CPA FINANCIAL REPORTING PART 2 CPA SECTION 3 STUDY TEXT

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1 CPA FINANCIAL REPORTING PART 2 CPA SECTION Sample STUDY TEXT

2 KASNEB SYLLABUS PAPER NO. 9 FINANCIAL REPORTING GENERAL OBJECTIVE This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her to prepare financial statements for various entities and account for specialised transactions in both the public and private sectors 9. 0 LEARNING OUTCOMES A candidate who passes this paper should be able to: Account for various assets and liabilities Prepare financial statements including published financial statements for various types of organisations Account for specialised transactions Prepare group financial statements Apply International Financial Reporting Standards (IFRSs) and International Public Sector Accounting Standards (IPSASs) in preparing non-complex financial statements. CONTENT 9.1 Assets and liabilities - Assets and liabilities covered in Paper No.1: Financial Accounting still examinable (in the context of published financial statements) - Non- current assets held for sale - Borrowing costs - Investment property - Financial instruments (presentation, recognition, classes, measurement, de-recognition and disclosures) (excluding impairment, hedging and embedded derivatives) - Leases (all aspects including dealers and sale and leaseback) - Income tax (current and deferred tax but not deferred tax in the case of groups) - Provisions, contingent liabilities and contingent assets 9.2 Further aspects of partnerships - Dissolutions (including piece-meal) - Conversion of a partnership into a company 9.3 Specialized transactions - Sample - Contracts with customers (revenue recognition): Hire Purchase/ Installment sales (split of hire purchase profit into interest and gross profit and using actuarial method and sum of digits to account for interest); sale of goods; construction contracts and real estate, provision of services. - Government grants Contact: Page 2

3 9.4 Financial statements of various types of organizations - Farming - Insurance - Banks - Professional firms (lawyers and accountants) - Independent local, dependent and foreign branches - Co-operative societies 9.5 Published financial statements - Presentation of financial statements (income statement, statement of comprehensive incomes, statement of changes in equity, statement of financial position and the notes to financial statements) - Accounting policies, changes in accounting estimates and errors (prior period errors) - Events after the reporting period - Discontinued operations (exclude disposal of subsidiaries) 9.6 Subsidiaries (groups), associates and jointly controlled entities - Accounting for one subsidiary (consolidated income statement, consolidated statement of financial position and a statement of cash flows - group financial statements); consolidated statement of cash flows also covers associate companies and jointly controlled entities but excludes acquisition and disposal of subsidiaries during the year - Accounting treatment of associate companies - Jointly controlled entity 9.5 Financial statements of public sector entities (Provisions of the following IPSAS (emphasis on distinctions with equivalent IASs/IFRS) - Presentation of financial statements - Accounting policies, changes in accounting estimates and errors - Borrowing costs - Consolidated and separate financial statements - Investments in associates - Interests in joint ventures - Events after the reporting date - Construction contracts, leases and inventories - Provisions, contingent liabilities and contingent assets 9.8 Emerging issues in financial reporting - Sample Contact: Page 3

4 TABLE OF CONTENTS TOPIC PAGE Topic 1: Assets and liabilities...5 Topic 2: Further aspect of partnerships...85 Topic 3: Special transactions Topic 4: Financial statements for various types of organisations Topic 5: Published financial statements Topic 6: Subsidiaries (groups), associates and jointly controlled entities Topic 7: Financial statements of public sector entities Revised on: July Sample Contact: Page 4

5 TOPIC 1 ASSETS AND LIABILITIES ASSETS AND LIABILITIES Introduction Property, plant and equipment are tangible items that are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and are expected to be used during more than one period. Recognition of Property, Plant and Equipment IAS 16 states that the cost of an item of property, plant and equipment shall be recognized as an asset if, and only if: it is probable that future economic benefits associated with the item will flow to the entity; and The cost of the item can be measured reliably. This recognition principle shall be applied to all costs at the time they are incurred, both incurred initially to acquire or construct an item of property, plant and equipment and incurred subsequently after recognition to add to, replace part of or service it. Initial costs Some items of property, plant and equipment might be necessary to acquire for safety or environmental reasons. Although they do not directly increase the future economic benefits, they might be inevitable to obtain future economic benefits from other assets and therefore, should be recognized as an asset. For example, water cleaning station might be necessary in order to proceed with some chemical processes within chemical manufacturer. Subsequent costs Day-to-day servicing of the item shall be recognized in profit or loss as incurred, because they just maintain (not enhance) item s capacity to bring future economic benefits. However, some parts of the item of property, plant and equipment may require replacement at regular intervals, for example, aircraft interiors. In such a case, an entity derecognizes carrying amount of older part and recognizes the cost of new part into the carrying amount of the item. The same applies to major inspections for faults, overhauling and similar items. Contact: Page 5

