured) once approved.

Every insurance claim requires some kind of proof of damage or injury before an insurer will
pay. For example: on auto claims, someone said, there are five elements of proof that will come
into play: what you tell insurance companies, what the other party tells them, a police report,
witnesses and physical damage at the scene.

Types of insurance companies

Classification of insurance companies
There are life and general insurance. Life insurance is a written contract between the insured
and the insurer, that provides for the payment of a sum to the insured on the date of the maturity
of the contract or on the unfortunate death of the insured, whichever occurs earlier.
In other words, life assurance guarantees that on the policyholder (insured) attaining a certain

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age or on his death, he will receive a certain amount of money paid to him by the insurer.
Throughout the period of the policy, the insured has to pay regular premiums. Life insurance
is known as assurance because ultimately the policy must be paid; whether due to death or
maturity. The examples of life insurance are: (i) whole life assurance; (ii) term life assurance;
and (annuity).
On the contrary, general insurance or non-life insurance policies provide payments depending on
the loss from a particular financial event. General insurance typically comprises any insurance
that is not determined to be life insurance.
The examples of general insurance are:
(i) fire insurance;
(ii) marine insurance;
(iii) miscellaneous insurance (automobile, stock, homeowners, etc.).
If categorized on the type of risk, we can distinguish between the following types of insurance:

Risk Type of insurance

Loss through fire Fire insurance

Risk of sea transport to goods and ship Marine Insurance
Accident Motor vehicle insurance or Accident
insurance
Loss by theft Burglary insurance
Dishonesty of employees Fidelity insurance
Damage to third parties Third party insurance
Injury/sickness/death to workers at place of Workmen’s compensation
work
Death at advanced age Life assurance

Loss of profits due to fire or natural causes Consequential loss insurance

Key terms used in insurance companies accounts

1. Annuity – This is an annual payment, which a life insurance office guarantees to pay regularly as long
as one lives in consideration of a lumpsum received at the beginning. The amount of the payment
is specified by the policy, and may be constant throughout the annuity period, or may increase at a
prescribed rate. It is almost the reverse of a life policy contract. The amount payable depends upon the
age of person concerned (called an annuitant) and the prevailing rate of interest. The regular payment
(annuity) is an expense, whereas the lumpsum received at the beginning is called “consideration for
annuities granted” and is income.

2. Bonus. Bonus is the share of profit that the policyholder gets from the insurance company. Bonus in
cash: if the insurer has with profit policy, he will get the bonus from the corporation. If the bonus is
paid in cash, it is shown on debit side of the revenue account as an expense. Interim bonus will not
be shown anywhere while preparing final accounts. Instead it will be adjusted while calculating true
surplus and amount to be paid to policyholders. Bonus in reduction of premium is bonus which is
payable in cash but the policyholder has opted not to accept it in cash, and instead offset this against
premiums due from him. It is shown both on the debit side (as an expense) and credit side (by adding
to the premium) of revenue account.

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3. Claim means the amount payable by the insurance company. If the amount is payable due to the death
of the policyholder it is called a “claim by death”. If the claim is paid upon the policyholder attaining the
age mentioned in the policy, it is known as claims by maturity (or survivance).

4. Endowment policy is a policy, which matures on the policyholder attaining a certain age or on his death,
whichever is earlier.

5. Pensions: Pension policies involve paying regular or single premiums to create a stream of income
(starting at retirement), usually also with the option of paying a capital sum. In essence, these policies
are savings contracts, leading to a deferred annuity and a capital payment.

6. Premium: the premium received during the accounting period plus outstanding at the end of the period
plus bonus in reduction of premium minus outstanding premium at the beginning of the period minus
reinsurance premium is to be shown under this heading.

7. Premiums: A premium is a sum paid to the life office to assure the benefit specified by the policy.

8. Reinsurance: When a company accepts a business of more value and in order to reduce the risk,
may pass on some business to the other company, it is called reinsurance. The company, which
passes some business to the other company, gets a commission, which is known as commission
on reinsurance ceded (it is an income credited to Revenue A/c). The company which accepts such
business pays a commission on reinsurance accepted (it is an expense debited to Revenue A/c).

9. Retrocession. This occurs in case an insurance company reinsures one property with more than one
reinsurance company.

10. Reversionary bonus is that which is payable only on the maturity of the policy.

11. Surrender value: because many of the assurance policies are used, in part or whole, as a savings
vehicle, policyholders may wish not to continue with premium payments, so the insurer builds into the
contract a provision for its surrender for a cash sum prior to the end of the policy term. The amount
payable will generally be less than the total premiums already paid by the policyholder.

12. Whole life policy is a life policy that only matures on the death of the insured.

13. With profits policies are those policies on which, in addition to a guaranteed sum payable on maturity,
a share of the profits of the life office will be payable.

14. Without profits policies are those which entitle the policy holder to get only a fixed sum of money on
maturity.

Insurance company operations

The most important insurance company operations consist of the following:

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 • Underwriting
• Ratemaking
• Production
• Reinsurance
• Claim settlement
• Investments

Underwriting
Underwriting refers to the process of selecting, classifying, and pricing applicants for insurance.
The underwriter is the person who decides to accept or reject an application. An underwriter
selects certain types of risks that have historically produced a profit and rejecting those risks
that do not fit the underwriting criteria of insurer. Good underwriting of risk selection normally
produces a favourable loss ratio. This means the premium collected, less loss and expenses,
produces a profit for the insurer.

Insurers must carefully underwrite all risks to avoid being the victim of adverse selection. Adverse
selection is selection against the insurance company. It is the tendency of insureds with a greater-
than-average chance of loss to purchase insurance.

In addition, insurers will sometimes use reinsurance as a means of reducing their exposure of
loss for a particular risk. Often an insurer will cede part of a risk to a reinsurer to avoid being
exposed to a larger than usual loss.

Rating and ratemaking

• Ratemaking refers to the pricing of insurance and the calculation of insurance premiums. The
premium paid by insured is the result of multiplying a rate determined by actuaries by the number
of exposure units, and then adjusting by various rating plans (a process called rating).
• A rate is the price per unit of insurance. An exposure unit is the unit of measurement used in
insurance pricing, which varies by line of insurance.

Calculation of the premium

Insurance companies need to set a price for the cover given which is sufficient to pay:

• the cost of any benefits which may be paid to the policyholder,

• the commission paid to salespersons or intermediaries,
• the costs of administering the policy, and
• the target profit.

Calculating the level of premium for a particular type of policy involves the expertise of a
company’s actuary. There are four main factors the actuary must consider when setting the level
of premium:

• mortality
• current and future investment income (‘interest’)
• current and future expenses
• a contingency factor

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 Production
The term production refers to the sales and marketing activities of insurers. Agents who sell
insurance are frequently referred to as producers. This word is used because an insurance
company can be legally chartered, personnel can be hired, and policy forms printed, but no
business is produced until a policy is sold. The key to the insurer’s financial success is an
effective sales force.
Agency department: Life insurers have an agency or sales department. This department is
responsible for recruiting and training new agents and for supervision of general agents, branch
office managers, and local agents. Property and casualty insurers have marketing departments.
To assist agents in the field, special agents may also be appointed. A special agent is a highly
specialized technician who provides local agents in the field with technical help and assistance
with their marketing problems.

Claims settlement
Every insurance company has a claims division or department for adjusting claims. This section
of the chapter examines the basic objectives in adjusting claims, the different types of claim
adjustors, and the various steps in the claim-settlement process. From the insurer’s viewpoint,
there are several basic objectives in settling claims:

• Verification of a covered loss

• Fair and prompt payment of claims
• Personal assistance to the insured

The first objective in settling claims is to verify that a covered loss has occurred . This step
involves determining whether a specific person or property is covered under the policy, and the
extent of the coverage. This objective is discussed in greater detail later in the chapter.
The second objective is the fair and prompt payment of claims. If a valid claim is denied, the
fundamental social and contractual purpose of protecting the insured is defeated. Also, the
insurer’s reputation may be harmed, and the sales of new policies may be adversely affected.
Fair payment means that the insurer should avoid excessive claim settlements and should resist
the payment of fraudulent claims, because they will ultimately result in higher premiums.

Some unfair claim practices prohibited by these laws include the following:

• Refusing to pay claims without conducting a reasonable investigation.

• Not attempting in good faith to provide prompt, fair, and equitable settlements of claims in
which liability has become reasonably clear.
• Compelling insureds or beneficiaries to institute lawsuits to recover amounts due under its
policies by offering substantially less than the amounts ultimately recovered in suits brought by
them.

There are several important steps in settling a claim:

• Notice of loss must be given

• The claim is investigated
• A proof of loss may be required
• A decision is made concerning payment

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 Reinsurance
Reinsurance is another important insurance operation. Reinsurance is an arrangement by which
the primary insurer that initially writes the insurance transfers to another insurer (reinsurer) part
or all of the potential losses associated with such insurance. The primary insurer that initially
writes the insurance is called the ceding company. The insurer that accepts part or all of the
insurance from the ceding company is called the reinsurer. The amount of insurance retained
by the ceding company for its own account is called the retention limit or net retention. The
amount of insurance ceded to the reinsurer is known as the cession. Finally, reinsurer in turn
may reinsure part or all of the risk with another insurer. This is known as a retrocession and the
second reinsurer is called a retrocessionaire.

Reinsurance is used for several reasons. The most important reasons include the following:

• Increase underwriting capacity

• Stabilize profits
• Reduce the unearned premium reserve
• Provide protection against a catastrophic loss
• Reinsurance also enables an insurer to retire from a territory or class of business and to
obtain underwriting advice from the reinsurer. An insurer can also use reinsurance to retire
from the business or from a given line of insurance or territory.
• Reinsurance permits insurer’s liabilities for existing insurance to be transferred to another
carrier; thus, policyholders’ coverage remains undisturbed.
• Finally, reinsurance allows an insurer to obtain the underwriting advice and assistance of
the reinsurer. An insurer may wish to write a new line of insurance, but it may have little
experience with respect to underwriting the line. The reinsurer can often provide valuable
assistance with respect to rating, retention limits, policy coverages, and other underwriting
details.
• There are two principal types of reinsurance: facultative reinsurance and treaty reinsurance.
• There are two basic methods for sharing losses: pro rata and excess-of-loss.

• Under the pro rata method, a ceding company and reinsurer agree to share losses
and premiums based on some proportion.
• Under the excess-of-loss method, the reinsurer pays only when covered losses
exceed a certain level.

Investments
The investment function is extremely important in the overall operations of insurance
companies. Because premiums are paid in advance, they can be invested until needed to pay
claims and expenses.

Insurance company financial statements

Statement of profit and loss
The main elements of an income statement are revenue and expense. For the insurance
companies, revenue consists mainly of premiums and investment income, although some
insurers may also have other sources of revenue, such as service fees. The premium revenue of
an insurance company will be affected by its reinsurance activities. On the other hand, expenses
include claims and costs involved in their settlement, commissions to agents and brokers, and
operating expenses. The increase in actuarial liabilities, which are discussed in the section on

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the balance sheet, is often a significant expense item in the income statement of a life insurer.

Statement of Profit or loss for the period …….

(hypothetical data)
2015 2014
$ $
Gross premiums 74,146 73,451
Premiums ceded to reinsurers (18,756) (19,112)
Net premiums 55,390 54,339
Fees and commission income 5,364 2,231
Investment income 8,221 7,682
Net realised gains and losses 213 93
Fair value gains and losses 1,044 992
Other operating income 91 85
Other revenue 14,933 11,083
Total revenue 70,323 65,422
Gross benefits and claims paid (38,418) (39,410)
Claims ceded to reinsurers 10,273 10,546
Gross change in contract liabilities (7,837) (7,172)
Change in contract liabilities ceded to 1,592 1,691
reinsurers
Net benefits and claims (34,390) (34,345)
Finance costs (1,066) (954)
Profit attributable to unit-holders (267) (111)
Other operating and administrative expenses (22,334) (20,371)
Other expenses (23,667) (21,436)
Total benefits, claims and other expenses (58,057) (55, 781)
Profit before share of profit of an associate 12,266 9,641
Share of profit of an associate 129 230
Profit before tax 12,395 9,871
Income tax expense (2,239) (1,973)
Profit for the year 10,156 7,898

Profit attributable to:

Equity holders of the parent 10,004 7,898
Non-controlling interests 152 –
10,156 7,898

Statement of financial position

For general insurance companies, the largest components on the liability side of the balance
sheet are technical provisions, comprising the provision for unearned premiums and provision
for outstanding claims. In North America, these items are often referred to as the unearned

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premium reserve and the outstanding claim reserve. Despite this common terminology, these
amounts are not reserves at all, at least as used outside the industry. Reserves are amounts that
have been earmarked for contingencies, but they are not owed to anyone and are not liabilities
of the company.
Unearned premiums and outstanding claims are true liabilities. For life insurers, unearned
portions of premiums are included as part of the actuarial provisions.
Usually, most of the assets on the balance sheet of an insurance company are its investments,
including those supporting liabilities to policyholders and those made using surplus funds. The
nature of the insurance business, where commissions and other expenses may be incurred in
order to produce future premium income, together with the matching principle, may result in the
recognition of deferred expenses as an asset.

Summarized Balance Sheet of Insurance Companies (hypothetical data)

ASSETS EQUITY AND LIABILITIES

$ $
Intangible assets 12,728 Capital and reserves 1,138,530
Investments 3,065,990 Subordinated liabilities 53,494
Investments for the benefit of life Technical provisions 2,470,240
assurance
policyholders who bear the 140,411 Unit linked ‘Life’ assurance 163,477
investment risk reserves
Receivables 786,309 Deposits received from reinsurers ..
Other assets 221,568 Liabilities 491,646
Prepayments and accrued income 117,075 Accruals and deferred income ..
Total Assets 4,344,081 Total Liabilities 4,344,081

INSURANCE CLAIMS
In the course of running operations, the business is exposed to a number of risks such as fire,
burglary, accidents, etc. Out of all these risks, the fire risk is the most dangerous. In case it goes
out of control, it may involve loss both in terms of property as well as human lives. A prudent
business secures itself against such losses by taking a proper insurance policy. Such policy is
usually taken for two types of losses:
• loss to the property such as stock, plant, buildings, etc. and
• loss of profits on account of dislocation of the business.

In this section, we will focus on estimating the mount of loss of stock and profits as a result of
fire.

Loss of stock
A fire insurance policy can be taken for indemnification against loss of stock on account of fire.
The policy is usually for a year. The insurance company agrees to compensate the insured for
any loss that he may suffer on account of loss of stock on account of fire, in consideration of a
certain amount being paid as premium.
When fire insurance policy for loss of stock has been taken, the business is protected from such
loss. For this purpose one has to pay a premium. This policy is usually for a year. The amount
for which a policy is taken is called the policy amount. Information about fire loss is given to the
insurance company by the insured. Insurance company sends assessors who have technical
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knowledge relating to the circumstances under which fire broke out and they also determine the
amount of loss caused due to this fire. After making complete investigation, they give a report to
the insurance company mentioning therein the causes due to which fire broke out and whether
the claim is covered by the policy or not. They also mention the value of loss caused due to fire
in their report.

Determination of loss of stock

The value of stock lost on account of fire can be ascertained by finding out the value of stock
on the date of fire less the value of salvaged stock. The value of stock on the date of fire can be
ascertained as follows:

Opening stock
Add: Purchases (from the beginning of the accounting year to the date of fire) xx
Less: Cost of goods sold (from the beginning of the accounting year to the date of fire) xx
= Value of stock on the date of fire xx
Less: Stock of salvaged (salvaged stock) xx
= Value of stock lost on account of fire xx

The value of stock can also be ascertained by preparing a memorandum trading account as
follows:

Memorandum Trading Account

Opening stock xx Sales xx
Purchases xx Value of stock lost on fire (balancing xx
figure)
Wages (and other direct expenses) xx
Gross profit (on basis of rate of xx
gross profit)

xx xx
Note that all items debited and credited are those up to the date of fire.
The excess of the debit side over the credit side indicates value of loss of stock.

Determination of amount of claim

The amount of claim for loss of stock to be filed with the insurance company depends on two
factors: rate of gross profit and average clause.

(i) Rate of gross profit

As explained above, for determination of the loss, the information regarding cost of sales is
necessary. This can be ascertained by deducting the amount the amount of ‘gross profit’ from the
sales made by the business.

Calculation of cost of goods sold

1. Sales up to the date of fire are found out and from these sales, gross profit on them is deducted.
Sales – gross profit = cost of goods sold
2. Rate of gross profit on sales is to be found out. Mostly this rate is given in the question. If this rate is
given, then
Gross profit = sales x rate/100
3. When rate of gross profit on cost is given, then the rate of gross profit on sales can easily be found.

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 Suppose gross profit of 25% on cost (mark-up), then on sales is 25/125
Sales – gross profit = cost of sales
If the percentage of gross profit is not given in the question, then on the basis of performance
of the business through trading accounts of previous 3 to 5 years, an estimate for the current
year’s rate of gross profit is to be made. Moreover, while calculating such rate of gross profit,
any abnormal factors affecting the rate of gross profit should be ignored. For example, if certain
damaged goods had to be sold away at a price lower than their cost of sales, they need not be
considered for the purpose of determination of the rate of gross profit.

(ii) Average clause

Some businessmen are of the opinion that even if fire breaks out, the whole stock will not be
burnt by fire, hence they take an insurance policy for partial stock. By doing so, they have to pay
less amount of premium also, because the amount insured is less than full value of stock.
In order to discourage under-insurance, usually the “average clause” is inserted in all contracts
of fire insurance. When this clause is inserted, the insurance company pays the proportionate
amount of loss which the amount insured bears to total amount of stock.
The object of average clause is to limit the liability of the insurance company to the proportion
of the actual amount of loss which the insured amount bears to the actual value of the property.

For example, stock worth $40,000 is insured only for $30,000 and if the loss amounts to $18,000,
the claim admitted by the insurance company will be as follows:

It is to be noted that the average clause comes into play only if it is proved that loss sustained
by the insured is less than the sum insured. If the loss is more than the amount insured, then the
insurance company pays only the amount insured.
In other words,

• If the loss is more than the sum insured, the insured can recover the whole amount in spite of
the average clause.
• If the policy value is less than the value of stock on the date of fire, the entire amount of loss will
not be borne by the insurance company. The average clause will be applicable and so the loss
is borne by both the insurance company and the owner of the property.

Example: A fire occurred in the premises of Kamina ltd on 25th August, 2014 where a large part
of the stock was destroyed. Salvage was $15,000. Kamina ltd gives you the following information
for the period January 1, 2014 to 25th August, 2014:

• Purchases $85,000
• Sales $90,000
• Goods costing $5,000 were taken by A for personal use
• Cost price of the stock on January 1, 2014 was $40,000.

Over the past few years, A has been selling goods at a consistent gross profit margin of 33⅓%.
The insurance policy was for $50,000. It included an average clause
Required: Prepare a statement of claim to be made on the insurance company.

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Solution

Statement of claim
$
Closing stock on 25th August, 2014 (as per Memorandum Trading 60,000
A/c)
Less: Salvage 15,000
Loss of stock 45,000
Application of average clause: $
Value of stock on hand 60,000
Amount of policy 50,000
Admissible claim (50,000*45,000)/60,000 37,500

Loss of profit or consequential loss

An ordinary fire insurance policy covers the loss on account of stock or properties destroyed by
fire, but it does not cover loss of profit due to inability to produce or sell the goods as a result of
fire. In order to cover the consequential loss or loss of profit, a separate insurance policy is taken.
This policy covers the following losses:

• Loss of profit due to inability to produce or sell

• Loss of fixed costs due to their non-recovery or less recovery due to no production or less
production as a result of fire
• Increased cost of working as a result of fire e.g. renting new business premises on temporary
basis Under the consequential loss or loss of profit, insurance company indemnifies the
insured any loss of profit suffered by him consequent on the destruction of business properties
by fire.

4.2.2.1. Amount of policy

Considerable care should exercise in determining the amount for which a loss of profits policy
should be taken. The policy should be adequate to cover the likely amount of loss which the
insured may suffer on account of dislocation of the business. While determining the amount
of policy the insured should take into account not only the amount of net profit he earns but
also the amount of standing or fixed charges which have been charged against the revenue for
determining the amount of net profit. Of course, he may not get such incomes covered by the
insurance policy which will not be affected by dislocation of his business on account of fire, for
example the income from investments, rent from the property let out, etc.

Example: A company has decided to arrange for a loss of profit insurance. You are asked to
compute the sum for insurance from the following figures for last financial year. It is anticipated
that the current financial year turnover will increase by 10% and that all standing charges will
remain unchanged.

Profit and loss account

Particulars $ Particulars $
Variable expenses 210,000 Sales 300,000
Fixed expenses: Interest on investment 5,000
Wages of skilled employees (Admin. Staff) 30,000
Depreciation 10,000
Insurance premium 1,000

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 Audit fee 400
Directors’ fees 400
Travelling expenses 4,000
Postage and telephone 300
Trade and subscriptions 100
Rent, rates, and taxes 3,000
Net profit 45,800
305,000 305,000

Solution

Amount of policy
Particulars $
Trading profit:
Sales 330,000
Less: Variable costs 231,000
Policy should be taken as 99,000
Alternatively, the amount of policy can be ascertained as follows:
Net profit as shown by Profit and loss account 45,800
Add: Increase in profit on account of increase in sales* 9,000
Fixed expenses 49,200
104,000
Less: Interest on investment (non-trading income) 5,000
Amount of policy 99,000
*i.e increase in sales less increase in variable costs = (300,000*10/100)-(210,000*10/100)

Computation of claim
Loss of profit occurs because of loss of sales on account of dislocation of the business. Moreover,
the insured may have to incur certain additional expenses to mitigate the amount of loss. There
may also be certain savings in expenses of the business because of its being closed down
for some period. All these have to be taken into consideration while calculating the amount of
insurance claim.

There are 7 steps followed in the computation of amount of claim for loss of profit:

• Determination of the period of claim

• Calculation of short sales
• Calculation of percentage rate of gross profit for insurance claim
• Calculation of loss of profit due to short sales
• Increased cost of working
• Saving in expenses
• Average clause

1. Period of claim
Here the dislocation period and the indemnity period are compared. For example, if the indemnity
period is 4 months whereas the dislocation period of the business is 3 months, and then the
claim will be made for 3 months. On the contrary, if the dislocation period of business is 6 months
considering indemnity period of 4 months, the period of claim will be 4 months. The period of
claim should not go beyond indemnity period.
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2. Short sales
The term short sales refers to the loss of sales on account of fire resulting in dislocation of
business. This is the difference between the standard turnover and the actual turnover during
the period of fire.
The computation of short sales requires the understanding of the following terms:

• Standard turnover. The term standard turnover refers to the turnover for the period corresponding
with the indemnity period during the preceding year adjusted in view of the trends noticed during
the accounting year in which the fire occurred.
• Indemnity period. The term indemnity period refers to the period beginning with the occurrence
of the damage, and ending not later than 12 months, thereafter during which the results of a
business shall be affected in consequence of the damage. This period is selected by the insured
himself. It is not necessary for the policy to cover the entire indemnity period. Of course, it is
essential that, on the date of fire leading to partial or complete closure of the business activity,
the police must be in force.

Example:
Fire occurs on 1st March 2018 resulting in a dislocation of the business activities for a period
of 3 months. During the same period the sales in the last year amounted to $10,000. However,
during the current year beginning with 1st January 2018, the sales were showing an increasing
trend of 10%. The actual sales during the period of dislocation amounted to $4,000. Calculate
the short sales.

Solution

Computation of short sales: $

Standard turnover 10,000
($10,000+($10,000*10/100)
Less: Actual sales during the period of 4,000
dislocation
Short sales 6,000

3. Rate of gross profit

The term rate of gross profit has got a different meaning than that of what is commonly understood.
It is ascertained as follows:

All the figures related to net profit, insured standing charges, and turnover relate to the last
accounting period.
In case on net loss, the rate of gross profit will be determined as follows:

If all the standing charges are not insured, the amount of net loss will have to be reduced as
follows:

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4. Loss due to short sales
The loss due to short sales is calculated by applying the rate of gross profit on account of short
sales. For example, if short sales are $7,000 and the rate of gross profit is 20%, the loss of profit
on account of short sales amounts to $1,400 (i.e $7,000*20/100).

5. Increased cost of working

The insured may have to incur certain additional expenses to keep the business running during
the indemnity period. Such increased working expenses will be allowed subject to a limit which
is the least of the two figures resulting from the following:

Example: Calculate from the following data the amount of permissible increased working
expenses:

Short sales $10,000

Rate of gross profit 20%
Increased working expenses $1,000
Insured standing charges $5,000
Uninsured standing expenses $3,000
Short sales avoided through increased cost of $4,000
working
Net profit $5,000
Solution
The amount of increased working expenses will be the least of the two limits calculated as
follows:

The increased working expenses will be allowed only to the extent of $769. Both the claim for
loss of profit on account of short sales and increased working expenses should not exceed the
amount calculated by applying the rate of gross profit to standard sales.
Example:

Standard sales $20,000

Rate of gross profit 20%
Actual sales $4,000
Increased working expenses $1,000
Calculate then overall limit for loss of profit on account of shirt sales and increased working
expenses.

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Solution

Loss of profit due to short sales (16,000×20/100) $3,200

Increased working expenses $1,000
$4,200
However, the total of claim for increased working expenses and loss of profit due to short sales
should not exceed $4,000 (i.e 20,000×20/100). This is on the logic that if the insured had not
done anything, the maximum loss would have been restricted to this amount. Insurance company
will, therefore, pay $4,000 only.

6. Saving in expenses
Any saving in expenses will have to be deducted from the amount calculated as explained above.

7. Average clause
Finally, the amount calculated will be proportionally reduced if the sum insured under the policy
is less than the amount for which the policy should have been taken.
The amount for which the policy should have been taken is determined by applying the rate of
gross profit to the turnover for 12 months immediately preceding the date of fire. Such turnover
may have to be adjusted keeping in view the trend of sales in the accounting year in which the
fire occurs.

Example

Short sales $20,000

Increased working expenses $1,000
Rate of gross profit 20%
Saving in expenses $200
Sales during 12 months immediately preceding $100,000
the fire
Amount of policy $15,000
The sales are showing an increasing trend of 10% since the commencement of the accounting
year. Required: Calculated the amount of claim to be admitted by the insurance company.

Solution

$
Loss of profit due to short sales (20,000$20/100) 4,000
Increased working expenses 1,000
5,000
Less: Saving in expenses 200
Claim for loss of profit and increased working 4,800
expenses
However, the above claim will be subject to the average clause:
Amount for which the policy should have been taken: 110,000×20/100 2,000
Amount for which the policy has been taken 15,000
Amount of claim to be admitted by the insurance company = (4,800×15,000)/22,000= $3,273

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Question 1:
From then following data, compute a consequential loss claim:
Financial year ends on 31st December, Turnover $200,000
Indemnity period 6 months
Period of interruption: 1st July to 31st October
Net profit $18,000
Standing charges $42,000 out of which $10,000 have not been insured
Sum assured $50,000 standard turnover $65,000
Turnover in the period of interruption $25,000 out of which $6,000 was from a rented place at
$600 per month
Annual turnover $240,000
Savings in standing charges $4,725 per annum
Date of fire: night of 30th June
It was agreed between the insurer and the insured that then business trends would lead to an
increase of 10% in the turnover.

Solution
Statement of claim for loss and profit
Computation of short of sales: $
Standard turnover 65,000
Add: 10% increase in turnover 6,500
71,500
Less: Sales during the dislocation period 25,000
Short sales 46,500
Gross profit on short sales @25% 11,625
Add: Increased cost of working, limited to gross profit on 1,500
$6,000
(sales resulting from increased expenses)
Less: Saving in expenses or Standing charges (4,725÷3) 13,125
Gross claim 1,575
11,550
Since the sum assured is less than the amount for which the policy should have been taken,
average clause shall apply.
Amount for which policy should have been taken: 25% of 264,000 (i.e $240,000+$24,000)=$66,000

Workings

$
1. Gross profit rate: Net profit 18,000
Add: Insured standing charges (42,000-10,000) 32,000
Gross profit 50,000
Turnover 200,000
Gross profit rate 25%

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2. Increased cost of working (lowest of the following):

3. The amount of $13,125 (i.e gross profit on short sales and increased working expenses) is
within the overall limit of 20% of $71,500

BANKRUPTCY AND LIQUIDATION OF COMPANIES

OVERVIEW OF INSOLVENCY AND BANKRUPTCY

Introduction to financial distress

Meaning of financial distress

A firm that does not generate enough cash flow to make a contractually required payment, such
as an interest payment, will experience financial distress.
Virtually all businesses undergo financial difficulties at various times. Economic downturns,
poor product performance, and litigation losses can create cash flow difficulties for even the
best-managed organizations. Most companies take remedial actions and work to return their
operations to normal profitability more often they reorganize their financial structure.
If problems persist, a company can eventually become insolvent, unable to pay debts as the
obligations come due. Insolvency is defined as a condition in which a company is unable to meet
debts as they mature. The insolvent company is unable to meet its liabilities).
When creditors are not paid, they obviously attempt to protect their financial interests in hope of
reducing the possibility of loss. They may seek recovery from the distressed company in several
ways: repossessing assets, filing lawsuits, foreclosing on loans, and so on.

The final and only solution for a financially distressed business which has become insolvent
is to liquidate its assets, service its debts, distribute any remaining funds to shareholders, and
terminate the business. However, prior to that, management usually tries to work closely with the
company’s creditors to provide for their claims while attempting to ensure the firm’s continuing
existence. Various non-judicial arrangements with creditors are available. If these fail, the
company usually ends up in a judicial action under the direction of a bankruptcy court.

Causes of business failure

A company’s intrinsic value is the present value of its expected future free cash flows. There are
many factors that can cause this value to decline. These factors include

• general economic conditions,

• industry trends, and
• company’s specific problems such as shifting consumer tastes, obsolescent technology, and
changing demographics in existing retail locations. Financial factors, such as too much debt
and unexpected increases in interest rates, can also cause business failures.

Signals of a financial distress

Financial distress is surprisingly hard to define precisely. This is true partly because of the variety
of events befalling firms under financial distress. The list of events is almost endless, but here
are some examples:

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 • Dividend reductions
• Plant closings
• Losses
• Layoffs
• CEO resignations

Strategies for solving financial distress

What happens in financial distress? There are many responses to financial distress that a firm
can make. These include one or more of the following turnaround strategies.

• Asset expansion policies

• Operational contraction policies
• Financial policies
• External control activity
• Changes in managerial control
• Wind up company (liquidation)

Concepts of insolvency, bankruptcy and receivership

Many people often confuse the terms “insolvency” and “bankruptcy,” assuming them to mean
the same thing. However, these two words, though similar, actually have different meanings:

• Simply speaking, insolvency is a financial state of being – one that is reached when you are
unable to pay off your debts on time.
• Bankruptcy, on the other hand, is a legal process that serves the purpose of resolving the issue
of insolvency.

In short,

• Insolvency is a situation which arises due to the inability to pay off the outstanding debts on
time to the creditors because the assets are not enough to cover up the liabilities
• Bankruptcy is a situation in which an individual / organization sends an application to the
relevant court, wherein he declares himself as insolvent due to his inability to pay off debts
and expenses, seeking to be declared as a bankrupt
• Receivership is a type of corporate bankruptcy in which a receiver is appointed by bankruptcy
courts or creditors to run the company. The receiver may be appointed by a bankruptcy court,
as a matter of private proceedings, or by a governing body.

COMPANY LIQUIDATION
Meaning and modes of liquidation
Meaning of liquidation
To liquidate means to turn an asset into cash. Liquidation is ‘the process of law whereby a
company is wound up to terminate its corporate life’. It is also referred to (either alternatively or
concurrently) in some jurisdictions as winding up and/or dissolution. In accounting, liquidation
means termination of the firm as a going concern. If a company cannot meet its liabilities a
liquidator will be appointed to realise (sell) the assets of the company and the proceeds, net of
transactions costs, are distributed to the creditors in order of established priority. If there is any
surplus in hand then it is to be distributed to its shareholders. Usually, assets are not adequate
to fully satisfy creditor claims. In this case, creditors share according to the terms of the general
assignment.

