Escolar Documentos
Profissional Documentos
Cultura Documentos
SCHOOL OF BUSINESS
JAMES GATAUWA
Published by Kenya Methodist University (KeMU)
P.O. BOX 267 60200 Meru
Tel: 254 064 30301, 31146
COURSE OUTLINE
Course Description
This is a highly specialized course offered to second year students. The student will learn
concepts and procedures that apply to accounting for assets. This entails coverage of
measurement and presentation of current and non-current assets including intangible assets.
Course Objectives
The objective of the course is to provide information to enable;
1. Students to understand the theory and practice proficiency in the accounting treatment of
assets.
2. Students to understand the essential business and accounting terminology that they need
to succeed in a business environment.
3. Students to understand the acquisition and disposal of assets.
4. To equip students with the knowledge necessary for advanced studies in professional and
academic accountancy.
Course Plan
Topic 1
Topic 2
Topic 3
Topic 4
Topic 5
Topic 6
Topic 7
Topic 8
Course Delivery
A combination of lectures, discussions, case studies, library research e.t.c.
Course Materials
Textbooks, accounting standards, handouts, journal articles and any other relevant materials.
Course Assessment
Examination
70%
30%
100%
INTRODUCTION
1.1 Accounting
It is the process of identifying, measuring and interpreting of economic information that assists
users of this information to make informed judgments or decisions.
Accounting continued to develop but increased in importance with the rise in popularity of
companies as the predominant form of business entity. Due to the separation of ownership and
management, shareholders had less detailed knowledge of business operations. Hence,
accountants were required to produce and interpret financial information to enable shareholders
to make decisions. Accounting standards were later developed to make it easier to compare
different companies and the accounting profession grew in order to assist in the application of
these sometimes, complex accounting standards.
The growth in computerization has seen a reduction in traditional bookkeeping work, and with
globalization it means that many clients have been multinational companies requiring advice on
many areas in addition to accounting.
b. Cost Accounting - It relates to the collection, classification, ascertainment of cost & its
accounting and cost control relating to the various elements of cost i.e. materials, labour and
overheads.
c. Management Accounting - It relates to the use of accounting data collected with the help of
financial accounting and cost accounting for the purpose of policy formulation, planning, control
and decision making by management.
d. Tax Accounting - It assists in complying with the provisions of complex tax laws governing
income tax, sales tax, excise duties, custom duties e.t.c.
b. Shareholders - They need to know the profitability of an entity and how much of profits they
can withdraw from the entity for their own use.
c. Employees - They have a right to information about the entitys financial situation because
their future careers and salaries/wages depend on it.
d. Lenders of finance - They need to be sure that the entity is able to pay interest payments and
principal amounts promptly.
e. Suppliers and Customers - Suppliers need to know about the entitys ability to pay debts
while customers need to know that the entity is a secure source of supply.
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f. Taxation authorities - They need to know about the entitys profits in order to assess the tax
payable by the entity.
g. Financial analysts and Advisers - They need information for their clients or audience.
h. The Public
The IASB Framework was approved by the IASC Board in April 1989 for publication in July
1989, and adopted by the IASB in April 2001. In September 2010, as part of a bigger project to
revise the Framework the IASB revised the objective of general purpose financial reporting and
the qualitative characteristics of useful information. The Conceptual Framework sets out the
concepts that underlie the preparation and presentation of financial statements for external users.
The Conceptual Framework deals with:
The objective of general purpose financial reporting is to provide financial information about the
reporting entity that is useful to existing and potential investors, lenders and other creditors in
making decisions about providing resources to the entity.
a. Relevance
Only relevant information can be useful. Information is relevant when it helps users evaluate
past, present or future events or it confirms or corrects previous evaluations. Information on the
financial position and performance is often used to predict future position and performance and
other things of interest to the user such as the likely dividend, wages rises. The manner of
showing information will enhance the ability to make predictions e.g. by highlighting unusual
items.
b. Faithful representation
Information must represent faithfully the transactions it purports to represent in order to be
reliable. There is a risk that this may not be the case, not due to bias, but due to inherent
difficulties in identifying the transactions or finding an appropriate method of measurement or
presentation.
c. Comparable
Users must be able to compare an entitys financial statements
a) Through time to identify trends
b) With other entitys statements, to evaluate their relative financial position, performance
and changes in financial position.
The consistency of treatment is important across like items over time, within the entity and
across all entities.
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d. Understandable
Users must be able to understand financial statements. They are assumed to have some business,
economic and accounting knowledge and to be able to apply themselves to study the information
properly.
e. Verifiable
The ability through consensus among measurers to ensure that information represents what it
purports to represent or that the chosen method of measurement has been used without error or
bias.
f. Timely
Users should have information available to them before it loses its capacity to influence
decisions.
An 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.
A liability is a present obligation of the entity arising from past events, the settlement of
which is expected to result in an outflow from the entity of resources embodying
economic benefits.
Equity is the residual interest in the assets of the entity after deducting all its liabilities.
Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in increases in
equity, other than those relating to contributions from equity participants.
Expenses are decreases in economic benefits during the accounting period in the form of
outflows or depletions of assets or incurrences of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants.
The Framework also lays out the formal recognition criteria that have to be met to enable
elements to be recognised in the financial statements. The recognition criteria that have to be met
are that;
it is probable that any future economic benefit associated with the item will flow to or
from the entity and
Accounting concepts they are the basic assumptions or conditions upon which the
science of accounting is based.
Accounting conventions they are the circumstances or traditions which guide the
accountants while preparing the accounting statements.
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Accounting Concepts
1.3.1 Business Entity Concept
This concept implies that a business unit is separate and distinct from the person who supplies
capital to it. The accounting equation (Assets = liabilities + capital) is an expression of this
concept since it shows that the business itself owns the assets and in turn owes to the various
claimants.
(ii)
For example, if an entity acquires an asset, it must have given up some other asset such as cash
or the obligation to pay for it in future. There must be a double entry to have a complete record
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of each business transaction, an entry being made in the receiving account and an entry of the
same account in the giving account. Thus, every DR. must have a corresponding CR. and vice
versa and upon this dual aspect has been raised the Double Entry system of accounting. The
accounting equation (Assets = liabilities + capital) is based on dual aspect concept.
1.4.2 Replacement Cost It is the amount needed to replace an item with identical item.
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1.4.3 Net Realizable Value It is the expected price less any costs still to be incurred in getting
the item ready for sale and then selling it.
1.4.4 Economic Value It is the value derived from an assets ability to generate income.
Example
ABC enterprises bought a machine five years ago for sh. 1,500,000. An identical machine can be
purchased at sh. 2,000,000. The machine is now worn out but it can be restored to a working
order at a cost of sh. 500,000. It can then be sold for sh. 1,000,000. Determine the historical cost,
replacement cost and net realizable value.