6 Measurement Initial Measurement An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its cost. The cost of an item of property, plant and equipment comprises: 1. its purchase price including import duties, non-refundable purchase taxes, after deducting trade discounts and rebates 2. Any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. Examples of these costs are: costs of site preparation, professional fees, initial delivery and handling, installation and assembly, etc., 3. The initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located. The cost of an item of property, plant and equipment is the cash price equivalent at the recognition date. If payment is deferred beyond normal credit terms, the difference between the cash price equivalent and the total payment is recognized as interest over the period of credit (unless such interest is capitalized in accordance with IAS 23). If an asset is acquired in exchange for another non-monetary asset, the cost will be measured at the fair value unless (a) the exchange transaction lacks commercial substance or (b) the fair value of neither the asset received nor the asset given up is reliably measurable. If the acquired item is not measured at fair value, its cost is measured at the carrying amount of the asset given up. Subsequent Measurement An entity may choose two accounting models for its property plant and equipment: 1. Cost model An entity shall carry an asset at its cost less any accumulated depreciation and any accumulated impairment losses. 2. Revaluation model An entity shall carry an asset at a revalued amount. Revalued amount is its fair value at the date of the revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses. An entity shall revalue its assets with sufficient regularity so that the carrying amount does not differ materially from its fair value at the end of the reporting period. If an item of property, plant and equipment is revalued, the entire class of property, plant and equipment to which that asset belongs shall be revalued. The change of asset s carrying amount as a result of revaluation shall be treated in the following way: Contact: Page 6

7 Change in Carying Amount Increase Decrease Other comprehensive income (heading Revolution surplus ) Profit or loss Where Profit or loss if reverses previous revaluation decrease of the same value Other comprehensive income if reduces previously recognized revaluation surplus (heading Revaluation surplus ) Depreciation (both models) Depreciation is defined as the systematic allocation of the depreciable amount of an asset over its useful life. The items of property, plant and equipment are usually depreciated in order to maintain matching principle as they are in operation for more than 1 year, they assist in producing the revenues in more than 1 year and therefore, their cost shall be spread among those years in order to match the revenue they help to produce. When dealing with the depreciation the basic things considered are: Depreciable amount: Depreciable amount is simply HOW MUCH you are going to depreciate. It is the cost of an asset, or other amount substituted for cost, less its residual value. Depreciation period: Depreciation period is simply HOW LONG you are going to depreciate and it is basically asset s useful life. Useful life is the period over which an asset is expected to be available for use by an entity; or the number of production or similar units expected to be obtained from the asset by an entity.ifrs16 lists several factors that shall be considered when establishing item s useful life: expected usage of the item, expected physical wear and tear, technical or commercial obsolescence of the item, and legal or other limits on the use of the asset. Useful life and asset s residual value (input to depreciable amount) shall be reviewed at least at the end of each financial year. If there is a change in the expectations comparing to previous estimates, then change shall be accounted for as a change in an accounting estimate in line with IAS 8 (no restatement of previous periods). Depreciation method: Depreciation method is simply HOW, IN WHAT MANNER you are going to depreciate. The depreciation method used shall reflect the pattern in which the asset s future economic benefits are expected to be consumed by the entity.an entity may select from variety of depreciation methods, such as straight-line method, diminishing balance method and the units of production methods. Selected method shall be reviewed at least at the end of each financial year. If there is a change in the expected pattern of asset s usage, then the depreciation method shall be changed and be accounted for as a change in an accounting estimate in line with IAS8 (no restatement of previous periods).depreciation shall be recognized in profit or loss unless it is capitalized into the carrying amount of another asset (for example, inventories, or another item of property, plant and equipment). Each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately. For example, aircraft interior cost might be depreciated separately from the remaining airplane cost. Contact: Page 7

8 Methods for Providing Depreciation Fixed assets differ from each other in their nature so widely that the same depreciation methods cannot be applied to each. The following methods have therefore been evolved for depreciating various assets: 1. Fixed Percentage on Diminishing Balar1!:e Method 2. Sum of the years Digits Method. 3. Annuity Method. 4. Depreciation Fund Method. 5. Insurance Policy Method. 6. Revaluation Method. 7. Machine Hour Rate Method. 8. Depletion Method. 9. Repairs Provision Method. Fixed Installment or Straight Line or Fixed Percentage on Original Cost. Under this method, the Depreciation is calculated on the basis of either a fixed percentage of the original value of the asset or divides the original value of asset by the number of years of its estimated life. Every year, the same amount is written off as Depreciation so as to reduce the asset account to nil. Diminishing Balance Method = Under the diminishing Balance method, depreciation is calculated at a fixed percentage on the opening balance of each year. Each year the opening balance may be decreasing in value. This decreasing book value is commonly known as written down value of the asset. While applying the depreciation rate both salvage or scrap value and removal costs are ignored. There are no possibilities to reduce the book value to zero. Sum of the Years Digits Method It gives decreasing depreciation charge year by year. For the purpose of obtaining yearly depreciation diminishing percentages to the cost of the asset, less salvage value is applied. Under this method, the rate of depreciation is a fraction having the sum of the digits representing the useful life of the asset as its denominator and individual year as its numerator. ( ) Contact: Page 8

