Course Name: Intermediate Accounting

Course Code: ACF 353

KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY

College of Art and Social SciencesSchool of Business

BSc. Bus. Admin III (Accounting Option)

Course Outline

• This course seeks to lay a foundation for thestudy of more advanced studies in the theoryand practice of modern accounting. It istherefore expected that every student wouldparticipate in the class with the requiredcommitment and zeal in order not to be leftbehind. The course is build around six majorunits as outlined below

Course Content

• Unit One: Framework for Financial Reporting andRelevant Basic Standards

• Unit Two: Partnership Accounting- Introductionand Regulatory Framework

• Unit Three: Goodwill and Revaluation of Assets• Unit Four: Changes in Partnership Constitution

Unit Five: Dissolution of Partnership• Unit Six: Amalgamation and Conversion of

Partnership to Limited Liability Company• Unit Seven: Joint Venture Accounting

Unit One: Framework for Financial Reporting and Relevant Basic Standards

Learning Objectives

After this unit you should be able to:

1. Explain the IASB’s Framework for the Preparationand Presentation of Financial Statements.

2. State the requirements of IAS 1 – Presentation ofFinancial Statements

3. Understand the definition, measurements,recognition and disclosure requirements relating tonon-current assets

To achieve the above stated learningobjectives, our focused would be on thefollowing

• 1-1 The Conceptual Framework

• 2-1 IAS 1 Presentation of Financial Statements

• 3-1 IAS 2 Accounting For Inventories

• 4-1 Accounting For Non-Current Assets

1-1 The Conceptual Framework

Introduction

The International Accounting Standards Board(IASB) developed a conceptual framework, that laysout the broad principles to be applied whendeveloping accounting standards and whendetermining an appropriate accounting treatment.This conceptual framework is called the Frameworkfor the Preparation and Presentation of FinancialStatements.

Purpose and Status of the Framework

According to the Framework, its purpose is to: • Assist the IASB in the development of future IASs and

in its review of existing IASs;• Assist the IASB in promoting harmonization of

regulations, accounting standards and procedures byreducing the number of alternative treatmentspermitted by IASs;

• Assist national standard-setting bodies in developingnational standards;

• Assist preparers of financial statements in applying IASsand in dealing with topics that are not subject to anIAS;

Purpose and Status of the Framework ctd

• Assist auditors in forming an opinion as towhether financial statements comply with IASs;

• Assist users of financial statements in interpretingthe information contained in a set of financialstatements;

• Provide those who are interested in the work ofthe IASB information about its approach to theformulation of IASs.

• The Framework is not an Accounting Standardand does not override the requirements of anyIAS.

Users and Their Information Needs

The Framework identifies several different user groups offinancial statements and discusses their information needs.The framework identifies user groups as:• Investors (existing and potential);• Lenders (existing and potential);• Employees;• Business contacts, i.e. customers, suppliers, competitors;• The general public;• The government, i.e. tax authorities;

Scope of the Framework

The framework covers the following topics:• The objective of financial statements;• Underlying assumptions of financial statements;• Qualitative characteristics of financial statements;• The elements of financial statements;• Recognition of the elements of financial

statements;• Measurement of the elements of financial

statements;• Concepts of capital and capital maintenance

Objective of Financial Statements

The objective of financial statements is toprovide information about the:

• Financial position

• Financial performance

• Changes in the financial position

of an enterprise that is useful to a wide range ofusers in making economic decisions

Underlying Assumptions

The Framework states that there are twounderlying assumptions:

• Accruals;

• Going concern

Qualitative Characteristics of Financial Statements

The Framework discusses four characteristicsthat make financial information useful to users:

• Understandability;

• Relevance;

• Reliability;

• Comparability.

Understandability

Information needs to be readily understandable by users. Informationthat may be relevant to decision making should not be excluded on thegrounds that it may be too difficult for certain users to understand.

Understandability depends on:• The way in which information is presented; and• The capabilities of users

It is assumed that users:• Have a reasonable knowledge of business and economic activities;

and• Are willing to study the information provided with reasonable

diligence

Relevance

Information is relevant when it influences theeconomic decisions of users by helping themevaluate past, present or future events orconfirming or correcting their past evaluations.

• The relevance of information can be affected byits nature and materiality.

• According to the Framework, information ismaterial if its omission or misstatement couldinfluence the decisions of users.

Reliability

Users must be able to rely on information if it is going to be useful inmaking economic decision.Information is reliable if:• It is free from material error;• It is free from deliberate or systematic error (i.e. it is neutral);• It is complete within the bounds of materiality• It is a faithful representation;• In conditions of uncertainty, a degree of caution (i.e. prudence) has

been applied in exercising judgment and making the necessaryestimates.

In summary, reliable information should be free of material error,neutral, complete, have faithful representation; and be prudent.

Qualities of reliability• Faithful representationIf information is to represent faithfully the transactions and other events that itpurports to represent, they must be accounted for and presented in accordance withtheir substance and economic reality and not just their legal form.

• NeutralityInformation must be neutral, i.e. free from bias. Financial statements are not neutral if,by the selection or presentation of information, they influence the making of a decisionor judgment in order to achieve a predetermined result or outcome.

