OO OO Disagreement There are some situations where the auditors may disagree about the accounting treatment, or disclosure, of information contained in the accounts. For example, they may be unhappy about the bad debt provisions or inventory values. Or, they may believe that the company is not complying with the relevant GAAP. Limitation of scope This occurs when there is inadequate, or insufficient, information available to the auditors; therefore they are unable to determine whether proper accounting records have been kept.
This often happens in small companies, where sometimes there is insufficient information to support some of the items shown in the accounts. This is given when the auditors have been unable to obtain sufficient evidence to support an opinion on the financial statements.
This is given when the auditors believe that the information in the accounts is seriously misleading. They will then state that in their opinion the accounts do not give a true and fair view.
The notes to the accounts My advice is to read these first. They tell you the accounting policies used in the preparation of the accounts and how all the numbers in the accounts have been calculated. Careful reading of the notes is essential if you want to spot creative accounting or potential problems facing the company.
As it is not concerned with the cash that has been received and paid during the year, profitable businesses can fail. If this is combined with the income statement in the statement of comprehensive income, all the gains and losses the company has recognised in the period are shown on one page. The notes to the accounts will disclose the accounting policies and give additional information about the financial statements.
The terminology, content and presentation of accounts are determined by the accounting rules used. You may be interested in one or the other, or both.
To make it easier to find your way around the book, information on UK GAAP will be and followed by a line denoting the end of preceded by a Union Jack the section. The income statement shows you whether the company is selling its products, or services, for more or less that it costs to deliver them to its customers. The income statement is not concerned with whether the company has received the cash for its sales or paid for its costs. Consequently these costs are charged to property, plant and equipment.
You might also think about costs in the following way. Even if you hate DIY you can usually be talked into a capital project! The distinction is important in accounting, as only revenue costs are charged to the income statement. Any capital costs are charged to the balance sheet. This means that it is possible for companies to improve their profitability and apparent net worth by capitalising costs. Both profits and asset values improved! Company builds the asset This is where the problems start, as the company has to calculate the cost of production.
Before companies could decide whether they capitalised interest costs, but now they must capitalise them if all the following conditions are met: —— The company spends money buying the asset. Once the asset is ready for use, or sale, the company can no longer capitalise any borrowing costs. In its accounts their accounting policies disclose: Borrowing costs Borrowing costs directly attributable to the acquisition or construction of qualifying assets are capitalised.
Qualifying assets are those that necessarily take a substantial period of time to prepare for their intended use. All other borrowing costs are recognised in the Group Income Statement in the period in which they occur.
The capitalisation rate used to determine the amount of finance costs capitalised during the year was 5. Interest capitalised is deducted in determining taxable profit in the year in which it is incurred.
What does an income statement look like? IAS 1 The presentation of financial statements requires that any material items of income and expense should be shown separately, and prescribes the minimum information that must be shown. However, companies can disclose more information as long as the terms are defined and are consistently used from one period to another.
Group accounts show only the third party sales; any sales within the group are not shown on the income statement, although they may be disclosed in the notes to the accounts. Revenue can arise from the sale of goods or services, or from licence fees and royalties, and companies have to disclose the amount of revenue arising from each category in the notes to the accounts. Companies obtain their revenue from various sources and IAS 18 Revenue requires companies to disclose, in the notes to the accounts, any significant amounts of revenue arising from: OO the sale of goods; OO the rendering of services; OO interest; OO royalties; OO dividends.
Clearly most companies would not include the last three as part of their revenue. Companies also have to disclose any revenue arising from exchanges of goods, or services, which has been included in each significant category of revenue. OO Time. This is used in long-term contracts, where the revenue shown in the income statement is based on the completed percentage of the contract. So you can see that revenue can only be shown in the income statement when it has been earned.
Any advance payments for sales are not shown in the income statement until the sales are recognised as revenue. They are shown as deferred income and included in trade and other payables on the balance sheet, as the company has an obligation to provide the warranty in the future.
