<?page no="0"?> Carsten Berkau Financial Statements International Accounting (IFRS) 9 th Edition <?page no="1"?> Financial Statements <?page no="2"?> Professor Dr. Carsten Berkau teaches accounting at Osnabrück University UAS and in South Africa, Malaysia, South Korea and China. Other books: Basics of Accounting / Bilanzen / Management Accounting <?page no="3"?> Carsten Berkau Financial Statements International Accounting (IFRS) 9 , revised Edition Translated by Keabetswe Sylvia Berkau <?page no="4"?> Umschlagmotiv: © iStockphoto · Murmakova Bibliografische Information der Deutschen Nationalbibliothek Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über http: / / dnb.dnb.de abrufbar. 9 th , revised Edition 2025 8 th , revised Edition 2024 7 th , revised Edition 2022 6 th , revised and extended Edition 2021 5 th Edition 2020 4 th Edition 2019 DOI: https: / / doi.org/ 10.24053/ 9783381134724 © UVK Verlag 20 25 - E in Unternehmen der Narr Francke Attempto Verlag GmbH + Co. KG , Dischingerweg 5 · D-72070 Tübingen Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. 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Internet: www.narr.de eMail: info@narr.de Druck: Elanders Waiblingen GmbH ISBN 978-3-381-13471-7 (Print) ISBN 978-3-381-13472-4 (ePDF) <?page no="5"?> Berkau: Financial Statements 9e 1-5 I Contents I Contents............................................................................................1-5 II Introduction ................................................................................... 1-13 1 Conventions for Simplification ............................................................ 1-15 1.1 Accounting Periods .........................................................................................1-15 1.2 Accounting Technical Terms.........................................................................1-15 1.3 Account Names ...............................................................................................1-15 1.4 Alphabetic Order .............................................................................................1-15 1.5 Basics .................................................................................................................1-15 1.6 Bilanzen .............................................................................................................1-15 1.7 Bookkeeping Entries .......................................................................................1-16 1.8 Bookkeeping Entry Format ...........................................................................1-16 1.9 Calculations.......................................................................................................1-16 1.10 Capital Gain Tax CGT in South Africa .......................................................1-16 1.11 Case Studies ......................................................................................................1-16 1.12 Case Study Text Format .................................................................................1-16 1.13 Cash/ Bank Distinction ...................................................................................1-16 1.14 Cash Flow Separation .....................................................................................1-16 1.15 Companies ........................................................................................................1-16 1.16 Cost-Expense-Congruence ............................................................................1-17 1.17 Country..............................................................................................................1-17 1.18 Currency Unit...................................................................................................1-17 1.19 Data Format in Tables ....................................................................................1-17 1.20 Data Sheets .......................................................................................................1-17 1.21 Prepayments of Income Taxes ......................................................................1-17 1.22 Hints ..................................................................................................................1-17 1.23 How it is Done.................................................................................................1-17 1.24 Income Taxes ...................................................................................................1-18 1.25 Journal Entries .................................................................................................1-18 1.26 Financial Statements for Taxation ................................................................1-18 1.27 Names................................................................................................................1-18 1.28 Nominal Accounts’ Names ............................................................................1-18 1.29 Labour Accounting..........................................................................................1-18 1.30 Language ...........................................................................................................1-18 1.31 Learning Objectives.........................................................................................1-19 1.32 Legal Forms of a Business .............................................................................1-19 1.33 Length of a Month/ Year................................................................................1-19 1.34 Level of Precision ............................................................................................1-19 1.35 Links/ QR-Codes .............................................................................................1-19 1.36 Literature ...........................................................................................................1-19 1.37 Non-existing Items ..........................................................................................1-19 <?page no="6"?> Berkau: Financial Statements 9e 1-6 1.38 Online Materials .............................................................................................. 1-19 1.39 Payment Terms ................................................................................................ 1-19 1.40 Presentation of Accounts............................................................................... 1-20 1.41 Pro-Rated Depreciation/ Interest.................................................................. 1-20 1.42 Quotation of Law Texts/ Standards ............................................................. 1-21 1.43 Sequence of Bookkeeping Entries ................................................................ 1-21 1.44 Sign of Numbers on Financial Statements .................................................. 1-21 1.45 Tax on Capital Returns (Dividend Tax) ...................................................... 1-21 1.46 Transaction Costs............................................................................................ 1-21 1.47 Value Added Tax, Goods and Service Tax ................................................. 1-21 1.48 VAT Reduction ............................................................................................... 1-21 1.49 Working Definitions ....................................................................................... 1-22 1.50 Work-in-Process Account.............................................................................. 1-22 1.51 Writing Management Terms .......................................................................... 1-22 1.52 WWW................................................................................................................ 1-22 1.53 Youtube Videos ............................................................................................... 1-22 1.54 10-20-30 Rule ................................................................................................... 1-22 2 Financial Statements based on German HGB.....................................2-23 2.1 What is in the Chapter? .................................................................................. 2-23 2.2 Learning Objectives ........................................................................................ 2-23 2.3 Legal Forms for German Companies .......................................................... 2-23 2.4 Obligation of Keeping Bookkeeping Records and Preparing F/ S.......... 2-24 2.5 Establishment of a Company ........................................................................ 2-25 2.6 Income Tax Calculation ................................................................................. 2-26 2.7 Value added tax VAT. .................................................................................... 2-26 2.8 C/ S KIELING TAXI GmbH - 20X1 ........................................................ 2-27 2.9 C/ S KIELING TAXI GmbH - 20X2......................................................... 2-34 2.10 Summary ........................................................................................................... 2-42 2.11 Working Definitions ....................................................................................... 2-42 2.12 Question Bank ................................................................................................. 2-43 2.13 Solutions ........................................................................................................... 2-43 3 Financial Statements based on IFRSs .................................................3-44 3.1 What is in the Chapter? .................................................................................. 3-44 3.2 Learning Objectives ........................................................................................ 3-44 3.3 IFRSs ................................................................................................................. 3-44 3.4 How to Access IFRSs ..................................................................................... 3-45 3.5 C/ S KENILWORTH MTS Ltd. - 20X1.................................................... 3-45 3.6 C/ S KENILWORTH MTS Ltd. - 20X2.................................................... 3-58 3.7 Summary ........................................................................................................... 3-68 3.8 Working Definitions ....................................................................................... 3-68 3.9 Question Bank ................................................................................................. 3-69 3.10 Solutions ........................................................................................................... 3-70 <?page no="7"?> Berkau: Financial Statements 9e 1-7 4 Accounting for Retailers ...................................................................... 4-71 4.1 What is in the Chapter? ...................................................................................4-71 4.2 Learning Objectives.........................................................................................4-71 4.3 Trading Transactions ......................................................................................4-71 4.4 Gross Profit Calculation .................................................................................4-72 4.5 Trial Balance .....................................................................................................4-73 4.6 Trading Account ..............................................................................................4-73 4.7 C/ S RYNEVELD Ltd....................................................................................4-73 4.8 C/ S TELUK Sdn. Bhd. ..................................................................................4-89 4.9 Worksheet for T/ B Calculations...................................................................4-89 4.10 Summary ...........................................................................................................4-89 4.11 Working Definitions........................................................................................4-90 4.12 Question Bank..................................................................................................4-90 4.13 Solutions............................................................................................................4-91 5 Basics of Financial Statement Analysis ...............................................5-92 5.1 What is in the Chapter? ...................................................................................5-92 5.2 Learning Objectives.........................................................................................5-92 5.3 Company Appraisal .........................................................................................5-92 5.4 Situational Awareness about the Industry ...................................................5-93 5.5 C/ S ROSENDAHL Ltd. ...............................................................................5-93 5.6 Steps of F/ S Analysis ......................................................................................5-94 5.7 Defining Information Requirements ............................................................5-94 5.8 Formal Checking..............................................................................................5-94 5.9 Horizontal Analysis .........................................................................................5-95 5.10 Vertical Analysis...............................................................................................5-95 5.11 Basics of Ratio Analysis ..................................................................................5-95 5.12 C/ S CAPELIFT (Pty) Ltd. ............................................................................5-97 5.13 Performance Ratios - CAPELIFT (Pty) Ltd. .............................................5-98 5.14 Liquidity Ratios - CAPELIFT (Pty) Ltd. ..................................................5-103 5.15 Capital Structure Ratios - CAPELIFT (Pty) Ltd. ....................................5-105 5.16 Market Value Ratios - CAPELIFT (Pty) Ltd. ..........................................5-107 5.17 Summary .........................................................................................................5-108 5.18 Working Definitions......................................................................................5-108 5.19 Question Bank................................................................................................5-108 5.20 Solutions..........................................................................................................5-109 6 Formal Financial Statement Requirements ....................................... 6-110 6.1 What is in the Chapter? .................................................................................6-110 6.2 Learning Objectives.......................................................................................6-110 6.3 IFRSs Consistency .........................................................................................6-110 6.4 Qualitative Characteristics of Financial Statements .................................6-111 6.5 C/ S BATHURST Ltd. ..................................................................................6-113 6.6 Statement of Financial Position - BATHURST Ltd. ..............................6-122 6.7 Statement of Profit or Loss - BATHURST Ltd. .....................................6-124 <?page no="8"?> Berkau: Financial Statements 9e 1-8 6.8 Statement of Changes in Equity - BATHURST Ltd. ............................. 6-126 6.9 Statement of Cash Flows - BATHURST Ltd. ......................................... 6-126 6.10 Notes - BATHURST Ltd............................................................................ 6-128 6.11 ESG-Reporting .............................................................................................. 6-132 6.12 Summary ......................................................................................................... 6-135 6.13 Working Definitions ..................................................................................... 6-135 6.14 Question Bank ............................................................................................... 6-135 6.15 Solutions ......................................................................................................... 6-136 7 Non-current Assets on the Balance Sheet ......................................... 7-137 7.1 What is in the Chapter? ................................................................................ 7-137 7.2 Learning Objectives ...................................................................................... 7-137 7.3 Initial Recognition ......................................................................................... 7-137 7.4 C/ S GETEN (Pty) Ltd. ............................................................................... 7-138 7.5 Qualifying Assets........................................................................................... 7-140 7.6 C/ S LANGDAM Bhd. ................................................................................ 7-140 7.7 Subsequent Valuation ................................................................................... 7-142 7.8 C/ S GELLENDORFF Ltd. ....................................................................... 7-143 7.9 Impairment Loss ........................................................................................... 7-145 7.10 Impairment Loss - GELLENDORFF Ltd. ............................................. 7-145 7.11 Revaluations ................................................................................................... 7-155 7.12 C/ S TINNEN Ltd. ....................................................................................... 7-155 7.13 Disposal of Assets ......................................................................................... 7-166 7.14 C/ S YSTERFONTEIN Ltd. ...................................................................... 7-167 7.15 Investment Property ..................................................................................... 7-170 7.16 C/ S MERSEBURG Ltd............................................................................... 7-171 7.17 Assets Held for Sale ...................................................................................... 7-172 7.18 C/ S OVERBERG (Pty) Ltd........................................................................ 7-173 7.19 Intangible Assets ........................................................................................... 7-175 7.20 C/ S Dentist PAARDEBERG..................................................................... 7-175 7.21 Research and Design Costs.......................................................................... 7-176 7.22 C/ S WESPOORT Ltd. ................................................................................ 7-177 7.23 Leases .............................................................................................................. 7-177 7.24 C/ S KRIGE (Pty) Ltd. ................................................................................. 7-179 7.25 C/ S ALIGSE Ltd. ......................................................................................... 7-184 7.26 C/ S RICHTERSVELD (Pty) Ltd. - Lessee ............................................. 7-186 7.27 C/ S RICHTERSVELD (Pty) Ltd. - Lessor ............................................. 7-189 7.28 Short-term Leases.......................................................................................... 7-192 7.29 C/ S JONKERS GmbH ............................................................................... 7-192 7.30 Financial Instruments ................................................................................... 7-193 7.31 C/ S NATBERGEN (Pty) Ltd. - Bonds held to Maturity ..................... 7-195 7.32 Derivatives...................................................................................................... 7-197 7.33 MOLLENBERG Ltd. - Call Option......................................................... 7-197 7.34 Summary ......................................................................................................... 7-200 7.35 Working Definitions ..................................................................................... 7-200 <?page no="9"?> Berkau: Financial Statements 9e 1-9 7.36 Questions Bank ..............................................................................................7-201 7.37 Solutions..........................................................................................................7-202 8 Business Combinations .....................................................................8-203 8.1 What is in the Chapter? .................................................................................8-203 8.2 Learning Objectives.......................................................................................8-203 8.3 Group Accounting.........................................................................................8-203 8.4 Separate Financial Statements IAS 27 ........................................................8-206 8.5 C/ S BRENO Ltd...........................................................................................8-206 8.6 Consolidated Financial Statements .............................................................8-211 8.7 C/ S GAMKA/ SWARTBERG Group - Initial Consolidation .............8-212 8.8 C/ S GAMKA/ SWARTBERG Group - Subsequent Consolidations .8-219 8.9 C/ S PORTERSVILLE/ HENDERSON Group....................................8-227 8.10 Intra-Group Profit Consolidation...............................................................8-233 8.11 C/ S PATTEN/ SPYKER.............................................................................8-233 8.12 Joint Venture Accounting ............................................................................8-241 8.13 C/ S QUICKARMS-RESPONSE-FIRE Joint Operations ....................8-242 8.14 C/ S CLOSE-WATCH - Joint Venture ......................................................8-246 8.15 Summary .........................................................................................................8-251 8.16 Working Definitions......................................................................................8-251 8.17 Question Bank................................................................................................8-251 8.18 Solutions..........................................................................................................8-252 9 Current Assets on the Balance Sheet .................................................9-253 9.1 What is in the Chapter? .................................................................................9-253 9.2 Learning Objectives.......................................................................................9-253 9.3 Current and non-Current Assets .................................................................9-253 9.4 Inventories ......................................................................................................9-254 9.5 C/ S GREENACRES Ltd. ...........................................................................9-255 9.6 Perpetual Inventory System .........................................................................9-257 9.7 C/ S GREENACRES Ltd. - Perpetual Inventory System......................9-258 9.8 Returns ............................................................................................................9-260 9.9 Differences in Inventory Valuation ............................................................9-264 9.10 Different Purchase Price Application.........................................................9-264 9.11 C/ S ROSEFIELD Ltd. ................................................................................9-264 9.12 Loss on Valuation..........................................................................................9-270 9.13 C/ S HEISTEL (Pty) Ltd. .............................................................................9-270 9.14 Manufacturing Accounting ..........................................................................9-271 9.15 Overhead Application ...................................................................................9-273 9.16 C/ S RIEBEECK-KASTEEL (Pty) Ltd.....................................................9-274 9.17 C/ S RIEBEECK-KASTEEL (Pty) Ltd. (i)...............................................9-278 9.18 C/ S RIEBEECK-KASTEEL (Pty) Ltd. - IAS 2.13 (ii) ..........................9-278 9.19 Manufacturing Summary Account ..............................................................9-282 9.20 C/ S HEUNING Ltd. ...................................................................................9-282 9.21 Receivables......................................................................................................9-285 <?page no="10"?> Berkau: Financial Statements 9e 1-10 9.22 C/ S CHELMSFORD................................................................................... 9-286 9.23 Securities ......................................................................................................... 9-288 9.24 C/ S NOKOX (Pty) Ltd. .............................................................................. 9-289 9.25 C/ S NOKOX (Pty) Ltd. continued......................................................... 9-291 9.26 Prepaid Expenses .......................................................................................... 9-293 9.27 Cash and its Equivalents .............................................................................. 9-293 9.28 Summary ......................................................................................................... 9-294 9.29 Working Definitions ..................................................................................... 9-294 9.30 Question Bank ............................................................................................... 9-294 9.31 Solutions ......................................................................................................... 9-295 10 Statement of Cash Flows............................................................... 10-296 10.1 What is in the Chapter? ..............................................................................10-296 10.2 Learning Objectives ....................................................................................10-296 10.3 Cash Flow Statement Obligation ..............................................................10-296 10.4 C/ S EIMKE Ltd. ........................................................................................10-297 10.5 Direct Method .............................................................................................10-302 10.6 C/ S EIMKE Ltd. - Direct Method .........................................................10-302 10.7 Reconciliation of Profits with Operating Cash Flows...........................10-303 10.8 Step (1) ..........................................................................................................10-304 10.9 Step (2) ..........................................................................................................10-304 10.10 Step (3) ......................................................................................................10-305 10.11 Step (4) ......................................................................................................10-305 10.12 Step (5) ......................................................................................................10-305 10.13 Step (6) ......................................................................................................10-305 10.14 Step (7) ......................................................................................................10-305 10.15 Step (8) ......................................................................................................10-307 10.16 Step (9) ......................................................................................................10-307 10.17 Step (10) ....................................................................................................10-308 10.18 Step (11) ....................................................................................................10-308 10.19 Step (12) ....................................................................................................10-308 10.20 Step (13) ....................................................................................................10-308 10.21 C/ S EIMKE Ltd. - Reconciliation Method .......................................10-308 10.22 Derivative Method...................................................................................10-311 10.23 Summary ...................................................................................................10-312 10.24 Working Definitions................................................................................10-312 10.25 Question Bank..........................................................................................10-312 10.26 Solutions....................................................................................................10-313 11 Equity on the Balance Sheet .......................................................... 11-314 11.1 What is in the Chapter? ..............................................................................11-314 11.2 Learnings Objectives ..................................................................................11-314 11.3 Equity ............................................................................................................11-314 11.4 Issued Capital ...............................................................................................11-314 11.5 C/ S YARRA Ltd. - 20X0..........................................................................11-315 <?page no="11"?> Berkau: Financial Statements 9e 1-11 11.6 Reserves........................................................................................................ 11-316 11.7 C/ S YARRA Ltd. - 20X0 continued.................................................... 11-317 11.8 C/ S YARRA Ltd. - 20X1 ......................................................................... 11-317 11.9 C/ S YARRA Ltd. - 20X2 ......................................................................... 11-321 11.10 Retained Earnings ................................................................................... 11-323 11.11 Summary................................................................................................... 11-326 11.12 Working Definitions ............................................................................... 11-326 11.13 Question Bank ......................................................................................... 11-326 11.14 Solutions ................................................................................................... 11-327 12 Statement of Profit or Loss and Other Comprehensive Income. 12-328 12.1 What is in the Chapter? .............................................................................. 12-328 12.2 Learning Objectives.................................................................................... 12-328 12.3 Statement of Profit or Loss and Other Comprehensive Income ....... 12-329 12.4 C/ S ABINGTON Ltd. - Nature of Expense Method ........................ 12-330 12.5 C/ S SUDHUIZEN PLC - Nature of Expense Method ..................... 12-334 12.6 C/ S ABINGTON Ltd. - Cost of Sales Format .................................... 12-342 12.7 C/ S SUDHUIZEN PLC - Cost of Sales Format................................. 12-346 12.8 Summary ...................................................................................................... 12-352 12.9 Working Definitions................................................................................... 12-352 12.10 Question Bank ......................................................................................... 12-353 12.11 Solutions ................................................................................................... 12-354 13 Statement of Changes in Equity ................................................... 13-355 13.1 What is in the Chapter? .............................................................................. 13-355 13.2 Learning Objectives.................................................................................... 13-355 13.3 IFRS Regulations ........................................................................................ 13-355 13.4 C/ S BELMONT Ltd. ................................................................................ 13-356 13.5 C/ S BELMONT Ltd. - Share Issue/ Treasury Shares .......................... 13-358 13.6 C/ S BELMONT Ltd. - Profit or Loss.................................................... 13-359 13.7 C/ S BELMONT Ltd. - Other Comprehensive Income ...................... 13-360 13.8 C/ S BELMONT Ltd. - Revaluations...................................................... 13-361 13.9 C/ S BELMONT Ltd. - Appropriation of Profits ................................. 13-362 13.10 Summary................................................................................................... 13-364 13.11 Working Definition................................................................................. 13-364 13.12 Question Bank ......................................................................................... 13-364 13.13 Solutions ................................................................................................... 13-365 14 Liabilities on the Balance Sheet.................................................... 14-366 14.1 What is in the Chapter? .............................................................................. 14-366 14.2 Learning Objectives.................................................................................... 14-366 14.3 Liabilities ...................................................................................................... 14-366 14.4 Certain Liabilities ........................................................................................ 14-367 14.5 C/ S WARWICK Ltd. - Buying Goods on Credit ................................. 14-368 14.6 C/ S BATHURST Ltd. - Bank Loan........................................................ 14-368 <?page no="12"?> Berkau: Financial Statements 9e 1-12 14.7 C/ S MEUL Ltd. - Amortised Costs ........................................................14-370 14.8 Bonds Issue ..................................................................................................14-371 14.9 C/ S BRIZA Ltd. - Bonds ..........................................................................14-371 14.10 C/ S MEMEL PLC - Annuity and Extra Repayments .......................14-372 14.11 Provisions..................................................................................................14-372 14.12 C/ S SEENA Ltd. - Measurement of Provisions ...............................14-372 14.13 C/ S HADRA (Pty) Ltd. - Provision for Pension Funds ...................14-374 14.14 C/ S DUMMOND (Pty) Ltd. - Provision of rework .........................14-375 14.15 C/ S SALMAN Ltd. - Provisions due to Onerous Contracts ...........14-381 14.16 Summary ...................................................................................................14-382 14.17 Working Definitions................................................................................14-382 14.18 Question Bank..........................................................................................14-382 14.19 Solutions....................................................................................................14-383 15 Abbreviations ................................................................................ 15-384 16 Table of Figures .............................................................................16-391 17 Links ............................................................................................. 17-395 18 Literature....................................................................................... 18-396 <?page no="13"?> Berkau: Financial Statements 9e 1-13 II Introduction This 9th edition considers feedback we received from our readers and students in South Africa and Germany. Same as the 5th edition, this new edition of the textbook is published bilingual: in English as well as in German. Bilanzen 6e is the same as Financial Statements 9e. Regarding the content, we added new case studies, e.g., HEUNING Ltd., ALIGSE Ltd., which we made good experiences with in class. Furthermore, we adjusted the disclosure of recordings following the students‘ preferences. Bookkeeping entries are shown in the journal entry format in this English version, whereas they appear in the German edition in the DR- CR-format. In both editions we keep up the disclosure of figures as integers as introduced with the 8 th edition of financial statements. Although, calculations in the text remain accurate to two digits after the decimal point. Some of the financial instrument case studies have been moved to the online materials bank to match the page with the syllabus structure. Formally, we now introduced in both textbooks Note-paragraphs. They should make the reading more interesting and understandable. However, they are an addition to the syllabus. The content of Financial Statements focuses on IFRSs. Standards are quoted in the text. You are motivated to study the standards. Our quotations help you to find the right standards and paragraphs. Financial Statements covers the syllabus of an international Accounting class at bachelor’s and master’s level. We expect readers to bring basic knowledge of international Bookkeeping as taught in our textbook Basics of Accounting. We follow a case-based teaching method with 66 case studies in this textbook. We added some links to further case studies we published in the KOR and IRZ magazines. They are on master’s level and linked to the textbook. From the publisher's website, you can follow the link: https: / / files.narr.digital/ 97833811 / cases.zip to download online materials: 350 exam tasks with solutions and links to video clips we recorded for you. Furthermore, the textbook includes a lot of QR codes with additional materials linked to. You can scan them in the text or navigate through the online materials bank to find them. We write our textbooks as an international academic team from Germany and South Africa. They are based on our teaching experience in Osnabrück/ Lingen (Ems), Cape Town, Enschede, Gqeberha/ George, Grahamstown, Kuantan, Seoul, and Shanghai. We thank our colleagues at Hochschule Osnabrück, in particular Prof. Dr. Marion Wendehals, and those at our partner universities for their valuable input. A big thanks to Dr. Jürgen Schechler from UVK Verlag. Dr. Schechler is our lector in Munich, and we enjoy the very friendly and highly efficient cooperation with <?page no="14"?> Berkau: Financial Statements 9e 1-14 him for all our textbooks (Basics of Accounting, Bilanzen, Financial Statements, and Management Accounting). Finally, we thank our students and readers for their feedback and questions which helped us to continuously improve our textbooks. We trust you will enjoy this 9 th edition of our Financial Statements! Cape Town, in August 2025 Keabetswe and Carsten Berkau <?page no="15"?> Berkau: Financial Statements 9 e 1-15 1 Conventions for Simplification The below-listed conventions apply merely for case simplifications. Accounting can become complicated, but we reduce its complexity to a level that is appropriate for studying. E.g., we do not follow a chart of accounts and therefore do not apply account numbers to keep our cases simple. In the real Accounting profession, must find the right account - however this is not regarded as necessary if you study Accounting for Management purposes. The conventions below are about legal forms, tax rates, formats, etc. They apply for this textbook, for our Basics of Accounting, for our Management Accounting, and all online study materials in the same way. At this stage of studying Accounting, you might not understand all the conventions. We put them at the beginning of the textbook, so you know where to find them. The sequence is in alphabetic order (English). 1.1 Accounting Periods All Accounting periods start on 1.01.20XX and end on 31.12.20XX. For keeping examples transferable to later years, we indicate the decades by an X, as in 20X4. X is followed by Y, then Z. 1.2 Accounting Technical Terms At the end of every chapter, we explain new technical terms. This is to help with the understanding of the content. These simple explanations are written for Accounting beginners. The Accounting technical terms are not as formal nor are they enforceable like definitions provided by the IASB. 1.3 Account Names All account names are written with capital letters in the text, such as ‘Cash/ Bank account’. However, an account not subjected to our recordings is written in lower letters. For a bank account with Deutsche Bank the writing is in lower letters: bank account. We do not make Bookkeeping entries therein, but Deutsche Bank AG does. However, the Cash/ Bank account applicable to calculate the item cash/ bank on the balance sheet is part of our Accounting work. 1.4 Alphabetic Order All lists are in alphabetic order. 1.5 Basics Basics refers to the textbook Berkau: Basics of Accounting. It is recommended that you read our Basics before you study Financial Statements. It introduces to international Bookkeeping and explains major Accounting concepts without direct reference to IFRSs. We frequently quote the Basics in this textbook. 1.6 Bilanzen The textbook Berkau: Bilanzen is a close German translation of this textbook. All cases and all exhibits are the same. <?page no="16"?> Berkau: Financial Statements 9 e 1-16 1.7 Bookkeeping Entries All Bookkeeping entries are printed in bold and cover the whole page’s width for highlighting purpose. 1.8 Bookkeeping Entry Format Bookkeeping entries are disclosed by debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. See below a Bookkeeping entry for the acquisition of a motor vehicle: DR Property, Plant, Equipment... 20,000 EUR DR VAT.......................... 4,000 EUR CR Cash/ Bank.................... 24,000 EUR The identifier for Bookkeeping entries in the text, like “Bookkeeping entry (1)” can be found in the accounts as “(1)”, too. In contrast to chapter (2) and to the German version of this textbook Bilanzen, we show journal entries in this textbook Financial Statements. 1.9 Calculations For calculations, we only show the currency units with the results. E.g., 10 + 20.50 = 30.50 EUR. Furthermore, figures in calculations come without digits after the decimal point if zero. Results are always printed in bold to find calculated figures in the text easily. 1.10 Capital Gain Tax CGT in South Africa Capital gain tax rate in South Africa is assumed to be at the total income tax rate for companies. No deductions and allowances apply for the sake of simplicity. 1.11 Case Studies We keep case studies in this textbook as easy as possible even as they might look unrealistic. The teaching of Accounting is key. 1.12 Case Study Text Format Case studies appear in a different text format than the normal text (Italic fonts). 1.13 Cash/ Bank Distinction There is no difference between the Cash account and the Bank account. A withdrawal would be recorded as DR Cash/ Bank - CR Cash/ Bank. If nothing else has been mentioned business activities are carried out on cash. 1.14 Cash Flow Separation Interest payments and receipts are always considered to be finance cash flows, even as IAS 7.33 allows their classification as operating cash flows as well as those resulting from financing activities. This applies to all case studies. VAT payments/ receipts from investing activities (acquisitions/ disposals) are cash flows from investments. 1.15 Companies Legal forms are not part of our Accounting syllabus. They are covered by <?page no="17"?> Berkau: Financial Statements 9 e 1-17 our Basics. We only assume that companies discussed in the textbook must prepare financial statements. This is the attitude of the IASB, too. In contrast to IFRSs, we do not refer to companies as “entities”. Once you read the expression entity in the standards, remember they are referring to companies. IFRSs apply in other jurisdictions for, e.g., a doctor’s clinic in the legal form of a partnership which does not count as company per se. We apply the technical terms “business,” “firm” and “company”. In this textbook, most companies are limited companies, e.g., GmbH, AG, Pty Ltd., PLC, Inc., etc. 1.16 Cost-Expense-Congruence By default, costs are expenses and vice versa. 1 1.17 Country All cases discussed in this textbook take place in countries where IFRSs apply to single-entity financial statements. Due to our teaching in Cape Town, most foreign examples refer to South Africa. 1.18 Currency Unit For all examples, the reporting currency is based on the country of the case study although IAS 21 defines more accurate criteria for the application of currencies. We use the common threeletter-codes for abbreviation, like ZAR for South African Rand or GBP for British Pound Sterling. 1 For cost definitions und cost separations, study our textbook Management Accounting, chapter (4). 1.19 Data Format in Tables In tables, negative figures are displayed in brackets. E.g., (7.50) equals -7.50 EUR. 1.20 Data Sheets We show the most important data for case studies in their data sheets. This is only to show most of the figures of a case in a comprehensive form. The data sheets do not replace the explanation of the case in the book, nor should they be seen as task description. 1.21 Prepayments of Income Taxes No provisional tax payments are made to the national revenue service in our case studies. Taxes are calculated at the yearend and added to short-term liabilities, mostly to the Income Tax Liabilities account. (For German companies, § 249 HGB applies. Therefore, income taxes count as provisions in Germany.) 1.22 Hints Note, hints are given in the text about additional information or explanations. They always start with “Note,…” They appear in a special, smaller format. 1.23 How it is Done (1) You find How-it-is Done sections in this textbook. (2) They offer you short and clear instructions for your Accounting work. <?page no="18"?> Berkau: Financial Statements 9 e 1-18 (3) In open-book exams the instructions given should serve you a cheat sheet. 1.24 Income Taxes For our textbooks, a simplified income tax model applies. Income taxes amount to 30 % of the pre-tax profit EBT. In a real company, replace the simplified calculations by the figures from the tax professionals. 1.25 Journal Entries In this 8 th edition all Bookkeeping entries have been disclosed as journal entries which is the usual format in international Accounting classes. However, for the German textbook Berkau: Bilanzen, Bookkeeping entries have been maintained. The journal entries show the date, the relevant accounts and include a narrative. The Bookkeeping entry above will look as below. It now contains information about the date and nature of the Bookkeeping entry. Note, that in the textbook the column headers “DR” and “CR” are not shown. DR CR @ 2.01.20X1 Property, Plant, Equipment PPE 20,000 Value Added Tax VAT 4,000 Cash/ Bank C/ B 24,000 (acquisition of a business car) 1.26 Financial Statements for Taxation We do not cover tax calculations. Tax statements are only relevant for us to determine income taxes (simplified calculation) and deferred taxes. As deferred taxes matter for revaluations, you find tax Profit and Loss accounts in chapter (7). 1.27 Names We name companies and indicate them by capital letters. E.g., SCHULZE-BRAMMELKAMP Ltd. No links or reference to existing persons or companies are intended. 1.28 Nominal Accounts’ Names The nominal accounts are marked by the year they are linked to, such as Labour-20X1 LAB. 1.29 Labour Accounting Recording labour always refers to the Labour account and is termed labour even as wages and salaries are discussed. Labour accounting is discussed in chapter (19) of our textbook Basics of Accounting in detail. 1.30 Language This textbook is written in South African English. <?page no="19"?> Berkau: Financial Statements 9 e 1-19 1.31 Learning Objectives Every chapter starts with the learning objectives and ends with a summary. We also give you a brief overview of the content in the What is in the Chapter? -paragraphs. 1.32 Legal Forms of a Business In this textbook, we use Ltd., (Pty) Ltd., Sdn. Bhd., Bhd., AG, GmbH, UG, PLC, Inc., etc. If no legal form is given, assume the company is privately owned, such as SANDPIPER BOOKS for a privately owned bookstore. 1.33 Length of a Month/ Year For workings, the below mentioned figures are relevant. 1 month = 21.5 days = 4.3 weeks. 1 year = 12 evenly long months = 365 days = 52 weeks. 1.34 Level of Precision We work exactly to integers or to figures with two digits after the decimal point. Results from workings are rounded, too. We usually calculate in MS-Excel; hence, calculations in the background are more precise than disclosed. All financial statements show figures rounded to the nearest full currency amount. 1.35 Links/ QR-Codes Links provided through QR-codes in the book direct you to further explanations and readings. 1.36 Literature The main source for preparing financial statements are the standards issued by the International Accounting Standard Board IASB. At the end of the textbook, we recommend further readings for you. 1.37 Non-existing Items In case something has not been mentioned it does not exist. 1.38 Online Materials The online materials are at the time of printing this textbook 354 exam tasks with solutions. Their names refer to the chapter and contain a counting figure, like Task_A10.14-Sunlands, which is linked to the textbook Financial Statements (A), chapter 10, and is the 14 th exam task. As higher the count is as newer is the task. 1.39 Payment Terms If nothing has been mentioned about payment terms, payments and receipts are recorded through the Cash/ Bank account. In this textbook, payments/ receipts for taxation and dividends are due in the next following Accounting period. Payments taking place during the year, and which are evenly distributed are recorded on 30.06.20XX or 1.07.20XX. This way, monthly payments are replaced by a comprehensive Bookkeeping entry, e.g., twelve monthly rent payments are recorded as one payment to the extent of the annual rent expense in the middle of the <?page no="20"?> Berkau: Financial Statements 9 e 1-20 year to keep the number of Bookkeeping entries low. 1.40 Presentation of Accounts Accounts are displayed in a T-format. The figures therein are rounded to the next currency unit. Accounts have a three-letter indicator column used for Bookkeeping entry identification or contra-entry references. All nominal accounts show the Accounting period as a suffix, such as Depreciation-20X4. See the accounts based on the car acquisition and its depreciation (depreciation is amounting to: 20,000/ 5 = 4,000 EUR.): D C D C (1) 20,000 (1) 4,000 D C D C (1) 24,000 ACC 4,000 D C DPR 4,000 Cash/ Bank C/ B Depreciation-20X1 DPR Accumulated depreciation ACC Property, plant, equipment PPE Value added tax VAT Figure 1.1: Accounts 1.41 Pro-Rated Depreciation/ Interest Although provided as annual rates, depreciation, and interest are calculated monthly accurate to a full month. Remember, all months have the same length. Hence, monthly depreciation and the rate of interest are calculated as the annual depreciation rate divided by 12. In the case of a company holding an asset for a shorter period than a full year, those months will count for depreciation in which the asset is owned for the major duration - more than 15 days. Interest rates are given per annum (/ a) and compounded annually (no compounded interest calculation within a year). For loans taken for shorter periods than a full year, interest is calculated per rate and accurate to the month, too. For a bank loan of 100,000 EUR obtained on 9.06.20X4 with an annual rate of interest of 10 %/ a, the interest paid at the end of the year is: 7 × 100,000 × 10%/ 12 = 5,833.33 EUR. If dates are not the beginning or the end of an Accounting period, the month is underlined to direct your attention thereto, as in 11.06.20X4. By default, interest and repayments take place at yearends, which is on 31.12.20XX. Interest is only calculated for debts, such as bank loans, bonds, etc. Overdrafts of a bank account get ignored. <?page no="21"?> Berkau: Financial Statements 9 e 1-21 An exception is chapter (37) in the Basics. 1.42 Quotation of Law Texts/ Standards Law texts/ standards are quoted like ‘§ 266 HGB’ or ‘IAS 1.68’. We use the original law names. Note, that IFRS paragraphs can be subjected to changes by IASB. 1.43 Sequence of Bookkeeping Entries The sequence of Bookkeeping entries follows the logical process defined by the text. Bookkeeping identifiers, like “(1), (2), (3) …” do not indicate the sequence of recording. 1.44 Sign of Numbers on Financial Statements Following international procedures, expenses on income statements are recorded as negative. This is known as the (DR)CR format. On the balance sheet, figures usually are positive, retained earnings and treasury stock are exempted. On a cash flow statement receipts are disclosed as positive and payments as negative figures. The statement of equity is in the (DR)CR format, which shows equity and increases thereof as positive and decreases with a minus sign. 1.45 Tax on Capital Returns (Dividend Tax) The tax on capital returns is an income tax. In this textbook, the rate of capital returns is 25 % based on the capital income. Note, for the company declaring the dividend, the tax on capital returns is no company tax, although it owes it. It is a withholding tax in most countries and is levied from private persons. Dividends received by companies are income tax-free - compared to § 8b KStG. 1.46 Transaction Costs We ignore transaction costs, like costs for selling goods/ services, taking out and repaying bank loans, issuing shares or bonds, etc. 1.47 Value Added Tax, Goods and Service Tax VAT stands for value added tax and GST for Goods and Service Tax. Except in, e.g., the United Arabic Emirates or some U.S. states like Delaware, Alaska, consumers pay VAT - sometimes referred to as sales tax when buying goods or services. In this textbook, we apply one single VAT account for input-VAT and output- VAT. The VAT rate is 20 %. We ignore reduced VAT rates as levied in many countries for food, books, etc. 1.48 VAT Reduction It is assumed that every company discussed in this textbook is registered for VAT reduction. Therefore, every company acts as VAT vendor. Note, that in some exercises you might find in the Required paragraph a hint like “Ignore VAT”. The mentioned paragraph it found always at the bottom of a task and tells you exactly what you should do. <?page no="22"?> Berkau: Financial Statements 9 e 1-22 1.49 Working Definitions At the end of every chapter, you are provided with short and easily understandable definitions for new Accounting terms. They are merely a glossary and should support your understanding. 1.50 Work-in-Process Account We apply the Work-in-Process account as a reconciliation account for all job orders and call it Work-in-Process WIP. We also use a Work-in-Process account for single job orders but then add the job order ID thereto, like “Work-in-Process 4711” for job order 4711. 1.51 Writing Management Terms We write academic disciplines, like Accounting, Marketing, Management, etc., in capital letters. 2 If this link is copied from the online version of the textbook, remove its line break! 1.52 WWW We provide you with of exercises, exam tasks, solutions, and further materials. Pls., check the link: https: / / files.narr.digi 97833811 / cases.zip 2 Most of the cases are copied from our exam tasks at Hochschule Osnabrück or its partner universities, in South Africa, China, South Korea, and Malaysia. 1.53 Youtube Videos On our YouTube channel (Carsten Berkau), we published video materials based on the case studies in this text-book. Follow the link on UVK website related to this textbook. 1.54 10-20-30 Rule In this textbook, the 10-20-30 rule applies. If not mentioned otherwise, the nominal interest rate is 10 %/ a, the VAT rate is 20 % and the total income tax rate is 30 %/ a. <?page no="23"?> Berkau: Financial Statements 9 e 2-23 2 Financial Statements based on German HGB 2.1 What is in the Chapter? We here introduce Accounting based on the German Handelsgesetzbuch HGB. We demonstrate the preparation of financial statements by the case study KIELING TAXI GmbH which is based in Hanover and therefore follows German law for its single-entity financial statements. The German GAAPS (generally accepted accounting principles) are the Handelsgesetzbuch and the laws for limited companies, e.g., GmbHG and AktG. In the first period, we only prepare financial statements. Only for the 2 nd Accounting period, we discuss Bookkeeping entries. The case study about a taxi company covers very few business activities to demonstrate the basics of German Accounting only: its establishment, the acquisition of a motor vehicle, the equipment of the car with taxi appliances, depreciation on non-current assets, payments for labour and operations as well as revenue recognition from taxi rides. The case study covers the Accounting periods 20X1 and 20X2. In the first Accounting period, the entire profit is carried forward to the next year. For 20X2, we record Bookkeeping entries following German standards and prepare financial statements following HGB standards. The appropriation of profits is discussed with portions of the distributable amount accrued to earnings reserves, paid as dividends, and carried forward to 20X3. Note, the distributable amount is the profit after income tax increased by a profit carried forward and reduced by a loss carried forward. Required additions to reserves are not distributable. Distributable refers to the company declaring a dividend paid out to the owners. 2.2 Learning Objectives After studying this chapter, you can prepare a balance sheet and an income statement for a company in Germany and achieve sufficient communication skills to talk and write about German Accounting. You got familiarised with major technical Accounting terms and understand the basic Accounting rules as laid out in the German Handelsgesetzbuch HGB. The achieved knowledge enables you later to compare German HGB to international Accounting standards IFRSs. For international students, this chapter provides a brief introduction to German Accounting. As we consider a lot of simplifications in this textbook, this chapter cannot qualify you as a Bookkeeper, but you understand what they are doing. 2.3 Legal Forms for German Companies In Accounting, the legal form of companies matters. We distinguish private companies and companies in public ownership. Private companies are in the legal form of a sole proprietor, a partnership, or a privately owned limited company. A partnership in Germany is called a <?page no="24"?> Berkau: Financial Statements 9 e 2-24 GbR 3 . Like a single proprietor, all owners of a GbR are held fully and jointly reliable for all assets and liabilities of their business. Public companies are limited companies with widely distributed ownership. If a company's shares are traded publicly at a stock exchange, everyone is allowed to buy its shares and to participate in profit distribution. Public companies must be distinguished from state-owned enterprises, which are owned by the public sector (state, county). State-owned companies are not discussed in this textbook. In contrast to private companies, the possible loss for the owners of a limited company is limited to equity. Equity comprises of the share capital, reserves, and accumulated profits. As owners are not held liable in an overindebtedness situation for their company’s debts, creditor protection becomes the major reason for the obligation to prepare financial statements in Germany. Business partners of a limited company must be able to assess the financial position of a company and its liquidity before they enter in a business relationship to calculate their risks. Note, a limited company is over-indepted once its liabilities exceed the total of assets. This leads to negative equity. In such a situation, the obligation is immanent to cease business procedures and to file for bankruptcy. Note, the management of a limited company is held responsible for its actions, in a case of negligence, deliberate intent or 3 Short for: Gesellschaft bürgerlichen Rechts, check §§ 705 - 741 BGB. wilful misconduct. The responsibility can be exercised in the owners’ interest. In Germany, limited companies and retailers must apply the German Handelsgesetzbuch HGB. The HGB contains paragraphs dedicated to retailers as well as to limited companies. 2.4 Obligation of Keeping Bookkeeping Records and Preparing F/ S § 242 HGB requires retailers and limited companies to keep Bookkeeping records and to prepare annual financial statements (general-purpose F/ S). All retailers keep Bookkeeping records based on § 239 HGB and record a register of assets following § 240 HGB. Retailers classified as small companies are exempted (from applying §§ 238 - 241 HGB) if they earn an annual revenue below 600,000 EUR/ a for two following years and reporting an annual surplus not exceeding 60,000 EUR/ a, see §241a HGB. This exemption applies for retailers that are not limited ones only. In addition to retailers, any firm in the legal form of a limited company prepares financial statements based on § 264 HGB. Limited companies in Germany are Gesellschaft mit beschränkter Haftung GmbH (or as a small cousin thereof Unternehmergesellschaft UG (haftungsbeschränkt)) and Aktiengesellschaft AG. AGs are companies based on shares. A GmbH is a privately owned limited company, like a PLC or a (Pty) Ltd. in the UK or Australia and South Africa respectively. Study the <?page no="25"?> Berkau: Financial Statements 9 e 2-25 German company’s acts, GmbHG and AktG for details. Commercial financial statements in Germany include a balance sheet and an income statement (§ 242 HGB). Limited companies additionally prepare an attachment and a business report in compliance with § 264 HGB. The attachment is a part of the financial statements, see § 264 HGB. Therefore, it is relevant for Auditing. Note, auditing means that a qualified expert in Accounting (the auditor) checks (= audits) the financial statements and Bookkeeping records for correctness. An auditor does not judge a company but states whether its financial statements are in accordance with applied Bookkeeping policies and Accounting standards (HGB/ IFRSs). Auditing is obligatory for mediumsized and large limited companies based on § 316 HGB. The attachment contains further disclosures regarding the balance sheet and income statement based on § 284 HGB. Note, the German expression for all elements of financial statements is “der Jahresabschluss (the financial statement), whereas the IASB (International Accounting Standard Board) terms this a full set of financial statements. 2.5 Establishment of a Company With the establishment of a limited company in Germany, it gets registered. The register (Handelsregisterrolle) is kept at local courts (Amtsgericht). The representatives of a limited company appoint an attorney for registration. The attorney drafts a contract, also known as the memorandum of incorporation (MoI) or the articles, that amongst other items determines the purpose of the company, its address, the legal representatives etc. With the set-up of the MOI, Accounting work starts: One document required with the MOI is the opening balance sheet following § 240 HGB and is prepared in the format prescribed in § 266 HGB. Usually, the opening balance sheet only discloses issued capital and cash/ bank at the time of incorporation. The issued capital are the funds the owners contribute to the company. A company can also be established by a contribution of assets other than cash/ bank which then requires the further asset items to be disclosed on the balance sheet. After its establishment, limited companies must prepare and disclose financial statements for taxation as well as for commercial purposes. Therefore, companies prepare two sets of financial statements which follow different laws. Commercial financial statements follow the German HGB, and the other ones are based on German income tax law EStG. Financial statements along HGB are published at local courts and financial statements for taxation must be transferred as E- Bilanz to the German revenue service (Finanzamt). The Accountants prepare both kind of financial statements. As HGB and EStG follow different objectives, one single multiple-purpose Jahresabschluss is unlikely to happen. In this textbook, we focus on commercial law HGB in Germany and internationally on IFRSs. <?page no="26"?> Berkau: Financial Statements 9 e 2-26 Before we put aside the tax statements, we cover two aspects which are relevant for our Accounting work and Bookkeeping: (1) Simplified income tax calculation. (2) Value added tax. 2.6 Income Tax Calculation In Taxation classes at the university, details of national income tax calculations for companies are taught. The tax law strives for a fair income tax system. This principle means that a person/ company with high income pays higher tax rates than someone who earns less (tax progression). 4 Therefore, the income tax law follows the capability of taxpayers to contribute to the common welfare of the society. Note, from Cost Accounting principles for cost allocations are known, e.g. applied for internal cost allocations between cost centres or for product calculations. Based on the identity principle, only direct costs are assigned to cost objects. Based on the cost-by-cause principle the cost allocations follow the reasons for cost occurrences. The average principle distributes costs evenly. The capacity principle is based on the potential of cost objects to cover costs, e.g. determined based on net selling prices. Tax laws include various and detailed regulations and numerous exceptions for income tax adjustments. For this textbook, we simplify the income tax calculation. We multiply a company’s pre-tax profit by a total income tax rate of 30 %. For a genuine business, you must replace that tax substitute with a detailed tax calculation. 5 4 Check the business plan case study SCHLUCHMAN in our textbook Management Accounting, chapter (6). 2.7 Value added tax VAT. Value added tax VAT is a consumer tax and is paid by buyers of goods or recipients of services. The VAT rate is the same for all consumers. Companies usually are exempted from VAT, as they do not consume but buy goods or services for manufacturing and service rendering purposes. Companies that buy goods or services initially pay input-VAT but get refunded by the revenue service later. This way, companies are not charged VAT. The refund is received based on a VAT return form submitted to the revenue service. All companies registered for VAT reduction must collect output- VAT from their customers on behalf of the revenue service. VAT is calculated based on the revenue. Therefore, the expression Umsatzsteuer (for tax based on revenues) is common in Germany. Technically, every company keeps a record of its VAT payments and receipts in a VAT account. Based on the conventions in this textbook in chapter (1), they pay in the next following Accounting period the excess of output-VAT over input-VAT to the revenue service. Real companies make these payments in monthly intervals. If output-VAT does not exceed the input-VAT, the company receives a refund. For the sake of simplification, we apply in this textbook a uniform VAT rate of 20 % and pretend all companies are registered for VAT reduction by default. No reduced VAT rates apply. Below, we discuss our first case study KIELILNG TAXI GmbH. The case study resembles the case of 5 See Schneeloch, D.; Meyering S.; Patek, G.: Betriebliche Steuerlehre. <?page no="27"?> Berkau: Financial Statements 9 e 2-27 KENILWORTH METERED TAXI SERVICE Ltd. discussed in the next chapter (3) for studying international Accounting. This way, you can compare German HGB to international Accounting standards IFRSs. 2.8 C/ S KIELING TAXI GmbH - 20X1 For the KIELING TAXI GmbH case study, we apply German HGB and make Bookkeeping entries following the DATEV format. Note, DATEV (Datenverarbeitung für steuerberatende Berufe) is a German company that provides Accounting services. As it is interlinked with the revenue service, it acts as pro-forma standard setter in Accounting. In the first Accounting period, the focus is on the preparation of financial statements; no Bookkeeping entries will be discussed but we provide them through the online study materials bank. Below, you see a data sheet for KIELING TAXI GmbH which contains the major information about the case study. Data Sheet for KIELING TAXI GmbH Domicile: Germany (Hanover). Reporting currency: EUR. Classification: Service provider. Establishment: 1.01.20X1; owner's contribution: 50,000 EUR, 10,000 EUR thereof as taxi license. Acquisition of a car: 30,000 EUR net amount, value of taxi equipment: 5,000 EUR net amount. Depreciation: straight-line method over three years, residual value 8,000 EUR. Relevant Accounting periods 20X1/ 20X2. Revenue: 100,000 EUR / 105,000 EUR. Labour (for drivers): 50,000 EUR / 55,000 EUR. Operational expenses (VATable): 15,000 EUR / 16,000 EUR. Appropriation of profits: 20X1: profit carried forward / 20X2: 10,000 EUR payment to owners, 10,000 EUR added to reserves, remainder carried forward to 20X3. VAT rate: 20 %. Note, data sheets for the case studies only display collected the information from the text following; they do not replace the text, nor do they serve as case study description. Their purpose is to provide an overview of the data. Mr Kieling starts his taxi business and buys a taxi license in Hanover. He establishes the privately owned limited company KIELING TAXI GmbH. A GmbH follows the German company’s act (GmbHG) and requires a minimum contribution of 25,000 EUR from its owners (all together). A company in the legal form of GmbH needs to be registration at the local court. Mr Kieling makes an appointment with the attorney Dr. Meppen. He contributes 50,000 EUR to the company which is partially paid into the bank account of the future limited company. Mr Kieling opens an account at Commerzbank in Hanover and deposits 40,000 EUR before he pays his attorney a visit. The remainder portion of the contribution is provided as taxi license, worth 10,000 EUR. Its valuation is measured at cost. Note, at costs is short for based on cost of acquisition, see IAS 16.15. The valuation follows then the cost model. On 27.12.20X0, Mr Kieling presents proof of payment for his contribution to the company funds by a stamped bank <?page no="28"?> Berkau: Financial Statements 9 e 2-28 statement and the taxi license. He also provides the attorney with an opening balance sheet in compliance with the formal requirements in § 266 HGB. See the opening balance sheet in Figure 2.1. Following § 244 HGB, Mr Kieling submits the balance sheet in German and all figures in EUR. Note, for the English version of the textbook, we translate German financial statements into English. You cannot provide the authorities with financial statements in a foreign language! Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets II. Capital reserves III. Financial assets III. Earnings reserves IV. Profit/ Loss carried forward B. Current assets V. Annual surplus/ loss I. Inventories II. Receivables and other B. Provisions assets I. Provisions for pension funds III. Securities II. Tax provisions IV. Cash, cash on 40,000 III. Other provisions Bundesbank cash on banks, checks C. Payables C. Accurals on debit side D. Accruals on the credit side D. Deferred taxes on the debit side E. Deferred taxes on the credit side E. Difference of asset offsetting on the asset side 50,000 50,000 Kieling Taxi GmbH BALANCE SHEET as at 1.01.20X1 Figure 2.1: KIELING TAXI GmbH’s opening balance sheet The attorney, Dr. Meppen, prepares the memorandum of incorporation (MOI) by which Theo Kieling is appointed as chief executive officer (CEO) of KIELING TAXI GmbH. He legally represents the company in the future. Dr. Meppen submits the MOI at the local court in Hanover which leads to the following events: (1) KIELING TAXI GmbH is registered at the registrar in Hanover and (2) the revenue service assigns a German tax-payer ID to the new company. KIELING TAXI GmbH receives a notification of establishment from the local court as well as from the German revenue service in Hanover (Finanzamt). On 2.01.20X1, KIELING TAXI GmbH commences its operations. It now must keep Bookkeeping records and take stock every yearend. At the time of incorporation, the company owns the taxi license at a value of 10,000 EUR and holds 40,000 EUR in its bank account at Commerzbank. On 4.01.20X1, KIELING TAXI GmbH buys a used Mercedes-Benz E220d at a cost of acquisition of 30,000 EUR (net value). <?page no="29"?> Berkau: Financial Statements 9 e 2-29 Cost of acquisition always is the net amount. To support the valuation at net values, it is required that the invoice from the car dealer discloses the VAT portion, see § 255 HGB and § 15 UStG. KIELING TAXI GmbH claims a VAT refund of: 30,000 × 20% = 6 6,000 EUR in the next Accounting period. If the taxi company bought the car from a private person, no VAT reduction would be possible. Note, to reduce VAT from a bill/ an invoice, both parties must be registered for VAT reduction. The buyer must be allowed to reduce VAT by registration for VAT reduction at the revenue service and the seller must be registered as well to disclose the VAT portion on the invoice. KIELING TAXI GmbH orders a specialised taxi car manufacturer to configure the car for its intended use as a metered taxi. The car gets equipped with a yellow taxi light mounted on the roof, a radio for communication with the taxi dispatcher, a meter and seat sensors which cost in total 6,000 EUR (gross value). The manufacturer discloses the input-VAT portion on its invoice. VAT is amounting to: 5,000 × 20% = 1 1,000 EUR. Following § 255 HGB, the total costs of acquisition for the taxi are: 30,000 + 5,000 = 3 35,000 EUR. KIELING TAXI GmbH pays the car dealer and the manufacturer together: 35,000 × (1 + 20%) = 442,000 EUR per bank transfer. At this stage, we introduce a simplification for the VAT calculation procedure which only applies for calculations based on the textbook VAT rate of 20 %: How it is Done (VAT calculation, based on a 20 % VAT rate) (1a)If the net value is given, multiply the net value by 120 % or by 1.2 to calculate the gross value. (1b)If the net value is given and you want to know the VAT amount, multiply the net value by 20 % or divide it by 5. (2a)If VAT is known and you want to know the gross value, multiply the VAT amount by 6. (2b)If VAT amount is known and you want to determine the net value, divide the VAT amount by 20 % or multiply it by 5. (3a)If the gross value is known and you want to determine the net value, divide the gross value by 120 % or by 1.2. (3b)If the gross value is given and you want to know VAT amount, divide the gross value by 120 % and multiply it by 20 % thereafter. Alternatively, divide the gross value by 6. Depreciation on the taxi follows straight-line method over the useful life of three years. Note, Based on the German Afa-list, motor vehicles are depreciated over six years. The Mercedes here is pre-owned. <?page no="30"?> Berkau: Financial Statements 9 e 2-30 The depreciation table issued by the German finance minister applies for the tax statements in Germany and is considered for the commercial financial statements here, too. KIELING TAXI GmbH estimates to sell the car at 8,000 EUR (net value) after 31.12.20X3. Therefore, the depreciable amount of the taxi is: 35,000 - 8,000 = 2 27,000 EUR. Annual depreciation is: 27,000 / 3 = 9 9,000 EUR/ a. After making deductions for depreciation, KIELING TAXI GmbH carries the car at a value of: 42,000 / 120% - 9,000 = 226,000 EUR as per 31.12.20X1. Depreciation is recorded at the end of the Accounting period. During the Accounting period 20X1, KIELING TAXI GmbH earns 100,000 EUR in revenues with taxi rides. Due to the registration for VAT reduction, the taxi passengers (all together) pay the gross amount which is termed proceeds: 100,000 × 120% = 1 120,000 EUR. Labour for the drivers is 50,000 EUR/ a and KIELING TAXI GmbH pays for operations 18,000 EUR/ a, the latter one is the gross value. Here, the operational expenses are VATable because they fall under 3 rd party expenses. Their net value is: 18,000 / 120% = 1 15,000 EUR/ a. Observe below the Bookkeeping entries in the journal in Figure 2.2. To keep this case study simple, we record all single business activities by one comprehensive Bookkeeping entry dated to the middle of the Accounting period 20X1 (30.06.20X1). This means, we do not record all single taxi rides. Nr Amount Date Narrative DR CR OV 10,000 2.01.20X1 Establishment of business Licenses Issued capital 40,000 Cash/ Bank Issued capitall (1) 30,000 4.01.20X1 Acquisition of taxi car P, P, E Cash/ Bank 6,000 VAT Cash/ Bank (2) 5,000 5.01.20X1 Taxi equipment P, P, E Cash/ Bank 1,000 VAT Cash/ Bank (3) 9,000 31.12.20X1 Depreciation taxi car Depreciation P, P, E (4) 100,000 30.06.20X1 Revenue from taxi rides Cash/ Bank Revenue 20,000 Cash/ Bank VAT (5) 50,000 30.06.20X1 Labour Labour Cash/ Bank (6) 15,000 30.06.20X1 Operating expenses Operational exp. Cash/ Bank 3,000 VAT Cash/ Bank Kieling Taxi GmbH JOURNAL 20X1 Figure 2.2: KIELILNG TAXI GmbH’s journal (20X1) The profit or loss calculation determines the pre-tax profit for 20X1. For the calculation we deduct labour, operational expenses, and depreciation from revenues: 100,000 - 50,000 - 15,000 - 9,000 = 226,000 EUR. The values used for profit calculation are always net of VAT. They are either revenues, other income, or expenses: - Revenue: 100,000 EUR. - Labour: 50,000 EUR. - Operational expenses: 15,000 EUR. - Depreciation: 9,000 EUR. <?page no="31"?> Berkau: Financial Statements 9e 2-31 In the next year 20X2, KIELING TAXI GmbH pays income tax liabilities of: 26,000 × 30% = 7 7,800 EUR. They are expenses for 20X1 but payable in 20X2. Next, we discuss the balance sheet as per 31.12.20X1. It discloses all assets on its left-hand side (asset side, debit side). At KIELING TAXI GmbH, assets are the motor vehicle and the taxi license as well as cash/ bank. The motor vehicle’s carrying value after depreciation is: 35,000 - 9,000 = 226,000 EUR. No depreciation on the license applies as it does not expire (given). The closing balance for the Cash/ Bank account is: 40,000 - 36,000 - 6,000 + 120,000 - 50,000 - 18,000 = 50,000 EUR. The cash/ bank values are based on gross amounts resulting from: - Partial owner’s contribution, as paid: 40,000 EUR. - Taxi acquisition: 36,000 EUR. - Taxi configuration: 6,000 EUR. - Proceeds: 120,000 EUR. - Labour (drivers): 50,000 EUR. - Payment for taxi operations: 18,000 EUR. On the credit side of the balance sheet, KIELING TAXI GmbH discloses equity which is the issued capital of 50,000 EUR and the profit after taxes shown as retained earnings. It is calculated as pretax profit less income tax expenses: 26,000 - 7,800 = 1 18,200 EUR. Underneath of the equity section, an income tax provision of 7,800 EUR is disclosed. KIELING TAXI GmbH is registered for VAT reduction and acts as VAT vendor. Its output-VAT results from taxi rides. The total of input-VAT receivables is: 6,000 + 1,000 + 3,000 = 1 10,000 EUR. The values for the calculation of the payment to the revenue service are based on: - Output-VAT from taxi rides: 20,000 EUR. - Input-VAT from car acquisition: 6,000 EUR. - Input-VAT from taxi equipment: 1,000 EUR. - Input-VAT from operational expenditures: 3,000 EUR. KIELING TAXI GmbH reports VAT liabilities as the difference between outputand input-VAT to an extent of: 20,000 - 10,000 = 110,000 EUR. They are disclosed on the balance sheet as short-term liability. We prepare the balance sheet based on the classification of KIELING TAXI GmbH as a small and limited German company following § 267 HGB. The formal requirements are based on § 266 HGB. Small and limited companies prepare balance sheets applying an abridged format. Note, a German limited company is considered small following § 267 HGB, if it does not exceed two of the following borderlines for two subsequent years: 7.5 Mio EUR total of the balance sheet, 15 Mio EUR in revenue, 50 employees (measured in full time equivalents). The illustrated Bookkeeping entries and the T-accounts for KIELING TAXI GmbH are available for download. Pls., scan Link 2.A: Link 2.A: KIELING TAXI GmbH <?page no="32"?> Berkau: Financial Statements 9e 2-32 Observe below the balance sheet for KIELING TAXI GmbH as per 31.12.20X1 in Figure 2.3. We translated the balance sheet for this textbook. It must be prepared in German, see above. Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets 26,000 II. Capital reserves III. Financial assets III. Earnings reserves IV. Profit/ Loss carried forward B. Current assets V. Annual surplus/ loss 18,200 I. Inventories II. Receivables and other B. Provisions assets I. Provisions for pension funds III. Securities II. Tax provisions 7,800 IV. Cash, cash on 50,000 III. Other provisions Bundesbank cash on banks, checks C. Payables 10,000 C. Accurals on debit side D. Accruals on the credit side D. Deferred taxes on the debit side E. Deferred taxes on the credit side E. Difference of asset offsetting on the asset side 86,000 86,000 Kieling Taxi GmbH BALANCE SHEET as at 31.12.20X1 Figure 2.3: KIELING TAXI GmbH’s abridged balance sheet (20X1) German law requires companies to submit financial statements in the format prescribed by §§ 266, 275 HGB to the local court. The formal requirements are strict; items on financial statements must be named as termed in the law text and the structure of items must follow a prescribed sequence. On the balance sheet, we find some items to be disclosed in contrast to international Accounting on the balance sheet, but which are not relevant for the case of KIELING TAXI GmbH. 6 Study our textbook Basics of Accounting, chapter (18). We discuss those items but keep our explanations short: (a) Accruals are ruled by § 250 HGB. The reporting company discloses expenditures that have been paid before the balance sheet day but are expenses for a certain period after that day (in the next Accounting period). We refer in this textbook to those items as prepaid expenses. 6 (b) On the credit side, accruals are recorded for receipts before the balance sheet day that is revenue for a certain period after that day (in the <?page no="33"?> Berkau: Financial Statements 9e 2-33 next Accounting period). These values are often advanced payments or deposits received from customers. 7 (c) Deferred taxes are income tax considerations for tax income (asset side) or expenditures (credit side) that differ from actual tax calculations based on German tax law EStG and disclosed on financial statements for taxation. (d) If a company discloses losses that exceed the total of equity, § 268 HGB stipulates, that it must disclose the difference between the loss and the total of equity under the item not-covered loss on the asset side of the balance sheet. In cases when this item applies, bankruptcy is likely to happen. Note, a limited company must file for bankruptcy if it is over-indebted or unable to make required payments. Below, we resume the case study KIELING TAXI GmbH: KIELING TAXI GmbH prepares a profit or loss statement which belongs to the set of financial statements following German HGB. Its format follows § 275 HGB. It can be prepared based on the nature of expense method or the cost of sales format. 8 KIELING TAXI GmbH prepares a profit or loss statement following the nature of expense method. It is depicted in Figure 2.4. Note, a profit and loss statement can be prepared based on the nature of expense method or cost of sales format. (1) Under the nature of expense format, all expenses are deducted from revenues. An increase in finished goods is considered a negative cost. (2) Under the cost of sales format only the cost of goods sold are deducted from revenues. The method requires cost allocations towards finished goods. Both methods calculate the same profit. See the details in chapter (12). 7 Study our textbook Basics of Accounting, chapter (15). 8 Study our textbook Basics of Accounting, chapter (28). <?page no="34"?> Berkau: Financial Statements 9e 2-34 [EUR] 1. Revenue 100,000 2. Increase/ decrease resulting from finisched and semi-finished goods inventory changes 3. Other recognised finished goods 4. Other operating profit 5. Materials (a) Expenses for raw materials, supplies and for other aquired goods (b) Expenses for 3rd party services 6. Labour (50,000) (a) Salaries (b) Expenses for social payments and expenses for pension provisions and for support 7. Depreciation (9,000) (a) on intangible non-current assets and P, P, E as well as for recognised finished goods and for expenses to commence and enhence operating processes (b) on current assets as far as they exceed normal depreciation 8. Other operating expenses (15,000) 9. Investment revenue 10. Revenue resulting from other securities and lending financial assets 11. Other interest and similar revenue 12. Depreciation on financial assets and current securities 13. Interest and similar expenses 14. Operating profit 26,000 15. Extraordinary Revenue 16. Extraordinary expenses 17. Extraordinary profit 18. Income taxes (7,800) 19. Other taxes 20. Annual surplus/ loss 18,200 Kieling Taxi GmbH STATEMENT of PROFIT and LOSS for the year 20X1 Figure 2.4: KIELING TAXI GmbH’s profit and loss statement (20X1) Mr Kieling holds an annual meeting and decides about the appropriation of profits. Companies can either declare a dividend, add profit to reserves or carry forward their profit or loss to the next Accounting period. The latter postpones the decision about the profit appropriation for one year. The owners also can decide to mix the appropriation of profits. Here, KIELING TAXI GmbH carries forward the entire profit of 18,200 EUR to the next Accounting period 20X2. 2.9 C/ S KIELING TAXI GmbH - 20X2 Below, we discuss the Accounting period 20X2: At the beginning of the Accounting period 20X2, KIELING TAXI GmbH pays for income taxes and VAT liabilities. With this paragraph, we start to demonstrate Bookkeeping entries for all business activities. For this case study we apply German Bookkeeping, in the following chapters (3) to (14) of this textbook, all Bookkeeping entries are recorded according to the international format. <?page no="35"?> Berkau: Financial Statements 9e 2-35 KIELING TAXI GmbH starts the Accounting period 20X2 with an Opening Balance Sheet account. The company applies accounts based on the chart of accounts in the DATEV-4 format. You can download the DATEV-4 chart of accounts through Link 2.B below. Link 2.B: DATEV-4 chart of accounts A company that prepares its books for recording a new Accounting period, will carry forward balancing figures for the items on the prior balance sheet in the 9000-Balancing-Figures account. Study the accounts as per 1.01.20X2 in Figure 2.5. Therein, the standard account numbers and names based on the DATEV-4 chart of accounts apply but have been translated into English for teaching purpose. When we open accounts, we refer to the contra accounts by their fourdigit-codes in line with the DATEV-4 chart of accounts. Some accounts do not carry numbers as the Accounting software generates them automatically and therefore, they are not listed in the chart of accounts, e.g., Annual Surplus account. D C D C 2900 50,000 0110 10,000 9000 10,000 2970 18,200 0520 26,000 3020 7,800 1810 50,000 3800 10,000 86,000 86,000 9000-Balancing figures EBK 0110 Licences D C D C 9000 26,000 9000 50,000 0520 Motor vehicles, cars 1810 Bank account Commerzbank D C D C 9000 50,000 9000 18,200 2900 Issued capital 2970 Profit carried forward D C D C 9000 7,800 9000 10,000 3020 Tax provisions for income tax 3800 VAT payables Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X2) <?page no="36"?> Berkau: Financial Statements 9e 2-36 During 20X2, KIELING TAXI GmbH records the business activities below: (A) Payment of income tax for 20X1 to the extent of 7,800 EUR. (B) Payment of VAT liabilities for 20X1 to the extent of 10,000 EUR. (C) Depreciation on the taxi to the extent of 9,000 EUR. (D) Payment for labour 55,000 EUR. (E) Payment for operational expenses 19,200 EUR (gross amount). (F) Revenue recognition from taxi rides to the extent of 105,000 EUR (net amount). (G) Transfer of 126,000 EUR cash to the Bank account with Commerzbank. KIELING TAXI GmbH makes Bookkeeping entries (A) - (F) for its business activities in 20X2. Note, that we apply Bookkeeping entries as this case study follows German Accounting procedures. They are disclosed in the international DR-CR format instead of “Soll an Haben”. DR 3020 Tax Provisions ......... 7,800 EUR CR 1810 Bank Account CoBa....... 7,800 EUR DR 3800 Output-VAT.............. 10,000 EUR CR 1810 Bank Account CoBa....... 10,000 EUR DR 6222 Depreciation on Cars.... 9,000 EUR CR 0520 Motor Vehicles, Cars.... 9,000 EUR DR 6010 Labour.................. 55,000 EUR CR 1810 Bank Account CoBa....... 55,000 EUR DR 6300 Operational Expenses.... 16,000 EUR DR 1400 Input-VAT............... 3,200 EUR CR 1810 Bank Account CoBa....... 19,200 EUR DR 1600 Cash.................... 126,000 EUR CR 3800 Output-VAT.............. 21,000 EUR CR 4200 Revenue................. 105,000 EUR DR 1810 Bank Account CoBa....... 126,000 EUR CR 1600 Cash.................... 126,000 EUR Under German Bookkeeping, the contra entry for depreciation is recorded in the asset account. After recording above Bookkeeping entries, KIELING TAXI GmbH calculates its profit as shown in the accounts below in Figure 2.6. With Bookkeeping entry (G), we transfer cash received to the Bank account. As we apply the DATEV chart of accounts we separate Cash and Bank accounts. <?page no="37"?> Berkau: Financial Statements 9e 2-37 Bookkeeping entry (H) 9 adds income tax expenses of 30 % of the pretax profit to the Income Tax Provisions account. Based on § 249 HGB, income taxes are disclosed as provisions. 10 KIELING TAXI GmbH decides about the appropriation of its profits on the annual general meeting AGM. Note, the annual general meeting is an annual gathering of the owners of a limited company. The purpose of the AGM is the approval of financial statements, decisions about the appropriation of profits, election of board members, appointment of auditors etc. The distributable amount is the profit carried forward from 20X1 plus 20X2’s annual surplus: 18,200 + 17,500 = 35,700 EUR. KIELING TAXI GmbH’s profit appropriation is: - 10,000 EUR are accrued to earnings reserves. - 10,000 EUR dividend is paid out in the future. It results in an entry in the short-term liabilities. - 15,700 EUR are carried forward to the next period. The appropriation of profits is recorded as Bookkeeping entries (I), (J), and (K). On 31.12.20X2: DR 2970 Profit c/ f.............. 10,000 EUR CR 3519 Liabilities to Owners... 10,000 EUR DR 2970 Profit c/ f.............. 8,200 EUR DR Annual Surplus............... 1,800 EUR CR 2960 Other Earnings Reserves. 10,000 EUR DR Annual Surplus............... 15,700 EUR CR Retained Earnings............ 15,700 EUR Observe the accounts at KIELING TAXI GmbH in Figure 2.6 after the appropriation of profits. For teaching purposes, we display the account 9000 twice. It is the opening account (Eröffnungsbilanzkonto EBK) and the closing account (Schlussbilanzkonto SBK). D C D C 2900 50,000 0110 10,000 EBK 10,000 SBK 10,000 2970 18,200 0520 26,000 3020 7,800 1810 50,000 3800 10,000 86,000 86,000 9000-Balancing figures EBK 0110 Licences Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) 9 Not shown. 10 In contrast, IFRSs require the disclosure as income tax liabilities. <?page no="38"?> Berkau: Financial Statements 9e 2-38 D C D C EBK 26,000 (C) 9,000 EBK 50,000 (A) 7,800 SBK 17,000 (G) 126,000 (B) 10,000 26,000 26,000 (D) 55,000 (E) 19,200 SBK 84,000 176,000 176,000 0520 Motor vehicles, cars 1810 Bank account Commerzbank D C D C SBK 50,000 EBK 50,000 (I) 10,000 EBK 18,200 (J) 8,200 18,200 18,200 2900 Issued capital 2970 Profit carried forward D C D C (A) 7,800 EBK 7,800 (B) 10,000 EBK 10,000 SBK 7,500 (H) 7,500 3800 3,200 (F) 21,000 15,300 15,300 SBK 17,800 31,000 31,000 3020 Tax provisions for income tax 3800 Output-VAT D C D C (C) 9,000 P&L 9,000 (D) 55,000 P&L 55,000 6222 Depreciation on cars 6010 Labour D C D C (E) 16,000 P&L 16,000 (E) 3,200 3800 3,200 6300 Operational expenses 1400 Input-VAT D C D C (F) 126,000 (G) 126,000 P&L 105,000 (F) 105,000 1600 Cash 4200 Revenue Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) continued <?page no="39"?> Berkau: Financial Statements 9e 2-39 D C D C 6010 55,000 4200 105,000 (H) 7,500 P&L 7,500 6222 9,000 6300 16,000 EBT 25,000 105,000 105,000 76XX 7,500 EBT 25,000 A/ S 17,500 25,000 25,000 Profit and Loss 76XX Income tax expenses D C D C (J) 1,800 P&L 17,500 SBK 10,000 (I) 10,000 (K) 15,700 17,500 17,500 Annual surplus 3519 Liabilities to owners D C D C SBK 10,000 (J) 10,000 SBK 15,700 (K) 15,700 2960 Other earnings reserves Retained earnings D C 0520 17,000 2900 50,000 0110 10,000 2960 10,000 1810 84,000 R/ E 15,700 3519 10,000 3020 7,500 3800 17,800 111,000 111,000 9000 Balancing figures SBK Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) continued The Bookkeeping records are for the preparation of financial statements. KIELING TAXI GmbH prepares an income statement based on its Profit and Loss- 20X2 account. The income statement is depicted in Figure 2.7. Note, that in this textbook we present for uniform disclosure reasons all income statements in a (DR)CR-format, which means that credit entries, like for revenue and other income, are positive, and all debit entries for expenses are shown as negative figures. This format is common for international Accounting and will be continued for the rest of the textbook. In Germany, usually expenses are disclosed as positive values. <?page no="40"?> Berkau: Financial Statements 9e 2-40 [EUR] 1. Revenue 105,000 2. Increase/ decrease resulting from finisched and semi-finished goods inventory changes 3. Other recognised finished goods 4. Other operating profit 5. Materials (a) Expenses for raw materials, supplies and for other aquired goods (b) Expenses for 3rd party services 6. Labour (55,000) (a) Salaries (b) Expenses for social payments and expenses for pension provisions and for support 7. Depreciation (9,000) (a) on intangible non-current assets and P, P, E as well as for recognised finished goods and for expenses to commence and enhence operating processes (b) on current assets as far as they exceed normal depreciation 8. Other operating expenses (16,000) 9. Investment revenue 10. Revenue resulting from other securities and lending financial assets 11. Other interest and similar revenue 12. Depreciation on financial assets and current securities 13. Interest and similar expenses 14. Operating profit 25,000 15. Extraordinary Revenue 16. Extraordinary expenses 17. Extraordinary profit 18. Income taxes (7,500) 19. Other taxes 20. Annual surplus/ loss 17,500 Kieling Taxi GmbH STATEMENT of PROFIT and LOSS for the year 20X2 Figure 2.7: KIELING TAXI GmbH’s income statement (20X2) Based on § 276 HGB, small and limited companies are free to combine items (1) - (5) and disclose them as gross profit (Rohergebnis) instead. Next, we discuss the balance sheet: A company prepares its balance sheet either before or after the appropriation of profits. In case the appropriation of profits is considered, the company must follow § 268 HGB: If the profit has been fully distributed (meaning no profit/ loss is carried forward), the item annual surplus becomes zero and must be omitted. Under a partial appropriation of profits, the item annual surplus is replaced by retained earnings. The item retained earnings (Bilanzgewinn) then discloses the profit or loss carried forward. In the next Accounting period, it gets transferred from retained earnings to profit carried forward. KIELING TAXI GmbH opts for a disclosure of the balance sheet under consideration of the appropriation of profits. Therefore, it replaces the items profit carried forward from 20X1 and annual surplus by retained earnings. Retained earnings are amounting to: 18,200 + 17,500 - 10,000 - 10,000 = 1 15,700 EUR. <?page no="41"?> Berkau: Financial Statements 9e 2-41 KIELING TAXI GmbH is a small and limited company which can execute some privileges to simplify the disclosure of its balance sheet. The privileges of small and limited companies are: (a) The balance sheet follows an abridged format that requires only the disclosure of items indicated by letters and Roman numerals (§ 266 HGB). (b) Small and limited companies do not explain certain receivables based on § 268 HGB in the attachment to the financial statements. (c) Small and limited companies do not explain certain payables based on § 268 HGB in the attachment to the financial statements. (d) § 274a HGB exempts small and limited companies from formal regulations about accruals and deferred taxes based on §§ 268, 274 HGB. The above exemptions and simplifications apply for KIELING TAXI GmbH. Observe its abridged balance sheet as per 31.12.20X2 in Figure 2.8. Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets 17,000 II. Capital reserves III. Financial assets III. Earnings reserves 10,000 IV. Retained earnings 15,700 B. Current assets I. Inventories B. Provisions II. Receivables and other I. Provisions for pension funds assets II. Tax provisions 7,500 III. Securities III. Other provisions IV. Cash, cash on 84,000 Bundesbank C. Payables 27,800 cash on banks, checks D. Accruals on the credit side C. Accurals on debit side E. Deferred taxes on the credit side D. Deferred taxes on the debit side E. Difference of asset offsetting on the asset side 111,000 111,000 Kieling Taxi GmbH BALANCE SHEET as at 31.12.20X2 Figure 2.8: KIELING TAXI GmbH’s abridged balance sheet (20X2) §§ 284 - 288 HGB rule the attachment. The attachment is based on German HGB a part of a full set of financial statements and must be audited if the financial statements are audited. For small and limited companies, an abridged attachment applies based on § 288 HGB. No attachment has been prepared for KIELING TAXI GmbH. To study a real attachment, check the financial statements of <?page no="42"?> Berkau: Financial Statements 9e 2-42 Lufthansa AG, which can be downloaded by the Link 2.C below: Link 2.C: Lufthansa AG’s attachment 2.10 Summary German retailers and companies in the legal form of a limited company prepare and report financial statements based on §§ 242 and 264 HGB. The financial statements in Germany include a balance sheet and an income statement. Limited companies also prepare an attachment and a business report. In case a company participates in the capital market and is not obliged to prepare group statements, it must disclose an extra cash flow statement. (§ 264 HGB). We discussed the case study KIELILNG TAXI GmbH, which is a German limited company and prepared its financial statements for two Accounting periods. After the last one, the company appropriates its profits. The balance sheet provided for the 2 nd Accounting period has been set up under the consideration of profit appropriation. 2.11 Working Definitions Accruals: Item on the balance sheet that is income or expense for a specific time after the balance sheet date. Attachment: Disclosure of information linked to the financial statements and required by §§ 284 - 288 HGB. Appropriation of profits: Distribution of profits to reserves, dividends or profit/ loss carried forward to the next Accounting period. Balance sheet: Statement of financial position that discloses assets, equity, and liabilities. Bankruptcy: A situation that triggers legal procedures of liquidation due to over-indebtedness or insolvency. Business report: Disclosure of the company’s situation at the time of reporting. It also is termed management report. DATEV-4 chart of accounts: Standard list of accounts applicable for electronic transfer of financial statements and accounts. Distributable amount: The amount a company can pay as a dividend to its shareholders without dissolving reserves. It includes the profit carried forward and the annual surplus. In case the company carries forward a loss it must deduct it. Excluded from the distributable amount are contributions to legal reserves (§ 150 AktG) and preference dividends. Financial statements: In Germany, financial statements include: a balance sheet, an income statement and for limited companies an attachment. Limited companies also must prepare a business report. A set of financial statements can include a statement of cash flows, as well. Handelsgesetzbuch HGB: German law for retailers and limited companies about financial statements. Income statement: Statement of profit or loss. <?page no="43"?> Berkau: Financial Statements 9e 2-43 Limited company: A company with restricted responsibility linked to its equity. Non-covered loss on the asset side: A loss that exceeds the equity is required to be disclosed on the asset side of the German balance sheet. Provision: Uncertain liability, e.g., for income taxes or other expenses based on § 249 HGB. Value added tax: Tax levied in most countries on consumptions. 2.12 Question Bank (1) On 12.07.20X6, a German company buys a machine for a gross value of 15,000 EUR. For the machine installation and its transport, an expert charges together 1,200 EUR (net value). The company agreed to pay for the latter one in the next year. How much is depreciation in 20X6 if it follows straight line method over 5 years? 1. 1,370 EUR . 2. 1,500EUR . 3. 1,250 EUR . 4. 3,288 EUR . (2) A German company that earns a pre-tax profit of 80,000 EUR, carrying forward a loss of 20,000 EUR and adding half of the distributable amount to reserves (no other appropriation of profits) discloses as retained earnings: 1. 38,000 EUR . 2. 30,000 EUR . 3. 50,000 EUR . 4. 18,000 EUR . (3) A German company buys a machine and pays a partial amount of 100,000 EUR and adds 44,000 EUR to payables. How much is the cost of acquisition? You must consider VAT. 1. 144,000 EUR . 2. 120,000 EUR . 3. 100,000 EUR . 4. 44,000 EUR . (4) A German company buys a business car for 56,400 EUR gross purchase price. The car is paid half in the actual Accounting period and to the other half in the next one. How much is the input-VAT claim to the German revenue service? 1. 11,280 EUR. 2. 4,700 EUR . 3. 9,400 EUR . 4. 5,640 EUR . (5) A German company pays 360 EUR/ m rent per month. Rent is due 3 months in advance. The rent is the gross value. How much rent is disclosed under accruals (Aktivischer Rechnungsabgrenzungsposten)? 1. 0 EUR. 2. 1,080 EUR . 3. 900 EUR . 4. 360 EUR . 2.13 Solutions 1-1, 2-4, 3-2, 4-3, 5-3. <?page no="44"?