• CompletenessInformation must be complete and free from error within the bounds of materiality. Amaterial error or an omission can cause the financial statements to be false ormisleading and thus unreliable and deficient in terms of relevance.

• PrudencePrudence involves using a degree of caution in the use of judgment to make estimatesin the financial statements in conditions of uncertainty, i.e. gains and assets are notoverstated and losses and liabilities are not understated.

Comparability

Users must be able to compare financial statements over a period of time inorder to identify trends in financial position and performance. Users mustalso be able to compare financial statements of different entities to be able toassess their relative financial position and performance.

• In order to achieve comparability, similar items should be treated in aconsistent manner from one period to the next and from one entity toanother. However, it is not appropriate for an entity to continueaccounting for transactions in a certain manner if alternative treatmentsexist that would be more relevant and reliable.

• Disclosure of accounting policies should also be made so that users canidentify any changes in these policies or differences between the policiesof different entities.

The Elements of Financial Statements

Financial statements show the effect of financialtransactions by grouping them into broad classes,i.e. the elements of financial statements. Theelements of financial statements are:

• Assets;

• Liabilities;

• Equity;

• Income;

• Expenses.

Elements of F/S cont.a) Assets

• An asset is a resource controlled by the enterprise as a resultof a past event and from which future economic benefits areexpected to flow to the enterprise.

b) Liabilities

• A liability is a present obligation arising from past events, thesettlement of which is expected to result in an outflow ofresources from the enterprise.

c) Equity

• Equity is the residual interest in the assets of the enterpriseafter deducting all its liabilities.

d) IncomeIncome is increases in economic benefits during the accounting period in the form of inflows orenhancements of assets or decreases of liabilities that result in increases in equity, other thanthose relating to contributions from equity participants.The definition of income includes revenue and gains.• Revenue is income that arises in the course of ordinary activities, i.e. sales.• Gains represent other items that meet the definition of income e.g. gains on disposal of non-

current assets and unrealized gains, e.g. on revaluation.e) ExpensesExpenses are decreases in economic benefits during the accounting period in the form ofoutflows or depletions of assets or incurrence’s of liabilities that result in decreases in equity,other than those relating to distributions to equity participants.The definition of expenses includes losses as well as expenses that arise in the course of ordinaryactivities.• Expenses that arise in the ordinary course of activities are items such as wages, purchases

and depreciation.• Losses include items such as on disposal of non-current assets and unrealized losses, eg.

losses on revaluation.

Assets, liabilities and equity interest

• Assets, liabilities and equity interest AssetsAn asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.To explain further the parts of the definition of an asset:• Controlled by the entity-control is the ability to obtain the economic benefits and to restrict the

access to others (eg. by a company being the sole user of its plant and machinery, or by selling surplus plant and machinery). An asset does not have to be legally owned, the key factor is whether the entity has control over the future economic benefits that the item will provide. A leased vehicle could therefore be an asset.

• Past events – the event must be past before an asset can arise, e.g. equipment will only become an assets when there is a right to demand delivery or access to the asset. Dependent on the terms of a contract this could be on acceptance of an order or on delivery.

• Future economic benefits-these are evidenced by the prospective receipt of cash. This could be the cash itself, a debt receivable or any item which may be sold, eg a factory may not be sold if it houses the materials for manufacturing. When the goods are sold the economic benefit resulting from the use of the factory will be realized in cash.

LiabilitiesLiabilities are an entity’s obligations to transfer economic benefits as a result of a pasttransactions or events. To explain further the parts of the definition of a liability:• Obligations-these may be legal or constructive. A constructive obligation is an

obligation which is the result of expected practice rather than required by law orlegal contract.

• Transfer of economic benefits-this could be a transfer of cash, or other property,the provision of a service, or the refraining from activities which would otherwisebe profitable.

• Past transactions or events – similar points are made here to those under assets.

EquityEquity is the residual amount after deducting all liabilities of the entity from all of theentity’s assets.Equity may be sub-classified in the financial statements into share capital, Incomesurplus and other reserves.

Recognition of the Elements of Financial Statements

In order to recognize items in the statement offinancial position or income statement, thefollowing criteria should be satisfied:

• It meets the definition of an element of financialstatements.

• It is probable that any future economic benefitassociated with the item will flow to or from theenterprise.

• The item has a cost or value that can bemeasured with reliability.

Recognition Criteria

An asset is recognized if:

• It gives rights or other access to future economic benefits controlled by anentity as a result of past events;

• It can be measured with reliability;

• There is sufficient evidence of its existence.

A liability is recognized if:

• There is an obligation to transfer economic benefits as a result of pasttransactions or events;

• It can be measured with reliability;

• There is sufficient evidence of its existence.

Income is recognized if:

• An increase in future economic benefits arises from an increase in an asset (or a reduction in a liability); and

• The increase can be measured reliably.

Expenses are recognized if:

• A decrease in future economic benefit arises from a decrease in an asset (or an increase in a liability); and

• The decrease can be measured reliably.

