<?page no="0"?> Financial Statements International Accounting (IFRS) 7 th Edition Carsten Berkau <?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) 7 , revised Edition UVK Verlag · München Translated by Keabetswe Sylvia Berkau <?page no="4"?> ISBN 978-3-7398-3221-0 (Print) ISBN 978-3-7398-8221-5 (ePDF) Umschlagmotiv: © iStockphoto · matdesign24 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. 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/ 9783739882215 © UVK Verlag 20 22 - ein Unternehmen der Narr Francke Attempto Verlag GmbH + Co. KG , xxDischingerweg 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 CPI books GmbH, Leck <?page no="5"?> Berkau: Financial Statements 7e 1-5 I Contents I Contents............................................................................................. 1-5 II Introduction .................................................................................... 1-13 1 Conventions ..................................................................................... 1-14 1.1 Accounting Periods ........................................................................................1-14 1.2 Accounting Technical Terms ........................................................................1-14 1.3 Account Names ..............................................................................................1-14 1.4 Alphabetic Order............................................................................................1-14 1.5 Basics................................................................................................................1-14 1.6 Bookkeeping Entries......................................................................................1-14 1.7 Bookkeeping Entry Format ..........................................................................1-14 1.8 Calculations .....................................................................................................1-15 1.9 Case Studies.....................................................................................................1-15 1.10 Case Study Text ..............................................................................................1-15 1.11 Cash Flow Separation ....................................................................................1-15 1.12 Companies .......................................................................................................1-15 1.13 Cost-Expense-Congruence............................................................................1-15 1.14 Country ............................................................................................................1-15 1.15 Currency Unit..................................................................................................1-15 1.16 Data Format in Tables ...................................................................................1-16 1.17 Data Sheets......................................................................................................1-16 1.18 Prepayments of Income Taxes .....................................................................1-16 1.19 How it is Done ...............................................................................................1-16 1.20 Income Taxes..................................................................................................1-16 1.21 Financial Statements for Taxation................................................................1-16 1.22 Names ..............................................................................................................1-16 1.23 Language..........................................................................................................1-16 1.24 Learning Objectives .......................................................................................1-16 1.25 Legal Forms of a Business.............................................................................1-16 1.26 Length of a Month/ Year...............................................................................1-16 1.27 Level of Precision ...........................................................................................1-16 1.28 Links.................................................................................................................1-17 1.29 Literature .........................................................................................................1-17 1.30 Non-existing Items.........................................................................................1-17 1.31 Online Materials..............................................................................................1-17 1.32 Payment Terms ...............................................................................................1-17 1.33 Presentation of Accounts ..............................................................................1-17 1.34 Pro-Rated Depreciation/ Interest .................................................................1-18 1.35 Quotation of Law Texts/ Standards .............................................................1-18 1.36 Sequence of Bookkeeping Entries................................................................1-18 1.37 Tax on Capital Returns (Dividend Tax) ......................................................1-18 <?page no="6"?> Berkau: Financial Statements 7e 1-6 1.38 Transaction Costs........................................................................................... 1-18 1.39 Value Added Tax, Goods and Service Tax................................................. 1-18 1.40 VAT Reduction .............................................................................................. 1-19 1.41 Working Definitions ...................................................................................... 1-19 1.42 Work-in-Process Account............................................................................. 1-19 1.43 Writing Management Terms ......................................................................... 1-19 1.44 WWW .............................................................................................................. 1-19 1.45 Youtube Videos.............................................................................................. 1-19 1.46 10-20-30 Rule.................................................................................................. 1-19 2 Financial Statements based on HGB ............................................. 2-20 2.1 What is in this Chapter? ................................................................................ 2-20 2.2 Learning Objectives ....................................................................................... 2-20 2.3 Legal Forms for Companies ......................................................................... 2-20 2.4 Obligation of Keeping Bookkeeping Records ........................................... 2-21 2.5 Establishment of a Company ....................................................................... 2-22 2.6 Income Tax Calculation ................................................................................ 2-23 2.7 Value added tax VAT. ................................................................................... 2-23 2.8 C/ S KIELING TAXI GmbH - 20X1 ....................................................... 2-24 2.9 C/ S KIELING TAXI GmbH-20X2 .......................................................... 2-30 2.10 Summary.......................................................................................................... 2-39 2.11 Working Definitions ...................................................................................... 2-39 2.12 Question Bank................................................................................................ 2-40 2.13 Solutions: ......................................................................................................... 2-41 3 Financial Statements based on IFRSs ............................................ 3-42 3.1 What is in the Chapter? ................................................................................. 3-42 3.2 Learning Objectives ....................................................................................... 3-42 3.3 IFRSs ............................................................................................................... 3-42 3.4 How to Access IFRSs.................................................................................... 3-42 3.5 C/ S KENILWORTH MTS Ltd. - 20X1 ................................................... 3-44 3.6 C/ S KENILWORTH MTS Ltd. - 20X2 ................................................... 3-56 3.7 Summary.......................................................................................................... 3-65 3.8 Working Definitions ...................................................................................... 3-65 3.9 Question Bank................................................................................................ 3-66 3.10 Solutions.......................................................................................................... 3-67 4 Accounting for Retailers.................................................................. 4-68 4.1 What is in the Chapter? ................................................................................. 4-68 4.2 Learning Objectives ....................................................................................... 4-68 4.3 Dealerships...................................................................................................... 4-68 4.4 Gross Profit Calculation................................................................................ 4-69 4.5 C/ S DEMANN GmbH................................................................................ 4-69 4.6 Trial Balance ................................................................................................... 4-70 4.7 Trading Account ............................................................................................ 4-71 <?page no="7"?> Berkau: Financial Statements 7e 1-7 4.8 C/ S RYNEVELD Ltd...................................................................................4-71 4.9 C/ S TELUK Sdn. Bhd. .................................................................................4-86 4.10 Worksheet for T/ B Calculations ..................................................................4-87 4.11 Summary ..........................................................................................................4-88 4.12 Working Definitions ......................................................................................4-88 4.13 Question Bank ................................................................................................4-89 4.14 Solutions ..........................................................................................................4-90 5 Basics of Financial Statement Analysis .......................................... 5-91 5.1 What is in the Chapter? .................................................................................5-91 5.2 Learning Objectives .......................................................................................5-91 5.3 Company Appraisal ........................................................................................5-91 5.4 Situational Awareness about a Company ....................................................5-92 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 .............................................................................................5-96 5.11 Basics of Ratio Analysis .................................................................................5-96 5.12 C/ S CAPELIFT (Pty) Ltd.............................................................................5-98 5.13 Performance Ratios - CAPELIFT (Pty) Ltd. .............................................5-99 5.14 Liquidity Ratios - CAPELIFT (Pty) Ltd. ................................................. 5-105 5.15 Capital Structure Ratios - CAPELIFT (Pty) Ltd. ................................... 5-106 5.16 Market Value Ratios - CAPELIFT (Pty) Ltd. ......................................... 5-109 5.17 Summary ....................................................................................................... 5-110 5.18 Working Definitions ................................................................................... 5-110 5.19 Question Bank ............................................................................................. 5-110 5.20 Solutions ....................................................................................................... 5-111 6 Formal Financial Statement Requirements...................................6-112 6.1 What is in the Chapter? .............................................................................. 6-112 6.2 Learning Objectives .................................................................................... 6-112 6.3 IFRSs Consistency....................................................................................... 6-112 6.4 Qualitative Characteristics of Financial Information.............................. 6-113 6.5 C/ S BATHURST Ltd. ................................................................................ 6-115 6.6 Statement of Financial Position - BATHURST Ltd. ............................. 6-122 6.7 Statement of Profit or Loss - BATHURST Ltd. .................................... 6-124 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. ......................................................................... 6-127 6.11 Summary ....................................................................................................... 6-132 6.12 Working Definitions ................................................................................... 6-132 6.13 Question Bank ............................................................................................. 6-132 6.14 Solutions ....................................................................................................... 6-133 <?page no="8"?> Berkau: Financial Statements 7e 1-8 7 Non-current Assets on the Balance Sheet .................................... 7-134 7.1 What is in the Chapter? ............................................................................... 7-134 7.2 Learning Objectives ..................................................................................... 7-134 7.3 Initial Recognition........................................................................................ 7-134 7.4 C/ S GETEN (Pty) Ltd. .............................................................................. 7-135 7.5 Qualifying Assets.......................................................................................... 7-136 7.6 C/ S LANGDAM Bhd. ............................................................................... 7-137 7.7 Subsequent Valuation .................................................................................. 7-138 7.8 C/ S GELLENDORFF LLC...................................................................... 7-139 7.9 Impairment Loss .......................................................................................... 7-140 7.10 Impairment Loss - GELLENDORFF LLC............................................ 7-140 7.11 Revaluations.................................................................................................. 7-148 7.12 C/ S TINNEN K.K. .................................................................................... 7-148 7.13 C/ S STEENBERG Ltd. - Case (i)............................................................ 7-157 7.14 C/ S STEENBERG Ltd. - Case (ii)........................................................... 7-159 7.15 Disposal of Assets........................................................................................ 7-161 7.16 C/ S YSTERFONTEIN Ltd....................................................................... 7-161 7.17 Investment Property and Assets Held for Sale ........................................ 7-164 7.18 C/ S MERSEBURG Ltd.............................................................................. 7-164 7.19 Assets Held for Sale..................................................................................... 7-166 7.20 C/ S OVERBERG (Pty) Ltd....................................................................... 7-166 7.21 Intangible Assets .......................................................................................... 7-168 7.22 C/ S Dentist PAARDEBERG.................................................................... 7-168 7.23 Design and Research Costs......................................................................... 7-169 7.24 C/ S WESPOORT Ltd. ............................................................................... 7-169 7.25 Leases............................................................................................................. 7-170 7.26 C/ S KRIGE (Pty) Ltd. ................................................................................ 7-171 7.27 C/ S MERVE (Pty) Ltd. - Lessee ............................................................... 7-175 7.28 C/ S MERVE (Pty) Ltd. - Lessor .............................................................. 7-179 7.29 C/ S VLAEBURG Ltd. - Lessee................................................................. 7-180 7.30 C/ S VLAEBURG Ltd. - Lessor................................................................ 7-184 7.31 Short-term Leases ........................................................................................ 7-186 7.32 C/ S JONKERS GmbH .............................................................................. 7-186 7.33 Financial Instruments .................................................................................. 7-187 7.34 C/ S HAWKINS Ltd. / STEYN GmbH - Cross-Border Investments 7-188 7.35 C/ S HAVENGA Ltd. - Bonds .................................................................. 7-191 7.36 C/ S NATBERGEN (Pty) Ltd. - Bonds held to Maturity ..................... 7-192 7.37 C/ S DORRING-TON Ltd. / ROTTMAN Ltd. - Pref. Shares ........... 7-194 7.38 Derivatives .................................................................................................... 7-196 7.39 MOLLENBERG Ltd. - Call Option ........................................................ 7-197 7.40 Summary........................................................................................................ 7-199 7.41 Working Definitions .................................................................................... 7-199 7.42 Questions Bank ............................................................................................ 7-200 7.43 Solutions........................................................................................................ 7-201 <?page no="9"?> Berkau: Financial Statements 7e 1-9 8 Business Combinations................................................................. 8-202 8.1 What is in the Chapter? .............................................................................. 8-202 8.2 Learning Objectives .................................................................................... 8-202 8.3 Group Accounting ...................................................................................... 8-202 8.4 Separate Financial Statements IAS 27....................................................... 8-205 8.5 C/ S BRENO Ltd. ....................................................................................... 8-206 8.6 Consolidated Financial Statements............................................................ 8-211 8.7 C/ S GAMKA/ SWARTBERG Group - Initial Consolidation............. 8-211 8.8 C/ S GAMKA/ SWARTBERG Group - Subsequent Consolidations . 8-218 8.9 C/ S PORTERSVILLE/ HENDERSON Group.................................... 8-227 8.10 Intra-Group Profit Consolidation ............................................................. 8-232 8.11 CS PATTEN/ SPYKER............................................................................. 8-233 8.12 Joint Venture Accounting .......................................................................... 8-240 8.13 C/ S QUICKARMS-RESPONSE-FIRE Joint Operations.................... 8-241 8.14 C/ S CLOSEWATCH - Joint Venture...................................................... 8-245 8.15 Summary ....................................................................................................... 8-250 8.16 Working Definitions ................................................................................... 8-250 8.17 Question Bank ............................................................................................. 8-250 8.18 Solutions ....................................................................................................... 8-251 9 Current Assets on the Balance Sheet ............................................ 9-252 9.1 What is in the Chapter? .............................................................................. 9-252 9.2 Learning Objectives .................................................................................... 9-252 9.3 Current and non-Current Assets ............................................................... 9-252 9.4 Inventories.................................................................................................... 9-253 9.5 C/ S GREENACRES Ltd. ......................................................................... 9-254 9.6 Perpetual Inventory System ....................................................................... 9-255 9.7 C/ S GREENACRES Ltd. - Perpetual Inventory System..................... 9-256 9.8 Different Inventory Valuation ................................................................... 9-259 9.9 Purchase Price Change................................................................................ 9-259 9.10 C/ S ROSEFIELD Ltd. .............................................................................. 9-259 9.11 Loss on Valuation........................................................................................ 9-264 9.12 C/ S HEISTEL (Pty) Ltd. ........................................................................... 9-264 9.13 Manufacturing Accounting......................................................................... 9-265 9.14 Overhead Application................................................................................. 9-266 9.15 C/ S RIEBEECK-KASTEEL (Pty) Ltd. .................................................. 9-267 9.16 C/ S RIEBEECK-KASTEEL (Pty) Ltd. - IAS 2.13 (β) ......................... 9-270 9.17 Manufacturing Summary Account ............................................................ 9-273 9.18 C/ S RIEBEECK-KASTEEL (Pty) Ltd. - case (γ)................................. 9-273 9.19 Receivables ................................................................................................... 9-274 9.20 C/ S CHELMSFORD ................................................................................. 9-274 9.21 Securities ....................................................................................................... 9-277 9.22 C/ S NOKOX (Pty) Ltd. ............................................................................ 9-277 9.23 C/ S TRAGER GmbH ............................................................................... 9-279 <?page no="10"?> Berkau: Financial Statements 7e 1-10 9.24 C/ S GRENVILLE AG............................................................................... 9-280 9.25 C/ S NOKOX (Pty) Ltd. continued ........................................................ 9-281 9.26 Prepaid Expenses ......................................................................................... 9-283 9.27 Cash and its Equivalents ............................................................................. 9-284 9.28 C/ S BAKENSKOP PLC............................................................................ 9-284 9.29 Summary........................................................................................................ 9-285 9.30 Working Definitions .................................................................................... 9-285 9.31 Question Bank.............................................................................................. 9-286 9.32 Solutions........................................................................................................ 9-287 10 Statement of Cash Flows ..............................................................10-288 10.1 What is in the Chapter? .............................................................................10-288 10.2 Learning Objectives ...................................................................................10-288 10.3 Cash Flow Statement Obligation ............................................................. 10-288 10.4 C/ S EIMKE Ltd. ....................................................................................... 10-290 10.5 Direct Method ............................................................................................10-294 10.6 C/ S EIMKE Ltd. - Direct Method ........................................................10-294 10.7 Reconciliation of Profits with Operating Cash Flows........................... 10-295 10.8 Why Step (1)? ..............................................................................................10-296 10.9 Why step (2)? ..............................................................................................10-296 10.10 Why Step (3)? ..............................................................................................10-297 10.11 Why Step (4)? ..............................................................................................10-297 10.12 Why Step (5)? ..............................................................................................10-297 10.13 Why Step (6)? ..............................................................................................10-297 10.14 Why Step (7)? ..............................................................................................10-298 10.15 Why Step (8)? ..............................................................................................10-299 10.16 Why Step (9)? ..............................................................................................10-300 10.17 Why Step (10)? ............................................................................................10-300 10.18 C/ S EIMKE Ltd. - Reconciliation Method........................................... 10-300 10.19 Derivative Method .....................................................................................10-303 10.20 Summary...................................................................................................... 10-304 10.21 Working Definitions ..................................................................................10-304 10.22 Question Bank............................................................................................ 10-304 10.23 Solutions...................................................................................................... 10-305 11 Equity on the Balance Sheet ........................................................ 11-306 11.1 What is in the Chapter? .............................................................................11-306 11.2 Learnings Objectives .................................................................................11-306 11.3 Equity ..........................................................................................................11-306 11.4 Issued Capital..............................................................................................11-306 11.5 C/ S YARRA Ltd. - 20X0 .........................................................................11-307 11.6 Reserves....................................................................................................... 11-308 11.7 C/ S YARRA Ltd. - 20X0 continued.................................................... 11-308 11.8 C/ S YARRA Ltd. - 20X1 .........................................................................11-309 11.9 C/ S YARRA Ltd. - 20X2 .........................................................................11-314 <?page no="11"?> Berkau: Financial Statements 7e 1-11 11.10 Retained Earnings...................................................................................... 11-315 11.11 Summary ..................................................................................................... 11-318 11.12 Working Definitions ................................................................................. 11-318 11.13 Question Bank ........................................................................................... 11-319 11.14 Solutions ..................................................................................................... 11-320 12 Statement of Profit or Loss and Other Comprehensive Income. 12-321 12.1 What is in the Chapter? ............................................................................ 12-321 12.2 Learning Objectives .................................................................................. 12-321 12.3 Statement of Profit or Loss and Other Comprehensive Income........ 12-321 12.4 C/ S ABINGTON Ltd. - Nature of Expense Method ........................ 12-323 12.5 C/ S SUDHUIZEN PLC - Nature of Expense Method ..................... 12-327 12.6 C/ S ABINGTON Ltd. - Cost of Sales Format.................................... 12-333 12.7 C/ S SUDHUIZEN PLC - Cost of Sales Format................................. 12-337 12.8 Summary ..................................................................................................... 12-342 12.9 Working Definitions ................................................................................. 12-342 12.10 Question Bank ........................................................................................... 12-343 12.11 Solutions ..................................................................................................... 12-344 13 Statement of Changes in Equity ..................................................13-345 13.1 What is in the Chapter? ............................................................................ 13-345 13.2 Learning Objectives .................................................................................. 13-345 13.3 IFRS Regulations ....................................................................................... 13-345 13.4 C/ S BELMONT Ltd. ............................................................................... 13-346 13.5 C/ S BELMONT Ltd. - Share Issue/ Treasury Shares .......................... 13-348 13.6 C/ S BELMONT Ltd. - Profit or Loss ................................................... 13-349 13.7 C/ S BELMONT Ltd. - Other Comprehensive Income ...................... 13-350 13.8 C/ S BELMONT Ltd. - Revaluations ..................................................... 13-351 13.9 C/ S BELMONT Ltd. - Appropriation of Profits................................. 13-352 13.10 Summary ..................................................................................................... 13-354 13.11 Working Definition ................................................................................... 13-354 13.12 Question Bank ........................................................................................... 13-354 13.13 Solutions ..................................................................................................... 13-355 14 Liabilities on the Balance Sheet...................................................14-356 14.1 What is in the Chapter? ............................................................................ 14-356 14.2 Learning Objectives .................................................................................. 14-356 14.3 Liabilities..................................................................................................... 14-356 14.4 Certain Liabilities ....................................................................................... 14-357 14.5 C/ S WARWICK Ltd. - Buying Goods on Credit................................. 14-359 14.6 C/ S BATHURST Ltd. - Bank Loan ....................................................... 14-360 14.7 C/ S MEUL Ltd. - Amortised Costs....................................................... 14-362 14.8 Bonds Issue ................................................................................................ 14-366 14.9 C/ S BRIZA Ltd. - Bonds ......................................................................... 14-368 14.10 C/ S MEMEL PLC - Annuity and Extra Repayments.......................... 14-370 <?page no="12"?> Berkau: Financial Statements 7e 1-12 14.11 Provisions.................................................................................................... 14-374 14.12 C/ S SEENA Ltd. - Measurement of Provisions ..................................14-374 14.13 C/ S HADRA (Pty) Ltd. - Provision for Pension Funds ......................14-376 14.14 C/ S DUMMOND (Pty) Ltd. - Provision of rework.............................14-377 14.15 C/ S SALMAN Ltd. - Provisions due to Onerous Contracts ............... 14-383 14.16 Summary...................................................................................................... 14-384 14.17 Working Definitions ..................................................................................14-384 14.18 Question Bank............................................................................................ 14-385 14.19 Solutions...................................................................................................... 14-386 15 Abbreviations................................................................................15-387 16 Table of Figures ...........................................................................16-394 17 Links .............................................................................................17-398 18 Literature ......................................................................................18-399 <?page no="13"?> Berkau: Financial Statements 7e 1-13 II Introduction We prepared this 7 th edition of the textbook Financial Statements based on the feedback and questions received from our students. We added a further case study for leasing and simplified the revaluation paragraph. Minor data changes apply for the case studies in chapter (7), (9), (11), (12) and (13). The content of Financial Statements focusses on IFRSs. We only discuss in chapter (2) German law to show you differences in terms of Bookkeeping. Financial Statements covers the syllabus of an international Accounting class on bachelors’ and masters’ level. We expect from our readers fundamental knowledge in Bookkeeping as introduced in our textbook Basics of Accounting and the videos related thereto. You’ll find footnotes to the relevant Basics-chapters to support your studies. Although you know about German Bookkeeping, we strongly recommend reading the first part of our Basics of Accounting and study the international format. Financial Statements teaches you how to prepare financial statements in compliance with IFRSs. We quote relevant IFRS standards and paragraphs to direct you to the applied regulations. We follow a case-based teaching approach with 64 case studies in this textbook. You’ll learn Accounting by detailed case observations. From the publisher's website you can follow the link: http: / / www.meta.narr.de/ 978373983 2210/ cases.zip to download more than 350 exam tasks with complete solutions. We also provide you with a link to our videos. 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 colleague at Hochschule Osnabrück, Prof. Dr. Marion Wendehals, and all professors at our partner universities for their valuable input. We also thank Dr. Jürgen Schechler from UVK Verlag for the pleasant cooperation. Dr. Schechler is our lector in Munich, and we enjoy the very friendly and highly efficient cooperation with 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 improve our textbooks. For sending us comments on textbooks, pls., write to: BOOK@Prof-Berkau.de. Enjoy the 7 th edition of Financial Statements! Cape Town, in July 2022 Keabetswe and Carsten Berkau <?page no="14"?> Berkau: Financial Statements 6e 1-14 1 Conventions The below listed conventions apply merely to simplify the cases. These conventions are about legal forms, tax rates, formats etc. They apply for this textbook, for our Basics of Accounting, for our Management Accounting and for all online study materials. 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. 1.1 Accounting Periods Accounting periods start on 1.01.20XX and end on 31.12.20XX. Furthermore, to keep the examples transferable to later years, we write the decades with 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. They help you to easily understand the content. These are simple explanations if you are beginners in Accounting. The Accounting technical terms are not as formal and enforcable as the 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 small letters. Assume there is a bank account with Deutsche Bank, and we refer thereto. The writing is with small 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 For all lists, we apply an alphabetic order. 1.5 Basics Our Basics refers to the textbook Berkau: Basics of Accounting. You must read our basics before you start reading our Financial Statements. It introduces you to Bookkeeping and major Accounting concepts without consideration of International Accounting standards IFRSs. We frequently quote the Basics. 1.6 Bookkeeping Entries All Bookkeeping entries are printed in bold and cover a whole page’s width. 1.7 Bookkeeping Entry Format We write debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. See e.g., a Bookkeeping entry for the acquisition of a motor vehicle: <?page no="15"?> Berkau: Financial Statements 6e 1-15 DR Motor Vehicle................ 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR The identifier for Bookkeeping entries in the text, like “Bookkeeping entry (1)” can be found in the accounts as “(1)”, as well. 1.8 Calculations For calculations, we only show the units with the results. E.g., 10 + 20.50 = 30.50 EUR. Furthermore, the figures in calculations come without digits after the decimal point in case they are zero. Results are printed in bold to find calculated figures easily. All calculations are exact to the EURcent or any other currency as 1/ 100amounts. 1.9 Case Studies We keep case studies in this textbook as easy as possible even as they might look unrealistic. Teaching of Accounting is our priority. 1.10 Case Study Text We write case studies in a different text format than the normal text (Italic fonts). 1.11 Cash Flow Separation Interest payments in this textbook are always considered financing cash flows, even as IAS 7.33 allows their recognition as operating as well as financing cash flows. This applies for all case studies. 1.12 Companies For the textbook, the legal form of companies does not matter. Legal forms are not part of our Accounting syllabus. They are covered by our Basics. We only assure that companies 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. We apply the technical terms “business”, “firm” and “company”. Most companies are limited companies in this textbook, like GmbH, AG, Pty Ltd., PLC, Inc. etc. 1.13 Cost-Expense-Congruence By default, costs are expenses and vice versa. 1.14 Country All cases take place in countries where IFRSs apply for single entity financial statements. For our teaching in Cape Town, many examples refer to South African companies. 1.15 Currency Unit For all examples, the reporting currency is based on the country of the case study. We use the common 3 letter codes for abbreviation, like ZAR for South African Rand or GBP for British Pound Sterling. <?page no="16"?> Berkau: Financial Statements 6e 1-16 1.16 Data Format in Tables In tables, negative figures are shown in brackets. E.g., (7.50) equals -7.50 EUR. 1.17 Data Sheets WWe show the most important data for case studies in their data sheets. 1.18 Prepayments of Income Taxes No provisional tax payments are made to the national revenue service in our case studies. Taxes are calculated at the year-end and added to short-term liabilities, mostly to the Income Tax Liabilities account. For German companies, § 249 HGB applies, and income taxes are shown as provisions. 1.19 How it is Done (1) You find How-it-is Done sections in this textbook. (2) They offer you very short and clear instructions for your Accounting work. 1.20 Income Taxes For our textbooks and the IFRSs, a simplified income tax model applies. Income taxes amount to 30 % of the pre-tax profit EBT. 1.21 Financial Statements for Taxation We do not cover tax calculations. Tax statements are relevant for us to determine income taxes (simplified calculation) and deferred taxes. 1.22 Names We name companies and mark them with capital letters. E.g., SCHULZE- BRAMMELKAMP Ltd. No links to actual existing persons or companies are intended. The names work as identifiers, so you can use them for your communication with your classmates. 1.23 Language This textbook is written in South African English. With the 5 th edition, a German version is available, too. The translation from the English text is sentence-by-sentence (not word by word). 1.24 Learning Objectives Every chapter starts by the learning objectives and ends by a summary. We also give you a short overview by our What is in the Chapter? -paragraphs. 1.25 Legal Forms of a Business For this textbook, we use Ltd., (Pty) Ltd., Sdn. Bhd., Bhd., AG, GmbH, UG, PLC, Inc. etc. If no legal form has been mentioned, assume the company is privately-owned, such as SANDPIPER BOOKS for a privatelyowned bookstore. 1.26 Length of a Month/ Year 1 month = 21.5 days = 4.3 weeks. 1 year = 12 evenly long months = 365 days = 52 weeks. 1.27 Level of Precision We work exact to 2 digits after the decimal point. Results from workings are <?page no="17"?> Berkau: Financial Statements 6e 1-17 rounded, too. We calculate sometimes in MS-Excel; hence, calculations in the background are more precise than they appear. All financial statements show figures rounded to the nearest full currency amount. 1.28 Links Links in the book direct you to further explanations and readings. 1.29 Literature The main source of 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. 1.30 Non-existing Items In case something has not been mentioned it does not exist. 1.31 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 Financial Statements (A), chapter 10 and is the 14 th exam task. As higher the count as newer the task is. 1.32 Payment Terms If nothing has been mentioned about the payment terms, payments and receipts are recorded in the Cash/ Bank account. In this textbook, payments/ receipts for taxation and for dividends are due in the next following Accounting period. 1.33 Presentation of Accounts Accounts are displayed in the T-format. They have a 3-letter indicator column used for Bookkeeping entry identification or contra-entry references. Nominal accounts show the Accounting periods as a suffix, such as Depreciation-20X4. See the accounts for the car acquisition’s Bookkeeping entry: D C D C (1) 20,000.00 (1) 4,000.00 D C (1) 24,000.00 Cash/ Bank C/ B Property, plant, equipment PPE Value added tax VAT Figure 1.1: Accounts <?page no="18"?> Berkau: Financial Statements 6e 1-18 1.34 Pro-Rated Depreciation/ Interest Although provided as annual rates, depreciation and interest are calculated monthly accurate to a full month. Monthly depreciation and the rate of interest are calculated as annual depreciation rate divided by 12. In 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 100,000.00 EUR taken 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. Note, that in case of the loan is calculated based on the effective interest method (at amortised costs) the effective interest rate applies which exceeds the annual rate if payments are made every month. If dates are different to the beginning or end of the Accounting period, the month is underlined to direct your attention thereto, as in 11.06.20X4. By default, interest and pay-off payments take place at the end of the Accounting period, which is 31.12.20XX. Interest is only calculated for debts, such as bank loans, bonds etc. Overdrafts of bank accounts are in general ignored. An exception is chapter (37) in our Basics. 1.35 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. 1.36 Sequence of Bookkeeping Entries The sequence of Bookkeeping entries comes along the logical process defined by the text. Bookkeeping identifiers, like “(1), (2), (3) …” do not indicate nor prescribe a sequence of recording. 1.37 Tax on Capital Returns (Dividend Tax) The tax on capital returns is an income tax. The rate on capital returns is 25 % based on the capital gain for this textbook. Note, on the side of the company that declares the dividend, the tax on capital returns is no company tax, although companies owe 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. 1.38 Transaction Costs We ignore transaction costs, like costs for selling goods/ services, taking and repaying bank loans, issuing shares or bonds etc. 1.39 Value Added Tax, Goods and Service Tax VAT stands for value added tax and GST for Goods and Service Tax. Except in e.g., United Arabic Emirates or <?page no="19"?> Berkau: Financial Statements 6e 1-19 some U.S. states like Delaware, Alaska etc., consumers pay VAT - or 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 in our textbooks is 20 %. We ignore reduced VAT rates as levied in many countries for food, books etc. 1.40 VAT Reduction It is assumed that every company discussed in this textbook is registered for VAT reduction. 1.41 Working Definitions At the end of every chapter, you find short and easily understandable definitions for new Accounting terms. They are merely a glossary and should support your understanding. For enforceable and more precise definitions study IFRSs! 1.42 Work-in-Process Account We apply the Work-in-Process account as reconciliation account for all job orders and call it Work-in-Process WIP. We also apply 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. 1.43 Writing Management Terms We write academic disciplines, like Accounting, Marketing, Management etc., with capital letters. 1.44 WWW We provide you with a lot of exercises and further materials. Pls., check the link: http: / / www.meta.narr.de/ 978373983 2210/ cases.zip Most of the exercises are our exam tasks from Hochschule Osnabrück or its partner universities, in South Africa, China, South Korea and Malaysia. 1.45 Youtube Videos On our Youtube channel (Carsten Berkau) we publish video materials which are based on the case studies on this textbook. Find their links on Twitter and on the UVK website. 1.46 10-20-30 Rule In this textbook, the 10-20-30 rule applies. If not mentioned otherwise, the interest rate is 10 %/ a, the VAT rate is 20 % and the total income tax rate is 30 %/ a. <?page no="20"?> Berkau: Financial Statements 7e 2-20 2 Financial Statements based on HGB 2.1 What is in this Chapter? In this first chapter, we look at the German Handelsgesetzbuch HGB and introduce legal aspects of Accounting in Germany. We demonstrate the preparation of financial statements for the case study KIELING TAXI GmbH which follows German law. We expect you know the basics of Bookkeeping and Accounting as covered in chapters (1) - (15) in our textbook Basics of Accounting. 1 This means you know the statements (balance sheet, income statement), you can record Bookkeeping entries and know the Accounting equation, you can make entries in T-accounts and you have sufficient knowledge about real and nominal accounts, e.g. you can record depreciation. In this chapter, we discuss a taxi company with very few business activities: its establishment, the acquisition of a motor vehicle, the equipment of the car with taxi appliances, depreciation, payment of labour and operations and the revenue recognition. For the first Accounting period, we only calculate profit and set up financial statements following German law. As no profit is paid to owners nor added to reserves, the entire profit is carried forward to the next Accounting period. In the 2nd period 20X2, we show all Bookkeeping entries and prepare financial statements following HGB standards and also consider the appropriation of profits (from both years). 1 See our textbook Basics of Accounting, chapters (1) - (15). 2.2 Learning Objectives After studying this chapter (2), you can prepare a balance sheet and an income statement for a company in Germany and achieved sufficient communication skills to talk and write about Accounting in a professional environment. You got familiarised with technical terms of German Accounting and understand the major Accounting rules from the German Handelsgesetzbuch HGB. 2.3 Legal Forms for Companies Regarding legal forms, we distinguish private companies and companies in public ownership. Private companies can be in the legal form of a sole proprietor, a partnership or a privately-owned limited company. A partnership in Germany is called a GbR, short for Gesellschaft bürgerlichen Rechts, check §§ 705 - 741 BGB. Same as a single proprietor, the owners of a GbR are fully and jointly reliable for all assets and liabilities of their business. Therefore, they take the risk of losing their interest and being held reliable for the debts. Public companies are limited companies with distributed ownership. (We do not cover public companies that are state owned as those follow different Accounting rules.) If a company's shares are traded publicly at a stock exchange, everyone can buy its shares and become a partial owner. <?page no="21"?> Berkau: Financial Statements 6e 2-21 The owners of a limited company only can lose their equity. They are not held responsible for their company’s debts. Therefore, the creditor protection is the major reason for preparing financial statements based on HGB in Germany. We explain the technical term equity shortly: for now, equity is the owners’ contribution of funds to their business plus all profits kept in the company and after reduction of losses. The equity can be seen as the book value of the company as the company valuation is derived from Bookkeeping records. Other methods for the valuation of companies are based on their fair market value or present values of future free cash flows. 2 In Germany, limited companies as well as retailers must apply the German GAAPs (generally accepted Accounting principles). The German GAAPs are referred to as the German Handelsgesetzbuch HGB. The HGB contains paragraphs dedicated to retailers as well as to limited companies. 2.4 Obligation of Keeping Bookkeeping Records The German HGB requires retailers and limited companies to keep Bookkeeping records of their business and preparing regularly (annually) financial statements. § 242 HGB applies. All retailers must keep Bookkeeping records based on § 239 HGB and record a register of assets by § 240 HGB. This applies for all retailers regardless of their legal form. Retailers classified as small companies get exempted 2 See Schmidtlin, N.: Company Valuation and Seppelfricke, P.: Unternehmensbewertungen. (from applying §§ 238 - 241 HGB) if earning an annual revenue below 600,000.00 EUR/ a for two following years and reporting an annual surplus not exceeding 60,000.00 EUR/ a, see §241a HGB. This exemption only applies for trading companies that are not limited companies. Besides of retailers, any firm in the legal form of a limited company must prepare financial statements based on § 264 HGB. For limited companies, GmbHG and AktG are the German companies’ acts. Limited companies in Germany are Gesellschaft mit beschränkter Haftung GmbH (or as a small cousin thereof which is an Unternehmergesellschaft UG (haftungsbeschränkt)) and the Aktiengesellschaft AG. AGs are companies based on shares. They are often public corporations. In contrast, a GmbH is a privately owned limited company, like a PLC or a (Pty) Ltd. in the UK or in Australia and South Africa respectively. Study the German company’s acts, the GmbHG and AktG for details. In this textbook, most German case studies are in the legal form of limited companies. You easily can see that the name of those companies contains the suffix GmbH or AG. Financial statements in Germany include a balance sheet and an income statement (§ 242 HGB). Limited companies additionally must prepare an appendix and a business report in compliance with § 264 HGB. In contrast to the business report, the appendix <?page no="22"?> Berkau: Financial Statements 6e 2-22 counts as part of the financial statements, see § 264 HGB. The appendix shows further disclosures regarding the balance sheet and income statement of the company based on § 284 HGB. The German expression for financial statements is Jahresabschluß. 2.5 Establishment of a Company At first, we study the establishment of a German limited company: To establish a limited company in Germany a registration is required. The register is kept at local courts. The representatives of a limited company must appoint an attorney for the registration. The attorney drafts a contract, also known as memorandum of incorporation (MoI) or the articles that amongst other items determine the purpose of the company, its address, the names of legal representatives etc. Here, the Accounting work starts already! One item linked to the memorandum of incorporation is an opening balance sheet that is required by § 240 HGB and must be prepared in the format prescribed in § 266 HGB. In most cases, the opening balance sheet only discloses the issued capital and cash/ bank as at the time of incorporation. The issued capital is money the owners pay into the company’s bank account. However, a company can also be established by assets other than cash/ bank. 3 After its establishment, a limited company must prepare and disclose financial statements for taxation and for commercial purposes as well. Note, companies prepare two sets of financial statements which are based 3 Read for an example our textbook Basics of Accounting, chapter (33). on different laws. One follows the German HGB and the other one follows German income tax law (Einkommensteuergesetz EStG). These laws in Germany support different objectives, which is creditor protection and fair tax levies. Therefore, one single multi-purpose set of financial statements that serves commercial and tax law is unlikely to work out. Most companies prepare two sets of financial statements. In this textbook we focus on commercial law which is in Germany HGB and internationally IFRSs. In general, the commercial financial statements require a publication at the local court. This can be done online through the website of the Bundesanzeiger Verlag. To submit financial statements for taxation in Germany they must be prepared as E-Bilanz (§ 5b EStG). Technically, the standardised format requires a company to apply certified Bookkeeping software to meet the interface requirements. In Germany, financial statements are transferred following specific protocols, like DATEV format. DATEV is a German organisation that supplies Software for Accounting and Taxation. In this book, we focus on commercial financial statements. We do not cover tax law and financial statements for Taxation. However, before we put aside the tax law, we cover two aspects which are relevant for Accounting and Bookkeeping: (1) Simplified income tax calculation. (2) Value added tax. <?page no="23"?> Berkau: Financial Statements 6e 2-23 2.6 Income Tax Calculation In Tax classes at the university, details of national income tax calculations are discussed. The tax law strives to fair levies of income taxes. In terms of tax law, fairness does not mean that everyone pays the same amount. It means that a person/ company with high earnings must pay higher tax rates than someone who earns less (tax progression). 4 The income tax law is based on the capability of the tax-payers to contribute to common welfare. Tax laws include various detailed regulations and numerous exceptions for income tax adjustments e.g., tax free earnings for low income groups, tax-payer classifications based on marriage status and allocation of different tax rates thereto etc. In this textbook, we simplify the income tax calculation. We multiply a company’s net profit with a total income tax rate of 30 %. For a real business, you must replace our tax formula by a detailed tax calculation. 5 Our tax calculation is consistent with how the IASB calculates income taxes in IFRSs examples. 2.7 Value added tax VAT. Value added tax VAT is a consumer tax and is paid by the buyer of goods or recipient of services. The VAT-rate is the same for every consumer, no matter whether she/ he is rich or poor. Companies in general are exempted from VAT, as they do not consume but buy goods or services for the pur- 4 Check the business plan case study SCHLUCHMAN in our textbook Management Accounting, chapter (6). pose of manufacturing and service rendering. Companies that buy goods or services pay input VAT but will be refunded by the revenue service in the next Accounting period. Hence, companies are not charged VAT. The refund is received based on a VAT form the company submits every month. 6 From the selling perspective, companies must collect output-VAT from their customers on behalf of the revenue service. The output-VAT is paid to the revenue service in the next Accounting period. If the buyer is a company, it will later receive a refund itself. Technically, all companies keep a record of VAT payments and receipts in their VAT accounts. Effectively, they pay only the excess of output-VAT over input-VAT. In out textbooks, a rate of 20 % applies. Companies must register for VAT refunding at the revenue service which happens by default when the company is establishment in Germany. The characteristic “registered-for-VATreduction” is allocated to every company. A VAT reduction includes the privilege to receive a refund for input- VAT but comes with the obligation to collect output-VAT from the customers. Only very few exemptions for micro businesses where a company must prove the fulfilment of size-based criteria linked to revenue and profits applies. Following our conventions, we consider VAT reduction as default case for all textbook case studies and study materials. Below, we discuss our first case study KIELILNG TAXI GmbH. The case 5 See Schneeloch, D.; Meyering S.; Patek, G.: Betriebliche Steuerlehre. 6 Following our conventions, we consider annual refunding/ paying. <?page no="24"?> Berkau: Financial Statements 6e 2-24 study resembles the case of 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. Note, that the reporting company cannot choose which standards to apply. 2.8 C/ S KIELING TAXI GmbH - 20X1 For the KIELING TAXI GmbH case study, we repeat some basic knowledge of Accounting and cover how to prepare financial statements. We refer to the German HGB and make Bookkeeping entries following the DATEV format. Below, you see a short summary (data sheet) of the major information used in the KIELING TAXI GmbH case study. Note, this is not a task description as you might find in an examination but a collection of relevant data, as we will provide in the following text. Data Sheet for KIELING TAXI GmbH DDomicile: Germany (Hanover). Reporting currency: EUR. Classification: Service provider. Establishment: 1.01.20X1; owner's contribution: 50,000.00 EUR, 10,000.00 EUR thereof as license. Acquisition of a car: 30,000.00 EUR net amount, taxi equipment 5,000.00 EUR net amount. Depreciation: straight-line method over 3 years, residual value 8,000.00 EUR. Relevant Accounting periods 20X1/ 20X2. 7 The owner’s contribution in this case study is higher than required. We avoid discussing loans in this chapter and keep the case simple. Revenue: 100,000.00 EUR / 105,000.00 EUR. Labour for drivers: 50,000.00 EUR / 55,000.00 EUR. Operational expenses (VATable): 15,000.00 EUR / 16,000.00 EUR. Appropriation of profits: 20X1: carried forward / 20X2: 10,000.00 EUR payment to owners, 10,000.00 EUR to reserves, remainder carried forward. VAT 20 %. Mr Theo Kieling starts his own taxi business and buys a taxi license in Hanover. His taxi is registered under the taxi-number 43. To limit financial risks from his taxi business, Mr Kieling establishes a privately-owned but limited firm by the name of KIELING TAXI GmbH. A GmbH follows German company’s act GmbHlaw (GmbHG) and requires a minimum contribution of 25,000.00 EUR from its owners (all together). The establishment of a GmbH company requires legal conveyance through an attorney and registration at the local court as well as at the German revenue service. Mr Kieling makes an appointment with his attorney Dr. Meppen. The company is based on Mr Kieling’s contribution of 50,000.00 EUR which is partially paid on cash. 7 Mr Kieling opens an account at Commerzbank in Hanover and pays in 40,000.00 EUR before he meets the attorney. The remaining portion of the contribution is assigned to the company as taxi license, worth 10,000.00 EUR. The valuation is at its cost of acquisition. On 27.12.20X0, Mr Kieling visits his attorney and proves his contribution by a stamped bank statement and the taxi license issued by the city of Hanover. He <?page no="25"?> Berkau: Financial Statements 6e 2-25 also provides an opening balance sheet in compliance with the formal requirements in § 266 HGB. See the opening balance sheet in Figure 2.1. Based on § 244 HGB, Mr Kieling submits the balance sheet in German and all figures in EUR amounts. 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 and notary, Dr. Meppen, prepares the articles by which Theo Kieling is appointed as chief executive officer (CEO) of KIELING TAXI GmbH. Dr. Meppen submits the articles to the local court in Hanover which causes two events: (1) KIELING TAXI GmbH is registered by the registry office in Hanover and (2) the company becomes a taxpayer. Mr Kieling receives a notification of establishment from the local court as well as from the German revenue service in Hanover. The latter one assigns to KIELING TAXI GmbH a tax ID-number and confirms the registration for VAT reduction as well. On 2.01.20X1, the business of KIELING TAXI GmbH commences. From now, the company must keep Bookkeeping records and take stock. At the time of incorporation, the company owns the taxi license and 40,000.00 EUR. On 4.01.20X1, KIELING TAXI GmbH buys a used Mercedes-Benz E200 CDI at costs of acquisition of 30,000.00 EUR (net value). For VAT registered companies, the cost of acquisition always is the net amount if the bill discloses VAT, see § 253 HGB and § 15 UStG. The car dealership is registered for VAT reduction and discloses input-VAT on its invoice. KIELING TAXI GmbH claims for input- VAT refund in the next Accounting period. <?page no="26"?> Berkau: Financial Statements 6e 2-26 Next, KIELING TAXI GmbH orders a specialised taxi car manufacturer to configure the car for its intended use as metered taxi. The Mercedes-Benz receives a yellow taxi sign on its roof, a radio for communication with the taxi dispatch, a meter and seat sensors which cost in total 6,000.00 EUR (gross value). The manufacturer discloses input-VAT on its invoice. It is: 5,000 × 20% = 1 1,000.00 EUR. Following §255 HGB, the total costs of acquisition (net values) for the taxi are: 30,000 + 5,000 = 3 35,000.00 EUR. KIELING TAXI GmbH pays the car dealer and manufacturer: 35,000 × (1 + 20%) = 42,000.00 EUR per bank transfer. At this stage, we introduce a simplification for the VAT calculation procedure which only applies, as we calculate based on a 20% VAT rate. We insert the how-it-is-done paragraph below: How it is Done (VAT calculation, based on a 20 % VAT rate) (1a) If the net value is given and we want to know the gross value, multiply the net value with 120 % or with 1.2. (1b)If the net value is given and we want to know VAT, multiply with 20 % or divide by 5. (2a) If VAT is known and we want to know the gross value, multiply VAT with 6. (2b) If VAT is known and we want to know the net value, divide by 20 % or multiply with 5 (3a) If the gross value is given and we want to know the net value, divide by 120 % or 1.2. (3b) If the gross value is given and we want to know VAT divide by 120 % and multiply with 20 %. Alternatively, divide the gross value by 6. Depreciation on the taxi follows straight-line method over a useful life of 3 years 8 . The depreciation table issued by the German finance minister applies. KIELING TAXI GmbH estimates to sell the car for 8,000.00 EUR (net value) after 31.12.20X3. Therefore, the depreciable amount of the taxi is: 35,000 - 8,000 = 27,000.00 EUR. Annual depreciation is: 27,000 / 3 = 9 9,000.00 EUR/ a. After making deductions for depreciation, KIELING TAXI GmbH carries the car at a value of: 42,000 / 120% - 9,000 = 2 26,000.00 EUR 8 Based on the German Afa-list motor vehicles are depreciated over five years. However, the Mercedes is pre-owned. on 31.12.20X1. Depreciation is recorded at the end of the Accounting period. During the Accounting period 20X1, KIELING TAXI GmbH earns a revenue of 100,000.00 EUR with the taxi rides. Due to the registration for VAT reduction, the taxi passengers (all together) pay the gross amount which is: 100,000 × 120% = 1120,000.00 EUR. Labour for the drivers is 50,000.00 EUR/ a and KIELING TAXI GmbH pays for operational expenses 18,000.00 EUR/ a, the latter one is the gross value. Here, the operational ex- <?page no="27"?> Berkau: Financial Statements 6e 2-27 penses are VATable because they fall under 3 rd party expenses. The net value for operational expenses is: 18,000 / 120% = 115,000.00 EUR/ a. The taxi drivers at KIELING GmbH are freelancers and paid 50,000.00 EUR/ a. Observe below the recording of Bookkeeping entries in the format of a journal. To keep this case study simple, we record all business activities as aggregated single Bookkeeping entries dated to the middle of the Accounting period 20X1 (30.06.20X1). This means, we do not record multiple taxi rides but make one Bookkeeping entry for the annual revenue to keep the number of activities low. Nr Amount Date Narrative DR CR OV 10,000.00 2.01.20X1 Establishment of business Licenses Issued capital 40,000.00 Cash/ Bank Issued capitall (1) 30,000.00 4.01.20X1 Acquisition of taxi car P, P, E Cash/ Bank 6,000.00 VAT Cash/ Bank (2) 5,000.00 5.01.20X1 Taxi equipment P, P, E Cash/ Bank 1,000.00 VAT Cash/ Bank (3) 9,000.00 31.12.20X1 Depreciation taxi car Depreciation P, P, E (4) 100,000.00 30.06.20X1 Revenue for taxi rides Cash/ Bank Revenue 20,000.00 Cash/ Bank VAT (5) 50,000.00 30.06.20X1 Labour Labour Cash/ Bank (6) 15,000.00 30.06.20X1 Operating expenses Operational exp. Cash/ Bank 3,000.00 VAT Cash/ Bank Kieling Taxi GmbH JOURNAL 20X1 Figure 2.2: KIELILNG TAXI GmbH’s journal (20X1) The profit or loss calculation gives us the pre-tax profit for 20X1. We determine the profit as revenue minus labour minus operational expenses minus depreciation: 100,000 - 50,000 - 15,000 - 9,000 = 2 26,000.00 EUR. The values for the profit calculation are: - Revenue: 100,000.00 EUR. - Labour: 50,000.00 EUR. - Operational expenses: 15,000.00 EUR. - Depreciation: 9,000.00 EUR. KIELING TAXI GmbH pays income taxes based on our simplified income tax calculation to the extent of: 26,000 × 30% = 77,800.00 EUR. We now discuss the balance sheet as at 31.12.20X1. A balance sheet discloses all assets on its left-hand side. At KIELING TAXI GmbH, assets contain the motor vehicle as non-current asset and the taxi license as intangible asset as well as cash/ bank. The motor vehicle’s value after depreciation is: 35,000 - 9,000 = 26,000.00 EUR. No depreciation on the license applies as it does not expire nor does its value change. It even can be sold on at the price initially paid. The closing balance for the Cash/ Bank account is: 40,000 - 36,000 - 6,000 + 120,000 - 50,000 - 18,000 = 5 50,000.00 EUR. The values above (cash/ bank) include VAT and result from: - Contribution: 40,000.00 EUR. - Taxi acquisition: 36,000.00 EUR. - Taxi configuration: 6,000.00 EUR. <?page no="28"?> Berkau: Financial Statements 7e 2-28 - Proceeds: 120,000.00 EUR. - Labour (drivers): 50,000.00 EUR. - Taxi operations: 18,000.00 EUR. On the credit side of the balance sheet, we see KIELING TAXI GmbH’s equity which includes the issued capital of 50,000.00 EUR and the profit after taxes disclosed as annual surplus to an extent of: 26,000 - 7,800 = 1 18,200.00 EUR. Underneath of the equity, the company shows an income tax provision of 7,800.00 EUR. Due to the registration for VAT reduction, KIELING TAXI GmbH considers VAT. The output-VAT results from taxi rides during the Accounting period 20X1 and got collected by the drivers. The recorded input-VAT is: 6,000 + 1,000 + 3,000 = 1 10,000.00 EUR. The values result from: - Output-VAT from taxi rides: 20,000.00 EUR. - Input-VAT for car acquisition: 6,000.00 EUR. - Input-VAT for taxi configuration: 1,000.00 EUR. - Input-VAT for operating expenditures: 3,000.00 EUR. Preparing the VAT form for the German revenue service, KIELING TAXI GmbH calculates its current VAT liabilities: 20,000 - 10,000 = 1 10,000.00 EUR. The value shows on the balance sheet as a shortterm liability. We prepare a balance sheet based on the classification of KIELING TAXI GmbH as a small and limited company following § 267 HGB. The formal requirements for a balance sheet’s disclosure are based on § 266 HGB. Small and limited companies prepare their balance sheets following an abridged format. The illustrated Bookkeeping entries and the T-accounts for KIELING TAXI GmbH based on German account formats are available for download. Pls., scan Link 2.A: Link 2.A: KIELING TAXI GmbH Observe below the balance sheet of KIELING TAXI GmbH as at 31.12.20X1 in Figure 2.3. We translated the balance sheet for this textbook. However, § 244 HGB rules a balance sheet in Germany must be prepared in German. <?page no="29"?> Berkau: Financial Statements 7e 2-29 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) The 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; all items must be named exactly as shown in the law text and must be listed following the sequence prescribed. A set of financial statements in line with § 264 HGB includes a balance sheet, an income statement and an appendix for limited companies. The company also must prepare a business report. On the balance sheet we see a few items that do not apply for KIELING TAXI GmbH. We discuss those but keep our explanations short: 9 Read our textbook Basics of Accounting, chapter (18). (a) Accruals are ruled by § 250 HGB. The reporting company discloses expenses that have been paid already but only become expenses in a later Accounting period. We refer to those items as prepaid expenses. Prepaid rent is a common example. 9 (b) On the credit side, accruals are recorded for income that is revenue for later Accounting periods. These values are often advanced payments or deposits received from customers. 10 Same as with (a), prepayments must be relevant for profit or loss in a specific Accounting period. Information about the period and revenue/ expense type is mandatory for recognition. 10 Read our textbook Basics of Accounting, chapter (15). <?page no="30"?> Berkau: Financial Statements 7e 2-30 (c) Deferred taxes are income tax considerations for tax income (asset side) or expenditures (credit side) that differ from actual tax payments based on national tax law. § 274 HGB requires temporary difference to exist which means, differences must level out in future Accounting periods. (d) In a situation when a company discloses losses that exceed its equity, items on the credit side exceed the total of assets. Based on § 268 HGB, a company must show then the difference under the item notcovered loss on the asset side of the balance sheet. In these cases, a company’s equity becomes negative, and a bankruptcy is likely to happen. Excessive indebtedness requires the company to stop operations immediately for protection of the creditors from further losses. Negative equity means that a company cannot retire its debts. Below, we continue the case study KIELING TAXI GmbH: 2.9 C/ S KIELING TAXI GmbH- 20X2 KIELING TAXI GmbH prepares a profit or loss statement. Its format is prescribed by § 275 HGB. It can be prepared based on the nature of expense method or the cost of sales format. 11 KIELING TAXI GmbH prepares a profit or loss statement based on the nature of expense method. It is shown in Figure 2.4. 11 Read our textbook Basics of Accounting, chapter (28). <?page no="31"?> Berkau: Financial Statements 7e 2-31 [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 the appropriation of profits. In general, companies can either declare a dividend, add the profit to reserves which means a reinvestment or they can carry forward the profit or loss to the next Accounting period. The latter alternative postpones the decision about the profit appropriation for one year. KIELING TAXI GmbH decides to carry forward the profit to the next Accounting period 20X2. 12 12 We keep this case study simple and do not look at dividends yet. We do so for 20X2 further below. Below, we discuss the Accounting period 20X2: At the beginning of the Accounting period 20X2, KIELING TAXI GmbH pays income taxes and its VAT liabilities. We now cover all Bookkeeping entries. KIELING TAXI GmbH starts the Accounting period 20X2 with an Opening Balance Sheet account. The company applies accounts based on the chart of accounts following the DATEV-4 format. You can download the DATEV-4 chart of accounts through the Link 2.B below. <?page no="32"?> Berkau: Financial Statements 7e 2-32 Link 2.B: DATEV-4 chart of accounts We record 20X2’s business activities of KIELING TAXI GmbH in a format transferable to the taxonomy applicable for electronic data transfer of financial statements to the German revenue service. We prepare the accounts in the required format which is DATEV-4 for instance. A company that starts Bookkeeping for a new Accounting period, will carry forward balancing figures for the items on the prior balance sheet by the 9000-Balancing-Figures account. Study the accounts as at 1.01.20X2 in Figure 2.5. 13 Therein, the standard account numbers and names apply but are translated to English. For the opening of accounts, we indicate contra accounts by their 4 digits code in line with DATEV-4 chart of accounts. Some accounts do not carry numbers as they would be created by Accounting software and do not belong to the chart of accounts, like the Annual Surplus account. D C D C 2900 50,000.00 0110 10,000.00 9000 10,000.00 2970 18,200.00 0520 26,000.00 3020 7,800.00 1810 50,000.00 3800 10,000.00 86,000.00 86,000.00 9000-Balancing figures EBK 0110 Licences D C D C 9000 26,000.00 9000 50,000.00 0520 Motor vehicles, cars 1810 Bank account Commerzbank D C D C 9000 50,000.00 9000 18,200.00 2900 Issued capital 2970 Profit carried forward D C D C 9000 7,800.00 9000 10,000.00 3020 Tax provisions for income tax 3800 VAT payables Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X2) 13 Technically, your Bookkeeping software prevents you from changing or translating accounts’ names. <?page no="33"?> Berkau: Financial Statements 7e 2-33 During the Accounting period 20X2, KIELING TAXI GmbH records the business activities below: (A) Payment of income tax for 20X1 to the extent of 7,800.00 EUR. (B) Payment of VAT payables for 20X1 which are 10,000.00 EUR. (C) Depreciation on the taxi to the extent of 9,000.00 EUR. (D) Payment for labour which is amounting to 55,000.00 EUR. (E) Operational expenses of 16,000.00 EUR (net amount). (F) Earning revenue from taxi rides to the extent of 105,000.00 EUR (net amount). (G) Transfer of cash to the Bank account to the extent of 126,000.00 EUR. KIELING TAXI GmbH makes Bookkeeping entries (A) - (F) for its business activities in 20X2: DR 3020 Tax Provisions ......... 7,800.00 EUR CR 1810 Bank Account CoBa ....... 7,800.00 EUR DR 3800 Output-VAT.............. 10,000.00 EUR CR 1810 Bank Account CoBa ....... 10,000.00 EUR DR 6222 Depreciation on Cars.... 9,000.00 EUR CR 0520 Motor Vehicles, Cars.... 9,000.00 EUR DR 6010 Labour.................. 55,000.00 EUR CR 1810 Bank Account CoBa ....... 55,000.00 EUR DR 6300 Operational Expenses.... 16,000.00 EUR DR 1400 Input-VAT............... 3,200.00 EUR CR 1810 Bank Account CoBa ....... 19,200.00 EUR DR 1600 Cash.................... 126,000.00 EUR CR 3800 Output-VAT.............. 21,000.00 EUR CR 4200 Revenue ................. 105,000.00 EUR DR 1810 Bank Account CoBa ....... 126,000.00 EUR CR 1600 Cash.................... 126,000.00 EUR Note, that with German Bookkeeping, the contra entry for depreciation is in the Asset account. 14 After recording the Bookkeeping entries, KIELING TAXI GmbH calculates its profit 14 Compare to the recording of depreciation following international Accounting as discussed in our textbook Basics of Accounting, chapter (17). as shown in the accounts below in Figure 2.6. With Bookkeeping entry (G), we transfer all cash received for taxi rides to the Bank account. As we apply the DATEV chart of accounts we deal with separate <?page no="34"?> Berkau: Financial Statements 7e 2-34 Cash and Bank accounts. Bookkeeping entry (H) 15 adds income tax expenses which are based on the simplified total income tax rate of 30 % to the Income Tax Provisions account. Based on § 249 HGB, income taxes must be disclosed as provisions. 16 KIELING TAXI GmbH now records the appropriation of profits, too. The distributable amount is the profit carried forward plus 20X2’s annual surplus: 18,200 + 17,500 = 3 35,700.00 EUR. The company decides about the appropriation of profits on its annual general meeting. KIELING TAXI GmbH’s profit appropriation is as below: - 10,000.00 EUR additions to reserves. - 10,000.00 EUR payment to owner(s). - 15,700.00 EUR carried forward. The appropriation of profits is recorded in the Bookkeeping entries (I), (J), (K). DR 2970 Profit c/ f.............. 10,000.00 EUR CR 3519 Liabilities to Owners... 10,000.00 EUR DR 2970 Profit c/ f.............. 8,200.00 EUR DR Annual Surplus............... 1,800.00 EUR CR 2960 Other Earnings Reserves. 10,000.00 EUR DR Annual Surplus............... 15,700.00 EUR CR Retained Earnings............ 15,700.00 EUR Observe the accounts at KIELING TAXI GmbH in Figure 2.6 after the appropriation of profits. For teaching purposes, we show the account 9000 twice. It is the opening account (Eröffnungsbilanzkonto EBK) and the closing account (Schlußbilanzkonto SBK). D C D C 2900 50,000.00 0110 10,000.00 EBK 10,000.00 SBK 10,000.00 2970 18,200.00 0520 26,000.00 3020 7,800.00 1810 50,000.00 3800 10,000.00 86,000.00 86,000.00 9000-Balancing figures EBK 0110 Licences Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) 15 Not shown. 16 In contrast, IFRSs require the disclosure as income tax liabilities. <?page no="35"?> Berkau: Financial Statements 7e 2-35 D C D C EBK 26,000.00 (C) 9,000.00 EBK 50,000.00 (A) 7,800.00 SBK 17,000.00 (G) 126,000.00 (B) 10,000.00 26,000.00 26,000.00 (D) 55,000.00 (E) 19,200.00 SBK 84,000.00 176,000.00 176,000.00 0520 Motor vehicles, cars 1810 Bank account Commerzbank D C D C SBK 50,000.00 EBK 50,000.00 (I) 10,000.00 EBK 18,200.00 (J) 8,200.00 18,200.00 18,200.00 2900 Issued capital 2970 Profit carried forward D C D C (A) 7,800.00 EBK 7,800.00 (B) 10,000.00 EBK 10,000.00 SBK 7,500.00 (H) 7,500.00 3800 3,200.00 (F) 21,000.00 15,300.00 15,300.00 SBK 17,800.00 31,000.00 31,000.00 3020 Tax provisions for income tax 3800 Output-VAT D C D C (C) 9,000.00 P&L 9,000.00 (D) 55,000.00 P&L 55,000.00 6222 Depreciation on cars 6010 Labour D C D C (E) 16,000.00 P&L 16,000.00 (E) 3,200.00 3800 3,200.00 6300 Operational expenses 1400 Input-VAT D C D C (F) 126,000.00 (G) 126,000.00 P&L 105,000.00 (F) 105,000.00 1600 Cash 4200 Revenue D C D C 6010 55,000.00 4200 105,000.00 (H) 7,500.00 P&L 7,500.00 6222 9,000.00 6300 16,000.00 EBT 25,000.00 105,000.00 105,000.00 76XX 7,500.00 EBT 25,000.00 A/ S 17,500.00 25,000.00 25,000.00 Profit and Loss 76XX Income tax expenses Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) continued <?page no="36"?> Berkau: Financial Statements 7e 2-36 D C D C (J) 1,800.00 P&L 17,500.00 SBK 10,000.00 (I) 10,000.00 (K) 15,700.00 17,500.00 17,500.00 Annual surplus 3519 Liabilities to owners D C D C SBK 10,000.00 (J) 10,000.00 SBK 15,700.00 (K) 15,700.00 2960 Other earnings reserves Retained earnings D C 0520 17,000.00 2900 50,000.00 0110 10,000.00 2960 10,000.00 1810 84,000.00 R/ E 15,700.00 3519 10,000.00 3020 7,500.00 3800 17,800.00 111,000.00 111,000.00 9000 Balancing figures SBK Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) continued The Bookkeeping records are the basis for the preparation of financial statements. KIELING TAXI GmbH prepares an income statement (statement of profit and loss) based on the Profit and Loss account. Note, with a Bookkeeping software system is in use, the income statement will be prepared automatically. The income statement is displayed in Figure 2.7. Note, that in this textbook we disclose expenses as negative figures. This way, the income statements are prepared in a (DR)CR-format, which means that credit entries like revenue is positive, and all debit entries are shown as negative figures. This is consistent with the profit calculation by which we determine the annual surplus deducting expenses from revenues. 17 17 Our convention is not consistent with German law but with all other statements in this textbook. <?page no="37"?> Berkau: Financial Statements 7e 2-37 [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 can combine items (1) - (5) and disclose their gross profit 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 for its balance sheet’s items, the company must follow § 268 HGB. It states that in case the profit has been fully distributed, which means no profit or loss is carried forward to the next Accounting 18 Different to retained earnings following IFRSs. period, the item annual surplus becomes zero and does not show. In case the company prepares the balance sheet under partial appropriation of profits, the item annual surplus is replaced by retained earnings. The item retained earnings 18 then discloses the profit or loss carried forward. KIELING TAXI GmbH opts for disclosure of the balance sheet under consideration of the appropriation of profits. It replaces the items profit carried forward from 20X1 and annual surplus by retained earnings. Retained earnings are: <?page no="38"?> Berkau: Financial Statements 7e 2-38 18,200 + 17,500 - 10,000 - 10,000 = 115,700.00 EUR. Observe the balance sheet below that does not follow exactly the formal requirements set by § 266 HGB because the items have been translated to English for teaching purposes. KIELING TAXI GmbH falls into the category of small and limited companies regarding § 267 HGB. Its total of assets and capital/ liabilities does not exceed 6,000,000.00 EUR and its revenue is below 12,000,000.00 EUR/ a. Furthermore, KIELING TAXI GmbH employs less than 50 employees. § 267 HGB states that a limited company that does not exceed two of the above threshold values for two following Accounting periods is classified as a small and limited company. 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) Based on § 274a HGB, small and limited companies do not prepare a register of non-current assets as otherwise required by § 268 HGB. (c) Small and limited companies do not explain certain receivables based on § 268 HGB. (d) Small and limited companies do not explain certain payables based on § 268 HGB. (e) § 274a HGB exempts small and limited companies from regulations about accruals and deferred taxes based on §§ 268, 274 HGB. The above exemptions and simplifications apply for KIELING TAXI GmbH. Observe the abridged balance sheet as at 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) <?page no="39"?> Berkau: Financial Statements 7e 2-39 Besides the balance sheet and the income statement, § 264 HGB states that a complete set of financial statements includes an appendix for limited companies. §§ 284 - 288 HGB rule the appendix. For small and limited companies, an abridged appendix applies based on § 288 HGB. To study a real appendix, check the financial statements of Lufthansa AG below: Link 2.C: Lufthansa AG’s appendix 2.10 Summary German trading companies and companies in the legal form of a limited company must 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 appendix and a business report. In case a company participates on the capital market and is not preparing group statements, it must disclose a cash flow statement. (§ 264 HGB). We discussed the case study KIELILNG TAXI GmbH, which is a German limited company and prepared its financial statements over two Accounting periods. After the last period, the company decides about the appropriation of its profits. The balance sheet provided for the 2 nd Accounting period shows the items after the appropriation of profits. 2.11 Working Definitions Accruals: Item on the balance sheet that is income or expense for a specific time after the balance sheet date. Appendix: Disclosure of information linked to the financial statements and required by §§ 284 - 288 HGB. German financial statements of limited companies must be enhanced by an appendix. Appropriation of profits: Using profit after tax as either addition to reserves, payment to owners or carrying profit or loss forward to the next Accounting period. Balance sheet: Statement of financial position that discloses assets, equity and liabilities in an aggregated form. Bankruptcy: Situation that triggers legal procedures of liquidation due to over-indebtedness or insolvency. Business report: Disclosure about the situation the company is in at the time of reporting and in the nearby future. The business report is required for limited companies that are not classified as small. 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 <?page no="40"?> Berkau: Financial Statements 7e 2-40 loss it must deduct the loss carried forward from its annual surplus. 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 appendix. 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 that states that financial statements are to be prepared and how to do so. Income statement: Statement of profit or loss that compares income and expenses for profit calculation. Its structure is given by § 275 HGB. Limited company: A company with restrictions regarding liabilities to the amount of its equity. Non-covered loss on the asset side: A loss that exceeds the equity is required being disclosed on the asset side of the German balance sheet based on § 266 HGB. Provision: Uncertain liability e.g., for income taxes or other expenses based on § 249 HGB. Provisions require a present obligation at the time of reporting. Register of non-current assets: List of long-term assets that shows the costs of acquisition as well as accumulated depreciation and accumulated impairment losses for assets or groups thereof. Value added tax: Tax levied in most countries on consumption. In this textbook, the common VAT rate is 20 %. No reduced VAT rates apply. 2.12 Question Bank (1) A German company in the legal form of a limited company must prepare financial statements which comprise of … 1. … a balance sheet, an income statement, an appendix, and in case of participation on the capital market and no group membership a cash flow statement. 2. … a balance sheet, an income statement, an appendix, a management report and in case of participation on the capital market and group membership a cash flow statement. 3. … a balance sheet, an income statement, an appendix, a management report and in case of participation on the capital market and no group membership a cash flow statement. 4. … a balance sheet, an income statement, a management report and in case of participation on the capital market and group membership a cash flow statement. (2) A German company that earns a pre-tax profit of 80,000.00 EUR, carrying forward a loss of 20,000.00 EUR and adding half of the distributable amount to reserves (no other appropriation of profits) discloses as retained earnings: 1. 38,000.00 EUR . 2. 30,000.00 EUR . 3. 50,000.00 EUR . 4. 18,000.00 EUR . (3) A German company buys a machine and pays a partial amount of 100,000.00 EUR and adds 44,000.00 <?page no="41"?> Berkau: Financial Statements 7e 2-41 EUR to payables. How much are the cost of acquisition? 1. 144,000.00 EUR . 2. 120,000.00 EUR . 3. 100,000.00 EUR . 4. 44,000.00 EUR . (4) A German company in the legal form of a limited company earns a revenue of 5,000,000.00 EUR and discloses a total of assets of 10,000,000.00 EUR. No non-covered loss is disclosed on its asset side. The number of employees is 100. How do you classify the company regarding its size based on § 267 HGB? 1. Micro firm. 2. Small limited company 3. Medium-sized limited company. 4. Big corporation. (5) Financial statements in Germany along § 244 HGB are to prepare in… 1. … German, in any currency. 2. … English and in EUR. 3. … German and in EUR. 4. … English and in any currency. 2.13 Solutions 1-1, 2-4, 3-2, 4-3, 5-3. <?page no="42"?> Berkau: Financial Statements 7e 3-42 3 Financial Statements based on IFRSs 3.1 What is in the Chapter? In this chapter, we discuss a case like KIELING TAXI GmbH in chapter (2). In this chapter, we teach the preparation of financial statements in compliance with International Financial Reporting Standards IFRSs. Therefore, the case study is about a company that is based in South Africa where IFRSs apply for single-entity-financial statements. The case study KENILWORTH METERED TAXI SERVICE Ltd. contains the establishment of the company, the acquisition of 10 motor vehicles and their equipment with taxi appliances (roof sign, radio etc.), depreciation, labour, payment for operations and revenue recognition. In contrast to chapter (2), now all Bookkeeping entries are made in the international format and a full set of financial statements is prepared following IFRSs. In contrast to German law, the 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 we focus on the case of KENILWORTH METERED TAXI SERVICE Ltd., we introduce International Accounting Standards IFRSs to provide you with knowledge of how to find, understand and apply the standards. 19 19 You find a more detailed introduction to IFRSs in our textbook Basics of Accounting, chapter (4). 3.2 Learning Objectives After studying this chapter, you know how to record Bookkeeping entries along international format, and you have seen financial statements following IFRSs. You can prepare easy financial statements for Accounting case studies in compliance with IFRSs. Notes will be covered later, in chapter (6). Notes are different to the appendix as required by German HGB. The notes contain a detailed explanation about applied Accounting policies and contain information regarding disclosure and valuation of items on financial statements. 3.3 IFRSs International Financial Reporting Standards IFRSs are the standards for international Accounting. In Germany, international Accounting applies for group statements of those groups which are participating on the capital market 20 ; all single-entity financial statements must be prepared following German HGB. IFRSs are issued by the International Accounting Standard Board IASB. Before we start with the Accounting work, we demonstrate how to access the standards. 3.4 How to Access IFRSs For academic purposes, the IFRS Foundation offers a free access to the standards. 20 Read our textbook Basics of Accounting, chapter (4). <?page no="43"?> Berkau: Financial Statements 7e 3-43 You must register and log in with a username and password. For registration, indicate that your industry is Education/ Academia and your role is Student. After registration you can access your IFRS account online and can download the standards and further materials linked thereto. Our access is shown in the screenshot below in Figure 3.1. Figure 3.1: Access to IFRS Foundation.org (example) Once you signed in, you can download unaccompanied standards, meaning standards in their original English version. The IFRS Foundation does not charge Accounting students. On their student website, the IASB writes: We provide no-cost access to the unaccompanied Standards published actually in our Red Book. Select the Standard or Interpretation you wish to view here.” You also find additional materials on their website. See Figure 3.2 which shows you the standards for download. <?page no="44"?> Berkau: Financial Statements 7e 3-44 Figure 3.2: IFRS.org: Standards for download International Accounting applies in many parts of the world, including South Korea, European Union, India, Hong Kong, Australia, Malaysia, Pakistan, GCC countries 21 , Russia, Chile, Philippines, South Africa, Singapore and Turkey, but not in the United States. In this textbook, we only discuss cases about companies headquartered in countries where IFRSs apply. All our case studies are fictional. 3.5 C/ S KENILWORTH MTS Ltd. - 20X1 Below, we demonstrate the application of IFRSs for the case study KENILWORTH METERED TAXI SERVICE Ltd. based in Cape Town. The currency for this case study is South African Rand ZAR. You need knowledge about international Bookkeeping and Accounting 21 GCC = Council Cooperation for the Arab States of the Gulf. 22 Read our textbook Basics of Accounting, chapters (6) - (19), (31) and (33). Note, for the case for this case study. We sourced out Bookkeeping to the textbook Basics of Accounting as this is taught in preparatory classes in most universities. 22 We recommend all readers (also those ones who learned Bookkeeping following the German system) to make yourself familiar with the balance sheet, the income statement, T-accounts and reconciliation accounts and the international Bookkeeping entry format. Furthermore, study some examples for assets, equity and liabilities and expenses, in particular depreciation, and revenue recognition. You should also study how to continue Accounting work after the balance sheet dates (recording multiple periods) and know about company establishments and changes in legal forms before you continue reading. studies therein youtube videos are provided online. <?page no="45"?