Week 9 - Accounting for companies: format of financial statements, capital and liabilities Pt2

Question 1

What is a contingency in accounting?

Answer 1

A contingency is a condition that exists at the end of the reporting period, where the outcome will only be confirmed by the occurrence (or non-occurrence) of one or more uncertain future events.

Question 2

What is a contingent gain or loss?

Answer 2

A contingent gain or loss depends on the occurrence of a contingent event. The gain or loss is not certain until the event happens (or doesn’t happen).

Question 3

How are contingent losses recognised in the financial statements?

Answer 3

Contingent losses are not recognised in the financial statements unless the loss is probable and can be estimated reliably. If only possible, they are disclosed in the notes to the financial statements.

Question 4

What are examples of contingent losses?

Answer 4

Bills of exchange received that have been discounted

Corporation tax disputes

Failure by another party to pay a debt the company has guaranteed

Pending legal actions against the company

Question 5

What’s the treatment for a contingent gain?

Answer 5

Contingent gains are not recognised in financial statements until they are virtually certain. However, if the gain is probable, it may be disclosed in the notes.

Question 6

Where are contingencies disclosed in the financial statements?

Answer 6

Contingencies (whether gains or losses) are typically disclosed in the notes to the financial statements, except in rare cases when the event is virtually certain.

Question 7

What is the definition of a possible contingent liability?

Answer 7

A possible contingent liability arises from past events whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events, and these events are not wholly within the control of the entity.

Question 8

What is the definition of a probable contingent liability?

Answer 8

A probable contingent liability arises from past events but is not recognised because:

It is not probable that an outflow of resources (economic benefits) will be required to settle the obligation, or

The amount of the obligation cannot be measured reliably.

Question 9

How are possible contingent liabilities treated in financial statements?

Answer 9

Possible contingent liabilities are typically disclosed in the notes to the financial statements but not recognised on the balance sheet.

Question 10

How are probable contingent liabilities treated in financial statements?

Answer 10

Probable contingent liabilities are not recognised on the balance sheet unless:

It is probable that an outflow of economic resources will occur, and

The amount can be measured reliably.
If not, they are disclosed in the notes to the financial statements.

Question 11

What makes a contingent liability probable?

Answer 11

It is probable that the company will have to settle the obligation in the future (i.e., more likely than not) or the amount can be measured with reasonable reliability.

Question 12

What makes a contingent liability possible?

Answer 12

It is possible that the company will have to settle the obligation, but the likelihood is less than probable and the event’s occurrence is uncertain.

Question 13

Why are contingent liabilities not recognised in the financial statements?

Answer 13

Contingent liabilities are not recognized because:

It is unlikely they will occur (less than probable)

Even if the event occurs, it may not result in a liability or may not involve an outflow of resources

The amount cannot be estimated reliably

Question 14

Where should contingent liabilities be disclosed?

Answer 14

Contingent liabilities should be disclosed in the notes to the financial statements, unless the probability of occurrence is remote, in which case they should not form part of the financial statements.

Question 15

What should the note on contingent liabilities include?

Answer 15

The note should include:

A description of the contingent liability

An estimate of the likely financial impact

An indication of the likelihood of the event occurring

Question 16

What is the treatment for a remote contingent liability?

Answer 16

A remote contingent liability should not be disclosed in the financial statements, as the likelihood of it occurring is considered extremely low.

Question 17

Can a contingent liability ever be recognised in the financial statements?

Answer 17

Yes, if it meets the criteria for probable (i.e., more likely than not) and can be measured reliably. In that case, it would be recognized as a provision rather than just a contingent liability.

Question 18

What kind of liability? Provision, contingent
or ordinary liability
An announcement is made that 1,000 jobs will be made redundant in the next year. The cost of the redundancy programme is estimated at £1.5m

Answer 18

Analysis:
Past event: The redundancy programme has been announced, which is a past event.

Obligation: The company has a present obligation to pay redundancy costs.

