Advanced Financial Accounting - II CH 1-4

Harambee University Lecture Note
CHAPTER ONE
ACCOUNTING FOR INCOME TAX
Introduction
Corporations and PLC must declare income (profit) tax as per tax laws developed and
declared by the tax authority. This is said to be tax Purpose Financial Report. At the
same time, these companies need to produce annual financial reports for creditors and
investors on the bases of IFRS and said to be General Purpose Financial Report).
Therefore, IFRS and tax regulations differ in a number of ways, the amounts of
accounting profit (IFRS income statement) and Taxable profit (profit as per tax law)
will differ too. Therefore, the following balances will differ:
 Income tax expense ( based on financial statement Income)
 Income taxes payable (based on tax law income)
IFRS- Financial Income Tax payable to authority

Statements
 Taxable Income
 Financial Profit before tax  Income Taxes Payable
 Income Tax Expense
 Income tax: is a type of tax that governments impose on income generated by

business and individuals with in their jurisdiction. Income taxes include all
domestic and foreign taxes that are based on taxable profits.
 Pre-tax financial income: is a financial reporting term. It also is often referred to
as income before taxes, income for financial reporting purposes, or income for
book purposes.
 Taxable income (income for tax purposes): is a tax accounting term. It indicates
the amount used to compute income taxes payable.
 Income tax expenses: amount of current and deferred tax expense in profit or
loss for the period
 Current tax expense: the amount of income taxes payable for the period.
 Deferred tax expense: the amount of tax due to the tax authorities in future
periods
 A temporary difference: is the difference between the tax basis of an asset or
liability and its reported (carrying or book) amount in the financial statements,
which will result in taxable amounts or deductible amounts in future years.
 Deferred tax liability represents the increase in taxes payable in future years as a
result of taxable temporary differences existing at the end of the current year.
 Deferred tax asset: represents the increase in taxes refundable (or saved) in future
years as a result of deductible temporary differences existing at the end of the
current year.
1|Page By:Merga Adugna(MBA)

Income tax expense

 Is Computed based on financial statement/accounting profit
 Is equal to financial statement profit * tax rate
 Is the sum of current tax expense and differed tax expense or Income tax
payable less deferred tax asset
Income tax expense = Accounting profit * Tax rate
Income taxes payable
 Is computed based profit computed as per tax law
 It is current tax expense actually paid to tax authority
Income tax payable = Taxable profit * tax rate
The difference between Income tax expense and Income taxes payable is either differed
tax asset or differed tax liability
Why Accounting profit is different from taxable profit?
There are certain revenues that are not recognized by financial income but allowed by
tax authority. For example: Unearned revenues are reported as liability for financial
report purpose and become revenue when the goods/service is provided. However, it is
reported as revenue for tax purpose when cash is collected (it doesn't wait until goods
are delivered). Thus, revenue for tax purpose will be more than revenue for financial
reporting purpose
There are certain disallowed expenses by tax authority:
 Depreciation expense difference( Financial statement depreciation rate and Tax
depreciation rate are different)
 Annual Leave Expense
 Severance expense
 Bad Debts Expenses
 Fine & Penalty expense
 Entertainment Expenses
Therefore, the financial statement profit is recomputed by considering these revenues
and expenses as follows:
Income tax Payable and Taxable Profit computation
Financial profit before tax (Accounting profit)……………....………xxx
Add: Unearned revenue …………………………………………………x
Add: Disallowed expenses
–Depreciation expense (as per financial reporting)…………………x
–Annual Leave Expense ……………………………………………..x
–Severance Expense …………………………………………………x
–Depreciation expense on leasehold Land…………………………. .x
–Bad Debts Expenses ……………………………………………….. x
–Fine & Penalty……………………………………………………… x

–Entertainment Expenses ……………………………………………x
Less: Allowed expenses
Depreciation for tax purposes………………………………………….(x)
Taxable profit…………………………………………………………………....xx
Tax Payable (30% of taxable profit)....……………………………… ..xx
Basic Concepts
Income Approach (Revenue and expense)
 Accounting Profit: It is profit or loss for a period determined in accordance
with IFRS.
 Taxable profit (tax loss): It is the profit (loss) for a period, determined in
accordance with income tax law.
 The difference between Accounting Profit and Taxable profit is temporary
difference and permanent difference.
Balance Sheet Approach (Asset and liability)

 The tax base: The amount attributed to that asset or liability for tax purposes
 Carrying amount: The amount attributed to that asset or liability as per IFRS
 The difference between tax base and Carrying amount is temporary difference
and permanent difference.
Taxable temporary difference: It is temporary difference that will result in taxable
amounts in determining taxable profit of future periods. Results in deferred tax liability
today
 Deferred tax liability: is the amount of income taxes payable in future periods
in respect of taxable temporary differences at the end of current period.
Taxable temporary differences Exists:
 When accounting profit > Taxable profit ( Income approach)
 When carrying amount(BV) > tax base of asset(B/sheet approach) or
 When carrying amount(BV) < tax base of liability(B/sheet approach)
It reduces current tax payable in the year of origination but will increase future tax
payable on reversal. The effects of taxable temporary differences should be recognized
as deferred tax liabilities.
Deductible temporary difference: It is temporary differences that will result in
amounts that are deductible in determining taxable profit of future periods at the end of
current period. Results in deferred tax asset today
 Deferred Tax Asset: It is the amounts of income taxes recoverable in future
periods in respect of deductible temporary differences.
Deductible temporary differences Exists:

 When accounting profit < Taxable profit ( Income approach)

 When carrying amount(BV) < tax base of asset(B/sheet approach) or
 When carrying amount(BV) >tax base of liability(B/sheet approach)
These increase current tax payable on origination but will reduce future tax payable on
reversal. The tax effects of deductible temporary differences should be recognized as
reductions in deferred tax liabilities or an increase in deferred tax assets.
Permanent Differences
Permanent difference is from items that enter into financial income before tax but never
into taxable income. It Affect only the period tax expense in which they occur.
Permanent difference does not give rise to future taxable or deductible amounts
(deferred tax asset or liability)
Tax expense is the aggregate amount included in the determination of profit or loss for
the period. It comprises current tax expense (current tax income) and deferred tax
expense (deferred tax income).
Accounting for Net Operating Losses
A net operating loss (NOL) occurs for tax purposes in a year when tax-deductible
expenses exceed taxable revenues. An inequitable tax burden would result if companies
were taxed during profitable periods without receiving any tax relief during periods of
net operating losses. Under certain circumstances, therefore, the federal tax laws permit
taxpayers to use the losses of one year to offset the profits of other years. Companies
accomplish this income-averaging provision through the carryback and carry forward
of net operating losses. Under this provision, a company pays no income taxes for a
year in which it incurs a net operating loss.
Loss Carryback
Through use of a loss carryback, a company may carry the net operating loss back two
years and receive refunds for income taxes paid in those years. The company must apply
the loss to the earlier year first and then to the second year. It may carry forward any
loss remaining after the two-year carryback up to 20 years to offset future taxable
income.
Loss Carry forward
A company may forgo the loss carryback and use only the loss carry forward option,
offsetting future taxable income for up to 20 years.
If a carryback fails to fully absorb a net operating loss, or if the company decides not to
carry the loss back, then it can carry forward the loss for up to 20 years. Because
companies use carry forwards to offset future taxable income, the tax effect of a loss
carry forward represents future tax savings. Realization of the future tax benefit depends
on future earnings, an uncertain prospect. The key accounting issue is whether there
should be different requirements for recognition of a deferred tax asset for:
 Deductible temporary differences
 Operating loss carry forwards.

Financial Statement Presentations
a) Balance Sheet
Deferred tax accounts are reported on the balance sheet as assets and liabilities.
Companies should classify these accounts as a net current amount and a net noncurrent
amount. An individual deferred tax liability or asset is classified as current or
noncurrent based on the classification of the related asset or liability for financial
reporting purposes. A company considers a deferred tax asset or liability to be related
to an asset or liability if reduction of the asset or liability causes the temporary
difference to reverse or turn around. A company should classify a deferred tax liability
or asset that is unrelated to an asset or liability for financial reporting, including a
deferred tax asset related to a loss carry forward, according to the expected reversal date
of the temporary difference.
b) Income Statement
Companies should allocate income tax expense (or benefit) to continuing operations,
discontinued operations, extraordinary items, and prior period adjustments. This
approach is referred to as intra period tax allocation. In addition, companies should
disclose the significant components of income tax expense attributable to continuing
operations:
1. Current tax expense or benefit.
2. Deferred tax expense or benefit, exclusive of other components listed below.
3. Investment tax credits.
4. Government grants (if recognized as a reduction of income tax expense).
5. The benefits of operating loss carry forwards (resulting in a reduction of
income tax expense).
6. Adjustments of a deferred tax liability or asset for enacted changes in tax
laws or rates or a change in the tax status of a company.
7. Adjustments of the beginning-of-the-year balance of a valuation allowance
because of a change in circumstances that causes a change in judgment about
the reliability of the related deferred tax asset in future years.

CHAPTER TWO
2. SHARE BASED PAYMENT (IFRS 2)
2.1 Introduction
Share schemes are a common feature of director and executive remuneration and in
some countries the authorities may offer tax incentives to encourage more companies
to offer shares to employees. Companies whose shares or share options are regarded as
a valuable 'currency' commonly use share based payment to obtain employee and
professional services. The increasing use of share-based payment has raised questions
about the accounting treatment of such transactions in company financial statements.
Share options are often granted to employees at an exercise price that is equal to or
higher than the market price of the shares at the date the option is granted.
Consequently, the options have no intrinsic value and so no transaction is recorded in
the financial statements. This leads to an anomaly: if a company pays its employees in
cash, an expense is recognized in profit or loss, but if the payment is in share options,
no expense is recognized.
2.2 Definition of Share Based Payment
 A share-based payment transaction is one in which an entity receives goods or
services as consideration for its equity instruments, or by incurring a liability
based on the price or value of its shares or other equity instruments.
 Transactions whereby entities purchase goods or services from other parties,
such as suppliers and employees, by issuing shares or share options to those
other parties are increasingly common.
 Share-based payments are transactions where an entity settles an obligation in
shares or incurs a cash obligation linked to the share price of the entity.
2.3. Scope of the Standard
The standard specifically covers:
 IFRS 2 covers both employee share-based payment arrangements and the
issuance of shares (and rights to shares) in return for services and goods.
 The accounting for all share-based payment transactions including those that are
equity-settled, cash-settled and those in which the terms of the arrangement
provide a choice of whether the entity settles cash (or other assets) or by issuing
equity instrument.
a) Equity-settled share-based payment transaction, the entity receives
goods or services as consideration for equity instruments (including shares
or share options) of the entity. An equity instrument is a contract that
evidences a residual interest in the assets of an entity after deducting all of
its liabilities.