9 Annuity Method Under the Annuity method, the annual depreciation charges would be ascertained with the help of Annuity table. This method gives importance to interest factor. Other methods do not take into account the interest factor while investing the assets. Fixed interest rate is charged on the opening balance of each year and then cost of asset together with interest thereon is written off equally over the life of the asset. Depreciation Fund Method Depreciation fund method provides an adequate financial requirement for the replacement of the asset when the asset is replaced by a new one. Depreciation fund account is opened and the amount of depreciation is credited to that account. The asset account stands year after year at its original cost. At the end of each year, the amount of depreciation is debited and depreciation fund account is credited and the corresponding amount is invested in securities of some reputed companies, for the purpose of mobilizing funds for replacement. Insurance Policy Method Under this method, an insurance policy is taken from the insurance company for the purpose of replacement of an asset. At the end of the definite period, the insurance company will pay the assured sum with the help of which asset can be repurchased. Revaluation Method This method is suitable for small and diverse items of asset such as bottles, corks, trade marks, loose tools, livestock etc. Under this method the amount of depreciation is ascertained to find the difference between the book value of the asset and the real value of the asset. At the end of the year the difference is taken as depreciation. Suppose on first January, 2005 the value of loose tools was Shs.1, 600 and during the year Shs.2, 000 worth of tools were purchased. Now, if at the end of the year, the loose tools are considered to be worth only Shs.2, 400, the depreciation comes to Shs.1, 200, i.e. Shs. 1, ,000 2,400 Machine Hour Rate Method The Economic Life of the asset is estimated in terms of working hours. Hourly rate is determined by dividing total cost of the asset by total number of hours to be operated in its life time. The annual depreciation charge is calculated by applying this rate to the actual number of hours operated in the particular accounting period. Machine hour rate = Depreciation for the year = (Cost Scrap Value ) Total hours (who1e lifetime) Machine Hour value Estimated Hours in a year Contact: Page 9

10 Depletion Method The Economic Life of the asset is determined by geographical survey methods in terms of total units of resource deposits. The depletion rate per unit is calculated by dividing the total cost of the asset by the estimated available number of units. Repairs Provision Method Under this method, first the total repair and renewal costs are determined for the whole life of the asset and then it is added to the capital cost to get a total value. Then, this value is divided by its estimated life. The resultant value is treated as Repair, Renewals and depreciation. It has to be charged to the profit and loss Account each year. The corresponding Credit is given to provision for depreciation and Repairs account. Impairment Here, IAS 16 refers to another standard, IAS 36 Impairment of Assets that prescribes rules for reviewing the carrying amount of assets, determining their recoverable amount and impairment loss, recognizing and reversing impairment loss and more. IAS 16 states that compensation from third parties for items of property, plant and equipment that were impaired, lost or given up shall be included in profit or loss when the compensation becomes receivable. For example, claim for compensation of damage on insured property from insurance company is recognized to profit or loss when insurance company accepts claim, closes the case and agrees to compensate (or after whatever procedure is agreed in the insurance contract). Derecognition IAS 16 prescribes that the carrying amount of an item of property, plant and equipment shall be derecognized on disposal; or when no future economic benefits are expected from its use or disposal. The gain (not classified as revenue!) or loss arising from the derecognition of an item of property, plant and equipment shall be included in profit or loss when the item is derecognized. The gain or loss from the derecognition is calculated as the net disposal proceeds (usually income from sale of item) less the carrying amount of the item. Intangible Assets An intangible asset is an identifiable non-monetary asset without physical substance and helps your company make money. Examples include patents, copyrights, brands and franchises trademarks etc. The International Accounting Standards Board, or IASB, further states that intangible assets must arise out of a legal contract or be separable so that they can be sold. An example is a novel copyright. It has no physical presence, but it enables the owner to profit from the sale of the book. That copyright can be sold so that the new owner can profit from future book sales. The copyright is therefore both valuable and separable and should be recorded as an intangible asset. Contact: Page 10

11 This is a SAMPLE (Few pages extracted from the complete notes: Note page numbers reflects the original pages on the complete notes). It s meant to show you the topics covered in the notes. Download more at our websites: or To get the complete notes either in softcopy form or in Hardcopy (printed & Binded) form, contact us: Call/text/whatsApp someakenya@gmail.com info@someakenya.co.ke info@someakenya.com Get news and updates about kasneb by liking our page Or following us on twitter Pass on first attempt Buy quality notes and avoid a refers/retakes which costs more money and time Sample/preview is NOT FOR SALE

