119 terms

AAT LEVEL 4: Financial statements of Limited Companies

What are the 4 general aims of financial statements?
- To identify how well the business has performed in the period
- To identify the value of assets & liabilities of the business
- To help understand the cashflow position of the company
- To communicate these things to the users of the accounts in as clear a manner as is possible
Name 4 advantages of trading as a limited company
- Limited liability status
- Easier to raise finance
- Company continues to operate regardless of the ownership
- Taxed under corporation tax
Name 4 disadvantages of trading as a limited company
- Company accounts must be submitted at Companies House & anyone can access them
- More regulation to comply with (Companies Act 2006)
- Accounts of larger companies must be audited
- Issues of shares are highly regulated
What are the 5 components of financial statements? (As required by IAS1)
- Statement of profit & loss
- Statement of financial position
- Statement of changes in equity
- Statement of cashflows
- Notes to the financial statements
What is the formula for equity?
Share capital + retained profit - other reserves
Define 'nominal value of shares'
The faces value of shares, which is decided at the time of issue and will remain the same going forward
Define 'market value of shares'
This is the value which existing shares can be traded at, the price the owner of the shares will charge someone else to buy them
Define 'authorised share capital'
The total number of shares a company can issue
Define 'allotted share capital'
The shares which have actually been issued
What are ordinary shares?
Have voting rights attached and ordinary shareholders can receive a dividend at the discretion of the directors
What are preference shares?
Shares which carry the right to a fixed rate dividend (which is paid before any dividend to ordinary shareholders), and they do not have voting rights
What is the double entry when shares are issued at nominal value?
Dr Bank
Cr Share capital
What is included in retained profits?
Retained earnings b/fwd + Current year profit - Dividends = Retained earnings c/fwd
What are other reserves that could be seen included in the equity section of company accounts?
- Share premium account
- Revaluation reserve
- Capital redemption reserve
- General reserve
What 4 things are included in the regulatory framework?
- International Accounting Standards (IAS's)
- International Financial Reporting Standards (IFRS's)
- Companies Act 2006
- Framework for the Preparation and Presentation of Financial Statements
What does the IFRS Foundation do?
They appoint the IASB, Advisory council & Interpretations Committee members, raise funds for the IASB and monitor the IASB's effectiveness
What does the IFRS Advisory council do?
They take recommendations from individuals, corporations and national standard setters and then provides advise to the IASB on priority areas of accounting
What does the IASB do?
Set International accounting standards (IFRS's, and previously, IAS's)
What does the IFRS Interpretations Committee do?
Reports to the IASB with interpretations of IFRSs and in the context of the Framework, provides guidance on financial reporting issues not specifically addressed by IFRSs
What is the process of setting standards? (5 things)
1) Topic is identified
2) Topic is discussed and the IASB may set up a working group
3) Discussion paper is issued and public comment invited
4) An exposure draft is issued (circulated to accountancy bodies, government and all other interested parties) for public comment
5) IASB consults with SAC (Standards Advisory Council) and working groups before an iFRS is voted on and issued
What 3 things are directors responsible for under the Companies Act 2006?
- Keeping proper accounting records
- Responsible for preparing the financial statements, having them audited and presenting them to shareholders in a general meeting
- Filing the accounts at Companies House
What is the conceptual framework?
Is produced by the IASB & sets out some generally accepted accounting principles which apply to preparation and presentation of financial statements.
Name 4 advantages of a principle based approach over a rules based approach
- An individual must use their judgement in applying the Framework, rather than following a tick box exercise
- As there are no individual scenarios, it is less likely to go out of date
- When following a principle it is harder to avoid the requirements
- The spirit of the regulation can be followed where there is no specific accounting treatment
What seven sections is the Conceptual framework broken down into?
- The objectives of the financial statements
- The users and their information needs
- The underlying assumptions of the financial statements
- The qualitative characteristics of the financial statements
- The elements of the financial statements
- Recognition of the elements in the financial statements
- Measurement of elements in the financial statements
What is the objective of general purpose financial reporting?