> Berkau: Financial Statements 7e 3-45 Data Sheet for KENILWORTH METERED TAXI SERVICE Ltd. DDomicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Service provider. Establishment: 1.01.20X1; share capital: 5,000,000.00 ZAR, 10.00 ZAR/ share. Acquisition of 10 cars at 360,000.00 ZAR/ car gross amount, taxi equipment 24,000.00 ZAR/ car net amount. Depreciation: straight-line method over 4 years, no residual value. Relevant Accounting periods: 20X1 / 20X2. Revenue: 12,500,000.00 ZAR / 13,200,000.00 ZAR. Labour for drivers (freelancers): 7,000,000.00 ZAR / 8,000,000.00 ZAR. Labour for dispatching and management: 1,650,000.00 ZAR / 1,650,000.00 ZAR. Operational expenses (VATable): 2,000,000.00 ZAR / 2,000,000.00 ZAR. Rent (not VATable): 12,000.00 ZAR/ m / 12,000.00 ZAR/ m, payment one month in advance, from 1.07.20X2 onwards: 13,800.00 ZAR/ m. Appropriation of profits: 20X1: carried forward / 20X2: 30 % dividends, 20 % reserves, 50 % carried forward. VAT 20 %. KENILWORTH METERED TAXI SERVICE Ltd. is a taxi company that provides metered taxi and airport shuttle services and is established in Cape Town by the issue of 500,000 ordinary shares at 10.00 ZAR/ s each. At the time of incorporation, on 1.01.20X1, the company’s share capital is: 10 × 500,000 = 5,000,000.00 ZAR which is also the book value of the company at that time. KENILWORTH METERED TAXI Service Ltd. applies IFRSs for its financial statements as it is domiciled in South Africa. The owners pay 5,000,000.00 ZAR into KENILWORTH METERED TAXI Service Ltd.’s bank account at FNB Bank 23 . They further set up a memorandum of incorporation and establish the business online through CIPC 24 . At the same time, the company is registered at the South African Revenue Service SARS and the tax characteristic VAT reduction is set. For the company, the VAT rate from chapter (1) applies: 20 %. 25 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 in accordance with IAS 1.54. It is shown below in Figure 3.3. 23 FNB = First National Bank of South Africa. 24 CIPC = Companies and Intellectual Property Commission, check: www.CIPC.co.za. 25 The real VAT rate in South Africa is 15 %. <?page no="46"?> Berkau: Financial Statements 7e 3-46 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 3.3: KMTS Ltd.’s opening balance sheet On 2.01.20X1, KENILWORTH METERED TAXI SERVICE Ltd. buys 10 Toyotas at a purchase price of 360,000.00 ZAR/ car and pays them per bank transfer. The price above is the gross value. Next, we record Bookkeeping entry (1). Note, für this case study, we do not distinguish between cash and bank as we later add both values to determine the item cash/ bank on the balance sheet. In contrast, a real business must separate these accounts. 26 For the case study, we apply the Property, Plant and Equipment account. Alternatively, KENILWORTH METERED TAXI SERVICE Ltd. could apply a Motor Vehicle account as a subordinated account to the P, P, E account. 27 We also do not follow a specific format for the structure of the balance sheet. IAS 1.57 states explicitly that the standard (IAS 1) does not prescribe the order or format of presentation. DR P, P, E Account.............. 3,000,000.00 ZAR DR VAT.......................... 600,000.00 ZAR CR Cash/ Bank.................... 3,600,000.00 ZAR After the initial recognition of the cars, we continue with their equipment. We postpone and consider depreciation as part of the adjustments in this case study; it is recorded at the end of the Accounting period. Like in the previous case study, the cars are configured as metered taxi cars by a taxi equipment specialist. The alteration costs 24,000.00 ZAR/ car. The value is net of VAT. Hence, KENILWORTH METERED TAXI SERVICE Ltd. pays: 120% × 24,000 × 10 = 2 288,000.00 ZAR. It is recorded as Bookkeeping entry (2): 26 Read our textbook Basics of Accounting, chapter (37). 27 As we do not follow a standardised chart of accounts for international Accounting, the name of the account is not prescribed. The procedure is simplified in comparison to practical Accounting work. In general, companies apply a standardised chart of accounts. <?page no="47"?> Berkau: Financial Statements 7e 3-47 DR P, P, E ACCOUNT.............. 240,000.00 ZAR DR VAT.......................... 48,000.00 ZAR CR Cash/ Bank.................... 288,000.00 ZAR During the Accounting period 20X1, KENILWORTH METERED TAXI SERVICE Ltd. earns a revenue of 12,500,000.00 ZAR. Due to its registration for VAT reduction the passengers must pay the gross amount which includes output- VAT. It gives a total annual receipt of: 120% × 12,500,000 = 1 15,000,000.00 ZAR. The revenue recognition is recorded as Bookkeeping entry (3) below. We pretend the Bookkeeping entry is recorded in the middle of the year to keep the case study simple. DR Cash/ Bank.................... 15,000,000.00 ZAR CR VAT.......................... 2,500,000.00 ZAR CR Revenue...................... 12,500,000.00 ZAR The taxi drivers at KENILWORTH METERED TAXI SERVICE Ltd. earn 500,000.00 ZAR/ (a × driver). The company employs 14 drivers. All taxi drivers work on a freelancer basis. The labour costs for all taxi drivers is: 14 × 500,000 = 77,000,000.00 ZAR/ a. Accounting for labour results in Bookkeeping entry (4) which is recorded on 30.06.20X1. 28 DR Labour....................... 7,000,000.00 ZAR CR Cash/ Bank.................... 7,000,000.00 ZAR The dispatcher at KENILWORTH METERED TAXI SERVICE Ltd. earns 650,000.00 ZAR/ a. The dispatcher works in the headquarters on the radio and answers the customers' requests on the phone. He then assigns the orders to the taxi drivers per radio call. The manager at KENILWORTH METERED TAXI SERVICE Ltd. earns 1,000,000.00 ZAR/ a. On 30.06.20X1, labour for dispatcher and manager is recorded as Bookkeeping entry (5). It is: 650,000 + 1,000,000 = 1,650,000.00 ZAR/ a. DR Labour....................... 1,650,000.00 ZAR CR Cash/ Bank.................... 1,650,000.00 ZAR Operational expenses for the taxis e.g., for petrol, maintenance, spare parts, repairs, cash wash etc., cost 2,000,000.00 ZAR/ a. The amount is paid to 3 rd party companies and, therefore, is subjected to VAT. Hence, the paid price is: 120% × 28 The consideration as freelancers simplifies the case study. For Accounting for labour, read our textbook Basics of Accounting, chapter (19). 2,000,000 = 2 2,400,000.00 ZAR/ a. It is recorded as Bookkeeping entry (6) below on 30.06.20X1. We acknowledge all payments to other companies include a VAT portion by <?page no="48"?> Berkau: Financial Statements 7e 3-48 default. 29 IAS 2.11 and IAS 16.16 state that cost of purchase/ acquisition for companies, which are registered for VAT reduction, are always net amounts. DR Operational Expenses......... 2,000,000.00 ZAR DR VAT.......................... 400,000.00 ZAR CR Cash/ Bank.................... 2,400,000.00 ZAR For the rent of the office building and the garages, KENILWORTH METERED TAXI SERVICE Ltd. pays 12,000.00 ZAR/ m. No input-VAT is included in the rent payments. KENILWORTH METERED TAXI SERVICE Ltd. rents from a private owner, who is not registered for VAT reduction. Hence, KENILWORTH METERED TAXI SERVICE Ltd. cannot claim input-VAT for rent from the 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 payments for rent in 20X1, the last one is for January 20X2. (All) rent payments are amounting to: 13 × 12,000 = 1156,000.00 ZAR. For simplification, we make only one Bookkeeping entry (7): DR Rent......................... 156,000.00 ZAR CR Cash/ Bank.................... 156,000.00 ZAR Next, we show KENILWORTH METERED TAXI SERVICE Ltd.’s Bookkeeping records in Figure 3.4. The accounts are not balanced-off yet. The reason is that no adjustments have been recorded at this stage. The figures in brackets you see in the accounts refer to the number of the Bookkeeping entries. They are identifiers. Note, that we added a 3-letter-code to the account names. D C D C OV 5,000,000.00 (1) 3,600,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 Cash/ Bank C/ B Issued capital ISS Figure 3.4: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts 29 Read our textbook Basics of Accounting, chapter (20) to (23). <?page no="49"?> Berkau: Financial Statements 7e 3-49 D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 (2) 48,000.00 (6) 400,000.00 Property, Plant, Equipment PPE Value addedd tax VAT [20%] D C D C (3) 12,500,000.00 (4) 7,000,000.00 (5) 1,650,000.00 Revenue-20X1 REV Labour-20X1 LAB D C D C (6) 2,000,000.00 (7) 156,000.00 Operational expenses-20X1 OEX Rent-20X1 RNT Figure 3.4: KENILWORTH METERED TAXI SERVICE Ltd.'s accounts continued Next, KENILWORTH METERED TAXI SERVICE Ltd. records the adjustments at the end of the Accounting period. Adjustments are Bookkeeping entries made at the end of every Accounting period in preparation of the financial statements. The 1 st Bookkeeping entry is for depreciation. In this case study, depreciation applies only for the taxis. It is based on straight-line method under consideration of a useful life of 4 years. No residual value applies. Annual depreciation is: (3,000,000 + 240,000) / 4 = 8810,000.00 ZAR/ a. Note, that in compliance with IAS 16.16 the taxi configurations count as cost of acquisition. On 31.12.20X1, we record depreciation by Bookkeeping entry (8): In contrast to chapter (2), the credit entry is now made in the Accumulated Depreciation account. This is the default account for IFRSs. In the accounts, the adjustment Bookkeeping entries are not identified by their numbers, but we use the 3-letter-code of the contra account as reference. This means the Bookkeeping entry (8) is shown in the Depreciation account as ACC and in the Accumulated Depreciation account as DPR. DR Depreciation ................. 810,000.00 ZAR CR Acc. Depr.................... 810,000.00 ZAR Another adjustment is made for accruals. 30 To accrue payments means we make them, but we allocate the next 30 Read our textbook Basics of Accounting, chapter (13) and (18). year's costs to prepaid expenses, because they are not for the actual Accounting period. The recording of 13 <?page no="50"?> Berkau: Financial Statements 7e 3-50 monthly rental payments requires assigning the last one to prepaid expenses. The company pays in December 20X1 rent for January 20X2. To allocate the 13 th payment to the business activities in the next year, we must transfer one monthly rent of 12,000.00 ZAR to the Prepaid Expenses account. In contrast to German Accounting, no accrual item (aktivischer Rechnungsabgrenzungsposten) is disclosed on the balance sheet. At the beginning of the next Accounting period, KENILWORTH METERED TAXI SERVICE Ltd. transfers the prepaid expenses to the Rent-20X2 account. DR Prepaid expenses............. 12,000.00 ZAR CR Rent......................... 12,000.00 ZAR After completion of initial Bookkeeping entries and recording the adjustments, we balance-off all accounts. Observe the accounts at KENILWORTH METERED TAXI SERVICES Ltd. below in Figure 3.5. D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 b/ d 1,452,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C c/ d 12,500,000.00 (3) 12,500,000.00 (4) 7,000,000.00 b/ d 12,500,000.00 (5) 1,650,000.00 c/ d 8,650,000.00 8,650,000.00 8,650,000.00 b/ d 8,650,000.00 Revenue-20X1 REV Labour-20X1 LAB Figure 3.5: KMTS Ltd.’s accounts after adjustments (20X1) <?page no="51"?> Berkau: Financial Statements 7e 3-51 D C D C (6) 2,000,000.00 c/ d 2,000,000.00 (7) 156,000.00 PRE 12,000.00 b/ d 2,000,000.00 c/ d 144,000.00 156,000.00 156,000.00 b/ d 144,000.00 Operational expenses-20X1 OEX Rent-20X1 RNT D C D C ACC 810,000.00 c/ d 810,000.00 c/ d 810,000.00 DPR 810,000.00 b/ d 810,000.00 b/ d 810,000.00 Depreciation-20X1 DPR Acc depr ACC D C RNT 12,000.00 c/ d 12,000.00 b/ d 12,000.00 Prepaid expenses PRE Figure 3.5: KMTS Ltd.’s accounts after adjustments (20X1) continued The next step is the profit calculation. We close-off 31 all nominal accounts to the Profit and Loss account. You might have noticed that all nominal accounts are marked with the Accounting period in Figure 3.5. This makes it easier to distinguish nominal and real accounts. Nominal accounts are: - Rent-20X1. - Labour-20X1. - Operational expenses-20X1. - Depreciation-20X1. - Revenue-20X1. To understand the Profit and Loss account easily, we apply the 3-letter-code as references too. See the Profit and Loss account in Figure 3.6. We see on the first glance which expenses are disclosed in the Profit and Loss account and can transfer the figures to the income statement without searching Bookkeeping entry numbers. 31 To learn how to balance-off and close-off accounts, study the textbook Basics of Accounting, chapters (10) and (11). The pre-tax profit of KENILWORTH METERED TAXI SERVICE Ltd. is: 12,500,000 - 2,000,000 - 144,000 - 810,000 - 8,650,000 = 8 896,000.00 ZAR. The pre-tax-profit is also referred to as the earnings before taxation EBT. The values for the profit calculation are: - Revenue: 12,500,000.00 ZAR. - Operational expenses: 2,000,000.00 ZAR. - Rent: 144,000.00 ZAR. - Depreciation: 810,000.00 ZAR. - Labour: 8,650,000.00 ZAR. Based on our income tax model, 30 % multiplied with earnings before taxes gives the total of income taxes. Hence, the earnings after taxes EAT (annual surplus A/ S) are: 896,000 × (1 - 30%) = 627,200.00 ZAR. <?page no="52"?> Berkau: Financial Statements 7e 3-52 Check the accounts as displayed in Figure 3.6 after adjustments are completed. D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 b/ d 1,452,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 12,500,000.00 (3) 12,500,000.00 (4) 7,000,000.00 P&L 12,500,000.00 b/ d 12,500,000.00 (5) 1,650,000.00 c/ d 8,650,000.00 8,650,000.00 8,650,000.00 b/ d 8,650,000.00 P&L 8,650,000.00 Revenue-20X1 REV Labour-20X1 LAB D C D C (6) 2,000,000.00 c/ d 2,000,000.00 (7) 156,000.00 PRE 12,000.00 b/ d 2,000,000.00 P&L 2,000,000.00 c/ d 144,000.00 156,000.00 156,000.00 b/ d 144,000.00 P&L 144,000.00 D C D C ACC 810,000.00 c/ d 810,000.00 c/ d 810,000.00 DPR 810,000.00 b/ d 810,000.00 P&L 810,000.00 b/ d 810,000.00 Operational expenses-20X1 OEX Rent-20X1 RNT Depreciation-20X1 DPR Acc depr ACC Figure 3.6: KMTS Ltd.’s accounts after profit calculation (20X1) <?page no="53"?> Berkau: Financial Statements 7e 3-53 D C D C RNT 12,000.00 c/ d 12,000.00 OEX 2,000,000.00 REV 12,500,000.00 b/ d 12,000.00 RNT 144,000.00 DPR 810,000.00 LAB 8,650,000.00 EBT 896,000.00 12,500,000.00 12,500,000.00 ITE 268,800.00 b/ d 896,000.00 R/ E 627,200.00 896,000.00 896,000.00 Prepaid expenses PRE Profit and Loss-20X1 P&L D C D C ITL 268,800.00 c/ d 268,800.00 c/ d 268,800.00 ITE 268,800.00 b/ d 268,800.00 P&L 268,800.00 b/ d 268,800.00 D C c/ d 627,200.00 P&L 627,200.00 b/ d 627,200.00 Income tax expenses ITE Income tax liabilities ITL Retained earnings R/ E Figure 3.6: 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. In contrast to the Profit and Loss account, IAS 1.81A - 1.82B do not force the reporting company to disclose all single expenses as items on the income statement. For instance, KENILWORTH METERED TAXI SERVICE Ltd. can combine operational expenses and rent to an item "other expenses" on its statement of profit or loss and other comprehensive income. The value is: 2,000,000 + 144,000 = 2 2,144,000.00 ZAR. Find below the income statement for KENILWORTH METERED TAXI SERVICE Ltd. in Figure 3.7. Note, that in this textbook, financial statements are disclosed with figures rounded to the nearest integer. <?page no="54"?> Berkau: Financial Statements 7e 3-54 [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 3.7: KMTS Ltd.’s income statement (20X1) The next statement to prepare is the balance sheet. IAS 1.10 calls it the statement of financial position. In the case of KENILWORTH METERED TAXI SERVICE Ltd., only few items need calculations for their disclosure; most items can be taken directly 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 and gives: 3,240,000 - 810,000 = 2,430,000.00 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: 1,452,000.00 ZAR. In contrast to German Bookkeeping, we only apply one VAT account for the recording of input-VAT (debit side) and output-VAT (credit side). Note, that VAT is no income tax and therefore cannot be disclosed under income tax liabilities. Observe the balance sheet in Figure 3.8. <?page no="55"?> Berkau: Financial Statements 7e 3-55 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 3.8: KMTS Ltd.’s balance sheet (20X1) IAS 1.10 rules that 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 (income statement), a statement of cash flows and a statement of changes in equity. Additionally, notes are required. You find the remaining statements below in Figure 3.9 and Figure 3.10. An example for the notes can be found in chapter (6). The cash flow 32 is the difference between the opening value and the closing figure 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 lower than its opening balance. The cash flow is: 4,906,000 - 5,000,000 = -994,000.00 ZAR. So far, KENILWORTH METERED TAXI SERVICE Ltd. burned cash by its business activities, but we consider that the negative cash flow primary results from investments. It is not seldom for companies to disclose in the first year negative total cash flows due to paid acquisitions. To analyse the details of cash flows, a cash flow statement must be prepared. We do not discuss cash flow statements in detail here, but you find the company’s statement of cash flows in Figure 3.9. To understand if and why the book value of the company changes, we disclose a company’s equity development by a statement of changes in equity 33 . Here, equity changed by: 5,627,200 - 5,000,000 = 6 627,200.00 ZAR. Check the statement of changes in equity in Figure 3.10. Further explanation about the statement of changes in equity can be found in chapter (13). 32 We discuss cash flow statements in our textbook Basics of Accounting, chapter (32). Further considerations to cash flow statements follow in chapter (10) of this textbook. 33 Check our textbook Basics of Accounting, chapter (30). <?page no="56"?> Berkau: Financial Statements 7e 3-56 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 3.9: 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 3.10: KMTS Ltd.’s statement of changes in equity (20X1) After we prepared the first Accounting period’s financial statements, we continue our Accounting work with the next fiscal year 20X2. Applying international Bookkeeping, we continue all real accounts. No opening nor closing accounts apply. All nominal accounts are “fresh” in the new Accounting period because the previous ones are closed-off to the Profit and Loss account with the recording of adjustments. 34 34 Read our textbook Basics of Accounting, chapter (31). 3.6 C/ S KENILWORTH MTS Ltd. - 20X2 For the case study KENILWORTH METERED TAXI SERVICE Ltd., we observe how the company continues its operations and the Accounting work: In contrast to the previous Accounting period 20X1, KENILWORTH METERED TAXI SERVICE Ltd. earns a higher revenue of 13,200,000.00 ZAR and hires 2 new taxi drivers. Furthermore, the landlord increases rent from 1.07.20X2 onwards by 15 %. The new rent is: (1 + 15%) × 12,000 = 113,800.00 ZAR/ m. Otherwise, nothing <?page no="57"?> Berkau: Financial Statements 7e 3-57 changes. Note, in 20X2, no investments take place. Once a new Accounting period starts, we must make some preparatory Bookkeeping entries. In general, these initial Bookkeeping entries relate to the below listed activities: - Prepaid expenses from last year. - Income tax payments. - VAT payments. - Payments of other short-term liabilities e.g., resulting from supplies. - Collection of receivables as scheduled. - Payment for dividends. etc. KENILWORTH METERED TAXI SERVICE Ltd. transfers 12,000.00 ZAR prepaid rent from the Prepaid Expenses account to the Rent-20X2 account. The Bookkeeping entry for this transfer is (A). To distinguish Bookkeeping entries from different Accounting periods we change the identifiers. For the Accounting period 20X2, we mark the new Bookkeeping entries with capital letters. DR Rent......................... 12,000.00 ZAR CR Prepaid Expenses............. 12,000.00 ZAR KENILWORTH METERED TAXI SERVICE Ltd. pays income taxes from 20X1 which are due in the Accounting period 20X2. Another tax payment is for the excess of output-VAT over input-VAT which results in a payment of 1,452,000.00 ZAR. Observe Bookkeeping entries (B) and (C), both are recorded on 1.01.20X2. DR Income Tax Liabilities....... 268,800.00 ZAR CR Cash/ Bank.................... 268,800.00 ZAR DR VAT.......................... 1,452,000.00 ZAR CR Cash/ Bank.................... 1,452,000.00 ZAR Check the accounts after the preparatory Bookkeeping entries are recorded in Figure 3.11. As last year’s entries do not matter anymore, we grey them out. <?page no="58"?> Berkau: Financial Statements 7e 3-58 D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 (B) 268,800.00 (C) 1,452,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 (C) 1,452,000.00 b/ d 1,452,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C RNT 12,000.00 c/ d 12,000.00 c/ d 810,000.00 DPR 810,000.00 b/ d 12,000.00 (A) 12,000.00 b/ d 810,000.00 Prepaid expenses PRE Acc depr ACC D C D C c/ d 627,200.00 P&L 627,200.00 c/ d 268,800.00 ITE 268,800.00 b/ d 627,200.00 (B) 268,800.00 b/ d 268,800.00 D C (A) 12,000.00 Rent-20X2 RNT Retained earnings R/ E Income tax liabilities ITL Figure 3.11: KMTS Ltd.’s accounts (20X2) In 20X2, the Bookkeeping entries below for the business activities of KENILWORTH METERED TAXI SERVICE Ltd. are recorded: (D) Revenue 13,200,000.00 ZAR. The gross value is: 120% × 13,200,000 = 15,840,000.00 ZAR. All passengers pay on cash. The Bookkeeping entry (D) is recorded on 30.06.20X2. <?page no="59"?> Berkau: Financial Statements 7e 3-59 DR Cash/ Bank.................... 15,840,000.00 ZAR CR VAT.......................... 2,640,000.00 ZAR CR Revenue...................... 13,200,000.00 ZAR (E) Labour: There are 16 taxi drivers employed. We consider the dispatcher and the manager, too: 16 × 500,000 + 650,000 + 1,000,000 = 9 9,650,000.00 ZAR. Bookkeeping entry (E) for labour is recorded on 30.06.20X2. DR Labour....................... 9,650,000.00 ZAR CR Cash/ Bank.................... 9,650,000.00 ZAR (F) Rent increases in the middle of the Accounting period 20X2. As there was a prepayment for 20X2 already, the Bookkeeping entries for rent in total are: 5 × 12,000 + 7 × 13,800 = 1 156,600.00 ZAR. As the rent for January was paid in December 20X1, only 5 rental payments at 12,000.00 ZAR/ m are made. The next following payments are for July/ 20X2 - January/ 20X3 and are amounting to 13,800.00 ZAR/ m each. At the end of the year, the rent for January/ 20X3 will be transferred to the Prepaid Expenses account. Below, you see the rent Bookkeeping entry (F) for the 12 single entries. DR Rent......................... 156,600.00 ZAR CR Cash/ Bank.................... 156,600.00 ZAR (G) Operational expenses are again 2,000,000.00 ZAR/ a. They are recorded on 30.06.20X2. DR Operating Expenses........... 2,000,000.00 ZAR DR VAT.......................... 400,000.00 ZAR CR Cash/ Bank.................... 2,400,000.00 ZAR We also record adjustments; they are made for depreciation and the rent's accrual. They result in Bookkeeping entries (H) and (I), as recorded on the 31.12.20X2. DR Depreciation ................. 810,000.00 ZAR CR Acc. Depr.................... 810,000.00 ZAR DR Prepaid Expenses............. 13,800.00 ZAR CR Rent......................... 13,800.00 ZAR As in the previous Accounting period, we balance-off all accounts and close-off all nominal accounts for 20X2 to the Profit and Loss-20X2 (P2L) account. Based on our recordings, we can calculate the profit for 20X2. <?page no="60"?> Berkau: Financial Statements 7e 3-60 Observe the accounts for 20X2 in Figure 3.12. D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 (B) 268,800.00 (D) 15,840,000.00 (C) 1,452,000.00 (E) 9,650,000.00 (F) 156,600.00 (G) 2,400,000.00 c/ d 6,818,600.00 20,746,000.00 20,746,000.00 b/ d 6,818,600.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 (C) 1,452,000.00 b/ d 1,452,000.00 (G) 400,000.00 (D) 2,640,000.00 c/ d 2,240,000.00 4,092,000.00 4,092,000.00 b/ d 2,240,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C RNT 12,000.00 c/ d 12,000.00 c/ d 810,000.00 DPR 810,000.00 b/ d 12,000.00 (A) 12,000.00 b/ d 810,000.00 RNT 13,800.00 c/ d 13,800.00 c/ d 1,620,000.00 DPR 810,000.00 25,800.00 25,800.00 1,620,000.00 1,620,000.00 b/ d 13,800.00 b/ d 1,620,000.00 Prepaid expenses PRE Acc depr ACC Figure 3.12: KMTS Ltd.’s accounts after profit calculation (20X2) <?page no="61"?> Berkau: Financial Statements 7e 3-61 D C D C c/ d 627,200.00 P&L 627,200.00 c/ d 268,800.00 ITE 268,800.00 b/ d 627,200.00 (B) 268,800.00 b/ d 268,800.00 c/ d 1,036,840.00 P2L 409,640.00 c/ d 175,560.00 ITE 175,560.00 1,036,840.00 1,036,840.00 444,360.00 444,360.00 b/ d 1,036,840.00 b/ d 175,560.00 Retained earnings R/ E Income tax liabilities ITL D C D C (A) 12,000.00 PRE 13,800.00 c/ d 13,200,000.00 (D) 13,200,000.00 (F) 156,600.00 c/ d 154,800.00 P2L 13,200,000.00 b/ d 13,200,000.00 168,600.00 168,600.00 b/ d 154,800.00 P2L 154,800.00 D C D C (E) 9,650,000.00 c/ d 9,650,000.00 (G) 2,000,000.00 c/ d 2,000,000.00 b/ d 9,650,000.00 P2L 9,650,000.00 b/ d 2,000,000.00 P2L 2,000,000.00 Rent-20X2 RNT Revenue-20X2 REV Labour-20X2 LAB Operational expenses-20X2 OEX D C D C ACC 810,000.00 c/ d 810,000.00 RNT 154,800.00 REV 13,200,000.00 b/ d 810,000.00 P2L 810,000.00 LAB 9,650,000.00 OEX 2,000,000.00 DPR 810,000.00 EBT 585,200.00 13,200,000.00 13,200,000.00 ITE 175,560.00 b/ d 585,200.00 R/ E 409,640.00 585,200.00 585,200.00 D C ITL 175,560.00 c/ d 175,560.00 b/ d 175,560.00 P2L 175,560.00 Depreciation-20X2 DPR Profit and Loss-20X2 P2L Income tax expensess-20X2 ITE Figure 3.12: KMTS Ltd.’s accounts after profit calculation (20X2) continued The owners are keen to earn a return on the funds they invested in the business. In a company based on shares, the payment to the owners for their share of the profit is called a dividend. KENILWORTH METERED TAXI SERVICE Ltd. did not pay dividends for 20X1. This 35 Not to declare dividends was intended to keep the case study simple. means, shareholders did not receive any returns so far 35 . On the annual general meeting at the beginning of 20X3 when the chief executive officer CEO or chief financial officer CFO reports on the previous Accounting period 20X2 and presents and explains the financial statements, the shareholders of <?page no="62"?> Berkau: Financial Statements 7e 3-62 KENILWORTH METERED TAXI SERVICE Ltd. declare a dividend of 30 % of the distributable amount. The amount distributable for dividend payments contains the profit carried forward plus the annual surplus from 20X2. The value can be reduced for preference dividends which does not apply for KENILWORTH METERED TAXI SERVICE Ltd. National restrictions might apply, too. In the case of KENILWORTH METERED TAXI SERVICE Ltd., the distributable amount shows in the Retained Earnings account, observe Figure 3.13. It is: 627,200 + 409,640 = 11,036,840.00 ZAR. Based on the decision made on the annual general meeting, 30 % will be paid to the shareholders, which is: 30% × 1,036,840 = 3 311,052.00 ZAR. 20 % is transferred to the Earnings Reserves account: 20% × 1,036,840 = 207,368.00 ZAR. The remainder is carried forward to the next Accounting period; the annual general meeting will decide in 20X4 about its appropriation. In general, international corporations prepare financial statements under the consideration of the appropriation of profits. KENILWORTH METERED TAXI SERVICE Ltd. records the dividend as payables to the owners. They will be paid in 20X3. The account applicable is the Shareholders for Dividend account. It falls under payables (A/ P account). The additions to earnings reserves do not affect the total of equity because they remain in the business e.g., for reinvestments. The non-appropriated earnings according to the decision made on the annual general meeting are carried forward to the next Accounting period. No Bookkeeping entry is required for carrying forward profit or loss as the amount just stays in the Retained Earnings account as its balancing figure. An investor holding 10,000 ordinary shares of KENILWORTH METERED TAXI SERVICE Ltd. receives a dividend of: (10,000/ 500,000) × 311,052 = 6 6,221.04 ZAR. Her/ his return on investment is: 6,221.04 / 100,000 = 6 6.22%. The investor also benefits from the increase in equity, as the book value of the company increases by: (1,036,840 - 311,052) / 5,000,000 = 1 14.52%. DR Retained Earnings............ 311,052.00 ZAR CR Shareholders 4 Dividend A/ P.. 311,052.00 ZAR DR Retained Earnings............ 207,368.00 ZAR CR Earnings Reserves............ 207,368.00 ZAR Below, we disclose only accounts relevant for the appropriation of profits. Study Figure 3.13. <?page no="63"?> Berkau: Financial Statements 7e 3-63 D C D C c/ d 627,200.00 P&L 627,200.00 c/ d 207,368.00 R/ E 207,368.00 b/ d 627,200.00 b/ d 207,368.00 c/ d 1,036,840.00 P2L 409,640.00 1,036,840.00 1,036,840.00 S4D 311,052.00 b/ d 1,036,840.00 E-R 207,368.00 c/ d 518,420.00 1,036,840.00 1,036,840.00 b/ d 518,420.00 Retained earnings R/ E Earnings reserves E-R D C c/ d 311,052.00 R/ E 311,052.00 b/ d 311,052.00 Shareholder for dividend S4D Figure 3.13: KMTS Ltd.’s accounts for profit appropriation (20X2) KENILWORTH METERED TAXI SERVICE Ltd. prepares its financial statements under the consideration of the appropriation of profits. See below the set of financial statements except of the notes. Observe Figure 3.14, Figure 3.15, Figure 3.16 and Figure 3.17. [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 3.14: KMTS Ltd.’s income statement (20X2) <?page no="64"?> Berkau: Financial Statements 7e 3-64 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 3.15: 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 3.16: KMTS Ltd.’s cash flow statement (20X2) <?page no="65"?> Berkau: Financial Statements 7e 3-65 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 31.12.20X1 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 3.17: KMTS Ltd.’s statement of changes in equity (20X2) 3.7 Summary International Bookkeeping is not much different to the German way. Both Accounting systems apply the double entry system. The preparation of financial statements is based on nominal and real accounts. Internationally, no 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 the Accounting periods 20X1 and 20X2. In general, companies prepare financial statements under the consideration of the appropriation of profits. The appropriation of profits either adds earnings to reserves for reinvestments or to dividends payables (Shareholders for Dividend account) in the next Accounting period. Profit or loss not appropriated is transferred to the next Accounting period and shows as balance brought forward in the Retained Earnings account. 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. International Accounting Standards IFRSs: Accounting Standards issued by the International Accounting Standard Board that are either an IAS (International Accounting Standard) or an IFRS (International Financial Accounting Standard). Paragraph: Section of a Standard. Paragraphs are identified by numbers. Set of Financial Statements: In line with IAS 1.10, a set of financial statement 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. It can include a further balance sheet if <?page no="66"?> Berkau: Financial Statements 7e 3-66 IAS 8 applies regarding changes in Accounting policies. Standard Setter: Organisation that issues standards. For IFRSs, the standard setter is the International Accounting Standard Board headquartered in Canary Wharf, London. Statement of Cash Flows: A statement that shows increases and decreases of the cash/ bank item structured by classifications: operative, investing and financing. 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. It discloses operating profits and extraordinary earnings and expenses. 3.9 Question Bank (1) A company reporting in accordance with IFRSs must disclose … 1. .… a statement of financial position, an income statement, a statement of cash flows and notes. 2. … a balance sheet, an income statement, a statement of changes in equity, a statement of cash flows and notes. 3. … a statement of financial position, a statement of profit or loss and other comprehensive income, a cash flow statement, a register of non-current assets and the notes. 4. … a balance sheet, an income statement, a statement of cash flows, a statement of changes of liabilities and notes. (2) A company that prepares financial statements in accordance with IFRSs must disclose a statement of cash flows … 1. … only if participating on the capital market. 2. … in any case. 3. … when a group member. 4. …not as a group member as the parent discloses changes in cash flows in the group statements already. (3) A company that pays 12,000.00 EUR for labour and makes 1 monthly payment in advance, records labour in the actual Accounting period as below: 1. DR Labour … 12,000.00 EUR, CR Cash/ Bank … 12,000.00 EUR. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 2. DR Labour … 1,000.00 EUR, CR Prepaid Expenses … 1,000.00 EUR. DR Labour … 12,000.00 EUR, CR Cash/ Bank … 12,000.00 EUR. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 3. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. DR Labour … 11,000.00 EUR, CR Cash/ Bank … 11,000.00 EUR. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 4. DR Labour … 11,000.00 EUR, CR Cash/ Bank … 11,000.00 EUR. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. <?page no="67"?> Berkau: Financial Statements 7e 3-67 (4) A company that makes the debit entries Labour: 10,000.00 EUR, Rent: 1,200.00 EUR, Prepaid insurance: 450.00 EUR, Depreciation on factory building: 600.00 EUR, Depreciation on motor vehicles: 900.00 EUR, Operational expenses: 2,400.00 EUR, discloses the expenses below on the statement of profit or loss and other comprehensive income: 1. Labour: 10,000.00 EUR, Rent: 1,200.00 EUR, Prepaid expenses 450.00 EUR, Depreciation: 1,500.00 EUR, Other expenses: 2,400.00 EUR. 2. Labour: 10,000.00 EUR, Rent: 1,200.00 EUR, Depreciation: 1,500.00 EUR, Other expenses: 4,050.00 EUR. 3. Labour: 10,000.00 EUR, Depreciation: 1,500.00 EUR, Other expenses: 3,600.00 EUR. 4. Labour: 10,450.00 EUR, Depreciation: 1,500.00 EUR, Other expenses: 3,600.00 EUR. (5) A company pays for this year’s rent 1,080.00 EUR during this Accounting period and must pay another 360.00 EUR in the next one (for this Accounting period). Before, the 360.00 EUR are recorded as accounts payables. Rent is subjected to VAT. How much is rent on the income statement? 1. 900.00 EUR . 2. 1,080.00 EUR . 3. 1,200.00 EUR . 4. 1,440.00 EUR . 3.10 Solutions 1-2, 2-2, 3-2, 4-3, 5-3. <?page no="68"?> Berkau: Financial Statements 7e 4-68 4 Accounting for Retailers 4.1 What is in the Chapter? This chapter is an introduction to financial statements for retailers in compliance with international Accounting. We cover most common instruments in Bookkeeping, like the Trial Balance T/ B and the Trading account T/ A. Accounting for traders is simple because no production steps and therefore, no material flows must be considered. With this chapter, we introduce financing based on a bank loan as well. This chapter also gives you a short revision of Bookkeeping. These are the main topics: - Gross profit calculation. - Trading Account. - Trial Balance. We discuss the case study RYNEVELD Ltd. which is a trader for office paper. We apply a periodic inventory system and prepare a Trading account for the gross profit calculation. To check the correctness of the Bookkeeping entries, we prepare a trial balance before and after the adjustments are recorded. 4.2 Learning Objectives After studying this chapter, you can prepare financial statements for retailers making international Bookkeeping entries and you can prepare financial statements in accordance with IFRSs. You will learn the relevant standards. You are also familiar with the gross 36 Read our textbook Basics of Accounting, chapter (26). and net profit calculations and can apply a Trading Account and use the Trial Balance before and after the adjustments are made. 4.3 Dealerships We start Accounting for retailers from the application of a period inventory movement system 36 . As a simplification, all goods are bought at the same unit purchase price. Retailers calculate profit in a two-stepapproach: at first, they calculate the gross profit and thereafter they continue profit calculations to determine the net profit (earnings before taxes). A gross profit is the difference between revenue and material expenses. Revenue is the compensation received from customers for goods and services. When we refer to material expenses, we mean the cost of purchase for goods. This is always their net value. IAS 2.11 and IAS 16.16 apply. Step 2 is the net profit calculation. The net profit is revenue minus all expenses except of income tax expenses. The net profit calculation starts from the gross profit and requires deducting further expenses other than materials. In this textbook, we calculate the income taxes by multiplying the income tax rate with the net profit. We then arrive at the earnings after taxes which is also called annual surplus. <?page no="69"?> Berkau: Financial Statements 7e 4-69 4.4 Gross Profit Calculation We explain the procedure of gross profit calculation (1 st step) by a small case study about a plumber who also deals with spare parts. The plumber is a retailer and service provider at the same time. Data Sheet for DEMANN GmbH DDomicile: Germany (Lingen (Ems)). Reporting currency: EUR. Classification: Repair. Accounting period: n/ a. Order revenue: 500.00 EUR. Order costs: material: 120.00 EUR labour: 130.00 EUR; partial depreciation: 10.00 EUR; partial Management costs 40.00 EUR and tool expenses: 25.00 EUR. Material increases to 138.00 EUR. VAT 20 %. 4.5 C/ S DEMANN GmbH The plumber DEMANN GmbH in the Emsland (Germany) repairs a central heating system in a private house. The repair requires a replacement pump which costs 120.00 EUR ex VAT. After the repair, DEMAN GmbH bills 600.00 EUR including VAT. This gives for DEMANN GmbH a revenue of: 600 / 120% = 5 500.00 EUR. When we analyse the bill, we notice an item for the pump as material expenses. Below, we calculate the customer order from the perspective of DEMANN GmbH. We know the pump costs for DEMANN GmbH 120.00 EUR (net value). For the profit regarding this customer order, our first step is its gross profit calculation. The gross profit is the revenue (net value) of 500.00 EUR minus the cost of goods sold (net values) of 120.00 EUR for the pump. Hence, the gross profit is: 500 - 120 = 3 380.00 EUR. What does that figure tell the plumber/ seller? It says that the gross profit must cover DEMANN GmbH’s total customer order costs, the income taxes and the profit for the repair. In other words: The gross profit is the revenue of the company without material expenses. In contrast, the net profit (also pre-tax profit) is the profit before taxes which requires the deduction of all costs for operations from the gross profit. Based on the net profit, we calculate income taxes. We could say, the net profit is what remains for the company, its owners and the revenue service. To calculate the customer order’s net profit, DEMANN GmbH further deducts labour, depreciation on the van the plumber drives to the site with, a portion of Management costs, costs for tools etc. Here, labour is 130.00 EUR, proportionate depreciation is 10.00 EUR, proportionate Management costs are 40.00 EUR and costs for tools are 25.00 EUR. The order’s net profit then is: 380 - 130 - 10 - 40 - 25 = 1175.00 EUR. This is DEMANN GmbH’s pre-tax profit. Based on our simplification about the income tax model, the income taxes are: 175 × 30% = 5 52.50 EUR. This gives a profit after taxes for DEMANN GmbH to the extent of: 175 - 52.50 = 1 122.50 EUR. Once we divide this profit by the revenue, we arrive at the net profit as percentage on sales being: 122.50 / 500 = 2 24.50 %. We could say, with every Euro received in revenue, the company earns 0.25 EUR after taxes. To study the technical terms of profit calculation we analyse the order calculation in Figure 4.1. It has the format of an income statement. The only differ- <?page no="70"?> Berkau: Financial Statements 7e 4-70 ence is that we "interrupt" the profit calculation for retailers and determine the gross profit. No order calculation is required by IFRSs. Here, we only prepare one to show the calculation procedures. [EUR] Revenue 500 Other income 0 500 Materials (120) Gross profit 380 Labour (130) Depreciation (10) Other expenses (65) Earnings before int. & taxes (EBIT) 175 Interest 0 Earnings before taxes (EBT), Net Profit 175 Income tax expenses (53) Deferred taxes 0 Earnings after taxes (EAT) 123 Demann GmbH Order's STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME Figure 4.1: DEMANN GmbH’s order calculation Next, we alter the case study and assume, the supplier for spare parts increases prices by 15 %. The pump then costs: 120 × (1 + 15%) = 1 138.00 EUR. This is an increase of: 138 - 120 = 1 18.00 EUR. If DEMANN GmbH plans to earn the same gross profit as before, it must pass on the price increase for the pump to its customer and increase its next invoice by a net amount of 18.00 EUR. Therefore, a repair will cost the customer: (500 + 18) × 120 % = 6 621.60 EUR. This way, the gross profit remains the same: 621.60 / 120% - 138 = 3 380.00 EUR. 37 The trial balance is introduced in chapter (29) of our textbook Basics of Accounting. 4.6 Trial Balance Next, we study the application of the trial balance and the Trading account by the case study of the office material trader RYNEVELD Ltd. in George (South Africa). The company deals with office paper. A trial balance is a list of all accounts and their balancing figures. 37 In the old days of Bookkeeping, Accountants used it for checking consistency with the double entry system. The Bookkeepers could easily see whether they miscalculated something. On a <?page no="71"?> Berkau: Financial Statements 7e 4-71 Trial Balance, the total of the debit balanced accounts (b/ d on the debit side) must equal the total of the credit balanced ones (b/ d on the credit side). 38 Nowadays, Accounting software prechecks all Bookkeeping entries before recording, which prevents us from making faulty entries. However, the trial balance might help you in an exam to detect errors. In a company, the trial balance provides us with an overview of accounts and their balancing figures as well as it supports Bookkeeping data transfer e.g., between group companies. 4.7 Trading Account The Trading account is prepared after the original Bookkeeping entries for business operations are checked with the trial balance. It resembles a Profit and Loss account, but it only covers revenues and material expenses. The balancing figure of the Trading account is the gross profit. The Trading account pairs well with a periodic inventory system. Under this concept the company only takes stock once per Accounting period. The expenses for materials are then calculated as a comparison of closing stock and opening balances and all stock additions (purchases). 4.8 C/ S RYNEVELD Ltd. Next, we apply the trial balance and the Trading Account for the office paper trader RYNEFELD Ltd. 38 Read our textbook Basics of Accounting, chapter (10) - (12). Data Sheet for RYNEVELD Ltd. DDomicile: South Africa (George). Reporting currency: ZAR. Classification: Retailer. Accounting period: 20X6. Share issue: 100,000 × 5.00 ZAR/ s. Financing: bank loan 200,000.00 ZAR; interest 6 %/ a, pay-off: 40,000.00 ZAR/ a. Rent: 36,000.00 ZAR/ a; payment one month in advance. Store equipment (P, P, E): 200,000.00 ZAR; depreciation: straight-line method over 10 years. Purchases: 250,000.00 ZAR. Closing stock: 22.4 % Revenue: 545,000.00 ZAR. Operational costs (non-VATable): 15,000.00 ZAR/ m. VAT 20 %. RYNEVELD Ltd. is incorporated on 1.01.20X6 by an issue of 100,000 ordinary shares at 5.00 ZAR/ s face value. On 2.01.20X6, RYNEVELD Ltd. takes a bank loan of 200,000.00 ZAR. The annual rate of interest is 6 %/ a and is due at the end of every year. Pay-off of the bank loan is constantly 40,000.00 ZAR/ a. It is paid together with interest at year-ends. The rent for the shop is 36,000.00 ZAR/ a; no VAT applies. RYNEVELD Ltd. pays the rent one month in advance. The first payment for January is paid on 2.01.20X6, for February on 30.01.20X6 and so on. RYNEVELD Ltd. acquires store equipment shelves, tables etc. for 240,000.00 ZAR on 2.01.20X6. The price (gross value) is paid instantly. The store equipment is written-off along straightline method over 10 years. No residual value applies for depreciation. <?page no="72"?> Berkau: Financial Statements 7e 4-72 RYNEVELD Ltd. purchases office paper for 300,000.00 ZAR (gross amount) and pays half of the price in January and the other half in 20X7. At the end of the Accounting period 20X6, RYNEVELD Ltd. takes stock and calculates that 22.4 % (in value) of the office paper is still in storage. During the fiscal year 20X6, RYNEVELD Ltd. earns a revenue of 545,000.00 ZAR. All customers pay on cash. Operational costs, mainly labour, is 15,000.00 ZAR/ m during 20X6. As the expenses for operations are internal expenses, we do not consider VAT 39 . 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 account and in the Profit and Loss account. We prepare a trial balance for RYNEVELD Ltd. after recording all business activities. We cover the business activities separately: At the time of incorporation, RYNEVELD Ltd. issues ordinary shares at a total value of: 100,000 × 5 = 5 500,000.00 ZAR. See Bookkeeping entry (1): DR Cash/ Bank.................... 500,000.00 ZAR CR Issued Capital............... 500,000.00 ZAR When borrowing money from the bank, RYNEVELD Ltd. receives an amount from the bank to the extent of 200,000.00 ZAR. This is the principal (nominal value) of the bank loan. It is recorded as Bookkeeping entry (2). The interest (Bookkeeping entry (3)) for 20X6 is: 6% × 200,000 = 1 12,000.00 ZAR. As interest is monthly paid in general, it does not fall under adjustments; however, the payoff of the loan does. RYNEVELD Ltd. must pay-off 40,000.00 ZAR every year. The pay-off Bookkeeping entry falls under adjustments and is recorded on 31.12.20X6. We record adjustments after the preparation of the first trial balance. Observe the Bookkeeping entries (2) and (3) below: DR Cash/ Bank.................... 200,000.00 ZAR CR Interest Bearing Liabilities. 200,000.00 ZAR DR Interest..................... 12,000.00 ZAR CR Cash/ Bank.................... 12,000.00 ZAR The rent is not subjected to VAT as the property owner is not registered for VAT-reduction. 39 Consider for an exam that whether operational expenses are VATable depends on the case. Rent is paid in advance except of January’s rent. RYNEVELD Ltd. must make 13 rental payments - the last one thereof counts as a prepayment for 20X4. We Therefore, it must be given. If not, work with the net amounts. <?page no="73"?> Berkau: Financial Statements 7e 4-73 firstly record the 13 payments as aggregated Bookkeeping entry (4). The accrual is recorded later as adjustment. DR Rent......................... 39,000.00 ZAR CR Cash/ Bank.................... 39,000.00 ZAR The acquisition of the store equipment is the next business activity. The cost of acquisition (net value) is 200,000.00 ZAR. IAS 16.16 states that input-VAT is not included in the cost of acquisition if the buying company is registered for VAT reduction. The Bookkeeping (5) entry is: DR P, P, E Account.............. 200,000.00 ZAR DR VAT.......................... 40,000.00 ZAR CR Cash/ Bank.................... 240,000.00 ZAR Depreciation on the interior falls under adjustments and will be discussed later. Our next Bookkeeping entry is for the purchase of the office paper. As we apply the periodic system for inventory movements, we must record the materials as an addition to the Purchase account. 40 As the input-VAT is refundable by the revenue service, it is not part of the cost of purchase, see IAS 2.11. The input-VAT is recorded as an asset because it is a claim against the revenue service. Observe Bookkeeping entry (6) below. Note, the payment is split into two parts, one in 20X6 - the remainder in 20X7. Note, we do not split VAT. VAT applies when the Bookkeeping entry is made which is the day of closing the deal. It counts once revenue/ expenses are recognised. RYNEVELD Ltd. claims the total value of input-VAT to the extent of 50,000.00 ZAR immediately. This follows the VAT law. DR Purchase..................... 250,000.00 ZAR DR VAT.......................... 50,000.00 ZAR CR Cash/ Bank.................... 150,000.00 ZAR CR Accounts Payables............ 150,000.00 ZAR The closing stock of goods at the end of the Accounting period is recognised together with the adjustments. For now, we ignore the closing stock. The stock taking is after the balance sheet date and must be recorded at that time. 40 Read the textbook Basics of Accounting, chapter (26). The revenue recognition gives 545,000.00 ZAR. The proceeds are the gross values thereof and are: 545,000 × 120% = 6 654,000.00 ZAR. See Bookkeeping entry (7) below: <?page no="74"?> Berkau: Financial Statements 7e 4-74 DR Cash/ Bank.................... 654,000.00 ZAR CR VAT.......................... 109,000.00 ZAR CR Revenue...................... 545,000.00 ZAR Operational costs are recorded as Bookkeeping entry (8). DR Operational Expenses......... 180,000.00 ZAR CR Cash/ Bank.................... 180,000.00 ZAR We observe the Bookkeeping entries made so far. The next following Bookkeeping entries all fall under adjustments. Study the accounts in Figure 4.2. D C D C (1) 500,000.00 (3) 12,000.00 c/ d 500,000.00 (1) 500,000.00 (2) 200,000.00 (4) 39,000.00 b/ d 500,000.00 (7) 654,000.00 (5) 240,000.00 (6) 150,000.00 (8) 180,000.00 c/ d 733,000.00 1,354,000.00 1,354,000.00 b/ d 733,000.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 200,000.00 (2) 200,000.00 (3) 12,000.00 c/ d 12,000.00 b/ d 200,000.00 b/ d 12,000.00 Interest bearing liabilities IBL Interest-20X6 INT D C D C (4) 39,000.00 c/ d 39,000.00 39,000.00 39,000.00 b/ d 39,000.00 Rent-20X6 RNT Prepaid expenses PRE D C D C (5) 200,000.00 c/ d 200,000.00 (5) 40,000.00 (7) 109,000.00 b/ d 200,000.00 (6) 50,000.00 c/ d 19,000.00 109,000.00 109,000.00 b/ d 19,000.00 Property, Plant, Equipment PPE Value added tax VAT Figure 4.2: RYNEVELD Ltd.’s accounts before adjustments <?page no="75"?> Berkau: Financial Statements 7e 4-75 D C D C (6) 250,000.00 c/ d 250,000.00 c/ d 150,000.00 (6) 150,000.00 b/ d 250,000.00 b/ d 150,000.00 Purchase-20X6 PUR Accounts payables A/ P D C D C c/ d 545,000.00 (7) 545,000.00 (8) 180,000.00 c/ d 180,000.00 b/ d 545,000.00 b/ d 180,000.00 Revenue-20X6 REV Operational expenses-20X6 OEX Figure 4.2: RYNEVELD Ltd.’s accounts before adjustments continued Next, we prepare a trial balance to cross-check our Bookkeeping entries for consistency with the double entry system. You see the trial balance in Figure 4.3. Compare it to the accounts in Figure 4.2. As a trial balance is prepared for monitoring purposes, we do not round figures to the nearest Rand but disclose them accurate to the cent. Account Debit entries Credit entries [ZAR] [ZAR] Cash/ Bank C/ B 733,000.00 Issued Capital ISS 500,000.00 Interest bearing Liabilities IBL 200,000.00 Interest-20X6 INT 12,000.00 Rent-20X6 RNT 39,000.00 Property, Plant, Equipment PPE 200,000.00 Value added Tax VAT 19,000.00 Purchase-20X6 PUR 250,000.00 Accounts payables A/ P 150,000.00 Revenue-20X6 REV 545,000.00 Operational expenses-20X6 OEX 180,000.00 Total: 1,414,000.00 1,414,000.00 Ryneveld Ltd. TRIAL BALANCE as at 31.12.20X6 Figure 4.3: RYNEVELD Ltd.’s trial balance How it is Done (Trial Balance): (1) Make Bookkeeping entries for all business activities in the relevant accounts. Balance-off all accounts. (2) Prepare a list with lines for each account therein. Make two columns, one for debit entries and the other one credit entries. Enter the balances brought down for all accounts in the columns debit entry or credit entry <?page no="76"?> Berkau: Financial Statements 7e 4-76 according to the side they belong to. A debit balanced account’s balance is entered on the debit side. A credit balanced account’s balance is entered on the credit side. (3) Compare the totals of the columns for debit and credit. If they are the same your Bookkeeping records are looking good. However, the trial balance does not prove correctness. We continue our Accounting work with the adjustments. Adjustments are those Bookkeeping entries we record in preparation of financial statements at the end of the Accounting period. For RYNEVELD Ltd., we record the adjustments as below: (a) Depreciation. (b) Pay-off of bank loan. (c) Reclassification of next pay-off. (d) Accruals for rent (e) Gross profit calculation. (f) Net profit calculation. (g) Income tax calculation. Ad (a): Depreciation RYNEVELD Ltd. records depreciation on the store equipment. Depreciation always is based on net amounts as input- VAT is refunded and, thus, cannot be an expense. Depreciation on the interior at RYNEVELD Ltd. is: (240,000 / 120%) / 10 = 220,000.00 ZAR. In contrast to the Bookkeeping entries for business activities, we now enter the 3-letter-code for the contra account in the accounts, like ACC for Accumulated Depreciation account in the Depreciation-20X6 account. DR Depreciation................. 20,000.00 ZAR CR Acc. Depr.................... 20,000.00 ZAR Ad (b): Pay-off of the Bank Loan The loan contract with the bank states that RYNEVELD Ltd. must pay-off 40,000.00 ZAR per annum. The Bookkeeping entry is shown below. DR Interest Bearing Liabilities. 40,000.00 ZAR CR Cash/ Bank.................... 40,000.00 ZAR Ad (c): Reclassification of next Pay-off The upcoming repayment for the loan in 20X7 is 40,000.00 ZAR, as well. IFRSs require a reporting company to separate short-term liabilities from long-term ones. The current/ non-current distinction can be found in IAS 1.60 and IAS 1.61. Therefore, RYNEVELD Ltd. must reclassify the next year’s repayment as shortterm liabilities. The Accounts Payables A/ P account applies. Before the reclassification, pay-off was a long-term liability in the Interest Bearing Liabilities account. The names of the accounts can be misleading. The fact that an amount is taken out of the Interest Bearing Liabilities account does not mean that no interest payment is required anymore. The <?page no="77"?> Berkau: Financial Statements 7e 4-77 interest in 20X7 considers the principal (nominal value of the bank loan) less the pay-off in 20X6 and, thus, is based on the amount RYNEVELD Ltd. owes its bank as at 1.01.20X7. Interest-20X7: (200,000 - 40,000) × 6% = 9 9,600.00 ZAR. The interest calculation does not depend on the account the owing amount is allocated to. Therefore, on the balance sheet as at 31.12.20X6, there are 120,000.00 ZAR in the Interest Bearing Liabilities account and 40,000.00 ZAR in the Accounts Payables account; both figures count for the interest calculation in 20X7. DR Interest Bearing Liabilities. 40,000.00 ZAR CR Accounts Payables A/ P ........ 40,000.00 ZAR Ad (d): Accruals (Rent) In compliance with IAS 1.27, the income statement is prepared under the accrual basis of Accounting. This requires recognising expenses in the Accounting period they are for. Payments or receipts of cash do not matter for the allocation to Accounting periods. Here, January 20X7’s rent is separated from the rent in 20X6, which makes the accrual in Bookkeeping entry (5) necessary. 41 The last payment for rent is for January 20X7. Hence, we take the amount out of the income statement and make a debit entry in the Prepaid Expense account. That way, we “park” the expenses and transfer them only in the next Accounting period to the expense account: Rent- 20X7 account. Prepaid expenses are an asset on the balance sheet. See the Bookkeeping entry below: DR Prepaid Expenses ............ 3,000.00 ZAR CR Rent......................... 3,000.00 ZAR Ad (e) Gross Profit Calculation For gross profit calculation, the Trading account applies. 42 With a Trading account in use, we calculate the material expenses by a comparison of opening values for inventory, purchases and the closing stock. Further adjustments might become relevant, if a company sends back goods to its supplier or if its customers return goods they previously have bought. See Figure 4.4 where we show the entry names and their contra accounts’ 3-letter-codes only. 41 Read our textbook Basics of Accounting, chapter (18). 42 Read our textbook Basics of Accounting, chapter (22). <?page no="78"?> Berkau: Financial Statements 7e 4-78 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 4.4: Elements of a Trading account Returns 43 are either returns outwards or returns inwards. Returns outwards are recorded if a company sends goods back to its supplier. The Returns Outwards account applies. We record returns outwards at the net value the goods have been purchased for, which are the cost of purchase. This gives an entry on the credit side of the Returns Outwards account. Once closed-off to the Trading account the item appears therein on the credit side, as well. Compare to Figure 4.4. Alternatively, we can credit the Purchase account which implies a negative purchase transaction. A credit entry is also required in the VAT account to adjust the input-VAT previously (at the time of purchase) recorded. The debit entry is made either in the Accounts Receivables account (for a voucher received), in the Accounts payables account (if the supplier reduces the bill) or in the Cash/ Bank account (for a refund). If customers sending 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 output-VAT which was previously recorded (at the time of the sale). The credit entry can be made 43 Read our textbook Basics of Accounting, chapter (20) - (23) to understand the VAT implication of returns. in the Accounts payables account (for a voucher issued), in the Accounts Receivables account (for a bill reduction) or in the Cash/ Bank account (for a refund). Regarding an inward return, the stock level depends on the action taken after the inward return is received. The returned goods can either be added to stock or discarded. This depends on the return reason. If goods are faulty and the company cannot rework them, it will cast them away. If the customer only made a bad purchase and the goods are still in perfect condition, they will be added to stock. In the latter case, the company should not benefit nor suffer from the return. Therefore, the company must add returned goods at the same costs to stock they previously got released at, if unknown the best estimate applies. 44 At RYNEVELD Ltd., no returns take place. RYNEVELD Ltd. records additions to stock as purchases and takes stock at the beginning and end of the Accounting periods. As the company is established in 20X6, no opening stock exists in that Accounting period. The total of purchases is the net amount of the prices and is 250,000.00 ZAR. No goods are returned by customers. Thus, 44 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="79"?> Berkau: Financial Statements 7e 4-79 for recording the debit side of the Trading account, we only make one Bookkeeping entry that closes-off the Purchase account to the Trading account: DR Trading Account.............. 250,000.00 ZAR CR Purchase..................... 250,000.00 ZAR To prepare the credit side of the Trading account, we close-off the Revenue account and take stock. The revenue is the net selling price of the goods sold which is 545,000.00 ZAR. The stock taking results in a value of 22.4 % of the purchased goods which is: 22.4% × 250,000 = 5 56,000.00 ZAR. No goods are returned to suppliers which leaves the Returned Outwards account zero-balanced. On the credit side of the Trading account, we make two entries linked to the Bookkeeping entries below: DR Revenue...................... 545,000.00 ZAR CR Trading Account.............. 545,000.00 ZAR DR Inventories.................. 56,000.00 ZAR CR Trading Account.............. 56,000.00 ZAR The Trading account is displayed in Figure 4.5. Ad (f): Net Profit Calculation For the net profit calculation (earnings before taxation), we deduct all remaining expenses from the gross profit - except of 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 on the Profit and Loss account. A net loss would result in a debit entry on the Profit and Loss account. Observe the next Bookkeeping entries. The related accounts are shown in Figure 4.5. DR P&L-Account.................. 20,000.00 ZAR CR Depreciation DPR ............. 20,000.00 ZAR DR P&L-Account.................. 180,000.00 ZAR CR Operational Expenses OEX ..... 180,000.00 ZAR DR P&L-Account.................. 36,000.00 ZAR CR Rent RNT..................... 36,000.00 ZAR <?page no="80"?> Berkau: Financial Statements 7e 4-80 DR P&L-Account.................. 12,000.00 ZAR CR Interest INT................. 12,000.00 ZAR DR Trading Account T/ A.......... 351,000.00 ZAR CR P&L-Account.................. 351,000.00 ZAR Ad (g): Income Tax Calculation The calculation of income taxes follows our simplified tax model. The income tax expenses are 30% of the pretax profit (EBT). At RYNEVELD Ltd., income taxes are: (351,000 - 20,000 - 180,000 - 36,000 - 12,000) × 30% = 103,000 × 30% = 330,900.00 ZAR. We make a simplified Bookkeeping entry for income taxes as below (short cut). The correct Bookkeeping entry for income taxes would be: DR Income Tax Expenses . . . - CR Income Tax Liabilities . . . and then: DR P&L-Account . . . - CR Income Tax Expenses . . . This way, we recorded income tax for KENILWORTH METERED TAXI SERVICE Ltd. in chapter (3). Here, we keep the Bookkeeping entry simple: DR P&L-Account.................. 30,900.00 ZAR CR Income Tax Liabilities ITL... 30,900.00 ZAR After deducting income tax expenses from the pre-tax profit, we arrive at the annual surplus which is closed-off to the Retained Earnings account. An Annual Surplus account (Jahresüberschusskonto) or Retained Earnings account (Bilanzgewinn- oder -verlustkonto) as required by the German HGB (§ 268 HGB) does not exist for international Accounting. There is only one Retained Earnings account that differs from the German Bilanzgewinn- und -verlustkonto. At RYNEVELD Ltd., the addition to retained earnings is: 103,000 - 30,900 = 72,100.00 ZAR. Observe the Bookkeeping entry below. It would be inverted for loss recording. In that case, no income taxes would apply based on our tax model. DR P&L-Account.................. 72,100.00 ZAR CR Retained Earnings R/ E........ 72,100.00 ZAR Find below in Figure 4.5 all accounts of RYNEVELD Ltd. after recording adjustments. <?page no="81"?> Berkau: Financial Statements 7e 4-81 D C D C (1) 500,000.00 (3) 12,000.00 c/ d 500,000.00 (1) 500,000.00 (2) 200,000.00 (4) 39,000.00 b/ d 500,000.00 (7) 654,000.00 (5) 240,000.00 (6) 150,000.00 (8) 180,000.00 c/ d 733,000.00 1,354,000.00 1,354,000.00 b/ d 733,000.00 IBL 40,000.00 c/ d 693,000.00 733,000.00 733,000.00 b/ d 693,000.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 200,000.00 (2) 200,000.00 (3) 12,000.00 c/ d 12,000.00 C/ B 40,000.00 b/ d 200,000.00 b/ d 12,000.00 P&L 12,000.00 A/ P 40,000.00 c/ d 120,000.00 200,000.00 200,000.00 b/ d 120,000.00 Interest bearing liabilities IBL Interest-20X6 INT D C D C (4) 39,000.00 PRE 3,000.00 RNT 3,000.00 c/ d 3,000.00 c/ d 36,000.00 b/ d 3,000.00 39,000.00 39,000.00 b/ d 36,000.00 P&L 36,000.00 Rent-20X6 RNT Prepaid expenses PRE D C D C (5) 200,000.00 c/ d 200,000.00 (5) 40,000.00 (7) 109,000.00 b/ d 200,000.00 (6) 50,000.00 c/ d 19,000.00 109,000.00 109,000.00 b/ d 19,000.00 Property, Plant, Equipment PPE Value added tax VAT D C D C (6) 250,000.00 c/ d 250,000.00 c/ d 150,000.00 (6) 150,000.00 b/ d 250,000.00 T/ A 250,000.00 b/ d 150,000.00 c/ d 190,000.00 A/ P 40,000.00 190,000.00 190,000.00 b/ d 190,000.00 Accounts payables A/ P Purchase-20X6 PUR Figure 4.5: RYNEVELD Ltd.’s accounts after adjustments (20X6) <?page no="82"?> Berkau: Financial Statements 7e 4-82 D C D C c/ d 545,000.00 (7) 545,000.00 (8) 180,000.00 c/ d 180,000.00 T/ A 545,000.00 b/ d 545,000.00 b/ d 180,000.00 P&L 180,000.00 Revenue-20X6 REV Operational expenses-20X6 OEX D C D C ACC 20,000.00 c/ d 20,000.00 c/ d 20,000.00 DPR 20,000.00 b/ d 20,000.00 P&L 20,000.00 b/ d 20,000.00 Depreciation-20X6 DPR Accumulated depreciation ACC D C D C PUR 250,000.00 REV 545,000.00 OV 0.00 GP 351,000.00 INV 56,000.00 T/ A 56,000.00 c/ d 56,000.00 601,000.00 601,000.00 56,000.00 56,000.00 P&L 351,000.00 b/ d 351,000.00 b/ d 56,000.00 Trading account-20X6 T/ A Inventories INV D C D C DPR 20,000.00 T/ A 351,000.00 c/ d 30,900.00 P&L 30,900.00 OEX 180,000.00 b/ d 30,900.00 RNT 36,000.00 INT 12,000.00 EBT 103,000.00 351,000.00 351,000.00 D C ITL 30,900.00 b/ d 103,000.00 c/ d 72,100.00 P&L 72,100.00 R/ E 72,100.00 b/ d 72,100.00 103,000.00 103,000.00 Retained earnings R/ E Income tax liabilities ITL Profit or Loss-20X6 P&L Figure 4.5: 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 Inventory account to the Trading account. Make a debit entry in the Trading account and a credit entry in 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 45 , record the payments made or vouchers granted and record the net portion of 45 Returns are covered in our textbook Basics of Accounting, chapter (21) without and in chapter (23 with consideration of VAT. <?page no="83"?> Berkau: Financial Statements 7e 4-83 the 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 in storage, they will be considered for inventory 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 were returned to suppliers record them in the Returns Outwards account and consider VAT based on the cost of purchase. Make a debit entry in the Cash/ Bank account or in the Accounts Receivables or in 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 once the Bookkeeping entries for adjustments are complete. It is shown in Figure 4.6. As all nominal accounts are closed-off either to the Trading account or the Profit and Loss account they do not show on the adjusted trial balance. The balancing figures of these accounts are zero. This applies for the Profit and Loss account as well as for the Trading account. <?page no="84"?> Berkau: Financial Statements 7e 4-84 Account Debit entries Credit entries [ZAR] [ZAR] Cash/ Bank C/ B 693,000.00 Issued Capital ISS 500,000.00 Interest bearing Liabilities IBL 120,000.00 Prepaid expenses PRE 3,000.00 Property, Plant, Equipment PPE 200,000.00 Value added Tax VAT 19,000.00 Accounts payables A/ P 190,000.00 Accumulated Depreciation ACC 20,000.00 Income Tax Liabilities ITL 30,900.00 Retained Earnings R/ E 72,100.00 Inventories INV 56,000.00 952,000.00 952,000.00 Ryneveld Ltd. ADJUSTED TRIAL BALANCE as at 31.12.20X6 Figure 4.6: 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, like for depreciation, accruals etc. Calculate the earnings before taxes and earnings after taxes. Make 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. We recommend copying the previous trial balance and adjust the copied version. Therefore, 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. No entry in the adjusted trial balance is required for them. After preparing the adjusted trial balance, compare the total of the balancing figures for all listed accounts on 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 <?page no="85"?> Berkau: Financial Statements 7e 4-85 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. There are only few changes necessary 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 = 1180,000.00 ZAR and the A/ P item is: 19,000 + 190,000 = 2 209,000.00 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 4.7. 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 4.7: 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. 46 All revenues and expenses are recorded through profit or loss as they are considered as core business activities. The income statement is shown in Figure 4.8. 46 You find an example for other comprehensive income in chapter (12). <?page no="86"?> Berkau: Financial Statements 7e 4-86 [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 4.8: RYNEVELD Ltd.’s income statement We do not discuss RYNEVELD Ltd.’s statement of cash flows and its statement of changes in equity to avoid repetitions. You can download the two statements by the Link 4.A below: Link 4.A: RYNEVELD Ltd. We recommend working on task A4.38 which covers the next following Accounting period for the case study RYNEVELD Ltd. 47 47 You’ll find the task in the study material portal linked to this textbook. 4.9 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 debts become irrecoverable. It can be downloaded by the QR code in the Link 4.B below: Link 4.B: TELUK Sdn. Bhd. <?page no="87"?> Berkau: Financial Statements 7e 4-87 4.10 Worksheet for T/ B Calculations As an alternative method, we explain next how to prepare financial statements based on a worksheet for the trial balance. We start-off again from where the first trial balance has been prepared. Instead of recording the transactions in accounts, we now make entries directly in the Δ -trial balances. At first, we show the method for depreciation, later we consider all further adjustments for RYNEVELD Ltd. In the Δ -trial balance, we make the entries for depreciation. For processing the adjusted trial balance, we add the values from the original trial balance and the Δ -trial balance. Observe the procedure in Figure 4.9 about depreciation only. Account Debit entries Credit entries Debit entries Credit entries [ZAR] [ZAR] [ZAR] [ZAR] Cash/ Bank 733,000.00 Issued Capital 500,000.00 Interest bearing liabilities 200,000.00 Interest INT 12,000.00 Rent RNT 39,000.00 Prepaid expenses 0.00 Property, Plant, Equipment 200,000.00 Value added Tax 19,000.00 Purchase PUR 250,000.00 Accounts payables 150,000.00 Revenue REV 545,000.00 Operational expenses OEX 180,000.00 Depreciation 20,000.00 20,000.00 Accumulated depreciation 20,000.00 20,000.00 Total: 20,000.00 20,000.00 1,434,000.00 1,434,000.00 Ryneveld Ltd. Δ - TRIAL BALANCE as at 31.12.20X6 Ryneveld Ltd. ADJUSTED TRIAL BALANCE as at 31.12.20X6 Figure 4.9: Worksheet for adj. trial balance preparation (1 st step) Below, we apply this method for all other adjustments at RYNEVELD Ltd. It covers recording of depreciation, pay-off of the bank loan, reclassification of next pay-off values, gross profit calculation, net profit calculation and income tax calculation. Note that cells are overwritten multiple times. <?page no="88"?> Berkau: Financial Statements 7e 4-88 Account Debit entries Credit entries Debit entries Credit entries [ZAR] [ZAR] [ZAR] [ZAR] Cash/ Bank 40,000.00 693,000.00 Issued Capital 500,000.00 Interest bearing liabilities 80,000.00 120,000.00 Interest INT 12,000.00 Rent RNT 39,000.00 Prepaid expenses 3,000.00 3,000.00 Property, Plant, Equipment 200,000.00 Value added Tax 19,000.00 Purchase PUR 250,000.00 Accounts payables 40,000.00 190,000.00 Revenue REV 545,000.00 Operating expenses OEX 180,000.00 Depreciation 20,000.00 20,000.00 Accumulated depreciation 20,000.00 20,000.00 Gross profit 351,000.00 351,000.00 Inventories 56,000.00 56,000.00 Earnings before taxes 103,000.00 103,000.00 Retained earnings 72,100.00 72,100.00 Income tax liabilities 30,900.00 30,900.00 Total: 1,158,000.00 1,158,000.00 952,000.00 952,000.00 Ryneveld Ltd. Δ - TRIAL BALANCE as at 31.12.20X6 Ryneveld Ltd. ADJUSTED TRIAL BALANCE as at 31.12.20X6 Figure 4.10: Complete worksheet for adj. trial balance preparation 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.C. Link 4.C: BINNEVELD Ltd. Note, you do not have to apply the worksheet method for the adjusted trial balance preparation and can apply accounts instead. However, this method can help you to speed up profit calculations. 4.11 Summary In this chapter, we covered the preparation of financial statements based on trial balance and Trading account. The chapter refers to the trading industry where the gross profit calculation is important. We assumed that companies apply the periodic inventory system. We also introduced the worksheet method for the preparation of financial statements based on the trial balance. 4.12 Working Definitions Accumulated Depreciation Account: Account applicable to record an assets lifetime depreciation. <?page no="89"?> Berkau: Financial Statements 7e 4-89 Adjusted Trial Balance: Trial balance after all adjustments have been recorded. Gross Profit: Difference between revenue and material expenses. The gross profit calculation is relevant for retailers. Net Profit: Profit after interest and before income taxes. The net profit 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. Trading Account: Section of the Profit and Loss account that only deals with revenue and material expenses. The balancing figure is the gross profit. Trial Balance: The trial balance is a list of all accounts in use which shows the balancing figures (Bal. b/ d) thereof. The total of the balancing figures on the debit side shall equal the total of the balancing figures on the credit side to confirm consistency with the double entry system. 4.13 Question Bank (1) A company got an opening value for inventories of 56,000.00 EUR. During the Accounting period, the company purchases goods for 300,000.00 EUR and later for 350,000.00 EUR. At the end of the Accounting period, stock taking reveals that there are goods for 100,000.00 EUR left. The sales are amounting to 850,000.00 EUR. Depreciation on the store equipment is 40,000.00 EUR. How much is the company's gross profit? 1. 244,000.00 EUR . 2. 204,000.00 EUR . 3. 144,000.00 EUR . 4. 104,000.00 EUR . (2) A company records an opening value of inventories of 300.00 EUR. The closing balance is amounting to 100.00 EUR. During the Accounting period, there were two purchases, one at 1,000.00 EUR and the other one at 2,000.00 EUR (net amounts). The revenue equals 5,000.00 EUR. How much is the gross profit? 1. 1,200.00 EUR . 2. 1,800.00 EUR . 3. 2,200.00 EUR . 4. 1,600.00 EUR . (3) The items disclosed on the debit side of the Trading Account are: 1. Opening value of finished goods, revenue, labour. 2. Purchases, returns inwards, opening stock. 3. Opening value of inventories, labour, returns outwards. 4. Closing stock of inventories, revenue, returns inwards. (4) On 2.04.20X4, a company buys a machine at 24,000.00 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 straight-line method over 5 years. Depreciation expenses for 20X4 are: 1. 1,800.00 EUR . 2. 3,600.00 EUR . 3. 2,700.00 EUR . 4. 2,000.00 EUR . <?page no="90"?> Berkau: Financial Statements 7e 4-90 (5) A company buys goods for 100,000.00 EUR cost of purchase. The opening value of inventories as at the beginning of the year is amounting to 20,000.00 EUR. During the Accounting period, the company sells goods valued at 58,000.00 EUR and returns goods for 18,000.00 EUR. The sales are 150,000.00 EUR. How much is the gross profit? 1. 92,000.00 EUR . 2. 106,000.00 EUR . 3. 86,000.00 EUR . 4. 136,000.00 EUR . 4.14 Solutions 1-1; 2-2; 3-2; 4-3; 5-1. <?page no="91"?> Berkau: Financial Statements 7e 5-91 5 Basics of Financial Statement Analysis 5.1 What is in the Chapter? In this chapter, we cover the basics of financial statement analysis. For the preparation of a thorough financial statement analysis, you need a lot of background knowledge about the industry. We cannot teach you that in a textbook. Therefore, we only refer to the major ratios regarding performance, liquidity, capital structure and market valuation and explain their meaning. We apply them for CAPELIFT Ltd., a small service provider in the Aviation industry. We chose Aviation for the case study as everyone has an idea about operations of an airline. 5.2 Learning Objectives After studying this chapter, you know the most important aspects of financial statement analysis and you will understand the meaning of major ratios. This will give you a head-start for the preparation of your first real financial statement analysis. 5.3 Company Appraisal In this chapter, we put you in the position to assess a company. We focus on reading financial statements not on their preparation. Therefore, you find yourself now on the other side of the table of Accounting work. We demonstrate that the idea of calculating just few ratios and thereby obtaining enough knowledge about a company is wrong. It even stays wrong if you calculate a whole lot of ratios. It would be the same as if your doctor always starts her/ his examination with a great blood count which means the laboratory tests your sample against all diseases possible. In Medicine the approach is different. Your blood sample is only checked for those diseases the doctor expects you to have based on the symptoms your body is showing. We follow a similar approach in Accounting. We prepare certain industry related ratios only to verify an initial hypothesis made about the situation of a company. Thereafter we check those figures which can prove our initial diagnosis or tell us otherwise. In the latter case, the hypothesis was wrong, and we start over again. If you take your car to a car repair shop, you might tell the mechanic that your car makes funny noises when driving through a curve and she/ he will test drive your car, check the noise and will later examine your wheel bearings before she/ he tells you her/ his diagnosis and what the repair will cost you. Most probably the mechanic does not check the lamps, because she/ he starts with an idea about what the reason is: wheel bearings. In this case, the mechanic has special knowledge and experience which tells her/ him that a car making noises in a turn has a defective wheel bearing. She/ he even can tell you which wheel bearing is damaged, depending on the direction of the turn. We follow the same process for financial statement analysis: We must build knowledge about situations a company is in and how they show on <?page no="92"?> Berkau: Financial Statements 7e 5-92 the financial statements. When you listen to financial analysts, you will see/ hear that from certain ratios they assess the company without even going into the company. Building knowledge about financial statement analysis only comes from studying a lot of cases. We prepare you for starting this process and introduce the first steps in financial statement analysis. As we later intend to study financial statements of a real airline (COMAIR Limited), we introduce financial statement analysis by a fictional small airline CAPELIFT Ltd. We provide you with a link to COMAIR Limited’s financial statements. Read the COMAIR Limited business report to make yourself familiar with Aviation. The Link 5.A takes you to COMAIR Limited. Link 5.A: COMAIR Limited. In this textbook, we focus on companies that prepare financial statements following IFRSs. We also assume the company’s financial statements have been audited already. Auditors check financial statements for correctness. In many countries, Auditing is required by national law and is necessary for the approval of financial statements and so for the appropriation of profits. Auditing is not ruled by IFRSs because it falls under national law. 5.4 Situational Awareness about a Company The start for financial statement analysis is checking basic financial ratios to obtain an overview. Later in financial statement analysis procedures, we follow a specific hypothesis about the company's situation and check ratios linked thereto. At first, we apply standard performance ratios e.g., the return as percentage of sales. If we want to understand e.g., poor revenues better, we put the standard ratios aside and start preparing industry specific ones. E.g., in Aviation the on-time-performance rate (on time departures divided by the number of all flights) is an important figure that measures whether a flight's actual time of departure (pushback time) is within a 15 min tolerance measured against the scheduled time of departure. Airlines need to check their on-time-performance because their customers' satisfaction depends on punctuality. The on-time-performance is disturbed if the ramp work is not finished before departure, if the aircraft comes in late from a previous flight, if the crew is not ready, if the aircraft has write-ups in its technical logbook which must be addressed before its next take-off, if boarding is not completed, if the air traffic control does not give push-back/ taxi clearance etc. In financial statement analysis, we develop and check industry specific ratios and define further subordinate ratios that affect our main ratios. Digging-in into supporting ratios in financial statement analysis is referred to as drill-down. We must understand the business well, to define ratios and conduct a proper financial statement analysis. <?page no="93"?> Berkau: Financial Statements 7e 5-93 We discuss below an easy example of a small Aviation service provider to prepare ourselves for a financial statement analysis of a real airline. As we cannot teach industry specific knowledge in Accounting, we keep our financial statements at the basics. At first, we show how a hypothesisdriven financial analysis could work. We check the production firm ROSENDAHL Ltd. which is in distress followed by general considerations about financial statement analysis. 5.5 C/ S ROSENDAHL Ltd. ROSENDAHL Ltd. is a production firm for sneakers. We already assume the company experiences difficulties selling its products because they are out of fashion. How do we prove our first idea about the situation ROSENDAHL Ltd. is in? We look for symptoms of poor selling numbers. We might see that the item inventories on the balance sheet is too high and check the notes for details to find what inventory categories are significantly high (higher than they should be). We detect that inventory consists to a high extent of finished goods. We must find out, what the inventory levels should be to judge about the actual situation. Regarding the inventory levels of finished goods, we expect the company has only enough stock to deliver its customers on time. Some buffer stock might be added to stock levels too. This way, if its customers change their demands, the company can adjust its products and meet their new demands by producing amended goods. If the inventory level exceeds the acceptable number, we say it is too high. Excessive inventories arouse our attention in financial statement analysis. Another indicator can be the increase of stock levels over the course of time if a company struggles to sell its goods but continues producing them. We further check the income statement which might show poor revenues and high storage costs and high expenses for Innovation Management and Marketing. A revenue is low if the numbers, selling prices or rebates are noticeable different from their budgeted values. If a company increases stock by producing more goods than can be sold the situation is noticeable. For our sneaker manufacturer, we also monitor the return on sales which might be low, as ROSENDAHL Ltd. tries to clear stock (of its ugly sneakers) by granting trade discounts or sale on specials. A return on sales tells us how much a company earns per currency unit received, for example the profit per cashed-in EUR. With temporary price reductions, a company tries to “pump goods into the market” without changing its market position or its regular prices. This might also result in an increase of receivables if the company offers its customers convenient payment conditions to make the sale more attractive. We assume, in total, ROSENDAHL Ltd. discloses poor profit for the period due to its low sales. However, overstocking does not result in decreasing profits instantly. As the sneakers are added to stock at their cost of manufacturing, profitability might still be looking good. But the lack in sales and the increasing inventories must be addressed at it is a risk. If ROSENDAHL Ltd. prepares its income statement following the nature of expense method, <?page no="94"?> Berkau: Financial Statements 7e 5-94 an increase of stock additions will be disclosed thereon. 48 We might also detect on ROSENDAHL Ltd.’s VAT statement that output-VAT in comparison to input-VAT is lower than in prior periods. As ROSENDAHL Ltd. now filled its storages with its (ugly) sneakers, the production situation is characterised by overcapacity. The firm tries to reduce production or to take promotional measures as the goods are currently not selling. As an alternative, the company might start launching different products, like sneakers in a more popular design or colour. Production firms have difficulties to react to changes of demand as most costs are fixed e.g., depreciation and indirect labour. Therefore, the overhead allocation rate is considerably high. As ROSENDAHL Ltd. does not generate enough cash from its sale of sneakers, the company might have gone into financial distress. This is caused by a lack in cash receipts and high capital costs for financing inventories. The operating cash flows will show poor inflows but normal outflows for materials, Marketing, consultancy etc. As a result of low cash inflows, the company might have accepted unfavourable loan conditions which we recognise by their significant high interest rates or at least increases thereof. The story of ROSENDAHL Ltd. shows that we must look at the full picture before we start with conclusions about single ratios. Never calculate a bunch of standard ratios and try to develop a quick conclusion. Rather, try to 48 Read our textbook Basics of Accounting, chapter (28). gain a first impression from basic ratios and thereafter follow a hypothesis driven ratio analysis. For the analysis of financial statements, we cannot tolerate contradicting conclusions. If our results are not consistent, we continue analysing and check alternative conclusions. 5.6 Steps of F/ S Analysis For a structured financial statement analysis, we follow the steps below: (1) Defining information requirements. (2) Formal checks. (3) Horizontal analysis. (4) Vertical analysis. (5) Ratio analysis. 5.7 Defining Information Requirements The reason for financial statement analysis can be starting a business relationship with the company e.g., as a supplier or as a customer, or we want to invest in the company e.g., buying shares, or we check a competitor of our own business, or we apply for a job in the company of interest etc. There might be a lot of reasons for financial statement analysis and our information needs will determine the way we analyse our data. 5.8 Formal Checking Before we begin with a financial statement analysis, we check whether we got the right financial statements from a reliable source. In general, we prepare financial statement analysis from <?page no="95"?> Berkau: Financial Statements 7e 5-95 outside of the business. The analyst is not employed in the Accounting department and has no access to the books. This means, our analysis is limited to the published financial statements and no drill-down from financial data to the original Bookkeeping entry is possible. Hence, we only rely on the information provided by the financial statements and have no chance to e.g., ask the Accountant our questions. In some cases, we might even find financial statement analysis results online because other experts share their findings with the public. This information can help us to get a first idea about the situation of the business. Financial statement analysis is an interpretation of financial data, not a neutral examination thereof. Therefore, we should not rely on financial statements analysis from others. For correctness of financial statements, we check whether they were audited and in case they were, we study the Auditors’ opinion. It very often gives already detailed information about the company’s financial statements. Only if the Auditors confirm the financial statements have been prepared correctly and present fairly the financial position, financial performance and cash flows of the company, we should put work into the analysis of the financial statements. In contrast to financial statement analysis, Auditing is a formal check which makes it is more reliable. Auditors do not share their opinion about the wellbeing or chances of a company, as they focus on the correctness of financial statements and the compliance with laws and standards. Correctness of financial statements is an important precondition for the interpretation of financial data. We do not waste our energy on faulty financial statements. The financial statements must contain a remark which Accounting standards apply. We here narrow our view on financial statements prepared based on IFRSs. 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 may require adjustments for our ratio calculations, which are based on IFRSs. E.g., financial statements prepared in Germany require recalculations for items e.g., accruals or differences on asset valuations. E.g., a return on assets requires considering whether prepayments exist which are carried outside of the asset section. In Germany prepayments are not regarded as assets; internationally, prepayments are disclosed under current assets. Those differences affect ratio values and require due diligence regarding their interpretation; we must check whether adjustments are necessary. 5.9 Horizontal Analysis A horizontal analysis tells the reader of financial statements the timeline of figures. It provides us with information about the development of ratios in a company e.g., revenue history. It is always a good idea to look at developments under consideration of the common situation in the industry. There might be general developments e.g., a financial crisis or market changes e.g., caused by internet trading, which re- <?page no="96"?> Berkau: Financial Statements 7e 5-96 quire us to examine the company’s position in a changing industry. We must answer the question whether the whole industry faces a global market change or whether a competitor is increasing its share of the market on our company’s account. With the horizontal analysis, we can study a company in different situations and can assess how the company reacts to special situations. 5.10 Vertical Analysis A vertical analysis tells us about the proportions of single items as part of the whole amount. It can give us information of how much inventory a manufacturing firm carries as a percentage of its total assets. For the interpretation of vertical analysis results we need normative information. Normative information means that there is a good or best practice percentage known, which we try to achieve. However, we do not follow the approach of general rules (golden rule for the balance sheet), as you might find in many textbooks for Finance. We always should understand the business well enough to decide whether the ratio indicates a good situation or requires adjustments. Following a general rule without proper understanding it, never is desirable. If we illustrate the results of a vertical analysis, we draw a pie diagram. E.g., it shows how much labour a company pays as a percentage of its total of expenses, which might be an important information if the company plans to relocate production facilities to a country where labour costs are lower. 5.11 Basics of Ratio Analysis In general, the financial statements give us already quite good information about a company. The purpose of financial statements is according to IAS 1.9: “[…] The objective of financial statements 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 provides information about the financial position. The statement of profit or loss and other comprehensive income provides information about the financial 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 financing activities. In total, a lot of information needs users of financial statements have, can be satisfied by the financial statements already. However, for special information purpose, it is helpful to determine ratios which combine data derived from various financial statements. Very often in Accounting, ratio analysis focusses on comparisons. We assess companies for ranking, finding a suitable company based on given selection criteria, or for preparing benchmarks etc. For that reason, we strive to calculate figures to compare characteristics of companies, like their performance, liquidity, capital structure or market value. We later will structure ratio based analysis following these four information needs. Not all companies are comparable per se. E.g., different sizes of companies can disturb comparisons. Although the statement of profit or loss and other <?page no="97"?> Berkau: Financial Statements 7e 5-97 comprehensive income tells us about the financial performance, we cannot compare companies of different sizes. A 3,000-employees-consulting firm earns a higher profit than a start-up consultant operating as freelancer from a private home and alone. To compare firms different in size, we calculate ratios as percentages of figures that can indicate the size of the business. The net profit as a percentage of sales shows how much cash a company earns per every Euro/ Dollar/ Rand received. The sale in the denominator factors in the company size into the equation. 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 We can easily derive data for gross profits and sales from income statements. The gross profit tells us how much revenue is left after deduction of material expenses and it shows how much of profit is left for the business activity costs and profit together. The sales represent cash, or its equivalent, received from the customers and gives us an idea about the size of the business. Which company is best? Only if we calculate the gross profit as percentage of sales, we can see which company is most successful at selling its products on the market. Therefore, we divide gross profit by the revenue. We can say, for every 100.00 EUR (input) 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 (output). Hence, the best performer is company C. The ratio profit as percentage of sales POS measures the yield it gives us an output-over-input-ratio. It tells us the efficiency of the deployed resources. Ratios are a very common instrument for financial statement analysis. Many thereof are calculated with data we derive from the financial statements. Some data depend on the Accounting period, others come from the balance sheet. If we take a figure from income statements e.g., the revenue, it is timerelated, in general on the entire Accounting period (1 year). In contrast, a figure derived from a real account, like property, plant and equipment is not. It is linked to a date, in general, to the balance sheet date. For the calculation of ratios as fractions with nominators/ denominators from income statements and balance sheets, we must decide, which data from which balance sheet dates apply: (a) the opening values, (b) the closing values or (c) the average of the above. In this textbook we follow alternative (b). There are good <?page no="98"?