Measurement of the Elements of Financial Statements

Measurement is the process of determining the monetary amounts at which theelements of financial statements are to be recognized and carried in the balance sheetand income statement.There are a number of different ways of measuring the elements including:

Historical cost• Assets are recorded at the amount of cash paid or the fair value of the

consideration given to acquire them at the time of their acquisition. Liabilities arerecorded at the amount of proceeds received in exchange for the obligation or atthe amounts of cash expected to be paid to satisfy the liabilities.

Current cost• Assets are carried at the amount of cash that would have to be paid if the same or

an equivalent asset was acquired currently. Liabilities are carried at the amount ofcash that would be required to settle the obligation currently.

Realizable (settlement) value• Assets are carried at the amount of cash that could currently be obtained

by selling the asset in an orderly disposal. Liabilities are carried at theirsettlement values, eg. the undiscounted amount of cash expected to bepaid to satisfy the liabilities.

Present value• Assets are carried at the present discounted value of the future net cash

inflows that the item is expected to generate. Liabilities are carried at thepresent discounted value of the future net cash outflows that areexpected to be required to settle the liabilities.

The Framework does not state which measurement basis should be used byentities but highlights that the historical cost basis is the most commonlyused, often combined with other bases, e.g inventories being valued at thelower of cost and net realizable value.

Concepts of Capital and Capital Maintenance

There are two concepts of capital:• A financial concept of capital. With this method, capital = net assets

or equity of the entity. This concept should be used if the mainconcern of the user of the financial statements is the maintenanceof the nominal value invested capital. This is used by most entitiesto prepare financial statements.

• A physical concept of capital. With this method capital = productivecapacity of the entity (measured as units of output per day). Thismethod should be used if the main concern of the user of thefinancial statements is the operating capacity of the entity.

• Capital maintenance means preserving the value of the capital ofthe entity, and reporting profit only if the capital of the entity hasbeen increased by activities and events in the accounting period.

The Framework and the standard-setting process

The Framework provides a point of reference to the IASB when developing individual standards. Sincethe standards will then be developed with reference to a common set of concepts the standardsthemselves will become more consistent.The IFRS Interpretations Committee (IFRIC) issue guidance where issues have arisen which are notspecifically covered by a standard. The IFRS interpretations Committee can therefore ensure itsguidance is consistent with agreed underlying principles by referring to the Framework.

Currently many IASs allow alternative treatments. The development of the Framework is expected toresult in these alternatives being removed and the preferred treatment will be the one that is consistentwith the Framework.

Users and Their Information NeedsThe principal classes of users of financial statements are• present and potential investors,• employees,• lenders,• suppliers and other trade creditors,• customers,• governments and their agencies and• the general public.

All of these categories of users rely on financial statements to help them in decision making. • The Framework also concludes that because investors are providers of risk capital

to the entity, financial statements that meet their needs will also meet most of thegeneral financial information needs of other users. Common to all of these usergroups is their interest in the ability of an entity to generate cash and cashequivalents and of the timing and certainty of those future cash flows.

• The Framework notes that financial statements cannot provide all the informationthat users may need to make economic decisions. For one thing, financialstatements show the financial effects of past events and transactions, whereas thedecisions that most users of financial statements have to make relate to the future.Further, financial statements provide only a limited amount of the non-financialinformation needed by users of financial statements.

• While all of the information needs of these user groups cannot be met by financialstatements, there are information needs that are common to all users, and generalpurpose financial statements focus on meeting these needs.

Question; Identify and discuss the information needs of users of financial information.

Answer(a) Investors are the providers of risk capital• (i) Information is required to help make a decision about buying or selling shares, taking up a rights issue and

voting.• (ii) Investors must have information about the level of dividend, past, present and future and any changes in share

price.• (iii) Investors will also need to know whether the management has been running the company efficiently.• (iv) As well as the position indicated by the statement of comprehensive income, statement of financial position

and earnings per share (EPS), investors will want to know about the liquidity position of the company, thecompany's future prospects, and how the company's shares compare with those of its competitors.

(b) Employees need information about the security of employment and future prospects for jobs in the company, and tohelp with collective pay bargaining.(c) Lenders need information to help them decide whether to lend to a company. They will also need to check that thevalue of any security remains adequate, that the interest repayments are secure, that the cash is available forredemption at the appropriate time and that any financial restrictions (such as maximum debt/equity ratios) have notbeen breached.(d) Suppliers need to know whether the company will be a good customer and pay its debts.(e) Customers need to know whether the company will be able to continue producing and supplying goods.(f) Government's interest in a company may be one of creditor or customer, as well as being specifically concerned withcompliance with tax and company law, ability to pay tax and the general contribution of the company to the economy.(g) The public at large would wish to have information for all the reasons mentioned above, but it could be suggestedthat it would be impossible to provide general purpose accounting information which was specifically designed for theneeds of the public.

Financial statements cannot meet all these users' needs, but financial statements which meet the needs of investors (providers of risk capital) will meet most of the needs of other users.The Framework emphasizes that the preparation and presentation of financial statements is primarily the responsibility of an entity's management. Management also has an interest in the information appearing in financial statements.

• Responsibility For Financial Statements The management of an entity has the primary responsibility for preparing and presenting the entity's financial statements.

• The Objective Of Financial Statements The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions.