To provide information about the reporting entity that is useful to existing and potential investors, lenders and other payables in making decisions about providing resources to the entity.
What does the accruals concept say?
That costs and revenues should be matched together and included in the period to which they relate
Define 'going concern'
The assumption that the business will continue trading for the foreseeable future (next 12 months)
Financial information can make a difference to decisions if it has: (3 things)
- Predictive value (can be used to predict future outcomes)
- Confirmatory value (provides feedback about previous evaluation)
- Information's relevance is affected by its nature and materiality
The conceptual framework states that information that is relevant and faithful represented can be enhanced by the 4 'enhancing qualitative characteristics, what are these?
- Comparability
- Verifiability
- Timeliness
- Understandability
Define 'assets'
A resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise
Define 'liabilities'
A present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits
Define 'equity'
The residual interest in the assets of an entity after deducting all its liabilities
Define 'income'
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 owners
Define 'expenses'
Decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or increases of liabilities that result in decreases in equity, other than those relating to distributions to owners
An element of the financial statements should be recognised if it... (3 things)
- Meets the definition of an element
- It is probable that future economic benefits associated with the item will flow either to or from the entity
- The item has a cost of value that can be reliably measured
What is the historical cost?
Original price paid
What is the current cost?
Measured at replacement cost, what it would cost if you bought it today
What is the realisable value?
Measured at the amount you would receive if you sold the asset today
What is the present value?
Measured at the discounted value of all future cash flows
What are the 5 fundamental ethical principles as according to the AAT?
- Integrity
- Objectivity
- Professional (and technical) competence and due care
- Confidentiality
- Professional behaviour
IAS1 requires compliance with 5 fundamental accounting concepts..
- Accruals
- Going Concern
- Consistency
- Offsetting
- Materiality and aggregation
What are bonus shares?
- Can give away free or bonus shares to existing shareholders
- No money received
- In proportion to their existing holding
- Share capital must increase by the number of shares issued x nominal value
What are rights shares?
- Company offers shares to existing shareholders, for higher than nominal value but lower than market value
- In proportion to their existing holding
What things re the shares have to be disclosed within the financial statements?
- The number of shares authorised
- The number of shares issued and paid for
- The nominal value of the share
- Class of share
What is the revaluation reserve?
Used when an asset is revalued, it is a non distributable reserve
What is retained earnings?
The accumulation of profits and losses made over the year after deducting and dividends
What 3 disclosures are necessary in relation to reserves?
- Each reserve should have a description to its nature and purpose
- There should be a reconciliation between the brought forward and the carry forward amounts
- Any proposed dividends which have not been approved by the year end should also be disclosed, giving the date of declaration and the amount of the dividend
When should a dividend be included?
Date when it was declared
IAS 1 states that line items must be presented for.. (6 things)
- Revenue
- Finance cost
- Share of the profit of associate
- Tax expense
- Post tax profit from discontinued operations
- Profit of loss
What is a cash equivalent?
Short term, highly liquid investments which are readily convertible into known amounts of cash
What is the indirect method (of calculating operating activities)?
- More commonly used
- Net profit or loss is adjusted for non cash items and working capital adjustments
What is the direct method (of calculating operating activities)?
- Shows actual cash receipts & payment from customers and to suppliers
- More difficult to prepare as information is not readily available
What are operating activities?
The cash flows from the normal revenue producing activities of the business
What are investing activities?
The cash flows from the acquisition and disposal of non current assets and cash returns from investments (dividends and interest)
What are financing activities?
The cash flows which result in a change in the size and composition of the contributed equity (share capital) and borrowings of the entity
If you were to use the indirect method, you would start with the profit before interest and tax and then make 3 adjustments, what are these?
1) Non-cash items e.g. depreciation
2) Items that are dealt with elsewhere e.g. investment income
3) Working capital movements
Give 5 examples of non cash adjustments
1) Depreciation
2) Amortisation
3) Profit on disposal of a NCA
4) Loss on disposal of a NCA
5) Movement in provision
What are the two requirements for something to be included in property, plant and equipment?