> Berkau: Financial Statements 7e 5-98 reasons for alternatives (a) and (c), however, we apply the closing values, as we can derive all from one set of financial statements. In other than academic situations we recommend calculating the average value from opening and closing figures; this is alternative (c). Below, we classify ratios regarding aspects they can measure and follow these classifications for our following description: - Performance ratios. - Liquidity ratios. - Capital structure ratios. - Market value ratios. 5.12 C/ S CAPELIFT (Pty) Ltd. To explain the most common ratios, we apply them for the service provider CAPELIFT (Pty) Ltd. below. Next, we introduce the firm. Data Sheet for CAPELIFT (Pty) Ltd. DDomicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Aviation. Issued capital: 7,500,000.00 ZAR. Accounting period: 20X8. Fleet: 1 jet, 1 piston engine aircraft. Financing: bank loans; interest: 5.9 %/ a. Pilots: Freelancers. VAT: 20 %. CAPELIFT (Pty) Ltd. is a small airline that offers charter flights. The company operates two aircrafts, a Bombardier Learjet (jet) and a Mooney Bravo (single piston engine aircraft). The company is based at Cape Town Int’l airport. Both aircrafts are financed by bank loans at a rate of interest of 5.9 %/ a. On its balance sheet, the company discloses an issued capital of: 1,000,000 × 7.50 = 7,500,000.00 ZAR which is the ordinary share capital. CAPELIFT (Pty) Ltd. owns its aircrafts and carries them as assets under P, P, E. It records a bank loan for their financing. CAPELIFT (Pty) Ltd. has a pool of commercial licensed pilots who can be seen as stand-by crew and work on a freelancer basis, meaning they bill CAPELIFT (Pty) Ltd. for their flights per flight time (Hobbs-hours) and charge travel expenses for lay-overs. CAPELIFT (Pty) Ltd. passes the crew bills on to its customers without further surcharge. CAPELIFT (Pty) Ltd.’s clients are mostly business-people who charter the planes for business trips to smaller, domestic airfields. See below the financial statements for the Accounting period 20X8. <?page no="99"?> Berkau: Financial Statements 7e 5-99 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) [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 the result of running a business. It is an indicator whether a company reaches its goals, most prominently, whether it earns money from its business operations. In contrast to the productivity, the performance ratios are based on currency units per output or input. To achieve success, a company must work efficiently as measured by a return. We frequently value financial success in the monetary equivalents received when selling goods or services to customers. It is compared to the effort a company takes to produce goods or render services. Performance ratios <?page no="100"?> Berkau: Financial Statements 7e 5-100 measure the yield (efficiency) and are based on the comparison between input and output. In terms of Mathematics, performance gives us either a difference or a percentage. The primary source for financial performance measurement is the statement of profit or loss and other comprehensive income. It compares the revenue received to expenses for goods production or service rendering and the sale thereof. Hence, profit calculation can measure the total financial performance already. Profit is merely the difference between output and input and gets expressed as a figure followed by a currency unit, like 7,000.00 EUR. In addition to the pure profit calculation, financial performance ratios frequently compare profit to inputs, like capital, sales or investments. In general, we try to exclude the influence of misleading bias from performance measurement e.g., national taxes, bank loans’ interest or dividends etc. For the comparison of performance figures in various industries, we are aware of 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, like airlines, earn a significant lower return on capital than companies that earn money based on human capital, like law firms. Therefore, inter-industry comparisons can provide misleading information. Below, we introduce the most common financial performance ratios: - 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. Fixed Asset Turnover: The Fixed Asset Turnover measures the revenue as a percentage of the noncurrent assets. The revenue is the proceeds calculated after deducting trade discounts, VAT and further selling costs e.g., transport, from the proceeds. Dividing the revenue by the non-current assets tells us whether a company made good investment decisions. A Fixed Asset Turnover is difficult to read if the company offers a lot of different products/ services which are produced on the same machines. Therefore, if you can allocate revenue to single investments, you should do so. This gives you an investment based Fixed Asset Turnover. The ratio allows to assess investments and applies for Asset Management decisions. Fixed Asset Turnover is based on carrying values. Hence, a service rendered by deployment of highly depreciated machinery that leads to the same sales as obtainable with new machines gives a higher Fixed Asset Turnover. CAPELIFT (Pty) Ltd. could obtain a high Fixed Asset Turnover by flying old aircrafts if customers accept this, and the authorities certify their airworthiness. However, if customers request fancy new aircrafts and are not prepared to fly with old ones, revenues and profit will decrease, and the Fixed Asset Turnover goes down with it. The Fixed Asset Turnover for an airline depends mostly on the utilisation <?page no="101"?> Berkau: Financial Statements 7e 5-101 rate and load factor. A load factor is the occupation per seat capacity. Aircrafts only earn money when airborne. Many airlines compare their pure flight time to the total period. Hence, the aim is to spend as less time on the ground (on taxiways and at the ramps) as possible. Therefore, long haul flights result in higher Fixed Asset Turnovers than domestic flights if flown with the same aircrafts. As passengers are intolerant for delays and cancellations, carriers must keep transportation capacity stand-by. Hence, the total utilisation rate and Fixed Asset Turnover is traded off to a 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 ratio indicates low performance because CAPELIFT (Pty) Ltd. has a low utilisation rate. The company does not fly line, but it charges high prices. Its customers expect an aircraft availability that matches their travel plans. To boost its Fixed Asset Turnover, CAPELIFT (Pty) Ltd. could think of replacing the fast, but expensive Mooney. Its Marketing department must research whether customers are prepared to accept longer and less comfortable flight times at lower prices. We discuss further below the plans to acquire an additional plane, a Cessna C172. Inventory Turnover: The Inventory Turnover is a performance ratio for production firms and trading companies. It measures how often stock is virtually replaced/ sold completely during an Accounting period. The ratio applies in Logistics to identify fast moving and slow moving goods. In Accounting, it is regarded as a performance measurement to calculate how quick goods are sold. A high Inventory Turnover makes a company flexible as it does not take long to clear stock, if goods depend on trends, like in the fashion industry, or are perishable. Inventory Turnover is very high where companies sell every day’s goods e.g., groceries in discounters. The ratio is low for specialised companies that seek to offer a high variety of goods to its customers, such as KaDeWe selling a huge variety of e.g., expensive chocolate brands, in Berlin’s central department store. In Accounting, we consider the quick selling of goods as high performance. A company selling its goods fast also will pay low inventory and capital costs. For our case study CAPELIFT (Pty) Ltd. inventories are nearly 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 even 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 investment and its costs of capital are mostly covered by the creditors. Hence, only capital the company pays for - either by divi- <?page no="102"?> Berkau: Financial Statements 7e 5-102 dends or as interest - is employed capital. To calculate capital employed we add the total of equity and all longterm liabilities on the credit side of the balance sheet. The nominator is the pre-tax profit to keep the ratio free of 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) = 114.18 %. For interpretation, we must compare the Return on Capital Employed to the rate of interest in South Africa which is approximately at 9 %/ a. Hence, the business model and the risk taking works out in comparison to interest expectations for financial instruments and under consideration of the inflation rate. 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. In line with IFRSs, the denominator is simply the balance sheet’s sum. For the nominator, taxes and interest are not deducted to consider the full performance of the company regarding productivity or service rendering. Taxes and interest matter. One major problem of the Return on Assets is that highly depreciated machinery increases the ratio although production/ service amounts do not change. An UBER driver who drives the same number of rides every Accounting period will experience an increase in performance only due to a decrease in the carrying value for the car because it gets depreciated. The Return on Assets often 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 based on financial statements. CAPELIFT (Pty) Ltd.’s Return on Assets is: 12,950,000 / 90,000,000 = 1 14.39%. If we compare the Return on Assets to the rate of interest for loans, we get an idea about the pre-tax profit margin of the business in case the company would be financed completely by loans. Return on Shareholders’ Funds: Return on Shareholders’ Funds ROSF (= Return on Equity) is a ratio that represents the benefit that flows to investors. So far, we only focussed on performance from the point of view of the company or plant manager. We next cover the investors’ side. Return on Equity represents potential returns to the owners as e.g., declared dividends. The possibility of earnings refers to the pending dividend decision made by managers/ owners on the annual general meeting. To use the Return on Shareholders’ Funds as a performance ratio, we must cancel out the impact the decision about the appropriation of profits. Company taxes are to be deducted as they are not distributable to shareholders. The ROSF is calculated as EAT divided by the total of equity. We do not consider the actual dividends. Those could be based on profits carried forward from previous Accounting periods. We consider the equity increase by earnings only. The earning definition in IAS 33.12 applies. <?page no="103"?> Berkau: Financial Statements 7e 5-103 A Return on Shareholders’ Funds does not only measure performance but also depends on the leverage effect. We discuss the leverage together with the ratios on capital structure later in this chapter. CAPELIFT (Pty) Ltd.’s Return on Shareholders’ Funds is: 7,000,000 / (7,500,000 + 6,000,000 + 7,000,000) = 334.15%. The figure is extremely high as the company is deep in debts and is achieving a good performance based on its Return on Assets which is above the rate of interest for bank loans. Return as the Percentage of Sales (Return of Sales): Return as Percentage of Sales determines the annual surplus over sales. The ratio tells us how much money is earned as annual surplus when the company sells its products. E.g., we want to know how much profit an airline makes if we buy a ticket that costs 100.00 EUR. A high percentage indicates the sale of innovative products and efficient sales/ service/ production activities. It also shows us the market position of the firm. A service provider in a monopoly situation achieves a high Return as Percentage of Sales. This is not the case in a highly competitive market, like in car manufacturing, where the companies must innovate their products and offer their customers trade discounts to maintain or to expand their share of the market. The net profit as percentage of sales is often related to earnings from operations only. Taxation and interest do not have an impact on the Return as a Percentage on Sales. We do not follow the German classification in gross and net return on sales here with the gross return on sales being linked to the pre-tax profit and including non-operative profits, as the translation to English leads to the term gross profit which is not applicable here. 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 14.00 ZAR for every 100.00 ZAR received from its customers paying for tickets. Earnings per Share: Earnings per Share EPS is the only ratio that is subjected to 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 dividend decisions made by the company’s management or by its owners on the annual general meeting. Once we factor in the decision about dividend declaration, the ratio will no longer measure the pure performance. Hence, EPS measures the earnings for a full dividend payable to ordinary shareholders divided by the number of ordinary shares. In contrast to dividend calculations, it does not include profits carried forward but is only based on actual earnings. IAS 33.10 defines the EPS calculations. Some items are to be deducted before earnings are 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: <?page no="104"?> Berkau: Financial Statements 7e 5-104 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 calculation procedures that follow IAS 33.26 - IAS 33.29. CAPELIFT (Pty) Ltd. is based on 1,000,000 ordinary shares. Its earnings are 7,000,000.00 ZAR which results in Earnings per Share of: 7,000,000 / 1,000,000 = 7 7.00 ZAR/ s. The Earnings per Share ratio is mostly known from the denominator for the Price-Earnings ratio that compares the market share price of shares to the earnings per share. For further considerations about 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. (Economic Value Added is a trademark of Steward Stern Management Services). For Economic Value Added calculation, the net operating profit after taxes is compared to the difference between assets and short-term liabilities, the latter one multiplied with the Weighted Average Cost of Capital WACC. The WACC is a rate and is disclosed as percentage per annum. The difference between assets and short-term liabilities represents the capital employed by the investors. Short-term liabilities are deducted to consider their financing by a company's creditors. By multiplying the capital employed with the WACC, we determine the profit that can be earned with an alternative investment under consideration of actual interest and cost of equity. This way, EVA compares net operating profits to the opportunity costs. The result is a difference of how much the shareholders’ company’s value increases more than an alternative investment and is measured in the currency unit and applicable under consideration of income taxes by a so called tax shield, here (1 - 30%). The tax shield considers that the alternative investment is 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 taken from the income statement and divided by the interest bearing liabilities to determine the interest rate. The payoff 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 loans is 5 %/ a which matches with a useful life of 20 years of the aircrafts. We are assuming that the bank loan finances the aircraft over their entire useful life. Therefore, interest payments are divided by: (1 + 5%) × 50,000,000 = 5 52,500,000.00 ZAR. The rate of interest is accordingly to our above calculation: 2,950,000 / <?page no="105"?> Berkau: Financial Statements 7e 5-105 52,500,000 = 5 5.62%/ a. We expect a return to shareholders of 10 %/ a as a dividend and calculate the WACC to: [10% × (7,500,000 + 6,000,000 + 7,000,000) + 5.62% × 52,500,000] / 73,000,000 = 6.85%/ a. The EVA compares the net operating profit with the interest income that could be earned on the capital market as opportunity costs. To compare the figures, we multiply the calculated WACC rate with the tax shield, which is: (1 - 30%) for this textbook. The tax shield considers our virtual interest earnings as taxable expenses. Hence, the Economic Value Added calculation is: 7,000,000 - 6.85% × (1 - 30%) × (90,000,000 - 16,500,000 - 3,000,000) = 3 3,619,525.00 ZAR. The company increased its value by 3.62 million ZAR in comparison to an investment on the capital market based on the calculated WACC rate. 5.14 Liquidity Ratios - CAPELIFT (Pty) Ltd. Liquidity is the ability to turn assets into an easily convertible form, preferably cash. Liquidity ratios tell us how quick a company’s assets can be “sold”. In general, long-term assets, like machinery or land is difficult to exchange. In contrast, the item cash/ bank’s state is already liquid. If we liquidate a company, we transform all assets to cash and take the money e.g., to retire the debts. 49 Liquidity ratios tell us how quick cash can be generated by selling assets to repay liabilities. 49 Read in our textbook Basics of Accounting about liquidations and disposal, chapter (34) and (35). We distinguish the liquidity ratios below: - Current Ratio. - Quick Ratio. - Cash Ratio. - Debtors’ Collection Days. Current Ratio: The Current Ratio is current assets divided by current liabilities. A current ratio of 100 % indicates that all current assets are financed by short-term liabilities. In that case, the financing of the business is at low risks as non-current assets are financed with long-term liabilities or equity and current assets with short-term 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 its short-term liabilities. As the value exceeds 100 %, we know that some current assets are financed longterm. However, the Current Ratio does not tell us how the Financing for longterm assets looks like. We do not know whether it is financed by equity or longterm debts. 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 to cash and exclude (deduct) them from current assets in the nominator to determine the Quick Ratio. This gives us <?page no="106"?> Berkau: Financial Statements 7e 5-106 (current assets - inventories - prepayments) divided by short-term liabilities. A Quick Ratio of 100 % means that the easily sellable assets cover the short-term debts. A company can repay its short-term liabilities without problems 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 a company owns to pay-off its liabilities instantly, or 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. At CAPELIFT (Pty) Ltd., the Cash Ratio is: 18,000,000 / 19,500,000 = 9 92.31%. The percentage is still very high and indicates that CAPELIFT (Pty) Ltd. holds a huge portion of cash. This is required in Aviation to cover costs for labour, fuel, lay-overs and airport fees close or before flight departures. A high liquidity is not per se a good indicator as it is a trade-off with the performance. A liquidity reserve does not finance business operations of a company and therefore lowers its average performance. Debtors’ Collection Days: The value of receivables is considered for the liquidity; receivables are difficult to collect on short notice. However, various industries have different periods for debt collection. To consider the average time span of debt collection the Debtors’ collection Days divides the (total of receivables × 365) by the sales on credit. We assume that at CAPELIFT (Pty) Ltd., half of the customers pay on cash and the remainder pays delayed. This gives a 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 their outstanding bills. Hence, 40 % of sales on credit are currently carried as receivables on the balance sheet. This is not a good sign in a country where the rate of interest is at 9 %/ a, because CAPELIFT (Pty) Ltd. must finance the receivables for almost 5 months as working capital. 5.15 Capital Structure Ratios - CAPELIFT (Pty) Ltd. We can derive the capital structure straight from the statement of financial position. Its credit side tells us where the company’s funds originate from: whether the company is financed by equity or liabilities. Regarding liabilities we also want to know the payment terms and strive to classify debts into long-term and short-term liability categories. In general, we prefer financing where long-term assets are financed by longterm debts and short-term assets are financed short-term. In contrast, it is risky to finance long-term assets you <?page no="107"?> Berkau: Financial Statements 7e 5-107 depend on by funds that are due on short notice. When we analyse debts for companies that report in accordance with IFRSs, we must 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 based on IFRS 9.5.4.1., which levels out volatility in measurement. We can assume the values applied for disclosure on the balance sheet represent the true and fair values of the debts. In comparison, the German HGB overrates liabilities which results in the disclosure of higher values than the actual borrowings are. Short-term liabilities are always disclosed at settlement values. We discuss below only few ratios as a lot of ratios for gearing provide us with identical information about the capital structure. At first, it is important to understand why we must analyse the capital structure. It is for the leverage effect and financing decisions, as you will learn below. 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. 50 For our calculations, we do not consider retained earnings as long-term as it is subjected to claims of shareholders every year. 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 %. This indicates that the company is highly indebted which is understandable for a capital-intensive industry, such as Aviation. We also check the coverage of long-term assets by the debt structure. CAPELIFT (Pty) Ltd. has long-term funds which is part of its equity and long-term debts resulting from bank loans to the total extent of: 7,500,000 + 6,000,000 + 50,000,000 = 6 63,500,000.00 ZAR to finance the property, plant and equipment carried at 60,000,000.00 ZAR. 50 We consider the coverage rate as sufficient to make sure the company can continue its business operations. In Accounting and Finance, the leverage effect applies. This effect can increase the Return on Shareholders’ Funds alone by excessive borrowing. The formula for the ROSF is: ROSF = RoA + D2E × (RoA i); therein is: RoA Return on Assets, as profit plus interest divided by the total of assets, D2E the Debt to Equity ratio and calculated as Liabilities over Equity and i is the (average) rate of interest for long-term debts. A company that is in debts can increase its Return on Shareholders’ Fund by growth and increasing its liabilities if the Return on Assets keeps exceeding the rate of interest i. Very often the leverage effect is shown in diagrams where returns and interest are represented as a steady function of borrowing as a line. This pretends that any value for the Debt to Equity ratio can be realised. But that is wrong, we <?page no="108"?> Berkau: Financial Statements 7e 5-108 must calculate returns and interest based on certain investment and financing scenarios. Even investments on the capital market do not come in any quantities and, therefore, no steady return function over debt ratios applies. For that reason, we refuse to draw return over borrowing diagrams. Instead, we calculate single scenarios for decision making. We prepared the calculation of returns for CAPELIFT (Pty) Ltd. if the firm acquires an additional aircraft Cessna C172 to expand its fleet. Follow the QR-code below in Link 5.C for further considerations about our micro airline. Link 5.C: CAPELIFT (Pty) Ltd. Ratios about capital structure are often referred to as gearing. The expression comes from Engineering where a gear box is transforming torque and revolutions per minute RPM. The performance depends on the relationship between the gear wheels to each other. A similar principle applies in business where the transformation is based on the Debt to Equity ratio if Return on Assets and the rate of interest remain constant. Caution, the leverage effect works both ways. It amplifies the Return on Shareholders’ Funds as well in a positive as in a negative way. This means, borrowing is risky, too. Working Capital: Working Capital is an absolute asset figure and is measured in currency units. It originates from Finance and is the difference between short-term assets and short-term liabilities. In Finance, we need to know the Working Capital to decide about the funds required for business operations. Besides the funding of machinery, a company need funds to keep the business going, like for inventories e.g., spare parts or goods to sell, and for receivables in case customers are offered convenient payment terms. On the other side (of the balance sheet), if suppliers offer short-term borrowings e.g., pay for goods next month or after goods have been sold, these short-term liabilities reduce the need for financing. Therefore, we deduct short-term liabilities for the calculation of the Working Capital. Running consignment stock can reduce the Working Capital but it often comes with higher purchase prices asked for by the suppliers. 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 at 31.12.20X8, its Working Capital is: 10,000,000 + 2,000,000 + 18,000,000 - (16,500,000 - 2,500,000) - 3,000,000 = 113,000,000.00 ZAR. In general, companies try to minimise their Working Capital. They try to keep inventories low and hold as less cash as possible. As mentioned above, in Aviation a lot of payments are due at the time of and before flight take-offs. They cause high working capital. <?page no="109"?> Berkau: Financial Statements 7e 5-109 Interest Coverage: Interest Coverage measures how much the net profit before interest can cover the 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 amount is low which proves that CAPELIFT (Pty) Ltd. is financed to a high extent. In contrast to the other ratios for gearing, Interest Coverage considers the costs for borrowing, too. If inverted and multiplied with 365 the Interest Coverage tells us how many days per year it takes to pay for borrowing. At CAPELIFT (Pty) Ltd. it takes: 365 / 4.39 = 8 83.14 days. This means, the company works from 1 st of January until 22 nd of March for the lending banks. 5.16 Market Value Ratios - CAPELIFT (Pty) Ltd. We only can calculate market value ratios if a company is listed publicly. In those cases, the share market price is accessible to the public and can be compared to the valuation derived from Accounting. 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 traded publicly. However, for teaching purpose, we pretend that its shares are traded at 15.00 ZAR/ s at the time of reporting (31.12.20X8). We also pretend that CAPELIFT (Pty) Ltd. declares a dividend of 50 % of its earnings for the Accounting period 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 earnings. As we divide the market price by the EPS, the Price Earnings Ratio gives the number of periods it takes to break even if the company always would declare a dividend of 100 % of its earnings. At CAPELIFT (Pty) Ltd., the Price Earnings Ratio is: 25 / (7,000,000 / 1,000,000) = 3.57. Hence, an investor must wait 4 years before he breaks even with the shares by dividends received. The Price- Earnings-Ratio is used for company comparisons and tells us about the confidence of the investors in the profitability of the company. Dividend Yield: The dividend yield is the dividend paid divided by the fair market price per share. It is an efficiency ratio that shows the return on investment from the investors’ perspective. We must weaken our statement above to the wording “it is a kind of efficiency ratio” as the payment for the shares is only 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%. <?page no="110"?> Berkau: Financial Statements 7e 5-110 Market Book Ratio: The Market Book Ratio of a share determines the fair market value as traded at a stock exchange as a percentage of the book value. The Market Book Value shows the confidence of potential investors in the company to increase the shareholders’ value as they are prepared to pay a price above the book value. The book value merely reflects a situation where a company is bought with the intention to be liquidated at fair values. We assume the Market Book Value normally is above 100 % as its benefits should exceed the yield obtained by its liquidation. 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 undertaken if financial statements can be trusted, best after being audited. 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 is in. We demonstrated a financial statement analysis for a small service provider in Aviation. The case is fictional and is discussed on order to prepare you for a real financial statement analysis of an existing airline. A link to a South African aviation business is provided in this chapter. 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 must be 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 amounts taken from financial statements. 5.19 Question Bank (1) A company discloses a Return on Assets of 20 %. The equity is 100,000.00 EUR and the liabilities are 120,000.00 EUR. 1. The gross profit is 44,000.00 EUR. 2. The net profit is 44,000.00 EUR. 3. The net profit is 30,800.00 EUR. 4. The net profit is 20,000.00 EUR. (2) A company discloses inventories of 40,000.00 EUR, receivables of 10,000.00 EUR and a balancing figure of cash/ bank of 20,000.00 EUR. The short-term liabilities are amounting to 50,000.00 EUR. Which statement is correct? <?page no="111"?> Berkau: Financial Statements 7e 5-111 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 25,000.00 EUR. It declares a dividend of 50 % of the distributable amount to its ordinary shareholders. The preference dividend is 5,000.00 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 100,000.00 EUR. The weighted average costs of capital are 5 %/ a. The assets are amounting to 1,000,000.00 EUR and the short-term liabilities are 400,000.00 EUR. How much is the Economic Value Added? 1. 70,000.00 EUR . 2. 49,000.00 EUR . 3. 40,000.00 EUR . 4. 50,000.00 EUR . 5.20 Solutions 1-2, 2-4, 3-2, 4-4, 5-2. <?page no="112"?> Berkau: Financial Statements 7e 6-112 6 Formal Financial Statement Requirements 6.1 What is in the Chapter? This chapter discusses the application of IAS 1. We discuss the presentation of financial statements following IFRSs. Here, we cover the notes as well. We explain and demonstrate formal Accounting aspects for the case BATHURST Ltd. in Australia. The company is a car rental based on shares. BATHURST Ltd. prepares financial statements in compliance with IFRSs. In the case study, a complete set of financial statements is prepared for the 2nd Accounting period after its establishment. We also introduce the Bookkeeping entries for the effective interest method which is covered in detail in chapter (14) of this textbook. To show as many formal aspects as possible in this case study, BATHURST Ltd. discloses a loss in the first Accounting period, it also has a negative balancing figure in its Cash/ Bank account which must be disclosed as liability. To demonstrate the difference of normal profit to extraordinary income, we make BATHURST Ltd. invest in bonds and benefit from interest income which is not its core business (renting out cars). The chapter starts with the qualitative characteristics of IFRSs financial statements. 6.2 Learning Objectives In this chapter, you learn the formal requirements for the presentation of financial statements as set by the 51 Read about legal aspects of Accounting in the textbook Basics of Accounting, chapter (4). IASB. After studying this chapter, you are familiarised with IAS 1 and can prepare financial statements formally correct. 51 6.3 IFRSs Consistency IAS 1.16 requires a company that prepares financial statements complying with IFRSs to make an unreserved and explicit statement in the notes about the compliance with IFRS. Companies normally do so in the notes, as you can see in Figure 6.8 for our case study BATHURST Ltd. For general purpose financial statements, a company must at least annually prepare a full set of financial statements following IAS 1.10. General purpose financial statements are those statements a company normally prepares at the end of every Accounting period. No special occasions, like mergers or liquidations, trigger the reporting of general purpose financial statements. In accordance with our conventions in chapter (1), general purpose financial statements are prepared as at 31.12.20XX. Special circumstances can require reporting in shorter intervals e.g., a listing at the New York Stock Exchange requires companies to prepare financial statements quarterly. IAS 1.36 rules the frequency of reporting. It also says 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 the fiscal year. <?page no="113"?> Berkau: Financial Statements 7e 6-113 In compliance with IAS 1.10, a full set of financial statements comprises 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 are required to disclose applied Accounting policies and explanatory information for certain items on the financial statements. Based on IAS 1.38 and IAS 1.38A, all financial statements must disclose comparative information about the preceding Accounting period. In case a company changes Accounting policies or parameters thereof, like altering depreciation parameters, it must prepare a balance sheet for the balance sheet date two Accounting periods prior to the day when the reporting period ends, which means the company presents in total three balances sheets, see IAS 1.40A. 6.4 Qualitative Characteristics of Financial Information Financial statements follow Accounting principles, like: (a) Fair presentation (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) Consistency of presentation (IAS 1.45). Ad (a): Fair Presentation A basic principle of 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. This includes that no user group is prioritised, like creditors by the German HGB. The information provided by financial statements is about the financial position, the profitability and the cash flows. 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 The going concern principle of Accounting requires that the user of financial statements can trust the company to continue its operations for the foreseeable future. The 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 to do so, it must disclose these circumstances and prepare financial statements under disclosure of liquidation values. <?page no="114"?> Berkau: Financial Statements 7e 6-114 Ad (c): Accrual Basis of Accounting Accounting theory regards the purpose of financial statements as to inform the users about the financial performance. This requires ascertaining that income and expenses are recorded in 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. Therefore, a cash flow statement naturally cannot follow the accrual basis of Accounting. See IAS 1.27 and F OB17. In contrast to the statement of cash flows, the income statement must follow 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 importance. IAS 1.29 requires important items to be presented separately unless the items are immaterial regarding Accounting objectives. Hence, if an item on the balance sheet is not material the reporting company shall not omit the item but choose an aggregated disclosure together with other items. Ad (e): Prohibition of Offsetting IAS 1.32 says no offsetting is allowed except permitted by a special standard. Offsetting means to deduct negative amounts from positive ones and only 52 An exception is in IAS 7.22. disclosing the difference thereof. We do so when we consider depreciation on assets or pay-off amounts for liabilities. However, offsetting notes payables and receivables for a business partner is not accepted under the above-mentioned standard. 52 However, it is common to offset inputand output-VAT as we only apply one VAT account. Ad (f): Consistency of Presentation IAS 1.45 requires continuing the presentation formats, classifications of items and valuations from one period to the next one. Hence, we cannot change the presentation or classification of items. The standard rules that changes are only accepted if the company needs items to be presented differently for them to provide better information that is more reliable and more relevant to users of the financial statements and if the revised structure is likely to be continued. Financial statements must follow identification requirements in line with IAS 1.49. The standard says how a statement header looks like and what information must be included therein. Following IAS 1.51, the header must show the name of the reporting company, the date/ period the statement is for, the reporting currency and the level of rounding. For single-entity financial statements, the name of the reporting company is disclosed together with its legal form e.g., KIELING Taxi GmbH. The legal form disclosure indicates that the financial statements are not group statements. <?page no="115"?> Berkau: Financial Statements 7e 6-115 6.5 C/ S BATHURST Ltd. Below, we study the car rental business BATHURST Ltd. in Melbourne. We prepare a full set of financial statements including notes for a 2-year-Accounting period. The financial statements under discussion are as at the balance sheet date 31.12.20X6. Therefore, we cover the period from 1.01.20X5 until 31.12.20X6, which is two full years. Data sheet for BATHURST Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: Service provider. Accounting periods: 20X5 / 20X6. Share issue: 50,000 × 6.00 AUD/ s. Financing: bank loan 150,000.00 AUD; interest 2.5 %/ a. Assets: 3 cars; 65,000.00 AUD/ car; depreciation 15,000.00 AUD/ car; residual value: 5,000.00 AUD/ car; office: 150,000.00 AUD; depreciation on office: 12,500.00 AUD/ a. Output: 850 days / 980 days. Net renting price per car: 156.00 AUD/ d / 195.00 AUD/ d. Operational expenses: 48,000.00 AUD / 65,000.00 AUD (not VATable). Bonds (2.01.20X6): face value: 200,000.00 AUD; coupon rate 4 %/ a (annually) VAT 20 %. BATHURST Ltd. is based on 50,000 ordinary shares at 6.00 AUD/ s. The share capital is 300,000.00 AUD. The company is a car rental. The company is established on 1.01.20X4. At the beginning of the Accounting period 20X5 (one year later), BATHURST Ltd. owns three cars Mercedes-Benz C-class. Every car is one year old. Depreciation is calculated following straight-line method over 4 years, the residual value at the end of their useful life is 5,000.00 AUD/ car. Costs of acquisition are 65,000.00 AUD/ car. From the acquisition of the cars, BATHURST Ltd. discloses an input VAT claim of 39,000.00 AUD due in 20X5, which is disclosed as receivables on its balance sheet in Figure 6.1. The company runs its rental business from an office which has been acquired at 150,000.00 AUD. As at 1.01.20X5, the company has depreciated its office by 12,500.00 AUD. For financing the office, BATHURST Ltd. took a bank loan on 1.01.20X4. Its principal is 150,000.00 AUD and the annual rate of interest is 2.5 %/ a. Every year, BATHURST Ltd. pays-off 15,000.00 AUD. On 1.01.20X5, the amount owing is: 150,000 - 15,000 = 1135,000.00 AUD. On the balance sheet, the bank loan is disclosed with 120,000.00 AUD interest bearing liabilities and 15,000.00 AUD short-term liabilities, the latter one is for the pay-off in the next Accounting period 20X5. IAS 1.60 applies. Figure 6.1 gives you the pro-forma balance sheet of BATHURST Ltd. as at 1.01.20X5. BATHURST Ltd.'s operations commence on 1.01.20X5. In the previous Accounting period 20X4, the company made acquisitions and discloses a loss of 61,250.00 AUD which results from the depreciation on the office to the extent of 12,500.00 AUD, from the depreciation on the 3 cars to the extent of 45,000.00 AUD and from interest for the bank loan. The latter one is amounting to: 2.5% × 150,000 = 3 3,750.00 AUD. Therefore, the loss is: 12,500 + 45,000 + 3,750 = 61,250.00 AUD. The loss is carried forward to the next Accounting period 20X5 and is the balancing figure of the retained earnings account. Losses which <?page no="116"?> Berkau: Financial Statements 7e 6-116 are not covered by dissolving reserves are disclosed as negative retained earnings on the balance sheet. As the total of equity remains positive, no reason for bankruptcy exists. Detailed information about the calculation of the opening values on the balance sheet and the application of the effective interest method for the bank loan disclosure can be downloaded below through Link 6.A. The effective rate of interest is 2.5 %/ a because the loan will be redeemed at the principal. Furthermore, annual payments of interest apply. In those cases, the effective rate of interest equals the nominal one. Link 6.A: BATHURST Ltd. 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) In 20X5, BATHURST Ltd. receives a VAT refund from the Australian revenue service to the extent of 39,000.00 AUD. This is recorded as Bookkeeping entry (1). BATHURST Ltd. rents out its cars at a rate of 156.00 AUD/ d (ex VAT). During the Accounting period 20X5. Its number of car-days-rent-outs is 850. BATHURST Ltd.’s revenue is: 850 × 156 = 1 132,600.00 AUD. The revenue is paid in full and recorded as Bookkeeping entry (2). Operational expenses in 20X5 are 48,000.00 AUD. (Bookkeeping entry (3)). The costs for operations are not VATable. All costs for the operations are paid in full. The interest calculation for the bank loan is based on the amount owing which is on 1.01.20X5: 120,000 + 15,000 = 1135,000.00 AUD. Based on the effective interest method in compliance with IFRS 9, interest is calculated as 2.5% × 135,000 = 3 3,375.00 AUD. We record a debit entry in the Interest account and credit the amount to cash/ bank. This is Bookkeeping entry (4). <?page no="117"?> Berkau: Financial Statements 7e 6-117 Next, we discuss the calculations and Bookkeeping entries made for the effective interest method. In the case of BATHURST Ltd., the application of the effective interest method results in the same expenses for the bank loan. 53 If not interested in the Bookkeeping entries applicable for the effective interest method, you can skip the next paragraphs and continue with the adjustments where the ** is. In compliance with IFRSs, BATHURST Ltd. must disclose the bank loan as a liability and apply the effective interest method. This does not change the need to separate short-term from long-term liabilities following IAS 1.60. We calculate the effective interest rate to be 2.5 %/ a; the same as the nominal rate of interest. For 20X5, this gives an effective interest expense of: 135,000.00 × 2.50 % = 33,375.00 AUD. The interest paid for the bank loan in 20X5 is: (150,000 - 15,000) × 2.5% = 33,375.00 AUD (the same). See below the Bookkeeping entries made for the bank loan. The effective interest rate can be calculated by iteration and guarantees that the final value of the bank loan is zero after settlement of all scheduled payments. For the calculation of the effective interest rate, we set up a payment vector and assume interest is paid between the periods. The payment vector for the bank loan is: BL(t) = {150,000; (18,750); (18,375); (18,000); (17,625); (17,250); (16,875); (16,500); (16,125); (15,750); (15,325)}. The internal rate of return for the payments is 2.5 %/ a. You can easily calculate the internal rate of return with the MS-Excel function IRR(). 54 Here, the effective rate of interest equals the nominal interest rate, because all payments are made at year-ends, and the total of the pay-off payments equals the principal. For applying the effective interest method, we make 2 Bookkeeping entries for interest, the first one is for the effective interest and the second one for the paid one. Here, both interest rates are the same; therefore, we can cut the recording short and debit the Interest account and make a credit entry in cash/ bank. DR Interest..................... 3,375.00 AUD CR Interest Bearing Liabilities. 3,375.00 AUD DR Interest Bearing Liabilities. 3,375.00 AUD CR Cash/ Bank.................... 3,375.00 AUD * Next, we record adjustments. At BATHURST Ltd., they are for the pay-off of the bank loan and for depreciation. The pay-off amounts for the bank loan in the next following year are 15,000.00 53 We discuss the method here as the bank loan must be carried at amortised costs. In chapter (14), we get back to the case study BATHURST Ltd. and calculation interest for alterations of the AUD/ a and classified as short-term liabilities 1 Accounting period before the payment. The payments reduce shortterm liabilities. See the Bookkeeping entry for the pay-off in 20X5 which are incase, like monthly interest payments instead of annual ones. 54 With a German office system in use, the MS- Excel function is named IKV(). <?page no="118"?> Berkau: Financial Statements 7e 6-118 dicated by the 3 letter code for the contra accounts (C/ B and A/ P). The pay-off portion of the bank loan for 20X6 is transferred to the Short-term Liabilities account by the Bookkeeping entry marked as (A/ P and IBL). In 20X5 and in 20X6, depreciation on the cars is 15,000.00 AUD/ (a × car). The total annual depreciation is: 3 × 15,000 = 445,000.00 AUD/ a. Depreciation in 20X5 is recorded as Bookkeeping entries marked as (ACC and DPR). Depreciation on the office is 12,500.00 AUD/ a and is recorded as a further Bookkeeping entry in 20X5 which is also marked as (ACC and DPR). Next, we calculate BATHURST Ltd.’s profit. The pre-tax profit (EBT) in 20X5 is: 132,600 - 45,000 - 12,500 - 3,375 - 48,000 = 2 23,725.00 AUD. After tax reduction a profit of: (1 - 30%) × 23,725 = 16,607.50 AUD remains as annual surplus. Observe the accounts in Figure 6.2. D C D C OV 345,000.00 c/ d 345,000.00 OV 57,500.00 b/ d 345,000.00 DPR 45,000.00 c/ d 115,000.00 DPR 12,500.00 115,000.00 115,000.00 b/ d 115,000.00 Property, plant and equipment PPE Acc depr ACC D C D C A/ P 15,000.00 OV 120,000.00 C/ B 15,000.00 OV 15,000.00 c/ d 105,000.00 c/ d 15,000.00 IBL 15,000.00 120,000.00 120,000.00 30,000.00 30,000.00 b/ d 105,000.00 b/ d 15,000.00 D C D C ACC 45,000.00 P5L 57,500.00 (4) 3,375.00 P5L 3,649.94 ACC 12,500.00 57,500.00 57,500.00 Interest bearing liabilities IBL Short-term liabilities A/ P Depreciation-20X5 DPR Interest-20X5 INT D C D C P5L 132,600.00 (2) 132,600.00 OV 39,000.00 (1) 39,000.00 c/ d 26,520.00 (2) 26,520.00 65,520.00 65,520.00 b/ d 26,520.00 Revenue-20X5 REV Value added tax VAT Figure 6.2: BATHURST Ltd.’s accounts (20X5) <?page no="119"?> Berkau: Financial Statements 7e 6-119 D C D C OV 47,250.00 (3) 48,000.00 (3) 48,000.00 P5L 48,000.00 (1) 39,000.00 (4) 3,375.00 (2) 159,120.00 A/ P 15,000.00 c/ d 178,995.00 245,370.00 245,370.00 b/ d 178,995.00 Cash/ Bank C/ B Operational expenses-20X5 OEX D C D C DPR 57,500.00 REV 132,600.00 c/ d 7,117.50 ITL 7,117.50 INT 3,375.00 b/ d 7,117.50 OEX 48,000.00 EBT 23,725.00 132,600.00 132,600.00 ITL 7,117.50 b/ d 23,725.00 R/ E 16,607.50 23,725.00 23,725.00 D C D C OV 61,250.00 P5L 16,607.50 c/ d 300,000.00 OV 300,000.00 c/ d 44,642.50 b/ d 300,000.00 61,250.00 61,250.00 b/ d 44,642.50 Retained earnings R/ E Share capital ISS Profit and Loss-20X5 P5L Income tax liabilities ITL Figure 6.2: BATHURST Ltd.'s accounts (20X5) continued In the Accounting period 20X6, BATHURST Ltd. pays income taxes as Bookkeeping entry (A) and VAT liabilities as (B). Next, the revenue resulting from renting out cars in the Accounting period 20X6 for 980 days is recognised as: 980 × 195 = 1191,100.00 AUD. In 20X6, the price for a daily rent is higher than before: 195.00 AUD/ d. Only 55 % of the proceeds are paid by the customers instantly. Observe Bookkeeping entry (C) which contains a portion for receivables. Operational expenses in 20X6 increase and now are 65,000.00 AUD. They are recorded by Bookkeeping entry (D). All 55 Learn about bonds in the case study KILDARE Ltd. and regarding the bond holder Bill Elmwood expenses for operations are paid on cash. To use its cash reserves efficiently, BATHURST Ltd. invests 200,000.00 AUD in bonds 55 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 apply. The bonds earn interest income of: 200,000 × 4% = 8 8,000.00 AUD. We record the gain on the credit side of the Interest Income account (CPN for Coupon) as Bookkeeping entry (F). BATHURST Ltd.'s investment leads to an overdraft of the bank account. Therein our textbook Basics of Accounting, chapter (15). <?page no="120"?> Berkau: Financial Statements 7e 6-120 fore, it must disclose the balancing figure of the Cash/ Bank account as a shortterm liability on the balance sheet to the extent of 3,516.50 AUD. 56 The interest in 20X6 as paid to the bank is: (105,000 + 15,000) × 2.5% = 3 3,000.00 AUD. Interest is recorded as Bookkeeping entry (G). Next, we cover the adjustments recorded on 31.12.20X6. At BATHURST Ltd., the adjustments are the pay-off of the bank loan and depreciation. The pay-off amount reduces the shortterm liabilities by 15,000.00 AUD, see the Bookkeeping entry for the payment marked as (C/ B and A/ P). Again, pay-off for the next upcoming Accounting period 20X7 is transferred from the Interest Bearing Liabilities account to shortterm liabilities, see the Bookkeeping entry marked as (A/ P and IBL). Depreciation on cars stays at 45,000.00 AUD/ a and depreciation on the office is 12,500.00 AUD/ a. We record depreciation as adjustment; therefore, we indicate the Bookkeeping entries with the 3letter-codes for the contra accounts (ACC and DPR). Observe the profit calculation at BATHURST Ltd. in the Profit and Loss account shown in Figure 6.3. After profit calculation, BATHURST Ltd. suggests its shareholders to declare a dividend of 0.10 AUD/ s. The financial statements are prepared under the appropriation of profits and show a dividend to the shareholders of: 50,000 × 0.10 = 5 5,000.00 AUD disclosed as shortterm liabilities. We show BATHURST Ltd.’s accounts as at 31.12.20X6 in Figure 6.3. D C D C OV 345,000.00 c/ d 345,000.00 OV 57,500.00 b/ d 345,000.00 DPR 45,000.00 c/ d 115,000.00 DPR 12,500.00 115,000.00 115,000.00 b/ d 115,000.00 (D) 45,000.00 c/ d 172,500.00 (E) 12,500.00 172,500.00 172,500.00 b/ d 172,500.00 D C D C A/ P 15,000.00 OV 120,000.00 C/ B 15,000.00 OV 15,000.00 c/ d 105,000.00 c/ d 15,000.00 IBL 15,000.00 120,000.00 120,000.00 30,000.00 30,000.00 A/ P 15,000.00 b/ d 105,000.00 C/ B 15,000.00 b/ d 15,000.00 c/ d 90,000.00 c/ d 15,000.00 IBL 15,000.00 105,000.00 105,000.00 30,000.00 30,000.00 b/ d 90,000.00 b/ d 15,000.00 Interest bearing liabilities IBL Short-term liabilities A/ P Property, plant, equipment PPE Acc depr ACC Figure 6.3: BATHURST Ltd.’s accounts (20X6) 56 Read our textbook Basics of Accounting, chapter (37). <?page no="121"?> Berkau: Financial Statements 7e 6-121 D C D C ACC 45,000.00 P6L 57,500.00 (G) 3,000.00 P6L 3,000.00 ACC 12,500.00 57,500.00 57,500.00 Depreciation-20X6 DPR Interest-20X6 INT D C D C P6L 191,100.00 (C) 191,100.00 OV 39,000.00 (1) 39,000.00 c/ d 26,520.00 (2) 26,520.00 65,520.00 65,520.00 (B) 26,520.00 b/ d 26,520.00 c/ d 38,220.00 (C) 38,220.00 64,740.00 64,740.00 b/ d 38,220.00 Revenue-20X6 REV Value added tax VAT D C D C OV 47,250.00 (3) 48,000.00 (D) 65,000.00 P6L 65,000.00 (1) 39,000.00 (4) 3,375.00 (2) 159,120.00 A/ P 15,000.00 c/ d 178,995.00 245,370.00 245,370.00 b/ d 178,995.00 (A) 7,117.50 (C) 126,126.00 (B) 26,520.00 (F) 8,000.00 (D) 65,000.00 (E) 200,000.00 (G) 3,000.00 ´c/ d 3,516.50 A/ P 15,000.00 316,637.50 316,637.50 b/ d 3,516.50 Cash/ Bank C/ B Operational expenses-20X6 OEX D C D C DPR 57,500.00 REV 191,100.00 c/ d 7,117.50 P5L 7,117.50 INT 3,000.00 CPN 8,000.00 (A) 7,117.50 b/ d 7,117.50 OEX 65,000.00 c/ d 22,080.00 P6L 22,080.00 EBT 73,600.00 29,197.50 29,197.50 199,100.00 199,100.00 b/ d 22,080.00 ITL 22,080.00 b/ d 73,600.00 R/ E 51,520.00 73,600.00 73,600.00 Profit and loss-20X6 P6L Income tax liabilities ITL Figure 6.3: BATHURST Ltd.’s accounts (20X6) continued <?page no="122"?> Berkau: Financial Statements 7e 6-122 D C D C OV 61,250.00 P5L 16,607.50 c/ d 5,000.00 R/ E 5,000.00 c/ d 44,642.50 b/ d 5,000.00 61,250.00 61,250.00 b/ d 44,642.50 P6L 51,520.00 DIV 5,000.00 c/ d 1,877.50 51,520.00 51,520.00 b/ d 1,877.50 Retained earnings R/ E Dividends/ p DIV D C D C (E) 200,000.00 c/ d 200,000.00 P6L 8,000.00 (F) 8,000.00 b/ d 200,000.00 D C D C (C) 103,194.00 c/ d 103,194.00 c/ d 300,000.00 OV 300,000.00 b/ d 103,194.00 b/ d 300,000.00 Financial instruments FIN Interest income-20X6 CPN Accounts receivables A/ R Share capital ISS Figure 6.3: BATHURST Ltd.’s accounts (20X6) continued Below, we prepare the annual financial statements for 20X6. IAS 1.38 requires preparing financial statements that include a column for the comparative figures (last period). BATHURST Ltd. prepares annual financial statements every year on its balance sheet date 31 st December. Annual reporting is a requirement resulting from IAS 1.36. Annual financial statements meet the needs of general-purpose financial statements based on IAS 1.7. BATHURST Ltd.’s 20X6’s financial statements show comparative information for 20X5 in line with the Framework F QC20 and IAS 1.38. Below, we cover all financial statements in detail: (1) Statement of financial position. (2) Statement of profit of loss and other comprehensive income. 57 Read in the Conceptual Framework for Financial Reporting: F 4.8 - 4.14. (3) Statement of changes in equity. (4) Statement of cash flows. (5) Notes. 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 and from which future economic benefits are expected to flow to the company. 57 An asset differs from a <?page no="123"?> Berkau: Financial Statements 7e 6-123 Vermögensgegenstand on a German balance sheet 58 . - A liability is a present obligation of the company arising from past events the settlement of which is expected to result in an outflow from the company of resources embodying economic benefits. 59 - Equity is the residual interest in the assets of the company after deducting all its liabilities. 60 The equity definition refers to the difference of assets and liabilities. We can easily verify the evaluation of equity when we think about a liquidation 61 . A company that sells all its assets at fair values and retires its debts at fair values without transaction costs, determines its equity as the remaining company value. This is called book value of the business as we derive it from the Bookkeeping records (books). At BATHURST Ltd., the book value of the company is 301,877.50 AUD as at 31.12.20X6. This is a book value per share of: 301,877.50 / 50,000 = 6 6.08 AUD/ s. The book value only exceeds the face value of the shares at 0.08 AUD/ s; this is caused by not earning revenues in 20X4 to keep our case study simple. Hence, BATHURST Ltd. carried a loss from the first year forward to the Accounting period 20X5. BATHURST Ltd. prepares the balance sheet as disclosed 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. It discloses the name (BATHURST 58 This is the reason, why we translate asset as Vermögenswert and not Vermögensgegenstand. 59 Read in the Conceptual Framework for Financial Reporting: F 15 - F 19. Ltd.), indicates whether it is a single-entity financial statement, separate financial statement (IAS 27) or a group statement by disclosure of its legal form 60 Read in the Conceptual Framework for Financial Reporting: F 20 - F 23. 61 Recording of liquidations is covered in our textbook Basics of Accounting, chapter (34). <?page no="124"?> Berkau: Financial Statements 7e 6-124 (Ltd.), shows the balance sheet-date (31.12.20X6), indicates the reporting currency (AUD for Australian Dollars) and gives the rounding level (AUD for full Australian Dollars). The 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, like cars and property, and cash/ bank and receivables as short-term assets. The single values of the items of property, plant and equipment do not show on the balance sheet but are disclosed in the notes on the register of non-current assets (see below). Regarding the liabilities, the separate disclosure is more difficult as the bank loan contains a shortterm portion (the pay-off for the next Accounting period) as well as a long-term portion. IAS 1.69 covers the distinction of liabilities. In contrast to short-term liabilities, long-term ones are disclosed in accordance with the effective interest method required in IFRS 9.5.3.1 and IFRS 9.4.2.1. As the bank loan is kept until settlement a valuation based on amortised costs (effective interest method) applies. As at 31.12.20X6, BATHURST Ltd. discloses its long-term liabilities resulting from the bank loan at 90,000.00 AUD and short-term liabilities at 15,000.00 AUD; the latter ones are due on 31.12.20X7. Short-term liabilities are disclosed as accounts payables (A/ P) on the balance sheet and at BATHURST Ltd., they include the short-term bank loan pay-off, VAT liabilities and claims of the shareholders for the dividend as well as BATHURST Ltd.’s bank account overdraft. The tax liabilities require disclosure as an extra item according to IAS 1.54 in combination with IAS 12. The item only shows income tax liabilities. No VAT liabilities can be disclosed under this item. For VAT payables we apply the item short-term liabilities A/ P (see above). BATHURST Ltd.’s equity is calculated by deducting liabilities from the total of assets and gives: 372,500 + 103,194 - 90,000 - 61,736.50 - 22,080 = 3301,887.50 AUD. It includes shares (ordinary shares) and retained earnings. 6.7 Statement of Profit or Loss - BATHURST Ltd. The statement of profit or loss and other comprehensive income shows profit or loss and extraordinary items for gains and losses. IAS 1.81A - IAS 1.105 specify the disclosure of profit or loss and other comprehensive income. The conceptual framework for financial reporting F 4.24 specifies that the financial performance depends directly on income and expenses. In line with F 5.25, income is defined as increase in economic benefits during the Accounting period as inflow and enhancement of assets or decrease of liabilities that lead to an increase in equity - other than equity changes linked to owners, like share issues. In contrast, expenses are seen as decreases of economic benefits during the Accounting period in form of outflows or depletion of assets or incurrences of liabilities resulting in a decrease of equity - again: other than equity changes linked <?page no="125"?> Berkau: Financial Statements 7e 6-125 to owners. (A payment of dividends is no expense.) Income can be revenue and gains - based on F 4.29. Revenue is the funds received in exchange for business activities; F 4.29 lists items, like sales, fees, interest, dividends, royalties and rent. F 4.31 does not define gains but gives examples. Along those, gains are extraordinary income e.g., sales of noncurrent assets. Gains shall be disclosed separately from revenues and very often are reported net of expenses. BATHURST Ltd. discloses the statement of profit or loss and other comprehensive income as displayed in Figure 6.5. 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) BATHURST Ltd. must disclose the revenue from renting out cars separate to interest income from bonds, based on IAS 1.82. At BATHURST Ltd., the income adds up to 199,100.00 AUD in 20X6. The expenses include depreciation and other expenses, which are here operational expenses. An income statement does not show all single items of expenses, only as detailed as required by 62 Read our textbook Basics of Accounting, chapter (28). IAS 1.82. An income statement is more concentrated than a Profit and Loss account. A company can prepare the income statement based on the nature of expenses (IAS 1.102) or based on the cost of sales (IAS 1.103). 62 It is common Accounting practice to disclose the earnings before interest and taxes EBIT on a separate line. IAS 1.82 requires the disclosure of finance costs <?page no="126"?> Berkau: Financial Statements 7e 6-126 separately which is shown for BATHURST Ltd. as interest item resulting from the bank loan. After deduction of income taxes, which are calculated based on national tax law, the annual profit (earnings after taxes) is disclosed on the bottom line. 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, like share issues or dividends. The standard requires companies to prepare a statement of changes in equity, which e.g., shows columns for components of equity and lines at the beginning and end of the Accounting period as well as lines for changes of equity during the Accounting period, see IAS 1.108 and IAS 1.109. In Figure 6.6, we show BATHURST Ltd.’s statement of changes in equity for the Accounting periods 20X5 and 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 (20X6) BATHURST Ltd. changed its equity by the profits earned in 20X5 and 20X6 as well as by declaring the dividend for the Accounting period 20X6. The statement of changes in equity discloses how the book value of the company changes due to profit or loss and transactions with owners. 6.9 Statement of Cash Flows - BATHURST Ltd. The cash flow statement is required by IAS 1.10 and as laid out in IAS 1.111, IAS 7 covers the calculation thereof. <?page no="127"?> Berkau: Financial Statements 7e 6-127 20X6 20X6 20X5 20X5 [AUD] [AUD] [AUD] [AUD] Cash flow from operating acitivities Proceeds 126,126 159,120 Operating expenses (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 about the previous Accounting period 20X5, too. The cash flow statement must present the cash flows of the reporting Accounting period classified in operating, investing and financing activities, based on IAS 7.10. 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. For the calculation of operating cash flows, a company can either apply the direct method or reconcile the operating cash flow from the earnings after taxes. Both methods comply with IAS 7.18. 63 63 Read our textbook Basics of Accounting, chapter (32). BATHURST Ltd. calculates its operating cash flow based on the direct method. We derive the cash flows straight from the Cash/ Bank account. Interest earned as well as paid are considered as cash flows from financing activities in accordance with IAS 7.33. Interest paid for the bank loan and received from the bonds are reported separately, see IAS 7.31. No offsetting is accepted. The dividend payments are classified as financial cash flow following IAS 7.34. The income tax payment is disclosed as operating cash flow which is consistent with IAS 7.35. 6.10 Notes - BATHURST Ltd. In contrast to German Accounting, notes are a more detailed description <?page no="128"?> Berkau: Financial Statements 7e 6-128 of Accounting policies. IAS 1.112 requires the notes to provide information about the basis of preparation of financial statements and the Accounting policies applied as well as showing information required by IFRSs that is not disclosed in other financial statements e.g., the register of non-current assets. IAS 1.113 states that notes must be presented in a systematic manner to make them understandable and comparable. Often the financial statements contain figures referring to paragraphs in the notes - comparable to footnotes. Every company must prepare notes. The notes are an element of a full set of financial statements. BATHURST Ltd. prepares the notes based on the information 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. The notes of BATHURST Ltd. are following, linked to the financial statements as at 31.12.20X6 in Figure 6.8. BBathurst 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. 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 <?page no="129"?> Berkau: Financial Statements 7e 6-129 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 at 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 5.00 AUD/ s. Authorised shares: 100,000 ordinary shares at 6.00 AUD/ s nominal amount Issued shares: 50,000 ordinary shares at 6.00 AUD/ s 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. (c) Interest bearing liabilities The non-current interest bearings liabilities result from a bank loan with COMMONWEALTH BANK. The bank loan is a mortgage with an annual rate of interest of 2.5 %/ a. The principal is 150,000.00 AUD. The annual pay-off amount is 15,000.00 AUD/ a. The bank loan is secured by the office building, as separate title property, located in 3141 Melbourne, 193 Toorak Rd. <?page no="130"?> Berkau: Financial Statements 7e 6-130 The bank loan is valuated based on amortised costs. The effective interest method applies. The present value of loans is: 105,000.00 AUD. The short-term liability portion thereof is 15,000.00 AUD. The settlement amount for the bank loan is: 105,000.00 AUD. There are no further bank loans. ((d) Tangible assets Tangible assets are 1 office, separate titled in an office block and 3 cars Mercedes-Benz C-class. The office was transferred to Bathurst Ltd. 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 150,000.00 AUD. The office is financed by a bank loan (mortgage) of 150,000.00 AUD. Depreciation on the building is based on straight line method and is amounting to 12,500.00 AUD/ y. The cars are disclosed on the register of non-current assets as a group of cars. The cars have been purchased at 65,000.00 AUD/ car on 2.01.20X4. The residual value of the cars is estimated to be: 3 × 5,000 = 1 15,000.00 AUD. Depreciation is over a period of 4 years along straight-line method. Depreciation costs on motor vehicles are 15,000.00 AUD/ a. 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 values is displayed on group level below: Cars Office total [AUD] [AUD] [AUD] opening amount 20X5 150,000 137,500 287,500 additions 0 disposal 0 depreciation (45,000) (12,500) (57,500) impairment loss 0 revaluations 0 closing amount 20X5 105,000 125,000 230,000 additions 0 disposal 0 depreciation (45,000) (12,500) (57,500) impairment loss 0 revaluations 0 closing amount 20X6 60,000 112,500 172,500 Bathurst Ltd. RECONCILIATION of OPENING VALUES with CLOSING VALUES as at 31.12.20X6 <?page no="131"?> Berkau: Financial Statements 7e 6-131 ((e) Inventory Bathurst Ltd. does not carry inventories as at 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 for the earnings from 20X6 and are amounting to 22,080.00 AUD. No prepayments for income taxes were made. The amount for income tax is due on 15.01.20X7. Income taxes are disclosed as short-term liabilities on the balance sheet under income tax liabilities. VAT payables The revenue earned by renting out motor vehicles is VATable at a VAT rate of 20 %. The VAT payables are amounting to: 38,220.00 AUD. It 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. declared a dividend to its registered shareholders to an extent of 0.10 AUD/ s. The total of dividends is amounting to: 50,000 × 0.10 = 5 5,000.00 AUD. The proposed payment of dividends needs approval on the annual meeting held on 30.05.20X7. The dividend is due on 15.06.20X7. The dividend will be paid to shareholders registered on 1.06.20X6. (h) Revenue Car rental (core business) BATHURST Ltd. earned a revenue of 191,100.00 AUD by renting out motor vehicles in Australia. All revenue was collected by immediate bank transfers (card payments or cash payments). No trade discounts have been allowed. No receivables result from business operations. Financial revenue A coupon revenue of 8,000.00 AUD was earned from holding 2,000 bonds of Bank of Queensland. The bonds will mature on 6.11.20Y9 and their nominal value is 100.00 AUD/ bond. The annual coupon rate is 4 %/ a. The bonds are traded at 100.00 AUD/ b as at 31.12.20X6. (i) Expenses Total expenses at BATHURST Ltd. are amounting to 125,125.00 AUD. The expenses in detail are listed below: - Depreciation on cars and office: 57,500.00 AUD. - Interest on bank loan: 3,000.00 AUD (effective rate of interest: 2.5 %/ a). - Operational expenses, such as: labour, maintenance, cleaning: 65,000.00 AUD. <?page no="132"?> Berkau: Financial Statements 7e 6-132 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. The notes are signed by BATHURST Ltd.’s chief executive officer (CEO), Mr P. Lansfield. 6.11 Summary In this chapter, we covered the formal aspects of financial reporting. We mostly discussed implications resulting from the Framework, IAS 1 and IAS 7. We provided a full set of financial statements for the case study BATHURST Ltd., a car rental 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. 6.12 Working Definitions Accounting Period: The time span financial statements are prepared for. In this textbook, the Accounting period is always one year. Effective Interest Method: Valuation of a liability or financial instrument measured by a payment vector with revaluation of its elements based on internal rate of return. The effective rate of interest calculation requires iterations. Notes: Disclosure of Accounting policies and explanation of items on financial statements. 6.13 Question Bank (1) A Malaysian company is established on 15.03.20X4. Its balance sheet date is 31 st of December. How does the company disclose its first financial statements? 1. One 15 days period and 3 quarterly reports. 2. One 3.5 months long period and 1 half year report. 3. A shortened report for the period 15.03.-31.12.20X4. 4. A full Accounting period with zero amounts for the time between 1.01.-14.03.20X4. (2) A statement of changes in equity discloses: 1. Opening value of equity, issued capital, all reserves, profits, cash flows, dividends paid. 2. Opening value of equity, closing value of equity, dividend payments, additions to reserves, revaluations. <?page no="133"?> Berkau: Financial Statements 7e 6-133 3. Opening value of equity, profit before taxation, dividend declarations, revaluations, resolving reserves, closing equity. 4. Opening value of equity, profit after taxation, dividend declared, revaluations, closing value of equity. (3) A company reports in its notes: 1. The standards applied, the postal address of the company, the register of non-current assets and the remuneration of auditors. 2. All standards, the address of the company and all its subsidiaries, the register of current assets, the position of the board of directors, the total of assets. 3. All applied standards, the method of depreciation and the register of non-current assets, the reconciliation of opening and closing amounts for non-current assets, the valuation of inventory, dividends declared. 4. All applied standards, the method of depreciation and the register of current assets, the reconciliation of opening and closing amounts for current assets, the valuation of inventory, dividends declared. (4) The financial statements’ header shows: 1. The name of the reporting company, the time when the financial statements are prepared, the currency unit, the rounding of figures. 2. The name of the reporting company, its legal form, the balance sheet date or the reporting period’s ending, the currency unit, the rounding of figures. 3. The name of the reporting company and its legal form, the balance sheet date or the reporting period’s ending, the currency unit, the data format. 4. The name of the reporting company, an indication of group/ single entity statement, the time for which the financial statements are prepared, the currency unit, the rounding of figures, the international standards and paragraphs applicable. (5) Which standards apply for assets? 1. IAS 16, IAS 2, IFRS 9. 2. IAS 17, IAS 2, IFRS 18. 3. IAS 37, IAS 16, IFRS 9. 4. IAS 33, IAS 16, IAS 2. 6.14 Solutions 1-3, 2-4, 3-3, 4-2, 5-1. <?page no="134"?> Berkau: Financial Statements 7e 7-134 7 Non-current Assets on the Balance Sheet 7.1 What is in the Chapter? This chapter familiarises you with the recognition and measurement of noncurrent assets. Non-current assets stay in general in the company for more than 1 Accounting period. Therefore, changes in valuation, like depreciation, impairment loss and revaluation, become important. You learn about the initial recognition, subsequent valuations and about the disposal of assets. 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 for impairments as a special subsequent valuation. 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, that is why this chapter contains 19 case studies. 7.2 Learning Objectives After studying this chapter, you know how to recognise and evaluate noncurrent assets. You can record noncurrent assets at the time of initial valuation and know when and how to apply the cost model and revaluation model for their subsequent valuations. You also understand the recording for selling or for disposals of non-current assets 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 chapters about the topics below: (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 the entity as a result of past events and from which future economic benefits are expected to flow to the entity. The IFRSs focus on economic benefits and make the recognition and valuation of assets dependent thereon. 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 to cash in the case of a disposal. A reporting company must control its assets for recognition. If a company cannot control an asset, it cannot disclose it on its balance sheet. E.g., a doctor who considers his patient list as a potential for earning a profit cannot disclosed the list on her/ his balance sheet, as doctors do not control their patients’ economic decisions, like which doctor they go to. Neither does <?page no="135"?> Berkau: Financial Statements 7e 7-135 a good reputation or a well-known brand, like Coca Cola, qualify for recognition as the reputation and the resulting customer behaviour are not controllable. The requirement of a past event to exist defines how the reporting company obtained possession of the asset and determines the measurement thereof e.g., an asset can be added to the company by acquisition, donation, leasing etc. IAS 16 further rules how to recognise assets. Recognition (F 4.37) means to add an item to the non-current assets on the balance sheet. For recognition, we decide whether and where to put an asset on the balance sheet and must assign a value to it. For the initial asset recognition, the reporting company must be able to measure an assets value reliably. Hence, a recognition requires both, the acknowledgement of future economic benefits linked thereto and its measurement. As a recognition requirement, IAS 16.7 rules that economic benefits must be associated with the asset and that its costs can be measured reliably. In case an asset includes major spare parts, like the interior of an aircraft or its power plants, assets must be recognised separately as single items based on IAS 16.8. An aircraft regularly is disclosed as a set of assets e.g., fuselage, engines and interior even as these assets are physically mounted by bolts, rivets etc. Different depreciation parameters can apply for its components e.g., the fuselage of an aircraft has a longer useful life than the power plants. IAS 16.14 also says regular 64 An example for an aircraft depreciation is discussed in out textbook Basics of Accounting, chapter (17). maintenance (major part inspections, checks) must be added to the costs 64 . At first, we discuss the initial recognition of assets. IAS 16.15 states: An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its costs. IAS 16.16 names 3 different cost categories for asset valuation. We must add them for the calculation of an asset's total value. (a) Acquisition price, including import duties, non-refundable VAT 65 , less trade discounts and rebates. (b) Directly attributable costs. (c) Cost of dismantling the asset. 7.4 C/ S GETEN (Pty) Ltd. Find below the small case study of GETEN (Pty) Ltd.: Data Sheet for GETEN (Pty) Ltd. DDomicile: South Africa (Gqeberha). Reporting currency: ZAR. Classification: Manufacturing. Acquisition of a saw: 24,000.00 ZAR gross purchase price. Trade discount 5 %. VAT 20 %. GETEN (Pty) Ltd. is a production firm and buys a saw at a price of 24,000.00 ZAR. The price is the gross value and includes 20 % input-VAT. The seller offers GETEN (Pty) Ltd. a trade discount of 5 % on the saw. The saw is an item of property, plant and equipment and falls under non-current 65 Only applicable if no VAT registration applies. <?page no="136"?> Berkau: Financial Statements 7e 7-136 assets. Future economic benefit is expected to flow to the buyer when she/ he deploys the saw in the production process. To recognise the saw, GETEN (Pty) Ltd. calculates the cost of acquisition as: (24,000/ 120%) × (1 - 5%) = 1 19,000.00 ZAR. The costs can be calculated reliably as they are derived from the acquisition price. We record the granted discount as a received trade discount and make the Bookkeeping entries accordingly. DR P, P, E Account.............. 20,000.00 ZAR DR VAT.......................... 4,000.00 ZAR CR Cash/ Bank.................... 24,000.00 ZAR DR Cash/ Bank.................... 1,200.00 ZAR CR Discount Received............ 1,200.00 ZAR DR Discount Received............ 1,200.00 ZAR CR VAT.......................... 200.00 ZAR CR P, P, E Account.............. 1,000.00 ZAR The Bookkeeping entries can be recorded easier if directly based on the reduced acquisition costs. 66 After we made 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 19,000.00 ZAR. 7.5 Qualifying Assets If an asset still requires configurations, changes or further steps of manufacturing for its intended deployment, qualifying costs apply and must be added to the asset’s value in compliance with IAS 16.16. 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, like the distance meter, markings, GPS, radio etc., are additional 66 Study the recording of discounts in out textbook Basics of Accounting, chapter (36). costs of acquisition and must be written-off together with the taxi in later Accounting periods - instead of recording them as expenses in the first Accounting period. Adding expenses to the cost of acquisition applies for interest spent for financing the asset’s qualifying, as well. IAS 23.8 requires the reporting company to capitalise borrowing costs. Hence, a taxi company which takes a bank loan to finance the car’s alterations must adds the interest thereof to the costs of acquisition. IAS 23.10 sets out requirements for the capitalisation of borrowing costs. In contrast, other (non-specific) interest or costs for repairs e.g., exhauster replacements or tyre changes, fall under regular operations and are recorded through profit or loss in the Accounting period when they occur. <?page no="137"?> Berkau: Financial Statements 7e 7-137 7.6 C/ S LANGDAM Bhd. For qualifying assets, we study the case of LANGDAM Bhd. in Kuala Lumpur: Data Sheet for LANGDAM Bhd. DDomicile: Malaysia (Kuala Lumpur). Reporting currency: MYR. Classification: Service provider. Acquisition of software: 340,000.00 MYR net purchase price. Customising costs: 100,000.00 MYR. VAT 20 %. LANGDAM Bhd. is a consultancy based on shares in Malaysia. The company buys the computer software ADMACC for its order management e.g., for hours billing. The net purchase price for ADMACC software is 340,000.00 MYR. In addition to the software purchase, a computer specialist customises LANGDAM Bhd.’s software. Customising software means to make initial software settings and enter master data. The software specialist charges 100,000.00 MYR (net value). Customising service costs are directly attributable costs based on IAS 16.16. Therefore, the initial recognition of the software ADMACC is recorded as below: DR P, P, E Account.............. 340,000.00 MYR DR VAT.......................... 68,000.00 MYR CR Cash/ Bank.................... 408,000.00 MYR DR P, P, E Account.............. 100,000.00 MYR DR VAT.......................... 20,000.00 MYR CR Cash/ Bank.................... 120,000.00 MYR The software ADMACC is measured at 440,000.00 MYR. This is the value for its initial recognition. 67 It contains qualifying costs. Assets can also be acquired based on exchanges of goods and/ or can lead to delayed payments which adds an interest portion to the cost of acquisition. We do not cover these cases in the textbook but prepared 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. 67 See: IAS 16.15 - IAS 16.28. Link 7.A: RAVENWOOD GmbH Link 7.B: OTZE AG <?page no="138"?> Berkau: Financial Statements 7e 7-138 How it is Done (Initial Asset Recognition): (1) Determine the asset to be disclosed. Check whether the recognition criteria are fulfilled. The asset must provide an economical benefit for its owner 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. (3) A company that is registered for VAT reduction must deduct input-VAT. (4) In case the company pays import duties e.g., if importing the asset from a foreign country, add import duties to the net value. Calculate target country-specific input-VAT for the new gross value payable. Deduct VAT if the importing company is registered for VAT reduction at the time of its 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 as required. (8) If an interest component applies, make a debit entry for interest. 7.7 Subsequent Valuation A subsequent valuation is any valuation following the initial one. A valuation determines the value at which the asset is carried and therefore is referred to as the carrying value. Assets that do not change in valuation e.g., land, are carried at costs always. However, many assets change their valuation due to deployment or with increasing prices. For subsequent valuations, IAS 16.29 states that a 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, like: (a) Depreciation. (b) Impairment loss. (c) Reversal of an impairment loss. A valuation based on the revaluation model in line with IAS 16.31 refers to the fair value which can be based on: (a) Current values. (b) Net realisable values. (c) Values in use. In general, revaluations apply if assets are underrated on the balance sheet. This means the fair value exceeds the <?page no="139"?> Berkau: Financial Statements 7e 7-139 value the assets are carried at. If an asset is overrated, an impairment loss is recorded based on IAS 36.8. In this section, we discuss case studies covering: depreciation, impairment loss and revaluations (in this sequence). 7.8 C/ S GELLENDORFF LLC. Below, we repeat initial valuations and thereafter study impairment losses and depreciations by the South Korean company GELLENDORFF LLC. Data Sheet for GELLENDORFF LLC. DDomicile: South Korea (Seoul). Reporting currency: KRW × 10 3 . Classification: n/ a. Acquisition of a motor vehicle at 72,000.00 tKRW. Accounting periods: 20X1 - 20X5. Depreciation: straight-line method over 5 years, residual value: 10,000.00 tKRW. On 4.04.20X4: impairment loss due to accident towards, case (i): 24,040.00 tKRW; case (ii): 19,450.00 tKRW. Repair: 8,400.00 tKRW gross amount. Evaluation after repair in case (ii): 3 months later at 24,040.00 tKRW). VAT 20 %. On 2.01.20X1, GELLENDORFF LLC buys a business car Kia Sorento and pays a gross purchase price of 72,000,000.00 KRW. KRW is the abbreviation for Korean Won. We work in 1,000s of Won, hence, our currency unit is tKRW = 1,000.00 Won. The net value is: 72,000 / 120% = 60,000.00 tKRW which is the cost of acquisition. Depreciation 68 is based on straight-line method and after its useful life of 5 years the car is expected to be sold at 10,000.00 tKRW which is today's best estimated future net selling price. IAS 16.6 defines the residual value as the net value a company would currently obtain from its disposal. Disposal costs e.g., car dealer commissions on sale, must be deducted. The initial recognition of the business car along the cost model is at 60,000.00 tKRW. DR P, P, E @cost Account........ 60,000.00 tKRW DR VAT.......................... 12,000.00 tKRW CR Cash/ Bank.................... 72,000.00 tKRW After the first Accounting period, the Kia Sorento is depreciated to an extent of 1/ 5 of its depreciable amount. The depreciable value of an asset is the expected loss in value over the entire useful life (5 years). The depreciable amount in accordance with IAS 16.6 is the cost of an asset less its residual value. Applying straight-line method, we divide the depreciable amount by the useful life. Here, the annual depreciation is: (60,000 - 10,000) / 5 = 110,000.00 tKRW/ a. The Bookkeeping entry for depreciation at GELLENDORFF LLC is shown below. Make credit entries for depreciation in the Accumulated Depreciation account: 68 Read the introduction about depreciation and learn different depreciation methods by studying our textbook Basics of Accounting, chapter (17). <?page no="140"?> Berkau: Financial Statements 7e 7-140 DR Depreciation-20X1............ 10,000.00 tKRW CR Acc. Depr.................... 10,000.00 tKRW The carrying value of the Kia Sorento as at 31.12.20X1 is: 60,000 - 10,000 = 5 50,000.00 tKRW. 7.9 Impairment Loss Besides regular depreciation, an asset’s value can drop due to an extraordinary event, like an accident. An unscheduled loss in valuation is referred to as an impairment loss. IAS 36 deals with impairment losses and rules their measurement and if applicable reversals thereof. We record an impairment loss in the period when it happens. Other reasons for impairment losses are that assets become out of fashion or are traded lower as a result of technical progress, which applies for computers frequently. 7.10 Impairment Loss - GELLENDORFF LLC. Below, we study two different cases for GELLENDORFF LLC. In case (i), its Kia Sorento is crashed and repaired immediately. In case (ii), the business car is crashed as well but the repair takes place a few months later. The cases differ regarding the depreciation that is recorded between accident and repair. It applies despite of the car not being driven for 3 months. An impairment loss is the difference in value by which a non-current asset is overrated. It is calculated as the difference between the obtainable recoverable amount (fair value) and the actual 69 For case i, all Bookkeeping entries are indicated by ‘. carrying value. The recording of an impairment loss reduces the current value towards the fair value of an asset. We make a credit entry in the Accumulated Impairment Loss account. Ad (i): Impairment Loss and Immediate Repair 69 with a Reversal of the Impairment Loss On 4.04.20X4, GELLENDORFF LLC’s business car is crashed. Depreciation before the accident is recorded as Bookkeeping entry (1’). The carrying value prior to the accident was: 60,000 - 3 × 10,000 - 2,500 = 2 27,500.00 tKRW. The repair costs 8,400.00 tKRW (gross amount) and is recorded as Bookkeeping entry (2’). After the repair, a qualified appraiser evaluates the car at 24,040.00 tKRW. The drop in valuation is the impairment loss: 27,500 - 24,040 = 3,460.00 tKRW. IAS 36.59 states that if the carrying value (actual measurement without impairment) exceeds the recoverable amount, the carrying value shall be reduced to its recoverable amount. IAS 36.6 says, a recoverable amount is the lower of the value the asset can be sold at on an active market (fair value) and its value in use, which is the total of discounted cash flows resulting from its deployment. A value in use is e.g., future and discounted rental income from property. For a normal tangible asset, we simply compare the carrying amount to the fair value derived from an estimate (from an appraiser). If the carrying value exceeds the fair value, <?page no="141"?> Berkau: Financial Statements 7e 7-141 we record an impairment loss to the extent of the excess. In case of GELLENDORFF LLC's car accident, the valuation is taken from the expert’s valuation. The company records an impairment loss to the extent of: 27,500 - 24,040 = 3 3,460.00 tKRW as Bookkeeping entry (3’), observe below. Note, that the repair of a non-current asset is irrelevant for its valuation. You must record it through profit or loss. If you drive an old VW Polo worth 8,000.00 EUR and you get involved in an accident which leads to a repair of 2,500.00 EUR (net value) for a new bumper and a new fender, your car’s value is still 8,000.00 EUR and not 10,500.00 EUR because the repair restores your car’s previous condition. DR Impairment Loss.............. 3,460.00 tKRW CR Acc. Impairment Loss......... 3,460.00 tKRW IAS 36.63 rules depreciation after an impairment loss. Depreciation shall be adjusted to the asset’s revised valuation for future periods. A residual value is to be considered for calculation of the depreciable value if it exists. A residual value must be checked e.g., a reporting company must determine, whether a motor vehicle that was previously damaged by a car accident can be sold after its useful life still at the same price as a car without damage history. An asset that is depreciated based on the time does not stop to lose value because of damages for periods not in use. Depreciation must be continued at adjusted values e.g., after recording an impairment loss. After the repair and recording of the impairment loss, depreciation for GELLENDORFF LLC's car is resumed on 10.04.20X4. Monthly depreciation now is: (24,040 - 10,000) / 21 = 6 668.57 tKRW/ m. Note, that depreciation is accurate to the month. Depreciation for the rest of the Accounting period is: 9 × 668.57 = 6 6,017.14 tKRW and is recorded as Bookkeeping entry (4’). In general, assets, like cars, machinery or buildings, are insured against damages and losses. The insurance company must pay for damages like repairs and a permanent loss in valuation. GELLENDORFF LLC insured the Kia Sorento and confirms to the insurance company its VAT registration status. The insurance refunds the damage based on net amounts as GELLENDORFF LLC receives a refund for the input-VAT on the repair from the revenue service. The payment of the insurance company covers the repair and the impairment loss. The compensation received is: 8,400/ 120% + (27,500 - 24,040) = 10,460.00 tKRW. The insurance’s payment is recorded as Bookkeeping entry (5’). Observe the accounts in Figure 7.1. DR Cash/ Bank.................... 10,460.00 tKRW CR Insurance Compensation ....... 10,460.00 tKRW <?page no="142"?> Berkau: Financial Statements 7e 7-142 D C D C OV 60,000.00 c/ d 60,000.00 OV 30,000.00 b/ d 60,000.00 (1') 2,500.00 c/ d 38,517.14 (4') 6,017.14 38,517.14 38,517.14 b/ d 38,517.14 Property, plant, equipment PPE Acc depr ACC D C D C (3') 3,460.00 c/ d 3,460.00 c/ d 3,460.00 (3') 3,460.00 b/ d 3,460.00 b/ d 3,450.00 Impairment loss-20X4 IL Acc Impairment Loss AIL D C D C (1') 2,500.00 (2') 7,000.00 c/ d 7,000.00 (4') 6,017.14 c/ d 8,517.14 b/ d 7,000.00 8,517.14 8,517.14 b/ d 8,517.14 Depreciation-20X4 DPR Repair-20X4 RPR D C D C (2') 1,400.00 c/ d 1,400.00 (5') 10,460.00 (2') 8,400.00 b/ d 1,400.00 c/ d 2,060.00 10,460.00 10,460.00 b/ d 2,060.00 Value added tax VAT Cash/ Bank C/ B D C c/ d 10,460.00 (5') 10,460.00 b/ d 10,460.00 Insurance-20X4 INS Figure 7.1: GELLENDORFF LLC’s accounts (i) How it is Done (Recording an Impairment Loss): (1) Check for overrating of the non-current asset (or group of assets) by comparing the carrying value to the recoverable amount. (2) If the carrying value exceeds the recoverable amount, calculate the difference. It is the measurement for the impairment loss. (3) Record an impairment loss as a debit entry in the Impairment Loss account and a credit entry in the Accumulated Impairment Loss account. (4) Resume depreciation with amounts based on the altered valuation. (Divide the new carrying amount less <?page no="143"?> Berkau: Financial Statements 7e 7-143 its residual value by the remainder of the useful life.) Ad (ii): Impairment Loss, Delayed Repair and Partial Reversal of an Impairment Loss 70 Next, we repeat the case of GELLENDORFF LLC but slightly alter the story. We consider the Kia Sorento is repaired 3 months after the accident. As the repair causes a decrease of the damage, GELLENDORFF LLC orders the expert to estimate the damage after the repair again and adjusts the carrying amount accordingly. This leads to a reversal of the impairment loss recorded after the accident. Reversing an impairment loss applies if the value of a non-current asset increases after an impairment loss. Here, the increase of the car’s value is caused by the repair. However, the repair is no indicator for the increase in value. Therefore, an appraiser must evaluate the car to determine its fair value. A reporting company is obliged to check changes in asset valuations for those assets that were subjected to impairment losses based on IAS 36.110. This means to check whether indications for the recognised impairment loss in prior Accounting periods are still valid. An increase of the recoverable amount must reverse or change the impairment loss following IAS 36.114. Below, we study again the business car at GELLENDORFF LLC's and rewind the case study to the point where the accident occurs. We alter the case study then regarding its timeline: the repair is postponed to 3.07.20X4. […] On 4.04.20X4, the business car is involved in a crash. Depreciation prior to the accident is recorded as Bookkeeping entry (1’’). The carrying value before the accident is: 60,000 - 3 × 10,000 - 2,500 = 227,500.00 tKRW. After the accident, the car’s value drops to 19,450.00 tKRW as estimated by the expert 71 . Hence, the impairment loss - Bookkeeping entry (2’’) is: 27,500 - 19,450 = 8 8,050.00 tKRW. It reflects the reduction of the asset’s carrying value due to the damage. We record the impairment loss on 6.04.20X4 shortly after the accident took place. The residual value of the car is not affected. DR Impairment Loss-20X4......... 