Question two

Consider the following situations. In each case, do wehave an asset or liability within the definitions given bythe Framework? Give reasons for your answer.• (a) Pat Co has purchased a patent for GH¢20,000. The

patent gives the company sole use of a particularmanufacturing process which will save GH¢3,000 ayear for the next five years.

• (b) Baldwin Co paid Don Brennan GH¢10,000 to set upa car repair shop, on condition that priority treatmentis given to cars from the company's fleet.

• (c) Deals on Wheels Co provides a warranty with everycar sold.

Answer.

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

• (b) This cannot be classified as an asset. Baldwin Co hasno control over the car repair shop and it is difficult toargue that there are 'future economic benefits'

• (c) The warranty claims in total constitute a liability;the business has taken on an obligation. It would berecognised when the warranty is issued rather thanwhen a claim is made.

Harmonization versus Standardization

Harmonization tends to mean the process of increasing the compatibility of accounting practices by setting bounds to their degree of variation.

Standardization tends to imply the imposition of a rigid and narrower set of rules. Standardization also implies that one technically correct method can be identified for every aspect of accounting and then this can be imposed on all preparers of accounts.

Due to the variations between countries discussed above, full standardization of accounting practices is unlikely. Harmonization is more likely, as the agreement of a common conceptual framework of accounting practices.

The Need for Harmonization of Accounting Standards • Each country has its own accounting regulation, financial statements and reports prepared for shareholders and

other uses are based on principles and rules that can vary widely from country to country. Multinational entities may have to prepare reports on activities on several bases for use in different countries, and this can cause unnecessary financial costs. Furthermore, preparation of accounts based on different principles makes it difficult for investors and analysts to interpret financial information. This lack of comparability in financial reporting can affect the credibility of the entity’s reporting and the analysts’ reports and can have a detrimental effect on financial investment.

• The increasing levels of cross-border financing transactions, securities trading and direct foreign investment has resulted in the need for a single set of rules by which assets, liabilities and income are recognized and measured.

• The number of foreign listings on major exchanges around the world is continually increasing and many worldwide entities may find that they are preparing accounts using a number of different rules and regulations in order to be listed on various markets.

Barriers to harmonization

• Different purposes of financial reporting. In some countries the purpose is solely for tax assessment, while in others it is for investor decision making

• Different legal systems. These prevent the development of certain accounting practices and restrict the options available

• Different user groups. Countries have different ideas about who the relevant user groups are and the respective importance. In the USA creditor and investor group are given prominence while in Europe employees enjoy a higher profile

• Needs of developing countries. Developing countries are obviously behind in the standard setting process and they need to develop the basic standards and principles already in place in most developed countries.

• Nationalism is demonstrated in an unwillingness to accept another country’s standard.• Cultural differences result in objectives for accounting system differing from one country to

country• Unique circumstances. Some countries may be experiencing unusual circumstances which affect all

aspects of everyday life and impinge on the ability of countries to produce proper reports, for example hyper inflation, civil war, currency restriction and so on.

• The lack of strong accountancy bodies. Many countries do not have strong independent accountancy or business bodies which would press for better standards and greater harmonization.

Advantages of Global Harmonization

The advantages of harmonization will be based on the benefits of users and preparers of accounts as follows:• Investors, both individual and corporate, would like to be able to compare the financial results of different

companies internationally as well as nationally in making investment decisions• Multinational companies would benefit from harmonization for many reasons including the following:• Better access would be gained to foreign investors funds• Management control would be improved, because harmonization would aid internal communication of financial

information.• Appraisal of foreign entities for takeovers and mergers would be more straight forward• It would be easier to comply with reporting requirements of overseas stock exchanges• Preparation of group accounts would be easier• A reduction in audit costs might be achieved• Transfer of accounting staff across national boarders would be easier• Governments of developing countries would save time and money if they could adopt international standards and,

in these were used internally, governments of developing countries could attempt to control the activities of foreign multinational companies in their own country. These companies could not ‘hide’ behind foreign accounting practices which are difficult to understand.

• Tax authorities. It will be easier to calculate tax liability of investors including multinationals who receive income from multinational sources

• Regional economic groups usually promote trade within a specific geographical region. This would be aided by common accounting practices within the region.

• Large international accounting firms would benefit as accounting and auditing would be much easier if similar accounting practices existed throughout the world.

IAS 1 PRESENTATION OF FINANCIAL STATEMENTS

Objective of IAS 1 • The objective of IAS 1 (2007) is to prescribe the basis for presentation of

general purpose financial statements, to ensure comparability both withthe entity's financial statements of previous periods and with the financialstatements of other entities. IAS 1 sets out the overall requirements forthe presentation of financial statements, guidelines for their structure andminimum requirements for their content. [IAS 1.1] Standards forrecognizing, measuring, and disclosing specific transactions are addressedin other Standards and Interpretations.

Scope• IAS 1 Applies to all general purpose financial statements based on

International Financial Reporting Standards.• General purpose financial statements are those intended to serve users

who are not in a position to require financial reports tailored to theirparticular information needs.