Long-term contracts Construction companies have different problems, as large construction contracts often span a number of years. Normally, revenue and profit can only be shown in the income statement once the full terms of the contract have been fulfilled. However, if a construction company waited until the project is finished before including a contract in the income statement, the accounts would not reflect a fair view of its financial performance. It might complete no contracts in one year and three in the following year.
Consequently there is a different way of accounting for long-term contracts, and this is known as the percentage of completion method. IAS 11 Construction contracts applies to construction contracts, and contracts for services that are directly related to the construction of an asset.
The accounting standard provides detailed guidance on contract accounting including: OO Bid costs — Companies can incur significant costs bidding for contracts, and these costs are usually allocated to the contract from the date the contract is secured.
OO Contract losses — If a company believes that a contract will make a loss, the full loss must be taken immediately in the income statement. OO Profitable contracts — If the contract is almost certainly profitable, the value of work completed is shown as revenue and any costs relating to the work done are charged to cost of sales. Consequently, there will be assets, and possibly liabilities, on the balance sheet reflecting the amounts owed by, or to, the customer.
The asset shows with trade and other receivables, and the liability shows with trade and other payables. Example 2. Construction contracts Revenue arises from increases in valuations on contracts. Where the outcome of a construction contract can be estimated reliably and it is probable that the contract will be profitable, revenue and costs are recognised by reference to the stage of completion of the contract activity at the balance sheet date.
Stage of completion is assessed by reference to the proportion of contract costs incurred for the work performed to date relative to the estimated total costs, except where this would not be representative of the stage of completion. When it is probable that total contract costs will exceed total contract revenue, the expected loss is recognised as an expense immediately. Variations and claims are included in revenue where it is probable that the amount, which can be measured reliably, will be recovered from the customer.
When the outcome of a construction contract cannot be estimated reliably, contract revenue is recognised to the extent of contract costs incurred where it is probable those costs will be recoverable. Contract costs are recognised as expenses in the period in which they are incurred. Bid costs Costs associated with bidding for contracts are written off as incurred. When it is probable that a contract will be awarded, usually when the Group has secured preferred bidder status, costs incurred from that date to the date of financial close are carried forward in the balance sheet.
When the Group retains an interest in the special purpose vehicle and accounts for its interest as an associate or joint venture, the credit is recognised over the life of the construction contract to which the costs relate. Trade and other receivables Construction work in progress is stated at cost plus profit recognised to date less a provision for foreseeable losses and less amounts billed and is included in amounts due from customers for contract work.
Amounts valued and billed to customers are included in trade receivables. Where the cash received from customers exceeds the value of work performed, the balance is included in credit balances on long-term contracts.
The major difference between IAS 11 and SSAP 9 Stocks and long term contracts is the presentation on the balance sheet, as the UK has always included contract work in progress with stock. Operating costs These are the costs of materials, labour and overheads used in sales.
Whilst most manufacturing companies use their manufacturing costs as their cost of sales, not all do. What was the percentage of staff costs capitalised the previous year? Why have inventories increased? You can see that this presentation gives you enough information to be able to start to ask some sensible questions, but this is the least popular presentation of the income statement.
However, this presentation is popular in some European countries. For example Eon, the German power company, uses this presentation. Other categories of income included within other operating income are backhaul income and credits earned from the recycling of waste and packaging material.
Interest is included, but may only be a relatively small component. Interest Companies show interest receivable, dividends receivable and similar income as interest receivable. Interest payable covers interest on loans and preference dividends. Preference shares are usually classified as debt, as they have fixed dividends and often have a repayment date — called a redemption date. A company could be having difficulties with its bankers, but on the income statement the interest shown may be only a small proportion of the interest charge if most of the interest has been capitalised.
Most of these have to be revalued to their market value at the end of the financial year, with any profit or loss shown in the income statement as part of other finance income or expense. This means that it includes cash, receivables and payables. Receivables are shown net of any bad debt provisions; a realisable value rather than a market value.
