accounting 2a

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_______________________________________ACCOUNTING 2 A MODULE

CODE CAC 2106

1.0 The Manufacturing Account

A manufacturing entity transforms basic raw materials into marketable products. During themanufacturing process costs are incurred which eventually forms the basis for calculating the

cost price of the manufactured products.

Manufacturing accounts are prepared for internal management use only. The Company will be

producing its own finished goods. Their purpose is to distinguish between the cost and

profitability associated with manufacturing operations and those associated with trading. The

manufacturing business will produce its own finished goods rather than buy them from others

thus purchases will be replaced by the cost of manufacture. Our task is to construct the

manufacturing account in which the cost of manufacturing goods will be ascertained.

1.1 Format

Manufacturing account for the year ended 31 Dec 2009

$ $

Direct materials

Opening stock of raw materials *

Add purchases of raw materials *

Carriage inwards *

Less returns *

Less closing stock of raw materials * *

Direct labour *



Direct expenses *

= Prime cost *

Production overheads *

Production cost **

Add opening work in progress *

Less closing work in progress *

Cost of goods manufactured **

1.2 Production costs

Direct material

Direct labourDirect expenses = prime cost

+

overheads = production costs

1.3 DIRECT COSTS

Applies to costs, which can be readily associated with the product, i.e. its possible to trace the

cost of making an item to the item being manufactured. Include the following:

Direct materials: These are the materials used in the manufacturing process, which directly varies

with production.

Direct labour: relates to labour costs of factory staff who are directly involved in the

manufacturing of the products.

Direct expenses

1.4 INDRECT EXPENSES

Production overheads: all other expenses that are incurred in the manufacturing process. Theses

are fixed costs because they do not vary with production and are charged to products using basis

of apportionment which include the following:



Floor space

No of employees

Property valuation

1.5 CLOSING INVENTORIES

Ra w materials: unprocessed inventory

Work in progress: partly completed inventory

Finished goods: completed inventory.

1.6 Manufacturing profit

Market value of goods transferredThe purpose of a manufacturing account is to determine whether the firm benefits or loses out by

manufacturing the goods rather than buying them from the open market. To determine the

manufacturing profit or loss, the market value (sometimes called transfer value) is established. In

such a case any unsold goods will contain an element of manufacturing profit not yet realized.

Therefore, a provision for unrealized profit must be created.

The manufacturing profit is added to the total cost of the finished products manufactured to give

the costs of the finished products that are transferred to the sales department

On the trading account the manufacturing profit is added as other income after gross profit.

Provision for unrealized profit on finished inventory

Accounts affected are the

Other income

Manufacturing profit *

Less /add provision for unrealized profit (*)

Profit *

Statement of financial position



Stock *

Less provision for unrealized profit (*)

NB Calculation of unrealized profit where goods are transferred at a cost plus 33 and 1/3 %

Stock figure is at 1.3333

Therefore provision = stock figure *. 333331.33333

Mark up =Gross profit

Cost of sales

Margin =Gross profit

Sales

Mark up to Margin

Margin = Mark up

Mark up +100

Margin to Mark up

Mark up = Margin

100 - Margin

The provision account



31 Dec 2008 Bal c/d * Dec2008 Profit and loss * 2009 bal

b/d *

NB it is possible to meet a situation where manufactured stock fall and accordingly the

manufacturing profit may simply be increased by the addition of provision for unrealized profit

no longer required.

1.7 Apportionment of expenses

Costs, which are not identifiable with any cost centre, are apportioned using basis of

apportionment. The basis used will depend on the circumstances using the most equitable way of

doing it

Example 1



J H is a manufacturer. He presents you with the following list of balances and requests that you

construct the manufacturing and the statement of comprehensive income for the year ended 31

December 2008

$ $ Advertising 1154 Audit fee 420 Bank charges 98 Carriage inwards 2405 Insurance

105 Loan interest 2000 Office equipment at cost 6400 Office salaries 8250 Office lighting

and heating 110 Plant maintenance 1246 Plant at cost 46505 Postage and telephones 326

Factory power and lighting 2051 Rates 940 Sales 256490 Purchases 107475 Sales

department salaries 3242 Stock of raw materials 1 Jan 2008 16425 Stock of finished goods 1

Jan 2008 7292 Stock of work in progress 1 Jan 2008 2417 Factory wages 29640

Additional notes:

Stock as at 31 December 2008

Raw materials 19047

Work in progress 2160

Finished goods (600 units) 6000

Depreciation for the year is to be provided for at the rate of 20% on cost for plant at 15% on cost

for office equipment.

There is an amount of $247 outstanding for factory power and lighting. The rates are prepaid to

the extent of $300

A provision is to be made for doubtful debts.

20000 units of completed production were transferred to the selling dept at $10each.

Solution



JH

Manufacturing and the statement of comprehensive income for the year ended 31 December

2008

$ $ Opening stock of raw materials 16425 Purchases of raw materials 107475 Add carriage

inwards 2405 109880 126305 Less closing stock 19047 107258 Direct wages 29640

Prime cost 136898 Production overheads Plant maintenance 1246 Plant Depreciation 9301

Power and lighting 2298 12845 149743 Add opening work in progress 2417 Less closing

work in progress 2160 257 Production cost 150000 Transfer value of goods (20000*10 )

200000 Profit 50000

Sales 256490 Less cost of goods sold Opening stock of finished goods 7292 Transfer value

200000 207292 Less closing stock of finished goods 6000 201292 Gross profit 55198Factory profit 50000 Add Provision unrealized profit 323 50323 Less expenses

Selling and distribution Sales dept salaries and expenses 3242 Advertising 1154 Doubtful

debts 256 4652 Administrative expenses Rates 640 Insurance 105 Office lighting

and heating 110 Depreciation of office equipment 960 Audit fees 420 Office salaries 8250

Postage and telephones 326 Bank charges 98 10909 Finance costs Loan interest

2000 17561 Profit for the year 87960



2.0 Statements of Cash Flows (IAS 7)

2.1 In order for a business to survive the ability to make profits may not be enough. It is also

important for a business to generate sufficient cash to meet maturing obligations and to pursue

all the opportunities desired by management. History has shown that profitable businesses can be

severely restricted as a result of inadequate management of cash. Therefore businesses should

pay great attention to both liquidity and profitability if they are to succeed.

IAS 7 requires Cash flow statements to be presented together with other financial statements .It

is a statement which shows cash inflows and outflows during the accounting period .The purpose

of this statement is to reveal to users how cash was generated and used by the company during

the period under review. Therefore there is need for cash situation indicating sources and uses

the reason being that many businesses fail and are wound up because of cash shortages despite

adequate profits being made. Cash flow statements can signal the development of a problem.

Basically it shows where the cash resources came from and have gone. A Cash flow statement

gives a guide to the quality of the company’s profits. Profits are not necessarily a reliable

measure of the company’s performance. Companies can adjust profits to suit their own purpose



using accruals or matching concept or provisions. However to be successful in business a

company must make a profit.

2.2 Importance

Users of financial statements specifically need information on the following issues:

Management and shareholders are interested in the company’s ability to increase cash.

Company’s ability to generate cash, timing and certainty that it will be generated sufficient

profits are made to finance bus activities. Shareholders are also interested in whether thecompany will fund dividend payments, however dividend payment levels must not preclude

reinvestment that is necessary to ensure future viability.

Help explain the existence of an overdraft Why the bank balance is high when there is a loss

Legal need for some companies to prepare them

Help determine the cash flows which the business may be able to generate in the future

How far the bus will be able to meet future commitments tax dues loan repayments interest

payments, contracts that could possibly lose quite a lot of money. Non payment could cause

viability problems

The need of the company to utilize the cash flows because the company’s survival in busines s

depends on the ability to generate cash.

It’s more comprehensive than profit, which depends on the accounting conventions and concepts.

Creditors are more interested in a company’s ability to repay them than in its profitability i.e.

profit indicate that cash is likely to be available but cash flow accounting is more direct.

Enables comparisons of results of different companies to be made.

Cash flow forecasts are easier to prepare and more useful than profit forecast.

Reporting cash flows satisfy the needs of all users better.

2.3 Definition of terms



Cash flow is simply a summary of the cash receipts and payments of a business

Cash: cash on hand and deposits

Cash equivalent: are highly liquid short-term investments that are held for the purpose of

meeting short-term commitments (readily convertible into cash}.

Operating activities: the principal revenue producing activities of the company. Operating

activities represent the main activities that a business entity performs to generate profits or

revenue. They include the cash receipts from customers and cash payments to suppliers and

employees.

Investing activities: it results from the acquisition or disposal of non current assets e. g long

term assets and other investments not included in cash equivalent.

Investment in PPE (*)

Replacement of PPE (*)

Additions to PPE (*)

Proceeds from sale of PPE *

Acquisition of investments (*)

Proceeds from sale of investments *

Net cash flow from investing activities **

NB On disposal of non current assets a disposal account must be prepared to calculate the actual

amount received and to determine the profit or loss on disposal.

Financing activities: These are the activities that result in changes in the size and composition of

the equity capital and borrowings of a business entity. The cash flows can be determined by

comparing the two balance sheets or by using the statement of changes in equity.

The cash and cash equivalents: this is the final balance of the cash flow statement and shows the

increase or decrease in cash during the period. This indicates to users whether or not the

company has experienced a net cash inflow during the year. This enhances the understanding of



the liquidity position of the company. Secondly users can easily identify the sources of cash

inflows (external financing vs. internally generated) and the uses to which that cash has been put.

Note:

Interest and dividends received and paid may be classified as operating, investing or financing

cash flows provided that they are classified consistently from period to period. (IAS 7.31)

Taxation: cash flow arising from taxes on income are normally classified as operating unless

they can be specifically identified with financing or investing activities (IAS 7 .35)

.

For the purpose of cash flows, the activities of an entity are categorized into 3 main classes;

2.4 Objective of the statements of cash flows

The objective of the cash flow statement is to provide useful information regarding the historical

changes in cash and cash equivalents of the entity.

The statement of cash flows enables the users of financial statements to formulate an opinion and

make a better estimate of the cash performance of an entity.

Users may find the information beneficial for the following purposes;

to formulate an opinion regarding the risk profile of an entity by paying particular attention to the

ability of an entity to;

pay interest and dividends;

make capital repayments on borrowed funds;

access the correct resources of financing;

to forecast the cash which will probably be available in the future to finance expansions

to determine which sources of cash have been used to finance operating and investing activities

to evaluate whether the entity is capable of generating sufficient cash flows from operating

activities so that a part of it can be ploughed back into the entity



to evaluate the timing and certainty of generated cash in order to assess the ability of the entity to

adapt to changing circumstances.

to enhance the comparability of operating results of entities by eliminating the effect of different

accounting policies.

to assess the relationship between the profitability and cash flows the entity.

The provision of cash flow information is primarily aimed at more effectively informing users

about the liquidity and solvency of the entity. This information is of utmost importance as cash

deficits could result in the financial failure of an entity, hence the statement of cash flow could

recognize possible problems; in this regard timeously,as it provides better quality information

regarding the timing amounts of cash flows of an entity.

2.5 Elements of cash flow statements

The cash flow statement balances to cash and cash equivalents. In the statement, the cash flows

are categorized as follows:

Cash flow from operating activities

Cash flow from investing activities, and

Cash flow from financing activities.

It is obvious that these three categories are mathematically related in that cash retained from

operating activities plus the cash effects from financing activities are used in the investing

activities. Conversely, cash retained from operating activities may be utilized from both

investing and financing activities. Other combination also exits. The Standard is not prescriptive

as to the format of the cash flow statement, suggesting instead that the format most appropriate

to the particular business be used to reflect the cash flow from operating, financing and investing

activities. Cash flow from the transaction may for example, be disclosed under two activities,

such as the repayment of the loan shown under financing activities, while the payment of interest

is sown under operating activities. Furthermore, items such as interest and dividends maybe

shown under operating, investing or financing activities.