1) Held for use in the production or supply of goods or services, for rental to others, or for admin purposes
2) Expected to be used for more than one accounting period
What is the framework recognition criteria for a non-current asset?
1) It is probable that future economic benefits associated with the item will flow to the entity
2) The cost of the item can be measured reliably
Give examples of directly attributable costs (for a NCA)?
- Salaries paid to employees for constructing the asset
- Cost of site preparation
- Delivery and handling costs
- Installation and assembly costs
- Cost of testing the asset to ensure it is functioning correctly
- Professional fees
- Non refundable taxes and other acquisition costs (duties)
Give examples of costs that are NOT directly attributable costs
- Costs of opening the facility
- Admin or general overheads
- Costs of advertising
- Costs of conducting business
- Initial operating losses
Define expense (in relation to a NCA)
Any repairs or maintenance expense which puts the asset back to its original condition
Define enhancement (in relation to a NCA)
Any expenditure that results in an enhancement to the performance of the asset e.g. upgrading a machine to improve its output
What are the two methods of dealing with the measurement of a NCA?
1) Cost model - cost less acc. depreciation
2) Revaluation model - Fair value less any acc. dep
What is the frequency of valuation?
They should be made with sufficient frequency that the carrying amount of the asset doesn't differ materially from its actual fair value
What is depreciation?
The systematic allocation of the depreciable amount of an asset over its useful life
What asset should not be depreciated?
What are the two most common methods of depreciation?
Straight line and reducing balance
How often should the method of depreciation and the useful life be reviewed?
How would you calculation the depreciation if the rate of depreciation or the useful life has altered?
NBV - residual value / remaining useful life
When should an asset be derecognised?
- It is disposed of; or
- When no future economic benefits are expected from its use of disposal
What recognition criteria is set out in the Framework for intangible assets?
- It is probably that the expected future economic benefits attributed to the asset will flow to the entity
- The cost of the asset can be measured reliably
What type of goodwill can be recognised in the financial statements?
Purchased goodwill
Define research
This is the original investigation undertaken to gain new scientific or technical knowledge
Define development
This is the application of the initial research findings to a plan or design for the production of new or substantially improved materials, devices, products, processes and systems prior to the start of commercial production or use
What does PIRATE stand for?
- Probably future economic benefits will be generated by the asset
- Intention to complete and use/sell asset
- Resources adequate and available to complete and use/sell asset
- Ability to use/sell asset
- Technical feasibility of completing asset for use/sale
- Expenditure can be measured reliably
An intangible asset is initially recognised at cost, but what are the two methods of subsequent measurement?
- Cost - cost less acc. amortisation
- Revaluation - Fair value less acc. amortisation
Define 'carrying amount'
Amount at which an asset is recognised after the deduction of depreciation or amortisation
Define 'impairment loss'
Amount by which the carrying amount of an asset exceeds its recoverable amount
Define 'fair value'
The price that would be received to sell an asset or paid to transfer a liability in a transaction in the market at a measurement date
Define 'recoverable amount'
The value of an asset and is calculated as the higher of the value in use and its fair value less costs to sell
Define 'value in use'
The present value of future cash flows to be generated through the use of the asset
How do you value inventory?
The lower of the cost and the NRV
What is the net realisable value?
Selling price less costs to sell
Give 4 examples where inventory may be sold for less than cost
- Where there has been an increase in costs or a fall in selling price
- Where the inventories have deteriorated or become obsolete
- Where a decision has been made as part of the company's marketing strategy to sell products at a loss
- Where errors in production or purchasing have occurred
What is a finance lease?