8,050.00 tKRW CR Acc. Impairment Loss......... 8,050.00 tKRW Three months later, on 3.07.20X4, GELLENDORFF LLC repairs the damaged Kia Sorento and pays the penal beater 70 We mark Bookkeeping entries by ‘’. 8,400.00 tKRW (gross amount). Check Bookkeeping entry (3’’). The repair is an expense and recorded through profit or loss. 71 The damage is different to the previous case (i). <?page no="144"?> Berkau: Financial Statements 7e 7-144 DR Repair....................... 7,000.00 tKRW DR VAT ......................... 1,400.00 tKRW CR Cash/ Bank.................... 8,400.00 tKRW After the impairment loss, depreciation is resumed in April/ 20X4 and is recorded until July/ 20X4. The remaining useful life is 21 months. Monthly depreciation is: (19,450 - 10,000) / 21 = 4 450.00 tKRW/ m. GELLENDORFF LLC depreciates the business car over the next three months based on the impaired value. After that period and the repair, a new expertise is prepared. The Bookkeeping entry’s amount for 3 months of depreciation is: 3 × 450 = 1 1,350.00 tKRW. Check Bookkeeping entry (4’’). DR Depreciation-20X4............ 1,350.00 tKRW CR Acc. Depr.................... 1,350.00 tKRW GELLENDORFF LLC checks whether the recoverable amount remains after the impairment loss and the repair. It does not. The repair increased the car’s value. We apply the valuation model, because on 3.07.20X4 a qualified appraiser determines the business car’s value as 24,040.00 tKRW. The fact, that the business car’s value is 24,040.00 tKRW on 3.07.20X4 indicates an increase in value. It requires a Bookkeeping entry we refer to as reversal of impairment loss. IAS 36.109 - 36.125 apply. 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 Impairment Loss account. IAS 36.117 caps the amount of a reversal of an impairment loss to the value that would apply without prior impairment loss recognition. If the value is higher, a revaluation following IAS 16.31 must apply. We calculate the highest value of GELLENDORFF LLC’s business car in line with IAS 36.117: Without accident, the Kia Sorento’s value on 3.07.20X4 would have been: 60,000 - 3.5 × (60,000 - 10,000) / 5 = 25,000.00 tKRW. Hence, the reversal of the impairment loss is within the limits set in IAS 36.117. The valuation of 20,040.00 tKRW is below 25,000.00 tKRW. The Bookkeeping entry (5’’) is made on 10.07.20X4 with an amount of: 24,040 - (19,450 - 1,350) = 5 5,940.00 tKRW. The increase in valuation is a reversal of the impairment loss from 6.04.20X4. DR Acc Impairment Loss.......... 5,940.00 tKRW CR Impairment Loss (rev)........ 5,940.00 tKRW After recording the partial reversal of the impairment loss, GELLENDORFF LLC resumes regular depreciation. Monthly depreciation now is: (24,040 - 10,000) / 18 = 7 780.00 tKRW/ m. Bookkeeping entry <?page no="145"?> Berkau: Financial Statements 7e 7-145 (6’’) records depreciation for the remainder of the Accounting period which is: 6 × 780 = 4 4,680.00 tKRW. Next, we consider the car insurance’s compensation for GELLENDORFF LLC. IAS 16.65 requires recording compensation from third parties for P, P, E items through profit or loss when the compensation is receivable. This means once compensation is granted. It is then credited to the Profit and Loss account. The time of payment does not matter as a recording of receivables reflects the compensation already. For illustration purposes, we record the insurance compensation and study the accounts. The repair of 8,400.00 tKRW is fully covered. The insurance company pays the net amount because GELLENDORFF LLC is registered for VAT reduction and claims input-VAT from the revenue service itself. The loss in valuation is based on the recorded impairment loss and its partial reversal: 8,050 - 5,940 = 2,110.00 tKRW. GELLENDORFF LLC receives a compensation of: 8,400/ 120% + 2,110 = 9 9,110.00 tKRW from its insurance company recorded as Bookkeeping entry (7’’). The Insurance-20X4 account is closed-off to the Profit and Loss account. GELLENDORFF LLC is left with: 9,110 - 8,400 = 7 710.00 tKRW on cash and a repaired but impaired car. We add the input-VAT claim to the cash difference: 710 + 1,400 = 2 2,110.00 tKRW. Hence, cash received from the insurance fully covers the loss in value and the repair. The regulations in IAS 16.65 result in a zero-sum game because the impairment loss, the repair and the compensation are recorded through profit or loss. Study the accounts in Figure 7.2. D C D C OV 60,000.00 c/ d 60,000.00 OV 30,000.00 b/ d 60,000.00 (1'') 2,500.00 (4'') 1,350.00 c/ d 38,530.00 (6'') 4,680.00 38,530.00 38,530.00 b/ d 38,530.00 Property, plant, equipment PPE Acc depr ACC D C D C (2'') 8,050.00 (5'') 5,940.00 (5'') 5,940.00 (2'') 8,050.00 c/ d 2,110.00 c/ d 2,110.00 8,050.00 8,050.00 8,050.00 8,050.00 b/ d 2,110.00 b/ d 2,110.00 Impairment loss-20X4 IL Acc Impairment Loss AIL Figure 7.2: GELLENDORFF LLC’s accounts (ii) <?page no="146"?> Berkau: Financial Statements 7e 7-146 D C D C (1'') 2,500.00 (3'') 7,000.00 c/ d 7,000.00 (4'') 1,350.00 b/ d 7,000.00 (6'') 4,680.00 c/ d 8,530.00 8,530.00 8,530.00 b/ d 8,530.00 Depreciation-20X4 DPR Repair-20X4 RPR D C D C (3'') 1,400.00 c/ d 1,400.00 (7'') 9,110.00 (3'') 8,400.00 b/ d 1,400.00 c/ d c/ d 710.00 9,110.00 9,110.00 b/ d 710.00 Value added tax VAT Cash/ Bank C/ B D C c/ d 9,110.00 (7'') 9,110.00 b/ d 9,110.00 Insurance-20X4 INS Figure 7.2: GELLENDORFF LLC's accounts (ii) continued How it is Done (Reversing an Impairment Loss): (1) After recording an impairment loss, monitor the valuation of the previously impaired asset. (2) Determine the fair value of the asset as the recoverable amount. (3) In case the asset is underrated, check how much the valuation of the asset would have been without impairment loss recorded in prior Accounting periods. This value is the maximum for reversing the impairment loss. Note, that a repair can trigger the reversal of an impairment loss, but its value does not determine its amount. (4) Reverse the impairment loss to its recoverable amount but do not exceed the limit of valuation. Record a debit entry in the Accumulated Impairment Loss account and a credit entry in the Impairment Loss account. (5) Close-off the Impairment Loss account to the Profit and Loss account at the end of the Accounting period. 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. We show these statements for GELLENDORFF LLC in Figure 7.3 and Figure 7.4 linked to case (ii): <?page no="147"?> Berkau: Financial Statements 7e 7-147 Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount [tKRW] [tKRW] [tKRW] [tKRW] Kia Sorento 60,000 (38,530) (2,110) 19,360 . . . Gellendorff LLC REGISTER of NON-CURRENT ASSETS as at 31.12.20X4 Figure 7.3: GELLENDORFF LLC’s register of non-current assets 20X4 20X3 [tKRW] [tKRW] OV as at 1.01. 30,000 40,000 Depreciation (7,180) (10,000) Adjusted depreciation (1,350) Impairment loss (8,050) Reversal impairment loss 5,940 Revaluation Value at 31.12. 19,360 30,000 Gellendorff LLC P, P, E-RECONCILIATION STATEMENT as at 31.12.20X4 Figure 7.4: GELLENDORFF LLC’s asset-reconciliation statement We recommend studying the case study OBSERVATRY Ltd. in task A7.40. 72 If declining method for depreciation applies and an impairment loss is reversed, we must check in an extra working whether a revaluation applies or the changes in valuation only result in a reversal of an impairment loss. IAS 36.117 applies. A reversal of an impairment loss is recorded through profit or loss. Any valuation that exceeds the valuation based on regular 72 You will find the task in the study material portal linked to this textbook. depreciation leads to a revaluation and results in a revaluation reserve on the equity section. If a revaluation follows an impairment loss, a company must determine which portion exceeds the reversal of an impairment loss and counts for revaluation. The case GROOTVLEI Ltd. covers declining method and reversing of a prior impairment loss. Check case study GROOTVLEI Ltd. that is accessible online through Link 7.C. <?page no="148"?> Berkau: Financial Statements 7e 7-148 Link 7.C: GROOTVLEI Ltd. If a reporting company changes depreciation parameters or the method of depreciation IAS 8.22 and IAS 1.10 require disclosing changes as if made one Accounting period prior to the reporting period to adjust the comparative information following IAS 1.38. Study as an example for altered depreciation parameters case study TYGERVALLEY Ltd. IAS 8 applies. Link 7.D: TYGERVALLEY Ltd. 7.11 Revaluations Revaluations are recorded if a non-current asset’s value exceeds its carrying value. The situation is the opposite of an impairment loss. Now, the carrying value indicates an underrated non-current asset. Revaluations are always subsequent valuations. Even if a company buys an asset below its fair value, a so called lucky-buy, it must recognise the asset at costs. The first revaluation can take place on the next following balance sheet date. As example for the application of the revaluation model, we study below a welding machine of TINNEN K.K. in Japan. The company’s currency unit is Japanese Yen (JPY). Tax rates apply as disclosed in chapter (1). The total income taxes are amounting to 30 % based on the pre-tax profit. Income taxes are relevant, as deferred taxes apply for revalued assets. 7.12 C/ S TINNEN K.K. In contrast to other case studies, we first describe the calculations, show how-it-is-done-paragraphs and thereafter explain the concept by referring to the calculations in the case study. Data Sheet for TINNEN K.K. DDomicile: Japan (Tokyo). Reporting currency: JPY. Classification: Manufacturing. Accounting periods: 20X3 - 20X4. Item of property, plant and equipment: welding machine. Cost of acquisition: 800,000.00 JPY on 2.01.20X3. Depreciation: declining method at 1.67 %/ m. Revaluation at 1.07.20X4: 750,000.00 JPY. In both Accounting periods: other revenue: 1,400,000.00 JPY and other expenses: 600,000.00 JPY. VAT 20 %. On 2.01.20X3, TINNEN K.K. buys a welding machine at 800,000.00 JPY (net amount). The useful life of the welding machine is 5 years and declining method <?page no="149"?> Berkau: Financial Statements 7e 7-149 applies for depreciation. The depreciation rate is 1.67%/ m. 73 We record the acquisition and depreciation for the Accounting period 20X3. The paid acquisition price is the gross value: 800,000 × 120% = 9 960,000.00 JPY. TINNEN K.K. pays the total price instantly. Check Bookkeeping entry (1). DR P, P, E @COST ............... 800,000.00 JPY DR VAT.......................... 160,000.00 JPY CR Cash/ Bank.................... 960,000.00 JPY Depreciation following declining method is easy to calculate if we determine the carrying value directly. At the end of the year, it is: 800,000 × (1 - 1.67%) 12 = 653,615.67 JPY. The difference between the carrying value on 31.12.20X4 and the cost of acquisition is the annual depreciation. Depreciation here is: 800,000 - 653,615.67 = 1 146,384.33 JPY/ a. The depreciation is recorded as Bookkeeping entry (2). How it is Done (Declining Method): (1) Determine the depreciable amount. It is the cost of acquisition less residual value. (2) Calculate the depreciation rate r applicable for the Accounting period e.g., the monthly or annual depreciation rate. (3) Determine the periods of depreciation e.g., x months. (4) Calculate the carrying value as at the end of the depreciation period by multiplying the actual carrying value with the factor (1 r) x . (5) In order to calculate depreciation, deduct the new carrying value from the previous one. (6) Make a debit entry in the Depreciation account and a credit entry for accumulated depreciation. Besides of depreciation, TINNEN K.K. records operational expenses (3) to the extent of 600,000.00 JPY (non-VATable) and earns a revenue (4) of 1,400,000.00 JPY. Observe the profit calculation in Figure 7.5. TINNEN K.K. carries its profit forward to the next Accounting period 20X4. 73 Read our textbook Basics of Accounting, chapter (17). In the next year, on 1.07.20X4, a qualified appraiser estimates the welding machine’s value to be 750,000.00 JPY. At first, we check at which value the welding machine is carried on 30.06.20X4 which is before the revaluation takes place: 653,615.67 × (1 - 1.67%) 6 = 5590,797.56 JPY. Hence, the value estimated by the appraiser exceeds the carrying amount and results in a revaluation in compliance with IAS <?page no="150"?> Berkau: Financial Statements 7e 7-150 16.31. The estimate of the qualified appraiser is considered as reliable measurement for the fair value of the welding machine. Next, we study the Bookkeeping entries for revaluations. A revaluation Bookkeeping entry is like recording replacements. In terms of Accounting, a replacement is a procedure for major parts of an assets being exchanged e.g., the engines of an aircraft. For that reason, we call Bookkeeping entries recorded for revaluations replacement Bookkeeping entries. Follow our QR code for studying ordinary replacement Bookkeeping entries for the case study CORAL Ltd. Link 7.E: CORAL Ltd. In contrast to a replacement Bookkeeping entry, we only virtually replace the (entire) asset by its revaluated asset. Hence, we do not increase figures for the asset’s carrying value, but we remove the asset that is carried at costs and replace it by the revalued one in our books. To distinguish the valuations, we indicate the valuation by a suffix added to the account name: @VALUATION. We apply the P, P, E @COST account for assets measured following the cost model and a P, P, E @(RE)VALU- ATION account for assets carried at fair values based on the revaluation model. Note, we also make that distinction on the register of non-current assets. Assets are either carried at costs or at valuation. Consequently, a revalued asset does not show its acquisition date but the date when the revaluation took place. This becomes relevant for currency exchange rates. There are two alternative methods for revaluations: net replacement method and gross replacement method. In general, a net replacement method applies if an appraiser estimates the fair value for a non-current asset. The revaluation is then recorded at the time of the (re)valuation. In contrast, the gross replacement method applies if the revaluation is based on an increase of prices for the same kind of assets which pulls the revaluation forward to the time of acquisition. In the case study TINNEN K.K., the net replacement method applies; however, we provide you with a link to the gross replacement method at the end of the case study, so you can study both methods and compare them. Before the revaluation of the welding machine, TINNEN K.K. records depreciation for the period from 1.01.20X4 until 30.06.20X4: Depreciation is: 653,615.67 - 590,797.56 = 6 62,818.11 JPY. We use capital letters for Bookkeeping entry identification. Depreciation is recorded as Bookkeeping entry (C). Next, we record the (virtual) replacement of the asset following its increase in value. The increase of the machine’s value is: 750,000 - 590,797.56 = 159,202.44 JPY. <?page no="151"?> Berkau: Financial Statements 7e 7-151 The Bookkeeping entry (R) 74 is shown below. Note, that the difference in valuation always is recorded in the Revaluation Reserves account at first. DR P, P, E @VALUATION .......... 750,000.00 JPY DR Acc. Depr.................... 209,202.44 JPY CR P, P, E @COST................ 800,000.00 JPY CR Revaluation Reserves......... 159,202.44 JPY Following the revaluation, the revalued asset increases the item property, plant and equipment on der debit side of the balance sheet as well as creates a revaluation reserve on the credit side to the same extent. No profit or loss is recorded. Revaluations are not permitted on financial statements for taxation. Those follow national tax law. This leads to a different asset valuation between the IFRSbalance sheet and the one for taxation. From the point of view of the income tax law, an immediate sale of the welding machine after its revaluation leads to a taxable profit of: 750,000.00 - 590,797.56 = 1 159,202.44 JPY as this is the difference between the best estimate for the net selling price (fair value) and the carrying value on the balance sheet for taxation. Hence, TINNEN K.K. has the potential to sell the machine above the carrying value. 750,000.00 JPY is the fair value; therefore, it is the net selling price most likely obtainable by selling the welding machine. This value is referred to as the recoverable amount. Regarding our simplified tax model, the profit of an immediate sale of the welding machine results in income taxes of: 159,202.44 × 30% = 4 47,760.73 JPY. IAS 12 deals with income tax recognition. In compliance with IAS 12.20, TINNEN K.K. must recognise the income taxes resulting from a revaluation and followed by an immediate disposal as a deferred tax liability. The potential of earning a profit on disposal determines the deferred tax liabilities. The Bookkeeping entry is directly linked to the revaluation; therefore, we indicate it by (R’). DR Revaluation Reserves......... 47,760.73 JPY CR Deferred Tax Liabilities..... 47,760.73 JPY The deferred tax liabilities are recorded as a liability based on IAS 12.15. To get the full picture, study the accounts in Figure 7.5. 74 R = Revaluation. When a revaluated asset is depreciated, the revaluation reserves and the deferred taxes are proportionally closedoff to the Retained Earnings account. Regarding the case study TINNEN K.K., we look at the second half of the <?page no="152"?> Berkau: Financial Statements 7e 7-152 Accounting period 20X4, when the welding machine is depreciated: TINNEN K.K. depreciates the welding machine after revaluation. Depreciation is based on the new carrying value of 750,000.00 JPY. Hence, depreciation for the months July/ 20X4 until December/ 20X4 is: 750,000 - 750,000 × (1 - 1.67%) 6 = 772,081.48 JPY. The percentage of depreciation based on the depreciable amount is: 72,081.48 / 750,000 = 99.61%. Therefore, TINNEN K.K. dissolves 9.61 % of the deferred tax liabilities: 9.61% × 47,760.73 = 4 4,590.22 JPY and of the initially recorded revaluation reserves: 9.61% × 159,202.44 = 15,300.73 JPY. The Bookkeeping entries (D’) and (D’’) are based on IAS 16.41 and are shown below. DR Deferred Tax Liabilities..... 4,590.22 JPY CR Revaluation Reserves......... 4,590.22 JPY DR Revaluation Reserves......... 15,300.73 JPY CR Retained Earnings............ 15,300.73 JPY Next, we calculate the earnings before taxation at TINNEN K.K. In 20X4, the operating expenses and the revenue are the same as in 20X3. The net profit in 20X4 is: 1,400,000 - 134,899.59 - 600,000 = 6 655,100.41 JPY. It considers depreciation of the revalued welding machine as expenses to the extent of 134,899.59 JPY. We here follow our simplified tax calculation which is based on the total income tax rate of 30 % the EBT is multiplied with. In the case of TINNEN K.K., the tax calculation is based on an asset valuation at costs (cost model). Therefore, the depreciation for the tax calculation deviates from depreciation following IFRSs. At TINNEN K.K., the tax-depreciation is: 653,615.67 - 653,615.67 × (1 - 1.67%) 12 = 1119,598.86 JPY. The income tax calculation gives: (1,400,000 - 119,598.86 - 600,000) × 30% = 2 204,120.34 JPY. The income taxes are transferred to the IFRSs financial statements which means we copy them from the Tax-Profit and Loss account into the IFRS-Profit and Loss account. The copied income tax expenses appear as too high in comparison to the profit calculation based on IFRSs. This means that EBT IFRS multiplied by 30 % gives lower income tax expenses of: 665,100.41 × 30% = 1 199,530.12 JPY. The difference in tax calculation to the extent of: 204,120.34 - 665,100.41 × 30% = 44,590.22 JPY is recorded as deferred tax income, which is deducted from actual tax expenses but not paid back by the revenue service. It is based on temporarily too high income taxes as copied from the tax calculations. The deferred tax income compensates prior with the revaluation recorded deferred tax liabilities. Those are dissolved through profit realisation either by (here) depreciation or disposal. The contra entry is in the Retained Earnings account shown as Bookkeeping entry (G). <?page no="153"?> Berkau: Financial Statements 7e 7-153 D C D C (4) 1,680,000.00 (1) 960,000.00 (2) 146,384.33 P3L 146,384.33 (3) 600,000.00 c/ d 120,000.00 1,680,000.00 1,680,000.00 b/ d 120,000.00 (A) 196,084.70 (F) 1,680,000.00 (B) 120,000.00 (E) 600,000.00 c/ d 883,915.30 1,800,000.00 1,800,000.00 b/ d 883,915.30 Cash/ Bank C/ B Depreciation-20X3 DPR D C D C c/ d 146,384.33 (2) 146,384.33 (3) 600,000.00 P3L 600,000.00 (R) 209,202.44 b/ d 146,384.33 (C) 62,818.11 209,202.44 209,202.44 c/ d 72,081.48 (D) 72,081.48 b/ d 72,081.48 Acc depr ACC Operational expenses-20X3 OEX D C D C (1) 800,000.00 c/ d 800,000.00 (1) 160,000.00 (4) 280,000.00 b/ d 800,000.00 (R) 800,000.00 c/ d 120,000.00 280,000.00 280,000.00 (B) 120,000.00 b/ d 120,000.00 c/ d 280,000.00 (F) 280,000.00 400,000.00 400,000.00 b/ d 280,000.00 PPE @COST Value added tax VAT D C D C P3L 1,400,000.00 (4) 1,400,000.00 DPR 146,384.33 REV 1,400,000.00 OEP 600,000.00 NP3 653,615.67 1,400,000.00 1,400,000.00 ITL 196,084.70 b/ d 653,615.67 R/ E 457,530.97 653,615.67 653,615.67 Revenue-20X3 REV Profit and Loss-20X3 P3L Figure 7.5: TINNEN K.K.’s accounts (20X4) <?page no="154"?> Berkau: Financial Statements 7e 7-154 D C D C c/ d 196,084.70 P3L 196,084.70 c/ d 457,530.97 P3L 457,530.97 (A) 196,084.70 b/ d 196,084.70 (G) 4,590.22 b/ d 457,530.97 c/ d 204,120.34 ITL 204,120.34 (D'') 15,300.73 400,205.04 400,205.04 c/ d 933,811.77 P4L 465,570.29 b/ d 204,205.34 938,401.99 938,401.99 b/ d 933,811.77 Income tax liabilities ITL Retained earnings R/ E D C D C (C) 62,818.11 (R) 750,000.00 c/ d 750,000.00 (D) 72,081.48 c/ d 134,899.59 b/ d 750,000.00 134,899.59 134,899.59 b/ d 134,899.59 P4L 134,899.59 Depreciation-20X4 DPR PPE @VALUATION D C D C (R') 47,760.73 (R) 159,202.44 (D') 4,590.22 (R') 47,760.73 (D'') 15,300.73 (D') 4,590.22 c/ d 43,170.51 c/ d 100,731.20 47,760.73 47,760.73 163,792.66 163,792.66 b/ d 43,170.51 b/ d 100,731.20 Revaluation reserves R-R Deferred tax liabilities DTL D C D C (E) 600,000.00 P4L 600,000.00 P4L 1,400,000.00 (F) 1,400,000.00 Operational expenses-20X4 OEX Revenue-20X4 REV D C D C DPR 134,899.59 REV 1,400,000.00 DPR 119,598.86 REV 1,400,000.00 OEX 600,000.00 OEX 600,000.00 NP4 665,100.41 NP4 680,401.14 1,400,000.00 1,400,000.00 1,400,000.00 1,400,000.00 ITL 204,120.34 b/ d 665,100.41 ITL 204,120.34 b/ d 680,401.14 R/ E 465,570.29 (G) 4,590.22 R/ E 476,280.80 669,690.63 669,690.63 680,401.14 680,401.14 Profit and Loss-20X4 P4L Tax-Profit and Loss-20X4 P4L Figure 7.5: TINNEN K.K.’s accounts (20X4) continued Before we discuss tax deferrals, we summarise revaluations by a How-itis-Done-paragraph. For the Bookkeeping entries, we consider you apply one P, P, E account per asset. Carrying items of property, plant and equipment in separate accounts is called Asset Management. <?page no="155"?> Berkau: Financial Statements 7e 7-155 How it is Done (Revaluations, Net Replacement Method): (1) Determine the fair value e.g., by an expertise. (2) Create a new P, P, E @VALUATION account and enter the new value on the debit side. (3) Make a credit entry in the previous P, P, E @COST account to close it off. (4) Close-off the Accumulated Depreciation account by making a debit entry. (5) If the revaluation follows an impairment loss close-off the Accumulated impairment loss after reversing the impairment loss completely through profit or loss. (6) Record the difference in valuation on the credit side of the Revaluation Reserves account. (7) As the national tax law prohibits revaluations, deduct the 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 IFRS values. Depreciation is based on the revalued amount. (2) Make a debit entry in the Depreciation account and credit the amount to 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 by making a debit entry in the Deferred Tax Liability account and a credit entry in the Revaluation Reserves account. (5) Dissolve the same percentage of the ordinary revaluation reserves by debiting the Revaluation Reserves account and making a credit entry in the Retained Earnings account. (6) Calculate earnings before taxes following IFRSs. (7) Calculate earnings before taxes by following national tax law and determine income tax expenses. (8) Copy the income tax expenses into the IFRS-Profit and Loss account. (9) As the income taxes exceed the EBT IFRS × 30% tax calculation, determine the difference and deduct it from the income taxes. (10) Calculate the annual surplus (EAT) and transfer it to equity. (11) Make a Bookkeeping entry for the deferred tax income as credit entry in the Profit and Loss account and a debit entry in the Retained Earnings account. <?page no="156"?> Berkau: Financial Statements 7e 7-156 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 recording and dissolving deferred tax liabilities and revaluation reserves. Revaluations and deferred taxes are only recorded on financial statements following IFRSs. A revaluation is not recorded through profit or loss. A company like TINNEN K.K. that revalues its non-current asset does not realise profit, but it increases its equity to the same extent as its assets increase in value. A profit only is realised once the asset is sold - therefore we call the account for disposals the Realisation account, or when it is depreciated completely. Following IAS 12.15, a deferred tax liability must be recognised for all taxable, temporary differences. In the case of TINNEN K.K. taxable differences result from the revaluation and from increased depreciation in the periods following the revaluation. The difference is temporary because the revaluation is dissolved by depreciation. For the measurement of deferred taxes IAS 12.51 applies. We calculate with a standard income tax rate of 30 %. When we revalue TINNEN K.K.'s welding machine, both sides of the balance sheet increase by 159,202.44 JPY. On its credit side, the revaluation reserves are: 159,202.44 - 47,760.73 = 111,441.71 JPY and the deferred tax liabilities are: 159,202.44 × 30% = 47,760.73 JPY. To realise a profit a company must either (1) sell the asset or (2) depreciate it. (1) Selling the welding machine at its time of revaluation at its fair value (= 750,000.00 JPY) results in a zero profit regarding its commercial financial statements and as a profit on disposal of: 750,000 - 590,797.56 = 159,202.44 JPY for taxation. The income taxes on the disposal are: 30% × 159,202.44 = 47,760.73 JPY. As the company disclosed deferred taxes of 47,760.73 JPY, it must dissolve them with the sale and add them to revaluation reserves. It further must dissolve the revaluation reserves to its full extent of: 111,441.71 + 47,760.73 = 159,202.44 JPY. This amount is transferred to retained earnings and becomes distributable to the owners. At the same time, the profit after taxes is 111,441.71 JPY higher and a deferred tax income of 47,760.73 JPY is added to the Retained Earnings account on the debit side. Consequently, the TINNEN K.K.’s shareholders are entitled to receive a dividend of: 159,202.44 - 47,760.73 = 111,441.71 JPY in total, which is the profit on disposal after taxation. (2) If the company depreciates the asset to an extent - like TINNEN K.K. - of 72,091.48 JPY which is 9.61 % of the new value, it dissolves its deferred tax liabilities and revaluation reserves to the same percentage. This leads to 4,590.22 JPY deferred taxes added to the revaluation reserves and to dissolving 15,300.73 JPY revaluation reserves at the end of the Accounting period. Dissolving revaluation reserves means to add them to retained earnings. This way, 15,300.73 JPY become distributable to shareholders. At the same time, a profit difference applies because depreciation of the revalued machine is <?page no="157"?> Berkau: Financial Statements 7e 7-157 higher than depreciation for tax purposes. In case of TINNEN K.K., 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 JPY. The difference in depreciation leads to the same difference in profits: 680,401.14 - 665,100.41 = 15,300.73 JPY and causes a tax difference of: 15,300.73 × 30% = 4,590.22 JPY. We call this difference a deferred tax income as it is the difference between a tax calculation following IFRSs 665,100.41 × 30% = 199,530.12 JPY and the actual income taxes of 204,120.34 JPY. The difference of: 204,120.34 - 199,530.12 = 4,590.22 JPY is caused by higher depreciation on the welding machine. As its contra entry is recorded on the debit side of the Retained Earnings account, it reduces the dissolved revaluation reserves. We could say, we deduct the tax implication from the revaluation reserves and determine the distributable portion of the depreciation for the revalued welding machine as: 15,300.73 - 4,590.22 = 10,710.51 JPY. This is a partial (9.61 %) realisation of the revaluation of the welding machine. To cross-check our calculation, we multiply the distributable amount for TINNEN K.K.’s owners as discussed for the sale (1) with the percentage of depreciation: 111,441.71 × 9.61 % = 10,710.51 JPY. 75 If an asset got a residual value, the above shown Bookkeeping entries lead to a remainder of the revaluation reserves. They are then dissolved only at the time of disposal. This way, the 75 We replace 9.61 % with the exact value of 72,081.48 / 750,000 = 9,610864%. equality of retained earnings following IFRSs and tax law only is fulfilled after the asset has been written-off completely or after its disposal. We recommend limiting the calculation of the percentage of depreciation to the depreciable amount. This dissolves revaluation reserves completely with the depreciation. We explain this procedure below for the case study STEENBERG Ltd. In case (i) we dissolve revaluation reserves as recommended: The percentage base is the depreciable value. In case (ii), we calculate the percentage based on the complete revalued asset. We show, that in case (ii) retained earnings will differ over the useful life. 7.13 C/ S STEENBERG Ltd. - Case (i) The company STEENBERG Ltd. has a business car VW Up. The car's costs of acquisition are 12,000.00 EUR on 1.07.20X8. Depreciation is following straight line method over a useful life of 5 years. A residual value of 2,400.00 EUR applies. On 1.03.20X9, the car is revalued. Its new value is 11,500.00 EUR. Following IFRSs, depreciation in 20X9 is: 320 + 10 × (11,500 - 2,400)/ (60 - 6 - 2) = 22,070.00 EUR. The revaluation reserves are: 11,500 - (12,000 - 960 - 320) = 7 780.00 EUR. STEENBERG Ltd. must transfer 30 % thereof to deferred tax liabilities, which is: 30% × 780 = 2 234.00 EUR. Excluding the residual value, the percentage of depreciation (after 1.03.20X9) is: 1,750 / (11,500 - 2,400) = <?page no="158"?> Berkau: Financial Statements 7e 7-158 119.23 %. When STEENBERG Ltd. depreciates its asset, it dissolves 19.23 % of the revaluation reserves and deferred taxes. This results in dissolving revaluation reserves of: 19.23% × 780 = 1 150.00 EUR. 76 Check below the accounts for case (i). D C D C OV 12,000.00 (R) 12,000.00 OV 960.00 c/ d 1,280.00 DPR 320.00 1,280.00 1,280.00 (R) 1,280.00 b/ d 1,280.00 P, P, E-Up @cost [1.07.20X8] PPC Accumulated depreciation ACC D C D C (R) 11,500.00 c/ d 11,500.00 (R2) 234.00 (R) 780.00 b/ d 11,500.00 c/ d 546.00 780.00 780.00 R/ E 150.00 b/ d 546.00 c/ d 441.00 DTL 45.00 591.00 591.00 b/ d 441.00 P, P, E-UP @ VALUATION PPV Revaluation reserves account RR D C D C c/ d 1,750.00 1,750.00 RR 45.00 (R2) 234.00 b/ d 1,750.00 c/ d 189.00 234.00 234.00 0.1522 b/ d 189.00 Accumulated depreciation AC2 Deferred tax liabilities D C D C DTI 13.50 RR 150.00 DPR 320.00 REV 25,000.00 c/ d 16,156.00 P8L 16,019.50 DPR 1,750.00 16,169.50 16,169.50 EBT 22,930.00 b/ d 16,156.00 25,000.00 25,000.00 ITL 6,924.00 b/ d 22,930.00 R/ E 16,019.50 DTI 13.50 22,943.50 22,943.50 Retained earnings R/ E IFRS-Profit and Loss-20X8 P8L D C D C DPR 1,920.00 REV 25,000.00 c/ d 6,924.00 PTL 6,924.00 EBT 23,080.00 b/ d 6,924.00 25,000.00 25,000.00 ITL 6,924.00 b/ d 23,080.00 R/ E 16,156.00 TAX-Profit and Loss-20X8 PTL Income tax liabilities ITL Figure 7.6: STEENBERG Ltd. accounts (i) 76 To avoid rounding adjustments, we replace the percentage by: 1,750 / 9,100. <?page no="159"?> Berkau: Financial Statements 7e 7-159 In Figure 7.6, we calculate the deferred tax income: For the profit calculation, we randomly pick a cash revenue of 25,000.00 EUR. It must be high enough to cause a taxable profit. We calculate income tax expenses of: 30% × (25,000 - (12,000 - 2,400)/ 5) = 6 6,924.00 EUR. The deferred tax income then is: 30% × (30% × (25,000 - 2,070) - 6,924) = 1 13.50 EUR. The annual surplus is calculated in the IFRS-Profit and Loss account: (25,000 - 2,070) + 13.50 - 6,924 = 1 16,019.50 EUR. As retained earnings increase by annual surplus and dissolved revaluation reserves and decrease by deferred tax income, the increase in retained earnings on the IFRS balance sheet is in total: 16,019.50 + 150 - 13.50 = 1 16,156.00 EUR. The equity increase on the tax balance sheet is the same: (1 - 30%) × (25,000 - (12,000 - 2,400)/ 5) = 1 16,156.00 EUR. This equality of changes in retained earnings allows us to check our Bookkeeping entries. The equity increases are colour-marked in Figure 7.6. However, this does not work, if we allocate revaluation reserves to residual values. We demonstrate the same case study as case (ii) below. 7.14 C/ S STEENBERG Ltd. - Case (ii) Next, we base the percentage of depreciation and of dissolving revaluation reserves on the entire asset value, instead of its depreciable value. The percentage in case (ii) is: 1,750 / 11,500 = 1 15.22% 77 . In case (ii), the dissolved deferred tax liabilities and the dissolved revaluations are lower. However, the profit calculation does not change; therefore, the deferred tax income remains the same. The lower dissolved revaluation reserves show in the Retained Earnings account. Now, retained earnings following IFRSs are 16,124.70 EUR and retained earnings following the tax law is still 16,156.00 EUR. Check the accounts in Figure 7.7. An equality of retained earnings will only exists after complete depreciation and after the remainder of the revaluation reserves and deferred tax liabilities have been dissolved. This is, why we recommend basing the percentage for dissolving revaluation reserves and deferred tax income on the distributable amount only. However, in compliance with IFRSs, both cases (i) and (ii) are valid. D C D C OV 12,000.00 (R) 12,000.00 OV 960.00 c/ d 1,280.00 DPR 320.00 1,280.00 1,280.00 (R) 1,280.00 b/ d 1,280.00 P, P, E-Up @cost [1.07.20X8] PPC Accumulated depreciation ACC Figure 7.7: STEENBERG Ltd.'s accounts (ii) 77 For our calculations, we apply the fraction instead of the rounded percentage. <?page no="160"?> Berkau: Financial Statements 7e 7-160 D C D C (R) 11,500.00 c/ d 11,500.00 (R2) 234.00 (R) 780.00 b/ d 11,500.00 c/ d 546.00 780.00 780.00 R/ E 118.70 b/ d 546.00 c/ d 462.91 DTL 35.61 581.61 581.61 b/ d 462.91 P, P, E-UP @ VALUATION PPV Revaluation reserves account RR D C D C c/ d 1,750.00 1,750.00 RR 35.61 (R2) 234.00 b/ d 1,750.00 c/ d 198.39 234.00 234.00 0.1522 b/ d 198.39 Accumulated depreciation AC2 Deferred tax liabilities D C D C DTI 13.50 RR 118.70 DPR 320.00 REV 25,000.00 c/ d 16,124.70 P8L 16,019.50 DPR 1,750.00 16,138.20 16,138.20 EBT 22,930.00 b/ d 16,124.70 25,000.00 25,000.00 ITL 6,924.00 b/ d 22,930.00 R/ E 16,019.50 DTI 13.50 22,943.50 22,943.50 Retained earnings R/ E IFRS-Profit and Loss-20X8 P8L D C D C DPR 1,920.00 REV 25,000.00 c/ d 6,924.00 PTL 6,924.00 EBT 23,080.00 b/ d 6,924.00 25,000.00 25,000.00 ITL 6,924.00 b/ d 23,080.00 R/ E 16,156.00 TAX-Profit and Loss-20X8 PTL Income tax liabilities ITL Figure 7.7: STEENBERG Ltd.’s accounts (ii) continued An alternative to the net replacement method is the gross replacement method. It applies in cases if the revaluation is caused by an increase in costs of acquisition. Follow below the Link 7.F to the case study JANSSENS Ltd. Link 7.F: JANSSENS Ltd. <?page no="161"?> Berkau: Financial Statements 7e 7-161 7.15 Disposal of Assets The disposal of an asset is recorded through the Realisation account. 78 In case an item of property, plant and equipment is disposed after prior revaluation, we must dissolve the revaluation reserves and deferred tax liabilities completely. Only the disposal proceeds and the carrying value (Property, Plant and Equipment account, Accumulated Depreciation account and Accumulated Impairment Loss account) are closed-off to the Realisation account. 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 is more appropriate. IAS 16.67 states, that a de-recognition must be recorded for a disposal or if no further benefits are expected from the asset. A profit (referred to as a gain) or loss on disposal are to be added to the Profit and Loss account based on IAS 16.68. A gain on disposal of non-current assets should not be considered a revenue. The distinction made is to not mix gains on disposals with revenues that result from core operations of the company. 7.16 C/ S YSTERFONTEIN Ltd. We study the case of YSTERFONTEIN Ltd. YSTER- FONTEIN Ltd. is a construction company in Johannesburg. Data Sheet for YSTERFONTEIN Ltd. DDomicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Construction. Accounting period: 20X1 - 20X6. Plot: 300 m 2 ; cost of acquisition 225,000.00 ZAR plus conveyancing fees 50,000.00 ZAR. Revaluation to 3,000.00 ZAR/ m 2 . Sale on 30.11.20X6 at 1,000,000.00 ZAR. VAT n/ a. On 4.01.20X1, YSTERFONTEIN Ltd. buys a plot of 300 m 2 intended for the use as parking lot for its business cars and construction vehicles. The purchase price is 225,000.00 ZAR. For conveyancing, YSTERFONTEIN Ltd. pays 50,000.00 ZAR. 79 The total costs of acquisition are: 225,000 + 50,000 = 2 275,000.00 ZAR. On 5.07.20X5, the municipality declares the land which includes YSTERFONTEIN Ltd.’s parking lot an industrial zone and, therefore, the property price goes up to 3,000.00 ZAR/ m 2 . YSTERFONTEIN Ltd. revaluates its parking lot. The new value is: 300 × 3,000 + 50,000 = 9 950,000.00 ZAR. The costs for conveyancing are still included in the property valuation. The Bookkeeping entry for the revaluation is disclosed below: DR P, P, E @VALUATION ........... 950,000.00 ZAR CR P, P, E @COST................ 275,000.00 ZAR CR Revaluation Reserves......... 675,000.00 ZAR 78 Read our Basics of Accounting, chapters (34) and (35). 79 In South Africa, no acquisition tax for property applies. <?page no="162"?> Berkau: Financial Statements 7e 7-162 DR Revaluation Reserves......... 202,500.00 ZAR CR Deferred Tax Liabilities..... 202,500.00 ZAR On 30.11.20X6, YSTERFONTEIN Ltd. sells the plot to a neighbour at 1,000,000.00 ZAR. The sale of the plot is transferred by the attorney Dr BOKPUNT. After the deal, YSTERFONTEIN Ltd. receives the selling price per bank transfer. The Bookkeeping entries are made through the Realisation account. YSTERFONTEIN Ltd. makes the Bookkeeping entries as below: DR Deferred Tax Liabilities..... 202,500.00 ZAR CR Revaluation Reserves......... 202,500.00 ZAR DR Revaluation Reserves......... 675,000.00 ZAR CR Retained Earnings............ 675,000.00 ZAR DR Cash/ Bank.................... 1,000,000.00 ZAR CR Realisation.................. 1,000,000.00 ZAR DR Realisation.................. 950,000.00 ZAR CR P, P, E @VALUATION........... 950,000.00 ZAR Check YSTERFONTEIN Ltd.’s accounts which only contain business activities regarding the plot (simplification). D C D C OV 950,000.00 (4) 950,000.00 OV 472,500.00 (2) 675,000.00 (1) 202,500.00 675,000.00 675,000.00 PPE @VALUATION Revaluation Reserves R-R D C D C (1) 202,500.00 OV 202,500.00 DTI 202,500.00 (2) 675,000.00 c/ d 507,500.00 P&L 35,000.00 710,000.00 710,000.00 b/ d 507,500.00 Deferred tax liabilities DTL Retained earnings R/ E D C D C (4) 950,000.00 (3) 1,000,000.00 (3) 1,000,000.00 . . . (5) 50,000.00 1,000,000.00 1,000,000.00 Realisation-20X6 REA Cash/ Bank C/ B Figure 7.8: YSTERFONTEIN Ltd.’s accounts <?page no="163"?> Berkau: Financial Statements 7e 7-163 D C D C P&L 50,000.00 (5) 50,000.00 EBT 50,000.00 GoD 50,000.00 ITL 217,500.00 b/ d 50,000.00 R/ E 35,000.00 DTI 202,500.00 252,500.00 252,500.00 Gain on disposal-20X6 GoD Profit and Loss-20X6 P&L D C D C c/ d 217,500.00 P&L 217,500.00 EBT 725,000.00 GoD 725,000.00 b/ d 217,500.00 ITL 217,500.00 b/ d 725,000.00 R/ E 507,500.00 725,000.00 725,000.00 Income tax liabilities ITL Profit and Loss for Taxation PLT Figure 7.8: YSTERFONTEIN Ltd.’s accounts continued How it is Done (Disposal of an Asset): (1) Record all depreciation or impairment losses until the time of disposal. If the asset is carried at revaluation, dissolve revaluation reserves and deferred tax liabilities. (2) Prepare a Realisation account for the disposal. (3) Record payments received as a debit entry in the Cash/ Bank account and a credit entry in the Realisation account. For receivables make Bookkeeping entries accordingly. (4) Record output-VAT collected with the disposal as a debit entry in the Realisation account and a credit entry in the VAT account. (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. If the Realisation account is debit balanced the balancing figure is a loss on disposal. If the Realisation account is credit balanced the balancing figure is a gain/ profit on disposal. (8) Close-off the Realisation account to the Profit and Loss account. The Profit and Loss for Taxation account is colour-marked in Figure 7.8 to indicate that it is not part of the Bookkeeping entries for IFRSs financial statements. <?page no="164"?> Berkau: Financial Statements 7e 7-164 YSTERFONTEIN Ltd. applies a Realisation account to calculate the gain on disposal for the land. It is: 1,000,000 - 950,000 = 550,000.00 ZAR. From the point of view of taxation, the profit on disposal is: 1,000,000 - 275,000 = 725,000.00 ZAR. Therefore, the income taxes are: 725,000 × 30% = 217,500.00 ZAR. As we compare the amount to those expected from a gain of 50,000.00 ZAR, the income taxes are higher to the extent of: 217,500 - 15,000 = 2 202,500.00 ZAR. YSTERFONTEIN Ltd. records a deferred tax income to the same extent as prior deferred tax liabilities. Hence, YSTERFONTEIN Ltd.’s equity increases as if revaluation has never 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. 80 7.17 Investment Property and Assets Held for Sale Investment property is land and buildings held for earning a 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 those cases, IAS 16 applies. IAS 40.5 states further that investment property does not apply for assets held for sale. A company that buys land/ buildings 80 You will find the task in the study material portal linked to this textbook. as a property dealer does not apply IAS 40 but IFRS 5 instead. IAS 40.7 says that investment property is in general independent from other ordinary business of the company. IAS 40.10 allows property to be separated in owner occupied portions and items of investment property. Owner-occupation also applies for hotels. The service character dominates and makes the whole hotel fall under property, plant and equipment as ruled by IAS 16. 7.18 C/ S MERSEBURG Ltd. Below, we study an office block partly used by MERSEBURG Ltd.: Data Sheet for MERSEBURG Ltd. Domicile: South Africa (Grahamstown). Reporting currency: ZAR. Classification: Service provider. Investment property: 21,021,000.00 ZAR; office block with 42 offices, bought on 1.01.20X7. Depreciation: 420,420.00 ZAR. Revaluation to 25,200,000.00 ZAR on 1.01.20X8. VAT n/ a. On 2.01.20X7, MERSEBURG Ltd. buys an office block with 42 single offices in Grahamstown, South Africa. The costs of acquisition are 21,000,000.00 ZAR. Additional costs for the transfer apply. Those are 21,000.00 ZAR. One of the offices is used for the administration of the other 41 offices. The offices are separable as laid out in IAS 40.10. We assume, all offices have the same size and value. Due to different use, MERSEBURG Ltd. must account for the offices separately. The <?page no="165"?> Berkau: Financial Statements 7e 7-165 owner-occupied office is regarded 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 by the Bookkeeping entry below with partial allocated conveyancing costs: DR Investment Property.......... 20,520,500.00 ZAR DR P, P, E @COST................ 500,500.00 ZAR CR Cash/ Bank.................... 21,021,000.00 ZAR MERSEBURG Ltd. rents out its 41 offices and receives a monthly rental income therefrom. In case the offices' fair value changes, IAS 40.35 requires recording the differences in value as gain or loss in the Accounting period when the changes take place. This is different to revaluations along IAS 16.39. We show the distinction regarding MERSEBURG Ltd.’s offices: In 20X7, MERSEBURG Ltd. applies the cost model and depreciates the 42 offices to an extent of 420,420.00 ZAR (all together). The offices are carried then at a valuation of: 21,021,000 - 420,420 = 220,600,580.00 ZAR at the end of the Accounting period 20X7. On 2.01.20X8, MERSEBURG Ltd. acknowledges that the office values increased from 20,600,580.00 ZAR to 25,200,000.00 ZAR. The self-occupied office requires a revaluation based on IAS 16. The carrying value was 490,490.00 ZAR and the new value is 600,000.00 ZAR. The revaluation is recorded as the Bookkeeping entries below: DR P, P, E @VALUATION ........... 600,000.00 ZAR DR Acc. Depr.................... 10,010.00 ZAR CR P, P, E @COST................ 500,500.00 ZAR CR Revaluation Reserves......... 109,510.00 ZAR DR Revaluation Reserves......... 32,853.00 ZAR CR Deferred Tax Liabilities..... 32,853.00 ZAR 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) = 4,489,910.00 ZAR see the Bookkeeping entry below: DR Investment Property.......... 4,489,910.00 ZAR CR Gain on Reval. of InvProp.... 4,489,910.00 ZAR <?page no="166"?> Berkau: Financial Statements 7e 7-166 7.19 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 there is a plan to sell the asset. Noncurrent assets held for sale shall be valued at the lower of carrying costs and fair value less cost to sell (IFRS 5.15.). We emphasise here that assets along IFRS 5 are no inventories. They merely represent non-current assets of the company that are to be disposed due to discontinued operations or they have no economic benefit left and will be discarded. This applies also for replaced assets, like a taxi company that bought a new car and intends to sell the old one. A company shall not depreciate a non-current asset while it is classified as held for sale based on IFRS 5.25. IFRS 5.38 requires separate disclosure of non-current assets held for sale. 7.20 C/ S OVERBERG (Pty) Ltd. We explain the concept behind IFRS 5 by the case study OVERBERG (Pty) Ltd., a surf shop at the Atlantic Ocean in Cape Town. Data Sheet for OVERBERG (Pty) Ltd. DDomicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Service provider. Assets for sale: 15 kite surfing units, cost of acquisition: 20,000.00 ZAR/ KSU on 2.01.20X4; useful life: 4 years; residual value: 8,000.00 ZAR/ KSU. Intention to sell from 1.10.20X5 due to discontinued operations; selling price 10,000.00 ZAR/ KSU. On 31.12.20X6, 10 kite surfing unites are left. VAT 20 %. OVERBERG (Pty) Ltd. is a surf shop in the Western Cape of South Africa. The business sells surf equipment in Cape Town and runs a kite surfing training centre at Camps Bay’s waterfront. 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 20,000.00 ZAR/ u on 2.01.20X4. Depreciation on the KSUs follows straight-line method over a useful life of 4 years. The residual value per KSU is 8,000.00 ZAR/ KSU. On 1.10.20X6, OVERBERG (Pty) Ltd. intends to close the kite surfing training centre and to turn it into a surf shop instead. Therefore, the training centre activities fall under discontinued operations. No training classes are offered after 1.11.20X6. OVERBERG (Pty) Ltd. plans to sell the KSUs at 10,000.00 ZAR/ u (ex VAT). No additional selling costs are relevant, as OVERBERG (Pty) Ltd. sells the KSUs in its own shop. At the beginning of the Accounting period 20X6, the KSUs are carried at 14,000.00 ZAR/ u each. Depreciation for the period 1.01.20X6 until 31.10.20X6 is: 10 × (14,000 - 8,000) / 24 = 2 2,500.00 ZAR/ KSU. When OVERBERG (Pty) Ltd. stops its kite surfing training on 1.11.20X6, it carries every KSU at 14,000 - 2,500 = 1 11,500.00 ZAR/ KSU. IFRS 5.15 requires the valuation of the KSUs at the lower of the carrying value and the fair value less costs to sell. OVERBERG (Pty) Ltd.’s intention to sell the KSUs at 10,000.00 ZAR/ u determines their fair values. Hence, the KSUs are held for sale and written-down in accordance with IFRS 5.20 from 11,500.00 <?page no="167"?> Berkau: Financial Statements 7e 7-167 ZAR/ KSU to 10,000.00 ZAR/ KSU. OVERBERG (Pty) Ltd. makes the Bookkeeping entry below. We call the account for assets held for sale Disposals account: DR Disposals.................... 150,000.00 ZAR DR Acc. Depr.................... 127,500.00 ZAR DR IL on Discontinued Operations 22,500.00 ZAR CR P, P, E ACCOUNT KSU .......... 300,000.00 ZAR After classifying the KSUs as assets held for sale, OVERBERG (Pty) Ltd. stops depreciation. At the end of Accounting period 20X6, OVERBERG (Pty) Ltd. sells 5 of the KSUs at a net selling price of 10,000.00 ZAR/ u. See Bookkeeping entry (3). The remaining KSUs are still in the shop on 31.12.20X6. Observe in Figure 7.9 the accounts as at 31.12.20X6. D C D C OV 300,000.00 (2) 300,000.00 (2) 127,500.00 OV 90,000.00 (1) 37,500.00 127,500.00 127,500.00 P, P, E (KSU) Acc depr ACC D C D C (1) 37,500.00 P&L 37,500.00 (2) 150,000.00 (3) 50,000.00 c/ d 100,000.00 150,000.00 150,000.00 b/ d 100,000.00 Depreciation-20X6 DPR Disposals DIS D C D C (2) 22,500.00 P&L 22,500.00 (3) 60,000.00 c/ d 60,000.00 b/ d 60,000.00 Impairment Loss on discontinued op ILD Cash/ Bank C/ B D C D C c/ d 10,000.00 (6) 10,000.00 DPR 37,500.00 b/ d 10,000.00 ILD 22,500.00 NL 60,000.00 60,000.00 60,000.00 b/ d 60,000.00 R/ E 60,000.00 Value added tax VAT Profit and Loss P&L D C P&L 60,000.00 c/ d 60,000.00 b/ d 60,000.00 Retained earnings R/ E Figure 7.9: OVERBERG (Pty) Ltd.’s accounts <?page no="168"?> Berkau: Financial Statements 7e 7-168 7.21 Intangible Assets Intangible assets are assets without physical substance e.g., licenses, rights, warranties, patents, design costs, 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 significant. In the case of software, the intangible portion is the major part, hence, we classify software as intangible. Although cash and its equivalents may be regarded as intangible, it is always recorded as non-current asset under cash/ bank or as financial instruments. IAS 38.12 requires intangible assets to be identifiable which means they are 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. 7.22 C/ S Dentist PAARDEBERG We discuss our next case PAARDEBERG, who is a dentist: Data Sheet for Dr. Paardeberg. DDomicile: Germany (Hamburg) Reporting currency: EUR. Classification: Doctor’s clinic. Cost of acquisition: 750,000.00 EUR. Assets’ value: 80,000.00 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. The value of the clinic is obviously higher than the assets linked thereto, such as the surgery room, the waiting area equipment, computer systems etc. The main value that determines the selling price for the clinic is the patient base. Although there is a material economic benefit when taking over the clinic, the patients are not controlled by the business. Therefore, the acquisition of the clinic cannot be based on the recognition of the patient list. The patient base cannot be recorded as intangible asset. In case Dr. Paardeberg pays a price for the clinic that exceeds the tangible assets’ total the difference between cost of acquisition and the sum of tangible assets is regarded as goodwill. Goodwill is derived from the clinic’s acquisition and, thus, an identifiable intangible asset because it is derived from contractual rights. The acquisition of the clinic is in exchange of 750,000.00 EUR, 80,000.00 EUR thereof is linked to tangible equipment. PAARDEBERG makes the Bookkeeping entry below: DR P, P, E Account.............. 80,000.00 EUR DR Goodwill..................... 670,000.00 EUR CR Cash/ Bank.................... 750,000.00 EUR After initial recognition of intangible assets at cost, the subsequent valuation is based on depreciation over the useful life or on valuations, the latter one requires a regular impairment/ revaluation test. <?page no="169"?> Berkau: Financial Statements 7e 7-169 In the case of the dentist’s clinic PAARDEBERG, the goodwill resulting from the excellent reputation and the future patients’ visits depends on the doctor’s performance and his friendliness. Therefore, the goodwill is subjected to changes. PAARDEBERG must check the economic benefits resulting from the goodwill regularly. If patients refrain from coming back, an impairment loss must be recorded towards the derived goodwill. 7.23 Design and Research Costs The costs for development and product design are intangible assets, too. Their costs are based on cost calculations and are depreciated over the periods, in which the goods are produced. Special requirements apply to consider design costs as cost of development based on IAS 38.54 - 38.64. Special recognition criteria for the classification as development are laid out: The first phase of the product design process when new knowledge is obtained, is seen as “research”. Its costs cannot be allocated as intangible asset but shall be recorded through profit or loss for the year, research is undertaken. Once the design process transitions to its next phase “development”, the reporting company should demonstrate that it fulfils 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. Read IAS 38.57 for the details. In no case, self-generated brands, customer lists etc., should be recognised as intangible assets. 7.24 C/ S WESPOORT Ltd. As a case for the recording of design costs we study the case of WESPOORT Ltd. in East London. Data Sheet for WESPOORT Ltd. DDomicile: South Africa (East London). Reporting currency: ZAR. Classification: Manufacturing. Design costs: 600,000.00 ZAR. Fulfilment of criteria along IAS 38.57 on 3.03.20X4. Production commences on 31.05.20X4. Production amount: 96,000 lawn mowers over 2 years. VAT n/ a. WESPOORT Ltd. is a company that produces lawn mowers in the Eastern Cape Province. For the next season, WESPOORT Ltd. designs a new cordless lawn mower. It undertakes 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 600,000.00 ZAR for engineering. During the development phase, WESPOORT Ltd. records labour, depreciation on design software (CAD) and expenses for product testing. WESPOORT Ltd. demonstrates the fulfilment of the requirements in IAS 38.57 on 3.03.20X4. WESPOORT Ltd. intends to produce 96,000 units of the new lawn mower during the period June/ 20X4 until May/ 20X6. The development is completed on 31.05.20X4 and production commences right thereafter. WESPOORT Ltd. records development costs to the extent of 600,000.00 ZAR as intangible asset and depreciates them at the year-end proportionate to the number of lawn mowers produced. The production quantities of lawn mowers <?page no="170"?> Berkau: Financial Statements 7e 7-170 are evenly distributed over the entire production period. Hence, the partial development cost depreciation for the production period of 7 months in 20X4 is: 7 × 600,000 / 24 = 1 175,000.00 ZAR. Observe below the Bookkeeping entries for the recognition and depreciation of development expenses as intangible assets: DR Intangible Assets............ 600,000.00 ZAR CR Depreciation................. 100,000.00 ZAR CR Labour....................... 350,000.00 ZAR CR Other Expenses (Testing)..... 150,000.00 ZAR DR Depreciation................. 175,000.00 ZAR CR Intangible Assets............ 175,000.00 ZAR 7.25 Leases A lease is a contract between a lessee and a lessor about an identified asset’s use for a period in exchange for consideration (payment) that is in the ownership of the lessor. 81 However, the asset is in control of the lessee. The legal conveyance of the asset is an essential factor regarding the lease contract and results in the recognition thereof. 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 in a car rental shop. 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. The right-of-use-asset can either be disclosed as item of property, plant and equipment or as a special item on the balance sheet e.g., under rights. Lease liabilities are recorded and disclosed like other financial liabilities. In accordance with IFRS 16.22, the lessee discloses all leased assets on the financial statements which affects its performance ratios e.g., the Return 81 Study leases with the case COSSAL Ltd. in our textbook Basics of Accounting, chapter (15). on Assets. Very short-term leases and leases of minor importance/ valuation are exempted from recognition and are recorded as expenses, see IFRS 16.5. Recording a lease commences with the asset transfer (conveyance). 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 lessee recognises the right of use asset and the lease liability at the commencement of the lease. The costs of the right-of-use-asset contain the lease liability, plus prior payments, other direct costs and estimated restoring costs, as required by IFRS 16.24. For the recognition of the lease liability, IFRS 16.26 requires measuring lease liabilities at present values. <?page no="171"?> Berkau: Financial Statements 7e 7-171 7.26 C/ S KRIGE (Pty) Ltd. For understanding the basics of leasing, we discuss the case study KRIGE (Pty) Ltd. The case is simple because we consider a lease for 2 years only. See below the case of KRIGE (Pty) Ltd.: Data Sheet for KRIGE (Pty) Ltd. DDomicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Transportation, UBER. Leasing object: Toyota car for 2 years. Leasing rates: 120,000.00 ZAR/ a. Restoring costs: 50,000.00 ZAR. VAT ignored. Mr Krige is an UBER driver and runs his business in Johannesburg. He establishes KRIGE (Pty) Ltd. and prepares financial statements following IFRSs. KRIGE (Pty) Ltd. closes a lease contract about the taxi car with a Toyota dealer for a 2 years period, commencing on 2.01.20X3 and ending 31.12.20X4. The lease comes with a lease rate of 5 %/ a. 82 KRIGE (Pty) Ltd. pays 120,000.00 ZAR/ a leasing fees. Furthermore, KRIGE (Pty) Ltd. estimates the restoring costs of the car for minor repairs, like scratches and dents, to be 50,000.00 ZAR. Under consideration of these payments, the payment vector for the taxi car (in ZAR) is: TC(t) = {0; -120,000; (-120,000 - 50,000)} = { {0; -120,000; -170,000}. The total lease liability is its present value: 120,000/ 1.05 + 170,000/ 1.05 2 = 268,480.73 ZAR. The actual value for the car is unknown as the dealer does not reveal it. KRIGE (Pty) Ltd. recognises the right-of-use-asset at the present value (as at 2.01.20X3) of all lease rates which includes the restoring costs: 268,480.73 ZAR. We recognise the lease at its commencement. KRIGE (Pty) Ltd. records the lease as Bookkeeping entry (1) below on 2.01.20X3: DR Right-of-use-Asset........... 268,480.73 ZAR CR Lease Liability.............. 268,480.73 ZAR Next, we record the lease liability to the same extent. For its disclosure on 31.12.20X3, interest is to be considered as an expense: 268,480.73 × 5% = 13,424.04 ZAR. At the time of recognition on the balance sheet, the payment for 20X3 has been made already and the next payment falls into the classification of short-term liabilities. We record the payment as Bookkeeping entry (3). In compliance with IAS 1.60, we disclose 82 The lessor decides about the interest in the lease. We assume here that a new car costs 600,000.00 ZAR and can be leased out for 5 years at 120,000.00 ZAR/ a. The rate of interest the payments for 20X4 as short-term liabilities. As we do not discount shortterm liabilities, we first add interest to the extent of: (268,480.73 × 1.05 - 120,000) × 5% = 8 8,095.24 ZAR. One year later, on 31.12.20X4, KRIGE (Pty) Ltd. retires the remaining lease liability. Therefore, it will not appear on its balance sheet per 31.12.20X4. Observe the Bookkeeping entries (2) to (5) below which are recorded in 20X3. r that fulfils the equation: 600,000 = 120,000 × ((1+r) 5 -1)/ (r × (1 + r) 5 ) is 4.88%/ a and is rounded to 5 %/ a. <?page no="172"?> Berkau: Financial Statements 7e 7-172 DR Interest..................... 13,424.04 ZAR CR Lease Liability IBL.......... 13,424.04 ZAR DR Lease Liability IBL.......... 120,000.00 ZAR CR Cash/ Bank.................... 120,000.00 ZAR DR Interest..................... 8,095.24 ZAR CR Lease Liability IBL.......... 8,095.24 ZAR DR Lease Liability IBL.......... 170,000.00 ZAR CR Short-term Liabilities....... 170,000.00 ZAR Depreciation on the right-of-use-asset is based on straight-line method without residual value, as the right-of-use-asset is measured based on all payments including 50,000.00 ZAR for repairs. Therefore, depreciation is: 268,480.73 / 2 = 1134,240.37 ZAR. It is recorded by Bookkeeping entry (6). DR Depreciation................. 134,240.37 ZAR CR Acc. Depr.................... 134,240.37 ZAR To provide you with the full picture, we show the accounts in Figure 7.10. D C D C (1) 268,480.73 c/ d 268,480.73 (3) 120,000.00 (1) 268,480.73 b/ d 268,480.73 (5) 170,000.00 (2) 13,424.04 (4) 8,095.24 290,000.00 290,000.01 Right-of-use-asset RUA Lease liability IBL D C D C c/ d 120,000.00 (3) 120,000.00 c/ d 170,000.00 (5) 170,000.00 b/ d 120,000.00 b/ d 170,000.00 Cash/ Bank C/ B Short-term liabilities A/ P D C D C (6) 134,240.37 P3L 134,240.37 c/ d 134,240.37 (6) 134,240.37 b/ d 134,240.37 Depreciation-20X3 DPR Acc depr ACC Figure 7.10: KRIGE (Pty) Ltd.’s accounts (20X3) <?page no="173"?> Berkau: Financial Statements 7e 7-173 D C D C DPR 134,240.37 NL 155,759.65 P3L 155,759.65 c/ d 155,759.65 INT 21,519.28 b/ d 155,759.65 b/ d 155,759.65 R/ E 155,759.65 D C (2) 13,424.04 P3L 21,519.28 (4) 8,095.24 21,519.28 21,519.28 Profit and Loss-20X3 P3L Retained earnings R/ E Interest-20X3 INT Figure 7.10: KRIGE (Pty) Ltd.'s accounts (20X3) In the next Accounting period 20X4, KRIGE (Pty) Ltd. depreciates the car by Bookkeeping entry (A) and pays the agreed 170,000.00 ZAR. The payment is recorded as Bookkeeping entry (B): 120,000 + 50,000 = 1 170,000.00 ZAR. No interest applies as the interest has been pulled forward in the previous accounting period to avoid discounting of short-term liabilities. For the disposal of the car, we apply a Realisation account. The disposal of the car is recorded as Bookkeeping entries (C’) and (C’’). DR Depreciation ................. 134,240.37 ZAR CR Acc. Depr.................... 134,240.37 ZAR DR Short-term Liabilities (A/ P). 170,000.00 ZAR CR Cash/ Bank.................... 170,000.00 ZAR DR Realisation .................. 268,480.73 ZAR CR Right-of-use-Asset........... 268,480.73 ZAR DR Acc. Depr.................... 268,480.73 ZAR CR Realisation .................. 268,480.73 ZAR In Figure 7.11, the Realisation account is zero-balanced. The total expenses are depreciation and restoring costs. <?page no="174"?> Berkau: Financial Statements 7e 7-174 D C D C (1) 268,480.73 c/ d 268,480.73 P3L 155,759.65 c/ d 155,759.65 b/ d 268,480.73 (C') 268,480.73 b/ d 155,759.65 P4L 134,240.37 c/ d 290,000.02 290,000.02 290,000.02 b/ d 290,000.02 Right-of-use-asset RUA Retained earnings R/ E D C D C c/ d 120,000.00 (3) 120,000.00 c/ d 170,000.00 (5) 170,000.00 b/ d 120,000.00 (B) 170,000.00 b/ d 170,000.00 c/ d 290,000.00 (B) 170,000.00 290,000.00 290,000.00 b/ d 290,000.00 Cash/ Bank C/ B Short-term liabilities A/ P D C D C (A) 134,240.37 P4L 134,240.37 c/ d 134,240.37 (6) 134,240.37 b/ d 134,240.37 (C'') 268,480.74 (A) 134,240.37 268,480.74 268,480.74 Depreciation-20X4 DPR Acc depr ACC D C D C DPR 134,240.37 NL 134,240.37 (C') 268,480.73 (C'') 268,480.73 b/ d 134,240.37 R/ E 134,240.37 Profit and Loss-20X4 P4L Realisation REA Figure 7.11: KRIGE (Pty) Ltd.’s accounts (20X4) IFRS 16.23 requires carrying the rightof-use-asset at cost. As the costs frequently are unknown by the lessee, IFRS 16.26 applies. It states that the initial costs are the present value of the lease rates for the leasing liability. For discounting the interest rate implicit in the lease applies. For subsequent valuation on the debit side, the right-of-use-asset is depreciated based on an appropriate depreciation method and its parameters. How it is Done (Recording Leases): (1) Examine whether a lease applies. (2) Determine the value of the lease object or the right-of-use-asset. It is the asset’s fair value or if unknown the present value of all lease rates. For present value calculation apply the discount rate implicit in the lease. <?page no="175"?> Berkau: Financial Statements 7e 7-175 (3) Adjust the asset calculation for all lease payments linked to the lease. Those payments are rates and further payments e.g., for restoring the leased asset. (4) Record the leased asset as a right-of-use-asset and as a lease liability at the same time. (5) Record depreciation on the leased asset or the right-of-use-asset. (6) Record the lease liability changes based on the lease valuation based on present value calculations. You must compound the lease liability with the interest rate applicable. (7) The carrying value of the right-of-use-asset and the lease liability can differ due to different measurement methods. (8) At the end of the lease term, record a disposal of the asset in a Realisation account and the retirement of the lease liabilities. Consider all payments linked to the termination of the lease. 7.27 C/ S MERVE (Pty) Ltd. - Lessee In some cases, leases are used to finance an asset which after the lease period will be kept by the lessee. The lease Bookkeeping entries look the same. We discuss the case of Vicky van der Merve who runs a steak restaurant in Melbourne, called MERVE (Pty) Ltd. Data Sheet for MERVE (Pty) Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: Hospitality Management. Leasing object: Grill for 2 years. Gross purchase price: 108,000.00 AUD. Lease rates: 24,000.00 AUD/ a. Lease period: 20X4, 20X5. Discount rate in the lease: 5 %/ a Type of lease: Finance lease. Purchase of the grill at 60,000.00 AUD gross value. VAT rate = 20%. In her restaurant kitchen, Vicky operates an industrial grill which costs 108,000.00 AUD incl. VAT. She signs a lease contract for 2 years which includes the option to buy the grill after the lease at 60,000.00 AUD (gross amount). The annual lease rates are 24,000.00 AUD/ a (net amounts). Vicky van der Merve's lease commences on 2.01.20X4. As Vicky van der Merve intends to keep the grill, she must at first recognise a lease followed by an acquisition of the used grill two years later. The lease rates are 24,000.00 AUD/ a. The discount rate of the lease is 5 %/ a. The payment vector for the leased grill is: LG (t) = {0.00; 24,000.00; 24,000.00}. Its present value is: 24,000 / 1.05 + 24,000 / 1.05 2 = 44,625.85 AUD, on 2.01.20X4. We record the initial recognition on 2.01.20X1 at its present value and record depreciation and lease payments on 31.12.20X4 and 31.12.20X5. The payment vector starts with 0.00 AUD for the initial recognition. This indicates that no payment takes place yet. The lease rate is paid at the end of the Accounting period. <?page no="176"?> Berkau: Financial Statements 7e 7-176 (1) Initial recognition of the lease at its present value on 2.01.20X4. DR Right-of-use-Asset........... 44,625.85 AUD CR Lease Liabilities............ 44,625.85 AUD At the end of the first Accounting period 20X4, MERVE (Pty) Ltd. pays the lease rate. This is the second element of the vector LG(t): 24,000.00 AUD. Before the payment, the lease liability is compounded for interest: 5% × 44,625.85 = 2 2,231.29 AUD. As VAT is refunded in the next Accounting period, MERVE (Pty) Ltd. pays VAT on cash. This way, we easily keep VAT out of the equation. We acknowledge that the company does not finance VAT payments with loans. After the lease payment on 31.12.20X4, we close-off the lease liabilities to short-term liabilities in accordance with IAS 1.60. The interest on the short-term liabilities is: (46,857.14 - 24,000) × 5% = 1 1,142.86 AUD. We record the compounding before the transfer to the Short-term Liabilities account. This way, all short-term liabilities are based on settlement values (no discounting applies). Check Bookkeeping entry (2b). Bookkeeping entries (2a) and (2b) are interest recording for the lease; (3, 4) are the agreed lease rate payments including input-VAT. DR Interest..................... 2,231.29 AUD CR Lease Liabilities............ 2,231.29 AUD DR Interest..................... 1,142.86 AUD CR Lease Liabilities............ 1,142.86 AUD DR Lease Liabilities............ 24,000.00 AUD CR Cash/ Bank.................... 24,000.00 AUD DR VAT.......................... 4,800.00 AUD CR Cash/ Bank.................... 4,800.00 AUD MERVE (Pty) Ltd. closes-off the Lease Liabilities account to short-term liabilities. The transfer is at the discounted leasing rate times 5 %: 22,857.14 × 5% = 24,000.00 AUD. MERVE (Pty) Ltd. depreciates the grill following straight-line method. Depreciation is: 44,625.85 / 2 = 22,312.93 AUD. (5) Transfer of short-term liabilities and (6) depreciation of the right-of-use-asset. <?page no="177"?> Berkau: Financial Statements 7e 7-177 DR Lease Liabilities............ 24,000.00 AUD CR Short-term Liabilities....... 24,000.00 AUD DR Depreciation ................. 22,312.93 AUD CR Acc. Depr.................... 22,312.93 AUD Check the accounts in Figure 7.12: D C D C (1) 44,625.85 c/ d 44,625.85 (3) 24,000.00 (1) 44,625.85 b/ d 44,625.85 (5) 24,000.00 (2a) 2,231.29 (2b) 1,142.86 48,000.00 48,000.00 Right-of-use-asset RUA Lease liabilities IBL D C D C (2a) 2,231.29 P4L 3,374.15 (3) 24,000.00 (2b) 1,142.86 c/ d 28,800.00 (4) 4,800.00 3,374.15 3,374.15 28,800.00 28,800.00 b/ d 28,800.00 Interest-20X4 INT Cash/ Bank D C D C (4) 4,800.00 c/ d 4,800.00 c/ d 24,000.00 (5) 24,000.00 b/ d 4,800.00 b/ d 24,000.00 Value added tax VAT Accounts payables A/ P D C D C (6) 22,312.93 P4L 22,312.93 c/ d 22,312.93 (6) 22,312.93 b/ d 22,312.93 Depreciation-20X4 DPR Accumulated depreciation ACC D C D C DPR 22,312.93 P4L 25,687.08 c/ d 25,687.08 INT 3,374.15 R/ E 25,687.08 b/ d 25,687.08 25,687.08 25,687.08 Profit and Loss-20X4 P4L Retained earnings R/ E Figure 7.12: MERVE (Pty) Ltd.’s accounts (20X4) In the next Accounting period 20X5, MERVE (Pty) Ltd. receives the VAT refund and pays the last lease rate. MERVE (Pty) Ltd. also depreciates the right-of-use-asset. (A - D) VAT receipt, interest recording and lease rate payment including value added tax VAT and depreciation. <?page no="178"?> Berkau: Financial Statements 7e 7-178 DR Cash/ Bank.................... 4,800.00 AUD CR VAT.......................... 4,800.00 AUD DR Short-term Liabilities....... 24,000.00 AUD CR Cash/ Bank.................... 24,000.00 AUD DR VAT.......................... 4,800.00 AUD CR Cash/ Bank.................... 4,800.00 AUD DR Depreciation................. 22,312.93 AUD CR Accumulated Depreciation..... 22,312.93 AUD For the termination of MERVE (Pty) Ltd.’s lease, we apply the Realisation account. The Right-of-use-asset account and the Accumulated Depreciation account are closed-off to the Realisation account. The Bookkeeping entries (E) and (F) for the disposal are made in the adjustment format. The Realisation account is zero-balanced. Eventually, MERVE (Pty) Ltd. decides to buy the (used) grill at the agreed price of 60,000.00 AUD (gross value). (G) Acquisition of the used grill on 30.12.20X5: DR Realisation.................. 46,857.14 AUD CR Right-of-use-asset........... 46,857.14 AUD DR Accumulated Depreciation..... 46,857.14 AUD CR Realisation.................. 46,857.14 AUD DR P, P, E Account.............. 50,000.00 AUD DR VAT.......................... 10,000.00 AUD CR Cash/ Bank.................... 60,000.00 AUD Check the accounts in Figure 7.13: D C D C (1) 44,625.85 c/ d 44,625.85 (3) 24,000.00 (1) 44,625.85 b/ d 44,625.85 REA 44,625.85 (5) 24,000.00 (2a) 2,231.29 (2b) 1,142.86 48,000.00 48,000.00 Right-of-use-asset RUA Lease liabilities IBL D C D C (4) 4,800.00 c/ d 4,800.00 c/ d 24,000.00 (5) 24,000.00 b/ d 4,800.00 (A) 4,800.00 (B) 24,000.00 b/ d 24,000.00 (C) 4,800.00 (G) 10,000.00 c/ d 14,800.00 19,600.00 19,600.00 b/ d 14,800.00 Value added tax VAT Accounts payables A/ P Figure 7.13: MERVE (Pty) Ltd. accounts (20X5) <?page no="179"?> Berkau: Financial Statements 7e 7-179 D C D C (6) 22,312.93 P4L 22,312.93 c/ d 22,312.93 (6) 22,312.93 b/ d 22,312.93 REA 44,625.85 (D) 22,312.93 44,625.85 44,625.85 Depreciation-20X4 DPR Accumulated depreciation ACC D C D C DPR 22,312.93 P4L 25,687.08 c/ d 25,687.08 INT 3,374.15 R/ E 25,687.08 b/ d 25,687.08 25,687.08 25,687.08 P5L 22,312.93 c/ d 48,000.01 48,000.01 48,000.01 b/ d 48,000.01 Profit and Loss-20X4 P4L Retained earnings R/ E D C D C DPR 22,312.93 R/ E 22,312.93 (D) 22,312.93 P5L 22,312.93 D C D C (G) 50,000.00 c/ d 50,000.00 RUA 44,625.85 ACC 44,625.85 b/ d 50,000.00 Profit and Loss-20X5 P5L Depreciation-20X5 DPR Property, plant, equipment PPE Realisation-20X5 REA D C D C (2a) 2,231.29 P4L 3,374.15 (3) 24,000.00 (2b) 1,142.86 c/ d 28,800.00 (4) 4,800.00 3,374.15 3,374.15 28,800.00 28,800.00 (A) 4,800.00 b/ d 28,800.00 (B) 24,000.00 (C) 4,800.00 c/ d 112,800.00 (G) 60,000.00 117,600.00 117,600.00 b/ d 112,800.00 Interest-20X4 INT Cash/ Bank Figure 7.13: MERVE (Pty) Ltd.’s accounts (20X5) continued 7.28 C/ S MERVE (Pty) Ltd. - Lessor We look at the lessor of the industrial grill. The lease is a finance lease. The lessor records in its books the net investment in lease which is the present value of the expected payments. It does not matter whether MERVE (Pty) Ltd. buys the grill or someone else. For the lessor, the estimated disposal proceeds are 60,000.00 AUD (gross value). For discounting, we consider the interest rate implicit in the lease of 5 %/ a. On 2.01.20X4, the net present value is: 24,000 / 1.05 + (24,000 + 50,000) / 1.05 2 = 889,997.32 AUD. For the calculation of the receivables the VAT-portion of 10,000.00 AUD does not matter as it is <?page no="180"?> Berkau: Financial Statements 7e 7-180 linked to a liability for the output-VAT to the same extent. The lessor de-recognises the grill and replaces it by the net investment in lease which we add to the Accounts Receivables account. Check the recording of the Bookkeeping entry below: DR Accounts Receivables......... 89,977.32 AUD Loss on De-recognition.......... 22.68 AUD CR P, P, E Account.............. 90,000.00 AUD The loss on de-recognition depends on the lease rates, the lessor is asking for. In this case study, it was intended to consider the smallest possible difference between the derecognised asset and the receivables because the major income for the lessor is financial income. In the Accounting period 20X4, the lessor records a financial income of: 89,977.32 × 5% = 4 4,498.87 AUD. We add the value to the net investment in lease: 89,977.32 + 4,498.87 = 9 94,476.19 AUD. The first payment from MERVE (Pty) Ltd. is received on 31.12.20X4. Its net value is 24,000.00 AUD which we deduct from receivables. The finance income is: (94,476.19 - 24,000) × 5% = 3 3,523.81 AUD. On the balance sheet, we disclose on 31.12.20X4 a value for the investment in lease of: 94,476.19 - 24,000 + 3,523.81 = 7 74,000.00 AUD. On the next balance sheet date, the lessor receives the lease rate of 24,000.00 AUD and the net purchase price for the grill of 50,000.00 AUD 83 . The finance income is zero, as with the receipts the Accounts Receivables account is zero-balanced: 74,000 - 24,000 - 50,000 = 0 0.00 AUD. We recommend working on task A7.62, which covers the company LANGLEY Ltd. leasing out a business car. 84 83 We ignore VAT. 7.29 C/ S VLAEBURG Ltd. - Lessee Below, we study the case of VLAEBURG Ltd., which is a freight airline. We now cover a case with longer periods and an included down payment which is required to reduce the risk for the lessor: Data Sheet for VLAEBURG Ltd.: Domicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: service provider. Leasing object: Piper M350 for 3 years (20X4 - 20X6). Leasing rates: 1,240,000.00 ZAR/ a. Leasing rate of interest: 5 %/ a. Down payment: 1,950,000.00 ZAR; refunded at the end of the lease. Restoring costs: 800,000.00 JPY. VAT ignored. IAS 1.60 ignored. On 2.01.20X4, the South African company VLAEBURG Ltd. agrees on a contract with an aircraft lessor about the lease of an aircraft Piper M350 for a period of 3 years. A down payment of 1,950,000.00 ZAR is required. All 3 lease payments of 1,240,000.00 ZAR/ a are due at the year-ends: in 20X4, in 20X5 and in 20X6. VLAEBURG Ltd. and the lessor estimate restoring aircraft costs for 84 You will find the task in the study material portal linked to this textbook. <?page no="181"?> Berkau: Financial Statements 7e 7-181 the repair of scratches and cleaning to be 800,000.00 ZAR. These costs are referred to as residual value guarantee costs. When the aircraft is returned, the lessor will refund the down payment of 1,950,000.00 ZAR (on 31.12.20X6). The aircraft dealer (lessor) does not reveal the aircraft’s value. The measurement of the right-of-use-asset is based on the present value of all lease payments: down payment, rates, and estimated restoring payments. IFRS 16.23 and IFRS 16.24 apply. The value of the right-of-us-asset for the Piper M350 is derived from the payment vector for the lease: L(t) = {(1,950,000.00); (1,240,000.00); (1,240,000.00); (90,000.00)}. The last vector element includes the costs for restoring and the refund: (1,240,000) - 800,000 + 1,950,000 = - -90,000 ZAR. IFRS 16.26 requires calculating the total of present values of all not yet paid lease rates. For discounting, we apply the interest rate implicit in the lease, which is 5 %/ a. The present value as at 2.01.20X4 is: 1,950,000 +1,240,000 × ((1 + 5%) 3 - 1) / ((5% × (1 + 5%) 3 ) + (800,000 - 1,950,000) × (1 + 5%) -3 = 1,950,000 + 3,376,827.56 - 993,413.24 = 4,333,414.32 ZAR. Note, we are focussing on the financial statements. The first one, we prepare is for 20X4. However, we record the lease at the time of its commencement which is one year before, on 2.01.20X4. At that time, the down payment is due. Next, we study a finance schedule for the lease which includes the payments and the right-of-use-asset. It proves that the lease valuation results in a present value of zero as we consider the right-ofuse-asset together with the lease liability. See Figure 7.14. 0.05 20X3 20X4 20X5 20X6 [ZAR] [ZAR] [ZAR] [ZAR] Lease rates (1,240,000.00) (1,240,000.00) (1,240,000.00) Down payment (1,950,000.00) Refund 1,950,000.00 Restoring costs (800,000.00) RUA 4,333,414.32 valuation 5% (2,383,414.32) 2,502,585.04 valuation 5% (1,262,585.04) 1,325,714.29 valuation 5% (85,714.29) 90,000.00 0.00 0.00 0.00 0.00 VLAEBURG Ltd. LEASE LIABILITY VALUATION PLAN (20X3 - 20X6) Figure 7.14: VLAEBURG Ltd.’s finance schedule for the lease <?page no="182"?> Berkau: Financial Statements 7e 7-182 The Bookkeeping entries at the time of commencement of the lease are as below. (1) Recognition of the right-of-useasset: DR Right-of-us-asset............ 4,333,414.32 ZAR CR Lease Liabilities............ 4,333,414.32 ZAR The next Bookkeeping entry is for the down payment. As it is considered for the calculation of the right-of-use-asset, we debit the Lease Liabilities account. (2) Down payment on 2.01.20X4: DR Lease Liabilities............ 1,950,000.00 ZAR CR Cash/ Bank.................... 1,950,000.00 ZAR On 31.12.20X4, VLAEBURG Ltd. must pay the 1 st leasing rate and compound the lease liability. The interest on the lease liability is: 5% × 2,383,414.32 = 1119,170.72 ZAR. We record the revaluation of the lease liabilities and the payment of the 1 st lease rate as Bookkeeping entries (3) and (4) on 31.12.20X4. DR Interest..................... 119,170.72 ZAR CR Lease Liabilities............ 119,170.72 ZAR DR Lease Liabilities............ 1,240,000.00 ZAR CR Cash/ Bank.................... 1,240,000.00 ZAR At the same time, the right-of-use-asset is depreciated. Depreciation follows straight-line method without residual value. Depreciation is: 4,333,414.32 / 3 = 1 1,444,471.44 ZAR. We make the Bookkeeping entry (5) on 31.12.20X4 and record the adjustments thereafter. DR Depreciation................. 1,444,471.44 ZAR CR Acc. Depr.................... 1,444,471.44 ZAR The expenses for the Accounting period 20X4 consist of depreciation and interest. The total is: 1,444,471.44 + 119,170.72 = 1 1,563,642.16 ZAR. As we record the lease liabilities and the rightof-use-asset at present values and include the repairs, the expenses on the income statement exceed the lease rate. Note, for the sake of simplicity (when calculating interest), we do not disclose long-term and short-term liabilities separately; we ignore IAS 1.60 for this case study. Therefore, we do not transfer next Accounting period’s lease rates to a Short-term Liabilities account but keep them in the Lease Liabilities account. Figure 7.15 displays the accounts at VLAEBURG Ltd. as at the end of the lease. Therein, the Bookkeeping entries <?page no="183"?> Berkau: Financial Statements 7e 7-183 for 20X5 are marked by Roman numerals and the ones for 20X6 by capital letters. D C D C (1) 4,333,414.32 c/ d 4,333,414.32 (2) 1,950,000.00 (1) 4,333,414.32 b/ d 4,333,414.32 c/ d 2,383,414.32 4,333,414.32 4,333,414.32 (4) 1,240,000.00 b/ d 2,383,414.32 c/ d 1,262,585.03 (3) 119,170.72 2,502,585.03 2,502,585.03 (B) 1,240,000.00 b/ d 1,262,585.03 c/ d 85,714.29 (I) 63,129.25 1,325,714.29 1,325,714.29 (B) 1,240,000.00 b/ d 85,714.29 (C) 800,000.00 (A) 4,285.71 (D) 1,950,000.00 2,040,000.00 2,040,000.00 Right-of-use-asset RUA Lease liabilities IBL D C D C (4) 1,444,471.44 P4L 1,444,471.44 c/ d 1,444,471.44 (4) 1,444,471.44 b/ d 1,444,471.44 c/ d 2,888,942.88 (III) 1,444,471.44 2,888,942.88 2,888,942.88 b/ d 2,888,942.88 REA 4,333,414.32 (D) 1,444,471.44 4,333,414.32 4,333,414.32 Depreciation-20X4 DPR Accumulated depreciation ACC D C D C (2) 1,950,000.00 (3) 119,170.72 P4L 119,170.72 c/ d 3,190,000.00 (4) 1,240,000.00 3,190,000.00 3,190,000.00 b/ d 3,190,000.00 c/ d 4,430,000.00 (II) 1,240,000.00 4,430,000.00 4,430,000.00 (D) 1,950,000.00 b/ d 4,430,000.00 (B) 1,240,000.00 c/ d 4,520,000.00 (C) 800,000.00 6,470,000.00 6,470,000.00 b/ d 4,520,000.00 Cash/ Bank C/ B Interest-20X4 INT Figure 7.15: VLAEBURG Ltd.’s accounts (20X4 - 20X6) <?page no="184"?> Berkau: Financial Statements 7e 7-184 D C D C DPR 1,444,471.44 P4L 1,563,642.16 c/ d 1,563,642.16 INT 119,170.72 R/ E 1,563,642.16 b/ d 1,563,642.16 1,563,642.16 1,563,642.16 P5L 1,507,600.69 c/ d 3,071,242.85 3,071,242.85 3,071,242.85 b/ d 3,071,242.85 P6L 1,448,757.15 c/ d 4,520,000.00 4,520,000.00 4,520,000.00 b/ d 4,520,000.00 Profit and Loss-20X4 P4L Retained earnings R/ E D C D C (I) 63,129.25 P5L 63,129.25 (III) 1,444,471.44 P5L 1,444,471.44 D C D C DPR 1,444,471.44 (A) 4,285.71 P6L 4,285.71 INT 63,129.25 R/ E 1,507,600.69 1,507,600.69 1,507,600.69 Interest-20X5 Depreciation-20X5 DPR Profit and Loss-20X5 P5L Interest-20X6 INT D C D C (D) 1,444,471.44 P6L 1,444,471.44 DPR 1,444,471.44 INT 4,285.71 R/ E 1,448,757.15 1,448,757.15 1,448,757.15 D C RUA 4,333,414.32 ACC 4,333,414.32 Depreciation-20X6 DPR Profit and Loss-20X6 P6L Realisation-20X6 REA Figure 7.15: VLAEBURG Ltd.’s accounts (20X4 - 20X6) continued The case study VLAEBURG Ltd. shows that at the end of the lease, the aircraft is returned to the lessor. To dissolve the right-of-use-asset, we apply the Realisation account: We close-off the Right-ofuse-Asset account and the Accumulated Depreciation account to the Realisation account. It is zero-balanced thereafter. The total of expenses as recorded in the Retained Earnings account are depreciation and interest. We calculate the same expenses by adding all lease rates and the restoring costs: 3 × 1,240,000 + 800,000 = 4 4,520,000.00 ZAR. 7.30 C/ S VLAEBURG Ltd. - Lessor Next, we discuss the recognition of the lease on the lessor’s side. The lease is classified as a finance lease, as all risks are transferred to VLAEBURG Ltd. The lessor recognises the lease as receiva- <?page no="185"?> Berkau: Financial Statements 7e 7-185 bles (net investment in lease) and considers estimated residual proceeds of the plane. We assume, the aircraft is sold at the end of the last lease period e.g., to VLAEBURG Ltd. The lessor estimates the residual value to be 14,960,000.00 ZAR 85 . As we calculate the receivables at the time of the commencement of the lease period, we discount the value based on a discount rate of 5 %/ a. This is the rate of interest implicit in the lease. The discounting gives a present value for the disposal proceeds of: 14,960,000 / 1.05 3 = 112,923,010.47 ZAR. We must add this value to the receivables from the lessee. It gives: 4,333,414.32 + 12,923,010.47 = 17,256,424.79 ZAR. Below, we record the acquisition of the aircraft and its de-recognition as Bookkeeping entries (α) and (β). DR P, P, E account (PIPER)...... 17,000,000.00 ZAR CR Cash/ Bank.................... 17,000,000.00 ZAR DR Accounts Receivables A/ R ..... 17,256,424.79 ZAR CR P, P, E Account (Piper)...... 17,000,000.00 ZAR CR Profit on De-recognition..... 256,424.79 ZAR On 1.01.20X4, the lessor discloses on its balance sheet no aircraft but lease receivables of 17,256,424.79 ZAR. At the end of the first lease period, the lessor receives the down payment and the agreed lease rate, together the cash inflows are: 1,950,000 + 1,240,000 = 3,190,000.00 ZAR. The payments are credited against receivables. Check Bookkeeping entry (γ): DR Cash/ Bank.................... 3,190,000.00 ZAR CR Accounts Receivables A/ R ..... 3,190,000.00 ZAR Next, we accrue interest as a finance income to be disclosed on the statement of profit or loss and other comprehensive income. The amount is: 5% × (17,256,424.79 - 3,190,000) = 703,321.24 ZAR. Observe Bookkeeping entry (δ): DR Accounts Receivables A/ R ..... 703,321.24 ZAR CR Finance Income............... 703,321.24 ZAR The total profit for the lessor in the first lease period is: 256,424.79 + 703,321.24 = 9 959,746.03 ZAR. 85 We assume costs of acquisition of 1,000,000.00 USD multiplied by the exchange rate of the ZAR to the USD of 17. The useful life is 25 years, 3 We must consider in the last lease period the refund of the down payment and most probably expenses for the repair of the aircraft. Therefore, the lessor thereof, the plane is leased out. Hence the residual value is (17,000,000 / 25) × 22 = 14,960,000.00 ZAR. <?page no="186"?> Berkau: Financial Statements 7e 7-186 must record expenses for the mechanics to repair the aircraft. This example is based on the uncertain assumption that the plane is sold at 14,960,000.00 ZAR after 3 years or can be leased out at a present value of the disposal proceeds. Note, the example is based on 3 years to keep the number of Bookkeeping entries to a minimum for this textbook. If the lessor leases out an aircraft for 30 years, the residual value is lower in comparison to the lease receivables. The calculation becomes less uncertain that way. 7.31 Short-term Leases Leases can also be short-term and then must be recorded as expenses. See below the case study JONKERS GmbH, a consultancy in Osnabrück. 7.32 C/ S JONKERS GmbH The company regularly visits its clients and bills the travel expenses directly without adding further surcharges. 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: DDomicile: Germany (Osnabrück). Reporting currency: EUR. Classification: Consultancy. Rent of an Audi A4 car on 6.06.20X7 for 4 days. Leasing rates: 135.00 EUR/ d. Insurance rate: 40.00 EUR/ d. VAT ignored. On 6.06.20X7, JONKERS GmbH visits a client in Saarbrücken. From the local car rental, JONKERS GmbH hires an Audi A4. It returns the car on 9.06.20X7, which results in a rental expense for 4 days: 4 × 135 = 5 540.00 EUR. Although the risk of accident is transferred to JONKERS GmbH, no lease contract applies. JONKERS GmbH insures the car and adds the insurance costs to its travel expenses. Insurance is: 4 × 40 = 1 160.00 EUR. Later, JONKERS GmbH charges its client the total travel costs of: 540 + 160 = 7700.00 EUR. The refund is not recorded as revenue but as a credit entry in the Travel Expense account. Short-term rent of the car does not fall under leases. It is a service of the car rental although JONKERS GmbH has the full use of the car and can e.g., decide where to drive. However, it cannot sell the car. In case of JONKERS GmbH, IFRS 16.5 applies as the lease is short-term and of minor value. JONKERS GmbH records the cost by two Bookkeeping entries: (1) for the car rental and (2) for the refund received from its client. DR Travel Expenses (OEP)........ 700.00 EUR CR Cash/ Bank.................... 700.00 EUR DR Cash/ Bank.................... 700.00 EUR CR Travel Expenses (OEP)........ 700.00 EUR <?page no="187"?> Berkau: Financial Statements 7e 7-187 7.33 Financial Instruments For studying 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 company. E.g., if a company buys fresh shares, it shows those shares as an item of non-current assets and the emitting corporation discloses the shares as issued capital and most probably under capital reserves, as well (for the premium). IAS 32.11 defines the details of financial assets and financial liabilities. A financial asset is e.g., a right to receive cash whereas a financial liability can be a contractual obligation to deliver cash. In this textbook, long-term financial instruments are covered in this chapter (7) on the debit side as financial assets. In chapter (14) we discuss financial liabilities. Their measurements are based on the same standards. Below, we discuss case studies which result in a different recognition and measurement of financial assets. We cover various financial assets to provide you with a wide range of knowledge of how to recognise and measure them. For an overview, we list below the discussed financial assets together with their case study names: (a) Cross-border investment in another company, based on ordinary shares - HAWKINS Ltd. / STEYN GmbH. (b) Bonds traded at 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 or measurement. IFRS 7 and IFRS 9 do. All aspects of how to disclose financial instruments have been moved to IFRS 7: Financial Instruments, Disclosure. Measurement can now be found in IFRS 9. IAS 39 also prescribes how to value financial instruments, so reporting companies can still choose whether to follow IAS 39 or IFRS 9. We only focus on IFRS 9 as IAS 39 will be superseded shortly. The valuation of financial instruments depends on their classification. This requires us to deal with the classification of financial assets at first. Therefore, we focus on the owners' side. Financial assets are investments, ownership of shares, bonds, receivables, currency futures, call options etc. We discuss here only a selection of examples of how to record and measure financial assets as the owner. 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 language which refers to what the owner intends to do with her/ his financial assets. We distinguish financial assets held until ma- <?page no="188"?> Berkau: Financial Statements 7e 7-188 turity from those held for trading purpose. If e.g., a company holds bonds 86 until redemption (until they mature), it must disclose its bonds at amortised costs 87 . If a shareholder intends to sell its 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 at all, this is the default case. We focus on that kind of financial assets in chapter (9). Here, in chapter (7) we focus on financial assets on the non-current asset section of the balance sheet. We discuss below the case of HAWKINS Ltd., a South African company that prepares its financial reports in accordance with IFRSs and holds an investment in a German company. 7.34 C/ S HAWKINS Ltd. / STEYN GmbH - Cross-Border Investments Below, we give an overview of the case study: Data Sheet for HAWKINS Ltd. DDomicile: South Africa (Upington). Reporting currency: ZAR. Classification: n/ a. Investment: 8 % in STEYN GmbH, issued capital 100,000.00 EUR; book value: 245,000.00EUR. Currency exchange rate 15.00 ZAR : 1.00 EUR, later: 15.50 ZAR : 1.00 EUR. STEYN GmbH's profit: 25,000.00 EUR, dividend half thereof. VAT ignored. 86 Study bonds in our textbook Basics of Accounting, chapter (15). 87 Amortised costs means that the effective interest method applies. Check the Bookkeeping entries of the case study BATHURST Ltd. in chapter (6). HAWKINS Ltd. holds 8 % of STEYN GmbH in Germany. STEYN GmbH is an online dealer for motor vehicle tyres in Hamburg and based on an issued capital of 100,000.00 EUR. The company’s book value is 245,000.00 EUR at the time when HAWKINS Ltd. buys 8 % of the German firm at 19,600.00 EUR. The share price is justified by the book value of STEYN GmbH which is 245 % of its issued capital. 88 The book value of the acquired shares with a nominal value of 8,000.00 EUR is: 8,000 × 245% = 1 19,600.00 EUR. No fresh shares are issued when HAWKINS Ltd. buys its investment in STEYN GmbH. The currency exchange rate at the time of acquisition on 2.07.20X3 is: 15.00 ZAR = 1.00 EUR. HAWKINS Ltd. pays in its home currency: 15 × 19,600 = 2 294,000.00 ZAR. We ignore transaction costs based on the conventions laid out in chapter (1). Based on IAS 32.11, a financial asset applies for HAWKINS Ltd., as stock of another company falls under equity instruments. As the German company is in the legal form of a GmbH, we do not call the buyer a shareholder but a (partial) owner. HAWKINS Ltd.'s business model implies that the investment is timely unlimited. This supports the disclosure of the investment as non-current financial assets on its balance sheet. IFRS 9.5.1.1 requires the initial recognition at 294,000.00 ZAR which is at the costs of acquisition. HAWKINS Ltd. records the buy as Bookkeeping entry (1), see below: 88 Equity that increases the issued capital e.g., results from earnings added to reserves and/ or profits carried forward from prior Accounting periods. <?page no="189"?> Berkau: Financial Statements 7e 7-189 DR Financial Asset STEYN ........ 294,000.00 ZAR CR Cash/ Bank.................... 294,000.00 ZAR One could assume HAWKINS Ltd. has to record its shares in STEYN GmbH as an investment like a subsidiary or an associated company. It does not have to as the investment in the German company is below 20 % of STEYN GmbH’s total issued capital. 