12 TOPIC 2 FURTHER ASPECTS OF PARTNERSHIPS DISSOLUTION OF A PARTNERSHIP Introduction: The dissolution of partnership among all the partners of a firm is called the Dissolution of the Firm. Dissolution of Partnership involves a change in the relation of partnership business, if the remaining partners resolve to continue the concern. In such cases there will be a new partnership but the firm will continue in a reconstituted form. Dissolution of firm means complete breakdown of the relation of partnership among all the partners. When all the partners resolve to dissolve the partnership, the dissolution of firm occurs, i.e. the firm is wound up. If the business comes to an end, it is said that the firm has been dissolved. Dissolution of firm means the closing down of the business. Firm s dissolution implies partnership dissolution but not vice versa. That is dissolution of partnership does not mean dissolution of firm, but the dissolution of firm will be dissolved on any one of the following ways: (a) Dissolution by Agreement A firm may be dissolved at any time with the consent of all partners. For instance, when a firm does not expect good prospects in the future, a firm can be dissolved by mutual consent of all partners. (b) Compulsory Dissolution A firm is compulsorily dissolved by operation of law when all the partners except one become insolvent or when all the partners become insolvent or when business becomes illegal or when the number of partners exceeds twenty in case of ordinary business or ten in case of banking. (c) Dissolution on the Happening of Certain Contingencies A firm is dissolved, in the absence of contrary, in the event of any of the following circumstances: (i) (ii) (iii) (iv) The expiry of the term for which it was formed. The completion of the venture for which the partnership was constituted. The death of a partner. The adjudication of a partner as an insolvent. Contact: Page 85

13 (d) Dissolution by Notice of Partnership at Will Where a partnership is at will, the firm may be dissolved by any partner giving notice in writing to all the other partners of his intention to dissolve the firm. (e) Dissolution by the Court The court is empowered to order the dissolution of a firm consequent on a suit by a partner in the following cases: i) When a partner becomes insane or unsound of mind. ii) When a partner becomes permanently incapable of performing his duties, be it mental or physical. iii) When a partner is proved guilty of misconduct which is likely to affect adversely the business of the firm. iv) When a partner conduct himself in such a way that it is not possible for the other partners to carry on partnership with him. v) When a partner transfers his interest or share to third party. vi) When the business cannot be carried out except at a loss. (It must be remembered that the object of partnership is to earn profits and if that object is not fulfilled, the firm can be dissolved). vii) When it appears to be just and equitable. For instance, continued quarrelling, deadlock in the management, refusal to attend matters of business, absence of cooperation etc. among the partners. (The court has wide discretionary powers). Liability for Acts Done After Dissolution When a firm is dissolved a public notice must be given of the dissolution. If it is not done, the partners continue to be liable as such to third parties for any act done by any of them after the dissolution, and in such a case, the act of a partner done after dissolution is deemed to be an act done before the dissolution. Settlement of Accounts As soon as a firm is dissolved, it ceases to transact normal business. The mode of settlement of accounts between partners after the dissolution of a firm is determined by the partnership agreement. In the absence of any specific agreement as to the mode of settlement of accounts after the dissolution of the firm, the Partnership Act laid down the following provisions for settlement of accounts. a) Losses, including deficiencies of capital, shall be paid first out of profit, next out of capital, and lastly, if necessary, by the partners individually in their profit-sharing ratio. b) The assets of the firm including any sums contributed by the partners to make up deficiencies of capital shall be applied in the following manner and order: i) In paying the debts of the firm to third parties. ii) In paying each partner rateably what is due to him from the firm for advances. iii) In paying to each partner rateably what is due to him on account of capital, and iv) (iv)the surplus, if any, will be divided among the partners in their profit sharing ratio. Contact: Page 86

14 Dissolution Accounts: When a business is discontinued, the firm is said to be dissolved. As a result, all the accounts be closed. It is, therefore, necessary to open Realisation Account, Cash or Bank Account and Partners Capital Accounts. 1. Realisation Accounts is opened for all transactions relating to realisation of assets and payment of liabilities. That is, on dissolution, it is essential to make sale of assets of the firm, realize cash and paying off the liabilities. Realisation of assets and settlement of liabilities are centred round the Realisation Account. It is a nominal Account. The transactions realisation and settlement are over, the difference, being gain or loss will be transferred to Capital Accounts. 2. Cash/Bank Account is opened to record all cash transactions. When the purpose is over the Cash Account shows a balance, which is equal to the amounts due to partners. 3. Capital Accounts are opened to make all entries connected with the partners accounts. Current Accounts, if any, are transferred to Capital Accounts. Finally the Capital Accounts are closed by receiving or paying cash. Journal Entries 1. Close the current accounts to their capital accounts: a. If a credit balance: Dr: Partner s current account xx Cr: Partner s capital account xx b. If a debit balance: Dr: Partners Capital account xx Cr: Partner s Current account xx 2. Close all assets at book values except cash bank to the realization account. Thus: Dr: Realization a/c xx Cr: Individual assets a/c xx 3. To record cash proceeds on disposal of assets: Dr: Bank a/c xx Cr: Realization a/c xx 4. To record assets taken over by partners at agreed values Dr: Partner s Capital a/c xx Cr: Realization a/c xx 5. With the dissolution expenses: a. If paid by the firm; Dr. Realization a/c xx Cr.Bank a/c xx b. If borne by the partner; Contact: Page 87

