KENYA METHODIST UNIVERSITY

Distance Learning Material

SCHOOL OF BUSINESS

DEPARTMENT OF ACCOUNTING, FINANCE &

INVESTMENTS

ACCT 330: INTERMEDIATE ACCOUNTING I

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.

Pre-requisite: PRINCIPLES OF ACCOUNTING II

Course Plan

Topic 1

The Conceptual Framework for Financial Reporting

Need for a Conceptual Framework
Arguments for and against a Conceptual Framework
Generally Accepted Accounting Practice
Objectives of Financial Reporting

Topic 2

Accounting for Financial Instruments

Classification of Financial Instruments
Recognition of Financial Instruments
Measurement of Financial Instruments
Reporting of Financial Instruments
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Topic 3

Accounting for Receivables

Nature of Receivables
Valuation of Receivables
Accounting for Doubtful Debts
Reporting of Receivables

Topic 4

Accounting for Inventories

Nature of Inventories
Valuation of Inventories
Reporting of Inventories

Topic 5

Accounting for Construction Contracts

Nature of Construction Contracts
Valuation of Construction Contracts
Reporting of Construction Contracts

Topic 6

Accounting for Leases

Nature of Leases
Valuation of Leases
Reporting of Leases

Topic 7

Accounting for Property, Plant and Equipment

Nature of Property, Plant and Equipment
Valuation of Property, Plant and Equipment
Depreciation of Property, Plant and Equipment
Reporting Property, Plant and Equipment

Topic 8

Accounting for Intangible Assets

Nature of Intangible Assets
Valuation of Intangible Assets
Reporting Intangible Assets

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%

Coursework (C.A.Ts & Assignments)

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.

1.1.1 History of Accounting

It is not known who invented accounting. However accounting records were used by ancient
traders, farmers, e.t.c. to control their assets, monitor their costs, collect payments and calculate
earnings. In 1494, Luca Pacioli an Italian monk codified existing bookkeeping practice i.e. the
double entry bookkeeping system.

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.

1.1.2 Bookkeeping vs. Accounting

Bookkeeping is the art and science of correctly recording in books of accounts all those business
transactions that result in the transfer of money or moneys worth.
Accounting is mainly concerned with the design of the system of records, the preparation of
reports based on the recorded data, the interpretation of the reports and finally communicating
the results of the interpretation to interested persons.

1.1.3 Sub-fields of Accounting

a. Financial Accounting - It is mainly concerned with recording business transactions in the

books of accounts in a way that the financial performance for a particular period and financial
position on a particular date can be known.

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.

1.1.4 Users of Financial Statements and Accounting Information

a. Managers - They need information about an entitys financial situation as it is currently and as
it is expected in future hence enabling them to manage the business efficiently and to make
effective decisions.

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

1.2 The Conceptual Framework

The International Accounting Standards Board (IASB) is the body mandated to develop
international accounting standards (IAS)/international financial reporting standards (IFRS). The
Conceptual Framework for Financial Reporting (The Framework) is the main reference
document for the development of accounting standards. The Framework can also be described as
a theoretical base, a statement of principles, a philosophy and a map. However it should be noted
that the Framework is not an accounting standard, and where there is perceived to be a conflict
between the Framework and the specific provisions of an accounting standard, then the
accounting standard prevails.

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 financial reporting

The qualitative characteristics of useful financial information

The definition, recognition and

measurement of the elements from which financial

statements are constructed

Concepts of capital and capital maintenance

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.

1.2.1 The Qualitative Characteristics of Financial Information

Qualitative characteristics identify the types of information that are likely to be most useful to
the existing and potential investors, lenders and other creditors for making decisions about the
reporting entity on the basis of information in its financial report (financial information).
Examples of qualitative characteristics of financial information include;

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.

1.2.2 The Elements of Financial Statements

The IASB indicates that the elements directly related to the measurement of financial position
are assets, liabilities and equity while the elements of financial performance are income and
expenses. These are defined as follows:

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;

an item that meets the definition of an element and

it is probable that any future economic benefit associated with the item will flow to or
from the entity and

the items cost or value can be measured with reliability.

1.2.3 Capital and Capital Maintenance

The IASB explains the concept of capital maintenance as concerned with how an entity defines
the capital that it seeks to maintain. It provides the linkage between the concepts of capital and
the concepts of profit because it provides the point of reference by which profit is measured; it is
a prerequisite for distinguishing between an entitys return on capital and its return of capital;
only inflows of assets in excess of amounts needed to maintain capital may be regarded as profit
and therefore as a return on capital. Hence, profit is the residual amount that remains after
expenses (including capital maintenance adjustments, where appropriate) have been deducted
from income. If expenses exceed income the residual amount is a loss.

1.3 Accounting Concepts & Conventions

Accounting principles are guidelines to establish standards for sound accounting practices and
procedures in reporting the financial status and periodic performance of a business.
Accounting standards are written /policy document issued by governments or professional
institutes or other regulatory bodies covering various aspects of recognition, measurement,
treatment, presentation and disclosure of accounting transactions in the financial statements.

Accounting principles can be classified into two categories;

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.

1.3.2 Money Measurement Concept

Money is the most reliable unit of measurement in order to achieve homogeneity of financial
data. The advantages of expressing business transactions in terms of money is that money serves
as a common denomination by means of which heterogonous facts about a business can be
expressed in terms of numbers (i.e. money) which are capable of additions and subtractions.

1.3.3 Going Concern Concept

It is assumed that a business unit has a reasonable expectation of continuing business of a profit
for an indefinite period of time. Transactions are recorded in the books keeping in view the going
concern aspect of the business unit. It is because of this concept that supplies supply goods and
service and other business firms enter into business transactions with the business unit.