2.5.1 Cash and cash equivalents



Cash consist of cash on hand and demand deposits, while cash equivalents consist of short-term

highly liquid investments that are readily convertible to known amounts of cash that are subject

to significant risk of changes in value. Short- term is usually vied as three months or less from

date of acquisition. Equity investments usually do not meet the requirements of classification as

cash equivalents, while bank overdrafts normally do. Note that cash movements between cash

and cash equivalents are not reflected separately as they are part of the normal cash management

activities of the entity to which the cash flow statement reconciles. The reporting entity discloses

the accounting policy for determining cash and cash equivalents and discloses the components

and a reconciliation of the components to the equivalent items in the balance sheet. If the policy

is adopted for determining components is changed by the entity, it is accounted for accordance

with IAS 8 on accounting policies, changes in accounting estimates errors. If cash and cash

equivalents are held in a foreign currency and are subsequently converted to the reportingcurrency, the effect of the exchanging rate charges will form part of the reconciliation cash and

cash equivalents.

2.5.2 Cash flow from operating activities

Operating activities are normally the chief revenue — producing activities of the entity, including

also other activities that do not constitute investing or financing activities. The cash generated

from operating activities is normally the cash effect of transactions and other events that are used

in determining the profit or loss of an entity. This represents the difference between the cash

received from customers during the period and cash paid in respect of goods and services. It also

includes cash receipts from royalties’ fees, commissions and other revenues, cash payments to

and on behalf of employees, cash payments or refunds of income taxes and cash receipts and

payments from contracts held for dealing or trading purposes, since such contracts constitute the

inventory of the popular entity. In the case of an insurance entity, cash receipts and payments for

premiums and claims, annuities and other policy benefits are also included.

The figure for cash flow from operating activities enables the users of the financial statement to

evaluate the cash component of the normal operating activities for the period, and in doing so to

gauge the quality of the earnings. Also, it gives an indication of the extent to which the

operations of the entity have generated sufficient cash flows to repay loans, maintain the

operating capability of the entity, pay dividends and make new investments without having to



sort to external sources of financing. Cash generated from operations is calculated in one of two

ways and is disclosed as such in the cash flow statement namely;

The indirect method, or

The direct method

Although the standard encourages entities to use the direct method to report cash flows from

operating activities, no prescriptive guidance is given in IAS 7 as to under which circumstances

the respective method to be used. This situation calls for the application of consistency in terms

of IAS 8. If a Standard allows an explicit choice of accounting policy, but is silent on the manner

of exercising that choice, an entity should choose and apply consistently one of those accounting

policies. In this case it means that the entity should decide whether it wants to use the direct or

indirect method in the cash flow statement. Once the choice is made, the chosen method should

be applied consistently from year to year.

The indirect method

Under this method, cash generated by operations comprises two components, namely profit

before working capital changes and changes in working capital, which are disclosed accordingly;

Profit before working capital changes. This figure is calculated by adjusting the profit before tax

for investment income and interest changes and for those items which do not involve the flow of

cash. Examples of the latter include depreciation charges, impairment of goodwill, profit or loss

on disposal of property plant and equipment, and unrealized foreign exchange gains or losses,

fair value adjustments to investment property and financial assets and undistributed profit of

associates and minority interest. Profit before working capital changes may, alternatively, be

shown as the difference between revenue and expenses. In this case, only these three figures will

be disclosed in the cash flow statement.

Changes in working capital. Movements in working capital, in other words, changes in current

assets and current liabilities, are taken in consideration in determining the cash generated from

operations. The following items are included amongst these: inventories, receivables, bills

receivable, payables, provisions, bills payable as well as income accrued, income received in



advance, expenses both payable and prepaid. However this does not include taxation and

dividends payable, as these are dealt with individually in the cash flow statement. In addition, cas

h at bank, cash in hand and cash equivalents such as money market instruments are also excluded

from the calculation, as these represent the opening and closing balances respectively of the cash

flow statement.

The direct method

In this method cash generated by operations is disclosed as being the difference between the two

following items;

Gross cash receipt from customers, and

Gross cash paid to suppliers and employees.

Only the major classes of gross cash receipts and payments are disclosed accordance with themethod. These two figures cannot be reduced directly from the income statement, and they

therefore provide additional useful information which can be used in estimating future cash

flows. The f igures are determined either by referring to the entity’s accounting records or making

the necessary additional calculations. For a trader, these additional calculations entail adjusting

sales and cost of sales for changes in inventory, receivables, payables and non-cash items, and

other items for which the cash effects are investing or financing cash flows.

2.5.3 Cash flow from investing activities

Investing activities are those which relate to the acquisition and disposal of long term assets and

other investments, which do not fall within the definition of each equivalent.

Examples of cash flow arising from investing activities;

To acquire property, plant and equipment, including capitalized development cost and self

constructed property, plant and equipment, intangible assets and other long term assets

From the disposal of property, plant and equipment, intangible assets and other long term assets

To acquire equity or debt instruments of other entities and interest in joint venture

Representing advances and loans to or from other parties or their repayment

For financial future contracts forward contracts, options and swap contracts, except where these

are held for speculative purposes or if they are classified as financial activities.



Method of presenting the cash flow statements

(a) Indirect Method

XYZ LTD

Statement of Cash Flows for the Year Ended 31 December 2009

Cash flows from Operating Activities $ $

Net Profit before interest and taxation XXXX

Adjustment for:- Depreciation XX

- Increase in Provision Doubtful Debts XX

- Loss on disposal of fixed assets XX

- Investment Income – (Dividend Received) (XX) XXX

Operating Profit before Working Capital changes XXXX

Increase in Trade and Other Receivables (XX)

Decrease in Inventory XX

Decrease in Trade Payables (XX)

Increase in Pre-payments (XX)

Increase in Accruals XX XXXX

Cash generated from Operating Activities XXXX

Interest Paid (XX)

Interest received XX

Dividend received XX

Dividend paid (XX)

Tax Paid (XX) XXX

Net cash inflow from Operating Activities XXX

Cash flows from Investing Activities

Proceeds from sale of equipment XX



Purchase of machinery (XX)

Net Cash used in Investing Activities (XXX)

Cash flows from Financial Activities

Proceeds from issue of shares XX

Proceeds from Long-term borrowing XX

Redemption of shares (XX)

Payment of Finance Lease liabilities (XX)

Net Cash inflow from Financing Activities XXX

Increase in Cash and Cash Equivalents_ _ _ _ _ _ _ _ _X_X_X_

_A_d_d_:_ _C_a_s_h_ _a_n_d_ _C_a_s_h_ _E_q_u_i_v_a_l_e_n_t_s_ _a_t_ _s_t_a_r_t_ _

_ _ _ _ _ _ _ _X_X_

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_

_

_

_

_N_e_t_ _P_r_o_f_i_t_ _o_r_ _l_o_s_s_ _i_s_ _a_d_j_u_s_t_e_d_ _f_o_r_ _n_o_n_-_c_a_s_h_

_t_r_a_n_s_a_c_t_i_o_n_s_,_ _w_h_i_c_h_ _i_n_c_l_u_d_e_ _t_h_e_ _f_o_l_l_o_w_i_n_g_:_

_D_e_p_r_e_c_i_a_t_i_o_n_ _i_s_ _n_o_t_ _a_ _c_a_s_h_ _e_x_p_e_n_s_e_ _b_u_t_ _i_s_

_d_e_d_u_c_t_e_d_ _i_n_ _a_rriving at the profit figure. Therefore to eliminate it add it back.

Profit or loss on disposal of assets: the loss is added back while profit is subtracted.

Property plant and equipment purchased on credit

The writing of bad debts

Provision for doubtful debts

Yearend adjustments where accrued expenses and income are taken into account and prepared

expenses and amounts received in advance are deducted.

Credit purchases and credit sales

Discount allowed and received

NB

An increase in stock means less cash, cash was spent on buying stock.



An increase in debtors means debtors have not paid as much hence less cash.

If we pay off creditors the figure decreases means less cash.

Direct Method

Under this method the major classes of gross cash receipts and payments are disclosed. Control

accounts are used to calculate missing figures such as cash sales and cash purchases.

XYZ LTD

Statement of Cash Flows for the Year Ended 31 December 2009

Cash flows from Operating Activities $ $

Cash Receipts from Customers XXXX

Cash Paid to Suppliers (Creditors) (XX)

Cash Paid to Employees (Wages) (XX)

Cash Paid for other Operating Expenses (XX)

Cash Generated from Operations XXXX

Interest Paid (XX)

Interest received XX

Dividend received XX

Dividend paid (XX)

Tax Paid (XX) (XX)

Net Cash inflow from Operating Activities XXX

Cash flows from Investing Activities

Proceeds from equipment XX

Purchase of equipment (XX)

Net Cash used in Investing Activities (XX)

Cash flows from Financing Activities

Proceeds from issue of shares XX

Proceeds from Long-term borrowing XX



Redemption of shares (XX)

Payment of Finance Lease liabilities (XX)

Net Cash inflow from Financing Activities XX

Increase in Cash and Cash Equivalents XX

Add: Cash and Cash Equivalents at start XX

______________________________________________________________________________

_____________________________________4" _C_a_s_h_ _a_n_d_ _C_a_s_h_

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_A_ _c_a_s_h_ _g_e_n_e_r_a_t_o_r_ _p_r_o_d_u_c_e_s_ _m_o_r_e_ _c_a_s_h_ _t_h_a_n_

_i_t_ _c_a_n_ _a_b_s_o_r_b_._ _A_ _c_a_s_h_ _s_i_n_k_ _u_s_e_s_ _m_o_r_e_ _ _

_c_a_s_h_ _t_h_a_n_ it generates. This will be determined by:

Nature of demand for its products

Working capital requirement and

Investment in fixed assets

2. Whether cash is being produced or absorbed from operating or non-operating activities.

For example if operating activities are absorbing cash is it a worthwhile investment or not and at

what stage is the co in the business life cycle. The company should have an alternative source i.e.

from non-operating activities

3 How is the company financing any cash shortfall or using any surplus

Cash generator cash sink

How the money is used how is the money found

Borrowing repaid additional funds borrowed

Shares repurchased new shares issued

Cash reserves increased cash reserves run down

4 The quality of the company‘s profits

A Profit matched with cash would generally indicate a positive state of affairs



Reasons for the differences between cash and profit

Profit calculation is based on accounting conventions and concepts.

Depreciation is a measure of consumption of fixed assets its charged to Profit and loss account

but its not accompanied by a cash payment.

Goodwill on acquisition of a business not included in profit and loss, interest on loan for

buildings (capitalized borrowing costs); increases in creditors the business has use of assets

without paying for them etc.

In order for a business to survive the ability to make profits may not be enough. Its important

that the business should generate sufficient cash in order to meet maturing obligation. Inability to

meet current financial liabilities will often force the business to cease trading. Thereforebusinesses must pay great attention to liquidity and profitability if they are to succeed.

2.6 Uses

Help in assessing:

The ability of the bus to generate future cash flows

The effect of major events i.e. issue of shares, acquisition of subs,

the ability of the business to meet future commitment ( loan repayments interest, taxation etc

The likely future financing needs.

To assess the reasons for differences between reported profit and related cash flows.

Example 1 The following financial statements were prepared for a sole trader, trading as The

Rand Shop. The Rand Shop The Income Statement for the year ended 31 December

2008. $ $ Sales 30 000 Consumable Inventory (consumed) (7 000) Rental expenses

(1 000) Wages (3 100) Water and electricity (1 700) Telephone expenses (300)



Insurance expense (200) Depreciation (1 500) (14 800) Profit before finance cost 15 200

Finance cost _(625) Profit for the year 14 575 The Rand Shop Balance sheet as

at 31 December 2008 2008 2007 Assets Non Current Assets Property Plant and

Equipment 98 500 90 000 Current Assets Inventory (Consumable) 9 000 6 000

Trade and other receivables 19 000 14 000 Prepaid expenses 1 525 Cash and Cash

equivalent 475 3625 128 500 113 625 Equity and liabilities Capital 35 000 30

000 Drawings 5 000 3 000 Reserves 28 200 13 625 55 200 40 625 Non

Current Liabilities Long term loan 55 000 50 000 Current Liabilities Trade and

other payables 18 300 23 000 128 500 113 625 NB:- All notes are excluded.