15 Dr.Realization a/c Cr: Partner s Capital a/c xx xx 6. With the liabilities paid. Thus; Dr. Individual liabilities a/c xx Cr. Bank a/c xx a. If a discount if received from creditors. Thus; Dr. Creditor s a/c xx Cr. Realization a/c xx b. To record interest on liabilities paid Dr. Realization a/c xx Cr. Bank a/c xx 7. with the balancing figure in the realization account being either profit or loss, share it among the partners using the P&L ratio. a. If a profit: Dr. Realization a/c xx Cr: Partner s Capital a/c xx b. If a loss: Dr. Partners Capital a/c xx Cr. Realization a/c xx 8. After all above adjustments the balances in the bank a/c and the partners capital a/c should be opposite and equal. If this is the case, then pay the partners by: Dr. Partner s capital a/c xx Cr.Bank a/c xx a. If one of the partners has a debit balance then he will be required to pay the same. Thus: Dr. Bank a/c xx Cr. Partner Capital a/c xx b. If the partner has a debit balance and he s unable to pay for the same. Then apply the rule of GARNER VS MURRAY If, at the time of dissolution, a partener owes a sum of money to the firm, he has to pay it to the firm. But if he is insolvent, he will not be able to do so, at least not fully. The sum which is irrecoverable from an insolvent partner is, therefore, a loss. The question arises whether this loss is like the ordinary loss to be shared by the solvent partner in the profit sharing ratio or whether it is an extraordinaryloss. Before the decision in Garner vs. Murray was made, such a loss was treated as ordinary loss. Illustration 1 Akinyi and Chinedu were in partnership sharing profit and losses in the ratio of 3:2 respectively. Their statement of financial position as at 31 December 2010 was as follows: Contact: Page 88

16 This is a SAMPLE (Few pages extracted from the complete notes: Note page numbers reflects the original pages on the complete notes). It s meant to show you the topics covered in the notes. Download more at our websites: or To get the complete notes either in softcopy form or in Hardcopy (printed & Binded) form, contact us: Call/text/whatsApp someakenya@gmail.com info@someakenya.co.ke info@someakenya.com Get news and updates about kasneb by liking our page Or following us on twitter Pass on first attempt Buy quality notes and avoid a refers/retakes which costs more money and time Sample/preview is NOT FOR SALE

17 TOPIC 3 SPECIALISED TRANSACTIONS CONTRACTS WITH CUSTOMERS (REVENUE RECOGNITION) Meaning of revenue IAS 18 defines revenue as The gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants The following implications flow from this definition: a) Revenue should be stated before deduction of costs of sale. For example if goods are sold for ksh that cost the seller ksh to manufacture the revenue is ksh , not ksh b) Revenue is recognised on the provision of goods and services that relate to the ordinary activities of the entity. If an entity disposes of property, plant and equipment at the end of its useful economic life the proceeds of disposal are not revenue for the entity. Instead the profit or loss on disposal is treated as a deduction from operating expenses (or as a separate line item in the statement of profit or loss, if it is sufficiently material). c) Sales taxes that are collected from the customer and remitted to the relevant authorities are not revenue. For example if goods are sold for ksh , inclusive of recoverable sales taxes of 10%, the revenue is $ , not ksh d) If the seller is acting as agent, rather than as the principal, in a transaction, the revenue the seller should recognise is the amount of commission receivable rather than the gross amount collected from the customer. For example, if a travel agent sells a holiday to a customer for ksh.10,000 plus a commission of ksh.1000, so that the customer pays ksh.11,000 and the travel agent remits ksh.10,000 to the entity actually providing the holiday, then the travel agent recognises revenue of ksh Principles underpinning recognition of revenue IAS 18 outlines the recognition principles in three parts: 1. Sale of goods: Revenue is recognised when all the following conditions have been satisfied (2): a) The seller has transferred the significant risks and rewards of ownership of the goods to the buyer. Contact: Page 131