Probable and measurable: The cost is probable and can be measured reliably (£1.5 million).

Conclusion:
This is a Provision, as the company has a present obligation with a probable outflow of economic resources and the cost can be estimated reliably.

Question 19

What kind of liability? Provision, contingent
or ordinary liability
The company has sub-let three leasehold properties to other business tenants. If these tenants default on the rent, the company will be liable for future rentals with a maximum liability of £500,000

Answer 19

Analysis:
Past event: The company has sub-let properties, but the default is uncertain.

Obligation: The company does not yet have a present obligation—the liability is conditional on the tenants’ default.

Uncertainty: The future default is possible but not certain, and the maximum liability is known (£500,000).

Conclusion:
This is a Contingent Liability, as the company’s obligation depends on the uncertain future event (the tenants’ default), and it is only disclosed in the notes unless it is probable.

Question 20

What kind of liability? Provision, contingent
or ordinary liability
The company has acquired a subsidiary in Australia for which the tax authorities are claiming a tax bill of £3m in relation to a transaction prior to the acquisition. The action is being strongly defended by the company.

Answer 20

Analysis:
Past event: The tax authorities are claiming a tax bill related to an event before the acquisition.

Obligation: The company has a potential obligation, but it is not probable that it will result in a liability due to the strong defence.

Uncertainty: The outcome is uncertain, and the liability is possible rather than probable.

Conclusion:
This is a Contingent Liability, as the company has a possible obligation that depends on the outcome of the ongoing defence against the tax claim.

Question 21

What is issued share capital?

Answer 21

Issued share capital is the number of shares issued by the company, multiplied by the nominal value per share. It represents the total capital raised from shareholders through the issuance of shares.

Question 22

What is a share premium account?

Answer 22

The share premium account reflects the amount at which shares are issued above their nominal value. For example, if a share with a nominal value of £1 is sold for £5, the share premium would be £4 per share.

Question 23

What is retained earnings?

Answer 23

Retained earnings represent the cumulative profits earned by the company less cumulative dividends paid to shareholders. These earnings can be distributed as dividends or retained for reinvestment.

Question 24

How are retained earnings treated in the financial statements?

Answer 24

Retained earnings are shown under equity on the balance sheet. They reflect past profitability that has not been paid out to shareholders as dividends. This balance can be reinvested back into the company.

Question 25

What is a revaluation reserve?

Answer 25

The revaluation reserve represents the cumulative increase (net of decreases) in asset values when assets are revalued (e.g., land, buildings). It accounts for the appreciation in asset value over time, but any decrease in value is typically deducted from the reserve.

Question 26

Can the revaluation reserve be distributed?

Answer 26

Generally, the revaluation reserve cannot be directly distributed as dividends. However, if assets are sold or impaired, the reserve may be transferred to retained earnings.

Question 27

What are other reserves?

Answer 27

Other reserves include various other amounts that may be set aside for specific purposes, such as: Legal reserves Statutory reserves Currency translation reserves These reserves are usually created based on specific legal, regulatory, or business needs and can be used for specific purposes depending on their nature.

Question 28

How does a company decide on its dividends from retained earnings?

Answer 28

A company can distribute dividends from its retained earnings if there are sufficient profits. The board of directors will assess whether to declare a dividend based on profitability, future plans, and other considerations like cash flow needs.

Question 29

What is share premium?

Answer 29

Share premium is the amount by which shares are issued above their nominal value. For example, if a company issues shares with a nominal value of £1 at £5 each, the share premium is £4.

Question 30

What is the nominal value per share?

Answer 30

The nominal value (or par value) is a fixed face value set when the company is formed. It is the minimum price at which shares can be issued. This value does not change over time, even if the market value of the shares increases or decreases.

Question 31

What is the net asset value per share?

Answer 31

The net asset value per share is the total net assets of the company divided by the number of shares in issue. It represents the amount of a company's assets notionally owned by an owner of 1 share. Formula: Net asset value per share = Total Net Assets/ Number of Shares issued This value changes based on the company's profits and retained earnings, which increase its net assets.