Additional information 1) The sales figure represents services rendered For cash $18 000

On credit $12000 2) The trade other receivables pertain solely to debtors to whom services

were rendered on credit. 3) The prepayments comprise the following:- Interest expense625 Wages 500 Insurance expense 400 1 525 4) Trade and other payables

comprise the following:- 2007 2008 Trade creditors (purchase of inventory) 23 000 18

000 Accrued telephone expenses 300 23 000 18 300 5) The depreciation recorded in

respect of vehicles amounted to $800 and in respect of machinery $700. 6) The addition to

property plant and equipment was paid in full, no property, plant and equipment were sold

during the financial year ended 31 December 2008. 7) The carrying amounts in respect of

vehicle and machinery are as follows:- 2008 2007 $ $ Vehicles 39 200 40 000

Machinery 59 300 50 000 98 500 90 000 8) The drawings and the additional capital

made by the owner were in cash. 9) The interest in respect of the long term loan is not

capitalized. 10) The inventory (consumable material) was disclosed at cost.

REQUIRED:- Prepare the cash flow statement of the Rand Shop for the year ended 31

December 2008 according to the direct method. (IAS 7 requirement). (25 marks )

The Rand Shop The Cash flow statement for the year ended 31 December 2008 $ $

Cash flow from operating activities cash receipts from customers 25000 1 mark cash

paid to suppliers and employees 21900 1 mark cash generated from operations 3100 1 mark

interest paid 1250 1 mark Drawings 5000 1 mark Net cash used in operating activities

(3150) Cash flow from investing activities Purchase of Fixed Assets 10000 (10000)

1 mark Cash flow from financing activities Proceeds from capital contributions

5000 1 mark Proceeds from long term loan 5000 10000 1 mark Net decrease cash and



equivalent (3150) Cash and cash equivalent at beginning of year 3625 1 mark Cash and

cash equivalent at year end 475 1 mark Workings Debtors control Bal b/d

14000 bank 7000 2 mark Sales 12000 bal c/d 19000 26000 26000

Credit and cash sales 7000+18000 =25000 Creditors control bank 15000 Bal b/d 23000

bal c/d 18000 Purchase 10000 2 mark 33000 33000 Property plant and

equipment Bal b/d 90000 Depreciation 1500 Bank 10000 Balance c/d 98500 2 mark

100000 100000

Long term loan Bal b/d 50000 Balance c/d 55000 bank 5000 1 mark 55000 55000

Capital account Drawings 5000 Bal b/d 40625 P & L 14575 Balance c/d 55200bank 5000 2 mark 100000 60200 6) Other Expenses Interest expense

Profit and loss 625 Prepaid 625 1 mark 1250 Wages Profit and loss

3100 add prepaid 500 1 mark 3600 insurance expense 200 prepaid 400 1

mark paid 600 Telephone expenses Profit and loss 300 Accrued 300 1

mark paid nil Water & electricity 1700 1 mark paid in full Rental

expenses Profit and loss 1000 1 mark paid in full

2.7 Advantages and limitations of cash flow

The advantages of cash flow statements are often presented in terms of the deficiencies of the

statement of comprehensive income and the statement of financial position. This should not be

interpreted to mean that cash flow statements are an alternative to income statement but provide

useful additional information

Most readers appreciate the meaning and importance of cash and will therefore find cash flow

statements easier to understand and more relevant

Cash flow statements are more objective in that cash received and paid are observable events. In

contrast the profit and loss and the balance sheet are based on the accruals concept and matching

principle, which involves subjective allocations, valuations.



Profit is only a symbol or measure of performance. The ultimate success and survival of the

company depend on its ability to generate and use cash in the most efficient way.

Future dividends, the repayment of loans and payment to trade creditors depend primarily on the

availability of cash and not profits. (Cash flow statements allow users to make more accurate

perditions of future dividends)

3.0 Implications of Capital Structure on Earnings

Capital structure refers to the way in which capital funds have been or should be raised i.e. how

much debt and how much equity?

The benefit derived from using debt wisely may lead to a firm increasing its overall value and

lowering its cost of capital.

3.0 The Capital Structure

This is the composition of the capital of a company. Companies are financed predominantly by

the issue of shares, debentures and by retaining part of each year’s profits and this represent the

long-term capital available to the company. The short-term capital is represented by the credit

facilities offered by trade creditors and bank overdrafts.

3.1 The importance of capital structure

The capital structure of a business is important because it has significant influence on the risk to

lenders and on the return to shareholders. Investors will assess the degree of risk of their



investment using the gearing ratio. This is the relationship between borrowings and equity. The

important aspect of gearing is its relationship with risk. The

The reason for issuing a variety of shares is to tape funds held by investors with differing

investment needs. For example young investors are interested in the growth in the value of his

shares so he buys ordinary shares. While a retired man is interested in preference shares, he is

assured of a low but certain return. Institutional investors are interested in different classes

depending on the needs of their customers.

A highly geared company means that company’s earnings are committed to paying interest on

debentures and preference dividend.

Gearing may have an important effect on the distribution of profits

The investment in ordinary shares in a highly geared company is speculative.

Gearing is relevant to the long term stability of a business

3.2 Risk and return of each category

Companies are financed by different types of capital and each type expects a return in the form

of interest or dividend.

3.2 .1 Ordinary shares

These are designed for an investor who is prepared to take a relatively high level of risk to obtain

high returns.

Entitled to receive returns only after other claims have been satisfied.

Ordinary shareholders have voting rights i.e. have effective control over the company’s

activities. The number of shares held will determine voting power.

Holders are entitled to a dividend or any appreciation in share values arising from expectations

concerning earnings and growth prospects.

As owners they provide the bulk of share capital.

They carry the right to the whole of the profits remaining after preference shareholders have

been paid dividend.

The capital is at risk in the event of company failure.( rank last as claimants)

Extra funds may be reinvested to finance future ventures.



Provide the bulk of share capital. These are the shares, which carry the right to the whole of the

profits remaining after PS has been paid the dividend. Their capital is at risk in the event of

business failure shareholders may lose all the capital invested since they rank last as claimants on

the residual assets. In return enjoy the right to the whole Net Profit one as dividends and if

retained in increased value of the net corporate assets

3. 2.2 Preference shares

They are designed for the investor who does not wish to take the degree of risk associated with

ordinary shares.

The investor is prepared to accept the prospects of lower, more secure returns.

Entitles the holder to a fixed rate of dividend payable before any ordinary dividend.In the event of the company being wound up preference shareholders may rank before ordinary

shareholders for repayment.

Preference shares may be cumulative or non cumulative, this confers on the holders the right to

any arrears of dividend.

Dividend is paid if sufficient profits are made and are not given voting rights.

These give holders preferential rights as regards dividend and repayment of capital on winding

up. They can be issued as redeemable and be cumulative (i.e. right to receive dividend lost bad in

years.

_

3.2.3 Loan capital or debentures

Companies may borrow funds on a long term basis. One important long-term loan is the

debenture. These loans are divided into units in order to attract a wide range of investors. A

debenture may be secured or unsecured by the company’s assets by either a fixed or floating

charge.

a ) Fixed charge



It will be granted over a fixed asset and will mean that while the charge is operative the asset

must be kept intact (may not be traded or exchanged). This is of great benefit to the holder

because the secured asset is specifically available.

b) Floating charge: may apply to all assets and the asset may be traded or exchanged but on

breach of a debenture deed the charge will crystallize i.e. has priority. In the event of default the

specified assets may be seized and sold on behalf of debenture holders. Debenture holders are

guaranteed both to repayment of loan capital and interest as specified in the conditions of issue.

Summary of characteristics of shares and loan stock

Ordinary shares Preference shares Debentures 1. owners of the company who are normally

entitled to vote at general meetings 1. No voting rights 1. No voting rights 2. Receive a dividend

declared by directors and it varies each year depending on the profit and it is an appropriation.

Receive a fixed rate of dividend each year, which constitutes an appropriation of profits. Have

priority over ordinary dividends Receive a fixed rate of interest which constitutes a charge

against income in computing the profit.

Have priority over preference dividends 3..Last to be repaid the value of their shares in the event

of the company going into liquidation Repaid before the ordinary shareholders in the event of

liquidation. Repaid before the ordinary and preference shareholders in the event of liquidation 4.

Non repayable except on the liquidation of the company Except for redeemable are non

repayable except on the liquidation of the company Repayable after affixed period of time

5.Rights are specified in Articles of association Rights are specified in Articles of association

Rights are specified in the terms of issue 6. Dividends are non deductible for tax purposes

Dividends are non deductible for tax purposes Interest deductible for tax purposes

3.2.4 Types of preference shares



Non cumulative – don’t receive arrears of dividends

Cumulative-if the dividend on these shares is not paid in any year the holders are entitled to it in

the next year that there is sufficient profit before any other shareholder receives a dividend.

Redeemable – the only type of preference share that is repaid by the company after the expiration

of the period specified when they were issued.

Participating – in addition to receiving a fixed annual rate of dividend they are also entitled to a

further dividend, which is the nature of a dividend on ordinary shares.

Advantages

Non repayable (except 3 above)

The annual cost or dividend is known thus facilitating planning.

In extreme circumstances the annual dividend can be waived

Disadvantages

The dividends are not deductible for tax purposes.

3.2.5 Types of Debentures

Unsecured /naked- in the event of the company going into liquidation these are repaid before the

shareholders but after other creditors.

With a fixed charge – secured on assets that the company cannot dispose of without the trustee

for the debenture holder’s permission. In the event of the security being in jeopardy or the

company not paying the annual interest the trustee can take legal possession of the assets, sell

them and repay the debenture holders.

With a floating charge- secured on assets but the company can sell the secured assets but must

replace them with assets of an equivalent amount

Convertible loan stock- carries the right at the holder’s option to convert them into ordinary

shares within a given time period fixed when they are issued.

Advantages

The annual cost / interest is known

The interest is deductible for tax purposes



Disadvantages

They have to be repaid after the expiration of the period specified when they were issued.

The interest must be paid before the shareholders receive any dividend. This can be a burden

when the proceeds of the issue have been used to finance expansion that may result in revenue

during the early years or where there is a reduction in the annual profit or high interest rates.

3.3 Gearing

It is a method of comparing how much of the long-term capital of the business is provided by

equity and how much is provided by prior charge capital, investors who are entitled to interest or

dividend before ordinary shareholders can have a dividend themselves. Gearing is important

when a company wants to raise extra capital. A highly geared company might find it difficult toraise a loan. Potential lenders feel that ordinary shareholders should provide a high proportion of

the total capital for the business. The moment they are not doing so means they are worried that

profits are not sufficient to meet future interest payments.

Advantages of gearing

Debt capital is cheaper

The return or reward ( interest or preference dividend) is fixed permanently and therefore

diminishes in real terms if there is inflation . Ordinary shareholders usually expect dividend

growth.

The required return by debt holders is lower than that of equity holders because debt capital is

often secured on company assets, ordinary share capital is a more risky investment

Payments of interest attract tax relief whereas dividend does not.

Debt capital does not carry voting rights but ordinary share capital does. Therefore the issue of

debt capital leaves pre-existing voting rights unchanged.

If profits are rising and interest is fixed ordinary shareholders will benefit from the growth in

profits.

Disadvantages



If profits fall even slightly the profit available to shareholders will fall at a greater rate.

3.4 Share capital and debentures compared

Shareholders are members of a company while providers of loan capital are creditors. In the

event of the company being wound up creditors have priority claims over the assets of the

company over shareholders.

Shareholders receive dividends whereas the holders of loan capital are entitled to interest (an

expense charged against revenue). Interest is paid whether a profit is made or not. Preference

shareholders and ordinary shareholders receive a dividend provided sufficient profits are made

and available for distribution and directors consider it prudent.

Loan capital holders can take legal action against a company if the interest is not paid when due

whereas shareholders cannot enforce the payment of dividends.Security: debenture holders are offered some form of security (fixed or floating charge.)

Voting rights debenture holders and preference shareholders do not have voting rights.