18 b) The seller does not retain control over the goods or managerial involvement with them to the degree usually associated with ownership. c) The amount of revenue can be measured reliably. d) It is probable that the economic benefits associated with the transaction will flow to the seller e) The costs incurred or to be incurred by the seller in respect of the transaction can be measured reliably. As far as these conditions are concerned, it is notable that: A number of the conditions ((a) and (b) particularly) are subject to a degree of interpretation and therefore there can be some uncertainty about whether or not revenue should be recognised. The conditions are such that all are likely to be satisfied at a particular point in time and so there is a critical point at which all the revenue from the sale of goods would be recognised. This approach contrasts with the approach taken to the recognition of revenue from the provision of services (see below): 2. Provision of services: As stated above, there is a different approach taken to the recognition of revenue from the provision of services. IAS 18 states that where the outcome of a transaction involving the rendering of services can be estimated reliably, associated revenue should be recognised by reference to the stage of completion of the transaction at the end of the reporting period. In other words, the revenue is recognised gradually, rather than all at one critical point, as is the case for revenue from the sale of goods. IAS 18 further states that the outcome of a transaction can be estimated reliably when all the following conditions are satisfied: a) The amount of revenue can be measured reliably. b) It is probable that the economic benefits associated with the transaction will flow to the seller. c) The stage of completion of the transaction at the end of the reporting period can be measured reliably. d) The costs incurred to date for the transaction and the costs to complete the transaction can be measured reliably. IAS 18 does not prescribe one single method that should be used for determining the stage of completion of a service transaction. However the standard does provide some examples of suitable methods (4): a) Surveys of work performed. b) Services performed to date as a percentage of total services to be performed. c) The proportion that costs incurred to date bear to the estimated total costs of the transaction. If it is not possible to reliably measure the outcome of a transaction involving the provision of services (perhaps because the transaction is in its very early stages) then revenue should be recognised only to the extent of costs incurred by the seller, assuming these costs are recoverable from the buyer (5). Contact: Page 132

19 Construction contracts IAS 18 does not adequately address the issue of revenue recognition on a construction contract. However, IAS 11 applies the basic principles we have already identified to such contracts, which are defined in IAS 11 as follows (6): Contracts specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use. Most construction contracts are fixed price contracts. In such contracts the seller agrees to a fixed contract price, or a fixed rate per unit of output, which in some cases could be subject to cost escalation clauses (6). Whilst a construction contract relates to the supply of goods, the critical event basis used in IAS 18 as a means of determining the timing of the recognition of revenue on the supply of goods is not really suitable. This is because the supply by the seller in the case of a construction contract takes place gradually over the term of the contract. Therefore IAS 11 basically requires that, where the outcome of a construction contract can be recognised reliably, revenue on such contracts should be recognised according to the stage of completion of the contract (7). IAS 11 imposes conditions very similar to the ones included in IAS 18 for the provision of services (3) that need to be satisfied before the outcome of a construction contract can be recognised reliably (8): a) Total contract revenue can be measured reliably. b) It is probable that the economic benefits associated with the contract will flow to the seller. c) Both the seller s costs to complete the contract and the stage of contract completion at the end of the reporting period can be measured reliably. d) The seller s costs to date attributable to the contract can be clearly identified and measured reliably so that actual costs incurred can be compared with prior estimates. As is the case with service revenue recognition in IAS 18, IAS 11 does not prescribe one single method of computing the stage of completion of a construction contract. IAS 11 provides the following examples of methods that might be suitable (9): a) The proportion that contract costs incurred for work performed to date bear to total estimated contract costs. b) Surveys of work performed. c) Completion of a physical proportion of the contract work. In another similarity with the treatment of revenue from the rendering of services under IAS 18, IAS 11 states that (10): Where the outcome of a construction contract cannot be estimated reliably revenue shall be recognised only to the extent of contract costs incurred that it is probable will be recoverable. In summary, then, IAS 11 very much applies the principles set out in IAS 18 (for the recognition of revenue on the rendering of services) to the recognition of revenue from construction contracts. Contact: Page 133

20 3. Interest, royalties and dividends IAS 18 states that entities should recognise revenue from the use of their assets yielding interest, royalties and dividends when (11): a) It is probable that the economic benefits associated with the transaction will flow to the entity. b) The amount of the revenue can be measured reliably. The exact basis for the recognition of revenue from the use by others of the seller s assets depends on the type of transaction (12): a) Interest revenue should be recognised on the effective interest basis. b) Royalties should be recognised on an accruals basis in accordance with amounts receivable as a result of asset use up to the reporting date. c) Dividend revenue should be recognised when the right to receive payment is established. Often this does not happen in the case of dividends until the shareholder actually receives the dividend. HIRE PURCHASE/ INSTALLMENT SALES HIRE PURCHASE In hire purchase transactions, the buyer will be required to pay a deposit and the remaining balance to be paid in form of installments. As a result, the total amount paid by the buyer is called the Hire Purchase Price (H.P.P) Accounting for Hire Purchase transactions will require both books of the buyer and the seller be maintained. Accounts maintained in Books of the Buyer i. Asset account ii. Hire Purchase Liability account/ Hire Purchase vendor account/ Hire Purchase sellers account. iii. Interest expense account iv. Depreciation account (provision) Accounting Entries in the books of the Buyer 1. On purchase of the asset on hire purchase: Dr. Asset a/c xx Cr. Hire Purchase Liability xx 2. To record deposit on hire purchase transaction Dr. Hire Purchase Liability a/c xx Cr. Bank a/c xx Contact: Page 134