1.3.4 Cost Concept

This concept implies that an asset is recorded in the books at the price paid to acquire it and that
this cost is the basis for all subsequent accounting for the asset. This concept does not mean that
the asset will always be shown at cost but it means that cost becomes the basis for all future
accounting for the asset.

1.3.5 Dual Aspect Concept

This concept implies that every financial transaction involves a two-fold aspect;
(i)

yielding of a benefit and

(ii)

The giving of that benefit

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
11

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.

1.3.6 Accounting Period Concept

The users of an entitys financial information require regular reports and accounts in order to
determine the financial position and performance of an entity hence the need to prepare accounts
in a periodic basis rather than when the entity is terminated.

1.3.7 Matching Concept

The determination of profit of a particular accounting period is essentially a process of matching
the revenue recognized during the period and the costs to be allocated to the period.

1.3.8 Realization concept

This concept implies that revenue is considered as being earned on the date at which it is realized
i.e. on the date when the property in goods passes to the buyer and he becomes legally liable to
pay.

1.3.9 Accruals Concept

This concept implies that entities should prepare their financial statements on the basis that
transactions are recorded in them, not as the cash is paid or received, but as the revenues or
expenses are earned or incurred in the accounting period to which they relate.

1.4 The Bases of Valuation

Items in the financial statements can be valued under a number of bases. These are;
1.4.1 Historical Cost It is a basic principle of accounting whereby items are normally stated in
accounts at historical cost i.e. at the amount which the business paid to acquire them.

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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ACCOUNTING FOR FINANCIAL INSTRUMENTS

2.1 Definitions
2.1.1 Financial Instrument
It is any contract that gives rise to a financial asset of one entity and a financial liability or equity
instrument of another entity.
Financial instruments include:

Primary instruments (e.g. receivables, payables and equity securities); AND

Derivative instruments (e.g. financial options, futures and forwards, interest rate swaps
and currency swaps).

2.1.2 Financial Asset

It is any asset that is;

Cash

An equity instrument of another entity

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

of the entitys own equity instruments

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.

2.1.3 Financial Liability

It is any liability that is;

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:
14

o a non-derivative for which the entity is or may be obliged to deliver a variable

number of the entitys own equity instruments

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.

2.1.5 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.

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

It is settled at a future date.

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2.2 Classification of Financial Instruments

IAS 32 Financial Instruments: Presentation provides the rules on classifying financial
instruments as either liabilities or equity.

2.2.1 Liabilities and Equity

The issuer of a financial instrument must classify it as a financial liability, financial asset or
equity instrument on initial recognition in accordance with the substance of the contractual
arrangement. Therefore a financial instrument will be classified as a liability if the issuer has a
contractual obligation to deliver cash or another financial asset to the holder or to exchange
financial instruments on potentially unfavorable terms.
For example, redeemable preference shares will be classified as a financial liability since the
issuer has the contractual obligation to deliver cash to the holders on the redemption date.

A financial instrument is only an equity instrument if both of the following conditions are met:

The instrument includes no contractual obligation:

o to deliver cash or another financial asset to another entity;

OR

o to exchange financial assets or financial liabilities with another entity under

conditions that are potentially unfavorable to the issuer.

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.

2.2.2 Compound Instruments

It is a financial instrument that has characteristics of both equity and liabilities. E.g. a debt that
can be converted into shares. IAS 32 requires that compound financial instruments be split into
their component parts:

a financial liability (the debt)

an equity instrument (the option to convert into shares)

The above component parts must be shown separately in the financial statements.
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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

Present Value (liability component)

442.919m

Net Proceeds of the issue

500m

Equity component (500-442.919)

57.081m

The annual finance costs and year end carrying amounts

Year

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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The carrying amounts at 1/Jan/2005 are:

Equity

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.

2.2.3 Interest, Dividends, Losses and Gains

The accounting treatment of interest, dividends, losses and gains relating to a financial
instrument follows the treatment of the instrument itself.
a) Interest, dividends, losses and gains relating to a financial instrument classified as a
financial liability should be recognized as income or expense in profit or loss.
b) Distributions to holders of financial instrument classified as an equity instrument should
be debited directly to equity by the issuer.
c) Transaction costs of an equity transaction shall be accounted for as a deduction from
equity.

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.

2.2.4 Offsetting a Financial Asset and a Financial Liability

IAS 32 states that a financial asset and a financial liability may only be offset in very limited
circumstances. The net amount may only be reported when the entity:

has a legally enforceable right to offset the amounts

intends either to settle on a net basis OR to realize the asset and settle the liability
simultaneously.

18

The IASB in January 2011 issued an Exposure Draft Offsetting financial assets and financial
liabilities whereby it proposed the following;

Offsetting criteria An entity would be required to offset a recognized financial asset

and a recognized financial liability if and only if it has an enforceable unconditional right
to set-off and intends either to settle the asset and liability on a net basis or to realize the
asset and settle the liability simultaneously.

Application The offsetting criteria above apply whether the right of set-off arises from
a bilateral or multilateral arrangement.

Enforceable in all circumstances A right to set-off must be legally enforceable in all

circumstances and its exercisability must not be contingent on a future event.

Disclosure An entity is required to disclose information about offsetting and related

arrangements to enable users of its financial statements to understand the effect of those
arrangements on its financial position.

2.3 Recognition and Measurement of Financial Instruments

IFRS 9 Financial Instruments issued in November 2009 and updated in October 2010 replaced
parts of IAS 39 with respect to the recognition, derecognition, classification and measurement of
financial assets and liabilities.

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.

2.3.1 Classification of financial assets

On recognition, IFRS 9 requires that financial assets are classified as measured at either;

Amortised cost, or

Fair value.

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The IFRS 9 classification is made on the basis of both;

The entitys business model for managing the financial assets, and
The contractual cash flow characteristics of the financial asset.

2.3.2 Classification of financial liabilities

On recognition, IFRS 9 requires that financial liabilities are classified as measured at either;

At fair value through profit or loss, or

Financial liabilities at amortised cost.

