<?page no="2"?> Carsten Berkau Basics of Accounting Bookkeeping, Financial Statements and Management Accounting 3 rd Edition UVK Verlagsgesellschaft mbH · Konstanz und München <?page no="3"?> for Morero Bibliografische Information der Deutschen Bibliothek Die Deutsche Bibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über <http: / / dnb.ddb.de> abrufbar. ISBN 978-3-86764-759-5 Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt. Jede Verwertung außerhalb der engen Grenzen des Urheberrechtsgesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar. Das gilt insbesondere für Vervielfältigungen, Übersetzungen, Mikroverfilmungen und die Einspeicherung und Verarbeitung in elektronischen Systemen. © UVK Verlagsgesellschaft mbH, Konstanz und München 2017 Einbandgestaltung: Susanne Fuellhaas, Konstanz UVK Verlagsgesellschaft mbH Schützenstr. 24 · 78462 Konstanz Tel. 07531-9053-0 · Fax 07531-9053-98 www.uvk.de <?page no="4"?> Contents 1. Conventions 1-7 Part (A): 1 st Steps in Accounting 13 2. Cafeteria Example for the Balance Sheet Preparation 2-14 3. Shareholders’ View on Business: McDonald’s Corporation 3-24 4. Legal Aspects of Accounting 4-30 5. The Excel Accountant 5-37 Part (B): Easy Bookkeeping 51 6. Introduction to Statements of Financial Position and Comprehensive Income 6-53 7. Activities on the Asset Side 7-59 8. Activities on both Sides of the Statement of Financial Position 8-63 9. Profit and Loss Activities 9-71 10. Introduction to T-Accounts for Real Accounts 10-79 11. T-Accounts for Profit and Loss 11-90 12. Introduction to Bookkeeping Entries 12-97 13. Special Asset Accounts 13-107 14. Special Equity Accounts 14-113 15. Special Liability Accounts - Payables, Bank Loans and Provisions 15-119 16. Reconciliation Accounts 16-130 17. Depreciation 17-139 18. Further Expenses and Accruals 18-146 19. Accounting for Labour 19-152 20. Trading Business: Purchases and Returns 20-163 21. Trading Business: Purchases and Returns plus VAT 21-171 22. Trading Business: Sales 22-181 23. Trading Business: Sales plus VAT 23-198 24. Privately Owned Business: Drawings 24-213 25. Production Firms 25-225 26. Inventory Systems 26-235 27. Cost Formulas 27-260 28. Income Statement along the Cost of Sales Format 28-273 29. Preparing the Trial Balance 29-308 30. Tax Calculation, Profit Appropriation and Changes in Equity 30-325 31. Multi-Period Bookkeeping 31-336 32. Introduction to Statements of Cash Flows 32-354 Part (C): Advanced Bookkeeping 387 33. Establishment of a Business and Legal Form Changes 33-388 34. Liquidations 34-430 35. Disposals 35-439 36. Discounts 36-451 37. Cash Book: Reconciliation with the Bank Statement 37-464 38. Petty Cash Book 38-478 39. Books of Original Entry 39-491 <?page no="5"?> Berkau: BASICS of ACCOUNTING 1-4 Part (D): Management Accounting 505 40. Cost Planning / Business Plan 40-508 41. Cost Behaviour / Cost Separation 41-528 42. Cost Volume Profit Analysis (CVP-Analysis) 42-534 43. Degree of Operating Leverage (DOL) 43-547 44. Structure of Cost Accounting Systems 44-562 45. Flexible Budgeting / Marginal Cost Accounting 45-581 46. Cost Centre Efficiency Check 46-593 47. Cost Allocations 47-598 48. Reporting on Manufacturing Accounting 48-613 49. Job Order Costing (Manufacturing Accounting) 49-621 50. Process Costing (Manufacturing Accounting) 50-631 51. Multi-Level Contribution Margin Accounting 51-642 52. Activity Based Costing 52-646 53. Abbreviations 53-658 54. Table of Figures 54-661 55. Literature 55-669 Part (A) is an introduction to the first steps of Accounting. We aim to familiarise you with the subject and to make you understand what Accounting is good for. Part (A) contains the chapters 2 … 5. Part (B) provides you with a first glance at bookkeeping. We want you to learn bookkeeping from the scratch on and introduce you smoothly into the Accountant’s activities. By this text book we won’t make you a professional bookkeeper however you will be able to understand how bookkeeping works and you will be able to make basic postings for academic and practical cases. It is further the aim of this text book to get across the fundamentals of financial statements along international Accounting. Part (B) contains the chapters 6 … 32. Part (C) is named advanced bookkeeping and will provide you further insights of bookkeeper’s work. In many universities part (B) will be subject to an introduction class and part (C) will be allocated to the main class in Accounting, often called Financial Accounting. Part (C) contains typical aspects of Accounting like disposal of assets, liquidation, etc. Part (C) contains chapters 33 … 39. Part (D) is about Managerial Accounting. The part is new in comparison to the Accounting-Intro. We discuss Managerial Accounting from 2 point of views. By the first one, we look at the entire business and set up a business plan, discuss cost behaviour and introduce to a cost volume profit analysis. We further demonstrate the structure of Cost Accounting Systems. With regard to the 2 nd point of view, we go through the details of Management Accounting and show Cost Accounting systems, efficiency checking and cost allocations. We introduce the modern concept of Activity Based Costing, too. Part (D) contains chapters 40 … 52. <?page no="6"?> Berkau: BASICS of ACCOUNTING 1-5 Introduction This text book is a follow up for the Accounting-Intro we published in 2013 and in its 2 nd edition in 2014. It is a preparatory course for Berkau: Bilanzen (Financial Accounting along IFRSs) and its translation: Berkau/ Lecholo: Accounting-2-Go. The university expects you to selfstudy Bookkeeping and basics of Accounting before you attend classes in Financial Accounting and Management Accounting. We accompany you on the first steps in Bookkeeping and cover fundamental knowledge about financial statement preparation and Managerial Accounting. Accounting is an instrument to control the business. Managers have to report in form of financial statements, too. They think “Accounting”. Actions taken are scrutinised on their impact on profit and cash flows. Accounting is the language of managers. This text book will teach you the basic vocabulary and grammar of Accounting. There are four parts covered: (A) 1 st Steps in Financial Accounting (B) Easy Bookkeeping (C) Advanced Bookkeeping (D) Management Accounting This text book is based on mini-cases, such as you find in exams. We do not much explain Accounting rules, but we show you how Accounting is done. This is an easy approach to learn Accounting. You will develop a feeling for Accounting by the variety of cases. Bookkeeping is no science but a technique. By practising Accounting you will get more and more self-confident. Visiting our website on www.uvk-lucius.de/ Bilanzen, you’ll find a whole lot of exercises and examination tasks including detailed solutions. Most mistakes made in Accounting examinations are caused by weak Bookkeeping abilities. We also intend to close the gap between German Buchhaltung and international bookkeeping. With this text book you can develop a sound basis for Accounting classes based on IFRSs or US-GAAPs - no matter whether you study at your home university or abroad. Many Accounting classes in Germany and in foreign countries are taught in English. It makes sense to learn international Accounting in English as it keeps you away from switching between languages. In particular, if you want to study abroad, you should learn Accounting in English. However, we do not teach you languages. We are writing this text book as an international team from Germany and South Africa. This third edition now also contains chapters for Management Accounting. In this text book, Keabetswe is responsible for the language. As an Accountant and native speaker, she edited most of the text and made it correct and easy understandable. <?page no="7"?> Berkau: BASICS of ACCOUNTING 1-6 We extend our thanks to Prof. Dr. Marion Wendehals, who works closely together with us and is a precious discussion partner for all cases covered in this text book and exam tasks put on our website www.uvk-lucius.de/ bilanzen. We also thank Dr. Jürgen Schechler from UVK-Lucius, who is our lector. Thank you for the very pleasant cooperation and for being so open to all new ideas! Enjoy Accounting! Cape Town and Osnabrück, in October 2016 Keabetswe Sylvia Berkau Prof. Dr. Carsten Berkau <?page no="8"?> Berkau: BASICS of ACCOUNTING 1-7 1. Conventions In this text book some conventions apply in order to simplify the cases. These conventions are about legal forms, tax rates, formats, etc. They also apply for all examples and exercises you’ll find online on the UVK- Lucius.de-website. At this stage you do not have to understand them, we just put them at the beginning of the book for you to find them easily and to understand that they will apply for the whole book. Companies: Here, the legal form of companies does not count very much. Legal forms are country-wise different and are not subject to the Accounting syllabus. However, in contrast to IFRSs we do not refer to companies as “entities”. The IFRS-expression is legally motivated and does not help you to understand Accounting any better. Once you take a look at one of the standards and find the word “entity” just remember they are referring to a company. The standards do so in order to avoid legal aspects linked to national law with regard to the definition of a company. However, we use the technical term “the business”, “firm” and “company” interchangeably. Accounting Periods: Accounting period always start on 1.01. and end on 31.12. Furthermore, to keep the examples transferable to later classes, we indicate the decade by an X, as in 20X4. X is followed by Y etc. Financial Statements for Taxation: It is not intended to deepen your knowledge in tax statements. However, tax statements are relevant to determine income taxes liabilities and deferred tax. To keep examples simple, the total income tax rate always equals to 30 %. Quotation of Law Texts: Law texts are quoted like § 266 II HGB or IAS 1.68. We use the original law names and do not translate. So, the HGB is the German Civic Code, called in German: Handelsgesetzbuch (HGB). For the Intro we quote paragraphs without particular section or standards without paragraph. Note, that IFRS paragraphs are subject to changes quite often. Calculations: In order for you to find calculation results they will be printed in bold. In contrast to the single figures, they come with 2 digits after the decimal point and with the unit, such as 1 + 2.50 = 3.50 EUR. Bookkeeping Entries: We write the bookkeeping entries as debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. All Bookkeeping entries are printed in bold to make you focus on them. <?page no="9"?> Berkau: BASICS of ACCOUNTING 1.8 See, e.g. the acquisition of a motor vehicle: DR Motor Vehicle................ 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR When writing bookkeeping entries in the text, account names always are written with capital letters. The Motor Vehicle account is written by capital M and capital V. If you are German, pls. avoid the expression “to” as a kind of translation of the German “an”. There is no direction inside of bookkeeping entries. The identifier for a bookkeeping entry comes in brackets always, such as bookkeeping entry (1). Sequence of Bookkeeping Entries: The sequence of bookkeeping entries comes along the logical procedure defined by the examples. Sometimes this is not exactly the timely order. If there is an amount for an expense and the expense is paid for the next Accounting period too, the bookkeeping entries at the beginning of the year and at yearend will be displayed together. It can happen that you get the impression of bank overdrafts that occur during the Accounting period. We are going to ignore them. In particular, we won’t pay an interest thereon due to simplify the case studies. For cash and bank accounts the balancing figure at the yearend is relevant only. If there is the acquisition of assets and later on these assets are written off by depreciation, we put these bookkeeping entries next to each other in the text, although the acquisition might take place on 2.01.20XX and depreciation is recorded on 31.12.20XX. Presentation of Accounts: Accounts are displayed in the easiest format. See the accounts for the above mentioned car acquisition bookkeeping entry: D C D C (1) 20,000.00 (1) 4,000.00 D C (1) 24,000.00 Cash/ Bank P,P,E VAT Figure 1.1: Accounts In exhibits and on Powerpoint slides, accounts are often displayed by abbreviation due to a better overview. Instead of “Property, Plant and Equipment” we write “P, P, E”. Names of <?page no="10"?> Berkau: BASICS of ACCOUNTING 1-9 accounts only start by a capital letters and then the remaining name is written in small letters. E.g.: Motor vehicle as the header of an account displayed. Check chapter 10 of this Intro for further formal aspects about the accounts. Account Names: All names of accounts that are used in the text book for bookkeeping entries are written with caps, such as Cash/ Bank account. We intent you to focus on the accounts for financial statement preparation. This is the reason why we write account with small letters. However, an account that is not subject of our postings is written with small letters. Assume there is a bank account with Deutsche Bank and we refer to that account. In that situation the writing is with small letters: bank account. We do not make bookkeeping entries therein, but Deutsche Bank AG does. In T-accounts only the first word of the accounts name is a capital, such as “Interest bearing liabilities IBL”. In bookkeeping entries, the name always is written with caps, ad mentioned above. Currency Unit: For all examples the currency unit will be Euro (EUR). In case the EUR is multiplied by 1,000 it is called tEUR. Be aware all bookkeeping entries and accounts will be in EURs. The reporting currency in the statements is EUR also. Value Added Tax: VAT stands for value added tax. Except of the United Arabic Emirates and the U.S. state Delaware, consumers pay VAT. There is only one VAT account. This is different to German bookkeeping, where input-VAT and output-VAT is recorded in separate accounts Vorsteuerforderung and Umsatzsteuerschuld. For international Accounting make debit and credit entries in the VAT account. The VAT rate for all case studies and examples equals to 20 %. We ignore any lower/ reduced VAT rates as apply in some countries for food, books etc. Total Income Tax: All tasks and exams are based on a total income tax rate of 30 %. 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 return amount. Note, the tax on capital returns is not regarded as income tax for the company, although it is owed by the company on behalf of its shareholders. The tax on capital returns is a withholding tax. In Germany it is an Abgeltungssteuer. 10-20-30 Rule: In most examples the 10-20-30 rule applies. As long as not mentioned otherwise the interest rate is 10 %, the VAT rate is 20 % and the total income tax rate is 30 %. <?page no="11"?> Berkau: BASICS of ACCOUNTING 1-10 Case Studies: The case studies provided by this text book are as easy as possible to keep the stories simple and focus on Accounting. Sometimes you’ll get the impression the examples are too easy or unreal. However, our aim is not on story telling. Level of Precision: The level of precision is 2 digits after the decimal point. Results from workings can be rounded also. You can use rounded figures for further calculations. Sometimes we calculate by MS Excel; in that case the calculation in the background is better than the one displayed and visible to you. (Note, rounding is a minor problem for you.) Calculations: In calculations we will show the units only for the results. E.g.: 10 + 20.50 = 30.50 EUR. Furthermore, the calculations are without any digits after the decimal point in case they equal to zero. The final result is printed bold and comes always with two digits after the decimal point and the currency unit. Printing results bold should help you to find numbers calculated easily in the text. All calculations are accurate to the EUR-cent. Data format in tables: In tables, negative figures are displayed in brackets. (7.50) equals to -7.50 EUR. In all tables the currency is EUR. Payment Terms: Payments for all kind of taxes and for dividends are due in the next Accounting period. Furthermore, we ignore any consequence on tax income resulting from profits carried forward or backwards as along German tax law. Deferred Payment of Income Taxes: There are no deferred payments made to the revenue services. Precision of Depreciation and Interest: Although given as annual rates, depreciation and interest are calculated on a pro rata temporis (PRT) basis and accurate to the month. Monthly depreciation is the annual depreciation divided by 12. In case the company is in possession of the asset for a shorter period than a year, a month counts for depreciation if the asset is deployed for the major duration thereof. If the asset is bought on 6.01.20X1 the January will become relevant for depreciation. If the asset is sold on 28.12.20X1 the December will be relevant for depreciation. If the asset is sold on 5.12.20X1, the December won’t count for depreciation. Interest rates will be provided on an annual basis with annual compound. For loans that are taken for shorter periods than a year, interest is also calculated on a pro rata temporis basis accurate to months. The monthly rate of interest is the annual rate divided by 12. The interest is compounded annually and paid at the end of the Accounting period. If a bank loan of 100,000.00 EUR is taken on 4.06.20X4 and the annual rate of interest is 10 %, the interest paid at yearend <?page no="12"?> Berkau: BASICS of ACCOUNTING 1-11 will equal to: 7 × 100,000 × 10%/ 12 = 5,833.33 EUR. Interest is only calculated for debts, such as bank loans, bonds etc. No overdraft of the bank account is considered. In particular, we do not check a bank loan’s balance during the Accounting period for overdrafts and determine interest thereon. However, an overdrawn bank loan leads to a liability recognition. Length of a Month/ Year: 1 month = 21.5 days = 4.3 weeks. 1 year = 12 months = 365 days = 52 weeks. Cash Flow Separation: An operating cash flow is a cash flow that does not result from investing nor financing activities. However, interest payments are always regarded as financing cash flow. Names: We always use names for companies and write them by capital letters. E.g. SCHULZE-BRAMMELKAMP Ltd. There are no links to actual existing persons or companies intended. In case there are similarities it will be a coincidence. In case we refer to actually existing firms we make that clear by the text. You can search for the case studies by the names online in case we refer to it. We only use them once for a case study. Legal Forms of a Business: For this Intro we normally use Ltd., (Pty) Ltd., AG, GmbH, Corp. to indicate that the companies are limited companies. If nothing has been mentioned together with the company’s name you can assume the company is a privately owned business, like SANDPIPER BOOKS for a privately owned bookstore. Rules of the German Company Act (AktG) only will apply if the firm is in the legal form of an Aktiengesellschaft (AG). Notes: In the text book we sometimes give you some notes in brackets. They always start by (Note, …) These are some additional hints to better understand our examples or some remarks why we do something the way we do it. You do not have to learn theses “notes”. Working Definitions: In the text we write some definitions in bold letters and copy them to the end of each chapter to make learning Accounting easier for you. We deliberately call them working definitions. The working definitions help you to understand the concepts. In contrast proper academic definitions are more accurate but more difficult to understand. Learning Objectives and Summaries: Every chapter starts by the learning objectives and ends by a summary. <?page no="13"?> Berkau: BASICS of ACCOUNTING 1-12 Non-existing items: In case something has not been mentioned in a case study you should assume it won’t exist. Sometimes case studies have been cut short in order to get a point made more clearly. Language: This Intro is written in South African English. Case Study Text We write case studies in a different format than normal text. Bookkeeping Entries All Bookkeeping entries are printed in bold and cover the whole page’s width. This way we move them into the centre of the text. <?page no="14"?> Part (A): 1 st STEPS IN ACCOUNTING By the following chapters we will provide an overview about Accounting. We do not want to teach Accounting at this stage. However, we’ll give you enough information in order to you understand what bookkeeping and Accounting is about. We try to motivate you to study Accounting. Accounting only starts by part (B). Chapter (2) Cafeteria Example for the Balance Sheet Preparation / Accounting Equation starts by an easy example and intends to introduce into Accounting. We want to teach you what Accounting is about. For this reason, we refer to an example of a campus cafeteria and show you all steps of the business establishment. We are keen to introduce the Accounting equation as basic concept of Accounting. You will prepare the first balance sheet and income statement in that chapter. The chapter (3) Shareholders’ View on Business: McDonald’s Corporation introduces a real existing company most of you know. The focus on chapter 3 is not to run a financial statement analysis. This will be subject to chapter 5 of the text book Bilanzen and the ebook Accounting-2-Go. We here want to draw your attention to the investor. Assume you want to invest your money into a business that is traded publicly. You will see that the main and almost only information you can get from a business comes with their financial statements. We introduce you to the time value of money concept which is relevant for finance and will show you whether or not it is a good bargain to buy shares of McDonald’s corporation. Legal Aspects about Accounting are subject to chapter (4). We cannot explain bookkeeping without mentioning that there are national Accounting principles (GAAPs = Generally Accepted Accounting Principles) and International Financial Reporting Standards IFRS. These laws and standards provide the legal framework of Accounting. We intend to provide you with some basic knowledge about Accounting regulations without going through paragraphs and standards. After reading that chapter you might know where to look for information if you need any. We named chapter (5) The Excel-Accountant. We explain a file provided online based on a spreadsheet program together with this ebook you can download on the website www.uvk-lucius.de/ Bilanzen. Chapter 5 explains the tabs therein. <?page no="15"?> Berkau: BASICS of ACCOUNTING 2-14 2. Cafeteria Example for the Balance Sheet Preparation Learning Objective: In this chapter, you’ll achieve a basic understanding of financial statements (balance sheet and income statement) and learn about the Accounting equation. We do not introduce bookkeeping entries at this stage. Accountants disclose for the management and the capital providing parties, such as banks and shareholders, whether or not the business is profitable and what the situation is alike the business is in. In order to understand the financial position of a business a balance sheet is prepared. It shows assets, which are the potentials of the company and the financial sources they come form, such as owners’ funds and liabilities. The balance sheet or − along International Financial Reporting Standards IFRSs referred to as the statement of financial position − represents the Accounting equation. “The total of the assets is the total of capital and liabilities.” The balance sheet shows on one side the assets and on the other side one equity and liabilities. The sums of both sides equal each other. (Note, that is the reason for Accountants to call the statement of financial position the balance sheet.) The balance of assets and equity plus liabilities means, all assets of the business are financed either by equity or liabilities. Equity represents funds coming from the owners of the business and liabilities are funds provided by creditors such as banks, suppliers (who did not get paid yet), bond holders, revenue service etc. The income statement is the second statement to be introduced. It compares revenue earned by the business to its expenses. Revenue is received from customers for goods/ services sold. Expenses are paid to suppliers of goods or to service providers. There are also expenses without payments linked thereto, such as depreciation. In case the total revenue exceeds expenses, the company earns profit. Income taxes are to be paid based on the income tax rate - study the national tax law for details. We determine the income taxes as earnings before taxes EBT × income tax rate. Financial statements are provided at every end of an Accounting period. Along the text book conventions, all Accounting periods end on the 31 December and the total income tax rate equals to 30 %. (Note, we sometimes call the Accounting period a year and refer to the balance sheet date as the yearend.) In this chapter, we do not only provide financial statements as at the end of the Accounting period but after each and every business activity in order to demonstrate how financial statements work. How it is done (preparing a balance sheet): (1) Prepare a balance sheet in a T-format. (2) Create sections for assets on the left hand side (debit side) and for capital and liabilities on the <?page no="16"?> Berkau: BASICS of ACCOUNTING 2.15 right hand side (credit side). (3) Allocate all assets, capital and liabilities to sections. Thereafter, assign all changes on assets to the asset section and all changes on capital and on liabilities to the capital section and the liabilities section. Do so by adding increases to the section and reduce amounts if assets/ capital/ liabilities decrease. (4) Check at any moment the fulfilment of the Accounting Equation. In order to study the Accounting equation (equality of assets and equity/ liabilities) and its impact on financial statements, we observe an example of a snack shop run by student Ingo Kensington: Ingo Kensington establishes his own business on campus. The concept for the company is a simplified university cafeteria. Ingo Kensington does not have enough money for financing the cafeteria business. He asks his classmates to contribute to the cafeteria business. He manages to find 20 fellow students who contribute 30.00 EUR into the business (each). Equity adds up to: 20 × 30 = 600.00 EUR . This amount also is called the owners’ capital. Capital is the amount of funds assigned to the owners of a business. Here, the money paid in by the founders is their contribution to the business. The investors are the owners of the business. The expression „issued capital” results from companies based on shares. When a company is established by share issue portions of the business are sold to the shareholders, who by this own a share of the business and will be entitled to receive a portion (share) of the profit the business earns. In case of the cafeteria the total capital amounts to 600.00 EUR, such as invested by the students. The amount of 600.00 EUR is an asset also and is the cafeteria’s cash on hand. It is recognised as the cash/ bank item on the balance sheet. It is part of the assets. An asset is any item which is part of the company’s resources. Most of the resources are of physical nature, but they can also be intangibles, such as rights. An example for a right is a production firm manufacturing goods under license. The license bought from a patent holder falls under such rights and is recognised as an intangible asset. Here, the cafeteria’s money is cash and consists of EUR-bills and coins probably. We say the company has 600.00 EUR on cash or in the cash/ bank item. The next step for Ingo Kensington and his buddies is to get hold of more funds, in order to finance the assets to be deployed in the cafeteria. They want to spend money on a refrigerator, plates and cutlery and they further have to purchase bread, butter and chocolate cream, etc. They realise, the money they contributed, is not enough. Thus, they decide to lend money from the bank. <?page no="17"?> Berkau: BASICS of ACCOUNTING 2-16 Ingo Kensington and his fellows set up a detailed business plan (check chapter Cost Planning/ Business Plan ) and pay the local bank a visit. The business plan explains the business concept and in particular contains a calculation of how the cafeteria earns money and how it is financed. The house bank approves their business concept and is prepared to lend the cafeteria business money which amounts to 400.00 EUR. The students get the money transferred into their bank account and put assign it to cash/ bank. Cash now amounts to: 600 + 400 = 1,000.00 EUR . The cafeteria’s situation can be described by the Accounting equation. The Accounting equation is the basis of Accounting. It states that the total of assets equals to the total of capital and liabilities. The Accounting equation is: ∑ ∑ ∑ = = = + = n i m j l k k j i Liability Capital Asset 1 1 1 (with: i = index for assets, i = 1 … n, j = index for capital, j = 1 …m, k = index for liabilities, k = 1 … l) We simplify the equation as below: ∑Assets = ∑Capital + ∑Liabilities Here: 1,000 = 600 + 400 = 1,000.00 EUR The Accounting equation can be checked on the balance sheet, too. The total of assets is on the left hand side and capital and liabilities are listed on the right hand side. We name the left side “debit” and the right one “credit”. The balance sheet contains assets on the debit side indicated by capital A. It contains items of capital and liabilities on the right hand side, indicated by capital C and capital L - representing capital and liabilities. Observe the KENSINGTON CAFETERIA’s balance sheet below. The items not relevant for the cafeteria business are greyed out in Figure 2.1. (Note, do not worry about the grey items, we will explain them later in the text book.) <?page no="18"?> Berkau: BASICS of ACCOUNTING 2.17 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 600.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab 400.00 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 1,000.00 Tax liabilities 1,000.00 1,000.00 Kensington Cafeteria's STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 2.1: KENSINGTON CAFETERIA’s statement of financial position (balance sheet) In Figure 2.1, the asset side contains cash only. The amount of 1,000.00 EUR is displayed as the cash/ bank item on the asset side (A). The equity is named owners‘ capital and contains 600.00 EUR. The bank loan is displayed as the item interest bearing liability and amounts to 400.00 EUR. A liability represents funds coming from other parties than the owners of a business. In general, long-term liabilities are bank loans or bonds. Accountants assume that long term debts require interest. For that reason, long-term liabilities are shown as interest bearing liabilities. Capital and liabilities are displayed on the capital and liability side (C, L). The Accounting equation is fulfilled as long as the totals of both sides of the balance sheet add up to the same amount. From now onwards, the balance sheet is used to check the fulfilment of the Accounting equation. The next step for Ingo Kensington and his fellow students is to invest their cash. They buy equipment. They spend 500.00 EUR on a refrigerator. The fridge is an asset and appears on the statement of financial position. The item is called property, plant and equipment (P, P, E). After spending the money on the fridge, cash/ bank equals to: 1,000 - 500 = 500.00 EUR . The balance sheet for KENSINGTON CAFETERIA looks as below in Figure 2.2: <?page no="19"?> Berkau: BASICS of ACCOUNTING 2.18 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 500.00 Issued capital 600.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab 400.00 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 500.00 Tax liabilities 1,000.00 1,000.00 Kensington Cafeteria's STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 2.2: KENSINGTON CAFETERIA’s statement of financial position (2) As shown in Figure 2.2, cash has been reduced to 500.00 EUR by spending money on the fridge. There is a 500.00 EUR amount representing the refrigerator as part of the property, plant and equipment item. The Accounting equation is fulfilled, as the total of assets now is: 500 + 500 = 1,000.00 EUR and the total of capital and liabilities is: 600 + 400 = 1,000.00 EUR , too. By the next steps we prepare the income statement. It tells how much money the cafeteria earns. KENSINGTON CAFETE- RIA sells the rolls/ sandwiches at 0.75 EUR. The cafeteria sells 100 sandwiches on 200 days/ a. The money received from the customers is called revenue and equals to 0.75 × 200 × 100 = 15,000.00 EUR . The material expenses (Accountants call them materials) are rolls at 0.20 EUR/ p, butter at 2.00 EUR/ p which lasts for 50 sandwiches (0.04 EUR/ sandwich) and chocolate cream at 0.06 EUR/ sandwich. Additionally, the cafeteria business pays labour. (Note, in order to make the business concept easy to understand, we call the materials for the sandwich “rolls”. The product sold by the cafeteria is called “sandwich” although it is a buttered roll.) Labour contains the salary for 2 students buttering rolls and earning 4.00 EUR/ break. They only sell sandwiches during the breaks. There are 2 breaks per school day. Accordingly, labour equals to: 2 × 2 × 4 = 16.00 EUR/ d for buttering the rolls. The students prepare 100 sandwiches every business day. For groceries errands, one student is paid 8.00 EUR/ business day. Eventually, the cafeteria’s manager earns 120.00 EUR/ month. Rent for the cafeteria is 100.00 EUR/ month and paid to the university on cash. Observe the calculation of expenses below: The amount for materials is: (0.20 + 0.04 + 0.06) × 100 × 200 = 6,000.00 EUR/ y . <?page no="20"?> Berkau: BASICS of ACCOUNTING 2-19 Labour adds up to: 16 × 200 + 8 × 200 + 120 × 12 = 6,240.00 EUR/ y . Other expenses are for rent only. It equals to: 100 × 12 = 1,200.00 EUR/ y . The last item is for interest which is 15% based on the loan’s amount: 15% × 400 = 60.00 EUR/ y . For this chapter, income taxes and VAT are ignored. [EUR] Revenue 15,000.00 Other income 15,000.00 Materials 6,000.00 Labour 6,240.00 Depreciation Other expenses 1,200.00 Earnings before int and taxes (EBIT) 1,560.00 Interest 60.00 Earnings before taxes (EBT) 1,500.00 Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) 1,500.00 Kensington Cafeteria's STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X0 Figure 2.3: KENSINGTON CAFETERIA’s statement of comprehensive income As it can be seen on the income statement, the cafeteria earns a profit of 1,500.00 EUR per year. After earning and recording the profit, the balance sheet looks as displayed by Figure 2.4. The income statement is linked to the balance sheet as it make cash/ bank increase and the profit is displayed as an increase of equity. The item on the balance sheet is called retained earnings. <?page no="21"?> Berkau: BASICS of ACCOUNTING 2-20 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 500.00 Issued capital 600.00 Intangibles Reserves Financial assets R/ E 1,500.00 Current assets Liabilities Inventory Interest bear liab 400.00 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 2,000.00 Tax liabilities 2,500.00 2,500.00 Kensington Cafeteria's STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 2.4: KENSINGTON CAFETERIA’s statement of financial position (3) The earned profit has been transferred to capital. It is now in the retained earnings (R/ E) item of the equity section of the statement of financial position. As there is no income tax considered the item for tax liabilities remains blank. We assume all business activities are on cash. So, cash increases by 1,500.00 EUR. Observe that the Accounting equation is still fulfilled. The total of assets equals the total of capital and liabilities. ∑Assets = ∑Capital + ∑Liabilities Now: 500 + 2,000 = 2,100 + 400 = 2,500.00 EUR . The next step for the cafeteria business is to pay the owners a share of the profit. They are entitled to receive a share of the profit based on the portion they own of the business. The reason for investments is to receive a share of the profit as return. The profit distribution is subject to national law and depends on the legal form of the business. E.g., the distribution of profit and loss in a German Offene Handelsgesellschaft (public trading company) is special and subject to regulations along § 121 HGB. Here, the company decides to give half of the profit to the proprietors and the other half remains in the business for reinvestments. The appropriation of profits after taxes often requires financial statements preparation, auditing and approval by the owners. Auditing requires that a qualified auditor checks the financial statements and calculations and valuations therein for correctness. Based on the decision about the appropriation of profits in the cafeteria, an amount of: 1,500/ 2 = 750.00 EUR is put to dividends-“to be paid” which is a liability. These liabilities are short-term liabilities and called payables. It is common <?page no="22"?> Berkau: BASICS of ACCOUNTING 2.21 practice for Accountants to use the abbreviation A/ P (accounts payables) for that item on the balance sheet. The other half of the profit is added to equity permanently. In case a company keeps the profit, they post it to reserves. Reserves are part of the owners’ equity. After the appropriation of the profits KENSINGTON CAFETERIA’s statement of financial position looks as below in Figure 2.5: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 500.00 Issued capital 600.00 Intangibles Reserves 750.00 Financial assets R/ E 0.00 Current assets Liabilities Inventory Interest bear liab 400.00 A/ R A/ P 750.00 Prepaid expenses Provisions Cash/ Bank 2,000.00 Tax liabilities 2,500.00 2,500.00 Kensington Cafeteria's STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 2.5: KENSINGTON CAFETERIA’s statement of financial position (4) Still, the Accounting equation is fulfilled. Check Figure 2.5. ∑Assets = ∑Capital + ∑Liabilities Now: 500 + 2,000 = 1,350 + 1,150 = 2,500.00 EUR At the end of the first year, KENSINGTON CAFETERIA pays a share of the profit to its twenty owners. Every single owner receives a share of 1/ 20 of the distributed profit. As all owners hold the same portion of equity, the profit distribution is the same for all of them. The profit per owner equals to: 750/ 20 = 37.50 EUR/ owner . Check the balance sheet after payments have been made in Figure 2.6: <?page no="23"?> Berkau: BASICS of ACCOUNTING 2.22 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 500.00 Issued capital 600.00 Intangibles Reserves 750.00 Financial assets R/ E 0.00 Current assets Liabilities Inventory Interest bear liab 400.00 A/ R A/ P 0.00 Prepaid expenses Provisions Cash/ Bank 1,250.00 Tax liabilities 1,750.00 1,750.00 Kensington Cafeteria's STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 2.6: KENSINGTON CAFETERIA’s statement of financial position (5) The Accounting equation is still fulfilled. Observe below the calculation: ∑Assets = ∑Capital + ∑Liabilities Now: 500 + 1,250 = 1,350 + 400 = 1,750.00 EUR . The total of equity is seen as book value of a business. The idea is, that in case all assets are sold at their carrying amounts and all liabilities are paid-off at the recognised amounts, the remaining value is owned by the equity holders. We call the difference between assets and debts the book value of the company, because the values are retrieved from the bookkeeping records. This concept of business valuation requires carrying all items at their fair values. There are other approaches to determine the value of a business. The book value calculation is one of them and very common in Accounting. We now assume KENSINGTON CAFETERIA is liquidated after one year of business. Liquidation means to discontinue all business activities and sell all assets. As cash is easy to exchange, Accountants say it is more liquid than other assets - such as machinery, aircrafts, intangible assets etc. Furthermore, all debts are paid-off and the remaining amount (equity) is distributed to the owners. The fridge is sold at 500.00 EUR as it is its carrying amount. The carrying amount of an asset is the amount recorded by Accounting. The amount of cash after the disposal of the refrigerator is: 1,250 + 500 = 1,750.00 EUR . Cash is used to retire the <?page no="24"?> Berkau: BASICS of ACCOUNTING 2-23 debts. Here the amount of long-term liabilities results from the bank loan. After paying-off, there is still: 1,750 - 400 = 1,350.00 EUR left over. This amount equals to the book value of: 600 + 750 = 1,350.00 EUR . Accordingly, we can say KENSINGTON CAFETERIA’s value is 1,350.00 EUR after its first year. Consider the reserves being part of equity and increasing the owners’ fortune. All owners of KENSINGTON CAFETERIA hold an equal share of the company. For each and every owner the share is worth: 1,350/ 20 = 67.50 EUR . We have to consider every owner has received a dividend of: 750 / 20 = 37.50 EUR already. So every owner has: 67.50 + 37.50 = 105.00 EUR . The same amount can be derived from the statement of financial position and the income statement. The contribution of owners was 600.00 EUR and the profit earned equals to 1,500.00 EUR. Accordingly, the owners’ share is: (600 + 1,500)/ 20 = 105.00 EUR/ owner . Summary: The balance sheet and the income statement show the financial situation of the company. The balance sheet gives an overview about assets and the financing of the business. The balance sheet follows the Accounting equation. ∑Assets = ∑Capital + ∑Liabilities. The income statement displays how the company earns its profit. The financial statements are seen as a reporting instrument, which informs the owners and the creditors about the situation of the company. Working definitions: Asset: An asset is any item which is part of the company’s resources. Capital: Capital is the amount of funds assigned to the owners of a business. Liabilities: A liability represents funds coming from other parties than the owners of a business Business plan: The business plan explains the business concept and in particular contains a calculation how the cafeteria is to become a successful company and how it will be financed. Accounting equation: The Accounting equation is the basis of Accounting. It states that the total of assets equals the total of capital and liabilities. <?page no="25"?> Berkau: BASICS of ACCOUNTING 3-24 3. Shareholders’ View on Business: McDonald’s Corporation Learning Objective: We show in this chapter the use of Accounting from the investors’ point of view. This should bring Accounting closer to you, because it shows options to an own involvement in companies. Do not see Accounting as bookkeeping. Bookkeeping is only a technique that guarantees right figures for financial statements. However, Accounting is a report for investors to make economic decisions and to understand whether and how much money a business earns. As a business person, Accounting does not provide you with business ideas. It only measures and displays how much money a company earns. You need that information to access business and make investment decisions. Thus, Accounting tells you whether your business is successful. McDonald’s Corp. is an American company based on shares. The concept of the company is similar to KENSINGTON CAFETERIA as explained by the previous chapter. However, McDonald’s Corp. is way bigger. However, if you understood KENSINGTON CAFETERIA, you will understand McDonald’s Corp., too. McDonald’s Corp. is a franchisee. This means, many restaurants you see in the world are actually not owned by McDonald’s Corp. but pay a fee in order to sell food under the name of McDonald’s Corp. in restaurants which appear along the corporate identity policy of Mc Donald’s Corp. The McDonald’s Corp. story starts with its founders who noticed a restaurant producing burgers in a very short time (fast food) and selling them successfully at a low price of $0.15. They bought the restaurant in Illinois and sold the burgers under the name McDonald’s Corp. and in a restaurant with the golden arcs. The yellow arcs which look like an “M” became the brand symbol for McDonald’s Corp.’s restaurants later. Today, McDonald’s Corporation is a company earning a revenue of $25,413 million in 2015. $8,925 million thereof are earned by franchised revenues. McDonald’s corporation runs 36,525 restaurants worldwide. McDonald’s Corporation is based on 1,660.6 million common shares. Pls., check the internet for the last financial statements of McDonald’s Corp. before continuing reading. We now take a look at McDonald’s Corp. from the investors’ point of view (at the same time). The student Joana buys one share of McDonald’s Corporation on 8.04.2008 at a share price of 35.65 EUR traded at the New York Stock Exchange (NYSE). The face value of the share is 0.01 US-Dollar. The face value is the nominal value of a share and is reported in the capital section on the balance sheet. In contrast, the value as traded at a stock exchange is the market value of a share. It represents <?page no="26"?> Berkau: BASICS of ACCOUNTING 3-25 at what price shareholders buy and sell shares among one another. McDonald’s Corp. does not know how much Joana paid for her share and its financial statements do not show either. However, McDonald’s Corp. gets to know that Joana is a shareholder. McDonald’s Corp. registers its shareholders, in particular for two reasons: (1) to invite them to the annual meetings so they can exercise their voting rights and (2) to pay them a dividend. McDonald’s Corporation pays a quarterly dividend to the shareholders that amounts to 0.25 EUR/ share on average. In order to simplify the case, we here consider an average dividend. Joana sells her share in May 2013 at a share price of 78.10 EUR. We analyse whether or not the purchase and sale of the share was a good bargain. The answer depends very much on the time value of money and the rate of discounting. For long-term decisions, we have to consider that today’s money is worth more than future payments. The rate of interest for calculating the time value of money is the weighted average cost of capital WACC. The time value of money is a concept of discounting future payments. 100.00 EUR you hold today is better than 100.00 EUR you will receive in 5 years’ time. The reason is that during a period of 5 years you can pay 100.00 EUR into your bank account and can earn an interest thereon. Alternatively, you could invest the 100.00 EUR into a business and earn a return on your investment, such as Joana does as shareholder of McDonald’s Corp. The latter alternative includes the risk that a company does not earn expected profits or even files for bankruptcy. In the latter case the investors lose all their shares, which means they are rated at zero. Investors who take risks want to receive a compensation in return for risk taking. Accordingly, the return on the investments in shares should exceed interest you earn by saving the money in a bank account. The risk of investing in shares is higher than to deposit money in a bank account. Therefore, the return for investors should be higher. As the early 100.00 EUR are valued higher than later ones, we discount money received later by a rate of interest that represents the capital income option. We assume, the rate applied for discounting is constant over all five Accounting periods. We further assume the rate of interest called i is = 10 %. Today, the option to receive 100.00 EUR in 5 years’ time is worth: 100 / (1 + 10%) 5 = 62.09 EUR. In order to check this valuation, we assume we invest 62.09 EUR on the capital market for the 1st year. The money is compounded annually: The money we have at the end of the 1 st period is 62.09 EUR plus the return of 62.09 × 10% = 6.21 EUR. The total fortune as at the end of the first Accounting period equals to: 62.09 + 6.21 = 68.30 EUR. We repeat the investment and leave the full amount of 68.30 EUR in the bank account. This will increase the funds to: 68.30 × (1 + 10%) = 75.13 EUR. In the next year, the funds have increased up to: 75.13 × (1 + 10%) = 82.64 EUR. In the next year we have already 90.90 EUR and in the last year we reach 99.99 EUR. (Note, we rounded off after each Accounting period, so it is likely the valuation suffers from a rounding difference.) <?page no="27"?> Berkau: BASICS of ACCOUNTING 3-26 Accountants do love spreadsheet programs! They use the background formulas to compute amounts. We want to analyse our investment of 62.09 EUR by using MS Excel spreadsheet program. See the design of our Excel sheet for a financial schedule prepared in Figure 3.1. A financial schedule is an annual (column) plan of certain investing and financing activities (lines) in order to determine the final value of the investor’s funds. Here, the final value equals to 100.00 EUR in 20X5. The investments are regular bank savings which earn an annual interest at an interest rate of 10%, compounded annually. All investments have a duration of exactly 1 year. Figure 3.1: Calculation of an investment of 62.09 EUR In Figure 3.1, the discount rate is 10 %, which is the classroom rate. In real businesses the discount rate applied is based on the average cost of capital. This rate is the average rate of equity cost and costs for debts and is weighted based on the portions of equity and debt, the investor finances investments with. We apply a financial plan such as in Figure 3.1 in order to check the McDonald’s Corp. share deal. See below the input data calculations for the financial schedule in the spreadsheet displayed in Figure 3.2: Joana has to lend 20.00 EUR from a bank at an annual rate of interest of 4.50 %. Her total funds required to buy the McDonald’s Corp. share is: 35.65 - 0.25 - 0.25 - 0.25 = 34.90 EUR , because she receives 3 quarterly dividends in the same Accounting period of 2008. We calculate accurate to the year. She has to pay interest for the bank loan: 20 × 4.5% × (9/ 12) = 0.68 EUR in the first Accounting period. Remember Joana bought her share in April, which requires to lend the money for 9 months in 2008. Thus, her required equity funds are: 34.90 + 0.68 - 20 = 15.58 EUR . <?page no="28"?> Berkau: BASICS of ACCOUNTING 3-27 Joana has 15.58 EUR and lends 20.00 EUR from the bank. We calculate Joana’s weighted average cost of capital WACC: In Joana’s example the weighted average costs of capital are based on funds of 15.58 EUR equity and 20.00 EUR debts. The return she could achieve on the capital market with alternative investments but at the same risk are 3.00 %/ a, such as the return from a BurgerKing share, for example. The average cost of capital is not (3 + 4.5) / 2 = 3.75 % , because Joana’s capital structure does not contain equal equity and debts portions. Joana’s weighted average cost of capital amounts to: (15.58 × 3% + 20 × 4.5%) / 35.58 = 3.84% . (Note, the amount is rounded off.) We now assess Joana’s share buy, in order to determine whether the investment in McDonald’s Corporation was a good deal. The return on the McDonald’s Corporation share is 0.25 EUR/ quarter. In 20X8 she receives 3 quarterly dividend payments as she is a registered shareholder on 30.06., on 30.09. and on 31.12. From 2009 until 2012 she is entitled to receive 4 quarterly dividends and she gets one quarterly dividend payment at the end of the 1 quarter of 2013. In the last Accounting period she sells the share at 78.10 EUR. In the same Accounting period she earns a dividend of 0.25 EUR for the first quarter. The total money she receives is: 78.10 + 0.25 = 78.35 EUR in 2013. We put all payments into a vector called McD(t) for the McDonald’s Corporation share payments which looks as below: McD(t) = {-34.90; 1.00; 1.00; 1.00; 1.00; 78.35} The first element of the vector (here: negative 34.90 EUR) is the payment for the share buy less 3 quarterly dividends paid in 2008, the second figure is the dividend for 2009, the third figure the dividend for 2010, the fourth figure the dividend for 2011, the fifth figure the dividend for 2012 and the last figure is the total of one quarterly dividend plus the money received when the share is sold. Joana pays-off the bank loan at the end of the investment period and puts money left over at any yearend into her saver’s account at the local Sparkasse. She earns an annual interest of 1.2 % thereby. Interest for the bank loan is per annum: 20 × 4.5% = 0.90 EUR . In 2008, the amount is pro rata temporis: 9 × 0.90 / 12 = 0.68 EUR , as the bank loan is taken for 9 months only. In 2013, interest is 5 × 0.90 / 12 = 0.38 EUR . In all the other Accounting periods, Joana’s bank loan’s interest equals to 0.90 EUR/ a. Observe the financial schedule set up for Joana’s share below in Figure 3.2. <?page no="29"?> Berkau: BASICS of ACCOUNTING 3-28 t=2008 t=2009 t=2010 t=2011 t=2012 t=2013 Equity 15.58 Investment at McD's Corp (34.90) 1.00 1.00 1.00 1.00 78.35 Bank loan 20.00 (20.00) Interest on bank loan (0.68) (0.90) (0.90) (0.90) (0.90) (0.38) Investment at Sparkasse (0.10) 0.10 Investment at Sparkasse (0.20) 0.20 Investment at Sparkasse (0.30) 0.31 Investment at Sparkasse (0.41) 0.41 0.00 0.00 0.00 0.00 0.00 58.38 Figure 3.2: Financial schedule for Joana’s McDonald’s Corporation share As it can be seen by the schedule the dividend earned is enough to pay the interest on the bank loan. However, the deal becomes profitable, as the share of McDonald’s increased in value during the investment period. The final value of Joana’s fortune equals to 58.38 EUR. Her input was 15.58 EUR. The present value of the increase in funds is: (58.38 / (1 + 3.84%) 5 ) - 15.58 = 32.77 EUR . We can say, the opportunity to buy the share of McDonald’s Corporation is worth 32.77 EUR on 8.04.2008. Consider any investment which comes with a positive present value is better than doing nothing. In case the share price increase would have been predictable, all people would have bought McDonald’s Corporation shares on 8.04.2008. However, not all share prices during the financial crises increased! (Note, before you start to invest you should take under consideration that buying shares cost you transaction fees and that the banks charge you for the administration of a securities deposit and administration account.) The example of McDonald’s Corporation shows two ways of how to earn money with shares. Both approaches work together, they do not exclude each other. (1) The first source of earning money is that the shareholder is a partial owner of the company and is entitled to earn a portion of its profit, which is commonly called a dividend. The dividend actually is based on the profit and the available amount of equity for distribution. The available amount for distribution normally is the profit of the period plus profits carried forward from prior Accounting periods. It also can contain funds resulting from dissolving reserves. Note, dividend calculation is subject to national law, in Germany, the company’s act (AktG) applies. (2) The other way to earn money with shares is to buy a share and benefit from the share price increase. This is called capital appreciation. Share prices increases when they are under high demand by their potential buyers. A company that earns huge profits and pays constantly good dividends is more attractive than a company suffering from losses in a weak economy. Share price appreciation requires an ability to foresee the share prices, which needs to have an insight into the company’s further development and <?page no="30"?> Berkau: BASICS of ACCOUNTING 3-29 knowledge about the industry/ economy. Potential buyers of shares listen to analysts, who monitor the companies properly. One of the basic sources of information for investors and analysts are the financial statements listed companies have to prepare and publish quarterly. For non-listed companies, annual financial statements apply. The financial statements disclose how much profit a company earned during the last Accounting period and give an indication about the financial position of the business. The financial position of a company is linked to the assets, which are its potentials to earn profit, and the financing, which indicates how risky the financial structure of the business is and how much can be paid to investors and creditors. Investors often check the non-current assets and derive estimates on how well the company will perform in the future based on past investment returns or by other companies, such as competitors. The cash flow statement provides further information on the potential of future investments and, for example, whether or not a company is able to finance a bond redemption. Auditors check financial statements. Thus, readers of financial statements can rely on the correctness of the financial statements. Auditing is required by national law and by the stock exchange regulations, such as the Security Exchange Commission SEC in the USA, which applies for McDonald’s Corp. Summary: Companies such as McDonald’s Corp. are based on huge amounts of shares which allow the financing of the business and to invest in business opportunities. Buying shares of companies offers investors to participate in the profit of the company by earning a dividend, which is a share of the company’s profit, and to benefit from share price increases. However, no loss participations are required which means an imbalanced risk distribution. In business management, payments in different Accounting periods are compared based on the time value of money concept. The discount rate refers to the weighted average cost of capital WACC. Investors make decisions based on financial statements provided by companies. They try to foresee a company’s economical value. Do not gamble with shares! Working Definition: Face Value: The face value is the nominal value of a share and will be reported on in the capital section of the balance sheet as issued capital. Market Value: The value as traded at a stock exchange is the market value of a share. Time Value of Money: The time value of money is a concept of discounting future payments. Available Amount for Distribution: The available amount for distribution normally is the profit of the period plus profits carried forward from prior Accounting periods. <?page no="31"?> Berkau: BASICS of ACCOUNTING 4-30 4. Legal Aspects of Accounting Learning Objectives: We’ll introduce to legal aspects of Accounting in this chapter. The chapter helps you to achieve knowledge with regard to regulations about Accounting along the International Financial Reporting Standards IFRSs and German GAAPs (Handelsgesetzbuch). Furthermore, we refer to the Company’s Act, such as Aktiengesetz AktG in Germany. After studying this chapter, you know where to find relevant paragraphs for Accounting problems. As long as the owner runs a business as a sole proprietor, his/ her business is no one else’s business. The owner is reliable to him-/ herself, but has to prepare personal tax statements. A privately owned business is no legal entity. It belongs to his/ her owner. Increases of the business value are increases of the owner’s fortune and fall under taxable profit. In contrast, public companies, such as those based on shares, require commercial reports, called financial statements. Furthermore, all trading businesses must prepare financial statements, small sole traders in the sense of § 241a HGB are exempted. Preparing financial statements gives helpful information about a company’s situation and about the way of how the company earns profit. Public companies belong to their owners who in general are not involved in the daily business. E.g., a shareholder is an owner but is not involved in the operating business. Owners have a strong interest in understanding how their company is performing and want to determine whether or not they can expect an appropriate return on their investments. In case you buy shares of a company, you want to know how your business is growing and you want to be able to predict, whether your total mix of investments in companies is strong or weak. We’ll call the mix of investments you are holding your portfolio. However, an owner such as a shareholder of a company cannot drop by at the company’s offices and check the business operations or even interfere therewith. Thus, Joana cannot fly to Illinois and knock at the door of McDonald’s Corporation’s headquarter in order to change the product mix of German McDonald’s restaurants. She only can attend the annual meetings and exercise her voting rights. The main source of information for the owners of a public company (as well as for anyone else interested in the company, such as business partners, employees, applicants etc.) are the financial statements. (Note, if you apply for a job at a public company, you should study the financial statements in order to find out, whether or not you should work for it! ) Along IFRSs, a set of financial statements contains a statement of financial position, a statement of comprehensive income, a statement of cash flows and a statement of changes in equity. Furthermore, notes are required. The information provided by financial statements results from the bookkeeping records companies have to keep by law. All transactions in a business that <?page no="32"?> Berkau: BASICS of ACCOUNTING 4-31 effect its financial position and/ or its profit/ loss are recorded. The German law, that requires the disclosure of information about the business as financial statements, is the Handelsgesetzbuch (HGB). The Handelsgesetzbuch applies for all trading and/ or public companies. § 238 HGB requires trading companies preparing financial statements and § 264 requires the same for public companies. However, other businesses, such as a doctor’s clinic, law firms, artists, engineers, consultants etc., do not prepare financial statements but have to provide information about their profit only for reasons of tax calculations. Tax statements are financial statements, such as balance sheet and income statement prepared for tax calculation. In Germany, a business that falls under § 18 EStG (freelancer paragraph) can prepare a simplified tax declaration following § 4 III EStG. EStG is the German tax law, called Einkommensteuergesetz. The simplified tax declaration is referred to as 4- 3-Gewinnermittlung. According to the German Handelsgesetzbuch, a company is required to provide a complete list of all assets, of all liabilities and of all equity at the time of commencement of a company’s transactions as well as later at least after every Accounting period, which normally is one year. (Note, the German Handelsgesetzbuch refers to Kaufmann. We translate the German word Kaufmann or Handelsunternehmen by dealer, dealership, trading business, etc. When it comes to the German law, it is not recommended to translate technical terms to English. Thus, if you plan to run a German company, check the definition for Kaufmann and don’t make decisions based on translations thereof. However, the German law sees someone as a trader who sells goods. A photographer who sells frames or cameras will be seen as a dealer, e.g. However, as long as the photographer does not trade, he/ she will be regarded as a freelancer (Freiberufler) with regard to § 18 EStG.) § 240 HGB requires that every salesman has to prepare a proper register of his land, his receivables and payables, his money and all further assets and to provide exact information about their values as at the beginning of the business. He/ she further has to prepare such a register after the end of each and every Accounting period. § 241a Handelsgesetzbuch allows dealers who run their business under the legal form of a sole dealership and who runs a small company with regard to revenue and profit figures, to not keep bookkeeping records and to not prepare financial statements. This exemption from keeping bookkeeping records and preparing financial statements does not apply for small limited companies. There are special regulations for limited companies, too. These regulations are about the form of financial statements, e.g. §§ 266 and 275 HGB apply, which prescribe the structure and item naming of statements. The German Handelsgesetzbuch is stricter with regard to formal aspects than international Accounting standards, check IAS 1 for details. § 315 Handelsgesetzbuch requires financial statements must be audited for <?page no="33"?> Berkau: BASICS of ACCOUNTING 4-32 medium-sized and big public companies. Auditing means that a qualified and authorised Accounting expert checks bookkeeping records and the financial statements and ensures the documents have been prepared correctly. Correct preparation means, they have been prepared based on commonly agreed bookkeeping standards and they are consistent to the commercial law/ IFRSs. The statements must provide a correct view on assets values, the financial position of the company and its profit and loss situation. E.g., a violation of Accounting rules in favour of the company would mean to overstate assets or understate liabilities. Auditors do not check the financial statements completely but draw samples from the bookkeeping records and check the financial statements and the process of the preparation thereof. They deliver a report/ statement about the findings of the auditing. Without financial statements being audited no approval of the financial statements is possible. The approval is required for the appropriation of profits, such as for the declaration of dividends. Preparing faulty financial statements is less a regulatory offense, but results in withholding of dividends from the shareholders. All companies in Germany have to provide the financial statements along the requirements of the Handelsgesetzbuch unless they are exempted by § 241a Handelsgesetzbuch. IFRSs contain Accounting rules also but the regulations are slightly different to the Handelsgesetzbuch. International Accounting is relevant for companies that are involved in international business or belong to a group. The regulations for international Accounting are set by the International Accounting Standards Board IASB based in London, Cannon Street. We call the IASB the standard setter. For more information about the IASB and the procedure to issue standards, visit their website: www.ifrs. org. The IASB issues standards to particular Accounting problems - such as statement of cash flows, revenue recognition, financial instruments etc., which contain paragraphs. The standards released are the result of an international cooperative designand negotiation process. Standards can be downloaded from the IASB website. The standards have numbers and are either called IAS or IFRS. In order to refer to both of them we use the abbreviation IFRSs. The structure of the IFRSs is subject to chapter 3 in the text book Bilanzen and the ebook Accounting-2-Go. At the time of writing, following standards are issued: IAS 1 - Presentation of Financial Statements IAS 2 - Inventories IAS 7 - Statements of Cash Flow IAS 8 - Accounting Policies, Changes in Accounting Estimates and Errors IAS 10 - Events after the Reporting Period IAS 12 - Income Taxes IAS 16 - Property, Plant and Equipment IAS 19 - Employee Benefits <?page no="34"?> Berkau: BASICS of ACCOUNTING 4-33 IAS 20 - Accounting for Government Grants and Disclosure of Government Assistance IAS 21 - The Effects of Changes in Foreign Exchange Rates IAS 23 - Borrowing Costs IAS 24 - Related Party Disclosures IAS 26 - Accounting and Reporting by Retirement Benefit Plans IAS 27 - Separate Financial Statements IAS 28 - Investments in Associates and Joint Ventures IAS 29 - Financial Reporting in Hyperinflationary Economies IAS 32 - Financial Instruments: Presentation IAS 33 - Earnings per Share IAS 34 - Interim Financial Reporting IAS 36 - Impairment of Assets IAS 37 - Provisions, Contingent Liabilities and Contingent Assets IAS 38 - Intangible Assets IAS 39 - Financial Instruments: Recognition and Measurement IAS 40 - Investment Property IAS 41 - Agriculture Standards issued after 2002 are called International Financial Reporting Standards IFRS: IFRS 1 - First-Time Adoption of International Financial Reporting Standards IFRS 2 - Share-Based Payment IFRS 3 - Business Combinations IFRS 4 - Insurance Contracts IFRS 5 - Non-Current Assets Held for Sale and Discontinued Operations IFRS 6 - Exploration for and Evaluation of Mineral Resources IFRS 7 - Financial Instruments: Disclosures IFRS 8 - Operating Segments IFRS 9 - Financial Instruments IFRS 10 - Consolidated Financial Statements IFRS 11 - Joint Arrangements IFRS 12 - Disclosure of Interests in Other Entities IFRS 13 - Fair Value Measurement IFRS 14 - Regulatory Deferral Accounts IFRS 15 - Revenue from Contracts with Customers IFRS 16 - Leases There further is a framework that describes the principles of international Accounting. Some countries nowadays apply the international Accounting standards IFRSs completely other ones only partly. South Africa, e.g., does not fol- <?page no="35"?> Berkau: BASICS of ACCOUNTING 4-34 low national regulations for Accounting anymore and applies the international Accounting standards fully. The international standards are combined with the companies act in South Africa and the corporate governance King III report. Germany decided not to follow the IFRSs. However, the Germans made adjustments to the Handelsgesetzbuch, the GmbHG and the AktG, etc., known as BilMoG (BilanzModernisierungsGesetz). Companies preparing group statements and based in Europe have to apply IFRSs in case they participate in the capital market. A group consists of at least 2 companies which have a parent-subsidiary-relationship. Parentsubsidiary-relationships are ruled by the company’s act in Germany. The criterion for a group is that one company (parent) controls the other one (subsidiary). Often, the majority (more than 50%) of the voting rights is regarded as indicator for control. Participation in the financial market is fulfilled, once the companies or one of the group members are listed publicly with equity or liability instruments. It does not matter whether the parent or the subsidiary is listed. E.g., if one company of the group issues shares listed at a stock exchange, the whole group will qualify for IFRSs application. The same applies, if a company issues publicly traded bonds/ debentures. Groups have to prepare financial statements similar to a single company that shows the figures for the entire group. Group statements contain a set of financial statements for the whole group that is prepared under the assumption of the group being a single company. The group members are regarded as departments of the group therein. Group statements do not free the group members from the preparation of single financial statements. E.g., a group containing a parent in Germany and a Dutch subsidiary, with the German parent listed at Frankfurt stock exchange, has to prepare single financial statements along Handelsgesetzbuch and the Dutch Woertbook van Koophandel for the two companies and group statements along IFRSs. The Group Accounting adds up all items of the German and the Dutch company. Assume the German company owns items of property, plant and equipment to the extent of 1,000,000.00 EUR and the Dutch one of 700,000.00 EUR. In the group statements the item of property, plant and equipment will be recognised at 1,000,000 + 700,000 = 1,700,000.00 EUR. Group internal profits, receivables/ payables and proprietor relationships have to be adjusted/ cancelled out - referred to as consolidation. Group Accounting is covered by chapter 8 of the text book Bilanzen and the ebook Accounting-2-Go. Before financial statements can be compared or summarized for the preparation of group statements, they must be transferred to the same law/ Accounting standard. Companies, which are group members, therefore transform their single financial statements to IFRSs in case the group statements have to be prepared along international Accounting standards. The international version of the single statements prepared in accordance to <?page no="36"?> Berkau: BASICS of ACCOUNTING 4-35 IFRSs is called financial statements number 2 (Handelsbilanz 2). You can compare the preparation of group statements to adding fractions: if you add 1/ 3 and 1/ 4, you first have to transfer the single summands to the same denominator (here: 12). Group statements require to transfer single statements to IFRSs as their common “denominator”. GAAPs are generally accepted Accounting principles which apply for preparing financial statements and keeping bookkeeping records. National GAAPs in Germany are national laws for Accounting in particular the Handelsgesetzbuch. Other GAAPs are UK-GAAPs, US-GAAPs, etc. In general, you might think the application of different laws won’t make a big difference but actually, it does! Often the regulations along the national GAAPs and the IFRSs are very similar so that 95 % of the regulations do not differ much. However, if regulations are different (in 5 % of the cases) the picture can totally change with regard to the values disclosed. E.g., the German GAAPs do not allow the recognition of development expenses but IFRSs do. Assume a production firm like a car manufacturer, spending a lot of money on the design of a new product: Recognizing the development expenses or not will change the total of the balance sheet enormously. There is a mismatch of the amount of regulations and their potential to change financial statements. The laws mentioned follow different purposes. The German Handelsgesetzbuch aims to protect creditors. In accordance to this principle, financial statements are required being prepared with the intention to understate assets and profits, because a low profit leads to low dividends, which is in favour of the creditors, because it prevents the company from bankruptcy. Maintaining equity on high level, such as by requesting legal reserve recognition, makes it less likely that the company becomes debtsoverloaded. Excessive indebtedness leads to bankruptcy by national law. In contrast to the public and the creditors, shareholders are less interested in creditors’ protection and might see the legal reserve as means to cut dividends short which results in a reduction of their returns. Consider before you form your own opinion the risk structure of the stakeholders in the business. In contrast to the German Handelsgesetzbuch, the international Accounting standards follow the true and fair view principle. The reporting purpose is to recognise assets and liabilities at the amount they actually have. Check the example below to understand: A company takes a bank loan of 100,000.00 EUR and has to pay-off the amount in 20 years completely. It must recognise the bank loan on the credit side of the statement of financial position because it is a liability. In case the rate of interest on the capital market is 10 %, the bank loan’s actual value as at today will be 100,000 × (1 + 10%) -20 = 14,864.36 EUR. Someone, who takes the latter amount and puts it into a bank account which earns interest of 10 %/ a, annually compounded, will come up with 100,000.00 EUR at the end of 20 years. The IFRSs therefore <?page no="37"?> Berkau: BASICS of ACCOUNTING 4-36 require discounting liabilities and recognise them at 14,864.36 EUR. In contrast, the German Handelsgesetzbuch prescribes the loan recognition at 100,000.00 EUR, which is the most likely settlement value. Artificial increase of a liabilities will understate the company’s financial position. Thus, the Handelsgesetzbuch discloses the business’ situation worse than it actually is due to reasons of creditor protection. Summary: Financial statements have to be prepared along the national law. German companies have to prepare the financial statements along the German Handelsgesetzbuch. Other countries apply international Accounting standards IFRSs for the single statements. European groups that participate in the capital market have to prepare their group statements along IFRSs. Therefore, all group members have to transform their financial statements to IFRSs in preparation of the group statements. National GAAPs and IFRSs results in different statements. E.g., the German HGB understates the company’s financial position in order to protect creditors whereas IFRSs recognition follows the true and fair view principle. Working Definitions: GAAPs: GAAPs are generally accepted Accounting principles which apply for preparing financial statements and keeping bookkeeping records. Tax Statements: Tax statements are financial statements, such as a balance sheet and an income statement prepared for tax calculation. Group: A group consists of at least 2 companies which have a parent-subsidiary-relationship. Group Statements: Group statements contain a set of financial statements for the whole group that is prepared under the assumption of the group being a single company. <?page no="38"?> Berkau: BASICS of ACCOUNTING 5-37 5. The Excel Accountant Learning Objectives: In this chapter you do not learn Accounting but about a file for download on the UVK-Lucius website that helps you to edit your bookkeeping entries for the use in the university. This chapter also contains some hints for the use in later chapters of the book. Do not get confused if you find aspects mentioned that will be covered further down in the text book. The aim is to provide you a MS-Excel sheet for most of the calculations applied in the entire text book and the text book Bilanzen and the ebook Accounting-2-Go. In a real company the bookkeepers apply Accounting software. The preparation of the Accounting software according to the needs of the company and the adjusting process thereof is called customising. There are a lot of parameters which have to be set before the software works. The market leader of software for enterprise resource planning systems (ERP-systems) is SAP AG. The software is based on transactions. E.g., transaction FB50 makes a bookkeeping entry. Before you can post, the company code, the Accounting area, the bookkeeping type, the chart of accounts, etc. must be set up. This is meant by customising the system. In the university and at home you will mostly make bookkeeping entries on MS Excel, because in the university, you do not face mass data problems, such as in a real company. Thus, MS Excel will do it for the first steps. We regard MS Excel as a very valuable tool for Accounting learners. In more advanced classes, for example in Managerial Accounting, SAP customising is part of the syllabus, for example at Hochschule Osnabrück. On the UVK-Lucius.de/ Bilanzenwebsite you’ll be provided with a file called AccountsAndStandards-FOR- MAT.xls. This file has been used for the preparation of all financial statements and all accounts in this text book. We recommend applying it also for your first steps in Accounting. We offer this file as an additional service to all our readers. The spreadsheets have been prepared by an English MS-Excel 2016 system. According to the setting therein, figures appear in the format of the text book. You can adjust MS-Excel to the English data format also, but consider this is not a file setting but a system setting. This means once you change it to the German format all files you open will appear in the German figure format again. See Figure 5.1 for the adjustment window. <?page no="39"?> Berkau: BASICS of ACCOUNTING 5-38 Figure 5.1: Excel options for the adjustment of the data format Another format is the style data appear in the tables. We use the format 1,000.00 EUR for a positive amount and (1,000.00 EUR) for a negative one. In the university venue the brackets are easier to see than a minus sign. You can make these changes with the font menu yourself. (Note, in order to make figures appear in columns properly you should leave a blank after the positive amount at the place where closing bracket for negative amounts appears. Furthermore, take non-proportional fonts for figures.) <?page no="40"?> Berkau: BASICS of ACCOUNTING 5-39 Figure 5.2: Format adjustment (fonts) We recommend you adjusting your menu in MS Excel that way that you can insert lines easily. There is a function line insert you should add to the function bar. It will help you a lot! The file AccountAndStatement- FORMAT.xls provides you tabs with templates for Accounting. They are: - Accounts - TB (trial balance) - BS (statement of financial position) - IS (statement of comprehensive income) - CFS (statement of cash flows) - SCE (statement of changes in equity) - RoA (register of non-current assets) - Int&PayOff (schedule for interest and pay-off scheduling) - PCB (petty cash book) - CB (cash book) - BankStatement (bank statement) <?page no="41"?> Berkau: BASICS of ACCOUNTING 5-40 Account: The accounts are prepared as T-accounts. The accounts do not contain any formulas as the accounts’ length varies. According to this text book, the column width is: 1-4-16-0.08-4-16-1. The accounts come with a header which is centred and bold. On the left side there is a D indicating the debit side and on the right hand side a C stands for credit. No currency is mentioned, because all bookkeeping entries for this text book and the text book Bilanzen and the ebook Accounting-2-Go are made in EUR. The line in the middle is a very narrow cell filled black. Its width is 0.08. The cells appear as a thin vertical line which separates the debit side from the credit side. This way, you can copy bookkeeping entries from the debit to the credit side without copying the cell format. It helps you when you record the entry in the contra account. The style in the data cells is bold courier new. Thus, the figures all have the same distance to each other and can be added easily when you see them in the accounts. If you add the accounts figures, apply the sum function. See the account tab in Figure 5.3. Figure 5.3: Account tab <?page no="42"?> Berkau: BASICS of ACCOUNTING 5-41 (TB) Trial Balance: The trial balance will be introduced in chapter Preparing the Trial Balance. The trial balance is a list of all accounts and the balance brought down therein. It applies to check the double entry system and will help you to detect faulty bookkeeping entries. Transfer the names of the account tab into the list provided and enter the balances brought down into the list. The balances are to be entered on the debit side of the trial balance, if the account is debit balanced and on the credit side for credit balanced accounts. The total is calculated and should be the same on the debit as on the credit side of the trial balance. See Figure 5.4 for the trial balance tab. When you prepare the adjusted trial balance, we recommend copying the non-adjusted one for a start. An adjusted trial balance is prepared after the adjustments at the end of the Accounting period have been completed. At that time the nominal accounts have been closed off to the Trading account or to the Profit and Loss account. Their balancing figure will be zero then. After copying the unadjusted trial balance, strike through all closedoff accounts and change their values to zero. Insert additional lines at the bottom for new accounts required, such as the Retained Earnings account, Income Tax Liability account or the Reserves account. Again, the total on the debit side should be equal to the total of the credit side in order to fulfil the Accounting equation. Figure 5.4: Trial balance tab <?page no="43"?> Berkau: BASICS of ACCOUNTING 5-42 (BS) Statement of Financial Position: The statement of financial position tab contains a template for a simple balance sheet. It reads Statement of Financial Position such as requested by IAS 1. The total is calculated in the bottom line. All items can be adjusted by you and you can add further lines by the insert line key. You have to adjust the statement of financial position depending on the legal form of the business. E.g., a sole dealership won’t disclose an item for issued capital, but for owner’s equity. See the statement of financial position tab Figure 5.5. The balance sheet template provided is different to the one we apply in chapter 5 and 6 of the text book Bilanzen and the ebook Accounting-2-Go. We prefer to work with the T-Account format for practising Accounting. As you can see in Figure 5.5, the total on the debit side and on the credit side are compared in the statement of financial position tab to indicate inconsistencies with the Accounting equation. In the statement, there is only one entry in the Property, Plant and Equipment account and the difference is 300,000.00 EUR therefore. The financial statements require to enter the name of the reporting company and its legal form. Furthermore, the date, when the balance sheet is prepared is to be mentioned in the header. Adjust the date once you prepare the balance sheet. Figure 5.5: Statement of financial position tab <?page no="44"?> Berkau: BASICS of ACCOUNTING 5-43 (IS) Statement of Comprehensive Income: The template for the income statement is provided along the nature of expense method. You easily can adjust it to the cost of sales format if required. In the header you see STATEMENT of COMPREHENSIVE INCOME, which is the name required in accordance with IAS 1. For data input, pls., key in all figures as positive amounts. Do not use a negative figure for expenses as the formulas provided together with the statement will deduct expenses automatically. In Figure 5.6 the revenue of 10,000.00 EUR is deducted by expenses of 100.00 EUR; 200.00 EUR; etc. In order to change the income statement to the cost of sales format overwrite “Materials” by “Cost of Sales COS” and change further items as required. For consistency reasons, we recommend to not write the values in the cells but use the MS-Excel functions to copy them from your Profit and Loss account and if applicable from the Trading account. In case the earnings before taxes are negative or zero, the income taxes become zero, too. There is an if-function provided in the income tax cell. See below the statement of comprehensive income tab in Figure 5.6: Figure 5.6: Statement of comprehensive income tab <?page no="45"?> Berkau: BASICS of ACCOUNTING 5-44 (CFS) Statement of Cash Flows: The statement of cash flows tab contains a template filled with some examples for cash flows. Feel free to change the items of the cash flows in the MS Excel sheet. The formulas linked to the cells add up the cash flow from operating, investing and financing activities to the right side and calculate the total cash flow also. Key in cash inflows as positive amounts and cash outflows as negative figures. In Figure 5.7 we keyed in a few amounts, such as 1,000.00 EUR; 2,000.00 EUR; etc. The statement of cash flows is introduced by chapter Introduction to Statements of Cash Flows. In that chapter you will learn different methods of how to prepare a statement of cash flows. The format provided in the MS Excel file is based on the reconciliation of profits with operating cash flows. Along that method you will prepare the cash flow statement along a standard procedure. We provide that format, because it is for all companies the same one. However, feel free to change the operating cash flow items by making adjustments to your convenience. After preparing the statement of cash flows, we recommend checking the total cash flow with the difference between the opening and closing amount in the Cash/ Bank account. Figure 5.7: Statement of cash flows tab <?page no="46"?> Berkau: BASICS of ACCOUNTING 5-45 (SCE) Statement of Changes in Equity: The statement of changes in equity is covered by chapter Tax Calculation, Profit Appropriation and Statement of Changes in Equity. The statement shows how equity, that represents the book value of a company, changes by share issues, recording reserves and by earnings profit and its appropriation. The statement of changes in equity contains columns for the items on the balance sheet and lines for changes thereof. In each line the total of equity is the sum of the equity items, such as issued capital, reserves and retained earnings. Furthermore, the lines are added top down, because the first line discloses the opening amount and the lined thereafter changes in equity. In order to determine the equity as at the end of the accounting period the total of the lines must be calculated. The statement of changes in equity requires that figures are added up in direction left-right and top-down. The formulas have been linked to the cells already. In Figure 5.8 some figures have been entered into the form. You have to make the right entries for the profit appropriation: If there is a profit transferred to reserves it is required to make a negative entry in the retained earnings column which represents a debit entry and a positive one for reserves, which indicates a credit entry. The format in the statement of changes in equity is (DR)CR, which means, debit entries are negative, as they reduce equity. A profit paid to shareholders reduces equity, too. It requires one negative figure entered in retained earnings column. Equity will decrease by declaring a dividend, because the Shareholder for Dividend account does not belong to equity. Be aware, the equity reduction is recorded in the statement by only one entry as the contra entry is in the liability section - in the Shareholder for Dividend account. Figure 5.8: Statement of changes in equity tab <?page no="47"?> Berkau: BASICS of ACCOUNTING 5-46 (RoA) Register of non-current Assets: The register of non-current assets is required along IFRSs and belongs to the notes. The register of non-current assets is covered by chapter Depreciation and chapter 7 of the text book Bilanzen and the ebook Accounting-2-Go. The register of non-current assets is prepared on group level along IFRSs. However, in classroom examples or in exam tasks there are only few assets and it is required to disclose them by single entries. Every asset is recorded by a line which contains the cost of acquisition, the accumulated depreciation and the accumulated impairment loss. The column at the right border shows the carrying amount which is calculated by the formula linked to the cells. You have to enter the amounts for accumulated depreciation and for accumulated impairment losses as negative amounts in order to obtain the correct formula result. Observe some fantasy figures entered into the form in Figure 5.9. In case of a revaluation, you have to adjust the column cost/ revaluation and enter the amount the asset is revalued to. Figure 5.9: Register of non-current assets tab <?page no="48"?> Berkau: BASICS of ACCOUNTING 5-47 (Int&Pay-off) Interest and Pay-off Schedule: In Accounting it often is required to determine the amount of interest and of pay-off for a bank loan. The interest and pay-off schedule provided calculates liabilities per Accounting period. Our recommendation for the procedure to calculate, e.g., an annuity is as follows: (a) Enter the amount for the annual payment directly. (b) Write the rate of interest somewhere above the column interest. (c) Determine the amount of interest by multiplying the actual amount of the debts by the rate of interest. In the formula you should fix the rate of interest by the F4-key. (d) Determine the amount for pay-off by deducting interest from the annuity. (e) Go to the next line and add the formula for the actual amount which is previous amount less pay-off. (f) Now you can determine all amounts by just copying cells! (g) Adjust the last pay-off payment manually. See the interest and pay-off tab in Figure 5.10. See the interest calculation in the formula bar: “= C3 * $D$1”. Feel free to extend the template for the calculation of discounted liabilities. Discounting of liabilities is covered in chapter 14 of the text book Bilanzen and the ebook Accounting-2-Go. Figure 5.10: Interest and pay-off tab <?page no="49"?> Berkau: BASICS of ACCOUNTING 5-48 (PCB) Petty Cash Book: The petty cash book can be set up easily by the tab PCB. You have to make the entries for the balancing-off manually. The petty cash book is covered by chapter Petty Cash Book of this text book and by chapter 9 of the text book Bilanzen and the ebook Accounting-2- Go. Figure 5.11: Petty cash book tab (CB) Cash Book: The cash book tab is similar to the one for the petty cash book. You have to add the figures for balancing-off also. In contrast to the other tabs the header has been kept very simple to give the cash book the look of a normal account intentionally. The cash book is subject to chapter Cash Book, Reconciliation with the Bank Statement of this text book. See Figure 5.12. <?page no="50"?> Berkau: BASICS of ACCOUNTING 5-49 Figure 5.12: Cash book tab (BankStatement) Bank statement: The statements prepared by the banks come in a different layout and normally the Accountant does not have to write a bank statement. However, we provide you with a simple template for a bank statement you can use for practicing bank reconciliations. Bank statement reconciliation is subject to chapter Cash Book: Reconciliation with the Bank Statement in this text book. Figure 5.13: Bank statement tab <?page no="51"?> Berkau: BASICS of ACCOUNTING 5-50 Summary: We provide you online with a spread sheet you can use in preparation of bookkeeping records. However, this file is no attempt to design bookkeeping software but a simple editor we used for this text book ourselves and for many of the sample solutions you’ll find online on www.uvk-lucius.de/ Bilanzen. It is intended to make practising bookkeeping more convenient and efficient for you. <?page no="52"?> Part (B): EASY BOOKKEEPING We want to familiarise you with the basics in bookkeeping so you can prepare financial statements already after studying some of these chapters like an Accountant. We try to refer as less as possible to national laws or Accounting standards, in order to keep Accounting easy. We do not start by making bookkeeping entries intentionally because we want to show you that the main purpose of Accounting is to prepare financial statements. The chapter (6) Introduction to Statements of Financial Position and Statements of Comprehensive Income provides you with knowledge about the main financial statements. The statement of financial position is the balance sheet and the statement of comprehensive income is the income statement or profit and loss statement. The next chapters (7) Activities on the Asset Side, (8) Activities on both Sides of the Statement of Financial Position and (9) Profit and Loss Activities contain business activities that change at first only the asset side of the balance sheet, then the whole statement and thereafter the income statement as well. We use simple case studies ROHRBACH Ltd., FLASSKAMP AG and PELZER- HAGEN (Pty) Ltd. to go through the statements step-by-step. Preparing financial statements after each and every business activity becomes very demanding. We rather give you an (10) Introduction to T-Accounts and demonstrate how to apply them for the preparation of financial statements. We’ll show you how to use Taccounts and how to make entries therein. We further will teach you how to balance-off accounts and show all accounts for ROHRBACH Ltd. and FLASSKAMP AG. The chapter (11) is about T-Accounts for Profit and Loss and we use the case study PELZERHAGEN (Pty) Ltd. for explanation. We introduce the Profit and Loss account and show how to calculate profit. The chapter (12) Introduction to Bookkeeping Entries will show you how to write bookkeeping entries in a DR- CR-format. We explain all bookkeeping entries used for the case studies ROHRBACH Ltd., FLASSKAMP AG and PELZERHAGEN (Pty) Ltd. By the next chapters (13) Special Asset Accounts, (14) Special Equity Accounts and (15) Special Liability Accounts we go through the main sections of the statement of financial position and explain examples of activities. This way we provide you with a deeper knowledge about the items on the statement of financial position and practise bookkeeping entries. The chapter (16) Reconciliation Accounts introduces into the concept of hierarchical accounts. The chapter prepares for the asset management introduced by the next chapter (17) Depreciation. Depreciation is linked to property, <?page no="53"?> Berkau: BASICS of ACCOUNTING 5-52 plant and equipment and will be the first nominal account to discuss. Further Expenses and Accruals in chapter (18) follow and chapter (19) explains Accounting for Labour. In order to learn about concepts of profit calculation we start by trading businesses. At first only purchases will be considered. We’ll use the case studies APPLEDENE (Pty) Ltd. and KLIPFONTAIN Ltd. Chapter (20) Trading Business: Purchases and Returns shows how these companies buy goods and return some thereof to the supplier. In Chapter (21) Trading Business: Purchases and VAT we repeat the previous chapter but consider input- VAT. The following chapters are structured likewise. They add sales to the trading business. Chapter (22) Trading Business: Sales uses the case studies CORNFLOWER Ltd. and DURANT (Pty) Ltd. in order to show revenue recognition and profit calculation. In chapter (23) Trading Business: Sales and VAT the same business activities are discussed under consideration of output-VAT. The chapter (24) Privately Owned Businesses: Drawings describes the appropriation of profits in privately owned business. In chapter (25) Production Firms we introduce and the bookkeeping entries required for manufacturing firms. In addition to trading business, production firms have to consider material flows and product calculation. The chapter (26) Inventory Systems introduces to the recording of material flows based on the perpetual system and chapter (27) Cost Formulas shows how to deal with similar items of goods that cannot be recorded and valued as single items. The chapter (28) Income Statement along the Cost of Sales Format compares the two formats for the income statement and shows the benefit of the cost of sales format for a profitability analysis based on different products. The chapter also contains the case study MONTAGU Ltd. which is linked to the last 4 chapters. The chapter (29) Preparing the Trial Balance is the start of the adjustments as made at the yearend. We introduce a means to check our bookkeeping entries before preparing the financial statements. The trial balance is applied in the next following chapters consequently. The following chapter (30) Tax Calculation, Profit Appropriation and Statement Changes in Equity is about profit calculation and how profit changes the book value of the company by changing equity. In order to understand how to continue the financial records of the previous Accounting period the chapter (31) Multi Period Bookkeeping shows how to transfer real accounts from the previous Accounting period to the next one. Eventually, chapter (32) Introduction to Statements of Cash Flows shows how to set up a statement of cash flows. We’ll explain the case studies MANSELL Ltd. and PARKLANDSMAIN to prepare a statement of cash flows directly and by reconciliation statement. After studying all chapters of part (B) you can prepare financial statements along international bookkeeping procedures. <?page no="54"?> Berkau: BASICS of ACCOUNTING 6-53 6. Introduction to Statements of Financial Position and Comprehensive Income Learning Objectives: Here, we introduce the statement of financial position in order to explain the items therein. It is intended to present the statement of financial position as a valuable reporting instrument for owners, creditors and further parties, who have an interest in the financial position of the company. Every business activity changes the statement of financial position. After studying this chapter, you will see you can record any business activities as change on the balance sheet. In this text book, we won’t introduce formats for financial statements in conformity to national or international GAAPs. We start by a very simple format almost free of GAAP-requirements. This format would be acceptable for financial statements along the IFRSs. (Note, its structure has been copied from the IFRSs’ appendix.) For German companies, the structure for financial statements provided by this text book, won’t fit. Instead, §§ 266 and 275 Handelsgesetzbuch HGB apply. These paragraphs prescribe the items and the order thereof on the balance sheet and income statement. You are supposed to study chapter 2 of the text book Bilanzen or the ebook Accounting-2-Go for financial statements along the German Handelsgesetzbuch HGB. The statement of financial position − as it applies in this text book − looks as below. Some Accountants still call it the balance sheet B/ S, so do we: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank Tax liabilities STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 6.1: Statement of financial position <?page no="55"?> Berkau: BASICS of ACCOUNTING 6-54 The statement of financial position has 2 sides: (1) Asset side and (2) Capital/ liability side. The asset side is the left hand side of the statement of financial position. It displays the use of the funds. Using funds means buying assets that are deployed business. Accountants call the asset side “debit side of the balance sheet”, also. The capital/ liability side is the right hand side of the statement of financial position. It displays where the company’s funds come from: they originate from the owners’ contribution and/ or from receiving funds by the creditors. Accountants call it “credit side” or “claims side of the balance sheet”. Ad (1) Asset Side of the Statement of Financial Position The asset side contains all assets of the business. In general, assets are distinguished along of how long they stay in the company. Non-current assets are assets that will be longer than one Accounting period in use. The former expression “fixed assets” implies, assets cannot be changed at all, and is old fashioned. Assets deployed for less than a year, are called current assets. In contrast to current assets most of noncurrent assets will be written-off over the course of time. Depreciation reflects the decrease of an asset’s value by an expense linked to the time or the extent of application. However, assets that do not deplete, are not subject to depreciation, such as land. The first non-current asset item on the balance sheet is property, plant and equipment (P, P, E). This item contains buildings, land, machinery and equipment. The expression P, P, E originates from the header of IAS 16: Property, Plant and Equipment. Assets are to be recognised at the actual value of the asset. The actual value is referred to as its carrying amount. In case a value of an asset decreases by depreciation, the amount in the P, P, E item is to be recognised at the cost of acquisition less any depreciation and any impairment loss. An impairment loss is an extraordinary depreciation. Along IFRSs, increases in value of non-current assets are required, when the assets’ fair value increases. The upgrading of assets is called revaluation in terms of Accounting. IFRSs require companies to carry all their assets at their fair value. In cases an asset’s fair value exceeds the current value, IAS 16 states, the company has to revalue the asset. E.g. company PEINE Ltd. carries a machine at 1,200.00 EUR. Its fair value equals to 1,500.00 EUR. PEINE Ltd. has to increase the machine’s carrying amount by 300.00 EUR. The revaluation will change the machine’s amount in P, P, E to 1,500.00 EUR. (Note, revaluations will be covered by chapter 7 of the text book Bilanzen and the ebook Accounting-2-Go.) Besides of property, plant and equipment, a balance sheet contains intangible assets also. Intangibles are assets that have no physical nature. Often intangibles are rights, patents, etc. Fi- <?page no="56"?> Berkau: BASICS of ACCOUNTING 6-55 nancial assets are intangible also. However, they are linked to financial instruments and contain assets like shares, bonds or debentures the company is holding. DÖHREN AG buys shares of company CAMBS AG at 1,000.00 EUR. The shares of CAMBS AG become part of DÖHREN AG’s financial asset items. DÖHREN AG recognises the shares along the fair value of 1,000.00 EUR on its balance sheet. The item thereon is financial assets. Current assets are assets that stay for shorter periods of time (less than a year) in the business. The first item of current assets on the balance sheet is inventories. Inventories are raw materials, work in process WIP and finished goods. A production firm that buys materials will disclose them as raw materials inventory. Once the production starts, materials in the factory that are assigned to job orders are recognised as work in process. Goods which have been manufactured but not yet been sold are shown as finished goods. Companies can distinguish the three kinds of inventory items on the face of the balance sheet or recognise one total item and describe the single amounts by the notes in detail. The notes are explanations of Accounting required by IFRSs. Further items of non-current assets are receivables (A/ R). The accounts receivables (A/ R) result from payments expected from customers or other business partners. (Note, the name A/ R indicates the receivables are recorded in several accounts, such as A/ R-LAMPENSCHULTE. That account A/ R-LAMPENSCHULTE would contain receivables the company is entitled to get from their business partner LAMPEN- SCHULTE.) Company ELZE GmbH lends WORCESTER AG an amount of 100,000.00 EUR. ELZE GmbH’s statement of financial position contains the amount as part of the A/ R item and it is regarded as a note receivable. Prepaid expenses are assets that result from payments made in advance. A company that pays rent for the next Accounting period during the current one, will recognise that payment as prepaid expense in accordance with IFRSs. (Note, Germans disclose prepayments as accruals (Aktiver Rechnungsabgrenzungsposten), which is no asset. The reason is, that prepaid expenses will become difficult to claim back in particular cases, such as bankruptcy.) The item cash/ bank represents all cash and bank accounts. In case a company runs several accounts at different banks, the item cash/ bank will add up all accounts and cash. GAMBANG Ltd. banks with 3 banks: there are 1,000.00 EUR on the Deutsche Bank account, 30,000.00 EUR on the Commerzbank account and 50.00 EUR on the account with Sparkasse Osnabrück. Furthermore, GAMBANG Ltd. holds 3.20 EUR on cash. The cash/ bank item on the balance sheet shows: C/ B = 1,000 + 30,000 + 50 + 3.20 = 31,053.20 EUR . Capital and Liability Side of the Statement of Financial Position: The capital and liabilities are often referred to as claims. They contain the funds provided by the owners and the creditors of the business. <?page no="57"?> Berkau: BASICS of ACCOUNTING 6-56 The equity section of the balance sheet starts with issued capital. Issued capital is the funds contributed by the owners when the company is established. If a company is privately owned, the equity section of the balance sheet will be called owner’s capital and there won’t be any further items in the equity section, such as reserves or retained earnings. The item reserves contains amounts that belong to the owners of the business. Reserves can result from earnings, from capital issues or from revaluations. Earnings reserves will increase, when a business earned profit and keeps it in the company. Capital reserves result from share issues with an issue price exceeding the nominal share value. The German company HAGEN AG issues 100 shares at 7.80 EUR/ share. The face value of the shares equals to 5.00 EUR/ share. The difference between the issue price and the face value equals to: 7.80 - 5 = 2.80 EUR/ share and is called the share premium. Here, HAGEN AG has to post 100 × 2.80 = 280.00 EUR to capital reserves. Liabilities are funds the company owes someone, such as bank loans, open bills from supplies and tax liabilities. A company is obliged to pay-off its liabilities. In the liability section of the statement of financial position a company discloses all amounts owing its creditors. A bank loan is recognised as interest bearing liability. Bonds and debentures are long-term debts also and require interest payments. In contrast, short-term liabilities are shown as payables (A/ P). Payables are due within the next Accounting period. Output-VAT is recorded as A/ P, as it is short-term, too. (Note, VAT is no income tax! ) Provisions are liabilities, which are uncertain to a particular extent. E.g.: pensions fund payments, provisions for court cases, etc. Liabilities for income taxes are to be recognised along IAS 12 separately. (Note, the German Handelsgesetzbuch requires recognising a provision for income taxes.) Statement of Comprehensive Income: The format for the statement of comprehensive income is given by figure 6.2: <?page no="58"?> Berkau: BASICS of ACCOUNTING 6-57 [EUR] Revenue Other income 0.00 Materials Labour Depreciation Other expenses Earnings before int and taxes (EBIT) Interest Earnings before taxes (EBT) 0.00 Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) 0.00 STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X0 Figure 6.2: Statement of comprehensive income The statement of comprehensive income compares the revenue earned by the company to its expenses. The bottom line displays the profit earned during the Accounting period, called earnings after taxes. Another name for the statement of comprehensive income is income statement I/ S. The amounts on the face of the income statement always are net amounts. Revenue or also called sales is the money or the equivalent thereof, the company receives for selling goods or rendering services. Some companies earn other income resulting from extra activities, such as a production firm selling its property. Expenses represent the consumption of business resources. They contain materials, labour etc. Depreciation is an expense as well, that reflects the reduction of a non-current asset’s value by deployment or depletion. KINDERHAUS GmbH buys a new delivery van at 10,000.00 EUR. The duration KINDERHAUS GmbH intends to deploy the van, is 5 years. Assumed the van gets used to the same extent every year, the annual depreciation will be constantly 10,000/ 5 = 2,000.00 EUR/ a . Other expenses are expenses other than materials, labour and depreciation. For example, rent, fees, insurance rates etc. If the profit is calculated before interest has been deducted, it will be called earnings before interest and taxes (EBIT). After interest has been deducted from EBIT the remaining profit is earnings before taxes. Some Accountants call the pre-tax profit “net profit” (NP). After taxes have been deducted from EBT the profit for the period is called earnings after taxes (EAT) or annual surplus A/ S. <?page no="59"?> Berkau: BASICS of ACCOUNTING 6-58 Summary: Companies prepare financial statements based on bookkeeping records in order to provide information about the business to their owners, creditors, employees, the government and anyone else, who has an interest on the company. The main financial statements are the statement of financial position and the statement of comprehensive income. Before the revision of IAS 1, these statements were called balance sheet and income statement. The statement of financial position compares all assets to the total of capital and liabilities. The statement of comprehensive income shows how the business earns profit by deducting all expenses from the revenue. Working Definitions: Asset side: The asset side is the left hand side of the statement of financial position. It displays the use of the funds by the business. Capital/ liability side: The capital/ liability side is the right hand side of the statement of financial position. It displays where the funds come from: from the owners and/ or the creditors of the business. Non-current Assets: Non-current assets are assets that will be longer than one Accounting period in use. Depreciation: Depreciation reflects the decrease of an asset’s carrying amount by an expense linked to the time or the extent of application. Impairment loss: An impairment loss is an extraordinary depreciation. Intangible assets: Intangibles are assets that have no physical nature. Notes: The notes are explanations of Accounting required by IFRSs. Current Assets: Current assets are assets that stay for shorter periods of time (less than a year) in the business. Intangibles: Intangibles are assets that have no physical structure. Prepaid Expenses: Prepaid expenses are assets that result from payments in advance. Cash/ Bank: The item cash/ bank represents all cash and bank accounts. Issued Capital: Issued capital is the funds contributed by the owners when the company is established. Liabilities: Liabilities are funds the company owes someone. Provisions: Provisions are liabilities which are uncertain to a particular extent. Statement of Comprehensive Income: The statement of comprehensive income compares the revenue earned by the company to its expenses. Revenue: Revenue − or also called sales − is the money or the equivalent thereof, the company receives for selling goods or rendering services. Expenses: Expenses represent the consumption of business resources. <?page no="60"?> Berkau: BASICS of ACCOUNTING 7-59 7. Activities on the Asset Side Learning Objectives: In this chapter we’ll study activities that cause changes on the asset side of the statement of financial position. You will learn how to record those activities on the balance sheet. It is not intended to introduce bookkeeping entries yet. You will understand the balance sheet as an instrument for recording changes in assets by studying this chapter. Activities changing the asset side of the balance sheet increase one asset and decrease another one. This results from the Accounting equation. Those transactions can be seen as asset swops. As for now, only the asset side will be effected, we ignore the credit side of the statement of financial position. For that reason, the capital and liability items are displayed in grey for this chapter. As the operations only effect assets, for all activity one asset increases and another one will decrease. For the explanations thereof, we use the case study ROHRBACH Ltd., which is a cell phone dealer. At the beginning of fiscal year 20X5, ROHRBACH Ltd. has 250,000.00 EUR in the Cash/ Bank account. Take a look at the balance sheet in Figure 7.1 and find the item cash/ bank and its amount of 250,000.00 EUR therein. (Note, obviously the money is either cash or it is in the bank account. We do not distinguish cash and bank at this stage.) A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 250,000.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.1: ROHRBACH Ltd.’s statement of financial position (asset side) We’ll now discuss some activities that change items recognised on the asset side of the statement of financial position. <?page no="61"?> Berkau: BASICS of ACCOUNTING 7-60 - Activity 1: purchase on cash. - Activity 2: acquisition of equipment on cash. - Activity 3: cash sale. - Activity 4: disposal of a non-current assets. Activity 1: ROHRBACH Ltd. buys from its supplier STEHLE AG 1,000 smart phones at 150.00 EUR each on 3.01.20X5. The supplier’s bill is 1,000 × 150 = 150,000.00 EUR immediately due. The delivery of the smart phones increases the amount of stock by 150,000.00 EUR. ROHRBACH Ltd. pays 150,000.00 EUR per bank transfer into the supplier’s bank account. Cash decreases by this payment to the extent of 150,000.00 EUR and now equals to: 250,000 - 150,000 = 100,000.00 EUR . Take a look at the balance sheet in Figure 7.2 in order to check the changes. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 150,000.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.2: ROHRBACH Ltd.’s statement of financial position (asset side) Activity 2: On 6.02.20X5, ROHRBACH Ltd. buys from another supplier 4 shelves for storing the phones. The shelves cost 1,175.00 EUR each. ROHRBACH Ltd. pays the amount 4 × 1,175 = 4,700.00 EUR immediately. After delivery and payment of the phone shelves ROHRBACH Ltd.’s bank account contains 100,000 - 4,700 = 95,300.00 EUR . The phone shelves appear as an item of property, plant and equipment on the balance sheet. <?page no="62"?> Berkau: BASICS of ACCOUNTING 7-61 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 4,700.00 Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 150,000.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 95,300.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.3: ROHRBACH Ltd.’s statement of financial position (asset side) Activity 3: On 8.02.20X5, ROHRBACH Ltd. sells 67 smartphones at 150.00 EUR each. The money received equals to: 67 × 150 = 10,050.00 EUR . The sale reduces the smartphone amount by 67 units which means a decrease of 10,050.00 EUR. According to the output, the value of stock now is: 150,000 - 10,050 = 139,950.00 EUR . The amount of cash equals to: 95,300 + 10,050 = 105,350.00 EUR . A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 4,700.00 Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 139,950.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 105,350.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.4: ROHRBACH Ltd.’s statement of financial position (asset side) <?page no="63"?> Berkau: BASICS of ACCOUNTING 7-62 Activity 4: On 22.03.20X5, ROHRBACH Ltd. sells 2 of the shelves at a price of 1,175.00 EUR. This counts as disposal of a non-current asset. The amount of property, plant and equipment is reduced by: 2 × 1,175 = 2,350.00 EUR . The remaining amount equals to: 4,700 - 2,350 = 2,350.00 EUR . The amount for the disposal of the phone shelves is received on cash. According to the cash inflow, the amount of the cash/ bank item equals to: 105,350 + 2,350 = 107,700.00 EUR . Observe these amounts being recognised on the statement of financial position by Figure 7.5. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 2,350.00 Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 139,950.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 107,700.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.5: ROHRBACH Ltd.’s statement of financial position (asset side) The total asset amount equals to: 2,350 + 139,950 + 107,700 = 250,000.00 EUR . This amount is the same as at the beginning of the Accounting period. Compare this to the amount displayed by Figure 7.1. All activities effect 2 asset-items on the statement of financial position at the same time. Thus, they result in a zero sum game. Activity 1 increases inventory and decreases cash/ bank. Activity 2 increases property, plant and equipment and decreases cash/ bank. Activity 3 increases cash/ bank and decreases inventory. Activity 4 increases cash/ bank and decreases property, plant and equipment. Summary: Activities that effect the asset side only, increase one asset and decrease another one at the same time. <?page no="64"?> Berkau: BASICS of ACCOUNTING 8-63 8. Activities on both Sides of the Statement of Financial Position Learning Objectives: In this chapter we introduce activities that effect both sides of the statement of financial position. You will enhance your knowledge about the balance sheet by studying this chapter. Activities that will cause entries on both sides of the balance sheets, are mainly purchases and sales of assets on credit or payments linked to receivables or loans. We are going to record all these activities separately and will show the balance sheet after each and every business activity. We study the company FLASSKAMP AG, which is a German company based on shares. FLASSKAMP AG is established on 2.01.20X3. The company is a dealer for grass mowers. We’ll show the following activities: Activity 1: founding the business. Activity 2: purchase of goods. Activity 3: lending money from the bank. Activity 4: acquisition of non-current assets. Activity 5: payment for debts. Activity 6: selling goods. Activity 7: receiving money from customers. Activity 8: payment for debts. Activity 1: The proprietors pay 500,000.00 EUR into the bank account on 2.01.20X3. The contribution of the proprietors is to be shown as cash/ bank item on the asset side. At the same time the amount is to be displayed as owners’ equity. The funds provided by the owners represent their claim against the company and are shown as equity on the statement of financial position. FLASSKAMP AG is a company based on shares. The company issued 50,000 shares at a face value of 10.00 EUR per share. The share issue is par value. Issuing shares par value means the issue price is the same as the face value per share. In other words, no share premium applies. Observe FLASSKAMP AG’s statement of financial position as at 31.12.20X3 below in Figure 8.1. <?page no="65"?> Berkau: BASICS of ACCOUNTING 8-64 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 500,000.00 Tax liabilities 500,000.00 500,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.1: FLASSKAMP AG’s statement of financial position Activity 2: On 15.02.20X3, the company orders from its supplier 400 grass mowers at a purchase price of 230.00 EUR. The amount has not yet been paid. FLASSKAMP AG agrees with its supplier to pay for the delivered mowers later. Accordingly, FLASSKAMP AG owes the supplier 400 × 230 = 92,000.00 EUR . The mowers are FLASSKAMP AG’s merchandise goods and will be recognised as inventory. Recognition means to put something on the balance sheet. This can be any asset or capital or a liability. As no payment has been made yet, FLASSKAMP AG still owes the supplier the amount of 92,000.00 EUR. The amount owed is to be shown as payables. The item on the face of the balance sheet is called accounts payables (A/ P) - observe the changes in Figure 8.2. <?page no="66"?> Berkau: BASICS of ACCOUNTING 8-65 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 92,000.00 Interest bear liab A/ R A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 500,000.00 Tax liabilities 592,000.00 592,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.2: FLASSKAMP AG’s balance sheet Activity 3: FLASSKAMP AG takes a bank loan from its house bank in order to buy a new show room on 1.03.20X3. The bank loan taken is 200,000.00 EUR. The amount of the bank loan is paid into FLASSKAMP AG’s bank account and will be visible as the cash/ bank item. At the same time, FLASSKAMP AG owes the bank the amount of 200,000.00 EUR. Accordingly, the amount is to be recognised as a liability on the credit side. The bank loan is considered being long-term. There is interest to be paid for the liability. This implies, the bank loan is recorded as interest bearing liabilities item. <?page no="67"?> Berkau: BASICS of ACCOUNTING 8-66 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 92,000.00 Interest bear liab 200,000.00 A/ R A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 700,000.00 Tax liabilities 792,000.00 792,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.3: FLASSKAMP AG’s statement of financial position Activity 4: FLASSKAMP AG buys a new show room on 4.03.20X3. Acquisition is buying an asset that is recognised as a non-current one. In contrast, any buying of current assets like inventory is referred to as purchase. The show room costs 600,000.00 EUR. FLASSKAMP AG moves the business into the new show room but didn’t pay the 600,000.00 EUR yet. The show room is for selling mowers and qualifies as property, plant and equipment. It is recognised as a such. The amount FLASSKAMP AG owes the seller, is a short-term liability, because it is due during the next days. <?page no="68"?> Berkau: BASICS of ACCOUNTING 8-67 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 92,000.00 Interest bear liab 200,000.00 A/ R A/ P 692,000.00 Prepaid expenses Provisions Cash/ Bank 700,000.00 Tax liabilities 1,392,000.00 1,392,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.4: FLASSKAMP AG’s statement of financial position Activity 5: FLASSKAMP pays the amount due to the seller of the show room by transferring the money on 18.03.20X3. The amount paid reduces FLASSKAMP AG’s asset cash/ bank and the short-term liabilities at the same time: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 92,000.00 Interest bear liab 200,000.00 A/ R A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 792,000.00 792,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.5: FLASSKAMP AG’s statement of financial position <?page no="69"?> Berkau: BASICS of ACCOUNTING 8-68 Activity 6: On 16.05.20X3, FLASSKAMP AG sells 100 grass mowers at 230.00 EUR each. (Note, there is no margin considered at this stage in order to keep the example easy which means to keep it free of profit and loss.) The customers buy the mowers on credit. The amount they owe FLASSKAMP AG amounts to 100 × 230 = 23,000.00 EUR . As it has not been paid yet, the amount is recognised as an item of receivables (A/ R). At the same time, the value of inventory decreases, because the mowers have been taken out of the storage room. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 69,000.00 Interest bear liab 200,000.00 A/ R 23,000.00 A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 792,000.00 792,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.6: FLASSKAMP AG’s statement of financial position Activity 7: FLASSKAMP AG’s customers pay for the grass mowers 23,000.00 EUR on 9.06.20X3. The amount reduces the receivables (A/ R), because they do no longer owe the money, and it increases the cash/ bank item on the balance sheet. <?page no="70"?> Berkau: BASICS of ACCOUNTING 8-69 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 69,000.00 Interest bear liab 200,000.00 A/ R 0.00 A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 123,000.00 Tax liabilities 792,000.00 792,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.7: FLASSKAMP AG’s statement of financial position Activity 8: On 11.06.20X3, FLASSKAMP AG pays the money owing their mower supplier, by bank transfer. This activity will reduce the amount of cash/ bank by 92,000.00 EUR, because money is taken out of the bank account and will delete the payment obligation to the same extent. The remaining amount in the cash/ bank item now equals to 123,000 - 92,000 = 31,000.00 EUR . A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 69,000.00 Interest bear liab 200,000.00 A/ R 0.00 A/ P 0.00 Prepaid expenses Provisions Cash/ Bank 31,000.00 Tax liabilities 700,000.00 700,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.8: FLASSKAMP AG’s statement of financial position <?page no="71"?> Berkau: BASICS of ACCOUNTING 8-70 The activities above effect assets and capital/ liabilities: Activity 1 increases cash/ bank and increases issued capital. Activity 2 increases inventory and increases payables. Activity 3 increases cash/ bank and increases interest bearing liabilities. Activity 4 increases property, plant and equipment and increases payables. Activity 5 decreases cash/ bank and decreases payables. Activity 6 decreases inventory and increases receivables. Activity 7 decreases receivables and increases cash/ bank. Activity 8 decreases cash/ bank and decreases payables. The following rule applies: If the activities effect items on the same side of the balance sheet, one item will increase and the other one decreases. The total of the changes will be zero. If the activities effect items on both sides of the balance sheet, both items will decrease or both items will increase at the same time. This will change the total of the balance sheet. Summary: Activities that change assets and capital/ liabilities, effect both sides of the balance sheet. Increases of an asset are combined to an increase of capital/ liability or a decrease of another asset and vice versa. Working Definitions: Par value issue: Issuing shares par value means the issue price is the same as the face value per share. Recognition: Recognition means to put something on the face of the balance sheet. Acquisition: Acquisition is buying an asset that is recognised as a non-current one. <?page no="72"?> Berkau: BASICS of ACCOUNTING 9-71 9. Profit and Loss Activities Learning Objectives: This chapter introduces activities that effect assets, capital and liabilities, and profit and loss, too. It will be used to explain how activities change the equity section of the balance sheet. You will learn about the link between the balance sheet and the income statement. Only simple revenue and expense activities will be shown in order to prepare the income statement (= statement of comprehensive income). An income statement determines the company’s profit by subtracting all expenses from earned revenues. Revenue contributes to the increase of equity and increases resources of the company as compensation for the goods sold or services rendered. Revenue is linked to a payment or to receivables. E.g., a company that rents out an office block, will receive money from its tenant which is classified as rental income. For revenue that is obtained by selling goods the expression sales or sales revenue is common among Accountants. This applies in particular if the company is trading, such as a car dealer or a supermarket etc. We use in this text book the term revenue and the abbreviation Rev in the accounts. Expenses are all kind of resources consumed by the company’s activities. This can be materials used up in production, labour, fees paid to other companies, depreciation on machinery, interest paid for bank loans, insurances etc. Not all payments result in expenses. We observed ROHRBACH Ltd. buying equipment. This acquisition is no expense. Only once ROHRBACH Ltd. writes off the phone shelves, depreciation applies and this will be recorded as expense. An expense requires the deployment of resources or its loss in value. A company that uses up inventory, will record that as an expense. However, land cannot be written off, because it keeps its value. It does not get depleted. We now go through activities that are linked to revenue and to expenses and we explain their effects on profit. The aim is to show the profit calculation. We further transfer the profit for the period to the equity section of the statement of financial position. This will show how profit increases the owners’ funds. Profit will be transferred to retained earnings therefore. Retained earnings is the name of an item on the balance sheet that contains the current profit plus profits from previous Accounting periods. Retained earnings is the link between the balance sheet and the income statement. In contrast to the German law, there is no extra account for profit/ loss carried forward, but the amounts are recorded in the Retained Earnings account. In case a company makes a loss, the retained earnings will decrease and can become negative. We study the business activities of the hairdresser salon PELZERHAGEN (Pty.) Ltd.: The company PELZERHAGEN (Pty) Ltd. is established on 2.01.20X7. The company <?page no="73"?> Berkau: BASICS of ACCOUNTING 9-72 is a hairdresser salon. The company offers haircuts and gets the money from their customers on cash. PELZERHAGEN (Pty) Ltd.’s owners contribute 100,000.00 EUR (all together) and put it into the company’s bank account. After the establishment of the business its statement of financial position looks as follows in Figure 9.1: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 100,000.00 100,000.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 9.1: PELZERHAGEN (Pty) Ltd.’s statement of financial position We study the effects of equity increasing and decreasing activities by the examples below: - Activity 1: payment for an expense. - Activity 2: paying for another expense: labour. - Activity 3: acquisition of equipment on credit followed by depreciation on the equipment bought. - Activity 4: service rendered and receiving payments on cash. Activity 1: PELZERHAGEN (Pty) Ltd. rents a shop in a shopping mile and pays 3,400.00 EUR rent by bank transfer on 2.01.20X7 for the whole year. This amount effectuates PELZERHAGEN (Pty) Ltd.’s income statement (rent) and the asset side on the statement of financial position (cash/ bank). Rent is an expense and reduces the profit earned by PELZER-HAGEN (Pty) Ltd. After rent is paid, the cash/ bank item is reduced by 3,400.00 EUR. Cash/ bank now equals to 100,000 - 3,400 = 96,600.00 EUR . The income statement includes an item of “other expenses” that contains all expenses other than material expenses, labour and depreciation. The rent falls under other expenses and is recorded at an amount of 3,400.00 EUR. It is common to combine some expenses on the income statement in order to keep an overview of expenses. Companies could show all different kind of expenses on their income statement, but they actually do not want to reveal too much details about their revenue and cost structure. <?page no="74"?> Berkau: BASICS of ACCOUNTING 9-73 [EUR] Revenue Other income 0.00 Materials Labour Depreciation Other expenses 3,400.00 Earnings before int and taxes (EBIT) (3,400.00) Interest Earnings before taxes (EBT) (3,400.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (3,400.00) Pelzerhagen (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 9.2: PELZERHAGEN (Pty) Ltd.’s statement of comprehensive income We now take a look at PELZERHAGEN (Pty) Ltd.’s statement of financial position. It contains the activity recorded on 2.01.20X7. However, the statement shows the date 31.12.20X7, because there is no requirement for earlier disclosure. Thus, the activities are recorded as at the balance sheet date. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (3,400.00) Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 96,600.00 Tax liabilities 96,600.00 96,600.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 9.3: PELZERHAGEN (Pty) Ltd.’s statement of financial position <?page no="75"?> Berkau: BASICS of ACCOUNTING 9-74 The amount for retained earnings is negative, because at this stage PELZER- HAGEN (Pty) Ltd. only recorded an expense. This makes it look like a loss and there is no profit carried forward. The loss is debited to the Retained Earnings account and will be recognised as negative amount on the face of the balance sheet. (Note, negative amounts are not to be recognised on the face of the balance sheet. Only retained earnings and liabilities/ assets resulting from deferred taxes can become negative.) Activity 2: PELZERHAGEN (Pty) Ltd. pays the salary for the hairdressers of 48,000.00 EUR per bank transfer on 30.06.20X7. (Note, in order to keep the example simple, we assume the amount is paid in the middle of the year. However, the pay-day date is subject to the negotiation between employee and company when they set up the working contract.) The amount of 48,000.00 EUR is taken from the item cash/ bank on the balance sheet and is an expense with regard to the statement of comprehensive income at the same time. On the statement of financial position, the item for cash/ bank now equals to: 96,600 - 48,000 = 48,600.00 EUR . The income statement contains a new expense, which is labour: 48,000.00 EUR. Observe the income statement depicted in Figure 9.4. [EUR] Revenue Other income 0.00 Materials Labour 48,000.00 Depreciation Other expenses 3,400.00 Earnings before int and taxes (EBIT) (51,400.00) Interest Earnings before taxes (EBT) (51,400.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (51,400.00) Pelzerhagen (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 9.4: PELZERHAGEN (Pty) Ltd.’s statement of comprehensive income We take a look at the statement of financial position also. Remember, the statement of financial position here is only temporary as the statements are only required to be prepared as at the yearend. <?page no="76"?> Berkau: BASICS of ACCOUNTING 9-75 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (51,400.00) Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 48,600.00 Tax liabilities 48,600.00 48,600.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 9.5: PELZERHAGEN (Pty) Ltd.’s statement of financial position Activity 3: On 3.01.20X7, the hairdresser salon PELZERHAGEN (Pty) Ltd. buys equipment, such as chairs, hair dryer, etc. at a cost of acquisition of 50,000.00 EUR and agrees with its supplier to pay the amount in the next year. The statement of financial position from now on displays an item of property, plant and equipment and a short-term liability. The acquisition itself does not change profit and loss yet. The business got equipment and has recognised a payment obligation therefore. Only the deployment of the equipment leads to an expense and results in depreciation, see below: The equipment bought can be used during the next 5 Accounting periods at the same timely pattern. This means the reduction of the equipment’s value is the same for all 5 years. After 5 years of deployment, there won’t be any value left. This means the equipment totally gets depleted. According to this information, the company considers depreciation to be 50,000/ 5 = 10,000.00 EUR every year. The company shows depreciation as an expense on the statement of comprehensive income as at 31.12.20X7 - observe below. <?page no="77"?> Berkau: BASICS of ACCOUNTING 9-76 [EUR] Revenue Other income 0.00 Materials Labour 48,000.00 Depreciation 10,000.00 Other expenses 3,400.00 Earnings before int and taxes (EBIT) (61,400.00) Interest Earnings before taxes (EBT) (61,400.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (61,400.00) Pelzerhagen (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 9.6: PELZERHAGEN (Pty) Ltd.’s income statement In the temporary statement of financial position, P, P, E is recognised at the cost of acquisition less the amount of (accumulated) depreciation, which equals to: 50,000 - 10,000 = 40,000.00 EUR . PELZERHAGEN (Pty) Ltd. bought its equipment on credit, so there are payables to the extent of 50,000.00 EUR still on the credit side of the balance sheet. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 40,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (61,400.00) Current assets Liabilities Inventory Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 48,600.00 Tax liabilities 88,600.00 88,600.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 9.7: PELZERHAGEN (Pty) Ltd.’s statement of financial position <?page no="78"?> Berkau: BASICS of ACCOUNTING 9-77 Activity 4: PELZERHAGEN (Pty) Ltd. renders services (haircuts) to its customers and earns 130,000.00 EUR of revenue. Assumingly, this activity only takes place on 20.12.20X7. The money is paid by the customers on cash immediately. The amount of cash/ bank on the balance sheet increases by the payment received from the customers. The new amount is 48,600 + 130,000 = 178,600.00 EUR (after the transaction). The amount for the revenue is to be shown in the first line of the statement of comprehensive income. All activities are considered by the income statement by now. The income statement further contains an item for income tax expenses. Income taxes are paid proportionally based on the profit. The total income tax rate we apply in this text book is 30 %. According to the tax calculation, PELZERHAGEN (Pty) Ltd. has to pay 30% × 68,600 = 20,580.00 EUR on income taxes. The amount is due in the next Accounting period. PELZERHAGEN (Pty) Ltd. recognises a liability for income taxes to the extent of 20,580.00 EUR on their balance sheet. [EUR] Revenue 130,000.00 Other income 130,000.00 Materials Labour 48,000.00 Depreciation 10,000.00 Other expenses 3,400.00 Earnings before int and taxes (EBIT) 68,600.00 Interest Earnings before taxes (EBT) 68,600.00 Income tax expenses 20,580.00 Deferred taxes Earnings after taxes (EAT) 48,020.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 9.8: PELZERHAGEN (Pty) Ltd.’s statement of comprehensive income The profit earned by the company increases the owners’ funds. It is to be transferred to equity on the balance sheet accordingly. This means, there is an increase of the company’s value. Equity represents the company’s book value. Observe the statement of financial position for PELZERHAGEN (Pty) Ltd. in Figure 9.9. The amount for the equipment therein is the cost of acquisition less depreciation: 50,000 - 10,000 = 40,000.00 EUR . The cash/ bank item is 100,000 - 3,400 - 48,000 + 130,000 = 178,600.00 EUR . The <?page no="79"?> Berkau: BASICS of ACCOUNTING 9-78 profit has been transferred from the income statement to retained earnings and is 48,020. The payables result from the acquisition of property, plant and equipment. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 40,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 48,020.00 Current assets Liabilities Inventory Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 178,600.00 Tax liabilities 20,580.00 218,600.00 218,600.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 9.9: PELZERHAGEN (Pty) Ltd.’s statement of financial position Summary: Activities that effect profit/ loss of a business are shown on the statement of comprehensive income. The difference between revenue and expenses is the profit. A negative profit is called loss. Income taxes are based on the pre-tax profit and are calculated in this text book with a constant IT-rate of 30 %. Losses do not cause income taxes nor refunds. The earnings after taxes (EAT) are transferred to retained earnings and will increase the owners’ equity in the balance sheet if positive. The equity of the balance sheet represents the book value of the business. Working Definition: Retained Earnings: Retained earnings is the name of an item on the balance sheet that contains the profit and profits from previous Accounting periods. <?page no="80"?