b) Cash-settled share-based payment transaction, the entity acquires goods

or services by incurring a liability to transfer cash or other assets to the
supplier of those goods or services for amounts that are based on the price
or value of the entity’s shares or other equity instruments.
c) Share-Based Payment Transactions with Cash Alternatives when the
terms of the arrangement provide either the entity or the counterparty with
the choice of settlement either in cash (or other assets) or by issuing equity
instruments,
The following types of transactions are not within the scope of IFRS 2, and therefore
not accounted for as share-based payment transactions:
 Transactions with counterparties acting as shareholders rather than as suppliers
of goods or services
 Shares issued as consideration to acquire a business accounted for under IFRS
3 Business Combinations
 Transactions in which a share-based payment is made in exchange for control
of a business
 Share-based payment transactions in which the entity receives or acquires goods
or services under a contract within the scope of financial instruments standards.
 Acquisition of associates, because Investments in Associates and Joint Ventures
is the specific standard applicable to the transaction
 Acquisition of a joint controlling interest in a joint venture, because IAS 28 is
the specific standard applicable to the transaction.
2.4 Share Based Payment Related Terms
 The grant date; is the date at which the entity and another party agree to a
share-based payment arrangement. At grant date, the entity confers on the
counterparty the right to cash, other assets, or the entity’s equity instruments,
provided that the specified vesting conditions are met.
 Employees and others providing similar services; are individuals who
render personal or similar services to the entity.
 Vesting conditions determine whether the entity receives the required
services from the counterparty. Vesting conditions are subdivided into
service conditions and performance conditions.

 Service condition is the requirement to complete a specified

period of service.
 Performance condition is the requirement to complete a specific
period of service and to meet specified performance targets.
Performance conditions are subdivided further into market
conditions and non-market performance conditions.
 Market condition contains a performance target that is related to the market
price of the equity instruments of the entity.
 Non-market performance condition contains a performance target that is not
related to the market price of the equity instruments of the entity.
 Non-vesting conditions do not determine whether the entity receives the
required services but affect the counterparty’s entitlement to receive the share-
based payment.
 Fair value is the amount for which an asset could be exchanged, a liability
settled, or an equity instrument granted between knowledgeable, willing parties
in an arm’s-length transaction.
 Intrinsic value is the difference between the fair value of the shares to which
the counterparty has the right to subscribe or which it has the right to receive,
and the price the counterparty is required to pay for those shares.
 A share option is a contract that gives the holder the right but not the obligation
to subscribe to the entity’s shares at a fixed or determinable price for a specified
period of time.
2.5. Share Based Payment Accounting Treatment
Share-based payments could be:
 Cash settled, that is, by a cash payment based on the value of equity
instruments
 Equity settled, that is, by the issue of equity instruments
 Cash or equity settled (at the option of the entity or supplier).
2.6. Recognition and Measurement of Share Based Payment
An entity should recognize the goods or services received or acquired in a share
based payment transaction when it obtains the goods or services are received.
If the goods or services received do not meet the requirements to be recognized as
an asset the entity shall recognize as an expense (for example, services received or
employee benefits).
Share-based payment transactions should be measured at:
 The fair value of the goods or services received in an equity-settled share-
based payment transaction is recognized in the financial statements

 If the fair value of the goods or services cannot be estimated reliably, as for
employee services, the goods and services are measured by reference to the
fair value of the equity instruments granted.
 Goods or services received in a cash-settled share-based payment
transaction are measured at the fair value of the liability incurred.
2.7. Presentation and Disclosure
An entity should disclose information that enables users of the financial statements to
understand the nature and extent of share-based payment arrangements that existed
during the period.
An entity should provide a description of:
 each type of share-based payment arrangement that existed at any time during
the period; and
 the general terms and conditions of each arrangement, such as vesting
requirements, the maximum term of options granted, and the method of
settlement (for example, whether in cash or equity).
 An entity should provide the number and weighted average exercise prices of
share options for each of the following groups of options:
 Outstanding at the beginning of the period
 Granted during the period
 Forfeited during the period
 Exercised during the period
 Expired during the period
 Outstanding at the end of the period
 Exercisable at the end of the period.
For share options granted during the period, the weighted average fair value of those
options at the measurement date and information on how that fair value was measured
should be disclosed, including:
 the option pricing model used and the inputs to that model, including:
– the weighted average share price
– exercise price;
– expected volatility;
– option life;
– expected dividends;
– the risk-free interest rate; and
– any other inputs to the model, including the method used and the assumptions
made to incorporate the effects of expected early exercise;
 how expected volatility was determined, including an explanation of the extent
to which expected volatility was based on historical volatility