Question 32

How does the net asset value per share change over time?

Answer 32

The net asset value per share changes over time as the company generates profits and retains earnings, which increase its net assets. These retained profits increase the shareholder’s equity.

Question 33

What is the market value per share?

Answer 33

The market value per share is the price at which a share is traded on the stock market. This value is determined by supply and demand and reflects investor expectations about the company’s future financial performance. It can be higher or lower than the nominal or net asset value depending on the company’s perceived future growth, profitability, and risk.

Question 34

How does the market value per share differ from the other two values?

Answer 34

The market value per share reflects the current demand for shares in the market, based on investors’ expectations of future performance, whereas the nominal value per share is fixed and does not change, and the net asset value per share reflects the underlying assets and the company’s equity, which can also fluctuate with company performance.

Question 35

How does a company record the share premium in its financial statements?

Answer 35

When shares are issued above their nominal value, the excess amount over the nominal value is recorded as share premium in the equity section of the balance sheet. For example: If a company issues 1,000 shares with a nominal value of £1 each for £5 per share, the share premium will be £4 per share (1,000 shares × £4). The entry would be: Dr: Bank (Cash) £5,000 Cr: Share Capital £1,000 Cr: Share Premium £4,000

Question 36

What happens if a company issues shares at a value below their nominal value?

Answer 36

Issuing shares below their nominal value is not allowed under most legal frameworks because it would result in the company receiving less than the par value for its shares, potentially undermining the company's capital base. This could lead to legal or regulatory consequences.

Question 37

Explaining share premium: Three possible share values example * When Zappco Ltd was formed on 01/01/2015, it sold 10,000 ordinary shares, with a nominal value of £1 each, to its founding shareholders at a price of £1 each paid in cash * What is the net asset value per share immediately after this share issue? – Assets = £10,000 cash – Liabilities = zero – Net assets = £10,000 – Number of shares = 10,000 – Therefore net asset value per share = £10,000 / 10,000 shares = £1 per share * At the date the company was formed, net asset value per share therefore equals the £1 nominal value per share * In the 5 years to 31/12/2019, Zappco Ltd did not issue any more shares or revalue any assets, but retained £440,000 in profits – Calculate the company’s net asset value per share and nominal value per share at 31/12/2019

Answer 37

Step 1: Net Asset Value Per Share at 31/12/2019 Total Assets = £450,000 (including £440,000 of retained profits + initial £10,000 cash) Total Liabilities = £0 Net Assets = Assets - Liabilities = £450,000 Number of Shares Outstanding = 10,000 Net Asset Value per share = Net Assets/ Number of shares = £450,000/10,000 = £45 per share So, the net asset value per share at 31/12/2019 is £45. Step 2: Nominal Value Per Share at 31/12/2019 The nominal value per share does not change over time unless the company undergoes a corporate action like a stock split or consolidation. It remains at the value originally set when the company was incorporated. In this case, the nominal value per share remains £1 as initially set on 01/01/2015. Therefore, the nominal value per share at 31/12/2019 is still £1. Step 3: Issuing New Shares for Additional Funds The company now decides to raise an additional £90,000 by issuing new shares that are identical to the existing shares. These new shares must have the same £1 nominal value as the existing shares. To determine the number of new shares to issue: Number of new shares to issue = Funds to be raised/ Nominal value per share = £90,000/£1 = 90,000 shares Now, the company will issue 90,000 new shares at their nominal value of £1 each. Since the shares are issued at £1, and the nominal value is also £1, there will be no share premium in this case. The entire £90,000 will go to the company’s share capital. Conclusion: Net Asset Value per Share (31/12/2019): £45 Nominal Value per Share (31/12/2019): £1 Amount to Sell New Shares: Since the shares are sold at their nominal value of £1, there is no share premium in this case.

Question 38

Let's break down the example where Zappco Ltd issues new shares for £1 each to raise £90,000 in cash. We'll walk through the steps to calculate the new net assets, number of shares, and the net asset value per share.