Objective of Financial Statements

The objective of general-purpose financial statements is to provideinformation about the financial position, financial performance, and cashflows of an entity that is useful to a wide range of users in making economicdecisions. To meet that objective, financial statements provide informationabout an entity's:• assets• liabilities• equity• income and expenses, including gains and losses• contributions by and distributions to owners• cash flows• That information, along with other information in the notes, assists users

of financial statements in predicting the entity's future cash flows and, inparticular, their timing and certainty.

Components of Financial Statements

A complete set of financial statements should include:• a Statement of Financial Position (Balance Sheet) at the end of the

period• a Statement of Comprehensive Income for the period (or an income

statement and a statement of comprehensive income)• a statement of changes in equity for the period• a statement of cash flows for the period• notes, comprising a summary of accounting policies and other

explanatory notesAn entity may use titles for the statements other than those statedabove.Reports that are presented outside of the financial statements –including financial reviews by management, environmental reports, andvalue added statements – are outside the scope of IFRSs.

Fair Presentation and Compliance with IFRSs

• The financial statements must "present fairly" the financialposition, financial performance and cash flows of an entity.

• The application of IFRSs, with additional disclosure whennecessary, is presumed to result in financial statementsthat achieve a fair presentation.

• IAS 1 acknowledges that, in extremely rare circumstances,management may conclude that compliance with an IFRSrequirement would be so misleading that it would conflictwith the objective of financial statements set out in theFramework. In such a case, the entity is required to departfrom the IFRS requirement, with detailed disclosure of thenature, reasons, and impact of the departure.

The Accounting Concepts in IAS 1

• Going Concern An entity preparing IFRS financial statements ispresumed to be a going concern. If managementconcludes that the entity is not a going concern, thefinancial statements should not be prepared on agoing concern basis, in which case IAS 1 requires aseries of disclosures.• Accrual Basis of AccountingIAS 1 requires that an entity prepare its financialstatements, except for cash flow information, usingthe accrual basis of accounting.

• Consistency of PresentationThe presentation and classification of items in the financial statements shall beretained from one period to the next unless a change is justified either by a change incircumstances or a requirement of a new IFRS.• Materiality and AggregationEach material class of similar items must be presented separately in the financialstatements. Dissimilar items may be aggregated only if they are individuallyimmaterial.• Offsetting: Assets and liabilities, and income and expenses, may not be offset

unless required or permitted by an IFRS.• Comparative InformationIAS 1 requires that comparative information shall be disclosed in respect of theprevious period for all amounts reported in the financial statements, both face offinancial statements and notes, unless another Standard requires otherwise.If comparative amounts are changed or reclassified, various disclosures are required.

Structure and Content of Financial Statements GPFS

Clearly identify: • the financial statements • the reporting enterprise • whether the statements are for the enterprise or for a group • the date or period covered • the presentation currency • the level of precision (thousands, millions, etc.) Reporting Period • There is a presumption that financial statements will be prepared at

least annually. If the annual reporting period changes and financial statements are prepared for a different period, the entity must disclose the reason for the change and a warning about problems of comparability.

Statement of Financial Position (Balance Sheet)

An entity must normally present a classified statement of financial position,separating current and noncurrent assets and liabilities. Only if a presentationbased on liquidity provides information that is reliable and more relevant maythe current/noncurrent split be omitted.• Current assets are cash; cash equivalent; assets held for collection, sale, or

consumption within the entity's normal operating cycle; or assets held fortrading within the next 12 months. All other assets are noncurrent.

• Current liabilities are those to be settled within the entity's normaloperating cycle or due within 12 months, or those held for trading, orthose for which the entity does not have an unconditional right to deferpayment beyond 12 months. Other liabilities are noncurrent.

• When a long-term debt is expected to be refinanced under an existingloan facility and the entity has the discretion the debt is classified as non-current, even if due within 12 months.

Statement of Comprehensive Income• Comprehensive income for a period includes profit or loss for that period plus

other comprehensive income recognized in that period. As a result of the 2003revision to IAS 1, the Standard is now using 'profit or loss' rather than 'net profit orloss' as the descriptive term for the bottom line of the income statement.

• All items of income and expense recognized in a period must be included in profitor loss unless a Standard or an Interpretation requires otherwise.

The components of other comprehensive income include:•changes in revaluation surplus (IAS 16 and IAS 38)•actuarial gains and losses on defined benefit plans recognised in accordance with IAS19•gains and losses arising from translating the financial statements of a foreignoperation (IAS 21)•gains and losses on re-measuring available-for-sale financial assets (IAS 39)•the effective portion of gains and losses on hedging instruments in a cash flow hedge(IAS 39).

SoFP

Minimum items on the face of the statement of financial position a. property, plant and equipmentb. investment propertyc. intangible assetsd. financial assets (excluding amounts shown under (e), (h), and (i))e. investments accounted for using the equity methodf. biological assetsg. inventoriesh. trade and other receivablesi. cash and cash equivalentsj. assets held for salek. trade and other payablesl. provisionsm. financial liabilities (excluding amounts shown under (k) and (l))n. liabilities and assets for current tax, as defined in IAS 12o. deferred tax liabilities and deferred tax assets, as defined in IAS 12p. liabilities included in disposal groupsq. non-controlling interests , presented within equity andr. issued capital and reserves attributable to owners of the parent

ACCOUNTING FOR INVENTORIES- IAS 2

• Objective of IAS 2

The objective of IAS 2 is to prescribe theaccounting treatment for inventories. It providesguidance for determining the cost of inventoriesand for subsequently recognizing an expense,including any write-down to net realizable value.It also provides guidance on the cost formulasthat are used to assign cost to inventories.