 Whether and how any other features of the option grant were incorporated into
the measurement of fair value, such as a market condition.
understand how the fair value of the goods or services received or the fair value of the
equity instruments granted during the period was determined.
For share options exercised during the period, an entity should disclose the weighted
average share price at the date of exercise.
For share options outstanding at the end of the period, an entity should disclose the
range of exercise prices and weighted average remaining contractual life.
For share-based payment arrangements that were modified during the period, an entity
should disclose:
 an explanation of those modifications;
 the incremental fair value granted (as a result of those modifications)
 Information on how the incremental fair value granted was measured, consistent
with the requirements set out above, where applicable.
understand the effect of share-based payment transactions on the entity’s profit or loss
for the period and on its financial position. As a result the entity should disclose at least
the following:
 the total expense recognized for the period arising from share-based payments,
including separate disclosure of that portion of the total expense that arises from
transactions accounted for as equity-settled share-based payment transactions;
 for liabilities arising from share-based payment transactions:
– the total carrying amount at the end of the period; and
– the total intrinsic value at the end of the period of liabilities for which the
counterparty’s
right to cash or other assets had vested by the end of the period.
10 | P a g e By:Merga Adugna(MBA)
CHAPTER THREE
ACCOUNTING FOR AGRICULTURE (IAS 41)
3.1 Introduction
The accounting treatment, financial statement presentation, and disclosures related to
agricultural activity, a matter not covered in other Standards. Agricultural activity is the
management by an entity of the biological transformation of living animals or plants
(biological assets) for sale, into agricultural produce, or into additional biological assets.
The accounting treatment for biological assets during the period of growth,
degeneration, production, and procreation, and for the initial measurement of
agricultural produce at the point of harvest. It requires measurement at fair value less
estimated point-of-sale costs from initial recognition of biological assets up to the point
of harvest, other than when fair value cannot be measured reliably on initial recognition.
However, this standard does not deal with processing of agricultural produce after
harvest; for example, processing grapes into wine and wool into yarn.
3.2 Agriculture-Related Terms
The following terms are used in this Standard with the meanings specified:
Agricultural activity is the management by an entity of the biological transformation
of biological assets for sale, into agricultural produce, or into additional biological
assets.
Agricultural produce is the harvested product of the entity’s biological assets.
Biological asset is a living animal or plant.
 Bearer Biological Asset
It is used in the production or supply of agricultural produce
It is expected to bear produce for more than one period
It is not intended to be sold as a living plant or harvested as agricultural produce, except
for incidental scrap sales
Example: livestock from which milk is produced, grape vines, fruit trees, coffee trees
and trees from which firewood is harvested while the tree remains
 Consumable Biological Asset
Biological assets which do not meet all of the above requirements
Example: livestock intended for the production of meat, livestock held for sale, fish in
farms, crops such as maize and wheat, and trees being grown for lumber
Biological transformation comprises the processes of growth, degeneration,
production, and procreation that cause qualitative or quantitative changes in a biological
asset.
A group of biological assets is an aggregation of similar living animals or plants.
Harvest is the detachment of produce from a biological asset or the cessation of a
biological asset’s life processes.
Agricultural activity covers a diverse range of activities; for example, raising livestock,
forestry, annual or perennial cropping, cultivating orchards and plantations, floriculture,
and aquaculture (including fish farming). Certain common features exist within this
diversity:
a) Capability to change. Living animals and plants are capable of biological
transformation.
b) Management of change. Management facilitates biological transformation by
enhancing, or at least stabilising, conditions necessary for the process to take place
(for example, nutrient levels, moisture, temperature, fertility, and light). Such
management distinguishes agricultural activity from other activities. For example,
harvesting from unmanaged sources (such as ocean fishing and deforestation) is
not agricultural activity.
c) Measurement of change. The change in quality (for example, genetic merit,
density, ripeness, fat cover, protein content, and fibre strength) or quantity
(for example, progeny, weight, cubic metres, fibre length or diameter, and number
of buds) brought about by biological transformation is measured and monitored
as a routine management function.
Biological transformation results in the following types of outcomes:
a) asset changes through
 growth (an increase in quantity or improvement in quality of an animal or
plant),
 degeneration (a decrease in the quantity or deterioration in quality of an

animal or plant), or
 procreation (creation of additional living animals or plants)
b) Production of agricultural produce such as latex, tea leaf, wool, and milk.
3.3 Application of accounting for agriculture (IAS41)
This Standard shall be applied to account for the following when they relate to
agricultural activity:
 Biological assets;
 Agricultural produce at the point of harvest only
 Government grants related to agricultural assets