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Modes of liquidation

(1) Voluntary liquidation

When the members and creditors decide to wind up the company without the intervention of the
court, it is known as voluntary winding up of a company.
It could be in the following circumstances:

1) If the period fixed for the duration of company has been expired or an event on occurrence of which
the company is to be wound up has occurred and company in general meeting has passed an ordinary
resolution requiring the company to be wound up.
2) If the company passes a special resolution that it may be wound up voluntarily.

Voluntary liquidations are of two types:

• By its Members: Members voluntary winding up applies to solvent companies and a declaration
of solvency is necessary within a certain time immediately preceding the date of resolutions for
winding up. The declaration must specify the director’s opinion that company has no doubt or it
will be able to pay debts in full within three years of the commencement of the winding up.
• By the creditors: Creditors voluntary winding up applies to insolvent companies. In such case,
the company calls a meeting of the creditors on the same day or the next day following the day
fixed for company’s general meeting for passing the resolution for winding up.

(2) Compulsory liquidation

A compulsory winding up occurs by an order of the court made on a petition filed by the company,
its creditors or shareholders etc.
Neither a voluntary nor an involuntary petition automatically creates a bankruptcy case.

• After passing a resolution for the voluntary winding up, the court may, at any time, make an
order that voluntary winding up shall continue but subject to such supervision court and with
such liberty for creditors, contributories or others to apply to the court, and generally on such
terms and conditions as the court think fit.
• A court rejects voluntary petitions if the action is considered detrimental to the creditors.
• Involuntary petitions also can be rejected unless evidence exists to indicate that the debtor is not
actually able to meet obligations as they come due. Merely being slow to pay is not sufficient.

. Accounting treatment of liquidation

The end of going concern
A basic assumption of accounting is that a business is considered a going concern unless the
evidence to the contrary is discovered. As a result, assets such as inventory, land, buildings, and
equipment are traditionally reported based on historical cost rather than net realizable value.
Unfortunately, not all companies prove to be going concerns.
Bankruptcy courts administer liquidations in the interests of a corporation’s creditors and
shareholders. The intent in liquidation is to maximize the net amount recovered from disposal of
the debtor’s assets. Bankruptcy courts appoint accountants, attorneys, or experienced business
managers as trustees to administer the liquidation.
The entire liquidation process is governed by the Bankruptcy Code, which describes the specific
procedures to be followed and reports to be made. A very important aspect of liquidation is
determining the legal rights of each creditor and establishing priorities for those rights.

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Liquidation process
The steps involved in the liquidation of a company depends on whether the liquidation is a
decision from the Court or it was a declaration from creditors or a voluntary liquidation from the
shareholders. There are common steps to be considered and they includes:

1. Preparation of a statement of affairs and a list of creditors: a statement of affairs as of the most recent
date possible; and a list of creditors with full names, addresses and to whose attention notices of the
creditors meeting must be sent by the management of the company to the Liquidator
2. Appointment of a liquidator: he/she may be appointed by the court and approved by the creditors.
3. Sale of the assets. The liquidator will sell the non-cash assets to transform them into cash
4. Settlement of debts. The liquidator will publish, in an appointed newspaper, notice to the creditors that
they should submit any proof of debts. In addition, the liquidator must send notice in writing to all persons
appearing from the company’s books and records to be creditors (including contingent creditors) inviting
them to file a claim against the company within the allocated time period. After the period by which
creditors must submit their claims has expired the liquidator will arrange for the settlement of all of the
company’s outstanding liabilities.
5. After settlement of the company’s debts, the liquidator will return the capital and surplus assets, if any,
to the shareholders.

5.2.2.3. Trustee accounting and reporting

(1) Statement of affairs
In addition to the legal statement of affairs, which consists of responses to questions regarding
a debtor’s financial condition, the other report with the same name is the accounting statement
of affairs.
The accounting statement of affairs is the basic accounting report made at the beginning of the
liquidation process. It is a balance sheet of a potentially liquidating concern rather than of a
going concern. Thus, it shifts the emphasis for assets from historical cost to estimated realizable
values and the allocation of proceeds to creditors and stockholders. It is important to note that
the statement of affairs is based on estimated values available to creditors, and the actual values
realized from the liquidation of assets may differ.

The primary purpose of statement of affairs is to approximate the estimated amounts available
to each class of claims. It thereby assists all concerned parties in reaching a decision as to what
insolvency action is preferable. Although the statement assumes a liquidation of the insolvent
company, the statement also is used to evaluate the reasonableness of a corporate reorganization.
The statement of affairs is an important planning report instrument for a company’s anticipated
liquidation. The statement of affairs presents

• the book values of the debtor company’s balance sheet accounts,

• the estimated fair market values of the assets,
• the order of the claims, and
• the estimated deficiency to the general unsecured creditors.

(2) Trustee accounting

Upon accepting the assets, the trustee usually establishes a set of accounting records to account
for the receivership.
The trustee’s accounting records include a liability of the trustee that is created to recognize the
debtor’s interest in the assets accepted by the trustee. This new account is credited for the book
value of the assets accepted and is usually named for the debtor company in receivership. The
trustee does not transfer the debtor’s liabilities because these remain the debtor company’s legal

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responsibility. The general form of the trustee’s opening entry when accepting the assets of the
debtor company follows:

Assets xx
To Debtor company—In Receivership xx

The actual entry details the individual asset accounts and includes the debtor’s company
name.
(3) Statement of realization and liquidation
Trustees examine the proofs of all creditors’ claims against the debtor’s bankruptcy estate, that
is, the debtor’s net assets. Sometimes the trustee receives title to all assets as a receivership,
becomes responsible for the debtor’s actual management, and must direct a plan of liquidation.
A trustee who takes title to the debtor’s assets in a liquidation must make a periodic financial
report to the bankruptcy court on the progress of the liquidation and on the fiduciary relationship
held. Trustees’ reports are different from the traditional financial statements because their legal
rights and responsibilities differ from those of the debtor company’s management.

Trustees prepare a monthly report, called a statement of realization and liquidation to the
bankruptcy court. It shows the results of the trustee’s fiduciary actions beginning at the point
the trustee accepts the debtor’s assets. The statement has three major sections: assets,
supplementary items, and liabilities. The debtor’s liabilities are not transferred to the trustee,
but the trustee may incur new liabilities that must be reported in the statement of realization and
liquidation.

Assets

Assets to be realized Assets realized

Assets acquired Assets not realized

Supplementary items
Supplementary charges Supplementary credits

Liabilities
Liabilities liquidated Liabilities to be liquidated
Liabilities not liquidated Liabilities incurred

Assets
The assets section of the statement is divided into the four groups shown above:

• The assets to be realized are those received from the debtor company.
• The assets acquired are those subsequently acquired by the trustee.
• The assets realized are those sold by the trustee.
• The assets not realized are those remaining under the trustee’s responsibility as of the end of
the period.

Cash is usually not reported in the statement of realization and liquidation because a separate
cash flow report is typically made.

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Supplementary Items
The supplementary items section of the report consists of the two items shown above.

• Supplementary charges include the trustee’s administration fees and any cash expenses paid
by the trustee.
• Supplementary credits may include any unusual revenue items.

Liabilities
Although the trustee does not record the debtor’s liabilities, the trustee settles some of the
debtor’s payables and may incur new payables during the receivership. The liabilities section of
the statement is divided as shown above:

• The liabilities liquidated are creditors’ claims settled during the period.
• The liabilities not liquidated are those outstanding at the end of the reporting period.
• The liabilities to be liquidated are those debts remaining on the books of the debtor company
for whose liquidation the trustee is responsible as of the date of appointment.
• Finally, the liabilities incurred are new obligations the trustee incurred.

(4) Procedure for cash distribution

The liquidator will realized assets of the company and distributes the proceeds from realisation
among the various claimants in the following order:

• Legal charges
• Liquidator’s remuneration
• Cost or expenses of winding up
• Workmen’s dues
• Preferential creditors
• Full secured creditors, creditors secured by floating charges, and partially secured creditors
• Unsecured creditors

In case some surplus is still left, it will be distributed among the contributories as follows:

• Preferential shareholders
• Equity shareholders

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STUD UNIT 4:
GROUP ACCOUNTS AND BUSINESS COMBINATIONS
• Applicable standards (IAS 27,IAS 28 IFRS 3 ,IFRS 10 ,IFRS 11and IFRS 13)
• Consolidated statements of financial position, consolidated statements of comprehensive
income, including reserve reconciliations, consolidated statements of cash flow, acquisition
and disposal of subsidiaries and associates (both domestic and overseas) during the year.
• Takeover of sole traders.
• Accounting treatements of associate and joint ventures

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An entity may expand by acquiring shares in other entities. Where one entity gains control over
another entity, a parent-subsidiary relationship now exists between the two entities.

Each will prepare their own individual financial statements, using the IFRS’s in the normal way.
However, in addition, the parent and subsidiary (collectively referred to as the group) are obliged
by law to prepare a combined set of accounts, known as the consolidated accounts. These
consolidated accounts are prepared and presented as if all the companies in the group are
just one single entity. This means that it is necessary to exclude transactions between group
companies, as failure to do so could result in the assets and profits being overstated for group
purposes.

The accounting rules governing the preparation of consolidated accounts (also known as group
accounts) are set out in a number of standards, namely:

• IFRS 3 (Revised) Business Combinations

• IAS 27 Separate Financial statements

• IFRS 10 Consolidated financial statements
• IAS 28 Investments in Associates
• IAS 31 Interests in Joint Ventures

IFRS 3 has recently been revised and those revisions are now examinable. The main changes
that have been introduced are as follows:

• Expenses that can be treated as part of acquisition costs have been restricted.
• The treatment of Contingent Consideration has been significantly altered.
• A new method of measuring Non-Controlling Interests (formerly known as Minority Interest)
has been introduced. This new method (though not mandatory), if used, will have an effect on
goodwill.
• The recognition and measurement of identifiable assets and liabilities of the acquired subsidiary
has been refined. Guidance has now been provided on intangible assets such as market-related,
customer-related, artistic-related and technology-related assets

IAS 27 covers some of the principles that must be applied in consolidating the accounts of group
companies. It also sets out the circumstances when subsidiary companies must be excluded
from consolidation.

B. DEFINITIONS
In both IFRS 10 and IFRS 3, the definitions of a subsidiary and control are the same.

A subsidiary is an entity, including an unincorporated entity such as a partnership that is controlled

by another entity, known as the parent.

Control is the power to govern the financial and operating policies of an entity so as to obtain
benefits from its activities.

A group is a parent and all its subsidiaries.

Non-Controlling Interest is the equity in a subsidiary not attributable to a parent. Previously, this
was referred to as the Minority Interest.

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C. CONTROL
The extent to which an entity can control another is central to deciding the appropriate accounting
treatment. Control is normally established when one company owns more than 50% of the shares
carrying voting rights of another company.

IFRS 10 however, outlines four other situations where control exists. Even though the parent
might own half or less of the voting power of another company, control also exists when there is:

• Power over more than half of the voting rights by virtue of an agreement with other investors;
• Power to govern the financial and operating policies of the entity under a statute or an
agreement
• Power to appoint or remove the majority of the members of the board of directors or
equivalent governing body and control of the entity is by that board or body; or
• Power to cast the majority of votes at meetings of the board of directors or equivalent
governing body and control of the entity is by that board or body.

A parent loses control when it loses the power to govern the financial and operating policies of
the subsidiary. The loss of control can occur with or without a change in ownership levels; for
example, if the subsidiary becomes subject to an administrator or liquidator.

D. EXEMPTIONS FROM THE REQUIREMENT TO PREPARE CONSOLIDATED

FINANCIAL STATEMENTS
IFRS 10 requires that, in general, all parent entities must prepare and present consolidated
financial statements that include all of its subsidiaries.

However, there are exemptions from the requirement to prepare group accounts if, and only if,
the following situations apply:
• The parent is itself a wholly owned subsidiary, or is a partially owned subsidiary and its other
owners have been informed about, and do not object to, the parent not presenting
consolidated financial statements.

For example:
P %

75

S %

P owns 75% of the ordinary shares of S and S owns 60% of the ordinary shares of T.
P must prepare group accounts combining all three companies. S may have to prepare group
accounts combining S and T. But if the other owners of S (25%) agree, S is exempt from
preparing such group accounts.

• The exemption only applies if the parents shares or debt is not traded in a public market or is
about to issue shares in a public market; and
• The ultimate parent (or intermediate parent) of the parent produces consolidated financial
statements that comply with IFRS’s.

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 • The parent did not file nor is it filing its financial statements with a securities commission or other
regulator for the purpose of issuing shares.

All subsidiaries of the parent must be included in the consolidated accounts. Previously, it
was argued that some subsidiaries should be excluded from the group accounts. But now, the
standards are unequivocal. There are no exceptions to the requirement for a subsidiary under
the control of the parent to be included in the group accounts.

However, if on acquisition a subsidiary meets the criteria to be classified as held for sale in
accordance with IFRS 5, it must be accounted for in accordance with that standard. This requires
that it will be shown separately on the face of the consolidated Statement of Financial Position.
There should be evidence that the subsidiary has been acquired with the intention of disposing
it within 12 months and management is actively seeking a buyer.

A subsidiary that has previously been excluded from consolidation and is not disposed of within
the 12 month period must be consolidated from the date of acquisition.

However, if there are severe restrictions on the ability of the parent to manage a subsidiary, so that
its ability to transfer funds to the parent is impaired, then such an entity must be excluded from
the consolidation process, as control has effectively been lost. In this situation, the investment in
the subsidiary will be treated under IAS 39, as a non-current asset investment.

E. ACCOUNTING DATES
IAS 27 requires that the financial statements of the individual companies in the group be prepared
as of the same reporting date. If the reporting date of the parent and subsidiary differ, then the
subsidiary should prepare additional financial statements as of the same date as the parent,
unless it is impracticable to do so.

If it is considered impracticable, then the financial statements of the subsidiary should be adjusted
for significant transactions or events that occur between the date of the subsidiary’s financial
statements and the date of the parent financial statements. However, the difference between the
reporting dates must not be more than three months.

F. ACCOUNTING POLICIES
All companies in the group should have the same accounting policies, without exception. If
a member of the group uses different policies from those adopted in the financial statements,
appropriate adjustments are made to its financial statements in preparing consolidated financial
statements.

G. CESSATION OF CONTROL
If an entity ceases to be a subsidiary, then the investment in the entity will be accounted for
in accordance with IAS 39 Financial Instruments from the date it ceases to be a subsidiary,
provided that it does not become an associate company or a jointly controlled entity.

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H. DISCLOSURE
IAS 27 requires the following disclosures:
• The nature of the relationship between the parent and subsidiary when the parent does not
own more than half of the voting power.
• The reasons why the ownership of more than half of the voting rights by the investee does not
constitute control.
• The reporting date of the subsidiary if different from the parent, and the reason for the
difference.
• The nature and extent of any significant restrictions on the ability of the subsidiary to transfer
funds to the parent in the form of dividends or to repay loans or advances.

I. ACQUISTION COSTS
In the previous IFRS 3, directly related costs such a professional fees (legal, accounting, valuation
etc.) could be included as part of the cost of the acquisition. This is now no longer the case and
such costs must now be expensed.

The costs of issuing debt or equity are to be accounted for under the rules of IAS 39 Financial
Instruments: Recognition and Measurement.

CONTINGENT CONSIDERATION
The previous version of IFRS 3 required contingent consideration to be accounted for only if it
was considered
probable that it would become payable. This approach has now been amended.

The revised standard requires the acquirer to recognise the fair value of any contingent
consideration at the date of acquisition to be included as part of the consideration for the acquiree.
The “fair value” approach is consistent with the way in which other forms of consideration are
valued. Fair value is defined as “the amount for which an asset could be exchanged, or liability
settled between knowledgeable, willing parties in an arm’s length transaction”.

However, applying this definition to contingent consideration is not easy as the definition
is largely hypothetical. It is most unlikely that the acquisition-date liability for contingent
consideration could be (or would be) settled by “willing parties in an arm’s length transaction”. It
is expected that in an examination context, the fair value of any contingent consideration at the
date of acquisition will be given (or how to calculate it).

The payment of contingent consideration may be in the form of equity or a liability such as a debt
instrument and should be recorded as such under the rules of IAS 32 Financial Instruments:
Presentation (or other applicable standard).

The standard also addresses the problem of changes in the fair value of any contingent
consideration after acquisition date. If the change is due to additional information obtained after
acquisition date that affects the fact or circumstances as they existed at acquisition date, this is
treated as a “measurement period adjustment” and the liability (and goodwill) are re-measured.
In essence, this is a retrospective adjustment and is similar in nature to an adjusting event under
IAS 10 Events After the Reporting Period.

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However, changes due to events after the date of acquisition (for example, achieving a profit
target which requires a higher payment than was provided for at acquisition) are treated as
follows:

Contingent consideration classified as equity shall not be re-measured and its subsequent
settlement will be accounted for within equity, e.g.
Debit Retained Earnings
Credit Share Capital / Share Premium

Contingent consideration classified as an asset* or a liability that

• Is a financial instrument and is within the scope of IAS 39 must be measured at fair value, with
any resulting gain or loss recognised either in profit or loss, or in other comprehensive income
in accordance with that IFRS
• Is not within the scope of IAS 39 shall be accounted for in accordance with IAS 37 Provisions,
Contingent Liabilities and Contingent Assets (or other IFRSs as appropriate).

*Contingent consideration is normally a liability but may be an asset if the acquirer has the right
to a return of
some of the consideration transferred, if certain conditions are met.

An acquirer has a maximum period of 12 months to finalise the acquisition accounting. The
adjustment period ends when the acquirer has gathered all the necessary information, subject
to the one year maximum. There is no exemption from the 12-month rule for deferred tax assets
or changes in the amount of contingent consideration. The revised standard will only allow
adjustments against goodwill within this one-year period.

Deferred consideration should be measured at fair value at the date of acquisition. This means
that future payment should be shown at its Present Value, by discounting the future amount at
the company’s cost of capital. Each year, the discount will be then “unwound”. This will increase
the deferred liability every year, with the discount treated as a finance cost in the Statement of
Comprehensive Income.

EXAMPLE
WR Ltd acquires 27 million shares in LR Ltd. The consideration is effected by a share for share
exchange of two shares in WR Ltd for every three shares acquired in LR Ltd and a cash payment
of RWF2 per share
acquired, payable 3 years after acquisition. WR Ltd.’s shares have a nominal value of RWF1 and
a market value of RWF2.50 at acquisition.

WR Ltd.’s cost of capital is 10%.

The cost of the investment is recorded as:

Shares: (27/3) x 2 = 18 million shares issued, valued at RWF2.50 each.
Consideration: RWF45 million
Cash: 27 million shares x RWF2 = RWF54 million
Present Value = RWF54m x .751 = RWF40.55m
Total consideration: RWF45m + RWF40.55m = 85.55m

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 The Present Value of the cash consideration is then unwound in years 1 to 3, for example
Year 1 40.55 x 10% = RWF4.055m
Debit Statement of Comprehensive Income (Finance Cost) 4.055m
Credit Deferred Consideration (liability in SFP) 4.055m

J. MECHANICS AND TECHNIQUES

For the preparation of a consolidated statement of financial position, the following six steps
should be followed:
1. Establish Group Structure.
Determine the % holding in the subsidiary and when the control was established

2. Carry out consolidation adjustments.

For example, inter company debts must be eliminated, revaluations of assets at acquisition must
be
accounted for, inter company profits must be adjusted for.
These adjustments will be dealt with in detail in a later
chapter.
3. Calculate Goodwill arising on the acquisition of the subsidiary.
Depending on the method of measuring Non-Controlling Interest, goodwill can be measured in
one of two ways:

Proportion of Net Assets Method Fair Value Method

RWF RWF
Cost of Investment X Cost of Investment X
Less: Less:
Parents share of net Parents share of net
assets assets
Total Goodwill Fair Value of NCI at X
acquisition
impaired to date

(X) Less: X
Carrying Value in SFP Parents Share + NCI
Share
(X)
Less:

Total Goodwill X
impaired to date

If goodwill on acquisition is positive, the following consequences should be observed:

• It is capitalised as an intangible asset in Non-Current Assets
• It should not be amortised
• It should be tested for impairment on an annual basis

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If impairment arises, the accounting entries for the treatment of the impairment loss depends on
the method used to value NCI.

Proportion of Net Assets Method:

Debit Group Retained Earning
Credit Goodwill

Fair Value Method:

Debit Group Retained Earnings (group %)
Debit NCI (group %) Credit Goodwill

Negative Goodwill
IFRS 3 refers to negative goodwill as “discount on acquisition”. It arises when the fair value of the
consideration given to acquire the subsidiary is less than the fair value of the net assets purchased.

It is an unusual situation to arise, and the standard advises that should negative goodwill be
calculated, the calculation should be reviewed, to ensure that the fair value of assets and liabilities
are not inadvertently misstated.

Following the review, any negative goodwill remaining is credited to the Statement of
Comprehensive Income immediately.

4. Calculate Non-Controlling Interest

The value at which NCI is shown in the Statement of Financial Position depends on the method
used to value it:

Proportion of Net Assets Method

NCI % of net assets of subsidiary at the reporting date X

OR

Fair Value Method

NCI % of net assets of subsidiary at the reporting date X
NCI share of goodwill X
NCI share of goodwill impairment (X)
X

5. Calculate Consolidated Reserves

The Retained Earnings to be included in the consolidated statement of financial position are
calculated as follows:
Retained Earnings of parent (subject to adjustments in step 2) X
PLUS
Group share of post-acquisition earnings of subsidiary (subject to adjustments in step 2) X
LESS
Total Goodwill Impairments to date (X)
X

It is important to make a distinction between pre-acquisition and post-acquisition reserves.

Pre-Acquisition reserves are the reserves existing at the date the subsidiary company is
acquired. They are included in the goodwill calculation.

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 Post-Acquisition reserves are reserves generated after the date of acquisition. They are included
in group reserves.

6. Prepare Consolidated Statement of Financial Position

The assets and liabilities of the subsidiary and parent are combined in the final statement of
financial position. The assets and liabilities will include any adjustments arising in Step 2.

In addition, the Goodwill, NCI and Consolidated reserves as calculated in Steps 3, 4 and 5 are
included. Note that the Share Capital and Share Premium to be included will be those of the
parent company only.

EXAMPLE
The draft SFPs of PD Ltd and PR Ltd at the 31st December 2010 are shown below:

PD Ltd PR Ltd
RWF’000 RWF’000
Assets
Property, Plant and Equipment 90 100
Investment in PR Ltd (at cost) 110 -
Current Assets 50 30
250 130
Equity and Liabilities
Ordinary share Capital RWF1 100

Retained earnings 120 20

220 120
Current Liabilities 30 10
250 130

PD Ltd purchased 80% of the ordinary shares of PR Ltd on 1st January 2010 when the retained
profits of PR Ltd were RWF15,000. To date, goodwill is not impaired.

Prepare the consolidated Statement of Financial position at the 31st December 2010, assuming
that the PD Group values the non-controlling interest using the proportion of net assets method.

Step 1 Establish Group Structure

PR Ltd
Group 80%
NCI 20%

PR Ltd is a subsidiary, having been acquired 1 year ago.

Step 2 Adjustments
Not applicable in this question

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Step 3 Calculate Goodwill
First, determine the net assets of the subsidiary:
At date of At date of
acquisition SFP

RWF’000 RWF’000
Share Capital 100 100
Retained Earnings 15 20
115 120

Cost of Investment 110

Less:
Share of net assets acquired at acquisition
(115 x 80%) 92
Goodwill 18

No Impairment of Goodwill has occurred. Thus, goodwill to be included in the consolidated SFP
is RWF18,000

Step 4 Calculate NCI

20% x RWF120,000 = RWF24,000

Step 5 Calculate Consolidated Retained Earnings

PD Ltd.
Per SFP 120

PR Ltd.
Per SFP 20
At acquisition 15
Post Acquisition 5
x group share x 80%
4
Consolidated Retained Earnings 124

Step 6 Prepare Consolidated Statement of Financial Position

PD GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AT 31ST DECEMBER 2010

ASSETS
RWF’000
NON-CURRENT ASSETS

goodwill 18
Property, plant and equipment (90 + 100) 190
208
CURRENT ASSETS (50 + 30) 80
288

EQUITY AND LIABILITIES

Ordinary share capital
100
Retained Earnings
124

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 224
Non-Controlling Interest 24
248
CURRENT LIABILITIES (30 + 10) 40
288
EXAMPLE
FR Ltd acquired 80% of the share capital of TK Ltd on the 1st January 2009, when the reserves
of TK Ltd were RWF125,000. FR Ltd paid an initial cash consideration of RWF1,000,000. In
addition, FR Ltd issued 200,000 shares as consideration with a nominal value of RWF1 and
a current market value of RWF1.80. It was also agreed at acquisition that FR Ltd would pay a
further RWF500,000 in three years time (i.e. 1st January 2012). Current interest rates are 10%
pa. The shares and the deferred consideration have not yet been recorded.

The following are the Statements of Financial Position of FR Ltd and TK Ltd at 31st December
2010:
FR.Ltd TK Ltd
RWF’000

RWF’000
ASSETS
NON-CURRENT ASSETS 5,500
Property, Plant and equipment 1,500
Investment in TK Ltd, at cost 1,000 -

CURRENT ASSETS
Inventory 550 100
Receivables 400 200
Cash 200 50
7,650 1,850
EQUITY AND LIABILITIES
CAPITAL AND RESERVES
Share Capital 2,000 500
Retained earnings 1,400 300
3,400 800
NON-CURRENT LIABILITIES 3,000 400
CURRENT LIABILITIES 1,250 650
7,650 1,850

The FR group values the Non-Controlling Interest using the fair value method. At the date of
acquisition, the fair value of the 20% Non-Controlling Interest was RWF380,000.

The consolidated goodwill has been impaired by one fifth of its value.

Prepare the consolidated statement of financial position at 31st December 2010.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 281

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SOLUTION
Step 1 Establish Group Structure

TK Ltd

Group
80% NCI
20%
TK Ltd is a subsidiary, having been acquired 2 years ago.

Step 2 Adjustments
(i) Record the issue of shares

RWF’000 RWF’000

Debit Investment in TK LTd (200,000 x RWF1.80) 360

Credit Share Capital (200,000 x RWF1) 200
Credit Share Premium 160

(ii) Record the deferred consideration

Debit Investment in TK Ltd 375
Credit Deferred Consideration 375

RWF500,000 discounted at 10% for 3 years is RWF375,000 (approximately)

(iii) Unwind the discount

375 x 10% 37.5

412.5 x 10% 41.3
Total finance cost to date 78.8 (say 79)
Debit Retained Earnings (F) 79
Credit Deferred consideration 79

Step 3 Calculate Goodwill

First, determine the net assets of the subsidiary:
At date of At date of
acquisition SFP
RWF’000 RWF’000
Share Capital 500 500
Retained Earnings 125 300

625 800

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 RWF’000
Cost of Investment (1,000+360+375) 1,735
Less:
Share of net assets acquired at acquisition
(625 x 80%) 500
Goodwill – Parents Share 1,235

Fair value of NCI at acquisition 380

NCI share of net assets at acq (625 x 20%) 125
Goodwill – NCI Share 255

Total Goodwill arising on acquisition: 1,235 + 255 = 1,490

Goodwill is impaired by 1/5th, i.e. 1,490 x 1/5th = 298

Debit Retained Earnings (FR Ltd) (298 x 80%) 238

Debit NCI (298 x 20%) 60

Credit Goodwill 298.0

Thus, Goodwill in the SFP will be 1,490 – 298 = 1,192

Step 4 Calculate NCI

Share of net assets at date of SFP (20% x RWF800) 160
Share of goodwill 255
Share of impairment (60)
355

Step 5 Calculate Consolidated Retained Earnings

FR Ltd.
Per SFP 1,400
Unwinding of discount 1,321
(79)

TK Ltd
Per SFP 300
At acquisition
Post Acquisition 140
125 1,461
175 x group share
x 80%

Less: Goodwill amortised (298 x 80%) (238)

Consolidated Retained Earnings 1,223

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Step 6 Prepare Consolidated Statement of Financial Position

FR GROUP
CONSOLIDATED STATEMENT OF FINANCIAL POSITION AT 31ST DECEMBER 2010

ASSETS
RWF’000
NON-CURRENT ASSETS

Goodwill 1,192
Property, plant and equipment (5,500 + 1,500) 7,000
8,192
CURRENT ASSETS
Inventory (550 + 100) 650
Receivables (400 + 200) 600
Cash (200 + 50) 250
9,692
EQUITY AND LIABILITIES
Ordinary share capital (2,000 + 200) 2,200
Share premium 160
Retained Earnings 1,223
3,583
Non-Controlling Interest 355
3,938
NON-CURRENT LIABILITIES (3,000 + 400) 3,400

CURRENT LIABILITIES (1,250 + 650) 1,900

Deferred Consideration (375 +79) 454
9,692

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CONSOLIDATED FINANCIAL STATEMENTS 2 – ADVANCED CONSOLIDAT-
ED STATEMENT OF FINANCIAL POSITION

Once the basic concept of consolidating accounts has been understood, the more complicated
adjustments can be introduced.

The adjustments involve a number of different scenarios, but a theme common to most of them
is that they involve amounts that have been paid or remain payable between companies in the
group.

B. DETERMINING THE FAIR VALUE OF NET ASSETS

When the parent company acquires the subsidiary company, the identifiable assets and liabilities
acquired must be accounted for at their fair values on preparation of the subsequent consolidated
financial statements (IFRS 3). This is to ensure that an accurate figure is calculated for goodwill
(as well as to ensure the purchase price paid is accurate).

IFRS 3 defines the fair value of an asset (and a liability) as being the amount for which an asset
could be exchanged, or a liability settled, between knowledgeable willing parties in an arm’s
length transaction.

The standard goes on to outline how the fair values of various assets and liabilities can be
determined and is summarised in the following table:

Category of Asset / Liability Fair Value

Land and Buildings Market Value
Plant & Equipment Market value.
If no evidence of market value exists, then:
Depreciated Replacement Cost
Intangibles Estimated value
Securities traded on active Current Market Value
market
Non-marketable securities Estimated Value
Receivables Present Value of amounts to be received. (do not
discount if short term)
Payables Present Value of amounts to be paid
(do not discount if short term)
Raw Materials Current Replacement Cost
Work-In-Progress Selling Price of finished goods minus the total of:
Costs to complete
Disposal costs
Reasonable profit allowance

Finished Goods Selling Price minus the total of:

Disposal costs
Reasonable profit allowance
Contingent liabilities Should be included in net assets acquired, if
their fair value can be measured reliably, even if
they would not normally be recognised

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In general, only assets and liabilities that existed at the date of acquisition can be included in the
calculation of goodwill.

Acquired intangible assets must always be recognised and measured. Unlike the previous IFRS
3, there is no exception where reliable measurement cannot be obtained.

If further evidence regarding the fair values of acquired assets and liabilities only becomes
available after acquisition (i.e. some asset or liability values were only estimated at acquisition),
the consolidated financial statements should be adjusted to reflect this additional evidence. But,
this adjustment can only be made if the new evidence becomes available within twelve months
after the acquisition.

If this is the case, the assets or liabilities should be adjusted to the new values, as if these new
values had been used from the date of acquisition.