Definition

Inventories are assets held:• For sale in the ordinary course of business• In the process of production for sale• In the form of materials or supplies to be consumed in

the production process or• in the rendering of services• In the case of a service provider, inventories include

the cost of the service for which the related revenuehas not yet been recognized (for example work inprogress of auditors, lawyers, and architects)

Inventories under IAS 2 excludes

• Work in progress arising under constructioncontracts (IAS 11)

• Financial Instruments (IAS 39)

• Biological assets related to agricultural activityand agricultural produce at the point ofharvest (IAS 41)

Categories of inventory

Inventories comprise:

• Goods or other assets purchased for resale

• Consumable stores

• Raw materials and components purchased forincorporation into products for sale

• Products and services in intermediate stages ofcompletion

• Finished goods

The fundamental principle of IAS 2 in valuing inventory

• The basic principle of IAS 2 is that inventory should be valued at the lower of cost and net realizable value (NRV)

Cost

Cost is defined as the amount incurred in bringing the items of inventory totheir present location and condition i.e. cost of purchase and cost ofconversion. Thus cost of inventories should include:• Cost of purchase (Purchase price, import duties, transportation cost,

handling cost) trade discounts and rebates are deducted when arriving atthe cost of purchase

• Costs of conversion which comprises: Costs which are specifically attributable to units of production e.g. direct

labour, direct expenses and sub contracted work. Production over heads, if any, attributable in any particular circumstances

of the business in bringing the product or service to its present locationand condition

• Other costs incurred in bringing the inventory to its present location andcondition. E.g cost of designing products for specific customer needs.

Costs to be excluded in valuing stock

The following costs should be excluded from cost of stock and should be charged as expenses of the period in which they are incurred:• Abnormal wastes• Storage costs• Administrative overheads which do not contribute in bringing inventories

to their present condition and location• Selling costs• Foreign exchange differences arising directly on the recent acquisition of

inventories invoiced in a foreign currency• Interest cost when inventories are purchased with deferred settlement

terms • The standard cost and retail methods may be used for the measurement

of cost, provided that the results approximate actual cost.

Cost

• For inventory items that are not interchangeable,specific costs are attributed to the specific individualitems of inventory.

• For items that are interchangeable, IAS 2 allows theFIFO or weighted average cost formulas. The LIFOformula, which had been allowed prior to the year2003, is no longer allowed.

• The same cost formula should be used for allinventories with similar characteristics as to theirnature and use to the enterprise. For groups ofinventories that have different characteristics differentcost formulas may be justified.

Net realizable value (NRV)

• NRV is the estimated selling price in theordinary course of business less estimatedcosts of completion and estimated costsnecessary to make the sale. Any write-downto NRV should be recognized as an expense inthe period in which the write-down occurs.Any reversal should be recognized in theincome statement in the period in which thereversal occurs.

Recognition as an expense

• The carrying amount of inventories sold should be recognized as anexpense in the period in which the related revenue is recognized.

• The amount of any write down of inventories to net realizable valueand other losses of inventories should be recognized as an expensein the period the write down or loss occurs.

• The amount of any reinstatement of cost of inventories, arisingfrom an increase in net realizable value, should be recognized as areduction of expense in the period the reinstatement occurs.

• Some inventories may be allocated to other assets accounts, forexample inventory used as a component of self-constructedproperty, plant or equipment. Inventory allocated to another assetin this way are recognized as an expense during the useful life ofthe asset.

Disclosure requirements

The following must be disclosed in accordance with IAS 2• Accounting policy adopted including the cost formula

used.• Total carrying amount classified appropriately• Amount of inventories carried at NRV• The amount of inventories pledged as security for

liabilities.• The amount recognized as an expense or as income

during the period in respect of inventories writtendown to the net realizable value, net of reinstatementsof cost, the circumstances or events that led to thereversals or write-down

Illustration One (1)

Materials costing GH¢15,000 bought forprocessing and assembly for a profitable specialorder. Since buying these items, the cost pricehas fallen to GH¢12,500

At what price should the inventory be includedin the financial statements?

Suggested solution

Inventory should be valued at GH¢15,000.GH¢12,500 is irrelevant. The rule is lower of costor net realizable value; not lower of cost andreplacement cost. Since the material will beprocessed before sale there is no reason tobelieve that the NRV will be below cost.

Illustration two(2)

Equipment was constructed for a customer for anagreed price of GH¢20,000. This has recently beencompleted at a cost of GH¢18,600. It has now beendiscovered that in order to meet certainregulations, conversion with an extra cost ofGH¢5,000 will be required. The customer hasaccepted partial responsibility and agreed to meethalf of the extra cost.

Required: Value the inventory for accountingpurposes.

Suggested solution

IAS 2 requires that inventory should be valued atthe lower of cost or NRV hence the inventorywould be valued at GH¢17,500. (i.e. GH¢20,000estimated selling price less cost to complete andsell GH¢5,000/2).