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.

2.3.3 Measurement of financial assets

Financial instruments are initially measured at the transaction price (fair value of the
consideration given). The exception is where part of the consideration given is for something
other than the financial asset.
Financial assets are subsequently measured at either;

Fair value or

Amortised cost, using the effective interest method.

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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Year Opening balance

Interest income (10%)

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.

2.3.4 Measurement of financial liabilities

Financial liabilities are initially measured at transaction price. Any transaction costs are deducted
from the above amount for financial liabilities classified as measured at amortised cost. After
initial recognition, all financial liabilities should be measured at amortised cost, with the
exception of financial liabilities at fair value through profit or loss. Financial liabilities measured
at amortised cost use the effective interest method to record them in the financial statements.
However, financial liabilities at fair value through profit or loss are re-measured to fair value
each year in accordance with IFRS 13 Fair value measurement with any gain or loss recognized
in profit or loss.
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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;

Significant financial difficulty of the issuer

A breach of contract e.g. default of interest or principal payments

It becomes probable that the borrower will enter bankruptcy

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.
22

Net proceeds
Face value

50,000

Less: 16% discount

(8,000)

Less: issue costs

(2,000)

Initial recognition of liability

40,000

Repayments
Capital

50,000

Premium on redemption

4,611

Principal to be redeemed

54,611

Interest paid (50,000 x 5% x 5 years)

12,500
67,111

Total finance cost

27,111

The following is a table to show the closing liabilities at the end of each year.
Year

Opening balance

Effective interest rate

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).

23

2.3.6 Derecognition of Financial Instruments

A financial asset should be derecognized if one of the following occur:

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.

2.4 Disclosure of Financial Instruments

IFRS 7 Financial Instruments: Disclosures provides the disclosure requirements for financial
instruments. The standard requires qualitative and quantitative disclosures about exposure to
risks arising from financial instruments and specifies minimum disclosures about credit risk,
liquidity risk and market risk.
There are 2 main categories of disclosures required;

Information about the significance of financial instruments.

Information about the nature and extent of risks arising from financial instruments.

An entity should disclose the following in the Statement of Financial Position;

Carrying amount of financial assets and liabilities

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

The existence of multiple embedded derivatives

Any defaults and breaches

24

An entity should disclose the following in the Statement of Comprehensive Income;

Net gains /losses

Interest income/expense

Impairment losses by class of financial asset

2.4.1 Significance of financial instruments

An entity must disclose the significance of financial instruments for their financial position and
performance. The disclosures must be made for each class of financial instruments.
An entity must disclose items of income, expense, gains and losses with separate disclosure of
gains and losses from each class of financial instrument.

2.4.1.1 Qualitative Disclosures

They describe;

Risk exposures for each type of financial instrument

Managements objectives, policies and processes for managing those risks

Changes from the prior period

2.4.1.2 Quantitative Disclosures

They provide information about the extent to which the entity is exposed to risk, based on
information provided internally to the entitys key personnel.

25

ACCOUNTING FOR RECEIVABLES

3.1. Definitions
3.1.1 Receivables It refers to amounts due from individuals and other companies. They are
claims that are expected to be collected in cash. Receivables can be classified as;

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.

3.2 ACCOUNTS RECEIVABLES

Illustration
Calton Ltd on 1 July 2011 sold merchandise on account to Caltex Ltd for sh. 1,000 on terms
2/10, n/30. On July 5, Caltex returns merchandise worth sh.100 to Calton Ltd. On July 11, Calton
receives payment from Caltex Ltd for the balance due. The journal entries to record these
transactions on the books of Calton Ltd are as follows;
July 1

Accounts Receivable Caltex Ltd

1,000

Sales

July 5

1,000

Sales Returns and Allowances

100

Accounts Receivable Caltex Ltd

26

100

July 11

Cash

882

Sales discount

18

Accounts Receivable Caltex Ltd

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.

3.2.1 VALUATION OF ACCOUNTS RECEIVABLE

Receivables are mainly reported to the statement of financial position as an asset. However
determining the amount to report is sometimes difficult since some receivables will become
uncollectible.
Each customer must satisfy the credit requirements of the seller before the credit sale is
approved. Inevitably, some accounts receivable become uncollectible. For example, one of the
customers may not be able to pay because of a decline in sales due to a downturn in the
economy. Credit losses are recorded as debits to Bad Debts Expense (or Uncollectible Accounts
Expense). Such losses are considered a normal and necessary risk of doing business on a credit
basis. There are two methods used in accounting for uncollectible accounts.

the direct write-off method

the allowance method.

Direct Write-off Method

Here, when a particular account is determined to be uncollectible, the loss is charged to Bad
Debts Expense. It is accounted for as follows;
DR. Bad Debt Expense

xx

CR. Accounts Receivable

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;

Uncollectible accounts receivables are estimated. This estimate is treated as an expense

and is matched against sales in the same accounting period in which the sales occurred.

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

CR. Allowance for doubtful accounts

12,000

28

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.

Write-off of an uncollected account

Companies use various methods of collecting past-due accounts, such as letters, calls and legal
action. When all means of collecting a past-due account have been exhausted and collection
appears impossible, the account should be written-off. To prevent premature or unauthorized
write-offs, each write-off should be formally approved in writing by management. To maintain
good internal control, authorization to write off accounts should not be given to someone who
also has daily responsibilities related to cash or receivables.
Illustration
Assume that the director of finance of Cathy Furniture Ltd authorizes a write-off of the sh. 500
balance owed by R.A. Ware on March 1, 2011. The entry to record the write-off is:
DR. Allowance for Doubtful Accounts

500

CR. Accounts Receivable R.A. Ware

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;
29

Accounts Receivable
Jan. 1 Bal. b/d

200,000

Mar. 1 Bal. c/d

199,500

Mar. 1

500

Allowance for doubtful accounts

Mar. 1

500

Jan. 1 Bal. b/d

12,000

Mar. 1 Bal. c/d

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

Allowance for doubtful accounts

12,000

11,500

Net Realizable value

188,000

188,000

RECOVERY OF AN UNCOLLECTIBLE ACCOUNT

Sometimes a company collects from a customer after the account has been written off. There are
two entries required to record recovery of a bad debt: (1) The entry made in writing off the
account is reversed to reinstate the customers account. (2) The collection is journalized in the
usual manner.