21 3. To recognize interest expense on hire purchase Dr. Interest expense a/c xx Cr. Hire Purchase liability/ HP vendor a/c xx 4. To record installment paid when due: Thus, Dr. HP liability/ HP vendor a/c xx Cr. Bank / Cash a/c xx 5. To record depreciation expense for the period Dr. Depreciation a/c xx Cr. Asset a/c xx 6. To close the interest expense a/c to P&L a/c xx Dr.P&L a/c xx Cr. Interest expenses a/c xx 7. To recognize depreciation expense in the P&L a/c Dr. P&L a/c xx Cr. Depreciation expense a/c xx Accounts maintained in Books of the seller - Hire Purchase Debtors a/c - Hire Purchase sales a/c - HP trading a/c - Interest income/ receivable a/c - Repossession a/c - Provision for unrealized profit a/c Accounting Entries in the books of the seller 1. To record sale of items on hire purchase with the cash prize: Dr. HP Debtor s a/c xx Cr. HP sales a/c xx 2. To record deposits received from the buyer Dr. Bank a/c xx Cr. HP debtor s a/c xx 3. To account for interest income receivable Dr. HP debtor s a/c xx Cr. Interest income receivable a/c xx 4. To record installments received when due; Dr. Bank a/c xx Cr. HP debtor s a/c xx 5. Close the interest income a/c to P&L a/c. Thus; Contact: Page 135

22 TOPIC 4 FINANCIAL STATEMENTS OF VARIOUS TYPES OF ORGANISATIONS FARMING International Accounting Standards (IAS ) 41 describes the accounting treatment, financial statements presentation and disclosures related to agricultural activities. IAS 41 doesn t cover all other activities covered by other IAS e.g. fixed assets held by agricultural concerns. Agriculture-related definitions The following terms are used in this Standard with the meanings specified: Agricultural activity is the management by an entity of the biological transformation and harvest of biological assets for sale or for conversion into agricultural produce or into additional biological assets. Agricultural produce - is the harvested product of the entity s biological assets. A biological asset - is a living animal or plant. Biological transformation -comprises the processes of growth, degeneration, production, and procreation that cause qualitative or quantitative changes in a biological asset. A group of biological assets - is an aggregation of similar living animals or plants. Harvest is the detachment of produce from a biological asset or the cessation of a biological asset s life processes. Costs to sell are the incremental costs directly attributable to the disposal of an asset, excluding finance costs and income taxes Agricultural activity covers a diverse range of activities; for example, raising livestock, forestry, annual or perennial cropping, cultivating orchards and plantations, floriculture, and aquaculture (including fish farming). Certain common features exist within this diversity: Capability to change Living animals and plants are capable of biological transformation; Management of change Management facilitates biological transformation by enhancing, or at least stabilising, conditions necessary for the process to take place (for example, nutrient levels, moisture, temperature, fertility, and light). Such management distinguishes agricultural activity from other activities. For example, harvesting from unmanaged sources (such as ocean fishing and deforestation) is not agricultural activity; and Contact: Page 166

23 Measurement of change The change in quality (for example, genetic merit, density, ripeness, fat cover, protein content, and fibre strength) or quantity (for example, progeny, weight, cubic metres, fibre length or diameter, and number of buds) brought about by biological transformation or harvest is measured and monitored as a routine management function. Recognition and measurement An entity shall recognise a biological asset or agricultural produce when and only when: a) The entity controls the asset as a result of past events; b) It is probable that future economic benefits associated with the asset will flow to the entity c) The fair value or cost of the asset can be measured reliably. Initial recognition Measurement Biological assets within the scope of IAS 41 are measured on initial recognition and at subsequent reporting dates at fair value less estimated costs to sell, unless fair value cannot be reliably measured. Agricultural produce is measured at fair value less estimated costs to sell at the point of harvest. Because harvested produce is a marketable commodity, there is no 'measurement reliability' exception for produce. The gain on initial recognition of biological assets at fair value less costs to sell, and changes in fair value less costs to sell of biological assets during a period, are included in profit or loss. A gain on initial recognition (e.g. as a result of harvesting) of agricultural produce at fair value less costs to sell are included in profit or loss for the period in which it arises. All costs related to biological assets that are measured at fair value are recognised as expenses when incurred, other than costs to purchase biological assets. IAS 41 presumes that fair value can be reliably measured for most biological assets. However, that presumption can be rebutted for a biological asset that, at the time it is initially recognised, does not have a quoted market price in an active market and for which alternative fair value measurements are determined to be clearly unreliable. In such a case, the asset is measured at cost less accumulated depreciation and impairment losses. But the entity must still measure all of its other biological assets at fair value less costs to sell. If circumstances change and fair value becomes reliably measurable, a switch to fair value less costs to sell is required. Other issues The change in fair value of biological assets is part physical change (growth, etc) and part unit price change. Separate disclosure of the two components is encouraged, not required. Agricultural produce is measured at fair value less costs to sell at harvest, and this measurement is considered the cost of the produce at that time (for the purposes of IAS 2 Inventories or any other applicable standard). Contact: Page 167