Answer 38

Step 1: Number of New Shares to Issue To raise £90,000 using £1 nominal value shares: Number of new shares = Funds to raise/ nominal value per share = £90,000/£1 = 90,000 shares So, Zappco Ltd will need to issue 90,000 new shares to raise the required funds. Step 2: Net Assets After the New Share Issue Current Net Assets (31/12/2019) = £450,000 (from previous calculations) Funds Raised from New Shares = £90,000 (since each share is sold at £1, the company will raise £90,000 from 90,000 shares) The new total net assets will be: New Net Assets = Old Net Assets + Funds Raised from New Shares = £450,000 + £90,000 = £540,000 So, the new total net assets will be £540,000. Step 3: Total Number of Shares After the New Share Issue Existing Shares = 10,000 (from the initial share issue) New Shares Issued = 90,000 (to raise £90,000) The total number of shares outstanding after the new issue will be: Total shares = Existing shares + New Shares = 10,000 + 90,000 = 100,000 So, the total number of shares will now be 100,000. Step 4: New Net Asset Value Per Share Now, let's calculate the net asset value per share after the share issue: Net Asset Value per Share = Total Net Assets/ Total Number of shares = £540,000/100,000 = £5.4 per share So, after the new shares are issued, the net asset value per share will be £5.40. Step 5: Impact on Original Shareholders Before the new share issue, the net asset value per share was £45 (calculated earlier). After the new share issue, the net asset value per share drops to £5.40. This means that each original shareholder’s net assets per share has fallen from £45 to £5.40. Original Shareholders’ Net Asset Value per Share Before New Issue = £45 Original Shareholders’ Net Asset Value per Share After New Issue = £5.40 Summary of Changes: Number of new shares issued = 90,000 Total net assets after new issue = £540,000 Total number of shares after new issue = 100,000 Net asset value per share after new issue = £5.40 Original shareholders’ net asset value per share drops from £45 to £5.40 In this example, the net asset value per share decreases for the original shareholders because the equity is now divided among more shares, even though the company’s net assets have increased.

Question 39

What is creative accounting?

Answer 39

Creative accounting refers to the use of loopholes or flexibility in accounting standards to manipulate financial results and mislead stakeholders about a company's financial position and performance. It does not necessarily involve illegal practices but often breaches ethical standards.

Question 40

What is the main goal of creative accounting?

Answer 40

To make the company’s financial results look better or more stable than they really are. Often, it is used to "smooth" earnings, reducing year-to-year volatility to make profit growth appear steady and predictable.

Question 41

What is "earnings management" and how is it related to creative accounting?

Answer 41

"Earnings management" is the US term for creative accounting. It involves adjusting revenues, expenses, or provisions in a way that produces consistent or target profits over time.

Question 42

Why do companies engage in earnings smoothing?

Answer 42

Because investors and analysts prefer companies with stable, predictable profit growth. "Smooth" earnings make a company appear less risky, which can lead to higher share prices or lower borrowing costs.

Question 43

What are some common techniques used in creative accounting?

Answer 43

Accelerating revenue recognition: Booking revenue before it is truly earned. Delaying expenses: Deferring the recognition of expenses to future periods. Using provisions creatively: Overestimating liabilities in good years and reducing them in bad years to even out profits. Changing depreciation methods or estimates to affect profit. Classifying costs as capital rather than expense to reduce impact on current profits.

Question 44

What is the impact of creative accounting on stakeholders?

Answer 44

It misleads shareholders, investors, and creditors by presenting a distorted view of financial health. In the long term, it can damage credibility, invite regulatory scrutiny, and lead to legal penalties or reputation loss.

Question 45

What’s the difference between legal accounting choices and unethical creative accounting?

Answer 45

Legal accounting choices follow the letter and spirit of accounting standards. Creative accounting may follow the letter of the law but violates the intent by misleading users. Ethics and transparency are key in distinguishing them.

Question 46

Give an example of creative accounting from real life.