> Berkau: Financial Statements 9e 3-44 3 Financial Statements based on IFRSs 3.1 What is in the Chapter? We discuss here a case study which is like KIELING TAXI GmbH in chapter (2). Now, we demonstrate the preparation of its financial statements in compliance with International Financial Reporting Standards IFRSs. The case study is about a company based in South Africa where IFRSs apply for single-entity-financial statements. Note, single-entity-financial statements are for one company only. In contrast, a group statement summarises single-entityfinancial statements for all group members. Group Accounting is discussed in chapter (8). The case study KENILWORTH METERED TAXI SERVICE Ltd. contains the establishment of the company, the acquisition of ten motor vehicles and their equipment with taxi appliances (roof light, radio etc.), depreciation on motor vehicles, labour recognition, payment for operations and revenue recognition. In contrast to chapter (2), all Bookkeeping entries are recorded based on journal entries and a full set of financial statements is prepared. The elements of a set of financial statements as ruled by IAS 1.10 are a statement of financial position (balance sheet), a statement of profit or loss and other comprehensive income (income statement), a statement of changes in equity, a statement of cash flows and the notes. Before the discussion of the case study KENILWORTH METERED TAXI 11 You find a more detailed introduction to IFRSs in our textbook Basics of Accounting, chapter (4). SERVICE Ltd., we introduce International Accounting Standards IFRSs to provide you with knowledge of how to find, understand and apply IFRS standards. 11 3.2 Learning Objectives After studying this chapter, you can record Bookkeeping entries following the international format, and you have seen the preparation of financial statements based on IFRSs. You can prepare simple financial statements for Accounting case studies in compliance with IFRSs. However, notes and ESG reporting are only covered in chapter (6). 3.3 IFRSs International Financial Reporting Standards IFRSs are “the law” for international Accounting. In Germany, international Accounting applies for group statements once one group member is participating in the capital market; all single-entity financial statements must be prepared following the German HGB. International Accounting applies in many parts of the world, including South Korea, the European Union, India, Hong Kong, Australia, Malaysia, Pakistan, GCC countries, Chile, Philippines, South Africa, Singapore and Turkey, but not in the United States. International Accounting standards IFRSs are issued by the International <?page no="45"?> Berkau: Financial Statements 9e 3-45 Accounting Standard Board IASB in London. Before starting the Accounting work, we demonstrate where to access the standards, after creating a student profile with the IFRS foundation. 3.4 How to Access IFRSs For academic purposes, the IFRS Foundation offers free of charge access to the standards that are one year and older. Follow the link below to learn how to gain access. As an alternative, download a video that demonstrates the registration procedure and a standard download accessible from the study material bank. Link 3.A: Download IFRSs for students 3.5 C/ S KENILWORTH MTS Ltd. - 20X1 We demonstrate the application of IFRSs for KENILWORTH METERED TAXI SERVICE Ltd. based in Cape Town. The reporting currency is South African Rand ZAR. Note, the exchange rate between EUR and South African Rand is 1 EUR : 20 ZAR. To calculate the Euro amount, divide the Rand value by 20. 12 Study our textbook Basics of Accounting, chapters (6) - (19), (31) and (33). In the case study, we discuss and show Bookkeeping entries for all business activities by journal entries. Later they become visible in the T-accounts in use for the preparation of the financial statements. You need basic knowledge of international Bookkeeping for this case study. 12 Note, in addition to Bookkeeping conventions all nominal accounts include the Accounting period as a suffix in this textbook, and all accounts come with a threeletter-code serving as reference for the adjustments. For KENILWORTH METERED TAXI SERVICE Ltd., we discuss the steps below for the Accounting periods 20X1 and 20X2: (1) Establishment. (2) Recording original business activities by journal entries and disclosure in T-accounts. (3) Recording adjustments including profit and income tax calculations. (4) Preparation of the income statement and deciding about the appropriation of profits. (5) Preparation of the balance sheet. (6) Preparation of statement of changes in equity. (7) Preparation of the statement of cash flows. Notes will be omitted for this case study. Data Sheet for KENILWORTH METERED TAXI SERVICE Ltd. <?page no="46"?> Berkau: Financial Statements 9e 3-46 Domicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Service provider. Establishment: before 1.01.20X1; share capital: 5,000,000 ZAR, nominal value per share: 10 ZAR/ share. The company commences operations on 1.01.20X1 Acquisition of 10 cars at 360,000 ZAR/ car gross amount, taxi equipment 24,000 ZAR/ car (net value). Depreciation: following straight-line method over a useful life of four years without residual value. Accounting periods: 20X1 / 20X2. Revenue: 12,500,000 ZAR / 13,200,000 ZAR. Labour for (all) drivers: 7,000,000 ZAR / 8,000,000 ZAR. Labour for dispatcher and manager together: 1,650,000 ZAR/ a / 1,650,000 ZAR/ a. Operational expenses (VATable): 2,000,000 ZAR / 2,000,000 ZAR. Rent (non-VATable): 12,000 ZAR/ m / 12,000 ZAR/ m, to be paid one month in advance, from 1.07.20X2 onwards: 13,800 ZAR/ m. Appropriation of profits: in 20X1 profit completely carried forward / 20X2: 30 % dividends to shareholders, 20 % reserves, 50 % profit carried forward. VAT rate: 20 %. KENILWORTH METERED TAXI SERVICE Ltd. is a taxi company that provides metered taxi services. The company is established in Cape Town by an issue of 500,000 ordinary shares at 10 ZAR/ share each. At the time of incorporation, before 1.01.20X1, the company’s share capital is: 10 × 500,000 = 5,000,000 ZAR. KENILWORTH METERED TAXI SERVICE Ltd. commences operations on 1.01.20X1. Note, in this textbook we discuss different scenarios for the establishment of companies. The establishment is either before or within the first Accounting period. In case it is before, the opening balance sheet shows the issued capital, and the receipt thereof does not count as cash flow for the period. If the establishment occurs during the Accounting period, no opening balance sheet is discussed, and the receipt of issued capital becomes cash flow relevant. KENILWORTH METERED TAXI Service Ltd. applies international Accounting standards IFRSs for its financial statements as it is domiciled in South Africa. The owners pay together 5,000,000 ZAR into KENILWORTH METERED TAXI Service Ltd.’s bank account at FNB Bank 13 . The company is registered with the South African Revenue Service SARS and for VAT reduction by default. A VAT rate of 20 % applies. Note, the VAT rate in South Africa is 15 %. The name of the company is KENILWORTH METERED TAXI SERVICE Ltd. which is abbreviated as KMTS Ltd. in the text. The opening statement of financial position (balance sheet) is prepared following IAS 1.54. It is shown below in Figure 3.1. As the establishment and the contribution of the owners took place before 1.01.20X1, the share capital as well as the balancing figure of cash/ bank show as opening values in the accounts. 13 FNB = First National Bank of South Africa. <?page no="47"?> Berkau: Financial Statements 9e 3-47 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E Share capital 5,000,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities (liab.) Inventory Long-term liab. Acc. receivables A/ R Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 5,000,000 Income tax liab. Total assets 5,000,000 Total equity and liab. 5,000,000 Kenilworth Metered Taxi Service Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X1 Figure 3.1: KMTS Ltd.’s opening balance sheet At first, we discuss investments in noncurrent assets, which are motor vehicles only. On 2.01.20X1, KENILWORTH METERED TAXI SERVICE Ltd. buys ten Toyotas at a purchase price (gross value) of 360,000 ZAR/ car and pays them per bank transfer. We record Bookkeeping entry (1). We do not distinguish between cash and bank. In a genuine business the Bookkeeper must separate these accounts. 14 Note, for the sake of simplification, we do not distinguish cash and bank nor accounts with different banks. In the first place, the preparation of the balance sheet matters, which discloses one item only. For the content of case studies discussed in this textbook, the differentiation in cash and bank is not relevant. For the case study, we allocate the cars to the Property, Plant and Equipment account. Alternatively, KENILWORTH METERED TAXI SERVICE Ltd. could apply a Motor Vehicle account as a subordinated account to its P, P, E account. 14 Study our textbook Basics of Accounting, chapter (37). We do not follow a specific format for the balance sheet structure. IAS 1.57 states explicitly that the standard (IAS 1) does not prescribe the order or format of presentation. Note, in this textbook and for all study materials, we always use the same template. The MS-Excel file with the templates is available for download through the online material bank. The disclosure of Bookkeeping entries in the text comes in the international journal entry format. The reporting currency is the national currency ZAR by default (not shown). The first line shows the date of recording and in most cases the Bookkeeping entry ident number corresponding to the entry made in the T-accounts for reference. Account names without indention and with the amounts in the first column are debit entries. Indented account names with amounts to the right are credit entries. The last line is the narrative in brackets. <?page no="48"?> Berkau: Financial Statements 9e 3-48 @ 2.01.20X1 (1) Property, Plant, Equipment PPE 3,000,000 Value Added Tax VAT 600,000 Cash/ Bank C/ B 3,600,000 (acquisition of ten motor vehicles) After the initial motor vehicle recognition, we continue with their equipment on 9.01.20X1. We postpone the discussion about depreciation to the yearend as it is considered an adjustment. Note, in terms of Bookkeeping, we distinguish original entries which are linked to business activities from adjustments. Adjustments are recorded at the end of the Accounting period dated on 31.12.20XX. To distinguish adjustments and original Bookkeeping entries, the latter ones are numbered with different indices for multiple-period cases, e.g., numbers in the first year and capital letters for the second one. For adjustments, the three-letter-code of the contra account serves as reference in the accounts. In this case study, we make a difference between original Bookkeeping entries and adjustments. In an Accounting exam, all business activities are given and can be worked on in the sequence of their appearance in the text. This way, you ensure to not forget Bookkeeping entries. Like in the previous case study, the cars are configured as metered taxi cars by a taxi manufacturer. The motor vehicle modification costs 24,000 ZAR/ car. The value is net of VAT. Hence, KENILWORTH METERED TAXI SERVICE Ltd. pays: 120% × 24,000 × 10 = 2 288,000 ZAR. It is recorded as Bookkeeping entry (2). The first debit entry is recorded in the P, P, E-Account as equipment of non-current assets belongs to the cost of acquisition based on IAS 16.16. @ 9.01.20X1 (2) Property, Plant, Equipment PPE 240,000 Value Added Tax VAT 48,000 Cash/ Bank C/ B 288,000 (alteration of ten motor vehicles by the taxi manufacturer) During the Accounting period 20X1, KENILWORTH METERED TAXI SERVICE Ltd. earns a revenue of 12,500,000 ZAR. Due to its registration as VAT vendor, the passengers must pay the gross amount including output-VAT. This results in total proceeds of: 120% × 12,500,000 = 1 15,000,000 ZAR. The revenue recognition is recorded as Bookkeeping entry (3) below. Note, we pretend the Bookkeeping entry is recorded in the middle of the year for all proceeds together. This also applies for expenses. All expenses are recorded on 30.06. and all revenues and other income on 1.07. of the Accounting period. <?page no="49"?> Berkau: Financial Statements 9e 3-49 @ 1.07.20X1 (3) Cash/ Bank C/ B 15,000,000 Value Added Tax VAT 2,500,000 Revenue-20X1 REV 12,500,000 (revenue recognition from taxi rides) The taxi drivers at KENILWORTH METERED TAXI SERVICE Ltd. each earn 500,000 ZAR/ (a × driver). The company employs 14 drivers. Labour for all taxi drivers together is: 14 × 500,000 = 7,000,000 ZAR/ a. Accounting for labour results in Bookkeeping entry (4) which is recorded on 30.06.20X1. 15 Note, Accounting for labour is simplified in this textbook. There is no consideration for labour tax nor for other indirect labour cost (social security contributions and pension fund payments). This way, we pretend that labour is paid to freelancers. A complete Accounting for labour discussion can be found in chapter (19) of the Basics of Accounting as this is more subjected to Bookkeeping than to financial statement preparation. @ 30.06.20X1 (4) Labour-20X1 LAB 7,000,000 Cash/ Bank C/ B 7,000,000 (recording for labour taxi drivers) The dispatcher at KENILWORTH METERED TAXI SERVICE Ltd. earns 650,000 ZAR/ a. He works in the headquarters on the radio and answers the phone to take orders from the customers. He assigns the orders to the taxi drivers per radio call. The manager at KENILWORTH METERED TAXI SERVICE Ltd. earns 1,000,000 ZAR/ a. On 30.06.20X1, labour for the dispatcher and manager is recorded as Bookkeeping entry (5) together due to simplifications. It is: 650,000 + 1,000,000 = 1,650,000 ZAR/ a. @ 30.06.20X1 (5) Labour-20X1 LAB 1,650,000 Cash/ Bank C/ B 1,650,000 (recording for labour dispatcher, manager) Annual operational expenses for the taxis, e.g., petrol, maintenance, spare parts, repairs, car wash etc., are 2,000,000 ZAR/ a. The amount is paid to 3 rd party companies and, therefore, is subjected to VAT. Hence, the paid price 15 Study Accounting for labour in our textbook Basics of Accounting, chapter (19). is: 120% × 2,000,000 = 2 2,400,000 ZAR/ a. It is recorded as Bookkeeping entry (6) below on 30.06.20X1. Remember, the international chart of accounts only considers one VAT-account for inputand <?page no="50"?> Berkau: Financial Statements 9e 3-50 output-VAT together. Make debit entries for input-VAT and credit the account for output-VAT. Note, all payments to other companies include a VAT portion by default. IAS 2.11 and IAS 16.16 state that the cost of purchase/ acquisition for companies, which are registered for VAT reduction, are always net values after a further deduction of discounts and rebates. @ 30.06.20X1 (6) Operational Expenses-20X1 OEX 2,000,000 Value Added Tax VAT 400,000 Cash/ Bank C/ B 2,400,000 (costs for operations recognition) For the office building and garage rent, KENILWORTH METERED TAXI SERVICE Ltd. pays 12,000 ZAR/ m. No input-VAT is included in the payments for rent. KENILWORTH METERED TAXI SERVICE Ltd. rents from a private owner, who is not registered for VAT reduction and is not supposed to disclose the VAT portion on the rental contract. Hence, KENILWORTH METERED TAXI SERVICE Ltd. cannot claim input-VAT on rent from South African Revenue Service SARS. Rent is due one month in advance. However, rent for January 20X1 is paid on 2.01.20X1, because the company did not exist before. Therefore, KENILWORTH METERED TAXI SERVICE Ltd. makes 13 monthly payments for rent in 20X1, the last one is for January/ 20X2. (All) rent payments together are amounting to: 13 × 12,000 = 1156,000 ZAR. As an expedient, we make one Bookkeeping entry (7) on 30.06.20X1: @ 30.06.20X1 (7) Rent-20X1 RNT 156,000 Cash/ Bank C/ B 156,000 (recording 13 monthly payments for rent) Study KENILWORTH METERED TAXI SERVICE Ltd.’s Bookkeeping records in Figure 3.2! The accounts are not yet balanced-off because no adjustments have been recorded at this stage. D C D C OV 5,000,000 (1) 3,600,000 OV 5,000,000 (3) 15,000,000 (2) 288,000 (4) 7,000,000 (5) 1,650,000 (6) 2,400,000 (7) 156,000 Cash/ Bank C/ B Issued capital ISS Figure 3.2: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts <?page no="51"?> Berkau: Financial Statements 9e 3-51 D C D C (1) 3,000,000 (1) 600,000 (3) 2,500,000 (2) 240,000 (2) 48,000 (6) 400,000 Property, Plant, Equipment PPE Value addedd tax VAT [20%] D C D C (3) 12,500,000 (4) 7,000,000 (5) 1,650,000 Revenue-20X1 REV Labour-20X1 LAB D C D C (6) 2,000,000 (7) 156,000 Operational expenses-20X1 OEX Rent-20X1 RNT Figure 3.2: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts continued KENILWORTH METERED TAXI SERVICE Ltd. records the adjustments at the yearend. Adjustments are Bookkeeping entries made in preparation of the financial statements. The 1 st adjustment Bookkeeping entry is for depreciation. In this case study, depreciation only applies for taxis. It is based on a straight-line method under consideration of a useful life of four years. No residual value applies. Note, under straight-line method the annual depreciation is calculated by dividing the depreciable amount by the useful life. For the sake of simplification, we consider depreciation accurate to the month; every monthly depreciation is (1/ 12) of the annual depreciation. As an alternative, the diminishing balance depreciation method can be applied. Under the declining method, the opening value for the period is reduced based on a given percentage p. If the percentage is given as a monthly rate, the carrying value after twelve months is calculated based on the opening value OV as: OV × (1 - p) 12 . Another method, the units of production method, is discussed in the Basics of Accounting, chapter (17). Annual depreciation is based on the cost of acquisition for the cars as well as on their alteration: (3,000,000 + 240,000) / 4 = 8810,000 ZAR/ a. The calculation follows IAS 16.16. On 31.12.20X1, we recognise depreciation. In contrast to chapter (2), the credit entry is now made in the Accumulated Depreciation account. This is the default contra account for international Accounting. @ 31.12.20X1 Depreciation-20X1 DPR 810,000 Accumulated Depreciation ACC 810,000 (recognition of depreciation) <?page no="52"?> Berkau: Financial Statements 9e 3-52 Another adjustment is recorded for accruals in the Prepaid expense account. 16 To accrue expenditures means that we allocate them as next year's costs to prepaid expenses. They do not count for the actual Accounting period. The company pays in December 20X1 rent for January/ 20X2. All rental payments have been debited to the Rent-20X1 account so far. To assign the thirteenth payment to the business activities in the next year, we must transfer one monthly rent of 12,000 ZAR to the Prepaid Expenses account (DR Prepaid Expense account - CR Rent-20X1). At the beginning of the next Accounting period, KENILWORTH METERED TAXI SERVICE Ltd. accrues then the prepaid expenses to the Rent- 20X2 account (DR Rent-20X2 - CR Prepaid Expense account). Note, if rent were VATable, no adjustments for input-VAT would be recorded with the accrual. @ 31.12.20X1 Prepaid Expenses PRE 12,000 Rent-20X1 RNT 12,000 (allocating rent for 20X2 to prepaid expenses) After completion of initial Bookkeeping entries and recording the adjustments, we balance-off all accounts. Observe the accounts at KENILWORTH METERED TAXI SERVICES Ltd. in Figure 3.3 below. D C D C OV 5,000,000 (1) 3,600,000 c/ d 5,000,000 OV 5,000,000 (3) 15,000,000 (2) 288,000 b/ d 5,000,000 (4) 7,000,000 (5) 1,650,000 (6) 2,400,000 (7) 156,000 c/ d 4,906,000 20,000,000 20,000,000 b/ d 4,906,000 Cash/ Bank C/ B Issued capital ISS Figure 3.3: KMTS Ltd.’s accounts after adjustments (20X1) 16 Study our textbook Basics of Accounting, chapter (13) and (18). <?page no="53"?> Berkau: Financial Statements 9e 3-53 D C D C (1) 3,000,000 (1) 600,000 (3) 2,500,000 (2) 240,000 c/ d 3,240,000 (2) 48,000 3,240,000 3,240,000 (6) 400,000 b/ d 3,240,000 c/ d 1,452,000 2,500,000 2,500,000 b/ d 1,452,000 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C c/ d 12,500,000 (3) 12,500,000 (4) 7,000,000 b/ d 12,500,000 (5) 1,650,000 c/ d 8,650,000 8,650,000 8,650,000 b/ d 8,650,000 Revenue-20X1 REV Labour-20X1 LAB D C D C (6) 2,000,000 c/ d 2,000,000 (7) 156,000 PRE 12,000 b/ d 2,000,000 c/ d 144,000 156,000 156,000 b/ d 144,000 Operational expenses-20X1 OEX Rent-20X1 RNT D C D C ACC 810,000 c/ d 810,000 c/ d 810,000 DPR 810,000 b/ d 810,000 b/ d 810,000 Depreciation-20X1 DPR Acc depr ACC D C RNT 12,000 c/ d 12,000 b/ d 12,000 Prepaid expenses PRE Figure 3.3: KMTS Ltd.’s accounts after adjustments (20X1) continued The next step is the profit calculation. We close-off all nominal accounts to the Profit and Loss account. Nominal accounts are: - Rent-20X1. - Labour-20X1. - Operational expenses-20X1. - Depreciation-20X1. - Revenue-20X1. To read the Profit and Loss account easily, we use the three-letter-codes as references. See the Profit and Loss account in Figure 3.4. We recognise the source of expense easily by the three-letter-code when we prepare the income statement. The pre-tax profit of KENILWORTH METERED TAXI SERVICE Ltd. is: 12,500,000 - 2,000,000 - 144,000 - 810,000 - 8,650,000 = 8896,000 ZAR. The <?page no="54"?> Berkau: Financial Statements 9e 3-54 pre-tax profit is referred to as the earnings before taxation EBT. The amounts for the profit calculation are: - Revenue: 12,500,000 ZAR. - Operational expenses: 2,000,000 ZAR. - Rent: 144,000 ZAR. - Depreciation: 810,000 ZAR. - Labour: 8,650,000 ZAR. Based on our income tax model, 30 % multiplied by earnings before taxes give the total of income tax expenses. The earnings after taxes EAT (annual surplus A/ S) are: 896,000 × (1 - 30%) = 6 627,200 ZAR. Check the accounts in Figure 3.4 after the completion of adjustments including the calculations of profit and income taxes. D C D C (1) 3,000,000 (1) 600,000 (3) 2,500,000 (2) 240,000 c/ d 3,240,000 (2) 48,000 3,240,000 3,240,000 (6) 400,000 b/ d 3,240,000 c/ d 1,452,000 2,500,000 2,500,000 b/ d 1,452,000 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C OV 5,000,000 (1) 3,600,000 c/ d 5,000,000 OV 5,000,000 (3) 15,000,000 (2) 288,000 b/ d 5,000,000 (4) 7,000,000 (5) 1,650,000 (6) 2,400,000 (7) 156,000 c/ d 4,906,000 20,000,000 20,000,000 b/ d 4,906,000 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 12,500,000 (3) 12,500,000 (4) 7,000,000 P&L 12,500,000 b/ d 12,500,000 (5) 1,650,000 c/ d 8,650,000 8,650,000 8,650,000 b/ d 8,650,000 P&L 8,650,000 Revenue-20X1 REV Labour-20X1 LAB Figure 3.4: KMTS Ltd.’s accounts after profit calculation (20X1) <?page no="55"?> Berkau: Financial Statements 9e 3-55 D C D C (6) 2,000,000 c/ d 2,000,000 (7) 156,000 PRE 12,000 b/ d 2,000,000 P&L 2,000,000 c/ d 144,000 156,000 156,000 b/ d 144,000 P&L 144,000 D C D C ACC 810,000 c/ d 810,000 c/ d 810,000 DPR 810,000 b/ d 810,000 P&L 810,000 b/ d 810,000 Operational expenses-20X1 OEX Rent-20X1 RNT Depreciation-20X1 DPR Acc depr ACC D C D C RNT 12,000 c/ d 12,000 OEX 2,000,000 REV 12,500,000 b/ d 12,000 RNT 144,000 DPR 810,000 LAB 8,650,000 EBT 896,000 12,500,000 12,500,000 ITE 268,800 b/ d 896,000 R/ E 627,200 896,000 896,000 Prepaid expenses PRE Profit and Loss-20X1 P&L D C D C ITL 268,800 c/ d 268,800 c/ d 268,800 ITE 268,800 b/ d 268,800 P&L 268,800 b/ d 268,800 D C c/ d 627,200 P&L 627,200 b/ d 627,200 Retained earnings R/ E Income tax expenses ITE Income tax liabilities ITL Figure 3.4: KMTS Ltd.’s accounts after profit calculation (20X1) - continued The Profit and Loss account shows the difference between revenue and expenses. We also see how much is profit after taxation already. The Three-Letter- Code R/ E indicates that the Annual surplus gets allocated to equity. In contrast to the Profit and Loss account, IAS 1.81A - 1.82B do not force the reporting company to disclose all single expenses on their income statement. For instance, KENILWORTH METERED TAXI SERVICE Ltd. can combine operational expenses and rent to a single item "other expenses" on its statement of profit or loss and other comprehensive income. Its value is: 2,000,000 + 144,000 = 2,144,000 ZAR. Find below the income statement for KENILWORTH METERED TAXI SERVICE Ltd. in Figure 3.5. Note, <?page no="56"?> Berkau: Financial Statements 9e 3-56 this case study does not cover other income. This will be discussed in the chapters (6), (8) and (9). [ZAR] Revenue 12,500,000 Other income 0 12,500,000 Materials 0 Labour (8,650,000) Depreciation (810,000) Other expenses (2,144,000) Earnings before int. & taxes (EBIT) 896,000 Interest 0 Earnings before taxes (EBT) 896,000 Income tax expenses (268,800) Deferred taxes 0 Earnings after taxes (EAT) 627,200 Kenilworth Metered Taxi Service Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X1 Figure 3.5: KMTS Ltd.’s income statement (20X1) The next statement to prepare is the balance sheet. Its technical term is statement of financial position. For KENILWORTH METERED TAXI SERVICE Ltd., only few items need calculations for their disclosure; most values can be copied from the real accounts. The value for the item property, plant and equipment is derived from the Property, Plant and Equipment account and the Accumulated Depreciation account: 3,240,000 - 810,000 = 2 2,430,000 ZAR. The value for accounts payables includes the difference between output-VAT and input-VAT which is the balancing figure of the Value Added Tax account: 1,452,000 ZAR. Note, under an international Bookkeeping system, we only apply one VAT account for the recording of input-VAT (debit side) and output-VAT (credit side). VAT liabilities are disclosed as short-term liabilities on the balance sheet. A disclosure under income taxes would be a formal mistake. Observe the balance sheet in Figure 3.6. <?page no="57"?> Berkau: Financial Statements 9e 3-57 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 2,430,000 Share capital 5,000,000 Intangibles Reserves Financial assets Retained earnings 627,200 Current assets Liabilities (liab.) Inventory Long-term liab. Acc. receivables A/ R Short-term liab. A/ P 1,452,000 Prepaid expenses 12,000 Provisions Cash/ Bank 4,906,000 Income tax liab. 268,800 Total assets 7,348,000 Total equity and liab. 7,348,000 Kenilworth Metered Taxi Service Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 3.6: KMTS Ltd.’s balance sheet (20X1) You find the remaining statements for a full set of financial statements below in Figure 3.7 and Figure 3.15 at the chapter’s end. An example for notes can be found in chapter (6). A cash flow is the difference between the opening value and the closing balance of the Cash/ Bank account. KENILWORTH METERED TAXI SERVICE Ltd.’s cash flow in 20X1 is negative as the closing balance of the cash/ bank item is below its opening value. The cash flow is: 4,906,000 - 5,000,000 = -994,000 ZAR. So far, KENILWORTH METERED TAXI SERVICE Ltd.’s business activities burned cash, but the negative cash flow mostly results from investment activities. It is not seldom for companies to disclose negative total cash flows for their first year of operation due to investments. Note, the value for cash flows depends on the industry a company is in and its type of Financing. Industries with high capital demand for machinery, such as 17 Study our textbook Basics of Accounting, chapter (30) or in this textbook chapter (13). production firms, and with asset financed by loans will disclose higher negative cash flows in comparison to a service provider who leases its non-current assets. To analyse the details of cash flows, a cash flow statement is prepared. This statement segregates cash flows in payments/ receipts for operations, for investments and for financing activities. We do not discuss cash flow statements in detail here, but you find the company’s statement of cash flows in Figure 3.7. Cash flow statements are discussed in detail in chapter (10). To understand if and why the book value of the company changes, we disclose the company’s equity development on its statement of changes in equity 17 . The book value equals the equity as disclosed on the balance sheet therefore, it is derived from the Bookkeeping records. At KENILWORTH METERED TAXI SERVICE Ltd., equity increased by: 5,627,200 - 5,000,000 = 6 627,200 ZAR during the Accounting period 20X1. <?page no="58"?> Berkau: Financial Statements 9e 3-58 Check the statement of changes in equity in Figure 3.15. Further explanation about the statement of changes in equity can be found in chapter (13). Cash flow from operating acitivities [ZAR] [ZAR] Proceeds 15,000,000 Payment for operating expenses (2,400,000) Payment for labour (8,650,000) Payment for rent (156,000) 3,794,000 Cash flow from investing activities Investments (3,888,000) (3,888,000) Cash flow from financing activities 0 Total cash flow (94,000) Kenilworth Metered Taxi Service Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X1 Figure 3.7: KMTS Ltd.’s cash flow statement (20X1) Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X1 5,000,000 5,000,000 Profit 20X1 627,200 627,200 as at 31.12.20X1 5,000,000 0 627,200 5,627,200 Kenilworth Metered Taxi Service Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X1 Figure 3.8: KMTS Ltd.’s statement of changes in equity (20X1) After we prepared financial statements for the first Accounting period, we continue with 20X2. Under an international Bookkeeping system, all real accounts are continued. In contrast, all nominal accounts must be defined again because the previous ones have been closed-off to the Profit 18 Study our textbook Basics of Accounting, chapter (31). and Loss account when recording adjustments. 18 3.6 C/ S KENILWORTH MTS Ltd. - 20X2 KENILWORTH METERED TAXI SERVICE Ltd. continues its operations and Accounting work: In contrast to 20X1, KENILWORTH METERED TAXI SERVICE <?page no="59"?> Berkau: Financial Statements 9e 3-59 Ltd. earns in the Accounting period 20X2 higher revenues of 13,200,000 ZAR and employs two more taxi drivers. The landlord increases rent from 1.07.20X2 onwards (once-off) by 15 %. The new monthly rent is: (1 + 15%) × 12,000 = 1 13,800 ZAR/ m. No other changes occur. In 20X2 no investments take place. For a new Accounting period, we must carry out preparatory Bookkeeping entries. Usually, these initial Bookkeeping entries relate to the below-listed activities: - Accrual of prepaid expenses. - Payments for income tax liabilities. - Settlement of VAT payables. - Payments of other short-term liabilities, e.g., resulting from supplies, as scheduled. - Debt collection as scheduled. - Dividend payments as scheduled. etc. KENILWORTH METERED TAXI SERVICE Ltd. transfers 12,000 ZAR prepaid rent from the Prepaid Expenses account to the Rent-20X2 account. The Bookkeeping entry for this transfer is marked (A). For the Accounting period 20X2, we indicate Bookkeeping entries by capital letters. @ 1.01.20X2 (A) Rent-20X2 RNT 12,000 Prepaid Expenses PRE 12,000 (rent accural from prepaid expenses) KENILWORTH METERED TAXI SERVICE Ltd. pays 20X1’s income taxes liabilities in 20X2. Another tax payment is for the excess of output-VAT over input-VAT which results in a payment of 1,452,000 ZAR to SARS. Observe Bookkeeping entries (B) and (C); both are recorded on 1.01.20X2. @ 1.01.20X2 (B) Income Tax Liabilities ITL 268,800 Cash/ Bank C/ B 268,800 (payment of income tax liabilities for 20X1 to SARS) @ 1.01.20X2 (C) Value Added Tax VAT 1,452,000 Cash/ Bank C/ B 1,452,000 (payment of VAT liabilities for 20X1 to SARS) Check the accounts after completion of the preparatory Bookkeeping entries in Figure 3.9. As last year’s entries do not matter anymore, we grey them out. <?page no="60"?> Berkau: Financial Statements 9e 3-60 D C D C OV 5,000,000 (1) 3,600,000 c/ d 5,000,000 OV 5,000,000 (3) 15,000,000 (2) 288,000 b/ d 5,000,000 (4) 7,000,000 (5) 1,650,000 (6) 2,400,000 (7) 156,000 c/ d 4,906,000 20,000,000 20,000,000 b/ d 4,906,000 (B) 268,800 (C) 1,452,000 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000 (1) 600,000 (3) 2,500,000 (2) 240,000 c/ d 3,240,000 (2) 48,000 3,240,000 3,240,000 (6) 400,000 b/ d 3,240,000 c/ d 1,452,000 2,500,000 2,500,000 (C) 1,452,000 b/ d 1,452,000 Property, Plant, Equipment PPE Value added tax VAT D C D C RNT 12,000 c/ d 12,000 c/ d 810,000 DPR 810,000 b/ d 12,000 (A) 12,000 b/ d 810,000 Prepaid expenses PRE Acc depr ACC D C D C c/ d 627,200 P&L 627,200 c/ d 268,800 ITE 268,800 b/ d 627,200 (B) 268,800 b/ d 268,800 D C (A) 12,000 Rent-20X2 RNT Retained earnings R/ E Income tax liabilities ITL Figure 3.9: KMTS Ltd.’s accounts (20X2) In 20X2, KENILWORTH METERED TAXI SERVICE Ltd. records the business activities below: (D) Revenue recognition. (E) Labour recognition. (F) Rent recognition. (G) Recognition of operational expenses. (D) KENILWORTH METERED TAXI SERVICE Ltd. earns a revenue of: 13,200,000 ZAR. The proceeds are: 120% × 13,200,000 = 1 15,840,000 ZAR. <?page no="61"?> Berkau: Financial Statements 9e 3-61 All passengers pay on cash. The Bookkeeping entry (D) is recorded on 1.07.20X2. @ 1.07.20X2 (D) Cash/ Bank C/ B 15,840,000 Value Added Tax VAT 2,640,000 Revenue-20X2 REV 13,200,000 (revenue recognition) (E) Labour now is for 16 taxi drivers employed. We consider labour for the dispatcher as well as for the manager and record labour of: 16 × 500,000 + 650,000 + 1,000,000 = 9 9,650,000 ZAR. Bookkeeping entry (E) for all labour is made on 30.06.20X2. @ 30.06.20X2 (E) Labour-20X2 LAB 9,650,000 Cash/ Bank C/ B 9,650,000 (labour recognition) (F) Rent increases in the middle of the Accounting period 20X2 by 15 %. As there was a prepayment, the Bookkeeping entry for rental payments in total is: 5 × 12,000 + 7 × 13,800 = 1 156,600 ZAR. As the rent for January/ 20X2 was paid in December 20X1, only five rental payments to the extent of 12,000 ZAR/ m are made. The following seven payments are for the time span from July/ 20X2 to January/ 20X3 and amount to 13,800 ZAR/ m each. At the end of the year, the rent for January/ 20X3 will be accrued to the Prepaid Expenses account. Below, you see the rent Bookkeeping entry (F) for twelve single payments together and dated on 30.06.20X2. @ 30.06.20X2 (F) Rent-20X2 RNT 156,600 Cash/ Bank C/ B 156,600 (recording rental payments) (G) Operational expenses are again 2,000,000 ZAR/ a. They are VATable and get recorded on 30.06.20X2. @ 30.06.20X2 (G) Operational Expenses-20X2 OEX 2,000,000 Value Added Tax VAT 400,000 Cash/ Bank C/ B 2,400,000 (operational expense recognition) <?page no="62"?> Berkau: Financial Statements 9e 3-62 We next record adjustments; they include depreciation and the rent-20X3 accrual. They both are recorded on 31.12.20X2. @ 31.12.20X2 Depreciation-20X2 DPR 810,000 Accumulated Depreciation ACC 810,000 (depreciation recognition) @ 31.12.20X2 Prepaid Expenses PRE 13,800 Rent-20X2 RNT 13,800 (rent Jan/ 20X3 allocation to prepaid expenses) As in the previous Accounting period, we balance-off all accounts and close-off the nominal accounts to the Profit and Loss-20X2 (P2L) account. Based on our Bookkeeping entries, we calculate the profit for 20X2. Observe the accounts for 20X2 in Figure 3.10. D C D C OV 5,000,000 (1) 3,600,000 c/ d 5,000,000 OV 5,000,000 (3) 15,000,000 (2) 288,000 b/ d 5,000,000 (4) 7,000,000 (5) 1,650,000 (6) 2,400,000 (7) 156,000 c/ d 4,906,000 20,000,000 20,000,000 b/ d 4,906,000 (B) 268,800 (D) 15,840,000 (C) 1,452,000 (E) 9,650,000 (F) 156,600 (G) 2,400,000 c/ d 6,818,600 20,746,000 20,746,000 b/ d 6,818,600 Cash/ Bank C/ B Issued capital ISS Figure 3.10: KMTS Ltd.’s accounts after profit calculation (20X2) <?page no="63"?> Berkau: Financial Statements 9e 3-63 D C D C (1) 3,000,000 (1) 600,000 (3) 2,500,000 (2) 240,000 c/ d 3,240,000 (2) 48,000 3,240,000 3,240,000 (6) 400,000 b/ d 3,240,000 c/ d 1,452,000 2,500,000 2,500,000 (C) 1,452,000 b/ d 1,452,000 (G) 400,000 (D) 2,640,000 c/ d 2,240,000 4,092,000 4,092,000 b/ d 2,240,000 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C RNT 12,000 c/ d 12,000 c/ d 810,000 DPR 810,000 b/ d 12,000 (A) 12,000 b/ d 810,000 RNT 13,800 c/ d 13,800 c/ d 1,620,000 DPR 810,000 25,800 25,800 1,620,000 1,620,000 b/ d 13,800 b/ d 1,620,000 Prepaid expenses PRE Acc depr ACC D C D C c/ d 627,200 P&L 627,200 c/ d 268,800 ITE 268,800 b/ d 627,200 (B) 268,800 b/ d 268,800 c/ d 1,036,840 P2L 409,640 c/ d 175,560 ITE 175,560 1,036,840 1,036,840 444,360 444,360 b/ d 1,036,840 b/ d 175,560 Retained earnings R/ E Income tax liabilities ITL D C D C (A) 12,000 PRE 13,800 c/ d 13,200,000 (D) 13,200,000 (F) 156,600 c/ d 154,800 P2L 13,200,000 b/ d 13,200,000 168,600 168,600 b/ d 154,800 P2L 154,800 D C D C (E) 9,650,000 c/ d 9,650,000 (G) 2,000,000 c/ d 2,000,000 b/ d 9,650,000 P2L 9,650,000 b/ d 2,000,000 P2L 2,000,000 Labour-20X2 LAB Operational expenses-20X2 OEX Rent-20X2 RNT Revenue-20X2 REV Figure 3.10: KMTS Ltd.’s accounts after profit calculation (20X2) continued <?page no="64"?> Berkau: Financial Statements 9e 3-64 D C D C ACC 810,000 c/ d 810,000 RNT 154,800 REV 13,200,000 b/ d 810,000 P2L 810,000 LAB 9,650,000 OEX 2,000,000 DPR 810,000 EBT 585,200 13,200,000 13,200,000 ITE 175,560 b/ d 585,200 R/ E 409,640 585,200 585,200 D C ITL 175,560 c/ d 175,560 b/ d 175,560 P2L 175,560 Depreciation-20X2 DPR Profit and Loss-20X2 P2L Income tax expensess-20X2 ITE Figure 3.10: KMTS Ltd.’s accounts after profit calculation (20X2) continued Owners of limited companies are keen to earn a return on the funds they invested in their business. For a company based on shares, the payments to the owners for profit share are called a dividend. Note, the owners of a limited company decide on their annual general meeting about the appropriation of profits. The decision can be anticipated when preparing financial statements. The precondition for the final decision about the appropriation of profits is that financial statements have been audited and approved. For the auditing procedures, a company appoints an auditor who checks the correctness of the financial statements. KENILWORTH METERED TAXI SERVICE Ltd. did not declare a dividend for 20X1. Hence, its shareholders did not yet receive a return. Therefore, earnings from the previous Accounting period now are distributable to owners, too. At the annual general meeting held at the beginning of 20X3, the shareholders of KENILWORTH METERED TAXI SERVICE Ltd. declare a dividend of 30 % of the distributable amount. The distributable amount includes the profit carried forward as well as the annual surplus from 20X2. The distributable amount is the balancing figure of the Retained Earnings account, observe Figure 3.11. It is: 627,200 + 409,640 = 1 1,036,840 ZAR. Under an international Bookkeeping system, the profit carried forward remains in the Retained Earnings account. There is no extra account for profits/ losses carried forward. Note, the German translation Bilanzgewinn for Retained Earnings account is not accurate. Based on the decision made by the shareholders, 30 % of the distributable amount will be paid out as dividends, which is: 30% × 1,036,840 = 3 311,052 ZAR. 20 % is accumulated to earnings reserves: 20% × 1,036,840 = 2207,368 ZAR. The remainder is carried forward to the <?page no="65"?> Berkau: Financial Statements 9e 3-65 next Accounting period; the annual general meeting will decide in 20X4 about its appropriation. An investor holding 10,000 ordinary shares of KENILWORTH METERED TAXI SERVICE Ltd. receives a dividend of: (10,000/ 500,000) × 311,052 = 66,221.04 ZAR. Her/ his return on investment is: 6,221.04 / 100,000 = 6 6.22%. The investor further benefits from the increase in equity to the extent of: (1,036,840 - 311,052) / 5,000,000 = 14.52%. Note, in general, international limited companies prepare financial statements under the consideration of profit appropriation. KENILWORTH METERED TAXI SERVICE Ltd. records the dividends as payables to its owners on their balance sheet. It anticipates the owners’ decision. Dividends will be paid in 20X3. The account for dividends is the Shareholders for Dividend account. It falls under payables (A/ P account). The additions to earnings reserves do not change the total of equity because they result in an equity swop, and remain in the business e.g., for reinvestments. The non-appropriated earnings according to the shareholders’ decision are carried forward to the next Accounting period. No Bookkeeping entry is required for carrying forward profit or loss as the amount is kept in the Retained Earnings account. @ 31.12.20X2 Retained Earnings R/ E 311,052 Shareholders for Dividends A/ P 311,052 (recording devidends as payables) @ 31.12.20X2 Retained Earnings R/ E 207,368 Earnings Reserves E-R 207,368 (addition to earnings reserves) Below, we disclose only accounts relevant for the appropriation of profits. Study Figure 3.11. <?page no="66"?> Berkau: Financial Statements 9e 3-66 D C D C c/ d 627,200 P&L 627,200 c/ d 207,368 R/ E 207,368 b/ d 627,200 b/ d 207,368 c/ d 1,036,840 P2L 409,640 1,036,840 1,036,840 S4D 311,052 b/ d 1,036,840 E-R 207,368 c/ d 518,420 1,036,840 1,036,840 b/ d 518,420 Retained earnings R/ E Earnings reserves E-R D C c/ d 311,052 R/ E 311,052 b/ d 311,052 Shareholder for dividend A/ P Figure 3.11: KMTS Ltd.’s accounts for profit appropriation (20X2) See below the set of financial statements, with the notes excluded. Observe Figure 3.12, Figure 3.13, Figure 3.14 and Figure 3.15. The cash flow statement and the statement of changes in equity are disclosed as part of a full set of financial statements. They are subjected to explanations in chapters (10) and (13). We recommend returning to the case study KENILWORTH METERED TAXI SERVICE Ltd. after studying the details in those chapters to check the statements again. [ZAR] Revenue 13,200,000 Other income 0 13,200,000 Materials 0 Labour (9,650,000) Depreciation (810,000) Other expenses (2,154,800) Earnings before int. & taxes (EBIT) 585,200 Interest 0 Earnings before taxes (EBT) 585,200 Income tax expenses (175,560) Deferred taxes 0 Earnings after taxes (EAT) 409,640 Kenilworth Metered Taxi Service Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X2 Figure 3.12: KMTS Ltd.’s income statement (20X2) <?page no="67"?> Berkau: Financial Statements 9e 3-67 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 1,620,000 Share capital 5,000,000 Intangibles Reserves 207,368 Financial assets Retained earnings 518,420 Current assets Liabilities (liab.) Inventory Long-term liab. Acc. receivables A/ R Short-term liab. A/ P 2,551,052 Prepaid expenses 13,800 Provisions Cash/ Bank 6,818,600 Income tax liab. 175,560 Total assets 8,452,400 Total equity and liab. 8,452,400 Kenilworth Metered Taxi Service Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 3.13: KMTS Ltd.’s balance sheet (20X2) Cash flow from operating acitivities [ZAR] [ZAR] Proceeds 15,840,000 Payment for operating expenses (2,400,000) Payment for labour (9,650,000) Payment for rent (156,600) Tax payments (1,720,800) 1,912,600 Cash flow from investing activities 0 Cash flow from financing activities 0 Total cash flow 1,912,600 Kenilworth Metered Taxi Service Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X2 Figure 3.14: KMTS Ltd.’s cash flow statement (20X2) <?page no="68"?> Berkau: Financial Statements 9e 3-68 Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X1 5,000,000 5,000,000 Profit 20X1 627,200 627,200 as at 31.12.20X1 5,000,000 0 627,200 5,627,200 Profit 20X2 409,640 409,640 Dividend 20X2 (311,052) (311,052) Additions Res. 20X2 207,368 (207,368) 0 as at 31.12.20X2 5,000,000 207,368 518,420 5,725,788 Kenilworth Metered Taxi Service Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X2 Figure 3.15: KMTS Ltd.’s statement of changes in equity (20X2) 3.7 Summary International Bookkeeping is not much different to the German system. Both Accounting systems apply the double entry system. The preparation of financial statements is based on nominal and real accounts. Internationally, no extra opening nor closing accounts apply. IAS 1.10 defines that a full set of financial statements includes a balance sheet (statement of financial position), an income statement (statement of profit or loss and other comprehensive income), a statement of cash flows, a statement of changes in equity and the notes. We discussed the case study KENILWORTH METERED TAXI SERVICE Ltd. in Cape Town and prepared its financial statements for 20X1 and 20X2. In general, companies prepare financial statements under the consideration of the appropriation of profits. The appropriation of profits includes profits or losses carried forward. The shareholders decide to make additions to earnings reserves, pay out dividends (Shareholders for Dividend account). Profit or loss portions that are not distributed get carried forward to the next Accounting period and show as retained earnings on the statement of financial position. 3.8 Working Definitions Appropriation of Profits, under: If financial statements are prepared under the appropriation of profits, dividends and additions to reserves are considered. Notes: Explanations about Accounting policies, applied methods and its parameters. It includes further information about items on the financial statements. Paragraph: Section of a Standard. Paragraphs are identified by numbers. Set of Financial Statements: In line with IAS 1.10, a set of financial statements comprises a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows and the notes. Standard Setter: An organisation that issues standards. <?page no="69"?> Berkau: Financial Statements 9e 3-69 Statement of Cash Flows: A statement that shows increases and decreases of the cash/ bank item. Statement of Changes in Equity: A statement that discloses the additions to and deductions from equity items on the balance sheet. Statement of Financial Position: Balance sheet that compares the total of assets to equity and liabilities. Statement of Profit or Loss and Other Comprehensive Income: Income statement based on IFRSs. 3.9 Question Bank (1) On 2.07.20X5, a company reporting following IFRSs buys a business car at 72,000 EUR gross amount. For the equipment as a taxi, it pays another 3,600 EUR (gross value). Depreciation follows straight line method over 5 years. At the end of its useful life, the car is likely to be sold at 3,000 EUR. How much is depreciation in 20X6? 1. 14,520 EUR . 2. 12,000 EUR . 3. 6,000 EUR . 4. 12,600 EUR . (2) A company that prepares financial statements under IFRSs earns a profit before interest and taxation of 250,000 EUR. The interest is amounting 4,200 EUR. How much is the annual surplus? 1. 254,200 EUR . 2. 177,940 EUR . 3. 170,800 EUR . 4. 203,360 EUR . (3) A company earns a profit after tax of 100,000 EUR. It carries forward a profit from the last period of 50,000 EUR. On the annual general meeting the 500 ordinary shareholders declare a dividend of 7.5 EUR/ share and carry forward the remainder. How much is in the Retained Earnings account if every ordinary shareholder holds 10 shares? 1. 50,000 EUR . 2. 112,500 EUR . 3. 62,500 EUR . 4. 37,500 EUR . (4) A company that makes the debit entries Labour: 10,000 EUR, Rent: 1,200 EUR, Prepaid insurance: 450 EUR, Depreciation on factory building: 600 EUR, Depreciation on motor vehicles: 900 EUR, Operational expenses: 2,400 EUR, discloses the expenses below on the statement of profit or loss and other comprehensive income: 1. Labour: 10,000 EUR, Rent: 1,200 EUR, Prepaid expenses 450 EUR, Depreciation: 1,500 EUR, Other expenses: 2,400 EUR. 2. Labour: 10,000 EUR, Rent: 1,200 EUR, Depreciation: 1,500 EUR, Other expenses: 4,050 EUR. 3. Labour: 10,000 EUR, Depreciation: 1,500 EUR, Other expenses: 3,600 EUR. 4. Labour: 10,450 EUR, Depreciation: 1,500 EUR, Other expenses: 3,600 EUR. (5) A company pays for this year’s rent 1,080 EUR during this Accounting period and must pay another 360 EUR in the next one (for this Accounting period). Before, the 360 EUR are recorded as accounts payables. Rent is subjected to VAT. How much is the rent on the income statement? <?page no="70"?> Berkau: Financial Statements 9e 3-70 1. 900 EUR . 2. 1,080 EUR . 3. 1,200 EUR . 4. 1,440 EUR . 3.10 Solutions 1-2, 2-2, 3-2, 4-3, 5-3. <?page no="71"?> Berkau: Financial Statements 9e 4-71 4 Accounting for Retailers 4.1 What is in the Chapter? This chapter is an introduction to financial statements for retailers. We follow international Accounting and apply IFRSs. Financial statements for retailers are more complicate than for service providers but easier than for production firms, as we must consider inventory movements, but do not calculate products because measurement of merchandise goods is at cost of acquisition. Retailers apply special Accounting instruments, e.g., the trial balance T/ B and the Trading account T/ A which are introduced in this chapter. Retailers record inventory movements for goods received and released from stock which includes returns to suppliers and from customers. In this chapter, we introduce loan financing. We discuss the case study RYNEVELD Ltd. which is a trader for office paper. For didactical reasons, the company only deals with one product type. We apply a periodic inventory system and prepare a Trading account for the gross profit calculation. Note, an inventory system applies for recording movement of goods. Under a periodic system, a company only takes stock at the end of every Accounting period. Cost of goods can be calculated by adding all purchases to the opening value and deducting closing stock. The alternative is a perpetual system which requires recording additions to and releases from stock. To check the correctness of Bookkeeping entries, e.g., during an Accounting exam, we demonstrate the application of a trial balance before adjustments and by an adjusted trial balance after adjustments. At the end of the chapter, we discuss profit calculations for retailers. The case study RYNEVELD Ltd. comes with three Accounting periods from which only the first one 20X6 is covered in the textbook. The second period 20X7 is subjected to a task with solution you can access from the study material bank. The last period 20X8 is provided as self-marking test. You can download a solution form from the study material bank which determines your exam result following the German grading system based on the solution you enter. 4.2 Learning Objectives After studying this chapter, you can prepare commercial financial statements for retailers making international Bookkeeping entries and you can prepare financial statements under IFRSs. You have learned how to apply relevant standards for retailers. You also can calculate the gross and net profit and know the meaning thereof. You can apply a Trading Account and use the trial balance before and after adjustments to check your Bookkeeping consistency with the double entry system. 4.3 Trading Transactions Retailers’ business model is to buy goods from suppliers and to sell them <?page no="72"?> Berkau: Financial Statements 9e 4-72 on to their customers. Under a periodic inventory movement system, they apply a Purchase account to record goods received. For the gross profit calculation, retailers compare revenues and purchases in the Trading account. In this chapter, Accounting work is based on a periodic inventory movement system 19 . Under a periodic inventory system, stock is taken at the beginning and end of each Accounting period and costs of goods sold are determined by comparison of inventory levels under consideration of purchases. Retailers calculate their profit in a twostep approach: at first, they determine the gross profit and thereafter continue profit calculations for the net profit (earnings before taxes). By the last step, income taxes are calculated. A gross profit is the difference between revenue and cost of goods sold. We measure the cost of goods sold by the cost of purchase. Cost of purchase and cost of acquisition refer to the net value after deduction of discounts and rebates. IAS 2.11 and IAS 16.16 apply, respectively. Note, the term purchase cost applies for materials and goods whereas the term cost of acquisition indicates investments which are debited to the Property, Plant, Equipment account. In general, trading is not interlinked with IAS 16. The standard only matters for other income obtained by the disposal of non-current assets. Inventory valuation can be subjected to value adjustments or write-offs due to stock deterioration. 20 19 Study our textbook Basics of Accounting, chapter (26). We introduce the perpetual inventory system in chapter (9). The next step is the calculation of earnings before income tax which is also referred to as the net profit calculation. The net profit is the gross profit after deduction of all further expenses, e.g., labour, depreciation, operational expenses etc., but except of income tax expenses. The deduction of income tax expenses is the last step of profit calculation. In this textbook, we simplify income tax calculations by multiplying a uniform income tax rate by the net profit. This easy calculation prevents us from discussing Taxation based on national tax laws. Earnings after taxes are also called annual surplus. In total, the profit calculation for a retailer follows the structure below: Revenue ./ . Cost of merchandise goods sold Gross profit ./ . Further expenses (labour, depreciation, other expenses) Net profit (EBT) ./ . Income tax expenses Annual surplus (EAT) 4.4 Gross Profit Calculation We explain the gross profits by a small case study DEMANN GmbH which is plumber who also acts as retailer for heater spare parts. Therefore, the company is retailer and service provider at the same time. You find the case study following the Link 4.A below: 20 Check case study HEISTEL (Pty) Ltd. in chapter (9), where inventory becomes subjected to value adjustments due to technical progress. <?page no="73"?> Berkau: Financial Statements 9e 4-73 Link 4.A: DEMANN GmbH. 4.5 Trial Balance Next, we study the trial balance as well as the Trading account. We explain the concepts by the case study RYNEVELD Ltd. in George (South Africa). A trial balance is a list of all accounts and their balancing figures as per balance sheet day. 21 In the old days, Accountants used it for checking consistency of Bookkeeping records with the double entry system. On a trial balance, the total of the debit-balanced accounts (balance b/ d on the debit side) must equal the total of the creditbalanced ones (balance b/ d on the credit side). 22 Nowadays, Accounting software pre-checks the Bookkeeping entries before recording, which prevents users from faulty entries. The trial balance provides us with an overview of accounts and their balancing figures as well as supports Bookkeeping data transfers, e.g., between group members in preparation of group Accounting. 4.6 Trading Account The Trading account is prepared after the Bookkeeping entries have been 21 The trial balance is introduced in chapter (29) of our textbook Basics of Accounting. completed and checked for consistency by the trial balance. Revenues are closed-off to its credit side and material expenses to the debit side. The balancing figure in a Trading account represents the gross profit. A Trading account pairs well with a periodic inventory system. Then material expenses (or cost of goods sold) are calculated as opening inventory balances plus material/ goods receipts (purchases) minus closing stock (inventory level). Note, you must closeoff the Inventory account(s), the Purchase account, and the Revenue account to the Trading account. Also returns inwards and returns outwards are transferred to the Trading account. We apply the Trading account for RYNEVELD Ltd.’s business. 4.7 C/ S RYNEVELD Ltd. Find below the data sheet for RYNEVELD Ltd. Data Sheet for RYNEVELD Ltd. Domicile: South Africa (George). Reporting currency: ZAR. Classification: Retailer. Accounting period: 20X6. Share issue: 100,000 × 5 ZAR/ share on 1.01.20X6. Financing: bank loan 200,000 ZAR; interest rate 6 %/ a, pay-off: 40,000 ZAR/ a constantly. Rent: 36,000 ZAR/ a; payment one month in advance. Store equipment (P, P, E): 200,000 ZAR; depreciation: straight-line method over ten years. Purchases: 250,000 ZAR. 22 Study our textbook Basics of Accounting, chapter (10) - (12). <?page no="74"?> Berkau: Financial Statements 9e 4-74 Closing stock of inventories: 22.4 % of available stock. Revenue: 545,000 ZAR. Operational costs (non-VATable): 15,000 ZAR/ m. VAT rate: 20 %. RYNEVELD Ltd. is incorporated on 1.01.20X6 by an issue of 100,000 ordinary shares at 5 ZAR/ share (face value). On 2.01.20X6, RYNEVELD Ltd. takes out a bank loan of 200,000 ZAR. The annual rate of interest is 6 %/ a and due at yearends. The loan’s pay-off amount is constantly 40,000 ZAR/ a. It is paid together with interest at yearends. The rent for the shop is 36,000 ZAR/ a; no VAT applies. RYNEVELD Ltd. pays the rent one month in advance. The first payment for January/ 20X6 is paid on 2.01.20X6, for February/ 20X6 on 30.01.20X6 and so on. RYNEVELD Ltd. acquires store equipment shelves, tables etc. - and pays 240,000 ZAR on 2.01.20X6. The price is the gross value. The store equipment is depreciated following straight-line method over ten years. No residual value applies. RYNEVELD Ltd. purchases office paper for 300,000 ZAR (gross amount) and pays half of the price in January/ 20X6 and the other half one year later in January/ 20X7. At the end of 20X6, RYNEVELD Ltd. takes stock. 22.4 % (in value) of the office paper is still in storage. During the fiscal year 20X6, RYNEVELD Ltd. earns revenues of 545,000 ZAR. All customers pay on cash. Operational costs, mainly labour, are 15,000 ZAR/ m during 20X6. We do not consider VAT on operations. Below, we discuss the Bookkeeping entries for the business activities and prepare a trial balance for RYNEVELD Ltd. Thereafter, we calculate gross and net profit in the Trading and Profit and Loss account, respectively. At the time of incorporation, RYNEVELD Ltd. issues ordinary shares at a total value of: 100,000 × 5 = 5500,000 ZAR. The share issue takes place on 1.01.20X6. Therefore, the share issue counts as Bookkeeping entry (1) and becomes cash flow relevant in 20X6: @ 1.01.20X6 (1) Cash/ Bank C/ B 500,000 Issued Capital ISS 500,000 (issue of 100,000 ordinary shares at a nominal value of 5 ZAR/ s) RYNEVELD Ltd. takes out a loan from its house bank. The loan issue is 200,000 ZAR. This is the nominal value of the loan and referred to as the principal. It is recorded as Bookkeeping entry (2) under interest bearing liabilities. The interest (Bookkeeping entry (3)) for 20X6 is: 6% × 200,000 = 1 12,000 ZAR. Besides of interest, RYNEVELD Ltd. must pay-off 40,000 ZAR every year. The payoff Bookkeeping entry falls under adjustments and is recorded after preparing the first trial balance. As interest is often paid during the year it is not regarded as adjustment but recognised like a normal Bookkeeping entry. <?page no="75"?> Berkau: Financial Statements 9e 4-75 Observe the Bookkeeping entries (2) and (3) below: @ 2.01.20X6 (2) Cash/ Bank C/ B 200,000 Interst Bearing Liabilities IBL 200,000 (loan issue (principal recognition)) @ 31.12.20X6 (3) Interest-20X6 INT 12,000 Cash/ Bank C/ B 12,000 (interest recognition) Rent is 3,000 ZAR/ m and not subjected to VAT. Here, the landlord is not registered for VAT reduction. Rent is paid in advance except for the 1 st payment. Hence, RYNEVELD Ltd. makes thirteen rental payments during 20X6 - the last one counts as prepayment for January/ 20X4. We record the thirteen payments as aggregated Bookkeeping entry (4) on 30.06.20X6. The accrual of prepaid expenses for the last payment is recorded as adjustment. @ 30.06.20X6 (4) Rent-20X6 RNT 39,000 Cash/ Bank C/ B 39,000 (rent recognition, thirteen payments for Jan/ 20X6 until Jan/ 20X7) The acquisition of the store equipment is recorded at cost of acquisition (net value) of 200,000 ZAR. VAT applies as the seller is acting as a VAT vendor. The Bookkeeping (5) entry is recorded on 5.01.20X6: @ 5.01.20X6 (5) Property, Plant, Equipment PPE 200,000 Value Added Tax VAT 40,000 Cash/ Bank C/ B 240,000 (acquisition of the store interior) Depreciation on the store equipment falls under adjustments and will be discussed later. Our next Bookkeeping entry is for the purchase of office paper. We make a debit entry in the Purchase account as 23 Study our textbook Basics of Accounting, chapter (26). we apply a periodic system. 23 The purchase is VATable. The input-VAT is recorded as a debit entry in the VAT account and represents a claim against the South African Revenue Service SARS. <?page no="76"?> Berkau: Financial Statements 9e 4-76 Observe Bookkeeping entry (6) below. Based on the purchase terms and conditions, the payment is split into two parts, one thereof is due instantly in 20X6 - the remainder in 20X7. Note, remember to never split VAT. VAT applies once the deal is closed and when the Bookkeeping entry is recorded. In compliance with the national VAT law, RYNEVELD Ltd. claims the total value of input-VAT to the extent of 50,000 ZAR immediately. @ 6.01.20X6 (6) Purchase-20X6 PUR 250,000 Value Added Tax VAT 50,000 Accounts Payables A/ P 150,000 Cash/ Bank C/ B 150,000 (purchase and receipt of goods; office paper) The closing stock of merchandise goods at the end of 20X6 is recognised when adjustments are recorded. For now, we ignore the closing stock of goods. The stock-taking takes place on the balance sheet date and must be recorded then. RYNEVELD Ltd. recognises revenues of 545,000 ZAR. The proceeds are the gross value thereof and are amounting to: 545,000 × 120% = 6654,000 ZAR. See Bookkeeping entry (7) which is recorded in the middle of the Accounting period: @ 1.07.20X6 (7) Cash/ Bank C/ B 654,000 Value Added Tax VAT 109,000 Revenue-20X6 REV 545,000 (revenue recognition) Operational expenses are recorded as Bookkeeping entry (8). The amount is not subjected to VAT: 12 × 15,000 = 180,000 ZAR. @ 30.06.20X6 (8) Operational Expenses-20X6 OEX 180,000 Cash/ Bank C/ B 180,000 (recognition of operations, e.g., labour) Observe the accounts at this stage of recording in Figure 4.1. <?page no="77"?> Berkau: Financial Statements 9e 4-77 D C D C (1) 500,000 (3) 12,000 c/ d 500,000 (1) 500,000 (2) 200,000 (4) 39,000 b/ d 500,000 (7) 654,000 (5) 240,000 (6) 150,000 (8) 180,000 c/ d 733,000 1,354,000 1,354,000 b/ d 733,000 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 200,000 (2) 200,000 (3) 12,000 c/ d 12,000 b/ d 200,000 b/ d 12,000 Interest bearing liabilities IBL Interest-20X6 INT D C D C (4) 39,000 c/ d 39,000 39,000 39,000 b/ d 39,000 Rent-20X6 RNT Prepaid expenses PRE D C D C (5) 200,000 c/ d 200,000 (5) 40,000 (7) 109,000 b/ d 200,000 (6) 50,000 c/ d 19,000 109,000 109,000 b/ d 19,000 Property, Plant, Equipment PPE Value added tax VAT D C D C (6) 250,000 c/ d 250,000 c/ d 150,000 (6) 150,000 b/ d 250,000 b/ d 150,000 Accounts payables A/ P Purchase-20X6 PUR D C D C c/ d 545,000 (7) 545,000 (8) 180,000 c/ d 180,000 b/ d 545,000 b/ d 180,000 Revenue-20X6 REV Operational expenses-20X6 OEX Figure 4.1: RYNEVELD Ltd.’s accounts before adjustments Next, we prepare the trial balance to check our Bookkeeping entries for consistency with the double-entry system. We enter the balancing figures of each account (balance brought down <?page no="78"?> Berkau: Financial Statements 9e 4-78 b/ d) to the trial balance. You see the trial balance in Figure 4.2. Compare it to the accounts in Figure 4.1. Account Debit entries Credit entries [ZAR] [ZAR] Cash/ Bank C/ B 733,000 Issued Capital ISS 500,000 Interest bearing Liabilities IBL 200,000 Interest-20X6 INT 12,000 Rent-20X6 RNT 39,000 Property, Plant, Equipment PPE 200,000 Value added Tax VAT 19,000 Purchase-20X6 PUR 250,000 Accounts payables A/ P 150,000 Revenue-20X6 REV 545,000 Operational expenses-20X6 OEX 180,000 Total: 1,414,000 1,414,000 Ryneveld Ltd. TRIAL BALANCE as at 31.12.20X6 Figure 4.2: RYNEVELD Ltd.’s trial balance How it is Done (Trial Balance): (1) Make Bookkeeping entries for all business activities in T-accounts. Balance-off all accounts. (2) Prepare a list with lines for each account therein. Define two columns, one for debit balances and the other one credit balances. Copy the balances brought down for each account to the columns debit entry or credit entry. (3) Compare the totals of the debit column to the one for the credit column. If they equal your Bookkeeping records “are looking good”. However, the trial balance does not prove correctness, but a mistake would show. We continue with the adjustments. Adjustments are Bookkeeping entries recorded in preparation of financial statements at the end of an Accounting period. For RYNEVELD Ltd., we record the adjustments below: (a) Depreciation. (b) Loan pay-off. (c) Reclassification of next year’s payoff following IAS 1.60. (d) Rent accruals. (e) Gross profit calculation. (f) Net profit calculation. (g) Income tax calculation. <?page no="79"?> Berkau: Financial Statements 9e 4-79 Ad (a): Depreciation RYNEVELD Ltd. records depreciation on its store equipment. Depreciation is based on cost of acquisition; hence, values are net of VAT. Depreciation on the interior at RYNEVELD Ltd. is: (240,000 / 120%) / 10 = 2 20,000 ZAR. @ 31.12.20X6 Depreciation-20X6 DPR 20,000 Accumulated Depreciation ACC 20,000 (recording depreciation on the store interior) Ad (b): Loan Pay-off The loan contract states that RYNEVELD Ltd. must pay-off 40,000 ZAR per annum. The Bookkeeping entry is shown below. @ 31.12.20X6 Interest Bearing Liabilities IBL 40,000 Cash/ Bank C/ B 40,000 (paying-off the bank loan following the loan terms and conditions) Ad (c): Reclassification of next Pay-off The upcoming repayment for the loan in 20X7 is 40,000 ZAR, too. IFRSs require a separation of short-term liabilities from long-term ones. RYNEVELD Ltd. must reclassify the next year’s repayment as short-term liabilities. The Accounts Payables A/ P account applies. The Bookkeeping entry transfers long-term liabilities to short-term liabilities. Note, the names of the accounts can be misleading. The fact that a loan portion is transferred from the Interest Bearing Liabilities account to accounts payables does not mean that no interest applies. The interest in 20X7 considers the principal (nominal value of the bank loan) less repayments in 20X6 and, thus, is based on the amount RYNEVELD Ltd. owes its bank as of 1.01.20X7. Therefore, the interest-20X7 is: (200,000 - 40,000) × 6% = 9,600 ZAR. On the balance sheet as per 31.12.20X6, 120,000 ZAR are in the Interest Bearing Liabilities account and 40,000 ZAR in the Accounts Payables account; both figures count for the interest calculation in 20X7. @ 31.12.20X6 Interest Bearing Liabilities IBL 40,000 Accounts Payables A/ P 40,000 (reclassification of the pay-off of the bank loan following IAS 1.60) Ad (d): Rent Accruals In compliance with IAS 1.27, the income statement is prepared under the accrual basis of Accounting. This requires recognition of expenses in the Accounting period they are for. No <?page no="80"?> Berkau: Financial Statements 9e 4-80 payments nor receipts of cash matter for the allocation of expenses or revenues to Accounting periods. At RYNEVALD Ltd., the January/ 20X7’s rent must be separated from the rent in 20X6 by recording an accrual. 24 We remove the rent for January/ 20X7 from the expense account and record a debit entry in the Prepaid Expense account. That way, we “park” the expense and transfer them only in the next Accounting period to the expense account for 20X7. In contrast to financial statements following HGB, prepaid expenses are disclosed as current asset on the balance sheet. See the Bookkeeping entry below: @ 31.12.20X6 Prepaid Expenses PRE 3,000 Rent-20X6 RNT 3,000 (accrual for January/ 20X7 rent) Ad (e) Gross Profit Calculation For gross profit calculation, the Trading account applies. 25 Gross profit is the difference between revenues and cost of goods sold. Further adjustments might apply, if a company returns goods to its supplier or if its customers return goods. See Figure 4.3 for the possible entries in a Trading account. D C INV Opening stock REV Sales revenue PUR Purchases INV Closing stock R.I. Returns inwards R.O. Returns outwards Trading account-20XX T/ A Figure 4.3: Elements of a Trading account Returns 26 are either returns outwards or returns inwards. Returns outwards are recorded for sending goods back to suppliers. The Returns Outwards account applies. We consider returns outwards at net values for the profit calculation, as they are based on the cost of purchase. This gives an entry on the credit side of the Returns Outwards account. Once closed-off to the 24 Study our textbook Basics of Accounting, chapter (18). 25 Study our textbook Basics of Accounting, chapter (22). Trading account, the item appears therein as a credit entry. Note, as an alternative, the Purchase account can be credited. A further credit entry is required in the VAT account to adjust the input-VAT claim. The debit entry is made either in the Accounts Receivables account (for a voucher), in the Accounts Payables 26 Study our textbook Basics of Accounting, chapter (20) - (23) to understand the VAT implication of returns. <?page no="81"?> Berkau: Financial Statements 9e 4-81 account (if the supplier reduces the invoice) or in the Cash/ Bank account (for a cash refund or bank transfer). Next, we discuss returns inwards: If customers send back goods, they are recorded on the debit side of the Return Inwards account at their net selling price. Alternatively, you might debit the Revenue account. A further debit entry is recorded in the VAT account to adjust the output-VAT liability recognised with the sale. The credit entry can be made in the Accounts Payables account (for a voucher issued), in the Accounts Receivables account (for an invoice reduction) or in the Cash/ Bank account (for a refund). For a return inward, the stock level depends on the action taken after the return inwards has been received. The returned goods can either be stored or discarded. This depends on the reason for the return. If goods are faulty and damage beyond repair, they are disposed of. No stock level adjustments are necessary then. If the customer only made a purchase by accident and the goods are still in good condition, they will be added to stock and sold on. A company must record returned goods at the same costs as previously released, if unknown the best estimate applies. 27 At RYNEVELD Ltd., no returns occur. Note, however, in 20X7, a return outward takes place (task). RYNEVELD Ltd. records purchases and takes stock at yearends. When the company is established in 20X6, no opening stock exists. The purchases are 250,000 ZAR. The Purchase account is closed-off to the Trading account: @ 31.12.20X6 Trading Account-20X6 T6A 250,000 Purchase-20X6 PUR 250,000 (closing-off purchases to T/ A account) For the credit side of the Trading account, we close-off the Revenue account and take stock. The revenue is 545,000 ZAR. The stock-taking results in a value of 22.4 % of the purchased goods which is: 22.4% × 250,000 = 5 56,000 ZAR. No goods are returned to suppliers. On the credit side of the Trading account, we make two entries: 27 Check the case study MONTAGU (Pty) Ltd. for the details and Bookkeeping entries of returns inwards. You find it in our textbook Basics of Accounting, chapter (28). <?page no="82"?> Berkau: Financial Statements 9e 4-82 @ 31.12.20X6 Revenue-20X6 REV 545,000 Trading Account-20X6 T/ A 545,000 (closing-off revenues to T/ A account) Inventories INV 56,000 Trading Account-20X6 T/ A 56,000 (recording closing inventory after stock taking) The Trading account is depicted in Figure 4.4. Ad (f): Net Profit Calculation For the net profit calculation (earnings before taxation), we deduct all remaining expenses from the gross profit - except from income tax expenses. At RYNEVELD Ltd., those expenses are depreciation, operational expenses, rent and interest. We close-off all expense accounts to the Profit and Loss account. We further close-off the Trading account to the Profit and Loss account which gives us the gross profit as credit entry in the Profit and Loss account. Note, a net loss would result in a debit entry in the Profit and Loss account. Observe the next Bookkeeping entries. The related accounts are shown in Figure 4.4. @ 31.12.20X6 Profit and Loss-20X6 P6L 20,000 Depreciation-20X6 DPR 20,000 (closing-off depreciation to the P6L account) Profit and Loss-20X6 P6L 180,000 Operational Expenses-20X6 OEX 180,000 (closing-off operatinal expenses to the P6L account) Profit and Loss-20X6 P6L 36,000 Rent-20X6 RNT 36,000 (closing-off rent to the P6L account) Profit and Loss-20X6 P6L 12,000 Interest-20X6 INT 12,000 (closing-off interest to the P6L account) Trading Account-20X6 T6A 351,000 Profit and Loss-20X6 P6L 351,000 (closing-off the Trading account to the P6L account) Ad (g): Income Tax Calculation Based on the conventions in chapter (1), income tax expenses are amounting to 30% of the pre-tax profit. At RYNEVELD Ltd., income taxes are: (351,000 - 20,000 - 180,000 - 36,000 - 12,000) × 30% = 103,000 × 30% = 3 30,900 ZAR. We make a simplified Bookkeeping entry for income taxes as below (shortcut). Note, the full Bookkeeping entry for the income tax expenses would be: DR Income Tax Expenses . . . - CR Income Tax Liabilities . . . followed by: <?page no="83"?> Berkau: Financial Statements 9e 4-83 DR P&L-Account . . . - CR Income Tax Expenses . . . We recorded income tax for KENILWORTH METERED TAXI SERVICE Ltd. in chapter (3) by these Bookkeeping entries. Here, we take the short-cut. @ 31.12.20X6 Profit and Loss-20X6 P6L 30,900 Income Tax Liabilities ITL 30,900 (recognition of income tax expenses as liabilities) After deduction of income tax expenses from the pre-tax profit, we arrive at the annual surplus which is closed-off to the equity account Retained Earnings account. Note, an Annual Surplus account (Jahresüberschusskonto) combined with a Retained Earnings account (Bilanzgewinn) as required by the German HGB (§ 268 HGB) does not apply for international Accounting. There is only one Retained Earnings account. At RYNEVELD Ltd., the annual surplus is: 103,000 - 30,900 = 7 72,100 ZAR. Observe the Bookkeeping entry below. It would be inverted for recording a loss. In that case, no income taxes would apply based on our tax model. @ 31.12.20X6 Profit and Loss-20X6 P6L 72,100 Retained Earnings R/ E 72,100 (allocation of annual surplus to R/ E account) Find below in Figure 4.4 all accounts of RYNEVELD Ltd. after adjustments. D C D C (1) 500,000 (3) 12,000 c/ d 500,000 (1) 500,000 (2) 200,000 (4) 39,000 b/ d 500,000 (7) 654,000 (5) 240,000 (6) 150,000 (8) 180,000 c/ d 733,000 1,354,000 1,354,000 b/ d 733,000 IBL 40,000 c/ d 693,000 733,000 733,000 b/ d 693,000 Cash/ Bank C/ B Issued capital ISS Figure 4.4: RYNEVELD Ltd.’s accounts after adjustments (20X6) <?page no="84"?> Berkau: Financial Statements 9e 4-84 D C D C c/ d 200,000 (2) 200,000 (3) 12,000 c/ d 12,000 C/ B 40,000 b/ d 200,000 b/ d 12,000 P6L 12,000 A/ P 40,000 c/ d 120,000 200,000 200,000 b/ d 120,000 Interest bearing liabilities IBL Interest-20X6 INT D C D C (4) 39,000 PRE 3,000 RNT 3,000 c/ d 3,000 c/ d 36,000 b/ d 3,000 39,000 39,000 b/ d 36,000 P6L 36,000 Rent-20X6 RNT Prepaid expenses PRE D C D C (5) 200,000 c/ d 200,000 (5) 40,000 (7) 109,000 b/ d 200,000 (6) 50,000 c/ d 19,000 109,000 109,000 b/ d 19,000 Property, Plant, Equipment PPE Value added tax VAT D C D C (6) 250,000 c/ d 250,000 c/ d 150,000 (6) 150,000 b/ d 250,000 T/ A 250,000 b/ d 150,000 c/ d 190,000 A/ P 40,000 190,000 190,000 b/ d 190,000 Purchase-20X6 PUR Accounts payables A/ P D C D C c/ d 545,000 (7) 545,000 (8) 180,000 c/ d 180,000 T/ A 545,000 b/ d 545,000 b/ d 180,000 P6L 180,000 Revenue-20X6 REV Operational expenses-20X6 OEX D C D C ACC 20,000 c/ d 20,000 c/ d 20,000 DPR 20,000 b/ d 20,000 P6L 20,000 b/ d 20,000 Depreciation-20X6 DPR Accumulated depreciation ACC Figure 4.4: RYNEVELD Ltd.’s accounts after adjustments (20X6) - continued <?page no="85"?> Berkau: Financial Statements 9e 4-85 D C D C PUR 250,000 REV 545,000 OV 0 GP 351,000 INV 56,000 T/ A 56,000 c/ d 56,000 601,000 601,000 56,000 56,000 P6L 351,000 b/ d 351,000 b/ d 56,000 Trading account-20X6 T/ A Inventories INV D C D C DPR 20,000 T/ A 351,000 c/ d 30,900 P6L 30,900 OEX 180,000 b/ d 30,900 RNT 36,000 INT 12,000 EBT 103,000 351,000 351,000 D C ITL 30,900 b/ d 103,000 c/ d 72,100 P6L 72,100 R/ E 72,100 b/ d 72,100 103,000 103,000 Retained earnings R/ E Income tax liabilities ITL Profit or Loss-20X6 P6L Figure 4.4: RYNEVELD Ltd.’s accounts after adjustments (20X6) - continued How it is Done (Trading Account Based on a Periodic Inventory System): (1) Transfer the opening value of the inventories to the Trading account. Make a debit entry in the Trading account and a credit entry the Inventory account. (2) Record all purchases in the Purchase account. Consider input-VAT. At the end of the Accounting period, close-off the Purchase account to the Trading account. (3) Record all sales in the Revenue account. Consider output-VAT. Close-off the Revenue account to the Trading account. (4) In case of returns inwards, record the payments made or vouchers granted and record the net selling price on the debit side of the Returns Inwards account. Alternatively, record negative revenues. Close-off the Returns Inwards account to the Trading account. If goods are received add them to stock or discard them. If put on stock, they will be considered for stock taking at the end of the Accounting period. (5) Determine the closing stock of inventories (take stock). Record the closing stock of inventories as a debit entry in the Inventory account and a credit entry in the Trading account. (6) If goods are returned to suppliers record them in the Returns Outwards account and consider VAT based <?page no="86"?> Berkau: Financial Statements 9e 4-86 on the cost of purchase. Make a debit entry in the Cash/ Bank account or the Accounts Receivables or the Accounts Payables account and credit the VAT account. Make a credit entry in the Returns Outwards account or as an alternative in the Purchase account (negative purchase). Close-off the Returns Outwards account to the Trading account. (7) Determine the balancing figure of the Trading account. If the Trading account is debit balanced (b/ d), the balancing figure is a gross loss. If the Trading account is credit-balanced, the balancing figure is a gross profit. Transfer the gross profit or gross loss to the Profit and Loss account by closing-off the Trading account thereto. The adjusted trial balance is prepared after completion of adjustments. Check Figure 4.5. As nominal accounts are closed-off either to the Trading account or the Profit and Loss account they do not appear on the adjusted trial balance. Their balancing figures are zero. This applies to the Profit and Loss account as well as to the Trading account. Account Debit entries Credit entries [ZAR] [ZAR] Cash/ Bank C/ B 693,000 Issued Capital ISS 500,000 Interest bearing Liabilities IBL 120,000 Prepaid expenses PRE 3,000 Property, Plant, Equipment PPE 200,000 Value added Tax VAT 19,000 Accounts payables A/ P 190,000 Accumulated Depreciation ACC 20,000 Income Tax Liabilities ITL 30,900 Retained Earnings R/ E 72,100 Inventories INV 56,000 952,000 952,000 Ryneveld Ltd. ADJUSTED TRIAL BALANCE as at 31.12.20X6 Figure 4.5: RYNEVELD Ltd.’s adjusted trial balance (20X6) How it is Done (Adjusted Trial Balance): (1) Prepare a trial balance. (2) Record the adjustments for the profit calculation, e.g., for depreciation, accruals etc. Calculate the earnings before taxes and earnings after taxes. Make <?page no="87"?> Berkau: Financial Statements 9e 4-87 Bookkeeping entries for income taxes and retained earnings. In case you prepare financial statements after the appropriation of profits, calculate and record dividends and/ or additions/ reductions to/ from reserves. Balance-off the Retained Earnings account. In case a company carries forward a profit/ loss, there will be a balance b/ d to be considered for the Retained Earnings account. (3) Transfer the adjustments to the trial balance. Delete the nominal accounts that have been closed-off to the Profit and Loss account. Consider that the Trading account as well as the Profit and Loss account are closed-off, too. After preparing the adjusted trial balance, compare the total of the balancing figures for all listed accounts in the debit column to the credit column. (4) Prepare the income statement based on the information you retrieve from the Trading account and the Profit and Loss account. Prepare the balance sheet based on the real accounts listed on the adjusted trial balance. You might combine accounts for the balance sheet preparation, e.g., the P, P, E account and the Accumulated Depreciation account. Based on the adjusted trial balance, we prepare the balance sheet for RYNEVELD Ltd. Only few changes are made to prepare the statement of financial position. We must offset the Property, Plant and Equipment account against accumulated depreciation and add VAT liabilities to the accounts payables. The P, P, E item on the balance sheet gives: 200,000 - 20,000 = 1 180,000 ZAR and the A/ P item is: 19,000 + 190,000 = 2 209,000 ZAR. Otherwise, we can copy the values from the adjusted trial balance directly to the balance sheet. Observe RYNEVELD Ltd.’s statement of financial position as shown in Figure 4.6. <?page no="88"?> Berkau: Financial Statements 9e 4-88 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 180,000 Share capital 500,000 Intangibles Reserves Financial assets Retained earnings 72,100 Current assets Liabilities (liab.) Inventory 56,000 Long-term liab. 120,000 Accounts receivables Short-term liab. A/ P 209,000 Prepaid expenses 3,000 Provisions Cash/ Bank 693,000 Income tax liab. 30,900 Total assets 932,000 Total equity and liab. 932,000 Ryneveld Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X6 Figure 4.6: RYNEVELD Ltd.’s balance sheet (20X6) The Income statement is derived from the Trading account and the Profit and Loss account. It fulfils the requirements of IAS 1.82. At RYNEVELD Ltd., no other comprehensive income matters. All revenues and expenses have been recorded through profit or loss. The income statement is shown in Figure 4.7. [ZAR] Revenue 545,000 Other income 0 545,000 Materials (194,000) Labour 0 Depreciation (20,000) Other expenses (216,000) Earnings before int. & taxes (EBIT) 115,000 Interest (12,000) Earnings before taxes (EBT) 103,000 Income tax expenses (30,900) Deferred taxes 0 Earnings after taxes (EAT) 72,100 Ryneveld Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X6 Figure 4.7: RYNEVELD Ltd.’s income statement We do not discuss RYNEVELD Ltd.’s statement of cash flows and its <?page no="89"?> Berkau: Financial Statements 9e 4-89 statement of changes in equity to avoid repetitions. You can download these statements by the Link 4.B below: Link 4.B: RYNEVELD Ltd. We recommend working on task A4.38 which is about 20X7 for the case study RYNEVELD Ltd. 28 4.8 C/ S TELUK Sdn. Bhd. The case study TELUK Sdn. Bhd. is about a trading business for office materials and includes return transactions and recording of bad debts as well. Bad debts are recorded when a company has reason to believe that its debtor is insolvent and thus the receivables become irrecoverable. The case study can be downloaded through the QR code in the Link 4.C below: Link 4.C: TELUK Sdn. Bhd. 28 Find the task in the study material bank. 4.9 Worksheet for T/ B Calculations As an alternative method, we explain how to prepare financial statements based on a worksheet for the trial balance. The worksheet method explanation can be downloaded by the QR code in the Link 4.D below: Link 4.D: Worksheet method You find a further example for the preparation of financial statements via the worksheet method below linked to the case study BINNEVELD Ltd. which is a surf shop. Check Link 4.E. Link 4.E: BINNEVELD Ltd. Note, that you do not have to apply the worksheet method; however, this method can help you to expedite profit calculations. 4.10 Summary In this chapter, we covered the preparation of financial statements based on trial balance and Trading account. The <?page no="90"?> Berkau: Financial Statements 9e 4-90 chapter refers to retailers where the gross profit calculation is important. We applied the periodic inventory system and introduced returns. We get back to that subject in chapter (9) when the perpetual inventory movement system is discussed. We also introduced the worksheet method for the preparation of financial statements based on the trial balance. 4.11 Working Definitions Accumulated Depreciation Account: Account for recording an asset's depreciation over the entire lifetime. Adjusted Trial Balance: Trial balance after all recording adjustments. Gross Profit: Difference between revenue and material expenses. Liability: Present obligation that results in a future outflow of economic benefits. Net Profit: Profit after interest and before income taxes. It equals earnings before taxation EBT. Periodic Inventory System: Inventory system where stock-taking is required at the beginning and the end of the Accounting period. Returns: Material/ goods sent back to suppliers (outward) or goods brought back by customers (inward). Trading Account: Section of the Profit and Loss account that only deals with revenue and material expenses. Its balancing figure is the gross profit. Trial Balance: The trial balance is a list of all accounts in use which shows their balancing figures (Bal. b/ d). It is used to check consistency with the double-entry system. 4.12 Question Bank (1) A company shows an opening value for inventories of 56,000 EUR. During the Accounting period, the company purchases goods for 300,000 EUR and later for 350,000 EUR. At the end of the Accounting period, stock-taking reveals that there are goods for 100,000 EUR left. The sales are amounting to 850,000 EUR. Depreciation on the store equipment is 40,000 EUR. How much is the company's gross profit? 1. 244,000 EUR . 2. 204,000 EUR . 3. 144,000 EUR . 4. 104,000 EUR . (2) A company records an opening value of inventories of 300 EUR. The closing balance is amounting to 100 EUR. During the Accounting period, there were two purchases, one at 1,000 EUR and the other one at 2,000 EUR (net amounts). The revenue equals 5,000 EUR. How much is the gross profit? 1. 1,200 EUR . 2. 1,800 EUR . 3. 2,200 EUR . 4. 1,600 EUR . (3) A retailer for baseball caps records an opening stock value of: 90 × 34 EUR/ u = 3,060 EUR. During the Accounting period, the retailer purchases 500 baseball caps at 35 EUR/ u of which 50 are returned to the supplier due to quality issues. 344 baseball caps are sold at 70 EUR/ u. 80 customers receive a discount of 10%. The retailer records inventory movements following the <?page no="91"?> Berkau: Financial Statements 9e 4-91 first-in-first-out cost formula. How much is the gross profit? 1. 9,820 EUR . 2. 11,570 EUR . 3. 12,130 EUR . 4. 27,320 EUR . (4) On 2.04.20X4, a company buys a machine at 24,000 EUR gross amount. The seller offers a 10% trade discount on the machine on 1.07.20X4. Depreciation commences in April and is based on the straight-line method over 5 years. How much is depreciation for 20X4? 1. 1,800 EUR . 2. 3,600 EUR . 3. 2,700 EUR . 4. 2,000 EUR . (5) A company buys goods for 100,000 EUR cost of purchase. The opening value of inventories at the beginning of the year amounts to 20,000 EUR. During the Accounting period, the company sold goods valued at 58,000 EUR and returned goods for 18,000 EUR. The sales are 150,000 EUR. How much is the gross profit? 1. 92,000 EUR . 2. 106,000 EUR . 3. 86,000 EUR . 4. 136,000 EUR . 4.13 Solutions 1-1; 2-2; 3-2; 4-3; 5-1. <?page no="92"?> Berkau: Financial Statements 9e 5-92 5 Basics of Financial Statement Analysis 5.1 What is in the Chapter? In this chapter, we introduce the financial statement analysis. For the preparation of a thorough financial statement analysis, we apply industry specific metrics. Therefore, we discuss here only the start of a financial statement analysis and refer to major common financial ratios that measure performance, liquidity, capital structure, and market valuation. We explain their calculations and show how to read them if prepared by others. We apply them on the case study CAPELIFT Ltd., which is a service provider in the Aviation industry. 5.2 Learning Objectives After studying this chapter, you know the most important aspects of financial statement analysis and understand the meaning of standard metrics. This prepares you for a financial statement analysis in the genuine business world. 5.3 Company Appraisal We take the position of a company appraiser and focus on the reading and interpretation of the financial statements. For a financial statement analysis, no Bookkeeping knowledge, or the ability to prepare financial statements is required. Financial statement analysis means to calculate figures based on information derived from financial statements that support an evaluation of a company or a comparison between companies. Note, we place this chapter at the beginning of the textbook, so we can give an impression about how others will read financial statements we prepare as Accountants. In financial statement analysis, we do more than calculating standard ratios to obtain sufficient knowledge about a company. As we show later in this chapter, the financial statement analysis supports a profound evaluation of a company, mostly based on industry specific calculations. Therefore, the basics as taught here in an Accounting textbook might cover 5 % of a financial statement analysis. It serves as a start for a financial statement analysis. To begin with a financial statement analysis, we calculate standard ratios. Based on their interpretation, we develop a hypothesis about the situation, a company is in. This leads then to a deeper analysis. The procedure for a financial statement analysis can be compared to a medical doctor’s strategy. If your doctor has no idea about your status and cannot see any symptoms, she/ he would start the examination with a great blood count and tests you for all possible diseases. We follow a similar approach in Accounting: We prepare standard financial metrics to gain an overview. Later your doctor might have an idea about your disease and continues with further tests to support her/ his suspicion. We do the same in financials Statement analysis: We develop a hypothesis and define and calculate further ratios to verify or falsify it. <?page no="93"?> Berkau: Financial Statements 9e 5-93 As we analyse here financial statements in the Aviation industry, we introduce financial statement analysis based on industry specific ratios for the fictional company CAPELIFT Ltd. which is the case study for the entire chapter (5). 5.4 Situational Awareness about the Industry A financial statement analysis can be initiated by different situations. The intention of the analyst drives the financial statement analysis strategy. One of the most common situations is that the analyst intends to support a decision about buying company shares. Others could be to find a suitable employer, or to check a potential business partner. As we assume to run a financial statement analysis as a potential buyer, we apply standard performance metrics e.g., return figures. Later we investigate the reasons for high or low performance and prepare industry specific metrics. For a deeper financial statement analysis, we calculate metrics linked to the Aviation industry as required for the case study CAPELIFT (Pty) Ltd. To analyse for what reasons the company is high or low performing, we calculate subordinated metrics. Digging into supporting ratios is termed drill-down technique in Reporting 29 . E.g., in Aviation the on-time-performance rate (on time departures divided by the number cycles (= Landing and taking-off)) is an important key figure to measure whether a flight's actual time of departure (push-back time) is 29 see our textbook Management Accounting, chapter (17). within a 15 min tolerance measured against the schedule. Airlines check their on-time-performance because their customers' satisfaction depends on their flight’s punctuality. Delays in departure occur for several reasons, which must be investigated further. Delays happen if the ramp work is slow, if the aircraft comes in late, if the crew is not ready, if preflight checks are not completed on time, if the aircraft has write-ups, if the air traffic controller does not give push-back/ taxi clearance etc. Therefore, further metrics are created to monitor an airlines performance. Note, in an Accounting textbook we cannot discuss one industry’s specific ratios and their calculations. Therefore, we discuss basics of financial statement analysis. Next, we discuss how metrics are interlinked and how a hypothesis driven financial statement analysis works. We analyse the fictional manufacturer ROSENDAHL Ltd. 5.5 C/ S ROSENDAHL Ltd. ROSENDAHL Ltd. is a production firm for sneakers. We know already that the company is low performing. We show which combination of metrics point to the situation and how to find a strategy to improve the performance. Read about ROSENDAHL Ltd. following the Link 5.A below. <?page no="94"?> Berkau: Financial Statements 9e 5-94 Link 5.A: ROSENDAHL Ltd. The case of ROSENDAHL Ltd. demonstrates how the full picture helps to derive the right conclusions from a set of single metrics and to initiate changes in the business model. As in medicine, the findings must not contradict each other. If they do, the hypothesis needs to be adjusted. 5.6 Steps of F/ S Analysis For a structured financial statement analysis, we follow the procedure below: (1) Defining information requirements. (2) Formal checks. (3) Horizontal analysis. (4) Vertical analysis. (5) Ratio analysis. (_) Industry specific, hypothesis driven analysis of financial statements. 5.7 Defining Information Requirements Our information needs determine financial statement analysis procedures. There can be several reasons for a financial statement analysis, as explained above. We pretend that we derive our information needs from an investment decision. Investors are interested in the longterm performance and the potential of a company to generate cash flows. 5.8 Formal Checking At the beginning, we check whether we got the right financial statements from a reliable source. As analysts, we are usually not employed by the company, and our first source of information are the financial statements. Frequently, we find financial statement analysis results from other experts who share their findings with the industry. Nowadays, we also can consult AI to gain a first impression about a company’s situation. Keep in mind that financial statement analysis is an interpretation of financial ratios, but not a neutral examination. Therefore, caution is required when relying on results from others, especially if their intentions are unknown. For the correctness of financial statements, we check the auditors’ opinion. Only if the auditors confirm the financial statements’ correctness, we analyse them. Correctness means that the financial statements are conform with the IFRSs. They must include a remark about applied Accounting standards. IAS 1.16 states “An entity whose financial statements comply with IFRSs shall make an explicit and unreserved statement of such compliance in the notes […]”. Financial statements prepared in accordance with other (national) GAAPs require different ratios or adjustments to metrics. E.g., financial statements prepared in Germany require amendments for the consideration of accruals or different asset valuations. <?page no="95"?> Berkau: Financial Statements 9e 5-95 5.9 Horizontal Analysis A horizontal analysis provides information about the development of metrics in a company e.g., revenue history. For interpretation, we consider the common situation in the industry. There might be general developments, e.g., a financial crisis or market/ technology changes which explain ratio behaviour but also the company’s position in a volatile environment. For the revenue interpretation, it is important whether the whole industry is affected, or a competitor is increasing its market share. 5.10 Vertical Analysis A vertical analysis determines proportion ratios. E.g., it tells us how much inventory a manufacturer carries as a percentage of its total assets. For the interpretation of a vertical analysis, we need normative information. However, we do not intend following general rules as can be found in some Finance textbooks. We always strive for a thorough understanding of the business model to decide ourselves whether a metric indicates a good or a bad situation. For illustration of a vertical analysis, we think of a pie diagram. E.g., it shows how much labour a company pays as a percentage of its total of expenses, which might be a valuable information if the company plans to relocate manufacturing facilities to a location where labour costs less. 5.11 Basics of Ratio Analysis Items on financial statements provide already useful information. The purpose of financial statements according to IAS 1.9 is: “[…] to provide information about the financial position, financial performance and the cash flows of an entity that is useful for a wide range of users in making economic decisions. […].” The balance sheet reflects the financial position. The statement of profit or loss and other comprehensive income indicates the performance and how much thereof is repetitive and how much is extraordinary. The statement of cash flows shows the total cash flow and single cash flows from operations, from investing and from financing activities. Many information needs are satisfied by the financial statements already without us calculating new ratios. However, for specific information purpose, we develop metrics by a combination of data derived from various statements, e.g., data from the balance sheet and the income statement for the calculation of return ratios. Ratio analysis is based on comparisons. We assess companies for rankings, direct comparison or for finding a company that fulfils specific criteria. Ratios measure performance, liquidity, capital structure or market value. We follow these information categories for a structure of our ratio-based analysis. Companies cannot be compared directly because their sizes disturb a meaningfulness conclusion of comparisons. Although the statement of profit <?page no="96"?> Berkau: Financial Statements 9e 5-96 or loss and other comprehensive income tells us about the financial performance, their size matters for interpretation. A 3,000-employee-consulting firm obviously earns a higher profit than a start-up consultant operating as freelancer from home and alone. To compare firms which are different in size, we calculate ratios that factor in the size of the business. E.g., the net profit as a percentage of sales indicates how much a company earns per currency unit received. Here, the sales factor in the company size. We check the companies A, B, C and D below and receive the data as depicted in Figure 5.1. Company Gross profit Sales GP/ Sales A 200,000.00 848,000.00 23.58% B 300,000.00 1,252,000.00 23.96% C* 500,000.00 1,927,500.00 25.94% D 350,000.00 1,468,400.00 23.84% Figure 5.1: Company data Information for gross profits and sales come from income statements. The gross profit indicates how much of revenue is left after deduction of material expenses. This is left for business processes, like production, administration, product design and profit earning. The sales in figure 5.1 represent cash received from customers A, B, C, D, and measure the business size. Which company performs best? Only if we calculate a ratio like the gross profit as percentage of sales, we can answer this question. Therefore, we divide gross profits by revenues in the right column in Figure 5.1. For every 100 EUR received, company A earns a gross profit of 23.58 EUR, company B: 23.96 EUR, company C: 25.94 EUR and company D: 23.84 EUR. Hence, the best performer is company C. The ratio profit as percentage of sales measures a yield it gives us an outputover-input-ratio. It reflects the efficiency of deployed resources. Ratios are common in financial statement analysis. We can derive them from the financial statements. Some data depend on the Accounting period; others are taken from the balance sheet at a certain time. If we use a figure from profit or loss, e.g., revenue, it is related to the reporting period, usually one year. A figure from the balance sheet is valid on the balance sheet date. For the calculation of ratios as fractions with nominators/ denominators from income statements and balance sheets, we must decide about the time link of the data: (a) opening values, (b) closing values or (c) average of the above. In this textbook we follow alternative (b). There are good reasons for alternatives (a) and (c), however, we go for closing values, as it is easy to derive them from one set of financial statements. In other than teaching contexts, we recommend calculating the average from opening and closing figures. <?page no="97"?> Berkau: Financial Statements 9e 5-97 We classify metrics based on aspects they measure: - Performance ratios. - Liquidity ratios. - Capital structure ratios. - Market value ratios. 5.12 C/ S CAPELIFT (Pty) Ltd. We apply the most common ratios for the service provider CAPELIFT (Pty) Ltd. Below, we introduce the company. Data Sheet for CAPELIFT (Pty) Ltd. Domicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Aviation. Issued capital: 7,500,000 ZAR. Accounting period: 20X8. Fleet: 1 jet, 1 piston engine aircraft. Financing: bank loans; interest: 5.9 %/ a. Pilots: Freelancers. VAT rate: 20 %. CAPELIFT (Pty) Ltd. is a small Aviation firm offering charter flights. The company operates two aircrafts, a jet, and a single-piston engine aircraft. The company is based at Cape Town Int’l Airport. Both aircrafts are financed by bank loans at an interest rate of 5.9 %/ a. On its balance sheet, CAPELIFT (Pty) Ltd. discloses the issued capital of: 1,000,000 × 7.50 = 7 7,500,000 ZAR which is its ordinary share capital. CAPELIFT (Pty) Ltd. owns its aircrafts. The crew is pool of commercial licensed pilots who work on a freelancer basis. They bill CAPELIFT (Pty) Ltd. for their service per flight time and charge travel expenses for layovers. CAPELIFT (Pty) Ltd. passes the crew bills on to its customers without extra charge. CAPELIFT (Pty) Ltd.’s clients are mostly businesspeople who charter the planes for trips to small and domestic airfields. See below its financial statements for 20X8. Most of the discussed metrics are derived from the financial statements. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 60,000,000 Share capital 7,500,000 Intangibles Reserves 6,000,000 Financial assets Retained earnings 7,000,000 Current assets Liabilities (liab.) Inventory Long-term liab. 50,000,000 Acc. receivables A/ R 10,000,000 Short-term liab. A/ P 16,500,000 Prepaid expenses 2,000,000 Provisions Cash/ Bank 18,000,000 Income tax liab. 3,000,000 Total assets 90,000,000 Total equity and liab. 90,000,000 CapeLift (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 5.2: CAPELIFT (Pty) Ltd.’s balance sheet (20X8) <?page no="98"?