The financing costs of final salary pension schemes must be shown as other financial income and expense. For statutory purposes these are required to be shown with in net financial income and expense above. Gains or losses for future year transactions are in respect of financial instruments held by the Group to provide stability of future trading cash flows.
OO profits or losses arising from disposal of investments; OO discontinued operations; OO litigation settlements; OO other reversals of provisions. Some of these would obviously be exceptional items. They can either be shown in the income statement itself or disclosed in the notes. Exceptional items are covered by FRS 3 Reporting financial performance.
It requires that most exceptional items are included in the relevant operating cost heading, with the details disclosed in the notes to the accounts. These are usually shown separately with companies showing two operating profit figures: one before exceptional items, and the other after exceptional items.
This is particularly important if you are looking at overseas accounts, where historically exceptional items have been shown in the notes rather than in the income statement.
Property, plant and equipment are things the business means to keep. But all businesses sell assets when they reach the end of their useful life. This is shown as a profit because the machine is over depreciated. Profits, or losses, on sale or termination of subsidiaries is just an extension of this. Companies have assets and liabilities. Their liabilities are deducted from their assets to arrive at their net assets.
If a company is sold for more than its net assets, the seller reports a profit. However, they are disclosed in the notes. The international rules call this an entity, whereas the UK rules calls this an undertaking. When investors have significant influence they usually have a seat on the board of directors, or the equivalent governing body. This is called the equity method of accounting.
If the investment is not classed as an associate, or a subsidiary, only the income received from the investment will be shown in the income statement as part of interest receivable and similar income.
The international rules interpret the equity method in a different way from the UK rules. To classify an investment as an associate, the international rule only requires the investor to have the power to participate, whereas the UK accounting standard, FRS 9 Associates and joint ventures , requires the investor to actually participate in the decision making. Any material exceptional items and interest are separately disclosed on the income statement itself, immaterial amounts are disclosed in the notes.
Company A has to consolidate its investment in Company B. Associates can have a significant effect on reported profitability, but may have a minimal effect on cash flow. A joint venture could be a jointly controlled business referred to as an entity in the international rules , jointly controlled operations, or jointly controlled assets. Venture capitalists, mutual funds, unit trusts and similar organisations do not have to account for their jointly controlled businesses in the following way.
These are shown at fair value, and are covered by a different accounting rule IAS39 Financial instruments: recognition and measurement. A jointly controlled business is usually accounted for in the same way as associates, using the equity method, but currently IAS 31 Interests in joint ventures also allows proportional consolidation. Proportional consolidation is unusual in the UK, but is common in other parts of Europe. It may not be allowed in the future, as the IAS has issued a discussion document that would remove this option.
A jointly controlled asset is one that is under the joint control, and often ownership, of assets used specifically in a joint venture. The revenue from the asset and the expenses incurred are incorporated into the income statement in accordance with the contractual arrangement.
This often happens in the construction industry where major projects are managed through joint ventures. There are also more disclosures of balance sheet items. This is because the way that the accounting rules recognise income and expenses is often different from the tax rules. This means that most companies prepare three sets of accounts, the statutory published accounts, the tax accounts and their detailed management accounts.
OO the main deferred tax assets and liabilities and how they have changed during the year; OO any unrecognised deferred tax assets and liabilities.
So this is the tax charge that you would expect. Now let me explain deferred tax. Other things have different values in the tax accounts and the published accounts. These differences between the two sets of accounts are called timing differences. They can either be permanent, where they appear in one set of accounts but not the other. Or, they could show in the published accounts in a different year than they show in the tax accounts.
Perhaps the best example of a timing difference is the different property, plant and equipment values that are found in the two sets of accounts. Each company determines its depreciation charge, and the depreciation charged on the same asset is often different in one company to another. The tax authorities in the UK ignore the depreciation charge, as it varies from one company to another, and gives companies a standard tax allowance.
This is called a capital allowance. Company tax allowances work essentially the same way as personal tax allowances, reducing the taxable profit. These differences could either be taxable the book value is higher than the tax value or deductible the book value is lower than the tax value. At the end of the five years it believes that the machine will be worth nothing.