30

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

Accounts receivable R.A. Ware

500

Allowance for doubtful debts

July 1

Cash

500
500

Accounts receivable R.A. Ware

500

BASES USED FOR ALLOWANCE METHOD

In real life, companies must estimate the amount of the expected uncollectibles if they use the
allowance method. Two bases are used to determine this amount: (1) percentage of sales, and (2)
percentage of receivables. Both bases are generally accepted and the choice is a management
decision.
The percentage of sales basis results in a better matching of expenses with revenues-an income
statement view point. The percentage of receivables basis produces the better estimate of cash
realizable value-a balance sheet view point. Under both bases, it is necessary to determine the
companys past experience with bad debt losses.

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

Cr. Allowance for doubtful accounts

8,000

31

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
32

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

Cr. Allowance for doubtful accounts

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.

DISPOSING OF ACCOUNTS RECEIVABLE

Receivables are sold for two major reasons. First, receivables may be sold because they may be
the only reasonable source of cash. When money is tight, companies may not be able to borrow
money in the usual credit markets. Or, if money is available, the cost of borrowing may be
prohibitive. Second, billing and collection are often time consuming and costly. It is often easier
for a retailer to sell the receivable to another party with expertise in billing and collection
matters.

3.3 NOTES RECEIVABLE

Credit can be granted in exchange for a promissory note. A promissory note is a written promise
to pay a specified amount of money on demand or at a definite time. Promissory notes may be
used;
(1) when individuals and companies lend or borrow money
(2) when the amount of transaction and the credit period exceed normal limits or
(3) in settlement of accounts receivable.
In a promissory note, the party making the promise to pay is called the maker. The party to
whom payment is to be made is called the payee. The payee may be specifically identified by
name or may be designated simply as the bearer of the note. Notes receivable give the payee a
stronger legal claim to assets than accounts receivable. Like accounts receivable, notes
receivable can be readily sold to another party.

33

THE MATURITY DATE

When the life of a note is expressed in terms of months, the due date when it matures is found by
counting the months from the date of issue. For instance, the maturity date of a three-month note
dated May 1 is August 1. A note drawn on the last day of a month matures on the last day of a
subsequent month. That is, a July 31 note due in two months matures on September 30. When
the due date is stated in terms of days, you need to count the exact number of days to determine
the maturity date. In counting, the date the note is issued is omitted but the due date is included.

The basic formula for computing interest on an interest-bearing is:

Face value

Annual interest rate

Time (years) =

Interest

Example
Terms of the Note

Interest Computation

Sh. 800, 18%, 120 days

sh. 800 x 18% x 120/365 = sh. 47.34

Sh. 1000, 15%, 6 months

sh. 1000 x 15% x 6/12 = sh. 75

Sh. 2000, 12%, 1 year

sh. 2000 x 12% x 1/1 = sh. 240

RECOGNITION AND VALUATION

Illustration
Assume a $1,000, 2-month, 12% promissory note is used to settle an open account. The journal
entry will be as follows;
Dr. Notes receivable

1000

Cr. Accounts receivable

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.

34

DISPOSING OF NOTES RECEIVABLE

Notes may be held to their maturity date, at which time the face value plus accrued interest is
due. Sometimes the maker of the note defaults and an adjustment to the accounts must be made.
At other times the holder of the note speeds up the conversion to cash by selling the note.

Honor of Notes Receivable

A note is honored when it is paid in full at its maturity date. For an interest-bearing note, the
amount due at maturity is the face value of the note plus interest for the length of time specified
on the note.

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

Dishonor of Notes Receivable

A dishonored note is a note that is not paid in full at maturity. A dishonored note receivable is no
longer negotiable. However, the payee still has a claim against the maker of the note. Therefore
the Notes Receivables account is usually transferred to an Account Receivable.
Assume that Canton Ltd on October 1 indicates that it cannot pay at the present time. The entry
to record the dishonor of the note depends on whether eventual collection is expected. If Betty
Ltd expects eventual collection, the amount due (face value and interest) on the note is debited to
Accounts Receivable. Betty Ltd would make the following entry at the time the note is
dishonored (assuming no previous accrual of interest).

35

October 1

Accounts Receivable Canton Ltd

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.

Sale of Notes Receivable

The accounting for the sales of notes receivables is recorded similarly to the sale of accounts
receivable.

36

ACCOUNTING FOR INVENTORIES

4.1 Definitions
4.1.1 Inventory is defined as an asset that an entity;

Intends to sell in the normal course of business (finished product)

Holds in production for future sale (work in progress)

Uses currently in the production of goods to be sold (raw materials).

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.

Expected selling price

Net realizable value

Historical cost

Current replacement 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.

37

4.2.1 Purchase cost

IAS 2 lists the following as composed of the costs of purchase of inventories;

Purchase price; plus

Import duties and other taxes; plus

Transport, handling and any other cost directly attributable to the acquisition of finished
goods, services and materials; less

Trade discounts, rebates and other similar amounts.

4.2.2 Conversion costs

They consist of two main parts namely;

Costs directly related to the units of production

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.

4.2.3 Other costs

These costs can only be recognised if they are incurred in bringing the inventories to the present
location and condition. IAS 2 lists some types of cost which should NOT be included in the cost
of inventories. These are;

Abnormal amounts of wasted materials, labour or other production costs.