> Berkau: Financial Statements 9e 5-98 [ZAR] Revenue 50,000,000 Other income 0 50,000,000 Materials 0 Labour (14,000,000) Depreciation (2,500,000) Other expenses (20,550,000) Earnings before int. & taxes (EBIT) 12,950,000 Interest (2,950,000) Earnings before taxes (EBT) 10,000,000 Income tax expenses (3,000,000) Deferred taxes 0 Earnings after taxes (EAT) 7,000,000 CapeLift (Pty) Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 5.3: CAPELIFT (Pty) Ltd.’s income statement (20X8) 5.13 Performance Ratios - CAPELIFT (Pty) Ltd. Financial performance measures whether a company earns money from operations. In contrast to productivity, the performance metrics are based on currency units. We express financial success in monetary equivalents received for selling goods or rendering services. Performance ratios measure the efficiency. Therefore, financial success must be related to the effort for production or service rendering. In terms of Mathematics, performance is expressed either as difference or percentage. The primary source for financial performance metrics is the income statement. It compares revenues to expenses for goods production or service rendering and the sale thereof. The profit measures an absolute financial performance already. In addition to the mere profit calculation, financial performance ratios frequently compare profit to inputs, e.g., capital, sales, or investments. We want to exclude misleading bias from performance measurement, e.g., the impact of national taxation, bank loans’ interest or dividends to owners etc. For performance comparison over various industries, we consider major differences which depend on the business model of a company. E.g., a consultancy’s input is not capital but human resources. For that reason, production firms and other capital-intensive industries disclose significant lower returns on capital than companies with a business model based on human capital, like law firms or a doctor’s clinic. Below, we introduce the most common financial performance ratios and apply them to CAPELIFT (Pty) Ltd.: <?page no="99"?> Berkau: Financial Statements 9e 5-99 - Fixed Asset Turnover. - Inventory Turnover. - Return on Capital Employed. - Return on Assets. - Return on Shareholders’ Funds. - Return as Percentage of Sales. - Earnings per Share. - Economic Value Added. Note, in this textbook, we write ratios in capital letters. Fixed Asset Turnover: The Fixed Asset Turnover measures the revenue as a percentage of noncurrent assets. The revenue is proceeds after deduction of trade rebates/ discounts, output-VAT and further selling costs, e.g., for transportation. Dividing revenues by the total of noncurrent assets tells us whether a company made good investment decisions. A Fixed Asset Turnover is difficult to read if a company offers various products/ services manufactured on the same machines. It allows to assess investment decisions ex post and supports decisions in Asset Management. The Fixed Asset Turnover is based on carrying values. A service rendered by a deployment of highly depreciated machinery earning the same sales as under deployment of new machines leads to a higher Fixed Asset Turnover. CAPELIFT (Pty) Ltd. could achieve a high Fixed Asset Turnover by deploying old aircrafts if acceptable by its customers. If not, revenues and profit decrease, and with it the Fixed Asset Turnover goes down, too. The Fixed Asset Turnover in Aviation depends on the deployment rate and load factor. A load factor is the occupation per seat capacity as a percentage. Aircrafts only earn money when airborne. Many airlines measure pure flight time as percentage of a year. The objective is to avoid time on the ground. Therefore, long haul flights give higher Fixed Asset Turnovers than domestic flights if flown with the same aircrafts. As passengers are intolerant of delays and cancellations, carriers hold transportation capacity as stand-by equipment. Hence, the total deployment rate and Fixed Asset Turnover is a traded-off between performance and the reliability of service. Stand-by resources weaken the Fixed Asset Turnover as they cause idle time. CAPELIFT (Pty) Ltd. calculates a Fixed Asset Turnover of: 50,000,000 / 60,000,000 = 8 83.33%. The performance is low, because CAPELIFT (Pty) Ltd.’s deployment rate is poor. It does not fly line, and therefore, must charge high prices for individual charter flights. Its customers expect an aircraft availability that suits their travel plans. To boost its Fixed Asset Turnover, CAPELIFT (Pty) Ltd. could replacing the fast, but expensive jet. Its Marketing department must research whether customers are prepared to accept longer and less comfortable flights for less money. We discuss further below the plans to acquire a further aircraft. Inventory Turnover: The Inventory Turnover is a performance metric mostly applicable in production firms and for retailers. It measures how often stock is virtually replaced/ sold per year. The ratio is used in Logistics to identify fast-moving and slow-moving goods. In Ac- <?page no="100"?> Berkau: Financial Statements 9e 5-100 counting, it is a performance measurement that shows how fast goods can be sold. A high Inventory Turnover indicates flexibility as it does not take long to clear stock. This matters, when goods depend on trends, e.g., in the fashion industry, or are perishable. Inventory Turnover is remarkably high where companies sell every day’s goods e.g., groceries in discounters. It becomes low for specialised companies that offer a high variety of goods to its customers, such as KaDeWe selling all sorts of chocolate brands in their Berlin’s central department store. In Accounting, the ability to sell goods quickly is seen as high performance. A company selling its goods fast pays low costs for inventory and capital. For CAPELIFT (Pty) Ltd., inventories are almost irrelevant. The company does not carry inventories for Aviation gas/ kerosene nor for spare parts as the aircrafts are maintained at a wharf in the airport vicinity. Therefore, we do not calculate an Inventory Turnover for CAPELIFT (Pty) Ltd. Return on Capital Employed: Return on Capital Employed refers to the portion of equity and long-term liabilities that is invested in the company. In contrast, short-term liabilities are not regarded as investments, and its costs of capital are usually covered by creditors. Hence, only capital the company pays for - either by dividends or by interest - falls under employed capital. To calculate capital employed, we add the total of equity and all long-term liabilities. The nominator is the pre-tax profit to keep the ratio free from income tax bias and make it comparable between various countries where different tax rates apply. CAPELIFT (Pty) Ltd.’s Return on Capital Employed is: 10,000,000 / (7,500,000 + 6,000,000 + 7,000,000 + 50,000,000) = 14.18 %. For interpretation, we must compare the Return on Capital Employed to the rate of interest in South Africa which is approximately 9 %/ a. Hence, the business model works out in comparison to interest income earned on the capital market. Return on Assets: The Return on Assets measures the profit before interest and taxes (EBIT) as a percentage of all assets at their carrying values. The denominator is the IFRS-balance sheet’s total. For the nominator, taxes and interest are not deducted to measure the full performance of a company regarding productivity or service rendering. One major problem of the Return on Assets ratio is that highly depreciated machinery increases the ratio although production/ service remains constant. An UBER driver with the same number of rides per year will increase the performance metrics only due to a value decrease caused by depreciation on the car. The Return on Assets applies in companies and groups to rank the productivity of certain plants, branches, or subsidiaries. It is free of tax and interest bias and easily to calculate. CAPELIFT (Pty) Ltd.’s Return on Assets is: 12,950,000 / 90,000,000 = 114.39%. If compared to the rate of interest, we can estimate the (pre-tax) profit margin in <?page no="101"?> Berkau: Financial Statements 9e 5-101 case the company would be financed completely by loans. Return on Shareholders’ Funds: Return on Shareholders’ Funds ROSF represents the benefit that is available to investors. The shareholders’ funds include all items of equity: issued capital, reserves and retained earnings. In contrast, the denominator of the return on equity is calculated as book value: total of assets less liabilities. Here, both calculations result in the same denominator. So far, we focussed on performance from the company’s perspective. We now take the investors’ seat. ROSF represents returns to the owners as e.g., declared dividends. To use the Return on Shareholders’ Funds as a meaningful performance metric, we must cancel out the impact of the appropriation of profits as well as of a company’s income taxes. They both are irrelevant for performance. Therefore, the ROSF is the net profit after tax (NPAT) as a percentage of total equity. The net profit after tax is revenue less all expenses, tax, and interest. NPAT also can include extraordinary income, e.g., interest income from bonds. Equity is measured before the appropriation of profits to focus on performance. The equity calculation is before dividends are deducted. The ratio could be based on actual dividends. It is not because dividends are based on profits carried forward from previous years, too. Therefore, they depend also on the performance of the past. CAPELIFT (Pty) Ltd.’s Return on Shareholders’ Funds is: 7,000,000 / (7,500,000 + 6,000,000 + 7,000,000) = 34.15%. The figure is high as the company is deep in debts and therefore only discloses low equity and is well performing significantly above the market interest rate. Return as the Percentage of Sales (Return of Sales): Return as Percentage of Sales is annual surplus as percentage of sales. It says how much earnings result from the sale of products or services. E.g., we want to know the profit an airline earns on a ticket that costs us 100 EUR (net value). A high percentage indicates the sale of innovative products and efficient sales/ service/ production procedures. It also represents a good market position of the firm. Typically, a service provider in a monopoly situation achieves a high Return as Percentage of Sales. This is not the case in highly competitive markets, like in car manufacturing, where the companies must innovate their products and allow discounts to maintain or to expand their share of the market. The net profit as percentage of sales is usually related to earnings from operations only. Taxation and interest do not affect the Return as a Percentage of Sales. The Return as Percentage of Sales (or Return on Sales ROS) for CAPELIFT (Pty) Ltd. is: 7,000,000 / 50,000,000 = 1 14%. This means the airline earns an annual surplus of 14 ZAR for every 100 ZAR received from its customers paying for tickets or charter. <?page no="102"?> Berkau: Financial Statements 9e 5-102 Earnings per Share: Earnings per Share EPS is the only ratio subjected to a standardisation by IFRSs. The standard setter dedicated IAS 33 to EPS. We discuss Earnings per Share as a performance measurement. Performance should not be biased by dividends. Once we factor in the decision about dividends, the ratio will no longer measure performance. Therefore, EPS is earnings for a full dividend that is payable to ordinary shareholders by the number of ordinary shares. In contrast to dividend calculations, it does not include profits carried forward but only counts earnings from the actual Accounting period. IAS 33.10 defines the EPS calculations. Some items are deducted before earnings become distributable to ordinary shareholders: (a) preference dividends and (b) in Germany, additions to legal reserves, compare with IAS 33.14. IAS 33.12 rules the calculation of earnings: The amount that is distributable to the ordinary shareholders is divided by the number of ordinary shares based on IAS 33.19. Changes in the number of shares during the Accounting period with or without payment/ receipts are ruled by the calculations following IAS 33.26 - IAS 33.29. CAPELIFT (Pty) Ltd. is based on 1,000,000 ordinary shares. Its earnings are 7,000,000 ZAR which results in Earnings per Share ratio of: 7,000,000 / 1,000,000 = 7 7 ZAR/ share. The Earnings per Share ratio is mostly known from the denominator for the Price-Earnings ratio that compares the 30 Economic Value Added is a trademark of Steward Stern Management Services. market share price of shares to the earnings per share. For EPS calculations follow the link below. Link 5.B: EPS calculations Economic Value Added TM : The Economic Value Added is the increase of the company’s value due to its earnings. 30 For Economic Value Added (EVA) calculation, the net operating profit after taxes NOPAT is compared to the difference between assets and short-term liabilities, multiplied by Weighted Average Cost of Capital WACC. The WACC is disclosed as percentage. Note, that in contrast to the ROSF we now refer to the NOPAT, which is based on operating profits, extraordinary income and expenses do not matter. The difference between assets and short-term liabilities represents the capital employed by the investors. Short-term liabilities are deducted as financed by creditors. By multiplying the capital employed by the WACC, we determine the profit that can be earned with an alternative investment under consideration of actual interest and cost of equity. It is further multiplied by a tax shield, see below. EVA compares net operating profits to its <?page no="103"?> Berkau: Financial Statements 9e 5-103 opportunity costs. The result is a difference of how much the company’s value increases over an alternative investment on the capital market. It is measured in a currency unit and considers a tax shield, which means for this textbook, the capital employed must be multiplied by the WACC and the factor (1 - 30%). The latter one is called tax shield and considers that the opportunity costs represent taxable income. For CAPELIFT (Pty) Ltd. the Weighted Average Costs of Capital require calculating the average bank loan’s rate of interest. The absolute interest payments are derived from the income statement and divided by interest bearing liabilities to determine the interest rate. The pay-off portion of the bank loan for the next Accounting period is disclosed as accounts payables but is subjected to interest payments, too. We assume the pay-off for the bank loan is 5 %/ a which matches with a useful life of 20 years for aircrafts. Hence, the bank loan finances the aircraft over their entire useful life (assumption). Therefore, interest payments are divided by: (1 + 5%) × 50,000,000 = 52,500,000 ZAR. The rate of interest is: 2,950,000 / 52,500,000 = 5 5.62%/ a. We expect a dividend claim from shareholders of 10 %/ a and calculate WACC as: [10% × (7,500,000 + 6,000,000 + 7,000,000) + 5.62% × 52,500,000] / 73,000,000 = 6 6.85%/ a. The EVA compares the net operating profit to the interest income that could be earned on the capital market. To compare the figures, we multiply the calculated WACC rate by the tax shield. 31 Study our textbook Basics of Accounting for liquidations and disposal, chapter (34) and (35). The Economic Value Added is: 7,000,000 - 6.85% × (1 - 30%) × (90,000,000 - 16,500,000 - 3,000,000) = 3 3,619,525 ZAR. The company increased in value by 3.62 million ZAR in comparison to an investment on the capital market. 5.14 Liquidity Ratios - CAPELIFT (Pty) Ltd. Liquidity is the ability to transform assets into an easily convertible form, preferably into cash. Liquidity ratios tell us how quick a company’s assets can be “sold”. In general, to exchange long-term assets, like machines or land, takes more time and effort than cash or money in a bank account which is liquid already. The sequence of liquidity matters for the ratio calculations below. By liquidating a company, we convert all assets to cash which is used to retire the debts. 31 Liquidity ratios tell us how quick cash can be generated by selling assets to repay liabilities. We distinguish the liquidity ratios below: - Current Ratio. - Quick Ratio. - Cash Ratio. - Debtors’ Collection Days. Current Ratio: The Current Ratio is calculated as short-term assets divided by current liabilities. A current ratio of 100 % indicates that all short-term assets are financed by current liabilities. In that <?page no="104"?> Berkau: Financial Statements 9e 5-104 case, the financing of the business is not risky as non-current assets are financed by long-term liabilities or equity and short-term assets by current liabilities. At CAPELIFT (Pty) Ltd., the Current Ratio is: 30,000,000 / 19,500,000 = 1 153.85%. The Current Ratio proves that CAPELIFT (Pty) Ltd. has enough current assets to pay-off short-term liabilities. As the value exceeds 100 %, we know that some current assets are financed by long-term funds. However, the Current Ratio does consider the long-term assets’ Financing. Quick Ratio: In contrast to the Current Ratio, the Quick Ratio only includes current assets that can be sold on short notice. We assume that inventories and prepayments are not easily convertible into cash and exclude (deduct) them from current assets in the nominator of the Quick Ratio. This gives current assets less inventories less prepayments divided by short-term liabilities. A Quick Ratio of 100 % means that the easily to liquidate assets cover short-term debts. A company then can repay its short-term liabilities on short notice. At CAPELIFT (Pty) Ltd., the Quick Ratio is: 28,000,000 / 19,500,000 = 1 143.59%. Hence, the quickly sellable current assets are sufficient for paying-off shortterm liabilities. Cash Ratio: The Cash Ratio is a further step into the direction of short-term liquidations. It tells us how much cash and cash equivalents can pay-off the liabilities within a few banking days. A Cash Ratio of 100 % means the company holds the short-term liabilities on cash or in a bank account. This indicates a high liquidity. However, in that situation is no need to finance the business because funds are available. At CAPELIFT (Pty) Ltd., the Cash Ratio is: 18,000,000 / 19,500,000 = 9 92.31%. The percentage is still high and indicates that CAPELIFT (Pty) Ltd. holds a sufficient portion of cash. Good liquidity is required in Aviation to cover costs for labour, fuel and maintenance, lay-overs, and airport landing fees. A high liquidity is not per se a good indicator as there is a trade-off between liquidity and performance. Liquidity reserves are not available for financing business operations and therefore weaken the performance and return ratios. Debtors’ Collection Days: The receivables are considered for liquidity, but they are difficult to collect on short notice. Therefore, the debtors’ collection days are relevant for liquidity. They consider the average time span for debt collection. The ratio Debtors’ collection Days divides the (total of receivables × 365) by credit sales. The Debtors’ Collection Days depend on the industry. We assume that at CAPELIFT (Pty) Ltd., half of the customers pay on cash, and <?page no="105"?> Berkau: Financial Statements 9e 5-105 the others do later. This gives Debtors’ Collection Days of: 10,000,000 × 365 / 25,000,000 = 1 146 days. In other words, it takes the debtors on average: 146/ 365 = 4 40 % of the year to pay for their bills. This means that 40 % of sales on credit are currently carried as receivables on the balance sheet. This is not good in a country where a market rate of interest of 9 %/ a applies, because CAPELIFT (Pty) Ltd. finances the receivables for almost five months. 5.15 Capital Structure Ratios - CAPELIFT (Pty) Ltd. We can derive the capital structure straight from the statement of financial position. On its credit side, we see where the company’s funds originate from: We see whether the company is financed by equity or liabilities. For liabilities, we further need to know the payment terms and strive for classification of debts into long-term and short-term liabilities. In general, we prefer a financing structure with long-term assets being financed by long-term debts and shortterm assets being financed by shortterm funds. In contrast, it is risky to finance long-term assets you depend on by funds that can be reclaimed on short notice. When we analyse debts for companies that report in accordance with IFRSs, we consider that long-term liabilities are disclosed at fair values or at amortised costs. For amortised cost calculation, we determine the liability’s value by the effective interest method, smoothing out volatilities. We can assume the values applied for disclosure on the balance sheet reflect the true and fair values for debts. However, it is required compounding liabilities and making payments for them, like interest and pay-off. Short-term liabilities are disclosed at settlement values by default. We discuss below only some common ratios out of many gearing ratios because they all provide the same or similar information about capital structures. Note, the capital structure is called gearing. This expression is related to the leverage effect and based on a transmission like in a gearbox. We analyse the capital structure for considerations about the leverage effect and for financing/ investing decisions. We cover: - Debt-to-Equity ratio D2E. - Working Capital. - Interest Coverage. Debt-to-Equity Ratio: The Debt-to-Equity ratio is the relationship between liabilities and the total of equity. We divide liabilities by equity. At CAPELIFT (Pty) Ltd., the Debt-to-Equity (D2E) ratio is: (90,000,000 - 20,500,000) / 20,500,000 = 3 3.39 or we say it is 339 %. It indicates high indebtedness which is expectable in a capitalintensive industry. We check the coverage of long-term assets based on the capital structure. CAPELIFT (Pty) Ltd. holds long-term funds which is partly equity and longterm debts resulting from bank loan financing in total of: 7,500,000 + <?page no="106"?> Berkau: Financial Statements 9e 5-106 6,000,000 + 50,000,000 = 6 63,500,000 ZAR to finance its property, plant and equipment carried at 60,000,000 ZAR. We consider the coverage rate as sufficient to ensure the ability to keep up the business operations. Note, for the calculations, we omit retained earnings as they are subjected to claims of the owners. In Accounting and Finance, the leverage effect applies. 32 Based on the leverage effect, the Return on Shareholders’ Funds can increase solely from excessive borrowing if the Return on Assets exceeds the costs of capital. The effect focusses on the Return on Equity. Therefore, its formula describes the effect best if based on gearing: The formula for the ROE is: ROE = ROA + D2E × (ROA i); therein is: ROA Return on Assets, as EBIT divided by the total of assets, D2E the Debt-to- Equity ratio and i is the (average) rate of interest for long-term loans. A company that is in debts can increase its Return on Equity by higher gearing, given that the Return on Assets exceeds the interest. The leverage effect works in both ways: It amplifies the Return on Equity in a positive as well as in a negative direction. The leverage effect is relevant for investment decisions if business growth needs financing. We prepared the calculation of returns for CAPELIFT (Pty) Ltd. in case it acquires a further aircraft to expand its fleet which is fully loan financed. Follow the QR-code 32 Find a detailed description of the leverage effect and the explanation of its formulas in our Management Accounting textbook, chapter (7). below in Link 5.C for further considerations about the airline. Link 5.C: CAPELIFT (Pty) Ltd. Working Capital: Working Capital is an absolute asset metric and is measured in currency units. It originates from Finance and is the difference between short-term assets and short-term liabilities. In Finance, the Working Capital represents funds required for running the business operations other those for investments. A company needs funds to start and maintain its business operations, e.g., to pay for material and merchandise goods, and for the coverage of receivables when clients are offered convenient (late) payment terms. On the other side (of the balance sheet), if suppliers offer purchases on credit, they reduce the financing needs. Therefore, short-term liabilities are deducted for the calculation of the Working Capital. 33 CAPELIFT (Pty) Ltd. discloses a Working Capital that consists of receivables, prepaid expenses, cash/ bank less shortterm liabilities (without the long-term debts’ pay-off portion) and tax liabilities. As per 31.12.20X8, its Working Capital is: 10,000,000 + 2,000,000 + 18,000,000 33 Running a consignment stock reduces Working Capital but it usually comes with higher purchase prices for the goods. <?page no="107"?> Berkau: Financial Statements 9e 5-107 - (16,500,000 - 2,500,000) - 3,000,000 = 113,000,000 ZAR. In general, companies try to keep their Working Capital low. They strive for low inventories and holding as less cash as possible. As mentioned above, in Aviation several payments are due at the time of and before flights. Therefore, companies need high Working Capital. Interest Coverage: Interest Coverage measures how much the net profit before interest can cover interest (expenses). The calculation is: EBIT divided by interest. The Interest Coverage at CAPELIFT (Pty) Ltd. is: 12,950,000 / 2,950,000 = 4 4.39. The value is low and indicates that CAPELIFT (Pty) Ltd. is financed to a high extent. In contrast to the other metrics for gearing, Interest Coverage considers the costs for borrowing. If inverted and multiplied with 365 the Interest Coverage indicates how many days per year it takes to pay interest out of the profit. At CAPELIFT (Pty) Ltd. it takes: 365 / 4.39 = 83.14 days. This means, the company works from 1 st of January until 22 nd of March for its banks. 5.16 Market Value Ratios - CAPELIFT (Pty) Ltd. We only can calculate market value ratios for companies that are publicly listed. Then, the share market price is accessible to the public and can be compared to a valuation derived from the books. The below listed market value ratios apply: - Price/ Earnings Ratio. - Dividend Yield. - Market Book Ratio. No fair market value is available for CAPELIFT (Pty) Ltd. as its shares are not publicly traded. However, for teaching purpose, we pretend in this textbook that its shares are traded at 15 ZAR/ share at the time of reporting (31.12.20X8). We also pretend that CAPELIFT (Pty) Ltd. declares a dividend of 50 % of its earnings in 20X8. Price Earnings Ratio P/ E: The Price Earnings Ratio compares the fair market price of a share to the Earnings per Share. Hence, we calculate the market price paid for a share divided by its annual and fully distributable income. As we divide the market price by the EPS, the Price Earnings Ratio gives the number of periods it takes to break even - given that the company always declares a dividend of 100 % and the time value of money is ignored. At CAPELIFT (Pty) Ltd., the Price Earnings Ratio is: 25 / (7,000,000 / 1,000,000) = 3.57. Hence, an investor must wait four years before she/ he breaks even with her/ his shares by potentially received dividend proceeds. The Price-Earnings- Ratio is used for company comparisons and tells us about the investors’ confidence in the profitability potential of the reporting company. Dividend Yield: The dividend yield is the declared/ paid dividend divided by the fair market price per share. It is an efficiencybased metric that shows the return on <?page no="108"?> Berkau: Financial Statements 9e 5-108 investment from the investors’ perspective. Note, we must weaken the above statement to the wording “it is a kind of efficiency ratio” as the payment for the shares only can be assumed to be at the actual share market price. At CAPELIFT (Pty) Ltd. the Dividend Yield is: (7,000,000 / 2) / (25 × 1,000,000) = 14%. Market Book Ratio: The Market Book Ratio of a share determines the fair market value as a percentage of its book value. The Market Book Value reflects the confidence of potential investors in the company to increase the shareholders’ value as they are prepared to overpay shares in comparison to their book value. The book value would be suitable in a situation where an entire company is bought with the intention to liquidate it at fair values. In general, the Market Book Value exceeds 100 % as its economic benefits should exceed its liquidation proceeds. At CAPELIFT (Pty) Ltd., the Market Book Value is: 25 / ((7,500,000 + 6,000,000 + 7,000,000) / 1,000,000) = 1 121.95%. 5.17 Summary We introduced the basics of the Financial Statement Analysis for companies that prepare their financial statements in compliance with IFRSs. The Financial Statement Analysis should only be conducted if we can trust on the correctness of financial statements, preferably based on Audits. The Financial Statement Analysis contains a horizontal analysis, a vertical analysis, and a ratio analysis. Most common financial ratios are linked to performance, liquidity, and gearing. For listed companies, market value ratios apply. A financial statement analysis requires profound knowledge about the industry the company operates in. We demonstrated a financial statement analysis for a small service provider in Aviation. The case is fictional and is discussed to prepare you for a real financial statement analysis of an existing airline. 5.18 Working Definitions Financial Statement Analysis: Evaluation of a company based on its financial statements. Liquidity: Ability of a company to retire its debts on short notice. For paying-off liabilities, assets are sold. Market Value Ratios: Ratios that compare the share price of a company with Accounting data derived from financial statements. A market value ratio tells the investor whether the share price is valuable. Performance: Ability of a company to be productive regarding goods manufacturing or rendering of services. Ratio: In Accounting, a ratio is a figure calculated from values taken from financial statements. 5.19 Question Bank (1) A company discloses a Return on Assets of 20 %. The equity is 100,000 EUR and the liabilities are 120,000 EUR. 1. The gross profit is 44,000 EUR. 2. The net profit is 44,000 EUR. <?page no="109"?> Berkau: Financial Statements 9e 5-109 3. The net profit is 30,800 EUR. 4. The net profit is 20,000 EUR. (2) A company discloses inventories of 40,000 EUR, receivables of 10,000 EUR and a balancing figure of cash/ bank of 20,000 EUR. The short-term liabilities are amounting to 50,000 EUR. Which statement is correct? 1. The cash ratio is 29 %. 2. The current ratio is 60 %. 3. The quick ratio is 60 %. 4. The cash ratio is 40 %. (3) A company shows 40 % liabilities at an interest rate of 4 %/ a and 60 % of equity. Its shareholders expect a return of 10 %. How much are the weighted average cost of capital? 1. 7.0 % . 2. 7.6 % . 3. 4.0 % . 4. 6.4 % . (4) A company with 10,000 ordinary shareholders and 5,000 preference shareholders earns a pre-tax profit of 25,000 EUR. It declares a dividend of 50 % of the distributable amount to its ordinary shareholders. The preference dividend is 5,000 EUR. How much are its Earnings per Share if all shares have the same nominal value? 1. 1.50 EUR . 2. 1.25 EUR . 3. 0.70 EUR . 4. 0.63 EUR . (5) A company earns an operating profit before taxes of 100,000 EUR. The weighted average costs of capital are 5 %/ a. The assets are amounting to 1,000,000 EUR and the short-term liabilities are 400,000 EUR. How much is the Economic Value Added? 1. 70,000 EUR . 2. 49,000 EUR . 3. 40,000 EUR . 4. 50,000 EUR . 5.20 Solutions 1-2, 2-4, 3-2, 4-4, 5-2. <?page no="110"?> Berkau: Financial Statements 9e 6-110 6 Formal Financial Statement Requirements 6.1 What is in the Chapter? This chapter covers formal aspects of financial statements following IAS 1. We show how to present a full set of financial statements. This now includes the notes. We use the case study BATHURST Ltd. in Australia for demonstration purpose. The company is a car rental based on shares. BATHURST Ltd. prepares its financial statements in compliance with IFRSs. For the case study, a complete set of financial statements is prepared for the 2nd Accounting period after the company’s establishment. We also introduce Bookkeeping entries following the effective interest method for the bank loan disclosure. In comparison to other case studies in this textbook, the case study BATHURST Ltd. is more complex and requires more detailed explanation, e.g., for its opening values. For teaching purpose, we consider that BATHURST Ltd. makes a loss in its first Accounting period and reports a negative cash flow. Its negative balancing figure of the Cash/ Bank account must be disclosed as short-term liability. To explain the difference of revenues to extraordinary income, we make BATHURST Ltd. buy bonds and earn interest income from its coupons which is obviously not the core business for a car rental shop. The chapter starts with an introduction to qualitative characteristics of IFRSs financial statements following 34 Study legal aspects of Accounting in our textbook Basics of Accounting, chapter (4). the regulations of the framework and IAS 1. 6.2 Learning Objectives In this chapter, you learn about formal requirements for the presentation of financial statements. After studying this chapter, you are familiarised with the framework and IAS 1 and you can prepare financial statements formally correct. 34 6.3 IFRSs Consistency IAS 1.16 requires that a company preparing financial statements following IFRSs makes an unreserved and explicit statement on its notes about their IFRS compliance. Check Figure 6.8 for the notes of BATHURST Ltd. For general-purpose financial statements, a company must at least annually prepare and publish a full set of financial statements. General-purpose financial statements are statements a company usually prepares at the end of every year. No special occasions, like mergers or liquidations, trigger the reporting of general-purpose financial statements. In accordance with our conventions in chapter (1), generalpurpose financial statements are prepared at yearends. Special circumstances can require reporting financial statements more frequently, e.g., listing at the New York Stock Exchange requires companies to prepare financial statements quarterly. <?page no="111"?> Berkau: Financial Statements 9e 6-111 IAS 1.36 rules the frequency of reporting. It also stipulates how to prepare financial statements in cases the Accounting period is shorter, e.g., if the establishment of the company takes place in the middle of a fiscal year. In compliance with IAS 1.10, a full set of financial statements comprises of a statement of financial position (balance sheet), a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows and the notes. The notes describe the applied Accounting policies and provide explanatory information about certain items on the financial statements. Based on IAS 1.38 and IAS 1.38A, financial statements must disclose comparative information about the preceding year. If a company changes its Accounting policies or parameters thereof, e.g., it alters its depreciation method, it must prepare a further balance sheet as per balance sheet date two Accounting periods prior to the actual balance sheet day, which results in the company presenting in total three balances sheets, see IAS 1.40A. 6.4 Qualitative Characteristics of Financial Statements IFRS Financial statements follow the Accounting principles as listed below: (a) Faithful representation (IAS 1.15). (b) Going concern principle (IAS 1.25). (c) Accrual basis of Accounting (IAS 1.27). (d) Materiality and aggregation (IAS 1.29). (e) Prohibition of offsetting (IAS 1.32). (f) Comparability by consistency of presentation (IAS 1.45). These principles will be discussed below. Ad (a): Faithful Representation The dominant principle for international Accounting is fair presentation. IAS 1.9 defines that the objective of financial statements is to provide information useful to a wide range of users to support their economic decisions. No user group should be prioritised. This is different to the status of creditors following the German HGB. Information provided by financial statements is financial position, profitability, and cash flows of a company. To serve the needs of all users of financial statements, a company shall not bias information. IAS 1.15 states the fair presentation requires the faithful representation following the conceptual framework’s definitions and recognition criteria for assets, liabilities, income, and expenses. F OC12 (conceptual framework for financial reporting) states that information must be complete, neutral, and free from errors. Ad (b): Going Concern Based on the going concern principle of Accounting, the user of financial statements must be able to trust the reporting company to continue its operations for the near future. A company must be able to continue its business if not stated otherwise. If the management of the reporting company does not intend or cannot continue its business or sees significant uncertainties in <?page no="112"?> Berkau: Financial Statements 9e 6-112 doing so, it must disclose these circumstances and prepare its financial statements under the disclosure of liquidation values. Ad (c): Accrual Basis of Accounting Accounting theory sees the purpose of financial statements in informing users about the financial performance of the reporting company. This requires income and expenses to be allocated to the Accounting periods they belong to. The accrual basis of Accounting is required by F 44 (conceptual framework for financial reporting) and states that, under this principle, allocations are to be made towards the Accounting periods they are for and not as cash or its equivalent is paid or received. See IAS 1.27 and F OB17. Note, a cash flow statement naturally cannot follow the accrual basis of Accounting as it follows cash payments and receipts. In contrast to the statement of cash flows, the income statement always applies the accrual principle. This leads among other aspects to the disclosure of prepaid expenses and to the recording of depreciation on assets etc. Ad (d): Materiality and Aggregation Materiality in terms of Accounting refers to information importance. IAS 1.29 requires items to be presented separately unless the items are immaterial for the Accounting objectives. If items are not material the reporting company shall not omit them but can disclose them together with other ones. Ad (e): Prohibition of Offsetting IAS 1.32 prohibits offsetting except it is explicitly permitted by a standard. Note, offsetting refers to the deduction of negative amounts from positive ones and disclosure of the remainder only. We do so when considering depreciation on assets or paying-off liabilities. Then we deduct the pay-off amount from the liabilities and disclose the resulting debts. Offsetting payables and receivables is unacceptable under the above-mentioned standard. One exception is the disclosure of VAT receivables and payables based on inputand output- VAT entries as we apply one VAT account only. Ad (f): Comparability by Consistency of Presentation IAS 1.45 requires continuing applied presentation formats, classifications of items and valuation methods over the time. The standard rules that changes are only accepted if the company needs items to be presented differently to provide better information which is more reliable and more relevant to users of the financial statements and if the revised structure is likely to be continued in the future. Financial statements must follow identification requirements in line with IAS 1.49. The standard determines a statement header, and which information is disclosed thereon. Following IAS 1.51, the header must identify the statement and show the name of the reporting company, the date/ period of the statement, its reporting currency, and the <?page no="113"?> Berkau: Financial Statements 9e 6-113 level of precision (rounding). For single-entity financial statements, the name of the reporting company must be disclosed together with its legal form, e.g., KIELING Taxi GmbH. The legal form disclosure indicates that the financial statements are no group statements. 6.5 C/ S BATHURST Ltd. Below, we study the car rental business BATHURST Ltd. in Melbourne. The company prepares a full set of financial statements which includes its notes for a two-year-Accounting period. The reporting period for the financial statements is 20X6; we cover the period from 1.01.20X5 until 31.12.20X6. The statements from 20X5 are disclosed for comparison purpose. Data sheet for BATHURST Ltd. Domicile: Australia (Melbourne). Reporting currency: AUD. Classification: Service provider. Reporting periods: 20X5 / 20X6. Share issue: 50,000 × 6 AUD/ share on 1.01.20X4. Financing: bank loan 150,000 AUD; interest rate 2.5 %/ a. Assets: three cars purchased at 65,000 AUD/ car; annual depreciation 15,000 AUD/ car; residual value per car: 5,000 AUD/ car; office: 150,000 AUD; depreciation on office: 12,500 AUD/ a. Volume (output): 850 car-days / 980 cardays. Net rental revenue (price) per car: 156 AUD/ (d × car) / 195 AUD/ (d × car). Operational expenses: 48,000 AUD / 65,000 AUD (non-VATable). Bonds held from (2.01.20X6): face value of all bonds: 200,000 AUD; coupon rate 4 %/ a (annual payments) VAT rate: 20 %. BATHURST Ltd. is based on 50,000 ordinary outstanding shares at 6 AUD/ share each. Its share capital is: 50,000 × 6 = 300,000 AUD. BATHURST Ltd. is a car rental. The company was established on 1.01.20X4. At the beginning of 20X5 (one year later), BATHURST Ltd. owns three cars Mercedes-Benz C-class. Every car is one year old at that time. Depreciation is calculated following straightline method over four years, the residual value at the end of the useful life is 5,000 AUD/ car. Costs of acquisition are 65,000 AUD/ car. From the cars’ acquisition, BATHURST Ltd. discloses on 31.12.20X4 an input-VAT claim of: 3 × 20% × 65,000 = 339,000 AUD. The VAT receivables are disclosed on the balance sheet in Figure 6.1. BATHURST Ltd. runs its rental business from an office acquired at 150,000 AUD. No VAT applies for the acquisition of buildings. For the sake of simplicity, we ignore acquisition tax. Depreciation is calculated following straight-line method over a useful life of twelve years. As per 1.01.20X5, the company has depreciated its office to the extent of: 150,000 / 12 = 1 12,500 AUD. To finance the office, BATHURST Ltd. took out a bank loan on 1.01.20X4 with a principal of 150,000 AUD. The annual rate of interest is 2.5 %/ a. Each year, BATHURST Ltd. repays a constant amount of 15,000 AUD/ a. On 1.01.20X5, the outstanding loan balance is amounting to: 150,000 - 15,000 = 1135,000 AUD. On the balance sheet, the bank loan is disclosed with 120,000 AUD interest bearing liabilities and 15,000 AUD short-term liabilities, the latter amount is for the pay-off in the next year (31.12.20X5). IAS 1.60 about <?page no="114"?> Berkau: Financial Statements 9e 6-114 the separate disclosure of long-term and short-term liabilities applies. Note, a separation of short-term and long-term assets and liabilities serves the information needs of readers of financial statements. Frequently, short-term assets are inventory, which can be reduced easily by a cease of order activities whereas the liquidation of non-current assets becomes more complicated. Long-term liabilities require disclosure at present values or at amortised costs to consider the time value of money concept. In contrast, we show short-term liabilities at their settlement value. Figure 6.1 displays BATHURST Ltd.’s proforma balance sheet as per 1.01.20X5. BATHURST Ltd.'s business operations commence on 1.01.20X5. Before, the company only made acquisitions and disclosed a loss of 61,250 AUD caused by depreciation on the office to the extent of 12,500 AUD, depreciation on the three cars 45,000 AUD and by interest for the bank loan. The interest is amounting to: 2.5% × 150,000 = 33,750 AUD. Therefore, the loss is: 12,500 + 45,000 + 3,750 = 6 61,250 AUD and gets is carried forward to 20X5. This is the balancing figure of Retained Earnings account as shown on the balance sheet as equity. Losses that are not compensated by dissolving reserves are disclosed as negative retained earnings. Note, in contrast to German Accounting, we do not disclose a profit or loss carried forward by a separate item on the balance sheet. The amounts remain in retained earnings and are disclosed as such on the balance sheet. Detailed information about the calculation of the opening values on the balance sheet and the application of the effective interest method (see below) for the bank loan disclosure can be downloaded through Link 6.A. At BATHURST Ltd., the effective rate of interest is 2.5 %/ a. The nominal rate of interest equals the effective rate as the loan is redeemed at its principal’s value and annual interest payments apply. A simple method to determine the effective rate of interest is to calculate the internal rate of return for the loan vector. We use the MS-Excel function IRR() for the calculation of the effective rate of interest. The payment vector for the loan is BL(t) = {150,000; (18,750); (18,375); (18,000); (17,625); (17,250); (16,875); (16,500); (16,125); (15,750); (15,375)}. Its internal rate of return gives: IRR(BL(t)) = 2 2.5%/ a. Link 6.A: BATHURST Ltd. <?page no="115"?> Berkau: Financial Statements 9e 6-115 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 287,500 Share capital 300,000 Intangibles Reserves Financial assets Retained earnings (61,250) Current assets Liabilities (liab.) Inventory Long-term liab. 120,000 Accounts receivables 39,000 Short-term liab. A/ P 15,000 Prepaid expenses Provisions Cash/ Bank 47,250 Income tax liab. Total assets 373,750 Total equity and liab. 373,750 Bathurst Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X5 Figure 6.1: BATHURST Ltd.’s balance sheet (20X4) Next, we discuss the business activities in 20X5: BATHURST Ltd. receives a VAT refund from the Australian revenue service of 39,000 AUD. This is recorded as Bookkeeping entry (1). We do not include all Bookkeeping entries for this case study in the text. The ID-numbers serve as reference for the T-accounts disclosed in Figure 6.2. BATHURST Ltd. rents out its cars at a rate of 156 AUD/ d (net value). During the Accounting period 20X5, its output measured in number of car-days-rentouts is 850. BATHURST Ltd.’s revenue is: 850 × 156 = 1 132,600 AUD. The proceeds are paid in full and recorded as Bookkeeping entry (2). Note, in German there is no translation for proceeds. Proceeds is the gross value for the revenues and therefore represents cash receipts resulting from selling goods or services. Operational expenses in 20X5 are 48,000 AUD and recorded as Bookkeeping entry (3). The operational costs are non-VATable. BATHURST Ltd. pays for operational expenses on cash and in full. The interest calculation for the bank loan is based on the outstanding loan balance as per 1.01.20X5 because BATHURST Ltd. pays for interest and pay-off at the yearends. On 1.01.20X5, the company owes the bank: 120,000 + 15,000 = 1 135,000 AUD. In accordance with IFRS 9, the effective interest method applies for interest calculations. Interest is: 2.5% × 135,000 = 3 3,375 AUD. We make a debit entry in the Interest account and credit cash/ bank. This gives Bookkeeping entry (4). The following paragraphs discuss the calculations and Bookkeeping entries for the effective interest method. Note, the effective rate of interest is calculated for the comparison of loan offers and factors in all additional payments like fees and premiums as well as compound interest calculations for payments made during the year, e.g., monthly payments. The effective interest rate exceeds the nominal rate of interest. <?page no="116"?> Berkau: Financial Statements 9e 6-116 In compliance with IFRSs, BATHURST Ltd. recognises the bank loan as liability and applies the effective interest method for loan valuation. This does not affect the need to separate short-term from long-term liabilities based on IAS 1.60. For BATHURST Ltd.’s loan the effective interest rate is 2.5 %/ a, which is equal to the nominal rate. In cases when effective interest differs from the nominal interest rate, interest recognised through profit and loss deviates from payment made for interest. Therefore, two separate Bookkeeping entries are required. At BATHURST Ltd. and for 20X5, the interest expense is: 135,000 × 2.5% = 3 3,375 AUD. The interest payment to the bank in 20X5 is: (150,000 - 15,000) × 2.5% = 33,375 AUD. For applying the effective interest method, we make two Bookkeeping entries for interest, the first one is for the interest expense and linked to the income statement and the second one refers to the payment and therefore is cash flow relevant. If both interest rates are the same, we can simplify the journal entry and debit the Interest account and make a credit entry in cash/ bank. @ 31.12.20X5 Interest-20X5 INT 3,375 Interest Bearing Liabilities IBL 3,375 (interest recognition) Interst Bearing Liabilities IBL 3,375 Cash/ Bank C/ B 3,375 (recording interest payment) Next, we record adjustments. At BATHURST Ltd., they comprise of the repay for the bank loan and depreciation on the office and the three cars. The loan’s pay-off in the next following year is again 15,000 AUD/ a and must be classified as short-term liability. The payments to the bank reduce short-term liabilities as we debit the Short-term Liability account and credit cash/ bank. Observe the pay-off Bookkeeping entry in 20X5 which is indicated by the three-letter-codes linked to the contra accounts (C/ B and A/ P). After the payment, the loan’s pay-off for 20X6 is accrued to the Short-term Liabilities account by a Bookkeeping entry marked as (A/ P and IBL). As the pay-off payments at BATHURST Ltd. are constant, a combination of the latter Bookkeeping entries is possible, however, for an annuity they would differ as the interest portion diminishes and pay-off payments increase due to payments being constant over the time. Note, in business and management annuities are frequently in use as their calculation is easy because of the application of annuity factors and liquidity planning get simplified as the same payments are made every year. This increases predictability of cash flows. Next, we discuss depreciation. In 20X5 and in 20X6, depreciation on the cars is 15,000 AUD/ (a × car). The cars’ total annual depreciation charge is: 3 × 15,000 = 45,000 AUD/ a. All depreciation in 20X5 is recorded as Bookkeeping entries marked as ACC and DPR. Depreciation on the office is 12,500 AUD/ a and is recorded as a further <?page no="117"?> Berkau: Financial Statements 9e 6-117 Bookkeeping entry in 20X5 which is marked as ACC and DPR, too. Note, that with an Asset Management in use a company will apply an Accumulated Depreciation on Car account and an Accumulated Depreciation on Office account. Note, Asset Management follows an account structure where for each asset one asset account and one accumulated depreciation account is in use. This is standard procedure. The same ACC code should not indicate different accounts, probably a company would use ACc and ACo for abbreviation, one for each car and another one for the office. Next, we calculate BATHURST Ltd.’s profit. The pre-tax profit marked as EBT (for earnings before income taxation) in 20X5 is: 132,600 - 45,000 - 12,500 - 3,375 - 48,000 = 2 23,725 AUD. After tax reduction a profit of: (1 - 30%) × 23,725 = 116,607.50 AUD remains and is transferred to retained earnings (R/ E). Observe all accounts in Figure 6.2, in particular study the Profit and Loss-20X5 P5L account. D C D C OV 345,000 c/ d 345,000 OV 57,500 b/ d 345,000 DPR 45,000 c/ d 115,000 DPR 12,500 115,000 115,000 b/ d 115,000 Property, plant and equipment PPE Acc depr ACC D C D C A/ P 15,000 OV 120,000 C/ B 15,000 OV 15,000 c/ d 105,000 c/ d 15,000 IBL 15,000 120,000 120,000 30,000 30,000 b/ d 105,000 b/ d 15,000 Interest bearing liabilities IBL Short-term liabilities A/ P D C D C ACC 45,000 P5L 57,500 (4) 3,375 P5L 3,375 ACC 12,500 57,500 57,500 Depreciation-20X5 DPR Interest-20X5 INT D C D C P5L 132,600 (2) 132,600 OV 39,000 (1) 39,000 c/ d 26,520 (2) 26,520 65,520 65,520 b/ d 26,520 Revenue-20X5 REV Value added tax VAT Figure 6.2: BATHURST Ltd.’s accounts (20X5) <?page no="118"?> Berkau: Financial Statements 9e 6-118 D C D C OV 47,250 (3) 48,000 (3) 48,000 P5L 48,000 (1) 39,000 (4) 3,375 (2) 159,120 A/ P 15,000 c/ d 178,995 245,370 245,370 b/ d 178,995 Cash/ Bank C/ B Operational expenses-20X5 OEX D C D C DPR 57,500 REV 132,600 c/ d 7,118 ITL 7,118 INT 3,375 b/ d 7,118 OEX 48,000 EBT 23,725 132,600 132,600 ITL 7,118 b/ d 23,725 R/ E 16,608 23,725 23,725 Profit and Loss-20X5 P5L Income tax liabilities ITL D C D C OV 61,250 P5L 16,608 c/ d 300,000 OV 300,000 c/ d 44,643 b/ d 300,000 61,250 61,250 b/ d 44,643 Retained earnings R/ E Share capital ISS Figure 6.2: BATHURST Ltd.’s accounts (20X5) - continued Below, the recordings for 20X6 are discussed. BATHURST Ltd. pays income tax liabilities by Bookkeeping entry (A) and VAT liabilities as (B). The revenue from renting out cars for 980 days is recognised as: 980 × 195 = 191,100 AUD (net value) through profit and loss. In 20X6, the price per daily rent increased to 195 AUD/ (d × car). Now, only 55 % of the proceeds are received on cash - the remainder is expected to be received in the next year on cash and, therefore, it is recorded under receivables. Observe Bookkeeping entry (C) which debits a portion of proceeds to receivables. Proceeds are gross values, hence, the receivables recorded are amounting to: 191,100 × 120% × (1 - 55%) = 1 103,194 AUD. Operational expenses in 20X6 increase too and now are amounting to 65,000 AUD. Operations are recorded as Bookkeeping entry (D) and are non- VATable. BATHURST Ltd. pays all operational expenses instantly and on cash. To make its cash reserves earn interest BATHURST Ltd. buys bonds for 200,000 <?page no="119"?> Berkau: Financial Statements 9e 6-119 AUD 35 with an annual coupon rate of 4 %/ a on 2.01.20X6 - recorded as Bookkeeping entry (E). BATHURST Ltd. is the bondholder. No transaction costs on acquisition apply based on the conventions of this textbook. The bonds earn an interest income of: 200,000 × 4% = 8,000 AUD. We record the gain on the credit side of the Interest Income account (CPN for Coupon) as Bookkeeping entry (F). The interest income generated by the bonds counts as other income as it is not linked to the core business of the company. As BATHURST Ltd.'s investment in the bonds causes an overdraft of its bank account, it must disclose the balancing figure of its Cash/ Bank account as short-term liability on the balance sheet to the extent of 3,516.50 AUD. 36 The interest expenses for the loan in 20X6 as paid to the bank are: (105,000 + 15,000) × 2.5% = 3 3,000 AUD. Its calculation is based on the outstanding loan balance as per 1.01.20X6 and includes short-term and long-term liability portions. Interest is recorded as Bookkeeping entry (G). Next, we discuss the adjustments as recorded on 31.12.20X6. At BATHURST Ltd., the adjustments consider the pay-off payments for the bank loan and recognition of depreciation. The loan repayment is deducted from short-term liabilities to the extent of 15,000 AUD, see the Bookkeeping entry marked as (C/ B and A/ P). Again, the payoff payment for 20X7 is reclassified and transferred from the Interest Bearing Liabilities account to short-term liabilities, see the Bookkeeping entry marked as (A/ P and IBL). IBL stands for interest bearing liabilities; these are long-term liabilities. Depreciation on cars remains 45,000 AUD/ a and depreciation on the office is 12,500 AUD/ a. Observe the profit calculation at BATHURST Ltd. in the Profit and Loss- 20X6 account as disclosed in Figure 6.3. Based on the profit calculation, BATHURST Ltd.’s owners declare a dividend of 0.10 AUD/ share. The financial statements are prepared under the appropriation of profits and disclose a dividend payable to shareholders of: 50,000 × 0.10 = 5 5,000 AUD as a shortterm liability. As the face value per share is 6 AUD/ share the number of outstanding shares is: 300,000 / 6 = 5 50,000 shares. We need to know the total of shares to calculate the dividend value for all shareholders. We show BATHURST Ltd.’s accounts as at 31.12.20X6 in Figure 6.3. 35 Learn about bonds in the case study KILDARE Ltd. and regarding the bond holder Bill Elmwood in our textbook Basics of Accounting, chapter (15). 36 Study our textbook Basics of Accounting, chapter (37). <?page no="120"?> Berkau: Financial Statements 9e 6-120 D C D C OV 345,000 c/ d 345,000 OV 57,500 b/ d 345,000 DPR 45,000 c/ d 115,000 DPR 12,500 115,000 115,000 b/ d 115,000 (D) 45,000 c/ d 172,500 (E) 12,500 172,500 172,500 b/ d 172,500 D C D C A/ P 15,000 OV 120,000 C/ B 15,000 OV 15,000 c/ d 105,000 c/ d 15,000 IBL 15,000 120,000 120,000 30,000 30,000 A/ P 15,000 b/ d 105,000 C/ B 15,000 b/ d 15,000 c/ d 90,000 c/ d 15,000 IBL 15,000 105,000 105,000 30,000 30,000 b/ d 90,000 b/ d 15,000 Interest bearing liabilities IBL Short-term liabilities A/ P Property, plant, equipment PPE Acc depr ACC D C D C ACC 45,000 P6L 57,500 (G) 3,000 P6L 3,000 ACC 12,500 57,500 57,500 Depreciation-20X6 DPR Interest-20X6 INT D C D C P6L 191,100 (C) 191,100 OV 39,000 (1) 39,000 c/ d 26,520 (2) 26,520 65,520 65,520 (B) 26,520 b/ d 26,520 c/ d 38,220 (C) 38,220 64,740 64,740 b/ d 38,220 Revenue-20X6 REV Value added tax VAT Figure 6.3: BATHURST Ltd.’s accounts (20X6) <?page no="121"?> Berkau: Financial Statements 9e 6-121 D C D C OV 47,250 (3) 48,000 (D) 65,000 P6L 65,000 (1) 39,000 (4) 3,375 (2) 159,120 A/ P 15,000 c/ d 178,995 245,370 245,370 b/ d 178,995 (A) 7,118 (C) 126,126 (B) 26,520 (F) 8,000 (D) 65,000 (E) 200,000 (G) 3,000 ´c/ d 3,517 A/ P 15,000 316,638 316,638 b/ d 3,517 Cash/ Bank C/ B Operational expenses-20X6 OEX D C D C DPR 57,500 REV 191,100 c/ d 7,118 P5L 7,118 INT 3,000 CPN 8,000 (A) 7,118 b/ d 7,118 OEX 65,000 c/ d 22,080 P6L 22,080 EBT 73,600 29,198 29,198 199,100 199,100 b/ d 22,080 ITL 22,080 b/ d 73,600 R/ E 51,520 73,600 73,600 Profit and loss-20X6 P6L Income tax liabilities ITL D C D C OV 61,250 P5L 16,608 c/ d 5,000 R/ E 5,000 c/ d 44,643 b/ d 5,000 61,250 61,250 b/ d 44,643 P6L 51,520 DIV 5,000 c/ d 1,878 51,520 51,520 b/ d 1,878 Retained earnings R/ E Dividends/ p DIV Figure 6.3: BATHURST Ltd.’s accounts (20X6) continued <?page no="122"?> Berkau: Financial Statements 9e 6-122 D C D C (E) 200,000 c/ d 200,000 P6L 8,000 (F) 8,000 b/ d 200,000 D C D C (C) 103,194 c/ d 103,194 c/ d 300,000 OV 300,000 b/ d 103,194 b/ d 300,000 Financial instruments FIN Interest income-20X6 CPN Accounts receivables A/ R Share capital ISS Figure 6.3: BATHURST Ltd.’s accounts (20X6) continued Next, we prepare the annual financial statements for the reporting period 20X6. IAS 1.38 dictates to prepare financial statements with disclosure of a column for comparative figures (last period). We do not do that in this textbook for layout reasons. Instead, we disclose two separate sets of financial statements, one is for the reporting period and the other one for the purpose of comparison. An exception are the financial statements for BATHURST Ltd. in this chapter. For BATHURST Ltd., all commercial financial statements are discussed in detail below: (1) Statement of financial position. (2) Statement of profit of loss and other comprehensive income. (3) Statement of changes in equity. (4) Statement of cash flows. (5) Notes. 37 Read in the Conceptual Framework for Financial Reporting: F 4.8 - 4.14. 38 Read in the Conceptual Framework for Financial Reporting: F 15 - F 19. 6.6 Statement of Financial Position - BATHURST Ltd. The statement of financial position is the balance sheet. In F 4.4, the IASB defines the elements of financial position as assets, liabilities, and equity. Definitions for the elements are given as: - An asset is a resource controlled by the company as result of past events. From assets future economic benefits are expected to flow to the company. 37 An asset differs from the German term Vermögensgegenstand on a German balance sheet (HGB-Bilanz) with regard to the recognition criteria. - A liability is a present obligation of the company arising from past events the settlement of which is expected to result in an outflow of resources embodying economic benefits. 38 Liabilities include provisions. - Equity is the residual value in assets after deduction of all liabilities. 39 39 Read in the Conceptual Framework for Financial Reporting: F 20 - F 23. <?page no="123"?> Berkau: Financial Statements 9e 6-123 At BATHURST Ltd., the book value of the company is 301,877.50 AUD as per 31.12.20X6. This results in a share’s book value of: 301,877.50 / 50,000 = 6.04 AUD/ share. The book value per share exceeds the face value only by 0.04 AUD/ share; this is caused by not earning revenues in 20X4 (to keep the case study simple). Hence, BATHURST Ltd. carries a loss from the first year forward to 20X5. On the balance sheet, the loss carried forward reduces at first the distributable amount. Its retained earnings are disclosed after deduction of dividends: 51,520 - 44,642.50 - 5,000 = 1,877.50 AUD BATHURST Ltd. prepares the balance sheet as shown in Figure 6.4 for 20X6. A 20X6 20X5 20X6 20X5 C, L Non-current assets [AUD] [AUD] Equity [AUD] [AUD] P, P, E 172,500 230,000 Share capital 300,000 300,000 Intangibles Reserves Financial assets 200,000 Retained earnings 1,878 (44,643) Current assets Liabilities (liab.) Inventory Long-term liab. 90,000 105,000 Accounts receivables 103,194 Short-term liab. A/ P 61,737 41,520 Prepaid expenses Provisions Cash/ Bank 0 178,995 Income tax liab. 22,080 7,118 Total assets 475,694 408,995 Total equity and liab. 475,694 408,995 Bathurst Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X6 Figure 6.4: BATHURST Ltd.’s balance sheet (20X6) In line with IAS 1.51, BATHURST Ltd.’s must clearly identify its financial statements, here: statement of financial position. The disclosure of the name (BATHURST Ltd.) indicates whether the balance sheet is a single-entity financial statement, a separate financial statement (IAS 27), or a group statement. The legal form (here: Ltd.) refers to a company, so the financial statement is for a single entity, here BATHURST Ltd. The header also reveals the balance sheetdate (31.12.20X6), indicates the reporting currency (AUD for Australian Dollars) and marks the rounding level, here to the next full Australian Dollar. The formal requirements for the statement of financial position are laid out in IAS 1.54. BATHURST Ltd.’s financial statements disclose all required items of assets, liabilities, and equity. IAS 1.60 requires reporting companies to disclose current and non-currents assets and liabilities separately. BATHURST Ltd. shows long-term assets under non-current assets. This applies for cars and property. Current assets are the items cash/ bank and receivables. No single values for items of assets show on the balance sheet but are disclosed in the notes on a register of non-current assets (see below). Regarding liabilities, the separation is more differentiated as the bank loan contains a short-term portion (the pay-off for the next year) as <?page no="124"?> Berkau: Financial Statements 9e 6-124 well as a long-term portion. IAS 1.69 covers the distinction of liabilities. In contrast to short-term liabilities, long-term debts must be disclosed at amortised costs following the effective interest method for recognition as required by IFRS 9.5.3.1 and IFRS 9.4.2.1. Bank loans are kept until settlement which supports their valuation at amortised costs. At amortised costs means the liability is compounded by the effective rate of interest and all payments made must be deducted. In chapter (14) we get back to the case study BATHURST Ltd. and then discuss payments during the year and fee consideration. This will cause a difference between effective interest rate and nominal interest rate. In this chapter, we consider equal rates to simplify the case study. As per 31.12.20X6, BATHURST Ltd. discloses long-term liabilities resulting from the bank loan of 90,000 AUD and shortterm liabilities of 15,000 AUD; the latter ones are due on 31.12.20X7. Here, short-term liabilities are recorded as accounts payables (A/ P) and include the short-term bank loan’s pay-off payment, VAT liabilities and dividend claims from the shareholders. Also, the bank account overdraft counts as a short-term liability which results from BATHURST Ltd.’s bond acquisition. The income tax liabilities require extra disclosure following IAS 1.54 in combination with IAS 12 on the balance sheet. That item only shows liabilities from income taxes. No VAT liabilities are reported under this item. VAT payables are disclosed as short-term liabilities A/ P (see above). BATHURST Ltd.’s equity is calculated by deduction of all liabilities from the total of assets and gives: 372,500 + 103,194 - 90,000 - 61,736.50 - 22,080 = 301,887.50 AUD. It includes the issued capital from ordinary shares and retained earnings. 6.7 Statement of Profit or Loss - BATHURST Ltd. The statement of profit or loss and other comprehensive income provides information about the profitability resulting from general revenues and from other income. 40 In general, other income is not linked to the business model of the company. The term extraordinary applies if a gain results from exceptional situations. Various income can cause the application of different income tax rates. BATHURST Ltd. discloses the statement of profit or loss and other comprehensive income for 20X6 as depicted in Figure 6.5. 40 IAS 1.81A - IAS 1.105 specify the disclosure of profit or loss and other comprehensive income. <?page no="125"?> Berkau: Financial Statements 9e 6-125 20X6 20X5 [AUD] [AUD] Revenue 191,100 132,600 Other income 8,000 0 199,100 132,600 Depreciation (57,500) (57,500) Other expenses (65,000) (48,000) Earnings before int. & taxes (EBIT) 76,600 27,100 Interest (3,000) (3,375) Earnings before taxes (EBT) 73,600 23,725 Income tax expenses (22,080) (7,118) Earnings after taxes (EAT) 51,520 16,608 Bathurst Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X6 Figure 6.5: BATHURST Ltd.’s income statement (20X6) With application of IFRSs, it is common to show revenue and other income as positive figures and expenses as negative. The (DR)CR-format applies. Figures in brackets are negative. BATHURST Ltd. discloses revenues from renting out cars separately to interest income from its bonds, based on IAS 1.82. BATHURST Ltd.’s income adds up to 199,100 AUD in 20X6. The expenses are depreciation and other expenses, which represent business operations only. An income statement does not show all single items of expenses; it follows IAS 1.82. The disclosure on the financial statements is less in the details as the Bookkeeping records. A company is free to prepare the income statement along the nature of expenses method (IAS 1.102) or based on the cost of sales format (IAS 1.103). 41 Note, that special disclosure rules apply for the cost 41 Study our textbook Basics of Accounting, chapter (28). of sales format to provide the reader of financial statements with further information about the categories of expenses. E.g., by disclosing the cost of goods sold a company does not show cost categories like labour, materials, or depreciation. Therefore, the reporting company must give detailed information about its expense structure on its notes to enable users of financial statements to estimate the impact of, e.g., salary increases, on profitability. It is widespread practice to disclose earnings before interest and taxes EBIT as separate line item. This supports the calculation of return ratios. IAS 1.82 requires the explicit disclosure of finance costs which is shown for BATHURST Ltd. as interest item. It refers here to the loan financing. After deduction of income taxes as calculated based on national tax law and following the 30% textbook <?page no="126"?> Berkau: Financial Statements 9e 6-126 simplification, the annual surplus is disclosed on the bottom line under earnings after taxation EAT. 6.8 Statement of Changes in Equity - BATHURST Ltd. In compliance with IAS 1.106, equity changes either by profit or loss, by other comprehensive income or by transactions with the owners. The latter one refers to share issues/ redemptions or dividend declarations. The standard requires companies to prepare a statement of changes in equity, which shows columns for equity items and lines at the beginning and end of the year as well as for changes of equity during the Accounting period, see IAS 1.108 and IAS 1.109. In Figure 6.6, we present BATHURST Ltd.’s statement of changes in equity for the time span from 20X5 to 20X6. Share capital Reserves Retained earnings total [AUD] [AUD] [AUD] [AUD] as at 1.01.20X5 300,000 (61,250) 238,750 Profit 20X5 (EAT) 16,608 16,608 as at 31.12.20X5 300,000 0 (44,643) 255,358 Profit 20X6 (EAT) 51,520 51,520 Dividend 20X6 (5,000) (5,000) as at 31.12.20X6 300,000 0 1,878 301,878 Bathurst Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X6 Figure 6.6: BATHURST Ltd.’s statement of changes in equity (20X5/ 20X6) BATHURST Ltd. equity changes with profits earned in 20X5 and 20X6 as well as by dividends declared for 20X6. The statement of changes in equity records how the book value of the company changes due to profit or loss and transactions with owners. As BATHURST Ltd. recorded other comprehensive income through profit and loss the statement of changes in equity also includes the interest income which increases retained earnings. As an alternative, other comprehensive income and other expenses can be disclosed in a statement separated from the income statement, which is less common. It requires the disclosure of one statement of profit or loss and another one for the gains from other income. 6.9 Statement of Cash Flows - BATHURST Ltd. Cash flow statements are required by IAS 1.10 and as laid out in IAS 1.111; IAS 7 covers the calculation and the disclosure of cash payments and receipts. In contrast to German HGB, a cash flow statement is mandatory following IFRSs. In Germany (HGB), only companies participating in the <?page no="127"?> Berkau: Financial Statements 9e 6-127 capital market prepare cash flow statements. 20X6 20X6 20X5 20X5 [AUD] [AUD] [AUD] [AUD] Cash flow from operating acitivities Proceeds 126,126 159,120 Payment for operations (65,000) (48,000) Income tax payment (7,118) VAT payment (26,520) 39,000 27,489 150,120 Cash flow from investing activities Bond investment (200,000) 0 (200,000) 0 Cash flow from financing activities Coupon received 8,000 Interest paid (3,000) (3,375) Pay-off bank loan (15,000) (15,000) (10,000) (18,375) Total cash flow (182,512) 131,745 Bathurst Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X6 Figure 6.7: BATHURST Ltd.’s statement of cash flows (20X6) The statement of cash flows discloses comparative information from 20X5, too. The cash flow statement classifies cash flows in those caused by operating, investing, and financing activities, see IAS 7.10. 42 For the cash flows from operations, a company either applies the direct method or reconciles it with its earnings after taxes. Both methods comply with IAS 7.18. 43 For the sake of simplification, BATHURST Ltd. calculates its operating cash flow 42 IAS 7.14 gives examples of cash flows from operations. IAS 7.16 lists cash flows from investing activities and IAS 7.17 shows examples for financial cash flows. based on the direct method. The reconciliation method is discussed in chapter (10). Following the direct method, a reporting company derives the operating cash flows from its Cash/ Bank account. 44 Interest earned as well as paid are considered as cash flows from financing activities in accordance with IAS 7.33. This follows the conventions laid out in chapter (1) - an interest disclosure as operational cash flow is possible under IFRSs, too. Interest paid for the bank loan and received from the bonds are reported separately, see IAS 7.31. Offsetting is prohibited. 43 Study our textbook Basics of Accounting, chapter (32). 44 The reconciliation method is discussed in chapter (10) in detail. <?page no="128"?> Berkau: Financial Statements 9e 6-128 Dividend payments are classified as financial cash flow following IAS 7.34, because they are initiated by the share issue which is financing the business. The payments for income taxes fall under operating cash flows which is consistent with IAS 7.35. 6.10 Notes - BATHURST Ltd. In comparison to the attachment based on German Accounting, notes are a more detailed description of Accounting policies. IAS 1.112 requires the notes to provide information about the basis of financial statements and the applied Accounting policies. Furthermore, notes show information required by IFRSs that is not disclosed in other financial statements, e.g., a register of non-current assets. IAS 1.113 states that notes must be presented in a systematic manner to make them understandable and comparable. Frequently, the financial statements contain references to the notes - this works like footnotes. All reporting companies prepare notes under IFRSs. The notes belong to a full set of financial statements. BATHURST Ltd. prepares its notes linked to the items below: (a) Accounting policies. (b) Equity. (c) Non-current interest bearing liabilities. (d) Tangible assets. (e) Inventory. (f) Tax liabilities. (g) Dividends. (h) Revenue. (i) Expenses. BATHURST Ltd.’s notes are related to the financial statements as per 31.12.20X6 and are depicted in Figure 6.8. Bathurst Ltd. NOTES to FINANCIAL STATEMENTS as at 31.12.20X6 (a) Accounting Policy These annual financial statements are prepared in accordance with IFRSs and the Company’s Act in Australia. (IAS 1.16) The international standards below apply: - IAS 1, - IAS 7, - IAS 12, - IAS 16, - IAS 32, - IFRS 7, - IFRS 9, - IFRS 13, - IFRS 15. <?page no="129"?> Berkau: Financial Statements 9e 6-129 The company was established on 2.01.20X4 in the legal form of a limited company (Ltd.) under Australian law. Its balance sheet date is 31.12. BATHURST Ltd. is registered for VAT reduction. The board of directors as at 31.12.20X6 is: - Chief executive officer (CEO), chair: Peter Lansfield (holding 10,000 ordinary shares) - Chief financial officer (CFO): Patricia Glenroy (holding 5,000 ordinary shares) - Chief operations officer (COO): Hank McKay (holding 6,000 ordinary shares) The independent Australian Auditing firm SAFETRUST Ltd. has audited the financial statements on 5.02.20X7. The statement of auditors discloses that in their opinion, the financial statements present fairly, in all material respects, the financial position of BATHURST Ltd. as of 31 December 20X6, and its financial performance and cash flows for the year then ended in accordance with International Financial Reporting Standards and the requirements of the company’s act in Australia. The Accounting period 20X6 started on 1.01.20X6 and ended on 31.12.20X6. Comparative information is given for the fiscal year 20X5 as per 31.12.20X5. The financial statements are prepared on historical cost basis. Tangible assets are valued at cost less accumulated depreciation. Depreciation method is straight-line method for tangible assets. Liabilities are reported on amortised cost basis applying the effective interest method in compliance with IFRS 9. (b) Equity Issued capital: BATHURST Ltd. was established on 2.01.20X3 by a par value share issue of 50,000 ordinary shares at 6 AUD/ share. - Authorised shares: 100,000 ordinary shares at 6 AUD/ share nominal amount - Issued shares: 50,000 ordinary shares at 6 AUD/ share nominal amount Reserves: - Capital reserves: n/ a. - Earnings reserves: n/ a. - Revaluation reserves: n/ a. Retained earnings: Retained earnings result from the valuation of liabilities and annual surplus of prior Accounting periods. <?page no="130"?> Berkau: Financial Statements 9e 6-130 (c) Interest bearing liabilities The interest bearings liabilities result from a bank loan with COMMONWEALTH BANK. The bank loan is a mortgage with a nominal, annual rate of interest of 2.5 %/ a. The principal is 150,000 AUD. The annual pay-off amount is 15,000 AUD/ a. The bank loan is secured by the office building, as separate title property, located in 3141 Melbourne, 193 Toorak Rd. The bank loan recognition is based on amortised costs. The effective interest method applies. The present value of the loan is: 105,000 AUD. The short-term liability portion therein is 15,000 AUD. The settlement amount for the bank loan is: 105,000 AUD. There are no further bank loans. (d) Tangible assets Tangible assets are one office, separate titled in an office block and three cars, type of Mercedes-Benz C-class. The office was conveyed into Bathurst Ltd.’s ownership on 5.01.20X4. The address is 193 Toorak Rd, 3141 Melbourne. The floor size of the office is 47 m 2 . The purchase price plus cost of conveyance (total costs of acquisition) are 150,000 AUD. The office is financed by a bank loan (mortgage) of 150,000 AUD. Depreciation on the building is based on straight line method and is amounting to 12,500 AUD/ a. The cars are disclosed on a register of non-current assets as a group of cars. The cars have been purchased at 65,000 AUD/ car on 2.01.20X4. The residual value of the cars is estimated to be: 3 × 5,000 = 1 15,000 AUD. Depreciation applies over a useful life period of four years based on straight-line method. Depreciation charges on motor vehicles are 15,000 AUD/ (a × car). Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount Office (Toorak Rd, Melbourne) 150,000 (37,500) 0 112,500 Cars 3 Mercedes-Benz C-class 195,000 (135,000) 0 60,000 Total 172,500 Bathurst Ltd. REGISTER of NON-CURRENT ASSETS as at 31.12.20X6 The reconciliation of opening values with closing amounts is disclosed on asset group levels below: <?page no="131"?> Berkau: Financial Statements 9e 6-131 Cars Office total [AUD] [AUD] [AUD] Opening value 20X5 150,000 137,500 287,500 Additions 0 Disposal 0 Depreciation (45,000) (12,500) (57,500) Impairment loss 0 Revaluations 0 Closing value 20X5 105,000 125,000 230,000 Additions 0 Disposal 0 Depreciation (45,000) (12,500) (57,500) Impairment loss 0 Revaluations 0 Closing value 20X6 60,000 112,500 172,500 Bathurst Ltd. RECONCILIATION of OPENING VALUES with CLOSING VALUES as at 31.12.20X6 (e) Inventory Bathurst Ltd. does not carry inventories as per 31.12.20X6. (f) Tax liabilities Income taxes (IAS 12) All income tax liabilities along IAS 12 are resulting from income taxes. The income taxes are based on earnings from 20X6 and are amounting to 22,080 AUD. No prepayments for income taxes have been made. The amount for income tax is due on 15.01.20X7. Income taxes are disclosed as short-term liabilities on the balance sheet and under the income tax liability item. VAT payables The revenues earned by renting out motor vehicles are VATable at a VAT rate of 20 %. The VAT payables are: 38,220 AUD. The value is net of input-VAT claims. The amount is disclosed as short-term liability under the item accounts payables A/ P. VAT payables are due on 15.01.20X7. (g) Dividends BATHURST Ltd.’s owners declared a dividend to its registered shareholders to an extent of 0.10 AUD/ share. The total of dividends is: 50,000 × 0.10 = 5 5,000 AUD. The proposed payment of dividends needs approval at the annual meeting held on 30.05.20X7. The dividend is due on 15.06.20X7. The dividend will be paid to all shareholders registered on 1.06.20X6. <?page no="132"?> Berkau: Financial Statements 9e 6-132 (h) Revenue Car rental (core business) BATHURST Ltd. earned a revenue of 191,100 AUD by renting out motor vehicles in Australia. No trade rebates/ discounts have been allowed. Receivables of 103,194 AUD result from business operations. Financial revenue An interest income of 8,000 AUD was earned from holding 2,000 bonds of Bank of Queensland. The bonds mature on 6.11.20Y9, and their nominal value is 100 AUD/ bond. The annual coupon rate is 4 %/ a. The bonds are traded at 100 AUD/ b as per 31.12.20X6. (i) Expenses Total expenses at BATHURST Ltd. are amounting to 125,125 AUD. The expense values are disclosed in detail below: - Depreciation on cars and office: 57,500 AUD. - Interest on bank loan: 3,000 AUD (effective rate of interest: 2.5 %/ a). - Operational expenses, like: labour, maintenance, cleaning: 65,000 AUD. Melbourne, in January 20X7 Peter Lansfield ______________________ (CEO - BATHURST Ltd.) Figure 6.8: BATHURST Ltd.’s notes (20X6) The notes above are in line with IAS 1. They are signed by BATHURST Ltd.’s chief executive officer (CEO), Mr P. Lansfield. 6.11 ESG-Reporting ESG abbreviates Environment, Social, and Governance. BATHURST Ltd. is not obliged to prepare an ESG report yet. Companies increasingly report about their ESG performance in addition to their financial reports. Similar as financial statements that are prepared to disclose the responsibility for the funds provided by the owners, an ESG report discloses ESG targets and achievements to show a company’s impact on the environment, its contribution to social equality and proofs due diligence. Below we show a fictive ESG report for BATHURST Ltd. prepared for 20X6 as attachment to its notes. Thereafter we discuss standardisation for ESG reports. <?page no="133"?> Berkau: Financial Statements 9e 6-133 Bathurst Ltd. ESG-Report as at 31.12.20X6 BATHURST Ltd. is a car rental in Melbourne, Australia, and voluntarily reports about its ESG performance and its objectives. It includes ESG aspects in its daily decisions. E - Environment BATHURST Ltd. is a service provider and aims to become CO2 neutral by 20Y0. It strives for the introduction of carbon accounting to control its CO2 emissions. It strives for improvement of its greenhouse gas footprint regarding scope (1) direct emissions: BATHURST Ltd. operates a paperless office where no invoices or other correspondence with its customers is printed out. The renting-out is based on a smart phone app. The car maintenance and cleaning are conducted in environmentally friendly and certified facilities and avoids waste of water and the use of aggressive cleaning chemicals. Scope (2) indirect emissions: BATHURST Ltd. will install a solar panel system and will heat from 20X8 onwards its office with solar energy produced by its own panels mounted on the roof. Scope (3) - other emissions: The fleet of the company is consequently changed to emission neutral cars. BATHURST Ltd. does not invest in piston engine driven motor vehicles in the future. After regular replacement of all cars, BATHURST Ltd. solely rents out electric cars which are charged on its own wall boxes and get fed with solar electricity. S - Social Equality BATHURST Ltd. is committed to social equality. At the time of reporting, its board members are 1/ 3 women. With its hiring procedures the company ensures that aspects of social equality and inclusion are considered when deciding about new employees joining the company. The safety and working place healthy of its offices is controlled regularly. BATHURST Ltd. assigned one board member (Mr McKay) with the task of working place security. G - Governance The corporate governance is based on risk management for the company (calculated on MonteCarloSimulations of identified and annually revised risk assessments) and the establishment of supply chains that guarantee the consideration of aspects of social equality and environmentally friendly production and service rendering. The rented-out cars are supporting e-mobility and are acquired from car manufacturers who report their ESG-performance themselves and in the future only with certified business partners. With national networking the company strives for building business cooperations with other rental companies to reduce the energy consumption on ferry rides for car returns. BATHURST Ltd. includes stakeholders by polls in their decision-making procedures. BATHURST Ltd. invests in ESC education and reports voluntarily about its ESG achievements on social media and on its notes (as an attachment named ESG report). <?page no="134"?> Berkau: Financial Statements 9e 6-134 Melbourne, in January 20X7 Peter Lansfield ______________________ (CEO - BATHURST Ltd.) Figure 6.9: ESG report BATHURST Ltd.(20X6) Consumers are nowadays interested in the environmental and social impact of the products/ services they buy and consume. Also, investors and creditors frequently check ESG reports to evaluate companies. Companies like BATHURST Ltd. report on ESG nowadays voluntarily which frequently is combined with making their own ESG efforts visible to the public. It works also as Marketing instrument which is not negative per se as it motivates the reporting companies to think about and reveal their contribution to environment friendly business models, to lessen social inequality and to improve their corporate governance. However, the actual requirements for reports bear a risk of greenwashing. With the standardisation of ESG reporting, more comparable valuations of companies become possible. ESG reports will be lifted to the level of financial reporting and become part of the management report which makes them subjected to auditing procedures. In the EU, about 50,000 companies will be required to formally prepare ESG reports. These are companies that exceed two out of three criteria for two following years: more than 250 employees, earning more than 50,000,000 EUR in revenues, and disclosing a total on the balance sheet of more than 25,000,000 EUR. For ESG reporting a double materiality count: The impact of the company on environment is termed an inside-out materiality and the impact of the environment on its finance is referred to as outside-in materiality. ESG metrics are non-financial ratios and are either quantitative or qualitative. Quantitative metrics are e.g., (E) greenhouse gas emissions, usage of energy and water, waste reduction, carbon footprint; (S) employee turnover rates, accident statistics; (G) board diversity, etc. Qualitative metrics are more difficult to compare and are e.g., (E) the climate change strategy; (S) company’s commitment to diversity, social equality and inclusion, labour practices, workplace health and safety; (G) building responsible supply chain partnerships, fair executive compensation, risk management, ethical business practice etc. Qualitative metrics give more room for interpretation and discussions. The standardisation is ruled by different organisations. We only name the most important ones here: - Global Reporting Initiative’s GRI standards <?page no="135"?> Berkau: Financial Statements 9e 6-135 - SABS standards - IFRS Sustainability Disclosure Standards (developed by IFRS Foundation and its new established ISSB International Sustainability Standards Board) The board works together with EFRAG and GRI to ensure that the standards are compatible with local regulations. So far IFRS S1 and IFRS S2 have been released. - CSRD is the European “Corporate Sustainability Reporting Directive”. It is relevant for listed and large companies in Europe. The reporting requirements are based on numerous data points which provide readers of ESG-reports with comparable information, e.g., ESRS 45 E1 about climate change comes with 276 disclosure items. The ESRS are developed by EFRAG European Financial Reporting Advisory Group. We here focus on the ISSB that published two standards IFRS S1 and IFRS S2. The first one is about general requirements for disclosure of sustainability related financial information and the second one about climate related disclosure. 6.12 Summary In this chapter, we covered the formal aspects for financial and ESG reporting. We mostly discussed implications resulting from the Framework, IAS 1 and IAS 7. We provided you with a full set of financial statements for the case study BATHURST Ltd., a car rental 45 ESRS = European Sustainability Reporting Standards business in Melbourne. The financial statements include a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows and the notes. Special disclosure aspects for loans, bank account overdrafts, other income, interest on the cash flow statement etc. have been discussed. 6.13 Working Definitions Accounting Period: The time span financial statements are prepared for. In this textbook, the Accounting period is always one year. Notes: Disclosure of Accounting policies and explanation of items on financial statements. 6.14 Question Bank (1) A company is established by a share issue of 100,000 ordinary shares at 1 EUR/ share on 10.03.20X4. It redeems 10,000 shares on 1.10.20X4. On the annual general meeting the shareholders decide about the appropriation of profits to the extent of 200,000 EUR. They decide to declare a dividend of 0.50 EUR/ share and to carry forward the rest. How much is the balance of the Retained Earnings account on their balance sheet as per 31.12.20X4? 1. 125,000 EUR . 2. 150,000 EUR . 3. 155,000 EUR . 4. 159,583 EUR . <?page no="136"?> Berkau: Financial Statements 9e 6-136 (2) On 4.07.20X3 a company takes out a bank loan (annuity) of 100,000 EUR. The rate of interest is 3 %/ a. The annuity is 10,000 EUR/ a. In the first year (20X3), the annuity is calculated per rate (consider the time of the loan issue). How much is the bank loan disclosure on the balance sheet as long-term liabilities (you must consider IAS 1.60)? 1. 85,790 EUR . 2. 96,500 EUR . 3. 93,000 EUR . 4. 89,395 EUR . (3) A company reports on its notes about other comprehensive income. It earned during the last Accounting period interest income and a profit on disposal from bonds. The bonds were bought on 1.01.20X6 at 95,000 EUR, which is at a 5 % discount. The nominal value is 100,000 EUR. On 1.07.20X6, the fair market value for the bonds is 98,000 EUR but the company managed to sell them at that day for 100,000 EUR. How much is the other comprehensive income for the period? 1. 10,000 EUR . 2. 4,500 EUR . 3. 7,500 EUR . 4. 5,250 EUR . (4) A company preparing financial statement based on IFRSs buys materials for 50,000 EUR. It consumes half thereof for manufacturing. Half of the goods, which contain the materials are sold during the Accounting period. The company prepares the income statement based on the cost of sales format. How much are the material expenses to be explained extra in the notes? 1. 50,000 EUR . 2. 12,500 EUR . 3. 25,000 EUR . 4. 0 EUR . (5) On 3.01.20X4, a company reporting financial statements following IFRSs buys a machine at a price of 120,000 EUR (gross amount). The seller offers a discount on 4.03.20X4 of 10 %. Depreciation follows diminishing balance method at 1.5 %/ m. Prepare a register of non-current assets! How much is the carrying value as per 31.12.20X5? 1. 62,620 EUR . 2. 83,493 EUR . 3. 69,578 EUR . 4. 62,406 EUR . 6.15 Solutions 1-3, 2-4, 3-3, 4-2, 5-1. <?page no="137"?> Berkau: Financial Statements 9e 7-137 7 Non-current Assets on the Balance Sheet 7.1 What is in the Chapter? This chapter discusses recognition and measurement of non-current assets, e.g., machinery, business cars, restaurant interior etc. In general, non-current assets remain in the company for more than one Accounting period. Therefore, changes in valuation, e.g., depreciation, impairment loss and revaluation matter. The chapter structure follows a life cycle model: we start off from the initial recognition of assets, then cover subsequent valuations and finally discuss disposals thereof. We focus on IAS 16 and IAS 36. IAS 16 deals with the recognition and measurement of property, plant and equipment, and IAS 36 contains regulations about impairment losses. This chapter also covers special assets, like intangible assets (IAS 38), investment property (IAS 40), leases (IFRS 16), financial instruments (IAS 32, IAS 39, IFRS 7 and IFRS 9) and capitalisation of borrowing costs (IAS 23). We discuss every aspect by single case studies. 7.2 Learning Objectives After studying this chapter, you know how to recognise and measure noncurrent assets following IFRSs. You can record non-current assets at the time of initial valuation and know whether and how to apply the cost model and revaluation model (IAS 16) for subsequent valuations. You also understand the Bookkeeping entries for selling or disposals and are aware of special aspects based on IFRS 5 for assets held for sale. You understand Accounting for leases, investment property and financial instruments. You learn in this chapter about the topics below and in the given sequence and get familiarised with the IFRSs standards thereto: (1) Initial recognition. (2) Subsequent valuation. (3) Disposal of assets. (4) Investment property and assets held for sale. (5) Intangible assets. (6) Leases. (7) Financial instruments. 7.3 Initial Recognition Based on F 4.4 (conceptual framework for financial reporting), an asset is a resource controlled by a company as result of past events and from which future economic benefits are expected. The IFRSs focus on the economic benefit rather than on legal possession. Therefore, recognition and valuation of assets depend on the expectation of economic benefit and the reliability of the measurement. F 4.8 defines a future economic benefit as the potential to contribute to the flow of cash or its equivalents into a company. This can be based on the asset’s potential to contribute to production, service rendering, administration or on its convertibility into cash. A reporting company must be able to control the asset. If a company cannot control an asset, it cannot recognise it on its balance sheet. E.g., a medical doctor who considers his patient list as a potential for future economic benefit cannot disclosed it, as doctors do not control their patients’ decisions about which <?page no="138"?> Berkau: Financial Statements 9e 7-138 doctor they visit. Neither does a good reputation or a well-known brand qualify for recognition as they and the resulting customer behaviour are out of its owner’s control. The requirement about a past event defines how the reporting company obtained possession/ access of/ to the asset and determines its valuation, e.g., an asset can get into a company’s control by acquisition, donation, leasing etc. IAS 16 further determines how to recognise assets. An asset recognition (F 4.37) means to add an item to the asset side of the balance sheet. For recognition, a company needs to know the asset’s value. At the time of initial recognition, the reporting company must be able to reliably measure an asset’s value. Above mentioned aspects lead to the recognition requirements as stated in IAS 16.7: an economic benefit must be associated with the asset, and its costs can be measured reliably. In some cases, assets are split for their recognition into single parts. This applies if an asset includes major spare parts. Those assets are recognised separately based on IAS 16.8. An airliner is usually disclosed as a set of assets, e.g., fuselage, engines, and interior even as these assets are physically mounted together by bolts, rivets etc. Different depreciation parameters can apply for components, e.g., the fuselage or the power plants. IAS 16.14 also stipulates that regular maintenance (major part inspections, checks) must be added to the airliner’s costs 46 . 46 An example for an aircraft depreciation is discussed in out textbook Basics of Accounting, chapter (17). For separate recognition, the materiality of components matters, e.g., winter tyres for a car are not recorded separately as their value is insignificant. At first, we focus on the initial asset recognition. Technically, the recognition is a Bookkeeping entry which debits the Property, Plant, Equipment and VAT account and makes credit entries in cash/ bank and/ or payables. For the measurement, IAS 16.15 states: An item of property, plant and equipment that qualifies for recognition shall be measured at costs. At costs refers to the cost of acquisition. These are defined in IAS 16.16. The paragraph identifies three cost categories for the asset valuation. We must add them for the calculation of an asset's total value. (a) Acquisition price, including import duties, non-refundable VAT, less trade discounts and rebates. (b) Directly attributable costs. (c) Cost of disposal of and dismantling the asset. 7.4 C/ S GETEN (Pty) Ltd. Find below the case study GETEN (Pty) Ltd. to study acquisition cost. Data Sheet for GETEN (Pty) Ltd. Domicile: South Africa (Gqeberha). Reporting currency: ZAR. Classification: Manufacturer. Acquisition of a stationary saw: 24,000 ZAR gross purchase price. Trade discount 5 %. VAT rate: 20 %. GETEN (Pty) Ltd. is a manufacturer and buys on 17.09.20X1 a stationary saw at <?page no="139"?> Berkau: Financial Statements 9e 7-139 a price of 24,000 ZAR. The price is the gross value and includes 20 % input- VAT. GETEN (Pty) Ltd. is registered for VAT reduction. The seller of the stationary saw offers GETEN (Pty) Ltd. a trade discount of 5 % on the saw price. A discount is a price reduction at the point of sale. If granted later, we call it a rebate. Here, the stationary saw’s price is for GETEN (Pty) Ltd.: 95% × 24,000 = 2 22,800 ZAR. The stationary saw is an item of property, plant and equipment and falls under non-current assets. Future economic benefit is expected to flow to the buyer (GETEN (Pty) Ltd.) when it deploys the saw for its production. To recognise the stationary saw, GETEN (Pty) Ltd. calculates its cost of acquisition as: (24,000/ 120%) × (1 - 5%) = 1 19,000 ZAR. The input-VAT is not included in the costs as GETEN (Pty) Ltd. acts as VAT vendor and is entitled to receive a refund for input-VAT from the revenue service. Only non-refundable taxes count as cost of acquisition. Note, as in this textbook (and in exam tasks) all companies are registered for VAT reduction according to chapter (1), VAT can never become a part of the cost of acquisition. The discount must be deducted under IAS 16.16(a), too. The costs of the stationary saw can be calculated reliably as they are derived from the paid price. We record the granted discount separately for teaching purposes as a received trade discount and make the Bookkeeping entries accordingly. The consideration of 19.000 ZAR as reduced net purchase price would simplify the recordings. 47 @ 17.09.20X1 Property, Plant, Equipment PPE 20,000 Value Added Tax VAT 4,000 Cash/ Bank C/ B 24,000 (acquisition of a saw without consideration of discount granted) Cash/ Bank C/ B 1,200 Discount Received Account DRA 1,200 (recording discount received) Discount Received Account DRA 1,200 Value Added Tax VAT 200 Property, Plant, Equipment PPE 1,000 (closing-off the Discount Received account) As the seller allows the discount at the point of sale, the Bookkeeping entry can be simplified as below: 47 Study the recording of discounts and rebates in out textbook Basics of Accounting, chapter (36). <?page no="140"?> Berkau: Financial Statements 9e 7-140 @ 17.09.20X1 Property, Plant, Equipment PPE 19,000 Value Added Tax VAT 3,800 Cash/ Bank C/ B 22,800 (acquisition of a stationary saw under consideration of a discount received) After recording the Bookkeeping entry for the saw, its initial recognition is completed, and the value of the saw as disclosed in the Property, Plant and Equipment account is 19,000 ZAR. 7.5 Qualifying Assets If an asset still requires configurations, changes, or further steps of manufacturing for its intended deployment, qualifying costs and finance costs apply and must be added to the qualified asset’s value in compliance with IAS 16.16(b). A taxi company buying a car and installing a distance meter configures the motor vehicle for its intended use as a (metered) taxi. The taxi appliance costs, e.g., the distance meter, markings, GPS, radio, installation service costs etc., are additional costs of acquisition and must be recorded as well as depreciated together with the taxi - instead of recognising them in the first Accounting period through profit or loss. They are no major spare parts either due to their minor value. Adding expenses to the cost of acquisition can apply for interest spent on financing the asset’s qualification, too. IAS 23.8 requires the reporting company to capitalise borrowing costs. IAS 23.10 defines requirements for the capitalisation of borrowing costs 48 . In contrast, other (non-specific) interest 48 Study for qualifying assets and capitalisation of interest: Berkau, C.: Kapitalisierung von Fremdkapitalkosten für das Errichten einer or costs for repairs, e.g., exhauster replacement or tyre changes, fall under regular operations and are recorded through profit or loss when they occur. 7.6 C/ S LANGDAM Bhd. For the understanding of qualifying assets, we study the case of LANGDAM Bhd. in Kuala Lumpur: Data Sheet for LANGDAM Bhd. Domicile: Malaysia (Kuala Lumpur). Reporting currency: MYR. Classification: Service provider. Acquisition of software: 340,000 MYR net purchase price. Customising costs: 100,000 MYR. VAT rate 20 %. Note, consider a currency exchange rate of the Malaysian Ringgit to the EUR at 5 MYR : 1 EUR. LANGDAM Bhd. is a consultancy based on shares in Malaysia. On 24.11.20X6, the company buys the computer software ADMACC for its order management. The net purchase price for the ADMACC software is 340,000 MYR. In addition to the software purchase, a computer specialist customises LANGDAM Bhd.’s software. Vermietungsimmobilie. In: KOR 24(2024)10, pg. 399-404. <?page no="141"?> Berkau: Financial Statements 9e 7-141 Note, customising a software means to make initial software settings and define the master data. The software specialist charges 100,000 MYR (net value). The customising service costs are directly attributable costs under IAS 16.16(b). Therefore, the initial recognition of the software ADMACC is recorded as below: @ 24.11.20X6 Property, Plant, Equipment PPE 340,000 Value Added Tax VAT 68,000 Cash/ Bank C/ B 408,000 (acquisition of ADMACC software) Property, Plant, Equipment PPE 100,000 Value Added Tax VAT 20,000 Cash/ Bank C/ B 120,000 (recognition of customizing service costs as cost of acquisition) Now, the software ADMACC is measured at: 340,000 + 100,000 = 4 440,000 MYR. This is the valuation for its initial recognition. 49 It includes qualifying costs and is the depreciation base. Assets can also be acquired based on exchanges of goods and/ or can lead to delayed payments which add an interest portion to the cost of acquisition. We do not cover these cases in the textbook but offer case study material for download. Study the special case studies accessible through Link 7.A and Link 7.B to enhance your knowledge about initial valuations. Link 7.A: RAVENWOOD GmbH Link 7.B: OTZE AG How it is Done (Initial Asset Recognition): (1) Determine the asset to be recognised. Check whether the recognition criteria are fulfilled. The asset must provide an economical benefit, and its valuation must be reliable. (2) Apply the cost model. Based on the cost model, the costs of acquisition are calculated following IAS 16.16. 49 See: IAS 16.15 - IAS 16.28. <?page no="142"?> Berkau: Financial Statements 9e 7-142 (3) A company registered for VAT reduction must deduct input-VAT from the price. (4) In case the company pays import duties, add import duties to the net value. Calculate target countryspecific input-VAT for the new gross value payable. Deduct VAT if the importing company is registered for VAT reduction at the time of recognition. (5) Deduct rebates or trade discounts received from the supplier. (6) If the seller includes an interest portion in the price, disclose interest separately. If the company capitalises borrowing costs, no separation is necessary. (7) Make a debit entry in the Property, Plant and Equipment account for the cost of acquisition, another debit entry for the input-VAT in the VAT account and credit the Cash/ Bank account or the Accounts Payables account according to the case. (8) If a separate interest component applies, make a debit entry for interest in the Interest account. 