NOTE

Gearing expresses the relationship that exists between total borrowings (the proportion of fixed

interest capital (loan capital and fixed div P/S to ordinary shares) and the total amount of

ordinary shareholders funds.. A company with a large proportion of fixed interest and fixed div

bearing capital to ordinary capital is highly geared. Any fluctuation in net profit may affect the

return accruing to ordinary shareholders. The important aspect of gearing is its relation to risk.

The impact of a company borrowing money and paying interest rather than funding itself from

its equity capital is important. Apart from increased risk from gearing the introduction of

borrowing brings a legal risk that the lender may take over the company’s assets. Gearing is

important when investing in ordinary shares of a company. A highly geared company means that

a high proportion of the company’s earnings are committed to paying interest on debentures and/

or preference dividends. In a lowly geared then a high proportion of the company ‘s earnings can

be paid out as ordinary dividend..



The choice of any capital structure will be determined by the investor’s attitude towards risk and

the judgement about the level and stability of the company over the longer term.

Compare and Contrast each of the following forms of long term finance under the following

headings: Forms Ordinary Shares Preference shares Debentures 1)

Voting rights 2) Type of return to holders 3) Security of investment 4) Member /

Creditor 5) Tax relief on interest or dividend payments ( 10 marks) Example

S PLC has been formed to trade as a food outlet as at 31 December 2008 .It wants to recapitalise

its business as an expansion process. It is currently considering three possible long-term capital

structures, which are stipulated below

Capital structure

Option 1 2 3

$m $m $m

Ordinary shares of $1 each 4 10 20

10% $1 Preference shares 6 4 -

12% Debentures 10 6 -

20 20 20

Profits (before interest) for the next three years are estimated as follows:

Year 1 2 3

Profits $3m $5m $1.8m

Ignore taxation



Required

Calculate the gearing ratio for each financing option (3 marks)

Calculate the earnings per share for each of the three years assuming

a) Option 1 (5 marks)

b) Option 2 (5 marks)

c) Option 3 is chosen (5marks)

Which of the three financing options would you choose and why (7 marks)

Example

Assume that two companies, X Ltd and Y Ltd, are of equal size, undertake similar business

activities and enjoy the same market but are financed differently i.e. have different capital

structures. Further assume that both companies distribute all their net earnings. The following

information relates to the two companies:

X Ltd Y Ltd

$ $

Ordinary share capital ($1 shares) 60 000 30 000

12% Debentures - 30 000

Capital employed (CE) 60 000 60 000

Earnings before interest and tax (EBIT) 40% of CE 40% of CE

Marginal tax rate 40% 40%

Required:

Prepare an income statement for each company and calculate EPS.

Assuming you hold 2 000 shares in each of the two companies, what total dividend would you

receive from each company?

Assuming the current earnings before interest and tax (EBIT) are to be maintained for the

foreseeable future by both companies, what action would you take? Give reasons.



What amount of EBIT should X Ltd earn in order to have an EPS similar to that of

Y Ltd ? (Homework)

SOLUTION

a) Comprehensive income statements

X Ltd Y Ltd

$ $

EBIT (40% of CE) 24 000 24 000

Interest expense - (3 600)

Earnings before tax (EBT) 24 000 20 400

Taxation (40% of EBT) (9 600) (8 160)Earnings after tax (EAT) 14 400 12 240

Number of ordinary shares 60 000 30 000

EPS 24cents 40.8 cents

b) Number of shares held 2 000 2 000

Total dividend received $480 $816

c) In view of the fact that the dividend in Y Ltd is greater than that in X Ltd and that

the current earnings are to be maintained for the foreseeable future, I would sell

my shares in X Ltd and use the proceeds to buy more shares of Y Ltd. This should

improve my future earnings.

ANALYSIS OF CAPITAL STRUCTURE ON EARNINGS

Y Ltd which employed debt financing in its capital structure had a higher EPS than X

Ltd. This was due to the following reasons:

By employing debt finance Y Ltd was able to save $1 440 in taxes because interest is a tax-

allowable expense.



By employing debt finance Y Ltd was able to increase the earnings available to equity holders.

Remember, the borrowed funds generated a return of 40% but only 12% will be paid back as

interest the balance being used to boost the ordinary shareholders’ earnings. That is :

Total return on debt finance = 40% x $30 000 = $12 000

Less interest on debt finance = 12% x $30 000 = $ 3 600

Amount used to boost earnings for ordinary shareholders = $ 8 400

Add total return on equity finance = 40% x $30 000 = $12 000

Total earnings before tax available to ordinary shareholders = $20 400

Debt is a cheaper source of finance because tax on interest is borne by the state i.e. the

company’s ultimate cost of debt is the after -tax cost. In this case, the 12% coupon interest rate isthe before-tax cost of debt and the after-tax cost debt is 7.2% i.e. 12%(1 – 0.4) where 0.4 is the

tax rate. Because of the tax saving of $1 440, the firm’s ultimate interest bill is therefore $3 600

less $1 440 = $2 160. As a percentage of debentures this = 7,2% ($2 160/$30 000).



4.0 Issue of shares and Debentures

Public companies once registered are allowed to issue shares to the public. The aim is to raise

large amounts of capital to finance businesses. The book keeping for issue of shares closely

resembles the introduction of new capital by a sole trader

4.1 Shares issued in full on application

4.1.1 Shares issued at par

Example



1 000 ordinary shares with a nominal value of $4 are to be issued. Applications, together with the

necessary money, are received for exactly 1 000 shares. The shares are then allotted to the

applicants.

Bank

Ordinary share applicants 4 000

Ordinary share applicants

Ordinary share capital 4 000 Bank 4 000

Ordinary share capital


4.1.2 Shares issued at a Premium

Example

1 000 ordinary shares with a nominal value of $4 each are to be issued for $10 each. Thus a

premium for $6 per share has been charged. Applicants and the money sre received for exactly 1

000 shares.

Bank

Balance b/d --


Ordinary share applicants

Ordinary share capital 4 000

Share premium 6 000 Bank 10 000

10 000 10 000

Share premium

Ord. share applicants 6 000



Ordinary share capital

Balance b/d --

Ord. share applicants 4 000

Note: $4 000 is shown because share capital is shown at a nominal value and not as total issued

value. The $6 000 share premium must therefore be credited to a share premium account to

preserve double entry balancing.

4.2 Issue of shares Payable by installments

The shares considered so far have all been issued as paid in full on application. Conversely,many issues are made which require payment by installments. These are probably more common

with public companies than with private companies. It should be noted that a public company is

now not allowed to allot a share unless there has been paid on it a sum equal to at least 1 quarter

of its nominal value plus the whole of any premium.

Applications are received together with the application monies.

The applications are vetted and the shares allotted, letters of allotment being sent out.

The excess application monies from wholly successful, or where the application monies received

exceed both the application and allotment monies required, and partly unsuccessful applicants,

are returned to them. Usually, if a person has been partly unsuccessful, his excess application

monies are held by the company and will reduce the amount needed to be paid by him on

allotment.

Allotment monies are received.

The next installment, known as the first call is requested.

The monies are received from the first call.

The next installment, known as the second call is requested.

The monies are received from the second call.



Example:

A company is issuing 1 000 shares, 7% preference shares of $1 each, payable 10% on

application, 20% on allotment, 40% on the first call and 30% on the second and final call.

Applicants are received for 1 550 shares. A refund of the money is made in respect of 50 shares,

while for the remaining 1500 applied for, an allotment is to be made on the basis of 2 shares for

every 3 applied for (assume that this will involve any fractions of shares). The excess application

monies are set-off against the allotment monies asked for. Allen who had applied for 150 shares

fails to pay the First and second Call monies due on his shares. The directors conform to the

provisions of the \articles of Association and Allen is forced to suffer the forfeiture of his shares.

These shares were subsequently issued at 75% of nominal value to J, Dougan, Dougan pays for

the shares.

Prepare the necessary ledger accounts.

Bank

Application monies 155 application and

Allotment monies (1 000 x 20% allotment fund 5

Less application monies $50) 150

First call 400

Second call 300

J Dougan 75

Application and Allotment

Bank-refund of

Application monies 5 Bank 155

Preference share capital 300 Bank 150

305 305



First call

Bank 360

Preference share capital 400 Forfeited shares 40

400 400

Second call

Bank 270

Preference share capital 300 Forfeited shares 30

300 300

7% Preference share capitalForfeited shares 100 Application & allotment 300

Balance c/d 900 First call 400

Second call 300

1 000 1 000

Balance b/d 900

Balance c/d 1 000 J Dougan 100

1 000 1 000

Balance b/d 1 000

Forfeited shares

First call 40

Second call 30

Balance c/d 30 Preference share capital 100

100 100

J Dougan 25

Balance c/d 5 Balance c/d 30

30 30



J Dougan

Bank 75

Forfeited shares

Preference share capital 100 (discount on re-issue) 25

100 100

4.3 The double entry to record all the stages follows

1 issue of prospectus no accounting entries no accounting entries

STEP 1

Applicants will fill in the application form and send application money. An application and

allotment account must be opened to show the amount received from or owing by applicants on

application and allotment.

Receipt of application monies

Dr Bank / cash

Cr Application and allotment

Being cash received on application

Step 2

In case of over subscription applicants are refunded

Dr Application and allotment

Cr Cash / bank

Being cash returned on non-allotment

Step 3



Allotment of shares and it is the time that the share capital account must be credited with the

total due on application and allotment


Cr Share capital

Being amt receivable on application and allotment

If the shares are issued at a premium (with portion of the premium)


Cr Share Premium

Step 4

Receipt of money due on allotmentDr Bank /cash

Cr Application and allotment

Being total amount due on allotment

Step 5

A call will be made and up to this point the shareholders will be debtors of the company.

Dr Call account

Cr Share capital account

With money due on call

Step 6

Receipt of call money

Dr Bank

Cr Call account

Being money received on call



Note that after these entries the only remaining accounts will be share capital and bank accounts.

CAPITAL = ASSETS

NOTE:

At times where shares are over subscribed share will be allotted on a prorata basis and the money

overpaid applied to the money due on allotment rather than being refunded.

Call monies can be received in advance or in arrears

Shares may be issued at a premium. A share premium account will be credited with the premium.


Cr Share premium accBeing shares issued on premium

4. 4 Forfeiture of shares

The powers to forfeit are stated in the Articles of association. This amounts to cancellation of

shares and reduces the share capital. The amount paid on application and allotment is not

returned to the member and represents a profit to the company. A forfeited share account is

opened.

The procedure made on non-payment of a call.

Step 1

Dr share capital account

Cr forfeited share account

Being cancellation of shares and transfer from share capital account of the called up amount

Step 2

Dr forfeited share account



Cr Call account

Being transfer from the call account of the call made but not paid.

Step 3

The balance on forfeited shares account should be transferred to share premium

Dr forfeited share account

Cr share premium account

Being the balance (profits)

NB The shares were forfeited when certain monies were paid on application and allotment.

These shares can be reissued and the company should ensure that it receives in total not less thanthe nominal value of the shares.

4. 5 RE ISSUE OF FORFEITED SHARES

A forfeited re issue account is opened (personal account for re issue)

Step 1 Dr forfeited shares re issue account

Cr share capital account

Being new called up value of the shares

Step 2 Dr cash

Cr forfeited shares re issue account

Being cash received on re issue.

Step 3 Close the forfeited shares re issue account to the forfeited share account.

Dr Forfeited shares account

Cr Forfeited shares re issue account



Thus reducing the amount transferred to the share premium account.

Balance on reissue

Dr Forfeited shares re issue account

Cr Shares Premium

NB the ledger accounts vs. journals. Ledger accounts are T accounts.

Example 1

The Authorized and Issued Share Capital of Prospective plc Ltd was 100 000 Ordinary Shares of

$1 each. The Authorized Share Capital was increased to 200 000 divided into Ordinary Shares of

$1 each and the company issued 75 000 Ordinary Shares of $1 each at 150 cents per sharepayable as : On application(including premium) $0.75 On allotment $0.40 On call

Balance 120 000 applications were received and applications for 20 000 shares were

unsuccessful and the cash paid in respect of such shares was returned. All other applications

were reduced proportionately and the balance of application moneys being applied to the amount

due on allotment. The balance due on allotment was received except in the case of one allotee of

300 shares. These shares were forfeited and reissued as fully paid at 140 cents per share. The

remaining shareholders paid the call due. REQUIRED: Show a) The ledger

accounts necessary to record the above transactions ( 20 marks ) b) How the balance on these

accounts would appear in the company's balance sheet on 31 December 2008. ( 5 marks )

Example 2

a) What are the advantages and disadvantages of companies with a share capital ?