If an asset is to be revalued upwards at the date of acquisition, from its carrying amount to its fair
value, then the following adjustment is made when preparing the consolidated accounts:

Debit Asset Account

Credit Revaluation Reserve (Fair Value adjustment) of Subsidiary at date of acquisition and at
the SFP date

With the amount of the increase. (If it is a decrease, reverse the above journal entry)

Example
P acquired 75% of the share capital of S, four years ago. At the date of acquisition, the fair value
of a machine
exceeded the book value by RWF10,000, in the books of S. S depreciates the machine at 20%
per annum, straight-line.
Solution
When preparing the consolidated accounts, the following journal adjustment will be carried out:
RWF RWF
Dr. Machine Account 10,000

Cr. Revaluation at acq and SFP 10,000

date

In addition, the depreciation will have to be accounted for. For group purposes, the depreciation
should be based on the fair value.

Thus RWF10,000 x 20% x 4 years = RWF80,000

For group purposes, this RWF8,000,000 will have to be charged. Thus:

RWF RWF
Dr Reserves (S) 80,000

Cr Asset Account 80,000

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(This is the shortest way of putting through the depreciation. The reserves of S fall by RWF80,000,
which is the effect that RWF80,000 extra depreciation would have. Likewise, the asset book
value will fall also).

C. INTER-COMPANY INVENTORY PROFIT

Companies in a group often trade with each other. If one company in the group sells goods to
another company in the group, at a profit, then a problem arises if the buyer has some or all of
those goods in stock at the Statement of Financial Position date.

The goods, shown in inventory, will contain an element of profit which from a group perspective,
has not been realised. Bearing in mind that the group accounts seek to present the members of
the group as if they were one single entity, this profit must be eliminated.

Thus the action necessary is:

• Calculate the profit on inter-company inventory

• Eliminate the profit. This can be done by:

• Dr Reserves of seller
• Cr Inventory
With the profit on inventory

Example
P acquired 75% of S four years ago. During the year, P sold goods to S for RWF10,000. This
included a mark- up of 25%. At the end of the year, S has one quarter of the goods remaining
in stock.

Solution
(a) Calculate profit.
The goods were sold for RWF10,000 including a mark-up of 25%. This means the profit on the
transaction was RWF2,000.

One quarter of the goods remains in stock, so one quarter of the profit remains also. Thus
RWF2,000 x ¼
= RWF500 must be eliminated.

(b) Eliminate the profit.

RWF RWF
Dr Reserves of P* 500
Cr Inventory 500
*P sold the goods and recorded the profit. Thus it is P’s reserves that are adjusted.

D. INTER-COMPANY PROFIT ON SALE OF A NON-CURRENT ASSET

This is similar to the previous situation. One company in the group sells a non-current asset to
another company in the group, at a profit. For the same reasons as above, this profit must be
eliminated (and thus the asset shown at its original cost to the group).

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 • Calculate the profit.
• Eliminate the profit. This can be done by:

• Dr Reserves of seller
• Cr Asset Account
With the profit

Example
P purchased 75% of S, four years ago. Two years ago, S sold a machine with a book value of
RWF20,000 to P
for RWF23,000.

P charges depreciation on its assets at 20% per annum, straight-line.

Solution
(a) Calculate the inter-group profit.
The profit made by S on the sale was RWF3,000. (b) Eliminate the profit

RWF RWF
Dr Reserves of S 3,000
Cr Machine Account 3,000

However, there is also the extra problem of depreciation. P on buying the asset, charges
depreciation on its cost to P (RWF23,000). But, for group purposes the asset should be
depreciated based on its original cost to the group (RWF20,000)

Thus, for group purposes, over the last two years, total extra depreciation charged by P on the
asset would be:

RWF3,000 x 20% x 2 years = RWF1,200

To rectify this for the consolidated accounts

RWF RWF
Dr Machine Account 1,200
Cr Reserves of P* 1,200

*P purchased the asset, so P charged the depreciation. This journal adjustment reverses the
extra depreciation charged.

E. INTER-COMPANY DEBTS
As the entities in the group are being presented as if they are just one single economic entity,
amounts owing between group companies must be eliminated for consolidation purposes.

The holding company and subsidiary are likely to trade with each other, which could lead to
inter-company debtors and creditors arising at the year end. Inter-company indebtedness
should be cancelled out when preparing the consolidated Statement of Financial Position.

288 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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Example:
Set out below are the respective Statement of Financial Positions of H Limited and S Limited.

Statement of Financial Position

H Ltd S Ltd
RWF RWF
Non Current Assets 700 300
Investment in Subsidiary 500 -
Inventories 240 220
Receivables 190 180
Bank 70 170
1,700 870

Ordinary Share Capital 1,000 500

(RWF1 shares)
Reserves 500 250
1,500 750
Payables 200 120
1,700 870

H Limited acquired 100% of S Limited several years ago when the reserves of S Limited were
Nil. At the year- end H Limited’s receivables figure includes RWF60 owing from S Limited. S
Limited’s payables figure includes RWF60 owing to H Limited.
Consolidated Statement of Financial Position H Ltd Group
RWF
Non Current Assets (700 + 300) 1,000
Inventories (240 + 220) 460
Receivables (190 + 180 - 60) 310
Bank (70 + 170) 240
2,010

Ordinary Share Capital 1,000

Reserves (500 + 250) 750
1,750
Payables (200 + 120 – 60) 260
2,010
Note:
The receivables and payables are reduced by RWF60, which is the inter-company
indebtedness.
Inter-company transactions include loans by the holding company to the subsidiary and vice
versa and current accounts maintained by the holding company and subsidiary.

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Example:
Set out below are the respective Statement of Financial Positions of H Limited and S Limited.

Statement of Financial
Position

H Ltd S Ltd
RWF RWF
Non Current Assets 700 900
Investment in Subsidiary 500 -
Loan to S Limited 300 -
Current Account 200 -
Other Current Assets 50 350
1,750 1,250

Ordinary Share Capital 1,000 500

(RWF1 shares)
Reserves 750 250
1,750 750
Loan from H Limited - 300
Current Account - 200
1,750 1,250

H Limited acquired 100% of S Limited several years ago when the reserves of S Limited were
Nil. H Limited made a loan of RWF300 to S Limited to help finance the expansion of S Limited.
H Limited and S Limited trade with each other and maintain a current account to identify their
indebtedness.
Consolidated Statement of Financial Position H Limited Group

RWF
Non Current Assets (700 + 900) 1,600

Current Assets (50 + 350) 400

2,000

Ordinary Share Capital 1,000

Reserves (750 + 250) 1,000
2,000

The loan by H Limited to S Limited cancels out against the loan in S Limited’s Statement of
Financial Position. Likewise the current account in H Limited cancels out against the current
account in S Limited. Occasionally the receivables/payables or the current accounts maintained
by the holding company and subsidiary company may not agree, the reason for this difference
will be due to either inventory in transit and/or cash in transit from one entity to another.

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Example:
Set out below are the respective Statement of Financial Positions of H Limited and S Limited.

Statement of Financial
Position

H Ltd S Ltd
RWF RWF
Non Current Assets 1,800 1,000
Investment in Subsidiary 500 -
Current Account 200 -
Inventory 300 270
Receivables 250 260
Bank 150 100
3,200 1,630

Ordinary Share Capital 2,000 500

Reserves 1,070 840
3,070 1,340
Current Account - 150
Payables 130 140
3,200 1,630

H Limited acquired 100% of S Limited for RWF500 several years ago when the latter had a
reserves balance of Nil. Inventory in transit from S Limited to H Limited at cost price amounted
to RWF20. Cash in transit from S Limited amounted to RWF30.

In this instance it is useful to:

• Open an inter-company account
• Insert the current account balances from the respective Statement of Financial Positions
• Increase (debit) inventory and bank in the consolidated Statement of Financial Position by the
amounts for inventory in transit and cash in transit
• Credit the inter-company account with the amounts for inventory and cash in transit thereby
reconciling the current accounts

Consolidated Statement of Financial Position H Limited Group

RWF
Non Current Assets (1,800 + 1,000) 2,800
Inventory (300 + 270 + 20) 590
Receivables (250 + 260) 510
Bank (150 + 100 + 30) 280
4,180
Ordinary Share Capital 2,000
Reserves (1,070 + 840) 1,910
3,910
Payables (130 + 140) 270
4,180

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Current Account - H Limited

Inter-Company Account

RWF RWF
Current Account - -

H Limited 200 Current Account - 150

S Limited
Inventory 20
Bank 30
200 200

F. PREFERENCE SHARES IN A SUBSIDIARY COMPANY

When establishing whether a parent-subsidiary situation exists, preference shares are generally
ignored as they usually do not carry voting rights. Therefore, the holders of these shares do
not participate in deciding the financial and operating policies of the company. (There are rare
exceptions to this rule).

However, the holders of preference shares are entitled to participate in the profits of a company
upon its winding up.

The parent, as well as purchasing ordinary (equity) shares, may also purchase preference
shares, though the relevant percentage holdings may be different. For example, P might own
75% of the equity shares of S, but only 30% of the preference shares.

In calculating the goodwill figure, the cost of preference shares is compared to their nominal
value. This will be done in the cost of control account.

The nominal value of the preference shares held by outside interests will be reflected in the Non-
Controlling
Interest account.

G. LOAN NOTES IN A SUBSIDIARY COMPANY

Loan notes/debentures/loan stock etc. do not affect the parent-subsidiary relationship either.

If the parent buys these loan notes, like preference shares, the difference between their cost and
nominal value will be included in the cost of control account in arriving at the overall goodwill
figure.

The balance of the loan notes not held by the parent, though held by outside interests, is not
included in the Non- Controlling Interest figure. Rather, it is shown separately as non-current
liabilities in the consolidated Statement of Financial Position.

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H. INTER-COMPANY DIVIDENDS

The treatment of inter-group dividends can be confusing. This is mainly because there are a
number of different possible situations.

IAS 10 Events After the Reporting Date allows dividends to be included as a liability in the
balance only if those dividends had been declared before the year-end. Declared means that the
dividends have been appropriately authorised and are no longer at the discretion of the entity.

So, in treating dividends payable in the question, make sure that they can be recognised in
the first place. There are two classes of dividends to be aware of when preparing consolidated
accounts:
• Dividends out of post-acquisition profits.
These are dividends paid or payable out of profits that have been earned since the date of
acquisition.
• Dividends out of pre-acquisition profits.
These are dividends paid or payable out of profits earned before the acquisition date. It is an
important distinction to make, as the accounting treatment of each is very different.

Dividends Out of Post Acquisition Profits

There are a number of possible situations in regard to such dividends:
• Dividends paid by the Subsidiary to the Parent
If the dividend has already been paid to the parent, then no further adjustment is required when
preparing the consolidated Statement of Financial Position.
• Dividends proposed by the Subsidiary and the Parent has taken account of this in its books
Here, because the parent has taken credit for its share, it is rather similar to the treatment of inter-
company debts. One company in the group owes money to another company in the group, in this
case a dividend.

Inter-company amounts must be cancelled for group purposes. To do this:

Dr Dividends Payable
Cr Dividends Receivable
With the inter-group amount

Example
P acquired 75% of S, four years ago. In the current year, the directors of S propose a dividend
of RWF80,000. The proposal is made prior to the year-end. P reflects the dividend receivable
in its books.

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Solution

Extracts from the Statements of Financial Position of P and S would show:

P S P S
RWF RWF RWF RWF
Dividends 60,000 - Dividends Payable - 80,000
Receivable*
*P owns 75% of the shares, so it will get 75% of the dividend i.e. RWF80,000 x 75% =
RWF60,000
Thus, the required journal entry would be:

RWF RWF
Dr Dividends Payable 60,000

Cr Dividends Receivable 60,000

In the “T” accounts, it would be represented as follows:

Dividends Receivable
RWF RWF

Balance b/d (P) 60,000 Dividends Payable 60,000

Dividends Payable
RWF RWF
Dividend Receivable 60,000 Balance b/d (S) 80,000

Balance c/d 20,000

The remaining balance of RWF20,000 dividends payable represents dividends payable to

outsiders and would be shown as a current liability in the consolidated Statement of Financial
Position.
(c) Dividends proposed by the subsidiary and the parent has not taken account of this in its books
In this case, the parent has not reflected the dividend due to it in its own books. The easiest
treatment is to bring the dividend receivable into the books of the Parent Company and then
cancel the inter company amount.

The procedure would be as follows:

Dr Dividends Receivable
Cr Reserves of Parent

With the amount of the inter-group dividend

Then:
Dr Dividends Payable
Cr Dividends Receivable
With the amount of the inter-group dividend

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Example
Same as before, except P does not reflect its share of the dividend in its books.

Solution
Extracts from the Statement of Financial Position of P and S would show:

P S P S
RWF RWF RWF RWF
Dividends Receivable - - Dividends Payable - 80,000
The required journal entries would be:

RWF RWF
Dr Dividends Receivable 60,000
Cr Reserves P 60,000

Being the parents share (75%) of the subsidiary’s dividend

Then:

RWF RWF
Dr Dividends Payable 60,000
Cr Dividends Receivable 60,000

Being the cancellation of the inter-group amount

The “T” accounts would show:

Dividends Payable 
RWF RWF
Dividends Receivable 60,000
Balance b/d (S) 80,000

Balance c/d * 20,000

Dividends Receivable

RWF RWF
Reserves (P) 60,000 Dividends Payable 60,000

*Again this balance would be shown as a current liability in the consolidated Statement of
Financial

Position.
Dividends out of Pre-Acquisition Profits
These are dividends paid out of the subsidiary’s reserves at the date of acquisition. The parent
company should
reduce the cost of its investment by the amount of the pre-acquisition dividend it receives.

Care should be taken to reduce the reserves of the subsidiary at the date of acquisition by the

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total dividend it receives. Goodwill is then calculated using this reduced cost of investment and
the subsidiary reserves after the dividend.

Thus, on receipt of such a dividend, the parent should:

Dr Bank
Cr Cost of investment in the subsidiary
With the parents share of the dividend

Example
H Limited acquired 80% of S Limited for RWF1,700 when the latter company’s reserves were
RWF1,000. Several months after the acquisition, S Limited paid a dividend of RWF150 out of
their RWF1,000 reserves. H
Limited credited its share of the dividend, 80% of RWF150, i.e. RWF120 and reduced the cost
of the investment from RWF1,700 to RWF1,700 - RWF120, i.e. RWF1,580. The Statements of
Financial Position of H Limited and S Limited are set out below several years after acquisition.

Statement of Financial Position

H Ltd S Ltd
RWF RWF
Non Current Assets 6,000 3,000
Investment in Subsidiary 1,580 -
Current Assets 3,420 2,000

11,000 5,000

Share Capital 5,000 500

Reserves 6,000 4,500
11,000 5,000
Calculation of Goodwill:
Cost of Investment in S 1,580

Less:
Share of net assets acquired:
Capital 500
Reserves (1,000 – 150) 850
1,350
Group share 80% 1,080
Goodwill 500

Assuming the group uses the proportion of net assets method for valuing NCI

Calculation of NCI:
20% x (500 + 4,500) = 1,000

Calculation of Consolidated Reserves: H

Per SFP 6,000

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 Per SFP 4,500
At acquisition 850 2,920
(1,000 – 150)
Post Acquisition 3,650 8,920
Group Share x
80%

Consolidated Statement of Financial Position H Limited Group

RWF
Non Current assets (6000 + 3,000) 9,000
Goodwill 500
Current Assets (3,420 + 2,000) 5,420
14,920

Share Capital 5,000

Reserves 8,920
13,920
Non-Controlling Interest 1,000
14,920
Note:
Pre-acquisition dividends as with pre-acquisition reserves do not affect the calculation of the
Non-Controlling
Interest.

Often in examination questions, the holding company may have credited its share of the pre-
acquisition dividend to its reserves. In this case, a correcting journal entry should be made in
preparing the consolidated Statement of Financial Position, i.e.

Dr H Limited reserves
Cr Investment in Subsidiary
Thereby effectively reducing the cost of the investment

I. ACQUISITIONS OF SUBSIDIARY DURING THE YEAR

When the parent company acquires the subsidiary during a year, it may be necessary to
calculate the revenue reserves at that date in order to determine goodwill.

Example
H Limited acquired 80% of S Limited on 30th June 20X4 for RWF350. The revenue reserves of
S Limited at 1st January 20X4 were RWF100. Set out below are the respective Statements of
Financial Position of H Limited and S Limited.

Statement of Financial Position

H Ltd S Ltd
RWF RWF
Non Current Assets 600 280
Investment in Subsidiary 350 -

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 Current Assets 250 70
1,200 350

Share Capital 500 200

Revenue Reserves 700 150
1,200 350
The profits of S Limited were RWF50 for the year and are deemed to have accrued evenly
throughout the year.

Calculation of Goodwill:
Cost of Investment 350
Less:
Share of net assets acquired at acquisition
Capital 200
Reserves (see below) 125
325
x group share x 80% 260
Goodwill 90
Reserves at acquisition:
RWF Reserves at 1st January 20X4 100
Profits accrued to 30th June 20X4 RWF50 x 6/12 25
125

Consolidated Statement of Financial Position H Limited Group

RWF
Non Current Assets (600 + 280) 880
Goodwill 90
Current Assets (250 + 70) 320
1,290
Share Capital 500
Reserves 700 + (150 – 125 x 80%) 720
1,220
Non-Controlling Interest (350 x 20%) 70
1,290
Before we look at a comprehensive example requiring the preparation of a consolidated Statement
of Financial Position, remember the six steps to be taken in solving the question.
1. Establish Group Structure
Which company is the acquirer and to what extent do they control the acquiree? When was the
subsidiary acquired?
Group structure is established by reference to the number of ordinary shares held by the parent
company
(usually in questions, anyway. See alternative ways of establishing control at the beginning of this
area).

2. Determine the adjustments to be made and the journal entries to effect these adjustments.

3. Calculate Goodwill arising on acquisition

Watch for the method of measuring NCI and the impact that this may have on the goodwill figure too

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 The goodwill calculation, at its most basic, measures what was paid for the investment and what
was acquired in return.
What was paid is found in P’s Statement of Financial Position in its investment in subsidiary
(subject to any adjustments e.g. pre-acquisition dividends, deferred consideration, contingent
consideration).
What was received is its share of the capital and reserves (i.e.net assets) that existed at the date
of acquisition.
The difference between these amounts will be either positive or negative goodwill.

Examine the question to see if goodwill has become impaired. If it has, reduce goodwill and set
it against consolidated reserves.

4. Calculate Non-Controlling Interest

Give the Non-Controlling Interest their share of all capital and all reserves that exist at the Statement
of Financial Position date.
This figure will appear in the consolidated Statement of Financial Position

5. Calculate Consolidated Reserves

6. Prepare the consolidated Statement of Financial Position.

Example
HDY acquired 4 million of SBL’s equity shares paying RWF4.50 each and RWF500,000 (at
par) of its 10% redeemable preference shares on 1st April 20X5. At this date the accumulated
retained earnings of SBL were RWF8,400,000.
Reproduced below are the draft Statements of Financial Position of the two companies at 31st
March 20X8.

Assets
Non Current Assets
HDY SBL
RWF’000 RWF’000 RWF’000 RWF’000
Property, plant and equipment 42,450 22,220
Investment in SBL:
 Equity 18,000 -

Extracts from the unadjusted Statement of Comprehensive Income of SBL for the year to 31st
March 20X8 are:
RWF’000

Profit before interest and tax 5,400

Interest paid
10% Loan notes (400)
Preference dividend (200)
4,800
Income taxes (1,600)
Retained profit for period 3,200

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The following information is relevant:
(1) Included in the property, plant and equipment of SBL is a large area of development land at its
cost of RWF5 million. Its fair value at the date SBL was acquired was RWF7 million and by 31st
March 20X8 this had risen to RWF8.5 million. The group valuation policy for development land is
that it should be carried at fair value and not depreciated.

(2) Also at the date that SBL was acquired, its property, plant and equipment included plant that had
a fair value of RWF4 million in excess of its carrying value. This plant had a remaining life of 5
years. The group calculates depreciation on a straight-line basis. The fair value of SBL’s other
net assets approximated to their carrying values.

(3) During the year SBL sold goods to HDY for RWF1.8 million. SBL adds a 20% mark-up on cost
to all its sales. Goods with a transfer price of RWF450,000 were included in HDY’s inventory at
31st March
20X8.
The balance on the current accounts of the parent and subsidiary was RWF240,000 on 31st March
20X8.

REQUIREMENT

(a) Prepare the Consolidated Statement of Financial Position of HDY at 31st March 20X8, assuming
the group uses the proportion of net assets method for measuring Non-Controlling Interest.
Goodwill is not impaired.

(b) Calculate the Non-Controlling Interest in the adjusted profit of Sibling for the year to 31st March
20X8.
1. Establish Group Structure
SBL Preference Shares
Group (4m/5m) 80% 25%
Non-Controlling Interest 20% 75%

2. Journal Adjustments

(a) Revaluation of Property Plant and Equipment

There are two increases to consider:
From RWF5 million to RWF7 million at acquisition
From RWF7 million to RWF8.5 million in the post acquisition period

(i) The first increase occurs at acquisition.

RWF’000 RWF’000
Dr Property, Plant and Equipment 2,000
Cr Revaluation reserve at acquisition and at SFP date 2,000

(ii) The second increase occurs in the post-acquisition period

RWF’000 RWF’000
Dr Property, Plant and Equipment 1,500
Cr Revaluation Reserve 1,500

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(b) Revaluation of Plant at Acquisition

RWF’000 RWF’000
Dr Property, Plant and Equipment 4,000
Cr. Revaluation reserve at acquisition and at SFP date 4,000

Also, the depreciation implication must be considered. Additional depreciation is:

RWF4m
= RWF800,000 pa x 3 years * = RWF2,400,000
5 years

Therefore:

RWF’000 RWF’000
Dr Reserves SBL 2,400
Cr Property, Plant and Equipment 2,400
*Acquisition occurred three years ago.

(c) Inter-Company Profit on Inventory

SBL sold goods to HDY for RWF1.8 million

20% mark-up on cost
RWF450,000 goods remain in stock

(i) Calculate profit on inventory

RWF450,000 = 120%
RWF375,000 = 100%
RWF75,000 = profit

(ii) Cancel profit

RWF’000 RWF’000
Dr Reserves SBL (seller) 75
Cr Inventory 75
(d) Inter-Company Debts
Balance on current accounts is RWF240,000. Cancel it.

RWF’000 RWF’000
Dr Payables 240
Cr Payables 240

3. Calculate Goodwill

First, determine net assets

of SBL:
At date of At date of
acquisition SFP
‘000 ‘000
capital 5,000 5,000

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 retained earnings 8,400 15,280
fair value adjustment: land 2,000 2,000
plant 4,000 4,000
Post-Acq revaluation: land - 1,500
depreciation adjustment - (2,400)
inventory adjustment - (75)

19,400 25,305

Cost of investment 18,000

Less:
Share of net assets (19,400 x (15,520)
acquired 80%)
GOODWILL ON ACQUISITION 2,480

The redeemable preference shares were acquired at par. No premium was paid, thus no
goodwill implication.

4. Calculate NCI

20% x 25,305 = 5,061

Note:
Because the preference capital is redeemable, the portion belonging to the Non-Controlling
Interest must be shown as a liability, in accordance with IAS 32.

5. Calculate Consolidated Reserves:

Retained earnings
HDY
Per SFP 52,640

SBL
Per SFP 15,280
Depreciation (2,400)
Inventory profit (75)
12,805
At Acquisition 8,400
Post acquisition 4,405
Group Share x 80% 3,524
Consolidated Retained Earnings 56,164

Revaluation Reserve
SBL
Per SFP -
Revaluation 1,500
1,500
At acquisition -
Post acquisition 1,500
Group Share x 80% 1,200

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6. Prepare Statement of Financial Position
(a)

RWF’000 RWF’000
Assets
Non Current Assets
Property, plant and equipment (W1) 69,770
Consolidated goodwill (see cost of control 2,480 72,250
account)

Current assets
Inventories (9,850 + 6,590 – 75) 16,365
Trade receivables (11,420 + 3,830 – 240) 15,010
Cash and bank 490 31,865
Total assets 104,115

Equity and liabilities

Equity attributable to equity holders of the
parent
Equity capital 10,000
Reserves:
Revaluation 1,200
Retained earnings 56,164 67,364
Non-Controlling Interest
5,061

72,425
Non-current liabilities
10% Loan notes (12,000 + 4,000) 16,000

10% Redeemable preference capital (NCI 1,500 17,500

share)
Current liabilities
Trade payables (5,600 + 3,810 – 240) 9,170
Operating overdraft 570
Provision for income taxes 4,450
(2,470 + 1,980)
14,190
Total equity and liabilities 104,115

Workings (Note all figures in RWF’000)

(W1) Property, plant and equipment
Balance from question - HDY 42,450
- SBL 22,220

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 Revaluation of land 3,500
Revaluation of plant 4,000

Deduct additional depreciation (20% x 4,000 for three years) (2,400)

69,770

(b) Non-Controlling Interest in adjusted profit of SBL

RWF’000
Profit before tax per question 4,800
Additional depreciation (800)
Unrealised profit on inventories (75)
Adjusted profit before tax 3,925
Taxation (1,600)
Adjusted profit after tax 2,325
Thus the Non-Controlling Interest is: RWF2,325,000 x 20% =
RWF465,000

Example
Pink ltd purchased 80% of the shares in Silver Ltd on 1st April 2007 in a 1 for 2 share exchange.
Pink ltd issued
5 of its own shares for every 2 it acquired in Silver. The market value of Pink ltd shares on 1st
April 2007 was RWF3 each. The share issue has not yet been recorded in Pink ltd. The retained
earnings of Silver at acquisition were RWF430,000.

The summarised statements of financial position of both companies are:

Statement of Financial Position at 31st March 2010

PINK SILVER
RWF’000 RWF’000
RWF’000 RWF’000
Assets
Non Current Assets
Property, Plant and Equipment 620 660
Investments 20 10
640 670
Current Assets
Inventory 240 280
Receivables 170 210
Bank 20 40
430 530
1,070 1,200

150
Equity and liabilities
Capital and reserves
Ordinary shares of RWF1 each 400

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 Retained Earnings 450 700
850 850
Non Current Liabilities
7% Debentures - 150
Current Liabilities
Trade payables 170 155
Taxation 50 45
220 200
1,070 1,200

You are provided with the following additional information:

(1) Silver had plant in its financial statements at the date of acquisition with a carrying value of
RWF100,000 but with fair value of RWF120,000. The plant had a remaining life of 10 years at
acquisition.

(2) Goodwill is to be measured in full. The fair value of the non-controlling interests at the date
of acquisition was RWF250,000. Goodwill is to be impaired by 30% at the reporting date.

(3) At the start of the current financial year, Pink transferred a machine to Silver in exchange
for RWF15,000. The asset had a remaining economic life of 3 years at the date of transfer. It had
a carrying value of RWF12,000 in the books of Pink at the date of transfer.

(4) Silver sold goods to Pink for RWF60,000, including a mark-up of 20%. At the year end, Pink had
40% of these goods remaining in inventory.

(5) At the year end, Silver’s books showed a receivables balance of RWF6,000 as being due
from Pink. This amount disagreed with the payables balance of RWF1,000 in Pink’s books. The
difference is caused by a payment sent to Silver shortly before the year end, which Silver had not
received prior to cut-off.

Prepare the consolidated Statement of Financial Position for the year ended 31st March 2010.

All workings in RWF’000

Step 1 Establish Group Structure

SILVER
Group 80%
NCI 20%
Silver is a subsidiary acquired 3 years ago.

Step 2 Adjustments

(i) Record the purchase of Silver

Silver has 150,000 shares

Pink acquired 80%
Thus:
Pink acquired 120,000

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 shares. Terms of Share Exchange 5 for 2
Shares issued by Pink (120,000/2) x 5 = 300,000 shares

Fair Value of Shares RWF3 per share

Total Consideration 300,000 shares x RWF3 = RWF900,000

Debit Investment in Silver 900,000

Credit Share capital Pink 300,000
Credit Share premium Pink 600,000
(ii) Revaluation at acquisition

Debit PPE 20,000

Credit Revaluation at acq. 20,000

date and date of SFP

Depreciation
20,000 = 2,000 p.a.
10 yrs x 3 years
6,000

Debit Retained Reserves (S) 6,000

Credit PPE 6,000

(iii) Sale of Non-Current Asset at a profit

Debit Retained Reserves (P) 3,000
Credit PPE 3,000

Depreciation
3,000 = 1,000 p.a.
3 years x 1 year

1,000

Debit PPE 1,000

Credit Retained Earnings (S) 1,000

(iv) Inter company profit on inventory

60,000 = cost + 20% (or 120% of cost)
50,000 = cost
10,000 = profit x 40%
4,000

Debit Retained Earnings (S) 4,000

Credit Inventory 4,000
(v) Inter company debt

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 Step 3 Calculate Goodwill
(Fair Value Method)
First, determine net assets of Silver:
At date of At date of
acquisition SFP
RWF‘000 RWF‘000
Capital 150 150
Retained earnings 430 700
Fair value adjustment: PPE 20 20
Depreciation adjustment: PPE - (6)
Depreciation adjustment - 1
Inventory adjustment - (4)

600 861

Cost of investment 900

Less:
Share of net assets acquired (600 x 80%) (480)

Goodwill on Acquisition – PARENTS SHARE 420

Fair Value of NCI at acquisition 250

Less:
NCI share of Net Assets at acquisition (600 x 20%) (120)

Goodwill on Acquisition – NCI SHARE 130

Total Goodwill = 420 + 130

= 550

Goodwill impaired by 30%, i.e. 550 x 30% = 165

Debit Retained Earnings (Pink) 132

Debit NCI 33
Credit Goodwill 165

Goodwill to be included in Consolidated Statement of Financial Position = 550 – 165 = 385

Step 4 Calculate NCI

Share of Net Assets at SFP (20% x 861) = 172.2

Share of goodwill = 130.0

Goodwill (Amortised) = ( 33.0)
269.2

Step 5 Calculate Consolidated Reserves

The consolidated reserves will be the reserves of the Parent Company’s (as adjusted for
consolidation purposes)
plus the group share of the post acquisition reserves of the Subsidiary (as adjusted for

CPA EXAMINATION I1.2 FINANCIAL REPORTING 307

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consolidation purposes).

PINK
Per SFP 450
Profit on sale of asset ( 3)
Goodwill impaired (132)
315.0
SILVER
Per SFP 700

FV adjustment 20

Depreciation adjustment (6)

Depreciation adjustment 1

Inventory adjustment (4)

711
At Acquisition (430 + 20) 450
Post Acquisition 261
Group share 80%
208.8

Consolidated reserves 523.8

Step 6 Prepare the Consolidated Statement of Financial Position

Pink Group
Consolidated Statement of Financial Position at 31st March 2010

PINK
RWF’000 RWF’000

Assets
Non Current Assets
Property, Plant and Equipment (620+660+20-6-3+1) 1,292
Goodwill 385
Investments (20+10) 30 1,707
Current Assets
Inventory (240+280-4) 516
Receivables (170+210-5-1) 374
Bank (20+40+5) 65 955
2,662

Equity and liabilities

Capital and reserves
Ordinary shares of RWF1 each (400+300) 700
Share Premium 600

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 Retained Earnings 523.8 1, 823.8
Non-Controlling Interest 269.2 2,093

Non Current Liabilities

7% Debentures 150
Current Liabilities
Trade payables (170+155-1) 324
Taxation (50+45) 95
419

CONSOLIDATED FINANCIAL STATEMENTS 3 – ASSOCIATES AND JOINT

VENTURES INVESTMENTS IN ASSOCIATES AND INTERESTS IN JOINT
VENTURES

Associates
Sometimes the investment in another entity is not enough to give it control, but such is the
amount of voting
power acquired that the investor exercises significant influence over the investee.

In this case, the entity in which such an investment is held is called an “associate” company.

Thus, the associate is an entity over which the investor has significant influence and that is
neither a subsidiary nor an interest in a joint venture.

Significant influence is the power to participate in the financial and operating policy decisions
of the investee but is not control or joint control over those policies. The standard goes on to
state that if the investor has 20% or more of the voting power of the investee, then there is a
presumption of participating interest.

A shareholding of less than 20% does not give significant influence, unless such influence can
be clearly demonstrated.