> Berkau: BASICS of ACCOUNTING 10-79 10. Introduction to T-Accounts for Real Accounts Learning Objectives: In this chapter we introduce T-accounts as instrument for preparing financial statements. After studying this chapter, you will be able to understand the concept of real and nominal accounts and can record easy business activities therein. You will learn how to make entries and to balance-off accounts. The business activities discussed in the previous chapters all determine items displayed on the balance sheet and/ or income statement. It would be possible, recording business activity effects on financial statements by always prepare new statements. However, this means a lot of effort in Accounting. In order to simplify the recording procedure, companies apply recording based on accounts. All accounts together are called the bookkeeping records. All changes caused by business activities will be recorded by making entries in the accounts. At the end of every year/ Accounting period, the value of the accounts will be calculated and copied to the financial statements. This way, accounts represent items of financial statements. Recording means, keeping a list of how business activities change items. Entries are made like adding lines to a list. One side is for increases and the opposite one is for decreases. We introduce T-accounts right now. Like the balance sheet, T-accounts come with two sides. They are called debit side (left) and credit side (right). One of the sides will show the opening value and all increases in the account, whereas the opposite side shows the decreases. Which side contains the opening value and the increases and which one the decreases, depends on the item, the account represents. E.g., an account representing and item of property, plant and equipment. Increases thereof will be seen as additions to the value and losses in value as decreases. Asset accounts show opening amounts and increases on the debit side. An asset reduction, such as depreciation or sales of items, leads to an entry on the credit side of the asset account. We introduce a Cash account. Cash is a current assets recognised on the asset side of the balance sheet. Cash accounts display the opening amount on the debit side if positive. Our account displays an opening value of 100.00 EUR. It is recorded as a debit entry. The account looks as below in Figure 10.1. <?page no="81"?> Berkau: BASICS of ACCOUNTING 10-80 D C OV 100.00 Cash Figure 10.1: T-Account „Cash“ Every account has a name shown on the top of the “T”. The name is linked to an ID number. All names and IDs for accounts are listed in the chart of accounts. The list of all accounts in use is referred to as the chart of accounts. A chart of accounts is necessary in order to use the same account names over different companies. Companies that belong to a group, will apply the same chart of accounts. We do not apply standard chart of accounts in this text book to keep Accounting simple. We assume each item of the balance sheet and each item of the income statement is an account. That will be our simplified classroomchart of accounts. There is a P, P, E account, an Intangible account, a Financial Instrument account, an Inventory account etc. The account’s name in Figure 10.1 is Cash. Thus, it belongs to the item cash/ bank on the balance sheet. In the account, we have to mention the currency unit and the level of rounding that applies for the account. In this text book, the currency for all accounts EUR and amounts are displayed by two digits after the decimal point. In case of the Cash account in figure 10.1 the opening value (OV) amounts to 100.00 EUR. From the previous chapters, we know already that cash is an asset and accordingly, the account belongs to an item on the asset side of the balance sheet. An asset account is an account which records the value of an asset item on the balance sheet. The opening amount of asset accounts is always shown on the debit side, if positive. The Accountant will record any increases on the debit side and any decreases on the credit side. We now observe a few changes of the Cash account: (1) Input of 200.00 EUR. (2) Another input of 400.00 EUR. (3) Output of 130.00 EUR. (4) Another output of 40.00 EUR. (5) Another output of 125.00 EUR. <?page no="82"?> Berkau: BASICS of ACCOUNTING 10-81 D C OV 100.00 (3) 130.00 (1) 200.00 (4) 40.00 (2) 400.00 (5) 125.00 Cash Figure 10.2: T-account format for the Cash account The account now contains a few debit entries and a few credit entries. The entries come with narrative information. The narrative information given here is only the reference number of the entries (1) ... (5), which refers to the text. We want to determine how much money is in the Cash account. We say we want to know the account’s balance or the balancing figure of the Cash account after the entries (1) ... (5) have been made. It is the opening amount plus all increases less all decreases. The balancing figure equals to: 100 + 200 + 400 - 130 - 40 - 125 = 405.00 EUR. To balance-off an account means determining the balancing figure of an account. The process of balancingoff an account, doesn’t change the value of the account. An account can be balanced-off at any time and as often as necessary. The process of balancing-off only enters a debit entry and a corresponding credit entry in the same account to the same amount. If we balance-off an account, the balancing figure is entered into the account by the reference “balance carried down“ or “Bal c/ d“ or just “c/ d“. After we inserted the balancing figure into the Cash account in Figure 10.3 on the credit side, the total of the debit side equals to the total of the credit side. Both sums equal to 700.00 EUR. We write the balancing figure as opening amount for the next Accounting period to the opposite side of where the entry for the balance carried down has been made. It is called the “balance brought down“ or “Bal b/ d“ or just “b/ d“. Observe the balancing-off of the Cash account in Figure 10.3. D C OV 100.00 (3) 130.00 (1) 200.00 (4) 40.00 (2) 400.00 (5) 125.00 c/ d 405.00 700.00 700.00 b/ d 405.00 Cash Figure 10.3: T-Account „Cash“ <?page no="83"?> Berkau: BASICS of ACCOUNTING 10-82 In case we want to show the balancing figure of the Cash account on the face of the balance sheet we make a copy according to the balance brought down in the balance sheet. This is no bookkeeping entry! It will look as follows from Figure 10.4: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 405.00 Tax liabilities 405.00 STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 10.4: Cash amount displayed on the balance sheet. All accounts linked to balance sheet’s items on the asset side got the same structure as the Cash account. They show a positive amount on the debit side, they increase on the debit side and they decrease on the credit side. Accounts linked to items of the balance sheet’s credit side, such as equity or liabilities, are inverted. This means they will show the opening amount on the credit side and increases there also. Decreases are made by debit entries. This applies for the Issued Capital account, for the Reserves accounts etc. All accounts which are linked to the balance sheet are called real accounts. Accounts linked to the income statement are called nominal accounts. They can be seen as subordinated accounts to the Retained Earnings account. Remember, the Retained Earnings (R/ E) account is on the credit side. Increases of retained earnings mean the company’s profit increases. This applies for revenues. Revenues are represented by credit entries in nominal accounts. According to that, expense accounts will be debited for recording an expense. You can learn as a rule: Revenue always gives a credit entry and expenses lead to debit entries. In order to start with Accounting, we assign one account to each item of the balance sheet and to each item of the income statement. Accordingly, our chart of accounts will be: <?page no="84"?> Berkau: BASICS of ACCOUNTING 10-83 (1) Property, plant and equipment (2) Intangibles (3) Financial assets (4) Inventory (5) Accounts receivables (6) Prepaid expenses (7) Cash/ bank (8) Issued capital (9) Reserves (10) Retained earnings (11) Interest bearing liabilities (12) Accounts payables (13) Provisions (14) Tax liabilities (15) Revenue (16) Other income (17) Materials (18) Labour (19) Depreciation (20) Other expenses (21) Interest (22) Income tax expenses (23) Deferred taxes Our chart of the accounts is simple and we shall stick to it for the whole text book. Later we will assign more accounts to one item, which gives subordinated accounts. This means for the Cash/ Bank account, there will be an account with Commerzbank, another one with Deutsche Bank, another one with Sparkasse Osnabrück etc. All accounts based on the chart of accounts form the general ledger. A general ledger contains the basic accounts without any subordinated accounts. We start to make entries for the cell phone dealer ROHRBACH Ltd. as introduced in chapter Introduction to Statements of Financial Position and Statement of Comprehensive Income: ROHRBACH Ltd. applies the following asset accounts: - Property, plant and equipment. - Inventory. - Cash/ bank We set up ROHRBACH Ltd.’s accounts and post an opening value of 250,000.00 EUR to the Cash/ Bank account. D C D C D C OV 250,000.00 Cash/ Bank P,P,E Inventory Figure 10.5: ROHRBACH Ltd.‘s accounts The activities are as follows, see chapter Activities on the Asset Side : (1) Purchase of 1,000 smart phones and payment by bank transfer of 150,000.00 EUR on 3.01.20X5. (2) Acquisition of 4 shelves at 4,700.00 EUR and payment thereof on 6.02.20X5. (3) Sales of 67 phones and receiving money 10,050.00 EUR on 8.02.20X5. <?page no="85"?> Berkau: BASICS of ACCOUNTING 10-84 (4) Disposal of 2 shelves on 22.03.20X5. The money obtained amounts to 2,350.00 EUR. Note, the shelves were sold at the same price as the have been bought at. There is no profit considered. For entries in the accounts, it is common to mention the date and the relevant contra account(s). This information is called narrative. Thus, the accounts look as displayed by Figure 10.6: D C Cash/ Bank 6.02.20X5 4,700.00 Cash/ Bank 22.03.20X5 2,350.00 Bal c/ d 31.12.20X5 2,350.00 4,700.00 4,700.00 Bal b/ d 1.01.20X6 2,350.00 D C Cash/ Bank 3.01.20X5 150,000.00 Cash/ Bank 8.02.20X5 10,050.00 Bal c/ d 31.12.20X5 139,950.00 150,000.00 150,000.00 Bal b/ d 1.01.20X6 139,950.00 D C OV 1.01.20X5 250,000.00 Inventory 3.01.20X5 150,000.00 Inventory 8.02.20X5 10,050.00 P,P,E 6.02.20X5 4,700.00 P,P,E 22.03.20X5 2,350.00 Bal c/ d 31.12.20X5 107,700.00 262,400.00 262,400.00 Bal b/ d 1.01.20X6 107,700.00 Inventory Cash/ Bank P,P,E Figure 10.6: ROHRBACH Ltd.’s accounts For this text book, we are going to simplify the display of the accounts. The bookkeeping entries only will be identified by the bookkeeping number, here: (1) ... (4). The date is mentioned in the text, so we won’t write it into the accounts again. The bookkeeping entries made in the accounts for ROHRBACH Ltd. then look along our text book account display as in Figure 10.7: D C D C (2) 4,700.00 (4) 2,350.00 (1) 150,000.00 (3) 10,050.00 c/ d 2,350.00 c/ d 139,950.00 4,700.00 4,700.00 150,000.00 150,000.00 b/ d 2,350.00 b/ d 139,950.00 P,P,E Inventory Figure 10.7: ROHRBACH Ltd.’s accounts <?page no="86"?> Berkau: BASICS of ACCOUNTING 10-85 D C OV 250,000.00 (1) 150,000.00 (3) 10,050.00 (2) 4,700.00 (4) 2,350.00 c/ d 107,700.00 262,400.00 262,400.00 b/ d 107,700.00 Cash/ Bank Figure 10.7: ROHRBACH Ltd.’s accounts (continued) The format in figure 10.7 is easy to prepare and offers you a quick way of making bookkeeping entries in exams, too. (Note, there is no law prescribing regulations about how to make bookkeeping entries.) If you compare the balancing figures in ROHRBACH Ltd.’s accounts (check the balances brought down), you’ll find the same amounts as provided by the balance sheet in Figure 10.8. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 2,350.00 Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 139,950.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 107,700.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 10.8: ROHRBACH Ltd.’s statement of financial position (asset side) We apply the knowledge about accounts for the second case study FLASSKAMP AG. In contrast to the previous example, FLASSKAMP AG runs accounts that are linked to the capital/ liability side of the statement of financial position, too. We stick to our account display as introduced above by Figure 10.7. For the case study we introduce capital/ liability accounts. Capital/ liability accounts are linked to capital or to liabilities and will show the opening values on the credit side. Capital/ liabilities accounts are real accounts. They show any increases on the credit side and will decrease by entries made on the debit side. Before studying the FLASSKAMP AG case <?page no="87"?> Berkau: BASICS of ACCOUNTING 10-86 study, we observe a Liability account for a bank loan. We here also want to show an account continued over more than one Accounting period. The bank loan is represented by an Interest Bearing Liabilities account and is linked to the capital/ liability side of the statement of financial position. Observe the account in Figure 10.9: D C (1) 5,000.00 OV 100,000.00 c/ d 95,000.00 100,000.00 100,000.00 (2) 5,000.00 b/ d 95,000.00 c/ d 90,000.00 95,000.00 95,000.00 b/ d 90,000.00 Interest bearing liabilities Figure 10.9: Liability account In this case, taking the bank loan gives an opening value of 100,000.00 EUR to be displayed on the credit side. The account for interest bearing liabilities is linked to the interest bearing liability item on the credit side of the statement of financial position. The pay-off bookkeeping entries reduce the obligation to pay money back to the bank and are to be made on the debit side. Every year’s pay-off is 5,000.00 EUR in this example. Observe the first 2 years of the bank account to understand the way accounts work when they belong to the capital/ liability side and study their difference to asset accounts. Here, the balances brought down are on the credit side always. This means there is still a liability. Payments that reduce the liabilities are made by debiting the amounts to the Interest Bearing Liability account, see bookkeeping entry (1) and (2). After the first Accounting period the balance of the IBL account is 95,000.00 EUR. After 2 years it is 90,000.00 EUR. After 2 years the bank loan is worth 90,000.00 EUR. That is the amount to be displayed on the balance sheet as at the balance sheet date also. The sum of the debit and credit entries is shown below a line and is underlined twice. Every account that has a balancing figure will show this as balance brought down underneath of the sum. If an account is “empty” in the meaning of balanced to zero, there won’t be a balancing figure. The sum will be on the bottom line then. How it is done (balancing-off an account): (1) Check whether your account is a (a) real or (b) nominal account. (2a) If the account is a real account, that belongs to the debit side of the balance sheet, make bookkeeping <?page no="88"?> Berkau: BASICS of ACCOUNTING 10-87 entries for increases on the debit side and bookkeeping entries for decreases on the credit side. If the account is a real account, that belongs to the credit side of the balance sheet, make bookkeeping entries for increases on the credit side and bookkeeping entries for decreases on the debit side. (2b) If the account is a nominal account, make bookkeeping entries for revenues on the credit side and bookkeeping entries for expenses on the debit side. (3) Add up both sides of the account. (4) Insert a figure on the “shorter” side in order to make the sums of the debit side and of the credit side equal. (5) Name the inserted figure balance carried down and indicate this in the account by “Bal c/ d” or only “c/ d”. (6) Write under the figures of the bookkeeping entries and the balance carried down the sum of the debit side and the sum of the credit side. Double underline the totals. (7) Transfer the amount of the balance carried down to the opposite side. If the balance carried down is on the debit side, make an entry underneath the sum on the credit side. If the balance carried down is on the credit side, make an entry underneath the sum on the debit side. (8) Name the entry of step (7) balance brought down and indicate the figure by “Bal b/ d” or “b/ d”. After learning the way capital/ liability accounts work, we’ll apply this knowledge for the FLASSKAMP AG case study, too. FLASSKAMP AG has to record 8 activities: (1) Activity 1: Share issue of 50,000 ordinary shares on 2.01.20X3. The issued shares amount to 500,000.00 EUR. (2) Activity 2: Purchase of 400 grass mowers on credit 92,000.00 EUR on 15.02.20X3. (3) Activity 3: Taking a bank loan 200,000.00 EUR on 1.03.20X3. (4) Activity 4: On 4.03.20X3, FLASSKAMP buys a new show room at 600.000,00 EUR and agrees to pay later. (5) Activity 5: On 18.03.20X3, FLASS- KAMP AG pays the amount due for the show room into the seller’s bank account. It is 600,000.00 EUR. (6) Activity 6: FLASSKAMP AG sells 100 grass mowers on credit on 16.05.20X3. The amount is 23,000.00 EUR. (7) Activity 7: On 9.06.20X3, FLASSKAMP AG’s customers pay 23,000.00 EUR for the grass mowers into the company’s bank account. (8) Activity 8: On 11.06.20X3, FLASS- KAMP AG pays the amount of 92,000.00 <?page no="89"?> Berkau: BASICS of ACCOUNTING 10-88 EUR owing the grass mower supplier into his bank account. The accounts applied in the FLASSKAMP AG case study are: - Property, plant and equipment. - Inventory. - Accounts receivables. - Cash/ bank. - Issued capital. - Interest bearing liabilities. - Accounts payables. Observe the accounts and their entries in Figure 10.10 below: D C D C (4) 600,000.00 c/ d 600,000.00 c/ d 500,000.00 (1) 500,000.00 b/ d 600,000.00 b/ d 500,000.00 D C D C (2) 92,000.00 (6) 23,000.00 c/ d 200,000.00 (3) 200,000.00 c/ d 69,000.00 b/ d 200,000.00 92,000.00 92,000.00 b/ d 69,000.00 D C D C (6) 23,000.00 (7) 23,000.00 (5) 600,000.00 (2) 92,000.00 (8) 92,000.00 (4) 600,000.00 692,000.00 692,000.00 D C (1) 500,000.00 (5) 600,000.00 (3) 200,000.00 (8) 92,000.00 (7) 23,000.00 c/ d 31,000.00 723,000.00 723,000.00 b/ d 31,000.00 Inventory Interest bearing liabilities A/ R A/ P P,P,E Issued Capital Cash/ Bank Figure 10.10: FLASSKAMP AG’s accounts Compare the balancing figures in the accounts to the balance sheet items. In order to provide a better overview, the asset accounts have been placed to the left hand side and the capital/ liability accounts to the right hand side in Figure 10.10. (Note, in general, we place the accounts along the order they appear in the text.) <?page no="90"?> Berkau: BASICS of ACCOUNTING 10-89 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 69,000.00 Interest bear liab 200,000.00 A/ R 0.00 A/ P 0.00 Prepaid expenses Provisions Cash/ Bank 31,000.00 Tax liabilities 700,000.00 700,000.00 Flasskamp AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 10.11: FLASSKAMP AG’s statement of financial position Summary: Accounts apply to record activities. They contain a debit and a credit side. Entries for increases of assets will be made on the debit side. Reductions of the assets lead to credit entries in the asset accounts. Entries for increases of capital or of liabilities will be made on the credit side. Reductions of capital and liabilities lead to debit entries in the capital/ liability accounts. All accounts linked to the balance sheet are called real accounts. The balancing figure of the real accounts is displayed as balance brought down and is copied into the statement of financial position. Accounts for profit calculation are linked to retained earnings. They are referred to as nominal accounts. Increases are credited and decreases debited to nominal accounts. Working Definitions: Real Account: Accounts which are linked to the balance sheet are called real accounts. Nominal Account: Accounts linked to the income statement are called nominal accounts. General Ledger: A general ledger contains the basic accounts without any subordinated accounts. Asset Account: An asset account is an account which records an asset item on the balance sheet. Capital/ Liability Account: Capital/ liability accounts are linked to capital or to liabilities will show the opening values on the credit side. Balancing-off an Account: To balance-off an account means determining the balancing figure of an account. Chart of Accounts: The list of all accounts in use is referred to as the chart of accounts. <?page no="91"?> Berkau: BASICS of ACCOUNTING 11-90 11. T-Accounts for Profit and Loss Learning Objectives: In this chapter, we deal with nominal accounts representing revenue and expenses. The outcome of the chapter is to learn how to make bookkeeping entries for profit relevant activities and how to apply the Profit and Loss account. After studying this chapter, you can calculate profit. In the previous chapters, we only made entries in real accounts. Therefore, no profit and loss calculation applied based on bookkeeping records made. The previous case studies ROHRBACH Ltd. and FLASSKAMP AG were free of profit which means, the companies sold goods at the same price as they have purchased them for before. We record revenue and expense now. Revenue will increase the profit of the business expenses will decrease it. Later on, the resulting profit is transferred to the Retained Earnings account in the equity section on the statement of financial position. Thus, profit will increase the book value of the business - a loss reduces it. Revenue entries are recorded on the credit side. Bookkeeping entries for expenses will be debit entries. In contrast to the real accounts, nominal accounts won’t be transferred straight onto the balance sheet. They will be closed-off to the Profit and Loss account at first. Only the Profit and Loss account is transferred to the balance sheet and increases/ decreases the figure of retained earnings. Closing-off an account to another account means to put the balancing figure of the source account into the target account. By closing-off an account, its balancing figure becomes zero; the account is deleted that way. The previous balancing figure will appear as an entry in the target account. How it is done (closing-off an account to another one) (1) Determine which source account should be closed-off to which target account. (2) Balance-off the source account. (3) In the source account make an entry opposite to the balance brought down to the same amount as the balance brought down. (4) Make the contra entry in the target account. The PELZERHAGEN (Pty) Ltd. case study is about profit and loss. Nominal accounts apply. After recording revenues and expenses, we close-off all nominal accounts to the Profit and Loss account, which means, we transfer all revenues and expenses to profit and loss at the end of the Accounting period. The balancing figure of the P&L account is the profit for the period and will be <?page no="92"?> Berkau: BASICS of ACCOUNTING 11-91 transferred to the Retained Earnings account on the balance sheet. We now go through the PELZER- HAGEN (Pty) Ltd. case study again. It will lead us through the bookkeeping entries for the profit calculation. The case study contains 4 activities: (1) Paying 3,400.00 EUR rent by bank transfer on 2.01.20X7. (2) Paying salaries of 48,000.00 EUR by bank transfer on 30.06.20X7. (3a) Acquisition of equipment for 50,000.00 EUR on credit on 3.01.20X7 and (3b) depreciation on equipment on 31.12.20X7. (4) Earning revenue 130,000.00 EUR on 20.12.20X7. PELZERHAGEN (Pty) Ltd. applies the following accounts: - Property, plant and equipment. - Cash/ bank. - Issued capital. - Revenue. - Other expenses (rent). - Salaries. - Profit and Loss account. - Income tax expenses. At the beginning of the Accounting period 20X7, PELZERHAGEN (Pty) Ltd.’s balance sheet looks as displayed in Figure 11.1: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 100,000.00 100,000.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 11.1: PELZERHAGEN (Pty) Ltd.’s statement of financial position The first step is the transfer of opening values into the accounts. It gives us the opening values (OV). The opening amounts are provided by the statement of financial position. In the PELZER- HAGEN (Pty) Ltd. case study there are opening values for the Cash/ Bank account and for the Issued Capital account. In cases one B/ S item is linked to more than one account, the opening amounts cannot be copied from the <?page no="93"?> Berkau: BASICS of ACCOUNTING 11-92 statement of financial position. In that situation the amounts are to be taken from the accounts. For instance, the balance sheet item cash/ bank does not tell how much is the balancing figure in the Commerzbank, Deutsche Bank and Sparkasse Osnabrück account and how much cash is on hand. However, this problem is a class room problem only, as in general, accounts will be continued from the previous Accounting periods. Thus, there is no need to read the figures from the financial statements. Compare the opening values in PEL- ZERHAGEN (Pty) Ltd.’s accounts in Figure 11.2. to the balance sheet. D C D C OV 100,000.00 (1) 3,400.00 c/ d 100,000.00 OV 100,000.00 (4) 130,000.00 (2) 48,000.00 b/ d 100,000.00 c/ d 178,600.00 230,000.00 230,000.00 b/ d 178,600.00 D C D C (3a) 50,000.00 (3b) 10,000.00 (1) 3,400.00 c/ d 3,400.00 c/ d 40,000.00 b/ d 3,400.00 P&L 3,400.00 50,000.00 50,000.00 b/ d 40,000.00 D C D C (2) 48,000.00 c/ d 48,000.00 c/ d 50,000.00 (3a) 50,000.00 b/ d 48,000.00 P&L 48,000.00 b/ d 50,000.00 D C D C c/ d 130,000.00 (4) 130,000.00 Sal. 48,000.00 Rev 130,000.00 P&L 130,000.00 b/ d 130,000.00 Dpr 10,000.00 Rnt 3,400.00 EBT 68,600.00 130,000.00 130,000.00 ITL 20,580.00 b/ d 68,600.00 R/ E 48,020.00 68,600.00 68,600.00 P,P,E Rent Salaries A/ P Cash/ Bank Issued Capital Revenue Profit and Loss Figure 11.2: PELZERHAGEN (Pty) Ltd.’s accounts <?page no="94"?> Berkau: BASICS of ACCOUNTING 11-93 D C D C c/ d 48,020.00 P&L 48,020.00 c/ d 20,580.00 P&L 20,580.00 b/ d 48,020.00 b/ d 20,580.00 D C (3b) 10,000.00 c/ d 10,000.00 b/ d 10,000.00 P&L 10,000.00 R/ E Income tax liabilities Depreciation Figure 11.2: PELZERHAGEN (Pty) Ltd.’s accounts (continued) We observe all bookkeeping entries made for the activities. They can be identified by the ID numbers of the activities (1) ... (4) in the accounts. After making the bookkeeping entries, all real accounts are balanced-off and the balancing figure is taken to the statement of financial position. It is depicted by Figure 11.4. E.g., the Cash/ Bank account’s balancing figure is 178,600.00 EUR. The amount for the balance brought down is on the debit side of the Cash/ Bank account. We call an account like that a debit balanced account. The Cash/ Bank account being debit balanced means, PELZERHAGEN (Pty) Ltd. has money on cash or in the bank, here to the extent of 178,600.00 EUR. A credit balanced Bank account indicates a bank overdraft. After making bookkeeping entries for the 4 activities, all nominal accounts will be closed-off to the Profit and Loss account: These are the Rent account, the Salary account, the Revenue account and the Depreciation account. E.g., the amount for rent is 3,400.00 EUR as indicated by entry (1). The Rent account is balanced-off and reveals a balance brought down on the debit side to the extent of 3,400.00 EUR. Check the Salary account and the Depreciation account also. In contrast, the Revenue account is credit balanced to an extent of 130,000.00 EUR. The balances of the nominal accounts are transferred to the Profit and Loss account. The entry P&L on the credit side of the Rent account closes it off. By this, the Rent account has no balancing figure anymore, because it became zero. The account is deleted. At the same time, the 3,400.00 EUR appear on the debit side of the Profit and Loss account, 3 rd line. The reference there reads Rent account (Rnt). The transfer of the rent results in a debit entry in the Profit and Loss account and a credit entry in the Rent account to the same extent of 3,400.00 EUR. The Profit and Loss account receives all revenues and expenses. Here, it got debit entries for salaries, for depreciation and rent. The total of the expenses in the Profit and Loss account equals to: 48,000 + 10,000 + 3,400 = 61,400.00 EUR . Furthermore, the Profit and Loss account receives the revenue from closing-off the Revenue account. PEL- ZERHAGEN (Pty) Ltd.’s pre-tax profit is calculated by deducting expenses from its revenue. The profit before taxes equals to: 130,000 - 61,400 = 68,600.00 EUR . The amount is derived by balancing-off the Profit and Loss account. The Profit and Loss account shows the pretax profit as EBT. <?page no="95"?> Berkau: BASICS of ACCOUNTING 11-94 The Profit and Loss account provides all the information required to set up the income statement. Compare the account to the income statement as shown in Figure 11.3: [EUR] Revenue 130,000.00 Other income 130,000.00 Materials Labour 48,000.00 Depreciation 10,000.00 Other expenses 3,400.00 Earnings before int and taxes (EBIT) 68,600.00 Interest Earnings before taxes (EBT) 68,600.00 Income tax expenses 20,580.00 Deferred taxes Earnings after taxes (EAT) 48,020.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 11.3: PELZERHAGEN (Pty) Ltd.’s statement of comprehensive income For tax calculations, we take a look at the statement of comprehensive income, before we study the accounts. The income tax is deducted from the earnings before taxes (= pre-tax profit). Along the conventions for this text book the total income tax rate is 30 % based on the pre-tax profit. 30 % × 68,600 = 20,580.00 EUR. In the income statement the amount for taxes is deducted from earnings before taxes. The result is the annual surplus also known as earnings after taxes EAT. We now continue the Profit and Loss account in the same way, as we did with the Interest Bearing Liability account in Figure 10.9: We add up all entries and make an entry “b/ d” underneath of the sum, here to the extent of 68,600.00 EUR. The next debit entry in the Profit and Loss account represents income tax expenses which amount to 20,580.00 EUR. The contra entry is in the Income Tax Liability account. After that, the Profit and Loss account is closed-off to the Retained Earnings account in Figure 11.2. Underneath of the tax entry, there is a debit entry with the reference “R/ E”. The Retained Earnings account is a real account. It belongs to the credit side of the statement of financial position. The amount transferred equals to: 68,600 - 20,580 = 48,020.00 EUR and appears on the face of the statement of financial position as retained earnings. There is also an entry in the Retained Earnings account on the credit side with the reference “P&L”. See the statement of financial position displayed in Figure 11.4: <?page no="96"?> Berkau: BASICS of ACCOUNTING 11-95 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 40,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 48,020.00 Current assets Liabilities Inventory Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 178,600.00 Tax liabilities 20,580.00 218,600.00 218,600.00 Pelzerhagen (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 11.4: PELZERHAGEN (Pty) Ltd.’s statement of financial position How it is done (profit calculation with the Profit and Loss account) (1) Make debit entries for expenses in the relevant nominal accounts. (2) Make credit entries for revenues in the relevant nominal accounts. (3) Close-off all nominal accounts to the Profit and Loss account. (4) Determine the balancing figure of the Profit and Loss account which is EBT. The balancing figure can be (a) on the debit side or (b) on the credit side. (5a) If the balancing figure of the Profit and Loss account is on the debit side, the business earns a profit. Determine income taxes by multiplying the total income tax rate by EBT. Determine earnings after taxes by reducing EBT by income taxes. Make credit entries in the Income Tax Liability account and in the Retained Earnings account. (5b) If the balancing figure of the Profit and Loss account is on the credit side, the business makes a loss. Close-off the Profit and Loss account to the Retained Earnings account by making a debit entry in the Retained Earnings account and a credit entry in the Profit and Loss account. <?page no="97"?> Berkau: BASICS of ACCOUNTING 11-96 Summary: Accounts support the preparation of financial statements. The accounts are linked to items of the balance sheet and to items of the income statement. The income statement is prepared by the Profit and Loss account. All accounts linked to revenues will be credited - all accounts for expenses will be debited. After profit calculation, the amount for earnings after taxes is transferred to the Retained Earnings account. Income tax expenses are credited to the Income Tax Liability account on the statement of financial position. Working Definition: Closing-off: Closing-off an account to another account means to put the balancing figure of the source account into the target account. <?page no="98"?> Berkau: BASICS of ACCOUNTING 12-97 12. Introduction to Bookkeeping Entries Learning Objectives: This chapter introduces bookkeeping entries. Talking in bookkeeping entries will become your language as an Accountant. The bookkeeping entry tells in which accounts entries are made. It further gives the amount. We explain the double entry system as the underlying concept of making bookkeeping entries. After studying this chapter, you will understand recording the business activities. In the previous chapters, we made entries with regard to items of the statement of financial position and in the statement of comprehensive income. Later, we made entries in accounts, too. So far we just made the entries in the statements or in the accounts but we did not write them down. However, we start writing and memorizing complete bookkeeping entries from this chapter onwards. Furthermore, we’ll acknowledge that a lot of similar activities exists leading to the same kind of bookkeeping entries. A bookkeeping entry is the recording of a business activity. It contains a debit entry and a credit entry. Bookkeeping entries contain information which account is changed, on which side an entry is made (debit or credit side), which amount is recorded and when the recording is made (date). Ad (1): Account’s name: The account name is written into the bookkeeping entry. In case we apply a chart of accounts which contains numbers for identifying accounts, the ID number is mentioned as well. E.g., “3100 Bank account”. Ad (2): Recording on the debit or credit side: We indicate by writing debit entry or credit entry which side of the account is increased. Bookkeeping entries are always added to accounts. No negative amount will be added. No deductions or deletions in accounts are allowed. A debit entry is marked by “DR” for debit recorded, a credit entry is marked by “CR” for credit recorded. Ad (3): Amount recorded: The amount added to an account is written down correctly and in full. No rounding or whatsoever is allowed! Bookkeeping entries are at the exact amount which contains the full EUR amount plus two digits for the EURcent. Ad (4): Date: The date of the bookkeeping entry is mentioned next to the bookkeeping entry. The date is exact to the day. No timely information is required for recording. If you apply bookkeeping on a computer system, the software will put a time stamp at your bookkeeping entry, which will identify bookkeeping entries made on the same day. <?page no="99"?> Berkau: BASICS of ACCOUNTING 12-98 (Note, in this text book we only mention the date in the text.) Recording a business activity leads to at least one debit and one credit entry. This is for fulfilling the Accounting equation. A compound bookkeeping entry is one that contains more than one debit entry and/ or more than one credit entry. The sum of debit entries equals to the total of credit entries in a compound bookkeeping entry. Along common regulations, a bookkeeping entry never gets changed. This comes from the old days, when bookkeeping entries were made on paper. In order to guarantee the correctness of recording, it is not allowed to delete or manipulate entries. The entries had to be written with indelible ink. Once the entry has been made, it will stay. This rule applies with software solutions, too. You are not able to delete or change entries after they have been recorded. Remember: The bookkeeping entries will determine the values on the financial statements. In order to ensure the data disclosed thereon are correct, bookkeeping regulations are very strict. In case, something is to change, you have to make a follow-up bookkeeping entry, and both entries will stay on the system. This makes Accounting transparent and prevents from fraud. Today’s software solutions make sure you don’t make wrong bookkeeping entries. They computer systems precheck every entry before posting. However, in the university you’ll make entries on paper and/ or maybe on MS Excel, which means you make bookkeeping entries without any prechecks, but you can change them later. For bookkeeping the double entry system applies. It is closely linked to the Accounting equation we introduced in chapter Cafeteria Example for the Balance Sheet Preparation with regard to the KENSINGTON CAFETERIA case study. The Accounting equation states that always the total of assets equals to the total of capital and liabilities. Check all entries we made so far in the previous chapters you will see that we always made for each and every activity one entry in an account on the debit side and a contra entry in another account on the credit side. If you follow this rule strictly, the debit side and the credit side of the balance sheet will equal to each other. This concept of making debit entries and credit entries together, is referred to as the double entry system. The concept is based on the Accounting equation. In order to state bookkeeping entries, it is common Accounting practice to name the debit entry at first. The debit entry is followed by the credit entry. In case of compound bookkeeping entries, the debit entries are mentioned at first followed by the credit entries. Among the debit entries and among the credit entries, no rule about the sequence exists. In this text book we write bookkeeping entries always in bold fonts style to highlight them within the text. We further use non-proportional fonts types in order to display the figures straight and at the same position (a 111 has the same width as a 999). This will help <?page no="100"?> Berkau: BASICS of ACCOUNTING 12-99 you to add up the debit and credit entries, when you see them on paper. However, due to the format of this text book, we don’t indent credit entries, such as below: DR Inventory 150,000.00 EUR CR Cash/ Bank 150,000.00 EUR All entries made with regard to activities are identified by an ID-number, such as (1), (2), (3) etc. The bookkeeping description in the text always contains the date. Sometimes, the bookkeeping description is just an announcement and no grammatically correct full sentence, such as “Recording depreciation on 31.12.20X8”. The date for adjustments always is the 31.12.20XX. Adjustments are about depreciation, accruals, balancingand closing-off accounts, income tax calculation etc. Bookkeeping entries made when preparing financial statements and which are not linked to ordinary business activities, are referred to as adjustments. They do not have an ID number in this text book. In the accounts the contra account will be shown as reference. We observed this already, when the Depreciation account was closed-off to the Profit and Loss account in Figure 11.2. The reference was “Dpr” in the Profit and Loss account and “P&L” in the Depreciation account. (Note, in order to make T-accounts wider, the reference column in this text book’s account display is more narrow and allows only abbreviations with not more than 3 letters.) We study below the bookkeeping entries for the case studies ROHRBACH Ltd., FLASSKAMP AG and PEL- ZERHAGEN (Pty) Ltd.: As at the beginning of the fiscal year 20X5, ROHRBACH Ltd. has an amount of 250,000.00 EUR in the bank account. The first activity (1) is about the purchase of cell phones, which are put on stock on 3.01.20X5. The bookkeeping entry is as below: (1) Purchase of material on 3.01.20X5. DR Inventory.................... 150,000.00 EUR CR Cash/ Bank.................... 150,000.00 EUR The second activity is about the acquisition of the shelves: (2) Acquisition of shelves 4,700.00 EUR on 6.02.20X5. DR P, P, E Account.............. 4,700.00 EUR CR Cash/ Bank.................... 4,700.00 EUR The third entry is about the sales of the smart phones at 10,050.00 EUR. (3) Sales of phones on 8.02.20X5. <?page no="101"?> Berkau: BASICS of ACCOUNTING 12-100 DR Cash/ Bank.................... 10,050.00 EUR CR Inventory.................... 10,050.00 EUR The last bookkeeping entry for ROHRBACH Ltd. is the disposal of a noncurrent asset, two phone shelves in particular. The company sold 2 shelves on 22.03.20X5. The amount paid by the buyer was at the cost of ROHRBACH Ltd.’s acquisition. Thus, ROHBACH Ltd. does not earn a profit by the disposal of the shelves. The bookkeeping entry is: (4) Disposal of shelves on 22.03.20X5. DR Cash/ Bank.................... 2,350.00 EUR CR Property, Plant, Equipment... 2,350.00 EUR These were all bookkeeping entries ROHRBACH Ltd. made in chapter Activities on the Asset Side . The bookkeeping entries for the FLASSKAMP AG case study are a few more. In contrast to the ROHRBACH Ltd. case study, they consider the asset side of the statement of financial position and the credit side (for capital and liabilities), too. The first bookkeeping entry made for FLASSKAMP AG is the share issue on 2.01.20X3. FLASSKAMP AG issued 50,000 ordinary shares at 10.00 EUR each. The money obtained by the share issue increases the Cash/ Bank account by 50,000 × 10 = 500,000.00 EUR . At the same time, the capital of the business increases. The Issued Capital account belongs to the credit side of the statement of financial position. For that reason, the account is to be credited. The bookkeeping entry is: (1) Share issue 500,000.00 EUR on 2.01.20X3. DR Cash/ Bank.................... 500,000.00 EUR CR Issued Capital............... 500,000.00 EUR We quickly check the fulfilment of the Accounting equation. The total of assets is 500,000.00 EUR. So is the total of capital and liabilities. The next bookkeeping entry FLASSKAMP AG makes, is about inventory purchase. The business buys grass mowers on credit. This means, there is an obligation to pay the amount later. Here, the amount for current assets (grass mowers) increases by 92,000.00 EUR and the short-term liability to pay the supplier’s bill increases also. (2) Purchase of inventory 92,000.00 EUR on 15.02.20X3. DR Inventory.................... 92,000.00 EUR CR Accounts Payables............ 92,000.00 EUR We check the Accounting equation again. Now, the total of assets amounts to 92,000 + 500,000 = 592,000.00 EUR . The total of capital and liabilities equals to: 500,000 + 92,000 = 592,000.00 EUR . The Accounting equation still is fulfilled after making bookkeeping entry (2). <?page no="102"?> Berkau: BASICS of ACCOUNTING 12-101 Later, FLASSKAMP AG takes a bank loan. The amount is put into the bank account and is a payment obligation at the same time, because FLASSKAMP AG has to pay-off the amount later. (3) Taking a bank loan 200,000.00 EUR on 1.03.20X3. DR Cash/ Bank.................... 200,000.00 EUR CR Interest Bearing Liabilities. 200,000.00 EUR We check again the fulfilment of the Accounting equation at this stage. The total of assets is 92,000 + 700,000 = 792,000.00 EUR . The total on the credit side of the balance sheet equals to: 500,000 + 200,000 + 92,000 = 792,000.00 EUR . FLASSKAMP AG uses the money obtained by the bank loan and provided by its shareholders, to buy a show room. A show room is a non-current asset and is an item of property, plant and equipment. The acquisition increases the assets and increases payables, too. (4) Acquisition of a show room 600,000.00 EUR on 4.03.20X3. DR P, P, E Account.............. 600,000.00 EUR CR Account Payables............. 600,000.00 EUR Once more we check the Accounting equation. The total of assets now is 600,000 + 92,000 + 700,000 = 1,392,000.00 EUR . The total of capital and liabilities equals to 500,000 + 200,000 + 692,000 = 1,392,000.00 EUR . On 18.03.20X3, FLASSKAMP AG pays the amount owing the show room seller by bank transfer. This transaction reduces the amount of money in the Cash/ Bank account. It will be credited for that reason. The payment dissolves the liability which leads to a debit entry, because the Accounts Payables account is on the credit side and decreases of liabilities are recorded by debit entries. See the bookkeeping entry as below: (5) Pay-off of the short term liabilities for the show room on 18.03.20X3. DR Accounts Payables............ 600,000.00 EUR CR Cash/ Bank.................... 600,000.00 EUR We check the Accounting equation again. The total of assets now is 600,000 + 92,000 + 100,000 = 792,000.00 EUR . The total of capital and liabilities is 500,000 + 200,000 + 92,000 = 792,000.00 EUR . FLASSKAMP AG sells goods for 23,000.00 EUR on 16.05.20X3. The money has not yet been paid by the customers. Accordingly, FLASSKAMP AG makes an entry in the Accounts Receivables account which means the company still requests the money transfer from its customers. The Accounts Receivables account is an asset, because it represents a claim against the customers to pay for the goods bought. The expression „on credit“-sales for a sale which is not on cash, sounds wrong as there is a debit entry to be <?page no="103"?> Berkau: BASICS of ACCOUNTING 12-102 made in the Accounts Receivables account. However, “on credit” is a common Accounting term. (6) Sales of goods on 16.05.20X5 at an amount of 23,000.00 EUR on credit. DR Accounts Receivables......... 23,000.00 EUR CR Inventory.................... 23,000.00 EUR The Accounting equation is still fulfilled after this bookkeeping entry. The total of assets is 600,000 + 69,000 + 23,000 + 100,000 = 792,000.00 EUR . The total of the capital and liability accounts equals to: 500,000 + 200,000 + 92,000 = 792,000.00 EUR . The money for the goods sold (grass mowers) is paid by FLASSKAMP AG’s customers on 9.06.20X3. This means an increase of money in the Bank account and the balancing-off of the Accounts Receivables account. Increase of an asset means a debit entry (in the Cash/ Bank account) and to close-off the Accounts Receivables account requires crediting the amount to the A/ R account. (7) Payment of 23,000.00 EUR received from customers on 9.06.20X3. DR Cash/ Bank.................... 23,000.00 EUR CR Accounts Receivables......... 23,000.00 EUR The Accounting equation is fulfilled. The total of assets is 600,000 + 69,000 + 123,000 = 792,000.00 EUR . The total of capital and liability accounts equals to: 500,000 + 200,000 + 92,000 = 792,000.00 EUR . The last bookkeeping entry for FLASSKAMP AG is the payment for the delivered grass mowers. The payment gets FLASSKAMP AG out of the shortterm debts as the Accounts Payables account will be closed-off. Paying money means a decrease of cash or bank recorded by a credit entry, and the closingoff of the Accounts Payables account, which requires a debit entry. (8) Paying-off debts 92,000.00 EUR on 11.06.20X3. DR Accounts Payables............ 92,000.00 EUR CR Cash/ Bank.................... 92,000.00 EUR Now the Accounting equation looks as follows: 600,000 + 69,000 + 31,000 = 500,000 + 200,000 = 700,000.00 EUR . The total of assets is on the left hand side of the equation and the total of capital and liabilities is on the right hand side thereof. Compare the bookkeeping entries made in this chapter to the accounts displayed in Figure 10.10. From here onwards, we trust in the correct way of making bookkeeping entries along the double entry system. This means we stop always checking the fulfilment of the Accounting equation for the following case studies! We trust that the bookkeeping entries are correct and introduce in chapter Preparing the Trial Balance a concept to check the fulfilment of the Accounting equation more efficiently. <?page no="104"?> Berkau: BASICS of ACCOUNTING 12-103 The next case study PELZERHAGEN (Pty) Ltd. contains bookkeeping entries that change profit and loss, too. There are nominal accounts involved and we have to prepare bookkeeping entries for adjustments. See below: At the beginning of the fiscal year 20X7, PELZERHAGEN (Pty) Ltd. has an amount of 100,000.00 EUR in the bank. The item cash/ bank shows 100,000.00 EUR. The same amount is in the issued capital item on the credit side of the statement of financial position. The amounts were given as opening values for the case study and are marked by OV which is the abbreviation for opening value. PELZERHAGEN (Pty) Ltd.‘s first activity takes place on 2.01.20X7. PELZER- HAGEN (Pty) Ltd. pays rent to an extent of 3,400.00 EUR. Paying rent is an expense. All expenses will decrease the profit, which is linked to the Retained Earnings account. R/ E is an item on the credit side of the statement of financial position. According to that position, there is a debit entry to be made in the expense account. As rent has been paid by bank transfer, the Cash/ Bank account is credited. (1) Rent of 3,400.00 EUR paid by bank transfer on 2.01.20X7. DR Rent......................... 3,400.00 EUR CR Cash/ Bank.................... 3,400.00 EUR On 30.06.20X7, PELZERHAGEN (Pty) Ltd. pays 48,000.00 EUR salaries by bank transfer. Here, we consider labour as an expense paid to the employees. Check chapter Accounting for Labour in this text book for further details. The amount for labour will decrease the profit as it is an expense. There is a debit entry to be made in the Labour account. The Cash/ Bank account is credited because PELZERHAGEN (Pty) Ltd. pays by transferring the amount into their employees’ accounts. (2) Paying for labour on 30.06.20X7. DR Salaries..................... 48,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR The next activity is linked to non-current assets. It contains two bookkeeping entries. The first one is for the acquisition of the equipment and the second one is linked to the depreciation thereof. We firstly focus on the acquisition of the equipment. PELZERHAGEN (Pty) Ltd.’s buys it on credit. This requires crediting the Accounts Payables (A/ P) account. Observe bookkeeping entry (3a) made by PELZERHAGEN (Pty) Ltd: (3a) Acquisition of the equipment on 3.01.20X7. DR P, P, E Account.............. 50,000.00 EUR CR Accounts Payables............ 50,000.00 EUR <?page no="105"?> Berkau: BASICS of ACCOUNTING 12-104 After PELZERHAGEN (Pty) Ltd. bought the equipment, its value decreases by deployment. PELZERHAGEN (Pty) Ltd. writes-off the amount for equipment by bookkeeping entry (3b). The date for that bookkeeping entry is 31.12.20X7, because depreciation is part of the adjustments. Depreciation is an expense. Note, there is no money flow linked to depreciation. For now, the contra entry is made in the Property, Plant and Equipment account. Later we’ll apply a special account called Accumulated Depreciation. (3b) Depreciation on equipment on 31.12.20X7. DR Depreciation................. 10,000.00 EUR CR P, P, E Account.............. 10,000.00 EUR On 20.12.20X7, PELZERHAGEN (Pty) Ltd. makes a bookkeeping entry for revenue. Revenue increases the profit of the business and leads to a credit entry in the Revenue account. The revenue is earned on cash by PELZERHAGEN (Pty) Ltd. Thus, there is a debit entry in the Cash/ Bank account. This entry indicates that cash is received from customers and the amount in the Cash/ Bank account increases. (4) Revenue earned on cash is credited to the Revenue account on 20.12.20X7. DR Cash/ Bank.................... 130,000.00 EUR CR Revenue...................... 130,000.00 EUR By now, the original activities have been posted by PELZERHAGEN (Pty) Ltd.‘s bookkeeper completely. The next step is about the adjustments. At this stage, all expense accounts, such as the Rent, Labour and Depreciation account, are debit balanced. All income/ revenue accounts, such as the Revenue account, are credit balanced. Nominal accounts are closed-off to the Profit and Loss account. The bookkeeping entries for adjustments are as follows and take place on 31.12.20X7: DR P&L-Account.................. 3,400.00 EUR CR Rent......................... 3,400.00 EUR DR P&L-Account.................. 48,000.00 EUR CR Salaries..................... 48,000.00 EUR DR P&L-Account.................. 10,000.00 EUR CR Depreciation................. 10,000.00 EUR DR Revenue...................... 130,000.00 EUR CR P&L-Account.................. 130,000.00 EUR In the Profit and Loss account you can observe the entries made. “Sal” stands for Salaries, “Dpr” stands for Depreciation and “Rev” stands for Revenue. We <?page no="106"?> Berkau: BASICS of ACCOUNTING 12-105 use the term sales interchangeably and write in the accounts “Sal”. The balancing figure in the Profit and Loss account is called earnings before taxes because the tax expenses are still to be posted to profit and loss, which means a reduction from EBT. Here, earnings before taxes equal to: 130,000 - 3,400 - 48,000 - 10,000 = 68,600.00 EUR . The balance brought down is marked by “b/ d”. In order to keep the examples simple, we assume the income tax rate is 30 % based on EBT. Thus, the income taxes amount to: 0.3 × 68,600 = 20,580.00 EUR . The remaining amount is earnings after taxes EAT: 68,600 - 20,580 = 48,020.00 EUR . If the company made a loss you have to debit the loss to the Retained Earnings account because it decreases the company’s equity. DR P&L-Account.................. 20,580.00 EUR CR Income Tax Liabilities....... 20,580.00 EUR DR P&L-Account.................. 48,020.00 EUR CR Retained Earnings............ 48,020.00 EUR Right now, all bookkeeping entries have been made. Compare the real accounts and the recognitions made on the face of the statement of financial position. All nominal accounts have been closed-off to the Profit and Loss account. The Profit and Loss account itself gets closed-off to the Income Tax Liability account and to the Retained Earnings account. As PEL- ZERHAGEN (Pty) Ltd. earns a profit after taxes of 48,020.00 EUR, the equity accounts will increase by the same amount. Summary: Bookkeeping entries contain debit entries and credit entries. Bookkeeping follows the double entry system in order to fulfil the Accounting equation. A bookkeeping entry is described by DR/ CR, the account name, the amount and the date of recording. There is at least one debit entry and one credit entry. Compound bookkeeping entries can have more than one debit entry or more than one credit entry. The total value of debit entries must equal to total value of credit entries within one bookkeeping entry. In Accounting, there are real accounts and nominal accounts. All real accounts are linked to the statement of financial position and represent assets, equity or liabilities. All nominal accounts are closed-off to the Profit and Loss account. The profit after taxes is transferred to the equity section of the statement of financial position. It increases the item retained earnings if positive, otherwise will reduce it. Working Definitions: Bookkeeping Entry: A bookkeeping entry is the recording of a business activity. It contains a debit entry and a credit entry. Compound Bookkeeping Entry: A compound bookkeeping is one entry that contains more than one debit entry and/ or more than one credit entry <?page no="107"?> Berkau: BASICS of ACCOUNTING 12-106 Adjustment: Bookkeeping entries made when preparing financial statements and which are not linked to ordinary business activities, are referred to as adjustments. <?page no="108"?> Berkau: BASICS of ACCOUNTING 13-107 13. Special Asset Accounts Learning Objectives: In this chapter we introduce further asset accounts. It is intended to familiarise you with more assets and bookkeeping entries related thereto. We follow the asset structure of the balance sheet for explanations. After studying this chapter, you have gained more experience in terms of making bookkeeping entries for assets. You further will learn about special assets and their request with regard to special recordings. Putting an asset on the balance sheet, requires that the object meets the asset definition and fulfills the recognition criteria. Assets are resources from which a future economic benefit is expected to flow to the company. A future economic benefit can result from the asset’s deployment or its sale. The recognition criteria further request that the costs of the asset can be determined reliably. Along IFRSs all assets are to be recognised on the statement of financial position and are to be classified as either non-current or current assets. According to that distinction, there are accounts for non-current assets and current assets. Non-current assets often are written-off by use whereas current assets stay less than one year in the business and will be finished up. Some non-current assets such as land won’t be depreciated, because they do not deplete. Examples for short-term assets are materials, receivables, securities, prepaid expenses and cash. For some assets, a recognition prohibition exists. For example, self-generated goodwill cannot be recognised. If someone opens a hairdresser salon and achieves a good reputation, the reputation will be regarded as self-generated goodwill and must not be recognised. When assets are acquired, they must be recognised instantly, which means the asset account is to be debited. We study (1) non-current asset and (2) current asset recognition Ad (1): Non-current Assets When a company buys tangible assets a debit entry will be made most likely in the Property, Plant and Equipment account. This intends the asset is acquired for deployment in the company. On 1.08.20X6, PAHANG Ltd. acquires machinery for the use in production. The cost of acquisition equals to 89,000.00 EUR and are paid by bank transfer. The Accountant will make the bookkeeping entry below on 1.06.20X6: DR P, P, E Account.............. 89,000.00 EUR CR Cash/ Bank.................... 89,000.00 EUR There might be circumstances that property counts as investment property along IAS 40. Investment property is land and/ or buildings that are for renting out or held in order <?page no="109"?> Berkau: BASICS of ACCOUNTING 13-108 to earn a profit by capital appreciation. They have to be assigned to an extra account called Investment Property account. However, if and once a company intends to deploy the property item, it becomes an item of property, plant and equipment from that time onwards. There are special regulations how an asset is to be reclassified from investment property to property, plant and equipment along IFRSs. POLLOK Ltd. buys land and an office block which is built on that plot. The cost of acquisition is 1,000,000.00 EUR. The land and the building are intended for renting out. The Accountant makes the bookkeeping entry below on 3.05.20X4. DR Investment Property.......... 1,000,000.00 EUR CR Cash/ Bank.................... 1,000,000.00 EUR LINTON Ltd. acquires a business car on cash. The car is for business use. The car is bought at the local car dealership at 25,000.00 EUR. The car is a tangible asset and therefore it is regarded as a kind of machinery and is posted to property, plant and equipment. The Accountant makes a bookkeeping entry as below on 4.02.20X6. DR P, P, E Account.............. 25,000.00 EUR CR Cash/ Bank.................... 25,000.00 EUR NEWTON (Pty) Ltd. buys office furniture on 3.03.20X4. The cost of acquisition is 13,500.00 EUR. The furniture is bought on credit. That means, NEWTON (Pty) Ltd. has to pay the amount later. The furniture is for use in the business. NEWTON (Pty) Ltd.‘s bookkeeper posts the furniture into the Property, Plant and Equipment account on 3.03.20X4 by the bookkeeping entry below: DR P, P, E Account.............. 13,500.00 EUR CR Accounts Payables............ 13,500.00 EUR When a company uses rights in order to produce a product under license, they buy the rights and have to recognise them as an intangible asset. The asset’s use can be limited for a certain period of time according to the agreement. An intangible asset is an asset without physical nature. Further examples for intangible assets are licenses, warranties, patents, software, franchise etc. Special intangibles cannot be recognised as they are legally prohibited from recognition. E.g. customer lists, patients’ data, etc. cannot be recognised. Only those items can be recognised, the company gains control over. This is the reason, why customer lists, soccer players, sun light for a solar energy provider, nice view for a hotel, etc. are exempted from recognition. MISSIONVALE Ltd. intends to produce staplers. There is a company holding a <?page no="110"?> Berkau: BASICS of ACCOUNTING 13-109 patent on a special mechanism for staplers, MISSIONVALE Ltd. wants to produce. In order to manufacture the staplers, MISSIONVALE Ltd. acquires a license from the patent holder at 10,000.00 EUR on 6.02.20X3. The license is paid for by bank transfer. The bookkeeping entry is linked to intangible assets, which are classified as non-current assets. The bookkeeping entry is made on 6.02.20X3. DR Intangible Assets............ 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR KABEGA Ltd. buys shares of McDonald’s Corporation on 24.11.20X6. The company intends to hold the shares for a longer period of time and expects to benefit from the dividend quarterly declared by McDonald’s Corporation. The shares are bought at a share price of 72.00 EUR/ share. KABEGA Ltd. buys 2,000 shares through its house bank. The face value of the McDonald’s Corporation’s share is 0.01 US-$/ share. However, the price KABEGA Ltd. paid for the share, is relevant for the initial recognition. The shares value equals to: 2,000 × 72 = 144,000.00 EUR . The bookkeeper puts the shares into the Financial Instruments account on 24.11.20X6. DR Financial Instruments........ 144,000.00 EUR CR Cash/ Bank.................... 144,000.00 EUR When a company sells assets the relevant asset account is to be credited. The amount of money or its equivalent received will be added to the Cash/ Bank account on its debit side. SCHAUDER Ltd. owns a truck. Its carrying amount equals to 67,000.00 EUR as recognised on the statement of financial position. SCHAUDER Ltd. sells the vehicle at a net selling price of 67,000.00 EUR on 4.01.20X6. The money is received on cash from the buyer. No VAT is considered for this case. The Accountant of SCHAUDER Ltd. makes a bookkeeping entry for the disposal of the truck on 4.01.20X6. DR Cash/ Bank.................... 67,000.00 EUR CR P, P, E Account.............. 67,000.00 EUR In case a company buys an asset and receives a discount, the discount is to be deducted from the price. Learn about discounts that are allowed after the date and posting of acquisition in chapter Discounts of this text book. DUNOON Ltd. buys a drilling machine from its supplier on 5.04.20X8. The supplier allows a discount of 5 % on the net selling price of 100.00 EUR. The costs of acquisition are 100 × (1 - 5%) = 95.00 EUR . The Accountant makes the bookkeeping entry below on 5.04.20X8. <?page no="111"?> Berkau: BASICS of ACCOUNTING 13-110 DR P, P, E...................... 95.00 EUR CR Cash/ Bank.................... 95.00 EUR Ad (2): Current Assets Current assets are inventories, receivables, securities, prepaid expenses and cash/ bank. Here, we apply certain accounts for different kind of inventory, for receivables, for securities, for prepaid expenses and for cash/ bank. When a business buys inventory the cost are referred to as the purchase costs. We later (chapter Trading Business) introduce a special Purchase account for the purchases of inventory. GOVAN Ltd. is a table cloths manufacturer. On 3.02.20X1, GOVAN Ltd. buys from its supplier fabric for 15,000.00 EUR on cash. The recording of purchase is on 3.02.20X1 as below: DR Inventory (Materials)........ 15,000.00 EUR CR Cash/ Bank.................... 15,000.00 EUR The company sells on 5.04.20X1 finished goods (table clothes) to a whole seller at 35,000.00 EUR. The money is received by bank transfer from the buyer. DR Cash/ Bank.................... 35,000.00 EUR CR Inventory (Finished Goods)... 35,000.00 EUR How it is done (asset recognition): (1) Distinguish between current and non-current assets. (2) Choose the correct asset account that applies. (3) Determine the cost of acquisition or cost of purchase by deducting discounts and input-VAT. (4) Debit the cost of acquisition or cost of purchase to the relevant asset account. (5) Credit the payment or the payables to the Cash/ Bank account or to Accounts Payables (A/ P) account. When companies make payments for service in advance - so called prepayments and the time the service paid for is after the balance sheet’s day, the Accountant has to transfer them into the Prepaid Expenses account. Examples for prepaid expenses are rent, labour, insurances, etc., paid for the next Accounting period for. We learn about this concept in detail in chapter Further Expenses and Accruals of this text book. ALBANS Ltd. orders a magazine from the local book store. The magazine is issued every month. The magazine is to be paid for one year in advance. The cost for one year’s magazine issues is 120.00 EUR. ALBANS Ltd. buys the magazine on 1.07.20X4 and makes the payment through the bank account. The contract commences on 1.07.20X4 and ends on 30.06.20X5. No VAT is relevant here. During the period, one magazine issue is <?page no="112"?> Berkau: BASICS of ACCOUNTING 13-111 sent to ALBANS Ltd. every month. The balance sheet date of ALBANS Ltd. is 31.12. The contract for the magazine is recorded by two bookkeeping entries on 1.07.20X4 and 31.12.20X4: DR Magazine Expenses............ 120.00 EUR CR Cash/ Bank.................... 120.00 EUR DR Prepaid Expenses............. 60.00 EUR CR Magazine Expenses............ 60.00 EUR The second bookkeeping entry is made as adjustment at the end of the Accounting period, on 31.12.20X4. The Prepaid Expenses account is linked to the prepaid expenses item in the current asset section of the balance sheet. When a business distinguishes different bank accounts and runs one or more cash accounts the Cash/ Bank account is split up into different subordinated accounts. The sum of the balances of all accounts will be displayed on the statement of financial position. SCHOENMAKERSKOP Ltd. banks with Deutsche Bank and Sparkasse Osnabrück. Furthermore, SCHOENMAKERS- KOP Ltd. applies a Cash account. On 2.01.20X6, the opening value for the bank account with Deutsche Bank is 54,000.00 EUR and for the account with Sparkasse Osnabrück is 4,000.00 EUR. The company has 300.00 EUR on cash. On the statement of financial position SCHOENMAKERSKOP Ltd. displays 54,000 + 4,000 + 300 = 58,300.00 EUR . On 23.01.20X6, SCHOENMAKERSKOP Ltd. receives 6,000.00 EUR from a customer. The customer transfers the money into SCHOENMAKERSKOP Ltd.‘s Deutsche Bank account. SCHOEN- MAKERSKOP Ltd. withdraws 500.00 EUR and puts it into cash two days later. Observe the bookkeeping entries made on 23.01.20X6 and 25.01.20X6 below: DR Deutsche Bank account........ 6,000.00 EUR CR Accounts Receivables......... 6,000.00 EUR DR Cash......................... 500.00 EUR CR Deutsche Bank account........ 500.00 EUR The transfers can be studied better by the T-accounts: <?page no="113"?> Berkau: BASICS of ACCOUNTING 13-112 D C D C OV 54,000.00 (2) 500.00 OV 4,000.00 c/ d 4,000.00 (1) 6,000.00 c/ d 59,500.00 b/ d 4,000.00 60,000.00 60,000.00 b/ d 59,500.00 D C D C OV 300.00 OV 6,000.00 (1) 6,000.00 (2) 500.00 c/ d 800.00 800.00 800.00 b/ d 800.00 Cash A/ R Bank account with Deutsche Bank Bank account with Sparkasse Osnarbrück Figure 13.1: SCHOENMAKERSKOP Ltd.‘s accounts The amount to be displayed on the statement of financial position now equals to: 59,500 + 4,000 + 800 = 64,300.00 EUR . Summary: Asset accounts are for non-current and current assets. The accounts will increase by debit entries and decreased by credit entries. Particular accounts are Property, Plant and Equipment (P, P, E), Investment Property, Intangible Assets, Financial Assets, Inventory, Accounts Receivables, Prepaid Expenses and Cash/ Bank. Working Definitions: Asset: Assets are resources from which a future economic benefit is expected to flow to the company. Investment Property: Investment property is land and/ or buildings that are for renting out or hold to make a profit by capital appreciation. Intangible Assets: An intangible asset is an asset without physical nature. <?page no="114"?> Berkau: BASICS of ACCOUNTING 14-113 14. Special Equity Accounts Learning Objectives: In this chapter, some special equity accounts will be introduced. We provide you with an overview on issued capital and reserves. Additionally, the application of the Retained Earnings account is explained in more detail. After studying this chapter, you will understand how equity is brought into the business and how profit and loss will change the equity section and the book value of the business. The owners’ equity is split up in three major accounts: Issued Capital account, Reserves account and Retained Earnings account. The issued capital is the value of shares at face value. This is the amount the company at least is held responsible for. The face value of a share is its nominal value. This amount is credited to the Issued Capital account. Reserves are parts of the company’s equity that results from earnings, share issues and revaluations. Reserves increase the book value of the company. The Retained Earnings account receives any earnings after taxes from the profit and loss account and contains all profits/ losses carried forward from prior Accounting periods. Reductions occur for dividends declared and additions made to reserve accounts. When a business is established the proprietors contribute funds to the business. The amount might be prescribed by national laws like the company’s act. The funds put into the business are the amount by which the company is held responsible for its actions. The issued capital cannot be changed except of further share issues or share redemptions. The issued capital is always recognised at its face value. The nominal amount is credited to the Issued Share account. Any share issues at an issue price that exceeds the face value require to post the difference between the issue price and the face value to share premiums or straight to capital reserves. PLEASANT Ltd. is founded by their proprietors contributing 50,000.00 EUR (all together) on 2.01.20X1. The money is paid into PLEASANT Ltd.’s Bank account. DR Cash/ Bank.................... 50,000.00 EUR CR Issued Capital............... 50,000.00 EUR ARLINGTON Ltd. is based on shares. The company is established on 2.01.20X5 by a share issue of 20,000 shares at 5.00 EUR each. The shareholders pay the amount by bank transfer through a bank. The issued capital amounts to: 20,000 × 5 = 100,000.00 EUR . DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR <?page no="115"?> Berkau: BASICS of ACCOUNTING 14-114 MALABAR Ltd. is a production firm based on shares. The company is established on 2.01.20X3 by an issue of 100,000 ordinary shares. The face value of the shares is 1.00 EUR. The issue price of each share is 1.34 EUR. The amount contributed by the shareholders equals to: 100,000 × 1.34 = 134,000.00 EUR . As this amount exceeds the face value of shares, the difference on funds is put into the Share Premium account. DR Cash/ Bank.................... 134,000.00 EUR CR Issued Capital............... 100,000.00 EUR CR Share Premium................ 34,000.00 EUR The potential use of share premiums depends on national law. In most countries the amount is transferred to the Capital Reserves account. Capital reserves belong to equity such as issued capital. No mingling of capital reserves with the issued capital is allowed. MALABAR Ltd. adds the share premium to capital reserves on 2.01.20X3. DR Share Premium................ 34,000.00 EUR CR Capital Reserves............. 34,000.00 EUR The amount for issued capital never changes. Even in case the company makes a loss, the amount is still recognized at the face value. The share price such as traded at a stock exchange (market price) does not change the issued capital value either. VANSTADENS Ltd. is established on 2.01.20X5 by a share issue of 50,000 ordinary shares at 1.45 EUR/ s as to be the face value per share. The issue price per share was 1.70 EUR. At the yearend, the shares are traded at the national stock exchange at 2.50 EUR each. The issued capital amounts to: 50,000 × 1.45 = 72,500.00 EUR . The capital reserves contain the share premium as paid at the time of share issue and equal to: (1.70 - 1.45) × 50,000 = 12,500.00 EUR . At the time of the establishment of the business, the Accountant credits the Issued Capital account and the Share Premium account, whereas the debit entry is in cash/ bank: DR Cash/ Bank.................... 85,000.00 EUR CR Issued Capital............... 72,500.00 EUR CR Share Premium................ 12,500.00 EUR DR Share Premium................ 12,500.00 EUR CR Capital Reserves............. 12,500.00 EUR Although the value of shares increased to 2.50 EUR at the end of the Accounting period, both, the Issued Capital account and the Capital Reserves account, remain unchanged at 72,500.00 EUR and 12,500.00 EUR. <?page no="116"?> Berkau: BASICS of ACCOUNTING 14-115 The financial statements of the shares issuing company do not depend on the market price of shares as traded at a stock exchange. The company only suffers from a low share price by other investors’ option of an unfriendly taking over, because it then becomes easy (cheap) to buy shares and achieve more voting rights. It might even happen that another party obtains the majority of issued shares and thus controls the business. A business that earns profits during the years increases its equity. The Retained Earnings account will be credited. If the company decides to reinvest the funds, an increase will be recorded in the Reserves account and there is a debit entry in the Retained Earnings account. The appropriation is either putting earnings into the Reserves account, paying a dividend to the shareholders or carrying forward the profit. In case the company does not pay the annual surplus or parts thereof to the proprietors, the profit stays in earnings reserves and will be carried forward to the next Accounting period. The same applies for a loss. SLOVO Ltd. earned a profit after taxes in 20X5 of 300,000.00 EUR. The company decides to not declare a dividend and to keep the profit for reinvestments. That way the profit increases the company’s equity by the Retained Earnings account and later the Earnings Reserves account. On 31.12.20X5, SLOVO Ltd.‘s Accountant makes the bookkeeping entries as below: DR P&L.......................... 300,000.00 EUR CR Retained Earnings............ 300,000.00 EUR DR Retained Earnings............ 300,000.00 EUR CR Earnings Reserves............ 300,000.00 EUR (In Germany, the company’s act (AktG) limits the amount to be put into Earnings Reserves by § 58 AktG. To 50 % for that reason, the appropriation for companies in the legal form of an AG follows often a 50: 50ratio.) A company that declares a dividend to the extent of the full profit decreases its equity. Declaring a dividend means to pay the profit to shareholders or to recognise a liability for doing so later. The payable account applying for dividend payments is called Shareholder for Dividend account. Declaring a dividend means to transfer the profit from equity to liabilities, in other words: equity is reduced. BRAMHOPE Ltd. earns a profit after taxes of 100,000.00 EUR in 20X4. The amount is declared as a dividend to BRAMHOPE Ltd.‘s shareholders. On 31.12.20X4, BRAMHOPE Ltd.‘s Accountant credits the profit to the Accounts Payables account. Thus, the profit does not increase the equity of the business. <?page no="117"?> Berkau: BASICS of ACCOUNTING 14-116 DR P&L.......................... 100,000.00 EUR CR Retained Earnings............ 100,000.00 EUR DR Retained Earnings............ 100,000.00 EUR CR A/ P (ShD).................... 100,000.00 EUR A company also can keep the profit earned in the Retained Earnings account. This means it carries the profit forward to the next Accounting period. ARCADIA Ltd. earns a profit after taxes of 30,000.00 EUR in 20X6. The amount is displayed as the bottom line of the Profit and Loss account as earnings after taxes. On 31.12.20X6, the Accountant transfers the amount to the equity section of the statement of financial position by closing-off the Profit and Loss account to the Retained Earnings account. As there is no further bookkeeping entry, the profit remains in the Retained Earnings account. That is where the name “Retained Earnings“ comes from. A company can carry forward the profit and can make a decision about the appropriation thereof in later Accounting periods. It can even carry forward the profit for more than one period. This results in kind of depriving the shareholders of their dividend. DR P&L.......................... 30,000.00 EUR CR Retained Earnings............ 30,000.00 EUR In case a company makes losses, equity decreases. We assume RENSBURG Ltd. got the following amounts in its accounts at the beginning of the Accounting period: Issued Capital account = 100,000.00 EUR, Earnings Reserves account 200,000.00 EUR and Retained Earnings account 100,000.00 EUR, which results from previous Accounting periods. RENSBURG Ltd. makes a loss in 20X7 that equals to 45,000.00 EUR. It results from a revenue of 200,000.00 EUR which is reduced by expenses for labour 100,000.00 EUR, depreciation 55,000.00 EUR and rent 90,000.00 EUR. The loss equals to: 200,000 - 100,000 - 55,000 - 90,000 = -45,000.00 EUR . The amount appears at the bottom line of the statement of comprehensive. There are no income taxes to be paid by RENSBURG Ltd. due to the loss. (Note, check the conventions at the beginning of this text book! ) As the balancing figure of RENSBURG Ltd.‘s Profit and Loss account is on the credit side, the bookkeeping entry now appears “twisted”, because the amount is debited to the Retained Earnings account. This decreases the profit carried forward from previous Accounting periods: DR Retained Earnings............ 45,000.00 EUR CR P&L.......................... 45,000.00 EUR <?page no="118"?> Berkau: BASICS of ACCOUNTING 14-117 A debit entry in the Retained Earnings account decreases the equity of the business. After making the bookkeeping entries, RENSBURG Ltd.‘s equity equals to: 100,000 + 200,000 + 55,000 = 355,000.00 EUR . In the previous Accounting period, it was still 400,000.00 EUR. See RENSBURG Ltd.‘s accounts below: D C D C c/ d 100,000.00 OV 100,000.00 c/ d 200,000.00 OV 200,000.00 b/ d 100,000.00 b/ d 200,000.00 D C D C P&L 45,000.00 OV 100,000.00 Lab 100,000.00 Rev 200,000.00 c/ d 55,000.00 Dpr 55,000.00 100,000.00 100,000.00 Rnt 90,000.00 EBT 45,000.00 b/ d 55,000.00 245,000.00 245,000.00 b/ d 45,000.00 R/ E 45,000.00 Retained earnings R/ E Profit and Loss P&L Issued Capital Earnings Reserves Figure 14.1: RENSBURG Ltd.‘s accounts (Note, companies applying the German Handelsgesetzbuch (HGB) use the Annual Surplus account in a different way. See § 266 HGB for the structure of the balance sheet and rules for equity recognition with regard to reserves and their increase and decrease laid out by § 272 HGB. The aspects of retained earnings are linked to the Annual Surplus account and the Bilanzgewinn (R/ E) account along § 268 HGB.) How it is done (appropriation of profit) (1) Credit the profit for the period to the Retained Earnings account. (2) Decide about the appropriation of profit or parts thereof: (a) carrying forward, (b) putting into reserves and/ or (c) declaring a dividend (3a) Nothing needs to be done. Leave the amount in the Retained Earnings account. (3b) Take the amount for reserves out of the Retained Earnings account by a debit entry and credit the amount to the Earnings Reserves account. (3c) Take the amount to be declared as a dividend out of the Retained Earnings account and credit the amount to the Shareholder for Dividend account. Close-off the Shareholder for Dividend account to the Accounts Payables account. <?page no="119"?> Berkau: BASICS of ACCOUNTING 14-118 (4) You might face partial appropriations of profit by combining (a), (b) and (c). Summary: Equity contains issued capital, reserves and retained earnings. Issued capital is the amount obtained from share issues. Profits and losses change the total value of a company’s equity. They are posted to retained earnings. A company that intends to reinvest the profit, will transfer it to the earnings reserves. A declaration of a dividend reduces the retained earnings and will credit the profits to the Shareholder for Dividend account which is part of the short-term liabilities. Definitions: Face value: The face value of a share is its nominal amount. Issued Capital: The issued capital is the value shares at face value. Reserves: Reserves are parts of the company’s equity that results from earnings, share issues and revaluations. Retained Earnings: The Retained Earnings account receives any earnings after taxes from the profit and loss account and contains all profits/ losses carried forward from prior Accounting periods. <?page no="120"?> Berkau: BASICS of ACCOUNTING 15-119 15. Special Liability Accounts - Payables, Bank Loans and Provisions Learning Objectives: In this chapter we introduce particular liability accounts and give examples for bookkeeping entries linked thereto. The aim is to familiarise you with the liability section of the statement of financial position. Furthermore, we intent to give examples about bank loans and the calculation of interest and payoff amounts. A liability is an obligation to pay an amount of money or its equivalent or to deliver goods/ services. The IFRSs and many national GAAPs require distinguishing between longterm and short-term liabilities. The reason is long-term liabilities are to be discounted along IFRSs for fair value presentation. Discounting means the value is marked down as more as the payment is settled in the future. In Germany, § 253 HGB only requires disclosing debts at the settlement amount. However, provisions are to be discounted, too. Discounting a liability leads to a recognition of long-term debts at present value. A payment obligation of 100,000.00 EUR that is completely due in 20 years’ time provided the rate of interest is 10 % is worth today: 100,000 × (1 + 10%) -20 = 14,864.36 EUR. A debtor who has to pay 100,000.00 EUR in 20 years’ time could just deposit the amount of 14,864.36 EUR in a bank account and wait for 20 years in order to gain the 100,000.00 EUR that way. In contrast, not discounting liabilities means that the liability recognition is overrated and the financial position displayed on the balance sheet makes the company’s financial position look worse than it actually is. The German Handelsgesetzbuch (HGB) follows creditors’ protection. This is the reason for disclosing loans at settlement amounts. A settlement amount is the amount of money that actually has to be paid in order to pay-off the loan. The settlement amount for the above mentioned loan equals to 100,000.00 EUR. For now, we do not discount liabilities for the sake of simplicity. Discounting will be taught in chapter 14 of the text book Berkau: Bilanzen or the ebook Accounting-2-Go. Thus, we ignore discounting and recognize liabilities at their settlement amount for now. However, we record liabilities separate, in the meaning of long-term and short-term liabilities are not mingled with one another. Thus, we apply an account for long-term liabilities and another one for short-term liabilities. As far as we apply the simplified structure of the statement of financial position as introduced in the previous chapters, the account for long-term liabilities is the Interest Bearing Liabilities account and the one for shortterm liabilities is just Accounts Payables. A company buying goods on credit will show the liability as short-term payables in the Accounts Payables A/ P account. <?page no="121"?> Berkau: BASICS of ACCOUNTING 15-120 JEGESVILLE Ltd. buys a business car Mercedes c-class on credit at a purchase price of 50,000.00 EUR from a local car dealership on 18.05.20X3. The amount is to be paid later. JEGESVILLE Ltd.‘s bookkeeper makes a bookkeeping entry for the asset recognition and for the short-term liability on 18.05.20X3. DR P, P, E...................... 50,000.00 EUR DR VAT.......................... 10,000.00 EUR CR Accounts Payables............ 60,000.00 EUR On 30.05.20X3, JEGESVILLE Ltd. pays the amount due to the local car dealership by bank transfer. This way the payment obligation is fulfilled. DR Accounts Payables............ 60,000.00 EUR CR Cash/ Bank.................... 60,000.00 EUR Liabilities that require the payment of interest normally are long-term liabilities. Those liabilities are bank loans for example. The amount due in later Accounting periods is classified as a longterm liability. Accordingly, the longterm liability is credited to the Interest Bearing Liability account. SLAMMERT Ltd. takes a bank loan from its house bank on 1.07.20X5. The amount the bank lends SLAMMERT Ltd. is 100,000.00 EUR. It is agreed that SLAMMERT Ltd. pays-off the loan in 10 years’ time. The bookkeeper at SLAMMERT Ltd. makes the following bookkeeping entry on 1.07.20X5 which indicates that the business received the amount of 100,000.00 EUR in their bank account and creates a payment obligation at the same time. DR Cash/ Bank.................... 100,000.00 EUR CR IBL.......................... 100,000.00 EUR The fact that the bank requires a rate of interest of 6 %/ a based on the amount of the bank loan, is regarded as an expense for the actual Accounting period. The amount is to be paid at the yearend as agreed by the contract and is an expense for 20X5. Interest is calculated accurate to the month. For interest calculation we need to know the monthly rate of interest. Along the agreed conventions for this text book, the monthly rate of interest equals to the annual interest rate divided by 12. No compound interest calculation applies within an Accounting period! In other words, interest compounds annually. As SLAMMERT Ltd. takes the bank loan in the middle of the year, interest is half of its annual rate. SLAMMERT Ltd. pays: 100,000 × 6% / 2 = 3,000.00 EUR . The bank draws the amount from SLAM- MERT Ltd.’s bank account (not the liability account). The cash/ bank item in the statement of financial position is effectuated thereby. <?page no="122"?> Berkau: BASICS of ACCOUNTING 15-121 DR Interest..................... 3,000.00 EUR CR Cash/ Bank.................... 3,000.00 EUR A bank loan coming with a constant payment for interest and payoff (together) is called an annuity. The agreement is about the amount to be paid which contains interest and pay-off as well. If the rate of interest is constant, the absolute amount for interest shrinks by the course of time as the debtor pays-off the loan every year. Thus the owed amount drops. Interest is always based on the rate and the amount owed. For an annuity the development of absolute interest and pay-off is opposite to one another. The amount for pay-off will increase and the interest paid decreases. In case of a bank loan that requires pay-offs every Accounting period, the amount to be paid-off in the next Accounting period is considered short-term. It has to be transferred from the Interest Bearing Liability account to the Accounts Payables A/ P account as required by IAS 1. CHATTY Ltd. takes an annuity from their local bank of 25,000.00 EUR on 2.01.20X3. The contract states that the rate of interest is 4.5 %/ a and that the constant payment, CHATTY Ltd. has to make, is 2,500.00 EUR/ a payable at each yearend. When the bank loan is taken the bookkeeper has to make the entries below: DR Cash/ Bank.................... 25,000.00 EUR CR IBL.......................... 25,000.00 EUR In order to oversee the payments we prepare a payment schedule for CHATTY Ltd.‘s bank loan. Observe the payment schedule as depicted in Figure 15.1: <?page no="123"?> Berkau: BASICS of ACCOUNTING 15.122 0.045 Year Opening amount Interest Pay-off Annuity Rest 20X3 25,000.00 1,125.00 1,375.00 2,500.00 23,625.00 20X4 23,625.00 1,063.13 1,436.88 2,500.00 22,188.13 20X5 22,188.13 998.47 1,501.53 2,500.00 20,686.59 20X6 20,686.59 930.90 1,569.10 2,500.00 19,117.49 20X7 19,117.49 860.29 1,639.71 2,500.00 17,477.77 20X8 17,477.77 786.50 1,713.50 2,500.00 15,764.27 20X9 15,764.27 709.39 1,790.61 2,500.00 13,973.67 20Y0 13,973.67 628.81 1,871.19 2,500.00 12,102.48 20Y1 12,102.48 544.61 1,955.39 2,500.00 10,147.09 20Y2 10,147.09 456.62 2,043.38 2,500.00 8,103.71 20Y3 8,103.71 364.67 2,135.33 2,500.00 5,968.38 20Y4 5,968.38 268.58 2,231.42 2,500.00 3,736.96 20Y5 3,736.96 168.16 2,331.84 2,500.00 1,405.12 20Y6 1,405.12 63.23 1,405.12 1,468.35 (0.00) Figure 15.1: CHATTY Ltd.‘s annuity payment schedule The amount of interest in the first year 20X3 is: 25,000 × 4.5% = 1,125.00 EUR . As per agreement the amount paid at every yearend is 2,500.00 EUR and consists of interest and pay-off. The pay-off amount in 20X3 equals to: 2,500 - 1,125 = 1,375.00 EUR . The Accountant makes bookkeeping entries for interest and pay-off on 31.12.20X3. DR Interest..................... 1,125.00 EUR DR Interest Bearing Liability... 1,375.00 EUR CR Cash/ Bank.................... 2,500.00 EUR At this stage the balancing figure in the Interest Bearing Liability account is 25,000 - 1,375 = 23,625.00 EUR . In the next year 20X4 the liability is 23,625.00 EUR which is the amount interest is based on. Thus, interest in 20X4 is: 23,625 × 4.5% = 1,063.13 EUR . The amount for pay-off increases compared to the previous year. It is now 2,500 - 1,063.13 = 1,436.88 EUR . (Note, the exact amounts are 1,063.125 EUR and 1,436.875 EUR. In Figure 15.1, both amounts are displayed at an accuracy of 2 digits after the decimal point, which means they are rounded to the next EURcent. However, the MS Excel spread sheet program adds the amounts correctly ignoring the display thereof. So, the amount paid equals to: 1,063.13 + 1,436.88 = 2,500.00 EUR not to 2,500.01 EUR.) Before 20X4’s bookkeeping entries are recorded, the Accountant transfers liability next due to short-term liabilities, which is an adjustment bookkeeping entry on 31.12.20X3. <?page no="124"?> Berkau: BASICS of ACCOUNTING 15.123 DR IBL.......................... 1,436.88 EUR CR Accounts Payables............ 1,436.88 EUR No payment has been made with regard to the annuity for 20X4 yet. There is only an account swop. The amount for payoff-20X4 has been transferred from long-term to short-term liabilities. In order to comprehend CHATTY Ltd.‘s annuity, take a look at the accounts involved below in Figure 15.2. D C D C (1) 25,000.00 (2) 2,500.00 (2) 1,125.00 P&L 1,125.00 c/ d 22,500.00 25,000.00 25,000.00 b/ d 22,500.00 D C D C (2) 1,375.00 (1) 25,000.00 c/ d 1,436.88 (3) 1,436.88 (3) 1,436.88 b/ d 1,436.88 c/ d 22,188.12 25,000.00 25,000.00 b/ d 22,188.12 Cash/ Bank Interest Interest bearing liabilities Accounts payables Figure 15.2: CHATTY Ltd.‘s accounts How it is done (liability recognition) (1) Determine the amount of the liability. This amount normally is the most likely settlement amount for the liability. (2) Distinguish between (a) short-term liabilities and (b) long-term liabilities and (c) liabilities that contain portions being long-term and other ones being short-term. (3a) If the liability is a short-term liability, credit the amount to the relevant short-term liability account. You may take the Accounts Payables A/ P account. (3b) If the liability is a long-term liability, credit the amount to the relevant long-term liability account. You may take the Interest Bearing Liabilities account of a Bond account. Discount long-term liabilities. (3c) If the liability contains long-term liability portions and short-term liability ones, you may set up a liability schedule for calculating the short-term liabilities at first. Transfer the whole liability to the <?page no="125"?> Berkau: BASICS of ACCOUNTING 15-124 relevant long-term liability account and make a debit entry for the short-term portion and credit that amount to the relevant short-term liability account. Then, discount long-term liabilities. Record the difference in the Retained Earnings R/ E account. In case the bank loan comes with a constant pay-off amount the calculation is easier. However, extra pay-off amounts can be offered by the bank, which makes the calculation of interest slightly more complicated. Observe the FOLCROFT (Pty) Ltd. bank loan example. On 1.04.20X4, FOLCROFT (Pty) Ltd. takes a bank loan from its house bank. The amount is 75,000.00 EUR. FOLCROFT (Pty) Ltd. agrees to pay-off an amount of 2,000.00 EUR every yearend. The interest rate equals to 3.1 %/ a. The bank offers that FOLCROFT (Pty) Ltd. can payoff an extra amount of 5,000.00 EUR in 20X5, 20Y0, 20Y5 etc. The extra amount for pay-off is paid on 30.06 of the year involved. In this case, interest calculation requires two steps. One portion of interest is calculated before the extra pay-off and the second one thereafter. Take a look at the schedule depicted by Figure 15.3. <?page no="126"?> Berkau: BASICS of ACCOUNTING 15-125 0.031 Year Opening amount Interest Pay-off Rest 20X2 75,000.00 1,743.75 2,000.00 73,000.00 20X3 73,000.00 2,263.00 2,000.00 71,000.00 20X4 71,000.00 2,201.00 2,000.00 69,000.00 20X5 69,000.00 2,061.50 7,000.00 62,000.00 20X6 62,000.00 1,922.00 2,000.00 60,000.00 20X7 60,000.00 1,860.00 2,000.00 58,000.00 20X8 58,000.00 1,798.00 2,000.00 56,000.00 20X9 56,000.00 1,736.00 2,000.00 54,000.00 20Y0 54,000.00 1,596.50 7,000.00 47,000.00 20Y1 47,000.00 1,457.00 2,000.00 45,000.00 20Y2 45,000.00 1,395.00 2,000.00 43,000.00 20Y3 43,000.00 1,333.00 2,000.00 41,000.00 20Y4 41,000.00 1,271.00 2,000.00 39,000.00 20Y5 39,000.00 1,131.50 7,000.00 32,000.00 20Y6 32,000.00 992.00 2,000.00 30,000.00 20Y7 30,000.00 930.00 2,000.00 28,000.00 20Y8 28,000.00 868.00 2,000.00 26,000.00 20Y9 26,000.00 806.00 2,000.00 24,000.00 20Z0 24,000.00 666.50 7,000.00 17,000.00 20Z1 17,000.00 527.00 2,000.00 15,000.00 20Z2 15,000.00 465.00 2,000.00 13,000.00 20Z3 13,000.00 403.00 2,000.00 11,000.00 20Z4 11,000.00 341.00 2,000.00 9,000.00 20Z5 9,000.00 201.50 7,000.00 2,000.00 20Z6 2,000.00 62.00 2,000.00 0.00 Figure 15.3: FOLCROFT (Pty) Ltd.’s bank loan schedule The first recognition of the bank loan is for the financial statements as at 31.12.20X2. The bookkeeping entry at the moment of taking the loan is made on 1.04.20X2: DR Cash/ Bank.................... 75,000.00 EUR CR IBL.......................... 75,000.00 EUR The amount for the first interest payment is based on the duration FOL- CROFT (Pty) Ltd. owes the amount. The time span is 9 months. For that reason, the amount for 20X2’s interest equals to: 9 × 75,000 × 3.2% / 12 = 1,743.75 EUR. The amount for payoff has been agreed to 2,000.00 EUR every year. The agreement doesn’t say anything with regard to shorter periods, so the pay-off amount of 2,000.00 EUR is valid even in the first year. The Accountant records the payment on 31.12.20X2. At the same time, the next <?page no="127"?> Berkau: BASICS of ACCOUNTING 15.126 following pay-off payment is classified as short-term liability and therefore it is transferred to the Accounts Payables A/ P account. DR Interest..................... 1,743.75 EUR DR IBL.......................... 2,000.00 EUR CR Cash/ Bank.................... 3,743.75 EUR DR IBL.......................... 2,000.00 EUR CR Accounts Payables ........... 2,000.00 EUR In the next year 20X3, the interest is 3.1% × 73,000 = 2,263.00 EUR. The amount for pay-off equals to 2,000.00 EUR. In the next year 20X4, the interest is 3.1% × 71,000 = 2,201.00 EUR. The amount for pay-off equals to 2,000.00 EUR. In the next year 20X5, the interest is calculated by two steps, because there is an extra pay in the middle of the year. Before the extra pay-off at the end of June, the amount owed equals to 69,000.00 EUR. This is the opening amount. The 6-months interest amount equals to: 6 × 69,000 × 3.1%/ 12 = 1,069.50 EUR. After the extra pay-off amount, the amount owed the bank is: 69,000 - 5,000 = 64,000.00 EUR. The 6-months interest amount for the second half of 20X5 equals to: 6 × 64,000 x 3.1%/ 12 = 992.00 EUR. The total amount for interest in 20X5 equals to: 1,069.50 + 992 = 2,061.50 EUR. At the end of the year 20X5, there is the normal payoff. The total pay-off for 20X5 equals to: 5,000 + 2,000 = 7,000.00 EUR. The last bookkeeping entry for FOLCROFT (Pty) Ltd.’s bank loan takes place on 31.12.20X6: DR Interest..................... 62.00 EUR DR Accounts Payables............ 2,000.00 EUR CR Cash/ Bank.................... 2,062.00 EUR Sometimes, a business takes a downpayment from a customer. Down-payments are not part of the proceeds yet, but they can be used to cover later payment obligations. Proceeds is a technical term in Accounting for received cash or its equivalent or for receivables the company gets in return for a revenue. Once revenue is recorded the transaction of sales or service rendering has been processed and the bookkeeping entry becomes tax relevant for income taxes (through the Profit and Loss account) and for output-VAT. Thus, we have to distinguish downpayments from partial payments (proceeds) made in advance properly. The bookkeeping entries differ as well as legal and tax obligations do. A partial payment is legally the signification of the deal. If someone pays an amount as part of the settlement of the deal, the deal is closed with the payment - no matter how much the portion of the payment is. In that case, the <?page no="128"?> Berkau: BASICS of ACCOUNTING 15-127 payment signifies the deal and requires in most of the cases the revenue recognition and to credit output-VAT. We take a look at the car dealership KAMPUNG Ltd. - our next case study. KAMPUNG Ltd. offers a Mercedes A160 cdi at a gross selling price of 33,000.00 EUR. The customer SCOFIELD is interested in the car and wants to make sure, he can buy it later. He only carries 1,000.00 EUR on cash at the time, he is in the car dealership KAMPUNG Ltd. Thus, SCOFIELD signs the sales contract at KAMPUNG Ltd.’s sales office and makes a payment of 1,000.00 EUR, which counts as a partial payment. For KAMPUNG Ltd., the deal is sealed and the company expects SCOFIELD to pay the amount by the end of the week. The Accountant makes a bookkeeping entry as below: DR Cash/ Bank.................... 1,000.00 EUR DR Accounts Receivables......... 32,000.00 EUR CR VAT.......................... 5,500.00 EUR CR Revenue...................... 27,500.00 EUR SCOFIELD brings the money as promised a few days later and the Accountant records the final payment as below: DR Cash/ Bank.................... 32,000.00 EUR CR Accounts Receivables......... 32,000.00 EUR In contrast to a partial payment, a down-payment does not signify the deal. Down-payments are required to make sure, the deal will be closed in the future. We study a similar case with the car dealership KAMPUNG Ltd. KAMPUNG Ltd. offers another customer BURROWS a Mercedes C180 Kompressor at a gross selling price of 42,000.00 EUR. BURROWS only can see the car on a picture, because the car stands in an affiliated showroom of the car dealership KAMPUNG Ltd. As BURROWS is very keen to buy the car, KAMPUNG Ltd. offers him to fetch the car to its local show room. To make sure, BURROWS is willing to buy the car, KAMPUNG Ltd. asks him for a down-payment of 100.00 EUR. The amount is paid on cash and the agreement is, that the 100.00 EUR will be deducted from the selling price later, if BURROWS buys the car. BURROWS pays 100.00 EUR and the Accountant makes the bookkeeping entry for the downpayment below: DR Cash/ Bank.................... 100.00 EUR CR Deferred Income.............. 100.00 EUR <?page no="129"?> Berkau: BASICS of ACCOUNTING 15-128 A few days later, BURROWS buys the Mercedes C180 Kompressor. The Accountant now makes a bookkeeping entry for the sale as below: DR Cash/ Bank.................... 41,900.00 EUR DR Deferred Income.............. 100.00 EUR CR VAT.......................... 7,000.00 EUR CR Revenue...................... 35,000.00 EUR The down-payment does not cause any revenue recognition, because the sale did not take place at the time when the down-payment is received. In contrast, a partial payment is seen as fulfilment of one party’s obligation of the agreed duties and signifies the sale. In case a business got a payment obligation that is uncertain, it has to recognise a provision. A provision is an uncertain liability. It can be uncertain with regard to the amount, to the date of payment(s) or even uncertain to occur. Examples for provisions are payments that result from pending court cases which are not certain with regard to the amount or the sentence of the law case. Pensions are also subject to provisions as the length of the payment to the beneficiary is unknown and/ or the pension duration is uncertain. For further examples, check IAS 37! We study below the case study ALBANS Ltd., that is drawn to court: ALBANS Ltd. got sued for patent infringement. It manufactures a product another business holds a patent on. The fine expected, equals to 200,000.00 EUR if ALBANS Ltd. is convicted. The Accountant estimates, the probability to be found guilty is 50 %. The amount of 200,000.00 EUR doesn’t qualify for a liability recognition, because the payment is uncertain with regard to its occurrence and amount. The court case is expected to take place on 13.02.20X8, which falls into the next Accounting period. For that reason, ALBANS Ltd. has to recognise a provision on 31.12.20X7. The amount is based on the expected value of the fine of: 50% × 200,000 = 100,000.00 EUR . DR Other Expenses............... 100,000.00 EUR CR Provision.................... 100,000.00 EUR The provision is to be dissolved in case the verdict is in ALBANS Ltd.‘s favour. Otherwise, ALBANS Ltd. has to dissolve the provision also but has to pay the 200,000.00 EUR fine, too. In case ALBANS Ltd. is found guilty and the judge makes it pay a fine of 200,000.00 EUR, the Accountant has to make the bookkeeping entries as below: <?page no="130"?> Berkau: BASICS of ACCOUNTING 15.129 DR Provision.................... 100,000.00 EUR DR Other Expenses............... 100,000.00 EUR CR Cash/ Bank.................... 200,000.00 EUR (Note, in Germany provisions are to be recognised for income tax obligations also. However, along IFRSs a recording of a tax liability is in order. We follow international law and international standards here and recognise income tax liabilities as certain liabilities.) ESTERHUIZEN Ltd. earns a pre-tax profit of 450,000.00 EUR in 20X8. The amount for income taxes is 450,000 × 30% = 135,000.00 EUR . The amount is shortterm and to be credited to a special account along IAS 12 on 31.12.20X8. We call this account Income Tax Liabilities account. The correct name is Liabilities and Assets for Income Taxes along IAS 12 account. (No VAT is to record in this account, because VAT is no income tax.) DR P&L.......................... 135,000.00 EUR CR Income Tax Liabilities....... 135,000.00 EUR When ESTERHUIZEN Ltd. pays its income taxes, the Income Tax Liability account is closed-off to its Cash/ Bank account. The bookkeeping entries made on 10.01.20X9 by ESTERHUIZEN Ltd.‘s Accountant are: DR Income Tax Liabilities....... 135,000.00 EUR CR Cash/ Bank.................... 135,000.00 EUR Summary: Liabilities can be short-term and longterm. They are kept in different accounts. In case a liability is uncertain, a provision is recognised. Dissolving or reducing liabilities means to make a debit entry in the liability account. Long-term liabilities are discounted along IFRSs in order to recognize them at their fair value. Working Definitions: Liability: A liability is an obligation to pay an amount of money or to deliver goods/ services. Settlement amount: A settlement amount is the amount of money that actually has to be paid in order to payoff the loan. Annuity: A bank loan coming with a constant payment for interest and payoff (together) is called an annuity. Provision: A provision is an uncertain liability. It can be uncertain with regard to the amount, to the due date or even uncertain to occur. <?page no="131"?> Berkau: BASICS of ACCOUNTING 16-130 16. Reconciliation Accounts Learning Objectives: In this chapter we introduce reconciliation accounts. The aim is to study the concept of a 1 : n-relationship between accounts and items of the statement of financial position. After studying this chapter, you will understand full account structures and can apply subsidiary ledgers. In Accounting it is sometimes helpful to split up one account into subordinated accounts. This results in a subsidiary ledger. The total of subordinated accounts linked to an item of financial statements is its subsidiary ledger. It helps in situations, if several items are recorded together but information is needed on a more detailed level. So far, we only applied accounts directly linked to an item of the statement of financial position or the statement of comprehensive income. All these accounts are linked to the general ledger. The general ledger is a set of accounts without any subordinated accounts. One of the balance sheet items split up frequently is property, plant and equipment. It makes sense to maintain a special account for each item of property, plant and equipment in order to determine its singular value. In case a company dedicates single accounts to every item of property, plant and equipment, we call it an asset management. Asset management is a subsidiary ledger where instead of making bookkeeping entries in one P, P, E account every item of property, plant and equipment is represented by its own subordinated account. In order to determine the total value for all items of P, P, E, one summary account is maintained. This account is referred to as the reconciliation account. A reconciliation account is a summary account for a subsidiary ledger. It shows the amount of all items together. The reconciliation account for the asset management is the Property, Plant and Equipment account. The balance of the reconciliation account is disclosed on the balance sheet as the P, P, E item. Other items that are recorded in subsidiary ledgers are receivables, cash/ bank, payables, payroll and reserves. How it is done (running a subsidiary ledger) (1) Set up subordinated accounts for objects and create a reconciliation account. (2) Make bookkeeping entries within these subordinated accounts. (3) At the yearend determine the balancing figure of all subordinated accounts. (4a) Close-off subordinated accounts to the reconciliation account. <?page no="132"?> Berkau: BASICS of ACCOUNTING 16-131 At this stage, we recommend an alternative approach. The closing-off of accounts deletes all information linked to the single items. However, the subsidiary ledger is maintained to just keep that information in separate accounts and to continue the accounts over the Accounting periods. For that reason, it is better to consider the reconciliation account being a copy alongside of the double entry system. Accordingly, the how it is done advice is modified as below: …Avoid step (4a) and continue by (4b)! (4b) Leave the subordinated accounts untouched. (5) In order to determine the total of the subordinated accounts add the balancing figures thereof. (6) If the accounts are real accounts, continue the subordinated accounts. We explain the application of an asset management by the case study DAGBREEK Ltd. with regard to their motor vehicle accounts. DAGBREEK Ltd. applies subordinated accounts for each car. DAGBREEK Ltd. has a business car in use. The car’s license plate is OS-S 2344. DAGBREEK Ltd. identifies its cars by their licences. The car’s value, as carried by the company in the bookkeeping records, is 12,000.00 EUR on 2.01.20X7. DAGBREEK Ltd.’s account is named after the car’s ID: P, P, E - OS-S 2344. It is a subordinated account to the P, P, E account. On 28.01.20X7, DAGBREEK Ltd. buys an additional business car and pays for it by instant bank transfer. The license plate of the new car reads: OS-B 4095. The cost of acquisition for the car is 53,000.00 EUR. The Accountant makes the following bookkeeping entry on 1.02.20X7 after defining a subordinated account, called P, P, E - OS-B 4095: (1) Acquisition of the car OS-B 4095 on 28.01.20X7. DR P, P, E - OS-B 4095.......... 53,000.00 EUR CR Cash/ Bank.................... 53,000.00 EUR We are taking a look at DAGBREEK Ltd.‘s accounts and their structure: DAGBREEK Ltd. applies 2 motor vehicle accounts named after the license plates. You’ll find the reconciliation account “P, P, E account”, too. However, the amounts therein are greyed out, as no closing-off has taken place yet. This means, the subordinated accounts still apply. Once DARGBREEK Ltd. makes the reconciliation account “Property, Plant and Equipment account” count, it means it will double the amount of property, plant and equipment. Accordingly, the subordinated accounts are to be deleted by the closing-off. As long as DAGBREEK Ltd.’s subordinated accounts have not been closedoff, the P, P, E account only contains a kind of copy of the debit entries in the subordinated accounts. <?page no="133"?> Berkau: BASICS of ACCOUNTING 16-132 D C D C OV 12,000.00 (1) 53,000.00 D C D C OV ... (1) 53,000.00 OV 12,000.00 (1) 53,000.00 P,P,E - OS-S 2344 P,P,E - OS-B 4095 Cash/ Bank P,P,E Figure 16.1: DAGBREEK Ltd.‘s accounts as at 1.02.20X7 DAGBREEK Ltd.‘s reconciliation account is the Property, Plant and Equipment account. It is the bottom right account in Figure 16.1. (Note, the accounts are not balanced-off at this stage, because no depreciation is considered yet.) The reconciliation account represents the amounts of all items of property, plant and equipment. Often Accountants tend to close-off the subordinate accounts to the reconciliation account. This is common for German bookkeeping, as real accounts are not continued. We do not do that here, because the reason for the subordinated accounts is to keep them and to benefit from the detailed information stored therein. We see the reconciliation account as a means to determine the total value to be displayed on the balance sheet’s item. We recommend maintaining the singular accounts of the subsidiary ledger. Thus, DAG- BREEK Ltd. keeps the P, P, E - OS 2344 account and the P, P, E - OS 4095 account and only adds up the balances for recognition on the balance sheet. See the next example RETIEF (Pty) Ltd. below for further consideration: RETIEF (Pty) Ltd. is in the transport business. The company runs 4 trucks (A, B, C and D), all bought in 20X4. The value of the trucks as at 2.01.20X7 is 120,000.00 EUR/ u. On 5.01.20X7, RETIEF (Pty) Ltd. buys a new truck (E) at cost of acquisition of 230,000.00 EUR. The deal was closed by paying the amount of 230,000.00 into the dealership’s bank account. We ignore VAT. RETIEF (Pty) Ltd. applies an asset management. We assume there are no further items of property, plant and equipment. The new truck E replaces truck A, which is sold at 120,000.00 EUR on 20.01.20X7. In order to maintain information about the single trucks, the Accountant makes entries in the subsidiary ledger only. Observe below: (1) Acquisition of truck E on 5.01.20X7. DR P, P, E - Truck E............ 230,000.00 EUR CR Cash/ Bank.................... 230,000.00 EUR (2) Disposal of truck A on 20.01.20X7. <?page no="134"?> Berkau: BASICS of ACCOUNTING 16-133 DR Cash/ Bank.................... 120,000.00 EUR CR P, P, E - Truck A ............ 120,000.00 EUR After the last bookkeeping entry, the account Property, Plant and Equipment - truck A is no longer required. Its balance is zero. The Accountant deletes the account after the Accounting period. In order to understand the concept of the asset management and the application of subordinated accounts, take a look at RETIEF (Pty) Ltd.‘s accounts below as at 20.01.20X7, which is after the disposal of truck A. Check Figure 16.2. D C D C OV 120,000.00 (2) 120,000.00 OV 120,000.00 D C D C OV 120,000.00 OV 120,000.00 D C D C OV 480,000.00 (2) 120,000.00 OV ... (1) 230,000.00 (1) 230,000.00 c/ d 590,000.00 (2) 120,000.00 710,000.00 710,000.00 b/ d 590,000.00 D C (1) 230,000.00 P,P,E Cash/ Bank P,P,E - Truck E P, P, E - Truck C P,P,E - Truck D P,P,E - Truck A P, P, E - Truck B Figure 16.2: RETIEF (Pty) Ltd.‘s accounts The Property, Plant and Equipment account is the reconciliation account for all trucks operated by RETIEF (Pty) Ltd. The opening value is the amount retrieved from all its subordinated accounts. It equals to: 120,000 + 120,000 + 120,000 + 120,000 = 480,000.00 EUR . After the bookkeeping entries for the acquisition of truck E and the disposal of truck A, the amount is 0 + 120,000 + 120,000 + 120,000 + 230,000 = 590,000.00 EUR . (Note, the accounts are not balanced-off yet as depreciation is not yet recorded.) (Note, in some examples we do not provide full account information in order to keep the examples simple. An amount not specified appears as “…”, see the Cash/ Bank account’s opening value.) The reconciliation account can be seen as a parallel account to the subordinated ones, which discloses the total of the balancing figures in the subsidiary ledger. In order to indicate, the account not being an account along the double entry system, the bookkeeping entries made therein are greyed out in this text book. This is the concept, today’s computer software applies, too. When asset <?page no="135"?> Berkau: BASICS of ACCOUNTING 16-134 recognition is recorded, the Accounting software makes double debit entries. One of them is in the subordinated account and the other one will be in the reconciliation account. For this reason you have to define the reconciliation account once you create a subsidiary ledger customizing Accounting software. The same concept of subsidiary ledgers applies for receivables and payables. The name of the item on the face of the balance sheet for receivables and payables indicates already that these accounts are reconciliation accounts because they are named “Accounts Receivables (A/ R)” and “Accounts Payables (A/ P)”. E.g., the Accounts Receivables account is the reconciliation account for all debtors’ accounts. The singular accounts for receivables are linked to the name or ID of the business partners and are therefore referred to as individualised accounts. Consider any structure of accounts can be realised by creating subordinated accounts. There is no restriction even to set up a multi-level hierarchy of accounts. We study the sales ledger of DESPATCH Ltd. next: DESPATCH Ltd. is a dealer for printer/ fax machines/ scanners. At the beginning of 20X2, the business has inventory of 100,000.00 EUR on stock. DESPATCH Ltd. sells its goods on credit to their customers and offers them to pay their bills in a year’s time. Many of the customers do so. During 20X2, DESPATCH Ltd. sells 20 printers to customer HEUWEL (on 2.03.20X2). The printer’s net selling price is 130.00 EUR each. They further sell a fax machine (255.00 EUR) to CAMPHER on 4.05.20X2 and 12 scanners to BORUS on 29.06.20X2 at 138.00 EUR each. Observe the bookkeeping entries in 20X2: (1) Printer sold to HEUWEL on 2.03.20X2: 20 × 130 = 2,600.00 EUR . DR A/ R - HEUWEL................. 2,600.00 EUR CR Inventory.................... 2,600.00 EUR (2) Fax machine sold to CAMPHER on 4.05.20X2. DR A/ R - CAMPHER................ 255.00 EUR CR Inventory.................... 255.00 EUR (3) Scanners sold to BORUS at 12 × 138 = 1,656.00 EUR, on 29.06.20X2. DR A/ R - BOTHASRUS ............. 1,656.00 EUR CR Inventory.................... 1,656.00 EUR Observe the accounts to get the full picture below: <?page no="136"?> Berkau: BASICS of ACCOUNTING 16-135 D C D C OV 100,000.00 (1) 2,600.00 (1) 2,600.00 c/ d 2,600.00 (2) 255.00 b/ d 2,600.00 (3) 1,656.00 c/ d 95,489.00 100,000.00 100,000.00 b/ d 95,489.00 D C D C (2) 255.00 c/ d 255.00 (3) 1,656.00 c/ d 1,656.00 b/ d 255.00 b/ d 1,656.00 D C (1) 2,600.00 (2) 255.00 (3) 1,656.00 c/ d 4,511.00 4,511.00 4,511.00 b/ d 4,511.00 Inventory A/ R - HEUWEL A/ R A/ R - CAMPHER A/ R - BORUS Figure 16.3: DESPATCH (Pty) Ltd.’s accounts The accounts A/ R - HEUWEL, A/ R - CAMPHER and A/ R - BORUS form DESPATCH (Pty) Ltd.’s sales ledger. The sales ledger is a subsidiary ledger to the Accounts Receivables account. In the next year, DESPATCH (Pty) Ltd.’s customers pay the open bills. The bookkeeping entries are: (A) Payment received from HEUWEL on 2.03.20X3. DR Cash/ Bank.................... 2,600.00 EUR CR A/ R - HEUWEL................. 2,600.00 EUR (B) Payment received from CAMPHER on 4.05.20X3. DR Cash/ Bank.................... 255.00 EUR CR A/ R - CAMPHER ................ 255.00 EUR (C) Payment received from BOTHASRUS on 29.06.20X3. DR Cash/ Bank ................... 1,656.00 EUR CR A/ R - BORUS .................. 1,656.00 EUR <?page no="137"?> Berkau: BASICS of ACCOUNTING 16-136 (Note, that the identifiers for the next year’s bookkeeping entries are (A), (B) and (C) in 20X3 in order to distinguish Accounting periods.) Observe the accounts in 20X3 for DESPATCH (Pty) Ltd. as at on 31.12.20X3: D C D C OV 100,000.00 (1) 2,600.00 (1) 2,600.00 c/ d 2,600.00 (2) 255.00 b/ d 2,600.00 (A) 2,600.00 (3) 1,656.00 c/ d 95,489.00 100,000.00 100,000.00 b/ d 95,489.00 D C D C (2) 255.00 c/ d 255.00 (3) 1,656.00 c/ d 1,656.00 b/ d 255.00 (B) 255.00 b/ d 1,656.00 (C) 1,656.00 D C D C (1) 2,600.00 OV ... (2) 255.00 (A) 2,600.00 (3) 1,656.00 c/ d 4,511.00 (B) 255.00 4,511.00 4,511.00 (C) 1,656.00 b/ d 4,511.00 (A) 2,600.00 (B) 255.00 (C) 1,656.00 4,511.00 4,511.00 Inventory A/ R - HEUWEL A/ R Cash/ Bank A/ R - CAMPHER A/ R - BORUS Figure 16.4: DESPATCH (Pty) Ltd.’s accounts The concept described works for the purchase ledger the same way. Its reconciliation account is the Accounts Payables (A/ P) account. The purchase ledger is a subsidiary ledger to the Accounts Payables account. WINTERHOEK Ltd. is a production firm. On 4.07.20X5, WINTERHOEK buys 2 drilling machines on credit from its supplier VALLEISIG at the cost of acquisition of 3,500.00 EUR each. Furthermore, WIN- TERHOEK Ltd. orders material from supplier DeMIST at 50,000.00 EUR purchase cost on 8.09.20X5. It is agreed to pay half of the amount immediately and the rest later. On 10.10.20X5, WINTERHOEK Ltd. pays the amount of 63,000.00 EUR it owes its supplier KRUIS since last year. The amount of inventory is no longer in the Inventory account as the materials have been used up already. WINTER- HOEK Ltd.’s Accountant makes the entries below: <?page no="138"?> Berkau: BASICS of ACCOUNTING 16-137 (1) Acquisition of drilling machines equals to: 2 × 3,500 = 7,000.00 EUR purchased from VALLEISIG on credit on 4.07.20X5. DR P, P, E Account.............. 7,000.00 EUR CR A/ P - VALLEISIG .............. 7,000.00 EUR (2) Purchase of materials from DeMIST half/ half on 8.09.20X5. Purchase cost is 50,000.00 EUR. Half of it equals to: 50,000/ 2 = 25,000.00 EUR . DR Inventory.................... 50,000.00 EUR CR A/ P - DeMIST................. 25,000.00 EUR CR Cash/ Bank.................... 25,000.00 EUR (3) Payment of the amount owed KRUIS, on 10.10.20X5. DR A/ P - KRUIS ................. 63,000.00 EUR CR Cash/ Bank.................... 63,000.00 EUR Observe WINTERHOEK Ltd.‘s accounts as at 31.12.20X5. D C D C (3) 63,000.00 OV 63,000.00 (3) 63,000.00 OV 63,000.00 (1) 7,000.00 c/ d 32,000.00 (2) 25,000.00 95,000.00 95,000.00 b/ d 32,000.00 D C D C (1) 7,000.00 c/ d 7,000.00 (2) 50,000.00 c/ d 50,000.00 b/ d 7,000.00 b/ d 50,000.00 D C D C c/ d 7,000.00 (1) 7,000.00 c/ d 25,000.00 (2) 25,000.00 b/ d 7,000.00 b/ d 25,000.00 A/ P - KRUIS A/ P A/ P - VALLEISIG A/ P - DeMIST PPE Inventory Figure 16.5: WINTERHOEK Ltd.‘s accounts <?page no="139"?> Berkau: BASICS of ACCOUNTING 16-138 D C OV ... (2) 25,000.00 (3) 63,000.00 Cash/ Bank Figure 16.5: WINTERHOEK Ltd.’s accounts (continued) A company holding accounts with with different banks will use the Cash/ Bank account as reconciliation account, too. Compare the example SCHOENMAKERSKOP Ltd. in chapter Special Asset Accounts of this text book. Summary: Reconciliation accounts are summary accounts. They will be used parallel to the double entry system. A subsidiary ledger keeps information about single items, like assets, bank accounts, debtors, creditors and employees. Working Definitions: Subsidiary Ledger: The total of subordinated accounts that belongs to an item of financial statements is a subsidiary ledger. General Ledger: The general ledger is a set of accounts without any subordinated accounts. Asset Management: Asset management is a subsidiary ledger where instead of making bookkeeping entries in one P, P, E account every item of property, plant and equipment is represented by its own account. Reconciliation Account: A reconciliation account is a summary account for a subsidiary ledger. Sales Ledger: The sales ledger is a subsidiary ledger to the Accounts Receivables account. Purchase Ledger: The purchase ledger is a subsidiary ledger to the Accounts Payables account. <?page no="140"?> Berkau: BASICS of ACCOUNTING 17-139 17. Depreciation Learning Objectives: In this chapter we introduce depreciation. In order to be prepared for revaluations along IAS 16, we apply the Accumulated Depreciation account as the contra account for postings to depreciation. After studying this chapter, you will be familiar with the basics of depreciation methods and you will be able to record depreciation within the subsidiary ledger asset management. You also can set up a register of noncurrent assets that displays accumulated depreciation and impairment losses for the items therein. Depreciation is a technical term in Accounting for an expense that reflects a non-current asset’s loss in value by its deployment. Most of the assets lose their value by use. Although some of them won’t. E.g., land does not, as it does not deplete by use. Some other assets lose value just by the time elapsed. Park your car for 1 year in the garage without driving and you’ll experience a drop in value during that period! (Pls., read the conventions about depreciation at the beginning of this text book! ) For now, we only want to apply straight line method for depreciation. This method applies if the curve of the asset’s carrying amount over the time follows a straight line. This implies depreciation over the useful life will be constant. The useful life is the time an asset can be used. Calculation of depreciation per period along straight line method is as follows: We take the amount of the cost of acquisition and divide it by the number of periods the asset will be deployed according to the estimated useful life. In case the asset is in use for partial periods, depreciation is calculated on a PRT basis. See further considerations about depreciation methods in chapter 7 of the text book Bilanzen and the ebook Accounting-2-Go. DODD Ltd. acquires a saw machine at 120,000.00 EUR on 3.02.20X4. The saw is paid by bank transfer immediately. The useful life of the saw is 5 years. Depreciation along straight line method amounts to 120,000/ 5 = 24,000.00 EUR/ a . In accordance to the conventions in this text book, we apply depreciation accurate to the month. Thus, a month counts for depreciation if the asset is more than half of the month in use. DODD Ltd.’s saw is deployed 11 months in 20X4. Accordingly, depreciation amounts to: 11 × 24,000/ 12 = 22,000.00 EUR in 20X4. In contrast to the PELZERHAGEN (Pty) Ltd. case study, we modify the bookkeeping entries from here onwards: We apply the Accumulated Depreciation account. The Accumulated Depreciation account is the contra account for depreciation. The Accumulated Depreciation account will gather all depreciation expenses over the useful life of an asset. Values a company carries the assets at, are calculated by deducting any (accumulated) depreciation and any impairment losses from the cost of acquisition. Impairment losses will be dis- <?page no="141"?> Berkau: BASICS of ACCOUNTING 17-140 cussed further below, for now we regard them as extra depreciations. The calculation of the carrying amount is the difference of the cost of acquisition as recognised by the Property, Plant and Equipment account less the balancing figure of the Accumulated Depreciation and Accumulated Impairment Loss account. Companies running an asset management dedicate an Accumulated Depreciation account for each and every asset they depreciate. You will learn this concept by the following case studies. However, there is no legal obligation for asset management. DODD Ltd. makes a bookkeeping entry when it buys the saw applying along an asset management: (1) Saw acquisition at 120,000.00 EUR on 3.02.20X4. DR P, P, E - Saw Machine........ 120,000.00 EUR CR Cash/ Bank.................... 120,000.00 EUR (2) Depreciation on the saw machine 24,000.00 EUR on 31.12.20X4. DR Depreciation................. 22,000.00 EUR CR Acc. Depr. - Saw Machine..... 22,000.00 EUR The account Accumulated Depreciation applies, because it helps to prepare the register of non-current assets later on. The register of non-current assets is a list of all items of P, P, E that discloses every item’s cost of acquisition, the date of acquisition, the accumulated depreciation, the accumulated impairment losses and the carrying amount. The statement is required on group level for all depreciable non-current assets along IAS 1. In order to demonstrate the use of the Accumulated Depreciation account we make a bookkeeping entry for DODD Ltd.’s 20X5 Accounting period, too. As we apply straight line method for depreciation the amount for depreciation is 24,000.00 EUR in 20X5. (A) Depreciation on the saw machine 24,000.00 EUR on 31.12.20X5. DR Depreciation................. 24,000.00 EUR CR Acc. Depr. - Saw Machine..... 24,000.00 EUR We take a closer look at the accounts after two Accounting periods. We display the Depreciation-20X4 account for illustration purpose. <?page no="142"?> Berkau: BASICS of ACCOUNTING 17-141 D C D C (1) 120,000.00 c/ d 120,000.00 c/ d 22,000.00 (2) 22,000.00 b/ d 120,000.00 b/ d 22,000.00 c/ d 46,000.00 (A) 24,000.00 46,000.00 46,000.00 b/ d 46,000.00 P,P,E saw Acc depr saw D C D C (2) 22,000.00 P&L 22,000.00 (A) 24,000.00 P&L 24,000.00 D C OV ... (1) 120,000.00 Cash/ Bank Depreciation 20X4 Depreciation 20X5 Figure 17.1: DODD Ltd.’s accounts as at 31.12.20X5 As we can read from the accounts, the carrying amount for the saw is the value in the Property, Plant and Equipment account less Accumulated Depreciation: 120,000 - 46,000 = 74,000.00 EUR . Along international bookkeeping conventions, there is no sense in closing-off the Accumulated Depreciation account to the Property, Plant and Equipment account. This would destroy the chance to set up a register of non-current assets straight away. Companies have to prepare the register of non-current assets as part of the notes. In the right column of the register of non-current assets, the carrying amount is disclosed. The carrying amount is the amount the asset is to be recognized at on the balance sheet. DODD Ltd.’s saw machine is valued at 74,000.00 EUR. The initial amount of 120,000.00 EUR has been decreased by depreciation of: 22,000 + 24,000 = 46,000.00 EUR . The register of non-current assets for DODD Ltd. looks as below, observe the only item being the “saw machine” therein: Asset Cost of acquisition Acc. depr. Acc. impairm. losses Carrying amount Saw machine 120,000.00 (46,000.00) 74,000.00 74,000.00 Dodd Ltd.'s REGISTER of NON-CURRENT ASSETS as at 31.12.20X5 Figure 17.2: DODD Ltd.’s register of non-current assets <?page no="143"?> Berkau: BASICS of ACCOUNTING 17-142 Other reasons for an asset’s value to decrease are impairment losses. An impairment loss is a reduction of the carrying amount that does not occur on a regular timely basis but will be caused by accidents or price drops, for instance. Under consideration of impairment losses, the carrying amount is calculated as the cost of acquisition less any accumulated depreciation and less any accumulated impairment losses. Later (in the textbook Bilanzen and the ebook Accounting-2-Go, chapter 7), we’ll learn about valuations at fair value that require revaluations of assets as it is required by IAS 16. A revaluation is an increase of an asset’s carrying amount. Bookkeeping entries for depreciation are made at the end of the Accounting period as adjustments. Although an asset has been disposed before the yearend, a PRT-depreciation expense is considered along the conventions in this text book. Observe the FAIR- BRIDGE Ltd. case study below: FAIRBRIDGE Ltd. is a pizza delivery service. The delivery vehicles are VW Polos. The Polo that is licensed with OS-FB 333, was bought on 2.01.20X2 at 18,000.00 EUR. VAT is ignored for this case study. The useful life for all delivery vehicles is 4 years. The annual depreciation on the VW Polo is: 18,000/ 4 = 4,500.00 EUR . The monthly depreciation is: 4,500 / 12 = 375.00 EUR . On the 2.01.20X4, the car OS-FB 333 is 2 years old. Its carrying amount equals to: 18,000 - 9,000 = 9,000.00 EUR . The other VW Polo with license plates reading OS-FB 222 is in use since 2.07.20X0. The cost of acquisition and the useful life are the same as for OS-FB 333. Its value as at 2.01.20X4 is: 18,000 - 15,750 = 2,250.00 EUR . See FAIRBRIDGE Ltd.’s register of noncurrent assets as at 2.01.20X4: Asset Cost of acquisition Acc. depr. Acc. impairm. losses Carrying amount VW Polo OS-FB 222 18,000.00 (15,750.00) 2,250.00 VW Polo OS-FB 333 18,000.00 (9,000.00) 9,000.00 11,250.00 Fairbridge Ltd.'s REGISTER of NON-CURRENT ASSETS as at 31.12.20X3 Figure 17.3: FAIRBRIDGE Ltd.’s register of non-current assets as at 31.12.20X3 FAIRBRIGDE continues the deployment of the VW Polo OS-FB 222 until 31.03.20X4. The car has been used 3 years and 9 months by then. The carrying amount of the car then equals to: 18,000 - 16,875 = 1,125.00 EUR . FAIRBRIDGE Ltd. sells the car at 1,125.00 EUR on 31.03.20X4. On 1.04.20X4, FAIRBRIDGE buys a new VW Polo at 20,000.00 EUR. Its useful life is 4 years, as well as for the other cars. The new car is licensed under OS-FB 444. The annual depreciation of the new VW Polo is: 20,000 / 4 = 5,000.00 EUR . Depreciation only applies for 9 months in 20X4: (3/ 4) × 5,000 = 3,750.00 EUR . <?page no="144"?> Berkau: BASICS of ACCOUNTING 17-143 The bookkeeping entries for FAIRBRIDGE Ltd.’s VW Polos in 20X4 are as follows: (1) Depreciation on VW Polo “OS-FB 222”, recorded on 31.12.20X4 (for 3 months). DR Depreciation................. 1,125.00 EUR CR Acc. Depr. OS-FB 222......... 1,125.00 EUR (2) Sale of the VW Polo OS-FB 222 on 31.03.20X4 at 1,125.00 EUR. DR Cash/ Bank.................... 1,125.00 EUR DR Acc. Depr. OS-FB 222......... 16,875.00 EUR CR P, P, E - OS-FB 222.......... 18,000.00 EUR (3) Acquisition of the new VW Polo OS- FB 444 on 1.04.20X4. DR P, P, E - OS-FB 444.......... 20,000.00 EUR CR Cash/ Bank.................... 20,000.00 EUR (4) Depreciation on the new VW Polo for 9 months on 31.12.20X4. Depreciation charge amounts to 9 × 20,000 / (4 × 12) = 3,750.00 EUR . DR Depreciation................. 3,750.00 EUR CR Acc. Depr. - OS-FB 444....... 3,750.00 EUR (5) Depreciation on the VW Polo OS-FB 333 for one year on 31.12.20X4: DR Depreciation................. 4,500.00 EUR CR Acc. Depr. - OS-FB 333....... 4,500.00 EUR Observe FAIRBRIDGE Ltd.’s accounts as at 31.12.20X4 below: D C D C OV 18,000.00 (2) 18,000.00 (2) 16,875.00 OV 15,750.00 (1) 1,125.00 16,875.00 16,875.00 PPE OS-FB 222 Acc depr OS-FB 222 Figure 17.4: FAIRBRIDGE Ltd.’s accounts <?page no="145"?> Berkau: BASICS of ACCOUNTING 17-144 D C D C OV 18,000.00 c/ d 18,000.00 OV 9,000.00 b/ d 18,000.00 c/ d 13,500.00 (5) 4,500.00 13,500.00 13,500.00 b/ d 13,500.00 PPE OS-FB 333 Acc depr OS-FB 333 D C D C (3) 20,000.00 c/ d 20,000.00 c/ d 3,750.00 (4) 3,750.00 b/ d 20,000.00 b/ d 3,750.00 D C D C (1) 1,125.00 P&L 9,375.00 OV ... (3) 20,000.00 (4) 3,750.00 (2) 1,125.00 (5) 4,500.00 9,375.00 9,375.00 D C D C OV 36,000.00 (2) 18,000.00 (2) 16,875.00 OV 24,750.00 (3) 20,000.00 c/ d 38,000.00 (1) 1,125.00 56,000.00 56,000.00 (4) 3,750.00 b/ d 38,000.00 c/ d 17,250.00 (5) 4,500.00 34,125.00 34,125.00 b/ d 17,250.00 PPE (summary) Acc depr (summary) PPE OS-FB 444 Acc depr OS-FB 444 Depreciation 20X4 Cash/ Bank Figure 17.4: FAIRBRIDGE Ltd.’s accounts (continued) We prepare the register of non-current assets for FAIRBRIDGE Ltd.’s delivery cars as at the yearend of the next Accounting period. Observe Figure 17.5: Asset Cost of acquisition Acc. depr. Acc. impairm. losses Carrying amount VW Polo OS-FB 222 disposed disposed disposed VW Polo OS-FB 333 18,000.00 (13,500.00) 4,500.00 VW Polo OS-FB 444 20,000.00 (3,750.00) 16,250.00 38,000.00 (17,250.00) 0.00 20,750.00 Fairbridge Ltd.'s REGISTER of NON-CURRENT ASSETS as at 31.12.20X4 Figure 17.5: FAIRBRIDGE Ltd.’s register of non-current assets as at 31.12.20X3 As you can observe by Figure 17.4, the sums of the cost of acquisition and of <?page no="146"?> Berkau: BASICS of ACCOUNTING 17-145 the accumulated depreciation equal to the amounts recorded in the reconciliation accounts. Summary: Depreciation is an expense that reflects the reduction of a non-current asset’s value. Most of non-current assets lose value by use or by the time elapsed. Depreciation is an expense without a payment linked thereto. The contra account for depreciation is the Accumulated Depreciation account. The overview about the assets’ value is given by the register of non-current assets for all depreciable non-current assets a company deploys. Any lose in value that occurs accidently or irregularly is referred to as an impairment loss. The contra account for impairment losses is the Accumulated Impairment Loss account. Working Definitions: Depreciation: Depreciation is a technical term in Accounting for an expense that reflects a non-current asset’s loss in value by its deployment The useful life of an asset: The useful life of an asset is the time the asset can be used. Accumulated Depreciation account: The Accumulated Depreciation account is the contra account for depreciation. Register of non-current Assets: The register of non-current assets is a list of all items of P, P, E that discloses every item’s cost of acquisition, the date of acquisition, the accumulated depreciation, the accumulated impairment losses and the carrying amount. Carrying amount: The carrying amount is the amount the asset is to be recognized at. Impairment Loss: An impairment loss is a carrying amount deduction that does not occur on a regular timely basis but will be caused by accidents or price drops, for instance. Revaluation: A revaluation is an increase of an asset’s carrying amount. <?page no="147"?> Berkau: BASICS of ACCOUNTING 18-146 18. Further Expenses and Accruals Learning Objectives: In this chapter we introduce some activities in order for you to become familiar with the statement of comprehensive income and the items therein. In particular the accrual principle which applies if payments are made in the actual Accounting period for expenses in the next Accounting period becomes subject to our attention. After studying this chapter, you can record and accrue prepaid expenses along IFRSs. You understand the matching principle along which expenses and revenues are assigned to accounting periods they belong to - no matter when payments are made or received. Prepaid expenses are expenses paid in one Accounting period but relevant for another (future) Accounting period. Expenses in the business will be recorded by making debit entries. All expenses contribute to a profit reduction regardless of whether or not a payment has been made. Expenses are debited to nominal accounts, like labour, rent, depreciation, internet fees, etc. Some expenses are VAT-relevant, e.g. if a service from a third party is received. Below, we observe the case study SIMONI Ltd. for studying prepaid expenses. SIMONI Ltd. is a dealership for computer games. The business rents a sales room in a mall and pays 1,500.00 EUR monthly rent. The payment is to be made in advance before the month starts. On 2.01.20X4 SIMONI Ltd. starts its business and pays rent on 2.01.20X1 accordingly. Otherwise, the payments always take place on the 28th of the previous month as stated in the rent agreement with the landlord. SIMONI Ltd. pays rent by bank transfer. The business sets up a stop-order with their house bank. This means the same amount is paid every month into the landlord’s account until SIMONI Ltd. makes the bank stop the money transfers. SIMONI Ltd.’s Accountant makes the bookkeeping entries for rent as follows: (1) Recording January’s rent on 2.01.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (2) Recording February’s rent on 28.01.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (3) Recording March’s rent on 28.02.20X4. <?page no="148"?> Berkau: BASICS of ACCOUNTING 18-147 DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (4) Recording April’s rent on 28.03.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (5) Recording May’s rent on 28.04.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (6) Recording June’s rent on 28.05.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (7) Recording July’s rent on 28.06.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (8) Recording August’s rent on 28.07.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (9) Recording September’s rent on 28.08.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (10) Recording October’s rent on 28.09.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (11) Recording November’s rent on 28.10.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR <?page no="149"?> Berkau: BASICS of ACCOUNTING 18-148 (12) Recording December’s rent on 28.11.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (13) Recording January 20X5’s rent on 28.12.20X4. DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR We take a look at the Rent account and at the Cash/ Bank account, assuming the opening value in the Cash/ Bank account was 75,000.00 EUR. Compare Figure 18.1. D C D C (1) 1,500.00 OV 75,000.00 (1) 1,500.00 (2) 1,500.00 (2) 1,500.00 (3) 1,500.00 (3) 1,500.00 (4) 1,500.00 (4) 1,500.00 (5) 1,500.00 (5) 1,500.00 (6) 1,500.00 (6) 1,500.00 (7) 1,500.00 (7) 1,500.00 (8) 1,500.00 (8) 1,500.00 (9) 1,500.00 (9) 1,500.00 (10) 1,500.00 (10) 1,500.00 (11) 1,500.00 (11) 1,500.00 (12) 1,500.00 (12) 1,500.00 (13) 1,500.00 (13) 1,500.00 c/ d 55,500.00 75,000.00 75,000.00 b/ d 55,500.00 Rent Cash/ Bank Figure 18.1: SIMONI Ltd.’s accounts Obviously, the rent paid exceeds the rent for the Accounting period 20X4. The amount in the Rent accounts shows 13 × 1,500 = 19,500.00 EUR . In case SIMONI Ltd. transfers the full amount as debited to the Rent account (for 13 months) to the Profit and Loss account, the January 20X5’s rent will count as an expense for 20X4. This will result in a mismatch between expenses and Accounting periods. For this reason, the bookkeeper accrues the amount for January 20X5. The amount is “parked” in an extra Prepaid Expense account on the balance sheet. The bookkeeping entry (14) transfers the rent for January 20X5 into that account. Accrues are adjustments and recorded on 31.12. of the Accounting period. (14) Transfer of next year’s rent into the Prepaid Expenses account on 31.12.20X4. <?page no="150"?> Berkau: BASICS of ACCOUNTING 18-149 DR Prepaid Expenses............. 1,500.00 EUR CR Rent......................... 1,500.00 EUR We now take a closer look at the accounts in Figure 18.2 after recording prepaid expenses and prepare the financial statements therefrom. D C D C (1) 1,500.00 (14) 1,500.00 OV 75,000.00 (1) 1,500.00 (2) 1,500.00 (2) 1,500.00 (3) 1,500.00 (3) 1,500.00 (4) 1,500.00 (4) 1,500.00 (5) 1,500.00 (5) 1,500.00 (6) 1,500.00 (6) 1,500.00 (7) 1,500.00 (7) 1,500.00 (8) 1,500.00 (8) 1,500.00 (9) 1,500.00 (9) 1,500.00 (10) 1,500.00 (10) 1,500.00 (11) 1,500.00 (11) 1,500.00 (12) 1,500.00 (12) 1,500.00 (13) 1,500.00 c/ d 18,000.00 (13) 1,500.00 19,500.00 19,500.00 c/ d 55,500.00 b/ d 18,000.00 P&L 18,000.00 75,000.00 75,000.00 b/ d 55,500.00 D C D C Rent 18,000.00 EBTc/ 18,000.00 (14) 1,500.00 c/ d 1,500.00 b/ d 18,000.00 R/ E 18,000.00 b/ d 1,500.00 D C D C P&L 18,000.00 c/ d 18,000.00 c/ d 75,000.00 OV 75,000.00 b/ d 18,000.00 b/ d 75,000.00 R/ E Issued Capital P&L Prepaid expenses Rent Cash/ Bank Figure 18.2: SIMONI Ltd.’s accounts At the beginning of the next Accounting period 20X5, SIMONI Ltd. will undo the accrual. This means, the prepaid expenses will get transferred to the expense account. There will be a bookkeeping entry, such as: DR Rent......................... 1,500.00 EUR CR Prepaid Expenses............. 1,500.00 EUR Observe the statement of financial position as at 31.12.20X4 below: <?page no="151"?> Berkau: BASICS of ACCOUNTING 18-150 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 75,000.00 Intangibles Reserves Financial assets R/ E (18,000.00) Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses 1,500.00 Provisions Cash/ Bank 55,500.00 Tax liabilities 57,000.00 57,000.00 Simoni Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 18.3: SIMONI Ltd.’s statement of financial position as at 31.12.20X4 (Note, the German Handelsgesetzbuch requires a special item called Aktiver Rechnungsabgrenzungsposten (accrual) for prepayments. The special item on the German Bilanz indicates that accruals are not regarded as assets. Germans consider prepaid rent, prepaid insurance or prepaid labour as uncertain and non-tradable.) SIMONI Ltd.’s statement of comprehensive income for 20X4 looks as in Figure 18.4. In particular it shows the rent for 12 months correctly along the matching principle, being: 12 × 1,500 = 18,000.00 EUR . [EUR] Revenue Other income 0.00 Materials Labour Depreciation Other expenses 18,000.00 Earnings before int and taxes (EBIT) (18,000.00) Interest Earnings before taxes (EBT) (18,000.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (18,000.00) Simoni Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 18.4: SIMONI Ltd.’s statement of comprehensive income for 20X4 <?page no="152"?