89 As no associate nor subsidiary applies, HAWKINS Ltd. discloses its shares as a financial asset following IFRS 9. There is no need to prepare group statements nor separate financial statements following IAS 27. The initial valuation is at cost (see above). The subsequent valuation of the shares in STEYN GmbH depends on their EUR value and the exchange rate to the South African Rand. We assume the shares are still worth 19,600.00 EUR on the balance sheet date of 31.12.20X3 but at the end of the Accounting period 20X3, the currency exchange rate has changed in HAWKINS Ltd.’s favour due to a weak South African Rand ZAR. The South African Rand has depreciated against the Euro. The exchange rate is: 15.50 ZAR = 1.00 EUR on 31.12.20X3. As the financial asset’s valuation is based on EUR values, HAWKINS Ltd. shares of STEYN GmbH are worth: 19,600 × 15.50 = 3 303,800.00 ZAR. The question for HAWKINS Ltd. is whether it must adjust its valuation? Yes, it does. Fair value presentation applies. In general, amortised costs never apply for shares as they can be sold on. Although its intention to keep the shares HAWKINS Ltd. must applies a fair value presentation, here, 89 Accounting for business combinations is covered in chapter (8). through other comprehensive income. The discussion about the business model above is only to assign the share in STEYN GmbH to the non-current asset section on the balance sheet. The fact that HAWKINS Ltd. core business is not Finance leads to the classification of gains from share price increases into other comprehensive income. HAWKINS Ltd. considers the increase in share values as gain due to the favourable currency exchange rate changes to the extent of: 19,600 × 15.50 - 294,000 = 99,800.00 ZAR. HAWKINS Ltd. records the currency gain together with the profit share as shown below in Bookkeeping entry (3). Therein, the increase of the shares due to equity increase is considered, which causes the difference due to the exchange rate exceed 9,800.00 ZAR towards 10,150.00 ZAR. The shares increase in valuation because STEYN GmbH increases its equity by adding earnings to reserves, see below. Next, we check the dividends received. STEYN GmbH earned a net profit (EBT) of 25,000.00 EUR during the Accounting period 20X3. The company pays half of its earnings after taxes to its owners and adds the other half to earnings reserves. Hence, the profit share receivable by HAWKINS Ltd. is: 8% × 25,000 × (1 - 30%) / 2 = 7700.00 EUR which is in HAWKINS home currency: 700 × 15.50 = 10,850.00 ZAR. STEYN GmbH adds: 25,000 × (1 - 30%) / 2 = 88,750.00 EUR to its earnings reserves <?page no="190"?> Berkau: Financial Statements 7e 7-190 which results in an equity increase. The shares are not traded publicly. So, we do not have any other indication for the valuation of shares than the company’s equity. Therefore, the fair value of the financial asset at HAWKINS Ltd. is adjusted through other comprehensive income and now is: 8% × (245,000 + 8,750) × 15.50 = 3 314,650.00 ZAR. This kind of measurement is referred to as ad-equity-valuation. It is the default measurement for associated companies and ruled by IAS 28. We apply the method due to the lack of an active market for the shares in STEYN GmbH. HAWKINS Ltd. records the value adjustment of: 314,650 - 294,000 = 2 20,650.00 ZAR through other comprehensive income. The amount contains the equity increase from the addition to reserves as well as the value increase caused by the favourable currency exchange rate increase. The profit share (portion of the profit appropriation) as paid to HAWKINS Ltd. is: 700 × 15.50 = 10,850.00 ZAR. As STEYN GmbH is no company based on shares, we do not call this a dividend. In total, HAWKINS Ltd.’s financial asset results in a gain of 10,850 + 20,650 = 31,500.00 ZAR. Observe the Bookkeeping entries (2) and (3). Due to IFRS 9.5.7.10, HAWKINS Ltd. records the currency gain separately. It is: 8% × (245,000 + 8,750) × (15.50 - 15) = 110,150.00 ZAR. Hence, the gain due to equity increase (addition to reserves) is: 20,650 - 10,150 = 1 10,500.00 ZAR. DR Cash/ Bank.................... 10,850.00 ZAR CR Other Comprehensive Income... 10,850.00 ZAR DR Financial Asset STEYN........ 20,650.00 ZAR CR Gain on Currency Rate........ 10,150.00 ZAR CR Other Comprehensive Income... 10,500.00 ZAR In terms of return figures, the gain gives a: (10,850 + 10,150 + 10,500) / 0.5 × (294,000 + 314,650) = 1 10.35 % return on investment for HAWKINS Ltd. On HAWKINS Ltd.’s balance sheet, the financial asset is now disclosed at 314,650.00 ZAR. Other comprehensive income is disclosed on the statement of profit or loss and other comprehensive income as: 10,850 + 20,650 = 3 31,500.00 ZAR. Special reporting requirements apply for HAWKINS Ltd. due to IFRS 7, like credit and market risk disclosure. Permanent changes in the valuation of financial assets cause volatility on the balance sheet and gains/ expenses on the income statement of the holder/ owner of financial assets. IFRSs allow a valuation at amortised cost to prevent the balance sheet from oscillating asset disclosures. IFRS 9.4.1.2 requires carrying financial assets at amortised costs if the company’s business model is keeping the assets and receiving regular cash flows on specific dates. Those cash flows can result from interest, pay-off and redemption payments, but not from capital appreciation. A valuation at amortised costs means a systematic approximation of the initial valuation to the final value. Technically, the effective <?page no="191"?> Berkau: Financial Statements 7e 7-191 interest method applies. If the initial value and the final one equal, amortised costs remain constant, as in the case of BATHURST Ltd. in chapter (6). A company that holds bonds until they mature must disclose them at amortised costs, too. Carrying financial assets at amortised costs is an alleviation in contrast to volatile fair value recognition. Only those financial instruments which are held until maturity qualify for disclosure at amortised costs - what is held ready to sell requires a fair value presentation through profit and loss or other comprehensive income - like shares. 7.35 C/ S HAVENGA Ltd. - Bonds HAVENGA Ltd. buys bonds which are traded on the bond market. The bonds have a face value of 5,000,000.00 ZAR (nominal value) and the time to maturity is 25 years. They are issued on 2.01.20X2. This is when HAVENGA Ltd. acquires them. The coupon rate of the bonds (yield) is 11 %/ a. Observe the Bookkeeping entry (1) at the time of acquisition below which is based on the cost model: DR Financial Assets............. 5,000,000.00 ZAR CR Cash/ Bank.................... 5,000,000.00 ZAR On 31.12.20X3, HAVENGA Ltd. receives the coupon which is: 5,000,000 × 11% = 5 550,000.00 ZAR. The Bookkeeping entry (2) for the coupon receipt shows the bonds’ income which is added to other comprehensive income: DR Cash/ Bank.................... 550,000.00 ZAR CR Bond Income .................. 550,000.00 ZAR For further information about HAVENGA Ltd.’s bond valuation, check the link below: Link 7.G: Bond valuation During the next years, the bonds’ value fluctuates and on balance sheet dates, the fair market values are: - 20X3: 6,306,624.27 ZAR - 20X4: 6,164,191.10 ZAR - 20X5: 5,961,479.99 ZAR - 20X6: 5,095,205.27 ZAR - 20X7: 5,000,000.00 ZAR Following IFRS 9.4.1.2, HAVENGA Ltd. records its bonds at amortised costs. Therefore, HAVENGA Ltd. ignores the changes in bond market values. HAVENGA Ltd.’s bonds are disclosed constantly at 5,000,000.00 ZAR which results in temporary underratings. HAVENGA Ltd.’s business model is to keep the bonds until maturity. At the date of redemption, it will receive 5,000,000.00 ZAR no matter what the bond price might have been in between. <?page no="192"?> Berkau: Financial Statements 7e 7-192 The valuation at HAVENGA Ltd. was constantly at the cost of acquisition because the company bought the bonds at face value and the redemption takes place at face value, too. Therefore, the measurement at amortised costs is simple. In case a holder buys bonds at another price than at par and the bonds are held to 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 the measurement at amortised costs by the next case study NATBERGEN (Pty) Ltd. 7.36 C/ S NATBERGEN (Pty) Ltd. - Bonds held to Maturity Below, we show the data sheet for NATBERGEN (Pty) Ltd. Data Sheet for NATBERGEN (Pty) Ltd. DDomicile: Australia (Brisbane). Reporting currency: AUD. Classification: n/ a. Bonds at 400,000.00 AUD, cost of acquisition: 350,000.00 on 3.01.20X3. Bonds mature on 31.12.20X7. Coupon rate: 8 %/ a, 32,000.00 AUD/ a. VAT ignored. On 3.01.20X3, NATBERGEN (Pty) Ltd. buys bonds 5 years before their maturity at 350,000.00 AUD. The face value is 400,000.00 AUD. We say the acquisition is at a discount (below-par). A listing of bonds below their principal results either from an interest market rate that exceeds the coupon rate or from the investors mistrusting the issuer’s capability to pay coupons and 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 = 3 32,000.00 AUD/ a. Dividend and interest depend on the nominal value and must in general be recorded through profit or loss or other comprehensive income. NATBERGEN (Pty) Ltd. initially recognises its bonds at 350,000.00 AUD (cost of acquisition). Check the Bookkeeping entry below: DR Investment held to maturity.. 350,000.00 AUD CR Cash/ Bank.................... 350,000.00 AUD NATBERGEN (Pty) Ltd. intends to keep the bonds until maturity and to benefit only from bond related payments. The bond payments are linked to interest (coupon) and repayment of principal. 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 only considers opening and closing values and payments made or received. Here NATBERGEN (Pty) Ltd. buys the bonds at 350,000.00 AUD (opening value) and receives at the time of redemption (on 31.12.20X7) 400,000.00 AUD. In between coupons are received. Amortised costs reflect the increase in valuation of the bonds by systematic adjustments. The effective rate of interest is used to compound the current value. All payments for coupons and redemption must be deducted for the <?page no="193"?> Berkau: Financial Statements 7e 7-193 bond valuation. Check the valuation of NATBERGEN (Pty) Ltd.’s bonds in Figure 7.16. and in the how-it-is-done paragraph below. It results in a valuation of zero after the bonds are redeemed by the issuer. 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) with the effective rate of interest. (4) Deduct all payments for coupons and/ or redemption (5) The result is the final value of the financial asset (bond). We calculate the effective rate of interest with the payment vector B(t) = {(350,000); 32,000; 32,000; 32,000; 32,000; 432,000}. It gives 11.42 %/ a. An alternative approach to determine the effective rate of interest is to prepare a financial schedule and use the goal seek function, see Link 7.H. Link 7.H: 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 7.16: Bond measurement at effective interest At maturity, NATBERGEN (Pty) Ltd. has increased the bonds incrementally to a valuation of 400,000.00 AUD which is the settlement value at redemption. We discuss below another case study DORRINGTON Ltd. which is about redeemable preference shares. <?page no="194"?> Berkau: Financial Statements 7e 7-194 7.37 C/ S DORRING-TON Ltd. / ROTTMAN Ltd. - Pref. Shares Preference shares have in general no voting rights, but the dividend is based on a percentage of their nominal value. This counts as an advantage as the dividend does not depend on the performance of the issuing company and, therefore, is free of risks. In case of a liquidation of the company, preference shareholders rank between creditors and ordinary shareholders. This counts as a further advantage; however, only if anything is left for distribution. In the case of a liquidation due to an Accounting insolvency (liabilities exceed the assets) nothing is sharable amongst the owners. By default, preference shares are cumulative, meaning a pending (not declared) preference dividend from previous years must be paid at first before further dividends can be declared. Next, we focus on the company that issues the preference shares, which is DORRINGTON Ltd. Later, we discuss the shareholders’ side (ROTTMAN Ltd.) where the preference shares are recognised as financial assets and carried at their fair values with adjustments made through other comprehensive income. The ROTTMAN Ltd. view is relevant for this chapter (7) as the company carries the preference shares as financial instruments on its balance sheet. Data Sheet for DORRINGTON Ltd. and ROTTMAN Ltd. DDomicile: South Africa (Kimberly). Reporting currency: ZAR. Classification: n/ a. 90 In Germany, redeemable preference shares are not allowed as they are regarded as liability instruments. Issued capital: 100,000 ordinary shares at 10.00 ZAR/ s. Issue of 10,000 preference shares, dividend: 12 %/ a based on principal, issue price 11.23 ZAR/ s on 2.01.20X7. ROTTMAN Ltd. holds 1,000 preference shares. Share price on 31.12.20X7: 10.90 ZAR/ s. ROTTMAN Ltd. sells 1,000 preference shares on 30.03.20X8 at the market price of 11.00 ZAR/ s. VAT ignored. DORRINGTON Ltd. issues preference shares. The preference shares’ dividend is 12 %/ a based on the nominal value of 10,00 ZAR/ s. DORRINGTON Ltd.'s preference shares are redeemable. 90 Redeemable preference shares are bought back at the time when they mature. The fair market price applies for redemption. According to international policy, DORRINGTON Ltd. discloses its preference shares under issued capital and capital reserves on the equity section of its balance sheet. The premium which is the difference between issue price and nominal value is recorded under capital reserves. DORRINGTON Ltd. is based on 100,000 ordinary shares at 10.00 ZAR/ s. The issued capital is: 100,000 × 10 = 1,000,000.00 ZAR before the issue of preference shares. On 2.01.20X7, DORRINGTON Ltd. issues 10,000 preference shares at 11.23 ZAR/ s which is the issue price. The face value of the preference shares is 10.00 ZAR/ s. For the recording of the preference shares, we apply IAS 32.15. At DORRINGTON Ltd., the preference <?page no="195"?> Berkau: Financial Statements 7e 7-195 shares are recorded as equity instruments at nominal values. The premium of: 11.23 - 10 = 1 1.23 ZAR/ s which is received upon issue is multiplied with the number of shares and added to capital reserves. It gives a credit entry of: 10,000 × 1.23 = 1 12,300.00 ZAR. Next, we change the perspective towards the shareholders. We analyse one preference shareholder, ROTTMAN Ltd. that owns 1,000 preference shares bought at 11.23 ZAR/ s on 2.01.20X7. ROTTMAN Ltd.’s intention is not to keep the preference shares until redemption but to sell them in the nearby future - but not during the first Accounting period. Therefore, the preference shares are initially recorded at cost: 1,000 × 11.23 = 1 11,230.00 ZAR in the non-current asset section. Observe Bookkeeping entry (I) recorded in the Bookkeeping records of ROTTMAN Ltd. (the preference shareholder). DR Financial Assets ............ 11,230.00 ZAR CR Cash/ Bank.................... 11,230.00 ZAR At the end of the fiscal year 20X7, the preference shares are traded at 10.90 ZAR/ s at the Johannesburg Stock Exchange JSE. As ROTTMAN Ltd. classifies the preference shares to be carried at fair values (FVTOCI) the preference shares are disclosed at fair market prices which results in the recording of an impairment loss to the extent of: (11.23 - 10.90) × 1,000 = 3 330.00 ZAR which is deducted from other comprehensive income. ROTTMAN Ltd. must record the impairment loss through other comprehensive income, as share trading is not its core business. The preference dividend received by ROTTMAN Ltd. is based on the face value of its shares and is: 12% × 10,000 = 11,200.00 ZAR. It is a dividend income recorded through other comprehensive income, observe Bookkeeping entries (II), (III) at the preference shareholder’s side below: DR Impairment Loss FA ........... 330.00 ZAR CR Financial Assets............. 330.00 ZAR DR Cash/ Bank.................... 1,200.00 ZAR CR Dividend Income.............. 1,200.00 ZAR ROTTMAN Ltd., sells its 1,000 preference shares on 30.03.20X8 at 11.00 ZAR/ s. After the fair value disclosure as at the previous balance sheet date (31.12.20X7), the selling price results in a gain on disposal through other comprehensive income to the extent of: (11 - 10.90) × 1,000 = 1 100.00 ZAR. Observe Bookkeeping entry (A): To keep the case study simple, we do not consider that the preference shares earned an interest claim of: 25% × 12% × 1,000 × 10 = 300.00 ZAR from January/ 20X8 until March/ 20X8. With a cum-interest sale the earned preference dividend claim would be added to the price at which shares are sold at. We here assume, that <?page no="196"?> Berkau: Financial Statements 7e 7-196 the selling price of 11.00 ZAR/ s considers the interest income already. DR Cash/ Bank.................... 11,000.00 ZAR CR Financial Assets............. 10,900.00 ZAR CR Other Comprehensive Income... 100.00 ZAR In line with IFRS 9.5.2.1, the following rule applies: A preference shareholder who keeps shares carries them at amortised costs but can opt for recognition at fair values through other comprehensive income FVTOCI. If the intention is holding shares for trading purposes, the valuation is based on fair values through profit or loss FVTPL. Regardless to measurement, preference dividends received are recorded through profit or loss or other comprehensive income. We discuss another case study online which contains a financial liability resulting from writing a call option for a specific number of ordinary shares. That leads to the recognition of an equity instrument. See the case study HELWAN AIRWAYS Ltd. which buys the rights for a route in return of a call option linked to its own shares. You reach the case through Link 7.I. Link 7.I: HELWAN AIRWAYS Ltd. 7.38 Derivatives A special form of financial instruments are derivatives. They are often acquired for hedging purposes. 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. Next, we discuss the case of electro manufacturer MOLLENBERG Ltd. which buys a call option for copper to secure its production costs at a market with volatile commodity prices. 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 got more alternatives as the seller (the option writer), we describe his situation as long. Accordingly, the option writer is in the short position. In case the market price falls under the stroke price when the option is exercised the option becomes futile, we say, "out of the money" and the option holder is left with the expenses for the option, which is its premium. No obligation to exercise the option applies. If the market price is above the strike price “in the money”, the option holder benefits from the price difference. However, the profit made is reduced for the premium previously paid. Call options make sense if their <?page no="197"?> Berkau: Financial Statements 7e 7-197 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. 7.39 MOLLENBERG Ltd. - Call Option We discuss the case of the production firm MOLLENBERG Ltd. which buys a call option on copper at a premium of 10,000.00 AUD. Below, we show its data sheet. Data Sheet for MOLLENBERG Ltd. DDomicile: 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 UDS/ lb. Currency exchange rates: 69.00 USD = 100.00 AUD; 72.00 USD = 100.00 AUD. Premium: 10,000.00 AUD. VAT ignored. MOLLENBERG Ltd. needs copper for its production. The copper price fluctuates and MOLLENBERG Ltd. expects the purchase prises to increase in the nearby future. It buys a call option which allows it to purchase copper at 3.60 AUD/ lb 91 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: 69.00 USD = 100.00 AUD. MOLLENBERG Ltd. pays for the premium 10,000.00 AUD. The quantity of the copper purchase agreed on 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: DR Call Option (FA) ............ 10,000.00 AUD CR Cash/ Bank.................... 10,000.00 AUD If on 31.12.20X5, the copper price is below 3.60 AUD/ lb the option becomes (temporarily) void as MOLLENBERG Ltd. could rather buy copper without exercising its call option. However, a drop in copper price will not impair the call option as MOLLENBERG Ltd. does not know the price on 31.12.20X9 yet (4 years later). The valuation of the call option as at the balances sheet date 20X5 is at fair value through other comprehensive income. The reason is that there is still a chance to sell on the call option. 91 Copper is traded in pounds (lbs.) We assume, on 31.12.20X5, the copper price is 2.65 USD/ lb and the exchange rate is: 72.00 USD = 100.00 AUD. For the fair value calculation of the call option, we calculate the temporary gain related to that 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 360,000.00 AUD. Hence, the fair value of the financial instrument is: 368,055.56 - 360,000 = 8 8,055.56 AUD. This means a decrease in valuation com- <?page no="198"?> Berkau: Financial Statements 7e 7-198 pared to the cost of acquisition (premium) of: 10,000 - 8,055.56 = 1 1,944.44 AUD. MOLLENBERG Ltd. who measures the call option at fair value through other comprehensive income adjusts its valuation by making Bookkeeping entry (2). The valuation considers that the advantage of buying cheap is reduced due to the premium. DR Other Comprehensive Income... 1,944.44 AUD CR Call Option (FA)............. 1,944.44 AUD In the next following Accounting periods, MOLLENBERG Ltd. must adjust its option’s measurement based on copper prices and the exchange rates to the USD again. The valuation reflects its profit under consideration of the premium. If the price is below 360,000.00 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 processed for the purchase of copper, the option gets expensed and will be added to the 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 desired copper quantity is 365,000.00 AUD on 31.12.20X9. The costs of purchase now are: 360,000 + 8,055.56 = 3 368,055.56 AUD. Consider that we recorded in 20X5 expenses to the extent of 1,944.44 AUD which are allocated towards the Accounting period 20X5 as impairment loss at that moment. Therefore, the total purchase costs are 370,000.00 AUD. The above shown value applies for all copper prices in excess of 360,000.00 AUD. We keep in mind that the decision to buy the option was made in 20X5 already. If the copper price falls below 360,000.00 AUD, MOLLENBERG Ltd. will not exercise its call option. We now assume (as an alternative scenario) the copper price is 355,000.00 AUD on 31.12.20X9. MOLLENBERG Ltd. forfeits the call option, buys copper at 355,000.00 AUD and records an impairment loss on the call option. Thus, the costs of purchase are: 355,000.00 AUD and the impairment loss is 8,055.56 AUD. We also must consider the recording of the impairment loss in 20X5 to an extent of 1,944.44 AUD. In comparison to not buying the call option, the expenses increase by: 8,055.56 + 1,944.44 = 110,000.00 AUD. These are the costs for the premium. So far, we discussed financial instruments held for longer periods that are classified as non-current assets. Companies can hold, shares or bonds or other financial instruments short-term, too. In that case we allocate them to the security item on the balance sheet which is found in the current asset section. We cover those cases in chapter (9). <?page no="199"?> Berkau: Financial Statements 7e 7-199 How it is Done (Recording Financial Assets as non-Current Assets): (1) Determine whether the financial asset is held short-term or long-term. For short-term recognition check chapter (9) in this textbook. (2) If the financial asset is held for long-term periods, we recognise the financial asset at its costs as a non-current asset. (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. 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. 7.40 Summary Non-current assets are property, plant and equipment or intangible assets or financial instruments. A special recognition is required for leases which is based on a right-of-use-asset that falls under intangible non-current assets and a lease liability at the same time. As non-current assets are held for a longer period than a fiscal year, changes in valuation become relevant. Examples for subsequent measurement are depreciation, impairment loss and revaluations. In contrast, 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. 7.41 Working Definitions Amortised Costs: To keep an asset or liabilities at amortised costs is a simplification of its measurement accepted for financial instruments that are intended to keep until maturity. It replaces a fair value presentation. The calculation of amortised costs is based on the effective interest method. Call Option: Right but not an obligation to buy assets at an agreed price in the future. Carrying Value: Measurement of an asset at which it is disclosed on the 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 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="200"?> Berkau: Financial Statements 7e 7-200 Financial Asset: Shares, bonds, options etc., bought to keep them for more than one Accounting period. Gross Replacement Method: Method of recording a valuation based most probably on a change of cost of acquisition for new assets. Adjustments are recorded as if the asset was bought at the increased price. Impairment Loss: Difference between a carrying value and a subsequent, lower valuation that is regarded as extraordinary. Intangible Asset: Asset without physical nature. Investment: Ownership of a portion of another business e.g., holding more than 20 % or its shares. In general, investments are subsidiaries, partial ownership in associated companies or result from joint ventures. Investment Property: In general, land or buildings held for renting out or capital appreciation. Lease: Contract to use an asset and taking control by paying its owner a certain consideration for an agreed time span. The duration of the lease must be material. 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 most probably an expertise at the time of adjustment of 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. The Realisation account is closed-off to the profit or loss or to other comprehensive income. Recoverable Amount: Obtainable selling price or value in use - whatever is higher. Revaluation: Assigning a value to an asset that exceeds the carrying value. Value in Use: Valuation of an asset based on received cash flows. 7.42 Questions Bank (1) Which IFRS standards rule depreciation and impairment loss? 1. IAS 14, IAS 36. 2. IAS 16, IAS 36. 3. IAS 16, IAS 38. 4. IAS 14, IAS 38. (2) A car is acquired at a price of 78,000.00 EUR (gross amount) and is fetched from Stuttgart for 1,200.00 EUR gross amount. The dealership offers a trade discount of 10 % for the car. How much are the resulting cost of acquisition? 1. 71,400.00 EUR . 2. 59,500.00 EUR . 3. 59,400.00 EUR . 4. 58,500.00 EUR . (3) The Realisation Account shows: 1. The net selling price on the credit side and the carrying value of the sold asset on the debit side. 2. A profit on disposal on the credit side. 3. The output-VAT on the credit side. 4. The gross selling price on the credit side, the output-VAT on the debit side, the P, P, E amount on the debit side, the total of accumulated depreciation on the credit <?page no="201"?> Berkau: Financial Statements 7e 7-201 side and the total of accumulated impairment loss on the debit side. (4) A machine is carried at 80,000.00 EUR at the beginning of the Accounting period 20X1. Its depreciable amount is 70,000.00 EUR and there are 5 years remaining for depreciation. On 1.04.20X2 the machine is damaged, and the remaining amount is 55,000.00 EUR. Depreciation is resumed a few days later. How many expenses do you record in 20X2? 1. 21,500.00 EUR . 2. 22,000.00 EUR . 3. 7,500.00 EUR . 4. 20,000.00 EUR . (5) A company buys a machine on 2.03.20X3 at 5,000.00 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 at 31.12.20X4? 1. 4,085.36 EUR . 2. 3,205.85 EUR . 3. 3,000.00 EUR . 4. 3,078.90 EUR . 7.43 Solutions 1-2; 2-2; 3-1; 4-4; 5-2. <?page no="202"?> Berkau: Financial Statements 7e 8-202 8 Business Combinations 8.1 What is in the Chapter? In this chapter, we look at Group Accounting which is required for 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. The latter ones require consolidations. A group is a set of companies that are linked to each other by controlling relationships, meaning one company holds power over another one, mostly by holding rights of ownership. 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 controlled by other companies together. If the companies X and Y control Z together, then Z is the joint venture and X and Y are investors. This chapter covers 1 case study for separate financial statements, 3 case studies for Group Accounting and 1 joint venture example. 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 about Group Accounting. You can prepare group statements on case study level and can apply a consolidation worksheet as provided by our CH5-file. 92 92 Read the instructions about that file in our textbook Basics of Accounting, chapter (5). 8.3 Group Accounting Groups must prepare financial statements in addition to the single-entity financial statements for each group member. Hence, a group of three companies with one parent and two subsidiaries prepares four sets of financial statements, three single-entity financial statements for each member and one for the entire group - the group statements. A parent is a company executing control power, a subsidiary is the dependent company. We also cover the preparation and presentation of separate financial statements following IAS 27, if companies hold investments in other companies. Same as the IASB states in IAS 27.3, we do not discuss reasons why separate financial statements are required but in case they must be prepared we show how to do it. Separate financial statements are single-entity financial statements which consider the reporting company holding investments in subsidiaries. Nowadays, many companies are involved in groups, either as a parent or as a subsidiary. It is the aim of this chapter to provide you with a sound knowledge about Group Accounting and consolidation techniques. Consolidation is an Accounting technical term for calculations made in group statements to remove double or multiple considerations of items which are caused by the process of adding financial statements for Group Accounting. <?page no="203"?> Berkau: Financial Statements 7e 8-203 Group Accounting can be demanding as the calculations are complex, and we must describe all companies of a case study. We start with separate financial statements following IAS 27, cover initial and subsequent consolidations based on IFRS 3 and IFRS 10 and discuss Joint Venture Accounting based on IFRS 11 at the end of this chapter. We teach the major methods, like the acquisition method, equity method and show Bookkeeping entries for consolidations. Group Accounting does not result in making real Bookkeeping entries. Hence, “making consolidation Bookkeeping entries” does not fall under genuine Bookkeeping work. It is more a common term for preparing consolidated financial statements. Group statements are derived from single-entity financial statements of the group members. You will see the difference further below. This chapter refers to the file CH5.xls that provides you with an MS-Excel based consolidation worksheet. Keep it handy when you study this chapter. The file follows the procedure of recording consolidations. Relevant standards for Group Accounting 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 IFRS 12: Disclosure of Interest in other Entities. IAS 27 rules the Accounting for separate financial statements. A separate financial statement is a statement of a parent or a joint venture investor that covers investments either at its costs or at fair values in accordance with IFRS 9 or based on Equity Accounting as ruled in IAS 28 (IAS 27.10). A company that does not hold investments does not prepare separate financial statements, check IAS 27.7. IAS 28 refers to associated companies and to joint ventures. In particular, the equity method is subjected to regulations in IAS 28.10 and the following paragraphs. IFRS 3 contains regulations about business combinations based on the acquisition method. A business combination only applies if the acquired assets and liabilities constitute a business. This can apply for subsidiaries, associated companies and joint ventures. E.g., if you only buy all buses of a travel service company, this will not constitute a group, see IFRS 3.3. IFRS 10 covers consolidated financial statements. Consolidated financial statements are financial statements for groups. A group includes the parent and all its subsidiaries. In consolidated financial statements, the assets, liabilities, equity, income, expenses and cash flows of the parents and of all subsidiaries are presented as those of a single economic entity. 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 an agreement between the owners about how to jointly make decisions. IFRS 12 requires companies to disclose information about nature, risks and interest in other companies. It helps the reader of financial statements to evaluate the impacts thereof on the <?page no="204"?> Berkau: Financial Statements 7e 8-204 financial position, on the financial performance and on cash flows of business combinations. Group Accounting is about the combination of businesses. A business combination exists if one company dominates another one by taking over control. This often is based to the rights of ownership. For Accounting, the percentage of control matters. 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 in line with IFRS 9 which is initially at cost and for subsequent measurement at fair values through profit or loss or through other comprehensive income. 93 As substitute for fair values the book value of a company can be used. 94 (2) 20 % … 50 % of control defines an investment in an associated company with substantial influence executed by the owner. For the valuation of the associated company, the equity method applies where an increase/ decrease of the investment value is calculated proportionally to the percentage at which its book value changes. Hence, an associated company that increases by 12 % in book value will increase in value on the balance sheet of its owner by 12 %, too. An owner of associate companies prepares separate financial statements in line with IAS 27. In detail, IAS 27.6 applies. 93 We cover these cases in chapter (7) and (9). (3) > 50% of control requires the preparation of group statements. Group statements are financial statements of the entire group which cover all subsidiaries of the group. This also includes subsidiaries of subsidiaries in a multiplelevel group structure. The percentages of control can differ from what you normally expect to be the portion of ownership. They are based on control criteria. Before we continue with percentages of control in multiple-level groups, we define the technical term control. Control refers to the power to govern the financial and operating policies of a company to obtain benefits from its activities (IFRS 10, appendix A). Criteria of control are defined by IFRS 10.7. In a multiple-level group, a company can be a subsidiary and parent at the same time. The calculation of influence is 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 calculated ownership for C is: 60% × 55% = 33%. It only matters that A controls B which defines full power and counts as 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 %, as well. As a consequence, A must prepare 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 94 Check the case of HAWKINS Ltd. in chapter (7). <?page no="205"?> Berkau: Financial Statements 7e 8-205 covered by Group Accounting of A already. IFRS 10.31 applies and rules that 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. We could say, in terms of the control hierarchy in the group the highest parent shields its lower investment companies from preparing extra group statements. Only the top parent prepares group statements and includes all companies below (in terms of the control hierarchy). In Accounting slang this is referred to as the Christmas tree principle, because with a Christmas tree’s upper branches shield lower ones against rain. The percentage replacement of 60 % with full control power (100 %) in the example follows the full consolidation principle. This means that group members are always considered to an extent of 100 % for consolidated financial statements. This makes sense, as the company which considers a subsidiary for its consolidated financial statements can only be the parent. There is not such a thing like 2 parents regarding the control hierarchy in Accounting. Hence, if two companies hold another one at 70 % and 30 % only the one that gains major (70 %) power over the company includes it in its group statements and to the extent of 100 %. The other one is considered as non-controlling interest holder. In terms of Group Accounting, control is never shared (This is the major difference to Joint Venture Accounting.). For Group Accounting all subsidiaries are considered regardless of where they are domiciled (global consolidation principle). Hence, Group Accounting ignores geographical borders. Accounting rules apply based on the parent's jurisdiction. For simplification, we assume in this textbook that all companies prepare single entity-financial statements and Group Accounting following IFRSs. Besides of hierarchical control relationships, there are joint ventures which are companies owned and controlled by more than one company collectively. Jointly control is mostly ruled by contracts. In general, both investors must agree to decisions. No decisions based on majority are accepted. We cover those aspects at the end of this chapter. We discuss Group Accounting in three steps: (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 or investors. The major difference to group statements is that they do not follow the regulations of IFRS 10 about consolidations. This leads to a measurement of investments based on the portion a parent or investor is holding. Separate financial statements are always prepared for a single company. <?page no="206"?> Berkau: Financial Statements 7e 8-206 8.5 C/ S BRENO Ltd. Next, we discuss separate financial statements for the case study BRENO Ltd. hat holds a financial asset as well as an investment in an associated company. Data Sheet for BRENO Ltd. DDomicile: South Africa (Bloemfontein). Reporting currency: ZAR. Classification: n/ a. Investments: 36.5 % of SANBONA Ltd.; 9 % of SUURENBERG Ltd. Profits (EAT): BRENO Ltd.: 280,000.00 ZAR / SUURENBERG Ltd.: 34,000.00 ZAR / SABONA Ltd.: 24,000.00 ZAR. Dividends: 40 % / 25 % / 15 %. Share price SUURENBERG Ltd.: at acquisition 3.00 ZAR/ s, 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. counts as a financial asset. The characteristics for holding an associated company (SABONA Ltd.) are significance of influence and are here fulfilled. In line with IAS 28.5, a company has significant influence, if holding 20 % or more of the voting power. BRENO Ltd. does not apply group statements but prepares separate financial statements and discloses 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 the Accounting period 20X5. Focus on the non-current asset section where the investment and the financial asset are disclosed. 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., IFRS 9 is applicable. During the Accounting period 20X5, the three companies earn the below listed profits and make payments to their owners as disclosed below, as well. To keep the case study simple, we assume dividends are paid based on the annual sur- <?page no="207"?> Berkau: Financial Statements 7e 8-207 plus. This means, no profit is carried forward and no loss is carried forward from prior Accounting periods. - BRENO Ltd.: profit before taxes (and before dividends): 280,000.00 ZAR, dividend: 40 % of the final profit after taxes and after revaluation of investments in associates and financial assets. - SUURENBERG Ltd.: profit after taxes 34,000.00 ZAR, dividend 25 % thereof. - SABONA Ltd.: profit after taxes: 24,000.00 ZAR, dividend 15 % thereof. The dividend receipts from investments are not yet included in the income statement and balance sheet of BRENO Ltd. No appropriation of profits has been considered so far, either. Observe BRENO Ltd.’s income statement as shown in Figure 8.2 below: [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 1.00 ZAR/ s ordinary share was 3.00 ZAR/ s. BRENO Ltd. holds 9,000 shares. The costs of acquisition of the shares are: 3 × 9,000 = 2 27,000.00 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. The share price <?page no="208"?> Berkau: Financial Statements 7e 8-208 of 3.00 ZAR/ s is the fair value at the time of acquisition. With the profit earned during the Accounting period 20X5, the share price for SUURENBERG Ltd. increases on 31.12.20X5 by 0.18 ZAR/ s as traded at Johannesburg Stock Exchange. The fair market value of the shares is 3.18 ZAR/ s. This results in an increase of: 0.18 / 3 = 66.00%. Therefore, BRENO Ltd. increases the value 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 1,620.00 ZAR. BRENO Ltd. makes the Bookkeeping entry below in its books: DR Financial Asset ............. 1,620.00 ZAR CR Other Comprehensive Income... 1,620.00 ZAR BRENO Ltd.’s share of the dividends declared by SUURENBERG Ltd. (25 %) is linked to 9 % of ownership and is: 9% × 34,000 × 25% = 7 765.00 ZAR. BRENO Ltd. records the dividend received as other comprehensive income. DR Cash/ Bank.................... 765.00 ZAR CR Other Comprehensive Income... 765.00 ZAR For the investment in the associated company SABONA Ltd., BRENO Ltd. applies the equity method following IAS 28.10. The equity method increases the value of an investment based on profits earned by the associated company reduced for dividends received. 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 24,000.00 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 73,000.00 ZAR which is 36.5 % of all shares. Accordingly, SABONA Ltd.’s issued capital is: 73,000 / 36.5% = 200,000.00 ZAR. The dividend paid to SABONA Ltd.’s owners is 15 % of the profit of 24,000.00 ZAR and is to be deducted following IAS 28.10 and IAS 27.12. The reason is, that the book value of SABONA Ltd. decreases by the dividend payment. A debit entry is made in SABONA Ltd.’s Retained Earnings account. Hence, the increase in equity is linked to the portion which is not transferred to owners: 12% × (1 - 15%) = 1 10.2%. The value of the associated company SABONA Ltd. increases by: 73,000 × 10.2% = 7 7,446.00 ZAR. Furthermore, the dividend of: 15% × 24,000 × 36.5% = 1 1,314.00 ZAR is received and recorded through other comprehensive income. Observe the Bookkeeping entries below: <?page no="209"?> Berkau: Financial Statements 7e 8-209 DR Investment @equity........... 7,446.00 ZAR CR Other Comprehensive Income... 7,446.00 ZAR DR Cash/ Bank.................... 1,314.00 ZAR CR Other Comprehensive Income... 1,314.00 ZAR IAS 27.12 requires the deduction of dividends from the investment value because it leads to an equity decrease. We considered the dividend deduction already when we calculated an investment increase of 7,446.00 ZAR because we multiplied with 10.2 % instead of with 12 %. Regarding the other comprehensive income, dividends result in a zero-sum-game as 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 income calculation. 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 291,145.00 ZAR. See the income statement in Figure 8.3.The dividend portion of this amount is: 40% × 291,145 × (1 - 30%) = 881,520.60 ZAR. It is recorded as a liability to shareholders and disclosed as short-term debt on the balance sheet. Dividends are paid in 20X6 (simplification, see above). The value for retained earnings is: 140,000 + 203,802 - 81,520.60 = 262,281.40 ZAR. The other 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: 765 + 1,620 + 7,446 + 1,341 = 11,172.00 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="210"?> Berkau: Financial Statements 7e 8-210 [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) In many countries, like in Germany, the disclosure of an equity instrument increasing/ decreasing due to price fluctuations and the application of the equity method are prohibited for single-entity financial statements as the measurement includes unrealised profits. Profit only is considered as realised once the assets, here: the investments, are sold. Then, the investment does not show on the balance sheet anymore. How it is Done (Separate Financial Statements): (1) Determine whether separate financial statements must be prepared (IAS 27). National law applies. (2) If separate financial statements apply, prepare them for the holder of the investment. (3) Recognise financial assets at cost or at fair values through either profit or loss or through other comprehensive income based on IFRS 9. (4) Disclose investments in associates or joint ventures following Equity Accounting 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. <?page no="211"?> Berkau: Financial Statements 7e 8-211 (7) If applying the equity method, a dividend paid by the associate or joint venture reduces the investment’s valuation. Record a deduction of assets accordingly. 8.6 Consolidated Financial Statements Consolidated financial statements are referred to as derived financial statements because a group itself does not keep Bookkeeping records. Group statements are based only on singleentity financial statements. This gives us some extra work regarding the preparation of subsequent group statements as we must maintain the initial consolidations (manually). This technically means, we must repeat the initial capital consolidation every Accounting period. With an application of Accounting software, this should not become a problem. However, in an Accounting class is receives our extra attention. In contrast to financial statements along IAS 27, Group Accounting requires consolidations. We start our discussion with consolidations and prepare group statements for three case studies thereafter. For the consolidated financial statements, all single-entity financial statements of group members are “addedup” item-wise. For the calculations, financial statements must be uniform regarding formal aspects. The same as fraction adding e.g., 1/ 3 + 1/ 2 = 5/ 6, requires finding a common denominator, the addition of financial statements requires applying the same GAAPS, reporting in the same currency, referencing to the same balance sheet date etc. E.g., a group that includes a Dutch and South African company with the South African one being the parent, must transfer the financial statements prepared in the Netherlands following the Dutch Woertbook van Koophandel to IFRSs. Furthermore, it must re-value assets measured in EURs to the South African Rand ZAR. Only then, financial statements can be added. Addition by item means, we add every item separately, like: PPE Dutch + PPE SAn = PPE- Group . Adding financial statements can cause items counting double, like the interest in the subsidiary and its assets. To avoid multiple considerations, consolidations eliminate intra-group balances, transactions, income and expenses. 8.7 C/ S GAMKA/ SWARTBERG Group - Initial Consolidation Next, we study the case of the GAMKA/ SWARTBERG group below and introduce the acquisition method following IFRS 3.4. It requires identifying the acquirer (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. Later, we discuss another case of PORTERSVILLE Ltd. and its subsidiary HENDERSON Ltd. to learn about profit consolidations. With the last case study PATTEN/ SPYKER we cover group member transactions and the consolidation of intra-group profits. <?page no="212"?> Berkau: Financial Statements 7e 8-212 Data Sheet for GAMKA/ SWARTBERG DDomicile: 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. With the acquisition, the companies become a group. GAMKA Ltd. is the owner of 80 % of the ordinary shares of SWARTBERG Ltd. and takes over control of SWARTBERG Ltd. By gaining control power, GAMKA Ltd. is the parent; SWARTBERG Ltd. is the subsidiary. GAMKA Ltd. and SWARTBERG Ltd. both prepare single-entity financial statements and one set of financial statements for the group. The group statements contain a full set of financial statements which consider all group members as “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 helps us to distinguish group statements from single-entity financial statements. 95 A full set of financial statement comprises in general of a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of cash flows, a statement of changes in equity and the notes. IAS 1.10 applies for group statements, too. 95 See e.g., Figure 8.10. To determine the items on the GAMKA Group’s statement of financial position the Accountant adds all balance sheet items for the group members. For recognition and measurement, fair values as on acquisition date apply (IFRS 3.18). E.g., PPE GAMKA + PPE SWARTBERG = 230,000 + 40,000 = 2 270,000.00 ZAR. The above values are derived from the balance sheets shown in Figure 8.5 and Figure 8.6. For the group’s balance sheet, a capital consolidation is necessary because 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. To clear Group Accounting from the above-mentioned multiple considerations, the group statements require capital consolidation by which the investment and the total subsidiary’s equity are cancelled out. In general, consolidations consist of capital consolidation, a consolidation of intra-group receivables/ payables and a intra-group profit consolidation on the balance sheet as well as on the income statement for the group. The objective is to eliminate multiple considerations of items or to delete effects of inter-group transactions, like internal profits. A capital consolidation is a calculation that eliminates the investment in subsidiaries and their equity on group statements. As the subsidiary valuation is based on the acquisition method and equity valuations are based on nominal values, a difference can result which ei- <?page no="213"?> Berkau: Financial Statements 7e 8-213 ther is a goodwill or a negative goodwill. If only a percentage of a subsidiary is acquired, the equity portion linked to ownership is cancelled out against the cost of acquisition. The equity portion that does not belong to the group is disclosed as non-controlling interest in the equity section of the group statement of financial position. This is the portion of owners who are no group members e.g., for an investor holding 30 % of a subsidiary. We always apply a full consolidation at 100 %, even if the parent only holds 70 % of a subsidiary. Therefore, group statements cover the entire subsidiary including the portion held by others. This is the reason, why the group statements disclose the portion of those owners who do not control a subsidiary. In the old days, this portion was called minority interest. A consolidation of receivables and payables removes all mutual debts and receivables between group members. A profit consolidation results in the deduction of intra-group profits on the group’s income statement and the equity section of the group’s balance sheet. A profit consolidation can also cause asset revaluations, if e.g., one group member sells goods to another one and earns a profit thereby. Together with the profit elimination a goods valuation adjustment becomes necessary. Regarding consolidations, we distinguish initial consolidation and subsequent ones. An initial consolidation is recorded at acquisition date in general when the group is defined by the parent gaining control power over the subsidiary. Any subsequent consolidation is recorded after the initial one. Accountants refer to calculations as “making consolidation Bookkeeping entries” because it is important to adjust the debit and credit sides together. However, no real Bookkeeping entries are made. Consolidations are calculated based on financial statements, like balance sheets or income statements. Therefore, we must repeat the initial consolidation every Accounting period to carry them forward. An exception only applies, when the group structure is changed e.g., with the acquisition of a further share in a subsidiary. Consolidated financial statements do not cause nor do they affect payments. No tax payments nor dividends depend on group statements. The only purpose of Group Accounting is providing information. Below, we study consolidations for the GAMKA GROUP. The two group members provide the financial statements on 31.12.20X3 as below. This is one day before the acquisition (1.01.20X4): <?page no="214"?> Berkau: Financial Statements 7e 8-214 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 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 show the names of the group members. We see their legal form disclosed on the headers. All items on the balance sheets are measured at fair values and have been prepared under IFRSs regulations. The reporting currency is the South African Rand ZAR. The financial statements of both group members are prepared without consideration of the appropriation of profits; therefore, all profits are carried forward to the next Accounting period 20X4. We prepare group statements as at 31.12.20X4 (one year later). At first, we prepare the capital consolidation: When GAMKA Ltd. buys 80 % of SWARTBERG Ltd. on 1.01.20X4, its book value is: 50,000 + 28,000 = 7 78,000.00 ZAR. The book value of GAMKA Ltd.’s investment is 80 % thereof: 80% × (50,000 + 28,000) = 6 62,400.00 ZAR. <?page no="215"?> Berkau: Financial Statements 7e 8-215 GAMKA Ltd. pays the (previous) owners 65,000.00 ZAR in exchange of 80 % of SWARTBERG Ltd.’s ordinary shares. This means, the payment exceeds the book value of the acquired share in SWARTBERG Ltd. Because of the acquisition, the statement of financial position now discloses an investment at cost of 65,000.00 ZAR and a reduced item cash/ bank compared to the situation before the acquisition. The cash/ bank item now is: 100,000 - 65,000 = 3 35,000.00 ZAR. GAMKA Ltd. bought the subsidiary at a price above its book value, probably for strategic intentions e.g., regarding the present market position of SWARTBERG Ltd., or the acquirer expects a high potential of the business in the future etc. 96 GAMKA Ltd. makes the Bookkeeping entry below which indicates that the subsidiary is recorded at cost. See in Figure 8.7 the balance sheet for GAMKA Ltd. on 1.01.20X4 after the acquisition. DR Investment Subsidiary........ 65,000.00 ZAR CR Cash/ Bank.................... 65,000.00 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 is disclosed at its cost of acquisition of 65,000.00 ZAR. This is the value of 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. 96 Read our textbook Management Accounting, chapter (11). did not change with 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. <?page no="216"?> Berkau: Financial Statements 7e 8-216 Both companies still must prepare single-entity financial statements. We now prepare the group statements. They are indicated as GAMKA GROUP statements. Adding the financial statements is supported by a consolidation worksheet as shown below in Figure 8.8. 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 is shown as aggregated balance sheet (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 = 270,000.00 ZAR. By adding financial statements, the investment of 65,000.00 ZAR and all its assets are disclosed on the debit side. Con- 97 Compare to Figure 8.6. sider, that the book value of the acquired company is the total of its assets less its liabilities: 100,000 - (10,000 + 12,000) = 7 78,000.00 ZAR. 97 This means SWARTBERG Ltd. now counts more than 180 % on the group statements. "More" refers to the goodwill not yet disclosed but included in the amount of 65,000.00 ZAR. 100 % is the result of a full consolidation, even though only 80 % is the percentage of ownership. The multiple consideration of the subsidiary would result in misleading information. <?page no="217"?> Berkau: Financial Statements 7e 8-217 To avoid multiple considerations of subsidiaries, we must record a capital consolidation. The aim is to cancel out the investment and the partial book value of SWARTBERG Ltd. and to disclose the excess of payment as a goodwill. 80 % of SWARTBERG Ltd.’s value is: 80% × 78,000 = 6 62,400.00 ZAR. The overpayment is: 65,000 - 62,400 = 2 2,600.00 ZAR. We make a Bookkeeping entry as shown in the column for capital consolidation (CAP.CONS). This is ruled by IFRS 3.32. 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 contains 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: 2,600 + 40,000 + 22,400 = 65,000.00 ZAR. The second step allocates the portion of 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. The equity section of a consolidated balance sheet contains an item called non-controlling interest. For the GAMKA Group, this item contains 20 % of the shares at nominal values and 20 % of the retained earnings at the time of acquisition. This gives: 20% × 50,000 = 10,000.00 ZAR and: 20% × 28,000 = 5,600.00 ZAR. These initial capital consolidation bookkeeping entries are maintained for subsequent consolidations. For subsequent consolidations, they must be repeated as the consolidation is based on single-entity financial statements which means that consolidation Bookkeeping entries are not saved. The consolidated statement of financial position for GAMKA GROUP is displayed in Figure 8.10. It is derived from the right column in the consolidation worksheet. <?page no="218"?> Berkau: Financial Statements 7e 8-218 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 on the (next) consolidation chart. The consolidation bookkeeping entry is: DR Goodwill..................... 2,600.00 ZAR DR Issued Capital............... 50,000.00 ZAR DR Retained Earnings............ 28,000.00 ZAR CR Investments.................. 65,000.00 ZAR CR Non-ctrl. Interest........... 15,600.00 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 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="219"?> Berkau: Financial Statements 7e 8-219 [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 you with some background information about the business operations which is not relevant for 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: 230,000 - 16,000 = 2 214,000.00 ZAR. Goods have been released from stock which gives a reduction of 10,000.00 ZAR in the Inventory account: 170,000 - 10,000 = 160,000.00 ZAR. We assume all business activities - except of depreciation are on cash. GAMKA Ltd. pays 30,000.00 <?page no="220"?> Berkau: Financial Statements 7e 8-220 ZAR to the revenue service for income tax liabilities from 20X3. A cash revenue of 200,000.00 ZAR is deducted for labour and materials. Hence, the item cash/ bank is: 35,000 + 200,000 - 14,000 - 100,000 - 30,000 = 9 91,000.00 ZAR. On the credit side, there is no change in issued capital and the earnings after tax are added to retained earnings: 70,000 + 42,000 = 1 112,000.00 ZAR. In the liability section, the only change is in the Income Tax Liability account: 30,000 - 30,000 + 18,000 = 1 18,000.00 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="221"?> Berkau: Financial Statements 7e 8-221 We repeat the explanation of the single-entity financial statements for SWARTBERG Ltd. Again: if you are happy with the financial statements without further explanation, you can 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 takes place: 40,000 - 10,000 = 3 30,000.00 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 and material payments. The item cash/ bank is: 30,000 + 35,000 - 15,000 - 12,000 = 3 38,000.00 ZAR. There are no changes in issued capital and the item retained earnings is: 28,000 + 7,000 = 3 35,000.00 ZAR. Shortterm liabilities remain unchanged, and the income tax liabilities are based on the payment of 20X3’s debts. The item tax liabilities is: 12,000 - 12,000 + 3,000 = 33,000.00 ZAR. * The consolidation procedures are based on the consolidation worksheet again. After we enter the figures for the single-entity balance sheets we see the aggregated balance sheet already. On the consolidation worksheet, the initial consolidation Bookkeeping entries are given. We apply the comprehensive Bookkeeping entry for capital consolidation as calculated above. Observe the consolidation worksheet in Figure 8.15. <?page no="222"?> Berkau: Financial Statements 7e 8-222 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) No changes regarding investment valuation nor for the percentage of ownership apply. The only adjustment required is for the profit and the portion belonging to the non-controlling interest holders thereof. No inter-group profits took place. The profit of the subsidiary is 7,000.00 ZAR as disclosed on the income statement. A portion of 80 % belongs to the group and the remaining 20 % are assigned to noncontrolling interest holders. Hence, we allocate: 80% × 7,000 = 5 5,600.00 ZAR to the group and: 7,000 - 5,600 = 1 1,400.00 ZAR to the non-controlling interest holders. This is also disclosed at the bottom of the income statement, see Figure 8.16. <?page no="223"?> Berkau: Financial Statements 7e 8-223 [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............ 1,400.00 ZAR CR Non-ctrl Interest............ 1,400.00 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 7e 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 income statements for the group members directly. 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 = 47,600.00 ZAR. The value is negative on the income statement as we allocate it to the retained earnings. The portion of the subsidiary’s profit allocated to noncontrolling interest holders is based on the percentage they are holding: 20% × 7,000 = 1 1,400.00 ZAR. <?page no="225"?> Berkau: Financial Statements 7e 8-225 [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 additions 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 49,000.00 ZAR. 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) <?page no="226"?> Berkau: Financial Statements 7e 8-226 A full set of financial statement includes a statement of cash flows, too: We assume that all activities are on cash - depreciation exempted. We prepare the statement of cash flows for the group based on the reconciliation method as explained in detail in chapter (10). The cash flow calculation for this case is shown 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 64,000.00 ZAR. 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 the 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. <?page no="227"?> Berkau: Financial Statements 7e 8-227 Make further adjustments to align the copies with IFRSs if they have been prepared following other GAAPs. (4) Add all financial statements item-wise. Call the resulting financial statement the aggregated financial statements. (5) Prepare a capital consolidation based on the acquisition method. Make the consolidation Bookkeeping entries in 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) Do a consolidation of 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/ HENDERS ON Group Below, we discuss a profit consolidation and its impact on the valuation of inventories as well as dividends. We introduce another case study which is PORTERSVILLE Ltd. who buys on 3.01.20X2 80 % of its supplier HENDERSON Ltd. HENDERSON Ltd. is a trading business. All shares of PORTERSVILLE Ltd. as well as of HENDERSON Ltd. have a face value of 1.00 AUD/ s. Data Sheet for PORTERSVILLE/ HENDERSON DDomicile: Australia (Sydney). Reporting currency: AUD. Classification: n/ a. Investment: PORTERSVILLE Ltd. holds 80 % of HENDERSON Ltd. Acquisition date: 3.01.20X2, acquisition costs 520,000.00 AUD for 400,000 ordinary shares. Book value of HENDERSON Ltd. at that time: 600,000.00 AUD. Acquisition method applies. Actual Accounting period: 20X5 Dividend at HENDERSON Ltd.: 0.15 AUD/ s. Inventories at PORTERSVILLE Ltd.: goods for 100,000.00 AUD bought from HENDERSON Ltd. Cost of acquisition at HENDERSON Ltd.: 65,000.00 AUD. VAT ignored. On 3.01.20X2, PORTERSVILLE Ltd. buys a 80 % share in HENDERSON Ltd. when its retained earnings are 100,000.00 AUD. No reserves were disclosed on the HENDERSON Ltd.’s balance sheet at that time. Find below the balance sheets of both companies as at 31.12.20X5 - three years later. <?page no="228"?> Berkau: Financial Statements 7e 8-228 PORTERSVILLE Ltd.'s inventories include goods for 100,000.00 AUD, bought from HENDERSON Ltd. This is the price it paid to HENDERSON Ltd. on acquisition. HENDERSON Ltd. bought the goods itself for 65,000.00 AUD from a supplier. HENDERSON Ltd. pays a dividend of 0.15 AUD/ s for the Accounting period 20X5. The dividend is not considered for the financial statements as disclosed in Figure 8.22 and Figure 8.23 (before appropriation of profits). No profit/ loss carried forward applies for the financial statements for PORTERSVILLE Ltd. nor 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) 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) At first, we repeat the capital consolidations: The capital consolidation as at the time of acquisition on 3.01.20X2 considers a buy of 400,000 ordinary shares of HENDERSON Ltd. at a price of <?page no="229"?> Berkau: Financial Statements 7e 8-229 520,000.00 AUD. The total equity of HENDERSON Ltd. at that time was: 500,000 + 100,000 = 6 600,000.00 AUD. The book value of the shares at the time of acquisition was: 80% × 600,000 = 480,000.00 AUD. See the consolidation Bookkeeping entry below: DR Goodwill..................... 40,000.00 AUD DR Issued Shares................ 500,000.00 AUD DR Retained Earnings............ 100,000.00 AUD CR Non-ctrl. Interest........... 120,000.00 AUD CR Investment................... 520,000.00 AUD The capital consolidation remains unchanged. We enter the figures into the consolidation worksheet below. The only alteration is for the consideration of retained earnings as 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 acquisition. As stated earlier, no profit/ loss carrying forward applies for the case study. 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 of 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 = 2 200,000.00 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. We transfer the 40,000.00 AUD for the non-controlling interest holders to their account. For layout reasons, we hide the single company <?page no="230"?> Berkau: Financial Statements 7e 8-230 columns in Figure 8.25. The split is required to consider that the profits after the acquisition of the subsidiary are allocated to the group and the non-controlling interest holders correctly. 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) 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 100,000.00 AUD from HENDERSON Ltd. and discloses them at cost. In contrast, the group statements must consider the asset valuation at cost of acquisition for the group. These are the purchase costs for HENDERSON Ltd. amounting to 65,000.00 AUD. This is: 100,000 - 65,000 = 3 35,000.00 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 from the point of view of Group Accounting. The goods have been exchanged between group companies. 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 35,000.00 AUD. This gives: 35,000 × (1 - 30%) = 2 24,500.00 AUD deductions for retained earnings and: 35,000 × 30% = 110,500.00 AUD for income taxes. Although Group Accounting has no impact on taxation we record a deduction of income tax liabilities. Below, the next consolidation step for the PORTERSVILLE Group is recorded in Figure 8.26. <?page no="231"?> Berkau: Financial Statements 7e 8-231 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/ s. The total dividend is: 0.15 × 500,000 = 75,000.00 AUD. A portion of: 80% × 75,000 = 6 60,000.00 AUD is an intragroup dividend and does not require consideration on consolidated financial statements. The other portion of: 75,000 - 60,000 = 1 15,000.00 AUD is a payment to non-controlling interest holders which are considered as group-outsiders. Hence, a dividend payment is recorded as a cash reduction of 15,000.00 AUD for 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 towards 20X6 and allocate a 20 % portion thereof towards the non-controlling interest holders. The retained earnings of HENDERSON Ltd. were 210,000.00 AUD on the singleentity-balance sheet. Remember, that no profit is carried forward. Hence, the retained earnings result from profits earned in 20X5. We deducted 24,500.00 AUD for intra-group profits and another 75,000.00 AUD for dividends. Hence, the remaining retained earnings are: 210,000 - 24,500 - 75,000 = 1 110,500.00 AUD. A 20 % portion of this amount is assigned to the non-controlling interest holders. It results in a transfer of: 110,500 × 20% = 2 22,100.00 AUD to noncontrolling interest holders for the profit earned in 20X5. The amount of 37,100.00 AUD deducted from the group retained earnings is for the dividend paid to non-controlling interest holders and the non-controlling interest holders’ share of profits: 15,000 + 22,100 = 3 37,100.00 AUD. Accordingly, we deduct 15,000.00 AUD from cash/ bank. See below in Figure 8.27 the last column filled in the consolidation worksheet for the PORTERSVILLE Group and in Figure 8.28 the consolidated balance sheet. <?page no="232"?> Berkau: Financial Statements 7e 8-232 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 (15,000) 1,025,000 5,720,000 (480,000) 0 (35,000) (15,000) 5,190,000 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) (22,100) (182,100) 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 15,000 (5,190,000) Figure 8.27: Consolidation worksheet for PORTERSVILLE Group (4) 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 182,100 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 1,025,000 Income tax liab. 379,500 Total assets 5,190,000 Total equity and liab. 5,190,000 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 is affected. The elimination of the intra-group profit can increase 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 <?page no="233"?> Berkau: Financial Statements 7e 8-233 the parent whose value adjustment causes 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 the subsidiary which is partly paid on credit. We must consolidate the intra-group profit and consider an increase of the subsidiary's equity, which we allocate partly to the non-controlling interest holders. Note, long-term changes of intragroup profit consolidations must be considered if material. 8.11 CS PATTEN/ SPYKER PATTEN Ltd. is a consultancy and bought 60 % of the production firm SPYKER (Pty) Ltd. on 1.01.20X0 at 700,000.00 AUD. See below in Figure 8.29 and in Figure 8.30 the balance sheet of the group companies. 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 <?page no="234"?> Berkau: Financial Statements 7e 8-234 Next, we discuss the preparation of the balance sheets as at 31.12.20X0, when we prepare the first consolidated financial statements. 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 200,000.00 AUD. PATTEN Ltd. records a consulting revenue of 450,000.00 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 annual costs of (all) consultancy are labour to an extent of 400,000.00 AUD and the entire depreciation. The costs are equally allocated to consultancy orders. During the fiscal year 20X0, the production firm SPYKER (Pty) Ltd. depreciates its machinery by 50,000.00 AUD. It purchases materials for 500,000.00 AUD and records a closing stock of raw materials of 70,000.00 AUD. The opening value of raw materials to an extent of 200,000.00 AUD (see its balance sheet) are consumed in production. At the end of the Accounting period, no closing stock of finished goods exists. Labour is 400,000.00 AUD, 75 % thereof is for production. SPYKER (Pty) Ltd. receives from its parent consultation and is charged 135,000.00 AUD for it. The consultation is about the marketing of its products. Therefore, the consultancy expenses are not related to production. The revenue in 20X0 is calculated as 150 % of the costs of manufacturing. 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 comprehensive 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 at both companies. 98 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) 98 The regulations are based on national tax law. We here adhere to the conventions in chapter (1). <?page no="235"?> Berkau: Financial Statements 7e 8-235 [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) 99 Below, we explain PATTEN Ltd.'s financial statements at the end of the first Accounting period. Depreciation is 15 % of the items of property, plant and equipment: 15% × 600,000 = 9 90,000.00 AUD. The figures for labour and revenue are given. The revenue resulting from the consultation for its subsidiary SPYKER (Pty) Ltd. is: 30% × 450,000 = 135,000.00 AUD. The payment received is: 135,000 / 2 = 6 67,500.00 AUD. PATTEN Ltd. receives 30,000.00 AUD in dividends from its subsidiary as other comprehensive income. The distributable amount is the profit after taxes including the received dividends 142,000.00 AUD. Therefore, PATTEN Ltd.’s dividend is: 10% × 142,000 = 1 14,200.00 AUD which is paid in 20X0 100 already. The income taxes at PATTERN are not based on the dividends received from SPYKER (Pty) Ltd.: 30% × (190,000 - 30,000) = 4 48,000.00 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 = 548,300.00 AUD. The retained earnings are disclosed after the appropriation of profits: (1 - 10%) × 142,000 = 1 127,800.00 AUD. The subsidiary SPYKER (Pty) Ltd. prepares its financial statements as disclosed in Figure 8.33 and Figure 8.34. 99 The income tax calculation does not consider the other income from dividends. 100 To simplify the case study, we break with our conventions and pay dividends in the Accounting period they are for. <?page no="236"?> Berkau: Financial Statements 7e 8-236 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 given to be 50,000.00 AUD. The material expenses are calculated based on a periodic inventory system. They are: 200,000 + 500,000 - 70,000 = 6 630,000.00 AUD. Labour is 400,000.00 AUD; 300,000.00 AUD thereof is for production. The revenue is calculated to be 150 % of the cost of manufacturing: (50,000 + 630,000 + 300,000) × 150% = 1 1,470,000.00 AUD. <?page no="237"?> Berkau: Financial Statements 7e 8-237 SPYKER (Pty) Ltd. received non-manufacturing related 101 consultancy of: 135,000.00 AUD and paid half of the amount instantly: 135,000 / 2 = 667,500.00 AUD. The dividends paid by SPYKER (Pty) Ltd. are amounting to 10 % of the distributable amount. The retained earnings from the previous Accounting period to the extent of 321,500.00 AUD can be paid to the owners. The payment to owners is: 10% × (321,500 + 178,500) = 5 50,000.00 AUD; 30,000.00 thereof is for PATTEN Ltd. According to the case study, the dividend is paid in 20X0. To understand the item retained earnings better, we calculate its value: 321,500 + 178,500 - 50,000 = 450,000.00 AUD. For the capital consolidation, we prepare a worksheet as 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 to the extent of: 700,000 - 60% × (500,000 + 178,500 + 321,500) = 1 100,000.00 AUD remains. Furthermore, 40 % of equity is allocated to non-controlling interest holders: 40% × (500,000 + 178,500 + 321,500) = 200,000 + 71,400 + 128,600 = 4400,000.00 AUD. We combine the Bookkeeping entries for capital consolidation as below. DR Goodwill..................... 100,000.00 AUD DR Issued Capital............... 500,000.00 AUD DR Reserves..................... 178,500.00 AUD DR Retained earnings............ 321,500.00 AUD CR Investments.................. 700,000.00 AUD CR Non-Ctrl. Interest........... 400,000.00 AUD Check the worksheet for capital consolidation in Figure 8.35. 101 Therefore, the consultancy fees do not become part of the cost of manufacturing. <?page no="238"?> Berkau: Financial Statements 7e 8-238 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) the elimination of the intra-group profit, (2) consolidation of the intra-profit related receivables and payables, (3) the allocation of non-controlling interest and (4) the consolidation of the dividends. (1) The service must be eliminated from the consolidation sheet. As both parties recorded expense/ revenue and cash/ bank, the intra-group profit is neutral to the group statements already. No adjustments become necessary for the elimination of profit. However, without the inter-group profit, the SPYKER (Pty) Ltd.'s profit after taxes would be higher to the extent of: (1 - 30%) × 135,000 = 94,800.00 AUD. The profit of the parent is lower to the same amount. As the difference affects the subsidiary, the noncontrolling-interest must be adjusted. On the consolidation worksheet, we allocate the higher profit of the subsidiary to an extent of 40 % to the non-controlling interest holders: 40% × 94,800 = 37,800.00 AUD. Check the column Service on the consolidation worksheet in Figure 8.36. (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 consolidated. The value is 135,000 / 2 = 667,500.00 AUD. Check the column Debts on the consolidation worksheet in Figure 8.36. (3) The profit before elimination of the intra-group service of SKYPER (Pty) Ltd. is 178,500.00 AUD after taxation. It must be split between non-controlling interest holders and the group at a 40 : 60 ratio: The transfer to non-controlling interest holders is: 40% × 178,500 = 71,400.00 AUD. Check the column nonctrl on the consolidation worksheet in Figure 8.36. <?page no="239"?> Berkau: Financial Statements 7e 8-239 (4) Regarding the dividend, we consider that the payment has already been made because dividends are paid in 20X0 following this case study. Therefore, SPYKER (Pty) Ltd.’s dividend got deducted from its retained earnings. The dividend paid by SPYKER (Pty) Ltd. to PATTEN Ltd. is considered by the Bookkeeping entries made because we refer to the financial statements after appropriation of profits (check Figures 8.31 and Figure 8.33). The cash has been paid/ received in the Cash/ Bank accounts and the Retained Earnings accounts got debited. This includes the payment of the dividend to non-controlling interest holders as a payment at SPYKER (Pty) Ltd. and its deduction from retained earnings at SPYKER (Pty) Ltd. We must deduct SPYKER (Pty) Ltd.’s dividend of: 40% × 50,000 = 2 20,000.00 AUD from the group's retained earnings and add it to non-controlling interest. 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 71,400 (127,100) Non-ctrl int. 0 (400,000) (37,800) (20,000) (71,400) (529,200) 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 statement of financial position for the PATTEN/ SPYKER Group in Figure 8.37 and the consolidated income statement in Figure 8.38. <?page no="240"?> Berkau: Financial Statements 7e 8-240 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 127,100 Goodwill 100,000 Non-ctrl. Int. 529,200 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) 102 8.12 Joint Venture Accounting Joint Venture Accounting only applies if joint arrangements exist. IFRS 11.4 defines a joint arrangement as an agreement where two or more parties share joint control. For joint control 102 The dividends are irrelevant for the income tax calculation. unanimous consent is required for all decisions as laid out by IFRS 11.7. One or more companies exercising control power over another one, requires Equity Accounting based on IAS 28 or a disclosure following IFRS <?page no="241"?> Berkau: Financial Statements 7e 8-241 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 the type of joint arrangement. In line with IFRS 11.15, a joint operation is a joint arrangement 103 where the controlling parties keep the rights on their own assets and an obligation for their own liabilities. The companies share profit and costs proportionally to their holdings. No extra company is 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 based on Equity Accounting on the financial statements of the investors. 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. 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 103 The expression arrangement is very abstract. Think of a joint project, although some characteristics of Project Management are not met. together. There is a third partner involved: FIRE Ltd. which contributes 10 %. Data Sheet for QUICKARMS- RESONSE-FIRE operations DDomicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Security Service. Partners: QUICKARMS Ltd., RESPONSE (Pty) Ltd., FIRE Ltd. Portions: 45 % / 45 % / 10 %. Assets all together: 150,000.00 ZAR. Joint revenue: 700,000.00 ZAR. Joint costs: materials: 80,000.00 ZAR; labour: 500,000.00 ZAR. VAT ignored. The contract states that only unanimous decisions of the three parties can be made. Therefore, FIRE Ltd. can block a motion even with its 10 % of holdings. 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 the liabilities. In their financial statements, QUICKARMS Ltd., RESPONSE (Pty) Ltd. as well as FIRE Ltd. consider the assets (cars, weapons) for the joint patrol service to the extent of 150,000.00 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 67,500.00 ZAR of the deployed assets. The partners pay for the acquisition of joint assets based on their <?page no="242"?> Berkau: Financial Statements 7e 8-242 share. The disclosure requirements based on IFRS 11.20 apply. Depreciation applies based on straight-line method over three years. It is agreed that RESPONSE (Pty) Ltd. collects all revenues and pays for all operations of the joint patrol service. At yearends, RESPONSE (Pty) Ltd. transfers the share of profits to the other operators. Look at the balance sheet of QUICKARMS Ltd. in Figure 8.39. It shows the assets for the joint control as share in joint assets. They are: 45 % × 150,000 = 667,500.00 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) During the Accounting period 20X7, the revenue for the joint patrol service is 700,000.00 ZAR. The consumption of materials is 80,000.00 ZAR and labour is 500,000.00 ZAR, all paid on cash. The profit of the joint patrol service is: 700,000 - 80,000 - 500,000 = 120,000.00 ZAR. At the end of the Accounting period 20X7, QUICKARMS Ltd. is entitled to receive a profit share of: 45% × 120,000 = 54,000.00 EUR from its partner RESPONSE (Pty) Ltd. QUICKARMS Ltd. must add depreciation on its assets that were deployed for the joint patrol service to the extent of: 45% × (150,000 / 3) = 222,500.00 ZAR. As QUICKARMS Ltd. discloses a portion of the joint assets on its financial statements, it must depreciate them itself. For our calculations, we start with the income statement of QUICKARMS Ltd. It does not include any 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. <?page no="243"?> Berkau: Financial Statements 7e 8-243 [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 54,000.00 ZAR and for the depreciation on the deployed assets to the extent of: 22,500.00 ZAR: <?page no="244"?> Berkau: Financial Statements 7e 8-244 DR Depreciation................. 22,500.00 ZAR CR Acc. Depr. (joint)........... 22,500.00 ZAR DR Receivables.................. 54,000.00 ZAR CR Other Comprehensive Income... 54,000.00 ZAR After recording the above Bookkeeping entries and considering an income tax increase of: (54,000 - 22,500) × 30% = 99,450.00 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 104 104 The other income received is no dividend. It is subjected to income tax. <?page no="245"?> Berkau: Financial Statements 7e 8-245 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 for the 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 comprehensive income. (4) Consider 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. We do not intend to compare the figures for an evaluation of joint arrangement types. We only demonstrate the Accounting work and omit tax or legal aspects. 8.14 C/ S CLOSEWATCH - Joint Venture If the three companies agree in a joint venture, a company will be established. The three investors jointly control the new company CLOSE-WATCH (Pty) Ltd. IFRS 11.24 requires disclosing the joint venture partly on the balance sheet of the investor’s financial statement 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: 200,000.00 ZAR. <?page no="246"?> Berkau: Financial Statements 7e 8-246 LLending 25,000.00 ZAR from QUICKARM Ltd. Property, plant and equipment: 150,000.00 ZAR. Revenue: 700,000.00 ZAR. Materials: 80,000.00 ZAR; labour: 500,000.00 ZAR. VAT ignored. Find below the balance sheet of CLOSE- WATCH (Pty) Ltd. in Figure 8.44. The company CLOSE-WATCH (Pty) Ltd. is established with 200,000.00 ZAR. 150,000.00 ZAR therefrom is invested in assets, like cars and weapons. The company further borrows from QUICKARMS Ltd. 25,000.00 ZAR. 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 During the Accounting period 20X7, CLOSE-WATCH (Pty) Ltd. records a profit of 49,000.00 ZAR after taxes. No dividend is declared. The short-term liabilities of 25,000.00 ZAR got repaid by then. <?page no="247"?> Berkau: Financial Statements 7e 8-247 [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. show the investment at costs to the extent of: 45% × 200,000 = 9 90,000.00 ZAR. FIRE Ltd. discloses a financial asset at 20,000.00 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 as at 1.01.20X7 are shown below in Figure 8.47. Therein, receivables are disclosed, too. <?page no="248"?> Berkau: Financial Statements 7e 8-248 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 the Accounting period 20X7, the value of CLOSE-WATCH (Pty) Ltd. increased by: (249,000 - 200,000) / 200,000 = 2 24.5%. As no dividend has been declared by CLOSE-WATCH (Pty) Ltd., the investments on the balance sheet at QUICKARM Ltd. and RESPONSE (Pty) Ltd. increase by 24.5 %, too. The new valuation is: (1 + 24.5%) × 90,000 = 112,050.00 ZAR. The contra entry for the increase in valuation is made in the Investment Income account; it is not considered for the calculation of income tax. Therefore, retained earnings is: 1,300,000 + 22,050 - 35,000 - 500,000 - 50,000 - 43,000 - 201,600 = 492,450.00 ZAR. Note, the income taxes of 201,600.00 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 separate financial statements. <?page no="249"?> Berkau: Financial Statements 7e 8-249 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 stays at 20,000.00 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 has no impact on the valuation: no consolidation applies. 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 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 proportionally and at costs. (3b) If the separate financial statements are subsequently required, recognise the joint venture proportionally 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="250"?> Berkau: Financial Statements 7e 8-250 8.15 Summary Group Accounting is linked to the preparation of separate financial statements along IAS 27, to consolidated financial statements along IFRS 3 or to joint arrangements along IFRS 11. Minor investments are disclosed as financial instruments following IFRS 9. Investments with significant influence are measured based on the equity method based on 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 how single companies prepare and present their single-entity financial statements. No payments depend on Group Accounting. In Europe, Group Accounting based on IFRSs is required if one group member participates actively on the public capital market. 8.16 Working Definitions Acquisition Method: Method of Group Accounting. The items of the acquired company are valued as at the time of gaining ownership. Associated Company: An associated company is 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 counting of the acquisition of a subsidiary. Consolidated Financial Statements: Statements of a group in which items are shown as those of a single entity. 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 associates and joint ventures based on the changes of the book value. IAS 28.10 rules the equity method. Group Accounting: Preparation of financial statements for business combinations. Joint Arrangements: Joint operations or joint ventures. Profit Consolidation: Cancelation of intra-group profits and adjustment of valuations for assets linked thereto. Separate Financial Statements: Statements prepared by a parent/ investor that show the proportionate share in subsidiaries, associates and joint operations based on IAS 27. 8.17 Question Bank (1) A Ltd. buys 210 shares of B Ltd. which is based on 300 shares at 10.00 EUR/ s. At the time of acquisition, the Retained Earnings Account at B Ltd. is 1,000.00 EUR. The costs of the investment are 2,900.00 EUR. How much is the goodwill? 1. Nil . 2. 100.00 EUR . 3. 200.00 EUR . 4. (120.00 EUR) . (2) L Ltd. buys 550 shares of S Ltd. which is based on 1,000 shares at 5.00 EUR/ s. At the time of acquisition, the Retained Earnings account is 1,500.00 EUR. At the beginning of the fiscal year, the opening balance for S Ltd.’s Retained Earnings account is 5,000.00 EUR. How much is the non-controlling <?page no="251"?> Berkau: Financial Statements 7e 8-251 interest disclosed on the consolidated balance sheet? 1. 5,175.00 EUR . 2. 5,000.00 EUR . 3. 6,325.00 EUR . 4. 4,500.00 EUR . (3) Which statement is correct? 1. An investment in an associate is one that is below 20 % of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 28. 2. An investment in an associate is one that is more than 20 % of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 28. 3. An investment in an associate is one that is more than 20% of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 27. 4. An investment in an associate is one that is more than 25% of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 27. (4) On 1.01.20X2, Y Ltd. buys 50 shares of C Ltd. which is based on 200 ordinary shares at 10.00 EUR/ s. The total costs of acquisition are 500.00 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 2,000.00 EUR and C Ltd.’s one equals 1,000.00 EUR. What is the disclosure of the investment in C Ltd. on Y Ltd.’s single entity statement of financial position? 1. 1,250.00 EUR . 2. 1,000.00 EUR . 3. 750.00 EUR . 4. 500.00 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 1,000.00 EUR. The subsidiary declares a dividend of 600.00 EUR. The closing balance of the Retained Earnings account (after appropriation of profits) is 1,500.00 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 (non-controlling portion)? 1. 660.00 EUR . 2. 200.00 EUR . 3. 360.00 EUR . 4. 900.00 EUR . 8.18 Solutions 1-2, 2-4, 3-2, 4-3, 5-2. <?page no="252"?> Berkau: Financial Statements 7e 9-252 9 Current Assets on the Balance Sheet 9.1 What is in the Chapter? Current assets stay on the balance sheet for shorter periods than a year. They are inventories, receivables, securities, and cash/ bank. In contrast to German Accounting, prepaid expenses are current assets, too. They meet the characteristics for assets set by the conceptual framework for financial reporting F 4.8 - F 4.13. 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 discuss Manufacturing Accounting 105 for the product calculation. We focus on the perpetual system for inventory movements but also show differences to the periodic system as known from chapter (4). As financial instruments can be held for short-term periods, this chapter considers their recognition and measurement. We continue the considerations about financial instruments started in chapter (7). This chapter contains the case study GREENACRES Ltd. to show different inventory movement systems. With the case study ROSEFIELD Ltd. we explain the release of goods from stock when different prices apply, and we introduce the major cost formulas first-in-first-out and weighted average method. The case study HEISTEL (Pty) Ltd. covers a situation where inventory is marked down and get revalued at their net realisable values. Manufacturing Accounting is discussed with the case 105 Read for Manufacturing Accounting our textbook Basics of Accounting, chapter (25) and regarding Job Order Costing and Process Costing our study RIEBEEK-KASTEEL (Pty) Ltd. which is a printing company for maps. We focus on the cost flow in a production firm and cover aspects of idle costs following IAS 2.13. Further 4 case studies are discussed for the valuation of financial assets which are classified as short-term ones in 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 also get familiarised with the calculation of finished goods applying Work-in-Process Accounts and the Manufacturing Overheads Accounts. You further learn Accounting for receivables and securities. After studying this chapter, you can disclose and evaluate current assets following 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 except of in situations when a reporting company prepares financial statements following liquidity aspects. IAS 1.61 states that items should be classified based on a 12-month rule. IAS 1.66 defines current assets as assets that are realised, sold or consumed within a normal operating cycle of 12 months, merchandise goods, or textbook Management Accounting, chapter (18), (19). <?page no="253"?> Berkau: Financial Statements 7e 9-253 cash/ bank. All other items are noncurrent assets. The above classification is not strict for all individual items of inventory but applies in general. E.g., a production firm that manufactures gear boxes and has one gear box that has been produced based on a customer’s specifications on stock for 2 years does not change its classification towards noncurrent assets. For the gear box, the general classification as inventory applies: The minimum of inventory turnover is assumed to be 1/ 365d. As inventories are held for shorter periods than one year, no depreciation applies. However, extraordinary depreciation can occur. In those cases, we do not refer to an impairment loss but record an inventory decrease or loss in valuation. Similar rules apply for bad debts. Bad debts are receivables a company considers to be irrecoverable. They are allocated against the Bad Debts account which is an expense account. 