Answer 46

Enron is a classic case, where the company used off-balance sheet entities to hide debt and inflate profits. WorldCom similarly capitalised expenses that should’ve been recorded immediately, falsely inflating profit figures.

Question 47

How can accruals be used in creative accounting to increase profits?

Answer 47

By understating closing accruals, the company reports a lower expense in the income statement, which increases profits artificially.

Question 48

How can accruals be manipulated to decrease profits?

Answer 48

By overstating closing accruals, expenses are increased in the current period, which lowers reported profits—useful for shifting profits to future periods.

Question 49

How can prepayments be manipulated to increase profits?

Answer 49

By overstating closing prepayments, expenses in the income statement are reduced (because more of the payment is treated as an asset), which increases profits.

Question 50

How can prepayments be manipulated to decrease profits?

Answer 50

By understating closing prepayments, more of the payment is expensed immediately, increasing current expenses and reducing profits.

Question 51

What’s the formula to calculate an expense using accruals?

Answer 51

Expense (Income Statement) = Closing Accrual + Payment – Opening Accrual (B/S) This shows how adjusting the accruals can directly affect reported expenses and, in turn, profits.

Question 52

What’s the formula to calculate an expense using prepayments?

Answer 52

Expense (Income Statement) = Opening Prepayment + Payment – Closing Prepayment Changes to the closing prepayment figure will impact the amount of expense reported.

Question 53

Why might a company want to reduce profits in a given year using accruals/prepayments?

Answer 53

To lower tax liabilities, manage investor expectations, or create a profit reserve they can release in future years to "smooth" earnings.

Question 54

Why is manipulating accruals/prepayments risky?

Answer 54

Because it distorts the true financial performance, misleads stakeholders, and may breach accounting standards if done deliberately or materially.

Question 55

How can overstating the useful life of a non-current asset increase profits?

Answer 55

If a company overstates the asset’s useful life, the annual depreciation expense is reduced, which increases profits in the short term.

Question 56

How does understating the useful life of a non-current asset affect profits?

Answer 56

Understating the useful life increases the annual depreciation expense, thereby reducing reported profits—useful if the company wants to shift profits to future periods.

Question 57

What effect does understating residual values have on profits?

Answer 57

It increases depreciation expense over the asset’s life (since more cost is allocated), which decreases profits in the current period.

Question 58

How does overstating residual values increase profits?

Answer 58

By reducing the depreciable amount (cost – residual value), depreciation expense goes down, and profits increase.

Question 59

How does changing from straight-line to reducing balance depreciation affect profits?

Answer 59

Reduces depreciation in early years for some assets, increasing short-term profits (if the asset was more efficiently depreciated using reducing balance).

Question 60

What happens when a company switches from reducing balance to straight-line depreciation early in an asset’s life?

Answer 60

Depreciation may increase in early years, which decreases profits—potentially useful if the company wants to smooth earnings.

Question 61

What's the formula for calculating depreciation?

Answer 61

Annual Depreciation = (Cost – Residual Value) / Useful Life Manipulating any of these variables affects profit via depreciation expense.

Question 62

Why might a company manipulate depreciation methods or estimates?

Answer 62

To smooth earnings, manage tax liabilities, or influence stakeholder perceptions of profitability and stability.

Question 63

Is changing depreciation method allowed under accounting rules?

Answer 63

Yes, but only if justified—the company must disclose the change and explain why it gives a more reliable or relevant view of the asset’s consumption.

Question 64

Why is inventory a key area for creative accounting?

Answer 64

Because inventory affects both cost of goods sold (COGS) and closing inventory, which in turn directly impacts gross profit and net income.

Question 65

What is “window dressing” in the context of inventory?

Answer 65

It refers to manipulating inventory values near year-end to make the company’s financial position look better—e.g., overstating inventory to inflate assets and profits.

Question 66

How can changing inventory cost flow assumptions affect profits?