> Berkau: BASICS of ACCOUNTING 18-151 How it is done (accruals): (1) Make bookkeeping entries as along business activities including all payments. (2) Check whether or not expense have been recorded, which are linked to a later Accounting period. (3) In case step (2) is positive, transfer expenses paid that are relevant for the next Accounting period(s) to the Prepaid Expenses account. Credit the amount to the relevant expense account in order to reduce expenses. (4) Prepare financial statements. (5) At the beginning of the next Accounting period close-off the Prepaid Expenses account to the relevant expense account. Summary: Expenses, such as rent, insurance, labour, etc. are often paid in advance. In order to assign the correct expenses to the statement of comprehensive income, accruals are recorded. Along the accrual principle, expenses are to be assigned to the Accounting period they belong to and not to the period of payment. Working Definitions: Prepaid Expenses: Expenses that are paid in one Accounting period but are relevant for another (future) Accounting period. (Note, along this definition you could consider the P, P, E account as a prepaid expense account, too what is absolutely correct. The acquisition is a prepayment for depreciation.) <?page no="153"?> Berkau: BASICS of ACCOUNTING 19-152 19. Accounting for Labour Learning Objectives: In this chapter we’ll take a closer look at Accounting for labour. We will introduce payroll accounts and how a withdrawal tax for labour works, We will explain the recording of overtime, incentives and vacation with regard to payroll Accounting, too. After studying this chapter, you will be able to record labour, even in special situations that occur in business. Labour is paid regularly in advance, too. In order to keep the next case study simple, we assume labour to be paid at the 15th of each month for the month it counts for. So, a company pays 50 % of labour in advance and the other half after labour has been delivered by the employees. Often labour payments are combined with payments for social security and with taxes to be paid on labour (payroll tax). The special rules for German companies will be explained in the text book Bilanzen and in the ebook Accounting-2-Go in chapter 4. For now, we only apply simple percentages (such as 25 % for social security and 20 % for payroll tax). Labour expenses are called just labour. Labour contains payroll tax paid on behalf of the employee as well as social security payments. Latter ones consist of insurance for unemployment, of pension funds contributions and of health care coverage. Payroll tax is deducted from the salary of the employee. This concept is known as withholding tax. The company pays the payroll tax straight to the revenue service. However, payroll tax is no company tax as it is a payment owed by the employee but not by the company. In most countries, the payment for the employee is based on the gross salary. The gross salary contains payroll taxes and - such as in Germany - half of the social security payments. Thus, the social security payment is split up at a half : half ratio between the company and the employee. The portion covered by the employee is called employee’s contribution to social security. It is included in the gross salary. The company owes other half of social securities. However, the company’s contribution is not part of the employee’s gross salary but it counts as labour. For this text book we make assumptions for the amounts as follows: Full in the meaning of both halves of social security is 25 % of the gross salary and payroll tax 20 % thereof. Payroll tax is withdrawn from the employee’s salary (pay as you earn - PAYE). The expenses for labour equal to: 25/ 2 + 100 = 112.5 % of the gross salary, because it includes the company’s contribution to 25 % of social securities. The calculation for labour is explained by the following case study: SUIDERLAND Ltd. has an employee LAMPEN-KÖTTER on its payroll, who earns a monthly gross salary of 3,500.00 EUR. The payroll tax included therein is deducted and the social security contribution is calculated by 25 % of the gross salary divided by 2, because LAMPEN-KÖTTER has to pay for half of it himself. LAMPEN-KÖTTER’s net salary is the amount he gets paid after deduction of payroll tax and half of the <?page no="154"?> Berkau: BASICS of ACCOUNTING 19-153 social security payments. LAMPEN- KÖTTER’s net salary amounts to: 3,500 - 20% × 3,500 - 25% × 3,500/ 2 = 3,500 × (1 - 20% - 25%/ 2) = 2,362.50 EUR/ m . Accordingly, the payroll tax equals to: 20% × 3,500 = 700.00 EUR/ m . Half of his social security amounts to: 25 % × 3,500 × (1/ 2) = 437.50 EUR/ m . It is assumed that the net salary is paid on the 15th of every month. However, the amounts for social security and for taxes are due at every month end. SUIDERLAND Ltd. makes the bookkeeping entries in January for LAMPEN-KÖTTER’s salary: (1) Recording net salary and transferring payroll tax and half of the social security payments to payables on 15.01.20X3. DR Labour....................... 3,500.00 EUR CR A/ P (Payroll Tax)............ 700.00 EUR CR A/ P (Social Security 50%).... 437.50 EUR CR Cash/ Bank.................... 2,362.50 EUR (2) Putting SUIDERLAND Ltd.’s contribution to LAMPEN-KÖTTER’s social security into Accounts Payables on 31.01.20X3. DR Labour....................... 437.50 EUR CR A/ P (Social Security 50%).... 437.50 EUR (3) Payment of taxes and social security on 31.01.20X3. DR A/ P (Taxes on Labour)........ 700.00 EUR DR A/ P (Social Security 100%)... 875.00 EUR CR Cash/ Bank.................... 1,575.00 EUR Observe the accounts for the payments in Figure 19.1: D C D C (1) 3,500.00 (3) 875.00 (1) 437.50 (2) 437.50 P&L 3,937.50 (2) 437.50 3,937.50 3,937.50 875.00 875.00 D C D C (3) 700.00 (1) 700.00 OV ... (1) 2,362.50 (3) 1,575.00 Taxes payables Cash/ Bank Labour Social securities payables Figure 19.1: SUIDERLAND Ltd.’s accounts <?page no="155"?> Berkau: BASICS of ACCOUNTING 19-154 How it is done (labour payment): (1) Calculate the gross salary. There might be accruals to consider. (2) Debit the gross salary to the Labour account and credit the payroll tax (as withholding tax) and the employee’s contribution to social security to payables and pay the net salary to the employee. (Three credit entries! ) (3) Debit the amount for the employer’s contribution to social security to labour and credit the amount to payables, too. (4) Pay social contribution by debiting the employer’s and employee’s contribution to social security to the payables and make a credit entry in the Cash/ Bank account. (5) Pay payroll tax by making a debit entry in the payables account. (Note, do not add payroll tax to tax liabilities as they do not count for company taxes.) The payment for labour and the calculation of the gross salary can be different, if the contract for labour is based on an hourly basis or by completion of work. This is called piecework labour. We will explain this by the case study CLARITON Ltd. CLARITON Ltd. is a small production firm for baseball caps. The business runs a division for cap manufacturing, where it employs one manager and 3 production operators. The manager receives an annual salary of 50,400.00 EUR which is the gross salary. Along national law, there is a withholding tax on labour. In this case study a payroll tax rate of 20 % based on the gross salary applies. The gross salary and a 25 % portion for social security thereof are paid at the month end. CLARITON Ltd. has 3 operators, who are paid by piecework. This means they will be paid based on the amount of baseball caps they manufacture. It is agreed they receive a gross salary of 1.50 EUR/ baseball cap. Furthermore, they will receive an incentive of 0.50 EUR per baseball cap completed once they exceed a daily production amount of 60 baseball caps. Working night shift or weekend shift pays a worker 150 % of the normal salary. Every worker gets a (paid) leave of 10 days per annum. Payday is every 25 th of each month. We will start recording labour by the manager’s salary: The gross salary amounts to 50,400.00 EUR. The payroll tax on the gross salary is: 20% × 50,400 = 10,080.00 EUR/ a . Social security is: 25% × 50,400 = 12,600.00 EUR/ a . CLARITON Ltd. pays half of the social security which is: 12,600/ 2 = 6,300.00 EUR/ a . Every month end, CLARITON Ltd. makes the bookkeeping entries as follows for its manager. The monthly gross salary is: 50,400/ 12 = 4,200.00 EUR/ m , payroll tax amounts to: 10,080/ 12 = 840.00 EUR/ m and social security contribution equals <?page no="156"?> Berkau: BASICS of ACCOUNTING 19-155 to: 6,300/ 12 = 525.00 EUR/ m . The manager’s net salary equals to: 4,200 - 840 - 525 = 2,835.00 EUR/ m . (1, … 12) Recording the manager’s salary. DR Labour....................... 4,200.00 EUR CR Payroll Tax / p.............. 840.00 EUR CR Social Security / p.......... 525.00 EUR CR Cash/ Bank.................... 2,835.00 EUR (13 … 24) Posting labour tax. DR Payroll Tax / p.............. 840.00 EUR CR Cash/ Bank.................... 840.00 EUR (25 … 48) Posting social security. DR Labour....................... 525.00 EUR CR Social Security / p........... 525.00 EUR DR Social Security / p........... 1,050.00 EUR CR Cash/ Bank.................... 1,050.00 EUR The next step is about the operators in the manufacturing division. For bookkeeping entries in December, we assume all workers completed 60 baseball caps per working day so far and 2 of the workers took their paid leave already. Figure 19.2 illustrates the calendar for the relevant period. Consider 25 December 20X8 being a public holiday. The payday is pulled forward to 24 December in that month. Consider, there is no Christmas bonus paid by CLARITON Ltd. As the workers have a claim on 2 weeks of paid leave, their salary per cap increases at a 50 : 2 ratio. The gross salary per baseball cap is: 52 × 1.50/ 50 = 1.56 EUR/ u therefore. For every baseball cap completed an amount of 1.50 EUR is assigned to the salary and 0.06 EUR to a worker-related Vacation account. The Vacation account is used for paying the leave for the employees once they take it. The weekend shifts are seen as extra shifts and do not contribute to the Vacation account. In this example, the 25 December is a public holiday. The day is off. Mo Tu We Th Fr Sa Su Mo Tu We Th Fr Sa Su 1 2 1 2 3 4 5 6 7 3 4 5 6 7 8 9 8 9 10 11 12 13 14 10 11 12 13 14 15 16 15 16 17 18 19 20 21 17 18 19 20 21 22 23 22 23 24 25 26 27 28 24 25 26 27 28 29 30 29 30 31 November 20X8 December 20X8 Figure 19.2: Calendar Nov 20X8 and Dec 20X8 <?page no="157"?> Berkau: BASICS of ACCOUNTING 19-156 During December 20X8, CLARITON Ltd. produces on 3 Saturdays, which are: 6 December, 13 December and 20 December 20X8. We take a look at GÜNTER’s work. He works in November on 3 days after payday (26, 27 and 28 November) and produces every day thereof 60 baseball caps. He is entitled to receive a salary of: 3 × 60 × 1.50 = 270.00 EUR resulting from work-days in November 20X8. Furthermore, he works on 18 regular daily shifts. This will pay him a gross salary of: 18 × 60 × 1.50 = 1,620.00 EUR . Additionally, GÜNTER works 3 extra shifts, which gives him a salary of: 3 × 60 × 2.25 = 405.00 EUR . Thus, GÜNTER’s gross salary for December 20X8 amounts to: 270 + 1,620 + 405 = 2,295.00 EUR . (49) Payment for GÜNTER’s salary on 24 December 20X8: The amount for payroll tax is: 20% × 2,295 = 459.00 EUR . The social security payment for GÜNTER in full is: 25% × 2,295 = 573.75 EUR . GÜNTER’s contribution is half thereof: 573.75/ 2 = 286.88 EUR . This leads to GÜNTER’s net salary to an extent of: 2,295 - 459 - 286.88 = 1,549.12 EUR . DR Labour....................... 2,295.00 EUR CR Payroll Tax / p............... 459.00 EUR CR Social Security / p........... 286.88 EUR CR Cash/ Bank.................... 1,549.12 EUR (50 … 52) The amount for labour tax and social security will be paid on 31.12.20X8. DR Payroll Tax / p............... 459.00 EUR CR Cash/ Bank.................... 459.00 EUR DR Labour....................... 286.87 EUR CR Social Security / p........... 286.87 EUR DR Social Security / p........... 573.75 EUR CR Cash/ Bank.................... 573.75 EUR GÜNTER works normal shifts on 3 days in November 20X8 and on 18 days in December 20X8. These days will contribute to his Vacation account. Accordingly, 0.06 EUR/ baseball cap are debited to GÜNTER’s Vacation account. CLARITON Ltd. makes a bookkeeping entry for: 0.06 × 60 × (3 + 18) = 75.60 EUR . (53) CLARITON Ltd. adds this amount to labour expenses on 24.12.20X8. DR Labour....................... 75.60 EUR CR Vacation GÜNTER.............. 75.60 EUR <?page no="158"?> Berkau: BASICS of ACCOUNTING 19-157 The Vacation account is an account that will be debited for GÜNTER’s paid leave. The account is linked to Management Accounting but is worth to be mentioned here, as it is a labour account. We assume GÜNTER works 50 weeks and produces every day 60 baseball caps which pay him 1.50 EUR each. CLARITON additionally considers 0.06 EUR/ baseball cap as labour and adds: 50 × 60 × 5 × 0.06 = 900 EUR to the vacation account over the year. The amount of 900 EUR is the salary paid during GÜNTER’s leave of 2 weeks. His leave pay is (was): 2 × 5 × 60 × 1.50 = 900.00 EUR , too. We study another operator WERNER: WERNER takes the first 2 weeks in December off. He works on 3 days in November 20X8, such as GÜNTER. He contributes to the Saturday shift on 20 December 20X8. Accounting for his labour is as follows (3 November days plus paid leave plus 8 December working days plus Saturday shift): 3 × 60 × 1.50 + 900 + 8 × 60 x 1.50 + 1 × 60 × 2.25 = 2,025.00 EUR . (54 … 57) Bookkeeping entries for WERNER’s salary on 24.12.20X8 and 31.12.20X8 are as follows: The salary results from tax payments being: 20% × 2,025 = 405.00 EUR and social security of 25% × 2,025 = 506.25 EUR . Half of the latter amount is WERNER’s contribution to social security: 506.25/ 2 = 253.13 EUR . His net salary equals to: 2,025 - 405 - 253.13 = 1,366.87 EUR . The gross salary is taken from the Vacation Account to an extent of 900.00 EUR. DR Vacation Account............. 900.00 EUR DR Labour....................... 1,125.00 EUR CR Payroll Tax / p.............. 405.00 EUR CR Social Security / p........... 253.13 EUR CR Cash/ Bank.................... 1,366.87 EUR The payments for labour tax and for social security follow: DR Payroll Tax / p............... 405.00 EUR CR Cash/ Bank.................... 405.00 EUR DR Labour....................... 253.12 EUR CR Social Security / p........... 253.12 EUR DR Social Security / p........... 506.25 EUR CR Cash/ Bank.................... 506.25 EUR (58) CLARITON Ltd. makes a bookkeeping entry in WERNER’s Vacation account on 24.12.20X8. He works on 3 November and on 8 December being relevant for his Vacation account. The amount is: 60 × 0.06 × (3 + 8) = 39.60 EUR . <?page no="159"?> Berkau: BASICS of ACCOUNTING 19-158 DR Labour....................... 39.60 EUR CR Vacation WERNER.............. 39.60 EUR The third operator, MARGRET, always produces 20 extra baseball caps during each of her shifts and stays at home on all Saturdays in December 20X8. Her salary in December is based on 3 days worked in November and on 18 days in December. Her gross salary amounts to: (3 + 18) × (80 × 1.50 + 20 × 0.50) = 2,730.00 EUR . (59) MAGRET’s gross salary is the basis for taxes on labour and social security. Payroll tax is: 20% × 2,730 = 546.00 EUR . Social Security is: 0.25 × 2,730 = 682.50 EUR . MARGRET’s contribution to social security is: 682.50/ 2 = 341.25 EUR . So, her net salary amounts to: 2,730 - 546 - 341.25 = 1,842.75 EUR . CLARITON Ltd. records labour for MARGRET on 24 December 20X8: DR Labour....................... 2,730.00 EUR CR Payroll Tax / p.............. 546.00 EUR CR Social Security / p.......... 341.25 EUR CR Cash/ Bank.................... 1,842.75 EUR (60 … 62) On 31.12.20X8, CLARITON Ltd. records the payments for labour tax and for social security: DR Payroll Tax / p.............. 546.00 EUR CR Cash/ Bank.................... 546.00 EUR DR Labour....................... 341.25 EUR CR Social Security / p........... 341.25 EUR DR Social Security / p........... 682.50 EUR CR Cash/ Bank.................... 682.50 EUR MARGRET’s claim on paid leave is for 2 weeks at a weekly workload of 60 baseball caps such as for her co-workers. Extra baseball caps do not contribute to vacation. For that reason, the amount transferred into MARGRET’s Vacation account equals to: 60 × 0.06 × (3 + 18) = 75.60 EUR . (63) CLARITON Ltd. records her vacation claim on 31.12.20X8. DR Labour....................... 75.60 EUR CR Vacation Account............. 75.60 EUR In MARGRET’s case, it would be wrong to keep the incentive expenses in the labour account. This would lead to higher expenses for the extra baseball caps. (They cannot be sold at a higher net selling price, because they have been manufactured during overtime or earned the worker an incentive.) For that reason, CLARITON takes out the expenses for the <?page no="160"?> Berkau: BASICS of ACCOUNTING 19-159 incentives of the Labour account. So also Margret will receive only 450.00 EUR/ w payment when she is on leave, such as her colleagues. (64) Transfer of incentive on 24 December 20X8: 20 × 0.5 × (3 +18) = 210.00 EUR : DR Incentive.................... 210.00 EUR CR Labour....................... 210.00 EUR The latter internal bookkeeping entry does not mean the incentive will be taken out of the expenses. The reason for the cost separation is the allocation to baseball caps with regard to the calculation of unit costs. Besides the special amounts for labour as discussed above, the piecework labour gives us another challenge. As we learned by chapter Further Expenses and Accruals , accruals apply. In our case, labour for the workers does not cause prepaid expenses, but there will be a payment obligation to be recorded. All operators work in November and get paid in December therefor. Later, they work 4 days in December which will be paid in the next Accounting period. We’ll start our labour accrual postings by the work delivered in December. (The dissolving of November accruals is explained further below.) GÜNTER, WERNER and MARGRET work on 4 days in December each, which are 26.12.20X8, 29.12.20X8, 30.12.20X8 and 31.12.20X8. The work load needs to be considered as liability. We assume GÜNTER and WERNER work on normal capacity of 60 baseball caps. The amount to be transferred to liabilities on 31.12.20X8 equals to: 4 × 60 × 1.50 = 360.00 EUR for each of them. At this stage of Accounting no tax or social security is relevant. Tax expense are considered in January. (65, 66) Transfer of last December day’s work to liabilities. DR Labour....................... 360.00 EUR CR Salary GÜNTER / p............. 360.00 EUR DR Labour....................... 360.00 EUR CR Salary WERNER / p............. 360.00 EUR (67) MARGRET’s work in December is based on normal capacity plus extra achievements and equals to: 4 × 80 × 1.50 + 4 × 20 × 0.5 = 520.00 EUR . She completed 80 baseball caps. CLARITON Ltd. records the transfer on 31.12.20X8. DR Labour....................... 520.00 EUR CR Salary MARGRET / p............ 520.00 EUR Similar to bookkeeping entry (64), we take out the incentives of the Labour account. The amount therefor equals to: 4 × 20 × 0.50 = 40.00 EUR . <?page no="161"?> Berkau: BASICS of ACCOUNTING 19-160 DR Incentives................... 40.00 EUR CR Labour....................... 40.00 EUR According to the transfers made in December, the amount taken out of the accounts in December for the work delivered in November is for GÜNTER and WERNER (each): 3 × 60 × 1.50 = 270.00 EUR each. For MARGRET the amount is: 3 × 80 × 1.50 + 3 × 20 × 0.50 = 390.00 EUR . The amount is to be taken out of the Labour account in December as it belongs to labour in November 20X8. (a … c) The bookkeeping entries are: DR Salary GÜNTER / p............. 270.00 EUR CR Labour....................... 270.00 EUR DR Salary WERNER / p............. 270.00 EUR CR Labour....................... 270.00 EUR DR Salary MARGRET / p............ 390.00 EUR CR Labour....................... 390.00 EUR In order to keep the case study as simple as possible, we only show the accounts as at 1.12.20X8 and make the bookkeeping entries for labour in December 20X8 therein. The opening values in exhibit 19.3 are as follows: - Vacation GÜNTER account. GÜNTER took vacation already. Therefore, the account’s balancing figure is -75.60 EUR. (Note, this is a reverse calculation only. We assume the year has exactly 52 weeks with 5 working days. We do so, in order to avoid all labour bookkeeping entries over the full Accounting period.) - The Vacation WERNER account got an opening value of: 900 - 39.60 = 860.40 EUR . The account is credit balanced. - The Vacation MARGRET account got an opening value of -75.60 EUR, same as GÜNTER’s account. - The opening value for the Labour (workers) account results from the work charged in November and paid in December. D C D C (12) 4,200.00 (24) 840.00 (12) 840.00 (36) 525.00 c/ d 4,725.00 (50) 459.00 (49) 459.00 4,725.00 4,725.00 (55) 405.00 (54) 405.00 b/ d 4,725.00 (60) 546.00 (59) 546.00 2,250.00 2,250.00 Labour manager Payroll tax / p Figure 19.3: CLARITON Ltd.’s accounts <?page no="162"?> Berkau: BASICS of ACCOUNTING 19-161 D C D C (48) 1,050.00 (12) 525.00 (12) 2,835.00 (52) 573.75 (36) 525.00 (24) 840.00 (57) 506.25 (49) 286.88 (48) 1,050.00 (62) 682.50 (51) 286.87 (49) 1,549.12 (54) 253.13 (50) 459.00 (56) 253.12 (52) 573.75 (59) 341.25 (54) 1,366.87 (61) 341.25 (55) 405.00 2,812.50 2,812.50 (57) 506.25 (59) 1,842.75 (60) 546.00 (62) 682.50 Social securities / p Cash/ Bank D C D C OV 75.60 (53) 75.60 (54) 900.00 OV 860.40 (58) 39.60 900.00 900.00 D C D C OV 75.60 (63) 75.60 (64) 210.00 c/ d 250.00 (67) 40.00 250.00 250.00 b/ d 250.00 D C D C (a) 270.00 OV 270.00 (b) 270.00 OV 270.00 c/ d 360.00 (65) 360.00 c/ d 360.00 (66) 360.00 630.00 630.00 630.00 630.00 b/ d 360.00 b/ d 360.00 Vacation GÜNTER Vacation WERNER Vacation MARGRET Incentives Labour GÜNTER / p Labour WERNER / p Figure 19.3: CLARITON Ltd.’s accounts (continued) <?page no="163"?> Berkau: BASICS of ACCOUNTING 19-162 D C D C (c) 390.00 OV 390.00 OV 930.00 (a) 270.00 c/ d 520.00 (67) 520.00 (49) 2,295.00 (b) 270.00 910.00 910.00 (51) 286.87 (c) 390.00 b/ d 520.00 (53) 75.60 (64) 210.00 (65) 360.00 (67) 40.00 (54) 1,125.00 (56) 253.12 (58) 39.60 (66) 360.00 (59) 2,730.00 (61) 341.25 (63) 75.60 (67) 520.00 c/ d 8,212.04 9,392.04 9,392.04 b/ d 8,212.04 Labour MARGRET / p Labour Figure 19.3: CLARITON Ltd.’s accounts (continued) Summary: Some expenses are paid in advance. In Accounting we make entries in Prepaid Expenses accounts therefore. In cases an employee works after payday for the same month, the accrual principle of Accounting requires the recording of a liability to the extent of his/ her salary earned in the previous month. The Labour account contains bookkeeping entries for payroll tax and for social security. These amounts will be put to payables at first, if not paid at the same time as the net salary. The payables are dissolved once they become due. <?page no="164"?> Berkau: BASICS of ACCOUNTING 20-163 20. Trading Business: Purchases and Returns Learning Objectives: In this chapter we study basic activities for dealerships. This chapter only considers purchases and returns outwards. We introduce the Purchase account and the Returns Inwards account. All activities are without VAT consideration. We repeat this entire chapter as chapter Trading Business: Purchases and Returns plus VAT by applying the same case studies APPLEDEEN (Pty) Ltd. and KLIPFONTEIN Ltd. with consideration of VAT. In this text book we divide the trading business in two parts. Purchases and Sales. Purchases are studied at first, Sales will be discussed by the next following chapters Trading Business: Sales and chapter Trading Business: Sales plus VAT. After studying these chapters, you will be familiar with the bookkeeping entries for trading businesses. All dealerships record normal activities such as rent, insurance, labour, depreciation as we covered by the previous chapters already. We now focus on inventory movements with regard to the goods the companies trade, in particular. A trading business buys goods from suppliers and sells them to its customers. Sometimes the customers are companies, too. In that case we call the dealership a B2B-dealer - as: Business - to - Business dealer. A business that buys goods in order to sell them to its customers or that use them as materials in production, makes debit entries in a special account called Purchase account. All goods bought will be debited to the Purchase account at first. The Purchase account is an intermediate account for goods bought as inventory. As part of the adjustments, the Purchase account will be closed-off to the Trading account. However, there will be two ways to calculate the material expenses. (a) The company runs a periodic inventory system. Material expenses are calculated by the opening amount of inventory increased by purchases and reduced by the closing stock. The company must count stock at every Accounting periods’ end in order to determine the closing stock. (b) The company runs a perpetual inventory system. The materials will be transferred from the Purchase account to the Material Inventory account. Any release from stock will result in a credit entry in the Material Inventory account and a debit entry in the Material Expenses account. The material expenses will be closed-off to the Profit and Loss account as part of the adjustments. For now, we will introduce a periodic inventory system only. (Note, chapter Perpetual Inventory System will cover the inventory movements based on the perpetual inventory system and will compare both inventory systems.) The application of the periodic inventory system implies the dealer only makes bookkeeping entries for purchases. There are no postings for releases from stock. At the end of the Accounting period, the business runs a stock count in order to determine how many goods are left over. <?page no="165"?> Berkau: BASICS of ACCOUNTING 20-164 All purchases will be entered into the Purchase account. The bookkeeping entry for purchases on cash or per bank transfer always is: DR Purchase..................... EUR CR Cash/ Bank.................... EUR In case the purchase is on credit, the bookkeeping entry is: DR Purchase..................... EUR CR Accounts Payables............ EUR We will study inventory movements for a grocery dealer: APPLEDENE (Pty) Ltd. is a local grocery dealer. The business buys fruits, meat, bread, etc. from its suppliers and sells them to their customers in a corner shop. On 2.01.20X7, APPLEDENE (Pty) Ltd. is founded by the proprietors’ contribution that amounts to 80,000.00 EUR. The Accountant makes the bookkeeping entry below: (1) Establishment of the business on 2.01.20X7. DR Cash/ Bank.................... 80,000.00 EUR CR Issued Capital............... 80,000.00 EUR APPLEDENE (Pty) Ltd. rents the shop from its landlord. The contract with the landlord states that on every 3.01. of the year the full amount for the annual rent is to be paid by bank transfer. Rent amounts to 24,000.00 EUR/ a. The Accountant makes the bookkeeping entry as follows. (2) Payment for the annual rent on 3.01.20X7. DR Rent......................... 24,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR APPLEDENE (Pty) Ltd. weekly buys bread from a bakery and pays the due amount per bank transfer. The weekly purchases are at 250.00 EUR each. The Accountant makes the bookkeeping entries as below: (3) … (54) Purchase of bread every week at 250.00 EUR. DR Purchase..................... 250.00 EUR CR Cash/ Bank.................... 250.00 EUR APPLEDENE (Pty) Ltd. further buys fruits from its fruit supplier and pays the amount on cash. During the first week the purchases were for 400.00 EUR. Accordingly, the Accountant makes the bookkeeping entry as follows: (55) Purchase of fruits on 5.01.20X7. <?page no="166"?> Berkau: BASICS of ACCOUNTING 20-165 DR Purchase..................... 400.00 EUR CR Cash/ Bank.................... 400.00 EUR The fruit purchases take place every week during 20X7 at the same price. The bookkeeping entries (56) … (106) look the same as bookkeeping entry (55). The contract with the butchery states that APPLEDENE (Pty) Ltd. gets daily meat deliveries and has to pay the due amount by the weekend. The daily delivery is for 100.00 EUR. The Accountant makes the bookkeeping entries as below: (107) Purchase of meat every day. DR Purchase..................... 100.00 EUR CR Accounts Payables............ 100.00 EUR (138) Payment for the meat. Consider the 1 st day being a Monday. DR Accounts Payables............ 700.00 EUR CR Cash/ Bank.................... 700.00 EUR At the end of the year, APPLEDENE (Pty) Ltd. runs a stock count and detects bread for 250.00 EUR and meat for 1,400.00 EUR on stock. No fruits are left over. The material expenses for the groceries equals to all purchases less closing stock. APPLEDENE (Pty) Ltd. gets material expenses for its goods which equal to: 52 × 250 + 52 × 400 + 365 × 100 - 250 - 1,400 = 68,650.00 EUR . This is the amount for material expenses to be recognised on the statement of comprehensive income. Observe the accounts for APPLEDENE (Pty) Ltd as depicted in Figure 20.1. D C D C (1) 80,000.00 (2) 24,000.00 c/ d 80,000.00 (1) 80,000.00 (3-) 13,000.00 b/ d 80,000.00 (55-) 20,800.00 c/ d 14,200.00 ( ) 36,400.00 94,200.00 94,200.00 b/ d 14,200.00 D C D C (2) 24,000.00 c/ d 24,000.00 (3-) 13,000.00 P&L 70,300.00 b/ d 24,000.00 P&L 24,000.00 (55-) 20,800.00 ( ) 36,500.00 70,300.00 70,300.00 Cash/ Bank Issued capital Rent Purchase Figure 20.1: APPLEDENE (Pty) Ltd.’s accounts <?page no="167"?> Berkau: BASICS of ACCOUNTING 20-166 D C D C ( ) 36,400.00 ( ) 36,500.00 Prh 70,300.00 Inv 250.00 c/ d 100.00 Rnt 24,000.00 Inv 1,400.00 36,500.00 36,500.00 ... b/ d 100.00 D C P&L 250.00 P&L 1,400.00 c/ d 1,650.00 1,650.00 1,650.00 b/ d 1,650.00 Accounts payables Profit and Loss Inventory Figure 20.1: APPLEDEENE (Pty) Ltd.’s accounts (continued) Now, the profit and loss account contains the amount of material expenses which equals to: 70,300 - 250 - 1,400 = 68,650.00 EUR and the amount of rent being 24,000.00 EUR. The closing stock of inventories contains the amounts detected by stock count. The material expenses are not disclosed as one item but are entries for purchase and closing stocks. (Note, as far we didn’t consider any sales. For that reason, the profit and loss account is not balanced-off yet.) Sometimes, a buyer sends back goods bought. In these situations, the former receiver of the goods makes an entry in the Returns Outwards account. A Returns Outwards account is like a negative Purchase account and applies when goods are sent back to suppliers. The Returns Outwards account will be closed-off to the Trading account in a periodic inventory system. The contra entry for a return is in the Cash/ Bank account if the buyer receives the money back instantly. However, more often, the seller will send a voucher or will reduce the amount owed by its customer. In those cases, the buyer will either debit the amount to the Accounts Receivables account for the voucher or makes a debit entry in the Accounts Payables account for the reduction of the bill. How it is done (returns outwards): (1) Make bookkeeping entries for purchases. (2) In case a good is faulty or does not meet the requirements, send it back to the supplier. (3) Credit the amount for goods sent back to the Returns Outwards account and make a debit entry in the Cash/ Bank account, if received money, or in the Accounts Payables, if the bill is reduced by the supplier or in the Accounts Receivables for a voucher. (4) With a periodic inventory system in use close-off the Returns Outwards account to the Trading account. <?page no="168"?> Berkau: BASICS of ACCOUNTING 20-167 Below, we observe the next example KLIPFONTEIN Ltd. KLIPFONTEIN Ltd. is established on 2.01.20X5 and is a dealer for kitchen tools. The business is based on shares and is established by an issue of 100,000 ordinary shares at 1.00 EUR each. The issue price equals to the face value. (1) Establishing KLIPFONTEIN Ltd. by a share issue on 2.01.20X5. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR KLIPFONTEIN Ltd. orders from a pot factory 130 5l-pots with a glass lit at 23.00 EUR each. The pots are paid by bank transfer on 2.01.20X5. The amount to be paid is: 130 × 23 = 2,990.00 EUR . (2) Purchase of 5l-pots with a glass lit on 2.01.20X5. DR Purchase..................... 2,990.00 EUR CR Cash/ Bank.................... 2,990.00 EUR Half of the 5l-pots with a glass lit have scratches on the lit. KLIPFONTEIN Ltd. calls the supplier’s manager and sends back the damaged pots. The supplier immediately transfers half of the purchase price into KLIPFONTEIN Ltd.’s bank account on 9.01.20X5. (3) Return of 65 damaged 5l-pots with a glass lit on 9.01.20X5. DR Cash/ Bank.................... 1,495.00 EUR CR Returns Outwards............. 1,495.00 EUR On 10.01.20X5, KLIPFONTEIN Ltd. orders from another supplier 200 26cm-pans at 31.00 EUR each. It is agreed that KLIPFONTEIN Ltd. will pay the purchase price of: 200 × 31 = 6,200.00 EUR on 1.02.20X5. (4) Purchase of 26cm-pans on 10.01.20X5 on credit. DR Purchase..................... 6,200.00 EUR CR Accounts Payables............ 6,200.00 EUR The quality management detects one box with 6 pans only 22 cm of size. KLIPFONTEIN Ltd.’s purchase manager calls the supplier and agrees to return the 6 little pans. The supplier adjusts the bill to KLIPFONTEIN Ltd. according to the return. The amount due is dropped to: 6,200 - 6 × 31 = 6,014.00 EUR . The bookkeeping entry made is about the returns outwards only. The returns outwards amount to: 6 × 31 = 186.00 EUR . The amount is debited to the Accounts Payables account for that particular supplier. (5) Return of 6 small pans on 15.01.20X5. <?page no="169"?> Berkau: BASICS of ACCOUNTING 20-168 DR Accounts Payables............ 186.00 EUR CR Returns Outwards............. 186.00 EUR KLIPFONTEIN Ltd. pays the amount due to the supplier as agreed on 1.02.20X5. (6) Payment of the reduced purchase price on 1.02.20X5. DR Accounts Payables............ 6,014.00 EUR CR Cash/ Bank.................... 6,014.00 EUR On 3.02.20X5, KLIPFONTEIN Ltd. orders 500 24-piece-cutlery sets at 19.50 EUR/ p from their supplier and transfers the due amount into the supplier’s bank account by electronic bank transfer. The cutlery sets are delivered a few days later. The quality management detects that all sets only contain 18 pieces because tea spoons are missing completely. KLIPFONTEIN Ltd. returns the whole delivery and gets a voucher from the supplier with his apologies in return. (7) Order of 24-piece-cutlery sets at: 500 × 19.50 = 9,750.00 EUR on 3.02.20X5. DR Purchase..................... 9,750.00 EUR CR Cash/ Bank.................... 9,750.00 EUR (8) Return of incomplete cutlery sets on 7.02.20X5. DR Accounts Receivables......... 9,750.00 EUR CR Returns Outwards............. 9,750.00 EUR On 23.02.20X5, KLIPFONTEIN Ltd. orders 120 exclusive 12-steak-knife-sets from the supplier who delivered the cutlery recently. The 12-steak-knife-sets are 36.00 EUR each. The amount for the steak knives is: 120 × 36 = 4,320.00 EUR . The amount is not paid because KLIPFONTEIN Ltd. uses a portion of its voucher for payment. The amount still open equals to: 9,750 - 4,320 = 5,430.00 EUR . The Accountant makes the bookkeeping entry (9): (9) Purchase of 120 12-steak-knife-sets on 23.02.20X5. DR Purchase..................... 4,320.00 EUR CR Accounts Receivables......... 4,320.00 EUR On 3.04.20X5, KLIPFONTEIN Ltd. orders 450 steel made salad bowls at 25.00 EUR/ p from the supplier that delivered the cutlery and the 12-steak-knives-sets earlier on. The due amount is: 450 × 25 = 11,250.00 EUR . The amount is paid partly by the voucher and by a money transfer on 5.04.20X5. The money put into the supplier’s bank account amounts to: 11,250 - 5,430 = 5,820.00 EUR . (10) Purchase of steal bowls on 5.04.20X5: <?page no="170"?> Berkau: BASICS of ACCOUNTING 20-169 DR Purchase..................... 11,250.00 EUR CR Accounts Receivables......... 5,430.00 EUR CR Cash/ Bank.................... 5,820.00 EUR In order to retrieve all bookkeeping entries, take now a look at KLIPFONTEIN Ltd.’s accounts below: D C D C (1) 100,000.00 (2) 2,990.00 c/ d 100,000.00 (1) 100,000.00 (3) 1,495.00 (6) 6,014.00 b/ d 100,000.00 (7) 9,750.00 (10) 5,820.00 c/ d 76,921.00 101,495.00 101,495.00 b/ d 76,921.00 Cash/ Bank Issued Capital D C D C (2) 2,990.00 (3) 1,495.00 (4) 6,200.00 (5) 186.00 (7) 9,750.00 c/ d 11,431.00 (8) 9,750.00 (9) 4,320.00 11,431.00 11,431.00 (10) 11,250.00 c/ d 34,510.00 b/ d 11,431.00 34,510.00 34,510.00 b/ d 34,510.00 D C D C (5) 186.00 (4) 6,200.00 (8) 9,750.00 (9) 4,320.00 (6) 6,014.00 (10) 5,430.00 6,200.00 6,200.00 9,750.00 9,750.00 Accounts Payables Accounts Receivables Purchase Returns Outwards Figure 20.2: KLIPFONTEIN Ltd.’s accounts in 20X5 At the end of the Accounting period, there are no goods left on stock in KLIPFONTEIN Ltd.’s store. The material expenses amount to the purchases less returns outwards. The total expenses as in the above example equal to: 34,510 - 11,431 = 23,079.00 EUR . In order to check the amount, we calculate the amounts purchased but not sent back: 1,495 + 6,014 + 4,320 + 11,250 = 23,079.00 EUR . Summary: A trading business that buys goods, makes debit entries in the Purchase account therefor. Goods sent back are considered by credit entries in the Returns Outwards account. The total amount of the goods bought is the difference between the balancing figure <?page no="171"?> Berkau: BASICS of ACCOUNTING 20-170 in the Purchase account and the Returns Outwards account. The Purchase account and the Returns Outwards account will be closed-off to the Trading account. Working Definitions: Purchase Account: The Purchase account is an intermediate account for goods bought as inventory. Returns Outwards Account: A Returns Outwards account is like a negative Purchase account used to record goods sent back to suppliers. <?page no="172"?> Berkau: BASICS of ACCOUNTING 21-171 21. Trading Business: Purchases and Returns plus VAT Learning Objectives: In this chapter we introduce input value added tax (input-VAT). In order to keep the chapter simple, we use the same case studies as in the previous chapter Trading Business: Purchases and Returns Outwards: APPLEDENE (Pty) Ltd. and KLIPFONTEIN Ltd. The costs of purchases are the same as in the previous chapter, so the input- VAT is added to the net amounts. After studying this chapter, you will be able to understand the concept of value added tax and you can record purchases and returns under consideration of input-VAT. In most countries there is a consumer tax, exceptions are the United Arabic Emirates and the US state Delaware. The consumer tax is levied on all purchases/ sales and is called value added tax VAT. The name comes from the calculation of the tax. It is based on the value of the goods/ services purchased and will be added to the price. A consumer tax based on the net amount of purchased goods/ services is a value added tax (input-VAT). Some countries call VAT a goods&service tax GST. We stick to the term value added tax. VAT is paid by every consumer, no matter whether the person is citizen or foreigner. Companies that purchase cannot be distinguished from consumers at the point of sales. They have to pay VAT. Actually, they pay the price of the good they purchase plus a surcharge, called VAT. A buyer who buys a product at 200.00 EUR pays 200 + (VAT rate × 200). In this text book the VAT rate is 20 %. Accordingly, the payment for the product above equals to: 200 + 20% × 200 = 240.00 EUR. There are different VAT rates for different countries. Germany’s tax rate is 19 %. Furthermore, there are some goods that go with a lower VAT rate, e.g. books, groceries, drugs, etc. All normal consumers pay the amount including VAT because they consume. The price tags show you gross amounts always. (an exception are the U.S.) The amount excluding VAT is called the net amount. The amount including VAT is called the gross amount. The VAT tax you pay when you buy goods is called input-VAT. However, companies do not fall under consumers. When companies purchase goods, they buy it as an input resource, such as materials or as supplies to produce goods or to render services. For that reason, they are entitled to get the input-VAT refunded by the revenue service. On the other side, companies collect VAT from their customers. The VAT tax the company collects when the customer buys products/ services is called output-VAT. As the seller collects the VAT on behalf of the revenue service, companies receive output-VAT based on their sales from customers and pay input- VAT to their suppliers. At the end of the Accounting period, companies declare the VAT received and the VAT paid and are refunded to the extent of the difference, in case input-VAT exceeds output-VAT. In the other case, <?page no="173"?> Berkau: BASICS of ACCOUNTING 21-172 they must pay the difference to the revenue service. Imagine a product produced in several production steps each of them in a different company. The first company sells the semi-finished good to the second one and gets the amount including VAT paid for the sale. The second one sells the good at the gross price also. If there is no refunding system, products will get more and more expensive because of VAT payments. As more production steps occur as more expensive the product will become. This would even generate a compound VAT. For that reason, companies get refunded for input-VAT and must pay output- VAT collected. Companies have to register for VAT reduction. Otherwise they will be treated as consumers. A VAT registered company gets refunded for input-VAT and collects output-VAT on behalf of the revenue service. The collected output-VAT is to be paid to the revenue service. If the company opts for VAT reduction, all selling prices of their products will include output- VAT. In other words, a VAT registered company has to be more expensive than a non-registered company in order to earn the same revenue. If you are VAT registered and sell a product at 80 EUR net selling price, the price for your customer equals to: 80 + 20% × 80 = 96.00 EUR. Without VAT registration, the customer pays only 80.00 EUR. A customer who is not VAT registered itself, will rather buy at your competitor for 80.00 EUR. In case the customer is VAT registered itself, the price difference does not matter to it, as you disclose the VAT amount on your bill. Whenever there is a bookkeeping entry for purchases the amount for VAT will be debited to the VAT account. Along IFRSs there are some regulations with regard to costs we mention here: The cost of purchase and the cost of acquisition are always net amounts. The standards IAS 2 and IAS 16 state, that these costs are after VAT deductions. Furthermore, consider VAT refunds and claims not depending on payments. In case someone buys a product on credit, he/ she will be entitled to claim input-VAT - even in cases he/ she has not paid at all. The same applies for partial payments. So, Accountants never split VAT! How it is done (input-VAT) (1) Determine net amount by dividing the gross amount by 120 %. (2) Determine gross amount by multiplying the net amount by 120 %. (3) Calculate VAT by multiplying the net amount by 20 %. (4) When purchasing goods, make a debit entry in the Purchase account for the net amount. (5) Make a debit entry for input-VAT in the VAT account. <?page no="174"?> Berkau: BASICS of ACCOUNTING 21-173 (6) Credit the gross amount to the Cash/ Bank account and/ or Accounts Payables. There might be partial payments. We now go again through the previous examples APPLEDENE (Pty) Ltd. and KLIPFONTEIN Ltd. and consider VAT. We repeat the case studies and the only change is an input-VAT at a VAT rate of 20 %. APPLEDENE (Pty) Ltd. is the grocery dealer covered in chapter Trading Business: Purchase and Returns Outwards . APPLEDENE (Pty) Ltd. is registered for VAT reduction. The bookkeeping entry for founding the business is not effected by VAT, because there is no buying/ selling involved. On 2.01.20X7, APPLEDENE (Pty) Ltd.’s Accountant makes the bookkeeping entry below: (1) Establishment of the business on 2.01.20X7. DR Cash/ Bank.................... 80,000.00 EUR CR Issued Capital............... 80,000.00 EUR APPLEDENE (Pty) Ltd. rents the shop from its landlord. In case the landlord did not apply for VAT reduction, rent stays free of VAT. Rent between companies becomes subject of VAT, if and only if both parties are registered for VAT reduction. APPLEDENE (Pty) Ltd.’s landlord is a private owner. Here, only APPLEDENE (Pty) Ltd. can reduce VAT. So, rent is not VAT relevant here. The Accountant makes the bookkeeping entry as before. (2) Payment for annual rent on 3.01.20X7. DR Rent......................... 24,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR APPLEDENE (Pty) Ltd. weekly buys bread from a bakery and pays the due amount per bank transfer. The bakery is a VAT registered business and sells the bread at the gross amount to APPLEDENE (Pty) Ltd. The weekly purchases are 250 + 50 = 300.00 EUR . The Accountant makes the bookkeeping entries as below. The gross amount is: 250 × 120% = 300.00 EUR . The input-VAT is: 250 × 20% = 50.00 EUR . Calculating the net amount based on the gross amount gives: 300 / 120% = 250.00 EUR . (3) … (54) Purchase of bread every week at 300.00 EUR. DR Purchase..................... 250.00 EUR DR VAT.......................... 50.00 EUR CR Cash/ Bank.................... 300.00 EUR Observe the accounts at this stage for APPLEDENE (Pty) Ltd. <?page no="175"?> Berkau: BASICS of ACCOUNTING 21-174 D C D C (1) 80,000.00 (2) 24,000.00 (1) 80,000.00 (3) 300.00 (4) 300.00 ... ... (54) 300.00 D C D C (2) 24,000.00 (3) 250.00 (4) 250.00 ... ... (54) 250.00 D C (3) 50.00 (4) 50.00 ... ... (54) 50.00 VAT Rent Purchase Cash/ Bank Issued Capital Figure 21.1: APPLEDENE (Pty) Ltd.’s accounts after 54 bookkeeping entries APPLEDENE (Pty) Ltd. further buys fruits from the fruit supplier and pays the amount on cash. In the first week the purchases were 400.00 EUR. The gross amount is: 400 × 120% = 480.00 EUR . Input-VAT amounts to: 400 × 20% = 80.00 EUR . The amount to be paid is: 400 + 80 = 480.00 EUR . Accordingly, the Accountant makes the bookkeeping entry as follows: (55) … (106) Purchase of fruits on 5.01.20X7. DR Purchase..................... 400.00 EUR DR VAT.......................... 80.00 EUR CR Cash/ Bank.................... 480.00 EUR The contract with the butchery states that APPLEDENE (Pty) Ltd. gets daily meat deliveries and has to pay the due amount at the end of the week. The daily delivery is at 100.00 EUR. The gross amount is 100 + 20 = 120.00 EUR . The Accountant makes the bookkeeping entries as below: (107) Purchase of meat every day. DR Purchase..................... 100.00 EUR DR VAT.......................... 20.00 EUR CR Accounts Payables............ 120.00 EUR (138) Payment for the meat for the full week amounts to 7 × 120 = 840.00 EUR . <?page no="176"?> Berkau: BASICS of ACCOUNTING 21-175 DR Accounts Payables............ 840.00 EUR CR Cash/ Bank.................... 840.00 EUR (Note, we assume that the first day is on a Monday. This gives us 365 meat deliveries and 52 payments. Accordingly, there is an amount of: 100 × 120% = 120.00 EUR outstanding. Observe the A/ P Account.) At the end of the year, APPEDENE (Pty) Ltd. runs a stock count and detects bread for 250.00 EUR and meat for 1,400.00 EUR. There are no fruits left over. As you can see the amounts in the bookkeeping records like inventory and property, plant and equipment always are net amounts. The expenses for the groceries are the total of the purchases less the closing stock. APPLEDENE (Pty) Ltd. got expenses for goods which equal to: 52 × 250 + 52 × 400 + 365 × 100 - 250 - 1,400 = 68,650.00 EUR . Figure 21.2 gives you the accounts on an annual basis under consideration of VAT. Observe the profit and loss account not being effectuated by the VAT consideration. D C D C (1) 80,000.00 (2) 24,000.00 c/ d 80,000.00 (1) 80,000.00 (3-) 15,600.00 b/ d 80,000.00 (55-) 24,960.00 c/ d 28,240.00 ( ) 43,680.00 108,240.00 108,240.00 b/ d 28,240.00 D C D C (2) 24,000.00 c/ d 24,000.00 (3-) 13,000.00 P&L 70,300.00 b/ d 24,000.00 P&L 24,000.00 (55-) 20,800.00 ( ) 36,500.00 70,300.00 70,300.00 Cash/ Bank Issued capital Rent Purchase Figure 21.2: APPLEDENE (Pty) Ltd.’s accounts (aggregated) <?page no="177"?> Berkau: BASICS of ACCOUNTING 21-176 D C D C ( ) 43,680.00 ( ) 43,800.00 Prh 70,300.00 Inv 250.00 c/ d 120.00 Rnt 24,000.00 Inv 1,400.00 43,800.00 43,800.00 ... b/ d 120.00 D C D C P&L 250.00 (3-) 2,600.00 P&L 1,400.00 c/ d 1,650.00 (55-) 4,160.00 1,650.00 1,650.00 ( ) 7,300.00 c/ d 14,060.00 b/ d 1,650.00 14,060.00 14,060.00 b/ d 14,060.00 Value added tax (20%) Accounts payables Profit and Loss Inventory Figure 21.2: APPLEDENE (Pty) Ltd.’s accounts (aggregated) (continued) When companies return goods to their supplier (returns outwards) an adjustment is to make in the VAT account, too. This is required to calculate the correct input-VAT amount for refund by the revenue service. Returns outwards are treated the same as negative purchases. See for further details the KLIPFONTEIN Ltd. case study from chapter Trading Business: Purchases and Returns Outwards: How it is done (returns outwards with VAT consideration): (1) Determine the net amount and the gross amount of goods to return. (2) Check whether (a) or not (b) your company applies a Returns Outwards account. (3) Make a debit entry for the gross amount in the Accounts Payables, if the purchase has not been paid yet. Make a debit entry for the gross amount in the Accounts Receivables, if the seller sends you a voucher. Make a debit entry for the gross amount in the Cash/ Bank account, if the money is transferred back. Consider combinations for partial payments. (4) Adjust the input-VAT claim by making a credit entry in the VAT account for the input-VAT linked to the returned product. (5a) Make a credit entry in the Returns Outwards account for the net amount of the product returned. (6a) Close-off the Purchase account and the Returns Outwards account to the Trading Account. (5b) Make a credit entry in the Purchase account for the net amount of the product returned. (6b) Close-off the Purchase account to the Trading Account. <?page no="178"?> Berkau: BASICS of ACCOUNTING 21-177 (Note, in case a company applies a perpetual inventory system, you must reduce stock for the returns instead of the purchase account.) KLIPFONTEIN Ltd. is established on 2.01.20X5. (1) Establishing KLIPFONTEIN Ltd. by a share issue on 2.01.20X5. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR KLIPFONTEIN Ltd. orders from a pot factory 130 5l-pots with a glass lit at 23.00 EUR each. The price is the net amount. In order to calculate the price to be paid, KLIPFONTEIN Ltd. has to multiply the amount by 120 %: 23 × 120% = 27.60 EUR . The amount to be paid is: 130 × 27.60 = 3,588.00 EUR . (2) Purchase of 5l-pots with a glass lit on 2.01.20X5. DR Purchase..................... 2,990.00 EUR DR VAT.......................... 598.00 EUR CR Cash/ Bank.................... 3,588.00 EUR Half of the 5l-pots with a glass lit are returned. The supplier instantly transfers half of the purchase price (gross amount) into KLIPFONTEIN Ltd.’s bank account on 9.01.20X5. KLIPFONTEIN Ltd. makes an adjustment for input-VAT also. The amount refunded is: 65 × 23 × 120% = 1,794.00 EUR . (3) Return of 65 damaged 5l-pots with a glass lit on 9.01.20X5. DR Cash/ Bank.................... 1,794.00 EUR CR VAT.......................... 299.00 EUR CR Returns Outwards............. 1,495.00 EUR On 10.01.20X5, KLIPFONTEIN Ltd. orders from another supplier 200 26cm-pans at 31.00 EUR (purchase cost) each. The gross amount is: 31 × 120% = 37.20 EUR . It is agreed that KLIPFONTEIN Ltd. will pay the purchase price of: 200 × 37.20 = 7,440.00 EUR on 1.02.20X5. (4) Purchase of 26cm-pans on 10.01.20X5 on credit. DR Purchase..................... 6,200.00 EUR DR VAT.......................... 1,240.00 EUR CR Accounts Payables............ 7,440.00 EUR KLIPFONTEIN Ltd.’s sends back 6 pans. The supplier adjusts the bill sent to KLIPFONTEIN Ltd. earlier on. The amount due is: 7,440 - 6 × 37.20 = 7,216.80 EUR . The bookkeeping entry made is for the returns outwards only. They amount to: 6 × 37.20 = 223.20 EUR . No inventory movement is recorded, because KLIPFONTEIN Ltd. runs a periodic inventory system. At the time of stock count the reduction of 6 pans will lead to a lower stock level automatically. <?page no="179"?> Berkau: BASICS of ACCOUNTING 21-178 (5) Return of 6 small pans on 15.01.20X5. DR Accounts Payables............ 223.20 EUR CR VAT.......................... 37.20 EUR CR Returns Outwards............. 186.00 EUR KLIPFONTEIN Ltd. pays the due amount to the supplier as agreed on 1.02.20X5. (6) Payment of purchase price on 1.02.20X5. DR Accounts Payables............ 7,216.80 EUR CR Cash/ Bank.................... 7,216.80 EUR On 3.02.20X5, KLIPFONTEIN Ltd. orders 500 24-piece-cutlery sets at cost of purchase of 19.50 EUR/ p from their supplier and pays the due amount which equals to: 500 × 19.5 × 120 % = 11,700.00 EUR into the supplier’s bank account by electronic bank transfer. The cutlery sets are delivered a few days later. The quality management detects all sets only contain 18 pieces, because tea spoons are missing completely. KLIPFONTEIN Ltd. returns the whole delivery and gets a voucher from its supplier. (7) Order of 24-piece-cutlery sets at 11,700.00 EUR on 3.02.20X5. DR Purchase..................... 9,750.00 EUR DR VAT.......................... 1,950.00 EUR CR Cash/ Bank.................... 11,700.00 EUR (8) Return of incomplete cutlery sets on 7.02.20X5. DR Accounts Receivables......... 11,700.00 EUR CR VAT.......................... 1,950.00 EUR CR Returns Outwards............. 9,750.00 EUR On 23.02.20X5 KLIPFONTEIN Ltd. orders 120 exclusive 12-steak-knives-sets from the supplier who delivered the cutlery recently. The 12-steak-knife-sets are at a net amount of 36.00 EUR each. The amount for the 12-steak-knife-sets to be paid is: 120 × 36 × 120% = 5,184.00 EUR . The amount is not paid because KLIPFONTEIN Ltd. takes a portion of its voucher for payment. The amount still open is: 11,700 - 5,184 = 6,516.00 EUR . The bookkeeper makes the bookkeeping entry (9): (9) Purchase of 120 12-steak-knife-sets on 23.02.20X5. <?page no="180"?> Berkau: BASICS of ACCOUNTING 21-179 DR Purchase..................... 4,320.00 EUR DR VAT.......................... 864.00 EUR CR Accounts Receivables......... 5,184.00 EUR On 3.04.20X5, KLIPFONTEIN Ltd. orders 450 steel made salad bowls at 25.00 EUR/ p (net amount) from the supplier that delivered cutlery and 12-steakknife-sets earlier on. The due amount is: 450 × 25 × 120% = 13,500.00 EUR . The amount is paid partly by the voucher and by money transfer on 5.04.20X5. The money paid into the supplier’s bank account amounts to: 13,500 - 6,516 = 6,984.00 EUR . (10) Purchase of steal bowls on 5.04.20X5. DR Purchase..................... 11,250.00 EUR DR VAT.......................... 2,250.00 EUR CR Accounts Receivables......... 6,516.00 EUR CR Cash/ Bank.................... 6,984.00 EUR In order to retrieve all bookkeeping entries, take now a look at KLIPFONTEIN Ltd.’s accounts in Figure 21.3: D C D C (1) 100,000.00 (2) 3,588.00 c/ d 100,000.00 (1) 100,000.00 (3) 1,794.00 (6) 7,216.80 b/ d 100,000.00 (7) 11,700.00 (10) 6,984.00 c/ d 72,305.20 101,794.00 101,794.00 b/ d 72,305.20 D C D C (2) 2,990.00 (3) 1,495.00 (4) 6,200.00 (5) 186.00 (7) 9,750.00 c/ d 11,431.00 (8) 9,750.00 (9) 4,320.00 11,431.00 11,431.00 (10) 11,250.00 c/ d 34,510.00 b/ d 11,431.00 34,510.00 34,510.00 b/ d 34,510.00 D C D C (5) 223.20 (4) 7,440.00 (8) 11,700.00 (9) 5,184.00 (6) 7,216.80 (10) 6,516.00 7,440.00 7,440.00 11,700.00 11,700.00 Cash/ Bank Issued capital Accounts Payables Accounts Receivables Purchase Returns outwards Figure 21.3: KLIPFONTEIN Ltd.’s accounts <?page no="181"?> Berkau: BASICS of ACCOUNTING 21-180 D C (2) 598.00 (3) 299.00 (4) 1,240.00 (5) 37.20 (7) 1,950.00 (8) 1,950.00 (9) 864.00 (10) 2,250.00 c/ d 4,615.80 6,902.00 6,902.00 b/ d 4,615.80 VAT Figure 21.3: KLIPFONTEIN Ltd.’s accounts (continued) At the end of the Accounting period, there are no goods left on stock in KLIPFONTEIN Ltd.’s store. The material expenses amount to the amount purchased less returns outwards. The total material expenses as in the above example are: 34,510 - 11,431 = 23,079.00 EUR . In order to check the amount, we calculate the amounts purchased but not sent back: 1,495 + 6,014 + 4,320 + 11,250 = 23,079.00 EUR . Summary: VAT is a tax based on the purchase price of goods bought. VAT registered companies claim back input-VAT at the end of an Accounting period. When buying goods companies debit input-VAT to the VAT account. When returning goods to suppliers, companies have to adjust the VAT account by making credit entries in order to compensate input-VAT of goods returned. Working Definitions: Value Added Tax: A consumer tax based on the net amount of purchased goods/ services is a value added tax (input-VAT). Input-VAT: Input-VAT is the VAT tax you pay when you buy goods. Output-VAT: The VAT tax the company collects when the customer buys products/ services, is called output- VAT. <?page no="182"?> Berkau: BASICS of ACCOUNTING 22-181 22. Trading Business: Sales Learning Objectives: In this chapter, the most common postings for sales are discussed. All sales are based on a periodic inventory system. The Trading account applies to calculate the gross profit. This chapter does not consider VAT. However, we will repeat the case studies herein by the next chapter Trading Business: Sales plus VAT and then consider input-VAT as well as output-VAT. After studying this chapter, you will be familiar with recording sales in a trading business. You also will learn how to calculate the gross profit via the Trading Account. A trading company buys goods and sells them to its customers. By the previous chapters, we only covered purchases, because we tried to keep the case studies simple. Now, we are going to add the second perspective: sales. This will complete our view on trading businesses. When we record sales, we make bookkeeping entries for cash received and/ or receivables obtained and for the revenue, However, we won’t record any cost of sales. As we apply a periodic inventory system, we determine the cost of sales based on closing stocks at the end of the Accounting period. The cost of sales will be the opening value of goods, plus purchases and less closing stock. Returns might apply also and cause adjustments to the cost of sales calculation. Inventory systems are subject to chapter Perpetual Inventory System of this text book. For all sales we credit the Sales account. The name revenue or sales revenue is common for this account also. There is no distinction between those technical terms. However, for dealerships, the expression sales seem to be more appropriate and more common in use. Due to our 3 letter abbreviation policy, we write “Rev” in the accounts. The debit entry for sales is either in the Cash/ Bank account or in receivables depending on the way the customers pay for goods and/ or services. Be aware, there might be partial payments also which lead to debit entries in both accounts and will give you a compound bookkeeping entry. In order to determine the profit earned during the Accounting period, we compare purchases and sales. However, purchases will be increased by opening amounts in the Inventory account and reduced by closing stock and returns outwards if there are any. Furthermore, other expenses like rent, labour, etc. are to be considered for profit calculation. Similar to returns outwards, returns inwards may apply which are recorded once customers send back goods. For trading businesses, the gross profit is an important figure. The gross profit is the difference between sales less returns inwards and less material expenses. For calculating the gross profit companies apply the Trading account. <?page no="183"?> Berkau: BASICS of ACCOUNTING 22-182 How it is done (calculating gross profit): (1) Calculate sales (net amount) (2) If there are any returns inwards deduct them from sales. (3) Deduct purchases and opening values of stock. (4) Add closing stock and returns outwards if there are any. (5) The result is the gross profit to be transferred to the credit side of the Profit and Loss account if positive. A negative amount is called gross loss and is transferred to the debit side of the Profit and Loss account. The following example is about a car dealer. CORNFLOWER Ltd. is a car dealership for all makes. The business is established on 2.01.20X9 by an issue of 20,000 ordinary shares at 5.00 EUR/ share. The share issue is par value. This means the shares are issued at their face value amount. (1) Issue of shares on 2.01.20X9. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR The rent for the show room is paid for the full year in advance. There are no accruals relevant. The rent for the show room, car yard and workshop equals to 36,000.00 EUR/ a. CORNFLOWER Ltd. pays the amount per bank transfer on 2.01.20X9. (2) Rent payment on 2.01.20X9. DR Rent......................... 36,000.00 EUR CR Cash/ Bank.................... 36,000.00 EUR On 2.01.20X9, the purchase manager buys 3 used VW Polos built in 20X7 at 16,000.00 EUR each. The previous owners receive their money by CORNFLOWER Ltd. paying the purchase price into their bank accounts one day later. The Accountant makes the bookkeeping entry below: (3) Purchase of VW Polos at: 3 × 16,000 = 48,000.00 EUR . DR Purchase..................... 48,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR On 12.01.20X9, one of the VW Polos is sold at 17,500.00 EUR. The sale is on cash. (4) Sale of the VW Polo at 17,500.00 EUR on 12.01.20X9. <?page no="184"?> Berkau: BASICS of ACCOUNTING 22-183 DR Cash/ Bank.................... 17,500.00 EUR CR Sales........................ 17,500.00 EUR On 14.01.20X9 CORNFLOWER Ltd. buys a Mercedes B-class from 20X8 at 20,000.00 EUR. The deal is on credit and CORNFLOWER Ltd. has to pay during the next week. (5) Purchase of a Mercedes B-class on 14.01.20X9. DR Purchase..................... 20,000.00 EUR CR Accounts Payables............ 20,000.00 EUR CORNFLOWER pays one week later the purchase price for the Mercedes B-class. (6) Payment for Mercedes B-class on 22.01.20X9. DR Accounts Payables............ 20,000.00 EUR CR Cash/ Bank.................... 20,000.00 EUR On the next day, the Mercedes B-class is sold at 22,000.00 EUR. The customer pays a portion of the price to the extent of 5,000.00 EUR on cash and agrees to pay the remaining amount within 3 days’ time. This is a partial payment that signifies the sale. (7) Sale of Mercedes B-class on 21.01.20X9. DR Cash/ Bank.................... 5,000.00 EUR DR Accounts Receivables......... 17,000.00 EUR CR Sales........................ 22,000.00 EUR On 24.01.20X9, the buyer of the Mercedes B-class pays the remaining amount into CORNFLOWER Ltd.’s bank account. (8) Receiving the amount of 17,000.00 EUR from the Mercedes B-class sale on 24.01.20X9. DR Cash/ Bank.................... 17,000.00 EUR CR Accounts Receivables......... 17,000.00 EUR Before we explain the calculation of gross profit by the Trading account, we take a look at the accounts at this stage as depicted by Figure 22.1. The nominal accounts are not balanced off yet. <?page no="185"?> Berkau: BASICS of ACCOUNTING 22-184 D C D C (1) 100,000.00 (2) 36,000.00 c/ d 100,000.00 (1) 100,000.00 (4) 17,500.00 (3) 48,000.00 b/ d 100,000.00 (7) 5,000.00 (6) 20,000.00 (8) 17,000.00 c/ d 35,500.00 139,500.00 139,500.00 b/ d 35,500.00 Cash/ Bank Issued capital D C D C (2) 36,000.00 (3) 48,000.00 (5) 20,000.00 Rent Purchase D C D C (4) 17,500.00 (6) 20,000.00 (5) 20,000.00 (7) 22,000.00 D C (7) 17,000.00 (8) 17,000.00 Sales Accounts payables Accounts receivables Figure 22.1: CORNFLOWER Ltd.’s accounts Revenue is the money or its equivalent flowing into the company for selling the goods/ services. The total revenue amounts to the balancing figure in the Sales account which equals to: 17,500 + 22,000 = 39,500.00 EUR . The gross profit for a dealership is the revenue less material expenses. Here, we have to deduct the cost of purchase from the revenue. The cars sold - which is one Polo and one Mercedes B-class were bought at: 16,000 + 20,000 = 36,000.00 EUR . Accordingly, the gross profit of the cars amounts to: 39,500 - 36,000 = 3,500.00 EUR . The example is easy because the gross profit earned by each cars is known. It is: 17,500 - 16,000 = 1,500.00 EUR for the VW Polo and it is: 22,000 - 20,000 = 2,000.00 EUR for the Mercedes B-class. Together, the gross profit equals to: 1,500 + 2,000 = 3,500.00 EUR . However, the net profit is negative, because we have to deduct the show room/ car yard/ workshop-rent from the gross profit. CORNFLOWER Ltd.’s net loss equals to: 3,500 - 36,000 = - 32,500.00 EUR . We now take a closer look at the accounts and study a method of how to determine the gross and the net profit. For the gross profit calculation, we apply the Trading account (T/ A). The Trading account is an account that displays on the debit side the opening value of inventory, all purchases and all returns inwards. On the credit side, there is sales, closing stock and all returns outwards. The balancing figure of the Trading ac- <?page no="186"?> Berkau: BASICS of ACCOUNTING 22-185 count is the gross profit. If the balancing figure (balance c/ d) of the Trading account is on the credit side the trader makes a gross loss. How it is done (gross profit calculation): (1) Make bookkeeping entries for purchases and revenue. (2) Transfer the opening value of inventories to the debit side of the Trading account by closing-off the Inventory account to the Trading account. (3) Close-off the Purchase account to the Trading account. (4) Close-off the Sales account to the Trading account. (5) Run a stock count. Make a debit entry for closing stock in the Inventory account and credit the amount to the Trading account. (6) Close-off the Returns Inwards account. (7) Close-off the Returns Outwards account. (8) Balance-off the Trading account in order to calculate the gross profit or gross loss. A gross profit results from a credit balanced Trading account. A gross loss results from a debit balanced Trading account. (9) Close-off the Trading account to the Profit and Loss account. CORNFLOWER Ltd.’s Trading account contains on its debit side no opening value for inventory. The total of purchases amounts to the cost of purchase of the three VW Polos and the Mercedes B-class: 3 × 16,000 + 20,000 = 68,000.00 EUR . On the credit side, we observe the total of sales, 39,500.00 EUR. The closing stock consists of the two VW Polos which have not been sold yet. They are carried at their cost of purchase which equals to: 2 × 16,000 = 32,000.00 EUR . The balancing figure in the Trading account is the gross profit. It amounts to: 39,500 + 32,000 - 68,000 = 3,500.00 EUR . The gross profit appears as balance carried down on the debit side of the Trading account. We did not record any inventory movements linked to the sales. CORNFLOWER Ltd. applies a periodic inventory system. Thus, stock to the extent of 32,000.00 EUR is debited to the Inventory account. The bookkeeping entry is made on 31.12.20X9 as it is an adjustment. DR Inventory.................... 32,000.00 EUR CR Trading Account.............. 32,000.00 EUR Observe the accounts in Figure 22.2: <?page no="187"?> Berkau: BASICS of ACCOUNTING 22-186 D C D C (1) 100,000.00 (2) 36,000.00 c/ d 100,000.00 (1) 100,000.00 (4) 17,500.00 (3) 48,000.00 b/ d 100,000.00 (7) 5,000.00 (6) 20,000.00 (8) 17,000.00 c/ d 35,500.00 139,500.00 139,500.00 b/ d 35,500.00 Cash/ Bank Issued capital D C D C (2) 36,000.00 c/ d 36,000.00 (3) 48,000.00 b/ d 36,000.00 P&L 36,000.00 (5) 20,000.00 c/ d 68,000.00 68,000.00 68,000.00 b/ d 68,000.00 T/ A 68,000.00 Rent Purchase D C D C (4) 17,500.00 (6) 20,000.00 (5) 20,000.00 c/ d 39,500.00 (7) 22,000.00 39,500.00 39,500.00 T/ A 39,500.00 b/ d 39,500.00 D C D C (7) 17,000.00 (8) 17,000.00 Prh 68,000.00 Rev 39,500.00 GP 3,500.00 Inv 32,000.00 71,500.00 71,500.00 P&L 3,500.00 b/ d 3,500.00 Sales Accounts payables Accounts receivables Trading account D C D C T/ A 32,000.00 c/ d 32,000.00 Rnt 36,000.00 T/ A 3,500.00 b/ d 32,000.00 NL 32,500.00 36,000.00 36,000.00 b/ d 32,500.00 R/ E 32,500.00 D C P&L 32,500.00 c/ d 32,500.00 b/ d 32,500.00 R/ E Inventory Profit and Loss Figure 22.2: CORNFLOWER Ltd.’s accounts The procedure of net profit calculation is described in detail below. All bookkeeping entries are made on 31.12.20X9: After balancing-off all accounts, the Sales account is closed-off to the Trading account: <?page no="188"?> Berkau: BASICS of ACCOUNTING 22-187 DR Sales........................ 39,500.00 EUR CR Trading Account.............. 39,500.00 EUR The total of purchases is transferred to the Trading account also: DR Trading Account.............. 68,000.00 EUR CR Purchase..................... 68,000.00 EUR In this example the stock count is quite easy. There are two VW Polos left in the show room worth: 2 × 16,000 = 32,000.00 EUR . The balancing figure of the Trading account is the gross profit. The amount is displayed as GP therein. The Trading account is closed-off to the Profit and Loss account by the next bookkeeping entry. DR Trading Account.............. 3,500.00 EUR CR Profit and Loss.............. 3,500.00 EUR In the Profit and Loss account, entries resulting from other activities than trading are considered. The rent for the show room/ car yard/ workshop is relevant. The Rent account is closed-off to the Profit and Loss account. DR Profit and Loss.............. 36,000.00 EUR CR Rent......................... 36,000.00 EUR The Profit and Loss account is balancedoff. The account is debit balanced. This indicates a net loss. It equals to: 3,500 - 36,000 = -32,500.00 EUR . Net loss is a technical term for a negative profit after taxes. Net profit stands for a positive amount. A net profit is the sales less all expenses (income tax expenses exempted) that occurred during the Accounting period. It is the same as earnings before taxes. CORNFLOWER Ltd.’s net loss amounts to 32,500.00 EUR. The amount is transferred to the Retained Earnings account by closing-off the Profit and Loss account thereto: DR Retained Earnings............ 32,500.00 EUR CR Profit and Loss.............. 32,500.00 EUR Observe the financial statements for CORNFLOWER Ltd. in Figure 22.3. <?page no="189"?> Berkau: BASICS of ACCOUNTING 22-188 [EUR] Revenue 39,500.00 Other income 39,500.00 Materials 36,000.00 Labour Depreciation Other expenses 36,000.00 Earnings before int and taxes (EBIT) (32,500.00) Interest Earnings before taxes (EBT) (32,500.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (32,500.00) Cornflower Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X9 Figure 22.3: CORNFLOWER Ltd.’s statement of comprehensive income for 20X9 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (32,500.00) Current assets Liabilities Inventory 32,000.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 35,500.00 Tax liabilities 67,500.00 67,500.00 Cornflower Ltd's STATEMENT of FINANCIAL POSITION as at 31.12.20X9 Figure 22.4: CORNFLOWER Ltd.’s statement of financial position as at 31.12.20X9 With regard to the valuation of goods on stock, IAS 2 and § 255 HGB apply: The valuation is always at cost of purchase (net amount). No additions are allowed. <?page no="190"?> Berkau: BASICS of ACCOUNTING 22-189 How it is done (calculation of net profit): (1) Determine gross profit by the Trading account. (2) Close-off the Trading account to the Profit and Loss account. (3) Make debit entries for all further expenses, including interest. (4) Balance-off the Profit and Loss account. (5) At this stage, the balancing figure in the Profit and Loss account represents the net profit. We name it earnings before taxes (= EBT). We discuss another case study below, where the amounts are not that easy to oversee, which is the case in most trading companies. Think about a grocery shop like Lidl, Aldi, Checker’s, Tesco, Woolworth etc. Furthermore, we now consider returns. There will be returns inwards and returns outwards. Again, we make the bookkeeping entries at first and then will apply the Trading account in order to calculate the gross profit. DURANT (Pty) Ltd. provides the statement of financial position at the beginning of 20X7. It is depicted in Figure 22.5: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 80,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 35,000.00 Current assets Liabilities Inventory 59,000.00 Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 61,000.00 Tax liabilities 15,000.00 200,000.00 200,000.00 Durant (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 22.5: DURANT (Pty) Ltd.’s statement of financial position DURANT (Pty) Ltd. is a dealership for photo equipment. The company trades cameras, video recorders, tripods, photo frames, photo printers, etc. The figures presented by the balance sheet result from previous years: (a) Property, plant and equipment: DURANT (Pty) Ltd. bought a shop in a mall at 100,000.00 EUR. The shop has been depreciated by 20,000.00 EUR. <?page no="191"?> Berkau: BASICS of ACCOUNTING 22-190 (b) Inventory results from 65 cameras at 536.00 EUR/ p, from 52 video cameras at 254.00 EUR, from 304 photo frames at 19.00 EUR/ p and from 8 photo printers at 647.00 EUR/ p. The amount for the inventory item equals to: 65 × 536 + 52 × 254 + 304 × 19 + 8 × 647 = 59,000.00 EUR . (c) DURANT (Pty) Ltd. has 61,000.00 EUR in the bank account. (d) Issued capital: DURANT (Pty) Ltd. was founded by a contribution of its proprietors to the extent of 100,000.00 EUR. (e) Retained earnings: The company earned a profit before taxes of 50,000.00 EUR in 20X6 which was 35,000.00 EUR after taxes. (f) Accounts payables: There are still open bills, as DURANT (Pty) Ltd. owes the amounts as to the extent as displayed. (g) The income tax liabilities are 15,000.00 EUR. We transfer the opening amounts to the real accounts at first. Observe Figure 22.6. D C D C OV 100,000.00 OV 20,000.00 D C D C OV 59,000.00 OV 61,000.00 D C D C OV 100,000.00 OV 35,000.00 Issued capital R/ E Inventory Cash/ Bank P,P,E Acc depr D C D C OV 50,000.00 OV 15,000.00 Accounts payables Tax liabilities IAS 12 Figure 22.6: DURANT (Pty) Ltd.’s accounts The amount for property, plant and equipment goes to 2 accounts: Property, Plant and Equipment account and the Accumulated Depreciation account, both are linked to the shop. On 2.01.20X7, DURANT (Pty) Ltd. pays the income tax liabilities from the last Accounting period. (1) Payment for income taxes on 2.01.20X7. DR Income Tax Liabilities....... 15,000.00 EUR CR Cash/ Bank.................... 15,000.00 EUR <?page no="192"?> Berkau: BASICS of ACCOUNTING 22-191 On 3.01.20X7, DURANT (Pty) Ltd. paysoff some short-term debts to their camera supplier. The amount is: 65 × 536 = 34,840.00 EUR . (2) Pay-off of short-term liabilities on 3.01.20X7. DR Accounts Payables............ 34,840.00 EUR CR Cash/ Bank.................... 34,840.00 EUR On 14.01.20X7, DURANT (Pty) Ltd. sells 12 cameras at 700.00 EUR each on cash. (3) Sale on cash: 12 × 700 = 8,400.00 EUR on 14.01.20X7. DR Cash/ Bank.................... 8,400.00 EUR CR Sales........................ 8,400.00 EUR On 15.01.20X7 DURANT (Pty) Ltd. sells 34 photo frames at 30.00 EUR each on credit. The customer agrees to pay the amount owed within the next days per bank transfer. (4) Sale on credit: 34 × 30 = 1,020.00 EUR on 15.01.20X7. DR Accounts Receivables......... 1,020.00 EUR CR Sales........................ 1,020.00 EUR The money from the customer who bought the frames is received on 18.01.20X7. (5) Payment from customer received on 18.07.20X7. DR Cash/ Bank.................... 1,020.00 EUR CR Accounts Receivables......... 1,020.00 EUR However, the customer with the frames returns one frame, because it has a broken glass. The customer receives a voucher in return. DURANT (Pty) Ltd. does not repair the frame but throws it away. Throwing away an item of inventory means an expense. It won’t count for the stock count at the Accounting period’s end. (6) Return inwards of one frame and giving away a voucher for compensation of the customer on 23.01.20X7. DR Returns Inwards.............. 30.00 EUR CR Accounts Payables............ 30.00 EUR On 1.02.20X7, DURANT (Pty) Ltd. orders 100 tripods from their supplier at 134.00 EUR each. The deal is on credit. The amount is: 100 × 134 = 13,400.00 EUR . (7) Purchase of tripods on 1.02.20X7. <?page no="193"?> Berkau: BASICS of ACCOUNTING 22-192 DR Purchase..................... 13,400.00 EUR CR Accounts Payables............ 13,400.00 EUR On 4.02.20X7, DURANT (Pty) Ltd. sells 22 video cameras at 320.00 EUR each on cash. (8) Sale of video cameras: 22 × 320 = 7,040.00 EUR on 4.02.20X7. DR Cash/ Bank.................... 7,040.00 EUR CR Sales........................ 7,040.00 EUR One of the tripods ordered from the supplier has a jammed leg. DURANT (Pty) Ltd.’s quality manager detects the faulty tripod and sends it back. The supplier adjusts the bill to DURANT (Pty) Ltd. by a 134.00 EUR reduction. (9) Return outwards of one tripod on 6.02.20X7. DR Accounts Payables............ 134.00 EUR CR Returns Outwards............. 134.00 EUR On 8.02.20X7, DURANT (Pty) Ltd. pays the amount owing the tripod supplier by bank transfer. The amount is: 13,400 - 134 = 13,266.00 EUR . (10) Payment of the tripods’ bill on 8.02.20X7. DR Accounts Payables............ 13,266.00 EUR CR Cash/ Bank.................... 13,266.00 EUR On 31.12.20X7, DURANT (Pty) Ltd. depreciates the store by 2,000.00 EUR. (11) Depreciation on the store on 31.12.20X7. DR Depreciation................. 2,000.00 EUR CR Accumulated Depreciation..... 2,000.00 EUR After making the bookkeeping entries the accounts look as displayed by Figure 22.7. D C D C OV 100,000.00 c/ d 100,000.00 OV 20,000.00 b/ d 100,000.00 c/ d 22,000.00 (11) 2,000.00 22,000.00 22,000.00 b/ d 22,000.00 P,P,E Acc depr Figure 22.7: DURANT (Pty) Ltd.’s accounts <?page no="194"?> Berkau: BASICS of ACCOUNTING 22-193 D C D C OV 59,000.00 OV 61,000.00 (1) 15,000.00 (3) 8,400.00 (2) 34,840.00 (5) 1,020.00 (10) 13,266.00 (8) 7,040.00 c/ d 14,354.00 77,460.00 77,460.00 b/ d 14,354.00 Inventory Cash/ Bank D C D C c/ d 100,000.00 OV 100,000.00 OV 35,000.00 b/ d 100,000.00 D C D C (2) 34,840.00 OV 50,000.00 (1) 15,000.00 OV 15,000.00 (9) 134.00 (6) 30.00 (10) 13,266.00 (7) 13,400.00 c/ d 15,190.00 63,430.00 63,430.00 b/ d 15,190.00 Issued capital R/ E Accounts payables Tax liabilities IAS 12 D C D C (3) 8,400.00 (4) 1,020.00 (5) 1,020.00 (4) 1,020.00 c/ d 16,460.00 (8) 7,040.00 16,460.00 16,460.00 b/ d 16,460.00 Sales Accounts receivables D C D C (6) 30.00 c/ d 30.00 (7) 13,400.00 c/ d 13,400.00 b/ d 30.00 b/ d 13,400.00 D C D C c/ d 134.00 (9) 134.00 (11) 2,000.00 c/ d 2,000.00 b/ d 134.00 b/ d 2,000.00 Returns outwards Depreciation Returns inwards Purchases Figure 22.7: DURANT (Pty) Ltd.’s accounts (continued) Some of the accounts, such as Retained Earnings account, Inventory account, etc., have not been balanced-off as they will be debited or credited by the profit calculation, later on. In order to prepare the Trading account, DURANT (Pty) Ltd. runs a stock count. It results in: 53 cameras, 30 video cameras, 270 photo frames, 99 tripods and <?page no="195"?> Berkau: BASICS of ACCOUNTING 22-194 8 photo printers. The inventory valuation gives a value of: 53 × 536 + 30 × 254 + 270 × 19 + 99 × 134 + 8 × 647 = 59,600.00 EUR . Observe the gross profit and net profit calculation by Figure 22.8: D C D C OV 100,000.00 c/ d 100,000.00 OV 20,000.00 b/ d 100,000.00 c/ d 22,000.00 (11) 2,000.00 22,000.00 22,000.00 b/ d 22,000.00 D C D C OV 59,000.00 T/ A 59,000.00 OV 61,000.00 (1) 15,000.00 T/ A 59,600.00 c/ d 59,600.00 (3) 8,400.00 (2) 34,840.00 118,600.00 118,600.00 (5) 1,020.00 (10) 13,266.00 b/ d 59,600.00 (8) 7,040.00 c/ d 14,354.00 77,460.00 77,460.00 b/ d 14,354.00 P,P,E Acc depr Inventory Cash/ Bank D C D C c/ d 100,000.00 OV 100,000.00 OV 35,000.00 b/ d 100,000.00 c/ d 36,234.80 P&L 1,234.80 36,234.80 36,234.80 b/ d 36,234.80 D C D C (2) 34,840.00 OV 50,000.00 (1) 15,000.00 OV 15,000.00 (9) 134.00 (6) 30.00 c/ d 529.20 P&L 529.20 (10) 13,266.00 (7) 13,400.00 15,529.20 15,529.20 c/ d 15,190.00 b/ d 529.20 63,430.00 63,430.00 b/ d 15,190.00 D C D C (3) 8,400.00 (4) 1,020.00 (5) 1,020.00 (4) 1,020.00 c/ d 16,460.00 (8) 7,040.00 16,460.00 16,460.00 T/ A 16,460.00 b/ d 16,460.00 Sales Accounts receivables Issued capital R/ E Accounts payables Tax liabilities IAS 12 Figure 22.8: DURANT (Pty) Ltd.’s accounts <?page no="196"?> Berkau: BASICS of ACCOUNTING 22-195 D C D C (6) 30.00 c/ d 30.00 (7) 13,400.00 c/ d 13,400.00 b/ d 30.00 T/ A 30.00 b/ d 13,400.00 T/ A 13,400.00 Returns inwards Purchases D C D C c/ d 134.00 (9) 134.00 (11) 2,000.00 c/ d 2,000.00 T/ A 134.00 b/ d 134.00 b/ d 2,000.00 P&L 2,000.00 D C D C Inv 59,000.00 Rev 16,460.00 Dpr 2,000.00 T/ A 3,764.00 Purch 13,400.00 Inv 59,600.00 NP 1,764.00 R.I. 30.00 R.O. 134.00 3,764.00 3,764.00 GP 3,764.00 R/ E 1,234.80 b/ d 1,764.00 76,194.00 76,194.00 TL 529.20 P&L 3,764.00 b/ d 3,764.00 1,764.00 1,764.00 Return outwards Depreciation T/ A Profit and Loss Figure 22.8: DURANT (Pty) Ltd.’s accounts (continued) The financial statements for DURANT (Pty) Ltd. follow, see Figure 22.9 and Figure 22.10: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 78,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 36,234.80 Current assets Liabilities Inventory 59,600.00 Interest bear liab A/ R A/ P 15,190.00 Prepaid expenses Provisions Cash/ Bank 14,354.00 Tax liabilities 529.20 151,954.00 151,954.00 Durant (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 22.9: DURANT (Pty) Ltd.’s statement of financial position <?page no="197"?> Berkau: BASICS of ACCOUNTING 22-196 [EUR] Revenue 16,430.00 Other income 16,430.00 Materials 12,666.00 Labour Depreciation 2,000.00 Other expenses Earnings before int and taxes (EBIT) 1,764.00 Interest Earnings before taxes (EBT) 1,764.00 Income tax expenses 529.20 Deferred taxes Earnings after taxes (EAT) 1,234.80 DURANT (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 22.10: DURANT (Pty) Ltd. statement of comprehensive income On the statement of comprehensive income, the amount for recognised revenue is: sales less returns inwards: 16,460 - 30 = 16,430.00 EUR . The amount for material expenses is: opening value for inventory plus purchases less closing stock of inventories less returns outwards: 59,000 + 13,400 - 59,600 - 134 = 12,666.00 EUR . As the example is simple, we can determine profit directly. We just do that in order to proof the correctness of calculation above. DURANT (Pty) Ltd. earns a profit from selling the goods at a higher price as it purchased them for. Thus, the profit is the sum of the amounts of goods sold times the difference between sales prices and costs of purchases. In particular DURANT (Pty) Ltd. sold 12 cameras, 34 - 1 = 33 photo frames and 22 video cameras. One photo frame was damaged and had to be expensed, because it was discarded. The purchase of tripods is not relevant for the profit. The same applies for the return outwards thereof. The gross profit amounts to: 12 × (700 - 536) + 33 × (30 - 19) - 19 + 22 × (320 - 254) = 3,764.00 EUR . The net profit is the gross profit less any further expenses. In this case study only depreciation is to be deducted: 3,783 - 2,000 = 1,764.00 EUR . The income tax liabilities are to be deducted from the net profit in order to determine the annual surplus: 1,764 × (1 - 30%) = 1,234.80 EUR . Summary: In a trading business, the gross profit is calculated by the Trading account. The net profit is calculated in the Profit and Loss account. <?page no="198"?> Berkau: BASICS of ACCOUNTING 22-197 Working Definitions: Gross Profit: The gross profit is the difference between sales less returns inwards and less material expenses. Trading Account: The Trading account is an account that displays on the debit side the opening value of inventory, all purchases and all returns inwards. On the credit side there is sales, closing stock and all returns outwards. The balancing figure of the Trading account is the gross profit. Net Profit: A net profit is the sales less all expenses (income tax expenses exempted) that occurred during the Accounting period. <?page no="199"?> Berkau: BASICS of ACCOUNTING 23-198 23. Trading Business: Sales plus VAT Learning Objectives: We study again the cases of CORNFLOWER Ltd. and DURANT (Pty) Ltd. from the previous chapter and will consider VAT for purchases and sales. We will see VAT does not effect a business’s profit, but will change the payments and payables (or receivables) on the balance sheet. After studying this chapter, you will be able to record input and output-VAT. You know also the amount to be paid to or get refunded from the revenue service. For the case studies all costs, expenses and net selling prices remain unchanged. We start our extended repetition by CORNFLOWER Ltd., the car dealership: CORNFLOWER Ltd. is established on 2.01.20X9 by an issue of 20,000 ordinary shares at 5.00 EUR/ share. The share issue is par value. No VAT is relevant for share issues. (1) Issue of shares on 2.01.20X9 at: 20,000 × 5 = 100,000.00 EUR . DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR The annual rent for the show room is paid in advance. The rent for the show room, which includes the car yard and the workshop, is: 36,000.00 EUR/ a. CORNFLOWER Ltd. and its landlord are VAT registered companies. The rent is VAT relevant therefore. CORNFLOWER Ltd. pays the amount for rent to the extent of: 36,000 × 120% = 43,200.00 EUR per bank transfer on 2.01.20X9. (2) Rent payment on 2.01.20X9. DR Rent......................... 36,000.00 EUR DR VAT.......................... 7,200.00 EUR CR Cash/ Bank.................... 43,200.00 EUR On 2.01.20X9, the purchase manager buys 3 used VW Polos built in 20X7 at 16,000.00 EUR each. The amount is the net purchase cost. The payment required is increased by input-VAT: 16,000 × 120% = 19,200.00 EUR/ car . The previous owners get paid by CORNFLOWER Ltd. transferring the amount into their bank accounts the next day. The Accountant makes the bookkeeping entry below: (3) Purchase of VW Polos at: 3 × 16,000 × 120% = 57,600.00 EUR on 2.01.20X9. DR Purchase..................... 48,000.00 EUR DR VAT.......................... 9,600.00 EUR CR Cash/ Bank.................... 57,600.00 EUR <?page no="200"?> Berkau: BASICS of ACCOUNTING 23-199 On 12.01.20X9, one of the VW Polos is sold at a net selling price of 17,500.00 EUR. It is a cash sale. The buyer pays 17,500 × 120% = 21,000.00 EUR . If a VAT registered company sells an asset, it is obliged to collect output-VAT on behalf of the revenue service. This results in credit entries in the VAT account. Thus, the payment obtained from the VW Polo customer is increased by 20% of output- VAT. (4) Sale of the VW Polo at 21,000.00 EUR on 12.01.20X9. DR Cash/ Bank.................... 21,000.00 EUR CR VAT.......................... 3,500.00 EUR CR Sales........................ 17,500.00 EUR On 14.01.20X9, CORNFLOWER Ltd. buys a Mercedes B-class from 20X8 at 20,000.00 EUR (net amount). The deal is on credit and CORNFLOWER Ltd. has to pay during the next week the gross amount of: 20,000 × 120% = 24,000.00 EUR . (5) Purchase of Mercedes B-class on 14.01.20X9. DR Purchase..................... 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Accounts Payables............ 24,000.00 EUR One week later, CORNFLOWER pays the price for the Mercedes B-class. Payments are at the agreed price. No entry in the VAT account is relevant as it is only a money transfer activity. (6) Payment for Mercedes B-class on 21.01.20X9. DR Accounts Payables............ 24,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR The next day, the Mercedes B-class is sold at a 22,000.00 EUR net selling price. The amount to be received from the buyer amounts to: 22,000 × 120% = 26,400.00 EUR . The customer pays a portion of the price on cash (5,000.00 EUR) and agrees to pay the remaining amount within 3 days’ time. Even in case the business receives the amount for the item sold later, the credit entry in the VAT account is made to the full extent! See the 3 rd entry below. The reason for this entry lays in the revenue recognition, which is signified by the partial payment. (7) Sale of Mercedes B-class on 22.01.20X9. DR Cash/ Bank.................... 5,000.00 EUR DR Accounts Receivables......... 21,400.00 EUR CR VAT.......................... 4,400.00 EUR CR Sales........................ 22,000.00 EUR <?page no="201"?> Berkau: BASICS of ACCOUNTING 23-200 On 24.01.20X9, the buyer of the Mercedes B-class pays the remaining amount into CORNFLOWER Ltd.’s bank account. (8) Receiving amount of 21,400.00 EUR from the Mercedes B-class sale on 24.01.20X9. DR Cash/ Bank.................... 21,400.00 EUR CR Accounts Receivables......... 21,400.00 EUR Before we explain the profit calculation by the Trading account, we take a look at the accounts at this stage in Figure 23.1. D C D C (1) 100,000.00 (2) 43,200.00 c/ d 100,000.00 (1) 100,000.00 (4) 21,000.00 (3) 57,600.00 b/ d 100,000.00 (7) 5,000.00 (6) 24,000.00 (8) 21,400.00 c/ d 22,600.00 147,400.00 147,400.00 b/ d 22,600.00 D C D C (2) 36,000.00 (3) 48,000.00 (5) 20,000.00 D C D C (4) 17,500.00 (6) 24,000.00 (5) 24,000.00 (7) 22,000.00 D C D C (7) 21,400.00 (8) 21,400.00 (2) 7,200.00 (4) 3,500.00 (3) 9,600.00 (7) 4,400.00 (5) 4,000.00 c/ d 12,900.00 20,800.00 20,800.00 b/ d 12,900.00 Cash/ Bank Issued capital Sales Accounts payables Accounts receivables VAT Rent Purchase Figure 23.1: CORNFLOWER Ltd.’s accounts We now calculate CORNFLOWER Ltd.’s profit. After balancing-off all accounts, the Sales account is closed-off to the Trading account: DR Sales........................ 39,500.00 EUR CR Trading Account.............. 39,500.00 EUR <?page no="202"?> Berkau: BASICS of ACCOUNTING 23-201 The Purchase account is closed-off to the Trading account, too. DR Trading Account.............. 68,000.00 EUR CR Purchase..................... 68,000.00 EUR CORNFLOWER Ltd. runs a periodic inventory system, so it is required to closeoff the Inventory account to the Trading account. There are two cars left at this stage, worth 16,000.00 EUR each. Thus, the closing stock amounts to: 2 × 16,000 = 32,000.00 EUR . This amount is not changed by VAT as inventory is valued at net amounts always. DR Inventory.................... 32,000.00 EUR CR Trading Account.............. 32,000.00 EUR The balancing figure of the Trading account is the gross profit. The Trading account is closed-off to the Profit and Loss account. DR Trading Account.............. 3,500.00 EUR CR Profit and Loss.............. 3,500.00 EUR In the Profit and Loss account, entries resulting from other activities than trading are considered. Here, rent for the show room/ car yard/ workshop is relevant. The Rent account is closed-off to the Profit and Loss account. DR Profit and Loss.............. 36,000.00 EUR CR Rent......................... 36,000.00 EUR The Profit and Loss account is balancedoff. CORNFLOWER Ltd.’s net loss amounts to 32,500.00 EUR. The Profit and Loss account is closed-off to the Retained Earnings account: DR Retained Earnings............ 32,500.00 EUR CR Profit and Loss.............. 32,500.00 EUR <?page no="203"?> Berkau: BASICS of ACCOUNTING 23-202 D C D C (1) 100,000.00 (2) 43,200.00 c/ d 100,000.00 (1) 100,000.00 (4) 21,000.00 (3) 57,600.00 b/ d 100,000.00 (7) 5,000.00 (6) 24,000.00 (8) 21,400.00 c/ d 22,600.00 147,400.00 147,400.00 b/ d 22,600.00 Cash/ Bank Issued capital D C D C (2) 36,000.00 c/ d 36,000.00 (3) 48,000.00 b/ d 36,000.00 P&L 36,000.00 (5) 20,000.00 c/ d 68,000.00 68,000.00 68,000.00 b/ d 68,000.00 T/ A 68,000.00 Rent Purchase D C D C (4) 17,500.00 (6) 24,000.00 (5) 24,000.00 c/ d 39,500.00 (7) 22,000.00 39,500.00 39,500.00 T/ A 39,500.00 b/ d 39,500.00 D C D C (7) 21,400.00 (8) 21,400.00 (2) 7,200.00 (4) 3,500.00 (3) 9,600.00 (7) 4,400.00 (5) 4,000.00 c/ d 12,900.00 20,800.00 20,800.00 b/ d 12,900.00 D C D C Prh 68,000.00 Rev 39,500.00 Rnt 36,000.00 T/ A 3,500.00 GP 3,500.00 Inv 32,000.00 NL 32,500.00 71,500.00 71,500.00 36,000.00 36,000.00 P&L 3,500.00 b/ d 3,500.00 b/ d 32,500.00 R/ E 32,500.00 D C D C P&L 32,500.00 c/ d 32,500.00 T/ A 32,000.00 c/ d 32,000.00 b/ d 32,500.00 b/ d 32,000.00 R/ E Inventory Sales Accounts payables Accounts receivables VAT Trading account Profit and Loss Figure 23.2: CORNFLOWER Ltd.’s accounts Observe the financial statements for CORNFLOWER Ltd. in Figure 23.3. <?page no="204"?> Berkau: BASICS of ACCOUNTING 23-203 [EUR] Revenue 39,500.00 Other income 39,500.00 Materials 36,000.00 Labour Depreciation Other expenses 36,000.00 Earnings before int and taxes (EBIT) (32,500.00) Interest Earnings before taxes (EBT) (32,500.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (32,500.00) Cornflower Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X9 Figure 23.3: CORNFLOWER Ltd.’s statement of comprehensive income for 20X9 The statement of comprehensive income is not effectuated by VAT. All amounts are net amounts therein. Compare this statement to Figure 22.3! There are only few changes in comparison to the previous chapter’s statement of financial position with regard to the Cash/ Bank account and the Accounts Receivables account. The amount for VAT is debit balanced. This results from purchases exceeding the sales in this case study. They bought four cars but sold only two thereof. Accordingly, CORNFLOWER Ltd. claims a VAT refund. On the face of the statement of financial position this is shown as an asset. The VAT claim is recognised as receivables. <?page no="205"?> Berkau: BASICS of ACCOUNTING 23-204 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (32,500.00) Current assets Liabilities Inventory 32,000.00 Interest bear liab A/ R 12,900.00 A/ P Prepaid expenses Provisions Cash/ Bank 22,600.00 Tax liabilities 67,500.00 67,500.00 Cornflower Ltd's STATEMENT of FINANCIAL POSITION as at 31.12.20X9 Figure 23.4: CORNFLOWER Ltd.’s statement of financial position as at 31.12.20X9 CORNFLOWER Ltd. prepares a VAT statement at the end of the Accounting period and applies for a VAT refund. The bookkeeping entry for the VAT claim clearance will be recorded in the next Accounting period. Thus, the bookkeeping ID is a capital letter and the Accounting period 20Y0: (A) VAT refund on 1.01.20Y0. DR Cash/ Bank.................... 12,900.00 EUR CR VAT.......................... 12,900.00 EUR We now go through the DURANT (Pty) Ltd. case study and consider VAT also. This example contains returns which require to make adjustments for VAT, too. DURANT (Pty) Ltd. trades cameras, video recorders, tripods, photo frames, photo printers, etc. The figures provided come from the statement of financial position as at the beginning of 20X7: <?page no="206"?> Berkau: BASICS of ACCOUNTING 23-205 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 80,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 35,000.00 Current assets Liabilities Inventory 59,000.00 Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 61,000.00 Tax liabilities 15,000.00 200,000.00 200,000.00 Durant (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 23.5: DURANT (Pty) Ltd.’s statement of financial position The opening values are the same as in the previous chapter and are transferred to the accounts. We do not consider VAT claims or payment obligations resulting from output-VAT resulting from 20X6, here. See Figure 23.6: D C D C OV 100,000.00 OV 20,000.00 D C D C OV 59,000.00 OV 61,000.00 P,P,E Acc depr Inventory Cash/ Bank D C D C OV 100,000.00 OV 35,000.00 D C D C OV 50,000.00 OV 15,000.00 Issued capital R/ E Accounts payables Tax liabilities IAS 12 Figure 23.6: DURANT (Pty) Ltd.’s accounts On 2.01.20X7, DURANT (Pty) Ltd. pays the income tax liabilities from the previous Accounting period. (1) Payment for income taxes on 2.01.20X7. <?page no="207"?> Berkau: BASICS of ACCOUNTING 23-206 DR Income Tax Liabilities....... 15,000.00 EUR CR Cash/ Bank.................... 15,000.00 EUR On 3.01.20X7, DURANT (Pty) Ltd. paysoff some short-term debts owing their camera supplier. The amount is: 34,840 × 120% = 41,808.00 EUR . (2) Pay-off of short-term liabilities on 3.01.20X7. DR Accounts Payables............ 41,808.00 EUR CR Cash/ Bank.................... 41,808.00 EUR On 14.01.20X7, DURANT (Pty) Ltd. sells 12 cameras at 700.00 EUR/ p on cash. As VAT registered company, DURANT (Pty) Ltd.’s selling prices are the gross amounts: They contain VAT. (3) The sale on cash results in a payment, which equals to: 12 × 700 × 120% = 10,080.00 EUR on 14.01.20X7. DR Cash/ Bank.................... 10,080.00 EUR CR VAT.......................... 1,680.00 EUR CR Sales........................ 8,400.00 EUR On 15.01.20X7, DURANT (Pty) Ltd. sells 34 photo frames at 36.00 EUR/ u on credit. The amount of 36.00 EUR is the gross selling price. In order to determine the net amount for the sales, we calculate: 34 × 36/ 120% = 1,020.00 EUR . VAT according to this calculation equals to: 1,020 × 20% = 204.00 EUR . The customer agrees to pay the amount owed within the next days per bank transfer. (4) Sale on credit at a total price of: 34 × 30 × 120% = 1,224.00 EUR on 15.01.20X7. DR Accounts Receivables......... 1,224.00 EUR CR VAT.......................... 204.00 EUR CR Sales........................ 1,020.00 EUR The payment from the customer, who bought the frames, is received on 18.01.20X7. (5) Payment received from customer on 18.07.20X7. DR Cash/ Bank.................... 1,224.00 EUR CR Accounts Receivables......... 1,224.00 EUR However, the customer with the frames returns one, due to a broken glass. The customer receives a voucher in return. DURANT (Pty) Ltd. does not repair the frame, but casts it off. The refund is relevant to VAT, but the discard is not. <?page no="208"?> Berkau: BASICS of ACCOUNTING 23-207 DURANT (Pty) Ltd. can claim back the amount of VAT credited to the VAT account at the time of sale to the extent of 6.00 EUR. However, credit entry as part of the bookkeeping entries (4) cannot be changed. It is recorded already. The amount has to be compensated therefore. This is done by making bookkeeping entry (6). (6) Return inwards of one frame and giving away a voucher for customer compensation on 23.01.20X7. DR Returns Inwards.............. 30.00 EUR DR VAT.......................... 6.00 EUR CR Accounts Payables............ 36.00 EUR DURANT (Pty) Ltd. orders 100 tripods from their supplier at 134.00 EUR each. The amount of 134.00 EUR is the unit cost of purchase. The money to be paid for each tripod amounts to: 134 × 120% = 160.80 EUR . The purchase is on credit: it takes place on 1.02.20X7. The amount is: 100 × 134 × 120% = 16,080.00 EUR . (7) Purchase of tripods on 1.02.20X7. DR Purchase..................... 13,400.00 EUR DR VAT.......................... 2,680.00 EUR CR Accounts Payables............ 16,080.00 EUR On 4.02.20X7, DURANT (Pty) Ltd. sells 22 video cameras at a net selling price of 320.00 EUR each on cash. (8) Sales of video cameras at a gross selling price of: 22 × 320 × 120% = 8,448.00 EUR on 4.02.20X7. DR Cash/ Bank.................... 8,448.00 EUR CR VAT.......................... 1,408.00 EUR CR Sales........................ 7,040.00 EUR One of the tripods ordered from the supplier is returned to the supplier. The supplier modifies the bill therefore by a 160.80 EUR reduction. (9) Return outwards of one tripod on 6.02.20X7. DR Accounts Payables............ 160.80 EUR CR VAT.......................... 26.80 EUR CR Returns Outwards............. 134.00 EUR On 8.02.20X7, DURANT (Pty) Ltd. pays the amount owing the tripod supplier by bank transfer. The amount is: 16,080 - 160.80 = 15,919.20 EUR . (10) Payment of the tripods’ bill on 8.02.20X7. <?page no="209"?> Berkau: BASICS of ACCOUNTING 23-208 DR Accounts Payables............ 15,919.20 EUR CR Cash/ Bank.................... 15,919.20 EUR On 31.12.20X7, DURANT (Pty) Ltd. depreciates the store by 2,000.00 EUR. Depreciation is not VAT relevant. (11) Depreciation on the store on 31.12.20X7. DR Depreciation................. 2,000.00 EUR CR Accumulated Depreciation..... 2,000.00 EUR After making the bookkeeping entries, DURANT (Pty) Ltd.’s accounts look as displayed in Figure 23.7. D C D C OV 100,000.00 c/ d 100,000.00 OV 20,000.00 b/ d 100,000.00 c/ d 22,000.00 (11) 2,000.00 22,000.00 22,000.00 b/ d 22,000.00 P,P,E Acc depr D C D C c/ d 100,000.00 OV 100,000.00 OV 59,000.00 b/ d 100,000.00 D C D C (2) 41,808.00 OV 50,000.00 (1) 15,000.00 OV 15,000.00 (9) 160.80 (6) 36.00 (10) 15,919.20 (7) 16,080.00 c/ d 8,228.00 66,116.00 66,116.00 b/ d 8,228.00 Issued capital Inventory Accounts payables Tax liabilities IAS 12 D C D C c/ d 134.00 (9) 134.00 (11) 2,000.00 c/ d 2,000.00 b/ d 134.00 b/ d 2,000.00 D C OV 35,000.00 R/ E Returns outwards Depreciation Figure 23.7: DURANT (Pty) Ltd.’s accounts <?page no="210"?> Berkau: BASICS of ACCOUNTING 23-209 In order to prepare the Trading account, DURANT (Pty) Ltd. counts stock. The result is 53 cameras, 30 video cameras, 270 photo frames, 99 tripods and 8 photo printers. The inventory valuation gives an amount of closing stock to the extent of: 53 × 536 + 30 × 254 + 270 × 19 + 99 × 134 + 8 × 647 = 59,600.00 EUR . The amount is the same as in chapter Trading Business: Sales, because inventory always is valued at net amounts. Observe the calculation of gross profit and net profit in Figure 23.8: D C D C OV 100,000.00 c/ d 100,000.00 OV 20,000.00 b/ d 100,000.00 c/ d 22,000.00 (11) 2,000.00 22,000.00 22,000.00 b/ d 22,000.00 D C D C (6) 6.00 (3) 1,680.00 OV 61,000.00 (1) 15,000.00 (7) 2,680.00 (4) 204.00 (3) 10,080.00 (2) 41,808.00 (8) 1,408.00 (5) 1,224.00 (10) 15,919.20 c/ d 632.80 (9) 26.80 (8) 8,448.00 c/ d 8,024.80 3,318.80 3,318.80 80,752.00 80,752.00 b/ d 632.80 b/ d 8,024.80 D C D C c/ d 100,000.00 OV 100,000.00 OV 59,000.00 T/ A 59,000.00 b/ d 100,000.00 T/ A 59,600.00 c/ d 59,600.00 118,600.00 118,600.00 b/ d 59,600.00 D C D C (2) 34,840.00 OV 50,000.00 (1) 15,000.00 OV 15,000.00 (9) 160.80 (6) 36.00 c/ d 529.20 P&L 529.20 (10) 15,919.20 (7) 16,080.00 15,529.20 15,529.20 c/ d 15,196.00 b/ d 529.20 66,116.00 66,116.00 b/ d 15,196.00 Cash/ Bank P,P,E Acc depr Issued capital Inventory Accounts payables Tax liabilities IAS 12 VAT D C D C (3) 8,400.00 (4) 1,224.00 (5) 1,224.00 (4) 1,020.00 c/ d 16,460.00 (8) 7,040.00 16,460.00 16,460.00 T/ A 16,460.00 b/ d 16,460.00 Sales Accounts receivables Figure 23.8: DURANT (Pty) Ltd.’s accounts <?page no="211"?> Berkau: BASICS of ACCOUNTING 23-210 D C D C (6) 30.00 c/ d 30.00 (7) 13,400.00 c/ d 13,400.00 b/ d 30.00 T/ A 30.00 b/ d 13,400.00 T/ A 13,400.00 D C D C c/ d 134.00 (9) 134.00 (11) 2,000.00 c/ d 2,000.00 T/ A 134.00 b/ d 134.00 b/ d 2,000.00 P&L 2,000.00 Return outwards Depreciation Return inwards Purchases D C D C OV 35,000.00 Inv 59,000.00 Rev 16,460.00 b/ d 36,234.80 P&L 1,234.80 Prh 13,400.00 Inv 59,600.00 36,234.80 36,234.80 R.I. 30.00 R.O. 134.00 b/ d 36,234.80 GP 3,764.00 76,194.00 76,194.00 P&L 3,764.00 b/ d 3,764.00 D C Dpr 2,000.00 T/ A 3,764.00 NP 1,764.00 3,764.00 3,764.00 R/ E 1,234.80 b/ d 1,764.00 ITL 529.20 1,764.00 1,764.00 Profit and Loss Trading account R/ E Figure 23.8: DURANT (Pty) Ltd.’s accounts (continued) The financial statements for DURANT (Pty) Ltd. are displayed in Figure 22.9 and Figure 22.10. The amount for VAT is posted to payables as output-VAT exceeds input-VAT for this case study. <?page no="212"?> Berkau: BASICS of ACCOUNTING 23-211 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 78,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 36,234.80 Current assets Liabilities Inventory 59,600.00 Interest bear liab A/ R A/ P 8,860.80 Prepaid expenses Provisions Cash/ Bank 8,024.80 Tax liabilities 529.20 145,624.80 145,624.80 Durant (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 23.9: DURANT (Pty) Ltd.’s statement of financial position There are no changes with regard to the statement of comprehensive income in comparison to chapter Trading Business: Sales . [EUR] Revenue 16,430.00 Other income 16,430.00 Materials 12,666.00 Labour Depreciation 2,000.00 Other expenses Earnings before int and taxes (EBIT) 1,764.00 Interest Earnings before taxes (EBT) 1,764.00 Income tax expenses 529.20 Deferred taxes Earnings after taxes (EAT) 1,234.80 DURANT (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 23.10: DURANT (Pty) Ltd. statement of comprehensive income In the next Accounting period, DURANT (Pty) Ltd. is obliged to pay the amount owed for VAT. (A) Payment for VAT payables from last year on 2.01.20X8. <?page no="213"?> Berkau: BASICS of ACCOUNTING 23-212 DR VAT.......................... 632.80 EUR CR Cash/ Bank.................... 632.80 EUR How it is done (posting output-VAT): (1) Determine the gross and the net amount of the sales or revenue. (2) Make a debit entry for the gross amount in the Cash/ Bank account or Accounts Receivables. Consider partial payments accordingly. (3) Credit output-VAT to the VAT account. (4) Credit the net amount to the Sales/ Revenue account. How it is done (VAT claim): (1) Make all entries in the VAT account for input-VAT and output-VAT. (2) Balance-off the VAT account. (3) Prepare a VAT statement with the revenue service. (4) If output-VAT exceeds input-VAT transfer the difference to the revenue service once it is due. If input-VAT exceeds output-VAT, you expect the authorities to refund you the difference. Summary: VAT registered companies have to credit output-VAT to the VAT account once they post sales. The output-VAT is collected by the company on behalf of the revenue service. Returns outwards are similar to a sale activity and require crediting the VAT account, too. Crediting the VAT account means a payment obligation for VAT in the next Accounting period according to the conventions that apply for this text book. This obligation is not effected by any payment received from customers. The consideration of VAT effects the Cash/ Bank account, receivables and payables. The statement of comprehensive income is not effectuated by VAT consideration, as long as the net selling prices equal to the no-VATconsidered values. <?page no="214"?> Berkau: BASICS of ACCOUNTING 24-213 24. Privately Owned Business: Drawings Learning Objectives: After studying how to earn profit, we demonstrate in this chapter, how a private owner of a company receives an income from his/ her business by withdrawing money or goods. The appropriation of profits for limited companies is covered by the chapter Tax Calculation, Profit Appropriation and Statement of Changes in Equity. Here, we explain also that using company assets privately or taking out goods from stock is regarded as an owner’s benefit and counts such as drawing. Companies based on shares and earning a profit either distribute their profit to shareholders or they keep it in the business for reinvestments. Privately owned companies do not declare dividends but the owners will make drawings in order to participate from the profit their business earns. A drawing is taking out assets (e.g. materials or cash) of a business or using business assets privately. Making a drawing decreases the business’ equity. Therefore, the bookkeeping entry for drawings has to be on the debit side of an equity account. For privately owned businesses we apply the Drawings account. It belongs to the equity section. In contrast to limited companies, the equity section for privately owned businesses is simpler. In general, there is only one item, named owners’ equity. The Drawing account reduces owners’ equity. It is important to understand that a drawing is never relevant for profit calculation. It does not change the profitability of the business. Drawings and private deployments of business assets must not go through the Profit and Loss account. Thus, drawings are no expenses of the business. On the other side - better: the contra entry to be considered on the debit side - a drawing will reduce the amount of assets taken away from the business. It is also necessary making adjustments in the VAT account for drawings. Private deployment of assets is not eligible for VAT reduction, as it is not linked to business operations. Thus, the owner taking assets count as consumer and is not allowed to deduct input-VAT. We explain this situation by a theft case: Think of an owner of a company, who buys himself a new car and pays 84,000.00 EUR for it. His company claims the input-VAT from the revenue service. The car is only used privately. If the owner does not adjust the VAT account at the yearend, he will buy his private car “free of VAT”. This is tax evasion and is punishable by national VAT law. <?page no="215"?> Berkau: BASICS of ACCOUNTING 24-214 How it is done (cash drawing): (1) When taking the money out of the Cash/ Bank account, record it as a drawing. It gives a debit entry in the Drawings account and a credit entry in the Cash/ Bank account. (2) At the end of the Accounting period close-off the Drawings account to the Owners’ equity account. How it is done (drawing based on withdrawal of goods or using resources): (1) Determine the net amount and the gross amount of the goods withdrawn or calculate the value of the privately deployed resources. (Can be complicated! ) (2) When taking out the goods or using the resources, make a debit entry in the Drawings account to the extent of the gross value of the goods/ service. (3) Adjust the VAT account: Credit the input-VAT recorded beforehand to the VAT account. This cancels out the input-VAT claim. (4a) For withdrawing goods, credit the net amount to the related Inventory account or Purchase account. If the asset is a non-current asset, make the credit entry in the relevant account like P, P, E account for instance. (4b) For using resources make a credit entry in the expense account related. You might have to consider adjustments for VAT also. (5) Close-off the Drawings account to the Owners’ Equity account. We apply the how-it-is-done instructions for the business car example above. When buying the car, the owner of the business posts the car to P, P, E: DR P, P, E...................... 70,000.00 EUR DR VAT.......................... 14,000.00 EUR CR Cash/ Bank.................... 84,000.00 EUR When taking the car out of the company completely, the owner must record a drawing: DR Drawings..................... 84,000.00 EUR CR VAT.......................... 14,000.00 EUR CR P, P, E...................... 70,000.00 EUR <?page no="216"?> Berkau: BASICS of ACCOUNTING 24-215 Later, the owner closes-off the Drawings account to the Owners’ Equity account: DR Owner’s Equity............... 84,000.00 EUR CR Drawings..................... 84,000.00 EUR Now the situation is cleared: The owner has ceteris paribus no VAT claim resulting from the car acquisition. Furthermore, the car is no longer a company asset. The owner paid 84,000.00 EUR for the acquisition, received a refund of 14,000.00 EUR and paid 14,000.00 EUR output-VAT once conveying the car to his private assets. We modify the situation slightly and discuss a situation, in case the owner only uses the car partly (50 %) privately and half on business purpose. The car now stays in the bookkeeping records of the company as its item of property, plant and equipment. We ignore further motor vehicle costs, such as insurance and petrol for this case. The bookkeeping entry for the car’s acquisition is the same as above. As the car stays in the business, it becomes subject to depreciation. Assume the car is written off along straight line method and the useful life is 5 years. Depreciation on the car for a full year amounts to: 70,000/ 5 = 14,000.00 EUR. DR Depreciation................. 14,000.00 EUR CR Acc. Depr.................... 14,000.00 EUR The expense for a one year car deployment at a half : half ratio will be: 14,000.00/ 2 = 7,000.00 EUR. This is the equivalent value for using the car for half of a year privately. The owner makes the bookkeeping entry below. It is recorded as drawing. DR Drawings .................... 7,000.00 EUR CR Depreciation................. 7,000.00 EUR The drawing is high enough in order to adjust input-VAT, too. If the car is permanently in private use to the extent of 50 %, we accept that 7,000.00 EUR of the input-VAT paid at the time of acquisition is to be adjusted. To spread the amount for drawings over 5 years, gives a further drawing for input-VAT to the extent of: 7,000/ 5 = 1,400.00 EUR. We record the drawing as below and close-off the Drawings account to the Owner’s Equity account: DR Drawings..................... 1,400.00 EUR CR VAT.......................... 1,400.00 EUR <?page no="217"?> Berkau: BASICS of ACCOUNTING 24-216 DR Owner’s Equity............... 8,400.00 EUR CR Drawings..................... 8,400.00 EUR After the latter bookkeeping entry, the input-VAT claim is reduced based on the drawing and the expense account is reduced to an extent of 50 %. According to the drawing, the owner’s equity is now 8,400.00 EUR lower as this is the equivalent to the (gross) car deployment for half of a year. Now, we observe a privately owned company and drawings by the case study VANGUARD: VANGUARD is established in 20X5 by its owner T.L. VanGuard. VANGUARD is privately owned by T.L. VanGuard. The company assets are fully T.L. Van- Guard’s property. Money invested in his company stays in his ownership. Profit earned with the company will increase T.L. VanGuard’s fortune. Accordingly, he has to submit a private income statement to the revenue service where he declares the profit as his own one in. T.L. VanGuard opens a bank account, which he dedicates to his company and pays into that account 60,000.00 EUR as his investment. T.L. VanGuard is reliable for the bank account. The firm VAN- GUARD is a pie baking and selling business. The company is located in a shopping mall next to the entrance gate of a supermarket. The concept is baking a variety of pies (different fillings: steak & kidney, chicken & mushroom, etc.) and selling these freshly baked pies to the customers who enter or leave the supermarket. T.L. VanGuard operates a pie oven and a heat lamp in his bakery shop. The shop is a rental. On the 2.01.20X9, VANGUARD presents the statement of financial position as provided by Figure 24.1. As a trading company, VANGUARD has to prepare financial statements by national law, even as it is no limited company with regard to its legal form. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 54,000.00 Owner's capital 60,000.00 Intangibles Reserves Financial assets R/ E 40,000.00 Current assets Liabilities Inventory 10,000.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 36,000.00 100,000.00 100,000.00 VANGUARD's STATEMENT of FINANCIAL POSITION as at 1.01.20X9 Figure 24.1: VANGUARD’s statement of financial position <?page no="218"?> Berkau: BASICS of ACCOUNTING 24-217 VANGUARD’s statement of financial position does not display issued capital. There was no issue of shares when the company was founded. Instead, the item is called owner’s capital. With a partnership, we would write “owners’ capital” in order to indicate there are more than one owner. (Note, the distinction in capital and retained earnings is for teaching purpose. The company can just disclose an owner’s equity to the extent of 100,000.00 EUR.) It is advised to transfer the opening amounts into the company’s accounts for further bookkeeping entries. This is shown in Figure 24.2: D C D C OV 90,000.00 OV 36,000.00 D C D C OV 10,000.00 OV 36,000.00 D C D C OV 60,000.00 OV 40,000.00 Owner's capital R/ E Inventories Cash/ Bank P, P, E Acc depr Figure 24.2: VANGUARD’s accounts The oven and the heat lamp were bought at 90,000.00 EUR cost of acquisition. The annual depreciation amounts to 9,000.00 EUR. VANGUARD is a VAT registered company. The landlord also is registered for VAT reduction. When VANGUARD pays the amount for rent, VAT is be considered. The annual rent is 30,000.00 EUR (net amount). The amount is paid by bank transfer on 7.01.20X9. The gross amount is: 30,000 × 120% = 36,000.00 EUR . (2) Rent payment on 7.01.20X9. DR Rent......................... 30,000.00 EUR DR VAT.......................... 6,000.00 EUR CR Cash/ Bank.................... 36,000.00 EUR VANGUARD further purchases materials which is dough and ingredients for the pie fillings. The amount is 55,200.00 EUR (ex VAT). The purchase is paid by bank transfer on 9.01.20X9 and amounts to: 55,200 × 120% = 66,240.00 EUR . (3) Purchase of materials on 9.01.20X9 <?page no="219"?> Berkau: BASICS of ACCOUNTING 24-218 DR Purchase..................... 55,200.00 EUR DR VAT.......................... 11,040.00 EUR CR Cash/ Bank.................... 66,240.00 EUR The sales person earns an annual income of 28,800.00 EUR. The amount includes labour taxes and social security. The amount is considered being the total of labour here. It is paid on 15.01.20X9 by bank transfer. (4) Payment of labour on 15.01.20X9. DR Labour....................... 28,800.00 EUR CR Cash/ Bank.................... 28,800.00 EUR VANGUARD bakes a pie with any filling at 2.00 EUR unit costs. The costs do not contain the salary for the sales person working in the shop. Selling expenses in general are non-manufacturing expenses. The net selling price per pie is 3.50 EUR. VANGUARD sells during the year 48,960 pies. All customers are supposed to pay on cash as VANGUARD does not offer a credit card service. The simplified bookkeeping entry for the revenue is made on 30.06.20X9. The gross amount of cash received is: 48,960 × 3.50 × 120% = 205,632.00 EUR . In order to keep the example as easy as possible, we assume one customer buys all pies in the middle of the year. (5) Revenue earned by pie sales on 30.06.20X9. The net amount is: 205,632 / 120% = 171,360.00 EUR . DR Cash/ Bank.................... 205,632.00 EUR CR VAT.......................... 34,272.00 EUR CR Sales........................ 171,360.00 EUR On 1.07.20X9, T.L. VanGuard withdraws money from his company. He pays himself an amount of 30,000.00 EUR every 6 months. The taking out of cash is no expense for VANGUARD. It won’t be disclosed later on the face of the statement of comprehensive income. We apply the Drawings account for the transaction. (6) Drawing of 30,000.00 EUR on 1.07.20X9. DR Drawings..................... 30,000.00 EUR CR Cash/ Bank.................... 30,000.00 EUR On 31.12.20X9, VANGUARD makes a bookkeeping entry for depreciation. The amount is 9,000.00 EUR. The cost of acquisition (net amount) for the oven and the heat lamp were 90,000.00 EUR and the useful life was estimated to be 10 years. VANGUARD applies straight line method for depreciation. Annual depreciation is: 90,000/ 10 = 9,000.00 EUR/ a . (7) Depreciation recorded on 31.12.20X9: <?page no="220"?> Berkau: BASICS of ACCOUNTING 24-219 DR Depreciation................. 9,000.00 EUR CR Accumulated Depreciation..... 9,000.00 EUR T.L. VanGuard enjoys his own pies and eats every day 4 pies himself. He’ll work in his shop during 260 days/ a. Thus, he eats: 4 × 260 = 1,040 pies per Accounting period. We assume all costs for baking the pies contain VAT. The machines (oven and lamp) that are depreciated, the ingredients and rent are all relevant for input- VAT. Although depreciation itself is not relevant to VAT, the adjustment requires reducing the input-VAT claim on the machines bought by T.L. VanGuard. The labour for the sales person is not relevant for the pies T.L. VanGuard eats himself because the pies are not sold. The unit costs per pie amount to 2.00 EUR. The costs for the pies he eats amount to: 260 × 4 × 2 = 2,080.00 EUR . We have to consider a credit entry in the VAT account to reduce the amount of input-VAT for the following activities: acquisition, purchase and rent. The gross amount for the pies eaten by T.L. Van- Guard is: 2,080 × 120% = 2,496.00 EUR . In order to make the bookkeeping entry for the drawing, VANGUARD has to calculate the pies. The costs of baking pies contain per annum: depreciation on the oven and the heat lamp, materials and rent: 9,000 + 61,000 + 30,000 = 100,000.00 EUR . Every pie costs 2.00 EUR, so the EUR amount above represents 50,000 pies. The amount for materials is not the same as for the purchases, but VAN- GUARD had an amount of 10,000.00 EUR in the Inventory account at the beginning of the Accounting period. The calculation is relevant for the drawing. Otherwise VANGUARD could just run a stock count and calculate the material costs per pie in the Trading account. The amount of 61,000.00 EUR is given, here. The amount of input-VAT is to be reduced by: 2,496 - 2,080 = 416.00 EUR . VANGUARD runs a periodic inventory system. For that reason, VANGUARD has to deduct the expenses for the 1,040 pies per expense item when recording the drawings. The amounts are: for depreciation: 1,040 × 9,000 / 50,000 = 187.20 EUR ; for materials: 1,040 × 61,000 / 50,000 = 1,268.80 EUR and for rent: 1,040 × 30,000 / 50,000 = 624.00 EUR . Taking out these costs of: 187.20 + 1,268.80 + 624 = 2,080.00 EUR makes them not count as expenses for the business. (8) Bookkeeping entries for taking out pies on 31.12.20X9. DR Drawings..................... 2,496.00 EUR CR VAT.......................... 416.00 EUR CR Depreciation................. 187.20 EUR CR Materials.................... 1,268.80 EUR CR Rent......................... 624.00 EUR At the end of the year, T.L. VanGuard takes out another amount of 30,000.00 EUR. (9) Drawing of 30,000.00 EUR on 31.12.20X9: <?page no="221"?> Berkau: BASICS of ACCOUNTING 24-220 DR Drawings..................... 30,000.00 EUR CR Cash/ Bank.................... 30,000.00 EUR We take a look at VANGUARD’s accounts: D C D C OV 90,000.00 c/ d 90,000.00 OV 36,000.00 b/ d 90,000.00 c/ d 45,000.00 (7) 9,000.00 45,000.00 45,000.00 b/ d 45,000.00 P, P, E Acc depr D C D C OV 10,000.00 OV 36,000.00 (1) 12,000.00 (5) 205,632.00 (2) 36,000.00 (3) 66,240.00 (4) 28,800.00 (6) 30,000.00 (9) 30,000.00 c/ d 38,592.00 241,632.00 241,632.00 b/ d 38,592.00 D C D C c/ d 60,000.00 OV 60,000.00 OV 40,000.00 b/ d 60,000.00 Inventories Cash/ Bank Owner's capital R/ E D C D C (8) 1,268.80 (2) 30,000.00 (8) 624.00 c/ d 29,376.00 30,000.00 30,000.00 b/ d 29,376.00 D C D C (2) 6,000.00 (5) 34,272.00 (3) 55,200.00 c/ d 55,200.00 (3) 11,040.00 (8) 416.00 b/ d 55,200.00 c/ d 17,648.00 34,688.00 34,688.00 b/ d 17,648.00 Rent VAT Purchase Material expenses Figure 24.3: VANGUARD’s accounts <?page no="222"?> Berkau: BASICS of ACCOUNTING 24-221 D C D C (4) 28,800.00 c/ d 28,800.00 c/ d 171,360.00 (5) 171,360.00 b/ d 28,800.00 b/ d 171,360.00 Labour Sales D C D C (6) 30,000.00 (7) 9,000.00 (8) 187.20 (8) 2,496.00 c/ d 8,812.80 (9) 30,000.00 c/ d 62,496.00 9,000.00 9,000.00 62,496.00 62,496.00 b/ d 8,812.80 b/ d 62,496.00 Drawings Depreciation Figure 24.3: VANGUARD’s accounts (continued) Before VANGUARD can calculate the profit, it is necessary to count stock. The value of materials on stock is 4,200.00 EUR. The amount was to be expected as there was an opening value of 10,000.00 EUR and VANGUARD bought materials for 55,200.00 EUR. We know already that the materials are 61,000.00 EUR. Thus, the closing stock amounts to: 10,000 + 55,200 - 61,000 = 4,200.00 EUR . VANGUARD has to deduct the material expenses to the extent of the withdrawn (eaten) pies in the Trading account. D C D C OV 90,000.00 c/ d 90,000.00 OV 36,000.00 b/ d 90,000.00 c/ d 45,000.00 (7) 9,000.00 45,000.00 45,000.00 b/ d 45,000.00 D C D C OV 10,000.00 T/ A 10,000.00 OV 36,000.00 (2) 36,000.00 T/ A 4,200.00 c/ d 4,200.00 (5) 205,632.00 (3) 66,240.00 14,200.00 14,200.00 (4) 28,800.00 b/ d 4,200.00 (6) 30,000.00 (9) 30,000.00 c/ d 50,592.00 241,632.00 241,632.00 b/ d 50,592.00 D C D C c/ d 60,000.00 OV 60,000.00 OV 40,000.00 b/ d 60,000.00 c/ d 84,640.00 P&L 44,640.00 84,640.00 84,640.00 b/ d 84,640.00 Owner's capital R/ E Inventories Cash/ Bank P, P, E Acc depr Figure 24.4: VANGUARD’s accounts <?page no="223"?> Berkau: BASICS of ACCOUNTING 24-222 D C D C (3) 55,200.00 c/ d 55,200.00 (2) 30,000.00 (8) 624.00 b/ d 55,200.00 T/ A 55,200.00 c/ d 29,376.00 30,000.00 30,000.00 b/ d 29,376.00 P&L 29,376.00 D C D C (2) 6,000.00 (5) 34,272.00 T/ A 1,268.80 (8) 1,268.80 (3) 11,040.00 (8) 416.00 c/ d 17,648.00 34,688.00 34,688.00 b/ d 17,648.00 Purchase Rent VAT Material expenses D C D C (4) 28,800.00 c/ d 28,800.00 c/ d 171,360.00 (5) 171,360.00 b/ d 28,800.00 P&L 28,800.00 T/ A 171,360.00 b/ d 171,360.00 D C D C (6) 30,000.00 (7) 9,000.00 (8) 187.20 (8) 2,496.00 c/ d 8,812.80 (9) 30,000.00 c/ d 62,496.00 9,000.00 9,000.00 62,496.00 62,496.00 b/ d 8,812.80 P&L 8,812.80 b/ d 62,496.00 D C D C Inv 10,000.00 Rev 171,360.00 Dpr 8,812.80 T/ A 111,628.80 Prh 55,200.00 Inv 4,200.00 Lab 28,800.00 GP 111,628.80 Mat 1,268.80 Rnt 29,376.00 176,828.80 176,828.80 NP 44,640.00 P&L 111,628.80 b/ d 111,628.80 111,628.80 111,628.80 R/ E 44,640.00 b/ d 44,640.00 44,640.00 44,640.00 Trading account T/ A Profit and Loss P&L Drawings Depreciation Labour Sales Figure 24.4: VANGUARD’s accounts (continued) VANGUARD’s financial statements are displayed in Figure 24.5 and Figure 24.6: The income statement is free of expenses for T.L. VanGuard drawings (money taken out and pies he eats). Observe below: <?page no="224"?> Berkau: BASICS of ACCOUNTING 24-223 [EUR] Revenue 171,360.00 Other income 171,360.00 Materials 59,731.20 Labour 28,800.00 Depreciation 8,812.80 Other expenses 29,376.00 Earnings before int and taxes (EBIT) 44,640.00 Interest Earnings before taxes (EBT) 44,640.00 Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) 44,640.00 Vanguard's STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X9 Figure 24.5: VANGUARD’s statement of comprehensive income The amount for materials in the income statement equals to: 61,000 - 1,268.80 = 59,731.20 EUR . A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 45,000.00 Owner's capital 60,000.00 Intangibles Drawings (62,496.00) Financial assets R/ E 84,640.00 Current assets Liabilities Inventory 4,200.00 Interest bear liab A/ R A/ P 17,648.00 Prepaid expenses Provisions Cash/ Bank 50,592.00 99,792.00 99,792.00 VANGUARD's STATEMENT of FINANCIAL POSITION as at 1.01.20X9 Figure 24.6: VANGUARD’s statement of financial position Although, drawings is an item of the equity section, companies offset drawings with retained earnings and owners’ capital before they prepare the statement <?page no="225"?> Berkau: BASICS of ACCOUNTING 24-224 of financial position. Thus they only recognise one item named owner’s equity which would have been: 60,000 - 62,496 + 84,640 = 82,144.00 EUR . Summary: Taking assets out of a business is called drawings. Drawings are to be deducted from expenses recorded in the Profit and Loss account. Drawings do not change the profit of the business. In the event of assets other than cash are taken out, input-VAT is to be adjusted to the extent of goods/ services drawn. The Drawings account is to be closedoff to the Owners’ Equity account. Working Definition: Drawing: A drawing is taking out assets (e.g. materials or cash) of a business or to use business assets privately. <?page no="226"?> Berkau: BASICS of ACCOUNTING 25-225 25. Production Firms Learning Objectives: A production firm’s Accounting system is more difficult than a trading business’s one’s, because material/ goods movements inside of the factory must be recorded. Furthermore, overhead allocations take place in order to calculate the cost of goods manufactured. At the end of the Accounting period, the production firm has to recognise the value of finished goods and work in process on the balance sheet. The inventory of finished goods is to be valued at its costs of manufacturing. In this chapter, we’ll introduce Manufacturing Accounting as a means to calculate the unit cost of goods. After studying this chapter, you will be able to calculate unit costs of products manufactured and those, which will be still under production as they have not been finished yet. You will be familiar with the cost flow in production firms and you can prepare a balance sheet based on correct inventory valuations. Any asset bought is recognised at its cost of acquisition less accumulated depreciation and accumulated impairment losses. In some cases, revaluations apply. The costs of an asset produced in a factory are to be disclosed at its cost of manufacturing. The costs of manufacturing contain direct costs, such as materials and labour, and portions of overheads for resources deployed in the manufacturing process. All costs linked to production, such as materials, labour, depreciation on production facilities, supervisor’s salary etc., count as cost of manufacturing. However, costs not linked to production (called non-manufacturing overheads), such as administration costs and cost for distribution and advertising, never do. We refer to chapter 9 of the text book Bilanzen and of the ebook Accounting-2-Go for further consideration of Manufacturing Accounting. In production firms, at least 3 kinds of stock accounts apply. There are inventory accounts for raw materials, for work in process and for finished goods. Some companies even put semi-finished goods on stock and apply a Semi-Finished Goods Inventory account, too. We here stick to the basic 3 categories of Inventory accounts. The material flow is: raw materials → work in process → finished goods. Material bought is debited to the Raw Material Inventory account. Once materials are released from stock, because they go into a product, the Accountant will post them to the relevant job order. A job order is an internal order in a factory. It gathers all costs that occur during the production process. The reconciliation account for all job orders is the Work in Process WIP account - it represents the value of all products under production. (Note, in order to not confuse you with too many account names, we call the account for job order 90684: “WIP-90684”. The reconciliation account is named just “WIP account”. In the text below, we refer to WIP because a company is not obliged to apply subordinated job order accounts. However, they do for Management Accounting purpose.) <?page no="227"?> Berkau: BASICS of ACCOUNTING 25-226 The WIP account is debited for direct costs and applied overheads. Once the production is finished, the goods are put on stock. The Accountant then makes a debit entry in the Finished Goods Inventory account and credits the amount to the WIP account. Once a company sells the goods, they are released from stock (finished goods inventory) and put on the income statement as an expense. The expense account for finished goods released from stock is the Cost of Sales COS account. Once a good is sold, the Accountant makes a debit entry in the Cost of Sales account and debits the amount to the Finished Goods Inventory account. The costs of sales (= cost of goods sold) are the costs of manufacturing for goods that have been sold during the Accounting period. Why do Accountants in production firms have to know about the product calculation? It is for inventory valuation (raw materials + WIP + finished goods) on the balance sheet. The inventory valuation urges companies to calculate their goods on stock and those still in the factory. Furthermore, the detailed calculation of goods is required by Management Accounting. It is covered in part D of this text book. How it is done (expensing finished goods): (1) After materials have been purchased, assign them to an Inventory account. Best is to apply a Raw Materials Inventory account as a subordinated account to the Inventory account. (2) When a job order requests a release from stock assign the materials to that particular job order. Make a debit entry in the Job Order account and credit the amount to the Raw Materials Inventory account. (3) Assign further expenses to the job order. Do that either directly or by cost allocation. Other expenses can be direct labour, depreciation, material overheads etc. (4) Once a job order is finished, transfer the goods manufactured to the finished goods inventory. Close-off the Job Order account to the Inventory (finished goods) account. Best, apply a Finished Goods Inventory account. (5) Consider a sale of finished goods as expense. Debit the amount to the Cost of Sales (COS) account. (6) Close-off the Cost of Sales account to the Profit and Loss account. We explain the basic bookkeeping entries in this chapter by a case study about the bicycle manufacturer REGENT BIKE (Pty) Ltd. REGENT BIKE (Pty) Ltd. is a bicycle assembling firm. The company is established on 2.01.20X2 when the proprietors pay 50,000.00 EUR into the company’s bank account. <?page no="228"?> Berkau: BASICS of ACCOUNTING 25-227 (1) Establishment of the company on 2.01.20X2. DR Cash/ Bank.................... 50,000.00 EUR CR Issued Capital............... 50,000.00 EUR REGENT BIKE (Pty) Ltd. registers for VAT reduction. REGENT BIKE (Pty) Ltd. rents a workshop at 1,000.00 EUR/ month and pays rent in advance for the whole year on 2.01.20X2. The landlord is a private person. Accordingly, rent is not VAT relevant for REGENT BIKE (Pty) Ltd. The rent is paid by bank transfer into the landlord’s bank account. (2) Rent payment on 2.01.20X2. DR Rent......................... 12,000.00 EUR CR Cash/ Bank.................... 12,000.00 EUR On 3.01.20X2, REGENT BIKE (Pty) Ltd. buys 40,000 wheels at 21.00 EUR (net amount) each. Furthermore, REGENT BIKE (Pty) Ltd. buys 30,000 frames at 56.00 EUR (net amount) each. The net amount of the purchases is: 40,000 × 21 + 30,000 × 56 = 2,520,000.00 EUR . The amount including VAT is 2,520,000 × 120% = 3,024,000.00 EUR . REGENT BIKE (Pty) Ltd. pays it by a bank transfer to the supplier’s bank accounts. (3) Purchase of wheels and frames on 3.01.20X2. DR Purchase..................... 2,520,000.00 EUR DR VAT.......................... 504,000.00 EUR CR Cash/ Bank.................... 3,024,000.00 EUR The purchase is transferred to the Raw Materials Inventory account immediately. REGENT BIKE (Pty) Ltd. applies special Inventory accounts: for raw materials, for WIP and for finished goods. (4) Putting materials on stock on 3.01.20X2. DR Raw Materials Inventory...... 2,520,000.00 EUR CR Purchase..................... 2,520,000.00 EUR REGENT BIKE (Pty) Ltd. pays salaries for the assembling team. For the sake of a simplification, we here ignore taxes on labour and social security and assume the workers are employed on a freelancer basis. The amount for labour paid is 96,000.00 EUR. REGENT BIKE (Pty) Ltd. pays the amount in the middle of the year. (5) Payment for labour on 1.07.20X2. <?page no="229"?> Berkau: BASICS of ACCOUNTING 25-228 DR Labour....................... 96,000.00 EUR CR Cash/ Bank.................... 96,000.00 EUR During the Accounting period 20X2, REGENT BIKE (Pty) Ltd. produces 20,000 bicycles. The bookkeeping entries with regard to costs linked to production are debited to the WIP account. The amount for labour equals to 96,000.00 EUR. The amount for rent is 12,000.00 EUR. For materials we consider 40,000 wheels and 20,000 frames being released from stock. The EURamount therefor is: 40,000 × 21 + 20,000 × 56 = 1,960,000.00 EUR . There are still materials left on stock. (6) Production of 20,000 bicycles as recorded in the WIP account, on 2.02.20X2. DR WIP.......................... 2,068,000.00 EUR CR Raw Materials................ 1,960,000.00 EUR CR Labour....................... 96,000.00 EUR CR Rent......................... 12,000.00 EUR All bicycles are finished on 4.12.20X2 and put on stock. This means the bicycles are physically put into the storage room and posted to the finished goods inventory. (7) Completion of 20,000 bicycles on 4.12.20X2. DR Finished Goods Inventory..... 2,068,000.00 EUR CR WIP.......................... 2,068,000.00 EUR A valuation of one bicycle requires dividing all cost of manufacturing by the lot size. The lot size is the amount of goods manufactured by one job order. Here, the unit costs are: 2,068,000/ 20,000 = 103.40 EUR/ u . During the Christmas sale, REGENT BIKE (Pty) Ltd. sells 17,500 bicycles at a net selling price of 200.00 EUR/ u to a wholesaler. The transaction is made on 6.12.20X2 and the wholesaler pays by bank transfer instantly. The net amount is: 17,500 × 200 = 3,500,000.00 EUR . The gross amount equals to: 3,500,000 × 120% = 4,200,000.00 EUR . (8) Sale of 17,500 bicycles on 6.12.20X2. DR Cash/ Bank.................... 4,200,000.00 EUR CR VAT.......................... 700,000.00 EUR CR Sales........................ 3,500,000.00 EUR The previous bookkeeping entry only considers the payment linked to the sale. No cost of sales have been recorded yet. Now, we post the material flow for the bicycles delivered to the customer. There is a debit entry in the Cost of Sales account. The credit entry is made in the Finished Goods Inventory account as the bicycles are released from stock. The bookkeeping entry is made on the same day as the sales take place, on <?page no="230"?> Berkau: BASICS of ACCOUNTING 25-229 6.12.20X4. The valuation is at unit costs of 103.40 EUR. The costs of sales amount equals to: 103.40 × 17,500 = 1,809,500.00 EUR . (9) Releasing 17,500 bicycles from stock on 6.12.20X4. DR Cost of Goods Sold (COS)..... 1,809,500.00 EUR CR Finished Goods Inventory..... 1,809,500.00 EUR The cost for distribution and for administration are 10,000.00 EUR/ a and 30,000.00 EUR/ a respectively. The amounts are paid on cash on 31.12.20X2. These costs are non-manufacturing costs. They must not be posted to WIP. If they were added to work in process, the calculation and inventory valuation would contain non-manufacturing costs. This is strictly prohibited by IAS 2 and § 255 HGB. (10), (11) Distribution and administration expenses recorded on 31.12.20X2. DR Distribution................. 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR DR Administration............... 30,000.00 EUR CR Cash/ Bank.................... 30,000.00 EUR Before we determine the profit earned by REGENT BIKE (Pty) Ltd., we take a look at the accounts and study the bookkeeping entries. Observe Figure 25.1: D C D C (1) 50,000.00 (2) 12,000.00 c/ d 50,000.00 (1) 50,000.00 (8) 4,200,000.00 (3) 3,024,000.00 b/ d 50,000.00 (5) 96,000.00 (10) 10,000.00 (11) 30,000.00 c/ d 1,078,000.00 4,250,000.00 4,250,000.00 b/ d 1,078,000.00 D C D C (2) 12,000.00 (6) 12,000.00 (3) 2,520,000.00 (4) 2,520,000.00 Cash/ Bank Issued capital Rent Purchase Figure 25.1: REGENT BIKE (Pty) Ltd.’s accounts <?page no="231"?> Berkau: BASICS of ACCOUNTING 25-230 D C D C (3) 504,000.00 (8) 700,000.00 (4) 2,520,000.00 (6) 1,960,000.00 c/ d 196,000.00 c/ d 560,000.00 700,000.00 700,000.00 2,520,000.00 2,520,000.00 b/ d 196,000.00 b/ d 560,000.00 VAT RM Inventory D C D C (5) 96,000.00 (6) 96,000.00 (6) 2,068,000.00 (7) 2,068,000.00 D C D C (7) 2,068,000.00 (9) 1,809,500.00 (8) 3,500,000.00 c/ d 258,500.00 2,068,000.00 2,068,000.00 b/ d 258,500.00 D C D C (10) 10,000.00 (11) 30,000.00 D C (9) 1,809,500.00 FG Inventory Sales Cost of goods sold Labour WIP Distribution Administration D C D C (1) 50,000.00 (2) 12,000.00 c/ d 50,000.00 (1) 50,000.00 (8) 4,200,000.00 (3) 3,024,000.00 b/ d 50,000.00 (5) 96,000.00 (10) 10,000.00 (11) 30,000.00 c/ d 1,078,000.00 4,250,000.00 4,250,000.00 b/ d 1,078,000.00 D C D C (2) 12,000.00 (6) 12,000.00 (3) 2,520,000.00 (4) 2,520,000.00 Cash/ Bank Issued capital Rent Purchase Figure 25.1: REGENT BIKE (Pty) Ltd.’s accounts (continued) Some of the accounts have been balanced-off already. In this case study, it is not necessary to run a stock count as the inventory movements have been recorded by the Accounting system. The closing stock of the raw materials inventories is 560,000.00 EUR. This amount equals to the value of 10,000 frames left on stock: 10,000 × 56 = 560,000.00 EUR . The balancing figure in the Cost of <?page no="232"?> Berkau: BASICS of ACCOUNTING 25-231 Goods Sold (COS) account results from 2,500 bicycles, valued at their cost of manufacturing: 2,500 × 103.40 = 258,500.00 EUR . The next step is to close-off the Cost of Goods Sold (COS) account to the Profit and Loss account. The earnings after taxes will be transferred to retained earnings after income taxes are deducted. The pre-tax profit is calculated by subtracting the cost of goods sold (COS), distribution costs and administration costs from sales: 3,500,000 - 1,809,500 - 10,000 - 30,000 = 1,650,500.00 EUR . A company that applies the Cost of Goods Sold (COS) account will prepare its income statement along the cost of sales format. Observe Figure 25.3 to familiarise yourself with the new structure for the income statement. See the profit calculation as described above in Figure 25.2: D C D C (2) 12,000.00 (6) 12,000.00 (3) 2,520,000.00 (4) 2,520,000.00 D C D C (3) 504,000.00 (8) 700,000.00 (4) 2,520,000.00 (6) 1,960,000.00 c/ d 196,000.00 c/ d 560,000.00 700,000.00 700,000.00 2,520,000.00 2,520,000.00 b/ d 196,000.00 b/ d 560,000.00 D C D C (5) 96,000.00 (6) 96,000.00 (6) 2,068,000.00 (7) 2,068,000.00 D C D C (7) 2,068,000.00 (9) 1,809,500.00 P&L 3,500,000.00 (8) 3,500,000.00 c/ d 258,500.00 2,068,000.00 2,068,000.00 b/ d 258,500.00 D C D C (10) 10,000.00 c/ d 10,000.00 (11) 30,000.00 c/ d 30,000.00 b/ d 10,000.00 P&L 10,000.00 b/ d 30,000.00 P&L 30,000.00 VAT RM Inventory Labour WIP Rent Purchase FG Inventory Sales Administration Distribution <?page no="233"?> Berkau: BASICS of ACCOUNTING 25-232 D C D C (10) 10,000.00 c/ d 10,000.00 (11) 30,000.00 c/ d 30,000.00 b/ d 10,000.00 P&L 10,000.00 b/ d 30,000.00 P&L 30,000.00 D C D C (9) 1,809,500.00 P&L 1,809,500.00 COS 1,809,500.00 Rev 3,500,000.00 c/ d 1,690,500.00 3,500,000.00 3,500,000.00 Dstr 10,000.00 b/ d 1,690,500.00 Adm 30,000.00 NP c/ 1,650,500.00 1,690,500.00 1,690,500.00 R/ E 1,155,350.00 b/ d 1,650,500.00 ITL 495,150.00 1,650,500.00 1,650,500.00 Administration Distribution Cost of goods sold Profit and Loss Figure 25.2: REGENT BIKES (Pty) Ltd.’s accounts D C D C c/ d 1,155,350.00 P&L 1,155,350.00 c/ d 495,150.00 P&L 495,150.00 b/ d 1,155,350.00 b/ d 495,150.00 R/ E Income tax liabilities Figure 25.2: REGENT BIKE (Pty) Ltd.’s accounts (continued) The financial statements for REGENT BIKE (Pty) Ltd. follow depicted by Figure 25.3 and Figure 25.4: <?page no="234"?