106 Current assets are: (1) Inventories. (2) Receivables. (3) Securities. (4) Prepaid expenses. (5) Cash/ bank. 9.4 Inventories IAS 2.6 defines inventories: They are assets a company trades with or assets needed for operations e.g., for production or service rendering. They can be high in values, like in the retailing industry or in production firms. In contrast, service rendering companies e.g., 106 Read the case study MOSSEL SPORTS in our textbook Basics of Accounting, chapter (34). consultancies, law firms or software developers, carry only low levels of stock. Our considerations start-off from the case study of the South African trading company GREENACRES Ltd. For retailers, inventories are merely merchandise goods purchased and sold on to their customers. The case study GREENACRES Ltd. explains the difference between two alternative inventory systems 107 , the periodic and the perpetual system. We explain the Bookkeeping entries for both systems with the same example. At first, we explain the already known periodic system followed by the introduction of the perpetual system for the same case. For retailers, like GREENACRES Ltd., the Trading account applies for gross profit calculations. Applying a periodic inventory system, a company must take stock once per Accounting period, in general on 31.12.20XX. Additions to inventories are recorded in the Purchase account. No Bookkeeping entries for stock releases are made. A company only determines its consumption of inventories as the difference between opening value and closing stock. Nowadays, a periodic system for inventory movements applies seldom and only if inventory values are of minor interest. With the periodic inventory system in use, a company only knows its stock levels on balance sheet dates. In contrast, a perpetual inventory system records both: inputs and outputs of stock. Therefore, a company always knows its inventory values. 107 Read our textbook Basics of Accounting, chapter (26). <?page no="254"?> Berkau: Financial Statements 7e 9-254 The valuation of inventory is always based on net values if companies are registered for VAT reduction. IAS 2.11 defines the costs of purchase. They are the net purchase price less trade discounts and rebates. Also, attributable costs e.g., for transportation and handling, are added to the valuation of inventories. Once the goods’ values change, the valuation is at cost of purchase or at net realisable values, whatever 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, therefore, a reporting company cannot choose: Once the value decreases, the lower value applies. If inventory values increase (after purchase), the purchase price is always the highest possible valuation for inventories. No revaluations, like for non-current assets, apply. IAS 2.6 defines the net realisable value. Commonly, we can say it is the fair value of inventories which is defined by IFRS 13.6 as the price that would been received by selling the asset in an orderly transaction. Writing down inventories from costs to net realisable values ensures that inventory items are always carried at fair values which is what can be obtained from sale or use (IAS 2.28). 9.5 C/ S GREENACRES Ltd. The case study GREENACRES Ltd. is about a company dealing with lamps. See below the data sheet for the case study: Data sheet for GREENACRES Ltd. DDomicile: South Africa (Gqeberha). Reporting currency: ZAR. Classification: Retailer. Opening value: 168,000.00 ZAR; Purchase 1,200,000.00 ZAR; unit costs: 1,200.00 ZAR/ u; net selling price: 2,000.00 ZAR/ u. Sales amount: 800 units (400 + 250 + 150). VAT 20 %. GREENACRES Ltd. discloses an opening value for inventories of 168,000.00 ZAR which is 140 lamps at 1,200.00 ZAR/ u on 31.12.20X4. In the Accounting period 20X5, GREENACRES Ltd. buys 1,000 further lamps at 1,200.00 ZAR/ u. The lamps are the same as the one which are on stock already. At first, we apply a periodic system for all inventory movements. The valuation of the lamps always is at costs of purchase. In this case study, the prices for the lamps are constant. The Bookkeeping entry (1) for the purchase of lamps is shown below. DR Purchase..................... 1,200,000.00 ZAR DR VAT.......................... 240,000.00 ZAR CR Cash/ Bank.................... 1,440,000.00 ZAR During the Accounting period 20X5, GREENACRES Ltd. sells 800 lamps at a net selling price of 2,000.00 ZAR/ u. The Bookkeeping entry (2) is for the revenue and shown below: <?page no="255"?> Berkau: Financial Statements 7e 9-255 DR Cash/ Bank.................... 1,920,000.00 ZAR CR VAT.......................... 320,000.00 ZAR CR Revenue...................... 1,600,000.00 ZAR No stock releases are recorded for a sale if we apply the periodic system. At the end of the Accounting period 20X5, GREENACRES Ltd. takes stock of its lamps, which gives the value of lamps still on stock: 340 × 1,200 = 4 408,000.00 ZAR. Only at the end of Accounting period 20X5, GREENACRES Ltd. records the closing stock with reference (3-digitcode for the contra account: T/ A) to the Trading account as Bookkeeping entry (3). The valuation of closing stock is based on its unit costs of purchase. Observe the Bookkeeping entry below and the gross profit calculation in Figure 9.1. DR Inventories.................. 408,000.00 ZAR CR Trading Account.............. 408,000.00 ZAR D C D C OV 168,000.00 T/ A 168,000.00 OV . . . (1) 1,440,000.00 (3) 408,000.00 c/ d 408,000.00 (2) 1,920,000.00 c/ d 480,000.00 576,000.00 576,000.00 1,920,000.00 1,920,000.00 b/ d 408,000.00 b/ d 480,000.00 Inventories (lamps) INV Cash/ Bank C/ B D C D C (1) 1,200,000.00 T/ A 1,200,000.00 (1) 240,000.00 (2) 320,000.00 c/ d 80,000.00 320,000.00 320,000.00 b/ d 80,000.00 Purchase-20X5 PUR Value added tax VAT D C D C T/ A 1,600,000.00 (2) 1,600,000.00 INV 168,000.00 REV 1,600,000.00 PUR 1,200,000.00 (3) 408,000.00 GP 640,000.00 2,008,000.00 2,008,000.00 b/ d 640,000.00 Revenue-20X5 REV Trading account-20X5 T/ A Figure 9.1: GREENACRES Ltd.’s accounts (periodic system) 9.6 Perpetual Inventory System Next, we repeat the case study GREENACRES Ltd., but apply a perpetual system for the inventory movements. With a perpetual system, a company adds purchases to the Inventory account directly (no Purchase account needed) and records releases from stock. This enables the company to always know its stock levels. It only <?page no="256"?> Berkau: Financial Statements 7e 9-256 needs to balance-off the Inventory account. Retailers use bar codes or RFID technology for tracking their stock movements and recording inventory levels. Logistics refers to inventory levels for their order management. Bookkeeping entries with a perpetual inventory system slightly change in comparison to the periodic system. To demonstrate the effect of obtaining stock level information between balance sheet dates, we alter the case study GREENACRES Ltd. a bit. The alteration is about the sale amounts: Instead of one single sale we now consider three single sales that add up to the same value as in the previous case. 9.7 C/ S GREENACRES Ltd. - Perpetual Inventory System GREENACRES Ltd. buys 1,000 lamps and records Bookkeeping entry (A). After acquisition, Bookkeeping entry (B) adds the lamps’ value straight to the Inventory account. You better combine the Bookkeeping entries (A) and (B) by making the debit entry in the Inventory account directly (recommended). DR Purchase..................... 1,200,000.00 ZAR DR VAT.......................... 240,000.00 ZAR CR Cash/ Bank.................... 1,440,000.00 ZAR DR Inventories.................. 1,200,000.00 ZAR CR Purchase..................... 1,200,000.00 ZAR In contrast to the previous scenario, revenue is now earned by three single sales, at 400 lamps, at 250 lamps and at 150 lamps. All lamps are sold at a net selling price of 2,000.00 ZAR/ u. The total number of lamps sold is: 400 + 250 + 150 = 8 800 lamps. The revenue (C 1 ) is: 400 × 2,000 = 8 800,000.00 ZAR, revenue (C 2 ) is: 250 × 2,000 = 5 500,000.00 ZAR and revenue (C 3 ) is: 150 × 2,000 = 3 300,000.00 ZAR. GREENACRES Ltd. records three Bookkeeping entries (D 1 … D 3 ) for the inventory movements of the lamps. Bookkeeping entries (D 1 … D 3 ) are debit entries for material expenses and credit entries in the Inventory account. Those Bookkeeping entries are made based on the cost of purchase, which is the net value. The expense account for a trading company is not called Material Expense account but Cost of Goods Sold account. The extra Cost of Goods Sold account keeps our Trading account clear from numerous Bookkeeping entries for stock movements. The expense recognition for sold inventories follows IAS 2.34 and must be recorded in the Accounting period the sale takes place. A writing-down of inventories would require expense recognition in the period of when the values change. At GREENACRES Ltd., Bookkeeping entries for inventory movements are based on the unit cost of purchase which is here constantly 1,200.00 ZAR/ u. Observe the Bookkeeping entries (C 1 ) - (D 3 ) below: <?page no="257"?> Berkau: Financial Statements 7e 9-257 DR Cash/ Bank.................... 960,000.00 ZAR CR VAT.......................... 160,000.00 ZAR CR Revenue...................... 800,000.00 ZAR DR Cost of Goods Sold........... 480,000.00 ZAR CR Inventory.................... 480,000.00 ZAR DR Cash/ Bank.................... 600,000.00 ZAR CR VAT.......................... 100,000.00 ZAR CR Revenue...................... 500,000.00 ZAR DR Cost of Goods Sold........... 300,000.00 ZAR CR Inventory.................... 300,000.00 ZAR DR Cash/ Bank.................... 360,000.00 ZAR CR VAT.......................... 60,000.00 ZAR CR Revenue...................... 300,000.00 ZAR DR Cost of Goods Sold........... 180,000.00 ZAR CR Inventory.................... 180,000.00 ZAR With a perpetual system, GREENACRES Ltd. always knows its stock level e.g., after the 2 nd sale it is: 168,000 + 1,200,000 - 480,000 - 300,000 = 5 588,000.00 ZAR. GREENACRES Ltd. does not take stock anymore, as the Accounting system knows the inventory values already. Study the accounts at GREENACRES Ltd. in Figure 9.2. If applying a perpetual inventory movement system, a company makes two Bookkeeping entries per sale, one for the revenue based on the selling price and one for stock movements based on inventory valuation at either cost of purchase or if lower: at net realisable values. D C D C OV 168,000.00 (D 1 ) 480,000.00 OV . . . (A) 1,440,000.00 (B) 1,200,000.00 (D 2 ) 300,000.00 (C 1 ) 960,000.00 (D 3 ) 180,000.00 (C 2 ) 600,000.00 c/ d 408,000.00 (C 3 ) 360,000.00 c/ d 480,000.00 1,368,000.00 1,368,000.00 1,920,000.00 1,920,000.00 b/ d 408,000.00 b/ d 480,000.00 Inventories (lamps) INV Cash/ Bank C/ B Figure 9.2: GREENACRES Ltd.’s accounts (perpetual system) <?page no="258"?> Berkau: Financial Statements 7e 9-258 D C D C (A) 1,200,000.00 (B) 1,200,000.00 (A) 240,000.00 (C 1 ) 160,000.00 (C 2 ) 100,000.00 c/ d 80,000.00 (C 3 ) 60,000.00 320,000.00 320,000.00 b/ d 80,000.00 Purchase-20X5 PUR Value added tax VAT D C D C T/ A 1,600,000.00 (C 1 ) 800,000.00 (D 1 ) 480,000.00 T/ A 960,000.00 (C 2 ) 500,000.00 (D 2 ) 300,000.00 (C 3 ) 300,000.00 (D 3 ) 180,000.00 1,600,000.00 1,600,000.00 960,000.00 960,000.00 Revenue-20X5 REV Cost of goods sold-20X5 COS D C COS 960,000.00 REV 1,600,000.00 GP 640,000.00 1,600,000.00 1,600,000.00 b/ d 640,000.00 Trading account-20X5 T/ A Figure 9.2: GREENACRES Ltd.'s accounts (perpetual system) continued How it is Done (Recording Under a Perpetual Inventory System): (1) Record purchases in a Purchase account and transfer them into the Inventory account. Better, add purchases straight to the Inventory account. It is recommended running separate Inventory accounts for different goods. (2) When selling goods, make entries for the revenue based on the selling price. (3) Make debit entries in the Cost of Goods Sold account for the items sold and released from stock. Measure inventory movements at cost of purchase or net realisable values. (4) If required, calculate the inventory level(s) by balancing-off the Inventory account(s). (5) At the year-end, apply a Trading account for the gross profit calculation. Consider the sold goods by closing-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. (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. <?page no="259"?> Berkau: Financial Statements 7e 9-259 9.8 Different Inventory Valuation So far, we discussed inventories with constant stock values. However, values can change due to two effects: (1a) Different purchase prices apply. (1b) Loss in valuation: Inventory valuation can change during the period goods are on stock, like loss caused by deterioration, damage etc. 9.9 Purchase Price Change A change of purchase prices does not affect Accounting much as the principle of specific identification applies. Following these regulations, 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 we are not able to distinguish goods from each other due to technical restrictions or high numbers e.g., for fluids, such as gasoline in a tank or screws in a box. Sometimes, if the units’ value is too low to justify the effort for inventory tracking. For ordinarily interchangeable goods, cost formulas can be applied. With reference to IAS 2.25, these formulas are based on the firstin-first-out (FIFO) principle and on weighted average cost calculation. 108 9.10 C/ S ROSEFIELD Ltd. Below, we study ROSEFIELD Ltd. - a drone dealer. It applies a perpetual system for its inventory movements. In the first case (i), it applies first-infirst-out formula, below (ii), we repeat the case study and apply the weighted average cost formula. First-in-First-out - Case (i): ROSEFIELD Ltd. is a dealership for drones in Melbourne. Find below its data sheet. Data Sheet for ROSEFIELD Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: Retailer. Opening value: zero. Purchases: see Figure 9.3. Sales: I-VI/ 20X0: 100 × Drone-400s; VII- XII/ 20X0: 148 × Drone-400s; 126 × Drone-500s. Net selling prices: Drone-400: 200.00 AUD/ u; Drone-500: 350.00 AUD/ u. VAT 20 %. ROSEFIELD Ltd. buys its drones from an Australian supplier at different purchase prices. As drones of the same kind are ordinarily interchangeable, ROSEFIELD Ltd.’s valuation is based on a cost formula, here: first-in-first-out. The drones carry a type identifier. Drones with the same name, like Drone-400, are identical. ROSEFIELD Ltd. applies a perpetual inventory system and uses separate inventory accounts for Drone-400s and Drone-500s. 108 Cost formulas are discussed in our textbook Basics of Accounting, chapter (27). <?page no="260"?> Berkau: Financial Statements 7e 9-260 Date Item Amount Purchase price [AUD] 5.01.20X0 Drone-400 80 120.00 5.01.20X0 Drone-500 50 200.00 1.04.20X0 Drone-400 100 125.00 1.04.20X0 Drone-500 100 210.00 1.07.20X0 Drone-400 75 130.00 1.07.20X0 Drone-500 100 215.00 1.10.20X0 Drone-400 100 130.00 Rosefield Ltd. PURCHASE JOURNAL for the period ended 31.12.20X0 Figure 9.3: ROSEFIELD Ltd.’s purchases At the beginning of the Accounting period 20X0, no drones are on stock. During the Accounting period 20X0, ROSEFIELD Ltd. sells 100 Drone-400s in the first half of the year and another 148 Drone-400s in the second half of the year. The net selling price per Drone-400 is 200.00 AUD/ u. No Drone-500 is sold during the first half of the Accounting period. In the second half of the year, ROSEFIELD Ltd. sells 126 Drone-500s at a net selling price of 350.00 AUD/ u. To keep the case simple, we assume the sales take place either on 30.06.20X0 or 31.12.20X0. The first sale of 100 Drone-400s causes inventory releases of: 80 × 120 + 20 × 125 = 1 12,100.00 AUD. Thereafter, 80 Drone-400s are left at 125.00 AUD/ u. The revenue thereof is: 100 × 200 = 20,000.00 AUD. ROSEFIELD Ltd. records the sale of drones as below by Bookkeeping entries (8) and (9i) on 30.06.20X0: DR Cash/ Bank.................... 24,000.00 AUD CR VAT.......................... 4,000.00 AUD CR Revenue...................... 20,000.00 AUD DR Cost of Goods Sold........... 12,100.00 AUD CR Inventories (D-400).......... 12,100.00 AUD In the second half of the Accounting period 20X0, ROSEFIELD Ltd. sells 148 Drone-400s at 200.00 AUD/ u which results in a revenue of: 148 × 200 = 29,600.00 AUD. The cost of goods sold are: (100 - 20) × 125 + (148 - 80) × 130 = 1 18,840.00 AUD. Observe Bookkeeping entries (10) and (11i) which ROSEFIELD Ltd. records on 31.12.20X0. DR Cash/ Bank.................... 35,520.00 AUD CR VAT.......................... 5,920.00 AUD CR Revenue...................... 29,600.00 AUD <?page no="261"?> Berkau: Financial Statements 7e 9-261 DR Cost of Goods Sold........... 18,840.00 AUD CR Inventories (D-400).......... 18,840.00 AUD The sale of the Drone-500s gives a revenue of: 126 × 350 = 4 44,100.00 AUD. The cost of goods sold are: 50 × 200 + (126 - 50) × 210 = 2 25,960.00 AUD. We observe Bookkeeping entries (12) and (13i) recorded both on 31.12.20X0. DR Cash/ Bank.................... 52,920.00 AUD CR VAT.......................... 8,820.00 AUD CR Revenue...................... 44,100.00 AUD DR Cost of Goods Sold........... 25,960.00 AUD CR Inventories (D-500).......... 25,960.00 AUD Study the accounts in Figure 9.4. You find the gross profit calculation therein. D C D C (1) 9,600.00 (9i) 12,100.00 (2) 10,000.00 (13i) 25,960.00 (3) 12,500.00 (11i) 18,840.00 (4) 21,000.00 (5) 9,750.00 (6) 21,500.00 c/ d 26,540.00 (7) 13,000.00 c/ d 13,910.00 52,500.00 52,500.00 44,850.00 44,850.00 b/ d 26,540.00 b/ d 13,910.00 Drones-400 INV Drones-500 INV D C D C (1) 1,920.00 (8) 4,000.00 (8) 24,000.00 (1) 11,520.00 (2) 2,000.00 (10) 5,920.00 (10) 35,520.00 (2) 12,000.00 (3) 2,500.00 (12) 8,820.00 (12) 52,920.00 (3) 15,000.00 (4) 4,200.00 (4) 25,200.00 (5) 1,950.00 (5) 11,700.00 (6) 4,300.00 (6) 25,800.00 (7) 2,600.00 c/ d 730.00 c/ d 4,380.00 (7) 15,600.00 19,470.00 19,470.00 116,820.00 116,820.00 b/ d 730.00 b/ d 4,380.00 Value added tax VAT Cash/ Bank C/ B D C D C (8) 20,000.00 (9i) 12,100.00 (10) 29,600.00 (11i) 18,840.00 c/ d 93,700.00 (12) 44,100.00 (13i) 25,960.00 c/ d 56,900.00 93,700.00 93,700.00 56,900.00 56,900.00 T/ A 93,700.00 b/ d 93,700.00 b/ d 56,900.00 T/ A 56,900.00 Revenue-20X0 REV Cost of goods sold-20X0 COS Figure 9.4: ROSEFIELD Ltd.’s accounts (i: FIFO) <?page no="262"?> Berkau: Financial Statements 7e 9-262 D C COS 56,900.00 REV 93,700.00 GP 36,800.00 93,700.00 93,700.00 b/ d 36,800.00 Trading account-20X0 T/ A Figure 9.4: ROSEFIELD Ltd.’s accounts (i: FIFO) continued Weighted Average - Case (ii): If a company applies the weighted average method, it must calculate for every stock release the average value of drones under consideration of the actual numbers. Therefore, sales taking place either on 30.06.20X0 or 31.12.20X0 has an impact on the valuations. We do not repeat all Bookkeeping entries, but we replace Bookkeeping entries (9i), (11i) and (13i) which are linked to stock releases. Bookkeeping entry (9ii) replaces Bookkeeping entry (9i). In contrast to the FIFO method, ROSEFIELD Ltd. now calculates the weighted average costs of the Drone-400s on the 30.06.20X0: (80 × 120 + 100 × 125) / 180 = 1 122.78 AUD/ u. Hence, the inventory movement is: 100 × 122.78 = 1 12,278.00 AUD. The exact value is 12,277.78 AUD. 109 The Bookkeeping entry (9ii) is recorded on 30.06.20X0 as below: DR Cost of Goods Sold........... 12,278.00 AUD CR Inventories (D-400).......... 12,278.00 AUD The Bookkeeping entry (11ii) replaces Bookkeeping entry (11i). The valuation of Drone-400s at weighted average method on 31.12.20X0 is: ((180 - 100) × 122.78 + 75 × 130 + 100 × 130) / (80 + 75 + 100) = 1 127.73 AUD/ u. Hence, the cost of goods sold are: 148 × 127.73 = 18,904.04 AUD. The exact amount is 18,904.44 AUD. Observe the Bookkeeping entry (11ii) below: DR Cost of Goods Sold .......... 18,904.04 AUD CR Inventories (D-400).......... 18,904.04 AUD The Bookkeeping entry (13ii) replaces Bookkeeping entry (13i). The valuation of the Drone-500s at weighted average method on 31.12.20X0 is: (50 × 200 + 100 × 210 + 100 × 215) / (50 + 100 + 100) = 2 210.00 AUD/ u. Therefore, the cost of 109 We follow here exam regulations, where we calculate exact to 2 digits after the decimal point for workings. sales for the Drone-500s is: 126 x 210 = 26,460.00 AUD. The Bookkeeping entry (13ii) is recorded on 31.12.20X0, observe it below as well as the gross profit calculation in Figure 9.5: <?page no="263"?> Berkau: Financial Statements 7e 9-263 DR Cost of Goods Sold........... 26,460.00 AUD CR Inventories (D-500).......... 26,460.00 AUD D C D C (1) 9,600.00 (9ii) 12,277.78 (2) 10,000.00 (13ii) 26,460.00 (3) 12,500.00 (11ii) 18,904.66 (4) 21,000.00 (5) 9,750.00 (6) 21,500.00 c/ d 26,040.00 (7) 13,000.00 c/ d 13,667.56 52,500.00 52,500.00 44,850.00 44,850.00 b/ d 26,040.00 b/ d 13,667.56 Inventory Drone-400 INV Inventory drone-500 INV D C D C (1) 1,920.00 (8) 4,000.00 (8) 24,000.00 (1) 11,520.00 (2) 2,000.00 (10) 5,920.00 (10) 35,520.00 (2) 12,000.00 (3) 2,500.00 (12) 8,820.00 (12) 52,920.00 (3) 15,000.00 (4) 4,200.00 (4) 25,200.00 (5) 1,950.00 (5) 11,700.00 (6) 4,300.00 (6) 25,800.00 (7) 2,600.00 c/ d 730.00 c/ d 4,380.00 (7) 15,600.00 19,470.00 19,470.00 116,820.00 116,820.00 b/ d 730.00 b/ d 4,380.00 Value added tax VAT Cash/ Bank C/ B D C D C (8) 20,000.00 (9ii) 12,277.78 (10) 29,600.00 (11ii) 18,904.66 c/ d 93,700.00 (12) 44,100.00 (13ii) 26,460.00 c/ d 57,642.44 93,700.00 93,700.00 57,642.44 57,642.44 b/ d 93,700.00 b/ d 93,700.00 b/ d 57,642.44 T/ A 57,642.44 Revenue-20X0 REV Cost of goods sold-20X0 COS D C COS 57,642.44 REV 93,700.00 GP 36,057.56 93,700.00 93,700.00 b/ d 36,057.56 Trading account-20X0 T/ A Figure 9.5: ROSEFIELD Ltd.’s accounts (ii: weighted average) How it is Done (Inventory Calculations based on Weighted Average Cost Formula): (1) Determine the unit costs and quantities 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 number of <?page no="264"?> Berkau: Financial Statements 7e 9-264 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 additions. 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 with the unit costs c. (5) Continue by step (2) and (3) for inputs or (4) for outputs. You also can study the ROSEFILED Ltd. case study with consideration of returns and trade discounts and with more purchases and sales of drones. Download the extended version of the case study through the QR code below, shown in Link 9.A. Link 9.A: ROSEFIELD Ltd. 9.11 Loss on Valuation Inventory valuation can decrease due to deterioration, damage or declining of selling prices, as well. In those cases, assets are written-down to their net realisable values, as required by IAS 2.28. We can compare this procedure to an impairment loss; however, the technical term is writing inventory down or off (if destroyed completely). The valuation of down-writing results in an expense in the Accounting period the decrease in valuation occurs. IAS 2.30 requires determining the net realisable value based on best evidence available. 9.12 C/ S HEISTEL (Pty) Ltd. Below we study the case of HEISTEL (Pty) Ltd. regarding a decrease in valuation. Data Sheet for HEISTEL (Pty) Ltd. DDomicile: Germany (Saarbrücken). Reporting currency: EUR. Classification: Retailer. Opening value: 38,250.00 EUR (45 laptops at 850.00 EUR/ u. Net selling price: 1,200.00 EUR/ u. New gross selling price (on special): 999.00 EUR/ u. VAT 20 %. The internet retailer for laptops HEISTEL (Pty) Ltd. recently bought 200 laptops from its supplier SUNNY AG at cost of purchase of 850.00 EUR/ u. The net selling price is 1,200.00 EUR/ u. At the end of the Accounting period 20X4, there are 45 laptops on stock. SUNNY AG started already with the production of a new laptop type. To clear its stock, HEISTEL (Pty) Ltd. plans to sell the laptops at 999.00 EUR/ u gross selling price in January/ 20X5. The net selling price per unit is: 999 / 120% = 8 832.50 EUR/ u. The planned (future) sale is sufficient evidence for writing-down the laptops as per balance sheet date on 31.12.20X4. The valuation decrease in total is: 45 × (850 - 832.50) = 7 787.50 EUR. The Bookkeeping entry below shows how to record the decrease. Later, the Loss on <?page no="265"?> Berkau: Financial Statements 7e 9-265 Write-down Inventory account will be closed-off to profit or loss. DR Loss on Write-down Inventory. 787.50 EUR CR Inventory.................... 787.50 EUR DR P&L Account.................. 787.50 EUR CR Loss on Write-down Inventory. 787.50 EUR The new valuation of the 45 laptops on the statement of financial position is: 45 × 832.50 = 3 37,462.50 EUR. Losses caused by damage of deterioration are recorded similarly. 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 fair 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 Write-down Inventory account. Make the contra entry in the Inventory account. (5) At the end of the Accounting period, close-off the Loss on Write-down Inventory account to the Profit and Loss account. An alternative inventory measurement method based on IAS 2.22 is the retail method. The method is based on selling prices and a known percentage sales margin. It only applies for cases if it is impracticable to apply other costing methods. The retail method is appropriate if large numbers of fast turning goods (inventories with high turnover) exist. 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 110 You will find the task in the study material portal linked to this textbook. drop in inventory values due to discontinuation of one laptop model. 110 9.13 Manufacturing Accounting If companies produce goods themselves, inventory costs for finished goods include cost of conversion. Direct materials together with costs of conversion give the cost of manufacturing. IAS 2.12 defines cost of conversion. They are direct labour costs plus systematically allocated manufacturing overheads. For the calculation of finished goods, the Work-in-Process account applies. <?page no="266"?> Berkau: Financial Statements 7e 9-266 We cover only Job Order Costing as it is the most common method in Manufacturing Accounting and applies for all production types. In cases of similar or equal products e.g., in a brewery or in pharmaceutical production firms, Process Costing can apply. 111 With a Job Order Costing system, direct costs, like purchase costs for materials and direct labour, are added to the debit side of the Work-in-Process account. The Work-in-Process account stands for job orders and represents the cost of the goods produced in one batch. Different goods are recorded in separate Work-in-Process accounts. A job order is an internal order in a factory e.g., an order to produce 1,000 drums for washing machines. In contrast, a customer order is an order for one client that is linked to the final product and, in general, has lower quantities e.g., 1 washing machine per customer. Manufacturing Accounting requires further the recording of expenses in the factory and their allocation to finished goods. At first, all manufacturing overheads are recorded in singular expense accounts, linked to cost categories, like depreciation, supervisors’ salary etc., and then transferred to the Manufacturing Overheads account which represents a cost centre. For us, a cost centre is a small production department. All cost centres get discharged by the application of overheads. This leads to a debit entry in the Work-in-Process account and a credit entry made in the Manufacturing Overheads account. 111 Process Costing is covered in our textbook Management Accounting for the case study EDEWECHT (Pty) Ltd. in chapter (19). 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. In manufacturing companies and production firms, there are three different kinds of accounts: - Work-in-Process account: directly linked to single job orders. - Manufacturing Overheads accounts: linked to cost centres or cost centre groups in production. - Non-manufacturing accounts: linked to the entire company but not to production and named after their function e.g., Administration account, Marketing account etc. The Work-in-Process account supports the calculation of batches and unit costs. Once all costs are added to the Work-in-Process account including applied overheads from cost centres the total costs are divided by the lot size and result in the unit costs of manufacturing. The purpose of the Manufacturing Overhead account is to support the allocation of factory overheads to products. 9.14 Overhead Application The allocation of manufacturing overheads to job orders (Work-in-Process account) is called overhead application. In Financial Accounting, the application of overheads follows a Full Cost Accounting system. This means, <?page no="267"?> Berkau: Financial Statements 7e 9-267 variable and fixed manufacturing overheads are transferred all together. 112 IAS 2.12 requires the application of overheads. For overhead application, we multiply the performance of the cost centre with a predetermined overhead allocation rate, like 150.00 EUR per machine-hour. A job order for which the cost centre worked 3 hours then is charged with: 3 × 150 = 450.00 EUR of the manufacturing overheads. These are added to the direct costs on the Work-in-Process account’s debit side. The most accurate calculation is achieved if all calculations are based on actual costs. However, during production, the actual data are not yet available. E.g., a storage manager who puts finished goods on stock when production is completed cannot wait for the Accounting period to end to get to know about their unit costs. Therefore, the overhead application is based on budgeted values at normal capacity. This can cause applied overheads to differ from actual ones. We call cases where all allocated manufacturing overheads of a cost centre exceed the costs in the Manufacturing Overheads account over-applications. More manufacturing overheads are then transferred to work-in-process than exist. This results in a credit-balanced Manufacturing Overheads account. In the opposite case, if not all costs are allocated to job orders, we refer to the situation as under-applied. It will result in a debit balanced Manufacturing Overheads account. Whatever the situation is, a company cannot carry forward an imbalanced Manufacturing Overheads 112 In Management Accounting, we apply marginal Cost Accounting systems to avoid miscalculations induced by over-capacity. account to the next Accounting period. Therefore, the Manufacturing Overheads accounts are closed-off to the Cost of Goods Sold account. IAS 2.13 requires applying manufacturing overheads based on normal capacity. Normal capacity is the average capacity in the past with consideration of usual interruptions caused by maintenance and impairments. Normal capacity application means the cost allocations in the manufacturing cost centre is based on normal-capacity cost rates. A cost rate is calculated as the budgeted overheads divided by the performance at normal capacity. Performance units measure the output of a cost centre e.g., machine hours, kWh, number of products etc. As in Financial Accounting the application of overheads is based on Full Cost Accounting, deviations from normal capacity would increase/ decrease the cost of conversion of finished goods. 113 Therefore, IAS 2.13 requires the application of normal capacity and the transfer of remaining idle costs from the Manufacturing Overheads account to the Cost of Goods Sold account. We discus those different scenarios for the case study REIEBEEK- KASTEEL (Pty) Ltd. below. 9.15 C/ S RIEBEECK-KASTEEL (Pty) Ltd. Below, we study an under-application of overheads for the case of RIEBEECK-KASTEEL (Pty) Ltd., a production firm for maps in South Africa, to understand Manufacturing Accounting and IAS 2.13. 113 This will cause fluctuations of cost of manufacturing. <?page no="268"?> Berkau: Financial Statements 7e 9-268 Data Sheet for RIEBEECK-KASTEEL (Pty) Ltd. DDomicile: South Africa (Langebaan). Reporting currency: ZAR. Classification: Manufacturer. Periods: Jan 20X6 budgeted / Jan 20X6 actual. Overheads: depreciation: 250,000.00 ZAR/ m; supervisors’ salary: 110,000.00 ZAR/ m; administration: 124,000.00 ZAR/ m. Production: 600,000 maps in 160 hrs / 450,000 maps in 124 hrs. Materials: paper 1.20 ZAR/ u; ink 0.80 ZAR/ u. Net selling price: 7.00 ZAR/ u. VAT 20 %. RIEBEECK-KASTEEL (Pty) Ltd.’s manufacturing process requires materials, like paper and ink. For the printing of maps RIEBEECK-KASTEEL (Pty) Ltd. uses an A1 colour printer which is depreciated monthly by 250,000.00 ZAR/ m. The supervisors’ salary in the printing department is 110,000.00 ZAR/ m. Administration costs are 124,000.00 ZAR/ m. In January/ 20X6, RIEBEECK-KASTEEL (Pty) Ltd. plans to print 600,000 maps. The scheduled production time is 160 hours, which results in an output rate of: 600,000 / 160 = 3 3,750 u/ hour. We measure the performance of the printing department in hours. Material expenses per map for paper are 1.20 ZAR/ u and for ink 0.80 ZAR/ u. For the intended map production quantity, RIEBEECK-KASTEEL (Pty) Ltd. purchases paper for: 1.20 × 600,000 = 7 720,000.00 ZAR. Ink is purchased for: 0.80 × 600,000 = 4480,000.00 ZAR. The net selling price per map is 7.00 ZAR/ u. RIEBEECK- KASTEEL (Pty) Ltd. plans to sell all maps during the Accounting period VI/ 20X6. The expected revenue is: 7 × 600,000 = 4,200,000.00 ZAR. In Figure 9.6, we show Manufacturing Accounting based on budgeted amounts. We apply the predetermined overhead allocation rate based on normal capacity for printer depreciation and supervisors’ salary. It is: (250,000 + 110,000) / 160 = 2 2,250.00 ZAR/ h. Next, we record for the budgeted balance sheet the product calculation and the profit. D C D C OV . . . (1) 864,000.00 (1) 144,000.00 (12) 840,000.00 (12) 5,040,000.00 (2) 576,000.00 (2) 96,000.00 (4) 110,000.00 c/ d 600,000.00 (5) 124,000.00 840,000.00 840,000.00 c/ d 3,366,000.00 b/ d 600,000.00 5,040,000.00 5,040,000.00 b/ d 3,366,000.00 Cash/ Bank C/ B Value added tax VAT D C D C (1) 720,000.00 (6) 720,000.00 (2) 480,000.00 (7) 480,000.00 Inventory (paper) INP Inventory (ink) INI Figure 9.6: RIEBEECK-KASTEEL (Pty) Ltd.’s budgeted accounts <?page no="269"?> Berkau: Financial Statements 7e 9-269 D C D C (3) 250,000.00 (8) 250,000.00 c/ d 250,000.00 (3) 250,000.00 b/ d 250,000.00 Depreciation on printer-20X6 DPR Accumulated depreciation ACC D C D C (4) 110,000.00 (9) 110,000.00 (5) 124,000.00 P&L 124,000.00 Supervisors' salary-20X6 LAB Administration-20X6 ADM D C D C (6) 720,000.00 (10) 1,560,000.00 (8) 250,000.00 WIP 360,000.00 (7) 480,000.00 (9) 110,000.00 MOH 360,000.00 360,000.00 360,000.00 1,560,000.00 1,560,000.00 Work-in-Process-20X6 WIP Manufacturing overheads-20X6 MOH D C D C (10) 1,560,000.00 (11) 1,560,000.00 (11) 1,560,000.00 P&L 1,560,000.00 Finished goods inventory FGI Cost of goods sold-20X6 COS D C D C P&L 4,200,000.00 (12) 4,200,000.00 COS 1,560,000.00 REV 4,200,000.00 ADM 124,000.00 EBT 2,516,000.00 4,200,000.00 4,200,000.00 b/ d 2,516,000.00 Revenue-20X6 REV Profit and Loss-20X6 P&L Figure 9.6: RIEBEECK-KASTEEL (Pty) Ltd.’s budgeted accounts continued Once we divide the cost of manufacturing by the lot size, we calculate the unit costs of manufacturing: 1.560,000 / 600,000 = 2 2.60 ZAR/ u. The budgeted amounts are based on full capacity and the sale of all maps. Below, we repeat the calculation based on actual amounts. Now, RIEBEECK- KASTEEL (Pty) Ltd. only prints 450,000 maps which takes 124 hours. Note, that the production process is less productive than scheduled; the output rate now dropped to: 450,000 / 124 = 3 3,629.03 u/ hour. The lower efficiency requires us to allocate manufacturing overheads by hours not by units. The company produces 75 % of the planned number of maps in 77.50 % of the time. The lower quantity of maps causes a closing stock of materials, for paper and for ink. The paper left is worth: (600,000 - 450,000) × 1.20 = 1 180,000.00 ZAR and the ink: (600,000 - 450,000) × 0.80 = 120,000.00 ZAR. RIEBEECK-KASTEEL (Pty) Ltd. sells 385,000 maps at 7.00 ZAR/ u each. RIEBEECK-KASTEEL (Pty) Ltd. now puts <?page no="270"?> Berkau: Financial Statements 7e 9-270 450,000 - 385,000 = 6 65,000 maps in storage (finished goods). The map calculation is used for the inventory valuation on the balance sheet. We apply two alternative calculations, (α) under the assumption that the lower map quantity represents a normal capacity situation and we do not record idle costs in the printing department, and (β) following IAS 2.13. The latter one is required if the deviation in product quantities is considerable. The answer to the question what normal capacity is and what overcapacity means, is subjected to judgement of the reporting entity. Here, a decrease of 25 % of map numbers is regarded as substantial. Later, we show as case (γ) the same calculations as for (β), but under the application of the Manufacturing Summary Account. (α): No Idle Plant Costs (α) A Full Cost Accounting system adds all overheads to finished goods, hence, 360,000.00 ZAR are added to the Workin-Process account. The allocated overheads include idle costs. RIEBEECK- KASTEEL (Pty) Ltd. has: 160 - 124 = 3 36 hours of idle time. The printer and the supervisor cannot be deployed for other products, as the company only prints maps. RIEBEECK-KASTEEL (Pty) Ltd. cannot reduce depreciation and must pay for the supervisor as agreed per employment contract. The supervisor is not employed on a piecework contract 114 . Therefore, the unit costs increase in comparison to budgeted values to: (450,000 × (1.20 + 0.80) + 360,000) / 450,000 = 2 2.80 ZAR/ u. The profit is: 114 For Accounting for labour, study chapter (19) in our textbook Basics of Accounting. 385,000 × (7 - 2.80) - 124,000 = 1,493,000.00 ZAR. 9.16 C/ S RIEBEECK-KASTEEL (Pty) Ltd. - IAS 2.13 (β) To demonstrate the application of IAS 2.13, we provide the accounts in Figure 9.7. With recognition of idle time for the printer and the supervisor, the manufacturing overheads are applied based on the actual performance (in hours) multiplied with the predetermined (budgeted) overhead allocation rate. At RIEBEECK-KASTEEL (Pty) Ltd., the predetermined overhead allocation rate is: 360,000 / 160 = 2 2,250.00 ZAR/ h. Hence, RIEBEECK-KASTEEL (Pty) Ltd.’s applied overheads are: 124 × 2,250 = 279,000.00 ZAR. The remainder of the manufacturing overheads is seen as idle cost: 360,000 - 279,000 = 8 81,000.00 ZAR. Observe the profit calculation in Figure 9.7 based on overheads applied as discussed above. We consider the idle plant costs of 81,000.00 ZAR as expenses in the Cost of Goods Sold account. The credit entry is in the Manufacturing Overheads account. Alternatively, idle costs can be debited to the Profit and Loss account directly. On the income statement, they are then combined with cost of goods sold or can be disclosed under other expenses. 115 In case of an over-application, those Bookkeeping entries are inverted and thus cause a decrease of cost of goods sold item on the income statement. 115 The preference is a disclosure together with cost of goods sold. <?page no="271"?> Berkau: Financial Statements 7e 9-271 D C D C OV . . . (1) 864,000.00 (1) 144,000.00 (12) 539,000.00 (12) 3,234,000.00 (2) 576,000.00 (2) 96,000.00 (4) 110,000.00 c/ d 299,000.00 (5) 124,000.00 539,000.00 539,000.00 c/ d 1,560,000.00 b/ d 299,000.00 3,234,000.00 3,234,000.00 b/ d 1,560,000.00 Cash/ Bank C/ B Value added tax VAT D C D C (1) 720,000.00 (6) 540,000.00 (2) 480,000.00 (7) 360,000.00 c/ d 180,000.00 c/ d 120,000.00 720,000.00 720,000.00 480,000.00 480,000.00 b/ d 180,000.00 b/ d 120,000.00 Inventory (paper) INP Inventory (ink) INI D C D C (3) 250,000.00 (8) 250,000.00 c/ d 250,000.00 (3) 250,000.00 b/ d 250,000.00 Depreciation on printer-20X6 DPR Accumulated depreciation ACC D C D C (4) 110,000.00 (9) 110,000.00 (5) 124,000.00 P&L 124,000.00 Supervisors' salary-20X6 LAB Administration-20X6 ADM D C D C (6) 540,000.00 (10) 1,179,000.00 (8) 250,000.00 WIP 279,000.00 (7) 360,000.00 (9) 110,000.00 c/ d 81,000.00 MOH 279,000.00 360,000.00 360,000.00 1,179,000.00 1,179,000.00 b/ d 81,000.00 COS 81,000.00 Work-in-Process-20X6 WIP Manufacturing overheads-20X6 MOH D C D C (10) 1,179,000.00 (11) 1,008,700.00 (11) 1,008,700.00 P&L 1,089,700.00 c/ d 170,300.00 MOH 81,000.00 1,179,000.00 1,179,000.00 1,089,700.00 1,089,700.00 b/ d 170,300.00 Finished goods inventory FGI Cost of goods sold-20X6 COS Figure 9.7: RIEBEECK-KASTEEL (Pty) Ltd.’s actual accounts (IAS 2.13) <?page no="272"?> Berkau: Financial Statements 7e 9-272 D C D C P&L 2,695,000.00 (12) 2,695,000.00 COS 1,089,700.00 REV 2,695,000.00 ADM 124,000.00 EBT 1,481,300.00 2,695,000.00 2,695,000.00 b/ d 1,481,300.00 Revenue-20X6 REV Profit and Loss-20X6 P&L Figure 9.7: RIEBEECK-KASTEEL (Pty) Ltd.’s actual accounts (IAS 2.13) Due to a longer production time per map in comparison to the budgeted amounts, the unit costs per map increase to: 1,179,000 / 450,000 = 2 2.62 ZAR/ u. However, the unit costs are below the absorption cost rate of 2.80 ZAR/ u, which includes the idle costs. We consider a difference in production numbers of 25 % as a significant deviation which leaves no alternative to following IAS 2.13. How it is Done (Recording Idle Plant Costs): (1) Add direct costs to the Work-in-Process account. (2) Add manufacturing overheads to the Manufacturing Overheads account. (3) Add non-manufacturing overheads to single expense accounts and later close them off to the Profit and Loss account. (4) Compare actual manufacturing overheads to those calculated based on normal capacity (via predetermined overhead allocation rate POR). Check whether actual and normal capacity significantly differ from each other. (5a) 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. (5b) If actual and normal capacity differ significantly from each other, apply overhead calculation based on normal capacity and disclose idle costs as an expense in cost of sales or in profit or loss. Add applied manufacturing overheads to the Work-in-Process accounts. Close-off the Manufacturing Overheads account which most probably contains under-/ over-applied manufacturing overheads to the Cost of Goods Sold account. Record inventory movements when goods are completed towards the Finished Goods Inventory account. <?page no="273"?> Berkau: Financial Statements 7e 9-273 9.17 Manufacturing Summary Account A Manufacturing Summary Account is a reconciliation account for manufacturing overheads and work-in-process. It applies if a periodic inventory movement system is in use and if the Workin-Process account and the Manufacturing Overhead account are linked to the same cost centres. This situation is seldom and can be observed where a company applies a Process Costing 116 . For the easy case study RIEBEECK- KASTEEL (Pty) Ltd., a Manufacturing Summary account can be applied and is shown below. Note, we do not recommend the application of Manufacturing Summary accounts, but you should know what it is. 9.18 C/ S RIEBEECK-KASTEEL (Pty) Ltd. - case (γ) For the case study RIEBEECK-KASTEEL (Pty) Ltd. following IAS 2.13 we apply a Manufacturing Summary Account. It requires a periodic inventory system. Therefore, we need to know the inventory valuations which we copy from the previous calculations. The calculation of finished goods requires excluding the idle costs. - Paper: 1.20 ZAR/ u. - Ink: 0.80 ZAR/ u. - Maps: 2.62 ZAR/ u. At RIEBEECK-KASTEEL (Pty) Ltd. we only have one Work-in-Process account and one Manufacturing Overhead account which is now replaced by its reconciliation account. D C D C OV.P 720,000.00 FGI 1,179,000.00 FGI 1,008,700.00 P&L 1,089,700.00 OV.I 480,000.00 INP 180,000.00 MSA 81,000.00 DPR 250,000.00 INI 120,000.00 1,089,700.00 1,089,700.00 LAB 110,000.00 c/ d 81,000.00 1,560,000.00 1,560,000.00 b/ d 81,000.00 COS 81,000.00 D C D C MSA 1,179,000.00 COS 1,008,700.00 COS 1,089,700.00 REV 2,695,000.00 c/ d 170,300.00 ADM 124,000.00 1,179,000.00 1,179,000.00 EBT 1,481,300.00 b/ d 170,300.00 2,695,000.00 2,695,000.00 b/ d 1,481,300.00 Manufacturing summary account-20X6 MSA Cost of goods sold-20X6 Finished goods inventory FGI Profit and Loss-20X6 P&L Figure 9.8: RIEBEECK-KASTEEL (Pty) Ltd.'s Manufacturing Summary Account (γ) In the Manufacturing Summary account, we see the opening values for the paper 116 For Process Costing, study chapter (19) of our textbook Management Accounting. (OV.P) and for ink (OV.I). Furthermore, all expenses at RIEBEECK-KASTEEL (Pty) <?page no="274"?> Berkau: Financial Statements 7e 9-274 Ltd. are added, which here is depreciation (DPR) and the supervisor's salary (LAB). After production, the closing stocks for paper (INP) and ink (INI) as well as for the maps (FGI) are determined. The balancing figure in the Manufacturing Summary account represents the idle costs which are added to cost of goods sold. The remainder of Bookkeeping entries is the same as in Figure 9.7. The problem with the Manufacturing Summary Account is that it only works in special situations and that the periodic system requires calculating the unit cost of manufacturing in a separate working. We recommend working on the case study HEUNING Ltd. which is a manufacturer for garden tools. Task A9.49a follows the weighted average method and task A9.49b is the same case study but based on the cost formula first-in-first-out. The case HEUNING Ltd. comes with 4 Job Order accounts (WIP) and 2 Manufacturing Overheads accounts. 117 9.19 Receivables Receivables are recorded in the current-asset section of the balance sheet and most likely result from payments expected to come from customers in arrears. Those receivables, in general, contain a VAT portion which matters if bad debts must be recognised (writing-off receivables). Besides of trade receivables, there are input-VAT receivables linked to claims to the revenue service and receivables resulting from granted loans to other parties. 117 You will find the task HEUNING Ltd. in the study material portal linked to this textbook. Those receivables normally do not include VAT. Receivables fall under financial instruments as they are contracts ruled by IAS 32.11. Companies must report potential impairments thereof due to credit risks following IFRS 7.9. Trade receivables depend on credit risks because the owing party can fail its payment obligations e.g., if filing for bankruptcy. IFRS 9.3.1.2 requires a fair value measurement of financial assets through either the profit or loss or other comprehensive income. 9.20 C/ S CHELMSFORD Below, we study trade receivables based on the case of CHELMSFORD Ltd., an Australian car dealer. Data Sheet for CHELMSFORD Ltd. DDomicile: Australia (Sydney). Reporting currency: AUD. Classification: dealership. Periods: 20X3 / 20X4. Sale of car: 65,000.00 AUD (net amount) on 5.04.20X3 payable on 4.04.20X4 Interest: 3,000.00 AUD (net amount) VAT 20 %. CHELMSFORD Ltd. records trade receivables from its sale of a VW Caddy Diesel to the extent of 81,600.00 AUD. The company accepted a sale where the customer buys the van on 5.04.20X3 and pays the complete price one year later (4.04.20X4). An Interest portion of 3,000.00 AUD (net value) is included in the settlement value. The agreement between CHELMSFORD Ltd. and its customer is about the delivery of the van and the payment of: (65,000 + 3,000) × <?page no="275"?> Berkau: Financial Statements 7e 9-275 120% = 8 81,600.00 AUD in 20X4. 65,000.00 AUD is the car’s regular net selling price. The Bookkeeping 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 short-term liabilities (A/ P). At CHELMSFORD Ltd., a deferred interest income linked to the next Accounting period is recorded. The interest income is for the period of April 20X3 until March 20X4. Hence it falls under the actual Accounting period 20X3 to an extent of 9 months. The actual interest income is: 3,000 × 9/ 12 = 2 2,250.00 AUD in 20X3. The remainder is deferred interest income for the next Accounting period 20X4 to an extent of: 3,000 - 2,250 = 750.00 AUD. DR Accounts Receivables......... 81,600.00 AUD CR Interest Income.............. 2,250.00 AUD CR Deferred Interest Income..... 750.00 AUD CR VAT.......................... 13,600.00 AUD CR Revenue...................... 65,000.00 AUD The valuation of the financial asset is based on the amount the customer is owing, which is the 81,600.00 AUD settlement value. As the entire note receivable results from one car deal, the financial asset is recorded as a single item. From prior experience, CHELMSFORD Ltd.’s credit risk regarding its customers failure to pay is calculated to be 10 % of the debts. On average 10 % of receivables are written-off as bad debts because the expected receipts are not paid and are not collectable either. Hence, CHELMSFORD Ltd. calculates the fair value of its trade receivable based on estimated credit risks. The bad debt portion resulting from the van sale is: 10% × 81,600 = 8 8,160.00 AUD. At the end of the Accounting period 20X3, CHELMSFORD Ltd. records the risk as an adjustment for the trade receivables in Bookkeeping entry (2). The recording of bad debts is here a precautious consideration of the potential credit risk that will be reversed once the payment is received or must be extended to the full amount if the customer fails to pay. DR Bad Debts.................... 6,800.00 AUD DR VAT.......................... 1,360.00 AUD CR Accounts Receivables......... 8,160.00 AUD The recording of bad debts resulting from trade receivables includes a debit entry in the VAT account as it reduces CHELMSFORD Ltd.’s output-VAT payment obligation. The revenue recognition at the time of closing the deal requires CHELMSFORD Ltd. to record the full output-VAT although no cash from its customer has been received. The interest income as well as the bad debts are closed-off to the Profit or Loss- 20X3 account (not shown). <?page no="276"?> Berkau: Financial Statements 7e 9-276 The buyer of the van pays the agreed price of 81,600.00 AUD on time (in 20X4). The payment changes the fair value of the receivables, as the cash receipt voids the previously recorded credit risk. Therefore, we record the payment in two steps, the first one is a reversal of the prior writing-down of the receivables and the second one is the full settlement of the receivable. Observe Bookkeeping entries (a) and (b). DR Accounts Receivables......... 8,160.00 AUD CR VAT.......................... 1,360.00 AUD CR Reversal Bad Debts........... 6,800.00 AUD DR Cash/ Bank.................... 81,600.00 AUD CR Accounts Receivables......... 81,600.00 AUD The last Bookkeeping entry (b) counts as de-recognition of the financial asset. To allocate the interest portion correctly, CHELMSFORD Ltd. adds the deferred interest to the Interest Income account. How it is Done (Valuation of Receivables): (1) Determine the settlement value SMV, in general, it is the gross value if resulting 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 add it to receivables. (3) Determine credit risks, preferably as a percentage rate (rr). (4) Calculate the fair value of receivables under consideration of credit risks by multiplying the settlement value with the factor: (1 - rr). (5) Record the writing-down as bad debts, make a debit entry in the Bad Debts account to the extent of the net amount of the settlement value multiplied with 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) Check the solvency of the debtor regularly. (7a) If the debtor is insolvent write-off the remaining receivables as bad debts. 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. <?page no="277"?> Berkau: Financial Statements 7e 9-277 (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 entire cash receipt. 9.21 Securities Securities fall under financial instruments and are ruled by IFRS 9. We call them securities, as they are financial asset kept under conditions which makes their liquidation easy. Securities earn interest or gains from capital appreciation. In rainy days, the owner can sell her/ his securities quickly and use the cash receipts to increase her/ his liquidity. The characteristics of securities resemble those of other financial instruments. To benefit from the option to sell them on short notice, they must be recognised as current financial assets and at fair values. Financial assets in general are contracts which result from equity or liability instruments, like shares or bonds. A company that buys 100 shares of McDonald’s Corporation carries them as securities. In case the company needs cash urgently, it can sell the shares at a stock exchange through its bank. The classification of financial instrument in line with IFRS 9.4.1.2 refers to the business model of its owner. The business model in terms of IFRS 9 considers the holder’s intention. If securities are held for sale, fair value presentation through profit or loss (FVTPL) or fair value presentation through other comprehensive income (FVTOCI) applies. The “T” for “through” refers to how adjustments from the current valuation towards new fair values are recorded. Securities in the current asset section normally fall under this classification (FVTPL or FVTOCI). In contrast, financial assets which solely are held for the receipt of contractual cash flows must be carried at amortised costs along IFRS 9.4.1.2 and are covered in chapter (7). Shares always are carried at FVTPL/ FVTOCI. In compliance with IFRS 9.5.1.1, securities are initially measured at costs and later at fair values (IFRS 9.5.7). The valuation of publicly traded securities can be derived from market prices as traded at a stock exchange or the bond market. 9.22 C/ S NOKOX (Pty) Ltd. We discuss below three case studies about securities. The first one is about shares and the next following ones about bonds and futures. At first, the share-related case study NOKOX (Pty) Ltd. is discussed: Data Sheet for NOKOX (Pty) Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: n/ a. Period: 20X8. Purchase of 30,000 shares of MCD at 150.00 AUD/ s on 30.04.20X8 <?page no="278"?> Berkau: Financial Statements 7e 9-278 DDividend: 1.00 USD/ s. Currency exchange rate 1.00 USD : 1.50 AUD / 1.00 USD : 1.40 AUD. Share price at NSE: 105.00 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. Fee: 25,000.00 AUD. Currency exchange rate 1.00 USD : 1.48 AUD. On 30.04.20X8, NOKOX (Pty) Ltd. buys 30,000 shares of McDonald’s corporation at 150.00 AUD/ s. The shares are traded at 100.00 USD/ s. The currency exchange rate is 1.00 USD = 1.50 AUD. The costs of purchase are: 30,000 × 150 = 44,500,000.00 AUD. NOKOX (Pty) Ltd. intends to sell the shares in the next Accounting period 20X9. The shares are classified as securities. On 31.12.20X8, NOKOX (Pty) Ltd. receives a dividend of 42,000.00 AUD from the shares. The dividend is 1.00 USD/ s. The Australian Dollar depreciated against the US-Dollar and is traded now at: 1.00 USD = 1.40 AUD. Hence, the dividend receipt is: 30,000 × 1.40 = 4 42,000.00 AUD. The dividend is recorded as gain through other comprehensive income. It is classified as a gain because NOKOX (Pty) Ltd.’s core business is not share trading. Therefore, dividend income is regarded as extraordinary. At the same time, the share of McDonald’s Corporation is traded at the New York Stock Exchange NYSE at 105.00 USD/ s. The shares’ value in Australian Dollars as at the balance sheet date is: 30,000 × 105 × 1.40 = 4 4,410,000.00 AUD. Due to the weak Australian Dollar, NOKOX (Pty) Ltd. loses: 4,500,000 - 4,410,000 = 9 90,000.00 AUD. The loss in valuation exceeds the dividend income. We deduct the dividends from the loss in valuation and calculate a net loss of: 90,000 - 42,000 = 4 48,000.00 AUD. NOKOX (Pty) Ltd. records the dividends and the share price loss through other comprehensive income as below because the shares are carried at fair values through other comprehensive income in compliance with IFRS 9.4.1.2A. If a recording through other comprehensive income applies, we preferably record the gains or losses in a special Other Income account and disclose these items on the income statement marked as extraordinary. DR Cash/ Bank.................... 42,000.00 AUD CR Dividend Income OI........... 42,000.00 AUD DR Loss on Valuation OI......... 90,000.00 AUD CR Securities McD............... 90,000.00 AUD On its financial statements, NOKOX (Pty) Ltd. reports a loss caused by currency exchange rate. We continue the case study NOKOX (Pty) Ltd. further below and then consider Hedging. Hedging is an instrument to fight a loss due to currency exchanges by investing in financial instruments that compensates the threatening loss. Special disclosure rules apply. Before we continue with the case NOKOX (Pty) <?page no="279"?> Berkau: Financial Statements 7e 9-279 Ltd., we cover another type of securities: bonds. If you prefer to continue reading about NOKOX (Pty) Ltd. and are already familiarised with options, move to the *. There, we discuss hedging the shares by a call option. Otherwise, learn about options below. 9.23 C/ S TRAGER GmbH See next the case study TRAGER GmbH: Data Sheet for TRAGER GmbH DDomicile: Germany (Münster). Reporting currency: EUR. Classification: n/ a. Period: 20X8. Purchase of 300 Bonds at 78.00 EUR/ b. Nominal amount: 100.00 EUR/ b. Coupon: 4 %/ 6m. Bond listing on 31.12.20X4 at 84 (%). VAT n/ a. On 3.04.20X8, TRAGER GmbH buys 300 bonds at 78.00 EUR/ b each (price as traded at the bond market). The bonds’ principal is 100.00 EUR/ b. This is the value the bonds mature at on settlement date and the coupon is based on. The bonds pay semi-annually a coupon of 4%/ 6m, which is on 30.06. and on 31.12. every year. TRAGER GmbH plans to sell its bonds in January/ 20X9. Due to its business model, TRAGER GmbH holds the bonds at fair values through other comprehensive income. At the time of bond purchase, TRAGER GmbH records the cost of acquisition for its bonds: 300 × 78 = 2 23,400.00 EUR. DR Investment in Bonds (Sec.)... 23,400.00 EUR CR Cash/ Bank.................... 23,400.00 EUR At the time of the coupon payments, on 30.06.20X8 as well as on 31.12.20X8, TRAGER GmbH receives coupon payments of: 300 × 4 = 1 1,200.00 EUR. The company records the receipts as interest income which is recorded through other comprehensive income twice. DR Cash/ Bank.................... 1,200.00 EUR CR Interest Income OCI.......... 1,200.00 EUR On 31.12.20X8, TRAGER GmbH must evaluate its bonds at their fair market values. At that date, the bonds are traded at 84.00 EUR/ b. We say alternatively, the bonds are listed at 84 (percent). On the financial statements, the bonds are disclosed at: 300 × 84 = 25,200.00 EUR. The difference in valuation is: 25,200 - 23,400 = 1 1,800.00 EUR. TRAGER GmbH records the gain as the Bookkeeping entry below through other comprehensive income: DR Investments Bonds............ 1,800.00 EUR CR Other Comprehensive Income... 1,800.00 EUR <?page no="280"?> Berkau: Financial Statements 7e 9-280 9.24 C/ S GRENVILLE AG Besides bonds and shares, securities can be future contracts, too. Read our next case study GRENVILLE AG: Data Sheet for GRENVILLE AG DDomicile: Germany (Essen). Reporting currency: EUR. Classification: n/ a. Period: 20X5. Exchange of 10,000.00 USD towards 9,000.00 EUR on 31.12.20X5. Currency exchange rate: on 2.01.20X5: 1.10 USD = 1.00 EUR / on 31.12.20X5: 1.25 USD = 1.00 EUR. VAT n/ a. 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 10,000.00 USD to 9,000.00 EUR on 31.12.20X5. No payment is made so far. The bank's transaction fees (commission) are included. The forward exchange contract secures an expected payment of 10,000.00 USD from GRENVILLE AG’s overseas customer. At the time of the agreement the currency exchange rate is: 1.10 USD = 1.00 EUR. Therefore, the transaction costs are: 10,000/ 1.1 - 9,000 = 9 90.91 EUR. Accounting for the forward exchange contract requires recording Bookkeeping entry (1) at the time of recognition (2.01.20X5): DR Accounts Receivable (FEC).... 9,000.00 EUR DR Fees......................... 90.91 EUR CR Accounts Payables ($10,000).. 9,090.91 EUR The contract is recognised as a future receipt and a present obligation to pay 10,000.00 USD and the fees. The first one is worth: 10,000 / 1.1 = 9 9,090.91 EUR. In contrast to a call option, this contract is binding and leads to the agreed receipt and payment at the specified date 31.12.20X5. On 31.12.20X5, the currency exchange rate has changed to: 1.25 USD = 1.00 EUR. Hence, the actual value of the 10,000.00 USD drops to: 10,000 / 1.25 = 8,000.00 EUR. Therefore, GRENVILLE AG earns a currency gain from the future exchange contract of: 9,091.91 - 8,000 = 1,091.91 EUR. Consider the bank fees as expenses that were considered with payables. The contract makes GRENVILLE AG receive: 9,000 - 8,000 = 1 1,000.00 EUR in cash. Note, the 8,000.00 EUR are paid in USD. On 31.12.20X5, the financial asset is derecognised when Deutsche Bank pays the agreed EUR amount in exchange for 10,000.00 USD received. Observe Bookkeeping entry (2): DR Cash/ Bank.................... 1,000.00 EUR DR Accounts Payable ($10,000)... 9,090.91 EUR CR Accounts Receivables (FEC)... 9,000.00 EUR CR Gain on Currency............. 1,090.91 EUR For the case study GRENVILLE AG, a recognition of the forward exchange contract on the balance sheet is not required because as at 31.12.20X5, the <?page no="281"?> Berkau: Financial Statements 7e 9-281 currency contract has been settled already. As the case study GRENVILLE AG shows, short-term financial assets can be used to secure a currency exchange risk. This falls under Hedging. Hedging allows based on IFRS 9.5.7.1 (a) the application of special rules to simplify Accounting for and disclosure of financial instruments. 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 transaction. * 9.25 C/ S NOKOX (Pty) Ltd. continued After studying 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 by the purchase of a call option on USD. The profit mentioned above is the increase of the shares from 100.00 USD to 105.00 USD plus the dividend payment. Hence, NOKOX (Pty) Ltd. earns: 30,000 × (105 - 100) + 30,000 × 1 = 1 180,000.00 USD. Without currency exchange rate decrease, the dividend gain in AUD would have been: 180,000 × 1.50 = 270,000.00 AUD. Due to the depreciation of the AUD against the USD, NOKOX (Pty) Ltd. loses: (3,000,000 + 180,000) × (1.50 - 1.40) = 3 318,000.00 AUD. The difference is: 180,000 × 1.50 - 318,000 = - - 48,000.00 AUD, which is recorded as a net loss. To secure its profit, NOKOX (Pty) Ltd. buys on 4.04.20X8 at costs of 25,000.00 AUD an option to exchange 2,700,000.00 USD on 31.12.20X8 to 4,000,000.00 AUD. The exchange rate on 4.04.20X8 is: 1.00 USD = 1.48 AUD. At first, we record the option separately from the shares. We refer to this recognition variant as case (i). Later, we discuss a combined presentation under case (ii). The latter one then is in line with IFRS 9.6. (i): Separate Positions The option is bought at 25,000.00 AUD and is recorded as a single item at cost. At the time of purchasing the MCD shares, the option is not helping as the exchange rate is: 1.00 AUD = 1.50 USD. Using the option would even result in a loss of: 2,700,000 × 1.50 - 4,000,000 = 50,000.00 AUD. On the 31.12.20X8, the option’s value is higher. Based on the currency exchange rate, 2,700,000.00 USD are worth: 2,700,000 × 1.40 = 3 3,780,000.00 AUD. The value of the option is: 4,000,000 - 3,780,000 = 2 220,000.00 AUD. The difference is the options benefit less its cost of acquisition (fee). This gives: 220,000 - 25,000 = 1 195,000.00 AUD. Once we deduct NOKOX (Pty) Ltd.’s (currency-) loss from the share valuation and its dividends from the realised gain <?page no="282"?> Berkau: Financial Statements 7e 9-282 of the call option, we calculate a profit of: 195,000 - 48,000 = 1 147,000.00 AUD. Observe the Bookkeeping entries below for the initial and subsequent valuation of the call option. DR Call Option.................. 25,000.00 AUD CR Cash/ Bank.................... 25,000.00 AUD DR Call Option.................. 195,000.00 AUD CR Option Gain OI............... 195,000.00 AUD 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 2,700,000.00 USD worth: 2,700,000 × 1.40 = 3 3,780,000.00 AUD for 4,000,000.00 AUD. The latter transaction is shown as Bookkeeping entry (i3). See the accounts in Figure 9.9. DR Cash/ Bank AUD................ 4,000,000.00 AUD CR Cash/ Bank USD................ 3,780,000.00 AUD CR Call Option.................. 220,000.00 AUD D C D C (3) 90,000.00 (2) 42,000.00 (1) 4,500,000.00 (3) 90,000.00 c/ d 147,000.00 (i2) 195,000.00 c/ d 4,410,000.00 237,000.00 237,000.00 4,500,000.00 4,500,000.00 b/ d 147,000.00 b/ d 4,410,000.00 Other comprehensive income-20X8 OCI Securities SEC D C D C (i1) 25,000.00 (i3) 220,000.00 (2) 42,000.00 (1) 4,500,000.00 (i2) 195,000.00 (i3) 4,000,000.00 (i1) 25,000.00 220,000.00 220,000.00 c/ d 4,263,000.00 (i3) 3,780,000.00 8,305,000.00 8,305,000.00 b/ d 4,263,000.00 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 an item of current assets that combines the two financial instruments. Its initial valuation is based on the shares valued at costs and the call option valued at cost of acquisition: 30,000 × 100 × 1.50 + 25,000 = 4 4,525,000.00 AUD. On 31.12.20X8, the shares’ value drops to: 30,000 × 105 × 1.40 = <?page no="283"?> Berkau: Financial Statements 7e 9-283 44,410,000.00 AUD. The valuation of the call option is derived from the cost of acquisition and the gain of: 25,000 + 195,000 = 2 220,000.00 AUD, see above. Hence, the total item’s value is: 4,410,000 + 220,000 = 4 4,630,000.00 AUD. The residual valuation change of the hedge item is: 4,630,000 - 4,525,000 = 105,000.00 AUD. We add this amount to the dividend received: 30,000 × 1 × 1.40 = 442,000.00 AUD, which is a gain outside of the combined item. Hence, the total gain is: 105,000 + 42,000 = 1 147,000.00 AUD. In contrast to case (i) we here disclose a gain from the combined item of 105,000.00 AUD and a gain from the dividend receipt to the extent of 42,000.00 AUD. 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. Do not depreciate securities. (3) Monitor the securities’ fair value; this is normally the fair market price at 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 best apply a Realisation account. In case a security is used, like executing a call option, record an expense to the extent of the security and make the contra entry in the Securities account for the invalidation of the security. 9.26 Prepaid Expenses Prepaid expenses are payments e.g., for labour, rent, insurance etc., dedicated to certain future periods e.g., January of the next Accounting period and paid in advance. The characteristics of prepaid expenses resemble those of receivables. The difference is that prepaid expenses are settled by services but not by cash. In terms of Accounting theory, prepaid expenses are regarded as accruals, meaning they 118 Read our textbook Basics of Accounting, chapter (18). are recorded when paid and disclosed as current assets on the balance sheet. 118 In contrast to the regulations based on German HGB, the IASB regards prepaid expenses as current assets. They fulfil the recognition criteria of assets once there is a future economic benefit and they can be measured reliably. In contrast, German HGB shows an extra item outside of the current asset <?page no="284"?> Berkau: Financial Statements 7e 9-284 section, referred to as Rechnungsabgrenzungsposten (separate item). 9.27 Cash and its Equivalents We record cash and its equivalents in the Cash/ Bank account. It is cash, like coins and bills on hand, and cash at 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. In general, companies keep separate records for each bank account for Bank Reconciliation purposes. 119 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. 9.28 C/ S BAKENSKOP PLC See the case study BAKENSKOP PLC below. Data Sheet for BAKENSKOP PLC DDomicile: Botswana (Gaborone). Reporting currency: BWP. Classification: trader. Period: 20X5. Opening value: 500,000.00 BWP. Addition: 20,000.00 EUR. Currency exchange rate 1.00 BWP : 0.09 EUR / 1.00 BWP : 0.07 EUR. VAT n/ a. 119 Read our textbook Basics of Accounting, chapter (37). BAKENSKOP PLC is a Botswanan trading company. Its reporting currency is Botswanan Pula BWP. As the company imports goods from Europe, BAKENSKOP PLC runs an extra bank account in EUR. At the beginning of fiscal year 20X5, BAKENSKOP PLC’s EUR-bank account’s opening value is 40,000.00 EUR. The currency exchange rate is: 1.00 BWP = 0.08 EUR. Hence, the opening value in the account based on the reporting currency is: 40,000 / 0.08 = 5 500,000.00 BWP. This is the value disclosed on the balance sheet as at 1.01.20X5. On 1.10.20X5, BAKENSKOP PLC buys 20,000.00 EUR at an exchange rate of: 1.00 BWP = 0.09 EUR. The amount is added to the EUR-bank account. On 31.12.20X5, the currency exchange rate is: 1.00 BWP = 0.07 EUR. BAKENSKOP PLC discloses a balancing figure of 60,000.00 EUR on its bank account. The value of the bank account measured in the reporting currency Botswanan Pula is: 60,000 / 0.07 = 8 857,142.86 BWP. After we determined the fair value of the bank account’s balancing figure, we record the impact the currency exchange rate has on earnings in other comprehensive income. A recognition as profit or loss does not apply as BAKENSKOP PLC is no bank (business model). The first 40,000.00 EUR make BAKENSKOP PLC earn: 40,000 × (0.07 -1 - 0.08 -1 ) = 71,428.57 BWP. The receipt from October 20X5 results in another gain of: 20,000 × (0.07 -1 - 0.09 -1 ) = 663,492.06 BWP. The resulting gain from currency exchanges is: 71,428.57 + 63,492.06 = 134,920.63 BWP. <?page no="285"?> Berkau: Financial Statements 7e 9-285 BAKENSKOP PLC does not convert every Bookkeeping entry to the reporting currency as the bank account is based on EUR. Therefore, prior Bookkeeping entries have been made in EUR. There is only a revaluation Bookkeeping entry required on 31.12.20X5 which is shown below. Observe the accounts in Figure 9.10: DR Cash/ Bank.................... 134,920.63 BWP CR Gain in Currency Exchange OCI 134,920.63 BWP D C D C [EUR] [EUR] [BWP] [BWP] OV 40,000.00 OV 500,000.00 (1) 20,000.00 c/ d 60,000.00 (1) 222,222.22 60,000.00 60,000.00 OCI 134,920.64 c/ d 857,142.86 b/ d 60,000.00 857,142.86 857,142.86 b/ d 857,142.86 Cash/ Bank EUR Cash/ Bank BWP D C [BWP] [BWP] c/ d 134,920.64 BWP 134,920.64 b/ d 134,920.64 Other comprehensive income-20X5 OCI Figure 9.10: BAKENSKOP PLC’s foreign currency bank accounts 9.29 Summary The current asset section include 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, 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 as 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. 9.30 Working Definitions Bad Debts: Expense account for irrecoverable receivables. Hedging: Carrying two financial instruments with opposite risks, such as a receivable in USD and a future in USD. Idle Costs: Expenses for unused production facilities. Inventories: Asset held for sale or for support of production or for service rendering. Work-in-Process Account: Account in Manufacturing Accounting that rep- <?page no="286"?> Berkau: Financial Statements 7e 9-286 resents a job order. The Work-in-Process account is the reconciliation account for multiple Job Order accounts. See also the conventions in chapter (1). Manufacturing Accounting: Accounting for finished goods valuation in manufacturing companies and production firms. Manufacturing Accounting is based on Work-in-Process accounts and Manufacturing Overheads accounts. Manufacturing Overheads Account: An account to gather all overheads linked to production. Net Realisable Value: Measurement at fair value at which an asset can be sold among knowledgeable, willing and independent parties (orderly transaction). Overhead Application: Allocation of manufacturing overheads to job orders by making a debit entry in the Workin-Process account and a credit entry in the Manufacturing Overheads account. Securities: Short-term financial instruments. 9.31 Question Bank (1) A company records as manufacturing overheads: 30,000.00 EUR depreciation, 55,000.00 EUR indirect labour and 6,000.00 EUR factory insurance expenses. The planned output 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. 51,600.00 EUR . 2. 54,600.00 EUR . 3. 86,000.00 EUR . 4. 91,000.00 EUR . (2) A company records the following additions to stock. 100 at 34.00 EUR, 200 at 33.00 EUR, 150 at 35.00 EUR. Based on a weighted average cost formula, how much is a stock release of 25 units? 1. 841.67 EUR . 2. 850.00 EUR . 3. 847.22 EUR . 4. 875.00 EUR . (3) A company buys 400 pullovers at 96.00 EUR/ u gross amount. The dealer offered a trade discount of 10 % which has been considered for the price already. How much are unit costs of purchase before trade discount deduction? 1. 88.00 EUR . 2. 88.89 EUR . 3. 106.67 EUR . 4. 72.72 EUR . (4) A company carries a note receivable from selling goods to the extent of 1,500.00 EUR. The customer is most probably (80 % probability) insolvent. How much are the recorded bad debts? 1. 0.00 EUR . 2. 1,000.00 EUR . 3. 1,250.00 EUR . 4. 1,500.00 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 246.00 EUR/ b and the principal of the bond is 250.00 EUR/ b. On <?page no="287"?> Berkau: Financial Statements 7e 9-287 31.12.20X5, the coupon at 5.4 %/ a is paid. At which value are the bonds disclosed on the balance sheet as at 31.12.20X5? 1. 12,964.20 EUR . 2. 12,171.37 EUR . 3. 12,500.00 EUR . 4. 12,300.00 EUR . 9.32 Solutions 1-1, 2-3, 3-2, 4-2, 5-4. <?page no="288"?> Berkau: Financial Statements 7e 10-288 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. It discusses the direct method as we applied for KENILWORTH METERED TAXI Ltd. in chapter (3) and the reconciliation of profits with the operating cash flows we prepared BATHURST Ltd.’s cash flow statement with in chapter (6). The reconciliation method is what most companies apply. The derivative method is covered, too; however, we put it on the study material portal accessible via QR code link. We start this chapter with liquidity planning followed by the procedures to prepare a cash flow statement based on the reconciliation method for operating cash flows in detail. Different to other chapters in this textbook, we first prepare the cash flow statement following the direct method and then provide you with a how-it-is-done paragraph which is explained in detail step-by-step. We apply these steps for the case EIMKE Ltd. which leads to the same cash flows as based on the direct method. In this chapter, we require basic knowledge about cash flows as laid out in the textbook Basics of Accounting. 120 10.2 Learning Objectives After studying cash flows in this chapter, you understand the need of reporting cash flows resulting from different 120 Read in our textbook Basics of Accounting, chapter (32) which is an introduction about cash flow statements. kinds of activities, and you can apply the direct method for a full statement of cash flows and the reconciliation method for the calculation of cash flows from operations. You understand the steps which are required for the reconciliation of earnings after taxes with cash flows from operations in detail. You also develop a feeling of what impact business activities have on the cash flows and you can analyse cash flow statements from other companies. From studying cash flow statements, you learn to estimate which cash flows are likely to repeat in the future and what are once-off payments/ receipts. 10.3 Cash Flow Statement Obligation 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 the company’s liquidity situation by analysing the cash/ bank item on the balance sheet in combination with its statement of cash flows. They strive to predict future liquidity and cash flows and try to assess whether a cash flow is likely to repeat in the future. A cash flow leads to a change of the cash/ bank item on the balance sheet during an Accounting period. E.g., a payment made through the bank account. By the definitions of IAS 7.6 <?page no="289"?> Berkau: Financial Statements 7e 10-289 cash is cash on hand and demand positions. Cash equivalents are shortterm, highly liquid investments readily convertible to cash not under risk of changes. The latter means the valuation does not change due to transfer. A statement of cash flows resembles a liquidity plan (cash budget) 121 . A liquidity plan determines the balancing figure of cash/ bank in the future. In comparison to a cash flow statement, there are only four major formal differences: (1) A liquidity plan starts from the opening value of cash/ bank and ends with the closing balance of the cash/ bank item (liquidity) whereas the statement of cash flows only discloses all changes in cash/ bank and therefore starts with a zero and ends with the total cash flow. (2) A cash flow statement classifies types of cash flows to support estimates of future receipts/ payments. Cash flows resulting from operating activities are likely to repeat if the business model is continued, whereas a cash flow from financing or investing activities is regarded as a singular event. (3) The cash flow statement refers to the past and the liquidity plan is a budgeting instrument. (4) In comparison to a cash flow statement, the calculated liquidity is adjusted for potential bank loans and overdrafts which can be taken. For international Accounting, IAS 1.10 defines that the statement of cash flows is always a part of a complete set of financial statements. Hence, all reporting companies that apply IFRSs must prepare and disclose a statement of cash flows. Below, we discuss the benefits of preparing cash flow statements: Think about a company that is profitable but only generates low amounts of cash with its activities. How can this happen? If a company is incapable of collecting cash from its customers, its revenues from sales are recorded as receivables, such as: DR Accounts Receivables......... DR VAT.......................... CR Revenue...................... Because of the lack in cash collections, the company’s cash/ bank item's value remains low and cannot increase by the company's operations. Assume further, the company always pays for its own bills on time. Then, the company most probably is left with a negative cash flow. This bankrupts the company sooner or later because companies need to maintain solvency for going concern. 121 Read our textbook Management Accounting, chapter (6). For the calculation of the total cash flow, no extra financial statement is necessary as we can read out the difference of the cash/ bank item from the balance sheets for two following Accounting periods. However, for predicting the cash flows we must know and understand the details of cash flow. This leads to a split of the total cash flows into partial cash flows. <?page no="290"?> Berkau: Financial Statements 7e 10-290 The main purpose of the statement of cash flows is to divide the cash flows of the Accounting period into single cash flows as instructed in IAS 7.10. The classifications below must be disclosed: - Cash flows from operations. - Cash flows from investing activities. - Cash flows from financing activities. It is always a good idea to analyse the cash flows separately. We do not want to mix operating cash flows with investing cash flows. A favourable cash flow is a high operating cash flow as it tells us that the business operations generate cash inflows. In contrast, a good investing cash flow should be negative as it indicates that the company is investing in future activities and is creating and/ or increasing its potential to generate cash and profits. Once the investing cash flow becomes positive, it might indicate that the reporting company is under liquidation, at least the company is selling non-current assets to a higher extent than it is investing in new assets. In general, we consider this as a bad sign. In total, a high positive operating cash flow is favourable, but a high positive investing cash flow is not. Offsetting of operating and investing cash flows would cancel out singular cash flows. This is not what we want. Therefore, the major goal of a cash flow statement is cash flow separation. 10.4 C/ S EIMKE Ltd. To get familiarised with cash flow statements and liquidity planning, we discuss the case study EIMKE Ltd. in Melbourne. At first, we prepare a liquidity plan and thereafter we transform the cash budget into a statement of cash flows (after the reporting Accounting period ends). Data Sheet for EIMKE Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: production firm. Period: 20X8. Opening values: see balance sheet as a 31.12.20X7. Activities in 20X8: paying income tax 30,000.00 AUD, buying goods 60,000.00 AUD (gross amount), depreciation 20,000.00 AUD, collecting receivables 2,500.00 AUD, bank loan payment 3,000.00 AUD, revenue 120,000.00 AUD, materials 60,000.00 AUD. VAT 20 %. EIMKE Ltd. is a production firm in Australia. It discloses the statement of financial position at the end of the previous Accounting period as shown in Figure 10.1. On the statement of financial position, a bank loan is disclosed at a value of 20,000.00 AUD. Following IAS 1.60, the pay-off portion thereof is disclosed as a short-term liability. The retained earnings are based on last year’s profit and do not contain profits/ losses carried forward. The income tax liabilities result from the profit earned in 20X7 and are due in 20X8. The receivables disclosed on the debit side of the balance sheet are from payments expected to be received from customers. <?page no="291"?> Berkau: Financial Statements 7e 10-291 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) At first, we prepare a liquidity plan for the next upcoming Accounting period 20X8. EIMKE Ltd. plans the business activities as below: (1) Payment of income tax liabilities to an extent of 30,000.00 AUD. (2) Purchase and payment of materials at cost of purchase of 50,000.00 AUD (gross amount: 60,000.00 AUD). (3) Depreciation to the extent of 20,000.00 AUD. (4) Collection of half of the receivables disclosed on the balance sheet in Figure 10.1. 122 (5) Payment of interest 1,000.00 AUD and pay-off 2,000.00 AUD for its bank loan deducted from its short- 122 EIMKE Ltd. carries the remainder in accounts receivables as no indication for recoverability issues is present. Alternatively, the company must write them off as bad debts. term Liabilities account (IAS 1.60 applies). (6) Earning a revenue of 120,000.00 AUD. From the proceeds (gross value) 90 % are paid by the customers, the remainder proceeds are collected in the next Accounting periods. (7) Material consumption of 60,000.00 AUD in production. From the above business activities, only (1), (2), (4), (5) and (6) are cash relevant. The Accountant prepares a liquidity plan for EIMKE Ltd. as shown in Figure 10.2. In the liquidity plan, the closing balance of cash/ bank is calculated by adding the total cash flows to the opening value. <?page no="292"?> Berkau: Financial Statements 7e 10-292 [AUD] Opening value 50,000 Collection of receivables (4) 2,500 Proceeds (6) 129,600 Income tax payment (1) (30,000) Purchase (2) (60,000) Interest payment (5) (1,000) Pay-off payment (5) (2,000) Liquidity 89,100 Eimke Ltd. LIQUIDITY PLAN for the period 20X8 Figure 10.2: EIMKE Ltd.’s liquidity plan (20X8) How it is Done (Liquidity Plan): (1) Determine the opening value of the item cash/ bank. (2) Calculate all additions to cash/ bank. Consider gross amounts for receipts if output-VAT applies. (3) Deduct all payments. Consider gross amounts if input-VAT applies. (4) Add all items on the liquidity plan to determine the closing balance of cash/ bank which is referred to as the liquidity. We acknowledge that EIMKE Ltd.'s liquidity increases. It was 50,000.00 AUD on 31.12.20X7 and one year later it is 89,100.00 AUD as estimated for 31.12.20X8. Therefore, the total cash flow is: 89,100 - 50,000 = 3 39,100.00 AUD. To transform our liquidity plan to a statement of cash flows 123 , we pretend all activities follow the business plan. After the Accounting period, EIMKE Ltd. prepares a statement of cash flows. Based on the liquidity planning, we delete the opening value and classify all cash flows. Operating activities at 123 This is obviously not the standard procedure but applies here for the sake of teaching. EIMKE Ltd. are the tax payment (1), the purchase (2), the collection of receivables (4) and the proceeds (6). There are financing activities for the pay-off payment of the bank loan (5) and the payment of interest (5). In line with IAS 7.33, interest can be classified as operating or financial cash flow. We follow our conventions in chapter (1) and consider all interest payments as financing activities. No investments apply for EIMKE Ltd. in 20X8. Observe below the statement of cash flows in Figure 10.3. <?page no="293"?> Berkau: Financial Statements 7e 10-293 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 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, tax payments, sales etc. (4) Investing cash flows are caused by acquisitions and sales of non-current assets like buying machinery or their disposal. (5) Financing cash flows are linked to the financing of the business and frequently change debt or equity items on the balance sheet. Examples are taking bank loans, issuing shares and bonds as well as paying/ receiving dividends, interest, coupons and payments to retire debts. Our conventions in chapter (1) apply. (6) Calculate operating, investing and financing cash flow by adding single receipts and deducting single payments. (7) Add all cash flow categories for total cash flow calculation. The 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). <?page no="294"?> Berkau: Financial Statements 7e 10-294 - Derivative method. This method derives cash flows from 2 balance sheets, the income statement, the register of non-current assets and the profit appropriation. It allows a cash flow statement preparation from “outside of the company”. For EIMKE Ltd. we applied the direct method above. IAS 7.18 focusses on the operating cash flow and refers to the direct method based on cash receipts and payments. In contrast, the indirect method reconciles profits with operating cash flows. The investing and financing cash flow must always be determined directly. 10.5 Direct Method The direct method starts from the Cash/ Bank account and classifies all entries therein in 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 that are linked to the latter ones, like interest payments and repayments of liabilities as financing activities. IAS 7.33 applies. The application of the direct method is simple. We analyse the Cash/ Bank account and classify all entries therein into operating, investing and financing receipts/ payments. With a high number of entries in the Cash/ Bank account, the cash flow statement preparation procedures become 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. Actual receipts and payments are the same as scheduled in the liquidity plan. D C D C OV 50,000.00 (1) 30,000.00 OV 5,000.00 (4) 2,500.00 (4) 2,500.00 (2) 60,000.00 (6) 14,400.00 c/ d 16,900.00 (6) 129,600.00 (5) 3,000.00 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) We classify cash flows as follows: (1), (2), (4) and (6) are operative cash flows, (5) is financing cash flow regarding the interest as well as the payoff portion. The statement of cash flows is the same as shown in Figure 10.3. <?page no="295"?> Berkau: Financial Statements 7e 10-295 10.7 Reconciliation of Profits with Operating Cash Flows With the indirect method, we reconcile profits with operating cash flows. The investing and financing cash flows must be calculated directly (from cash/ bank). It is not possible to derive non-operating cash flows from profit or loss. There is no information available, as the income statement only refers to operations. Taking a bank loan e.g., leads to an interest expense on the statement of profit or loss but a bank loan’s principle cannot be derived from profits. The same applies for investments that cause depreciation. Depreciation does not tell us about the cost of acquisition nor about residual values. Hence, for investing and financing activities only the direct method works out. In contrast to investing and financing cash flows, the operating cash flow requires the recording of operations like we do for the preparation of the income statement. A Profit and Loss account records business activities for profit calculation purposes. Thus, the recording refers to profitability figures, like revenue and expenses. A statement of (operating) cash flows requires recording the same activities but is based on receipts and payments. We do not want to record all the operations twice. Therefore, we adjust profits for those activities that (1) are relevant for profitability but do not affect cash flows and (2) vice versa to derive cash flows from profit calculations. Business activities that fall under (1) are relevant for profitability but neutral to cash e.g., depreciation, additions to provisions etc. Business activities that fall under (2) are cash relevant but without impact on the profitability e.g., purchases and payments for materials which are not yet consumed in production (which leads to a stock increase), payments in connection to receivables/ payables, prepaid expenses, VAT receivables/ payables etc. A company that buys materials on credit without using them does not record material expenses through profit or loss. Instead, it records an increase in inventories, VAT receivables and in the payables. Therefore, we must record in the reconciliation process a cash outflow for inventory increase and input-VAT (payments) and for the increase of payables a positive cash flow (receipt). The advantage of the reconciliation method is that the calculation of operating cash flows is not based on numerous, single Bookkeeping entries but on few adjustments for the income statement based on balance sheet items. This limits the workload for the preparation of the cash flow statement significantly. The following how-it-is-done paragraph shows the steps of the approach. Thereafter, we explain its procedure in detail for EIMKE Ltd.'s cash flow statement. <?page no="296"?> Berkau: Financial Statements 7e 10-296 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 irrelevant for payments, like depreciations, expenses for additions to provisions, interest payments etc. (3) Deduct earned interest as it is a financing cash flow. (4) Add decreases of receivables, deduct increases thereof. (5) Add decreases of prepaid expenses, deduct increases thereof. (6) Add decreases of inventory, deduct increases thereof. (7) Add increases of short-term liabilities and provisions, deduct decreases thereof. (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. For a good understanding how the reconciliation method works, we explain its steps in detail below. If you prefer to skip the explanations, proceed to the case study EIMKE Ltd. further below and continue reading where the * is. 10.8 Why Step (1)? The annual profit is the result of a comparison of revenues and expenses and gives us the profitability of the company. However, it needs adjustments as all items on the income statement have been considered regardless of their payments/ receipts. 10.9 Why step (2)? Expenses without payments in the same Accounting period are not cash relevant. As we aim for the cash flow statement preparation, these expenses are irrelevant but have been considered for the profit or loss calculation. Therefore, we must erase them. We exclude these expenses from the calculation of cash flows. E.g., depreciation <?page no="297"?> Berkau: Financial Statements 7e 10-297 is not cash relevant as its Bookkeeping entry is: DR Depreciation ................. CR Accumulated Depreciation..... Another example is an expense recorded together with addition to provisions. Those expenses are relevant for the profit in the actual Accounting period, but the payments will take place in the future. Therefore, we delete those expenses. 124 Interest results in payments but they are classified as financing cash flows. Therefore, we add interest payments to the profit and consider it for financing cash flow calculation in step (12). 10.10 Why Step (3)? A received interest 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) reclassifies cash flows from interest expenses and income. 10.11 Why Step (4)? We analyse step (4) regardless of singular Bookkeeping entries. Any decrease of receivables is considered a payment where a debtor paid its liability. Hence, we consider a reduction in receivables a cash receipt. In the opposite case if receivables increase, we consider a payment to the debtor, which she/ he is obliged to repay in the future. What counts is the fact that money is paid, which results in a negative operating cash flow. In Figure 124 Check step (7), too. 10.7, an increase of receivables is recorded as negative cash flow. 10.12 Why Step (5)? In terms of cash flow calculations, we do not distinguish receivables and prepaid expenses. A receivable is a (paid) claim for repayment and prepaid expenses is a (paid) claim for service delivery e.g., for rent, insurance, work etc. 10.13 Why 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. In general, we consider an increase of inventories as a payment which results in a negative cash flow. An inventory decrease is a cash receipt in exchange for delivered goods. All changes in inventories are valued based on cost of acquisition or cost of manufacturing. If a company applies the nature of expense method 125 for its income statement, changes in inventories of finished goods are disclosed on the income statement already and can be copied therefrom. For that reason, the nature of expense method is favourable if cash flows from operations are calculated by reconciliation method. 125 Check chapter (12) in this textbook or our textbook Basics of Accounting, chapter (28) <?page no="298"?> Berkau: Financial Statements 7e 10-298 10.14 Why Step (7)? Changes in short-term payables and provisions are not linked to financial cash flows. 