However, an important point to understand is that, though a shareholding of between 20% and
50% will normally constitute an investment in an associate, the investor must actually exercise
its significant influence.

This is usually evidenced by:

• Representation on the board of directors
• Participation in policy making processes
• Material transactions between parties
• Interchange on managerial personnel
• Provision of essential technical information

B. EQUITY METHOD OF ACCOUNTING

Associates are accounted for using the equity method of accounting. This is a method whereby
the investment is initially recognised at cost and adjusted thereafter for the post-acquisition
change in the investor’s share of net assets in the investee.

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In the Statement of Comprehensive Income, the profit or loss of the investee is included in the
profit or loss of the investee.
The investment in an associate must be accounted for using the equity method, except in the
following circumstances:

• The investment is classified as held for sale in accordance with IFRS 5.

• If a parent also has an investment in an associate, but that parent is itself a subsidiary, then it
does not have to present consolidated financial statements.
• Similar exemptions apply to IAS 27, mentioned in the previous chapters.

Use of the equity method must cease if the investor loses significant influence over an
associate.
Differing Dates
When applying the equity method, the associate company’s most recent financial statements are
used. When the
accounting dates differ, the associate should produce financial statements at the same date of
the investor. Where this is impracticable, the financial statements of the different date may be
used, but subject to adjustment for significant events and transactions.

Differing Accounting Policies

If the associate uses different accounting policies from the investor, adjustments must be made
to bring the
associates policies into line with the investors, when the equity method is being applied.

C. DISCLOSURE REQUIREMENTS
The following must be disclosed in respect of an associate:

• Fair value of investments in associates for which there are published price quotations
• Summarised financial information of associates, including aggregated amounts of assets,
liabilities, revenues and profit or loss
• Reasons explaining the existence or otherwise of significant influence
• Reporting date of associate if different to investor and reasons for the difference
• Nature and extent of any significant restrictions on the ability of the associates to transfer funds
to the investor
• Unrecognised share of losses of an associate, both for the period and cumulatively, if an investor
has discontinued recognition of its share of losses of an associate
• The fact that an associate is not accounted for using the equity method, together with summarised
financial information of such associates, including total assets, total liabilities, revenues and
profit or loss
• The investors share of contingent liabilities of an associate incurred jointly with other investors
and those contingent liabilities that arise because the investor is severally liable for all or part of
the liabilities of the associate

Investments in associates accounted for using the equity method must be classified as non-
current assets. The investor’s share of the profit or loss of the associates, and the carrying
amount of the investment, must be disclosed separately in the accounts.

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D. MECHANICS AND TECHNIQUES
None of the individual assets and liabilities of the associate are consolidated with those of the
parent and subsidiaries.

Under equity accounting, the investment in an associate is carried to the consolidated balance
sheet at a valuation. This valuation is calculated as:

Original cost of investment

+ group share of post acquisition profits of associate
(or – group share of post acquisition losses of associate)

To achieve this, the journal entry required will be:

Dr Investment in Associate
Cr Reserves of Parent
With the group share of post-acquisition profits of associate

In addition, the goodwill arising on acquisition of the shares in the investment must be calculated.
This goodwill is not separately shown; rather it is included in the cost of the investment.

However, if the goodwill becomes impaired, this will reduce the value of the investment.

Therefore:
Dr Reserves of Parent
Cr Investment in Associate

With the amount of goodwill impaired

Calculating the goodwill is done as follows:

RWF RWF
Cost X
Less: Share of Net Assets at Acquisition
Investors share of share capital X
Investors share of share premium X
Investors share of reserves X
(X)
Goodwill X

Note: If the question mentions nothing about impairment, there is no need to calculate goodwill.

Example
P acquired 25% of the ordinary share capital of A for RWF640,000 on 31st December 20X2 when
the retained earnings of A stood at RWF720,000. P appointed two directors to the board of A and
the investment is regarded as long-term. Both companies prepare their financial statements to
31st December each year. The summarised balance sheet of A on 31st December 20X4 is as
follows:
RWF’000
Sundry assets 2,390
Capital and reserves
Share capital 800

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 Share premium 450
Retained earnings 1,140
2,390

A has made no new issues of shares nor has there been any movement in the share premium
account since P
acquired its holding.

Show at what amount the investment in A will be shown in the consolidated balance sheet of P
as on 31st
December 20X4.
Solution
This figure is calculated as:
RWF
Cost 640,000
Share of post-acquisition profits (25% x (1,140 – 720)) 105,000
745,000
In a “T” account it would look like this (in investor’s accounts)

Investment in Associate Account

Balance b/d (cost) 640,000

Reserves P 105,000 Balance c/d 745,000

745,000 745,000
Balance b/d 745,000

Alternatively, the figure could be calculated as follows:

Investment in Associate
RWF
RWF2,390,000 x 25% 597,500
Add Goodwill (see below) 147,500
745,000
Goodwill Calculation:

RWF RWF
Cost of investment 640,000
Less: Share of net assets at acquisition
Share capital (25% x 800,000) 200,000
Share premium (25% x 450,000) 112,500
(25% x 720,000) 180,000
(492,500)
Goodwill 147,500
Note: The first method is generally easier

E. TRANSACTIONS BETWEEN GROUP AND ASSOCIATE

Inter-Company Sales

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An adjustment is only required in the case of sales between the associate and the group if
inventories remain at
the balance sheet date as a result of the trading.

Thus:
• Calculate the profit on inventory
• Calculate the group share of the profit
• Cancel the group share of profit. This is done as follows:

• Dr Reserves of Parent
• Cr Investment in Associate
With the group share of profit on inventory
(Note: If the inventory lies with the parent, credit inventory instead of investment in associate)

Inter-Company Debts
Because the associate company is not consolidated, inter-company loans (between the
investor and associate)
will not be cancelled out.

Loans to and from associates and parents are not netted off. Long-term loans may appear,
sometimes, in the same section as investments in associates, though this is rarely done.

Example
The summarised balance sheets of BCP, TNL and RSH as at 31st March 20X7 are as follows:

BCP TNL RSH

RWF’000 RWF’000 RWF’000
Non-current assets:
Property, Plant and Equipment 3,820 4,425 500
Development expenditure - 200 -
Investments 1,600 - -
5,420 4,625 500
Current assets:
Inventory 2,740 1,280 250
Receivables 1,960 980 164
Cash at bank 1,260 - 86
5,960 2,260 500
Total assets 11,380 6,885 1,000

Equity:
Ordinary shares of .25 each 4,000 500 200
Reserves:
Share premium 800 125
Retained earnings at 31st March 2,300 380 450
20X6
Retained for year 1,760 400 150
8,860 1,405 800
Current liabilities:
Trade payables 2,120 3,070 142

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 Bank overdraft - 2,260 -
Taxation 400 150 58
2,520 5,480 200
Total equity and liabilities 11,380 6,885 1,000

The following information is

relevant:
(i) Investments
BCP acquired 1.6 million shares in TNL on 1st April 20X6 paying .75rwf per share. On 1st
October 20X6
BCP acquired 40% of the share capital of RSH for RWF400,000.
(ii) Group Accounting Policies
Development expenditure
Development expenditure is to be written off as incurred. The development expenditure in
the balance sheet of TNL relates to a project that was commenced on 1st April 20X5. At the
date of acquisition the value of the capitalised expenditure was RWF80,000. No development
expenditure of TNL has yet been depreciated.

(iii) Intra-Group Trading

The inventory of BCP includes goods at a transfer price of RWF200,000 purchased from TNL
after the acquisition. The inventory of RSH includes goods at a transfer price of RWF125,000
purchased from BCP. All transfers were at cost plus 25%.

The receivables of BCP include an amount owing from TNL of RWF250,000. This does
not agree with the corresponding amount in the books of TNL due to a cash payment of
RWF50,000 made on 29th March 20X7 which had not been received by BCL at the year end.

(iv) Share Premium

The share premium account of TNL arose prior to the acquisition
by BCP.

Required
A consolidated statement of financial position of the BCP Group as at 31st March 20X7, using
the proportion of net assets method to value NCI.

1. Establish group structure

TNL RSH
Group 80% 40%
Non-Controlling 20% 60%
Interest
Thus, TNL is a subsidiary, acquired at the start of RSH is an associate, acquired
the year. year. during the

2. Carry out journal adjustments (all figures in

RWF’000)
(a) Treat associate company

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 RWF’000
RWF’000
Dr Investment in RSH 30
Cr Reserves BCP 30

Being the group share of post-acquisition reserves i.e. 40% x (150 x 6/12)
No mention is made of any goodwill being impaired. Therefore there is no need to calculate
goodwill of associate in this question.

(b) Accounting policies

The subsidiary TNL adopts a different accounting policy to the parent in relation to development
expenditure. For consolidation purposes, TNL’s policy must be changed in order to bring the
subsidiary into line with the group. Thus, all of TNL’s development expenditure must be written
off.
But of the RWF200,000 capitalised, RWF80,000 was spent in the pre-acquisition period.
When writing off the amount, part of the write-off will affect the pre-acquisition profits and part of
the write-off will affect the post acquisition profits.

Firstly,

RWF’000 RWF’000
Dr Reserves TNL 200
Cr Development Expenditure 200

Secondly,
When calculating goodwill later in the cost of control account, remember that the reserves of
TNL
at the date of acquisition fall RWF80,000 from RWF380,000 to RWF300,000.

(c) Intra-group trading

TNL sold goods to BCP. BCP sold goods to RSH. Firstly, TNL sales to BCP
RWF200,000 remains in inventory. This includes a mark-up of 25%.

RWF200,000 = 125% (of cost)

RWF160,000 = 100% (of cost)
RWF40,000 = 25% (profit)

RWF’000 RWF’000
Dr Reserves TNL (seller) 40
Cr Inventory 40

Being the profit contained in inventory

Secondly,
BCP sold goods to RSH

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 (i) Calculate profit
RWF125,000 = 125% (of cost)
RWF100,000 = 100% (of cost)

RWF25,000 = 25% (profit)

(ii) Calculate group share of the profit

RWF25,000 x 40% = RWF10,000
(iii) Eliminate the profit

RWF’000 RWF’000
Dr Reserves of BCP 10
Cr Investment in RSH 10

Being the group share of profit on inventory

Note the difference in treating inter-company sales with subsidiaries

and associates.

(d) Inter-company balances

Cash in Transit
RWF’000
RWF’000

Dr Cash 50
Cr Receivables 50
Being the cash in transit
Then
RWF’000
Dr Payables 200 RWF’000
Cr Receivables 200

Being the agreed inter-company debt

3. Calculate Goodwill

First, determine the net assets of TNL:

At At
Acquisition Date SFP Date
RWF’000 RWF’000
Share Capital 500 500
Share Premium 125 125
Retained Earnings 380 780
Development Exp. (80) (200)
Inventory profit - (40)
925 1,165

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 Cost of Investment 1,200
Less
Share of net assets acquired (80% x 925) 740
Goodwill 460

No impairment of Goodwill in the question.

4. Calculate Non-Controlling Interest

20% x 1,165 = 233

5. Calculate Consolidated Retained Earnings

BCP
Per SFP 4,060
Profit on inventory (10)
Investment in associate 30

TNL
Per SFP 780
Profit on inventory (40)
Development Expenditure (200)
540
At Acquisition (380 – 80) 300
Post Acquisition 240
X group share x 80% 4,080
192
4,272

6. Prepare Consolidated SFP

BCP Group
Consolidated Statement of Financial Position as at 31st March 20X7
RWF’000 RWF’000

Non current assets:

Property, Plant & Equipment (3,820 + 4,425) 8,245

Goodwill 460
Investment in associate (Note 1) 420
9,125
Current assets:
Inventory (2,740 + 1,280 – 40) 3,980
Receivables (1,960 + 980 – 250) 2,690
Bank (1,260 + 50 cash in transit) 1,310

7,980

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 Total assets 17,105

Equity attributable to equity holders of the

parent: 4,000
Ordinary shares of 25 each
Reserves:
Share premium 800
Retained earnings 4,272

5,072
9,072
Non-Controlling Interest 233

Current liabilities: 9,305

Trade payables (2,120 + 3,070 – 200) 4,990

Bank overdraft 2,260
Taxation (400 + 150) 550
7,800
Total equity and liabilities 17,105

Note 1:
Investment in associated company
RWF’000
Share of net assets [(800 x 40%) – 10 310
inventory]
Goodwill 110
420
Notice in the balance sheet above, there is only one figure concerning the investment in the
associate. The individual assets and liabilities of the associate company are not included in the
group accounts. BCP does not control RSH.

F. INTERESTS IN JOINT VENTURES

IAS 31 outlines the accounting treatment necessary in dealing with joint ventures.

A joint venture is a contractual arrangement whereby two or more parties undertake an economic
activity that is subject to joint control. (Note that the term joint venture can also refer to an entity
that is jointly controlled by other entities).

Joint control is the contractually agreed sharing of control over an economic activity and it exists
only when the strategic financial and operating decisions relating to the activity require the
unanimous consent of the parties sharing control. (These parties are known as the venturers).

The contract therefore becomes a very important factor in a joint venture. The contract may take
a variety of forms e.g. a contract between the venturers, the minutes of discussions between
venturers or writing an arrangement into the articles of the joint venture.

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However, it is usually in writing and deals with such matters as:

• The activity, duration and reporting obligations of the joint venture

• The appointment of the board of directors of the joint venture
• The voting rights of the venturers
• Capital contributions of the venturers
• Profit sharing arrangements

The contractual arrangement must ensure that no single venturer is in a position to control the
activity on their own. Duties may be delegated to different venturers but if one has the power to
govern the financial and operating policies of the economic activity, then the venture becomes a
subsidiary and not a joint venture.
Types of Joint Ventures
There are three different types of joint venture

• Jointly controlled operations

• Jointly controlled assets
• Jointly controlled entities

Jointly Controlled Operations

In this joint venture, the venturers use their own assets and resources rather than establishing
a corporation,
partnership or other entity. Each venturer uses its own property, plant and equipment and carries
its own inventories. It also incurs its own expenses and liabilities and raises its own finance.
The activities of the joint venture might be carried out by the venturer’s employees alongside the
venturer’s other, similar activities.

The agreement between the venturers usually indicates how the revenue and any expenses
incurred in common are to be shared out.
An example would be where two venturers, X and Y, combine their resources and expertise to
build a new rocket. Different parts of the manufacturing process are carried out by each. Each
incurs its own cost and share the revenue, as agreed by contract.

Each venturer should recognise in its financial statements:

• The assets that it controls and the liability that it incurs; and
• The expenses that it incurs and the share of income that it earns from the joint venture

Separate accounting records for the joint venture might not be kept. But the venturers might
prepare management accounts in order to assess performance.

Jointly Controlled Assets

This is where the joint venturers jointly control (and often jointly own) one or more assets which
are dedicated to the purposes of the joint venture.

Each venturer takes a share of the output from the assets and each bears an agreed share of
the expenses incurred.

Such a joint venture is often used in the oil, gas and mineral extraction industries. For example
a number of oil companies may jointly own a pipeline. Each uses it to transport their own oil and
each pays an agreed proportion of the expenses.
CPA EXAMINATION I1.2 FINANCIAL REPORTING 319
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Each venturer should recognise in its financial statements:

• Its share of the jointly controlled asset, classified by nature

• Any liabilities it has incurred
• Its share of liabilities jointly incurred with other venturers
• Income from the sale or use of the output of the assets, together with expenses incurred

Accounting records may be limited in the case of jointly controlled assets, perhaps merely
recording common expenses.

Jointly Controlled Entity

This is a joint venture which establishes a corporation, partnership or other entity in which each
venturer has an
interest. In essence, it operates like other entities, but the venturers exercise joint control over
its activities.

The jointly controlled entity has its own assets, liabilities, income and expenses. Each venturer
is entitled to a share of the profits of the joint venture.
The jointly controlled entity maintains its own records and prepares its own financial
statements. Each venturer contributes cash and/or other resources which are included in the
records of the venturer as an investment in a joint venture.

In the preparation of consolidated financial statements, IAS 31 recognises two methods that
are acceptable:

• Proportionate (proportional) Consolidation

• The Equity Method

The equity method approach treats the joint venture in the same way as an associate, i.e. the
investment in the joint venture is increased by the group share of the post acquisition profits of
the joint venture.

Proportionate Consolidation
This is a method of accounting whereby a venturer’s share of each of the assets, liabilities,
income and expenses
of a jointly controlled entity is combined, line by line, with similar items in the venturer’s financial
statements or reported as separate line items in the venturer’s financial statements.
Applying this method means that the balance sheet of the venturer includes its share of the
assets that it jointly controls and its share of the liabilities it is jointly responsible for.

The Statement of Comprehensive Income of the venturer will include its share of the income and
expenses.

Exceptions to Proportionate Consolidation and Equity Method

Interests in jointly controlled entities that are classified as held for sale must be accounted for in
accordance with IFRS 5.

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G. DISCLOSURE
A venturer must disclose the aggregate of the following contingent liabilities, unless probability
of loss is remote, separately from the amount of other contingent liabilities:

• Any contingent liabilities the venturer has incurred in relation to its interests in joint ventures,
and its share of contingent liabilities incurred jointly with other venturers.
• Its share of the contingent liabilities of the joint ventures themselves for which it is
contingently liable.
• Those contingent liabilities arising because the venturer is contingently liable for the liabilities
of other venturers in the joint venture.

A venturer must disclose commitments in respect of the joint venture separately to other
commitments.
A venturer must disclose a listing and description of interests in significant joint ventures and the
proportion of ownership held in jointly controlled entities.
A venturer must also disclose the method it uses to account for its interest in jointly controlled
entities.

Example:
AGT, a medium-sized listed company, entered into an expansion programme on 1st October 20X7.
On that date the company purchased from BSH two investments in private limited companies:

• The entire share capital of CDW; and

• 50% of the share capital of DBT.

Both investments were previously wholly owned by BSH. DBT was to be run by AGT and BSH
as a jointly controlled entity. AGT makes up its financial statements to 30th September each
year. The terms of the acquisitions were:

CDW
The total consideration was based on a price earnings (PE) multiple of 12 applied to the reported
profit of RWF2 million of CDW for the year to 30th September 20X7. The consideration was
settled by AGT issuing an 8% Loan Note for RWF14 million (at par) and the balance by a new
issue of RWF1 equity shares, based on a market value of RWF2.50 each.

DBT
The value of DBT at 1st October 20X7 was mutually agreed as RWF37.5 million. AGT satisfied
its share (50%)
of this amount by issuing 7.5 million RWF1 equity shares (market value RWF2.50 each) to BSH

Note: AGT has not recorded the acquisition of the above investments or the issuing of the
consideration. The summarised balance sheets of the three entities at 30th September 20X8 are:

The following information is relevant:

• The book values of the net assets of CDW and DBT at the date of acquisition were considered
to be a reasonable approximation to their fair values.
• The retained profits of CDW and DBT for the year to 30th September 20X8 were RWF8
million and RWF2 million respectively. No dividends have been paid by any of the entities
during the year.

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 • Debut, the jointly controlled entity, is to be accounted for using proportional
consolidation, the benchmark treatment in IAS 31 Interests in Joint Ventures.
• Negative goodwill should be accounted for in accordance with IFRS 3 Business Combinations.

Required

(a) Prepare the journal entries (ignoring narratives) to record the acquisition of CDW and DBT in
the accounting records of AGT as at 1st October 20X7. Show your workings.
(b) Prepare the Consolidated Balance Sheet of AGT as at 30th September 20X8.

Solution

(a) Recording the acquisition of CDW.

Consideration is RWF2 million x 12 = RWF24 million

RWF14 m loan notes given. Thus, the balance of RWF10m satisfied Market value
by shares. of the

shares was RWF2.50. This means that 4 million shares were issued.
Therefore:
RWF’000 RWF’000
Dr Investment in CDW 24,000
Cr 8% Loan notes 14,000
Cr Equity shares 4,000
Cr Share premium 6,000

Recording the purchase of DBT. Value of DBT is RWF37.5 million

The value of AGT’s share 50% is RWF18.75 million
AGT issued 7.5 million shares with a market value of RWF2.50 each. Therefore:

RWF’000 RWF’000
Dr Investment in DBT 18,750
Cr Share capital 7,500
Cr Share premium 11,250
(b) 1. Establish group structure

CDW DBT
Group 100% 50%
Non-Controlling Interest - -
Joint Venture 50%
Clearly, CDW is a subsidiary. DBT is being run as a joint venture and the
proportional consolidation method is required.

2. Adjustments
In this question there are no journal adjustments required, apart from the need to record
the investments, as seen above.
3. Calculate Goodwill

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 CDW
First, determine the net assets of CDW

At date of At date of
Acquisition SFP
RWF’000 RWF’000
Share Capital 20,000 20,000
P/L reserves 7,000* 15,000
27,000 35,000
* 15,000 – 8,000
Cost of Investment 24,000
Less:
Share of Net assets Acquired (27,000 x 100%) 27,000
Negative Goodwill 3,000

The negative goodwill is credited in full immediately to the consolidated reserves.

DBT
First, determine the net assets of DBT

At date of At date of
Acquisition SFP
RWF’000 RWF’000
Share Capital (50%) 12,500 12,500
P/L reserves 1,250* 2,250**
13,750 14,750
*(4,500 – 2,000) x 50%
**4,500 x 50%
Cost of Investment 18,750
Less:
Share of Net assets Acquired 13,750
Goodwill 5,000

The goodwill is not impaired and so will be shown at 5,000 in the Consolidated SFP
4.Calculate NCI
Not Applicable in this question
5. Calculate Consolidated Reserves
AGT
Per SFP 20,800
Negative Goodwill 3,000
23,800
CDW
Per SFP 15,000
At Acquisition 7,000
Post Acquisition 8,000
Group share x
100%
DBT
Per SFP (50%) 2,250
At Acquisition (50%) 1,250

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 8,000
Post Acquisition 1,000

Total 32,800
AGT Consolidated Statement of Financial Position as at 30th September 20X8

RWF’000 RWF’000

Assets
Non-current assets
Property Plant & Equipment 71,790
Goodwill 5,000
76,790
Current assets
Inventories 26,160
Trade and Other Receivables 18,570
Cash 3,430 48,160
124,950
Equity and Liabilities
Capital and Reserves
Equity capital 21,500
Share premium 17,250
Consolidated Accumulated Profit 32,800
71,550
Non-current liabilities
8% Loan notes 14,000

Current liabilities
Trade payables 29,440
Overdraft 1,540
Provision for Income Tax 8,420 39,400
124,950

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Consolidated Financial Statements 4 – Consolidated Statement of
Comprehensive Incomes

INTRODUCTION
The purpose of the consolidated Statement of Comprehensive Income is to present the results
of the parent company and the subsidiary as if it were a combined/single entity.

Example 1
H. Ltd owns 100% of S. Ltd acquired when the latter company had a reserves/profit and loss
balance of Nil.

Statement of Comprehensive Income H Ltd S Ltd

RWF RWF
Profit before Tax 1,000 500
Tax (400) (200)
Profit after Tax 600 -
Dividends Paid (100) 300
Balance brought forward 700 300
Balance carried forward RWF1,200 RWF300

To prepare the consolidated Statement of Comprehensive Income we open up “Columnar

Workings” in the consolidated working papers, enter in H. Ltd’s Statement of Comprehensive
Income, enter in S. Ltd’s Statement of Comprehensive Income and then add together the amounts.

H Ltd S Ltd Total

RWF RWF RWF
Profit before Tax 1,000 500 1,500
Tax (400) (200) (600)
Profit after Tax 600 300 900
Dividends Paid (100) - (100)
500 300 800
Balance brought forward 700 - 700
Balance carried forward RWF1,200 RWF300 RWF1,500

The total column represents the consolidated Statement of Comprehensive Income which is
presented thus:

Consolidated Statement of Comprehensive Income RWF

Profit before Tax 1,500

Tax
(600)
Profit for period
900

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 Attributable as follows:
Equity holders in parent
900
Movement on reserves:
Opening Balance 700

Profit for period 900

Dividend
(100)
Balance carried forward RWF1,500

One point to note at this stage is that the dividends in the Consolidated Statement of Comprehensive
Income represent those of the parent company only. The treatment of subsidiary’s dividends will
be dealt with in a later section.

B. NON-CONTROLLING INTEREST
If there is a Non-Controlling Interest in a subsidiary, give them their share of the profit after tax
of the subsidiary. The Non-Controlling Interest is shown below the consolidated Statement of
Comprehensive Income, alongside the share of profit attributable to the parent

Note the full profit before tax and tax of the subsidiary are consolidated.

Furthermore, if the Fair Value method is being used, then the NCI share of any goodwill impairment
must be deducted in arriving at the NCI amount in the consolidated Statement of Comprehensive
Income.

Example 2
Assume the same facts as before except H. Ltd. owns 80% of S. Ltd.
Columnar Workings H Ltd S Ltd Total
RWF RWF RWF
Profit before Tax 1,000 500 1,500
Tax (400) (200) (600)
600 300 900
Non-Controlling Interest 20% - (60) (60)

600 240 840

Dividends Paid (100) - (100)
500 240 740
Balance brought forward 700 Nil 700
Balance carried forward RWF1,200 RWF240 RWF1,440

Consolidated Statement of Comprehensive Income RWF

Profit before Tax 1,500
Tax (600)
Profit for period 900
Attributable as follows:
Equity holders in parent 840

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 Non-Controlling Interest 60
900

Movement on reserves:
Balance brought forward 700
Profit for period 840
Dividends Paid (100)
Balance carried forward RWF1,440

C. PROFIT AND LOSS - BALANCE FORWARD IN SUBSIDIARY

In examination questions it is normal for students to be given the Statement of Comprehensive
Income of the parent company and subsidiary several years after acquisition. In practice a
consolidated Statement of Comprehensive Income will be prepared each year and the balance
forward of profits will be known. For examinations it is necessary to work out the balance brought
forward. It comprises the parent company’s balance forward plus group’s share of the post
acquisition profits of the subsidiary.

Example 3
H. Ltd acquired 100% of S. Ltd when the balance on the latter company’s reserves was Nil.

Statement of Comprehensive Income H Ltd S Ltd

RWF RWF
Profit before Tax 1,000 500

Tax (400) (200)

600 300
Dividends Paid
(100) -
500 300
Balance brought forward 700 400

Balance carried forward RWF1,200 RWF700

Columnar Workings H Ltd S Ltd Total
RWF RWF RWF
Profit before Tax 1,000 500 1,500

Tax (400) (200) (600)

600 300 900
Dividends Paid (100) - (100)
500 300 800

Balance brought forward 700 400 1,100

Non-Controlling Interest Nil
Pre Acquisition - Nil -
Balance brought forward 700 400 1,100
Balance carried forward RWF1,200 RWF700 RWF1,900

Consolidated Statement of Comprehensive Income RWF

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 Profit before Tax 1,500
Tax (600)
Profit for period 900
Attributable as follows:
Equity holders of Parent 900

Movement in reserves:
Balance brought forward 1,100
Profit for period 900
Dividends Paid (100)

Balance carried forward RWF1,900

Example 4Assume the same facts as before except H. Ltd owns

80% of S. Ltd.
Columnar Workings H Ltd S Ltd Total
RWF RWF RWF
Profit before Tax 1,000 500 1,500
Tax (400) (200) (600)
600 300 900
Non-Controlling Interest - (60) (60)
600 240 840
Dividends Paid (100) - (100)
500 240 740

Balance brought forward 700 400

Non-Controlling Interest (80)
Pre Acquisition Nil
700 320 1,020
RWF1,200 RWF560 RWF1,760

Example 5
 Same facts as Example 4 except H. Ltd acquired its interest in S. Ltd when the latter company
had a profit and loss balance of RWF150.

Columnar Workings H Ltd S Ltd Total

RWF RWF RWF
Profit before Tax 1,000 500 1,500
Tax (400) (200) (600)
600 300 900

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 Non-Controlling Interest - (60) (60)
600 240 840
Dividends Paid (100) - (100)
500 240 740

Balance brought forward 700 400

Non-Controlling Interest (80)
(120)
700 200 900
Balance carried forward RWF1,200 RWF440 RWF1,640

Test
H. Ltd acquired 75% of S. Ltd when the latter company has a profit and loss balance of RWF100.
Statement of Comprehensive H Ltd S Ltd
Income RWF RWF
2,000 800
Profit before Tax
Tax (1,200) (300)

Profit after Tax 800 500

Dividends (60) -
740 500
Balance brought forward 860 460
Balance carried forward RWF1,600 RWF960

Solution
Columnar Workings H Ltd S Ltd Total
RWF RWF RWF
Profit before Tax 2,000 800 2,800
Tax (1,200) (300) (1,500)

800 500 1,300

Non-Controlling Interest 25% - (125) (125)
800 375 1,175
Dividends Paid (60) - (60)

740 375 1,115

Balance brought forward 860 460

Non-Controlling Interest 25% (115)
Pre-acquisition RWF100 x 75% (75)
860 270 1,130

Balance carried forward RWF1,600 RWF645 *RWF2,245

This figure represents the parent company’s profit and loss balance of RWF1,600 plus group’s

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share of the post acquisition profits of the subsidiary, i.e. Balance Now RWF960 - Balance
Acquisition RWF100 = 860 x 75% = RWF645.

D. INTER COMPANY PROFITS

Inter company profits arise on:-
Inventory and Non Current Assets

The principle is to eliminate inter company profits and show assets at their cost to the group.
The elimination of profits or losses relating to intragroup transactions should be dealt with in
the Statement of Comprehensive Income of the company in which the profit/loss arose.

Example 6
H. Ltd sold goods to S. Ltd, which originally cost RWF500 at a profit of RWF80. Half of the
goods were in S.
Ltd’s inventory at the year end. H. Ltd owns 80% of S. Ltd.
H Ltd S Ltd
RWF RWF
1,000 500
Profit before Tax
Tax (400) (200)

600 300

Balance brought forward 400 Nil

Balance carried forward RWF1,000 RWF300

Inventory Adjustment RWF80 x 1/2 = RWF40

DR Consolidated Statement of Comprehensive Income RWF40
CR Inventory Account RWF40
Columnar Workings H Ltd S Ltd Total
RWF RWF RWF
Profit before Tax 1,000 500
Inventory Adjustment (40)
-
960 500 1,460
Tax (400) (200) (600)
560 300 860
Non-Controlling Interest - (60) (60)
560 240 800
Balance brought forward 400 - 400
Balance carried forward RWF960 RWF240 RWF1,200

Example 7
Assume the same facts as Example 6 except that S. Ltd sold the goods to H. Ltd. In this
instance the inventory profit is eliminated in the Statement of Comprehensive Income of S. Ltd.

330 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
 Columnar Workings H Ltd S Ltd Total
RWF RWF RWF
Profit before Tax 1,000 500
Inventory Adjustment - (40)
1,000 460 1,460
Tax (400) (200) (600)
600 260 860
Non-Controlling Interest - (52) (52)
600 208 808
Balance brought forward 400 -
400
Balance carried forward RWF1,000 RWF208 RWF1,208

Where non-current assets are sold by the parent company to the subsidiary or vice versa two
problems emerge

• Inter company profit on sale of non-current assets.

• Excess depreciation arising in the company acquiring the non-current assets.