7.7 Subsequent Valuation A subsequent valuation is any valuation following the initial recognition, e.g., for depreciation, impairment loss, and revaluation. In general, a measurement determines the value an asset is carried at and disclosed on the balance sheet. It is referred to as the carrying amount of an asset. Some assets’ value does not diminish by deployment, e.g., land, hence, land is not subjected to depreciation. However, there is a possibility for revaluations due to a decrease of property prices or an impairment loss. Most assets lose value due to their deployment or obsolescence. For subsequent valuations, IAS 16.29 states that the reporting company must evaluate assets either based on the cost model or at valuation. A subsequent valuation based on the cost model in compliance with IAS 16.30 includes the initial costs of acquisition and all adjustments, such as: (a) Depreciation. (b) Impairment loss. (c) Reversal of an impairment loss. Depreciation reflects the regular deployment of an asset and the value reduction thereof. Bookkeeping entries for depreciation consider an expense on the debit side and the diminishment of the asset’s carrying value on the credit side. The best measurement for depreciation would be based on factors that directly reduce the asset’s value. E.g., depreciation on aircrafts is calculated based on the units of production method with a Hobbs meter measuring the engine running time. However, as a practical expedient, the reporting company measures depreciation based on the useful life. Note, that for this reason an asset which is not in use must be continuously depreciated. An impairment loss is an extraordinary depreciation which can be caused by <?page no="143"?> Berkau: Financial Statements 9e 7-143 overuse of assets or by accidents, e.g., by tool breakage of a production machine. The requirement to record an impairment loss is indicated by a recoverable amount falling below an asset’s carrying value (IAS 36.59). The difference between the recoverable amount (which is the lower of the fair value or the value in use) is recorded as an expense, termed impairment loss on the debit side and a credit entry in the Accumulated Impairment Loss account. Thereafter, depreciation in future periods must be adjusted towards the impaired assets carrying amount following IAS 36.63. An impairment loss can be reversed based on IAS 36.110. In those cases, the (new) recoverable amount is capped to the asset’s value that would have been recorded if no impairment loss had been recognised. If the value is higher, a revaluation must be recorded for the portion the new valuation exceeds the carrying value based on regular depreciation. A subsequent valuation based on the revaluation model in line with IAS 16.31 refers to the fair value based on: (a) Current values. (b) Net realisable values. (c) Values in use. In general, revaluations must be carried out for underrated assets. This means the fair value exceeds the carrying value. In the next section, we cover case studies about: depreciation, impairment loss and revaluations (in this sequence). 7.8 C/ S GELLENDORFF Ltd. We study depreciation and impairment loss for GELLENDORFF Ltd.’s business car. We consider an impairment loss caused by a car accident with is covered by GELLENDORFF Ltd.’s insurance company. This way, we demonstrate the recording of insurance compensations under other income. Data Sheet for GELLENDORFF Ltd. Domicile: Australia (Perth). Reporting currency: AUD. Classification: n/ a. Acquisition of a motor vehicle at 80,000 AUD with a 10 % rebate: thus, 72,000 AUD gross purchase price. Date of acquisition: 2.04.20X1. Accounting periods: 20X1 - 20X5. Depreciation: straight-line method over five years, residual value: 10,000 AUD. On 4.04.20X4: impairment loss due to an accident towards, case (i): 24,700 AUD; case (ii): 18,400 AUD. Repair: 8,400 AUD (gross amount). Evaluation after repairs: case (i) on 8.04.20X4; in case (ii): three months later 22,400 AUD) on 8.07.20X4. The residual value decreases by 2,300 AUD (case (ii) only). In both cases the insurance compensates GELLENDORFF Ltd. for the net value of the repair and the impairment loss. VAT rate: 20 %. On 2.04.20X1, GELLENDORFF Ltd. buys a business car Volkswagen ID.4 and pays a gross purchase price of 80,000 AUD. The car fulfils the recognition criteria: It provides GELLENDORFF Ltd. with future economic benefit and the price can be measured reliably. The car seller allows GELLENDORFF Ltd. a 10 % rebate one month later. The cost of acquisition is <?page no="144"?> Berkau: Financial Statements 9e 7-144 determined based on IAS 16.16 and requires a reduction for rebate consideration. 50 For the Volkswagen ID.4, the cost of acquisition is: (1 - 10%) × 80,000 / 120% = 6 60,000 AUD. As GELLENDORFF Ltd. is acting as VAT vendor, input-VAT is refundable and cannot be part of the cost of acquisition. Therefore, the car’s net value after deduction of the rebate is 72,000 AUD. If the seller would have allowed a discount instantly, the acquisition could be recognised based on the reduced price. As GELLENDORFF Ltd. receives the rebate one month after the acquisition, we record the initial purchase directly and the received rebate through a Rebate Received account, see the journal entries below. Notice, the Rebate Received account does not show in Figure 7.1 and Figure 7.2 as it is closed-off to the Property, Plant, Equipment account and the Value added Tax account in 20X1. The accounts shown are for the Accounting period 20X4 only. @ 2.04.20X1 Property, Plant, Equipment PPE 66,667 Value Added Tax VAT 13,333 Cash/ Bank C/ B 80,000 (acquisition of the business car) @ 4.05.20X1 Cash/ Bank C/ B 8,000 Rebate Received Account RRA 8,000 (receipt of 10% rebate) Rebate Received Account RRA 8,000 Property, Plant, Equipment PPE 6,667 Value Added Tax VAT 1,333 (PPE and VAT reduction according to a rebate allowed by the seller) Depreciation 51 is based on the cost of acquisition and here follows straight-line method. After the useful life of five years, the car is expected to be sold at 10,000 AUD which is the best estimate for the future net selling price. IAS 16.6 defines the residual value as the net value a company would currently obtain from an asset’s disposal. Disposal costs, e.g., car dealer commissions, must be deducted. Currently obtainable refers to the selling price for a five-year-old, comparable car that could be obtained as at today. 50 Read chapter (36) about the recording of discounts received in our textbook Basics of Accounting. After the first year, the Volkswagen ID.4 is depreciated to an extent of 75% of its annual depreciable value due to its acquisition in April. The depreciable value of an asset is the estimated loss in value over the entire useful life of five years. Following IAS 16.6, this is the cost of an asset less its residual value. Applying straight-line method, we divide the depreciable amount by the useful life to calculate the annual depreciation of: (60,000 - 10,000) / 5 = 1 10,000 AUD/ a. The recorded depreciation in 20X1 is: 75% × 10,000 = 7 7,500 AUD. 51 Study depreciation methods in our textbook Basics of Accounting, chapter (17). <?page no="145"?> Berkau: Financial Statements 9e 7-145 The journal entry for depreciation at GELLENDORFF Ltd. is shown below. Note, for IFRS Accounting, we always make credit entries in the Accumulated Depreciation account. The reason is that this allows later a recording of revaluations. @ 31.12.20X1 Depreciation-20X1 DPR 7,500 Accumulated Depreciation ACC 7,500 (recording depreciation on the business car) The carrying value of the Volkswagen ID.4 as at 31.12.20X1 is: 60,000 - 7,500 = 552,500 AUD. In the Accounting periods 20X2 and 20X3, the car is depreciated by 10,000 AUD/ a each. Its carrying value as per 1.01.20X4 is: 52,500 - 10,000 - 10,000 = 332,500 AUD. 7.9 Impairment Loss In addition to regular depreciation, an asset’s value can suddenly drop due to an extraordinary event. An unexpected loss in valuation is referred to as impairment loss. This is an expense. Any impairment loss must be recorded in the Accounting period when it occurs. The Bookkeeping entries for impairment losses are DR Impairment Loss- 20XX - CR Accumulated Impairment Loss. It looks like Bookkeeping entries for depreciation. If the reasons for an impairment loss recognised in prior Accounting periods does not exist anymore and the item has increased in valuation, a company must reverse the impairment loss towards its new value. The Bookkeeping entry then is a debit entry in the Accumulated Impairment Loss account, and the amount is credited to the Impairment Loss account (or the Reversal Impairment Loss account). Note, the reversal of an impairment loss is capped towards the asset’s value obtained by normal depreciation. Most of the companies insure assets against accidental loss in valuation. In the extended case study GELLENDORFF Ltd., we demonstrate an impairment loss and the recognition of the compensation by the insurance after the company submitted a claim. 7.10 Impairment Loss - GELLENDORFF Ltd. Below, we study two alternative cases for an impairment loss on GELLENDORFF Ltd.’s business car. In case (i), its business car drops in valuation due to an accident and is repaired immediately. As GELLENDORFF Ltd. expects the car’s value after repair to be below the value before the accident, it assigns an appraiser to estimate its value after repair. Both, the repair, and the impairment loss are covered by its insurance. In case (ii), the business car is crashed and taken to an appraiser, too. The car is repaired three months later. After the repair, the company asks the appraiser to estimate the lasting impairment loss which is covered by the insurance as well as the repair. <?page no="146"?> Berkau: Financial Statements 9e 7-146 The cases differ regarding the depreciation charge and the timeline. In case (ii) there is depreciation for the period between accident and repair. Furthermore, a reversal impairment is recorded after the repair. Note, cars are depreciated based on their useful life and not on milage. Hence, for a car not in use, depreciation must be continued, even if the car’s registration is cancelled. In general, a damaged asset, like a car or machinery, gets repaired without a lasting impairment loss. Therefore, it is unlikely that an asset is appraised after repair, this only occurs if the owner expects a damage left. We here fabricated the case study to demonstrate the recording of an impairment loss and its reversal at different times for teaching purposes. Ad (i): Impairment Loss with Immediate Repair 52 On 4.04.20X4, GELLENDORFF Ltd.’s business car is involved in an accident. Before recording the damage, we calculate depreciation for a three-months period. Depreciation charge for the period January/ 20X4 - March/ 20X4 is recorded as Bookkeeping entry (1’). It is a quarter of the annual depreciation as we record depreciation accurate to a month based on the conventions in chapter (1). Therefore, the carrying value prior to the accident is: 60,000 - 7,500 - 2 × 10,000 - 2,500 = 330,000 AUD. After the accident, the car is repaired. The repair costs are 8,400 AUD (gross 52 For case i, all Bookkeeping entries are indicated by ‘. amount) and are recorded as Bookkeeping entry (2’) on 7.04.20X4. Input-VAT reduction can be claimed, as the car repair shop is registered for VAT reduction. After the repair on 8.04.20X4, a qualified appraiser evaluates the car at 24,700 AUD. The difference between the carrying value before the accident and the new amount following the expertise must be recorded under impairment loss to the extent of: 30,000 - 24,700 = 5 5,300 AUD. Note, the impairment loss is not connected to the repair costs. IAS 36.59 states that if the carrying value exceeds the recoverable amount, the carrying value shall be reduced to its recoverable amount. The recoverable amount is the lower of the value the asset can be sold at on an active market (fair market value) and its value in use, which is the total of discounted cash flows resulting from deployment (IAS 36.6). A value in use is e.g., the total of future and discounted rental income from property. If the carrying value exceeds the recoverable amount, an asset is overrated. For most tangible assets, we simply compare the carrying value in the books to the fair value (based on an appraiser’s estimate). The difference is then recorded as impairment loss through profit and loss. GELLENDORFF Ltd.'s records an impairment loss of 5,300 AUD as Bookkeeping entry (3’). See below the journalised entries recorded in March/ 20X4 and April/ 20X4 in GELLENDORFF Ltd.’s books. <?page no="147"?> Berkau: Financial Statements 9e 7-147 @ 31.03.20X4 (1') Depreciation-20X4 DPR 2,500 Accumulated Depreciation ACC 2,500 (recording three months of depreciation) @ 7.04.20X4 (2') Repair-20X4 REP 7,000 Value added Tax VAT 1,400 Cash/ Bank C/ B 8,400 (repair of the car) @ 8.04.20X4 (3') Impairment Loss-20X4 I/ L 5,300 Accumulated I/ L account AIL 5,300 (impairment loss of the car based on the appraiser's estimate) IAS 36.63 rules depreciation after an impairment loss. Depreciation is adjusted to the asset’s revised valuation. A residual value must be considered for the calculation of the depreciable value if existent. After the repair and recording of the impairment loss, depreciation on GELLENDORFF Ltd.'s car is resumed. The residual value is not affected for case (i). Monthly depreciation now is: (24,700 - 10,000) / 24 = 6 612.50 AUD/ m. Depreciation for the rest of 20X4 is amounting to: 9 × 612.50 = 55,512.50 AUD and is recorded as Bookkeeping entry (4’). Observe the journalised entry for the adjusted depreciation below. @ 31.12.20X4 (4') Depreciation-20X4 DPR 5,513 Accumulated Depreciation ACC 5,513 (recording adjusted depreciation after the repair) GELLENDORFF Ltd. insured its Volkswagen ID.4 and confirms to the insurance company its VAT registration status. The insurance refunds the repair based on net amounts as GELLENDORFF Ltd. claims a VAT refund from the revenue service. Note, following IAS 16.65 the insurance refund for a damage on an item of property, plant, equipment is recorded once granted by the insurance company and not when payments are received. Therefore, we record two Bookkeeping entries at separate times. The compensation from the insurance company includes the repair and the (lasting) impairment loss and is amounting to: 7,000 + 5,300 = 1 12,300 AUD and gets paid shortly after notification. This is recorded as Bookkeeping entry (5’) and (6’). Observe the accounts in Figure 7.1. <?page no="148"?> Berkau: Financial Statements 9e 7-148 @ 30.08.20X4 (5') Accounts Receivables A/ R 12,300 Insurance Refunds-20X4 IRA 12,300 (approval of the insurance refund) @ 2.09.20X4 (6') Cash/ Bank C/ B 12,300 Accounts Receivables A/ R 12,300 (receipt of insurance compensation) The receipt of insurance refund is not recognised through profit or loss as it does not reflect ordinary revenue of the business. It must be recorded through other comprehensive income to indicate that the receipt is extraordinary. D C D C OV 60,000 c/ d 60,000 OV 27,500 b/ d 60,000 (1') 2,500 c/ d 35,513 (4') 5,513 35,513 35,513 b/ d 35,513 Property, plant, equipment PPE Acc depr ACC D C D C (3') 5,300 c/ d 5,300 c/ d 5,300 (3') 5,300 b/ d 5,300 b/ d 5,300 Impairment loss-20X4 I/ L Acc Impairment Loss AIL D C D C (1') 2,500 (2') 7,000 c/ d 7,000 (4') 5,513 c/ d 8,013 b/ d 7,000 8,013 8,013 b/ d 8,013 Depreciation-20X4 DPR Repair-20X4 REP D C D C (2') 1,400 c/ d 1,400 (6') 12,300 (2') 8,400 b/ d 1,400 c/ d 3,900 12,300 12,300 b/ d 3,900 Value added tax VAT Cash/ Bank C/ B Figure 7.1: GELLENDORFF Ltd.’s accounts (i) <?page no="149"?> Berkau: Financial Statements 9e 7-149 D C D C c/ d 12,300 (5') 12,300 (5') 12,300 (6') 12,300 b/ d 12,300 Insurance refunds-20X4 IRA Accounts receivables A/ R Figure 7.1: GELLENDORFF Ltd.’s accounts (i) continued How it is Done (Recording an Impairment Loss): (1) Check for overrating of the non-current asset (or group of assets) by comparison of the carrying value to its recoverable amount. (2) If the carrying value exceeds the recoverable amount, calculate the difference. It is the amount for the impairment loss. (3) Record an impairment loss as a debit entry in the Impairment Loss-20XX account and a credit entry in the Accumulated Impairment Loss account. (4) Resume depreciation with amounts based on the revised valuation. (You must divide the new carrying amount after deduction of its residual value by the remainder of the useful life.) Ad (ii): Impairment Loss, Delayed Repair and Partial Reversal of an Impairment Loss 53 Next, we repeat the case of GELLENDORFF Ltd. but slightly alter the timeline of the story. We now consider the Volkswagen ID.4 gets repaired three months after the accident. An appraiser estimates the value of the car directly after the accident and again after completion of the repair. The latter one leads to a reversal of the impairment loss. Furthermore, we demonstrate a change in residual value caused by the accident. Note, a reporting company is obliged to monitor changes in asset valuation on a regular basis for assets subjected to prior impairment losses. An increase of the recoverable amount must reverse or change the impairment loss following IAS 36.114. A reversal of an impairment loss is the complete cancellation thereof whereas a 53 We mark Bookkeeping entries now by ‘’. change of the impairment loss only mitigates the value adjustment. Below, we rewind the case study to the day of the accident on 4.04.20X4. We alter the case study regarding to its timeline and car values: the car is repaired on 3.07.20X4 (three month later). Therefore, adjusted depreciation applies for the time span between the accident and the repair. The recoverable amount directly after the accident is 18,400 AUD as estimated by a certified appraiser, and after repairing it is 22,400 AUD. The residual value in case (ii) drops to 7,700 AUD as estimated by the appraiser, too. […] On 4.04.20X4, the GELLENDORFF Ltd.’s business car is involved in an accident. Depreciation prior to the accident is recorded as Bookkeeping entry (1’’). The carrying value before the accident <?page no="150"?> Berkau: Financial Statements 9e 7-150 is: 60,000 - 7,500 - 2 × 10,000 - 2,500 = 30,000 AUD same as for case (i)). After the accident, the car’s value is according to the expert’s estimate 18,400 AUD. Note, the damage value is different to the previous case (i). The impairment loss as recorded under Bookkeeping entry (2’’) is: 30,000 - 18,400 = 1 11,600 AUD. The impairment loss is recorded on 6.04.20X4. Based on the appraiser’s estimate, the car’s residual value is not yet affected. @ 31.03.20X4 (1'') Depreciation-20X4 DPR 2,500 Accumulated Depreciation ACC 2,500 (recording three months of depreciation) @ 6.04.20X4 (2'') Impairment Loss-20X4 I/ L 11,600 Accumulated I/ L account AIL 11,600 (recognition of impairment loss based on the appraiser's estimate) GELLENDORFF Ltd. takes the car for repair on 3.07.20X4. Although the car is not in use for three months, depreciation must be recorded based on the valuation after impairment loss recognition. The adjusted depreciation for three months is: 3 × (18,400 - 10,000) / 24 = 1,050 AUD. See below the journal entries for the adjusted depreciation. @ 30.06.20X4 (3'') Depreciation-20X4 DPR 1,050 Accumulated Depreciation ACC 1,050 (three months depreciation recognition after impairment loss) On 3.07.20X4, GELLENDORFF Ltd. repairs the damaged Volkswagen ID.4 and pays the car repair shop 8,400 AUD (gross amount). Check Bookkeeping entry (3’’). The repair is an expense and is recognised through profit or loss. Note, repairs in combination with a prior impairment loss does not cause changes or reversal of impairment losses. Repairs are recognised through profit or loss. A repair only is made to restore a condition prior to the damage. After the repair (4’’) the appraiser estimates the recoverable value of the car to 22,400 AUD and confirms that its residual value has now decreased to 7,700 AUD (reason: car with prior accident damage). The estimate mitigates the impairment loss by recording Bookkeeping entry (5’’). This leads to an increase of the carrying value for the car to the extent of: 22,400 - (18,400 - 1,050) = 5,050 AUD. The reversal of the impairment loss is recorded as an inverse impairment loss Bookkeeping entry (5’’) with a debit entry made in the Accumulated Impairment Loss account and a credit entry in the (reversal) Impairment Loss account. Alternatively, we can record the credit <?page no="151"?> Berkau: Financial Statements 9e 7-151 entry in the Impairment Loss-20X4 account. The latter one is a negative expense recognition. IAS 36.117 caps a reversal of an impairment loss to the asset’s value that would apply without prior impairment loss recognition. For checking, we calculate the maximum value for GELLENDORFF Ltd.’s business car in line with IAS 36.117: Without accident, the Volkswagen ID.4’s value on 3.07.20X4 would have been: 60,000 - (0.75 + 2 + 0.5) × (60,000 - 10,000) / 5 = 227,500 AUD. Hence, the mitigation of the impairment loss is within the limits set by IAS 36.117. The recoverable amount of 22,400 AUD is below 27,500 AUD. @ 3.07.20X4 (4'') Repair-20X4 REP 7,000 Value added Tax VAT 1,400 Cash/ Bank C/ B 8,400 (repair of the car) @ 6.07.20X4 (5'') Accumulated I/ L Account AIL 5,050 Impairment Loss-20X4 I/ L 5,050 (changes made to the impairment loss recognised on 6. 04 .20X4) After the adjustment of the impairment loss, depreciation is resumed and recorded for the period July/ 20X4 until December/ 20X4. The adjusted depreciation for the second half of 20X4 considers the reduction of the residual value and is amounting to: 6 × (22,400 - 7,700) / 21 = 4 4,200 AUD. See below the Bookkeeping entry (6’’) which is already an adjustment Bookkeeping entry. @ 31.12.20X4 (6'') Depreciation-20X4 DPR 4,200 Accumulated Depreciation ACC 4,200 (six months depreciation after recording of an impairment loss) Next, we consider the insurance compensation for GELLENDORFF Ltd.’s repair expenses and the impairment loss. The repair of 7,000 AUD is fully covered. The insurance company pays the net amount. The loss in valuation is based on the recorded impairment loss which was partially reversed: 11,600 - 5,050 = 6,550 AUD. GELLENDORFF Ltd. receives a compensation of: 7,000 + 6,550 = 13,550 AUD from its insurance recorded as Bookkeeping entry (7’’). The Insurance Refund account is closed-off to other comprehensive income (not shown). Study the accounts in Figure 7.2. <?page no="152"?> Berkau: Financial Statements 9e 7-152 D C D C OV 60,000 c/ d 60,000 OV 27,500 b/ d 60,000 (1'') 2,500 (3'') 1,050 c/ d 35,250 (6'') 4,200 35,250 35,250 b/ d 35,250 Property, plant, equipment PPE Acc depr ACC D C D C (1'') 2,500 (4'') 7,000 c/ d 7,000 (3'') 1,050 b/ d 7,000 (6'') 4,200 c/ d 7,750 7,750 7,750 b/ d 7,750 Depreciation-20X4 DPR Repair-20X4 REP D C D C (2'') 11,600 (5'') 5,050 (5'') 5,050 (2'') 11,600 c/ d 6,550 c/ d 6,550 11,600 11,600 11,600 11,600 b/ d 6,550 b/ d 6,550 Impairment loss-20X4 I/ L Acc Impairment Loss AIL D C D C (4'') 1,400 c/ d 1,400 (7'') 13,550 (4'') 8,400 b/ d 1,400 c/ d c/ d 5,150 13,550 13,550 b/ d 5,150 Value added tax VAT Cash/ Bank C/ B D C c/ d 13,550 (7'') 13,550 b/ d 13,550 Insurance refund-20X4 IRA Figure 7.2: GELLENDORFF Ltd.’s accounts (ii) How it is Done (Reversal/ Change of an Impairment Loss): (1) After recording an impairment loss, monitor the recoverable amount of the previously impaired asset on a regular basis. (2) Determine the recoverable value of the asset. <?page no="153"?> Berkau: Financial Statements 9e 7-153 (3) In case the asset is underrated, check how much the valuation of the asset would have been without impairment loss recognition. This value is the maximum for the asset valuation based on a reversal/ change of the impairment loss. If the recoverable value is below the maximum amount, continue with step (4a). Otherwise go to step (4b)! (4a)Reverse/ change the impairment loss to its recoverable value. Record a debit entry in the Accumulated Impairment Loss account and a credit entry in the (reversal) Impairment Loss account. A reversal impairment loss or a change of an impairment loss is a negative expense. (4b)Change the impairment loss to its capped value as in step (4a). Thereafter record a revaluation for the remainder of the value increase. You find revaluations discussed in this chapter (7) further down. A company must report in the notes about the valuation of its non-current assets. In general, a register of noncurrent assets and a reconciliation statement are prepared based on asset groups. Those statements are disclosed for GELLENDORFF Ltd. in Figure 7.3 and Figure 7.4 linked to case (ii) as at the yearend of 20X4: Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount [AUD] [AUD] [AUD] [AUD] Volkswagen ID.4 60,000 (35,250) (6,550) 18,200 . . . Gellendorff Ltd. REGISTER of NON-CURRENT ASSETS as at 31.12.20X4 Figure 7.3: GELLENDORFF Ltd.’s register of non-current assets <?page no="154"?> Berkau: Financial Statements 9e 7-154 20X4 20X3 [AUD] [AUD] OV as per 1.01.20X4 32,500 42,500 Depreciation (2,500) (10,000) Adjusted depreciation (5,250) Impairment loss (11,600) Reversal impairment loss 5,050 Revaluation Value at per 31.12.20X4 18,200 32,500 Gellendorff Ltd. P, P, E-RECONCILIATION STATEMENT as at 31.12.20X4 Figure 7.4: GELLENDORFF Ltd.’s asset-reconciliation statement We recommend studying the case study OBSERVATRY Ltd. in task A7.40. 54 The case study OBSERVATRY Ltd. includes disposals of non-current assets as discussed further down or which you can read about in the Basics of Accounting. 55 If the diminishing balance method (= declining method) for depreciation applies and an impairment loss is reversed, an extra working is required to calculate the maximum value for the reversal of the impairment loss. IAS 36.117 applies. A change/ reversal of an impairment loss is recorded through profit or loss. Any valuation that exceeds the maximum valuation results in a revaluation. Once a revaluation follows an impairment loss recognition, the reporting company must determine whether and which portion thereof exceeds the maximum reversal of an impairment loss and is subjected to revaluation. The major 54 You will find the task in the study material bank. 55 Disposals are discussed in our textbook Basics of Accounting, chapter (35). An example for a difference between a reversal of an impairment loss and a revaluation is the credit entry. For a reversal of an impairment loss, we record a credit entry in the Impairment Loss-20XX account which means it is recorded through profit or loss. For a revaluation, the contra entry is recorded in the Revaluation Reserves account which is an equity account. The case GROOTVLEI Ltd. below covers declining method and the partial reversal of an impairment loss. Check case study GROOTVLEI Ltd. that is accessible through Link 7.C. Link 7.C: GROOTVLEI Ltd. disposal of an asset after its revaluation can be found in chapter (7.16). <?page no="155"?> Berkau: Financial Statements 9e 7-155 If a reporting company changes depreciation parameters or the method of depreciation, IAS 8.22 and IAS 1.10 require the disclosure of changes as if made one Accounting period prior to the reporting period to consider adjustments for comparative information (IAS 1.38). Note, in those cases the comparative financial statements differ from the financial statements for the last Accounting period. Study as an example for altered depreciation parameters case study TYGERVALLEY Ltd. IAS 8 applies. Link 7.D: TYGERVALLEY Ltd. 7.11 Revaluations A revaluation is the increase of a noncurrent asset to its recoverable value. It must be recorded once a non-current asset’s fair value exceeds the actual value. Hence, for revaluations, a noncurrent asset must be underrated. Note, revaluations must be recorded following IFRSs, but they are prohibited based on German law. Both regulations are strict. The reporting company cannot decide whether to revalue the asset. German tax law does not allow revaluations, but follows the cost model for asset valuation, meaning the cost of acquisition are reduced by depreciation and impairment loss only. Revaluations only apply as subsequent valuations. Even if a company makes a lucky-buy, it must initially recognise the asset at costs, check IAS 16.15. A subsequent valuation can be conducted later. Note, A lucky-buy is to buy sth. at a price below its actual fair market value. For the application of the revaluation model, we study below a welding machine at TINNEN Ltd. in Stellenbosch, SA. The company’s reporting currency is South African Rand ZAR. An income tax rates applies at 30 %. Income taxes are relevant for revaluations, as deferred taxes result from carrying assets at different values for commercial and tax purposes. 7.12 C/ S TINNEN Ltd. In contrast to other case studies, we first describe the calculations and the How-it-is-Done-paragraph and explain the concept later with reference to the calculations. For an overview, we describe the standard procedure: Once a non-current asset is underrated, its carrying value must be increased towards the recoverable amount. The value increase is added to the non-current asset as well as to the equity section as revaluation reserve. No profit is realised if the asset remains in the company’s ownership. IAS 16.42 and IAS 12.18 require that a percentage to the extent the total income tax rate (here: 30 %) of the revaluation reserve must be accrued to deferred tax liabilities. The remaining 70 % stay in the Reval- <?page no="156"?> Berkau: Financial Statements 9e 7-156 uation Reserves account. Once the revalued asset is sold, disposed of or (partially) depreciated, the full amount (sale/ disposal) or a portion (depreciation) of the deferred taxes is transferred back to revaluation reserves. Thereafter the full/ partial revaluation reserves are accumulated to retained earnings. With transfer to retained earnings, dissolved revaluation reserves become distributable to owners because a (full/ partial) profit realisation took place. We demonstrate the procedure with the case study TINNEN Ltd. For teaching reasons, we cover two Accounting periods and consider for income tax calculations further revenues and expenses. Data Sheet for TINNEN Ltd. Domicile: South Africa (Stellenbosch). Reporting currency: ZAR. Classification: Manufacturing. Accounting periods: 20X3 - 20X4. Item of PPE: welding machine. Cost of acquisition: 800,000 ZAR on 2.01.20X3. Depreciation: diminishing balance method at 1.67 %/ m. Revaluation on 1.07.20X4: 750,000 ZAR. In both Accounting periods: other revenue: 1,400,000 ZAR and other expenses: 600,000 ZAR. VAT rate: 20 %. On 2.01.20X3, TINNEN Ltd. buys a welding machine at 800,000 ZAR (net amount). The useful life of the welding machine is five years; diminishing balance method applies for depreciation. The depreciation rate is 1.67 %/ m. 56 At first, TINNEN Ltd. records the acquisition and depreciation in 20X3. The paid purchase price is the gross value of: 800,000 × 120% = 9 960,000 ZAR. TINNEN Ltd. pays the price per bank transfer. Check Bookkeeping entry (1). @ 2.01.20X3 (1) P, P, E-Account PPE 800,000 Value Added TAX VAT 160,000 Cash/ Bank C/ B 960,000 (acquisition of the welding machine) Note, to distinguish accounts for revalued assets, it is widespread practice to indicate the model of measurement as a suffix, e.g., the P, P, E-Account with at cost of acquisition (@cost) as the measurement follows the cost model. Depreciation follows diminishing balance method. Note, the easiest way to calculate depreciation following diminishing balance method is to focus on carrying values. Do 56 Study our textbook Basics of Accounting, chapter (17). not calculate the depreciation but the asset value after depreciation. With a given depreciation rate dr and the number of periods t, the new carrying amount ca n is: ca n = (1 - dr) t × ca o . Depreciation charge is the difference between the old and the new carrying value: depr = ca o - ca n . Follow the case TINNEN Ltd. for the application of the procedure. At the end of 20X3, the welding machine’s carrying value is: 800,000 × (1 - <?page no="157"?> Berkau: Financial Statements 9e 7-157 1.67%) 12 = 6653,615.67 ZAR. The difference between the carrying value on 31.12.20X4 and the cost of acquisition gives the annual depreciation for 20X3. It is: 800,000 - 653,615.67 = 1 146,384.33 ZAR. The depreciation is recorded as Bookkeeping entry (2). @ 31.12.20X3 (2) Depreciation-20X3 DPR 146,384 Accumulated Depreciation ACC 146,384 (recognition of depreciation for 20X3) How it is Done (Declining Method, Diminishing Balance Method): (1) Determine the depreciable amount. That is the cost of acquisition in the first period or the actual carrying amount for later periods less residual value (if exists). (2) Apply the applicable depreciation rate dr, e.g., the monthly or annual depreciation rate (in general, it is given, but it can happen that you must calculate monthly rates based on annual rates; then you must apply compound interest calculations). (3) Determine the periods of depreciation, e.g., t months. (4) Calculate the carrying value as at the end of the depreciation period by multiplying the actual carrying value by the factor (1 dr) t . (5) To calculate depreciation, deduct the new carrying value from the previous one. (6) Make a debit entry in the Depreciation-20XX account and credit accumulated depreciation. Besides of depreciation, TINNEN Ltd. recognises operational expenses (3) of 600,000 ZAR (non-VATable) and earns a revenue (4) of 1,400,000 ZAR (VATable). Observe the profit calculation in Figure 7.5. TINNEN Ltd. carries forward its profit to 20X4. @ 30.06.20X3 (3) Operational Expenses-20X3 OEX 600,000 Cash/ Bank C/ B 600,000 (recognition of expenses for other operations) @ 1.07.20X3 (4) Cash/ Bank C/ B 1,620,000 Value Added Tax VAT 280,000 Revenue-20X3 REV 1,400,000 (revenue recognition in 20X3) <?page no="158"?> Berkau: Financial Statements 9e 7-158 On 1.07.20X4, a qualified appraiser estimates the welding machine’s recoverable amount to be 750,000 ZAR. At first, we calculate the welding machine’s book value as per 30.06.20X4 which is one day before its revaluation. TINNEN Ltd. recognises depreciation for six months and calculates the book value as: 653,615.67 × (1 - 1.67%) 6 = 590,797.56 ZAR. The recoverable value as estimated by the appraiser (= 750,000 ZAR) exceeds the carrying amount and thus requires a revaluation in compliance with IAS 16.31. The estimate from the qualified appraiser counts as reliable measurement for the fair value. A Bookkeeping entry made for revaluations resembles replacement Bookkeeping entries. Note, a replacement Bookkeeping entry is recorded for the exchange of parts of an asset. If a truck engine is replaced, the carrying value of the old engine is credited to the Property, Plant, Equipment account and the value for the new one is recorded on its debit side. We call Bookkeeping entries made for revaluations replacement Bookkeeping entries because we replace virtually the asset by an asset of higher value instead of adding the difference in valuation. Follow the QR code for studying ordinary replacement Bookkeeping entries with the case study CORAL Ltd. Link 7.E: CORAL Ltd. In contrast to the case study CORAL Ltd., revaluations at TINNEN Ltd. only virtually replace the entire asset by a revalued one. Hence, we pretend to remove the asset carried at costs by the revalued one in our books. To indicate revaluations, we add the suffix @VALUATION to the P, P, E account. We apply the P, P, E @COST account if following the cost model and a P, P, E @(RE)VALUATION account when an asset is carried at fair values based on the revaluation model. There are two alternative methods for revaluations: net replacement method and gross replacement method. In general, the net replacement method applies if an appraiser estimates the recoverable amount. The revaluation is then recorded at the time of (re)valuation. In contrast, the gross replacement method applies for revaluations based on a general increase of purchase costs for the same kind of assets. That method pulls the time of revaluation forward to the acquisition date. In the case study TINNEN Ltd., the net replacement method applies; however, we provide you with a QR code link to the gross replacement method at the end of the case study, for a method comparison. <?page no="159"?> Berkau: Financial Statements 9e 7-159 Before the revaluation of the welding machine, TINNEN Ltd. records depreciation for the period from January/ 20X4 until June/ 20X4: Depreciation is: 653,615.67 - 590,797.56 = 6 62,818.11 ZAR. We use capital letters for Bookkeeping entry identification as we now record the next year’s Bookkeeping entries. Depreciation is shown as Bookkeeping entry (C) because (A) and (B) are used for payments of income tax and VAT liabilities. Check the accounts in Figure 7.5. @ 30.06.20X4 © Depreciation-20X4 DPR 62,818 Accumulated Depreciation ACC 62,818 (depreciation recognition for six months) Next, we record the revaluation towards 750,000 ZAR based on the net replacement bookkeeping entry. The increase of the machine’s value is: 750,000 - 590,797.56 = 1 159,202.44 ZAR. The Bookkeeping entry (R) 57 is shown below. The debit entry in the P, P, E @ VALUATION account adds the new value of the asset and the credit entry in the P, P, E @COST account cancels out the cost of acquisition. Accordingly, accumulated depreciation recorded so far must be deleted as the cost of acquisition less accumulated depreciation is the book value of the welding machine at costs. The difference in valuations is added to the revaluation reserves. Note, the deletion of accumulated depreciation together with the recording of revaluations based on the net replacement method is the reason, why the contra entry for recording depreciation under IFRSs always must be made in the Accumulated Depreciation account. As with the application of German HGB no revaluations apply, German Bookkeepers are used to record the contra entry for depreciation on the credit side of the P, P, E- Account. @ 1.07.20X4 (R) P, P, E @Valuation Account PPV 750,000 Accumulated Depreciation ACC 209,202 P, P, E @Cost Account PPC 800,000 Revaluation Reserves R-R 159,202 (net replacement Bookkeeping entry for revaluation) In almost all jurisdictions, revaluations are not accepted for the tax statements. This results in a different asset valuation on the IFRS-balance sheet in comparison to the one for taxation. 57 R for Revaluation. Therefore, an immediate sale of the welding machine at its fair market value after the revaluation would cause a taxable profit of: 750,000 - 590,797.56 = <?page no="160"?> Berkau: Financial Statements 9e 7-160 159,202.44 ZAR as this is the difference between the fair value and the tax base. Following our simplified income tax model, the profit from an immediate sale of the welding machine results in income taxes of: 159,202.44 × 30% = 47,760.73 ZAR. IAS 12 deals with income tax recognition. In compliance with IAS 12.20, TINNEN Ltd. must recognise the potential income taxes from the revaluation as deferred tax liability. As the Bookkeeping entry is linked to the revaluation, we indicate it by (R’). @ 1.07.20X4 (R') Revaluation Reserves R-R 47,761 Deferred Tax Liability DTL 47,761 (disclosure of deferred tax liability) For the full picture, study the accounts in Figure 7.5. Once a revalued asset is depreciated, the revaluation reserves and the deferred taxes are proportionally dissolved. We study TINNEN Ltd. in the second half of 20X4: TINNEN Ltd. depreciates the welding machine after revaluation. Depreciation is now based on the new carrying value of 750,000 ZAR. Hence, depreciation for the months July/ 20X4 until December/ 20X4 is: 750,000 - 750,000 × (1 - 1.67%) 6 = 772,081.48 ZAR. Depreciation is recorded as Bookkeeping entry (D). @ 31.12.20X4 (D) Depreciation-20X4 DPR 72,081 Accumulated Depreciation ACC 72,081 (depreciation recognition) The percentage of depreciation based on the entire depreciable amount is: 72,081.48 / 750,000 = 9 9.61%. Therefore, TINNEN Ltd. dissolves 9.61 % of the deferred tax liabilities: 9.61% × 47,760.73 = 4 4,589.81 ZAR and of the initially recorded revaluation reserves: 9.61% × 159,202.44 = 1 15,299.35 ZAR. The Bookkeeping entries (D) and (D’) follow IAS 16.41. @ 31.12.20X4 (D') Deferred Tax Liability DTL 4,590 Revaluation Reserves R-R 4,590 (dissolving deferred tax liability) @ 31.12.20X4 (D'') Revaluation Reserves R-R 15,299 Retained Earnings R/ E 15,299 (dissolving revaluation reserves due to depreciation) Next, we calculate the profit at TINNEN Ltd. In 20X4, operating expenses and revenue are the same as in 20X3. The net profit in 20X4 is: 1,400,000 - 134,899.59 - 600,000 = 6655,100.41 ZAR. It considers depreciation on the welding machine as <?page no="161"?> Berkau: Financial Statements 9e 7-161 expenses to the extent of 62,818.11 + 72,081.48 = 1 134,899.59 ZAR for the entire year. TINNEN Ltd. follows our simplified tax calculation based on the total income tax rate of 30 %. The tax calculation follows South African tax law. For taxation, the asset valuation is at costs and depreciation deviates from depreciation based on IFRSs. With tax profit calculations deviating from IFRSs, deferred tax must be calculated and disclosed on the IFRS-financial statements: At TINNEN Ltd., the depreciation for taxation is: 653,615.67 - 653,615.67 × (1 - 1.67%) 12 = 1119,598.86 ZAR. The income tax calculation therefore is: (1,400,000 - 119,598.86 - 600,000) × 30% = 204,120.34 ZAR. These correct income taxes apply for the IFRSs financial statements. Note, technically, we copy them from the Tax-Profit and Loss-20X4 account into the IFRS-Profit and Loss -20X4 account. The copied income tax expenses (real) exceed those following IFRS profit calculation (virtual). The difference in tax calculations is here caused by higher depreciation following IFRSs and is amounting to: 204,120.34 - 665,100.41 × 30% = 4,590.22 ZAR. It is disclosed as deferred tax income, which gets deducted from real tax expenses on the income statement and is debited to the Retained Earnings account. Study Bookkeeping entry (G). Note, the debit entry in the Retained Earnings account means that those income taxes are not refunded by the revenue service. D C D C (4) 1,680,000 (1) 960,000 (2) 146,384 P3L 146,384 (3) 600,000 c/ d 120,000 1,680,000 1,680,000 b/ d 120,000 (A) 196,085 (F) 1,680,000 (B) 120,000 (E) 600,000 c/ d 883,915 1,800,000 1,800,000 b/ d 883,915 Cash/ Bank C/ B Depreciation-20X3 DPR Figure 7.5: TINNEN Ltd.’s accounts (20X4) <?page no="162"?> Berkau: Financial Statements 9e 7-162 D C D C c/ d 146,384 (2) 146,384 (3) 600,000 P3L 600,000 (R) 209,202 b/ d 146,384 (C) 62,818 209,202 209,202 c/ d 72,081 (D) 72,081 b/ d 72,081 Acc depr ACC Operational expenses-20X3 OEX D C D C (1) 800,000 c/ d 800,000 (1) 160,000 (4) 280,000 b/ d 800,000 (R) 800,000 c/ d 120,000 280,000 280,000 (B) 120,000 b/ d 120,000 c/ d 280,000 (F) 280,000 400,000 400,000 b/ d 280,000 PPE @COST Value added tax VAT D C D C P3L 1,400,000 (4) 1,400,000 DPR 146,384 REV 1,400,000 OEP 600,000 NP3 653,616 1,400,000 1,400,000 ITL 196,085 b/ d 653,616 R/ E 457,531 653,616 653,616 Revenue-20X3 REV Profit and Loss-20X3 P3L D C D C c/ d 196,085 P3L 196,085 c/ d 457,531 P3L 457,531 (A) 196,085 b/ d 196,085 (G) 4,590 b/ d 457,531 c/ d 204,120 ITL 204,120 (D'') 15,299 400,205 400,205 c/ d 933,810 P4L 465,570 b/ d 204,205 938,400 938,400 b/ d 933,810 Income tax liabilities ITL Retained earnings R/ E Figure 7.5: TINNEN Ltd.’s accounts (20X4) continued <?page no="163"?> Berkau: Financial Statements 9e 7-163 D C D C (C) 62,818 (R) 750,000 c/ d 750,000 (D) 72,081 c/ d 134,900 b/ d 750,000 134,900 134,900 b/ d 134,900 P4L 134,900 Depreciation-20X4 DPR PPE @VALUATION D C D C (R') 47,761 (R) 159,202 (D') 4,590 (R') 47,761 (D'') 15,299 (D') 4,590 c/ d 43,171 c/ d 100,733 47,761 47,761 163,793 163,793 b/ d 43,171 b/ d 100,733 Revaluation reserves R-R Deferred tax liabilities DTL D C D C (E) 600,000 P4L 600,000 P4L 1,400,000 (F) 1,400,000 Operational expenses-20X4 OEX Revenue-20X4 REV D C D C DPR 134,900 REV 1,400,000 DPR 119,599 REV 1,400,000 OEX 600,000 OEX 600,000 NP4 665,100 NP4 680,401 1,400,000 1,400,000 1,400,000 1,400,000 ITL 204,120 b/ d 665,100 ITL 204,120 b/ d 680,401 R/ E 465,570 (G) 4,590 R/ E 476,281 669,691 669,691 680,401 680,401 Profit and Loss-20X4 P4L Tax-Profit and Loss-20X4 P4L Figure 7.5: TINNEN Ltd.’s accounts (20X4) continued We summarise revaluation procedures by a How-it-is-Done paragraph. For the reference to Bookkeeping entries, we consider the application of an Asset Management, meaning there is one P, P, E account per asset. How it is Done (Revaluations, Net Replacement Method): (1) Determine the recoverable amount, e.g., by an estimation from a certified appraiser. (2) Create a new P, P, E @VALUATION account and enter the recoverable amount on the debit side. (3) Make a credit entry in the P, P, E @COST account to close it off. <?page no="164"?> Berkau: Financial Statements 9e 7-164 (4) Close-off the Accumulated Depreciation account by making a debit entry. (5) If the revaluation follows an impairment loss, reverse the impairment loss completely to the maximum value. (6) Record the difference in valuation on the credit side of the Revaluation Reserves account. (7) Deduct the income tax portion from revaluations reserves and add them to the Deferred Tax Liabilities account. How it is Done (Depreciation of Revalued Assets): (1) Determine depreciation expenses based on the revalued asset. (2) Make a debit entry in the Depreciation account and credit the Accumulated Depreciation account. (3) Calculate the percentage of depreciation based on the depreciable amount. (4) Dissolve the same percentage of the deferred tax liabilities: DR Deferred Tax Liability account - CR Revaluation Reserves account. (5) Dissolve the same percentage of the ordinary revaluation reserves: DR Revaluation Reserves account - CR Retained Earnings account. (6) Calculate earnings before taxes following IFRSs. (7) Calculate earnings before taxes along national tax law and determine income tax expenses. (8) Copy the (real) income tax expenses into the IFRS- Profit and Loss account. (9) The income taxes exceed the EBT IFRS × 30% tax calculation. Therefore, calculate the difference and deduct it from the income taxes in the Profit and Loss account. Debit retained earnings. (10)Calculate the annual surplus (EAT) and transfer it to retained earnings. So far, we only discussed the Bookkeeping entries for recording deferred taxes caused by revaluations in compliance with IAS 12. Next, we discuss the reason for our recordings and dissolving deferred tax liabilities and revaluation reserves. We refer to the case study TINNEN Ltd. Revaluations and deferred taxes are recorded on the commercial financial statements following IFRSs. A revaluation is never recorded through profit or loss as no profit realisation takes place. Therefore, a revaluation increases equity to the same extent as assets increase in value. Following IAS 12.15, a deferred tax liability is recognised for temporary income tax differences. With a revaluation, taxable differences exist at the time of the revaluation as deferred tax <?page no="165"?> Berkau: Financial Statements 9e 7-165 liabilities and in periods after the revaluation as deferred tax income caused by higher depreciation. The difference is temporary because deferred tax resulting from revaluations is cancelled out against those caused by depreciation. As we follow a simplified income tax model the tax rates are constant over the time. For the measurement of deferred taxes IAS 12.51 applies. When we revalue TINNEN Ltd.'s welding machine, both sides on the balance sheet increase by 159,202.22 ZAR. On the credit side, the increase is split at a 70 : 30 ratio between revaluation reserves and deferred tax liability. The revaluation reserves are: 159,202.44 - 47,760.73 = 1 111,441.71 ZAR and the deferred tax liabilities are: 159,202.44 × 30% = 4 47,760.73 ZAR. For a realisation of profit from a revaluation, the company must either (1) sell/ dispose of the revalued asset or (2) depreciate it. (1) Selling the welding machine immediately at its recoverable amount (= 750,000 ZAR) results in a zero profit on the commercial financial statements and as a profit on disposal of: 750,000 - 590,797.56 = 1 159,202.44 ZAR for taxation. The income taxes for the gain on disposal are: 30% × 159,202.44 = 47,760.73 ZAR. As the company disclosed deferred taxes of 47,760.73 ZAR at the time of revaluation, it dissolves them with the sale and accrues them to revaluation reserves. It further must dissolve the complete revaluation reserves because the revalued asset is disposed of: 111,441.71 + 47,760.73 = 1 159,202.44 ZAR. This amount is added to retained earnings and thus becomes distributable to the owners. At the same time, a deferred tax income of 47,760.73 ZAR is added to the Retained Earnings account on the debit side. This entry reduces the distributable amount for the income tax portion of the revaluation. It results from the difference in profit caused by different depreciation between the statement for taxation and the IFRS statement: 159,202.44 × 30% = 4 47,760.73 ZAR. Remember, the IFRS gain on disposal is zero. Consequently, TINNEN Ltd.’s shareholders are entitled to receive a dividend of: 159,202.44 - 47,760.73 = 1 111,441.71 ZAR in total, which is the value of the gain on disposal after income tax. (2) In contrast to a sale, depreciation leads to a partial profit realisation but works in the same way. If the company depreciates the revalued asset to a certain extent - as TINNEN Ltd. did at 9.61 % it dissolves deferred tax liabilities and revaluation reserves to the same percentage. This leads to 9.61% × 47,760.73 = 4 4,589.81 ZAR deferred taxes dissolved and added to the revaluation reserves. 9.61 % of the revaluation reserves are dissolved: 9.61% × 159,202.44 = 1 15,299.35 ZAR. The latter amount is accrued to retained earnings. This way, 15,299.35 ZAR become distributable to shareholders. At the same time, a profit difference applies because the depreciation of a revalued machine exceeds depreciation to where the asset is carried at cost. In case of TINNEN Ltd., we can take the difference from Figure 7.5 (DPR on the Profit and Loss accounts). It is: 134,899.59 - 119,598.86 = 15,300.73 ZAR. The difference in depreciation results in an income tax difference of: 15,300.73 × 30% = 44,590.22 ZAR. It is termed a deferred tax income <?page no="166"?> Berkau: Financial Statements 9e 7-166 as it is deducted from income tax expenses. As its contra entry is recorded on the debit side of the Retained Earnings account, it reduces the dissolved revaluation reserves for their tax portion towards: 15,299.35 - 4,589.81 = 10,709.54 ZAR. That is a partial (9.61 %) realisation of the revaluation of the welding machine after tax. To check our calculations, we multiply the distributable amount for TINNEN Ltd.’s owners as discussed for the sale (1) with the percentage of depreciation. This gives: 111,441.71 × 9.61 % = 10,709.55 ZAR. One cent rounding difference results from the rounding of the percentage of depreciation. If an asset has a residual value, the above shown Bookkeeping entries will result in a remainder of the revaluation reserves. They are dissolved once the company disposes of the revalued asset. Thus, the requirement for equality of retained earnings based on IFRSs and on national tax law only is fulfilled once the asset is depreciated completely or after its final disposal. If the calculation of the percentage of depreciation is based on the depreciable amount, revaluation reserves get completely dissolved by depreciation. We discuss case study STEENBERG Ltd. In case (i) we dissolve revaluation reserves based on the percentage based on the depreciable amount. In case (ii), we calculate the percentage based on the complete recoverable value of the revalued asset. We can prove, that in case (ii) retained earnings 58 Study our Basics of Accounting, chapters (34) and (35). will differ between financial statements following IFRSs and income tax statements during the useful life. At the end of the useful life, both cases give the same balancing figure for the Retained Earnings account. Follow below the Link 7.F to the case study STEENBERG Ltd. Link 7.F: STEENBERG Ltd. An alternative to the net replacement method is the gross replacement method. It applies when the revaluation is caused by a price increase. Follow the Link 7.F to the case study JANSSENS Ltd. Link 7.G: JANSSENS Ltd. 7.13 Disposal of Assets A disposal of an asset is best recorded through a Realisation account. 58 In case an item of property, plant and equipment is disposed of after prior revaluation, we must at first dissolve the <?page no="167"?> Berkau: Financial Statements 9e 7-167 revaluation reserves and deferred tax liabilities completely towards retained earnings. Only the disposal proceeds and the carrying value (Property, Plant and Equipment account, Accumulated Depreciation account and Accumulated Impairment Loss account) should be closed-off to the Realisation account. Based on IAS 16.68, the Realisation account is closed-off to the Profit and Loss account - we say is recorded through profit or loss although in case of disposals the expression other comprehensive income would sound more appropriate because the disposal of non-current assets is a gain. IAS 16.67 states, that a de-recognition must be recorded for disposals or once no further benefits are expected from the asset. 7.14 C/ S YSTERFONTEIN Ltd. We study the case of YSTERFONTEIN Ltd. It is a construction company based in Johannesburg which sells its revalued property. Data Sheet for YSTERFONTEIN Ltd. Domicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Construction. Accounting periods: 20X1 - 20X6. Plot: 300 m 2 ; cost of acquisition 225,000 ZAR plus conveying fees 50,000 ZAR. Revaluation to 3,000 ZAR/ m 2 . Sale on 30.11.20X6 at 1,000,000 ZAR. VAT n/ a. On 4.01.20X1, YSTERFONTEIN Ltd. buys a plot 300 m 2 in size intended for its use as parking lot for business cars and construction vehicles. The purchase price is 225,000 ZAR. For conveyance, YSTERFONTEIN Ltd. pays 50,000 ZAR. Note, In South Africa, no acquisition tax for property applies. However, the SARS imposes a capital gain tax on sales income exceeding the cost of acquisition. Various deductions and allowances apply. Check the South African tax law. The total costs of acquisition are: 225,000 + 50,000 = 2 275,000 ZAR. On 5.07.20X5, the municipality of Johannesburg declares the land which includes YSTERFONTEIN Ltd.’s parking lot an industrial zone and, therefore, the property price increases to 3,000 ZAR/ m 2 . YSTERFONTEIN Ltd. must revalue its parking lot. Its new, recoverable value is: 300 × 3,000 + 50,000 = 9 950,000 ZAR. The costs for conveyance are included in the property valuation. The Bookkeeping entry for the revaluation is disclosed below. Note, land is not subjected to regular depreciation. A portion of 30% (income tax rate) is accrued to the deferred tax liabilities as shown as Bookkeeping entry (2): 30% × 675,000 = 2 202,500 ZAR. <?page no="168"?> Berkau: Financial Statements 9e 7-168 @ 5.07.20X5 (1) and (2) P, P, E @Valuation PPV 950,000 P, P, E @Cost PPC 275,000 Revaluation Reserves R-R 675,000 (revaluation of the plot) Revaluation Reserves R-R 202,500 Deferred Tax Liabilities DTL 202,500 (transfer of deferred tax liabilities) On 30.11.20X6, YSTERFONTEIN Ltd. sells the plot at 1,000,000 ZAR. The Bookkeeping entries are made through the Realisation account after deferred tax and revaluation reserves have been closed-off to retained earnings. Note, the separation of dissolving of revaluation reserves and deferred tax liabilities from recordings in the Realisation account is important as revaluations must not be recorded through profit or loss. In contrast, gains on disposal must be recorded through profit or loss (better: other income) and are relevant for profit and income tax calculations. @ 30.11.20X6 Deferred Tax Liabilities DTL 202,500 Revaluation Reserves R-R 202,500 (dissolving deferred taxes) Revaluation Reserves R-R 675,000 Retained Earnings R/ E 675,000 (dissolving revaluation reserves) Cash/ Bank C/ B 1,000,000 Realisation-20X6 REA 1,000,000 (cash receipt from buyer) Realisation-20X6 REA 950,000 P, P, E @Valuation PPV 950,000 (closing-off of the PPE account) In South Africa, a capital gain tax exists. The capital gain is calculated by deduction of the cost of acquisition from the sales proceeds. Here, the capital gain is amounting to: 1,000,000 - 275,000 = 725,000 ZAR. No deduction and allowances are discussed here for the sake of simplification. The rate for the capital gain tax is the total income tax rate of 30 %. See below the journal entry for the capital gain tax recording: 30% × 725,000 = 217,500 ZAR. Note, The capital gain tax recording is not part of the syllabus of international Accounting. It has been added here to make the case study look more real and would be taught in an International Taxation class. <?page no="169"?> Berkau: Financial Statements 9e 7-169 @ 31.12.20X6 Capital Gain Tax CGT 217,500 Accounts Payables A/ P 217,500 (disclosure of capital gain tax as short-term liabilities) Check YSTERFONTEIN Ltd.’s accounts which only contain business activities in connection with the plot. D C D C OV 950,000 (D) 950,000 OV 472,500 (B) 675,000 (A) 202,500 675,000 675,000 PPE @VALUATION Revaluation Reserves R-R D C D C (A) 202,500 OV 202,500 DTI 202,500 (B) 675,000 c/ d 507,500 OCI 35,000 710,000 710,000 b/ d 507,500 Deferred tax liabilities DTL Retained earnings R/ E D C D C (D) 950,000 (C) 1,000,000 (C) 1,000,000 . . . GoD 50,000 1,000,000 1,000,000 Realisation-20X6 REA Cash/ Bank C/ B D C D C OCI 50,000 (5) 50,000 EBT 50,000 GoD 50,000 ITL 217,500 b/ d 50,000 R/ E 35,000 DTI 202,500 252,500 252,500 Gain on disposal-20X6 GoD Other comprehensive income-20X6 OCI D C D C c/ d 217,500 PLT 217,500 EBT 725,000 GoD 725,000 b/ d 217,500 A/ P 217,500 b/ d 725,000 R/ E 507,500 725,000 725,000 Accounts payables A/ P Profit and Loss for Taxation PLT Figure 7.6: YSTERFONTEIN Ltd.’s accounts <?page no="170"?> Berkau: Financial Statements 9e 7-170 How it is Done (Disposal of an Asset): (1) Record all depreciation or impairment losses for the periods before the asset is disposed of. If the asset is carried at revaluation values, dissolve revaluation reserves and deferred tax liabilities. (2) Prepare a Realisation account. (3) Record received proceeds as a debit entry in the Cash/ Bank account and a credit entry in the Realisation account. For sales on credit record receivables accordingly. (4) Record output-VAT collected on the disposal as a debit entry in the Realisation account and a credit entry in the VAT account - if VAT applies. (5) Close-off the P, P, E account to the Realisation account. (6) Close-off the Accumulated Depreciation account and, if existing, the Accumulated Impairment Loss account, to the Realisation account. (7) Determine the balancing figure of the Realisation account. (8) Close-off the Realisation account to the Profit and Loss account or the Other Comprehensive Income account. YSTERFONTEIN Ltd. applies a Realisation account to calculate the gain on disposal for the plot. It is: 1,000,000 - 950,000 = 50,000 ZAR. From the tax perspective, the profit on disposal is: 1,000,000 - 275,000 = 725,000 ZAR. Therefore, the capital gain taxes are: 725,000 × 30% = 2 217,500 ZAR. These taxes do not fall under income tax liabilities and must be recorded under short-term payables. As we compare the capital gain tax to expected income tax from a gain of 50,000 ZAR, the capital gain tax exceeds the taxes on other comprehensive income by: 217,500 - 15,000 = 2 202,500 ZAR. YSTERFONTEIN Ltd. records deferred tax income to the same extent as the dissolved deferred tax liabilities. Hence, YSTERFONTEIN Ltd.’s equity 59 Find the task in the study material bank. increases as if no revaluation has been recorded. YSTERFONTEIN Ltd. case study is simple as plots are not depreciable. Furthermore, no VAT applies for property sales. We recommend working on task A7.55 PAROW Ltd., which is about the revaluation of a plot, too. 59 7.15 Investment Property Investment property is land and buildings held for earning rental income or for capital appreciation. IAS 40 applies. IAS 40.5 states that investment property is never land and buildings that are used for goods production, service rendering or administration. In <?page no="171"?> Berkau: Financial Statements 9e 7-171 those cases, IAS 16 applies. It is termed self-occupation. IAS 40.5 states further that investment property does not apply for assets held for sale. A company that buys land/ buildings for a short-term sale does not apply IAS 40 but IFRS 5 instead. Assets held for sale are discussed in the paragraphs 7.19 and 7.20. IAS 40.10 allows property to be separated in owner occupied portions and investment property. Owner occupation also applies for hotels. IAS 40 is explained by the case study MERSEBURG Ltd. below. 7.16 C/ S MERSEBURG Ltd. MERSEBURG Ltd. acquires an office block for earning rental income and to a small portion for owner-occupation (administration of the office block). IAS 40 and IAS 16 apply. Data Sheet for MERSEBURG Ltd. Domicile: South Africa (Grahamstown). Reporting currency: ZAR. Classification: rental business. Investment property: 21,021,000 ZAR; office block with 42 units, acquired on 2.01.20X7. Depreciation: 420,420 ZAR. Revaluation towards 25,200,000 ZAR on 2.01.20X8. VAT n/ a. On 2.01.20X7, MERSEBURG Ltd. buys an office block with 42 single offices in Grahamstown. The acquisition price is 21,000,000 ZAR. Additional costs apply for conveyance. Those are 21,000 ZAR. One of the offices is used for the administration of the other 41 offices. The office block is separable as laid out in IAS 40.10. For the sake of simplicity, we pretend, all offices are of the same size and value. Due to different use, MERSEBURG Ltd. must account for the offices separately. The owner-occupied office is classified as property, plant and equipment and falls under IAS 16 whereas the other 41 offices are investment property as defined in IAS 40.5. At the time of acquisition, MERSEBURG Ltd. records the office block based on the offices use by the Bookkeeping entry below with partially allocated conveyance costs, e.g. the owner-occupied office at cost of acquisition of: (1/ 42) × 21,021,000 = 5 500,500 ZAR. @ 2.01.20X7 Investment Property IVP 20,520,500 P, P, E @cost PPC 500,500 Cash/ Bank C/ B 21,021,000 (office acquisition for rental income and owner-occupation purposes) MERSEBURG Ltd. rents out 41 offices and receives a monthly rental income therefrom. In case the recoverable amount of the offices increases or decreases, IAS 40.35 requires recording the valuation changes as gain or loss. This is a different procedure for the 41 office units to revaluations following IAS 16.39, as gains are recognised instead of recording revaluation reserves and deferred <?page no="172"?> Berkau: Financial Statements 9e 7-172 tax liabilities. We show the alternative valuations for MERSEBURG Ltd.’s differently occupied offices: In 20X7, MERSEBURG Ltd. applies the cost model and depreciates the 42 offices over a useful life of 50 years to an extent of: (1/ 50) × 21,021,000 = 4 420,420 ZAR (all together). The offices are carried at a value of: 21,021,000 - 420,420 = 2 20,600,580 ZAR at the end of the Accounting period 20X7. On 2.01.20X8, MERSEBURG Ltd. acknowledges that the office block’s value increased from 20,600,580 ZAR to 25,200,000 ZAR. The owner-occupied office requires a revaluation based on IAS 16. The carrying value was 490,490 ZAR and the new recoverable amount is 600,000 ZAR. The revaluation is recorded as the Bookkeeping entries below, which includes the rise of deferred tax liabilities of 30% × 109,510 = 3 32,853 ZAR. This is a net replacement Bookkeeping entry. @ 2.01.20X8 P, P, E @valuation PPV 600,000 Accumulated Depreciation ACC 10,010 P, P, E @cost PPC 500,500 Revaluation Reserves R/ R 109,510 (revaluation of the self occupied office, net replacement Bookkeeping entry) Revaluation Reserves R-R 32,853 Deferred Tax Liabilities DTL 32,853 (allocation of the tax portion to deferred tax liabilities) In contrast to the owner-occupied office, the value increase for the investment property (41 offices) is recorded through profit or loss and disclosed as a gain on revaluation of investment property. It is: 41 × (600,000 - 490,490) = 4 4,489,910 ZAR see the Bookkeeping entry below: @ 2.01.20X8 Investment Property IVP 4,489,910 Gain on Revaluation of IVP GO 4,489,910 (revaluation gain on investment property recognition) 7.17 Assets Held for Sale IFRS 5 applies for non-current assets held for sale. According to IFRS 5.8, a requirement for non-current assets to be classified as held for sale is that a plan exists to sell the asset. The start of the marketing procedures could serve as proof of the sales intention. Noncurrent assets held for sale shall be valued at the lower of carrying costs and fair value less cost to sell (IFRS 5.15.). Assets along IFRS 5 are no inventories. They merely represent non-current assets of the company that are to be disposed of due to discontinued operations, or they have no economic benefit. This applies also for replaced assets, like a taxi company that bought a new car and intends to sell its old one. A company shall not depreciate a non-current asset while it is classified as held for sale based on IFRS 5.25. <?page no="173"?> Berkau: Financial Statements 9e 7-173 IFRS 5.38 requires separate disclosure of non-current assets held for sale. 7.18 C/ S OVERBERG (Pty) Ltd. We explain the concept of IFRS 5 by the case study OVERBERG (Pty) Ltd., a surf shop at the West beach in Cape Town. The company sells its kite surf units previously deployed for surfing classes. Data Sheet for OVERBERG (Pty) Ltd. Domicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Service provider. Assets for sale: 15 kite surfing units (KSU), cost of acquisition: 20,000 ZAR/ KSU on 2.01.20X4; useful life: four years; residual value: 8,000 ZAR/ KSU. Intention to sell from 1.10.20X5 due to discontinued operations; net selling price 10,000 ZAR/ KSU. On 31.12.20X6, 10 kite surfing unites left. VAT rate: 20 %. OVERBERG (Pty) Ltd. is a surf shop in Cape Town. The company sells surf equipment at the West beach and runs a kite surfing training centre in Camps Bay. For the kite surfing training centre, OVERBERG (Pty) Ltd. bought 15 kites and surfboards we refer to as KSU (kite surfing unit). The KSUs are acquired at unit costs of acquisition of 20,000 ZAR/ KSU on 2.01.20X4. Depreciation on the KSUs follows straight-line method over a useful life of four years. The residual value per KSU is 8,000 ZAR/ KSU. On 1.10.20X6, OVERBERG (Pty) Ltd. decides to close its kite surfing training centre down and to turn it into a surf shop instead. Therefore, the training centre activities belong to discontinued operations. No training classes are offered after 1.11.20X6. OVERBERG (Pty) Ltd. plans to sell the KSUs at 10,000 ZAR/ KSU (ex VAT). No additional selling costs apply, as OVERBERG (Pty) Ltd. sells the KSUs in its own surf shop. At the beginning of 20X6, the KSUs are carried at 14,000 ZAR/ u each. Depreciation for the period January/ 20X6 until October/ 20X6 is: 10 × (14,000 - 8,000) / 24 = 2 2,500 ZAR/ KSU. The Bookkeeping entry as disclosed in Figure 7.9 for depreciation is (1). When OVERBERG (Pty) Ltd. ceases its kite surfing training operations on 1.11.20X6, it carries each KSU at: 14,000 - 2,500 = 111,500 ZAR/ KSU. IFRS 5.15 requires the valuation of the KSUs at the lower of the carrying value and the recoverable amount less costs to sell. OVERBERG (Pty) Ltd.’s intention to sell the KSUs at 10,000 ZAR/ KSU determines their fair values. Hence, the KSUs are held for sale and written down in accordance with IFRS 5.20 from 11,500 ZAR/ KSU to 10,000 ZAR/ KSU. OVERBERG (Pty) Ltd. makes the Bookkeeping entry (2) below. We term the account for assets held for sale Disposal Assets account DAA: @ 1.11.20X6 (2) Disposal Assets Account DAA 150,000 Accumulated Depreciation ACC 127,500 IL on Discontinued Ops ILD 22,500 P, P, E - KSU 300,000 (writing-off KSUs due to discontinuation of training centre activities) <?page no="174"?> Berkau: Financial Statements 9e 7-174 After classification of the KSUs as assets held for sale, OVERBERG (Pty) Ltd. discontinues their depreciation. At the end of 20X6, OVERBERG (Pty) Ltd. sells five of the KSUs at a net selling price of 10,000 ZAR/ KSU. See Bookkeeping entry (3). @ 20.12.20X6 (3) Cash/ Bank C/ B 60,000 Value Added Tax VAT 10,000 Disposal Assets Account DAA 50,000 (sale of five KSUs) Note, the Bookkeeping entry (3) is easier than one for the sale of inventories. The KSUs are carried already at the selling price which is their recoverable amount. The left KSUs are still in the shop on 31.12.20X6. Observe in Figure 7.7 the accounts as per 31.12.20X6. D C D C OV 300,000 (2) 300,000 (2) 127,500 OV 90,000 (1) 37,500 127,500 127,500 P, P, E (KSU) Acc depr ACC D C D C (1) 37,500 P&L 37,500 (2) 150,000 (3) 50,000 c/ d 100,000 150,000 150,000 b/ d 100,000 Depreciation-20X6 DPR Disposal assets account DAA D C D C (2) 22,500 P&L 22,500 (3) 60,000 c/ d 60,000 b/ d 60,000 Impairment Loss on discontinued ops ILD Cash/ Bank C/ B D C D C c/ d 10,000 (6) 10,000 DPR 37,500 b/ d 10,000 ILD 22,500 NL 60,000 60,000 60,000 b/ d 60,000 R/ E 60,000 Value added tax VAT Profit and Loss-20X6 P&L Figure 7.7: OVERBERG (Pty) Ltd.’s accounts <?page no="175"?> Berkau: Financial Statements 9e 7-175 D C P&L 60,000 c/ d 60,000 b/ d 60,000 Retained earnings R/ E Figure 7.7: OVERBERG (Pty) Ltd.’s accounts continued 7.19 Intangible Assets Intangible assets are assets without physical substance, e.g., licenses, rights, warranties, patents, design costs, right of use assets, goodwill etc. IAS 38 rules intangible assets. IAS 38.4 states that in some cases, intangible assets are linked to assets with physical substance, e.g., software comes with an installation-CD and a printed manual. We then must assess which component of the asset is dominant. Note, this book (Berkau: Financial Statements) is regarded as software due to its included QR Codes. Following a decision from the local court in Munich, a reduced VAT rate in Germany does not apply to this book. In the case of software, the intangible portion is the major part, hence, we must classify software as intangible asset. Although cash and in particular its equivalents may be regarded as intangible, it is always recorded as non-current asset under cash/ bank or as financial instrument. IAS 38.12 requires intangible assets to be identifiable which means they must be separable and exchangeable between individuals, or they must result from contractual or legal rights. Following IAS 38.13, intangible assets shall be in the control of the reporting company. 7.20 C/ S Dentist PAARDEBERG We discuss the next case PAARDEBERG, who is a dentist. The case is about the ability of recognition of a patient base: Data Sheet for Dr. Paardeberg. Domicile: Germany (Hamburg) Reporting currency: EUR. Classification: Doctor’s clinic. Cost of acquisition: 750,000 EUR. Assets’ value: 80,000 EUR VAT n/ a. Dr Paardeberg is a dentist and plans the acquisition of a clinic in Hamburg. He buys the clinic from a doctor who wants to relocate to Asia. Note, the case of a doctor’s clinic has been added deliberately to this textbook to demonstrate that IFRSs are applicable to entities that are no companies. The value of the clinic is significantly higher than the assets linked thereto, such as the surgery room appliances, the waiting area furniture, computer systems etc. The major value that determines the selling price for the clinic is its patient base. Although, there is economic benefit resulting from the base of existing patients when taking over the clinic, the patients are not controlled by the business. Therefore, Dr Paardeberg cannot recognise the patient list. In case Dr. Paardeberg pays a price for the clinic that exceeds its tangible assets’ total by <?page no="176"?> Berkau: Financial Statements 9e 7-176 far, the difference between cost of acquisition and the sum of tangible assets is recorded as goodwill. Goodwill results from the clinic’s acquisition and thus, becomes an identifiable intangible asset because it is derived from contractual rights. The acquisition of the clinic is in exchange of 750,000 EUR; 80,000 EUR thereof is linked to tangible equipment. PAARDEBERG makes the Bookkeeping entry on 4.03.20X7 as below: @ 4.03.20X7 Property, Plant, Equipment PPE 80,000 Goodwill G/ W 670,000 Cash/ Bank C/ B 750,000 (acquisition of a dentist clinic with goodwill consideration) After initial recognition of intangible assets at cost, the subsequent valuation is based on depreciation over the useful life or on the revaluation model, the latter one requires regular impairment/ revaluation tests. In the case of the dentist’s clinic PAARDEBERG, the goodwill is derived from the cost of acquisition and depends on the reputation, the doctor’s performance, and the decision of the patients. Therefore, the goodwill is subjected to changes in valuation. PAARDEBERG must monitor the economic benefits resulting from the goodwill regularly. If patients refrain from coming back, an impairment loss must be recorded towards the derived goodwill. In a situation of a growth of the patient base due to the high competence of Dr Paardeberg, an increase of goodwill is not allowed. Note, a self-generated goodwill cannot be recognised on financial statements. 7.21 Research and Design Costs The costs for development and product design are intangible assets, too. In contrast, research expenses are prohibited from recognition. Development and Design costs are based on cost calculations and are capitalised and depreciated over the number of periods, in which the goods are produced. Note, to capitalise costs means to disclose an expense on the balance sheet. Here, the capitalisation is about disclosure the total of development expenses as an intangible asset. Therefore, the expenses must be removed from the income statement or the Profit and Loss account, respectively. Specific requirements apply to consider design costs as cost of development based on IAS 38.54 - 38.64. Recognition criteria help to distinguish research and development: The first phase when new knowledge is obtained, is seen as “research”. Its costs cannot be capitalised but shall be recognised through profit or loss for the year of the research. Once the process transitions to its development phase, the reporting company must demonstrate its fulfilment of the criteria laid out in IAS 38.57, e.g., feasibility, intention, and ability of marketing the product, the potential of producing the goods etc. <?page no="177"?> Berkau: Financial Statements 9e 7-177 7.22 C/ S WESPOORT Ltd. As a case study about the capitalisation of design costs, we discuss the case of WESPOORT Ltd. in East London. The company recognises design costs for a new lawn mower model. Data Sheet for WESPOORT Ltd. Domicile: South Africa (East London). Reporting currency: ZAR. Classification: Manufacturing. Design costs: 600,000 ZAR. Fulfilment of recognition criteria on 3.03.20X4. Production commences on 31.05.20X4. Production volume: 96,000 lawn mowers in two years. VAT n/ a. WESPOORT Ltd. is a manufacturer for lawn mowers in the Eastern Cape Province. For the next season, WESPOORT Ltd. designs a new cordless lawn mower model. It conducts a Marketing Research and runs tests with rechargeable batteries. Thereafter, on 3.03.20X4, WESPOORT Ltd. starts to design the new lawn mower model and spends 600,000 ZAR on engineering. During the development phase, WESPOORT Ltd. records labour, depreciation on the design software system (CAD system) and expenses for product tests. WESPOORT Ltd. demonstrates the fulfilment of the development requirements on 3.03.20X4. WESPOORT Ltd. intends to produce 96,000 units of the new lawn mower model during the periods June/ 20X4 until May/ 20X6. The development phase ends on 31.05.20X4 and production commences right thereafter. WESPOORT Ltd. capitalises development costs to the extent of 600,000 ZAR which is depreciated at the yearend proportionate to the production volume of the new lawn mowers. The production volume is evenly distributed over the entire production period of two years. Hence, the partial development cost depreciation for the production period of seven months in 20X4 is: 7 × 600,000 / 24 = 1 175,000 ZAR. Observe below the Bookkeeping entries for the capitalisation and depreciation of development expenses as intangible, non-current assets: @ 31.05.20X4 Intangible Assets ITA 600,000 Depreciation-20X4 DPR 100,000 Labour-20X4 LAB 350,000 Other Expenses (testing) OTH 150,000 (capitalisation of development costs) @ 31.12.20X4 Depreciation-20X4 DPR 175,000 Accumulated Depreciation ACC 175,000 (recognition of depreciation on intangible assets) 7.23 Leases Following IFRS 16.9, a lease is a contract between a lessee and a lessor <?page no="178"?> Berkau: Financial Statements 9e 7-178 about an identified asset’s use for a period in exchange for a consideration (payment). 60 With the lease contract, the asset underlaying the lease contract gets in control of the lessee. The legal conveyance of the asset is an essential factor regarding the lease contract and results in the recognition of a right of use asset. The fact, that the lessee controls the asset distinguishes it from other services, where - in contrast the supplier still decides about the asset’s use, like a car rental. The lessee recognises the leased asset as a right-of-control-the-use of an asset (also termed right-of-use-asset RUA) and a lease liability, both at present values. Note, in contrast to financing by loan of, e.g., a car, where the car is recognised as a non-current asset, a lease only requires capitalisation of the right of use asset (RUA) for the period of the lease contract. The lease capitalisation affects performance ratios, e.g., the Return on Assets. Very short-term leases and leases of minor importance are exempted from recognition and are recorded as expenses based on the simplified approach, see IFRS 16.5. As an example for the application of the simplified approach following IFRS 16.5, we refer to the case study ALIGSE Ltd. in paragraph 7.27. A lease is recorded in the lessee’s books at the time of the asset transfer. 60 Study leases with the case COSSAL Ltd. in our textbook Basics of Accounting, chapter (15). For the lessee, a lease contract is like a rental contract. It pays for the underlying asset’s use, but not for the asset. Later, it returns the asset to the lessor. IFRS 16.9 requires at the commencement of a lease the reporting company to assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period in exchange for consideration. […]. The measurement of the right-of-useasset contains the present values for the lease instalments, plus prior payments, other direct costs and estimated restoring costs, as required by IFRS 16.24. For the recognition of the lease liability following IFRS 16.26 their disclosure at present values is mandated. The discount rate for the present value calculation is either the interest rate implicit in the lease or the incremental borrowing rate of the lessee. The latter one is only a substitute to the first one. Note, the rate implicit in the lease can be calculated based on the value of the underlying lease object and the lease payments. Frequently, the lessor only knows the value of the underlying asset. Note, the incremental borrowing rate is the interest rate for a further loan under consideration of the lessor’s debts. Next, we cover the lease recognition in the lessor’s books. For the lessor, a lease is a financial service. The lessor finances the lessee’s use of the underlying asset. Therefore, its revenue is interest income. Only if the lessor is a retailer, a sales revenue is recorded in its <?page no="179"?> Berkau: Financial Statements 9e 7-179 books, as demonstrated in the case study RICHTERSVELD Ltd. In general, the lessor is in the possession of the underlying asset already. Ownership results from prior purchase or manufacturing. The lessor allocates the lease object to receivables by a Bookkeeping entry like DR Lease Receivables account - CR P, P, E account. Here, we discuss the lessee’s books at first. A further case study about lessors follows. 7.24 C/ S KRIGE (Pty) Ltd. For teaching the basics of leasing, we discuss the case study KRIGE (Pty) Ltd.: Data Sheet for KRIGE (Pty) Ltd. Domicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: transportation, UBER. Lease object: Toyota car for two years. Lease payments: 120,000 ZAR/ a. Restoring costs: 50,000 ZAR. VAT ignored. Mr Krige is an UBER driver in Johannesburg. He establishes the company KRIGE (Pty) Ltd. which prepares financial statements following IFRSs. KRIGE (Pty) Ltd. enters in a lease contract over a taxi with a Toyota dealer for a two-years-period, commencing on 2.01.20X3 and ending 31.12.20X4. The lease comes with an interest rate of 5 %/ a. The rate is used for discounting. Note, The lessor decides about the interest in the lease. We calculate here with a new car costing 600,000 ZAR and leased out for five years at 120,000 ZAR/ a. When dissolving the equation: 600,000 = 120,000 × ((1+r) 5 -1)/ (r × (1 + r) 5 ) for r we get 4.88%/ a and round to up 5 %/ a for the sake of simplification. KRIGE (Pty) Ltd. pays annually 120,000 ZAR/ a lease instalments. Furthermore, KRIGE (Pty) Ltd. estimates the restoring costs for minor repairs, e.g., scratches and dents, to be 50,000 ZAR at the end of the lease. Note, frequently the measurement of the returned assets for car leases follows the milage. If the lessee estimates to overuse the car by exceeding the agreed milage limit, it will consider the car’s value decrease as payables under residual value guarantee. The payment vector for the taxi is: TC(t) = {0; -120,000; (-120,000 - 50,000)} = { {0; -120,000; -170,000}. The total lease liability is the vector’s present value of: 120,000/ 1.05 + 170,000/ 1.05 2 = 268,480.73 ZAR. KRIGE (Pty) Ltd. does not know the original price for the taxi as the dealer does not reveal its cost of acquisition. Hence, we apply the rate of 5 % (given) but will explain by the next case study how to calculate the interest implicit in a lease based on the cost of acquisition for the underlying asset. KRIGE (Pty) Ltd. recognises the right-ofuse-asset at its present value (as per 2.01.20X3) of all lease payments which includes the restoring costs: 268,480.73 ZAR. The Bookkeeping entry (1) is recorded on 2.01.20X3: <?page no="180"?> Berkau: Financial Statements 9e 7-180 @ 2.01.20X3 (1) Right-of-Use-Asset RUA 268,481 Lease Liabilitiy IBL 268,481 (recognition of the lease) For disclosure of the lease liability as per 31.12.20X3, its value is compounded over one year at 5 %; this results in a recognition of interest of: 268,480.73 × 5% = 113,424.04 ZAR and is recorded as Bookkeeping entry (2). On the balance sheet date 20X3, the lease payment for 20X3 has been made and the next payment falls under short-term liabilities. We record the payment as Bookkeeping entry (3). In compliance with IAS 1.60, we disclose the payments for 20X4 as short-term liabilities. We refrain from compounding the value over one year by 5 %. To double-check the amount, we can discount the next year’s settlement value by 5 % which gives: 170,000 / 1.05 = 1 161,904.76 ZAR. One year later, on 31.12.20X4, KRIGE (Pty) Ltd. retires the remaining lease liability. It will not be disclosed on the balance sheet as per 31.12.20X4 anymore. Observe the Bookkeeping entries (2) to (4) below which are recorded in 20X3. @ 31.12.20X3 (2) - (4) Interest-20X3 INT 13,424 Lease Liability IBL 13,424 (interest expense recognition) Lease Liability IBL 120,000 Cash/ Bank C/ B 120,000 (recording the lease payment at the yearend) Lease Liability IBL 161,905 Short-term Liabilities A/ P 161,905 (separation of short-term liabilities) IFRS 16.23 requires carrying the rightof-use-asset at cost. The cost of acquisition are the present values of all lease payments. Note, payments made at the commencement of the lease are considered for the measurement of the right-of-use-asset but do not count for the lease liabilities as they have been settled already. For subsequent valuation of the rightof-use-asset, it is depreciated based on an appropriate depreciation method and its parameters. In general, straightline method applies. Here, depreciation on the right-of-useasset is based on straight-line method without residual value consideration. Depreciation in both years is: 268,480.73 / 2 = 1 134,240.37 ZAR. The first one is recorded through profit or loss as Bookkeeping entry (5). <?page no="181"?> Berkau: Financial Statements 9e 7-181 @ 31.12.20X3 (5) Depreciation-20X3 DPR 134,240 Accumulated Depreciation ACC 134,240 (recognition of depreciation on the right of use asset) Study the accounts in Figure 7.8. D C D C (1) 268,481 c/ d 268,481 (3) 120,000 (1) 268,481 b/ d 268,481 (4) 161,905 (2) 13,424 281,905 281,905 Right-of-use-asset RUA Lease liability IBL D C D C c/ d 120,000 (3) 120,000 c/ d 161,905 (4) 161,905 b/ d 120,000 b/ d 161,905 Cash/ Bank C/ B Short-term liabilities A/ P D C D C (5) 134,240 P3L 134,240 c/ d 134,240 (5) 134,240 b/ d 134,240 Depreciation-20X3 DPR Accumulated depreciation ACC D C D C DPR 134,240 NL 147,664 P3L 147,664 c/ d 147,664 INT 13,424 b/ d 147,664 b/ d 147,664 R/ E 147,664 D C (2) 13,424 P3L 13,424 Profit and Loss-20X3 P3L Retained earnings R/ E Interest-20X3 INT Figure 7.8: KRIGE (Pty) Ltd.’s accounts (20X3) In 20X4, KRIGE (Pty) Ltd. depreciates the right-of-use-asset by Bookkeeping entry (A) and pays the agreed 170,000 ZAR. The payment is recorded as Bookkeeping entry (B) and includes the lease instalment and the given value guarantee payment: 120,000 + 50,000 = 1 170,000 ZAR. Bookkeeping entry (C) calculates the interest on the short-term liabilities. It is: 161,904.76 × 5% = 8 8,095.24 ZAR. Note, in general, the separate disclosure of short-term liabilities and longterm liabilities comes together with a different measurement. However, lease liabilities are usually held at present values which applies for their long-term as well as for their shortterm portion. <?page no="182"?> Berkau: Financial Statements 9e 7-182 Interest is capitalised towards the shortterm liabilities. Therefore, the Shortterm Liability account discloses the compounding of liabilities over one year at 5 %. As a result, the short-term liabilities increase before payment is made towards: 161,904.76 + 8,095.24 = 1 170,000 ZAR. For the disposal of the car, we apply a Realisation account. The disposal of the car is recorded as Bookkeeping entries (D’) and (D’’). @ 31.12.20X4 (A), (B), (C), (D') and (D'') Depreciation-20X4 DPR 134,240 Accumulated Depreciation ACC 134,240 (recording depreciation on the right of use asset) Short-term Liabilities A/ P 170,000 Cash/ Bank C/ B 170,000 (recording the lease payment at the yearend) Interest-20X4 INT 8,095 Short-term Liabilities A/ P 8,095 (compound liabilities at 5 %) Realisation-20X4 REA 268,481 Right-of-Use-Asset RUA 268,481 (disposal of the right of use asset) Accumulated Depreciation ACC 268,481 Realisation-20X4 REA 268,481 (derecognition of accumulated depreciation) In Figure 7.9, the Realisation account is zero-balanced. The total expenses are depreciation, interest and restoring costs. D C D C (1) 268,481 c/ d 268,481 P3L 147,664 c/ d 147,664 b/ d 268,481 (D') 268,481 b/ d 147,664 P4L 142,336 c/ d 290,000 290,000 290,000 b/ d 290,000 Right-of-use-asset RUA Retained earnings R/ E Figure 7.9: KRIGE (Pty) Ltd.’s accounts (20X4) <?page no="183"?> Berkau: Financial Statements 9e 7-183 D C D C c/ d 120,000 (3) 120,000 c/ d 161,905 (4) 161,905 b/ d 120,000 (B) 170,000 b/ d 161,905 c/ d 290,000 (B) 170,000 (C) 8,095 290,000 290,000 170,000 170,000 b/ d 290,000 Cash/ Bank C/ B Short-term liabilities A/ P D C D C (A) 134,240 P4L 134,240 c/ d 134,240 (5) 134,240 b/ d 134,240 (D'') 268,481 (A) 134,240 268,481 268,481 Depreciation-20X4 DPR Acc depr ACC D C D C (3) 120,000 (1) 268,481 (C) 8,095 P4L 8,095 (4) 161,905 (2) 13,424 281,905 281,905 Lease liabilities IBL Interest-20X4 INT D C D C DPR 134,240 NL 142,336 (D') 268,481 (D'') 268,481 INT 8,095 142,336 142,336 Profit and Loss-20X4 P4L Realisation REA Figure7.9: KRIGE (Pty) Ltd.’s accounts (20X4) continued How it is Done (Recording Leases): (1) Examine whether a lease applies. (2) Determine the value of the right-of-use-asset. (3) Determine the lease liabilities as the present value of future lease payments. Consider extra payments like for restoring costs. (4) Record the right-of-use-asset and the lease liability at the same time. (5) Depreciate the right-of-use-asset. (6) Compound the lease liability every year and deduct lease payments. (7) The carrying values of the right-of-use-asset and the lease liability can differ due to their measurements. <?page no="184"?> Berkau: Financial Statements 9e 7-184 (8) At the end of the lease term, record a disposal of the right-of-use-asset and the retirement of the lease liabilities. 7.25 C/ S ALIGSE Ltd. The case ALIGSE Ltd. is to demonstrate the recording of a lease following the simplified approach along IFRS 16.5. Note, ALIGSE Ltd.’s lease is no operating lease. The term operative vs. financial lease is based on the classification in IFRS 16.61. Here we discuss finance leases following the general approach or short-term leases based on IFRS 16.5 which are recorded following the simplified approach. A rental agreement which does not transfer risks and rewards will be discussed in the case study JONKERS GmbH in paragraphs 7.30 and 7.31 is termed an operating lease. Data Sheet for ALIGSE Ltd. Domicile: South Africa (Bloemfontein). Reporting currency: ZAR. Classification: n/ a. Lease object: computer for two years. Lease instalments: 1,000 ZAR/ m for the first year, 1,300 ZAR/ m for the second year. Lease period: 1.04.20X1 - 31.03.20X3. VAT ignored. The recording based on the simplified approach is ruled by IFRS 16.6: The lessee recognises the lease payments associated with the lease as an expense on either straight-line basis over the lease term or another systematic basis. ALIGSE Ltd. leases a computer from BENNINGSEN (Pty) Ltd. for a period of 24 months. This lease qualifies as a lease of a low-value asset and thus qualifies for the recognition exemption. ALIGSE Ltd. chooses to apply the recognition exemption to this lease. Note, IFRS 16.5 does not force the reporting entity to apply the simplified approach but tolerates the reporting entity to follow the general approach for finance leases. The lease payments are 1,000 ZAR/ m for the first year and 1,300 ZAR/ m for the second year. The lease commences on 1.04.20X1. ALIGSE Ltd. fiscal years end on 31.12.20XX. As ALIGSE Ltd. follows the simplified approach, it determines the average monthly lease payments for the entire lease: (12 × 1,000 + 12 × 1,300) / 24 = 1,150 ZAR/ m. For the lease, payments differ from the expenses. In 20X1, the lease expense is amounting to: 9 × 1,150 = 1 10,350 ZAR. The payments are only: 9 × 1,000 = 9,000 ZAR. As the lease payments are lower than the lease expenses, ALIGSE Ltd. must record short-term liabilities. We provide the journal entries pretending there is only one entry made at the yearend. <?page no="185"?> Berkau: Financial Statements 9e 7-185 @ 31.12.20X1 Lease Expense-20X1 LEX 10,350 Cash/ Bank C/ B 9,000 Accounts Payables A/ P 1,350 (recognition of lease expenses) In the next fiscal year 20X2, the expenses give: 12 × 1,150 = 1 13,800 ZAR. The payments made are based on the lease agreement and are amounting to: 3 × 1,000 + 9 × 1,300 = 114,700 ZAR. As now the lease payments exceed the lease expenses, payables are released to the extent of: 14,700 - 13,800 = 9 900 ZAR. This means the balancing figure of the payables are at the yearend of 20X2: 1,350 - 900 = 4450 ZAR. We disclose the journal entry representing the twelve payments and expenses: @ 31.12.20X2 Lease Expense-20X2 LEX 13,800 Accounts Payables A/ P 900 Cash/ Bank C/ B 14,700 (recognition of lease expenses) In the last year 20X3, the lease agreement ends on 31.03.20X3. There are only three payments to record: 3 × 1,300 = 33,900 ZAR. The lease expenses are amounting to: 3 × 1,150 = 3 3,450 ZAR. The release from payables is: 3,900 - 3,450 = 4 450 ZAR. Observe the journal entry for the recording of the lease in 20X3 below: @ 31.12.20X3 Lease Expense-20X3 LEX 3,450 Accounts Payables A/ P 450 Cash/ Bank C/ B 3,900 (recognition of lease expenses) How it is Done (Simplified Approach for Lease Recording): (1) Check whether criteria in IFRS 16.5 are met (low value, short-term lease). (2) Decide whether to apply the recognition exemption. (3) Calculate the average lease expenses for the entire lease term. (4) Record annual lease expenses (consider prepayments, accounts payables etc.) Overpayments lead to prepaid expenses, and underpayments require to record the lease expenses on credit (A/ P). (5) Check at the end of the lease term whether the lease payments equal the sum of lease expenses. <?page no="186"?> Berkau: Financial Statements 9e 7-186 7.26 C/ S RICHTERSVELD (Pty) Ltd. - Lessee For the case study RICHTERSVELD (Pty) Ltd. which is a finance lease we discuss the lessee’s and the lessor’s books. RICHTERSVELD (Pty) Ltd. is a bakery. It enters in a lease with the retailer BOULANGER Ltd. about a kneading machine. Based on IFRS 16.63, situations that indicate finance leases are those, where risks and rewards are transferred to the lessee, where the lessee has an option to purchase the underlying asset and it is at the inception date reasonably certain that the lessee exercises the purchase option, where the lease term covers the major part of the economic life, where the present value of the lease payments amounts to the value of the underlying asset and where the underlying asset is of specialised nature that only the lessee can use it. Not all criteria need to be fulfilled. Data Sheet for RICHTERSVELD (Pty) Ltd. Domicile: Australia (Melbourne). Reporting currency: AUD. Classification: Food industry (bakery). Asset underlying the lease: kneading machine for two years. Gross purchase price: 108,000 AUD. Initial payment: 10,000 AUD. Lease payments: 24,000 AUD/ a. Lease period: 20X4, 20X5. Interest rate (incremental borrowing rate lessee): 8 %/ a Type of lease: Finance lease. Purchase option: at 45,000 AUD at the end of the lease. VAT rate = 20 %. RICHTERSVELD (Pty) Ltd. is a bakery in Melbourne. For its bread unit, the company enters in a lease with BOULANGER Ltd. over a kneading machine. RICHTERSVELD (Pty) Ltd. intends to lease the machine for two years and can purchase it thereafter. At the commencement of the lease a payment of 10,000 AUD is due. The lease instalments are 24,000 AUD/ a. For the time after the lease, the lease contract includes a purchase option to buy the machine at 45,000 AUD. RICHTERSVELD (Pty) Ltd. guarantees the value of the machine to be 45,000 AUD after its two years of deployment. Due to intensive usage of the machine with high volumes, it expects the machine to be worth only 43,000 AUD at the end of the lease term. Therefore, a payment of 2,000 AUD is expected to be made to fulfil the given value guarantee. Under IFRS 16.27 the payment becomes part of the right-ofuse-asset. RICHTERSVELD (Pty) Ltd. intends to exercise the purchase option but is not sure about it yet. Note, following IFRS 16.27 the exercise price for the purchase option is to be considered for the calculation of the right-ofuse-asset and the lease liabilities if the lessee is certain to exercise the option. RICHTERSVELD (Pty) Ltd. applies for its calculations of the right-of-use-asset and the lease liabilities its incremental borrowing interest rate of 8 %/ a, as the interest rate implicit in the lease is unknown for RICHTERSVELD (Pty) Ltd. The value of the right-of-use-asset is the present value of all lease payments. The <?page no="187"?> Berkau: Financial Statements 9e 7-187 vector for the lease is: R(t) = {10,000; 24,000; (24,000 + 2,000)} = { {10,000; 24,000; 26,000}. Its present value based on a discount rate of 8 % is: 10,000 + 24,000/ (1 + 8%) + 26,000/ (1 + 8%) 2 = 54,513.03 AUD. The right-of-use-asset exceeds the lease liability by 10,000 AUD, as the initial payment has been made in t=0 and therefore, it is no liability. RICHTERSVELD (Pty) Ltd. recognises the lease on 2.01.20X4 by Bookkeeping entry (1). @ 2.01.20X4 (1) Right-of-Use-Asset RUA 54,513 Lease Liabilitiy IBL 44,513 Cash/ Bank C/ B 10,000 (recognition of the lease of the kneading machine) At the end of 20X4, RICHTERSVELD (Pty) Ltd. records interest of: 44,513.03 × 8% = 33,561.04 AUD and depreciation of: 54,513.03/ 2 = 2 27,256.52 AUD. Furthermore, the lease payment of 24,000 AUD is paid to the lessor. Observe the Bookkeeping entries (2) - (4). Note, We ignore here the separate disclosure of short-term and long-term liabilities along IAS 1.60. That aspect got covered by the case study KRIGE (Pty) Ltd. already. @ 31.12.20X4 (2), (3), (4) Depreciation-20X4 DPR 27,257 Accumulated Depreciation ACC 27,257 (recognition of depreciation on the right of use asset) Lease Liabilities IBL 24,000 Cash/ Bank C/ B 24,000 (recording the lease payment at the yearend) Interest-20X4 INT 3,561 Lease Liabilitiy IBL 3,561 (interest expenses recognition for 20X4) Study the accounts as per 31.12.20X4 in Figure 7.10. <?page no="188"?> Berkau: Financial Statements 9e 7-188 D C D C (1) 54,513 c/ d 54,513 OV . . . (1) 10,000 b/ d 54,513 c/ d 34,000 (3) 24,000 34,000 34,000 b/ d 34,000 D C D C (3) 24,000 (1) 44,513 (2) 3,561 P4L 3,561 c/ d 24,074 (2) 3,561 48,074 48,074 b/ d 24,074 Right of use asset RUA Cash/ Bank C/ B Lease liability IBL Interst-20X4 INT D C D C (4) 27,257 P4L 27,257 c/ d 27,257 (4) 27,257 b/ d 27,257 D C D C DPR 27,257 R/ E 30,818 P4L 30,818 c/ d 30,818 INT 3,561 b/ d 30,818 30,818 30,818 Depreciation-20X4 DPR Accumulated depreciation ACC Profit and Loss-20X4 P4L Retained earnings R/ E Figure 7.10: RICHTERSVELD (Pty) Ltd.’s accounts (20X4) In 20X5, RICHTERSVELD (Pty) Ltd. recognises interest expenses of: (44,513.03 × 1.08 - 24,000) × 8% = 1 1,925.93 AUD and depreciation to the extent of 27,256.52 AUD. Observe the accounts after recording expenses and making payments to the lessor in Figure 7.11. D C D C (1) 54,513 c/ d 54,513 OV . . . (1) 10,000 b/ d 54,513 REA 54,513 c/ d 34,000 (3) 24,000 34,000 34,000 b/ d 34,000 c/ d 60,000 (B) 26,000 60,000 60,000 b/ d 60,000 Right-of-use-asset RUA Cash/ Bank C/ B Figure 7.11: RICHTERSVELD (Pty) Ltd.’s accounts (20X5) <?page no="189"?> Berkau: Financial Statements 9e 7-189 D C D C (3) 24,000 (1) 44,513 (2) 3,561 P4L 3,561 c/ d 24,074 (2) 3,561 48,074 48,074 (B) 26,000 b/ d 24,074 (C) 1,926 26,000 26,000 Lease liability IBL Interst-20X4 INT D C D C (4) 27,257 P4L 27,257 c/ d 27,257 (4) 27,257 b/ d 27,257 c/ d 54,513 (A) 27,257 54,513 54,513 REA 54,513 b/ d 54,513 Depreciation-20X4 DPR Accumulated depreciation ACC D C D C DPR 27,257 R/ E 30,818 P4L 30,818 c/ d 30,818 INT 3,561 b/ d 30,818 30,818 30,818 P5L 29,182 c/ d 60,000 60,000 60,000 b/ d 60,000 Profit and Loss-20X4 P4L Retained earnings R/ E D C D C (A) 27,257 P5L 27,257 (C) 1,926 P5L 1,926 D C D C DPR 27,257 R/ E 29,182 RUA 54,513 ACC 54,513 INT 1,926 29,182 29,182 Profit and Loss-20X5 P5L Realisiation-20X5 REA Depreciation-20X5 DPR Interest-20X5 INT Figure 7.11: RICHTERSVELD (Pty) Ltd.’s accounts (20X5) continued 7.27 C/ S RICHTERSVELD (Pty) Ltd. - Lessor Next, we discuss the lease of the kneading machine in the lessor’s books. The lessor is BOULANGER Ltd. which is a retailer for industrial kitchen appliances. Its model is to buy the machines from the manufacturer and sell them on with adding a sales margin of 25 % to the cost of acquisition. In the case of the kneading machine, the company buys it a gross purchase price of 86,400 AUD. The cost of acquisition is: 86,400 / 120% = 7 72,000 AUD. The market value for the kneading machine is 72,000 × (1 + 25%) = 9 90,000 AUD <?page no="190"?> Berkau: Financial Statements 9e 7-190 (net selling price). Accordingly, the margin for BOULANGER Ltd. from the sale of the machine is: 90,000 - 72,000 = 18,000 AUD. On 2.01.20X4, we record the acquisition of the kneading machine at BOULANGER Ltd. as Bookkeeping entry (1) VAT applies at a VAT rate of 20 %. @ 2.01.20X4 Asset Held for Lease A4L 72,000 Value Added Tax VAT 14,400 Cash/ Bank C/ B 86,400 (recognition of the kneading machine) For the calculation of the interest rate implicit in the lease, we determine the payment vector of the lease which is based on the fair market value of the kneading machine 61 and the payments expected from RICHTERSVELD (Pty) Ltd. B(t) = {(-90,000 + 10,000); 24,000; (24,000 + 45,000)} = { {-80,000; 24,000; 69,000}. The vector considers the purchase of the machine or its return at the agreed and guaranteed value. Its internal rate of return is calculated by the MS-Excel function Internal Rate of Return: IRR(B(t)) = 9 9.07 44 %/ a. Under a return of the machine after two years at the expected value and adding extra costs for the fulfilment of the given value guarantee, the vector also is: B(t) = {- 80,000; 24,000; (24,000 + 2,000 + 43,000)} = {-80,000; 24,000; 69,000}. Hence, the interest implicit in the lease does not change depending on whether the lessee exercises the purchase option. As BOULANGER Ltd. receives the initial payment from RICHTERSVELD (Pty) Ltd., the receivables are the present value of the future payments: 24,000/ (1 + 9.07 44 %) + 69,000 / (1 + 9.07 44 %) 2 = 80,000.05 AUD. By the Bookkeeping entries (2) and (3), BOULANGER Ltd. recognises its revenue and the cost of sale. The difference gives the sales profit. Bookkeeping entry (4) records the interest income for 20X4 as: 80,000.05 × 9.0744% = 77,259.56 AUD, and Bookkeeping entry (5) records the receipt from the lessee to the extent of 24,000 AUD. Find below the Bookkeeping entries as recorded in the lessor’s books for 20X4. 61 IFRS 16.71 applies. <?page no="191"?> Berkau: Financial Statements 9e 7-191 @ 31.12.20X4 Cash/ Bank C/ B 10,000 Accounts Receivables A/ R 80,000 Revenue-20X4 REV 90,000 (sales revenue recognition of the kneading machine) Cost of Sale-20X4 COS 72,000 Asset Held for Lease A4L 72,000 (recording the cost of sale) Accounts Receivables A/ R 7,260 Interest Income-20X4 I4I 7,260 (recording interest income for 20X4 based on the rate implicit in the lease) Cash/ Bank C/ B 24,000 Accounts Receivables A/ R 24,000 (cash receipt from the lessee RICHTERSVELD (Pty) Ltd.) In Figure 7.12 all relevant accounts for BOULANGER Ltd. are shown. Calculations have been made based on the rate implicit in the lease which has been determined by the IRR() function in MS- Excel. 62 D C D C (1) 72,000 (3) 72,000 (1) 14,400 c/ d 14,400 b/ d 14,400 (B) 14,400 Asset held for lease A4L Value added tax VAT D C D C OV . . . (1) 86,400 (2) 80,000 (5) 24,000 (2) 10,000 (4) 7,260 c/ d 63,260 (5) 24,000 87,260 87,260 c/ d 52,400 b/ d 63,260 (D) 69,000 86,400 86,400 (C) 5,740 (B) 14,400 b/ d 52,400 69,000 69,000 (D) 69,000 (A) 7,578 c/ d 23,422 83,400 83,400 b/ d 23,422 D C D C P4L 90,000 (2) 90,000 (3) 72,000 P4L 72,000 Revenue-20X4 REV Cost of sale-20X4 COS Cash/ Bank C/ B Accounts receivables A/ R Figure 7.12: BOULANGER Ltd.’s accounts 62 Examples about lease modifications can be found in: Berkau/ Neethling/ Msiza: Case Study FIUMICINO (Pty) Ltd.: Lease Modifications in the Lessors' Books - IFRS 16. in: KOR 24(2024)7/ 8, pg. 297-303. <?page no="192"?