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, we compensate the deduction in step (6) by adding cash to short-term liabilities (step (7)) for a granted supplier loan. This means the purchase-on-credit-transaction is divided into a paid purchase and a granted cash-loan. This received loan must be recorded by this step (7) as cash inflow. When a company repays short-term debts, this transaction is not recorded on the income statement because repayments do not affect profitability. On the reconciliation statement, we must disclose this cash outflow for the retirement of short-term loans. It appears as a negative cash flow caused by a reduction of short-term liabilities. In contrast, changes of long-term liabilities are classified as financing cash flows. IAS 1.60 requires an increase of shortterm liabilities and a decrease of interest bearing liabilities to separate longterm liabilities from short-term liabilities. If a company pays for an annuity, the interest is considered on the income statement. Following IAS 1.60, we disclose the pay-off portion of the annuity one year before its settlement under short-term liabilities and pay them off at the end of the Accounting period. The pay-off is then a cash flow from financing activities. The previous increase of the short-term liabilities is no cash flow but a liability swop without payment. Therefore, the preparation of a cash flow statement via reconciliation statement requires a thorough analysis of short-term liabilities. The pay-off of 2,000.00 AUD at EIMKE Ltd. is recorded as financing cash flow even as it causes a decrease in short-term liabilities. Check Figure 10.3. It is compensated by the reclassification which leads to constant 2,000.00 AUD disclosed under accounts payables. An easy way to avoid misinterpretations is running extra accounts for short-term bank loans which can be ignored for reconciliations then. A dissolving of provisions results in negative expenses which compensates the ordinary recorded expenses (at the time of recognition) on the income statement. This means, the expense is initially debited to expenses and when the provision is dissolved, we debit the provisions and make a credit entry in the expense account. The credit entry neutralises the previously recorded expense. Therefore, dissolving a provision does not give an expense on the income statement. However, when a provision is dissolved, payments are made and must be considered on the cash flow statement for the period, when the payment takes place. As an example, we observe a company that dissolves a provision for rework: When the provision is recorded, the expenses for rework are recorded on the income statement. We make a Bookkeeping entry (1) as below. It means to pull forward the expense without payment. <?page no="299"?> Berkau: Financial Statements 7e 10-299 DR Rework Expenses.............. CR Provisions................... In the period when the provision is dissolved, the cash relevant Bookkeeping entry (A) for the rework is initially recorded as: DR Rework Expenses.............. CR Cash / Bank................... As the expenses have been considered in the previous Accounting period on the income statement, dissolving the provision cancels out the expenses pulled forward. It can be done by recording a Bookkeeping entry (B), like: DR Provisions................... CR Rework Expenses.............. Obviously, we can combine Bookkeeping entries (A) and (B) and record: DR Provisions................... CR Cash/ Bank.................... Dissolving a provision is not recorded through profit or loss. It should not, because it has been considered one Accounting period before. The payment takes place in the period when the provision is dissolved and is recorded as above. Therefore, it is relevant for the statement of cash flows in the year of dissolving and falls under payment without expense. Note, in many cases, the value of the actual expenses can differ from estimates. Therefore, it is recommended to record dissolving of provisions by the above discussed Bookkeeping entries (A) and (B). You find examples for provisions in chapter (14). For reconciliation, keep in mind: 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 you see on the statements: Recording a provision is shown as an expense on the income statement. In contrast, dissolving a provision is cancelled out on the income statement but is derived from the balance sheet, where we can see it. Dissolving provisions leads to negative cash flows. 10.15 Why Step (8)? Income taxes are short-term liabilities. They are due in the next following Accounting period. In case you start the cash flow reconciliation by the earnings before taxes, <?page no="300"?> Berkau: Financial Statements 7e 10-300 ignore current income tax liability increases. To not get confused, reconcile from the annual surplus in particular if prepayments or partial payments are made. 10.16 Why Step (9)? The step can be combined with step (4) as VAT receivables fall under receivables. We discuss input-VAT paid together with the Bookkeeping entry for the purchase. It does not matter whether the payment for the purchase has been made in full because a partial payment results in a short-term liability disclosure and is covered in step (7). A company records VAT receivables for purchases and acquisition 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. Otherwise, we assume that companies only run one VAT account and do not distinguish what VAT is paid for. If we record investing cash flows based on gross amounts, we must ignore input-VAT on the VAT account for step (9). In general, it is acceptable to consider all input-VAT refunds from the revenue service as operating cash flows. Based on our conventions in chapter (1), which states that we consider VAT payments/ receipts in the next Accounting period, we prefer recording cash flows with their gross amounts. 10.17 Why Step (10)? Output-VAT is collected from customers and buyers on behalf of the revenue service and results in cash inflows. Therefore, output-VAT is a positive cash flow at the time of collection and a negative cash flow when paid to the revenue service. Same as for step (9) applies to major disposals of non-current assets. The following steps (11) to (13) are standard procedure and do not require our further attention. 10.18 C/ S EIMKE Ltd. - Reconciliation Method Below, we study the reconciliation method for our case study EIMKE Ltd. The reconciliation is calculated on the statement of cash flows as shown in Figure 10.7. The calculations refer to the figures on its balance sheet and the income statement disclosed in Figure 10.5 and Figure 10.6. * After the Accounting period 20X8, EIMKE Ltd. discloses the balance sheet and income statement as shown in Figure 10.5 and Figure 10.6. <?page no="301"?> Berkau: Financial Statements 7e 10-301 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) We record the bank loan as interest bearing liabilities and short-term liabilities for a proper current/ non-current distinction following IAS 1.60. We assume the pay-off for the next Accounting period again is 2,000.00 AUD. [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 27,300.00 AUD. At first, we must add interest, as interest is a cash flow, but it is linked to financing <?page no="302"?> Berkau: Financial Statements 7e 10-302 activities. The operating cash flow so far is: 27,300 + 1,000 = 2 28,300.00 AUD. The adjustments for activities that are expenses/ revenue but are irrelevant for cash apply for depreciation only. As depreciation is deducted on the income statement, we must add it on the reconciliation statement. The operating cash flow after adjustment for depreciation is: 28,300 + 20,000 = 4 48,300.00 AUD. The next adjustment is for activities that are cash/ bank-relevant but are not recorded on the income statement. At EIMKE Ltd., inventories decrease: 10,000 - 20,000 = -1 10,000.00 AUD. A decrease of inventories is regarded for the cash flow reconciliation as cash sale, hence, it is a positive cash flow of 10,000.00 AUD. Our operating cash flow calculation so far gives: 48,300 + 10,000 = 5 58,300.00 AUD. The next item is the Accounts Receivables account. Receivables increase by: 16,900 - 5,000 = 1 11,900.00 AUD. An increase of receivables is seen as payment and results in a claim to get the money back. Payments are negative cash flows and are deducted for our cash flow calculation. The operating cash flow so far is: 58,300 - 11,900 = 4 46,400.00 AUD. Next, we check changes in payables. They increase by 14,000.00 AUD which is VAT related. We show an extra item for VAT payables on the reconciliation statement for teaching purposes. Any increase of payables is considered as a receipt. We add the amount to our cash flow calculation: 46,400 + 14,000 = 6 60,400.00 AUD. Income tax liabilities are payables, as well. The changes in income tax liabilities are: 11,700 - 30,000 = - -18,300.00 AUD. The income tax liability decreases. A reduction of liabilities is regarded as a payment and is deducted for the cash flow calculation: 60,400 - 18,300 = 42,100.00 AUD. 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 = 22,000.00 AUD. The reduction of liabilities indicates a payment and is a negative cash flow. Furthermore, we must deduct interest paid. Therefore, the total cash flow for EIMKE Ltd. is: 42,100 - 2,000 - 1,000 = 3 39,100.00 AUD. Observe the cash flow statement based on the indirect method (= reconciliation method) in Figure 10.7. <?page no="303"?> Berkau: Financial Statements 7e 10-303 [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), go online to Link 10.A below. Link 10.A: RYNEVELD Ltd. 126 You will find the task in the study material portal linked to this textbook. We recommend studying the case KATERNBERG (Pty) Ltd. in task A10.23. 126 The task also contains a solution prepared following the derivative method which follows below: 10.19 Derivative Method A higher sophisticated method in cash flow calculation is the derivative method which can be applied even if no Bookkeeping records are available but only German financial statements <?page no="304"?> Berkau: Financial Statements 7e 10-304 are provided. 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. 10.20 Summary Statements of cash flows are part of the financial statements. The cash flow statements show changes in the cash/ bank item on the balance sheet and separate the total cash flow in single cash flow categories resulting from operations, investing and financing activities. For cash flow calculations, the direct method and indirect method apply. The latter one is recommended as it does not require analysing numerous Bookkeeping entries but can be prepared based on figures taken from the income statement and the balance sheet. 10.21 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. 10.22 Question Bank (1) How is an increase of a shortterm liability resulting from supplies considered in the cash flow statement based on the reconciliation of profits with the cash flows from operations? 1. Not at all. 2. As a cash inflow. 3. As a cash outflow to its full extent. 4. As a partial cash outflow based on the portion of payment. (2) Which are financial cash flows? 1. Bank loan repayment, trade discount, interest. 2. Bond issue, interest, bond redemption. 3. Bank loan principle, bank overdraft, VAT. 4. Interest, coupon, insurance fees. (3) Which statement about the reconciliation statement is incorrect? 1. Depreciation is added to earnings after taxes. 2. Interest earned is added to earnings before taxes. 3. Increases of VAT payables are added to earnings after taxes. 4. Prepaid expenses are deducted from earnings before taxes. (4) A company earns a profit after taxes of 381,500.00 AUD. Depreciation is 60,000.00 AUD. Interest income is 45,000.00 AUD. How much is the operating cash flow? <?page no="305"?> Berkau: Financial Statements 7e 10-305 1. 510,950.00 AUD . 2. 560,000.00 AUD . 3. 530,000.00 AUD . 4. 396,500.00 AUD . (5) Which statement is correct? 1. A company only prepares a statement of cash flows if it is a group member, regardless to whether being parent or subsidiary. 2. Along IFRSs every company prepares a statement of cash flows. 3. Along IFRSs only listed public companies must prepare a statement of cash flows. 4. Based on § 264 I HGB companies participating on the public capital market do not have to prepare a cash flow statement. 10.23 Solutions 1-2, 2-2, 3-2, 4-2, 5-2. <?page no="306"?> Berkau: Financial Statements 7e 11-306 11 Equity on the Balance Sheet 11.1 What is in the Chapter? In this chapter (11), we cover the equity section on the balance sheet that comprises of the issued capital, reserves and the item retained earnings. With the case study YARRA Ltd., we show all important aspects of equity item recognition and measurement. The chapter is structured by the major items of the equity section on the balance sheet: (1) Issued capital. (2) Reserves. (3) Retained earnings. The case study YARRA Ltd. covers all material aspects of equity over a 3 year Accounting period. It covers the issue of ordinary and preference shares and the payment of preference and ordinary dividends. We discuss the Bookkeeping entries for treasury shares and for the appropriation of profits. 11.2 Learnings Objectives After studying this chapter, you are familiarised with the equity section and can measure and disclose equity on the statement of financial position. You also understand how special transactions with owners work, like share issues of ordinary and preference shares and share redemptions. You learn about the profit appropriation, as well. You can determine the book value of a company. You know the difference between earnings and profit following IAS 33. 127 Read our textbook Basics of Accounting, chapter (33). 11.3 Equity In contrast to other chapters, the equity refers to regulations based on national Company's Acts more than on international Accounting standards. The equity disclosure depends on the legal form of a company. 127 Next, we discuss the above listed items of the equity section in the given sequence. 11.4 Issued Capital We start off from the discussion of general knowledge about legal company forms and distinguish private companies with a limited liability, like limited liability companies LLC (in the US), limited liability corporations LLC (UK), companies with limited liability GmbH (Germany), proprietary limited companies (Pty) Ltd. (in the Commonwealth and South Africa) from public companies based on shares. Companies go public by an initial public offering IPO and are often listed with their shares at a stock exchange. Legal forms for companies based on shares are corporations Corp., Inc. (in the US), public limited companies PLC, Ltd (UK), Stock companies AG (Germany), and public companies Ltd. (Commonwealth, South Africa). No matter whether a limited company is publicly traded at stock exchanges, the Accounting principles for recording of equity are the same. When a company issues capital, it receives funds, which are added to the Cash/ Bank account and are credited <?page no="307"?> Berkau: Financial Statements 7e 11-307 to the Issued Capital account. In this textbook, we call all portions of issued capital “shares”. Hence, a share issue means that partial ownership of the company is conveyed to investors who add funds to the company in return. Trading of shares does not affect equity. Shares can be ordinary shares or preference shares. Ordinary shares come with the common rights of ownership, like a claim on dividends, and voting rights on the annual general meeting. In contrast, preference shares offer the holder a preference dividend which is a percentage based on the nominal share value but do not allow the preference shareholders to vote. Their fixed dividends are a trade-off for the lack in voting rights. A fixed dividend claim is regarded as favourable as it does not depend on the profit. We say the investors’ risk is low because dividends are more predictable. Nevertheless, companies also can decide to not pay a preference dividend. In this case, no dividends to ordinary shareholders cannot declared either. If preference shares are cumulative, the omitted dividend must be repaid in future Accounting periods. The process of share issuing is based on an Allotment account. 128 To keep Accounting simple, we here only cover a simplified version of the Bookkeeping entries: When a company is established as an incorporated enterprise, owners pay their contribution into the company’s bank account, and we make a credit entry in the equity section for issued capital. Capital reserves apply if a premium is included in the issue 128 Read our textbook Basics of Accounting, chapter (33) for the details of recording share issues. price. A company based on shares calls this a share issue. In case the company is a privately owned limited company, we refer to making contributions. 11.5 C/ S YARRA Ltd. - 20X0 We study the case of YARRA Ltd. a limited public company based in Durban. The case study covers a period of three years. Data Sheet for YARRA Ltd. DDomicile: South Africa (Durban). Reporting currency: ZAR. Classification: n/ a. Ordinary shares: 1,000,000 shares, nominal value 1.00 ZAR/ s. Profit before taxation (20X0): 200,000.00 ZAR. Preference share capital: 500,000.00 ZAR; cumulative preference shares; dividend claim: 5 %/ a; issued on 30.06.20X0. Preference dividend: 12,500.00 ZAR. Shareholder: 90,000 ordinary shares. Share issue 500,000 ordinary shares on 1.07.20X1 at 1.24 ZAR/ s. Share price on 1.07.20X1: 1.60 ZAR/ s. Share price on 1.10.20X1: 1.03 ZAR/ s. Share redemption: 200,000 shares. Share price on 1.11.20X1: 1.00 ZAR/ s. Share redemption: 100,000 shares. Profit (20X1): 0.00 ZAR. Profit (20X2): 192,500.00 ZAR. Appropriation of profits: 200,000.00 ZAR to reserves, ordinary dividend: 0.04 ZAR/ s, preference dividend 25,000.00 ZAR. VAT n/ a. On 2.01.20X0, YARRA Ltd. issues 1,000,000 ordinary shares at 1.00 ZAR/ s <?page no="308"?> Berkau: Financial Statements 7e 11-308 each. The share issue is at nominal values which we refer to as par-value-issue. The Bookkeeping entry is as below: DR Cash/ Bank.................... 1,000,000.00 ZAR CR Issued Capital............... 1,000,000.00 ZAR As YARRA Ltd. is a company based on shares it is common to apply a Share Capital account instead of the Issued Capital account. Therein the nominal value of the shares is recorded, which is here 1,000,000.00 ZAR. If a company issues shares at a price exceeding the nominal share value, the difference is called a share premium. This does not apply for the initial share issue at YARRA Ltd. Later, on 30.06.20X0, YARRA Ltd. issues 500,000 preference shares at 1.00 ZAR/ s. The preference shares come with a fixed dividend claim of 5 %/ a based on their nominal value. Preference shares only pay a dividend proportionate to the time they are outstanding. At YARRA Ltd., the preference shares are issued in the middle of the Accounting period. Hence, only 50 % of the annual preference dividend is paid for the first year. The preference shareholders receive: 50% × 500,000 × 1 × 5% = 1 12,500.00 ZAR. YARRA Ltd.'s preference shares are cumulative. Its preference shares are recorded in the Issued Capital Preference Shares account. It is common to apply different accounts for different kind of shares. Here, YARRA Ltd. keeps an Issued Capital Ordinary Shares account and an Issued Capital Preference Shares account, check Figure 11.6 at the end of this chapter. 129 For the sake of simplification, no depreciation applies in this case study. Hence, profits are to the same extent as cash is received. 11.6 Reserves Building reserves in a company is like what private households do when they save money for rainy days. They put money aside which they previously earned. The reserves on the balance sheet are: - Capital reserves. - Earnings reserves. - Revaluation reserves. The name of the Reserves accounts reveals the origin of the funds therein. Capital reserves result from share issues (premiums), earnings reserves come from the appropriation of profits and revaluation reserves apply when a company re-values its non-current assets following IAS 16.31. After the discussion of activities for YARRA Ltd. in 20X0, we calculate its book value and discuss capital reserves: A capital reserve is an account where we record the difference between the issue price and the nominal value. In some countries a temporary Share Premium account applies, which is not yet a reserve. 11.7 C/ S YARRA Ltd. - 20X0 continued In 20X0, YARRA Ltd. buys non-current assets at 500,000.00 ZAR 129 and earns a <?page no="309"?> Berkau: Financial Statements 7e 11-309 profit after taxation of 140,000.00 ZAR. The company prepares the balance sheet as in Figure 11.1. No dividend has been declared so far. In the notes, YARRA Ltd. explains that its ordinary share capital is: 1,000,000 × 1 = 11,000,000.00 ZAR and the preference share capital is: 500,000 × 1 = 500,000.00 ZAR. The separation is required in IAS 1.79. On its annual general meeting, the shareholders declare a preference dividend of 12,500.00 ZAR. No further dividends are declared. This means, no profit is distributed to the ordinary shareholders. The remainder of the profit is carried forward to the next Accounting period 20X1. The balance sheet is prepared under the consideration of the appropriation of profits which leads to retained earnings of: 140,000 - 12,500 = 1 127,500.00 ZAR. The preference dividends are disclosed as shortterm liabilities; observe below in Figure 11.1. 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 tells us the book value of YARRA Ltd.: 1,700,000 - 60,000 - 12,500 = 1 1,627,500.00 ZAR. This gives a book value per ordinary or preference share of: 1,627,500 / 1,500,000 = 1 1.09 ZAR/ s. A book value is no market price. It is simply the total equity divided by the number of shares (same nominal value assumed for all shares outstanding). 11.8 C/ S YARRA Ltd. - 20X1 A few months later, on 2.05.20X1, YARRA Ltd.’s shareholders decide on their annual general meeting to issue 500,000.00 ordinary shares. The fresh shares are issued on 1.07.20X1 at an issue price of 1.24 ZAR/ s. Their nominal value is 1.00 ZAR/ s. The premium is: 1.24 - 1.00 = 0 0.24 ZAR/ s. To raise capital e.g., for financing business extension, a company can take a loan, issue bonds or fresh shares. If a company issues fresh shares, the issue price should exceed the nominal value per share. This reflects that a company added profits to equity in the past e.g., <?page no="310"?> Berkau: Financial Statements 7e 11-310 by recording additions to earnings reserves. Therefore, the book value exceeds the nominal value, if a company earned profits in prior Accounting period. It could sink below the nominal value, too. E.g., a GmbH that is established with 25,000.00 EUR and makes a loss of 3,000.00 EUR in its first period, is worth: 25,000 - 3,000 = 22,000.00 EUR. If shares are traded publicly e.g., at a stock exchange, the situation is slightly different because the share prices are determined by supply and demand. This results in a (fair) market value. Ordinary and preference shares are traded separately from each other. To keep the case study simple, we pretend the market value for YARRA Ltd.’s ordinary and preference shares is the same. With share trading, we get a nominal value, a book value and a market value which are most likely different. An issue price for fresh shares should exceed their book value. The book value represents the value per share if the company is liquidated at fair values. Existing shareholders suffer from issue prices below the fair market value as the fresh shares decrease the average share valuation. This is very likely to happen as an issue price cannot exceed the fair market price at the time of issuance. The reason is that no one buys fresh shares if the existing ones are cheaper. Therefore, a share issue fails if the market price sinks below the issue price. Next, we deepen the discussion about share prices by studying the case of YARRA Ltd. On 1.07.20X1, YARRA Ltd.’s shares are traded at 1.60 ZAR/ s. Hence, the issue price of 1.24 ZAR/ s is below the fair market value. 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/ s. Therefore, an existing shareholder loses: 1.60 - 1.51 = 0.09 ZAR/ s whereas the buyer of fresh shares wins: 1.51 - 1.24 = 0 0.27 ZAR/ s. Why can a company not issue fresh shares precisely at their fair market values? This would be the best scenario. The reason is simple: a fresh share issue must be announced in advance when the market share price is yet unknown for the day of issuance. Precautionary, the issue share price is chosen and published below the expected market share price to avoid a share issue failure. Consider, that share issues are expensive in terms of transaction costs which we here ignore following our conventions in chapter (1). Even with prudent calculations, the problem of a loss for existing shareholders remains. A common way to avoid losses due to decreasing share prices caused by fresh share issues is making a rights issue. Then, all owners of the existing shares receive a purchase right which is tradable and compensates for the losses expected from share valuation. This motivates existing shareholders to agree on a fresh share issue on the annual general meeting. It also supports a selection of investors. We discuss a rights issue for YARRA Ltd. below: On 1.07.20X1, YARRA Ltd. issues the fresh shares at a 1: 3 ratio, meaning: per three existing shares one fresh share is issued. The fresh share number is 500,000. The difference between estimated fair market value and average <?page no="311"?> Berkau: Financial Statements 7e 11-311 share price after the issue is: 1.60 - 1.51 = 00.09 ZAR/ s. YARRA Ltd. compensates every existing ordinary and preference shareholder by one purchase right per three shares holding. Accordingly, the right's value must be 0.27 ZAR/ right. Note, the issuer does not pay for the rights. The right’s value is derived from a share price calculation and is determined as the price at which the existing shareholders do not win or lose. We study a shareholder of YARRA Ltd. holding 90,000 shares. She/ he receives 30,000 purchase rights at: 3 × 0.09 = 0.27 ZAR/ right. Now, the shareholder got two alternatives: - Selling on the rights will result in a gain of: 30,000 × 0.27 = 8 8,100.00 ZAR. Her/ his total fortune thereafter is: 8,100 + 90,000 × 1.51 = 1 144,000.00 ZAR. - Investing in fresh shares requires buying the fresh shares and paying 1.24 ZAR per fresh share and using the purchase right her-/ himself. The shareholder’s fortune then becomes also: 120,000 × 1.51 - 30,000 × 1.24 = 144,000.00 ZAR. The procedure based on a rights issue is fair as it offers existing shareholders a zero sum game regarding their fortune. To confirm, we check the valuation of the shares before the share issue. The fortune of our shareholder before the fresh share issue was: 90,000 × 1.60 = 144,000.00 ZAR. We next study Bookkeeping entries for a share issue. Issued capital always is disclosed at nominal values. If shares are issued with a premium, the premium is added to capital reserves. At YARRA Ltd., we consider an issue price of 1.24 ZAR/ s exceeding the nominal value of 1.00 ZAR/ s. The nominal portion of the share price is allocated towards issued capital. The premium is: (1.24 - 1.00) × 500,000 = 1 120,000.00 ZAR. See the entire Bookkeeping (C) entry below: DR Cash/ Bank.................... 620,000.00 ZAR CR Issued Capital............... 500,000.00 ZAR CR Capital Reserves............. 120,000.00 ZAR How it is Done (Share Issue): (1) Determine the nominal value of shares. (2) Multiply the number of shares issued with the nominal value per share. Add the nominal value to the issued capital. (3) Check the issue price. If the issue price exceeds the nominal value of the shares, record a share premium in the equity section on the balance sheet. Apply the Capital Reserves account. (4) Debit the Cash/ Bank account. Next, we study the opposite of a share issue: A company can also buy its own shares back and redeem them thereafter. Note, that these will be two steps. <?page no="312"?> Berkau: Financial Statements 7e 11-312 Share buy backs are an instrument to change voting right proportions and/ or to control share prices because the number of shares available for trading decreases. It can be used like a secret dividend. Next, we discuss two events: (1) YARRA Ltd. buys back its own shares and redeems them and (2) YARRA Ltd. buys back more own shares and keeps them as treasury stock. (1) On 1.10.20X1, YARRA Ltd.’s equity is as below: Its share capital is: 1,500,000 + 500,000 = 2 2,000,000.00 ZAR. In the Capital Reserves account, YARRA Ltd. discloses 120,000.00 ZAR from the preference share issue. The Retained Earnings are 127,500.00 ZAR. The share price on 1.10.20X1 is down to 1.03 ZAR/ s (given). In this situation, YARRA Ltd. buys back 200,000 of its own ordinary shares. Based on IAS 32.33 we refer to these own shares as treasury shares. We record them in the Treasury Stock account, check Bookkeeping entry (D). YARRA Ltd.’s intention is to redeem (dissolve) these shares to the extent of: 200,000 × 1.03 = 2 206,000.00 ZAR. IAS 32.33 instructs us to record the share redemption in equity and not through profit or loss. This means, for a share redemption, we debit the issued capital and the capital reserves. Observe Bookkeeping entries (D) and (E). The Bookkeeping entries at YARRA Ltd. for the share buy-back with immediate redemption is displayed below. (D) Share buy-back at market values on 1.10.20X1: DR Treasury Stock............... 206,000.00 ZAR CR Cash/ Bank.................... 206,000.00 ZAR (E) Redemption of the shares on 1.10.20X1: DR Issued Capital............... 200,000.00 ZAR DR Capital Reserves............. 6,000.00 ZAR CR Treasury Stock Account....... 206,000.00 ZAR (2) YARRA Ltd.’s shares’ price further drops and on 1.11.20X1, the fair market value of its shares is down to 1.00 ZAR/ s. In this situation, YARRA Ltd. buys back another 100,000 of its own shares. The Bookkeeping entry below does not consider a loss as the share acquisition is recorded at nominal values. The Bookkeeping entry (F) is shown below. Note, YARRY Ltd. does not redeem these treasury shares and has no intention to do so in the next Accounting period either. However, as we will observe when discussing the next Accounting period’s appropriation of profits, treasury stock is excluded from earning dividends. DR Treasury Stock Account....... 100,000.00 ZAR CR Cash/ Bank.................... 100,000.00 ZAR <?page no="313"?> Berkau: Financial Statements 7e 11-313 In 20X1, YARRA Ltd. does not earn a profit and therefore it does not declare dividends. YARRA Ltd.’s equity situation after the share issue, share buy-back and share redemption is shown in Figure 11.2. In Figure 11.4, a more detailed equity section disclosure is provided. 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 shares bought back based on their fair market value, as paid for. (3) Record a debit entry for the treasury shares and a credit entry in the Cash/ Bank account. Treasury shares are valued at cost. (4) Redeem shares by making a debit entry in the Issued Capital account. Dissolve capital reserves to the extent the treasury share price exceeds their nominal value. Debit the Capital Reserves account. (5) Record a credit entry in the Treasury Stock account. (6) Combine Bookkeeping entries (3) to (5) for recording an immediate redemption. (7) National Company’s Act regulations might apply. Check beforehand. Below, we discuss earnings reserves recorded with the appropriation of profits in the third Accounting period of YARRA Ltd. Additions to earnings reserves result from profit earned during the Accounting period and profits carried forward from prior ones. After profit <?page no="314"?> Berkau: Financial Statements 7e 11-314 calculation, the profit after taxes is added to the Retained Earnings account. The 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 following Accounting period. In the case of an approval for additions to earnings reserves, the amount decided on is transferred from retained earnings to earnings reserves. Special national rules apply for the appropriation of profits and additions to reserves as well as for deductions/ dissolving of reserves. 11.9 C/ S YARRA Ltd. - 20X2 We continue the case study YARRA Ltd. and discuss its fiscal year 20X2. In 20X2, YARRA Ltd. earns a profit after taxes of 192,500.00 ZAR on cash. The profit is added to the Retained Earnings account and the income tax liabilities. The income tax liabilities are: 30% × 192,500 / (1 - 30%) = 8 82,500.00 ZAR after income taxes are recorded. For the item cash/ bank we disclose at this stage of calculation: 1,441,500 + 192,500 / (1 - 30%) = 11,716,500.00 ZAR. Retained earnings are now: 127,500 + 192.500 = 320,000.00 ZAR which includes the profit carried forward from 20X0. We refer to the balance in the Retained Earnings account as the distributable amount, as it is transferable to the owners by dividend payments. A single investor’s portion of the profit is proportionate to her/ his holdings. Thus, a shareholder who owns 4 % of the company, has a claim on the total dividends to the extent of 4 %. If the company decides to add the profit or portions thereof to the reserves, a debit entry is recorded in the Retained Earnings account and the portion of profit is credited to earnings reserves. Once added to earnings reserves, these funds can only be released if the company decides to do so on its annual general meeting. Special national rules might apply. YARRA Ltd. holds an annual general meeting on 4.04.20X3 and decides to add 200,000.00 ZAR to earnings reserves and to pay a dividend of 0.04 ZAR/ s to its ordinary shareholders. The total value of ordinary dividends is: 0.04 × 1,200,000 = 4 48,000.00 ZAR. Treasury shares do not participate in the appropriation of profits. The total preference dividend includes the one pending from the previous year 20X1 and is: 2 × 500,000 × 5% = 5 50,000.00 ZAR. Remember, YARRA Ltd.’s preference shares are cumulative. The remainder of the distributable profit is carried forward to the Accounting period 20X3. Dividends to the extent of: 48,000 + 50,000 = 98,000.00 ZAR are added to short-term liabilities. The earnings reserves are combined with capital reserves for the disclosure on the balance sheet. However, in the notes, YARRA Ltd. discloses the singular items and explains them by the statement of changes in equity, as well. Find below the Bookkeeping entries made for the appropriation of profits on 31.12.20X2. The recordings anticipate the decision on the annual general meeting as the distribution was only suggested by YARRA Ltd.’s board of directors at the time when preparing the <?page no="315"?> Berkau: Financial Statements 7e 11-315 financial statements. It needs to be approved which also requires an Auditing of the financial statements. DR P&L-Account.................. 192,500.00 ZAR CR Retained Earnings............ 192,500.00 ZAR DR P&L-Account.................. 82,500.00 ZAR CR Retained Earnings............ 82.500.00 ZAR DR Retained Earnings............ 98,000.00 ZAR CR Shareholders Dividend A/ P .... 98,000.00 ZAR DR Retained Earnings............ 200,000.00 ZAR CR Earnings Reserves............ 200,000.00 ZAR After making the Bookkeeping entries above, YARRA Ltd. prepares its balance sheet after appropriation of profits as 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 114,000.00 ZAR in capital reserves and 200,000.00 ZAR in earnings reserves. At YARRA Ltd., no revaluations of assets apply. We covered revaluation reserves in chapter (7) already. 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. Portions for preference dividends or, in Germany, for legal reserves, do not contribute to earnings. IAS 33 defines earnings. Following IAS 33.12, earnings are profit or loss from continuing operations and profit or loss to parent adjusted for after-tax amounts for preference dividends or <?page no="316"?> Berkau: Financial Statements 7e 11-316 settlements or other effects of preference dividends. IAS 33 refers to the earnings of the actual Accounting period whereas the retained earnings can contain portions from prior Accounting periods, too. Profit/ loss carried forward does not count for the calculation of earnings. In case a company declares a dividend, its equity is reduced because we make a debit entry in the Retained Earnings account and credit the Shareholders for Dividend account which is linked to the item short-term liabilities on the balance sheet. Dividend payments are irreversible. Additions/ deductions to earnings reserves fall under financing activities. Reductions of reserves and their dissolving are limited by national law, like by the Company’s Act AktG in Germany, and require in general a decision from the annual general meeting. A carrying forward of profits in the Retained Earnings account postpones the decision about the profit appropriation. The funds then stay in equity and will be added to the distributable amount for the next following year. Carrying forward a loss is an alternative to dissolving reserves. There are tax and reserves implications a company should consider based on national tax law and/ or Company’s Act. This applied for the case BATHURST Ltd. (chapter (6)) in its first Accounting period. 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. 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) <?page no="317"?> Berkau: Financial Statements 7e 11-317 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) Below, we provide the accounts for YARRA Ltd. Therein, the Bookkeeping entries in 20X0 are identified by numbers, in 20X1 by caps and in 20X2 by small letters. D C D C (1) 1,000,000.00 (5) 500,000.00 c/ d 1,000,000.00 (1) 1,000,000.00 (2) 500,000.00 1,000,000.00 1,000,000.00 (3) 200,000.00 c/ d 1,200,000.00 (E) 200,000.00 b/ d 1,000,000.00 1,700,000.00 1,700,000.00 c/ d 1,300,000.00 (C) 500,000.00 b/ d 1,200,000.00 (A) 60,000.00 1,500,000.00 1,500,000.00 (C) 620,000.00 (B) 12,500.00 b/ d 1,300,000.00 (D) 206,000.00 (F) 100,000.00 c/ d 1,441,500.00 1,820,000.00 1,820,000.00 b/ d 1,441,500.00 (a) 275,000.00 c/ d 1,716,500.00 1,716,500.00 1,716,500.00 b/ d 1,716,500.00 Cash/ Bank C/ B Issued capital ordinary shares ISO D C D C c/ d 500,000.00 (2) 500,000.00 c/ d 60,000.00 (3) 60,000.00 500,000.00 500,000.00 (A) 60,000.00 b/ d 60,000.00 b/ d 500,000.00 c/ d 82,500.00 (a) 82,500.00 b/ d 82,500.00 Issued capital preference shares ISP Income tax liabilities ITL Figure 11.6: YARRA Ltd.'s accounts <?page no="318"?> Berkau: Financial Statements 7e 11-318 D C D C c/ d 12,500.00 (4) 12,500.00 (4) 12,500.00 (3) 140,000.00 (B) 12,500.00 b/ d 12,500.00 c/ d 127,500.00 (b) 48,000.00 140,000.00 140,000.00 c/ d 98,000.00 (c) 50,000.00 (b) 48,000.00 b/ d 127,500.00 98,000.00 98,000.00 (c) 50,000.00 (a) 192,500.00 b/ d 98,000.00 (d) 200,000.00 c/ d 22,000.00 298,000.00 320,000.00 b/ d 22,000.00 Shareholders for Dividend A/ P Retained earnings R/ E D C D C (5) 500,000.00 c/ d 500,000.00 c/ d 60,000.00 (3) 60,000.00 b/ d 500,000.00 (B) 60,000.00 b/ d 60,000.00 c/ d 82,500.00 (a) 82,500.00 b/ d 82,500.00 Property, plant, equipment P, P, E Income tax liabilities ITL D C D C (D) 206,000.00 (E) 206,000.00 (E) 6,000.00 (C) 120,000.00 (F) 100,000.00 c/ d 100,000.00 c/ d 114,000.00 306,000.00 306,000.00 120,000.00 120,000.00 b/ d 100,000.00 b/ d 114,000.00 D C c/ d 200,000.00 (d) 200,000.00 b/ d 200,000.00 Treasury stock account TSA Capital Reserves RES Earnings reserves RES Figure 11.6: YARRA Ltd.'s accounts continued 11.11 Summary Equity is the book value of the business. You calculate the total of equity on a balance sheet prepared under IFRSs by deducting all debts from the total of assets. The total of equity changes based on transactions with owners, like for share issues, share redemptions or declarations of dividends. It also increases or decreases by earnings and the appropriation thereof. Revaluations are recorded through equity, too. National law, in particular 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 its nominal value on the equity section under issued capital or share capital. We translate portions of ownership on a (Pty) <?page no="319"?> Berkau: Financial Statements 7e 11-319 Ltd. or a German GmbH by shares, too. Preference Shares: Shares without voting right but with a privileged rank regarding dividends and liquidation. 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 amount of outstanding ordinary shares. IAS 33 applies. Redemption of Shares: Shares bought back by the company to keep them as treasury shares or for invalidation. Share Premium: Positive difference between issue price and nominal value per share. The share premium is added to capital reserves. In Germany, § 272 HGB applies. Statement of Changes in Equity: Statement as element of financial statements that discloses the additions to and reductions from equity. See chapter (13). Treasury Shares: Shares bought back buy the issuing company. Treasury shares are carried in a negative Equity account or get deducted from Equity accounts. This is referred to as contraequity account. Treasury shares cannot participate in dividend or liquidation claims. 11.13 Question Bank (1) A company issues 10,000 fresh ordinary shares at 6.70 EUR/ s. The nominal value per share is 5.00 EUR/ s. What does the Bookkeeping entry look like? 1. DR Cash/ Bank … 50,000.00 EUR - CR Issued Capital … 50,000.00 EUR. 2. DR Cash/ Bank … 67,000.00 EUR - CR Issued Capital … 50,000.00 EUR, CR Earnings Reserves … 17,000.00 EUR. 3. DR Cash/ Bank … 67,000.00 EUR - CR Issued Capital … 50,000.00 EUR, CR Capital Reserves … 17,000.00 EUR. 4. DR Issued Capital … 67,000.00 EUR - CR Cash/ Bank … 50,000.00 EUR, CR Capital Reserves … 17,000.00 EUR. (2) On 1.10.20X3, a company issues 50,000 preference shares at an issue price of 1.30 EUR/ s. The premium is 0.30 EUR/ s. The preference dividend is 4.5 %/ a based on the nominal value. The company is based on 100,000 ordinary shares at 1.00 EUR/ s face value. The profit before taxes is 25,000.00 EUR. It is decided to declare a dividend of the entire profit. How much is the ordinary dividend rounded down to the nearest EUR-cent? 1. 0.22 EUR/ s . 2. 0.15 EUR/ s . 3. 0.14 EUR/ s . 4. 0.16 EUR/ s . (3) A company got 200,000 ordinary shareholders. The fair market value per share is 3.45 EUR/ s. The company decides to issue 50,000 ordinary shares at 3.00 EUR/ s based on a rights issue. How much is the value for one purchase right (for one fresh share issued)? 1. 0.09 EUR/ r . <?page no="320"?> Berkau: Financial Statements 7e 11-320 2. 0.36 EUR/ r . 3. 0.45 EUR/ r . 4. 0.23 EUR/ r . (4) A company earns a pre-tax profit of 100,000.00 EUR. The preference dividend is 6,000.00 EUR and got declared for the Accounting period. In the retained earnings a profit is carried forward to the extent of 50,000.00 EUR. How much are earnings based on IAS 33? 1. 64,000.00 EUR . 2. 94,000.00 EUR . 3. 114,000.00 EUR . 4. 144,000.00 EUR . (5) A company carries forward a loss of 26,000.00 EUR. In the actual Accounting period, it earns a profit after taxes of 75,000.00 EUR. At the end of June, the company issued 50,000 preference shares at 5.50 EUR/ s which is 0.50 EUR/ s above face value per share. 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. 43,500.00 EUR . 2. 39,000.00 EUR . 3. 44,000.00 EUR . 4. 49,000.00 EUR . 11.14 Solutions 1-3, 2-4, 3-2, 4-1, 5-3. <?page no="321"?> Berkau: Financial Statements 7e 12-321 12 Statement of Profit or Loss and Other Comprehensive Income 12.1 What is in the Chapter? Profit is the difference between revenue and expenses. In line with IAS 1.99, a company can either prepare the 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 other comprehensive income is included in the statement of profit or loss and other comprehensive income. For this textbook, we follow the combined statement. 130 The statement of profit or loss and other comprehensive income is part of a full set of financial statements along IAS 1.10. It contains income, like revenues and gains, and all expenses for the Accounting period no matter when payments are made or received. In this chapter, we teach how to prepare the statement of profit and loss and other comprehensive income for service providers and for production firms. We cover both formats for both applications (= 4 cases). We discuss the most important regulations regarding IFRSs. The chapter contains the case study ABINGTON Ltd. which is a law firm in Australia. Its profit calculation is simple, as the company is a service provider. We demonstrate its profit calculation following the nature of expense method and thereafter along the cost of sales format. The case of SUDHUIZEN PLC is a British production firm for coffee machines. It requires us to consider material flows. 130 We use the name income statement, which is the previous technical term and shorter. We also prepare a statement of profit or loss and other comprehensive income following the nature of expense method and the cost of sales format. For the first variant, the company applies a periodic inventory system whereas with the cost of sales format, SUDHUIZEN PLC applies a job order costing based on a perpetual system for inventory movements. 12.2 Learning Objectives After studying this chapter, you can prepare and read a statement of profit or loss and other comprehensive income. You can apply the cost of sales format and the nature of expense method and understand their differences. You further know what information a reporting company must present in the notes depending on which format it applies for the statement. You also understand the difference between profit and gains and between ordinary expenses and other expenses. 12.3 Statement of Profit or Loss and Other Comprehensive Income An income statement compares income with expenses, see IAS 1.88. The technical terms are defined by the conceptual framework for financial reporting. F 4.29 explains why the IASB does not distinguish properly between revenue and gains. Both are referred to as income. For teaching purposes, we apply the Accounting terms as follows: <?page no="322"?> Berkau: Financial Statements 7e 12-322 Revenue results from ordinary business, like selling/ producing goods or service rendering; a gain is classified as extraordinary, like a gain on disposal of non-current assets or interest gains earned by companies other than banks. In contrast, for a bank, interest income is 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, like salary, wages, materials etc. Extraordinary expenses are e.g., a water damage, except for an insurance company that covers those events. Profit or loss as disclosed by an income statement is the difference between all income and all expenses during an Accounting period. IAS 1.81 defines disclosure requirements for the income statement. As the user of financial statements analyses the statement of profit or loss and other comprehensive income to understand the business, not only pure profit or loss figures matter, but a more detailed view on singular items of income and expenses does. The detailed income and expenses explain how the company earns its money. The statement of profit or loss and other comprehensive income can follow a structure based on the nature or on the function of items. 131 - If the income statement follows the nature of the expenses, the expenses are classified based on cost categories, like labour, depreciation, materials etc. No cost allocations to other calculation objects are made. Examples for the income 131 Read our textbook Basics of Accounting, chapter (28). statement following the nature of expense method are given in IAS 1.102. - If the income statement is structured along the function of expenses for the company, it is prepared under consideration of costs for various cost objects and allocations of expenses thereto. Cost objects can be goods or services. IAS 1.103 covers the cost of sales format. The statement of profit or loss and other comprehensive income discloses income tax expenses, too. We here follow the simplified tax model, along which we multiply the total income tax rate with the pre-tax profit. In the previous chapters, we applied the nature of expense method because its number of Bookkeeping entries is lower and the recordings are simpler, because no allocations are made. About the decision which format a company should apply, IAS 1.99 only states the 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. In general, reporting companies do not provide more detailed information than they must. This technically means, that when preparing the income statement based on the Profit and Loss account, Accountants combine entries for their disclosure on the income statement, like rent and administration are shown together as other expenses. This meets the requirements in IAS 1.81. <?page no="323"?> Berkau: Financial Statements 7e 12-323 For this textbook, we follow a standard structure for the income statement, as shown in Figure 12.3 for the NoEformat and in Figure 12.9 for the COSformat. Income statements follow the accrual principle of Accounting. To calculate the profit or loss for the period, it is necessary to allocate income and expenses to the Accounting period they are for. This requires calculating profit regardless from when payments are made or received. A train ticket bought and paid today but travelled in the next Accounting period counts as a next Accounting period’s expense. We refer to the underlying principle as the accrual basis of Accounting. When we make Bookkeeping entries, the payment date is relevant for recording. By recording the adjustments, we ensure that all income and expenses are linked to the correct Accounting period before the income statement can be set up. 132 In the case of the train ticket, the purchase is recorded when the payment is made. To transfer the travel expenses to the next Accounting period, prepaid expenses are recorded which cancel-out the expense. Those are dissolved in the next following Accounting period which results in the correct allocation of the travel expenses to the Accounting period they belong to. An extended income statement as for companies based on shares in Germany following § 158 AktG does not apply for international Accounting. An appropriation of profits is disclosed in 132 Read our textbook Basics of Accounting, chapter (18). the statement of changes in equity, instead. Below, we compare the two different methods for the income statement: (a) Nature of expense method (NoE). (b) Cost of sales format (COS). We explain income statements by two case studies: (A) ABINGTON Ltd., an Australian law firm. (B) SUDHUIZEN PLC, a British coffee machine producer in the UK. 12.4 C/ S ABINGTON Ltd. - Nature of Expense Method We start our considerations with the case of the law firm ABINGTON Ltd. in Adelaide. Data Sheet for ABINGTON Ltd. DDomicile: Australia (Adelaide). Reporting currency: AUD. Classification: service provider. Employees: 6 attorneys, 20 paralegals. Salary: attorney 85,000.00 AUD/ a; paralegal: 38,000.00 AUD/ a. Direct costs for conveyancing: 680.00 AUD/ mandate attorney labour (only relevant for the COS format). Operational costs: 160,500.00 AUD/ a VATable. Rent: 5,000.00 AUD/ m due one month in advance; non-VATable. Manufacturing overheads: paralegal labour and operational expenses. Non-manufacturing overheads: Administration and rent. Accounting period: 20X4. Revenue: 700 conveyances at 3,600.00 AUD/ mandate VATable. <?page no="324"?> Berkau: Financial Statements 7e 12-324 OOther income: Interest income from bonds: 20,000.00 AUD/ a. Predetermined overhead allocation rate: 1,300.00 AUD/ mandate VAT 20 % ABINGTON Ltd. is a law firm and specialised in conveyancing property. ABINGTON Ltd. is residing in a rented office in Adelaide and employs 6 attorneys and 20 paralegals. In 20X4, ABINGTON Ltd. transferred 700 properties and earned a revenue of 3,600.00 AUD per mandate. Every attorney at ABINGTON Ltd. earns 85,000.00 AUD/ a. Paralegals earn 38,000.00 AUD/ a. Further operational costs linked to conveyancing are 160,500.00 AUD/ a, like lease rates for computer systems, office material, internet access etc. Operational expenses are VATable. The rent for the offices is 5,000.00 AUD/ m and must be paid one month in advance. At the beginning of the Accounting period 20X4, the Prepaid Expense account shows an opening value of 5,000.00 AUD. No VAT applies for rent. ABINGTON Ltd. earns an interest income from bonds to the extent of 20,000.00 AUD/ a. The coupons are regarded as extraordinary income, as ABINGTON Ltd.’s core business is law. Therefore, the interest earned from bonds is a gain and is disclosed as other income on the statement of profit or loss and other comprehensive income. Interest income is not VATable. Before we calculate ABINGTON Ltd.’s profit or loss, we make Bookkeeping entries in the accounts for below listed activities: (1) Allocating prepaid rent. (2) Rental payment (no VAT considered). (3) Labour for attorneys. (4) Labour for paralegals. (5) Operational expenses (VATable). (6) Revenue recognition (VATable). (7) Recording interest income from bonds. Find in Figure 12.1 the accounts with the activities recorded therein. The identifiers above linked to the business activities correspond with the Bookkeeping entry reference numbers. D C D C . . . (2) 60,000.00 OV 5,000.00 (1) 5,000.00 (6) 3,024,000.00 (3) 510,000.00 RNT 5,000.00 (7) 20,000.00 (4) 760,000.00 (5) 192,600.00 c/ d 1,521,400.00 3,044,000.00 3,044,000.00 b/ d 1,521,400.00 Cash/ Bank C/ B Prepaid expenses PRE Figure 12.1: ABINGTON Ltd.’s accounts (20X4) <?page no="325"?> Berkau: Financial Statements 7e 12-325 D C D C (1) 5,000.00 (3) 510,000.00 c/ d 510,000.00 (2) 60,000.00 c/ d 65,000.00 b/ d 510,000.00 65,000.00 65,000.00 b/ d 65,000.00 PRE 5,000.00 c/ d 60,000.00 65,000.00 65,000.00 b/ d 60,000.00 Rent-20X4 RNT Labour Attorneys-20X4 LAA D C D C (4) 760,000.00 c/ d 760,000.00 (5) 160,500.00 c/ d 160,500.00 b/ d 760,000.00 b/ d 160,500.00 Labour Paralegals-20X4 LAP Operational expenses-20X4 OEX D C D C c/ d 2,520,000.00 (6) 2,520,000.00 (5) 32,100.00 (6) 504,000.00 b/ d 2,520,000.00 c/ d 471,900.00 504,000.00 504,000.00 b/ d 471,900.00 Revenue-20X4 REV Value added taxes VAT D C c/ d 20,000.00 (7) 20,000.00 b/ d 20,000.00 Interest income-20X4 I/ I Figure 12.1: ABINGTON Ltd.’s accounts (NoE) continued Before profit is calculated, an adjustment for prepaid rent is required. ABINGTON Ltd. must obey the accrual principle of Accounting for its income statement preparation. See the Bookkeeping entry below for recording prepaid rent. To distinguish this Bookkeeping entry from the first one, we indicate adjustments by the contra accounts’ 3-letter-codes: PRE for prepaid expenses and RNT for rent. You find the entries for the adjustments in Figure 12.1 already. DR Prepaid Expenses............. 5,000.00 AUD CR Rent......................... 5,000.00 AUD The Profit and Loss account reveals ABINGTON Ltd.’s entire profit of 734,650.00 AUD after taxation. <?page no="326"?> Berkau: Financial Statements 7e 12-326 D C D C RNT 60,000.00 REV 2,520,000.00 c/ d 314,850.00 P&L 314,850.00 LAA 510,000.00 I/ I 20,000.00 b/ d 314,850.00 LAP 760,000.00 OEX 160,500.00 EBT 1,049,500.00 2,540,000.00 2,540,000.00 D C ITL 314,850.00 b/ d 1,049,500.00 c/ d 734,650.00 P&L 734,650.00 R/ E 734,650.00 b/ d 734,650.00 1,049,500.00 1,049,500.00 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 an income statement and combines certain entries in the Profit and Loss account to income statement items, like different labour categories that are summarised for the item labour and rent and operational expenses which are added for the item other expenses. The interest income earned by the bonds falls under other income. See the income statement prepared based on the nature of expense format below in Figure 12.3. [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 introducing the second income statement following the nature of expense method for a production firm. <?page no="327"?> Berkau: Financial Statements 7e 12-327 12.5 C/ S SUDHUIZEN PLC - Nature of Expense Method Our case study for Manufacturing Accounting is SUDHUIZEN PLC in York. Data Sheet for SUDHUIZEN PLC DDomicile: Great Britain (York). Reporting currency: GBP. Classification: Manufacturing. Product: coffee machines. Bill of Materials BOM: 1 water pump, 1 coffee capsule dispense unit CCDU. 1 box for shipping. Materials: see Figure 12.5; opening value for inventories: 45,000.00 GBP which contains materials and finished goods. Production amount (20X4): 30,000 units. Sales amount (20X4): 28,500 units; net selling price: 60.00 GBP/ p. Depreciation: 28,000.00 GBP/ a in Assembling; 1,000.00 GBP/ a in Cleaning; 2,000.00 GBP/ a in Shipping. Labour: 40,000 GBP/ a in Assembling; 30,000.00 GBP in Cleaning; 25,000.00 GBP/ a in Shipping; 55,000.00 GBP in Management/ Administration. VAT 20 % Regarding income statement preparation, a production firm requires additional Bookkeeping work, as a production firm adds self-manufactured goods to stock, which results in an increase of assets on the balance sheet and a reduction of expenses for the Accounting period in which finished goods are produced in. When finished goods’ inventories decreases by selling finished goods from stock, inverted Bookkeeping entries apply: The inventory item is decreased, and the cost of manufacturing are recorded as expenses. We discuss below the income statement for the coffee machine manufacturer SUDHUIZEN PLC. SUDHUIZEN PLC adds finished goods to stock at the end of the Accounting period 20X4. In terms of most expenses, the income statement for a production firm is not much different to non-manufacturing companies. However, once the value of finished goods inventories increases (because the company produces higher amounts than it sells), the additional stock is added to finished goods inventories and negative expenses must be recorded through profit or loss. This means, we make a debit entry in the Finished Goods Inventory account and an entry in the Profit and Loss account on the credit side. As all expenses of the period are considered for an income statement following the nature of expense method, we must cancel out the cost of manufacturing for those goods that we added to stock. Therefore, producing goods but not selling them does not affect profit or loss. The cost of manufacturing are withheld from profit calculation and are added to inventories on the balance sheet. For the recording of inventory movements, a periodic system is sufficient. We already recorded changes of inventories by making a “closing stock”-entry on the credit side of RYNEVELD (Pty) Ltd.’s Trading account in chapter (4). Caution! The consideration of changes in closing stock requires making an entry for the opening value and the closing stock in the Trading account at the same time. This way the changes (and not the closing stock) in inventory are recorded through profit or loss. In the case of RYNEVELD <?page no="328"?> Berkau: Financial Statements 7e 12-328 (Pty) Ltd. the opening value is zero; therefore, we only made the entry on the credit side of the Trading account. The valuation of inventory changes for finished goods is based on the costs of manufacturing which include the purchase cost of materials plus all costs of conversion. Conversion costs are direct labour and all manufacturing overheads. The latter ones must be related to production, like depreciation on factory building, machinery, and can include allocated portions of production management, maintenance costs etc. In contrast, common Administration and Marketing expenses, are nonmanufacturing costs, which we must exclude from the calculation of finished goods. For the recording of finished goods added to stock and the deferral of their manufacturing costs, look at case study ANKYO Ltd. You reach the case study via the Link 12.A. Link 12.A: ANKYO Ltd. Below, we apply the nature of expense method for SUDHUIZEN PLC. SUDHUIZEN PLC is a manufacturer for espresso machines in York. At the beginning of the Accounting period 20X4, SUDHUIZEN PLC has an opening value of expresso machines of 3,000.00 GBP. The number of machines is 100; accordingly, the unit cost of manufacturing per espresso machine on stock is: 3,000 / 100 = 330.00 GBP/ p. The unit costs result from the calculation of last Accounting period’s production. As the company’s production exceeded sales, SUDHUIZEN PLC put 100 not sold espresso machines on stock. They are of the same kind of espresso machines as produced in the Accounting period 20X4. SUDHUIZEN PLC applies the weighted average cost formula for all its inventory movements. An espresso machine includes a water pump and a coffee-capsule-dispenseunit CCDU. For shipping, the espresso machines are packed into a box. Shipping here refers to packing as the espresso machines are stored in a box; the transportation to customers is processed by a courier. At the beginning of the Accounting period 20X4, SUDHUIZEN PLC has 3,000 CCDUs at 14.00 GBP/ p on stock. Look at SUDHUIZEN PLC.’s balance sheet in Figure 12.4. <?page no="329"?> Berkau: Financial Statements 7e 12-329 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 process of the espresso machines follows a Job Order Costing. 133 To demonstrate the recording and calculations following a Process Costing system 134 , 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 process followed by packing in the Shipping department. All espresso machines are packed, even those which are not yet sold. Hence, finished goods refers to espresso machines in a box. SUDHUIZEN PLC runs three departments: Assembling, Cleaning and Shipping. During the Accounting period 20X4, SUDHUIZEN Ltd. purchases the materials below: Item Date of purchase Amount Unit costs Cost of purchase [GBP] [GBP] CCDU 2.01.20X4 30,000 14.00 420,000.00 Water pump 3.01.20X4 20,000 9.50 190,000.00 boxes 6.01.20X4 30,000 1.00 30,000.00 Water pump 14.01.20X4 20,000 10.50 210,000.00 cleaning soap for 100 machines 15.01.20X4 300 10.00 3,000.00 SUDHUIZEN PLC PURCHASE JOURNAL for the period ended 31.12.20X4 Figure 12.5: SUDHUIZEN PLC’s purchase ledger The purchase of cleaning soap is on credit. 133 Read our textbook Management Accounting, chapter (18). 134 Process Costing is covered in our textbook Management Accounting in chapter (19). <?page no="330"?> Berkau: Financial Statements 7e 12-330 During the Accounting period 20X4, SUDHUIZEN PLC produces 30,000 espresso machines. In 20X4, SUDHUIZEN PLC records 28,000.00 GBP/ a depreciation on the Assembling department, 1,000.00 GBP/ a depreciation on the Cleaning department and 2,000.00 GBP/ a depreciation on the Shipping department. Labour is 40,000.00 GBP/ a in the Assembling department, 30,000.00 GBP/ a in the Cleaning department and 25,000.00 GBP/ a in the Shipping department. SUDHUIZEN PLC records a further 55,000.00 GBP/ a labour in the Management/ Administration department which is not related to manufacturing. In 20X4, SUDHUIZEN PLC sells 28,500 espresso machines at 60.00 GBP/ p net selling price. As the number of espresso machines produces exceeds sales: 100 + 30,000 - 28,500 = 1 1,600 espresso machines are added to stock of finished goods. We make the Bookkeeping entries as below and follow at first a periodic inventory system based on the weighted average cost formula. This keeps our Accounting workload at bay, as we only measure how much materials are left on stock at the end of the Accounting period. There are only CCDUs (I.CC), water pumps (I.WP) and espresso machines (FGI) left. The three-digit codes represent the contra inventory accounts indicated on the Profit and Loss account. For the application of a periodic system, we do not need further inventory accounts than for finished goods (FGI), coffeecapsule-dispense-units (I.CC) and water pumps (I.WP). We only record the closing stock at the end of the Accounting period. This is when no boxes nor soap is left. The recorded business activities are: (1) Purchase of CCDUs. (2) Purchase of water pumps. (3) Purchase of boxes. (4) Purchase of water pumps. (5) Purchase of soap. (6) Depreciation Assembling. (7) Depreciation Cleaning. (8) Depreciation Shipping. (9) Accounting for labour in Assembling. (10) Accounting for labour in Cleaning. (11) Accounting for labour in Shipping. (12) Accounting for labour in Management/ Administration. (13) Revenue recognition. At the end of 20X4, there are: 3,000 × 14 = 442,000.00 GBP CCDUs on stock. There are further water pumps to the value of: 10,000 × (20,000 × 9.50 + 20,000 × 10.50) / 40,000 = 1 100,000.00 GBP on stock. SUDHUIZEN PLC carries a stock of 1,600 espresso machines which have not yet been sold. The value per espresso machine requires a calculation. This means, the left espresso machines are calculated based on annual average purchase costs. Furthermore, the opening amount of 100 espresso machines must be considered. To keep the case simple, we assume all espresso machines are sold on the same day and that the production of the espresso machines is completed all together before sales take place. As the nature of expense method does not support cost allocations, we must calculate the unit cost of manufacturing per finished goods in a working: The unit cost of manufacturing contain the materials plus depreciation and manufacturing overheads for labour which lead to unit costs of: 14 + (20,000 × 9.50 + <?page no="331"?> Berkau: Financial Statements 7e 12-331 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 expresso machines on stock at the beginning of the Accounting period are valued at 30.00 GBP/ p. Hence, the closing stock of 1,600 espresso machines is: 1,600 × (100 × 30 + 29.30 × 30,000) / 30,100 = 46,883.72 GBP. Find below SUDHUIZEN PLC’s accounts and the income statement in Figure 12.6 and Figure 12.7. The changes in inventories of finished goods are additions to stock less stock releases: 46,883.72 - 3,000 = 4 43,883.72 GBP. D C D C OV 100,000.00 c/ d 100,000.00 (1) 420,000.00 P&L 853,000.00 b/ d 100,000.00 (2) 190,000.00 (3) 30,000.00 (4) 210,000.00 (5) 3,000.00 853,000.00 853,000.00 Property, Plant, Equipment PPE Purchase-20X4 PRC D C D C c/ d 3,600.00 (5) 3,600.00 OV 42,000.00 P&L 42,000.00 b/ d 3,600.00 I.CC 42,000.00 c/ d 42,000.00 84,000.00 84,000.00 b/ d 42,000.00 Accounts payables A/ P Inventory CCDU I.CC D C D C P&L 100,000.00 c/ d 100,000.00 OV 3,000.00 P&L 3,000.00 b/ d 100,000.00 P&L 46,883.72 c/ d 46,883.72 49,883.72 49,883.72 b/ d 46,883.72 Inventory water pump I.WP Finished goods inventory FGI D C D C (1) 84,000.00 (13) 342,000.00 OV 5,000.00 (1) 504,000.00 (2) 38,000.00 (13) 2,052,000.00 (2) 228,000.00 (3) 6,000.00 (3) 36,000.00 (4) 42,000.00 (4) 252,000.00 (5) 600.00 (9) 40,000.00 c/ d 171,400.00 (10) 30,000.00 342,000.00 342,000.00 (11) 25,000.00 b/ d 171,400.00 (12) 55,000.00 c/ d 887,000.00 2,057,000.00 2,057,000.00 b/ d 887,000.00 Value added tax VAT Cash/ Bank C/ B Figure 12.6: SUDHUIZEN PLC’s accounts (NoE) <?page no="332"?> Berkau: Financial Statements 7e 12-332 D C D C c/ d 50,000.00 OV 50,000.00 c/ d 100,000.00 OV 100,000.00 b/ d 50,000.00 b/ d 100,000.00 Share capital ISS Reserves RES D C D C P&L 1,710,000.00 (13) 1,710,000.00 (12) 55,000.00 P&L 55,000.00 1,710,000.00 1,710,000.00 Sales revenue-20X4 REV Management/ Admin-20X4 M/ A D C D C (6) 28,000.00 P&L 31,000.00 (6) 28,000.00 (7) 1,000.00 (7) 1,000.00 (8) 2,000.00 c/ d 31,000.00 (8) 2,000.00 31,000.00 31,000.00 31,000.00 31,000.00 b/ d 31,000.00 Depreciation-20X4 DPR Acc depr ACC D C D C (9) 40,000.00 P&L 95,000.00 (12) 55,000.00 P&L 55,000.00 (10) 30,000.00 (11) 25,000.00 95,000.00 95,000.00 Labour-20X4 LAB Management/ Admin-20X4 M/ A D C D C FGI 3,000.00 Rev 1,710,000.00 c/ d 573,918.60 R/ E 573,918.60 I.CC 42,000.00 FGI 46,883.72 b/ d 573,918.60 PRC 853,000.00 I.CC 42,000.00 M/ A 55,000.00 I.WP 100,000.00 LAB 95,000.00 DPR 31,000.00 EBT 819,883.72 D C 1,898,883.72 1,898,883.72 c/ d 245,965.12 P&L 245,965.12 ITL 245,965.12 b/ d 819,883.72 b/ d 245,965.12 R/ E 573,918.60 819,883.72 819,883.72 Income tax liabilities ITL Profit and Loss-20X4 P&L Retained earnings R/ E Figure 12.6: SUDHUIZEN PLC’s accounts (NoE) continued <?page no="333"?> Berkau: Financial Statements 7e 12-333 [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, like labour (for manufacturing as well as for Management/ Administration), depreciation (on all machinery) etc. The increase in finished goods is based on a calculation of the cost of manufacturing and consider releases from finished goods inventory based on the weighted average cost formula. We deduct the costs of finished goods from the total expenses of the Accounting period, which results in an addition on the income statement. Releases from stock of finished goods are expenses. Next, we discuss the cost of sales format. We start again with the case study ABINGTON Ltd. 12.6 C/ S ABINGTON Ltd. - Cost of Sales Format We repeat the preparation of the income statement but apply the alternative method: cost of sales COS-format. As expenses are solely disclosed for goods/ services sold, no changes in closing stock of inventories are considered for earnings calculation. For ABINGTON Ltd. no changes in inventories apply, as its services are not storable. The cost of sales format discloses expenses considering their function within the company. At the first glance, this sounds easy, but it is not. The cost of sales format requires allocating costs to goods/ services which causes extra Accounting work. On the other hand, cost allocations provide the user of financial statements with better product information. An income statement based on the cost of sales format for a one-service <?page no="334"?> Berkau: Financial Statements 7e 12-334 company is easier than for a manufacturing firm with a lot of different goods produced in plenty of batches. ABINGTON Ltd. only renders one service: the legal transfer of property. The costs are either linked to the service, which we refer to as manufacturing costs, or are common costs which are disclosed separately on the income statement. The latter ones are non-manufacturing costs. Do not worry about the technical terms in Accounting, they are derived from Industrial Management. Manufacturing here means property conveyancing. At ABINGTON Ltd. the attorneys’ labour is divided into a portion of direct costs for conveyancing and another one of administration costs. Direct costs for conveyancing are 680.00 AUD/ mandate. We can calculate direct labour by multiplying these with the number of mandates. It is: 700 × 680 = 4 476,000.00 AUD. The costs for the attorneys are direct costs because an attorney represents the property buyer in court; therefore, a n : 1 relationship between attorney and mandate exists. In contrast, the paralegals work as specialists for certain operations, like preparing documents, maintaining contact with the deed’s office etc. Therefore, the paralegals labour is recorded as manufacturing (= conveyancing) overheads. The remainder of the attorneys’ costs is not linked to services, but it is for general administration work e.g., preparing a working contract for newly hired employees and thus considered to be administration costs. They are: 510,000 - 476,000 = 3 34,000.00 AUD. We do not repeat the first business activities but start-off after initial Bookkeeping entries have been completed as shown in Figure 12.1. This is before profit calculations. The cost of sales format requires a product calculation, here, the calculation per property transfer. The unit for transfers is mandates. The Work-in-Process account and the Manufacturing Overhead account apply. To avoid terms from Industrial Management, we rename the Manufacturing Overheads account and call it the Conveyance Overheads Account COH. All direct costs are closed-off to the WIPaccount. Attorneys’ costs are direct costs. They are: 680.00 AUD/ mandate (given). We add: 680 × 700 = 4 476,000.00 AUD to the WIP account. Attorneys’ costs to an extent of 34,000.00 AUD are for administration purpose and are not allocated towards mandates. Observe the Bookkeeping entries below. DR WIP-Account.................. 476,000.00 AUD CR Labour Attorneys............. 476,000.00 AUD DR Administration............... 34,000.00 AUD CR Labour Attorneys............. 34,000.00 AUD The labour of paralegals is completely related to mandates. The same applies for the operational costs. Both are transferred to the Conveyance Overheads account. These costs count as overheads as the paralegals work for more than <?page no="335"?> Berkau: Financial Statements 7e 12-335 one mandate following their specialisations. DR COH-Account.................. 760,000.00 AUD CR Labour Paralegals............ 760,000.00 AUD DR COH-Account.................. 160,500.00 AUD CR Operational Expenses......... 160,500.00 AUD The application of overheads is based on normal capacity at a cost rate of 1,300.00 AUD/ mandate. The company planned with 150,000 AUD operational costs only and determined a cost rate of: (760,000 + 150,000) / 700 = 1 1,300 AUD/ mandate (given). We allocate: 700 × 1,300 = 9 910,00.00 AUD, to the Workin-Process account and credit the amount to the Conveyance Overheads account. This results in an underapplication of overheads and requires us to transfer the not applied overheads to the Cost of Sales account: 920,500 - 910,000 = 1 10,500.00 AUD. We make a debit entry in the Cost of Sales account and credit conveyancing overheads. The Work-in-Process account is closedoff to the Profit and Loss account by the Cost of Sales account. Observe below the calculation of the conveyance service in the Work-in-Process account and the income statement as displayed in Figure 12.8 and Figure 12.9. D C D C . . . (2) 60,000.00 OV 5,000.00 (1) 5,000.00 (6) 3,024,000.00 (3) 510,000.00 RNT 5,000.00 (7) 20,000.00 (4) 760,000.00 (5) 192,600.00 c/ d 1,521,400.00 3,044,000.00 3,044,000.00 b/ d 1,521,400.00 Cash/ Bank C/ B Prepaid expenses PRE D C D C (1) 5,000.00 (3) 510,000.00 c/ d 510,000.00 (2) 60,000.00 c/ d 65,000.00 b/ d 510,000.00 WIP 476,000.00 65,000.00 65,000.00 ADM 34,000.00 b/ d 65,000.00 PRE 5,000.00 510,000.00 510,000.00 c/ d 60,000.00 65,000.00 65,000.00 b/ d 60,000.00 P&L 60,000.00 Rent-20X4 RNT Labour Attorneys-20X4 LAA Figure 12.8: ABINGTON Ltd.’s accounts (COS) <?page no="336"?> Berkau: Financial Statements 7e 12-336 D C D C (4) 760,000.00 c/ d 760,000.00 (5) 160,500.00 c/ d 160,500.00 b/ d 760,000.00 COH 760,000.00 b/ d 160,500.00 COH 160,500.00 Labour Paralegals-20X4 LAP Operational expenses-20X4 OEX D C D C c/ d 2,520,000.00 (6) 2,520,000.00 (5) 32,100.00 (6) 504,000.00 P&L 2,520,000.00 b/ d 2,520,000.00 c/ d 471,900.00 504,000.00 504,000.00 b/ d 471,900.00 Revenue-20X4 Value added tax VAT D C D C LAA 476,000.00 COS 1,386,000.00 LAP 760,000.00 WIP 910,000.00 COH 910,000.00 OEX 160,500.00 COS 10,500.00 1,386,000.00 1,386,000.00 920,500.00 920,500.00 Work-in-Process-20X4 WIP Conveyance overheads-20X4 COH D C D C LAA 34,000.00 P&L 34,000.00 WIP 1,386,000.00 P&L 1,396,500.00 COH 10,500.00 1,396,500.00 1,396,500.00 Administration-20X4 ADM Cost of Sales-20X4 COS D C D C COS 1,396,500.00 REV 2,520,000.00 c/ d 314,850.00 P&L 314,850.00 ADM 34,000.00 I/ / 20,000.00 b/ d 314,850.00 RNT 60,000.00 EBT 1,049,500.00 2,540,000.00 2,540,000.00 ITL 314,850.00 b/ d 1,049,500.00 R/ E 734,650.00 1,049,500.00 1,049,500.00 Profit and Loss-20X4 P&L Income tax liabilities ITL D C D C c/ d 20,000.00 (7) 20,000.00 c/ d 734,650.00 P&L 734,650.00 P&L 20,000.00 b/ d 20,000.00 b/ d 734,650.00 Interest income-20X4 I/ I Income tax liabilities ITL Figure 12.8: ABINGTON Ltd.’s accounts (COS) continued <?page no="337"?> Berkau: Financial Statements 7e 12-337 [AUD] Revenue 2,520,000 Other income 20,000 2,540,000 COS (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 other expenses for administration and rent. ABINGTON Ltd. discloses the interest income from the bonds as other income. A company can disclose single items for different services and goods 135 , however, IAS 1.81A does not explicitly require this. Only in cases a company operates in different industries, like a software design company that also offers consultancy, it must disclose revenue and expenses linked to its products as segment reporting. 12.7 C/ S SUDHUIZEN PLC - Cost of Sales Format Next, we study the income statement for SUDHUIZEN PLC again. 135 Check the case study ASHTON Ltd. in our textbook Basics of Accounting, chapter (28). We prepare a profit calculation based on one WIP account and three Manufacturing Overhead accounts - for every department one Manufacturing Overheads account as we follow a Job Order Costing. The Bookkeeping entries (1) to (12) are the same as for the nature of expense method. As we now apply the cost of sales format, the inventory movement system changes to a perpetual system. Therefore, we add purchases to the inventory accounts for CCDUs, water pumps, boxes and cleaning soap. We observe the handling of CCDUs. The purchases are transferred to the Inventory CCDU account. CCDUs released from stock are: 30,000 × 14 = 420.000.00 GBP. They are added to the WIP-account. Observe the Bookkeeping entries below about the CCDUs. <?page no="338"?> Berkau: Financial Statements 7e 12-338 DR Inventory CCDU............... 420,000.00 GBP CR Purchase..................... 420,000.00 GBP DR WIP-Account.................. 420,000.00 GBP CR Inventory CCDU............... 420,000.00 GBP Other materials are recorded the same way. The overheads, like labour and depreciation are added to the Manufacturing Overhead accounts because they are production related. See below the additions to the Manufacturing Overheads- Assembling account. DR MOH Assembling MOA........... 40,000.00 GBP CR Labour....................... 40,000.00 GBP DR MOH Assembling MOA........... 28,000.00 GBP CR Depreciation................. 28,000.00 GBP Labour and depreciation are allocated to the Cleaning and Shipping department likewise. The application of overheads does not cause overnor under-applications. Hence, all overheads are transferred to the Work-in-Process account. See e.g., the application of overheads in the Assembling department: DR WIP-Account.................. 68,000.00 GBP CR MOH Assembling MOA........... 68,000.00 GBP The application of manufacturing overheads in the other departments is recorded the same way. In a Job Order Costing system, the costs of manufacturing are transferred from the WIP-account to the Finished Goods Inventory account: DR FG Inventory................. 879,000.00 GBP CR WIP-Account.................. 879,000.00 GBP According to the perpetual inventory system, we make two Bookkeeping entries to record a sale. One is for the cash receipt and another one is for the inventory movement. The inventory movement requires adding 28,500 espresso machines to the Cost of Goods Sold account based on a valuation of cost of manufacturing. We easily can calculate the cost of manufacturing per batch by dividing the total costs of manufacturing by the lot size: 879,000 / 30,000 = 2 29.30 GBP/ p. Under consideration of the opening stock, the inventory movement is: 28,500 × (100 × 30 + 30,000 × 29.30) / 30,100 = 8 835,116.28 GBP. <?page no="339"?> Berkau: Financial Statements 7e 12-339 At SUDHUIZEN PLC, there is only one sale for all espresso machines together, to keep the case simple. It takes place after the production of all espresso machines is completed. We skip the Cost of Goods Sold account, but we identify the Bookkeeping entry for inventory movements by the 3-letter code COS. You find the contra entry in the Profit and Loss account. See below both Bookkeeping entries linked to the sale: DR Cash/ Bank.................... 2,052,000.00 GBP CR VAT.......................... 342,000.00 GBP CR Revenue...................... 1,710,000.00 GBP DR P&L-Account.................. 835,116.28 GBP CR FG Inventory................. 835,116.28 GBP After the sale, we prepare a Profit and Loss account and only consider expenses for the goods sold plus non-manufacturing expenses for Management / Administration. The profit is the same as calculated above applying the nature of expense method. Observe the profit calculation based on the accounts displayed in Figure 12.10. D C D C OV 100,000.00 c/ d 100,000.00 (1) 420,000.00 I.CC 420,000.00 b/ d 100,000.00 (2) 190,000.00 I.WP 400,000.00 (3) 30,000.00 I.BX 30,000.00 (4) 210,000.00 I.SP 3,000.00 (5) 3,000.00 853,000.00 853,000.00 Property, Plant, Equipment Purchase-20X4 PRC D C D C c/ d 3,600.00 (5) 3,600.00 OV 42,000.00 WIP 420,000.00 b/ d 3,600.00 PRC 420,000.00 c/ d 42,000.00 462,000.00 462,000.00 b/ d 42,000.00 Accounts payables A/ P Inventory CCDU I.CC D C D C PRC 400,000.00 WIP 300,000.00 PRC 30,000.00 WIP 30,000.00 c/ d 100,000.00 400,000.00 400,000.00 b/ d 100,000.00 Inventory water pump I.WP Inventory box I.BX Figure 12.10: SUDHUIZEN PLC’s accounts (COS) <?page no="340"?> Berkau: Financial Statements 7e 12-340 D C D C PRC 3,000.00 WIP 3,000.00 OV 3,000.00 COS 835,116.28 WIP 879,000.00 c/ d 46,883.72 882,000.00 882,000.00 b/ d 46,883.72 Inventory soap I.SP Finished goods inventory FG D C D C (1) 84,000.00 (13) 342,000.00 OV 5,000.00 (1) 504,000.00 (2) 38,000.00 (13) 2,052,000.00 (2) 228,000.00 (3) 6,000.00 (3) 36,000.00 (4) 42,000.00 (4) 252,000.00 (5) 600.00 (9) 40,000.00 c/ d 171,400.00 (10) 30,000.00 342,000.00 342,000.00 (11) 25,000.00 b/ d 171,400.00 (12) 55,000.00 c/ d 887,000.00 2,057,000.00 2,057,000.00 b/ d 887,000.00 Cash/ Bank C/ B Value added tax VAT D C D C c/ d 50,000.00 OV 50,000.00 c/ d 100,000.00 OV 100,000.00 b/ d 50,000.00 b/ d 100,000.00 Share capital SCP Reserves RES D C D C P&L 1,710,000.00 (13) 1,710,000.00 (12) 55,000.00 P&L 55,000.00 1,710,000.00 1,710,000.00 Sales revenue-20X4 REV Management/ Admin-20X4 M/ A D C D C (6) 28,000.00 MOA 28,000.00 (6) 28,000.00 (7) 1,000.00 MOC 1,000.00 (7) 1,000.00 (8) 2,000.00 MOS 2,000.00 c/ d 31,000.00 (8) 2,000.00 31,000.00 31,000.00 31,000.00 31,000.00 b/ d 31,000.00 Depreciation-20X4 DPR Acc depr ACC D C D C (9) 40,000.00 MOA 40,000.00 (12) 55,000.00 P&L 55,000.00 (10) 30,000.00 MOC 30,000.00 (11) 25,000.00 MOS 25,000.00 95,000.00 95,000.00 Labour-20X4 LAB Management/ Admin-20X4 M/ A Figure 12.10: SUDHUIZEN PLC’s accounts (COS) - continued <?page no="341"?> Berkau: Financial Statements 7e 12-341 D C D C I.CC 420,000.00 FGI 879,000.00 LAB 40,000.00 WIP 68,000.00 I.WP 300,000.00 DPR 28,000.00 MOA 68,000.00 68,000.00 68,000.00 I.SP 3,000.00 MOC 31,000.00 I.BX 30,000.00 MOS 27,000.00 879,000.00 879,000.00 Work-in-process account WIP MOH Assembling MOA D C D C LAB 30,000.00 WIP 31,000.00 LAB 25,000.00 WIP 27,000.00 DPR 1,000.00 DPR 2,000.00 31,000.00 31,000.00 27,000.00 27,000.00 MOH Cleaning MOC MOH Shipping MOS D C D C COS 835,116.28 Rev 1,710,000.00 c/ d 573,918.60 R/ E 573,918.60 M/ A 55,000.00 b/ d 573,918.60 EBT 819,883.72 1,710,000.00 1,710,000.00 ITL 245,965.12 b/ d 819,883.72 R/ E 573,918.60 D C 819,883.72 819,883.72 c/ d 245,965.12 P&L 245,965.12 b/ d 245,965.12 Income tax liabilities Profit and Loss-20X4 P&L Retained earnings R/ E Figure 12.10: SUDHUIZEN PLC’s accounts (COS) continued If you get the impression the cost of sales format is more Accounting work, you are right. However, this only matters if you calculate in the university on paper or in MS-Excel. In real Accounting, your Bookkeeping software makes all calculations. After customizing your Accounting system, a few more accounts will not bother you. The advantage of the cost of sales format lays in the calculation of goods/ services in the accounts. You do not need a working sheet for calculations as you do for the nature of expense method. However, in the end, the reporting company decides what information is provided by the financial statements, either cost categories by the nature of expense method or good/ service costs by the cost of sales format. The accounts following a Process Costing at SUIDHUIZEN PLC are accessible through Link 12.B below. Link 12.B: SUIDHUIZEN PLC <?page no="342"?> Berkau: Financial Statements 7e 12-342 Below, the income statement based on the cost of sales format is disclosed: As the cost of sales format does not support information about expenses but is based on allocations, a reporting company preparing the income statement based on the cost of sales format must provide additional information about the expenses as stated in IAS 1.105. In the case of SUDHUIZEN PLC, the income statement as displayed in Figure 12.11 requires 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 in the profit and loss section 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, whatever information is better for the reader of financial statements. Hence, the decision of how to prepare the income statement is with the reporting company. The presentation of profit or loss is in the income statement. 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 figures. 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. Costs: Expenses that are linked to the ordinary business of a company. In this textbook, we pretend that costs equal expenses and vice versa. Cost of Sales: Format for the presentation of a statement of profit or loss which classifies expenses based on <?page no="343"?> Berkau: Financial Statements 7e 12-343 functions. Allocations of expenses apply to assign costs to objects, such as certain goods or services. Gain: Extraordinary revenue. 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. In the old days, an income statement was net of other comprehensive income. Nowadays, we apply the name income statement for a statement that includes ordinary and extraordinary profits/ gains and expenses. IAS 1.81 applies. 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 does not result from continued operations, such as profit 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 350.00 EUR and a closing stock of 120.00 EUR. The revenue is amounting to 1,000.00 EUR. Operational expenses are 200.00 EUR. How much is the profit before income taxes? 1. 1,030.00 EUR . 2. 680.00 EUR . 3. 570.00 EUR . 4. 1,150.00 EUR . (2) Which statement is correct? 1. The COS-format applies allocations to assign expenses to cost categories. 2. The NoE-format records expenses based on its function for the entity. 3. The NoE-format uses cost allocations to assign expenses to cost objects. 4. The NoE-format records expenses based on characteristics and not along its function. (3) Which of the below listed items are disclosed on the statement of profit or loss and other comprehensive income that is prepared along the COS-format? 1. Revenue, cost of services rendered, administration expenses, interest. 2. Revenue, gain, cost of goods sold, depreciation, interest. 3. Profit, gain, labour, manufacturing depreciation, interest. 4. Revenue, dividend income, labour, interest. (4) A company spends 50,000.00 EUR on materials (net amount) and 70,000.00 EUR on direct labour. The applied overheads are 40,000.00 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. The company sells 622 of the goods. How much are the cost of sales? 1. 124,400.00 EUR . 2. 125,974.68 EUR . 3. 128,400.00 EUR . 4. 120,400.00 EUR . <?page no="344"?> Berkau: Financial Statements 7e 12-344 (5) Which accounts are required in order to prepare a statement of profit or loss and other comprehensive income following the nature of expense format? 1. Revenue account, Purchase account, Trading account, Manufacturing Overheads account. 2. Revenue account, Purchase account, Inventory of Finished Goods account and Administration account. 3. Trading account, Purchase account, Finished Goods Inventory account, Manufacturing Overheads account. 4. Revenue account, Cost of Sales account, Manufacturing Overheads account, Work-in-Process account. 12.11 Solutions 1-3, 2-4, 3-1, 4-4, 5-2. <?page no="345"?> Berkau: Financial Statements 7e 13-345 13 Statement of Changes in Equity 13.1 What is in the Chapter? The statement of changes in equity tells the user of financial statements how the book value of a company changed during the reported Accounting period. That information helps investors to make reasonable economic decisions, like buying or selling their portions of ownership. In this chapter, we cover the preparation of a statement of changes in equity with the case study BELMONT Ltd., a share-based gym in Gqeberha (Port Elizabeth). We cover different activities which change its equity: Share issue, recording treasury shares after a buy-back of ordinary shares, dividend receipts from assets an investment in an associated company, profit earning, the appropriation of profits as well as a revaluation of assets. In contrast to the case covered in chapter (11), all activities take place in one Accounting period. 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 we must disclose in the notes regarding equity. 13.2 Learning Objectives After studying this chapter, you can read and prepare a statement of changes in equity. You know what needs to be reported on the statement of changes in equity and can determine how various business activities change the book value of a company. You get 136 IAS 8 rules changes in Accounting policies, estimates and errors. familiarised with the major IFRS standards ruling the statement of changes of equity and know about the equity disclosure requirements in the notes. 13.3 IFRS Regulations No IFRS standard is directly 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, like income, effects of changes connected with IAS 8 136 , profit and loss, other comprehensive income 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. In Germany, no statement of changes in equity is required but § 158 AktG makes companies based on shares extend their income statements for the disclosure of their appropriation of profits. Below, we study BELMONT Ltd. preparing its statement of changes in equity step by step. A statement of changes in equity considers: (1) Share issue/ treasury shares. (2) Profit or loss. <?page no="346"?> Berkau: Financial Statements 7e 13-346 (3) Other comprehensive income. (4) Revaluations of assets. (5) Appropriation of profits. Each change in equity is disclosed as a line on the statement of changes in equity. After the introduction of the case study BELMONT Ltd. below, we cover the preparation of its statement of changes in equity in detail. We startoff from the opening equity values and add lines to the statement for its equity changes. After adding a line, we disclose the statement of changes in equity in the Figures 13.2 to Figures 13.7. All these exhibits show the same statement, which gives you the chance to observe its development. 13.4 C/ S BELMONT Ltd. In this case study, only aspects of equity matter. We do not record all Bookkeeping entries but focus on events that change the equity of the company. In the end, we disclose the entire statement for BELMONT Ltd. which contains all equity changes in Figure 13.7. For its preparation in academia, it is recommended to record the equity changes in detail. Regarding MS-Excel, we apply cell combinations to aggregate the statement’s columns but keep the detailed information in the background. This way, it is possible to derive the single information needed to prepare the notes although no Accounting software system is in use. Data Sheet for BELMONT Ltd. DDomicile: South Africa (Gqeberha, PE). Reporting currency: ZAR. Classification: service provider. Reporting period: 20X7. Issued capital: 1,000,000 ordinary shares at 1.00 ZAR/ s. Issue of 500,000 preference shares at 1.00 ZAR/ s on 31.03.20X7, issue price: 1.50 ZAR/ s; dividend claim: 7 % based on face value; rights issue. Share buy-back: on 1.10.20X7: 200,000 ordinary shares at 2.05 ZAR/ s. Profit after taxes (20X7): 490,000.00 ZAR. Other comprehensive income (20X7): gain on disposal before taxation 100,000.00 ZAR. Investment income from 40 %-cafeteria ownership (20X7): 32,000.00 ZAR. Asset revaluation; increase of the value for bikes: 15,000.00 ZAR. Appropriation of profits: preference dividends; 0.05 ZAR/ s ordinary dividend; 100,000.00 ZAR added to reserves. VAT n/ a. BELMONT Ltd. is a gym in Gqeberha. The company is based on 1,000,000 ordinary shares at 1.00 ZAR/ s. As at 1.01.20X7, BELMONT Ltd. discloses the balance sheet shown in Figure 13.1. <?page no="347"?> Berkau: Financial Statements 7e 13-347 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 entries for the first line of the statement of changes in equity. The total of equity is: 1,000,000 + 400,000 - 150,000 = 1 1,250,000.00 ZAR. The value includes earnings reserves and a loss carried forward. BELMONT Ltd. could have dissolved its negative earnings reserves to compensate the loss from the previous year(s) but it is not obliged to do so. As BELMONT Ltd. does not dissolve reserves, it carries forward the loss which reduces its distributable amount in 20X7. In the case of BELMONT Ltd., the reserves shown are completely earnings reserves dissolvable at the discretion of the company. Following the Company’s Act, an owners' approval on the annual general meeting is required for dissolving earnings reserves. Observe below in Figure 13.2 the first line of the statement of changes in equity for BELMONT Ltd. The header indicates that the statement of changes in equity is prepared for its disclosure on 31.12.20X7. We continue its preparation; the numbers in brackets at the end of the captions indicate our preparation progress. Below, you find the statement of changes in equity, after step (1) was entered: 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) <?page no="348"?> Berkau: Financial Statements 7e 13-348 13.5 C/ S BELMONT Ltd. - Share Issue/ Treasury Shares On 31.03.20X7, BELMONT Ltd. issues 500,000 preference shares at 1.00 ZAR/ preference share. The preference shares come with a 7 %/ a dividend claim based on their nominal value. BELMONT Ltd. issues the shares at an issue price of 1.50 ZAR/ s 137 . As the issue price for the preference shares exceeds the nominal value, a premium of: 1.50 - 1.00 = 0 0.50 ZAR/ preference share is added to capital reserves. This gives: 500,000 × 0.50 = 250,000.00 ZAR. The simplified Bookkeeping entry for the share issue is shown below 138 : DR Cash/ Bank.................... 750,000.00 ZAR CR Issued Capital (pref. shares) 500,000.00 ZAR CR Capital Reserves............. 250,000.00 ZAR Next, we discuss a share buy-back. Repurchasing own shares takes the shares off the market and excludes them from dividend receipts. A share brought back is no asset as the company cannot be its own shareholder. Therefore, treasury shares are considered as a negative equity item on the balance sheet as well as on the statement of changes in equity. Treasury stock changes performance ratios, like the Return on Assets or the Earnings per Share and can affect the share price of remaining shares. IAS 32.33 rules treasury shares. The shares are to be deducted from equity at values derived from the consideration paid. On 1.10.20X7, BELMONT Ltd. buys 200,000 of its own (ordinary) shares back. The paid share price is 2.05 ZAR/ s. The cost method applies following IAS 32.33 which means the treasury shares are carried at their cost of (re-)acquisition. No changes of capital reserves apply. BELMONT Ltd. does not redeem its treasury shares. Accordingly, no profit or loss is recorded for the share buy-back transaction. DR Issued Capital - Treasury.... 