The depreciation charge is part of the operating costs in the income statement. Most UK companies use the straight line method to calculate their depreciation charge, but tax allowances in the UK are calculated using a different method.
The tax allowance is given on a reducing balance basis. Some companies, largely overseas and small UK companies, use this method to calculate their depreciation charge. You can see that that the tax value of the asset is very different from the book value of the asset when assets are depreciated on a straight line basis and tax allowances are given on a reducing balance basis.
In the early years it is worth more in the published accounts, but from the third year onwards it is worth more in the tax accounts. In the first two years there would be a deferred tax liability a future tax payment and from year three onwards there would be a deductible difference, a deferred tax asset a future tax repayment or credit note.
Deferred tax assets may be small, unless the company has a large pension deficit and, or, has made large acquisitions, as they can only be shown if they are recoverable. If only the current tax had been charged the effective tax rate would have been Deferred tax just follows normal accounting practice — a deferred tax liability is effectively an accrual for tax, and a deferred tax asset is a tax prepayment.
Deferred tax brings the tax accounts and the published accounts into line. Deferred tax must be provided for in full for all temporary differences between the tax value of the assets and liabilities and their book value in the financial statements unless the temporary difference arises from: OO the initial recognition of goodwill this only applies to a potential deferred tax liability ; OO the initial recognition of an asset or a liability in a transaction that is not a business combination and that affects neither accounting profit nor taxable profit; OO investments in subsidiaries, branches, associates and joint ventures but only where certain criteria apply.
Reconciling the tax charge to the profit before tax in the income statement There will be a note to the accounts that reconciles the tax charge with the reported operating profit before tax. Apart from small companies, the notes will show you how the tax charge has been calculated. This is the minimum presentation and more information can be shown on the income statement. FRS 3 Reporting financial performance requires acquisitive companies to show a more detailed profit and loss account, analysing profits between discontinued and continuing operations and clearly identifying, on the profit and loss account, the contribution arising from acquisitions.
Companies preparing their accounts using the international rules provide less information in their income statements. This enables you to see what the revenue and profit would have been if the business had been acquired at the beginning of the period.
This means that a UK profit and loss account often appears more complicated than the income statements prepared under IFRS as in Example 2. IAS 27 Consolidation requires companies to consolidate any businesses that they control. Usually, but not always, control and ownership are the same. Control is defined as the power to govern the operating and financial policies of a business to obtain benefits from its activities.
Control is presumed to exist when a company has the majority of the votes in another business, but can also arise when: OO a company has an agreement with other investors effectively giving it the majority of the voting rights; OO it has the power to govern the financial and operating policies of another business under a statute or an agreement; OO it has the power to appoint, or remove, the majority of the board of directors; OO it has the power to cast the majority of the votes at a board meeting.
This means that effectively there can be large minority interests where the company has been forced to consolidate because it has the power to control the subsidiary. It can have the control, but does not own all of the shares. This effectively makes off-balance sheet funding much more difficult. Enron held some of its debt and some of its loss making businesses in partnerships where it effectively controlled them.
And all its cash flows will be taken into the cash flow statement. Unfortunately, not all subsidiaries are profitable. Dividends that are proposed, or declared after the balance sheet date but before the financial statements have been issued are disclosed, but not recognised as a liability. There are legal restrictions on the amount of dividends that companies are allowed to pay. All companies can only pay dividends if they have accumulated sufficient profits. This means that it is possible for companies to pay dividends when they have made a loss, but only if they have accumulated sufficient profits in the past to cover the dividend payment.
Dividends can be paid until the distributable reserves reach zero. The Companies Act places another restriction on the payment of dividends for UK public companies. They may only pay dividends when the value of their net assets total assets less all liabilities including provisions for liabilities and charges is not less than the total of their share capital and undistributable reserves.