Solution
Historical cost = sh. 1,500,000
Replacement cost = sh. 2,000,000
Net realizable value = sh. 1,000,000 sh. 500,000 = sh. 500,000
Example
ABC enterprises bought another machine for sh. 2,400,000. It is estimated that the new machine
will generate profits of sh. 400,000 per year for its useful life of 8 years. What is the economic
value?
Solution
Economic value = sh. 400,000 x 8yrs = sh. 3,200,000
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Derivative instruments (e.g. financial options, futures and forwards, interest rate swaps
and currency swaps).
Cash
A contractual right:
o to receive cash or another financial asset from another entity
OR
o to exchange financial instruments with another entity under conditions that are
potentially favorable to the entity
A contract that will or may be settled in the entitys own equity instruments and is:
o a non derivative for which the entity is or may be obliged to receive a variable
number
OR
o a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entitys own
equity instruments.
A contractual obligation:
o to deliver cash or another financial asset to another entity
OR
o to exchange financial instruments with another entity under conditions that are
potentially unfavorable to the entity
A contract that will or may be settled in the entitys own equity instruments and is:
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OR
o a derivative that will or may be settled other than by the exchange of a fixed
amount of cash or another financial asset for a fixed number of the entitys own
equity instruments.
2.1.4 Equity Instrument
It is any contract that evidences a residual interest in the assets of an entity after deducting all its
liabilities. In the recent past there has been a rapid international expansion in the use of financial
instruments. Therefore the development of international accounting standards to govern the
accounting for financial instruments has been considered imperative due to some of the
following reasons;
(a)Financial instruments are of international concern and also other national standard-setters.
(b)There has been significant growth in the usage of financial instruments in the recent past
which has overtaken the development of their accounting.
(c) There has been high profile disasters involving derivatives which have raised questions on the
disclosure and accounting for these financial instruments.
2.1.6 Derivatives
It is a financial instrument or other contracts with all of the following characteristics;
Its value changes in response to the change in a specified interest rate, financial
instrument price, commodity price, foreign exchange rate, index of prices or rates, credit
rating or credit index or another variable
It requires no initial net investment or an initial net investment that is smaller than would
be required for other types of contracts that would be expected to have a similar response
to changes in market factors
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A financial instrument is only an equity instrument if both of the following conditions are met:
OR
If the instrument will or may be settled in the issuers own equity instruments, it is:
o a non derivative that includes no contractual obligation for the issuer to deliver a
variable number of its own equity instruments;
OR
o a derivative that will be settled only by the issuer exchanging a fixed amount of
cash or another financial asset for a fixed number of its own equity shares.
The above component parts must be shown separately in the financial statements.
16
Illustration
In 1/jan/2002 China Ltd issued a sh.500 million three year convertible bond at par. There were
no issue costs and the coupon rate is 10% payable annually in arrears on 31 Dec. The bond is
redeemable at par on 1/Jan/2005. Bondholders may opt for conversion where by conversion is at
two 25 cent shares for every sh.1 owed to each bondholder on 1/Jan/2005. Bonds issued by
similar companies without any conversion rights currently bear interest at 15%.
How will the financial instrument be recorded in the financial statements assuming that all
bondholders opt for full conversion?
Solution
o Calculate the present value of the debt component by discounting the cash flows at the
market rate of interest for an instrument similar in all respects, except that it doesnt have
conversion rights.
o Deduct the present value of the debt from the proceeds of the issue. The difference will
be the Equity component. The cash payments on the bond should be discounted to their
present value using the interest rate for a bond without the conversion rights that is 15%.
Date
Cash flow
Discount Factor
Present Value
31/12/02
interest
50m
1/1.15
43.478m
31/12/03
interest
50m
1/1.15
37.807m
31/12/04
interest
50m
1/1.15
32.876m
01/01/05
principal
500m
1/1.15
328.758m
442.919m
500m
57.081m
Bal b/d
2002
442.919
2003
2004
effective int.(15%)
Payments
Bal c/d
66.438
(50)
459.357
459.357
68.904
(50)
478.261
478.261
71.739
(50)
500
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57.081
Liability - (bond)
500
557.081
The conversion terms are two 25c shares for every sh. 1, hence sh.500m x 2 = 1 billion shares
with a nominal value of sh. 250 m. The remaining sh. 307.081 m will be classified as share
premium.
For Example, Dividends paid in respect of preference shares classified as a liability will be
charged as a finance expense through profit and loss. Dividends paid on shares classified as
equity will be reported in the statement of changes in equity.
intends either to settle on a net basis OR to realize the asset and settle the liability
simultaneously.
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The IASB in January 2011 issued an Exposure Draft Offsetting financial assets and financial
liabilities whereby it proposed the following;
Application The offsetting criteria above apply whether the right of set-off arises from
a bilateral or multilateral arrangement.
An entity should initially recognize a financial asset or a financial liability in its statement of
financial position when it becomes a party to the contractual provisions of the instrument e.g.
-commitments to buy or sell goods should not be recognized until one party has fulfilled its part
of the contract.
-forward contracts are recognized as assets or liabilities on the commitment/contract date and not
on the date when the item under contract is transferred from the seller to the buyer.
Amortised cost, or
Fair value.
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A financial liability is classified at fair value through profit or loss if it is held for trading or upon
initial recognition it is designated at fair value through profit or loss.
Fair value or
Illustration
On 1 January 2011 Ballack Ltd purchased a debt instrument for its fair value of sh. 1,000,000.
The debt instrument has a maturity date of 31 December 2015. The principal amount is sh.
1,250,000 and the fixed interest rate is 4.72% paid annually. The effective interest rate is 10%.
Account for the financial instrument over its five year term.
The company will receive interest of sh. 59,000 (1,250,000 x 4.72%) per annum and sh.
1,250,000 at maturity.
The following is an amortization table over the five years.
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Interest received
Closing balance
1,000,000
100,000
(59,000)
1,041,000
1,041,000
104,000
(59,000)
1,086,000
1,086,000
109,000
(59,000)
1,136,000
1,136,000
113,000
(59,000)
1,190,000
1,190,000
119,000
(1,250,000 + 59,000)
The closing balance represents the financial asset per annum hence these amounts are posted in
the statement of financial position while the interest received of sh. 59,000 per annum and sh.
1,250,000 at end of year five is posted in the cash flow statement. The interest income per annum
is posted in the income statement.
Illustration
On 1 November 2011, Betty Ltd acquired a quoted investment in the shares of Lilly Ltd with the
intention of holding it in the long term. The cost of the investment is sh. 1,000,000. At Betty
Ltds year end on 31 December 2011, the market price of a similar investment was sh.
1,200,000. Account for the financial asset.