> Berkau: BASICS of ACCOUNTING 25-233 [EUR] Revenue 3,500,000.00 Other income 3,500,000.00 Cost of goods sold 1,809,500.00 Margin 1,690,500.00 Distribution 10,000.00 Administration 30,000.00 Earnings before int and taxes (EBIT) 1,650,500.00 Interest Earnings before taxes (EBT) 1,650,500.00 Income tax expenses 495,150.00 Deferred taxes Earnings after taxes (EAT) 1,155,350.00 Regent Bike (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X2 Figure 25.3: REGENT BIKE (Pty) Ltd.’s statement of comprehensive income The amount for inventory on the balance sheet results from raw materials and finished goods: 560,000 + 258,500 = 818,500.00 EUR . The amount for accounts payables A/ P results from output-VAT. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Issued capital 50,000.00 Intangibles Reserves Financial assets R/ E 1,155,350.00 Current assets Liabilities Inventory 818,500.00 Interest bear liab A/ R A/ P 196,000.00 Prepaid expenses Provisions Cash/ Bank 1,078,000.00 Tax liabilities 495,150.00 1,896,500.00 1,896,500.00 Regent Bikes (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 25.4: REGENT BIKES (Pty) Ltd.’s statement of financial position <?page no="235"?> Berkau: BASICS of ACCOUNTING 25-234 Summary: Production firms apply three special Inventory accounts. There is a Raw Materials Inventory account, a Work in Process account and a Finished Goods Inventory account. Cost for the goods still in the manufacturing process will be recorded in the WIP account until the production process is completed. Once production is completed, the costs of the products are transferred to the Finished Goods Inventory account. Finished goods are expensed, once they are sold. For expensing finished goods the Cost of Goods Sold (COS) account is debited and Finished Goods Inventory account is credited. Working Definitions: Cost of Manufacturing: The costs of manufacturing contain direct costs, such as materials and labour, and portions of overheads for resources deployed in the manufacturing process. Job Order: A job order is an internal order in a factory. WIP account: The reconciliation account for all job orders is the Work in Process WIP account - it represents the value of all products under production. Cost of Sales/ Cost of Goods Sold: The expense account for finished goods released from stock is called the Cost of Sales account. Lot Size: The lot size is the amount of goods manufactured by one job order. <?page no="236"?> Berkau: BASICS of ACCOUNTING 26-235 26. Inventory Systems Learning Objectives: In this chapter we introduce a more sophisticated inventory system that allows the determination of stock levels at any time. So far, we focussed on a periodic inventory system which only records inputs and requires stock counts at the end of the Accounting period. We now show how inventory movements can be recorded whenever goods are taken from stock. Applying a perpetual inventory system, real-time information about stock levels is available at any time. After studying this chapter, you are qualified to discuss and decide about appropriate inventory systems and you can apply a periodic and a perpetual one. We start by a retrospection: when we calculated profit in a trading business, we applied the Purchase account and closed it off to the Trading account at the end of the Accounting period. We computed the material expenses as opening amount of the inventories plus all purchases less closing stock and less any returns inwards. In order to determine the closing stock, we counted stock. As stock counting takes place at the end of the Accounting period, the inventory system is referred to as periodic inventory system. A periodic inventory system records inventory movements based on input postings and stock counting at the end of the Accounting period. How it is done (periodic inventory system): (1) Prepare Inventory accounts for particular kind of stock like materials, work in process and finished goods. Split up accounts for different kind of inventory, for different materials e.g. (2) The opening amount of inventory is displayed on the debit side of the Inventory account. (3) Add purchases to the debit side of the Trading account. Credit the Purchases account accordingly. (4) When taking goods (materials, finished goods) from stock, do not make entries. (5) When you prepare the financial statements on the balance sheet day, count stock. Credit the closing stock to the Trading account and make a corresponding debit entry in the Inventory account. Calculate material expenses as opening value plus purchases less closing stock. Consider returns, too. (7) Consider special situations that might occur like disposals, impairment losses, value adjustments, discounts etc. <?page no="237"?> Berkau: BASICS of ACCOUNTING 26-236 Many companies need to know the current level of their goods/ parts on stock at real-time. E.g., a trading company wants to know the amount of goods still on stock in order to decide when to re-order further goods. If you shop in a department store, you can see that at the cash point scanners are used to read the price tags. The scanners make the cashiers’ lives more comfortable because he/ she does not have to key in the prices anymore. However, the main reason for the scanner application is that the barcode information contains the goods identification number, which is captured to deduct the good sold from stock. So, the scan triggers a bookkeeping entry such as: DR Cost of Sales account - CR Inventory account. If a company records releases from stock, it applies a perpetual inventory system. A perpetual inventory system records inventory movements in realtime, based on inputs and outputs. No stock count is necessary, if a perpetual system applies. Most of companies nowadays run a perpetual inventory system at least for their important goods/ parts. Only less important material movements such as the stock of office materials (pencils) might be calculated based on a periodic inventory system. How it is done (perpetual inventory system): (1) Prepare Inventory accounts for particular kind of stock like materials, work in process and finished goods. Split up accounts for different kind of inventory, for different materials e.g. (2) The opening amount of inventory is displayed on the debit side of the Inventory account. (3) Add purchases to the debit side of the Inventory account. Credit the Purchases account accordingly. (4) When taking goods (materials, finished goods) from stock, make a debit entry in the Material Expense account or the Cost of Goods Sold (COS) account and credit the amount to the relevant Inventory account. (5) Once you want to know the level of stock of a particular item, balance-off the relevant Inventory account. (6) When you prepare the financial statements on the balance sheet day, balance-off the accounts also and add stock levels of different goods to the inventory item on the balance sheet. (7) Consider special situations that might occur like disposals, impairment losses, value adjustments, discounts etc. In order to explain a perpetual inventory system, we’ll study an example of the furniture dealership WITSAND (Pty) Ltd. We first discuss the periodic <?page no="238"?> Berkau: BASICS of ACCOUNTING 26-237 system and later present the same example again but then applying the perpetual inventory system. This way, you can see the differences between the inventory movement systems clearly. Periodic Inventory System: WITSAND (Pty) Ltd. is a bed store. It sells double beds (160 × 200), queen size beds (140 × 200), single beds (90 × 200) and cots (80 × 150). The purchase prices (net amounts) for the beds are 200.00 EUR/ u for a double bed, 190.00 EUR/ u for a queen size bed, 180.00 EUR/ u for a single bed and 150.00 EUR/ u for a cot. At the beginning of the Accounting period, WITSAND (Pty) Ltd. has 3 double beds and 14 cots on stock. The opening amount for stock is: 3 × 200 + 14 × 150 = 2,700.00 EUR . The opening statement of financial position for WITSAND (Pty) Ltd. as at 2.01.20X3 is provided by Figure 26.1. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 25,000.00 Share capital 50,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 2,700.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 22,300.00 Tax liabilities 50,000.00 50,000.00 Witsand (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X3 Figure 26.1: WITSAND (Pty) Ltd.’s statement of financial position The accounts at the beginning of the Accounting period look as displayed in Figure 26.2. The Inventory account therein is linked to all beds on stock. D C D C OV 25,000.00 OV 2,700.00 P,P,E Inventory Figure 26.2: WITSAND (Pty) Ltd.’s accounts <?page no="239"?> Berkau: BASICS of ACCOUNTING 26-238 D C D C OV 22,300.00 OV 50,000.00 Cash/ Bank Issued capital Figure 26.2: WITSAND (Pty) Ltd.’s accounts (continued) WITSAND (Pty) Ltd. purchases beds in January. It buys 15 double beds at a cost of purchase of 200.00 EUR/ u, 20 queen size beds at a cost of purchase of 190.00 EUR/ u, 30 single beds at a cost of purchase of 180.00 EUR/ u and 25 cots at 150.00 EUR/ u. All above amounts are net amounts. No costs have been changed. The payments are made by bank transfer, immediately. Thus, the contra account for the purchases always is the Cash/ Bank account. (1) Purchase of 15 double beds on 4.01.20X3 at cost of purchase of: 15 × 200 = 3,000.00 EUR . DR Purchase..................... 3,000.00 EUR DR VAT.......................... 600.00 EUR CR Cash/ Bank.................... 3,600.00 EUR (2) Purchase of 20 queen size beds on 4.01.20X3 at cost of purchase of: 20 × 190 = 3,800.00 EUR . DR Purchase..................... 3,800.00 EUR DR VAT.......................... 760.00 EUR CR Cash/ Bank.................... 4,560.00 EUR (3) Purchase of 30 single beds on 4.01.20X3 at cost of purchase of: 30 × 180 = 5,400.00 EUR . DR Purchase..................... 5,400.00 EUR DR VAT.......................... 1,080.00 EUR CR Cash/ Bank.................... 6,480.00 EUR (4) Purchase of 25 cots on 4.01.20X3 at cost of purchase of: 25 × 150 = 3,750.00 EUR . DR Purchase..................... 3,750.00 EUR DR VAT.......................... 750.00 EUR CR Cash/ Bank.................... 4,500.00 EUR <?page no="240"?> Berkau: BASICS of ACCOUNTING 26-239 The next postings are for sales. The net selling prices at WITSAND (Pty) Ltd. are as below: double bed: 350.00 EUR/ u, queen size bed: 300.00 EUR/ u, single bed 250.00 EUR/ u, cot 200.00 EUR/ u. On 8.01.20X3, WITSAND (Pty) Ltd. sells 2 double beds, 5 queen size beds and 10 cots on cash. The bookkeeping entries are as below: (5) Sale of 2 double beds, 5 queen size beds and 10 kids’ beds on 8.01.20X3 at a net selling price of: 2 × 350 + 5 × 300 + 10 × 200 = 4,200.00 EUR . The gross amount thereof equals to: 4,200 × 120% = 5,040.00 EUR . DR Cash/ Bank.................... 5,040.00 EUR CR VAT.......................... 840.00 EUR CR Sales........................ 4,200.00 EUR On 9.02.20X3, WITSAND (Pty) Ltd. sells 8 double beds, 7 queen size beds and 15 single beds at a net selling price of: 8 × 350 + 7 × 300 + 15 × 250 = 8,650.00 EUR . The gross amount equals to: 8,650 × 120% = 10,380.00 EUR . (6) Sales of beds on 9.02.20X3. DR Cash/ Bank.................... 10,380.00 EUR CR VAT.......................... 1,730.00 EUR CR Sales........................ 8,650.00 EUR On 7.03.20X3, WITSAND (Pty) Ltd. orders 20 double beds and pays the amount of 240.00 EUR/ u on cash. The total net amount of the purchase is: 20 × 200 = 4,000.00 EUR . The gross amount equals to: 4,000 × 120% = 4,800.00 EUR . (7) Purchase of 20 double beds on 7.03.20X3. DR Purchase..................... 4,000.00 EUR DR VAT.......................... 800.00 EUR CR Cash/ Bank.................... 4,800.00 EUR On 9.07.20X3, WITSAND (Pty) Ltd. sells 24 double beds, 8 queen size beds, 5 single beds and 29 cots on cash. The net selling price is: 24 × 350 + 8 × 300 + 5 × 250 + 29 × 200 = 17,850.00 EUR . The gross amount equals to: 17,850 × 120% = 21,420.00 EUR . (8) Sales of beds on 9.07.20X3. DR Cash/ Bank.................... 21,420.00 EUR DR VAT.......................... 3,570.00 EUR CR Sales........................ 17,850.00 EUR There is only one further activity at WITSAND (Pty) Ltd.: The company pays 2,000.00 EUR rent per bank transfer. For rent, no VAT is relevant because the landlord is not registered for VAT reduction. <?page no="241"?> Berkau: BASICS of ACCOUNTING 26-240 (9) Rent for the shop (31.12.20X3). DR Rent......................... 2,000.00 EUR CR Cash/ Bank.................... 2,000.00 EUR The Accountant balances-off all accounts, see Figure 26.3. D C D C OV 25,000.00 c/ d 25,000.00 OV 2,700.00 c/ d 2,700.00 b/ d 25,000.00 b/ d 2,700.00 D C D C OV 22,300.00 (1) 3,600.00 c/ d 50,000.00 OV 50,000.00 (5) 5,040.00 (2) 4,560.00 b/ d 50,000.00 (6) 10,380.00 (3) 6,480.00 (8) 21,420.00 (4) 4,500.00 (7) 4,800.00 (9) 2,000.00 c/ d 33,200.00 59,140.00 59,140.00 b/ d 33,200.00 P,P,E Inventory Cash/ Bank Issued capital D C D C (1) 600.00 (5) 840.00 (1) 3,000.00 (2) 760.00 (6) 1,730.00 (2) 3,800.00 (3) 1,080.00 (8) 3,570.00 (3) 5,400.00 (4) 750.00 (4) 3,750.00 (7) 800.00 (7) 4,000.00 c/ d 19,950.00 c/ d 2,150.00 19,950.00 19,950.00 6,140.00 6,140.00 b/ d 19,950.00 b/ d 2,150.00 D C D C (5) 4,200.00 (9) 2,000.00 c/ d 2,000.00 (6) 8,650.00 b/ d 2,000.00 c/ d 30,700.00 (8) 17,850.00 30,700.00 30,700.00 b/ d 30,700.00 VAT Purchase Sales Rent Figure 26.3: WITSAND (Pty) Ltd.’s accounts <?page no="242"?> Berkau: BASICS of ACCOUNTING 26-241 Although the accounts are blocked for the Accounting period already, the balancing figure of the Inventory account shows the opening amount as at the beginning of the Accounting period still: 2,700.00 EUR. At the end of the Accounting period 20X3, WITSAND (Pty) Ltd. runs a stock count. This is required for the application of a periodic inventory system. It reveals that there are still: 3 + 15 - 2 - 8 + 20 - 24 = 4 double beds on stock. There are: 20 - 5 - 7 - 8 = 0 queen size beds left. The amount of single beds is: 30 - 15 - 5 = 10 single beds and there are no cots left: 14 + 25 - 10 - 29 = 0 cots . Thus, the closing stock value adds up to: 4 × 200 + 10 × 180 = 2,600.00 EUR . WITSAND (Pty) Ltd. applies a Trading account for gross profit calculation. According to a periodic inventory system, the amount of inventory, the purchases and the closing stock are transferred to the Trading account. All figures together represent the total of material expenses. Furthermore, the Sales account is closed-off to the Trading account. DR T/ A .......................... 2,700.00 EUR CR Inventory.................... 2,700.00 EUR Applying a periodic inventory system requires always transferring opening and closing amounts of inventory to the Trading account, as well as all purchases. DR T/ A .......................... 19,950.00 EUR CR Purchase..................... 19,950.00 EUR DR Inventory.................... 2,600.00 EUR CR T/ A .......................... 2,600.00 EUR The latter bookkeeping entry is based on the closing stock as determined by stock count. The next bookkeeping entry transfers sales to the Trading account by closing-off the Sales account to the Trading account. DR Sales........................ 30,700.00 EUR CR T/ A .......................... 30,700.00 EUR The gross profit of WITSAND (Pty) Ltd. amounts to: 30,700 + 2,600 - 2,700 - 19,950 = 10,650.00 EUR . This amount is transferred to the Profit and Loss account by closing-off the Trading account thereto. DR T/ A .......................... 10,650.00 EUR CR Profit and Loss.............. 10,650.00 EUR The Rent account is closed-off to the Profit and Loss account - and not to the Trading account. Rent is no inventory movement and thus not relevant for the gross profit calculation. <?page no="243"?> Berkau: BASICS of ACCOUNTING 26-242 DR Profit and Loss.............. 2,000.00 EUR CR Rent......................... 2,000.00 EUR The earnings before taxes are: 10,650 - 2,000 = 8,650.00 EUR . The amount for income taxes is: 8,650 × 30% = 2,595.00 EUR and for retained earnings: 8,650 - 2,595 = 6,055.00 EUR . They are transferred to the Income Tax Liability account and to the Retained Earnings account. DR P&L.......................... 2,595.00 EUR CR Income Tax Liabilities....... 2,595.00 EUR DR P&L.......................... 6,055.00 EUR CR Retained Earnings............ 6,055.00 EUR Observe the accounts in Figure 26.4. D C D C OV 25,000.00 c/ d 25,000.00 OV 2,700.00 c/ d 2,700.00 b/ d 25,000.00 b/ d 2,700.00 T/ A 2,700.00 T/ A 2,600.00 c/ d 2,600.00 5,300.00 5,300.00 b/ d 2,600.00 P,P,E Inventory D C D C OV 22,300.00 (1) 3,600.00 c/ d 50,000.00 OV 50,000.00 (5) 5,040.00 (2) 4,560.00 b/ d 50,000.00 (6) 10,380.00 (3) 6,480.00 (8) 21,420.00 (4) 4,500.00 (7) 4,800.00 (9) 2,000.00 c/ d 33,200.00 59,140.00 59,140.00 b/ d 33,200.00 Cash/ Bank Issued capital D C D C (1) 600.00 (5) 840.00 (1) 3,000.00 (2) 760.00 (6) 1,730.00 (2) 3,800.00 (3) 1,080.00 (8) 3,570.00 (3) 5,400.00 (4) 750.00 (4) 3,750.00 (7) 800.00 (7) 4,000.00 c/ d 19,950.00 c/ d 2,150.00 19,950.00 19,950.00 6,140.00 6,140.00 b/ d 19,950.00 T/ A 19,950.00 b/ d 2,150.00 VAT Purchase Figure 26.4: WITSAND (Pty) Ltd.’s accounts <?page no="244"?> Berkau: BASICS of ACCOUNTING 26-243 D C D C (5) 4,200.00 (9) 2,000.00 c/ d 2,000.00 (6) 8,650.00 b/ d 2,000.00 P&L 2,000.00 c/ d 30,700.00 (8) 17,850.00 30,700.00 30,700.00 T/ A 30,700.00 b/ d 30,700.00 D C D C Inv 2,700.00 Sales 30,700.00 Rent 2,000.00 T/ A 10,650.00 Purch 19,950.00 Inv 2,600.00 NP c/ 8,650.00 GP c/ 10,650.00 10,650.00 10,650.00 33,300.00 33,300.00 Tax 2,595.00 b/ d 8,650.00 P&L 10,650.00 b/ d 10,650.00 R/ E 6,055.00 8,650.00 8,650.00 Trading account Profit and Loss Sales Rent D C D C c/ d 2,595.00 P&L 2,595.00 c/ d 6,055.00 P&L 6,055.00 b/ d 2,595.00 b/ d 6,055.00 Income tax liabilities Retained earnings Figure 26.4: WITSAND (Pty) Ltd.’s accounts (continued) Observe the financial statements as at 31.12.20X3 for WITSAND (Pty) Ltd. in Figure 26.5 and Figure 26.6. The amount for payables in the statement of financial position results from VAT payables. This is the amount output-VAT exceeds input-VAT: 6,140 - 3,990 = 2,150.00 EUR . <?page no="245"?> Berkau: BASICS of ACCOUNTING 26-244 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 25,000.00 Share capital 50,000.00 Intangibles Reserves Financial assets R/ E 6,055.00 Current assets Liabilities Inventory 2,600.00 Interest bear liab A/ R A/ P 2,150.00 Prepaid expenses Provisions Cash/ Bank 33,200.00 Tax liabilities 2,595.00 60,800.00 60,800.00 Witsands (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X3 Figure 26.5: WITSAND (Pty) Ltd.’s statement of financial position The statement of comprehensive income shows material expenses resulting from the opening value of stock plus the purchases and less closing stock to an extent of: 2,700 + 19,950 - 2,600 = 20,050.00 EUR . [EUR] Revenue 30,700.00 Other income 30,700.00 Materials 20,050.00 Labour Depreciation Other expenses 2,000.00 Earnings before int and taxes (EBIT) 8,650.00 Interest 0.00 Earnings before taxes (EBT) 8,650.00 Income tax expenses 2,595.00 Deferred taxes Earnings after taxes (EAT) 6,055.00 Witsand (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 26.6: WITSAND (Pty) Ltd.’s statement of comprehensive income <?page no="246"?> Berkau: BASICS of ACCOUNTING 26-245 Perpetual Inventory System: With a perpetual inventory system, bookkeeping entries for material inputs are the same. Applying a periodic inventory system, no releases from stock are recorded. However, in a perpetual inventory system, bookkeeping entries for releasing goods/ parts from stock are made. This gives the advantage of reading stock levels from the Inventory accounts at any time. The number of the bookkeeping entries increase for this case study WITSAND (Pty) Ltd, once we apply the perpetual inventory system. Think about a big supermarket with a lot of sale transactions. The bookkeeping entries made applying the perpetual inventory system, will be much more than for a periodic inventory system. Every customer buying goods triggers a bookkeeping entry for every single item bought. In order to not confuse you with previous postings, the example linked to the perpetual inventory system identifies its bookkeeping entries now by letters, such as (a), (b), (c) etc. The accounts at the beginning of the Accounting period look similar to those as in Figure 26.2. In contrast to Figure 26.2, there are now special accounts for the different kinds of beds. You could apply subordinated inventory accounts for a periodic inventory system as well. For the perpetual inventory system, the splitting of the Inventory account makes more sense, because we want to know the stock level of particular goods, e.g. queen size beds. WITSAND (Pty) Ltd. keeps an Inventory account for double beds, one for queen size beds, one for single beds and another one for cots. The opening amounts for double beds are: 3 × 200 = 600.00 EUR and for cots: 14 × 150 = 2,100.00 EUR . No queen size beds nor single beds are on stock at the beginning of the Accounting period. D C D C OV 25,000.00 OV 600.00 D C D C OV 0.00 OV 0.00 P, P, E Inventory double bed Inventory queen size Inventory single bed D C D C OV 2,100.00 OV 22,300.00 Inventory cots Cash/ Bank Figure 26.7: WITSAND (Pty) Ltd.’s accounts <?page no="247"?> Berkau: BASICS of ACCOUNTING 26-246 D C OV 50,000.00 Issued capital Figure 26.7: WITSAND (Pty) Ltd.’s accounts (continued) When any inventory movements are recorded with a perpetual inventory system, the amounts are debited/ credited to the Inventory accounts, instantly. This gives two bookkeeping entries for each purchase. Observe the case study WITSAND (Pty) Ltd. again, now under considering the application of a perpetual inventory system: WITSAND (Pty) Ltd. purchases 15 double beds at a cost of purchase of 200.00 EUR/ u, 20 queen size beds at cost of purchase of 190.00 EUR/ u, 30 single beds at a cost of purchase of 180.00 EUR/ u and 25 cots at 150.00 EUR/ u. All amounts are net amounts. The payments are made by immediate bank transfers. Thus, the contra entries for all purchases are made in the Cash/ Bank account. (a, b) Purchase of 15 double beds on 4.01.20X3 at a cost of purchase of: 15 × 200 = 3,000.00 EUR . DR Purchase..................... 3,000.00 EUR DR VAT.......................... 600.00 EUR CR Cash/ Bank.................... 3,600.00 EUR DR Inventory - Double Bed....... 3,000.00 EUR CR Purchase..................... 3,000.00 EUR (c, d) Purchase of 20 queen size beds on 4.01.20X3 at a cost of purchase of: 20 × 190 = 3,800.00 EUR . DR Purchase..................... 3,800.00 EUR DR VAT.......................... 760.00 EUR CR Cash/ Bank.................... 4,560.00 EUR DR Inventory - Queen Size....... 3,800.00 EUR CR Purchase..................... 3,800.00 EUR (e, f) Purchase of 30 single beds on 4.01.20X3 at a cost of purchase of: 30 × 180 = 5,400.00 EUR . <?page no="248"?> Berkau: BASICS of ACCOUNTING 26-247 DR Purchase..................... 5,400.00 EUR DR VAT.......................... 1,080.00 EUR CR Cash/ Bank.................... 6,480.00 EUR DR Inventory - Single Bed....... 5,400.00 EUR CR Purchase..................... 5,400.00 EUR (g, h) Purchase of 25 cots on 4.01.20X3 at a cost of purchase of: 25 × 150 = 3,750.00 EUR . DR Purchase..................... 3,750.00 EUR DR VAT.......................... 750.00 EUR CR Cash/ Bank.................... 4,500.00 EUR DR Inventory - Cots............. 3,750.00 EUR CR Purchase..................... 3,750.00 EUR When selling the beds, WITSAND (Pty) Ltd. now makes two postings, too. The first one is the same as with a periodic inventory system and is linked to the cash or its equivalents received. It is based on prices. The second one is about releasing goods from stock and is based on purchase costs. The contra account is the Cost of Goods Sold (COS) account, where the amount is debited as expense. Accountants call this “expensing goods”. Be aware, in a production firm the valuation of products follows the costs of manufacturing, which contain direct costs, such as materials and labour, and applied overheads. On 8.01.20X3, WITSAND (Pty) Ltd. sells 2 double beds, 5 queen size beds and 10 cots on cash. The bookkeeping entries are as below: (i, j) Sales of 2 double beds at a net selling price of: 2 × 350 = 700.00 EUR on 8.01.20X3. The gross amount is: 700 × 120% = 840.00 EUR . Releasing the 2 double beds from stock reduces inventory to an extent of: 2 × 200 = 400.00 EUR . DR Cash/ Bank.................... 840.00 EUR CR VAT.......................... 140.00 EUR CR Sales........................ 700.00 EUR DR Cost of Goods Sold........... 400.00 EUR CR Inventory - Double Bed....... 400.00 EUR (k, l) Sales of 5 queen size beds at a net selling price of: 5 × 300 = 1,500.00 EUR on 8.01.20X3. The gross amount equals to: 1,500 × 120% = 1,800.00 EUR . Releasing 5 queen size beds from stock reduces inventory to an extent of: 5 × 190 = 950.00 EUR . <?page no="249"?> Berkau: BASICS of ACCOUNTING 26-248 DR Cash/ Bank.................... 1,800.00 EUR CR VAT.......................... 300.00 EUR CR Sales........................ 1,500.00 EUR DR Cost of Goods Sold........... 950.00 EUR CR Inventory - Queen Size....... 950.00 EUR (m, n) Sales of 10 cots on 8.01.20X3 at a net selling price of: 10 × 200 = 2,000.00 EUR : The gross amount equals to: 2,000 × 120% = 2,400.00 EUR . Releasing 10 cots from stock reduces inventory to an extent of: 10 × 150.00 EUR = 1,500.00 EUR . DR Cash/ Bank.................... 2,400.00 EUR CR VAT.......................... 400.00 EUR CR Sales........................ 2,000.00 EUR DR Cost of Goods Sold........... 1,500.00 EUR CR Inventory - Cots............. 1,500.00 EUR On 9.02.20X3, WITSAND (Pty) Ltd. sells 8 double beds, 7 queen size beds and 15 single beds. (o, p) Sales of 8 double beds on 9.02.20X3 at a net selling price of: 8 × 350 = 2,800.00 EUR . The gross amount equals to: 2,800 × 120% = 3,360.00 EUR . Releasing 8 double beds from stock reduces inventory to an extent of: 8 × 200.00 EUR = 1,600.00 EUR . DR Cash/ Bank.................... 3,360.00 EUR CR VAT.......................... 560.00 EUR CR Sales........................ 2,800.00 EUR DR Cost of Goods Sold........... 1,600.00 EUR CR Inventory - Double Bed....... 1,600.00 EUR (q, r) Sales of 7 queen size beds on 9.02.20X3 at a net selling price of: 7 × 300 = 2,100.00 EUR . The gross amount equals to: 2,100 × 120% = 2,520.00 EUR . Releasing 7 queen size beds from stock reduces inventory to an extent of: 7 × 190.00 EUR = 1,330.00 EUR . DR Cash/ Bank.................... 2,520.00 EUR CR VAT.......................... 420.00 EUR CR Sales........................ 2,100.00 EUR DR Cost of Goods Sold........... 1,330.00 EUR CR Inventory - Queen Size....... 1,330.00 EUR (s, t) Sales of 15 single beds on 9.02.20X3 at a net selling price of: 15 × 250 = 3,750.00 EUR . The gross amount equals to: 3,750 × 120% = 4,500.00 EUR . <?page no="250"?> Berkau: BASICS of ACCOUNTING 26-249 Releasing the 15 single beds from stock reduces inventory by: 15 × 180.00 EUR = 2,700.00 EUR . DR Cash/ Bank.................... 4,500.00 EUR CR VAT.......................... 750.00 EUR CR Sales........................ 3,750.00 EUR DR Cost of Goods Sold........... 2,700.00 EUR CR Inventory - Single Bed....... 2,700.00 EUR At this stage, the Accountant wants to know all stock levels and balances-off the inventory accounts. Observe the accounts in Figure 26.8, in particular take a look at the balancing figures of the inventory accounts. D C D C OV 25,000.00 c/ d 25,000.00 OV 600.00 (j) 400.00 b/ d 25,000.00 (b) 3,000.00 (p) 1,600.00 c/ d 1,600.00 3,600.00 3,600.00 b/ d 1,600.00 D C D C OV 0.00 (l) 950.00 OV 0.00 (t) 2,700.00 (d) 3,800.00 (r) 1,330.00 (f) 5,400.00 c/ d 2,700.00 c/ d 1,520.00 5,400.00 5,400.00 3,800.00 3,800.00 b/ d 2,700.00 b/ d 1,520.00 P, P, E Inventory double bed Inventory queen size Inventory single bed D C D C OV 0.00 (l) 950.00 OV 0.00 (t) 2,700.00 (d) 3,800.00 (r) 1,330.00 (f) 5,400.00 c/ d 2,700.00 c/ d 1,520.00 5,400.00 5,400.00 3,800.00 3,800.00 b/ d 2,700.00 b/ d 1,520.00 Inventory queen size Inventory single bed Figure 26.8: WITSAND (Pty) Ltd.’s accounts <?page no="251"?> Berkau: BASICS of ACCOUNTING 26-250 D C D C OV 2,100.00 (n) 1,500.00 OV 22,300.00 (a) 3,600.00 (h) 3,750.00 c/ d 4,350.00 (i) 840.00 (c) 4,560.00 5,850.00 5,850.00 (k) 1,800.00 (e) 6,480.00 b/ d 4,350.00 (m) 2,400.00 (g) 4,500.00 (o) 3,360.00 (q) 2,520.00 (s) 4,500.00 c/ d 18,580.00 37,720.00 37,720.00 b/ d 18,580.00 Inventory cots Cash/ Bank D C D C c/ d 50,000.00 OV 50,000.00 (a) 3,000.00 (b) 3,000.00 b/ d 50,000.00 (c) 3,800.00 (d) 3,800.00 (e) 5,400.00 (f) 5,400.00 (g) 3,750.00 (h) 3,750.00 15,950.00 15,950.00 D C D C (a) 600.00 (i) 140.00 (i) 700.00 (c) 760.00 (k) 300.00 (k) 1,500.00 (e) 1,080.00 (m) 400.00 (m) 2,000.00 (g) 750.00 (o) 560.00 (o) 2,800.00 (q) 420.00 (q) 2,100.00 (s) 750.00 c/ d 12,850.00 (s) 3,750.00 c/ d 620.00 12,850.00 12,850.00 3,190.00 3,190.00 b/ d 12,850.00 b/ d 620.00 VAT Sales Issued capital Purchase D C (j) 400.00 (l) 950.00 (n) 1,500.00 (p) 1,600.00 (r) 1,330.00 (t) 2,700.00 c/ d 8,480.00 8,480.00 8,480.00 b/ d 8,480.00 Cost of goods sold (COS) Figure 26.8: WITSAND (Pty) Ltd.’s accounts (continued) The balancing figures in the inventory accounts tell WITSAND (Pty) Ltd. the amount of beds available. There are: 1,600/ 200 = 8 double beds , 1,520/ 190 = 8 queen size beds , 2,700/ 180 = 15 single beds and 4,350/ 150 = 29 cots available. It might look somehow clumsy to derive the amount of beds by dividing the EUR amount by the costs of purchase. You might consider to write the amounts of beds next to the amounts, when you do Accounting on paper, e.g. in an exam. In <?page no="252"?> Berkau: BASICS of ACCOUNTING 26-251 real business, the information available from the Accounting system, is the value of the items, e.g. 1,600.00 EUR for double beds. Note, that even the purchase price can vary, if resulting from different purchases. The sales manager finds the amount of double beds too low and orders further beds of this kind. On 7.03.20X3, WITSAND (Pty) Ltd. orders 20 double beds and pays the amount of 240.00 EUR/ u on cash. The total net amount of the purchases is: 20 × 200 = 4,000.00 EUR . The gross amount equals to: 4,000 × 120% = 4,800.00 EUR . (u, v) Purchase of 20 double beds on 7.03.20X3. The beds are added to stock. DR Purchase..................... 4,000.00 EUR DR VAT.......................... 800.00 EUR CR Cash/ Bank.................... 4,800.00 EUR DR Inventory - Double Bed....... 4,000.00 EUR CR Purchase..................... 4,000.00 EUR On 9.07.20X3, WITSAND (Pty) Ltd. sells 24 double beds, 8 queen size beds, 5 single beds and 29 cots on cash. (w, x) Sales of 24 double beds on 9.07.20X3 at a net selling price of: 24 × 350 = 8,400.00 EUR . The gross amount equals to: 8,400 × 120% = 10,080.00 EUR . Releasing 24 double beds from stock reduces inventory to an extent of: 24 × 200.00 EUR = 4,800.00 EUR . DR Cash/ Bank.................... 10,080.00 EUR CR VAT.......................... 1,680.00 EUR CR Sales........................ 8,400.00 EUR DR Cost of Goods Sold........... 4,800.00 EUR CR Inventory - Queen Size....... 4,800.00 EUR (y, z) Sales of 8 queen size beds on 9.07.20X3 at a net selling price of: 8 × 300 = 2,400.00 EUR . The gross amount equals to: 2,400 × 120% = 2,880.00 EUR . Releasing 8 queen size beds from stock reduces inventory to an extent of: 8 × 190.00 EUR = 1,520.00 EUR . DR Cash/ Bank.................... 2,880.00 EUR CR VAT.......................... 480.00 EUR CR Sales........................ 2,400.00 EUR DR Cost of Goods Sold........... 1,520.00 EUR CR Inventory - Queen Size....... 1,520.00 EUR By this bookkeeping entry, the queen size beds are finished up. The balancing figure equals to zero. (Note, we continue bookkeeping entry identification by capital letters, as small letters are finished.) <?page no="253"?> Berkau: BASICS of ACCOUNTING 26-252 (A, B) Sales of 5 single beds on 9.07.20X3 at a net selling price of: 5 × 250 = 1,250.00 EUR . The gross amount equals to: 1,250 × 120% = 1,500.00 EUR . Releasing 5 single beds from stock reduces inventory to an extent of: 5 × 180.00 EUR = 900.00 EUR . DR Cash/ Bank.................... 1,500.00 EUR CR VAT.......................... 250.00 EUR CR Sales........................ 1,250.00 EUR DR Cost of Goods Sold........... 900.00 EUR CR Inventory - Queen Size....... 900.00 EUR (C, D) Sales of 29 cots on 9.07.20X3 at a net selling price of: 29 × 200 = 5,800.00 EUR . The gross amount equals to: 5,800 × 120% = 6,960.00 EUR . Releasing 29 cots from stock reduces inventory to an extent of: 29 × 150.00 EUR = 4,350.00 EUR . DR Cash/ Bank.................... 6,960.00 EUR CR VAT.......................... 1,160.00 EUR CR Sales........................ 5,800.00 EUR DR Cost of Goods Sold........... 4,350.00 EUR CR Inventory - Costs............ 4,350.00 EUR By this bookkeeping entry, the Inventory - Costs account is balanced-off to zero. The costs are finished. WITSAND (Pty) Ltd. pays 2,000.00 EUR rent per bank transfer. (E) Rent on the shop (31.12.20X3) DR Rent......................... 2,000.00 EUR CR Cash/ Bank.................... 2,000.00 EUR The Accountant balances-off all accounts (Figure 26.9) D C D C OV 25,000.00 c/ d 25,000.00 OV 600.00 (j) 400.00 b/ d 25,000.00 (b) 3,000.00 (p) 1,600.00 c/ d 1,600.00 3,600.00 3,600.00 b/ d 1,600.00 (x) 4,800.00 (v) 4,000.00 c/ d 800.00 5,600.00 5,600.00 b/ d 800.00 P, P, E Inventory double bed Figure 26.9: WITSAND (Pty) Ltd.’s accounts <?page no="254"?> Berkau: BASICS of ACCOUNTING 26-253 D C D C OV 0.00 (l) 950.00 OV 0.00 (t) 2,700.00 (d) 3,800.00 (r) 1,330.00 (f) 5,400.00 c/ d 2,700.00 c/ d 1,520.00 5,400.00 5,400.00 3,800.00 3,800.00 b/ d 2,700.00 (B) 900.00 b/ d 1,520.00 (z) 1,520.00 c/ d 1,800.00 2,700.00 2,700.00 b/ d 1,800.00 Inventory queen size Inventory single bed D C D C OV 2,100.00 (n) 1,500.00 OV 22,300.00 (a) 3,600.00 (h) 3,750.00 c/ d 4,350.00 (i) 840.00 (c) 4,560.00 5,850.00 5,850.00 (k) 1,800.00 (e) 6,480.00 b/ d 4,350.00 (D) 4,350.00 (m) 2,400.00 (g) 4,500.00 (o) 3,360.00 (q) 2,520.00 (s) 4,500.00 c/ d 18,580.00 37,720.00 37,720.00 b/ d 18,580.00 (u) 4,800.00 (w) 10,080.00 (E) 2,000.00 (y) 2,880.00 (A) 1,500.00 (C) 6,960.00 c/ d 33,200.00 40,000.00 40,000.00 b/ d 33,200.00 Inventory cots Cash/ Bank D C D C c/ d 50,000.00 OV 50,000.00 (a) 3,000.00 (b) 3,000.00 b/ d 50,000.00 (c) 3,800.00 (d) 3,800.00 (e) 5,400.00 (f) 5,400.00 (g) 3,750.00 (h) 3,750.00 15,950.00 15,950.00 (u) 4,000.00 (v) 4,000.00 Issued capital Purchase Figure 26.9: WITSAND (Pty) Ltd.’s accounts (continued) <?page no="255"?> Berkau: BASICS of ACCOUNTING 26-254 D C D C (a) 600.00 (i) 140.00 (i) 700.00 (c) 760.00 (k) 300.00 (k) 1,500.00 (e) 1,080.00 (m) 400.00 (m) 2,000.00 (g) 750.00 (o) 560.00 (o) 2,800.00 (q) 420.00 (q) 2,100.00 (s) 750.00 c/ d 12,850.00 (s) 3,750.00 c/ d 620.00 12,850.00 12,850.00 3,190.00 3,190.00 b/ d 12,850.00 b/ d 620.00 (w) 1,680.00 (w) 8,400.00 (u) 800.00 (y) 480.00 (y) 2,400.00 (A) 250.00 (A) 1,250.00 c/ d 2,150.00 (C) 1,160.00 c/ d 30,700.00 (C) 5,800.00 3,570.00 3,570.00 30,700.00 30,700.00 b/ d 2,150.00 b/ d 30,700.00 VAT Sales D C D C (j) 400.00 (E) 2,000.00 c/ d 2,000.00 (l) 950.00 b/ d 2,000.00 (n) 1,500.00 (p) 1,600.00 (r) 1,330.00 (t) 2,700.00 c/ d 8,480.00 8,480.00 8,480.00 b/ d 8,480.00 (x) 4,800.00 (z) 1,520.00 (B) 900.00 (D) 4,350.00 c/ d 20,050.00 20,050.00 20,050.00 b/ d 20,050.00 Cost of goods sold (COS) Rent Figure 26.9: WITSAND (Pty) Ltd.’s accounts (continued) At the end of the Accounting period 20X3, WITSAND (Pty) Ltd. prepares the Trading account for the gross profit calculation. The Cost of Goods Sold COS account is closed-off to the Trading account. The expenses are material expenses only. Furthermore, the Sales account is closed-off to the Trading account. DR T/ A.......................... 20,050.00 EUR CR Cost of Goods Sold........... 20,050.00 EUR DR Sales........................ 30,700.00 EUR CR T/ A.......................... 30,700.00 EUR The gross profit of WITSAND (Pty) Ltd. amounts to: 30,700 - 20,050 = 10,650.00 EUR . This amount is transferred to the Profit and Loss account by closing-off the Trading account. <?page no="256"?> Berkau: BASICS of ACCOUNTING 26-255 DR T/ A .......................... 10,650.00 EUR CR Profit and Loss.............. 10,650.00 EUR The Rent account is closed-off to the Profit and Loss account, too. DR Profit and Loss.............. 2,000.00 EUR CR Rent......................... 2,000.00 EUR The earnings before taxes are: 10,650 - 2,000 = 8,650.00 EUR . The amount for income taxes is: 8,650 × 30% = 2,595.00 EUR and for retained earnings: 8,650 - 2,595 = 6,055.00 EUR. They get transferred to the Income Tax Liability account and the Retained Earnings account. DR P&L.......................... 2,595.00 EUR CR Income Tax Liabilities....... 2,595.00 EUR DR P&L.......................... 6,055.00 EUR CR Retained Earnings............ 6,055.00 EUR Observe the accounts in Figure 26.10 D C D C OV 25,000.00 c/ d 25,000.00 OV 600.00 (j) 400.00 b/ d 25,000.00 (b) 3,000.00 (p) 1,600.00 c/ d 1,600.00 3,600.00 3,600.00 b/ d 1,600.00 (x) 4,800.00 (v) 4,000.00 c/ d 800.00 5,600.00 5,600.00 b/ d 800.00 D C D C OV 0.00 (l) 950.00 OV 0.00 (t) 2,700.00 (d) 3,800.00 (r) 1,330.00 (f) 5,400.00 c/ d 2,700.00 c/ d 1,520.00 5,400.00 5,400.00 3,800.00 3,800.00 b/ d 2,700.00 (B) 900.00 b/ d 1,520.00 (z) 1,520.00 c/ d 1,800.00 2,700.00 2,700.00 b/ d 1,800.00 P, P, E Inventory double bed Inventory queen size Inventory single bed Figure 26.10: WITSAND (Pty) Ltd.’s accounts <?page no="257"?> Berkau: BASICS of ACCOUNTING 26-256 D C D C OV 2,100.00 (n) 1,500.00 OV 22,300.00 (a) 3,600.00 (h) 3,750.00 c/ d 4,350.00 (i) 840.00 (c) 4,560.00 5,850.00 5,850.00 (k) 1,800.00 (e) 6,480.00 b/ d 4,350.00 (D) 4,350.00 (m) 2,400.00 (g) 4,500.00 (o) 3,360.00 (q) 2,520.00 (s) 4,500.00 c/ d 18,580.00 37,720.00 37,720.00 b/ d 18,580.00 (u) 4,800.00 (w) 10,080.00 (E) 2,000.00 (y) 2,880.00 (A) 1,500.00 (C) 6,960.00 c/ d 33,200.00 40,000.00 40,000.00 b/ d 33,200.00 Inventory cots Cash/ Bank D C D C c/ d 50,000.00 OV 50,000.00 (a) 3,000.00 (b) 3,000.00 b/ d 50,000.00 (c) 3,800.00 (d) 3,800.00 (e) 5,400.00 (f) 5,400.00 (g) 3,750.00 (h) 3,750.00 15,950.00 15,950.00 (u) 4,000.00 (v) 4,000.00 D C D C (a) 600.00 (i) 140.00 (i) 700.00 (c) 760.00 (k) 300.00 (k) 1,500.00 (e) 1,080.00 (m) 400.00 (m) 2,000.00 (g) 750.00 (o) 560.00 (o) 2,800.00 (q) 420.00 (q) 2,100.00 (s) 750.00 c/ d 12,850.00 (s) 3,750.00 c/ d 620.00 12,850.00 12,850.00 3,190.00 3,190.00 b/ d 12,850.00 b/ d 620.00 (w) 1,680.00 (w) 8,400.00 (u) 800.00 (y) 480.00 (y) 2,400.00 (A) 250.00 (A) 1,250.00 c/ d 2,150.00 (C) 1,160.00 c/ d 30,700.00 (C) 5,800.00 3,570.00 3,570.00 30,700.00 30,700.00 b/ d 2,150.00 T/ A 30,700.00 b/ d 30,700.00 VAT Sales Issued capital Purchase Figure 26.10: WITSAND (Pty) Ltd.’s accounts (continued) <?page no="258"?> Berkau: BASICS of ACCOUNTING 26-257 D C D C (j) 400.00 (E) 2,000.00 c/ d 2,000.00 (l) 950.00 b/ d 2,000.00 (n) 1,500.00 (p) 1,600.00 (r) 1,330.00 (t) 2,700.00 c/ d 8,480.00 8,480.00 8,480.00 b/ d 8,480.00 (x) 4,800.00 (z) 1,520.00 (B) 900.00 (D) 4,350.00 c/ d 20,050.00 20,050.00 20,050.00 b/ d 20,050.00 T/ A 20,050.00 D C D C COS 20,050.00 Rev 30,700.00 Rent 2,000.00 T/ A 10,650.00 GP 10,650.00 NP 8,650.00 30,700.00 30,700.00 10,650.00 10,650.00 P&L 10,650.00 b/ d 10,650.00 Tax 2,595.00 b/ d 8,650.00 R/ E 6,055.00 8,650.00 8,650.00 Cost of goods sold (COS) Rent Trading account Profit and Loss D C D C c/ d 2,595.00 P&L 2,595.00 c/ d 6,055.00 P&L 6,055.00 b/ d 2,595.00 b/ d 6,055.00 Income tax liabilities Retained earnings Figure 26.10: WITSAND (Pty) Ltd.’s accounts (continued) Observe the financial statements as at 31.12.20X3 for WITSAND (Pty) Ltd. in Figure 26.11 and Figure 26.12. The amount for payables in the statement of financial position results from VAT payables. Inventory is linked to the single inventory accounts and adds up to: 800 + 1,800 = 2,600.00 EUR . <?page no="259"?> Berkau: BASICS of ACCOUNTING 26-258 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 25,000.00 Share capital 50,000.00 Intangibles Reserves Financial assets R/ E 6,055.00 Current assets Liabilities Inventory 2,600.00 Interest bear liab A/ R A/ P 2,150.00 Prepaid expenses Provisions Cash/ Bank 33,200.00 Tax liabilities 2,595.00 60,800.00 60,800.00 Witsands (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X3 Figure 26.11: WITSAND (Pty) Ltd.’s statement of financial position The statement of comprehensive income shows material expenses resulting from the cost of goods sold. [EUR] Revenue 30,700.00 Other income 30,700.00 Cost of goods sold 20,050.00 Other expenses 2,000.00 Earnings before int and taxes (EBIT) 8,650.00 Interest 0.00 Earnings before taxes (EBT) 8,650.00 Income tax expenses 2,595.00 Deferred taxes Earnings after taxes (EAT) 6,055.00 Witsand (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 26.12: WITSAND (Pty) Ltd.’s statement of comprehensive income Summary: Applying different inventory system does not change financial statements. When applying a perpetual inventory system, the company does counts stock. The perpetual inventory system provides information about stock lev- <?page no="260"?> Berkau: BASICS of ACCOUNTING 26-259 els at any time. This real-time information is helpful for Logistics. However, a periodic inventory system often applies for minor important goods/ parts. Accounting classes start in general with the periodic inventory system, because it is easier in terms of making bookkeeping entries (there are fewer). However, many students find the perpetual inventory system more meaningful, because it shows the closing stock as balancing figure in the inventory accounts before the adjustments are made. Working Definitions: Periodic Inventory System: A periodic inventory system records inventory movements based on input postings and stock counting at the end of the Accounting period. Perpetual Inventory System: A perpetual inventory system records inventory movements in real-time, based on inputs and outputs. <?page no="261"?> Berkau: BASICS of ACCOUNTING 27-260 27. Cost Formulas Learning Objectives: In this chapter we’ll introduce cost formulas by the case study MALGAS (Pty) Ltd. Cost formulas apply, if the company stores goods of the same kind and cannot identify goods separately. The reason can be, that there are too many of the same goods, such as screws or some office material or that the recorded goods are liquids/ gases. The cost formulas differ with regard to the assumption about the sequence the goods are consumed. We’ll demonstrate, that the application of different cost formulas leads to different inventory valuations and has an impact on the profit calculation. After studying this chapter, you can apply cost formulas and you can discuss their effect on inventories and profit. In general, all asset must be valued individually. However, in case an individual valuation is not feasible or economically not applicable, companies are allowed to value indistinct or similar assets together. As long as goods are put in at the same costs, the order of consumption does not matter. But if items are bought at different purchase costs, the companies have to assume a particular for the consumption or stock releases thereof. Think about a box of screws in a workshop department. The screws might have been bought at different purchase prices but they are all the same. Whenever new packages of screws are bought, they are put into the box. After a while, the screws in the box are intermingled and it is no longer possible to determine at which price a particular screw has been purchased. A similar situation applies for tanks fluids are filled in. You do not know which litre of petrol at which price is consumed by your car when you filled up the tank at different prices. It is assumed you do not empty your tank completely. A cost formula is an assumption about the sequence goods are used up. The most common cost formulas are weighted average, first-in-first-out and last-in-first-out. A company that applies the first-in-first-out cost formula assumes that the items of inventory will be used in the same sequence as they have been bought. FIFO is allowed along IFRSs and Handelsgesetzbuch. Last-in-first-out applies, if goods are piled up and the goods released from stock will be taken from the top of the stack. Last-in-first-out only is to be applied in cases the real order of consumption follows actually this order. Think about a company that deals with steal mats which are very heavy. It is very unlikely, that the steal mats lying at the bottom of the pile will be used before all other ones on top have been taken. Weighted average method means, the average costs of the assets on stock are calculated once they are consumed. This applies in particular with liquids and gases. In general, changing cost formulas is not allowed in Accounting. It will infringe the principle of consistency which is required for preparing financial statements. If cost formulas are changed, it has to happen be for a good reason and it applies for all assets of the similar kind. Be aware, the change of cost formulas might trigger <?page no="262"?> Berkau: BASICS of ACCOUNTING 27-261 calculations along IAS 8. Here, we consider a change of cost formulas to be unlikely. We’ll explain the application of different cost formulas by the example MALGAS (Pty) Ltd., which is a fashion store (trading business). As the cost formulas determine profit, we explain the application of the formulas by an example which includes the profit calculation in a Profit and Loss account, too. We show the same case study applying the different cost formulas three times. MALGAS (Pty) Ltd. displays the statement of financial position as provided by Figure 27.1. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 100,000.00 Share capital 100,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 7,000.00 Interest bear liab 0.00 A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 43,000.00 Tax liabilities 150,000.00 150,000.00 Malgas (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 27.1: MALGAS (Pty) Ltd.’s statement of financial position The opening value of the stock results from 10 dresses bought at a purchase price of 700.00 EUR each. On 2.02.20X4, MALGAS (Pty) Ltd. buys further 50 dresses at purchase costs of 710.00 EUR/ u on cash. The dresses look the same as the ones already on stock. Their net amount is: 50 × 710 = 35,500.00 EUR . The gross amount equals to: 35,500 × 120% = 42,600.00 EUR . (1) Purchase of 50 dresses on 2.02.20X4. DR Purchase..................... 35,500.00 EUR DR VAT.......................... 7,100.00 EUR CR Cash/ Bank.................... 42,600.00 EUR The dresses are posted to inventory, because MALGAS (Pty) Ltd. runs a perpetual inventory system. (2) Transfer of purchases to stock on 2.02.20X4. <?page no="263"?> Berkau: BASICS of ACCOUNTING 27-262 DR Inventory.................... 35,500.00 EUR CR Purchase..................... 35,500.00 EUR On 4.04.20X4, MALGAS (Pty) Ltd. sells 28 dresses at a net selling price of 990.00 EUR on cash. The price does not depend on the cost of purchase for the dresses. See bookkeeping entry (3, 4) below. The bookkeeping entry (4) depends on the cost formula applied. It is shown further down in this chapter and the bookkeeping number will indicate which cost formula applies, such as (A4), (B4) or (C4) for different scenarios A, B and C. For bookkeeping entry (3) the amount of sales is: 28 × 990 = 27,720.00 EUR . The gross amount equals to: 27,720 × 120% = 33,264.00 EUR . (3) Sale of 28 dresses on 4.04.20X4. DR Cash/ Bank.................... 33,264.00 EUR CR VAT.......................... 5,544.00 EUR CR Sales........................ 27,720.00 EUR On 5.5.20X4, MALGAS (Pty) Ltd. purchases another 50 dresses at 720.00 EUR/ u. These are the same dresses as the ones on stock. The net amount is: 50 × 720 = 36,000.00 EUR . The gross amount equals to: 36,000 × 120% = 43,200.00 EUR . (5) Purchase of 50 dresses on 5.05.20X4 on cash. DR Purchase..................... 36,000.00 EUR DR VAT.......................... 7,200.00 EUR CR Cash/ Bank.................... 43,200.00 EUR (6) Putting the purchases on stock on 5.05.20X4. DR Inventory.................... 36,000.00 EUR CR Purchase..................... 36,000.00 EUR On 6.06.20X4, MALGAS (Pty) Ltd. sells 53 dresses at a net selling price of 990.00 EUR/ u on cash. The amount of sales is: 53 × 990 = 52,470.00 EUR . The gross amount equals to: 52,470 × 120% = 62,964.00 EUR . (7) Sale of 53 dresses on 6.06.20X4. DR Cash/ Bank.................... 62,964.00 EUR CR VAT.......................... 10,494.00 EUR CR Sales........................ 52,470.00 EUR For purchases and for revenue recognition, the applied cost formulas do not matter. Only stock releases depend on the cost formulas. The next bookkeeping entry (8) depends again on the cost formula applied. Below; we show 3 different scenarios A, B and C, which are <?page no="264"?> Berkau: BASICS of ACCOUNTING 27-263 linked to the three different cost formulas. These formulas are (A) weighted average method, (B) first-in-first-out and (C) last-in-first-out. The different scenarios only become relevant for stock releases - when the dresses are sold. Thus, only bookkeeping entries A4, A8, B4, B8, C4 and C8 depend on the applied cost formulas. Weighted Average (A): When MALGAS (Pty) Ltd. applies the weighted average method the dresses sold on 4.04.20X4 are valued at the average price taking under consideration different amounts of dresses at different prices. The weighted average cost formula values inventory movements at their average cost of purchase. The average is called weighted, as the prices count based on their amounts. How it is done (weighted average cost formula): (1) Determine the average amount of opening stock. (2) When goods are put on stock, calculate the average unit costs by unit cost of opening stock multiplied by opening amount plus stock input as input amount times unit costs of input and divide the total thereof by the total amount of stock. (3) When stock is released, determine the stock reduction by output amount times weighted average unit costs as described above. (4) Continue the procedure based on inputs and releases of stock. MALGAS (Pty) Ltd.’s unit costs after the first purchase equal to: (10 × 700 + 50 × 710) / 60 = 708.33 EUR/ u . The release from stock when selling 28 dresses equals then to: 28 × 708.77 = 19,833.33 EUR . (A4) Releasing dresses from stock on 4.04.20X4. DR Cost of Goods Sold........... 19,833.33 EUR CR Inventory.................... 19,833.33 EUR The amount of the dresses sold on 6.06.20X4 is: 53 × (((60 - 28) × 708.33 + 50 × 720) / ((60 - 28) + 50)) = 37,918.63 EUR . One dress sold is worth: ((57 - 28) × 708.77 + 50 × 720) / ((57 - 28) + 50) = 715.45 EUR/ u . (A8) Releases from stock on 6.06.20X4. DR Cost of Goods Sold........... 37,918.63 EUR CR Inventory.................... 37,918.63 EUR The Accountant balances-off all accounts and prepares the Profit and Loss account. Observe the accounts in Figure 27.2: <?page no="265"?> Berkau: BASICS of ACCOUNTING 27-264 D C D C OV 100,000.00 c/ d 100,000.00 OV 7,000.00 (A4) 19,833.33 b/ d 100,000.00 (2) 35,500.00 (A8) 37,918.63 (6) 36,000.00 c/ d 20,748.04 78,500.00 78,500.00 b/ d 20,748.04 D C D C OV 43,000.00 (1) 42,600.00 c/ d 100,000.00 OV 100,000.00 (3) 33,264.00 (5) 43,200.00 b/ d 100,000.00 (7) 62,964.00 c/ d 53,428.00 139,228.00 139,228.00 b/ d 53,428.00 D C D C c/ d 50,000.00 OV 50,000.00 (1) 35,500.00 (2) 35,500.00 b/ d 50,000.00 (5) 36,000.00 (6) 36,000.00 71,500.00 71,500.00 D C D C (1) 7,100.00 (3) 5,544.00 (3) 27,720.00 (4) 7,200.00 (7) 10,494.00 c/ d 80,190.00 (7) 52,470.00 c/ d 1,738.00 80,190.00 80,190.00 16,038.00 16,038.00 P&L 80,190.00 b/ d 80,190.00 b/ d 1,738.00 P, P, E Inventory Cash/ Bank Issued capital Accounts payables Purchase VAT Sales D C D C (A4) 19,833.00 COS 57,751.63 Rev 80,190.00 (A8) 37,918.63 c/ d 57,751.63 NP 22,438.37 57,751.63 57,751.63 80,190.00 80,190.00 b/ d 57,751.63 Tax 6,731.51 b/ d 22,438.37 R/ E 15,706.86 22,438.37 22,438.37 D C D C c/ d 6,731.51 P&L 6,731.51 c/ d 15,706.86 P&L 15,706.86 b/ d 6,731.51 b/ d 15,706.86 Cost of goods sold (COS) Profit and Loss Income tax liabilities Retained earnings Figure 27.2: MALGAS (Pty) Ltd. accounts (A) <?page no="266"?> Berkau: BASICS of ACCOUNTING 27-265 Observe the statement of comprehensive income in Figure 27.3: [EUR] Revenue 80,190.00 Other income 80,190.00 COS 57,751.96 Earnings before int and taxes (EBIT) 22,438.04 Interest 0.00 Earnings before taxes (EBT) 22,438.04 Income tax expenses 6,731.41 Deferred taxes Earnings after taxes (EAT) 15,706.63 Malgas (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 27.3: MALGAS (Pty) Ltd.’s statement of comprehensive income (A) The statement of financial position is given by Figure 27.4. The amount for inventories depends on the valuation based on the applied cost formula. Here the value equals to: (10 + 50 - 28 + 50 - 53) × 715.45 = 20,748.05 EUR . A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 100,000.00 Share capital 100,000.00 Intangibles Reserves Financial assets R/ E 15,706.63 Current assets Liabilities Inventory 20,748.04 Interest bear liab 0.00 A/ R A/ P 51,738.00 Prepaid expenses Provisions Cash/ Bank 53,428.00 Tax liabilities 6,731.41 174,176.04 174,176.04 Malgas (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 27.4: MALGAS (Pty) Ltd.’s statement of financial position (A) <?page no="267"?> Berkau: BASICS of ACCOUNTING 27-266 First-In-First-Out (B): When applying the first-in-first-out formula, the dresses sold at first are valued at their purchase costs, which represents the dresses on stock at the beginning of the Accounting period. After using up the first dresses, the ones from the first purchase of the Accounting period are taken, then the next ones and so on. The first-in-first-out cost formula is based on the assumption that items are released from stock by the same sequence they were added to stock before. How it is done (first-in-first-out): (1) Determine the opening amount on stock with regard to all inputs. (2) When material is put on stock, make a bookkeeping entry and keep in mind the amount of materials and the unit cost of purchase. (3) When materials are released from stock, make inventory postings with regard to the unit costs like the opening input has been released at first, followed by the first purchase and the last input comes last. (4) Continue. . . The first dresses are valued at 700.00 EUR/ u and the next ones at 710.00 EUR/ u. The cost of goods sold with regard to the first sales, then are: 10 × 700 + 18 × 710 = 19,780.00 EUR/ u . (B4) Releasing dresses from stock on 4.04.20X4. DR Cost of Goods Sold........... 19,780.00 EUR CR Inventory.................... 19,780.00 EUR After that release, there are still 32 dresses at 710.00 EUR/ u on stock. For the second release, the value equals to: 32 × 710 + (53 - 32) × 720 = 37,840.00 EUR . (B8) Inventory movements for releasing 53 dresses from stock on 6.06.20X4. DR Cost of Goods Sold........... 37,840.00 EUR CR Inventory.................... 37,840.00 EUR Observe the accounts for MALGAS (Pty) Ltd. in Figure 27.5. <?page no="268"?> Berkau: BASICS of ACCOUNTING 27-267 D C D C OV 100,000.00 c/ d 100,000.00 OV 7,000.00 (A4) 19,780.00 b/ d 100,000.00 (2) 35,500.00 (A8) 37,840.00 (6) 36,000.00 c/ d 20,880.00 78,500.00 78,500.00 b/ d 20,880.00 D C D C OV 43,000.00 (1) 42,600.00 c/ d 100,000.00 OV 100,000.00 (3) 33,264.00 (5) 43,200.00 b/ d 100,000.00 (7) 62,964.00 c/ d 53,428.00 139,228.00 139,228.00 b/ d 53,428.00 D C D C c/ d 50,000.00 OV 50,000.00 (1) 35,500.00 (2) 35,500.00 b/ d 50,000.00 (5) 36,000.00 (6) 36,000.00 71,500.00 71,500.00 D C D C (1) 7,100.00 (3) 5,544.00 (3) 27,720.00 (4) 7,200.00 (7) 10,494.00 c/ d 80,190.00 (7) 52,470.00 c/ d 1,738.00 80,190.00 80,190.00 16,038.00 16,038.00 P&L 80,190.00 b/ d 80,190.00 b/ d 1,738.00 P, P, E Inventory Cash/ Bank Issued capital Accounts payables Purchase VAT Sales D C D C (B4) 19,780.00 COS 57,620.00 Rev 80,190.00 (B8) 37,840.00 c/ d 57,620.00 NP 22,570.00 57,620.00 57,620.00 80,190.00 80,190.00 b/ d 57,620.00 Tax 6,771.00 b/ d 22,570.00 R/ E 15,799.00 22,570.00 22,570.00 D C D C c/ d 6,771.00 P&L 6,771.00 c/ d 15,799.00 P&L 15,799.00 b/ d 6,771.00 b/ d 15,799.00 Cost of goods sold (COS) Profit and Loss Income tax liabilities Retained earnings Figure 27.5: MALGAS (Pty) Ltd.’s accounts (B) The statement of comprehensive income displays a slightly higher profit compared to the weighted average method for stock releases. <?page no="269"?> Berkau: BASICS of ACCOUNTING 27-268 [EUR] Revenue 80,190.00 Other income 80,190.00 COS 57,620.00 Earnings before int and taxes (EBIT) 22,570.00 Interest 0.00 Earnings before taxes (EBT) 22,570.00 Income tax expenses 6,771.00 Deferred taxes Earnings after taxes (EAT) 15,799.00 Malgas (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 27.6: MALGAS (Pty) Ltd.’s statement of comprehensive income (B) Observe the statement of financial position in Figure 27.7. The amount of closing stock in the statement of financial position is for scenario B (first-in-firstout): 29 × 720 = 20,880.00 EUR . A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 100,000.00 Share capital 100,000.00 Intangibles Reserves Financial assets R/ E 15,799.00 Current assets Liabilities Inventory 20,880.00 Interest bear liab 0.00 A/ R A/ P 51,738.00 Prepaid expenses Provisions Cash/ Bank 53,428.00 Tax liabilities 6,771.00 174,308.00 174,308.00 Malgas (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 27.7: MALGAS (Pty) Ltd.’s statement of financial position (B) Last-In-First-Out (C): The last-in-first-out formula normally does not apply. It only can be used exceptionally. Here, the sequence the dresses are released from stock, does not request a last-in-first-out formula. However, we show the effect of its application with regard to inventory valuation and profit calculation. <?page no="270"?> Berkau: BASICS of ACCOUNTING 27-269 The last-in-first-out cost formula records inventory valuations based on the reverse sequence of how they were put on stock before. How it is done (last-in-first-out): (1) Determine the opening amount on stock with regard to all inputs. (2) When material is put on stock, make a bookkeeping entry and keep in mind the amount of materials and the unit cost of purchase. (3) When materials are released from stock, make inventory postings with regard to the unit costs like the last input has been released at first, then the second last one etc. (4) Continue. . . The first stock releases on 4.04.20X4 are taken from the recent input on 2.02.20X4, thus, it amounts to: 28 × 710 = 19,880.00 EUR . (C4) Release of 28 dresses on 4.04.20X4. DR Cost of Goods Sold........... 19,880.00 EUR CR Inventory.................... 19,880.00 EUR The second release is taken from the second purchase and to the extent of 3 dresses from the first one. The value of the inventory movement when selling 53 dresses is: 50 × 720 + 3 × 710 = 38,130.00 EUR . (C8) Second release of 53 dresses on 6.06.20X4. DR Cost of Goods Sold........... 19,880.00 EUR CR Inventory.................... 19,880.00 EUR Observe the accounts in Figure 27.8. D C D C OV 100,000.00 c/ d 100,000.00 OV 7,000.00 (A4) 19,880.00 b/ d 100,000.00 (2) 35,500.00 (A8) 38,130.00 (6) 36,000.00 c/ d 20,490.00 78,500.00 78,500.00 b/ d 20,490.00 P, P, E Inventory Figure 27.8: MALGAS (Pty) Ltd.’s accounts (C) <?page no="271"?> Berkau: BASICS of ACCOUNTING 27-270 D C D C OV 43,000.00 (1) 42,600.00 c/ d 100,000.00 OV 100,000.00 (3) 33,264.00 (5) 43,200.00 b/ d 100,000.00 (7) 62,964.00 c/ d 53,428.00 139,228.00 139,228.00 b/ d 53,428.00 Cash/ Bank Issued capital D C D C c/ d 50,000.00 OV 50,000.00 (1) 35,500.00 (2) 35,500.00 b/ d 50,000.00 (5) 36,000.00 (6) 36,000.00 71,500.00 71,500.00 D C D C (1) 7,100.00 (3) 5,544.00 (3) 27,720.00 (4) 7,200.00 (7) 10,494.00 c/ d 80,190.00 (7) 52,470.00 c/ d 1,738.00 80,190.00 80,190.00 16,038.00 16,038.00 P&L 80,190.00 b/ d 80,190.00 b/ d 1,738.00 D C D C (C4) 19,880.00 COS 58,710.00 Rev 80,190.00 (C8) 38,830.00 c/ d 58,710.00 NP 21,480.00 58,710.00 58,710.00 80,190.00 80,190.00 b/ d 58,710.00 Tax 6,444.00 b/ d 21,480.00 R/ E 15,036.00 21,480.00 21,480.00 D C D C c/ d 6,444.00 P&L 6,444.00 c/ d 15,036.00 P&L 15,036.00 b/ d 6,444.00 b/ d 15,036.00 Income tax liabilities Retained earnings Cost of goods sold (COS) Profit and Loss Accounts payables Purchase VAT Sales Figure 27.8: MALGAS (Pty) Ltd.’s accounts (C) (continued) Applying last-in-first-out cost formula, the profit of MALGAS (Pty) Ltd. is lower. Observe the statement of comprehensive income in Figure 27.9: <?page no="272"?> Berkau: BASICS of ACCOUNTING 27-271 [EUR] Revenue 80,190.00 Other income 80,190.00 COS 58,710.00 Earnings before int and taxes (EBIT) 21,480.00 Interest 0.00 Earnings before taxes (EBT) 21,480.00 Income tax expenses 6,444.00 Deferred taxes Earnings after taxes (EAT) 15,036.00 Malgas (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 27.9: MALGAS (Pty) Ltd.’s statement of comprehensive income (C) On the balance sheet, the closing stock of inventories is calculated as opening value of 7,000.00 EUR plus the amount left from the first purchase. These are: 50 - 28 - 3 = 19 dresses . The value of closing stock is: 10 × 700 + 19 × 710 = 20,490.00 EUR . A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 100,000.00 Share capital 100,000.00 Intangibles Reserves Financial assets R/ E 15,036.00 Current assets Liabilities Inventory 20,490.00 Interest bear liab 0.00 A/ R A/ P 51,738.00 Prepaid expenses Provisions Cash/ Bank 53,428.00 Tax liabilities 6,444.00 173,918.00 173,218.00 Malgas (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 27.10: MALGAS (Pty) Ltd.’s statement of financial position (C) The last-in-first-out method reduces the profit in case of increasing prices. A company could decrease its profit substantially by buying a lot of inventory. This is one of the reasons, why you should only apply this method exceptionally for commercial financial statements. <?page no="273"?> Berkau: BASICS of ACCOUNTING 27-272 The cost formula does not depend on the inventory movement system applied. If a company applies a periodic inventory system, the Accountant has to determine the value of the closing stock, as we did above for the balance sheet. Summary: When items of inventory are similar or equal to each other and the effort for tracking the purchase prices is unacceptable high, cost formulas can be applied for recording inventory movements as part of the preparation of financial statements. The most popular formulas are weighted average method, first-in-first-out and exceptionally applicable: last-in-first-out formula. The different cost formulas lead to different amounts in inventory valuation and profit calculation. Working Definitions: Weighted Average Cost Formula: The weighted average cost formula values inventory movements at their average cost of purchase. The average is called weighted, as the prices for the goods count based on their amounts. First-in-First-out Cost Formula: The first-in-first-out cost formula is based on the assumption that items are released from stock by the same sequence they were added to stock before. Last-in-First-out Cost Formula: The last-in-first-out cost formula records inventory valuations based on the reverse sequence of how they were put on stock before. <?page no="274"?> Berkau: BASICS of ACCOUNTING 28-273 28. Income Statement along the Cost of Sales Format Learning Objectives: In this chapter we’ll introduce another format for the statement of comprehensive income. It shows the cost of sales of the products/ services a company produces/ renders and is a helpful reporting instrument for making product/ service mix decisions. In order to show the differences to the previous nature of expense format, we use one case study and prepare the income statement along both formats. After this chapter, you will be able to prepare the statement of comprehensive income along both formats and you will know how to apply the two formats “Nature of Expense (NoE)” and “Cost of Sales (COS)” for the profitability analysis in Management Accounting, too. You will be able to distinguish the formats and can discuss advantages and disadvantages thereof. Companies use the statement of comprehensive income for reporting about their profitability and for making management decisions. The comparison of revenue and expenses shows, how the business earns its money. There are two ways to set up a statement of comprehensive income: the nature of expense method and the cost of sales format. Both formats give the same profit. The income statement along the nature of expense format calculates profit starting with the revenue and deducting all costs for the period; it adjusts the revenue for costs of manufacturing for stock increases of finished goods and/ or inventory deductions, both together referred to as changes in inventory. The income statement along the nature of expense format shows all cost categories relevant for profit and helps to understand and predict how profit changes as a result of variations of costs, e.g. what happens, if labour increases by 3 %. In contrast, the income statement along the cost of sales format starts with the revenue and deducts only costs for the goods/ services sold. The income statement along the cost of sales format will show by which products/ services the company earns money. It is a useful report to support product/ service mix decisions and can be prepared as a profitability analysis including multiple contribution margin Accounting. There is a chapter Multi- Level Contribution Margin Accounting at the end of this text book. The difference between the formats only is relevant, once a company produces a different amount of goods/ services than sold during the Accounting period. In this - most likely - situation, changes in the finished goods’ inventory amount will occur. As the statement of comprehensive income compares revenues to expenses, both amounts should be linked to the same quantity of goods/ services. In case the company changes inventories of finished goods and/ or work in process, a comparison between revenue and expenses requires either revenue adjustments or changes in expenses. Otherwise, the profit information is distorted. As mentioned above, the na- <?page no="275"?> Berkau: BASICS of ACCOUNTING 28-274 ture of expense method will adjust revenues by changes in inventory of finished goods, whereas the cost of sales format adjusts expenses in order to only take expenses for sold goods into consideration. The advantage of the statement of comprehensive income along the cost of sales format lays in the option to prepare a statement that provides particular columns for certain products, certain customer groups, certain regions and/ or certain market segments. An income statement along the cost of sales format can be separated with regard to cost objects in order to provide detailed information about partial profits. It tells the company by which products/ customers/ market segments it earns its profit. Actually, the contribution margin tells how much revenue is left to cover fixed costs after proportional costs have been deducted: A contribution margin is a product’s revenue less its proportional costs. The contribution margin gets its name from the fact, that the contribution margins of all products must cover all fixed costs of the company in order to earn profit. In other words: the contribution margin is the product’s portion of revenue exceeding costs, that is contributed to the coverage of fixed costs. We now explain the difference between the formats for the statement of comprehensive income with regard to the statement calculation. The case study is about a wine farm ASHTON Ltd. that produces more wines than it sells in the Accounting period 20X4. We first prepare the statement of comprehensive income along the nature of expense method as we are already used to it. In the next step we prepare the same statements along the cost of sales format. We start off making bookkeeping entries that are identical for both methods. Only later, we split the text and (1) make bookkeeping entries for the nature of expense method and (2) for the cost of sales format separately. ASHTON Ltd. is a wine farm. The company produces pinotage and merlot wines. The business is established on 2.01.20X4 by an ordinary share issue of 100,000 shares at 10.00 EUR each. (1) Share issue on 2.01.20X4. DR Cash/ Bank.................... 1,000,000.00 EUR CR Issued Capital............... 1,000,000.00 EUR The simplified business concept is to plant vines on its land, to harvest the grapes, to put them into barrels and to fill them into bottles. The business process requires resources as land, labour and materials, such as vines and bottles. On 3.01.20X4, ASHTON Ltd. takes a bank loan for financing its business. The loan is 500,000.00 EUR. The rate of interest is 5 %/ a and an amount of 50,000.00 EUR is to be paid-off every year. Interest and pay-off are due at the end of every Accounting period. (2) Lending 500,000.00 EUR from the bank on 3.01.20X4. <?page no="276"?> Berkau: BASICS of ACCOUNTING 28-275 DR Cash/ Bank.................... 500,000.00 EUR CR Interest Bearing Liabilities. 500,000.00 EUR (3, 4a) Paying interest and pay-off for the bank loan on 31.12.20X4. Interest is: 5% × 500,000 = 25,000.00 EUR . The amount for pay-off is 50,000.00 EUR. DR Interest..................... 25,000.00 EUR CR Cash/ Bank.................... 25,000.00 EUR DR Interest Bearing Liabilities. 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR Along IFRSs requirements, short-term liabilities must be recognized separately. ASHTON Ltd. puts the next year’s pay-off amount into the Short-term Liabilities account, which is the Accounts Payables account (4b). DR Interest Bearing Liabilities. 50,000.00 EUR CR Account Payables............. 50,000.00 EUR ASHTON Ltd. buys land and vines at 2,000,000.00 EUR (net amount). (When we talk about the vine, we refer to the plant, where the grapes are growing on. The wine is the product, we only refer to by the vine-species, such as pinotage and merlot. Pinotage is a South African dry red. The land cost 40 % of the total acquisitions: 40% × 2,000,000 = 800,000.00 EUR . ASHTON Ltd. pays for the pinotage vines 40 % more than for the merlot vines even as the amount of plants is the same for both. We do not depreciate land, as it is not depleted. The vines are deployed for 10 years on ASHTON Ltd.’s land and are depreciated along straight line method. (5) Acquisition of land and vines on 5.01.20X4, the land is recorded at first: DR P, P, E - Land............... 800,000.00 EUR DR VAT.......................... 160,000.00 EUR CR Cash/ Bank.................... 960,000.00 EUR Buying vines at a 140 : 100 ratio equals to: 7 : 5. According to this ratio, the pinotage vines costs: 7 × 60% × 2,000,000/ 12 = 700,000.00 EUR . The merlot vine costs are: 700,000/ 140% = 500,000.00 EUR . (6, 7) Acquisition of vines on 5.01.20X4. DR P, P, E - Pinotage........... 700,000.00 EUR DR VAT.......................... 140,000.00 EUR CR Cash/ Bank.................... 840,000.00 EUR <?page no="277"?> Berkau: BASICS of ACCOUNTING 28-276 DR P, P, E - Merlot............. 500,000.00 EUR DR VAT ......................... 100,000.00 EUR CR Cash/ Bank.................... 600,000.00 EUR Depreciation on pinotage vines amounts to: 700,000/ 10 = 70,000.00 EUR/ a . Depreciation on merlot vines equals to: 500,000/ 10 = 50,000.00 EUR/ a . (8, 9) Depreciation on vines recorded on 31.12.20X4. DR Depreciation................. 70,000.00 EUR CR Acc. Depr. - Pinotage........ 70,000.00 EUR DR Depreciation................. 50,000.00 EUR CR Acc. Depr. - Merlot.......... 50,000.00 EUR ASTHON Ltd. buys 10 barrels (volume: 50,000 litres each) at cost of acquisition of 400,000.00 EUR (all together) on 6.01.20X4. The amount is ex VAT. The barrels can be deployed over a period of 20 years. The depreciation method is straight line method without residual value. (10) Acquisition of barrels on 6.01.20X4. DR P, P, E - Barrels............ 400,000.00 EUR DR VAT.......................... 80,000.00 EUR CR Cash/ Bank.................... 480,000.00 EUR The depreciation on the barrels amounts to: 400,000/ 20 = 20,000.00 EUR/ a . (11) Depreciation on barrels on 31.12.20X4. DR Depreciation................. 20,000.00 EUR CR Acc. Depr. - Barrels......... 20,000.00 EUR ASHTON Ltd. spends 250,000.00 EUR on the harvesting process and for filling the barrels (all of them). The amount of pinotage equals to the amount of merlot wines. So do the harvesting and filling expenses. In order to keep the case study simple, the amount is paid in the middle of the Accounting period. (12) Paying for labour on 30.06.20X4. DR Labour....................... 250,000.00 EUR CR Cash/ Bank.................... 250,000.00 EUR After the maturing process (during the same Accounting period), ASHTON fills the wine into bottles, labels and corks them. ASHTON Ltd. spends on the bottle filling/ labelling/ corking process 150,000.00 EUR for labour and buys 500,000 glass bottles at 0.36 EUR/ u (gross amount) also. (13) Paying labour on 30.06.20X4. <?page no="278"?> Berkau: BASICS of ACCOUNTING 28-277 DR Labour....................... 150,000.00 EUR CR Cash/ Bank.................... 150,000.00 EUR The total amount for the purchase costs of the bottles is: 500,000 × 0.36/ 120% = 150,000.00 EUR . The gross amount equals to: 150,000 × 120% = 180,000.00 EUR . (14) Purchase of bottles on 30.01.20X4. DR Purchase..................... 150,000.00 EUR DR VAT.......................... 30,000.00 EUR CR Cash/ Bank.................... 180,000.00 EUR ASHTON Ltd. sells 230,000 bottles of merlot wine at a net selling price of 4.80 EUR/ u on a bulk sale and 180,000 bottles of pinotage wine at 5.10 EUR/ u through their own farm shop. We calculate the net selling price for the sales: The merlot wine is sold at: 230,000 × 4.80 = 1,104,000.00 EUR and the pinotage wine at: 180,000 × 5.10 = 918,000.00 EUR . The gross amounts are for the merlot wine equals to: 1,104,000 × 120% = 1,324,800.00 EUR and for the pinotage wine it equals to: 918,000 × 120% = 1,101,600.00 EUR . (15) Sales of merlot wines, recorded on 31.12.20X4. DR Cash/ Bank.................... 1,324,800.00 EUR CR VAT.......................... 220,800.00 EUR CR Sales........................ 1,104,000.00 EUR (16) Sale of pinotage wine on 31.12.20X4. DR Cash/ Bank.................... 1,101,600.00 EUR CR VAT.......................... 183,600.00 EUR CR Sales........................ 918,000.00 EUR This whole process is to be considered taking one Accounting period only. Take a look at ASHTON Ltd.’s accounts so far in Figure 28.1. The accounts have not yet been balanced-off, because they will be continued. <?page no="279"?> Berkau: BASICS of ACCOUNTING 28-278 D C D C (1) 1,000,000.00 (3) 25,000.00 (1) 1,000,000.00 (2) 500,000.00 (4a) 50,000.00 (15) 1,324,800.00 (5) 960,000.00 (16) 1,101,600.00 (6) 840,000.00 (7) 600,000.00 (10) 480,000.00 D C (12) 250,000.00 (4b) 50,000.00 (13) 150,000.00 (14) 180,000.00 Cash/ Bank Issued capital Accounts payables A/ P D C D C (4a) 50,000.00 (2) 500,000.00 (3) 25,000.00 (4b) 50,000.00 D C D C (5) 800,000.00 (5) 160,000.00 (15) 220,800.00 (6) 140,000.00 (16) 183,600.00 (7) 100,000.00 (10) 80,000.00 (14) 30,000.00 D C D C (6) 700,000.00 (8) 70,000.00 D C D C (7) 500,000.00 (9) 50,000.00 D C D C (8) 70,000.00 (10) 400,000.00 (9) 50,000.00 (11) 20,000.00 D C D C (12) 250,000.00 (11) 20,000.00 (13) 150,000.00 D C D C (15) 1,104,000.00 (14) 150,000.00 (16) 918,000.00 Sales Purchase Depreciation P, P, E barrels Labour Acc depr barrels Interest bearing liabilities Interest P, P, E merlot Acc depr merlot P, P, E land VAT P, P, E pinotage Acc depr pinotage Figure 28.1: ASHTON Ltd.’s accounts <?page no="280"?> Berkau: BASICS of ACCOUNTING 28-279 We now prepare the statement of comprehensive income along two alternative methods. At first, we make entries and set up the statement along the nature of expense method. After completing the process, we start over and prepare the entries and the statement along the cost of sales format. Nature of Expense Method (NoE): In order to determine the profit for ASHTON Ltd., we apply the Trading account and the Profit and Loss account, too. Along the nature of expense method, all nominal accounts will be balancedoff and closed-off to either the Trading account or to the Profit and Loss account. The Purchase account, the Sales account and the Returns account are closed-off to the Trading account. So, is the closing stock of the Inventory account. All further expense accounts are closed-off to the Profitand-Loss account. How it is done (profit and loss along nature of expense format): (1) Make bookkeeping entries for revenue and expenses. (2) Close-off all revenue and expense accounts to the Trading account and/ or the Profit and Loss account. (3) If there is an increase or decrease of stock with regard to finished goods, calculate the products at first. (4) Calculate profit by adding increases of stock of finished goods to revenues and deduct decreases of stock of finished goods and all further expenses. In order to determine the material expenses, apply the Trading account. For this example, we calculate the profit by one step in contrast to the previous examples, in order to point out the concept of closing-off all nominal accounts to the Trading account and Profit and Loss account. This is done by the bookkeeping entries below: DR Profit and Loss.............. 25,000.00 EUR CR Interest..................... 25,000.00 EUR DR Profit and Loss.............. 140,000.00 EUR CR Depreciation................. 140,000.00 EUR DR Profit and Loss.............. 400,000.00 EUR CR Labour....................... 400,000.00 EUR DR Sales........................ 2,022,000.00 EUR CR Trading Account.............. 2,022,000.00 EUR <?page no="281"?> Berkau: BASICS of ACCOUNTING 28-280 DR Trading Account.............. 150,000.00 EUR CR Purchase..................... 150,000.00 EUR All bookkeeping entries are made without expense splitting according to their use for different products. On the debit side, the Trading account shows the opening value for inventory, the purchases and the returns inwards. The credit side takes the sales, the closing stock of inventory and the returns outwards. ASHTON Ltd. does not have any returns nor opening stock. However, there is a closing stock of 70,000 bottles pinotage wine and 20,000 bottles merlot wine. The knowledge about the amount of bottles isn’t enough to determine the closing stock. ASHTON Ltd. has to calculate the product costs at first. These are the unit costs per bottle pinotage and bottle merlot wine. Thus, both products must be calculated. The calculation is prepared apart from the bookkeeping records - such as a kind of working. ASHTON Ltd.’s calculation of the unit costs contains portions of the expenses for labour, for depreciation and for the glass bottles. However, interest is regarded as a non-manufacturing expense. The costs of manufacturing per bottle of pinotage are: 400,000/ 500,000 + (70,000 + 10,000) / 250,000 + 0.30 = 0.80 + 0.32 + 0.30 = 1.42 EUR . Labour is relevant for all wines to the same extent. Depreciation is considered for the pinotage vines separately. The 10,000.00 EUR further depreciation results from half of the barrels because the amount of wines is split up based on a half : half ratio. The closing stock of pinotage wine is calculated to be: 70,000 × 1.42 = 99,400.00 EUR . The costs of manufacturing per bottle of merlot are: 400,000/ 500,000 + (50,000 + 10,000) / 250,000 + 0.30 = 0.80 + 0.24 + 0.30 = 1.34 EUR . Labour is relevant for all wines to the same extent. Depreciation is considered for the merlot vines separately. The 10,000.00 EUR further depreciation results from half of the barrels because the amount of wines is split up based on a half : half ratio. The closing stock of merlot wine is calculated to be: 20,000 × 1.34 = 26,800.00 EUR . As ASHTON Ltd. is established in 20X4, the closing stock of finished goods, which equals to: 99,400 + 26,800 = 126,200.00 EUR , is the increase of inventory. The closing stock of wines is recorded by the next bookkeeping entries. DR Inventory.................... 99,400.00 EUR CR Trading Account.............. 99,400.00 EUR DR Inventory.................... 26,800.00 EUR CR Trading Account.............. 26,800.00 EUR The gross profit for ASHTON amounts to: 2,022,000 + 99,400 + 26,800 - 150,000 = 1,998,200.00 EUR and is transferred to the Profit and Loss account by closingoff the Trading account. <?page no="282"?> Berkau: BASICS of ACCOUNTING 28-281 DR Trading Account.............. 1,998,200.00 EUR CR Profit and Loss.............. 1,998,200.00 EUR The balancing figure of the Profit and Loss account gives the pre-tax profit, which is: 1,998,200 - 400,000 - 140,000 - 25,000 = 1,433,200.00 EUR . The income taxes are calculated on an income tax rate of 30 % and equal to: 1,433,200 × 30% = 429,960.00 EUR . The retained earnings are: 1,433,200 - 429,960 = 1,003,240.00 EUR . Observe ASHTON Ltd.’s accounts to get the full picture. They are displayed in Figure 28.2. D C D C (1) 1,000,000.00 (3) 25,000.00 c/ d 1,000,000.00 (1) 1,000,000.00 (2) 500,000.00 (4a) 50,000.00 b/ d 1,000,000.00 (15) 1,324,800.00 (5) 960,000.00 (16) 1,101,600.00 (6) 840,000.00 (7) 600,000.00 (10) 480,000.00 (12) 250,000.00 D C (13) 150,000.00 c/ d 50,000.00 (4b) 50,000.00 (14) 180,000.00 b/ d 50,000.00 c/ d 391,400.00 3,926,400.00 3,926,400.00 b/ d 391,400.00 Cash/ Bank Issued capital Accounts payables A/ P D C D C (4a) 50,000.00 (2) 500,000.00 (3) 25,000.00 c/ d 25,000.00 (4b) 50,000.00 b/ d 25,000.00 P&L 25,000.00 c/ d 400,000.00 500,000.00 500,000.00 b/ d 400,000.00 D C D C (5) 800,000.00 c/ d 800,000.00 (5) 160,000.00 (15) 220,800.00 b/ d 800,000.00 (6) 140,000.00 (16) 183,600.00 (7) 100,000.00 (10) 80,000.00 (14) 30,000.00 c/ d 105,600.00 510,000.00 510,000.00 b/ d 105,600.00 P, P, E land VAT Interest bearing liabilities Interest Figure 28.2: ASHTON Ltd.’s accounts <?page no="283"?> Berkau: BASICS of ACCOUNTING 28-282 D C D C (6) 700,000.00 c/ d 700,000.00 c/ d 70,000.00 (8) 70,000.00 b/ d 700,000.00 b/ d 70,000.00 D C D C (7) 500,000.00 c/ d 500,000.00 c/ d 50,000.00 (9) 50,000.00 b/ d 500,000.00 b/ d 50,000.00 P, P, E merlot Acc depr merlot P, P, E pinotage Acc depr pinotage D C D C (8) 70,000.00 (10) 400,000.00 c/ d 400,000.00 (9) 50,000.00 b/ d 400,000.00 (11) 20,000.00 c/ d 140,000.00 140,000.00 140,000.00 b/ d 140,000.00 P&L 140,000.00 D C D C (12) 250,000.00 c/ d 20,000.00 (11) 20,000.00 (13) 150,000.00 c/ d 400,000.00 b/ d 20,000.00 400,000.00 400,000.00 b/ d 400,000.00 P&L 400,000.00 D C D C (15) 1,104,000.00 (14) 150,000.00 c/ d 150,000.00 c/ d 2,022,000.00 (16) 918,000.00 b/ d 150,000.00 T/ A 150,000.00 2,022,000.00 2,022,000.00 T/ A 2,022,000.00 b/ d 2,022,000.00 Sales Purchase Depreciation P, P, E barrels Labour Acc depr barrels D C D C Purch 150,000.00 Rev 2,022,000.00 Int 25,000.00 T/ A 1,998,200.00 Inv 99,400.00 Dpr 140,000.00 GP 1,998,200.00 Inv 26,800.00 Lab 400,000.00 2,148,200.00 2,148,200.00 NP 1,433,200.00 P&L 1,998,200.00 b/ d 1,998,200.00 1,998,200.00 1,998,200.00 Tax 429,960.00 b/ d 1,433,200.00 R/ E 1,003,240.00 1,433,200.00 1,433,200.00 Trading account Profit and Loss Figure 28.2: ASHTON Ltd.’s accounts (continued) <?page no="284"?> Berkau: BASICS of ACCOUNTING 28-283 D C D C T/ A 99,400.00 c/ d 429,960.00 P&L 429,960.00 T/ A 26,800.00 c/ d 126,200.00 b/ d 429,960.00 126,200.00 126,200.00 b/ d 126,200.00 D C c/ d 1,003,240.00 P&L 1,003,240.00 b/ d 1,003,240.00 Inventory Income Tax Liability Retained earnings Figure 28.2: ASHTON Ltd.’s accounts (continued) The Accountant prepares the financial statements for ASHTON Ltd. See the statement of comprehensive income along the nature of expense method and the statement of financial position below in Figure 28.3 and Figure 28.4. [EUR] Revenue 2,022,000.00 Changes in inventory 126,200.00 2,148,200.00 Materials 150,000.00 Labour 400,000.00 Depreciation 140,000.00 Other expenses 0.00 Earnings before int and taxes (EBIT) 1,458,200.00 Interest 25,000.00 Earnings before taxes (EBT) 1,433,200.00 Income tax expenses 429,960.00 Deferred taxes Earnings after taxes (EAT) 1,003,240.00 Ashton Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 28.3: ASHTON Ltd.’s statement of comprehensive income (NoE) The amount of changes in inventory is the closing stock of wines. It amounts to: 99,400 + 26,800 = 126,200.00 EUR . The amount looks like revenue because the wines produced but not sold yet are on the credit side of the Trading account. The inventory valuation follows strictly the cost of manufacturing along IAS 2. The consideration of the changes in inventory of finished goods (wines) can be seen as excluding the expenses for unsold wines from the profit calculation. Once the statement of comprehensive income is prepared along the nature of expense method, you cannot see the <?page no="285"?> Berkau: BASICS of ACCOUNTING 28-284 contribution of different products to the profit any more. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 2,260,000.00 Share capital 1,000,000.00 Intangibles Reserves Financial assets R/ E 1,003,240.00 Current assets Liabilities Inventory 126,200.00 Interest bear liab 400,000.00 A/ R 105,600.00 A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 391,400.00 Tax liabilities 429,960.00 2,883,200.00 2,883,200.00 Ashton Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 28.4: ASHTON Ltd.’s statement of financial position The amount for property, plant and equipment is the total of the carrying amounts of land, vines and barrels: 800.000 + 630,000 + 450,000 + 380,000 = 2,260,000.00 EUR . The receivables result from the balancing figure in the VAT account. Cost of Sales Format (COS): When we prepare the statement of comprehensive income, it is advised to split up cost along products. We apply the subordinated Work in Process accounts and the Manufacturing Overhead account. The subordinated Work in Process accounts are dedicated to pinotage and merlot and will be named “WIP - Pinotage account” and “WIP - Merlot account”. How it is done (profit calculation along the cost of sales method): (1) Make all bookkeeping entries for revenue and expenses. (2) Run a manufacturing costing by applying Work in Process accounts for direct costs of products and Manufacturing Overhead accounts for indirect costs. Consider only manufacturing expenses. Apply overheads. This includes the transfer of underor over-applied overheads to the Cost of Goods Sold (COS) account, too. If particular information is required for different <?page no="286"?> Berkau: BASICS of ACCOUNTING 28-285 products, dedicate a particular Work in Process account to your product of interest. (3) Once production is finished, close-off the relevant Work in Process account to the Inventory of Finished Goods account. You may apply cost formulas for inventory movements if goods are interchangeable or intermingle, such as liquids or gas. (4) Once products get sold, transfer the expenses to the Cost of Goods Sold (COS) account and credit the amount to the Inventory of Finished Goods account. (5) Calculate profit by deducting cost of goods sold from revenue. Reduce the amount(s) by non-manufacturing expenses. Direct costs are bottle costs. They are transferred to an inventory account at first, and then they are posted to work in process. DR Inventory - Bottles.......... 150,000.00 EUR CR Purchase..................... 150,000.00 EUR DR WIP - Pinotage............... 75,000.00 EUR CR Inventory - Bottles.......... 75,000.00 EUR DR WIP - Merlot................. 75,000.00 EUR CR Inventory - Bottles.......... 75,000.00 EUR As the vines are deployed for one product only (no blends! ), they are classified as direct costs. They are transferred to the Work in Process accounts. DR WIP - Pinotage............... 70,000.00 EUR CR Depreciation................. 70,000.00 EUR DR WIP - Merlot................. 50,000.00 EUR CR Depreciation................. 50,000.00 EUR The depreciation on barrels and labour costs are manufacturing overheads. However, interest is not. Thus, the accounts for labour and depreciation are closed-off to the Manufacturing Overheads account. DR Manufacturing Overheads...... 420,000.00 EUR CR Depreciation................. 20,000.00 EUR CR Labour....................... 400,000.00 EUR The manufacturing overheads are for both products to the same extent. The overheads are split up along a half : half ratio to the Work in Process accounts for <?page no="287"?> Berkau: BASICS of ACCOUNTING 28-286 merlot and pinotage. The portion for each product equals to: 420,000/ 2 = 210,000.00 EUR . DR WIP - Pinotage............... 210,000.00 EUR CR Manufacturing Overheads...... 210,000.00 EUR DR WIP - Merlot................. 210,000.00 EUR CR Manufacturing Overheads...... 210,000.00 EUR In contrast to this basic case study, in most real companies, the application of overheads is based on a predetermined overhead allocation basis. We cover overhead applications in the Management Accounting part in chapter Job Order Costing. The Work in Process accounts for pinotage and merlot are closed-off to the Inventory of Finished Goods account. Here, we apply two different Inventory of Finished Goods accounts - one for pinotage and the other one for merlot wines. DR FG Inventory - Pinotage...... 355,000.00 EUR CR WIP - Pinotage............... 355,000.00 EUR DR FG Inventory - Merlot........ 335,000.00 EUR CR WIP - Merlot................. 335,000.00 EUR When ASHTON Ltd. sells its wines, it makes bookkeeping entries for releasing the sold bottles from stock. The portion of pinotage wines (sold) is: (180,000/ 250,000) × 355,000 = 255,600.00 EUR . The amount is transferred to the Cost of Goods Sold account. DR Cost of Goods Sold........... 255,600.00 EUR CR FG Inventory - Pinotage...... 255,600.00 EUR Similar to the pinotage, the portion of merlot is calculated as follows: (230,000/ 250,000) × 335,000 = 308,200.00 EUR . DR Cost of Goods Sold........... 308,200.00 EUR CR FG Inventory - Merlot........ 308,200.00 EUR Only one Cost of Goods Sold (COS) account applies for both wines at ASHTON Ltd. The profit is calculated in the Profit and Loss account only. The costs of goods sold cover all manufacturing expenses. The bookkeeping entries for sales, cost of goods sold and interest close off the accounts to the Profit and Loss account and look as follows: <?page no="288"?> Berkau: BASICS of ACCOUNTING 28-287 DR Sales........................ 2,022,000.00 EUR CR Profit and Loss.............. 2,022,000.00 EUR DR Profit and Loss.............. 563,800.00 EUR CR Cost of Goods Sold........... 563,800.00 EUR DR Profit and Loss.............. 25,000.00 EUR CR Interest..................... 25,000.00 EUR The pre-tax profit is the same as along the nature of expense method. Thus, we do not have to repeat the income tax calculation. Observe the accounts in Figure 28.5: D C D C (1) 1,000,000.00 (3) 25,000.00 c/ d 1,000,000.00 (1) 1,000,000.00 (2) 500,000.00 (4a) 50,000.00 b/ d 1,000,000.00 (15) 1,324,800.00 (5) 960,000.00 (16) 1,101,600.00 (6) 840,000.00 (7) 600,000.00 (10) 480,000.00 D C (12) 250,000.00 c/ d 50,000.00 (4b) 50,000.00 (13) 150,000.00 b/ d 50,000.00 (14) 180,000.00 c/ d 391,400.00 3,926,400.00 3,926,400.00 b/ d 391,400.00 Cash/ Bank Issued capital Accounts payables A/ P D C D C (4) 50,000.00 (2) 500,000.00 (3) 25,000.00 c/ d 25,000.00 (4b) 50,000.00 b/ d 25,000.00 P&L 25,000.00 c/ d 400,000.00 500,000.00 500,000.00 b/ d 400,000.00 Interest bearing liabilities Interest D C D C (5) 800,000.00 c/ d 800,000.00 (5) 160,000.00 (15) 220,800.00 b/ d 800,000.00 (6) 140,000.00 (16) 183,600.00 (7) 100,000.00 (10) 80,000.00 (14) 30,000.00 c/ d 105,600.00 510,000.00 510,000.00 b/ d 105,600.00 P, P, E land VAT Figure 28.5: ASHTON Ltd.’s accounts <?page no="289"?> Berkau: BASICS of ACCOUNTING 28-288 D C D C (6) 700,000.00 c/ d 700,000.00 c/ d 70,000.00 (8) 70,000.00 b/ d 700,000.00 b/ d 70,000.00 D C D C (7) 500,000.00 c/ d 500,000.00 c/ d 50,000.00 (9) 50,000.00 b/ d 500,000.00 b/ d 50,000.00 D C D C (8) 70,000.00 (10) 400,000.00 c/ d 400,000.00 (9) 50,000.00 b/ d 400,000.00 (11) 20,000.00 c/ d 140,000.00 140,000.00 140,000.00 b/ d 140,000.00 WIP 70,000.00 WIP 50,000.00 c/ d 20,000.00 140,000.00 140,000.00 b/ d 20,000.00 MOH 20,000.00 Depreciation P, P, E barrels P, P, E merlot Acc depr merlot P, P, E pinotage Acc depr pinotage D C D C (12) 250,000.00 c/ d 20,000.00 (11) 20,000.00 (13) 150,000.00 c/ d 400,000.00 b/ d 20,000.00 400,000.00 400,000.00 b/ d 400,000.00 MOH 400,000.00 Labour Acc depr barrels D C D C (15) 1,104,000.00 (14) 150,000.00 c/ d 150,000.00 c/ d 2,022,000.00 (16) 918,000.00 b/ d 150,000.00 Inv 150,000.00 2,022,000.00 2,022,000.00 P&L 2,022,000.00 b/ d 2,022,000.00 Sales Purchase D C D C Inv 75,000.00 Inv 75,000.00 Dpr 70,000.00 Dpr 50,000.00 MOH 210,000.00 c/ d 355,000.00 MOH 210,000.00 c/ d 335,000.00 355,000.00 355,000.00 335,000.00 335,000.00 b/ d 355,000.00 FG 355,000.00 b/ d 335,000.00 FG 335,000.00 WIP-pinotage WIP-merlot Figure 28.5: ASHTON Ltd.’s accounts (continued) <?page no="290"?> Berkau: BASICS of ACCOUNTING 28-289 D C D C Prh 150,000.00 WIP 75,000.00 Dpr 20,000.00 WIP 75,000.00 Lab 400,000.00 c/ d 420,000.00 150,000.00 150,000.00 420,000.00 420,000.00 b/ d 420,000.00 WIP 210,000.00 WIP 210,000.00 420,000.00 420,000.00 D C D C WIP 355,000.00 COS 255,600.00 WIP 335,000.00 COS 308,200.00 c/ d 99,400.00 c/ d 26,800.00 355,000.00 355,000.00 335,000.00 335,000.00 b/ d 99,400.00 b/ d 26,800.00 D C D C FG 308,200.00 COS 563,800.00 Rev 2,022,000.00 FG 255,600.00 c/ d 563,800.00 Int 25,000.00 563,800.00 563,800.00 NP 1,433,200.00 b/ d 563,800.00 P&L 563,800.00 2,022,000.00 2,022,000.00 Tax 429,960.00 b/ d 1,433,200.00 R/ E 1,003,240.00 1,433,200.00 1,433,200.00 Inventory bottles Manufacturing Overheads FG inventory pinotage FG inventory merlot Cost of goods sold (COS) Profit and Loss D C D C c/ d 429,960.00 P&L 429,960.00 c/ d 1,003,240.00 P&L 1,003,240.00 b/ d 429,960.00 b/ d 1,003,240.00 Income tax liabilities Retained earnings Figure 28.5: ASHTON Ltd.’s accounts (continued) Figure 28.6 depicts the statement of comprehensive income along the cost of sales format. <?page no="291"?> Berkau: BASICS of ACCOUNTING 28-290 [EUR] Revenue 2,022,000.00 Other income 2,022,000.00 Cost of goods sold 563,800.00 Earnings before int and taxes (EBIT) 1,458,200.00 Interest 25,000.00 Earnings before taxes (EBT) 1,433,200.00 Income tax expenses 429,960.00 Deferred taxes Earnings after taxes (EAT) 1,003,240.00 Ashton Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 28.6: ASHTON Ltd.’s statement of comprehensive income (COS) The statement of financial position is the same as in Figure 28.4. There is no reason to show it again, here. The advantage of the cost of sales format lays in the option to show the contribution margin for each product separately. We display the statement of comprehensive income again with revenues and costs of goods sold separated along the wines ASHTON Ltd. sells. See Figure 28.7. [EUR] Pinotage Merlot Revenue 918,000.00 1,104,000.00 Other income 918,000.00 1,104,000.00 Cost of goods sold 308,200.00 255,600.00 Contribution margin 609,800.00 848,400.00 Total EBIT Interest Earnings before taxes (EBT) Income tax expenses Deferred taxes Earnings after taxes (EAT) Ashton Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 1,003,240.00 1,458,200.00 25,000.00 1,433,200.00 429,960.00 Figure 28.7: ASHTON Ltd.’s income statement based on Contribution Margin Accounting) <?page no="292"?> Berkau: BASICS of ACCOUNTING 28-291 In the last three chapters we covered inventory movements, cost formulas and income statements along different formats. The case study MONTAGU Ltd. summarises these aspects. In particular, we show how inventory valuations are made outside of the bookkeeping records. MONTAGU Ltd. is a dealership for office material. The company is established on 2.01.20X8 by a share issue of 10,000 shares at 1.00 EUR each. The share issue is par value. MONTAGU Ltd. pays 12,000.00 EUR for rent and 36,000.00 EUR for labour (sales people) during the Accounting period 20X8. MONTAGU Ltd.’s purchases/ sales at are as follows for its products punchers and staplers. The purchase costs provided are net amounts, you have to consider value added tax at a VAT rate of 20 %. - 5.01.20X8: Purchase of 1,000 punchers at 2.30 EUR each and purchase of 5,600 staplers at 5.10 EUR each. - 5.04.20X8: Purchase of 1,200 punchers at 2.20 EUR each and purchase of 6,000 staplers at 5.50 EUR each. - 5.07.20X8: Purchase of 500 punchers at 2.50 EUR each and purchase of 10,000 staplers at 4.90 EUR each. - 5.10.20X8: Purchase of 900 punchers at 2.38 EUR each and purchase of 15,000 staplers at 4.30 EUR each. MONTAGU Ltd. applies the weighted average cost formula. Consider a discount allowed by the stapler supplier on all staplers bought during a year after the purchase amount exceeds 25,000 staplers to be 10 % off. Thus, a 10 % discount applies for the 25,001 st and any further stapler bought. The discount is not considered by the purchase prices above. During 20X8, punchers are sold at a net selling price of 5.00 EUR/ u and staplers at 10.00 EUR/ u. The selling date is in the middle of the quarter to keep the case study simple: - 15.02.20X8: Sales of 850 punchers and 4,012 staplers. - 15.05.20X8: Sales 600 punchers and 7,050 staplers. - 15.08.20X8: Sales of 750 punchers and 8,750 staplers. 10 staplers thereof are returned by the customers within a month and put on stock as they are not damaged. The customers are refunded by the price paid for the staplers. - 15.11.20X8: Sales of 1,000 punchers and 15,988 staplers. Consider all transactions are on cash. Below, we record the bookkeeping entries for MONTAGU Ltd. and set up a Profit and Loss account in preparation of the income statement and the balance sheet. Observe the bookkeeping entries below: (1) Share issue of: 10,000 × 1 = 10,000.00 EUR share capital on 2.01.20X8. DR Cash/ Bank.................... 10,000.00 EUR CR Share Capital................ 10,000.00 EUR (2) Payment for rent by bank transfer on 2.01.20X8. <?page no="293"?> Berkau: BASICS of ACCOUNTING 28-292 DR Rent......................... 12,000.00 EUR CR Cash/ Bank.................... 12,000.00 EUR (3) Payment for labour by bank transfer on 31.12.20X8. DR Labour....................... 36,000.00 EUR CR Cash/ Bank.................... 36,000.00 EUR We set up a table for the purchases and sales of punchers and staplers - one for each product. We exceed the tables later on by adding inventory valuations. The tables contain in the first step only the above given information. “+” stands for an increase of stock, ‘-“ for decreases. Item Price paid/ u Amount Date + punchers 2.30 1,000 5.01.20X8 punchers (850) 15.02.20X8 + punchers 2.20 1,200 5.04.20X8 punchers (600) 15.05.20X8 + punchers 2.50 500 5.07.20X8 punchers (750) 15.08.20X8 Return of punchers sold in July. Punchers are put on stock. 10 15.09.20X8 + punchers 2.38 900 5.10.20X8 punchers (1,000) 15.11.20X8 Figure 28.8: MONTAGU Ltd.’s inventory movements for punchers Item Price paid/ u Amount Date + stapler 5.10 5,600 5.01.20X8 stapler (4,012) 15.02.20X8 + stapler 5.50 6,000 5.04.20X8 stapler (7,050) 15.05.20X8 + stapler 4.90 10,000 5.07.20X8 stapler (8,750) 15.08.20X8 + stapler 4.30 15,000 5.10.20X8 stapler (15,988) 15.11.20X8 Figure 28.9: MONTAGU Ltd.’s inventory movements for staplers For the following bookkeeping entries, we calculate the amount and value of punchers/ staplers on stock by applying the weighted average cost formula. See details of the inventory valuation in Figure 28.10. <?page no="294"?> Berkau: BASICS of ACCOUNTING 28-293 Item Price paid/ u Amount Stock Value Change Stock level + punchers 2.30 1,000 1,000 2.30 2,300.00 2,300.00 punchers (850) 150 2.30 (1,955.00) 345.00 + punchers 2.20 1,200 1,350 2.21 2,640.00 2,985.00 punchers (600) 750 2.21 (1,326.67) 1,658.33 + punchers 2.50 500 1,250 2.33 1,250.00 2,908.33 punchers (750) 500 2.33 (1,745.00) 1,163.33 Return of punchers sold in July. Punchers are put on stock. 10 510 2.33 23.27 1,186.60 + punchers 2.38 900 1,410 2.36 2,142.00 3,328.60 punchers (1,000) 410 2.36 (2,360.71) 967.89 Figure 28.10: MONTAGU Ltd.’s inventory movements for punchers 1 st line: MONTAGU Ltd. bought 1,000 punchers on 5.01.20X8. The amount on stock is 1,000 at this stage. Their value is 2.30 EUR each or all together cost 2,300.00 EUR. 2 nd line: After selling 850 punchers, the stock level is down to: 1,000 - 850 = 150 punchers . The costs per unit are still 2.30 EUR. The level of stock in EUR amounts to: 150 × 2.30 = 345.00 EUR . 3 rd line: MONTAGU Ltd. purchases 1,200 punchers on 5.04.20X8 at 2.20 EUR. The increase of stock value is: 2.20 × 1,200 = 2,640.00 EUR . The stock level in units is: 150 + 1,200 = 1,350 punchers . The costs per unit of the punchers are calculated by weighted average cost formula. There are 150 punchers bought at 2.30 EUR/ u and 1,200 punchers purchased at 2.20 EUR/ u. Accordingly, the unit costs are: (150 × 2.30 + 1,200 × 2.20) / (150 + 1,200) = 2.21 EUR/ u . (Note, the amount is rounded off. Although, in the MS-Excel file in Figure 28.10 amounts are displayed as rounded, they stay accurate in the system.) The EUR amount for the puncher stock level is: 1,350 × 2.21 = 2,983.50 EUR . The exact amount is 2,985.00 EUR. 4 th line: When MONTAGU Ltd. sells 600 punchers, it’s stock reduction is based on the unit costs calculated: 2.21 EUR/ u. The stock level with regard to units equals to: 1,350 - 600 = 750 punchers . The reduction with regard to the EUR amounts is: 600 × 2.21 = 1,326.00 EUR . The accurate amount is 1,326.67 EUR. Now the stock level amounts to: 750 x 2.21 = 1,657.50 EUR . The exact amount is 1,658.33 EUR. 5 th line: The next purchase of 500 punchers takes place on 5.07.20X8. The punchers cost 2.50 EUR per unit. The increase of punchers leads to a stock level of: 750 + 500 = 1,250 punchers . The increase of stock in terms of EUR amounts is: 500 × 2.50 = 1,250.00 EUR . After this input, the level on stock is: 1,658.33 + 1,250 = 2,908.33 EUR . The weighted average cost per puncher are: 2,908.33/ 1,250 = 2.33 EUR/ u . 6 th line: MONTAGU Ltd. sells 750 punchers on 15.08.20X8. The stock level after the sale is: 1,250 - 750 = 500 punchers . The stock reduction is based on the weighted average costs per puncher: 2.33 EUR/ punchers. The stock reduction with regard to the EUR amount is: 750 × <?page no="295"?> Berkau: BASICS of ACCOUNTING 28-294 2.33 = 1,747.50 EUR . The exact amount is 1,745.00 EUR. Accordingly, the new stock level equals to: 2,908.33 - 1,745 = 1,163.33 EUR . 7 th line: 10 customers return their punchers bought on 15.08.20X8. Every customer only bought one puncher. After the return inwards, MONTAGU Ltd. puts on stock the punchers taken back. The value of the returned punchers is 2.33 EUR/ u. The punchers are returned within a month which means they are the last ones sold by MONTAGUE Ltd. For the last sales, the weighted average costs are 2.33 EUR/ u. According to this calculation, the increase of stock in terms of units is 10 punchers. The stock level after the returns inwards is: 500 + 10 = 510 punchers . The level of stock in terms of the EUR amount is: 1,163.33 + 10 × 2.33 = 1,186.63 EUR . The accurate amount is 1,186.60 EUR. 8 th line: On 5.10.20X8, MONTAGU Ltd. buys 900 punchers at 2.38 EUR each. The increase of stock is 900 punchers. The stock level after the purchase in terms of units is: 510 + 900 = 1,410 punchers . The increase of the puncher stock level in EUR amounts is: 900 × 2.38 = 2,142.00 EUR . The new balancing figure of the stock account is: 1,186.60 + 2,142 = 3,328.60 EUR . The weighted unit costs per puncher amount to: 3,328.60/ 1,410 = 2.36 EUR . The amount is rounded off. 9 th line: When MONTAGU Ltd. sells 1,000 punchers, the stock level in terms of units drops to: 1,410 - 1,000 = 410 punchers . The stock reduction in EUR amounts is: 1,000 × 2.36 = 2,360.00 EUR . The accurate amount is 2,360.71 EUR. The closing balance of the Inventory - Puncher account is: 3,328.60 - 2,360.71 = 967.89 EUR . We now make the bookkeeping entries for punchers based on the inventory movements calculated above. (Note, we do not show the fastest approach here, as for a periodic inventory system we only need to know the closing stock of punchers and the value thereof. However, we demonstrate here the calculation like it is made by Accounting.) (4) Purchase of 1,000 punchers on 5.01.20X8. DR Purchase..................... 2,300.00 EUR DR VAT.......................... 460.00 EUR CR Cash/ Bank.................... 2,760.00 EUR (5) It is recommended running goods related inventory accounts. MONTAGU Ltd. records the increase of punchers on 5.01.20X8 in the Inventory Punchers account. DR Inventory Punchers........... 2,300.00 EUR CR Purchase..................... 2,300.00 EUR (6) Sale of 850 punchers at 5.00 EUR net selling price on 15.02.20X8. The revenue is 4,250.00 EUR. The price paid by the customers including VAT is: 4,250 × 120 % = 5,100.00 EUR . <?page no="296"?> Berkau: BASICS of ACCOUNTING 28-295 DR Cash/ Bank.................... 5,100.00 EUR CR VAT.......................... 850.00 EUR CR Revenue...................... 4,250.00 EUR (7) Inventory movement linked to the sales of 850 punchers on 15.02.20X8. The valuation is at costs: 850 × 2.30 = 1,955.00 EUR . DR Cost of Sales (COS).......... 1,955.00 EUR CR Inventory Punchers........... 1,955.00 EUR (8) Purchase of 1,200 punchers at 2.20 EUR/ u on 5.04.20X8. The gross amount is: 2,640 × 120% = 3,168.00 EUR . DR Purchase .................... 2,640.00 EUR DR VAT.......................... 528.00 EUR CR Cash/ Bank.................... 3,168.00 EUR (9) Transfer of purchases to inventory on 5.04.20X8. DR Inventory Punchers........... 2,640.00 EUR CR Purchase..................... 2,640.00 EUR (10) Sales of 600 punchers on 15.05.20X8. The gross amount is: 600 × 5 × 120% = 3,600.00 EUR . DR Cash/ Bank.................... 3,600.00 EUR CR VAT.......................... 600.00 EUR CR Revenue...................... 3,000.00 EUR (11) Inventory movement for the puncher sales on 15.05.20X8. The cost amount is read from Figure 28.10 - Change-column directly. The amount is better than the calculation based on rounded unit costs, which gives: 600 × 2.21 = 1,326.00 EUR . DR Cost of Sales (COS).......... 1,326.67 EUR CR Inventory Punchers........... 1,326.67 EUR (12) Purchase of 500 punchers at 2.50 EUR/ u on 5.07.20X8. The gross amount is: 1,250 × 120% = 1,500.00 EUR . <?page no="297"?> Berkau: BASICS of ACCOUNTING 28-296 DR Purchase .................... 1,250.00 EUR DR VAT.......................... 250.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (13) Transfer of purchases to inventory on 5.07.20X8. DR Inventory Punchers........... 1,250.00 EUR CR Purchase..................... 1,250.00 EUR (14) Sale of 750 punchers on 15.08.20X8. The gross amount is: 750 × 5 × 120% = 4,500.00 EUR . DR Cash/ Bank.................... 4,500.00 EUR CR VAT.......................... 750.00 EUR CR Revenue...................... 3,750.00 EUR (15) Inventory movement for the puncher sales on 15.08.20X8. The amount of 1,745.00 EUR is taken from Figure 28.10 - Change-column directly. DR Cost of Sales (COS).......... 1,745.00 EUR CR Inventory Punchers........... 1,745.00 EUR On 15.09.20X8, 10 punchers are returned to MONTAGU Ltd. The customers are not satisfied with the punchers, but no damage on the punchers is detected. Thus, MONTAGU Ltd. puts the punchers on stock again. The puncher input is based on the unit costs the punchers were released from stock at the time of sales. (16) The puncher buyers are refunded to the extent of the price they paid for the puncher in July. The total refund is: 5 × 10 × 120% = 60.00 EUR . Instead of applying a Returns Inwards account, MONTAGUE Ltd. records a negative sale / revenue. This bookkeeping entry format is based on the international chart of accounts which does not contain Return Inwards accounts. DR Revenue...................... 50.00 EUR DR VAT.......................... 10.00 EUR CR Cash/ Bank.................... 60.00 EUR (17) The increase of stock for the returned punchers is linked to a reduction in the Cost of Sales (COS) account. This means, the expenses for selling the goods are reduced to the extent of 10 punchers, because these goods are returned. The amount is taken directly from Figure 28.10 - Change-column − directly. <?page no="298"?> Berkau: BASICS of ACCOUNTING 28-297 DR Inventory Punchers........... 23.27 EUR CR Cost of Sales (COS).......... 23.27 EUR (18) Purchase of 900 punchers at 2.38 EUR/ u on 5.10.20X8. The gross amount is: 2,142 × 120% = 2,570.40 EUR . DR Purchase .................... 2,142.00 EUR DR VAT.......................... 428.40 EUR CR Cash/ Bank.................... 2,570.40 EUR (19) Transfer of purchases to inventory on 5.10.20X8. DR Inventory Punchers........... 2,142.00 EUR CR Purchase..................... 2,142.00 EUR (20) Sales of 1,000 punchers on 15.11.20X8. The gross amount is: 1,000 × 5 × 120% = 6,000.00 EUR . DR Cash/ Bank.................... 6,000.00 EUR CR VAT.......................... 1,000.00 EUR CR Revenue...................... 5,000.00 EUR (21) Inventory movement for the puncher sales on 15.11.20X8. The amount is taken from Figure 28.10 - Change-column − directly. DR Cost of Sales (COS).......... 2,360.71 EUR CR Inventory Punchers........... 2,360.71 EUR In Figure 28.12, the closing stock of punchers is 967.89 EUR as calculated by Figure 28.10. Below, the stapler movement is shown in Figure 28.11. The table is along the same format as in Figure 28.10. No stapler is returned during 20X8. However, special attention is given to the discount allowed by the stapler supplier. <?page no="299"?> Berkau: BASICS of ACCOUNTING 28-298 Item Price paid/ u Amount Stock Value Change Stock level + stapler 5.10 5,600 5,600 5.10 28,560.00 28,560.00 stapler (4,012) 1,588 5.10 (20,461.20) 8,098.80 + stapler 5.50 6,000 7,588 5.42 33,000.00 41,098.80 stapler (7,050) 538 5.42 (38,184.84) 2,913.96 + stapler 4.90 10,000 10,538 4.93 49,000.00 51,913.96 stapler (8,750) 1,788 4.93 (43,105.63) 8,808.33 + stapler 4.30 15,000 16,788 4.37 64,500.00 73,308.33 Discount (4,988.00) 68,320.33 stapler (15,988) 800 4.07 (65,064.65) 3,255.67 Figure 28.11: MONTAGU Ltd.’s inventory movement for staplers 1 st line: On 5.01.20X8, MONTAGU Ltd. purchases 5,600 staplers at a net purchase price of 5.10 EUR/ u. The purchase value is: 5,600 × 5.10 = 28,560.00 EUR . 2 nd line: In the next quarter (on 15.02.20X8), MONTAGU Ltd. sells 4,012 staplers. The remaining amount of staplers on stock is: 5,600 - 4,012 = 1,588 staplers . The unit costs for staplers are 5.10 EUR/ u. The decrease of stock is: 4,012 × 5.10 = 20,461.20 EUR . The new stock level is: 28,560 - 20,461.20 = 8,098.80 EUR . 3 rd line: On 5.04.20X8, MONTAGU Ltd. purchases 6,000 staplers at 5.50 EUR. The increase of stock equals to: 6,000 × 5.50 = 33,000.00 EUR . The new level of staplers on stock based on the EUR amount is: 8,098.80 + 33,000 = 41,098.80 EUR . The amount of staplers is: 1,588 + 6,000 = 7,588 staplers . The average costs per stapler are: 41,098.80 / 7,588 = 5.42 EUR/ u . 4 th line: During the next quarter on 15.05.20X8, MONTAGU Ltd. sells 7,050 staplers. The new amount of staplers on stock is: 7,588 - 7,050 = 538 staplers . The decrease of stock by selling 7,050 staplers is: 7,050 × 5.42 = 38,211.00 EUR . The exact amount is 38,184.84 EUR. The rounding differences with regard to the staplers are quite high, because the stapler amounts per inventory movement are big. The new stock level is: 41,098.80 - 38,184.84 = 2,913.96 EUR . 5 th line: On 5.07.20X8 MONTAGU Ltd. buys 10,000 staplers at a net purchase price of 4.90 EUR/ u. The increase of stock is: 10,000 × 4.90 = 49,000.00 EUR . The level of staplers on stock is: 2,913.96 + 49,000 = 51,913.96 EUR . The amount of staplers now is: 538 + 10,000 = 10,538 staplers . The weighted average costs per stapler are: 51,913.96 / 10,538 = 4.93 EUR/ u . 6 th line: During the third quarter of 20X8 on the 15.08.20X8, MONTAGU Ltd. sells 8,750 staplers. The amount of staplers after the sales is: 10,538 - 8,750 = 1,788 staplers . The decrease of stock value is: 8,750 × 4.93 = 43,137.50 EUR . The exact amount along the MS-Excel calculation in Figure 28.11 is: 43,105.63 EUR. The stock level after the sales is 51,913.96 - 43,105.63 = 8,808.33 EUR . 7 th line: On 5.10.20X8, MONTAGU Ltd. orders 15,000 staplers at purchase costs of 4.30 EUR/ u. The amount of staplers on stock increases and now is: 1,788 + 15,000 = 16,788 staplers . The increase with regard to the value is: 15,000 × 4.30 = 64,500.00 EUR . The closing stock after <?page no="300"?> Berkau: BASICS of ACCOUNTING 28-299 this purchase is: 8,808.33 + 64,500 = 73,308.33 EUR . The weighted average unit costs are: 73,308.33/ 16,788 = 4.37 EUR/ u . 8 th line: By the previous purchase MONTAGU Ltd. qualifies for the discount offered by the stapler supplier. The terms of the discount state, that in case MONTAGU Ltd. exceeds an order amount of 25,000 staplers there will be a discount of 10 % for all staplers beyond that mark. During the Accounting period 20X8, MONTAGU Ltd. ordered: 5,600 + 6,000 + 10,000 + 15,000 = 36,600 staplers . Thus, the costs of 11,600 staplers from the last delivery on 5.10.20X8 will be reduced by 10 %. The discount is: 11,600 × 4.30 × 10% = 4,988.00 EUR . This amount is ex VAT. The full discount includes VAT and amounts to: 4,988 × 120% = 5,985.60 EUR . IAS 2 states that the costs are the purchase price less VAT and less discounts. Thus, the inventory of staplers is to be reduced by 4,988.00 EUR. The closing stock amounts to: 73,308.33 - 4,988 = 68,320.33 EUR . The average cost per staplers change also by discount consideration. The unit costs now are: 68,320.33/ 16,788 = 4.07 EUR/ u . The VAT account is adjusted for the discount received by MONTAGU Ltd., too. 9 th line: MONTAGU Ltd. sells 15,988 staplers during the last quarter of 20X8 on the 15.11.20X8. The decrease of stock caused by the sales is: 15,988 × 4.07 = 65,071.16 EUR . The accurate amount is 65,064.65 EUR. The closing stock as at the balance sheet date is: 68,320.33 - 65,064.65 = 3,255.68 EUR . The MS-Excel accurate amount is 3,255.67 EUR. Below, all bookkeeping entries for the stapler movements are provided: (22) Purchase of staplers on 5.01.20X8. The gross amount is: 28,560 × 120% = 34,272.00 EUR . DR Purchase..................... 28,560.00 EUR DR VAT.......................... 5,712.00 EUR CR Cash/ Bank.................... 34,272.00 EUR (23) The purchases are transferred to the Inventory Staplers account. DR Inventory Staplers........... 28,560.00 EUR CR Purchase..................... 28,560.00 EUR (24) Sales of 4,012 punchers at 10.00 EUR net selling price each. The revenue is: 4,012 × 10 = 40,120.00 EUR . The gross amount is: 40,120 × 120% = 48,144.00 EUR . DR Cash/ Bank.................... 48,144.00 EUR CR VAT.......................... 8,024.00 EUR CR Revenue...................... 40,120.00 EUR <?page no="301"?> Berkau: BASICS of ACCOUNTING 28-300 (25) The inventory reduction is taken from Figure 28.11 and amounts to 20,461.20 EUR. DR Cost of Sales (COS).......... 20,461.20 EUR CR Inventory Staplers........... 20,461.20 EUR (26) Purchase of staplers on 5.04.20X8. The gross amount is: 33,000 × 120% = 39,600.00 EUR . DR Purchase..................... 33,000.00 EUR DR VAT.......................... 6,600.00 EUR CR Cash/ Bank.................... 39,600.00 EUR (27) The purchases are transferred to the Inventory Staplers account. DR Inventory Staplers........... 33,000.00 EUR CR Purchase..................... 33,000.00 EUR (28) Sales of 7,050 punchers at 10.00 EUR net selling price each. The revenue is: 7,050 × 10 = 70,500.00 EUR . The gross amount is: 70,500 × 120% = 84,600.00 EUR . DR Cash/ Bank.................... 84,600.00 EUR CR VAT.......................... 14.100.00 EUR CR Revenue...................... 70,500.00 EUR (29) The inventory reduction is taken from Figure 28.11 and amounts to 38,184.84 EUR. DR Cost of Sales (COS).......... 38,184.84 EUR CR Inventory Staplers........... 38,184.84 EUR (30) Purchase of staplers on 5.07.20X8. The gross amount is: 49,000 × 120% = 58,800.00 EUR . DR Purchase..................... 49,000.00 EUR DR VAT.......................... 9,800.00 EUR CR Cash/ Bank.................... 58,800.00 EUR <?page no="302"?> Berkau: BASICS of ACCOUNTING 28-301 (31) The purchases are transferred to the Inventory Staplers account. DR Inventory Staplers........... 49,000.00 EUR CR Purchase..................... 49,000.00 EUR (32) Sales of 8,750 punchers at 10.00 EUR net selling price each. The revenue is: 8,750 × 10 = 87,500.00 EUR . The gross amount is: 87,500 × 120% = 105,000.00 EUR . DR Cash/ Bank.................... 105,000.00 EUR CR VAT.......................... 17,500.00 EUR CR Revenue...................... 87,500.00 EUR (33) The inventory reduction is taken from Figure 28.11 and amounts to 43,105.63 EUR. DR Cost of Sales (COS).......... 43,105.63 EUR CR Inventory Staplers........... 43.105.63 EUR (34) Purchase of staplers on 5.10.20X8. The gross amount is: 64,500 × 120% = 77,400.00 EUR . DR Purchase..................... 64,500.00 EUR DR VAT.......................... 12,900.00 EUR CR Cash/ Bank.................... 77,400.00 EUR (35) The purchases are transferred to the Inventory Staplers account. DR Inventory Staplers........... 64,500.00 EUR CR Purchase..................... 64,500.00 EUR (36) The stapler supplier offers a discount of 10 % on all staplers bought in exceed of 25,000 staplers. 11,600 staplers are valued 10 % off According to this discount offer. The discount’s gross amount is: 11,600 × 4.30 × 10% × 120% = 5,985.60 EUR . The net amount of the discount is: 5,985.60/ 120% = 4,988.00 EUR . The discount is recorded after the purchase. Thus, the contra account for the discount is the Cash/ Bank account. MONTAGU Ltd. records the discount on 6.10.20X8 (one day after the purchase). <?page no="303"?> Berkau: BASICS of ACCOUNTING 28-302 DR Cash/ Bank.................... 5,985.60 EUR CR Discount..................... 5,985.60 EUR (37) According to IAS 2, the costs of purchase are to adjust towards the lower amount. MONTAGU Ltd. makes a credit entry in the Inventory Staplers account. Furthermore, the VAT claim decreases with the discount, as MONTAGU Ltd. didn’t pay the full price, but only 90 % thereof. On 6.10.20X8, MONTAGU Ltd. records the discount received from its supplier. DR Discount..................... 5,985.60 EUR CR VAT.......................... 997.60 EUR CR Inventory Staplers........... 4,988.00 EUR (38) Sales of 15,988 punchers at 10.00 EUR net selling price each. The revenue is: 15,988 × 10 = 159,880.00 EUR . The gross amount is: 159,880 × 120% = 191,856.00 EUR . DR Cash/ Bank.................... 191,856.00 EUR CR VAT.......................... 31,976.00 EUR CR Revenue...................... 159,880.00 EUR (39) The inventory reduction is taken from Figure 28.11 and amounts to 65,064.65 EUR. DR Cost of Sales (COS).......... 65,064.65 EUR CR Inventory Staplers........... 65,064.65 EUR Observe the closing stock of Inventory Staplers account being the same as in Figure 28.11 on the bottom line. The profit calculation can be observed by Figure 28.12. <?page no="304"?> Berkau: BASICS of ACCOUNTING 28-303 D C D C (1) 10,000.00 (2) 12,000.00 c/ d 10,000.00 (1) 10,000.00 (6) 5,100.00 (3) 36,000.00 b/ d 10,000.00 (10) 3,600.00 (4) 2,760.00 (14) 4,500.00 (8) 3,168.00 (20) 6,000.00 (12) 1,500.00 (24) 48,144.00 (16) 60.00 (28) 84,600.00 (18) 2,570.40 (32) 105,000.00 (22) 34,272.00 (36) 5,985.60 (26) 39,600.00 (38) 191,856.00 (30) 58,800.00 (34) 77,400.00 c/ d 196,655.20 464,785.60 464,785.60 b/ d 196,655.20 D C D C (2) 12,000.00 P&L 12,000.00 (3) 36,000.00 P&L 36,000.00 Cash/ Bank Share capital Rent Labour D C D C (4) 2,300.00 (5) 2,300.00 (4) 460.00 (6) 850.00 (8) 2,640.00 (9) 2,640.00 (8) 528.00 (10) 600.00 (12) 1,250.00 (13) 1,250.00 (12) 250.00 (14) 750.00 (18) 2,142.00 (19) 2,142.00 (16) 10.00 (20) 1,000.00 (22) 28,560.00 (23) 28,560.00 (18) 428.40 (24) 8,024.00 (26) 33,000.00 (27) 33,000.00 (22) 5,712.00 (28) 14,100.00 (30) 49,000.00 (31) 49,000.00 (26) 6,600.00 (32) 17,500.00 (34) 64,500.00 (35) 64,500.00 (30) 9,800.00 (37) 997.60 183,392.00 183,392.00 (34) 12,900.00 (38) 31,976.00 c/ d 39,109.20 75,797.60 75,797.60 b/ d 39,109.20 D C D C (5) 2,300.00 (7) 1,955.00 (16) 50.00 (6) 4,250.00 (9) 2,640.00 (11) 1,326.67 (10) 3,000.00 (13) 1,250.00 (15) 1,745.00 (14) 3,750.00 (17) 23.27 (21) 2,360.71 (20) 5,000.00 (19) 2,142.00 c/ d 967.89 (24) 40,120.00 8,355.27 8,355.27 (28) 70,500.00 b/ d 967.89 (32) 87,500.00 P&L 373,950.00 (38) 159,880.00 374,000.00 374,000.00 Purchase VAT Inventory punchers Revenue Figure 28.12: MONTAGU Ltd.’s accounts <?page no="305"?> Berkau: BASICS of ACCOUNTING 28-304 D C D C (7) 1,955.00 (17) 23.27 (23) 28,560.00 (25) 20,461.20 (11) 1,326.67 (27) 33,000.00 (29) 38,184.84 (15) 1,745.00 (31) 49,000.00 (33) 43,105.63 (21) 2,360.71 (35) 64,500.00 (37) 4,988.00 (25) 20,461.20 (39) 65,064.65 (29) 38,184.84 c/ d 3,255.68 (33) 43,105.63 175,060.00 175,060.00 (39) 65,064.65 P&L 174,180.43 b/ d 3,255.68 174,203.70 174,203.70 D C D C (37) 5,985.60 (36) 5,985.60 Lab 36,000.00 Rev 373,950.00 Rnt 12,000.00 COS 174,180.43 EBT 151,769.57 373,950.00 373,950.00 IT 45,530.87 b/ d 151,769.57 R/ E 106,238.70 151,769.57 151,769.57 D C D C c/ d 45,530.87 P&L 45,530.87 c/ d 106,238.70 P&L 106,238.70 b/ d 45,530.87 b/ d 106,238.70 Income tax liabilities Retained earnings (R/ E) Cost of Sales (COS) Inventory staplers Discount Profit and Loss Figure 28.12: MONTAGU Ltd.’s accounts (continued) The statement of comprehensive income is prepared along the cost of sales format. Observe Figure 28.13 below. <?page no="306"?> Berkau: BASICS of ACCOUNTING 28-305 [EUR] Revenue 373,950.00 Other income 373,950.00 Cost of sales (COS) 174,180.43 Labour 36,000.00 Depreciation 0.00 Other expenses 12,000.00 Earnings before int and taxes (EBIT) 151,769.57 Interest 0.00 Earnings before taxes (EBT) 151,769.57 Income tax expenses 45,530.87 Deferred taxes Earnings after taxes (EAT) 106,238.70 MONTAGU Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 28.13: MONTAGU Ltd.’s statement of comprehensive income The balance sheet is displayed by Figure 28.14: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 0.00 Share capital 10,000.00 Intangibles Reserves Financial assets R/ E 106,238.70 Current assets Liabilities Inventory 4,223.57 Interest bear liab A/ R A/ P 39,109.20 Prepaid expenses Provisions Cash/ Bank 196,655.20 Tax liabilities 45,530.87 200,878.77 200,878.77 Montagu Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 28.14: MONTAGU Ltd.’s statement of financial position The income statement along the nature of expense method would have been easier to prepare once the calculations in Figure 28.10 and Figure 28.11 are made. <?page no="307"?> Berkau: BASICS of ACCOUNTING 28-306 The changes in inventory are the closing stocks of punchers and staplers. The amounts are taken from the bottom line of the calculations: 967.89 + 3,255.67 = 4,223.56 EUR . The total of purchases is: 2,300 + 2,640 + 1,250 + 2,142 + 28,560 + 33,000 + 49,000 + 64,500 = 183,392.00 EUR . The material expenses are: 183,392 - 4,223.56 - 4,988 = 174,180.44 EUR . The income statement along the nature of expense method looks like below in Figure 28.15: [EUR] Revenue 373,950.00 Other income 373,950.00 Materials 174,180.44 Labour 36,000.00 Depreciation 0.00 Other expenses 12,000.00 Earnings before int and taxes (EBIT) 151,769.56 Interest 0.00 Earnings before taxes (EBT) 151,769.56 Income tax expenses 45,530.87 Deferred taxes Earnings after taxes (EAT) 106,238.69 MONTAGU Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 28.15: MONTAGU Ltd. statement of comprehensive income along the NoE format Summary: Companies can prepare the statement of comprehensive income along the nature of expense method or the cost of sales format. Both formats provide the same amount of profit. The nature of expense method considers all expenses and makes adjustments to the revenue by changes in inventory. The cost of sales format is based on the revenue less cost for goods sold during the Accounting period. The cost of sales format is often used for Management Accounting purposes as it provides information about the contribution margin of products, customers, marketing segments, etc. IFRSs and Handelsgesetzbuch do not prescribe any method for income statement calculation. Working Definitions: Statement of Comprehensive Income along the Nature of Expense Method: The income statement along the nature of expense format calculates <?page no="308"?> Berkau: BASICS of ACCOUNTING 28-307 profit starting with the revenue and deducting all costs for the period; it adjusts the revenue for costs of manufacturing for stock increases of finished goods and/ or inventory deductions, both together referred to as changes in inventory. Statement of Comprehensive Income along the Cost of Sales Format: The income statement along the cost of sales format starts with the revenue and deducts only costs for the goods/ services sold. Contribution Margin: A contribution margin is a product’s revenue less its proportional costs. <?page no="309"?> Berkau: BASICS of ACCOUNTING 29-308 29. Preparing the Trial Balance Learning Objectives: In this chapter we learn how to derive the financial statements via the trial balance. The concept of the trial balance checks the bookkeeping entries with regard to the double entry system. The application of the trial balance will help to avoid bookkeeping errors. The trial balance actually is a list of balancing figures of all accounts in use. At any time, the total of debit entries has to equal the total of credit entries. After studying this chapter, you will be able to check your bookkeeping steps which can be very helpful in Accounting exams. However, if you make bookkeeping entries by a software system in a company, you can skip this chapter. Applying the trial balance shows already at the beginning of the Accounting procedure whether your bookkeeping entries are in line with the double entry system. The concept is quite simple: After making bookkeeping entries, we balance-off all accounts and compare the total of balancing figures on the debit side to those on the credit side. If both sums equal each other, the bookkeeping records are likely to be consistent with regard to the double entry system. Actually, the comparison can only indicate mistakes. However, equal sums indicate a high probability that the entries made are correct with regard to the double entry system. The concept of the trial balance and the adjusted trial balance will be introduced by the case study PENTZ Ltd. PENTZ Ltd. is both, a production firm and dealership. The example deliberately is more complicated than the previous case studies in order to demonstrate the power of the trial balance concept. The trial balance works as follows: 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 every account therein. Make two columns, one called debit entries and the other one credit entries. Enter the balances brought down for all accounts in the columns debit entry or credit entry according to the side they belong to. (3) Compare the total of the columns debit entries and credit entries. If they equal one another, the bookkeeping looks good. (4) Make the adjustment postings like depreciation, accruals etc. Make bookkeeping entries for the profit and <?page no="310"?> Berkau: BASICS of ACCOUNTING 29-309 loss calculation including income tax and appropriation of profit if required. (5) Transfer the adjustments to the trial balance. Delete accounts that have been closed-off to the Profit and Loss account. Consider that the Profit and Loss account gets closed-off as well. Again, compare the total of the balancing figures for the accounts. (6) Prepare the income statement based on the information you retrieve from the Profit and Loss account. Prepare the balance sheet based on the real accounts displayed by the adjusted trial balance. We start the case study PENTZ Ltd. by making bookkeeping entries linked to the business activities. Later we’ll prepare a trial balance. We further make bookkeeping entries for adjustments and derive the Profit and Loss account. After that step, we prepare the adjusted trial balance. In total our bookkeeping procedure contains the following steps: Step (A): Making bookkeeping entries. Step (B): Preparing the trial balance. Step (C): Checking the trial balance Step (D): Making adjustments. Step (E): Preparing the adjusted trial balance. Step (F): Deriving financial statements. Step (A): Making Bookkeeping Entries: PENTZ Ltd. is a production firm for surfboards. The company deals with surf equipment, such as protection bags, sun glasses, wet suits etc., too. PENTZ Ltd. is based on shares and established on 2.01.20X4. PENTZ Ltd. issues 20,000 ordinary shares at 5.00 EUR/ share. The share issue is at face value. The share capital amounts to: 20,000 × 5 = 100,000.00 EUR . (1) Share issue on 2.01.20X4. DR Cash/ Bank.................... 100,000.00 EUR CR Share Capital................ 100,000.00 EUR PENTZ Ltd. rents its shop at the beach front from its landlord. Although PENTZ Ltd. is a VAT registered company, it does not consider VAT for rent, because the landlord is a private person. The rent amounts to 5,000.00 EUR/ quarter and is to be paid in advance. The payment dates are: 2.01.20X4, 31.03.20X4, 30.06.20X4, 30.09.20X4 and 31.12.20X4. The last payment is for the first quarter of 20X5. PENTZ Ltd. pays for rent by bank transfers. (2) … (6) Payment for rent on 2.01.20X4, 31.03.20X4, 30.06.20X4, 30.09.20X4 and 31.12.20X4. DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR <?page no="311"?> Berkau: BASICS of ACCOUNTING 29-310 DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR On 3.01.20X4, PENTZ Ltd. buys a workshop for shaping and painting surfboards. The workshop contains a workbench, shaping tools, brushes and spray paint equipment. The workshop cost 21,500.00 EUR (net amount). The workshop is paid half by bank transfer and the other half in the next year. (7) Acquisition of the workshop on 3.01.20X4. DR P, P, E Account.............. 21,500.00 EUR DR VAT.......................... 4,300.00 EUR CR Cash/ Bank.................... 12,900.00 EUR CR Accounts Payables............ 12,900.00 EUR The workshop is intended to be deployed until 31.12.20X7. Thus, its useful life is 4 years. PENTZ Ltd. applies straight line method for depreciation. Accordingly, the depreciation charge for 20X4 is: 21,500/ 4 = 5,375.00 EUR . Although depreciation is subject to adjustments PENTZ Ltd. makes a bookkeeping entry for depreciation right away. However, the posting date is 31.12.20X4. (8) Depreciation on workshop on 31.12.20X4. DR Depreciation................. 5,375.00 EUR CR Acc. Depr.................... 5,375.00 EUR PENTZ Ltd. buys materials for surfboard manufacturing. The surfboard’s materials are the PE-body (not yet shaped), resin and paint. PENTZ Ltd. purchases 150 bodies at a net purchase price of 200.00 EUR each, 100 litre of resin at 1,350.00 EUR (net amount) and 400 cans of paint 500ml at 7.00 EUR each (ex VAT). The materials are paid by bank transfer on 14.01.20X4. The prices (gross amounts) are for the bodies: 150 × 200 × 120% = 36,000.00 EUR , for the resin: 1,350 × 120% = 1,620.00 EUR and for the paint: 400 × 7 × 120% = 3,360.00 EUR . (9) … (11) Purchase of materials on 14.01.20X4. <?page no="312"?> Berkau: BASICS of ACCOUNTING 29-311 DR Purchase..................... 30,000.00 EUR DR VAT.......................... 6,000.00 EUR CR Cash/ Bank.................... 36,000.00 EUR DR Purchase..................... 1,350.00 EUR DR VAT.......................... 270.00 EUR CR Cash/ Bank.................... 1,620.00 EUR DR Purchase..................... 2,800.00 EUR DR VAT.......................... 560.00 EUR CR Cash/ Bank.................... 3,360.00 EUR For production, PENTZ Ltd. applies material-specific Raw Material Inventory accounts (RM). The accounts are dedicated to the particular materials such as bodies, resin and paint. Thus, there is a RM-Body account, a RM-Resin account and a RM-Paint account. However, PENTZ Ltd. applies a periodic inventory system. On 15.01.20X4, the Accountant makes the bookkeeping entries (12) … (14). (12) … (14) Putting materials on stock and transferring them to raw materials on 15.01.20X4. DR RM-Bodies.................... 30,000.00 EUR CR Purchase..................... 30,000.00 EUR DR RM-Resin..................... 1,350.00 EUR CR Purchase..................... 1,350.00 EUR DR RM-Paint..................... 2,800.00 EUR CR Purchase..................... 2,800.00 EUR PENTZ Ltd. intends to produce 125 surfboards during the Accounting period 20X4. We calculate the unit costs of manufacturing. Depreciation per board is: 5,375/ 125 = 43.00 EUR . The amount of resin is 500 ml per board. Resin expenses per board are: 0.5 × 1,350 / 100 = 6.75 EUR . The paint used per board is 2 cans. Costs per board are: 2 × 7 = 14.00 EUR . Manufacturing-linked labour is for a famous surfer, who works exclusively for PENTZ Ltd. He claims 350.00 EUR for shaping one board. In the Accounting period 20X4, PENTZ Ltd. produces 125 boards and pays for the shaping and painting specialist: 125 × 350 = 43,750.00 EUR . The surfboard shaper gets paid on cash in the middle of the year. (15) Accounting for labour on 30.06.20X4. DR Labour....................... 43,750.00 EUR CR Cash/ Bank.................... 43,750.00 EUR <?page no="313"?> Berkau: BASICS of ACCOUNTING 29-312 PENTZ Ltd. posts the manufacturing cost of 125 surfboards to WIP. Direct labour amounts to 43,750.00 EUR. Depreciation is 5,375.00 EUR. The materials are for bodies: 125 × 200 = 25,000.00 EUR , for resin: 125 × 6.75 = 843.75 EUR and for paint: 125 × 14 = 1,750.00 EUR . Accordingly, the total cost of production equals to: 43,750 + 5,375 + 25,000 + 843.75 + 1,750 = 76,718.75 EUR . (16) Production expenses are charged to the WIP account on 1.07.20X4. DR Work in Process.............. 76,718.75 EUR CR Labour....................... 43,750.00 EUR CR Depreciation................. 5,375.00 EUR CR RM-Bodies.................... 25,000.00 EUR CR RM-Resin..................... 843.75 EUR CR RM-Paint..................... 1,750.00 EUR PENTZ Ltd. completes all surfboards and puts them on stock on 30.09.20X4. (17) The bookkeeping entries for the surfboards completed and transferred to the Finished Goods Inventory account are recorded on 30.09.20X4. DR Finished Goods Inventory..... 76,718.75 EUR CR Work in Process.............. 76,718.75 EUR The unit costs for every surfboard are: 76,718.75/ 125 = 613.75 EUR . As all costs of manufacturing are direct costs, the amount of unit cost of manufacturing is easy to confirm: 200 + 350 + 43 + 6.75 + 14 = 613.75 EUR . On 2.11.20X4, PENTZ Ltd. sells 100 surfboards. Half of the customers pay on cash and the other half buys the boards on credit. They will pay in 20X5. The net selling price for one surfboard is 1,100.00 EUR. The amount of sales is: 100 × 1,100 = 110,000.00 EUR . The gross amount equals to: 110,000 × 120% = 132,000.00 EUR . (18) Sales of 100 surfboards on 2.11.20X4. DR Cash/ Bank.................... 66,000.00 EUR DR Accounts Receivables......... 66,000.00 EUR CR VAT.......................... 22,000.00 EUR CR Sales........................ 110,000.00 EUR At the same time, PENTZ Ltd. has to expense the surfboards taken from stock (finished goods). The bookkeeping entry with regard to the cost of sales represents the flow of goods. The amount is based on the unit cost of manufacturing and equals to: 100 × 613.75 = 61,375.00 EUR . (19) The Accountant expenses the surfboards as costs of goods sold on 2.11.20X4. <?page no="314"?> Berkau: BASICS of ACCOUNTING 29-313 DR Cost of Goods Sold (COS)..... 61,375.00 EUR CR Finished Goods Inventory..... 61,375.00 EUR In addition to production, PENTZ Ltd. is a trading business, too. The company buys wet suits and sells them to its customers. On 3.11.20X4, PENTZ Ltd. buys 50 wet suits at 76.00 EUR/ u (ex VAT) and pays for the goods received by bank transfer. The costs of purchase are: 50 × 76 = 3,800.00 EUR . The gross amount equals to: 3,800 × 120% = 4,560.00 EUR . In order to not mingle materials for production and merchandise goods PENTZ Ltd. applies a special Merchandise Goods Inventory account. (20, 21) Purchase of merchandise goods on 3.11.20X4. DR Purchase..................... 3,800.00 EUR DR VAT.......................... 760.00 EUR CR Cash/ Bank.................... 4,560.00 EUR DR Merchandise Goods............ 3,800.00 EUR CR Purchase..................... 3,800.00 EUR On 15.11.20X4, PENTZ sells 20 wet suits on cash. The net selling price for one wet suit is 230.00 EUR. The sales amount to: 20 × 230 = 4,600.00 EUR . The cash received amounts to: 4,600 × 120% = 5,520.00 EUR . (22) Sales on cash on 15.11.20X4. DR Cash/ Bank.................... 5,520.00 EUR CR VAT.......................... 920.00 EUR CR Sales........................ 4,600.00 EUR PENTZ Ltd. pays the sales person in the surf shop 90,000.00 EUR on 2.12.20X4. (23) Salary payment for the sales person on 2.12.20X4. DR Labour....................... 90,000.00 EUR CR Cash/ Bank.................... 90,000.00 EUR As rent was paid in advance for 20X5, PENTZ Ltd. makes a bookkeeping entry for an adjustment already. The rent for the quarter I/ 20X5 is posted to prepaid expenses. (23) Accrual of quarter I/ 20X5’s rent on 31.12.20X4. DR Prepaid Expenses............. 5,000.00 EUR CR Rent......................... 5,000.00 EUR PENTZ Ltd. balances off the accounts. We take a look at the accounts displayed by Figure 29.1. . <?page no="315"?> Berkau: BASICS of ACCOUNTING 29-314 D C D C (1) 100,000.00 (2) 5,000.00 c/ d 100,000.00 (1) 100,000.00 (18) 66,000.00 (3) 5,000.00 b/ d 100,000.00 (22) 5,520.00 (4) 5,000.00 (5) 5,000.00 (6) 5,000.00 (7) 12,900.00 (9) 36,000.00 (10) 1,620.00 (11) 3,360.00 (15) 43,750.00 (20) 4,560.00 c/ d 45,190.00 (23) 90,000.00 216,710.00 217,190.00 b/ d 45,670.00 Cash/ Bank Issued capital D C D C (2) 5,000.00 (24) 5,000.00 (7) 21,500.00 c/ d 21,500.00 (3) 5,000.00 b/ d 21,500.00 (4) 5,000.00 (5) 5,000.00 (6) 5,000.00 c/ d 20,000.00 25,000.00 25,000.00 b/ d 20,000.00 Rent P,P,E D C D C (7) 4,300.00 (18) 22,000.00 c/ d 12,900.00 (7) 12,900.00 (9) 6,000.00 (22) 920.00 b/ d 12,900.00 (10) 270.00 (11) 560.00 (20) 760.00 c/ d 11,030.00 22,920.00 22,920.00 b/ d 11,030.00 D C D C (8) 5,375.00 (16) 5,375.00 c/ d 5,375.00 (8) 5,375.00 b/ d 5,375.00 VAT Accounts payables Depreciation Acc depr Figure 29.1: PENTZ Ltd.’s accounts <?page no="316"?> Berkau: BASICS of ACCOUNTING 29-315 D C D C (9) 30,000.00 (12) 30,000.00 (12) 30,000.00 (16) 25,000.00 (10) 1,350.00 (13) 1,350.00 c/ d 5,000.00 (11) 2,800.00 (14) 2,800.00 30,000.00 30,000.00 (20) 3,800.00 (21) 3,800.00 b/ d 5,000.00 37,950.00 37,950.00 Purchase RM-Bodies D C D C (13) 1,350.00 (16) 843.75 (14) 2,800.00 (16) 1,750.00 c/ d 506.25 c/ d 1,050.00 1,350.00 1,350.00 2,800.00 2,800.00 b/ d 506.25 b/ d 1,050.00 D C D C (15) 43,750.00 (16) 43,750.00 (16) 76,718.75 (17) 76,718.75 D C D C (17) 76,718.75 (19) 61,375.00 (18) 110,000.00 c/ d 15,343.75 c/ d 114,600.00 (22) 4,600.00 76,718.75 76,718.75 114,600.00 114,600.00 b/ d 15,343.75 b/ d 114,600.00 FG-Inventory Sales Labour WIP RM-Resin RM-Paint D C D C (18) 66,000.00 c/ d 66,000.00 (19) 61,375.00 c/ d 61,375.00 b/ d 66,000.00 b/ d 61,375.00 D C D C (21) 3,800.00 c/ d 3,800.00 (24) 5,000.00 c/ d 5,000.00 b/ d 3,800.00 b/ d 5,000.00 D C (23) 90,000.00 c/ d 90,000.00 b/ d 90,000.00 Labour - Sales person Accounts receivables Cost of goods sold Merchandise goods inventory MG Prepaid expenses Figure 29.1: PENTZ Ltd.’s accounts (continued) Step (B): Preparing the Trial Balance: The bookkeeping entries and the accounts look complex enough to explain the benefit of the trial balance. At this stage of recording, we might be uncertain, whether or not we made bookkeeping errors. <?page no="317"?> Berkau: BASICS of ACCOUNTING 29-316 In order to check the so far made postings with regard to their consistency to the double entry system, we set up the trial balance. A trial balance is a list of all accounts that shows their balances brought down sorted that way, that debit balanced accounts’ balancing figures are in one column and credit balanced accounts’ balancing figures in another one. At the bottom line of the columns, the total of the balancing figures for the debit side and for the credit side are shown. The both sums have to be the same amount. Any difference between the debit and credit side, indicates a breach with the double entry system. Figure 29.2 displays PENTZ Ltd.’s trial balance: Account Debit entries Credit entries Cash/ Bank 45,670.00 Issued Capital 100,000.00 Rent 20,000.00 Property, Plant, and Equipment 21,500.00 VAT 11,030.00 Accounts Payable 12,900.00 Depreciation 0.00 0.00 Accumulated Depreciation 5,375.00 Purchase 0.00 0.00 Raw Materials - Bodies 5,000.00 Raw Materials - Resin 506.25 Raw Materials - Paint 1,050.00 Labour (Production) 0.00 0.00 Work in Process 0.00 0.00 Finished Goods Inventory 15,343.75 Sales 114,600.00 Accounts Receivables 66,000.00 Cost of Goods Sold (COS) 61,375.00 Merchandise Goods Inventory 3,800.00 Prepaid Expenses 5,000.00 Labour (Sales Person) 90,000.00 Total: 289,575.00 289,575.00 Pentz Ltd.'s TRIAL BALANCE as at 31.12.20X4 Figure 29.2: PENTZ Ltd.’s trial balance The amounts for the manufacturing accounts are balanced to zero as these accounts have been closed-off to the Work in Process (WIP) account. This applies for labour (production), purchase and depreciation. The sales person’s labour is a non-manufacturing expense and must not be closed-off to the WIP account. As all surfboards have been completed, there is no closing stock in the <?page no="318"?> Berkau: BASICS of ACCOUNTING 29-317 WIP account. All surfboards manufactured have been transferred to the Finished Goods Inventory account. Step (C): Checking the Trial Balance Once the trial balance is in a good condition, we can continue our procedure of financial statements preparation. A good condition of the trial balance means the total of the debit entry column and the total of the credit entry column must be the same. Furthermore, we check criteria as indicated by Figure 29.3. Account Debit entries Credit entries non-current assets (e.g. PPE) x Accumulated Depreciation x current assets (e.g. Inventory) x Accounts Receivables x (x) Cash/ Bank x x Capital (e.g. Issued Capital) x Retained/ Earnings -x x Liabilities (e.g. IBL) x Accounts Payables (x) x Expenses (e.g. Labour) x Revenue x Total: sum sum TRIAL BALANCE as at 31.12.20X0 Figure 29.3: A good trial balance A good trial balance does not contain any figures that result from faulty balances. Besides the equality of the sums, there are some further checks possible: The balancing amounts for assets should always be on the debit side. This means the accounts are debit balanced. There can be exceptions for Cash/ Bank and for Accounts Receivables. Otherwise, asset accounts linked to object of physical nature cannot become credit balanced. The amount for the balancing figure of the Accumulated Depreciation account always has to be on the credit side. No negative depreciation is possible. The amounts for the accounts on the credit side of the statement of financial position should be on the credit side. This means the accounts are credit balanced. No negative capital is allowed. The only exception is about a negative balanced Retained Earnings account in cases of a loss or forwarded losses. Liabilities are credit balanced also. There can be an exception about the Accounts Payables. A debit balanced Account Payables account indicates the company being to receive money from its suppliers. That could happen <?page no="319"?