Answer 66

Switching from FIFO to LIFO (if allowed): Can reduce profits when prices are rising (higher COGS). Switching from LIFO to FIFO: Can increase profits (lower COGS, higher closing inventory). AVCO (Weighted Average): Sits between FIFO and LIFO. (Note: IFRS does not allow LIFO, but it’s still relevant under US GAAP.)

Question 67

How can misstating inventory counts inflate profits?

Answer 67

Overstating inventory on hand reduces COGS (since COGS = Opening Inventory + Purchases – Closing Inventory), which increases reported profit.

Question 68

What is the effect of mis-stating obsolete inventory write-downs?

Answer 68

Understating write-downs: Overstates the value of inventory and net income. Overstating write-downs: Reduces profit in the short term, possibly to smooth income over future periods.

Question 69

How do overhead allocations to manufacturing inventory relate to creative accounting?

Answer 69

Over-allocating overheads to inventory increases inventory value and reduces expenses in the current period, inflating profits. Under-allocating has the opposite effect

Question 70

How does IAS 2 Inventory prevent manipulation?

Answer 70

It provides rules on: Inventory valuation (lower of cost and net realizable value) Permitted cost flow assumptions (FIFO or weighted average under IFRS) Treatment of obsolete/damaged goods What can be included in inventory costs

Question 71

What’s the danger of inventory manipulation?

Answer 71

It can mislead investors, inflate stock prices, distort tax liabilities, and lead to regulatory penalties or loss of trust.

Question 72

What formula links inventory to profit in accounting?

Answer 72

Cost of Sales (COGS) = Opening Inventory + Purchases – Closing Inventory This directly affects Gross Profit = Revenue – COGS.

Question 73

How does overstating closing inventory affect profit?

Answer 73

COGS decreases → because closing inventory is subtracted Gross profit and net income increase Artificially inflates profit in the current year

Question 74

How does understating closing inventory affect profit?

Answer 74

COGS increases → due to a smaller closing inventory deduction Profit decreases Can be used to reduce tax or smooth profits over multiple years

Question 75

What is meant by “profit shifting” using inventory?

Answer 75

By overstating or understating inventory, a business can move profits from one year to another, making profits appear more stable or aligning results with expectations.

Question 76

Why does inventory manipulation reverse in the next year?

Answer 76

Because this year’s closing inventory becomes next year’s opening inventory. Any overstatement or understatement will affect next year’s COGS and profit in the opposite direction.

Question 77

Is inventory manipulation sustainable over time?

Answer 77

No. It typically reverses, and repeated manipulation becomes harder to conceal. Auditors and regulators often look for these patterns.

Question 78

What controls are in place to prevent inventory manipulation?

Answer 78

Inventory counts and reconciliations Auditor inspections IAS 2 rules on valuation (lower of cost and NRV) Disclosure requirements in financial statements

Question 79

How are provisions sometimes misused in creative accounting?

Answer 79

By overstating provisions, companies can inflate losses in one year and then release the provision in future years, artificially boosting profits.

Question 80

How can provisions be used after a company takeover?

Answer 80

New management creates large provisions for anticipated costs This reduces profits in the takeover year Later, unused provisions are released to boost future profits Makes new management appear successful and blames old management for initial losses

Question 81

What is “profit smoothing” using provisions?

Answer 81

In a profitable year, a company may create a large provision, reducing reported profits. Then in a less profitable year, they release the provision, increasing reported profits. This creates the illusion of stable earnings over time.

Question 82

Why is misuse of provisions seen as a serious issue?

Answer 82

It distorts the true financial position of the company and misleads investors about the company’s performance.

Question 83

How have accounting rules responded to misuse of provisions?

Answer 83

Rules like IAS 37 now require: Clear justification for provisions That the amount is reliably estimated That the liability is probable and based on a past event Detailed disclosures in financial statements

Question 84

Why is it harder to use provisions for creative accounting today?

Answer 84

Because of stricter regulations, auditor scrutiny, and mandatory disclosures, which make unjustified or excessive provisions easier to detect.