(4 marks) b) What are the

differences between private and public companies? (4 marks) c) A company with an authorized

capital of 2 000 000 ordinary shares of $1 each issued a prospectus and awaited application on

the following terms on 1 January 2008. 1 000 000 ordinary shares were issued at $1 each for

$2.00 each.



Terms of offer were as follows: i) 100 cents on application, received $1 500 000 on 1

January ii) 50 cents on allotment, received $500 000 on 31 March iii) 30 cents on First Call,

received $303 000 on 31 May iv) 20 cents on Final Call , received $197 000 on 31 July

One Applicant who had applied for 10000 shares asked the company secretary to accept an

advance payment on First Call as she was to travel outside the country. The request was granted

on 30 May

REQUIRED (a) Show all the necessary ledger accounts to record the above transactions. 15

marks ) (b) Show the balance sheet extract. ( 2 marks)

Solution 1

ISSUE OF SHARES Application & Allotment Refunds(20000*.75) 15000 Cash-

Application (120*.75) 90000 Share Capital 48750 Cash allotment bal 11205 (75*.65)Share premium 37500 Forfeited share account 45 75*.50 3 marks 101250 101250

Share Capital account 4 1/2 marks Forfeited share acc 300 Balance b/f 100000 1/2

mark Application & Allotment 48750 1 Call account 26250 1 Balance c/d 175000

Forfeited share account 300 1 175300 175300

Forfeited share account Application & Allotment 1 mark 45 Share capital 1/2 mark 300 3

marks call 1 mark 105 Re issue 120 Share premium 1/2 mark 270 420 420

CALL ACCOUNT Share Capital 26250 Cash 26145 1 mark (74700*.35) forfeited

acc 105 26250 26250 Share Premium Bal c/d 37770 Application &

Allotment 37500 1/2 mark Forfeited shares 270 37500 37500

Forfeited share reissued Share Capital 300 Cash 300*140c 420 2 marks Forfeited

shares 120 420 420 BANK Account Bal b/f 100000

application & allot 15000 5 1/2 marks app & allot 90000 bal c/d 212770 alloment 11205

call 26145 forfeited 420 227770 227770 Each entry a mark except for balance

c/d BAL B/D 1/2 MARK EACH



BALANCE SHEET EXTRACT AS 31 DECEMBER 2008 CURRENT ASSETS

Bank 212770 1 mark 212770 1/2 mark Equity and Liabilities share capital 175000

1 mark share premium 37500 1 mark Capital Reserve 270 1 mark 212770 1/2

mark Workings Application monies 75000*115 86250 amount received

100000*75 75000 Balance due on allotment 11250 Balance due on Allotment

11250 less 300*1.15 345 received on application 400*75 300 Transferred to forfeited

acc 45 11205

Solution 2

Difference between private and public A public company should be listed on the stockexchange A private company is not allowed to offer shares to the public. A Public company

has no limit as to the number of shareholders but a Pvt co is limited to 50 members. They are

stringent statutory requirements on public co : lodging of statutory documents publication

of financial statements 1 mark per point Bank account Application & Allotment

1500000 refund 500000 3 marks Application & Allotment 500000 bal c/d 2000000 First

call 303000 Final call 197000 2500000 2500000 Application &

Allotment Bank 500000 Bank application 1500000 Ordinary share capital 500000

Bank allotment 500000 4 1/2 marks marks Share Premium 1000000 First call 303000 First

call 300000 Final call 197000 Final call 200000 2500000 2500000

Ordinary share Capital account Balance c/d 1000000 Application & Allotment 500000 4

marks First call 300000 Final call 200000 1000000 1000000

First Call Share capital 300000 Bank 303000 1 1/2 marks Balance c/d 3000

303000 303000 Final call account Share capital 200000 Bal

b/d 3000 1 1/2 marks Bank 197000 200000 200000 1 mark

for showing all workings Balance sheet extract CURRENT ASSETS

BANK 2000000 1 mark 2000000 1/2 mark EQUITIES & LIABILITIES

Ordinary share capital 1000000 1 mark Share premium 1000000 1 mark 2000000 1/2

mark



ISSUE OF DEBENTURES

The procedure is similar to the issue of shares. NB Premiums received on debentures are

regarded as capital profits and are therefore transferred to a capital reserve account.

5.0 Partnership Accounts

5.1 The need for partnerships

So far we have mainly considered businesses owned by only one person. Businesses set up to

make a profit can often have more than one owner. There are various reasons for multiple

ownership:

The capital required is more than one person can provide.

The experience or ability to manage the business cannot be found in one person alone.

Many people want to share management instead of doing everything on their own.

Very often the partners would be members of the same family.

5.2 Contents of a partnership agreement

Partnership agreements usually include items such as:

How the venue of the business premises and the name of the accountant, solicitors and bank

acting on behalf of the business.

How the profits and losses of the business are to be shared by the partners.

How salaries or drawings are to be arranged.



Whether interest is to be paid to capital accounts.

Whether interest is to be charged on any drawings.

The rate of the interest to be paid on any loans provided by partners.

Any aspects concerning control and responsibilities of partners.

The procedure in the event of admittance of a new partner or departure of an existing partner.

The procedure in the event of dissolution.

In the event of disagreement of partners and where a deeds of partnership does not exist the 1890

Partnership Act applies:

No interests to be paid on partners’ capital account.

Any profit or loss is to be shared equally between partners.

No interest is to be charged on drawings by partners.No partnership salaries are to be paid from profits.

Loans by partners will be entitled to interest at 5% per annum.

5.1 Reasons

One person cannot raise the capital needed- more capital resources

To tap a diversity of knowledge, experience and expertise in mgt of the bus i.e. the ability

required to manage the business cannot be found in one person alone. (Different special skills)

To cover for each other during holidays and sickness.

Many people want to share mgt risk: business risks are spread among more than one person.

Members of the family can combine to form a business.

Disadvantages

Partners cannot act independently as a sole trader.

Disputes: concerning the direction of the business, how much money partners are taking out of

business, some partners might feel are contributing more time and effort than others and are not

sufficiently rewarded.

A partner is jointly and severally liable that is if one person is sued in relation to the business the

other partners share in the responsibility.



Decision making may be frustrated by other partners

The number of members is limited to 20 people

Each partner except for limited partners must pay their share of any debtors.

.

Partnership agreements

The agreement can be verbal or in writing but written agreements mean less confusion about

what has been agreed.

Contents

The capital has to be contributed by each partnerThe profit sharing ratio has to be determined otherwise the partners will share equal.

Partners not to be charged interest on drawings

Partners not entitled to interest on capital and salaries

Arrangements for the admission of new partners

Procedures to be carried out when a partner retires or dies

WHERE NO PARTNERSHIP AGREEMENTS EXISTS

Profits and loses are to be shared equal

No interest to be allowed on capital, charged on drawings

Salaries are not allowed

Capital to be contributed

Amount introduced by each partner should be agreed upon. Capital balances do not necessarily

bear any relation to the division of profits. However to compensate partners who provide a large

share of the capital an interest on capital is paid. The rate of interest should be equivalent to the

rate of interest obtainable from the market.



Capital accounts

Fixed capital -capital contributed

Current account: are used to deal with the regular transactions between the partners and the firm.

i.e. share of profits, interest on capital, partners’ salaries, monthly drawings and interest on

drawings.

Salary

A partner who spends most of his time in the partnership business should be paid a salary. It

should reflect the amount and level of work undertaken for the business. The salary should be

fairly close to what the partner could reasonably expect to receive in equivalent employment.

5.3 Accounting for partnerships

The profit and loss account and balance sheet of a partnership are prepared and presented in a

very similar way to those of a sole trader.

Types of accounts

Statement of comprehensive income: similar to those of a sole trader

Statement of changes in equity

The purpose of this account is to show how the net profit (or loss) for the year has been allocated

between the partners.

Capital acc Capital acc Current acc Current acc Appropriation Total MR F MR G MR F MR G

Bal at 1 Jan * * * * ** Profit for year * * Salary to partner * (*) Interest on capital * *

(*) Bonus to partner * (*) Drawings (*) (*) (**) Interest on drawings (*) (*) * Share of

profits * * (*) Bal 31 Dec * * * * **



Statement of financial position : its similar to that of a sole trader expect that under capital we

capital and current accounts for each partner

For each partner: capital and current accounts

CAPITAL ACCOUNT

Goodwill ( new profit sharing ratio ) * Bal b/f * Cash

introduced * Goodwill ( old profit sharing ratio * Revaluation profit

* Bal c/d * **

**

CURRENT ACCOUNT

Drawings * Bal b/d * Interest

on drawings * Salary * Interest on capital

* Interest on loan * Share of profits * Bal

c/d * **

** Example

Oscar and Felix are in partnership. They share profits and losses in the ratio: Oscar 60%; Felix

40%. The following trial balance was extracted as at 31 March 2009.

Dr Cr $ $ Office equipment at cost 6 500 Motor vehicles at cost 9 200 Provision for

depreciation at 31.3.2008: Motor vehicle 3 680 Office equipment 1 950 Stock 27 340

Debtors and Creditors 20 960 16 275 Cash at bank 615

Cash in hand 140 Sales 90 370 Purchases 71 630 Salaries 8 417 Office expenses 1 370

Discount allowed 563 Current accounts at 31.3.2008: Oscar 1 379 Felix 1 211 Capital

accounts: Oscar 27 000 Felix 12 000 Drawings: Oscar 5 500 Felix 4 000 153

865 153 865



The following notes are applicable at 31.3.2009.

a. Stock $27 340.

b. Office expenses owing $110.

c. Provide for depreciation: Motor 20% of cost, office equipment 10% of cost.

d. Charge interest on capital at 10%.

e. Charge interest on drawings: Oscar $180; Felix $210.

Required

Draw up a set of financial statements for the year ended 31 March 2009for the partnership

Solution: Workings:

1. Depreciation: van = 20% x $9 200 = $1 840

Equipment = 10% x $6 500 = $ 650

2. Interest on Capital: Oscar = 10% x $27 000 = $2 700

Felix = 10% x $12 000 = $1 200

Oscar and Felix Partnership

Statement of Comprehensive for the year ended 31 March 2009

Sales 90 370

Less Cost of Goods sold:

Opening stock 24 970

Purchases 71 630

96 600



Less closing stock 27 340 69 260

Gross Profit 21 110

Less Expenses

Depreciation (1 840 + 650) 2 490

Office expenses (1 370 + 110) 1 480

Salaries 8 417

Disc. Allowed 563 12 950

Net profit for the year 8160


Statement of Changes in Equity for the year ended 31 March 2009

Capital Current Appropriation Total

Accounts Accounts Account

Oscar Felix Oscar Felix

_ $ $ $ $ $ $

Balances – 1 /04/2008 27 000 12 000 1 379 1 211 - 41 590

Net profit for year 8 160 8 160

Interest on Drawings (180) (210) 390 -

Interest on Capitals 2 700 1 200 (3 900) -

Share of Profit 2 790 1 860 (4 650) -

_Drawings (5 500) (4 000) (9 500)

_Balance on 31 /03/09 27 000 12 000 1 189 61 - 40 250


Statement of Financial Position as at 31 March 2009

Notes Dr Cr Non-current assets $ $

Property plant and equipment 2 7 580 Current assets Inventory

27 340 Debtors 20 960 Bank 615 Cash 140 49 055 56 635 Equity and Liabilities



Capital Accounts: Oscar 27 000 Felix 12 000

Current Accounts: Oscar 1 189 Felix 61 40 250 Non-current

Liabilities - Current Liabilities Creditors 16 275 Accruals 110 16 385 56 635

Oscar and Felix Ltd

Notes to the Financial Statements for the year ended 30 June 2006

1. Accounting Policy

Financial statements have been prepared on the historical cost basis and incorporate the

following principal policies which have been consistently applied in the previous years.