> Berkau: BASICS of ACCOUNTING 29-318 if the supplier sent a voucher in return, e.g. Only in case the trial balance fulfils these requirements, you should continue the Accounting process. Step (D): Making Adjustments: Although some adjustments like depreciation and accruals (Prepaid Expense account) have been pulled forward in the case of PENTZ Ltd. there are still some adjustments required to be made. The Inventory account for merchandise goods is closed-off to the Trading account. Be aware, the merchandise goods are linked to purchases. DR Trading Account.............. 3,800.00 EUR CR Merchandise Goods............ 3,800.00 EUR The closing stock of merchandise goods is still unknown. On 31.12.20X4, PENTZ Ltd. runs a stock count and detects 30 wetsuits, worth 76.00 EUR each. The valuation is based on their cost of purchase. Accordingly, the closing stock equals to: 30 × 76 = 2,280.00 EUR . Furthermore, sales resulting from trading are transferred to the Trading account. Sales amount to: 20 × 230 = 4,600.00 EUR . DR Sales........................ 4,600.00 EUR CR Trading Account.............. 4,600.00 EUR The closing stock of Merchandise Goods is transferred also. DR Merchandise Goods............ 2,280.00 EUR CR Trading Account.............. 2,280.00 EUR The gross profit calculated equals to: 4,600 + 2,280 - 3,800 = 3,080.00 EUR . The Trading account is closed-off to the Profit and Loss account: DR Trading Account.............. 3,080.00 EUR CR Profit and Loss.............. 3,080.00 EUR PENTZ Ltd. posts the sales from the surfboards and the cost of goods sold and further expenses for labour and rent to profit and loss. DR Sales........................ 110,000.00 EUR CR Profit and Loss.............. 110,000.00 EUR DR Profit and Loss.............. 61,375.00 EUR CR Cost of Goods Sold........... 61,375.00 EUR <?page no="320"?> Berkau: BASICS of ACCOUNTING 29-319 DR Profit and Loss.............. 90,000.00 EUR CR Labour....................... 90,000.00 EUR DR Profit and Loss.............. 20,000.00 EUR CR Rent......................... 20,000.00 EUR After the adjustments have been completed, the net profit will be calculated. It amounts to: 3,080 + 110,000 - 61,375 - 90,000 - 20,000 = -58,295.00 EUR . The amount for the net loss is transferred to the Retained Earnings account. DR Retained Earnings............ 58,295.00 EUR CR Profit and Loss.............. 58,295.00 EUR Observe the Profit and Loss account in Figure 29.4: D C D C (1) 100,000.00 (2) 5,000.00 c/ d 100,000.00 (1) 100,000.00 (18) 66,000.00 (3) 5,000.00 b/ d 100,000.00 (22) 5,520.00 (4) 5,000.00 (5) 5,000.00 (6) 5,000.00 (7) 12,900.00 (9) 36,000.00 (10) 1,620.00 (11) 3,360.00 (15) 43,750.00 (20) 4,560.00 c/ d 45,670.00 (23) 90,000.00 217,190.00 217,190.00 b/ d 45,670.00 Cash/ Bank Issued capital D C D C (2) 5,000.00 (24) 5,000.00 (7) 21,500.00 c/ d 21,500.00 (3) 5,000.00 b/ d 21,500.00 (4) 5,000.00 (5) 5,000.00 (6) 5,000.00 c/ d 20,000.00 25,000.00 25,000.00 b/ d 20,000.00 P&L 20,000.00 Rent P,P,E Figure 29.4: PENTZ Ltd.’s accounts <?page no="321"?> Berkau: BASICS of ACCOUNTING 29-320 D C D C (7) 4,300.00 (18) 22,000.00 c/ d 12,900.00 (7) 12,900.00 (9) 6,000.00 (22) 920.00 b/ d 12,900.00 (10) 270.00 (11) 560.00 (20) 760.00 c/ d 11,030.00 22,920.00 22,920.00 b/ d 11,030.00 D C D C (8) 5,375.00 (16) 5,375.00 c/ d 5,375.00 (8) 5,375.00 b/ d 5,375.00 VAT Accounts payables Depreciation Acc depr D C D C (9) 30,000.00 (12) 30,000.00 (12) 30,000.00 (16) 25,000.00 (10) 1,350.00 (13) 1,350.00 c/ d 5,000.00 (11) 2,800.00 (14) 2,800.00 30,000.00 30,000.00 (20) 3,800.00 (21) 3,800.00 b/ d 5,000.00 37,950.00 37,950.00 Purchase RM-Bodies D C D C (13) 1,350.00 (16) 843.75 (14) 2,800.00 (16) 1,750.00 c/ d 506.25 c/ d 1,050.00 1,350.00 1,350.00 2,800.00 2,800.00 b/ d 506.25 b/ d 1,050.00 D C D C (15) 43,750.00 (16) 43,750.00 (16) 76,718.75 (17) 76,718.75 Labour WIP RM-Resin RM-Paint D C D C (17) 76,718.75 (19) 61,375.00 (18) 110,000.00 c/ d 15,343.75 c/ d 114,600.00 (22) 4,600.00 76,718.75 76,718.75 114,600.00 114,600.00 b/ d 15,343.75 T/ A 4,600.00 b/ d 114,600.00 P&L 110,000.00 114,600.00 114,600.00 FG-Inventory Sales Figure 29.4: PENTZ Ltd.’s accounts (continued) <?page no="322"?> Berkau: BASICS of ACCOUNTING 29-321 D C D C (18) 66,000.00 c/ d 66,000.00 (19) 61,375.00 c/ d 61,375.00 b/ d 66,000.00 b/ d 61,375.00 P&L 61,375.00 D C D C (21) 3,800.00 c/ d 3,800.00 (24) 5,000.00 c/ d 5,000.00 b/ d 3,800.00 T/ A 3,800.00 b/ d 5,000.00 T/ A 2,280.00 c/ d 2,280.00 6,080.00 6,080.00 b/ d 2,280.00 Accounts receivables Cost of goods sold Merchandise goods inventory MG Prepaid expenses D C D C (23) 90,000.00 c/ d 90,000.00 MG 3,800.00 Rev 4,600.00 b/ d 90,000.00 P&L 90,000.00 GP 3,080.00 MG 2,280.00 6,880.00 6,880.00 P&L 3,080.00 b/ d 3,080.00 D C D C COS 61,375.00 T/ A 3,080.00 P&L 58,295.00 c/ d 58,295.00 Lab 90,000.00 Rev 110,000.00 b/ d 58,295.00 Rnt 20,000.00 NL 58,295.00 171,375.00 171,375.00 b/ d 58,295.00 R/ E 58,295.00 Labour - Sales person Trading Account Profit and Loss Retained Earnings Figure 29.4: PENTZ Ltd.’s accounts (continued) Step (E): Preparing the Adjusted Trial Balance: After calculating the loss for the period, we set up a trial balance again. It now is called the adjusted T/ B. A trial balance prepared after adjustments have been made is an adjusted trial balance. You’ll see that all accounts linked to profit and loss have been closed-off. These are the nominal accounts. Observe the adjusted trial balance for PENTZ Ltd. as depicted in Figure 29.5. <?page no="323"?> Berkau: BASICS of ACCOUNTING 29-322 Account Debit entries Credit entries Cash/ Bank 45,670.00 Issued Capital 100,000.00 Rent 0.00 0.00 Property, Plant, and Equipment 21,500.00 VAT 11,030.00 Accounts Payable 12,900.00 Depreciation 0.00 0.00 Accumulated Depreciation 5,375.00 Purchase 0.00 0.00 Raw Materials - Bodies 5,000.00 Raw Materials - Resin 506.25 Raw Materials - Paint 1,050.00 Labour (Production) 0.00 0.00 Work in Process 0.00 0.00 Finished Goods Inventory 15,343.75 Sales 0.00 0.00 Accounts Receivables 66,000.00 Cost of Goods Sold (COS) 0.00 0.00 Merchandise Goods Inventory 2,280.00 Prepaid Expenses 5,000.00 Labour (Sales Person) 0.00 0.00 Retained Earnings 58,295.00 Total: 174,975.00 174,975.00 Pentz Ltd.'s ADJUSTED TRIAL BALANCE as at 31.12.20X4 Figure 29.5: PENTZ Ltd.’s adjusted trial balance The amount for merchandise inventory has been changed to the actual amount because the stock count is considered after loss calculation. The new amount is 2,280.00 EUR. The amount for retained earnings is on the debit side. This occurs due to the loss. Step (F): Deriving Financial Statements: By the last step the financial statements are prepared. The adjusted trial balance is very close to the statement of financial position. It only contains real accounts. For the financial statements some minor adjustments are to be made, in particular some accounts are combined, such as P, P, E account and the Accumulated Depreciation account. The amount for property, plant and equipment is calculated by two accounts: Property, Plant and Equipment and Accumulated Depreciation account. The value to be recognized is: 21,500 - 5,375 = 16,125.00 EUR . We do not offset these accounts. <?page no="324"?> Berkau: BASICS of ACCOUNTING 29-323 The amount for the balancing figure in PENTZ Ltd.’s Cash/ Bank account is negative: It equals to -45,670.00 EUR. No negative amounts on the face of the statement of financial position are accepted, retained earnings and deferred taxes exempted. The amount has to be transferred to short-term liabilities. There is no bookkeeping entry required, because the Cash/ Bank account is to be continued in the next Accounting period. Actually, the bank account only is overdrawn. The amount for payables contains output-VAT and the payables resulting from supplies plus the negative bank account’s figure and equals to: 11,030 + 12,900 + 45,670 = 69,600.00 EUR . The value for inventory combines the Inventory accounts (for raw materials, for merchandise goods and for finished goods). It equals to: 5,000 + 506.25 + 1,050 + 2,280 + 15,343.75 = 24,180.00 EUR . Observe PENTZ Ltd.’s statement of financial position as below: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 16,125.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (58,295.00) Current assets Liabilities Inventory 24,180.00 Interest bear liab A/ R 66,000.00 A/ P 69,600.00 Prepaid expenses 5,000.00 Provisions Cash/ Bank 0.00 Tax liabilities 0.00 111,305.00 111,305.00 PENTZ Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 29.6: PENTZ Ltd.’s statement of financial position The statement of comprehensive income is directly derived from the Profit and Loss account. The amount for merchandise goods sold is the amount for the purchase of the wet suits purchases less their closing stock: 3,800 - 2,280 = 1,520.00 EUR . The amount represents 20 wet suits bought at 76.00 EUR/ u earlier on: 20 × 76 = 1,520.00 EUR . <?page no="325"?> Berkau: BASICS of ACCOUNTING 29-324 [EUR] Revenue 114,600.00 Other income 114,600.00 Cost of goods sold 61,375.00 Merchandise goods used 1,520.00 Labour (sales person) 90,000.00 Other expenses 20,000.00 Earnings before int and taxes (EBIT) (58,295.00) Interest Earnings before taxes (EBT) (58,295.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (58,295.00) PENTZ Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 29.7: PENTZ Ltd.’s statement of comprehensive income Summary: The trial balance is a list of accounts and their balancing figures. The trial balance can be used to detect bookkeeping errors with regard to the double entry system. Many companies apply the trial balance in order to provide an overview about the accounts after balancing them off and before financial statements are prepared. Working Definitions: Trial Balance: A trial balance is a list of all accounts that shows their balances brought down sorted that way, that debit balanced accounts’ balancing figures are in one column and credit balanced accounts’ balancing figures in another one. Adjusted Trial Balance: A trial balance prepared after adjustments is an adjusted trial balance. <?page no="326"?> Berkau: BASICS of ACCOUNTING 30-325 30. Tax Calculation, Profit Appropriation and Changes in Equity Learning Objectives: This chapter covers how companies pay income taxes, how they appropriate the profits and how they record changes in the equity section of the balance sheet. After studying this chapter, you understand the calculation of dividends and you can prepare a statement of changes in equity. The owners of a company seek to receive a return from their investments. The company will pay them a portion of its profit according to the share the owners hold in the business. Note, the level of payment depends on national company acts. We call the assignment of earnings to owners and/ or keeping them in the business for reinvestments appropriation of profits. The appropriation of profits is its distribution for declaring dividends, for putting profits into reserves and/ or for carrying a profit forward to the next Accounting period. Investors see the company as investment objects. They compare the amount put into the business to the returns they receive later. The percentage they receive is their capital appreciation and is measured as a return on investment figure. Limited companies do not apply the drawing concept as introduced in chapter Privately owned Business: Drawings. There are more owners, sometimes a few thousands of shareholders who own the business together. Limited companies declare dividends to pay them a return. A dividend is a share of the profit earned in the last or previous Accounting periods that is paid to the shareholders. Privately owned limited companies also declare dividends but won’t call them a dividend. When a company shares the profit with its owners, the Retained Earnings account is debited and the Cash/ Bank or the Shareholder for Dividend account, the latter one being a subordinated account to the Accounts Payables account, is credited. This reflects that by declaring and paying dividends, the company decreases its equity. For declaring the dividends financial statements have to be audited and the decision about the appropriation of profits has to be made and approved by the board and the supervisors or on the annual meeting. The auditing of the financial statement means an independent auditor will check the bookkeeping records and the financial statements. Unrestricted access to financial records and further information must be given to the auditors. The auditing of financial statements is required by national law. For example, in Germany § 315 HGB applies. According to that paragraph no financial statements will be approved and therefore no dividend can be paid before the financial statements are audited. The paragraph applies for German limited companies that are not classified as small ones in accordance to the size criteria stated by § 267 HGB. The criteria refer to the total of the balance sheet, the average amount <?page no="327"?> Berkau: BASICS of ACCOUNTING 30-326 of employees and earned revenue. Check other country’s national law with regard to auditing - it is not ruled by IFRSs. We take a closer look to a limited company for the explanation of tax calculation and the appropriation of profits along IFRSs. There is a more detailed discussion in chapter 12 of the text book Bilanzen and the ebook Accounting-2-Go. We explain the aspects of this chapter by the case study RAATS Ltd. RAATS Ltd. is a company based on shares. The company is established by an issue of 100,000 ordinary shares at 1.50 EUR each. See the financial statements as at 31.12.20X6 for RAATS Ltd. displayed by Figure 30.1: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 158,000.00 Issued capital 150,000.00 Intangibles Reserves 20,000.00 Financial assets R/ E 70,000.00 Current assets Liabilities Inventory Interest bear liab A/ R 22,000.00 A/ P Prepaid expenses Provisions Cash/ Bank 90,000.00 Tax liabilities 30,000.00 270,000.00 270,000.00 Raats Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X6 Figure 30.1: RAATS Ltd.’s statement of financial position In order to focus on taxes and the appropriation of profits, we cut the activities of RAATS Ltd. short: At the beginning of the Accounting period, RAATS Ltd. pays income tax liabilities of 30,000.00 EUR as recognised on the face of the balance sheet in the liability section. (1) Payment of income tax liabilities on 2.01.20X7. DR Tax Liabilities.............. 30,000.00 EUR CR Cash/ Bank.................... 30,000.00 EUR We assume RAATS Ltd. earns a cash revenue of 260,000.00 EUR and spends 150,000.00 EUR on cash for other expenses in the middle of the Accounting period. Assume all amounts are net amounts. The gross amounts are: 260,000 × 120% = 312,000.00 EUR and: 150,000.00 × 120% = 180,000.00 EUR . Assume the opening value of the VAT account is nil. <?page no="328"?> Berkau: BASICS of ACCOUNTING 30-327 (2, 3) Earning a cash revenue of 260,000.00 EUR and spending 150,000.00 EUR on expenses on 1.07.20X7. DR Cash/ Bank.................... 312,000.00 EUR CR VAT.......................... 52,000.00 EUR CR Sales........................ 260,000.00 EUR DR Other Expenses............... 150,000.00 EUR DR VAT.......................... 30,000.00 EUR CR Cash/ Bank.................... 180,000.00 EUR Observe below RAATS Ltd.’s accounts in Figure 30.2. D C D C OV 158,000.00 c/ d 158,000.00 OV 22,000.00 c/ d 22,000.00 b/ d 158,000.00 b/ d 22,000.00 D C D C OV 90,000.00 (1) 30,000.00 c/ d 150,000.00 OV 150,000.00 (2) 312,000.00 (3) 180,000.00 b/ d 150,000.00 c/ d 192,000.00 402,000.00 402,000.00 b/ d 192,000.00 D C D C OV 20,000.00 OV 70,000.00 D C D C (1) 30,000.00 OV 30,000.00 (3) 30,000.00 (2) 52,000.00 c/ d 22,000.00 52,000.00 52,000.00 b/ d 22,000.00 D C D C c/ d 260,000.00 (2) 260,000.00 (3) 150,000.00 c/ d 150,000.00 b/ d 260,000.00 b/ d 150,000.00 Sales Other expenses P,P,E Accounts receivables Reserves Retained earnings Income tax liabilities VAT Cash/ Bank Issued capital Figure 30.2: RAATS Ltd.’s accounts RAATS Ltd.’s Accountant prepares the trial balance as depicted in Figure 30.3: <?page no="329"?> Berkau: BASICS of ACCOUNTING 30-328 Account Debit entries Credit entries Property, Plant, and Equipment 158,000.00 Accounts Receivables 22,000.00 Cash/ Bank 192,000.00 Issued Capital 150,000.00 Reserves 20,000.00 Retained Earnings 70,000.00 Income Tax Liabilities 0.00 0.00 VAT 22,000.00 Sales 260,000.00 Other Expenses 150,000.00 Total: 522,000.00 522,000.00 Raats Ltd.'s TRIAL BALANCE as at 31.12.20X7 Figure 30.3: RAATS Ltd.’s trial balance RAATS Ltd.’s profit calculation follows: The company earns a pre-tax profit of: 260,000 - 150,000 = 110,000.00 EUR . In general, the calculation of income taxes follows the national tax law. Assume RAATS Ltd. is a German company. The German tax law Einkommensteuergesetz (EStG) requires income taxes that contain business tax, corporate tax and a surcharge for the German reunion based on the corporate tax. For RAATS Ltd. we assume the tax rates to be 14.17 % for the business tax, 15 % for the corporate tax and 5.5 % surcharge on the corporate tax for the German reunion. RAATS Ltd.’s total income taxes equal to: 110,000 × (14.17% + 15% × (1 + 5.5%)) = 32,994.50 EUR . We round up the total income tax rate which is 29.995 % to the nearest integer which is 30 %. The income tax rate then is: 110,000 × 30% = 33,000.00 EUR . Additional to the taxes of the company, the investor pays income taxes himself, if living in Germany and unlimited obliged to pay taxes. There is a dividend tax based on capital gains, called Kapitalertragsteuer. The shareholder’s income resulting from holding shares is the net basis for the dividend. The company does not pay the gross dividend to German shareholders. The dividend tax is withheld by the company and paid straight to the German revenue service. A withholding tax is payable by the company on behalf of the recipient of the funds, here the dividend tax is paid by the company on behalf of the shareholders. In Germany the dividend tax amounts to 25 % of the net dividend. Furthermore, there is a surcharge on the dividend tax for the German reunion to the extent of 5.5 %, too. When we prepare the Profit and Loss account we put the income tax amount on the debit side of the Profit and Loss <?page no="330"?> Berkau: BASICS of ACCOUNTING 30-329 account. This indicates income taxes are an expense. Observe the profit calculation for RAATS Ltd. in Figure 30.4: D C D C OV 158,000.00 c/ d 158,000.00 OV 22,000.00 c/ d 22,000.00 b/ d 158,000.00 b/ d 22,000.00 D C D C OV 90,000.00 (1) 30,000.00 c/ d 150,000.00 OV 150,000.00 (2) 312,000.00 (3) 180,000.00 b/ d 150,000.00 c/ d 192,000.00 402,000.00 402,000.00 b/ d 192,000.00 D C D C c/ d 20,000.00 OV 20,000.00 OV 70,000.00 b/ d 20,000.00 c/ d 147,000.00 P&L 77,000.00 147,000.00 147,000.00 b/ d 147,000.00 D C D C (1) 30,000.00 OV 30,000.00 (3) 30,000.00 (2) 52,000.00 c/ d 33,000.00 P&L 33,000.00 c/ d 22,000.00 63,000.00 63,000.00 52,000.00 52,000.00 b/ d 33,000.00 b/ d 22,000.00 D C D C c/ d 260,000.00 (2) 260,000.00 (3) 150,000.00 c/ d 150,000.00 P&L 260,000.00 b/ d 260,000.00 b/ d 150,000.00 D C Oth 150,000.00 Rev 260,000.00 NP 110,000.00 260,000.00 260,000.00 ITL 33,000.00 b/ d 110,000.00 R/ E 77,000.00 110,000.00 110,000.00 P,P,E Accounts receivables Profit and Loss Reserves Retained earnings Income tax liabilities ITL VAT Cash/ Bank Issued capital Sales Other expenses Figure 30.4: RAATS Ltd.’s accounts See also the adjusted trial balance after preparing the Profit and Loss account and closing it off to the Retained Earnings account in Figure 30.5: <?page no="331"?> Berkau: BASICS of ACCOUNTING 30-330 Account Debit entries Credit entries Property, Plant, and Equipment 158,000.00 Accounts Receivables 22,000.00 Cash/ Bank 192,000.00 Issued Capital 150,000.00 Reserves 20,000.00 Retained Earnings 147,000.00 Income Tax Liabilities 33,000.00 VAT 22,000.00 Sales 0.00 Other Expenses 0.00 Total: 372,000.00 372,000.00 Raats Ltd.'s TRIAL BALANCE as at 31.12.20X7 Figure 30.5: RAATS Ltd. adjusted trial balance The amount that can be paid to the shareholders, is the total amount in the Retained Earnings account. There are no profits carried forward in the Retained Earnings account. Dissolving of reserves is not an option for this case study. No credit entry for revaluations applies for RAATS Ltd. either. RAATS Ltd. declares a dividend of 40 % of the distributable amount. The distributable amount is the amount that is available to be paid to the shareholders without further reserves being dissolved and after all deductions that are relevant have been taken out. These reductions can be preference dividends or special reserves required by the national company’s act. The distributable amount is subject to national law, not to IFRSs. RAATS Ltd. does not make any deductions from the distributable amount, thus, it is 147,000.00 EUR. The dividend is not paid out yet, but put into the Shareholder for Dividend account for later payments. The amount that goes to the shareholders and tax authorities is: 40% × 147,000 = 58,800.00 EUR . The amount is not payable to the shareholders and revenue service before the financial statements have been audited and approved. (Note, we do not divide the gross dividend into net dividend and tax portion, because it stays a payable note, no matter to whom the amount is paid later. This is a simplification for the text book and the lectures/ exams.) Accountants call the account for dividend payables “Shareholder for Dividend ShD account”, because it leads to a list of shareholders eligible for receiving dividends. (4) Crediting the dividend to Dividends Payables ShD account on 31.12.20X7. <?page no="332"?> Berkau: BASICS of ACCOUNTING 30-331 DR Retained Earnings............ 58,800.00 EUR CR Dividends Payables ShD ....... 58,800.00 EUR RAATS Ltd. plans further to put 35 % of the distributable amount into the Earnings Reserves account and to carry forward the remaining portion of 25 % to the next Accounting period. The latter one does not require a bookkeeping entry. So, the amount just stays in the Retained Earnings account. (5) Crediting: 35% × 147,000 = 51,450.00 EUR to the Reserves account on 31.12.20X7 is posted as below: DR Retained Earnings............ 51,450.00 EUR CR Reserves..................... 51,450.00 EUR Observe the accounts after this transaction has been made as depicted in Figure 30.6 D C D C OV 158,000.00 c/ d 158,000.00 OV 22,000.00 c/ d 22,000.00 b/ d 158,000.00 b/ d 22,000.00 D C D C OV 90,000.00 (1) 30,000.00 c/ d 150,000.00 OV 150,000.00 (2) 312,000.00 (3) 180,000.00 b/ d 150,000.00 c/ d 192,000.00 402,000.00 402,000.00 b/ d 192,000.00 D C D C OV 20,000.00 OV 70,000.00 c/ d 78,800.00 R/ E 58,800.00 c/ d 147,000.00 P&L 77,000.00 78,800.00 78,800.00 147,000.00 147,000.00 b/ d 78,800.00 ShD 58,800.00 b/ d 147,000.00 Res 51,450.00 c/ d 36,750.00 147,000.00 147,000.00 b/ d 36,750.00 Reserves Retained earnings Cash/ Bank Issued capital P,P,E Accounts receivables Figure 30.6: RAATS Ltd.’s accounts <?page no="333"?> Berkau: BASICS of ACCOUNTING 30-332 D C D C (1) 30,000.00 OV 30,000.00 (3) 30,000.00 (2) 52,000.00 c/ d 33,000.00 P&L 33,000.00 c/ d 22,000.00 63,000.00 63,000.00 52,000.00 52,000.00 b/ d 33,000.00 b/ d 22,000.00 D C D C c/ d 260,000.00 (2) 260,000.00 (3) 150,000.00 c/ d 150,000.00 P&L 260,000.00 b/ d 260,000.00 b/ d 150,000.00 Income tax liabilities VAT Sales Other expenses D C D C Oth 150,000.00 Rev 260,000.00 c/ d 51,450.00 R/ E 51,450.00 NP 110,000.00 b/ d 51,450.00 260,000.00 260,000.00 TAX 33,000.00 b/ d 110,000.00 R/ E 77,000.00 110,000.00 110,000.00 Profit and Loss Dividend payable ShD Figure 30.6: RAATS Ltd.’s accounts (continued) In general, companies prepare their financial statements under consideration of the appropriation of profits. The financial statements for RAATS Ltd. after appropriation of profits look as depicted in Figure 30.7, Figure 30.8 and Figure 30.9: <?page no="334"?> Berkau: BASICS of ACCOUNTING 30-333 [EUR] Revenue 260,000.00 Other income 260,000.00 Materials Labour Depreciation Other expenses 150,000.00 Earnings before int and taxes (EBIT) 110,000.00 Interest Earnings before taxes (EBT) 110,000.00 Income tax expenses 33,000.00 Deferred taxes Earnings after taxes (EAT) 77,000.00 to reserves (§ 150 AktG) 0.00 to other earnings reserves 51,450.00 to shareholders 58,800.00 carried forward to next period 36,750.00 Raats Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 30.7: RAATS Ltd.’s prolonged statement of comprehensive income The prolonged statement of comprehensive income is required by § 158 AktG for German companies based on shares. The bottom section of this income statement indicates where the distributable amount goes to. The statement of financial position looks as displayed by Figure 30.8. <?page no="335"?> Berkau: BASICS of ACCOUNTING 30-334 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 158,000.00 Issued capital 150,000.00 Intangibles Reserves 71,450.00 Financial assets R/ E 36,750.00 Current assets Liabilities Inventory Interest bear liab A/ R 22,000.00 A/ P 80,800.00 Prepaid expenses Provisions Cash/ Bank 192,000.00 Tax liabilities 33,000.00 372,000.00 372,000.00 Raats Ltd.'s STATEMENT of FINANCIAL POSITION after appropriation of profit as at 31.12.20X6 Figure 30.8: RAATS Ltd.’s statement of financial position after appropriation of profit The amount in the Earnings Reserves account is the opening amount plus the portion that goes to reserves by appropriation of profits: 20,000 + 51,450 = 71,450.00 EUR . The amount for accounts payables contains liabilities for VAT and the dividend claims of the shareholders: 22,000 + 58,800 = 80,800.00 EUR . Along international Accounting standards the equity section of the balance sheet needs to be displayed by an extra statement called the statement of changes in equity. This is stated by IAS 1. Here, the equity changes result from the profit earned and its appropriation. Other changes in equity can be share issues or redemption and revaluations along IAS 16. Dissolving reserves can be a further change in equity. RAATS Ltd. earns a profit of 110,000.00 EUR before taxes. The amount which increases equity is 70 % thereof and is called earnings after taxes. It amounts to: 110,000 × 70% = 77,000.00 EUR . The appropriation of profits is 51,450.00 EUR and to be transferred into the Earnings Reserves account and 58,800.00 EUR declared as gross dividend, which is posted to the Dividend payables ShD account completely (net amount plus dividend tax). The latter one reduces equity. The increase of reserves does not. The Earnings Reserves account is an equity account. The profit carried forward is not regarded as a change in equity and does not need a special entry in the statement of changes in equity. The reason is, there is no profit carried forward item on the face of the IFRSs-balance sheet. However, Germans recognise profits/ losses carried forward in accordance with § 266 HGB. <?page no="336"?> Berkau: BASICS of ACCOUNTING 30-335 Share capital Reserves R/ E total as at 1.01.20X7 150,000.00 20,000.00 70,000.00 240,000.00 Profit 20X7 77,000.00 77,000.00 Dividend 20X7 (58,800.00) (58,800.00) Addition to res 51,450.00 (51,450.00) 0.00 as at 31.12.20X7 150,000.00 71,450.00 36,750.00 258,200.00 Raats Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X7 Figure 30.9: RAATS Ltd.’s statement of changes in equity. Summary: Companies have to pay taxes based on the pre-tax profit. In Germany, the total income tax rate depends on the location of the company. The amount is close to 30 % for limited companies. In this text book, the income tax rate is per convention fixed to 30 %, too. The appropriation of profits results in paying dividends to shareholders plus paying dividend tax on their behalf to the revenue service, putting amounts into earnings reserves or carrying forward profit to the next Accounting period. Companies can prepare the financial statements under consideration of the appropriation of profits. Any appropriation of profits requires the approval of financial statements. The statement of changes in equity depicts all increases or decreases of equity occurred during the last two Accounting periods. The shareholder can observe how the value of the company changes because equity reflects the book value of the business. For income tax calculation and the appropriation of profits, national law applies. Working Definitions: Appropriation of Profit: The appropriation of profits is its distribution for declaring dividends, for putting profits into reserves and/ or for carrying a profit forward to the next Accounting period. Dividend: A dividend is a share of the profit earned in the last or previous Accounting periods that is paid to the shareholders. Distributable amount: The distributable amount is the amount that is available to be paid to the shareholders without further reserves being dissolved and after all deductions that are relevant have been taken out also. Withholding tax: A withholding tax is payable by the company on behalf of the recipient of the funds, here the dividend tax is paid by the company on behalf of the shareholders. <?page no="337"?> Berkau: BASICS of ACCOUNTING 31-336 31. Multi-Period Bookkeeping Learning Objectives: In this chapter we’ll introduce a method how to maintain real accounts over the Accounting periods. This differs from German bookkeeping conventions, because Germans close-off real accounts to the Final-Balance- Sheet account at the end of the Accounting period. We study a 2-yearsexample to illustrate the continuation of real accounts and prepare the financial statement as at the end of the 2years-period. When we introduced Taccounts and their balancing-off, we mentioned you can balance-off and continue accounts at any time and as often as you desire. That is exactly what companies do at the end of every Accounting period. Accounts are balanced-off and then are continued in the next Accounting period. However, all nominal accounts are closed-off to the Profit and Loss account on the balance sheet date (adjustments). After studying this chapter, you can keep bookkeeping recordings for periods longer than one year. Real accounts are balanced-off at the end of every Accounting period. The date for the balance carried down will be 31.12.20XX. The balance brought down is regarded as the opening value for the next Accounting period. The date thereto will be 2.01.20XY. Besides of the continuation of real accounts, the preparation of financial statements works the same as we learned in the previous chapters. We observe the consultancy case study GOUSBLOM Ltd. to learn about the continuation of accounts. GOUSBLOM Ltd. is a consultancy and is established on 2.01.20X7 by share issue. GOUSBLOM Ltd. issues 500,000 ordinary shares at 1.00 EUR/ share par value. The amount of the capital issued equals to: 500,000 × 1 = 500,000.00 EUR . (1) Share issue on 2.01.20X7. DR Cash/ Bank.................... 500,000.00 EUR CR Issued Capital............... 500,000.00 EUR GOUSBLOM Ltd. is registered for VAT reduction. The company pays rent for an office block for the Accounting period 20X7 in advance on 2.01.20X7. The amount is free of VAT as the landlord rents out his property privately. Rent amounts to 48,000.00 EUR/ a and is paid by an instant bank transfer. The next year’s rent is due at the end of December 20X7 to the full extent of the fiscal year 20X8. Thus, the second payment for rent requires an accrual. (2) Payment for 20X7’s rent on 2.01.20X7. DR Rent......................... 48,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR <?page no="338"?> Berkau: BASICS of ACCOUNTING 31-337 (3) Payment of Accounting period 20X8’s rent on 20.12.20X7. DR Rent......................... 48,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR (4) The accrual of 20X8’s rent is part of the adjustments and is recorded on 31.12.20X7. DR Prepaid Expenses............. 48,000.00 EUR CR Rent......................... 48,000.00 EUR GOUSBLOM Ltd. buys 36 laptops for its consultants at a cost of acquisition of 4,000.00 EUR/ u. The acquisition of laptops takes place on 8.01.20X7 and GOUSBLOM Ltd. intends to use the computers for 4 years. Depreciation along straight line method without residual values gives: 4,000/ 4 = 1,000.00 EUR/ (a × computer) . At the date of acquisition same as the date of the bank transfer the Accountant makes a bookkeeping entry as below: (5) Acquisition of laptops at a gross amount being 36 × 4,000 × 120% = 172,800.00 EUR . DR P, P, E Account.............. 144,000.00 EUR DR VAT.......................... 28,800.00 EUR CR Cash/ Bank.................... 172,800.00 EUR Depreciation on laptops equals to: 1,000 × 36 = 36,000.00 EUR/ a . The bookkeeping entry is as below: (6) Depreciation on computers on 31.12.20X7. DR Depreciation................. 36,000.00 EUR CR Acc. Depr.................... 36,000.00 EUR GOUSBLOM Ltd.’s annual expenses for labour for the 30 consultants amount to 1,500,000.00 EUR. We ignore labour tax and social security for this example. The full payment is made in the middle of the year by bank transfer - we keep the example simple. (7) Payment for labour on 1.07.20X7. DR Labour....................... 1,500,000.00 EUR CR Cash/ Bank.................... 1,500,000.00 EUR The company earns a revenue based on its billable consultation days to the extent of 4,000,000.00 EUR and receives payments by bank transfers on 30.06.20X7. (8) Revenue earned on 30.06.20X7. <?page no="339"?> Berkau: BASICS of ACCOUNTING 31-338 DR Cash/ Bank.................... 4,800,000.00 EUR CR VAT.......................... 800,000.00 EUR CR Revenue...................... 4,000,000.00 EUR GOUSBLOM Ltd.’s Accountant balancesoff all accounts and prepares a trial balance as displayed by Figure 31.1 and Figure 31.2: (Note, we write cd7 (short for: c/ d 31.12.20X7) to indicate the accounts were balanced-off on 31.12.20X7. We write bd8 (short for: b/ d 1.01.20X8) for balance brought down on 1.01.20X8. This only applies for real accounts, because nominal accounts are closed-off.) D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (8) 4,800,000.00 (3) 48,000.00 bd8 500,000.00 (5) 172,800.00 (7) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 D C D C (2) 48,000.00 (4) 48,000.00 (4) 48,000.00 cd7 48,000.00 (3) 48,000.00 c/ d 48,000.00 bd8 48,000.00 96,000.00 96,000.00 b/ d 48,000.00 D C D C (5) 144,000.00 cd7 144,000.00 (5) 28,800.00 (8) 800,000.00 bd8 144,000.00 cd7 771,200.00 800,000.00 800,000.00 bd8 771,200.00 D C D C (6) 36,000.00 c/ d 36,000.00 cd7 36,000.00 (6) 36,000.00 b/ d 36,000.00 bd8 36,000.00 D C D C (7) 1,500,000.00 c/ d 1,500,000.00 c/ d 4,000,000.00 (8) 4,000,000.00 b/ d 1,500,000.00 b/ d 4,000,000.00 PPE VAT Depreciation Acc depr Rent Prepaid expenses Labour Revenue Cash/ Bank Issued capital Figure 31.1: GOUSBLOM Ltd.’s accounts 20X7 <?page no="340"?> Berkau: BASICS of ACCOUNTING 31-339 Observe the trial balance depicted by Figure 31.2. Account Debit entries Credit entries Cash/ Bank 3,531,200.00 Issued Capital 500,000.00 Rent 48,000.00 Prepaid Expenses 48,000.00 Property, Plant, and Equipment 144,000.00 VAT 771,200.00 Depreciation 36,000.00 Accumulated Depreciation 36,000.00 Labour 1,500,000.00 Revenue 4,000,000.00 Total: 5,307,200.00 5,307,200.00 Gousblom Ltd.'s TRIAL BALANCE as at 31.12.20X7 Figure 31.2: GOUSBLOM Ltd.’s trial balance 20X7 The next step is the preparation of the Profit and Loss account. The profit earned before taxation amounts to: 4,000,000 - 48,000 - 36,000 - 1,500,000 = 2,416,000.00 EUR . The Accountant closes-off all expense and revenue accounts to the Profit and Loss account on 31.12.20X7. DR Profit and Loss.............. 48,000.00 EUR CR Rent......................... 48,000.00 EUR DR Profit and Loss.............. 36,000.00 EUR CR Depreciation................. 36,000.00 EUR DR Profit and Loss.............. 1,500,000.00 EUR CR Labour....................... 1,500,000.00 EUR DR Revenue...................... 4,000,000.00 EUR CR Profit and Loss.............. 4,000,000.00 EUR The amount for income taxes amounts to: 2,416,000 × 30% = 724,800.00 EUR . The amount is debited to the Profit and Loss account and transferred to the Income Tax Liabilities account. The remaining amount goes into the Retained Earnings account. DR Profit and Loss.............. 724,800.00 EUR CR Income Tax Liabilities....... 724,800.00 EUR <?page no="341"?> Berkau: BASICS of ACCOUNTING 31-340 DR Profit and Loss.............. 1,691,200.00 EUR CR Retained Earnings............ 1,691,200.00 EUR GOUSBLOM Ltd.’s Accountant prepares an adjusted trial balance after making the bookkeeping entries for the profit calculation. Observe the accounts and the adjusted trial balance in Figure 31.3 and Figure 31.4: D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (8) 4,800,000.00 (3) 48,000.00 bd8 500,000.00 (5) 172,800.00 (7) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 D C D C (2) 48,000.00 (4) 48,000.00 (4) 48,000.00 cd7 48,000.00 (3) 48,000.00 c/ d 48,000.00 bd8 48,000.00 96,000.00 96,000.00 b/ d 48,000.00 P&L 48,000.00 D C D C (5) 144,000.00 cd7 144,000.00 (5) 28,800.00 (8) 800,000.00 bd8 144,000.00 cd7 771,200.00 800,000.00 800,000.00 bd8 771,200.00 D C D C (6) 36,000.00 c/ d 36,000.00 cd7 36,000.00 (6) 36,000.00 b/ d 36,000.00 P&L 36,000.00 bd8 36,000.00 D C D C (7) 1,500,000.00 c/ d 1,500,000.00 c/ d 4,000,000.00 (8) 4,000,000.00 b/ d 1,500,000.00 P&L 1,500,000.00 P&L 4,000,000.00 b/ d 4,000,000.00 Labour Revenue Cash/ Bank Issued capital PPE VAT Depreciation Acc depr Rent Prepaid expenses Figure 31.3: GOUSBLOM Ltd.’s accounts 20X7 <?page no="342"?> Berkau: BASICS of ACCOUNTING 31-341 D C D C Rnt 48,000.00 Rev 4,000,000.00 cd7 1,691,200.00 P&L 1,691,200.00 Dpr 36,000.00 bd8 1,691,200.00 Lab 1,500,000.00 NP 2,416,000.00 4,000,000.00 4,000,000.00 ITL 724,800.00 b/ d 2,416,000.00 R/ E 1,691,200.00 2,416,000.00 2,416,000.00 D C cd7 724,800.00 P&L 724,800.00 bd8 724,800.00 Income tax liabilities ITL Profit and Loss P&L Retained earnings R/ E Figure 31.3: GOUSBLOM Ltd.’s accounts 20X7 (continued) The amounts of the balancing figures can be observed as entries in the trial balance as depicted in Figure 31.4. Account Debit entries Credit entries Cash/ Bank 3,531,200.00 Issued Capital 500,000.00 Rent 0.00 0.00 Prepaid Expenses 48,000.00 Property, Plant, and Equipment 144,000.00 VAT 771,200.00 Depreciation 0.00 0.00 Accumulated Depreciation 36,000.00 Labour 0.00 0.00 Revenue 0.00 0.00 Income Tax Liabilities 724,800.00 Retained Earnings 1,691,200.00 Total: 3,723,200.00 3,723,200.00 Gousblom Ltd.'s ADJUSTED TRIAL BALANCE as at 31.12.20X7 Figure 31.4: GOUSBLOM Ltd.’s adjusted trial balance GOUSBLOM Ltd. declares a dividend for 20X7 to the extent of 0.50 EUR/ share. As there are 500,000 shares outstanding. Thus, the dividend equals to: 500,000 × 0.50 = 250,000.00 EUR . Furthermore, <?page no="343"?> Berkau: BASICS of ACCOUNTING 31-342 1,000,000 EUR are put into the Earnings Reserves account. The reinvestment of 1,000,000.00 EUR is transferred to the Earnings Reserves account based on a decision made on the annual meeting by GOUSBLOM Ltd.’s shareholders and the remaining amount of: 1,691,200 - 250,000 - 1,000,000 = 441,200.00 EUR is carried forward to the next Accounting period, which means it will be kept in the Retained Earnings account. Observe the bookkeeping entries made: DR Retained Earnings............ 250,000.00 EUR CR Dividends Payables (A/ P)..... 250,000.00 EUR DR Retained Earnings............ 1,000,000.00 EUR CR Earnings Reserves............ 1,000,000.00 EUR D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (8) 4,800,000.00 (3) 48,000.00 bd8 500,000.00 (5) 172,800.00 (7) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 D C D C (2) 48,000.00 (4) 48,000.00 (4) 48,000.00 cd7 48,000.00 (3) 48,000.00 c/ d 48,000.00 bd8 48,000.00 96,000.00 96,000.00 b/ d 48,000.00 P&L 48,000.00 D C D C (5) 144,000.00 cd7 144,000.00 (5) 28,800.00 (8) 800,000.00 bd8 144,000.00 cd7 771,200.00 800,000.00 800,000.00 bd8 771,200.00 D C D C (6) 36,000.00 c/ d 36,000.00 cd7 36,000.00 (6) 36,000.00 b/ d 36,000.00 P&L 36,000.00 bd8 36,000.00 Cash/ Bank Issued capital PPE VAT Depreciation Acc depr Rent Prepaid expenses Figure 31.5: GOUSBLOM Ltd.’s accounts 20X7 <?page no="344"?> Berkau: BASICS of ACCOUNTING 31-343 D C D C (7) 1,500,000.00 c/ d 1,500,000.00 c/ d 4,000,000.00 (8) 4,000,000.00 b/ d 1,500,000.00 P&L 1,500,000.00 P&L 4,000,000.00 b/ d 4,000,000.00 D C D C Rnt 48,000.00 Rev 4,000,000.00 c/ d 1,691,200.00 P&L 1,691,200.00 Dpr 36,000.00 ShD 250,000.00 b/ d 1,691,200.00 Lab 1,500,000.00 Res 1,000,000.00 NP 2,416,000.00 cd7 441,200.00 4,000,000.00 4,000,000.00 1,691,200.00 1,691,200.00 ITL 724,800.00 b/ d 2,416,000.00 bd8 441,200.00 R/ E 1,691,200.00 2,416,000.00 2,416,000.00 Labour Revenue Profit and Loss P&L Retained earnings R/ E D C D C cd7 724,800.00 P&L 724,800.00 cd7 250,000.00 R/ E 250,000.00 bd8 724,800.00 bd8 250,000.00 D C cd7 1,000,000.00 R/ E 1,000,000.00 bd8 1,000,000.00 Income tax liabilities ITL Dividends payables (ShD) Earnings Reserves Figure 31.5: GOUSBLOM Ltd.’s accounts 20X7 (continued) Observe the financial statements as set up after the appropriation of profits has been decided, which is as at 31.12.20X7 in Figure 31.6 and Figure 31.7: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 108,000.00 Issued capital 500,000.00 Intangibles Reserves 1,000,000.00 Financial assets R/ E 441,200.00 Current assets Liabilities Inventory Interest bear liab A/ R A/ P 1,021,200.00 Prepaid expenses 48,000.00 Provisions Cash/ Bank 3,531,200.00 Tax liabilities 724,800.00 3,687,200.00 3,687,200.00 Gousblom Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 31.6: GOUSBLOM Ltd.’s statement of financial position <?page no="345"?> Berkau: BASICS of ACCOUNTING 31-344 On the face of the statement of financial position, the amount for property, plant and equipment is the cost of acquisition less accumulated depreciation: 144,000 - 36,000 = 108,000.00 EUR . The amount for accounts payables contains the dividend to be paid to shareholders plus VAT/ payables. It equals to: 250,000 + 771,200 = 1,021,200.00 EUR . Observe the statement of comprehensive income. [EUR] Revenue 4,000,000.00 Other income 4,000,000.00 Materials Labour 1,500,000.00 Depreciation 36,000.00 Other expenses 48,000.00 Earnings before int and taxes (EBIT) 2,416,000.00 Interest Earnings before taxes (EBT) 2,416,000.00 Income tax expenses 724,800.00 Deferred taxes Earnings after taxes (EAT) 1,691,200.00 to other earnings reserves 1,000,000.00 to shareholders 250,000.00 carried forward to next period 441,200.00 Gousblom Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 31.7: GOUSBLOM Ltd.’s statement of comprehensive income When the next Accounting period 20X8 starts, all real accounts will be continued. However, the 20X7’s nominal accounts have been closed-off by the adjustments on 31.12.20X7 and do not appear below. At the beginning of 20X8, (on 2.01.20X8) GOUSBLOM Ltd. dissolves the prepaid expenses at first. The amount is transferred to the Rent account and will count as an expense for 20X8. In order to keep the example simple, we do not pay rent for 20X9 in advance here. The bookkeeping entries for the Accounting period 20X8 are identified by capitals. (A) Dissolving prepaid expenses on 2.01.20X8 gives the posting below: DR Rent......................... 48,000.00 EUR CR Prepaid Expenses............. 48,000.00 EUR <?page no="346"?> Berkau: BASICS of ACCOUNTING 31-345 GOUSBLOM Ltd. pays the amount due for income taxes, for VAT and the dividend (incl. dividend tax) as declared. (B) Payment for income taxes on 10.01.20X8. DR Income Tax Liabilities....... 724,800.00 EUR CR Cash/ Bank.................... 724,800.00 EUR (C) Payment for VAT on 10.01.20X8. DR VAT.......................... 771,200.00 EUR CR Cash/ Bank.................... 771,200.00 EUR (D) Payment for dividend as declared on 31.01.20X8. The payment takes place for this case study on 2.01.20X8. DR Dividends Payables (A/ P)..... 250,000.00 EUR CR Cash/ Bank.................... 250,000.00 EUR The amount for depreciation remains unchanged in comparison to the previous Accounting period 20X7. Thus, the bookkeeping entry is the same as one year ago. (E) Depreciation on laptops on 31.12.20X8. DR Depreciation................. 36,000.00 EUR CR Accumulated Depreciation..... 36,000.00 EUR The payment for labour in 20X8 is 1,700,000.00 EUR. We pretend it is paid on 1.07.20X8. The payment is made by bank transfer. The expenses of GOSEBLOM Ltd. are changed in comparison to the previous Accounting period slightly, in order to obtain a different profit figure for 20X8 than for 20X7. (F) Payment for labour on 1.07.20X8. DR Labour....................... 1,700,000.00 EUR CR Cash/ Bank.................... 1,700,000.00 EUR During the Accounting period 20X8, GOUSBLOM Ltd. earns a revenue of 4,100,000.00 EUR. All customers pay on cash. The payment equals to: 4,100,000 × 120% = 4,920,000.00 EUR . (G) Posting 20X8’s revenue on 30.06.20X8. <?page no="347"?> Berkau: BASICS of ACCOUNTING 31-346 DR Cash/ Bank.................... 4,920,000.00 EUR CR VAT.......................... 820,000.00 EUR CR Revenue...................... 4,100,000.00 EUR GOUSBLOM Ltd.‘s Accountant balances-off all accounts and prepares the trial balance at the yearend. D C D C (E) 36,000.00 c/ d 36,000.00 cd7 36,000.00 (6) 36,000.00 b/ d 36,000.00 bd8 36,000.00 cd8 72,000.00 (E) 36,000.00 72,000.00 72,000.00 bd9 72,000.00 Depreciation Acc depr Figure 31.8 shows the accounts and the next following Figure 31.9 contains the trial balance as at 31.12.20X8. D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (8) 4,800,000.00 (3) 48,000.00 cd8 500,000.00 bd8 500,000.00 (5) 172,800.00 bd9 500,000.00 (7) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 (B) 724,800.00 (G) 4,920,000.00 (C) 771,200.00 (D) 250,000.00 (F) 1,700,000.00 cd8 5,005,200.00 8,451,200.00 8,451,200.00 bd9 5,005,200.00 D C D C (A) 48,000.00 c/ d 48,000.00 (4) 48,000.00 cd7 48,000.00 b/ d 48,000.00 bd8 48,000.00 (A) 48,000.00 D C D C (5) 144,000.00 cd7 144,000.00 (5) 28,800.00 (8) 800,000.00 bd8 144,000.00 cd8 144,000.00 cd7 771,200.00 bd9 800,000.00 800,000.00 (C) 771,200.00 bd8 771,200.00 cd8 820,000.00 (G) 820,000.00 1,591,200.00 1,591,200.00 bd9 820,000.00 Cash/ Bank Issued capital PPE VAT Rent Prepaid expenses <?page no="348"?> Berkau: BASICS of ACCOUNTING 31-347 D C D C (E) 36,000.00 c/ d 36,000.00 cd7 36,000.00 (6) 36,000.00 b/ d 36,000.00 bd8 36,000.00 cd8 72,000.00 (E) 36,000.00 72,000.00 72,000.00 bd9 72,000.00 Depreciation Acc depr Figure 31.8: GOUSBLOM Ltd.’s accounts 20X8 D C D C (F) 1,700,000.00 c/ d 1,700,000.00 c/ d 4,100,000.00 (G) 4,100,000.00 b/ d 1,700,000.00 b/ d 4,100,000.00 Labour Revenue D C D C cd7 250,000.00 R/ E 250,000.00 c/ d 1,691,200.00 P&L 1,691,200.00 (D) 250,000.00 bd8 250,000.00 ShD 250,000.00 b/ d 1,691,200.00 Res 1,000,000.00 cd7 441,200.00 1,691,200.00 1,691,200.00 bd8 441,200.00 D C D C cd7 724,800.00 P&L 724,800.00 cd7 1,000,000.00 R/ E 1,000,000.00 (B) 724,800.00 bd8 724,800.00 bd8 1,000,000.00 Income tax liabilities ITL Reserves Dividends payables ShD Retained earnings R/ E Figure 31.8: GOUSBLOM Ltd.’s accounts 20X8 (continued) The trial balance is derived directly from the accounts. <?page no="349"?> Berkau: BASICS of ACCOUNTING 31-348 Account Debit entries Credit entries Cash/ Bank 5,005,200.00 Issued Capital 500,000.00 Rent 48,000.00 Prepaid Expenses 0.00 0.00 Property, Plant, and Equipment 144,000.00 VAT 820,000.00 Depreciation 36,000.00 Accumulated Depreciation 72,000.00 Labour 1,700,000.00 Revenue 4,100,000.00 Income Tax Liabilities 0.00 0.00 Retained Earnings 441,200.00 Reserves 1,000,000.00 Total: 6,933,200.00 6,933,200.00 Gousblom Ltd.'s TRIAL BALANCE as at 31.12.20X8 Figure 31.9: GOUSBLOM Ltd.’s trial balance The Accountant calculates the pre-tax profit of: 4,100,000 - 48,000 - 36,000 - 1,700,000 = 2,316,000.00 EUR . The bookkeeping entries are made on 31.12.20X8. DR Profit and Loss.............. 48,000.00 EUR CR Rent......................... 48,000.00 EUR DR Profit and Loss.............. 36,000.00 EUR CR Depreciation................. 36,000.00 EUR DR Profit and Loss.............. 1,700,000.00 EUR CR Labour....................... 1,700,000.00 EUR DR Revenue...................... 4,100,000.00 EUR CR Profit and Loss.............. 4,100,000.00 EUR Observe the accounts in Figure 31.10. <?page no="350"?> Berkau: BASICS of ACCOUNTING 31-349 D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (8) 4,800,000.00 (3) 48,000.00 cd8 500,000.00 bd8 500,000.00 (5) 172,800.00 bd9 500,000.00 (7) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 (B) 724,800.00 (G) 4,920,000.00 (C) 771,200.00 (D) 250,000.00 (F) 1,700,000.00 cd8 5,005,200.00 8,451,200.00 8,451,200.00 bd9 5,005,200.00 D C D C (A) 48,000.00 c/ d 48,000.00 (4) 48,000.00 cd7 48,000.00 b/ d 48,000.00 P&L 48,000.00 bd8 48,000.00 (A) 48,000.00 Cash/ Bank Issued capital Rent Prepaid expenses Figure 31.10: GOUSBLOM Ltd.’s accounts 20X8 D C D C (5) 144,000.00 cd7 144,000.00 (5) 28,800.00 (8) 800,000.00 bd8 144,000.00 cd8 144,000.00 cd7 771,200.00 bd9 144,000.00 800,000.00 800,000.00 (C) 771,200.00 bd8 771,200.00 cd8 820,000.00 (G) 820,000.00 1,591,200.00 1,591,200.00 bd9 820,000.00 D C D C (E) 36,000.00 c/ d 36,000.00 cd7 36,000.00 (6) 36,000.00 b/ d 36,000.00 P&L 36,000.00 bd8 36,000.00 cd8 72,000.00 (E) 36,000.00 72,000.00 72,000.00 b/ d_X 72,000.00 PPE VAT Depreciation Acc depr D C D C (F) 1,700,000.00 c/ d 1,700,000.00 c/ d 4,100,000.00 (G) 4,100,000.00 b/ d 1,700,000.00 P&L 1,700,000.00 P&L 4,100,000.00 b/ d 4,100,000.00 Labour Revenue <?page no="351"?> Berkau: BASICS of ACCOUNTING 31-350 D C D C cd7 250,000.00 R/ E 250,000.00 c/ d 1,691,200.00 P&L 1,691,200.00 (D) 250,000.00 bd8 250,000.00 ShD 250,000.00 b/ d 1,691,200.00 Res 1,000,000.00 cd7 441,200.00 1,691,200.00 1,691,200.00 bd8 441,200.00 cd8 2,062,400.00 P&L 1,621,200.00 2,062,400.00 2,062,400.00 bd9 2,062,400.00 D C D C cd7 724,800.00 P&L 724,800.00 cd7 1,000,000.00 R/ E 1,000,000.00 (B) 724,800.00 bd8 724,800.00 cd8 1,000,000.00 bd8 1,000,000.00 cd8 694,800.00 P&L 694,800.00 bd9 1,000,000.00 1,419,600.00 1,419,600.00 bd9 694,800.00 Income tax liabilities ITL Reserves Dividends payables ShD Retained earnings R/ E Figure 31.10: GOUSBLOM Ltd.’s accounts 20X8 (continued) D C Rnt 48,000.00 Rev 4,100,000.00 Dpr 36,000.00 Lab 1,700,000.00 NP 2,316,000.00 4,100,000.00 4,100,000.00 ITL 694,800.00 b/ d 2,316,000.00 R/ E 1,621,200.00 2,316,000.00 2,316,000.00 Profit and Loss P&L Figure 31.10: GOUSBLOM Ltd.’s accounts 20X8 (continued) Figure 31.11 shows the adjusted trial balance as at 31.12.20X8: <?page no="352"?> Berkau: BASICS of ACCOUNTING 31-351 Account Debit entries Credit entries Cash/ Bank 5,005,200.00 Issued Capital 500,000.00 Rent 0.00 0.00 Prepaid Expenses 0.00 0.00 Property, Plant, and Equipment 144,000.00 VAT 820,000.00 Depreciation 0.00 0.00 Accumulated Depreciation 72,000.00 Labour 0.00 0.00 Revenue 0.00 0.00 Income Tax Liabilities 694,800.00 Retained Earnings 2,062,400.00 Reserves 1,000,000.00 Total: 5,149,200.00 5,149,200.00 Gousblom Ltd.'s ADJUSTED TRIAL BALANCE as at 31.12.20X8 Figure 31.11: GOUSBLOM Ltd.’s adjusted trial balance GOUSBLOM Ltd. decides to carry forward the full profit to the next Accounting period. There are no bookkeeping entries to be made for that kind of appropriation of profits as the amount stays in the Retained Earnings account. The statement of financial position as at 31.12.20X8 looks as depicted in Figure 31.12: Observe also the income statement in Figure 31.13: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 72,000.00 Issued capital 500,000.00 Intangibles Reserves 1,000,000.00 Financial assets R/ E 2,062,400.00 Current assets Liabilities Inventory Interest bear liab A/ R A/ P 820,000.00 Prepaid expenses Provisions Cash/ Bank 5,005,200.00 Tax liabilities 694,800.00 5,077,200.00 5,077,200.00 Gousblom Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 31.12: GOUSBLOM Ltd.’s statement of financial position <?page no="353"?> Berkau: BASICS of ACCOUNTING 31-352 [EUR] Revenue 4,100,000.00 Other income 4,100,000.00 Materials Labour 1,700,000.00 Depreciation 36,000.00 Other expenses 48,000.00 Earnings before int and taxes (EBIT) 2,316,000.00 Interest Earnings before taxes (EBT) 2,316,000.00 Income tax expenses 694,800.00 Deferred taxes Earnings after taxes (EAT) 1,621,200.00 to reserves (§ 150 AktG) 0.00 to other earnings reserves to shareholders carried forward to next period 1,621,200.00 Gousblom Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 31.13: GOUSBLOM Ltd.’s statement of comprehensive income In Figure 31.13, the amount carried forward to the next Accounting period is the amount carried forward from 20X8 to 20X9. The amount displayed in the balance sheet contains the amount carried forward from 20X7 also. The total amount then gives: 1,621,200 + 441,200 = 2,062,400.00 EUR (retained earnings). How it is done (multi-period bookkeeping records): (1) Make bookkeeping entries for all business activities in the relevant accounts. (2) Balance-off all accounts. (3) Close-off all nominal accounts to the Trading account and Profit and Loss account. (4) Prepare financial statements. (5) Consider the balances brought down in the real accounts as opening values for the next Accounting period. (I) Make bookkeeping entries for all business activities in the relevant accounts. <?page no="354"?> Berkau: BASICS of ACCOUNTING 31-353 (II) Balance-off all accounts. . . . (Note, you might have to make some bookkeeping entries at the beginning of an Accounting period which result from a previous year. These bookkeeping entries can be the tax payments, dissolving prepaid expenses, payments for dividends etc. In exam tasks, often these Accounting period start-up bookkeeping entries are not extra mentioned.) Summary: In contrast to the German system of bookkeeping entries, real accounts are continued to the next Accounting period. <?page no="355"?> Berkau: BASICS of ACCOUNTING 32-354 32. Introduction to Statements of Cash Flows Learning Objectives: In this chapter we introduce the statement of cash flows. The statement of cash flows is part of a full set of financial statements along IAS 1. The cash flow statement shows increases or decreases on cash/ bank by the categories cash flows for operating activities, cash flow from investing activities and cash flow from financing activities. We will show how to prepare a cash flow statement along the direct method and show further the reconciliation of profits with the operating cash flows. After studying this chapter, you can read and analyse a cash flow statement. Furthermore, you can prepare cash flow statements along the direct method and the reconciliation method. In Germany, a statement of cash flows is not compulsory for single statements by national law (Handelsgesetzbuch). A single statement is a set of financial statements prepared for one company only. In contrast, group statements are prepared additional to single statements for groups and contain a consolidation of all single statements therein. The normal case in a German company is, no cash flow statement is provided. The statement of cash flows is only set up exceptionally: In case a company participates on the public capital market a statement of cash flows is required by § 264 Handelsgesetzbuch. Furthermore, group statements contain statement of cash flows by law. However, a cash flow statement is always to be prepared along IAS 1. A cash flow statement displays all payment activities sorted by the nature of payment. There are different methods to prepare a cash flow statement. Here, we introduce the direct method at first. The cash flows are to be classified in: cash flows from operating activities, cash flows from investing activities and cash flows from financing activities. The differentiation of cash flow is required as cash flows will compensate one another. A cash flow from operating activities should be high, whereas a cash flow from investing activities should be negative. Consider a high positive cash flow from investing activities indicates a liquidation! However, the financing cash flow should be positive. For that reason, the splitting in three cash flow categories is required and ruled by IAS 7. Along IAS 7 cash flows from operating activities are defined as follows: Cash flows from operating activities are all cash flows that are not linked to financing activities or investing activities. This residual definition is helpful, as the cash flows from investing and financing activities are easy to tell. Cash flows from investing activities result from payments for acquisitions and disposals of non-current assets. Cash flows from financing activities are e.g. linked to contributions of owners, such as shares issued, and to loans, <?page no="356"?> Berkau: BASICS of ACCOUNTING 32-355 such as bank loans or bonds. Furthermore, all payments linked to equity and liabilities, such as dividends, interest and pay-offs are regarded as cash flows from financing activities. In the second part of this chapter, we present a more efficient way to calculate cash flows from operating activities by the reconciliation method. In order to recognise the differences between the methods, the same case study is used for both methods. However, the cash flows from investing and financing activities are calculated along the direct method always. Frequently, cash flow statements do not consider VAT. In real companies, VAT is refunded/ paid within monthly periods, except of payments made in December. However, in this text book, all VAT payments to and from the revenue service are due in the next Accounting period, which is in the next year. For that reason, cash flows are based on gross amounts. We explain the direct method for cash flow calculation at first: Along the direct method all activities are recorded and the cash flow statement is derived from cash and bank accounts. We actually go through each and every entry in the Cash/ Bank account and classify them along their origin in operating, investing or financing entries. Direct Method: We’ll show the book store case study MANSELL Ltd. in order to explain the statement of cash flows. We explain the cash flows from all business activity with regard to their classifications. MANSELL Ltd. is established by a share issue on 2.01.20X4. The company issued 20,000 ordinary shares at 5.00 EUR/ share - all shares are issued par value. The bookkeeping entry is cash relevant, as there is a debit entry in the Cash/ Bank account. The money flow into the business is seen as a cash flow from financing activities, because issuing shares provides funds for the company. (1) Share issue: 20,000 × 5 = 100,000.00 EUR on 2.01.20X4. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR MANSELL Ltd. further takes a bank loan from its house bank. The money lent equals to 40,000.00 EUR. The rate of interest is 4.25 %/ a. The bank requires by the contract of loan, that every year an amount of 2,000.00 EUR is to be paidoff. MANSELL Ltd. takes the bank loan on 3.01.20X4 and has to pay the amount for interest which equals to: 4.25% × 40,000 = 1,700.00 EUR and for pay-off 2,000.00 EUR at the end of the Accounting period 20X4. The bookkeeping entries are: (2) Taking a bank loan on 3.01.20X4. <?page no="357"?> Berkau: BASICS of ACCOUNTING 32-356 DR Cash/ Bank.................... 40,000.00 EUR CR Interest Bearing Liab........ 40,000.00 EUR The debit entry in the Cash/ Bank account is a cash flow from financing activities. The same category applies for the interest payment and the pay-off. They both are financing activities. (3) Paying interest on 31.12.20X4. DR Interest..................... 1,700.00 EUR CR Cash/ Bank.................... 1,700.00 EUR (4) Paying-off debts on 31.12.20X4. DR Interest Bearing Liabilities. 2,000.00 EUR CR Cash/ Bank.................... 2,000.00 EUR At the end of the Accounting period, MANSELL Ltd. transfers liabilities due in the next period into an extra account for short-term liabilities, here: into the Accounts Payables account. Compare the CHATTY case study in chapter Special Liability Accounts - Payables, Bank Loans and Provisions with regard to separation of long-term and short-term liabilities along IAS 1. (5) Transferring next year’s pay-off amounts to Accounts Payables account on 31.12.20X4. DR Interest Bearing Liabilities. 2,000.00 EUR CR Accounts Payables............ 2,000.00 EUR Bookkeeping entry (5) does not contain a cash flow. It won’t appear in the statement of cash flows for that reason. The Cash/ Bank account is not effected. MANSELL Ltd. rents a shop from its landlord. The landlord is a private person. Therefore, rent is free of VAT. Rent of 24,000.00 EUR is paid for the full year and is to be considered as a cash flow from operating activities. Paying rent is no investment or linked to financing of the business either. (6) Payment for rent on 4.01.20X4. DR Rent......................... 24,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR MANSELL Ltd. buys 26 book shelves at 535.00 EUR each (The amount is ex VAT.). The bookshelves will be in use for more than a year and are considered as property, plant and equipment therefore. Any cash/ bank transaction for noncurrent assets is regarded as an investment. MANSELL Ltd. is registered for VAT reduction and pays the gross purchase price only at half. The payment is 26 × 535 × 120% / 2 = 8,346.00 EUR . The remaining portion is to be paid in the next Accounting period 20X5. The payment for the book shelves is classified as investing cash flow. The cash flow is negative as cash goes out of MANSELL Ltd.’s <?page no="358"?> Berkau: BASICS of ACCOUNTING 32-357 Cash/ Bank account. The acquisition is made and recorded on 5.01.20X4. (7) Acquisition of book shelves: 26 × 535 × 120% = 16,692.00 EUR on 5.01.20X4. DR P, P, E Account.............. 13,910.00 EUR DR VAT.......................... 2,782.00 EUR CR Cash/ Bank.................... 8,346.00 EUR CR Accounts Payables............ 8,346.00 EUR MANSELL Ltd. plans to deploy the book shelves for 10 years. Their useful life is 10 years, also. No residual value is considered. Annual depreciation on the book shelves equals to: 13,910/ 10 = 1,391.00 EUR/ a . Depreciation is not linked to any cash flow. (8) Depreciation on book shelves on 31.12.20X4. DR Depreciation................. 1,391.00 EUR CR Acc. Depr.................... 1,391.00 EUR On 8.01.20X4, MANSELL Ltd. buys 4,000 novels at a purchase price of 8.16 EUR each. The amount includes VAT. The total amount paid is 4,000 × 8.16 = 32,640.00 EUR . The net amount thereof equals to: 32,640/ 120% = 27,200.00 EUR . The purchase of books is a cash deal. The books are no investments as the books are posted to inventories. The purchase of merchandise is an operating activity. The payment of 32,640.00 EUR is a cash flow from operating activities therefore. (9) Purchase of books on 8.01.20X4. DR Purchase..................... 27,200.00 EUR DR VAT.......................... 5,440.00 EUR CR Cash/ Bank.................... 32,640.00 EUR On 5.04.20X4, MANSELL Ltd. sells 2,900 books at a net selling price of 14.50 EUR/ u on cash. The net amount of the sales equals to: 2,900 × 14.50 = 42,050.00 EUR . The amount received from customers is called proceeds and equals to: 42,050 × 120% = 50,460.00 EUR . The cash flowing to MANSELL Ltd. resulting from the sales is a cash flow from operating activities. (10) Cash sales on 5.04.20X4. DR Cash/ Bank.................... 50,460.00 EUR CR VAT.......................... 8,410.00 EUR CR Sales........................ 42,050.00 EUR We take a look at MANSELL Ltd.’s accounts at this stage in Figure 32.1: <?page no="359"?> Berkau: BASICS of ACCOUNTING 32-358 D C D C (1) 100,000.00 (3) 1,700.00 c/ d 100,000.00 (1) 100,000.00 (2) 40,000.00 (4) 2,000.00 b/ d 100,000.00 (10) 50,460.00 (6) 24,000.00 (7) 8,346.00 (9) 32,640.00 c/ d 121,774.00 190,460.00 190,460.00 b/ d 121,774.00 D C D C (4) 2,000.00 (2) 40,000.00 (3) 1,700.00 c/ d 1,700.00 (5) 2,000.00 b/ d 1,700.00 c/ d 36,000.00 40,000.00 40,000.00 b/ d 36,000.00 D C D C (5) 2,000.00 (6) 24,000.00 c/ d 24,000.00 c/ d 10,346.00 (7) 8,346.00 b/ d 24,000.00 10,346.00 10,346.00 b/ d 10,346.00 D C D C (7) 13,910.00 c/ d 13,910.00 (7) 2,782.00 (10) 8,410.00 b/ d 13,910.00 (9) 5,440.00 c/ d 188.00 8,410.00 8,410.00 b/ d 188.00 D C D C (8) 1,391.00 c/ d 1,391.00 c/ d 1,391.00 (8) 1,391.00 b/ d 1,391.00 b/ d 1,391.00 D C D C (9) 27,200.00 c/ d 27,200.00 c/ d 42,050.00 (10) 42,050.00 b/ d 27,200.00 b/ d 42,050.00 Cash/ Bank Issued Capital Purchase Sales Accounts payables Rent Property, plant, and equipment VAT Interest bearing liabilities Interest Depreciation Acc depr Figure 32.1: MANSELL Ltd.’s accounts <?page no="360"?> Berkau: BASICS of ACCOUNTING 32-359 In order to check the consistency with the double entry system, MANSELL Ltd.’s Accountant prepares a trial balance as displayed by Figure 32.2: Account Debit entries Credit entries Cash/ Bank 121,774.00 Issued Capital 100,000.00 Interest Bearing Liabilities 36,000.00 Interest 1,700.00 Accounts payables 10,346.00 Rent 24,000.00 Property, Plant, and Equipment 13,910.00 VAT 188.00 Depreciation 1,391.00 Accumulated Depreciation 1,391.00 Purchase 27,200.00 Sales 42,050.00 Total: 189,975.00 189,975.00 Mansell Ltd.'s TRIAL BALANCE as at 31.12.20X4 Figure 32.2: MANSELL Ltd.’s trial balance For the calculation of profit, MANSELL Ltd. has to count stock. The logistics manager detects a closing stock of books being 1,100 novels at 1,100 × 8.16/ 120% = 7,480.00 EUR of value. Observe the profit calculation by the Trading account and the Profit and Loss account inFigure 32.3: D C D C (1) 100,000.00 (3) 1,700.00 c/ d 100,000.00 (1) 100,000.00 (2) 40,000.00 (4) 2,000.00 b/ d 100,000.00 (10) 50,460.00 (6) 24,000.00 (7) 8,346.00 (9) 32,640.00 c/ d 121,774.00 190,460.00 190,460.00 b/ d 121,774.00 Cash/ Bank Issued Capital Figure 32.3: MANSELL Ltd.’s accounts <?page no="361"?> Berkau: BASICS of ACCOUNTING 32-360 D C D C (4) 2,000.00 (2) 40,000.00 (3) 1,700.00 c/ d 1,700.00 (5) 2,000.00 b/ d 1,700.00 P&L 1,700.00 c/ d 36,000.00 40,000.00 40,000.00 b/ d 36,000.00 Interest bearing liabilities Interest D C D C (5) 2,000.00 (6) 24,000.00 c/ d 24,000.00 c/ d 10,346.00 (7) 8,346.00 b/ d 24,000.00 P&L 24,000.00 10,346.00 10,346.00 b/ d 10,346.00 D C D C (7) 13,910.00 c/ d 13,910.00 (7) 2,782.00 (10) 8,410.00 b/ d 13,910.00 (9) 5,440.00 c/ d 188.00 8,410.00 8,410.00 b/ d 188.00 D C D C (8) 1,391.00 c/ d 1,391.00 c/ d 1,391.00 (8) 1,391.00 b/ d 1,391.00 P&L 1,391.00 b/ d 1,391.00 D C D C (9) 27,200.00 c/ d 27,200.00 c/ d 42,050.00 (10) 42,050.00 b/ d 27,200.00 P&L 27,200.00 P&L 42,050.00 b/ d 42,050.00 D C D C Pch 27,200.00 Rev 42,050.00 T/ A 7,480.00 c/ d 7,480.00 GP 22,330.00 Inv 7,480.00 b/ d 7,480.00 49,530.00 49,530.00 P&L 22,330.00 b/ d 22,330.00 Depreciation Acc depr Trading account Inventory Purchase Sales Accounts payables Rent Property, plant, and equipment VAT Figure 32.3: MANSELL Ltd.’s accounts (continued) <?page no="362"?> Berkau: BASICS of ACCOUNTING 32-361 D C D C Int 1,700.00 T/ A 22,330.00 c/ d 4,761.00 P&L 4,761.00 Rnt 24,000.00 b/ d 4,761.00 Dpr 1,391.00 NL 4,761.00 27,091.00 27,091.00 b/ d 4,761.00 R/ E 4,761.00 Profit and Loss Retained earnings Figure 32.3: MANSELL Ltd.’s accounts (continued) MANSELL Ltd. made a loss in 20X4. The adjusted trial balance is prepared to check the profit calculation and is shown by Figure 31.4: Account Debit entries Credit entries Cash/ Bank 121,774.00 Issued Capital 100,000.00 Interest Bearing Liabilities 36,000.00 Interest 0.00 0.00 Accounts payables 10,346.00 Rent 0.00 0.00 Property, Plant, and Equipment 13,910.00 VAT 188.00 Depreciation 0.00 0.00 Accumulated Depreciation 1,391.00 Purchase 0.00 0.00 Sales 0.00 0.00 Inventory 7,480.00 Retained Earnings 4,761.00 Total: 147,925.00 147,925.00 Mansell Ltd.'s ADJUSTED TRIAL BALANCE as at 31.12.20X4 Figure 32.4: MANSELL Ltd.’s adjusted trial balance The financial statements such as balance sheet and income statement are presented by Figure 32.5 and Figure 32.6 below. There is no appropriation of profit considered. At first, there is no profit earned and secondly, the appropriation of profits won’t change cash/ bank for the actual Accounting period. No dividend will be paid out to the owners at this stage. The material expenses recognised on the income statement, are purchased books less closing stock thereof. This equals to: 27,200 - 7,480 = 19,720.00 EUR . <?page no="363"?> Berkau: BASICS of ACCOUNTING 32-362 [EUR] Revenue 42,050.00 Other income 42,050.00 Materials 19,720.00 Labour Depreciation 1,391.00 Other expenses 24,000.00 Earnings before int and taxes (EBIT) (3,061.00) Interest 1,700.00 Earnings before taxes (EBT) (4,761.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (4,761.00) Mansell Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 32.5: MANSELL Ltd.’s statement of comprehensive income The statement of financial position is derived straight from the adjusted trial balance. See below: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 12,519.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (4,761.00) Current assets Liabilities Inventory 7,480.00 Interest bear liab 36,000.00 A/ R A/ P 10,534.00 Prepaid expenses Provisions Cash/ Bank 121,774.00 Tax liabilities 141,773.00 141,773.00 Mansell Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 32.6: MANSELL Ltd.’s statement of financial position <?page no="364"?> Berkau: BASICS of ACCOUNTING 32-363 The balance sheet requires some further attention: The item for property, plant and equipment is the amount read from the Property, Plant and Equipment account less accumulated depreciation. It equals to: 13,910 -1,391 = 12,519.00 EUR . The item for accounts payables contains the amount owed the supplier, short-term liabilities from the bank loan and output-VAT. The sum gives: 2,000 + 8,346 + 188 = 10,534.00 EUR . The cash flow amounts to the total of changes of cash/ bank. At the beginning of the Accounting period, no opening amount is recognised in the Cash/ Bank account. Accordingly, the total cash flow equals to the closing balance, which is: 121,774.00 EUR. The statement of cash flows shows where the total cash flow results from. Observe below MANSELL Ltd.’s statement of cash flows in Figure 32.7: Cash flow from operating acitivities Materials bought (32,640.00) Sales 50,460.00 Rent (24,000.00) (6,180.00) Cash flow from investing activities Investment in book shelves (8,346.00) (8,346.00) Cash flow from financing activities Share issue 100,000.00 Bank loan paid 40,000.00 Interest (1,700.00) Pay-off (2,000.00) 136,300.00 121,774.00 Mansell Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X4 Figure 32.7: MANSELL Ltd.’s statement of cash flows The cash flow statement does not require making new bookkeeping entries. It can be derived directly from the Cash/ Bank account. The statement of cash flows assigns cash flows to the categories cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. The cash flow statement is not prepared in order to determine the total cash flow. That one can easily be read from the cash/ bank account(s). The statement rather illustrates where the <?page no="365"?> Berkau: BASICS of ACCOUNTING 32-364 cash flow results from (which classification). We now study another method to derive a cash flow from operating activities. The problem with the direct method is, that a company that makes a lot of bookkeeping entries has to classify all its entries in the Cash/ Bank account and has to assign them to the relevant cash flow categories. Some companies make a few thousands of bookkeeping entries every day or even every minute, so the direct method might not really be applicable for them. Instead of analysing single cash flow operations, companies often apply the reconciliation of profits with the operating cash flow. It does not require preparing a cash flow statement from the scratch on. It starts with the income statement’ profit. In order to understand the reconciliation method, we acknowledge, that with regard to the operating cash flows a high overlap of entries in the income statement and the cash flow statement exists. However, there are expenses that do not cause an operating cash flow and there are cash flows that do not cause expenses. We name a few of those cases in order to develop a feeling for the differentiation. Expenses, that do not result in operating cash flows are depreciation, increases in provisions, interest etc. On the other hand, cash flow that are no expenses, result from purchases, if the inventories are not consumed. Other examples are changes in receivables and payables, including VAT and income tax payables. However, no indication will be given for investing or financing cash flows by the reconciliation method. Consider taking a bank loan: There is no evidence of taking a bank loan or paying it off in the income statement whatsoever. The same applies for share issues or bond issues. The income statement might recognise dividends or interest, but that information does not tell the amount of shares or of bonds. For this reason, the reconciliation only works for operating cash flows. The other cash flows are still to be calculated along the direct method. We do not explain the reconciliation method further, but we apply it for two case studies. PARKLANDSMAIN introduces the basics. Later on, we study again MANSELL Ltd. in order to compare direct method and reconciliation method. Reconciliation Method: PARKLANDSMAIN is a painting service company and offers outside wall coatings for private homes. The company is established as a privately owned business. No legal form indication is added to the firm’s name therefore. At the time of incorporation, the owner puts 5,000.00 EUR into the Cash/ Bank account. PARKLANDSMAIN buys a ladder for 600.00 EUR and paint for 1,000.00 EUR. All amounts are without VAT as we ignore VAT for this mini-case study. PARKLANDSMAIN makes the following bookkeeping entries on 2.01.20X7. (Note, in order to not confuse you by this interim-case study, we use Roman figures for the identification of bookkeeping entries.) (I) Establishment of the business by posting the money to cash/ bank. <?page no="366"?> Berkau: BASICS of ACCOUNTING 32-365 DR Cash/ Bank.................... 5,000.00 EUR CR Owner’s Capital.............. 5,000.00 EUR (II) Buying the ladder. DR P, P, E ...................... 600.00 EUR CR Cash/ Bank.................... 600.00 EUR (III) Buying paint. DR Inventory ................... 1,000.00 EUR CR Cash/ Bank.................... 1,000.00 EUR PARKLANDSMAIN works on one building during January 20X7. The order requires the payment of labour for the painter to an extent of 400.00 EUR. Furthermore, we record the consumption of one quarter of the paint and we record an earned revenue of 1,200.00 EUR. The customer pays half of the amount and agrees to pay for the other portion later on (next Accounting period). (IV) Recording labour on 31.01.20X7. DR Labour....................... 400.00 EUR CR Cash/ Bank.................... 400.00 EUR (V) Making the bookkeeping entry for the paint consumption on 31.01.20X7. DR Material Expenses............ 250.00 EUR CR Inventory.................... 250.00 EUR (VI) Posting the revenue on 31.01.20X7. DR Cash/ Bank.................... 600.00 EUR DR Accounts Receivables......... 600.00 EUR CR Revenue...................... 1,200.00 EUR (VII) At the yearend, the ladder is written off to an extent of half of the cost of acquisition. This amount is: 600/ 2 = 300.00 EUR . Depreciation on the ladder is recorded on 31.12.20X7 as adjustment. DR Depreciation................. 300.00 EUR CR Acc. Depr.................... 300.00 EUR <?page no="367"?> Berkau: BASICS of ACCOUNTING 32-366 We take a look at the accounts at this stage of the Accounting process. Check Figure 32.8: D C D C (I) 5,000.00 (II) 600.00 c/ d 5,000.00 (I) 5,000.00 (VI) 600.00 (III) 1,000.00 (IV) 400.00 c/ d 3,600.00 5,600.00 5,600.00 b/ d 3,600.00 D C D C (II) 600.00 c/ d 600.00 (III) 1,000.00 (V) 250.00 b/ d 600.00 c/ d 750.00 1,000.00 1,000.00 b/ d 750.00 D C D C (IV) 400.00 P&L 400.00 (V) 250.00 P&L 250.00 D C D C (VI) 600.00 c/ d 600.00 P&L 1,200.00 (VI) 1,200.00 b/ d 600.00 D C D C (VII) 300.00 P&L 300.00 c/ d 300.00 (VII) 300.00 b/ d 300.00 Depreciation Acc depr Labour Material expenses Accounts Reveivables (A/ R) Revenue Cash/ Bank Owner's Capital P, P, E Inventory (paint) D C D C Lab 400.00 Rev 1,200.00 c/ d 250.00 P&L 250.00 Mat 250.00 b/ d 250.00 Dpr 300.00 P 250.00 1,200.00 1,200.00 R/ E 250.00 b/ d 250.00 Profit and Loss account Retained earnings (R/ E) Figure 32.8: PARKLANDSMAIN’s accounts PARKLANDSMAIN is a privately owned business. For that reason, the company does not record income tax. The increase of value of the business will be subject to the private tax statement of <?page no="368"?> Berkau: BASICS of ACCOUNTING 32-367 its owner. Thus, in the Profit and Loss account, profit is not “before” or “after” taxation. This is the reason for calling it P = Profit. We can see already the profit is different to the cash flow. The profit equals to 250.00 EUR and the cash flow equals to 3,600.00 EUR. The total cash flow contains operating cash flows, the investing cash flow for the ladder and a financing cash flow resulting from the owner’s contribution. Observe below the cash flow statement as prepared along the direct method for PARKLANDSMAIN. It is depicted by Figure 32.9: Cash flow from operating acitivities Materials bought (1,000.00) Sales 600.00 Labour (400.00) (800.00) Cash flow from investing activities Investment in book shelves (600.00) (600.00) Cash flow from financing activities Owner's contribution 5,000.00 5,000.00 3,600.00 ParklandsMain's STATEMENT of CASH FLOWS for the period ended 31.12.20X7 Figure 32.9: PARKLANDSMAIN’s statement of cash flows The operating cash flow results from the purchase of paint at 1,000.00 EUR, from the labour paid 400.00 EUR and from the portion (50 %) of the received revenue. In total, the business makes a negative cash flow from operating activities. The cash flow from investing activities results from the acquisition of the ladder and is negative to an extent of 600.00 EUR. There is only one positive cash flow: the cash flow from financing the business when the owner contributed 5,000.00 EUR. <?page no="369"?> Berkau: BASICS of ACCOUNTING 32-368 [EUR] Revenue 1,200.00 Other income 1,200.00 Materials 750.00 Labour 400.00 Depreciation 300.00 Other expenses Earnings before int and taxes (EBIT) (250.00) Interest 0.00 Earnings before taxes (EBT) (250.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (250.00) ParklandsMain's STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 32.10: PARKLANDSMAIN’s income statement In this case study, we can oversee easily the reason for the difference in profit and operating cash flow. We see that the difference results from the customer not paying the full amount and from the paint not used up. Furthermore, depreciation on the ladder does not lead to a payment. We now try to adjust the profit amount in order to calculate the operating cash flow step by step. We start with 250.00 EUR of profit. At first we adjust the amount for depreciation. Depreciation is deducted in the profit calculation because it is an expense. As it does not result in a cash flow, we undo the deduction for depreciation. This will give us for the cash flow calculation: 250 + 300 = 550.00 EUR . By the second step, we want to consider that the business bought more paint than used up. This gives us an inventory’s closing stock of 750.00 EUR. According to this, we deduct the 750.00 “overpaid” materials. The new cash flow equals to the previous one less unused paint: 550 - 750 = -200.00 EUR . The last step is about the deduction of the amount not yet received from the customer which is a receivable of: 1,200/ 2 = 600.00 EUR . The cash flow equals now to: -200 - 600 = -800.00 EUR . This is also the cash flow from operating activities calculated by the direct method according to Figure 32.9. We proved we can reconcile the profit with the operating cash flow. This procedure does not work for the investing cash flow as the income statement does not provide enough information about the cost of acquisition. The same applies for the owner’s contribution, here. The income statement does not say anything about the financing of the business. We illustrate the reconciliation more formal by a reconciliation statement as displayed by Figure 32.11. <?page no="370"?> Berkau: BASICS of ACCOUNTING 32-369 Profit for the period 250.00 add: depreciation 300.00 550.00 add: interest for bank loan 0.00 550.00 Changes in working capital (1) Changes in A/ R (600.00) (2) Changes in inventory (750.00) (3) Changes in A/ P 0.00 (4) Changes in VAT (op) 0.00 (5) Changes in tax liabilities 0.00 Operating cash flow (800.00) ParklandsMain's RECONCILIATION of EARNINGS before TAXATION with CFoA for year ended 31.12.20X7 Figure 32.11: PARKLANDSMAIN’s reconciliation statement The reconciliation statement starts with the profit for the period. Depreciation is added as depreciation is considered as expense and deducted for profit calculation. As depreciation is neutral to the cash flow, the amount is to be added. Similar is the procedure for interest. Actually, interest is really paid. However, the reconciliation statement determines the cash flow resulting from operating activities only. This means the interest payment is to be neutralised by adding interest paid to the profit. With regard to the cash flow statement, interest will be considered as financial cash flows in the cash flow from financing activities section. By the next step the changes in working capital will be considered. In order to understand the concept of reconciliation, we assume that every change in the working capital has been made against the Cash/ Bank account. A company that increases receivables, assumes all added receivables result from lending money to other parties through the Cash/ Bank account. Thus, any increase in receivables results in a negative cash flow. Prepaid expenses are some sort of receivables also! There is a payment for a service rendered in the future. Thus, treat prepaid expense increases same as increases of receivables. Any inventory increase will be seen as a purchase through the Cash/ Bank account. According to that assumption, increases of stock will be seen as negative cash flows. However, a decrease of inventory is a positive cash flow. We assume that inventories, such as finished goods, are sold during the Accounting period. The changes in payables mean that someone lent the business money. This results in a buyer’s <?page no="371"?> Berkau: BASICS of ACCOUNTING 32-370 obligation to pay the money back and thus a positive cash flow. Changes in VAT will be considered like receivables, if the VAT account is debit balanced, and like payables, if it is credit balanced. In case the reconciliation statement starts by the profit after taxes an increase in tax liabilities is likely. (Only prepayments of income tax can cause a tax liability deduction.) Increases in tax liabilities will be linked to the operating cash flow. Any increase of a liability is regarded as positive cash flow. The major advantage of the reconciliation statement is that it takes the changes of the working capital from the balance sheet and not from single activities. Thus, the effort for calculating the operating cash flow is always the same, no matter how many business activities are operated. How it is done (reconciliation of profit with operating cash flows): (1) Take the profit after taxes from the income statement and put it into the reconciliation statement’s first line. (2) Add depreciation. (3) Add interest paid and deduct interest received. (4) Check the balance sheet for changes in receivables. Deduct the total of increases of receivables or add the total of decreases thereof. Consider prepaid expenses like receivables. (5) Check all inventory accounts. Deduct increases of inventory or add decreases thereof. (6) Check the balance sheet for changes in payables. Add the total of increases of payables or deduct the total of decreases thereof. (7) Check the VAT account if not already included in payables or receivables. Deduct increases of VAT receivables or add decreases of VAT receivables. Or add increases of VAT payables or deduct decreases of VAT. (8) Add increases of income taxes or deduct decreases thereof. (9) Transfer the operating cash flow into the statement of cash flows. (10) Consider adjustments for separating investing cash flow. (Note, a mistake often made in exams is that the working capital itself is considered instead of changes thereof.) PARKLANDSMAIN transfers the operating cash flow into the statement of cash flows as depicted by Figure 32.12. <?page no="372"?> Berkau: BASICS of ACCOUNTING 32-371 Cash flow from operating acitivities as by reconciliation (800.00) (800.00) Cash flow from investing activities Investment in book shelves (600.00) (600.00) Cash flow from financing activities Owner's contribution 5,000.00 5,000.00 3,600.00 ParklandsMain's STATEMENT of CASH FLOWS for the period ended 31.12.20X7 Figure 32.12 PARKLANDSMAIN’s statement of cash flows After studying PARKLANDSMAIN, we take our cash flow considerations to the next level and discuss MANSELL Ltd. again. In contrast to the previous case study, we consider VAT now. As we prepared already financial statements for MANSELL Ltd., we only apply the reconciliation method on the MANSELL Ltd. example. We want to determine the operating cash flow by reconciliation of its profits from the income statement. As you can observe below, we only need knowledge about the income statement and the statement of financial position for the cash flow calculation. There is no need for us to analyse accounts. We recall the both financial statements of the book store MANSELL Ltd., the income statement and the balance sheet - take a look at Figure 32.13 and Figure 32.14: <?page no="373"?> Berkau: BASICS of ACCOUNTING 32-372 [EUR] Revenue 42,050.00 Other income 42,050.00 Materials 19,720.00 Labour Depreciation 1,391.00 Other expenses 24,000.00 Earnings before int and taxes (EBIT) (3,061.00) Interest 1,700.00 Earnings before taxes (EBT) (4,761.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (4,761.00) Mansell Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 32.13: MANSELL Ltd.’s statement of comprehensive income (as above) A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 12,519.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (4,761.00) Current assets Liabilities Inventory 7,480.00 Interest bear liab 36,000.00 A/ R A/ P 10,534.00 Prepaid expenses Provisions Cash/ Bank 121,774.00 Tax liabilities 141,773.00 141,773.00 Mansell Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 32.14: MANSELL Ltd.’s statement of financial position (as above) We take the loss of 4,761.00 EUR out of the income statement and transfer it to the reconciliation statement. Then, we add depreciation of 1,391.00 EUR and interest of 1,700.00 EUR. Observe the first steps by the reconciliation statement as displayed in Figure 32.15. <?page no="374"?> Berkau: BASICS of ACCOUNTING 32-373 Profit for the period (4,761.00) add: depreciation 1,391.00 (3,370.00) add: interest for bank loan 1,700.00 (1,670.00) Changes in working capital (1) Changes in A/ R (2) Changes in inventory (3) Changes in A/ P (4) Changes in VAT (op) (5) Changes in tax liabilities Operating cash flow Mansell Ltd.'s RECONCILIATION of EARNINGS before TAXATION with CFoA for year ended 31.12.20X4 Figure 32.15: MANSELL Ltd.’s half of the reconciliation statement The next steps consider changes in the working capital. The balance sheet is for the first Accounting period of the book store. Thus, in order to determine changes, we have to deduct an “empty” balance sheet, which only contains zero values. There is no change in receivables. The changes in inventory are: 4,780 - 0 = 4,780.00 EUR . This is a negative cash flow. The increase of payables is: 10,534 - 0 = 10,534.00 EUR . The amount is seen as a positive cash flow. The receivables/ payables contain the amounts for VAT already. This is caused by taking the amounts from the balance sheet. (The balance sheet does not provide extra VAT items.) However, we have to consider that the amount for the payables has been reduced by 2,782.00 EUR input-VAT for the acquisition of the bookshelves. The bookshelves acquisition results in an investing cash flow - no operating cash flow. For that reason, we add the amount to payables on the reconciliation statement: 10,534 + 2,782 = 13,316.00 EUR . Furthermore, there is an amount of 8,346 EUR included in payables which results from the bookshelves (investment), also. This amount is to be deducted from payables. A further deduction has to be made, as the 20X5pay-off amount of 2,000.00 EUR for the bank loan has been added to the shortterm liabilities before. That one is linked to financing activities. This amount of 2,000.00 EUR is to be deducted, too. The amount as considered for changes in payables then equals to: 10,534 + 2,782 - 8,346 - 2,000 = 2,970.00 EUR . Because of the loss, there are no changes in income tax liabilities. Observe the reconciliations in Figure 32.16. <?page no="375"?> Berkau: BASICS of ACCOUNTING 32-374 Profit for the period (4,761.00) add: depreciation 1,391.00 (3,370.00) add: interest for bank loan 1,700.00 (1,670.00) Changes in working capital (1) Changes in A/ R 0.00 (2) Changes in inventory (7,480.00) (3) Changes in A/ P 2,970.00 (4) Changes in VAT (op) 0.00 (5) Changes in tax liabilities 0.00 Operating cash flow (6,180.00) Mansell Ltd.'s RECONCILIATION of EARNINGS before TAXATION with CFoA for year ended 31.12.20X4 Figure 32.16: MANSELL Ltd.’s (full) reconciliation statement The operating cash flow by reconciliation leads to the same statement of cash flows as along the direct method - only the item for operating cash flows is named differently: Cash flow from operating acitivities as per reconciliation (6,180.00) (6,180.00) Cash flow from investing activities Investment in book shelves (8,346.00) (8,346.00) Cash flow from financing activities Share issue 100,000.00 Bank loan paid 40,000.00 Interest (1,700.00) Pay-off (2,000.00) 136,300.00 121,774.00 Mansell Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X4 Figure 32.17: MANSELL Ltd.’s statement of cash flows <?page no="376"?> Berkau: BASICS of ACCOUNTING 32-375 We present another case study about a production firm applying the reconciliation method. We show how to calculate stock of finished goods therein and we deal with income taxes: SUNLANDS AG is a production firm for canvas chairs. The chairs consist of a frame (30.00 EUR/ u) and fabric (7.50 EUR/ u). The costs of materials as given in brackets are net amounts for materials. On 2.01.20X3, SUNLANDS AG issues 50,000 ordinary shares at a face value of 5.00 EUR/ share. The issue price amounts to 8.35 EUR/ share. On 1.07.20X3 they issue a bond: 100 bonds at 1,000.00 EUR/ bond face value. The bonds will be redeemed after 30 years. The rate of interest is 2.7 % per half year (the annual rate of interest is 5.4 %, compounded at the yearend) and the coupon rate is paid ever half of the year. Furthermore, SUNLANDS takes a bank loan on 2.01.20X3 at their house bank. The amount is 80,000.00 EUR. The rate of interest is 4.65 %/ a and will be paid as portion of the annuity (5,000.00 EUR/ a) at the yearends. Interest is a non-manufacturing expense. SUNLANDS pays for the acquisition of machinery 48,000.00 EUR (gross amount) on 2.01.20X3 and depreciates the machines along straight line method over a useful life 5 years under consideration of a residual amount 10,000.00 EUR. At the beginning of the Accounting period SUNLANDS buys materials for 10,000 canvas chairs (consider VAT) and pays labour for the production of 10,000 canvas chairs 113,000.00 EUR. 45 % of the price for materials is paid to the supplier, the remaining portion is to be paid in the upcoming year. The production amount in 20X3 is 10,000 canvas chairs. SUNLANDS Ltd. sells 8,467 canvas chairs at 103.20 EUR/ u (gross amount) during 20X3. The remaining canvas chairs are on stock of finished goods at the end of 20X3. Do not consider interest for inventory valuation. All customers pay on cash. We prepare a balance sheet and an income statement for 20X3 and derive an operating cash flow thereof for SUN- LANDS AG. Prepare a full cash flow statement along the direct method (cash flow from investing and financing activities). The total income tax rate for SUNLANDS is 30 % and the VAT rate is 20 %. There is no appropriation of profit. In order to determine the income statements there will be 2 methods: Nature of expense method and the cost of sales format. We here start by the nature of expense method as it is quite easy and does not require making many bookkeeping entries. After profit calculation we are going to make bookkeeping entries along the cost of sales format and set up the balance sheet and the statement of comprehensive income. We determine the operating cash flow stepwise and explain all necessary moves. The income statement along the nature of expense method requires calculating the revenue and the value of closing stock. The revenue is: 8,467 × 103.20 / 120% = 728,162.00 EUR . <?page no="377"?> Berkau: BASICS of ACCOUNTING 32-376 The unit costs per canvas chair amount to materials, labour and depreciation. Interest is a non-manufacturing expense. The unit costs are: (30 + 7.50) + 113,000 / 10,000 + (48,000 / 120% - 10,000) / (5 × 10,000) = 49.40 EUR . Profit before taxes amounts to revenue + changes in inventory of finished goods less materials, less depreciation and less interest for the bonds and the bank loan: 728,162 + (10,000 - 8,467) × 49.40 - (30 + 7.50) × 10,000 - 113,000 - (48,000 / 120% - 10,000) / 5 - 100 × 1,000 × 2.7% - 80,000 × 4.65% = 303,472.20 EUR . Observe SUNLANDS Ltd.’s statement of comprehensive income along the nature of expense method. [EUR] Revenue 728,162.00 Changes in FG-inventories 75,730.20 803,892.20 Materials 375,000.00 Labour 113,000.00 Depreciation 6,000.00 Other expenses 2,700.00 Earnings before int and taxes (EBIT) 307,192.20 Interest 3,720.00 Earnings before taxes (EBT) 303,472.20 Income tax expenses 91,041.66 Deferred taxes Earnings after taxes (EAT) 212,430.54 Sunland Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 32.18: SUNLANDS Ltd.’s income statement for 20X3 Before we take the profit before taxes for the calculation of the cash flow from operating activities we determine profit by the cost of sales format and make the bookkeeping entries therefore. (1) Recording the share issue on 2.01.20X3. DR Cash/ Bank.................... 417,500.00 EUR CR Issued Capital .............. 250,000.00 EUR CR Capital Reserves............. 167,500.00 EUR <?page no="378"?> Berkau: BASICS of ACCOUNTING 32-377 (2) Bond issue on 1.07.20X3. DR Cash/ Bank ................... 100,000.00 EUR CR Interest Bear. Liab. ........ 100,000.00 EUR (Note, along IFRSs the redeemable bonds must be discounted. As the discounting of liabilities is subject to chapter 14 of the text book Bilanzen and the ebook Accounting-2- Go, we do not discount liabilities for SUNLANDS AG.) (3) Payment of the coupon: 2.7% × 100,000 = 2,700.00 EUR . Consider the bonds being issued in the middle of the year. According to this date, the rate of interest is due for half a year only. DR Interest (Coupon) ........... 2,700.00 EUR CR Cash/ Bank.................... 2,700.00 EUR (4) Taking the bank loan of 80,000.00 EUR on 1.0120X3. DR Cash/ Bank.................... 80,000.00 EUR CR Interest Bear. Liab. ........ 80,000.00 EUR (5) Payment of the annuity (interest: 80,000 x 4.65% = 3,720.00 EUR and payoff: 5,000 - 3,720 = 1,280.00 EUR ). DR Interest .................... 3,720.00 EUR DR Interest Bear. Liab. ........ 1,280.00 EUR CR Cash/ Bank.................... 5,000.00 EUR (6) Acquisition of machinery on 2.01.20X3. The net amount is: 48,000/ 120% = 40,000.00 EUR . DR P, P, E ...................... 40,000.00 EUR DR VAT.......................... 8,000.00 EUR CR Cash/ Bank ................... 48,000.00 EUR (7) Depreciation per year is: ((48,000/ 120%) - 10,000) / 5 = 6,000.00 EUR . The residual amount is to be deducted from the cost of acquisition in order to receive the depreciable amount. You are supposed to check IAS 16 for that. The contra account for depreciation is the Accumulated Depreciation account. DR Depreciation ................ 6,000.00 EUR CR Acc. Depr.................... 6,000.00 EUR <?page no="379"?> Berkau: BASICS of ACCOUNTING 32-378 (8) Materials purchased (on cash: 10,000 × (30 + 7.50) × 120% ×∙45% = 202,500.00 EUR ; on credit: 10,000 × (30 + 7.50) × 120% ×∙55% = 247,500.00 EUR) . DR Purchase..................... 375,000.00 EUR DR VAT ......................... 75,000.00 EUR CR A/ P.......................... 247,500.00 EUR CR Cash/ Bank ................... 202,500.00 EUR (9) Recording labour. DR Labour....................... 113,000.00 EUR CR Cash/ Bank ................... 113,000.00 EUR (10) Revenue (see above) is: 8,467 × 103.20 / 120% = 728,162.00 EUR . DR Cash/ Bank.................... 873,794.40 EUR CR VAT.......................... 145,632.40 EUR CR Revenue...................... 728,162.00 EUR We will run a manufacturing Accounting based on one WIP account for canvas chairs and a manufacturing overhead account for labour and depreciation. As it has not been mentioned otherwise there are no overor under-applied overheads. Observe the accounts in Figure 32.19. D C D C (1) 417,500.00 (3) 2,700.00 c/ d 250,000.00 (1) 250,000.00 (2) 100,000.00 (5) 5,000.00 b/ d 250,000.00 (4) 80,000.00 (6) 48,000.00 (10) 873,794.40 (8) 202,500.00 (9) 113,000.00 c/ d 1,100,094.40 1,471,294.40 1,471,294.40 b/ d 1,100,094.40 D C D C c/ d 167,500.00 (1) 167,500.00 c/ d 100,000.00 (2) 100,000.00 b/ d 167,500.00 b/ d 100,000.00 Cash/ Bank Issued capital Capital reserves Liabilities (bonds) Figure 32.19: SUNLANDS Ltd.’s accounts <?page no="380"?> Berkau: BASICS of ACCOUNTING 32-379 D C D C (3) 2,700.00 c/ d 2,700.00 (5) 1,280.00 (4) 80,000.00 b/ d 2,700.00 P&L 2,700.00 c/ d 78,720.00 80,000.00 80,000.00 b/ d 78,720.00 Interest (coupon) Liabilities (loan) D C D C (5) 3,720.00 c/ d 3,720.00 (6) 40,000.00 c/ d 40,000.00 b/ d 3,720.00 P&L 3,720.00 b/ d 40,000.00 D C D C (6) 8,000.00 c/ d 8,000.00 (7) 6,000.00 MOH 6,000.00 b/ d 8,000.00 D C D C c/ d 6,000.00 (7) 6,000.00 (8) 375,000.00 Inv 375,000.00 b/ d 6,000.00 D C D C (8) 75,000.00 (10) 145,632.40 c/ d 247,500.00 (8) 247,500.00 c/ d 70,632.40 b/ d 247,500.00 145,632.40 145,632.40 b/ d 70,632.40 VAT (operating activities) Accounts payables VAT (investment) Depreciation Acc depr Purchase Interest (loan) P, P, E D C D C (9) 113,000.00 MOH 113,000.00 c/ d 728,162.00 (10) 728,162.00 P&L 728,162.00 b/ d 728,162.00 Labour Revenue Figure 32.19: SUNLANDS Ltd.’s accounts (continued) <?page no="381"?> Berkau: BASICS of ACCOUNTING 32-380 D C D C Inv m 375,000.00 FG 494,000.00 Lab 113,000.00 WIP 119,000.00 MOH 119,000.00 Dpr 6,000.00 494,000.00 494,000.00 119,000.00 119,000.00 D C D C Purch 375,000.00 WIP 375,000.00 WIP 494,000.00 COS 418,269.80 c/ d 75,730.20 494,000.00 494,000.00 b/ d 75,730.20 WIP canvas chairs MOH Inventory materials FG-Inventory canvas chairs D C D C FG 418,269.80 P&L 418,269.80 COS 418,269.80 Rev 728,162.00 Int 2,700.00 Int 3,720.00 EBT 303,472.20 728,162.00 728,162.00 ITL 91,041.66 303,472.20 R/ E 212,430.54 303,472.20 303,472.20 D C D C c/ d 212,430.54 P&L 212,430.54 c/ d 91,041.66 P&L 91,041.66 b/ d 212,430.54 b/ d 91,041.66 Cost of Sales (COS) Profit and Loss Retained earnings (R/ E) Income tax liabilities Figure 32.19: SUNLANDS Ltd.’s accounts (continued) We prepare the statement of comprehensive income and the statement of financial position as displayed below: <?page no="382"?> Berkau: BASICS of ACCOUNTING 32-381 [EUR] Revenue 728,162.00 Other income 0.00 728,162.00 Cost of sales (COS) 418,269.80 Earnings before int and taxes (EBIT) 309,892.20 Interest 6,420.00 Earnings before taxes (EBT) 303,472.20 Income tax expenses 91,041.66 Deferred taxes Earnings after taxes (EAT) 212,430.54 Sunlands Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 32.20: SUNLANDS Ltd.’s statement of comprehensive income The amounts in the statement of comprehensive income are taken from the Profit and Loss account directly. The income taxes amount to 30 % of the earnings before taxes: 303,472.20 × 30% = 91,041.66 EUR . A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 34,000.00 Share capital 250,000.00 Intangibles Reserves 167,500.00 Financial assets R/ E 212,430.54 Current assets Liabilities Inventory 75,730.20 Interest bear liab 178,720.00 A/ R 8,000.00 A/ P 318,132.40 Prepaid expenses Provisions Cash/ Bank 1,100,094.40 Tax liabilities 91,041.66 1,217,824.60 1,217,824.60 Sunlands Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 32.21: SUNLANDS Ltd.’s statement of financial position The amounts in the statement of financial position are as follows: The carrying amount of the machinery is cost of acquisition less depreciation: 40,000 - 6,000 = 34,000.00 EUR . The amount of inventory is the canvas chairs as left on stock. The amount is: (10,000 - 8,467) × 49.40 = 75,730.20 EUR . SUNLANDS Ltd. runs two VAT accounts. One of the VAT accounts is for VAT resulting from investing activities. The acquisition of machinery gives SUNLANDS <?page no="383"?> Berkau: BASICS of ACCOUNTING 32-382 Ltd. a claim for input-VAT paid of: 40,000 × 20% = 8,000.00 EUR . Further VAT is resulting from operating activities and transferred to the other VAT account. See Figure 32.19 for details. The amount of cash/ bank is the balancing figure in the Cash/ Bank account. The issued capital results from the face value of the ordinary shares issued at the time of incorporation. The amount of reserves results from the capital reserves recognised by the share issue. The amount in the Retained Earnings account is the profit after taxes earned by SUNLANDS Ltd. The amount is: 303,472.20 × (1 - 30%) = 212,430.54 EUR . Interest bearing liabilities are long-term debts. Here they result from the bank loan and the bonds issued. The amount is 78,720 + 100,000 = 178,720.00 EUR . The payables contain short-term liabilities as the amount owed the suppliers for purchases and operative VAT. The amount is: 247,500 + 70,632.40 = 318,132.40 EUR . The income taxes amount to 30 % of the earnings before taxes which equals to: 303,472.20 × 30% = 91,041.66 EUR . By the next step we determine the cash flow. The total cash flow can be derived easily from the statement of financial position. It is: 1,100,094.40 - 0 = 1,100,094.40 EUR . The cash flow is taken from the Cash/ Bank account and recognised by the statement of cash flows. See Figure 32.22 for details. <?page no="384"?> Berkau: BASICS of ACCOUNTING 32-383 Cash flow from operating acitivities Materials paid (202,500.00) Sales incl. VAT 873,794.40 Labour (113,000.00) 558,294.40 Cash flow from investing activities Investments (48,000.00) (48,000.00) Cash flow from financing activities Share issue at issue price 417,500.00 Bonds issued 100,000.00 Bank loan received 80,000.00 Interest for bond (2,700.00) Annuity for bank loan (5,000.00) 589,800.00 1,100,094.40 Sunlands Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X3 Figure 32.22: SUNLANDS Ltd.’s statement of cash flows In order to calculate the cash flow resulting from operating activities, most companies apply the reconciliation method. This approach takes always the same amount of calculations no matter how many bookkeeping entries have been made through the Cash/ Bank account. The reconciliation of profits and operating cash flows is displayed by Figure 32.23. <?page no="385"?> Berkau: BASICS of ACCOUNTING 32-384 Profit for the period 212,430.54 add: depreciation 6,000.00 218,430.54 add: interest for bank loan 3,720.00 add: interest for bonds 2,700.00 224,850.54 Changes in working capital (1) Changes in A/ R 0.00 (2) Changes in inventory (75,730.20) (3) Changes in A/ P 247,500.00 (4) Changes in VAT (op) 70,632.40 (5) Changes in tax liabilities 91,041.66 Operating cash flow 558,294.40 Sunlands Ltd.'s RECONCILIATION of EARNINGS before TAXATION with CFoA for year ended 31.12.20X3 Figure 32.23: Reconciliation statement The profit for the period is given as the earnings after taxes. We add depreciation as it does not lead to any payment and add interest as it belongs with the financial cash flow. The amount is: 212,430.54 + 6,000 + 2,700 + 3,720 = 224,850.54 EUR . Alternatively, SUNDLANDS AG can start the reconciliation statement by the earnings before taxes, which is 303,472.20 EUR. In that case, the changes in A/ P have to contain the income taxes. Instead of 247,500 the amount would be: 247,500 + 91,041.66 = 338,541.66 EUR . As 212,430.54 - 247,500 = -35,069.46 EUR as well as: 303,472.20 - 338,541.66 = -35,069.46 EUR it does not really matter which profit the reconciliation starts with. However, in exams we recommend to take the earnings after taxes as long as nothing about prepayments has been mentioned, because it results in fewer calculations. Below; we discuss the changes in working capital: The changes with regard to receivables are nil, as the increase of input-VAT receivables results from the acquisition of the machine and is regarded as an investing cash flow. The further changes result from the increase of inventory of finished goods (canvas chairs) to an extent of: 49.40 × 1,533 = 75,730.20 EUR . The increase of payables is the amount SUNLANDS Ltd. still owes its suppliers. It equals to: 10,000 × (30 + 7.50) × 120 % × 55% = 247,500.00 EUR . The VAT account for operating activities is credit balanced which indicates a request for VAT payables. The amount is the difference between output-VAT from sales <?page no="386"?> Berkau: BASICS of ACCOUNTING 32-385 and input-VAT from purchases. The increase in income tax liabilities results from the profit. The new statement of cash flows looks like below in Figure 32.24: Cash flow from operating acitivities as by reconciliation 558,294.40 558,294.40 Cash flow from investing activities Investments (40,000.00) Input VAT for investments (8,000.00) (48,000.00) Cash flow from financing activities Share issue at issue price 417,500.00 Bonds issued 100,000.00 Bank loan received 80,000.00 Interest for bond (2,700.00) Annuity for bank loan (5,000.00) 589,800.00 1,100,094.40 Sunlands Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X3 Figure 32.24: SUNLANDS Ltd.’s statement of cash flows The comparison of the total cash flow in the Cash/ Bank account to the cash flow shown in SUNLANDS AG’s statement of cash flow, confirms the cash flow calculation. In this case the balancing figure in the Cash/ Bank account equals the cash flow, because we discussed SUNLANDS AG’s first Accounting period. Thus, there was no opening amount in the Cash/ Bank account at the beginning of the Accounting period. Summary: The set of financial statements along IAS 1 contains a statement of cash flows. The cash flow results from changes in the Cash/ Bank account. It can be prepared directly from the Cash/ Bank account or by reconciliation of profits with the operating cash flows. Working Definitions: Single Statement: A single statement is a set of financial statements prepared for one company. Statement of Cash Flows: A cash flow statement displays all payment activities sorted by the nature of payment. Cash Flow from Operating Activities: Cash flows from operating activities are all cash flows that are not linked to financing activities or investing activities. <?page no="387"?> Berkau: BASICS of ACCOUNTING 32-386 Cash Flow from Investing Activities: Cash flows from investing activities result from payments for acquisitions and disposals of non-current assets. Cash Flow from Financing Activities: Cash flows from financing activities are e.g. linked to contributions of owners, such as shares issued, and to loans, such as bank loans or bonds. Furthermore, all payments linked to equity and liabilities, such as dividends, interest and pay-offs are regarded as cash flows from financing activities. <?page no="388"?> Part (C): ADVANCED BOOKKEEPING In this part of the text book we cover aspects of Financial Accounting and of Cost Accounting which are not ruled by national GAAPs or IFRSs. E.g., liquidations or discounts. For that reason, they are not covered by the text book Bilanzen nor the ebook Accounting-2-Go. The aspects presented in part (C) are not linked to the first steps in Accounting either, but they belong to a kind of advanced Accounting. In chapter (33) Establishment of a Business and Legal Form Changes we will introduce the founding of a business and accompany the company through its change of the legal form. Chapter (34) Liquidations is about dissolving a business. We will study the Liquidation account for structured postings. The case study MOSSEL SPORTS is about a fitness centre which is liquidated as its owner wants to relocate. Closely linked to liquidations is chapter (35) Disposals, that covers sales and discards of non-current assets. The next chapter (36) Discounts deals with immediate and deferred discounts and shows how to record them under consideration of VAT. Chapter (38) Cash Book - Reconciliation to the Bank Statement deals with the link between the Cash/ Bank account and the bank statement provided by the bank. We introduce the reconciliation process by the case study KRAGGA CONSULTANTS (Pty) Ltd. and cover the most common differences that can occur between cash book and bank statement. The chapter (38) Petty Cash Book covers the reimbursement system demonstrated by the case study SWART- KLIP Ltd. The simplifications of the bookkeeping system by books of original entry is explained in chapter (39) Books of Original Entry. We use the CD store MUIRFIELD (Pty) Ltd. to introduce the purchase journal, cash book and explain how to operate an open item bookkeeping with books of original entry. After studying part (C) of the text book you expand your knowledge about accounting and can prepare financial statements on an advanced level. For the text book, Financial Accounting is closed and will be continued by aspects of international Accounting along the IFRSs by the text book Bilanzen and the ebook Accounting-2-Go. <?page no="389"?> Berkau: BASICS of ACCOUNTING 33-388 33. Establishment of a Business and Legal Form Changes Learning Objectives: We introduce the incorporation of a business in this chapter. It is intended to provide an overview about bookkeeping entries for founding a privately owned business, a sole partnership and a public limited company. However, we cannot cover all legal forms. Pls., study national law to gain knowledge about legal forms and the particular legal consequences with regard to responsibilities and tax regulations. Below, we discuss a single business. Even when the legal form thereof changes a few times, the business concept stays the same. We focus on profit calculations and how the owners get a share of the profit as return on their investments. This chapter familiarises you with basic legal forms and with change management. For the discussion of the establishment of a company we use the snack shop example SALDANHA. The business concept is easy to understand. It starts as a sole trader and will later be turned into a partnership. At the end of this chapter, we accompany the business going public. Stephen Saldanha is Accounting student at a German university. Because he always gets hungry in the university, he asks for permission to sell snacks on campus. He gets approval and agrees on a rental contract which makes him pay 100.00 EUR/ month to the university. Stephen Saldanha withdraws all his savings from bank and buys himself a small sales shack and inventory for one month. By this, he starts already his own - privately owned business. Stephen Saldanha hopes to earn enough revenue during the actual month to purchase the next month’s groceries at least. His business is no legal entity but linked to his person. All business assets belong to Stephen Saldanha. He is liable for his business on his own and in full. Profit earned by the shop will be his personal income. Increases on assets will make his personal fortune grow. Furthermore, any taxable profit earned will count as his personal taxable income. He has to declare it as profit resulting from self-employment. Stephen Saldanha is liable for the business with all his personal assets. In particular when the company does not perform as well as planned and cannot pay-off its debts, Stephen Saldanha will be charged for the company’s debts to the full extent - as it is his own liability. The snack shop business is a sole dealership. The wooden stand (sales shack) costs 6,000.00 EUR including VAT. Stephen Saldanha pays the shack on cash. He further purchases snacks, such as chocolate bars, sweets, crackers, etc., for 3,000.00 EUR (gross amount) and starts to sell the goods in the university. He sells the snacks for double the amount he purchases them at. In order to be more accurate: the gross selling price is double of the purchase costs. In accordance to IAS 2, the purchase costs always are net amounts. As an Accounting student he keeps track of his business by recording his activities. He keeps financial records by making bookkeeping entries for revenues, materials and all other ex- <?page no="390"?> Berkau: BASICS of ACCOUNTING 33-389 penses. There is no need for him to record his transactions as his company is a small business according to German law. Since BilMoG small companies which are sole traderships are exempted from keeping bookkeeping records, as stated by § 241a HGB (Handelsgesetzbuch) However, Stephen Saldanha must prepare tax statements which requires a 4.3 Gewinnermittlungs-statement. A 4.3 Gewinnermittlung is a revenue and expense statement along the German income tax law that requires calculating profit by comparison of ingoing payments with cash outflows. It refers to § 4 III EStG. Along a 4.3 Gewinnermittlung, payments made for the business will be seen as expenses. Even in case the payment counts for future expenses, such as next Accounting period’s rent, they are regarded as actual expense. An exception is the acquisition of assets. The payment is no expense but depreciation on the assets bought is. Non-current assets are to be written-off by depreciation although the 4.3 calculation ignores accruals otherwise. We here do not follow the German tax law strictly, but we make Stephen Saldanha voluntarily prepare financial statements, such as a statement of financial position and a statement of comprehensive income, along IFRSs. We only focus on the commercial statements and do not prepare tax statements. Before starting any business activity, Stephen Saldanha counts the money he has at the bank. He has 9,000.00 EUR in his private bank account that he uses for the snack shop. In order to separate his private assets from the snack shop, Stephen Saldanha goes to the local bank and opens an account. He later will compare the inputs and withdrawals with the bank statements provided by the bank. (1) Stephen Saldanha makes a bookkeeping entry on 2.01.20X1 for the start of his business and him paying a contribution of 9,000.00 EUR thereto. As the snack shop is his own asset, no legal regulations about contributions to the business apply. DR Cash/ Bank.................... 9,000.00 EUR CR Owner’s Capital.............. 9,000.00 EUR Stephen Saldanha has to think about VAT. In case he registers for VAT reduction, he can deduct all input-VAT included in purchase prices he pays for inventories and investments. On the other hand, he must collect output-VAT on behalf of the revenue service from his clients. The output-VAT makes his snacks more expensive, as the revenue is the money obtained from the customers (proceeds) less output-VAT. He registers his business for VAT reduction. When he invests and purchases inventory, he makes bookkeeping entries such as below: (2) The investment into the sales shack takes place on 2.01.20X1. Stephen Saldanha pays 6,000.00 EUR. The net amount thereof equals to: 6,000/ 120% = <?page no="391"?> Berkau: BASICS of ACCOUNTING 33-390 5,000.00 EUR . Stephen Saldanha pays the shack seller per bank transfer immediately. DR P, P, E Account.............. 5,000.00 EUR DR VAT.......................... 1,000.00 EUR CR Cash/ Bank.................... 6,000.00 EUR (3 … 14) The purchase of the goods takes place every month. In the first month, Stephen Saldanha orders snacks at a total purchase price of 3,000.00 EUR including VAT. In the following months, the inventory orders are lower (2,400.00 EUR) in order to keep stock on a level of 500.00 EUR at any time. Stephen Saldanha sells every month goods for 2,000.00 EUR net amount. That way, the higher purchases from the first month gives him a constant stock level of 500.00 EUR in value. DR Purchase .................... 2,500.00 EUR DR VAT.......................... 500.00 EUR CR Cash/ Bank.................... 3,000.00 EUR The following 11 purchases are recorded on 1.02.20X1 to 1.12.20X1. Stephen Saldanha does not prepay purchases, but buys stock on the 1 st of the month for the month they are sold to his clients. DR Purchase .................... 2,000.00 EUR DR VAT.......................... 400.00 EUR CR Cash/ Bank.................... 2,400.00 EUR The amount of rent is free of VAT because the university as the landlord is regarded as non-profit body. Stephen Saldanha pays: 12 × 100 = 1,200.00 EUR rent on 30.06.20X1. This is along the agreement with the university vice president. (15) Payment for rent on 30.06.20X1. DR Rent......................... 1,200.00 EUR CR Cash/ Bank.................... 1,200.00 EUR In the first month, Stephen Saldanha sells 80 % of the snacks. This equals to: 80% × 3,000/ 120% = 2,000.00 EUR . The sales are constant over the Accounting period. He keeps his stock at 500.00 EUR of value and purchases in February … December inventory at 2,400.00 EUR/ month (gross amount) and sells them all. Sales amount for all months together to: 12 × 2,000 × 200% = 48,000.00 EUR . The net amount thereof equals to: 48,000/ 120% = 40,000.00 EUR . Obviously, Stephen Saldanha does not keep the inventory purchased in January for the whole year. His inventory movements follow a first-in-first-out policy. <?page no="392"?> Berkau: BASICS of ACCOUNTING 33-391 Thus, he sells the left over inventories from January at the beginning of February and so on. To keep the case study simple, we make one bookkeeping entry for all sales at the yearend: (16) Sale of snacks on 31.12.20X1. DR Cash/ Bank.................... 48,000.00 EUR CR VAT.......................... 8,000.00 EUR CR Sales........................ 40,000.00 EUR Observe the accounts for Stephen Saldanha’s snack shop as mentioned so far in Figure 33.1. D C D C (2) 5,000.00 c/ d 5,000.00 c/ d 9,000.00 (1) 9,000.00 b/ d 5,000.00 b/ d 9,000.00 D C D C (1) 9,000.00 (2) 6,000.00 (2) 1,000.00 (16) 8,000.00 (16) 48,000.00 (3) 3,000.00 (3) 500.00 (4) 2,400.00 (4) 400.00 (5) 2,400.00 (5) 400.00 (6) 2,400.00 (6) 400.00 (7) 2,400.00 (7) 400.00 (8) 2,400.00 (8) 400.00 (9) 2,400.00 (9) 400.00 (10) 2,400.00 (10) 400.00 (11) 2,400.00 (11) 400.00 (12) 2,400.00 (12) 400.00 (13) 2,400.00 (13) 400.00 (14) 2,400.00 (14) 400.00 (15) 1,200.00 c/ d 2,100.00 c/ d 20,400.00 8,000.00 8,000.00 57,000.00 57,000.00 b/ d 2,100.00 b/ d 20,400.00 Cash/ Bank VAT P, P, E Owner's capital Figure 33.1: SALDANHA’s accounts <?page no="393"?> Berkau: BASICS of ACCOUNTING 33-392 D C D C (3) 2,500.00 (16) 40,000.00 (4) 2,000.00 (5) 2,000.00 (6) 2,000.00 (7) 2,000.00 (8) 2,000.00 (9) 2,000.00 (10) 2,000.00 (11) 2,000.00 (12) 2,000.00 (13) 2,000.00 (14) 2,000.00 c/ d 24,500.00 24,500.00 24,500.00 b/ d 24,500.00 D C (15) 1,200.00 Purchase Sales Rent Figure 33.1: Stephen Saldanha’s accounts (continued) The company earns a positive operating cash flow resulting from materials and sales. It has to pay the difference between outputand input-VAT to the revenue service in the next Accounting period. Stephen Saldanha prepares a trial balance to check whether his records are consistent with the double entry system. The trial balance provides a more detailed overview about the snack shop. Observe Figure 33.2: Account Debit entries Credit entries Property, Plant, and Equipment 5,000.00 Owner's Capital 9,000.00 Cash/ Bank 20,400.00 VAT 2,100.00 Purchase 24,500.00 Sales 40,000.00 Rent 1,200.00 Total: 51,100.00 51,100.00 SALDANHA's TRIAL BALANCE as at 31.12.20X1 Figure 33.2: Stephen Saldanha’s trial balance <?page no="394"?> Berkau: BASICS of ACCOUNTING 33-393 Stephen Saldanha makes adjustments at the end of the first Accounting period. In particular, he makes bookkeeping entries for accruals and depreciation. When Stephen Saldanha runs a stock count at the end of the Accounting period, it reveals that there are still snacks for 500.00 EUR on stock. This is the amount intended to be on stock at all times. We observe the profit calculation according to a periodic inventory system for Stephen Saldanha’s shop. Stephen Saldanha only makes entries for purchases and not for releases from stock. That way, he must count stock at the end of the Accounting period. Material expenses are calculated as opening value plus purchases and less closing stock of snacks. We ignore returns at this stage as they are seldom in the snack shop industry. As part of the adjustments Saldanha records the closing stock of inventory which equals to 500.00 EUR on 31.12.20X1. DR Inventory.................... 500.00 EUR CR Trading Account.............. 500.00 EUR Furthermore, the Purchase account and the Sales account are closed-off to the Trading account on 31.12.20X1. DR Trading Account.............. 24,500.00 EUR CR Purchase..................... 24,500.00 EUR DR Sales........................ 40,000.00 EUR CR Trading Account.............. 40,000.00 EUR The Trading account shows the gross profit and is closed-off to the Profit and Loss account. The gross profit earned by Stephen Saldanha during the Accounting period 20X1 equals to sales less material expenses (= purchase less closing stock) and gives: 40,000 - 24,000 = 16,000.00 EUR . Material expenses are 24,000.00 EUR, because the amount for the closing stock is deducted from purchases: 24,500 - 500 = 24,000.00 EUR . The Trading account is closed-off to the Profit and Loss account on 31.12.20X1 by the bookkeeping entry below. DR Trading Account.............. 16,000.00 EUR CR Profit and Loss.............. 16,000.00 EUR Stephen Saldanha must consider depreciation. He intends to use the sales shack for 5 years and writes it off to an extent of: 5,000/ 5 = 1,000.00 EUR/ a . On 31.12.20X1 he depreciates the sales shack. <?page no="395"?> Berkau: BASICS of ACCOUNTING 33-394 DR Depreciation................. 1,000.00 EUR CR Accumulated Depreciation..... 1,000.00 EUR The other expenses are considered for calculating profit below. Here, other expenses only contain rent. DR Profit and Loss.............. 1,200.00 EUR CR Rent......................... 1,200.00 EUR DR Profit and Loss.............. 1,000.00 EUR CR Depreciation................. 1,000.00 EUR We take a look at the accounts in order to check, how Stephen Saldanha performs. In particular, we analyse the Trading account and the Profit and Loss account. As the snack shop is privately owned, Stephen Saldanha has to declare income taxes based on the earned profit. The profit from selling snacks in the university amounts to: 16,000 - 1,000 - 1,200 = 13,800.00 EUR . Stephen Saldanha transfers the profit to the Owner’s Capital account. DR Profit and Loss.............. 13,800.00 EUR CR Owner’s Capital.............. 13,800.00 EUR We observe the accounts after the profit calculation by Figure 33.5: D C D C (2) 5,000.00 c/ d 5,000.00 c/ d 9,000.00 (1) 9,000.00 b/ d 5,000.00 b/ d 9,000.00 c/ d 22,800.00 P&L 13,800.00 22,800.00 22,800.00 b/ d 22,800.00 P, P, E Owner's capital Figure 33.3: SALDANHA’s accounts <?page no="396"?> Berkau: BASICS of ACCOUNTING 33-395 D C D C (1) 9,000.00 (2) 6,000.00 (2) 1,000.00 (16) 8,000.00 (16) 48,000.00 (3) 3,000.00 (3) 500.00 (4) 2,400.00 (4) 400.00 (5) 2,400.00 (5) 400.00 (6) 2,400.00 (6) 400.00 (7) 2,400.00 (7) 400.00 (8) 2,400.00 (8) 400.00 (9) 2,400.00 (9) 400.00 (10) 2,400.00 (10) 400.00 (11) 2,400.00 (11) 400.00 (12) 2,400.00 (12) 400.00 (13) 2,400.00 (13) 400.00 (14) 2,400.00 (14) 400.00 (15) 1,200.00 c/ d 2,100.00 c/ d 20,400.00 8,000.00 8,000.00 57,000.00 57,000.00 b/ d 2,100.00 b/ d 20,400.00 D C D C (3) 2,500.00 Prh 24,500.00 Inv 500.00 (4) 2,000.00 GP 16,000.00 Rev 40,000.00 (5) 2,000.00 40,500.00 40,500.00 (6) 2,000.00 P&L 16,000.00 b/ d 16,000.00 (7) 2,000.00 (8) 2,000.00 (9) 2,000.00 (10) 2,000.00 (11) 2,000.00 (12) 2,000.00 (13) 2,000.00 (14) 2,000.00 c/ d 24,500.00 24,500.00 24,500.00 b/ d 24,500.00 T/ A 24,500.00 Purchase Trading account T/ A Cash/ Bank VAT D C D C (15) 1,200.00 c/ d 1,200.00 T/ A 40,000.00 (16) 40,000.00 b/ d 1,200.00 P&L 1,200.00 D C D C T/ A 500.00 c/ d 500.00 AcD 1,000.00 c/ d 1,000.00 b/ d 500.00 b/ d 1,000.00 P&L 1,000.00 Inventory Depreciation Rent Sales Figure 33.3: SALDANHA’s accounts (continued) <?page no="397"?> Berkau: BASICS of ACCOUNTING 33-396 D C D C Dpr 1,000.00 Dpr 1,000.00 T/ A 16,000.00 Rnt 1,200.00 NP 13,800.00 16,000.00 16,000.00 OE 13,800.00 b/ d 13,800.00 Acc depreciation AcD Profit and Loss P&L Figure 33.3: SALDANHA’s accounts (continued) The adjusted trial balance looks as below: Account Debit entries Credit entries Property, Plant, and Equipment 5,000.00 Owner's Capital 22,800.00 Cash/ Bank 20,400.00 VAT 2,100.00 Purchase 0.00 0.00 Sales 0.00 0.00 Rent 0.00 0.00 Depreciation 0.00 0.00 Inventory 500.00 Accumulated Depreciation 1,000.00 Total: 25,900.00 25,900.00 SALDANHA's ADJUSTED TRIAL BALANCE as at 31.12.20X1 Figure 33.4: SALDANHA’s adjusted trial balance Stephen Saldanha takes out 10,000.00 EUR of his business as a drawing. DR Drawings..................... 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR He takes the drawing because he wants to enjoy the profit earned and he has to pay his personal taxes, too. It is assumed that his personal income tax rate is 22.5 %. Accordingly, the amount owed the revenue service equals to: 22.5% × 13,800 = 3,105.00 EUR . He has to declare the full profit on his personal income tax statement. It does not matter, how much he took out as drawing before, because the business is no legal entity. The full profit earned counts as his <?page no="398"?> Berkau: BASICS of ACCOUNTING 33-397 personal income and is subject to the income tax levitation in his country. We assume all profit has been made in Stephen Saldanha’s home country, which is Germany. Stephen Saldanha does not make a bookkeeping entry for the tax payment, because this is his own business. Furthermore, Stephen Saldanha has to pay VAT liabilities in the next year. He makes another drawing of 2.100.00 EUR therefor. He uses that money for paying VAT liabilities at the beginning of the next Accounting period. Paying VAT is not relevant for the profit but it changes the cash flow. He does not make a bookkeeping entry for VAT in the Accounting period 20X1. However, he has to make it the next Accounting period in order to dissolve the VAT liability. After the drawings, the accounts look as below in Figure 33.5: D C D C (2) 5,000.00 c/ d 5,000.00 c/ d 9,000.00 (1) 9,000.00 b/ d 5,000.00 b/ d 9,000.00 c/ d 22,800.00 P&L 13,800.00 22,800.00 22,800.00 Drw 12,100.00 b/ d 22,800.00 c/ d 10,700.00 22,800.00 22,800.00 b/ d 10,700.00 D C D C (1) 9,000.00 (2) 6,000.00 (2) 1,000.00 (16) 8,000.00 (16) 48,000.00 (3) 3,000.00 (3) 500.00 (4) 2,400.00 (4) 400.00 (5) 2,400.00 (5) 400.00 (6) 2,400.00 (6) 400.00 (7) 2,400.00 (7) 400.00 (8) 2,400.00 (8) 400.00 (9) 2,400.00 (9) 400.00 (10) 2,400.00 (10) 400.00 (11) 2,400.00 (11) 400.00 (12) 2,400.00 (12) 400.00 (13) 2,400.00 (13) 400.00 (14) 2,400.00 (14) 400.00 (15) 1,200.00 c/ d 2,100.00 c/ d 20,400.00 8,000.00 8,000.00 57,000.00 57,000.00 b/ d 2,100.00 b/ d 20,400.00 Drw 10,000.00 Drw 2,100.00 c/ d 8,300.00 20,400.00 20,400.00 b/ d 8,300.00 Cash/ Bank VAT P, P, E Owner's capital Figure 33.5: SALDANHA’s accounts <?page no="399"?> Berkau: BASICS of ACCOUNTING 33-398 D C D C (3) 2,500.00 Prh 24,500.00 Inv 500.00 (4) 2,000.00 GP 16,000.00 Rev 40,000.00 (5) 2,000.00 40,500.00 40,500.00 (6) 2,000.00 P&L 16,000.00 b/ d 16,000.00 (7) 2,000.00 (8) 2,000.00 (9) 2,000.00 (10) 2,000.00 (11) 2,000.00 (12) 2,000.00 (13) 2,000.00 (14) 2,000.00 c/ d 24,500.00 24,500.00 24,500.00 b/ d 24,500.00 T/ A 24,500.00 D C D C (15) 1,200.00 c/ d 1,200.00 T/ A 40,000.00 (16) 40,000.00 b/ d 1,200.00 P&L 1,200.00 D C D C T/ A 500.00 c/ d 500.00 AcD 1,000.00 c/ d 1,000.00 b/ d 500.00 b/ d 1,000.00 P&L 1,000.00 D C D C c/ d 1,000.00 Dpr 1,000.00 Dpr 1,000.00 T/ A 16,000.00 b/ d 1,000.00 Rnt 1,200.00 NP 13,800.00 16,000.00 16,000.00 OE 13,800.00 b/ d 13,800.00 D C C/ B 10,000.00 C/ B 2,100.00 c/ d 12,100.00 12,100.00 12,100.00 b/ d 12,100.00 OE 12,100.00 Drawings Accumulated depreciation AcD Profit and Loss P&L Purchase Trading account T/ A Rent Sales Inventory Depreciation Figure 33.5: Stephen Saldanha’s accounts (continued) Stephen Saldanha finds that his business works very well. He is thinking about expanding the business. He plans to sell snacks in all faculty buildings of his university. In total, he wants to sell snacks at 7 locations during the next Accounting period. Stephen Saldanha discusses <?page no="400"?> Berkau: BASICS of ACCOUNTING 33-399 his plans with his Accounting classmates and they commit themselves to contribute to his snack shop business. They will invest money. In particular, 2 friends are prepared to establish a business in form of a partnership together with Stephen Saldanha. The founding of the new partnership takes place once the friends make the decision to partner up on 2.01.20X2. The business concept of the company is to sell snacks to students in the university same as in the Accounting period before. The friends reserve a name for the new partnership. It should no longer be called Saldanha, because the new investors do not want the partnership being dominated by Stephen Saldanha’s name. Instead, they call the business now SNACKY-TICKY-shop. The name is submitted to the authorities and gets approved because it is not equal or similar to any other already existing firm. The legal form of the business is a sole partnership, in Germany referred to as GbR (Gesellschaft bürgerlichen Rechts). The company’s purpose is achieving financial gain by dealing with food. By forming a partnership, the SNACKY- TICKY-shop does not become a legal entity. However, all partners are owners of the business together and will take unlimited responsibility for debts of the business or any other damage caused thereby. In other words, everyone can be hold responsible for the business by all his/ her private assets. E.g., if the SNACKY-TICKY-shop becomes unable to pay its debts, creditors can claim the personal assets from each owner to settle the outstanding amounts. This concept of being liable alone to the full extent for a common business is referred to as jointly and severally liability. This means a partner can be sued alone for the debts of the whole business or for any other payment obligation which results from the business like fines or fees. This becomes also relevant, if the business does not fulfil its duties, such as tax declarations or payment of employees etc. Claims against one partner are not limited to the share he/ she holds of the business. Every partner is a representative of the company and can sign contracts on behalf of the business as long as this is in accordance with the purpose of the business. Further regulations are subject to a partnership agreement as to be set up between the partners at the time of commencement of their partnership. The friends prepare a partnership contract. This agreement signifies the contribution of the two new partners is to the same extent as Stephen Saldanha’s one. Stephen Saldanha puts in his old business and all assets linked thereto. In particular this is the sales shack with a carrying amount of 4,000.00 EUR, the inventory of 500.00 EUR and the amount of cash which equals to 8,300.00 EUR. The total of his contribution is: 4,000 + 500 + 8,300 = 12,800.00 EUR . The amounts are taken from the balance sheet and represent the book value of the snack shop. Stephen Saldanha does not deduct VAT payables because he withdrew money from the business with the intention to pay-off the VAT liabilities before. Thus, the Cash/ Bank account is to be reduced for the VAT payables. He pays for the VAT liabilities in January 20X2 privately. The other partners agree to contribute the same amount of 12,800.00 EUR on cash. They pay the amount into the partnership’s <?page no="401"?> Berkau: BASICS of ACCOUNTING 33-400 bank account. The SNACKY-TICKY-shop opens a bank account in the company’s name to make recording cash easy. They deposit: 3 × 12,800 - 4,000 - 500 = 33,900.00 EUR . The partnership’s incorporation contract states how profits will be shared, too. For the SNACKY-TICKY-shop it is agreed profit should be divided equally among the partners. Thus, every partner receives 1/ 3 of the business’s income. We here acknowledge, that in the partnership the benefit is limited to 1/ 3, but the risk is taken at full by every partner. As the partnership is no legal entity every partner has to pay income taxes based on his personal income according to his/ her personal income tax rate. The 3 partners stay in a country (Germany), which applies a progressive tax rate system. This means, the personal income tax rate of every partner depends on other income earned, too. The partners agree further that all profits will be paid out at the end of every year. This is like a commitment to a 100 % dividend. All investments have to be made at an equal and extra contribution of the partners. No partner works for the SNACKY-TICKY-shop as employee. If they intend to do so, a special contract will be set up. The agreement states further, that leaving the partnership and adding new partners thereto requires an unrestricted approval of all remaining partners. The SNACKY-TICKY-shop prepares financial statements in order to provide the partners with transparent information about the company and to support decision making. On 2.01.20X2, the partners prepare a statement of financial position as shown in Figure 33.6: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 4,000.00 Partners' capital 38,400.00 Intangibles Financial assets Current assets Liabilities Inventory 500.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 33,900.00 38,400.00 38,400.00 SNACKY-TICKY-shop's STATEMENT of FINANCIAL POSITION as at 1.01.20X2 Figure 33.6: SNACKY-TICKY-shop’s statement of financial position <?page no="402"?> Berkau: BASICS of ACCOUNTING 33-401 The partners’ capital amounts to the total of their single contribution: 3 × 12,800 = 38,400.00 EUR . The bookkeeping records are prepared based on the statement of financial position. See below, how the opening amounts are transferred into the single accounts of the SNACKY-TICKY-shop. With regard to the reorganisation of the business, we acknowledge that the accounts of Stephen Saldanha’s snack shop are not continued. The opening amounts from the balance sheet are put into the accounts. With regard to the taking over of assets, we shortly discuss the sales shack brought in by Stephen Saldanha: We might expect, the sales shack is recorded as debit entry in the P, P, E account to an extent of 5,000.00 EUR and as credit entry of 1,000.00 EUR in the Accumulated Depreciation account. But the shack is seen as asset contribution of one partner. It is recorded by a debit entry in the P, P, E account to the extent of 4,000.00 EUR. For that reason, the asset is regarded as preowned asset at cost of acquisition of 4,000.00 EUR. D C D C OV 4,000.00 OV 38,400.00 D C D C OV 500.00 OV 33,900.00 P, P, E Partners' Capital Inventory Cash/ Bank Figure 33.7: SNACKY-TICKY-shop’s accounts In 20X2, the following transactions occur. The SNACKY-TICKY-shop takes a bank loan of 20,000.00 EUR. The rate of interest agreed on with the local bank is 5 %. (All partners can be held liable for the bank loan by their personal assets.) The pay-off payments amount to 2,000.00 EUR per annum - interest and pay-off are payable at the end of the year. Interest is compounded annually and paid at the end of each Accounting period. (1) Taking the bank loan of 20,000.00 EUR on 2.01.20X2. DR Cash/ Bank.................... 20,000.00 EUR CR Interest Bearing Liabilities. 20,000.00 EUR The bookkeeping entries for interest and pay-off and for transferring the pay-off amount for 20X3 to short-term liabilities, are as below: (2) Paying interest on 31.12.20X2. <?page no="403"?> Berkau: BASICS of ACCOUNTING 33-402 DR Interest .................... 1,000.00 EUR CR Cash/ Bank.................... 1,000.00 EUR (3) Pay-off payment on 31.12.20X2. DR Interest Bearing Liabilities. 2,000.00 EUR CR Cash/ Bank.................... 2,000.00 EUR (4) Transferring 20X3’s pay-off to shortterm liabilities on 31.12.20X2. DR Interest Bearing Liabilities. 2,000.00 EUR CR Short-term Liabilities....... 2,000.00 EUR The SNACKY-TICKY-shop does not discount liabilities as required along IFRSs. The SNACKY-TICKY-shop buys 6 sales shacks at 5,400.00 EUR (gross amount) each. The net amount is: 6 × 5,400/ 120% = 27,000.00 EUR . The amount for input-VAT equals to: 27,000 × 20% = 5,400.00 EUR . (5) Investment on new sales shacks on 2.01.20X2. DR P, P, E Account.............. 27,000.00 EUR DR VAT.......................... 5,400.00 EUR CR Cash/ Bank.................... 32,400.00 EUR Depreciation on the sales shacks is 1,000.00 EUR/ a for the old shack, which has been brought in by Stephen Saldanha at cost of acquisition of 4,000.00 EUR and has a remaining useful life of 4 years, and: 6 × 5,400 / (120% × 5) = 5,400.00 EUR/ a for the new ones. Depreciation on every new one equals to: 5,400/ 6 = 900.00 EUR/ p. (6) Depreciation on the sales shacks on 31.12.20X2 equals to: 1,000 + 6 × 900 = 6,400.00 EUR . DR Depreciation................. 6,400.00 EUR CR Accumulated Depreciation..... 6,400.00 EUR With regard to the sales shacks, we acknowledge that the SNACKY-TICKYshop does not apply an asset management. Depreciation and P, P, E is recorded for all assets together. The rental agreement with the university is continued and extended to the other locations at even better conditions. The university requests 500.00 EUR as monthly payment for all sales shacks together. The amount is paid in the middle of the year. (7) Payment for rent: 12 × 500 = 6,000.00 EUR on 30.06.20X2. DR Rent......................... 6,000.00 EUR CR Cash/ Bank.................... 6,000.00 EUR <?page no="404"?> Berkau: BASICS of ACCOUNTING 33-403 The purchases of snacks are similar to Stephen Saldanha’s snack shop. The first purchase is higher than the next following ones in order to start with a stock level of 500.00 EUR at all sale points. This stock level is to be maintained for the whole year. According to this plan, the SNACKY-TICKY-shop orders sweets, crackers and chocolate bars for: 2,400 + 6 × 3,000 = 20,400.00 EUR in January and for: 7 × 2,400 = 16,800.00 EUR in the following months. The amounts are gross amounts. The previous location of Stephen Saldanha’s trading business is continued by the SNACKY-TICKY-shop and uses the already existing inventory. The amount of 500.00 EUR for inventories is displayed by the statement of financial position already (8 … 20) Cash purchases on 3.01.20X2 and later from 1.02.20X2 … 31.12.20X2. DR Purchase..................... 17,000.00 EUR DR VAT.......................... 3,400.00 EUR CR Cash/ Bank.................... 20,400.00 EUR And later (12 ×): DR Purchase..................... 14,000.00 EUR DR VAT.......................... 2,800.00 EUR CR Cash/ Bank.................... 16,800.00 EUR Count the number of bookkeeping entries to find out that the SNACKY-TICKYshop orders and pays for 13 deliveries. This is in order to receive the materials before the month starts. There is one bookkeeping entry at the higher amount of 17,000.00 EUR and 12 purchases at 14,000.00 EUR/ purchases. In the SNACKY-TICKY-shop, the gross selling price is 220 % of the net purchase price. The SNACKY-TICKY-shop sells snacks at 369,600.00 EUR. To keep the example simple, there is only one bookkeeping entry recorded. (21) Sales of snacks at a gross amount of: 7 × 2,000 × 12 × 220% = 369,600.00 EUR on 1.07.20X2. DR Cash/ Bank.................... 369,600.00 EUR CR VAT.......................... 61,600.00 EUR CR Sales........................ 308,000.00 EUR The SNACKY-TICKY-shop hires and employs a few students to sell the snacks. During the Accounting period 20X2, the partnership pays 24,100.00 EUR to the sales persons. (22) Payment of employees on 31.12.20X2. DR Labour....................... 24,100.00 EUR CR Cash/ Bank.................... 24,100.00 EUR <?page no="405"?> Berkau: BASICS of ACCOUNTING 33-404 Before the adjustments are made the trial balance is prepared. Observe the accounts and the trial balance below in Figure 33.8 and Figure 33.9: D C D C OV 4,000.00 c/ d 38,400.00 OV 38,400.00 (5) 27,000.00 c/ d 31,000.00 b/ d 38,400.00 31,000.00 31,000.00 b/ d 31,000.00 P, P, E Partners' Capital D C D C OV 500.00 c/ d 500.00 OV 33,900.00 (2) 1,000.00 b/ d 500.00 (1) 20,000.00 (3) 2,000.00 (21) 369,600.00 (5) 32,400.00 (7) 6,000.00 (8) 20,400.00 (9) 16,800.00 (10) 16,800.00 (11) 16,800.00 (12) 16,800.00 (13) 16,800.00 (14) 16,800.00 (15) 16,800.00 (16) 16,800.00 (17) 16,800.00 (18) 16,800.00 (19) 16,800.00 (20) 16,800.00 (22) 24,100.00 c/ d 136,000.00 423,500.00 423,500.00 b/ d 136,000.00 Inventory Cash/ Bank D C D C (3) 2,000.00 (1) 20,000.00 (2) 1,000.00 c/ d 1,000.00 (4) 2,000.00 b/ d 1,000.00 c/ d 16,000.00 20,000.00 20,000.00 b/ d 16,000.00 Interest bearing liabilities Interest Figure 33.8: SNACKY-TICKY-shop’s accounts <?page no="406"?