> Berkau: Financial Statements 9e 7-192 D C D C COS 72,000 REV 90,000 P4L 7,260 (4) 7,260 EBT 25,260 I4I 7,260 97,260 97,260 ITL 7,578 b/ d 25,260 R/ E 17,682 D C D C c/ d 17,682 P4L 17,682 c/ d 7,578 P4L 7,578 b/ d 17,682 (A) 7,578 b/ d 7,578 c/ d 21,700 P5L 4,018 c/ d 1,722 P5L 1,722 21,700 21,700 9,300 9,300 b/ d 21,700 b/ d 1,722 Retained earnings R/ E Income tax liabilities ITL Profit and Loss-20X4 P4L Interest income-20X4 I4I D C D P5L 5,740 (C) 5,740 EBT 5,740 I5I 5,740 ITL 1,722 b/ d 5,740 R/ E 4,018 Interest income-20X5 I5I Profit and Loss-20X5 P5L Figure 7.12: BOULANGER Ltd.’s accounts continued 7.28 Short-term Leases Leases can also be short-term and then must be recorded as expense. See below the case study JONKERS GmbH, a consultancy based in Osnabrück. 7.29 C/ S JONKERS GmbH The company regularly visits its clients and bills travel expenses directly without adding further surcharges to them. At JONKERS GmbH, only short-term leases apply which are considered as an expense and recorded through profit or loss. Data Sheet for JONKERS GmbH: Domicile: Germany (Osnabrück). Reporting currency: EUR. Classification: Consultancy. Rent of an Audi A4 on 6.06.20X7 for four days. Lease rates: 135 EUR/ d. Insurance rate: 40 EUR/ d. VAT ignored. On 6.06.20X7, JONKERS GmbH visits a client in Saarbrücken. From a car rental, JONKERS GmbH hires an Audi A4. It returns the car on 9.06.20X7, which results in rental expenses for four days of: 4 × 135 = 5 540 EUR. Although the risk of accident is transferred to JONKERS GmbH, no lease applies following IFRS 16. JONKERS GmbH insures the car and accrues insurance fees to its Travel Expense account. Insurance is: 4 × 40 = 1 160 EUR. JONKERS GmbH charges its client the total travel costs of: 540 + 160 = 7 700 EUR. The settlement on travel expense receivables by the client is not recorded as revenue but as a credit entry in the Travel Expense account; it represents <?page no="193"?> Berkau: Financial Statements 9e 7-193 other income from third party’s expense coverage. JONKERS GmbH records the cost by two Bookkeeping entries: (1) for the car rental and (2) for the receipt of the settlement of receivables by its client. @ 9.06.20X7 Travel Expenses-20X7 TEX 700 Cash/ Bank C/ B 700 (recognition of travel expenses billed by the car rental) @ 1.07.20X7 Cash/ Bank C/ B 700 Travel Expenses-20X7 TEX 700 (recording the receipt of the refund) 7.30 Financial Instruments For financial instruments, we refer to IAS 32, (Financial Instruments, Presentation), IFRS 7: (Financial Instruments, Disclosure) and IFRS 9: (Financial Instruments). IAS 32.11 defines financial instruments. A financial instrument is any contract that gives rise to a financial asset at one company and a financial liability or equity instrument at another one. E.g., if a company buys fresh shares, it will disclose them as non-current assets and the emitting corporation records the entire share issue under issued capital and most probably under capital reserves as well (for the premium). In this textbook, long-term financial instruments are covered in this chapter (7). In chapter (14) we discuss financial liabilities. Their measurements are based on the same IFRS standards. Short-term financial assets are covered in chapter (9). We discuss several financial assets to provide you with a wide range of knowledge of how to recognise and measure financial instruments. However, most of the case studies have been moved to the online materials. We list below the discussed financial asset categories together with their case study names: (a) Cross-border investment in another company, based on ordinary shares - HAWKINS Ltd. / STEYN GmbH. (b) Bonds traded on a bond market - HAVENGA Ltd. (c) Bonds held to maturity - NATBERGEN (Pty) Ltd. (d) Preference Shares, held at FVTOCI and later Sold - DORRINGTON Ltd. / ROTTMAN Ltd. (e) Derivatives, call option to buy copper - MOLLENBERG Ltd. IAS 32 defines financial instruments but does not rule their recognition and measurement. However, IFRS 7 and IFRS 9 do. All aspects of how to disclose financial instruments have now been moved to IFRS 7: Financial Instruments, Disclosure. Aspects of measurement can be found in IFRS 9. In this chapter, we focus on the owners' side. Financial assets are investments, ownership of shares, bonds, re- <?page no="194"?> Berkau: Financial Statements 9e 7-194 ceivables, currency futures, call options etc. We cover here a selection of cases to show different ways of how owners record and measure financial assets. The main rule for the disclosure of financial instruments is to study the business model of the holding company. Business model is a technical term in Accounting which refers to what the owner intends to do with her/ his financial assets. We distinguish financial assets held until maturity from those held for trading purpose. If e.g., a company holds bonds 63 until they mature, it must disclose them at amortised costs. If a shareholder intends to sell her/ his stock whenever a good price can be obtained, we allocate the shares to the current asset section. The valuation is then based on fair market values. Note, as shares do not mature, this is the default case. We focus on current financial assets in chapter (9). We refer to the case of HAWKINS Ltd., a South African company that reports in accordance with IFRSs and holds an investment in a German company. The case description is accessible through the Link 7.G. 63 Study bonds in our textbook Basics of Accounting, chapter (15). Link 7.H: C/ S HAWKINS Ltd. / STEYN GmbH - Cross-Border Investments In the case HAVENGA Ltd., the limited company buys bonds which are traded on the bond market. Reach the case via the Link 7.I. Link 7.I: HAVENGA Ltd. - Bond valuation In case a holder buys bonds with a premium or discount and keeps them until maturity, the effective interest method applies in line with IFRS 9.4.1.2 and IFRS 9.5.4.1., which will approximate the bond valuation consequently towards its redemption value. We demonstrate a measurement at amortised costs by the case study NATBERGEN (Pty) Ltd. <?page no="195"?> Berkau: Financial Statements 9e 7-195 7.31 C/ S NATBERGEN (Pty) Ltd. - Bonds Held to Maturity Data Sheet for NATBERGEN (Pty) Ltd. Domicile: Australia (Brisbane). Reporting currency: AUD. Classification: n/ a. Bonds at 400,000 AUD, cost of acquisition: 350,000 on 3.01.20X3. Bonds mature on 31.12.20X7. Coupon rate: 8 %/ a. VAT ignored. On 3.01.20X3, NATBERGEN (Pty) Ltd. buys bonds five years before they mature at 350,000 AUD. Their face value is 400,000 AUD. We say the acquisition was at a discount (below-par). The discount usually is expressed as a percentage, here we could say, traded at 87.5 because the amount is: 350,000 / 400,000 = 887.5% of the face value. With a price of 440,000 AUD, we would have said, traded at 10, as the cost of acquisition is: 440,000 / 400,000 = (1 + 10%) above the nominal value. A bond price below principal results either from an interest market rate that exceeds the coupon rate or from the investors’ mistrust towards the issuer’s capability to pay coupons and/ or for redemption. The coupon rate of NATBERGEN (Pty) Ltd.’s bonds is 8 %/ a which makes the holder receive an annual coupon of: 8% × 400,000 = 332,000 AUD/ a. Dividend and interest always are calculated based on nominal values. NATBERGEN (Pty) Ltd. initially recognises the bonds at 350,000 AUD (cost of acquisition). Check the Bookkeeping entry below: @ 3.01.20X3 Financial Assets (Bonds) FNA 350,000 Cash/ Bank C/ B 350,000 (recognition of bonds) NATBERGEN (Pty) Ltd. keeps the bonds until maturity and benefits only from bond related payments. The bond payments are linked to interest (coupon) and repayment. Note, payments like this are called solely payments of principal and interest SPPI. Measurement at amortised costs applies. The calculation of the amortised costs ignores all fluctuations of the bonds’ fair market values. The effective interest method follows opening and closing values and payments made or received in between. Here, NATBERGEN (Pty) Ltd. buys the bonds at 350,000 AUD (opening value) and receives at the time of redemption (on 31.12.20X7) 400,000 AUD. In between and in the last year, coupons are received. The payment vector is: B(t) = {(350,000); 32,000; 32,000; 32,000; 32,000; 432,000}. Under a valuation at amortised costs, the current value is compounded at the effective rate of interest. All payments for coupons and redemption must be deducted for the bond valuation. Check the valuation of NATBERGEN (Pty) Ltd.’s bonds in Figure 7.16. and in the How-itis-Done paragraph below. It results in a valuation of zero after redemption. In the first year is gives: 350,000 × (1 + 11.41 77 %) - 32,000 = 357,961.95 AUD. <?page no="196"?> Berkau: Financial Statements 9e 7-196 Note, that we calculate the tables by MS- Excel and do not make rounding adjustments. This means we calculate the vector’s internal rate of return and lookup the result in the next formula. How it is Done (Effective Interest Method for Bonds on the Holder’s side) (1) Prepare the payment vector for the financial asset (bond). (2) Determine the effective rate of interest by the internal rate of return function in MS Excel. (3) Compound the actual value of the financial asset (bond) by the effective rate of interest. (4) Deduct all payments for coupons and/ or redemption (5) This results in the final value of the financial asset (bond). The effective rate of interest for the vector B(t) is 11.41 77 %/ a. An alternative approach is to calculate the effective rate of interest by a financial schedule, as demonstrated in Link 7.J. The link directs you to an MS-Excel sheet. Link 7.J: NATBERGEN (Pty) Ltd. Period Opening amount Eff. interest Coupon received/ redemption Carrying amount 20X3 350,000.00 39,962.10 32,000.00 357,962.10 20X4 357,962.10 40,871.19 32,000.00 366,833.29 20X5 366,833.29 41,884.08 32,000.00 376,717.37 20X6 376,717.37 43,012.62 32,000.00 387,729.99 20X7 387,729.99 44,270.01 432,000.00 (0.00) Natbergen (Pty) Ltd. BOND VALUATION PLAN (20X3 - 20X7) Figure 7.13: Bond measurement at effective interest <?page no="197"?> Berkau: Financial Statements 9e 7-197 Until the time of maturity, NATBERGEN (Pty) Ltd. increased the bonds incrementally to a value of 400,000 AUD which is the settlement value at redemption. We discuss below a further case study DORRINGTON Ltd. about redeemable preference shares. To access the case study DORRINGTON Ltd./ ROTTMAN Ltd. follow Link 7.K. Link 7.K: DORRINGTON (Pty) Ltd./ ROTTMAN Ltd. - preference shares 7.32 Derivatives A special form of financial instruments are derivatives. They are often acquired for risk compensation (hedging). Derivatives are financial instruments where the financial obligation of the issuer depends on a particular value, e.g., the price of commodities. Derivatives are futures, swaps, and options. The valuation of derivatives is based on fair values through profit or loss (FVTPL) or fair values through other comprehensive income (FVTOCI). We discuss the case of electro manufacturer MOLLENBERG Ltd. who buys a call option for copper to secure its production costs on a volatile market for commodities. Note, this chapter is not about the calculation of the cost of acquisition for MOLLENBERG Ltd.’s purchase of copper but for the financial instrument held to secure it. We only discuss the measurement of the call option at various times. A call option is a contract where the option holder receives a contractual right to buy commodities or financial instruments at a certain time or within a certain period for a fixed strike price by paying a premium (fee). Options can be sold on. As the option holder has more alternatives as the seller (the option writer), we describe her/ his situation as long. Accordingly, the option writer is in the short position. If the market price falls below the strike price when the option can be exercised the option becomes futile, we say, "out of the money" and the option holder paid the expenses for the option (premium) in vain. No obligation to exercise the option applies. If the market price exceeds the strike price (“in the money”), the option holder benefits from the price difference. However, the profit made must be reduced for the premium previously paid. Call options make sense if their holder expects the market prices to increase. Options can be linked to purchases (calls) or sales (puts). In the case of MOLLENBERG Ltd. the company takes a long call position. 7.33 MOLLENBERG Ltd. - Call Option MOLLENBERG Ltd. buys a call option on copper at a premium of 10,000 AUD. <?page no="198"?> Berkau: Financial Statements 9e 7-198 Data Sheet for MOLLENBERG Ltd. Domicile: Australia (Perth). Reporting currency: AUD. Classification: Manufacturing. Call option: 100,000 lbs. copper at 360,000 AUD. Copper prices: 2.50 USD/ lb; 2.65 USD/ lb. Currency exchange rates: 69 USD = 100 AUD; 72 USD = 100 AUD. Premium: 10,000 AUD. VAT n/ a. MOLLENBERG Ltd. needs copper as material for its products. The copper price fluctuates and MOLLENBERG Ltd. expects the purchase prises to increase in the nearby future. It buys a call option which allows the purchase of copper at 3.60 AUD/ lb on 31.12.20X9. The option is purchased on 14.05.20X5 when the copper price is 2.50 USD/ lb. The currency exchange rate to the US-Dollar was at that time: 69 USD : 100 AUD. MOLLENBERG Ltd. pays for the premium 10,000 AUD. The copper amount is 100,000 lbs. The initial valuation takes place on 14.05.20X5. MOLLENBERG Ltd. records the option as financial asset. Check below the Bookkeeping entry (1) which is recorded at cost of acquisition and represents the paid fees: @ 14.05.20X5 Financial Asset (call option) FNA 10,000 Cash/ Bank C/ B 10,000 (recognition of the call option for copper at costs (fee)) If on 31.12.20X5, the copper price is below 3.60 AUD/ lb the option becomes (temporarily) void as MOLLENBERG Ltd. could buy copper without exercising the call option. However, a drop in copper price will not impair the call option immediately as MOLLENBERG Ltd. does not know the price on 31.12.20X9 yet (four years later). The valuation of the call option as per 31.12.20X5 is at fair value through other comprehensive income. The reason is that there is still a chance to sell on the call option. We assume, that on 31.12.20X5, the copper price is 2.65 USD/ lb, and the exchange rate is: 72 USD : 100 AUD. For the fair value calculation of the call option, we calculate the temporary gain related to the purchase price. On 31.12.20X5, 100,000 lbs copper cost: 100,000 × 2.65 / 0.72 = 3368,055.56 AUD. Due to the call option, MOLLENBERG Ltd. can buy the copper at 360,000 AUD. Hence, the fair value of the option is: 368,055.56 - 360,000 = 8 8,055.56 AUD. This results in a decrease in valuation compared to the cost of acquisition of: 10,000 - 8,055.56 = 1 1,944.44 AUD. MOLLENBERG Ltd. who measures the call option at FVTOCI adjusts the measurement by making Bookkeeping entry (2). The valuation considers that the advantage of buying cheap is reduced for the premium. <?page no="199"?> Berkau: Financial Statements 9e 7-199 @ 31.12.20X5 Other Expenses-20X5 OTH 1,944 Financial Asset (call option) FNA 1,944 (loss recognition on call option) In the next years, MOLLENBERG Ltd. continues the adjustments of its call option measurement based on copper prices and the exchange rates to the USD. If the price is below 360,000 AUD on 31.12.20X9, the call option is out of the money and MOLLENBERG Ltd. records an impairment loss for the (remaining) premium as the call option becomes useless. If the call option is validated for the purchase of copper, the call option must be expensed. We are not supposed to consider the call option as cost of purchase for MOLLENBERG Ltd.’s copper. To keep the case study short, we assume that the valuation of 8,055.56 AUD from 20X5 stays (no further copper price changes) and the price for the required copper quantity is 365,000 AUD on 31.12.20X9. The costs of purchase for copper now are: 360,000 AUD. We add the cost of validation of the call option to the expenses on the income statement of 8,055.56 AUD. You might consider that we recorded in 20X5 already expenses to the extent of 1,944.44 AUD as impairment loss. Therefore, the total call option costs are 8.055,56 + 1.944,44 = 1 10,000 AUD. The above shown validation costs and costs of acquisition apply for all copper prices exceeding 360,000 AUD. We now assume (as an alternative scenario) the copper price is 355,000 AUD on 31.12.20X9. MOLLENBERG Ltd. forfeits the call option, buys copper at 355,000 AUD, and records an impairment loss on the call option. Thus, the costs of purchase are: 355,000 AUD and the impairment loss of 8,055.56 AUD. We also must consider the impairment loss from 20X5 to an extent of 1,944.44 AUD. Note, we do not disclose the materials at 365,000 AUD as the impairment loss is recorded through profit or loss already und separate to the cost of purchase. Securities to save a price are no cost of acquisition. In comparison to not buying the call option, the costs of acquisition are the same but there is an extra expense for the impairment loss of the call option to recognise (in different accounting periods) of: 8,055.56 + 1,944.44 = 1 10,000 AUD. These is the fee for the premium. So far, we discussed financial instruments held for longer periods. If companies hold shares or bonds or other financial instruments short-term, we allocate them to securities in the current asset section of the balance sheet. We discuss those instruments in chapter (9). How it is Done (Recording Financial Assets as non-Current Assets): (1) Determine whether the financial asset is held shortterm or long-term. For short-term recognition check chapter (9) in this textbook. <?page no="200"?> Berkau: Financial Statements 9e 7-200 (2) Recognise long-term financial assets at costs and as non-current assets. (3) For subsequent valuation check the business model of the company holding. It determines the valuation of the financial asset. (4) If the financial asset is held to maturity apply the effective interest method, this means the valuation is at amortised costs. If the financial asset is held ready to sell apply fair value presentation through either profit or loss or through other comprehensive income. (5) For the disposal of financial assets apply the Realisation account. (6) Record a gain or loss on disposal through either profit or loss or through other comprehensive income. 7.34 Summary Non-current assets are property, plant and equipment or intangible assets or financial instruments. A special recognition and measurement are required for leases which are recorded as a right-of-use-asset and a lease liability. As non-current assets are held for a longer period than a fiscal year, changes in valuation matter. Examples for subsequent measurement are depreciation, impairment loss and revaluations. Financial instruments are measured at amortised costs or following the fair value model. Carrying assets at amortised costs requires applying the effective interest method. De-recognitions of non-current assets are either recorded in profit or loss or other comprehensive income. It is recommended to apply the realisation account for disposals and to dissolve all deferred tax liabilities and revaluation reserves before derecognition if the asset previously has been revalued. 7.35 Working Definitions Amortised Costs: To keep an asset or liabilities at amortised costs simplifies its measurement and is accepted for financial instruments that are intended to keep until maturity. It is an expedient to fair value presentation. The calculation of amortised costs is based on the effective interest method. Bond: Financial instrument that pays the holder a regular coupon and is repaid in a lump sum when it matures. Call Option: Right but not an obligation to buy assets at an agreed price in the future. Carrying Value: Measurement of an asset in the books and on financial statements. Cost of Acquisition: Based on the conventions of this textbook in chapter (1) about VAT reduction: the net price for buying an asset less all discounts/ rebates and including all attributable costs. Fair Value: Measurement of an asset/ liability as it is transferred at on an active market, e.g., a bond price. <?page no="201"?> Berkau: Financial Statements 9e 7-201 Financial Asset: Shares, bonds, options etc., bought to keep them for more than one Accounting period. Gross Replacement Method: Method of recording a revaluation based on a change of cost of acquisition. Adjustments are virtually pulled forward to the time of acquisition. Impairment Loss: Difference between a carrying value and a subsequent, lower valuation. An impairment loss is recorded as an expense to adjust the valuation. Incremental Borrowing Rate: Interest rate at which a debtor can take out a further bank loan under consideration of its capital structure. Intangible Asset: Asset without physical nature. Investment Property: Land or buildings held for renting out or capital appreciation. Lease: Contract to use an asset and taking its control by paying its owner a consideration for an agreed time span. Lessee: Party that leases an asset from its owner. Lessor: Party that leases out an asset. Net Replacement Bookkeeping Entries: Method to record a revaluation based on an estimate. Present Value: Valuation where discounted values apply for measurement. Put Option: Right but no obligation to sell an asset at an agreed price in the future. Realisation Account: Account to record the disposal of assets. Recoverable Amount: Obtainable selling price or value in use - whichever is higher. Revaluation: Assigning a value to an asset that exceeds the carrying value. Value in Use: Valuation of an asset based on received and discounted cash flows. 7.36 Questions Bank (1) A Retailer in Australia enters for its salesperson in a lease over an electric driven business car for three years beginning with 2.01.20X1. The lease payments are 25,000.00 AUD/ a in arrears. No VAT applies. No restoring costs apply either. Determine the lease liabilities in the lessee’s books for the 1 st Accounting period if the interest rate implicit in the lease is 7.21 %/ a. 1. 75,000 AUD . 2. 65,357 AUD . 3. 70,069 AUD . 4. 50,000 AUD . (2) A car is acquired at a price of 78,000 EUR (gross amount) and is fetched from Stuttgart for 1,200 EUR gross amount. The dealership offers a trade discount of 10 % for the car. How much are the resulting cost of acquisition? 1. 71,400 EUR . 2. 59,500 EUR . 3. 59,400 EUR . 4. 58,500 EUR . (3) A company is registered for VAT reduction. It acquires a business car at a gross purchase price of 62,400 EUR on 3.07.20X4. The car is to be depreciated over five years following straight-line method under consideration of a residual value of 12,000 EUR. After an accident and a repair of 10,200 EUR <?page no="202"?> Berkau: Financial Statements 9e 7-202 (gross value, paid by the company) on 1.10.20X4 the business car is worth 38,000 EUR. The insurance company covers the repair costs and the impairment loss. How much is the compensation receivable from the insurance? 1. 20,500 EUR . 2. 22,200 EUR . 3. 30,380 EUR . 4. 12,000 EUR . (4) On 1.07.20X3, a company buys a machine at cost of acquisition of 300,000.00 EUR which is depreciated over 5 years without residual value following straight-line method. 2.5 years later, on 29.12.20X5, the machine is revalued and is disclosed at a fair value of 200,000.00 EUR. How much are the revaluation reserves as disclosed on the balance sheet on 31.12.20X5? 1. 50,000 EUR . 2. 56,000 EUR . 3. 80,000 EUR . 4. 35,000 EUR . (5) A company buys a machine on 2.03.20X3 at 5,000 EUR net amount. The useful life is 5 years and, depreciation follows declining method at 2%/ m. How much is the carrying value of the machine as per 31.12.20X4? 1. 4,085.36 EUR . 2. 3,205.85 EUR . 3. 3,000.00 EUR . 4. 3,078.90 EUR . 7.37 Solutions 1-2; 2-2; 3-1; 4-4; 5-2. <?page no="203"?> Berkau: Financial Statements 9e 8-203 8 Business Combinations 8.1 What is in the Chapter? Group Accounting supports the disclosure of investments in separate financial statements following IAS 27 as well as for the presentation of financial statements for business combinations, like groups or joint ventures. Business combinations following IFRS 3 require consolidations. A group is a set of companies that are linked to each other by control relationships, meaning one company holds most voting rights of another one. If company A owns companies B and C, all three companies form a group in terms of Accounting. A joint venture is a company that is (jointly) controlled by other companies. If the companies X and Y control Z together, then Z is the joint venture and X and Y are investors. This chapter covers one case study for separate financial statements, three case about Group Accounting and two joint venture examples. 8.2 Learning Objectives After studying this chapter, you understand the basics of consolidations and know how to prepare financial statements for business combinations. You know and understand the major regulations for Group Accounting. You can prepare group statements on case study level and apply a consolidation worksheet. 64 64 Study the instructions for that file in our textbook Basics of Accounting, chapter (5). 8.3 Group Accounting A group consists of a parent and subsidiary. A parent is the company exercising control power, a subsidiary is the dependent company. Groups must prepare financial statements for the entire group in addition to single-entity financial statements. A single-entity financial statement is a set of financial statements for a one company only. A group of three companies with one parent and two subsidiaries prepares four sets of financial statements, three single-entity financial statements and one for the group. Consolidation is an Accounting technical term for calculations made on group statements to remove double or multiple considerations of items which are caused by the process of adding financial statements in preparation of the group statements. Group Accounting is not based on real Bookkeeping entries. Hence, “Making consolidation Bookkeeping entries” does not fall under a general Bookkeeping definition. It is a common term for the preparation of consolidated financial statements. However, group statements are derived from single-entity financial statements only. Relevant standards for business combinations are IAS 27: Separate Financial Statements, IAS 28: Investments in Associates and Joint ventures, IFRS 3: Business Combinations, IFRS 10: Consolidated Financial Statements, IFRS 11: Joint Arrangements and <?page no="204"?> Berkau: Financial Statements 9e 8-204 IFRS 12: Disclosure of Interest in other Entities. IAS 27 rules the Accounting for separate financial statements. 65 A separate financial statement is a statement of a parent or a joint venture investor that covers investments either at costs or fair values in accordance with IFRS 9 or based on Equity Accounting as ruled by IAS 28 (IAS 27.10). A company not holding investments does not prepare separate financial statements, check IAS 27.7. IAS 28 refers to associated companies and to joint ventures. The equity method is subjected to regulations in IAS 28.10 and the following paragraphs. It rules, that investments in controlled companies increase/ decrease with their equity changes (to the same extent/ percentage). 66 IFRS 3 contains regulations about business combinations based on the acquisition method. A business combination applies once the acquired assets and liabilities constitute a business. This applies for subsidiaries, associated companies and joint ventures. E.g., someone buying all buses of a travel service company will not constitute a group, see IFRS 3.3. IFRS 10 covers consolidated financial statements. Consolidated financial statements are prepared for groups. A group comprises of a parent and all its subsidiaries. In consolidated financial statements, the assets, liabilities, equity, income, expenses and cash flows of the parent and all subsidiaries are 65 Same as the IASB states in IAS 27.3, we do not discuss reasons for the preparation of separate financial statements in case they are required we show only how to do it. considered as departments of a single company. IFRS 11 regulates joint arrangements which mostly is a company controlled collectively by more than one investor (joint venture), or a joint operation. Joint control of operations requires to determine how jointly making decisions works. IFRS 12 requires companies to disclose information about nature, risks, and interest in other companies. It helps the reader of the financial statements to evaluate the impact of business combinations on the financial position, financial performance and on cash flows. A business combination exists if one company dominates another one by taking over control. This usually refers to the amount of rights of ownership. Two threshold percentages are relevant, 20 % and 50 %. Commonly, (1) < 20 % of control does not imply any influence on the (partially) owned company. The owner discloses the investment as financial instrument under IFRS 9 which is initially at cost and for subsequent measurement at fair values through profit or loss or through other comprehensive income. 67 As an expedient for fair values the book value of a company can apply. (2) 20 % … 50 % of control defines an investment in an associated company with substantial influence exercised by the owner of the 66 Check the case study STEYN/ HAWKINS in chapter (7) where we applied the equity method. 67 We cover these cases in chapter (7) and (9). <?page no="205"?> Berkau: Financial Statements 9e 8-205 shares. For the valuation of an associated company, the equity method applies. Owners of associate companies prepare separate financial statements in line with IAS 27. (3) > 50% of control requires the preparation of group statements. Group statements are financial statements of the entire group which cover all group members. It also includes subsidiaries of subsidiaries based on a multiple-level group structure. The percentages of control can differ from the legal ownership portion because they are based on control criteria. Control refers to the power to govern the financial and operating policies of a company to obtain benefits from its operations (IFRS 10, attachment A). Criteria of control are defined by IFRS 10.7. In general, the percentage of ownership is easy to determine. However, in a multiple-level group structure, companies can be subsidiary and parent at the same time. The calculation of influence is then based on the control power. If company A owns 60 % of B, whereas B owns 55 % of C, A is in control of both companies B and C, even as the legal ownership for C only is: 60% × 55% = 33%. It only matters that A controls B which defines a full control power and counts 100 %. Next, B fully controls C because it holds 55 % of its shares. Hence, B controls C completely, and we consider the percentage of control to be 100 %, too. Therefore, A prepares consolidated financial statements that cover the companies A, B and C. Company B does not prepare consolidated financial statements for B and C, as this is covered by A’s Group Accounting already. IFRS 10.31 applies: Company B is an investment and evaluates its subsidiary C for separate financial statements following IFRS 9 initially at cost and later at fair values through profit or loss. For business combinations three principles apply: (1) Regarding the control hierarchy in the group the highest parent shields all lower members from preparing separate group statements. In Accounting slang this is termed the Christmas tree principle, because a Christmas tree’s upper branches shield the lower ones against rain. (2) Based on the principle of full consolidation, only one superordinated company exercises control. It is the one which holds more than 50 % of voting rights. A subsidiary is therefore considered for a group statement to an extent of 100 %. E.g., if two companies hold another one at 70 % and 30 % only the one that gained (70 %) of the power has absolute power over the company and includes it completely in its group statements. The other holder is considered as non-controlling interest holder. In Group Accounting, control is never shared like in Joint Venture Accounting where partial control is considered for disclosure. (3) Group Accounting refers to all subsidiaries regardless of where they are domiciled (global consolidation principle). Hence, Group Accounting ignores geographical borders. Accounting regulations apply based on the parent's jurisdiction. <?page no="206"?> Berkau: Financial Statements 9e 8-206 We cover Accounting for business combinations in three subordinated sections: (1) Separate financial statements. (2) Consolidated financial statements. (3) Joint Venture Accounting. 8.4 Separate Financial Statements IAS 27 IAS 27 rules separate financial statements. Separate financial statements are prepared by parents as well as by investors. The major difference to group statements is that no consolidations apply. Investments are measured based on their portion of ownership. Separate financial statements are only prepared for a single company and disclose their investments under assets. 8.5 C/ S BRENO Ltd. We discuss separate financial statements for the case study BRENO Ltd. that holds an interest in another company as well as an investment in an associated company. Data Sheet for BRENO Ltd. Domicile: South Africa (Bloemfontein). Reporting currency: ZAR. Classification: n/ a. Investments: 36.5 % of SABONA Ltd.; 9 % of SUURENBERG Ltd. Profits (EAT): BRENO Ltd.: 280,000 ZAR / SUURENBERG Ltd.: 34,000 ZAR / SABONA Ltd.: 24,000 ZAR. Dividends: 40 % / 25 % / 15 %. Share price SUURENBERG Ltd.: at acquisition 3 ZAR/ share, later increase 6 %. VAT ignored. BRENO Ltd. owns 36.5 % of SABONA Ltd. and 9 % of SUURENBERG Ltd. Hence, SABONA Ltd. is an associated company and the investment in SUURENBERG Ltd. is a financial asset. The characteristics for holding an associated company (SABONA Ltd.) are significance of influence. In line with IAS 28.5, a company has major influence, once holding 20 % or more of the voting power. BRENO Ltd. does not prepare group statements, nor does it carry out consolidations. It prepares separate financial statements with disclosure of SUURENBERG Ltd. as a financial asset and SABONA Ltd. as an associated company (investment) thereon. See in Figure 8.1 the statement of financial position for BRENO Ltd. as at the beginning of 20X5. Check the non-current asset section where the investment and the financial asset are disclosed. <?page no="207"?> Berkau: Financial Statements 9e 8-207 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 800,000 Share capital 500,000 Investments 73,000 Reserves 300,000 Financial assets 27,000 Retained earnings 140,000 Current assets Liabilities (liab.) Inventory 34,000 Long-term liab. Accounts receivables Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 66,000 Income tax liab. 60,000 Total assets 1,000,000 Total equity and liab. 1,000,000 Breno Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X5 Figure 8.1: BRENO Ltd.’s balance sheet (1.01.20X5) IAS 28 applies for the valuation of the share in SABONA Ltd.; for the valuation of the financial instrument SUURENBERG Ltd., it follows IFRS 9. During the Accounting period 20X5, the three companies earn the below listed profits and make dividend payments to their owners. No profit/ loss is carried forward. - BRENO Ltd.: profit before taxes (and before dividends): 280,000 ZAR, dividend: 40 % of the profit after taxes and after revaluation of investments in associates and financial assets. - SUURENBERG Ltd.: profit after taxes 34,000 ZAR, dividend 25 % thereof. - SABONA Ltd.: profit after taxes: 24,000 ZAR, dividend 15 % thereof. The dividend receipts from investments are not yet included on the income statement and balance sheet for BRENO Ltd. No appropriation of profits has been considered yet. Observe BRENO Ltd.’s income statement as shown in Figure 8.2 below: <?page no="208"?> Berkau: Financial Statements 9e 8-208 [ZAR] Revenue 750,000 Other income 0 750,000 Materials (10,000) Labour (120,000) Depreciation (80,000) Other expenses (250,000) Earnings before int. & taxes (EBIT) 290,000 Interest (10,000) Earnings before taxes (EBT) 280,000 Income tax expenses (84,000) Deferred taxes 0 Earnings after taxes (EAT) 196,000 Breno Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X5 Figure 8.2: BRENO Ltd.’s income statement (20X5) In this case study, all dividends are paid during the Accounting period they are for. This means BRENO Ltd. receives dividend payments in 20X5 from SABONA Ltd. and SUURENBERG Ltd. The shares of SUURENBERG Ltd. are disclosed as financial asset following IFRS 9 on BRENO Ltd.’s balance sheet. SUURENBERG Ltd. is listed at the Johannesburg Stock exchange JSE. At the time of acquisition by BRENO Ltd., its share price per 1 ZAR/ share ordinary share was 3 ZAR/ share. BRENO Ltd. holds 9,000 shares. The costs of acquisition for the shares are: 3 × 9,000 = 2 27,000 ZAR. This is the value disclosed on the balance sheet in Figure 8.1. BRENO Ltd. initially recorded the shares at costs in compliance with IFRS 9.5.1.1. With the profit earned during 20X5, the share price for SUURENBERG Ltd. increases on 31.12.20X5 by 0.18 ZAR/ share as traded at Johannesburg Stock Exchange (given). The fair market value per share is 3.18 ZAR/ share. This means in an increase of: 0.18 / 3 = 6 6%. Therefore, BRENO Ltd. increases the measurement of its shares, too. It carries the shares at their fair value through other comprehensive income based on IFRS 9.5.2.1. The increase of the shares is: 6% × 27,000 = 1 1,620 ZAR. BRENO Ltd. makes the Bookkeeping entry below in its books: @ 31.12.20X5 Financial Asset (SUURENB.) FNA 1,620 Other Compreh. Income-20X5 OCI 1,620 (value increase through other compreh. income for shares in SUURENBERG) <?page no="209"?> Berkau: Financial Statements 9e 8-209 BRENO Ltd.’s share of the dividends declared by SUURENBERG Ltd. (25 %) is linked to 9 % of ownership and is: 9% × 34,000 × 25% = 7 765 ZAR. BRENO Ltd. records the dividend received under other income. @ 31.12.20X5 Cash/ Bank C/ B 765 Other Comprehensive Income-20X5 OCI 765 (recording dividend receipt from SUURENBERG Ltd.) For the investment in the associated company SABONA Ltd., BRENO Ltd. applies the equity method following IAS 28.10. The equity method increases/ decreases the value of an investment based on the book value of the associated company. IAS 27.12 requires recording dividends through profit or loss unless the entity elects to use the equity method. SABONA Ltd. earned an annual surplus of 24,000 ZAR in 20X5. Linked to the total of its issued capital, this is a portion of: 24,000 / (73,000/ 36.5%) = 1 12%. The denominator calculates SABONA Ltd.’s equity based on the disclosure on BRENO Ltd.'s balance sheet. The share issue was par value. SABONA Ltd. is disclosed at 73,000 ZAR which is 36.5 % of all shares. Accordingly, SABONA Ltd.’s issued capital is: 73,000 / 36.5% = 200,000 ZAR. The dividend paid to SABONA Ltd.’s owners is 15 % of the profit of 24,000 ZAR and is to be deducted following IAS 28.10 and IAS 27.12. The reason is, that the book value of SABONA Ltd. decreased by the dividend payment. Hence, the increase in equity is based on the portion which is not distributed to owners: 12% × (1 - 15%) = 1 10.2%. The value of the associated company SABONA Ltd. increases by: 73,000 × 10.2% = 7 7,446 ZAR. Furthermore, a dividend of: 15% × 24,000 × 36.5% = 1 1,314 ZAR is received and recorded through other comprehensive income. Observe the Bookkeeping entries below: @ 31.12.20X5 Cash/ Bank C/ B 1,314 Other Comprehensive Income-20X5 OCI 1,314 (recording dividend receipt from SABONA Ltd.) Investment @Equit (SABONA) INV 7,446 Other Compreh. Income-20X5 OCI 7,446 (investment increase by measurment @ equity for SABONA interest) IAS 27.12 requires the deduction of dividends from the investment value because it is an equity decrease. We considered the dividend deduction already when calculating an investment increase of 7,446 ZAR because we multiplied by 10.2 % instead of 12 %. Regarding the other comprehensive income, dividends result in a zero-sum-game as <?page no="210"?> Berkau: Financial Statements 9e 8-210 the associate’s value decreases to the same extent as dividend income is received. Therefore, with the equity method, dividend payments do not matter for the investment measurement. As BRENO Ltd. is a company based on shares, no dividend tax applies. We show the financial statements of BRENO Ltd. after the appropriation of profits in Figure 8.3 and Figure 8.4. The profit before taxes is 291,145 ZAR. See the income statement in Figure 8.3. The dividend portion is: 40% × 291,145 × (1 - 30%) = 8 81,520.60 ZAR. It is recorded as a liability to shareholders and disclosed as short-term debt on the balance sheet. Dividends are paid in 20X6. The value for retained earnings is: 140,000 + 203,802 - 81,520.60 = 262,281.40 ZAR. The total extra income on BRENO Ltd.’s statement of profit or loss and other comprehensive income consists of the dividends from SUURENBERG Ltd. and from SABONA Ltd. and their increase in valuation to the extent of: 765 + 1,620 + 7,446 + 1,314 = 1 11,145 ZAR. A Non-current assets [ZAR] Equity [ZAR] P, P, E 720,000 Share capital 500,000 Investments 80,446 Reserves 300,000 Financial assets 28,620 Retained earnings 262,281 Current assets Liabilities (liab.) Inventory 34,000 Long-term liab. Accounts receivables Short-term liab. A/ P 81,521 Prepaid expenses Provisions Cash/ Bank 368,079 Income tax liab. 87,344 Total assets 1,231,145 Total equity and liab. 1,231,145 Breno Ltd. SEPARATE STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 8.3: BRENO Ltd.’s balance sheet (separate F/ S) <?page no="211"?> Berkau: Financial Statements 9e 8-211 [ZAR] Revenue 750,000 Other income 11,145 761,145 Materials (10,000) Labour (120,000) Depreciation (80,000) Other expenses (250,000) Earnings before int. & taxes (EBIT) 301,145 Interest (10,000) Earnings before taxes (EBT) 291,145 Income tax expenses (87,344) Deferred taxes 0 Earnings after taxes (EAT) 203,802 Breno Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X5 Figure 8.4: BRENO Ltd.’s income statement (separate F/ S) How it is Done (Separate Financial Statements): (1) Determine whether separate financial statements apply (IAS 27). National law must be considered (Company’s Act). (2) If separate financial statements apply, prepare them for the investment holder. (3) Recognise financial assets at cost or at fair values through either profit or loss or through other comprehensive income. (4) Disclose investments in associates or joint ventures following the equity method as laid out in IAS 28. (5) Record an investment in subsidiaries initially at costs and later at fair values through other comprehensive income. (6) Record dividends received from investments through either profit or loss or through other comprehensive income. (7) If applying the equity method, a dividend paid by the associate or joint venture reduces the investment’s measurement. Record a deduction of assets accordingly. 8.6 Consolidated Financial Statements Consolidated financial statements are referred to as derived because a group does not keep own Bookkeeping records. Group statements are based on <?page no="212"?> Berkau: Financial Statements 9e 8-212 the information taken from single-entity financial statements. This gives us some extra work regarding the preparation of subsequent group statements as we must maintain initial consolidations. Technically, we repeat the initial capital consolidation every year. By Accounting software, this should not become a problem as it goes comfortable, however students in an exam must do extra work for multiple Accounting period tasks about Group Accounting. In contrast to separate financial statements (IAS 27), Group Accounting requires consolidations. We discuss consolidation procedures and demonstrate them by three case studies. For consolidations, all single-entity financial statements of the group members are “added” item-by-item. To facilitate calculations, financial statements must be uniform regarding formal aspects. Like adding fractions, e.g., 1/ 3 + 1/ 2 = 5/ 6, requires finding a common denominator, the addition of financial statements only works if they follow the same GAAPS, report in the same currency, refer to the same balance sheet date etc. E.g., a group of a Dutch and South African company with the parent domiciled in South Africa, transfers the financial statements prepared in the Netherlands and applying the Dutch Woertbook van Koophandel into IFRSs. Furthermore, it must re-value its items towards the group reporting currency, here, the South African Rand ZAR. Once financial statements are uniform, we add them item by item. Addition by item means, we add every item separately, e.g., PPE Dutch + PPE SAn = PPE Group . Adding financial statements causes some items to count double, like the interest in the subsidiary and its assets. To avoid multiple considerations, consolidations need to eliminate intragroup balances, transactions, income, and expenses. This is termed to consolidate financial statements. 8.7 C/ S GAMKA/ SWARTBERG Group - Initial Consolidation We study the case of the GAMKA/ SWARTBERG group below and introduce the acquisition method following IFRS 3.4. It requires identifying the parent (GAMKA Ltd.), to determine the acquisition date (1.01.20X4), to recognise and measure all assets, liabilities, and non-controlling interest (see below) and to measure and recognise goodwill. The next case study PORTERSVILLE Ltd. and its subsidiary HENDERSON Ltd. demonstrates profit consolidations. By the case study PATTEN/ SPYKER we cover group member transactions and the consolidation of intra-group profits. Data Sheet for GAMKA/ SWARTBERG Domicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: n/ a. Investment: GAMKA Ltd. holds 80 % of SWARTBERG Ltd. Acquisition date: 1.01.20X4. Acquisition method applies. VAT ignored. On 1.01.20X4, GAMKA Ltd. buys 80 % of the ordinary shares of SWARTBERG Ltd. The acquisition makes the companies form a group. GAMKA Ltd. is the owner <?page no="213"?> Berkau: Financial Statements 9e 8-213 of 80 % of the ordinary shares of SWARTBERG Ltd. and controls SWARTBERG Ltd. By gaining control power, GAMKA Ltd. becomes the parent; SWARTBERG Ltd. is the subsidiary. GAMKA Ltd. and SWARTBERG Ltd. prepare each single-entity financial statements and one set of financial statements for the group. The group statements contain a full set of financial statements. All group members are considered as virtual departments of a single company (= the group). This means that all assets of GAMKA Ltd. and SWARTBERG Ltd. are disclosed on the balance sheet of GAMKA Group. Note, that the group name does not carry a legal form. This makes it easy to distinguish group statements from single-entity financial statements. 68 IAS 1.10 about a full set of financial statements applies for group statements, too. To calculate the items on GAMKA Group’s balance sheet (statement of financial position), we must add all balance sheet items for the group members. For recognition and measurement, fair value presentation as per acquisition date apply (IFRS 3.18). E.g., PPE GAMKA + PPE SWARTBERG = 230,000 + 40,000 = 270,000 ZAR. The above values are derived from the balance sheets in Figure 8.5 and Figure 8.6. For the group’s balance sheet, a capital consolidation must be carried out because right now some items count twice: GAMKA Ltd.’s investment in SWARTBERG Ltd. is an asset. Also, the assets of SWARTBERG Ltd. are considered as group assets. This results in a double recognition of the subsidiary’s asset. (Actually, it is not double but 1.8 68 See e.g., Figure 8.10. times 180 % because the parent holds 80 %.) To keep Group Accounting free from the above-mentioned multiple considerations, the group statements must undergo capital consolidation by which the investment and the total subsidiary’s equity are cancelled out. In general, consolidation procedures consist of a capital consolidation, a consolidation of intra-group receivables/ payables and an intra-group profit consolidation on the balance sheet as well as on the income statement. The objective for all steps is to eliminate multiple considerations of items or to delete effects of intergroup transactions, like internal profits. An internal profit results from group members selling goods or rendering service among each other. A capital consolidation eliminates the investment in a subsidiary against its equity. As the subsidiary valuation is based on the acquisition method and equity valuations are based on nominal values, a difference can remain which either is a goodwill or a negative goodwill. If only a percentage of a subsidiary is acquired, the equity portion that is linked to ownership is cancelled out against its cost of acquisition. The equity portion outside of the group is disclosed under non-controlling interest in the equity section of the group statement of financial position (extra item). This is the portion belonging to owners other than group members, e.g., allocated to an investor holding 30 % of a subsidiary. Due to the full consolidation principle, group statements always cover the entire subsidiary which includes the shares of others. In the old <?page no="214"?> Berkau: Financial Statements 9e 8-214 days, their equity portion was called minority interest. A consolidation of receivables and payables removes mutual debts and receivables of the members from the group statements. A profit consolidation deletes intragroup profits from the group’s income statement and from the equity section of the group’s balance sheet. The retained earnings and earnings reserves are involved. A profit consolidation can further initiate changes in asset measurements, if e.g., one group member sells goods to another one by earning a profit. Together with the profit elimination a goods valuation adjustment becomes necessary because the buyer measures the assets at its cost of acquisition which are net selling prices from another group member. For the group statements, the costs of acquisition apply upon entry into the group. This is the cost of acquisition for the first buyer inside of the group. The case of the PORTERSVILLE/ HENDERSON group further below is about asset valuation on group statements. For consolidations, we distinguish initial consolidation and subsequent ones. An initial consolidation is recorded at the time when the group is defined by the parent gaining control power over its subsidiary. Any subsequent consolidation is recorded after the initial one. Accountants term the repetition of consolidation steps “consolidation Bookkeeping entries” because adjustments are made on the debit and credit sides of the group statements together. Consolidated financial statements do not cause nor do they affect any payments. No tax payments nor dividends depend on the group statements. The only purpose of Group Accounting is providing information to the readers of the group statements. Below, we study consolidations for the GAMKA GROUP. Its two group members provide the financial statements as per 31.12.20X3 as below. This is one day before the acquisition (1.01.20X4) took place: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 230,000 Share capital 300,000 Intangibles Reserves Financial assets Retained earnings 70,000 Current assets Liabilities (liab.) Inventory 170,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 50,000 Prepaid expenses Provisions Cash/ Bank 100,000 Income tax liab. 30,000 Total assets 500,000 Total equity and liab. 500,000 Gamka Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.5: GAMKA Ltd.’s statement of financial position <?page no="215"?> Berkau: Financial Statements 9e 8-215 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 40,000 Share capital 50,000 Intangibles Reserves Financial assets Retained earnings 28,000 Current assets Liabilities (liab.) Inventory 30,000 Long-term liab. Accounts receivables Short-term liab. A/ P 10,000 Prepaid expenses Provisions Cash/ Bank 30,000 Income tax liab. 12,000 Total assets 100,000 Total equity and liab. 100,000 Swartberg Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.6: SWARTBERG Ltd.’s statement of financial position The single-entity financial statements in Figure 8.5 and Figure 8.6 relate to the group members. Note, that the header includes their legal forms. All items on the balance sheets are measured at fair values and have been calculated under IFRS. The reporting currency is for both companies South African Rand ZAR. The single-entity financial statements have been prepared before profit appropriations because all profits are carried forward to 20X4. We prepare group statements as per 31.12.20X4 (one year later). At first, we carry out the capital consolidation: When GAMKA Ltd. buys 80 % of SWARTBERG Ltd. on 1.01.20X4, WARTBERG Ltd.’s book value is: 50,000 + 28,000 = 7 78,000 ZAR. The book value of GAMKA Ltd.’s investment is 80 % 69 Study our textbook Management Accounting, chapter (11). thereof: 80% × (50,000 + 28,000) = 62,400 ZAR. GAMKA Ltd. pays 65,000 ZAR in exchange of 80 % of SWARTBERG Ltd.’s ordinary shares. The payment to the previous owner exceeds the book value of the acquired share in SWARTBERG Ltd. The statement of financial position now discloses 65,000 ZAR as value for the investment and a reduced cash/ bank item. Cash/ bank now is: 100,000 - 65,000 = 3 35,000 ZAR. GAMKA Ltd. overpaid the subsidiary in terms of its book value, probably with strategic intentions, e.g., because of the present market position of SWARTBERG Ltd., or the acquirer expects a high potential from the business in the future etc. 69 GAMKA Ltd. makes the Bookkeeping entry below which shows the subsidiary recorded at cost. 70 See in Figure 8.7 the balance sheet for GAMKA Ltd. on 1.01.20X4 after the acquisition. 70 We refrain from applying the journal entry format for consolidations to indicate that no real Bookkeeping entries are carried out. <?page no="216"?> Berkau: Financial Statements 9e 8-216 DR Investment Subsidiary........ 65,000 ZAR CR Cash/ Bank.................... 65,000 ZAR A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 230,000 Share capital 300,000 Intangibles Reserves Investment 65,000 Retained earnings 70,000 Current assets Liabilities (liab.) Inventory 170,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 50,000 Prepaid expenses Provisions Cash/ Bank 35,000 Income tax liab. 30,000 Total assets 500,000 Total equity and liab. 500,000 Gamka Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X4 Figure 8.7: GAMKA Ltd.’s balance sheet after acquisition On the single-entity financial statements, GAMKA Ltd.’s investment in the subsidiary must be disclosed at its cost of acquisition which is 65,000 ZAR. This is the value for the transferred consideration, here the price paid (IFRS 3.37). For the group statements, we “add” the items on both balance sheets. Note, that the balance sheet for SWARTBERG Ltd. did not change by the transfer of ownership. It only shows now the balance sheet date 1.01.20X4 (we do not disclose the balance sheet again but refer to Figure 8.6). With the acquisition of 80 % of SWARTBERG Ltd., GAMKA Ltd. becomes the parent and SWARTBERG Ltd. the subsidiary. Both companies continue preparing single-entity financial statements. We next set up the group statements. They are indicated as GAMKA GROUP statements. Adding the financial statements is supported efficiently by a consolidation worksheet as shown in Figure 8.8. <?page no="217"?> Berkau: Financial Statements 9e 8-217 PARENT SUBSIDIARY AGGR. CONS. F/ S N-cur Assets P,P,E 230,000 40,000 270,000 270,000 Investments 65,000 65,000 65,000 Goodwill 0 0 cur Assets Inventory 170,000 30,000 200,000 200,000 Cash/ Bank 35,000 30,000 65,000 65,000 500,000 100,000 600,000 600,000 SH's capital Issued capital (300,000) (50,000) (350,000) (350,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (70,000) (28,000) (98,000) (98,000) Non-ctrl int 0 0 Liabilities Int. bear. liab. (50,000) (50,000) (50,000) Payables (50,000) (10,000) (60,000) (60,000) Tax liabilities (30,000) (12,000) (42,000) (42,000) (500,000) (100,000) (600,000) (600,000) Figure 8.8: GAMKA Group’s consolidation worksheet (20X3.1) The consolidation worksheet adds the single-entity financial statements for GAMKA Ltd. and SWARTBERG Ltd. per item. The sum represents the aggregated balance sheet (column AGGR) which is the group balance sheet before consolidations. E.g., the item for property, plant and equipment on the aggregated financial statements gives: 230,000 + 40,000 = 2270,000 ZAR. By adding financial statements, the investment of 65,000 ZAR and all its assets are disclosed on the debit side. Remember, the book value of the acquired company is the total of its assets less its liabilities: 100,000 - (10,000 + 12,000) = 78,000 ZAR. 71 This means SWARTBERG Ltd. now counts more than 180 % on the group statements. "More" refers to the consideration of goodwill which is not yet disclosed but included in the 65,000 71 Compare to Figure 8.6. ZAR. 100 % is the result of a full consolidation although, only 80 % is the percentage of group ownership. The multiple consideration of the subsidiary is misleading for the readers of financial statements. To avoid multiple considerations of subsidiaries, a capital consolidation must be prepared. The aim is to cancel out the investment and the partial book value of SWARTBERG Ltd. and to disclose the excess of payment over the subsidiary’s book value under goodwill. 80 % of SWARTBERG Ltd.’s value is: 80% × 78,000 = 662,400 ZAR. The overpayment is: 65,000 - 62,400 = 2 2,600 ZAR. We make a Bookkeeping entry as shown in the column for capital consolidation (CAP.CONS). This is ruled by IFRS 3.32. <?page no="218"?> Berkau: Financial Statements 9e 8-218 Observe the capital consolidation as shown in the next consolidation chart in Figure 8.9 under CAP.CONS. PARENT SUBSIDIARY AGGR. CAP. CONS CAP. CONS CAP. CONS CONS. F/ S N-cur Assets P,P,E 230,000 40,000 270,000 270,000 Investments 65,000 65,000 (65,000) 0 Goodwill 0 2,600 2,600 cur Assets Inventory 170,000 30,000 200,000 200,000 Cash/ Bank 35,000 30,000 65,000 65,000 500,000 100,000 600,000 (62,400) 0 0 537,600 SH's capital Issued capital (300,000) (50,000) (350,000) 40,000 10,000 (300,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (70,000) (28,000) (98,000) 22,400 5,600 (70,000) Non-ctrl int 0 (10,000) (5,600) (15,600) Liabilities Int. bear. liab. (50,000) (50,000) (50,000) Payables (50,000) (10,000) (60,000) (60,000) Tax liabilities (30,000) (12,000) (42,000) (42,000) (500,000) (100,000) (600,000) 62,400 0 0 (537,600) Figure 8.9: GAMKA Group’s consolidation worksheet (20X3.2) The capital consolidation procedure includes two steps. The first one eliminates the acquisition costs of the investment and its partial (= 80 %) book value (issued capital and retained earnings) and discloses the goodwill of, together: 2,600 + 40,000 + 22,400 = 6 65,000 ZAR. The second step allocates 20 % of the shares’ nominal value and retained earnings to the other owners of SWARTBERG Ltd. (not GAMKA Ltd.). We refer to them as non-controlling interest holders. Therefore, the equity section of the consolidated balance sheet contains now an extra item called non-controlling interest. For the GAMKA Group, this item is 20 % of the shares at nominal values and 20 % of the retained earnings at the time of acquisition. This gives: 20% × 50,000 = 110,000 ZAR and: 20% × 28,000 = 55,600 ZAR. This initial capital consolidation must be maintained for subsequent consolidations. To do so, we repeat them every year because the consolidation leaves the single-entity financial statements unchanged. The consolidated statement of financial position for GAMKA GROUP is displayed in Figure 8.10. It is derived from the right column on the consolidation worksheet. <?page no="219"?> Berkau: Financial Statements 9e 8-219 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 270,000 Share capital 300,000 Intangibles Reserves Investment Retained earnings 70,000 Goodwill 2,600 Non-ctrl interest 15,600 Current assets Liabilities (liab.) Inventory 200,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 60,000 Prepaid expenses Provisions Cash/ Bank 65,000 Income tax liab. 42,000 Total assets 537,600 Total equity and liab. 537,600 Gamka Group consolidated STATEMENT of FINANCIAL POSITION as at 1.01.20X4 Figure 8.10: Consolidated balance sheet For further considerations (subsequent consolidations), we combine the initial consolidation Bookkeeping entries. That way, we can disclose them in one column in the future. The so-called consolidation bookkeeping entry is: DR Goodwill..................... 2,600 ZAR DR Issued Capital............... 50,000 ZAR DR Retained Earnings............ 28,000 ZAR CR Investments.................. 65,000 ZAR CR Non-ctrl. Interest........... 15,600 ZAR For the initial consolidation of GAMKA/ SWATBERG group, no consolidation of receivables/ payables nor for intra-group profit applies. 8.8 C/ S GAMKA/ SWARTBERG Group - Subsequent Consolidations We study the consolidated financial statements for GAMKA Ltd. and SWARTBERG Ltd. one year later: The companies disclose their income statements as below in Figure 8.11 and Figure 8.13 for the period ended on 31.12.20X4: <?page no="220"?> Berkau: Financial Statements 9e 8-220 [ZAR] Revenue 200,000 Other income (10,000) 190,000 Materials (14,000) Labour (100,000) Depreciation (16,000) Other expenses 0 Earnings before int. & taxes (EBIT) 60,000 Interest 0 Earnings before taxes (EBT) 60,000 Income tax expenses (18,000) Deferred taxes 0 Earnings after taxes (EAT) 42,000 Gamka Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 8.11: GAMKA Ltd.’s income statement (20X4) A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 214,000 Share capital 300,000 Intangibles Reserves Investment 65,000 Retained earnings 112,000 Current assets Liabilities (liab.) Inventory 160,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 50,000 Prepaid expenses Provisions Cash/ Bank 91,000 Income tax liab. 18,000 Total assets 530,000 Total equity and liab. 530,000 Gamka Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 8.12: GAMKA Ltd.’s balance sheet (20X4) For the understanding of the statement of financial position, we provide some background information about the business operations which is not relevant for the discussion about consolidations. You can skip these explanations if happy with the given balance sheet and continue reading where the * is. The item property, plant and equipment is reduced for depreciation and is amounting to: 230,000 - 16,000 = 214,000 ZAR. Goods have been released from stock which leads to a reduction of 10,000 ZAR in the Inventory account: 170,000 - 10,000 = 1 160,000 ZAR. We assume all business activities - except of depreciation are on cash. GAMKA Ltd. <?page no="221"?> Berkau: Financial Statements 9e 8-221 pays 30,000 ZAR to the revenue service for income tax liabilities from 20X3. A cash revenue of 200,000 ZAR is deducted for labour and materials. Hence, the item cash/ bank is: 35,000 + 200,000 - 14,000 - 100,000 - 30,000 = 9 91,000 ZAR. On the credit side is no change in issued capital and the earnings after tax are added to retained earnings: 70,000 + 42,000 = 1 112,000 ZAR. In the liability section, the only change is made in the Income Tax Liability account: 30,000 - 30,000 + 18,000 = 1 18,000 ZAR. We now study the subsidiary, SWARTBERG Ltd. in Figure 8.13 and Figure 8.14. [ZAR] Revenue 35,000 Other income 0 35,000 Materials (15,000) Labour 0 Depreciation (10,000) Other expenses 0 Earnings before int. & taxes (EBIT) 10,000 Interest 0 Earnings before taxes (EBT) 10,000 Income tax expenses (3,000) Deferred taxes 0 Earnings after taxes (EAT) 7,000 Swartberg Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 8.13: SWARTBERG Ltd.’s income statement (20X4) A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 30,000 Share capital 50,000 Intangibles Reserves Financial assets Retained earnings 35,000 Current assets Liabilities (liab.) Inventory 30,000 Long-term liab. Accounts receivables Short-term liab. A/ P 10,000 Prepaid expenses Provisions Cash/ Bank 38,000 Income tax liab. 3,000 Total assets 98,000 Total equity and liab. 98,000 Swartberg Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 8.14: SWARTBERG Ltd.’s balance sheet (20X4) <?page no="222"?> Berkau: Financial Statements 9e 8-222 We repeat the explanation of the single-entity financial statements for SWARTBERG Ltd. Again: if you are happy with the financial statements as given, skip this paragraph and continue reading at the *. The value for property, plant, and equipment on SWARTBERG Ltd.’s statement of financial position results from the previous value less depreciation, no acquisition nor revaluation take place: 40,000 - 10,000 = 3 30,000 ZAR. Inventories do not change. For the value of cash/ bank, we consider that all business activities - depreciation exempted are on a cash basis. They include income tax payment, revenue recognition and material payments. The item cash/ bank is: 30,000 + 35,000 - 15,000 - 12,000 = 3 38,000 ZAR. There are no changes in issued capital, and the item retained earnings is: 28,000 + 7,000 = 3 35,000 ZAR. Shortterm liabilities remain unchanged, and the income tax liabilities are based on the payment of 20X3’s debts. The tax liabilities are: 12,000 - 12,000 + 3,000 = 3,000 ZAR. * The consolidation procedures are based on the consolidation worksheet again. Once we enter the figures for the singleentity balance sheets, the aggregated balance sheet shows. On the consolidation worksheet, the initial consolidation Bookkeeping entries are recorded. We apply the comprehensive Bookkeeping entry for capital consolidation as calculated above. Observe the consolidation worksheet in Figure 8.15. PARENT SUBSIDIARY AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 214,000 30,000 244,000 244,000 Investments 65,000 65,000 (65,000) 0 Goodwill 0 2,600 2,600 cur Assets Inventory 160,000 30,000 190,000 190,000 Cash/ Bank 91,000 38,000 129,000 129,000 530,000 98,000 628,000 (62,400) 565,600 SH's capital Issued capital (300,000) (50,000) (350,000) 50,000 (300,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (112,000) (35,000) (147,000) 28,000 (119,000) Non-ctrl int 0 (15,600) (15,600) Liabilities Int. bear. liab. (50,000) (50,000) (50,000) Payables (50,000) (10,000) (60,000) (60,000) Tax liabilities (18,000) (3,000) (21,000) (21,000) (530,000) (98,000) (628,000) 62,400 (565,600) Figure 8.15: GAMKA Group’s consolidation worksheet (20X4.1) <?page no="223"?> Berkau: Financial Statements 9e 8-223 No changes in investment measurement nor for the percentage of ownership apply. The only adjustment required is for the profit and the non-controlling interest portion thereof. No inter-group profits took place. The profit of the subsidiary is 7,000 ZAR as disclosed on the income statement. A portion of 80 % belongs to the group and the remaining 20 % are assigned to non-controlling interest holders. Hence, we allocate: 80% × 7,000 = 5 5,600 ZAR to the group and: 7,000 - 5,600 = 11,400 ZAR to the noncontrolling interest holders. This is also disclosed at the bottom of the income statement, see Figure 8.16. [ZAR] Revenue 35,000 Other income 0 35,000 Materials (15,000) Labour 0 Depreciation (10,000) Other expenses 0 Earnings before int. & taxes (EBIT) 10,000 Interest 0 Earnings before taxes (EBT) 10,000 Income tax expenses (3,000) Deferred taxes 0 Earnings after taxes (EAT) 7,000 EAT controlling interest holders (5,600) EAT non-ctrl interest holders (1,400) 0 Swartberg Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 8.16: Extended income statement for SWARTBERG Ltd. (20X4) The next step of consolidations is to allocate the profit to the group and noncontrolling-interest holders on the balance sheet. We make the consolidation Bookkeeping entry as below: DR Retained Earnings............ 1,400 ZAR CR Non-ctrl Interest............ 1,400 ZAR Observe the Bookkeeping entry made on the consolidation worksheet and check the derived consolidated balance sheet in Figure 8.17 and Figure 8.18. <?page no="224"?> Berkau: Financial Statements 9e 8-224 PARENT SUBSIDIARY AGGR. CAP. CONS non-ctrl Int CONS. F/ S N-cur Assets P,P,E 214,000 30,000 244,000 244,000 Investments 65,000 65,000 (65,000) 0 Goodwill 0 2,600 2,600 cur Assets Inventory 160,000 30,000 190,000 190,000 Cash/ Bank 91,000 38,000 129,000 129,000 530,000 98,000 628,000 (62,400) 0 565,600 SH's capital Issued capital (300,000) (50,000) (350,000) 50,000 (300,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (112,000) (35,000) (147,000) 28,000 1,400 (117,600) Non-ctrl Int 0 (15,600) (1,400) (17,000) Liabilities Int. bear. liab. (50,000) (50,000) (50,000) Payables (50,000) (10,000) (60,000) (60,000) Tax liabilities (18,000) (3,000) (21,000) (21,000) (530,000) (98,000) (628,000) 62,400 0 (565,600) Figure 8.17: GAMKA Group’s consolidation worksheet (20X4.2) A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 244,000 Share capital 300,000 Intangibles Reserves Investment Retained earnings 117,600 Goodwill 2,600 Non-ctrl interest 17,000 Current assets Liabilities (liab.) Inventory 190,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 60,000 Prepaid expenses Provisions Cash/ Bank 129,000 Income tax liab. 21,000 Total assets 565,600 Total equity and liab. 565,600 GAMKA GROUP consolidated STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.18: GAMKA Group’s consolidated balance sheet (20X4) The consolidated income statement is straight forward because no intra-group profit applies. Therefore, we can add the group members’ income statements. See the result in Figure 8.19. We must split the subsidiary’s profit between the group and the non-controlling interest holders. The profit assigned to the group also contains the parent’s profit and is: 42,000 + 80% × 7,000 = 47,600 ZAR. The value is disclosed negative on the income statement as it is allocated towards retained earnings. The portion of the subsidiary’s profit allocated to non-controlling interest holders is based on their portion holding: 20% × 7,000 = 1 1,400 ZAR. It is a negative figure <?page no="225"?> Berkau: Financial Statements 9e 8-225 on the income statement, too. It represents the debit entry in the Profit and Loss account made for the transfer to the non-controlling interest on the group balance sheet. [ZAR] Revenue 235,000 Other income (10,000) 225,000 Materials (29,000) Labour (100,000) Depreciation (26,000) Other expenses 0 Earnings before int. & taxes (EBIT) 70,000 Interest 0 Earnings before taxes (EBT) 70,000 Income tax expenses (21,000) Deferred taxes 0 Earnings after taxes (EAT) 49,000 EAT controlling interest holders (47,600) EAT non-ctrl interest holders (1,400) 0 Gamka Group STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 8.19: GAMKA Group’s consolidated income statement (20X4) The statement of changes in equity requires extra entries for the profit distribution between controlling interest and non-controlling interest holders. See below the statement of changes in equity for the group as at 31.12.20X4 in Figure 8.20. Therein the profit allocation is only linked to the split of the subsidiary because the parent’s profit belongs to the group completely. We deduct the noncontrolling interest holders’ share of the profit from the group’s profit before the split which is 49,000 ZAR. <?page no="226"?> Berkau: Financial Statements 9e 8-226 Share capital Non-ctrl interest Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X4 300,000 15,600 70,000 385,600 Profit 20X4 49,000 49,000 Profit allocation 1,400 (1,400) 0 as at 31.12.20X4 300,000 17,000 117,600 434,600 Gamka Group STATEMENT of CHANGES in EQUITY as at 31.12.20X4 Figure 8.20: Consolidated statement of changes in equity (20X4) Group statements include a statement of cash flows, too: We assume that all activities of the case study are based on cash - depreciation exempted. The statement of cash flows for the group follows the reconciliation method as discussed in detail in chapter (10). The cash flow statement for the group is depicted in Figure 8.21. Cash flow from operating acitivities [ZAR] [ZAR] EBT 70,000 add Interest paid 0 add Depreciation 26,000 96,000 changes in working capital changes in A/ R 0 changes in inventory 10,000 changes in A/ P (42,000) changes in VAT/ r only materials 0 changes in VAT/ p 0 64,000 Cash flow from investing activities Investments 0 0 Cash flow from financing activities Financial activities 0 0 Total cash flow 64,000 Gamka Group STATEMENT of CASH FLOWS for the period ended 31.12.20X4 Figure 8.21: GAMKA Group’s consolidated SCF (20X4) The value of total cash flows equals the aggregated cash flows as we can derive from the single balance sheets of the group members: 91,000 + 38,000 - 30,000 - 35,000 = 6 64,000 ZAR. <?page no="227"?> Berkau: Financial Statements 9e 8-227 How it is Done (Consolidated Financial Statements): (1) Determine whether consolidated financial statements apply. (2) Determine the companies to be considered for consolidated financial statements. A company is included to consolidated financial statements once the parent executes control power. (3) Copy single-entity financial statements for preparation of Group Accounting. If needed, adjust the reporting currency, the reporting balance sheet date etc. Make further adjustments to align the copies with IFRSs if they have been prepared following alternative GAAPs. (4) Add the financial statements item-wise. Refer to the resulting financial statement as the aggregated financial statements. (5) Prepare a capital consolidation based on the acquisition method. Make the consolidation Bookkeeping entries on the consolidation worksheet. The capital consolidation is at the time of acquisition. (6) Run a profit consolidation. Cancel out any intragroup profits and adjust assets dependent on intragroup profits, e.g., the measurement of goods that have been traded between group members. (7) Consolidate internal receivables/ payables. Cancel out any intra-group receivables and liabilities. (8) In case dividends are considered, cancel out intragroup dividend payment/ receipt portions. (9) Prepare consolidated financial statements based on the figures on the consolidation worksheet (right column). 8.9 C/ S PORTERSVILLE/ HENDERSON Group Below, we discuss a profit consolidation and its impact on the valuation of inventories as well as dividends. PORTERSVILLE Ltd. buys on 3.01.20X2 a share of 80 % of its supplier HENDERSON Ltd. HENDERSON Ltd. is a retailer. All shares of PORTERSVILLE Ltd. as well as of HENDERSON Ltd. are at a nominal value of 1 AUD/ share. Data Sheet for PORTERSVILLE/ HENDERSON Domicile: Australia (Sydney). Reporting currency: AUD. Classification: n/ a. Investment: PORTERSVILLE Ltd. holds 80 % of HENDERSON Ltd. Acquisition date: 3.01.20X2, acquisition costs 520,000 AUD for 400,000 ordinary shares. Book value of HENDERSON Ltd. at time of acquisition: 600,000 AUD. Acquisition method applies. Actual Accounting period: 20X5 Dividend at HENDERSON Ltd.: 0.15 AUD/ share. <?page no="228"?> Berkau: Financial Statements 9e 8-228 Inventories at PORTERSVILLE Ltd.: goods for 100,000 AUD bought from HENDERSON Ltd. Cost of acquisition at HENDERSON Ltd.: 65,000 AUD. VAT ignored. On 3.01.20X2, PORTERSVILLE Ltd. buys an 80 % share of HENDERSON Ltd. when its retained earnings are 100,000 AUD. HENDERSON Ltd.’s balance sheet does not disclose reserves at that time. Find below the balance sheets for both companies as per 31.12.20X5 - three years later. PORTERSVILLE Ltd.'s inventories include goods for 100,000 AUD, bought from HENDERSON Ltd. This is the price paid to HENDERSON Ltd. on purchase. HENDERSON Ltd. bought the goods itself for 65,000 AUD from a supplier. HENDERSON Ltd. pays a dividend of 0.15 AUD/ share for 20X5. The dividend is not considered in the financial statements as disclosed in Figure 8.22 and Figure 8.23 (before appropriation of profits). No profit/ loss is carried forward on the financial statements of PORTERSVILLE Ltd. nor of HENDERSON Ltd. A C, L Non-current assets [AUD] Equity [AUD] P, P, E 2,300,000 Share capital 1,000,000 Intangibles Reserves 300,000 Investments 520,000 Retained earnings 700,000 Non-ctrl interest Current assets Liabilities (liab.) Inventory 260,000 Long-term liab. 1,000,000 Accounts receivables Short-term liab. A/ P 220,000 Prepaid expenses Provisions Cash/ Bank 440,000 Income tax liab. 300,000 Total assets 3,520,000 Total equity and liab. 3,520,000 Portersville Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 8.22: PORTERSVILLE Ltd.’s balance sheet (parent) <?page no="229"?> Berkau: Financial Statements 9e 8-229 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 1,300,000 Share capital 500,000 Intangibles Reserves 300,000 Investments Retained earnings 210,000 Non-ctrl interest Current assets Liabilities (liab.) Inventory 300,000 Long-term liab. 800,000 Accounts receivables Short-term liab. A/ P 300,000 Prepaid expenses Provisions Cash/ Bank 600,000 Income tax liab. 90,000 Total assets 2,200,000 Total equity and liab. 2,200,000 Henderson Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 8.23: HENDERSON Ltd.’s balance sheet (subsidiary) We repeat the initial capital consolidation: The capital consolidation as per 3.01.20X2 considers the acquisition of 400,000 ordinary shares of HENDERSON Ltd. at a price of 520,000 AUD. The total equity of HENDERSON Ltd. at that time was: 500,000 + 100,000 = 6 600,000 AUD. The book value of HENDERSON Ltd.’s shares at the time of their acquisition was: 80% × 600,000 = 4 480,000 AUD. See the consolidation Bookkeeping entry below: DR Goodwill..................... 40,000 AUD DR Issued Shares................ 500,000 AUD DR Retained Earnings............ 100,000 AUD CR Non-ctrl. Interest........... 120,000 AUD CR Investment................... 520,000 AUD The capital consolidation is maintained. We enter the figures on the consolidation worksheet below. The only alteration is made for the allocation of retained earnings to earnings reserves. Hence, the above debit entry is no longer in the Retained Earnings account but in the Earnings Reserves account. This follows the appropriation of profits in the year of the acquisition. No profit/ loss is carried forward in this case study. <?page no="230"?> Berkau: Financial Statements 9e 8-230 PARENT SUBSIDIARY AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 2,300,000 1,300,000 3,600,000 3,600,000 Investments 520,000 520,000 (520,000) 0 Goodwill 0 40,000 40,000 cur Assets Inventory 260,000 300,000 560,000 560,000 Cash/ Bank 440,000 600,000 1,040,000 1,040,000 3,520,000 2,200,000 5,720,000 (480,000) 0 5,240,000 SH's capital Issued capital (1,000,000) (500,000) (1,500,000) 500,000 (1,000,000) Reserves (300,000) (300,000) (600,000) 100,000 (500,000) Retained ear. (700,000) (210,000) (910,000) (910,000) Non-ctrl. int 0 (120,000) (120,000) Liabilities Int. bear. liab. (1,000,000) (800,000) (1,800,000) (1,800,000) Payables (220,000) (300,000) (520,000) (520,000) Tax liabilities (300,000) (90,000) (390,000) (390,000) (3,520,000) (2,200,000) (5,720,000) 480,000 0 (5,240,000) Figure 8.24: Consolidation worksheet for PORTERSVILLE Group (1) As the after-tax profit from 20X3 is added to reserves, we know that between 3.01.20X2 and 31.12.20X4, HENDERSON Ltd. increased its reserves by: 300,000 - 100,000 = 2 200,000 AUD. The value is allocated to the group and the non-controlling interest holders at a 4 : 1 ratio and gives us the next column in the consolidation worksheet. We split those earnings reserves at a 4 : 1 ratio which gives 160,000 : 40,000. The 40,000 AUD are accrued to non-controlling interest holders. For layout reasons, we hide the single company columns in Figure 8.25. AGGR. CAP. CONS non-CTRL CONS. F/ S N-cur Assets P,P,E 3,600,000 3,600,000 Investments 520,000 (520,000) 0 Goodwill 0 40,000 40,000 cur Assets Inventory 560,000 560,000 Cash/ Bank 1,040,000 1,040,000 5,720,000 (480,000) 0 0 0 5,240,000 SH's capital Issued capital (1,500,000) 500,000 (1,000,000) Reserves (600,000) 100,000 40,000 (460,000) Retained ear. (910,000) (910,000) Non-ctrl. int 0 (120,000) (40,000) (160,000) Liabilities Int. bear. liab. (1,800,000) (1,800,000) Payables (520,000) (520,000) Tax liabilities (390,000) (390,000) (5,720,000) 480,000 0 0 0 (5,240,000) Figure 8.25: Consolidation worksheet for PORTERSVILLE Group (2) <?page no="231"?> Berkau: Financial Statements 9e 8-231 The inventories disclosed on PORTERSVILLE Ltd.’s balance sheet contain an intra-group profit which was correctly disclosed on the single-entity financial statements. PORTERSVILLE Ltd. bought the goods at 100,000 AUD from HENDERSON Ltd. and discloses them at these costs. In contrast, the group statements follow an asset valuation at cost of acquisition from the viewpoint of the group. These are the purchase costs at HENDERSON Ltd. amounting to 65,000 AUD. This is: 100,000 - 65,000 = 3 35,000 AUD less than disclosed on the balance sheet of PORTERSVILLE Ltd. At the same time, the sales profit recorded by HENDERSON Ltd. becomes an unrealised profit for the group. The goods have been traded between group members. Hence, we deduct HENDERSON Ltd.’s profit in the Retained Earnings account as well as in the Income Tax Liabilities account by a total of 35,000 AUD. This gives: 35,000 × (1 - 30%) = 2 24,500 AUD reductions for retained earnings and: 35,000 × 30% = 110,500 AUD for income taxes. Although Group Accounting has no impact on taxation we must record a deduction of income tax liabilities. Note, if we did not consider the tax implication, the uncompleted Bookkeeping entries become a breach with the double entry system. Below, the next consolidation step for the PORTERSVILLE Group is recorded in Figure 8.26. AGGR. CAP. CONS non-CTRL Profit.CONS CONS. F/ S N-cur Assets P,P,E 3,600,000 3,600,000 Investments 520,000 (520,000) 0 Goodwill 0 40,000 40,000 cur Assets Inventory 560,000 (35,000) 525,000 Cash/ Bank 1,040,000 1,040,000 5,720,000 (480,000) 0 (35,000) 0 5,205,000 SH's capital Issued capital (1,500,000) 500,000 (1,000,000) Reserves (600,000) 100,000 40,000 (460,000) Retained ear. (910,000) 24,500 (885,500) Non-ctrl. int 0 (120,000) (40,000) (160,000) Liabilities Int. bear. liab. (1,800,000) (1,800,000) Payables (520,000) (520,000) Tax liabilities (390,000) 10,500 (379,500) (5,720,000) 480,000 0 35,000 0 (5,205,000) Figure 8.26: Consolidation worksheet for PORTERSVILLE Group (3) Next, we discuss the profit appropriation of the subsidiary HENDERSON Ltd. The company pays a dividend of 0.15 AUD/ share. The total dividend is: 0.15 × 500,000 = 7 75,000 AUD. A portion of: 80% × 75,000 = 660,000 AUD is an intragroup dividend and does not matter for consolidated financial statements. The other portion of: 75,000 - 60,000 = <?page no="232"?> Berkau: Financial Statements 9e 8-232 15,000 AUD is a payment to non-controlling interest holders which are group-outsiders. Hence, a dividend payment is recorded as a cash reduction of 15,000 AUD in terms of the group. The dividend is paid in 20X5 already to simplify the case study. We also consider how much of the retained earnings is left as a profit carried forward and allocate a 20 % portion thereof to non-controlling interest holders. The retained earnings of HENDERSON Ltd. were 210,000 AUD on the single-entity-balance sheet. Remember, that no profit is carried forward. Hence, the retained earnings result from profits earned in 20X5. We deducted 24,500 AUD for intra-group profits and another 75,000 AUD for dividends. Hence, the remaining retained earnings are: 210,000 - 24,500 - 75,000 = 1 110,500 AUD. A 20 % portion of this amount is assigned to the non-controlling interest holders. It results in a transfer of: 110,500 × 20% = 22,100 AUD to non-controlling interest holders for the profit in 20X5. The amount of 37,100 AUD deducted from the group retained earnings is for the dividend paid to non-controlling interest holders and for the non-controlling interest holders’ profit share: 15,000 + 22,100 = 3 37,100 AUD. See below in Figure 8.27 the right column filled on the consolidation worksheet for the PORTERSVILLE Group and in Figure 8.28 its consolidated balance sheet. AGGR. CAP. CONS non-CTRL Profit.CONS Dividends CONS. F/ S N-cur Assets P,P,E 3,600,000 3,600,000 Int. assets 0 0 Investments 520,000 (520,000) 0 Goodwill 0 40,000 40,000 cur Assets Inventory 560,000 (35,000) 525,000 Cash/ Bank 1,040,000 1,040,000 5,720,000 (480,000) 0 (35,000) 0 5,205,000 SH's capital Issued capital (1,500,000) 500,000 (1,000,000) Reserves (600,000) 100,000 40,000 (460,000) Retained ear. (910,000) 24,500 37,100 (848,400) Non-ctrl. int 0 (120,000) (40,000) (37,100) (197,100) Liabilities Int. bear. liab. (1,800,000) (1,800,000) Payables (520,000) (520,000) Tax liabilities (390,000) 10,500 (379,500) (5,720,000) 480,000 0 35,000 0 (5,205,000) Figure 8.27: Consolidation worksheet for PORTERSVILLE Group (4) <?page no="233"?> Berkau: Financial Statements 9e 8-233 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 3,600,000 Share capital 1,000,000 Intangibles Reserves 460,000 Investment Retained earnings 848,400 Goodwill 40,000 Non-ctrl interest 197,100 Current assets Liabilities (liab.) Inventory 525,000 Long-term liab. 1,800,000 Accounts receivables Short-term liab. A/ P 520,000 Prepaid expenses Provisions Cash/ Bank 1,040,000 Income tax liab. 379,500 Total assets 5,205,000 Total equity and liab. 5,205,000 Portersville GROUP CONSOLIDATED STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 8.28: PORTERSVILLE Group’s balance sheet 8.10 Intra-Group Profit Consolidation If we consolidate an intra-group profit, the allocation of retained earnings to the parent and to the non-controlling interest holders are affected. The elimination of the intra-group profit increases the subsidiary’s profit, if the parent earned the intra-group profit. In this case study, the subsidiary HENDERSON Ltd.’s profit on selling goods to the parent PORTERSVILLE Ltd. was deleted and we adjusted its retained earnings and the non-controlling interest portion thereof. If the subsidiary's profit increases due to intra-group profit consolidation, we must consider an increase of non-controlling interest. Examples are the receipt and payment of service from the parent, buying non-current assets from the parent with value adjustment for lower depreciation, taking a loan from the parent etc. In the next case study, we cover a group where the parent provides a consultancy service to its subsidiary which half paid for on credit. We must consolidate the intra-group profit and an increase of the subsidiary's equity, which we allocate partly to the noncontrolling interest holders. 8.11 C/ S PATTEN/ SPYKER PATTEN Ltd. is a consultancy and bought 60 % of the production firm SPYKER (Pty) Ltd. on 1.01.20X0 at 700,000 AUD. See below in Figure 8.29 and in Figure 8.30 the balance sheets of the group members. <?page no="234"?> Berkau: Financial Statements 9e 8-234 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 600,000 Share capital 1,000,000 Intangibles Reserves 400,000 Investment 700,000 Retained earnings Current assets Liabilities (liab.) Inventory 350,000 Long-term liab. 500,000 Acc. receivables A/ R Short-term liab. A/ P 100,000 Prepaid expenses Provisions Cash/ Bank 350,000 Income tax liab. Total assets 2,000,000 Total equity and liab. 2,000,000 Patten Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X0 Figure 8.29: PATTEN Ltd.'s balance sheet after acquisition A C, L Non-current assets [AUD] Equity [AUD] P, P, E 350,000 Share capital 500,000 Intangibles Reserves 178,500 Investment Retained earnings 321,500 Current assets Liabilities (liab.) Inventory 200,000 Long-term liab. 100,000 Acc. receivables A/ R 300,000 Short-term liab. A/ P 50,000 Prepaid expenses Provisions Cash/ Bank 300,000 Income tax liab. Total assets 1,150,000 Total equity and liab. 1,150,000 Spyker (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X0 Figure 8.30: SPYKER (Pty) Ltd.'s balance sheet We explain the figures on the balance sheets as per 31.12.20X0, when we prepare the first consolidated financial statements. We start with the parent PATTEN Ltd. During the fiscal year 20X0, the consultancy PATTEN Ltd. depreciates its items of property, plant, and equipment to an extent of 15 %. It records labour at 200,000 AUD. PATTEN Ltd. records a consulting revenue of 450,000 AUD, 30 % of the revenue results from consulting its subsidiary SPYKER (Pty) Ltd. SPYKER (Pty) Ltd. only pays half of the price, the other portion is due on 31.03.20X1. The costs for the consultancy service are labour to an extent of 200,000 AUD and depreciation. These costs are evenly allocated to all consultancy jobs of the company. During the fiscal year 20X0, the production firm SPYKER (Pty) Ltd. depreciates its machinery by 50,000 AUD. It purchases materials for 500,000 AUD and records a closing stock of raw materials of 70,000 AUD. The opening value of <?page no="235"?> Berkau: Financial Statements 9e 8-235 raw materials to an extent of 200,000 AUD (see its balance sheet) are consumed in production. At the end of the year, no finished goods are on stock. Labour is 400,000 AUD, 75 % thereof is for production. Note, this information is important for product calculations as their net selling price depends on their cost of manufacturing. SPYKER (Pty) Ltd. receives from its parent consulting service and gets charged 135,000 AUD. The consultation is about marketing of its products. Therefore, the consultancy costs are not included in the calculation of its products’ cost of manufacturing. The revenue in 20X0 equals 150 % of the costs of manufacturing. The total costs of manufacturing comprise of labour, depreciation, and materials. They are amounting to: 50,000 + 630,000 + 300,000 = 9980,000 AUD. Based on the price calculation, the revenue is: 150% × 980,000 = 1 1,470,000 AUD. At the end of the fiscal year 20X0, both companies declare and pay a dividend of 10 % of their distributable amounts. The distributable amount also contains other income earned during 20X0. Dividends received by a company are not subjected to tax on capital returns nor are they relevant for the income tax calculation of the recipient, hence, the full dividends are added to the distributable amounts in both companies. The companies prepare the balance sheets and income statements as below: A C, L Non-current assets [AUD] Equity [AUD] P, P, E 510,000 Share capital 1,000,000 Intangibles Reserves 400,000 Investment 700,000 Retained earnings 127,800 Current assets Liabilities (liab.) Inventory 350,000 Long-term liab. 500,000 Acc. receivables A/ R 67,500 Short-term liab. A/ P 100,000 Prepaid expenses Provisions Cash/ Bank 548,300 Income tax liab. 48,000 Total assets 2,175,800 Total equity and liab. 2,175,800 Patten Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 8.31: PATTEN Ltd.'s balance sheet (20X0) <?page no="236"?> Berkau: Financial Statements 9e 8-236 [AUD] Revenue 450,000 Other income 30,000 480,000 Materials 0 Labour (200,000) Depreciation (90,000) Other expenses 0 Earnings before int. & taxes (EBIT) 190,000 Interest 0 Earnings before taxes (EBT) 190,000 Income tax expenses (48,000) Deferred taxes 0 Earnings after taxes (EAT) 142,000 Patten Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X0 Figure 8.32: PATTEN Ltd.'s income statement (20X0) 72 We explain PATTEN Ltd.'s financial statements at the end of the first year. Depreciation is 15 % of the items of property, plant, and equipment: 15% × 600,000 = 9 90,000 AUD. The figures for labour and revenue are given. The revenue from the consultation of SPYKER (Pty) Ltd. is: 30% × 450,000 = 1 135,000 AUD. The payment received is 50 % thereof: 135,000 / 2 = 6 67,500 AUD. PATTEN Ltd. receives 30,000 AUD in dividends from its subsidiary as other income. The distributable amount is the profit after taxes including the received dividends of 142,000 AUD. Therefore, PATTEN Ltd.’s dividend is: 10% × 142,000 = 1 14,200 AUD which is paid in 20X0 already (simplification). The income taxes at PATTERN do not depend on the dividends received from SPYKER (Pty) Ltd.: 30% × (190,000 - 30,000) = 448,000 AUD. The item cash/ bank considers all payments including the receipt and payment of dividends: 350,000 + 450,000 - 67,500 - 200,000 + 30,000 - 14,200 = 548,300 AUD. The retained earnings are disclosed after the appropriation of profits: (1 - 10%) × 142,000 = 1 127,800 AUD. The subsidiary SPYKER (Pty) Ltd. prepares its financial statements as disclosed in Figure 8.33 and Figure 8.34. 72 The income tax calculation does not consider the other income from dividends. <?page no="237"?> Berkau: Financial Statements 9e 8-237 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 300,000 Share capital 500,000 Intangibles Reserves 178,500 Investment Retained earnings 450,000 Current assets Liabilities (liab.) Inventory 70,000 Long-term liab. 100,000 Acc. receivables A/ R 300,000 Short-term liab. A/ P 117,500 Prepaid expenses Provisions Cash/ Bank 752,500 Income tax liab. 76,500 Total assets 1,422,500 Total equity and liab. 1,422,500 Spyker (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 8.33: SPYKER (Pty) Ltd.'s balance sheet (20X0) [AUD] Revenue 1,470,000 Other income 0 1,470,000 Materials (630,000) Labour (400,000) Depreciation (50,000) Other expenses (135,000) Earnings before int. & taxes (EBIT) 255,000 Interest 0 Earnings before taxes (EBT) 255,000 Income tax expenses (76,500) Deferred taxes 0 Earnings after taxes (EAT) 178,500 Spyker (Pty) Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X0 Figure 8.34: SPYKER (Pty) Ltd.'s income statement (20X0) We discuss the figures on the financial statements of SPYKER (Pty) Ltd. below: Depreciation is 50,000 AUD (given). The material expenses are calculated based on a periodic inventory system. They are: 200,000 + 500,000 - 70,000 = 630,000 AUD. Labour is 400,000 AUD; 300,000 AUD thereof is for production. The revenue is calculated as 150 % of the cost of manufacturing: (50,000 + 630,000 + 300,000) × 150% = 1 1,470,000 AUD. SPYKER (Pty) Ltd. received non- <?page no="238"?> Berkau: Financial Statements 9e 8-238 manufacturing related 73 consultancy of: 135,000 AUD and paid half thereof instantly: 135,000 / 2 = 6 67,500 AUD. The dividends paid by SPYKER (Pty) Ltd. are 10 % of the distributable amount. The retained earnings from the previous year 321,500 AUD can be paid to owners and contribute to the distributable amount. The payment to owners is: 10% × (321,500 + 178,500) = 550,000 AUD; as the parent holds 60 % of the subsidiary, 60% × 50,000 = 3 30,000 AUD thereof is paid to PATTEN Ltd. The other portion of 20,000 AUD is accrued to non-controlling interest. According to the case study, dividends are paid in 20X0 already (simplification). To explain the item retained earnings, we calculate its value after payment of dividends: 321,500 + 178,500 - 50,000 = 4 450,000 AUD. For the capital consolidation, we prepare the worksheet below. In the first step, the costs of acquisition are consolidated towards 60 % of equity (issued capital, reserves and retained earnings) of SPYKER (Pty) Ltd. A goodwill of: 700,000 - 60% × (500,000 + 178,500 + 321,500) = 1 100,000 AUD remains. Furthermore, 40 % of equity is allocated to non-controlling interest: 40% × (500,000 + 178,500 + 321,500) = 200,000 + 71,400 + 128,600 = 4 400,000 AUD. We combine the Bookkeeping entries for the capital consolidation as below. DR Goodwill..................... 100,000 AUD DR Issued Capital............... 500,000 AUD DR Reserves..................... 178,500 AUD DR Retained earnings............ 321,500 AUD CR Investments.................. 700,000 AUD CR Non-Ctrl. Interest........... 400,000 AUD Check the worksheet for capital consolidation in Figure 8.35. 73 The consultancy fees do not count for the calculation of the cost of manufacturing. <?page no="239"?> Berkau: Financial Statements 9e 8-239 PARENT SUBSIDIARY AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 600,000 350,000 950,000 950,000 Int. assets 0 0 Investments 700,000 700,000 (700,000) 0 Goodwill 0 100,000 100,000 cur Assets Inventory 350,000 200,000 550,000 550,000 Receivables 300,000 300,000 300,000 Cash/ Bank 350,000 300,000 650,000 650,000 2,000,000 1,150,000 3,150,000 (600,000) 0 2,550,000 SH's capital Issued capital (1,000,000) (500,000) (1,500,000) 300,000 200,000 (1,000,000) Reserves (400,000) (178,500) (578,500) 107,100 71,400 (400,000) Retained ear. (321,500) (321,500) 192,900 128,600 0 Non-ctrl. Int 0 (400,000) (400,000) Liabilities Int. bear. liab. (500,000) (100,000) (600,000) (600,000) Payables (100,000) (50,000) (150,000) (150,000) Tax liabilities 0 0 (2,000,000) (1,150,000) (3,150,000) 600,000 0 (2,550,000) Figure 8.35: Worksheet for capital consolidation (PATTEN/ SPYKER) The next steps of consolidation are (1) Elimination of the intra-group profit. (2) Consolidation of the intra-group’s receivables and payables. (3) Allocation of non-controlling interest. (4) Consolidation of the dividends. (ad 1) The consultation service must be eliminated from the consolidation worksheet. As both parties recorded expense/ revenue and cash/ bank, the intra-group profit is neutral to the group statements already. No adjustments are required for elimination. However, the intra-group profit affects the subsidiary’s profit calculation and matters for the non-controlling interest. Without the inter-group profit, SPYKER (Pty) Ltd.'s profit after taxes would be higher to the extent of: (1 - 30%) × 135,000 = 9 94,500 AUD. The profit of the parent would be lower to the same extent. As the difference affects the subsidiary, we must adjust non-controlling-interest. On the consolidation worksheet, we allocate the higher profit of the subsidiary to an extent of 40 % (their share in the subsidiary) to the non-controlling interest holders: 40% × 94,500 = 3 37,800 AUD. Check the column Service on the consolidation worksheet in Figure 8.36. (ad 2) As the intra group consultation service was only paid to an extent of 50 %, the liabilities at the subsidiary and the receivables at the parent PATTEN Ltd. are cancelled out. The value is: 135,000 / 2 = 667,500 AUD. Check the column Debts on the consolidation worksheet in Figure 8.36. (ad 3) Before elimination of the intragroup service, the profit in 20X0 of SKYPER (Pty) Ltd. is: 178,500 - 50,000 = 128,500 AUD after taxation and deduction of dividends. It must be split between non-controlling interest holders <?page no="240"?> Berkau: Financial Statements 9e 8-240 and the group at a 40 : 60 ratio: The allocation to non-controlling interest is: 40% × 128,500 = 5 51,400 AUD. Check the column non-ctrl on the consolidation worksheet in Figure 8.36. (ad 4) For the dividends of the subsidiary, we acknowledge that payments have already been made. SPYKER (Pty) Ltd.’s dividends paid to the group are considered. However, the dividend portion to the non-controlling interest holders must be isolated and deducted from retained earnings and accumulated towards the non-controlling interest: 40% × 50,000 = 2 20,000 AUD. Check the column non-ctrl on the consolidation worksheet in Figure 8.36. AGGR. CAP. CONS Service Debts Div non-ctrl CONS. F/ S N-cur Assets P,P,E 810,000 810,000 Int. assets 0 0 Investments 700,000 (700,000) 0 Goodwill 0 100,000 100,000 cur Assets Inventory 420,000 420,000 Receivables 367,500 (67,500) 300,000 Cash/ Bank 1,300,800 1,300,800 3,598,300 (600,000) 0 (67,500) 0 0 2,930,800 SH's capital Issued capital (1,500,000) 500,000 (1,000,000) Reserves (578,500) 178,500 (400,000) Retained ear. (577,800) 321,500 37,800 20,000 51,400 (147,100) Non-ctrl int. 0 (400,000) (37,800) (20,000) (51,400) (509,200) Liabilities Int. bear. liab. (600,000) (600,000) Payables (217,500) 67,500 (150,000) Tax liabilities (124,500) (124,500) (3,598,300) 600,000 0 67,500 0 0 (2,930,800) Figure 8.36: Consolidation worksheet (PATTEN/ SPYKER) Below, we disclose the consolidated balance sheet for the PATTEN/ SPYKER Group in Figure 8.37 and its consolidated income statement in Figure 8.38. <?page no="241"?> Berkau: Financial Statements 9e 8-241 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 810,000 Share capital 1,000,000 Intangibles Reserves 400,000 Investment Retained earnings 147,100 Goodwill 100,000 Non-ctrl. Int. 509,200 Current assets Liabilities (liab.) Inventory 420,000 Long-term liab. 600,000 Acc. receivables A/ R 300,000 Short-term liab. A/ P 150,000 Prepaid expenses Provisions Cash/ Bank 1,300,800 Income tax liab. 124,500 Total assets 2,930,800 Total equity and liab. 2,930,800 Patten/ Spyker Group STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 8.37: Consolidated SFP for PATTEN/ SPYKER [AUD] Revenue 1,785,000 Other income 30,000 1,815,000 Materials (630,000) Labour (600,000) Depreciation (140,000) Other expenses 0 Earnings before int. & taxes (EBIT) 445,000 Interest 0 Earnings before taxes (EBT) 445,000 Income tax expenses (124,500) Deferred taxes 0 Earnings after taxes (EAT) 320,500 Patten/ Spyker Group STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X0 Figure 8.38: Consolidated income statement (PATTEN/ SPYKER) 74 8.12 Joint Venture Accounting Joint Venture Accounting requires an existing joint arrangement. IFRS 11.4 defines a joint arrangement as an agreement where two or more parties jointly control another one. With joint 74 The dividends are irrelevant for the income tax calculation. control unanimous consent is necessary for all decisions (IFRS 11.7) One or more companies exercising control power over another one, requires the application of Equity Ac- <?page no="242"?> Berkau: Financial Statements 9e 8-242 counting based on IAS 28 or an investment disclosure following IFRS 9 based on IFRS 11.24 and IFRS 11.25. The IASB distinguishes between joint operations and joint ventures. Following IFRS 11.14, the investor must determine which type of joint arrangement applies. In line with IFRS 11.15, a joint operation is a joint arrangement 75 where the controlling parties keep the rights on their own assets and an obligation for their own liabilities. The companies allocate profit and costs proportionally to their shares. No extra company must get established. In line with IFRS 11.16, a joint venture is a joint arrangement where the controlling parties have the rights to the assets of the joint arrangement. In general, this leads to the establishment of a limited company which is accounted for by Equity Accounting on the investor’s financial statements Based on IFRS 11.20 and IFRS 11.24, a joint operator recognises its assets, liabilities, profits, gain portions and expenses based on its share in interest. An investor in a joint venture recognises its arrangement as investment. Below, we demonstrate both joint arrangements based on comparable case studies: (1) Joint operation. (2) Joint venture. Note, the cases are similar, but no competitive evaluation is intended. We only show how different joint arrangements work. 75 The IFRS-expression arrangement sounds abstract. Think of a joint project, although some We demonstrate the Accounting work and omit tax-related or legal aspects. 