24 Agricultural land is accounted for under IAS 16 Property, Plant and Equipment. However, biological assets (other than bearer plants) that are physically attached to land are measured as biological assets separate from the land. In some cases, the determination of the fair value less costs to sell of the biological asset can be based on the fair value of the combined asset (land, improvements and biological assets). Government grants Unconditional government grants received in respect of biological assets measured at fair value less costs to sell are recognised in profit or loss when the grant becomes receivable. If such a grant is conditional (including where the grant requires an entity not to engage in certain agricultural activity), the entity recognises the grant in profit or loss only when the conditions have been met. Disclosure requirements in IAS 41 include: Aggregate gain or loss from the initial recognition of biological assets and agricultural produce and the change in fair value less costs to sell during the period description of an entity's biological assets, by broad group Description of the nature of an entity's activities with each group of biological assets and nonfinancial measures or estimates of physical quantities of output during the period and assets on hand at the end of the period Information about biological assets whose title is restricted or that are pledged as security Commitments for development or acquisition of biological assets Financial risk management strategies Reconciliation of changes in the carrying amount of biological assets, showing separately changes in value, purchases, sales, harvesting, business combinations, and foreign exchange difference Objectives of farm accounting a) For control purposes e.g. the farmer can control his activities such as stock inputs. b) To facilitate credit transactions with suppliers c) To help in making managerial decisions d) To evaluate the performance of the concern i.e. whether you are operating at a profit/ loss. e) To help the farmer in obtaining a loan i.e. financial assistance from third parties. Futures/ Characteristics of farm accounting 1. Inter-activity transfers; Dr. Revenue a/c (input) Cr. Revenue a/c (output). Generally a farm is employed with different economic activities e.g. poultry, fishing, crops, dairy cattle etc. As a result the output of one economic activity may be used by another economic activity as an input. To account for this, the output of the farmer activity should be treated as an income for that respective activity and as an expense for the latter activity. Contact: Page 168

25 2. Dominance of barter transactions/ payments in kind; Dr. Wages/ revenue a/c, Cr. Revenue a/c. The transactions relating to agriculture are not controlled by money. In many cases the payments are made in kind. In order to account for this opportunity such as payments in kind should be qualified in money terms of adjustments be made in respective accounts. e.g. if the workers received milk then liters of milk so given would be valued as selling price an amount be treated as revenue in livestock account and the same amount treated as wages in crop account. 3. Related items e.g. In sale of related items, the proceedings on sale related items should be treated as revenue in the same department e.g. sale of eggs and manure. In Family Labour: This is usually provided for free. It should be valued at market price and treated as capital i.e. the double entry would be: Dr. Wages/ General P&L account Cr. Capital a/c 4. Family consumption The family may consume some of the products. The products consumed should be valued at market price and treated as both revenue as well as drawings i.e. Dr. Drawings Cr. Sales a/c / Revenues 5. Workers/ Labourers consumption Labourers may at some point consume some products while working in the farm. The products consumed should be valued at market price and then treated as revenue in the respective accounts and treated as well as general expense accounts to be transferred to P&L. N/B: i. At the end of accounting period all biological assets should be measured at their fair market value less estimated point of sale cost. ii. Stud animals:these livestock not meant for sale or meat production. They are also maintained for other purposes such ploughing. They should be treated as fixed assets. Contact: Page 169

26 ILLUSTRATION Joseph Mokua, a farmer extracted the following trial balance as at 31 October 2004: Crop insurance Stocks as at 1 November 2003 Growing crops, wheat, seeds and fertilizers Livestock Livestock feeds Land and buildings at cost Farm machinery (cost Sh. 5,400,000) Profit and loss account balance (1 November 2003) Loan from Farmers Bank Ltd Sale of wheat Sale of cattle Sale of carcass Manager s personal account Bank overdraft Sundry creditors Interest on loan from Farmers Bank Ltd Office expenses Crop expenses Livestock wages Other livestock expenses Purchase of seeds Livestock purchases Livestock feeds purchased Capital Farmhouse expenses Staff meals Repairs to farm machinery Tools and implements (1 November 2003) Sundry debtors Cash in hand Manager s salary General farm labour wages Sh. 000 Sh ,000 1, ,000 3, ,500 1, , ,000 1,750 3, ,500 23,500 Additional information 1. The entire crop insurance was taken with effect from 1 November 2003 to provide an annual risk cover against crop losses due to climatic risks such as floods, drought and plant diseases. 2. Manager s salary and staff meals are charged to the livestock and crop activities in the ration of 1:4 respectively. 3. Depreciation on tools and implements is to be apportioned equally between the crop and livestock activities. The book value of tools and implements as at 31 October 2004 was Sh. 100, Contact: Page 170