1.1 Fixtures, Fittings and Equipment

Fixtures, fittings, tools and equipment are initially recognized at cost price and then subsequentlymeasured at historical cost less accumulated depreciation. Depreciation is charged on a straight

line basis, as 20% on the cost of assets on hand at the end of each year.

1.2 Inventory

Inventory is stated at the lower of cost or net realizable value.

1.3 Revenue

Revenue consists of the value of goods sold to customers and can be measured reliably.

2. Fixtures, fittings, tools and equipment $000

Carrying amount at 1 July 2005 208

Cost 340

Depreciation for the period (132)

Disposals (20 – 15) ( 5)

Additions 60

Carrying amount at 30 June 2006 187

Cost 340

Accumulated depreciation 193



3. Inventory

Inventory consists of finished goods totaling 100 000

Example 1

The trial balance of the partnership is as follows as at 31 December 2008. Dr Cr $

$ Sales 500 000 Property 100 000 Equipment 20 000 Stock - 1 January 30 000

Purchases 400 000 Wages 30 000 Debtors 30 000 Payment from Mr C. 40 000

Capital Mr A 60 000 Capital Mr B 60 000 Depreciation equipment 4 000

Depreciation- provision equipment 8 000 Creditors 32 000 Drawings A 20 000 B

20 000 C 15 000 Rates 1 000 Heating and lighting 2 000 Administration expenses

3 000 Cash 15 000 700 000 700 000 N.B. The trading information covers the wholeyear Additional information 1) On 31 March 2008 the partners Mr A and B agreed

to admit Mr C subject to property being revalued to $150 000 and goodwill at $30 000. 2) Old

New Partnership Partnership Interest on capital 10% 10% Salaries A $16 000 p.a $10

000 p.a B $24 000 p.a $20 000 p.a C $10 000 p.a Profit sharing ratio A 1/2

3/8 B 1/2 1/2 C 1/8 3) Depreciation on equipment is to be 20% per annum on a

straight line basis. 4) Prepaid wages amount to $2000 5) Rates of $600 were owing 6)

Administration expenses of $1000 dollars remain unpaid 7) Sales from January to March

amount to $100 000. Gross profit is 25% on sales. All other expenses other than cost of goods

sold and rates accrue evenly over the year. The rates for the first quarter amounted to $500 8)

The entries necessary to record revaluation of the property and goodwill have not been made. 9)

Revaluation reserve and goodwill are not to be shown in the books REQUIRED

Prepare: (a) The Trading and Profit and Loss and Appropriation Account for the year ended

2008 in a columnar form (showing results for 3 months and 9 months) (15 marks) (b) Partners

capital and current account including the adjustment for the admission of Mr. C © The balance

sheet as at 31 December 2008.(10 marks)

a) Two partners Mr. Tick and Check have traded for 3 months with capital balances of $12 000

and $15 000 respectively. They agreed to admit a friend Mr. Accuracy as a third partner are to

share profits equal from now on. Mr. Accuracy is to introduce $20 000 capital and goodwill is



agreed at $18 000 REQUIRED i) Record goodwill ii) Show additional entries necessary to

eliminate goodwill again from the accounts. ( 2 marks ) iii) Explain briefly what goodwill is

and why are adjustments necessary when a partner joins a partnership. (10 marks )

Solution

The trading and profit and loss account for the year ended 2008

January April to to March December $ $ Sales 100000 400000 1/4

mark Gross profit (25%of sales) 25000 100000 1 mark wages 7000 21000 1 mark

Depreciation 1000 3000 1 mark Rates 500 1100 1 mark Heat & light 500 1500 1 mark

Administration 3500 12500 10500 37100 1 mark Net Profit 12500 62900 1/4 mark

Salaries A 4000 7500 1 mark B 6000 15000 1 mark C 7500 Interest A 1500 7500 1

mark B 1500 7500 1 mark C 3000 1/4 mark Profit A -250 5588 1 mark B -250

7450 1 mark C 12500 1862 62900 1/4 mark CAPITAL ACCOUNTS eachentry a 1/4 A B C A B C Goodwill 11250 15000 3750 Bal b/d 60000 60000 Bal c/d

88750 85000 36250 Property 25000 25000 Goodwill 15000 15000 Cash 40000

Bal b/d 88750 85000 36250 CURRENT ACCOUNTS each entry a 1/4 A

B C A B C Bal b/d 20000 20000 15000 Salaries 11500 21000 7500 Bal c/d 5838 17200

interest 9000 9000 3000 Profit 5338 7200 1862 Bal c/d 2638 25838 37200 15000

25838 37200 15000 Bal b/d 2638 Bal b/d 5838 17200 ABC Non Current

Assets Property 150000 1/4 mark Equipment 12000 1/4 mark 162000

Current Assets Stock 55000 1 mark Trade debtors 30000 1/4 mark Prepayment

2000 1/4 mark cash 15000 1/4 mark 102000 Current Liabilities Trade creditors

32000 1/4 mark Accrued expenses 1600 33600 1/4 mark Working capital 68400 1/4

mark 230400 1/4 mark Capital Accounts A 88750 1/4 mark B 85000

1/4 mark C 36250 210000 1/4 mark Current Accounts A 5838 1/4 mark B

17200 1/4 mark C -2638 20400 1/4 mark 230400 1/4 mark

5.4 Partnership changes



The admission of a new partner, retirement or deaths of an existing partner constitutes the

termination of one partnership and the commencement of a new one. The assets and liabilities of

the existing partnership must be first valued and goodwill is brought in, in the old profit sharing

ratio and eliminated in the new. A revaluation and goodwill accounts are opened.

A change in the ownership structure of a partnership is regarded as a change in the business. The

existing partnership is dissolved.

Steps

Valuation of the business

REVALUATION ACCOUNT

Decrease in asset values * Increase in asset values * Increase inliabilities * Decrease in liabilities * Profit on revaluation

shared: X * Loss on revaluation X *

Z * Z *

Calculation of goodwill. A goodwill account is opened. When a new partner is introduced

because goodwill was earned before him, the old partners’ capital accounts are credited with the

value of goodwill in old profit sharing ratio. this is because the old partners are the ones who

built the good reputation. Goodwill is eliminated in the books by debiting the capital accounts in

the new profit sharing ratio.

5.5 Amalgamation

Reasons

Similar business to enable them to achieve economies of scale

The businesses are complementary (car washing and selling)

A variety of skills, expertise and experience may be concentrated in one co.

The enlarged firm maybe in a position to fulfill larger, more profitable contracts



The geographical area of operations may be enlarged

Accounting

Add the balance sheet of the firms together making necessary adjustments

Adjust the partners ‘s capital for goodwill

Deal with any assets not being transferred to the new firm

Assets taken over by partners should be debited to the capital acc at agreed values

Assets sold should be dealt with as normal disposals

Profit on disposal should be transferred to the capital account in partner’s old profit sharing

ratios

5. 6 Partnership Dissolution

This results in the termination of the activities of a partnership. The liquidation of the partnership

basically implies that the assets of the partnership must be converted into cash and liabilities

must be settled and the remaining cash paid to the partners in order to close off their capital

accounts.

A realization account

This account is used to determine the profit or loss on liquidation and it aids in the closure of the

ledger accounts of the partnership.

Reasons

No longer profitable

Disagreement between partners

Ill health or old age

Procedure

Assets are disposed of

Liabilities of the firm are paid to other creditors other than the partners



Partners repay their advances and current balances

The profit or loss on realization are apportioned to the partners acc in their profit sharing ratios

The balance of cash is used to pay creditors and expenses of dissolution

Whatever remains will repay the balances on the partners capital account

The balances on current accounts are transferred to capital accounts

A realization account is opened to record the sale of the assets

The realization account

REALISATION ACCOUNT

Book values of assets Sale/ disposal proceeds Realization expenses Cash sold To partners -

profits Partners accounts – assets taken over Assets * Cashsale/ proceeds * Cash realization expenses * Discount received

* Partners account: profit on Partners acc assets taken over Realization Mr. X * Mr.

X motor car * Mr. Z * * Mr. Z motor car

* ** **

The account is debited with the followings

Assets at net book values

Cost of dissolution

Bad debts and discount allowed

Profit on realization

Credits

Proceeds of sale of fixed assets

Assets taken over by partners at valuation

Discount received

Loss on realization

Other journal entries

Dr Cr

Creditors acc *



Bank *

Payment of creditors

Bank *

Debtors *

Cash from debtors

Partner loan *

Bank *

Repayment of partners loan to firm

Partner capital account *Bank *

Repayment of partner’s capital

Bank *

Partners capital *

Debit balance on partners’ capital acc

Example 1

On 31 December 2008, Paul, Queen and Rita decided to dissolve their partnership. They had

always shared profits in the ratio of 3:2:1 respectively.

Their goodwill was sold for $3 000, machinery for $1 800 and stock $1 900. There were 3 motor

cars all taken over by the partners at agreed values, Paul $800, Queen $1 000 and Rita $500. The

premises were taken over by Rita at $5 500. The amount collected from debtors amounted to $2

700 after dab debts and discounts have been deducted. The creditors were discharged for $1 600,

the difference being due to discounts received. The cost of dissolution amounted to $1 000.

Their last statement of financial position is summarized as:

Statement of financial position as 31 December 2008



$ $ $

Non-current assets

Premises 5 000

Machinery 3 000

Motor vehicle 2 500

10 500

Current assets

Stock 1 800

Debtors 3 000

Less provision for bad debts 200 2 800

Bank 1 400

6 00016 500

Equity and Liabilities:

Capital accounts: P 6 000

Q 5 000

R 3 000 14 000

Current accounts: P 200

Q 100

R 5 00 800

14 800

Current liabilities

Creditors 1 700

16 500

The accounts recordings are shown below.

Dr Premises A/c Cr



Date Details $ Date Details $ Balance b/d 5 000 Realisation 5 000 Dr

Machinery A/c Cr

Date Details $ Date Details $

Balance b/d 3 000

Realisation 3 000

Dr Motor vehicles A/c Cr

Date Details $ Date Details $ Balance b/d 2 500 Realisation 2 500

Dr Stock A/c Cr

Date Details $ Date Details $ Balance b/d 1 800 Realisation 1 800

Dr Debtors A/c Cr

Date Details $ Date Details $ Balance b/d 3 000 Provision for bad debts

Realisation 200

2 800 3 000 3 000 Dr Creditors A/c

Cr

Date Details $ Date Details $

Bank

Realization

1 600

100 Bank

1 700 1 700 1 700

Dr P Capital Cr

Date Details $ Date Details $ Realization

bank

800

6 000

Balance b/d

Current a/c

Realisation – profit 6 000

200



600 6 800 6 800

Dr Provision bad debts A/c Cr

Date Details $ Date Details $ Debtors 200 Balance b/d 200

Dr P Current A/c Cr

Date Details $ Date Details $ P: Capital 200 Balance b/d 200

Dr Q Current A/c Cr

Date Details $ Date Details $ Q: Capital 100 Balance b/d 100

Dr Q Capital A/c Cr

Date Details $ Date Details $ Realization: Motorcar

Bank 1 000

4 500 Balance b/dCurrent A/c

Realisation - profit

5 000

100

400 5 500 5 500

Dr R Capital A/c Cr

Date Details $ Date Details $ Realization: Motorcar

Bank 500

5 500 Balance b/d

Current A/c

Realisation - profit

Bank 3 000

500

200

2 300 6 000 6 000

Dr R Current A/c Cr

Date Details $ Date Details $ R: Capital 500 Balance b/d 500 Dr

Bank A/c Cr

Date Details $ Date Details $ Balance b/d



Realization: assets sold

Goodwill

Machinery

Stock

Debtors

R: Capital 1 400

3 000

1 800

1 900

2 7002 300 Creditors

Realization: costs

P: Capital

Q: Capital

1 600

1 000

6 000

4 500

13 100 13 100

Description of transactions:



The provision accounts are transferred to the relevant asset accounts so that the net balance on

the asset accounts may be transferred to the realisation account. Debit provision accounts. Credit

asset accounts.

The net book values of the assets are transferred to the realisation account. Debit realisation

account. Credit asset account.