Storage costs

Administrative costs

Selling costs

4.3 Inventory Systems

4.3.1 Perpetual Inventory System
The system is referred to as perpetual because the inventory account is continually adjusted for
each change in inventory, whether it is caused by a purchase, a sale, or a return of merchandise
by the company to its supplier. The cost of goods sold account, along with the inventory account,
is adjusted each time goods are sold or are returned by a customer.
38

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

Cr. Accounts Payable

600,000

Being the purchase of merchandise inventory

Dr. Accounts receivable

820,000

Cr. Sales revenue

820,000

Being the sales on account

Dr. Cost of Sales

540,000

Cr. Inventory

540,000

Being the cost of sales

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

4.3.2 Periodic Inventory System

This system is not designed to track either the quantities or cost of merchandise. The
merchandise inventory account balance is not adjusted as purchases and sales are made but only
periodically at the end of a reporting period. A physical count of the periods ending inventory is
made and costs are assigned to the quantities determined. Merchandise purchases, purchase
returns, purchase discounts, and freight-in are recorded in temporary accounts and the periods
cost of goods sold is determined at the end of the period by combining the temporary accounts
with the inventory account:

Beginning inventory + Net purchases Ending inventory = Cost of goods sold

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

Cr. Accounts payable

600,000

Being the purchase of merchandise inventory

Dr. Accounts receivable

820,000

Cr. Sales revenue

820,000

Being the sales on account

No entry is recorded for the cost of inventory sold.

40

4.3.3 Comparison of Perpetual and Periodic Inventory Systems

The key difference between a perpetual and a periodic system is that the periodic system
allocates cost of goods available for sale between ending inventory and costs of goods sold
(periodically) at the end of the period. In contrast, the perpetual system performs this allocation
by decreasing inventory and increasing cost of goods sold (perpetual) each time goods are sold.

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.

4.4 Inventory Valuation Techniques

4.4.1 Average Cost (AVCO)
This method assumes that cost of goods sold and ending inventory consist of a mixture of all the
goods available for sale. The average unit cost applied to goods sold or to ending inventory is not
simply an average of the various unit costs of purchases during the period but an average unit
cost weighted by the number of units acquired at the various unit costs.

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.

4.4.2 First-In, First-Out (FIFO)

This method assumes that units sold are the first units acquired. Beginning inventory is sold first,
followed by purchases during the period in the chronological order of their acquisition.
Periodic FIFO. Physical quantities on hand in a periodic inventory system are determined by
taking a physical count.
Perpetual FIFO. The ending inventory and cost of goods sold amounts are always produced in a
perpetual inventory system as in a periodic inventory system when FIFO is used. This is because
the same units and costs are first in and first out whether cost of goods sold is determined as each
sale is made or at the end of the period as a residual amount.

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

i) AVCO [Assuming a periodic inventory system]

sh.
Opening inventory (8,000 x 11)

88,000

+ Purchases

198,000
286,000

- Closing inventory (W.1)

(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

[Assuming a perpetual inventory system]

Date

Purchased

Sold

Balance

Inventory 8,000 x sh. 11 = sh. 88,000

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

2,000 x sh. 12 = sh. 24,000

= sh. 44,000
44,000

24,000 = sh.

Mar. 20

sh.68,000/6000 = sh. 11.33/unit

68,000

6,000 x sh. 14 = sh. 84,000

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

6,000 x sh. 15 = sh. 90,000

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

Total cost of sales

Sh. 163,600

ii) FIFO [Assuming a periodic inventory system]

sh.
Opening inventory (8,000 x 11)

88,000

+ Purchases

198,000
286,000

- Closing inventory (W.2)

(132,000)

Cost of sales

154,000

Workings
March 20

3,000 units x sh. 14 = sh. 42,000

October 15

6,000 units x sh. 15 = sh. 90,000

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.

4.4.3 Last-In, First-out (LIFO)

This method assumes that the units sold are the most recent units purchased. However, IAS 2
Inventories prohibits the use of this technique.

44

4.5 Goods written off or written down

An entity might be unable to sell all the goods purchased because of a number of reasons such
as;

Goods might be lost or stolen

Goods might be damaged

Goods might become obsolete or out of fashion.

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;

Nil if they are worthless

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

Amount written off

Fashion goods

2,100,000

400,000

1,700,000

Other goods (Bal. Figure)

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

Less: cost of sales

Opening inventory

8,800,000

Purchases

48,000,000

Closing inventory

(5,900,000)
(50,900,000)

Gross profit

30,500,000

46

ACCOUNTING FOR CONSTRUCTION CONTRACTS

5.1 Definitions
5.1.1 Construction contract is a contract specifically negotiated for the construction of one or
more substantial assets that are interdependent in their design, technology or function. IAS 11
Construction Contracts states that contract revenue and contract costs should be recognized as
revenue and expenses by reference to the stage of completion of the contract at the reporting date
provided that the outcome of the contract can be estimated reliably. This applies if the contract is
expected to make a profit.
If the contract is expected to make a loss, the whole loss to completion should be recognized as
an expense immediately.

5.1.2 Contract Revenue is:

The initial amount of revenue agreed in the contract.

Variations in contract work, claims and incentive payments: to the extent that they will
result in revenue that are capable of being reliably measured.

5.1.3 Contract Costs are:

Costs that relate directly to the specific contract.

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 that relate directly to a specific contract include:

Site labour costs.

Costs of materials used in construction.

Depreciation of plant and equipment used.

Costs of moving plant, equipment and materials to and from the contract site.

Costs of hiring plant and equipment.

Costs of design and technical assistance directly related to the contract.

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;

fixed price contract

cost plus contract

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.