Example 8
One year ago H. Ltd sold a non-current asset to S. Ltd for RWF600 (original cost to H. Ltd
RWF500). S. Ltd
depreciates its non-current assets at 20% per annum. H. Ltd owns 80% of S. Ltd, balance at
acquisition Nil.
Statement of Comprehensive Income H Ltd S Ltd
RWF RWF
Profit before Tax 1,000 500
Tax (400) (200)
600 300
Balance brought forward 700 400
Balance carried forward RWF1,300 RWF700

(1) Non-Current Asset Profit RWF600 - RWF500 = RWF100

DR H Ltd Statement of Comprehensive Income RWF100

CR Non-Current Assets RWF100
and
(2) Excess Depreciation RWF100 x 20% = RWF20
DR Accumulated Depreciation/Non-Current Assets RWF20
CR S Ltd Statement of Comprehensive Income RWF20

CPA EXAMINATION I1.2 FINANCIAL REPORTING 331

STUDY MANUAL
 Columnar Workings H Ltd S Ltd Total
RWF RWF RWF
Profit before Tax 1,000 500

Non-Current Assets Adjustment (100)

Excess Depreciation - 20
900 520 1,420
Tax (400) (200) (600)
500 320 820
Non-Controlling Interest - (64) (64)

500 256 756

Balance brought forward 700 400

Non-Controlling Interest (20%) - (80)
Pre-Acquisition - Nil
700 320 1,020
RWF1,200 R WF576 RWF1,776

E. DIVIDENDS

Introduction
Dividends received/receivable from the subsidiary which have been credited to the parent
company’s Statement
of Comprehensive Income should be eliminated in preparing the consolidated accounts.
The profits of the subsidiary, out of which the dividends have been appropriated, are being
consolidated; if the dividends were not eliminated a duplication would arise in the consolidated
accounts.

Example 9
H Ltd acquired 100% of S Ltd when the latter company had a reserves balance of Nil.
Statement of Comprehensive Income H Ltd S Ltd
RWF RWF
Profit before Tax 1,300 500
Tax (400) (200)
900 300
Dividends Paid (100) (300)
800
Nil Balance brought forward 700 400
Balance carried forward RWF1,500 RWF400
Correct Solution

In the incorrect solution above the dividend of RWF300 is included in H Ltd and thereby
leading to a duplication of this amount in the consolidated profit before tax

A second problem needs to be tackled in the above example; that is the composition of the
consolidated Statement of Comprehensive Income retained balance of RWF1900. Simply put

332 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
how much of the RWF1900 is retained in the parent company’s Statement of Comprehensive
Income and the subsidiary profit and loss account?

Columnar Workings H Ltd S Ltd

RWF RWF RWF
Total Profit before Tax 1,300 500
Dividend Elimination (300) -
1,000 500 1,500
Tax (400) (200) (600)
600 300 900
Dividends Paid (100) - (100)
500 300 800

Balance brought forward 700 400 1,100

Balance carried forward RWF1,200 RWF700 RWF1,900

Incorrect Solution

H Ltd S Ltd

RWF RWF RWF

Total Profit RWF1,300 RWF500 RWF1,800

In the incorrect solution above the dividend of RWF300 is included in H Ltd and thereby
leading to a duplication of this amount in the consolidated profit before tax

A second problem needs to be tackled in the above example; that is the composition of the
consolidated Statement of Comprehensive Income retained balance of RWF1900. Simply put
how much of the RWF1900 is retained in the parent company’s Statement of Comprehensive
Income and the subsidiary profit and loss account?

Columnar Workings H Ltd S Ltd Total

RWF RWF RWF
Balance 1,200 700 1,900

Dividend Inter Company 300 (300) -

Retained RWF1,500 RWF400 RWF1,900

The approach is to transfer group’s share of the subsidiary’s post acquisition dividend from
the subsidiary’s column to the parent company’s column leaving retained of RWF1,500 in the
holding company and RWF400 in the subsidiary.

Non-Controlling Interest

Example 10
Assume the same facts as Example 9 except that H Ltd owns 80 % of S Ltd

CPA EXAMINATION I1.2 FINANCIAL REPORTING 333

STUDY MANUAL
 Columnar Workings (continued) H Ltd S Ltd Total
RWF RWF RWF
Profit before Tax 1,300 500

Dividend Elimination 300 x 80% (240) -

1,060 500 1,560

Tax (400) (200) (600)
660 300 960
Non-Controlling Interest - (60) (60)
660 240 900
Dividends Paid (100) - (100)
560 240 800

Balance brought forward 700 400

Non-Controlling Interest 20% (80)
Pre Acquisition Nil
700 320 1,020
1,260 560 1,820
Inter Company Dividend 240 (240) -

Balance carried forward RWF1,500 RWF320 RWF1,820

As you can see from example 10 group’s share of the dividend is eliminated from the profit
before tax workings and group’s share of the post acquisitions dividend is transferred from the
subsidiary to the parent company in computing the composition of the group retained profit.

Dividend Provided by Subsidiary not Credited to Profit and Loss by Parent Company
In this case no adjustment is required to the profits before tax as the dividend from the subsidiary
is not included
in the parent company’s profit before tax, however the transfer between the subsidiary and the
parent company is still required. A dividend provided by a subsidiary will ultimately be paid out
and increase the parent company’s reserves.

Example 11
H Ltd owns 75% of S Ltd. S Ltd provided a dividend of RWF200, which has not yet been taken
in by H Ltd.

334 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
Prepare the consolidated Statement of Comprehensive Income.
Statement of Comprehensive Income H Ltd S Ltd
RWF RWF
Profit before Tax 5,000 2,000
Tax (2,000) (800)
3,000 1,200
Dividend Provided Nil (200)
3,000 1,000
Balance brought forward Nil Nil
Balance carried forward RWF3,000 RWF1,000

Columnar Workings H Ltd S Ltd

RWF RWF RWF
Total Profit before Tax 5,000 2,000
Dividend Elimination Nil -
5,000 2,000 7,000
Tax (2,000) (800) (2,800)
3,000 1,200 4,200
Non-Controlling Interest - *(300) (300)
3,000 900 3,900

Dividend Inter Company 200 x 75% 150 (150) -

Balance carried forward RWF3,150 RWF750 RWF3,900

*The minority is entitled to their share of the profit after tax before dividends. Dividends paid out/
provided by the subsidiary will affect the amount retained by the Non-Controlling Interest in the
Statement of Financial Position not their entitlement in the Statement of Comprehensive Income.

Preference Dividends
The same principles that relate to ordinary dividends are applied when there are preference
dividends except
watch the calculation of the Non-Controlling Interest.

Example 12
H Ltd acquired 80% of S Ltd when the latter company had a reserves balance of Nil. H Ltd owns
none of the
8% Preferential Share Capital of Nominal Value RWF500. H Ltd has not recorded its share of
dividends provided by S Ltd.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 335

STUDY MANUAL
Statement of Comprehensive Income H Ltd S Ltd
RWF RWF
Profit before Tax 1,000 500
Profit after tax 600 300
Dividends Ordinary - (260)
Provided:
Preference - (40)
600 Nil
Balance brought forward 700 400
Balance carried forward RWF1,300 RWF400

Columnar Workings
H Ltd Ltd

RWF RWF RWF

Total Profit before Tax 1,000 500 1,500
Tax (400) (200) (600)
600 300 900
Non-Controlling Interest (working 1) (92) (92)
600 208 808
Balance brought forward 700 400
Non-Controlling Interest - (80)
700 320 1,020
1,300 528 1,828
Dividends Inter Company 260 x 80% 208 208) -
Balance carried forward RWF1,508 RWF320 RWF1,828

Working 1: Non-Controlling Interest

Profit after Tax 300
Preference dividend (40) x 100% = 40
Available to Ordinary Shareholders 260 x 20% = 52
Total RWF92
Test
H Ltd required 70% of the Ordinary Share Capital of S Ltd and 40% Preferential Share Capital
(nominal value RWF2,000) when the latter company had a reserves balance of RWF1,000. H Ltd
has credited its share of S Ltd dividends to profit before tax.

Statement of Comprehensive Income H Ltd S Ltd

RWF RWF
Profit before Tax 8,000 3,000
6,000 2,000
Dividends Preference - (200)
Provided:
Ordinary (100) (500)
5,900 1,300
Balance brought forward 3,100 1,700
Balance carried forward RWF9,000 RWF3,000

336 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
Solution

Columnar Workings H Ltd S Ltd

RWF RWF RWF
Total Profit before Tax 8,000 3,000
Dividend Elimination 200 x 40% (80) -
500 x 70% (350) -
7,570 3,000 10,570
Tax (2,000) (1,000) (3,000)
5,570 2,000 7,570
Non-Controlling Interest
(working1)

(Non equity RWF120) - (660) (660)

5,570 1,340 6,910
Dividend Provided (100) - (100)
5,470 1,340 6,810

Balance brought forward 3,100 1,700

Non-Controlling Interest RWF1,700

X 30% (510)
Pre Acquisition RWF1,000 x 70% 700)
3,100 490 3,590
Balance 8,570 1,830 10,400
Dividends Inter Company 80 (80)
350 (350) -

Balance carried forward RWF9,000 RWF1,400 RWF10,400

Working 1

Profit after Tax 2,000

Preference dividend (200) x 60% = 120
Available to Ordinary Shareholders 1,800 x 30% = 540
Total RWF660

F. TRANSFERS TO RESERVES
Group Share of transfers to reserves made by the subsidiary should be aggregated with the
parent company’s transfers to reserves.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 337

STUDY MANUAL
Example 13
H Ltd owns 75% of S Ltd acquired when the latter company had a reserves balance of Nil.

Statement of Comprehensive H Ltd S Ltd

Income RWF RWF
5,000 2,000
Profit before Tax
Tax (2,000) (800)

Profit after Tax 3,000 1,200

Transfer to plant replacement (300) (200)
reserve
2,700 1,000
Balance brought forward 800 300

RWF3,500 RWF1,300

Columnar Workings H Ltd S Ltd Total

RWF RWF RWF
Profit before Tax 5,000 2,000 7,000

Tax (2,000) (800) (2,800)

Profit after tax 3,000 1,200 4,200

Non-Controlling Interest 25% - (300) (300)

3,000 900 3,900

Transfer to plant replacement *(150)

reserve (300) (450)
2,700 750 3,450

Balance brought forward 800 300

Non-Controlling Interest 25% (75)

800 225 1,025
Balance carried forward RWF3,500 RWF975 RWF4,475
* Group’s share only.

G. DEBIT BALANCE ON STATEMENT OF COMPREHENSIVE INCOME AT

ACQUISITION
The accounting treatment of a debit balance on the subsidiary’s Statement of Comprehensive
Income at the date of acquisition is the opposite to that of a credit balance

338 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
Example 14
H Ltd acquired 80% of S Ltd when the latter company’s reserves were RWF(150)

Statement of Comprehensive Income H Ltd S Ltd

RWF RWF
Profit before Tax 1,000 500

Tax 400 200

Profit after tax 600 300

Dividends Paid (100) -

500 300
Balance brought forward 700 400
Balance carried forward RWF1,200 RWF700

Columnar Workings H Ltd S Ltd Total

RWF RWF RWF
Profit before Tax 1,000 500 1,500
Tax (400) (200) (600)

600 300 900

Non-Controlling Interest - (60) (60)

600 240 840

Dividends Paid (100) - (100)
500 240 740

Balance brought forward 700 400

Non-Controlling Interest 20% (80)
Pre Acquisition (150) x 80% 120
700 440 1,140

Balance carried forward RWF1,200 RWF680 RWF1,880

Example 5 shows the situation where there was a pre-acquisition profit and loss account
balance of RWF150.

H. SALES AND COST OF SALES

Company law requires the disclosure of group sales and group cost of sales, a problem arises
though where there is inter company trading.

Example 15
H Ltd owns 80% of S Ltd. H Ltd sold goods which cost RWF500 to S Ltd for RWF600, half of
the goods are included in S Ltd year end inventory.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 339

STUDY MANUAL
 Statement of Comprehensive Income H Ltd S Ltd
RWF RWF
Sales 10,600 5,000
Cost of Sales (8,500) (2,600)
Profit before Tax 2,100 2,400
Tax 1,000 800

Profit after Tax RWF1,100 RWF1,600

Balance brought forward Nil Nil
Inventory Profit RWF100 x 1/2 = RWF50

In this situation we introduce a further column into the Columnar Workings called an
adjustment column:-
• Aggregate the sales of H Ltd and S Ltd and adjust for the inter company sales,
• Aggregate the cost of sales of H Ltd and cost of sales of S Ltd and adjust for the inter
company sales.

Columnar Workings H Ltd S Ltd Adj. Total

RWF RWF RWF RWF
Sales 10,600 5,000 (600) 15,000
Cost of Sales (8,500) (2,600) (600) (10,550)
Inventory Profit (50) - - -
Profit before Tax 2,050 2,400 4,450
Tax (1,000) (800) (1,800)

Profit after Tax 1,050 1,600 2,650

Non-Controlling Interest (320) (320)
– 20% -
RWF1,050 RWF1,280 RWF2,330

I. DEBENTURE INTEREST
The amount of debenture interest charged in the consolidated Statement of Comprehensive
Income is that which has been paid to non-group debenture holders. Any inter company debenture
interest should cancel out.

Example 16
H Ltd owns 80% of the Ordinary Share Capital of S Ltd and 30% of the 15% debentures nominal
value
RWF1,000. The debenture interest of RWF150 has been accrued for in S Ltd but H Ltd has not
recorded its share of it yet.

340 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
 Statement of Comprehensive Income H Ltd S Ltd
RWF RWF
Profit before Tax and Interest 3,000 1,000
Debenture Interest - (150)
Profit before Tax 3,000 850
Tax (1,000) (300)
Profit after Tax 2,000 550
Balance brought forward Nil Nil

Balance carried forward RWF2,000 RWF550

In this case it is necessary to include in H Ltd the debenture interest receivable. When this
has been done the debenture interest receivable will cancel against the debenture interest
payable and leave the debenture interest payable to non group debenture holders charged in
the consolidated profit before tax.

Columnar Workings H Ltd S Ltd Total

RWF RWF RWF
Profit before Tax and Interest 3,000 1,000 4,000

Interest Adjustment RWF150 x 45 - -

30% - - (105)
Interest Payable - (150) -
3,045 850 3,895
Tax (1,000) (300) (1,300)
2,045 550 2,595
Non-Controlling Interest - (110) (110)
Balance carried forward RWF2,045 RWF440 RWF2,485

J. ACQUISITION OF SUBSIDIARY DURING THE YEAR

If a subsidiary is acquired during the year, only the post acquisition results of the subsidiary are
consolidated.

Example 17
H Ltd acquired 80% of S Ltd half way through the year. The respective non-consolidated
Statement of
Comprehensive Incomes are set out below. Prepare the consolidated Statement of Comprehensive
Income.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 341

STUDY MANUAL
 Solution

H Ltd S Ltd Total

Sales RWF RWF RWF
1,300 600 1,900

Cost of Sales (660) (265) (925)

Gross Profit 640 335 975
Administration (210) (90) (300)
Distribution (130) (60) (190)
Profit 300 185 485
Interest (80) (15) (95)
Profit before Tax 220 170 390
Tax (70) (45) (115)
Profit after Tax 150 125 275
Non-Controlling Interest - (25) (25)
150 100 250
Dividends (50) - (50)
100 100 200
Retained at Start of Year 400 120 -
Non-Controlling Interest - (24) -
Pre Acquisition - (96) 400
400 Nil
Brought forward 500 100 600

Consolidated Statement of Comprehensive

Income RWF RWF

Sales 1,300
Continuing
Acquisition 600
1,900
Cost of Sales (925)
Gross Profit 975
Administration (300)

Distribution (190)
Profit
Continuing 300
Acquisition 85
485
Interest (95)
Profit before Tax 390

342 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
 Tax (115)
Profit for period 275

Attributable as follows: Equity holders in parent 250

Non-Controlling Interest 25

275

Movement in Reserves:
Retained reserves brought forward 400
Profit for period 250
Dividends (50)
Retained reserves carried forward 600

K. ASSOCIATE COMPANIES IN THE STATEMENT OF COMPREHENSIVE INCOME

A reporting entity that prepares consolidated financial statements should include its
associates in those statements using the equity method of accounting.

Under this method, the associate company’s revenue, cost of sales and expenses are not
consolidated with those of the investing group. Instead, the investor’s share of the profit after tax
of the associate is brought into the consolidated Statement of Comprehensive Income. The
share of the associates profit is shown in the consolidated Statement of Comprehensive
Income before profit before tax.

This share of profit after tax will include any accounting adjustments that arise in the question in
relation to the associate, as well as any goodwill impairment that must be accounted for.

Example 1:
H Ltd acquired 80 % of S Ltd and 40% of A Ltd when both companies had reserves of RWFnil.
The Statement
of Comprehensive Incomes of each entity are as follows:

H Ltd S Ltd A Ltd

RWF RWF RWF
Profit 1,100 520 210
Interest (100) (20) (10)
Profit before tax 1,000 500 200
Tax (400) (200) (80)
Profit after tax 600 300 120

Balance brought forward 1,400 500 180

Balance carried forward 2,000 800 300

Requirement:
Prepare the consolidated Statement of Comprehensive Income.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 343

STUDY MANUAL
 Solution 1

H Ltd S Ltd Total

RWF RWF RWF
Profit 1,100 520 1,620
Interest (100) (20) (120)
Profit before tax 1,000 500 1,500
Tax (400) (200) (600)
Profit after tax 600 300 900
Non-Controlling Interest - (60) (60)
600 240 840

Brought forward 1,400 500 -

Non-Controlling Interest - (100) -
Pre-acquisition - Nil -
Group share 1,400 400 1,800
Carried forward 2,000 640 2,640

Associate Company:
Share of profit after tax RWF120 x 40% = RWF48
Share of profit brought forward (RWF180 – 0) x 40% = RWF72

Consolidated Statement of Comprehensive Income

RWF

Sales X
Cost of Sales (X)
Gross Profit X
Administrative (X)
Expenses (X)
Distribution Costs
Group Profit 1,620
Interest Payable: (120)
1,500
Share of Profit in Associate 48

Profit before Tax 1,548

Tax (600)
Profit for year 948

Attributable as follows: Equity holders in parent 888

344 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
 Non-Controlling Interest 60
948

Movement in Reserves
Retained Reserves brought forward (see note) *1,872

Profit for year 888

Retained reserves carried forward 2,760

*Retained Reserves Brought Forward RWF

H 1,400
S 400
A 72
1,872
If there are profits at the date of the acquisition of the associate, these must be considered when
calculating group’s share of post acquisition profits of the associate brought forward from earlier
years.

Example 2
Using the same facts as Example 1 except H Ltd acquired 80% of S Ltd and 40% of A Ltd when
the latter
company’s’ reserves were RWF200 and RWF80 respectively, calculate the retained profits
brought forward at the start of the year.
Solution 2

Retained Reserves Brought Forward RWF

H 1,400

S (RWF500 - RWF200) x 80% 240

A (RWF180 - RWF80) x 40% 40
1,680

In the consolidated statement of changes in equity, the investor’s share of the total recognised
gains and losses of its associates should be included , for example if there is a revaluation of
property in the associate, groups share of this should be included in statement of changes in
equity.

L. GOODWILL ON ACQUISITION OF AN ASSOCIATE

When an entity acquires an associate, fair values should be attributed to the investor’s underlying
assets and liabilities, identified using the investor’s accounting policies.

The investor’s assets used in calculating the goodwill arising should not include any goodwill
carried in the
Statement of Financial Position of the investee.

Example 3
H Ltd bought 40% of A Ltd for RWF260. The Statement of Financial Position of A Ltd at acquisition
was as follows:

CPA EXAMINATION I1.2 FINANCIAL REPORTING 345

STUDY MANUAL
 RWF
Non Current Assets 350
Current Assets 230
580
Ordinary Share Capital 500
Reserves 80
580
The non current assets were undervalued by RWF30. Goodwill, an acquisition, is calculated as
follows:

Consideration RWF 260

Fair value of net assets acquired RWF350 + 30 + 230 x 40% RWF 244

Alternatively:
Goodwill 16

Consideration RWF 260

Ordinary share capital (500 x 40%) RWF 200
Revaluation reserve (30 x 40%) 12
Reserves (80 x 40%) 32
Goodwill 16

Comprehensive Example
H Ltd acquired 70% of S Ltd and 25% of A Ltd in January 20X2 when the companies had reserve
balances of
RWF1,000 and RWF160 respectively.

The Statement of Comprehensive Income and Statement of Financial Position of each entity for
31 December 20X4 are set out below.

Statement of Comprehensive Income H Ltd S Ltd A Ltd
RWF RWF RWF
Sales 18,000 10,970 5,190
Cost of Sales (7,200) (4,150) (2,090)
Gross Profit 10,800 6,820 3,120
Administration (3,100) (2,070) (1,070)
Distribution (2,400) (1,500) (850)
Profit 5,300 3,250 1,200
Investment Income 400 - -
Interest (300) (250) (200)
Profit before Tax 5,400 300 1,000
Tax (2,400) (800) (400)
Profit after Tax 3,000 2,200 600
7,000 4,700 2,000

Statement of Financial Position H Ltd S Ltd A Ltd

RWF RWF RWF

346 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
 Property, Plant & Equipment 6,200 6,100 2,500
Investment in S Ltd 5,550 - -
Investment in A Ltd 650 - -
Current Assets 4,600 4,600 1,500
17,000 10,700 4,000

Ordinary Share Capital 10,000 6,000 2,000

Profit and Loss 7,000 4,700 2,000 
17,000 10,700 4,000

Requirement:
Prepare a consolidated Statement of Comprehensive Income and a consolidated Statement of
Financial Position for 31 December 20X4, using the proportion of net assets method.

Comprehensive Example - Solution

Consolidated Statement of Comprehensive Income For the Year Ended 31 December
20X4

RWF
Sales 28,970
Cost of sales (11,350)
Gross profit 17,620
Administration (5,170)
Distribution (3,900)
Profit 8,550
Interest (550)
Share of profit of Associate (see below) *150

Tax (3,200)
Profit for period 4,950

Attributable as follows:
Equity Holders in Parent 4,290
Non-Controlling Interest 660 4,950
Movement in Reserves:
Retained reserves brought forward (see below) **6,560
Profit for year 4,290
Dividend (800)
Retained reserves carried forward 10,050

(Note that the total of reserves in the Schedule of Movement in reserves is equal to the
Consolidated Reserves in the Statement of Financial Position below).

*Share of Profit in Associate

Group share of Profit After Tax, RWF600 x 25% = RWF150
Share of profit brought forward (RWF1,600 - RWF160) x 25% = RWF360
**Retained Reserves Brought Forward RWF
H Ltd 4,800
S Ltd 1,400

CPA EXAMINATION I1.2 FINANCIAL REPORTING 347

STUDY MANUAL
 A Ltd 360
6,560

Non-Current Assets
Intangibles
Consolidated Statement of Financial Position
RWF
Property Plant and Equipment (6,200 + 6,100) 12,300
Goodwill 650

Investment in associate 1,110

14,060
Current assets 9,200
23,260

Ordinary share capital 10,000

Reserves 10,050
20,050
Non-Controlling Interest 3,210
23,260

Statement of Comprehensive H Ltd S Ltd Total

Income RWF RWF RWF
Columnar Workings 18,000 10,970 28,970
Sales
Cost of sales (7,200) (4,150) (11,350)
Gross profit 10,800 6,820 17,620
Administration (3,100) (2,070) (5,170)

Distribution (2,400) (1,500) (3,900)

Profit 5,300 3,250 8,550

Investment income 400

Intercompany (400)
Interest (300) (250) (550)
Profit before tax 5,000 3,000 8,000
Tax (2,400) (800) (3,200)
Profit after tax 2,600 2,200 4,800
Non-Controlling Interest (2,200 x - (660) (660)
25%)
2,600 1,540 4,140
Dividend (800) - (800)

348 I1.2 FINANCIAL REPORTING CPA EXAMINATION

STUDY MANUAL
 1,800 1,540 3,340

Brought forward 4,800 3,000

Non-Controlling Interest (900)

Pre Acquisition (700)

4,800 1,400

Calculate Goodwill in Subsidiary

Cost of investment 5,550

Less:
Share of Net Assets Acquired (70% x (6,000 + 1,000)) 4,900

Goodwill 650

Associate

Cost of investment 650

Less:
Share of net asset acquired (25% x (2000 + 160)) 540
Goodwill 110
Investment in associate 650
Add:
Share of Post Acquisition Profits (25% x (2000 – 160)) 460

1,110
NCI on Consolidated SFP
30% x (6,000 + 4,700) = 3,210

Question:
PY Ltd acquired 70% of SW Ltd 3 years ago. Total Goodwill arising on acquisition was
RWF350,000. The Statement of Comprehensive Income of both companies are as follows:

Consolidated Statement of Comprehensive Income for the Year Ended 31st March 2010

PY Ltd SW Ltd
RWF’000 RWF’000
1,000 260
Revenue
750 80
Cost of Sales

Gross Profit 250 180

Operating expenses (60) (35)

CPA EXAMINATION I1.2 FINANCIAL REPORTING 349

STUDY MANUAL
 Finance costs (25) (15)
Investment Income 20 -
Profit before tax 185 130
Tax (100) (30)
Profit for the year 85 100

Statements of Changes in Equity

PY Ltd SW Ltd
RWF’000 RWF’000
Retained earnings b/f 1,575 770
Profit for the year 85 100
Dividends paid (60) (20)
Retained earnings c/f 1,600 850

You are provided with the following additional information:

• Satago had plant in its Statement of Financial position at the date of acquisition with a carrying
value of RWF100,000 but a fair value of RWF120,000. The plant had a remaining life of 10
years at acquisition. Depreciation is charged to cost of sales.
• Goodwill is to be measured in full Goodwill is to be impaired by 30% at the reporting date, of
which 1/3rd relates to the current year.
• SW Ltd sold some goods to PY Ltd for RWF60,000 at a mark-up of 20%, during the year. 40%
of the goods remained unsold at the year end.
• The dividends shown in the Statements of Changes in Equity had been paid by both
companies on 1st March 2010 to their respective shareholders.

Prepare the consolidated Statement of Comprehensive Income for the year ended 31st March
2010, using the Fair Value Method.

Solution

PY Ltd GROUP
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED
31ST MARCH 2010

RWF’000
Revenue (1,000 + 260 – 60) 1,200
Cost of sales (750 + 80 – 60 + 4 (inventory) + 2 776
(depreciation))
Gross Profit 424
Operating Expenses (65 + 35 + 35) (130)
Finance Costs (25 + 15) (40)
Investment Income (20 – (70% x 20)) 6

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 Profit before tax 260
Tax (100 + 30) (130)
Profit after tax 130
Attributable to: NCI Share 17.7
Parent Shareholders 112.3

Goodwill Impaired:
30% x 350 = 105
1/3rd relates to current year, this 35 is the impaired amount for the current year.
NCI share of the impairment: 30% x 105 = 35

NCI share of profit

SW Ltd PAT
100
Less:
Depreciation (2)
Profit in inventory (4)
94

NCI share 30% 28.2

Impairment (35 x 30%) (10.5)
17.7

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STUDY UNIT 5:
INTERPRETATION OF FINANCIAL STATEMENTS

• Ratio analysis, cash flow analysis, and the preparation of reports thereon

INTRODUCTION
The ability to comprehend, assess, interpret and criticise the financial statements and related
information of different businesses is the quality above all others, which distinguishes the
accountant from the bookkeeper. Complete mastery of accounts can be gained only as a
result of wide experience, but whatever your personal circumstances, you can increase your
understanding by careful and systematic reading of the financial columns of the daily press and
by close attention to the professional journals.

Examination questions frequently call for appraisal of a specific document presented in the
question, perhaps a statement of financial position or statement of comprehensive income.
Students often find such a problem difficult, not because they lack the necessary knowledge but
because they are uncertain how to apply it. As a result, points are jotted down on the answer
paper as they are thought of and such answers are naturally badly arranged and displayed and
fail to exhibit any logical process of order and reasoning.

The object of this study unit is to show you the method which must underlie all good reports and
appraisals, and the way in which they should be drafted.

Subject Matter for Analysis

Analysis of accounts usually means the analysis of SOFPs and trading and statements of
comprehensive income
(‘final accounts’) or their equivalent. Such accounts may be of two types:

• Published accounts, i.e. those prepared for the information of shareholders, etc.
• Internal accounts, i.e. those prepared for the information of the directors and management.

The second type, being the accounts upon which the policy of the concern is based are usually
in much greater detail than the first.

In either case, greater reliance can be placed on accounts which have been audited by a
professional firm of standing than on any others; in particular, accounts drawn up by a trader
himself are always open to question.

Analysis of accounts (meaning final accounts) does not, therefore, include any other accounts
which may appear in the books. It is not an audit of the books or an investigation into the way in
which the books have been kept. So long as the statement of financial position and accounts are
genuine, it does not matter whether the books have been well or badly kept.

Purpose of Analysis
The primary object of analysis of accounts is to provide information. Analysis which does not
serve this purpose is useless.

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The type of information to be provided depends on the nature and circumstances of the business
and the terms of reference. By the latter we mean the specific instructions given by the person
wanting the enquiry to the person making it. Of course, if the person making the enquiry is also
the person who will make use of the information thus obtained, he will be aware of the particular
points for which he is looking.

The position of the ultimate recipient of the information must be especially noted. Suppose you
are asked by a debenture holder to comment on the Statement of Financial Position of a company
in which he is interested. It should be a waste of time to report at length on any legal defects
revealed in the Statement of Financial Position. You would naturally pay attention to points which
particularly concern the debenture holder, e.g. the security for his loan to the company, and the
extent to which his interest in the debentures is ‘covered’ by the annual profits. This does not
mean that legal defects should be ignored. It is very important that they should be mentioned
(although briefly), for failure to comply with legal requirements may be indicative of more
serious shortcomings, possibly detrimental to the security of the debenture holder.

This matter of approach is vital to the task of analysis. We shall now consider certain special
matters in which various parties will be particularly interested. For the sake of illustration, we will
deal with their positions in relation to the accounts for a limited company, but many of the points
we are going to mention are relevant to the accounts of a sole trader or partnership.

B. INTERESTED PARTIES
Debenture Holders
These are interested in both the long- and short-term position of the company. In the long term
they are
interested in the company’s ability to repay the sums lent by them (assuming they are redeemable).
They would look to see whether a sinking fund has been created, and for the realisable value of
the assets which form security for their loans. The basis of valuation of assets would therefore
be important, and whether the depreciation provision is adequate.

In the short term the debenture holder will consider the company’s ability to pay the loan interest
and hence will examine the working capital (current assets less current liabilities).

Trade Payables
As a general rule, a trade creditor will rely on trade references or personal knowledge when
forming an opinion
on the advisability of granting or extending credit to a company. He is not often concerned with
the accounts, which he rarely sees, but if he does examine the accounts he will be as much
concerned with existing liabilities as with assets. In particular, he will note the following:

• Working capital position or ability of company to pay debts when they fall due.
• Ease with which current assets can be converted into cash.
• Prior claims to company’s assets in the event of a liquidation, i.e. secured loans or overdrafts.
• Earnings record and expansion programme.

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Bankers
Before making a loan or granting an overdraft, the bank would consider:

• The nature and purpose of the loan.

• The duration of the loan (bankers prefer the short- or medium-term loan to those for longer
periods).
• The arrangements for repayment.
• The prospects of repayment.
• Security and prior rights to the assets of the company on liquidation.
• Financial policies of the company, and calibre of management.

Shareholders
The average shareholder is interested in the future dividends he will receive. Future profits are
of secondary
importance, so long as they are adequate to provide the dividend.

Past dividends provide the basis on which future dividends may be estimated, just as past profits
afford a similar indication as to future profits. Estimates may, however, be upset because of
radical changes in the nature of trade, production methods, general economic conditions, etc.

If the shares are listed on a stock exchange, it will be found that the market price varies more or
less directly with the dividends declared. It is generally accepted that a company ought not to
pay out more than two-thirds of its distributable profits each year in the form of dividend.

Cover is a vital factor in respect of any shares carrying fixed dividend rights, e.g. preference
shares. The coefficient of cover is determined by dividing the annual dividend into the amount
of the annual profits.

With redeemable shares, attention will be paid to the ability of the company to redeem on the due
dates. There may be a sinking fund created for this purpose.

Overall, the shareholder would be concerned with whether the company still provides the best
home for his investment or whether his money would be better utilised elsewhere.

Directors and Management

These are interested in the actual results, to enable them to:

• Compare with competitors.

• Compare with budgeted or expected results.
• See whether capital has been utilised in the best way and profits maximised.