> Berkau: BASICS of ACCOUNTING 33-405 D C D C c/ d 2,000.00 (4) 2,000.00 (5) 5,400.00 (21) 61,600.00 b/ d 2,000.00 (8) 3,400.00 (9) 2,800.00 (10) 2,800.00 (11) 2,800.00 (12) 2,800.00 (13) 2,800.00 (14) 2,800.00 (15) 2,800.00 (16) 2,800.00 (17) 2,800.00 (18) 2,800.00 (19) 2,800.00 (20) 2,800.00 c/ d 19,200.00 61,600.00 61,600.00 b/ d 19,200.00 Short-term liabilities VAT D C D C (6) 6,400.00 c/ d 6,400.00 c/ d 6,400.00 (6) 6,400.00 b/ d 6,400.00 b/ d 6,400.00 D C D C (7) 6,000.00 c/ d 6,000.00 (8) 17,000.00 b/ d 6,000.00 (9) 14,000.00 (10) 14,000.00 (11) 14,000.00 (12) 14,000.00 (13) 14,000.00 (14) 14,000.00 (15) 14,000.00 (16) 14,000.00 (17) 14,000.00 (18) 14,000.00 (19) 14,000.00 (20) 14,000.00 c/ d 185,000.00 185,000.00 185,000.00 b/ d 185,000.00 Rent Purchase Depreciation Accumulated depreciation D C D C c/ d 308,000.00 (21) 308,000.00 (22) 24,100.00 c/ d 24,100.00 b/ d 308,000.00 b/ d 24,100.00 Sales Labour Figure 33.8: SNACKY-TICKY-shop’s accounts (continued) <?page no="407"?> Berkau: BASICS of ACCOUNTING 33-406 Account Debit entries Credit entries Property, Plant, and Equipment 31,000.00 Partners' Capital 38,400.00 Inventory 500.00 Cash/ Bank 136,000.00 Interest Bearing Liabilities 16,000.00 Interest 1,000.00 Short-term Liabilities 2,000.00 VAT 19,200.00 Depreciation 6,400.00 Accumulated Depreciation 6,400.00 Rent 6,000.00 Purchase 185,000.00 Sales 308,000.00 Labour 24,100.00 Total: 390,000.00 390,000.00 Snacky-Ticky-shop's TRIAL BALANCE as at 31.12.20X2 Figure 33.9: SNACKY-TICKY-shop’s trial balance At the end of the Accounting period 20X2, there are snacks on stock to the extent of: 7 × 500 + 14,000 - 500 = 17,000.00 EUR . There are snacks missing worth 500.00 EUR. The snacks have been expired and were cast off. With a periodic system the missing snacks only come to light at the time of stock count. Observe the bookkeeping entries in order to understand the profit calculation. The opening value for the inventories is 500.00 EUR, as taken over from Stephen Saldanha’s snack shop. The total of purchases equals to 185,000.00 EUR as read from the trial balance. The same applies for the revenue which equals to: 7 × 12 × 2,000 × 220%/ 120% = 308,000.00 EUR . The closing stock is 17,000.00 EUR. DR Trading Account.............. 500.00 EUR CR Inventory.................... 500.00 EUR DR Trading Account.............. 185,000.00 EUR CR Purchase..................... 185,000.00 EUR DR Sales........................ 308,000.00 EUR CR Trading Account.............. 308,000.00 EUR DR Inventory.................... 17,000.00 EUR CR Trading Account.............. 17,000.00 EUR <?page no="408"?> Berkau: BASICS of ACCOUNTING 33-407 DR Trading Account.............. 128,500.00 EUR CR Profit and Loss.............. 128,500.00 EUR DR Profit and Loss.............. 1,000.00 EUR CR Interest..................... 1,000.00 EUR DR Profit and Loss.............. 6,400.00 EUR CR Depreciation................. 6,400.00 EUR DR Profit and Loss.............. 6,000.00 EUR CR Rent......................... 6,000.00 EUR DR Profit and Loss.............. 24,100.00 EUR CR Labour....................... 24,100.00 EUR DR P&L.......................... 102,000.00 EUR CR Partners’ Capital............ 102,000.00 EUR The partners share the profit equally. The partnership agreement states that all profits are distributed completely to the owners. The amount every partner receives is: 102,000/ 3 = 34,000.00 EUR . The partners make 3 drawings to the extent of 34,000.00 EUR. DR Drawings..................... 34,000.00 EUR CR Cash/ Bank.................... 34,000.00 EUR Eventually, the Drawings account is closed-off to the Partners’ Capital account on 31.12.20X2. DR Partners’ Capital............ 102,000.00 EUR CR Drawings..................... 102,000.00 EUR Observe the accounts. D C D C OV 4,000.00 c/ d 38,400.00 OV 38,400.00 (5) 27,000.00 c/ d 31,000.00 Drw 102,000.00 b/ d 38,400.00 31,000.00 31,000.00 c/ d 38,400.00 P&L 102,000.00 b/ d 31,000.00 140,400.00 140,400.00 b/ d 38,400.00 P, P, E Partners' Capital Figure 33.10: SNACKY-TICKY shop’s accounts <?page no="409"?> Berkau: BASICS of ACCOUNTING 33-408 D C D C OV 500.00 c/ d 500.00 OV 33,900.00 (2) 1,000.00 b/ d 500.00 T/ A 500.00 (1) 20,000.00 (3) 2,000.00 T/ A 17,000.00 c/ d 17,000.00 (21) 369,600.00 (5) 32,400.00 17,500.00 17,500.00 (7) 6,000.00 b/ d 17,000.00 (8) 20,400.00 (9) 16,800.00 (10) 16,800.00 (11) 16,800.00 (12) 16,800.00 (13) 16,800.00 (14) 16,800.00 (15) 16,800.00 (16) 16,800.00 (17) 16,800.00 (18) 16,800.00 (19) 16,800.00 (20) 16,800.00 (22) 24,100.00 c/ d 136,000.00 423,500.00 423,500.00 b/ d 136,000.00 Drw 34,000.00 Drw 34,000.00 Drw 34,000.00 c/ d 34,000.00 136,000.00 136,000.00 b/ d 34,000.00 D C D C (3) 2,000.00 (1) 20,000.00 (2) 1,000.00 c/ d 1,000.00 (4) 2,000.00 b/ d 1,000.00 P&L 1,000.00 c/ d 16,000.00 20,000.00 20,000.00 b/ d 16,000.00 Interest bearing liabilities Interest Inventory Cash/ Bank Figure 33.10: SNACKY-TICKY-shop’s accounts (continued) <?page no="410"?> Berkau: BASICS of ACCOUNTING 33-409 D C D C c/ d 2,000.00 (4) 2,000.00 (5) 5,400.00 (21) 61,600.00 b/ d 2,000.00 (8) 3,400.00 (9) 2,800.00 (10) 2,800.00 (11) 2,800.00 (12) 2,800.00 (13) 2,800.00 (14) 2,800.00 (15) 2,800.00 (16) 2,800.00 (17) 2,800.00 (18) 2,800.00 (19) 2,800.00 (20) 2,800.00 c/ d 19,200.00 61,600.00 61,600.00 b/ d 19,200.00 D C D C (6) 6,400.00 c/ d 6,400.00 c/ d 6,400.00 (6) 6,400.00 b/ d 6,400.00 P&L 6,400.00 b/ d 6,400.00 Depreciation Accumulated depreciation Short-term liabilities VAT D C D C (7) 6,000.00 c/ d 6,000.00 (8) 17,000.00 b/ d 6,000.00 P&L 6,000.00 (9) 14,000.00 (10) 14,000.00 (11) 14,000.00 (12) 14,000.00 (13) 14,000.00 (14) 14,000.00 (15) 14,000.00 (16) 14,000.00 (17) 14,000.00 (18) 14,000.00 (19) 14,000.00 (20) 14,000.00 c/ d 185,000.00 185,000.00 185,000.00 b/ d 185,000.00 T/ A 185,000.00 D C D C c/ d 308,000.00 (21) 308,000.00 (22) 24,100.00 c/ d 24,100.00 T/ A 308,000.00 b/ d 308,000.00 b/ d 24,100.00 P&L 24,100.00 Sales Labour Rent Purchase Figure 33.10: SNACKY-TICKY-shop’s accounts (continued) <?page no="411"?> Berkau: BASICS of ACCOUNTING 33-410 D C D C Inv 500.00 Rev 308,000.00 Int 1,000.00 T/ A 139,500.00 Prh 185,000.00 Inv 17,000.00 Dpr 6,400.00 GP 139,500.00 Rnt 6,000.00 325,000.00 325,000.00 Lab 24,100.00 P&L 139,500.00 b/ d 139,500.00 NP 102,000.00 139,500.00 139,500.00 OE 102,000.00 b/ d 102,000.00 D C C/ B 34,000.00 C/ B 34,000.00 C/ B 34,000.00 c/ d 102,000.00 102,000.00 102,000.00 b/ d 102,000.00 OE 102,000.00 Drawings Drw Trading account T/ A Profit and Loss P&L Figure 33.10: SNACKY-TICKY-shop’s accounts (continued) Observe the adjusted trial balance for SNACKY-TICKY-shop in Figure 33.11. Account Debit entries Credit entries Property, Plant, and Equipment 31,000.00 Partners' Capital 38,400.00 Inventory 17,000.00 Cash/ Bank 34,000.00 Interest Bearing Liabilities 16,000.00 Interest 0.00 0.00 Short-term Liabilities 2,000.00 VAT 19,200.00 Depreciation 0.00 0.00 Accumulated Depreciation 6,400.00 Rent 0.00 0.00 Purchase 0.00 0.00 Sales 0.00 0.00 Labour 0.00 0.00 Total: 82,000.00 82,000.00 Snacky-Ticky-shop's ADJUSTED TRIAL BALANCE as at 31.12.20X2 Figure 33.11: SNACKY-TICKY-shop’s adjusted trial balance Every partner receives an amount of 34,000.00 EUR. They have to pay taxes on their income. In case the personal income tax rate is 22.5 %, the amounts <?page no="412"?> Berkau: BASICS of ACCOUNTING 33-411 owing the revenue service by one partner equals to: 22.5% × 29,500.00 = 7,650.00 EUR . The following Figure 33.12 and Figure 33.13 show the financial statements (balance sheet and income statement) for the SNACKY-TICKY-shop: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 24,600.00 Partners' capital 38,400.00 Intangibles Financial assets Current assets Liabilities Inventory 17,000.00 Interest bear liab 16,000.00 A/ R A/ P 21,200.00 Prepaid expenses Provisions Cash/ Bank 34,000.00 75,600.00 75,600.00 SNACKY-TICKY-shop's STATEMENT of FINANCIAL POSITION as at 1.01.20X2 Figure 33.12: SNACKY-TICKY-shop’s statement of financial position In contrast to the case study VAN- GUARD, we only apply one account for equity. The amount for the payables results from VAT (19,200.00 EUR), which is to be paid in the next Accounting period and from short-term liabilities (2,000.00 EUR) resulting from the pay-off amount of the bank loan. <?page no="413"?> Berkau: BASICS of ACCOUNTING 33-412 [EUR] Revenue 308,000.00 Other income 308,000.00 Materials 168,500.00 Labour 24,100.00 Depreciation 6,400.00 Other expenses 6,000.00 Earnings before int and taxes (EBIT) 103,000.00 Interest 1,000.00 Earnings before taxes (EBT) 102,000.00 Snacky-Ticky-shop's STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X2 Figure 33.13: SNACKY-TICKY-shop’s statement of comprehensive income The amount for materials in the income statement results from the opening amount plus purchases less closing stock as: 500 + 185,000 - 17,000 = 168,500.00 EUR . The amount for other expenses contains rent only. The waste of snacks to the extent of 500.00 EUR is considered by the material expenses already. The income statement for a privately owned company - here for a partnership - does not contain an income tax item, because taxes are paid privately. Stephen SALDANHA and his partners are excited about the way their business works out and the money they earned during the last Accounting period. They plan to enlarge the business and to become a country wide university snack provider. They receive an offer for snack vending machines at cost of 12,800.00 EUR/ u. The vending machines can sell the same amount of snacks as the sales persons do. The business concept will be selling snacks in all universities countywide and in all their faculties. After visiting the universities, they come up with a business plan based on 56 locations for the vending machines. The rent for one location is 35.00 EUR/ month. The business concept requires investments of: 56 × 12,800 × 120% = 860,160.00 EUR for the vending machines. Furthermore, there is a monthly snack purchase of 56 × 2,500 × 120% = 168,000.00 EUR for the initial filling of the vending machines. The following top-ups are financed by the cash flows of the previous months. The total funds requested amount to: 860,160 + 168,000 = 1,028,160.00 EUR . The partnership SNACKY-TICKY-shop cannot afford a payment that high. The partners plan to go public, which means they turn the business into a company based on shares. For that reason, they issue 100,000 shares at 10.00 EUR each. They liquidate the partnership. Every partner receives an amount of: 38,400/ 3 = 12,800.00 EUR therefrom. (Note, liquidations are subject to the next following chapter. The liquidation is not covered in detail at this stage of the text book. We only divide the book value of the business by 3 partners, which indicates the partnership <?page no="414"?> Berkau: BASICS of ACCOUNTING 33-413 sold the sales shacks at their carrying amount and returned the snacks to the supplier.) Every partner gets: 3,840/ 3 = 1,280 shares of the new company based on the ownership of the SNACKY-TICKY-shop. As the shares have a face value of 10.00 EUR, the contribution of the previous SNACKY-TICKY-shop owners equals to the liquidation income, which is: 1,280 × 10 = 12,800.00 EUR/ investor . All of them use their private assets resulting from the 20X2-year’s profit to buy further shares. Every previous partner buys 2,350 further shares. This is the amount of shares they can buy after deducting their personal income taxes (here: 22.5 %) from the drawings made. The tax on capital returns is ignored, because the SNACKY-TICKY-shop was a partnership. The amount of shares bought is based on the previous Accounting period’s profit and gives the amount of additional shares being: 102,000 × (1 - 22.5%) / (3 x 10) = 2,635 shares . The total amount of: (1,280 + 2,635) x 3 = 11,745 shares gives the partners a fairly higher than 11.74 % portion of the new business’ voting rights. The previous partners lose control over their business to the new shareholders by the share issue. They even do not have a veto for decisions that require a ¾ majority. In general, companies can be owned by the state or privately. Privately owned companies are private companies ((Pty) Ltd.), public companies (Ltd.) and personal liability companies (Inc.). A private company has restrictions on how to attract new shareholders and on how to sell shares. Shares can be issued through an intermediary e.,g, a bank. Furthermore, there is a restricted transferability of shares for privately owned companies. This means the memorandum of incorporation can state, that shares only can be sold if the sale is approved by the other shareholders and/ or have to be offered to the remaining shareholders at first. However, public companies can raise capital from the general public and the shares are freely transferable. A privately owned company gives the founders more control but it is more difficult for the shareholders to sell the shares. Thus, shares of a public company are more popular and are traded higher. The legal form for the snack shop is a public company and goes by the name SNACKY-TICKY Ltd. The name requires to be reserved what is done for “SNACKY- TICKY Ltd.”. The memorandum of incorporation is a document that sets out the rights and duties of the shareholders and directors. It is to be signed by the founders of the company. The company must be registered. By the date of incorporation, the company is regarded as a legal entity. The expression limited indicates that the shareholder’s liability is limited to the extent of equity and that every shareholder is liable with his/ her share of the equity only. In other words, the highest loss that can hit the shareholder is losing shares. Shareholders are not liable for any losses exceeding the amount of equity. Equity does not mean the share price, but the book value of the business. Besides of issued capital, this contains all reserves and retained earnings. <?page no="415"?> Berkau: BASICS of ACCOUNTING 33-414 The memorandum of incorporation signifies the purpose of the company, aspects of dissolving the company, the way how to elect the board of directors, the annual meetings, the power of directors, the shareholders’ rights, the authorization of shares, etc. The memorandum of incorporation must be consistent with national law. After preparing the share issue for SNACKY-TICKY Ltd., the shares are offered to the public through a bank par value. The shares are applied by the subscribers paying the money into the bank account. After the company receives the applications the shares will be allotted to the applicants. When SNACKY-TICKY Ltd. is founded 100,000 shares are applied for. The money is received and the first bookkeeping entry is made on 2.01.20X3: (1) Cash received from applicants of shares on 2.01.20X3. DR Cash/ Bank.................... 1,000,000.00 EUR CR Application and Allotment.... 1,000,000.00 EUR In case of SNACKY-TICKY Ltd., there is no underand no over-subscription of shares and the share issue is par value. Under-subscription of shares occurs if less shares are applied for than offered to the public. Oversubscription is a share issue with more applicants than share offers. In the event of over-subscription, the money paid in by applicants who did not receive shares has to be refunded. A par value share issue is a share issue at the nominal amount of the shares. Share issues at an issue price exceeding the nominal value require putting the difference between the issue price and the shares’ face value into a Share Premium account which is to be closed-off to the Capital Reserves account along German AktG, e.g. As all applicants become subscribers, the Application and Allotment account is closed-off. (2) Share allotted to subscribers and closed-off to Share Capital account on 2.01.20X3. DR Application and Allotment.... 1,000,000.00 EUR CR Share Capital................ 1,000,000.00 EUR Observe the accounts of the new company in Figure 33.14. <?page no="416"?> Berkau: BASICS of ACCOUNTING 33-415 D C D C (1) 1,000,000.00 (2) 1,000,000.00 (1) 1,000,000.00 D C (2) 1,000,000.00 Cash/ Bank Application and allotment Share capital Figure 33.14: SNACKY-TICKY Ltd.‘s accounts How it is done (share issue): (1) When shares are issued the applicants will pay the shares issue price into the Cash/ Bank account (through a bank for instance). Credit the Application and Allotment account respectively. (2) If there is an oversubscription pay back the amounts to applicants who do not become subscribers. (3) Allot shares to subscribers by debiting the amount of share issue price × amount to the Application and Allotment account. (4) Credit the amount of the face value of shares issued to the Issued Capital account. (5) If the issue price exceeds the face value of shares credit the difference between issue price and face value to the Share Premium account. (6) Close-off the Share Premium account to the Capital Reserves account after consideration of special postings for the share issue procedure along national law might have been made. At the time of incorporation, the opening statement of financial position looks as depicted by Figure 33.15. <?page no="417"?> Berkau: BASICS of ACCOUNTING 33-416 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Share capital 1,000,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 1,000,000.00 Tax liabilities 1,000,000.00 1,000,000.00 Snacky-Ticky Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X3 Figure 33.15: SNACKY-TICKY Ltd.’s statement of financial position The board of directors is elected and the new chief executive officer (CEO) is Stephen Saldanha. The company SNACKY- TICKY Ltd. is registered for VAT reduction. On the first board meeting the decision is made to acquire the vending machines and to place them at 56 university locations. The vending machines are bought on 10.01.20X3 at a gross purchase price of: 56 × 12,800 × 120% = 860,160.00 EUR . The price includes the installation of the vending machines by the seller, too. (3) Acquisition of vending machines on 10.01.20X3. DR P, P, E Account.............. 716,800.00 EUR DR VAT.......................... 143,360.00 EUR CR Cash/ Bank.................... 860,160.00 EUR The company takes a bank loan which is to be paid off at the end of the year. The amount is 50,000.00 EUR. The rate of interest is 6 %. As the bank loan is to be paid back within an Accounting period, the loan is classified as a short-term one completely. The relevant account is the Accounts Payables account although interest is paid. (4) Taking a bank loan on 11.01.20X3 at an amount of 50,000.00 EUR. DR Cash/ Bank.................... 50,000.00 EUR CR Short-term Liabilities....... 50,000.00 EUR (5) Payment of interest on 31.12.20X3. <?page no="418"?> Berkau: BASICS of ACCOUNTING 33-417 DR Interest..................... 3,000.00 EUR CR Cash/ Bank.................... 3,000.00 EUR (6) On 31.12.20X3, the company retires the bank loan. DR Short-term Liabilities....... 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR SNACKY-TICKY Ltd. negotiates with the snack supplier that he delivers the snacks directly to the vending machines and fills them. The purchase price is the same as the partnership paid before. SNACKY-TICKY Ltd. orders January’s snacks at a purchase price of: 56 × 2,500 = 140,000.00 EUR . (7) Purchase of snacks on 12.01.20X3. DR Purchase..................... 140,000.00 EUR DR VAT.......................... 28,000.00 EUR CR Cash/ Bank.................... 168,000.00 EUR For the other months, SNACKY-TICKY Ltd. orders a lower amount of 2,000.00 EUR/ m and machine. The purchase price is: 56 × 2,000 = 112,000.00 EUR/ month . (8 …18) Purchase of snacks on 1.02.20X3 … 1.12.20X3. (11 ×) - No purchase in advance. DR Purchase..................... 112,000.00 EUR DR VAT.......................... 22,400.00 EUR CR Cash/ Bank.................... 134,400.00 EUR The amount of rent is paid in the middle of the year. According to the offer, the rent is 35.00 EUR per month and location. The total amount for rent equals to: 56 × 35 × 12 = 23,520.00 EUR . Universities are not VAT registered. Accordingly, rent is free of VAT. (19) Payment of rent on 30.06.20X3. DR Rent......................... 23,520.00 EUR CR Cash/ Bank.................... 23,520.00 EUR SNACKY TICKY Ltd. sells snacks at a gross selling price of 180 % based on the net purchase price. SNACKY TICKY Ltd.’s revenue during every month equals to: 2,000 × 180% = 3,600.00 EUR . During the first month, SNACKY-TICKY only sold 80 % of the snacks purchased in order to build up stock. For that reason, the purchases in January are higher. The absolute amount of revenue is constant during the whole Accounting period 20X3. The level of stock remains constant after January 20X3. The total of annual sales is recorded on 1.07.20X3 in order to keep the case study simple and amounts to: 3,600 × 12 × 56 = 2,419,200.00 EUR . <?page no="419"?> Berkau: BASICS of ACCOUNTING 33-418 (20) Sales of snacks at a net selling price of 2,419,200/ 120% = 2,016,000.00 EUR is recorded on 31.12.20X3. DR Cash/ Bank.................... 2,419,200.00 EUR CR VAT.......................... 403,200.00 EUR CR Sales........................ 2,016,000.00 EUR SNACKY-TICKY Ltd.’s writes-off the vending machines along straight line method over a useful life of 5 years. Annual depreciation amounts to: 56 × 12,800/ 5 = 143,360.00 EUR . No residual value is to be considered for the vending machines. (21) Depreciation on vending machines on 31.12.20X3. DR Depreciation................. 143,360.00 EUR CR Accumulated Depreciation..... 143,360.00 EUR The Accountant of SNACKY-TICKY Ltd. balances-off all accounts and prepares the trial balance. Observe in the following Figure 33.16 and Figure 33.17 the accounts of SNACKY-TICKY Ltd. and its trial balance. <?page no="420"?> Berkau: BASICS of ACCOUNTING 33-419 D C D C (1) 1,000,000.00 (3) 860,160.00 (2) 1,000,000.00 (1) 1,000,000.00 (4) 50,000.00 (5) 3,000.00 (20) 2,419,200.00 (6) 50,000.00 (7) 168,000.00 (8) 134,400.00 (9) 134,400.00 (10) 134,400.00 (11) 134,400.00 (12) 134,400.00 (13) 134,400.00 (14) 134,400.00 (15) 134,400.00 (16) 134,400.00 (17) 134,400.00 (18) 134,400.00 (19) 23,520.00 c/ d 886,120.00 3,469,200.00 3,469,200.00 b/ d 886,120.00 D C D C c/ d 1,000,000.00 (2) 1,000,000.00 (3) 716,800.00 c/ d 716,800.00 b/ d 1,000,000.00 b/ d 716,800.00 Cash/ Bank Application and allotment Share capital P, P, E D C D C (3) 143,360.00 (20) 403,200.00 (7) 140,000.00 (7) 28,000.00 (8) 112,000.00 (8) 22,400.00 (9) 112,000.00 (9) 22,400.00 (10) 112,000.00 (10) 22,400.00 (11) 112,000.00 (11) 22,400.00 (12) 112,000.00 (12) 22,400.00 (13) 112,000.00 (13) 22,400.00 (14) 112,000.00 (14) 22,400.00 (15) 112,000.00 (15) 22,400.00 (16) 112,000.00 (16) 22,400.00 (17) 112,000.00 (17) 22,400.00 (18) 112,000.00 c/ d 1,372,000.00 (18) 22,400.00 c/ d 14,560.00 1,372,000.00 1,372,000.00 417,760.00 417,760.00 b/ d 1,372,000.00 b/ d 14,560.00 VAT Purchase Figure 33.16: SNACKY-TICKY Ltd.’s accounts <?page no="421"?> Berkau: BASICS of ACCOUNTING 33-420 D C D C (6) 50,000.00 (4) 50,000.00 (5) 3,000.00 c/ d 3,000.00 b/ d 3,000.00 D C D C (19) 23,520.00 c/ d 23,520.00 c/ d 2,016,000.00 (20) 2,016,000.00 b/ d 23,520.00 b/ d 2,016,000.00 D C D C (21) 143,360.00 c/ d 143,360.00 c/ d 143,360.00 (21) 143,360.00 b/ d 143,360.00 b/ d 143,360.00 Depreciation Accumulated depreciation Short-term liabilities Interest Rent Sales Figure 33.16: SNACKY-TICKY Ltd.’s accounts (continued) Account Debit entries Credit entries Cash/ Bank 886,120.00 Applicants and Allotment 0.00 0.00 Share Capital 1,000,000.00 Property, Plant, and Equipment 716,800.00 VAT 14,560.00 Purchase 1,372,000.00 Short-term Liabilities 0.00 0.00 Interest 3,000.00 Rent 23,520.00 Sales 2,016,000.00 Depreciation 143,360.00 Accumulated Depreciation 143,360.00 Total: 3,159,360.00 3,159,360.00 Snacky-Ticky Ltd.'s TRIAL BALANCE as at 31.12.20X3 Figure 33.17: SNACKY-TICKY Ltd.’s trial balance The Accountant makes the following adjustments at the end of the Accounting period 20X3: The calculation of profit is based on a periodic inventory system. The stock counted is worth: 56 × 500 = 28,000.00 EUR . The amount is transferred to the Trading account. DR Inventory.................... 28,000.00 EUR CR Trading Account.............. 28,000.00 EUR <?page no="422"?> Berkau: BASICS of ACCOUNTING 33-421 The gross profit is calculated in the Trading account. DR Trading Account.............. 1,372,000.00 EUR CR Purchase..................... 1,372,000.00 EUR DR Sales........................ 2,016,000.00 EUR CR Trading Account.............. 2,016,000.00 EUR The gross profit earned in 20X3 by SNACKY-TICKY Ltd. amounts to: 2,016,000 - (1,372,000 - 28,000) = 672,000.00 EUR . The Trading account is closed-off to the Profit and Loss account. DR Trading Account.............. 672,000.00 EUR CR Profit and Loss.............. 672,000.00 EUR Calculating the profit, interest, rent and depreciation are debited to the Profit and Loss account. Observe the calculation below: DR Profit and Loss.............. 3,000.00 EUR CR Interest..................... 3,000.00 EUR DR Profit and Loss.............. 23,520.00 EUR CR Rent......................... 23,520.00 EUR DR Profit and Loss.............. 143,360.00 EUR CR Depreciation................. 143,360.00 EUR The pre-tax profit equals to: 672,000 - 3,000 - 23,520 - 143,360 = 502,120.00 EUR . As SNACKY-TICKY Ltd. is a legal entity, the company has to pay income taxes. The total income tax rate in this text book is 30 %. According to this income tax rate, the income tax liabilities amount to: 502,120 × 30% = 150,636.00 EUR . The remaining amount is: 502,120 - 150,636 = 351,484.00 EUR and is transferred to the Retained Earnings account. DR Profit and Loss.............. 150,636.00 EUR CR Tax Liabilities.............. 150,636.00 EUR DR Profit and Loss.............. 351,484.00 EUR CR R/ E .......................... 351,484.00 EUR On the annual meeting, SNACKY-TICKY Ltd.’s shareholders agree on a dividend of 0.50 EUR/ share. The total amount of: 0.50 × 100,000 = 50,000.00 EUR is transferred to the Shareholder for Dividend account. <?page no="423"?> Berkau: BASICS of ACCOUNTING 33-422 DR R/ E.......................... 50,000.00 EUR CR Shareholder for Dividend..... 50,000.00 EUR Based on another agreement with regard to the appropriation of profits, the amount of 200,000.00 EUR is transferred to the Earnings Reserves account. DR R/ E.......................... 200,000.00 EUR CR Earnings Reserves............ 200,000.00 EUR The remaining amount is carried forward to the next Accounting period 20X4. It equals to: 351,484 - 50,000 - 200,000 = 101,484.00 EUR . Observe SNACKY-TICKY Ltd.’s accounts as displayed in Figure 33.18. Figure 33.18 D C D C (1) 1,000,000.00 (3) 860,160.00 (2) 1,000,000.00 (1) 1,000,000.00 (4) 50,000.00 (5) 3,000.00 (20) 2,419,200.00 (6) 50,000.00 (7) 168,000.00 (8) 134,400.00 (9) 134,400.00 (10) 134,400.00 (11) 134,400.00 (12) 134,400.00 (13) 134,400.00 (14) 134,400.00 (15) 134,400.00 (16) 134,400.00 (17) 134,400.00 (18) 134,400.00 (19) 23,520.00 c/ d 886,120.00 3,469,200.00 3,469,200.00 b/ d 886,120.00 D C D C c/ d 1,000,000.00 (2) 1,000,000.00 (3) 716,800.00 c/ d 716,800.00 b/ d 1,000,000.00 b/ d 716,800.00 Cash/ Bank Application and allotment Share capital P, P, E Figure 33.18: SNACKY-TICKY Ltd.’s accounts <?page no="424"?> Berkau: BASICS of ACCOUNTING 33-423 D C D C (3) 143,360.00 (20) 403,200.00 (7) 140,000.00 (7) 28,000.00 (8) 112,000.00 (8) 22,400.00 (9) 112,000.00 (9) 22,400.00 (10) 112,000.00 (10) 22,400.00 (11) 112,000.00 (11) 22,400.00 (12) 112,000.00 (12) 22,400.00 (13) 112,000.00 (13) 22,400.00 (14) 112,000.00 (14) 22,400.00 (15) 112,000.00 (15) 22,400.00 (16) 112,000.00 (16) 22,400.00 (17) 112,000.00 (17) 22,400.00 (18) 112,000.00 c/ d 1,372,000.00 (18) 22,400.00 c/ d 14,560.00 1,372,000.00 1,372,000.00 417,760.00 417,760.00 b/ d 1,372,000.00 T/ A 1,372,000.00 b/ d 14,560.00 D C D C (6) 50,000.00 (4) 50,000.00 (5) 3,000.00 c/ d 3,000.00 b/ d 3,000.00 P&L 3,000.00 VAT Purchase Short-term liabilities Interest D C D C (19) 23,520.00 c/ d 23,520.00 c/ d 2,016,000.00 (20) 2,016,000.00 b/ d 23,520.00 P&L 23,520.00 T/ A 2,016,000.00 b/ d 2,016,000.00 D C D C (21) 143,360.00 c/ d 143,360.00 c/ d 143,360.00 (21) 143,360.00 b/ d 143,360.00 P&L 143,360.00 b/ d 143,360.00 D C D C Prh 1,372,000.00 Inv 28,000.00 T/ A 28,000.00 c/ d 28,000.00 GP 672,000.00 Rev 2,016,000.00 b/ d 28,000.00 2,044,000.00 2,044,000.00 P&L 672,000.00 b/ d 672,000.00 Depreciation Accumulated depreciation Rent Sales Trading account Inventory Figure 33.18: SNACKY-TICKY Ltd.’s accounts (continued) <?page no="425"?> Berkau: BASICS of ACCOUNTING 33-424 D C D C Int 3,000.00 T/ A 672,000.00 c/ d 150,636.00 P&L 150,636.00 Rnt 23,520.00 b/ d 150,636.00 Dpr 143,360.00 NP 502,120.00 672,000.00 672,000.00 Tax 150,636.00 b/ d 502,120.00 R/ E 351,484.00 502,120.00 502,120.00 D C D C ShD 50,000.00 P&L 351,484.00 c/ d 50,000.00 P&L 50,000.00 Res 200,000.00 b/ d 50,000.00 c/ d 101,484.00 351,484.00 351,484.00 b/ d 101,484.00 D C c/ d 200,000.00 P&L 200,000.00 b/ d 200,000.00 Earnings reserves Res Profit and Loss P&L Tax liabilities Retained earnings R/ E Shareholder for dividend (ShD) Figure 33.18: SNACKY-TICKY Ltd.’s accounts (continued) The adjusted trial balance after appropriation of profit is to be seen in Figure 33.19. <?page no="426"?> Berkau: BASICS of ACCOUNTING 33-425 Account Debit entries Credit entries Cash/ Bank 886,120.00 Applicants and Allotment 0.00 0.00 Share Capital 1,000,000.00 Property, Plant, and Equipment 716,800.00 VAT 14,560.00 Purchase 0.00 Short-term Liabilities 0.00 0.00 Interest 0.00 Rent 0.00 0.00 Sales 0.00 0.00 Depreciation 0.00 0.00 Accumulated Depreciation 143,360.00 Inventory 28,000.00 Retained Earnings 101,484.00 Tax Liabilities 150,636.00 Earnings Reserves 200,000.00 Shareholder for Dividend (A/ P) 50,000.00 Total: 1,645,480.00 1,645,480.00 Snacky-Ticky Ltd.'s TRIAL BALANCE as at 31.12.20X3 Figure 33.19: SNACKY-TICKY Ltd.’s adjusted trial balance As SNACKY-TICKY Ltd. is a public company, it has to provide a full set of financial statements along IAS 1 which contains a statement of financial position, a statement of comprehensive income, a statement of cash flows and a statement of changes in equity. See the Figures 33.20 to 33.23 for the financial statements. (Note, no notes are considered for this case study. For studying notes, read the text book Bilanzen and the ebook Accounting-2-Go in particular chapter 6.) <?page no="427"?> Berkau: BASICS of ACCOUNTING 33-426 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 573,440.00 Share capital 1,000,000.00 Intangibles Reserves 200,000.00 Financial assets R/ E 101,484.00 Current assets Liabilities Inventory 28,000.00 Interest bear liab 0.00 A/ R 14,560.00 A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 886,120.00 Tax liabilities 150,636.00 1,502,120.00 1,502,120.00 Snacky-Ticky Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 33.20: SNACKY-TICKY Ltd.’s statement of financial position The amount for property, plant and equipment equals to: 716,800 - 143,360 = 573,440.00 EUR . The amount for accounts receivable results from the claim on input-VAT. (Note, in contrast to the previous statements of financial position, this one now contains the items reserves and retained earnings in the equity section.) <?page no="428"?> Berkau: BASICS of ACCOUNTING 33-427 [EUR] Revenue 2,016,000.00 Other income 2,016,000.00 Materials 1,344,000.00 Labour Depreciation 143,360.00 Other expenses 23,520.00 Earnings before int and taxes (EBIT) 505,120.00 Interest 3,000.00 Earnings before taxes (EBT) 502,120.00 Income tax expenses 150,636.00 Deferred taxes Earnings after taxes (EAT) 351,484.00 to reserves (§ 150 AktG) 0.00 to other earnings reserves 200,000.00 to shareholders 50,000.00 carried forward to next period 101,484.00 SNACKY-TICKY Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 33.21: SNACKY-TICKY Ltd.’s statement of comprehensive income The calculation of the cash flows follows the direct method. Cash flow calculations are not subject to our studies in this chapter. However, the statement of cash flows is to be provided along IAS 1 for a limited company. <?page no="429"?> Berkau: BASICS of ACCOUNTING 33-428 Cash flow from operating acitivities Materials bought (1,646,400.00) Sales 2,419,200.00 Rent (23,520.00) 749,280.00 Cash flow from investing activities Investments (860,160.00) (860,160.00) Cash flow from financing activities Share issue 1,000,000.00 Bank loan received 50,000.00 Interest (3,000.00) Pay-off (50,000.00) 997,000.00 886,120.00 Snacky-Ticky Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X3 Figure 33.22: SNACKY-TICKY Ltd.’s statement of cash flows Share capital Reserves R/ E total as at 1.01.20X3 1,000,000.00 0.00 0.00 1,000,000.00 Profit 20X3 351,484.00 351,484.00 Dividend 20X3 (50,000.00) (50,000.00) Reserves 200,000.00 (200,000.00) 0.00 as at 31.12.20X3 1,000,000.00 200,000.00 101,484.00 1,301,484.00 Snacky-Ticky Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X3 Figure 33.23: SNACKY-TICKY Ltd.’s statement of changes in equity In case the shareholder Stephen Saldanha wants to know the value of his fortune at the end of the Accounting period, he calculates the book value plus the dividend and comes up with the following amount. He owns: 2,635 × ((1,301,484 / 100,000) + 0.50) = 35,611.60 EUR . Earnings per share is a ratio defined by IAS 33. It is the amount of the earnings distributable to the shareholders divided by the average number of shares outstanding. It indicates how much a 100 % dividend declaration would be worth. The earnings per share are used as the denominator in the price-earnings-ratio. The earnings per share are: 351,484 / 100,000 = 3.51 EUR/ share . <?page no="430"?> Berkau: BASICS of ACCOUNTING 33-429 Summary: Companies can operate under different legal forms. The legal form has consequences with regard to the liability of the owners, tax payments and the appropriation of profits. We observed a similar business as a sole trader, a partnership and a public company. The public company is a legal entity and has to pay taxes itself. Public companies have to prepare a full set of financial statements along IFRSs. Working Definitions: 4.3 Gewinnermittlungs-Statement: A 4.3 Gewinnermittlung is a revenue and expense statement along the German income tax law that requires calculating profit by comparison of ingoing payments with cash outflows. It refers to § 4 III EStG. Par value share issue: A par value share issue is a share issue at the nominal amount of the shares. Underand over subscription: Under-subscription of shares happens when less shares are applied for than offered. Over-subscription is a share issue with more applicants than share offers. Memorandum of Incorporation: The memorandum of incorporation is a document that sets out the rights and duties of the shareholders and directors. Earnings per share EPS: Earnings per share is the amount of the earnings distributable to the shareholders divided by the average number of shares outstanding. <?page no="431"?> Berkau: BASICS of ACCOUNTING 34-430 34. Liquidations Learning Objectives: We introduce dissolving a business in this chapter. We present basic activities of how to liquidate a company. In particular we are going to introduce and explain the Liquidation account. When a company is liquidated, debts are to be settled and remaining assets are shared between the owners. After studying this chapter, you will know how to record a business liquidation. Liquidations will be required if the business activities are no longer continued. The company cease to exists. This does not always mean the business files for bankruptcy, it also can happen that, e.g., a partnership is dissolved, because the owner intends to withdraw funds in order to invest in another business. Or, as another example, the owner intends to relocate. The liquidation of a business means that all assets are sold. They are converted into cash. As cash is regarded to be easily exchanged between owners, we say that cash is kind of “liquid”. Turning assets into cash means the assets are converted to a more liquid form. On the other side of the balance sheet, all liabilities are paid-off. The remaining assets after settlement of all liabilities are shared between the owners. The memorandum of incorporation might determine how owners split up assets among each other. How it is done (liquidation): (1) After the decision for liquidation has been made do not continue operations. (2) Sell all assets preferably on cash. (3) Settle all outstanding liabilities by payments. (4) In case cash/ bank item exceeds liabilities, distribute the remaining amount to the owners according to their share of the business. In case cash/ bank item is too short to settle liabilities, file for bankruptcy. (5) If there are preference shareholders, consider them at first with regard to sharing the assets. Put them into a position in the pecking order so they enjoy priority over ordinary shareholders. We are going through an example to get across the idea of liquidations. MOSSEL SPORTS is a fitness centre. The company is privately owned by Marco Mossel. He prepares the statement of financial position voluntarily as below in Figure 34.1: <?page no="432"?> Berkau: BASICS of ACCOUNTING 34-431 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 120,000.00 Owner's capital 120,000.00 Intangibles R/ E 35,000.00 Financial assets Current assets Liabilities Inventory Interest bear liab 15,000.00 A/ R 10,000.00 A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 90,000.00 220,000.00 220,000.00 MOSSEL SPORTS' STATEMENT of FINANCIAL POSITION as at 1.01.20X5 Figure 34.1: MOSSEL SPORTS’ statement of financial position The amount of property, plant and equipment results from treadmill equipment that was bought on 3.01.20X1 and written off by an annual amount of 20,000 EUR. The carrying amount equals to: 200,000 - 20,000 - 20,000 - 20,000 - 20,000 = 120,000.00 EUR . The balancing figure in the Property, Plant and Equipment account is 200,000.00 EUR and the balance of the Accumulated Depreciation account is 80,000.00 EUR. The amount in the Accounts Receivables account results from claims against customers who still have to pay their annual exercising fees for 20X5. MOSSEL SPORTS’ equity contains the owner’s contribution at the time of incorporation plus reinvested earnings. The amount in the Retained Earnings account is the last year’s profit. Figure 34.2 displays the accounts for MOSSEL SPORTS. D C D C OV 200,000.00 OV 80,000.00 D C D C OV 10,000.00 OV 90,000.00 Accounts receivables Cash/ Bank PPE Acc Depr Figure 34.2: MOSSEL SPORTS’ accounts <?page no="433"?> Berkau: BASICS of ACCOUNTING 34-432 D C D C OV 120,000.00 OV 35,000.00 D C D C OV 15,000.00 OV 50,000.00 Owner's capital Retaines earnings Interest bearing liabilities Accounts payables D C D C OV 200,000.00 OV 80,000.00 D C D C OV 10,000.00 OV 90,000.00 Accounts receivables Cash/ Bank PPE Acc Depr Figure 34.2: MOSSEL SPORTS’ accounts (continued) The owner of MOSSEL SPORTS decides to give up his fitness centre, to grab all his money and to start a scuba diving school in Mauritius. The company is to be liquidated as at the earliest possible day in 20X5. The liquidation bookkeeping entries are described below: For the liquidation of MOSSEL SPORTS a Liquidation account is prepared. The Liquidation account is a temporary account that applies to record all liquidation activities. Later all accounts of the business will be closed-off to the Liquidation account and thus, the company won’t exist any longer. The date of liquidation is 3.01.20X5. No normal business activities will be operated after that day. MOSSEL SPORTS sells the treadmills which are carried at an amount of 120,000.00 EUR for 105,000.00 EUR. The payables are settled fully. Also the bank loan is paid-off completely. The still outstanding exercising fees are claimed from the customers and are paid to an extent of 80 % only. For MOSSEL SPORTS there is no use of going after the other outstanding fees, because the effort is too high in comparison to the uncertain outcome. Marco Mossel writes them off as bad debts. Bad debts are receivables that a business is probably not able to collect. The remaining receivables of MOSSEL SPORTS are closed-off to the Bad Debts account which represents an expense. At the time of liquidation on 3.01.20X5, the owner makes bookkeeping entries as below, all interlinked with the Liquidation account. The bookkeeping entries record the revenue and output-VAT received for assets and the disposal thereof by separate steps. The difference between the settlement amount <?page no="434"?> Berkau: BASICS of ACCOUNTING 34-433 and the carrying amount is either a loss or a profit on liquidation: (1a, 1b) Disposal of treadmills on 3.01.20X5 at 105,000.00 EUR. DR Accumulated Depreciation..... 80,000.00 EUR DR Liquidation.................. 120,000.00 EUR CR P, P, E Account.............. 200,000.00 EUR DR Cash/ Bank.................... 105,000.00 EUR DR Loss on Disposal............. 15,000.00 EUR CR Liquidation.................. 120,000.00 EUR (2a, 2b) Dissolving the Accounts Receivables account on 3.01.20X5 and receiving cash from clients. The amount paid by the clients does not cover all open receivables. This results in a loss on settlement as explained above, recorded as bad debts. DR Liquidation.................. 10,000.00 EUR CR Accounts Receivables......... 10,000.00 EUR DR Cash/ Bank.................... 8,000.00 EUR DR Loss on Settlement........... 2,000.00 EUR CR Liquidation.................. 10,000.00 EUR On the other side (of the balance sheet), MOSSEL SPORTS settles all payables in full. (3) Settlement of the bank loan liabilities on 3.01.20X5. DR Interest Bearing Liabilities. 15,000.00 EUR CR Cash/ Bank.................... 15,000.00 EUR (4) Settlement of outstanding payables in full on 3.01.20X5. DR Accounts Payables............ 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR In case the owners want to keep the results of the liquidation separate, they can apply subordinated accounts for liquidation and use the Liquidation account as reconciliation account thereof. In order to analyse the situation, we take a closer look at the accounts after the bookkeeping entries are recorded. See Figure 34.3: <?page no="435"?> Berkau: BASICS of ACCOUNTING 34-434 D C D C OV 200,000.00 (1a) 200,000.00 (1a) 80,000.00 OV 80,000.00 D C D C OV 10,000.00 (2a) 10,000.00 OV 90,000.00 (3) 15,000.00 (1b) 105,000.00 (4) 50,000.00 (2b) 8,000.00 c/ d 138,000.00 203,000.00 203,000.00 b/ d 138,000.00 PPE Acc Depr Accounts receivables Cash/ Bank D C D C OV 120,000.00 OV 35,000.00 D C D C (3) 15,000.00 OV 15,000.00 (4) 50,000.00 OV 50,000.00 D C D C (1a) 120,000.00 (1b) 120,000.00 (1b) 15,000.00 (2a) 10,000.00 (2b) 10,000.00 130,000.00 130,000.00 D C (2b) 2,000.00 Loss on settlement Owner's capital Retained earnings Interest bearing liabilities Accounts payables Liquidation Loss on sale Figure 34.3: MOSSEL SPORTS’ accounts At this stage of the liquidation process, the amount in the Cash/ Bank account is 138,000.00 EUR. This is the amount which is distributable to the owner. The owner Marco Mossel acknowledges this amount is less than the previous book value of the business. The difference equals to: 155,000 - 138,000 = 17,000.00 EUR. Thus, the liquidation of MOSSEL SPORTS results in a loss. The total of MOSSEL SPORTS equity equals to the total of the Owner’s Capital account’ s balance plus Retained Earnings account’s balance less Loss on Disposal account’s balance and less Loss on Settlement account’s balance and gives: 120,000 + 35,000 - 15,000 - 2,000 = 138,000.00 EUR . (5) The final liquidation bookkeeping entry is made on 3.01.20X5 by closing-off the Liquidation account. <?page no="436"?> Berkau: BASICS of ACCOUNTING 34-435 DR Owner’s Capital.............. 120,000.00 EUR DR Retained Earnings............ 35,000.00 EUR CR Loss on Disposal............. 15,000.00 EUR CR Loss on Settlement........... 2,000.00 EUR CR Cash/ Bank.................... 138,000.00 EUR The credit entry in the Cash/ Bank account indicates Marco Mossel is paid 138,000.00 EUR. Observe in Figure 34.4 all accounts being balancedand closed-off after the liquidation process is completed. D C D C OV 200,000.00 (1a) 200,000.00 (1a) 80,000.00 OV 80,000.00 D C D C OV 10,000.00 (2a) 10,000.00 OV 90,000.00 (3) 15,000.00 (1b) 105,000.00 (4) 50,000.00 (2b) 8,000.00 c/ d 138,000.00 203,000.00 203,000.00 b/ d 138,000.00 (5) 138,000.00 D C D C (5) 120,000.00 OV 120,000.00 (5) 35,000.00 OV 35,000.00 D C D C (3) 15,000.00 OV 15,000.00 (4) 50,000.00 OV 50,000.00 D C D C (1a) 120,000.00 (1b) 120,000.00 (1b) 15,000.00 (5) 15,000.00 (2a) 10,000.00 (2b) 10,000.00 130,000.00 130,000.00 D C (2b) 2,000.00 (5) 2,000.00 Liquidation Loss on disposal LoD PPE Acc Depr Loss on settlement Owner's capital Retained earnings Interest bearing liabilities Accounts payables Accounts receivables Cash/ Bank Figure 34.4: MOSSEL SPORTS’ accounts Now, MOSSEL SPORTS cease to exist. Marco Mossel has 138,000.00 EUR on cash that he can take to start over his new life as a scuba instructor in Mauritius. <?page no="437"?> Berkau: BASICS of ACCOUNTING 34-436 In cases a company sells its assets by earning a profit, income tax will become relevant and the profit on disposal is to be recorded through the Profit and Loss account. Income tax liabilities are to be settled within the process of liquidation. Below, we assume MOSSEL SPORTS is liquidated same as before. However, as alteration of the case study, the treadmills now are sold at 124,000.00 EUR (in the previous case the selling price was: 105,000.00 EUR). Furthermore, the money received from the customers equals to 7,500.00 EUR (in the previous case the settlement amount was 8,000.00 EUR). The profit on liquidation for the treadmills exceeds the loss on disposal for bad debts. In this case, the bookkeeping entries 1b and 2b will be: DR Cash/ Bank.................... 124,000.00 EUR CR Profit on Disposal........... 4,000.00 EUR CR Liquidation.................. 120,000.00 EUR DR Cash/ Bank.................... 7,500.00 EUR DR Loss on Disposal............. 2,500.00 EUR CR Liquidation.................. 10,000.00 EUR This leads to the accounts’ balances as below in Figure 34.5: D C D C OV 200,000.00 (1a) 200,000.00 (1a) 80,000.00 OV 80,000.00 D C D C OV 10,000.00 (2a) 10,000.00 OV 90,000.00 (3) 15,000.00 (1b) 124,000.00 (4) 50,000.00 (2b) 7,500.00 c/ d 156,500.00 221,500.00 221,500.00 b/ d 156,500.00 (5) 450.00 c/ d 156,050.00 156,500.00 156,500.00 b/ d 156,050.00 (6) 156,050.00 D C D C (6) 120,000.00 OV 120,000.00 c/ d 35,000.00 OV 35,000.00 (6) 36,050.00 b/ d 35,000.00 P&L 1,050.00 36,050.00 36,050.00 Owner's capital Retained earnings Accounts receivables Cash/ Bank PPE Acc Depr Figure 34.5: MOSSEL SPORTS accounts in case of profit on asset sale <?page no="438"?> Berkau: BASICS of ACCOUNTING 34-437 D C D C (3) 15,000.00 OV 15,000.00 (4) 50,000.00 OV 50,000.00 Interest bearing liabilities Accounts payables D C D C (1a) 120,000.00 (1b) 120,000.00 c/ d 4,000.00 (1b) 4,000.00 (2a) 10,000.00 (2b) 10,000.00 P&L 4,000.00 b/ d 4,000.00 130,000.00 130,000.00 D C D C (2b) 2,500.00 c/ d 2,500.00 LoS 2,500.00 PoD 4,000.00 b/ d 2,500.00 P&L 2,500.00 b/ d 1,500.00 4,000.00 4,000.00 ILT 450.00 b/ d 1,500.00 R/ E 1,050.00 1,500.00 1,500.00 D C (5) 450.00 P&L 450.00 Income tax liabilities ITL Loss on settlement LoS Profit and Loss Liquidation Profit on disposal PoD Figure 34.5: MOSSEL SPORTS accounts in case of profit on asset sale (continued) In this case, the profit resulting from sales and settlement becomes positive and taxable. The income tax liabilities are due and will be paid within the process of liquidation of a business in the legal form of a public company. We pretend MOSSEL SPORTS is a limited company and pay the income taxes straight away. In reality, the company is privately owned and Marco Mossel will pay the taxes on the profit on liquidation based on his personal tax declaration and based on his personal income tax rate. The bookkeeping entry (5) is: DR Income Tax Liabilities....... 450.00 EUR CR Cash/ Bank.................... 450.00 EUR The final bookkeeping entry (6) is: DR Owner’s Capital.............. 120,000.00 EUR DR Retained Earnings............ 36,050.00 EUR CR Cash/ Bank.................... 156,050.00 EUR <?page no="439"?> Berkau: BASICS of ACCOUNTING 34-438 Now, Marco Mossel even goes to Mauritius with more money: 156,050.00 EUR on cash. Liquidations of partnerships and of public companies work similar. In contrast to MOSSEL SPORTS the liquidation pays an agreed share of the profit to the proprietors/ shareholders based on the regulations signified by the memorandum of corporation. In case a company’s liquidation results in a negative amount for equity (liabilities cannot be settled) national law is considered with regard to the obligation to file for bankruptcy. In this case, the company often won’t be allowed to make the settlement payments on its own anymore, in order to guarantee the same share of liquidation payment to all creditors. In a situation of bankruptcy, shareholders lose their whole interest in the company (the shares are valued at zero), but won’t be held liable for debts. In the events of liquidation losses, managers or in companies based on shares the CEO and CFO (= chief financial officer) can be held liable for losses, resulting from mistakes/ misconducts that can be proved and used against them. Even own shareholders might sue their managers based on civil law, because they suffer a loss from losing their shares.) In this text book we are not keen to discuss many national law aspects. That is the reason, why the chapter is only illustrated by a case about a privately owned business. However, you will find a liquidation example about a public company in the text book Bilanzen and the ebook Accounting-2-Go in chapter 7. Summary: Liquidation is the process of dissolving a business. All assets are sold and converted into cash or cash equivalents. All debts are paid-off. The remaining amount is paid to the owners. The remaining amount can differ from the previous book value of the company. Profits and losses on liquidation increase or decrease the amount paid to the proprietors. Working Definitions: Liquidation Account: The Liquidation account is a temporary account that applies to record all liquidation activities. Bad Debts: Bad debts are receivables that a business is probably not able to collect. <?page no="440"?> Berkau: BASICS of ACCOUNTING 35-439 35. Disposals Learning Objectives: Disposals of non-current assets are to be recorded, once items do not fulfil the recognition requirements any longer. This can happen, because they are no longer deployed or they are sold. Postings for disposals become also relevant when a non-current asset is completely destroyed. This chapter covers the application of the Realisation account. After this chapter you can record disposal of assets. Along IFRSs an asset is an item that makes future economic benefits flow into the business that deploys or owns it. If and only if there is a future economic benefit resulting from the asset and the value measurement thereof can be relied on, the qualification criteria for an asset a met. An asset that provides no further benefit has to be deleted from the bookkeeping records. Providing no future economic benefit means, the asset cannot be sold nor used in any way possible. Some German companies write off an asset completely and assign a reminding value to the extent of 1.00 EUR thereto. This does not work along IFRSs. Once the asset is written off completely, either a revaluation to the fair value is recorded or its disposal. Other reasons for disposals are selling or discarding of assets. The bookkeeping entries for the disposal can be made all together by one bookkeeping. However, it is easier to apply the Realisation account and to split bookkeeping entries. A Realisation account is a temporary account that records all activities which are linked to the disposal of a non-current asset. The Realisation account splits the process of disposal in single activities, such as receiving cash, recording VAT, removing asset from the books etc. All activities are recorded separately. The contra entry for all postings is the Realisation account. How it is done (disposal of a non-current asset): (1) Create a Realisation account. (2) Close-off the non-current asset account (mostly the Property, Plant and Equipment account applies.) to the Realisation account. (3) Close-off the Accumulated Depreciation account dedicated to the relevant non-current asset to the Realisation account. If no asset management applies, take the relevant amount for the asset out of the general Accumulated Depreciation account. You might consider depreciation for the actual Accounting period at first. Do the same with regard to impairment losses and relevant accounts thereto. (4) When receiving a payment on cash, debit the amount to the Cash/ Bank account and make a credit entry in the <?page no="441"?> Berkau: BASICS of ACCOUNTING 35-440 Realisation account. When receiving a voucher or any other kind of receivables, debit the amount to the relevant account (mostly Accounts Receivables) and make a credit entry in the Realisation account. You might consider combinations. (5) In case the sale is relevant for output-VAT, make a debit entry in the Realisation account and credit the amount to the VAT account. (6) Balance-off the Realisation account. A debit balanced Realisation account means a loss on disposal a credit balanced one a profit on disposal. (7) Close-off the Realisation account to the Profit and Loss account. We explain the application of the Realisation account by the case study WARDRIF Ltd. WADRIF Ltd. operates 5 business cars at the beginning of the Accounting period 20X3 (2.01.20X3). The cars are writtenoff along straight line method over a useful life of 5 years. There is no residual value expected after the useful life is over. All cars are identified by their licence plates. The car “OS-W 100” is bought on 2.01.20X0, “OS-W 200” and “OS-W 300” are bought on 2.10.20X1, “OS-W 400” is bought on 2.01.20X2 and “OS-W 500” is bought on 1.07.20X2. The register of non-current assets is depicted by Figure 35.1: Asset Cost of acquisition Acc. depr. Acc. impairm. losses Carrying amount Car "OS-W 100" 35,000.00 (21,000.00) 0.00 14,000.00 Car "OS-W 200" 40,000.00 (10,000.00) 0.00 30,000.00 Car "OS-W 300" 40,000.00 (10,000.00) 0.00 30,000.00 Car "OS-W 400" 35,000.00 (7,000.00) 0.00 28,000.00 Car "OS-W 500" 60,000.00 (6,000.00) 0.00 54,000.00 156,000.00 Wardrif Ltd.'s REGISTER of NON-CURRENT ASSETS as at 1.01.20X3 Figure 35.1: WARDRIF Ltd.’s register of non-current assets Observe the accounts as at 2.01.20X3 in Fehler! Verweisquelle konnte nicht gefunden werden. . The opening amounts are identified as balances brought down therein. The accounts are continued from the previous Accounting period. <?page no="442"?> Berkau: BASICS of ACCOUNTING 35-441 D C D C b/ d 35,000.00 b/ d 21,000.00 P, P, E car "OS-W 100" Acc depr "OS-W 100" D C D C b/ d 40,000.00 b/ d 10,000.00 D C D C b/ d 40,000.00 b/ d 10,000.00 P, P, E car "OS-W 300" Acc depr "OS-W 300" P, P, E car "OS-W 200" Acc depr "OS-W 200" D C D C b/ d 35,000.00 b/ d 7,000.00 D C D C b/ d 60,000.00 b/ d 6,000.00 P, P, E car "OS-W 500" Acc depr "OS-W 500" P, P, E car "OS-W 400" Acc depr "OS-W 400" Figure 35.2: WARDRIF Ltd.’s accounts It is assumed, WARDRIF Ltd. earns a revenue of 200,000.00 EUR and has other expenses to the extent of 50,000.00 EUR. There are no other accounts considered. The revenue and the other expenses are paid through WARDRIF Ltd.’s bank account. (1) Revenue is recorded on 31.12.20X3. DR Cash/ Bank.................... 240,000.00 EUR CR VAT.......................... 40,000.00 EUR CR Revenue...................... 200,000.00 EUR (2) Recording other expenses on 31.12.20X3. DR Other Expenses............... 50,000.00 EUR DR VAT.......................... 10,000.00 EUR CR Cash/ Bank.................... 60,000.00 EUR On 25.06.20X3, WARDRIF Ltd. sells the cars “OS-W 200” and “OS-W 300” to a dealership. The dealer values the vehicles differently with regard to their working and body conditions. He pays for “OS-W 200” 31,050.00 EUR and for “OS-W 300” 31,890.00 EUR. The amounts are gross amounts. In order to <?page no="443"?> Berkau: BASICS of ACCOUNTING 35-442 record the disposals, WARDRIF Ltd.’s Accountant applies a Realisation account for each car. The car “OS-W 200” is sold at a price below its carrying amount. The carrying amount equals to: 40,000 - 14,000 = 26,000.00 EUR . WARDRIF Ltd. makes a loss on the disposal of: 31,050 / 120% - 26,000 = -125.00 EUR . The car “OS-W 300” is sold at a price above its carrying amount. The carrying amount equals to: 40,000 - 14,000 = 26,000.00 EUR . The profit on disposal is: 31,890 / 120% - 30,000 = 575.00 EUR . Accordingly, there will be a loss on disposal for one car and a profit on disposal for the other car. The carrying amount of both cars (each) is calculated as cost of acquisition less accumulated depreciation. Depreciation applies for the time between 1.01.20X3 and 25.06.20X3. According to the calculation of depreciation in this text book, the duration is 6 months. The cars are written-off to an extent of: (6/ 12) × 40,000/ 5 = 4,000.00 EUR . Both cars are sold after 21 months of deployment. The carrying amounts are: 40,000 - 21 x (40,000 / (5 x 12)) = 26,000.00 EUR . The net selling prices are: 31,050/ 120% = 25,875.00 EUR for “OS-W 200” and: 31,890 / 120% = 26,575.00 EUR for “OS- W 300”. When applying the Realisation account all bookkeeping entries are made through this account. The Realisation account is taken as contra account for all relevant entries. We observe the disposal of the car “OS-W 200”. (3) Receiving money on 25.06.20X3. DR Cash/ Bank.................... 31,050.00 EUR CR Realisation.................. 31,050.00 EUR (4) VAT posting for the money received by selling the car to the dealership on 25.06.20X3. The amount is: 25,875 × 20% = 5,175.00 EUR . DR Realisation.................. 5,175.00 EUR CR VAT.......................... 5,175.00 EUR The sold car “OS-W 200” is to be cancelled from the books. Accordingly, there is an entry required in the Property, Plant and Equipment account and in the Accumulated Depreciation account. The offset amounts represent the carrying amount of the asset. The carrying amount is calculated as the cost of acquisition less any accumulated depreciation. The cost of acquisition is 40,000.00 EUR. The calculation of the amount of accumulated depreciation requires making an entry for 20X3 Accounting period’s depreciation at first. The car was in use for 6 months during 20X3 before it gets disposed. Depreciation equals to: 6 × (40,000 / (5 × 60)) = 4,000.00 EUR . (5) Depreciation on “OS-W 200” on 25.06.20X3. DR Depreciation................. 4,000.00 EUR CR Accumulated Depreciation..... 4,000.00 EUR <?page no="444"?> Berkau: BASICS of ACCOUNTING 35-443 WARDRIF Ltd. applies an asset management. This means the subordinated accounts Accumulated Depreciation are dedicated to certain non-current assets. (6) Cancelling the car from the books requires to close-off the accounts to the Realisation account. This is done on 25.06.20X3. DR Realisation.................. 40,000.00 EUR CR P, P, E - “OS-W 200”......... 40,000.00 EUR (7) The Accumulated Depreciation “OS- W 200“ account is closed-off to the Realisation account on 25.06.20X3. DR Accumulated Depreciation..... 14,000.00 EUR CR Realisation.................. 14,000.00 EUR We acknowledge that the Realisation account is debit balanced at this stage. This indicates WARDRIF Ltd. made a loss on disposal. We obviously expected this as WARDRIF Ltd. sells the business car below its carrying amount. In Figure 35.3 the abbreviation LoD for loss on disposal marks the entry in the Profit and Loss account. The Realisation account for the car “OS- W 200” is closed-off to the Profit and Loss account by the next bookkeeping entry. DR Realisation “OS-W 200”....... 125.00 EUR CR Profit and Loss.............. 125.00 EUR The sale of the second car “OS-W 300” is recorded in a similar way. In contrast to the first car, WARDRIF Ltd. now earns a profit on disposal. (8) Receiving money on 25.06.20X3. DR Cash/ Bank.................... 31,890.00 EUR CR Realisation.................. 31,890.00 EUR (9) Recording VAT for the price obtained by selling the car “OS-W 300” to the dealership on 25.06.20X3. The amount for output-VAT equals to: 26,575 × 20% = 5,315.00 EUR . DR Realisation.................. 5,315.00 EUR CR VAT.......................... 5,315.00 EUR The sold car “OS-W 300” is cancelled from the books. Its depreciation is recorded on 25.06.20X3, just before the disposal. It amounts to: 6 × (40,000 / (5 × 60)) = 4,000.00 EUR . (10) Depreciation on “OS-W 300” on 25.06.20X3. <?page no="445"?> Berkau: BASICS of ACCOUNTING 35-444 DR Depreciation................. 4,000.00 EUR CR Accumulated Depreciation..... 4,000.00 EUR After making the bookkeeping entry for depreciation the cancelling from the books can begin. (11) The Property, Plant and Equipment account for the car is closed-off to the Realisation account. This is recorded on 25.06.20X3. DR Realisation.................. 40,000.00 EUR CR P, P, E - “OS-W 300”......... 40,000.00 EUR (12) Closing-off Accumulated Depreciation “OS-W 300“ to the Realisation account on 25.06.20X3. DR Accumulated Depreciation..... 14,000.00 EUR CR Realisation.................. 14,000.00 EUR The Realisation account is credit balanced. This indicates WARDRIF Ltd. earned a profit on the disposal. In Figure 35.3 the abbreviation PoD for profit on disposal is used in the Realisation account. The Realisation account for the car “OS- W 300” is closed-off to the Profit and Loss account. DR Profit and Loss.............. 575.00 EUR CR Realisation.................. 575.00 EUR WARDRIF Ltd. has an accident with the expensive car (observe the register of non-current assets) “OS-W 500” on 4.10.20X3. The car is totalled and has no value after the crash. However, the scrap dealer pays an amount of 600.00 EUR (gross amount) for the car wreck. In order to determine the damage WARDRIF Ltd. suffers, we calculate its carrying value at the time directly before the car crash. The vehicle was in use for: 6 + 9 = 15 months . Its carrying amount at the moment before the damage equals to: 60,000 - 15 × (60,000 / (5 × 12)) = 45,000.00 EUR . We do not consider any insurance plan for compensation of the accident’s damage in this case study. WARDRIF Ltd. records an impairment loss on the car before it gets sold to the scrap yard. The bookkeeping entries for the disposal are based on a Realisation account again. Before we make the bookkeeping entries linked to the crash, we record depreciation. As the crash takes place at the beginning of October, the duration for its deployment is 9 months. (13) Depreciation on the car “OS-W 500” to an extent of: 9 × (60,000 / (5 × 12)) = 9,000.00 EUR . <?page no="446"?> Berkau: BASICS of ACCOUNTING 35-445 DR Depreciation................. 9,000.00 EUR CR Accumulated Depreciation..... 9,000.00 EUR As the value of the car after the crash is zero, the Accountant makes an entry for an impairment loss to the extent of 45,000.00 EUR: The fact that the car later is sold at 500.00 EUR (net amount), does not determine the value of the car wreck. Selling the car at 500.00 EUR is regarded as a lucky sale. However, the amount cannot be taken as criterion for a revaluation as the difference in value (500.00 EUR) is not substantial. (Note, see for revaluations chapter 7 of the text book Bilanzen and the ebook Accounting-2-Go.) (14) Recording an impairment loss on 5.10.20X3. DR Impairment Loss.............. 45,000.00 EUR CR Accumulated Impairment Losses 45,000.00 EUR The next bookkeeping entries consider the Realisation account. Again, we dedicate a particular Realisation account to the car “OS-W 500”. At first, the payment of the scrap dealer is considered and VAT is considered, too. (15) Revenue resulting from the car wreck sale is recorded on 6.10.20X3. DR Cash/ Bank.................... 600.00 EUR CR Realisation.................. 600.00 EUR (16) VAT consideration takes place on 6.10.20X3. DR Realisation.................. 100.00 EUR CR VAT.......................... 100.00 EUR (17 … 19) Closing-off Property, Plant and Equipment account, Accumulated Depreciation account and Accumulated Impairment Losses account to the Realisation account on 6.10.20X3. DR Realisation.................. 60,000.00 EUR CR P, P, E “OS-W 500”........... 60,000.00 EUR DR Accumulated Depreciation..... 15,000.00 EUR CR Realisation.................. 15,000.00 EUR DR Accumulated Impairment Losses 45,000.00 EUR CR Realisation.................. 45,000.00 EUR <?page no="447"?> Berkau: BASICS of ACCOUNTING 35-446 The revenue earned by the disposal of the car wreck is taxable profit. There are no costs of goods disposed, as the carrying amount is zero. The net amount of 500.00 EUR is calculated by balancingoff of the Realisation account and is marked as PoD. The amount is transferred to the Profit and Loss account where the Realisation account is closedoff to. DR Realisation.................. 500.00 EUR CR Profit and Loss.............. 500.00 EUR The remaining cars of the WARDRIF Ltd. case study are depreciated at the end of the Accounting period: (20) Depreciation on car “OS-W 100” to the extent of: 35,000/ 5 = 7,000.00 EUR on 31.12.20X3. DR Depreciation................. 7,000.00 EUR CR Accumulated Depreciation..... 7,000.00 EUR (21) Depreciation on car “OS-W 400” to the extent of: 35,000/ 5 = 7,000.00 EUR on 31.12.20X3. DR Depreciation................. 7,000.00 EUR CR Accumulated Depreciation..... 7,000.00 EUR By the next steps, we calculate WARDRIF Ltd.’s profit applying its Profit and Loss account. For this example, we do not prepare a full set of financial statements. The example only covers the profit calculation and the non-current asset recognition by the register of non-current assets. For profit calculation we close-off all nominal accounts to the Profit and Loss account. Observe that even after closing-off the Accumulated Depreciation and Accumulated Impairment Loss accounts the expense accounts still count and contribute to the profit calculation in full. In contrast to the Accumulated Depreciation and Accumulated Impairment Loss account, the expense accounts are not linked to certain cars. DR Profit and Loss ............. 31,000.00 EUR CR Depreciation................. 31,000.00 EUR DR Profit and Loss.............. 45,000.00 EUR CR Impairment Loss.............. 45,000.00 EUR DR Profit and Loss.............. 50,000.00 EUR CR Other Expenses............... 50,000.00 EUR <?page no="448"?> Berkau: BASICS of ACCOUNTING 35-447 DR Revenue...................... 200,000.00 EUR CR Profit and Loss.............. 200,000.00 EUR The revenue earned by the disposal of cars and car wrecks does not go through the general Revenue account as car dealing is not WARDRIF Ltd.’s core business. Thus, the amount is not recognised in the statement of comprehensive income as revenue but as other income. If positive, we call it profit on disposal and disclose other income. If there is a loss on disposal, the amount is shown under the header other expenses. Observe the accounts displayed by figure 32.3. D C D C b/ d 35,000.00 c/ d 35,000.00 b/ d 21,000.00 b/ d 35,000.00 c/ d 28,000.00 (20) 7,000.00 28,000.00 28,000.00 b/ d 28,000.00 D C D C b/ d 40,000.00 (6) 40,000.00 (7) 14,000.00 b/ d 10,000.00 (5) 4,000.00 14,000.00 14,000.00 D C D C b/ d 40,000.00 (11) 40,000.00 (12) 14,000.00 b/ d 10,000.00 (10) 4,000.00 14,000.00 14,000.00 P, P, E car "OS-W 100" Acc depr "OS-W 100" P, P, E car "OS-W 300" Acc depr "OS-W 300" P, P, E car "OS-W 200" Acc depr "OS-W 200" D C D C b/ d 35,000.00 c/ d 35,000.00 b/ d 7,000.00 b/ d 35,000.00 c/ d 14,000.00 (21) 7,000.00 14,000.00 14,000.00 b/ d 14,000.00 D C D C b/ d 60,000.00 (17) 60,000.00 (18) 15,000.00 b/ d 6,000.00 (13) 9,000.00 15,000.00 15,000.00 P, P, E car "OS-W 400" Acc depr "OS-W 400" P, P, E car "OS-W 500" Acc depr "OS-W 500" Figure 35.3: WARDRIF Ltd.’s accounts <?page no="449"?> Berkau: BASICS of ACCOUNTING 35-448 D C D C b/ d 0.00 (2) 60,000.00 (2) 10,000.00 (1) 40,000.00 (1) 240,000.00 (4) 5,175.00 (3) 31,050.00 (9) 5,315.00 (8) 31,890.00 c/ d 40,590.00 (16) 100.00 (15) 600.00 c/ d 243,540.00 50,590.00 50,590.00 303,540.00 303,540.00 b/ d 40,590.00 b/ d 243,540.00 Cash/ Bank VAT D C D C c/ d 200,000.00 (1) 200,000.00 (2) 50,000.00 c/ d 50,000.00 P&L 200,000.00 b/ d 200,000.00 b/ d 50,000.00 P&L 50,000.00 D C D C (4) 5,175.00 (3) 31,050.00 (5) 4,000.00 (6) 40,000.00 (7) 14,000.00 (10) 4,000.00 LoD 125.00 (13) 9,000.00 45,175.00 45,175.00 (20) 7,000.00 b/ d 125.00 P&L 125.00 (21) 7,000.00 c/ d 31,000.00 31,000.00 31,000.00 b/ d 31,000.00 P&L 31,000.00 D C D C (9) 5,315.00 (8) 31,890.00 LoD 125.00 PoD 575.00 (11) 40,000.00 (12) 14,000.00 Dpr 31,000.00 PoD 500.00 PoD 575.00 IL 45,000.00 Rev 200,000.00 45,890.00 45,890.00 Oth 50,000.00 P&L 575.00 b/ d 575.00 NP 74,950.00 201,075.00 201,075.00 Tax 22,485.00 b/ d 74,950.00 R/ E 52,465.00 74,950.00 74,950.00 Revenue Other expenses Realisation "OS-W 200" Depreciation Realisation "OS-W 300" Profit and Loss P&L D C D C (19) 45,000.00 (14) 45,000.00 (14) 45,000.00 P&L 45,000.00 D C D C c/ d 52,465.00 P&L 52,465.00 (16) 100.00 (15) 600.00 b/ d 52,465.00 (17) 60,000.00 (18) 15,000.00 PoD 500.00 (19) 45,000.00 60,600.00 60,600.00 P&L 500.00 b/ d 500.00 Acc impairment losses "OS-W 500" Impairment loss Retained earnings R/ E Realisation "OS-W 500" Figure 35.3: WARDRIF Ltd.’s accounts (continued) <?page no="450"?> Berkau: BASICS of ACCOUNTING 35-449 D C c/ d 22,485.00 P&L 22,485.00 b/ d 22,485.00 Income tax liabilities Figure 35.3: WARDRIF Ltd.’s accounts (continued) The register of non-current assets only displays the remaining cars. See Figure 35.4. However, WARDRIF Ltd. mentions the sold and discarded cars by that statement. This is for text book reasons only. Asset Cost of acquisition Acc. depr. Acc. impairm. losses Carrying amount Car "OS-W 100" 35,000.00 (28,000.00) 0.00 7,000.00 Car "OS-W 200" disposed Car "OS-W 300" disposed Car "OS-W 400" 35,000.00 (14,000.00) 0.00 21,000.00 Car "OS-W 500" disposed 28,000.00 Wardrif Ltd.'s REGISTER of NON-CURRENT ASSETS as at 31.12.20X3 Figure 35.4: WARDRIF Ltd.’s register of non-current assets The statement of comprehensive income displays normal income and gains resulting from the disposals separately. Observe the other income resulting from the gains/ losses to be: 575 - 125 + 500 = 950.00 EUR . It is allowed to offset profit and loss on disposals such as WARDRIF Ltd. WARD- RIF Ltd. cannot be forced to apply an asset management and to maintain separate Realisation accounts. <?page no="451"?> Berkau: BASICS of ACCOUNTING 35-450 [EUR] Revenue 200,000.00 Other income 950.00 200,950.00 Materials Labour Depreciation 31,000.00 Impairment losses 45,000.00 Other expenses 50,000.00 Earnings before int and taxes (EBIT) 74,950.00 Interest 0.00 Earnings before taxes (EBT) 74,950.00 Income tax expenses 22,485.00 Deferred taxes Earnings after taxes (EAT) 52,465.00 Wardrif Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 35.5: WARDRIF Ltd.’s statement of comprehensive income The statement of comprehensive income discloses extraordinary gains resulting from the disposal of assets. Summary: A company that disposes assets applies a Realisation account for each asset disposed. The profit or loss on disposal is to be recognized in the statement of comprehensive income under the item of other income or other expenses. Working Definition: Realisation Account: A realisation account is a temporary account that is used to record all activities linked to the disposal of a non-current asset. <?page no="452"?> Berkau: BASICS of ACCOUNTING 36-451 36. Discounts Learning Objectives: A Company receiving or allowing discounts has to adjust the value of goods bough or the revenue. The same applies for the VAT account. We introduce the recording of discounts in this chapter. There are two approaches: one reduces costs/ sales directly at the point of purchase/ sales, and the another one considers discounts later. After studying this chapter, you can record discounts. You further are aware that discounts change amounts assets are carried at or the revenue recognition along IFRSs. Discounts are ruled by the IFRSs with regard to the initial asset valuation. IAS 2 and IAS 16 request deducting all discounts for asset valuations and IFRS 15 contains the regulations for revenue recognition. The valuation of assets/ revenue always has to be ex discounts. Thus, inventory movements, cost of sales and revenues are based on net amounts without discounts. Similar regulations apply for subsequent valuations that might have occurred, such as revaluations recorded by the gross replacement method. See further considerations on revaluations in chapter 7 of the text book Bilanzen and the ebook Accounting-2-Go. Discounts can never be disclosed on the face of financial statements. Even if a particular Discount account applies, it must be closed-off latest on the balance sheet date. If a customer buys on credit and receives a discount, the discount is to be deducted from receivables, too. The same applies for payables to suppliers. There are two methods for discount consideration: (1) Instant Discount (2) Deferred Discount Ad (1): Instant Discounts The easiest way to make a bookkeeping entry for a discount is to reduce the amount instantly. If you buy something for 100.00 EUR and you receive a 5%-discount, the adjusted amount equals to: 100 × (1 - 5%) = 95.00 EUR. We’ll show this method by a few examples and consider VAT, too. MELKBOS Ltd. is a grocery store. It purchases 2,500 litre of milk at 1.00 EUR each (net amount) from its supplier. The supplier allows MELKBOS Ltd. a discount of 4 % on the complete sale. MELKBOS Ltd. simply calculates the new price and prepares the bookkeeping entries. (a) Purchase of goods at the reduced price of: 2,500 × 1 × (1 - 4%) = 2,400.00 EUR on 5.04.20X5. DR Purchase..................... 2,400.00 EUR DR VAT.......................... 480.00 EUR CR Cash/ Bank.................... 2,880.00 EUR When MELKBOS Ltd. sells the groceries, it allows a 5%-discount to all customers, who buy the goods after 20h00. A customer who buys milk - the regular price <?page no="453"?> Berkau: BASICS of ACCOUNTING 36-452 is 1.60 EUR/ l (gross amount) - then pays: 1.60 × (1 - 5%) = 1.52 EUR/ l for a night purchase. Ingo SCHULZE-BRAM- MELKAMP buys 3 litres of milk and waits until 20h01 at the cashpoint. He then pays: 3 × 1.52 = 4.56 EUR . The net amount of his milk purchase equals to: 4.56/ 120% = 3.80 EUR . MELKBOS Ltd. records the sale as below: (b) Sale of 3 litre late-evening milk under instant consideration of a 5 % discount on 6.04.20X5. DR Cash/ Bank.................... 4.56 EUR CR VAT.......................... 0.76 EUR CR Sales........................ 3.80 EUR The consideration of immediate discounts received or allowed is fairly simple. We only change the prices for purchase/ sales and VAT. How it is done (immediate discounts): (1) Multiply the purchase price / sales price by the factor (1 - discount [%]). (2) If VAT applies, multiply VAT by the factor (1 - discount [%]), too. (3) Record the purchase/ sale based on the reduced amounts. Ad (2): Deferred Discount If the discount is allowed or received after the time of purchase/ sales, the bookkeeping entries will become more complicated. Some companies offer a discount after the sale has been recorded. For instance, they offer a discount once a certain amount of goods has been ordered by the customer. Or they use a discount to compensate an unsatisfied customer in order to avoid goods being returned. In these situations, a discount is posted to a Discount account. When a customer receives a discount, the account’s name is Discount Received. A company that sells goods to a reduced price, applies the Discount Allowed account. A Discount account is a temporary account to record discounts. It has to be closedoff to the Purchases-, Property, Plant and Equipment-, Salesand/ or VAT account. The discount will change the costs of purchase/ acquisition or the selling prices. If discounts are allowed/ received after the purchase/ sales date, valuations and subsequent bookkeeping entries must be adjusted. A discount received on the cost of acquisition changes depreciation, for example. The Discount account cannot be transferred to the statement of financial position. In any case, Discount accounts are to close-off to other accounts. In case a company delays recording a received discount, it will overstate the inventory valuation. As a consequence, expenses resulting from stock releases, such as cost of sales or <?page no="454"?> Berkau: BASICS of ACCOUNTING 36-453 manufacturing costs, will be too high and will decrease profits. On the other hand, inventory left on stock are overpriced. For this reasons, a company must record a discount, once it receives it. If the company buys on 2.01.20X5 goods and receives a discount thereon half a year later, the discount is to be recorded on 2.07.20X5 as deferred discount. Inventory adjustments are due at the same date. How it is done (deferred discounts): (1) Make bookkeeping entries for purchase and sale. (2) Once a discount is received, post it immediately to the Discount Received account. Credit the discount to the Discount received account and make a debit entry in the Cash/ Bank account if paid, or in the Accounts Payables if payment is still awaited. Once a discount is allowed, record it by the Discount Allowed account. Debit the discount to the Discount Allowed account. If you pay the discount directly, make a credit entry in the Cash/ Bank account. If you reduce an open bill or give the buyer/ customer a voucher, record a debit entry in the Accounts Receivables. (3) Split up the discount in a net amount and VAT. (4) Close-off the Discount Received account to inventory, non-current asset or service expenses and adjust the VAT account. Close-off the Discount Allowed account to the Sales/ Revenue account and VAT account. (5) Special bookkeeping entries might apply in particular situations. We’ll show the application of Discount accounts and their dissimilation by the example HETKRUIS Ltd., which is a trading business. HETKRUIS Ltd. is dealer for car parts and offers a 5 % discount on all goods for customers, who spend more than 25,000.00 EUR within 1 year, based on purchase prices. The discount applies for all goods bought within that period. FIXCARS (Pty) Ltd. is a car repair shop and buys its spare and replacement parts from HETKRUIS Ltd. During the last year, FIXCARS (Pty) Ltd. spent: - 10,000.00 EUR on parts in January 20X4, - 8,000.00 EUR in April 20X4 and - 12,000.00 EUR in December 20X4. All amounts are net amounts. The payments have not been made yet and payables have been recorded at FIXCARS (Pty) Ltd. Observe the bookkeeping entries made by FIXCARS (Pty) Ltd. below: (1) Purchase of parts on 5.01.20X4. <?page no="455"?> Berkau: BASICS of ACCOUNTING 36-454 DR Purchase..................... 10,000.00 EUR DR VAT.......................... 2,000.00 EUR CR Accounts Payables............ 12,000.00 EUR (2) Purchase of parts on 9.04.20X4. DR Purchase..................... 8,000.00 EUR DR VAT.......................... 1,600.00 EUR CR Accounts Payables............ 9,600.00 EUR (3) Purchase of parts on 15.12.20X4. DR Purchase..................... 12,000.00 EUR DR VAT.......................... 2,400.00 EUR CR Accounts Payables............ 14,400.00 EUR The purchase costs exceed the amount that qualifies for the discount offered by HETKRUIS Ltd. The total value of orders (net amounts) equals to: 10,000 + 8,000 + 12,000 = 30,000.00 EUR . The amount exceeds 25,000.00 EUR which is the mark for discount receiving. According to the purchases, FIXCARS (Pty) Ltd. is entitled to receive a 5%-discount on all parts and claims the discount from HETKRUIS Ltd. On 16.12.20X4, FIXCARS (Pty) Ltd. receives the discount. (4) On 16.12.20X4, FIXCARS (Pty) Ltd., posts the discount received from HETKRUIS Ltd. to discounts. It amounts to 5 %. As the dates of purchase are in the past, the discount is classified as deferred discount. The discount received from HETKRUIS Ltd. is: 5% × (12,000 + 9,600 + 14,400) = 1,800.00 EUR . DR Discount Received............ 1,800.00 EUR CR Accounts Payables............ 1,800.00 EUR The discount reduces the amount FIXCARS (Pty.) Ltd. owes HETKRUIS Ltd. The original bill is: (10,000 + 8,000 + 12,000) × 120% = 36,000.00 EUR . Thus, payables amount to 36,000.00 EUR, too. No payment has been made so far. The bookkeeping entry at the time of purchase was: DR Purchase..................... 30,000.00 EUR DR VAT.......................... 6,000.00 EUR CR Accounts Payables............ 36,000.00 EUR Recording the discount received changes the payables. One day later, on 16.12.20X4, FIXCARS (Pty) Ltd. pays the adjusted bill. (5) Payment of the amount due, which equals to: 36,000 - 1,800 = 34,200.00 EUR by bank transfer on 16.12.20X4. <?page no="456"?> Berkau: BASICS of ACCOUNTING 36-455 DR Accounts Payables............ 34,200.00 EUR CR Cash/ Bank.................... 34,200.00 EUR Take a look at Figure 36.1 which displays the accounts at FIXCARS (Pty) Ltd. D C D C (1) 10,000.00 (1) 2,000.00 (2) 8,000.00 (2) 1,600.00 (3) 12,000.00 (3) 2,400.00 Purchase VAT D C D C (4) 1,800.00 (1) 12,000.00 (4) 1,800.00 (2) 9,600.00 c/ d 34,200.00 (3) 14,400.00 36,000.00 36,000.00 (5) 34,200.00 b/ d 34,200.00 D C ... (5) 34,200.00 Cash/ Bank Accounts Payables Discount received Figure 36.1: FIXCARS (Pty) Ltd.’s accounts At this stage, the payment has been changed but the amounts in the Purchase account are overstated. Along IAS 2 inventories are to be recognised at the amount of the purchase price (net amount) less any discounts. But FIXCARS (Pty) Ltd. still displays prices without discount recognition. For that reason, the amounts are to be adjusted by 16.12.20X4, which is the date when the discount is received. The purchases can be identified separately and give three bookkeeping entries linked to the three purchases. FIXCARS (Pty) Ltd. adjusts the VAT account, too. The input-VAT claim is then based on the amount actually charged, which is the reduced price. (6, 7) Discount of purchase (1) on 16.12.20X4 which is: 10,000 × 5% = 500.00 EUR . Adjustment for VAT is: 2,000 × 5% = 100.00 EUR . DR Discount Received............ 500.00 EUR CR Purchase..................... 500.00 EUR DR Discount Received............ 100.00 EUR CR VAT.......................... 100.00 EUR <?page no="457"?> Berkau: BASICS of ACCOUNTING 36-456 (8, 9) Discount of purchase (2) on 16.12.20X4 which is 8,000 × 5% = 400.00 EUR . Adjustment for VAT is 1,600 × 5% = 80.00 EUR . DR Discount Received............ 400.00 EUR CR Purchase..................... 400.00 EUR DR Discount Received............ 80.00 EUR CR VAT.......................... 80.00 EUR (10, 11) Discount of purchase (3) on 16.12.20X4 which is: 12,000 × 5% = 600.00 EUR . Adjustment for VAT is: 2,400 × 5% = 120.00 EUR . DR Discount Received............ 600.00 EUR CR Purchase..................... 600.00 EUR DR Discount Received............ 120.00 EUR CR VAT.......................... 120.00 EUR Observe now the accounts in Figure 36.2. D C D C (1) 10,000.00 (6) 500.00 (1) 2,000.00 (7) 100.00 (2) 8,000.00 (8) 400.00 (2) 1,600.00 (9) 80.00 (3) 12,000.00 (10) 600.00 (3) 2,400.00 (11) 120.00 c/ d 28,500.00 c/ d 5,700.00 30,000.00 30,000.00 6,000.00 6,000.00 b/ d 28,500.00 b/ d 5,700.00 D C D C (4) 1,800.00 (1) 12,000.00 (6) 500.00 (4) 1,800.00 (2) 9,600.00 (7) 100.00 c/ d 34,200.00 (3) 14,400.00 (8) 400.00 36,000.00 36,000.00 (9) 80.00 (5) 34,200.00 b/ d 34,200.00 (10) 600.00 (11) 120.00 1,800.00 1,800.00 D C ... (5) 34,200.00 Cash/ Bank Purchase VAT Accounts Payables Discount received Figure 36.2: FIXCARS (Pty) Ltd.’s accounts The purchases of inventories have been marked down to the amount which is ex discount. It is now 28,500.00 EUR which is considered in the Trading account. <?page no="458"?> Berkau: BASICS of ACCOUNTING 36-457 Also, VAT has been adjusted to the right amount along the tax law. VAT can only be claimed to the extent of what has actually been charged/ paid. The total amount paid by FIXCARS (Pty) Ltd. is: (1 - 5%) × (10,000 + 8,000 + 12,000) × 120% = 34,200.00 EUR . The amount of input-VAT therein is: 20% × 34,200 / 120% = 5,700.00 EUR . In case FIXCARS (Pty) Ltd. received the discount immediately, bookkeeping entries would have been made, such as: DR Purchase..................... 28,500.00 EUR DR VAT.......................... 5,700.00 EUR CR Accounts Payables............ 34,200.00 EUR) We now check the accounts at HETKRUIS Ltd., who is the seller. In order to make the recording distinguishable to FIXCARS (Pty) Ltd.’s ones, we identify HETKRUIS Ltd.’s bookkeeping entries by capitals. HETKRUIS Ltd. sells the goods to FIXCARS (Pty) Ltd. and hasn’t received the payments yet. HETKRUIS Ltd. makes a bookkeeping entry for receivables. (A) Sale of parts on 5.01.20X4. DR Accounts Receivables......... 12,000.00 EUR CR VAT.......................... 2,000.00 EUR CR Sales........................ 10,000.00 EUR (B) Sale of parts on 9.04.20X4. DR Accounts Receivables......... 9,600.00 EUR CR VAT.......................... 1,600.00 EUR CR Sales........................ 8,000.00 EUR (C) Sale of parts on 15.12.20X4. DR Accounts Receivables......... 14,400.00 EUR CR VAT.......................... 2,400.00 EUR CR Sales........................ 12,000.00 EUR After making bookkeeping entry (C), the sales manager at HETKRUIS Ltd. notices that FIXCARS (Pty) Ltd. now qualifies for the discount. He sends a letter of notification to FIXCARS (Pty) Ltd. which allows them to deduct 5 % of the billed amounts. (D) Recording the discount of: 5% × (12,000 + 9,600 + 14,400) = 1,800.00 EUR on 16.12.20X4. For HETKRUIS Ltd. the discount changes the receivables and, thus, looks similar to an expense. <?page no="459"?> Berkau: BASICS of ACCOUNTING 36-458 DR Discount Allowed............. 1,800.00 EUR CR Accounts Receivable.......... 1,800.00 EUR Observe HETKRUIS Ltd.’s accounts in Figure 36.3: D C D C (A) 10,000.00 (A) 2,000.00 (B) 8,000.00 (B) 1,600.00 (C) 12,000.00 (C) 2,400.00 Sales VAT D C D C (A) 12,000.00 (D) 1,800.00 (D) 1,800.00 (B) 9,600.00 (C) 14,400.00 Accounts receivables Discount allowed Figure 36.3: HETKRUIS Ltd.’s accounts The payment from FIXCARS (Pty) Ltd. is received on 16.12.20X4. The amount cashed in equals to: 36,000 - 1,800 = 34,200.00 EUR . (E) Payment received from the customer FIXCARS Ltd. on 16.12.20X4. DR Cash......................... 34,200.00 EUR CR Accounts Receivables......... 34,000.00 EUR At this point, the amount for sales at HETKRUIS Ltd. still contains the amount before discount. So does the one for VAT liabilities. HETKRUIS Ltd. makes the adjustments below to display the correct amounts on 16.12.20X4. The Discount Allowed account is closed-off to the Sales and VAT account. (F, G) Discount of sale (1) on 16.12.20X4 which is: 10,000 × 5% = 500.00 EUR . Adjustment for VAT equals to: 2,000 × 5% = 100.00 EUR . DR Sale......................... 500.00 EUR CR Discount Allowed............. 500.00 EUR DR VAT.......................... 100.00 EUR CR Discount Allowed............. 100.00 EUR (H, I) Discount of sale (2) on 16.12.20X4 which is: 8,000 × 5% = 400.00 EUR . Adjustment for VAT is: 1,600 × 5% = 80.00 EUR . <?page no="460"?> Berkau: BASICS of ACCOUNTING 36-459 DR Sale......................... 400.00 EUR CR Discount Allowed............. 400.00 EUR DR VAT.......................... 80.00 EUR CR Discount Allowed............. 80.00 EUR (J, K) Discount of sale (3) on 16.12.20X4 which is: 12,000 × 5% = 600.00 EUR . Adjustment for VAT is: 2,400 × 5% = 120.00 EUR . DR Sales........................ 600.00 EUR CR Discount Allowed............. 600.00 EUR DR VAT.......................... 120.00 EUR CR Discount Allowed............. 120.00 EUR Observe the accounts in Figure 36.4. Note, the Discount Allowed account is closed-off. D C D C (F) 500.00 (A) 10,000.00 (G) 100.00 (A) 2,000.00 (H) 400.00 (B) 8,000.00 (I) 80.00 (B) 1,600.00 (J) 600.00 (C) 12,000.00 (K) 120.00 (C) 2,400.00 c/ d 28,500.00 c/ d 5,700.00 30,000.00 30,000.00 6,000.00 6,000.00 b/ d 28,500.00 b/ d 5,700.00 D C D C (A) 12,000.00 (D) 1,800.00 (D) 1,800.00 (F) 500.00 (B) 9,600.00 (E) 34,200.00 (G) 100.00 (C) 14,400.00 (H) 400.00 36,000.00 36,000.00 (I) 80.00 (J) 600.00 (K) 120.00 1,800.00 1,800.00 D C ... (E) 34,200.00 Cash/ Bank Accounts receivables Discount allowed Sales VAT Figure 36.4: HETKRUIS Ltd.’s accounts <?page no="461"?> Berkau: BASICS of ACCOUNTING 36-460 Now, the amounts in the Sales account and in the VAT account are correct and can be transferred to the Profit and Loss account or to the statement of financial position. In some events, the agreement on the discount takes place after the balance sheet date. Assume in the previous case study, HETKRUIS Ltd. allows a discount, once a customer orders for 50,000.00 EUR within a period of 2 years. If the discount is allowed for purchases in past Accounting periods, an adjustment for inventories only will be made for goods still on stock. In order to dissolve the Discount account, we recommend posting the discount received for prior Accounting period’s purchase to inventories as far as possible and closing-off the Discount account to other income. In particular it is not intended to adjust finished goods for discounted parts included therein, purchased before the discount but eligible for it. However, the VAT account needs adjustment (for other income), too. We show a discount received for an acquisition in the next case study BELLICK AG. In that case study, the discount is allowed in the next Accounting period due to a customer’s complaint. BELLICK AG buys a laptop from a computer store and pays 1,512.00 EUR per bank transfer on 1.10.20X7. BELLICK AG intends to deploy the laptop 3 years. After that period the laptop is discarded. The Accountant makes the bookkeeping entry for the acquisition and posts the laptop to non-current assets, on 1.10.20X7. DR P, P, E Account.............. 1,260.00 EUR DR VAT.......................... 252.00 EUR CR Cash/ Bank.................... 1,512.00 EUR On 31.12.20X7, the Accountant records depreciation on the laptop. Depreciation equals to: 3 × 1,260/ 36 = 105.00 EUR . On 31.12.20X7, BELLICK AG depreciates the laptop. DR Depreciation................. 105.00 EUR CR Accumulated Depreciation..... 105.00 EUR BELLICK AG balances-off the accounts. Check the accounts in Figure 36.5. D C D C (1) 1,260.00 c/ d 1,260.00 ... (1) 1,512.00 b/ d 1,260.00 c/ d 1,512.00 1,512.00 1,512.00 b/ d 1,512.00 P, P, E Cash/ Bank Figure 36.5: BELLICK AG’s accounts as at 31.12.20X7 <?page no="462"?> Berkau: BASICS of ACCOUNTING 36-461 D C D C (1) 252.00 c/ d 252.00 (2) 105.00 c/ d 105.00 b/ d 252.00 b/ d 105.00 P&L 105.00 D C D C c/ d 105.00 (2) 105.00 Dpr 105.00 NL 105.00 b/ d 105.00 VAT Depreciation - 20X7 Acc depr Profit and Loss P&L 20X7 Figure 36.5: BELLICK AG’s accounts as at 31.12.20X7 (continued) (A) BELLICK AG receives a refund for input-VAT on the laptop to an extent of 252.00 EUR. DR Cash/ Bank.................... 252.00 EUR CR VAT.......................... 252.00 EUR On 1.04.20X8, the computer expert detects that the laptop does not have a 500 GB hard disk drive, as agreed on by the purchase contract, but only a 320 GB hard disk drive. The computer dealer offers to take back the laptop or to allow BELLICK AG a discount of 72.00 EUR immediately. BELLICK AG opts for the discount. As the discount is for an asset acquired in a past Accounting period, a deferred discount is recorded. (B) On 2.04.20X8, BELLICK AG’s Accountant records a discount to the extent of 72.00 EUR and its payment. DR Cash/ Bank.................... 72.00 EUR CR Discount Received............ 72.00 EUR (C … E) The discount does not change the asset valuation in the previous Accounting period. Also, BELLICK AG does not have to change previous depreciation. The amount is of minor value. However, BELLICK AG changes the value of the laptop as at 1.04.20X8 and adjusts depreciation thereon. The Accountant records three bookkeeping entries: DR Discount Received............ 72.00 EUR CR VAT.......................... 12.00 EUR CR P, P, E Account.............. 60.00 EUR <?page no="463"?> Berkau: BASICS of ACCOUNTING 36-462 Depreciation.................... 105.00 EUR CR Accumulated Depreciation..... 105.00 EUR Depreciation.................... 297.00 EUR CR Accumulated Depreciation..... 297.00 EUR The adjusted depreciation equals to: 9 × (1260 - 60 - 105 - 105)/ 30 = 297.00 EUR . The deferred discount received changes the value of the laptop and depreciation from the time the discount is received onwards. For major assets, IAS 8 might apply. Observe Figure 36.6 for BELLICK AG’s accounts as at 31.12.20X8. They show the bookkeeping entries for the deferred discount received. D C D C (1) 1,260.00 c/ d 1,260.00 ... (1) 1,512.00 b/ d 1,260.00 (C) 60.00 c/ d 1,512.00 c/ d 1,512.00 1,512.00 (A) 252.00 b/ d 1,512.00 (B) 72.00 P, P, E Cash/ Bank D C D C (1) 252.00 c/ d 252.00 (D) 105.00 b/ d 252.00 (A) 252.00 (E) 297.00 c/ d 402.00 c/ d 12.00 (C) 12.00 402.00 402.00 264.00 264.00 b/ d 402.00 P&L 402.00 b/ d 12.00 VAT Depreciation-20X8 D C D C c/ d 105.00 (2) 105.00 Dpr 402.00 NL 402.00 b/ d 105.00 (D) 105.00 c/ d 507.00 (E) 297.00 507.00 507.00 b/ d 507.00 D C (C) 60.00 (B) 72.00 (C) 12.00 72.00 72.00 Acc depr Profit and Loss P&L 20X8 Discount received Figure 36.6: BELLICK AG’s accounts as at 31.12.20X8 <?page no="464"?> Berkau: BASICS of ACCOUNTING 36-463 Summary: Discounts can be received or allowed. The consideration of discounts is required along the IFRSs and national GAAPS, e.g., the German Handelsgesetzbuch. They state that the entries in the Purchaseor Property, Plant and Equipment account, in the Sales account and in the VAT account are ex discounts. Discounts are recorded once notice is taken thereof. For discounts known at the time of purchase/ sale, an instant discount is recorded. This leads to a reduction of amounts. In all other cases, when the decision about the discount is made after recording the purchase/ sales, a deferred discount is recorded. Then, the Discount accounts (Discount Received account or Discount Allowed account) apply. Working Definition: Discount Account: A Discount account is a temporary account to record discounts. <?page no="465"?> Berkau: BASICS of ACCOUNTING 37-464 37. Cash Book: Reconciliation with the Bank Statement Learning Objectives: Accountants represent bank accounts by internal accounts being subordinated to the Cash/ Bank account. The bank itself makes bookkeeping entries parallel to the Accountants of the account holding company, too. In this chapter we point out how to compare accounts with bank statements and how to adjust differences therein. After studying this chapter, you can explain reasons for differences between the bookkeeping records and the bank statements and you can reconcile the bank statements with the bookkeeping records. A bank statement is a summary of all activities with the bank over an Accounting period. Mostly, bank statements are printed on demand (online banking) or will be sent to the account holder monthly by the bank. An example for a bank statement is depicted by Figure 37.1. In general, the bank statement comes in a 3-column format and not as T-account, such as we are used to. Furthermore, consider the bank statement being prepared always from the bank’s point of view. This means, money you have in the bank account is regarded as payables by the bank. The reason is, the bank has to pay the money in the accounts back to the account holder. Accordingly, bank deposits will be printed on the credit side of the bank statement and withdrawals on its debit side. We take a closer look at a bank statement issued by the PROTEM BANK Ltd. for KRAGGA CONSULTANTS (Pty) Ltd. on 31.12.20X5. KRAGGA CONSULTANTS is established on 3.01.20X5 by a share issue of 100,000 ordinary shares at 1.00 EUR each. The company opened an account with PROTEM BANK on 3.01.20X5 and deposited the funds resulting from the share issue therein. The bank statement in Figure 37.1 shows bank transactions made by/ for KRAGGA CONSULTANTS (Pty) Ltd. as below: A deposit is any transaction to put money into a bank account. A deposit can be made by the account holder or by, e.g., a customer thereof. It can be done by visiting a bank and filling a deposit slip. Alternatively, an electronic fund transfer (EFT) can be made by internet banking. Receiving a stop order (see below) can be another way to receive funds. A stop order is an agreement with the bank to pay regularly money into another account. A stop order can be for monthly payments, for quarterly payments, etc. The order is called stop order as it continues until the account holder will stop it. A debit order is an order to let someone draw money from an account. It means the party that issues the debit order, allows the bank of the debit order receiving party to withdraw a certain amount of money from the account. <?page no="466"?> Berkau: BASICS of ACCOUNTING 37-465 Date Description/ narrative Fees Debits Credits Balance 3.01.20X5 Opening account 50.00 (50.00) 3.01.20X5 Deposit 100,000.00 99,950.00 7.01.20X5 Insurance 23049234 (stop order) 1.00 100.00 99,849.00 8.01.20X5 Debit order 4564684 60,000.00 39,849.00 9.01.20X5 Payment to 3rd party: Cell phone 0.50 360.00 39,488.50 24.03.20X5 Deposit 565432 240,000.00 279,488.50 7.04.20X5 Insurance 23049234 (stop order) 1.00 100.00 279,387.50 8.04.20X5 Withdrawal ATM 1.00 5,000.00 274,386.50 30.06.20X5 Service fees I-VI/ 20X5 6.00 274,380.50 7.7.20X5 Insurance 23049234 (stop order) 1.00 100.00 274,279.50 9.07.20X5 Deposit 015824 6,000.00 280,279.50 12.07.20X5 Cheque 546431 6,500.00 273,779.50 7.10.20X5 Insurance 23049234 (stop order) 1.00 100.00 273,678.50 25.11.20X5 EFT deposit 902323 54,000.00 327,678.50 25.11.20X5 EFT charges 2.00 327,676.50 20.12.20X5 Labour (stop order) 10.00 170,000.00 157,666.50 31.12.20X5 Service fees VII-XII/ 20X5 6.00 157,660.50 31.12.20X5 Interest income 2,969.85 160,630.35 31.12.20X5 Closing balance 160,630.35 PROTEM BANK LIMITED Registered Bank - Reg. no. 451/ 5413/ 078 STATEMENT / TAX INVOICE Kragga Consultants (Pty) Ltd. as at 31.12.20X5 Figure 37.1: KRAGGA CONSULTANTS (Pty) Ltd.’s bank statement A cheque is an alternative way of payment also. One party that issues (draws) a cheque allows the receiving party to withdraw money from its account. If there are sufficient funds the bank will transfer the money. Otherwise, the bank resends the cheque marked as R/ D = Refer to drawer. A returned cheque is called bounced or dishonoured. In case a cheque has not been cleared for more than 6 months, it will expire. The technical term for such a cheque will be a stale cheque. Cheques also can be cancelled by the issuer - e.g., if a customer does not receive the goods ordered he will makes use of this possibility to cancel the payment. Service fees are bank fees for running an account. They are levied based on periods (pro rata temporis) or on the amount of transactions. A withdrawal is taking cash out of a bank account. This can be done in the bank at a counter or through an automatic teller machine (ATM). An EFT transfer is a transfer made by internet banking. EFT stands for electronic funds transfer. EFT charges mean that the bank charges a transfer fee for using internet banking. Some banks charge the customer per transaction. Interest income is revenue earned by keeping money in an account. The bank determines the amount by <?page no="467"?> Berkau: BASICS of ACCOUNTING 37-466 an annual interest rate pro rata temporis based on the time the funds are in the account. Special terms may apply. At the end of the Accounting period, the bank statement indicates a closing balance for KRAGGA CONSULTANTS (Pty) Ltd. of 100,603.23 EUR. Before we reconcile the bank statement with the bookkeeping records, we take a closer look at KRAGGA CONSULTANTS (Pty) Ltd.’s accounts. Observe the bookkeeping entries made. Later, we’ll take its Cash/ Bank account and compare it to the bank statement. KRAGGA CONSULTANTS (Pty) Ltd. issues 100,000 1.00 EUR ordinary shares par value on 3.01.20X4. (1) Share issue on 3.01.20X4. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR KRAGGA CONSULTANTS (Pty) Ltd. agrees on an insurance contract to cover risks caused by faulty consultation. The insurance fees are 100.00 EUR per quarter payable on 7th of each quarter. (2, 5) Insurance payments take place on 7.01.20X5, 7.04.20X5, 7.07.20X5 and 7.10.20X5. DR Insurance.................... 100.00 EUR CR Cash/ Bank.................... 100.00 EUR DR Insurance.................... 100.00 EUR CR Cash/ Bank.................... 100.00 EUR DR Insurance.................... 100.00 EUR CR Cash/ Bank.................... 100.00 EUR DR Insurance.................... 100.00 EUR CR Cash/ Bank.................... 100.00 EUR On 8.01.20X5, KRAGGA CONSULTANTS (Pty) Ltd. buys computers and printers and pays 60,000.00 EUR by allowing the computer supplier to draw the amount from their bank account. The firm issues a debit order. (6) Acquisition of computers on 8.01.20X5. DR P, P, E Account.............. 50,000.00 EUR DR VAT.......................... 10,000.00 EUR CR Cash/ Bank.................... 60,000.00 EUR (7) On 9.01.20X5, KRAGGA CONSULTANTS (Pty) Ltd. buys a prepaid phone and pays 360.00 EUR via bank transfer. <?page no="468"?> Berkau: BASICS of ACCOUNTING 37-467 DR P, P, E Account.............. 360.00 EUR DR VAT.......................... 60.00 EUR CR Cash/ Bank.................... 300.00 EUR On 24.03.20X5, a customer transfers 240,000.00 EUR into KRAGGA CONSULTANTS (Pty) Ltd.’s bank account for consultancy bills. (8) Rendering service on 24.03.20X4. DR Cash/ Bank.................... 240,000.00 EUR CR VAT.......................... 40,000.00 EUR CR Revenue...................... 200,000.00 EUR On 8.04.20X5, the Accountant withdraws money from the bank account and puts it to cash. He uses a special account for cash called Petty Cash Book which is physically often just a box with money therein. (Note, we’ll introduce the petty cash book in the next chapter Petty Cash Book.) So far, the Petty Cash Book is a further cash account. (9) Withdrawal of money on 8.04.20X5. DR Petty Cash Book.............. 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR (10) On 9.07.20X5, a customer deposits 6,000.00 EUR in the bank account for consultancy service. DR Cash/ Bank.................... 6,000.00 EUR CR VAT.......................... 1,000.00 EUR CR Revenue...................... 5,000.00 EUR On 12.07.20X5, KRAGGA CONSULTANTS (Pty) Ltd. pays rent. There is no VAT to be considered. KRAGGA CONSULTANTS (Pty) Ltd. sends a cheque to its landlord. (11) Payment for rent on 12.07.20X5. DR Rent......................... 6,500.00 EUR CR Cash/ Bank.................... 6,500.00 EUR On 25.11.20X5, KRAGGA CONSULTANTS (Pty) Ltd. receives 54,000.00 EUR per electronic bank transfer from a customer for consultancy service. (12) Revenue received on 25.11.20X5. DR Cash/ Bank.................... 54,000.00 EUR CR VAT.......................... 9,000.00 EUR CR Revenue...................... 45,000.00 EUR <?page no="469"?> Berkau: BASICS of ACCOUNTING 37-468 KRAGGA CONSULTANTS (Pty) Ltd. pays their employees by stop order. The total payment amounts to 230,000.00 EUR. The money is paid-off on 20.12.20X5. (13) Payment for labour by stop order on 20.12.20X5. DR Labour....................... 230,000.00 EUR CR Cash/ Bank.................... 230,000.00 EUR At this stage, the bookkeeper has not yet seen the bank statement and balancesoff all accounts without making changes or adjustments. See the accounts in Figure 37.2: D C D C (1) 100,000.00 (2) 100.00 c/ d 100,000.00 (1) 100,000.00 (8) 240,000.00 (3) 100.00 b/ d 100,000.00 (10) 6,000.00 (4) 100.00 (12) 54,000.00 (5) 100.00 (6) 60,000.00 (7) 360.00 (9) 5,000.00 (11) 6,500.00 (13) 170,000.00 c/ d 157,740.00 400,000.00 400,000.00 b/ d 157,740.00 D C D C (2) 100.00 (6) 50,000.00 (3) 100.00 (7) 300.00 c/ d 50,300.00 (4) 100.00 50,300.00 50,300.00 (5) 100.00 c/ d 400.00 b/ d 50,300.00 400.00 400.00 b/ d 400.00 D C D C (6) 10,000.00 (8) 40,000.00 (8) 200,000.00 (7) 60.00 (10) 1,000.00 (10) 5,000.00 c/ d 39,940.00 (12) 9,000.00 c/ d 250,000.00 (12) 45,000.00 50,000.00 50,000.00 250,000.00 250,000.00 b/ d 39,940.00 b/ d 250,000.00 VAT Sales Cash/ Bank Issued capital Insurance P, P, E Figure 37.2: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts <?page no="470"?> Berkau: BASICS of ACCOUNTING 37-469 D C D C (9) 5,000.00 c/ d 5,000.00 (11) 6,500.00 c/ d 6,500.00 b/ d 5,000.00 b/ d 6,500.00 D C (13) 170,000.00 c/ d 170,000.00 b/ d 170,000.00 Labour Petty cash book Rent Figure 37.2: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts (continued) The Cash/ Bank account displays a balancing figure of 157,740.00 EUR. This is: 160,630.35 - 157,740 = 2,890.35 EUR less than displayed by the bank statement in Figure 37.1. For the explanation of the difference and to adjust the bookkeeping records, we reconcile the bank statement with the bookkeeping records. The reason for the bank reconciliation is that the reporting company has to ensure that the amount for the cash/ bank item on the statement of financial position is correct. The reconciliation process in particular makes sure, all available information provided by the bank statement is used to determine the correct amount for the cash/ bank item on the face of the statement of financial position. Reconciliation items therefore only appear in the Cash/ Bank account or on the bank statement but never in both at the same time. How it is done (bank statement reconciliation): (1) Compare the Cash/ Bank account to the bank statement provided. (2) Add bank fees withdrawn from the bank account without further notice. (3) Adjust timely differences in the Cash/ Bank account. (4) Calculate interest earned if there is any on a pro rata temporis basis. (5) Compare the adjusted Cash/ Bank account to the bank statement. We compare the Cash/ Bank account and the bank statement by checking debit entries in the bank account with credit entries in the bank statement and vice versa. The differences in KRAGGA CONSALTANTS (Pty) Ltd.’s case are marked in Figure 37.3 and Figure 37.4: <?page no="471"?> Berkau: BASICS of ACCOUNTING 37-470 D C (1) 100,000.00 (2) 100.00 (8) 240,000.00 (3) 100.00 (10) 6,000.00 (4) 100.00 (12) 54,000.00 (5) 100.00 (6) 60,000.00 (7) 360.00 (9) 5,000.00 (11) 6,500.00 (13) 170,000.00 c/ d 157,740.00 400,000.00 400,000.00 b/ d 157,740.00 Cash/ Bank Figure 37.3: KRAGGA CONSULTANTS (Pty) Ltd.’s Cash/ Bank account Date Description/ narrative Fees Debits Credits 3.01.20X5 Opening account 50.00 3.01.20X5 Deposit 100,000.00 7.01.20X5 Insurance 23049234 (stop order) 1.00 100.00 8.01.20X5 Debit order 4564684 60,000.00 9.01.20X5 Payment to 3rd party: Cell phone 0.50 360.00 24.03.20X5 Deposit 565432 240,000.00 7.04.20X5 Insurance 23049234 (stop order) 1.00 100.00 8.04.20X5 Withdrawal ATM 1.00 5,000.00 30.06.20X5 Service fees I-VI/ 20X5 6.00 7.7.20X5 Insurance 23049234 (stop order) 1.00 100.00 9.07.20X5 Deposit 015824 6,000.00 12.07.20X5 Cheque 546431 6,500.00 7.10.20X5 Insurance 23049234 (stop order) 1.00 100.00 25.11.20X5 EFT deposit 902323 54,000.00 25.11.20X5 EFT charges 2.00 20.12.20X5 Labour (stop order) 10.00 170,000.00 31.12.20X5 Service fees VII-XII/ 20X5 6.00 31.12.20X5 Interest income 2,969.85 31.12.20X5 Closing balance PROTEM BANK LIMITED Registered Bank - Reg. no. 451/ 5413/ 078 STATEMENT / TAX INVOICE Kragga Consultants (Pty) Ltd. as at 31.12.20X5 Figure 37.4: KRAGGA CONSULTANTS (Pty) Ltd.’s bank statement Here, there are no reconciliation items in the Cash/ Bank account, but on the bank statement. The items represent bank fees. They do not get billed extra but are deducted from the bank account. The Accountant of KRAGGA CONSULTANTS (Pty) Ltd. makes an adjustment bookkeeping entry on 31.12.20X5 for all bank charges. The amount equals to: 50 + 1 + 0.50 + 1 + 1 + 6 + 1 + 1 + 2 + 10 + 6 <?page no="472"?> Berkau: BASICS of ACCOUNTING 37-471 = 79.50 EUR . The bookkeeping entry according to this calculation is as follows and will be referred to as reconciliation 1 (RC1): DR Bank Fees.................... 79.50 EUR CR Cash/ Bank.................... 79.50 EUR There is another entry on the bank statement for earned interest. The bank pays for money kept in the bank account an annual interest by a rate of 1.5 %/ a. The interest is earned pro rata temporis which means based on the time the money is in the account. The daily rate of interest is 1.5%/ 365 = 0.000041 EUR/ d (rounded off). The interest earned is calculated based on the balances on the bank statement. Take the first balance which is 99,950.00 EUR. The amount is in the bank account for 4 days (from the 3.01.20X5 until 7.01.20X5). The interest earned during these days is 99,950 × 4 × 1.5% / 365 = 16.43 EUR . Accountants do not monitor the bank’s interest calculation. However, based on a spread sheet program it is fairly easy to determine the amount for earned interest. The amount here is 16.43 + 4.10 + 1.64 + 24.34 + 149.32 + 11.48 + 981.03 + 78.93 + 22.54 + 34.56 + 1,035.11 + 202.45 + 336.65 + 71.27 = 2,969.85 EUR .) The interest earned is credited to the Interest Earned account by the following bookkeeping entry, which is referred to as reconciliation 2 (RC2). DR Cash/ Bank.................... 2,969.85 EUR CR Interest Earned.............. 2,969.85 EUR After these adjustments, KRAGGA CONSULTANTS (Pty) Ltd.’s accounts look as displayed by Figure 37.5. . <?page no="473"?> Berkau: BASICS of ACCOUNTING 37-472 D C D C (1) 100,000.00 (2) 100.00 c/ d 100,000.00 (1) 100,000.00 (8) 240,000.00 (3) 100.00 b/ d 100,000.00 (10) 6,000.00 (4) 100.00 (12) 54,000.00 (5) 100.00 (6) 60,000.00 (7) 360.00 (9) 5,000.00 (11) 6,500.00 (13) 170,000.00 c/ d 157,740.00 400,000.00 400,000.00 b/ d 157,740.00 RC1 79.50 RC2 2,969.85 c/ d 160,630.35 160,709.85 160,709.85 160,630.35 Cash/ Bank Issued capital D C D C (2) 100.00 (6) 50,000.00 (3) 100.00 (7) 300.00 c/ d 50,300.00 (4) 100.00 50,300.00 50,300.00 (5) 100.00 c/ d 400.00 b/ d 50,300.00 400.00 400.00 b/ d 400.00 D C D C (6) 10,000.00 (8) 40,000.00 (8) 200,000.00 (7) 60.00 (10) 1,000.00 (10) 5,000.00 c/ d 39,940.00 (12) 9,000.00 c/ d 250,000.00 (12) 45,000.00 50,000.00 50,000.00 250,000.00 250,000.00 b/ d 39,940.00 b/ d 250,000.00 Insurance P, P, E VAT Sales D C D C (9) 5,000.00 c/ d 5,000.00 (11) 6,500.00 c/ d 6,500.00 b/ d 5,000.00 b/ d 6,500.00 D C D C (13) 170,000.00 c/ d 170,000.00 RC1 79.50 c/ d 79.50 b/ d 170,000.00 b/ d 79.50 Labour Bank fees Petty cash book Rent Figure 37.5: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts <?page no="474"?> Berkau: BASICS of ACCOUNTING 37-473 D C c/ d 2,969.85 RC2 2,969.85 b/ d 2,969.85 Interest earned Figure 37.5: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts (continued) The balancing figure of the Cash/ Bank account now is 160,630.35 EUR - same as on the bank statement. KRAGGA CONSULTANTS (Pty) Ltd.’s Accountant prepares the financial statements as below. Closing-off expense accounts to the Profit and Loss account. DR Profit and Loss.............. 400.00 EUR CR Insurance.................... 400.00 EUR DR Profit and Loss.............. 6,500.00 EUR CR Rent......................... 6,500.00 EUR DR Profit and Loss.............. 170,000.00 EUR CR Labour....................... 170,000.00 EUR Closing-off the Sales account and Interest Earned Account to the Profit and Loss account. DR Sales........................ 250,000.00 EUR CR Profit and Loss.............. 250,000.00 EUR DR Interest Earned.............. 2,969.85 EUR CR Profit and Loss.............. 2,969.85 EUR The earnings before taxes amount to 75,990.35 EUR. The amount for income tax expenses is: 30% × 75,990.35 = 22,797.11 EUR . The remaining amount is: 75,990.35 - 22,797.11 = 53,193.24 EUR . KRAGGA CONSULTANTS (Pty) Ltd.’s accounts after adjustments are shown by Figure 37.6: <?page no="475"?> Berkau: BASICS of ACCOUNTING 37-474 D C D C (1) 100,000.00 (2) 100.00 c/ d 100,000.00 (1) 100,000.00 (8) 240,000.00 (3) 100.00 b/ d 100,000.00 (10) 6,000.00 (4) 100.00 (12) 54,000.00 (5) 100.00 (6) 60,000.00 (7) 360.00 (9) 5,000.00 (11) 6,500.00 (13) 170,000.00 c/ d 157,740.00 400,000.00 400,000.00 b/ d 157,740.00 RC1 79.50 RC2 2,969.85 c/ d 160,630.35 160,709.85 160,709.85 160,630.35 D C D C (2) 100.00 (6) 50,000.00 (3) 100.00 (7) 300.00 c/ d 50,300.00 (4) 100.00 50,300.00 50,300.00 (5) 100.00 c/ d 400.00 b/ d 50,300.00 400.00 400.00 b/ d 400.00 P&L 400.00 D C D C (6) 10,000.00 (8) 40,000.00 (8) 200,000.00 (7) 60.00 (10) 1,000.00 (10) 5,000.00 c/ d 39,940.00 (12) 9,000.00 c/ d 250,000.00 (12) 45,000.00 50,000.00 50,000.00 250,000.00 250,000.00 b/ d 39,940.00 P&L 250,000.00 b/ d 250,000.00 Cash/ Bank Issued capital Insurance P, P, E VAT Sales D C D C (9) 5,000.00 c/ d 5,000.00 (11) 6,500.00 c/ d 6,500.00 b/ d 5,000.00 b/ d 6,500.00 P&L 6,500.00 D C D C (13) 170,000.00 c/ d 170,000.00 RC1 79.50 c/ d 79.50 b/ d 170,000.00 P&L 170,000.00 b/ d 79.50 P&L 79.50 Labour Bank fees Petty cash book Rent Figure 37.6: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts <?page no="476"?> Berkau: BASICS of ACCOUNTING 37-475 D C D C c/ d 2,969.85 RC2 2,969.85 Ins 400.00 Rev 250,000.00 P&L 2,969.85 b/ d 2,969.85 Rnt 6,500.00 Int 2,969.85 Lab 170,000.00 Fee 79.50 NP 75,990.35 252,969.85 252,969.85 ITL 22,797.11 b/ d 75,990.35 R/ E 53,193.25 75,990.35 75,990.35 D C D C c/ d 22,797.11 P&L 22,797.11 c/ d 53,193.25 P&L 53,193.25 b/ d 22,797.11 b/ d 53,193.25 Interest earned Profit and Loss P&L Income tax liabilities ITL Retained earnings R/ E Figure 37.6: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts (continued) See below the financial statements for KRAGGA CONSULTANTS (Pty) Ltd. Interest earned is categorized as other income. The bank fees count as other expenses. They cannot be financial costs such as interest, because they are fees. They are to be seen as 3 rd party expenses. The other expenses contain fees for the bank, insurance and rent: 79.50 + 6,500 + 400 = 6,979.50 EUR . [EUR] Revenue 250,000.00 Other income 2,969.85 252,969.85 Materials 0.00 Labour 170,000.00 Depreciation 0.00 Other expenses 6,979.50 Earnings before int and taxes (EBIT) 75,990.35 Interest 0.00 Earnings before taxes (EBT) 75,990.35 Income tax expenses 22,797.11 Deferred taxes Earnings after taxes (EAT) 53,193.25 Kragga Consultants (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X5 Figure 37.7: KRAGGA CONSULTANTS (Pty) Ltd.’s statement of comprehensive income <?page no="477"?> Berkau: BASICS of ACCOUNTING 37-476 In the statement of financial position, the amount for cash/ bank is: 160,630.35 + 5,000 = 165,630.35 EUR because the petty cash book is considered a cash account also. The amount for payables contains VAT to an extent of 39,940.00 EUR. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 50,300.00 Share capital 100,000.00 Intangibles Reserves Financial assets R/ E 53,193.25 Current assets Liabilities Inventory Interest bear liab 0.00 A/ R A/ P 39,940.00 Prepaid expenses Provisions Cash/ Bank 165,630.35 Tax liabilities 22,797.11 215,930.35 215,930.36 Kragga Consultants (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 37.8: KRAGGA CONSULTANTS (Pty) Ltd.’s statement of financial position Summary: The bank statement reveals further information which is not always directly available to the Accountant in the first place. Also, items can be missing in the bank statements which have been posted in the Accounting records due to timely differences. The reconciliation process compares the bookkeeping records to the bank statement and contains adjustments to make sure, all actual information for the cash and cash equivalent item of the statement of financial position and for the income statement (such as bank fees) are considered. Working Definitions: Bank Statement: A bank statement is a summary of all activities with the bank over an Accounting period. Deposit: A deposit is any transaction to put money into a bank account. A deposit can be made by yourself or by a customer for example. Stop order: A stop order is an agreement with the bank to pay regularly money into another account. Debit order: A debit order is an order to let someone draw money from an account. Cheque: A cheque is an alternative way of payment also. One party that issues (draws) a cheque allows the receiving party to withdraw money from its account. <?page no="478"?> Berkau: BASICS of ACCOUNTING 37-477 Service Fees: Service fees are bank fees for running an account. Withdrawal: A withdrawal is taking cash out of an account. This can be done in the bank or through an automatic teller machine (ATM). EFT Transfer: An EFT transfer is a transfer made by internet banking. EFT stands for electronic funds transfer. EFT Charges: EFT charges mean that the bank charges a transfer fee for using internet banking. Interest Income: Interest income is revenue earned by keeping money in the account. <?page no="479"?> Berkau: BASICS of ACCOUNTING 38-478 38. Petty Cash Book Learning Objectives: In this chapter we’ll explain how to apply the concept of the petty cash book and the imprest system (reimbursements) by the case study SWART- KLIP Ltd. After studying this chapter, you can apply the Petty Cash Book. Not all purchases and acquisitions go through bank accounts. Some activities are of minor value/ importance and are bought on cash. E.g., office errands are paid on cash. For keeping bookkeeping records and prepare proper income statements, it is necessary to assign even minor expenditures to the right expense accounts. It is common practice to run Petty Cash Books. The Petty Cash Book is a record for minor purchases bought on cash. At the beginning of the Accounting period, an amount - referred to as petty cash float - is paid to the keeper of the Petty Cash Book. The petty cash float is the initial amount in the petty cash book. After making purchases, the receipts are allocated to the applicable expense accounts, such as the Office Materials-, Decorationsor Business Entertainment account. Later on, the Petty Cash Book is filled up again, which means, an amount is paid into the Petty Cash Book, so that the petty cash float is reached again. The person responsible for the Petty Cash Book is called the petty cashier. In general, companies apply several petty cash books in their departments. We explain the Petty Cash Book by the case study SWARTKLIP Ltd., which contains expenses that are recorded through the petty cash book and compare it to expenditures passing it, because they are posted straight to normal expenses. How it is done (Petty Cash Book): (1) Draw an amount of cash from the Cash/ Bank account and debit it to the Petty Cash Book. This amount is the petty cash float. (2) Determine rules which kind of expenses will be recorded by the petty cash book and which ones do not. (3) When an expense is paid for, that is Petty Cash Book relevant, credit the gross amount to the petty cash book and make debit entries for input-VAT and particular expense columns therein. (4) At the end of the Accounting period or when the petty cash float has been finished, add expenses. (5) Transfer the sum of expenses and the sum of input- VAT to the expense accounts and the VAT account. (6) Reimburse the petty cashier for the money spent. <?page no="480"?> Berkau: BASICS of ACCOUNTING 38-479 SWARTKLIP Ltd. is an Accounting firm. The company prepares financial statements for its customers. SWARTKLIP Ltd. is established on 2.01.20X7 by a share issue. It issues 50,000 ordinary shares at 1.00 EUR each. The funds are put into the Bank account. SWARTKLIP Ltd. runs one Bank account, one Cash account and one Petty Cash Book. It does not mingle cash with bank. (1) Share issue on 2.01.20X7. DR Bank Account................. 50,000.00 EUR CR Issued Capital............... 50,000.00 EUR On 2.01.20X7, SWARTKLIP Ltd. takes a bank loan for financing its business from their local bank. SWARTKLIP Ltd. lends 100,000.00 EUR. The annual rate of interest is 3.5 % and is deducted from the Bank account at the end of the Accounting period. So is the pay-off amount, which is 5,000.00 EUR every year. When the bank loan is paid to SWARTKLIP Ltd., the amount is transferred into their Bank account. The first year’s interest amounts to: 3.5% × 100,000 = 3,500.00 EUR . (2, 4b) Payments resulting from the bank loan on 2.01.20X7 (the first one) and 31.12.20X7 (the latter ones). DR Bank Account................. 100,000.00 EUR CR Interest Bearing Liabilities. 100,000.00 EUR DR Interest..................... 3,500.00 EUR CR Bank Account................. 3,500.00 EUR DR Interest Bearing Liabilities. 5,000.00 EUR CR Bank Account................. 5,000.00 EUR DR Interest Bearing Liabilities. 5,000.00 EUR CR Accounts Payables............ 5,000.00 EUR On 3.01.20X7, SWARTKLIP Ltd. acquires computers and printers at a total amount of 84,000.00 EUR (net amount). The payment is made through the Bank account. (5) Acquisition of computer hardware on 3.01.20X7. DR P, P, E Account.............. 70,000.00 EUR DR VAT.......................... 14,000.00 EUR CR Bank Account................. 84,000.00 EUR The computer hardware is written off based on annual basis along straight line method. The useful life of hardware is 3.5 years. The depreciation amount for 20X7 is: 70,000 / 3.5 = 20,000.00 EUR/ a . (6) Depreciation on computer hardware on 31.12.20X7. <?page no="481"?> Berkau: BASICS of ACCOUNTING 38-480 DR Depreciation................. 20,000.00 EUR CR Acc. Depr.................... 20,000.00 EUR SWARTKLIP Ltd. pays rent for their offices on 6.01.20X7 to an extent of a full year’s rent. The landlord is not registered for VAT reduction. The amount for rent is 10,000.00 EUR. SWARTKLIP Ltd. transfers the amount via internet banking into the landlord’s bank account. (7) Rent payment on 6.01.20X7. DR Rent......................... 10,000.00 EUR CR Bank Account................. 10,000.00 EUR SWARTKLIP Ltd.’s Accountant withdraws 1,000.00 EUR on 15.01.20X7 at an automatic teller machine (ATM). The amount is put into the Cash account. (8) Money withdrawn on 15.01.20X7. DR Cash Account................. 1,000.00 EUR CR Bank Account................. 1,000.00 EUR In the back office, the employee Ms Dana works. On 20.01.20X7, she is appointed petty cashier for the back office department. The Accountant gives her the petty cash float of 500.00 EUR. The money is for minor office and company expenses. At the end of every Accounting period, the Petty Cash Book is filled up again to that amount. (9) Paying the petty cash float into the Petty Cash Book on 20.01.20X7. DR Petty Cash Book.............. 500.00 EUR CR Cash Account................. 500.00 EUR On 21.01.20X7, Ms Dana buys office materials at the local stationary shop such as punchers, staplers and pencils. The amount she pays at the stationary store is 240.00 EUR. She takes the receipt and keeps it for later refunds. Ms Dana got a template from her Accountant in order to record purchases therein. The template is based on MS Excel and looks as depicted in Figure 38.1. She enters the amounts net amounts and VAT separately into the petty cash book template. <?page no="482"?> Berkau: BASICS of ACCOUNTING 38-481 Date Narrative Input VAT Stationary Catering Decoration Business car 20.01.20X7 Opening PCB 500.00 21.01.20X7 Buying stationary, receipt_001 (40.00) (200.00) 500.00 (40.00) (200.00) 0.00 0.00 0.00 Swartklip Ltd.'s (back office) PETTY CASH BOOK as at 31.12.20X7 Figure 38.1: SWARTKLIP Ltd.‘s Petty Cash Book (1) Ms Dana also purchases paper at the stationary shop on 30.01.20X7. In contrast to the stationary tools, she orders the paper and asks for delivery into the office. The stationary store delivers the paper and sends the bill, which is transferred to the Accountant after Ms Dana confirmed the goods’ receipt. He pays the paper bill by internet banking on 2.02.20X7. Its net amount is 120.00 EUR (10) Purchase of paper on 30.01.20X7. DR Purchase..................... 100.00 EUR DR VAT.......................... 20.00 EUR CR Accounts Payables............ 120.00 EUR (11) Payment for the paper bill on 2.02.20X7. DR Accounts Payables............ 120.00 EUR CR Bank Account................. 120.00 EUR The amount of 120.00 EUR does not go through the Petty Cash Book. (12) The paper is transferred the Stationary Expenses account which is for all kind of office material expenses, on 2.02.20X7. The name indicates that these items are considered being consumables. This means, the puncher or stapler won’t get depreciated but will be expensed in 20X7 in full. DR Stationary Expenses.......... 100.00 EUR CR Purchase..................... 100.00 EUR SWARTKLIP Ltd. runs a perpetual inventory system for office materials. On 24.02.20X7, SWARTKLIP Ltd. expects a new customer coming for a meeting into the office. Ms Dana has to go to the flower shop and buy some flowers for 27.00 EUR. She further goes to the fruit shop and buys some fruits to be offered during the meeting. The fruits cost 12.00 EUR. At the local grocery store, she buys biscuits and instant coffee. The receipt <?page no="483"?> Berkau: BASICS of ACCOUNTING 38-482 she got in the grocery shop shows expenses to the extent of 18.00 EUR. Once back in the office, she enters her errands into the petty cash book template. It looks now as shown in Figure 38.2: Date Narrative Input VAT Stationary Catering Decoration Business car 20.01.20X7 Opening PCB 500.00 21.01.20X7 Buying stationary, receipt_001 (40.00) (200.00) 24.02.20X7 Flowers, receipt_002 (4.50) (22.50) 24.02.20X7 Fruits, receipt_003 (2.00) (10.00) 24.02.20X7 Groceries, receipt_004 (3.00) (15.00) 500.00 (49.50) (200.00) (25.00) (22.50) 0.00 Swartklip Ltd.'s (back office) PETTY CASH BOOK as at 31.12.20X7 Figure 38.2: SWARTKLIP Ltd.’s petty cash book (2) On 4.03.20X7, Ms Dana has to fuel-up the business car and to buy some ball pens at the stationary shop. Fuelling-up the car costs 69.00 EUR and she pays 30.00 EUR at the stationary shop. Now, the petty cash book looks as shown in Figure 38.3: Date Narrative Input VAT Stationary Catering Decoration Business car 20.01.20X7 Opening PCB 500.00 21.01.20X7 Buying stationary, receipt_001 (40.00) (200.00) 24.02.20X7 Flowers, receipt_002 (4.50) (22.50) 24.02.20X7 Fruits, receipt_003 (2.00) (10.00) 24.02.20X7 Groceries, receipt_004 (3.00) (15.00) 4.03.20X7 Gas station, receipt_005 (11.50) (57.50) 4.03.20X7 Stationary shop, receipt_006 (5.00) (25.00) 500.00 (66.00) (225.00) (25.00) (22.50) (57.50) Swartklip Ltd.'s (back office) PETTY CASH BOOK as at 31.12.20X7 Figure 38.3: SWARTKLIP Ltd.’s petty cash book (3) Later, Ms Dana presents all receipts at the Accountant. The total of gross amounts in the Petty Cash Book adds up to an amount of: 240 + 27 + 12 + 18 + 69 + 30 = 396.00 EUR . The Accountant pays the amount of 396.00 EUR into the Petty Cash Book on 5.03.20X7. He actually <?page no="484"?> Berkau: BASICS of ACCOUNTING 38-483 takes the amount out of cash and gives it to Ms Dana. (13) Refunding petty cash book for expenses on 5.03.20X7. DR Petty Cash Book.............. 396.00 EUR CR Cash......................... 396.00 EUR In case the total of the bottom line is summarized the amount will be: 896 - 66 - 225 - 25 - 22.50 - 57.50 = 500.00 EUR again. This is the amount of the petty cash float. Observe the Petty Cash Book in Figure 38.4: Date Narrative Input VAT Stationary Catering Decoration Business car 20.01.20X7 Opening PCB 500.00 21.01.20X7 Buying stationary, receipt_001 (40.00) (200.00) 24.02.20X7 Flowers, receipt_002 (4.50) (22.50) 24.02.20X7 Fruits, receipt_003 (2.00) (10.00) 24.02.20X7 Groceries, receipt_004 (3.00) (15.00) 4.03.20X7 Gas station, receipt_005 (11.50) (57.50) 4.03.20X7 Stationary shop, receipt_006 (5.00) (25.00) 5.03.20X7 Refunding all expenses so far 396.00 896.00 (66.00) (225.00) (25.00) (22.50) (57.50) Swartklip Ltd.'s (back office) PETTY CASH BOOK as at 31.12.20X7 Figure 38.4: SWARTKLIP Ltd.’s petty cash book (4) In order to assign the expenses paid on cash (see the petty cash book) and recorded by Ms Dana, it is important to assign the expenditures to the right expense accounts. It is the advantage of the Petty Cash Book that only sums of the expenses are recorded in the expense accounts. This easy example cannot demonstrate the power of the concept, because there are only a few errands considered. However, think about a few hundred entries/ month in order to understand the concept. The Accountant takes the Petty Cash Book template filled by Ms Dana and makes the bookkeeping entries below. (14, 18) Posting expenses and VAT paid on cash on 5.03.20X7. DR VAT.......................... 66.00 EUR CR Petty Cash Book.............. 66.00 EUR DR Stationary Expenses.......... 225.00 EUR CR Petty Cash Book.............. 225.00 EUR DR Catering Expenses............ 25.00 EUR CR Petty Cash Book.............. 25.00 EUR <?page no="485"?> Berkau: BASICS of ACCOUNTING 38-484 DR Decoration Expenses.......... 22.50 EUR CR Petty Cash Book.............. 22.50 EUR DR Business Car Expenses........ 57.50 EUR CR Petty Cash Book.............. 57.50 EUR By these entries, the input-VAT is debited to the VAT account. The other expense accounts are charged by the amounts recorded by the petty cashier. On 5.04.20X7, SWARTKLIP Ltd. receives a revenue payment from a customer. The amount is 75,000.00 EUR and includes VAT. The bookkeeping entry goes through SWARTKLIP Ltd.’s Bank account. (19) Posting revenue on 5.04.20X7. DR Bank Account................. 75,000.00 EUR CR VAT.......................... 12,500.00 EUR CR Revenue...................... 62,500.00 EUR (20) SWARTKLIP Ltd. pays labour of 50,000.00 EUR per bank transfer. DR Labour....................... 50,000.00 EUR CR Bank Account................. 50,000.00 EUR Observe the accounts after their balancing-off SWARTKLIP Ltd.’s bookkeeping records as shown in Figure 38.5. The balancing figure of the Petty Cash Book is 500.00 EUR. SWARTKLIP Ltd. does not regard the Petty Cash Book as a real account and prepares a T-account for petty cash. D C D C (1) 50,000.00 (3) 3,500.00 c/ d 50,000.00 (1) 50,000.00 (2) 100,000.00 (4a) 5,000.00 b/ d 50,000.00 (19) 75,000.00 (5) 84,000.00 (7) 10,000.00 (8) 1,000.00 (11) 120.00 (20) 50,000.00 c/ d 71,380.00 225,000.00 225,000.00 b/ d 71,380.00 Bank Issued capital Figure 38.5: SWARTKLIP Ltd.’s accounts <?page no="486"?> Berkau: BASICS of ACCOUNTING 38-485 D C D C (4a) 5,000.00 (2) 100,000.00 (3) 3,500.00 c/ d 3,500.00 (4b) 5,000.00 b/ d 3,500.00 c/ d 90,000.00 10,000.00 100,000.00 b/ d 90,000.00 D C D C (5) 70,000.00 c/ d 70,000.00 (5) 14,000.00 (19) 12,500.00 b/ d 70,000.00 (10) 20.00 (14) 66.00 c/ d 1,586.00 14,086.00 14,086.00 b/ d 1,586.00 Interest bearing liabilities Interest P, P, E VAT D C D C (6) 20,000.00 c/ d 20,000.00 c/ d 20,000.00 (6) 20,000.00 b/ d 20,000.00 b/ d 20,000.00 D C D C (7) 10,000.00 c/ d 10,000.00 (8) 1,000.00 (9) 500.00 b/ d 10,000.00 (13) 396.00 c/ d 104.00 1,000.00 1,000.00 b/ d 104.00 Rent Cash Depreciation Accumulated depreciation D C D C (9) 500.00 (14) 66.00 (10) 100.00 (12) 100.00 (13) 396.00 (15) 225.00 (16) 25.00 (17) 22.50 (18) 57.50 c/ d 500.00 D C 896.00 896.00 (20) 50,000.00 c/ d 50,000.00 b/ d 500.00 b/ d 50,000.00 D C D C (11) 120.00 (4b) 5,000.00 (12) 100.00 c/ d 5,000.00 (10) 120.00 (15) 225.00 c/ d 325.00 5,120.00 5,120.00 325.00 325.00 b/ d 5,000.00 b/ d 325.00 Petty cash book Purchase Accounts payables Stationary expenses Labour Figure 38.5: SWARTKLIP Ltd.’s accounts (continued) <?page no="487"?> Berkau: BASICS of ACCOUNTING 38-486 D C D C (16) 25.00 c/ d 25.00 (17) 22.50 c/ d 22.50 b/ d 25.00 b/ d 22.50 D C D C (18) 57.50 c/ d 57.50 c/ d 62,500.00 (19) 62,500.00 b/ d 57.50 b/ d 62,500.00 Catering expenses Decoration expenses Business car expenses Revenue Figure 38.5: SWARTKLIP Ltd.’s accounts (continued) By the next steps, the profit for SWARTKLIP Ltd. is calculated. All nominal accounts are closed-off to the Profit and Loss account. See the bookkeeping entries below and the accounts displayed by Figure 38.6. SWARTKLIP Ltd. is no trading business. Thus, here is no need for preparing a Trading account. DR Profit and Loss.............. 3,500.00 EUR CR Interest..................... 3,500.00 EUR DR Profit and Loss.............. 20,000.00 EUR CR Depreciation................. 20,000.00 EUR DR Profit and Loss.............. 10,000.00 EUR CR Rent......................... 10,000.00 EUR DR Profit and Loss.............. 325.00 EUR CR Stationary Expenses.......... 325.00 EUR DR Profit and Loss.............. 25.00 EUR CR Catering Expenses............ 25.00 EUR DR Profit and Loss.............. 22.50 EUR CR Decoration Expenses.......... 22.50 EUR DR Profit and Loss.............. 57.50 EUR CR Business Car Expenses........ 57.50 EUR DR Profit and Loss.............. 50,000.00 EUR CR Labour....................... 50,000.00 EUR DR Revenue...................... 62,500.00 EUR CR Profit and Loss.............. 62,500.00 EUR <?page no="488"?> Berkau: BASICS of ACCOUNTING 38-487 D C D C (1) 50,000.00 (3) 3,500.00 c/ d 50,000.00 (1) 50,000.00 (2) 100,000.00 (4a) 5,000.00 b/ d 50,000.00 (19) 75,000.00 (5) 84,000.00 (7) 10,000.00 (8) 1,000.00 (11) 120.00 (20) 50,000.00 c/ d 71,380.00 225,000.00 225,000.00 b/ d 71,380.00 D C D C (4) 5,000.00 (2) 100,000.00 (3) 3,500.00 c/ d 3,500.00 c/ d 95,000.00 b/ d 3,500.00 P&L 3,500.00 100,000.00 100,000.00 b/ d 95,000.00 Bank Issued capital Interest bearing liabilities Interest D C D C (5) 70,000.00 c/ d 70,000.00 (5) 14,000.00 (19) 12,500.00 b/ d 70,000.00 (10) 20.00 (14) 66.00 c/ d 1,586.00 14,086.00 14,086.00 b/ d 1,586.00 D C D C (6) 20,000.00 c/ d 20,000.00 c/ d 20,000.00 (6) 20,000.00 b/ d 20,000.00 P&L 20,000.00 b/ d 20,000.00 D C D C (7) 10,000.00 c/ d 10,000.00 (8) 1,000.00 (9) 500.00 b/ d 10,000.00 P&L 10,000.00 (13) 396.00 c/ d 104.00 1,000.00 1,000.00 b/ d 104.00 Rent Cash P, P, E VAT Depreciation Accumulated depreciation Figure 38.6: SWARTKLIP Ltd.’s accounts <?page no="489"?> Berkau: BASICS of ACCOUNTING 38-488 D C D C (9) 500.00 (14) 66.00 (10) 100.00 (12) 100.00 (13) 396.00 (15) 225.00 (16) 25.00 (17) 22.50 (18) 57.50 c/ d 500.00 D C 896.00 896.00 (20) 50,000.00 c/ d 50,000.00 b/ d 500.00 b/ d 50,000.00 P&L 50,000.00 D C D C (11) 120.00 (4b) 5,000.00 (12) 100.00 c/ d 5,000.00 (10) 120.00 (15) 225.00 c/ d 325.00 5,120.00 5,120.00 325.00 325.00 b/ d 5,000.00 b/ d 325.00 P&L 325.00 D C D C (16) 25.00 c/ d 25.00 (17) 22.50 c/ d 22.50 b/ d 25.00 P&L 25.00 b/ d 22.50 P&L 22.50 D C D C (18) 57.50 c/ d 57.50 c/ d 62,500.00 (19) 62,500.00 b/ d 57.50 P&L 57.50 P&L 62,500.00 b/ d 62,500.00 Catering expenses CaE Decoration expenses DcE Business car expenses BCE Revenue Petty cash book Purchase Accounts payables Stationary expenses StE Labour D C D C Int 3,500.00 Rev 62,500.00 P&L 21,430.00 c/ d 21,430.00 Dpr 20,000.00 b/ d 21,430.00 Rnt 10,000.00 StE 325.00 CaE 25.00 DcE 22.50 BCE 57.50 Lab 50,000.00 NL 21,430.00 83,930.00 62,500.00 b/ d 21,430.00 R/ E 21,430.00 Profit and Loss P&L Retained earnings R/ E Figure 38.6: SWARTKLIP Ltd.’s accounts (continued) For the statement of comprehensive income, the expenses for rent, stationary, catering, decoration and for the business car are added up and represented as the other expense item: 10,000 + 325 + 25 + 22.50 + 57.50 = 10,430.00 EUR . The statement of comprehensive income is displayed by Figure 38.7. <?page no="490"?> Berkau: BASICS of ACCOUNTING 38-489 [EUR] Revenue 62,500.00 Other income 62,500.00 Materials 0.00 Labour 50,000.00 Depreciation 20,000.00 Other expenses 10,430.00 Earnings before int and taxes (EBIT) (17,930.00) Interest 3,500.00 Earnings before taxes (EBT) (21,430.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (21,430.00) Swartklip Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 38.7: SWARTKLIP Ltd.’s statement of comprehensive income For the preparation of the statement of financial position, the items cash, bank and petty cash book are combined. The amount is: 71,380 + 104 + 500 = 71,984.00 EUR . The item accounts receivables results from VAT. The amount for the item property, plant and equipment is: 70,000 - 20,000 = 50.000.00 EUR . See the statement of financial position in Figure 38.8: A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 50,000.00 Share capital 50,000.00 Intangibles Reserves Financial assets R/ E (21,430.00) Current assets Liabilities Inventory Interest bear liab 95,000.00 A/ R 1,586.00 A/ P Prepaid expenses Provisions Cash/ Bank 71,984.00 Tax liabilities 123,570.00 123,570.00 Swartklip Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 38.8: SWARTKLIP Ltd.’s statement of financial position <?page no="491"?> Berkau: BASICS of ACCOUNTING 38-490 Summary: The petty cash book applies to record purchases and expenses paid on cash and regarded of minor interest. The concept guarantees that input-VAT and the expenses are recorded and allocated correctly. Instead of recording each and every purchase or expense, the petty cash book gathers purchases and expenses and allows making single bookkeeping entry for gathered expenses of the same kind all together. Working Definitions: Petty Cash Book: The petty cash book is a record for minor purchases bought on cash. Petty Cash Float: The petty cash float is the initial amount in the petty cash book. <?page no="492"?> Berkau: BASICS of ACCOUNTING 39-491 39. Books of Original Entry Learning Objectives: To our experience, you can survive as an Accountant without knowledge about books of original entry. Nowadays, we do not have the need to apply this concept anymore, because you’ll make bookkeeping entries by computer software. So you can make as many bookkeeping entries as you want. We only write this chapter with the intention to make you familiar with the concept of books of original entry in case you see it in a company or taught at another university. Books of original entries are part of the Accounting syllabus in most universities. Books of original entry are documents to gather purchases or sales, for example. They apply to keep the bookkeeping records free of numerous bookkeeping entries. A huge production company might have thousands of bookkeeping entries for purchases every day. In the old days of Accounting, when the bookkeeper made the entries on paper, the huge amount of bookkeeping entries would have filled the records quickly. It made sense to gather bookkeeping entries in a separate document alongside the bookkeeping records and to make bookkeeping entries for a few hundred of purchases together. In order to understand the concept of books of original entry think about a small paper block you keep in the glove compartment of your car. Every time when you go to a gas station to fuel-up your car, you write the amount you paid on the paper block and you keep the receipt, too. At the end of the month, you have a few entries on the paper block and you add up your petrol receipts. You then make one single bookkeeping entry for the sum of your petrol purchases together. You debit the net amount to the Petrol Expense account and the input-VAT to your VAT account and you make a credit entry in the Bank account - provided you always pay by your credit card at the gas stations. Your paper block will be regarded as a book of original entry. A book of original entry is a list for similar bookkeeping entries, such as purchases, sales, labour, etc. Only the total of the entries will be recorded in the bookkeeping records. The book of original entry, that contains the single entries, will be kept as a bookkeeping document. Books of original entry are called journals, too. E.g., purchase journal for a book of original entry that contains purchases. Companies apply books of original entry for purchases, for sales, for the cash book, for returns inwards and for returns outwards. In case a company applies books of original entry, the cash book dominates the other ones. Thus, purchases are only entered into the purchase journal, in case they have been made on credit. In contrast, a cash purchase is recorded in the cash book. The cash book differs from other books of original entries. It actually replaces the Cash/ Bank account. It is regarded as real account. It often contains columns for different banks and a cash column. A company that banks with Commerzbank AG and with <?page no="493"?> Berkau: BASICS of ACCOUNTING 39-492 Sparkasse Osnabrück will use 1 column for cash, one for bank “Commerzbank AG” and another one for bank “Sparkasse Osnabrück”. The format for the books of original entries which represent items on the debit side (e.g. Purchase Journal, Cash Book) is DR(CR). This means debit entries are displayed as positive amounts and credit entries are negative. Remember, we put negative amounts in brackets. If you compare the concept to the previous chapter Petty Cash Book, you will easily understand, the Petty Cash Book is a book of original entry, too. How it is done (purchase journal): (1) Create a purchase journal as a list document. (2) When a purchase occurs, check whether or not it is on cash. Cash purchases are not subject to the purchase journal. (3) Record a purchase on credit in the purchase journal. Make an entry for the net amount and for input- VAT. (4) If your company does not apply a Returns Outwards account, record returns outwards without compensation by payment as negative purchases in the Purchase Journal. (5) At the end of the Accounting period, add up purchases. (6) Transfer the total of purchases to the Purchase account and the total of VAT into the VAT account. (7) Make credit entries in the Accounts Payables, or rather in the subordinated business partner related accounts thereof. (Note, we describe the Purchase Journal as an example. Other journals work similarly.) We explain the concept of books of original entries by the case study MUIRFIELD (Pty) Ltd., which is a trading company. MUIRFIELD (Pty) Ltd. is a CD store in a local mall. The company is established by an Accounting student, who is a music expert. He buys CDs from different suppliers and runs a purchase ledger. This means, he wants to know from which supplier he bought CDs and whether or not the bill is still open (= not paid yet). However, he is not very much interested in analysing the customers, as he only accepts sales on cash. For this reason, he applies the Purchase Journal, a purchase ledger and a Cash Book. But he does not run a sales ledger. See the bookkeeping records of the music store below: MUIRFIELD (Pty) Ltd. is established by an issue of ordinary shares on 2.01.20X2. There are 50,000 ordinary shares issued at 1.00 EUR each. The shares are not traded publicly. MUIRFIELD (Pty) Ltd. uses a Cash Book which replaces the Cash/ Bank account. (1) Share issue on 2.01.20X2. <?page no="494"?