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Chapter 3

Preparation of Financial Statements

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Objectives

By the end of this chapter, you should be able to: understand the structure and content of

published financial statements; explain the nature of the items within published

financial statements; prepare the main primary statements that are

required in published financial statements (the statement of cash flows is covered in Chapter 5);

comment critically on the information included in published financial statements.

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Preparing an income statement

The steps are:

Prepare the trial balance Identify year-end adjustments Calculate year-end adjustments Prepare an internal income statement.

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Components of Financial Statements

Remember: The following accounts are included in:

The Balance sheet Assets Liabilities, and Equity

The Income Statement Revenue (income) Expenses

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The format of statements of income for publication

IAS 1 allows a company to choose between two formats for detailing income and expenses.

Format 1: Vertical with costs analysed according to function, for example cost of sales, distribution costs and administration expenses; or

Format 2: Vertical with costs analysed according to nature, for example raw materials, employee benefits expenses, operating expenses and depreciation.

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Classification of operating expenses and other income by function

Classify operating expenses into one of four categories:

Cost of sales Distribution and selling costs Administrative expenses Other operating income or expense.

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Cost of sales

May include: Direct materials; direct labour; other external

charges that comprise production costs from external sources.

Overheads: variable and fixed production overheads.

Depreciation and amortisation: depreciation of non-current assets used in production and impairment expense;

Adjustments: capitalisation of own work as a non-current asset.

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Distribution costs

Costs incurred after the production of the finished article and up to and including transfer of the goods to the customer.

For example: Warehousing costs such as rent, rates and wages Promotion costs such as advertising Selling costs such as sales staff salaries and

commissions and cost of rent, etc. on showrooms Transport costs, for example gross wages and

pension contributions of transport staff, vehicle costs such as running costs, maintenance and depreciation.

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Administrative expenses

Costs of running the business that have not been classified as either cost of sales or distribution costs.

For example: Administration, for example salaries Property costs, for example rent and rates Bad debts Professional fees – Eg. Audit fees, directors’

fees.

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Other operating income or expense

Derived from ordinary activities of the business that have not been included elsewhere.

For example: Income from intangible assets such as royalties Income from employees such as from canteen

repayments to use intangible assets like licences.

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Statement of comprehensive income

Figure 3.4 Statement of comprehensive incomeFigure 3.4 Statement of c

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Gains and losses that were previously recognised directly in equity and presented in the statement of changes in equity. Unrealised gains/losses that cannot be claimed as part of net profit from operationsFor example:From the revaluation of non-current assets and from other items relating to Financial Instruments and Employee Benefits.

Statement of comprehensive income (Continued)

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Figure 3.4 Statement of comprehensive income (Continued)

Statement of comprehensive income (Continued)

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Information disclosed by way of note

Accounting policies

Details of certain items that have been charged in arriving at Operating Profit.

For example: Showing the makeup of individual liabilities and assets Sensitive items such as auditors’ remuneration Subject to judgement - depreciation Exceptional items – unusually high/low, or occur

infrequently.

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Current tax

Current tax is:

An estimated figure Treated as an expense in the Statement of income A current liability in the Balance Sheet The actual tax expense for a year might be higher or lower

than the company’s estimate which leads to under- or over-provisions being made.

Under-provisions will be

Added to the following year’s estimated tax charged in the Statement of income.

Over-provisions will reduce the following year’s tax charge

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Deferred tax

Capital allowances Tax may be deferred when the percentage

allowed by the tax authorities for depreciation differs from the rate charged as depreciation by the company

Interest receivable – Income not chargeable to tax For tax purposes, it is a Taxable temporary

difference.

We look at accounting for tax next week

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The statement of financial position(Balance Sheet)

IAS 1 specifies which items are to be included on the face of the statement of financial position, for example Property, plant and equipment Inventories Trade and other payables.

It does not prescribe the order and presentation that is to be followed

In almost all cases it would be appropriate to split items into current and non-current.

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Assets in Balance Sheet

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Statement of changes in equity

The statement of changes in equity will show the following items:

a) Total comprehensive income and expense for the period, showing separately the total amounts attributable to equity holders of the parent and to non controlling interests

a) For each component of equity, the effects of changes in accounting policies and corrections of errors recognised in accordance with IAS 8

a) The amounts of transactions with equity holders in their capacity as equity holders, showing contributions by and distributions to equity holders separately.

