Adjustments to Financial Statements

Question 1

Inventories are assets…

Answer 1

(a) held for sale in the ordinary course of business;

(b) in the process of production for such sale; or

(c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

Question 2

Other facts about Inventory :

Answer 2

• It is very unlikely that all the purchases of inventory will be sold during the same period.
• Purchases that are still on hand at the end of the period are referred to as closing inventory (closing stock).
• Inventory is a current asset which is valued in the accounts at the lower of cost or net realisable value (IAS 2). This is an acknowledgement of the prudence concept

Question 3

The Flow of Inventory Costs

Answer 3

Question 4

Net realisable value =

Answer 4

Selling price less any related costs of sale

• If the inventory is expected to be sold for more than the cost, the profit is not recognised until it is sold – it is said to be held at cost and shown on the statement of financial position at cost
• However if the inventory is expected to be sold for less than cost, the loss should be recognised immediately – it is said to be held at net realisable value (i.e. less than cost)

Question 5

Inventory and Cost of Goods Sold

Answer 5

• When goods are sold, their cost becomes an expense (i.e. Cost of Goods Sold in the income statement)
• When calculating Cost of Goods Sold it is important to consider the inventory on hand at the end of the period. This is known as the Closing Inventory.
• The cost of goods sold is deducted from sales to determine Gross Profit.
• Valuing this can be difficult but it is very important to match the Sales revenue with the costs incurred in generating those Sales (Matching Concept)

Question 6

Opening and Closing Inventory, what to consider?

Answer 6

• When calculating Cost of Goods Sold, it is also important to consider the inventory at the start of the period.
• The Closing inventory at the end of one period becomes the Opening inventory at the beginning of the next period.
• We need to consider both opening and closing inventory to accurately calculate the Gross Profit.

Question 7

How to calculate the cost of goods sold ?

Answer 7

Cost of Goods Sold =

Opening inventory + Purchases – Closing inventory

In other words we need to consider:

• what we had in inventory at the start of the period (Opening inventory)
• what we purchased during the period
• what we have left in inventory at the end of the period (Closing inventory)

Question 8

The closing inventory is an …

Answer 8

Asset owned by the organisation.

Question 9

It is necessary to show the value of the closing inventory as…

Answer 9

A Current Asset in the Statement of Financial Position.

Question 10

Current asset means…

Answer 10

The asset is likely to be turned into cash within twelve months.

Question 11

Non-current Assets (Long-term)

Answer 11

• Expenditure that covers more than one accounting period is known as Capital Expenditure.
• This expenditure is included in the Statement of Financial Position as Non-current assets e.g. buildings, cars, furniture, computer equipment etc.
• Non-current assets can be viewed as the tools of the business.

Question 12

Current or Non-current asset?

Answer 12

Expenditure=dépense

Question 13

How should the cost of the non-current asset be allocated to the income statement over time?

Answer 13

• By calculating a depreciation expense – asset consumption (IAS 16).
• The matching concept suggests that the expense of the machine should be matched to the anticipated benefits generated by the machine over its useful life

Question 14

The depreciation amount to be charged to each accounting period is dependent on the following:

Answer 14

• The cost (or fair value) of the asset
• The useful life of the asset
• The residual value of the asset
• The depreciation method

Question 15

The two most popular depreciation methods are:

Answer 15

• Straight-line method
• Reducing-balance method

Question 16

The Straight Line Depreciation Allocates…

Answer 16

The amount to be depreciated evenly over the life of the asset

Question 17

Straight Line Depreciation Formula:

Answer 17

(Original Cost – Estimated residual value) / (Estimated life of the asset)

In other words:

• How much did the asset cost originally?
• How much could it be sold for at the end of its useful life?
• How many years will it be used for in the business?

Question 18

Depreciation affects both the Income Statement and the Statement of Financial Position:

Answer 18

• The annual depreciation is recorded in the Income Statement as an expense.
• A typical Statement of Financial Position would include the following:

1. Historic cost of asset
2. Accumulated depreciation to date
3. Net Book Value (Historic Cost minus accumulated depreciation)

Question 19

Non-current assets disclosure in the Statement of Financial Position:

Answer 19

Question 20

Reducing Balance Depreciation =

Answer 20

• Applies a fixed percentage to the carrying amount (NBV) of an asset each year.
• The effect is a higher depreciation charge in earlier years and lower charges in later years.
• The fixed percentage will normally be given in the question but can be calculated using formulae

Question 21

When should revenue be recognised?

At the time the order is placed?

At the time the customer receives the product?

At the time payment is received?

Answer 21

The main criteria for recognising revenue are:

• The revenue stream can be measured reliably
• It is probable that the economic benefits will be received by the business
• Ownership and control of the goods sold have passed to the buyer

Question 22

Recognising Expenses:

Answer 22

• The matching convention requires that expenses should be matched to the revenue that they help generate
• An expense reported in the Income Statement may not be the same as the cash paid for the expense
• Why? Examples?
• Adjustments for accruals and prepayments required

Question 23

What is an Accrual ?

Answer 23

• An accrual is an amount owing for any service supplied during a particular accounting period which has not yet been paid for by the end of the accounting period – the service expense for the period is greater than the cash paid to-date

Example – CD Ltd. has used electricity for 12 months but only paid £1,600 for the first 9 months. Although electricity has been used during the last three months, it has not been paid for. The estimated cost of electricity for the last quarter is £500

• Due to the Matching Concept it is important that the entity allows for (or accrues) the amount that it owes which relates to the current accounting period, as it must match the sales income with all relevant costs associated with those sales.

The amount to be accrued will be based on an estimate of 3 months supply of electricity (i.e £500 in our example)

Question 24

Show Accruals in the Income Statement:

Answer 24

Question 25

Show Accruals in the Statement of Financial Position

Answer 25

Question 26

What are Prepayments?

Answer 26

• A prepayment is an amount paid in advance for a service that will be provided in a subsequent period – when the amount paid for the service is greater than the expense for the current accounting period

Example - BH plc’s year end is 31 December. It bought a van on 1st April 2016 and paid an insurance premium of £600 for 12 months

• Due to the matching concept it is incorrect to charge the whole of insurance premium to the year ended 31 December 2016.

Three quarters of the premium relates to the year ended 31 December 2016 and the other quarter relates to the following year (i.e. Year ended 31 December 2017)

Question 27

Show Prepayments in the Income Statement :

Answer 27

Question 28

Show Prepayments in the Statement of Financial Position :

Answer 28

Question 29

Bad and Doubtful Debts :

Answer 29

• By recognising revenue we are claiming a profit on goods that have been sold, even if the cash is not received until after the end of the accounting period.
• This means we are taking a risk - if the goods are not eventually paid for we have over estimated the profit for the earlier period.

Question 30

Bad Debts Written Off

Answer 30

• Once it is clear that a debt is bad (i.e. it is highly likely that it will not be paid because the customer has gone bankrupt), then it must be written off to the income statement immediately as an expense – bad debts written off.
• Bad debts are also referred to as irrecoverable debts

Question 31

Allowances for Trade Receivables (Provision for doubtful debts)

Answer 31

• In business, it is prudent to allow for the possibility that some customers may not pay.
• This can be done by creating an allowance for ‘trade receivables’ (provision for doubtful debts) and debiting it to a special account.
• In order to do this, it is necessary to estimate the likely level of doubtful debts. This is normally expressed as a percentage of outstanding trade receivables.