Potential Takeover Bidders

In a takeover situation, the buying company may see hidden potential in another company in the
form of under-
valued assets or under-utilised funds. It may therefore be able to make a successful offer to the
shareholders, who may not be aware of their company’s real value. Potential takeover bidders
would consider:

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 • Current value of assets as opposed to book values.
• The asset-stripping potential, i.e. can the assets be sold off for a profit and the company
liquidated rather than bought as a going concern for continuation in the future?
• The effect of the directors’ financial and dividend policies in fostering shareholders’ loyalties
(e.g. is there ill feeling and aggravation at the annual general meeting?).

C. PROFITABILITY RATIOS
Control of all costs, direct and indirect, is essential if profit is to be maximised. In a broad and
general fashion, excluding the advanced techniques of budgetary control and cost accounting, it
is possible to watch total costs of each type, and to take action to reduce them when necessary.

This may be done by comparing manufacturing costs, administration costs, and selling and
distribution costs with profit (gross or net) or with sales. The broad headings, manufacturing
costs, etc. can, of course, be usefully analysed into their constituent parts and similar comparison
made with profit or sales. The trend of the ratio - whether there has been an increase or decrease
in costs as compared with profit or sales - is the significant factor.

Income as a Percentage of Turnover

Under this heading can be grouped the various profit margins:

• Gross Profit Percentage

This is: Gross Profit
Sales
(b) Net profit Percentage Before Tax

This is: Pre-Tax Profit

Sales
(c) Net Profit Percentage After Tax
After-Tax Profit
This is:
Sales
Each one will lend itself to comparison with previous years’ results or with the appropriate margins
of another company.

Like so many aspects of ratio analysis, these figures can only provide a rough measure and care
must be taken not to read too much into each. Consider the following example:

Product A Product B Product C

Year 1 Year 2 Year 1 Year 2 Year 1 Year 2

RWF RWF RWF RWF RWF RWF
Sales 80,000 100,000 40,000 50,000 120,000 150,000

Operating profit 10,000 18,000 8,000 7,000 18,000 25,000

Margin P/S 12.5% 18% 20% 14% 15% 16.6%

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Normally only totals would be studied and, as you can see, the company has increased sales
and increased total profits; its margin has also increased from 15% to between 16% and 17%.

Notice that to leave the matter with only totals would have ignored important underlying factors.
Product A has increased its profit margin but Product B has become less efficient, despite
increased sales.

The same sort of distorting factors can be seen in a situation where any final, total figures are
made up of different products each having a different margin of profit. This is called the product
mix and means that a total profit margin can change, even if efficiency has remained the same,
because there has been a change in the proportion of sales taken by component products. You
can see this important point illustrated in the following example:
Year 1 Year 2
RWF RWF
Sales Sales
Product X 30,000 Product X 70,000
Product Y 60,000 Product Y 220,000
90,000 290,000

Profit margins for X and Y for both years are 7% and 15% respectively.

We can calculate profit and profit margins:

Year 1 Year 2
RWF RWF
X Profit 2,100 X Profit 4,900
Y Profit 9,000 Y Profit 33,000

Total Profit 11,100 Total Profit 37,900

Total Margin 12.3% Total Margin 13.1%

Although margins have increased from 12.3% to 13.1% the company has not become any more
efficient. The reason for the better figures in Year 2 is because product Y, with a much better
margin of profit, has taken up a much larger share of total sales than has product X.

Even this illustration is itself an oversimplification and you must always approach profit margins
with caution. For instance, it is important to think about accounting policies. An example would
be the treatment of development expenditure, which can be capitalised and amortised, provided
the criteria in IAS 38 are met.

Net Income Related to Capital Employed

This is widely used but unfortunately the formula for capital employed is not widely agreed. The
ratio is used because it attempts to relate income generated to the resources employed.
The meaning of capital employed can be approached from two angles - the finance and the asset
approaches.
(a) Finance Method
Income is related to total funds invested in the business and this involves taking the total of
all shareholders’ (proprietors’ if sole trader or partnership) funds plus future and current liabilities
as shown in the Statement of Financial Position.

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 (b) Assets Method
Income is related to assets employed, being fixed assets and current assets as shown in the
SOFP. Thus the values placed on non-current and current assets will reflect directly on this ratio.
To capitalise brands, for example, is thought to strengthen a SOFP. But you can also appreciate
what it does to the return on capital employed, with the increase in assets it provides.
We are really talking about the same figure, as a SOFP(balance sheet) must balance. The
difference between the two will concern the assets or funds to be counted. Are all funds/assets
included in the figure for capital employed, whether employed during the year or not? Is working
capital to be counted, or only fixed capital?

There is no easy answer to these questions and again the wisest approach will be one of caution.
Generally, however, total funds or total assets will be favoured since investors expect all resources
to be used. In any case, all resources have an opportunity cost, i.e. alternative uses.

Net Income Related to Shareholders’ Funds

This may be useful in showing how efficiently a particular section of company capital is being
used and what is said here in connection with shareholders’ funds could equally apply to other
types of funds, loan capital, etc.

Various Expenses Related to Turnover

Using this ratio, wages, departmental expenses, selling expenses can all be related to sales.
Comparisons can be
made over periods of time and at the same time within the firm.

Value Added Per Employee

This is the amount added to the cost of materials consumed to cover labour charges, expenses
and gross profit,
divided by the number of employees. Thus a guide is obtained to the output per employee.

Sales Per Employee

This is obtained by dividing the value of sales for a period by the average number of persons
employed during that period. Expressed on its own it is of relative insignificance, but it is normally
used in comparison with
previous periods.

Times Covered for Interest and Dividends

This may be used to show how many times over a company could pay the demands on it in terms
of interest and/or dividends. Alternatively it can show how far income would have to fall before
dividend/interest was put
at risk. It is calculated by the formula:

Net Trading Income

Rate of Interest x Loans, etc outstanding

This can be applied to preference shares, loan stock and debentures.

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D. LIQUIDITY RATIOS
Current Ratio

(a) Definition
Current assets are compared with current liabilities. Generally speaking, the larger the former in
relation to the latter the more financially stable is the business. As a very general rule, total current
assets should be at least twice total current liabilities.

The length of time an asset is held or a liability is outstanding determines the category into which
it falls, i.e. whether current or non-current. If an asset is to be held for up to a year, not longer, or
a liability is to be paid off within a year, then one is a current asset and the other a current liability.
Non-current assets or ‘non-current” liabilities, e.g. loan capital, are of a permanent nature.

This ratio can also be referred to as the working capital ratio.

Consider the following example illustrating the current ratio:

Extract from Statement of Financial Position
RWF RWF RWF
Current Assets
Inventory 80,000
Accounts Receivable 110,000
Less Provision for Bad Debts 5,500 104,500
Cash at Bank and in hand 200 184,700
Less: Current Liabilities
Bank Overdraft 20,000
Accounts Payable 40,000 60,000
124,700
Current ratio 184,700 : 60,000 = 3 to 1 (approx.)

From the information given, therefore, it would appear that the current ratio is quite satisfactory.
The following points should, however, receive attention before any conclusion is reached:
(i) The type of trade carried on by the business. In particular, trade fluctuations, owing to
seasonality of sales of the product and the like, are extremely important. If the selling season
is a number of months away, the inventory carried may build up considerably (giving a larger
total of current assets) and yet, for all practical purposes, from the point of view of liquid
resources the position will have deteriorated.
(ii) Having regard to what is stated in (i), you will see that it is not the total ratio which is of
importance but rather the composition of the total assets and total liabilities. Referring to the
figures in the example, we may ask:

• Is the inventory composed mainly of raw materials or finished goods? Is the

inventory slow moving? The aim should be to predetermine a desirable relationship
between the different types of inventory and follow it as closely as possible.
• Will the receivables pay promptly?
• How quickly must the trade payables be paid off?
• Will the bank extend the overdraft or is there a danger of it being called in?
The real question is the rate at which money will be received into the business as compared
with the rate of payments to cover current liabilities. There is nothing static about a business

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but, unfortunately, this is often the erroneous impression gathered from accounting ratios. A
clear understanding of the underlying implications is essential if ratios are to be a useful tool of
management.
(b) Application
From what we have said, it should be clear that ‘2 to 1’ is only an approximate guide. At times a
lower or higher ratio may be regarded as normal, e.g. a 5 to 1 ratio may be present at certain times
of the year and be quite acceptable.

Once an ideal ratio for the business has been established, the most important point, from a financial
point of view, is to ascertain whether there is a rise or fall, for, generally speaking, the former may
be regarded as a favourable trend and the latter an unfavourable one. Again, no hard and fast rule
is possible for much depends upon the circumstances.

(c) Working Capital and the Current Ratio

The working capital is the excess of current assets over current liabilities. There is therefore a
direct connection between working capital and the current ratio. If working capital is inadequate,
so that the business is unable to pay its way, it will, if the worst comes to the worst, have to close
down. This state of affairs usually arises from over-trading, i.e. having a volume of turnover
which, with available working capital, is far too large. Typical steps leading to over-trading are:

• Large quantities of materials are purchased.

• Extra workers and staff are employed to deal with the additional production and
sales.
• There is a rise in all other operating costs.

Next, after a time, the length of which depends upon the production and sales cycles, extra
revenue from sales is received. Often a number of months will have elapsed before this extra
cash is received. There has, however, been immediate payment of wages and salaries and
only a limited period of credit will normally be allowed by payables. Possibly a bank overdraft
will be obtained to accommodate immediate needs. If not, or when the limit of the overdraft is
reached, an anxious creditor may apply for a petition, and the business may then be forced into
bankruptcy or liquidation.

Even if a business does manage to survive, it will not, for a considerable period, be able to take
advantage of a new market, the development of new ideas or a similar project. There is thus a
second danger of being forced out of business, this being brought about by the competition of
more progressive rival concerns.

In the circumstances outlined, only the availability of cash can avert the dangers. This is thus of
the greatest possible importance to any business; without cash it is unlikely to survive. Stocks
form part of the working capital and these, in the short term, are of limited value. It may be
possible to attract cash customers by giving a discount, but this will mean that less profit is
earned.

Because of the importance of paying payables promptly, it is advisable to fix a period of time
within which accounts have to be settled. Following normal commercial practice, this may be
taken as one month. If the business cannot meet its obligations within each month, then that is a
danger sign, which indicates that prompt remedial action should be taken. The next ratio greatly
assists in maintaining adequate cash or near cash resources.

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Liquidity Ratio (Acid Test or Quick Ratio)
The liquidity ratio is the relationship which exists between liquid assets (cash and good
receivables) and liquid
liabilities (trade payables). Any inventory, work-in-progress or other current assets which are not
cash or near cash do not enter into the comparison. There is thus a direct measure of solvency.

It is advantageous to keep this ratio in balance, as during the normal course of business events
revenue from receivables will usually be required to pay payables. This helps to maintain stocks
at a stable level and profits earned can be used to increase liquid resources.

If the liabilities are to be met, the ratio must clearly be at least 1 to 1, i.e. liquid assets must
be equal to payables. Any falling short indicates that additional cash has to be obtained. The
trend of the ratio will be a very helpful guide, for under stable trading conditions it should remain
steady, without appreciable movement either way. A sharp fall in the liquid assets available
without a similar fall in payables will show that immediate action is necessary.

Ratio of Current to Non-Current Assets

Current assets are compared with non-current assets and the ratio established. Owing to
differences in types of
business, and conditions under which they operate, it is virtually impossible to state a desirable
ratio which can be applied generally. For the individual business it should be possible to establish
the ideal ratio. Comparing ratios within an industry will usually show that the stronger businesses
have the larger proportion of current assets. There is nothing to be gained by comparing ratios
for concerns in different industries.

We’ve already explained the term ‘current assets’. Non-current assets are properties, machines,
equipment and other possessions held in the business permanently for the purpose of earning
profit. Examples are land and buildings, plant and machinery, office furniture and machinery,
motor vehicles and loose tools. The significant fact to remember is that these assets are not held
in the normal course of business, but are retained so that materials may be converted to finished
goods and the latter then sold.

Ratio of Shareholders’ to Payables’ Equity

Liabilities in a company Statement of Financial Position can be divided into two parts:
• Capital, reserves and undistributed profits owned by the shareholders (the net worth of the
business)
• Sums due to payables and lenders of loan capital (payables’ equity)

The two are compared to give the ratio of shareholders’ to payables’ equity. A strong business
will have the largest proportion of its total liabilities composed of the net worth. Weaker concerns
are those which are dependent upon payables and thus any adverse interference from them
may lead to serious consequences. The strong company is fully ruled by shareholders without
interference from payables.

Factors Affecting Liquidity

Three key factors influence the level of liquidity in a company, namely receivables, payables,
inventory.

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(a) Receivables
The earlier payment is received from receivables, the better is the liquidity position. A rough
measure of time taken by receivables to pay is possible by using the ratio:
Receivables (end of year)
x 365
Sales
This gives the number of days taken to pay, which can be very useful in terms of credit control.
This is illustrated by the following figures:
Year 1 Year 2
RWF RWF

Sales 80,000 Sales 120,000

Receivables 8,000 Receivables 20,000

RWF8,000 RWF20,000
x 365 = 36 days x 365 days = 61 days
RWF80,000 RWF120,000
Clearly credit control has been lax, and action is needed.

It is very important to remember that money owed by receivables is company money that has
alternative uses. Of course normal commercial courtesy demands that some time be
given to pay, but any unreasonable time means one company’s rightful funds in another
company’s bank account.

(b) Payables
The same reasoning applies here - the higher the payables figure, the higher the temporary
liquidity. For other reasons, however, too high a figure may mean danger. The calculation for
this is:
Payables (end of year)
x 365
Purchasers
This gives the number of days the company is being allowed to pay its payables.

(c) Rate of Stock Turnover

From the purely financial angle stock levels are important because high stock levels may
indicate the danger of tying up too much money in stocks (overstocking) or a sudden slowing
down in the stock turnover. Neither of these reasons for high stock figures in the Statement of
Financial Position is healthy.

Stock levels can be measured in the following ways:

(i) Stock turnover = Cost of goods sold Average stock

(i.e. average of opening and closing stock)
To show rate at which stock turns over.

(ii) Stock levels = Closing stock as a % Sales

This percentage can be measured against previous levels and comparisons can be made
with other firms and departments.
Of course there is rarely one Statement of Financial Position item called ‘inventory and you will have
to deal with the different types of inventory - raw materials, work in progress, finished goods

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E. INVESTMENT RATIOS

Introduction
In addition to the management ratios, investors frequently need to assess the merits of particular
investments.
The following ratios are commonly used, and can be illustrated by using the summarised accounts
of a limited company which follow.

Statement of Comprehensive Income for the year ending 31st December

RWF RWF
Net profit 100,000
Corporation tax (say) 25% 25,000
75,000
Balance 1st January 21,000
96,000
Proposed dividends:
Preference shares 10% 3,000
Ordinary shares 20% 30,000 33,000
Balance 31st December 63,000

SOFP as at 31st December

RWF RWF
Non-Current Assets 180,000

Current Assets:
Inventory 71,000
Accounts receivables 164,000
Cash at bank and in hand 5,000
240,000
420,000
Capital and Reserves:
Called up Share Capital:
30,000 RWF1
Preference Shares 30,000
600,000
Ordinary 25rwf Shares 150,000
180,000
General Reserve 79,000
Profit and Loss 63,000
142,000
Current Liabilities:
Accounts payable 65,000
Proposed dividends 33,000

98,000
420,000

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The shares were quoted on the Stock Exchange on 31 December at the following prices:

Preference shares .90rwf

Ordinary shares .60rwf

We will use these summarised accounts as the basis for illustrating the investment ratios.

Dividend Yield
This is the actual dividend payable for a year, including both interim and final, expressed as a
percentage of the
quoted share price. It is calculated as:

Dividend paid
x 100 = Dividend yield
Quoted share price x No. of Shares

In our example it will therefore be:

Shares 3,000
(a) (RWF0.9 x 30,000) = 11.1% approximately

30,000
(b) = 8.3% approximately
(RWF0.60 x 600,000)
The dividend yield is a measure of the income return on an investment, and ignores retained
profits. Normally, the higher the dividend yield on ordinary shares, the greater the risk, though
this is not always true. Preference shares tend to have a higher dividend yield than ordinary
shares, mainly to offset the fact that there is little scope for capital appreciation.

Dividend Cover
This ratio represents the extent to which the distributable profits compare with the
dividend payable.
Distributable profits represent the profits after corporation tax and any other appropriations have
been deducted. It is calculated in the following way:
Distributable profits
= Dividend cover
Dividend
In our example this will be:
(a) Preference Shares
75,000
= 25.0 times covered
3,000

(b) Ordinary Shares

In this case it will be necessary to adjust distributable profits for the interest paid to the preference
shareholders. The adjusted distributable profits will therefore be:

RWF
Profits after taxation 75,000
Less Preference dividend 3,000
Available for ordinary shares 72,000

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The cover for ordinary shares is thus:
72,000
= 2.4 times
30,000
Dividend cover is a test of a company’s ability to maintain its dividend level.

Earnings Yield
This is the profits available for distribution to the ordinary shareholders, expressed as a
percentage of the quoted market value of the ordinary share capital. It is computed as follows:
Distributable profits (less Preference dividends)
x 100 = Earnings yield
Number of ordinary shares x Market value

In our example the earnings yield will thus be:

72,000
x 100 = 20%
600,000 x RWF0.60
The earnings yield gives the true rate of return on an investment, assuming that all the profits
available for distribution are paid out as dividends. In the majority of cases a proportion of the
profits is retained, and it is the dividend yield that enables an investor to determine his income.

The earnings yield can also be expressed as earnings per ordinary share, which is the distributable
profit earned on one share. This is:

Distributable Profit = Earnings per ordinary share

Number of shares

From our example accounts it will be:

72,000
= RWF0.12 or .0012rwf per share
600,000

Price Earnings Ratio (or P/E Ratio)

This is the number of times the earnings per ordinary share will divide into the quoted price for
the share. The formula is:
Quoted share price
= P/E Ratio
Earnings per share

The P/E ratio is significant insofar as it establishes the number of years it will take for the capital
invested to be repaid out of earnings. In our example it will be:
0.60
= 5 times
0.12
It will therefore take 5 years, in this case, to recover from dividends the sum of money originally
invested. It can be compared with the payback period of assessing a capital product. Similar to
the dividend yield, the P/E ratio can be an indicator of risk; in this case, the higher the rate the
lower the risk, though this is not an absolute rule.

364 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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F. LIMITATIONS OF RATIO ANALYSIS
It must be emphasised that accounting ratios are only a means to an end, and not an end in
themselves. By comparing the relationship between figures, only trends or significant features
are highlighted. The real art in interpreting accounts lies in defining the reason for the features
and fluctuations. In order to do this effectively, the interested party may need further information
and a deeper insight into the business’s affairs. The following points should also be borne in
mind:

• The date to which the accounts are drawn up. Accurate information can only be obtained from
up-to-date figures. Seasonal trends should not be forgotten, as at the end of the peak season
the business presents the best picture of its affairs.
• The position as shown by the Statement of Financial Position. The arrangement of certain
matters can be misleading and present a more favourable position, i.e. making the effort to
collect debts just before the year-end in order to show more cash and lower receivables than
is usual; ordering goods to be delivered just after the year-end so that stocks and payables
can be kept as low as possible.
• Management interim accounts should be examined wherever possible to obtain a clearer idea
of trends.
• Comparison with similar businesses should also be made.

G. OTHER MEASURES OF BUSINESS OPERATIONS

The ratios we have outlined are the more common measures of company performance. Attention
should, however, be paid to the gearing of the company, i.e. the capital structure and the way the
company finances its assets. The word ‘capital’ here is used in a wider sense than share capital.

The lenders of funds to the company fall into two groups:

• Least Risk

• Debenture holders (who have first claim on money from a company in the event of a
winding-up)
• Payables (who are unsecured but can sue for their debts)
• Most Risk
Ordinary shareholders, who are only repaid in the event of a liquidation, when the least-risk group
has been fully repaid.

Gearing is the relationship of ordinary shareholders’ funds (sometimes called equity interest) to
preference shares and debentures (called fixed-return capital).

If a company is low-geared it means that the proportion of preference shares and debentures is
low compared with ordinary shares. Hence the preference shareholders and debenture holders
have greater security for payment of dividends/loan interest and the ordinary shareholders are
not liable to such violent changes in return on their investment, as there is less to pay before they
receive their entitlement.

High gearing, on the other hand, means a high proportion of preference shareholders and debenture
holders to ordinary shareholders. Here there is greater risk for the ordinary shareholders as a
greater proportion of the profits is to be paid out to a fixed return capital, before they receive their
entitlement.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 365

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H. WORKED EXAMPLE

Question
The following are financial statements provided by EPL Associates Inc, an American company:

Comparative Statements of Profit and Loss

Yr 2 Yr 3
RWF RWF

Gross sales 1,091,400 1,604,125

Less: Discounts 21,400 39,125
1,070,000 1,565,000
Cost of goods sold:
Opening inventory 50,500 65,000

Raw materials 225,000 293,000

Direct labour 485,000 795,000
Factory overhead 64,000 117,000
Depreciation 50,000 60,000
Closing inventory (65,000) (105,000)
809,500 1,225,000

Gross margin 260,500 340,000

Selling expenses (84,500) (121,000)
General and administrative (64,930) (73,310)
expenses

Operating profit 111,070 145,690

Other income (expenses) (20,000) 5,675
Taxation (40,982) (68,114)
Net profit 50,088 83,251

Comparative Statement of Financial Positions as at end of Year

Yr 2 Yr 3
RWF RWF
Current assets:
Cash 1,000 11,500
Receivables 52,500 95,000
Inventory 65,000 105,000
Prepaid expenses 4,000 6,000
122,500 217,500

Non-current assets 485,000 544,000

Less: Depreciation (342,000) (402,000)
143,000 142,000

366 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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 Other assets 20,000 15,000
Goodwill 50,000 50,000
70,000 65,000
335,500 424,500
Current liabilities:
Payables 35,000 78,000
Bank overdraft 16,000 -
Accrued expenses 40,000 60,750
Dividends payable 2,000 3,000
Taxes due 1,500 6,499
94,500 148,249

Bills of exchange 40,000 -

Provision for claims 10,000 10,000

Reserve for asset replacement 40,000 65,000
90,000 75,000

Net worth:
Preference shares 4,000 4,000
Ordinary shares 26,000 28,000
Capital surplus 5,000 10,000
Earned surplus 116,000 159,251
151,000 201,251
335,500 424,500

Reconciliation of Surplus in Year 2 and Year 3

Yr 2 Yr 3
RWF RWF
Earned surplus 90,912 116,000
Add: Net Profit 50,088 83,251
141,000 199,251
Less:
Dividends 5,000 15,000
Addition to reserve for asset replacement 20,000 25,000

Balance 116,000 159,251

EPLAssociates Inc is seeking additional finance, which your company is considering providing. You are
required:
• Using ratio analysis, to advise your company (in report format); and
• To state, with reasons, what additional statements you would ask for.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 367

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Solution

(a) Report
To: From: Board of Directors
Purpose: A. Student
To assess the advisability of providing finance to
EPL Associates Inc.

The following points arise from an examination of the financial statements provided by the
American company.

Sales and Profits

Yr 3 indicates an increase in turnover of 47% in money terms arising either from an increase in
selling
price or an increase in sales volume, or from a mix of the two. This has involved a reduction in
the gross margin (from 24.3% to 21.7%) although the operating profit as a percentage of sales
has reduced by a smaller sum - down by only 1.1%. The net operating margin of 9.3% does
leave some room to cover interest on any loan that we might make.

Turning to return on capital employed, the earnings before tax against net worth is 56.9% for Yr
3, an increase of 9.2% over the prior year.

The return is based on an assessment of non-current assets, which are presumably stated at
historic cost, as being fairly aged (this being indicated by depreciation being some 75% of cost).

Working Capital and Liquidity

Expenditure on fixed assets has been approximately covered by the retentions for depreciation
made
during the year. Retained profit after dividend has been taken almost exclusively into working
capital. This has led to some improvement of the current and liquidity ratios, which are still low:

Year 2 Year 3
Current ratio 0.85:1 1.3:1
Liquidity ratio 0.40:1 0.71:1
Looking at the constituents of working capital, the stock turnover does appear to have increased
a little but, without knowledge of the finished stock figures, this is impossible to tell with any
accuracy.

Receivables again cannot be accurately calculated as the sales trend over Yr 3 is unknown. It
appears that they are taking a little longer credit, though.
Trade suppliers’ credit has doubled and therefore does indicate a lengthening period of credit
taken.

Summary
More information is needed, as shown below, before any recommendation can be made. What
I can say
though is that trading seems to be well managed, with a substantial increase having been
possible without any large reduction in margins or any great increase in the value of stock and
receivables.
Non-current assets need replacing, which is presumably behind the request for finance. The
368 I1.2 FINANCIAL REPORTING CPA EXAMINATION
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company has a reserve of RWF65,000 for this purpose - and accumulated depreciation - but
these reserves and provisions are not in an immediately liquid form. Indeed, liquidity is low and
no indication is made as to whether payables are pressing.

There is likely also to be pressure from shareholders for increased dividends, the present level
being covered almost four times by available earnings.

Ratios Supporting Interpretation

Sales and Operating Profit

Yr 2 Yr 3 Movement
RWF’000 % RWF’000 % %
Net sales 1,070.00 100.00 1,565.00 100.00 46

Gross margin 260.50 24.3 340.00 21.7 2.6

Selling and administrative 149.43 13.9 194.31 12.4 1.5
costs

111.07 10.4 145.69 9.3 1.1

Return on Capital Employed

This is defined (in this instance) as:
Operating profit plus/(minus) other income/(expenses) as a percentage of net worth plus fixed
asset replacement reserve:
Year 2
RWF91,070
x 100 = 47.7%
191,000

Year 3
151,365
x 100 = 56.9%
266,251
9.2% increase

Working Capital
(i) Current ratio
Current assets: Current liabilities, bills and provisions
Yr 2 Yr 3 Movement
0.85:1 1.3:1 Increase 0.45 times

(ii) Liquidity ratio

Current assets excluding inventories: Current liabilities, bills and provisions
Yr 2 Yr 3 Movement
0.40:1 0.71:1 Increase 0.31 times

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(iii) Stock turnover (as far as this is available for data given) Cost of sales

Average of opening/closing inventory

Yr 2 Yr 3
Movement
Times turned over 14.02 14.41
Increase 0.39 times

(iv) Receivables turnover

Yr 2 Yr 3
Movement

RWF52,500 x 52 RWF95,0 = 2.5 weeks
1,070,000
RWF52,000 x 52 = 3.15 weeks
1,565,000
Increase 0.65 weeks

(b) Additional Statements Needed

• Accounts for Yr 0 and Yr 1 too, to enable the trend of results and cash flows to be
investigated.
• Data to enable closer analysis of stock and receivables to be made.
• Analysis of sales in units and money terms.
• Breakdown of costs to assess whether any changes in processes have been made. In
Yr 3 the following increases are apparent - raw materials 30%, direct labour 64%, factory
overheads 83%.
• Reasons why the finance is needed, including forward budgets.
• Details of security or guarantees.
B. ACCOUNTING FOR CONSIGNMENTS Background to consignments
Sometimes a business may not have its own retail premises but may instead choose to undertake
its business through an agent. In such situations, the business sending the goods is said to be
a consignor and the agent acting on their behalf is a consignee. The goods sent are said to be
delivered on a consignment basis.

Goods transferred Agent = Owner of goods

= consignment consignee = consignor

370 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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Accounting implications of consignment
The consignee will then sell the goods on behalf of the consignor, and normally retain an element
of the proceeds as a commission. They may also incur costs on behalf of the consignor
(e.g. shipping costs, storage costs), and depending on the specific conditions attaching to the
arrangement, can then deduct these costs from the proceeds before transferring the net
amount to the consignor. They will also have to account for these transactions with what
is effectively a receipts and payments account for the items involved.

It should be noted that legal ownership of the goods rests with the consignor until the goods are
sold. Any stock which remains unsold at the Reporting Date should be included in the inventory
figures for the consignor and not the consignee.

Bookkeeping in the records of the consignor

Three accounts are needed in the records of the consignor. These are;

• The Consignment Account: this is basically the profit and loss account for the
consignment transaction. Income received from selling the goods will be recorded here and
any expenses will be offset against it. The balance is obviously the profit or loss on the
transaction and will be transferred to the Statement of Consolidated Income.
• The Consignee account: this is the debtor or creditor account for the consignee. This will
show either any monies that the consignee is due to pay over to the consignor or vice-versa.
The former situation is more likely, especially if the consignee deducts their costs from the
proceeds before paying the net amount over to the consignor.
• The Consignment Inventory account: these are where all movements of stock are recorded.
When items are transferred from ‘normal’ inventory to that despatched on consignment then
the double entry will be to credit the ‘normal’ inventory and debit
• ‘consignment inventory’.

Arrangements will need to be made for regular stock-checks on the consignee’s premises,
especially around the Reporting Date. Any agreement should clearly specify who is to be
responsible for any losses in inventory due to misplacing them, theft or damage. It should also be
clear who is responsible for insuring the items involved. Any bad debts however would normally
be the responsibility of the consignor. However in some cases a special (del credere) commission
may be paid to the consignee, in which case they will be responsible for accounting for the bad
debt and picking up any corresponding loss.

At the end of the period, the unsold consignment inventory value should be carried forward to the
next accounting period in the books of the consignor as in any other form of inventory. However,
in line with the accounting rules on inventory (IAS 2 in the private sector, IPSAS
12 is the public sector accruals-based equivalent) all costs incurred in bringing that inventory to its
present location and condition can be included in the valuation of inventory including consignee’s
expenses, provided that the over-arching rule about inventory being shown as the lower of cost
or Net Realisable Value (NRV) is complied with. Note however that marketing costs incurred by
the consignee cannot be included.

Bookkeeping in the records of the consignee

To some extent, these are a mirror image of the consignor’s accounting entries. However it
should be noted that the consignor will not have an inventory account, as the stocks do not
belong to them. The account heads required are therefore merely a consignor account, which
records the proceeds collected by the consignee on behalf of the consignor, net of any expenses

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that the consignee is permitted to deduct such as commission and other direct costs of sale.
Any commission received will be credited to the appropriate account heading in the general
ledger and will be included in the year-end Financial Statements as part of the Statement of
Comprehensive Income in the same way as any other item of revenue. Similarly, any costs
which are not reimbursed – for example any bad debts that the consignee is responsible for – will
be debited to the appropriate expense head.

Example:
A book publisher sends 100 books worth 500,000 RwF to a shop on a sale or return basis. Their
original cost was 300,000. The shop has sold 60 of them by the end of the year, all at the agreed
selling price. Of the remaining 40, 10 are damaged and of no value – it has been agreed that the
consignor will bear the risk of any damage. The shop is paid a commission of
10% of any book sold.

Here are the relevant entries in the accounts:

• - Initial transfer of inventory (at lower of cost or NRV):

DR Consignment Inventory 300,000

CR Other Inventory 300,000

• - Sale of goods:

DR Consignee account 300,000

CR Profit and loss 300,000

DR Profit and loss 30,000

CR Consignee account (commission) 30,000
• Cost of sales:

DR Profit and loss 180,000

CR Consignment inventory 180,000

• - Inventory write-off:

DR Profit and loss (in Statement of Comprehensive Income)30,000

CR Consignment Inventory 30,000

At the reporting date, the relevant accounts would show (assuming that the consignee has not
paid any money over) the following:

Consignment Inventory

Initial amount transferred 300,000

Less books sold (180,000)

Less stock write-off (30,000)

Closing balance 90.000

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This represents the value of 30 books. A stock-take should be undertaken to ensure that there
are indeed 30 books left. There should also be a check that the sales value remains at 5,000
RwF per book. If it does not, and has dropped below the cost of the book – i.e. 3,000 per book
– then the value of inventory will also have to be written down.