8.13 C/ S QUICKARMS- RESPONSE-FIRE Joint Operations On 1.01.20X7, the security firms QUICKARMS Ltd. and RESPONSE (Pty) Ltd. decide to run a suburb patrol service together. There is a third partner involved which is FIRE Ltd. which contributes 10 %. Data Sheet for QUICKARMS- RESONSE-FIRE operations Domicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Security Service. Partners: QUICKARMS Ltd., RESPONSE (Pty) Ltd., FIRE Ltd. Portions: 45 % / 45 % / 10 %. Assets all together: 150,000 ZAR. Joint revenue: 700,000 ZAR. Joint costs: materials: 80,000 ZAR; labour: 500,000 ZAR. VAT ignored. The contract states that only unanimous decisions of the three parties become effective. Therefore, FIRE Ltd. can block a motion even with its 10 % of holdings. Hence, in a joint arrangement every partner can execute a veto control. The joint arrangement about the joint patrol service is classified as joint operation following IFRS 11.15. The investors have joint responsibility for the deployed assets and for liabilities. In their financial statements, QUICKARMS Ltd., RESPONSE (Pty) Ltd. as well as FIRE Ltd. consider the assets characteristics for Project Management are not met. <?page no="243"?> Berkau: Financial Statements 9e 8-243 (cars, weapons) for the joint patrol service to the extent of 150,000 ZAR as asset portions calculated proportionally to their holdings: QUICKARMS Ltd. and RESPONSE (Pty) Ltd. to an extend of 45 % each and FIRE Ltd. of 10 %. Hence, e.g., QUICKARMS Ltd. discloses: 45% × 150,000 = 6 67,500 ZAR of the deployed assets on its balance sheet. The partners pay for the acquisition of joint assets based on their share. The disclosure requirements based on IFRS 11.20 apply. Depreciation applies based on straightline method over three years. It is agreed that at first RESPONSE (Pty) Ltd. collects all revenues and pays for all operations of the joint patrol service. At yearend, RESPONSE (Pty) Ltd. transfers the share of profits to the other operators. Study the balance sheet of QUICKARMS Ltd. in Figure 8.39. It discloses the assets for the joint control as share in joint assets. They are: 45 % × 150,000 = 6 67,500 ZAR. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 300,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 67,500 Retained earnings Current assets Liabilities (liab.) Inventory Long-term liab. 115,000 Accounts receivables Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 247,500 Income tax liab. Total assets 615,000 Total equity and liab. 615,000 QuickArms Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 8.39: QUICKARMS Ltd.’s balance sheet (20X6) In 20X7, the entire revenue earned on the joint patrol service is 700,000 ZAR. The consumption of materials is 80,000 ZAR and labour is 500,000 ZAR. We assume all expenses are paid on cash. The profit of the joint patrol service is: 700,000 - 80,000 - 500,000 = 1120,000 ZAR. The income taxes thereon are: 120,000 × 30% = 36,000.00 ZAR. We do not yet record them as every joint operator pays income taxes on its share of the profit (after deductions made for depreciation). At the end of 20X7, QUICKARMS Ltd. is entitled to receive a profit share of: 45% × 120,000 = 5 54,000 EUR from its partner RESPONSE (Pty) Ltd. QUICKARMS Ltd. adds depreciation on its assets that were deployed in the joint patrol service operations to the extent of: 45% × (150,000 / 3) = 222,500 ZAR. As QUICKARMS Ltd. discloses the share on the joint assets on its financial statements, it must depreciate them. We prepare the income statement for QUICKARMS Ltd. It does not include any <?page no="244"?> Berkau: Financial Statements 9e 8-244 items linked to the joint patrol service yet. Observe the income statement in Figure 8.40. See below also the balance sheet without consideration of the joint patrol service. It is shown in Figure 8.41. [ZAR] Revenue 1,300,000 Other income 0 1,300,000 Materials (35,000) Labour (500,000) Depreciation (50,000) Other expenses (43,000) Earnings before int. & taxes (EBIT) 672,000 Interest 0 Earnings before taxes (EBT) 672,000 Income tax expenses (201,600) Deferred taxes 0 Earnings after taxes (EAT) 470,400 QuickArms Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 8.40: QUICKARMS Ltd.’s income statement A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 67,500 Retained earnings 470,400 Current assets Liabilities (liab.) Inventory Long-term liab. 115,000 Accounts receivables Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 969,500 Income tax liab. 201,600 Total assets 1,287,000 Total equity and liab. 1,287,000 QuickArms Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.41: QUICKARMS Ltd.’s balance sheet (20X7) For QUICKARMS Ltd.’s financial statements, we consider the share of the profit of the joint patrol service as receivables. We further add the depreciation on the assets for the joint patrol service to the expenses. We record Bookkeeping entries as below for the profit share of 54,000 ZAR and for the <?page no="245"?> Berkau: Financial Statements 9e 8-245 depreciation on the deployed assets to the extent of: 22,500 ZAR: @ 31.12.20X7 Depreciation-20X7 DPR 22,500 Accumulated Depreciation ACC 22,500 (recording depreciation on joined assets) Accounts Receivables A/ R 54,000 Other Compreh. Income-20X7 OCI 54,000 (other income recognition from joint operations) After recording the above Bookkeeping entries and calculating an income tax increase due to the joint operations of: (54,000 - 22,500) × 30% = 99,450 ZAR, the financial statements look as below: [ZAR] Revenue 1,300,000 Other income (joint) 54,000 1,354,000 Materials (35,000) Labour (500,000) Depreciation (50,000) Depreciation (joint) (22,500) Other expenses (43,000) Earnings before int. & taxes (EBIT) 703,500 Interest 0 Earnings before taxes (EBT) 703,500 Income tax expenses (211,050) Deferred taxes 0 Earnings after taxes (EAT) 492,450 QuickArms Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 8.42: QUICKARMS Ltd.’s income statement 76 76 The other income received is no dividend. It is subjected to income tax. <?page no="246"?> Berkau: Financial Statements 9e 8-246 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 45,000 Retained earnings 492,450 Current assets Liabilities (liab.) Inventory Long-term liab. 115,000 Accounts receivables 54,000 Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 969,500 Income tax liab. 211,050 Total assets 1,318,500 Total equity and liab. 1,318,500 QuickArms Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.43: QUICKARMS Ltd.’s balance sheet (20X7) How it is Done (Accounting for Joint Operations): (1) Mark assets assigned to joint operations on the balance sheet for extra disclosure. (2) Calculate the profit of the joint operations before taxation. (3) Transfer the pre-tax profit to the other joint operator(s) or receive it from the other joint operator(s) and consider it as other income. (4) Disclose depreciation and other expenses linked to joint operations separately on the income statement. (5) Prepare single-entity financial statements. The case study is repeated below for a joint arrangement classified as joint venture. This requires the establishment of a new company CLOSE- WATCH (Pty) Ltd. The content of the case study below is slightly different to the previous one. 8.14 C/ S CLOSE-WATCH - Joint Venture If the three companies agree in a joint venture, a separate company is established. The three investors jointly control the new company CLOSE-WATCH (Pty) Ltd. IFRS 11.24 requires the partial disclosure of the joint venture on the balance sheets of the investor as investment. Data Sheet for CLOSE-WATCH (Pty) Ltd. Domicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Security Service. Established: 1.01.20X7. Owners: QUICKARMS Ltd., RESPONSE (Pty) Ltd., FIRE Ltd. Share: 45 % / 45 % / 10 %. Issued capital: 200,000 ZAR. Borrowing 25,000 ZAR from QUICKARM Ltd. Property, plant, and equipment: 150,000 ZAR. Revenue: 700,000 ZAR. <?page no="247"?> Berkau: Financial Statements 9e 8-247 Materials: 80,000 ZAR; labour: 500,000 ZAR. VAT ignored. The balance sheet of CLOSE-WATCH (Pty) Ltd. shows in Figure 8.44. The company CLOSE-WATCH (Pty) Ltd. is established by 200,000 ZAR. 150,000 ZAR therefrom is invested in assets, like cars and weapons. The remainder is paid into the bank account of the firm. The company further borrows from QUICKARMS Ltd. 25,000 ZAR as disclosed under short-term liabilities in Figure 8.44. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 150,000 Share capital 200,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. A/ P 25,000 Prepaid expenses Provisions Cash/ Bank 75,000 Income tax liab. Total assets 225,000 Total equity and liab. 225,000 Close-Watch (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 8.44: CLOSE-WATCH (Pty) Ltd.’s opening balance sheet In 20X7, CLOSE-WATCH (Pty) Ltd. records a profit of 49,000 ZAR after taxes. No dividend has been declared yet. The short-term liabilities of 25,000 ZAR are paid back by then to QUICKARMS Ltd. <?page no="248"?> Berkau: Financial Statements 9e 8-248 [ZAR] Revenue 700,000 Other income 0 700,000 Materials (80,000) Labour (500,000) Depreciation (50,000) Other expenses 0 Earnings before int. & taxes (EBIT) 70,000 Interest 0 Earnings before taxes (EBT) 70,000 Income tax expenses (21,000) Deferred taxes 0 Earnings after taxes (EAT) 49,000 Close-Watch (Pty) Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 8.45: CLOSE-WATCH (Pty) Ltd.’s income statement A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 100,000 Share capital 200,000 Intangibles Reserves Financial assets Retained earnings 49,000 Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. A/ P 0 Prepaid expenses Provisions Cash/ Bank 170,000 Income tax liab. 21,000 Total assets 270,000 Total equity and liab. 270,000 Close-Watch (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.46: CLOSE-WATCH (Pty) Ltd.’s balance sheet (20X7) QUICKARM Ltd. and RESPONSE (Pty) Ltd. each disclose the investment at: 45% × 200,000 = 9 90,000 ZAR. FIRE Ltd. discloses a financial asset of 20,000 ZAR. At the time of acquisition, QUICKARMS Ltd. discloses separate financial statements which show its share in the joint venture at cost based on the equity method. For the major investors, Equity Accounting along IAS 28.10 applies. QUICKARMS Ltd.’s separate financial statements with reference to the investment (CLOSE-WATCH) as per 1.01.20X7 are <?page no="249"?> Berkau: Financial Statements 9e 8-249 shown below in Figure 8.47. Therein, receivables from lending 25,000 ZAR are disclosed, too. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 300,000 Share capital 400,000 Intangibles Reserves 100,000 Investment (joint) 90,000 Retained earnings Current assets Liabilities Inventory Interest bear liab 115,000 Accounts receivables 25,000 Accounts payables Prepaid expenses Provisions Cash/ Bank 200,000 Tax liabilities Total assets 615,000 Total equity and liab. 615,000 QuickArms / Close-Watch JOINT VENTURE SEPARATE STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 8.47: QUICKARMS/ CLOSE-WATCH (JV)’s balance sheet (IAS 27) At the end of 20X7, the value of CLOSE- WATCH (Pty) Ltd. increased by: (249,000 - 200,000) / 200,000 = 224.5%. As no dividend has been declared, the investments on the balance sheet at QUICKARM Ltd. and RESPONSE (Pty) Ltd. increase by 24.5 %, too. The new measurement is: (1 + 24.5%) × 90,000 = 112,050 ZAR. The contra entry for the increase in valuation is made in the Investment Income account which is omitted for the calculation of income tax. Note, it is an unrealised profit. Hence, retained earnings are: 1,300,000 + 22,050 - 35,000 - 500,000 - 50,000 - 43,000 - 201,600 = 4 492,450 ZAR. The income taxes of 201,600 ZAR remain unchanged. Below, the balance sheet for the investor QUICKARMS Ltd. is displayed in Figure 8.48 as separate financial statement. The profit and loss calculation, as reported in Figure 8.40 without consideration of the joint venture, applies and is adjusted for the investment income to disclose on separate financial statements. <?page no="250"?> Berkau: Financial Statements 9e 8-250 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000 Share capital 400,000 Intangibles Reserves 100,000 Investment (joint) 112,050 Retained earnings 492,450 Current assets Liabilities Inventory Interest bear liab 115,000 Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 947,000 Tax liabilities 201,600 Total assets 1,309,050 Total equity and liab. 1,309,050 QuickArms Ltd. SEPARATE STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.48: QUICKARM/ CLOSE-WATCH joint venture balance sheet As no indication for an increase in valuation exists for the financial asset at FIRE Ltd., the valuation remains 20,000 ZAR. Note, due to the application of the equity method based on IAS 28.10, the borrowing between the joint venture and one of its investors does not affect the valuation as no consolidation is carried out. How it is Done (Joint Venture Accounting): (1) Prepare financial statements for the joint venture and the investors. Check whether the joint venture is a financial asset or requires Equity Accounting. (2a)If the joint venture is recorded as financial asset, apply a valuation at cost or subsequently at fair values through profit or loss or through other comprehensive income. (2b)If the joint venture requires Equity Accounting, check whether separate financial statements are required. (3a)If the separate financial statements are initially required, recognise the joint venture partially and at costs per rate. (3b)If the separate financial statements are subsequently required, disclose the joint venture partially and based on the equity method. (4b)Record dividends received through profit or loss or through other comprehensive income. Deduct dividends paid from the valuation of the joint venture. (5) Prepare separate financial statements for the investors and the joint venture. <?page no="251"?> Berkau: Financial Statements 9e 8-251 8.15 Summary Group Accounting is linked to the preparation of separate financial statements following IAS 27, to consolidated financial statements along IFRS 3 or to joint arrangements in line with IFRS 11. Minor investments are disclosed as financial instruments following IFRS 9. Investments with significant influence are measured based on the equity method in accordance with IAS 28. Group Accounting aims to provide the user of financial statements with additional information. It has no impact on the need and the way of how single companies prepare and present their single-entity financial statements. No payments are calculated based on Group Accounting information. In Europe, Group Accounting based on IFRSs is required if one group member participates actively on the capital market. 8.16 Working Definitions Acquisition Method: Method in Group Accounting where items of the acquired company are valued as at the time of gaining ownership. Associated Company: A company the investor holds between 20 and 50 % from. A significance of influence is characteristic. Capital Consolidation: A calculation that cancels out the double consideration of assets and investments of a subsidiary. Control: Power to determine the strategy and operating decisions of another company. To exercise control power over another company, ownership is assumed to exceed 50 %. Equity Method: Measurement of associated companies and joint ventures based on the changes in the book value. Group Accounting: Preparation of financial statements for business combinations. Joint Arrangements: Joint operations or joint ventures. Profit Consolidation: Cancellation of intra-group profits with adjustments to assets linked thereto. Separate Financial Statements: Statements prepared by a parent/ investor that show the share in subsidiaries, associates, and joint operations. 8.17 Question Bank (1) A Ltd. buys 210 shares of B Ltd. which is based on 300 shares at 10 EUR/ s. At the time of acquisition, the Retained Earnings Account at B Ltd. is 1,000 EUR. The costs of the investment are 2,900 EUR. How much is the goodwill? 1. Nil . 2. 100 EUR . 3. 200 EUR . 4. (120 EUR) . (2) L Ltd. buys 550 shares of S Ltd. which is based on 1,000 shares at 5 EUR/ share. At the time of acquisition, the Retained Earnings account is 1,500 EUR. At the beginning of the fiscal year, the opening balance for S Ltd.’s Retained Earnings account is 5,000 EUR. How much is the non-controlling interest disclosed on the consolidated balance sheet? 1. 5,175 EUR . 2. 5,000 EUR . <?page no="252"?> Berkau: Financial Statements 9e 8-252 3. 6,325 EUR . 4. 4,500 EUR . (3) On 1.01.20X4, A Ltd. and B Ltd. establish the joint venture J (Pty) Ltd. at equal share of 50,000 EUR each. J (Pty) Ltd. earns a pretax profit of 35,000 EUR in 20X4. It declares a dividend of 4,500 EUR to both investors together. How much is the value of J (Pty) Ltd. on A Ltd.’s separate financial statements? 1. 50,000 EUR . 2. 55,000 EUR . 3. 62,250 EUR . 4. 65,250 EUR . (4) On 1.01.20X2, Y Ltd. buys 50 shares of C Ltd. which is based on 200 ordinary shares at 10 EUR/ share. The total costs of acquisition are 500 EUR. At the time of acquisition, the Retained Earnings account of C Ltd. is zero balanced. On 31.12.20X7, the closing balance of Y Ltd.’s Retained Earnings account is 2,000 EUR and C Ltd.’s one equals 1,000 EUR. What is the disclosure of the investment in C Ltd. on Y Ltd.’s single entity statement of financial position? 1. 1,250 EUR . 2. 1,000 EUR . 3. 750 EUR . 4. 500 EUR . (5) On 1.01.20X2, A (Pty) Ltd. buys 60 % of the shares of P Ltd. The opening balance of P Ltd.’s Retained Earnings account is 1,000 EUR. The subsidiary declares a dividend of 600 EUR. The closing balance of the Retained Earnings account (after appropriation of profits) is 1,500 EUR on the single entity financial statements. How much is the increase of P Ltd.’s equity due to profit/ dividend on the consolidated financial statements under non-controlling interest? 5. 660 EUR . 6. 200 EUR . 7. 360 EUR . 8. 900 EUR . 8.18 Solutions 1-2, 2-4, 3-2, 4-3, 5-2. <?page no="253"?> Berkau: Financial Statements 9e 9-253 9 Current Assets on the Balance Sheet 9.1 What is in the Chapter? Current assets usually stay in a company for less than one year. They comprise of inventories, receivables, securities, and cash/ bank. Based on IRFSs, we also regard prepaid expenses as current assets, because they meet the recognition criteria for assets set by the conceptual framework for financial reporting F 4.8 - F 4.13. These are future economic benefits and reliably valuation. In this chapter, we teach recognition and measurement of current assets. As inventories include raw materials, work-in-process as well as finished goods, we cover the basics of Manufacturing Accounting 77 for the calculation of finished goods in production firms. We introduce the perpetual system for inventory movements and show its difference from the periodic system as discussed in chapter (4). As financial instruments can also be held for short-term periods, this chapter considers their recognition and measurement as securities. This chapter starts-off from the case study GREENACRES Ltd. where we explain two inventory movement systems and their differences. With the case study ROSEFIELD Ltd. we explain stock releases at different material prices and introduce the cost formulas first-in-first-out and weighted average method. The case study HEISTEL (Pty) Ltd. discusses inventory measurement at values below their cost of purchase at net realisable 77 Study for Manufacturing Accounting our textbook Basics of Accounting, chapter (25) and for the difference between Job Order Costing and values. Manufacturing Accounting is discussed by the case study RIEBEEK-KASTEEL (Pty) Ltd. which is a printing company (manufacturer). Besides of the cost flow in production firms, we cover aspects of idle costs following IAS 2.13. Furthermore, four minor case studies are discussed for the valuation of short-term financial assets as securities and one for cash and its equivalents’ disclosure at the end of this chapter. 9.2 Learning Objectives In this chapter, you learn the recognition and measurement of short-term assets as ruled by IAS 2. You get familiarised with the calculation of finished goods applying Work-in-Process Accounts and the Manufacturing Overheads Accounts. You learn about Accounting for receivables and securities. After studying this chapter, you can disclose inventories in compliance with IAS 2 and financial instruments based on IFRS 9. 9.3 Current and non-Current Assets Current assets are disclosed separately from long-term ones based on IAS 1.60 on the statement of financial position. IAS 1.61 states that items should be segregated based on a twelve-month rule. IAS 1.66 defines current assets as assets that are realised, sold, or consumed within a normal operating cycle, merchandise Process Costing our textbook Management Accounting, chapter (18) and (19), respectively. <?page no="254"?> Berkau: Financial Statements 9e 9-254 goods, or cash/ bank. This includes receivables, too. All other items are regarded as non-current assets. The above classification applies not strictly for every single item of inventory. E.g., a production firm that manufactures gear boxes and has one gear box on stock that has been produced based on a customer’s specifications two years ago does not change its classification. Its general classification as inventory stays. As inventories are held for shorter periods than one year, no depreciation applies. However, value decreases can occur if inventory is measured at the lower of cost of purchase/ manufacturing and net realisable value. We term the latter one fair value presentation. Similar rules apply for bad debts. Bad debts are receivables considered to be irrecoverable. They are transferred to the Bad Debts account which is an expense account. 78 Recording bad debts means to write-off receivables by recording an expense and making a credit entry in the Accounts Receivables account. Current assets are: (1) Inventories. (2) Receivables. (3) Securities. (4) Prepaid expenses. (5) Cash/ bank. The next chapters follow the above structure for current assets. 78 Study the case study MOSSEL SPORTS in our textbook Basics of Accounting, chapter (34). 9.4 Inventories IAS 2.6 defines inventories: They are assets a company trades with or assets used for its operations, e.g., for production or service rendering. Their value can be high, e.g., in the retailing industry or production firms. In contrast, service rendering companies, e.g., consultancies, law firms or software developers only hold low levels of inventories. We start-off from the case study about the retailer GREENACRES Ltd. For traders, inventories are merely merchandise goods purchased and sold on to their customers. The case study GREENACRES Ltd. compares two alternative inventory systems 79 , the periodic and the perpetual system. We explain the Bookkeeping entries for both systems by an identical case. At first, we explain the already applied periodic system followed by the introduction of the perpetual system. A periodic system has been discussed with the case study RYNEVELD Ltd. already. For retailers, the Trading account applies for gross profit calculations when a periodic inventory system is in use. With a periodic inventory system, a company takes stock once per Accounting period, in general on 31.12.20XX. Hence, inventory levels are only known at the beginning and at the end of an Accounting period, but not in between. Stocking inventories is recorded in the Purchase account by debit entries. No Bookkeeping entries for stock releases are made. A company determines its inventory consumption by calculating the difference 79 Study our textbook Basics of Accounting, chapter (26). <?page no="255"?> Berkau: Financial Statements 9e 9-255 between opening value and purchases and deducts its closing stock. Extra adjustments must be recorded for returns outwards and inwards. Nowadays with increasing digitalisation, a periodic system seldom applies; it is only in use if inventory is of minor interest. In contrast, a perpetual inventory system records inputs as well as outputs. The Inventory accounts apply: we make debit entries for inputs and record stock releases as credit entries. Under a perpetual inventory system, a company knows about its inventory levels at any time. Monitoring stock levels supports retailers with data for their order management. In the paragraphs following, returns that have been introduced in chapter (4) are discussed with the case study GREENACRES Ltd. Now, four cases are covered: returns outwards and returns inwards for periodic and perpetual systems. The valuation of inventory is based on net values for companies registered for VAT reduction. This is the default case for this textbook following the conventions in chapter (1). IAS 2.11 defines costs of purchase. They are the net purchase price less trade discounts and rebates. Also, attributable costs, e.g., for transportation and goods handling, are added to the costs of purchase. For subsequent valuations, either the cost of purchase or the net realisable value applies, whichever is lower. See IAS 2.9: Inventories shall be measured at the lower of cost and net realisable value which is the estimated selling price less cost of completion and less costs to make the deal (IAS 2.6). The regulations for valuation are strict; this means the reporting company cannot choose between the valuation methods: Once inventory values sink below their initial purchase costs, the lower recoverable value applies. For increasing inventory values (after purchase), the purchase price marks the maximum of valuation. No revaluations, as for non-current assets, apply for inventories. IAS 2.6 defines the net realisable value as the fair value of inventories which is defined by IFRS 13.6 as the price obtained by selling the asset/ inventory in an orderly transaction. Writing-down inventories from purchase costs to net realisable values ensures that inventory is carried at fair values obtainable from their sale or use (IAS 2.28). A value in use can be, e.g., the present value of rental income for property. 9.5 C/ S GREENACRES Ltd. With the case study GREENACRES Ltd. we demonstrate the recording of inventories following alternative inventory systems. The company sells lamps. For the sake of simplicity, only one type of lamps is traded with. The costs of purchase are constant for this case study. See below the data sheet for GREENACRES Ltd.: Data sheet for GREENACRES Ltd. Domicile: South Africa (Gqeberha). Reporting currency: ZAR. Classification: Retailer. Opening value of inventories: 168,000 ZAR; Purchase 1,200,000 ZAR; unit costs: 1,200 ZAR/ u; net selling price: 2,000 ZAR/ u. Sales amount: 800 units (400 + 250 + 150). VAT rate: 20 %. <?page no="256"?> Berkau: Financial Statements 9e 9-256 At the beginning of 20X5, GREENACRES Ltd. discloses an opening value for its lamps of 168,000 ZAR which is for 140 lamps purchased at 1,200 ZAR/ u in the past. During the Accounting period 20X5 (for the sake of simplification on 30.06.20X5), GREENACRES Ltd. orders 1,000 lamps at 1,200 ZAR/ u (net of VAT). The lamps are of the same kind as those on stock at the beginning of 20X5. At first, we discuss the already known periodic system. The measurement for lamps is at their (constant) cost of purchase. The Bookkeeping entry (1) shows the purchase of lamps. @ 30.06.20X5 Purchase-20X5 PUR 1,200,000 Value Added Tax VAT 240,000 Cash/ Bank C/ B 1,440,000 (purchase of 1,000 goods) In 20X5, GREENACRES Ltd. sells in total 800 lamps by three single sales transactions, all at a net selling price of 2,000 ZAR/ u. The Bookkeeping entry (2a), (2b) and (2c) for the revenue recognition are recorded on 1.07.20X5, 1.08.20X4 and 1.09.20X4. @ 1.07.20X5 Cash/ Bank C/ B 960,000 Value Added Tax VAT 160,000 Revenue-20X5 REV 800,000 (revenue recognition for 400 sold goods) @ 1.08.20X5 Cash/ Bank C/ B 600,000 Value Added Tax VAT 100,000 Revenue-20X5 REV 500,000 (revenue recognition for 250 sold goods) @ 1.09.20X5 Cash/ Bank C/ B 360,000 Value Added Tax VAT 60,000 Revenue-20X5 REV 300,000 (revenue recognition for 150 sold goods) At the end of 20X5, GREENACRES Ltd. takes stock and determines that it has 340 lamps in storage. Their value is: 340 × 1,200 = 4 408,000 ZAR. GREENACRES Ltd. transfers the closing stock with reference (three-digit-code T/ A) to its Trading account by Bookkeeping entry (3). The valuation is based on the costs of purchase. On the Trading account, GREENACRES Ltd. calculates the cost of goods sold by deduction of the closing stock from the total of opening value for inventories and of purchases: 168,000 + 1,200,000 - 408,000 = 9 960,000 ZAR. The cost of goods sold are disclosed on the income statement. Observe the Bookkeeping <?page no="257"?> Berkau: Financial Statements 9e 9-257 entry below and thereafter the gross profit calculation in Figure 9.1. @ 31.12.20X5 Inventories INV 408,000 Trading Account-20X5 T/ A 408,000 (recording inventories after stock taking) D C D C OV 168,000 T/ A 168,000 OV . . . (1) 1,440,000 (3) 408,000 c/ d 408,000 (2a) 960,000 576,000 576,000 (2a) 600,000 b/ d 408,000 (2a) 360,000 c/ d 480,000 1,920,000 1,920,000 b/ d 480,000 Inventories (lamps) INV Cash/ Bank C/ B D C D C (1) 1,200,000 T/ A 1,200,000 (1) 240,000 (2a) 160,000 (2b) 100,000 c/ d 80,000 (2c) 60,000 320,000 320,000 b/ d 80,000 Purchase-20X5 PUR Value added tax VAT D C D C T/ A 1,600,000 (2a) 800,000 INV 168,000 REV 1,600,000 (2a) 500,000 PUR 1,200,000 (3) 408,000 (2a) 300,000 GP 640,000 1,600,000 1,600,000 2,008,000 2,008,000 b/ d 640,000 Revenue-20X5 REV Trading account-20X5 T/ A Figure 9.1: GREENACRES Ltd.’s accounts (periodic system) 9.6 Perpetual Inventory System We repeat the case study GREENACRES Ltd. but now apply a perpetual system for the inventory movements. Under the perpetual system, a reporting company adds purchases to the Inventory account directly (no Purchase account applies) and records stock releases at the time of their occurrence. The contra account is the Cost of Goods Sold account. This enables the company to determine its stock level by balancingoff its Inventory account. The cost of goods sold account is closed-off to the Trading Account for the calculation of the gross profit. <?page no="258"?> Berkau: Financial Statements 9e 9-258 9.7 C/ S GREENACRES Ltd. - Perpetual Inventory System In the case study the same opening value for lamps applies: 168,000 ZAR. GREENACRES Ltd. buys 1,000 lamps and records Bookkeeping entry (A) for the goods receipt. By making the Bookkeeping entry, the lamps increase the inventory level immediately. @ 30.06.20X5 Inventories INV 1,200,000 Value Added Tax VAT 240,000 Cash/ Bank C/ B 1,400,000 (adding the purchases to inventories) The three sales result in revenue recognition by three Bookkeeping entries, linked to 400 lamps, then 250 lamps and 150 lamps. All lamps are sold at a net selling price of 2,000 ZAR/ u. VAT applies. The total number of lamps sold is: 400 + 250 + 150 = 8 800 lamps. The revenue (C 1 ) is: 400 × 2,000 = 8 800,000 ZAR, revenue (C 2 ) is: 250 × 2,000 = 5 500,000 ZAR and revenue (C 3 ) is: 150 × 2,000 = 3 300,000 ZAR. GREENACRES Ltd. records also three Bookkeeping entries (B 1 … B 3 ) for the stock releases on 1.07.20X5, on 1.08.20X5, and on 1.09.20X5. The expense account for retailers is not termed Material Expense account but Cost of Goods Sold account. Expenses and revenues are recorded through profit and loss in the Accounting period 20X5. The difference is the gross profit. All Bookkeeping entries for inventory movements are based on the unit cost of purchase which here are constantly 1,200 ZAR/ u. Remember: Record sales always based on selling prices and inventory movements at their cost of purchase or manufacturing. Check Bookkeeping entries (B 1 ) - (C 3 ) below: @ 1.07.20X5 Cash/ Bank C/ B 960,000 Value Added Tax VAT 160,000 Revenue-20X5 REV 800,000 (revenue recognition for 400 goods sold) Cost of Goods Sold-20X5 COS 480,000 Inventories INV 480,000 (stock release for 400 goods) @ 1.08.20X5 Cash/ Bank C/ B 600,000 Value Added Tax VAT 100,000 Revenue-20X5 REV 500,000 (revenue recognition for 250 goods sold) Cost of Goods Sold-20X5 COS 300,000 Inventories INV 300,000 (stock release for 250 goods) <?page no="259"?> Berkau: Financial Statements 9e 9-259 @ 1.09.20X5 Cash/ Bank C/ B 360,000 Value Added Tax VAT 60,000 Revenue-20X5 REV 300,000 (revenue recognition for 150 goods sold) Cost of Goods Sold-20X5 COS 180,000 Inventories INV 180,000 (stock release for 150 goods) With a perpetual system, GREENACRES Ltd. knows its stock levels at any time, e.g., after the 2 nd sale: 168,000 + 1,200,000 - 480,000 - 300,000 = 588,000 ZAR. Study the accounts at GREENACRES Ltd. in Figure 9.2. D C D C OV 168,000 (B 1 ) 480,000 OV . . . (A) 1,440,000 (A) 1,200,000 (B 2 ) 300,000 (C 1 ) 960,000 (B 3 ) 180,000 (C 2 ) 600,000 c/ d 408,000 (C 3 ) 360,000 c/ d 480,000 1,368,000 1,368,000 1,920,000 1,920,000 b/ d 408,000 b/ d 480,000 Inventories (lamps) INV Cash/ Bank C/ B D C D C T/ A 1,600,000 (C 1 ) 800,000 (B 1 ) 480,000 T/ A 960,000 (C 2 ) 500,000 (B 2 ) 300,000 (C 3 ) 300,000 (B 3 ) 180,000 1,600,000 1,600,000 960,000 960,000 Revenue-20X5 REV Cost of goods sold-20X5 COS D C D C COS 960,000 REV 1,600,000 (A) 240,000 (C 1 ) 160,000 G/ P 640,000 (C 2 ) 100,000 1,600,000 1,600,000 c/ d 80,000 (C 3 ) 60,000 b/ d 640,000 320,000 320,000 b/ d 80,000 Trading account-20X5 T/ A Value added tax VAT Figure 9.2: GREENACRES Ltd.’s accounts (perpetual system) <?page no="260"?> Berkau: Financial Statements 9e 9-260 How it is Done (Recording Under a Perpetual Inventory System): (1) Record purchases directly in the Inventory account. Apply separate Inventory accounts for different goods. (2) When selling goods, make entries for the revenue recognition based on the selling price. (3) Make debit entries in the Cost of Goods Sold account for stock releases. Measure inventory movements at the lower of cost of purchase and net realisable values. (4) When required, calculate the inventory level(s) by balancing-off the Inventory account(s). (5) At the yearend, apply a Trading account for the gross profit calculation. Close-off the Cost of Goods Sold account to the Trading account. Do not make entries for opening values nor closing stock of inventories in the Trading account! Close-off the Revenue account to the Trading account, too. (6) In case of returns, make entries in the Inventory account according to the case. (7) Calculate the gross profit and close-off the Trading account to profit or loss. 9.8 Returns Returns outwards are recorded when a company sends back purchased goods to its supplier. When customers bring back goods they previously bought, we record a return inward. Recording returns is a Bookkeeping topic 80 ; however, it is covered here as their journal entries depend on the inventory system in use. Below, we discuss the case study GREENACRES Ltd. again but now consider 50 lamps to be returned to the supplier and 15 lamps brought back by its customers. The unit cost of purchase still is 1,200 ZAR/ u and net selling price is 2,000 ZAR/ u. (a) Returns outwards under the periodic inventory system. (b) Returns outwards under the perpetual inventory system. 80 Study chapters (20) - (23) in our textbook Basics of Accounting. (c) Returns inwards under the periodic inventory system. (d) Returns inwards under the perpetual inventory system. For all cases, entries can be made in the accounts already in use or in separate Returns Outwards and Returns Inwards account. Hence, a return outward can also be recorded as a negative purchase on the credit side of the Purchase account. The same applies for returns inwards: They can be recognised as negative sale on the debit side of the Revenue account. Preferred is a recording through returns accounts as it is easier. (a) Return of 50 lamps to the supplier under a periodic system: <?page no="261"?> Berkau: Financial Statements 9e 9-261 After the receipt of the delivery of 1,000 lamps, GREENACRES Ltd. detects 50 faulty lamps which are sent back to the supplier on 5.07.20X5. The unit purchase cost is 1,200 ZAR/ u. For returns, the Returns Outwards account applies which must be credited. The Returns Outwards account is a nominal account. Like purchases, returns outwards are recorded at the cost of purchase which is the net value. At the time of return and refund, the input-VAT claim is adjusted (reduced) by making a credit entry in the Value Added Tax account. The Cash/ Bank account is debited for the refund (gross value) if the supplier makes a payment immediately. As an alternative, suppliers can reduce their invoice which results in a debit entry in the payables or issue a voucher which gives a debit entry in receivables. Here, the supplier refunds GREENACRES Ltd. on cash. See below the Bookkeeping entries: @ 5.07.20X5 Cash/ Bank C/ B 72,000 Value Added Tax VAT 12,000 Returns Outwards-20X5 R.O. 60,000 (recognition of a return outwards - 50 goods) @ 31.12.20X5 Returns Outwards-20X5 R.O. 60,000 Trading Account-20X5 T/ A 60,000 (closing-off the Returns Outwards account to profit or loss) The above journal entries show that the Returns Outwards account is closed-off to the Trading Account or to profit or loss. Retailers will close it off to the Trading Account and manufacturers will apply the Profit and Loss account, respectively. Under the periodic system, returns outwards are deducted from purchases for the calculation of the cost of goods sold. At GREENACRES Ltd., the cost of goods sold is: 168,000 + 1,200,000 - 348,000 - 60,000 = 9 960,000 ZAR. The 348,000 ZAR result from inventory decrease caused by the return: 408,000 - 60,000 = 3 348,000 ZAR. The return outward does not affect the cost of goods sold. Therefore, returns outwards do not matter for profit calculations. (b) Return of 50 lamps to the supplier under a perpetual system: A return outwards results in a stock release which is combined with the input- VAT claim adjustment and the recording of a cash receipt/ invoice reduction/ voucher issue. The Returns Outwards account is closed-off to inventories at the time of the return outward. <?page no="262"?> Berkau: Financial Statements 9e 9-262 @ 5.07.20X5 Cash/ Bank C/ B 72,000 Value Added Tax VAT 12,000 Returns Outwards-20X5 R.O. 60,000 (recognition of a return outwards - 50 goods) Returns Outwards-20X5 R.O. 60,000 Inventories INV 60,000 (closing-off the Returns Outwards account to inventories) No further Bookkeeping entry is required, and the profit calculation is as disclosed in Figure 7.2. (c) Return inward of 15 lamps under the periodic system: On 12.10.20X5, GREENACRES Ltd.’s customers return 15 lamps they previously bought at a net selling price of 2,000 ZAR/ u. This is recorded as a return inward. For sake of simplification the return inward is recorded as one single business activity. The value is: 15 × 2,000 = 330,000 ZAR. A return inward reverses a sale. Therefore, returns inwards are recognised on the debit side and are measured at net selling prices of the goods brought back. At the same time, a return inward requires a reduction of the output-VAT liabilities. No output-VAT applies for returned goods, and a debit entry is recorded in the Value Added Tax account. The credit entry is either in cash/ bank for a payment, in payables for a voucher, or in receivables if the invoice is adjusted. The Bookkeeping entries for a return inward are recorded as shown below. Here a payment is considered for the customers’ refund. @ 12.10.20X5 Returns Inwards-20X5 R.I. 30,000 Value Added Tax VAT 6,000 Cash/ Bank C/ B 36,000 (recognition of a cash return of 15 goods) @ 31.12.20X5 Trading Account-20X5 T/ A 30,000 Returns Inwards-20X5 R.I. 30,000 (closing-off of the Returns Inwards account to profit or loss) With the application of a periodic inventory system, no further action in terms of Bookkeeping is required. If returned goods are not faulty, the seller adds them to stock. If the goods are faulty and are not repaired, they are disposed of. The outcome is considered once the company takes stock. Note, usually, a return inward is combined with a return outward when the seller takes back the goods from its customers and passes them on directly to its supplier. (d) Return of 15 lamps under a perpetual system: When GREENACRES Ltd. takes back the 15 lamps from its customers on 12.10.20X5, two options are considered: <?page no="263"?> Berkau: Financial Statements 9e 9-263 (d1) the customers return the lamps because of an accidental purchase, and the goods are intact. Goods are then added to inventories. In this case, the return inward requires two Bookkeeping entries. One for the reversal of the sale and the second one for the stock increase. The first one gives a debit entry in the Returns Inwards account based on the net selling price and adjusts the output-VAT by debiting the VAT account. A credit entry is made for the compensation (gross amount) either in cash/ bank in for payment, in payables for an invoice adjustment or in receivables if a voucher is issued. The second Bookkeeping entry reflects that goods are put on stock. This requires an adjustment of the Cost of Goods Sold account on the credit side as those goods are no further expenses and a debit entry is made in the Inventory account. The cost of purchase for the returned lamps as to be considered for the second Bookkeeping entry, is: 15 × 1,200 = 1 18,000 ZAR. At the yearend, the Returns Inwards account is closedoff to either profit or loss or to the Revenue account. Both methods lead to the same result in terms of profit. At GREENACRES Ltd. the value for the cost of goods sold under the assumption of returned goods added to stock gives: 480,000 + 300,000 + 180,000 - 15 × 1,200 = 9 942,000 ZAR. Therefore, the gross profit is: 1,600,000 - 30,000 - 942,000 = 6628,000 ZAR. Observe the journalised entries below: @ 12.10.20X5 Returns Inwards-20X5 R.I. 30,000 Value Added Tax VAT 6,000 Cash/ Bank C/ B 36,000 (recognition of a cash return of 15 goods) Inventories INV 18,000 Cost of Goods Sold-20X5 COS 18,000 (closing-off of the Returns Inwards account to profit or loss) @ 31.12.20X5 Trading Account-20X5 P5L 30,000 Returns Inwards-20X5 R.I. 30,000 (closing-off of the Returns Inwards account to profit or loss) For the case (d2), GREENACRES Ltd. simply omits the second Bookkeeping entry as goods are discarded. The cost for the discard has been recorded as cost of goods sold at the time of the sale. The cost of goods sold in 20X5 are: 480,000 + 300,000 + 180,000 = 9960,000 ZAR. At the same time, the revenue is reduced for the returns: 1,600,000 - 30,000 = 1,570,000 ZAR. The company’s gross profit is: 1,570,000 - 960,000 = 6 610,000 ZAR. The difference in gross profit calculations for case (d1) and case (d2) is: 15 × 1,200 = 1 18,000 ZAR. Once purchases and sales are based on variable values for cost of acquisition and for selling prices, the return calculation is more demanding and requires individual tracking of goods or the application of cost formulas which make <?page no="264"?> Berkau: Financial Statements 9e 9-264 assumptions about the sequence of stock releases. 81 9.9 Differences in Inventory Valuation So far, we discussed inventories with constant measurement. However, values of items of inventory differ due to two effects: (1a) Differences of purchase prices. (1b) Loss in valuation: Inventory valuation can decrease while goods are on stock, e.g., loss due to deterioration, damage etc. 9.10 Different Purchase Price Application Following the principle of specific identification, a company that bought inventories at different prices must carried them at individual costs, see IAS 2.23. An exception of individual inventory valuation applies if goods are interchangeable. Interchangeability means that it is not possible to distinguish goods from each other due to technical restrictions or due to a high quantity, e.g., for fluids, such as gasoline in a tank, or screws in a box. Sometimes, if the units’ value is simply too low to rectify the effort for inventory tracking. Ordinary interchangeability is also fulfilled for packages of specified groceries, e.g. chicken wings where the package carries a label with different BB-dates printed thereon. For ordinarily interchangeable goods, cost formulas apply for inventory valuation. With reference to IAS 2.25, they follow the first-in-first-out (FIFO) principle or the weighted average cost calculation. 82 81 Check the case MONTAGUE (Pty) Ltd. in chapter (28) of our textbook Basics of Accounting. We cover losses in valuations due to deterioration, obsolescence, or damages after the case study ROSEFIELD Ltd. under 9.12. 9.11 C/ S ROSEFIELD Ltd. ROSEFIELD Ltd. is a toy shop based on shares. It applies a perpetual system for its inventory movements. In the first case (i), ROSEFIELD Ltd. applies the first-in-first-out formula, below in case (ii), we cover the same case but then apply the weighted average cost formula. First-in-First-out - Case (i): ROSEFIELD Ltd. is a retailer for game consoles in Melbourne. There are two types of game-consoles: Game-Console- 400 and Game-Console-500. Data Sheet for ROSEFIELD Ltd. Domicile: Australia (Melbourne). Reporting currency: AUD. Classification: Retailer. Opening value: zero. Purchases: see Figure 9.3. Sales: I-VI/ 20X0: 100 × Game Consoles- 400; VII-XII/ 20X0: 148 × Game Consoles- 400; 126 × Game Consoles-500. Net selling prices: Game Console-400 at 200 AUD/ u; Game Console-500 at 350 AUD/ u. VAT rate: 20 %. ROSEFIELD Ltd. purchases the game consoles from a supplier at different prices. Its purchase journal is disclosed in Figure 9.3. Game consoles of the same type are ordinarily interchangeable; therefore, ROSEFIELD Ltd.’s inventory 82 Cost formulas are covered in our textbook Basics of Accounting, chapter (27). <?page no="265"?> Berkau: Financial Statements 9e 9-265 valuation does not follow individual identification but is based on a cost formula, here: first-in-first-out. All game consoles carry a type label for their identification. ROSEFIELD Ltd. applies two separate inventory accounts: one for Game Consoles-400 and the other one for Game Consoles-500. At the beginning of 20X0, no game consoles are on stock. See below the Purchase Journal as recorded in 20X0. Date Item Amount Purchase Cost [AUD] 5.01.20X0 Game Console-400 80 120 5.01.20X0 Game Console-500 50 200 1.04.20X0 Game Console-400 100 125 1.04.20X0 Game Console-500 100 210 1.07.20X0 Game Console-400 75 130 1.07.20X0 Game Console-500 100 215 1.10.20X0 Game Console-400 100 130 Rosefield Ltd. PURCHASE JOURNAL for the period ended 31.12.20X0 Figure 9.3: ROSEFIELD Ltd.’s purchases In 20X0, ROSEFIELD Ltd. sells 100 Game Consoles-400 in the first half of the year and another 148 Game Consoles-400 in the second half. The net selling price per Game Console-400 is 200 AUD/ u. No Game Console-500 is sold during the first half of 20X0. During the second half of the year, ROSEFIELD Ltd. sells 126 Game Consoles-500 at a net selling price of 350 AUD/ u. To keep the case simple, we pretend all sales take place either on 30.06.20X0 or 31.12.20X0. The first sale of 100 Game Consoles-400 on 30.06.20X0 causes stock releases valued at: 80 × 120 + 20 × 125 = 112,100 AUD. Thereafter, 80 Game Consoles-400 are left on stock at unit costs of 125 AUD/ u. The revenue earned by selling 100 Game Consoles-400 is: 100 × 200 = 20,000 AUD. ROSEFIELD Ltd. records the sale of Game Consoles-400 as Bookkeeping entries (8) and (9i) on 30.06.20X0: @ 30.06.20X0 Cash/ Bank C/ B 24,000 Value Added Tax VAT 4,000 Revenue-20X0 REV 20,000 (revenue recognition of 100 Game Consoles-400 sold) Cost of Goods Sold-20X0 COS 12,100 Inventories IN4 12,100 (stock release of 100 Game Consoles-400) <?page no="266"?> Berkau: Financial Statements 9e 9-266 In the second half of 20X0, ROSEFIELD Ltd. sells 148 Game Consoles-400 at 200 AUD/ u and earns a revenue of: 148 × 200 = 2 29,600 AUD. The costs of goods sold are: (100 - 20) × 125 + (148 - 80) × 130 = 1 18,840 AUD. Caution, although the account got balanced-off after the first half of 20X0, the given cost formula applies. The Bookkeeping entries (10) and (11i) show below. @ 31.12.20X0 Cash/ Bank C/ B 35,520 Value Added Tax VAT 5,920 Revenue-20X0 REV 29,600 (revenue recognition of 148 Game Consoles-400 sold) Cost of Goods Sold-20X0 COS 18,840 Inventories IN4 18,840 (stock release of 148 Game Consoles-400) With the sale of the Game Consoles-500 ROSEFIELD Ltd. earns a revenue of: 126 × 350 = 4 44,100 AUD. The cost of goods sold are: 50 × 200 + (126 - 50) × 210 = 25,960 AUD. Check Bookkeeping entries (12) and (13i) recorded both on 31.12.20X0. @ 31.12.20X0 Cash/ Bank C/ B 52,920 Value Added Tax VAT 8,820 Revenue-20X0 REV 44,100 (revenue recognition of 126 Game Consoles-500 sold) Cost of Goods Sold-20X0 COS 25,960 Inventories IN5 25,960 (stock release of 126 Game Consoles-500) Study the accounts in Figure 9.4. The gross profit calculation is in the Trading account. In contrast to the application of a periodic inventory movement system, the Trading account only shows revenues and cost of goods sold (COS). D C D C (1) 9,600 (9i) 12,100 (2) 10,000 (13i) 25,960 (3) 12,500 (11i) 18,840 (4) 21,000 (5) 9,750 (6) 21,500 c/ d 26,540 (7) 13,000 c/ d 13,910 52,500 52,500 44,850 44,850 b/ d 26,540 b/ d 13,910 Inventory Game Console-400 IN4 Inventory Game Console-500 IN5 Figure 9.4: ROSEFIELD Ltd.’s accounts (i: FIFO) <?page no="267"?> Berkau: Financial Statements 9e 9-267 D C D C (1) 1,920 (8) 4,000 (8) 24,000 (1) 11,520 (2) 2,000 (10) 5,920 (10) 35,520 (2) 12,000 (3) 2,500 (12) 8,820 (12) 52,920 (3) 15,000 (4) 4,200 (4) 25,200 (5) 1,950 (5) 11,700 (6) 4,300 (6) 25,800 (7) 2,600 c/ d 730 c/ d 4,380 (7) 15,600 19,470 19,470 116,820 116,820 b/ d 730 b/ d 4,380 Value added tax VAT Cash/ Bank C/ B D C D C (8) 20,000 (9i) 12,100 (10) 29,600 (11i) 18,840 c/ d 93,700 (12) 44,100 (13i) 25,960 c/ d 56,900 93,700 93,700 56,900 56,900 T/ A 93,700 b/ d 93,700 b/ d 56,900 T/ A 56,900 Revenue-20X0 REV Cost of goods sold-20X0 COS D C COS 56,900 REV 93,700 G/ P 36,800 93,700 93,700 b/ d 36,800 Trading account-20X0 T/ A Figure 9.4: ROSEFIELD Ltd.’s accounts (i: FIFO) continued Weighted Average - Case (ii): If ROSEFIELD Ltd. applies the weighted average cost formula, it must calculate for every stock release the average value of game consoles. The sales taking place either on 30.06.20X0 or 31.12.20X0 affects the value of each game console sold. The average value calculation solely considers the number and the costs for game consoles that have been purchased before. Note, for studying the differences, only Bookkeeping entries (9i), (11i) and (13i) for stock releases need to be replaced. Bookkeeping entry (9ii) replaces Bookkeeping entry (9i). In contrast to the FIFO cost formula, ROSEFIELD Ltd. now calculates the weighted average costs for the Game Consoles-400 on 30.06.20X0 as: (80 × 120 + 100 × 125) / 180 = 1122.78 AUD/ u. Hence, the inventory movement is: 100 × 122.78 = 12,278 AUD. The Bookkeeping entry (9ii) is recorded on 30.06.20X0 as below: <?page no="268"?> Berkau: Financial Statements 9e 9-268 @ 30.06.20X0 Cost of Goods Sold-20X0 COS 12,278 Inventories IN4 12,278 (stock release of 100 Game Consoles-400) The Bookkeeping entry (11ii) replaces Bookkeeping entry (11i). The valuation of Game Consoles-400 at weighted average cost on 31.12.20X0 is: ((180 - 100) × 122.78 + 75 × 130 + 100 × 130) / (80 + 75 + 100) = 1127.73 AUD/ u. Hence, the cost of goods sold are: 148 × 127.73 = 118,904.76 AUD. Note, the calculation is based on the exact value for the weighted average unit costs. No rounding of the value of 127.73 AUD/ u is considered. However, for the Bookkeeping entry (11ii), we consider the integer 18,905 AUD: @ 31.12.20X0 Cost of Goods Sold-20X0 COS 18,905 Inventories IN4 18,905 (stock release of 148 Game Consoles-400) The Bookkeeping entry (13ii) replaces Bookkeeping entry (13i). The valuation of the Game Consoles-500 at weighted average on 31.12.20X0 is: (50 × 200 + 100 × 210 + 100 × 215) / (50 + 100 + 100) = 2210 AUD/ u. Therefore, the cost of sales for the Game Consoles-500 is: 126 x 210 = 226,460 AUD. The Bookkeeping entry (13ii) is recorded on 31.12.20X0. Observe the gross profit calculation in the Trading account shown in Figure 9.5: @ 31.12.20X0 Cost of Goods Sold-20X0 COS 26,460 Inventories IN5 26,460 (stock release of 126 Game Consoles-500) D C D C (1) 9,600 (9ii) 12,278 (2) 10,000 (13ii) 26,460 (3) 12,500 (11ii) 18,905 (4) 21,000 (5) 9,750 (6) 21,500 c/ d 26,040 (7) 13,000 c/ d 13,668 52,500 52,500 44,850 44,850 b/ d 26,040 b/ d 13,668 Inventory Game Console-400 IN4 Inventory Game Console-500 IN5 Figure 9.5: ROSEFIELD Ltd.’s accounts (ii: weighted average) <?page no="269"?> Berkau: Financial Statements 9e 9-269 D C D C (1) 1,920 (8) 4,000 (8) 24,000 (1) 11,520 (2) 2,000 (10) 5,920 (10) 35,520 (2) 12,000 (3) 2,500 (12) 8,820 (12) 52,920 (3) 15,000 (4) 4,200 (4) 25,200 (5) 1,950 (5) 11,700 (6) 4,300 (6) 25,800 (7) 2,600 c/ d 730 c/ d 4,380 (7) 15,600 19,470 19,470 116,820 116,820 b/ d 730 b/ d 4,380 Value added tax VAT Cash/ Bank C/ B D C D C (8) 20,000 (9ii) 12,278 (10) 29,600 (11ii) 18,905 c/ d 93,700 (12) 44,100 (13ii) 26,460 c/ d 57,642 93,700 93,700 57,642 57,642 T/ A 93,700 b/ d 93,700 b/ d 57,642 T/ A 57,642 Revenue-20X0 REV Cost of goods sold-20X0 COS D C COS 57,642 REV 93,700 G/ P 36,058 93,700 93,700 b/ d 36,058 Trading account-20X0 T/ A Figure9.5: ROSEFIELD Ltd.’s accounts (ii: weighted average) continued How it is Done (Inventory Calculations based on Weighted Average Cost Formula): (1) Determine the unit costs and quantity of the opening value of inventory. (For inventory value calculations prepare extra workings.) (2) When you add items to the Inventory account determine their value and amount. (3) Calculate the weighted average unit costs by the formula c = (a × x + b × y)/ (a + b). a is the quantity of prior stock; x is the unit costs of prior stock; b is the number of goods added to stock and y is the cost of purchase for inputs. c is the unit costs of the current stock. Enhance the formula for multiple inputs. (4) When you release goods from stock, multiply their number by the unit costs c. (5) Continue by step (2) and (3) for inputs or (4) for outputs. <?page no="270"?> Berkau: Financial Statements 9e 9-270 You can study the extended ROSEFILED Ltd. case study with consideration of returns and trade discounts and more purchases and sales of game consoles. Download the case study through the QR code below, shown as Link 9.A. Link 9.A: ROSEFIELD Ltd. 9.12 Loss on Valuation Inventory valuation can decrease due to deterioration, damage or declining of selling prices, too. Stock is written down to their net realisable values, as required by IAS 2.28. The routine to mark down inventory resembles an impairment loss Bookkeeping entry; however, the technical term is inventory devaluation or writing-off inventory - the latter one for destroyed items of inventory. The down/ offwriting is recorded through profit or loss. IAS 2.30 requires calculating the net realisable value based on best evidence available. The contra entry is made on the credit side of the Inventory account. 9.13 C/ S HEISTEL (Pty) Ltd. Below we study the case of HEISTEL (Pty) Ltd. for the demonstration of inventory decreases in valuation. Data Sheet for HEISTEL (Pty) Ltd. Domicile: Germany (Saarbrücken). Reporting currency: EUR. Classification: Retailer. Opening value: 38,250 EUR (45 laptops at 850 EUR/ u. Net selling price: 1,200 EUR/ u. New gross selling price (on special): 999 EUR/ u. VAT rate: 20 %. The laptop retailer HEISTEL (Pty) Ltd. recently bought 200 laptops from its supplier SUNNY AG at unit costs of 850 EUR/ u. The net selling price is 1,200 EUR/ u. At the end of 20X4, there are 45 laptops left. SUNNY AG started already with the production of a new laptop model. To clear stock, HEISTEL (Pty) Ltd. intends to sell the laptops at 999 EUR/ u gross selling price in January/ 20X5. The net selling price per unit is: 999 / 120% = 832.50 EUR/ u. The planned (future) sale gives sufficient evidence for writingdown inventories on 31.12.20X4. The valuation decreases by: 45 × (850 - 832.50) = 7 787.50 EUR. The Bookkeeping entry below records the inventory writedown. The Loss on Devaluation account is recognised through profit and loss. <?page no="271"?> Berkau: Financial Statements 9e 9-271 @ 31.12.20X4 Loss on Devaluation-20X4 LOD 788 Inventories INV 788 (Inventory devaluation for laptops on stock due to stock clearance) Profit and Loss-20X4 P4L 788 Loss on Devaluation-20X4 LWD 788 (closing-off the Loss on Write Down account) The new valuation for the 45 laptops on the statement of financial position as per 31.12.20X4 is: 45 × 832.50 = 37,462.50 EUR. How it is Done (Writing-down Inventories): (1) Determine the carrying value and valuation of inventories as well as the fair value (net realisable value). (2) If the net realisable value is the same or above the carrying value, nothing needs to be done. (3) If the fair value is below the carrying value, determine the difference on valuation. (4) Record the difference on valuation as a debit entry in the Loss on Devaluation account (expense). Make the contra entry in the Inventory account. (5) At the end of the Accounting period, close-off the Loss on Devaluation account to the Profit and Loss account. An alternative inventory measurement method based on IAS 2.22 is the retail method. It is based on selling prices and a known percentage sales margin. It only applies for cases when it is impracticable to apply other costing methods. The retail method is appropriate for large volumes of fast turning goods. We recommend studying task A4.41 RIVERGATE (Pty) Ltd., which is an online trader for laptops. The task is about different laptop types and increasing purchase prices as well as a drop in inventory values due to discontinuation of one laptop model. 83 83 Find the task in the study material bank. 9.14 Manufacturing Accounting Manufacturing Accounting is about the measurement of finished goods inventories. The cost of manufacturing are expenses that occur for goods production. They comprise of direct materials and costs of conversion. IAS 2.12 defines cost of conversion. They comprise of direct labour costs plus systematically allocated manufacturing overheads, e.g., depreciation on production facilities, indirect labour etc. For the calculation of finished goods, the Work-in-Process account applies. <?page no="272"?> Berkau: Financial Statements 9e 9-272 We focus on Job Order Costing as it is the most common method in Manufacturing Accounting and always works. Note, if the same or comparable products are manufactured in the same sequence, e.g., in a brewery or in pharmaceutical industry, Process Costing can apply as an alternative. It requires all products are processed through the same workstations in an equal sequence. A Process Costing allocates manufacturing overheads from the applied workstations to the entire volume of production. 84 With a Job Order Costing system, direct costs, e.g., purchase costs for materials and direct labour, are accumulated towards job orders, represented by the Work-in-Process account. Note: The correct term for the account is job order account and the reconciliation account is called Work-in-Process account. To avoid different names for the same object, we name the account that represents a job order a Work-in-Process account. The account representing the job order 7441 is called the Work-in-Process- 7441 account. The naming becomes relevant in the exhibits showing the accounts. The Work-in-Process account shows the cost of the goods produced per batch. A job order is an internal order for parts production or for assembling a complete product. In contrast, a customer order is an order assigned to one client and related to a final product or spare parts if sold to customers. Manufacturing Accounting requires the recording of overheads in the factory and their allocation to finished goods. Overheads are expenses linked 84 Process Costing is covered in our textbook Management Accounting for the case study EDEWECHT (Pty) Ltd. in chapter (19). to more than one product or job order. To link them to production steps, allocations are required. In contrast, direct costs do not require allocations but are assigned straight (directly) to the product, like direct materials or direct labour. At first, manufacturing overheads are recorded in expense accounts linked to cost categories, like depreciation, supervisors’ salary etc. Thereafter, manufacturing overheads are allocated to departments/ cost centres. For now, a cost centre is just a small production department. All cost centres get discharged by the application of overheads. Overhead application means to charge the job orders for the service they receive in the cost centres. Therefore, manufacturing overheads must be allocated to job orders. The Workin-Process account is debited, and a credit entry is made in the Manufacturing Overheads account of the cost centre that renders the service. All overheads which are not linked to production are recorded in non-Manufacturing accounts, e.g., Administration, Other Expenses account etc. and closed-off to the Profit and Loss account directly. We summarise: In production firms, there are three distinct kinds of accounts: - Work-in-Process account: representing single job orders. - Manufacturing Overheads accounts: linked to cost centres or cost centre groups in production. - Non-manufacturing accounts: linked to departments not involved <?page no="273"?> Berkau: Financial Statements 9e 9-273 in production. They are usually named following their function, e.g., Administration account, Marketing account etc. The Work-in-Process account supports the calculation of finished goods per batch. Once all costs have been added to the Work-in-Process account including applied overheads from the used workstations their total costs are allocated to the Finished Goods Inventory account. If you divide the cost of manufacturing by the lot size the result is the unit costs of manufacturing. Note: In Production Management another term for a job order is batch. The production volume per batch is termed the lot size. As lower the lot size as more flexible production procedures get. However, from the point of view of economics there are good reasons for high lot sizes to distribute set up costs to more units of production. 9.15 Overhead Application The allocation of manufacturing overheads to job orders (DR Work-in-Process account - CR Manufacturing Overheads) is called overhead application. In Financial Accounting, the application of overheads follows a Full Cost Accounting system (Absorption Costing). Therefore, variable, and fixed manufacturing overheads are transferred together. Note, in Management Accounting partial cost accounting systems are preferred. They avoid the degression effect which causes the allocation of high portions of overheads to the unit cost of production in cases of overcapacity. When applying a cost-plus pricing, there is an imminent danger for manufacturers to overprice their products and to lose market shares. In Management Accounting a popular comparison is that the only guest should not pay for the entire hotel. IAS 2.12 rules the application of overheads. The standard is based on a full cost Accounting system. However, manufacturing overheads are not completely allocated to products. This only applies for near to normal capacity situations based on IAS 2.12f. Otherwise, for overhead application, we must multiply the actual performance of the cost centre by a predetermined overhead allocation rate which is calculated based on normal capacity, e.g., 150 EUR/ MH (per machine-hour). A job order for which the cost centre rendered 3 hours of service is then charged: 3 × 150 = 450 EUR of its manufacturing overheads. This amount is accrued to the Work-in-Process account on its debit side. The credit entry is made in the Manufacturing Overhead account of the cost centre. The most accurate calculation would be achieved if allocations were based on actual costs. However, during production, the actual data are not available (yet). Therefore, the overhead application follows budgeted rates at normal capacity. A predetermined overhead allocation rate is calculated as budgeted costs divided by normal volumes (normal capacity situation). The use of predetermined cost rates causes applied overheads to differ from actual ones. This results either in overor underapplication of overheads. An underapplication means that not all overheads are allocated to job <?page no="274"?> Berkau: Financial Statements 9e 9-274 orders. This often is referred to as idle costs (for unused capacity). To avoid an allocation of idle costs to products, IAS 2.13 requires the application of manufacturing overheads based on normal capacity. Normal capacity is the average capacity with consideration of usual interruptions, such as caused by maintenance and impairments. All Manufacturing Overheads accounts are closed-off to the Profit and Loss account after the completion of overhead applications. You could say the closing difference (“the rest”) is transferred to profit or loss. The remainder represents overor underapplied overheads of the cost centres in Production. These are expenses for the actual Accounting period. 9.16 C/ S RIEBEECK-KASTEEL (Pty) Ltd. Below, we study Manufacturing Accounting with a production firm that produces only one product (maps) in one manufacturing cost centre. We demonstrate under-application of overheads for RIEBEECK- KASTEEL (Pty) Ltd. and explain the treatment of idle cost following IAS 2.13. Another case study HEUNING Ltd. is following which demonstrates the application of manufacturing overheads from multiple cost centres towards several products. Data Sheet for RIEBEECK-KASTEEL (Pty) Ltd. Domicile: South Africa (Langebaan). Reporting currency: ZAR. 85 For the cost definition study our textbook Management Accounting, chapter (4). Classification: Manufacturer. Periods: Jan/ 20X6 budgeted / Jan/ 20X6 actual (monthly statements). Overheads: depreciation: 3,000,000 ZAR/ a; supervisors’ salary: 1,320,000 ZAR/ a; administration: 1,488,000 ZAR/ a. Production volume: 7,200,000 maps in 1,920 hrs / Job order in January/ 20X6: 450,000 maps in 124 hrs. Direct materials: paper 1.20 ZAR/ u.; ink 0.80 ZAR/ u. Net selling price: 7 ZAR/ u. In January 20X6, RIEBEECK-KASTEEL (Pty) Ltd. sells 385,000 maps. VAT rate: 20 %. Note, in this case study we often use the term cost instead of expense. This is normal for the technical term use in Accounting, e.g., we say cost of manufacturing although it is an expense. You find those expressions even in the standards. In this textbook we assume that costs equal expenses, see conventions in chapter (1). Therefore, we ignore non-business related expenses and imputed costs. 85 RIEBEEK-KASTEEL (Pty) Ltd.’s expenses comprise of direct costs, which are direct materials for paper and ink, and of overheads, which are indirect labour, depreciation, and administrative costs. Materials are purchased monthly based on the budgeted volume; no safety stock building is intended but stock of materials increase in underperforming situations. Monthly production volume is equally distributed over the year, meaning the monthly production amount is (1/ 12) of the annual volume. Stock releases depend on the actual volume. If RIEBEECK-KASTEEL (Pty) Ltd. prints less maps than budgeted for, the closing stock of materials increases. <?page no="275"?> Berkau: Financial Statements 9e 9-275 For the sake of simplicity, the opening values for both material types are zero. For the map printing, RIEBEECK-KASTEEL (Pty) Ltd. uses a printer with an annual depreciation of 3,000,000 ZAR/ a. Further manufacturing overheads are the supervisors’ salary in the printing department at 1,320,000 ZAR/ a. Administration costs of 1,488,000 ZAR/ a apply, but they are not linked to production. The above discussed costs are overheads as they are linked to more than one (here: monthly) job orders. In January/ 20X6, RIEBEECK-KASTEEL (Pty) Ltd. intends to print: 7,200,000 / 12 = 6600,000 maps in one batch. The scheduled production time is: 1,920 / 12 = 1 160 hours, which gives a budgeted output rate of: 600,000 / 160 = 3 3,750 u/ hour. RIEBEECK-KASTEEL (Pty) Ltd. measures its printing department’s volume in hours. The calculation of the predetermined overhead allocation rate is discussed further down. Its unit is measured in ZAR/ h as it also refers to the reference unit printing hours. Paper costs per map are 1.20 ZAR/ u (per paper sheet) and for ink 0.80 ZAR/ u (per one map printed). For the intended map volume in January/ 20X6, RIEBEECK- KASTEEL (Pty) Ltd. purchases paper for: 1.20 × 7,200,000 / 12 = 7 720,000 ZAR. Ink is purchased for: 0.80 × 7,200,000 / 12 = 480,000 ZAR. At the time of material purchases, RIEBEECK-KASTEEL (Pty) Ltd. does not know its actual production volume yet. Hence, no purchase on demand is possible. After job order completion in January/ 20X6, all maps are added to the Finished Goods Inventory account. When sold, the costs of manufacturing for the sales are recognised as expense in the Cost of Goods Sold account. The net selling price per map is 7 ZAR/ u. RIEBEECK- KASTEEL (Pty) Ltd. intends to sell all 600,000 maps in January 20X6. A revenue of: 7 × 600,000 = 44,200,000 ZAR is expected. In Figure 9.6, we show Manufacturing Accounting based on the budgeted volumes in January/ 20X6. This is to calculate the predetermined overhead allocation rate. We calculate the predetermined overhead allocation rate at normal capacity (= 160 hours for 600,000 maps). The rate allocates printer depreciation and the supervisors’ salary of the printing department to the job order based on the production volume (measured in hours). The predetermined overhead allocation rate is: (3,000,000 / 12 + 1,320,000) / 160 = 2 2,250 ZAR/ h. It is referred to as predetermined as it is based on budgeted volume and expenses. Below, we disclose all accounts with their planned values for January/ 20X6. Remember, that the accounts in Figure 9.6 are no Bookkeeping records for the actual production. They support product calculation and profit planning only. A company would make these calculations in its Cost Accounting department. For planning cash flows (not discussed in this textbook), we consider VAT and prepare a Cash/ Bank account. Overheads are considered by monthly amounts. <?page no="276"?> Berkau: Financial Statements 9e 9-276 D C D C OV . . . (1) 864,000 (1) 144,000 (12) 840,000 (12) 5,040,000 (2) 576,000 (2) 96,000 (4) 110,000 c/ d 600,000 (5) 124,000 840,000 840,000 c/ d 3,366,000 b/ d 600,000 5,040,000 5,040,000 b/ d 3,366,000 Cash/ Bank C/ B Value added tax VAT D C D C (1) 720,000 (6) 720,000 (2) 480,000 (7) 480,000 Inventory (paper) INP Inventory (ink) INI D C D C (3) 250,000 (8) 250,000 c/ d 250,000 (3) 250,000 b/ d 250,000 Depreciation on printer-20X6 DPR Accumulated depreciation ACC D C D C (4) 110,000 (9) 110,000 (5) 124,000 P&L 124,000 Supervisors' salary-20X6 LAB Administration-20X6 ADM D C D C (6) 720,000 (10) 1,560,000 (8) 250,000 WIP 360,000 (7) 480,000 (9) 110,000 MOH 360,000 360,000 360,000 1,560,000 1,560,000 Work-in-Process-20X6 WIP Manufacturing overheads-20X6 MOH D C D C (10) 1,560,000 (11) 1,560,000 (11) 1,560,000 P&L 1,560,000 Finished goods inventory FGI Cost of goods sold-20X6 COS Figure 9.6: RIEBEECK-KASTEEL (Pty) Ltd.’s budgeted accounts <?page no="277"?> Berkau: Financial Statements 9e 9-277 D C D C P&L 4,200,000 (12) 4,200,000 COS 1,560,000 REV 4,200,000 ADM 124,000 EBT 2,516,000 4,200,000 4,200,000 b/ d 2,516,000 Revenue-20X6 REV Profit and Loss-20X6 P&L Figure 9.6: RIEBEECK-KASTEEL (Pty) Ltd.’s budgeted accounts continued The overhead allocation in Figure 9.6 does not show overnor underapply overheads at belongs to the business plan. No one would plan idle costs, except the production capacity cannot be used otherwise. As IFRSs require applying a Full Cost Accounting system, unit costs of production increase due to underapplication of manufacturing overheads. Therefore, we carefully monitor the actual unit costs: They are calculated by dividing the cost of manufacturing by the lot size: 1,560,000 / 600,000 = 2 2.60 ZAR/ u. The budget is based on normal capacity and the assumption of a complete sale of maps. Below, we demonstrate the calculation of actual costs in a state of underperformance. We repeat the calculation; then it is based on actual volumes. In January/ 20X6, RIEBEECK-KASTEEL (Pty) Ltd. only prints 450,000 maps in 124 hours. Note, that the production process is less efficient than scheduled; the output rate dropped from 3,750 u/ hour to: 450,000 / 124 = 33,629.03 u/ hour. The allocation of overheads for manufacturing is based on the performance in the printing department in hours, not on its volume (maps), wo we can monitor the efficiency. RIEBEECK-KASTEEL (Pty) Ltd. produces 75 % of the planned volume in: 124/ 160 = 7 77.50 % of the budgeted time. The low actual map volume in combination with purchases being based on planned amounts result in a closing stock of raw materials for paper as well as for ink. The paper closing stock is amounting to: (600,000 - 450,000) × 1.20 = 1 180,000 ZAR and the ink is worth: (600,000 - 450,000) × 0.80 = 1 120,000 ZAR. RIEBEECK-KASTEEL (Pty) Ltd. sells 385,000 maps at 7 ZAR/ u in January/ 20X6. Therefore, it adds: 450,000 - 385,000 = 665,000 maps to stock of finished goods. The measurement of finished goods is based on actual volume and refers to the predetermined overhead allocation rate for the consideration of manufacturing overheads. We demonstrate below two alternative calculations, (i) under the assumption that the lower map volume represents a normal capacity situation and we do not separate idle costs (but add them to the unit cost of manufacturing), and (ii) following IAS 2.13 under separate disclosure of underapplied overheads. The latter one applies if the deviation in product volume is high. It requires to allocate manufacturing overheads based on predetermined overhead allocation rates <?page no="278"?> Berkau: Financial Statements 9e 9-278 and to mark the not-applied manufacturing overheads as idle cost. They are then disclosed on the income statement (idle costs). The reason to separate idle costs following IAS 2.13 is to avoid their accrual to units of production. This would increase their unit costs of manufacturing in low volume situations. Therefore, the paragraph states that idle costs should not be allocated to products but recognised separately through profit or loss. Idle costs are transferred to the Profit and Loss account if capacity deviates significantly from standard situations. What normal capacity in in contrast to overcapacity, is subjected to judgement. IAS 2.13 names criteria. For the case study, a decrease in map volume by 25 % is a substantial underperformance. Later, we cover as case (iii) the same calculations as for (ii) but apply a Manufacturing Summary Account for teaching purpose. 9.17 C/ S RIEBEECK-KASTEEL (Pty) Ltd. (i) A Full Cost Accounting system considers all manufacturing overheads for the finished goods calculation; hence 360,000 ZAR are allocated to the Work-in-Process account. No predetermined overhead allocation rate is required for the allocation of manufacturing overheads. Those manufacturing overheads include idle costs. RIEBEECK-KASTEEL (Pty) Ltd. has recorded idle costs for: 160 - 124 = 36 hours. RIEBEECK-KASTEEL (Pty) Ltd. cannot reduce depreciation and must also pay for its supervisor the full salary. The supervisor is not employed on a 86 For Accounting for labour, study chapter (19) in our textbook Basics of Accounting. piecework contract 86 . Labour then would be recorded under wages. Under a full cost Accounting system, manufacturing overheads are allocated to the job order to its full extend (DR Work-in-Process - CR Manufacturing Overhead account). Hence, the unit costs would increase (in comparison to budgeted values) to: (450,000 × (1.20 + 0.80) + 360,000) / 450,000 = 2 2.80 ZAR/ u. The monthly profit under consideration of the sales volume is: 385,000 × (7 - 2.80) - 124,000 = 1 1,493,000 ZAR. 9.18 C/ S RIEBEECK-KASTEEL (Pty) Ltd. - IAS 2.13 (ii) For the application of IAS 2.13, we refer to the accounts in Figure 9.7; now idle costs are firstly kept in the Manufacturing Overheads account and then closedoff to the Profit and Loss account. They are disclosed as expense for the period they occurred in. Together with recognition of idle time linked to depreciation and salary, the manufacturing overheads are applied based on the actual volume (measured in hours) multiplied by the predetermined overhead allocation rate. At RIEBEECK-KASTEEL (Pty) Ltd., the predetermined overhead allocation rate is: 360,000 / 160 = 2 2,250 ZAR/ h. Hence, RIEBEECK-KASTEEL (Pty) Ltd.’s applies only manufacturing overheads to the extent of: 124 × 2,250 = 2 279,000 ZAR to the job order. The remainder of the manufacturing overheads is idle cost of: 360,000 - 279,000 = 8 81,000 ZAR. They represent an expense for period and are recognised through profit or loss. <?page no="279"?> Berkau: Financial Statements 9e 9-279 Observe the profit calculation in Figure 9.7 as discussed above. We transfer idle costs of 81,000 ZAR to the Profit and Loss account. On the income statement, idle costs are disclosed under cost of goods sold or as other expenses. With an over-application of manufacturing overheads, the Bookkeeping entries must be inverted and cause a reduction of the cost of goods sold item on the income statement. Due to technical reasons linked to cost planning, an over-application is more seldom in production firms. D C D C OV . . . (1) 864,000 (1) 144,000 (12) 539,000 (12) 3,234,000 (2) 576,000 (2) 96,000 (4) 110,000 c/ d 299,000 (5) 124,000 539,000 539,000 c/ d 1,560,000 b/ d 299,000 3,234,000 3,234,000 b/ d 1,560,000 Cash/ Bank C/ B Value added tax VAT D C D C (1) 720,000 (6) 540,000 (2) 480,000 (7) 360,000 c/ d 180,000 c/ d 120,000 720,000 720,000 480,000 480,000 b/ d 180,000 b/ d 120,000 Inventory (paper) INP Inventory (ink) INI D C D C (3) 250,000 (8) 250,000 c/ d 250,000 (3) 250,000 b/ d 250,000 Depreciation on printer-20X6 DPR Accumulated depreciation ACC D C D C (4) 110,000 (9) 110,000 (5) 124,000 P&L 124,000 Supervisors' salary-20X6 LAB Administration-20X6 ADM D C D C (6) 540,000 (10) 1,179,000 (8) 250,000 WIP 279,000 (7) 360,000 (9) 110,000 c/ d 81,000 MOH 279,000 360,000 360,000 1,179,000 1,179,000 b/ d 81,000 P&L 81,000 Work-in-Process-20X6 WIP Manufacturing overheads-20X6 MOH Figure 9.7: RIEBEECK-KASTEEL (Pty) Ltd.’s actual accounts (IAS 2.13) <?page no="280"?> Berkau: Financial Statements 9e 9-280 D C D C (10) 1,179,000 (11) 1,008,700 (11) 1,008,700 P&L 1,008,700 c/ d 170,300 1,179,000 1,179,000 b/ d 170,300 Finished goods inventory FGI Cost of goods sold-20X6 COS D C D C P&L 2,695,000 (12) 2,695,000 COS 1,008,700 REV 2,695,000 MOH 81,000 ADM 124,000 EBT 1,481,300 2,695,000 2,695,000 b/ d 1,481,300 Revenue-20X6 REV Profit and Loss-20X6 P&L Figure 9.7: RIEBEECK-KASTEEL (Pty) Ltd.’s actual accounts (IAS 2.13) continued Due to a longer production time per map in comparison to the budgeted time, the manufacturing is less efficient and the unit costs per map slightly increase to: 1,179,000 / 450,000 = 2 2.62 ZAR/ u. However, those unit costs are clearly below the ones in case (i) which are 2.80 ZAR/ u. Consider that direct materials for paper and ink of 2 ZAR/ u are included. The high increase in unit costs of conversion to the extent of 0.20/ 0.60 = 3 33% is caused by idle cost allocations to products in case (i). Note, in terminology of international Accounting, costs of manufacturing are split into direct costs and overheads. The portion of unit cost of manufacturing that is no materials is termed cost of conversion. This includes direct labour. How it is Done (Manufacturing Accounting): (1) Record standard Bookkeeping entries for purchases (apply perpetual system) and for expenses, revenues, and other comprehensive income. (2) Define Work-in-Process accounts for job orders, Manufacturing Overhead accounts for cost centres and Administration account(s). (3) Record stock releases of materials as direct materials to the Work-in-Process accounts or as manufacturing overheads to cost centres. (4) Transfer direct labour to Work-in-Process accounts or as manufacturing overheads to cost centres. (5) Transfer other manufacturing overheads to cost centres or as administrative expenses if not production related. <?page no="281"?> Berkau: Financial Statements 9e 9-281 (6) Do not transfer interest if not linked to production as borrowing costs (IAS 23). (7) Add all manufacturing overheads in a cost centre. (8) Determine the predetermined overhead allocation rate for cost centres by dividing the total budgeted costs by the planned performance as measured in reference units. (9) Allocate manufacturing overheads to job orders by multiplying the actual performance with the predetermined overhead allocation rate. (10)Transfer not-applied overheads of the cost centres to profit or loss. Underapplied overheads lead to a debit entry in the Profit and Loss account and overapplied overheads give credit entries therein. (11)Add all costs per job order. These are direct materials and costs of conversion. The costs of conversion are direct labour and applied manufacturing overheads. (12)Transfer job order costs to the Finished Goods account once production is completed. (13)When finished goods are sold, record stock releases in the Cost of Goods Sold account. It can happen that you must consider different unit costs of manufacturing for various batches of production. Make Bookkeeping entries for revenues/ other comprehensive income. (14)Close-off the Cost of Goods Sold account(s), the Administration Expenses account(s), the Interest account(s), and the Revenue account(s) to profit or loss and calculate earnings before taxation. (15)Calculate income tax and close-off the Profit and Loss account to income tax liabilities and retained earnings. How it is Done (Recording Idle Plant Costs): (1) Follow the procedures of Manufacturing Accounting as described above: (1.1)Add direct costs to job orders (WIP account). (1.2)Add manufacturing overheads to cost centres (MOH account). (1.3)Add non-manufacturing overheads to expense accounts and later close them off to the Profit and Loss account. (2) For each cost centre compare actual manufacturing overheads to those calculated based on normal capacity (use predetermined overhead allocation rate <?page no="282"?> Berkau: Financial Statements 9e 9-282 POR). Check whether actual and normal capacity significantly deviate. (3a)If actual and normal capacity are close, apply actual overhead calculation by closing-off the Manufacturing Overheads account to the Work-in-Process accounts. Record inventory movements towards the Finished Goods Inventory account. (3b)If actual and normal capacity differ significantly, allocate manufacturing overheads based on normal capacity and recognise remaining idle costs as expenses through profit or loss. 9.19 Manufacturing Summary Account A Manufacturing Summary Account is a reconciliation account for manufacturing overheads and work-in-process. It applies only for periodic inventory movement system and when the Work-in-Process account and the Manufacturing Overhead account are linked to the same cost centres. The Application of the Manufacturing Summary account for the case study RIEBEECK-KASTEEL (Pty) Ltd. can be accessed through the Link 9.B. Link 9.B: RIEBEEK-KASTEEL (Pty) Ltd. 9.20 C/ S HEUNING Ltd. With the next case study HEUNING Ltd. we show the application of overheads from two Manufacturing Overhead accounts to four job orders for two different products. HEUNING Ltd. is a manufacturer for garden tools and purchases materials at different prices. Find below the data sheet for HEUNING Ltd. Data Sheet for HEUNING Ltd. Domicile: Australia (Melbourne). Reporting currency: AUD. Classification: manufacturer. Accounting period: 20X2. Opening values for materials: Inventory shaft: 3,500 AUD, inventory blades: 6,000 AUD. Purchases: see below! Job orders: (1) 500 shovels, (2) 500 rakes, (3) 600 shovels, (4) 400 shovels. Overheads: depreciation: 27,500 AUD; indirect labour: 51,000 AUD Cost centres: (A) Assembling, (B) Goods Inspection and Packaging; (C) Administration. Sale: 1,250 shovels at 120 AUD/ u; 450 rakes at 120 AUD/ u. Ignore VAT! The manufacturer HEUNING Ltd. produces shovels and rakes. A shovel consists of a shaft and a blade. A rake is made from the same shaft as for shovel and a claw. At the beginning of the Accounting period, HEUNING Ltd. discloses an opening value of materials on its statement of financial position: 700 shafts at 5 AUD/ u and 200 blades at 20 AUD/ u. In 20X2, HEUNING Ltd. purchases materials as below: <?page no="283"?> Berkau: Financial Statements 9e 9-283 (1) On 1.01.20X2, purchase of 900 claws at 25 AUD/ u. (2) On 1.01.20X2, purchase of 5,000 shafts at 5.50 AUD/ u. (3) On 1.01.20X2, purchase of 500 blades at 16 AUD/ u. (4) On 1.01.20X2, purchase of 600 blades at 16.25 AUD/ u. (5) On 1.01.20X2, purchase of 8,000 boxes at 0.95 AUD/ u. (6) On 1.10.20X2, purchase of 500 blades at 18.50 AUD/ u. HEUNING Ltd. runs four job orders in 20X2, on 5.01.20X2 for 500 shovels, on 5.04.20X2 for 500 rakes, on 5.07.20X2 for 600 shovels, and on 5.10.20X1 for 400 shovels. All job orders are carried out sequentially and are finished within one month. They start in the Assembling department and thereafter go to Goods Inspection and Packaging. There is a third department Administration which is not linked to manufacturing. HEUNING Ltd. applies a job order costing and the cost formula first-in-firstout. E.g., the first stock release of blades for job order (1) is calculated to be: 300 × 20 + 200 × 16 = 99,200 AUD. The allocation of overheads to the cost centres is given: Assembling is charged with 20,000 AUD for labour and 10,000 AUD for depreciation. The Goods Inspection & Packaging department gets 15,000 AUD of the labour costs and 8,000 AUD depreciation. The remainder of the overheads labour 16,000 AUD and depreciation 9,500 AUD is assigned to the Administration department. Next, we focus on the application of manufacturing overheads. In the Assembling cost centre, a predetermined overhead allocation rate of: 30,400 / 1,900 = 16 AUD/ u applies. It has been calculated based on planned Assembling overheads of 30,400 AUD and a production volume of 1,900 garden tools. For the sake of simplification, the reference unit is the number of manufactured garden tools (volume). Applying overheads leads to the cost allocations as disclosed in figure 9.9. Job order (1) is charged with: 500 × 16 = 8 8,000 AUD Assembling overheads. In the department Goods Inspection & Shipping overheads are applied based on the inspection time. The job orders spent the below listed durations in the Goods Inspection and Packaging department: Job order (1) for 17: 50 hrs = 1 1,050 min, (2) for 16: 20 hours = 9 980 min, (3) for 19: 30 hours = 1 1,170 min and (4) for 6: 20 hours = 3 380 min. As the actual capacity of 3,580 min does not significantly deviate from the normal capacity of 60 hours (= 3,600 min), manufacturing overheads are applied on a full cost basis following actual capacity. E.g., job order (1) must cover manufacturing overheads from Goods Inspection and Packaging to an extent of: 1,050 / 3,580 × 23,000 = 6 6,745.81 AUD. Check figure 9.8 for the overhead application. After completion of all job orders, shovels and rakes are added to the finished goods inventories. When sold the goods are released in a first-in-first-out sequence and recognised as expenses (cost of goods sold). E.g. 1,250 shovels sold are measured at their cost of manufacturing based on the job orders W1P, W3P and partially W4P, following their sequence of production: 26,920.81 + 30,661.76 + 150/ 400 × 18,146.34 = 64,387.45 AUD. In 20X2, HEUNING Ltd. earns a sales revenue of 120 × (1,245 + 450) = 2 203,400 AUD. <?page no="284"?> Berkau: Financial Statements 9e 9-284 Check the profit calculation in figure 9.8 which shows a selection of the major accounts for this case study. D C D C OV 3,500 W1P 2,500 OV 6,000 W1P 9,200 (2) 27,500 W2P 2,650 (3) 8,000 W3P 9,675 W3P 3,300 (4) 9,750 W4P 6,725 W4P 2,200 (6) 9,250 c/ d 7,400 c/ d 20,350 33,000 33,000 31,000 31,000 b/ d 7,400 b/ d 20,350 D C D C (1) 22,500 W2P 12,500 (5) 7,600 W1P 475 c/ d 10,000 W2P 475 22,500 22,500 W3P 570 b/ d 10,000 W4P 380 c/ d 5,700 7,600 7,600 b/ d 5,700 D C D C INS 2,500 FGS 26,921 INS 2,650 FGR 29,921 INB 9,200 INC 12,500 INX 475 INX 475 MOA 8,000 MOA 8,000 MOI 6,746 MOI 6,296 26,921 26,921 29,921 29,921 D C D C INS 3,300 FGS 30,662 INS 2,200 FGS 18,146 INB 9,675 INB 6,725 INX 570 INX 380 MOA 9,600 MOA 6,400 MOI 7,517 MOI 2,441 30,662 30,662 18,146 18,146 Work-in-Process (3) W3P Work-in-Process (4) W4P Work-in-Process (1) W1P Work-in-Process (2) W2P Inventories Claw INC Inventories Box INX Inventories Shaft INS Inventories Blade INB Figure 9.8: Accounts at HEUNING Ltd.’s <?page no="285"?> Berkau: Financial Statements 9e 9-285 D C D C LAB 20,000 W1P 8,000 LAB 15,000 W1P 6,746 DPR 10,000 W2P 8,000 DPR 8,000 W2P 6,296 W3P 9,600 W3P 7,517 OAO 2,000 W4P 6,400 W4P 2,441 32,000 32,000 23,000 23,000 D C D C LAB 16,000 P&L 25,500 W1P 26,921 COS 64,387 DPR 9,500 W3P 30,662 25,500 25,500 W4P 18,146 c/ d 11,341 75,729 75,729 b/ d 11,341 D C D C W2P 29,921 COS 26,929 FSI 64,387 P&L 91,316 c/ d 2,992 FRI 26,929 29,921 29,921 91,316 91,316 b/ d 2,992 D C D C P&L 203,400 C/ B 203,400 COS 91,316 REV 203,400 ADM 25,500 OAO 2,000 EBT 88,584 205,400 205,400 b/ d 88,584 Administration-20X2 Finished Shovel Inventories FSI Finished Rake Inventories FRI Cost of goods sold-20X1 COS Revenue-20X1 REV Profit and Loss-20X1 P&L Manufacturing OH Assembling MOA Manufacturing OH GIP MOG Figure 9.8 Accounts at HEUNING Ltd. continued We recommend working on the case study HEUNING Ltd. in task A9.49b which is the same but based on the cost formula weighted average method. 87 9.21 Receivables Receivables are recorded in the current-asset section of the balance sheet 87 Find the task HEUNING Ltd. in the study material bank. and reflect claims on future receipts. Receivables from customers in arrears frequently contain a VAT portion which matters for bad debts recognition (writing-off receivables). Besides of trade receivables, there are input- VAT receivables that represent claims against the revenue service and receivables resulting from granted loans to <?page no="286"?> Berkau: Financial Statements 9e 9-286 other parties. In general, the latter ones do not include VAT. Receivables fall under financial instruments and are contracts ruled by IAS 32.11. Reporting entities must disclose credit risks following IFRS 7.9, too. Trade receivables are risky to the extent that the debtor fails its payment obligations (e.g., due to bankruptcy). IFRS 9.3.1.2 requires a fair value measurement at recoverable amounts of all financial assets through either the profit or loss or other comprehensive income. 9.22 C/ S CHELMSFORD Below, we study trade receivables from an Australian car dealer. Data Sheet for CHELMSFORD Ltd. Domicile: Australia (Sydney). Reporting currency: AUD. Classification: dealership. Accounting periods: 20X3 / 20X4. Car sale: 65,000 AUD (net amount) on 5.04.20X3 payable on 4.04.20X4 Interest: 3,000 AUD (net amount) VAT rate: 20 %. CHELMSFORD Ltd. records trade receivables from the sale of a VW T-ROC to the extent of 81,600 AUD. The company accepted a sale where the customer buys the car on 5.04.20X3 and pays the complete price one year later (4.04.20X4). An interest portion of 3,000 AUD (net value) is included in the settlement value. The agreement between CHELMSFORD Ltd. and the buyer is about an immediate car delivery and the receipt of: (65,000 + 3,000) × 120% = 81,600 AUD in 20X4. 65,000 AUD is the car’s regular net selling price. The journal entry (1) shows the recording of a financial asset in CHELMSFORD Ltd.’s books. On the customer’s side, a financial liability is disclosed under shortterm liabilities (A/ P). At CHELMSFORD Ltd., a deferred interest income linked to the next Accounting period is recorded, too. The interest income is for the period April/ 20X3 until March/ 20X4. Although receipt is expected for 20X4 it is partly relevant for the Accounting period 20X3 to an extent of nine months. The actual interest income is: 3,000 × 9/ 12 = 2 2,250 AUD in 20X3. The remainder is deferred interest income of: 3,000 - 2,250 = 7 750 AUD. @ 5.04.20X3 Accounts Receivables A/ R 81,600 Interest Income-20X3 I3I 2,250 Deferred Interest Income DII 750 Value Added Tax VAT 13,600 Revenue-20X3 REV 65,000 (recognition of the car sale) The measurement of the short-term receivables is based on their settlement value. From experience, CHELMSFORD Ltd.’s credit risk regarding its customers’ payment failure is 10 % of the debts. Hence, <?page no="287"?> Berkau: Financial Statements 9e 9-287 on average 10 % of receivables are written-off as bad debts because they do not get paid and are not collectable either. CHELMSFORD Ltd. calculates the recoverable value of its receivables based on the estimated credit risks. The bad debt portion resulting from the car sale is: 10% × 81,600 = 8 8,160 AUD. At the end of 20X3, CHELMSFORD Ltd. records the credit risk as Bookkeeping entry (2). The recording of bad debts is here a precautious consideration of a potential payment failure and is reversed upon complete receipt of the 81,600 AUD. If the receivables are not received the bad debts are extended to the full amount. @ 6.04.20X3 Bad Debts Account-20X3 BDA 6,800 Value Added Tax VAT 1,360 Accounts Receivables A/ R 8,160 (precautious recording of bad debts based on credit risk) The recording of bad debts resulting from trade receivables includes a debit entry in the VAT account for the reduction of CHELMSFORD Ltd.’s output-VAT obligation from the sale. The revenue recognition at the time of the deal made CHELMSFORD Ltd. record its full output- VAT. The interest income as well as the bad debts are closed-off to the Profit or Loss- 20X3 account (not shown). The buyer of the car pays the agreed price of 81,600 AUD on time (in 20X4). The payment changes the fair value of the measurement of receivables, as the cash receipt validates the previously recorded credit risk. Therefore, we record the payment on the recipient’s side in two steps, the first one is for a reversal of the written-down receivables, and the second one is made for the settlement of the receivables. Observe both transactions as Bookkeeping entries (a) and (b). @ 5.04.20X4 (a), (b) Accounts Receivables A/ R 8,160 Value Added Tax VAT 1,360 Bad Debts Account-20X4 BDA 6,800 (bad debts reversal) Cash Bank C/ B 81,600 Accounts Receivables A/ R 81,600 (receipt of payment from the buyer as agreed) For a correct allocation of the interest portion, CHELMSFORD Ltd. accrues (in 20X3) deferred income to its Interest Income account, check journal entry (c). @ 31.12.20X4 Deferred Income DFI 750 Interest Income-20X4 I4I 750 (accrual of deferred interest income) <?page no="288"?> Berkau: Financial Statements 9e 9-288 How it is Done (Measurement of Receivables): (1) Determine the settlement value SMV, in general, it is the gross value if receivables result from selling goods or services. In case the receivables result from pure lending, no VAT applies. (2) If the settlement value contains an interest portion consider it for the measurement of receivables. (3) Determine credit risks of the debtor, preferably as a percentage (risk rate rr). (4) Determine the fair value of receivables under consideration of credit risks by multiplying the settlement value by the factor: (1 - rr). (5) Record the written-down receivables as bad debts, make a debit entry in the Bad Debts account to the extent of the net amount of the settlement value multiplied by the risk percentage: (1/ 120%) × SMV × rr. Make a debit entry in the VAT account for value added tax linked to the credit risk: (20%/ 120%) × SMV × rr and a credit entry in the Accounts Receivables account to the extent of: SMV × rr. (6) Monitor debtor’s solvency on a regular basis. (7a)If the debtor is insolvent write-off the remaining receivables as bad debts, too. Make a debit entry in the Bad Debts account and in the VAT account and cancel out the remaining receivables to the extent of SMV × (1 - rr) in the Receivables account A/ R. Later, close-off the Bad Debts account to the Profit and Loss account. (7b)If the debtor pays the outstanding receivables and if receivables were previously written down for a credit risk consideration, make a debit entry in the Accounts Receivables account to the extent of: SMV × rr and in the VAT account to the extent of: (20%/ 120%) × SMV × rr. Credit (1/ 120%) × SMV × rr to bad debts. (8b)Make a debit entry in the Cash/ Bank account and a credit entry in the Accounts Receivables account for the full cash receipt. 9.23 Securities Securities are financial instruments and are ruled by IFRS 9. They can be shares, bonds etc. We use the technical term securities, because they are held in an easily convertible to cash form. Securities are to earn interest income and/ or gains from capital appreciation. In rainy days, their owner can sell securities on short notice for an increase of liquidity. As the benefit is the option to sell them on short notice, they are disclosed under current assets and IFRS 9 requires their measurement at fair values. <?page no="289"?> Berkau: Financial Statements 9e 9-289 The classification of financial instrument in line with IFRS 9.4.1.2 depends on the holders’ business model. Securities held for sale are kept at fair values through profit or loss (FVTPL) or fair values through other comprehensive income (FVTOCI). In contrast, financial assets which solely are held for the receipt of contractual cash flows must be carried at amortised costs following IFRS 9.4.1.2 and are covered in chapter (7). In general, shares are carried at FVTPL/ FVTOCI. In compliance with IFRS 9.5.1.1, we measure securities initially at costs and subsequently at fair values (IFRS 9.5.7). Fair market values of publicly traded securities are prices as traded at a stock exchange or on bond market. Next, we discuss three case studies about securities. 9.24 C/ S NOKOX (Pty) Ltd. At first, we discuss the case study NOKOX (Pty) Ltd. that is related to shares and dividend income: Data Sheet for NOKOX (Pty) Ltd. Domicile: Australia (Melbourne). Reporting currency: AUD. Classification: n/ a. Period: 20X8. Purchase of 30,000 shares of MCD at 150 AUD/ share on 30.04.20X8. Dividend: 1 USD/ s. Currency exchange rate 1 USD : 1.50 AUD / 1 USD : 1.40 AUD. Share price at NYSE: 105 USD/ s on 31.12.20X8. VAT n/ a. * Call option: 2,700,000 USD at 4,000,000 AUD on 31.12.20X8. Acquisition: 4.04.20X8. Banking fee: 25,000 AUD. Currency exchange rate 1 USD : 1.48 AUD. On 30.04.20X8, NOKOX (Pty) Ltd. buys 30,000 shares of McDonald’s corporation at 150 AUD/ share each. The shares are traded at 100 USD/ s. At the time of acquisition, the currency exchange rate is: 1 USD = 1.50 AUD. The costs of purchase are: 30,000 × 150 = 4 4,500,000 AUD. We ignore transaction costs. NOKOX (Pty) Ltd. intends to sell the shares in 20X9. It classifies its shares as securities. On 31.12.20X8, NOKOX (Pty) Ltd. receives the 20X8-dividend of 42,000 AUD. The dividend is amounting to 1 USD/ s. By then, the Australian Dollar depreciated against the US-Dollar and is traded at: 1 USD : 1.40 AUD. Therefore, the dividend income in Australian Dollar is: 30,000 × 1.40 = 4 42,000 AUD. It is recorded as a gain because for NOKOX (Pty) Ltd. dividend income is extraordinary. At the same time, the shares of McDonald’s Corporation are traded at the New York Stock Exchange NYSE at 105 USD/ s. The shares’ Australian Dollar value is: 30,000 × 105 × 1.40 = 4 4,410,000 AUD. Due to the weak Australian Dollar, NOKOX (Pty) Ltd. lost: 4,500,000 - 4,410,000 = 9 90,000 AUD. The loss in valuation exceeds the dividend income. We deduct the loss in valuation from dividend income and calculate a net loss of: 90,000 - 42,000 = 448,000 AUD. NOKOX (Pty) Ltd. records the dividend income and the share price increase/ currency loss in compliance with IFRS 9.4.1.2A. The latter one is classified as other expenses (OTH). <?page no="290"?> Berkau: Financial Statements 9e 9-290 @ 31.12.20X8 Cash Bank C/ B 42,000 Dividend Income-20X8 OCI 42,000 (recognition of dividend income in reporting currency as gain) Loss in Valuation-20X8 OTH 90,000 Securities SEC 90,000 (value adjustment of shares in reporting currency) We continue the case study NOKOX (Pty) Ltd. further below and then cover Hedging, too. Hedging is here to compensate a loss from currency exchange rates by investing in “opposite” financial instruments. Before we continue the case NOKOX (Pty) Ltd. at the *, we cover bonds and options. Then, we demonstrate the hedging of its shares by a call option. Next, we continue with bonds. In the case study TRAGER GmbH, the company buys bonds and holds them under securities in the current asset section: The case study TRAGER GmbH can be accessed via the Link 9.C. Link 9.C: TRAGER GmbH Future contracts are recorded under securities, too. Study the case of GRENVILLE AG: On 2.01.20X5, GRENVILLE AG that trades goods with an US based customer enters in a contract (forward exchange contract) with Deutsche Bank to exchange 10,000 USD to 9,000 EUR on 31.12.20X5. The case study can be downloaded through Link 9.D. Link 9.D: GRENVILLE AG As the case study GRENVILLE AG shows, short-term financial assets can secure a currency exchange risk. This falls under hedging. Hedging allows based on IFRS 9.5.7.1 (a) the disclosure under special rules to simplify Accounting. We call the currency future in the prior case study a hedging instrument and the receivables expected from the overseas customer the hedged item. IFRS 9.6 allows to recognise losses and gains of both items together, which is referred to as matching concept. Instead of recording both items (hedged item and hedging instrument) separately, IFRS 9.6 requires a combined presentation. Technically this would fall under offsetting which is why an extra standard is necessary to legalise this procedure. <?page no="291"?> Berkau: Financial Statements 9e 9-291 * 9.25 C/ S NOKOX (Pty) Ltd. continued After the introduction to hedging, we continue the case study NOKOX (Pty) Ltd. which is the Australian investor who bought 30,000 MCD shares in 20X8. The situation is now altered as we consider that NOKOX (Pty) Ltd. secures its profit in USD by the purchase of a call option for USD. The profit in USD comprises of the capital appreciation from the share price increase from 100 USD/ s to 105 USD/ s plus the dividend income. Hence, NOKOX (Pty) Ltd. earns: 30,000 × (105 - 100) + 30,000 × 1 = 1 180,000 USD. Without currency exchange loss, the capital appreciation and the dividend gain in AUD would have been: 180,000 × 1.50 = 270,000 AUD. Due to the depreciation of the AUD against the USD, NOKOX (Pty) Ltd. loses: (3,000,000 + 180,000) × (1.50 - 1.40) = 3318,000 AUD. The difference results in a loss of: 270,000 - 318,000 = -48,000 AUD, once it is disclosed in the reporting currency AUD. To hedge the currency risk, NOKOX (Pty) Ltd. buys on 4.04.20X8 at costs of 25,000 AUD an option to exchange 2,700,000 USD on 31.12.20X8 to 4,000,000 AUD. The exchange rate on 4.04.20X8 is: 1 USD : 1.48 AUD. At first, we record the call option separately from the McD shares. We refer to this recognition as case (i). Later, we discuss a combined presentation under case (ii). The latter one is in line with IFRS 9.6. Case (i): Separate Positions The option is bought at 25,000 AUD and is recorded at cost. At the time of purchase, the call option is not helping as the exchange rate is: 1 AUD : 1.50 USD. Using the option would result in a loss of: 2,700,000 × 1.50 - 4,000,000 = 5 50,000 AUD - even without the consideration of the fee. On the 31.12.20X8, the option’s value is higher. Based on the currency exchange rate, 2,700,000 USD are worth: 2,700,000 × 1.40 = 33,780,000 AUD. The value of the option is: 4,000,000 - 3,780,000 = 2 220,000 AUD. We still must deduct the fees. This gives the measurement for the call option of: 220,000 - 25,000 = 1 195,000 AUD. We deduct NOKOX (Pty) Ltd.’s currency loss from the realised gain of the call option, which leaves a profit of: 195,000 - 48,000 = 1 147,000 AUD. Observe the Bookkeeping entries below for the initial and subsequent valuation of the call option. @ 4.04.20X8 Securities (Call Option) SEC 25,000 Cash/ Bank C/ B 25,000 (recognition of the call option at cost) @ 31.12.20X8 Securities (Call Option) SEC 195,000 Gain on Valuation-20X8 OCI 195,000 (recognition of gain from call option with fees deducted) <?page no="292"?