> Berkau: BASICS of ACCOUNTING 39-493 DR Cash Book (Bank)............. 50,000.00 EUR CR Issued Capital............... 50,000.00 EUR (Note, the bookkeeping entry contains the column within the Cash Book in brackets.) The cash book is an account but it isn’t displayed as T-account. See the cash book displayed by Figure 39.1 as a two column ledger in the DR(CR) format: Date Narrative Cash Bank 1.01.20X2 Share issue 50,000.00 Muirfield (Pty) Ltd.'s CASH BOOK for the year ended on 31.12.20X2 Figure 39.1: MUIRFIELD (Pty) Ltd.’s Cash Book Because the cash book is regarded as a real account, there is no reason to close it off to another account. In contrast, the other books of original entry’s totals are transferred to accounts. Compare the Purchase Journal to this procedure further down and the bookkeeping entry (4), which transfers the total of purchases and the total of input-VAT to the Purchase account and the VAT account. On 2.01.20X2, MUIRFIELD (Pty) Ltd. pays rent for the Accounting period 20X2. Rent for the store amounts to 12,000.00 EUR/ a and is paid by online banking. There is no VAT to be considered for rent as the landlord is a private person. The Cash Book applies, because the payment is per bank transfer. The amount is credited to the Cash Book’s bank column. (2) Payment for rent on 2.01.20X2. DR Rent......................... 12,000.00 EUR CR Cash Book (Bank)............. 12,000.00 EUR On 3.01.20X2, MUIRFIELD (Pty) Ltd. buys music compact disks. MUIRFIELD (Pty) Ltd. orders from different suppliers: from AFRICAN MUSIC Ltd. 1,000 house music compact disks at a net purchase price of 8.00 EUR/ u are ordered. The total cost of purchase amounts to: 8.00 × 1,000 = 8,000.00 EUR . The gross amount is: 8,000 × 120% = 8,160.00 EUR . from MUSIC IMPORT (Pty) Ltd. 800 jazz music compact disks at a net purchase price of 8.50 EUR/ u are ordered. The total cost of purchase amounts to: 8.50 × 800 = 6,800.00 EUR . The gross amount is: 6,800 × 120% = 8,160.00 EUR . from AFRICAN MUSIC Ltd. 500 R&B music compact disks at a net purchase price of 7.75 EUR/ u are ordered. The total cost of purchase amounts to: 7.75 × <?page no="495"?> Berkau: BASICS of ACCOUNTING 39-494 500 = 3,875.00 EUR . The gross amount is: 3,875 × 120% = 4,650.00 EUR . from eMUSIC Corp. 600 Hip-Hop music compact disks at a net purchase price of 10.50 EUR/ u are ordered. The total cost of purchase amounts to: 10.50 × 600 = 6,300.00 EUR . The gross amount is: 6,300 × 120% = 7,560.00 EUR . On 4.01.20X2, MUIRFIELD (Pty) Ltd. returns 100 scratched jazz music compact disks to the supplier MUSIC IMPORT (Pty) Ltd. The supplier allows MUIRFIELD to deduct the amount for the damaged products from the still outstanding bill. The return is recorded as negative purchase, because MUIRFIELD (Pty) Ltd. does not apply a Returns Outwards account. On 7.02.20X2, MUIRFIELD (Pty) Ltd. orders 2,000 sampler music compact disks from eMUSIC Corp. at a net purchase price of 6.75 EUR/ u. The total cost of purchase amounts to: 6.75 × 2,000 = 13,500.00 EUR . The gross amount is: 13,500 × 120% = 16,200.00 EUR . All of the above orders do not go through general ledger accounts, but result in entries in the Purchase Ledger. The total of the net purchases and the input-VAT are transferred to the Purchase account and the VAT account later. On 9.02.20X2, MUIRFIELD (Pty) Ltd. orders 200 house music compact disks from AFRICAN MUSIC Ltd. at a net purchase price of 8.00 EUR. MUIRFIELD (Pty) Ltd. pays via the internet immediately. As the payment takes place directly, the transaction does not require any entry in the Purchase Journal, but the Cash Book is effected and the amount is credited to the Cash Book’s bank column. The total purchase price amounts to: 8.00 × 200 = 1,600.00 EUR . The gross amount is: 1,600 × 120% = 1,920.00 EUR . MUIRFIELD (Pty) Ltd. has to make a bookkeeping entry in the Purchaseand VAT account as the Cash Book is now effected. (3) Purchase of compact disks on cash on 9.02.20X2. DR Purchase..................... 1,600.00 EUR DR VAT.......................... 320.00 EUR CR Cash Book (Bank)............. 1,920.00 EUR On 12.02.20X2, MUIRFIELD buys 500 kids music on compact disks from RAINBOW MUSIC Ltd. at a unit purchase price of 5.75 EUR. The total cost of purchase amounts to: 5.75 × 500 = 2,875.00 EUR . The gross amount is: 2,875 × 120% = 3,450.00 EUR . The purchase is on credit. This means, there is an entry in the Purchase Journal. At this stage, all purchases are made for the Accounting period 20X2. See the Purchase Journal as depicted by Figure 39.2: <?page no="496"?> Berkau: BASICS of ACCOUNTING 39-495 Date Narrative Net amount VAT Gross amount 3.01.20X2 1,000 House music-CDs from AFRICAN MUSIC Ltd 8,000.00 1,600.00 9,600.00 3.01.20X2 800 JAZZ music-CDs from MUSIC IMPORT (Pty) Ltd 6,800.00 1,360.00 8,160.00 3.01.20X2 500 R&B music-CDs from AFRICAN MUSIC Ltd 3,875.00 775.00 4,650.00 3.01.20X2 600 HipHop music-CDs from eMusic Corp 6,300.00 1,260.00 7,560.00 4.01.20X2 Return of 100 jazz music-CDs to MUSIC IMPORT (Pty) Ltd (800.00) (160.00) (960.00) 7.2.20X2 2,000 samler music -CDs from eMusic Corp 13,500.00 2,700.00 16,200.00 12.02.20X2 500 kids music-CDs from RAINBOW MUSIC Ltd. 2,875.00 575.00 3,450.00 40,550.00 8,110.00 48,660.00 Muirfield Ltd.'s PURCHASE JOURNAL for the period ended on 31.12.20X2 Figure 39.2: MUIRFIELD (Pty) Ltd.‘s purchase journal At the end of the Accounting period, MUIRFIELD (Pty) Ltd. transfers the total of purchases and the total of input-VAT to the Purchase account and to the VAT account. The credit entries are made in accounts of the sales ledger. This supports an open item bookkeeping system. An open item bookkeeping system is a purchase, sales or human resource ledger as a subsidiary ledger where every supplier, customer or employee has an individualised account. This way it becomes easy to observe which payment to which supplier, from which customer or to which employee is still outstanding (= open). The bookkeeping entries for the purchases and VAT are recorded all together. The credit entries in the accounts payables are made in individualised accounts such as A/ P (eMUSIC) account. See below the bookkeeping entry made on 31.12.20X2. (4) Purchases from the purchase ledger on 31.12.20X2. <?page no="497"?> Berkau: BASICS of ACCOUNTING 39-496 DR Purchase..................... 40,550.00 EUR DR VAT.......................... 8,110.00 EUR CR A/ P (AFRICAN MUSIC).......... 9,600.00 EUR CR A/ P (MUSIC IMPORT)........... 8,160.00 EUR CR A/ P (AFRICAN MUSIC).......... 4,650.00 EUR CR A/ P (eMUSIC)................. 7,560.00 EUR DR A/ P (MUSIC IMPORT)........... 960.00 EUR CR A/ P (eMUSIC)................. 16,200.00 EUR CR A/ P (RAINBOW)................ 3,450.00 EUR The 7th entry (marked) is a debit entry, because it is linked to a return outward. In the accounts the 4 th bookkeeping entry is shown with line references. The entry in the 7 th line is referred to as 4. 7 . (Note, it would have been better Accounting style pulling the 7th entry up to the other debit entries. We didn’t do that for a good overview’s sake.) On 5.01.20X2, MUIRFIELD (Pty) Ltd. sells 200 music compact disks. The gross selling price is 15.90 EUR/ u. The sale is on cash and requires making an entry in the Cash Book. The total gross amount is: 15.90 × 200 = 3,180.00 EUR . As the Cash Book is a real account, the debit entry can be made directly. See bookkeeping entry (5). (5) Sale of 200 CDs on 5.01.20X2 on cash. DR Cash Book (Cash)............. 3,180.00 EUR CR VAT.......................... 530.00 EUR CR Sales........................ 2,650.00 EUR The bookkeeping entry identification number (here: (5)) is shown in the narrative column in the Cash Book. See Figure 39.3. The credit entries are made in the T-accounts as displayed in . . On 9.01.20X2, MUIRFIELD (Pty) Ltd. sells 150 music compact disks. The gross selling price is 15.90 EUR/ u. The sale is on cash and requires an entry in the Cash Book. The total gross amount is: 15.90 × 150 = 2,385.00 EUR . (6) Sale of 150 CDs on 9.01.20X2 on cash. DR Cash Book (Cash)............. 2,385.00 EUR CR VAT.......................... 397.50 EUR CR Sales........................ 1,987.50 EUR On 15.01.20X2, MUIRFIELD (Pty) Ltd. sells 800 music compact disks. The gross selling price is 15.90 EUR/ u. The sale is on cash and requires an entry in the Cash Book. The total gross amount is: 15.90 × 800 = 12,720.00 EUR . (7) Sale of 800 CDs on 15.01.20X2 on cash. <?page no="498"?> Berkau: BASICS of ACCOUNTING 39-497 DR Cash Book (Cash)............. 12,720.00 EUR CR VAT.......................... 2,120.00 EUR CR Sales........................ 10,600.00 EUR On 16.01.20X2, MUIRFIELD pays 10,000.00 EUR into their bank account. The money is taken out on cash. The transaction only is visible in the Cash Book, because two columns of the cash book are involved only and at the same time. No other account is changed. (8) Cash payment into the bank account on 16.01.20X2. DR Cash Book (Bank)............. 10,000.00 EUR CR Cash Book (Cash)............. 10,000.00 EUR MUIRFIELD (Pty) Ltd. pays the amount owing eMUSIC Corp on 10.02.20X2 per bank transfer. The amount is: 7,560 + 16,200 = 23,760.00 EUR . (9) Payment of payables to eMUSIC Corp on 10.02.20X2. DR A/ P (eMUSIC)................. 23,760.00 EUR CR Cash Book (Bank)............. 23,760.00 EUR On 15.02.20X2, MUIRFIELD (Pty) Ltd. pays for labour 5,000.00 EUR by internet banking. (10) Payment for labour on 15.02.20X2. DR Labour....................... 5,000.00 EUR CR Cash Book (Bank)............. 5,000.00 EUR See the cash book and the other accounts in Figure 39.3 and . . <?page no="499"?> Berkau: BASICS of ACCOUNTING 39-498 Date Narrative Cash Bank 1.01.20X2 Share issue (1) 50,000.00 2.01.20X2 Paying rent (2) (12,000.00) 5.01.20X2 200 CDs sold at 15.90 EUR/ u (5) 3,180.00 9.01.20X2 150 CDs sold at 15.90 EUR/ u (6) 2,385.00 15.01.20X2 800 CDs sold at 15.90 EUR/ u (7) 12,720.00 16.01.20X2 Paid 6.000.00 EUR into the bank (8) (10,000.00) 10,000.00 9.02.20X2 Purchase of 200 house music-CDs (3) (1,920.00) 10.02.20X2 Paid bills from eMUSIC Corp 23,760.00 EUR (9) (23,760.00) 15.02.20X2 Payment for labour (10) (5,000.00) 31.12.20X2 Balance c/ d (8,285.00) (17,320.00) 0.00 0.00 1.01.20X3 Balance b/ d 8,285.00 17,320.00 Muirfield (Pty) Ltd.'s CASH BOOK for the year ended on 31.12.20X2 Figure 39.3: MUIRFIELD (Pty) Ltd.‘s cash book D C D C c/ d 50,000.00 (1) 50,000.00 (2) 12,000.00 c/ d 12,000.00 b/ d 50,000.00 b/ d 12,000.00 D C D C (3) 320.00 (5) 530.00 (3) 1,600.00 (4) 8,110.00 (6) 397.50 (4) 40,550.00 c/ d 42,150.00 (7) 2,120.00 42,150.00 42,150.00 c/ d 5,382.50 b/ d 42,150.00 8,430.00 8,430.00 b/ d 5,382.50 Issued capital Rent VAT Purchase D C D C (4. 1 ) 9,600.00 (4. 5 ) 960.00 (4. 2 ) 8,160.00 c/ d 14,250.00 (4. 3 ) 4,650.00 c/ d 7,200.00 14,250.00 14,250.00 8,160.00 8,160.00 b/ d 14,250.00 b/ d 7,200.00 A/ P (AFRICAN MUSIC) A/ P (MUSIC IMPORT) Figure 39.4: MUIRFIELD (Pty) Ltd.’s accounts (Cash Book in figure 39.3) <?page no="500"?> Berkau: BASICS of ACCOUNTING 39-499 D C D C (9) 23,760.00 (4. 4 ) 7,560.00 c/ d 3,450.00 (4. 7 ) 3,450.00 (4. 6 ) 16,200.00 b/ d 3,450.00 23,760.00 23,760.00 D C D C (5) 2,650.00 (10) 5,000.00 c/ d 5,000.00 (6) 1,987.50 b/ d 5,000.00 c/ d 15,237.50 (7) 10,600.00 15,237.50 15,237.50 b/ d 15,237.50 Sales Labour A/ P (eMUSIC) A/ P (RAINBOW) Figure 39.4: MUIRFIELD (Pty) Ltd.’s accounts (continued) In order to check the consistency with the double entry system and instead of preparing a trial balance, we add all debit balances and deduct all credit balances: 8,285 + 17,320 - 50,000 + 12,000 + 5,382.50 + 42,150 - 14,250 - 7,200 - 15,237.50 + 5,000 = 0.00 EUR . This means, the total of debit entries equals to total of the credit entries. (Note, this way we are running a „light“-trial balance because making bookkeeping entries in 2 figures (accounts and another one for journals) is likely to end up faulty. We recommend you doing this in exams also before profit calculation. Take a calculator and go through all accounts adding the debit balanced accounts’ balances and deducting the credit balanced ones.) MUIRFIELD (Pty) Ltd. runs a periodic inventory system and needs to count stock at the end of the Accounting period. It reveals that there are 900 house music compact disks, 600 jazz music compact disks, 250 R&B music compact disks, 350 Hip Hop music compact disks, 1,950 sampler music compact disks and 300 kids‘ music compact disks left. The value of the closing stock equals to: 900 × 8 + 600 × 8.50 + 250 × 7.75 + 350 × 10.50 + 1,950 × 6.75 + 300 × 5.75 = 32,800.00 EUR . The closing stock is credited to the Trading account. DR Inventory.................... 32,800.00 EUR CR Trading Account.............. 32,800.00 EUR All nominal accounts are closed-off to the Trading account or the Profit and Loss account. DR Sales ....................... 15,237.50 EUR CR Trading Account.............. 15,237.50 EUR <?page no="501"?> Berkau: BASICS of ACCOUNTING 39-500 DR Trading Account.............. 42,150.00 EUR CR Purchase..................... 42,150.00 EUR The purchases result from the Purchase Journal or are bought on cash. There is no difference between the purchases in terms of profit calculation. The amount for the gross profit is: 42,150 - 15,237.50 - 32,800 = 5,887.50 EUR . The amount is transferred to the Profit and Loss account by the next bookkeeping entry. DR Trading Account.............. 5,887.50 EUR CR P&L-Account.................. 5,887.50 EUR Further expense accounts are closed-off to the Profit and Loss account. DR Profit and Loss.............. 12,000.00 EUR CR Rent......................... 12,000.00 EUR DR Profit and Loss.............. 5,000.00 EUR CR Labour....................... 5,000.00 EUR MUIRFIELD (Pty) Ltd. makes a net loss of: 5,887.50 - 12,000 - 5,000 = 11,112.50 EUR . The amount is transferred into the Retained Earnings account. As it is a loss, the Retained Earnings Account is debited. DR Retained Earnings............ 11,112.50 EUR CR P&L-Account.................. 11,112.50 EUR Observe MUIRFIELD (Pty) Ltd.‘s accounts after profit calculation in Figure 39.5: D C D C c/ d 50,000.00 (1) 50,000.00 (2) 12,000.00 c/ d 12,000.00 b/ d 50,000.00 b/ d 12,000.00 P&L 12,000.00 D C D C (3) 320.00 (5) 530.00 (3) 1,600.00 (4) 8,110.00 (6) 397.50 (4) 40,550.00 c/ d 42,150.00 (7) 2,120.00 42,150.00 42,150.00 c/ d 5,382.50 b/ d 42,150.00 T/ A 42,150.00 8,430.00 8,430.00 b/ d 5,382.50 Issued capital Rent VAT Purchase Figure 39.5: MUIRFIELD (Pty) Ltd.‘s accounts (cash book in figure 40.3) <?page no="502"?> Berkau: BASICS of ACCOUNTING 39-501 D C D C (4. 1 ) 9,600.00 (4. 5 ) 960.00 (4. 2 ) 8,160.00 c/ d 14,250.00 (4. 3 ) 4,650.00 c/ d 7,200.00 14,250.00 14,250.00 8,160.00 8,160.00 b/ d 14,250.00 b/ d 7,200.00 D C D C (9) 23,760.00 (4. 4 ) 7,560.00 c/ d 3,450.00 (4. 7 ) 3,450.00 (4. 6 ) 16,200.00 b/ d 3,450.00 23,760.00 23,760.00 D C D C (5) 2,650.00 (10) 5,000.00 c/ d 5,000.00 (6) 1,987.50 b/ d 5,000.00 P&L 5,000.00 c/ d 15,237.50 (7) 10,600.00 15,237.50 15,237.50 T/ A 15,237.50 b/ d 15,237.50 Sales Labour A/ P (AFRICAN MUSIC) A/ P (MUSIC IMPORT) A/ P (eMUSIC) A/ P (RAINBOW) D C D C Prh 42,150.00 Rev 15,237.50 T/ A 32,800.00 c/ d 32,800.00 GP 5,887.50 Inv 32,800.00 b/ d 32,800.00 48,037.50 48,037.50 P&L 5,887.50 b/ d 5,887.50 D C D C Rnt 12,000.00 T/ A 5,887.50 c/ d 11,112.50 P&L 11,112.50 Lab 5,000.00 NL 11,112.50 b/ d 11,112.50 17,000.00 17,000.00 b/ d 11,112.50 R/ E 11,112.50 Trading Inventory Profit and Loss Retained earnings Figure 39.5: MUIRFIELD (Pty) Ltd.‘s accounts (continued) The financial statements are displayed by Figure 39.6 and Figure 39.7. In the statement of financial position, the amount for receivables results from VAT claims. The amount for cash/ bank is drawn from the cash column and the bank column of the Cash Book. It equals to: 8,285 + 17,320 = 25,605.00 EUR . The payables are the amounts owed to suppliers: 14,250 + 7,200 + 3,450 = 24,900.00 EUR . See the statement of financial position in Figure 39.6: <?page no="503"?> Berkau: BASICS of ACCOUNTING 39-502 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E Share capital 50,000.00 Intangibles Reserves Financial assets R/ E (11,112.50) Current assets Liabilities Inventory 32,800.00 Interest bear liab A/ R 5,382.50 A/ P 24,900.00 Prepaid expenses Provisions Cash/ Bank 25,605.00 Tax liabilities 63,787.50 63,787.50 Muirfield (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 39.6: MUIRFIELD (Pty) Ltd.‘s statement of financial position On the income statement, the amount for materials is calculated as all purchases less the closing stock: 42,150 - 32,800 = 9,350.00 EUR . The returns do not have to be considered again, as they are credited in the purchase journal already. See the statement of comprehensive income in Figure 39.7: [EUR] Revenue 15,237.50 Other income 15,237.50 Materials 9,350.00 Labour 5,000.00 Depreciation 0.00 Other expenses 12,000.00 Earnings before int and taxes (EBIT) (11,112.50) Interest 0.00 Earnings before taxes (EBT) (11,112.50) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (11,112.50) Muirfield (Pty) Ltd.'s STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X2 Figure 39.7: MUIRFIELD (Pty) Ltd.‘s statement of comprehensive income <?page no="504"?> Berkau: BASICS of ACCOUNTING 39-503 Summary: Books of original entry are documents to gather items resulting from numerous transactions, such as purchases, sales, returns, etc. The books of original entry allow to make bookkeeping entries for sums. Only the Cash Book is regarded as real account. The other books of original entry are no genuine accounts in terms of the double entry system. The total of their items must be transferred to accounts such as the total of purchases in the Purchase Journal to the Purchase account. Working Definitions: Books of Original Entry: A book of original entry is a list for similar bookkeeping entries, such as purchases, sales, labour, etc. Open Item Bookkeeping System: An open item bookkeeping system is a purchase, sales or human resource ledger as a subsidiary ledger where every supplier, customer or employee has an individualised account. <?page no="506"?> Part (D): Management Accounting In this part we introduce to the most common Management Account concepts. Management Accounting is Accounting for Managers. It is required in order to control the business. In contrast to Financial Accounting, which aims to inform the investors and creditors of the company about what happened in the last Accounting period, Management Accounting is focussed on the future of the business. For Management Accounting, there are no laws, such as IFRSs relevant. Management Accounting is a discipline which is based on production theory and cost theory. The information managers need in order to run the business are different to the financial statements. Managers need information that is linked to future activities and that is in general based on shorter periods than a year. Most managers plan and control the business based on monthly information. A further difference to Financial Accounting is that in Management Accounting the organisational unit to be planned is a small division of the company - not the whole company. Companies will be divided in units called cost centres which are managed separately. Often these cost centres are profit centres and plan their own income statement, called the profitability analysis. Companies run hundreds of responsibility centres, which will be planned and controlled by decentralised management. In the next chapters we first focus on the common aspects of Management Accounting. We introduce in the planning aspects and still focus on the entire company. The chapter Cost Planning/ Business Plan shows how to plan a company, which we demonstrate with two case study. One case study is a restaurant and the second one a production firm. Manufacturers have to plan materials. The planning of activities and costs requires to understand how costs will change based on the output. We show this by the chapter Cost Behaviour/ Cost Separation. We focus on an analysis of business cost functions and show how to use them for the business plan. A cost separation is a method to classify costs based on their changes caused by output variations. The next chapters are linked to the profit analysis. By the Cost-Volume- Profit-Analysis the company finds out how many products/ service it must produce in order to earn a profit. Furthermore, the company can study, how changes of business activities will change the profit. We introduce the method of what-if-Analysis in this chapter. Furthermore, we study the Degree of Operating Leverage. It tells you how much a change in output will change the profit or the cash flow. This ratio is closely linked to the previous chapters because the DOL depends directly on the cost structure of the business. <?page no="507"?> Berkau: BASICS of ACCOUNTING 39-506 With the next chapters, we start to show you how to do Management Accounting. The chapter Structure of Cost Accounting System introduces the steps of Management Accounting by a case study of a pizza restaurant. You will learn basic functions and technical terms of Management Accounting in that chapter. We show different Cost Accounting systems in the next chapter Flexible Budgeting/ Marginal Cost Accounting. The aim is to focus on decision based management and to show how a Marginal Cost Accounting system works. We further show the misleading information resulting from Absorption Costing, which assigns fixed costs to products. In particular, if production firms put finished goods on stock they disclose too high profits in the profitability and once they release the finished goods from stock, the profit is too low. We will demonstrate this effect by a case study LOGA (Pty) Ltd., which we study with regard to an Absorption Costing and a Marginal Costing in order to compare the systems. In the chapter Cost Centre Efficiency Check, we show how to monitor cost centres. We introduce to the variance analysis inside of cost centres. As Management Accounting is based on cost centre structures interaction between the organisational units takes place. The chapter Cost Allocations shows the methods of cost assignments caused by mutual performance relationships between cost centres. As Management Accounting is a field where Accountants provide managers with information, the way information is presented is important. Managers do not expect to discuss their business based on accounts. In chapter Reporting on Manufacturing Accounting, we show a production firm LEBUHRAYA (Pty) Ltd. and how the information of costs of manufacturing can be presented in a report. With regard to the calculation of products, which is one of the most important questions in Manufacturing Accounting, we show different calculation methods. The next chapters are linked to Manufacturing Accounting, which is Accounting in production firms that aims on the unit cost calculation. There are the chapters Job Order Costing and Process Costing. Another important question in Manufacturing Accounting is about the management of fixed costs. Fixed costs mostly occur in overhead departments. There are two approaches: Multi-Level Contribution Margin Accounting and Activity Based Costing. We introduce both ways by the last chapters of the Management Accounting part of this text book and show with case studies of hospitality management and an airline how they can be applied. The upcoming chapters are: (40) Cost Planning / Business Plan (41) Cost Behaviour / Cost Separation (42) Cost Volume Profit Analysis (CVP-Analysis) (43) Degree of Operating Leverage (DOL) (44) Structure of Cost Accounting Systems (45) Flexible Budgeting / Marginal Cost Accounting <?page no="508"?> Berkau: BASICS of ACCOUNTING 39-507 (46) Cost Centre Efficiency Check (47) Cost Allocations (48) Reporting on Manufacturing Accounting (49) Job Order Costing (Manufacturing Accounting) (50) Process Costing (Manufacturing Accounting) (51) Multi-Level Contribution Margin Accounting (52) Activity Based Costing <?page no="509"?> Berkau: BASICS of ACCOUNTING 40-508 40. Cost Planning / Business Plan Learning Objectives In this chapter we introduce planning tools for business. After studying this chapter, you should be able to understand the planning concept of Managerial Accounting. You should be able to prepare a business plan for a company and be able to understand the difference between profitability and liquidity planning. In order to plan a business, you have to anticipate the business activities of the upcoming Accounting periods. One way could be to predict all business activities separately and to make bookkeeping entries for each of them. After that you can prepare financial statements as a balance sheet, an income statement and a statement of cash flows. Once you obtain the future financial statements you can run a ratio analysis on them to access the business and to compare it to other companies or to prior Accounting periods. In Managerial Accounting the expression budgeting for the preparation of a business plan and in particular a cost plan is very much common. The difference between a plan and a budget is that the letter one is already approved. The main problem of preparing the cost plan for a company is to deal with different resources of the business. Departments compete for the allocation of resources. Under decentralised planning, the single departments prepare their own plans and the Management Accountant’s task is the coordination of the partial plans. We here focus on easy company structures and discuss business planning for small case studies. This implies to ignore contradicting partial plans and to start off with a case that is easy to oversee. A much better approach to prepare the business plan is to skip the bookkeeping entry part. You predict future activities and determine their effects on the financial statements. A common structure is to split up the business plan in: (1) Revenue plan (2) Cost plan (3) Profit plan (4) Liquidity plan and/ or cash flow statement (5) Budgeted balance sheet. We follow the latter approach and study the company KIRSTEN- BOSCH Ltd. We do not make any bookkeeping entry. KIRSTENBOSCH Ltd. is in the fast food business. The company is a franchisee of a worldwide operating fast food chain. KIRSTENBOSCH Ltd. is established on 2.01.20X0 by a share issue of 250,000 ordinary shares at 2.00 EUR each (face value). The share issue is par value. For financing, KIRSTENBOSCH Ltd. takes a bank loan of its house bank to the extent of 400,000.00 EUR. The bank loan comes with an annual rate of interest to be paid at the yearend of 5.00 %. The pay-off amount equals to 10.00 %/ a based on the nominal bank loan’s amount - here: 400,000.00 EUR. The <?page no="510"?> Berkau: BASICS of ACCOUNTING 40-509 pay-off amount of: 10% × 400,000 = 40,000.00 EUR is due at the end of every Accounting period, too. On 2.01.20X0, KIRSTENBOSCH Ltd. furnishes the interior of the restaurant along the corporate identity requirements given by the fast food chain and pays 600,000.00 EUR per bank transfer thereon. The outfit of the restaurant will remain unchanged for the next 3 years. After that period of time the interior must be changed again. There is no salvage value for furniture and outfit fittings. KIRSTENBOSCH Ltd. Writes-off the interior of the restaurant over three Accounting periods. For restaurant rent KIRSTENBOSCH Ltd. pays 5,000.00 EUR/ m one month in advance except of for the first month with is paid on 2.01.20X0 already. Later, the rent is paid on the 25 th of the previous month. KIRSTENBOSCH buys materials (meat pads, chicken parts, buns, salad, sauces etc.) for 1,000,000.00 EUR per year. The materials are paid to an extent of 90 % per bank transfer during the Accounting period they are for. The remaining amount is paid in the next year. KIRSTENBOSCH Ltd. pays for labour 300,000.00 EUR/ a. All workers are paid on cash. For administration KIRSTENBOSCH Ltd. pays 240,000.00 EUR/ a. KIRSTENBOSCH Ltd.’s revenue is 2,200,000.00 EUR every year. Income taxes are paid in the next following accounting period. The total income tax rate is 30 %. The appropriation of profits is planned as to post the entire earnings to reserves. We will prepare a business plan for KIRSTENBOSCH Ltd. which includes a revenue plan, a cost plan, a profit plan, a liquidity plan, a cash flow plan with reconciliation of profit with operating cash flows (all per year) and provide a balance sheet as at 31.12.20X2. This plan covers 3 Accounting periods and will contain 3 columns: 20X0, 20X1 and 20X2. The budgeted balance sheet only is required at the end of the planning period, as 31.12.20X2. We ignore VAT. The first step is to set up a revenue plan for KIRSTENBOSCH Ltd. A revenue plan is an aggregated list of planned and budgeted revenues for a business displayed on revenue group level for a particular Accounting period. Companies can plan the revenue on different aggregation levels. It is not required to make plans for each and every product. Many companies plan on product group level. However, the actual data are based on bookkeeping entries and are on an elementary level. E.g. a restaurant can plan revenue and costs based on product groups, such as burgers, chicken, salad, beverage. The burger group then contains hamburgers, cheeseburgers, double burger etc. Actual data on elementary level means, that the restaurant calculates costs based on single bookkeeping entries as occur, e.g., when Will visits the restaurant and orders three cheeseburgers and a large coke. Later the single bookkeeping entries are aggregated and used to determine the monthly amount of produced cheeseburgers, for instance. Here, the revenue is already known and equals to 2,200,000.00 EUR every year. <?page no="511"?> Berkau: BASICS of ACCOUNTING 40.510 20X0 20X1 20X2 REVENUE 2,200,000.00 2,200,000.00 2,200,000.00 Figure 40.1: KIRSTENBOSCH Ltd.’s revenue plan KIRSTENBOSCH Ltd.’s cost plan is the next one to prepare. The technical term cost differs from expenses slightly. Costs are deductions of resources caused by the business activities. Expenses that are not linked to business activities, will be classified as expenses but not as costs. If an airline sponsors a soccer team, it will define an expense but no costs. On the other hand, there can be costs that are no expenses, as they are not derived from payments. Think of an entrepreneur who works in his own company. In case he doesn’t pay himself a salary it won’t be regarded as an expense. In Management Accounting will call this opportunity costs. In this text book, we will only consider costs, that are expenses at the same time and to the same extent. (costs = expenses! ) The future costs are disclosed in a cost plan which is part of the business plan. A cost plan is a list of planned and budgeted costs for a business displayed on detailed costs or cost group level for a particular Accounting period. KIRSTENBOSCH Ltd.’s costs will be for materials, rent, labour, depreciation, administration and for interest. The amount for the materials is every year 1,000,000.00 EUR. It does not matter, whether the KIRSTENBOSCH Ltd. pays the amount or not. You will see later that payment will be relevant for the liquidity planning. Rent is given in this case study and its payment / prepayment does not matter for the cost allocations. Depreciation results from the investment for the interior made in 20X0. Later on, KIRSTENBOSCH Ltd. depreciates the asset along straight line method over the next three Accounting periods. Depreciation equals to: 600,000/ 3 = 200,000.00 EUR . Labour amounts every year to 300,000.00 EUR and administration costs at KIRSTEN- BOSCH Ltd. are 240,000.00 EUR every year. For the interest calculation we set up an interest and pay-off schedule. Therein, the amount for pay-off always is 10 %/ a of the nominal bank loan amount - which equals to 400,000 × 10% = 40,000.00 EUR . Interest is based on the rate of interest being 5.00 %/ a and the amount owed. E.g., in the accounting period 20X1 KIRSTENBOSCH Ltd. owes the bank 360,000.00 EUR. Thus, interest is: 360,000 × 5% = 18,000.00 EUR . Observe the interest and pay-off schedule as displayed in Figure 40.2. <?page no="512"?> Berkau: BASICS of ACCOUNTING 40.511 0.05 Year Opening amount Interest Pay-off Rest 20X0 400,000.00 20,000.00 40,000.00 360,000.00 20X1 360,000.00 18,000.00 40,000.00 320,000.00 20X2 320,000.00 16,000.00 40,000.00 280,000.00 Figure 40.2: KIRSTENBOSCH Ltd.’s interest and pay-off schedule The cost plan contains all costs: 20X0 20X1 20X2 COST Material 1,000,000.00 1,000,000.00 1,000,000.00 Rent 60,000.00 60,000.00 60,000.00 Depreciation 200,000.00 200,000.00 200,000.00 Labour 300,000.00 300,000.00 300,000.00 Administration 240,000.00 240,000.00 240,000.00 Interest 20,000.00 18,000.00 16,000.00 Sum 1,820,000.00 1,818,000.00 1,816,000.00 Figure 40.3: KIRSTENBOSCH Ltd.’s cost plan For profit calculation, costs will be deducted from the revenues. A profit plan is a schedule where planned and budgeted costs will be deducted from the revenues for a particular Accounting period. In some companies the profit plan is referred to as the profitability analysis by Management Accountants. As income taxes depend on the profit for the period, tax expenses will be displayed on the profit plan, too. Also the appropriation of profits is subject to the profit planning and is shown at the bottom line of the profit plan. For the case study KIRSTENBOSCH Ltd., the profit after taxes for 20X0 equals to: (2,200,000 - 1,820,000) × (1 - 30%) = 266,000.00 EUR . Taxes will be paid in the next following Accounting period but they count as an expense no matter at what time payment occurs. The profit after taxes is put to the Earnings Reserves account, which is relevant for the balance sheet later. Observe the profitability plan depicted by Figure 40.4. <?page no="513"?> Berkau: BASICS of ACCOUNTING 40-512 20X0 20X1 20X2 PROFIT Revenue 2,200,000.00 2,200,000.00 2,200,000.00 less costs (1,820,000.00) (1,818,000.00) (1,816,000.00) EBT 380,000.00 382,000.00 384,000.00 Income Tax (30%) (114,000.00) (114,600.00) (115,200.00) EAT 266,000.00 267,400.00 268,800.00 to: Earnings Reserves: 266,000.00 267,400.00 268,800.00 to: Dividend 0.00 0.00 0.00 Retained Earnings 0.00 0.00 0.00 Figure 40.4: KIRSTENBOSCH Ltd.’s profitability plan So far, we only considered profitability values. Profitability values determine the profit. All revenues and costs/ expenses effect the profit of the company. However, besides of profit maximisation, companies aim to earn cash flows. A positive cash flow is the increase of cash/ bank. In any case, a cash flow is a payment or money transfer. As higher the cash flow is, as higher becomes the probability for a company to be capable to pay bills. At this situation we consider two kind of amounts for the business plan: (1) Profit relevant one and (2) cash relevant ones. The latter one is discussed at first here. Later we show differences and how to reconcile profit with operating cash flows. A company that has enough cash is called liquid. The liquidity depends on the absolute amount in cash/ bank and the cash flows of the period. A poor cash flow (negative cash flow) will put the company in financial destress because it might be difficult to fulfil payment obligations. For this reason, companies include a cash flow- / liquidity planning in their business plan. In terms of closing down businesses, the term illiquidity describes a situation where the Cash/ Bank account is credit balanced and there are no assets for liquidation left. For a business plan a situation of illiquidity is/ should be exceptional. In general, companies plan liquidity in terms of the balancing figure of the Cash/ Bank account. They do not include liquidation revenues in their planning. However, a company facing a crisis or under liquidation might do. Profitability values can differ from payment values. A company that pays for an investment creates a cash outflow in the first accounting period which is no cost. In the next following Accounting periods the company will depreciate the asset which will cause an expense without payment. As profit and liquidity do not equal, a liquidity plan is prepared in addition to a profitability plan. A liquidity plan is a list that shows the opening amount of the Cash/ Bank account, adds cash inflows and deducts cash outflows for a future particular Accounting period. The bottom line on <?page no="514"?> Berkau: BASICS of ACCOUNTING 40.513 the liquidity plan discloses the balancing cash/ bank amount of a business. It is called the liquidity. We take a closer look at KIRSTENBOSCH Ltd. The company lists all payments and cash/ bank amounts in a liquidity plan. The plan starts off with the opening amount and adds cash flows. At the bottom line you can see the liquidity for the Accounting period. In the first Accounting period, the opening amount is zero. Observe Figure 40.5: 20X0 20X1 20X2 LIQUIDITY Open amount 935,000.00 1,363,000.00 Issue of shares 500,000.00 Bank loan taken 400,000.00 interest paid (20,000.00) (18,000.00) (16,000.00) Pay-off (40,000.00) (40,000.00) (40,000.00) Restaurant renewing (600,000.00) Rent (65,000.00) (60,000.00) (60,000.00) Labour (300,000.00) (300,000.00) (300,000.00) Admin (240,000.00) (240,000.00) (240,000.00) Material expenses paid (900,000.00) (1,000,000.00) (1,000,000.00) Proceeds 2,200,000.00 2,200,000.00 2,200,000.00 Tax paid 0.00 (114,000.00) (114,600.00) Closing amount C/ B 935,000.00 1,363,000.00 1,792,400.00 Figure 40.5: KIRSTENBOSCH Ltd.’s liquidity plan The opening amount in 20X0 for KIRSTENBOSCH Ltd. is zero, because the company is established in that year. Thus, the first payment will be the amount of: 250,000 × 2 = 500,000.00 EUR . The amount is a cash inflow - for that reason the amount is positive. The next cash inflow results from taking the bank loan. The amount paid by the bank into KIRSTENBOSCH Ltd.’s bank account equals to 400,000.00 EUR. Both amounts are once-off payments which means, they are not repeated. The amount for interest and pay-off will be paid at the yearend and equals in 20X0 to: 20,000 + 40,000 = 60,000.00 EUR . That amount is negative as KIRSTENBOSCH Ltd. pays it to the bank. It is a cash outflow. The payment for the investment is negative also. The full amount is paid in 20X0 and equals to 600,000.00 EUR. Rent is paid in advance. The monthly payment equals to 5,000.00 EUR. As the amount for January 20X0 is due in 20X0 and the amount for January 20X1 is paid in 20X0 also, thus, the total rent payments add up to: 13 × 5,000 = 65,000.00 EUR in 20X0. The amount is negative as KIRSTENBOSCH Ltd. pays the amount to the landlord. The amounts paid for labour and administration are the same as costs. Every Accounting period KIRSTENBOSCH Ltd. pays 300,000.00 EUR on labour and <?page no="515"?> Berkau: BASICS of ACCOUNTING 40-514 240,000.00 EUR on administration expenses. In the case of KIRSTENBOSCH Ltd., the company pays only 90 % of the material expenses in the same accounting period. The amount of: 10% × 1,000,000 = 100,000.00 EUR is paid one year later. As this will go on, the payments for purchases will be 900,000.00 EUR in 20X0 - but: 100,000 + 900,000 = 1,000,000.00 EUR in 20X1 and 20X2. According to deferred purchase payments, KIRSTEN- BOSCH Ltd. has to recognise 100,000.00 EUR payables for purchases in all three Accounting periods. The revenue of KIRSTENBOSCH Ltd. is paid on time by its customers. Therefore, the proceeds for all Accounting periods equal to 2,200,000.00 EUR. Tax payments for income taxes will be made one Accounting period later. For that reason, the tax payment in 20X0 is zero and in 20X1 it equals to: 30% × 382,000 = 114,600.00 EUR . The amount is negative as KIRSTENBOSCH Ltd. pays it into the national revenue service’s bank account. The total amount as at the end of Accounting period 20X0 in the Cash/ Bank account equals to: 500,000 + 400,000 - 60,000 - 600,000 - 65,000 - 300,000 - 240,000 - 900,000 + 2,200,000 = 935,000.00 EUR . Compare the result to the closing balancing figure recognised in the liquidity plan in Figure 40.5. We will call the amount the liquidity as the amount is cash or its equivalent and available on short-term notice. Companies try to guarantee the amount being positive, but try to keep it low. Money as a cash reserve is not available for investments and will pull down the company’s return figure. Thus, keep the liquidity as low as possible but make sure it remains positive. However, profit is to be maximised. Volatile business normally will have a higher reserve on cash - which means a higher liquidity than companies where cash flows are pretty sure predictable. In case the liquidity comes out negative, the Management Accountant has to amend the planning, for example by taking a higher bank loan or increasing selling prices or amounts into consideration. The latter one is subject to marketing research findings as higher prices do not directly increase the total revenues as the customers’ buying habits depend on the prices, too. In order to analyse the business future financial position, companies prepare a budgeted balance sheet. A budgeted balance sheet is a pro-forma statement of financial position at a future balance sheet date. The budgeted balance sheet will be prepared for the last day of the period covered by a business plan. The budgeted balance sheet does not have to apply the formal rules of a statement of financial position nor its detail level. <?page no="516"?> Berkau: BASICS of ACCOUNTING 40.515 20X0 20X1 20X2 BALANCE SHEET PPE 400,000.00 200,000.00 0.00 prepaid 5,000.00 5,000.00 5,000.00 Cash/ Bank 935,000.00 1,363,000.00 1,792,400.00 1,340,000.00 1,568,000.00 1,797,400.00 SCap 500,000.00 500,000.00 500,000.00 Reserves 266,000.00 533,400.00 802,200.00 Interest bear liab 360,000.00 320,000.00 280,000.00 A/ P 100,000.00 100,000.00 100,000.00 tax liab 114,000.00 114,600.00 115,200.00 1,340,000.00 1,568,000.00 1,797,400.00 Figure 40.6: KIRSTENBOSCH Ltd.’s pro-forma balance sheet KIRSTENBOSCH Ltd. balance sheet comes in a table format and looks quite different to what we are used to along the national GAAPs or IFRSs. However, it contains the same information for the Accounting periods 20X0, 20X1 and 20X2. The amount of P, P, E is for the store equipment bought in 20X0 is planned to be 600,000.00 EUR. The amount that appears on the balance sheet is deducted by depreciation and equals to: 600,000 - 200,000 = 400,000.00 EUR in 20X0. The prepaid expenses stand for the January rent. The amount displayed in 20X0 is for January 20X1, the amount in the 20X1 column is for January 20X2 and the last one is prepaid expenses for 20X3. The amount in Cash/ Bank item equals to the liquidity amount calculated above in the liquidity plan. SCap is an abbreviation for share capital and equals to: 250,000 × 2 = 500,000.00 EUR . The amount does not change during the planning period as no further shares will be issued nor redeemed. The reserves are earnings reserves and contain the annual surplus of the periods based on the decision about the appropriation of profits. The amount in 20X0 equals to the earnings after taxes. The amount in 20X1 equals to: 266,000 + 267,400 = 533,400.00 EUR . The last one equals to: 266,000 + 267,400 + 268,800 = 802,200.00 EUR . This means the reserves item equals to the accumulated profit for KIRSTENBOSCH Ltd. The amount for the bank loan in the interest bearing liability item can be directly read from the interest and pay-off schedule in the rest-column. The payable amount results from the short-term liabilities from the purchases. Tax liabilities are income tax liabilities and are recognised as a liability, because they are paid one Accounting period later. <?page no="517"?> Berkau: BASICS of ACCOUNTING 40.516 (Note, you can compare the annual totals of assets and equity + liabilities in order to check your business plan on consistency. It does not prove correctness of the business plan, but it indicates consistency with regard to the double entry system.) Companies prepare a planned cash flow statement, too. A planned cash flow statement is a list of future operating cash flows, investing cash flows and financial cash flows. The list is on cash flow group level mostly. Many companies determine the operating cash flow by reconciliation of the net operating profit with the operating cash flow. The cash flow statement contains similar data as the liquidity plan. However, in a cash flow statement the structure of cash flows is based on the origin of the cash flow triggers: operating activities, investing activities and financial activities. 20X1 20X2 20X3 CASH FLOWS CF operating activities EBT 380,000.00 382,000.00 384,000.00 adj for depreciation 200,000.00 200,000.00 200,000.00 adj for interest 20,000.00 18,000.00 16,000.00 tax paid 0.00 (114,000.00) (114,600.00) Changes in A/ P 100,000.00 Changes in tax liab. 0.00 0.00 0.00 Changes in A/ R, prep. exp (5,000.00) 695,000.00 486,000.00 485,400.00 CF investing activities adj for acquisition (600,000.00) (600,000.00) 0.00 0.00 CF financing activities Share issue 500,000.00 interest & pay-off (60,000.00) (58,000.00) (56,000.00) taking bank loan 400,000.00 840,000.00 (58,000.00) (56,000.00) Total cash flow 935,000.00 428,000.00 429,400.00 Figure 40.7: KIRSTENBOSCH Ltd.’s statement of cash flows The business plan allows to compare liquidity planning and future cash flows. The cash flows indicate the difference on cash/ bank. In the liquidity plan, the balancing figure of the Cash/ Bank account is calculated by adding cash flows to the opening amount. In order to check the amounts for KIRSTENBOSCH Ltd., we calculate the total cash flow for 20X1. It equals to the sum of cash flows from operating activities, cash flows from investing activities and cash flows from financing activities: 695,000 - 600,000 + 840,000 = 935,000.00 EUR . As there is no opening amount for the Cash/ Bank account, the <?page no="518"?> Berkau: BASICS of ACCOUNTING 40.517 liquidity equals to 935,000.00 EUR in 20X1. Compare the calculation to Figure 40.5. In the next Accounting period 20X2, along KIRSTENBOSCH Ltd.’s cash flow statement in Figure 40.7, the total cash flow equals to: 486,000 + 0 - 58,000 = 428,000.00 EUR . Based on the cash flow calculation, the liquidity is the sum of the opening amount (same as the closing amount of the previous period) and the cash flow: 935,000 + 428,000 = 1,363,000.00 EUR . This is the amount you can read from the table in Figure 40.5 - bottom line. Accordingly, the liquidity in the last accounting period equals to: 1,363,000 + 485,400 + 0 - 56,000 = 1,792,400.00 EUR . The amount is displayed in the liquidity plan in Figure 40.5 and as balancing figure of the Cash/ Bank account on the balance sheet - such as shown as the cash/ bank C/ B item in Figure 40.6. A business plan for a production firm is more complicated, because there are materials that are parts of the finished goods and cause inventory movements. We present the case study McTOY GmbH, which is a German toy manufacturer. McTOY is a case study for Management Accounting used in classes as a MS Excel task. You should prepare the solution by a spreadsheet program! The case study is about a production firm with different products where amounts and prices will change. Its solution might take 6 hours with Excel support, otherwise even longer.) McTOY GmbH is a production firm for bicycles, tricycles, and go-karts. The toys consist of a frame and 2, 3, or 4 wheels. The unit-amount of revenue for bicycles is 2,400, for tricycles 600, and for gokarts 960. The revenue for tricycles and go-karts increases during 20X1 to 20X4 by 100 units every year. The net selling price for a bicycles is 140.00 EUR for a tricycles 320.00 EUR and for a go-kart 350.00 EUR. The prices remain stable during the periods 20X1 to 20X4. Observe the revenue plan as in Figure 20X1 20X2 20X3 20X4 bicycles sold [units] 2400 2400 2400 2400 revenue bicycles [EUR] 336,000.00 336,000.00 336,000.00 336,000.00 tricycles sold [units] 600 700 800 900 revenue tricycles [EUR] 192,000.00 224,000.00 256,000.00 288,000.00 go-karts sold [units] 960 1060 1160 1260 revenue go-karts [EUR] 336,000.00 371,000.00 406,000.00 441,000.00 total revenue 864,000.00 931,000.00 998,000.00 1,065,000.00 REVENUE PLAN McToy GmbH for 20X1 to 20X4 Figure 40.8: McTOY GmbH’s revenue plan 40.8. <?page no="519"?> Berkau: BASICS of ACCOUNTING 40.518 In case you prepare the revenue plan with MS Excel, we recommend preparing a master data sheet. That sheet should be structured that way that you only calculate one toy and one Accounting period and determine the other data by copying cells. An example for this kind of master data sheet could look as in Figure 40.9: Figure 40.9: McTOY GmbH’s master data sheet McToy GmbH‘s costs contain start-up costs, material expenses and manufacturing expenses. The latter one is labour and overheads. Furthermore, non-manufacturing expenses are relevant. The start-up costs equal to 205,000.00 EUR. Direct materials are steel and wheels at the prices below: (1) 3.00 EUR/ kg steel, (2) 8.00 EUR/ steel wheel (3) 5.00 EUR/ plastic wheel (for the tricycles and go-karts). From the bill of materials (BOM), you know that a bicycle frame contains 9 kg of steel, the frame for tricycles 14 kg and the go-kart frame 26 kg. In order to calculate the material expenses for the bicycles in 20X1, McToy GmbH multiplies the amounts by their prices: 2,400 × 3 × 9 = 64,800.00 EUR . <?page no="520"?> Berkau: BASICS of ACCOUNTING 40-519 20X1 20X2 20X3 20X4 Start-up costs other 205,000.00 Material expenses Steel bicycle 64,800.00 64,800.00 64,800.00 64,800.00 tricycle 25,200.00 29,400.00 33,600.00 37,800.00 go-kart 74,880.00 82,680.00 90,480.00 98,280.00 Wheels bicycle 38,400.00 38,400.00 38,400.00 38,400.00 tricycle 9,000.00 10,500.00 12,000.00 13,500.00 go-kart 19,200.00 21,200.00 23,200.00 25,200.00 total material 231,480.00 246,980.00 262,480.00 277,980.00 expenses COST PLAN McToy GmbH for 20X1 to 20X4 Figure 40.10: McTOY GmbH’s cost plan (partial) (Note, the total material costs do not contain the start-up costs.) McTOY GmbH‘s production amounts equal to the sales amounts. This means, there is no closing stock of materials nor of finished goods. There are 3 production steps: welding, coating and the wheel assembling. Direct labour (at a cost rate 45.00 EUR/ h) for the Coating and Assembling department are as depicted in the routings. A routing is a document in a production firm that tells how much time a production step on which machine group takes to get processed. [min] per bicycles per tricycles per goKart Welding - - - Coating 15 15 15 Assembling 20 30 40 Figure 40.11: McTOY GmbH’s routing information (1) For welding no direct labour is required as McTOY GmbH deploys a welding robot. For the manufacturing overheads, the overhead allocation rates are given. Assume, the predetermined overhead allocation rates (POR) apply. All overhead rates are linked to the workload measured by the hour. In the welding department the hourly cost rate is 50.00 EUR, in the Coating department it equals to 42.00 EUR/ h and in the assembling department it equals to 8.00 EUR/ h. The operating time spent in the three department is given by Figure 40.12. It can be read from the routing as well. <?page no="521"?> Berkau: BASICS of ACCOUNTING 40.520 [min] per bicycles per tricycles per goKart Welding 18 30 48 Painting 15 15 15 Assembling 20 30 40 Figure 40.12: McTOY GmbH’s routing information (2) The calculation of the manufacturing costs for bicycles is based on minutes and goes as follows: 2,400 × (45/ 60) × 15 + 2,400 × (45/ 60) × 20 + 2,400 × (50/ 60) × 18 + 2,400 × (42/ 60) × 15 + 2,400 × (8/ 60) × 20 = 130,600.00 EUR . The amount contains direct labour costs and manufacturing overheads. You can read the same amount for bicycles from the cost plan: 36,000 + 25,200 + 6,400 + 27,000 + 36,000 = 130,600.00 EUR . 20X1 20X2 20X3 20X4 MANUFACTURING OVERHEADS Welding bicycle 36,000.00 36,000.00 36,000.00 36,000.00 tricycle 15,000.00 17,500.00 20,000.00 22,500.00 go-kart 38,400.00 42,400.00 46,400.00 50,400.00 Coating department bicycle 25,200.00 25,200.00 25,200.00 25,200.00 tricycle 6,300.00 7,350.00 8,400.00 9,450.00 go-kart 10,080.00 11,130.00 12,180.00 13,230.00 Assembling bicycle 6,400.00 6,400.00 6,400.00 6,400.00 tricycle 2,400.00 2,800.00 3,200.00 3,600.00 go-kart 5,120.00 5,653.33 6,186.67 6,720.00 DIRECT LABOUR Coating bicycle 27,000.00 27,000.00 27,000.00 27,000.00 tricycle 6,750.00 7,875.00 9,000.00 10,125.00 go-kart 10,800.00 11,925.00 13,050.00 14,175.00 Assembling bicycle 36,000.00 36,000.00 36,000.00 36,000.00 tricycle 13,500.00 15,750.00 18,000.00 20,250.00 go-kart 28,800.00 31,800.00 34,800.00 37,800.00 COST PLAN McToy GmbH for 20X1 to 20X4 Figure 40.13: McTOY GmbH’s cost plan (partial) <?page no="522"?> Berkau: BASICS of ACCOUNTING 40.521 Besides the above mentioned manufacturing costs there are labour costs for the supervisor. They are considered as manufacturing overheads. They are not included in the rates. They equal to 75,000.00 EUR per annum plus 12,000.00 further expenses for McTOY GmbH‘s contribution to social security for its supervisor. Depreciation is included in the rates for production. McToy GmbH buys machinery at the beginning of 20X1 to the extent of 676,000.00 EUR (net amount). The useful life of the items of property, plant and equipment is 8 years. There is no residual value to be considered. Depreciation is along straight line method. Accordingly, depreciation amounts to 676,000/ 8 = 84,500.00 EUR . Additionally, McTOY GmbH takes a bank loan of 700,000.00 EUR on 2.01.20X1. The bank loan is an annuity that comes with an annual payment to an extend of 56,000.00 EUR. The rate of interest is 6% per annum, annually compounded and based on the amount owed. Interest and pay-off are to be paid at the yearend. The bank loan is paid-off completely at the end of 20X4. Observe the interest and pay-off schedule for the bank loan in Figure 40.14. 0.06 Amount Interest Pay-off Annuity Year 700,000.00 42,000.00 14,000.00 56,000.00 20X1 686,000.00 41,160.00 14,840.00 56,000.00 20X2 671,160.00 40,269.60 15,730.40 56,000.00 20X3 655,429.60 39,325.78 655,429.60 694,755.38 20X4 Figure 40.14: McTOY GmbH’s bank loan The amount for interest appears in the cost plan. Further non-manufacturing expenses are: third party expenses (cleaning lady): 10,500.00 EUR/ a, membership fees for Verein Deutscher Ingenieure: 96.00 EUR/ a, building costs for the administration office: 36,000.00 EUR/ a, motor vehicle expenses (rent, petrol): 12,000.00 EUR/ a, administration expenses (clerk): 36,000.00 EUR/ a and annual insurance fees to an extent of 4,800.00 EUR. The aggregated cost plan is provided by Figure 40.15 <?page no="523"?> Berkau: BASICS of ACCOUNTING 40.522 20X1 20X2 20X3 20X4 Start-up costs other 205,000.00 Material expenses total 231,480.00 246,980.00 262,480.00 277,980.00 Production facillity costs total 144,900.00 154,433.33 163,966.67 173,500.00 Labour in production departments including supervisor 209,850.00 217,350.00 224,850.00 232,350.00 Other expenses 3rd party costs 10,500.00 10,500.00 10,500.00 10,500.00 Fees 96.00 96.00 96.00 96.00 Building costs 36,000.00 36,000.00 36,000.00 36,000.00 MV expenses 12,000.00 12,000.00 12,000.00 12,000.00 Administration 36,000.00 36,000.00 36,000.00 36,000.00 Insurance 4,800.00 4,800.00 4,800.00 4,800.00 Interest 42,000.00 41,160.00 40,269.60 39,325.78 141,396.00 140,556.00 139,665.60 138,721.78 Total costs 932,626.00 759,319.33 790,962.27 822,551.78 COST PLAN McToy GmbH for 20X1 to 20X4 Figure 40.15: McTOY GmbH’s aggregated cost plan The calculation of profit for 20X1 is as below: 864,000 - 932,626 = -68,626.00 EUR . The amount is negative and means a loss. There are no income taxes to be paid in 20X1. McTOY GmbH has to carry forward the loss to the next accounting period. (Note, the German tax law allows to deduct profits by carry forward/ backward to other accounting periods based on § 10 EStG. We ignore tax impacts on profits carried to other Accounting periods here due to simplicity.) The loss carried forward to the next Accounting period 20X2 reduces the distributable amount in that period. In 20X2, the profit after taxes equals to: 171,680 × (1 - 30%) = 120,176.47 EUR . The distributable amount for the appropriation of profits equals to: 120,176.47 - 68,626 = 51,550.47 EUR . As you can see, the loss carried forward effectuates the dividend and the reserves but it does not change income taxes. The business plan will be interesting for investors also. For that reason, we consider the calculation of the net dividend here. However, for the case study McTOY GmbH we apply German law. The law states that income from dividends is taxable at a tax rate of 25 % plus German Reunion tax at a tax rate of 5.5 %. The German law follows the approach of a withholding tax. Tax withholding means, the company owes the revenue service the taxes on behalf of its residential tax payers. <?page no="524"?> Berkau: BASICS of ACCOUNTING 40-523 (Note, along the German tax law, there is a tax exemption limit, which we ignore for the case study.) A residential tax payer, who earns 10,000.00 EUR on capital returns must pay 25 % tax thereon. He further has to pay 5.5 % based on the tax amount for the German reunion tax. The taxes on the 10,000.00 EUR dividend or interest income equal to: 2,500 × (1 + 5.5%) = 2,637.50 EUR. In case the residential tax payer is a church member 8 % or 9 % (depending on the county) will be added. (Note, for the case study we ignore the church tax.) 20X1 20X2 20X3 20X4 Revenue 864,000.00 931,000.00 998,000.00 1,065,000.00 Cost (932,626.00) (759,319.33) (790,962.27) (822,551.78) Earnings before Tax (68,626.00) 171,680.67 207,037.73 242,448.22 less income tax (30%) 0.00 51,504.20 62,111.32 72,734.47 Earnings after Taxes (68,626.00) 120,176.47 144,926.41 169,713.75 Earnings after Taxes (68,626.00) 120,176.47 144,926.41 169,713.75 add P/ L carried forward 0.00 (68,626.00) 0.00 0.00 Distributable Amount (68,626.00) 51,550.47 144,926.41 169,713.75 (1) Gross Dividend 0.00 25,775.23 72,463.21 84,856.88 less Capital Income Tax 0.00 (6,443.81) (18,115.80) (21,214.22) less German Reunion Tax 0.00 (354.41) (996.37) (1,166.78) Net Dividend 0.00 18,977.02 53,351.04 62,475.88 (2) Earnings Reserves 0.00 25,775.23 72,463.21 84,856.88 McTOY GmbH's PROFITABILITY ANALYSIS for 20X1 - 20X4 Figure 40.16: McTOY GmbH’s profit plan For McTOY GmbH the appropriation of profits is every year at a 50: 50-ratio as reserves to dividend. Thus, 50 % of the distributable amount are paid as a dividend and the other half will be added to the reserves. In 20X1, all owners of McTOY GmbH together, earn a net dividend of: (51,550.47 / 2) × (1 - 25% × (1 + 5.5%)) = 18,977.02 EUR . In the next year it will be 72,463.21 and in the last year they get 62,475.88 EUR. (Note, the total amount of taxes on McTOY GmbH’s earnings will be: 51,504.20 + 6,443.81 + 354.41 = 58,302.42 EUR .) You might ask yourself whether a planned loss is acceptable. Actually, the answer is No. In case the company got just established based on an issued capital of 25,000.00 EUR, the first year’s loss will exceed the equity. The commercial law will call a situation like that an accounting insolvency, meaning that debts exceed the equity. Along German law an accounting insolvency requires the company filing for bankruptcy. However, the case study considers an equity of 170,000.00 EUR, which heals the first loss of 68,626.47 EUR. <?page no="525"?> Berkau: BASICS of ACCOUNTING 40-524 The business plan contains a liquidity planning as well. Pls, consider for liquidity planning: The VAT rate is 20 %. VAT is to be paid or refunded in the next accounting period. Payment of taxes and for dividends are due in the next year. McToy GmbH’s equity (as issued capital) amounts to 170,000.00 EUR. The liquidity plan contains the opening amount in the Cash/ Bank account being 170,000.00 EUR and all cash inflows and cash outflows. Position 20X1 20X2 20X3 20X4 Opening value Equity 170,000.00 OV 0.00 146,178.00 574,018.67 782,846.57 170,000.00 146,178.00 574,018.67 782,846.57 Cash in Bank loan 700,000.00 0.00 0.00 0.00 Proceeds 864,000.00 931,000.00 998,000.00 1,065,000.00 Output VAT 172,800.00 186,200.00 199,600.00 213,000.00 VAT refund 0.00 222,496.00 49,396.00 52,496.00 1,736,800.00 1,339,696.00 1,246,996.00 1,330,496.00 Cash out Annuity (56,000.00) (56,000.00) (56,000.00) (694,755.38) Acquisition (676,000.00) 0.00 0.00 0.00 input VAT (acquisition) (135,200.00) 0.00 0.00 0.00 start-up costs (205,000.00) 0.00 0.00 0.00 input VAT (start-up) (41,000.00) 0.00 0.00 0.00 Material expenses (231,480.00) (246,980.00) (262,480.00) (277,980.00) VAT from materials (46,296.00) (49,396.00) (52,496.00) (55,596.00) Production facilities (144,900.00) (154,433.33) (163,966.67) (173,500.00) Labour in production (209,850.00) (217,350.00) (224,850.00) (232,350.00) other expenses (141,396.00) (140,566.00) (139,665.60) (138,721.78) adj: depr + interest 126,500.00 125,660.00 124,769.60 123,825.78 VAT payment 0.00 (172,800.00) (186,200.00) (199,600.00) Tax payment 0.00 0.00 (51,504.20) (62,111.32) dividend paid 0.00 0.00 (25,775.23) (72,463.21) (1,760,622.00) (911,865.33) (1,038,168.10) (1,783,251.91) Liquidity 146,178.00 574,008.67 782,846.57 330,090.66 McToy AG's LIQUIDITY PLAN for 20X1 to 20X4 Figure 40.17: McTOY GmbH’s liquidity plan In 20X1, the liquidity plan discloses as cash inflows the payment from the bank for the bank loan 700,000.00 EUR and the proceeds, which contain the net amount resulting from the revenue and output-VAT to the extent of: 864,000 × (1 + 20%) = 1,036,800.00 EUR . Together, the cash inflows add up to: 700,000 + <?page no="526"?> Berkau: BASICS of ACCOUNTING 40-525 1,036,800 = 1,736,800.00 EUR . The amount of output-VAT collected from the customers is paid to the revenue service in the next Accounting period 20X2. It results in a cash outflow of 172,800.00 EUR. In the next following Accounting periods, McTOY GmbH has to consider a cash inflow resulting from the refund of the input-VAT. Input-VAT is paid by McTOY GmbH on the start-up costs, the investment and the material expenses. The refund for the input-VAT paid in 20X1 and refunded in 20X2 equals to: 135,200 + 41,000 + 46,296 = 222,496.00 EUR . In 20X1, the amounts for cash outflows result from the bank loans annuity of 56,000.00 EUR, from the investment of: 676,000 × (1 + 20%) = 811,200.00 EUR , from the start-up costs of: 205,000 × (1 + 20%) = 246,000.00 EUR , from the purchase of the materials to an extent of: 231,480 × (1 + 20%) = 277,776.00 EUR , from the overheads in the factory of 144,900.00 EUR, from the labour costs in the factory of 209,850.00 EUR and from other expenses, which add up to 141,396.00 EUR as displayed in the cost plan. McTOY GmbH records an adjustment of: 84,500 + 42,000 = 126,500.00 EUR for depreciation and interest in the liquidity plan. Depreciation is deducted from cash outflows as it is an expense included in the production costs but does not get paid. The amount of interest is included in the other expenses but got considered by the annuity already. For that reason, depreciation and interest are added to the negative cash outflows. The total cash outflow during 20X1 equals to: 56,000 + 811,200 + 246,000 + 277,776 + 144,900 + 209,850 + 141,396 - 126,500 = 1,760,622.00 EUR . The liquidity is the amount of cash/ bank at the end of the accounting period. In 20X1 the amount equals to: 170,000 + 1,736,800 - 1,760,622 = 146,178.00 EUR . Even as the profitability plan indicates a loss the company does not run out of cash. However, the cash flow is negative. The payments for income taxes and for dividend only start in 20X3 as in 20X1 there is a loss and the payment for 20X2 takes place in the next following Accounting period 20X3. In order to check the financial position of the company, we prepare a budgeted balance sheet. It can be observed in Figure 40.18. <?page no="527"?> Berkau: BASICS of ACCOUNTING 40-526 A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 338,000.00 Share capital 170,000.00 Intangibles Reserves 183,095.32 Financial assets R/ E Current assets Liabilities Inventory Interest bear liab 0.00 A/ R 55,596.00 A/ P 213,000.00 Prepaid expenses SH4D 84,856.88 Cash/ Bank 330,090.66 Tax liabilities 72,734.47 723,686.66 723,686.66 McTOY GmbH's STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 40.18: McTOY GmbH’s budgeted balance sheet The balance sheet is prepared as at the 31.12.20X4. This is the last day of the period the business plan is for. The amount of property, plant, and equipment equals to the cost of acquisition less four times depreciation: 676,000 - 4 × 84,500 = 338,000.00 EUR . The receivables are the amount from input-VAT paid on material purchases in 20X4 which will be claimed back from the revenue service in 20X5. The amount for cash/ bank can be read from the liquidity plan. Equity equals to 170,000.00 EUR as given by the case study. The amount for the reserves is the total of additions to reserves in 20X2 - 20X4: 25,775.23 + 72,463.21 + 84,856.88 = 183,095.32 EUR . The payables result from the output-VAT collected from the customers and to be paid to the revenue service in 20X5. SHD stands for shareholders for dividend and contains the gross dividend. For the balance sheet, the tax on capital return is a liability as well as the dividend is. For that reason, there is no distinction made between the tax liability and the dividends payable. The tax liabilities displayed are income tax liabilities from 20X4 and payable in 20X5. Summary: Companies plan their operations for the next upcoming Accounting periods as a business plan. The business plan contains the revenue plan, the cost plan, the profitability plan, the liquidity plan, the pro-forma budgeted balance sheet and future cash flows. Working Definitions: Revenue Plan: A revenue plan is a list of planned and budgeted revenues for a business displayed on revenue group level for a particular Accounting period. Cost: Costs are deductions of resources caused by the business activities. <?page no="528"?> Berkau: BASICS of ACCOUNTING 40-527 Cost Plan: A cost plan is a list of planned and budgeted costs for a business displayed on detailed costs or cost group level for a particular Accounting period. Profit Plan: A profit plan is a schedule where planned and budgeted costs will be deducted from the revenues for a particular Accounting period. Liquidity Plan: A liquidity plan is a list that shows the opening amount of the Cash/ Bank account, adds cash inflows and deducts cash outflows for a future particular Accounting period Budgeted Balance Sheet: A budgeted balance sheet is a pro-forma statement of financial position at a future balance sheet date. Budgeted Cash Flow Statement: A planned cash flow statement is a list of future operating cash flows, investing cash flows and financial cash flows. Routing: A routing is a document in a production firm that tells how much time a production step on which machine group takes to get processed. <?page no="529"?> Berkau: BASICS of ACCOUNTING 41-528 41. Cost Behaviour / Cost Separation Learning Objectives In contrast to Financial Accounting, the Management Accountant predicts/ plans future costs. From studying cost behaviour, Management Accountants learn what costs depend on and how much costs are to be expected when producing certain amounts of goods or services. The knowledge about costs is necessary for setting up the business plan. In this chapter we demonstrate different cost behaviour patterns and study how to determine costs based on outputs planned. We distinguish between fixed and variable costs. The difference between fixed and variable costs is that variable costs depend on the output of the business whereas fixed costs stay unchanged no matter how much the output is. Costs are caused by business activities or by past events. An example for a past event is the acquisition of machinery which is followed by depreciation. Depreciation is a fixed cost. Other costs depend directly on production activities of a company, e.g. material expenses. A company producing only few goods, will have less material costs than one that produces numerous goods. In Management Accounting, costs are classified based on their behaviour. It describes, how costs will change based on their dependency on particular factors. The factors for variable costs depend on the output of a company. Proportional costs depend directly on the output. In order to understand the dependencies, take a look at an example: A car manufacturer records assembling costs for the dash boards built into its cars. The factor, these costs depend on, is the assembling time. With regard to cost behaviour, we know that the assembling time for two dash boards is double of the time for assembling one dash board. The time for three dash boards will be triple of the assembling time for one dash board, and so on. Thus, thee time for assembling dash boards depends proportionally on the amount of dash boards installed. Furthermore, the assembling costs depend proportionally on the assembling time. In total, we see that the assembling costs are proportional costs in this example. Management Accountants identify and plan factors like the assembling time in order to predict/ plan costs. In case costs depend proportionally on an output related factor, we refer to the factor as a reference unit. In the previous case the assembling time is the reference unit for the assembling cost centre. For now, we only distinguish between costs that depend on a reference unit and those that do not. The first ones are called proportional costs the latter ones are fixed. Fixed costs do not change with the output. An example for fixed costs is depreciation: No matter how many products are produced by a machine, it’s time-related depreciation costs will remain the same. Other cost behavioural patterns are step-fixed costs. Those are costs that increase if a particular unit amount is <?page no="530"?> Berkau: BASICS of ACCOUNTING 41-529 manufactured. Think about a university, that runs an examination department. There might be an administration officer who can serve for 100 students per semester. In case the university enrols 200 students, it needs to employ 2 officers. In case of 284 students, there will be 3 admin officers etc. If you draw the cost function depending on the student amount, the diagram will look like a flair of stairs. For this reason, Management Accountants call this cost behaviour pattern stepfixed costs. Most of the cases are related to mixed cost functions. Mixed costs contain a portion that is proportionally depending on the output and another portion that is fixed. For the cost planning it is required to isolate the portion that is fixed from the proportional costs. One approach on cost separation that is the technical term to determine the proportional cost portion and fixed costs within mixed costs is to analyse each cost separately. However, very often, hundreds of different cost categories apply in a company. For that reason, there are better ways and more efficient ways of cost separation. They all are based on the total costs, which contain different cost categories, such as labour, depreciation etc. Methods of cost separations are: (1) High-low method (2) Scatter graph (3) Regression method. All methods result in a mathematical cost function described as: C = PC × RU + FC, with C being total costs, PC = proportional costs, RU = reference unit and FC = fixed costs. The cost function can be shown by a C(RU) diagram, which displays the reference units on the x-axis and the costs on the y-axis. In order to compare the methods, we take a look at a case study. DANNING Ltd. is a tax attorney business. During the last four Accounting periods (months), DANNING Ltd. recorded the amount of tax statements prepared for clients. The costs result from the admin clerks for customer care as well as from the tax attorney’s remuneration. Thus, the total costs contain different cost categories already, which are different labour costs. For future planning (based on the amount of tax statements), DANNING Ltd. wants to predict its costs. For that reason, it has to determine the cost function C(TS) which depends on the reference unit tax statements (TS). DANNING Ltd. wants to know, how many costs apply for which amount of tax statements. It assumes, the costs for the customer care are fixed costs and the remuneration for the attorneys is variable to the amount of tax statements. However, the recorded data are the total costs and the amount of each cost category is unknown. We run a cost separation based on the three methods previously mentioned. Observe the recorded costs from the past month depicted by Figure 41.1: <?page no="531"?> Berkau: BASICS of ACCOUNTING 41-530 Month Costs [EUR] Tax statements January 27 500.00 30 February 32 500.00 40 March 37 500.00 50 April 30 000.00 35 Figure 41.1: DANNING Ltd.’s cost volume records ad (1): High-low Method Applying the high-low method, DANN- ING Ltd. only considers the months of January and March, as these will be the highest and lowest in terms of TS amounts. The amount of 30 TS is the lowest observation, the amount of 50 in March the highest one. DANNING Ltd. knows the costs for the low amount of tax statements which equals to: C(TS = 30) = 27,500.00 EUR and the peak month’s costs as: C(TS = 50) = 37,500.00 EUR. You can read the costs from the records. DANNING Ltd. considers the cost function as mixed cost. The variable portion depends on the reference unit TS (tax statements). The slope of the cost line represents the proportional costs and equals to (37,500 - 27,500) / (50 - 30) = 10,000 / 20 = 500.00 EUR/ TS . The fixed costs FC can be calculated based on the information provided for one month such as January. For January the cost function applies: C (TS = 30) = 27,500 = 500 × 30 + FC. We isolate the fixed costs and get: FC = 27,500 - 15,000 = 12,500.00 EUR . Based on the calculation of the proportional and fixed costs, DANNING Ltd.’s cost function is: C (TS) = 500 × TS + 12,500. The application of the high-low method is simple. The downside of this method lies in the fact that only 2 months are considered for the determination of the cost function. Be aware, only all costs must really meet the cost line in a diagram to consider this method being correct. Cost observations which contain cost deviations will make the high-low method fail or not being accurate. ad (2): Scatter Graph The scatter graph method requires drawing the monthly observations to scale which at DANNING Ltd.’s results in 4 marks in the cost - tax statement diagram. In the next step, we have to draw a line through the marks that way that all marks are on or at least very close to the cost line. Observe Figure 41.2. to study a hand drawn cost function for DANNING Ltd. <?page no="532"?> Berkau: BASICS of ACCOUNTING 41-531 Figure 41.2: DANNING Ltd.’s cost separation by scatter graph method Obviously,-the-scatter-graph-is-no-option- for- Accountants- as- it- is- not- accurate- enough- and- it- requires- drawing- on- pa‐ per.-However,-the-scatter-graph-method- is-nice-in-order-to-explain-cost-separation- in- academia- and- management- meet‐ ings.- ad-(3): -Regression-Method- The-regression-method-is-the-most-com‐ mon- approach- for- cost- separation.- The- regression- method- is- based- on- 2- inde‐ pendent-equations-linked-to-the-cost‐tax- statement-diagram.-The-2-equations-are- required- in- order- to- determine- 2- varia‐ bles-as-PC-=-proportional-costs-and-FC-=- fixed-costs.-The-equation-refers-to-all-ob‐ servations,-which-will-be-count-by-the-in‐ dex-i.-At-DANNING-Ltd.-i-=-1-…-4.- The cost formula to be determined comes with the common structure as: C (TS) = PC × TS + FC The first equation for the cost separation is based on i rectangles, which have an area of TS i × C i , with i = 1 … 4 for 4 monthly observations.            4 1 2 4 1 4 1 i i i i i i i TS PC TS FC TS C The second equation is based on the cost amounts only. There are 4 costamounts C i . The costs will be divided into a proportional portion and a fixed one. <?page no="533"?> Berkau: BASICS of ACCOUNTING 41-532 ∑ ∑ = = × + × = 4 1 4 1 4 i i i i TS PC FC C For easy calculations, we determine a few figures required by the equations by a MS Excel sheet as it goes quick and does not require further explanation. Consider these calculations as workings only. i C TS C x TS TS 2 1 27 500.00 30 825 000.00 900 2 32 500.00 40 1 300 000.00 1600 3 37 500.00 50 1 875 000.00 2500 4 30 000.00 35 1 050 000.00 1225 sum 127 500.00 155 5 050 000.00 6225 Figure 41.3: Workings for regression analysis We prepare the cost function for DANNING Ltd.’s costs depending on tax statement amounts: From the 1 st equation, we derive: 5,050,000 = FC × 155 + PC × 6,225. From the 2 nd equation, we derive: 127,500 = FC × 4 + PC × 155. => FC = (127,500 - PC × 155) / 4 We insert the 2 nd equation into the 1 st one: => 5,050,000 = 155 × (127,500 - PC × 155) / 4 + PC × 6,225 = 4,940,625 - PC × 6,006.25 + PC × 6,225 => PC = (5,050,000 - 4,940,625) / (6,225 - 6006.25) = 500.00 EUR/ TS Now, we insert the proportional costs PC into the 2 nd equation and calculate the fixed costs FC: => FC = (127,500 - 500 × 155) / 4 = 12,500.00 EUR . Again, the cost function for DANNING Ltd. equals to: C (TS) = 500 × TS + 12,500 . In case DANNING Ltd. expects 48 tax statements in May, the planned costs will equal to C (48) = 500 × 48 + 12,500 = 36,500.00 EUR . The common format for a regression method is based on the variable X and Y. The simple regression method determines a linear function Y(X) which has the form Y(X) = a × X + b. a is the slope of the line and b is the amount for X = 0. Y(0) = b. For n observations, indicated by i = 1 … n, the two equations will look as below: (1) ∑ ∑ ∑ = = = × + × = × n i i n i n i i i i X a X b Y X 1 2 1 1 <?page no="534"?> Berkau: BASICS of ACCOUNTING 41-533 (2) ∑ ∑ = = × + × = n i n i i i X a b n Y 1 1 Summary: Cost of a business can depend on the amount of certain units. For cost planning, Management Accountants seek to identify reference units the costs will proportionally depend on. However, not all costs depend on reference units. Some costs will be fixed costs. Cost separation is a method to determine the amount of proportional costs and fixed costs in a business, where mixed costs apply. The cost separation works for cost planning, as proportional costs will be calculated based on the output and fixed costs only change on decisions made by management. Working Definitions: Proportional Costs: Proportional costs depend directly on the output. Reference Unit: In case costs depend proportionally on an output related factor, we refer to the factor as a reference unit. Fixed Costs: Fixed costs do not change with the output. Mixed Costs: Mixed costs contain a portion that is proportionally depending on the output and another portion that is fixed. Cost Separation: Cost separation is the determination the proportional cost portions and fixed costs within mixed costs. <?page no="535"?> Berkau: BASICS of ACCOUNTING 42-534 42. Cost Volume Profit Analysis (CVP-Analysis) Learning Objectives The cost volume profit analysis (CVPanalysis) requires a cost separation as discussed in the previous chapter Cost Behaviour / Cost Separation. It helps managers to find the right level of activities for their business. Based on selling prices and costs, it shows from which activity level onwards the company earns profit. This chapter aims to explain the concept of a CVP-analysis. After studying the chapter, you should be able to apply and discuss the outcome of a CVP-analysis and be able to determine the product amount and/ or product mix that makes the company profitable. The CVP-analysis is also known as break-even analysis. This expression meets the concept quite well: Once the company starts its operations, fixed costs are likely to apply. A business without investments is very seldom. Think about a taxi company. It must first by a car it operates for rendering transport service. Without investments, the company has to rent the taxi car. Investments result from the acquisition of machinery and lead to fixed costs, such as depreciation. The first amount of products/ services won’t be able to cover all fixed costs. Only after the business produces a certain amount of goods / or renders so many services that it covers its fixed costs, the company earns profit. Then the revenue exceeds costs. We say, the company breaks-even. This means the Management Accountant of the company has to determine the right product/ service amount(s) in order to make the company profitable. In particular, the breaking even depends on the product amounts or service amounts sold. A company’s revenue has to cover all fixed costs and proportional costs to make the company earn a profit. Assume, there is a company that sells goods at 115.00 EUR with variable unit cost of manufacturing being 65.00 EUR. If the fixed costs are 1,000.00 EUR, the 50.00 EUR difference between revenue und variable unit costs: 115 - 65 = 50.00 EUR (= contribution margin) have to cover fixed costs. Only once 20 products are sold, the contribution margins will cover fixed costs: 20 × 50 = 1,000.00 EUR. At this stage, the company does not earn a profit: 20 × (115 - 65) - 1,000 = 0.00 EUR. From the 21 st product sold onwards, the business earns a profit. If the company sells 21 products the profit will be: 21 × (115 - 65) - 1,000 = 50.00 EUR. We say: the company has to produce and sell more than 20 goods in order to break-even. In this chapter we seek to find the critical amount from which onwards the company becomes profitable, such as the 20 units in the example above. The following assumptions are to be fulfilled to study a CVP-analysis: (1) The selling prices per unit are constant. In particular, there is no discount on high selling amounts, no “buy 10 - get one free”. (2) The unit cost function (cost as a function of the good/ service amounts) is constant. This means variable costs do not change. In case of constant unit <?page no="536"?> Berkau: BASICS of ACCOUNTING 42-535 costs, the cost diagram is a line. Cost separation must apply. Furthermore, fixed costs should not depend on the amounts, which implies there are no step-fixed costs. (3) Companies that are selling numerous goods must sell a constant mix of goods. This requires that the ratio of good amounts is always the same, such as “for 3 oranges the business sells 2 bananas”. (4) There are no changes of inventories of finished goods. The production amount equals to the sales amount. This means, goods are not put on stock or released from stock. We study the CVP analysis by the case study of DEERFIELD TOURS (Pty) Ltd., which is a tourist business. DEERFIELD TOURS (Pty) Ltd. is a tourist enterprise offering 1-week trips to the Garden route in South Africa. The trips start and end at Frankfurt (Main) airport in Germany. The variable costs per person (/ p) for the trip are the flights at 1,500.00 EUR each, the hotel costs: 7 × 100 = 700.00 EUR/ p and food at: 8 × 50 = 400.00 EUR/ p . In total, the variable costs are: 1,500 + 700 + 400 = 2,600.00 EUR/ p . The fixed costs are for the trip planning and administration 3,400.00 EUR and for the transport in a rented 25seater bus 7,000.00 EUR. DEERFIELD TOURS (Pty) Ltd. sells a trip at 3,900.00 EUR. The maximum traveller amount is 25. DEERFIELD TOURS (Pty) Ltd. reserves the right to cancel a trip if less than 10 travellers take the tour. In order to determine the costs DEER- FIELD TOURS (Pty) Ltd. prepares a MS Excel sheet and call it contribution income statement. It tells the company how much profit it will make based on the amount of travellers. It is called contribution income statement, as the contribution margin is calculated by deducting variable expenses from sales revenue. The calculation is depicted by Figure 42.1. Sales of 1 trips Item Total Per unit Sales 3,900.00 3,900.00 Variable expenses (2,600.00) (2,600.00) Contribution margin 1,300.00 1,300.00 less: Fixed expenses (10,400.00) Net profit (9,100.00) CONTRIBUTION INCOME STATEMENT Figure 42.1: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (1) In case they sell 10 trips the contribution income statement looks as in Figure 42.2. <?page no="537"?> Berkau: BASICS of ACCOUNTING 42-536 Sales of 10 trips Item Total Per unit Sales 39,000.00 3,900.00 Variable expenses (26,000.00) (2,600.00) Contribution margin 13,000.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 2,600.00 CONTRIBUTION INCOME STATEMENT Figure 42.2: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (2) In order to determine the break-even amount of tours we set up the equation for the profit. The revenue as amount of tours times the selling price has to equal the fixed costs plus the amount times the variable costs. We call X the amount of travellers. X × 3,900 = 10,400 + X × 2,600. We isolate X and arrive at: X = 10,400 / (3,900 - 2,600) = 10,400 / 1,300 = 8 travellers . To check the result, we calculate the profit for 8 travellers: 8 × (3,900 - 2,600) - 10,400 = 0.00 EUR . The break-even point in a CVP analysis is the amount of goods or the activity level where the company earns a zero profit. In case DEERFIELD TOURS (Pty) Ltd. makes the trip with 10 travellers, the profit will be: 10 × (3,900 - 2,600) - 10,400 = 2,600.00 EUR . Compare the result to Figure 42.2. After breaking-even with 8 travellers, DEERFIELD TOURS (Pty) Ltd. earns the contribution margin as profit. The contribution margin is the sales deducted by variable costs. We check the profit for 20 travellers. Sales of 20 trips Item Total Per unit Sales 78,000.00 3,900.00 Variable expenses (52,000.00) (2,600.00) Contribution margin 26,000.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 15,600.00 CONTRIBUTION INCOME STATEMENT Figure 42.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (3) DEERFIELD TOURS (Pty) Ltd.’s profit equals to 15,600.00 EUR. We analyse the result: 20 travellers is 12 more than the break-even amount. Accordingly, 12 × 1,300 = 15,600.00 EUR . <?page no="538"?> Berkau: BASICS of ACCOUNTING 42-537 What is the use of a CVP analysis for managers? It is actually more than just to find out the break-even point! It will support managers to make decisions with regard to find the right business concept and to tell them whether or not they improve the profit situation for the company. We study again the company DEERFIELD TOURS (Pty) Ltd. Let us assume DEERFIELD TOURS (Pty) Ltd. got on average 19 travellers. The business now plans to advertise the trips through an internet website in order to increase profit. The website costs will increase the fixed costs for the administration by 1,500.00 EUR. On the other hand, DEERFIELD TOURS (Pty) Ltd. expects to increase the average amount of travellers by 2. The Accountant wants to know, whether the campaign increases profit if there are: 19 + 2 = 21 travellers . In order to check our results, we easily change DEERFIELD TOURS (Pty) Ltd.’s contribution income statement. The Accountant adds 1,500.00 EUR to the fixed costs and adds 2 travellers based on the average amount of travellers. Sales of 19 trips Item Total Per unit Sales 74,100.00 3,900.00 Variable expenses (49,400.00) (2,600.00) Contribution margin 24,700.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 14,300.00 CONTRIBUTION INCOME STATEMENT Figure 42.4: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (base case) Sales of 21 trips Item Total Per unit Sales 81,900.00 3,900.00 Variable expenses (54,600.00) (2,600.00) Contribution margin 27,300.00 1,300.00 less: Fixed expenses (11,900.00) Net profit 15,400.00 CONTRIBUTION INCOME STATEMENT Figure 42.5: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (internet) As result of the internet campaign the profit actually increases by 15,400 - 14,300 = 1,100.00 EUR . The advice should be: Go for the internet campaign! As an alternative, the manager might consider to increase the value of the trip and add a bungee jumping option to the <?page no="539"?> Berkau: BASICS of ACCOUNTING 42-538 trip. The jump will cost the traveller, who takes the jump offer 100.00 EUR. DEERFIELD TOURS (Pty) Ltd. assumes that every second traveller is keen to jump from the bridge. For that reason, DEERFIELD TOURS (Pty) Ltd. adds 50.00 EUR to the sales price and to the variable costs at the same time. Due to the higher adventure value of the tour, the amount of travellers increases by one traveller. The administration costs for the trip increase by 500.00 EUR compared to the situation without the bungee jumping option (= base case). Thus the fixed expenses equal to 10,400 + 500 = 10,900.00 EUR . Sales of 20 trips Item Total Per unit Sales 79,000.00 3,950.00 Variable expenses (53,000.00) (2,650.00) Contribution margin 26,000.00 1,300.00 less: Fixed expenses (10,900.00) Net profit 15,100.00 CONTRIBUTION INCOME STATEMENT Figure 42.6: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (bungee jumping) With regard to the bungee-jumping option the profit increases by 15,100 - 14,300 = 800.00 EUR . Again, the advice is to go for the bungee jumping feature. Another question can be linked to the adjustment of revenue per traveller. We assume, DEERFIELD TOURS (Pty) Ltd. decides to run the tours with a more luxury bus. The costs for the new bus will be 11,000.00 EUR. However, the bus is a 35-seater which offers the option to increase the amount of travellers. The marketing department assumes the fancy bus will attract on average 6 more travellers. The question for DEERFIELD TOURS (Pty) Ltd. is: How much does the business has to change the net selling price per trip in order to earn the same profit as with regard to the base case, which is 19 travellers? In order to calculate the revenue, we got 2 options. (1) The first one is the elegant way: We take the equation for the profit and isolate the net selling price NSP: (19 + 6) × NSP - (19 + 6) × 2,600 - (10,400 + 4,000) = 14,300 EUR. The NSP equals to: NSP = (14,300 + 25 × 2,600 + 14,400) / 25 = 3,748.00 EUR . (2) The second one is Accounting-like: We apply the goal seek function from MS Excel: <?page no="540"?> Berkau: BASICS of ACCOUNTING 42-539 Figure 42.7: DEERFIELD TOURS (Pty) Ltd.’s calculation of the adjusted net selling price The net selling price drops with the newbus option because the assumption is made that DEERFIELD TOURS (Pty) Ltd. will have 6 more travellers. The advice is to go for the new bus. As we can observe, the CVP analysis can be used as a what-if analysis. A what-if analysis is no simulation. However, it is a calculation of the outcome by varying particular variables. It is regarded as a helpful means to prepare the business plan of a company. The CVP analysis can even help us to combine changes in the business plan, such as DEERFIELD TOURS (Pty) Ltd. runs the new bus and includes the bungee-jumping option in their tours. But how does a company like DEER- FIELD TOURS (Pty) Ltd. actually know, what will happen to the amount of customers, if it changes one of the parameters in the contribution income statement? The answer from the Accounting point of view is: It does not know! However, the experience will show and marketing research will provide answers. We take a look at DEERFIELD TOURS (Pty) Ltd. again: We assume, that the marketing department determines an expected amount for the amount of travellers taking the tours based on the internet advertising. The marketing department predicts the amount of the guests being 21 on average. The experts also say that the amount of travellers is normally distributed and the standard deviation equals to 4.37. See Figure 42.8. A normal distribution depends on the mean and the standard deviation. All other parameters are constant. Once you know the mean and the standard deviation of a normal distribution, you can determine the probability for the normal distribution by transition to a standard normal <?page no="541"?> Berkau: BASICS of ACCOUNTING 42-540 distribution and reading the probabilities from tables. We will do that right now for the normal distribution provided by the marketing director of DEERFIELD (Pty) Ltd. The marketing experts found out from 20 similar observations, that the traveller amount taking an internet offer was on average 21. Despite the low observation amount the experts assume the amounts being normally distributed. Normal distributed figures give you a bell shaped curve in case you draw a frequency-over-amounts-diagram. The technical term is: probability density function. The peak of the curve is where the mean is. Thus, the mean is the most likely amount. Amounts next to the mean are less likely and the probability for amounts farther away from the mean approximates zero. Observation Amount (t) Diff to mean (Diff) 2 1 20 -1 1 2 17 -4 16 3 21 0 0 4 18 -3 9 5 16 -5 25 6 24 3 9 7 20 -1 1 8 26 5 25 9 23 2 4 10 30 9 81 11 30 9 81 12 21 0 0 13 21 0 0 14 11 -10 100 15 21 0 0 16 19 -2 4 17 24 3 9 18 17 -4 16 19 21 0 0 20 20 -1 1 average: 21 standard dev.: 4.370354677 Figure 42.8: Observations For the determination the distribution of traveller amounts we need to know the mean (21) and the standard deviation. We can take the standard deviation straight from a MS Excel function. However, we calculate it on our own in order to demonstrate the approach. A standard deviation is the average of the differences to the mean. As differences can be <?page no="542"?> Berkau: BASICS of ACCOUNTING 42-541 positive and negative, we square them and calculate the standard deviation as ((1/ 20) × Sum of (diff) 2 ) 0.5 = 4.37 travellers (rounded off). The observations in Figure 42.8 can be transformed to a standard normal distribution. A standard normal distribution is normally distributed and the mean equals to 0 and the standard deviation equals to 1. There are tables available which can be used to read the probability for standard normal distributed amounts. We are going to use the table for the normal standard distributions shortly which is given by Figure 42.10. Before we start to calculate, we describe, what we want to know. Let us assume, DEERFIELD TOURS (Pty) Ltd. goes for the marketing campaign as discussed above. DEERFIELD TOURS (Pty) Ltd. wants to know, how risky the tour is in terms of making a loss. The average amount of 21 travellers is only the most likely event. The question is, how likely is an amount of travellers below the breakeven point. By the first step we calculate the breakeven point. We determine the amount of travellers based on the internet campaign by MS Excel. The result is provided by Figure 42.9. Sales of 9.154 trips Item Total Per unit Sales 35,700.00 3,900.00 Variable expenses (23,800.00) (2,600.00) Contribution margin 11,900.00 1,300.00 less: Fixed expenses (11,900.00) Net profit 0.00 CONTRIBUTION INCOME STATEMENT Figure 42.9: DEERFIELD TOURS (Pty) Ltd.’s break-even point (internet campaign) Based on the result of 9.15 travellers to break-even, we take the amounts of 0 to 9 travellers as the loss case. If DEERFIELD TOURS (Pty) Ltd. gets 10 travellers or more, the profit will be positive. In order to determine the probability for the worst case(s) of making a loss - without consideration how big it is - we want to know how likely is a situation where less than 10 travellers participate. For that reason, we transform the normal distribution, we got from the marketing experts, into a standard normal distribution. The values for the standard normal distribution will be called zamounts. The values of the normal distribution are the travellers. We name them “t” as in travellers. We apply the transformation formula, which transforms t-values to z-values: z(t) = (t - mean)/ standard deviation = (9 - 21) / 4.37 = -2.746 . We write more short: z(t = 9) = -2.746 . The z-value is negative, because it is below the mean. By the next step, we have to read the probability for z < -2.746 from the tables for a standard normal distribution. The probabilities for the z-amounts are available in text books of mathematics <?page no="543"?> Berkau: BASICS of ACCOUNTING 42-542 or you get them from the internet. Our table in Figure 42.10 lists the probabilities for an event based on the interval 0 … z. However, we need the probability for an event being below the z amount of -2.746. A normal distribution is symmetrical. This means we can determine the probability in question by calculating the contra probability. At first, we read the probability for 2.746 from the table: The probability for 2.74 equals to 49.69 % and the probability for 2.75 equals to 49.70 %. The amount we are looking for is between these two marks. By interpolation, we arrive at a zvalue for 2.746 being 49.696 % which gives 49.70 % after rounding. The last step is to calculate the probability in question by its contra probability, which equals to: 50% - 49.70% = 0.30 % . With the given marketing data in Figure 42.8, the probability for DEERFIELD TOURS (Pty) Ltd. of making a loss, equals to 0.30 %. This result should give the managers green light for the internet campaign! z 0 1 2 3 4 5 6 7 8 9 0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359 0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753 0.2 0.0793 0.8320 0.0871 0.0910 0.0948 0.0987 0.1626 0.1064 0.1103 0.1141 0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1334 0.1406 0.1443 0.1480 0.1517 0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879 0.5 0.1913 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224 0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549 0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852 0.8 0.2881 0.2910 0.2929 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133 0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389 1 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621 1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830 1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015 1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177 1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319 1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441 1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545 1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4618 0.4625 0.4633 1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706 1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767 2 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817 2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4844 0.4846 0.4850 0.4854 0.4857 2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890 2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916 2.4 0.4918 0.4920 0.0492 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936 2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952 2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964 2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974 2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981 2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986 3 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990 Figure 42.10: Standard normal distribution table As earlier mentioned the CVP-analysis applies for companies producing and selling more than one product. In this case the break-even point becomes a break-even line. In order to determine a certain point thereon, Accountants assume a fixed ratio between the product sales. This means per a certain <?page no="544"?> Berkau: BASICS of ACCOUNTING 42-543 amount of one product it will sell a certain amount of the other one. We apply the method for DEERFIELD (Pty) Ltd. We want to apply the CVP-analysis for DEERFIELD TOURS (Pty) Ltd. by expanding the tour offers. DEERFIELD TOURS (Pty) Ltd. offers next to the tours to South Africa, city trips to Kuala Lumpur in Malaysia. The calculation is as below: The trips to Malaysia start and end in Frankfurt (Main) in Germany, too. The variable costs per traveller for the trip are: the flight at 1,400.00 EUR, the hotel costs of: 7 × 80 = 560.00 EUR and food at: 8 × 40 = 320.00 EUR . In total, the variable costs equal to: 1,400 + 560 + 320 = 2,280.00 EUR . The fixed costs are for the trip planning and administration 3,400.00 EUR and for the transport in a rented 30-seater bus 5,000.00 EUR. DEERFIELD TOURS (Pty) Ltd. sells a trip at 3,500.00 EUR. The maximum traveller amount is 30. DEERFIELD TOURS (Pty) Ltd. reserves the right to cancel a trip if less than 10 travellers take the tour. For 5 trips to the Garden Route there is 1 trip to Kuala Lumpur. As the traveller amounts differ, we calculate a traveller ratio of: 5 × 25 : 30, as equals to: 125 : 30 . Observe the adjusted contribution income statement depicted by Figure 42.11. 125 30 travellers Item Garden Route Kuala Lumpur Sum Per unit Sales 487,500.00 105,000.00 592,500.00 100.0% Variable expenses (325,000.00) (68,400.00) (393,400.00) -66.4% Contribution margin 162,500.00 36,600.00 199,100.00 33.6% less: Fixed expenses (60,400.00) Net profit 138,700.00 CONTRIBUTION INCOME STATEMENT Figure 42.11: DEERFIELD TOURS (Pty) Ltd. 2-product statement The calculation in the 2-product contribution income statement contains the items below: (1) The amount of Kuala Lumpur travellers is calculated as: t KL = 30 × t GR / 125. (2) The sales for the Garden Route trip equals to: S GR = t GR × 3,900. (3) The sales for the Kuala Lumpur trip equals to: S KL = t KL × 3,500. (4) The variable costs for the Garden Route trip equals to: VC GR = t GR × 2,600. (5) The variable costs for the Kuala Lumpur trip equal to: VC KL = t KL × 2,280. (6) The contribution margin ratio is calculated as: (S GR + S KL ) - (VC GR + VC KL ) / (S GR +S KL ). The contribution margin ratio does not depend on the amount of travellers as long the equation (1) is valid: t KL = 30 × t GR / 125. (7) The fixed costs equal to: 5 × (3,400 + 7,000) + 3,400 + 5,000 = 60,400.00 EUR . For t GR = 100 and t KL = 24, the contribution margin ratio equals to: (100 × 3,900 + 24 × 3,500 - (100 × 2,600 + 24 × 2,280)) / (100 × 3,900 + 24 × 3,500) = <?page no="545"?> Berkau: BASICS of ACCOUNTING 42-544 0.34 = 33.60 % . Compare the result to the MS Excel calculation as demonstrated in Figure 42.12. 100 24 travellers Item Garden Route Kuala Lumpur Sum Per cent Sales 390,000.00 84,000.00 474,000.00 100.0% Variable expenses (260,000.00) (54,720.00) (314,720.00) -66.4% Contribution margin 130,000.00 29,280.00 159,280.00 33.6% less: Fixed expenses (60,400.00) Net profit 98,880.00 CONTRIBUTION INCOME STATEMENT Figure 42.12: DEERFIELD TOURS (Pty) Ltd.’s 2-product statement (2) Once we take a look at the contribution income statement, we understand that the contribution margin has to cover the fixed costs in order to break-even. This means, we are looking for traveller amounts for both trips, that will result in a contribution margin of 60,400.00 EUR. Accordingly, we can determine the sales amount being 60,400 / 33.6% = 179,761.90 EUR . The formula for the total sales depending on t GR is: 179,761.90 = t GR × 3,900 + 30 × (t GR / 125) × 3,500. t GR = 179,761.90 / (3,900 + (30 × 3,500) / 125) = 37.92 t GR . This means the travellers to Kuala Lumpur will be t KL = 30 × 39.92 / 125 = 9.1 . As the MS Excel sheet for the contribution income statement is well-structured, an easy option is the goal seek function again. Well-structured means, the cells in the spreadsheet are linked to each other without loops. <?page no="546"?> Berkau: BASICS of ACCOUNTING 42-545 Figure 42.13: Goal seek function break-even point calculation Rounding to the next integer for the traveller amount, gives a loss of 20.00 EUR. Be aware this amount is obtained by 5 trips to South Africa and one to Malaysia. 38 9 travellers Item Garden Route Kuala Lumpur Sum Per cent Sales 148,200.00 31,500.00 179,700.00 100.0% Variable expenses (98,800.00) (20,520.00) (119,320.00) -66.4% Contribution margin 49,400.00 10,980.00 60,380.00 33.6% less: Fixed expenses (60,400.00) Net profit (20.00) CONTRIBUTION INCOME STATEMENT Figure 42.14: DEERFIELD TOURS 2-product statement (3) Summary: The Cost Volume Profit analysis determines the profit for different levels of products/ services/ activity levels. Often, the CVP analysis is applied in order to determine the break-even point. This is the output amount where the company does not earn a profit (profit equals zero). A valuable use of the CVP analysis is in business when different amendments of the business plan are tested in order to find the best alternative. It is recommended to run CVP analysis on a spread sheet program such as MS Excel. <?page no="547"?> Berkau: BASICS of ACCOUNTING 42-546 Working Definitions: Break-Even Point: The break-even point in a CVP analysis is the goods amount or the activity level, where the profit equals to zero. Contribution Margin: The contribution margin is the sales deducted by variable costs. What-if analysis: A what-if analysis is a calculation of the outcome by varying particular variables. Standard Normal Distribution: A standard normal distribution is normally distributed and the mean equals to 0 and the standard deviation equals to 1. <?page no="548"?> Berkau: BASICS of ACCOUNTING 43-547 43. Degree of Operating Leverage (DOL) Learning Objectives: A company that breaks-even, will earn with every further product/ service sold a profit which equals to the contribution margin. The reason is, that once fixed costs are covered completely, profit will increase by the net operating income. The Degree of Operating Leverage (DOL) is a concept that will tell managers how profit will change based on variations in revenue. The DOL is regarded as a measurement for the flexibility of a business. After studying this chapter, you will be able to understand the DOL concept and can analyse the ratio DOL for a business. Managers strive for controlling the company’s financial position. In particular, they want to understand, how business reacts to certain changes. E.g., they want to understand how much profit will increase by one additional unit of product/ service sold. In order to familiarize ourselves with the concept of the degree of operating leverage, we refer to the already known example from the previous chapter Cost Volume Profit Analysis. We observed the case study DEERFIELD TOURS (Pty) Ltd. again. The company offers holiday trips on the Garden Route and identifies variable and fixed costs thereof. The break-even amount for the trips is at 8 travellers. Observe Figure 43.1: Sales of 8 trips Item Total Per unit Sales 31,200.00 3,900.00 Variable expenses (20,800.00) (2,600.00) Contribution margin 10,400.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 0.00 CONTRIBUTION INCOME STATEMENT Figure 43.1: DEERFIELD TOURS (Pty) Ltd. break-even point If DEERFIELD TOURS (Pty) Ltd. gets 8 travellers for a trip, all fixed costs will be covered. The company will earn no profit. Any additional traveller will contribute to the profit by his/ her net operating income. The net operating income is the profit that remains after all operational costs are paid. The net operating income term often applies in real estate business. If an investor buys property in order to rent it out, the net operating income will be his/ her rental income less all costs paid by the landlord such as renovation/ maintenance costs or maybe municipality rates. No overheads such as administration are deducted. The net operating income is similar to the contribution margin, <?page no="549"?> Berkau: BASICS of ACCOUNTING 43-548 however contribution margin is an expression that comes from calculation and is strictly linked to the difference between revenue and proportional costs. For DEERFIELD TOURS (Pty) Ltd., this means, once all fixed costs are covered and proportional costs are deducted from additional revenues, the contribution margin for additional travellers will increase the profit. In the case of DEER- FIELD TOURS (Pty) Ltd., the contribution margin per traveller equals to: 3,900 - 2,600 = 1,300.00 EUR . This is the amount, by which profit will increase, once all fixed costs are covered. We now study the figures for additional travellers after DEERFIELD TOURS Ltd. passed the breaks-even point. If DEER- FIELD TOURS (Pty) Ltd. gets 9 travellers, the profit will equal to 1,300.00 EUR. Observe the calculation in Figure 43.2: Sales of 9 trips Item Total Per unit Sales 35,100.00 3,900.00 Variable expenses (23,400.00) (2,600.00) Contribution margin 11,700.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 1,300.00 CONTRIBUTION INCOME STATEMENT Figure 43.2: DEERFIELD TOURS (Pty) Ltd.’s profit calculation (1 additional traveller) The calculation tells us, every new traveller makes DEERFIELD TOURS (Pty) Ltd. earn an additional profit of 1,300.00 EUR. So, the next traveller will make DEERFIELD TOURS (Pty) Ltd. earn a profit of 2,600.00 EUR. We check the amount of 11 travellers. This will be 3 travellers above break-even. All 3 travellers will each add 1,300.00 EUR to DEERFIELD TOURS (Pty) Ltd.’s profit, as the contribution margin is no longer required for the cover of fixed costs. Thus, we expect the profit to be: (11 - 8) × 1,300 = 3,900.00 EUR . Observe Figure 43.3. <?page no="550"?> Berkau: BASICS of ACCOUNTING 43-549 Sales of 11 trips Item Total Per unit Sales 42,900.00 3,900.00 Variable expenses (28,600.00) (2,600.00) Contribution margin 14,300.00 1,300.00 less: Fixed expenses (10,400.00) Net profit 3,900.00 CONTRIBUTION INCOME STATEMENT Figure 43.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (11 travellers) As our intention is to study relative changes in profit caused by increases/ decreases of sales, we compare the calculations in Figure 43.2 to those displayed in Figure 43.3: The sales - measured by the traveller amount - increases from 9 to 11. This is an 11/ 9 -1 = 22.22 % increase of customers. As result of this change in output there is an increase on profit to the extent of: (3,900 - 1,300) / 1,300 = 200 % ! (Note, as sales are based on constant prices, we only calculate the changes in sales based on the output count. This goes for the whole chapter.) We observe a 200 % increased profit as a result of a 22.22 % increase in sales. The factor between the changes in EBIT and in sales is called the degree of operating leverage DOL. The DOL equals to changes in terms of EBIT over changes in terms of sales. Sales EBIT DOL ∆ ∆ = For DEERFIELD TOURS (Pty) Ltd., the DOL equals to 200 % / 22.22 % = 9.00 . The degree of operating leverage is very high as the company’s profit increase is close to the break-even point. However, the idea of the degree of operating leverage is to understand how changes in sales will change profit. Companies with a high DOL will experience high changes in profit if sales changes. In order to make the meaning more visible, we write the equation with an isolated ∆EBIT: Sales DOL EBIT ∆ × = ∆ By this notation, we see that the DOL works as an amplifier for changes in sales. But, be aware that the DOL works in the opposite direction for decreases, too. Any sales reduction will make the profit shrink DOS-times! Companies with high DOL are classified as risky. DEERFIELD TOURS (Pty) Ltd. will half its profit if it loses 2 customers out of 11! <?page no="551"?> Berkau: BASICS of ACCOUNTING 43-550 There are two factors that determine the degree of operating leverage. (1) DOL-degression effect (2) fixed costs Ad (1): DOL-Degression Effect The DOL depends on the absolute amount of output. As the profit equals to zero at the break-even point and we measure changes as percentages, profit changes close to the break-even point will be relatively higher as more far away therefrom. The effect will become clear, once we observe the effect of an increase of 5 travellers based on a current situation of 20 at DEERFIELD TOURS (Pty) Ltd. This will result in an output increase of: 25/ 20 - 1 = 20.00 % . The profit will change by (((25 - 8) × 1,300) - ((20 - 8) × 1,300))) / ((20 - 8) × 1,300)) = (17 - 12) / 12 = 41.67 % . Now, the degree of operating leverage equals to: 41.67 % / 20 % = 2.08 . In contrast, the DOL measured for the 10 th and 11 th traveller was 9. The DOL-degression effect is of lower importance once the company earns a revenue away from the break-even point. Ad (2): Fixed Costs We are aware, that the degree of operating leverage depends highly on the amount of fixed costs. Managers who change the cost structure, such as adding fixed costs by investing activities, should be aware that this will not only change the Accounting situation but it will have an impact on the flexibility of the company. Changes in the cost structure towards fixed costs make the company inflexible. Once fixed costs are covered, a high DOL works in favour of the business, because all net operating income will contribute to EBIT. However, the coverage of fixed costs will be achieved at higher output of products/ services. In other words: the break-even point will be pushed in direction of higher outputs. Another aspect is, that shrinking sales and a high degree of operating leverage becomes dangerous, because the DOL works in both directions. In times of a weak economy, a high DOL will decrease profit even more. In order to understand the concept clearly, we take a look at a new case study about a company that has higher potential to change its fixed costs. We also want to study how an increase of output determines changes of the operating cash flow. DEERFIELD TOURS (Pty) Ltd. case study only contains low fixed costs. The company is kind of risk-free as in case of no travellers only admin costs apply. Furthermore, DEERFIELD TOURS (Pty) Ltd. has the option to cancel a trip and thus gets rid of almost all fixed costs. For understanding the DOL concept, we introduce a new company example about a manufacturer that has more fixed costs. The company invests in production facilities over a period of 5 years and is stuck to the fixed expenses for that period. EMS KAYAK Ltd. is a kayak manufacturer in Meppen in the Emsland. EMS KAYAK Ltd. sells a kayak at 400.00 EUR. The proportional costs per kayak equal to 200.00 EUR. The fixed costs for the manufacturer are 5,000.00 EUR and are <?page no="552"?> Berkau: BASICS of ACCOUNTING 43-551 linked to labour and administration expenses. The investment in the manufacturing facilities requires an investment in the boat hull machinery of 35,000.00 EUR, which is to be paid in 20X2. The amount can be written off during 5 Accounting periods along straight line method without residual value. During the Accounting periods 20X3 … 20X7, EMS KAYAK Ltd. estimates to sell 525 kayaks. The rate of interest is 10.00 % and will be used in order to determine the net present value (NPV) of the investment. There is no financing of EMS KAYAK Ltd. The present value calculation is based on the investing cash flow in 20X2 and the operating cash flows of the business of the next following 5 years. The returns take place from 20X3 to 20X7. For EMS KAYAK Ltd. an income tax rate of 30 % applies. To keep the case study simple, we assume that every Accounting period has the same costs and cash flows. As EMS KAYAK Ltd. wants to determine the net present value of the investment, it has to determine the payment vector for investing and operating cash flows. The investing cash flow equals to the cost of acquisition: -35,000.00 EUR. The operating cash flow contains the proceeds from the revenue of: 525 × 400 = 210,000.00 EUR . The negative operating cash flows are for the proportional costs of: 525 × 200 = 105,000.00 EUR and for the fixed costs which equal to 5,000.00 EUR. The operating cash flows during the Accounting periods 20X3 … 20X7 equals to: 210,000 - 105,000 - 5,000 = 100,000.00 EUR . In case EMS KAYAK Ltd. produces and sells different kayak amounts (#ky), the cash flows will change. The payment vector is based on 525 boats and equals to: CF 525 (t) = {-35,000; 72,100.00; 72,100.00; 72,100.00; 72,100.00; 72,100.00} . In order to determine, whether the kayak production is value adding, EMS KAYAK Ltd. calculates the net present value of the kayak production project. The net present value equals to: -35,000 + 72,100 × ((1 + 10%) 5 - 1) / (10% × (1 + 10%) 5 ) = 238,315.73 EUR . In order to calculate the cash flows and the profit quickly, we prepare a MS Excel file. The Figure 43.4 shows the profit and cash flow calculation and the net present value for an output of 525 kayaks. (Note, the present value calculation is only visible in this figure.) <?page no="553"?> Berkau: BASICS of ACCOUNTING 43-552 / u [EUR] [EUR] Sales 400.00 210,000.00 Proceeds 210,000.00 Prop. Costs 200.00 (105,000.00) Prop. Costs (105,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (27,900.00) EBT 93,000.00 OCF 72,100.00 less: tax (27,900.00) EAT 65,100.00 Output = 525 NPV 20X2 = 238,315.73 (35,000.00) + 72,100.00 × 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.4: EMS KAYAK Ltd.’s profit and cash flow calculation (1) Before we study changes in output and profit/ cash flows, we calculate breakeven points. How many kayaks (#ky) must EMS KAYAK Ltd. sell in order to break-even? The answer is based on the profit equation: EBT(#ky) = #ky x 200 + 5,000 + 7,000. After isolating the number of kayaks, it gives: #ky BE = 12,000 / 200 = 60 kayaks . Figure 43.5 proves the accounting break-even point. The Accounting break-even point is based on the output amount which makes the company earn a profit of zero. For EMS KAYAK Ltd. the kayak amount #ky for the Accounting break-even point equals to 60. The calculation of the Accounting break-even point is only based on the Accounting periods, when EMS KAYAK Ltd. receives a return from the investment. / u [EUR] [EUR] Sales 400.00 24,000.00 Proceeds 24,000.00 Prop. Costs 200.00 (12,000.00) Prop. Costs (12,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT 0.00 OCF 7,000.00 less: tax 0.00 EAT 0.00 Output = 60 NPV 20X2 = (8,464.49) (35,000.00) + 7,000.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.5: EMS KAYAK Ltd.’s Accounting break-even point <?page no="554"?> Berkau: BASICS of ACCOUNTING 43-553 If we want to know the cash break-even point, the kayak amount #ky C-BE must meet the point, where EMS KAYAK Ltd.’s operating cash flow is zero. Only from that amount #ky C-BE onwards, the project will add cash from operating activities. The cash break-even point is based on the output amount which makes the operating cash flow become zero. The cash break-even point is only relevant for the Accounting period when returns are received. For EMS KAYAK Ltd., the cash breakeven applies for 20X3, 20X4, 20X5, 20X6 and 20X7 in the same way. This depends on the case study design. In order to calculate the cash break-even point, we might consider the taxes-over-profit function. If EMS KAYAK Ltd. makes a loss, the taxes will be zero. In case of a profit, the taxes will equal to 30 % based on the earnings before taxes. However, for our calculations, the different sections of the tax curve are difficult to consider. For that reason, we are going to ignore the tax expenses being zero for negative profits. The cash flow equation then equals to: OCF(#ky C-BE ) = #ky C-BE × 400 - #ky C-BE × 200 - 5,000 - 30% × (#ky C-BE × 400 - #ky C-BE × 200 - 5,000 - 7,000) = #ky C-BE × 140 - 1,400 = 0. After isolating #ky C-BE , we calculate the cash break-even point being at #ky C-BE = 1,400 / 140 = 10 kayaks . Actually, due to the negative profit for 10 kayaks, the tax expenses become zero for 10 kayaks sold. For that reason, the operating cash flow of 10 kayaks is -3,000.00 EUR. / u [EUR] [EUR] Sales 400.00 4,000.00 Proceeds 4,000.00 Prop. Costs 200.00 (2,000.00) Prop. Costs (2,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT (10,000.00) OCF (3,000.00) less: tax 0.00 EAT (10,000.00) Output = 10 NPV 20X2 = (46,372.36) (35,000.00) + (3,000.00) * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.6: EMS KAYAK Ltd.’s profit and cash flow calculation (2) Once the pre-tax-profit is negative, the tax expenses will become zero. In the MS Excel sheet the tax cell contains: “if(EBT>0,-0.3×EBT,0)”. We have to adjust the equation for negative EBTs and calculate again: OCF(#ky C-BE ) = #ky C-BE × 400 - #ky C-BE × 200 - 5,000 - 30% × (#ky C- BE × 400 - #ky C-BE × 200 - 5,000 - 7,000) = #ky C-BE × 200 - 5,000 = 0. Accordingly, the financial break-even point is at: <?page no="555"?> Berkau: BASICS of ACCOUNTING 43-554 #ky C-BE = 5,000 / 200 = 25 kayaks . (Note, the more convenient approach to determine the financial break-even point is by the goal seek function provided by MS Excel! ) / u [EUR] [EUR] Sales 400.00 10,000.00 Proceeds 10,000.00 Prop. Costs 200.00 (5,000.00) Prop. Costs (5,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax 0.00 EBT (7,000.00) OCF 0.00 less: tax 0.00 EAT (7,000.00) Output = 25 NPV 20X2 = (35,000.00) (35,000.00) + 0.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.7: EMS KAYAK Ltd.’s cash break-even point The cash break-even point is important to know, if the company faces a situation of bankruptcy based on illiquidity and/ or wants to know, whether or not a project will contribute cash. Finally, we want to check on the financial break-even point. It is relevant for a decision about the investment. The question is: how many products/ services are to be produced/ rendered, in order to take an economical advantage of the investment. In contrast to the previous break-even point considerations, the financial cash flow is linked to investing and operating cash flows of all accounting periods and considers the time value of money. The financial break-even point is at that output amount that makes the net present value become zero. The formula for the calculation of the financial break-even point requires to deal with 5th degree polynomial. We do not bother ourselves with that. For EMS KAYAK Ltd., we just apply the goal seek function in MS Excel. Observe the result as displayed in Figure 43.8. <?page no="556"?> Berkau: BASICS of ACCOUNTING 43-555 / u [EUR] [EUR] Sales 400.00 30,379.75 Proceeds 30,379.75 Prop. Costs 200.00 (15,189.87) Prop. Costs (15,189.87) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (956.96) EBT 3,189.87 OCF 9,232.91 less: tax (956.96) EAT 2,232.91 Output = 75.9493702 NPV 20X2 = 0.00 (35,000.00) + 9,232.91 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.8: EMS KAYAK Ltd.’s financial break-even point We round the kayak amount #ky F-BE and get 76, which guarantees a positive net present value of the kayak production project. Observe Figure 43.9. / u [EUR] [EUR] Sales 400.00 30,400.00 Proceeds 30,400.00 Prop. Costs 200.00 (15,200.00) Prop. Costs (15,200.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (960.00) EBT 3,200.00 OCF 9,240.00 less: tax (960.00) EAT 2,240.00 Output = 76 NPV 20X2 = 26.87 (35,000.00) + 9,240.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.9: EMS KAYAK Ltd.’s financial break-even point EMS KAYAK Ltd. knows, that in case they sell 76 kayaks every year, the investment in the kayak production will become a zero-sum-game. We now study the degree of operating leverage DOL for different output situations. The base case (1) is linked to 525 kayaks. We assume the base case applies and EMS KAYAK Ltd. wants to increase production and sales by 200 kayaks. (The profit and cash flows for 525 kayaks can be read from Figure 43.4.) <?page no="557"?> Berkau: BASICS of ACCOUNTING 43-556 The situation is quite far away from the break-even point so we can assume that the degree on operating leverage will only slightly change with regard to the DOL-degression effect. The situation of EMS KAYAK Ltd. producing and selling 725 kayaks is displayed by Figure 43.10: / u [EUR] [EUR] Sales 400.00 290,000.00 Proceeds 290,000.00 Prop. Costs 200.00 (145,000.00) Prop. Costs (145,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (39,900.00) EBT 133,000.00 OCF 100,100.00 less: tax (39,900.00) EAT 93,100.00 Output = 725 NPV 20X2 = 344,457.76 (35,000.00) + 100,100.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.10: EMS KAYAK Ltd.’s profit and cash flow calculation (3) We calculate the degree of operating leverage which applies, if EMS KAYAK Ltd. increases production and sales from 525 to 725 kayaks: (Note, the index at the DOL ratio is linked to the figure of the status as given by the figure titles. (1) indicates the base case with 525 kayaks. (3) is linked to Figure 43.10.) In order to keep the calculations simple, we consider the selling price of the kayaks being constant and express the changes in sales by kayak amounts. The degree of operating leverage for an increase of 200 kayaks based on the 525 kayak-situation gives: DOL (1)-(3) = ((133,000/ 93,000) -1) / ((725/ 525) - 1) = 1.13 . In order to read the effect, we can say: a 1%-change in sales results in a 1.13% change of profit (here: EBIT). In order to check on the DOL-degression effect, we study another output situation. We want to determine, what happens if EMS KAYAK Ltd. increases production and sales by 100 further kayaks. The situation of EMS KAYAK Ltd. producing and selling 825 kayaks is shown by Figure 43.11 and is indicated by status (4). <?page no="558"?> Berkau: BASICS of ACCOUNTING 43-557 / u [EUR] [EUR] Sales 400.00 330,000.00 Proceeds 330,000.00 Prop. Costs 200.00 (165,000.00) Prop. Costs (165,000.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation (7,000.00) Tax (45,900.00) EBT 153,000.00 OCF 114,100.00 less: tax (45,900.00) EAT 107,100.00 Output = 825 NPV 20X2 = 397,528.77 (35,000.00) + 114,100.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.11: EMS KAYAK Ltd.’s profit and cash flow calculation (4) The DOL now changes slightly, only based on the DOL-degression effect: DOL (3)-(4) = ((153,000/ 133,000) - 1)/ ((825/ 725) - 1) = 1.09 . Now, a 1 % change in sales will cause a 1.09% change in profit. As we learned from the DOL-degression effect, it is normal, that as farther away the figures are from the break-even point, as lower the DOL gets. However, that is only a small effect if you consider that EMS KAYAK Ltd. operates far above the break-even point of 60 kayaks. Furthermore, only small changes in output will be possible for EMS KAYAK Ltd. as it cannot increase production significantly without making further investments. However, dramatic decreases of kayak production might be possible, maybe as a response to a new-competitor-penetrating-the-market situation. Now, we study what will happen, if EMS KAYAK Ltd. changes the cost structure in favour of variable costs. We know already, this will reduce the DOL and makes the business more flexible. We assume, that EMS KAYAK Ltd. farms out the hull production to a local supplier. EMS KAYAK Ltd. pays for each kayak 15.00 EUR but the investment in the hull production machine becomes obsolete. As a consequence, EMS KAYAK Ltd. does not have expenses for depreciation any more. In comparison to the previous situation, the unit costs increase slightly, as the application of depreciation gave: 7,000/ 525 = 13.33 EUR/ ky . Figure 43.12 discloses the financial situation of EMS KAYAK Ltd. producing 525 kayaks based on the outsource situation. There is no depreciation but the proportional costs increase by 15.00 EUR and now will be: 200 + 15 = 215.00 EUR/ ky . The fixed costs equal to 5,000.00 EUR still. These costs are for labour and administration. <?page no="559"?> Berkau: BASICS of ACCOUNTING 43-558 / u [EUR] [EUR] Sales 400.00 210,000.00 Proceeds 210,000.00 Prop. Costs 215.00 (112,875.00) Prop. Costs (112,875.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax (27,637.50) EBT 92,125.00 OCF 64,487.50 less: tax (27,637.50) EAT 64,487.50 Output = 525 NPV 20X2 = 209,458.36 (35,000.00) + 64,487.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.12: EMS KAYAK Ltd.’s profit and cash flow calculation (5) With the hull production outsourced to the supplier, EMS KAYAK Ltd. earns a profit before taxation of 92,135.00 EUR. We call this scenario: (5). We observe that the profit decreases in contrast to scenario (1) by: 93,000 - 92,125 = 875.00 EUR . This is for the increase in unit costs caused by the outsourcing of the hull production. However, EMS KAYAK Ltd. is better off as the DOL decreases. We check the increase by 200 kayaks in Figure 43.13, which displays scenario (6). / u [EUR] [EUR] Sales 400.00 290,000.00 Proceeds 290,000.00 Prop. Costs 215.00 (155,875.00) Prop. Costs (155,875.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax (38,737.50) EBT 129,125.00 OCF 90,387.50 less: tax (38,737.50) EAT 90,387.50 Output = 725 NPV 20X2 = 307,639.74 (35,000.00) + 90,387.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.13: EMS KAYAK Ltd. profit and cash flow calculation (6) The DOL for an increase by 200 kayaks based on the 525-kayak situation equals to: <?page no="560"?> Berkau: BASICS of ACCOUNTING 43-559 DOL (5)-(6) = ((129,125/ 92,125) - 1) / ((725/ 525) - 1) = 1.05 . This means, for an increase of 1 % of the kayaks the profit will increase by 1.05 %. For the next increase by 100 kayaks we study Figure 43.14, which shows the profit and cash flows for 825 kayaks with regard to the outsourcing situation. We indicate this scenario by number (7). / u [EUR] [EUR] Sales 400.00 330,000.00 Proceeds 330,000.00 Prop. Costs 215.00 (177,375.00) Prop. Costs (177,375.00) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax (44,287.50) EBT 147,625.00 OCF 103,337.50 less: tax (44,287.50) EAT 103,337.50 Output = 825 NPV 20X2 = 356,730.43 (35,000.00) + 103,337.50 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.14: EMS KAYAK Ltd.’s profit and cash flow calculation (7) The calculation of the DOL at higher output level makes the DOL decrease: Observe the DOL-degression effect for the additional increase in output at EMS KAYAK Ltd.: DOL (6)-(7) = ((147,625/ 129,125) - 1) / ((825/ 725) - 1) = 1.04 . We discussed about the break-even points in order to show that the risk situation for a business depends on its flexibility. This is easy to explain, as investments cannot be made undone. If the company needs to cut costs, investments must be liquidated. In contrast to fixed cost reductions, cost for suppliers can easily be reduced by order amounts. This means, that an outsourcing company shifts the risk to its new supplier. For the situation of EMS KAYAK Ltd. cooperating with the supplier in terms of hull production, the break-even points will go down, which indicates lower risks. As in this example all expenses for depreciation are zero, the profit and cash flow equal each other in the breakeven points. Furthermore, the investing cash flow becomes zero. This results in this easy case study in the situation of all break-even points being at the same amount of kayaks #ky. Observe the situation in Figure 43.15, that has been determined by goal seeking. <?page no="561"?> Berkau: BASICS of ACCOUNTING 43-560 / u [EUR] [EUR] Sales 400.00 10,810.81 Proceeds 10,810.81 Prop. Costs 215.00 (5,810.81) Prop. Costs (5,810.81) Fixed costs (5,000.00) fixed costs (5,000.00) Depreciation 0.00 Tax (0.00) EBT 0.00 OCF 0.00 less: tax (0.00) EAT 0.00 Output = 27.02702703 NPV 20X2 = 0.00 0.00 + 0.00 * 3.79 Interest rate = 0.10 (postnumerando) INCOME STATEMENT CASH FLOW STATEMENT Figure 43.15: EMS KAYAK Ltd.’s break-even point As result of the break-even point calculation, #ky BE = #ky C-BE = #ky F-BE = 27.03 kayaks. This is a significant reduction of risk as now the kayak amount to make the kayak production work decreases by: 27.03/ 75.95 - 1 = 64.41 % . The DOL(CF) is the degree of operating cash flow leverage. It measures the sensitivity of a firm’s operating cash flows to the sales. The DOL(CF) is: Sales OCF CF DOL ∆ ∆ = ) ( We determine the DOL(CF) for EMS KAYAK Ltd. with regard to the increase of 200 kayaks. The base case (1) applies. DOL(CF) (1)-(3) = ((100,100/ 72,100) - 1) / ((725/ 525) - 1) = 1.01 . The result means that an increase of 1 % sales will make the operating cash flow increase by 101 %. (The result does not surprise as most of the activities in this case study are on cash. The depreciation amount is quite low in comparison to the other expenses.) Summary: The degree of operating leverage DOL measures the sensitivity of the profit (EBIT, or in some cases only NOI) to changes in sales. The DOL depends on the cost structure. High DOLs will be regarded as risk factors, as a company will react to sales reductions by DOL-times profit reductions. Working Definitions: Net Operating Income (NOI): The net operating income is the profit that remains after all operating costs are paid Degree of Operating Leverage: The factor between the changes in EBIT and in sales is called the degree of operating leverage DOL. The DOL equals to changes in terms of EBIT over changes in terms of sales. <?page no="562"?> Berkau: BASICS of ACCOUNTING 43-561 Accounting Break-Even Point: The Accounting break-even point is based on the output amount which makes the company earn a profit of zero. Cash Break-even Point: The financial break-even point is based on the output amount which makes the operating cash flow become zero Financial Break-even Point: The financial break-even point is that output amount that makes the net present value become zero Degree of Operating Cash Flow Leverage: The DOL(CF) is the degree of operating cash flow leverage. It measures the sensitivity of a firm’s operating cash flows to the sales. <?page no="563"?> Berkau: BASICS of ACCOUNTING 44-562 44. Structure of Cost Accounting Systems Learning Objectives: Management Accounting systems represent the internal part of Accounting. Management Accounting systems provide managers with Accounting information. In this chapter, we explain the structure of Management Accounting systems. In particular, we show the cost flow through different steps of a Management Accounting system. After studying this chapter, you will be able to describe the features of a Management Accounting system and you can recognise parts of the Management Accounting systems when you see them in a company. Management Accounting is not required by law. Companies do not have to run a Management Accounting system. An exception are production firms who have to be able to calculate their finished goods on stock on the balance sheet date. In case a company does not operate a Management Accounting system, managers control the business based on financial statements. This is difficult, as financial statements are based on the whole company and they only look backwards, which means, the information is from past Accounting periods. In contrast to Financial Accounting, there are no regulations a company has to comply with. Management Accounting information are not made visible to the public, either. The information is for managerial use only in order to control the business. One aspect of business control is to plan future activities. For that reason, Management Accounting’s focus is on planning and checking. As we saw already with regard to the business plan, Management Accountants calculate future costs, which they compare later to actual costs. See chapter Cost Centre Efficiency Check. Most commonly, a Management Accounting system contains four major features: Cost Category-Accounting, Cost Centre-Accounting, Calculation and Profitability Analysis. See Figure 44.1 in order to study the structure therof. <?page no="564"?> Berkau: BASICS of ACCOUNTING 44-563 Figure 44.1: Management Accounting system A Management Accounting system is linked to Financial Accounting. There is an data interface between the two Accounting systems as indicated by the arrow from Financial Accounting to Management Accounting. Through this link, time-based data for expenses and for revenue are transferred to the Management Accounting system. Time based-data means, information comes with a time stamp, such as “rent for January 20X1”. (Note, from the point of view of data structuring, these data are represented by a relationship type between the entity type Rent and Time.) The data transfer does not work as a separate Management Accounting step. Once the Accountant makes a bookkeeping entry for rent, the debit entry will be copied straight to the Management Accounting system. However, other data won’t. If the bookkeeping entry is: DR Rent......................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR, only the debit entry with the expenses is recorded for Management Accounting purpose. Besides costs, revenues will be transferred to the Management Accounting system, too. In the box for the Financial Accounting system you see a reference to the General Ledger. Management Accounting data will be only transferred on an aggregated level. Subordinated accounts, such data from the sales ledger, are not relevant. Exceptions are Payroll Accounting and Asset Management. <?page no="565"?> Berkau: BASICS of ACCOUNTING 44-564 In the Cost Category Accounting step, data are distinguished in direct costs and overheads. This classification depends on the product the data are for. In particular, the Cost Separation applies as discussed in the chapter Cost Behaviour / Cost Separation. Cost Centre Accounting is linked to the organisational structure of a business. Many companies are way too big for controlling. Therefore, Management Accounting divides the company into cost centres and sets up a cost centre structure. A cost centre is an organisational unit within a company, where a manager is responsible for costs. We call the person the cost centre responsible or cost centre manager. Along KILGER/ PLAUT, it is required that there is preferably only one reference unit the costs of the Cost Centre depend on proportionally, and Accountants must be able to allocate costs to cost centres directly. Cost centre structures very often are structured as a hierarchy. This means, cost centres combined to superordinate cost centres on different aggregation levels. A hierarchy is a 1: n-relationship. In real companies, there are often a few hundred cost centres. (Note, although we say the cost centre structure is an organisational structure, cost centres are not the same as departments. Be aware the top level of the organisational chart is the board or management. In contrast the top level of cost centres is the entire company.) Cost Centre Accounting takes all the overheads from Cost Category Accounting. It can be seen as the Manufacturing Overhead Account. Compare to the Production Firm chapter. In Cost Centre Accounting cost rates will be calculated. For the calculation of the cost centre rate, the total of the cost centre overheads will be divided by the amount of its reference unit. Cost rates will be calculated for the future (planned costs) and based on actual data. As both data will be available in the cost centre and the cost centre manager is responsible for them, the plan-actual-comparison takes place in the cost centres. Actually, the calculations are provided by the Management Accounting system and reported to the cost centre manager as efficiency report. See chapter Cost Centre Efficiency Check in this text book for details. As cost centres exchange performance among each other, the cost rate calculation requires internal cost allocations. This can be quite complicated, once companies get complex cost centres relationships. In the Calculation, the unit costs of the products/ services are determined. The unit costs contain direct costs multiplied by their amounts (as 4 wheels for a Volkswagen Golf, the information is given by the bill of materials), and the overheads. The latter ones are calculated by cost centre rates × usage factor. We assume, the Volkswagen Golf dash board assembly cost rate equals to 150.00 EUR/ h and the assembling time for one dash board takes 10 min., the cost allocated to the product are: 10 × 150/ 60 = 25.00 EUR. All direct costs and overhead portions in the cost centres will be added up for the product/ service calculation. The last step, the Profitability Analysis, is very similar to the profit and loss calculation, as we are familiar with already from Financial Accounting. It can be based on the Nature of Expense method or the Cost of Sales format. Along the Cost of Sales format, the margin between all revenues less all <?page no="566"?> Berkau: BASICS of ACCOUNTING 44-565 product/ service costs (cost of sales) is calculated. Later overheads, which are not linked to products (non-manufacturing overheads) are deducted in order to determine the net operating profit. (Note, in contrast to Financial Accounting, any tax expenses are not subject to Management Accounting. Management Accountants calculate normally down to the earnings before taxes EBT or even stop at EBIT.) We want to study the Management Accounting system with a case study from Hospitality Management. The case study is about an Italian Restaurant, called GIULIO’s PIZZA& PAS- TA RISTORANTE. As in Management Accounting we do not care about taxes, the legal form of the restaurant does not matter. Consider the restaurant being in private ownership. GIULIO’s PIZZA&PASTA RISTORANTE offers pizza and different pasta meals like lasagne and cannelloni. All meals can be consumed in the restaurant or can be delivered by GIULIO’s PIZZA&PASTA RIS- TORANTE. We observe the budgeting of GIULIO’s PIZZA&PASTA RISTORANTE. GIULIO’s PIZZA&PASTA RISTORANTE offers 3 meals, which is tuna pizza, lasagne and cannelloni. In order to keep the case study simple, we assume the restaurant buys the pizza dough from its supplier. The same applies for the lasagne and cannelloni noodles. The ingredients of the meals are given by Figure 44.2, which we refer to as the bill of materials. It actually represents the material requirements per meal. Bill of materials BOM is an expression from manufacturing. As Business Management originates from production firms, many technical terms come from a factory environment. <?page no="567"?