Assets sold. Debit bank account. Credit realisation account.

Assets taken over by partners. Debit partners’ capital accounts. Credit realisation account.

Liabilities discharged. Credit bank account. Debit liability accounts.

Discounts on creditors. Debit creditors’ account. Credit realisation account.

Costs of dissolution. Credit bank account. Debit realisation account.

Profit or loss split in profit/loss-sharing ratio. Profit – debit realisation account. Credit partners’

capital accounts. The opposite if a loss.Transfer the balances on the partners’ current accounts to their capital accounts.

Any partner with a capital account in deficit, i.e. debits exceeding credits, must now pay in the

amount needed to cancel his indebtedness to the partnership firm. Debit bank account. Credit

capital account.

The credit balances on the partners’ capital accounts can now be paid to them. Credit bank

account. Debit partners’ capital accounts.

6.0 Issues in financial reporting

6.1 The purpose of financial reporting

The objective of preparing financial statements is to provide information about the financial

position (assets, liabilities and equity), performance (income and expenses, including gains and



losses), and cash flows of an entity in order to provide useful information to the users of financial

statements for making economic decisions. It also serves as proof of the results of management’s

stewardship of the resources of the entity.

In order for financial statements to be of value to users, the information provided by these

financial statements must possess certain qualitative characteristics such as relevance, reliability

and comparability. Further, financial statements must present a true and fair view of the entity’s

performance and financial position. (See the Chapter on the Accounting Framework).

6.2 Impact of Price Changes (Inflation)

Accounting measurement is based on a monetary standard, which has been assumed to be stable.

The approach to accounting employs money as the unit of measurement and assumes that theparticular currency will remain stable over time. However history has shown that money is not

always a stable measurement and that changes in the value of money can occur due to inflation.

Inflation can be described as

A reduction in the general purchasing power of a particular currency.

A rise in the general level of prices

A fall in the value of money

The accounts we have studied have been based on historical cost accounting. Under historical

cost accounting assets are recorded at the amount of cash and cash equivalent paid or the fair

value of the consideration given to them. Liabilities are recorded at the amount of proceeds

received in exchange for the obligation.

6.3 Historic Cost Accounting

It is a practice in accounting to record transactions at cost. This is known as the cost concept. It

is described as an objective method of recording the purchase of assets and services, and the sale

of goods because there can be general agreement about the monetary values attributed to the

transactions. The amounts can be supported by evidence such as invoice, receipts etc. Any other



basis of recording transactions would be subjective; the amount in which a transaction would be

recorded would be dependent upon individual points of view.

Under conditions of changing prices the above objectives of financial reporting are not achieved

as the financial statements are not relevant, are not reliable and are not comparable with those of

the previous periods. Furthermore, financial statements prepared under conditions of changing

prices do not present a true and fair view of the entity’s performance and financial position. Why

is this the so? This is so because the Historic Cost Accounting basis fails to present meaningful

financial statements under conditions of price changes.

Limitations of historical cost accounting

The unit of measurement $ in which the accounts are expressed is not stable over periods of time.

The amounts at which fixed assets are stated in the balance sheet do not represent current values

of assets. (Does not show the value of the business). Marked when one looks at how property

values can increase.

Depreciation based on historical cost is not a measure of the value of the fixed assets consumed.

Depreciation is inadequate to finance the replacement of fixed assets.

Historical cost profit will include stock profits arising from holding the stock during a period

when replacement cost increases.

It does not recognize the losses suffered through holding monetary assets during an inflationary

period nor gains on holding monetary liabilities.

ROCE is a key performance measure. During inflationary periods the use of historical cost profit

and asset values overstates (distorts) the rate of return because it incorporates inflated reported

profits and out of date asset values.

HCA do not reflect the erosion of capital caused by inflation.

Historical cost seems to be inapplicable in an inflationary environment. AS 29



Characteristics of a hyperinflationary economy includes

The general population prefers to keep its wealth in non-monetary assets or in a relatively stable

foreign currency.

Prices are normally quoted in a stable foreign currency.

Credit transactions take place at prices that compensate for the expected loss of purchasing

power during the period up to settlement.

Interest, wages and prices are linked to the price indexes.

The cumulative inflation rate over 3years is more than 100%.

6.3.1 Advantages of Historic Cost Accounting

AdvantagesIt’s familiar and understandable to most users and other people may be reluctant to learn other

possible approaches. Users and prepares of accounts understand the concept so the financial

statements are user friendly

All other approaches are based on them and time consuming to prepare and difficult for users to

understand.

It provides an objective, reliable base for financial statements Records are based on objectively

verifiable amounts (actual costs of transactions).

Historical costs can be determined by reference to fact rather than opinion hence the figures

produced are free from bias and capable of independent verification.

The absence of subjective judgment makes HC simple and cheap to implement.

6.3.2 Disadvantages of Historic Cost Accounting



Overstatement of profits: Profit is calculated as the difference of current sales less historic cost

of sales instead of current cost of sales. The profit for an accounting period should be: ‘The

amount which the owner of a business can consume and still be as well off at the end of the

period as he/she was at the start of the period.’ (Sir John Hicks 1930).

Inadequate Depreciation charges: The sole purpose of depreciation in conventional accounting is

to allocate the historic cost of fixed to the income statement over its useful life. The truth

however, is that each year is being charged its fair price of using the asset in as much as the firm

would be charged hiring charges if the asset had been hired and not owned. Therefore, under

conditions of price level changes, the charge for using the asset would also rise. But under

Historic Cost Accounting the depreciation charge, based on the asset’s cost would not change

even under conditions of changing prices. Hence the charge for depreciation is inadequate

resulting in high profits being reported.Gains and Losses on Monetary items are NOT disclosed: Monetary items are assets or liabilities

which are fixed in monetary terms and include such items like debtors, creditors, loans and cash.

In periods of inflation, a business losses purchasing power by holding monetary assets but gains

purchasing power by holding monetary liabilities. However, these gains and losses are not

revealed at all in a conventional profit and loss account. It can be argued that this is another short

coming of the conventional approach to financial accounting.

Holding gains on stock not identified: During a period of inflation, any stock of goods held by a

business for an appreciable amount of time will increase in monetary value. Such an increase is

known as a holding gain. In a conventional profit and loss account, holding gains are not shown

separately but are treated as part of the gross profit arising on the sale of goods. It has been

suggested that the profit and loss account would be more useful if the gross profit were analysed

so that holding gains were clearly identified.

Unrealistic fixed assets values: A combination of the historic cost convention and the realisation

convention means that fixed assets are normally shown in the balance sheet at historic cost and

that any increases in fixed asset values are not recognized until they are realized. As a

consequence, a conventional balance sheet often fails to show the true financial position of the

business, especially if the business owns assets (such as freehold land) which have been subject

to substantial price increases since acquisition.



Furthermore, the historic costs of all the fixed assets owned by the business are added together in

a conventional balance sheet, regardless of the fact that these costs have been incurred in

different years. Adding together the $3 000 paid for a freehold property in 1960 and the $100

000 paid for a similar property in 1997 seems to serve no useful purpose and yet the system of

historic cost accounting requires that these two figures should be aggregated. Because of these

problems, some businesses have now adopted the policy of showing land and buildings in the

balance sheet at current value rather historic cost.

Misleading accounting ratios: Accounting ratios are often used as a tool for analysis and

interpretation of financial statements. However, the limitations of historic cost accounting

suggest that it may be unwise to base economic decisions on a ratio analysis of figures shown in

a conventional set of accounts.

Misleading comparisons over time: One way of assessing the progress made by a business is tocompare its most recent results with those achieved in previous years. However, comparisons of

this nature can be misleading if the effects of inflation are neglected. For instance, a 10%

increase from one year to the next might be seen as encouraging, but if this occurs against a

background of 12% inflation, the sales revenue of the business has declined in real terms.

6.4 Alternative to historical accounting

6.4.1 Current purchasing power

The CPP system is based on the concept of (Real capital maintenance where the main objective

is to maintain the purchasing power of the shareholders funds. The system involves the

restatement of monetary amounts in the financial statements by reference to the movement in a

general price index since those amounts were first established. All monetary amounts in the

financial statements are thus restated to current purchasing power.

The profit and loss : contains a charge or credit to reflect the loss or gain on monetary items as a

result of the decline in the purchasing power of money.



Financial statements are shown at their current purchasing at the close of the accounting period

using Retail Price Index. This adjusts accounts for the rate of inflation.

Involves adjusting non-monetary assets in the balance sheet to current cost (using the consumer

price index). The difference between net assets at the beg and end of year gives a profit

The profit and loss figures are adjusted for a gain or a as a result of the decline in the purchasing

power.

6.4.1 Current cost accounting

This approach involves the adjustment of accounts to reflect the current value of owned and used

assets. e.g.

A machine at cost $40 000Depreciation $12 000

At date of purchase the index was 120 now it is 180 Therefore the current cost

Equals 40 000* 180 =$60 000

120

Accumulated depreciation =12 000*180 = 18000

120

It is based on the concept of physical capital maintenance where the objective is to maintain the

physical operating capability of the business. This achieved by charging against profits the

replacement cost of stocks and fixed assets consumed during the period and also making an

allowance for the impact of specific price changes on the funds required to finance monetary

working capital (debtors and creditors).

On the balance sheet fixed assets and stocks are stated at their current values which will be

usually be determined by reference to their replacement costs. The revaluation surpluses or

holding gains arising on these assets are reflected in a non-distributable reserve. CCA system is

based on specific price movements as opposed to movements in the general price level.



ADJUSTMENTS

Depreciation adjustment

Cost of sales adjustment

Monetary working capital adjustment

Any gains or loses are transferred to NDR

COST OF SALES ADJUSTMENT (COSA)

HCA CCA

Opening stock 9000 114/108 9500Purchases 19000 19000

Closing stock 10000 114/120 9500

Cost 18000 19000

Purchases of 19000are treated as 18000

DEPRECIATION ADJUSTMENT

Depreciation is based on cost this leads to an undercharge to P&L e.g.

Cost of plant =10 000 10yrs ago, lifespan is 5yrs and the index at acquisition 100

Average 132.5

Depreciation 2 000 HCA

CCA I

2 000*132.5/100

2650

MONETARY WORKING CAPITAL ADJUSTMENT (MWCA)



Adjust for loses which arises when holding monetary assets

Debtors – creditors at the beginning and end of year.

GEARING ADJUSTMENT

L/L+E

EFFECTS OF CCA

Involves the adjustment of figures in the profit and loss to reflect current costs at year end

Profits so distributed can be fully distributed without impairing capital.

However income statements cannot be compared

The adjusted account is appended as an annexure to HCA accountsIndices used are produced by the central statistical office. Because they refer to a specific basket

of goods the relevance of the resulting index is questionable.

6.5 Social Accounting

The limitations of financial statements as basis for decisions

The concept of money measurement results in the limitations of entries in the financial records to

those transactions which can be expressed in monetary terms. As a result there are many factors

affecting business which must be omitted from financial statements such as:

staff morale

the quality of staff (its degree of skill)

the quality of management of the business

the attitude of the public towards the business

the effect of the business upon the local community

the contribution, for good or ill, of the business to the environment

Where the business stands on political issues e.g. trading with countries with which there are

trading sanctions; trading in arms etc.

At this point it should be mentioned that attempts have been made to place values on many social

factors, but these are economists’ values rather than accountants’ values



and whatever their validity as economic concepts, are not generally recognized by accountants

as complying with the accounting concept of money measurement.

There are situations in which profitability alone should not be the sole of policy. For

ease of memory, and as a guide to the approach to social accounting aspects in examinations

questions, the non financial factors to be considered are summarized under the broad headings of

the FOUR P’S:

PEOPLE

PLACE

PRODUCTS

POLITICS.

It will often be found that there is a close relationship between these four factors e.g. people are

involved because of a threat to the environment or because some political issues is at stake.