The financial asset will be initially be recognized at sh. 1,000,000 and at the end of the period it
is remeasured to sh. 1,200,000. Therefore the difference of sh. 200,000 is recorded as an income
in the financial statements.
Illustration
Bent Ltd issued a bond for sh. 510,000 on 1 January 2011. The bond will be redeemed on 31
December 2012 for sh. 600,000. No interest is payable on the bond but the effective interest rate
is 6%. Account for the financial instrument.
The bond is a financial liability to Bent Ltd and it is measured at amortised cost. The finance cost
of the bond is the difference between its initial cost and the price at which it will be redeemed.
In 2011, interest cost is sh. 30,600 (6% x 510,000) while the financial liability as at 31 December
2011 is sh. 540,600 (510,000 + 30,600).
2.3.5 Impairment
At the end of each year, an entity should assess whether there is any objective evidence that a
financial asset or group of assets is impaired. IAS 39 gives examples of several indications that a
financial asset or group of assets may be impaired;
The disappearance of an active market for that financial asset because of financial
difficulties
Amortised Cost
The amortised cost of a financial asset or liability is: initial cost + interest repayments
The interest will be charged at the effective interest rate (i.e. the internal rate of return). The
effective interest rate method is a method of calculating the amortised cost of a financial liability
or financial asset using the effective interest rate and of allocating the interest.
Illustration
Mark Lynch Ltd issued a bond with a sh. 50,000 nominal value at a 16% discount on 1 January
2005. The issue costs were sh. 2,000. Interest of 5% of the nominal value is payable annually in
arrears. The bond will be redeemed after 5 years at a premium of sh. 4,611. The effective interest
rate is 12% p.a. Determine the entries to be made in the financial statements.
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Net proceeds
Face value
50,000
(8,000)
(2,000)
40,000
Repayments
Capital
50,000
Premium on redemption
4,611
Principal to be redeemed
54,611
12,500
67,111
27,111
The following is a table to show the closing liabilities at the end of each year.
Year
Opening balance
Payments
Closing balance
40,000
4,800
(2,500)
42,300
42,300
5,076
(2,500)
44,876
44,876
5,385
(2,500)
47,761
47,761
5,731
(2,500)
50,992
50,992
6,119
(2,500)
54,611
27,111
(12,500)
The effective interest is posted in the income statement per annum (i.e. 4,800 interest expense in
year 1; 5,076 interest expense in year 2 and so on) while the payment of 2,500 per annum is
posted to the cash flow statement. The closing balances are posted in the statement of financial
position as liability (i.e. 42,300 liability in year 1; 44,876 liability in year 2 and so on).
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the contractual rights to the cash flows of the financial asset have expired.
the financial asset has been sold and the transfer qualifies for derecognition because
substantially all the risks and rewards of ownership have been transferred from the seller
to the buyer.
Note: If the risks and rewards of ownership of the investment still lie with the entity, then no
derecognition should be done. A financial liability should be derecognized when the obligation
specified in the contract is discharged, cancelled or expires.
On derecognition, the difference between the carrying amount of the asset or liability and the
amount received or paid for it should be derecognized in the profit or loss for the period.
Information about the nature and extent of risks arising from financial instruments.
Any reason for reclassification between fair value and amortised cost or vice-versa
The carrying amount of financial assets the entity has pledged as collateral for liabilities
or contingent liabilities
Details of the assets and exposure to risk where the entity has made a transfer such that
part or all of the financial assets do not qualify for derecognition
Interest income/expense
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Accounts receivable - are amounts owed by customers on account. They result from the
sale of goods and services. These receivables are expected to be collected within 30 to 60
days. They are the most significant type of claim held by a company.
Notes receivable - are claims for which formal instruments of credit are issued as proof
of the debt. A note receivable normally extends for times period of 60 to 90 days or
longer and requires the debtor to pay interest. Notes and accounts receivables that result
from sales transactions are often called trade receivables.
Other receivables they include non-trade receivables. Examples are interest receivable,
loans to company officers, advances to employees, and income taxes refundable. These
are unusual. Therefore they are classified and reported as separate items in the statement
of financial position.
1,000
Sales
July 5
1,000
100
26
100
July 11
Cash
882
Sales discount
18
900
The chance to receive a cash discount usually occurs when a manufacturer sells to a wholesaler
or wholesaler sells to a retailer. A discount is given in these situations either to encourage prompt
payment or for competitive reasons.
xx
xx
27
Bad debts expense is often recorded in a period different from the period in which the revenue
was recorded. Hence the matching concept is ignored with regard to bad debts expense and sales
revenues in the income statement. Hence this method is not acceptable for financial reporting
purposes.
Allowance Method
The allowance method of accounting for bad debts involves estimating uncollectible accounts at
the end of each period. This provides better matching on the income statement and ensures that
receivables are stated at their cash or net realizable value on the balance sheet.
Cash or net realizable value is the net amount expected to be received in cash. It excludes
amounts that the company estimates it will not collect. Receivables are therefore reduced by
estimated uncollectible receivables in the balance sheet through use of this method.
The allowance method is required for financial reporting purpose when bad debts are material in
amount. It has three essential features namely;
Estimated uncollectibles are debited to Bad Debts Expense and are credited to Allowance
for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of
each period.
When a specific account is written off, actual uncollectibles are debited to Allowance for
Doubtful Accounts and credited to Accounts Receivable.
Illustration
Using the allowance method, assume that Cathy Furniture Ltd has credit sales of sh. 1,200,000 in
2011. Of this amount, sh. 200,000 remains uncollected at December 31. The credit manager
estimates that sh. 12,000 of these sales will be uncollectible. The adjusting entry to record the
estimated uncollectibles is:
DR. Bad Debt Expense
12,000
12,000
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Bad debts expense is reported in the income statement as an operating expense (usually as a
selling expense). Thus, the estimated uncollectibles are matched with sales in 2011.The expense
is recorded in the same year the sales are made.
Allowance for Doubtful Accounts shows the estimated amount of claims on customers that are
expected to become uncollectible in the future. This contra account is used instead of a direct
credit to Accounts Receivables because we do not know which customers will not pay. The
credit balance in the allowance account will absorb the specific write-offs when they occur. It is
deducted from accounts receivable in the current assets section of the statement of financial
position.
500
500
Bad Debts Expense is not increased when the write-off occurs. Under the allowance method,
every bad debt write-off is debited to the allowance account rather than to Bad Debts Expense. A
debit to Bad Debts Expense would be incorrect because the expense has already been recognized
when the adjusting entry was estimated for bad debts. Instead, the entry to record the write off of
an uncollectible account reduces both Accounts Receivable and the Allowance for Doubtful
Accounts. After posting, the general ledger accounts will appear as follows;
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Accounts Receivable
Jan. 1 Bal. b/d
200,000
199,500
Mar. 1
500
500
12,000
11,500
A write off affects only balance sheet accounts. The write off of the account reduces both
Accounts Receivable and Allowance for Doubtful Accounts. Cash realizable value in the balance
sheet, therefore, remains the same, as shown below;
Before write-off
After write-off
Accounts Receivable
200,000
199,500
12,000
11,500
188,000
188,000
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Illustration
Assume that on July 1, R. A. Ware pays the $500 amount that had been written off on March 1.