5.2 Accounting Methods for Contracts

IAS 11 gives the following as methods applicable in accounting for contracts;

Percentage of completion method

Completed Contract Method

5.2.1 PERCENTAGE OF COMPLETION METHOD

This is the most preferred approach under IAS 11. In this approach, costs and revenues are
apportioned to each accounting period on the basis of the work done so far.
Under this method, progress billings and amounts received from the contractee are not
considered in the determination of contracts profit or loss for the period but it is considered
when determining the value of Work-In-Progress and the balance due from the contractee at the
end of the accounting period. This method is suitable for those contracts whose costs to
completion can easily be determined at the inception of the contract. It obeys the Matching and
Periodicity Principles.
48

The following are the accounting entries made;

i.

On Costs being incurred on the contract (Direct and Operational Costs)

DR. Contract in Progress A/c
DR. Operating Expenses A/c
CR. Bank

ii.

On progress billings being made

DR. Contractee A/c
CR. Progress Billings A/c

iii.

On cash being received from the Contractee

DR. Bank A/c
CR. Contractee A/c

iv.

To write off the expenses at Year end

DR. Profit & Loss A/c
CR. Expenses A/c

Income Statement Extract

Year

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

Retained Earnings/(Loss) b/d

xxx

xxx

Retained Earnings/(Loss) c/d

xxx

xxx

xxx

Computation of Work-in-Progress
sh
Costs to date

xx

Earnings to date

xx

Value to date

xx

Less: Progress billings to date

xx

Work-in-Progress

xx
49

5.2.2 COMPLETED CONTRACT METHOD

In this approach, no revenue and contract costs should be recognized in earlier years until the
contract is complete or nearing completion. This method is suitable for those contracts whose
total costs to completion cannot be ascertained at the inception of the contract.
This method is mostly adopted for shorter contracts and it obeys the Prudence Concept of not
anticipating the revenues in earlier years until it is earned. The income statement of earlier years
will show losses to the extent of operating expenses incurred in those years.

Income Statement Extract

Year

Contract Revenue

xxx

Contract Costs

xx

Gross Profit

xxx

Operational Costs

(xx)

(xx)

(xx)

PROFIT/(LOSS)

(xx)

(xx)

xxx

Retained Earnings/(Loss) b/d

(xxx)

(xxx)

Retained Earnings/(Loss) c/d

(xxx)

(xxx)

(xxx)

Computation of Work-in-Progress
sh.
Costs to date

xx

Earnings to date

xx

Value to date

xx

Less: Progress billings to date

xx

Work-in-Progress

xx

Note: Where Work-in-Progress is negative, then it is a liability referred to as the excess of

billings over costs.

50

Contract Statement of Financial Position Extract

1

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

Excess of billings over costs

xxx

Total equity and liabilities

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.

Year ended 31 December

2009

2010

2011

sh. 000

sh. 000

sh. 000

Costs incurred in the year

300,000

330,000

120,000

Estimated costs to completion

300,000

270,000

Progress billings made in the year

270,000

480,000

100,000

Cash collections in the year

240,000

360,000

200,000

General administration expenses

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

Contract revenue (W.1)

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

Contract revenue (W.1)

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

Less: General administrative expenses

(15,000)

(20,000)

(18,000)

Net profit/(loss) for the year

110,000

(180,000)

117,000

Retained earnings b/d

110,000

(70,000)

Retained earnings c/d

110,000

(70,000)

47,000

ii)Completed Contract Method

b) Income Statement Extracts

i) Percentage of Completion Method

52

ii)Completed Contract Method

2009

2010

2011

000

000

000

Gross profit/(loss)

100,000

Less: General administrative expenses

(15,000)

(20,000)

(18,000)

Net profit/(loss) for the year

(15,000)

(20,000)

82,000

Retained earnings b/d

(15,000)

(35,000)

Retained earnings c/d

(15,000)

(35,000)

47,000

2009

2010

2011

000

000

000

Work-in-progress (W.2)

155,000

Contractee Account (W.3)

30,000

150,000

50,000

185,000

150,000

50,000

110,000

(70,000)

47,000

Excess of billings over costs (W.2)

155,000

Bank overdraft (W.4)

75,000

65,000

3,000

185,000

150,000

50,000

c) Statement of Financial Position Extracts

i) Percentage of Completion Method

Assets

Equity and Liabilities

Equity
Retained Earnings

Liabilities

53

ii)Completed Contract Method

2009

2010

2011

000

000

000

Work-in-progress (W.2)

30,000

Contractee Account (W.3)

30,000

150,000

50,000

60,000

150,000

50,000

(15,000)

(35,000)

47,000

Excess of billings over costs (W.2)

120,000

Bank overdraft (W.4)

75,000

65,000

3,000

60,000

150,000

50,000

Assets

Equity and Liabilities

Equity
Retained Earnings

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

50% x 850,000,000 = 425,000,000

2010

70% x 850,000,000 425,000,000 = 170,000,000

2011

850,000,000 425,000,000 170,000,000 = 255,000,000

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

Less: progress billings to date

(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

Less: progress billings to date

(270,000,000)

(750,000,000)

30,000,000

(120,000,000)

2009

2010

2011

Progress billings to date

270,000,000

750,000,000

850,000,000

Cash collections to date

(240,000,000)

(600,000,000)

(800,000,000)

30,000,000

150,000,000

50,000,000

ii)Completed Contract Method

3. Contractee Account

55

4. Bank Account
2009

2010

2011

Collections to date

240,000,000

600,000,000

800,000,000

Costs paid to date

(300,000,000)

(630,000,000)

(750,000,000)

Administrative expenses to date

(15,000,000)

(35,000,000)

(53,000,000)

Balance c/d

(75,000,000)

(65,000,000)

(3,000,000)

56

ACCOUNTING FOR LEASES

6.1 Definitions
6.1.1 Lease it is a contractual agreement between the lessor (owner of the property) and a
lessee (renter of the property) that grants the right to use specific property for a period of time in
return for cash payments. Common types of leases include operating and finance leases.