> Berkau: Financial Statements 9e 9-292 NOKOX (Pty) Ltd. records the gain from the call option and the loss from the shares as other comprehensive income. On 31.12.20X8, NOKOX (Pty) Ltd. exercises the option and exchanges 2,700,000 USD worth: 2,700,000 × 1.40 = 3 3,780,000 AUD into 4,000,000 AUD. The latter transaction is shown as Bookkeeping entry (i3). See the accounts in Figure 9.9. @ 31.12.20X8 Cash Bank (in AUD) C/ B 4,000,000 Cash/ Bank (in USD) C/ B 3,780,000 Securities SEC 220,000 (option exercise) D C D C (3) 90,000 (2) 42,000 (1) 4,500,000 (3) 90,000 c/ d 147,000 (i2) 195,000 c/ d 4,410,000 237,000 237,000 4,500,000 4,500,000 b/ d 147,000 b/ d 4,410,000 Other comprehensive income-20X8 OCI Securities SEC D C D C (i1) 25,000 (i3) 220,000 (2) 42,000 (1) 4,500,000 (i2) 195,000 (i3) 4,000,000 (i1) 25,000 220,000 220,000 c/ d 4,263,000 (i3) 3,780,000 8,305,000 8,305,000 b/ d 4,263,000 Option FA Cash/ Bank C/ B Figure 9.9: NOKOX (Pty) Ltd.’s accounts (ii): Hedging In compliance with IFRS 9.6.1.2, NOKOX (Pty) Ltd. combines the hedged item (shares) with the hedge instrument (call option). On its balance sheet, NOKOX (Pty) Ltd. discloses one item of current assets for both. Its initial valuation is based on the MCD shares and the call option, valued at cost of: 30,000 × 100 × 1.50 + 25,000 = 44,525,000 AUD. On 31.12.20X8, the shares’ value decreases to: 30,000 × 105 × 1.40 = 44,410,000 AUD. The valuation of the call option is derived from the cost of acquisition and the gain of 195,000 AUD and gives: 25,000 + 195,000 = 220,000 AUD, see above. The total of the hedging item’s value is: 4,410,000 + 220,000 = 4 4,630,000 AUD. The residual gain on valuation gives: 4,630,000 - 4,525,000 = 1 105,000 AUD. We add this amount to the dividend income of: 30,000 × 1 × 1.40 = 4 42,000 AUD, which is a gain outside of the combined item. The total gain is: 105,000 + 42,000 = 1 147,000 AUD. In contrast to case (i) we disclose a gain from the combined hedging item of 105,000 AUD and a dividend income to the extent of 42,000 AUD. <?page no="293"?> Berkau: Financial Statements 9e 9-293 How it is Done (Accounting for Securities): (1) Check the business model and the intention of holding securities. If they fall under current assets continue below with step (2), otherwise consider financial assets as in chapter (7). (2) Record the securities at cost of acquisition. (3) Monitor the securities’ fair value; this is usually the fair market price on the bond market. In case the value of securities changes, record changes either through profit or loss or through other comprehensive income. Make the contra entry in the Securities account. (4) For selling securities apply a Realisation account. In case a security is validated for executing a call option, record an expense to the extent of the security value and make the contra entry in the Securities account for the validation of the security. 9.26 Prepaid Expenses Prepaid expenses are payments, e.g., for labour, rent, insurance etc., allocated to certain future periods that have been paid for already. The characteristics of prepaid expenses resemble those of receivables. The difference is that prepaid expenses are settled by services and receivables on cash. In contrast to German HGB, the IASB regards prepaid expenses as current assets. They fulfil the criteria for asset recognition. In contrast, German HGB shows an extra item outside of the current asset section, referred to as Rechnungsabgrenzungsposten (accrual as separate item). 9.27 Cash and its Equivalents We disclose cash and its equivalents in the Cash/ Bank account. It is cash, like 88 Study our textbook Basics of Accounting, chapter (37). coins and bills on hand, and money in the bank. Investments that are as liquid as cash and convertible to known amounts of cash fall under cash equivalents (IAS 7.6) and we record them in the bank account, too In general, companies keep separate records for each bank account for bank reconciliation purposes. 88 The measurement of cash/ bank does not change except of when cash is held in a foreign currency. In those cases, the valuation is based on the currency exchange rate that applies on the transaction date for initial valuation and on the currency exchange rate on the balance sheet date for revaluations. Differences are recorded through profit or loss or other comprehensive income. See the case study BAKENSKOP PLC accessible through Linke 9E below. <?page no="294"?> Berkau: Financial Statements 9e 9-294 Link 9.E: BAKENSKOP PLC 9.28 Summary On the current asset section, we disclose inventories, receivables, securities, prepaid expenses, and cash/ bank. The valuation of inventories is at the lower of cost and net realisable values. For the valuation of finished goods in production firms, Manufacturing Accounting applies. Receivables are measured at settlement values but an adjustment for potential credit risks applies. Those adjustments as well as a complete payment failure of the debtor is recorded under bad debts. Securities are short-term financial instruments held at fair values through profit and loss or through other comprehensive income as by default. IFRS 9 applies for their valuation. In contrast to the German Handelsgesetzbuch, prepaid expenses are considered as current assets. 9.29 Working Definitions Bad Debts: Expense account for writing off irrecoverable receivables. Hedging: Carrying two financial instruments with opposite risks, such as a receivable in USD and a call option in USD on EUR. Idle Costs: Expenses for unused production facilities. Work-in-Process Account: Account in Manufacturing Accounting that represents a job order. The Work-in-Process account is the reconciliation account for Job Order accounts. See also the conventions in chapter (1). Manufacturing Accounting: Accounting for finished goods in production firms. Manufacturing Accounting is based on Work-in-Process accounts and Manufacturing Overheads accounts. Manufacturing Overheads Account: An account to gather overheads linked to production. Net Realisable Value: Measurement at fair value at which an asset can be sold among knowledgeable, willing, and independent parties by an orderly transaction). Overhead Allocation Rate: A predetermined overhead allocation rate is planned overheads divided by planned volume. The POR is used to support overhead applications. Overhead Application: Allocation of manufacturing overheads to job orders. Recoverable Amount: Measurement at the lower of cost to sell an asset and its value in use. Securities: Short-term financial instruments. Value in Use: Measurement of an asset based on discounted economic benefits obtained, like rental income from property. 9.30 Question Bank (1) A company records as manufacturing overheads: 30,000 EUR depreciation, 55,000 EUR indirect labour and 6,000 EUR factory insurance expenses. The planned output <?page no="295"?> Berkau: Financial Statements 9e 9-295 is 100,000 kg. The predetermined overhead allocation rate is 0.86 EUR/ kg. The actual performance is only 60,000 kg. How much are the applied overheads following IAS 2.13, if normal capacity applies and idle costs are recorded? 1. 51,600 EUR . 2. 54,600 EUR . 3. 86,000 EUR . 4. 91,000 EUR . (2) A company records the following stock additions. 100 at 34 EUR, 200 at 33 EUR, 150 at 35 EUR. Based on a weighted average cost formula, how much is a stock release of 25 units? 1. 842 EUR . 2. 850 EUR . 3. 847 EUR . 4. 875 EUR . (3) A production firm calculates the predetermined overhead allocation rate based on its manufacturing overheads budget 60,000 EUR and a planned performance of 400 machine hours. During the actual period, there are actual costs of 61,000 EUR and the recorded machine hours are 390 hours in the manufacturing department. (MOH- Account). How much are underapplied manufacturing overheads? 1. (1,500 EUR) . 2. 2,500 EUR . 3. 1,538 EUR. 4. Nil . (4) A company carries a note receivable from selling goods to the extent of 1,500 EUR. The customer is most probably (80 % probability) insolvent. How much are bad debts? 1. 0 EUR . 2. 1,000 EUR . 3. 1,250 EUR . 4. 1,500 EUR . (5) On 4.05.20X5, a company buys 50 bonds that mature in the next Accounting period (30.06.20X6). The purchase price is 246 EUR/ b, and the principal of the bond is 250 EUR/ b. On 31.12.20X5, the coupon at 5.4 %/ a is paid. At which value are the bonds disclosed on the balance sheet as per 31.12.20X5? 1. 12,964 EUR . 2. 12,171 EUR . 3. 12,500 EUR . 4. 12,300 EUR . 9.31 Solutions 1-1, 2-3, 3-2, 4-2, 5-4. <?page no="296"?> Berkau: Financial Statements 9e 10-296 10 Statement of Cash Flows 10.1 What is in the Chapter? This chapter covers how to prepare cash flow statements in compliance with IFRSs. The cash flow is the difference of the item cash/ bank disclosed on two following balance sheet dates. It shows whether cash/ bank increases or decreases during one Accounting period. There are three methods for cash flow calculation: the direct method, as applied for KENILWORTH METERED TAXI Ltd. in chapter (3), the reconciliation of profits with the operating cash flows, and the derivative method 89 , for which cash flows are derived from delta balance sheets. Usually, the reconciliation method applies. We start this chapter with the profit calculation, preparation of the Cash/ Bank account and the direct method for a cash flow statement. Thereafter we prepare a cash flow statement for the same case but based on the reconciliation method for calculating operating cash flows in detail. This chapter’s structure is based on the How-it-is-Done paragraph about the reconciliation of profits with operating cash flows. At first, we explain all steps in detail and thereafter apply them to the case study EIMKE Ltd. 10.2 Learning Objectives After studying cash flows in this chapter, you understand the need of reporting cash flows classified into categories 89 Find the derivative method in the study material bank. of cash flows from operations, investments, and finance. You can apply the direct method to a full statement of cash flows and the reconciliation method to cash flows from operations. You understand the steps of reconciliation of profits with cash flows from operations. 10.3 Cash Flow Statement Obligation Cash flows change the cash/ bank balance during an Accounting period. In IAS 1.10, a statement of cash flows is required as part of a full set of financial statements. Users of financial statements can assess a company’s liquidity situation by analysing the cash/ bank item on the balance sheet in combination with the statement of cash flows. They strive for anticipation of future liquidity and cash flow development to support their economic decisions about the reporting company. In terms of Mathematics, a statement of cash flows resembles a liquidity plan (cash budget) 90 . A liquidity plan calculates available funds by adding cash receipts to the opening balance of cash/ bank and deducts all payments. If banks allow further loans or bank overdrafts, these must be added to the closing balance of cash/ bank to determine a company’s liquidity. In comparison to a cash flow statement, there are four major formal differences: (1) A liquidity plan starts-off from the 90 Study our textbook Management Accounting, chapter (6). <?page no="297"?> Berkau: Financial Statements 9e 10-297 opening value of cash/ bank and ends with its closing balance (liquidity) whereas the statement of cash flows discloses changes in cash/ bank. (2) On a cash flow statement cash flows are classified into categories to support estimates of future receipts/ payments. Cash flows resulting from operating activities are usually repetitive whereas cash flows from financing or investing activities are once-off payments/ receipts. (3) A cash flow statement refers to the past and the liquidity plan is for budgeting purposes. (4) In contrast to a cash flow statement, the calculated liquidity is adjusted for bank loans and overdraft options. All reporting companies that apply IFRSs prepare and disclose a statement of cash flows. The total cash flow can already be read from the difference of the cash/ bank item on balance sheets for two following Accounting periods. On a statement of cash flows, the cash flow is disclosed following the below shown classification into: - Cash flows from operations. - Cash flows from investing activities. - Cash flows from financing activities. The major challenge of a cash flow statement preparation is the cash flow separation and the allocation of cash flows towards the above mentioned categories. 10.4 C/ S EIMKE Ltd. We discuss the case study EIMKE Ltd. in Melbourne. At first, we prepare its income statement and a Cash/ Bank account. Data Sheet for EIMKE Ltd. Domicile: Australia (Melbourne). Reporting currency: AUD. Classification: production firm. Period: 20X8. Opening values: see balance sheet as per 31.12.20X7. Activities in 20X8: paying income tax 30,000 AUD, buying goods 60,000 AUD (gross amount), depreciation 20,000 AUD, collecting receivables 2,500 AUD, bank loan payment 3,000 AUD, revenue 120,000 AUD, materials 60,000 AUD. VAT rate: 20 %. EIMKE Ltd. is a production firm in Australia. Its statement of financial position as per 31.12.20X7 is shown in Figure 10.1. <?page no="298"?> Berkau: Financial Statements 9e 10-298 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 75,000 Share capital 30,000 Intangibles Reserves Financial assets Retained earnings 70,000 Current assets Liabilities (liab.) Inventory 20,000 Long-term liab. 18,000 Accounts receivables 5,000 Short-term liab. A/ P 2,000 Prepaid expenses Provisions Cash/ Bank 50,000 Income tax liab. 30,000 Total assets 150,000 Total equity and liab. 150,000 Eimke Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 10.1: EIMKE Ltd.’s balance sheet (20X7) Some balance sheet items are explained below: EIMKE Ltd. discloses a bank loan at a total value of 20,000 AUD. Following IAS 1.60, the pay-off portion of 2,000 AUD which is included in the loan’s value is classified into and disclosed as shortterm liability. The pay-off amount of EIMKE Ltd.’s bank loan is constant and is given for this case study. Retained earnings of 70,000 AUD result from last year’s profit and do not contain profits/ losses carried forward. The income tax liabilities are based on the profit earned during 20X7 and are due in 20X8. The receivables reflect future receipts from customers for goods sold in the past. EIMKE Ltd. records the below business activities in 20X8: (1) Payment of income tax liabilities to an extent of 30,000 AUD. (2) Purchase and payment of materials at cost of purchase of 50,000 AUD (gross amount: 60,000 AUD). (3) Depreciation to the extent of 20,000 AUD. (4) Collection of half of the receivables disclosed on the balance sheet in Figure 10.1. (5) Payment of interest of 1,000 AUD and pay-off of 2,000 AUD for its bank loan; the latter one is deducted from its Short-term Liabilities account (IAS 1.60 applies). Payoff due in 20X9 must be allocated to short-term liabilities. (6) Earning a revenue of 120,000 AUD from goods sold. From the proceeds (gross value) 90 % are paid by the customers, the remainder proceeds will be collected in the next Accounting periods. (7) Material consumption of 60,000 AUD in production. We show the Bookkeeping entries (1) - (7). For the sake of simplification, revenues and stock releases are recorded on 1.07.20X8 and debt collection and materials on 30.06.20X8. Recordings for the bank loan are split into three separate Bookkeeping entries (5a) - (5c) made at the yearend. <?page no="299"?> Berkau: Financial Statements 9e 10-299 @ 1.01.20X8 (1) Income Tax Liabilities ITL 30,000 Cash/ Bank C/ B 30,000 (paying income tax liabilities resulting from 20X7) @ 30.06.20X8 (2) Inventories INV 50,000 Value Added Tax VAT 10,000 Cash/ Bank C/ B 60,000 (purchase of materials) @ 31.12.20X8 (3) Depreciation-20X8 DPR 20,000 Accumulated Depreciation ACC 20,000 (depreciation recognition) @ 30.06.20X8 (4) Cash Bank C/ B 2,500 Accounts Receivables A/ R 2,500 (debts collection) @ 31.12.20X8 (5) Interest-20X8 INT 1,000 Cash/ Bank C/ B 1,000 (interest recognition) Accounts Payables A/ P 2,000 Cash/ Bank C/ B 2,000 (pay-off of the bank loan from short-term liabilities) Interest Bearing Liab. IBL 2,000 Accounts Payables A/ P 2,000 (reclassification of next year's pay-off of the bank loan) @ 1.07.20X8 (6) Cash Bank C/ B 129,600 Accounts Receivables A/ R 14,400 Value Added Tax VAT 24,000 Revenue-20X8 REV 120,000 (revenue recognition) @ 30.06.20X8 (7) Material Expenses-20X8 MAT 60,000 Inventories INV 60,000 (material expenses recognition) From the above business activities, only (1), (2), (4), (5a), (5b) and (6) are relevant for cash flows. The Profit and Loss account is shown in Figure 10.2. The balance sheet as per 31.12.20X8 can be found further down in Figure 10.5. <?page no="300"?> Berkau: Financial Statements 9e 10-300 D C DPR 20,000 REV 120,000 INT 1,000 MAT 60,000 EBT 39,000 120,000 120,000 ITL 11,700 b/ d 39,000 R/ E 27,300 Profit and Loss-20X8 P8L Figure 10.2: EIMKE Ltd.’s Profit and Loss-20X8 account The comparison of cash/ bank balances indicates that EIMKE Ltd.'s liquidity increased. Cash/ bank on the balance sheet as per 31.12.20X7 was 50,000 AUD (Figure 10.1) and one year later it is 89,100 AUD. Check Figure 10.5. Therefore, EIMKE Ltd.’s total cash flow is: 89,100 - 50,000 = 3 39,100 AUD. In preparation of the statement of cash flows along the direct method, we classify cash flows recorded in the Cash/ Bank account into categories. Operating activities at EIMKE Ltd. are the income tax payment (1), the material purchases (2), the collection of receivables (4) and the proceeds from the sale of goods (6). Cash flows from financing activities include the pay-off payment of the bank loan (5b) and the payment of interest (5a). No investments took place at EIMKE Ltd. in 20X8. Check the indicators (o/ i/ f) on the Cash/ Bank account in Figure 10.4. Note, In line with IAS 7.33, interest can be classified as operating or financial cash flow. We follow our conventions and consider interest as financing activities by default. Observe below the statement of cash flows in Figure 10.3. <?page no="301"?> Berkau: Financial Statements 9e 10-301 Cash flow from operating acitivities [AUD] [AUD] Proceeds 129,600 Purchase payment (60,000) Collection of receivables 2,500 Tax payment (30,000) 42,100 Cash flow from investing activities Investments 0 0 Cash flow from financing activities Interest payment (1,000) Pay-off payment (2,000) (3,000) Total cash flow 39,100 Eimke Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X8 Figure 10.3: EIMKE Ltd.’s statement of cash flows (20X8) How it is Done (Cash Flow Statement - Direct Method): (1) Determine all receipts and payments relevant for the Accounting period from the Cash/ Bank account. (2) Classify cash flows into categories: operating, investing, and financing cash flows. (3) Operating cash flows result from the normal operations of the business, e.g., payments for purchases, labour payments, rent payments, income tax payments, receipts for sales etc. (4) Investing cash flows are caused by acquisitions and sales of non-current assets like buying machines or their disposal. (5) Financing cash flows are linked to the financing of the business and usually change debt or equity items on the balance sheet or are interest expenses respectively income. Examples are bank loans taken out, share and bond issues as well as paying/ receiving dividends, interest payments or receipts, coupons paid and payments to retire debts. Our conventions in chapter (1) apply. (6) Calculate operating, investing, and financing cash flows by adding receipts and deducting payments. (7) Add all cash flow categories for total cash flow calculation. <?page no="302"?> Berkau: Financial Statements 9e 10-302 A cash flow statement can be prepared by three methods. - Direct method. - Indirect method (reconciliation of profits with operating cash flows and calculating investing and financing cash flows directly). - Derivative method. (This method derives cash flows from two balance sheets, the income statement, the register of non-current assets and the profit appropriation. It allows a cash flow statement preparation from “outside”). For EIMKE Ltd., we applied the direct method above. For the understanding of technical terms consider: IAS 7.18 focusses on the operating cash flow only and refers to the direct method to be based on cash receipts and payments. In contrast, the indirect method (for the calculation of operating cash flows) reconciles profits with operating cash flows. The investing and financing cash flows must be determined directly and are not subjected to IAS 7.18. IAS 7 does not mention the derivative method for the cash flow calculation. 10.5 Direct Method The direct method follows the Cash/ Bank account and classifies all entries therein into operating, investing, and financing payments/ receipts. The cash flow categories are defined in IAS 7.6. Operating activities of a company aim to earn revenues and are not linked to investing nor financing of the business. Examples for operating cash flows can be found in IAS 7.14. Investing activities are the acquisition and disposal of non-current assets. Examples are mentioned in IAS 7.16. Financing activities change equity and/ or long-term liabilities. Find examples in IAS 7.17. We also consider all payments linked to the latter ones, e.g., interest payments and retirements of liabilities, to be financing activities. IAS 7.33 which is about the disclosure of interest payments and receipts and dividend income applies based on the conventions laid out in chapter (1). The application of the direct method is simple. With a high volume of entries in the Cash/ Bank account, the cash flow statement preparation gets extensive. 10.6 C/ S EIMKE Ltd. - Direct Method EIMKE Ltd.’s Cash/ Bank and Accounts Receivables account for 20X8 are displayed in Figure 10.4. The Cash/ Bank account also shows indices about the classification of receipts and payments. D C D C OV 50,000.00 (1) 30,000.00 o OV 5,000.00 (4) 2,500.00 o (4) 2,500.00 (2) 60,000.00 o (6) 14,400.00 c/ d 16,900.00 o (6) 129,600.00 (5) 3,000.00 f 19,400.00 19,400.00 c/ d 89,100.00 16,900.00 182,100.00 182,100.00 b/ d 89,100.00 Cash/ Bank C/ B Accounts receivables A/ R Figure 10.4: EIMKE Ltd.’s accounts (20X8) <?page no="303"?> Berkau: Financial Statements 9e 10-303 Cash/ Bank entries (1), (2), (4) and (6) are operative cash flows, (5a) and (5b) are financing cash flows. 10.7 Reconciliation of Profits with Operating Cash Flows With the indirect method, profits are reconciled with operating cash flows. For profit and loss calculations, we record business activities solely on a revenue and expense base. A statement of (operating) cash flows would require the recording of the same activities again but now based on payments and receipts. To reduce extra Accounting work, we refrain from double recording but adjust profits for activities that (1) are relevant for profitability but do not affect payments and receipts and (2) vice versa. Business activities that fall under (1) are e.g., depreciation, additions to provisions etc. Business activities that fall under (2) are e.g., purchases and payments for materials which are not consumed and therefore lead to increases of stock, payments in connection to receivables/ payables, prepaid expenses, VAT receivables/ payables etc. By the adjustments for (1) and (2), profit gets reconciled with operating cash flows. The advantage of the reconciliation method is that calculations are not based on business activities recorded by single Bookkeeping entries but on profit adjustments under consideration of balance sheet items. It cuts short the workload for the cash flow statement preparation significantly. The following How-it-is-Done paragraph shows the steps for the reconciliation procedure. The procedure is based on information derived from the profit and loss calculation and the timely differences between balance sheet items - not a record of business activities! The paragraph serves as structure for the upcoming description of the method for the reconciliation statement. How it is Done (Reconciliation of Profits with Operating Cash Flows): (1) Calculate profit for the period as earnings after taxes. (2) Add expenses for operations with no payments, e.g., depreciations, expenses for additions to provisions, interest payments etc. to the profit. Interest payments must be added as interest counts as financial cash flow. (3) Deduct interest income as it is a financing cash flow. (4) Add debt collections, deduct increases of receivables. (5) Add decreases of prepaid expenses, deduct increases thereof. (6) Add decreases of inventory, deduct increases thereof. <?page no="304"?> Berkau: Financial Statements 9e 10-304 (7) Add increases of short-term liabilities, deduct decreases thereof. Dissolving provisions results in a negative cash flow from operations. (8) Add increases of income tax liabilities, deduct decreases thereof. (9) Add decreases of VAT receivables (input-VAT refund receipt), deduct increases thereof (input-VAT paid to suppliers). (10)Add increases of VAT payables (output-VAT collected from customers), deduct decreases thereof (output- VAT paid to revenue service). (11)Add earnings after taxes and adjustments thereto from steps (2) to (10). The total is the operating cash flow. (12)Calculate investing and financing cash flow based on singular receipts and payments. (13)Add all cash flow categories for the total cash flow calculation. Next follows an explanation of the above listed steps in detail. The objective is to determine cash flows based on profit or loss adjustments and timely differences of balance sheet items. Therefore, the above How-it-is- Done paragraph use the wording increases and decreases. For the reconciliation of profits with the operating cash flows we either adjust the profit on the cash flow statement or disclose the adjustment on a separate reconciliation statement. 10.8 Step (1) The annual profit results from items on the income statement, meaning it is based on profitability calculations regardless of payments/ receipts. The profit after taxation is the starting point for the cash flow reconciliation method. 91 From the point of students, it is not recommended to start-off from the pretax profit as changes in income tax liabilities can be caused also by pre- As an alternative, the starting point for the reconciliation procedure can be the pretax profit. Then, increased income tax liabilities caused by income tax for the actual period must be ignored in step (8). 91 10.9 Step (2) Expenses without payments in the same Accounting period do not affect the cash/ bank balance. For the cash flow statement preparation, these expenses are irrelevant but are considered for the profit or loss calculation. As the Reconciliation method is based on the profit, we must cancel out expenses without payments. As expenses are deducted from revenues, cancelling them out requires adding them to profit. E.g., depreciation is not cash relevant as its Bookkeeping entry is a debit entry for depreciation and a paid taxes or payments made for prior Accounting periods. Therefore, calculations based on the pretax profit are prone to miscalculations. <?page no="305"?> Berkau: Financial Statements 9e 10-305 credit entry in the Accumulated Depreciation account. To eliminate depreciation, the expenses must be added to profits. Another example is an expense recorded together with additions to provisions. Those expenses are relevant for the profit in the actual Accounting period, but payments are made in the future. Therefore, we eliminate those expenses by adding their amount to profit. 92 Interest results in payments but they are classified as financing cash flows. Interest payments must be added to the profit and avoid a double consideration for the cash flow statement as they are disclosed as financial cash flow already on the cash flow statement. 10.10 Step (3) An interest income or income from dividends is classified as financing cash flow. The receipt is deleted for operating cash flow calculations and added to financing cash flows by step (12). Step (3) reallocates interest income from operating cash flows towards financing cash flows. 10.11 Step (4) We analyse step (4) regardless of individual Bookkeeping entries. Any decrease of receivables is considered a receipt for debt collection. In the opposite case, if receivables increase, we consider a payment made to the debtor, which she/ he is obliged to repay in the future. 92 Check step (7), too. 10.12 Step (5) For cash flow calculations, we do not distinguish between receivables and prepaid expenses. A note receivable is a (paid) claim which are repaid in the future and prepaid expenses is a (paid) claim for a receipt of service, e.g., for rent, insurance, work etc. We focus on the initial payment: Increases of prepaid expenses and receivables are payments and decreases are receipts. If prepaid expenses are not changed, no adjustment of profits is made for the reconciliation statement. 10.13 Step (6) Inventories represent current assets for which payments have been made. It does not matter whether inventories are raw materials, supplies or finished goods. Increases of inventories count as negative cash flows. An inventory decrease is a cash receipt in exchange for goods delivered. All changes in inventories are valued based on cost of acquisition or cost of manufacturing, because we consider VAT in an extra step. 10.14 Step (7) Changes in short-term payables and provisions are not linked to financial cash flows. They do not fall under financing. If payables to suppliers are recorded, the expense has been considered either in the income statement or by other cash flows already. E.g., when materials are purchased the increase of inventory is recorded as a negative cash flow in step (6). If the buyer does not pay, the cash outflow <?page no="306"?> Berkau: Financial Statements 9e 10-306 for the inventory increase based on step (6) is compensated by adding a cash inflow for the increase of shortterm liabilities (step (7)) to consider the granted supplier loan. No payment is made. Therefore, a purchase-oncredit-transaction is divided into a paid purchase and a granted cash-loan by the supplier. A company retiring short-term debts, does not disclose this on the income statement because repayments do not affect profitability. On the reconciliation statement, a cash outflow is disclosed for the reduction of short-term liabilities. In contrast, changes of longterm liabilities are financing cash flows. IAS 1.60 requires recording an increase of short-term liabilities and a decrease of interest bearing (= longterm) liabilities. If a company pays for the annuity, its interest portion is disclosed on the income statement. Following IAS 1.60, the pay-off portion of the loan is disclosed one year before its settlement under short-term liabilities and is paid-off at the next following yearend. The pay-off of a short-term liability becomes a cash flow from financing activities. In contrast, the previous increase of the short-term liabilities is no cash flow but a liability swop without relevance for the cash flow statement. Therefore, the preparation of a cash flow statement via reconciliation statement requires a thorough analysis of short-term liabilities. Dissolving provisions for expenses results in a compensation of expenses which were recognised at the time of rising the provision on the income statement. When a provision for expenses is dissolved, a debit entry in the provisions account and a credit entry in the expense account are made. Therefore, dissolving a provision does not result in a recognition of expenses on the income statement. However, when a provision is dissolved, payments are made and must be considered for the cash flow statement when the payment is made. As an example, we observe a company that dissolves a provision for rework: When the provision was recorded in 20X1, the expenses for rework are recognised on the income statement. We make Bookkeeping entry (1) as below. Consider that as pulling forward an expense without paying. @ 31.12.20X1 Rework-20X1 REW Provisions PRO (recognition of a provision for rework in 20X1) In the period of dissolving the provision (20X2), we record a cash relevant Bookkeeping (A) for the rework carried out. However, that Bookkeeping entry does not change the provision yet. As the expenses have been considered in the previous Accounting period on the income statement, dissolving the provision cancels out the actual <?page no="307"?> Berkau: Financial Statements 9e 10-307 expenses (20X2). 93 It is recorded as Bookkeeping entry (B). @ 30.06.20X2 (A) Rework-20X2 REW Cash/ Bank C/ B (recognition of rework carried out in 20X2) @ 30.06.20X2 (B) Provision PRO Rework-20X2 REW (provision for rework dissolved) Dissolving a provision is not disclosed as an expense through profit or loss as Bookkeeping entry (A) and (B) cancel out the expense, but its payment falls into the period when the provision is dissolved. Hence, the dissolving of the provision for rework becomes relevant for the statement of cash flows. For the reconciliation of profits with operating cash flows, rising a provision is covered by step (1) and (2) and its dissolving by step (7). The reason for this inequality in procedure is that the consideration depends on what becomes visible on financial statements: Recording a provision is shown as an expense on the income statement. In contrast, dissolving a provision is derived from the balance sheet, where it shows. Dissolving provisions usually gives a negative cash flow. 10.15 Step (8) Increases in income taxes are shortterm liabilities due in the next following Accounting period. Therefore, they are recorded as positive cash 93 Chapter (14) demonstrates a case for which the expenses differ from the provision’s value, check chapter (14). flows. If a company makes prepayments or pays income taxes from prior Accounting periods, the item income tax liabilities can decrease on the balance sheet which is due to a payment to the revenue service which exceeds the income tax expenses of the actual period. 10.16 Step (9) The step can be combined with step (4) as VAT receivables fall under receivables. A company usually records VAT receivables for purchases and acquisitions in one account which can make it difficult to segregate input-VAT payments for investments later. Input- VAT for investments should be considered as cash flow from investing activities. As an expedient, we can assume that companies only run one VAT account and do not distinguish what input-VAT is paid for. Therefore, investments are disclosed net of VAT on the cash flow statement. <?page no="308"?> Berkau: Financial Statements 9e 10-308 If we record investing cash flows based on gross amounts, we must ignore their input-VAT entry on the VAT account for step (9). In contrast, we consider all VAT refunds as operating cash flows, no matter whether the refund is linked to an investment or to operations. 10.17 Step (10) Output-VAT is collected from customers and buyers on behalf of the revenue service and results in cash receipts. Therefore, output-VAT gives a positive cash flow at the time of collection and a negative cash flow when paid to the revenue service. We consider for the cash flow statement preparation the difference between output- VAT payment and receipts. When non-current assets are disposed of, the output-VAT received from the buyer is a positive cash flow. If the reporting company runs one VAT account only, the VAT receipt from the disposal is operating cash flow. Hence the sales proceeds are disclosed free of VAT on the statement of cash flows. If a company runs separate VAT accounts, the receipt of output VAT on sale is an investing cash flow, hence the disposal of non-current assets is disclosed by gross amounts on the statement of cash flows. Note, following the conventions in chapter (1), disposals of assets are disclosed by gross values and the credit entry in the VAT account is ignored for the cash flows from operations. 10.18 Step (11) Based on the reconciliation procedure the profit is increased by positive cash flows and gets reduced by negative ones. This gives the cash flow from operations. 10.19 Step (12) Calculation of investing and financing cash flows following the direct method. Note, that investing cash flows are recorded based on gross amounts by default. The VAT implication of acquisitions and disposals of non-current assets must be ignored for the calculation of operating VAT-cash flows in step (9) and (10). 10.20 Step (13) The total cash flow is the sum of cash flows from operations, from investing and from financing activities. 10.21 C/ S EIMKE Ltd. - Reconciliation Method Below, the reconciliation method is applied to EIMKE Ltd. The reconciliation is calculated on the statement of cash flows as shown in Figure 10.7. The calculations refer to the figures disclosed on its balance sheet and the income statement as they can be derived from Figure 10.5 and Figure 10.6, respectively. <?page no="309"?> Berkau: Financial Statements 9e 10-309 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 55,000 Share capital 30,000 Intangibles Reserves Financial assets Retained earnings 97,300 Current assets Liabilities (liab.) Inventory 10,000 Long-term liab. 16,000 Accounts receivables 16,900 Short-term liab. A/ P 16,000 Prepaid expenses Provisions Cash/ Bank 89,100 Income tax liab. 11,700 Total assets 171,000 Total equity and liab. 171,000 Eimke Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 10.5: EIMKE Ltd.’s balance sheet (20X8) [AUD] Revenue 120,000 Other income 0 120,000 Materials (60,000) Labour 0 Depreciation (20,000) Other expenses 0 Earnings before int. & taxes (EBIT) 40,000 Interest (1,000) Earnings before taxes (EBT) 39,000 Income tax expenses (11,700) Deferred taxes 0 Earnings after taxes (EAT) 27,300 Eimke Ltd. STATEMENT of PROFIT & LOSS and other COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 10.6: EIMKE Ltd.’s income statement (20X8) The cash flow reconciliation starts from the earnings after taxes which are 27,300 AUD (1). At first (2), we add interest, as interest is a financing cash flow. The operating cash flow so far is: 27,300 + 1,000 = 28,300 AUD. The adjustments for activities that are expenses/ revenue but are irrelevant for cash apply for depreciation only. EIMKE Ltd. does not earn interest nor dividend income. As depreciation was deducted on the income statement, we add it on <?page no="310"?> Berkau: Financial Statements 9e 10-310 the reconciliation statement. The operating cash flow after adjustment for depreciation is: 28,300 + 20,000 = 4 48,300 AUD. This completes step (2) in the Howit-is-Done paragraph sequence. The next adjustments are made for activities that are cash/ bank-relevant but are not recorded on the income statement. The first item is the Accounts Receivables account. We read the changes in receivables from the comparison of the balance sheets. Receivables increase by: 16,900 - 5,000 = 111,900 AUD. An increase of receivables is seen as payment that results in a claim. Note, that the consideration of receivables is linked here to the old debts collection as well as to the proceeds to be received in the next year. The operating cash flow so far is: 48,300 - 11,900 = 3 36,400 AUD. Step (4) is completed. At EIMKE Ltd., inventories decrease by: 10,000 - 20,000 = -1 10,000 AUD. A decrease of inventories is considered for the cash flow reconciliation method as cash sale; hence, it is a positive cash flow of 10,000 AUD. The calculation of operating cash flows so far gives: 36,400 + 10,000 = 4 46,400 AUD. Step (6) is now completed. Next, we check changes in payables. There are only changes in income tax liabilities and VAT payables which are considered by step (8) and step (9). Income tax liabilities are disclosed as payables based on IFRSs. The changes in income tax liabilities are: 11,700 - 30,000 = - -18,300 AUD. As the payment for income taxes from the last period exceeds the actual income taxes expenses, the balance sheet item for income tax liability on the balance sheet decreases. A reduction of liabilities is considered as a payment for the cash flow calculation: 46,400 - 18,300 = 228,100 AUD. We completed step (8). Output-VAT liabilities increase by 24,000 - 10,000 = 114,000 AUD. The figure is the total of payables and receivables as disclosed on the balance sheet. However, we show extra items for VAT receivables and payables on the reconciliation statement. Any increase of payables is considered as a receipt. Decreases of VAT liabilities count as payments. We add the amount to our cash flow from operating activities: 28,100 + 14,000 = 4 42,100 AUD. This completes step (9) and (10). The financing cash flow can be derived from the changes in the Interest Bearing Liabilities account. The change of interest bearing liabilities is: 18,000 - 16,000 = 2 2,000 AUD. The reduction of liabilities indicates a payment and is a negative cash flow. Furthermore, we deduct paid interest. The total cash flow for EIMKE Ltd. is: 42,100 - 2,000 - 1,000 = 3 39,100 AUD. The step (12) is now completed. Observe the cash flow statement based on the indirect method (= reconciliation method for cash flows from operations) in Figure 10.7. <?page no="311"?> Berkau: Financial Statements 9e 10-311 [AUD] [AUD] Cash flow from operating acitivities Earnings after taxes EAT 27,300 add Interest 1,000 add Depreciation 20,000 48,300 changes in working capital changes in inventory 10,000 changes in A/ R (11,900) changes in prepaid expenses 0 changes in A/ P, not ITL 0 changes in income tax liabilities ITL (18,300) changes in VAT/ r only materials (10,000) changes in VAT/ p 24,000 42,100 Cash flow from investing activities Investments 0 0 Cash flow from financing activities Interest (1,000) Pay-off (2,000) (3,000) Total cash flow 39,100 Eimke Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X8 Figure 10.7: EIMKE Ltd.’s cash flow statement (20X8) To see the application of the indirect method for the RYNEVELD Ltd. case study as covered in chapter (4), follow Link 10.A below. Link 10.A: RYNEVELD Ltd. 94 Find the task in the study material portal. It is recommended studying the case KATERNBERG (Pty) Ltd. in task A10.23. 94 The task also contains a solution prepared following the derivative method which is referred to below. The derivative Method is less important nowadays because of the obligation to prepare and disclose a statement of cash flows following IAS 1.10. 10.22 Derivative Method A higher sophisticated method in cash flow calculation is the derivative method which can be applied even if <?page no="312"?> Berkau: Financial Statements 9e 10-312 no Bookkeeping records are available. Download the explanation and cash flow calculation based on the derivative method for the case EIMKE Ltd. below through Link 10.B: Link 10.B: EIMKE Ltd. 10.23 Summary Statements of cash flows belong to financial statements. A cash flow statement discloses changes in the cash/ bank item on the balance sheet and classifies the total cash flow into categories cash flow resulting from operations, from investing and from financing activities. For cash flow calculations, the direct method and indirect method apply. The latter one is recommended as it avoids the analysis of numerous single Bookkeeping entries but can be prepared based on figures taken from the income statement and two balance sheets. 10.24 Working Definitions Cash Equivalent: Short-term assets that are as liquid as cash and which are certain in terms of valuation. Cash Flow: Changes in the Cash/ Bank account. Reconciliation Method: Calculation of operating cash flows by adjusting the profit after taxes regarding revenue/ expenses without payments/ receipts and payments/ receipts irrelevant for profit or loss calculation. 10.25 Question Bank (1) A company invests in a machine bought at 102,000 EUR gross selling price. Later, in the same period, the seller offers and pays out (completely) a discount of 10 %. The payment of the machine is half in the actual accounting period and the other half in the next one. How much is the cash flow from financing activities, if the gross value is to be considered? 1. -51,000 EUR . 2. -40,800 EUR. 3. -34,000 EUR . 4. 10,200 EUR . (2) A company issues 100,000 ordinary shares at 1.30 EUR/ share. The face value is 1.00 EUR/ share. On their annual general meeting in the next year, the owners declare a dividend of 0.20 EUR/ share to be paid in the next Accounting period. The financial statements are prepared under the appropriation of profits. How much is the financing cash flow? 1. 100,000 EUR . 2. 130,000 EUR. 3. 80,000 EUR . 4. 110,000 EUR . (3) A company takes out a bank loan 100,000 EUR on 1.07.20X4. The rate of interest is 4.5 %/ a. The annual pay-off is 10,000 EUR/ a and is paid per rate. The issue fee for the loan is 1,500 EUR and is deducted from the loan issue. How <?page no="313"?> Berkau: Financial Statements 9e 10-313 much is the cash flow from financing activities? 1. 100,000 EUR . 2. 91,250 EUR . 3. 85,500 EUR . 4. -8,750 EUR . (4) A company earns a profit after taxes of 381,500 AUD. Depreciation is 60,000 AUD. Interest income is 45,000 AUD. How much is the operating cash flow? 1. 510,950 AUD . 2. 560,000 AUD . 3. 530,000 AUD . 4. 396,500 AUD . (5) A company earns a profit after tax of 500,000 EUR. The profit calculation considers depreciation of 100,000 EUR and an interest income of 50,000 EUR. How much is the cash flow from operations? 1. 650,000 EUR . 2. 764,286 EUR . 3. 550,000 EUR . 4. 564,286 EUR . 10.26 Solutions 1-2, 2-2, 3-2, 4-2, 5-2. <?page no="314"?> Berkau: Financial Statements 9e 11-314 11 Equity on the Balance Sheet 11.1 What is in the Chapter? Equity is funds provided by the owners of a company. It comprises not only of the issued capital which is the founders’ contribution at the time of the establishment but also of reserves and of non-distributed profits. The latter ones are disclosed under retained earnings. With the case study YARRA Ltd., we explain the major aspects of equity. The chapter follows the sequence of equity items on the balance sheet: (1) Issued capital. (2) Reserves. (3) Retained earnings. The case study YARRA Ltd. covers equity changes over three years, e.g. the issue of ordinary and preference shares, the appropriation of profits etc. We also explain a rights issue from the viewpoint of one shareholder. For share buy-backs we introduce the Treasury Stock account and its disclosure on the balance sheet. 11.2 Learnings Objectives After studying this chapter, you got familiarised with the equity section and can measure and disclose equity items correctly on the balance sheet following IFRSs. You also understand how special transactions with the owners work. You can record a profit appropriation and can determine the book value of a company. 95 Study our textbook Basics of Accounting, chapter (33). 11.3 Equity Equity disclosure refers to regulations based on national Company's Acts more than on international Accounting standards. The equity disclosure is based on the legal form of the reporting company. 95 Note, in this textbook we focus on limited companies. 11.4 Issued Capital Due to the dependency of the legal form for the equity disclosure, we start-off from a brief discussion about them. Note, this discussion about international companies continues the description of legal forms in Germany as covered in chapter (2). We distinguish between private companies with a limited liability, e.g., limited liability companies Ltd. (in the US), limited liability corporations Ltd. (UK), companies with limited liability GmbH (Germany), proprietary limited companies (Pty) Ltd. (in the Commonwealth and South Africa) and public companies based on shares. The latter ones can go public by an initial public offering IPO and can be listed at a stock exchange. Legal forms for companies based on shares are corporations Corp., incorporations Inc. (in the US), public limited companies PLC, Ltd (UK), Stock companies AG (Germany), and public companies Ltd. (Commonwealth, South Africa). By a share issue a company receives funds from its owners, which are added to the Cash/ Bank account and <?page no="315"?> Berkau: Financial Statements 9e 11-315 get credited to the Issued Capital account. If the issue price exceeds the nominal value of issued shares, the difference is recorded under capital reserves. Note, the difference between issue price and nominal value is called premium. In a limited company the ownership is shared among the owners. In this textbook, we term all portions of issued capital “shares”. A share issue conveys partial ownership to investors. Trading shares does not affect the equity of the company which shares are traded. However, it changes the structure of ownership and bears the risk of a takeover. Shares can be ordinary shares or preference shares. Ordinary shares come with the common rights of ownership, e.g., a claim on dividends, and with voting rights. In contrast, preference shares offer their holders the privilege of a preference dividend but excludes them from their right to vote. A preference dividend depends on the nominal share value and thus is independent of its profitability. Therefore, preference dividends are only subjected to low risks. Companies cannot declare a dividend on ordinary shares without preference dividends to be declared before. However, they can decide to not declare dividends at all. If preference shares are cumulative, the company must make up for omitted preference dividends before a declaration of dividends for the actual year. The procedure of a share issue includes an Allotment account. 96 To 96 Study our textbook Basics of Accounting, chapter (33) for the details of recording share issues. keep our case in this chapter simple, we follow a simplified recording procedure: We pretend that share issues are not overnor undersubscribed and only record a debit entry in cash/ bank and make credit entries directly in the Issued Capital and Capital Reserves accounts. The nominal value is accrued to the Issued Capital account, and the premium is allocated to capital reserves. 11.5 C/ S YARRA Ltd. - 20X0 YARRA Ltd. is a company based on shares in Durban, South Africa. This case study covers a period of three years. The intention of the case is to demonstrate as many equity transactions as possible. Note, the next following chapter (13) covers equity transactions as well as it is about the statement of changes in equity. Transactions, like a revaluation are only discussed once, e.g., for revaluations in chapter (13) only. Data Sheet for YARRA Ltd. Domicile: South Africa (Durban). Reporting currency: ZAR. Classification: n/ a. Ordinary shares: 1,000,000 shares, nominal value 1 ZAR/ share. Periods considered: 20X0 / 20X1 / 20X2. Pre-tax profits: 200,000 ZAR / nil / 275,000 ZAR. Investment in property, plant, equipment: 500,000 ZAR. (non-depreciable) Preference share capital: 500,000 ZAR; cumulative preference shares; dividend claim: 5 %/ a; issued on 30.06.20X0. Preference dividends: 12,500 ZAR / nil / (2 × 25,000 ZAR). <?page no="316"?> Berkau: Financial Statements 9e 11-316 Shareholder A. Visserhok: 90,000 ordinary shares. Share issue 500,000 ordinary shares on 1.07.20X1 at 1.24 ZAR/ share. Share price on 1.07.20X1: 1.60 ZAR/ share. Share price on 1.10.20X1: 1.03 ZAR/ share. Share redemption: 200,000 ordinary shares. Share price on 1.11.20X1: 1 ZAR/ share. Share redemption: 100,000 ordinary shares. Appropriation of profits (20X2): 200,000 ZAR to earnings reserves, ordinary dividend: 0.04 ZAR/ share, preference dividend 2 × 25,000 ZAR. VAT ignored. On 2.01.20X0, YARRA Ltd. issues 1,000,000 ordinary shares at 1 ZAR/ share. The share issue is a parvalue-issue which is a share issue at nominal values. The Bookkeeping entry is as below: @ 2.01.20X0 Cash Bank C/ B 1,000,000 Issued Capital Ord. ISO 1,000,000 (issue of 1,000,000 ordinary shares at 1 ZAR/ s) Later, on 30.06.20X0, YARRA Ltd. issues 500,000 preference shares at 1 ZAR/ share, again: par-value. The preference shares come with a dividend claim of 5 %/ a based on nominal values which is proportionate to the time they are outstanding. As YARRA Ltd. issues its preference shares in the middle of 20X0, only 50 % of the preference dividend claim is due in 20X0. The preference shareholders receive a dividend of: 50% × 500,000 × 1 × 5% = 1 12,500 ZAR. YARRA Ltd.'s preference shares are cumulative and recorded separately from ordinary shares in the Issued Capital Pref. account. @ 30.06.20X0 Cash Bank C/ B 500,000 Issued Capital Pref. ISP 500,000 (issue of 500,000 preference shares par value at 1 ZAR/ s) 11.6 Reserves Building reserves in a company is comparable to what private households do when they save money for rainy days. They put money aside which was previously earned. The reserves on the balance sheet are structured based on the origin of the funds: (1) Capital reserves. (2) Earnings reserves. (3) Revaluation reserves. Capital reserves result from share issues (premiums), earnings reserves are recorded by appropriations of profits and revaluation reserves apply for companies revaluing their items of non-current assets following IAS 16.31. <?page no="317"?> Berkau: Financial Statements 9e 11-317 11.7 C/ S YARRA Ltd. - 20X0 continued In 20X0, YARRA Ltd. buys non-current assets at 500,000 ZAR and earns a profit after taxation of: 200,000 × (1 - 30%) = 140,000 ZAR. The company prepares a balance sheet as depicted in Figure 11.1. Note, in this case study the non-current assets are not depreciated. This results to an easily recordable story line with pretax profit equal to the cash flow. Hence, the profit is recorded like DR Cash/ Bank 200,000 ZAR - CR Retained Earnings 140,000 ZAR - CR Income Tax Liabilities 60,000 ZAR. On its annual general meeting, the shareholders declare a preference dividend of 12,500 ZAR. No dividends to ordinary shareholders are declared. The remainder of the profit is carried forward to the Accounting period 20X1. The balance sheet is prepared under the consideration of the appropriation of profits which reduces retained earnings to: 140,000 - 12,500 = 1127,500 ZAR. The preference dividends are disclosed under short-term liabilities; observe below in Figure 11.1. At the end of the chapter, Figure 11.6 shows all accounts together for the periods 20X0 - 20X2. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 500,000 Share capital 1,500,000 Intangibles Reserves Financial assets Retained earnings 127,500 Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. 12,500 Prepaid expenses Provisions Cash/ Bank 1,200,000 Income tax liab. 60,000 Total assets 1,700,000 Total equity and liab. 1,700,000 Yarra Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 11.1: YARRA Ltd.’s balance sheet (20X0) The balance sheet shows YARRA Ltd.’s book value as per 31.12.20X0: 1,700,000 - 60,000 - 12,500 = 1,627,500 ZAR. For the case study, we pretend that ordinary and preference shares are traded at same prices. Therefore, we calculate equity metrics ignoring different classes of shares. The book value per (ordinary or preference) share is: 1,627,500 / 1,500,000 = 1 1.09 ZAR/ share. A book value is derived from the Bookkeeping entries and does not reflect the fair market value at which shares are traded. Here we divided the total equity by the number of outstanding shares as per 31.12.20X0. 11.8 C/ S YARRA Ltd. - 20X1 On 2.05.20X1, YARRA Ltd.’s shareholders decide at their annual general meeting the issue of another 500,000 ordinary shares. The fresh shares are issued on 1.07.20X1 at an issue price of 1.24 <?page no="318"?> Berkau: Financial Statements 9e 11-318 ZAR/ share. Their nominal value again is 1 ZAR/ share. Therefore, their premium is: 1.24 - 1 = 0 0.24 ZAR/ share. Note, a good issue price is based on the consideration of the book value per share and the share price. By a company adding profits to equity its book value exceeds the nominal value of all shares. It can get diminished due to a loss, too. E.g., if a German GmbH established by 25,000 EUR records a loss of 3,000 EUR in its first period, its book value becomes: 25,000 - 3,000 = 22,000 EUR. If shares are traded publicly its share price is determined by supply and demand. This results in a fair market value. In total, we have three share prices: the nominal value, the book value, and the fair market value. An issue price for fresh shares should exceed the book value but must stay under the fair market value to not jeopardise the share issue. Existing shareholders suffer from share issue prices below fair market values as the fresh shares reduce the average share price; we say the dilute the share values. We follow the considerations above and discuss them for the case of YARRA Ltd. On 1.07.20X1, YARRA Ltd.’s shares are traded at a share price of 1.60 ZAR/ share. Hence, the issue price of 1.24 ZAR/ share is below the fair market value but exceeds the book value of 1.09 ZAR/ share (as per 31.12.20X0). The weighted average share price for all shares after the share issue is: (1,500,000 × 1.60 + 500,000 × 1.24) / 2,000,000 = 1 1.51 ZAR/ share. An existing shareholder loses: 1.60 - 1.51 = 0 0.09 ZAR/ share whereas the buyer of fresh shares wins directly after the share issue: 1.51 - 1.24 = 00.27 ZAR/ share. To avoid losses in share valuation due to fresh share issues, YARRA Ltd. carries out a rights issue. With an issue of rights, all owners of the existing shares receive a purchase right which can be tradable and compensates for the losses expected from share price valuation. The rights received motivate existing shareholders to agree on share issues and facilitates a pre-selection of future investors. On 1.07.20X1, YARRA Ltd. issues 500,000 fresh shares at a 1: 3 ratio, meaning: per three existing shares one fresh share is issued. The difference between fair market value and the average share price after the issue is: 1.60 - 1.51 = 00.09 ZAR/ share. YARRA Ltd. compensates its existing ordinary and preference shareholders by one purchase right per three shares holding. Therefore, the fair right's value is 0.27 ZAR/ right. We study shareholder Anna Visserhok holding 90,000 shares of YARRA Ltd. She receives 30,000 purchase rights at: 3 × 0.09 = 0 0.27 ZAR/ right. Now, Ms Visserhok has two options: - Selling on her rights results in a gain of: 30,000 × 0.27 = 88,100 ZAR. Her fortune thereafter is: 8,100 + 90,000 × 1.51 = 1 144,000 ZAR. - Investing in fresh shares requires her to buy fresh shares at the issue price of 1.24 ZAR/ share and using her purchase rights. Ms Visserhok’s fortune becomes also: 120,000 × 1.51 - 30,000 × 1.24 = 1 144,000 ZAR. For confirmation, we check the valuation of Ms Visserhok’s shares before the <?page no="319"?> Berkau: Financial Statements 9e 11-319 share issue. It was: 90,000 × 1.60 = 144,000 ZAR. We study the Bookkeeping entries for share issues with a premium at YARRA Ltd. YARRA Ltd.’s shareholders pick up all issued shares. No overnor undersubscription of shares applies. We record the share issue at an issue price of 1.24 ZAR/ share which exceeds the nominal value of 1 ZAR/ share by 0.24 ZAR/ share. The nominal portion of the share price is accrued to the issued capital. The total premium is: (1.24 - 1) × 500,000 = 120,000 ZAR and is recorded as credit entry in the Capital Reserves account. @ 1.07.20X1 Cash Bank C/ B 620,000 Issued Capital Ord. ISO 500,000 Capital Reserves C-R 120,000 (issue of 500,000 ordinary shares at an issue price of 1.24 ZAR/ s) How it is Done (Share Issue): (1) Determine the nominal value of shares. (2) Multiply the number of shares issued by their nominal value. Add the nominal value for all fresh shares to the issued capital. (3) Check the issue price. If the issue price exceeds the nominal value, record the share premium for all fresh shares in the Capital Reserves account. (4) Debit the Cash/ Bank account for the issue price multiplied by the number of fresh shares. Next, we study share buy-backs and share redemptions. Note, that we must distinguish these activities. To explain the differences, we discuss two activities: (1) YARRA Ltd. buys-back its own shares and redeems them. (2) YARRA Ltd. buys-back further shares but keeps them as treasury stock. (1) On 1.10.20X1, YARRA Ltd.’s equity is: share capital: 1,500,000 + 500,000 = 2,000,000 ZAR; capital reserves 120,000 ZAR from the previous share issue and retained earnings are 127,500 ZAR. The fair market share price on 1.10.20X1 is only 1.03 ZAR/ share (given). In this situation, YARRA Ltd. buys back 200,000 of its own ordinary shares. Based on IAS 32.33 we term them treasury stock and debit them to the Treasury Stock account. Their measurement is at fair market values at the time of the share buyback: 200,000 × 1.03 = 2 206,000 ZAR. Note, we record treasury stock on the debit side as it represents an equity reduction. YARRA Ltd.’s intents to redeem them. The cost of acquisition applies which is based on the share price at the time of buy-back: 200,000 × 1.03 = 2206,000 ZAR. IAS 32.33 instructs recording the share redemption in equity and not through profit or loss. We debit the issued capital and the capital reserves. <?page no="320"?> Berkau: Financial Statements 9e 11-320 Observe Bookkeeping entries (D) and (E). Bookkeeping entry (D) is for share buyback at market values on 1.10.20X1 and (E) for share redemption at cost of acquisition. @ 1.10.20X1 (D), (E) Treasury Stock Account TSA 206,000 Cash/ Bank C/ B 206,000 (recording share buy back at acquisition cost) Issued Capital Ord. ISO 200,000 Capital Reserves C-R 6,000 Treasury Stock Account TSA 206,000 (share redemption) (2) YARRA Ltd.’s shares’ price further decreases and on 1.11.20X1, the fair market value of its shares is down to 1 ZAR/ share. YARRA Ltd. buys back another 100,000 of its own shares. However, YARRY Ltd. does not redeem the (new) treasury stock and has no intention to do so. @ 1.11.20X1 (F) Treasury Stock Account TSA 100,000 Cash/ Bank C/ B 100,000 (recording share buy back at acquisition cost) In 20X1, YARRA Ltd. does not earn profit and therefore refrains from declaring dividends. YARRA Ltd.’s equity situation after the share issue, share buy-backs and the share redemption is shown in Figure 11.2. In Figure 11.4, a more detailed equity section disclosure is shown. <?page no="321"?> Berkau: Financial Statements 9e 11-321 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 500,000 Share capital 1,700,000 Intangibles Reserves 114,000 Financial assets Retained earnings 127,500 Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. Prepaid expenses Provisions Cash/ Bank 1,441,500 Income tax liab. Total assets 1,941,500 Total equity and liab. 1,941,500 Yarra Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 11.2: YARRA Ltd.’s balance sheet (20X1) How it is Done (Share Redemption): (1) Determine the number of shares to redeem. (2) Record a share buy-back based on their fair market value. (3) Record a debit entry for the treasury stock and a credit entry in the Cash/ Bank account. Treasury shares are valued at acquisition costs. (4) Redeem shares by making a debit entry in the Issued Capital account. Dissolve capital reserves to the extent the treasury share price exceeds the nominal value of the shares. (5) Record a credit entry in the Treasury Stock account. (6) Combine Bookkeeping entries (3) to (5) for recording of immediate redemption. (7) National Company’s Act regulations might apply. Check beforehand. 11.9 C/ S YARRA Ltd. - 20X2 Below, we discuss earnings reserves recorded together with the appropriation of profits in 20X2 at YARRA Ltd. Additions to earnings reserves result from profit earned during the Accounting period and profits carried forward from prior ones. A limited company decides on its annual general meeting about the appropriation of profits which can result in additions to earnings reserves, declaration of dividends and/ or carrying forward profit or loss to the next year. Note, special national rules might apply for the appropriation of profits and additions to reserves as well as for a release of reserves. In 20X2, YARRA Ltd. earns a profit after taxes of 192,500 ZAR on cash. The profit <?page no="322"?> Berkau: Financial Statements 9e 11-322 is added to the Retained Earnings account and the income tax liabilities. The income tax expenses are: 30% × 192,500 / (1 - 30%) = 8 82,500 ZAR. Hence, the item cash/ bank is: 1,441,500 + 192,500 / (1 - 30%) = 11,716,500 ZAR. Retained earnings are: 127,500 + 192,500 = 320,000 ZAR which includes the profit carried forward from 20X0. Note, we refer to the balance of retained earnings as the distributable amount, as it can be paid to owners as dividends. If the company decides to add the profit or portions thereof to reserves, a debit entry is recorded in the Retained Earnings account, and we credit earnings reserves. Once added to earnings reserves, these funds can only be released if the owners decide on the general annual meeting to do so. Special national rules apply. YARRA Ltd. holds an annual general meeting on 4.04.20X3 and decides to add 200,000 ZAR to earnings reserves and declare a dividend. For the declaration of ordinary dividends, YARRA Ltd. first must make up for the omitted preference dividends from 20X1. Therefore, the total preference dividend in 20X2 includes the one pending from 20X1 and is: 2 × 500,000 × 5% = 5 50,000 ZAR. Remember, YARRA Ltd.’s preference shares are cumulative. YARRA Ltd.’s shareholders agree to pay an ordinary dividend of 0.04 ZAR/ share. The total value is: 0.04 × 1,200,000 = 48,000 ZAR. Treasury stock does not participate in the appropriation of profits. The remainder of the distributable profit is carried forward to the Accounting period 20X3. No Bookkeeping entry is recorded for carrying forward profits. In total, dividends of: 48,000 + 50,000 = 98,000 ZAR are added to short-term liabilities as they will be paid in 20X3. Find below the Bookkeeping entries for the appropriation of profits on 31.12.20X2. The recordings anticipate the decision at the annual general meeting as the distribution is only suggested by YARRA Ltd.’s board of directors at the time of preparing the financial statements. It needs the approval of the financial statements after the completion of audits. @ 31.12.20X2 Profit and Loss-20X2 P2L 192,500 Retained Earnings R/ E 192,500 (accumulating profits to retained earnings) Profit and Loss-20X2 P2L 82,500 Income Tax Liabilities ITL 82,500 (recognition of income taxes on profit) Retained Earnings R/ E 98,000 Shareholders for Dividends A/ P 98,000 (transfer of dividends to ordinary and preference shareholders to payables) Retained Earnings R/ E 200,000 Earnings Reserves E-R 200,000 (adding 200,000 ZAR of profits to earnings reserves) <?page no="323"?> Berkau: Financial Statements 9e 11-323 After making the Bookkeeping entries above, YARRA Ltd. prepares its balance sheet after appropriation of profits as disclosed in Figure 11.3. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 500,000 Share capital 1,700,000 Intangibles Reserves 314,000 Financial assets Retained earnings 22,000 Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. 98,000 Prepaid expenses Provisions Cash/ Bank 1,716,500 Income tax liab. 82,500 Total assets 2,216,500 Total equity and liab. 2,216,500 Yarra Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 11.3: YARRA Ltd.’s balance sheet (20X2) On the balance sheet, the total reserves are 314,000 ZAR, which include 114,000 ZAR in capital reserves and 200,000 ZAR in earnings reserves. 11.10 Retained Earnings Earnings is the portion of annual profit that is distributable to owners. It is calculated based on the profit after taxes. IAS 33 refers for the metric Earnings Per Share to the earnings of the actual Accounting period whereas the Retained Earnings account discloses profits from prior Accounting periods. Earnings per Share is a performance figure which should not be biassed by profits earned in prior Accounting periods as well as the actual period. When declaring dividends, a company reduces its equity because of debit entries are recorded in the Retained Earnings account. Carrying forward profits in the Retained Earnings account means to postpone the decision about the profit appropriation. It does not impact the equity’s total. Carrying forward a loss is an alternative to dissolving (earnings) reserves. There are tax and reserves implications a company should consider based on national tax law and/ or the Company’s Act for its decision. The disclosure of equity can either result in a detailed equity section on the balance sheet or in providing explanatory information in the notes. Below, we show an extended disclosure of the equity section for YARRA Ltd.’s balance sheet as at 31.12.20X1. <?page no="324"?> Berkau: Financial Statements 9e 11-324 20X1 20X0 C, L [ZAR] Equity [ZAR] [ZAR] . . . Share capital ordinary shares R1 1,300,000 1,000,000 ordinary treasury shares R1 (100,000) preference shares R1 500,000 500,000 Reserves Capital reserves 114,000 Earnings reserves 0 Retained earnings 127,500 127,500 Yarra Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 11.4: Detailed equity section on YARRA Ltd.’s B/ S (20X1) 20X2 20X1 C, L [ZAR] Equity [ZAR] [ZAR] . . . Share capital ordinary shares R1 1,300,000 1,300,000 ordinary treasury stock R1 (100,000) (100,000) preference shares R1 500,000 500,000 Reserves Capital reserves 114,000 114,000 Earnings reserves 200,000 0 Retained earnings 22,000 127,500 Yarra Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 11.5: Detailed equity section on YARRA Ltd.’s B/ S (20X2) In Figure 11.6, the accounts for YARRA Ltd. are disclosed. Bookkeeping entries in 20X0 are identified by figures, in 20X1 by capital letters and in 20X2 by lower ones. <?page no="325"?> Berkau: Financial Statements 9e 11-325 D C D C (1) 1,000,000 (5) 500,000 c/ d 1,000,000 (1) 1,000,000 (2) 500,000 1,000,000 1,000,000 (3) 200,000 c/ d 1,200,000 (E) 200,000 b/ d 1,000,000 1,700,000 1,700,000 c/ d 1,300,000 (C) 500,000 b/ d 1,200,000 (A) 60,000 1,500,000 1,500,000 (C) 620,000 (B) 12,500 b/ d 1,300,000 (D) 206,000 (F) 100,000 c/ d 1,441,500 1,820,000 1,820,000 b/ d 1,441,500 (a) 275,000 c/ d 1,716,500 1,716,500 1,716,500 b/ d 1,716,500 Cash/ Bank C/ B Issued capital ordinary shares ISO D C D C c/ d 500,000 (2) 500,000 c/ d 60,000 (3) 60,000 500,000 500,000 (A) 60,000 b/ d 60,000 b/ d 500,000 c/ d 82,500 (a) 82,500 b/ d 82,500 Issued capital preference shares ISP Income tax liabilities ITL D C D C c/ d 12,500 (4) 12,500 (4) 12,500 (3) 140,000 (B) 12,500 b/ d 12,500 c/ d 127,500 (b) 48,000 140,000 140,000 c/ d 98,000 (c) 50,000 (b) 48,000 b/ d 127,500 98,000 98,000 (c) 50,000 (a) 192,500 b/ d 98,000 (d) 200,000 c/ d 22,000 298,000 320,000 b/ d 22,000 Shareholders for Dividend A/ P Retained earnings R/ E D C D C (5) 500,000 c/ d 500,000 c/ d 60,000 (3) 60,000 b/ d 500,000 (B) 60,000 b/ d 60,000 c/ d 82,500 (a) 82,500 b/ d 82,500 Property, plant, equipment P, P, E Income tax liabilities ITL Figure 11.6: YARRA Ltd.'s accounts <?page no="326"?> Berkau: Financial Statements 9e 11-326 D C D C (D) 206,000 (E) 206,000 (E) 6,000 (C) 120,000 (F) 100,000 c/ d 100,000 c/ d 114,000 306,000 306,000 120,000 120,000 b/ d 100,000 b/ d 114,000 D C c/ d 200,000 (d) 200,000 b/ d 200,000 Earnings reserves E-R Treasury stock account TSA Capital Reserves C-R Figure 11.6: YARRA Ltd.'s accounts continued 11.11 Summary Equity is the book value of the business. On a balance sheet under IFRSs, equity can be calculated by deducting all liabilities from the total of assets. The equity changes by transactions with owners, like share issues, share redemptions or dividend declarations. It also increases or decreases by earnings and the appropriation thereof. Revaluations are recorded through equity, too. National law, e.g., the Company’s act, contains special rules for equity items on the balance sheet. 11.12 Working Definitions Equity: Difference between assets and liabilities. We refer to equity as the book value of the company. Shares: Partial ownership of a company. It is disclosed at nominal values on the equity section under issued capital or share capital. We translate portions of ownership on a (Pty) Ltd. or a German GmbH by shares, too. Preference Shares: Shares without voting right but with a privileged rank regarding dividends and liquidation proceed distribution. Reserves: Portions of equity resulting from appropriations of after-tax profits, share issues with a premium or revaluations. Earnings per Share Ratio: After-tax profit cleared of preference dividends, if applicable, divided by the number of outstanding ordinary shares. IAS 33 applies. Redemption of Shares: Shares bought-back by the own company for dissolving. Share Premium: Positive difference between issue price and nominal value per share. The share premium is added to capital reserves. Treasury Stock: Shares bought back buy the issuing company. Treasury stock is carried as negative equity. No treasury shares receive dividends or liquidation proceeds. 11.13 Question Bank (1) A company is established with a share issue of 100,000 shares at 8.50 EUR/ share. The face value per share is 5 EUR/ share. The company discloses a loss carried forward from previous Accounting periods of 6,000 EUR. The pretax <?page no="327"?> Berkau: Financial Statements 9e 11-327 profit is 80,000 EUR. The owners declare a dividend of half of the distributable amount; the remainder is added to earnings reserves. Disclose the items issued capital, reserves and retained earnings for a balance sheet that is prepared under the appropriation of profits. (Issued Capital/ Reserves/ Retained Earnings) 1. 500,000 EUR/ 350,000 EUR/ 25,000 EUR . 2. 850,000 EUR/ 25,000 EUR/ 0 EUR . 3. 500,000 EUR/ 375,000 EUR/ 0 EUR . 4. 500,000 EUR/ 25,000 EUR/ 350,000 EUR . (2) On 1.10.20X3, a company issues 50,000 preference shares at an issue price of 1.30 EUR/ share. The premium is 0.30 EUR/ share. The preference dividend is 4.5 %/ a based on the nominal value. The company is based on 100,000 ordinary shares at 1 EUR/ share face value. The profit before taxes is 25,000 EUR. It is decided to declare a full dividend. How much is the ordinary dividend rounded-down to the nearest EUR-cent? 1. 0.22 EUR/ share . 2. 0.15 EUR/ share . 3. 0.14 EUR/ share . 4. 0.16 EUR/ share . (3) A company has 200,000 ordinary shareholders. The fair market value per share is 3.45 EUR/ share. The company decides to issue 50,000 ordinary shares at 3 EUR/ share based on rights. How much is the value for one purchase right (for one fresh share issued)? 1. 0.09 EUR/ r . 2. 0.36 EUR/ r . 3. 0.45 EUR/ r . 4. 0.23 EUR/ r . (4) A company earns a pre-tax profit of 100,000 EUR. The preference dividend is 6,000 EUR and got declared for the Accounting period. In the retained earnings, a profit is carried forward to the extent of 50,000 EUR. The ordinary dividend is 50 % of the distributable amount and the remainder is accrued to reserves. The issued capital is 500,000 EUR. How much is the book value of the company? 1. 557,000 EUR . 2. 57,000 EUR . 3. 560,000 EUR . 4. 644,000 EUR . (5) A company carries forward a loss of 26,000 EUR. In the actual Accounting period, it earns a profit after taxes of 75,000 EUR. At the end of June, the company issued 50,000 preference shares at 5.50 EUR/ share which is 0.50 EUR/ share above face value. The preference dividend is 4 %/ a based on the nominal amount of the shares. How much is the distributable amount to (all) ordinary shareholders? 1. 43,500 EUR . 2. 39,000 EUR . 3. 44,000 EUR . 4. 49,000 EUR . 11.14 Solutions 1-3, 2-4, 3-2, 4-1, 5-3. <?page no="328"?> Berkau: Financial Statements 9e 12-328 12 Statement of Profit or Loss and Other Comprehensive Income 12.1 What is in the Chapter? Profit is the difference between revenues, other income, and expenses. Income that is not linked to the business model is classified as extraordinary. It is termed a gain. In line with IAS 1.99, a company can either prepare its income statement following the nature of expense method or the cost of sales format. It can be supplemented by a single statement of other comprehensive income (OCI), or gains are reported together with general income on the statement of profit or loss and other comprehensive income. In this textbook, we usually apply the combined statements. Note, instead of the official name of the statement: statement of profit or loss and other comprehensive income, we prefer the short form: income statement. All revenues, other income and all expenses are allocated to the Accounting period they are for no matter when their payments are made or cash is received. Note, the term gain and other income are used as synonyms here. Gain applies more in the text and marks income which is extraordinary. The term other income is the appropriate item on the income statement. We teach how to prepare the income statement for service providers and production firms. We cover both formats (nature of expense format and cost of sales format) for two case studies. We explain relevant regulations following IFRSs. For service renderer, we discuss the case study ABINGTON Ltd. which is an Australian law firm. Its profit calculation is simple, as no product calculation is required. However, ABINGTON Ltd. must calculate its service, but that does not include material flows. SUDHUIZEN PLC is a British production firm. It requires the consideration of material flows and manufacturing procedures. For the nature of expense method, SUDHUIZEN PLC applies a periodic inventory system. In contrast, we apply job order costing based on a perpetual inventory system for the support of the cost of sales format. 12.2 Learning Objectives After studying this chapter, you can prepare and read a statement of profit or loss and other comprehensive income from others. You can apply the cost of sales format and the nature of expense method and understand their differences. You further know which additional information must be disclosed in the notes depending on the applied format. You develop an awareness for the difference between profit and gains and between ordinary expenses and other expenses. <?page no="329"?> Berkau: Financial Statements 9e 12-329 12.3 Statement of Profit or Loss and Other Comprehensive Income On the income statement reporting companies compare their income to expenses, see IAS 1.88. Technical terms are defined in the conceptual framework for financial reporting. Profit and gains are referred to as income. For teaching purposes, we say: Revenue results from ordinary business, e.g., selling/ manufacturing goods or rendering services; a gain is extraordinary income, e.g., gains on disposal of non-current assets or interest income earned by companies other than banks. In contrast, a bank classifies its interest income as revenue. See examples given by F 4.31. An expense is, based on F 4.33, a loss or consumption of resources due to ordinary business, e.g., salary, wages, material consumption etc. Extraordinary expenses are recorded for e.g., a water damage or penalties, except for an insurance company that covers flood damages. Profit or loss as disclosed on the income statement is the difference between all income and all expenses during an Accounting period. IAS 1.81 defines their disclosure requirements. The detailed income and expenses figures show how a company earns money. The structure of the statement of profit or loss and other comprehensive income follows the nature or the function of items. 97 - For an income statement along the nature of the expenses, expenses are classified based on cost catego- 97 Study our textbook Basics of Accounting, chapter (28). ries, e.g., labour, depreciation, materials etc. No allocations are made to cost objects. Examples for the income statement following the nature of expense method are given in IAS 1.102. - If the income statement is structured following the function of expenses for the company, it is prepared under consideration of costs for cost objects. Cost objects usually are goods manufactured, or services rendered. The calculation of cost objects works by allocation and only applies to the cost of sales format. IAS 1.103 covers the cost of sales format. On its bottom line, a statement of profit or loss and other comprehensive income discloses income tax expenses to be deducted from the pre-tax profit to calculate the annual surplus (EAT). Note, in previous chapters, we preferably applied the nature of expense method because it requires less Bookkeeping work and is easily understandable. The advantage of a cost of sales format is, that product calculations are made on the accounts and the cost information is structured by products/ services. Therefore, the reporting company can calculate product margins and use them for product mix decisions. However, the latter one does not require to make product cost information public by the income statement. IAS 1.99 states that the reporting company shall choose the format that provides more reliable information, and which is more relevant. The formal income statement requirements are based on IAS 1.81. <?page no="330"?> Berkau: Financial Statements 9e 12-330 Note, for this textbook, we follow a standard structure, as shown in Figure 12.3 for the NoE-format and in Figure 12.9 for the COS-format. An extended income statement format as for German AGs following § 158 AktG does not apply for international Accounting. Appropriations of profits are disclosed on the statement of changes in equity instead. Below, we apply the two different methods for income statements: (a) Nature of expense method (NoE) and (b) Cost of sales format (COS) by two case studies: (A) ABINGTON Ltd., an Australian law firm. (B) SUDHUIZEN PLC, a British espresso machine producer. 12.4 C/ S ABINGTON Ltd. - Nature of Expense Method ABINGTON Ltd. is an Adelaide based law firm specialised in property conveyances. At first, it prepares its income statement following the nature of expense method. The structure of the income statement is shown below: Revenue +/ - Changes in Inventories of Finished goods ./ . Expenses = Earnings before Interest and Taxation (EBIT) ./ . Interest = Earnings before Taxation (EBT) ./ . Income Tax = Annual Surplus (EAT) Note, the speciality of the nature of expense method is the disclosure of changes in inventories of finished goods. This does not matter for service providers as service cannot be stored. Therefore, we discuss changes in inventories of finished goods only for the next case study SUDHUIZEN PLC. Data Sheet for ABINGTON Ltd. Domicile: Australia (Adelaide). Reporting currency: AUD. Classification: service provider. Employees: six attorneys, 20 paralegals. Salary: attorney 85,000 AUD/ a; paralegal: 38,000 AUD/ a. Direct costs for conveyance: 680 AUD/ mandate attorney labour (only relevant for the COS format). Operational costs: 160,500 AUD/ a VATable. Rent: 5,000 AUD/ m due one month in advance; non-VATable. Manufacturing overheads: paralegal labour and operational expenses. Non-manufacturing overheads: Administration (contribution of attorneys to administration) and rent. Accounting period: 20X4. Revenue: 700 conveyances at 3,600 AUD/ mandate, VATable. Other income: Interest income from bonds: 20,000 AUD/ a. Predetermined overhead allocation rate: 1,300 AUD/ mandate. VAT rate: 20 % Note, in this chapter the consideration of VAT is not critical. A profit calculation can be carried out without recording VAT. In class, this case study can be presented without VAT consideration. ABINGTON Ltd. resides in a rented office in Adelaide and employs six attorneys and 20 paralegals. In 20X4, ABINGTON Ltd. conveys 700 properties and earns a revenue of 3,600 AUD/ mandate. The total revenue is amounting to 700 × 3,600 <?page no="331"?> Berkau: Financial Statements 9e 12-331 = 22,520,000 AUD. Every attorney at ABINGTON Ltd. earns an annual salary of 85,000 AUD/ (a × attorney). Paralegals earn 38,000 AUD/ (a × paralegal). Further operational costs for property conveyances are 160,500 AUD/ a; they result from lease instalments for computer systems, from office material consumption, from internet access costs etc. The operational expenses are VATable. The rent for the offices is 5,000 AUD/ m and is paid one month in advance. At the beginning of the Accounting period 20X4, the Prepaid Expense account discloses an opening value of 5,000 AUD. No VAT applies for rent. ABINGTON Ltd. earns interest income from bonds to the extent of 20,000 AUD/ a. The coupons count as extraordinary income because ABINGTON Ltd.’s core business is law. No VAT applies for interest income. Before we calculate ABINGTON Ltd.’s profit or loss, we record the Bookkeeping entries for its activities: (1) Allocating prepaid rent. (2) Rental payment (no VAT considered). (3) Salary for attorneys. (4) Salary for paralegals. (5) Operational expenses (VATable). (6) Revenue recognition (VATable). (7) Interest income from bonds (non- VATable). @ 2.01.20X4 (1) Rent-20X4 RNT 5,000 Prepaid Expenses PRE 5,000 (accural of prepaid expenses to the rent account) @ 30.06.20X4 (2), (3), (4), (5) Rent-20X4 RNT 60,000 Cash/ Bank C/ B 60,000 (recognition of twelve payments for rent at 5,000 AUD each) Labour Attorneys-20X4 LAA 510,000 Cash/ Bank C/ B 510,000 (salary recognition for the attorneys: 6 × 85,000 AUD) Labour Paralegals-20X4 LAP 760,000 Cash/ Bank C/ B 760,000 (salary recognition for the paralegals: 20 × 38,000 AUD) Operational Expenses-20X4 OEX 160,500 Value Added Tax VAT 32,100 Cash/ Bank C/ B 192,600 (recognition of further expenses for legal operations) @ 1.07.20X4 (6), (7) Cash/ Bank C/ B 3,024,000 Value Added Tax VAT 504,000 Revenue-20X4 REV 2,520,000 (recognition of revenue: 700 × 3,600 AUD) Cash/ Bank C/ B 20,000 Interest Income-20X4 I4I 20,000 (recognition of interest income (given)) <?page no="332"?> Berkau: Financial Statements 9e 12-332 Figure 12.1 shows the accounts with the business activities recorded therein. The numbers for the business activities serve as Bookkeeping entry reference numbers. D C D C . . . (2) 60,000 OV 5,000 (1) 5,000 (6) 3,024,000 (3) 510,000 RNT 5,000 (7) 20,000 (4) 760,000 (5) 192,600 c/ d 1,521,400 3,044,000 3,044,000 b/ d 1,521,400 Cash/ Bank C/ B Prepaid expenses PRE D C D C (1) 5,000 (3) 510,000 c/ d 510,000 (2) 60,000 c/ d 65,000 b/ d 510,000 65,000 65,000 b/ d 65,000 PRE 5,000 c/ d 60,000 65,000 65,000 b/ d 60,000 Rent-20X4 RNT Labour Attorneys-20X4 LAA D C D C (4) 760,000 c/ d 760,000 (5) 160,500 c/ d 160,500 b/ d 760,000 b/ d 160,500 Labour Paralegals-20X4 LAP Operational expenses-20X4 OEX D C D C c/ d 2,520,000 (6) 2,520,000 (5) 32,100 (6) 504,000 b/ d 2,520,000 c/ d 471,900 504,000 504,000 b/ d 471,900 Revenue-20X4 REV Value added taxes VAT D C c/ d 20,000 (7) 20,000 b/ d 20,000 Interest income-20X4 I/ I Figure 12.1: ABINGTON Ltd.’s accounts (NoE) Before the profit calculation, prepaid expenses are recorded. See the adjustment <?page no="333"?> Berkau: Financial Statements 9e 12-333 Bookkeeping entry below which is indicated by the contra accounts’ three-letter-codes: PRE for prepaid expenses and RNT for rent. You find the adjustments in Figure 12.1 already. @ 31.12.20X4 Prepaid Expenses PRE 5,000 Rent-20X4 RNT 5,000 (rent accual of rent for January/ 20X5 towards prepaid expenses) The Profit and Loss account shows ABINGTON Ltd.’s entire profit of 734,650 AUD after taxation. Study the Profit and Loss-20X4 account that follows the nature of expense method in Figure 12.2. D C D C RNT 60,000 REV 2,520,000 c/ d 314,850 P&L 314,850 LAA 510,000 I/ I 20,000 b/ d 314,850 LAP 760,000 OEX 160,500 EBT 1,049,500 2,540,000 2,540,000 D C ITL 314,850 b/ d 1,049,500 c/ d 734,650 P&L 734,650 R/ E 734,650 b/ d 734,650 1,049,500 1,049,500 Profit and Loss-20X4 P&L Income tax liabilities ITL Retained earnings R/ E Figure 12.2: ABINGTON Ltd.’s Profit and Loss calculation (NoE) ABINGTON Ltd. prepares its income statement and combines several entries in the Profit and Loss account, e.g., different labour categories and rent and operational expenses are disclosed under other expenses. The interest income from the bonds is disclosed under other income. Study the income statement prepared based on the nature of expense format below in Figure 12.3. <?page no="334"?> Berkau: Financial Statements 9e 12-334 [AUD] Revenue 2,520,000 Other income 20,000 2,540,000 Materials 0 Labour (1,270,000) Depreciation 0 Other expenses (220,500) Earnings before int. & taxes (EBIT) 1,049,500 Interest 0 Earnings before taxes (EBT) 1,049,500 Income tax expenses (314,850) Deferred taxes 0 Earnings after taxes (EAT) 734,650 Abington Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 12.3: ABINGTON Ltd.’s income statement (NoE) We continue the case study ABINGTON Ltd. below for the cost of sales format after the second income statement following the nature of expense method for the production firm SUIDHUIZEN PLC. Note, for teaching in the classroom it is better to discuss both methods for one case study and change then over to the next case. This helps to memorise the figures. However, we maintain the methodbased structure here to demonstrate the differences between service providers and manufacturers. 12.5 C/ S SUDHUIZEN PLC - Nature of Expense Method Our case study for Manufacturing Accounting is the production firm SUDHUIZEN PLC in York. SUDHUIZEN PLC considers changes in inventories, for raw materials as well as for finished goods. Changes in raw materials are considered by the material expenses already. Changes in finished goods require an adjustment Bookkeeping entry. If finished goods inventory increases, costs of finished goods are added to stock and must be deducted from the total of costs of manufacturing, see chapter (9). Finished goods are measured at costs and added to inventories as current assets and disclosed on the balance sheet. Once goods are released from stock, we must consider an expense based on the cost of manufacturing that occurred when the goods have been produced and stored. Frequently cost formulas apply. Data Sheet for SUDHUIZEN PLC Domicile: Great Britain (York). Reporting currency: GBP. <?page no="335"?> Berkau: Financial Statements 9e 12-335 Classification: Manufacturing. Product: espresso machines. Bill of materials: one water pump, one coffee capsule dispense unit CCDU, one box for packaging per one espresso machine. Materials: see Figure 12.5; opening value for inventories: 45,000 GBP which contains materials and finished goods. Production volume (20X4): 30,000 units. Sales amount (20X4): 28,500 units; net selling price: 60 GBP/ u. Depreciation: 28,000 GBP/ a in Assembling; 1,000 GBP/ a in Cleaning; 2,000 GBP/ a in Shipping. Labour: 40,000 GBP/ a in Assembling; 30,000 GBP in Cleaning; 25,000 GBP/ a in Shipping; 55,000 GBP in Administration. VAT rate: 20 % For the income statement preparation in production firms, extra Bookkeeping work is necessary to calculate finished goods. When finished goods are accrued to finished goods inventory, we increase assets on the balance sheet and deduct their cost of manufacturing from costs on the income statement. This works as a credit entry for the changes in inventories of finished goods. Therefore, no costs of manufacturing count for goods produced but not yet sold. With the sale of finished goods, we decrease inventories and consider the manufacturing costs for the stock release as an expense, which is recorded under changes of finished goods on the debit side. To understand how to record finished goods’ accumulation to stock and the deferral of their manufacturing costs to later Accounting periods, study the case ANKYO Ltd. You reach the case study via the Link 12.A. Link 12.A: ANKYO Ltd. We discuss below the income statement for the espresso machine manufacturer SUDHUIZEN PLC. At the end of 20X4, the manufacturer adds finished and not yet sold espresso machines to stock. At the beginning of 20X4, SUDHUIZEN PLC discloses an opening value of espresso machines of 3,000 GBP. It results from 100 espresso machines produced in the past at unit costs of: 3,000 / 100 = 30 GBP/ u. As the company’s production volume exceeded sales amount in 20X3, SUDHUIZEN PLC put 100 not sold espresso machines on stock of finished goods. They are of the same kind of espresso machines they produce in 20X4. SUDHUIZEN PLC applies the weighted average cost formula on all inventory movements. Every espresso machine includes a water pump and a coffee-capsule-dispenseunit CCDU. For handling, the espresso machines are packed into a box. Therefore, the box is part of the finished good which is a packed espresso machine. At the beginning of 20X4, SUDHUIZEN PLC has 3,000 CCDUs at 14 GBP/ u on stock. Check the inventory disclosure on SUDHUIZEN PLC.’s balance sheet in Figure 12.4. It results from 100 packed espresso machines and 3,000 CCDUs <?page no="336"?> Berkau: Financial Statements 9e 12-336 measured at cost: 3,000 × 14 + 100 × 3 = 445,000 GBP. A C, L Non-current assets [GBP] Equity [GBP] P, P, E 100,000 Share capital 50,000 Intangibles Reserves 100,000 Financial assets Retained earnings Current assets Liabilities (liab.) Inventory 45,000 Long-term liab. Accounts receivables Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 5,000 Income tax liab. Total assets 150,000 Total equity and liab. 150,000 Sudhuizen PLC. STATEMENT of FINANCIAL POSITION as at 1.01.20X4 Figure 12.4: SUDHUIZEN PLC’s balance sheet (20X3) The production management for espresso machines is based on a Job Order Costing. 98 Note, An alternative procedure is Process Costing. To demonstrate the recordings and calculations following a Process Costing system, we prepared alternative income statement calculations which you can download through Link 12.B after the discussion of the cost of sales format. At first, the espresso machines are assembled in the Assembling department. The next step is a cleaning procedure followed by the packaging. All espresso machines get packaged; this includes those not yet sold. SUDHUIZEN PLC runs three manufacturing departments: Assembling, Cleaning and Packaging. During the Accounting period 20X4, SUDHUIZEN PLC purchases the materials below: Item Date of purchase Amount Unit costs Cost of purchase [GBP] [GBP] CCDU 2.01.20X4 30,000 14.00 420,000 Water pump 3.01.20X4 20,000 9.50 190,000 Box 6.01.20X4 30,000 1.00 30,000 Water pump 14.01.20X4 20,000 10.50 210,000 Cleaning soap for 100 machines 15.01.20X4 300 10.00 3,000 SUDHUIZEN PLC PURCHASE JOURNAL for the period ended 31.12.20X4 Figure 12.5: SUDHUIZEN PLC’s purchase ledger 98 Study our textbook Management Accounting, chapter (18). <?page no="337"?> Berkau: Financial Statements 9e 12-337 The purchase of cleaning soap is on credit. During the Accounting period 20X4, SUDHUIZEN PLC produces 30,000 espresso machines. SUDHUIZEN PLC records 28,000 GBP/ a depreciation on the Assembling department, 1,000 GBP/ a depreciation on the Cleaning department and 2,000 GBP/ a depreciation on the Packaging department. Wages are 40,000 GBP/ a in the Assembling department, 30,000 GBP/ a in the Cleaning department and 25,000 GBP/ a in the Shipping department. Furthermore, SUDHUIZEN PLC records 55,000 GBP/ a salaries in the Administration department which is not related to manufacturing. Wages and salaries are recorded in the Labour-20X4 account to simplify the case. In 20X4, SUDHUIZEN PLC sells 28,500 espresso machines at 60 GBP/ u net selling price. As the production volume for espresso machines exceeds the sales amount: 100 + 30,000 - 28,500 = 1 1,600 espresso machines are stored. We make the Bookkeeping entries as below and follow a periodic inventory system based on the weighted average cost formula. This keeps the Accounting workload low, as we only measure how much materials and finished goods are left on stock at the end of 20X4. These are 3,000 CCDUs (ICC), 10,000 water pumps (IWP) and 1,600 espresso machines (FGI). The three-digit-codes refer to the inventory accounts. For the application of a periodic system, no further inventory accounts than for finished goods (FGI), coffee-capsule-dispenseunits (ICC) and water pumps (IWP) are needed. We only record closing stocks at the end of 20X4, but we must calculate the finished espresso machines unit costs in a working (outside of the accounts). The recorded business activities are: (1) Purchase of CCDUs. (2) Purchase of water pumps. (3) Purchase of boxes. (4) 2 nd Purchase of water pumps. (5) Purchase of soap. (6) Depreciation Assembling. (7) Depreciation Cleaning. (8) Depreciation Packaging. (9) Wages in Assembling. (10) Wages in Cleaning. (11) Wages in Packaging. (12) Salary in Administration. (13) Revenue recognition. <?page no="338"?> Berkau: Financial Statements 9e 12-338 @ 2.01.20X4 (1) Purchase-20X4 PUR 420,000 Value Added Tax VAT 84,000 Cash/ Bank C/ B 504,000 (purchase of CCDUs: 30,000 × 14 GBP) @ 3.01.20X4 (2) Purchase-20X4 PUR 190,000 Value Added Tax VAT 38,000 Cash/ Bank C/ B 228,000 (purchase of water pumps: 20,000 × 9.50 GBP) @ 6.01.20X4 (3) Purchase-20X4 PUR 30,000 Value Added Tax VAT 6,000 Cash/ Bank C/ B 36,000 (purchase of boxes: 30,000 × 1 GBP) @ 14.01.20X4 (4) Purchase-20X4 PUR 210,000 Value Added Tax VAT 42,000 Cash/ Bank C/ B 252,000 (2nd purchase of water pumps: 20,000 × 10.50 GBP) @ 15.01.20X4 (5) Purchase-20X4 PUR 3,000 Value Added Tax VAT 600 Accounts Payables A/ P 3,600 (purchase of soap: 300 × 10 GBP) @ 31.12.20X4 (6) Depreciation-20X4 DPR 28,000 Accumulated Depreciation ACC 28,000 (depreciation on assets in the Assembling department) @ 31.12.20X4 (7) Depreciation-20X4 DPR 1,000 Accumulated Depreciation ACC 1,000 (depreciation on assets in the Cleaning department) @ 31.12.20X4 (8) Depreciation-20X4 DPR 2,000 Accumulated Depreciation ACC 2,000 (depreciation on assets in the Packaging department) @ 30.06.20X4 (9) Labour-20X4 LAB 40,000 Cash/ Bank C/ B 40,000 (wages in the Assembling department) @ 30.06.20X4 (10) Labour-20X4 LAB 30,000 Cash/ Bank C/ B 30,000 (wages in the Cleaning department) @ 30.06.20X4 (11) Labour-20X4 LAB 25,000 Cash/ Bank C/ B 25,000 (wages in the Packaging department) <?page no="339"?> Berkau: Financial Statements 9e 12-339 @ 30.06.20X4 (12) Labour-20X4 LAB 55,000 Cash/ Bank C/ B 55,000 (salary in the Administration department) @ 1.07.20X4 (13) Cash/ Bank C/ B 2,052,000 Value Added Tax VAT 342,000 Revenue-20X4 REV 1,710,000 (revenue recognition for 28,500 espresso machines at 60 GBP) In preparation of the Trading account, SUIDHUIZEN PLC measures closing stock. It accrues the values below to inventory and makes three credit entries for closing stock in the Trading account. for CCDUs: 3,000 × 14 = 442,000 GBP. for water pumps: 10,000 × (20,000 × 9.50 + 20,000 × 10.50) / 40,000 = 100,000 GBP. for finished goods a product calculation is required. SUDHUIZEN PLC carries the left espresso machines based on annual average purchase costs for materials and adds depreciation and labour. Furthermore, the opening value for 100 espresso machines is considered for the average cost calculation, see below. We calculate the unit cost of manufacturing in a working. It is based on CCDU costs, average water pump costs, box costs, and manufacturing overheads which consist of depreciation and labour: 14 + (20,000 × 9.50 + 20,000 × 10.50) / 40,000 + 1 + 0.10 + (31,000 + 95,000) / 30,000 = 14 + 10 + 1 + 0.1 + 4.2 = 2 29.30 GBP/ p. The closing stock of 1,600 espresso machines measured based on the average cost of manufacturing and weighted by the amount of the opening stock and the production volume in 20X4 is: 1,600 × (100 × 30 + 29.30 × 30,000) / 30,100 = 4 46,883.72 GBP. Find below SUDHUIZEN PLC’s accounts and the income statement in Figure 12.6 and Figure 12.7, respectively. The changes in inventories of finished goods are inputs less stock releases for 100 espresso machines from the previous period: 46,883.72 - 3,000 = 4 43,883.72 GBP. D C D C OV 100,000 c/ d 100,000 (1) 420,000 P&L 853,000 b/ d 100,000 (2) 190,000 (3) 30,000 (4) 210,000 (5) 3,000 853,000 853,000 Property, Plant, Equipment PPE Purchase-20X4 PUR Figure 12.6: SUDHUIZEN PLC’s accounts (NoE) <?page no="340"?> Berkau: Financial Statements 9e 12-340 D C D C c/ d 3,600 (5) 3,600 OV 42,000 P&L 42,000 b/ d 3,600 P&L 42,000 c/ d 42,000 84,000 84,000 b/ d 42,000 Accounts payables A/ P Inventory CCDU ICC D C D C P&L 100,000 c/ d 100,000 OV 3,000 P&L 3,000 b/ d 100,000 P&L 46,884 c/ d 46,884 49,884 49,884 b/ d 46,884 Inventory water pump IWP Finished goods inventory FGI D C D C (1) 84,000 (13) 342,000 OV 5,000 (1) 504,000 (2) 38,000 (13) 2,052,000 (2) 228,000 (3) 6,000 (3) 36,000 (4) 42,000 (4) 252,000 (5) 600 (9) 40,000 c/ d 171,400 (10) 30,000 342,000 342,000 (11) 25,000 b/ d 171,400 (12) 55,000 c/ d 887,000 2,057,000 2,057,000 b/ d 887,000 Value added tax VAT Cash/ Bank C/ B D C D C c/ d 50,000 OV 50,000 c/ d 100,000 OV 100,000 b/ d 50,000 b/ d 100,000 Share capital ISS Reserves RES D C D C P&L 1,710,000 (13) 1,710,000 (12) 55,000 P&L 55,000 Sales revenue-20X4 REV Administration-20X4 ADM Figure 12.6: SUDHUIZEN PLC’s accounts (NoE) continued <?page no="341"?> Berkau: Financial Statements 9e 12-341 D C D C (6) 28,000 P&L 31,000 (6) 28,000 (7) 1,000 (7) 1,000 (8) 2,000 c/ d 31,000 (8) 2,000 31,000 31,000 31,000 31,000 b/ d 31,000 Depreciation-20X4 DPR Accumulated depreciation ACC D C D C (9) 40,000 P&L 95,000 c/ d 245,965 P&L 245,965 (10) 30,000 b/ d 245,965 (11) 25,000 95,000 95,000 Labour-20X4 LAB Income tax liabilities ITL D C D C FGI 3,000 Rev 1,710,000 c/ d 573,919 R/ E 573,919 ICC 42,000 FGI 46,884 b/ d 573,919 PUR 853,000 ICC 42,000 M/ A 55,000 IWP 100,000 LAB 95,000 DPR 31,000 EBT 819,884 1,898,884 1,898,884 ITL 245,965 b/ d 819,884 R/ E 573,919 819,884 819,884 Profit and Loss-20X4 P&L Retained earnings R/ E Figure 12.6: SUDHUIZEN PLC’s accounts (NoE) continued <?page no="342"?