Complex financial transactions are an integral part of financial accounting. They can include advanced financial instruments, foreign exchange transactions, how to prepare basic financial statements for incorporated and unincorporated entities, leasing arrangements, and more.
These transactions require a deep understanding of accounting principles and standards, such as the regulatory framework - International Financial Reporting Standards (IFRS), which emphasize the qualitative characteristics of financial information.
For ACCA Financial Accounting (FA) students, mastering these fundamentals and the ability to interpret financial statements is not just about passing exams; it's about preparing for real-world scenarios where these skills are crucial.
Incorrectly processing these transactions can significantly affect a company's financial health, and the ability to accurately record and report financial information is a valued skill in the accounting profession.
In this article, we look at the steps you will take to complete these business transactions and prepare consolidated financial statements.
Financial Accounting FA - Syllabus Summary
This syllabus provides a strong foundation in financial reporting, income statements, and balance sheets.
You will learn how to prepare financial statements with a strong emphasis on the use of double entry, ensuring each transaction is accurately recorded in two separate accounts.
Later in the syllabus, topics such as sales transactions, assets, accruals, receivables, and provisions become commonplace. Lastly, reconciliations, the trial balance, corporate tax, the preparation of financial statements, and correcting errors are covered.
This syllabus is jam-packed with basic and complex information and transactions. With that in mind, we will cover some of the more difficult financial concepts.
VIVA offers students the most up-to-date course material, giving you flexible study options and support as you progress. Study with world-class tutor, James Griffiths. With 30 years of financial accounting experience, he brings a wealth of knowledge and practical wisdom to the table. We also offer:
- 12 hours of tuition
- On-demand video lectures
- 250 exam-grade questions
- Downloadable course notes covering the entire syllabus
The exam consists of two sections:
- Section A - 35 objective test questions with a total of 70 marks
- Section B - 2 multi-task questions of 15 marks each. These questions will test consolidations and accounts preparation.
Step-by-Step Example: Foreign Exchange Transactions
Let's walk through a foreign exchange transaction, which is a common type of complex financial transaction.
Recognise that a foreign exchange transaction has occurred. For example, a UK-based company purchases goods from a US supplier for $50,000 when the exchange rate is £1 = $1.3.
Record the initial purchase in the company's books in the functional currency. The purchase would be recorded as £38,461.54 (£1 = $1.3), with the corresponding credit to trade payables.
If the payment is made after some time, the payable must be revalued at each reporting date using the closing exchange rate. If the exchange rate changes to £1 = $1.2, the payable is now worth £41,666.67, and the company must recognize a foreign exchange loss.
When the payment is made, the company must again revalue the payable if the exchange rate changes. If the final exchange rate is £1 = $1.25, the payable is worth £40,000, and the company will recognise a foreign exchange gain or loss based on this final rate.
The financial statements must disclose the amount of foreign exchange gain or loss and the methods used to calculate it.
Step-by-Step Example: Accounting for Credit Facilities, Irrecoverable Debts, and Allowance for Receivables
Credit facilities are financial arrangements that allow businesses to borrow money up to a certain limit. Irrecoverable debts are amounts due to the company that is no longer expected to be collected. An allowance for receivables estimates the receivables the company does not expect to collect.
Here’s how these items are presented in financial statements:
Recognition of Credit Facility
When a company enters a credit facility agreement, it recognises a liability for any amounts drawn down under the facility. For example, if a company has drawn £50,000 from its credit facility, it records a liability of £50,000.
Interest incurred on the drawn amount is recorded as an expense in the income statement. If the annual interest rate is 5%, the company records an interest expense of £2,500 (£50,000 x 5%).
Identification of Irrecoverable Debts
Review the age analysis of receivables and identify specific debts that are deemed irrecoverable. For instance, if a customer owing £10,000 has gone bankrupt, that debt is identified as irrecoverable.
Recording Irrecoverable Debts
Write off the irrecoverable debt by debiting an expense account (bad debts expense) and crediting the receivables account. The entry would be a debit to bad debts expense and a credit to accounts receivable for £10,000.
Estimation of Allowance for Receivables
Estimate the allowance for doubtful debts using historical data on credit sales and past receivables that have been uncollectible. Assume a 2% allowance is deemed appropriate on a receivables balance of £200,000, resulting in an allowance of £4,000.
Recording Allowance for Receivables
Record the allowance by debiting bad debts expense and crediting allowance for doubtful accounts (a contra-asset account). The entry would be a debit to bad debts expense and a credit to allowance for doubtful accounts for £4,000.
Presentation in Financial Statements
Present the net receivables on the balance sheet, which is the gross receivables minus the allowance for doubtful accounts. In this case, it would be £196,000 (£200,000 - £4,000).
The credit facility liability is presented under liabilities, and the interest expense is included in the income statement.
Disclose the accounting policies for receivables, the credit facility, and any related interest rates or terms. Also, disclose the movement in the allowance for doubtful accounts, including the write-off of irrecoverable debts.
Step-by-Step Example: Accounting for Changes in Capital Structure
Capital structure refers to the way a company finances its operations and growth through different sources of funds, including ordinary shares, preference shares, loan notes, and retained earnings. Here's how various changes in capital structure are accounted for:
Issuance of Ordinary Shares
When a company issues new ordinary shares, it records the cash received as an increase in equity, specifically in the share capital account. If 10,000 new shares are issued at £1 each, the entry is a debit to cash and a credit to share capital for £10,000.
A bonus issue is made from a company's reserves to existing shareholders. It does not involve cash but converts reserves into issued share capital. If a company issues a 1 for 5 bonus issue from retained earnings, and there are 50,000 shares outstanding, 10,000 new shares are issued. The entry is a debit to retained earnings and a credit to share capital for the nominal value of the new shares.