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).

6.1.3 Operating lease is a lease other than a finance lease.

An operating lease is similar to a rental agreement. The entity normally rents the asset for only
part of its useful life.

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

6.1.6 Guaranteed residual value it is;

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.

6.1.7 Gross investment in the lease it is the aggregate of;

The minimum lease payments receivable by the lessor under a finance lease, and

Any unguaranteed residual value accruing to the lessor.

Net investment in the lease is the gross investment in the lease discounted at the interest rate
implicit in the lease.

6.1.8 Unearned finance income is the difference between;

The gross investment in the lease, and

The net investment 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;

Upon the occurrence of some remote contingency

With the permission of the lessor

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;

A lease is classified as either an operating lease or a finance lease, and

In the case of a finance lease, the amounts to be recognized at the lease term are
determined.

6.1.11 Economic life it is either;

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.

6.2 Classification of a Lease

A lease is mainly a finance lease if one or more of the following apply;
1. Ownership is transferred to the lessee at the end of the lease.
2. The lessee has the option to purchase the asset for less than its expected fair value at the date
the option becomes exercisable.
3. The lease term is for the major part of the economic life of the asset.
4. At inception of the lease, the present value of the minimum lease payments amounts to at least
substantially all of the fair value of the leased asset.
5. The leased asset are of a specialized nature so that only the lessee can use them without major
modifications being made.
6. The lessee will compensate the lessor if the lease is cancelled.

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.

6.3 Accounting for Leases

6.3.1 Finance Lease
i) Lessee
The accounting treatment of the lease requires reporting of the substance of the transaction i.e.
the lessee controls an asset and has a liability for the outstanding rentals. At the beginning of the
lease term;
Dr. Leased Asset
Cr. Lease Liability

The asset and liability are measured at the lower of;

Fair value of the asset

Present Value of the minimum lease payments

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;

Its useful life

The lease term

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 the minimum lease payments receivable, plus

60

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.

6.3.2 Operating Lease

i) Lessee
The substance of the transaction is that the lessee uses the asset but does not own nor control it.
Hence the lessee recognizes the lease rentals as an expense on a straight line basis over the lease
term unless another systematic and rational basis is more appropriate.

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

= 18,928,221.03 per annum

3.16987

b) The annual payments payable at the start of the year are;

60,000,000

= 17,207,311 per annum

PVIFA 4yrs, 10% * FVIF 1yr, 10%

c) Income Statement Extracts

[Annual payments payable at the start of the year]
2011

2012

Depreciation

15,000,000

15,000,000

Interest cost

4,279,000

2,987,000

[Annual payments payable at the end of the year]

2011

2012

Depreciation

15,000,000

15,000,000

Interest cost

6,000,000

4,707,000

62

Statement of Financial Position Extracts

[Annual payments payable at the start of the year]
2011

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

[Annual payments payable at the end of the year]

2011

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

Interest expense (10%)

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

Interest expense (10%)

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)

6.4 Sale and leaseback transactions

Here, an asset is sold by a seller and then the same asset is leased back to the same seller. The
lease payment and the sale price are normally interdependent because they are negotiated as part
of the same package.
The accounting treatment for the seller/lessee is;

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.

If the leaseback is an operating lease;

o Any profit or loss should be recognized immediately, provided it is clear that the
transaction is established at a fair value.
o Where the sale price is below fair value, any profit or loss should be recognized
immediately except that if the resulting loss is compensated by future lease
payments at below market price it should to that extent be deferred and amortised
over the period for which the asset is expected to be used.
o If the sale price is above fair value, the excess over fair value should be deferred
and amortised over the period over which the asset is expected to be used.

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

6.5 Disclosure in the financial statements

6.5.1 Finance lease
Lessee

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

Contingent rents recognized as an expense for the period

The total of future minimum sublease payments expected to be received under noncancellable subleases at the year end

A general description of the lessees significant leasing arrangements

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

Unearned finance income

The unguaranteed residual values accruing to the benefit of the lessor

The accumulated allowance for uncollectible minimum lease payments receivable

Contingent rents recognized in income

A general description of the lessors material leasing arrangements

6.5.2 Operating lease

Lessee

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

A general description of the lessees significant leasing arrangements

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

Total contingent rents recognized in income

A general description of the lessors leasing arrangements

66

ACCOUNTING FOR PROPERTY, PLANT & EQUIPMENT

7.1 Definitions
7.1.1 Asset It 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 (IASB Framework).
It is a probable future economic benefit obtained or controlled by a particular entity as a result of
past transactions or events (FASB, USA).

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.

7.1.3 Capital Expenditure It is expenditure which results in the acquisition of non-current

assets or an improvement in their earning capacity.
Capital expenditure is not charged as an expense in the income statement, although a
depreciation charge will usually be made to write off the capital expenditure gradually over time.
Depreciation charges are expenses in the income statement. Capital expenditure on non-current
assets results in the appearance of a non current asset in the statement of financial position of the
business.

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.

To maintain the existing earning capacity of non-current assets.

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

7.1.6 Revenue Income It is derived from the following sources;

The sale of trading assets, such as good held in inventory

The provision of services

Interest and dividends received from investment held by the business

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.

7.2 Accounting Treatment

Recognition of property, plant and equipment depends on two criteria;

It is probable that future economic benefits associated with the item will flow to the
entity

The cost of the item can be measured reliably

The asset is initially recognized at cost. The following form part of the cost of an asset;

Purchase price less trade discount

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.

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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

7.3.1 Depreciable assets

They are assets which;

Are expected to be used during more than one accounting period

Have a limited useful life AND

Are held by an enterprise for use in the production or supply of goods and services,
for rental to others or for administrative purposes.

7.3.2 Useful life

It is the period over which depreciable asset is expected to be used by the enterprise or the
number of production/similar units expected from the asset by the enterprise.