IAS 41 does not apply to:
 land related to agricultural activity
 Intangible assets related to agricultural activity
 Bearer plants related to agricultural activity
 Products that are the result of processing after the point of harvest, for example:
yarn/carpet, processed meats such as cured hams, tea, wine, rubber, logs
 Agricultural activity that is not managed, for example: harvesting from ocean
fishing
 Minerals, oil, natural gas and similar non-regenerative resources
Examples of biological assets, agricultural produce, and products that are the result of
processing after harvest
Biological assets Agricultural Products that are the result
produce of processing after harvest
Sheep Wool Yarn, carpet
Trees in a plantation Logs Lumber
forest
Plants Cotton Thread, clothing
Plants Harvested cane Sugar
Dairy cattle Milk Cheese
Pigs Carcass Sausages, cured hams
Bushes Leaf Tea, cured tobacco

Vines Grapes Wine
Fruit trees Picked fruit Processed fruit
3.4 Recognition and Measurement
An entity shall recognise a biological asset or agricultural produce when and only when:
 The entity controls the asset as a result of past events(legal ownership)
 It is probable that future economic benefits associated with the asset will flow
to the entity
 The fair value or cost of the asset can be measured reliably.
A biological asset shall be measured on initial recognition and at each balance sheet
date at its fair value less estimated point-of-sale costs, except for the case where the fair
value cannot be measured reliably. Agricultural produce harvested from an entity’s
biological assets shall be measured at its fair value less estimated point-of-sale costs at
the point of harvest.
Point-of-sale costs include:
 Commissions to brokers and dealers
 Levies by regulatory agencies and commodity exchanges
 Transfer taxes and duties
Point-of-sale costs exclude:
 Transport and other costs necessary to get assets to a market.
Fair value the estimation of fair value will be determined by applying the requirements
of IFRS 13 Fair Value Measurement. Fair value is the price that would be received to
sell the biological asset or agricultural produce in an orderly transaction between market
participants at the measurement date.
The fair value of an asset is based on its present location and condition. As a result, for
example, the fair value of cattle at a farm is the price for the cattle in the relevant market
less the transport and other costs of getting the cattle to that market.
CHAPTER FOUR
4. STATEMENT OF CASH FLOW
4.1 Introduction
The primary purpose of the statement of cash flows is to provide information about a
company’s cash receipts and cash payments during a period. A secondary objective is
to provide cash-basis information about the company’s operating, investing, and
financing activities. The statement of cash flows therefore reports cash receipts, cash
payments, and net change in cash resulting from a company’s operating, investing, and
financing activities during a period. Its format reconciles the beginning and ending cash
balances for the period.
Usefulness of the Statement of Cash Flows
The statement of cash flows provides information to help investors, creditors, and other
users:
1. The entity’s ability to generate future cash flows.
A primary objective of financial reporting is to provide information with which
to predict the amounts, timing, and uncertainty of future cash flows. By
examining relationships between items such as sales and net cash flow from
operating activities whether there are increases or decreases in cash.
2. The entity’s ability to pay dividends and meet obligations.
Without adequate cash, a company cannot pay employees, settle debts, pay out
dividends, or acquire equipment. A statement of cash flows indicates where the
company’s cash comes from and how the company uses its cash.
3. The reasons for the difference between net income and net cash flow from
operating activities.
The net income provides information on the performance of a company from
one period to another. Financial statement readers can benefit from knowing
why a company’s net income and net cash flow from operating activities differ,
and can assess for themselves the reliability of the income number.
4. The cash and noncash investing and financing transactions during the
period.
Besides operating activities, companies undertake investing and financing
transactions. Investing activities include the purchase and sale of assets other
than a company’s products or services.
Financing activities include borrowings and repayments of borrowings,
investments by owners, and distributions to owners. By examining a company’s
investing and financing activities, a financial statement reader can better
understand why assets and liabilities increased or decreased during the period.
4.2 Classification of Cash Flows