Illustration three (3)

Calculate the cost of inventory in accordance with IAS 2 from the followingdata relating to BSc. III ltd for the year ended 31st May 2007.

GH¢Direct cost of can opener per unit 1Direct labour cost of can opener per unit 1Direct expenses cost of can opener per unit 1Production overheads per year 600,000Administration overheads per year 200,000Selling overheads per year 300,000Interest payment per year 100,000There were 250,000 units of finished goods at the year end. You may assumethat there were no finished goods at start of the year and that there was nowork in progress. The normal level of production is 750,000 can openers, butin the year ended 31st May 2007, only 450,000 were produced because oflabour dispute.

Suggested solution

This question requires the classification of the cost elements provided so that only those costs that were incurred to bringing the asset into its present condition for the initial measurement.

Cost of total production of 450,000 can openersGH¢

Direct cost of materials for can opener 450,000(450,000×GH¢1)Direct labour cost of can opener 450,000(450,000×GH¢1)Direct expenses cost of can opener 450,000(450,000×GH¢1)Production overheads 360,000(GH¢600,000/750000×450,000)

1,710,000Cost of Goods Sold (200,000/450000× GH¢1,710,000) 760,000

Cost of Inventories (250,000/450000× GH¢1,710,000) 950,000

Note:IAS 2 only permits the inclusion of production overheads in the valuation of inventories and therefore administration, selling and interest costs (unless interest costs meet the requirements identified in the alternative treatment permitted under IAS 23, Borrowing costs) are not relevant here. The abnormal costs associated with labour dispute will be charged as an expense in the period they are incurred.Therefore cost of finished inventory =GH¢950,000

Illustration 4

Brilliant Trading Inc. purchases motorcycles from various countries and exports them to Europe. Brilliant Trading has incurred these expenses during 2005: (a) Cost of purchases (based on vendors’ invoices) (b) Trade discounts on purchases (c) Import duties (d) Freight and insurance on purchases (e) Other handling costs relating to imports (f) Salaries of accounting department (g) Brokerage commission payable to indenting agents for arranging imports (h) Sales commission payable to sales agents (i) After-sales warranty costs

Required Brilliant Trading Inc. is seeking your advice on which costs are permitted under IAS 2 to be included in cost of inventory.

Suggested solution

• Items (a), (b), (c), (d), (e), and (g) arepermitted to be included in cost of inventoryunder IAS 2. Salaries of accountingdepartment, sales commission, and after-saleswarranty costs are not considered cost ofinventory under IAS 2 and thus are notallowed to be included in cost of inventory

Illustration five (5)

Joegana Inc. is a newly established international trading company. Itcommenced its operations in 2013.• Joegana imports goods from China and sells in the local market. It uses the

FIFO method to value its inventory. Listed next are the purchases and salesmade by the entity during the year 2013:

Purchases• January 2013 10,000 units @ $ 25 each• March 2013 15,000 units @ $ 30 each• September 2013 20,000 units @ $ 35 eachSales• May 2013 15,000 units• November 2013 20,000 unitsRequired• Based on the FIFO cost flow assumption, compute the value of inventory

at May 31, 2013, September 30, 2013, and December 31, 2013

Suggested solution

(a) January 2013 Purchase + 10,000 units @ $25 = $250,000

March 2005 Purchase + 15,000 units @ $30 = $450,000

Total $700,000

(b) May 2013 Sales (15,000 units) – 10,000 units @ $25 = $(250,000)

– 5,000 units @ $30 = $(150,000)

$(400,000)

(c) Inventory valued on FIFO basis at May 31, 2013:

10,000 units @ $30 = $300,000

(d) September 2013 Purchase

+20,000 units @ $35 = $700,000

(e) Inventory valued on FIFO basis at September 30, 2013:

• 10,000 units @ $30 = $300,000

• 20,000 units @ $35 = $700,000

• $1,000,000

(f) November 2005 Sales (20,000 units) – 10,000 units @ $30 = $(300,000)

– 10,000 units @ $35 = $(350,000)

$(650,000)

(g) Inventory valued on FIFO basis at December 31, 2013:

10,000 units @ $35 = $350,000

Illustration six (6)

Vigilant LLC, a newly incorporated company, uses the latest version of a softwarepackage (EXODUS) to cost and value its inventory. The software uses the weighted-average cost method to value inventory.The following are the purchases and sales made by Vigilant LLC during 2006 (as anewly set up company, Vigilant LLC has no beginning inventory):Purchases• January 100 units @ $250 per unit• March 150 units @ $300 per unit• September 200 units @ $350 per unitSales• March 150 units• December 170 unitsRequiredVigilant LLC has approached you to compute the value of its inventory and the cost perunit of the inventory at March 31, 2006, September 30, 2006, and December 31, 2006,under the weighted-average cost method

ACCOUNTING FOR NON-CURRENT ASSETS

Definition and Features of Non-current assets• Non-current assets are distinguished from current assets by

the following characteristics: Are long-term in nature Are not normally acquired for resale Could be tangible or intangible Are used to generate income directly or indirectly for a

business Are not normally liquid assets (i.e. not easily and quickly

converted into cash without significant loss in value).