The entries are as follows;
July 1
500
Cash
500
500
500
Percentage of sales
In this basis, management estimates what percentage of credit sales will be uncollectible. This
percentage is based on past experience and anticipated credit policy. The percentage is applied to
either total credit sales or net credit sales of the current year.
Illustration
Assume that Gonzalez Company elects to use the percentage of sales basis. It concludes that one
percent of net credit sales will become uncollectible. If net credit sales for 2011 are $800,000,
the estimated bad debts expense is $8,000(1%*800,000). The journal entry is as follows;
Dr. Bad debts Expense
8,000
8,000
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This basis of estimating uncollectibles emphasizes the matching of expenses with revenues. As a
result, bad debts expense will show a direct percentage relationship to the sales base on which it
is computed. When the adjusting entry is made, the existing balance in allowance for doubtful
accounts is disregarded. The adjusted balance in this account should be a reasonable
approximation of the uncollectible receivables. If actual write-offs differ significantly from the
amount estimated, the percentage for future years should be modified.
Percentage of receivables
In this basis, management estimates what percentage of receivables will result in losses from
uncollectible accounts. An aging schedule is prepared, in which customer balances are classified
by the length of time they have been unpaid. Because of its emphasis on time, the analysis is
often called aging the accounts receivables.
After the accounts are aged, the expected bad debt losses are determined. This is done by
applying percentages based on past experience to the total in each category. The longer a
receivable is past due, the less likely is to be collected. Hence, the estimated percentage of
uncollectible debts increase as the number of days past due increases. An aging schedule for Dart
Company is shown below. Note the increasing percentages from 2 to 40%.
Total estimated bad debts for Dart Company ($2,228) represents the amount of existing customer
claims expected to become uncollectible in the future. This amount represents the required
balance in allowance for doubtful accounts at the balance sheet date. The amount of the bad debt
adjusting entry is the difference between the required balance and the existing balance in the
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allowance account. If the trial balance shows Allowance for Doubtful Accounts with a credit
balance of $528 an adjusting entry for $1,700 ($2,228 $528) is necessary as shown below:
Dr. Bad debts expense
1700
1700
The percentage of receivables method will normally result in better approximation of cash
realizable value. But it will not result in the better matching of expenses with revenues if some
customers accounts are more than one year past due. In such a case, bad debts expense for the
current period would include amounts related to the sales of a prior year.
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Time (years) =
Interest
Example
Terms of the Note
Interest Computation
1000
1000
Valuing short-term receivables is the same as valuing accounts receivable. Just like accounts
receivable, short-term notes receivables are reported at their cash (net) realizable value. The
notes receivable allowance account is Allowance for Doubtful Accounts. The estimations
involved in determining cash realizable value and in recording bad debts expense and related
allowance are similar.
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Illustration
Assume that Betty Ltd lends Canton Ltd $10,000 on June 1, accepting a 4-month, 9% interest
note. Interest will be $300 ($10,000 * 9% * 4/12). The amount due, the maturity value, will be
$10,300. To obtain payment, Betty Ltd (the payee) must present the note either to Canton Ltd
(the maker) or to the makers duly appointed agent, such as a bank. Assuming that Betty Ltd
presents the note to Canton Ltd on the maturity date, the entry by Betty Ltd to record the
collection is;
October 1
Cash
10,300
Notes Receivable
10,000
Interest Revenue
300
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October 1
10,300
Notes Receivable
10,000
Interest Revenue
300
If there is little chance of collection, the face value of the note would be written off by debiting
the Allowance for Doubtful Accounts. No interest revenue would be recorded because collection
will not occur.
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4.1.2 Net realizable value is the estimated selling price in the ordinary course of business less
the estimated costs of completion and estimated costs relevant to make the sale.
4.1.3 Fixed production overheads are indirect costs of production that remain relatively
constant regardless of the volume of production e.g. costs of factory management.
4.1.4 Variable production overheads are indirect costs of production that vary directly with the
volume of production e.g. indirect materials and indirect labour.
There are several methods which in theory can be used to value inventory.
Historical cost
However, IAS 2 Inventories states that inventories should be measured at the lower of cost and
net realizable value.
4.2 Measurement
The cost of inventories will consist of all of the following;
Purchase cost
Conversion costs
Other costs incurred in bringing the inventories to their present location and condition.
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Transport, handling and any other cost directly attributable to the acquisition of finished
goods, services and materials; less
Fixed and variable production overheads that are incurred in converting materials into
finished goods allocated in a systematic basis.
IAS 2 emphasises that fixed production overheads must be allocated to items of inventory on the
basis of normal capacity of the production facilities.
Storage costs
Administrative costs
Selling costs
Illustration
The Derrick Wholesale Beverage Company purchases soft drinks from producers and then sells
them to retailers. The company begins 2011 with merchandise inventory of $120,000 on hand.
During 2011 additional merchandise is purchased on account at a cost of $600,000. Sales for the
year, all on account, totalled $820,000. The cost of soft drinks sold is $540,000. Derrick uses the
perpetual inventory system to keep track of both inventory quantities and inventory costs. The
following journal entries record the above transactions.
Dr. Inventory
600,000
600,000
820,000
820,000
540,000
Cr. Inventory
540,000
The importance of the perpetual system is that it is designed to track inventory quantities from
their acquisition to their sale. If the system is accurate, it allows management to determine how
many goods are on hand on any date without having to take a physical count. However, physical
counts of inventory usually are made anyway, either at the end of the fiscal year or on a sample
basis throughout the year, to verify that the perpetual system is correctly tracking quantities. Any
differences between the quantity of inventory determined by the physical count and the quantity
of inventory according to the perpetual system could be caused by system errors, theft, breakage,
or spoilage. In addition to keeping up with inventory, a perpetual system also directly determines
how many items are sold during a period.
39
Illustration
The Derrick Wholesale Beverage Company purchases soft drinks from producers and then sells
them to retailers. The company began 2011 with merchandise inventory of $120,000 on hand.
During 2011 additional merchandise was purchased on account at a cost of $600,000. Sales for
the year, all on account, totalled $820,000. Derrick uses a periodic inventory system. A physical
count determined the cost of inventory at the end of the year to be $180,000. The following
journal entries record the above transactions.
Dr. Purchases
600,000
600,000
820,000
820,000
40
The choice between the two approaches usually is motivated by management control
considerations as well as the comparative costs of implementation. Perpetual systems can
provide more information about the dollar amounts of inventory levels on a continuous basis.