410,000.00 ZAR CR Cash/ Bank.................... 410,000.00 ZAR The statement of changes in equity is disclosed as below in Figure 13.3 after the issue of BELMONT Ltd.’s preference shares and the buy-back of a portion of its ordinary shares as at the end of the 137 For share issues, read out textbook Basics of Accounting, chapter (14). Accounting period 20X7. Per transaction, we add one line to the statement of changes in equity. The fair market value of BELMONT Ltd.’s shares (ordinary and preference shares) does not matter for the financial statements and the disclosure of equity. 138 A share issue for a public limited company requires applying an Application and Allotment account, see out textbook Basics of Accounting, chapter (33). <?page no="349"?> Berkau: Financial Statements 7e 13-349 See in Figure 13.3 the statement of changes in equity for BELMONT Ltd. as far as discussed at this stage (2). Therein, treasury stock is disclosed as negative share capital. 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 a profit after the deduction of income taxes to the extent of 700,000 × (1 - 30%) = 4 490,000.00 ZAR. The earnings are added to equity through the Retained Earnings account. The earnings after taxes exceed the loss carried forward. At the same time, we add the income taxes for the profit to the Income Tax Liability account. Observe the Bookkeeping entries below. The income tax calculation results in a tax liability of: 30% × 490,000 / (1 - 30%) = 2210,000.00 ZAR. DR P&L Account.................. 490,000.00 ZAR CR Retained Earnings............ 490,000.00 ZAR DR P&L Account.................. 210,000.00 ZAR CR Income Tax Liabilities....... 210,000.00 ZAR Below, we show the statement of changes in equity after recording profits. 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. See the statement of changes in equity at this stage (3) of the preparation in Figure 13.4. <?page no="350"?> Berkau: Financial Statements 7e 13-350 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 During the fiscal year 20X7, BELMONT Ltd. sells 4 of its treadmills at a total gain on disposal of 100,000.00 ZAR (before income taxes). The gain on disposal is not linked to BELMONT Ltd.'s ordinary business, therefore, it is called a gain - not a profit on disposal. The gain is taxable income and leads to income tax liabilities of: 100,000.00 × 30% = 3 30,000.00 ZAR. Hence, the addition to equity resulting from the gain on the disposal of the treadmills is: 100,000 - 30,000 = 70,000.00 ZAR. We make the entries below in the accounts: DR Cash/ Bank.................... 100,000.00 ZAR CR Gain on Disposal (OCI)....... 100,000.00 ZAR DR Gain on Disposal (OCI) ...... 70,000.00 ZAR CR Retained Earnings............ 70,000.00 ZAR DR Gain on Disposal (OCI)....... 30,000.00 ZAR CR Income Tax Liabilities....... 30,000.00 ZAR BELMONT Ltd. holds shares of a cafeteria on its premises which was previously sourced out. BELMONT Ltd. still owns 40 % of BELMONT-DINER (Pty) Ltd. The former employee and cafeteria chef owns the remainder number of shares. He runs the restaurant. BELMONT-DINER (Pty) Ltd. pays a 40 % portion of its profit (after taxation) to BELMONT Ltd. which is: 80,000 × 40% = 3 32,000.00 ZAR. The dividend is classified as other comprehensive income resulting from investments. Income taxes do not apply, see our conventions in chapter (1). No dividend tax (tax on capital returns) applies for BELMONT Ltd. as it is a company and not a private person. We record the Bookkeeping entry as below: DR Cash/ Bank.................... 32,000.00 ZAR CR Subsidiary Income (OCI)...... 32,000.00 ZAR <?page no="351"?> Berkau: Financial Statements 7e 13-351 See below the statement of changes in equity at BELMONT Ltd. in Figure 13.5 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 dividend 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 “bikes” are carried at 50,000.00 ZAR on 1.01.20X7. During the Accounting period 20X7, depreciation of 10,000.00 ZAR on the bikes is recorded which gives a carrying value of 40,000.00 ZAR before the revaluation. The bikes are disclosed under the item property, plant, equipment on the balance sheet. Without an explanation about the reasons for the value increase, we revalue the bikes by 15,000.00 ZAR - observe the simplified Bookkeeping entry below. DR Investment @valuation........ 55,000.00 ZAR CR Investment @cost............. 40,000.00 ZAR CR Revaluation Reserves......... 10,500.00 ZAR CR Deferred Tax Liabilities..... 4,500.00 ZAR The revaluation of the bikes increases BELMONT Ltd.’s equity by 10,500.00 ZAR (after deduction of deferred tax liabilities). See below in Figure 13.6 the statement of changes in equity (5) after recognition of the revaluation reserves and the reduction for deferred tax liabilities. As the revaluation of the bikes takes place at the end of December, no depreciation is recorded after the revaluation. <?page no="352"?> Berkau: Financial Statements 7e 13-352 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 dividend 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 An appropriation of profits is the distribution of profits between owners and the company. There are three options: (a) declaration of dividends, (b) addition to earnings reserves or (c) carrying forward the profit. Combinations of the above options can apply. To put it more precisely, we do not appropriate the annual profit but the distributable amount. This is the reason, why the expression about the appropriation is with a plural-s in profits. The distributable amount contains the profits or losses carried forward from prior Accounting periods and the earnings after taxes from the reporting period. In BELMONT Ltd.’s case, the distributable amount is: -150,000 + 490,000 + 70,000 + 32,000 = 4 442,000.00 ZAR. The revaluation reserves do not yet qualify for distribution. Only if a company depreciates a revalued asset, its revaluation reserves are proportionally dissolved and recorded in the Retained Earnings account, which makes them distributable to owners. Similar rules apply for a disposal of a former revalued asset. See chapter (7) for the details. To pay its ordinary shareholders a dividend, BELMONT Ltd. must first declare a preference dividend. We reduce the distributable amount to the ordinary shareholders by a deduction for the preference dividends. The preference dividend at BELMONT Ltd. is: 75% × 7% × 500,000 = 226,250.00 ZAR. The annual preference dividend is reduced by 25 % as the preference share issue took place on 31.03.20X7. The distributable amount to ordinary shareholders is: 442,000 - 26,250 = 415,750.00 ZAR. BELMONT Ltd. declares a dividend of 0.05 ZAR/ ordinary share. The total ordinary dividend is: 0.05 × 800,000 = 40,000.00 ZAR. Treasury shares are not eligible for dividends. On the annual general meeting, the owners of BELMONT Ltd. decide to add 100,000.00 ZAR to earnings reserves and to carry forward the remainder of the distributable amount. See below the Bookkeeping entries and the final statement of changes in equity in Figure 13.7. It is assumed that BELMONT Ltd. pays its shareholders the gross dividend. Here, <?page no="353"?> Berkau: Financial Statements 7e 13-353 dividend recipients take care of taxation regarding tax on capital returns themselves. In real Accounting, the company is owing the tax on capital returns for its domestic, private shareholders. As we do not know the domicile of BELMONT Ltd.’s shareholders we assume they are all private foreigners and record the gross dividend. DR Retained Earnings............ 166,250.00 ZAR CR Pref. Dividends/ p ............ 26,250.00 ZAR CR Ord. Dividends/ p............. 40,000.00 ZAR CR Earnings Reserves............ 100,000.00 ZAR 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 dividend 32,000 32,000 Revaluation 10,500 10,500 Pref. dividends (26,250) (26,250) Ord. dividends (40,000) (40,000) Additions to earn. res. 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 table that shows columns for each equity item on the balance sheet. Choose either a detailed statement of singular items or prepare an aggregated statement of changes in equity and disclose further information within the notes. (2) Determine and enter the equity values at the beginning of the Accounting period in the first line. Make all entries in the statement of changes in equity based on the Bookkeeping records. (3) Add a line for share issues and make entries in the issued capital column. Make further entries in the capital reserves column if shares are issued with a premium. (4) Add a line item for share buy-backs/ redemptions and make entries in the issued capital column and in the capital reserves column accordingly. <?page no="354"?> Berkau: Financial Statements 7e 13-354 (5) Add a line for profit or loss. Enter the profit after taxation in the retained earnings column. (6) Add a line for other comprehensive income. Enter other comprehensive income after taxation in the retained earnings column. (7) Add a line for the appropriation of profits. Change retained earnings and make additions to reserves if applicable. Deal with dissolving reserves accordingly. (8) Add a line for preference dividends. Reduce the retained earnings for the 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. Consider deferred taxes. (10) Add all line items and disclose the total per line in its right column. (11) Add all column lines and disclose the total on the bottom line. The bottom-line figures must be consistent with the balancing figures in the related accounts and with the balance sheet's equity section. 13.10 Summary The statement of changes in equity is required in IAS 1.10. It shows the additions and reductions in the equity section on the balance sheet. The columns represent the equity items and lines the transactions changing equity. If the reporting company combines items a detailed explanation in the notes must be provided. 13.11 Working Definition Statement of Changes in Equity: A statement that discloses the yearly additions and reductions of equity items on the balance sheet. 13.12 Question Bank (1) A company repurchases 20,000 of its ordinary shares at 34.00 EUR/ s. The face value is 10.00 EUR/ s. How does the company show the treasury shares on its balance sheet? 1. As an asset measured at 680,000.00 EUR. 2. As a negative capital of 680,000.00 EUR. 3. As an asset measured at 200,000.00 EUR. 4. As a negative capital of 200,000.00 EUR. (2) A company declares a dividend of 100,000.00 EUR from a distributable amount of 160,000.00 EUR. How is the transaction disclosed on the statement of changes in equity? 1. Deduction of 100,000.00 EUR from totals. 2. Addition of 60,000.00 EUR to retained earnings. 3. Deduction of 100,000.00 EUR from retained earnings. <?page no="355"?> Berkau: Financial Statements 7e 13-355 4. Deduction of 160,000.00 EUR from retained earnings and addition of 100,000.00 EUR to earnings reserves. (3) A company based on shares discloses a profit carried forward of 25,000.00 EUR. In the reporting period, the profit before taxation is 100,000.00 EUR. On 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 100,000.00 EUR by 40 %. How is the revaluation disclosed on the statement of changes in equity? 1. Increase of reserves by 40,000.00 EUR and increase of retained earnings by 40,000.00 EUR. 2. Increase of reserves by 28,000.00 EUR and increase of retained earnings by 28,000.00 EUR. 3. Increase of reserves by 40,000.00 EUR. 4. Increase of reserves by 28,000.00 EUR. (5) A company issues 200,000 shares at 5.50 EUR/ s which include a premium of 0.50 EUR/ s. It earns a pre-tax profit of 100,000.00 EUR. It re-values its non-current assets by 50,000.00 EUR and declares a dividend of 0.20 EUR/ s. How much is its equity as disclosed on the statement of changes in equity (total)? 1. 1,160,000.00 EUR . 2. 1,060,000.00 EUR . 3. 1,165,000.00 EUR . 4. 1,190,000.00 EUR . 13.13 Solutions 1-2, 2-3, 3-3, 4-4, 5-3. <?page no="356"?> Berkau: Financial Statements 7e 14-356 14 Liabilities on the Balance Sheet 14.1 What is in the Chapter? In this last chapter, we cover the valuation and presentation of liabilities on the financial statements. In general, liabilities fall under financial instruments which are disclosed on the borrowers’ balance sheet on the credit side as liabilities. The lenders record debit entries for financial assets. We repeat some aspects discussed already in chapter (7) and chapter (9) from the creditors' perspective. However, we now look from the opposite side (debtors’ perspective) at financial instruments. We also discuss provisions and show their recordings and disclosure. The chapter contains 5 case studies for financial liabilities, like loans and bonds. In the second half of this chapter, we discuss 4 case studies for provisions. 14.2 Learning Objectives After studying this chapter, you know the major group of liabilities: certain liabilities, provisions and contingent liabilities and you know their measurements and disclosure. 139 We teach you how to carry liabilities at amortised costs and how to apply the effective interest method. Furthermore, you develop an understanding for provisions and learn how to disclose them at their present values. You know the major IFRS-standards and paragraphs for the disclosure of liabilities and provisions. 139 Only liabilities and provisions are shown on financial statements. No contingent liabilities are disclosed. 14.3 Liabilities Liabilities result from present obligations and lead to a duty or a responsibility to act in a certain way (IAS 1.15). In a certain way means making a payment or providing goods or services in return of the settlement of the liability. The IASB distinguishes present and future obligations, the latter ones are no liabilities, like interest to be paid in upcoming Accounting periods. In contrast, an obligation to settle debts already exists at the date of reporting and, therefore, must be disclosed as a liability. See IAS 1.16. Below, we start-off our considerations from the classification of liabilities which is relevant for Accounting as how we measure liabilities depends thereon. 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 means, at least one of the characteristics of the liability is unknown, like payment terms (amount or date) or whether the payment must be made at all. A provision applies e.g., if a com- <?page no="357"?> Berkau: Financial Statements 7e 14-357 pany agrees to the payment of a pension for its manager. Then, a present obligation exists due to the contract, but the future payments and the terms thereof are uncertain. They depend on the beneficiary, whether she/ he is still alive when payments are due. If no present obligation exists a contingent liability applies. A contingent liability exists e.g., if a parent vouchers for its subsidiary. For the time the subsidiary is in no financial destress, no obligation exists. In general, contingent liabilities are not disclosed on financial statements. For financial instruments, IAS 32, IAS 39, IFRS 7, IFRS 9 apply. IFRS 13 rules their measurement. As IFRS 9 replaces IAS 39 in the nearby future, we focus on IFRS 9 for the reporting of liabilities. This determines e.g., loan valuations. 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. The major difference in terms of measurement is given by IFRS 9 and IAS 37: We carry certain liabilities at amortised costs or fair values whereas provisions require a disclosure at present values. 140 Therefore, some aspects covered in chapters (7) and (9) are repeated in this chapter (14). 14.4 Certain Liabilities In the easiest case, a liability is just a payment obligation. Whether you buy goods on credit or take a bank loan, you define a liability. It results in future payments or other transactions, like asset transfer or rendering of service. This way, 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 with the same methods on the lenders' side (assets) as on the borrowers’ side (liabilities). 140 IFRS 9.5.2.1 distinguishes financial instruments held at amortised costs and those that are carried at fair values. In general, a fair value presentation is the first choice for the holder of liability instruments e.g., a bond holder. Fair value presentation refers to the amount at which assets are exchanged or liabilities are transferred by orderly transactions. If bonds are traded, the bond price applies. The term orderly transaction is linked to normal business transactions, whereas e.g., a liquidation is not considered as being orderly, but as exceptional. In cases, when the valuation of liabilities fluctuates e.g., because bonds are traded publicly at a bond market, a company holding bonds is obliged to adjust the fair values regularly on its balance sheet through profit or loss or through other comprehensive income. The fluctuation of market prices causes permanent changes in the valuation of the financial asset. However, this does not apply for the disclosure of financial liabilities on the borrower’s side There is only a change of perspectives for the same regulations. <?page no="358"?> Berkau: Financial Statements 7e 14-358 which are redeemed at settlement values. As settlement values are given e.g., for bonds or loans, their fair value measurement together with all adjustments thereto would result in a zero-sumgame. The reason is that the settlement value is not depending on fair market values but on the principal of the bond or the bank loan. Therefore, liability instruments are carried at amortised costs. Carrying at amortised costs means to not follow fair market value fluctuations but to stick (keep) to or pursue (effective interest method) settlement values. Note, if the effective interest method is applied for standard loan cases as for BATHURST Ltd. in chapter (6) where the loan is paid-off at the same value as it was issued and payment terms rule annual payments for interest, the effective interest method carries loans always at settlement values. On the borrower’s side, a liability measurement is at amortised costs per default. Therefore, traded bonds with volatile market values do not affect their disclosure as liability on the bond issuer’s financial statement. Amortised costs of liabilities differ from settlement values, if payments are made in shorter intervals than a year, if fees apply and/ or if the settlement is at other values than the issue of the liability instrument. For debt valuation at amortised costs the effective interest method applies. 141 141 Read Appendix B of IFRS 9: IFRS 9.B4.1.2.9. 142 This is the default case in this textbook as ruled by our conventions in chapter (1). The effective interest method approximates the current liability value continuously towards its settlement value. In the case study BATHURST Ltd. in chapter (6) where the loan is received and redeemed at its nominal value the effective rate of interest equals the nominal rate of interest 142 . Therefore, the loan is always disclosed at settlement values. With the effective interest method for valuation, we must compound a liability with the effective interest rate and actual payments are deducted. 143 In the case of BATHURST, this procedure leads to carry the bank loan at nominal values because the effective interest rate for compounding equals the nominal one for payments. Next, we explain the effective interest method in detail. For the sake of teaching, we explain the technical term effective interest (not yet effective interest method) at first: In Finance, the effective interest rate is the rate applicable under consideration of a monthly compounded interest, because for most loans interest must be paid monthly. To determine the effective rate of interest if the annual interest rate is known, we use the formula i eff = (1 + i a / 12) 12 - 1. If e.g., the annual rate of interest is 2.4 %/ a, the effective rate of interest is: (1 + 0.2%) 12 - 1 = 2.43%/ a. The effective rate of interest also can put additional costs into consideration, like bank fees or it considers that the total of pay-offs exceeds the amount at which a loan was issued. We show this 143 Check the how-it-is-done paragraph regarding the effective interest method in chapter (7). <?page no="359"?> Berkau: Financial Statements 7e 14-359 for the case of MEUL Ltd. further below. Next, we discuss five liability cases: (1a) C/ S WARWICK Ltd.: buying goods on credit (short-term liability case). (1b) the altered C/ S BATHURST Ltd.: bank loan now with monthly payments and with a bank fee (at amortised costs) (1c) C/ S MEUL Ltd.: taking a bank loan at a discount and paying closing fees to the bank (at amortised cost). (1d) C/ S BRIZA: bonds (at amortised costs). (1e) C/ S MEMEL PLC: annuity with extra repayments (at amortised costs). In this chapter, we do not cover cases of long-term liabilities carried at volatile fair values. This only applies if the settlement is based on the fair value which is not the case with loans and bonds. Even a bond that is traded at a low price must be redeemed at its settlement value. We start off with the case study WARWICK Ltd. which is based on short-term payments. There is no need for the application of the effective interest method as the liabilities are short-term. 14.5 C/ S WARWICK Ltd. - Buying Goods on Credit Buying goods on credit results in general in a payment obligation that is due in the nearby future. IAS 1.56 instructs a company to classify its debts as short-term liability once it is due within a year. Therefore, we do not revalue short-term debts and carry them at initial valuation which is their settlement value. Data Sheet for WARWICK Ltd. DDomicile: Australia (Adelaide). Reporting currency: AUD. Classification: n/ a. Short-term payables: 120,000.00 AUD from purchases. Purchase date: 3.01.20X5. Repayment: 3.01.20X6. Interest: n/ a. VAT 20 %. WARWICK Ltd. buys goods from its supplier on 3.01.20X5 and agrees to pay the purchase price (gross amount) of 120,000.00 AUD on 3.01.20X6. We make the Bookkeeping entry below: DR Purchase..................... 100,000.00 AUD DR VAT.......................... 20,000.00 AUD CR Accounts Payables A/ P ........ 120,000.00 AUD In the next Accounting period, WARWICK Ltd. receives the input-VAT refund from the revenue service and pays the bill to its supplier, as well. The liability is disclosed on the statement of financial position as at 31.12.20X5 to the extent of 120,000.00 AUD. At the same time, WARWICK Ltd. discloses an input-VAT claim of 20,000.00 AUD linked to the purchase as receivables. <?page no="360"?> Berkau: Financial Statements 7e 14-360 14.6 C/ S BATHURST Ltd. - Bank Loan Next, 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 are both 2.5 %/ a. The reason for the rates being the same is that the interest is paid annually at year-ends, and that the loan is repaid exactly as it has been issued on 1.01.20X4. In preparation of the application of the effective interest method, we analyse the bank loan in terms of Mathematics. The loan is represented 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 year-ends. Therefore, the interest is paid in December for the entire year. However, BATHURST Ltd. received the payment for the loan issue 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 forward (a few hours) and place it on 31.12.20X3 at 23: 59 hours. Thus, payments during the first Accounting period in the financial plan start from an opening value of 150,000.00 AUD. The effective interest method considers an increase of the value in 20X4 based on the effective rate of interest, which gives: 150,000 × 2.5% = 3 3,750.00 AUD. Thereafter, the paid interest and the pay-off amount are deducted which gives us the closing value. In 20X4, the increase in valuation is the same as the interest paid to the bank. Therefore, only pay-off amounts are deducted. The closing value of the bank loan is: 150,000 + 3,750 - 3,750 - 15,000 = 1 135,000.00 AUD, of which 15,000.00 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 = 120,000.00 AUD. Again, 15,000.00 AUD thereof are recorded as short-term liabilities. The bank loan shows at: 120,000 - 15,000 = 1 105,000.00 AUD as you can observe in Figure 6.4. Before we change the payment terms in the case study BATHURST Ltd., we describe the recording of a loan held at amortised costs in a how-it-is-done paragraph. This is the same procedure as discussed in chapter (7) under the how-it-is-done paragraph for the effective interest method. 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 is to increase the loans value by multiplying with 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. (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 <?page no="361"?> Berkau: Financial Statements 7e 14-361 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 disclosure for BATHURST Ltd., we must change its payment terms. We consider that BATHURST Ltd. must pay for interest monthly. For 20X4, the monthly interest payments are: 3,750 / 12 = 3 312.50 AUD/ m. Although interest is paid every month, pay-off of the bank loan is due on 31.12.20X4 to its full extent of 15,000.00 AUD/ a - as before. This gives us a monthly payment vector for the first period: 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); (15,312.50)}. We calculate the internal rate of return for the above-given payment vector and come up with 0.20 83 %/ m which gives an annual rate of 2.52 88 %/ a (compound interest calculation). If we apply the formula discussed earlier in this chapter, we calculate the same effective interest rate: (1 + 2.5%/ 12) 12 - 1 = 2 2.52 88 %/ a. What is the impact of a change to monthly payments on the financial statements? We do not report monthly but disclose the total of interest (based on the effective interest rate) on the income statement. Check with step (3) of the above how-it-is-done paragraph. Hence, the monthly payments make the loan more expensive, which is approximately 2.06 AUD/ m in the cases study BATHURST Ltd. Therefore, interest increases on its income statement. Banks disclose the annual effective rate of interest in their terms and conditions T&Cs. Another reason for the effective interest rate exceeding the nominal interest is a discount regarding the issue of the bank loan. We could say the difference between issue amount for the bank loan and the sum of its pay-off payments is shed on the rate of interest. For BATHURST Ltd., we next consider 1,000.00 AUD loan closing fees is paid by BATHURST Ltd. upon loan issuance. The loan closing fee reduces the receipt from the bank in 20X4. The bank only pays 149,000.00 AUD on 1.01.20X4 for a bank loan with a principal of 150,000.00 AUD. Therefore, the bank loan's repayments exceed the initial receipt. Regarding the payment vector, only the first element changes, as interest and pay-off are based on the principal and remain the same. With the consideration of the fees, the internal rate of return for the vector increases to 2.63 42 %/ a. The increase in valuation is: 149,000 × 2.63% = 3 3,925.00 AUD. The value of the bank loan on 31.12.20X4 is: 149,000 + 3,925 - 3,750 - 15,000 = 1 134,175.00 AUD. One year later, it is: 134,175 + 3,534.48 - 3,375 - 15,000 = 1 119,334.48 AUD. From the closing values of the bank loan, a portion of 15,000.00 AUD must be disclosed as short-term debts and does not show as interest bearing liabilities on the financial statements but as short-term payables. With the application of the effective interest method, the final value of the loan becomes zero and the total of effective <?page no="362"?> Berkau: Financial Statements 7e 14-362 interest and the total of paid interest plus fees are the same. We deliberately uploaded Link 6.A as an MS-Excel file for you to make changes regarding the figures. 14.7 C/ S MEUL Ltd. - Amortised Costs Next, we explain in detail all Bookkeeping entries for a loan valuation at amortised cost for the case study MEUL Ltd. in Mossel Bay. The bank does not issue the full loan’s principal but deducts a service fee and further transaction costs. 144 Therefore, the effective interest rate exceeds the nominal rate of interest. Data Sheet for MEUL Ltd. DDomicile: South Africa (Mossel Bay). Reporting currency: ZAR. Classification: n/ a. Bank loan: 1,000,000.00 ZAR at a discount of 5 % and transaction fees of 20,000.00 ZAR. Rate of interest: 3 %/ a due at year-ends. Pay-out: 31.12.20X2. Pay-off: 250,000.00 ZAR at year-ends. Payment periods: 20X1 - 20X5. VAT n/ a. On 31.12.20X1, MEUL Ltd. takes a bank loan of 1,000,000.00 ZAR at an annual (nominal) rate of interest of 3 %/ a from FNB Bank. The bank loan is received with a discount of 5 % and once-off transaction costs (service fees) to the extent of 20,000.00 ZAR apply. A discount in connection with a bank loan means the bank pays the borrower a reduced amount based on the agreed discount rate. Here, the money received by MEUL Ltd. is: 1,000,000 × (1 - 5%) = 950,000.00 ZAR. Although the received amount is less than the principal, all interest and repayments are still based on the principal, here: 1,000,000.00 ZAR. MEUL Ltd. pays the service fees to the bank instantly. The bank loan’s annual rate of interest is 3 %/ a and payable at year-ends. The bank loan is to be paidoff every year by 250,000.00 ZAR/ a, commencing with the payment on 31.12.20X2. We calculate the annual payments in preparation of a payment vector for the entire loan. On 31.12.20X1, MEUL Ltd. receives the loan to the extent of: 1,000,000 × (1 - 5%) = 9 950,000.00 ZAR. It also pays associated transaction costs of 20,000.00 ZAR which further reduces the received cash to: 950,000 - 20,000 = 9 930,000.00 ZAR. The initial valuation is at 930,000.00 ZAR. See the Bookkeeping entries below: DR Cash/ Bank.................... 950,000.00 ZAR CR Interest Bearing Liabilities. 950,000.00 ZAR DR Transaction Costs............ 20,000.00 ZAR CR Cash/ Bank.................... 20,000.00 ZAR 144 In general, we ignore transaction costs in this textbook. However, to show its impact on the loan valuation, it is considered in this case study. <?page no="363"?> Berkau: Financial Statements 7e 14-363 The payments in the next following Accounting periods contain interest and pay-off. The latter one is constantly 250,000.00 ZAR. In contrast to repayments, interest payments are always 3 %/ a based on the periods opening value for the bank loan which is calculated as principal less accumulated pay-offs. The bank loan vector is: BL(t) = {930,000; (280,000); (272,500); (265,000); (257,500)}. For loan valuation, we apply the effective interest rate method and calculate the internal rate of return for the vector BL(t). The calculation is demanding as it requires solving the 4 th degree polynomial for the rate of interest; therefore, we take the more convenient interpolation route. We calculate an effective interest rate of 6.15 %/ a (rounded up from 6.14 94 %/ a) with the goal seek function of MS-Excel. See below the result of the interest calculation in Figure 14.1: 20X1 20X2 20X3 20X4 20X5 [ZAR] [ZAR] [ZAR] [ZAR] [ZAR] Interest (30,000) (22,500) (15,000) (7,500) loan and pay-off 930,000 (250,000) (250,000) (250,000) (250,000) eff. interest yield (930,000) 987,190 eff. interest yield (707,190) 750,678 eff. interest yield (478,178) 507,583 eff. interest yield (242,583) 257,500 0 0 0 0 0 Meul Ltd. BANK LOAN VALUATION CHART (20X1 - 20X5) Figure 14.1: Effective interest method at MEUL Ltd. To recalculate the figures, we provide the spreadsheet in Link 14.A for download: Link 14.A: MEUL Ltd. 145 The rate of internal return equals to 6.14 94104 %. MEUL Ltd. compounds the liability with 6.15 % every year and pays interest and pays-off amounts which retires the entire bank loan on 31.12.20X5. The settlement amount, calculated as the future value of MEUL Ltd.’s bank loan as at 31.12.20X5 is approximately 145 zero if we consider the payment received in 20X1 for the calculation, as well: 930,000 × (1 + 6.15%) 4 - 280,000 × (1 + 6.15%) 3 - 272,500 × (1 + 6.15%) 2 - 265,000 × (1 + 6.15%) - 257,500 = 0 0.00 ZAR. There is a rounding adjustment of 15.68 ZAR as we calculate with 6.15% instead of with the lower precise rate. <?page no="364"?> Berkau: Financial Statements 7e 14-364 After the first Accounting period as at 31.12.10X2, the Bookkeeping entries are: DR Short-term Liabilities A/ P... 250,000.00 ZAR CR Cash/ Bank.................... 250,000.00 ZAR DR Loan Expenses................ 57,189.52 ZAR CR Interest Bearing Liabilities. 57,189.52 ZAR DR Interest Bearing Liabilities. 250,000.00 ZAR CR Short-term Liabilities A/ P... 250,000.00 ZAR DR Interest-20X2................ 30,000.00 ZAR CR Cash/ Bank.................... 30,000.00 ZAR DR Interest Bearing Liabilities. 30,000.00 ZAR CR Interest-20X2................ 30,000.00 ZAR Below, we show the accounts for interest bearing liabilities, short-term liabilities, loan expenses and cash/ bank for the Accounting periods 20X1 until 20X5. The total of the expenses is: 57,189.52 + 43,487.98 + 29,405.10 + 14,917.40 = 1145,000.00 ZAR. D C D C (3) 250,000.00 (1) 950,000.00 (2) 20,000.00 (4) 20,000.00 (4) 20,000.00 c1d 680,000.00 950,000.00 950,000.00 (c) 250,000.00 b/ d 680,000.00 (d) 30,000.00 (b) 57,189.52 c2d 457,189.52 737,189.52 737,189.52 (ii) 250,000.00 b/ d 457,189.52 (iv) 22,500.00 (iii) 43,487.98 c3d 228,177.50 500,677.50 500,677.50 (B) 250,000.00 b/ d 228,177.50 (D) 15,000.00 (C) 29,405.10 c4d 7,417.40 265,000.00 265,000.00 b/ d 7,417.40 (II) 14,917.40 (III) 7,500.00 14,917.40 14,917.40 Interest bearing liabilities IBL Bank fees-20X1 FEE Figure 14.2: MEUL Ltd.’s accounts (20X1 - 20X5) <?page no="365"?> Berkau: Financial Statements 7e 14-365 D C D C (1) 950,000.00 (2) 20,000.00 c1d 250,000.00 (3) 250,000.00 c1d 930,000.00 (a) 250,000.00 b/ d 250,000.00 950,000.00 950,000.00 c2d 250,000.00 (c) 250,000.00 b/ d 930,000.00 (a) 250,000.00 500,000.00 500,000.00 (d) 30,000.00 (i) 250,000.00 b/ d 250,000.00 c2d 650,000.00 c3d 250,000.00 (ii) 250,000.00 930,000.00 930,000.00 500,000.00 500,000.00 b/ d 650,000.00 (i) 250,000.00 (A) 250,000.00 b/ d 250,000.00 (iv) 22,500.00 c4d 250,000.00 (B) 250,000.00 c3d 377,500.00 500,000.00 500,000.00 650,000.00 650,000.00 (I) 250,000.00 b/ d 250,000.00 b/ d 377,500.00 (A) 250,000.00 (D) 15,000.00 c4d 112,500.00 377,500.00 377,500.00 b/ d 112,500.00 (I) 250,000.00 c5d 145,000.00 (III) 7,500.00 257,500.00 257,500.00 b/ d 145,000.00 Cash/ Bank C/ B Short-term liabilities A/ P D C D C (b) 57,189.52 P2L 57,189.52 LE2 57,189.52 NL 57,189.52 Loan expenses-20X2 LE2 Profit and Loss-20X2 P2L D C D C (iii) 43,487.98 P3L 43,487.98 LE3 43,487.98 NL 43,487.98 Loan expenses-20X3 LE3 Profit and Loss-20X3 P3L D C D C (C) 29,405.10 P4L 29,405.10 LE4 29,405.10 NL 29,405.10 Loan expenses-20X4 LE4 Profit and Loss-20X4 P4L D C D C (II) 14,917.40 P5L 14,917.40 LE5 14,917.40 NL 14,917.40 Loan expenses-20X5 Profit and Loss-20X5 P5L Figure 14.2: MEUL Ltd.’s accounts (20X1 - 20X5) continued Interest is paid and calculated based on the principal of the bank loan which is 1,000,000.00 ZAR minus regular repayments. E.g., interest-20X2 is: 1,000,000 × 3% = 330,000.00 ZAR, and in 20X3: (1,000,000 - 250,000) × 3% = 2 22,500.00 ZAR etc. Eventually, the Cash/ Bank account’s balance in Figure 14.2 considers all payments from previous years: the initially received cash, all interest and repayments. As at 31.12.20X5, the balancing figure is: 950,000 - 20,000 - 75,000 - 4 × 250,000 = - -145,000.00 ZAR. <?page no="366"?> Berkau: Financial Statements 7e 14-366 If we add all loan expenses from the Bookkeeping entries (d), (iv), (D) and (III) we arrive at the same sum of: 57,189.52 + 43,487.98 + 29,405.10 + 14,917.40 = 1145,000.00 ZAR. This proves that the paid interest, discount and fees equal the sum of loan expenses following the effective interest method. How it is Done (Effective Interest Method for Liabilities): (1) Make sure the liability is held at amortised costs to rectify the application of the effective interest method. (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 entire payment vector. Determine the interest that applies if the present value of the payment vector becomes zero. If handy, take the iteration route e.g., as provided by goal seek-function in MS-Excel or use the function IRR() (with a German Office system it is IKV()). (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. We call that “Eff. Int. yield” in financial plans.) (6) Make Bookkeeping entries for payments. Consider short-term payments as debit entries in the Short-term Liabilities Account. (7) Record effective interest as expense through profit or loss. Why does international Accounting require applying the effective interest method? It allows a valuation that approximates the settlement value at maturity date systematically. Therefore, a bank loan that initially is underrated due to e.g., bank fees or other transaction costs, is revalued step by step until it reaches its settlement value - which is its principal. For a bank loan the effect is not as obvious as for bonds, as bonds are fully repaid at their time of maturity. See below considerations about bonds and the case study BRIZA Ltd. 14.8 Bonds Issue Borrowing through bonds is an alternative to financing with shares. A bond is a financial instrument where the bond issuer borrows from its bondholders and pays a constant interest referred to as a coupon. In contrast <?page no="367"?> Berkau: Financial Statements 7e 14-367 to a private loan, bonds are publicly issued. We classify bonds as a liability instrument which results in a bond disclosure on the credit side of the borrower's balance sheet. In general, companies and public entities, like countries or states, borrow from various investors through an intermediary e.g., a bank. Bonds are paid-off in a lump sum to the holders after a certain time which we refer to as time to maturity. Until bonds mature, the bond issuer (borrower) regularly pays an agreed interest, called the coupon. In general, the coupon rate is fixed over the entire time to maturity. As the bond issuer only pays-off at redemption, interest expenses (coupon payments) are constant over the time. Most of bonds have a 6 months -1 frequency of payments for coupons, such as paying the coupon on 30.06. and 31.12. every year. Alternatively, bonds can pay interest annually or quarterly. Mathematically, a bond at a nominal value of 10,000.00 EUR and a time to maturity of 20 years with a coupon rate of 5 %/ a is worth: 10,000 × (1 + 5%) - 20 + 500 × ((1 + 5%) 20 - 1) / ((1 + 5%) 20 × 5%) = 10,000.00 EUR. The bond valuation is based on the present value of its redemption value plus the discounted values of all coupons received until time to maturity (holder's view). The bond market rate of interest applies. For the bondholder, the valuation changes with the difference between coupon rate and market interest rate. If both rates are the same, the bond’s value is at its nominal value, referred to as the principal. If the market rate of interest decreases below the coupon rate, the value of the bond increases and vice versa. The market interest rate is the average rate for bonds. We take the bond above and calculate its value based on a market interest rate of 6 %/ a which exceeds the bond rate by 1 %/ a. The value of the bond drops then to: 10,000 × (1 + 6%) -20 + 500 × ((1 + 6%) 20 - 1) / ((1 + 6%) 20 × 6%) = 8,853.01 EUR. As bonds are listed at a percentage of their nominal value, we say the value is 88.53 (%). We now assume the market interest rate decreases to 4 %/ a: The bond’s value is now: 10,000 × (1 + 4%) -20 + 500 × ((1 + 4%) 20 - 1) / ((1 + 4%) 20 × 4%) = 11,359.03 EUR. Hence, the bond would be listed at 113.59 (%). Bonds can be traded publicly at a bond market. A price below the nominal value, say for our above discussed example at 9,000.00 EUR, makes an investor buy the bond at a discount - or below-par. A bond traded at a higher value than its principal comes with a premium - or we say: it is above-par. If the bond is sold at 9,000.00 EUR, the discounted bond’s value is 10% less than the principal. Even though, the bondholder receives 10,000.00 EUR for its redemption at the time of maturity. As closer the maturity day is, as more the listing of a bond approximates 100 (%). In Link 7.G we describe bond return figures for our case study HAVENGA Ltd. So far, we covered a bond valuation from the perspective of its holder. Based on IFRS 9.4.1.2, bonds are held at amortised costs if the business model of the bond holders indicates the bonds are not traded and payments received are for redemption or coupons only. In all other cases, IFRS 9.4.1.4 mandates a bond valuation based on fair market values either <?page no="368"?> Berkau: Financial Statements 7e 14-368 through profit or loss or through other comprehensive income for the holder. Here, we study the bond issuer (borrower): For the issuer of bonds, the price as traded at the bond market is irrelevant for their valuation as liability. Bonds are disclosed at their expected settlement values. Only if the bond redemption or the payment terms differ from full repayment at maturity date and annual payment of coupons, a bond valuation at amortised costs results in different valuations than nominal ones. In general, a company issues bonds to raise funds and agrees on a repayment obligation towards its bondholders. In contrast to shareholders, a bondholder lends the issuer money but has no say in the matter of the company’s business. A bondholder cannot decide what the company spends the funds on and how risky the business becomes. The major risk for the bondholder is that the bond issuer does not pay-off the principal at maturity or, even worse, fails paying the regular coupons, either. When a company issues a bond, it must record it as a liability. A present obligation exists to redeem the bond as well as a future obligation to pay the coupons. The disclosure on the credit side never reflects the market value at which bonds are traded, but their settlement value. Same as with loans, the borrower carries bonds at nominal costs as long as payment terms are “standard”, otherwise amortised costs apply for their disclosure. 14.9 C/ S BRIZA Ltd. - Bonds For bond recognition and disclosure on the borrower’s side, we discuss the case study BRIZA Ltd., a production firm in Melbourne. To discuss the effective interest method, the case study contains a redemption of the bonds after the time to maturity at a premium. Otherwise, the bond disclosure would be trivial: at nominal settlement value. Data Sheet for BRIZA Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: n/ a. Bonds: 10,000,000.00 AUD. Pay-out: 31.12.20X3. Payment periods: 20X3 - 20X8. Redemption at 4 % premium. Annual coupon: 6 %/ a. Transaction fee: 25,000.00 AUD. VAT n/ a. On 31.12.20X3, BRIZA Ltd. issues 1,000,000 bonds at 10.00 AUD/ b with a time to maturity of 5 years. The redemption of the bonds is agreed to take place on 31.12.20X8 at a premium of 4 %. Therefore, the payment when the bonds mature is: (1 + 4%) × 10,000,000 = 10,400,000.00 AUD. During the time to maturity, BRIZA Ltd. pays annually a coupon of 6 %/ a based on the principal, 600,000.00 AUD/ a. For the bondholders the total bond’s value is as long as the market interest rate stays at 6%: 600,000 × ((1 + 6%) 5 - 1) / (6% × (1 + 6%) 5 ) + 10,400,000 × (1 + 6%) -5 = 10,298,903.27 AUD. The difference to its nominal value results from the premium. Following IFRSs, BRIZA Ltd. carries the bonds at amortised costs. BRIZA Ltd. has no intention/ possibility to transfer the bonds. The bond’s payment in the last Accounting period on 31.12.20X8 is: <?page no="369"?> Berkau: Financial Statements 7e 14-369 10,400,000 + 600,000 = 1 11,000,000.00 AUD. For the bond issue, BRIZA Ltd.’s bank charges a service fee of 25,000.00 AUD. The bond’s payment vector therefore is: BND (t) = {9,975,000; (600,000); … ; (600,000); -11,000,000)}. We calculate the internal rate of return by solving the equation: 0 = 9,975,000 - (600,000 × ((1 + r) 5 - 1)/ (r × (1 + r) 5 ) - (10,000,000 + 400,000) × (1 + r) -5 for its interest rate r. The iteration calculates an effective interest rate of 6.76 %/ a (rounded). We calculate the effective rate of interest with the goal-seek-function in MS-Excel. We require the final value (bottom line, right) to become zero if the rate of effective interest which applies to compound bond values changes. On the bond valuation chart in Figure 14.3 the columns for 20X5 and 20X6 are hidden for the sake of space. 20X3 20X4 20X7 20X8 [AUD] [AUD] [AUD] [AUD] Bond 9,975,000.00 (600,000.00) (600,000.00) (11,000,000.00) eff. int. (9,975,000.00) 10,649,259.09 eff. int. (10,049,259.09) eff. int. eff. int. 10,903,533.70 eff. int. (10,303,533.70) 11,000,000.00 total: - - - (0.00) Briza Ltd.'s BOND VALUATION CHART (20X3 - 20X8) Figure 14.3: Effective interest calculation at BRIZA Ltd. The bond is valued initially at issue proceeds of: 10,000,000 - 25,000 = 9,975,000.00 AUD. For the following Accounting periods, we prepare a bond calculation table as shown in Figure 14.4. For teaching purposes, we disclose the bond’s valuation before redemption. After redemption, the value of the bond becomes zero as the bond will be de-recognised. No bond is disclosed on BRIZA Ltd.’s statement of financial position as at 31.12.20X8. The valuation starts from 9,975,000.00 AUD and approximates 10,400,000.00 AUD within five years. <?page no="370"?> Berkau: Financial Statements 7e 14-370 Previous valuation b/ d Effective interest Coupon Bond value c/ d [AUD] [AUD] [AUD] [AUD] 20X4 9,975,000.00 674,259.09 (600,000.00) 10,049,259.09 20X5 10,049,259.09 679,278.63 (600,000.00) 10,128,537.72 20X6 10,128,537.72 684,637.46 (600,000.00) 10,213,175.18 20X7 10,213,175.18 690,358.52 (600,000.00) 10,303,533.70 20X8 10,303,533.70 696,466.30 (600,000.00) 10,400,000.00 Briza Ltd. BOND CALCULATION (20X4 - 20X8) Figure 14.4: BRIZA Ltd.’s bond calculation When the bonds mature on 31.12.20X8, BRIZA Ltd. records the payments to its lenders as displayed below after making payments for the coupon. The bond is redeemed with a premium. The bondholders in total receive: 10,000,000 × (1 + 4%) = 110,400,000.00 AUD. DR Short-term Liabilities....... 10,400,000.00 AUD CR Cash/ Bank.................... 10,400,000.00 AUD 14.10 C/ S MEMEL PLC - Annuity and Extra Repayments An annuity is a bank loan with a constant payment which includes interest and pay-off. Interest is to be paid based on the amount owed at the beginning of the interest bearing period. Our conventions in chapter (1) state that interest compounds annually. However, an interest period of less than 1 year is calculated per rate and accurate to a month. Next, we discuss an annuity at MEMEL PLC in Manchester. Data Sheet for MEMEL PLC Domicile: Great Britain (Manchester). Reporting currency: GBP. Classification: n/ a. Bank loan (annuity): 100,000.00 GBP. Pay-out: 2.01.20X2. Payment periods: 20X2 - 20X4. Rate of interest: 4 %/ a. Extra pay-off: 1.07.20X3; 1.07.20X4. VAT n/ a. On 2.01.20X2, MEMEL PLC takes a bank loan of 100,000.00 GBP. The loan is an annuity with annual payments of 25,000.00 GBP/ a due at the end of the Accounting periods. In the years 20X3 and 20X4, an extra pay-off of 7,500.00 GBP is required on 1.07. as per bank loan agreement. The annual rate of interest for the bank loan is 4 %/ a. We prepare an interest and pay-off schedule for MEMEL PLC’s bank loan. It is displayed in Figure 14.5. <?page no="371"?> Berkau: Financial Statements 7e 14-371 Year Opening amount Interest Pay-off Annuity Rest [GBP] [GBP] [GBP] [GBP] [GBP] 20X2 100,000.00 4,000.00 21,000.00 25,000.00 79,000.00 1-6/ 20X3 79,000.00 1,580.00 7,500.00 71,500.00 7-12/ 20X3 71,500.00 1,430.00 21,990.00 25,000.00 49,510.00 1-6/ 20X4 49,510.00 990.20 7,500.00 42,010.00 7-12/ 20X4 42,010.00 840.20 23,169.60 25,000.00 18,840.40 20X5 18,840.40 753.62 18,840.40 19,594.02 (0.00) Memel PLC INTEREST and PAY-OFF SCHEDULE as at 31.12.20X2 Figure 14.5: MEMEL PLC’s annuity (20X2) The interest is calculated in 20X3 and 20X4 in 6 months intervals. That is why we disclose two lines per period for 20X3 and 20X4. The interest in the first half of 20X3 is: 79,000 × 4%/ 2 = 1 1,580.00 GBP. Despite of its calculation in two steps, MEMEL PLC makes the interest payment only on 31.12.20X3. The extra pay-off amount is deducted from the bank loan’s current value which gives us the amount MEMEL PLC is owing on 1.07.20X3: 79,000 - 7,500 = 7 71,500.00 GBP. The debts reduced by the extra payment determine the interest for the 2 nd half of 20X3 to the extent of: 71,500 × 4%/ 2 = 11,430.00 GBP. As the bank loan is an annuity, the interest calculated is included in the payment of 25,000.00 GBP/ a due at the end of 20X3. Accordingly: 25,000 - 1,580 - 1,430 = 21,990.00 GBP are paid off. The calculation in 20X4 follows the same steps. In 20X5, MEMEL PLC only pays-off 18,840.40 GBP which is the remainder. No extra re-payment is scheduled for 20X5. Below, we discuss the disclosure of the bank loan on MEMEL PLC’s balance sheet. For its disclosure as at 31.12.20X2, the payments for 20X2 do not matter as they have been paid already. The pay-off portion of the annuity including the extra pay-off in 20X3 to the extent of: 21,990 + 7,500 = 2 29,490.00 GBP are disclosed as short-term liabilities. As MEMEL PLC cannot transfer its liabilities, it must apply the effective interest method and carry the loan at its amortised costs. In academia, It is always a good idea, to determine a vector for the future payments as it provides us with an overview and allows internal rate of return calculations in MS-Excel. The vector is in arrears in terms of Mathematics. Therefore, we allocate the payment of 100,000.00 GBP to 20X1, which means on 31.12.20X1 - a few hours earlier than actually paid. In 20X2, MEMEL PLC pays the annuity of 25,000.00 GBP/ a. In 20X3 and 20X4, the paid amounts are: 25,000 + 7,500 = 3 32,500.00 GBP/ a each. In 20X5, the payment adds up to: 18,840.40 + 753.62 = 1 19,594.02 GBP. The vector for the annuity is: A(t) = {100,000; (25,000); (32,500); (32,500); (19,594.02)}. With this vector we consider 4 periods of interest, as the vector considers interest between the periods. We calculate an internal rate of return <?page no="372"?> Berkau: Financial Statements 7e 14-372 by MS-Excel (IRR-function) and get a rounded percentage of 3.88 %/ a. 146 See the financial schedule for the annuity in Figure 14.6. 20X1 20X2 20X3 20X4 20X5 [GBP] [GBP] [GBP] [GBP] [GBP] A(t) 100,000.00 (25,000.00) (32,500.00) (32,500.00) (19,594.02) eff. int. (100,000.00) 103,881.29 eff. int. (78,881.29) 81,942.91 eff. int. (49,442.91) 51,361.93 eff. int. (18,861.93) 19,594.02 0.00 0.00 0.00 0.00 0.00 MEMEL PLC FINANCIAL SCHEDULE (20X1 - 20X5) Figure 14.6: MEMEL PLC’s financial plan In 20X2, we consider the valuation based on the effective rate of interest. The actual payment is the annuity, and we take out an amount of 29,490.00 GBP for short term-liabilities at the end of the year. As a result, the bank loan is disclosed in 20X2 at: 100,000 + 3,881.29 - 25,000 - 29,490 = 4 49,391.29 GBP. The measurement for the loan in the following Accounting periods can be taken from Figure 14.7. c/ d Eff int. Annuity Short-term liab. b/ d [GBP] [GBP] [GBP] [GBP] [GBP] 20X2 100,000.00 3,881.29 (25,000.00) (29,490.00) 49,391.29 20X3 78,881.29 3,061.61 (32,500.00) (30,669.60) 18,773.31 20X4 49,442.91 1,919.02 (32,500.00) (18,840.40) 21.53 20X5 18,861.93 732.09 (19,594.02) 0.00 0.00 MEMEL PLC BANK LOAN CALCULATION (20X1 - 20X5) Figure 14.7: MEMEL PLC’s disclosure of annuity Observe the accounts at MEMEL PLC in Figure 14.8. 146 You might be surprised that the effective rate of interest drops below the nominal interest. The reason is that in 20X3 and 20X4 interest is calculated accurate to 6 months, but the vector places the pay-off payment to the year-ends. <?page no="373"?> Berkau: Financial Statements 7e 14-373 D C D C (1) 100,000.00 (2) 4,000.00 (2) 4,000.00 (1) 100,000.00 (3) 21,000.00 (3) 21,000.00 (5) 3,881.29 c2d 75,000.00 (4) 29,490.00 100,000.00 100,000.00 c2d 49,391.29 b/ d 75,000.00 (A) 29,490.00 103,881.29 103,881.29 (B) 3,010.00 (B) 3,010.00 b/ d 49,391.29 c3d 42,500.00 (E) 30,669.60 (C) 3,061.61 75,000.00 75,000.00 c3d 18,773.31 b/ d 42,500.00 (a) 30,669.60 49,442.91 52,452.91 (b) 1,830.40 (b) 1,830.40 b/ d 18,773.31 c4d 10,000.00 (e) 18,840.40 (c) 1,919.02 42,500.00 42,500.00 c4d 21.53 b/ d 10,000.00 (i) 18,840.40 20,692.33 20,692.33 c5d 9,594.02 (ii) 753.62 (ii) 753.62 b/ d 21.53 19,594.02 19,594.02 (iii) 732.09 b/ d 9,594.02 753.62 753.62 Cash/ Bank Interest bearing liabilities IBL D C D C c2d 29,490.00 (4) 29,490.00 P2L 3,881.29 c2d 3,881.29 (A) 29,490.00 b/ d 29,490.00 b/ d 3,881.29 c3d 30,669.60 (E) 30,669.60 P3L 1,919.02 c3d 5,800.32 60,159.60 60,159.60 5,800.32 5,800.32 (a) 30,669.60 b/ d 30,669.60 b/ d 5,800.32 c4d 18,840.40 (e) 18,840.40 P4L 0.00 c4d 5,800.32 49,510.00 49,510.00 5,800.32 5,800.32 (i) 18,840.40 b/ d 18,840.40 b/ d 5,800.32 P5L 3,881.29 c5d 9,594.02 9,681.61 9,594.02 b/ d 9,594.02 Short-term liabilities A/ P Retained earnings R/ E D C D C (5) 3,881.29 P2L 3,881.29 LE2 3,881.29 R/ E 3,881.29 Loan expenses-20X2 LE2 Profit and Loss-20X2 P2L D C D C (C) 3,061.61 P3L 3,061.61 LE3 3,061.61 R/ E 3,061.61 Loan expenses-20X3 LE3 Profit and Loss-20X3 P3L D C D C (c) 1,919.02 P4L 1,919.02 LE4 1,919.02 R/ E 1,919.02 Loan expenses-20X4 LE4 Profit and Loss-20X4 P4L Figure 14.8: MEMEL PLC’s accounts (20X2 - 20X5) <?page no="374"?> Berkau: Financial Statements 7e 14-374 D C D C (iii) 732.09 P4L 732.09 LE4 732.09 R/ E 732.09 Loan expenses-20X5 LE5 Profit and Loss-20X5 P5L Figure 14.8: MEMEL PLC’s accounts (20X2 - 20X5) continued 14.11 Provisions Following IFRSs, provisions fall under liabilities, too. IAS 37.10 defines provisions as liabilities of uncertain timing and/ or value. Besides of uncertainty, a provision requires the existence of a present obligation, such as resulting from a contract, derived from a pending lawsuit etc. IAS 37.13 states that provisions are based on a present obligation that must exist at the time of reporting. In compliance with IAS 37.27, contingent liabilities are not recognised on financial statements. A contingent liability is caused by future event(s). Its definition criteria are weaker than those for provisions. A contingent liability is either only a predicted future obligation or a present obligation that results in an outflow of future economic benefits but cannot be measured reliably. IAS 37.13 compares provisions with contingent liabilities. The recognition criteria for provisions are set in IAS 37.14: 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 pre-tax value of the expenses to settle the present obligation as known at the time of reporting. A company must calculate the value of a provision as its best estimate, see the case in IAS 37.39. We here provide you with a similar example for a manufacturing company. Data Sheet for SEENA Ltd. Domicile: Netherlands (Enschede). Reporting currency: EUR. Classification: Production. Output: 500,000 backpacks Minor damage 5.00 EUR; probability 10 %. Major damage: 37.00 EUR; probability 3 %. VAT n/ a. The production firm SEENA Ltd. produces backpacks. Faulty products are returned and must undergo rework. SEENA Ltd. knows if minor defects, like a not properly closing zipper, emerge during the next Accounting period 20X9, the damage per backpack will be 5.00 EUR/ backpack. If a major defect occurs e.g., a belt is not fixed properly or the fabric tears-off, the damage will be 37.00 EUR/ backpack. SEENA Ltd. produces 500,000 backpacks and knows from own experience that the probability for minor defects is 10 % and for major defects 3 %. On the balance sheet date 31.12.20X8, SEENA Ltd. calculates the best estimate for rework. It is: 500,000 × (10% × 5 + 3% × 37) = 805,000.00 EUR in the next Accounting period. Therefore, SEENA Ltd. recognises <?page no="375"?> Berkau: Financial Statements 7e 14-375 a provision of 805,000.00 EUR on its balance sheet for 20X8. The Bookkeeping entry is as below: DR Repair....................... 805,000.00 EUR CR Provisions................... 805,000.00 EUR In 20X9, SEENA Ltd. reworks backpacks at an expense of 750,000.00 EUR. As the previously recorded provisions for rework during the Accounting period 20X9 are no longer required they must be dissolved. IAS 37.61 requires provisions only to be used for expenditures they have been recognised for. The reason is that provisions are future but uncertain liabilities. Therefore, provisions reduce the taxable profit as they lead to a disclosure of expenses in the Accounting period when the reason for the provision comes to light. SEENA Ltd. makes the Bookkeeping entry below in 20X9. DR Provisions................... 805,000.00 EUR CR Repairs...................... 55,000.00 EUR CR Cash/ Bank.................... 750,000.00 EUR The credit entry in the Repairs account cancels out the overrated expenses recorded together with the provision in the previous Accounting period. Dissolving a provision works like a negative expense recognition, because the expenses have been considered in the previous Accounting period’s income statement already. In general, provisions reduce operating profits in the Accounting period of their recognition. Therefore, IAS 37.17 allows a recognition of provisions only if an event exists that causes the obligation e.g., a contract enforceable by law or an action causing justified expectations of other parties that lead to a future outflow of economic benefits. 147 Read our textbook Basics of Accounting, chapter (15). IAS 37.18 emphasis that any provision or liability requires a present obligation to exist at the reporting Accounting period’s end. In line with IAS 37.19, a provision must be unavoidable for the reporting company. The paragraph describes a future obligation to build-in filters for a certain kind of factory as avoidable because the company can change its process of manufacturing. In contrast, an already existing environmental damage caused by operating a power plant rectifies a provision as the damage has been done and requires future clean-up costs. 147 Situations that require provisions are, e.g.: - Agreement between a company and its employee to pay a pension. <?page no="376"?> Berkau: Financial Statements 7e 14-376 - 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. - 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 aspects of the measurement and disclosure of provisions. (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 adds a paragraph to the labour contract with its chief operating officer COO, Mrs Gartner, to pay her a pension after her board membership ends for the next following 4 years to the extent of annually 1,000,000.00 ZAR/ a, payable at the end of every year. It is assumed that Mrs Gartner will resign at the end of 20X5. Data Sheet for HADRA (Pty) Ltd. DDomicile: South Africa (Stellenbosch). Reporting currency: ZAR. Classification: n/ a. Pension plan: 4 × 100,000.00 ZAR/ a. Pension periods: 20X6, 20X7, 20X8, 20X9. At the time of filing the agreement, Mrs Gartner’s career plans or circumstances are uncertain. The agreement is uncertain in terms of the timing. There is a present obligation as the contract is enforceable. Therefore, a provision applies. IAS 37.45 requires the provision to be measured at its discounted best estimate. Present value disclosure applies if the discounting is material. IAS 37.47 defines the discount rate to be the pre-tax market rate for such a liability. We consider the market rate to be 10 %/ a. As the agreement between HADRA (Pty) Ltd. and Mrs Gartner has been filed in 20X2, a provision applies to be disclosed on the 20X2 financial statements. On 31.12.20X2, HADRA (Pty) Ltd. recognises on its balance sheet a provision: (1 + 10%) -3 × 1,000,000 × ((1 + 10%) 4 - 1) / ((1 + 10%) 4 × 10%) = 2 2,381,566.83 ZAR. HADRA (Pty) Ltd. makes the Bookkeeping entry as below: DR Labour....................... 2,381,556.83 ZAR CR Provisions................... 2,381,556.83 ZAR The provision is based on an annuity of 4 payments at the end of 20X6 - 20X9. The payments are discounted for 3 periods (20X2 to 20X5), as the present value is initially calculated by the annuity as at 31.12.20X5. This is the time of the expected resign but the provision is disclosed 3 years earlier, on 31.12.20X2. <?page no="377"?> Berkau: Financial Statements 7e 14-377 IFRSs treat provisions and liabilities differently. Liabilities are carried at fair values or, in case they are kept to maturity and the settlement value is known (default case), they must be disclosed at amortised costs. In contrast, a provision must be measured at present values which is the valuation at present time. Due to compound interest calculations, provisions are measured 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 signs a waiver declaration in favour of HADRA (Pty) Ltd., the provision is 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 100,000.00 ZAR/ a for a period of 4 years due to an estimated rework plan for delivered, faulty goods produced in the past. The annual payment of 100,000.00 ZAR/ a is only an estimate and therefore, the liability is classified as uncertain. It requires the disclosure of a provision. Data Sheet for DUMMOND (Pty) Ltd. DDomicile: South Africa (Atlantis). Reporting currency: ZAR. Classification: n/ a. Rework plan: 4 × 100,000.00 ZAR/ a. Provision disclosed in 20X2. On 2.01.20X2, DUMMOND (Pty) Ltd. in Atlantis learns that it must pay 400,000.00 ZAR for a 4-years-period to fulfil its re-work obligations. DUMMOND (Pty) Ltd. must rise a provision on 31.12.20X2. DUMMOND (Pty) Ltd. dissolves 100,000.00 ZAR of its re-work provision every Accounting period. We assume payments are due on year-ends. We apply a spreadsheet based on the CH5.xls file available on the study material portal for this textbook. As the provision is recorded in January for the first time, it is initially shown on the financial statements as at 31.12.20X2. Until that time, no discounting is calculated. Link 14.B: DUMMOND (Pty) Ltd. See below in Figure 14.9 the calculation for the provision and the first payment in 20X2. Note, that DUMMOND (Pty) Ltd. made payments before the provision is recognised. <?page no="378"?> Berkau: Financial Statements 7e 14-378 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 14.9: DUMMOND (Pty) Ltd.’s provisions (1) The dissolving of a portion of 100,000.00 ZAR results in a payment to the customers involved. You find the Bookkeeping entries (1) to (2) below. DR Re-work Expenses............. 100,000.00 ZAR CR Cash/ Bank.................... 100,000.00 ZAR DR Re-work Expenses............. 300,000.00 ZAR CR Provision.................... 300,000.00 ZAR After the above transactions, DUMMOND (Pty) Ltd. is left with 300,000.00 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 rework expected. (4) Make a debit entry for the rework in the Rework account and a credit entry in the Provisions account. (5) If the time value of money is material for valuation, discount provisions as shown further below. <?page no="379"?> Berkau: Financial Statements 7e 14-379 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 100,000.00 ZAR each, together they are 300,000.00 ZAR. We call this the settlement value, as the payments are due on 31.12.20X3, 31.12.20X4, 31.12.20X5 to pay-off the estimated re-work obligations. To determine the fair value of the settlement value, DUMMOND (Pty) Ltd. cannot simply disclose 300,000.00 ZAR in debts. For the consideration of the time value of money, a lower, discounted value applies. For the interest calculation, we apply the textbook rate of interest of 10 %/ a. In a real company, you must calculate with the average rate of interest that applies for an additional bank loan. The IASB calls this rate the incremental borrowing rate. It considers that a company already in debts is charged higher interest rates to factor in the increased risk for the lender. Here, it is sufficient if DUMMOND (Pty) Ltd. measures the 20X3’s payment at: 100,000/ (1 + 10%) -1 = 990,909.09 ZAR. On the spreadsheet in Figure 14.10 we calculate present values for the remaining two payments reserved for 20X4’s and 20X5’s re-work. 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 14.10: DUMMOND (Pty) Ltd.’s provisions (2) For the measurement of the provision, DUMMOND (Pty) Ltd. must discount it as at 31.12.20X2. The provisions’ fair value is its present value: 90,909.09 + 82,644.63 + 75,131.48 = 2 248,685.20 ZAR. There is a difference between the rework expenses due and the provisions’ fair value of: 400,000 - 100,000 - 248,685.20 = 5 51,314.80 ZAR. The difference is deducted from provisions and temporarily carried in the Retained Earnings account. See the Bookkeeping entry (3) below: DR Interest Bearing Liabilities. 51,314.80 ZAR CR Retained Earnings............ 51,314.80 ZAR <?page no="380"?> Berkau: Financial Statements 7e 14-380 The difference in the provision measurement is temporary as in the next Accounting period, DUMMON (Pty) Ltd. must revalue the provisions. It also must check the estimated measurement for re-work and whether the need for disclosure of the provision still exists. It could change e.g., if the customers do not claim. We here assume, the estimated payment obligation for reworking the goods remains, only the revaluation of the provisions based on the compounding matters. See below the calculation of the provisions’ present value as at 31.12.20X3 in Figure 14.11. 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 14.11: DUMMOND (Pty) Ltd.’s provisions (3) In 20X3, the payment obligation for 20X3 is due and 100,000.00 ZAR in provisions are dissolved for the payment. At first, we transfer the amounts to shortterm liabilities and make payments on 31.12.20X3. Before the payment, the provisions are compounded towards: 90,909.09 × (1 + 10%) = 1 100,000.00 ZAR. The remainder provision for future payments is revalued, too. The values for 20X4 and 20X5 are multiplied with the factor (1 + 10%) and result in: 82,644.63 × (1 + 10%) = 9 90,909.09 ZAR and: 75,131.48 × (1 + 10%) = 8 82,644.63 ZAR respectively. The entire revaluation increases the value of the provisions to the extent of: (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 all revaluations together as below (a): DR Retained Earnings............ 24,868.52 ZAR CR Interest Bearing Liabilities. 24,868.52 ZAR Bookkeeping entry (b) and (c) are for dissolving of 20X3’s provision. You find all Bookkeeping entries for the Accounting periods 20X2 - 20X5 in Figure 14.13. Check below in Figure 14.12 the recalculation of DUMMOND (Pty) Ltd.’s provisions in 20X4. <?page no="381"?> Berkau: Financial Statements 7e 14-381 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 14.12: DUMMOND (Pty) Ltd.’s provisions (4) Note, that the re-work expenses are only disclosed in 20X2. That is the year when the obligation for re-work was detected. No expenses are recorded in the years thereafter as the provisions are dissolved without an impact on profits or losses. It reflects that the estimated costs at the time of rising the provision are as high as the actual ones. For that reason, no Profit and Loss accounts for 20X3 - 20X5 is shown in Figure 14.13. D C D C (1) 100,000.00 P2L 400,000.00 (c) 100,000.00 (b) 100,000.00 (2) 300,000.00 (C) 100,000.00 (B) 100,000.00 400,000.00 400,000.00 (III) 100,000.00 (II) 100,000.00 Re-work-20X2 REW Short-term liabilitiy A/ P D C D C (3) 51,314.80 (1) 300,000.00 . . . (1) 100,000.00 c/ d 248,685.20 c/ d 100,000.00 300,000.00 300,000.00 100,000.00 100,000.00 (b) 100,000.00 b/ d 248,685.20 c/ d 100,000.00 c/ d 173,553.72 (a) 24,868.52 c/ d 200,000.00 (c) 100,000.00 273,553.72 273,553.72 200,000.00 200,000.00 (B) 100,000.00 b/ d 173,553.72 b/ d 200,000.00 c/ d 90,909.09 (A) 17,355.37 c/ d 300,000.00 (C) 100,000.00 190,909.09 190,909.09 300,000.00 300,000.00 (II) 100,000.00 b/ d 90,909.09 b/ d 300,000.00 (I) 9,090.91 c/ d 400,000.00 (III) 100,000.00 100,000.00 100,000.00 400,000.00 400,000.00 Provision PRO Cash/ Bank C/ B Figure 14.13: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) <?page no="382"?> Berkau: Financial Statements 7e 14-382 D C D C P2L 400,000.00 (4) 51,314.80 REW 400,000.00 R/ E 400,000.00 c/ d 348,685.20 400,000.00 400,000.00 b/ d 348,685.20 (a) 24,868.52 c/ d 373,553.72 373,553.72 373,553.72 b/ d 373,553.72 (A) 17,355.37 c/ d 390,909.09 390,909.09 390,909.09 b/ d 390,909.09 (I) 9,090.91 c/ d 400,000.00 400,000.00 400,000.00 b/ d 400,000.00 Retained earnings R/ E Profit and loss-20X2 P2L Figure 14.14: DUMMOND (Pty) Ltd.'s accounts (20X2 - 20X5) continued How it is Done (Discounting Provisions): (1) Calculate the payment vector elements 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 period and the reporting period. (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 elements by multiplying with the factor (1 + dr). This is referred to as compounding provisions. (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="383"?> Berkau: Financial Statements 7e 14-383 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 contract. An onerous contract only exists if both parties are bound to the contract. IAS 37.68 defines the contact to become onerous, if unavoidable costs resulting from the contract exceed economic benefits thereof. We study the case of the airline SALMAN Ltd., which scheduled a flight and sold tickets already. Due to an increase of costs the contract with the passengers becomes onerous for SALMAN Ltd. Data Sheet for SALMAN Ltd. CClassification: Aviation (Sydney). Flight SM050 on 10.05.20X5 PER-MEL Expected revenue: 75,000.00 AUD Costs: 400.00 AUD/ p. - 200 passengers Increase of costs: 10,000.00 AUD Provision disclosed: 31.12.20X2. VAT n/ a. SALMAN Ltd. is an airline headquartered in Sydney. To compete with other service providers, SALMAN Ltd. offers tickets for sale one year in advance. For its flight SM050 scheduled on 10.05.20X5 with an Airbus A321 from Perth to Melbourne, SALMAN Ltd. calculated a ticket price of 400.00 AUD/ passenger. The aircraft is a 200 seater and is fully booked on 31.12.20X4. The expected revenue is: 400 × 200 = 8 80,000.00 AUD. Operational flight expenses include crew labour, airport fees, fuel and depreciation. The total costs for the flight are calculated to be 75,000.00 AUD. Due to an increase of airport landing fees in Melbourne, the scheduled and sold flight becomes 10,000.00 AUD more expensive. On 31.12.20X4, SALMAN Ltd. records a provision due to an onerous contract to the extent of: 75,000 + 10,000 - 80,000 = 5,000.00 AUD. The flight has not yet taken place; hence, no certain liability exists. The contract between the passengers and the airline is binding. Therefore, SALMAN Ltd. cannot avoid the airport fees as the flight is scheduled for the route Perth-Melbourne. A deviation of the flight to Adelaide to avoid airport fees is no option but might become inevitable if pilots decide on short notice to divert the flight to its alternate Adelaide according to the flight plan. This only can be done in a case of emergency. SALMAN Ltd. makes the Bookkeeping entry below: DR Loss on Onerous Flight....... 5,000.00 AUD CR Provisions................... 5,000.00 AUD The provision is necessary as the user of SALMAN Ltd.’s financial statements must be informed about the potential loss, caused by actions and events in 20X4 which leads to an onerous contract in the next Accounting period. A present obligation to operate the flight exists because of the ticket sales. The flight costs are not certain but are calculated based on best estimates (assumingly landing in Melbourne). The expenses for the onerous contract are recorded in the reporting Accounting period 20X4 through profit or loss. <?page no="384"?> Berkau: Financial Statements 7e 14-384 How it is Done (Provisions for Onerous Contracts): (1) Determine whether an onerous contract exists. Is the contract binding? Does it most-probably lead to a loss? (2) Calculate the loss expected from fulfilling the contractual obligations as best estimate at the time of recording. (3) Make a debit entry in the Loss on Onerous Contract account and a credit entry in the Provisions account. (4) Check whether discounting of the provision applies. 14.16 Summary Liabilities are present obligations that result in an outflow of economic benefits, most likely in a cash outflow. Short-term liabilities are due within one Accounting period and are disclosed under the item accounts payables A/ P on the balance sheet. They are measured by their present obligation e.g., the money owed. About longterm debts, IFRSs distinguish three kinds of liabilities: certain liabilities e.g., bank loans or bonds, uncertain liabilities e.g., provisions, and contingent liabilities without a present obligation or which do not fulfil requirements for a liability disclosure. The latter ones are not disclosed on financial statements. As most companies do not intend to pass on certain liabilities to other parties (lender swop), they must be carried at amortised costs. In contrast, provisions are measured at present values if the time value of money is material - which in most of the cases applies. The reporting company must explain liabilities in the notes where further debt information, like about securities, is provided. 14.17 Working Definitions Annuity: Bank loan with a constant payment for interest and pay-off. Amortised Costs: To carry an asset or liabilities at amortised costs is a simplification of its measurement accepted for financial instruments that are intended to keep until maturity. It replaces a 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. Contingent Liability: Liability that is uncertain, not present and/ or does not fulfil recognition requirements. Effective Interest Method: Valuation of a liability or financial instrument measured by a payment vector with revaluation of its elements based on internal rate of return calculation. The effective rate of interest calculation requires iterations. Fair Value: Measurement of an asset/ liability as it is transferred at on an active market e.g., a bond price. Liabilities: Present obligation that results in future outflow of economic benefits. Onerous Contract: A contract a loss is most probably expected to result <?page no="385"?> Berkau: Financial Statements 7e 14-385 from, as it is likely that expenses exceed revenues. Present Obligation: An obligation that exists at the reporting date (31.12.20XX). Present Value: Valuation where discounted values apply for measurement. Provision: Uncertain liability which is uncertain regarding time and/ or contractual settlement (mostly payment). Also, the provision can be uncertain of occurrence. IAS 37 rules provisions. Provisions require a present obligation at the time of reporting. 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 expects to be fined based on a pending court case by 100,000.00 EUR. The probability to pay the penalty is 40 %. What is the correct Bookkeeping entry at the year-end? 1. DR Expenses … 60,000.00 EUR - CR Provisions … 60,000.00 EUR. 2. DR Expenses … 100,000.00 EUR - CR Provisions … 100,000.00 EUR. 3. DR Expenses … 50,000.00 EUR - CR Provisions … 50,000.00 EUR. 4. DR Expenses … 40,000.00 EUR - CR Provisions … 40,000.00 EUR. (3) A company issued bonds at 1,000,000.00 EUR with a discount of 10 %. The coupon rate is 5 %/ a. The bank charges 50,000.00 EUR issue fees and the effective rate of interest is 6.4 %. How much are expenses to be recorded in the first Accounting period? 1. 100,000.00 EUR . 2. 64,000.00 EUR . 3. 54,400.00 EUR . 4. 57,600.00 EUR . (4) A parent vouches for a subsidiary in another country and provides the bank with its financial statements following IFRSs. The agreement is that the parent will pay for the liabilities of its subsidiary in case the subsidiary becomes insolvent. How is the situation disclosed on the financial statements of the parent? 1. Contingent liability. 2. Provision. 3. Liability. 4. N/ a. (5) On 1.01.20X3, a company takes a bank loan of 100,000.00 EUR with a 3 % discount. The bank loan comes with a rate of interest of 5 %/ a and a fixed pay-off amount of 25.000.00 EUR/ a. What is the payment vector B(t) for the Accounting periods 20X3 - 20X6 if interest and pay-off is paid at the year-ends? 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)}. <?page no="386"?> Berkau: Financial Statements 7e 14-386 14.19 Solutions 1-2, 2-4, 3-3, 4-4, 5-2. <?page no="387"?> Berkau: Financial Statements 7e 15-387 15 Abbreviations / a per annum, per year Acc Accounting ACC Accumulated Depreciation Acc Depr Accumulated Depreciation Acc IL Accumulated Impairment Loss Adj, adj Adjustment, adjusted Afa Absetzung für Abnutzung AGB Australian Government Bond AGM Annual General Meeting Aggr. Aggregated AIL Accumulated Impairment Loss AO Abgabenordnung A/ P Accounts Payables A/ R Accounts Receivables A/ S Annual Surplus A(t) Annuity Vector ATM Automatic Teller Machine AUD Australian Dollar / b per Bond Bal Balance BCE Business Car Expenses Bear. Bearing BHD Berhad, legal form of a public limited company in Malaysia BKW Burger King Worldwide BL(t) Bank Loan Vector BoE Books of Original Entry BOM Bill of Materials b/ d Balance brought down BNK Bank account BP Business Plan B/ S, BS Balance Sheet C Credit CA Carrying Amoung, Carrying Value CAR Business Car Expenses CapRes Capital Rerserves CB Cash Book C/ B Cash/ Bank CC Cost Centre CCDU Coffee-Capsule-Dispense-Unit CD Compact Disk, Cost Driver CEO Chief Executive Officer c/ d Balance carried down <?page no="388"?> Berkau: Financial Statements 7e 15-388 c1d Balance carried down on 31.12.20X1 c/ f carried forward (Profit) CFO Chief Financial Officer, Accountant CFS Statement of Cash Flows CIPC Companies and Interlectual Property Commission, SA CGG Council Cooperation for the Arab States in the Gulf CH5.xls Excelfile linked to Chapter 5 of the textbook Basics of Accounting CIPC Companies and Intellectual Property Commission C, L Capital, Liabilities COH Conveyancing Overhead Account 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 CSH Cash D Debit / d per day D/ A Discount Allowed DEC Decoration Costs Dep Department Depr., DPR Depreciation DIV Dividend DR Debit Recorded, Debit Entry DR discount rate D/ R Discount received DRW Drawing DTE Deferred Tax Expenses DTI Deferred Tax Income DTL Deferred Tax Liabilities D2E Dept-to-Equity EAT Earnings After Taxes EBIT Earnings Before Interest and Taxes EBK Eröffnungsbilanzkonto EBT Earnings Before Taxes Eff. Effective e.g. Esempli gratia, for example EPS Earnings Per Share EStG Einkommensteuergesetz EUR Euro, Europe EVA Economic Value Added EXP Expense F Conceptual Framework of Financial Reporting <?page no="389"?> Berkau: Financial Statements 7e 15-389 FA Financial Accounting FAA Financial Assets Account FC Fixed Costs fCF Cash Flow from Financing Activities FEC Forward Exchange Contract FG Finished Goods FGI Finished Goods Inventories Fin Finance FIN Financial Instruments FNB First National Bank South Africa F/ S Financial Statements FSA Financial Statement Analysis FUE Fuel Costs 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 GoD Gain on Disposal GP Gross Profit GST Goods and Service Tax, same as Value Added Tax VAT HGB Handelsgesetzbuch IAS International Accounting Standards IASB International Accounting Standards Board IBL Interest Bearing Liabilities I.BX Inventory Box Account I.CC Inventory Coffee-Capsule-Dispense-Unit Account iCF Cash Flow from Investing Activities ID Identifier, Identification Number i.e. It Est IFRS International Financial Reporting Standards IKV() Internal Rate of Return Function (German MS-Excel) I/ L Impairment Loss ILD Impairment Loss Account for Discontiued Operations INA Intangible Assets Inc. Incorporation (USA) INI Inventory of Ink INP Inventory of Paper INT Interest INV Inventory InvProp Investment Property IPO Initial Public Offering IRM Inventory of raw materials IRR() Internal Rate of Return Function (MS-Excel) I/ S, IS Income Statement <?page no="390"?> Berkau: Financial Statements 7e 15-390 ISS Issued Capital IT Income Taxes ITE Income Tax Expenses ITL Income Tax Liabilities JL Journal JO Job Order JPY Japanese Yen JV Joint Venture KaDeWe Kaufhaus des Westens kg Kilogram K.K. Kaushik Kaisha KMTS Kenilworth Metered Taxi Service Ltd. KRW Korean Won KSU Kite Surfing Unit kWh Kilo Watt Hours LAA Attorney Labour Account LAB Labour LAP Paralegal Labour Account Lat. Latin / lb per Pound Lbs Pound LG(t) Vector for the leased grill l-h Labour Hours Liab Liability, Liabilities LLC Limited Liabilities Company LQD Liquidation account LSM Loss on settlement Ltd. Limited company LOD Loss on Disposal LOS Loss on Sales 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 MOP Manufacturing Overheads Production MOS Manufacturing Overheads Shipping MS Mircosoft MTN Maintenance <?page no="391"?> Berkau: Financial Statements 7e 15-391 MYR Malaysian Ringgit NoE Nature of Expense Method NOP Net Operating Profit NOPAT Net Operating Profit After Taxes NP Net Profit 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 Operations Ord. Ordinary OTE Other Expenses OTH Other Income OWN Owners Equity OV Opening Value P Profit / p Payable / p per Piece P&L Profit and Loss P1L Profit and Loss in 20X1 P/ C Partners' Capital PCB Petty Cash Book PLC Public Limited Company (in the UK) PLT Profit or Loss for Taxation POD Profit on Disposal POS Profit on Sales PPC Property, Plant and Equimpent @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, ZAR South African Rand / r Receivable R Rate <?page no="392"?> Berkau: Financial Statements 7e 15-392 RoA Register of non-current Assets R/ D Refer to Drawer R/ E Retained Earnings REC Reconciliation Account RES Reserves REV Revenue, Sales REVAL Revaluation RFID Radio Frequency Identification RI Residual Income R.I. Returns Inwards RM Malaysian Ringgit 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 RPM Revolutions per Minute RPR Repair rr Risk Rate R-R Revaluations Reserves RSA Republic of South Africa RU Reference Unit RuA Right of Use Asset / s per Share SAICA South African Institute of Chartered Accountants SAL Salary 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 SOH Service Overheads Account SPL Statement of Profit or Loss SPPI Solely Payments of Principal and Interest StB Steuerberater, tax attorney STY Stationary Expenses T/ A Trading Account T/ B, TB Trial Balance <?page no="393"?> Berkau: Financial Statements 7e 15-393 TC(t) Vector of Taxi Car Business Payments and Receipts TS Tax Statement TT Time Ticket / u per unit V Value VAT Value Added Tax, same as Goods and Service Tax GST VDI Verein Deutscher Ingenieure VIU Value in Use / w per week WACC Weighted Average Cost of Capital WIP Work in Progress, Work-in-Process WP Wirtschaftsprüfer, auditor ZAR South African Rand σ Standard deviation μ Mean <?page no="394"?> Berkau: Financial Statements 7e 16-394 16 Table of Figures Figure 1.1: Accounts 1.17 Figure 2.1: KIELING TAXI GmbH’s opening balance sheet 2-25 Figure 2.2: KIELILNG TAXI GmbH’s journal (20X1) 2-27 Figure 2.3: KIELING TAXI GmbH’s abridged balance sheet (20X1) 2-29 Figure 2.4: KIELING TAXI GmbH’s profit and loss statement (20X1) 2-31 Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X2) 2-32 Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) 2-34 Figure 2.7: KIELING TAXI GmbH’s income statement (20X2) 2-37 Figure 2.8: KIELING TAXI GmbH’s abridged balance sheet (20X2) 2-38 Figure 3.1: Access to IFRS Foundation.org (example) 3-43 Figure 3.2: IFRS.org: Standards for download 3-44 Figure 3.3: KMTS Ltd.’s opening balance sheet 3-46 Figure 3.4: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts 3-48 Figure 3.5: KMTS Ltd.’s accounts after adjustments (20X1) 3-50 Figure 3.6: KMTS Ltd.’s accounts after profit calculation (20X1) 3-52 Figure 3.7: KMTS Ltd.’s income statement (20X1) 3-54 Figure 3.8: KMTS Ltd.’s balance sheet (20X1) 3-55 Figure 3.9: KMTS Ltd.’s cash flow statement (20X1) 3-56 Figure 3.10: KMTS Ltd.’s statement of changes in equity (20X1) 3-56 Figure 3.11: KMTS Ltd.’s accounts (20X2) 3-58 Figure 3.12: KMTS Ltd.’s accounts after profit calculation (20X2) 3-60 Figure 3.13: KMTS Ltd.’s accounts for profit appropriation (20X2) 3-63 Figure 3.14: KMTS Ltd.’s income statement (20X2) 3-63 Figure 3.15: KMTS Ltd.’s balance sheet (20X2) 3-64 Figure 3.16: KMTS Ltd.’s cash flow statement (20X2) 3-64 Figure 3.17: KMTS Ltd.’s statement of changes in equity (20X2) 3-65 Figure 4.1: DEMANN GmbH’s order calculation 4-70 Figure 4.2: RYNEVELD Ltd.’s accounts before adjustments 4-74 Figure 4.3: RYNEVELD Ltd.’s trial balance 4-75 Figure 4.4: Elements of a Trading account 4-78 Figure 4.5: RYNEVELD Ltd.’s accounts after adjustments (20X6) 4-81 Figure 4.6: RYNEVELD Ltd.’s adjusted trial balance (20X6) 4-84 Figure 4.7: RYNEVELD Ltd.’s balance sheet (20X6) 4-85 Figure 4.8: RYNEVELD Ltd.’s income statement 4-86 Figure 4.9: Worksheet for adj. trial balance preparation (1 st step) 4-87 Figure 4.10: Complete worksheet for adj. trial balance preparation 4-88 Figure 5.1: Company data 5-97 Figure 5.2: CAPELIFT (Pty) Ltd.’s balance sheet (20X8) 5-99 Figure 5.3: CAPELIFT (Pty) Ltd.’s income statement (20X8) 5-99 Figure 6.1: BATHURST Ltd.’s balance sheet (20X4) 6-116 Figure 6.2: BATHURST Ltd.’s accounts (20X5) 6-118 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 <?page no="395"?> Berkau: Financial Statements 7e 16-395 Figure 6.6: BATHURST Ltd.’s statement of changes in equity (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 7.1: GELLENDORFF LLC’s accounts (i) 7-142 Figure 7.2: GELLENDORFF LLC’s accounts (ii) 7-145 Figure 7.3: GELLENDORFF LLC’s register of non-current assets 7-147 Figure 7.4: GELLENDORFF LLC’s asset-reconciliation statement 7-147 Figure 7.5: TINNEN K.K.’s accounts (20X4) 7-153 Figure 7.6: STEENBERG Ltd. accounts (i) 7-158 Figure 7.7: STEENBERG Ltd.'s accounts (ii) 7-159 Figure 7.8: YSTERFONTEIN Ltd.’s accounts 7-162 Figure 7.9: OVERBERG (Pty) Ltd.’s accounts 7-167 Figure 7.10: KRIGE (Pty) Ltd.’s accounts (20X3) 7-172 Figure 7.11: KRIGE (Pty) Ltd.’s accounts (20X4) 7-174 Figure 7.12: MERVE (Pty) Ltd.’s accounts (20X1) 7-177 Figure 7.13: MERVE (Pty) Ltd. accounts (20X5) 7-178 Figure 7.14: VLAEBURG Ltd.’s finance schedule for the lease 7-181 Figure 7.15: VLAEBURG Ltd.’s accounts (20X4 - 20X6) 7-183 Figure 7.16: Bond measurement at effective interest 7-193 Figure 8.1: BRENO Ltd.’s balance sheet (1.01.20X5) 8-206 Figure 8.2: BRENO Ltd.’s income statement (20X5) 8-207 Figure 8.3: BRENO Ltd.’s balance sheet (separate F/ S) 8-209 Figure 8.4: BRENO Ltd.’s income statement (separate F/ S) 8-210 Figure 8.5: GAMKA Ltd.’s statement of financial position 8-214 Figure 8.6: SWARTBERG Ltd.’s statement of financial position 8-214 Figure 8.7: GAMKA Ltd.’s balance sheet after acquisition 8-215 Figure 8.8: Consolidation worksheet (1) 8-216 Figure 8.9: Consolidation worksheet (2) 8-217 Figure 8.10: Consolidated balance sheet 8-218 Figure 8.11: GAMKA Ltd.’s income statement (20X4) 8-219 Figure 8.12: GAMKA Ltd.’s balance sheet (20X4) 8-219 Figure 8.13: SWARTBERG Ltd.’s income statement (20X4) 8-220 Figure 8.14: SWARTBERG Ltd.’s balance sheet (20X4) 8-220 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) 8-225 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) 8-228 Figure 8.24: Consolidation worksheet for PORTERSVILLE Group (1) 8-229 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 8-232 <?page no="396"?> Berkau: Financial Statements 7e 16-396 Figure 8.29: PATTEN Ltd.'s balance sheet after acquisition 8-233 Figure 8.30: SPYKER (Pty) Ltd.'s balance sheet 8-233 Figure 8.31: PATTEN Ltd.'s balance sheet (20X0) 8-234 Figure 8.32: PATTEN Ltd.'s income statement (20X0) 8-235 Figure 8.33: SPYKER (Pty) Ltd.'s balance sheet (20X0) 8-236 Figure 8.34: SPYKER (Pty) Ltd.'s income statement (20X0) 8-236 Figure 8.35: Worksheet for capital consolidation (PATTEN/ SPYKER) 8-238 Figure 8.36: Consolidation worksheet (PATTEN/ SPYKER) 8-239 Figure 8.37: Consolidated SFP for PATTEN/ SPYKER 8-240 Figure 8.38: Consolidated income statement (PATTEN/ SPYKER) 8-240 Figure 8.39: QUICKARMS Ltd.’s balance sheet (20X6) 8-242 Figure 8.40: QUICKARMS Ltd.’s income statement 8-243 Figure 8.41: QUICKARMS Ltd.’s balance sheet (20X7) 8-243 Figure 8.42: QUICKARMS Ltd.’s income statement 8-244 Figure 8.43: QUICKARMS Ltd.’s balance sheet (20X7) 8-245 Figure 8.44: CLOSE-WATCH (Pty) Ltd.’s opening balance sheet 8-246 Figure 8.45: CLOSE-WATCH (Pty) Ltd.’s income statement 8-247 Figure 8.46: CLOSE-WATCH (Pty) Ltd.’s balance sheet (20X7) 8-247 Figure 8.47: QUICKARMS/ CLOSE-WATCH (JV)’s balance sheet (IAS 27) 8-248 Figure 8.48: QUICKARM/ CLOSE-WATCH joint venture balance sheet 8-249 Figure 9.1: GREENACRES Ltd.’s accounts (periodic system) 9-255 Figure 9.2: GREENACRES Ltd.’s accounts (perpetual system) 9-257 Figure 9.3: ROSEFIELD Ltd.’s purchases 9-260 Figure 9.4: ROSEFIELD Ltd.’s accounts (i: FIFO) 9-261 Figure 9.5: ROSEFIELD Ltd.’s accounts (ii: weighted average) 9-263 Figure 9.6: RIEBEECK-KASTEEL (Pty) Ltd.’s budgeted accounts 9-268 Figure 9.7: RIEBEECK-KASTEEL (Pty) Ltd.’s actual accounts (IAS 2.13) 9-271 Figure 9.8: RIEBEECK-KASTEEL (Pty) Ltd.'s Manufacturing Summary Account 9-273 Figure 9.9: NOKOX (Pty) Ltd.’s accounts 9-282 Figure 9.10: BAKENSKOP PLC’s foreign currency bank accounts 9-285 Figure 10.1: EIMKE Ltd.’s balance sheet (20X7) 10-291 Figure 10.2: EIMKE Ltd.’s liquidity plan (20X8) 10-292 Figure 10.3: EIMKE Ltd.’s statement of cash flows (20X8) 10-293 Figure 10.4: EIMKE Ltd.’s accounts (20X8) 10-294 Figure 10.5: EIMKE Ltd.’s balance sheet (20X8) 10-301 Figure 10.6: EIMKE Ltd.’s income statement (20X8) 10-301 Figure 10.7: EIMKE Ltd.’s cash flow statement (20X8) 10-303 Figure 11.1: YARRA Ltd.’s balance sheet (20X0) 11-309 Figure 11.2: YARRA Ltd.’s balance sheet (20X1) 11-313 Figure 11.3: YARRA Ltd.’s balance sheet (20X2) 11-315 Figure 11.4: Detailed equity section on YARRA Ltd.’s B/ S (20X1) 11-316 Figure 11.5: Detailed equity section on YARRA Ltd.’s B/ S (20X2) 11-317 Figure 11.6: YARRA Ltd.'s accounts 11-317 Figure 12.1: ABINGTON Ltd.’s accounts (20X4) 12-324 Figure 12.2: ABINGTON Ltd.’s Profit and Loss calculation (NoE) 12-326 Figure 12.3: ABINGTON Ltd.’s income statement (NoE) 12-326 Figure 12.4: SUDHUIZEN PLC’s balance sheet (20X3) 12-329 <?page no="397"?> Berkau: Financial Statements 7e 16-397 Figure 12.5: SUDHUIZEN PLC’s purchase ledger 12-329 Figure 12.6: SUDHUIZEN PLC’s accounts (NoE) 12-331 Figure 12.7: SUDHUIZEN PLC’s income statement (NoE) 12-333 Figure 12.8: ABINGTON Ltd.’s accounts (COS) 12-335 Figure 12.9: ABINGTON Ltd.’s income statement (COS) 12-337 Figure 12.10: SUDHUIZEN PLC’s accounts (COS) 12-339 Figure 12.11: SUDHUIZEN PLC’s income statement (COS) 12-342 Figure 13.1: BELMONT Ltd.’s balance sheet (20X6) 13-347 Figure 13.2: BELMONT Ltd.’s statement of changes in equity (1) 13-347 Figure 13.3: BELMONT Ltd.’s statement of changes in equity (2) 13-349 Figure 13.4: BELMONT Ltd.’s statement of changes in equity (3) 13-350 Figure 13.5: BELMONT Ltd.’s statement of changes in equity (4) 13-351 Figure 13.6: BELMONT Ltd.’s statement of changes in equity (5) 13-352 Figure 13.7: BELMONT Ltd.’s statement of changes in equity (6) 13-353 Figure 14.1: Effective interest method at MEUL Ltd. 14-363 Figure 14.2: MEUL Ltd.’s accounts (20X1 - 20X5) 14-364 Figure 14.3: Effective interest calculation at BRIZA Ltd. 14-369 Figure 14.4: BRIZA Ltd.’s bond calculation 14-370 Figure 14.5: MEMEL PLC’s annuity (20X2) 14-371 Figure 14.6: MEMEL PLC’s financial plan 14-372 Figure 14.7: MEMEL PLC’s disclosure of annuity 14-372 Figure 14.8: MEMEL PLC’s accounts (20X2 - 20X5) 14-373 Figure 14.9: DUMMOND (Pty) Ltd.’s provisions (1) 14-378 Figure 14.10: DUMMOND (Pty) Ltd.’s provisions (2) 14-379 Figure 14.11: DUMMOND (Pty) Ltd.’s provisions (3) 14-380 Figure 14.12: DUMMOND (Pty) Ltd.’s provisions (4) 14-381 Figure 14.13: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) 14-381 <?page no="398"?> Berkau: Financial Statements 7e 17-398 17 Links Link 2.A: KIELING TAXI GmbH 2-28 Link 2.B: DATEV-4 chart of accounts 2-32 Link 2.C: Lufthansa AG’s appendix 2-39 Link 4.A: RYNEVELD Ltd. 4-86 Link 4.B: TELUK Sdn. Bhd. 4-86 Link 4.C: BINNEVELD Ltd. 4-88 Link 5.A: COMAIR Limited. 5-92 Link 5.B: EPS calculations 5-104 Link 5.C: CAPELIFT (Pty) Ltd. 5-108 Link 6.A: BATHURST Ltd. 6-116 Link 7.A: RAVENWOOD GmbH 7-137 Link 7.B: OTZE AG 7-137 Link 7.C: GROOTVLEI Ltd. 7-148 Link 7.D: TYGERVALLEY Ltd. 7-148 Link 7.E: CORAL Ltd. 7-150 Link 7.F: JANSSENS Ltd. 7-160 Link 7.G: Bond valuation 7-191 Link 7.H: NATBERGEN (Pty) Ltd. 7-193 Link 7.I: HELWAN AIRWAYS Ltd. 7-196 Link 9.A: ROSEFIELD Ltd. 9-264 Link 10.A: RYNEVELD Ltd. 10-303 Link 10.B: EIMKE Ltd. 10-304 Link 12.A: ANKYO Ltd. 12-328 Link 12.B: SUIZHUIZEN PLC 12-341 Link 14.A: MEUL Ltd. 14-363 Link 14.B: DUMMOND (Pty) Ltd. 14-377 <?page no="399"?> Berkau: Financial Statements 7e 18-399 18 Literature Arendse, R. [2019]: Fundamental Accounting. 8 th Edition. Cape Town. Berkau, C. [2021]: Basics of Accounting. 6 th Edition. Munich. Berkau, C. [2020]: Management Accounting. 6 th Edition. Munich. Berkau, C. 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[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="401"?> Layout Layout 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. www.uvk.de ISBN 978-3-7398-3221-0 This textbook covers the IAS/ IFRS-syllabus of financial accounting on bachelor’s and master’s level. It covers how to prepare financial statements and tackles special problems in IFRSs-accounting, like asset revaluations, manufacturing accounting, share issues, financial instruments, group statements, etc. The content is explained by more than 60 case studies completely illustrated with bookkeeping entries and financial statements. All chapters outline the learning objectives, provide an overview, cover the contents of relevant IAS/ IFRS-standards, include case studies and how-it-is-done-paragraphs. They end with a summary, the explanation of new technical terms and a question bank with solutions for checking your learning progress. Readers of this book can download further cases linked to the textbook by QR-codes and more than 350 exam tasks including solutions as well as youtube-videos from the author. The textbook helps you to learn IFRSs and to familiarise yourself with international accounting in English. It is an accurate translation of the textbook „Bilanzen“ from the same author.