Capital and revenue expenditure

It follows that a business’ expenditure may be classified as one of two types:

Capital expenditure• Expenditure on the acquisition of non-current assets required for use in the

business, not for resale.• Expenditure on existing non-current assets aimed at increasing their earning

capacity.• Capital expenditure is long-term in nature as the business intends to receive the

benefits of the expenditure over a long period of time.

Revenue expenditure• Expenditure on current assets.• Expenditure relating to running the business (such as administration costs)• Expenditure on maintaining the earning capacity of non-current assets e.g. repairs

and renewals.• Revenue expenditure relates to the current accounting period and is used to

generate revenue in the business.

Non-current asset registers

Non-current asset registers are, as the name suggests, arecord of the non-current assets held by a business. Theseform part of the internal control system of an organization.Typical items often found on a fixed assets register include:• Cost• Date of purchase• Description of asset• Serial/reference number• Location of asset• Depreciation method• Expected useful life• Net book value

Acquisition of a non-current asset

A non-current asset register is maintained in order to control non-current assets and keep track of whatis owned and where it is kept.It is periodically reconciled to the non-current asset accounts maintained in the general ledger.The cost of a non-current asset is any amount incurred to acquire the asset and bring it into workingcondition• Includes ExcludesCapital expenditure such as: Revenue expenditure such as:• Purchase price repairs• Delivery cost renewals• Legal fees repaintingSubsequent expenditure which enhances the asset The correct double entry to record the purchase is:• Dr Non-current asset X• Cr Bank/Cash/Payables X

A separate cost account should be kept for each category of non-current asset, e.g. motor vehicles, fixtures and fittings.

Subsequent expenditure on non-current asset

• Subsequent expenditure on the non-current asset canonly be recorded as part of the cost (or capitalized), if itenhances the benefits of the asset, i.e. increases therevenues capable of being generated by the asset.

• An example of subsequent expenditure which meetsthis criterion, and so can be capitalized, is an extensionto a shop building which provides extra selling space.

• An example of subsequent expenditure which does notmeet this criterion is repair work. Any repair costs mustbe debited to the income statement, i.e. expensed.

Example one Acquisition of NCA

BB Ltd started a business providing limousine taxi services on 1 January 2011. In the year to 31 December he incurred the following costs:

GH¢

Office premises 250,000Legal fees associated with purchase of office 10, 000Cost of materials and labour to paint office in BB Ltd’sfavourite colour, purple 300Mercedes E series estate cars 116,000Number plates for cars 210Delivery charge for cars 180Road license fee for cars 480Drivers’ wages for first year of operation 60,000Blank taxi receipts printed with BB Ltd’s businessName and number 450

What amounts should be capitalized as ‘Land and buildings’ and ‘Motor vehicles’?

ANSWER

(i) Land and buildings GH¢• Office premises 250,000

• Legal fees associated with purchase of office 10,000•

• Total 260,000

(ii) Motor Vehicles• Mercedes E series estate cars 116,000• Number plate 210• Delivery Charges 180

116,390

Example two

ICAG Ltd incurred the following costs in constructing an office building GH¢

• Purchase price of land 125,000• Legal fees 5,000• Stamp duty and other levies to Local Government authority 2,500• Site preparation and clearance 9,000• Cost of building materials used 50,000• Labour cost (from 1 January 2006 to 30 June 2007) 75,000• Architects fees 10,000• General overheads (allocated) 15,000

291,500

• Material costs were greater than anticipated. On investigation, it was realized that materials costing GH¢5,000 had been spoiled and was therefore wasted and a further GH¢ 7,500 was incurred as a result of faulty design work.

• As a result of the above problems, work on the building ceased for two weeks during July 2006 and it is estimated that approximately GH¢ 4,500 of the labour costs relate to this period.

• The building was completed on 1 April, 2007 and occupied on July 1, 2007.• Required • Calculate the cost of building that will be included in tangible non-current asset.

ANSWER

Only costs that are directly attributable to bring the assets intoworking condition for its intended use should be included. Labourcosts are only included for the period to 1 April 2007. The building wasavailable for use on that date, regardless of the fact that it was notactually in use until three months later

GH¢Purchase price of land 125,000Legal fees 5,000Stamp and other duties 2,500Site preparation and clearance 9,000Cost of materials used (50,000-5,000-7,500) 37,500Labour costs (75,000 x 15/18)-4,500 58,000Architects fees 10,000

247,000

Depreciation

• IAS 16 defines depreciation as ‘the measure of the cost or revaluedamount of the economic benefits of the tangible non-current asset thathas been consumed during the period’.

• In simple terms, depreciation is a mechanism to reflect the cost of using anon-current asset.

• Depreciation matches the cost of using a non-current asset to therevenues generated by that asset over its useful life.

• Depreciation must also be matched to the pattern of use of the asset. Thismust be regularly reviewed and may be changed if the method no longermatches the usage of the asset

• This is achieved by recording a depreciation charge each year, the effectof which is twofold (‘the dual effect’):

• Reduce the statement of financial position value of the non-current assetby cumulative depreciation to reflect the wearing out.

• Record the depreciation charge as an expense in the income statement tomatch to the revenue generated by the non-current asset.