The statement of cash flows classifies cash receipts and cash payments by operating,
investing, and financing activities.
1. Operating activities involve the cash effects of transactions that enter into the
determination of net income, such as cash receipts from sales of goods and
services, and cash payments to suppliers and employees for acquisitions of
inventory and expenses.
2. Investing activities generally involve long-term assets and include making and
collecting loans, and acquiring and disposing of investments and productive
long-lived assets.
3. Financing activities involve liability and stockholders’ equity items and
include obtaining cash from creditors and repaying the amounts borrowed, and
obtaining capital from owners and providing them with a return on, and a return
of, their investment.
The operating activities category is the most important. It shows the cash provided by
company operations. This source of cash is generally considered to be the best measure
of a company’s ability to generate enough cash to continue as a going concern.
Operating Activities
Cash inflows
From sales of goods or services
From returns on loans (interest) and on equity securities (dividends)
Cash outflows
To suppliers for inventory
To employees for services
To government for taxes
To lenders for interest
To others for expenses
Investing Activities
Cash inflows
From sale of property, plant, and equipment
From sale of debt or equity securities of other entities
From collection of principal on loans to other entities
Cash outflows
To purchase property, plant, and equipment
To purchase debt or equity securities of other entities
To make loans to other entities
Financing Activities
Cash inflows
From sale of equity securities
From issuance of debt (bonds and notes)
Cash outflows
To stockholders as dividends
To redeem long-term debt or reacquire capital stock
Note the following general guidelines about the classification of cash flows.
1. Operating activities involve income statement items.
2. Investing activities involve cash flows resulting from changes in investments
and long-term asset items.
3. Financing activities involve cash flows resulting from changes in long-term
liability and stockholders’ equity items.
Companies classify some cash flows such as investment income (interest and dividend)
and payments of interest to lenders relating to investing or financing activities as
operating activities. This is why companies report these items in the income statement,
where the results of operations are shown.
4.3 Sources of Data to Prepare Statements of cash flow
Companies prepare the statement of cash flows differently from the three other basic
financial statements:
1. Comparative balance sheets provide the amount of the changes in assets,
liabilities, and equities from the beginning to the end of the period.
2. Current income statement data help determine the amount of cash provided
by or used by operations during the period.
3. Selected transaction data from the general ledger provide additional detailed
information needed to determine how the company provided or used cash during
the period.
4.4 Major steps to prepare Statements of cash flow:
1. Determine the change in cash. This procedure is straightforward. A company
can easily compute the difference between the beginning and the ending cash
balance from examining its comparative balance sheets.
2. Determine the net cash flow from operating activities. This procedure is
complex. It involves analyzing not only the current year’s income statement but
also comparative balance sheets as well as selected transaction data.
3. Determine net cash flows from investing and financing activities. A company
must analyze all other changes in the balance sheet accounts to determine their
effects on cash.
4.5 Method of Statements of Cash Flow
Two different methods are available to adjust income from operations on an accrual
basis to net cash flow from operating activities. These are Indirect Method and Direct
Method.
4.5.1 Indirect Method
The indirect method (or reconciliation method) starts with net income and converts it
to net cash flow from operating activities. In other words, the indirect method adjusts
net income for items that affected reported net income but did not affect cash.
Adjustments should be made on net income under indirect method

NET INCOME------------------------------------------------------------------------------------
xxxx
Additions:
Depreciation expense----------------------------------------------------------xxx
Amortization of intangibles and deferred charges-------------------------xxx
Amortization of bond discount-----------------------------------------------xxx
Increase in deferred income tax liability------------------------------------xxx
Loss on investment in common stock using equity method--------------xxx
Loss on sale of plant assets---------------------------------------------------xxx
Loss on impairment of assets-------------------------------------------------xxx
Decrease in receivables--------------------------------------------------------xxx
Decrease in inventories--------------------------------------------------------xxx
Decrease in prepaid expense--------------------------------------------------xxx
Increase in accounts payable--------------------------------------------------xxx
Increase in accrued liabilities-------------------------------------------------xxx
xxx
Deductions:
Amortization of bond premium-------------------------------------------(xxx)
Decrease in deferred income tax liability--------------------------------(xxx)
Income on investment in common stock using equity method---------(xxx)
Gain on sale of plant assets------------------------------------------------(xxx)
Increase in receivables------------------------------------------------------(xxx)
Increase in inventories------------------------------------------------------(xxx)
Increase in prepaid expense------------------------------------------------(xxx)
Decrease in accounts payable----------------------------------------------(xxx)
Decrease in accrued liabilities---------------------------------------------(xxx)
(xxx)
Net Cash Flow from Operating Activities---------------------------------------------------
xxxx
Illustrate
Tax Consultants Inc. experienced continued success in 2011 and expanded its
operations to include the sale of computer software. The company balance sheets,
income statements, and selected data for 2011 are as follows:
Tax Consultants Inc.
Comparative Balance Sheets
As Of December 31
Assets 2011 2010
Increase/Decrease
Cash Br 54000 Br 37000 Br 17,000

Increase
Accounts receivable 68,000 26,000 42,000
Increase
Inventories 54,000 –0–
54,000 Increase
Prepaid expenses 4,000 6,000 2,000
Decrease
Land 45,000 70,000
25,000 Decrease
Buildings 200,000 200,000 –0–
Accumulated depreciation—buildings (21,000) (11,000)
10,000 Increase
Equipment 193,000 68,000
125,000 Increase
Accumulated depreciation—equipment (28,000) (10,000)
18,000 Increase
Totals Br 569,000 Br 386,000
Liabilities and Stockholders’ Equity
Accounts payable Br 33,000 Br 40,000 Br 7,000
Decrease
Bonds payable 110,000 150,000 40,000
Decrease
Common stock (Br 1 par) 220,000 60,000
160,000 Increase
Retained earnings 206,000 136,000
70,000 Increase
Totals Br 569,000 Br 386,000
Income Statement
For The Year Ended December 31, 2011
Revenues Br 890,000
Cost of goods sold Br 465,000
Operating expenses 221,000
Interest expense 12,000
Loss on sale of equipment 2,000 700,000
Income from operations 190,000
Income tax expense 65,000
Net income Br 125,000
Additional Information
a) Operating expenses include depreciation expense of Br 33,000 and expiration
of prepaid expenses of Br 2,000.
b) Land was sold at its book value for cash.