They also facilitate the preparation of interim financial statements by providing fairly accurate
information without the necessity of a physical count of inventory. On the other hand, a
perpetual system may be more expensive to implement than a periodic system. This is
particularly true for inventories consisting of large numbers of low-cost items. Perpetual systems
are more workable with inventories consisting of high-cost items such as construction equipment
or automobiles.
Periodic Average Cost. In a periodic inventory system, this weighted average is calculated at
the end of the period as follows;
Weighted-average unit cost = Cost of goods available for sale
Quantity available for sale
Perpetual Average Cost. The weighted-average unit cost in a perpetual inventory system
becomes a moving-average unit cost. A new weighted-average unit cost is calculated each time
additional units are purchased. The new average is determined after each purchase by first
41
adding the cost of the previous inventory balance and the cost of the new purchase, and second
dividing this new total cost by the number of units on hand. This average is then used to cost any
units sold before the purchase is made.
Illustration
Delta Ltd began the year 2011 with sh. 44,000 of inventory. The opening inventory was
composed of 8,000 units purchased for sh. 11 each. The merchandise transactions were as
follows;
Purchases
Date of purchase
units
unit cost
total cost
January 15
2,000
12
24,000
March 20
6,000
14
84,000
October 15
6,000
15
90,000
Totals
14,000
198,000
Sales
Date of sale
units
January 10
4,000
April 30
3,000
November 20
6,000
13,000
42
Required
Determine the cost of sales using the following inventory valuation techniques
i)AVCO and ii)FIFO
88,000
+ Purchases
198,000
286,000
(117,000)
Cost of sales
169,000
Workings
Weighted average cost/unit = 286,000/22,000 units = sh. 13.00
9,000 units x sh. 13 = sh. 117,000
Purchased
Sold
Balance
8,000 x sh. 11
b/d
= sh. 88,000
4,000 x sh. 11 = 4,000 x sh. 11
Jan. 10
sh. 44,000
Jan. 15
= sh. 44,000
44,000
24,000 = sh.
Mar. 20
68,000
68,000
84,000 = sh.
sh.152,000/12,000 = sh.12.67/unit
Apr. 30
152,000
3,000 x sh. 12.67 9,000
sh.
= sh. 38,000
sh.
12.67
114,000
43
Oct. 15
114,000
90,000 = sh.
sh.204,000/15,000= sh. 13.60/unit
Nov. 20
204,000
6,000 x sh. 13.60 9,000
sh.
= sh. 81,600
sh.
13.60
122,400
Sh. 163,600
88,000
+ Purchases
198,000
286,000
(132,000)
Cost of sales
154,000
Workings
March 20
October 15
Total
sh. 132,000
In a perpetual inventory system the cost of sales will be sh. 154,000 just like in a periodic
inventory system above since the same units and costs are first in and first out.
44
If at the end of the accounting period a business still has goods in inventory which are either
worthless or worth lower than their original cost, then the value of inventories should be written
down to;
Net realizable value, if the goods are worth less than their original cost.
Illustration
Dee Fashions has its financial year end at 31 December. On 1 January 2011 the company had
goods in inventory worth sh. 8,800,000. During the year the company purchased goods costing
sh. 48,000,000. Fashion goods which had cost sh. 2,100,000 were still held in inventory at 31
December 2011 and the management believes that these fashion goods can now be sold at a sale
price of sh. 400,000. The goods still held in inventory at the year end including the fashion goods
had an original purchase cost of sh. 7,600,000. Sales for the year were sh. 81,400,000. Determine
the gross profit at the year ending 31 December 2011.
Solution
Cost
Realisable value
Fashion goods
2,100,000
400,000
1,700,000
5,500,000
5,500,000
7,600,000
5,900,000
45
1,700,000
Dee Fashions
Income statement for the year ended 31 December 2011
Sales
81,400,000
8,800,000
Purchases
48,000,000
Closing inventory
(5,900,000)
(50,900,000)
Gross profit
30,500,000
46
Variations in contract work, claims and incentive payments: to the extent that they will
result in revenue that are capable of being reliably measured.
Costs that are attributable to contract activity in general and can be allocated to the
contract.
Such other costs that is specifically chargeable to the customer under the terms of the
contract.
Costs of moving plant, equipment and materials to and from the contract site.
47
Costs that may be attributable to contract activity in general and can be allocated to specific
contract include:
Insurance
Construction overheads
A construction contract mainly begins in one financial period and end in another thus creating a
challenge as to the contract income and costs that will be allocated to each financial period.
IAS 11 splits contracts into two;
5.1.4 Fixed Price Contract Is a contract in which the contractor agrees to a fixed contract
price or a fixed rate per unit of output which in some cases is subject to cost escalation clauses.
5.1.5 Cost Plus Contract Is a contract in which the contractor is reimbursed for the allowable
or otherwise defined costs + a % of these costs/ fixed fee.
ii.
iii.
iv.
Contract Revenue
xxx
xxx
xxx
Contract Costs
xx
xx
xx
Gross Profit
xxx
xxx
xxx
Operational Costs
xx
xx
xx
PROFIT/(LOSS)
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Computation of Work-in-Progress
sh
Costs to date
xx
Earnings to date
xx
Value to date
xx
xx
Work-in-Progress
xx
49
Contract Revenue
xxx
Contract Costs
xx
Gross Profit
xxx
Operational Costs
(xx)
(xx)
(xx)
PROFIT/(LOSS)
(xx)
(xx)
xxx
(xxx)
(xxx)
(xxx)
(xxx)
(xxx)
Computation of Work-in-Progress
sh.
Costs to date
xx
Earnings to date
xx
Value to date
xx
xx
Work-in-Progress
xx
50
Contractee Account
xxx
xxx
xxx
Bank
xxx
xxx
Work-in-Progress
xxx
Total Assets
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Assets
Equity
Retained Earnings
Liabilities
Bank overdraft
xxx
xxx
xxx
Illustration
Electine Construction Company Ltd entered into a contract to build an office block for Anex Ltd
on 15 October 2008. The construction was to start on 1 January 2009 and was to be completed in
three years. The contract price was sh. 850,000,000. The following information pertains the
contract as extracted from the books of Electine Construction Company Ltd.