A lease that transfers substantially all the risks and rewards of ownership of an asset (to the lessee)
Give 5 characteristics that may help to identify a finance lease
1) The lease transfers ownership of the asset to the lessee at the end of the lease term
2) The lessee has the option to purchase the asset at a price sufficiently below fair value at the exercise date
3) The lease term is for a major part of the asset's economic life even if title is not transferred
4) Present value of minimum lease payments amounts to substantially all of the asset's fair value at inception
5) The leased asset is so specialised that it could only be used by the lessee without major modifications being made
Define 'interest rate implicit in the lease'
The discount rate at which the present value of the minimum lease payments and the residual value would be equal to the fair value of the leased asset
Define 'incremental borrowing rate'
This is the rate of interest that the lessee would have to pay on a similar lease
What is the sum of digits formula?
n(n+1) / 2
What is the criteria from the Framework for a provision to be recognised?
- When an entity has a present obligation (legal or constructive) as a result of a past event
- It is probably that an outflow of economic resources will be required to settle the obligation
- A reliable estimate can be made of the amount of the obligation
What is a legal obligation?
Arises as a result of a contract or a legislation
What is a constructive obligation?
An obligation that derives from the actions of an entity where:
- From an established pattern of past practice, published policies or a specific statement the entity has indicated to other parties that it will accept certain responsibilities
- As a result the entity has created a valid expectation in other parties that it will discharge those responsibilities
What is a contingent liability?
- A possible obligation arising from past events whose existence will be confirmed only by the occurrence of one or more uncertain future events not wholly within the control of the entity; or
- A present obligation that arises from past events but is to recognised because: not probable that an outflow of economic benefit will be required to settle the obligation, or because the amount of the obligation cannot be measured with sufficient reliability
What is a contingent asset?
An asset arising from past events whose existence will only be confirmed by the occurrence of one or more uncertain future events not wholly within the control of the entity
What three types of revenue does IAS 18 recognise?
- Sale of goods
- Rendering of services
- Interest, royalties and dividends
A sale of goods can be recognised as revenue if all the following criteria are met.. (5)
- The entity has transferred to the buyer the significant risks and rewards of ownership of the goods
- The entity retains no continuing managerial involvement or effective control of the goods
- The amount of revenue can be measured reliably
- It is probably that economic benefits associated with the transaction will flow to the entity
- The costs incurred or to be incurred in respect of the transaction can be measured reliably
Rendering of services can be recognised as revenue if all the following criteria met.. (4)
- The amount of revenue can be measured reliably
- It is probable that the economic benefits associated with the transaction will flow to the entity
- The stage of completion of the transaction at the end of the reporting period can be measured reliably
- The costs incurred for the transaction & the costs to complete the transaction can be measured reliably
Define 'goodwill'
The excess of the cost of the acquisition over the fair value of the identifiable assets and liabilities acquired
Gross profit margin formula
Gross profit / revenue x 100
Operating profit margin formula
Operating profit / revenue x 100
Expenses ratio
Operating expenses / revenue x 100
Asset turnover
Revenue / Capital employed
Return on capital employed
Profit from operations/capital employed x 100
Return on total assets
Profit from operations/total assets x 100
Return on equity
Profit after tax/total equity x 100
Earnings per share
Profit after tax/number of issued ordinary shares
Current ratio
Current assets/current liabilities
Quick ratio
Current assets - inventory / current liabilities
What does the current ratio show?
It gives an indication of liquidity by showing how many times the current liabilities are covered by the current assets
Inventory holding period
Inventories/cost of sales x 365
Receivables collection period
Trade receivables/revenue x 365
Payables payment period
Trade payables/cost of sales x 365
Working capital cycle
Inventory days + Receivable days - Payable days
What does a long working capital cycle represent?
The longer the cycle the longer the business has to find financing
Gearing formula
Non current liabilities/equity + non current liabilities x 100
Interest cover formula
Profit from operations/finance costs
What does high gearing show?
Means there will be less profit available to distribute to shareholders as the profit will have been reduced by high interest charges. Also means lenders are less likely to want to lend the company money
Name 5 limitations of ratio analysis
1) Historial information
2) Comparison to other companies - other companies could use a different basis
3) Window dressing
4) Non financial information - ratios do not consider this
5) Markets and size