6.5 National Social Accounting

National accounts and those of local authorities are prepared using historic cost accounting it is

for the government to decide how best national accounts should be presented in certain

government departments as well as in local authorities. Management accounting is well

established in order to arrive at the best decision. In local government decisions are carefully

made so that:

minimum economic is archived by acquiring goods and services at the lowest possible cost

maximum efficiency is archived in converting goods and services into an output ( e.g.

administering housing or running a home help services)

Maximum effectiveness is attained in archiving the goals of the service ( e.g. by keeping

delinquent youth away from parked cars).

Examples

a) You are required to discuss the advantages and disadvantages of using Historical cost accounts

in preparing financial statements which are presented to shareholders (10 marks)

b) Explain what accountants mean by the convention of objectivity. (5 marks)

c) Discuss the alternatives to Historical Cost Accounting and state the advantages and

disadvantages of each method.



7.0 Investments Accounts

7.1 General background

It is fairly common practice for a business to invest in stocks and/or shares and/or debentures of

other companies. There are numerous and varied reasons for this practice.

For some companies (investment companies) it is the sole reason for their existence; the

investment income is their main, or only, revenue.

Investments may be acquired by any business as a temporary but profitable refuge for surplus

funds. Alternatively funds may be set aside and invested to provide finance for a specific future

objective. This might be a major expansion programme or the redemption of the company’s

debentures. In both these instances the investments would be sold, as required, to provide cash to

enable the objective to be achieved.An investing company may acquire a controlling interest in another company by obtaining a

majority holding, that is, in excess of 50% of the company’s voting shares. The company thus

controlled is then termed a subsidiary of the investing company, which is referred to as a holding

company.

In lieu of gaining outright control, the investing company may secure a substantial, but not a

controlling, interest in another company, in order to influence that company’s policy decisions.

Where the investment comprises 20% to 50% of the other company’s voting shares, the latter

may be termed an associated company.

A company may also place money on short term deposit to take advantage of high interest rates

but this practice is not further considered in this section.

7.2 Operating arrangements

There are two basic categories of trade investments.

Those which carry a fluctuating rate of return on nominal value – ordinary shares (equities),

Those which carry a fixed rate of return on nominal value – preference shares and debentures

etc.

A distinction can be made between those investments which are

Listed, that is, quoted on a recognized Stock Exchange, and

Unlisted, that is, unquoted on a recognized Stock Exchange



On the acquisition of trade investments the capital costs include brokerage and other charges

associated with the purchase. On disposal the capital proceeds are the net amount after deducting

of all expenses associated with selling. In each case, also, further adjustment may need to be

made in the light of accrued fixed interest or fixed dividend.

Fixed rate securities are ordinarily bought cum dividends or cum interest, that is, inclusive of

accrued dividend or interest. The quotation is given per $100 nominal. These terms are shortened

to cum div and to cum int . The implication of cum div \ cum int quotation is that the buyer

receives the whole of the next payment of dividends or interest without having held the

investment for the whole of the period to which that payment relates. Payments maybe on a

quarterly, half yearly or annual basis. Quotations are always cum dividends\ int unless

specifically stated to be ex div \ ex int.The institutions paying the dividends or interest do so the registered owners of the shares. Each

time the shares change hands the institution has to amend the appropriate statutory records, for

example, the Register of Shareholders. On payment date, the dividend or interest is paid to the

latest registered holder. About one month before paid date, each institution closes its transfer list

and ceases to record changes of ownership of its shares. This is done for administrative

convenience. If it were not done, the institutions would be placed in a position of great difficulty

and would be unable to prepare the payment documents until after payment date in order to make

those documents out to shareholders who had acquired their holdings at or near payment date.

The effect of suspending the recording of transfers until after payment date means that, where

securities have changed hands during this period, payment of dividend or interest will be made to

the original, not to the current, holder. On suspension of recording of transfers, the quotation

changes from cum div or cum int to ex dividend or ex interest, shortened to ex div and to ex int.

The application of this is that the next payment of dividend or interest is paid in its entirely to the

original holder despite the fact that he is no longer the holder at the time. However, in an ex div

or ex int quotation that part of the dividend or interest which the new holder will not receive

from the paying institution reduces the buying price.

These arrangements are inapplicable to type securities. An investing company may receive

additional shares of a class which it already holds by means of a bonus issue.



7.3 Accounting arrangements

In the books of the investing business a separate account is opened for each security. Each

investment account has three columns on each side of the account:-

Column 1- a memorandum column in which is recorded the nominal

value of each transaction in either value or quantitative terms.

Column 2- a (double entry) income column to record investment income

transactions.

Column 3- a (double entry) capital column to record the investment

capital transaction.

And is ruled thus:

Ordinary\ preference shares\ debentures in….

NomNo\$ Inc

$ Cap

$ Nom

No\$ Inc

$ Cap

$

EX DIV/INT PURCHASES

When securities are acquired cum div or cum int. the accrued dividend \ interest element is

debited to income column and the balance, being the capital cost is debited to the capital column.

In practice the accrued interest would be debited less income tax.


When securities are acquired ex div or ex int, the amount of dividend or interest by which the

buying price has been reduced, is debited to capital column and credited to income column and

the whole of the purchase cost is debited to capital column as well.




When securities are sold cum div or cum int, the accrued dividend/interest element is credited to

income column and the balance being capital proceeds, is credited to capital column.

When securities are sold ex div or ex int, the amount of dividend or interest by which the selling

price has been reduced is debited to income column and credited to the capital column and the

whole of the net sale proceeds are credited to capital column as well.

7.4 Profit and loss on Investment

Investments are ordinarily valued at cost of actual acquisition, adjusted, where necessary for the

cum or ex div\int quotation as illustrated in the foregoing subscriptions. Overtime the acquisition

fluctuate in the light of the prevailing economic, marketing and other conditions. Subject to whatis stated, its not usual to record these market profit\losses.

In investment accounts, profits or losses are normally recognized only when actually realized.

7.5 Partial disposal of the Holding

In the example given so far, the sale has been of complete holding. Minor complications arise

when there is a sale of only part of a holding. The question arises how to value the cost of the

investment sold (for comparison with the sale proceeds to see whether a profit or loss results).

Where, as in the examples up to this point, the holding was acquired at a single point in time, it is

simply a matter of taking that proportion of the original cost which the nominal disposals to the

total original nominal holding.

Example

On 1 January 19-4 Green Ltd bought $4 000 6 per cent Government Stock at $90, the cheque of

$3 680 paid being $3 600 for the stock and $80 for the brokerage charges. Interest is receivable

each year on 31 March, 30 June, 30 September, and 31 December.

On 1 February 19-5 $1000 nominal value of the stock is sold cum div, the net proceeds being

$950.



1 June 19-5, $2 000 nominal value sold ex div, net proceeds after brokerage being $1 710.

1 February 19-6, $5 000 nominal value bought cum div, the cost including brokerage being $4

370.

1 June 19-6, $1 000 nominal value bought ex div, cost including brokerage being $910.

Below is the Investment Account in Green’s books for the financial years ended 31 December

19-4, 19-5, 19-6. Taxation is ignored.



Investment – 6 per cent Government Stock

Nominal Income Capital Nominal IncomeCapital

$ $ $ $ $ $

19-4 19-4

Jan 1 Cash 4 000 3 680 Mar 31 Cash 60

Dec 31 Investment Income to Profit and Loss 240 Jun 30 ―

60

Sep 30 ― 60

Dec 31 ― 60

― 31Balance c/d 4 000 3 680

4 000 240 3 680 4 000 240 3 680

19-5 19-5Jan 1 Balance b/d 4 000 3 680 Feb 1 Cash sale proceeds

(A) 1 000 5 945

Jun 1 Adjustment for sale @ ex div price (B) 10 Mar 31 Cash ($3 000 x 6% x

3 months) 45

Dec 31 Investment income to Profit and Loss (C) 115 Jun 1Cash sale

proceeds 2 000 1 710

― 1Adjustment for sale @ ex div price (B)

10

― 30Cash ($3 000 x 6% x 3 months) 45

Sep 31 Cash ($1 000 x 6% x 3 months)

15

Dec 31 Cash ($1 000 x 6% x 3 months) 15

― 31P & L – loss on sale of Investments (D)

95

― 31Balance c/d 1 000 920

4 000 125 3 680 4 000 125 3 680

19-6 19-6

Jan 1 Balance b/d 1 000 920 Mar 31 Cash ($6 000 x 6% x 3 months)

90



Feb 1 Cash 5 000 25 4 345 Jun 1 Adjstmnt for purchase @ ex div price (E)

5

Jun 1 ― 1 000 910 ― 30Cash ($6 000 x 6% x 3 months) 90

― 1Adjstmnt for purchase @ ex div price (E) 5 Sep 30 Cash ($7 000 x 6% x

3 months) 105

Dec 31 Investment income to Profit and Loss (F) 370 Dec 31 Cash ($7 000 x 6% x

3 months) 105

― 31Balance c/d 7 000 6 180

7 000 395 6 180 7 000 395 6 180

19-7

Jan 1 Balance b/d 7 000 6 180



Notes:

(A) The sale proceeds $950 represent the sale of the right to one month’s interest, $1 000 x 6%

per annum for one month = $5, plus the right to the actual stock itself. This must therefore be the

balance of the net sale proceeds, $950 - $5 = $945.

(B) The sale at an ex div price means that Green Ltd will receive interest for June on this

$2 000 of stock even though the stock itself had passed out of Green’s ownership. The actual net

sale price is therefore $1 720, which is made up of $1 710 actually received plus $10 for the right

to one month’s interest retained. This is adjusted by debiting the Income column with $10 to

cancel the income which was not equated with ownership, and crediting the Capital column with

$10 representing the actual reduction in the sale price by selling at an ex div price. Note (C) will

illustrate the validity of debiting the income column, as without this entry the amount of

investment income transferred to the Profit and Loss account would not agree with the factsrelating to the duration of the investment and the rate of interest.

(C) The correctness of this can be proved if the interest actually accrued during ownership is

calculated:

$

6% per annum on $4 000 for one month = 20

6% per annum on $3 000 for four months = 60

6% per annum on $1 000 for seven months = 35

115

(D)

$ $

Cost of $1 000 nominal value of stock $3 680 x ¼ = 920

Sold on 1 February 19-5 for 945 25 profit

Cost of $2 000 nominal value of stock $3 680 x ½ = 1 840

Sold on 1 June 19-5 for (adjusted net sale price) 1 720 120 loss

95 net loss

(E) The stock bought on 1 June 19-6 for $910 ex div meant that June’s ownership would not

bring in any interest on the stock. The price paid for the stock would have been reduced by the

amount of June’s interest, i.e. $1 000 at 6% per annum for one month = $5. The true price paid



was therefore $915. This is represented by a debit of $5 in the Capital column, while a credit of

$5 in the Income column is made to show that ownership of fixed interest stock does in fact

bring in a return of interest in accordance with the length of ownership.

(F) This can be proved to be correct.

$

$1 000 at 6% per annum for one month = 5

$6 000 at 6% per annum for four months = 120

$7 000 at 6% per annum for seven months = 245

370

7.6 PRACTICE QUESTION

The following transactions of Trust Ltd took place during the year ended 30 June 2007:

2006

1 July Purchased $12 000 4% Consolidated Loan (interest payable 1 February and

1 August) at 60 ½ cum div.

12 July Purchased 2 000 ordinary shares of $0.50 each in Abee Ltd for $4 000.

1 August Received half-year’s interest on 4% consolidated loan.

15 August Abee Ltd made a bonus issue of three ordinary shares for every two held.

Trust Ltd sold 2 500 of the bonus shares for $1 each.

1 October Purchased 5 000 ordinary shares of $1 each in Ceedee Ltd at $0.775 each.

2007

2 January Sold $3 000 4% Consolidated Loan at 61 ex div.

1 February Received half-year’s interest on 4% Consolidated Loan.

1 March Received dividend of 18% on shares in Abee Ltd.

1 April Ceedee Ltd made a ‘rights’ issue of one share for every two held at

$0.50 per share. ‘Rights’ sold on mar ket for $0.25 per share.



1 June Received dividend of 12 ½% on shares in Ceedee Ltd.

REQUIRED:

Write up the relevant investment accounts as they would appear in the books of Trust Ltd for the

year ended 30 June 2007, bringing down the balances as to that date.

Ignore brokerage and stamp duty.



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