2009
2010
2011
sh. 000
sh. 000
sh. 000
300,000
330,000
120,000
300,000
270,000
270,000
480,000
100,000
240,000
360,000
200,000
15,000
20,000
18,000
51
Required
Using the completed contract and percentage of completion methods;
a) Compute the realized gross profit for each of the three years ended 31 December.
b) Prepare the income statement extracts for each of the three years ended 31 December.
c) Prepare the statement of financial position extracts for each of the three years ended 31
December.
a) Gross Profit
i)Percentage of Completion Method
2009
2010
2011
000
000
000
425,000
170,000
255,000
Contract costs
300,000
330,000
120,000
Gross profit
125,000
160,000
135,000
2009
2010
2011
000
000
000
850,000
Contract costs
750,000
Gross profit/(loss)
100,000
2009
2010
2011
000
000
000
Gross profit/(loss)
125,000
(160,000)
135,000
(15,000)
(20,000)
(18,000)
110,000
(180,000)
117,000
110,000
(70,000)
110,000
(70,000)
47,000
52
2010
2011
000
000
000
Gross profit/(loss)
100,000
(15,000)
(20,000)
(18,000)
(15,000)
(20,000)
82,000
(15,000)
(35,000)
(15,000)
(35,000)
47,000
2009
2010
2011
000
000
000
Work-in-progress (W.2)
155,000
30,000
150,000
50,000
185,000
150,000
50,000
110,000
(70,000)
47,000
155,000
75,000
65,000
3,000
185,000
150,000
50,000
Assets
Liabilities
53
2010
2011
000
000
000
Work-in-progress (W.2)
30,000
30,000
150,000
50,000
60,000
150,000
50,000
(15,000)
(35,000)
47,000
120,000
75,000
65,000
3,000
60,000
150,000
50,000
Assets
Liabilities
Workings
1. Contract Revenue
Costs to date
300,000,000
630,000,000
750,000,000
Costs to completion
300,000,000
270,000,000
Total costs
600,000,000
900,000,000
750,000,000
Costs to date
300,000,000
630,000,000
750,000,000
Total costs
600,000,000
900,000,000
750,000,000
50%
70%
100%
% of completion
54
Contract revenue
2009
2010
2011
2. Work-in-progress
i)Percentage of Completion Method
2009
2010
Costs to date
300,000,000
630,000,000
Earnings to date
125,000,000
(35,000,000)
Value to date
425,000,000
595,000,000
(270,000,000)
(750,000,000)
155,000,000
155,000,000
2009
2010
Costs to date
300,000,000
630,000,000
Earnings to date
Value to date
300,000,000
630,000,000
(270,000,000)
(750,000,000)
30,000,000
(120,000,000)
2009
2010
2011
270,000,000
750,000,000
850,000,000
(240,000,000)
(600,000,000)
(800,000,000)
30,000,000
150,000,000
50,000,000
3. Contractee Account
55
4. Bank Account
2009
2010
2011
Collections to date
240,000,000
600,000,000
800,000,000
(300,000,000)
(630,000,000)
(750,000,000)
(15,000,000)
(35,000,000)
(53,000,000)
Balance c/d
(75,000,000)
(65,000,000)
(3,000,000)
56
6.1.2 Finance lease transfers substantially all the risks and rewards incident to ownership of an
asset. A finance lease is basically a way of financing the use of an asset (by spreading the
payment over the life of the asset instead of paying the full amount all at once).
6.1.4 Minimum lease payments these are the payments over the lease term that the lessee is or
can be required to make, excluding contingent rent, costs for services and taxes to be paid by and
be reimbursable to the lessor, together with;
For a lessee, any amounts guaranteed by the lessee or by a party related to the lessee
For a lessor, any residual value guaranteed to the lessor by one of the following,
o The lessee
o A party related to the lessee
o An independent third party financially capable of meeting this guarantee
6.1.5 Interest rate implicit in the lease it is the discount rate that, at the inception of the lease,
causes the aggregate present value of
a) The minimum lease payments, and
b) The unguaranteed residual value
To be equal to the sum of
a) The fair value of the leased asset, and
b) Any initial direct costs.
57
For a lessee, that part of the residual value which is guaranteed by the lessee or by a party
related to the lessee
For a lessor, that part of the residual value which is guaranteed by the lessee or by a third
party unrelated to the lessor who is financially capable of discharging the obligations
under the guarantee.
Unguaranteed residual value is that portion of the residual value of the leased asset, the
realization of which by the lessor is not assured or is guaranteed solely by a party related to the
lessor.
The minimum lease payments receivable by the lessor under a finance lease, and
Net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.
6.1.9 Lease term it is the non-cancellable period for which the lessee has contracted to lease
the asset together with any further terms for which the lessee has the option to continue to lease
the asset, with or without further payment, when at the inception of the lease it is reasonably
certain that the lessee will exercise the option.
A non-cancellable lease is a lease that is cancellable only in one of the following situations;
If the lease enters into a new lease for the same or an equivalent asset with the same
lessor
Upon payment by the lessee of an additional amount such that, at inception, continuation
of the lease is reasonably certain
58
6.1.10 Inception of the lease it is earlier of the date of the lease agreement and the date of
commitment by the parties to the principal provisions of the lease. As this date;
In the case of a finance lease, the amounts to be recognized at the lease term are
determined.
The period over which an asset is expected to be economically usable by one or more
users, or
The number of production or similar units expected to be obtained from the asset by one
or more users.
6.1.12 Useful life it is the estimated remaining period, from the beginning of the lease term,
without limitation by the lease term, over which the economic benefits embodied in the asset are
expected to be consumed by the entity.
6.1.13 Contingent rent is that portion of the lease payments that is not fixed in amount but is
based on a factor other than just the passage of time.
59
7. Gains/losses from fluctuations in the fair value of the residual fall to the lessee (e.g. by means
of a rebate of lease payments).
8. The lessee has the ability to continue the lease for a secondary period at a rent that is
substantially lower than market rent.
The lease payments are split between the finance charge and the repayment of the outstanding
liability, that is, interest expense and the principal. The leased asset is depreciated over the
shorter of;
Any initial direct costs of the lessee are added to the amount recognized as an asset.
ii) Lessor
The lessor has no control of the asset hence he recognizes the lease as a receivable. The carrying
value is the lessors net investment in the lease.
The net investment in the lease equals;
the present value of any unguaranteed residual value accruing to the lessor.
The finance income is also recognized based on a pattern that gives a constant periodic rate of
return on the lessors net investment outstanding in respect of the lease in each period.
Initial indirect costs incurred by lessors are included in the initial measurement of the finance
lease receivable.
ii) Lessor
He recognizes the lease property as an asset. Also depreciation on the property is recognized in
the financial statements. Rental income from the operating lease is recognized in the income
statement on a straight line basis over the lease term unless another systematic and rational basis
is more appropriate.
Initial indirect costs incurred by lessors in negotiating and arranging this lease should be added
to the carrying amount of the leased asset and recognized as an expense over the lease term on
the same basis as lease income.