Consignment profit and loss

Sales 300,000

Less Cost of Sales (180,000)

Less Consignee commission ( 30,000)
Less stock write-off ( 30,000)
Profit 60,000

This profit would be transferred to the Statement of Comprehensive Income.

Consignee account

` Sales proceeds collected by consignee 300.000

Less Commission due (30,000)
Net proceeds due from consignee 270,000

This amount would remain as a debtor (receivable) until paid. The consignee would have a
consignor account which mirrors this, showing a creditor (payable) of 270,000 RwF until paid.
When payment is made the consignor account would be debited with 270,000 RwF and the bank
account credited with the same amount.

C. ACCOUNTING FOR BANKS

It is often the case that banks in particular will have very well-prepared financial statements,
though the absolute quality may depend to some extent on the context. Especially if a bank
is part of a large, multi-national organisation there will be strong internal pressure to ensure
that financial information is prudently prepared and that it is consistent (especially important as
financial information will usually have to be consolidated into multi-national financial statements
and any inconsistencies or errors could therefore have a serious impact).

There are also sound organisational reasons why banking tends to have high quality financial
statements, in many countries providing best practice in financial statements. The financial
statements for one thing are especially important and investors and other stakeholders will want
reassurance that the bank in question is organised on a sound financial footing; a situation of
course that has become more obviously important in the past few years with the serious financial
problems that have faced many banks.

Banks also tend to be able to attract top quality accounting staff through the relative attractiveness
of salaries and other benefits that they are able to offer. They are also, if they are part of a
multinational banking group, likely to be subject to strong internal audit reviews from the banks
that they are part of. They will also be subject to a greater degree of external regulation than
many other bodies. All of these reasons tend to drive up the quality of financial statements in
banks – though the recent problems faced globally by the industry suggest that even here there
is in some instances much room for improvement.

CPA EXAMINATION I1.2 FINANCIAL REPORTING 373

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Banks in Rwanda and accounting regulation
Banks are subject to IFRS accounting rules in Rwanda. Reviews of the banking sector in the
World Bank Report on the Observance of Standards and Codes (ROSC) Report of 2008 stated
that the market in Rwanda engaged in the main in traditional banking activities such as lending
and deposits and foreign exchange transactions. This perhaps means that the market has been
limited in terms of its risk exposure compared to some other nations where for example complex
financial instruments like derivatives are much more widely used.

The National Bank of Rwanda (BNR) regulates financial reporting by banks and non-bank financial
institutions and issues accounting instructions governing the treatment of specific transactions—
e.g. provisions for non-performing loans. In the exercise of powers conferred to it by its statutes,
the Banking Act, and other legal provisions, the National Bank of Rwanda is empowered to enact
regulations, issue instructions, and take decisions that banks, insurance companies, and other
financial institutions must comply with if they wish to do business.

The accounting and auditing requirements, as outlined in the Banking Act, are in addition to those
set by the Companies Act. The National Bank of Rwanda requires these institutions to designate
at least one external auditor chosen from a list that it prepares on a regular basis. External
auditors of banks are required to follow the generally prevailing standards of their profession
coupled with the regulations, instructions, and decisions of the Central Bank. The term of an
auditor’s mandate is three years, renewable only once.

Compliance with IFRS requirements is a pre-requisite for banks. However, there are
additional financial requirements that the banks are required to meet. The ROSC Report noted
that the banking and financial institutions were the only ones to have an accounting and reporting
framework in Rwanda in 2008 but were not fully in compliance with IFRS in practice. The Report
found that “most banks’ accounting treatment for investments in treasury bills and long-term
government stocks does not comply with determination of impairment, specifically in relation to
the impairment of loans and advances, under IAS 39.

Capital Adequacy Ratios

Banks are in a different financial position than most other institutions as they are holding large
sums of money on behalf of others and they may be required to repay money to investors at
short notice. Furthermore there is a very close and immediate connection between the health of
banks and the health of the economy as a whole. A serious failure in a bank can have serious,
and sometimes disastrous, repercussions for the global economy. The failure of the American
investment bank Lehman Brothers in 2008 had a major impact, not just on the US economy but
on that of the world as a whole. Ongoing challenges for European banks affected by the ‘Euro
crisis’ continue to create major pressures on the wider economy of that region.

For this reason, banks in Rwanda, along with many other countries, are required to maintain
prudent ratios of capital funds to ensure that they can meet repayment demands and by so doing
maintain confidence in the economy and amongst investors. Such regulations are called
‘prudential’ requirements and the BNR Department of Banking Supervision is responsible for
monitoring compliance with these requirements.

D. INSURANCE COMPANIES
There are no specific legal regulations applying to insurance companies. However they are
required to once more comply with IFRS requirements in their accounting and reporting practices.
The BNR Department of Supervision of Non-Banking Institutions is responsible for monitoring

374 I1.2 FINANCIAL REPORTING CPA EXAMINATION

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compliance with IFRS. However the ROSC Review found that the insurance sector was not, in
2008, meeting IFRS requirements..

E. LIQUIDATION & BANKRUPTCIES

Definition:
In law, liquidation is the process by which a company (or part of a company) is brought to an
end, and the assets and property of the company redistributed. Liquidation is also sometimes
referred to as winding up or dissolution, although dissolution technically refers to the last stage
of liquidation.

Liquidation may either be compulsory (Creditors’ Liquidation) or voluntary (Shareholders’

Liquidation)

The liquidator will normally have a duty to ascertain whether any misconduct has been conducted
by those in control of the company which has caused prejudice to the general body of creditors.
In some legal systems, the liquidator may be able to bring an action against errant directors or
shadow directors for either wrongful trading or fraudulent trading.

The liquidator must determine the company’s title to property to enforce their claims against the
assets of the company to the extent that they are subject to a valid security interest. In most
legal systems, only fixed security takes precedence over all claims, security by way of floating
charge may be postponed to the preferential creditors.

Priority of Claims on the company’s assets will be determined in the following order:-

• Liquidators Costs
• Creditors with fixed charge over assets
• Costs incurred by an administrator
• Amounts owing to employees for wages/superannuation
• Payments owing in respect of workers injuries
• Amounts owing to employees for leave
• Retrenchment payments owing to employees
• Creditors with floating charge over assets
• Creditors with security over assets
• Shareholders

Having wound up the company’s affairs, the liquidator must call a final meeting of the members,
creditors or both. The liquidator is then usually required to send final accounts to the Registrar
and to notify the court. The company is then dissolved.
In Rwanda please refer to website: Codes of Laws of Rwanda, Law no 08/2002 of 05/02/2002
relating to Regulations Governing Banks and other Financial Institutions.

Liquidation of Banks or Financial Institutions in Rwanda

Any bank or financial institution under liquidation must:-

• Inscribe after the company’s name, the words – IN LIQUIDATION and not act as a bank or a
financial institution except with a clear mention that it is under liquidation
• Immediately stop its operations except those strictly necessary for its liquidation

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 • Put up in all its premises open to the public, a notice showing its being under liquidation either
with the mention, of the Central Bank’s authorization or the Court’s judgement depending on
the case

The Central bank will supervise the bank or financial institution during the liquidation process.
The Central Bank receives copies of all documents and letters relating to liquidation. The legal
status of the bank or financial institution under liquidation remains unaltered till its closure.

In every liquidation of a bank or financial institution the realization of all assets’ and any eventual
guarantees (Article 53 paragraph 2), minus expenses linked to the liquidation shall be distributed
to the various categories of creditors as follows:-
• Guarantee holders up to the value of their guarantees
• Depositors
• The State
• Other Certified Creditors

The Court may authorize the liquidator to affix seals on properties of administrators and managers
whose responsibility seems to be involved in accordance with Article 65.

It may also authorize the liquidator to:-

• Seize and freeze or make restrictions on monies due to the persons as well as on movable or
fixed assets belonging to them;
• Make objections in such forms and effects as are allowed by the Civil Law to those same
persons exercising their rights to dispose of any fixed assets

Forced liquidation is pronounced by Court after distribution of the remainder and approval of the
liquidator’s accounts.

Bankruptcies
Bankruptcy is a legal status of a HYPERLINK “http://en.wikipedia.org/wiki/Insolvent” n
insolvent person or an organisation, that is, one who cannot repay the debts they owe to
HYPERLINK “http://en.wikipedia.org/wiki/Creditors” creditors. In most jurisdictions bankruptcy
is imposed by a court order, often initiated by the debtor.

Bankruptcy is not the only legal status that an insolvent person or organisation may have, and
the term bankruptcy is therefore not the same a HYPERLINK “http://en.wikipedia.org/wiki/
Insolvency” s insolvency. In some countries, including the HYPERLINK “http://en.wikipedia.
org/wiki/United_Kingdom” United Kingdom, bankruptcy is limited to individuals, and other
forms of insolvency proceedings, for example HYPERLINK “http://en.wikipedia.org/wiki/
Liquidation” , liquidation a HYPERLINK “http://en.wikipedia.org/wiki/Administration_
(law)” nd administration are applied to companies. In the United States the term bankruptcy is
applied more broadly to formal insolvency proceedings.

Bankruptcy prevents a person’s creditors from obtaining a HYPERLINK “http://en.wikipedia.

org/wiki/Legal_judgment” judgment against them. With a judgment a HYPERLINK “http://
en.wikipedia.org/wiki/Creditor” creditor can attempt to HYPERLINK “http://en.wikipedia.
org/wiki/Garnishment” garnish wages or seize certain types of property. However, if a
HYPERLINK “http://en.wikipedia.org/wiki/Debtor” debtor has no wages (because they are
HYPERLINK “http://en.wikipedia.org/wiki/Unemployment” unemployed or HYPERLINK
376 I1.2 FINANCIAL REPORTING CPA EXAMINATION
STUDY MANUAL
“http://en.wikipedia.org/wiki/Retirement” retired) and has no property, they are “ HYPERLINK
“http://en.wikipedia.org/wiki/Judgment_proof” judgment proof”, meaning a judgment would
have no impact on their financial situation. Creditors typically do not initiate legal action against
a debtor with no assets, because it’s unlikely they could collect the judgment.

If enough time passes, seven years in most jurisdictions, the debt is removed from the debtor’
HYPERLINK “http://en.wikipedia.org/wiki/Credit_history” s credit history.

HYPERLINK “http://en.wikipedia.org/wiki/Debtor” A debtor with no assets or income cannot

be garnished by a HYPERLINK “http://en.wikipedia.org/wiki/Creditor” creditor, and therefore
the “Take No Action” approach may be the correct option, particularly if the debtor does not
expect to have a steady income or property a creditor could attempt to seize.

F. IPSAS
Presentation of Financial Statements - IPSAS 1
IPSAS 1 (“Presentation of Financial Statements”) gives general guidance as to the types of
financial statements to be prepared in the public sector (along with IPSAS 2 on the cash flow
statement). It is drawn primarily from IAS 1. It should be applied to all general purpose financial
statements prepared and presented under the accrual basis of accounting in accordance
with IPSASs. In common with most IPSASs, it applies to all public sector entities other than
Government Business Enterprises which use IFRSs for their financial reporting.

It outlines that there are six basic components of financial statements namely a Statement of
Financial Position, a Statement of Financial Performance, a statement of changes in net assets/
equity, a cash flow statement, a comparison of budget and actual amounts (only if the budget is
made publicly available) and the notes to the financial statements. It is important to emphasise
that the disclosures in the notes are considered a fundamental part of the financial statements
– but detailed guidelines on what should go into the notes for specific elements of the financial
statements are found in individual IPSASs on the topics involved and not in IPSAS 1, which sets
out high level contents only.

Many of these financial statements are similar to those in use within the private sector. One
important difference however is the comparison of budget and actual amounts. This reflects the
fact that in the public sector the budget has a greater and different significance than it does in the
private sector. In particular it is a tool to help ensure accountability of those responsible for the
control of resources and their effective, efficient and economic use. IPSAS 1 does not give
detailed guidance on the budget v actual comparison statement which is covered in more detail
within IPSAS 24, “Presentation of Budget Information in Financial Statements” (this is one of the
few IPSASs for which there is no equivalent IFRS).

Entities are encouraged to present other information than that included in the financial statements
to assist users in assessing the performance of the entity, its stewardship of assets and making
an informed evaluation about decisions on the allocation of resources. Such information might
include performance indicators, statements of service performance, program reviews and
other reports by management. These areas will be further covered in the “Conceptual Framework”
which is currently being prepared by IFAC to provide a framework within which future IPSASs will
be prepared and current IPSASs possibly revised.

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IPSAS 1 states that financial statements shall 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, revenue, and expenses set out in IPSASs. The
application of IPSASs, with additional disclosures when necessary, is presumed to result in
financial statements that achieve a fair presentation.

An entity whose financial statements comply with IPSASs shall make an explicit and unreserved
statement of such compliance in the notes. Financial statements shall not be described as
complying with IPSASs unless they comply with all the requirements of IPSASs
– in other words selective application of IPSASs is not permitted.

In addition to the over-arching consideration of ‘fair presentation’ other important concepts are
included, for example;

• that the financial statements are prepared on the basis that the entity is a ‘going concern’
• that there is in normal circumstances consistency of presentation from one reporting period to
the next
• the concept of materiality and aggregation of large numbers of transactions into classes for
reporting purposes
• that the offsetting of assets and liabilities, or revenue and expenses, is not permitted unless
specifically allowed or required by an IPSAS
• that comparative information for previous periods will be included in the financial statements
unless an IPSAS allows or requires its non-inclusion (e.g. in the first reporting period for a new
entity)

Much of the detailed guidance in IPSAS 1 replicates that found in IAS 1 and is therefore not
replicated here. The main differences between the two are shown below:
• Commentary additional to that in IAS 1 has been included in IPSAS 1 to clarify the applicability
of the Standard to accounting by public sector entities, e.g., discussion on the application of the
going concern concept has been expanded.
• IAS 1 allows the presentation of either a statement showing all changes in net assets/
equity, or a statement showing changes in net assets/equity, other than those arising from
capital transactions with owners and distributions to owners in their capacity as owners. IPSAS
1 requires the presentation of a statement showing all changes in net assets/equity.
• IPSAS 1 uses different terminology, in certain instances, from IAS 1. The most significant
examples are the use of the terms “statement of financial performance,” and “net assets/equity”
in IPSAS 1. The equivalent terms in IAS 1 are “income statement,” and “equity”.
• IPSAS 1 does not use the term “income,” which in IAS 1 has a broader meaning than the term
“revenue.”
• IPSAS 1 contains commentary on timeliness of financial statements, because of the lack of
an equivalent Framework in IPSASs (paragraph 69). However this may be revised once the
Conceptual Framework is finalised.
• IPSAS 1 contains an authoritative summary of qualitative characteristics (based on the IASB
framework) in Appendix A. Again, this may be revised once the Conceptual Framework is
finalised.

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Cash Flow Statements – IPSAS 2
IPSAS 2 is drawn primarily from International Accounting Standard (IAS) 7, Cash Flow Statements.
You should note that although cash flow statements are discussed in detail in IPSAS 2, IPSAS 1
on the presentation of financial statements also makes reference to them.

In practice, there are no significant differences between IPSAS 2 and IAS 7. However there are
some differences in the detail, namely:
• Commentary additional to that in IAS 7 has been included in IPSAS 2 to clarify the applicability
of the standards to accounting by public sector entities. IPSAS 2 uses different
terminology, in certain instances, from IAS 7. The most significant examples are the use of the
terms “revenue,” “statement of financial performance,” and “net assets/equity” in IPSAS 2. The
equivalent terms in IAS 7 are “income,” “income statement,” and “equity.”
• IPSAS 2 contains a different set of definitions of technical terms from IAS 7 (paragraph8).
• n common with IAS 7, IPSAS 2 allows either the direct or indirect method to be used to
present cash flows from operating activities. Where the direct method is used to present cash
flows from operating activities, IPSAS 2 encourages disclosure of a reconciliation of surplus
or deficit to operating cash flows in the notes to the financial statements (paragraph
29).

Inventories - IPSAS 12

IPSAS 12 (“Inventories”) is drawn substantially from IAS 2. As the name suggests, its objective
is to prescribe the accounting treatment for inventories. Specifically it provides guidance on the
calculation of cost and the subsequent recognition of inventories as expenses when they are
consumed or sold. They also provide guidance on the write-down of inventories to their Net
Realisable Value (in the case of inventories held for re-sale, defined as the future sales proceeds
of any inventory less any future costs that would be incurred to make that sale happen).

The IPSAS outlines a number of situations where the rules outlined do not apply, for
example:
• Work-in-progress on construction contracts (specific rules are in IPSAS 11)
• Financial instruments (see IPSASs 28 and 29)
• Biological assets (IPSAS 27)

The basic rule, as it is in IAS 2, is that inventories should be carried in the Statement of
Financial Position (sometimes known as the Balance Sheet) until it is used or sold, at which

point the inventory will be charged to the Statement of Financial Performance. The
accounting is quite simple as the following example shows:

Entity X, a public sector education establishment buys 20,000,000 RwF of fuel oil in
December 2012, which it does not plan to use until 2013:

In the financial statements, the double entry for this transaction (assuming it is paid for in cash
when purchased is):

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 DEBIT Inventories (Statement of Financial Position) 20,000,000
CREDIT Cash (20,000,000)

When it is then used in 2013, the double entry would

be:

DEBITExpenses (Statement of Financial Performance) 20,000,000

CREDIT Inventories (20,000,000)

Inventories in the public sector may take a number of different forms, some of them quite
unusual. These include:
• Ammunition
• Consumable stores
• Maintenance materials
• Energy reserves
• Stocks of unissued currency

The cost of inventories shall comprise all costs of purchase, costs of conversion, and other costs
incurred in bringing the inventories to their present location and condition. Costs of purchase
includes any non-reclaimable taxes and import duties. If there are any conversion costs, such as
would be the case with a publicly-owned manufacturing environment which takes raw materials
and turns them into finished goods then any attributable overheads may also be added to the
cost as long as these overhead costs are allocated in a systematic fashion.

The accounting treatment in IPSAS 12 is similar to that in IAS 2. Basically, when inventories are
sold, exchanged, or distributed, the carrying amount of those inventories shall be recognized
as an expense in the period in which the related revenue is recognized. If there is no related
revenue, the expense is recognized when the goods are distributed or the related service is
rendered.

There are only a few differences between IPSAS 12 and IAS 2. IPSAS 12 requires that where
inventories are provided at no charge or for a nominal charge, they are to be valued at the lower
of cost and current replacement cost (in the public sector it is not as unusual for inventories to
move from one organisation to another on a free-of-charge basis as it is in the private sector).
In addition the financial statement known as the ‘Statement of Financial Performance’ is known
as the ‘Income Statement’ in IAS 2, which also uses the term
‘income’ rather than ‘revenue’.

Accounting Policies, Changes in Accounting Estimates and Errors - IPSAS 3

IPSAS 3 (“Accounting Policies, Changes in Accounting Estimates and Errors”) is drawn from IAS
8. The objective of this Standard is to prescribe the criteria for selecting and changing accounting
policies, together with the (a) accounting treatment and disclosure of changes in accounting
policies, (b) changes in accounting estimates, and (c) the corrections of errors. This Standard
is intended to enhance the relevance and reliability of an entity’s financial statements, and the
comparability of those financial statements over time and with the financial statements of other
entities.

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In the public, as in the private, sector an entity has some discretion as to the accounting policies it
adopts to most fairly represent the financial transactions of the business. Therefore it is important
that there is some guidance laid out to ensure that there is an appropriate methodology for the
adoption of accounting policies and also around how they are changed. Equally, mistakes will
from time to time be made in the preparation of financial statements and they may not always be
picked up in the audit subsequently. Therefore guidance is also required to ensure that if errors
are not discovered until after the financial statements have been formally approved then there
are appropriate measures adopted to react to the situation.

It should be noted that one of the allowable reasons for changing an accounting policy is the
publication of a new IPSAS. Entities will always have a transition period during which they may
move from the existing accounting treatment to that which is required by the new IPSAS. On
the other hand the management of the entity may feel that a different policy is required because
of changes that have taken place within the entity itself. Changes of accounting policy, which
usually require restatement of comparative figures and opening balances should not be confused
with changes in accounting estimate, which do not.

Estimates may often be used in government accounting for example estimated amounts of tax
revenues, estimated bad debt provisions for uncollected debts or the obsolescence of
inventory. When these estimates turn out to be in need of correction – and remember that an
estimate is almost certain to be incorrect to some extent because the outcome is uncertain.
These estimates should be corrected in the current financial period and not previous ones.

Errors can arise in respect of the recognition, measurement, presentation, or disclosure of

elements of financial statements. Financial statements do not comply with IPSASs if they contain
either material errors, or immaterial errors made intentionally to achieve a particular presentation
of an entity’s financial position, financial performance, or cash flows. Nevertheless some financial
statements may inadvertently contain material errors which are not picked up. If they do and the
financial statements have not yet been finalised then the drafts of these should of course be
collected before publication. However if they are only picked up once the financial statements
are approved then the correct accounting treatment is to adjust the comparative figures in the
next year’s financial statements and adjust the opening balances accordingly.

Once more the major differences between IPSAS 3 and IAS 8 mainly revolve around terminology.
IPSAS 3 uses the terms ‘Statement of Financial Performance’, accumulated surplus or deficit
and net assets/equity whereas in IAS 8 these are termed ‘income statement’,
‘retained earnings’ and ‘equity’. Also IPSAS 3 talks of ‘revenue’, which is called ‘income’ in

IAS 8. In addition, unlike IAS 8 IPSAS 3 does not require disclosures about earnings per share,
which are not normally relevant in a public sector context.
Events after the reporting date - IPSAS 14

IPSAS 14, “Events after the reporting date”, is drawn from IAS 10, “Events after the balance
sheet date”. Its objective is to prescribe;
• When an entity should adjust its financial statements for events after the reporting date; and
• The disclosures that an entity should give about the date when the financial statements were
authorized for issue, and about events after the reporting date.

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It also requires that an entity should not prepare its financial statements on a going concern basis
if events subsequent to the reporting date mean that this is not appropriate.

Events after the reporting date may be analysed into adjusting and non-adjusting in nature.
Adjusting events occur when information is received after the reporting date which gives more
evidence about a condition that already existed at the reporting date. One example would be
when a court case has been commenced against the entity where, say, a provision of
30,000,000 RwF has been established. If the court case is decided after the reporting date but
before the financial statements are organised and the court finds that the entity is liable to make
payments of 40,000,000 RwF then the financial statements should be adjusted accordingly.

Non-adjusting events are those which occur after the reporting date and, although significant, do
not normally give evidence of a condition existing at the balance sheet date. Examples given by
IPSAS 14 include a major fire after the reporting date that destroys a substantial asset, a major
acquisition or disposal, changes in tax rates or tax laws, large falls in asset values or big foreign
exchange losses. These non-adjusting events do not require the financial statements to be re-
stated but they should be disclosed in the notes to the financial statements if they are material.

There are no major differences in principle between IPSAS 14 and IAS 10, although some extra
guidance is given in the former to explain better how it applies to the private sector. Other than
that the differences are once more largely in terminology.

Property , Plant and Equipment - IPSAS 17

IPSAS 17 (“Property, Plant and Equipment”) is drawn primarily from IAS 16, which has the same
name. It provides one of the major challenges when public sector accounting moves from a cash
to an accruals basis for the first time. It is often a major exercise to assemble all the information
required to accurately state an entity’s Property, Plant and Equipment (PPE) values for the first
time. It is also necessary to establish policies on depreciation, that is allocating the cost of the
asset over the period in which it is expected to have a useful life and amortisation, which is
effectively a write-down that must be made when an asset suffers a permanent diminution in
value.

The objective of IPSAS 17 is to prescribe the accounting treatment for property, plant, and
equipment so that users of financial statements can discern information about an entity’s
investment in this and the changes in such investment. The principal issues in accounting for
property, plant, and equipment are (a) the recognition of the assets, (b) the determination of their
carrying amounts (a carrying amount is the value that the asset has in the Statement of Financial
Position), and (c) the depreciation charges and impairment losses to be recognized in relation
to them.

The Standard applies to all assets (except some which are specifically dealt with by other IPSAS)
including some that are quite specific to the public sector such as specialist military equipment
and infrastructure assets (these would be for example roads or bridges). It does not however
apply to mining activities when mineral reserves such as oil or gas are depleted by uses. It does
not apply either to biological assets (these include animals kept for resale or slaughter or crops
grown for harvesting) which are dealt with by IPSAS 27. Other IPSAS also deal with assets in
specific situations, such as IPSAS 16, which deals with properties held for investment purposes,
or IPSAS 13 on leased assets.

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As in private sector accounting, the general rules are that the cost of an item of property, plant,
and equipment shall be recognized as an asset if, and only if:
• It is probable that future economic benefits or service potential associated with the item will
flow to the entity; and
• The cost or fair value of the item can be measured reliably (fair value is the price at which
the property could be exchanged between knowledgeable, willing parties in an arm’s length
transaction).

The cost of an item of property, plant, and equipment comprises:

• Its purchase price, including import duties and non-refundable purchase taxes, after deducting
trade discounts and rebates.
• Any costs directly attributable to bringing the asset to the location and condition necessary for it
to be capable of operating in the manner intended by management.
• The initial estimate of the costs of dismantling and removing the item and restoring the site on
which it is located, the obligation for which an entity incurs either when the item is acquired, or
as a consequence of having used the item during a particular period for purposes other than to
produce inventories during that period.

Only directly attributable costs may be capitalised as part of the asset value. IPSAS 17 says
that these include:
• The costs of employee benefits (as defined in the relevant international or national accounting
standard dealing with employee benefits – the IPSAS dealing with this is IPSAS 25) arising
directly from the construction or acquisition of the item of property, plant, and equipment;
• Costs of site preparation;
• Initial delivery and handling costs;
• Installation and assembly costs;
• Costs of testing whether the asset is functioning properly, after deducting the net proceeds
from selling any items produced while bringing the asset to that location and condition (such
as samples produced when testing equipment); and
• Professional fees.

An important element of IPSAS 17 is that entities that are making the transition to accruals
accounting based on IPSAS for the first time have a five-year period to make that transition as far
as the recognition of plant, property and equipment under this particular Standard is concerned.

Further, an entity that adopts accrual accounting for the first time in accordance with IPSASs
shall initially recognize property, plant, and equipment at cost or fair value. For items of property,
plant, and equipment that were acquired at no cost, or for a nominal cost, cost is the item’s fair
value as at the date of acquisition (this might be the case if for example an asset was gifted as
part of a legacy or was transferred at no cost from another government department).

In such situations, the entity shall recognize the effect of the initial recognition of property, plant,
and equipment as an adjustment to the opening balance of accumulated surpluses or deficits for
the period in which the property, plant, and equipment is initially recognized.

Although IPSAS 17 is drawn primarily from IAS 16, Property, Plant and Equipment, as amended
by IAS 16 (part of the Improvements to IFRSs which was issued in May 2008) there are some
differences between the private and public sector versions of the Standard. As one detailed
example, at the time of issuing IPSAS 17, the IPSASB has not yet considered the applicability of
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IFRS 5, Non-current Assets Held for Sale andDiscontinued Operations to public sector entities;
therefore, IPSAS 17 does not reflect amendments made to IAS 16 consequent upon the issue
of IFRS 5.

However, the main differences between IPSAS 17 and IAS 16 (2003) are as follows:
• IPSAS 17 does not require or prohibit the recognition of heritage assets. An entity that recognizes
heritage assets is required to comply with the disclosure requirements of this Standard with
respect to those heritage assets that have been recognized and may, but is not required to,
comply with other requirements of this Standard in respect of those heritage assets. IAS 16
does not have a similar exclusion. (A heritage asset is one which has particular historic or
cultural significance, such as a Parliament building or an archaeological site which makes
the use of conventional asset valuation rules of limited relevance)
• IAS 16 requires items of property, plant, and equipment to be initially measured at cost. IPSAS
17 states that where an item is acquired at no cost, or for a nominal cost, its cost is its fair value
as at the date it is acquired.
• IAS 16 requires, where an enterprise adopts the revaluation model and carries items of property,
plant, and equipment at revalued amounts, the equivalent historical cost amounts should be
disclosed. This requirement is not included in IPSAS 17.
• Under IAS 16, revaluation increases and decreases may only be matched on an individual
item basis. Under IPSAS 17, revaluation increases and decreases are offset on a class of asset
basis (this could make a significant difference).
• IPSAS 17 contains transitional provisions for both the first time adoption and changeover
from the previous version of IPSAS 17. IAS 16 only contains transitional provisions for entities
that have already used IFRSs. Specifically, IPSAS 17 contains transitional provisions allowing
entities to not recognize property, plant, and equipment for reporting periods beginning on
a date within five years following the date of first adoption of accrual accounting in accordance
with IPSASs. The transitional provisions also allow entities to recognize property, plant, and
equipment at fair value on first adopting this Standard. IAS 16 does not include these transitional
provisions. This is an important concession in that it can sometimes be very difficult to assemble
all the necessary data to allow the transition to an accruals-based approach to asset
accounting and it allows public sector entities a significant amount of time to do so.
• IPSAS 17 contains definitions of “impairment loss of a non-cash-generating asset” and
“recoverable service amount.” IAS 16 does not contain these definitions. This is an important
distinction. A non-cash generating asset is one that is not held for the generation of a commercial
return and there are a number of these in use in the public sector which would not be the case
in the private sector.
• IPSAS 17 uses different terminology, in certain instances, from IAS 16. The most significant
examples are the use of the terms “statement of financial performance,” and “net assets/equity”
in IPSAS 17. The equivalent terms in IAS 16 are “income statement” and “equity.” IPSAS 17
does not use the term “income,” which in IAS 16 has a broader meaning than the term “revenue.”

Intangible Assets – IPSAS 31

This is one of the most recent IPSASs to be created and is based on International Accounting
Standard (IAS) 38, Intangible Assets published by the International Accounting Standards Board
(IASB). It also contains extracts from the Standing Interpretations Committee Interpretation 32
(SIC 32), Intangible Assets—Web Site Costs. It includes useful application guidance on how to
deal with website costs and has a number of illustrative examples which show how accounting
for intangible assets could be applied in various situations such as when a patent, copyright or
license is acquired from a public sector entity.
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The main differences between IPSAS 31 and IAS 38 are as follows:
• IPSAS 31 incorporates the guidance contained in the Standing Interpretation
Committee’s Interpretation 32, Intangible Assets—Web Site Costs as Application Guidance to
illustrate the relevant accounting principles.
• IPSAS 31 does not require or prohibit the recognition of intangible heritage assets (as is also
the case with tangible assets dealt with by IPSAS 17). An entity that recognizes intangible
heritage assets is required to comply with the disclosure requirements of this Standard with
respect to those intangible heritage assets that have been recognized and may, but is
not required to, comply with other requirements of this Standard in respect of those intangible
heritage assets. IAS 38 does not have similar guidance.
• IAS 38 contains requirements and guidance on goodwill and intangible assets acquired
in a business combination. IPSAS 31 does not include this guidance.
• IAS 38 contains guidance on intangible assets acquired by way of a government grant.
• Paragraphs 50–51 of IPSAS 31 modify this guidance to refer to intangible assets acquired
through non-exchange transactions. IPSAS 31 states that where an intangible asset is
acquired through a non-exchange transaction, the cost is its fair value as at the date it is
acquired.
• IAS 38 provides guidance on exchanges of assets when an exchange transaction lacks
commercial substance. IPSAS 31 does not include this guidance.

The examples included in IAS 38 have been modified to better address public sector
circumstances.
• IPSAS 31 uses different terminology, in certain instances, from IAS 38. The most significant
examples are the use of the terms “revenue,” “statement of financial performance,” “surplus or
deficit,” “future economic benefits or service potential,” “accumulated surpluses or deficits,”
“operating/operation,” “rights from binding arrangements (including rights from contracts or
other legal rights),” and “net assets/equity” in IPSAS 31. The equivalent terms in IAS 38 are
“income,” “statement of comprehensive income,” “profit or loss,” “future economic benefits,”
“retained earnings,” “business,” “contractual or other legal rights,” and “equity.”