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Statement of changes in equity

Figure 3.7 Statement of changes in equity for the year ended 31 December 20X1

After-tax profit from ordinary activitiesOther comprehensive income

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Other items appearing in a statement of changes in equity

Other items may include:

Prior period adjustments Share issues Transfers from revaluation reserve.

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Figure 3.8 Statement of changes in equity for year ended 31 October 20X1

Illustration

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The accounting rules for asset valuation

Property, plant and equipment Either historical cost or market value depending upon

accounting policy chosen from IAS 16Financial assets Certain classes of financial asset are required to be

recognised at fair value Inventory It is included at the lower of cost and net realisable

value. Provisions May be required to be discounted

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Notes to Balance Sheet

Notes giving greater detail of the make-up of items that appear in the statement of financial position

Notes setting out accounting policies Notes providing additional information to assist

predicting future cash flows Notes giving information of interest to other

stakeholders.

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Has prescribing the formats meant that identical transactions are reported identically?

Differences still arise

How inventory is valued The choice of depreciation policy Management attitudes The capability of the accounting system.

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Figure 3.13 Effect of physical inventory flow assumptions on the percentage grossprofit

% difference in gross profit

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What does an investor need in addition to the financial statements to make decisions? More quantitative information in the accounts (discussed in Chapter

4) including: Segmental analysis The impact of changes on the operation, for example a

breakdown of turnover, costs and profits for both new and discontinued operations

The existence of related parties.

More qualitative narrative information, including: Mandatory disclosures Chairman’s report Management Commentary Directors’ report Best practice disclosures: Operating and Financial Review Business Review in the Directors’ report.

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Mandatory disclosures

The write-down of assets to realisable value or recoverable amount

The restructuring of activities of the enterprise, and the reversal of provisions for restructuring

Disposals of items of property, plant and equipment

Disposals of long-term investments.

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Other Reports

Chairman’s reportManagement commentaryDirectors’ reportOperating & Financial Review (OFR)*Key Performance Indicators*Business review – social, environmental,

sustainability* Usually included in these other reports

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What is meant by a fair view?IAS 1 requirements

a) Select and apply accounting policies in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors

b) Present information, including accounting policies, in a manner that provides relevant, reliable, comparable and understandable information

c) Provide additional disclosures when compliance with the specific requirements in IFRSs is not enough.

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True and fair view – legal opinion

Accurate within acceptable limits Differences over acceptable limits Room for differences over method to adopt Cost effectiveness Sufficient in quantity and quality to satisfy

reasonable expectations. Complying with the accounting standards is not

enough – must also consider whether the standard(s) is/are appropriate in the particular situation.

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Fair override

Allowed if application of an IAS might be misleading

Explain why compliance with IASs would be misleading

Give sufficient information to calculate the adjustments required to comply with the standard.

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Review questions

1. Explain why two companies carrying out identical trading transactions could produce different gross profit figures.

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Review questions (Continued)

2. Classify the following items into cost of sales, distribution costs, administrative expenses, other operating income or item to be disclosed after trading profit:

(a) Personnel department costs(b) Computer department costs(c) Cost accounting department costs(d) Financial accounting department costs(e) Bad debts(f ) Provisions for warranty claims(g) Interest on funds borrowed to finance an increase in working

capital(h) Interest on funds borrowed to finance an increase in property plant

and equipment.

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Review questions (Continued)

1. When preparing accounts under Format 1 for an Income statement, how would a bad debt that was materially larger than normal be disclosed?

1. ‘Annual accounts have been put into such a straitjacket of overemphasis on uniform disclosure that there will be a growing pressure by national bodies to introduce changes unilaterally which will again lead to diversity in the quality of disclosure. This is both healthy and necessary.’ Discuss.

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Review questions (Continued)

1. Explain the relevance to the user of accounts if expenses are classified as ‘administrative expenses’ rather than as ‘cost of sales’.

1. IAS 1 Presentation of Financial Statements requires ‘other comprehensive income’ items to be included in the statement of comprehensive income and it also requires a statement of changes in equity.

Explain the need for publishing this information, and identify the items you would include in them.