Illustration
On 1 January 2011 Flanc Ltd leased to Denise Ltd a new machine that cost sh. 60 million. The
lease is a finance lease whereby Denise Ltd has to pay all executor costs and assume other risks
and costs of ownership. The lessor computed the periodic payments at an amount that will yield
an annual return on cost of 10% and the lessee also uses 10% to record the lease and calculate
the interest expense. The machine is expected to have a nil residual value at the end of the four
year lease term. Both the lessor and lessee have accounting years ending December 31.
61
Required:
a) Calculate the periodic lease payments throughout the lease term assuming the annual
payments are payable at end of each year.
b) Calculate the periodic lease payments throughout the lease term assuming the annual
payments are payable at the start of each year.
c) The income statement extract and statement of financial position extract as at the year 2011
for both cases (a) and (b). [Give extracts for both annual payments payable at the year end and
payments payable at the year start].
Solution
a) The annual payments payable at the end of the year are;
60,000,000
PVIFA4yrs, 10%
60,000,000
3.16987
2012
Depreciation
15,000,000
15,000,000
Interest cost
4,279,000
2,987,000
2012
Depreciation
15,000,000
15,000,000
Interest cost
6,000,000
4,707,000
62
2012
45,000,000
30,000,000
Non-current liability
32,852,000
17,210,000
Current liability
14,220,000
15,642,000
Assets
Machine
Liabilities
2012
45,000,000
30,000,000
Non-current liability
32,851,000
17,208,000
Current liability
14,221,000
15,643,000
Assets
Machine
Liabilities
Workings
1. Amortization table for annual payments payable at the start of the year
Year
Opening balance
Cash flows
Closing balance
60,000,000
(17,207,000)
4,279,000
47,072,000
47,072,000
(17,207,000)
2,987,000
32,852,000
32,852,000
(17,207,000)
1,565,000
17,210,000
17,210,000
(17,207,000)
63
2. Amortization table for annual payments payable at the end of the year
Year
Opening balance
Cash flows
Closing balance
60,000,000
6,000,000
(18,928,000)
47,072,000
47,072,000
4,707,000
(18,928,000)
32,851,000
32,851,000
3,285,000
(18,928,000)
17,208,000
17,208,000
1,721,000
(18,928,000)
A sale and leaseback transaction leading to a finance lease, the resulting profit or loss
should be deferred and amortised in the financial statements of the seller/lessee over the
lease term.
Also, in an operating lease where the fair value of the asset at the time of the sale is less than the
carrying amount, the loss should be recognized immediately.
64
The net carrying amount at the year end for each class of asset
A Reconciliation between the total of minimum lease payments at the year end and their
present value
The total of future minimum sublease payments expected to be received under noncancellable subleases at the year end
Lessor
A reconciliation between the total gross investment in the lease at the year end and the
present value of minimum lease payments receivable at the year end
The total of future minimum lease payments under non-cancellable operating lease for
each of the following periods;
o Not later than one year
o Later than one year and not later than five years
o Later than five years
The total of future minimum sublease payments expected to be received under noncancellable subleases at the year end
65
Lease and sublease payments recognized as an expense for the period, with separate
amounts for minimum lease payments, contingent rents and sublease payments
Lessor
For each class of asset, the gross carrying amount, the accumulated depreciation and
accumulated impairment losses at the year end
The future minimum lease payments under non-cancellable operating leases in the
aggregate and for each of the following periods;
o Not later than one year
o Later than one year and not later than five years
o Later than five years
66
7.1.2 Non-current Assets They are assets that a business/entity has acquired for use in the
business and lasts more than 1 year e.g. land & buildings, furniture and fittings & motor vehicles.
7.1.4 Revenue Expenditure It is expenditure which is incurred for either of the following
reasons;
For the purpose of the trade of the business. This includes expenditure classified as
selling and distribution expenses, administration expenses and finance charges.
7.1.5 Capital Income It is the proceeds from the sale of non-trading assets (i.e. proceeds from
the sale of non-current assets, including long term investment). The profits (or losses) from the
sale of non-current assets are included in the income statement of a business, for the account
period in which the sale takes place.
67
7.1.7 Residual Value It is the amount which an entity expects to receive on the sale of a non
current asset after using the asset.
7.1.8 Fair Value It is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date.
7.1.9 Carrying Amount It is the amount in which an asset is recognized after deducting any
accumulated depreciation and accumulated impairment losses.
It is probable that future economic benefits associated with the item will flow to the
entity
The asset is initially recognized at cost. The following form part of the cost of an asset;
Directly attributable costs of bringing the asset to working condition for intended use
Initial estimate of the costs of dismantling and removing the item and restoring the site
on which it is located.
The measurement of property, plant and equipment subsequent to initial recognition is either;
Cost model carry the asset at cost less depreciation and any accumulated impairment losses.
Revaluation model carry the asset at revalued amount, i.e. fair value less subsequent
accumulated depreciation any accumulated impairment losses.
68
7.3 Depreciation
A non-current asset has a cost and may have a limited useful life hence its value eventually
declining. It follows that charge should be made in the income statement to reflect the usage that
is made of the asset by the business/entity. This charge is called deprecation.
Example
A Mercedes Benz E240 was purchased at 60,000. It has a useful life of 20 years. Determine the
depreciation expense per year.
60,000 = 3000p.a
20
Are held by an enterprise for use in the production or supply of goods and services,
for rental to others or for administrative purposes.
Depreciation accounting is governed by IAS 16 Property, Plant and Equipment. This standard
requires a depreciable amount to be allocated on a systematic basis to each accounting period
during the useful life of the asset.
69
When determining the useful life of an asset the following factors should be considered
(i)
(ii)
(iii)
Time factors
(iv)
Legal factors
70
Solution
Depreciation expense = years remaining + 1
Depreciable amount
n (n + 1) / 2
Year 1
Year 2
Year 3
Year 4
Year 5
Example
An asset costing Sh. 600,000 has an estimated life of 5 years. The residual value is Sh. 70,000.
Determine the annual depreciation charge and the value of the non current asset in each of the 5
years.
Solution
Annual depreciation = 600,000 70,000 = 106,000
5
Accumulated depreciation is the total depreciation up to the current period. For instance
accumulated depreciation for year 2 is the total depreciation expense for year 1 plus year 2.
71
Accumulated depreciation for year 3 is the total depreciation expense for year 1 plus year 2 plus
year 3. The net book value (NBV) is the net of the cost of the asset and the accumulated
depreciation.
Year
Depreciation expense
Accumulated depreciation
106,000
106,000
494,000
106,000
212,000
388,000
106,000
318,000
282,000
106,000
424,000
176,000
106,000
530,000
70,000
Example
GM Ltd purchased equipment at a cost of Sh. 100,000. The useful life is 3 years, the residual is
Sh. 21,600. The entity calculated that the rate of depreciation should be 40% of the reducing
value of the asset. Determine the annual depreciation charge of the 3 years and the value of the
machinery for each of the 3 years.