Investment Property – IPSAS 16

IPSAS 16 is drawn primarily from International Accounting Standard (IAS) 40 (Revised
2003), Investment Property. In common with some other IPSASs, there are some transitional
arrangements that apply when an entity adopts accrual accounting for the first time in accordance
with IPSASs. These state that in such circumstances the entity shall initially recognize investment
property at cost or fair value. For investment properties that were acquired at no cost, or for a
nominal cost, cost is the investment property’s fair value as at the date of acquisition. The entity
should recognize the effect of the initial recognition of investment property as an adjustment to
the opening balance of accumulated surpluses or deficits for the period in which accrual
accounting is first adopted in accordance with IPSASs.

In terms of the comparison of IPSAS 16 to IAS 40 (2003), Investment Property, the IPSAS notes
that the IPSASB has not yet considered the applicability of IFRS 4, Insurance Contracts,
and IFRS 5, Non-current Assets Held for Sale and Discontinued Operations, to public sector
entities; therefore IPSAS 16 does not reflect amendments made to IAS 40 consequent upon the
issue of those IFRSs.

The other main differences between IPSAS 16 and IAS 40 are as follows:

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 • IPSAS 16 requires that investment property initially be measured at cost and specifies that
where an asset is acquired for no cost or for a nominal cost, its cost is its fair value as at the date
of acquisition. IAS 40 requires investment property to be initially measured at cost.
• There is additional commentary to make clear that IPSAS 16 does not apply to property held
to deliver a social service that also generates cash inflows. Such property is accounted
for in accordance with IPSAS 17, Property, Plant, and Equipment.
• IPSAS 16 contains transitional provisions for both the first time adoption and changeover
from the previous version of IPSAS 16. IAS 40 only contains transitional provisions for entities
that have already used IFRSs.
• IFRS 1 deals with first time adoption of IFRSs. IPSAS 16 includes additional transitional
provisions that specify that when an entity adopts the accrual basis of accounting for the first
time and recognizes investment property that was previously unrecognized, the adjustment
should be reported in the opening balance of accumulated surpluses or deficits.
• Commentary additional to that in IAS 40 has been included in IPSAS 16 to clarify the applicability
of the standards to accounting by public sector entities.
• IPSAS 16 uses different terminology, in certain instances, from IAS 40. The most significant
example is the use of the term “statement of financial performance” in IPSAS 16. The equivalent
term in IAS 40 is “income statement.” In addition, IPSAS 16 does not use the term “income,”
which in IAS 40 has a broader meaning than the term “revenue.”

Provisions, Contingent Liabilities and Contingent Assets – IPSAS 19

This International Public Sector Accounting Standard (IPSAS) is drawn primarily from International
Accounting Standard (IAS) 37 (1998), Provisions, Contingent Liabilities and Contingent Assets.
It includes guidance on what action should be taken when transitioning to using IPSAS 19 for
the first time, namely that the effect of adopting this Standard shall be reported as an adjustment
to the opening balance of accumulated surpluses/(deficits) for the period in which the Standard
is first adopted. Entities are encouraged, but not required, to (a) adjust the opening balance
of accumulated surpluses/(deficits) for the earliest period presented, and (b) to restate
comparative information. If comparative information is not restated, this fact shall be disclosed.

There are some differences between IPSAS 19 and IAS 37 as follows:

• IPSAS 19 includes commentary additional to that in IAS 37 to clarify the applicability of the
standards to accounting by public sector entities. In particular, the scope of IPSAS 19 clarifies
that it does not apply to provisions and contingent liabilities arising from social benefits
provided by an entity for which it does not receive consideration that is approximately equal
to the value of the goods and services provided directly in return from recipients of those benefits
(this is to take account of the fact that public sector entities often provide goods or services that
are “free at the point of delivery” to the end user or at least provided in return for consideration
that is below normal market values). However, if the entity elects to recognize provisions for
social benefits, IPSAS 19 requires certain disclosures in this respect.
• The scope paragraph in IPSAS 19 makes it clear that while provisions, contingent liabilities, and
contingent assets arising from employee benefits are excluded from the scope of the Standard,
the Standard, however, applies to provisions, contingent liabilities, and contingent assets arising
from termination benefits that result from a restructuring dealt with in the Standard.
• IPSAS 19 uses different terminology, in certain instances, from IAS 37. The most significant
examples are the use of the terms “revenue” and “statement of financial performance” in IPSAS
19. The equivalent terms in IAS 37 are “income” and “income statement.”

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 • The Implementation Guidance included in IPSAS 19 has been amended to be more reflective
of the public sector.
• IPSAS 19 contains an Illustrated Example that illustrates the journal entries for recognition
of the change in the value of a provision over time, due to the impact of the discount factor
(the discount factor measures the way that time affects the value ofmoney and is built into the
calculations of long-term provisions).
Accounting for revenues in the public sector (IPSASs 9 and 23)
There are two IPSASs in particular that focus on accounting for revenues in the public sector.
IPSAS 9 deals with accounting for what is known as exchange transactions and IPSAS 23 deals
with accounting for non-exchange transactions, especially taxes and transfers. As IPSAS
23 has no IFRS equivalent it will be necessary to discuss this in more detail than some other
IPSASs.

What is the difference between exchange and a non-exchange transactions?

Exchange transactions are transactions in which one entity receives assets or services, or has
liabilities extinguished, and directly gives approximately equal value (primarily in the form of
cash, goods, services, or use of assets) to another entity in exchange. This might be thought of
as being equivalent to a commercial transactions which explains why this IPSAS is based on an
IFRS (IAS 18, Revenue). So when, for example, a public sector provides goods and/or services
for which it receives in return a payment that is related to their market value then it should apply
IPSAS 9 in its accounting treatment.

If on the other hand there is no exchange of approximately equal value then IPSAS 23 will
apply – such transactions will be described as ‘non-exchange’ in nature. This will be the case for
many public sector transactions. For example when governments raise taxation revenues, there
is no direct correlation between them and consequent expenditures. Although the taxpayer will
rightly expect ‘value’ from their tax contributions, it is not normally possible to directly match their
individual contributions to say expenditures on health, education, defence or many other public
services.

IPSAS 9 – Exchange Transactions

As already mentioned these have a similar nature to commercial transactions and are therefore
based on IAS 18. IPSAS 9 reminds us that revenue is recognised when it is probable that future
economic benefits or service potential will flow to the entity and when such benefits can be
measured reliably.

There are no significant variations between IPSAS 9 and IAS 18, with the differences in detail
being as follows:
• The title of IPSAS 9 differs from that of IAS 18, and this difference clarifies that
• IPSAS 9 does not deal with revenue from non-exchange transactions.
• The definition of “revenue” adopted in IPSAS 9 is similar to the definition adopted in IAS 18.
The main difference is that the definition in IAS 18 refers to ordinary activities (IPSAS 9
makes no such distinction).
• Commentary additional to that in IAS 18 has also been included in IPSAS 9 to clarify the
applicability of the standards to accounting by public sector entities.
• IPSAS 9 uses different terminology, in certain instances, from IAS 18. The most significant
example is the use of the term “net assets/equity” in IPSAS 9. The equivalent term in IAS 18 is
“equity.”

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IPSAS 23 – Non-Exchange Transactions
The introduction to IPSAS 23 notes that the majority of government revenues is generated
in the form of taxes and transfers but that, until the passing of the Standard, there was no specific
guidance in how to deal with transactions involving such items.

In summary, IPSAS 23:

• Takes a transactional analysis approach whereby entities are required to analyse inflows
of resources from non-exchange transactions to determine if they meet the definition of an asset
and the criteria for recognition as an asset, and if they do, determine whether a liability is also
required to be recognized;
• Requires that assets recognized as a result of a non-exchange transaction initially be measured
at their fair value as at the date of acquisition;
• Requires that liabilities recognized as a result of a non-exchange transaction be recognized in
accordance with the principles established in IPSAS 19, Provisions, Contingent Liabilities and
Contingent Assets;
• Requires that revenue equal to the increase in net assets associated with an inflow of resources
be recognized;
• Provides specific guidance that addresses:

• Taxes; and
• Transfers, including:
• a. Debt forgiveness and assumption of liabilities;
• b. Fines;
• c. Bequests;
• d. Gifts and Donations, including goods in-kind;
• e. Services in-kind;
• Permits, but does not require, the recognition of services in-kind; and
• Requires disclosures to be made in respect of revenue from non-exchange transactions.

An entity will recognize an asset arising from a non-exchange transaction when it gains control
of resources that meet the definition of an asset and satisfy the recognition criteria. Contributions
from owners do not give rise to revenue, so each type of transaction is analysed, and any
contributions from owners are accounted for separately. Consistent with the approach set out in
this Standard, entities will analyse non-exchange transactions to determine which elements of
general purpose financial statements will be recognized as a result of the transactions.

Two kinds of revenue transaction are relevant within the framework of IPSAS 23. The first is when
an asset comes under the control of an entity without an approximately equivalent exchange
taking place in return. This would be the case when for example an asset is transferred to an
organisation free of charge (or, if there is a charge, it is significantly below market value). In such
circumstances a simple yes/no decision tree needs to be followed which is illustrated below.

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Simplistically summarised, the flowchart shows that in certain circumstances when a non-
exchange transaction takes place then it creates both an asset and also revenue. For example,
if an entity were given an asset for which they paid nothing but its market value was worth
5,000,000 RWF then the double entry for this would be to create an asset of 5,000,000 RwF and
to recognise revenue (as a credit entry) also of 5,000,000 RwF. However, if the entity incurs a
liability for that asset which is below its market value then the revenue should be reduced to the
extent of that liability.

Revenue from taxes

The general rule is that an entity shall recognize an asset in respect of taxes when the taxable
event occurs and the asset recognition criteria are met. The definition of an asset is met when
the entity controls the resources as a result of a past event (the taxable event) and expects to

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receive future economic benefits or service potential from those resources. In addition, it must be
probable that the inflow of resources will occur and that their fair value can be reliably measured.

Taxation revenue arises only for the government that imposes the tax, and not for other entities.
For example, where the Rwandan government imposes a tax that is collected by the RRA,
assets and revenue accrue to the government, not the taxation agency which is effectively acting
as a collection agency on behalf of government.

Taxes do not satisfy the definition of contributions from owners, because the payment of taxes
does not give the taxpayers a right to receive (a) distributions of future economic benefits or
service potential by the entity during its life, or (b) distribution of any excess of assets over
liabilities in the event of the government being wound up. Nor does the payment of taxes provide
taxpayers with an ownership right in the government that can be sold, exchanged, transferred,
or redeemed.

On the other hand, taxes satisfy the definition of a non-exchange transaction because the
taxpayer transfers resources to the government, without receiving approximately equal value
directly in exchange. While the taxpayer may benefit from a range of social policies established
by the government, these are not provided directly in exchange as consideration for the payment
of taxes.

Recognition of taxation revenue is based on the time at which the taxable event takes place,
examples of which are when:

• Income tax is the earning of assessable income during the taxation period by the taxpayer;
• Value-added tax is the undertaking of taxable activity during the taxation period by the taxpayer;
• Goods and services tax is the purchase or sale of taxable goods and services during the taxation
period;
• Customs duty is the movement of dutiable goods or services across the customs boundary;
• Property tax is the passing of the date on which the tax is levied, or the period for which the tax
is levied, if the tax is levied on a periodic basis.

Other types of non-exchange revenue

Fines are economic benefits or service potential received or receivable by a public sector entity,
from an individual or other entity, as determined by a court or other law enforcement body, as a
consequence of the individual or other entity breaching the requirements of laws or regulations.

Fines normally require an entity to transfer a fixed amount of cash to the government, and do not
impose on the government any obligations which may be recognized as a liability. As such, fines
are recognized as revenue when the receivable meets the definition of an asset and satisfies the
criteria for recognition as an asset which have already been discussed. Where an entity collects
fines in the capacity of an agent, the fine will not be revenue of the collecting entity. Assets
arising from fines are measured at the best estimate of the inflow of resources to the entity.

Sometimes a bequest may be made to a government entity. A bequest is a transfer made

according to the provisions of a deceased person’s will. The past event giving rise to the control
of resources embodying future economic benefits or service potential for a bequest occurs when
the entity has an enforceable claim, for example on the death of the person making the bequest.
Bequests that satisfy the definition of an asset are recognized as assets and revenue when it is

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probable that the future economic benefits or service potential will flow to the entity, and the fair
value of the assets can be measured reliably. Determining the probability of an inflow of future
economic benefits or service potential may be problematic if a period of time elapses between
the death of the testator and the entity receiving any assets.

The entity will need to determine if the deceased person’s estate is sufficient to meet all claims
on it, and satisfy all bequests. If the will is disputed, this will also affect the probability
of assets flowing to the entity. Therefore it can be seen that asset and revenue recognition is
not always a straightforward situation with bequests. It is necessary to obtain an estimate of the
fair value of bequeathed assets, for example by obtaining the latest market values for assets
bequeathed.

Disclosures
Both IFRSs and IPSASs are as much about disclosure as they are about accounting treatment.
IPSAS 23 has a list of disclosure requirements that apply specifically to non-exchange
transactions. These include a requirement to disclose the following details:

Either on the face of, or in the notes to, the general purpose financial statements:
• The amount of revenue from non-exchange transactions recognized during the period by
major classes showing separately:

• Taxes, showing separately major classes of taxes; and

• Transfers, showing separately major classes of transfer revenue.
• The amount of receivables recognized in respect of non-exchange revenue;

• The amount of liabilities recognized in respect of transferred assets subject to

conditions
• The amount of assets recognized that are subject to restrictions and the nature of those
restrictions; and
• The existence and amounts of any advance receipts in respect of non-exchange transactions.

An entity shall disclose in the notes to the general purpose financial statements:

• The accounting policies adopted for the recognition of revenue from non-exchange transactions;
• For major classes of revenue from non-exchange transactions, the basis on which the fair value
of inflowing resources was measured;
• For major classes of taxation revenue that the entity cannot measure reliably during the period
in which the taxable event occurs, information about the nature of the tax; and
• The nature and type of major classes of bequests, gifts, and donations.

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Borrowing Costs – IPSAS 5

IPSAS 5 is drawn primarily from IAS 23, Borrowing Costs. The Standard makes clear that
borrowing may be for commercial purposes or, in the case of government entities, for social
policy at a notional charge – IPSAS 5 specifically gives as an example of such an entity a
government housing department.

There are no significant differences between IPSAS 5 and IAS 23. Those small differences which
do exist are as follows:

• Commentary additional to that in IAS 23 has been included in IPSAS 5 to clarify the applicability
of the standards to accounting by public sector entities.
• IPSAS 5 uses different terminology, in certain instances, from IAS 23. The most significant
examples are the use of the terms “revenue,” “statement of financial performance,” and “net
assets/equity” in IPSAS 5. The equivalent terms in IAS 23 are “income,” “income statement,”
and “equity.”
• IPSAS 5 contains a different set of definitions of technical terms from IAS 23 (these are included
in paragraph 5 and cover ‘borrowing costs’ and ‘qualifying asset’).

Leases – IPSAS 13
This is drawn primarily from IAS 17, Leases. Several exceptions are outlined by IPSAS 13 where
other IPSASs will be applied instead. These are IPSAS 16 (Investment Properties) and IPSAS
27 (Biological Assets). Also not covered by IPSAS 13 are situations where there are leases to
explore or use mineral assets, oil, etc. and licensing agreements such as those covering motion
picture films, plays, patents and copyrights.

Specific mention is made of transitional arrangements that apply to leasing. Retrospective

application of IPSAS 13 by entities that have already adopted the accrual basis of accounting
and that intend to comply with IPSASs as they are issued is encouraged but not required.

There are no substantial differences between IPSAS 13 and IAS 17. Those differences that do
exist are as follows;

• Commentary additional to that in IAS 17 has been included in IPSAS 13 to clarify the applicability
of the standards to accounting by public sector entities.
• IPSAS 13 uses different terminology, in certain instances, from IAS 17. The most significant
examples is the use of the term “statement of financial performance” in IPSAS 13. The equivalent
term in IAS 17 is “income statement.”
• IPSAS 13 does not use the term “income,” which in IAS 17 has a broader meaning than the
term “revenue.”
• IPSAS 13 has additional implementation guidance that illustrates the classification of a lease,
the treatment of a finance lease by a lessee, the treatment of a finance lease by a lessor, and
the calculation of the interest rate implicit in a finance lease.

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Consolidated Financial Statements and other connected situations – IPSASs 6, 7 and 8

Consolidated and Separate Financial Statements - IPSAS 6

This IPSAS is drawn primarily from IAS 27. In government accounting, consolidation is an
important procedure as many governments seek to move towards full Whole of Government
Accounting. The major challenge is sometimes knowing what to consolidate and what not to
consolidate. The main criterion for this relates to questions of control rather than legal form; if
another entity has its financial and operating decisions controlled by another, then its financial
statements should be consolidated. A controlling entity or its controlled entity may be an investor
in an associate, or a venturer in a jointly controlled entity. In such cases, consolidated financial
statements prepared and presented in accordance with this Standard are also prepared so as
to comply with IPSAS 7, Investments in Associates, and IPSAS 8, Interests in Joint Ventures.

Helpfully, IPSAS 6 gives more guidance as to when control exists. It states that control is
presumed to exist when at least one of the following power conditions and one of the following
benefit conditions exists, unless there is clear evidence of control being held by another entity.

Power Conditions

• The entity has, directly or indirectly through controlled entities, ownership of a majority voting
interest in the other entity.
• The entity has the power, either granted by or exercised within existing legislation, to appoint or
remove a majority of the members of the board of directors or equivalent governing body, and
control of the other entity is by that board or by that body.
• The entity has the power to cast, or regulate the casting of, a majority of the votes that are likely
to be cast at a general meeting of the other entity.
• The entity has the power to cast the majority of votes at meetings of the board of directors or
equivalent governing body, and control of the other entity is by that board or by that body.

Benefit Conditions

• The entity has the power to dissolve the other entity and obtain a significant level of the residual
economic benefits or is required to bear significant obligations in such circumstances. For
example the benefit condition may be met if an entity has responsibility for the residual liabilities
of another entity.
• The entity has the power to extract distributions of assets from the other entity, and/or may be
liable for certain obligations of the other entity.

This is not the only test however. When one or more of the circumstances listed above does
not exist, the following factors are likely, either individually or collectively, to be indicative of the
existence of control.

Power Indicators

• The entity has the ability to veto operating and capital budgets of the other entity.
• The entity has the ability to veto, overrule, or modify governing body decisions of the other entity.
• The entity has the ability to approve the hiring, reassignment, and removal of key personnel
of the other entity.
• The mandate of the other entity is established and limited by legislation.
• The entity holds a golden share (or equivalent) in the other entity that confers rights to govern
the financial and operating policies of that other entity.

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Benefit Indicators

• The entity holds direct or indirect title to the net assets/equity of the other entity, with an
ongoing right to access these.
• The entity has a right to a significant level of the net assets/equity of the other entity in the
event of a liquidation, or in a distribution other than a liquidation.
• The entity is able to direct the other entity to cooperate with it in achieving its
objectives.
• The entity is exposed to the residual liabilities of the other entity.

IPSAS 6 notes that in some instances, an economic entity will include a number of intermediate
controlling entities. For example, in a publicly-controlled health sector while a department of
health may be the ultimate controlling entity, there may be intermediate controlling entities
at the local or regional health authority level. Accountability and reporting requirements within
each jurisdiction may specify which entities are required to (or exempted from the requirement
to) prepare consolidated financial statements. Where there is no specific reporting requirement
for an intermediate controlling entity to prepare consolidated financial statements for which
users are likely to exist, intermediate controlling entities are to prepare and publish consolidated
financial statements.

IPSAS 6 also interacts with other IPSASs. In one specific example, outlined in the Standard a
controlled entity should be excluded from consolidation when there is evidence that (a) control
is intended to be temporary because the controlled entity is acquired and held exclusively with
a view to its disposal within twelve months from acquisition, and (b) management is
actively seeking a buyer. Such controlled entities are classified and accounted for as financial
instruments. IPSAS 28, Financial Instruments: Presentation, IPSAS 29, Financial Instruments:
Recognition and Measurement, and IPSAS 30, Financial Instruments: Disclosures provides
guidance on financial instruments.

An example of temporary control is where a controlled entity is acquired with a firm plan to
dispose of it within twelve months. This may occur where an economic entity is acquired, and an
entity within it is to be disposed of because its activities are dissimilar to those of the acquirer.
Temporary control also occurs where the controlling entity intends to cede control over a
controlled entity to another entity – for example a national government may transfer its interest in
a controlled entity to a local government. For this exemption to apply, the controlling entity must
be demonstrably committed to a formal plan to dispose of, or no longer control, the entity that
is subject to temporary control. An entity is demonstrably committed to dispose of, or no longer
control, another entity when it has a formal plan to do so, and there is no realistic possibility of
withdrawal from that plan.

Having said that, a controlled entity is not excluded from consolidation because its activities are
dissimilar to those of the other entities within the economic entity, for example the consolidation
of GBEs with entities in the budget sector. Relevant information is provided by consolidating
such controlled entities and disclosing additional information in the consolidated
financial statements about the different activities of controlled entities. IPSAS
18, Segment Reporting, helps to explain the significance of different activities within the economic
entity.

There are challenges in the ‘mechanics’ of putting consolidated financial statements together. In
preparing consolidated financial statements, an entity combines the financial statements of the
controlling entity and its controlled entities line by line, by adding together like items of assets,

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liabilities, net assets/equity, revenue, and expenses. In order that the consolidated financial
statements present financial information about the economic entity as that of a single entity, the
following steps are then taken:
• The carrying amount of the controlling entity’s investment in each controlled entity and the
controlling entity’s portion of net assets/equity of each controlled entity are eliminated (the
relevant international or national accounting standard dealing with business combinations
provides guidance on the treatment of any resultant goodwill);
• Minority interests in the surplus or deficit of consolidated controlled entities for the reporting
period are identified; and
• Minority interests in the net assets/equity of consolidated controlled entities are identified
separately from the controlling entity’s net assets/equity in them. Minority interests in the net
assets/equity consist of:

• The amount of those minority interests at the date of the original combination;
and
• The minority’s share of changes in net assets/equity since the date of combination.

Balances, transactions, revenues, and expenses between entities within the economic entity
shall be eliminated in full. This is straightforward enough to understand in theory but in practice
requires well-coordinated cooperation between the various entities included in the group to
ensure that there is a consistent treatment of the transactions involved. It also requires consistent
accounting policies as IPSAS 6 requires that consolidated financial statements shall be prepared
using uniform accounting policies for like transactions and other events in similar circumstances.

On occasion, the IPSASs regime may allow transitional arrangements to apply to specific IPSASs
when an entity is moving to full accruals-based IPSAS implementation for the very first time.
IPSAS 6 is one of these. It states that entities are not required to comply with the requirement
concerning the elimination of balances and transactions between entities within the economic
entity for reporting periods beginning on a date within three years following the date of first
adoption of accrual accounting in accordance with IPSASs. This recognises the occasionally
complex procedures that may need to be set up to eliminate intra-entity transactions and balances.

This is because controlling entities that adopt accruals accounting for the first time in accordance
with IPSASs may have many controlled entities, with a significant number of transactions between
these entities. Accordingly, it may be difficult to identify some transactions and balances that
need to be eliminated for the purpose of preparing the consolidated financial statements of the
economic entity.

If entities choose to apply the transitional provisions, they shall disclose the fact that not all
balances and transactions occurring between entities within the economic entity have been
eliminated.

In terms of differences from IAS 27, Consolidated and Separate Financial Statements , from
which IPSAS 6 is drawn, has the following variations;
• At the time of issuing IPSAS 6, the IPSASB has not considered the applicability of IFRS 5, Non-
current Assets Held for Sale and Discontinued Operations, to public sector entities; therefore
IPSAS 6 does not reflect amendments made to IAS 27 consequent upon the issue of IFRS
5.

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 • Commentary additional to that in IAS 27 has been included in IPSAS 6 to clarify the applicability
of the Standard to accounting by public sector entities.
• IPSAS 6 contains specific guidance on whether control exists in a public sector context (these
can be found in paragraphs 28–41).
• IPSAS 6 uses different terminology, in certain instances, from IAS 27. The most significant
examples are the use of the terms “statement of financial performance,” “net assets/equity,”
“economic entity,” “controlling entity,” and “controlled entity” in IPSAS 6. The equivalent terms in
IAS 27 are “income statement,” “equity,” “group,”“parent,” and “subsidiary.”
• IPSAS 6 does not use the term “income,” which in IAS 27 has a broader meaning than the term
“revenue.”
• IPSAS 6 permits entities to use the equity method (see IPSAS 7) to account for controlled
entities in the separate financial statements of controlling entities.
• IPSAS 6 requires controlling entities to disclose a list of significant controlled entities in
consolidated financial statements. IAS 27 does not require this disclosure.
• IPSAS 6 includes a transitional provision that permits entities to not eliminate all balances and
transactions between entities within the economic entity for reporting periods beginning on a
date within three years following the date of first adoption of this Standard. IAS 27 does not contain
transitional provisions.
• IPSAS 6 contains additional illustrative examples that reflect the public sector context.

Investments in Associates - IPSAS 7

IPSAS 7 is drawn primarily from IAS 28, Accounting for Investments in Associates. However
it does not apply to investments held by joint ventures when the investments are measured at
fair value: in such situations IPSAS 29, Financial Instruments; Measurement and
Recognition is applied.

As the name implies, the Standard provides the basis for accounting for ownership interests in
associates. This occurs when the investment in the other entity confers on the investor the risks
and rewards incidental to an ownership interest. The Standard applies only to investments
in the formal equity structure (or its equivalent) of an investee. A formal equity structure means
share capital or an equivalent form of unitized capital, such as units in a property trust, but may
also include other equity structures in which the investor’s interest can be measured reliably.
Where the equity structure is poorly defined, it may not be possible to obtain a reliable measure
of the ownership interest.

Sometimes, contributions made by public sector entities may be referred to as an

“investment,” but may not give rise to an ownership interest. For example, a public sector entity
may make a substantial investment in the development of a hospital that is owned and operated
by a charity. While such contributions are non-exchange in nature, they allow the public sector
entity to participate in the operation of the hospital, and the charity is accountable to the
public sector entity for its use of public monies. However, the contributions made by the
public sector entity do not constitute an ownership interest, as the charity could seek alternative
funding and thereby prevent the public sector entity from participating in the operation of the
hospital. Accordingly, the public sector entity is not exposed to the risks, nor does it enjoy the
rewards, that are incidental to an ownership interest.

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The accounting for an associate uses the ‘equity method’, that is a method of accounting whereby
the investment is initially recognized at cost, and adjusted thereafter for the post- acquisition
change in the investor’s share of net assets/equity of the investee. The surplus or deficit of the
investor includes the investor’s share of the surplus or deficit of the investee.

The main differences between IPSAS 7 and IAS 28 are as follows:

• Commentary additional to that in IAS 28 has been included in IPSAS 7 to clarify the
applicability of the standards to accounting by public sector entities.
• IPSAS 7 applies to all investments in associates where the investor holds an
ownership interest in the associate in the form of a shareholding or other formal equity
structure. IAS 28 does not contain similar ownership interest requirements.
• However, it is unlikely that equity accounting could be applied unless the associate had a
formal or other reliably measurable equity structure.
• IPSAS 7 uses different terminology, in certain instances, from IAS 28. The most significant
examples are the use of the terms “statement of financial performance,” and “net assets/equity”
in IPSAS 7. The equivalent terms in IAS 28 are “income statement,” and “equity.”
• IPSAS 7 does not use the term “income,” which in IAS 28 has a broader meaning than the term
“revenue”.

Interests in Joint Ventures – IPSAS 8

IPSAS 8 is drawn primarily from IAS 31, also entitled Interests in Joint Ventures. The scope
paragraph states that an entity that prepares and presents financial statements under the accrual
basis of accounting shall apply this Standard in accounting for interests in joint ventures and the
reporting of joint venture assets, liabilities, revenue and expenses in the financial statements
of venturers and investors, regardless of the structures or forms under which the joint venture
activities take place. However, it does not apply to venturers’ interests in jointly controlled entities
held by:
• Venture capital organizations; or
• Mutual funds, unit trusts and similar entities including investment linked insurance funds that
are measured at fair value, with changes in fair value recognized in surplus or deficit in the
period of the change in accordance with IPSAS 29, Financial Instruments: Recognition and
Measurement.

The existence of a binding arrangement distinguishes interests that involve joint control from
investments in associates in which the investor has significant influence (as already referred
to in discussions on IPSAS 7, Investments in Associates.) For the purposes of IPSAS 8, an
arrangement includes all binding arrangements between venturers. That is, in substance, the
arrangement confers similar rights and obligations on the parties to it as if it were in the form of
a contract.

One example given by IPSAS 8 is when two government departments may enter into a formal
arrangement to undertake a joint venture, but the arrangement may not constitute a legal contract
because, in that jurisdiction, individual departments may not be separate legal entities with the
power to contract. Activities that have no binding arrangement to establish joint control are not
joint ventures for the purposes of IPSAS 8.

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A binding arrangement may be evidenced in a number of ways, for example by a contract between
the venturers or minutes of discussions between the venturers. In some cases, the binding
arrangement is incorporated in the enabling legislation, articles, or other by-laws of the joint
venture. Whatever its form, the arrangement is usually in writing, and deals with such matters as:
• The activity, duration and reporting obligations of the joint venture;
• The appointment of the board of directors or equivalent governing body of the joint venture
and the voting rights of the venturers;
• Capital contributions by the venturers; and the sharing by the venturers of the output,
revenue, expenses, surpluses or deficits, or cash flows of the joint venture.

The binding arrangement establishes joint control over the joint venture. Such a requirement
ensures that no single venturer is in a position to control the activity unilaterally. The arrangement
identifies (a) those decisions in areas essential to the goals of the joint venture that require the
consent of all the venturers, and (b) those decisions that may require the consent of a specified
majority of the venturers.

Many public sector entities establish joint ventures to undertake a variety of activities. The nature
of these activities ranges from commercial undertakings to provision of community services at no
charge. The terms of a joint venture are set out in a contract or other binding arrangement and
usually specify the initial contribution from each joint venturer and the share of revenues or other
benefits (if any), and expenses of each of the joint venturers.

Joint ventures take many different forms and structures. IPSAS 8 identifies three broad types
– jointly controlled operations, jointly controlled assets, and jointly controlled entities – that are
commonly described as, and meet the definition of, joint ventures. The following characteristics
are common to all joint ventures:
• Two or more venturers are bound by a binding arrangement; and
• The binding arrangement establishes joint control.

At the time of issuing IPSAS 8, the IPSASB has not considered the applicability of IFRS 3,
Business Combinations, and IFRS 5, Non-current Assets Held for Sale and Discontinued
Operations, to public sector entities. Therefore, IPSAS 8 does not reflect amendments made to
IAS 31 consequent on the issue of IFRS 3 and IFRS 5. The main differences between IPSAS 8
and IAS 31 are as follows:

• Commentary additional to that in IAS 31 has been included in IPSAS 8 to clarify the applicability
of the standards to accounting by public sector entities.
• IPSAS 8 uses different terminology, in certain instances, from IAS 31. The most significant
examples are the use of the terms “statement of financial performance,” and “net assets/equity”
in IPSAS 8. The equivalent terms in IAS 31 are “income statement,” and “equity.”
• IPSAS 8 does not use the term “income,” which in IAS 31 has a broader meaning than the term
“revenue.”
• IPSAS 8 uses a different definition of “joint venture” from IAS 31. The term “contractual
arrangement” has been replaced by “binding arrangement.”
• IPSAS 8 includes a transitional provision that permits entities that adopt proportionate
consolidation treatment to not eliminate all balances and transactions between venturers, their
controlled entities, and entities that they jointly control for reporting periods beginning on a
date within three years following the date of adopting accrual accounting for the first time in
accordance with IPSASs. IAS 31 does not contain transitional provisions

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