c) Cash dividends of Br 55,000 were declared and paid.
d) Interest expense of Br 12,000 was paid in cash.
e) Equipment with a cost of Br 166,000 was purchased for cash. Equipment with
a cost of Br 41,000 anda book value of Br 36,000 was sold for Br 34,000 cash.
f) Bonds were redeemed at their book value for cash.
g) Common stock (Br 1 par) was issued for cash.
Step 1: Determine the Change in Cash
The first step in the preparation of the statement of cash flows is to determine the change
in cash. As the comparative balance sheets show, cash increased Br 17,000 in 2011.
Step 2: Determine Net Cash Flow from Operating Activities
We explain the adjustments to net income of Br 125,000 as follows.
 Increase in Accounts Receivable. The increase in accounts receivable of Br
42,000 represents recorded accrual-basis revenues in excess of cash collections
in 2011. The company deducts this increase from net income to convert from
the accrual basis to the cash basis.
 Increase in Inventories. The Br 54,000 increase in inventories represents an
operating use of cash, not an expense. Tax Consultants therefore deducts this
amount from net income, to arrive at net cash flow from operations. In other
words, when inventory purchased exceeds inventory sold during a period, cost
of goods sold on an accrual basis is lower than on a cash basis.
 Decrease in Prepaid Expenses. The Br 2,000 decrease in prepaid expenses
represents a charge to the income statement for which Tax Consultants made no
cash payment in the current period. The company adds back the decrease to net
income, to arrive at net cash flow from operating activities.
 Decrease in Accounts Payable. When accounts payable decrease during the
year, cost of goods sold and expenses on a cash basis are higher than they are
on an accrual basis. To convert net income to net cash flow from operating
activities, the company must deduct the Br 7,000 in accounts payable from net
income.
 Depreciation Expense (Increase in Accumulated Depreciation). Accumulated
Depreciation Buildings increased Br 10,000 (Br 21,000 -Br 11,000). The
Buildings account did not change during the period, which means that Tax
Consultants recorded depreciation expense of Br 10,000 in 2011.
 Accumulated Depreciation—Equipment increased by Br 18,000 (Br 28,000 -
Br 10,000) during the year. But Accumulated Depreciation—Equipment
decreased by Br 5,000 as a result of the sale during the year. Thus, depreciation
for the year was Br 23,000. The company reconciled Accumulated
Depreciation—Equipment as follows.
Beginning balance Br 10,000
Add: Depreciation for 2011 23,000
33,000
Deduct: Sale of equipment 5,000
Ending balance Br 28,000
The company must add back to net income the total depreciation of Br
33,000(Br 10,000 + Br23,000) charged to the income statement, to determine
net cash flow from operating activities.
 Loss on Sale of Equipment. Tax Consultants Inc. sold for Br 34,000 equipment
that cost
Br 41,000 and had a book value of Br 36,000. As a result, the company reported
a loss of Br 2,000 on its sale. To arrive at net cash flow from operating activities,
it must add back to net income the loss on the sale of the equipment. The reason
is that the loss is a noncash charge to the income statement. The loss did not
reduce cash, but it did reduce net income
Step 3: Determine Net Cash Flows from Investing and Financing Activities
By analyzing the remaining changes in the balance sheet accounts, Tax Consultants
identifies cash flows from investing and financing activities.
 Land. Land decreased Br 25,000 during the period. As indicated from the
information presented, the company sold land for cash at its book value. This
transaction is an investing activity, reported as a Br 25,000 source of cash.
 Equipment. An analysis of the equipment account indicates the following.
Beginning balance Br 68,000
Add: Purchase of equipment 166,000
234,000
Less: Sale of equipment 41,000
Ending balance Br 193,000
The company used cash to purchase equipment with a fair value of Br 166,000 an
investing transaction reported as a cash outflow. The sale of the equipment for Br
34,000 is also an investing activity, but one that generates a cash inflow.
 Bonds Payable. Bonds payable decreased Br 40,000 during the year. As
indicated from the additional information, the company redeemed the bonds at
their book value. This financing transaction used Br 40,000 of cash.
 Common Stock. The common stock account increased Br 160,000 during the
year. As indicated from the additional information, Tax Consultants issued
common stock of Br 160,000 at par. This financing transaction provided cash of
Br 160,000.
 Retained Earnings. Retained earnings changed Br 70,000 (Br 206,000 - Br
136,000) during the year. The Br 70,000 change in retained earnings results
from net income of Br 125,000from operations and the financing activity of
paying cash dividends of Br 55,000.
Statement of Cash Flow under Indirect Method
Tax Consultants Inc. combines the foregoing items to prepare the statement of cash
flows shown as follows

Statement of Cash Flows
Increase (Decrease) In Cash
Cash flows from operating activities
Net income Br 125,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation expense Br 33,000
Loss on sale of equipment 2,000
Increase in accounts receivable (42,000)
Increase in inventories (54,000)
Decrease in prepaid expenses 2,000
Decrease in accounts payable (7,000) (66,000)
Net cash provided by operating activities 59,000
Cash flows from investing activities
Sale of land 25,000
Sale of equipment 34,000
Purchase of equipment (166,000)
Net cash used by investing activities (107,000)
Cash flows from financing activities
Redemption of bonds (40,000)
Sale of common stock 160,000
Payment of dividends (55,000)
Net cash provided by financing activities 65,000
Net increase in cash 17,000
Cash, January 1, 2011 37,000
Cash, December 31, 2011 Br 54,000
4.5.2 Direct Method