This means that whilst private companies can pay dividends if they have sufficient realised profits available, public companies may only do so after they have provided for any unrealised losses. However, the shareholders at the Annual General Meeting must approve the final dividend, and the directors will devote a lot of time in determining how much should be paid. Only private companies like paying dividends, although they are likely to have taken money out of the business well before they reach dividends!
Public companies are different — the directors are proposing to pay dividends to strangers. Public companies use the same underlying principle for dividends as the one used to decide the level of salary increase for employees — they pay the least they can get away with!
In fact the same things influence dividend decisions as influence salary decisions. To improve cash flow some companies offer a scrip dividend. A scrip dividend is where the shareholder receives extra shares instead of cash. This is often an attractive option for smaller shareholders as they can increase their stake in the company without paying dealing fees. Most companies follow the Articles the rules that govern the operation of the company laid out in the Companies Act.
If these Articles are followed, the only way the shareholders can change the dividend is to reduce it probably about as likely as you asking your boss to reduce the size of your next salary increase! The dividends have not been provided for and there are no income tax consequences. And adjustments are made to exclude: OO stock; OO prepayments. Companies involved in trading overseas have to make another adjustment, as they have to find a way to deal with exchange rates.
I now want to show you how these adjustments affect both the income statement and the balance sheet. Provisions Companies have to make provisions to cover the likely costs that will arise in the future from the sales they have made in this period. These include provisions made for: OO bad and doubtful debts; OO obsolete stock this may not be obsolete in the literal sense, but stock must be shown on the balance sheet at the lower of its cost or net realisable value ; OO warranty claims; OO litigation; OO rationalisation.
These two reduce asset values to their realisable amount. Whereas these are costs that will be paid in the future. The general rule is that asset values should not be overstated, and that receivables and inventories should be shown at the lower of their cost or market value. OO Those that are costs the business will incur in the future as a result of the sales warranty , or decisions rationalisation , that have been made in the period.
The total provision is disclosed in the notes on the receivables or inventories if the provision was for a stock writedown , where it may be referred to as an impairment. They are approximations and can be used by companies to move profit from one year to the next, as an over provision in one year could be written back later to boost profits when the cash is not needed.
The two standards are broadly similar, as they were developed at the same time. Provisions are only required when something has happened before the balance sheet date that gives rise to a measurable and clear obligation. The provision can only be made when the company has a detailed plan for the restructuring and there is an expectation that the plan will be implemented. Court cases are often disclosed as contingent liabilities, or could even be disclosed as a contingent asset in the notes to the accounts of the prosecuting company if it was probably going to win the case.
Accrued expenses These are outstanding invoices that relate to costs for items used in the period. A lot of your personal costs could be accrued: gas, electricity, telephone. If you were trying to prepare an income statement for the month of December you would have to identify the costs that relate to the period. This means that you would have to try to work out what proportion of your next gas bill, etc.
Consequently, at the end of the financial year your accountants will send an email to all cost centre managers asking for a list of their accrued expenses. Depreciation, amortisation and impairment Depreciation Depreciation is something you know about. Some things depreciate more than others.
Cars and computers generally depreciate faster than your other assets. Depreciation is a hidden business cost. The Companies Act requires companies to make a charge for depreciation to cover the cost of using their assets in the period.
IAS16 Property, plant and equipment covers depreciation of most property, plant, and equipment. OO Land and buildings are treated as separate assets, and land has an unlimited life and its depreciation is usually immaterial.
OO The method used to depreciate the assets is also reviewed annually to ensure that it is still the most appropriate method.
I talked about some of them when I discussed deferred tax earlier. Reducing balance This is sometimes also called the double declining balance method. It uses a fixed percentage each year and applies this to the reducing value of the asset to arrive at the net realisable value.
The percentage is calculated using the following formula, which gives the chosen residual value at the end of the life. Sum of the digits This method is largely used by leasing companies in the UK, but it is widely used overseas, particularly in the United States.
It gives a depreciation charge between the straight line method and the reducing balance method. Having found the sum of the digits, the next step is to find the depreciation factor for each year. This method of depreciation is often used for machinery and planes.