Depreciable amount of a depreciable asset is;

Historical cost Estimated residual value

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.

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When determining the useful life of an asset the following factors should be considered
(i)

Physical factors wear and tear; Rot/decay etc

(ii)

Economic factors obsolescence, inadequacy etc

(iii)

Time factors

(iv)

Legal factors

7.3.3 Depreciation methods

When a non current asset is depreciated, two things must be accounted for,

The charge for deprecation i.e. depreciation expense in an accounting period

The value of the non current asset in a particular period

Value of non-current asset = Cost Accumulated deprecation

There are several different methods of depreciation

1. Straight line method
2. Reducing balance method
3. Sum of digits method
4. Machine hour method depreciation is based on the number of hours a machine is
expected to operate
5. Units of output method deprecation is based on the number of output units a machine
is expected to produce

Sum of digits method

Example
Grande Limited bought a machine $10,000 on 1/11/2004. The estimated useful life of the asset is
5 years. Residual value is $1,000. Calculate the depreciation charge for each year over the assets
life.

70

Solution
Depreciation expense = years remaining + 1

Depreciable amount

n (n + 1) / 2

Year 1

5/15 x (10,000 1,000) = 3,000

Year 2

4/15 x (10,000 1,000) = 2,400

Year 3

3/15 x (10,000 1,000) = 1,800

Year 4

2/15 x (10,000 1,000) = 1,200

Year 5

1/15 x (10,000 1,000) = 600

9,000

Straight line method

The total depreciable amount is charged in equal installments to each accounting over the
expected useful life of the asset.
Annual deprecation = cost residual value
Useful life (in years)

Annual deprecation = deprecation rate (%) x Depreciable amount

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

Net book value (NBV)

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

Reducing balance method

This method calculates the annual deprecation charged as a fixed percentage of the value of the
asset as at the end of the previous accounting period.

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

Net Book Value

40% x 100,000 = 40,000

40,000

60,000

40% x 60,000 = 24,000

64,000 (i.e. 40,000 + 24,000)

36,000

40% x 36,000 = 14,400

78,400 (i.e. 40,000 + 24,000 + 21,600

14,400)

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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.

7.3.4 Change in the method of depreciation

If there are any changes in the expected pattern of use of the asset then the method used should
be changed. In such case, the remaining carrying value is depreciated under the new methods i.e.
only current and the future periods are affected.

7.3.5 Change in expected useful life or residual value of an asset

The depreciation charge of a non current asset depends on not only cost (or value) of the asset
and its estimated residual value, but also on its estimated useful life.

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

Cr. Revaluation reserve

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

ii) The net book value of land and buildings

2005
Building (300,000 50,000) = 250,000
Land

= 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.

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Journal entries in non-current assets disposal

Dr. Disposal of Non-current Assets A/c

xx

Cr. Non-current asset A/c

xx

Being the cost of the asset being disposed off

Dr. Accumulated depreciation Non-current asset a/c

xx

Cr. Disposal of Non current asset A/c

xx

Being the total accumulated depreciation of the asset that is being disposed off

Dr. Cash/Debtor

xx

Cr Disposal of non current asset A/c

xx

With the sale price of the asset

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

Less: accumulated depreciation (3yrs x 30,000)

(90,000)

Net book value at disposal

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.

Machine Cost Account

Balance b/d

110,000

Machine disposal

30,000

Balance c/d

80,000

110,000

110,000

Machine Accumulated depreciation Account

Machine disposal

12,000

Balance c/d

58,000

Balance b/d

70,000

70,000

70,000

Machine disposal Account

Machine cost

30,000

Machine Acc. Depreciation

12,000

Profit & Loss

1,000

Cash

19,000

31,000

31,000

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ACCOUNTING FOR INTANGIBLE NON-CURRENT ASSETS

8.1 Definitions
8.1.1 Intangible asset it is an identifiable non-monetary asset without physical substance. The
asset must be;

controlled by the entity as a result of past events in the past AND

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.

8.1.3 Development is the application of research findings or other knowledge to a plan or

design for the production of new or substantially improved materials, devices, products,
processes, systems or services prior to the commencement of commercial production or use.

8.1.4 Amortisation is the systematic allocation of the depreciable amount of an intangible

asset over its useful life.

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
77

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.

78

8.2 Components of R & D Costs

R & D costs will include all costs that are directly attributable to research and development
activities or that can be allocated on a reasonable basis. The costs may include;

salaries and wages and other employment related costs of personnel engaged in R & D
activities

costs of materials and services consumed 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

8.3 Recognition of R & D costs

The relationship between the R & D costs and the economic benefit expected to derive from
them will determine the allocation of costs to different periods. Recognition of the costs as an
asset will only occur where it is probable that the cost will produce future economic benefits for
the entity and where the costs can be measured reliably.

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.

79

(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;

the method of amortization used

the useful life of the assets or the amortization rate used

the carrying amount of internally-generated intangible assets

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 age of the brand name

The legal protection of the brand name

The status or position of the brand in its particular market

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

80

REFERENCES
Horngren, C.T., Harrison, W.T. and Bamber, L.S. (2005). Accounting. 6th Ed., Pearson Prentice
Hall.

IASs/IFRSs. (2011). International Accounting Standards/International Financial Reporting

Standards. IASB.
Larson, K.D. (1990). Fundamental Accounting Principles. 12th Ed., Richard D. Irwin Inc.
Maheshwari, S.N. and Maheshwari, S.K. (2005). Advanced Accountancy. Vol 1. 9th Ed., Vikas
Publishers.
Spiceland, D., Sepe, J. and Nelson, M. (2011). Intermediate Accounting. 6th Ed., McGraw-Hill
Irwin.
Weygandt, J.J., Kieso, D.E. and Kell, W.G. (1996). Accounting Principles. 4th Ed., John Wiley &
Sons Inc.

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