Solution
Year
Depreciation expense
Accumulated depreciation
40,000
60,000
36,000
72
Consistency is important. The depreciation method selected should be applied consistently from
period to period unless altered circumstances justify a change. When the method is changed, the
effect should be quantified and disclosed and the reason for the change should be stated.
7.4 REVALUATION
It mainly involves an upward adjustment of the value of the asset. It may also include a
downward adjustment. As a result of market or economic factors, it is common for market value
of non-current assets such as land and buildings to rise in spite of getting older.
If the assets rise in value the business/entity is not obliged to revalue the assets in the statement
of financial position. However to give a more true and fair view of the financial position of
the entity it may be appropriate to revalue some assets upwards.
When non-current assets are revalued, depreciation should be charged on the new amount,
however, following the prudence concept the increase in value should not be recorded a an
income since it will be realized until the asset is sold. The double entry is
Dr. Non-current asset
xx
xx
Example
Abdullah Inc. started business operations of selling/trading in car hire dealing on 1/1/2000. The
company purchased the business premises at a cost of Sh. 500,000 i.e. land worth Sh. 200,000
and buildings Sh. 300,000 with a nil residual value and a useful life of 30 years. On 1/1/2005,
73
Abdullah decided that his business premises were now worth Sh.1,500,000 i.e. land Sh. 750,000
and building Sh. 750,000.
Required
(i) Calculate the annual charge of depreciation for the 30 years.
(ii) Determine the net book value of land and buildings premises as at the end of 2005 and 2006.
Solution
i) Annual depreciation for the 30 years
Year 1 to 5 = 300,000/30 x 5 years = sh. 50,000 per annum
Year 6 to 30 = 750,000/25 = sh. 30,000 per annum
= 200,000
450,000
2006
Building (750,000 30,000) = 720,000
Land
= 750,000
1,470,000
7.5 DISPOSAL
Non-current assets are not purchased by a business with the intention of reselling them in the
normal course of trade. However, they might be sold off at some stage during their life, either
when their useful life is over or before then. A business might decide to sell off a non current
asset long before it useful life has ended. When a non-current asset is sold, there is likely to be a
profit or loss on disposal. This is the difference between the net sale price of the asset and its
carrying value at the time of disposal.
74
xx
xx
xx
xx
Being the total accumulated depreciation of the asset that is being disposed off
Dr. Cash/Debtor
xx
xx
Example
An entity purchased non-current assets on 1/1/2009 for $250,000. It had an estimated residual
value of $70,000. The asset was sold after 3 year on 1st January to another trader who paid
$175,000. Assuming the enterprise is using the straight-line method of depreciation, what is the
gain or loss on disposal.
Solution
Annual depreciation = 250,000 70,000
6
= $ 30,000 per year
$
Cost of the asset
250,000
(90,000)
160,000
Sales price
175,000
Gain on disposal
15,000
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Example
A business has machinery worth sh. 110,000 at cost. Depreciation is 20% p.a. straight line. The
total provision now stands at sh. 70,000. The business sells a machine at sh. 19,000 which it
purchased at sh. 30,000 exactly two years ago. Show the relevant ledger entries involved.
110,000
Machine disposal
30,000
Balance c/d
80,000
110,000
110,000
12,000
Balance c/d
58,000
Balance b/d
70,000
70,000
70,000
30,000
12,000
1,000
Cash
19,000
31,000
31,000
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something from which the entity expects future economic benefits to flow
8.1.2 Research it is original and planned investigation undertaken with the prospect of gaining
new scientific or technical knowledge and understanding.
8.1.5 Depreciable amount is the cost of an asset, or other amount substituted for cost, less its
residual value.
8.1.6 Useful life is the period over which an asset is expected to be available for use by an
entity or the number of production/similar units expected to be obtained from the asset by an
entity.
The IAS 38 Intangible Assets gives examples of activities which might be included in either
research or development, or which are neither but may be closely associated with both.
Research
-activities aimed at obtaining new knowledge
-the search for applications of research findings or other knowledge
-the search for product or process alternatives
-the formulation and design of possible new or improved product or process alternatives
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Development
-the design, construction and testing of pre-production prototypes and models
-the design of tools, jigs, moulds and dies involving new technology
-the design, construction and operation of a pilot plant that is not of a scale economically feasible
for commercial production
-the design construction and testing of a chosen alternative for new/improved materials
Illustration
Hanson Ltd is developing a new production process. During 2011, expenditure incurred was sh.
100,000,000 of which sh. 90,000,000 was incurred before 1 December 2011 and sh. 10,000,000
between 1 December 2011 and 31 December 2011. The company can show that, at 1 December
2011, the production process met the criteria for recognition as an intangible asset. The
recoverable amount of the know-how embodied in the process is estimated to be sh. 50,000,000.
Determine how the expenditure should be treated.
Solution
At the end of 2011, the production process is recognized as an intangible asset at a cost of sh.
10,000,000 since it is the expenditure incurred from the date when the recognition criteria were
met, that is 1 December 2011. The sh. 90,000,000 expenditure incurred before 1 December 2011
is expensed because the recognition criteria were not met. Therefore it will not be part of the cost
of production recognized in the statement of financial position.
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salaries and wages and other employment related costs of personnel engaged in R & D
activities
depreciation of property, plant and equipment to the extent that these assets are used for
R & D activities
overhead costs
other costs such as the amortization of patents and licences to the extent that these assets
are used for R & D activities
Research costs should be recognized as an expense in the period they are incurred.
Development costs will be recognized as an expense in the period they are incurred unless the
criteria for asset recognition presented below is met. Development costs initially recognized as
an expense should not be recognized as an asset in a later period.
Development expenditure should be recognized as an asset only when the business can
demonstrate ALL of the following;
(i) The technical feasibility of completing the intangible asset so that it will be available for
use or sale.
(ii) Its intention to complete the intangible asset and use or sell it.
(iii)Its ability to use or sell the intangible asset.
(iv)How the intangible asset will generate probable future economic benefits.
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(v) The availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset.
(vi)Its ability to measure reliably the expenditure attributable to the intangible asset during its
development.
8.4 Disclosure
The financial statements should disclose the accounting policies for intangible assets that have
been adopted. For each class of intangible assets disclosure is required of the following;
a reconciliation of the carrying amount as at the beginning and at the end of the period
Illustration
There may be difficulties in establishing the useful life of an intangible asset and hence
judgement would be needed. How would you determine the useful life of a purchased brand
name?
Solution
The factors to consider would be;
The stability and geographical spread of the market in which the branded products are
sold
The pattern of benefits that the brand name is expected to generate over time
The intention of the entity to use and promote the brand name over time
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REFERENCES
Horngren, C.T., Harrison, W.T. and Bamber, L.S. (2005). Accounting. 6th Ed., Pearson Prentice
Hall.
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