P1 Common Knowledge

Question 1

What does the accruals concept mean? Give three examples of year-end adjustments and explain why
such adjustments are necessary in the preparation of the final accounts.

Answer 1

The accruals concept means that all expenses incurred for the year whether paid or not, need to be
matched with all income earned for the same year whether received or not.
THREE EXAMPLES:
• Depreciation expense – this represents part of the cost that has been used up during the year;
• Unpaid bills for the year – these were incurred for the year so need to be entered whether paid or
not;
• Provision for trade receivables – this represents an estimate of those trade receivables that may
default from the credit sales that were made during the year.

Question 2

A business is a collector of VAT. Explain this statement with reference to the purchases and sales of a
retailer of computer equipment if this is subject to VAT.

Answer 2

This means that the business is charging VAT on the sales sold to its customers. This will be passed on to
the government. Until this is done, it will be recorded as a current liability as VAT payable.

Question 3

According to IAS 2, inventory is valued at the lower of cost and net realisable value. Define net
realisable value, and describe the accounting concept underlying the requirements of this financial
reporting standard on inventory valuation.

Answer 3

Net realizable value is the sales price of the inventory less any future cost to put it into saleable condition
and less any anticipated selling expenses. The valuation of inventory in such a case should be based
on prudence concept of accounting. This concept forces us to recognize a loss immediately, we are
aware of it, and therefore if the net realizable value of inventory is lower than its original cost, then it
should be valued at its net realizable value.This means inventory should be valued at lower of cost or net
realizable value.
The valuation of inventory at lower of cost or market value (NRV) is also in accordance to the matching
concept of accounting. Any reduction in the value of inventory will be reflected in the income statement
of the year in which the loss occurred and recognized rather than in the year in which the goods are sold.

Question 4

Inventory at year end included items costing €1000 that were shop soiled. It was estimated that they
could be repaired and cleaned at a cost of €100, and could then be sold for €700. Calculate the
carrying value of these inventory items at the financial year end. Describe the accounting rule
followed.

Answer 4

The carrying value of the inventory should be measured at the lower of cost or net realisable value. The
cost is 1000, the net realisable value is the selling price less the costs to clean them, therefore = 700 –
100 = 600. Hence the inventory should be reported at 600.

Question 5

Distinguish between the accounting treatment of purchased goodwill and internally generated
goodwill.

Answer 5

Purchased goodwill is treated in the books as a purchase transaction where the bank is Credited and the
goodwill account is shown as an asset in the SOFP. Internally generated goodwill is not shown in the
books because it cannot be reliably measured.

Question 6

Define gearing and identify ONE advantage and ONE disadvangtage of raising finance through debt
rather than equity.

Answer 6

Gearing [Debt/(Debt+Equity)] refers to the relationship, or ratio, of a company’s debt to equity. Gearing
shows the extent to which a firm’s operations are funded by lenders versus shareholders. Advantage of
raising finance through debt rather than equity: the business can plan its cash outflow as the interest to
be paid for the loans is known when the finance is raised.
Disadvantage: the interest is the cost of borrowing which needs to be paid irrespective if the business
makes a profit or a loss.

Question 7

Investing in R&D is creating a new asset which will generate income in future years. Discuss this
statement and explain why research costs and development costs are accounted for differently.

Answer 7

With research, the company is researching the unknown, and therefore, at this early stage, no future
economic benefit can be expected to flow to the entity. Expenditure on research does not directly lead to
future economic benefits, and capitalising such costs does not comply with the accruals concept.
Therefore, the accounting treatment for all research expenditure is to write it off to the profit and loss
account as incurred.
Development is the application of research findings. It can be recognised as an intangible asset if, and
only if, the following criteria are met:
- it is probable that future economic benefits from the asset will flow to the entity
- the cost of the asset can be reliably measured.
Once development costs have been capitalised, the asset should be amortised in accordance with the
accruals concept over its finite life. Amortisation must only begin when commercial production has
commenced (hence matching the income and expenditure to the period in which it relates).

Question 8

Briefly highlight the difference between a provision and a contingent liability. How are provisions and
contingent Liabilities accounted for?

Answer 8

Provision are provided for known or specified liabilities which will occur in future. Contingent liability is
provision made for unknown liabilities which may or may not occur in future. Provision are accounted for
as current liabilities as they will need to be paid in the future if it is more than 50% likely that the event will occur. Contingent liabilities are not included in the financial statements as there is less than 50%
chance of it happening, but are noted by means of a note in the accounts. They are uncertain.

Question 9

The financial statements are normally prepared on the assumption that the entity is a going concern.
Describe the going concern concept.

Answer 9

The going concern concept of accounting implies that the business entity will continue its operations in
the future. An example of the application of going concern concept of accounting is the computation of
depreciation on the basis of expected economic life of fixed assets rather than their current market value.
Companies assume that their business will continue for an indefinite period of time and the assets will be
used in the business until fully depreciated. Another example of the going concern assumption is the
prepayment and accrual of expenses. Companies prepay and accrue expenses because they believe that
they will continue operations in future.

Question 10

Distinguish between revenue and capital expenditure, supporting your answers with examples.