> Berkau: Financial Statements 9e 12-342 [GBP] Revenue 1,710,000 Changes in inventory 43,884 1,753,884 Materials (753,000) Labour (150,000) Depreciation (31,000) Other expenses 0 Earnings before int. & taxes (EBIT) 819,884 Interest 0 Earnings before taxes (EBT) 819,884 Income tax expenses (245,965) Deferred taxes 0 Earnings after taxes (EAT) 573,919 Sudhuizen PLC STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 12.7: SUDHUIZEN PLC’s income statement (NoE) On SUDHUIZEN PLC’s statement of profit or loss and other comprehensive income, aggregated costs are disclosed, e.g., labour (wages for Manufacturing as well as salary for Administration), depreciation (on all machines together). The increase in finished goods is based on a calculation of unit costs and considers the stock release of finished goods and the production volume of espresso machines. Next, we discuss the cost of sales format starting again with the case study ABINGTON Ltd. 12.6 C/ S ABINGTON Ltd. - Cost of Sales Format We repeat the profit calculation for ABINGTON Ltd. but prepare the income statement in cost of sales COSformat. The cost of sales format requires cost allocations to goods/ services which causes extra Accounting work. Under the cost of sales format, costs are allocated multiple times before they become cost of manufacturing for the final product. Manufacturers apply job orders and cost centres as interim cost allocation objects and consider complex n: m-relationhips. The allocation sequence for direct costs is from job orders to finished goods and for overheads it is from cost centres to job orders to finished goods. In the end, a company only shows the cost of manufacturing but does not disclose line items for depreciation or materials on its income statement as they are included already in the cost of manufacturing. Note, Business and Management and in particular Accounting originate from Industrial Management, therefore, many technical terms are linked to manufacturing. A law firm would not use the term job <?page no="343"?> Berkau: Financial Statements 9e 12-343 order but mandate instead, however it applies the Work-in-Process accounts as a reconciliation account for its services. An income statement based on the cost of sales format for a one-service company is significantly easier than for a manufacturer that produces different goods in several batches. Under the cost of sales format, we deduct only the expenses for finished goods sold from revenues, to calculate the profit before tax. See below the profit calculation structure following the cost of sales format: Revenue + Other Income = Total Income ./ . Cost of Goods Sold ./ . Other expenses = Earnings before Interest and Tax (EBIT) ./ . Interest = Pretax Profit (EBT) ./ . Income tax = Annual Surplus (EAT) ABINGTON Ltd. only renders one service: the legal transfer of property. Its costs are either linked to conveyance or are common costs to be disclosed separately on the income statement as nonmanufacturing overheads. At ABINGTON Ltd. the attorneys’ salary is divided into direct costs for conveyancing and overheads for administrative work. Note, the opposite of direct costs is overheads. Direct costs are given here at 680 AUD/ mandate. We calculate direct labour for all mandates: 700 × 680 = 476,000 AUD. The attorney costs are direct costs because an attorney represents the property buyer in court which establishes a n : 1 relationship between attorney and mandate. An Attorney represents n mandates, but a mandate is represented by one attorney. The remainder of the attorneys’ costs of: 510,000 - 476,000 = 3 34,000 AUD is dedicated to internal administration, e.g., preparing labour contracts with future colleagues or negotiating lease with the lessors etc. In contrast to attorneys, the paralegals work as specialists for certain functions, e.g., document preparation, maintaining contact with the deed’s office etc. Therefore, the paralegals’ labour is recorded as manufacturing overheads. The work of the paralegals establishes a n : m relationship between mandate and paralegal. This rectifies the cost term overheads. We do not repeat all Bookkeeping entries but start-off from initial Bookkeeping entries as shown in Figure 12.1. This is the situation before profit is calculated. The cost of sales format requires a product/ service calculation, here: the costs per property transfer. The reference unit for the property transfers is the number of mandates. The Work-in-Process account and the Manufacturing Overhead account apply. All direct costs are closed-off to the WIPaccount which are here the costs for the salary of attorneys: 680 × 700 = 4 476,000 AUD. The attorneys’ contribution to administration to the extent of 34,000 AUD <?page no="344"?> Berkau: Financial Statements 9e 12-344 is accrued to the Administration account. Observe the Bookkeeping entries below. @ 31.12.20X4 Work-in-Process-20X4 WIP 476,000 Labour Attorney-20X4 LAA 476,000 (accumulation of attorneys' costs to WIP) Administration-20X4 ADM 34,000 Labour Attorney-20X4 LAA 34,000 (closing-off the Labour Attorney account to Administration account) The salary of paralegals is completely service related; that means caused by conveyancing procedures. The same applies for operational expenses. Both are transferred to the Manufacturing Overheads account. @ 31.12.20X4 Manufacturing Overheads-20X4 MOH 760,000 Labour Paralegals-20X4 LAP 760,000 (transfer of paralegal costs to the MOH-account) Manufacturing Overheads-20X4 MOH 160,500 Operational Expenses-20X4 OEX 160,500 (transfer of operational expenses to the MOH-account) The application of overheads from the Manufacturing Overheads account towards the Work-in-Process account is based on the predetermined cost rate of 1,300 AUD/ mandate. ABINGTON Ltd. budgeted 150,000 AUD operational costs only and determined a cost rate based on 700 mandates of: (760,000 + 150,000) / 700 = 11,300 AUD/ mandate (given). We allocate: 700 × 1,300 = 910,000 AUD to the Work-in-Process account which results in an underapplication of overheads and requires transferring not applied overheads to the Profit and Loss account: 920,500 - 910,000 = 10,500 AUD. The Work-in-Process account is closedoff at first to the Cost of Goods Sold account and thereafter to the Profit and Loss account. Note, a service provider cannot store provided services so, we can skip the Cost of Goods Sold account. Observe below the calculation of services in the Work-in-Process account and the income statement in Figure 12.8 and Figure 12.9, respectively. <?page no="345"?> Berkau: Financial Statements 9e 12-345 D C D C . . . (2) 60,000 OV 5,000 (1) 5,000 (6) 3,024,000 (3) 510,000 RNT 5,000 (7) 20,000 (4) 760,000 (5) 192,600 c/ d 1,521,400 3,044,000 3,044,000 b/ d 1,521,400 Cash/ Bank C/ B Prepaid expenses PRE D C D C (1) 5,000 (3) 510,000 c/ d 510,000 (2) 60,000 c/ d 65,000 b/ d 510,000 WIP 476,000 65,000 65,000 ADM 34,000 b/ d 65,000 PRE 5,000 510,000 510,000 c/ d 60,000 65,000 65,000 b/ d 60,000 P&L 60,000 Rent-20X4 RNT Labour Attorneys-20X4 LAA D C D C (4) 760,000 c/ d 760,000 (5) 160,500 c/ d 160,500 b/ d 760,000 MOH 760,000 b/ d 160,500 MOH 160,500 Labour Paralegals-20X4 LAP Operational expenses-20X4 OEX D C D C P&L 2,520,000 (6) 2,520,000 (5) 32,100 (6) 504,000 c/ d 471,900 504,000 504,000 b/ d 471,900 Revenue-20X4 REV Value added tax VAT D C D C LAA 476,000 COS 1,386,000 LAP 760,000 WIP 910,000 MOH 910,000 OEX 160,500 P&L 10,500 1,386,000 1,386,000 920,500 920,500 Work-in-Process-20X4 WIP Manufacturing overheads-20X4 MOH D C D C LAA 34,000 P&L 34,000 WIP 1,386,000 P&L 1,386,000 Administration-20X4 ADM Cost of Sales-20X4 COS Figure 12.8: ABINGTON Ltd.’s accounts (COS) <?page no="346"?> Berkau: Financial Statements 9e 12-346 D C D C COS 1,386,000 REV 2,520,000 c/ d 314,850 P&L 314,850 ADM 34,000 I/ I 20,000 b/ d 314,850 MOH 10,500 RNT 60,000 EBT 1,049,500 2,540,000 2,540,000 ITL 314,850 b/ d 1,049,500 R/ E 734,650 1,049,500 1,049,500 Profit and Loss-20X4 P&L Income tax liabilities ITL D C D C P&L 20,000.00 (7) 20,000.00 c/ d 734,650.00 P&L 734,650.00 b/ d 734,650.00 Interest income-20X4 I/ I Income tax liabilities ITL Figure 12.8: ABINGTON Ltd.’s accounts (COS) continued [AUD] Revenue 2,520,000 Other income 20,000 2,540,000 COS and UAO (1,396,500) Other expenses (94,000) Earnings before int. & taxes (EBIT) 1,049,500 Interest 0 Earnings before taxes (EBT) 1,049,500 Income tax expenses (314,850) Deferred taxes 0 Earnings after taxes (EAT) 734,650 Abington Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 12.9: ABINGTON Ltd.’s income statement (COS) The income statement shows the total expenses attributable to conveyancing services and further expenses for administration and rent. ABINGTON Ltd. discloses the interest income from the bonds as other income. We combined the cost of property transfer and the underapplied manufacturing overheads (COS and UAO) as the increase of overheads is service related (operational expenses). 12.7 C/ S SUDHUIZEN PLC - Cost of Sales Format As the last case, we study the income statement for SUDHUIZEN PLC following the cost of sales format. For the cost of <?page no="347"?> Berkau: Financial Statements 9e 12-347 sales format, we replace the inventory movement system by a perpetual system. Therefore, we could add purchases to the inventory accounts for CCDUs, water pumps, boxes, and cleaning soap directly. Note, the accounts are copied directly from the case study on the nature of expense method. For that reason, the purchase account is maintained. Otherwise, we could not have copied the thirteen previous Bookkeeping entries. SUDHUIZEN PLC prepares a profit calculation based on one job order account (WIP account) and three Manufacturing Overhead accounts - one account per department. We only show the Bookkeeping entries made for CCDUs. The stock release of CCDUs and accrual to the WIP-account is measured at: 30,000 × 14 = 4 420,000 GBP. Observe the two Bookkeeping entries below for the CCDUs. @ 2.01.20X4 Inventories CCDUs ICC 420,000 Purchases-20X4 PUR 420,000 (transfer of purchase of CCDUs to stock) @ 30.06.20X4 Work-in-Process-20X4 WIP 420,000 Inventories CCDUs ICC 420,000 (stock release of CCDUs and their accumulation to WIP) The other materials are recorded in the same way. The overheads, labour and depreciation are added to the Manufacturing Overhead accounts because they are production related. An exception are the salaries for Administration. Observe below the Bookkeeping entry for the overhead application with a debit entry in the job order and a credit entry for the Assembling department. @ 30.06.20X4 Manufacturing OH Assembl-20X4 MOA 40,000 Labour-20X4 LAB 40,000 (transfer of labour costs to the Assembling department) Manufacturing OH Assembl-20X4 MOA 28,000 Depreciation-20X4 DPR 28,000 (transfer of depreciation to the Assembling department) Labour and depreciation are allocated to the Cleaning and Shipping department in the same way. Note, a Manufacturing Overhead account represents a cost centre or a department, whereas a Work-in-Process account stands for the job order or the product which is produced. Here, the application of overheads does not cause overnor underapplications. <?page no="348"?> Berkau: Financial Statements 9e 12-348 See the Bookkeeping entries for the application of overheads in the Assembling department: @ 30.06.20X4 Work-in-Process-20X4 WIP 68,000 Manufacturing OH Assembl-20X4 MOA 68,000 (application of overheads from assembling: 40,000 + 28,000 = 68,000 GBP ) The application of manufacturing overheads in the other departments is recorded in the same way. In a Job Order Costing system, the costs of manufacturing are transferred from the Work-in-Process account to the Finished Goods Inventory account after production is completed and finished goods have been put on stock. See the Work-in-Process account in Figure 12.10 for the calculation of espresso machines. Below we show the Bookkeeping entry for putting 30,000 espresso machines on stock. @ 30.06.20X4 Finished Goods Inventories FGI 879,000 Work-in-Process-20X4 WIP 879,000 (accumulation the batch of espresso machines to finished goods inventories) With a perpetual inventory system, we make two Bookkeeping entries per sale. One is for the cash receipt, and the other one is for the stock release. The inventory movement accrues 28,500 espresso machines to the Cost of Goods Sold account measured at their cost of manufacturing. We calculate the cost of manufacturing per unit by dividing the total costs of manufacturing by the lot size: 879,000 / 30,000 = 2 29.30 GBP/ u. Under consideration of the opening stock, the stock release at the time of sale is measured at weighted average costs: 28,500 × (100 × 30 + 30,000 × 29.30) / 30,100 = 835,116.28 GBP. At SUDHUIZEN PLC, we pretend that there is one sale for all espresso machines together (to simplify the case). Selling takes place after completion of production. See below both Bookkeeping entries: <?page no="349"?> Berkau: Financial Statements 9e 12-349 @ 1.07.20X4 Cash/ Bank C/ B 2,052,000 Value Added Tax VAT 342,000 Revenue-20X4 REV 1,710,000 (revenue recognition for 28,500 espresso machines at 60 ZAR/ u) Cost of Goods Sold-20X4 COS 835,116 Finished Goods Inventories FGI 835,116 (stock release of 28,500 espresso machines at weighted average costs) Profit and Loss-20X4 P&L 835,116 Cost of Goods Sold-20X4 COS 835,116 (sold espresso machines expensed) After the sale, we prepare the profit calculation in SUDHUIZEN PLC’s books. The profit is the same as calculated by the nature of expense method. Observe the profit calculation based on the accounts displayed in Figure 12.10. D C D C OV 100,000 c/ d 100,000 (1) 420,000 ICC 420,000 b/ d 100,000 (2) 190,000 IWP 400,000 (3) 30,000 IBX 30,000 (4) 210,000 ISP 3,000 (5) 3,000 853,000 853,000 Property, Plant, Equipment PPE Purchase-20X4 PUR D C D C c/ d 3,600 (5) 3,600 OV 42,000 WIP 420,000 b/ d 3,600 PUR 420,000 c/ d 42,000 462,000 462,000 b/ d 42,000 Accounts payables A/ P Inventory CCDU ICC D C D C PUR 400,000 WIP 300,000 PUR 30,000 WIP 30,000 c/ d 100,000 400,000 400,000 b/ d 100,000 Inventory water pump IWP Inventory box IBX Figure 12.10: SUDHUIZEN PLC’s accounts (COS) <?page no="350"?> Berkau: Financial Statements 9e 12-350 D C D C PUR 3,000 WIP 3,000 OV 3,000 COS 835,116 WIP 879,000 c/ d 46,884 882,000 882,000 b/ d 46,884 Inventory soap ISP Finished goods inventory FGI D C D C (1) 84,000 (13) 342,000 OV 5,000 (1) 504,000 (2) 38,000 (13) 2,052,000 (2) 228,000 (3) 6,000 (3) 36,000 (4) 42,000 (4) 252,000 (5) 600 (9) 40,000 c/ d 171,400 (10) 30,000 342,000 342,000 (11) 25,000 b/ d 171,400 (12) 55,000 c/ d 887,000 2,057,000 2,057,000 b/ d 887,000 Value added tax VAT Cash/ Bank C/ B D C D C c/ d 50,000 OV 50,000 c/ d 100,000 OV 100,000 b/ d 50,000 b/ d 100,000 Share capital ISS Reserves RES D C D C D P&L 1,710,000 (13) 1,710,000 (12) 55,000 P&L 55,000 Revenue-20X4 REV Administration-20X4 ADM D C D C (6) 28,000 MOA 28,000 (6) 28,000 (7) 1,000 MOC 1,000 (7) 1,000 (8) 2,000 MOS 2,000 c/ d 31,000 (8) 2,000 31,000 31,000 31,000 31,000 b/ d 31,000 Depreciation-20X4 DPR Accumulated depreciation ACC Figure 12.10: SUDHUIZEN PLC’s accounts (COS) - continued <?page no="351"?> Berkau: Financial Statements 9e 12-351 D C D C (9) 40,000 MOA 40,000 FGI 835,116 P&L 835,116 (10) 30,000 MOC 30,000 (11) 25,000 MOS 25,000 95,000 95,000 Labour-20X4 LAB Cost of goods sold-20X4 COS D C D C ICC 420,000 FGI 879,000 LAB 40,000 WIP 68,000 IWP 300,000 DPR 28,000 MOA 68,000 68,000 68,000 ISP 3,000 MOC 31,000 IBX 30,000 MOP 27,000 879,000 879,000 Work-in-process-20X4 WIP MOH Assembling MOA D C D C LAB 30,000 WIP 31,000 LAB 25,000 WIP 27,000 DPR 1,000 DPR 2,000 31,000 31,000 27,000 27,000 MOH Cleaning MOC MOH Packaging MOP D C D C COS 835,116 REV 1,710,000 c/ d 573,919 P&L 573,919 M/ A 55,000 b/ d 573,919 EBT 819,884 1,710,000 1,710,000 ITL 245,965 b/ d 819,884 R/ E 573,919 D C 819,884 819,884 c/ d 245,965 P&L 245,965 b/ d 245,965 Income tax liabilities Profit and Loss-20X4 P&L Retained earnings R/ E Figure 12.10: SUDHUIZEN PLC’s accounts (COS) continued The accounts following a Process Costing for the case of SUDHUIZEN PLC are accessible through Link 12.B below. <?page no="352"?> Berkau: Financial Statements 9e 12-352 Link 12.B: SUDHUIZEN PLC Below, the income statement based on the cost of sales format is disclosed: As the cost of sales format does not support information about expense types but is based on allocations to cost objects, a reporting company must provide additional information about its expenses in compliance with IAS 1.105. In the case of SUDHUIZEN PLC, the income statement as displayed in Figure 12.11 would require further disclosure about labour and depreciation in the notes. [GBP] Revenue 1,710,000 Cost of goods sold (835,116) Other expenses (55,000) Earnings before int. & taxes (EBIT) 819,884 Interest 0 Earnings before taxes (EBT) 819,884 Income tax expenses (245,965) Deferred taxes 0 Earnings after taxes (EAT) 573,919 Sudhuizen PLC STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 12.11: SUDHUIZEN PLC’s income statement (COS) 12.8 Summary IAS 1.82 determines what is disclosed on the statement of profit or loss and other comprehensive income. IAS 1.99 requires a reporting company to present an analysis of recognised expenses either based on nature of expenses or cost of sales. A structure for the nature of expense method is provided in IAS 1.102, another one for the cost of sales format follows in IAS 1.103. Both formats for the income statement result in the same profit or loss and other comprehensive income. 12.9 Working Definitions Accrual Basis of Accounting: Principle by which income and expenses are assigned to the period they are for, regardless of when payments or receipts take place. Cost of Sales: Format for the presentation of a statement of profit or loss <?page no="353"?> Berkau: Financial Statements 9e 12-353 which classifies expenses based on functions. Gain: Extraordinary income. Income: Increase of economic benefits during an Accounting period. Income can result from sales revenue or gains. Income Statement: Statement of profit or loss and other comprehensive income. Nature of Expense Method: Format for the presentation of a statement of profit or loss which classifies expenses based on cost categories. Other Comprehensive Income: Revenue that results from gains, e.g., gain on disposals of non-current assets. Product: Finished good or service. Revenue: Net amount of proceeds which are received as compensation for the sale of goods/ services. 12.10 Question Bank (1) A company records an opening value of finished goods of 350 EUR and a closing stock of 120 EUR. The revenue is amounting to 1,000 EUR. Operational expenses are 200 EUR. How much is the profit before income taxes? 1. 1,030 EUR . 2. 680 EUR . 3. 570 EUR . 4. 1,150 EUR . (2) A company prepares the income statement based on the cost of sales format. Revenues for its products A and B are 100,000 EUR and 350,000 EUR, respectively. The cost of sales are 80,000 EUR and 200,000 EUR, respectively. How much are the sales margins for its products A and B? 1. Nil. 2. -20,000 EUR and -150,000 EUR. 3. 150,000 EUR and 20,000 EUR. 4. 20,000 EUR and 150,000 EUR . (3) A company prepares its income statement following the nature of expense format. It applies the firstin-first-out cost formula. Its opening balance of finished goods is 2,750 EUR resulting from 200 goods at cost of manufacturing of 11 EUR/ u. In the actual accounting period, the company produced goods of the same kind in two batches: 1,000 × 11.50 EUR/ u and 1,000 × 12,00 EUR/ u. The sales amount is 1,900. How much are the changes in finished goods to be disclosed on the income statement? 1. 1,450 EUR . 2. 4,200 EUR . 3. 3,950 EUR . 4. 3,000 EUR . (4) A company spends 50,000 EUR on materials (net amount) and 70,000 EUR on direct labour. The applied overheads are 40,000 EUR. This is an over-application of overheads to the extent of 10 % based on the applied amount. During the Accounting period, 800 goods are manufactured. 100 thereof are faulty and disposed after putting in stock. The company sells 622 of the goods. How much are the cost of sales if overapplied overheads are deducted from cost of sales and unapplied overheads are added thereto? <?page no="354"?> Berkau: Financial Statements 9e 12-354 1. 124,400 EUR . 2. 125,975 EUR . 3. 128,400 EUR . 4. 120,400 EUR . (5) A manufacturer discloses an opening value of finished goods on its balance sheet of 400 × 10 = 4,000 EUR. During the Accounting period, the costs of manufacturing are constantly 11,00 EUR/ u. The production volume is 10,000 units from which 9,500 units are sold. How much are changes in inventories of finished goods if first-in-first-out cost formula applies? 1. 5,500 EUR . 2. 9,900 EUR . 3. 4,400 EUR . 4. 9,500 EUR . 12.11 Solutions 1-3, 2-4, 3-1, 4-4, 5-2. <?page no="355"?> Berkau: Financial Statements 9e 13-355 13 Statement of Changes in Equity 13.1 What is in the Chapter? The statement of changes in equity discloses changes of the book value of a company that occurred during the reported Accounting period. Events changing equity are: share issues/ redemptions, profits and other income earned and appropriated, and revaluation of non-current assets. The statement of changes in equity supports investors to make reasonable economic decisions, e.g., about buying or selling shares of the reporting company. We cover here the preparation of a statement of changes in equity for the case study BELMONT Ltd., a sharebased gym in Gqeberha (former: Port Elizabeth). We discuss business activities which affect its equity: Share issue, recording treasury stock after a buyback of ordinary shares, dividend receipts from an investment in an associated company, profit earned, the appropriation of profits as well as a revaluation of non-current assets. We refer in this chapter to the major IFRS standards and paragraphs for the preparation and disclosure of the statement of changes in equity and the information requirements in the notes about equity. 13.2 Learning Objectives After studying this chapter, you can read statement of changes in equity from other enterprises and prepare your own. You know reporting requirements for equity disclosure and 99 IAS 8 rules changes in Accounting policies, estimates and errors. can assess the impact of various business activities towards changes of a company’s book value. You get familiarised with the major IFRS regulations about the statement of changes of equity and know equity disclosure requirements. 13.3 IFRS Regulations No IFRS standard is solely dedicated to the statement of changes in equity. The most important regulations can be found in IAS 1.106 -1.110. Therein, the IASB mandates that a reporting company must prepare a statement of changes in equity as part of a full set of financial statements. IAS 1.106 requires the disclosure of information about equity changes, e.g., other income, effects of changes in Accounting policies and method parameters in connected with IAS 8 99 , profit or loss from business activities as well as transactions with owners. In compliance with IAS 1.106A and IAS 1.107, a company must provide a detailed view on other comprehensive income and on dividends - either in the notes or on the statement of changes in equity. We observe BELMONT Ltd. preparing its statement of changes in equity step by step. A statement of changes in equity shows line items for: (1) Share issue/ treasury shares. (2) Profit or loss. (3) Other comprehensive income. (4) Revaluations of assets. (5) Appropriation of profits. <?page no="356"?> Berkau: Financial Statements 9e 13-356 Items of equity as on the balance sheet are presented by columns on the statement of changes in equity. Note, for academic purpose, we recommend the preparation of a statement of changes in equity by MS-Excel using the group function on columns. That way, a statement of changes in equity includes the total of detailed items, e.g. the total of reserves based on capital, revaluation, and earnings reserves, which can be opened and closed. After the introduction of the case study BELMONT Ltd., we start with the opening equity values and add lines to the statement for each equity change. After line additions we disclose an interim status of the statement of changes in equity in Figure 13.2 to Figure 13.7., which allows following its development. For the case study BELLMONT Ltd. we prepared a statement of changes in equity which is more in the details as printed in the textbook. For the preparation of the exhibits in this chapter, we hide the detailed information to keep the statement narrow. The Link 13.A leads to the original Excel file which contains the details. 13.4 C/ S BELMONT Ltd. Below the description of BELMONT Ltd. is following as a data sheet. Link 13.A: BELMONT Ltd. Data Sheet for BELMONT Ltd. Domicile: South Africa (Gqeberha, PE). Reporting currency: ZAR. Classification: service provider. Reporting period: 20X7. Issued capital: 1,000,000 ordinary shares at 1 ZAR/ share. Issue of 500,000 preference shares at 1 ZAR/ share on 31.03.20X7, issue price: 1.50 ZAR/ share; dividend claim: 7 %/ a based on face value. Share buy-back on 1.10.20X7: 200,000 ordinary shares at 2.05 ZAR/ share. Profit after taxes (20X7): 490,000 ZAR. Other income (20X7): gain on disposal of treadmills before income tax 100,000 ZAR. Dividend income from 40 %-cafeteria ownership (20X7): 32,000 ZAR. Asset revaluation; value increase for bikes: 15,000 ZAR. Appropriation of profits: preference dividends; ordinary dividend 0.05 ZAR/ share; 100,000 ZAR added to earnings reserves. VAT ignored. BELMONT Ltd. is a gym in Gqeberha. The limited company is based on 1,000,000 ordinary shares at 1 ZAR/ share each. As per 1.01.20X7, BELMONT Ltd. discloses the balance sheet shown in Figure 13.1. <?page no="357"?> Berkau: Financial Statements 9e 13-357 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 800,000 Share capital 1,000,000 Intangibles Reserves 400,000 Investment 400,000 Retained earnings (150,000) Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables 200,000 Short-term liab. A/ P 250,000 Prepaid expenses Provisions Cash/ Bank 100,000 Income tax liab. Total assets 1,500,000 Total equity and liab. 1,500,000 Belmont Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 13.1: BELMONT Ltd.’s balance sheet (20X6) The equity section of the balance sheet provides the figures for the first line of the statement of changes in equity already. The total of equity is: 1,000,000 + 400,000 - 150,000 = 1 1,250,000 ZAR. The value includes issued capital at face values, the earnings reserves and a loss carried forward. 100 Observe below in Figure 13.2 the first line of the statement of changes in equity. The header indicates that the statement is prepared for its disclosure as per 31.12.20X7. We continue its preparation over the Accounting period and stick to the reporting date; the figures in brackets on the captions indicate the progress in preparation. Below, you find the statement of changes in equity, after step (1) - entering the opening values as copied from the balance sheet was carried out: Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Belmont Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.2: BELMONT Ltd.’s statement of changes in equity (1) 100 BELMONT Ltd. could have dissolved its earnings reserves to compensate for the loss from the previous year(s), but it is not obliged to do so. <?page no="358"?> Berkau: Financial Statements 9e 13-358 13.5 C/ S BELMONT Ltd. - Share Issue/ Treasury Shares On 31.03.20X7, BELMONT Ltd. issues 500,000 preference shares at 1 ZAR/ share. The preference shares come with a 7 %/ a dividend claim based on their nominal value. Due to the share issue on 31.03.20X7, the preference dividend claim in 20X7 only is (9/ 12) of the annual amount - if a preference dividend is declared on the annual general meeting. BELMONT Ltd. issues the shares at an issue price of 1.50 ZAR/ share 101 . As the issue price for the preference shares exceeds their nominal value, a premium of: 1.50 - 1 = 0 0.50 ZAR/ preference share is accrued to capital reserves. This gives: 500,000 × 0.50 = 2250,000 ZAR. The simplified Bookkeeping entry for the preference share issue is shown below 102 : @ 31.03.20X7 Cash/ Bank C/ B 750,000 Issued Capital Pref ISP 250,000 Capital Reserves C-R 500,000 (issue of 500,000 preference shares at an issue price of 1.50 ZAR/ s) Next, we discuss a share buy-back. Repurchasing own shares takes the shares from the market and excludes them from gaining dividend income. A share brought back is never an asset as the issuing company cannot act as its own shareholder. Therefore, treasury stock is disclosed as a negative equity item on the balance sheet as well as on the statement of changes in equity. This affects ratio calculations, check chapter (5) for the details. IAS 32.33 rules recognition and measurement for treasury stock. The shares are deducted from equity following the acquisition method, meaning at values derived from the consideration paid. On 1.10.20X7, BELMONT Ltd. buys 200,000 of its own (ordinary) shares back. The share price is 2.05 ZAR/ share at that time. No changes of capital reserves apply as BELMONT Ltd. does not redeem its treasury stock. The share buy-back is not recorded through profit or loss. See below the Bookkeeping entry. @ 1.10.20X7 Treasury Stock Account TSA 410,000 Cash/ Bank C/ B 410,000 (share buy-back of 200,000 ordinary shares at 2.05 ZAR/ s) The statement of changes in equity is disclosed in Figure 13.3 after the issue of BELMONT Ltd.’s 500,000 preference 101 For share issues, study our textbook Basics of Accounting, chapter (14). shares and the buy-back of 200,000 ordinary shares. For each transaction type, we disclose a single line item on the statement of changes in equity. Would a 102 A share issue requires applying an Application and Allotment account, see out textbook Basics of Accounting, chapter (33). <?page no="359"?> Berkau: Financial Statements 9e 13-359 company carry out multiple share issues, it combines them in one line item. We do not offset issues and buy-backs of shares, nor do we combine transactions linked to different classes of shares. Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Treasury shares (410,000) (410,000) Belmont Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.3: BELMONT Ltd.’s statement of changes in equity (2) 13.6 C/ S BELMONT Ltd. - Profit or Loss BELMONT Ltd. earns an operating profit after taxes of: 700,000 × (1 - 30%) = 490,000 ZAR. Note, the operating profit is linked to the core business of the company. No dividend or interest income is included. The annual surplus is accrued to the Retained Earnings account. The earnings after taxes exceed the loss carried forward. Therefore, a positive distributable amount exists from which dividends can be declared to the shareholders. See below the abridged Bookkeeping entry (The recording of income taxes does not matter for the statement of changes in equity in this chapter.). @ 31.12.20X7 Profit and Loss-20X7 P&L 490,000 Retained Earnings R/ E 490,000 (accumulating the annual surplus to equity under retained earnings) In Figure 13.4., we show the statement of changes in equity after recording profit. A more detailed analysis of the profit is not required for the statement of changes in equity, as the income statement discloses the details of profit calculation already. <?page no="360"?> Berkau: Financial Statements 9e 13-360 Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Ord. share redemption (410,000) (410,000) Profit 20X7 490,000 490,000 Belmont Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.4: BELMONT Ltd.’s statement of changes in equity (3) 13.7 C/ S BELMONT Ltd. - Other Comprehensive Income On 1.07.20X7, BELMONT Ltd. sells four treadmills at a total gain on disposal of 100,000 ZAR before income taxes. The gain is taxable income and leads to income tax liabilities of: 100,000 × 30% = 3 30,000 ZAR. Hence, the equity of BELMONT Ltd. increases due to the disposal of non-current assets by: 100,000 - 30,000 = 7 70,000 ZAR. We make the Bookkeeping entries relevant for equity changes below: @ 1.07.20X7 Cash/ Bank C/ B 100,000 Gain on Disposal-20X7 OCI 100,000 (disposal of treatmills) @ 31.12.20X7 Other Compreh Income 20X7 OCI 70,000 Retained Earnings R/ E 70,000 (accumulating the gain on disposal after income tax towards equity) BELMONT Ltd. holds an investment of a cafeteria on its premises. It owns 40 % of BELMONT-DINER (Pty) Ltd. The cafeteria chef owns the remainder interest. BELMONT-DINER (Pty) Ltd. pays a 40 % portion of its profit (after taxation) to BELMONT Ltd. which is: 80,000 × 40% = 32,000 ZAR. The dividend income is classified as other comprehensive income from investment. Income taxes do not apply. No dividend tax (tax on capital returns) applies for BELMONT Ltd. either as it is a company and no private investor. We recognise the investment income as extraordinary gain for BELMONT Ltd. and add it to equity: <?page no="361"?> Berkau: Financial Statements 9e 13-361 @ 31.12.20X7 Cash/ Bank C/ B 32,000 Subsidiary Income-20X7 OCI 32,000 (recognition of income from BELMONT-DINER (Pty) Ltd.) Other Compreh Income 20X7 OCI 32,000 Retained Earnings R/ E 32,000 (accumulating income from the interest in BELMONT-DINER (Pty) Ltd. to equity) See in Figure 13.5 the statement of changes in equity at BELMONT Ltd. at this stage (4). Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Ord. share redemption (410,000) (410,000) Profit 20X7 490,000 490,000 OCI gain on disposal 70,000 70,000 OCI cafeteria income 32,000 32,000 Belmont Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.5: BELMONT Ltd.’s statement of changes in equity (4) 13.8 C/ S BELMONT Ltd. - Revaluations On 20.12.20X7, BELMONT Ltd. records a revaluation of its cycling-equipment. The stationary bikes are carried in total at 50,000 ZAR on 1.01.20X7. During the Accounting period 20X7, a depreciation of 10,000 ZAR is recognised. Therefore, the stationary bikes are carried at 40,000 ZAR before the revaluation occurs. BELMONT Ltd. revalues the stationary bikes by 15,000 ZAR. The new value as estimated by a qualified appraiser is 55,000 ZAR. The simplified Bookkeeping entry is recorded as below and follows the net replacement Bookkeeping entry format. @ 20.12.20X7 P, P, E at Valuation PPV 55,000 Accumulated Depreciation ACC 10,000 P, P, E at Cost PPE 50,000 Revaluation Reserves R-R 10,500 Deferred Tax Liabilities DTL 4,500 (revaluation of stationary bikes from 40,000 ZAR to 55,000 ZAR) <?page no="362"?> Berkau: Financial Statements 9e 13-362 The revaluation of the stationary bikes increases BELMONT Ltd.’s equity by 10,500 ZAR (after deduction of deferred tax liabilities). See in Figure 13.6 the statement of changes in equity after recognition of the revaluation reserves and their reduction for deferred tax liabilities. Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Ord. share redemption (410,000) (410,000) Profit 20X7 490,000 490,000 OCI gain on disposal 70,000 70,000 OCI cafeteria income 32,000 32,000 Revaluation 10,500 10,500 Belmont Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.6: BELMONT Ltd.’s statement of changes in equity (5) 13.9 C/ S BELMONT Ltd. - Appropriation of Profits For an appropriation of profits, there are three options: (a) declaration of dividends, (b) addition to or reduction of earnings reserves or (c) carrying profit forward. Combinations of the above options apply and might be subjected to national law. Note, the term “profit” appropriation is not precise. We do not appropriate the annual surplus but the distributable amount. A distributable amount is based on profit or loss and considers the profits or losses carried forward from prior Accounting periods, too. Furthermore, national law, e.g., German HGB, rules obligations for building reserves or their dissolving. In BELMONT Ltd.’s case, the distributable amount is: -150,000 + 490,000 + 70,000 + 32,000 = 4 442,000 ZAR. The revaluation reserves do not qualify for distribution as no profit realisation, e.g. a partial one by depreciation, occurred yet (due to the revaluation at the yearend). To pay its ordinary shareholders a dividend, BELMONT Ltd. must declare a preference dividend. This reduces the distributable amount. The preference dividend is: (9/ 12) × 7% × 500,000 = 26,250 ZAR. Due to the share issue at the end of March/ 20X7, we consider the time span of the preference shares outstanding. The distributable amount to ordinary shareholders then is: 442,000 - 26,250 = 415,750 ZAR. BELMONT Ltd. declares a dividend of 0.05 ZAR/ ordinary share. The total ordinary dividend is: 0.05 × 800,000 = 40,000 ZAR. Treasury shares are not eligible for dividend income. Per owners’ decision at the annual general meeting, 100,000 ZAR are accrued to earnings reserves. The remainder distributable amount is carried forward. See below the Bookkeeping entry for the <?page no="363"?> Berkau: Financial Statements 9e 13-363 profit appropriation and the final statement of changes in equity in Figure 13.7. 103 The recording of the profit appropriation takes place on 31.12.20X7, which is before the annual general meeting is held. This is because the financial statements are prepared under the anticipation of how the owners will decide about the appropriation of profits. @ 31.12.20X7 Retained Earnings R/ E 166,250 Preference Dividends payable A/ P 26,250 Ordinary Dividends Payable A/ P 40,000 Earnings Reserves E-R 100,000 (appropriation of profits and other income in 20X7) Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Ord. share redemption (410,000) (410,000) Profit 20X7 490,000 490,000 OCI gain on disposal 70,000 70,000 OCI cafeteria income 32,000 32,000 Revaluation 10,500 10,500 Pref. dividends (26,250) (26,250) Ord. dividends (40,000) (40,000) Additions to E-Reserves 100,000 (100,000) 0 as at 31.12.20X7 1,090,000 760,500 275,750 2,126,250 Belmont Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X7 Figure 13.7: BELMONT Ltd.’s statement of changes in equity (6) How it is Done (Statement of Changes in Equity): (1) Prepare a spreadsheet with columns for each equity item on the balance sheet. Choose either a detailed statement or disclose further information in the notes. (2) Determine and enter the equity values at the beginning of the Accounting period in the first line. (3) Add a line for share issues and make entries in the issued capital and capital reserves if shares are issued with a premium. 103 We assumed that BELMONT Ltd. pays its shareholders the gross dividend, as we pretend, that they are all private foreigners. <?page no="364"?> Berkau: Financial Statements 9e 13-364 (4) Add a line item for share buy-backs/ redemptions and make entries in the issued capital and in the reserves accordingly. (5) Add a line item for profit or loss. Enter the profit after taxation in the retained earnings column. (6) Add a line item for other comprehensive income. Enter other comprehensive income after taxation in the retained earnings column. (7) Add a line item for the appropriation of profits. Change retained earnings and make additions to reserves if applicable. Deal with dissolved reserves accordingly. (8) Add a line item for preference dividends. Reduce the retained earnings for the preference dividends declared. (9) In case of a revaluation, make additions to the Revaluation Reserves account. If revalued assets are depreciated disclose a reduction of revaluation reserves and adjust retained earnings accordingly. Consider deferred taxes. (10)Add all column items and disclose the total per line in the right column. (11)Add all line items and disclose the total on the bottom line. The bottom-line figures must be consistent with the balance sheet items on the equity section. 13.10 Summary The statement of changes in equity is required by IAS 1.10. It discloses additions and deductions for equity items on the balance sheet. The columns represent the equity items and the lines the equity changing transactions. 13.11 Working Definition Statement of Changes in Equity: A statement that discloses the additions and reductions of equity items during the Accounting period. 13.12 Question Bank (1) A company repurchases 20,000 of its ordinary shares at 34 EUR/ share. The face value is 10 EUR/ share. How does the company show the treasury shares on its balance sheet? 1. As an asset measured at 680,000 EUR. 2. As a negative capital of 680,000 EUR. 3. As an asset measured at 200,000 EUR. 4. As a negative capital of 200,000 EUR. (2) A company declares a dividend of 100,000 EUR from a distributable amount of 160,000 EUR. How is the transaction disclosed on the statement of changes in equity? <?page no="365"?> Berkau: Financial Statements 9e 13-365 1. Deduction of 100,000 EUR from totals. 2. Addition of 60,000 EUR to retained earnings. 3. Deduction of 100,000 EUR from retained earnings. 4. Deduction of 160,000 EUR from retained earnings and addition of 100,000 EUR to earnings reserves. (3) A company based on shares discloses a profit carried forward of 25,000 EUR. In the reporting period, the profit before taxation is 100,000 EUR. At its annual general meeting the shareholders declare a dividend of 50 % of the distributable amount. There are 10,000 ordinary shares. How much is the dividend per share? 1. 6.25 EUR . 2. 5.00 EUR . 3. 4.75 EUR . 4. 7.00 EUR . (4) A company re-values its noncurrent assets that are recorded at 100,000 EUR by 40 %. How is the revaluation disclosed on the statement of changes in equity? 1. Increase of reserves by 40,000 EUR and increase of retained earnings by 40,000 EUR. 2. Increase of reserves by 28,000 EUR and increase of retained earnings by 28,000 EUR. 3. Increase of reserves by 40,000 EUR. 4. Increase of reserves by 28,000 EUR. (5) A company issues 200,000 shares at 5.50 EUR/ share which include a premium of 0.50 EUR/ share. It earns a pre-tax profit of 100,000 EUR. It re-values its non-current assets by 50,000 EUR and declares a dividend of 0.20 EUR/ share. How much is its equity as disclosed on the statement of changes in equity (total)? 1. 1,160,000 EUR . 2. 1,060,000 EUR . 3. 1,165,000 EUR . 4. 1,190,000 EUR . 13.13 Solutions 1-2, 2-3, 3-3, 4-4, 5-3. <?page no="366"?> Berkau: Financial Statements 9e 14-366 14 Liabilities on the Balance Sheet 14.1 What is in the Chapter? In this last chapter or the textbook, we cover the disclosure and measurement of liabilities. In general, liabilities are disclosed on the borrowers’ balance sheet on the credit side. In the liability section, the reporting company discloses certain liabilities, like bank loans or trade liabilities, and provisions. In this chapter, we also cover provisions and show how to rise and dissolve them. The chapter contains five case studies for certain liabilities, e.g., bank loans and bonds from the side of the debtor and bond issuer, respectively. In the second half of this chapter, we discuss four provision case studies. The focus is on the measurement of liabilities and provision either at fair values, amortised costs, or present values. 14.2 Learning Objectives After studying this chapter, you know the major groups of liabilities: certain liabilities, provisions, and contingent liabilities. You obtain knowledge about their measurements and disclosure. Note, only liabilities and provisions are disclosed on financial statements. No contingent liabilities are shown. You can record liabilities carried at amortised costs and make interest calculations based on the effective interest method. Furthermore, you develop a sound understanding for provisions and can disclose them. You know the major IFRS regulations for the measurement and disclosure of liabilities and provisions. 14.3 Liabilities Liabilities result from present obligations to act in a certain way (IAS 1.15). In a certain way refers to making payments or providing goods or services for the settlement of liabilities. The IASB distinguishes present and future obligations, the latter ones are no liabilities, e.g., interest payable in upcoming Accounting periods. In contrast, an obligation to repay a loan exists already from the date of issue. Therefore, it must be disclosed as liability instantly. See IAS 1.16. In compliance with IAS 1.46, liabilities are disclosed on the credit side of the balance sheet if an outflow of resources resulting from their settlement is likely (more likely than unlikely) and the value of the liability can be measured reliably. We distinguish certain liabilities and uncertain ones. A certain liability is e.g., a bank loan or a lease obligation. Uncertain liabilities are provisions or contingent liabilities. Uncertainty refers to at least one of the characteristics of the liability being unknown, e.g., a payment term (amount or date) or whether the payment must be made at all. A provision applies e.g., if a company calls back its own products, because they must be reworked. It is uncertain how many customers return items. The cost of rework might be uncertain, too. In such a case a present obligation exists even due to an enforceable contract, but the future payment requirements are uncertain. It depends on the beneficiary, whether she/ he follows the recall and/ or request compensation or rework. With <?page no="367"?> Berkau: Financial Statements 9e 14-367 no present obligation existing, we call it a contingent liability. A contingent liability exists e.g., if a parent vouches for its subsidiary. For the time the subsidiary is in no financial destress, no obligation exists. Contingent liabilities are not disclosed on financial statements. For liability instruments, e.g. loans, bonds etc., IAS 32, IAS 39, IFRS 7, IFRS 9 apply. IFRS 13 rules their measurement. For provisions, the IASB provides an extra standard: IAS 37. Below, we discuss recognition, measurement, and presentation of liabilities in two categories: (1) Certain liabilities. (2) Provisions. 14.4 Certain Liabilities A liability is in most cases a payment obligation. Whether you buy goods on credit or take out a bank loan, you define a liability. It results in future payments or other transactions, e.g., asset transfer or service rendering. Therefore, economic benefits are flowing out of the owing company. The IASB covers liabilities under financial instruments and thus supports an Accounting match, where liabilities are measured by the same methods in the lenders' books (assets) as in the borrowers’ books (liabilities). Therefore, some aspects covered in chapters (7) and (9) are repeated in this chapter (14). On the lenders’ side, IFRS 9.5.2.1 distinguishes financial instruments held at 104 Read Attachment B of IFRS 9: IFRS 9.B4.1.2.9. amortised costs and those that are carried at fair values. Check chapter (7) and (9). On the borrower’s side which is relevant for this chapter, liabilities are measured frequently at amortised costs. The market price for liabilities that are publicly traded does not cause measurement adjustments. Carrying at amortised costs means compounding liabilities by the effective rate of interest and deduction of payments. The liability disclosure differs from settlement values, when payments are made in shorter intervals than a year, or when banking fees apply and/ or the settlement is paid at a premium or a discount. For debt valuation at amortised costs, the effective interest method applies. 104 It approximates the current liability value continuously towards the settlement value. For the sake of teaching, we explain the technical term effective interest rate before we discuss the effective interest method for the measurement of liabilities. In Finance, the effective rate of interest is used to compare loan offers. The effective rate of interest is the rate applicable under consideration of a monthly compounded interest calculation. To calculate the effective rate of interest based on the nominal annual rate follows this formula: i eff = (1 + i a / 12) 12 - 1. If e.g., the annual rate of interest is 2.4 %/ a, the effective rate for monthly payments is: (1 + (2.4%/ 12)) 12 - 1 = (1 + 0,2%) 12 - 1 = 2.43%/ a. The effective rate of interest also factors in additional costs, e.g., banking fees or pay- <?page no="368"?> Berkau: Financial Statements 9e 14-368 off at a premium. Banks disclose the annual effective rate of interest in their T&Cs for loans. In this chapter, we cover five liability cases: (1a) C/ S WARWICK Ltd.: buying goods on credit (short-term liability case). (1b) The altered C/ S BATHURST Ltd. from chapter (6): bank loan now under consideration of monthly payments and with an initial banking fee (at amortised costs) (1c) C/ S MEUL Ltd.: taking out a bank loan at a discount and paying it off at a premium (at amortised cost). (1d) C/ S BRIZA: publicly traded bonds (at amortised costs). (1e) C/ S MEMEL PLC: annuity with extra repayments (at amortised costs). We start with the case study WARWICK Ltd. which is a case about short-term liabilities. 14.5 C/ S WARWICK Ltd. - Buying Goods on Credit Buying goods on credit results in a payment obligation that is due in the nearby future. IAS 1.56 instructs a company to classify its debts as shortterm liability once it is due within a year, more precisely: if due within the next Accounting period. We do not revalue short-term debts and carry them at initial valuation which is their settlement value. Short-term liabilities are not discounted. Data Sheet for WARWICK Ltd. Domicile: Australia (Adelaide). Reporting currency: AUD. Classification: n/ a. Short-term payables: 120,000 AUD from purchases. Purchase date: 3.01.20X5. Repayment: 3.01.20X6. Interest: n/ a. VAT rate 20 %. WARWICK Ltd. buys goods from its supplier on 3.01.20X5 and agrees to pay the purchase price (gross amount) of 120,000 AUD on 3.01.20X6. We make the Bookkeeping entry below: @ 3.01.20X5 Purchase-20X5 PUR 100,000 Value Added Tax VAT 20,000 Accounts Payables A/ P 120,000 (recognition of short-term debts from a purchase) In 20X6, WARWICK Ltd. pays the bill to its supplier at 120,000 AUD. The liability is disclosed on the statement of financial position as per 31.12.20X5 to the extent of 120,000 AUD under accounts payables. 14.6 C/ S BATHURST Ltd. - Bank Loan We refer to the case study BATHURST Ltd. from chapter (6) to explain the effective interest method. In chapter (6), the nominal and effective rate of interest both equal 2.5 %/ a because the interest is paid annually at yearends, and <?page no="369"?> Berkau: Financial Statements 9e 14-369 the loan is repaid at the principal which is the nominal value. In preparation of the effective interest method application, we write the loan as payment vector in arrears: L(t) = {150,000; (18,750); (18,375); (18,000); (17,625); (17,250); (16,875); (16,500); (16,125); (15,750); (15,325)}. This is correct as BAHTURST Ltd. pays for interest and pay-off at yearends. However, BATHURST Ltd. takes out the loan on 1.01.20X4 - almost one year before the first payment for interest and pay-off is due. For the vector representation, we pull the first payment slightly forward and place it on 31.12.20X3 at 23: 59 hours. Note, on a finance plan, interest is due between the periods. As in the version of chapter (6), the effective interest method considers an increase of the loan valuation in 20X4 based on the effective rate of interest, which gives: 150,000 × 2.5% = 3 3,750 AUD. Thereafter, the paid interest and the pay-off amount are deducted which gives us the closing value of: 150,000 + 3,750 - 3,750 - 15,000 = 1 135,000 AUD, of which 15,000 AUD are classified as short-term liabilities. In 20X5, the closing value of the bank loan is: 135,000 + 3,375 - 3,375 - 15,000 = 1 120,000 AUD. Again, 15,000 AUD thereof are disclosed and recorded under short-term liabilities. The bank loan shows on the balance sheet at: 120,000 - 15,000 = 1 105,000 AUD as you can observe in Figure 6.4. Before we alter the payment terms in the case study, we describe the recording procedure for a loan held at amortised costs in a How-it-is-Done paragraph. How it is Done (Recording a Loan at Amortised Costs): (1) Determine the effective rate of interest. (2) Compound the loan with its effective rate of interest which increases the loan’s value by multiplying it by the factor (1 + i eff ). (3) Record the compounding (2) as an interest expense and make a credit entry in the Loan account. (4) Deduct all payments for interest and pay-off from the loan’s carrying value. (5) For (4) make debit entries in the Loan account and/ or Short-term Liabilities account and credit the amounts to the Cash/ Bank account. Separate disclosure of short-term and long-term liabilities in accordance with IAS 1.60 applies. (6) The resulting figure is the new value of the loan. To change the loan measurement for BATHURST Ltd., we modify its payment terms. This will affect the value of the effective rate of interest. At first, we consider that BATHURST Ltd. pays interest monthly. As the pay-off is still due at yearends, the interest calculation is based on the opening value. The annual interest expense would be: <?page no="370"?> Berkau: Financial Statements 9e 14-370 150,000 × 2.5% = 3 3,750 AUD in 20X4; therefore, each monthly interest payment is: 3,750 / 12 = 3 312.50 AUD/ m. This gives us a monthly payment vector for 20X4: B m (t) = {150,000; (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (150,312.50)}. We calculate the internal rate of return for B m (t) and come up with 0.20 83 %/ m which gives an annual rate of: 2.52 88 %/ a following a monthly compounding interest calculation. If we apply the formula discussed above, we calculate the same effective interest rate: (1 + 2.5%/ 12) 12 - 1 = 22.52 88 %/ a. What is the impact of a change to monthly payments on the financial statements? They make the loan more expensive, which is approximately 2.06 AUD/ m in the cases study BATHURST Ltd. Therefore, interest expenses increase, but interest payments do not change (cash flows). Another reason for the effective interest rate exceeding the nominal interest rate is a loan issue at a discount. For BATHURST Ltd., we now discuss a 1,000 AUD service fee paid upon loan issue. Banking fees reduce the initial receipt from the bank. The bank only pays 149,000 AUD on 1.01.20X4 for a loan with a principal of 150,000 AUD. For the payment vector, only the first element changes, as interest and pay-off payments are always based on the principal. With the fees, the internal rate of return for the vector increases to 2.63 42 %/ a. The interest for 20X4 is now: 149,000 × 2.63% = 3 3,924.96 AUD. The value of the bank loan as per 31.12.20X4 is: 149,000 + 3,924.96 - 3,750 - 15,000 = 134,174.96 AUD. One year later, it is: 134,174.96 + 3,534.48 - 3,375 - 15,000 = 1 119,334.44 AUD. From the closing values, a portion of 15,000 AUD must be disclosed as shortterm liabilities. 14.7 C/ S MEUL Ltd. - Amortised Costs Next, we explain the loan measurement and all Bookkeeping entries for a loan for MEUL Ltd. in Mossel Bay at amortised cost. The bank does not issue the full loan’s principal but deducts a service fee and further transaction costs. Note, in general, w we ignore transaction costs in this textbook. However, to show its impact on the loan valuation, it is considered for this case study. Therefore, the effective interest rate exceeds the nominal rate of interest. The case can be downloaded by the Link 14.A. Link 14.A: MEUL Ltd. <?page no="371"?> Berkau: Financial Statements 9e 14-371 How it is Done (Effective Interest Method for Loan Liabilities): (1) Ensure the liability must be held at amortised costs. (2) Gather all payment-relevant information about the liability, e.g., discounts, fees, premiums, interest, pay-off payments. (3) Determine the payment vector for the liability. Consider long-term as well as short-term payments. (4) Calculate the internal rate of return for the payment vector. Use the MS-Excel function IRR(). (5) Prepare a financial schedule with columns for the Accounting periods and lines for payments (you must enter the vectors). Consider remaining funds as additional investments and compound them with the internal rate of return. (6) Record payments. (7) Record effective interest as expense through profit or loss. 14.8 Bonds Issue Borrowing through bonds is an alternative to financing by shares or loan taking. A bond is a financial instrument where the bond issuer borrows from its bondholders and pays them a constant interest referred to as a coupon. Bonds are repaid in a lump sum after their time to maturity. In general, the coupon rate is fixed. As the bond issuer only repays the bonds at the time of redemption, interest expenses remain constant. Most of bonds have a six months -1 frequency of coupon payments, such as paying the coupon on 30.06. and 31.12. every year. Alternatively, bonds can pay interest annually or quarterly. The frequency is decided by the bond issuer and belongs to the T&Cs. Bonds are disclosed at settlement values. Only if the bond redemption or the payment terms differ from full repayment at maturity date and annual coupon payments, a bond measurement at amortised costs results in a different disclosure. When a company issues a bond, it records a long-term liability for it. The Interest Bearing Liability account applies. A present obligation exists to repay the bond. 14.9 C/ S BRIZA Ltd. - Bonds For bond recognition and disclosure, we discuss the case study BRIZA Ltd., a production firm in Melbourne. To explain the application of the effective interest method, the case study covers a redemption at a premium. This means, the redemption proceeds exceed the nominal value of the bonds. The case can be downloaded by the Link 14.B. <?page no="372"?> Berkau: Financial Statements 9e 14-372 Link 14.B: BRIZA Ltd. 14.10 C/ S MEMEL PLC - Annuity and Extra Repayments An annuity is a bank loan with a constant payment for interest and pay-off (together). Interest is paid based on the opening amount for the actual Accounting period. Our conventions in chapter (1) state that interest compounds annually. An interest period of less than one year is calculated per rate and accurate to a month. We discuss an annuity at MEMEL PLC in Manchester. The case can be downloaded by the Link 14.C. Link 14.C: MEMEL Ltd. 14.11 Provisions Following IFRSs, provisions fall under liabilities. IAS 37.10 defines provisions as liabilities of uncertain timing and/ or value. For the recognition as a provision a present obligation must exist at the reporting time, e.g., from a contract, derived from a pending lawsuit etc. IAS 37.13 applies. The recognition criteria for provisions as defined in IAS 37.14 are: existence of a present obligation, probability of an outflow of economic benefits and reliable measurement. 14.12 C/ S SEENA Ltd. - Measurement of Provisions Based on IAS 37.41, the measurement of a provision is the best estimate of the expenses to settle the present obligation as known at the reporting time. A company must calculate the value of a provision as its best estimate, see the case in IAS 37.39. We provide a similar example for a manufacturer. Data Sheet for SEENA Ltd. Domicile: Netherlands (Enschede). Reporting currency: EUR. Classification: Production. Output: 500,000 backpacks Minor damage 5 EUR; probability 10 %. Major damage: 37 EUR; probability 3 %. VAT n/ a. The manufacturer SEENA Ltd. produces backpacks. Faulty products get reworked if returned by customers. SEENA Ltd. knows from experience that if minor defects, like a faulty zipper, emerge during the next Accounting period 20X9, the rework per backpack costs 5 EUR/ backpack. If a major defect occurs, e.g., a shoulder strap comes loose, the rework will be 37 EUR/ backpack. SEENA Ltd. produces 500,000 backpacks and calculates that the probability for minor defects is 10 % and for major ones 3 %. On the balance sheet date 31.12.20X8, SEENA Ltd. estimates the rework. It is: <?page no="373"?> Berkau: Financial Statements 9e 14-373 500,000 × (10% × 5 + 3% × 37) = 8 805,000 EUR. SEENA Ltd. recognises a provision of 805,000 EUR on its balance sheet for 20X8. The Bookkeeping entry shows below: @ 31.12.20X8 Rework-20X8 REW 805,000 Provision for Rework PRO 805,000 (rising a provision for rework on backpacks) In 20X9, SEENA Ltd. reworks backpacks for 750,000 EUR. The previously recorded provision for rework is dissolved. IAS 37.61 requires provisions only to be used for expenditures they have been recognised for. SEENA Ltd. makes the Bookkeeping entry below in 20X9 which dissolves the entire provision. @ 31.12.20X9 Provision for Rework PRO 805,000 Rework-20X9 REW 55,000 Cash/ Bank C/ B 750,000 (dissolving a provision for rework on backpacks) The credit entry in the Rework account cancels out the overrated expenses recorded together with the provision in 20X8. In general, provisions reduce operating profits for the Accounting period of their recognition. Therefore, IAS 37.17 allows a recognition of provisions only if an obligation exists. In line with IAS 37.19, a provision must be unavoidable for the reporting company. The paragraph describes a future obligation to install filters for a certain factory type as avoidable because the company can change its manufacturing routines. In contrast, an already existing environmental damage caused by operating a power 105 Study our textbook Basics of Accounting, chapter (15). plant rectifies a provision as the damage has been done and requires future clean-up costs. 105 Situations that require provisions are e.g.: - Agreement between a company and its employee about a pension. - Rework of products - even without enforceable legal leverage. - Pending lawsuits based on unlawful or probably unlawful activities in the past. - Deferred taxes. - Clean-up costs or dismantling costs. - Claims resulting from postponed vacation of employees. - Onerous contracts. <?page no="374"?> Berkau: Financial Statements 9e 14-374 - Restructuring costs, e.g., when operations are discontinued or changed. - . . . In this textbook we are unable to cover all cases for provisions. We only discuss three examples below, which explain their measurement and disclosure. (2a) Provision for pension funds. (2b) Provision for rework/ re-calls. (2c) Provision due to onerous contracts. 14.13 C/ S HADRA (Pty) Ltd. - Provision for Pension Funds On 3.01.20X2, HADRA (Pty) Ltd. in Stellenbosch makes a contract with its chief operating officer COO, Mrs Gartner, about paying her a pension after her board membership ends for the next following four years to the extent of annually 1,000,000 ZAR/ a, payable in arrears. It is assumed that Mrs Gartner will resign at the end of 20X5. Data Sheet for HADRA (Pty) Ltd. Domicile: South Africa (Stellenbosch). Reporting currency: ZAR. Classification: n/ a. Pension plan: 4 × 100,000 ZAR/ a. Pension periods: 20X6, 20X7, 20X8, 20X9. When signing the contract, Mrs Gartner’s future career path is uncertain. Therefore, the pension is uncertain in terms of the timing. A present obligation exists as the contract is enforceable. Hence, a provision applies. IAS 37.45 requires the provision to be measured at its present value. We estimate the pre-tax market rate to be 10 %/ a. As the contract has been closed in 20X2, HADRA (Pty) LTD: rises a provision for the financial statements as per 31.12.20X2. Its value is: (1 + 10%) -3 × 1,000,000 × ((1 + 10%) 4 - 1) / ((1 + 10%) 4 × 10%) = 2 2,381,566.83 ZAR. The provision is based on an annuity of 4 payments at the end of 20X6 - 20X9. The provision is discounted for three periods (20X2 to 20X5). The provision must be disclosed when the contract is signed: on 31.12.20X2. HADRA (Pty) Ltd. makes the Bookkeeping entry as below: @ 31.12.20X2 Provision for Pension PRO 2,381,557 Labour-20X2 LAB 2,381,557 (recognition of a provision for pension) IFRSs require different measurements for provisions and liabilities. Liabilities are carried at fair values or amortised costs. In contrast, a provision must be measured at present values. Due to compound interest calculations, provisions are disclosed below their settlement values. In accordance with IAS 37.59, a reporting company must review provisions annually. If the estimated timing for Mrs Gartner’s retirement changes, the provision requires adjustment. If Mrs Gartner dies or <?page no="375"?> Berkau: Financial Statements 9e 14-375 signs a waiver declaration in favour of HADRA (Pty) Ltd., the provision must be dissolved. Next, we discuss a provision’ measurement as subsequent valuation. 14.14 C/ S DUMMOND (Pty) Ltd. - Provision of rework DUMMOND (Pty) Ltd. is obliged to make annual payments of 100,000 ZAR/ a for a period of 4 years due to an estimated rework plan for delivered, faulty goods produced and sold in the past. The annual payment of 100,000 ZAR/ a is only an estimate for refunding customers for rework expenses and therefore, a provision for rework is disclosed. Data Sheet for DUMMOND (Pty) Ltd. Domicile: South Africa (Atlantis). Reporting currency: ZAR. Classification: n/ a. Rework plan: 4 × 100,000 ZAR/ a. Provision disclosed in 20X2. VAT n/ a. On 2.01.20X2, DUMMOND (Pty) Ltd. in Atlantis learns that it must pay 400,000 ZAR over a 4-years-period in arrears to fulfil its re-work obligations in cash. DUMMOND (Pty) Ltd. rises a provision on 31.12.20X2. DUMMOND (Pty) Ltd. dissolves 100,000 ZAR of its re-work provision every year. We prepare a spreadsheet. As the provision is recorded in January for the first time, it is initially shown on the financial statements as per 31.12.20X2. Until then, no discounting applies. Link 14.D: DUMMOND (Pty) Ltd. See below in Figure 14.1 the calculation for the provision and the first payment in 20X2. Note, that DUMMOND (Pty) Ltd. makes one payment before the provision is recognised on its balance sheet. Year Opening amount Pay-off Rest [ZAR] [ZAR] [ZAR] 20X2 400,000 100,000 300,000 20X3 300,000 100,000 200,000 20X4 200,000 100,000 100,000 20X5 100,000 100,000 0 Dummond (Pty) Ltd. PROVISION PLAN (20X2 - 20X5) Figure 14.1: DUMMOND (Pty) Ltd.’s provisions (1) <?page no="376"?> Berkau: Financial Statements 9e 14-376 Dissolving a portion of 100,000 ZAR results in a payment. You find the Bookkeeping entries (1) to (2) below. @ 31.12.20X2 (1), (2) Rework-20X2 REW 100,000 Cash/ Bank C/ B 100,000 (recognition of rework expenses) Rework-20X2 REW 300,000 Provision for Rework PRO 300,000 (recognition of a provision for rework) After the above transactions, DUMMOND (Pty) Ltd. is left with 300,000 ZAR in provisions in 20X2. How it is Done (Rising Provisions for Rework): (1) Determine whether a provision applies: Is there a present obligation at the time of reporting? Does the obligation result in a future outflow of resources? Can the rework obligation be measured reliably? If the above questions are answered by (3 ×) yes, continue: (2) Calculate the obligation based on the best estimate. Derive probabilities from experiences made in prior Accounting periods. Consider the actual number of goods to be reworked on. (3) Calculate an expense vector for expected rework. (4) Make a debit entry for the rework in the Rework account and credit the Provisions account. (5) If the time value of money is material for valuation, discount provisions as shown further below. The measurement of the provisions is based on present values if the time value is material for valuation. E.g., the time value of money matters when the rate of interest is high and/ or the period of rework is long, e.g., several years. Below we calculate the discounted values for the rework provision at DUMMOND (Pty) Ltd. The provision is resulting in three future payments of 100,000 ZAR due on 31.12.20X3, 31.12.20X4, and 31.12.20X5 to pay-off the estimated rework obligations. To determine the fair value of the settlement value, DUMMOND (Pty) Ltd. cannot just disclose 300,000 ZAR in debts. For the consideration of the time value of money, the lower and discounted value applies. For the interest calculation, we apply the incremental borrowing rate for DUMMOND (Pty) Ltd. It is 10 %. DUMMOND (Pty) Ltd. measures the 20X3’s payment at: 100,000/ (1 + 10%) <?page no="377"?> Berkau: Financial Statements 9e 14-377 = 990,909.09 ZAR. On the spreadsheet in Figure 14.2, we calculate present values for the other two payments linked to rework in 20X4 and 20X5. Year Opening amount Pay-off Discount Present value [ZAR] [ZAR] 10% [ZAR] 20X2 400,000.00 100,000.00 paid 20X3 300,000.00 100,000.00 1 0.91 90,909.09 20X4 200,000.00 100,000.00 2 0.83 82,644.63 20X5 100,000.00 100,000.00 3 0.75 75,131.48 Dummond (Pty) Ltd. PROVISION PLAN (20X2 - 20X5) Figure 14.2: DUMMOND (Pty) Ltd.’s provisions (2) For the measurement of its provision, DUMMOND (Pty) Ltd. must discount it as per 31.12.20X2. The provisions’ fair value is the present value of: 90,909.09 + 82,644.63 + 75,131.48 = 2 248,685.20 ZAR. There is a difference between the payments due and the provisions’ fair value of: 400,000 - 100,000 - 248,685.20 = 51,314.80 ZAR. The difference is deducted from provisions and temporarily carried in the Retained Earnings account. See the Bookkeeping entry (3) below: @ 31.12.20X2 (3) Provision for Rework PRO 51,315 Retained Earnings R/ E 51,315 (temporary revaluation of a provision) The difference in the provision valuation is temporary as in the next Accounting period, DUMMON (Pty) Ltd. must compound its provision. It must also check for changes in the estimated payments and whether the need for the provision still exists. It could change, e.g., if customers do not claim. We assume, the estimated payment obligation for reworking the goods stays, only the revaluation of the provisions based on the compounding matters for valuation. See below the calculation of the provisions’ present value as at 31.12.20X3 in Figure 14.3. <?page no="378"?> Berkau: Financial Statements 9e 14-378 Year Opening amount Pay-off Discount Present value [ZAR] [ZAR] 10% [ZAR] 20X2 400,000.00 100,000.00 paid 20X3 300,000.00 100,000.00 1 dissolved 20X4 200,000.00 100,000.00 1 0.91 90,909.09 20X5 100,000.00 100,000.00 2 0.83 82,644.63 3 Dummond (Pty) Ltd. PROVISION PLAN (20X3 - 20X5) Figure 14.3: DUMMOND (Pty) Ltd.’s provisions (3) In 20X3, the payment obligation for 20X3 is due and 100,000 ZAR of the provisions are dissolved. We transfer the amounts to short-term liabilities and record a payment on 31.12.20X3. Before the payment, the provisions are compounded: 90,909.09 × (1 + 10%) = 100,000 ZAR. The remainder of the provision is revalued. The values for 20X4 and 20X5 are compounded which gives: 82,644.63 × (1 + 10%) = 990,909.09 ZAR and: 75,131.48 × (1 + 10%) = 8 82,644.63 ZAR, respectively. The revaluation increases the provisions by: (100,000 - 90,909.09) + (90,909.09 - 82,644.63) + (82,644.63 - 75,131.48) = 2 24,868.52 ZAR. We make a Bookkeeping entry for both revaluations together as below (a): @ 31.12.20X3 (a) Retained Earnings R/ E 24,869 Provision for Rework PRO 24,869 (compounding the provision) Bookkeeping entry (b) and (c) dissolve 20X3’s provision. You find all Bookkeeping entries for the Accounting periods 20X2 - 20X5 in Figure 14.5. Check below in Figure 14.4 the recalculation of DUMMOND (Pty) Ltd.’s provisions in 20X4. Year Opening amount Pay-off Discount Present value [ZAR] [ZAR] 10% [ZAR] 20X2 400,000.00 100,000.00 paid 20X3 300,000.00 100,000.00 dissolved 20X4 200,000.00 100,000.00 1 dissolved 20X5 100,000.00 100,000.00 1 0.91 90,909.09 3 Dummond (Pty) Ltd. PROVISION PLAN (20X4 - 20X5) Figure 14.4: DUMMOND (Pty) Ltd.’s provisions (4) <?page no="379"?> Berkau: Financial Statements 9e 14-379 Note, that rework expenses are only recognised in 20X2. That is the year when the obligation for rework became known. No rework expenses are recorded in the years thereafter as the provisions are dissolved without any impact on profit or loss. It reflects that the estimated costs at the time of rising the provision are as high as the actual ones. However, the compounded interest is expensed. As an expedient, no Profit and Loss accounts for 20X3 - 20X5 are shown in Figure 14.5 but the value for interest is debited directly to the Retained Earnings account. D C D C (1) 100,000 P2L 400,000 (c) 100,000 (b) 100,000 (2) 300,000 (C) 100,000 (B) 100,000 400,000 400,000 (III) 100,000 (II) 100,000 Re-work-20X2 REW Short-term liabilitiy A/ P D C D C (3) 51,315 (2) 300,000 . . . (1) 100,000 c/ d 248,685 c/ d 100,000 300,000 300,000 100,000 100,000 (b) 100,000 b/ d 248,685 c/ d 100,000 c/ d 173,554 (a) 24,869 c/ d 200,000 (c) 100,000 273,554 273,554 200,000 200,000 (B) 100,000 b/ d 173,554 b/ d 200,000 c/ d 90,909 (A) 17,355 c/ d 300,000 (C) 100,000 190,909 190,909 300,000 300,000 (II) 100,000 b/ d 90,909 b/ d 300,000 (I) 9,091 c/ d 400,000 (III) 100,000 100,000 100,000 400,000 400,000 Provision PRO Cash/ Bank C/ B Figure 14.5: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) <?page no="380"?> Berkau: Financial Statements 9e 14-380 D C D C P2L 400,000 (3) 51,315 REW 400,000 R/ E 400,000 c/ d 348,685 400,000 400,000 b/ d 348,685 (a) 24,869 c/ d 373,554 373,554 373,554 b/ d 373,554 (A) 17,355 c/ d 390,909 390,909 390,909 b/ d 390,909 (I) 9,091 c/ d 400,000 400,000 400,000 b/ d 400,000 Retained earnings R/ E Profit and loss-20X2 P2L Figure 14.5: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) continued How it is Done (Discounting Provisions): (1) Calculate the payment vector of the provision based on best estimates at the time of initial recognition. (2) Decide whether time value of money is material for the valuation of the provision. Only if this is the case, continue with step (3). Otherwise recognise the provision without discounting. (3) Determine the discount rate dr. (4) Multiply each payment vector element by the factor (1 + dr) -n . n is the number of periods between the payment and reporting. (5) Add all discounted payment vector elements. The total is the measurement for the disclosure of the provisions. (6) If the provision has been recorded before, make an adjustment in valuation by a Bookkeeping entry: DR Provisions . . . - CR Retained Earnings . . . In the next Accounting period: (A) Dissolve the provisions to the extent they are relevant for the Accounting period (payment). (B) Revalue the remaining payment vector by compounding its elements. (C) Calculate the difference of actual and prior measurement of provisions. (D) Make a Bookkeeping entry for revaluation as: DR Retained Earnings account . . . - CR Provisions . . . <?page no="381"?> Berkau: Financial Statements 9e 14-381 14.15 C/ S SALMAN Ltd. - Provisions due to Onerous Contracts An onerous contract (IAS 27.66) requires a provision to the extent of the present obligation which is the loss resulting from the agreement. An onerous contract requires that both parties are bound to it. IAS 37.68 defines a contact to become onerous, if unavoidable costs resulting from the contract exceed its profit. We study the case of the airline SALMAN Ltd., which schedules a flight and sold it out already. Due to an increase of airport charges the contract with the passengers becomes onerous for SALMAN Ltd. Data Sheet for SALMAN Ltd. Classification: Aviation (Sydney). Flight SM050 on 10.05.20X5 PER-MEL Expected revenue: 75,000 AUD Costs: 400 AUD/ p. - 200 passengers Increase of costs: 10,000 AUD Provision disclosed: 31.12.20X2. VAT n/ a. SALMAN Ltd. is an airline headquartered in Sydney. To compete with its competitors, SALMAN Ltd. sells tickets already one year in advance. For its flight SM050 scheduled on 10.05.20X5 with an Airbus A321 from Perth to Melbourne, SALMAN Ltd. offered tickets for 400 AUD/ passenger. The aircraft is a 200seater and on 31.12.20X4 already fully booked. The expected revenue is: 400 × 200 = 8 80,000 AUD. Operational flight expenses are estimated to be 75,000 AUD. Due to an increase of airport landing fees in Melbourne, the scheduled and sold-out flight becomes 10,000 AUD more expensive. On 31.12.20X4, SALMAN Ltd. records a provision for an onerous contract to the extent of: 75,000 + 10,000 - 80,000 = 5 5,000 AUD. The flight has not yet taken place; hence, no certain liability applies. The contract between the passengers and the airline is binding. Therefore, SALMAN Ltd. cannot avoid the airport charges as the flight is scheduled for the route Perth- Melbourne. A deviation of the flight to Adelaide to avoid airport charges is not appropriate. No discounting of the provision is required as it is not material due to the brief time span. SALMAN Ltd. records the Bookkeeping entry for the provision below: @ 31.12.20X4 Loss on Onerous Contract-20X4 LOO 5,000 Provision Onerous Contract PRO 5,000 (rising a provision due to onerous contract) The provision informs the readers of SALMAN Ltd.’s financial statements about the potential loss due to the onerous contract. The flight costs are not certain but are calculated based on best estimates. The expenses for the onerous contract to the extent of 5,000 AUD are recorded in 20X4 through profit or loss. <?page no="382"?> Berkau: Financial Statements 9e 14-382 How it is Done (Provisions for Onerous Contracts): (1) Determine whether an onerous contract exists. Is the contract binding? Does it most-probably result in a loss? (2) Calculate the loss expected from fulfilling the contractual obligations as best estimate at the recording time. (3) Make a debit entry in the Loss on Onerous Contract account and credit provisions. (4) Check whether discounting of the provision applies. 14.16 Summary Liabilities are present obligations that result in an outflow of economic benefits, usually in a payment. Short-term liabilities are due within one Accounting period and are disclosed under accounts payables A/ P. They are measured by their present obligation, e.g., the money owed. IFRSs distinguish three types of long-term liabilities: certain liabilities, e.g., bank loans or bonds, uncertain liabilities, e.g., provisions, and contingent liabilities without a present obligation or without fulfilling liability disclosure requirements. The latter ones are not recognised on financial statements. As companies usually cannot pass on their liabilities, they are carried at amortised costs. In contrast, provisions are measured at present values if the time value of money is material. Otherwise, they are recorded at estimated costs. A reporting company must explain its liabilities in the notes. 14.17 Working Definitions Annuity: Bank loan with a constant payment including interest and payoff. Contingent Liability: Liability that is uncertain, not present and/ or does not fulfil recognition requirements. Onerous Contract: A contract a loss is most probably expected to result from. Present Obligation: An obligation that exists at the time of reporting. Provision: Uncertain liability which is uncertain regarding time and/ or contractual settlement (mostly payment). 14.18 Question Bank (1) The effective rate of interest for a bank loan that is paid weekly and for which the annual interest rate is 4.5 %/ a is amounting to … 1. 4.5000 %/ a . 2. 4.6008 %/ a . 3. 4.5940 %/ a . 4. 4.6025 %/ a . (2) A company dissolved 50,000 EUR rework provisions but credited 10,000 EUR thereof to the Repairs account. All rework is paid on cash. How much is the payment? 1. 10,000 EUR . 2. 60,000 EUR . 3. 50,000 EUR . 4. 40,000 EUR . <?page no="383"?> Berkau: Financial Statements 9e 14-383 (3) A company issued bonds at 1,000,000 EUR with a discount of 10 %. The coupon rate is 5 %/ a. The effective rate of interest is 6.4 %. How much are expenses to be recorded at the end of the first Accounting period (not the discount)? 1. 100,000 EUR . 2. 64,000 EUR . 3. 54,400 EUR . 4. 57,600 EUR . (4) A company rises a provision for a four-years pension in arrears with annual payments of 80,000 EUR. The rate of interest is 4 %. The first payment is in 3 years’ time. How much is the value of the provision? 1. 320,000 EUR. 2. 258,157 EUR. 3. 290,392 EUR. 4. 268,483 EUR. (5) On 1.01.20X3, a company takes a bank loan of 100,000 EUR with a 3 % discount. The bank loan comes with a rate of interest of 5 %/ a and a fixed pay-off amount of 25,000 EUR/ a. What is the payment vector B(t) for the Accounting periods 20X3 - 20X6 if interest and pay-off is paid at the yearends? 1. {70,000; (28,750); (27,500); (26,260)}. 2. {67,000; (28,750); (27,500); (26,250)}. 3. {75,000; (25,000); (25,000); (25,000)}. 4. {72,850; (28,900); (27,650); (26,400)}. 14.19 Solutions 1-2, 2-4, 3-4, 4-4, 5-2. <?page no="384"?> Berkau: Financial Statements 9e 15-384 15 Abbreviations / a per annum, per year A4L Asset Held for Lease Acc Accounting ACC Accumulated Depreciation Acc Depr Accumulated Depreciation Acc IL Accumulated Impairment Loss Adj, adj Adjustment, adjusted ADM Administration Account ADMACC Administration/ Accounting Afa Absetzung für Abnutzung AGB Australian Government Bond AGM Annual General Meeting Aggr. Aggregated AIL Accumulated Impairment Loss Account A/ P Accounts Payables A/ R Accounts Receivables A/ S Annual Surplus A(t) Annuity Vector AktG Company’s Act in Germany AUD Australian Dollar / b per Bond Bal Balance BB best before Bear. Bearing BDA Bad Debts Account BHD Berhad, the legal form of a public limited company in Malaysia BL(t) Bank Loan Vector B m (t) Bank Vector for Monthly Payments BND(t) Bond Vector BOM Bill of Materials b/ d Balance brought down B/ S, BS Balance Sheet B(t) Bond Vector, Bank Loan Vector BWP Botswanian Pula C Credit CA Carrying Amount, Carrying Value Cap.Cons. Capital Consolidation C-R Capital Reserves C/ B Cash/ Bank CC Cost Centre CCDU Coffee-Capsule-Dispense-Unit CEO Chief Executive Officer <?page no="385"?> Berkau: Financial Statements 9e 15-385 c/ d Balance carried down c1d Balance carried down on 31.12.20X1 c/ f carried forward (Profit) CFO Chief Financial Officer CFS Statement of Cash Flows CGT Capital Gain Tax CGG Council Cooperation for the Arab States in the Gulf CH5.xls Excel file linked to Chapter 5 of the textbook Basics of Accounting C, L Capital, Liabilities Cons. Consolidation COO Chief Operating Officer Corp Corporation COS Cost of Sales, Cost of Goods Sold CPN Coupon CR Credit Recorded, Credit Entry C/ S Case Study D Debit D2R Debt-to-Equity Ratio / d per day DAA Disposal Asset Account D/ A Discount Allowed DATEV German software company DATEV eG. Dep Department Depr., DPR Depreciation DIV Dividend DIS Disposal Account dr Discount rate DR Debit Recorded, Debit Entry (DR)CR Format where debit entries are disclosed as minus DRA Discount Received Account D/ R Discount received DTI Deferred Tax Income DTL Deferred Tax Liabilities EAT Earnings After Taxes Earn. Earnings EBIT Earnings Before Interest and Taxes EBK Eröffnungsbilanzkonto EBT Earnings Before Taxes Eff. Effective e.g. Esempli gratia, for example EPS Earnings Per Share ESG Environmental, Social, Governance EStG Einkommensteuergesetz, Income Tax Law in Germany EUR Euro, Europe EVA Economic Value Added <?page no="386"?> Berkau: Financial Statements 9e 15-386 EXP Expense F Conceptual Framework of Financial Reporting FA Financial Accounting FAA Financial Assets Account fCF Cash Flow from Financing Activities FEC Forward Exchange Contract FEE Fees Account FG Finished Goods FGI Finished Goods Inventories Fin Finance FIN Financial Instruments FNA Financial Asset Account FNB First National Bank South Africa F/ S Financial Statements FSA Financial Statement Analysis FV Fair Value FVTPL Fair Value Through Profit or Loss FVTOCI Fair Value Through Other Comprehensive Income GBP British Pound Sterling GmbH Gesellschaft mit beschränkter Haftung GmbHG Company’s Act in Germany GOD Gain on Disposal GP Gross Profit GST Goods and Service Tax, same as Value Added Tax VAT G/ W Goodwill Account HGB Handelsgesetzbuch IAS International Accounting Standards IASB International Accounting Standards Board IBL Interest Bearing Liabilities IBX Inventory Box Account ICC Inventory Coffee-Capsule-Dispense-Unit Account iCF Cash Flow from Investing Activities ID Identifier, Identification Number IFRSs International Financial Reporting Standards IKV() Internal Rate of Return Function (German MS-Excel) I/ L Impairment Loss IN4 Inventory Game Console 400 IN5 Inventory Game Console 500 INA Intangible Assets Inc. Incorporation (USA) INI Inventory of Ink INP Inventory of Paper INT Interest INV Inventory IPO Initial Public Offering <?page no="387"?> Berkau: Financial Statements 9e 15-387 IRM Inventory of raw materials IRR() Internal Rate of Return Function (MS-Excel) I/ S Income Statement ISO Issued Capital - Ordinary Shares ISP Issued Capital - Preference Shares ISS Issued Capital IT Income Taxes ITA Intangible Assets Account ITE Income Tax Expenses ITL Income Tax Liabilities IVP Investment Property Account JL Journal JO Job Order JV Joint Venture KaDeWe Kaufhaus des Westens kg Kilogram KMTS Kenilworth Metered Taxi Service Ltd. KSU Kite Surfing Unit kWh Kilo Watt Hours L(t) Loan Vector LAA Attorney Labour Account LAB Labour LAP Paralegal Labour Account / lb per Pound Lbs Pound l-h Labour Hours Liab. Liability, Liabilities LOD Loss on Disposal Account LOO Loss on Onerous Contract LOS Loss on Sales LSM Loss on settlement Ltd. Limited company m Metre / m per Month MA Management Accounting MAT Materials, Material Costs MBR Market Book Ratio McD McDonald's Corporation MG Merchandise Goods MOA Manufacturing Overheads Assembling MOC Manufacturing Overheads Cleaning MOI Memorandum of Incorporation MOH Manufacturing Overheads, also: Manufacturing Overheads Account MOS Manufacturing Overheads Shipping MS Microsoft <?page no="388"?> Berkau: Financial Statements 9e 15-388 MSA Manufacturing Summary Account MTN Maintenance MYR Malaysian Ringgit n/ a Not applicable NoE Nature of Expense Method Non-crtl. Non-Controlling NOP Net Operating Profit NOPAT Net Operating Profit After Taxes NP Net Profit NPAT Net Profit After Taxes NPO Non-Profit Organisation NSP Net Selling Price NYSE New York Stock Exchange oCF Cash Flow from Operating Activities OCI Other Comprehensive Income OE Owners' Equity OEX Operational expenses OP, ops Operations Ord. Ordinary OTH Other Expenses OV Opening Value P Profit / p Payable / p per Piece P&L Profit and Loss P1L Profit and Loss in 20X1 PLC Public Limited Company PLT Profit or Loss for Taxation POD Profit on Disposal POS Profit on Sales PPC Property, Plant and Equipment @cost PPE Property, Plant and Equipment PPV Property, Plant and Equipment @valuation PRE Prepaid Expenses Pref. Preference PRO Provisions Account PRT Per Rate, Proportional (pro rata temporis) (Pty) Ltd. Proprietary limited company (in Australia, South Africa) PTO Public Tender Offer PUR Purchases PV Present Value / q per Quarter QR Quick Response / r Receivable R Rate <?page no="389"?> Berkau: Financial Statements 9e 15-389 R(t) RICHTERSVELD (Pty) Ltd. Vector R/ E Retained Earnings REA Realisation Account REP Repair Account RES Reserves REV Revenue, Sales REVAL Revaluation REW Rework Account R.I. Returns Inwards RNT Rent R.O. Returns Outwards RoA Register of Non-current Assets ROA Return on Assets ROCE Return on Capital Employed ROSF Return on Shareholders' Funds RPR Repair rr Risk Rate RRA Rebate Received Account R-R Revaluations Reserves RU Reference Unit RUA Right-of-use-asset / s per Share SARS South African Revenue Service SBK Schlussbilanzkonto SCap, ISS Share Capital SCE Statement of Changes in Equity SCF Statement of Cash Flows SCI Statement of Comprehensive Income SEC Securities Sdn Bhd Sendirian Berhad SFP Statement of Financial Position SHD, S4D Shareholder for Dividend SMV Settlement Value SPL Statement of Profit or Loss SPPI Solely Payments of Principal and Interest Sth. Something SUURENB SUURENBERG Ltd. T/ A Trading Account T/ B Trial Balance TC(t) Vector of Taxi Car Business Payments and Receipts T&Cs Terms and Conditions TEX Travel Expense Account TS Tax Statement TSA Treasury Stock Account / u per unit <?page no="390"?> Berkau: Financial Statements 9e 15-390 USD US-Dollar UStG Umsatzsteuergesetz, VAT law in Germany V Value VAT Value Added Tax, same as Goods and Service Tax GST VATable Subjected to VAT VIU Value in Use / w per week WACC Weighted Average Cost of Capital WIP Work in Progress, Work-in-Process ZAR South African Rand Standard deviation μ Mean <?page no="391"?> Berkau: Financial Statements 9e 16-391 16 Table of Figures Figure 1.1: Accounts 1-20 Figure 2.1: KIELING TAXI GmbH’s opening balance sheet 2-28 Figure 2.2: KIELILNG TAXI GmbH’s journal (20X1) 2-30 Figure 2.3: KIELING TAXI GmbH’s abridged balance sheet (20X1) 2-32 Figure 2.4: KIELING TAXI GmbH’s profit and loss statement (20X1) 2-34 Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X2) 2-35 Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) 2-37 Figure 2.7: KIELING TAXI GmbH’s income statement (20X2) 2-40 Figure 2.8: KIELING TAXI GmbH’s abridged balance sheet (20X2) 2-41 Figure 3.1: KMTS Ltd.’s opening balance sheet 3-47 Figure 3.2: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts 3-50 Figure 3.3: KMTS Ltd.’s accounts after adjustments (20X1) 3-52 Figure 3.4: KMTS Ltd.’s accounts after profit calculation (20X1) 3-54 Figure 3.5: KMTS Ltd.’s income statement (20X1) 3-56 Figure 3.6: KMTS Ltd.’s balance sheet (20X1) 3-57 Figure 3.7: KMTS Ltd.’s cash flow statement (20X1) 3-58 Figure 3.8: KMTS Ltd.’s statement of changes in equity (20X1) 3-58 Figure 3.9: KMTS Ltd.’s accounts (20X2) 3-60 Figure 3.10: KMTS Ltd.’s accounts after profit calculation (20X2) 3-62 Figure 3.11: KMTS Ltd.’s accounts for profit appropriation (20X2) 3-66 Figure 3.12: KMTS Ltd.’s income statement (20X2) 3-66 Figure 3.13: KMTS Ltd.’s balance sheet (20X2) 3-67 Figure 3.14: KMTS Ltd.’s cash flow statement (20X2) 3-67 Figure 3.15: KMTS Ltd.’s statement of changes in equity (20X2) 3-68 Figure 4.1: RYNEVELD Ltd.’s accounts before adjustments 4-77 Figure 4.2: RYNEVELD Ltd.’s trial balance 4-78 Figure 4.3: Elements of a Trading account 4-80 Figure 4.4: RYNEVELD Ltd.’s accounts after adjustments (20X6) 4-83 Figure 4.5: RYNEVELD Ltd.’s adjusted trial balance (20X6) 4-86 Figure 4.6: RYNEVELD Ltd.’s balance sheet (20X6) 4-88 Figure 4.7: RYNEVELD Ltd.’s income statement 4-88 Figure 5.1: Company data 5-96 Figure 5.2: CAPELIFT (Pty) Ltd.’s balance sheet (20X8) 5-97 Figure 5.3: CAPELIFT (Pty) Ltd.’s income statement (20X8) 5-98 Figure 6.1: BATHURST Ltd.’s balance sheet (20X4) 6-115 Figure 6.2: BATHURST Ltd.’s accounts (20X5) 6-117 Figure 6.3: BATHURST Ltd.’s accounts (20X6) 6-120 Figure 6.4: BATHURST Ltd.’s balance sheet (20X6) 6-123 Figure 6.5: BATHURST Ltd.’s income statement (20X6) 6-125 Figure 6.6: BATHURST Ltd.’s statement of changes in equity (20X5/ 20X6) 6-126 Figure 6.7: BATHURST Ltd.’s statement of cash flows (20X6) 6-127 Figure 6.8: BATHURST Ltd.’s notes (20X6) 6-132 Figure 6.9: ESG report BATHURST Ltd.(20X6) 6-134 Figure 7.1: GELLENDORFF Ltd.’s accounts (i) 7-148 <?page no="392"?> Berkau: Financial Statements 9e 16-392 Figure 7.2: GELLENDORFF Ltd.’s accounts (ii) 7-152 Figure 7.3: GELLENDORFF Ltd.’s register of non-current assets 7-153 Figure 7.4: GELLENDORFF Ltd.’s asset-reconciliation statement 7-154 Figure 7.5: TINNEN Ltd.’s accounts (20X4) 7-161 Figure 7.6: YSTERFONTEIN Ltd.’s accounts 7-169 Figure 7.7: OVERBERG (Pty) Ltd.’s accounts 7-174 Figure 7.8: KRIGE (Pty) Ltd.’s accounts (20X3) 7-181 Figure 7.9: KRIGE (Pty) Ltd.’s accounts (20X4) 7-182 Figure 7.10: RICHTERSVELD (Pty) Ltd.’s accounts (20X4) 7-188 Figure 7.11: RICHTERSVELD (Pty) Ltd.’s accounts (20X5) 7-188 Figure 7.12: BOULANGER Ltd.’s accounts 7-191 Figure 7.13: Bond measurement at effective interest 7-196 Figure 8.1: BRENO Ltd.’s balance sheet (1.01.20X5) 8-207 Figure 8.2: BRENO Ltd.’s income statement (20X5) 8-208 Figure 8.3: BRENO Ltd.’s balance sheet (separate F/ S) 8-210 Figure 8.4: BRENO Ltd.’s income statement (separate F/ S) 8-211 Figure 8.5: GAMKA Ltd.’s statement of financial position 8-214 Figure 8.6: SWARTBERG Ltd.’s statement of financial position 8-215 Figure 8.7: GAMKA Ltd.’s balance sheet after acquisition 8-216 Figure 8.8: GAMKA Group’s consolidation worksheet (20X3.1) 8-217 Figure 8.9: GAMKA Group’s consolidation worksheet (20X3.2) 8-218 Figure 8.10: Consolidated balance sheet 8-219 Figure 8.11: GAMKA Ltd.’s income statement (20X4) 8-220 Figure 8.12: GAMKA Ltd.’s balance sheet (20X4) 8-220 Figure 8.13: SWARTBERG Ltd.’s income statement (20X4) 8-221 Figure 8.14: SWARTBERG Ltd.’s balance sheet (20X4) 8-221 Figure 8.15: GAMKA Group’s consolidation worksheet (20X4.1) 8-222 Figure 8.16: Extended income statement for SWARTBERG Ltd. (20X4) 8-223 Figure 8.17: GAMKA Group’s consolidation worksheet (20X4.2) 8-224 Figure 8.18: GAMKA Group’s consolidated balance sheet (20X4) 8-224 Figure 8.19: GAMKA Group’s consolidated income statement (20X4) 8-225 Figure 8.20: Consolidated statement of changes in equity (20X4) 8-226 Figure 8.21: GAMKA Group’s consolidated SCF (20X4) 8-226 Figure 8.22: PORTERSVILLE Ltd.’s balance sheet (parent) 8-228 Figure 8.23: HENDERSON Ltd.’s balance sheet (subsidiary) 8-229 Figure 8.24: Consolidation worksheet for PORTERSVILLE Group (1) 8-230 Figure 8.25: Consolidation worksheet for PORTERSVILLE Group (2) 8-230 Figure 8.26: Consolidation worksheet for PORTERSVILLE Group (3) 8-231 Figure 8.27: Consolidation worksheet for PORTERSVILLE Group (4) 8-232 Figure 8.28: PORTERSVILLE Group’s balance sheet 8-233 Figure 8.29: PATTEN Ltd.'s balance sheet after acquisition 8-234 Figure 8.30: SPYKER (Pty) Ltd.'s balance sheet 8-234 Figure 8.31: PATTEN Ltd.'s balance sheet (20X0) 8-235 Figure 8.32: PATTEN Ltd.'s income statement (20X0) 8-236 Figure 8.33: SPYKER (Pty) Ltd.'s balance sheet (20X0) 8-237 Figure 8.34: SPYKER (Pty) Ltd.'s income statement (20X0) 8-237 Figure 8.35: Worksheet for capital consolidation (PATTEN/ SPYKER) 8-239 <?page no="393"?> Berkau: Financial Statements 9e 16-393 Figure 8.36: Consolidation worksheet (PATTEN/ SPYKER) 8-240 Figure 8.37: Consolidated SFP for PATTEN/ SPYKER 8-241 Figure 8.38: Consolidated income statement (PATTEN/ SPYKER) 8-241 Figure 8.39: QUICKARMS Ltd.’s balance sheet (20X6) 8-243 Figure 8.40: QUICKARMS Ltd.’s income statement 8-244 Figure 8.41: QUICKARMS Ltd.’s balance sheet (20X7) 8-244 Figure 8.42: QUICKARMS Ltd.’s income statement 8-245 Figure 8.43: QUICKARMS Ltd.’s balance sheet (20X7) 8-246 Figure 8.44: CLOSE-WATCH (Pty) Ltd.’s opening balance sheet 8-247 Figure 8.45: CLOSE-WATCH (Pty) Ltd.’s income statement 8-248 Figure 8.46: CLOSE-WATCH (Pty) Ltd.’s balance sheet (20X7) 8-248 Figure 8.47: QUICKARMS/ CLOSE-WATCH (JV)’s balance sheet (IAS 27) 8-249 Figure 8.48: QUICKARM/ CLOSE-WATCH joint venture balance sheet 8-250 Figure 9.1: GREENACRES Ltd.’s accounts (periodic system) 9-257 Figure 9.2: GREENACRES Ltd.’s accounts (perpetual system) 9-259 Figure 9.3: ROSEFIELD Ltd.’s purchases 9-265 Figure 9.4: ROSEFIELD Ltd.’s accounts (i: FIFO) 9-266 Figure 9.5: ROSEFIELD Ltd.’s accounts (ii: weighted average) 9-268 Figure 9.6: RIEBEECK-KASTEEL (Pty) Ltd.’s budgeted accounts 9-276 Figure 9.7: RIEBEECK-KASTEEL (Pty) Ltd.’s actual accounts (IAS 2.13) 9-279 Figure 9.8: Accounts at HEUNING Ltd.’s 9-284 Figure 9.9: NOKOX (Pty) Ltd.’s accounts 9-292 Figure 10.1: EIMKE Ltd.’s balance sheet (20X7) 10-298 Figure 10.2: EIMKE Ltd.’s Profit and Loss-20X8 account 10-300 Figure 10.3: EIMKE Ltd.’s statement of cash flows (20X8) 10-301 Figure 10.4: EIMKE Ltd.’s accounts (20X8) 10-302 Figure 10.5: EIMKE Ltd.’s balance sheet (20X8) 10-309 Figure 10.6: EIMKE Ltd.’s income statement (20X8) 10-309 Figure 10.7: EIMKE Ltd.’s cash flow statement (20X8) 10-311 Figure 11.1: YARRA Ltd.’s balance sheet (20X0) 11-317 Figure 11.2: YARRA Ltd.’s balance sheet (20X1) 11-321 Figure 11.3: YARRA Ltd.’s balance sheet (20X2) 11-323 Figure 11.4: Detailed equity section on YARRA Ltd.’s B/ S (20X1) 11-324 Figure 11.5: Detailed equity section on YARRA Ltd.’s B/ S (20X2) 11-324 Figure 11.6: YARRA Ltd.'s accounts 11-325 Figure 12.1: ABINGTON Ltd.’s accounts (NoE) 12-332 Figure 12.2: ABINGTON Ltd.’s Profit and Loss calculation (NoE) 12-333 Figure 12.3: ABINGTON Ltd.’s income statement (NoE) 12-334 Figure 12.4: SUDHUIZEN PLC’s balance sheet (20X3) 12-336 Figure 12.5: SUDHUIZEN PLC’s purchase ledger 12-336 Figure 12.6: SUDHUIZEN PLC’s accounts (NoE) 12-339 Figure 12.7: SUDHUIZEN PLC’s income statement (NoE) 12-342 Figure 12.8: ABINGTON Ltd.’s accounts (COS) 12-345 Figure 12.9: ABINGTON Ltd.’s income statement (COS) 12-346 Figure 12.10: SUDHUIZEN PLC’s accounts (COS) 12-349 Figure 12.11: SUDHUIZEN PLC’s income statement (COS) 12-352 Figure 13.1: BELMONT Ltd.’s balance sheet (20X6) 13-357 <?page no="394"?> Berkau: Financial Statements 9e 16-394 Figure 13.2: BELMONT Ltd.’s statement of changes in equity (1) 13-357 Figure 13.3: BELMONT Ltd.’s statement of changes in equity (2) 13-359 Figure 13.4: BELMONT Ltd.’s statement of changes in equity (3) 13-360 Figure 13.5: BELMONT Ltd.’s statement of changes in equity (4) 13-361 Figure 13.6: BELMONT Ltd.’s statement of changes in equity (5) 13-362 Figure 13.7: BELMONT Ltd.’s statement of changes in equity (6) 13-363 Figure 14.1: DUMMOND (Pty) Ltd.’s provisions (1) 14-375 Figure 14.2: DUMMOND (Pty) Ltd.’s provisions (2) 14-377 Figure 14.3: DUMMOND (Pty) Ltd.’s provisions (3) 14-378 Figure 14.4: DUMMOND (Pty) Ltd.’s provisions (4) 14-378 Figure 14.5: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) 14-379 <?page no="395"?> Berkau: Financial Statements 9e 17-395 17 Links Link 2.A: KIELING TAXI GmbH 2-31 Link 2.B: DATEV-4 chart of accounts 2-35 Link 2.C: Lufthansa AG’s attachment 2-42 Link 3.A: Download IFRSs for students 3-45 Link 4.A: DEMANN GmbH. 4-73 Link 4.B: RYNEVELD Ltd. 4-89 Link 4.C: TELUK Sdn. Bhd. 4-89 Link 4.D: Worksheet method 4-89 Link 4.E: BINNEVELD Ltd. 4-89 Link 5.A: ROSENDAHL Ltd. 5-94 Link 5.B: EPS calculations 5-102 Link 5.C: CAPELIFT (Pty) Ltd. 5-106 Link 6.A: BATHURST Ltd. 6-114 Link 7.A: RAVENWOOD GmbH 7-141 Link 7.B: OTZE AG 7-141 Link 7.C: GROOTVLEI Ltd. 7-154 Link 7.D: TYGERVALLEY Ltd. 7-155 Link 7.E: CORAL Ltd. 7-158 Link 7.F: STEENBERG Ltd. 7-166 Link 7.G: JANSSENS Ltd. 7-166 Link 7.H: C/ S HAWKINS Ltd. / STEYN GmbH - Cross-Border Investments 7-194 Link 7.I: HAVENGA Ltd. - Bond valuation 7-194 Link 7.J: NATBERGEN (Pty) Ltd. 7-196 Link 7.K: DORRINGTON (Pty) Ltd./ ROTTMAN Ltd. - preference shares 7-197 Link 9.A: ROSEFIELD Ltd. 9-270 Link 9.B: RIEBEEK-KASTEEL (Pty) Ltd. 9-282 Link 9.C: TRAGER GmbH 9-290 Link 9.D: GRENVILLE AG 9-290 Link 9.E: BAKENSKOP PLC 9-294 Link 10.A: RYNEVELD Ltd. 10-311 Link 10.B: EIMKE Ltd. 10-312 Link 12.A: ANKYO Ltd. 12-335 Link 12.B: SUDHUIZEN PLC 12-352 Link 13.A: BELMONT Ltd. 13-356 Link 14.A: MEUL Ltd. 14-370 Link 14.B: BRIZA Ltd. 14-372 Link 14.C: MEMEL Ltd. 14-372 Link 14.D: DUMMOND (Pty) Ltd. 14-375 <?page no="396"?> Berkau: Financial Statements 9e 18-396 18 Literature Arendse, R. [2019]: Fundamental Accounting. 8 th Edition. Cape Town. Berkau, C. [2021]: Basics of Accounting. 6 th Edition. Munich. Berkau, C. [2021]: Vorratsbewertung von selbsterstellten Erzeugnissen nach IAS 2 (Teil 1), in: KoR 21(2021)12 Berkau, C: [2022]: Vorratsbewertung von selbsterstellten Erzeugnissen nach IAS 2 (Teil 2), in: KOR 22(2022)1. Berkau, C. [2022]: Risikomanagement für einen Flugzeugverleiher, in: KOR 22(2022)3. Berkau, C. [2022]: Neubewertung von Sachanlagen mit anschließender Auflösung von Rücklagen und Steuerlatenzen. In: KOR 22(2022)7-8. Berkau, C. [2022]: Bewertung von selbsterstellten Produkten bei volatilen Einkaufspreisen für Rohstoffe und schwankender Beschäftigung nach IAS 2, in: IRZ 17(2022)5. Berkau, C. [2023]: Earnings per Share und Eigenkapitalausweis in der IFRS Bilanz, in: KOR 23(2023)3. Berkau, C. [2023]: Management Accounting. 7 th Edition. Munich. Berkau, C. [2023]: Ausweis von Umsatzerlösen und sonstigen Erträgen, in: KOR 23(2023)7. Berkau, C. [2024]: Veränderung von Leasingverträgen durch den Leasingnehmer, in: KOR 24(2024)2 Berkau, C.; Msiza, N.; Neethling, A. [2024]: Lease Modifications in the Lessor’s Books, in: KOR 24(2024)7-8. Berkau, C. [2024]: Die Bilanzierung und Änderung von Leasingverträgen aus Leasingnehmer und -gebersicht, in: IRZ 19(2024)6. Berkau, C. [2025]: Erträge aus Währungsumrechnungen bei Fremdwährungsgeschäften und ausländischen Geschäftsbetrieben (IAS 21). In: IRZ 20(2025)6. Brigham, E.F.; Erhardt, M.C. [2019]: Financial Management - Theory and Practice. 16th Edition. Mason, OH. Brösel, G. [2024]: Grundwissen Konzernrechnungslegung. Ausgabe 2024, München. Buchholz, R. [2023]: Internationale Rechnungslegung. Die wesentlichen Vorschriften nach IFRS und HGB - mit Aufgaben und Lösungen. 16. Aufl., Berlin. Coenenberg, A.G.; Haller, A.; Schultze, W. [2024]: Jahresabschluss und Jahresabschlussanalyse, Betriebswirtschaftliche, handelsrechtliche, steuerrechtliche und internationale Grundsätze - HGB, IFRS und US-GAAP. 27. Aufl., Stuttgart. Dempsey, A. et al. [2020]: Introduction to Financial Accounting. 10 th Edition. Cape Town. Drury, C. [2017]: Management and Cost Accounting. 10 th Edition, Florence KY. <?page no="397"?> Berkau: Financial Statements 9e 18-397 Dusemond, M.; Küting, P.; Wirth, J. [2018]: Küting/ Weber - Der Konzernabschluss. Praxis der Konzernrechnungslegung nach HGB und IFRS. 14. Aufl., Stuttgart. Flood, J.M. [2019]: Wiley GAAP 2019. Interpretation and Application of Generally Accepted Accounting Principles. Hoboken NJ. Flynn, D.; Kornhof, C. [2016]: Fundamental Accounting. 7 th Edition. Cape Town. Garrison, R.H.; Noreen, E.W.; Brewer, P.C. [2018]: Managerial Accounting. 16 th Edition. Boston MA. Hahn, R. [2022]: Sustainability Management. Global Perspectives on Concepts, Instruments, and Stakeholders. Düsseldorf. 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[2018]: Accounting - An Introduction. 13 th Edition. Cape Town. Needles, B.E.; Powers, M: [2016] Financial Accounting. 11 th Edition, Boston, MA. Oppermann, H.R.B.; Booysen, S.F.; van der Merve, N. [2018]: Accounting Standards. A Comprehensive Question Book on International Financial Reporting Standards. 18 th Edition, Cape Town. Pellens, B. et al. [2021]: Internationale Rechnungslegung. IFRS 1 bis 16, IAS 1 - 41, IFRIC-Interpretationen, Standardentwürfe. 11. Aufl., Stuttgart. van Rensburg, R. et al. [2016]: Cost and Management Accounting. 3 rd Edition, Cape Town. Sailer, U.: Nachhaltigkeitscontrolling - So werden Unternehmen nachhaltig gesteuert. 4. Aufl., Stuttgart. <?page no="398"?> Berkau: Financial Statements 9e 18-398 Schmidtlin, N. [2014]: The Art of Company Valuation and Financial Statement Analysis. Chichester. Schneeloch, D.; Meyering, S.; Patek, G. [2016]: Betriebliche Steuerlehre. Band 1: Grundlagen der Besteuerung, Ertragsteuern. 7. Auf., München. Schwellnuß, A.-G. [2024]: Grundlagen für ein erfolgreiches Nachhaltigkeitscontrolling - Gestaltung und Umsetzung nachhaltiger Unternehmenssteuerung, Probleme, Instrumente und Kennzahlen. München. Seppelfricke, P. [2020]: Unternehmensbewertungen. Methoden, Übersichten und Fakten für Praktiker, Stuttgart. Service, C. [2022]: Gripping GAAP, Johannesburg. Laine, M.; Tregidga, H.; Unerman, J. [2021]: Sustainability Accounting and Accountability. Abingdon. Wood, F.; Sangster, A. [2018]: Business Accounting 1. 14 th Edition, Harlow et al. Wood, F.; Sangster, A. [2018]: Business Accounting 2. 14 th Edition. Harlow et al. <?page no="399"?> Layout www.uvk.de Prof. Dr. Carsten Berkau teaches accounting at Osnabrück University UAS and in South Africa, Malaysia, South Korea and China. Other books: Basics of Accounting / Bilanzen / Management Accounting Financial Statements is based on an international IFRS accounting syllabus as taught at UAS Osnabrück and its international partner universities. The textbook covers the preparation, disclosure, and analysis of financial statements on a bachelor’s and master’s level. It contains more than sixty case studies and numerous links to an online materials bank. As the cases dominate the textbook space, readers get the impression to observe accountants at work. The case studies comprise of detailed calculations, journal entries, T-accounts, and financial statements. For open book exams, the text includes how-it-is-done paragraphs which offer directions for accounting work. The textbook’s structure follows the sequence of balance sheet items beginning with non-current assets and ending at income tax liabilities. It further discusses a full set of financial statements. That comprises of the income statement, the statement of cash flows and the statement of changes in equity. The notes are provided for a case study including ESG reporting. Group accounting and joint venture accounting are covered as well. Readers can download numerous online materials, like exam tasks with solutions thereto, links to youtube clips produced by the author and spreadsheets for support of their accounting work in academia. Financial statements is a standard textbook for accounting classes taught at universities of applied sciences in English and supports managers and accountants who strive to enhance their knowledge about national accounting towards IFRS standards. ISBN 978-3-381-1347 1-7