For a rights issue, shares are offered to existing shareholders at a discount. The amount received is split between share capital (nominal value) and share premium. If 5,000 shares are issued at £1.50 each with a nominal value of £1, the entry is a debit to cash for £7,500, a credit to share capital for £5,000, and a credit to share premium for £2,500.
Issuance of Loan Notes
When loan notes are issued, the company records a liability for the amount received. If £100,000 in loan notes are issued at par, the entry is a debit to cash and a credit to loan notes payable for £100,000.
Issuance of Preference Shares
Preference shares are recorded similarly to ordinary shares. If £20,000 worth of preference shares are issued, the entry is a debit to cash and a credit to preference share capital for £20,000.
Payment of Dividends
Dividends on ordinary and preference shares are recorded as a reduction in equity when declared. If £5,000 in dividends are declared, the entry is a debit to retained earnings or other reserves and a credit to dividends payable.
Creation of Other Reserves
Other reserves, like a revaluation reserve, are created when, for example, an asset's fair value increases above its carrying amount. If an asset's fair value increases by £15,000, the entry is a debit to the asset and a credit to revaluation reserve for £15,000.
Presentation in Financial Statements
Equity instruments are presented in the equity section of the balance sheet. Ordinary and preference shares are listed under share capital, premiums on issued shares under share premium, and retained earnings and other reserves are listed separately.
Disclose the nature and purpose of each reserve within equity. For share issues, disclose the number of shares, the type of shares, and the reasons for the issue. For dividends, disclose the amount per share and the total cost of the dividends.
Step-by-Step Example: Recording Corporate Income Tax
Corporate income tax is a tax on the profits of a corporation. The tax is calculated on the taxable income of the corporation, which may differ from the accounting profit due to differences in accounting and tax laws. Here's a step-by-step example of how to record corporate income tax in financial statements:
Determination of Accounting Profit
Calculate the accounting profit before tax by subtracting expenses from revenues as per the accounting standards. For instance, a company has an accounting profit of £500,000 before tax.
Calculation of Taxable Income
Adjust the accounting profit for differences that are either temporary or permanent between accounting and tax laws. This may include adding back non-deductible expenses or deducting income that is not taxable. Assume the taxable income after adjustments is £480,000.
Computation of Current Tax Liability
Apply the current tax rate to the taxable income to compute the current tax liability. If the tax rate is 25%, the current tax liability would be £120,000 (25% of £480,000).
Recording Current Tax Expense
Record the current tax expense in the income statement. This is the amount of income tax payable for the period. In our example, the current tax expense is £120,000.
Recognition of Deferred Tax
If there are temporary differences, recognize deferred tax. For example, if the company has a depreciation difference of £20,000 (tax depreciation is greater than accounting depreciation), and the tax rate is 25%, a deferred tax asset of £5,000 is recognized.
Presentation in Financial Statements
Present the current tax liability on the balance sheet under current liabilities. The deferred tax asset or liability is presented as non-current. The total tax expense in the income statement is the sum of the current tax expense and the movement in deferred tax.
Payment of Tax
When the tax payment is made, debit the current tax liability and credit cash. This reflects the outflow of cash in payment of the tax liability.
Disclose the components of tax expense, reconciliation between accounting profit and taxable income, effective tax rate, and the amounts of deferred tax assets and liabilities. Also, disclose any uncertain tax positions and the movements in the current and deferred tax accounts.
Step-by-Step Example: Preparing a Statement of Cash Flows
The statement of cash flows is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents. It breaks down the analysis into operating, investing, and financing activities. Here's how to prepare a basic statement of cash flows.
Determine the Starting Point
Begin with the cash balance at the start of the period. This is usually the ending cash balance from the previous period's cash flow statement.
- Adjust the net income for non-cash transactions and changes in working capital to calculate cash flow from operating activities. For example:
- Add back non-cash expenses such as depreciation and amortization to net income.
- Adjust for gains or losses on the sale of assets, as these are investing activities.
- Adjust for changes in accounts receivable, inventory, and accounts payable. For instance, an increase in accounts receivable decreases cash flow, while an increase in accounts payable increases it.
Analyze changes in long-term assets to determine cash flow from investing activities. This includes:
- Cash paid for the purchase of property, plant, and equipment (PPE).
- Proceeds from the sale of PPE.
- Cash paid for the purchase of investment securities (other than cash equivalents).
- Proceeds from the sale of investment securities.
Review changes in long-term liabilities and equity to calculate cash flow from financing activities. This includes:
- Proceeds from issuing shares or debt.
- Payments made to repurchase shares or repay debt principal.
- Dividends paid to shareholders.
Presentation of the Cash Flow Statement
Present the total net cash provided by or used in each of the three activities. The sum of these totals will result in a net increase or decrease in cash for the period.
Reconciliation to Ending Cash Balance
Add the net increase or decrease in cash to the beginning cash balance to arrive at the ending cash balance for the period.
Disclose the significant non-cash transactions that did not involve cash flows during the period, such as depreciation, amortization, or stock-based compensation.
Also, disclose the method used to present the cash flow statement (direct or indirect method) and any supplemental information, such as interest and taxes paid.
In this article we have seen the importance of understanding the step-by-step processes that help you as a financial accountant to preserve the wealth and financial viability of your clients. Theory is never enough and it’s only when you merge theory with good, solid, practical knowledge that you get the most out of your studies.
ACCA FA Tutor, James Griffiths has 30 years of experience and can tell you how to apply the financial principles you learn in ACCA FA practically. When you study with VIVA you can be sure that you will get much more than course notes - you’ll get all of the real-world knowledge and application expertise that only our tutors can give you.