Any change in these will affect both profitability and asset values. Companies have to review asset lives, net residual value, and the appropriate depreciation method annually. This means that depreciation has to be based on the current market conditions. Only intangible assets with finite lives, such as patents, are amortised.
Consequently, they often show an operating profit figure before and after the amortisation of acquired intangible assets. Consequently nearly all assets must be assessed at each reporting date to see if their value is impaired, and some assets must be assessed annually. IAS 36 Impairment of assets does exclude some assets, such as inventories, construction contracts, deferred tax, as their accounting treatment is covered in other standards. Both external factors for example market or technology changes and internal factors for example changes in the way an asset is used could indicate that the asset is impaired.
To calculate the value in use, companies have to estimate any future cash flows derived from the asset and then discount them using an appropriate discount rate. FRS 11 Impairment of fixed assets and goodwill does not apply to current assets and there are some minor differences to IAS 36, which I will discuss in the next chapter. Summarising depreciation, amortisation and impairment Assets affect the income statement in two ways: OO Firstly, property, plant and equipment, and intangible assets have to be depreciated, or amortised, over their expected life.
Inventories are shown on the balance sheet when a business controls them, expects them to generate future economic benefits for example revenues or cash flows , and can reliably ascertain their value. They are analysed into their component parts, starting with raw materials and adding labour and overhead costs as the materials move through the production process. Inventories are shown on the balance sheet at the lower of their cost and net realisable value.
Net realisable value is the selling price less any further costs to completion and the estimated selling costs. This is designed to limit the costs that can be charged to stock. Companies have to determine the value the cost of goods used in sales, so they need to: OO measure the volume of units used in sales; OO calculate their value. Once the company has measured how many units it has in stock, they have to be valued. This is important, as small changes in stock values can have a disproportionate impact on reported profits in businesses where the materials cost is a large proportion of the total costs.
In practice valuing stock can be difficult and some guidance is given in the accounting rules. Companies have to cope with changing prices, and manufacturing businesses have to find a basis for valuing work in progress and finished goods. A number of retailers find it useful to show stock at resale value in their internal management accounts.
This is called the retail method. The accounting rules allow companies to use the retail method, as long as it is a reasonable approximation of the actual cost. All inventories are finished goods. Complex valuation They have different types of stock — materials, work in progress and finished goods stock. To cope with these difficulties, accountants have developed a number of different approaches to valuing stock. It does this by establishing the value of the closing stock.
First in first out This applies the principle of stock rotation to stock valuation. The first goods into the warehouse are assumed to be the first sent to the customer, so the latest deliveries will be in stock. Last in first out Last in first out charges the most recent deliveries into the profit and loss account.
Think about this for a minute — does this make sense? In the real world, would you send the newest stock to the customers before the oldest? The other point worth making is that my example is far too simple; to operate LIFO properly, companies have to calculate the last in each time they make a sale. This means that they would need a sophisticated accounting system to cope with the demands of operating LIFO. When production levels are abnormally low, any unallocated overheads are charged to the income statement.
Other stock items should be valued either on a first in first out basis or a weighted average cost. Different valuation methods can be used for different types of stock, but all similar stock must be valued using the same method.
Prepayments This is an unusual accounting term as it actually means what it says! Insurance and road tax are both prepayments, you have to pay for them before you get any benefits. Currency adjustments Any company exporting or importing goods, or that has a subsidiary or associate overseas, has to find a way of incorporating different currencies into its accounts.
Exchange rate accounting problems Exchange rates pose two problems: OO Which rate do you use? OO How do you account for any exchange differences? Just like companies, sometimes you win and sometimes you lose! This is quite common in industries such as shipping and oil, where revenues are earned in dollars, but a UK based company could incur most of its costs in sterling.
What if the cash received from the sale came in at a different rate than the exchange rate on the day of the sale? Publisher : Pearson Education. Rating : 4. Get BOOK. The book could significantly help people provide more effectively for their retirement and cope with the difficulties of pension planning from a far better informed perspective.
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