Answer 10

Capital expenditure occurs when the firm spends money to increase the value of the business by buying
or adding on to non current assets. E.g. purchase of machinery;
Revenue expenditure occurs when the firm spends money to maintain the value of the business. E.g.
repairs and maintenance.

Question 11

List FOUR books of original entry and give a short explanation of the purpose of each.

Answer 11

• Purchases Day Book: this includes a list of all purchases of credit;
• Sales Day Book: this includes a list of all sales on credit;
• Cash Book: includes movement of cash and bank transactions;
• Returns Outwards Day Book: this includes a list of all returns outwards.

Question 12

Explain the difference in the accounting treatment of changes in accounting estimates and changes in
accounting principles. Give ONE example of a change in accounting estimate and ONE example of a
change in accounting principles.

Answer 12

A change in an accounting principle is a change in a method used, such switching between AVCO to FIFO
inventory valuation methods. An example of an accounting estimate change could be the recalculation of
machine’s estimated life due to wear and tear.
Changes in accounting principles would require an adjustment to previous retained earnings.
Changes in accounting estimates will be reported in the year when the change has occurred.

Question 13

Explain the term ‘goods on sale or return basis’. Describe how such goods affect the valuation of
inventories of the seller and the buyer.

Answer 13

When goods are sent on a “sale or return” or on “approval” basis, these goods are not treated as sales
unless they are purchased by the customer. If at the inventory count date, these goods are still held by its
customers, then they are taken as unsold goods. In that case, they are included in the seller’s inventory
valuation but not in the figure for sales.

Question 14

Define the Materiality concept.

Answer 14

Information is material if omitting, misstating or obscuring it, could reasonably be expected to influence
the financial statements and consequently the decisions of the users of accounting information made on
the basis of those financial statements.

Question 15

Give TWO reasons why it is good practice to maintain proper accounting records.

Answer 15

Helps to stay organised when dealing with customers and suppliers
Enables one to manage a business and make it grow
Makes it easy to prepare management accounts
Makes it possible to find important information and documents quickly

Question 16

XYZ Ltd pays rent on 30th Dec every year. The rent paid on 31 Dec 2016 covered the period 1st Jan to
31 Dec 2017, while the rent paid on 31 Dec 2017 covered the period 1 Jan to 31 Dec 2018. In the
Financial statements for the financial year ended 31 Dec 2017, the accountant included as a ‘rent
expenses’ the value of the rent paid on 31 Dec 2017, arguing that it is the actual amount paid during
2017.
Explain whether you agree with the accountant, identifying the applicable accounting concept

Answer 16

For the financial year ended 31 Dec 2017, the rent expense to be included in the SOPL should have been
the rent paid on 31 Dec 2016. This is in accordance with the accruals concept. It is incorrect to record the
actual amount paid during 2017 in the SOPL since this was being paid for the next financial year. This
should have been included as a prepayment in the SOFP.

Question 17

Mr Cassar owns all the shares but 1 in the company ABC Ltd. During the year, Mr Cassar took €10,000
worth of cash from ABC Ltd for his own personal use. The accountant agrees with Mr Cassar’s view
that since Mr Cassar is practically the full owner of ABC Ltd, there is no need to distinguish between
the personal property of Mr Cassar and that of ABC Ltd.
Explain whether you agree with the accountant, identifying the applicable accountant concept.

Answer 17

Since ABC Ltd is a company, any cash withdrawals for Mr Cassar’s personal use are being taken out of
retained profits. There needs to be a distinction between the personal property of Mr Cassar and that of
ABC Ltd. This is in line with the business entity concept. It is incorrect to agree with Mr Cassar and his
accountant that there is no need to distinguish between them.

Question 18

In 2016, a company bought €10,000 worth of equipment. This equipment is being depreciated at 20%
using the reducing balance method. As at 31 Dec 2017, the replacement cost of the equipment is
€90,000.
Would it be correct to value the machine at €90,000 in the financial statements for 31 Dec 2017?
Explain your answer with reference to applicable financial reporting standards.

Answer 18

Non-current assets should be recorded at cost or at revaluation as per IAS 16. If an item of property,
plant or equipment requires replacement, the carrying amount will include the cost of replacing the part
of such an item when the cost is incurred provided that future benefits are reliably measured.
If the business decides to measure non-current assets using the revaluation model, the asset is carried at
its fair value, provided that this can be measured reliably. However, if an item is revalued, the entire class
of assets to which the asset belongs should be revalued.

Question 19

Describe the main purpose of preparing control accounts. List the sources of the Sales ledger Control
account.

Answer 19

Control accounts are prepared to check if the sales or purchases ledger is correct. It is a way of ensuring
that fraud is minimised.
Sources of the sales ledger control account:
Sales on Credit – Sales Day Book
Receipts from Trade receivables – Cash book
Returns Inwards – Returns Inwards day book
Discounts allowed – Cash book
Bad Debts – Journal
Set off – Journal
Sources of the Purchases ledger control account:
Purchases on Credit – Purchases Day Book
Payments to trade payables – Cash book
Returns Outwards – Returns outwards day book
Discounts Received – Cash book
Set off – Journa