Under the direct method the statement of cash flows reports net cash flow from
operating activities as major classes of operating cash receipts (e.g., cash collected from
customers and cash received from interest and dividends) and cash disbursements (e.g.,
cash paid to suppliers for goods, to employees for services, to creditors for interest, and
to government authorities for taxes).
Under the direct method, companies compute net cash provided by operating activities
by adjusting each item in the income statement from the accrual basis to the
cash basis. An efficient way to apply the direct method is to analyze the revenues and
expenses reported in the income statement in the order in which they are listed. The
company then determines cash receipts and cash payments related to these revenues and
expenses. In the following sections, we present the direct method adjustments for Tax
Consultants Inc from previous illustration. Adjustment (convert accrual basis to cash
basis) to determine net cash provided by operating activities under direct method
includes the followings:
Determining cash receipts from customer

Revenue from sales------------------------------xxx
Add: Decrease in account receivable ----------xx
Less: Increases in account receivable --------(xx)
Cash receipts from customer------------------xxx
Determining cash payments for suppliers
Cost of goods sold-------------------------------------xxx
Add: Increases in inventory --------------------------xx
Decreases in account payable ------------------xx
Less: Decreases in inventory ------------------------(xx)
Increase in account payable ------------------(xx)
Cash payments for suppliers-------------------------xxx
Determining cash payments for operating expenses
Operating expenses ---------------------------------xxx
Add: Increases in prepaid expenses ----------------xx
Decreases in accrued expense payable ------xx
Less: Decreases in prepaid expenses -------------(xx)
Increases in accrued expense payable------(xx)
Depreciation expenses ----------------------(xx)
Cash payments for operating expenses ---------xxx
Determining cash receipts from customer
Revenue from sales-----------------------------890000
Add: Decrease in account receivable ------------0
Less: Increases in account receivable -------(42000)
Cash receipts from customer-----------------848000
Determining cash payments for suppliers
Cost of goods sold------------------------------465000
Add: Increases in inventory -------------------54000
Decreases in account payable -----------7000
Less: Decreases in inventory --------------------0
Increase in account payable --------------0
Cash payments for suppliers---------------Br 526000
Determining cash payments for operating expenses
Operating expenses ---------------------------------221000
Add: Increases in prepaid expenses ----------------0
Decreases in accrued expense payable ------0
Less: Decreases in prepaid expenses -------------(2000)

Increases in accrued expense payable------(0)
Depreciation expenses ----------------------33000
Cash payments for operating expenses ----Br 186000
Statement of Cash Flow under direct Method
Tax Consultants Inc. combines the foregoing items to prepare the statement of cash
flows shown as follows
Statement of Cash Flows
Cash flows from operating activities
Cash received from customer ----------------------------------------848000
Cash payment:
To Suppliers ----------------------------(526000)
For operating expenses ----------------(186000)
For income tax----------------------------65000
For interest Expenses---------------------12000 (789000)
Net cash provided by operating activities-----------------------------------59000
Cash flows from investing activities
Sale of land -----------------------------------25,000
Sale of equipment ----------------------------34,000
Purchase of equipment --------------------(166,000)
Net cash used by investing activities-------------------------------------(107,000)
Cash flows from financing activities
Redemption of bonds ----------------------(40,000)
Sale of common stock ---------------------160,000
Payment of dividends ---------------------(55,000)
Net cash provided by financing activities---------------------------------65,000
Net increase in cash 17,000
Cash, January 1, 2011 37,000
Cash, December 31, 2011------------------------------------------------ Br 54,000

Advanced Financial Accounting - II CH 1-4

Uploaded by

Copyright:

Available Formats

Advanced Financial Accounting - II CH 1-4

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Advanced Financial Accounting - II CH 1-4

Uploaded by

Copyright:

Available Formats

Harambee University Lecture Note

IFRS- Financial Income Tax payable to authority

 Income tax: is a type of tax that governments impose on income generated by

1|Page By:Merga Adugna(MBA)

Income tax expense

–Fine & Penalty……………………………………………………… x

Balance Sheet Approach (Asset and liability)

3|Page By:Merga Adugna(MBA)

 When accounting profit < Taxable profit ( Income approach)

 Operating loss carry forwards.

5|Page By:Merga Adugna(MBA)

6|Page By:Merga Adugna(MBA)

b) Cash-settled share-based payment transaction, the entity acquires goods

7|Page By:Merga Adugna(MBA)

 Service condition is the requirement to complete a specified

8|Page By:Merga Adugna(MBA)

9|Page By:Merga Adugna(MBA)

 degeneration (a decrease in the quantity or deterioration in quality of an

 Government grants related to agricultural assets

Bushes Leaf Tea, cured tobacco

4.2 Classification of Cash Flows

To redeem long-term debt or reacquire capital stock

Adjustments should be made on net income under indirect method

Cash Br 54000 Br 37000 Br 17,000

b) Land was sold at its book value for cash.

Tax Consultants Inc.

4.5.2 Direct Method

Determining cash receipts from customer

Less: Decreases in prepaid expenses -------------(2000)

You might also like