> Berkau: BASICS of ACCOUNTING 44-566 Item Amount Purchase price/ u dough 150 g 0.80 tomato sauce 40 g 0.25/ 10g tuner 75 g 2.00/ 100g cheese 3 slices 0.20/ slice Item Amount Purchase price/ u Lasagne noodles 100 g 0.50/ 100g tomato sauce 50 g 0.25/ 10g minced meet 80 g 1.00/ 100g cheese 5 slices 0.20/ slice Item Amount Purchase price/ u cannelloni noodles 100 g 0.50/ 100g cream sauce 50 g 0.20/ 10g cooked ham 60 g 1.20/ 100g cheese 5 slices 0.20/ slice Tuna Pizza BILL OF MATERIALS Lasagne BILL OF MATERIALS Cannelloni BILL OF MATERIALS Figure 44.2: GIULIO’s PIZZA&PASTA Ristorante’s BOM Besides the meals, GIULIO’s PIZZA& PASTA RISTORANTE offers a precious Chianti wine. The purchase price therof per 750 ml bottle is 6.00 EUR. Next to direct materials, GIULIO’s PIZZA &PASTA RISTORANTE considers overheads. These costs are not linked to pizza nor to pasta meals. Overheads are non-direct costs which cannot be traced to a certain product or service. There is the salary for the cook at 4,000.00 EUR/ m, the salary for the order manager/ waiter at 2,800.00 EUR/ m, the salary for the driver at 9.00 EUR/ h and depreciation on the restaurant interior, which contains the kitchen facilities (pizza oven) and the delivery van. The acquisition of the stove is at 24,000.00 EUR, the restaurant interior costs 18,000.00 EUR. Both items will be depreciated along straight line method over 6 years. The delivery van is a pre-owned Fiat bought at 8,000.00 EUR. It will be depreciated over the next four Accounting periods. The operating costs for the delivery-Fiat are 1,000.00 EUR/ m. These costs include petrol, maintenance and tear and wear replacements like tyres, engine oil etc. Rental costs for the restaurant including water/ electricity supply add up to 3,000.00 EUR/ m. (Note, for Management Accounting considerations, we normally ignore VAT.) In Management Accounting the planning/ budgeting process starts with the <?page no="568"?> Berkau: BASICS of ACCOUNTING 44-567 performance calculation: the performance planning determines the amount of pizza, lasagne and cannelloni, GIULIO’s PIZZA&PASTA RISTORANTE sells in the next Accounting period. GIULIO’S PIZZA&PASTA RISTORANTE estimates 50,000 pizza, 30,000 lasagne and 10,000 cannelloni. Furthermore, GIULIO’S PIZZA&PASTA RISTORANTE estimates to sell 4,000 bottles of Chianti wine in the restaurant (by the glass). The food delivery is planned to be 20,000 food deliveries per annum. A food delivery takes on average 5 min. In the next step, budgeted costs are calculated, starting by direct costs. Here, direct costs are direct materials. The calculation of materials is based on the material requirement table (called BOM). 50 000 Tuna Pizza BILL OF MATERIALS Item Purchase price/ u Costs dough 150 g 0.80/ 150g 40 000.00 tomato sauce 40 g 0.25/ 10g 50 000.00 tuner 75 g 2.00/ 100g 75 000.00 cheese 3 slices 0.20/ slice 30 000.00 195 000.00 20 000 Lasagne BILL OF MATERIALS Item Purchase price/ u Costs Lasagne noodles 100 g 0.50/ 100g 10 000.00 tomato sauce 50 g 0.25/ 10g 25 000.00 minced meet 80 g 1.00/ 100g 16 000.00 cheese 5 slices 0.20/ slice 20 000.00 71 000.00 10 000 Cannelloni Bill OF MATERIALS Item Purchase price/ u Costs cannelloni noodles 100 g 0.50/ 100g 5 000.00 cream sauce 50 g 0.20/ 10g 10 000.00 cooked ham 60 g 1.20/ 100g 7 200.00 cheese 5 slices 0.20/ slice 10 000.00 32 200.00 Amount Amount Amount Figure 44.3: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs based on products In total, direct materials equal to: (1) Dough: 40,000.00 EUR (2) Tomato sauce: 50,000 + 25,000 = 75,000.00 EUR (3) Tuner: 75,000.00 EUR (4) Cheese: 30,000 + 20,000 + 10,000 = 60,000.00 EUR (5) Lasagne noodles: 10,000.00 EUR (6) Minced meet: 16,000.00 EUR (7) Cannelloni noodles: 5,000.00 EUR (8) White sauce: 10,000.00 EUR <?page no="569"?> Berkau: BASICS of ACCOUNTING 44-568 (9) Cooked ham: 7,200.00 EUR Besides the meals, Chianti wine is a direct cost, too. (10) Chianti wine: 6 × 4,000 = 24,000.00 EUR The total of direct materials equals to: 40,000 + 75,000 + 75,000 + 60,000 + 10,000 + 16,000 + 5,000 + 10,000 + 7,200 + 24,000 = 322,200.00 EUR . The next step is overhead calculation. There are indirect materials, which cannot be linked to particular products as they serve all products at the same time. This is why we refer to those costs as overheads, meaning over the heads (of here: products). There are material expenses for cooking oil in the kitchen and for dishwasher liquid being: 1,440 l olive oil at 2.50 EUR/ l which gives: 1,440 × 2.50 = 3,600.00 EUR and 720 l dishwasher liquid at 0.50 EUR/ l, which adds up to: 720 × 0.50 = 360.00 EUR . With regard to the other expenses, GIULIO’S PIZZA&PASTA RISTORANTE classifies them as overheads. These costs are salaries and depreciation. In total, GIULIO’s PIZZA&PASTA RISTORAN- TE’s overheads are as below: (a) Olive oil: 3,600.00 EUR/ a (b) Dishwasher liquid: 360.00 EUR/ a (c) Cook’s salary: 4,000 × 12 = 48,000.00 EUR/ a (d) Order manager’s/ waiter’s salary: 2,800 × 12 = 33,600.00 EUR/ a (e) Driver’s salary: 20,000 × (5/ 60) x 9 = 15,000.00 EUR/ a (f) Depreciation on the stove: 24,000/ 6 = 4,000.00 EUR/ a (g) Depreciation on the restaurant interior: 18,000/ 6 = 3,000.00 EUR/ a (h) Depreciation on the delivery-Fiat: 8,000/ 4 = 2,000.00 EUR/ a . (i) Operating expenses for the delivery- Fiat: 1,000 × 12 = 12,000.00 EUR/ a . (j) Rent for the whole restaurant: 3,000 × 12 = 36,000.00 EUR/ a . The overheads sum equals to: 3,600 + 360 + 48,000 + 33,600 + 15,000 + 4,000 + 3,000 + 2,000 + 12,000 + 36,000 = 157,560.00 EUR . After Cost Category Accounting the Management Accounting system contains the cost data as depicted by Figure 44.4. <?page no="570"?> Berkau: BASICS of ACCOUNTING 44-569 Figure 44.4: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (1) Direct costs will be allocated straight to the products, which will be pizza, lasagne, cannelloni and the Chianti wine by the glass. For cost planning GIULIO’S PIZZA& PAS- TA RISTORANTE divides the company into 3 cost centres. There is the kitchen, the restaurant/ order management and the shipping department, where deliveries are made. Direct costs will be assigned to the products as indicated by Figure 44.3. In contrast to the total material requirements, these costs are unit costs. Unit costs are costs based on one unit of the product/ service. Additionally, there are direct costs for the wine served in the restaurant (per glass). Observe the direct costs in Figure 44.5. As you can see, the amount of the products has been changed to 1. <?page no="571"?> Berkau: BASICS of ACCOUNTING 44-570 1 Tuna Pizza DIRECT COSTS Item Purchase price/ u Costs dough 150 g 0.80/ 150g 0.80 tomato sauce 40 g 0.25/ 10g 1.00 tuner 75 g 2.00/ 100g 1.50 cheese 3 slices 0.20/ slice 0.60 3.90 1 Lasagne DIRECT COSTS Item Purchase price/ u Costs Lasagne noodles 100 g 0.50/ 100g 0.50 tomato sauce 50 g 0.25/ 10g 1.25 minced meet 80 g 1.00/ 100g 0.80 cheese 5 slices 0.20/ slice 1.00 3.55 1 Cannelloni DIRECT COSTS Item Purchase price/ u Costs cannelloni noodles 100 g 0.50/ 100g 0.50 cream sauce 50 g 0.20/ 10g 1.00 cooked ham 60 g 1.20/ 100g 0.72 cheese 5 slices 0.20/ slice 1.00 3.22 1 Wine by the Glass DIRECT COSTS Item Purchase price/ u Costs wine 0.25 ml 6/ 0.75ml 2.00 2.00 Amount Amount Amount Amount Figure 44.5: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs For the cost planning, GIULIO’S PIZZA& PASTA RISTORANTE calculates overheads per cost centre and then determines a cost rate. The cost rate is calculated by dividing costs by the amount of the reference unit. We analyse the three cost centres below: Kitchen In the kitchen, the overheads are: (a) olive oil: 3,600.00 EUR/ a, (b) dishwasher liquid: 360.00 EUR/ a, (c) cook’s salary: 4,000 × 12 = 48,000.00 EUR/ a , (f) depreciation on the stove: 24000/ 6 = 4,000.00 EUR/ a and (j) rent for the whole restaurant: 3,000 × 12 = 36,000.00 EUR/ a . The rent is split up based on the restaurant area. The kitchen area is 20 m 2 and the restaurant/ order management area is 60 m 2 . Accordingly, 25% of the rent is allocated to the kitchen, which equals to: 0.25 × 36,000 = 9,000.00 EUR/ a . The total annual kitchen-overheads are: 3,600 <?page no="572"?> Berkau: BASICS of ACCOUNTING 44-571 + 360 + 48,000 + 4,000 + 9,000 = 64,960.00 EUR/ a . (Note, in GIULIO’S PIZZA&PASTA RISTORANTE, the cook must do the dishes.) Restaurant/ Order Management In the restaurant/ order management, the overheads are: (d) order manager/ waiter’s salary: 2,800 × 12 = 33,600.00 EUR/ a and (g) depreciation on the restaurant interior: 18,000/ 6 = 3,000.00 EUR/ a and (j) rent for the whole restaurant: 3,000 × 12 = 36,000.00 EUR/ a . The rent is split up based on the restaurant area relationship. Remember, the kitchen area is 20 m 2 and the restaurant’s/ order management’s area is 60 m 2 . The restaurant covers 75 % of the rent: 75% × 36,000 = 27,000.00 EUR/ a . The total of overheads in the restaurant/ order management equals to: 33,600 + 3,000 + 27,000 = 63,600.00 EUR/ a. Delivery In the Delivery department the overheads are (e) driver’s salary: 20,000 × (5/ 60) × 9 = 15,000.00 EUR/ a , (h) depreciation on the delivery-Fiat: 8,000 / 4 = 2,000.00 EUR/ a and (i) operating expenses for the delivery-Fiat: 1,000 × 12 = 12,000.00 EUR/ a . The total delivery overheads add up to 15,000 + 2,000 + 12,000 = 29,000.00 EUR/ a . We take a look at the Management Accounting system. The costs below are allocated to cost objects: Figure 44.6: GIULIO’S PIZZA&PASTA RISTORANTE Management Accounting system (2) <?page no="573"?> Berkau: BASICS of ACCOUNTING 44-572 The next step is cost rate calculation. The cost rate is costs of a cost centre divided by its output related reference unit. The reference unit in the kitchen is preparation time, measured by minutes. We assume, a pizza takes 3 min, a lasagne and a cannelloni take 2 min each. In GIULIO’S PIZZA&PASTA RISTORANTE, the total amount of preparation time will add up to: 3 × 50,000 + 2 × (20,000 + 10,000) = 210,000 min (= 3,500 h). The cost rate in the kitchen is: 64,960 / 3,500 = 18.56 EUR/ h = 0.31 EUR/ min . (Note, as the rates are rounded, we stick to the cost rate measured by EUR/ h for further calculations.) The reference unit in the restaurant/ order management is the amount of meals. The amount includes the wines served, too. The total amount equals to: 50,000 + 20,000 + 10,000 + 3 × 4,000 = 92,000 meals+drinks . The cost rate equals to: 63,600 / 92,000 = 0.69 EUR/ meal+drinks . The costs of the delivery department do not depend on the output. They are fixed. The costs are regarded as standby costs and won’t be allocated to products. After cost rate calculation and determination of fixed costs GIULIO’S PIZZA& PASTA RISTORANTE’s Management Accounting system contains the amounts for costs and rates as indicated by Figure 44.7. Figure 44.7: GIULIO’S PIZZA&PASTA RISTORANTE Management Accounting system (3) <?page no="574"?> Berkau: BASICS of ACCOUNTING 44-573 The next step is product calculation. For that reason, we stick to the account display. You should compare the next following steps to the chapter: Production Firms . (Note, in the accounts below, the ID-numbers (1) … (10) refer to the text above and not to bookkeeping entries.) Although materials are direct costs, some materials, e.g. cheese, are used for more than one product. Accordingly, these materials must be split up. In order to debit the direct costs for (2) tomato sauce and for (4) cheese, the Accountant made the bookkeeping entries below: DR WIP Pizza.................... 50,000.00 EUR DR WIP Lasagne.................. 25,000.00 EUR CR Purchase (2) ................ 75,000.00 EUR DR WIP Pizza.................... 30,000.00 EUR DR WIP Lasagne.................. 20,000.00 EUR DR WIP Cannelloni............... 10,000.00 EUR CR Purchase (4)................. 60,000.00 EUR We do not consider these bookkeeping entries as cost allocations, as there was no calculation required in order to divide costs. The technical term for the above assignments is cost tracing. Cost tracing is the assignment to Manufacturing Accounts without calculations. This means, the EURamount of tomato sauce and of cheese is already known. Cost tracing applies for direct costs. D C D C (1) 40,000.00 (5) 10,000.00 (2) 50,000.00 (2) 25,000.00 (3) 75,000.00 (6) 16,000.00 (4) 30,000.00 c/ d 195,000.00 (4) 20,000.00 c/ d 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 b/ d 195,000.00 b/ d 71,000.00 D C D C (7) 5,000.00 (10) 24,000.00 c/ d 24,000.00 (8) 10,000.00 b/ d 24,000.00 (9) 7,200.00 (4) 10,000.00 c/ d 32,200.00 32,200.00 32,200.00 b/ d 32,300.00 WIP cannelloni WIP chianti WIP pizza WIP lasagne Figure 44.8: GIULIO’S PIZZA&PASTA RISTORANTE’s Manufacturing accounts (1) <?page no="575"?> Berkau: BASICS of ACCOUNTING 44-574 For the overheads, the Management Accountant prepares cost centre accounts. As we are used to the term MOHaccounts, we here apply production firm language for the Hospitality Management case study. Remember, the MOHaccount represents a cost centre. In GIULIO’S PIZZA&PASTA RISTORANTE, there will be three cost centres. We make debit entries for the overheads (a) … (i). The last one (j) rent, requires allocations and is not recorded yet. D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (f) 4,000.00 D C (e) 15,000.00 (h) 2,000.00 (i) 12,000.00 MOH kitchen MOH restaurant/ order management MOH delivery Figure 44.9: GIULIO’S PIZZA&PASTA RISTORANTE’s Manufacturing accounts (2) (j) Rent requires a cost-split to allocate the overheads to the cost centres kitchen and restaurant/ order management. The ratio is given by the cost centre areas, see above. A cost allocation is the assignment of costs to cost objects - such as cost centres or products based on at least one dividing-calculation operation . Often, the calculations will be based on cost object characteristics - such as area, time, head count etc. for a cost centre. The cost allocation for (j) rent leads to the bookkeeping entry below: DR WIP kitchen.................. 9,000.00 EUR DR WIP Restaurant/ OM............ 27,000.00 EUR CR Rent......................... 36,000.00 EUR <?page no="576"?> Berkau: BASICS of ACCOUNTING 44-575 D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (j) 27,000.00 c/ d 63,600.00 (f) 4,000.00 63,600.00 63,600.00 (j) 9,000.00 c/ d 64,960.00 b/ d 63,600.00 64,960.00 64,960.00 b/ d 64,960.00 D C D C (e) 15,000.00 (j) 36,000.00 (j) 9,000.00 (h) 2,000.00 (j) 27,000.00 (i) 12,000.00 c/ d 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 b/ d 29,000.00 MOH delivery Rent MOH kitchen MOH restaurant/ order management Figure 44.10: GIULIO’S PIZZA&PASTA RISTORANTE’s Manufacturing accounts (3) The balancing figures in the accounts equal to the amounts depicted in the Calculation-box and Cost Centre-box in Figure 44.7. Pizza The overhead application is based on the cost rates calculated above. The WIP pizza account receives: 3 × 50,000 × 18.56 × (1/ 60) = 46,400.00 EUR from the kitchen. Furthermore, it receives: 50,000 × 0.69 = 34,500.00 EUR from the restaurant/ order management. The bookkeeping entries are: DR WIP Pizza.................... 46,400.00 EUR CR MOH Kitchen.................. 46,400.00 EUR DR WIP Pizza.................... 34,500.00 EUR CR MOH Restaurant/ OM ............ 34,500.00 EUR The unit costs per pizza equal to: (195,000 + 46,400 + 34,500) / 50,000 = 5.51 80 EUR/ pizza . Lasagne The WIP lasagne account receives: 2 × 20,000 × 18.56 × (1/ 60) = 12,373.33 EUR from the kitchen. Furthermore, it receives: 20,000 × 0.69 = 13,800.00 EUR from the restaurant/ order management. The bookkeeping entries are: <?page no="577"?> Berkau: BASICS of ACCOUNTING 44-576 DR WIP Lasagne.................. 12,373.33 EUR CR MOH Kitchen.................. 12,373.33 EUR DR WIP Lasagne.................. 13,800.00 EUR CR MOH Restaurant/ OM............ 13,800.00 EUR The unit costs per lasagne equal to: (71,000 + 12,373.33 + 13,800) / 20,000 = 4.85 867 EUR/ lasagne . Cannelloni The WIP cannelloni account receives: 2 × 10,000 × 18.56 × (1/ 60) = 6,186.67 EUR from the kitchen. Furthermore, it receives: 10,000 × 0.69 = 6,900.00 EUR from the restaurant/ order management. The bookkeeping entries are: DR WIP Cannelloni............... 6,186.67 EUR CR MOH Kitchen.................. 6,186.67 EUR DR WIP Cannelloni............... 6,900.00 EUR CR MOH Restaurant/ OM............ 6,900.00 EUR The unit costs per cannelloni equal to: (32,200 + 6,186.67 + 6,900) / 10,000 = 4.52 867 EUR/ cannelloni . Chianti The WIP Chianti account receives: 3 × 4,000 × 0.69 = 8,280.00 EUR from the restaurant/ order management. The bookkeeping entry is: DR WIP Chianti.................. 8,280.00 EUR CR MOH Restaurant/ OM............ 8,280.00 EUR The unit costs per Chianti equal to: (24,000 + 8,280) / 12,000 = 2.69 00 EUR/ Chianti . Observe GIULIO’S PIZZA&PASTA RISTO- RANTE’s accounts in Figure 44.11: <?page no="578"?> Berkau: BASICS of ACCOUNTING 44-577 D C D C (1) 40,000.00 (5) 10,000.00 (2) 50,000.00 (2) 25,000.00 (3) 75,000.00 (6) 16,000.00 (4) 30,000.00 c/ d 195,000.00 (4) 20,000.00 c/ d 71,000.00 195,000.00 195,000.00 71,000.00 71,000.00 b/ d 195,000.00 b/ d 71,000.00 Kit 46,400.00 Kit 12,373.33 R/ O 34,500.00 c/ d 275,900.00 R/ O 13,800.00 c/ d 97,173.33 275,900.00 275,900.00 97,173.33 97,173.33 b/ d 275,900.00 b/ d 97,173.33 D C D C (7) 5,000.00 (10) 24,000.00 c/ d 24,000.00 (8) 10,000.00 b/ d 24,000.00 (9) 7,200.00 R/ O 8,280.00 c/ d 32,280.00 (4) 10,000.00 c/ d 32,200.00 32,280.00 32,280.00 32,200.00 32,200.00 b/ d 32,280.00 b/ d 32,200.00 Kit 6,186.67 R/ O 6,900.00 c/ d 45,286.67 45,286.67 45,286.67 b/ d 45,286.67 WIP cannelloni WIP chianti WIP pizza WIP lasagne D C D C (a) 3,600.00 (d) 33,600.00 (b) 360.00 (g) 3,000.00 (c) 48,000.00 (j) 27,000.00 c/ d 63,600.00 (f) 4,000.00 63,600.00 63,600.00 (j) 9,000.00 c/ d 64,960.00 b/ d 63,600.00 Pzz 34,500.00 64,960.00 64,960.00 Lsg 13,800.00 b/ d 64,960.00 Pzz 46,400.00 Cnl 6,900.00 Lsg 12,373.33 Chi 8,280.00 Cnl 6,186.67 c/ d 120.00 64,960.00 64,960.00 63,600.00 63,600.00 b/ d 120.00 D C D C (e) 15,000.00 (j) 36,000.00 (j) 9,000.00 (h) 2,000.00 (j) 27,000.00 (i) 12,000.00 c/ d 29,000.00 36,000.00 36,000.00 29,000.00 29,000.00 b/ d 29,000.00 MOH delivery Rent MOH kitchen MOH restaurant/ order management Figure 44.11: GIULIO’S PIZZA&PASTA RISTORANTE’s Manufacturing accounts (4) <?page no="579"?> Berkau: BASICS of ACCOUNTING 44-578 At this stage the Management Accounting system looks as depicted by Figure 44.12. Figure 44.12: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (4) GIULIO’S PIZZA&PASTA RISTORANTE sells a pizza at 9.00 EUR and lasagne and cannelloni at 8.00 EUR each. A glass of wine cost 5.00 EUR. The revenue for GIULIO’S PIZZA&PASTA RISTORANTE equals to: 50,000 × 9 + 20,000 × 8 + 10,000 × 8 + 12,000 × 5 = 750,000.00 EUR . The calculation of profit is based on the cost of sales format. GIULIO’S PIZZA& PASTA RISTORANTE calculates profit being 750,000 less cost of sales. The cost of sales amount to: 275,900 + 97,173.33 + 45,286.67 + 32,280 = 450,640.00 EUR . (Note, the amount is taken from the WIP accounts and does not contain a rounding difference.) The contribution margin equals to: 750,000 - 450,640 = 299,360.00 EUR . In case we calculate based on the unit costs, we suffer from rounding differences. For the unit cost calculation, rounding differences in the kitchen and restaurant/ order management are not considered, but remain in the cost centres. 750,000 - 5.51 800 × 50,000 - 4.85 867 × 20,000 - 4.52 867 × 10,000 - 2.69 000 × 12,000 - 29,000 = 750,000 - 450,640.10 - 29,000 = 270,359.90 EUR . (In order to compare the result, you have to deduct the costs, remaining in the cost centres as result of rounding differences. 270,359.90 - 120 = 270,239.90 EUR . However, <?page no="580"?> Berkau: BASICS of ACCOUNTING 44-579 0.10 EUR rounding difference stays, as the unit costs got rounded and later multiplied by ten-thousands of units.) Take a look at GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system in Figure 44.13: Figure 44.13: GIULIO’S PIZZA&PASTA RISTORANTE’s Management accounting system (5) (Note, the rounding difference from the restaurant/ order management cost centre got transferred to fixed costs. This means the total of fixed costs equals to: 29,000 + 120 = 29,120.00 EUR .) In order to double-check the calculations, we add the costs at different states of calculation: 450,640 + 29,120 = 450,640 + 29,000 + 120 = 64,960 + 63,600 + 29,000 + 195,000 + 71,000 + 32,200 + 24,000 = 322,200 + 157,560 = 479,760.00 EUR . This means, the totals of costs do not change! Summary: A Management Accounting system takes costs from Financial Accounting system and divides them in direct costs and overheads. The direct costs are traced to the products/ services whereas overheads are allocated to cost centres. In the cost centre cost rates will be determined for calculation. The unit costs of a product/ service are its direct costs plus portions of the overheads. The latter ones are allocated based on the cost centre cost rates. The Profitability Analysis calculates the net operating profit of the business. <?page no="581"?> Berkau: BASICS of ACCOUNTING 44-580 Working Definitions: Overheads: Overheads (= overhead costs) are non-direct costs which cannot be traced to a certain product or service. Unit Costs: Unit costs are costs based on one unit of the product/ service. Cost Rate: The cost rate is costs of a cost centre divided by its output related reference unit. Cost Tracing: Cost tracing is the assignment to Manufacturing Accounts without calculations. Cost Allocation: A cost allocation is the assignment of costs to cost objects - such as cost centres or products based on at least one dividing-calculation operation. <?page no="582"?> Berkau: BASICS of ACCOUNTING 45-581 45. Flexible Budgeting / Marginal Cost Accounting Learning Objectives: So far in this text book, we presented Management Accounting systems based on full costs. Full costs, or by another technical term: Absorption Costing, means we do not separate overheads. (Note, direct cost always will be variable costs.) In this chapter, we take advantage of the cost separation as discussed about in the chapter Cost Behaviour / Cost Separation. This will offer a better way of cost and profit planning, as overheads can be predicted based on the output. After studying this chapter, you will be able to distinguish between flexible budgeting and full Cost Accounting system and you can apply calculations in cost planning based on separated costs. The expression “fixed costs” is somehow problematic! (Note, in the IFRSs vocabulary, the word fixed has been banned and got replaced by “non-current” This is, as even fixed costs are not engraved in stone but can changed.) With regard to Management Accounting, fixed costs refer to cost categories, not varying by the output of the business. The output of a business is the amount of products/ services. For output measurement Accountants apply reference units. The reference units depend proportionally on the output, such as the amount of goods manufactured or services rendered. It is important to emphasis the word proportionally. In Management Accounting, the Accounting periods are short and the range of product/ service amounts is normally limited between particular borders. This results in cost diagrams appearing as lines. Once we can draw the cost over reference unit function as a line, its costs depend proportionally on the reference unit. The slope of the cost curve is constant. In contrast to proportional costs functions, variable cost functions can have any form except of a vertical line. Remember, a vertical line indicates fixed costs. In order to apply precise cost terms, we will distinguish costs in proportional and fixed portions. In Management Accounting, there are principles for cost allocations. Most common rule is called the cost-bycause principle, meaning a cost object that causes costs will be charged. This implies a fair cost allocation. (Note, in private life, you follow this rule also: Who orders beer in the pub, pays.) There can be alternative cost allocation principles. One of them is the average principle and another one is the carrying capacity principle. Once you follow the average principle all costs will be divided to all objects on average. (Note, you apply this principle when you have dinner with your friends and share the bill equally - no matter what and how much everyone had.) The carrying capacity principle is based on the idea charging primary the <?page no="583"?> Berkau: BASICS of ACCOUNTING 45-582 strongest cost object. For instance, you assign overheads to the product, which sells best. (Note, if you go out with your family and your father pays the bill, the cost allocation principle of the carrying capacity applies.) In sophisticated Management Accounting, the cost-by-cause principle is preferred. This guarantees fairness with regard to cost allocations. For cost assignments, we distinguish two cases: direct costs and overheads. Direct costs are traced to the product straight away. When it comes to overheads, proportional overheads are allocated to cost objects along the cost-bycause principle. However, fixed overheads are not caused by cost objects and therefore, should not be allocated to products nor services at all. Let us study what happens, if fixed costs are allocated to products: Think about a hotel with 100 rooms. The costs for the hotel in this example only are depreciation on the hotel building. We assume, there is only one room occupied during the Accounting period. If the manager allocates fixed overheads - depreciation to the guests, the only guest in the hotel has to cover all costs. This is obviously not right and leads to biased cost information. In particular, the profit assigned to the guest will be negative and the manager would do exactly the wrong thing: chasing away the last customer he/ she has got, as the Accountant tells him/ her, the guest is causing a loss. We now want to study cost allocation based on a flexible budgeting linked to GIULIO’s PIZZA&PASTA RISTO- RANTE case study. We split overheads in proportional and fixed items. Based on the cost separation, we apply Cost Centre Accounting, Calculation and Profitability Analysis. We use the same case study as in chapter Structure of Cost Accounting Systems, in order to show the differences between full Cost Accounting system and Flexible Budgeting. With regard to the case study, all direct costs will be the same as in the previous chapter: (1) Dough: 40,000.00 EUR (2) Tomato sauce: 50,000 + 25,000 = 75,000.00 EUR (3) Tuner: 75,000.00 EUR (4) Cheese: 30,000 + 20,000 + 10,000 = 60,000.00 EUR (5) Lasagne noodles: 10,000.00 EUR (6) Minced meet: 16,000.00 EUR (7) Cannelloni noodles: 5,000.00 EUR (8) White sauce: 10,000.00 EUR (9) Cooked ham: 7,200.00 EUR (10) Chianti wine: 6 × 4,000 = 24,000.00 EUR With regard to the overheads, the case study is modified as below: (a) Olive oil: 3,600.00 EUR/ a. The consumption of olive oil actually depends proportionally on the meals. However, there is no intention by GIULIO’s PIZZA& PASTA RISTORANTE’s Accountant to plan costs based on millilitres of cooking oil consumption. We classify those overheads as artificial overheads. Artificial overheads can be allocated to products by the cost-bycause principle. However, they won’t, because the effort for correct calculations is not justified by its outcome, which is the accurate cost information. <?page no="584"?> Berkau: BASICS of ACCOUNTING 45-583 (b) Dishwasher liquid: 360.00 EUR/ a. The dishwasher liquid consumption is regarded as artificial overheads, too. (c) Cook’s salary was before: 4,000 × 12 = 48,000.00 EUR/ a . The cook’s salary now is changed in comparison to the previous chapter. The salary contains a fixed portion of 2,250.00 EUR/ m. Furthermore, the cook earns 6.00 EUR/ h of preparation time, no matter which meal he cooks. The reference unit for the kitchen cost centre is preparation hours, in short: prep-h. In total, the cook’s salary equals to: 27,000 + ((3 × 50,000) + 2 × (20,000 + 10,000)) × 6 × (1/ 60) = 48,000.00 EUR . Based on the product amounts of 50,000 pizza, 20,000 lasagne and 10,000 cannelloni, the cooks salary equals to the full Cost Accounting system’s amount. In case the meal amounts change, it won’t. (Note, the costs of the cook do not depend directly on the product amounts, but on the preparation time.) (d) Order manager’s/ waiter’s salary: 2,800 × 12 = 33,600.00 EUR/ a . The order manager/ waiter is considered as standby costs and is fixed with regard to the amount of meals/ drinks ordered and served. Stand-by costs are costs, which occur, when a company provides resources, without consideration of their use. Take as an example for stand-by costs fire fighters. (e, h, i) Driver’s salary: 20,000 × (5/ 60) x 9 = 15,000.00 EUR/ a , depreciation on the delivery-Fiat: 8,000/ 4 = 2,000.00 EUR/ a and operating expenses for the delivery-Fiat: 1,000 × 12 = 12,000.00 EUR/ a, will be replaced now by an outsourced delivery service and its costs. The costs per delivery tour will be 5.00 EUR/ tour. GIULIO’s PIZZA&PASTA RIS- TORANTE estimates the tour amount being 5,800 during the next Accounting period. This means, that 36.25 % of the meals will be delivered and one tour delivers 5 meals on average. (f) Depreciation on the stove: 24,000/ 6 = 4,000.00 EUR/ a (g) Depreciation on the restaurant/ order management interior: 18,000/ 6 = 3,000.00 EUR/ a. (j) Rent for the whole restaurant: 3,000 × 12 = 36,000.00 EUR/ a . The cost centre planning now is based on mixed costs, which means, there are proportional and fixed costs. Every cost centre i, gets its particular cost function in the form: C i (X) = PC i × X + FC i , with PC being the slope of the cost line and FC the fixed costs. Kitchen In the kitchen department GIULIO’s PIZZA&PASTA RISTORANTE got mixed costs. Mixed costs contain portions of proportional and fixed costs. The cost function of the kitchen cost centre depends on the preparation time. The X-value is measured by prep-h. The slope of the cost line is 6.00 EUR/ prep-h, because the cook’s salary is the only proportional cost element in the kitchen. Fixed costs contain the are artificial overheads for cooking oil at 3,600.00 EUR and dish washer liquid at 360.00 EUR, the base salary for the cook of 12 × 2,250 = 27,000.00 EUR and depreciation on the stove: 24,000/ 6 = 4,000.00 EUR . Additionally, there are 25 % of the rental costs, which equal to: 0.25 × 36,000 = 9,000.00 EUR . The sum of fixed costs gives: 3,600 + 360 + 27,000 + 4,000 + <?page no="585"?> Berkau: BASICS of ACCOUNTING 45-584 9,000 = 43,960.00 EUR . The cost line in the kitchen follows the mathematical equation: C kitchen (X) = 6.00 EUR/ prep-h × X + 43,960.00 EUR. The budgeted costs in the kitchen are based on the workload of: (3 × 50,000 + 2 × (20,000 + 10,000))/ 60 = 3,500 prep-h and equal to: C kitchen (3,500) = 6 × 3,500 + 43,960 = 64,960.00 EUR . Restaurant/ Order Management In the cost centre restaurant/ order management, all costs are fixed costs. They are: (d) order manager’s/ waiter’s salary: 2,800 × 12 = 33,600.00 EUR/ a and (g) depreciation on the restaurant/ order management interior: 18,000/ 6 = 3,000.00 EUR/ a and (j) rent for the restaurant’s/ order management’s area of 60 m 2 : 75% × 36,000 = 27,000.00 EUR/ a . The total of overheads in the restaurant/ order management equals to: 33,600 + 3,000 + 27,000 = 63,600.00 EUR/ a. The cost function is: C rest/ OM = 63,600.00 EUR. Delivery In the delivery department, costs are now completely proportionally depending on the amount of tours. The cost function equals to: C delivery (X) = 5.00 EUR/ tour × X. X is the amount of tours. The budgeted costs for 5,800 tours equal to: C delivery (5,800) = 5 × 5,800 = 29,000.00 EUR . The amount of tours depends on the output proportionally. 80,000 meals × 36.25% / 5 = 5,800 tours . The Management Accounting system for GIULIO’s PIZZA&PASTA RIS- TORANTE looks as depicted by Figure 45.1. Figure 45.1: GIULIO’s PIZZA&PASTA RISTORANTE’s ManAcc system with flexible costing <?page no="586"?> Berkau: BASICS of ACCOUNTING 45-585 We take a closer look at the Profitability Analysis. In contrast to the unit cost calculation in Figure 44.12 and Figure 44.13, the unit costs now are based on only proportional costs. All fixed costs of the cost centres are transferred to the fixed cost section of the income statement. We run a calculation - based on flexible budgeting below: Pizza The costs for the pizza contain the direct materials and proportional costs for the cook’s salary and the delivery service. The calculation is based on the planned amount of 50,000 pizza. The hours worked on pizza amount to: 3 × 50,000/ 60 = 2,500 prep-h . The proportional costs for the cook based on 2,500 prep-h equal to: 6 × 2,500 = 15,000.00 EUR . We have to consider the portion of pizza delivered by the outsourced service, too. (Note, the delivery service is no extra service charged for by GUILIO’s PIZZA& PASTA RISTORANTE. The costs are proportionally depending on the amount of pizza, lasagne and cannelloni. For this reason, we consider the delivery costs as proportional costs for the products.) The amount of delivered pizza equals to: 36.25% × 50,000 = 18,125 (delivered) pizza . The tour amount equals to: 18,125/ 5 = 3,625 tours . The delivery costs for 50,000 pizza equal to: 5 × 3,625 = 18,125.00 EUR . The total unit costs per single pizza, are calculated by the proportional costs of 50,000 pizza divided by 50,000. The unit costs are: (195,000 + 15,000 + 18,125)/ 50,000 = 4.56 EUR/ pizza . The amount is rounded off from 4.56 25 EUR/ pizza. Lasagne The proportional costs per lasagne are direct materials, cook’s proportional salary costs and delivery costs. The cook’s costs are based on the prep-h, which depend proportional on the lasagne amount. The prep-h for lasagne equal to: 2 × 20,000/ 60 = 666.67 prep-h . The cook’s proportional costs for preparing 20,000 lasagne equal to: 6 × 666.67 = 4,000.00 EUR . The amount of delivery tours equals to: 5 × (20,000 × 36.25%) / 5 = 7,250.00 EUR . The unit costs per lasagne equal to: (71,000 + 4,000 + 7,250)/ 20,000 = 4.11 EUR/ lasagne - rounded off from 4.11 25 EUR/ lasagne. Cannelloni The proportional cannelloni costs comprise the direct materials, the cook’s proportional costs and delivery costs. The cook’s cost depends on the workload, measured in prep-h. The amount of prep-h equals to: (2 × 10,000)/ 60 = 333.33 EUR/ prep-h . The cook’s proportional costs equal to: 6 × 333.33 = 2,000.00 EUR . The costs for delivery are half of the costs for lasagne delivery: 7,250/ 2 = 3,625.00 EUR . The sum of proportional costs gives: 32,200 + 2,000 + 3,625 = 37,825.00 EUR . The unit costs equal to: 37,825/ 10,000 = 3.78 EUR/ cannelloni . The amount is rounded off from 3.78 25 EUR/ cannelloni. Chianti The Chianti wine is not prepared by the cook nor is there any delivery of wines provided by GIULIO’s PIZZA&PASTA <?page no="587"?> Berkau: BASICS of ACCOUNTING 45-586 RISTORANTE. Therefore, the only unit costs are direct materials. They equal to: 24,000 / 12,000 = 2.00 EUR/ Chianti . The Profitability Analysis is based on the planned amounts of 50,000 pizza, 20,000 lasagne, 10,000 cannelloni and 12,000 glasses of Chianti wine. The costs of sales are based only on proportional costs. The difference between revenue and proportional costs is called the contribution margin. The budgeted contribution margin can be displayed as per unit, too. This is helpful for product mix decisions. GIULIO’s PIZZA&PASTA RISTORANTE’s contribution margin equals to: 50,000 × 9 + 20,000 × 8 + 10,000 × 8 + 12,000 × 5 - 4.56 25 × 50,000 - 4.11 25 × 20,000 - 3.78 25 × 10,000 - 2 × 12,000 = 750,000 - 372,200 = 377,800.00 EUR . (Note, in order to avoid rounding differences, the calculation is based on the original values. The 3 rd and 4 th digit after the decimal point are displayed in smaller letters.) (Note, in case you want to check the figure with Figure 44.4, where an amount of 322,200.00 EUR for direct costs is calculated, you have to add proportional overheads of 21,000.00 EUR (cook) and 29,000.00 EUR (delivery) to get the total amount for proportional costs of: 322,200 + 21,000 + 29,000 = 372,200.00 EUR .) All fixed costs are to be deducted from the contribution margin. The total of fixed costs contains the fixed kitchen overheads and fixed overheads in the restaurant/ order management. There are no fixed costs in the delivery cost centre here. Total fixed costs equal to: 43,960 + 63,600 = 107,560.00 EUR . GIULIO’s PIZZA&PASTA RISTORANTE’s profit equals to: 377,800 - 107,560 = 270,240.00 EUR . Observe GIULIO’s PIZZA&PASTA RISTO- RANTE’s Management Accounting system as displayed in Figure 45.2 in order to get an overview and compare the profit to Figure 44.13, which contains the full cost Accounting data. <?page no="588"?> Berkau: BASICS of ACCOUNTING 45-587 Figure 45.2: GIULIO’s PIZZA&PASTA RISTORANTE’s Management Accounting system The advantage of flexible budgeting is a better costs planning which is based on the performance. The profit can be calculated along a formula with the structure below: ∑ ∑ = = − × = m j n i i j j j FC X CM X P 1 1 ) ( ) ( (with: j = index for the product/ service, j = 1 … m, i = index for the cost centre, i = 1 … m, P = profit, CM = contribution margin, X i = amount of products/ services, FC = fixed costs) In the case study GIULIO’s PIZZA&PASTA RISTORANTE, the contribution margins per products are: CM pizza = 9 - 4.56 25 = 4.43 75 EUR/ u . CM lasagne = 8 - 4.11 25 = 3.88 75 EUR/ u . CM cannelloni = 8 - 3.78 25 = 4.21 75 EUR/ u . CM Chianti = 5 - 2 = 3.00 EUR/ u . We call X 1 the amount of pizza, X 2 the amount of lasagne, X 3 = the amount of cannelloni and X 4 the amount of Chianti. The profit function of GIULIO’s PIZZA&PASTA RISTORANTE equals to: P(X 1 , X 2 , X 3 , X 4 ) = 4.43 75 × X 1 + 3.88 75 × X 2 + 4.21 75 × X 3 + 3 × X 4 - 43,960 - 63,600. We check the equation with the budgeted amounts for X j : X 1 = 50,000 pizza, X 2 = 20,000 lasagne, X 3 = 10,000 cannelloni and X 4 = 12,000 Chianti: P (50,000; 20,000; 10,000; 12,000) = 4.43 75 × 50,000 + 3.88 75 × 20,000 + 4.21 75 × <?page no="589"?> Berkau: BASICS of ACCOUNTING 45-588 10,000 + 3 × 12,000 - 43,960 - 63,600 = 270,240.00 EUR . (Note, this is the amount as displayed in Figure 45.2.) However, GIULIO’s PIZZA&PASTA RISTO- RANTE now can plan based on different meal and drink amount scenarios (whatif analysis). Observe a few numbers given for the product amounts in Figure 45.3: X 1 X 2 X 3 X 4 CM pizza CM lasagne CM canneloni CM Chiant FC kitchen FC rest/ OM NOP 1 1 1 1 4.44 3.89 4.22 3.00 (43,960.00) (63,600.00) (107,544.46) 50,000 20,000 10,000 12,000 221,875.00 77,750.00 42,175.00 36,000.00 (43,960.00) (63,600.00) 270,240.00 55,000 15,000 15,000 10,000 244,062.50 58,312.50 63,262.50 30,000.00 (43,960.00) (63,600.00) 288,077.50 60,000 10,000 10,000 14,000 266,250.00 38,875.00 42,175.00 42,000.00 (43,960.00) (63,600.00) 281,740.00 0 40,000 40,000 12,000 0.00 155,500.00 168,700.00 36,000.00 (43,960.00) (63,600.00) 252,640.00 45,000 25,000 15,000 10,000 199,687.50 97,187.50 63,262.50 30,000.00 (43,960.00) (63,600.00) 282,577.50 30,000 30,000 30,000 0 133,125.00 116,625.00 126,525.00 0.00 (43,960.00) (63,600.00) 268,715.00 Figure 45.3: GIULIO’s PIZZA&PASTA RISTORANTE’s profit planning Flexible Budgeting allows an easy profit calculation that is based on different product/ service amounts. Managers can try different output scenarios and can plan performance and check the consequences on the profit straight away. However, the impact of flexible budgeting is even more important for companies which put finished goods on stock, or releases manufactured goods from stock for sale. However, this aspect is not relevant for service providers. We now study a further case study LOGA (Pty) Ltd., which is a CD manufacturer actually, it is a kind of record label. As we will demonstrate by the LOGA (Pty) Ltd. case study, a production firm, applying a full Cost Accounting system, is making mistakes with regard to the profit calculation, once it puts finished goods on stock. The reason for cost biasing lays in the deferment of fixed costs. In a full Cost Accounting system, finished goods put on stock, contain fixed costs. The fixed costs assigned to the finished goods on stock, only count for the profit calculation, once the goods are released from stock. As a consequence, a manager, who studies the Profitability Analysis, will get distorted cost information. The profit is too high, if the company puts goods on stock. It will be too low, if the company releases <?page no="590"?> Berkau: BASICS of ACCOUNTING 45-589 goods from stock, which contain fixed costs. A better cost planning will be achieved, if cost separation takes place and no fixed costs are allocated to products. A Management Accounting system, based on separated proportional and fixed costs elements is called a marginal costing system. The expression marginal results from the fact, that the system is able to disclose cost changes, resulting from a one-unit increase/ decrease of output figures. A company that applies a marginal Cost Accounting system, does not distort profit when putting finished goods on stock or releases finished goods from stock. A cost planning based on marginal costs, is referred to as Flexible Budgeting. (Note, for Financial Accounting along IFRSs and HGB, a full cost Accounting system is required only. This is the lowest standard of calculation. The damage with regard to profit and loss is limited, as long as all good put on stock will be released later on.) LOGA (Pty) Ltd. is in the CD business. They record music CDs from local artists, burn them, and distribute them online. In fiscal year 20X7, LOGA (Pty) Ltd. produces 1,000,000 CDs and sells 800,000 thereof. In 20X8 the business produces 1,000,000 CDs and sells 1,100,000 units. The same production and sales amounts as for 20X8 apply in 20X9. The production amount of CDs is the same in every Accounting period. For that reason, unit costs won’t change. The direct costs contain materials and labour. Material expenses for one CD are 0.10 EUR/ u. The amount for direct labour is 0.30 EUR/ u in the recording department. The overheads are partly manufacturing overheads. Depreciation on production facilities equals to 40,000.00 EUR/ a. Furthermore, there is a supervisors’ salary to be considered to the extent of 50,000.00 EUR/ a. The distribution costs (non-manufacturing expenses) are 1.00 EUR/ CD. The distribution costs are linked to the products and count as direct costs. Do not allocate them to the unit costs, as distribution is not linked to production. Fixed marketing expenses (non-manufacturing) are 150,000.00 EUR/ a. The sales amount per CD is 2.50 EUR. We prepare a profitability analysis for the periods 20X7, 20X8 and 20X9 at first: based (1) on a full cost Accounting system (Absorption Costing), and below: along a (2) marginal Cost Accounting system. We will demonstrate the differences by this approach. Ad (1): Absorption Costing For the Profitability Analysis, LOGA (Pty) Ltd. applies a profit and loss account along the cost of sales format. The company applies a first-in-first-out policy for inventory movements. (Note, as the unit costs are constant, the sequence of movements does not matter. However, we are going to mark the unit costs by a year-index.) The calculation of cost of sales requires a valuation of stock at the end of the Accounting period. For putting CDs on stock, the unit costs are debited to the Finished Goods account. LOGA (Pty) Ltd. makes a debit entry in the WIP account and a credit entry in the Finished Goods Inventory account. In case CDs are released from stock, they will be expensed, which means the CDs will be transferred to the Cost of Sales account. The Accountant makes a debit entry in the Cost <?page no="591"?> Berkau: BASICS of ACCOUNTING 45-590 of Sales account and a credit entry in the Finished Goods Inventory account. In 20X7, LOGA (Pty) Ltd. produced 1,000,000 CDs, 800,000 CDs are sold and the remaining 200,000 ones are put on stock. For inventory valuation, a calculation of CDs is required: Direct materials and direct labour equal to: 0.10 + 0.30 = 0.40 EUR/ CD . The manufacturing overheads are all fixed costs. The fixed overheads per CD contain depreciation and the supervisor’s salary. They equal to: (40,000 + 50,000) / 1,000,000 = 0.09 EUR/ CD 20X7 . The unit costs for 20X7 equal to: 0.40 + 0.09 = 0.49 EUR/ CD 20X7 . This gives a closing stock of: 200,000 × 0.49 = 98,000.00 EUR . In 20X7, the value of the produced CDs equals to: 0.49 × 1,000,000 = 490,000.00 EUR . For the cost of sales calculation, LOGA (Pty) Ltd. adds the opening value (stock releases) to the manufacturing amounts and deducts the value for the CDs put on stock. Observe Figure 45.4. In 20X7, the cost of sales equal to: 490,000 - 98,000 = 392,000.00 EUR . The revenue equals to: 800,000 × 2.50 = 2,000,000.00 EUR . The non-manufacturing costs are distribution costs plus fixed marketing expenses, which add up to: 1 × 800,000 + 150,000 = 950,000.00 EUR . The profit equals to: 2,000,000 - 392,000 - 950,000 = 658,000.00 EUR . Observe the Profitability Analysis as depicted in Figure 45.4. 20X7 20X8 20X9 Sales 2,000,000.00 2,750,000.00 2,750,000.00 less: COS + OV 0.00 (98,000.00) (49,000.00) + Manufactured (490,000.00) (490,000.00) (490,000.00) - Closing stock 98,000.00 49,000.00 Gross margin 1,608,000.00 2,211,000.00 2,211,000.00 less: distribution expenses (prop) (800,000.00) (1,100,000.00) (1,100,000.00) less: marketing (fixed) (150,000.00) (150,000.00) (150,000.00) Net operating profit 658,000.00 961,000.00 961,000.00 Figure 45.4: LOGA (Pty) Ltd.’s Profitability Analysis based on Absorption Costing In 20X8, the unit costs equal to: 0.10 + 0.30 + (40,000 + 50,000) / 1,000,000 = 0.49 EUR/ CD 20X8 (again). The revenue equals to: 1,100,000 × 2.50 = 2,750,000.00 EUR . The costs of sales result from 200,000 CDs 20X7 , which are released from stock, 1,000,000 CDs 20X8 , which were produced in 20X8, and from which 10 % are put on stock. In the Accounting period 20X9 the 100,000 CDs 20X8 are released from stock and are sold together with 1,000,000 CDs 20X9 . Ad (2): Marginal Costing Under a marginal Cost Accounting system, only proportional costs are considered for inventory valuation. Fixes costs are not allocated to products. The proportional unit costs equal to direct materials plus direct labour. The unit costs <?page no="592"?> Berkau: BASICS of ACCOUNTING 45-591 are: 0.10 + 0.30 = 0.40 EUR/ CD . As fixed costs for manufacturing are not assigned to products, The Accountant deducts them from the gross margin. (Note, applying a marginal Cost Accounting system, the gross margin becomes the contribution margin.) 20X7 20X8 20X9 Sales 2,000,000.00 2,750,000.00 2,750,000.00 less: COS + OV 0.00 (80,000.00) (40,000.00) + Manufactured (400,000.00) (400,000.00) (400,000.00) - Closing stock 80,000.00 40,000.00 Contribution margin 1,680,000.00 2,310,000.00 2,310,000.00 less: depreciation on factory (40,000.00) (40,000.00) (40,000.00) less: supervisor's salary (50,000.00) (50,000.00) (50,000.00) less: distribution expenses (prop) (800,000.00) (1,100,000.00) (1,100,000.00) less: marketing (fixed) (150,000.00) (150,000.00) (150,000.00) Net operating profit 640,000.00 970,000.00 970,000.00 Figure 45.5: LOGA (Pty) Ltd.’s Profitability Analysis based on Marginal Costing Now, profit differs from the one disclosed in Figure 45.4. However, in case we add up the profits over the three Accounting periods, we get the same amount, which is: 658,000 + 961,000 + 961,000 = 640,000 + 970,000 + 970,000 = 2,580,000.00 EUR . The reason for that occurrence is, that the CDs put on stock have been released completely. In case we compared only 2 Accounting periods, the total of the profits differs. Which profits are correct? The correct figures are the ones, calculated by marginal Cost Accounting system. The fixed costs for the supervisor and for depreciation have to count for the Accounting period they occur in. The profit in the Accounting period along Figure 45.4 is too high by 658,000 - 640,000 = 18,000.00 EUR . This difference equals to the amount of fixed costs included in 200,000 CDs 20X7 . The fixed costs therein amount to: 200,000 × (40,000 + 50,000) / 1,000,000 = 18,000.00 EUR . The profit in the statement of 20X7 is higher by 18,000.00 EUR, because the fixed costs included in the CD stock do not count for the profit. In the next year, the profit is 961,000.00 EUR for the full cost calculation and 970,000.00 EUR for the marginal costing. The marginal Cost Accounting system is correct. The full cost Accounting system indicates now a lower profit, as by releasing 100,000 CDs from stock, 100,000 × (40,000 + 50,000)/ 1,000,000 = 9,000.00 EUR fixed costs are expensed, and reduce the actual profit of 970,000.00 EUR to 961,000.00 EUR. The same effect takes place in 20X9. Absorption Costing changes the profit, as fixed costs allocated to finished goods are excluded from the profit calculation, if the goods are put on stock. We say, the fixed costs will be deferred. Deferred <?page no="593"?> Berkau: BASICS of ACCOUNTING 45-592 indicates, the opposite will happen, once the goods are released from stock. When the company releases goods from stock, their costs count for the actual accounting period. So do the fixed costs included in the unit costs. Summary: A flexible budgeting is a budgeting based on the amount of products/ services. The amounts will determine the profit. For unit cost calculation and for the Profitability Analysis it is strongly recommended to only consider proportional costs. This way, the cost allocation is based on the cost-by-cause principle and provides managers with fair and unbiased information. A margin costing will provide correct cost information for the profit calculation, as no fixed costs are included in the unit costs. Putting goods on stock does not distort the profit calculation, as it does under an Absorption Costing. Working Definitions: Artificial Overheads: Artificial overheads can be allocated to products by the cost-by-cause principle. However, they won’t, because the effort to calculate correctly is not justified by its outcome. Stand-by Costs: Stand-by costs are costs, which occur, when a company provides resources, without consideration of their use. Contribution Margin: The difference between revenue and proportional costs is called the contribution margin. Marginal Costing: A Management Accounting system, based on separated proportional and fixed costs elements is called a marginal costing system. Flexible Budgeting: A cost planning based on marginal costs, is referred to as flexible budgeting. <?page no="594"?> Berkau: BASICS of ACCOUNTING 46-593 46. Cost Centre Efficiency Check Learning Objectives A company performs well if the profit planned by the managers and Accountants is realized. This means, the company then works as scheduled. In order to make sure the performance is achieved as planned in the business plan, it is required to monitor the entire company. This should be done by efficiency checks in all cost centres. every cost centre has a manager who is responsible for the costs therein. There are also departments, where the manager is responsible for revenues, too. These ones will be called profit centre. In this chapter, we show how to monitor cost centres. After studying this chapter, you will be able to understand the information provided by a cost centre efficiency report. Furthermore, you will be able to monitor cost centres yourself. (Note, along a study of WEBER, only few centre managers is actually able to understand efficiency reports! ) For the following considerations, we apply a Marginal Cost Accounting system. The cost of a cost centre are planned based on proportional and fixed costs. Proportional costs depend on the reference unit of the cost centre and thus are linked to the output. Once the cost centre is in operation, the actual costs can be compared to the budget. If costs match, we say the cost centre works efficiently. You might ask yourself, why not planning costs generously, as in that case the actual costs meet the budget easily? The answer lays in the business plan. Managers try to plan costs as exact and as low as possible, as the products are sold on markets, where competitors try to sell them at a low price, too. Thus, costs are budgeted at the lowest possible level in order to make the company competitive. Companies who plan their product costs sloppy, will be overtaken by their competitors, who sell the same products at a lower price. At the first glance, the cost comparison is very straight forward. The actual costs should be the same as the budgeted ones. A difference in costs is an indicator for a negative deviation, which might have been caused by rework, wrong resource application, delays etc. However, things become more complicated, if the reference unit varies, too. We take a look at a case study from the manufacturing business: SALISBURY Ltd. produces laptop displays. The business applies a Marginal Cost Accounting system. Despite all cost categories could be measured separately, SALISBURY Ltd.’s cost planning is just based on its total costs. The company runs a cost separation and reveals 100,000.00 EUR of fixed costs. The proportional costs in the cost centre assembling depend on the workload X, measured in assembling-min. The slope of the cost function is 5.00 EUR/ asbl-min. SALISBURY Ltd. plans to assemble 3,000 displays during the Accounting periods April, May and June 20X6. Every display requires an assembling time of 4 asblmin. 3,000 displays require 4 × 3,000 = 12,000 asbl-min = 200 asbl-h . The cost function is: C asbl (X) = 5.00 × X asbl + 100,000. <?page no="595"?> Berkau: BASICS of ACCOUNTING 46-594 The budgeted costs for 12,000 assembling-min equal to: C asbl (X = 12,000) = 5.00 × 12,000 + 100,000 = 160,000.00 EUR . The recording of the actual costs is based on three cost categories: labour cost, energy costs and depreciation. Labour costs and energy costs depend proportionally on the assembling time. Depreciation is fixed and equals to 100,000.00 EUR. As it can be observed, the actual costs are more in the detail than budgeted costs. In April 20X6, the assembling time is exactly 12,000 asbl-min. The actual (a) labour costs L a/ 4-20X6 equal to 42,000.00 EUR and energy costs E a/ 4-20X6 equal to 20,350.00 EUR. Actual total costs for assembling in April equal to: C asbl/ a/ 4-20X6 = 42,000 + 20,350 + 100,000 = 162,350.00 EUR . A cost comparison gives a total cost variance in April 20X6 of: 162,350 - 160,000 = 2,350.00 EUR . As the variance is caused by a deviation of resource consumption, we will call it ∆c. Figure 46.1 illustrates the cost situation by a costvolume graph. Figure 46.1: SALISBURY Ltd’s cost variance in April 20X6 In May 20X6, SALISBURY Ltd. assembles less displays than scheduled. The output amounts only to 2,500 displays. The recorded actual labour costs equal to: L a/ 5- 20X6 = 38,000 EUR and the actual energy costs are: E a/ 5-20X6 = 13,500.00 EUR. Depreciation again was 100,000.00 EUR. The actual total costs equal to: C asbl/ a/ 5- 20X6 = 38,000 + 13,500 + 100,000 = 151,500.00 EUR . In contrast to the previous month, the actual reference unit differs from the budgeted one. The mark for the actual costs has been moved to the left in a cost-reference-unit-diagram. The actual amount for X a/ 5-20X6 equals to: 2,500 × 4 = 10,000 asbl-min . Observe the actual cost mark in Figure 46.2. <?page no="596"?> Berkau: BASICS of ACCOUNTING 46-595 Figure 46.2: SALISBURY Ltd’s variance in May 20X6 The comparison of actual costs and budgeted costs does not make sense, if the reference unit is different. The consumption variance has to be based on the same reference unit amount, which is 10,000 asbl-min. For the consumption variance the planned costs based on the actual reference unit are calculated. They amount to: C asbl (X = 10,000) = 5.00 × 10,000 + 100,000 = 150,000.00 EUR . According to the diagram, the consumption variance equals to: 151,000 - 150,000 = 1,000.00 EUR . The consumption variance is the difference between actual costs and the planned costs based on the actual reference unit value. The consumption variance is caused by resource deviations. The cost centre manager is held responsible for consumption variances. A second variance relevant for Managerial Cost Accounting is called the volume variance Δv. The volume variance is the difference between planned costs at actual reference unit and total planned costs on average, based on the actual reference unit. The volume difference is caused by deviations of the volume. With regard to the SALESBURY Ltd. case study, the total planned costs on average, based on the actual reference unit equal to: = 10,000 × 160,000/ 12,000 = 133,333.33 EUR . Accordingly, the volume difference is ∆v 5/ 20X6 = 150,000 - 133,333.33 = 16,666.67 EUR . For the cost centre manager, the volume of the cost centre is an input variable. He/ she cannot change it as the workload depends on outside factors, such as marketing, the economy etc. Thus, cost centre managers are not responsible for volume deviations. Only the consumption variance is used in order to access the performance in the cost centre. We say, in case the consumption variance is zero, the cost <?page no="597"?> Berkau: BASICS of ACCOUNTING 46-596 centre works efficiently. The cost centre efficiency report shows consumption variances recorded in the cost centres. Very often the variances are disclosed on cost category level. At SALISBURY Ltd. a detailed cost centre efficiency report is not possible due to the total cost related budget. In June 20X6, SALESBURY Ltd. produces more displays. The amount equals to 4,000 units. The actual costs recorded by the Accountant equal to labour: L a/ 6/ 20X6 = 50,000.00 EUR, energy expenses: E a/ 6/ 20X6 = 20,000 EUR and depreciation of 100,000.00 EUR. The total amount of actual costs equals to: 50,000 + 20,000 + 100,000 = 170,000.00 EUR . The planned costs based on 4,000 displays amount to: C asbl (X = 16,000) = 5.00 × 16,000 + 100,000 = 180,000.00 EUR . The consumption variance equals to: ∆c 6/ 20X6 = 170,000 - 180,000 = - 10,000.00 EUR . The volume variance equals to: ∆v 6/ 20X6 = 180,000 - 16,000 × 160,000/ 12,000 = 33,333.00 EUR . The negative consumption variance is not regarded as a good indicator for the cost centre manager’s work. A negative consumption variance means the cost centre works better than planned. This indicates a poor planning standard performed by the cost centre manager and/ or the Accountant. Summary: A cost centre efficiency report gives information about the performance of a cost centre. The cost centre works well, as long as the consumption variance is low. A negative consumption variance indicates a poor level of budgeting. Working Definitions: Consumption variance: The consumption variance is the difference between actual costs and the planned costs based on the actual reference unit value. Volume variance: The volume variance is the difference between planned <?page no="598"?> Berkau: BASICS of ACCOUNTING 46-597 costs at actual reference unit level and total planned costs on average, based on the actual reference unit. <?page no="599"?> Berkau: BASICS of ACCOUNTING 47-598 47. Cost Allocations Learning Objectives: Management Accounting provides information linked to particular cost objects. In order to calculate the costs of a cost object, the Accountant has to assign costs thereto. In this chapter we focus on the cost assignment process. After studying this chapter, you will understand how cost allocation works and can distinguish different steps in the allocation process. Furthermore, you will be able to apply different cost allocation methods. At the beginning of this chapter, we define cost allocation: Cost allocation is the process of assigning costs from one cost object to another one by applying mathematic operations, mostly based on the rule of three. As we can already see, the cost allocation takes away costs from one or more cost objects and assigns the costs to one or several other cost objects. An example is the cost allocation from cost centre costs to products in Manufacturing Accounting. In Management Accounting, cost allocations are relevant at 3 steps of the calculation process. (1 st allocation) Costs are deducted from expense accounts, such as labour, materials etc. and assigned to cost centres, (2 nd allocation) costs are taken from one cost centre and assigned to another one in order to consider internal exchanges between cost centres that occur, if one cost centre supports another one and (3 rd allocation) costs are taken from cost centres and assigned to products/ services for calculation. The method of cost allocations is to divide costs based either on a real most physical unit, such as kWh, m, min etc. or based on a value, such as unit costs of manufacturing. We will study the cost allocation process by a case study from Logistics. CLYDBANK Ltd. is a transportation firm. The company is divided in 4 cost centres. CC 01: city delivery CC 02: long distance transportation CC 03: support CC 04: storage The characteristics of the cost centres are used for cost allocation. Here, the units are not all of no physical nature. They are the number of employees, square metres in a cost centre and cost of acquisition. Study the cost centre characteristics instances as disclosed in Figure 47.1. <?page no="600"?> Berkau: BASICS of ACCOUNTING 47-599 Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1,100 100 200 Value of machinery 800,000.00 1,500,000.00 20,000.00 500,000.00 Output in hours 10,580 23,000 - 9,200 Clydbank Ltd's COST CENTRE CHARACTERISTICS Figure 47.1: CLYDBANK Ltd.’s cost centre characteristics The characteristics are important for the cost allocations below, because the cost distribution is based on these amounts. CLYDBANK Ltd.’s costs are mostly overheads. In total CLYDBANK got 4 cost categories: labour, room, insurance and HR costs. The overheads are recorded in debit balanced accounts. The Labour account’s balance is 4,120,000.00 EUR, the Room Cost account’s balance equals to 555,000.00 EUR, the Insurance account’s balance is 282,000.00 EUR and the Human Resource HR account’s balance is 120,000.00 EUR. Some of the overheads are easy to trace to the 4 cost centres, as they got planned therein and/ or caused by the cost centres. This applies for the labour costs in the case study. The amounts are CC 01: 920,000.00 EUR, CC 02: 2,250,000.00 EUR, CC 03: 350,000.00 EUR, and CC 04: 600,000.00 EUR. This means, the costs are allocated based on direct costs. There is no distribution of costs based on units. However, room costs for the building (depreciation) to the extent of 550,000.00 EUR, insurance costs of 282,000.00 EUR and costs for the human resource HR department of 120,000.00 EUR will be allocated to the cost centres based on units. These cost allocations are called 1 st allocations. 1 st Allocation The first cost allocation deducts costs from the cost category accounts, such as Room Cost account, Insurance account and Human Resource account and distributes them to cost centres. At CLYDBANK Ltd., the room costs of 555,000.00 EUR are distributed based on the square metres of the cost centres. Check the amounts of square metres in the cost centres. The cost allocation follows a 450 : 1,100 : 100 : 200 ratio. We cancel the ratio by dividing all figures by 50. This gives now a: 9 : 22 : 2 : 4 ratio. The room costs allocated to CC 01 equal to: 555,000 × 9 / (9 + 22 + 2 + 4) = 135,000.00 EUR . For the other cost centres we determine: 330,000.00 EUR, 30,000.00 EUR and 60,000.00 EUR. <?page no="601"?> Berkau: BASICS of ACCOUNTING 47-600 How it is done (cost allocation) (1) Determine the amount of the base figures of the cost objects the costs are to be assigned to. (2) Write the figures as an a : b : c ratio. If possible divide the a-, band c-amounts to an constant figure (cancellation). (3) Calculate the percentages of the cost objects by dividing the base figure of one cost object by the sum of all base figures: a / (a + b + c) (4) Multiply the total costs with the percentages. The insurance costs allocation to the cost centres is based on the machine value of the cost centre. The total of insurance costs equals to 282,000.00 EUR. We consider the cost of acquisition as the machine values because the insurance rates are based thereon. Thus, the total insurance costs are distributed based on a 800,000 : 1,500,000 : 20,000 : 500,000 ratio. We cancel to: 40 : 75 : 1 : 25. The portion of insurance costs to be assigned to the cost centre CC 01 equals to: 282,000 × 40 / (40 + 75 + 1 + 25) = 80,000.00 EUR . The other cost centres CC 02 … CC 04 are charged with 150,000.00 EUR, 2,000.00 EUR and 50,000.00 EUR. The same approach gives the HR costs of the cost centres allocated based on head count as: 27,600.00 EUR, 60,000.00 EUR, 8,400.00 EUR and 24,000.00 EUR. We can describe the cost allocations by accounts as well. E.g. a cost allocation of insurance costs to cost centre CC 03 is recorded as: DR MOH CC 03.................... 2,000.00 EUR CR Insurance ................... 2,000.00 EUR Take a look at the accounts in Figure 47.2. D C D C 4,120,000.00 (1) 920,000.00 555,000.00 (5) 135,000.00 (2) 2,250,000.00 (6) 330,000.00 (3) 350,000.00 (7) 30,000.00 (4) 600,000.00 (8) 60,000.00 4,120,000.00 4,120,000.00 555,000.00 555,000.00 Labour Room Figure 47.2: CLYDBANK Ltd.’s accounts <?page no="602"?> Berkau: BASICS of ACCOUNTING 47-601 D C D C 282,000.00 (9) 80,000.00 120,000.00 (13) 27,600.00 (10) 150,000.00 (14) 60,000.00 (11) 2,000.00 (15) 8,400.00 (12) 50,000.00 (16) 24,000.00 282,000.00 282,000.00 120,000.00 120,000.00 D C D C (1) 920,000.00 (2) 2,250,000.00 (5) 135,000.00 (6) 330,000.00 (9) 80,000.00 (10) 150,000.00 (13) 27,600.00 c/ d 1,162,600.00 (14) 60,000.00 c/ d 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 b/ d 1,162,600.00 b/ d 2,790,000.00 D C D C (3) 350,000.00 (4) 600,000.00 (7) 30,000.00 (8) 60,000.00 (11) 2,000.00 (12) 50,000.00 (15) 8,400.00 c/ d 390,400.00 (16) 24,000.00 c/ d 390,400.00 390,400.00 390,400.00 734,000.00 390,400.00 b/ d 390,400.00 b/ d 390,400.00 Insurance Human resources HR MOH CC 01 MOH CC 02 MOH CC 03 MOH CC 04 Figure 47.2: CLYDBANK Ltd.’s accounts (continued) Additionally, we disclose the cost allocation in a table as displayed in Figure 47.3. By the next step all cost centre costs are added up. Take a look at the results in the table. The costs of cost centre CC 01 equal to: 920,000 + 135,000 + 80,000 + 27,600 = 1,162,600.00 EUR therein. We can see, that the total of allocated costs equals to the balancing figure of the cost centre costs. The balancing figure of the MOH CC 01 account equals to 1,162,600.00 EUR, too. Check the spreadsheet for cost allocations depicted in Figure 47.3. <?page no="603"?> Berkau: BASICS of ACCOUNTING 47-602 Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000.00 1,500,000.00 20,000.00 500,000.00 Output in hours 10,580 23,000 - 9,200 assigned labour costs 920,000.00 2,250,000.00 350,000.00 600,000.00 Allocations Room costs 135,000.00 330,000.00 30,000.00 60,000.00 Insurance costs 80,000.00 150,000.00 2,000.00 50,000.00 HR costs 27,600.00 60,000.00 8,400.00 24,000.00 1,162,600.00 2,790,000.00 390,400.00 734,000.00 Figure 47.3: CLYBANK Ltd.’s cost allocations to cost centres 2 nd Allocation The second cost allocation is caused by performance exchanges between cost centres. In case one cost centre delivers a service for another one, the receiving cost centre reimburses the sending cost centre for the support. For these exchanges, bookkeeping entries will be made in accounts for cost centres involved in internal support relationships. Mutual supports between cost centres can get complicated, which is the reason for us, to explain further methods for internal cost allocations at the end of this chapter. For now, we stick to the CLYCBANK Ltd. case study and cover only a one directional exchange of performance between the cost centres. Sometimes, a cost centre delivers its performance completely to other cost centres. A cost centre that performs only for the support of other cost centres is called an auxiliary cost centre. At CLYDBANK Ltd., cost centre CC 03 is an auxiliary cost centre. It supports the other cost centres based on the percentages below: 20 % of its performance is for CC 01, 70 % for CC 02 and 10 % for CC 04. Once we add up the percentages, we recognize, all the performance is for the support of other cost centres: 20% + 70% + 10% = 100% . The percentages are linked to the total cost of the cost centre CC 03 after the 1 st cost allocations have been finished. The total costs of cost centre CC 03 at this stage equal to: 350,000 + 30,000 + 2,000 + 8,400 = 390,400.00 EUR . We cover next the 2 nd allocation which is from cost centre CC 03 to the other cost centres CC 01, CC 02 and CC 04. As cost centre CC 03 performs to an extent of 20 % for cost centre CC 01, an amount of: 20% × 390,400 = 78,080.00 EUR will be charged. The Accountant will make the bookkeeping entry (17) as below: <?page no="604"?> Berkau: BASICS of ACCOUNTING 47-603 DR MOH CC 01.................... 78,080.00 EUR CR MOH CC 03.................... 78,080.00 EUR The other cost centres will cover the remaining costs of cost centre CC 03. Cost centre CC 02 covers 70% × 390,400 = 273,280.00 EUR and cost centre CC 04 covers 10% × 390,400 = 39,040.00 EUR . Observe bookkeeping entries (18) and (19). DR MOH CC 02.................... 273,280.00 EUR CR MOH CC 03.................... 273,280.00 EUR DR MOH CC 04.................... 39,040.00 EUR CR MOH CC 03.................... 39,040.00 EUR In Figure 47.4, the internal cost allocations are recorded as the bookkeeping entries (17) … (19). D C D C (1) 920,000.00 (2) 2,250,000.00 (5) 135,000.00 (6) 330,000.00 (9) 80,000.00 (10) 150,000.00 (13) 27,600.00 c/ d 1,162,600.00 (14) 60,000.00 c/ d 2,790,000.00 1,162,600.00 1,162,600.00 2,790,000.00 2,790,000.00 b/ d 1,162,600.00 b/ d 2,790,000.00 (17) 78,080.00 c/ d 1,240,680.00 (18) 273,280.00 c/ d 3,063,280.00 1,240,680.00 1,240,680.00 3,063,280.00 3,063,280.00 b/ d 1,240,680.00 b/ d 3,063,280.00 D C D C (3) 350,000.00 (4) 600,000.00 (7) 30,000.00 (8) 60,000.00 (11) 2,000.00 (12) 50,000.00 (15) 8,400.00 c/ d 390,400.00 (16) 24,000.00 c/ d 734,000.00 390,400.00 390,400.00 734,000.00 734,000.00 b/ d 390,400.00 (17) 78,080.00 b/ d 734,000.00 (18) 273,280.00 (19) 39,040.00 c/ d 773,040.00 (19) 39,040.00 773,040.00 773,040.00 390,400.00 390,400.00 b/ d 773,040.00 MOH CC 01 MOH CC 02 MOH CC 03 MOH CC 04 Figure 47.4: CLYDBANK Ltd.’s accounts after internal cost allocations In a spreadsheet the internal cost allocations will be disclosed only by one <?page no="605"?> Berkau: BASICS of ACCOUNTING 47-604 line in the bottom part, named CC 03 under the header of “Internal Cost Allocations”. The reimbursed cost centre CC 03 therein is disclosed by a negative cost entry of 390,000.00, which indicates that the costs of cost centre CC 03 are covered completely by the receiving cost centres. The cost centres CC 01, CC 02 and CC 04 now got charged for the support from cost centre CC 03 to the extent of 78,080.00 EUR, 273,280.00 EUR and 39,040.00 EU. Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000.00 1,500,000.00 20,000.00 500,000.00 Output in hours 10,580 23,000 - 9,200 assigned labour costs 920,000.00 2,250,000.00 350,000.00 600,000.00 Allocations Room costs 135,000.00 330,000.00 30,000.00 60,000.00 Insurance costs 80,000.00 150,000.00 2,000.00 50,000.00 HR costs 27,600.00 60,000.00 8,400.00 24,000.00 1,162,600.00 2,790,000.00 390,400.00 734,000.00 Internal cost allocations CC 03 78,080.00 273,280.00 (390,400.00) 39,040.00 1,240,680.00 3,063,280.00 0.00 773,040.00 Figure 47.5: CLYDBANK Ltd.’s spreadsheet with internal cost allocations 3 rd Allocation The last cost allocation is for the product calculation. Products and services are charged by the cost centres for the performance received therein. The cost allocations are based on the output of the cost centre. Thus, all products will cover a proportional amount of the cost centre costs. The output of the cost centres is measured by its reference unit. At CLYDBANK Ltd., the outputs are given by the spreadsheet in Figure 47.1. E.g., the output of cost centre CC 01 equals to 10,580 hours. The cost rates for the 3 rd allocation of costs are measured by EUR per reference unit. The reason is, that the costs of the cost centre after the 1 st and 2 nd allocations are divided by the output to obtain the cost rate. At CLYDBANK Ltd. all cost rates are measured by EUR/ h. However, auxiliary cost centres do not contribute to the production of goods. They only do by supporting other cost centres. For that reason, there is no output related reference unit for auxiliary cost centres. At CLYDBANK Ltd. only the cost centres CC 01, CC 02 and CC 04 are output cost centres. <?page no="606"?> Berkau: BASICS of ACCOUNTING 47-605 An output cost centre is a cost centre that works directly for the product/ service. The cost rate for the cost allocation is determined by dividing the final costs (last row) of the cost centres by the reference unit’s amount. The cost rate of cost centre CC 01 equals to 1,240,680/ 10,580 = 117, 27 EUR/ h . Accordingly, a city delivery (CC 01) that takes 20 min, is charged by: 20 × 117.27/ 60 = 39.09 EUR . The cost rates for the other cost centres are: CC 02: 3,063,280/ 23,000 = 133.19 EUR/ h and CC 04: 773,040/ 9,200 = 84.03 EUR/ h . Figure 47.6 discloses the cost rates per cost centre as result of a 3-step cost allocation. Characteristics CC 01 (city) CC 02 (long distance) CC 03 (support) CC 04 (storage) # of employees 23 50 7 20 Square metres 450 1100 100 200 Value of machinery 800,000.00 1,500,000.00 20,000.00 500,000.00 Output in hours 10,580 23,000 - 9,200 assigned labour costs 920,000.00 2,250,000.00 350,000.00 600,000.00 Allocations Room costs 135,000.00 330,000.00 30,000.00 60,000.00 Insurance costs 80,000.00 150,000.00 2,000.00 50,000.00 HR costs 27,600.00 60,000.00 8,400.00 24,000.00 1,162,600.00 2,790,000.00 390,400.00 734,000.00 Internal cost allocations CC 03 78,080.00 273,280.00 (390,400.00) 39,040.00 1,240,680.00 3,063,280.00 0.00 773,040.00 Cost rates[EUR/ h] 117.27 133.19 n/ a 84.03 Figure 47.6: CLYDBANK Ltd.’s cost centre rates Cost allocations can be based on actual as well as on budgeted data. The 2 nd cost allocation with CLYD- BANK Ltd. is in one direction only. Cost centre CC 03 provides other cost centres with performance, but none of these cost centres supports CC 03. In such cases, the receiving cost centre gets charged and the sending cost centre is refunded by the cost allocation. We define a few technical terms with regard to the internal cost allocations. Primary costs are costs of a cost centre that will be assigned directly. This includes assignments by the 1 st allocation, meaning the costs come straight from Financial Accounting or are planned straight for the cost centre. Primary costs do not contain portions coming from other cost centres. The primary costs of cost centre CC 03 equal to 390,400.00 EUR. <?page no="607"?> Berkau: BASICS of ACCOUNTING 47-606 Once costs are assigned by 2 nd allocations, further costs are added to the costs in the cost centre. Total costs are primary costs plus all costs assigned to the cost centre by internal cost allocation (2 nd allocation). The total costs of cost centre CC 01 equal to: 1,162,600 + 78,080 = 1,240,680.00 EUR. The total costs contain primary costs of 1,162,600 EUR and secondary costs of 78,080.00 EUR, the latter ones resulting from internal cost allocations. Secondary costs are costs charged to a cost centre as a result from internal cost allocations (2 nd allocation). After a cost centre got refunded by other cost centres for internal performance exchange - the Accountant makes a credit entry for the costs covered - the remaining costs are called final costs. Final costs are primary costs plus secondary costs less discharged costs from internal cost allocations (2 nd allocation). The internal cost allocation (2 nd allocation) will become more difficult, if the performance exchange is mutual between the cost centres. This means one cost centre supports another one and gets support from that cost centre at the same time. In those cases, two similar cost allocation methods apply. (1) equation method and (2) iteration method. Ad (1): Equation Method The equation method is based on the concept that all costs will be charged and discharged simultaneously. There are two equations for every cost centre, one for the total costs TC and another one about the final costs FC. The index for the cost centres is i and j. i stands for the receiving cost centre and j for the providing one. The total number of cost centres is n. (i = 1 … n; j = 1 … n). PC i stands for the primary costs of a cost centre. The factor α ij is the portion of the providing cost centre’s performance, received by cost centre i. If cost centre A supports cost centre B to an extend of 35 % of its performance, α BA = 35%. ∑ = ⋅ + = n j j ij i i TC PC TC 0 α ) 1 ( 0 ∑ = − ⋅ = n i ij j j TC FC α In order to study internal cost allocations by the equation method, we take a look at the new case study HEIS- FELD Ltd. HEISFELD Ltd. is a consultancy. HEISFELD Ltd. is divided in four cost centres (1) Concept Development (C) (2) Webdesign (W) (3) Java Programming (J) (4) Administration (A) <?page no="608"?> Berkau: BASICS of ACCOUNTING 47-607 For all cost centers, the performance and output is measured by hours (C-h, W-h, J-h, A-h). The outputs are 300 W-h, 500 C-h and 100 J-h. As you can see, Administration is an auxiliary cost centre as it does not have an output. The internal cost allocations require performance planning or actual data about the performance. For performance planning the internal support relationships are relevant: HEISFELD Ltd.’s Accountant’s experience is that for 6 W-h in the Webdesign cost centre, it needs support from Concepts- Development to the extent of 1 C-h. For 2 J-h in the Java Programming cost centre, it needs 1 C-h support from the Concept Development. For 3 W-h in the Webdesign cost centre, it needs 1 J-h from the Java Programming cost centre. Administration is necessary as well: The requirements are 1 A-h per 10 J-h, 1 A-h per 3 W-h and 1 A-h per 25 C-h. The performance planning can be displayed by a performance equation per cost centre. In the equation for performance, the output marks the minimum of the performance. We name P i the performance of the cost centre i and set up 4 performance equations for 4 cost centres. i = C, W, J or A. The performance equations are: P C = 500 + 2 × P J + (1/ 6) × P W P W = 300 P J = 100 + (1/ 3) × P W P A = (1/ 10) × P J + (1/ 3) × P W + (1/ 25) × P C We can read from the 1 st equation that for the output of Concept Development and the support of Java Programming and Webdesign the performance P C is required. At this stage of the calculation, we do not know the amounts of hours performed in the cost centres - except of in the Webdesign cost centre, because it only works for its own output and does not support any other cost centres. We now have to solve the equation system. As P W is known, we can calculate P J : P J = 100 + 100 = 200 J-h . P C depends on only known parameters. P C = 500 + 2 × 200 + (1/ 6) × 300 = 950 C-h . The last amount is for the performance in the Administration cost centre: P A = (1/ 10) × 200 + (1/ 3) × 300 + (1/ 25) × 950 = 148 Ah . Observe Figure 47.7 for the internal performance relationships. Add the performance figures assigned to the outgoing arrows in order to check the performance calculation. Take a look at Java Programming cost centre. The performance equals to: 100 + 100 = 200 J-h . For the Administration the performance equals to: 10 + 100 + 38 = 148 A-h . The performance for Concept Development equals to: 500 + 400 + 50 = 950 C-h, and the Webdesign’s performance is only for the output, which equals to 300 W-h. <?page no="609"?> Berkau: BASICS of ACCOUNTING 47-608 Figure 47.7: HEISFELD Ltd.’s performance structure In order to give the performance relationships a better structure, we describe every exchange by α. The α-amount is, what we run the performance planning for. The α-amount is required for the cost allocation equations. Remember, α gives us the relative performance of the exchanged performance. The unit of α is %. α JA = 10/ 148 = 6.75% α WJ = 100/ 200 = 50% α WA = 100/ 148 = 67.57% α WC = 50/ 950 = 5.26% α CA = 38/ 148 = 25.68% α JC = 400/ 950 = 42.11% . Once we know the α-amounts, we can run a cost allocation. We take the primary costs from the table in Figure 47.8. Webdesign Concepts Java Progr Admin Prim Costs, prop [EUR] 10,100.00 33,000.00 4,000.00 7,360.00 Prim Costs, fixed [EUR] 20,000.00 20,200.00 20,000.00 40,000.00 sum 30,100.00 53,200.00 24,000.00 47,360.00 Figure 47.8: HEISFELD Ltd.’s primary costs The equations for the total costs of the cost centres are: <?page no="610"?> Berkau: BASICS of ACCOUNTING 47-609 TC C = 53,200 + (38/ 158) × TC A TC W = 30,100 + (100/ 200) x TC J + (100/ 158) × TC A + (50/ 950) × TC C TC J = 24,000 + (10/ 158) × TC A + (400/ 950) × TC C TC A = 47,360.00 EUR We prefer fractions over percentages to determine the total and final costs. At first we calculate the total costs for the Concept Development: TC C = 53,200 + (38/ 148) × 47,360 = 65,360.00 EUR . By the next step, we calculate the total costs in the Java Programming cost centre: TC J = 24,000 + (10/ 148) × 47,360 + (400/ 950) × 65,360 = 54,720.00 EUR . The total costs in the Website Design cost centre eventually are calculated being: TC W = 30,100 + (100/ 200) × 54,720 + (100/ 148) × 47,360 + (50/ 950) × 65,360 = 92,900.00 EUR . Now, we can calculate the final costs of the cost centres. We take the 2 nd equation for the final costs and determine FC for all four cost centres. FC C = TC C × (1 - (400/ 950) - (50/ 950)) = 34,400.00 EUR FC W = TC W × (1 - 0) = 92,900.00 EUR FC J = TC J × (1 - (100/ 200)) = 27,360.00 EUR FC A = 0.00 EUR In order to check the calculation, we apply a Management Accounting rule, which states that the total of costs does not change by allocations. Accordingly, the total of the primary costs equals to the total of the final costs. Here, 30,100 + 53,200 + 24,000 + 47,360 = 34,400 + 92,900 + 27,360 = 154,660.00 EUR . As the totals match, we can be sure the allocation is correct. (Note, in an Accounting exam, you can run the same test to pre-check your calculations.) Ad (2): Iteration The above discussed equation method always works. However, the calculations can become quite difficult due to complexity of the case: A company can have a few thousands of cost centres - all exchanging performance mutually. In those cases, the equation method leads to thousands of equations with thousands of variables to determine. It is actually possible, but no one runs an allocation like that. One of the reasons is, that the computers, on which we apply the cost allocations, do not solve equations. However, the computer is good at computing, that is why it is called computer. We now present a cost allocation method, which is based on computing and not on dissolving equations. This allocation method is called iteration, derived from the Latin word ire (= to walk). The method will work similar to the equation method, however, the cost allocations will be made step by step. In order to perform the iteration process efficiently, we prepare an MS Excel sheet. At the header, the spreadsheet displays the mutual cost centre support structure. In order to calculate accurately, the α-amounts are keyed in as fractions. However, the display will appear as a digital number. For instance, α JA - which is the exchange of <?page no="611"?> Berkau: BASICS of ACCOUNTING 47-610 administration support for the Java Programming cost centre - is keyed in as 10/ 148. The display on MS Excel shows 0.067567568. In order to indicate the accuracy of the figures, the display in Figure 47.9 is with multiple digits after the decimal point. The α-amounts result from the performance planning above. See them below as percentages. 0.067567568 now is 6.76%. α JA = 10/ 148 = 6.76% α WJ = 100/ 200 = 50% α WA = 100/ 148 = 67.57% α WC = 50/ 950 = 5.26% α CA = 38/ 148 = 25.68%. α JC = 400/ 950 = 42.11%. to: Concept development Webdesign Java programming Admin from: Concept development 0 0.052631579 0.421052632 0 Webdesign 0 0 0 0 Java programming 0 0.5 0 0 Administration 0.256756757 0.675675676 0.067567568 0 Figure 47.9: HEISFELD Ltd.’s cost centre support structure Similar to the equation method, the iteration process will determine the total costs at first. The total costs contain primary costs and costs received from other cost centres. In contrast to the equation method, the cost allocation now goes step-by-step. The first cost portion received from the sending cost centres is from the primary costs. Concept development receives: (38/ 148) × 47,360 = 12,160.00 EUR from the Administration cost centre. The Website Design cost centre receives costs from the Concept Development cost centre to the extent of: (50/ 950) × 53,200 = 2,800.00 EUR , from the Java Programming cost centre to the extent of: (100/ 200) × 24,000 = 12,000.00 EUR and from the Administration cost centre to the extent of: (100/ 148) × 47,360 = 32,000.00 EUR . In total the received costs add up to: 2,800 + 12,000 + 32,000 = 46,800.00 EUR . Java Programming cost centre receives: (400/ 950) × 53,200 = 22,400.00 EUR from the Concept Development cost centre and: (10/ 148) × 47,360 = 3,200.00 EUR from the Administration cost centre. In total the received costs add up to: 22,400 + 3,200 = 25,600.00 EUR . The Administration cost centre does not receive costs as it is an auxiliary cost centre. In the lower part of Figure 47.10, the sent costs are recorded. They equal to: Concept Development: 2,800 + 22,400 = 25,200.00 EUR Website Design: 0.00 Java Programming: 12,000.00 EUR Administration: 12,160 + 32,000 + 3,200 = 47,360.00 EUR By the next iteration step, the transferred costs are based on the costs from the previous step only. The costs received by the Concept Design cost centre from the 1 st step are 12,160.00 EUR. The <?page no="612"?> Berkau: BASICS of ACCOUNTING 47-611 costs received by the 2 nd step equal to zero, because the sending cost centre (Administration) did not receive support from other cost centres. The Website Design cost centre receives costs from the Concept Development cost centre to the extent of: (50/ 950) × 12,160 = 640.00 EUR , from the Java Programming cost centre to the extent of: (100/ 200) × 25,600 = 12,800.00 EUR and from the Administration cost centre zero. The total amount of received costs equals to: 640 + 12,800 = 13,440.00 EUR . The cost received by the Java Programming cost centre equals to: (400/ 950) × 12,160 = 5,120.00 EUR from the Concept Development cost centre and zero from administration. The cost sent by the 2 nd step equals to: Concept Development: 640 + 5,120 = 5,760.00 EUR Website Design: 0.00 EUR Java Programming: 12,800.00 EUR Administration: 0.00 EUR The iteration process continues that way. At the end, the final costs are calculated as total costs less sent costs such as along the equation method. Study the figures depicted by Figure 47.10. You will understand, the iteration process calculates the same final costs as the equation method. to: Concept development Webdesign Java programming Admin from: Concept development 0 0.052631579 0.421052632 0 Webdesign 0 0 0 0 Java programming 0 0.5 0 0 Administration 0.256756757 0.675675676 0.067567568 0 Total costs: Primary costs (0 step) 53,200.00 30,100.00 24,000.00 47,360.00 received costs 1 st step 12,160.00 46,800.00 25,600.00 0.00 received costs 2 nd step 0.00 13,440.00 5,120.00 0.00 received costs 3 rd step 0.00 2,560.00 0.00 0.00 65,360.00 92,900.00 54,720.00 47,360.00 Sent costs: Sent 1 st step 25,200.00 0.00 12,000.00 47,360.00 Sent 2 nd step 5,760.00 0.00 12,800.00 0.00 Sent 3 rd step 0.00 0.00 2,560.00 0.00 30,960.00 0.00 27,360.00 47,360.00 Final costs: 34,400.00 92,900.00 27,360.00 0.00 Figure 47.10: HEISFELD Ltd.’s iteration process <?page no="613"?> Berkau: BASICS of ACCOUNTING 47-612 In the case study HEISFELD Ltd., the allocation is based on budgeted full costs. In case the company applies a Marginal Cost Accounting system, it only takes the proportional costs into consideration. There is no need to run an internal cost allocation for fixed costs, as all fixed costs will be closed-off to the Profit and Loss account. In order to apply a monitoring based on cost centre efficiency checks, HEISFELD Ltd. has to run a 1 st allocation and to compare cost centre data. This implies to even check costs at the provider, if it they are for the support of another receiving cost centre. In those checks, the reference unit is the total performance and not the performance for the output. Monitoring has to apply on auxiliary cost centres as well. Summary: The Management Accounting systems consider cost allocations in order to determine costs for particular cost objects. There is a 1 st allocation required in order to assign overheads to cost centres. The 2 nd cost allocation is to consider the performance exchange between cost centres. Mutual support relationships require an equation method or can be calculated by iteration. The 3 rd cost allocation is based on cost centre cost rates. The allocation charges products with costs and discharges the cost centres where the product has been manufactured or the service been rendered. Cost allocations do not change the sum of costs in a company. Working Definitions: Cost Allocation: Cost allocation is the process of assigning costs from one cost object to another one by applying mathematic operations, mostly based on the rule of three. Auxiliary Cost Centre: A cost centre that performs only for the support of other cost centres is called an auxiliary cost centre. Output Cost Centre: An output cost centre is a cost centre that works directly for the product/ service. Primary Costs: Primary costs are costs of a cost centre that will be assigned directly. Total Costs: Total costs are primary costs plus all costs assigned to the cost centre by internal cost allocation. Secondary Costs: Secondary costs are costs charged to a cost centre as a result from internal cost allocations. Final costs: Final costs are primary costs plus secondary costs less discharged costs from internal cost allocations. <?page no="614"?> Berkau: BASICS of ACCOUNTING 48-613 48. Reporting on Manufacturing Accounting Learning Objectives: The role of Management Accountants in a company can be described as an internal consultant. Management Accountants support managers. They do so by calculating appropriate cost information for the control of the business and report them to managers. For the reporting quality the form of the reports is important. Management Accountants set up a kind of cockpit for managers where they give all relevant information in form of ratios and reports. The reports are like the instruments in an aircraft’s cockpit. We explain in this chapter an example of a report for a production firm about the costs of manufacturing. After studying this chapter, you will understand how reports are prepared and how to read them. You can apply reporting in other situations. In a company a lot of information about costs is available. It results from cost planning and from recording the actual business activities. The latter information is derived from bookkeeping records. Management Accountants’ task is to filter available data. Furthermore, Management Accountants prepare management information based on cost allocations to objects of interest, by providing comparisons and by calculating ratios, such as for performance and liquidity. The field of reporting is wide. In this text book, we demonstrate an example for a report linked to a case study of a production firm only. The subject of our report is the cost of sales of manufactured and sold goods. Two reports apply: - COS report and - Profitability statement Before we prepare the reports mentioned above, we study the case of the production firm LEBUHRAYA (Pty) Ltd. LEBUHRAYA (Pty) Ltd. is a production firm for exclusive wine bottles. On its balance sheet, LEBUHRAYA (Pty) Ltd. displays the opening values for inventory in its Raw Material Inventory account: 20,000.00 EUR - Work in Process account: 5,000.00 EUR. During the Accounting period 20X6, LEBUHRAYA (Pty) Ltd. records purchases to the extent of 100,000.00 EUR. The materials used in production are 55,000.00 EUR direct materials and 50,000.00 EUR indirect materials. The indirect materials are posted to the Manufacturing Overheads account. Furthermore, LEBUHRAYA (Pty) Ltd. records labour to an extent of 200,000.00 EUR. 180,000.00 EUR is direct labour and will be assigned to work in process. The remaining portion of 20,000.00 EUR is indirect labour. LEBUHRAYA (Pty) Ltd. posts indirect labour to the Manufacturing Overheads account, too. Another manufacturing overhead is depreciation. LEBBUHRAYA (Pty) Ltd.’s depreciation on the production facilities amounts to 80,000.00 EUR/ a. <?page no="615"?> Berkau: BASICS of ACCOUNTING 48-614 There are also non-manufacturing overheads, such as administration to the extent of 50,000.00 EUR and marketing expenses, which equal to 10,000.00 EUR. By the first step, we record the basic expenses such as received from Financial Accountant. (Note, there is not such a thing like a data transfer but an access to the data base in an Accounting software system nowadays.) The opening amounts in the accounts are displayed by Figure 48.1. D C D C OV 20,000.00 OV 5,000.00 Raw materials inventory Work in process WIP Figure 48.1: LEBUHRAYA (Pty) Ltd.’s opening amounts An opening amount in the WIP account indicates, there are job orders in production that have been started in prior Accounting periods but have not been finished yet. The amount of 5,000.00 EUR in LEBUHRAYA (Pty) Ltd.’s WIP account might contain labour, materials and applied overheads from 20X5. (1 … 3) On 2.01.20X6, LEBUHRAYA (Pty) Ltd. records labour and purchases. As we do not intend to prepare financial statements here, only managerial Accounting information is relevant. Thus, in Management Accounting, we only make bookkeeping entries without VAT consideration and ignore real accounts, such as Accounts Payables and the Cash/ Bank account for instance. By the bookkeeping entry (2), the Purchase account is closed-off to the Inventory account. However, we record full bookkeeping entries. DR Purchase..................... 100,000.00 EUR CR Cash/ Bank.................... 100,000.00 EUR DR Inventory.................... 100,000.00 EUR CR Purchase..................... 100,000.00 EUR DR Labour....................... 200,000.00 EUR CR Cash/ Bank.................... 200,000.00 EUR (4) LEBUHRAYA (Pty) Ltd. records depreciation on 31.12.20X6. DR Depreciation................. 80,000.00 EUR CR Accumulated Depreciation..... 80,000.00 EUR (5 … 9) In the Management Accounting system, LEBUHRAYA (Pty) Ltd. prepares a WIP account and a Manufacturing Overheads account. Direct materials <?page no="616"?> Berkau: BASICS of ACCOUNTING 48-615 and labour are assigned to the WIP account. Indirect materials, indirect labour and depreciation is posted to manufacturing overheads. On 1.03.20X6, the Management Accountant allocates materials, labour and depreciation to the WIP account and MOH account. DR WIP Account.................. 55,000.00 EUR CR Inventory Account............ 55,000.00 EUR DR MOH Account.................. 50,000.00 EUR CR Inventory Account............ 50,000.00 EUR DR WIP Account.................. 180,000.00 EUR CR Labour....................... 180,000.00 EUR DR MOH Account.................. 20,000.00 EUR CR Labour....................... 20,000.00 EUR DR MOH Account.................. 80,000.00 EUR CR Depreciation................. 80,000.00 EUR (10) LEBUHRAYA (Pty.) Ltd. applies overheads completely. Remember, overhead application means to assign costs from the MOH account to the products. 150,000.00 EUR are transferred from the MOH account to the WIP account. The bookkeeping entries are recorded on 15.03.20X6. DR WIP Account.................. 150,000.00 EUR CR MOH Account.................. 150,000.00 EUR (11) With the job orders recorded, LEBUHRAYA (Pty) Ltd. produces 405,000 wine bottles. 300,000 wine bottles thereof are completed on 31.03.20X6. LEBUHRAYA (Pty) Ltd. closes one of the job orders and puts 300,000 wine bottles on stock. The cost of manufacturing per wine bottle equal to 1.00 EUR/ u. The value of the finished goods inventory equals to: 1 × 300,000 = 300,000.00 EUR . DR Finished Goods Inventory..... 300,000.00 EUR CR WIP Account.................. 300,000.00 EUR (12) On 4.04.20X6, 150,000 wine bottles are sold at a net selling price of 1.50 EUR/ u. The total revenue equals to: 1.50 × 150,000 = 225,000.00 EUR . The revenue is recorded on 5.04.20X6. DR Cash/ Bank.................... 225,000.00 EUR CR Revenue...................... 225,000.00 EUR <?page no="617"?> Berkau: BASICS of ACCOUNTING 48-616 (13) The inventory movements are about 150,000 wine bottles released from stock. They are expenses and lead to a debit entry in the Cost of Sales account. The goods movement is recorded on 4.04.20X6. DR COS Account.................. 150,000.00 EUR CR FG Inventory................. 150,000.00 EUR (14; 15) In the case study LEBUHRAYA (Pty) Ltd., no further business activities take place. We record administration and marketing expenses, both on 30.06.20X6. They do not classify for manufacturing expenses. DR Administration............... 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR DR Marketing.................... 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR Take a look at LEBUHRAYA (Pty) Ltd.’s accounts in order to familiarise yourself with the profit calculation. Check Figure 48.2. D C D C OV 20,000.00 (5) 55,000.00 OV 5,000.00 (11) 300,000.00 (2) 100,000.00 (6) 50,000.00 (5) 55,000.00 c/ d 15,000.00 (7) 180,000.00 120,000.00 120,000.00 (10) 150,000.00 c/ d 90,000.00 b/ d 15,000.00 390,000.00 390,000.00 b/ d 90,000.00 D C D C (1) 100,000.00 (2) 100,000.00 ... (1) 100,000.00 (12) 225,000.00 (3) 200,000.00 (14) 50,000.00 (15) 10,000.00 Raw materials inventory Work in process WIP Purchase Cash/ Bank D C D C (3) 200,000.00 (7) 180,000.00 (4) 80,000.00 (9) 80,000.00 (8) 20,000.00 200,000.00 200,000.00 Labour Depreciation Figure 48.2: LEBUHRAYA (Pty) Ltd.’s accounts <?page no="618"?> Berkau: BASICS of ACCOUNTING 48-617 D C D C c/ d 80,000.00 (4) 80,000.00 (6) 50,000.00 (10) 150,000.00 b/ d 80,000.00 (8) 20,000.00 (9) 80,000.00 150,000.00 150,000.00 Acc depr Manufacturing overheads MOH D C D C (11) 300,000.00 (13) 150,000.00 P&L 225,000.00 (12) 225,000.00 c/ d 150,000.00 300,000.00 300,000.00 b/ d 150,000.00 D C D C (13) 150,000.00 P&L 150,000.00 (14) 50,000.00 P&L 50,000.00 FG inventory Sales Cost of sales COS Administration D C D C (15) 10,000.00 P&L 10,000.00 COS 150,000.00 Rev 225,000.00 Adm 50,000.00 Mkt 10,000.00 EBT 15,000.00 225,000.00 225,000.00 b/ d 15,000.00 Marketing Profit and Loss P&L D C D C (3) 200,000.00 (7) 180,000.00 (4) 80,000.00 (9) 80,000.00 (8) 20,000.00 200,000.00 200,000.00 Labour Depreciation Figure 48.2: LEBUHRAYA (Pty) Ltd.’s accounts (continued) On the statement of financial position, LEBUHRAYA (Pty) Ltd. discloses an inventory value to the extent of: 15,000 + 90,000 + 150,000 = 255,000.00 EUR . The amount contains raw materials, work in process and finished goods. The Profit and Loss account has not been closed-off to the Retained Earnings account yet, as we do not intend to prepare a balance sheet. We won’t disclose the retained earnings in this chapter. Furthermore, the Cash/ Bank account is not balanced-off either, as it does not matter for our purpose of reporting manufacturing costs. In order to inform managers at LEB- UHRAYA (Pty) Ltd. about the cost of sales structure and about the profit earned with 150,000 wine bottles, <?page no="619"?> Berkau: BASICS of ACCOUNTING 48-618 providing production mangers with Taccounts won’t be appropriate. The Management Accountant has to prepare a report which states the information required. Here, the Management Accountant prepares a Cost of Sales statement for the Accounting period 20X6. We study the report as shown in Figure 48.3. Item Amount OV Raw materials 20,000.00 Purchases 100,000.00 120,000.00 Closing stock raw materials (15,000.00) indirect materials (50,000.00) Total direct materials 55,000.00 Direct labor 180,000.00 Prime cost 235,000.00 Applied overheads 150,000.00 385,000.00 OV Work in process WIP 5,000.00 390,000.00 Closing stock work in process WIP (90,000.00) COST of MANUFACTURING 300,000.00 OV FG inventory 0.00 Closing stock of FG inventory (150,000.00) COST of GOODS SOLD COS 150,000.00 Lebuhraya (Pty) Ltd.'s STATEMENT of COST of GOODS SOLD as for the period ended 31.12.20X6 Figure 48.3: LEBUHRAYA (Pty) Ltd.’s statement of COS The report provides data about the total amount of cost of manufacturing and the total amount of cost of sales for the Accounting period 20X6. The cost of manufactured are linked to all 300,000 wine bottles completed. As half of them are sold during the Accounting period 20X6, the costs of sales are calculated by deducting the closing stock of finished goods from the cost of manufacturing: 300,000 - 150,000 = 150,000.00 EUR . In order to calculate the cost of manufacturing, 4 steps are reported. By these 4 steps the costs of manufacturing are calculated as a sum of materials, labour and overheads. The last step is an adjustment of recorded stock. (1) Calculation of materials (2) Calculation of labour (3) Application of overheads <?page no="620"?> Berkau: BASICS of ACCOUNTING 48-619 (4) Adjustments for opening and closing stock of finished goods Ad (1): Calculation of Materials The calculation of the total cost of manufacturing starts off from the opening amount for raw materials. The first calculation determines the direct cost of materials. The calculation is based on the opening amount of raw materials plus purchases less closing stock. Furthermore, indirect materials are deducted because they will be considered as part of the applied overheads further down. The calculation of direct materials gives: 20,000 + 100,000 - 15,000 - 50,000 = 55,000.00 EUR . Ad (2): Calculation of Labour For the LEBUHRAYA (Pty) Ltd. case study, labour is given as direct labour to the extent of 180,000.00 EUR. Indirect labour is not considered at this stage of the report calculation, as it is included in applied overheads. After adding labour, the costs of manufacturing equal to: 55,000 + 180,000 = 235,000.00 EUR . Ad (3): Application of Overheads With regard to the overheads, the manager is not to be bothered with the details. The report only adds 150,000.00 EUR or applied overheads to the calculation. In case further information is required by management, the Management Accountant can run a “data drill down” and provide further details about the costs. After adding overheads, the costs of manufacturing equal to: 235,000 + 150,000 = 385,000.00 EUR . Ad (4): Adjustments The calculated costs of manufacturing do not consider the closing balance of the WIP account nor its opening amount. However, the opening amount is relevant, as it represents production expenses from prior Accounting periods. At the same time, costs for goods not yet finished are not supposed to be included in the total costs of manufacturing. For this reason, the opening amount of the WIP account is added and the closing balancing figure is deducted. The total costs of manufacturing then equal to: 385,000 + 5,000 - 90,000 = 300,000.00 EUR . Although the costs of manufacturing can be read from accounts, the report as in the statement of cost of sales shown by Figure 48.3 provides the information more manager-friendly. Consider managers of production departments mostly are engineers. A further report prepared, is the profitability analysis as depicted in Figure 48.4. <?page no="621"?> Berkau: BASICS of ACCOUNTING 48-620 Item Amt. Sales 225,000.00 COST of GOODS SOLD (150,000.00) Gross margin 75,000.00 Extraordinary income 0.00 Gross income 75,000.00 Further expenses Administration (50,000.00) Marketing (10,000.00) Net operating profit 15,000.00 Lebuhraya (Pty) Ltd.'s STATEMENT of PROFITABILITY for the period ended 31.12.20X6 Figure 48.4: LEBUHRAYA (Pty) Ltd.’s profitability analysis Summary: Management Accountants provide information by reports. The reports contain calculations, ratios and/ or comparisons, which are useful for managers to make decisions. Reports are prepared on monthly and annual basis. Besides of standard reports, Management Accountants provide exceptional reports, too. <?page no="622"?> Berkau: BASICS of ACCOUNTING 49-621 49. Job Order Costing (Manufacturing Accounting) Learning Objectives: Manufacturing Accounting is a field that is relevant for Financial Accounting (inventory valuation) and for Management Accounting (calculation). The basics are covered by the chapter Production Firms and Inventory Valuation. We now present a job order costing method that is more in the details and that will refer to the concept of Management Accounting as discussed in chapter Structure of Cost Accounting Systems. Another method for special production firms will be introduced in the next following chapter Process Costing. After studying this chapter, you will understand the account structure underlying a cost accounting system. You will be able to apply a Job Order Costing system. One of the main purposes in Management Accounting is product calculation. It provides the unit cost of manufacturing for goods/ services. For production firms that produce their goods based on internal job orders, a job order costing system is appropriate. We studied already a job order costing system with the case study REGENT BIKE (Pty) Ltd. in chapter Production Firms. However, that case study was very simple and only covered one product manufactured. In real production firms there are a lot of job orders and manufacturing takes place in hundreds of cost centres. In this chapter, the overhead allocation now is based on a predetermined overhead allocation rate. A predetermined overhead allocation rate (POR) is a cost rate for charging products/ services with cost centre overheads that is based on budgeted overheads and budgeted cost centre outputs. In production firms, there are Manufacturing Overheads accounts for every cost centre. The budgeting procedure plans for all cost centres the total of overheads and the output as the reference unit amount, such as 500 production-hours. The predetermined overhead allocation rate is calculated as the total of overheads divided by the output of the cost centre - the latter is measured in reference units. The output often is referred to as the performance, too. Applying overheads is charging job orders with overheads caused by them. Overheads are posted to job orders and credited to the Manufacturing Overheads account. The application of overheads is shown as an arrow from cost centre Accounting to calculation in the structure of a Management Accounting system in Figure 44.1. A company that applies a Marginal Costing system, will only apply proportional costs. Production firms that apply an Absorption Costing will apply full overheads. According to that decision, the predetermined overhead allocation rate is based on either proportional costs or full costs. You might ask yourself at this stage, why do we not apply the actual cost rates. The answer is quite simple. At the time of calculation, the actual data for overheads are not yet available for cost allocations. Applying the predetermined overhead allocation rate, likely results in differences between actual overheads and <?page no="623"?> Berkau: BASICS of ACCOUNTING 49-622 applied overheads. This is visible as a deviation of manufacturing overheads. In the Manufacturing Overheads account the deviation remains after the application of overheads as its balancing figure. A debit balanced Manufacturing Overheads account indicates under-applied overheads - a credit balanced Manufacturing Overheads account indicates over-applied overheads. In both cases, the Manufacturing Overheads account will be closedoff to the Cost of Sales account. Thus, the deviation changes the profit/ loss. How it is done (job order costing) (1) Record bookkeeping entries for nominal accounts, such as labour, depreciation, administration etc. (2) Classify costs in manufacturing expenses and nonmanufacturing expenses. (3) Prepare Job Order accounts for internal job orders, mostly linked to certain products. (4) Prepare Manufacturing Overhead accounts per cost centre. Plan cost rates for cost centres by dividing budgeted overheads by planned output of the cost centre. (5) Allocate direct costs, such as direct labour and direct materials, to the job orders. Make debit entries in the applicable Job Order account. (6) Post manufacturing overheads to the applicable Manufacturing Overhead account. Applicable means apply the MOH account for the right cost centre. (7) Apply overheads based on the predetermined overhead allocation rate per job order. Determine the amount for the transferred manufacturing overheads by multiplying the actual job order amount by the predetermined overhead allocation rate. Make debit entries in the applicable Job Order accounts and credit the Manufacturing Overhead account. (8) Once a job order is finished, goods are transferred to the Finished Goods Inventory account. Make a debit entry in the Finished Goods Inventory account and credit the amount to the Job Order account. For unit cost calculation, divide the total costs of the finished goods by the lot size of the job order. (9) Balance-off the Job Order accounts. Use the Work in Process account as summary account. Its balancing figure is to be disclosed as inventory of work in process on the balance sheet. (10) Close-off the Manufacturing accounts to the Cost of Goods Sold COS account. (11) Once goods are sold, debit them to the Cost of Goods Sold COS account and reduce the finished goods <?page no="624"?> Berkau: BASICS of ACCOUNTING 49-623 inventories by a credit entry in the Finished Goods Inventory account. (12) Record the revenue. (13) Charge all non-manufacturing expenses to the Profit and Loss account. We now introduce a higher sophisticated example for a Job Order Costing system, which is about a manufacturer, MAHKOTA AG. MAHKOTA AG is a German company based on shares. The company produces cell phone pouches. In order to keep the case study simple, we ignore VAT. MAHKOTA AG applies an Absorption Costing system. On 2.01.20X2, MAHKOTA AG is established based on an issued share capital of 50,000.00 EUR. MAHKOTA AG takes a bank loan of 300,000.00 EUR that requires an annual payment of interest to the extent of 10,500.00 EUR. (1) On 2.01.20X2, MAHKOTA AG’s Accountant records the share issue. DR Cash/ Bank.................... 50,000.00 EUR CR Issued Capital............... 50,000.00 EUR (2; 3) The bank loan is recorded one day later. However, the interest for the bank loan is recorded at the time of its payment, which is on 31.12.20X2. DR Cash/ Bank.................... 300,000.00 EUR CR Interest Bearing Liab........ 300,000.00 EUR DR Interest..................... 10,500.00 EUR CR Cash/ Bank.................... 10,500.00 EUR We acknowledge that the interest is not an expense linked to production of cell phone pouches. It is regarded as a nonmanufacturing overhead item. (4) MAHKOTA AG buys machinery at 200,000.00 EUR that will be depreciated along straight line method without a residual value over its useful life of 5 years. Depreciation commences at the beginning of 20X2 (full year). Depreciation for 20X2 equals to: 200,000/ 5 = 40,000.00 EUR . The Accountant records the acquisition on 3.01.20X2 and depreciation thereon on 31.12.20X2. DR P, P, E Account.............. 200,000.00 EUR CR Cash/ Bank.................... 200,000.00 EUR DR Depreciation................. 40,000.00 EUR CR Acc. Depr. .................. 40,000.00 EUR (6 … 10) MAHKOTA AG buys materials at 120,000.00 EUR and finishes-off 103,000.00 EUR thereof. MAHKOTA AG manufactures 2 pouch types: pouch-A: a <?page no="625"?> Berkau: BASICS of ACCOUNTING 49-624 normal coverage for the back of the cell phone and pouch-B: same as pouch-A but it comes with a flap to cover the screen, too. Pouch-A gets 12,000.00 EUR direct materials per year and pouch-B gets 17,000.00 EUR/ a. The remaining materials are charged to the manufacturing cost centre. The Manufacturing Overheads account applies. On 15.01.20X2, MAHKOTA AG posts the purchase of materials to inventories. DR Purchase..................... 120,000.00 EUR CR Cash/ Bank.................... 120,000.00 EUR DR Inventories.................. 120,000.00 EUR CR Purchase..................... 120,000.00 EUR For production, MAHKOTA AG defines two job orders. Job order pouch-A for the production of pouches-A and the other one for pouches-B. The direct materials are allocated to the job orders. In order to apply the same names for subordinated accounts and the reconciliation account thereof, we name the account for job order pouch-A “Work in Process Pouch-A account” and the job order account for product pouch-B: “Work in Process Pouch-B account”. The name of the reconciliation account is “Work in Process WIP account”. The following postings apply on 15.01.20X2. DR WIP Pouch-A.................. 12,000.00 EUR CR Inventory.................... 12,000.00 EUR DR WIP Pouch-B.................. 17,000.00 EUR CR Inventory.................... 17,000.00 EUR The amount allocated to the Manufacturing Overheads account equals to: 120,000 - 12,000 - 17,000 - (120,000 - 103,000) = 74,000.00 EUR . DR MOH Account.................. 74,000.00 EUR CR Inventory.................... 74,000.00 EUR (11) Furthermore, depreciation is allocated to the manufacturing cost centre. DR MOH Account.................. 40,000.00 EUR CR Depreciation................. 40,000.00 EUR (12 … 14) MAHKOTA AG’s labour expenses amount to 300,000.00 EUR. All labour counts as overheads, 94,000.00 EUR thereof are for administration clerks. This means labour is classified to the extent of 94,000.00 EUR as nonmanufacturing expenses. The remaining amount of: 300,000 - 94,000 = <?page no="626"?> Berkau: BASICS of ACCOUNTING 49-625 206,000.00 EUR is debited to the Manufacturing account, because it classifies for manufacturing expenses. On 15.01.20X2, MAHKOTA AG records labour as below: DR Labour....................... 300,000.00 EUR CR Cash/ Bank.................... 300,000.00 EUR DR Administration............... 94,000.00 EUR CR Labour....................... 94,000.00 EUR DR MOH Account.................. 206,000.00 EUR CR Labour....................... 206,000.00 EUR (15; 17) The application of overheads is based on a predetermined overhead allocation rate of 16.00 EUR/ h. The production time is the reference unit in the manufacturing cost centre. The predetermined overhead allocation rate is based on the planned overheads to the extent of 320,000.00 EUR and the amount of 20,000 h production time. The predetermined overhead allocation rate is calculated as 320,000/ 20,000 = 16.00 EUR/ h. The actual production time in the manufacturing cost centre is 19,750 h. Half of the production time is spent on pouches-A and the other half on pouches-B. The overheads allocated to each product are: 9,875 × 16 = 158,000.00 EUR . The application of overheads results in two postings, recorded on 30.09.20X2. DR WIP A ........................ 158,000.00 EUR CR MOH Account.................. 158,000.00 EUR DR WIP B ........................ 158,000.00 EUR CR MOH Account.................. 158,000.00 EUR MAHKOTA AG applies less overheads than recorded in the Manufacturing Overheads account due to the lower production time. This gives a debit balanced Manufacturing Overheads account, which indicates under-applied overheads: There were less overheads applied than posted to the manufacturing overheads. The difference equals to: 74,000 + 40,000 + 206,000 - 2 × 158,000 = 4,000.00 EUR . The Manufacturing Overheads account is closed-off to the Cost of Goods Sold COS account. DR COS Account.................. 4,000.00 EUR CR MOH Account.................. 4,000.00 EUR The approach to get rid of un-applied overheads via the Cost of Goods Sold account, is caused by the regulations for inventory valuation. The costs resulting from a variation in overheads are not supposed to increase the value of inventories. Think about deviations resulting from mismanagement. For that reason, <?page no="627"?> Berkau: BASICS of ACCOUNTING 49-626 the under-applied costs cannot be assigned to inventories of finished goods nor to work in process. Regulations along IAS 2 and § 255 HGB apply. (18; 19) The unit costs for a pouch-A equal to 110,500/ 13,000 = 8.50 EUR/ u and for a pouch-B they equal to: 78,750/ 9,000 = 8.75 EUR/ u . The calculation is based on the production amounts of goods put on stock. During the Accounting period 20X2, MAHKOTA AG finishes the production of 13,000 pouches-A and 9,000 pouches-B. On 31.10.20X2, the finished goods are put on stock. The value of the finished pouches-A equals to: 8.50 × 13,000 = 110,500.00 EUR . The value of the finished pouches-B equals to: 8.75 × 9,000 = 78,750.00 EUR . MAHKOTA AG posts the amounts to the finished goods inventories on 31.10.20X2. DR FG Inventory A............... 110,500.00 EUR CR WIP A........................ 110,500.00 EUR DR FG Inventory B............... 78,750.00 EUR CR WIP B........................ 78,750.00 EUR (20 … 23) On 24.11.20X2, MAHKOTA AG sells 80 % of the finished goods pouch-A and 65 % of finished goods pouch-B. The sale requires 4 bookkeeping entries. The first two thereof are for the inventory movements. The costs of sales for the pouches are based on the unit costs of manufacturing and equal to (pouch-A): 80% × 13,000 × 8.50 = 88,400.00 EUR and (pouch-B): 65% × 9,000 × 8.75 = 51,187.50 EUR . The Accountant posts them to the cost of goods sold. DR COS Account.................. 88,400.00 EUR CR FG Inv A..................... 88,400.00 EUR DR COS Account.................. 51,187.50 EUR CR FG Inv B..................... 51,187.50 EUR The net selling price per pouch-A at MAHKOTA AG is 20.00 EUR and per pouch B is 28.00 EUR. The revenue equals to (pouch-A): 80% × 13,000 × 20 = 208,000.00 EUR and (pouch-B): 65% × 9,000 × 28 = 163,800.00 EUR . All customers pay on cash. The Accountant records the revenue on 24.11.20X2. DR Cash/ Bank.................... 208,000.00 EUR CR Revenue...................... 208,000.00 EUR DR Cash/ Bank.................... 163,800.00 EUR CR Revenue...................... 163,800.00 EUR Observe the profit calculation and the accounts for MAHKOTA AG’s pouch production in Figure 49.1. <?page no="628"?> Berkau: BASICS of ACCOUNTING 49-627 D C D C (1) 50,000.00 (3) 10,500.00 c/ d 50,000.00 (1) 50,000.00 (2) 300,000.00 (4) 200,000.00 b/ d 50,000.00 (22) 208,000.00 (6) 120,000.00 (23) 163,800.00 (12) 300,000.00 c/ d 91,300.00 721,800.00 721,800.00 b/ d 91,300.00 Cash/ Bank Issued capital D C D C c/ d 300,000.00 (2) 300,000.00 (3) 10,500.00 P&L 10,500.00 b/ d 300,000.00 D C D C (4) 200,000.00 c/ d 200,000.00 (5) 40,000.00 (11) 40,000.00 b/ d 200,000.00 Property, Plant, Equipment Depreciation Interest bearing liabilities IBL Interest D C D C c/ d 40,000.00 (5) 40,000.00 (6) 120,000.00 (7) 120,000.00 b/ d 40,000.00 D C D C (7) 120,000.00 (8) 12,000.00 (10) 74,000.00 (15) 158,000.00 (9) 17,000.00 (11) 40,000.00 (16) 158,000.00 (10) 74,000.00 (14) 206,000.00 c/ d 4,000.00 c/ d 17,000.00 320,000.00 320,000.00 120,000.00 120,000.00 b/ d 4,000.00 (17) 4,000.00 c/ d 17,000.00 Raw materials inventory Manufacturing overheads MOH Acc depr Purchase D C D C (8) 12,000.00 (18) 110,500.00 (9) 17,000.00 (19) 78,750.00 (15) 158,000.00 c/ d 59,500.00 (16) 158,000.00 c/ d 96,250.00 170,000.00 170,000.00 175,000.00 175,000.00 b/ d 59,500.00 b/ d 96,250.00 WIP pouch-A WIP pouch-B Figure 49.1: MAHKOTA AG’s accounts <?page no="629"?> Berkau: BASICS of ACCOUNTING 49-628 D C D C (12) 300,000.00 (13) 94,000.00 (13) 94,000.00 P&L 94,000.00 (14) 206,000.00 300,000.00 300,000.00 Labour Administration D C D C (17) 4,000.00 P&L 143,587.50 (18) 110,500.00 (20) 88,400.00 (20) 88,400.00 c/ d 22,100.00 (21) 51,187.50 110,500.00 110,500.00 143,587.50 143,587.50 b/ d 22,100.00 D C D C (19) 78,750.00 (21) 51,187.50 P&L 371,800.00 (22) 208,000.00 c/ d 27,562.50 (23) 163,800.00 78,750.00 78,750.00 371,800.00 371,800.00 b/ d 27,562.50 FG inventory pouch-B Revenue Cost of sales COS FG inventory pouch-A D C D C COS 143,587.50 Rev 371,800.00 c/ d 123,712.50 P&L 123,712.50 Adm 94,000.00 b/ d 123,712.50 Int 10,500.00 NP 123,712.50 371,800.00 371,800.00 R/ E 123,712.50 b/ d 123,712.50 Profit and Loss P&L Retained earnings R/ E D C D C (8) 12,000.00 (18) 110,500.00 (9) 17,000.00 (19) 78,750.00 (15) 158,000.00 c/ d 59,500.00 (16) 158,000.00 c/ d 96,250.00 170,000.00 170,000.00 175,000.00 175,000.00 b/ d 59,500.00 b/ d 96,250.00 WIP pouch-A WIP pouch-B Figure 49.1: MAHKOTA AG’s accounts (continued) We prepare a profitability analysis for MAHKOTA AG that displays the earned profit by each product type pouch-A and pouch-B. The adjustment of cost of sales for the under-applied overheads is assigned to other expenses therein. Interest is a non-manufacturing expense and is not included in the cost of goods sold. <?page no="630"?> Berkau: BASICS of ACCOUNTING 49-629 A B Revenue 208,000.00 163,800.00 Other income 208,000.00 163,800.00 COS, non-adjusted 88,400.00 51,187.50 119,600.00 112,612.50 Other expenses Earnings before int and taxes (EBIT) Interest Earnings before taxes (EBT) Mahkota AG's STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X2 232,212.50 98,000.00 134,212.50 10,500.00 123,712.50 Figure 49.2: MAHKOTA AG’s profitability analysis In order to proof the consistency with the double entry system, we prepare a pro-forma balance sheet for MAHKOTA AG as at 31.12.20X2. As the case study is intended for Management Accounting, no income taxes are considered. Observe the balance sheet in Figure 49.3. A C, L Non-current assets [EUR] Owners' capital [EUR] P, P, E 160,000.00 Share capital 50,000.00 Intangibles Reserves Financial assets R/ E 123,712.50 Current assets Liabilities Inventory 222,412.50 Interest bear liab 300,000.00 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 91,300.00 Tax liabilities 473,712.50 473,712.50 Mahkota AG's STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 49.3: MAHKOTA AG’s pro-forma balance sheet Summary: A job order costing system applies for the calculation of products manufactured by a company. The job order costing system is based on Work in Process WIP accounts and Manufacturing Overheads MOH accounts. The allocation of overheads leads to charge the cost objects with that portion of overheads they have cause in the cost <?page no="631"?> Berkau: BASICS of ACCOUNTING 49-630 centre(s). It results in a debit entry in the Work in Process WIP account(s) and a credit entry in the Manufacturing Overheads MOH account(s). The overhead allocation is based on predetermined overhead allocation rates. A difference between overheads and applied overheads is closed-off to the Cost of Sales account and will change the profit. Working Definition: Predetermined Overhead Allocation Rate: A predetermined overhead allocation rate (POR) is a cost rate for charging products/ services with cost centre overheads that is based on budgeted overheads and budgeted cost centre outputs. <?page no="632"?> Berkau: BASICS of ACCOUNTING 50-631 50. Process Costing (Manufacturing Accounting) Learning Objectives: This chapter introduces another structure for calculation. It only applies if all production steps are in a line and all products are manufactured in the same sequence of production steps. A Process Costing system is based on a similar account structure as job order costing. However, the meaning of the accounts differs. Process costing shows that with the flow of units through production their unit values increase. After studying this chapter, you will be able to understand and apply a Process Costing system and you can calculate goods produced in a line of production steps. You can distinguish a job order costing system from a process costing system. Despite of the similar name, a Process Costing system is not related to the German concept of Prozesskostenrechnung, which is a special form of activity based costing. We cover activity based costing in the chapter Activity Based Costing. Process costing is based on a multistep calculation. Within every step of production, the total costs of the cost centre are distributed to all units worked on therein. The unit costs per production step are added to the unit costs of the products from prior steps. This way, the unit costs grow production step by production step. The last production step results in the total unit costs of manufacturing. Process costing systems are applied when manufacturing is organised along a straight order of production steps. A process costing system applies in industries, where raw materials are converted into homogeneous products, such as in brick production, paper production or in breweries. It is required that the company produces them in a continuous flow of units. Units are often indistinguishable. In these situations, it makes no sense to identify materials, labour, and overheads with particular orders. Actually, no job orders are defined, as the material flow is constant. Thus, the special structure of the production layout leads to a simplification of product calculation. Although there is a continues flow of units, the best way to capture the idea of a process costing system is thinking about an assembling line, where a batch of units goes from one production step to the next one. It leaves the previous step of production after completion and is transferred to the next one. In a Process Costing system, the Work in Process account is linked to the department/ cost centre. Overheads are charged at first to the Work in Process accounts and later to the units of production. The cost allocation to the departments is the same as in a job order costing system. Costs are debited to the WIP accounts. Overheads can be allocated straight to the WIP account as it represents the cost centre already. However, some companies gather overheads in a Manufacturing Overhead account at first and apply all overheads together. That only requires one cost allocation per cost centre and is easy to apply. <?page no="633"?> Berkau: BASICS of ACCOUNTING 50-632 In a Process Costing system, costs “stick to the units of production”. After leaving a cost centre, the costs of that cost centre are assigned to the products and added to the unit costs. The costs are carried forward to the next cost centre. This leads to discharging the previous cost centre and charging the next following cost centre in line of production. After the costs of the last production step are added, the costs of the products will be debited to the Finished Goods Inventory account by closingoff the last cost centre’s WIP account. How it is done (process costing) (1) Record bookkeeping entries for nominal accounts, such as labour, depreciation, administration etc. (2) Classify costs in manufacturing expenses and nonmanufacturing expenses. (3) Prepare Work in Process accounts for every production step. (4a) Prepare Manufacturing Overhead accounts for the cost centres, where the production steps take place in. Apply overheads. (4b) Alternatively: debit the manufacturing overheads to the Work in Process accounts directly. (5a) If the products are finished within a production step, divide the total costs of the Work in Process account by the amount of products completed therein. (5b) If the products are not finished completely within a production step, transform the product amount to equivalent units. Calculate the equivalent unit as percentage of completion × amount of unfinished goods. For finished goods the equivalent unit per product is 1. Divide the costs of the current production step by the amount of equivalent units. The costs of previous production steps are allocated to the products by the product amount (not by equivalent units! ) Not completed goods are not transferred to the next production step and become the balancing figure (debit balanced) of the Work in Process account. Completed products are transferred to the next Work in Process account. (6) Transfer completed (with regard to the production step) products to the Work in Process account that represents the next following production step. Product values are amounts × unit costs. (7) Once the products are finished with regard to all production steps, transfer them to the Finished Goods Inventory account. Make a debit entry in the Finished Goods Inventory account and credit the amount to the Work in Process. For unit cost calculation, divide the <?page no="634"?> Berkau: BASICS of ACCOUNTING 50-633 total costs of the finished goods by the amount of goods finished during the Accounting period. (8) Once goods are sold, debit them to the Cost of Goods Sold COS account and reduce the finished goods inventories by a credit entry in the Finished Goods Inventory account. (9) Record the revenue. (10) Charge all non-manufacturing expenses to the Profit and Loss account. We illustrate the concept by a case study of a shoe manufacturer. We observe the first production steps of shoe manufacturer EDEWECHT Ltd., in order to understand the basics of a Process Costing system. EDEWECHT Ltd. produces shoes in 3 production steps. They are: (1) Manufacturing the shoe body, (2) Gluing the sole under the shoe (3) Leather treatment. The production process is organised in a line. The manufacturing always contains the three production steps (1) shoe body manufacturing, (2) gluing sole under and (3) leather treatment. EDEWECHT Ltd.’s cost centre structure is linked to the production steps. In Cost Centre CC- 001 the shoe body is manufactured. In cost centre CC-002 the sole is glued under the shoe and in cost centre CC-003 EDEWECHT Ltd. operates the leather treatment. With regard to the shoes, there is no disturbance with regard to the production flow and the sequence of production steps. All shoes are manufactured in a first-in-first-out order. EDE- WECHT Ltd. does not distinguish the shoes. During the Accounting period 20X4, EDEWECHT Ltd. records the following costs for purchases and total material expenses: 160,000,00 EUR, for labour: 540,000.00 EUR − therein: indirect labour in production: 450,000.00 EUR and for depreciation on production facilities: 120,000.00 EUR. There are no nonmanufacturing costs at EDEWECHT Ltd. EDEWECHT Ltd. records the costs in its accounts. D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 D C D C (3) 540,000.00 (4) 120,000.00 Purchases Materials inventory Labour Depreciation Figure 50.1: EDEWECHT Ltd.’s accounts <?page no="635"?> Berkau: BASICS of ACCOUNTING 50-634 D C D C ... (1) 160,000.00 (4) 120,000.00 (3) 540,000.00 Cash/ Bank Acc depr Figure 50.1: EDEWECHT Ltd.’s accounts (continued) At first, manufacturing costs are allocated to the cost centres. For the allocation of materials a 1 : 2 : 1 ratio with regard to the cost centres CC-001, CC-002 and CC-003 applies. Accordingly, 40,000.00 EUR are assigned to cost centre CC-001, 80,000.00 EUR to cost centre CC-002 and another 40,000.00 EUR to cost centre CC-003. Obviously, the sole is the most expensive material. The allocation of the other costs is similar: The allocation of direct labour follows a 1 : 1 : 1 ratio and the allocation of indirect labour is at a 3 : 1 : 1 ratio. Depreciation only applies in cost centre CC-003. (5 …8) EDEWECHT Ltd. posts the costs for materials, labour and depreciation to the cost centres as below: DR CC-001....................... 40,000.00 EUR DR CC-002....................... 80,000.00 EUR DR CC-003....................... 40,000.00 EUR CR Materials Inventory.......... 160,000.00 EUR DR CC-001....................... 30,000.00 EUR DR CC-002....................... 30,000.00 EUR DR CC-003....................... 30,000.00 EUR CR Materials Inventory.......... 90,000.00 EUR DR CC-001....................... 270,000.00 EUR DR CC-002....................... 90,000.00 EUR DR CC-003....................... 90,000.00 EUR CR Materials Inventory.......... 450,000.00 EUR DR CC-003....................... 120,000.00 EUR CR Depreciation................. 120,000.00 EUR Observe Figure 50.2 for the accounts. <?page no="636"?> Berkau: BASICS of ACCOUNTING 50-635 D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 (5) 160,000.00 D C D C (3) 540,000.00 (6) 90,000.00 (4) 120,000.00 (8) 120,000.00 (7) 450,000.00 540,000.00 540,000.00 Purchases Materials inventory Labour Depreciation D C D C ... (1) 160,000.00 (4) 120,000.00 (3) 540,000.00 D C D C (5) 40,000.00 (5) 80,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 200,000.00 Cash/ Bank Acc depr WIP CC-001 (body) WIP CC-002 (sole) D C (5) 40,000.00 (6) 30,000.00 (7) 90,000.00 (8) 120,000.00 280,000.00 WIP CC-003 (leather) D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 (5) 160,000.00 D C D C (3) 540,000.00 (6) 90,000.00 (4) 120,000.00 (8) 120,000.00 (7) 450,000.00 540,000.00 540,000.00 Purchases Materials inventory Labour Depreciation Figure 50.2: EDEWECHT Ltd.’s accounts <?page no="637"?> Berkau: BASICS of ACCOUNTING 50-636 There is no opening value for work in process at EDEWECHT Ltd. EDEWECHT Ltd. starts the production of 10,000 shoes in the Accounting period 20X4. 9,500 shoes are completed and put on stock. 500 shoes remain in the cost centre for leather treatment and are shown as balancing figure of the WIP CC-003 account. This means, these shoes are still under production. The leather treatment of the 500 remaining shoes is only completed to an extent of 20 %. In the cost centre CC-001 all costs for materials and labour are assigned to 10,000 shoes. This results in unit costs of: 340,000/ 10,000 = 34.00 EUR/ u after the first production step. Once the shoes are transferred to cost centre CC-002, the costs of the units are charged to the cost centre, too. The Accountant posts (9): DR WIP CC-002................... 340,000.00 EUR CR WIP CC-001................... 340,000.00 EUR The total costs of the cost centre CC-002 include materials and labour costs plus unit costs for 10,000 shoes which result from the previous production step of body manufacturing. The costs in cost centre CC-002 equal to: 80,000 + 30,000 + 90,000 + 340,000 = 540,000.00 EUR . Again, the cost centre costs are allocated to 10,000 shoes worked on in the cost centre CC-002. The unit costs for the shoes completed with regard to gluing the sole under equal to: 540,000/ 10,000 = 54.00 EUR/ u . After the completion of production step (2), all 10,000 shoes are transferred to the next cost centre CC-003. This requires transferring the shoe values of 54.00 EUR/ u for all shoes to cost centre CC-003. The amount equals to: 10,000 × 54 = 540,000.00 EUR . DR WIP CC-003................... 540,000.00 EUR CR WIP CC-002................... 540,000.00 EUR At this stage, the accounts for the cost centres look as depicted in Figure 50.3. <?page no="638"?> Berkau: BASICS of ACCOUNTING 50-637 D C D (5) 40,000.00 (9) 340,000.00 (5) 80,000.00 (10) 540,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 (9) 340,000.00 540,000.00 D C (5) 40,000.00 (6) 30,000.00 (7) 90,000.00 (8) 120,000.00 (10) 540,000.00 820,000.00 WIP CC-001 (body) WIP CC-002 (sole) WIP CC-003 (leather) Figure 50.3: EDEWECHT Ltd.’s WIP accounts So far, the case study EDEWECHT Ltd. shows the basics of a Process Costing system. If all production steps are completed, the last WIP account for cost centre CC-003 will be closed-off to the Finished Goods Inventory account. We now take the calculations along the process costing system to its next level: In particular, we study what will happen, if a production firm does not complete a production step. For the illustration thereof, we continue the case study EDEWECHT Ltd. We assume, the last production step is not completed during in the Accounting period 20X4. Not completed means, the leather treatment begun for all 10,000 units, but is not yet finished. In a situation like this, companies record a percentage of completion in order to indicate the process of production. If the production is only completed to a certain degree, unit costs are to be added only based on their level of completion. We study EDEWECHT Ltd.: All shoes now arrived in cost centre CC- 003. In the leather treatment cost centre, costs to the extent of: 40,000 + 30,000 + 90,000 + 120,000 = 280,000.00 EUR apply and are to be assigned to shoes. As only 9,500 units are completed and transferred to finished goods and there are still 500 shoes in the cost centre with the leather treatment completed at 20 %, the calculation requires further attention. In a Process Costing system non-completed products are represented by equivalent units. An equivalent unit is the amount of products calculated as amount of units × percentage of completion. Equivalent units apply in order to assign costs to not yet finished goods. Costs are not supposed to be assigned <?page no="639"?> Berkau: BASICS of ACCOUNTING 50-638 to the full amount of products regardless of their level of completion. This means, for the cost allocation of half finished goods only half of the amount counts, products completed to a degree of 10 % will count 1/ 10 etc. We apply the concept of cost allocation to equivalent units for EDE- WECHT: At EDEWECHT Ltd.’s cost centre CC-003, 9,500 shoes finished the leather treatment completely - but for 500 shoes the leather treatment is only completed to an extent of 20 %. EDEWECHT Ltd. cannot assign the cost centre CC-003’s costs equally to all 10,000 units. The unfinished goods only have to cover 20 % of the costs. For cost allocations, 500 uncompleted shoes are replaced by 500 × 20% = 100 equivalent units . The total cost of the cost centre will now be allocated to: 9,500 + 100 = 9,600 shoes/ equivalent units . 280,000/ 9600 = 29.17 EUR/ u will be added to every shoe that is complete. The calculation of the unit costs for finished shoes gives: 54 + 29.17 = 83.17 EUR/ u . (11) The total value of shoes posted to the finished goods inventory equals to: 9,500 × 83.17 = 790,115.00 EUR . DR FG Inventory................. 790,115.00 EUR CR WIP CC-003................... 790,115.00 EUR The value of the remaining 500 shoes in cost centre CC-003 equals to the balancing figure of the cost centre Work in Process CC-003 account. It equals to: 820,000 - 790,115 = 29,885.00 EUR . In order to double-check the amount, we calculate the 500 non-completed shoes. The costs added in cost centre CC- 003thereto equal to only 20 % of the value added to the finished shoes. Accordingly, the unit costs per unfinished shoe are: 54 + 20% × 29.17 = 59.84 EUR/ u . The calculation of the closing stock is based on 500 unfinished shoes and gives: 500 × 59.84 = 29,920.00 EUR. The comparison to the balancing figure reveals a rounding difference of 29,885 - 29,920 = 25.00 EUR . We continue the case study to determine EDEWECHT Ltd.’s profit. (12; 13) EDEWECHT Ltd. sells 8,000 shoes at a net selling price of 175.00 EUR/ u. All customers pay on cash. The revenue equals to: 175 × 8,000 = 1,400,000.00 EUR . The cost of sales equal to: 83.17 × 8,000 = 665,360.00 EUR . DR Cash/ Bank.................... 1,400,000.00 EUR CR Revenue...................... 1,400,000.00 EUR DR Cost of Sales................ 665,360.00 EUR CR FG Inventory................. 665,360.00 EUR <?page no="640"?> Berkau: BASICS of ACCOUNTING 50-639 The gross profit equals to: 1,400,000 - 665,360 = 734,640.00 EUR . The calculation is shown in the accounts in Figure 51.4. D C D C (1) 160,000.00 (2) 160,000.00 (2) 160,000.00 (5) 160,000.00 D C D C (3) 540,000.00 (6) 90,000.00 (4) 120,000.00 (8) 120,000.00 (7) 450,000.00 540,000.00 540,000.00 Purchases Materials inventory Labour Depreciation D C D C ... (1) 160,000.00 (4) 120,000.00 (12) 1,400,000.00 (3) 540,000.00 Cash/ Bank Acc depr Figure 50.4: EDEWECHT Ltd.’s accounts <?page no="641"?> Berkau: BASICS of ACCOUNTING 50-640 D C D C ... (1) 160,000.00 (4) 120,000.00 (12) 1,400,000.00 (3) 540,000.00 Cash/ Bank Acc depr D C D C (5) 40,000.00 (9) 340,000.00 (5) 80,000.00 (10) 540,000.00 (6) 30,000.00 (6) 30,000.00 (7) 270,000.00 (7) 90,000.00 340,000.00 (9) 340,000.00 540,000.00 D C D C (5) 40,000.00 (11) 790,115.00 (11) 790,115.00 (13) 665,360.00 (6) 30,000.00 c/ d 124,755.00 (7) 90,000.00 790,115.00 790,115.00 (8) 120,000.00 b/ d 124,755.00 (10) 540,000.00 c/ d 29,885.00 820,000.00 820,000.00 b/ d 29,885.00 D C D C P&L 1,400,000.00 (12) 1,400,000.00 (13) 665,360.00 P&L 665,360.00 WIP CC-001 (body) WIP CC-002 (sole) WIP CC-003 (leather) FG inventory Revenue Cost of goods sold COS D C COS 665,360.00 P&L 1,400,000.00 GP 734,640.00 1,400,000.00 1,400,000.00 b/ d 734,640.00 Profit and Loss P&L Figure 50.4: EDEWECHT Ltd.’s accounts (continued) Summary: In a Process Costing system, the calculation is based on the value added to units per cost centre. The value is carried forward to the next following production step’s cost centre. In a Process Costing system, cost centres are represented by Work in Process accounts. All direct costs and overheads are charged to the Work in Process accounts at first. The value added to every unit is the cost of the cost centre <?page no="642"?> Berkau: BASICS of ACCOUNTING 50-641 divided by the amount of units completed therein. The last WIP account will be closed-off to the Finished Goods Inventory account, if all units are completed. If units are not finished, their calculation is based on equivalent units. Working Definition: Equivalent Unit: An equivalent unit is the amount of products calculated as amount of units × percentage of completion. <?page no="643"?> Berkau: BASICS of ACCOUNTING 51-642 51. Multi-Level Contribution Margin Accounting Learning Objectives The management of fixed costs became an important task in Management Accounting, as fixed costs nowadays dominate the cost mix. Quite often, companies struggle to even find at least one cost category that is proportional. However, fixed costs can be structured and assigned to particular cost centre levels. The assignment is required to study dependencies and responsibilities for fixed costs. After studying this chapter, you can run a multi-level Contribution Margin Accounting system. In accordance to Marginal Cost Accounting, cost centres close-off their fixed costs accounts to the profitability analysis, namely to the Profit and Loss account. Fixed costs must not necessarily be allocated to all products together. Companies applying the cost of sales format for their profit and loss calculation, can assign fixed costs to particular cost objects, such as products, product groups, sales areas etc. By this allocations, marketing management is provided with valuable cost information about the fixed costs linked to cost objects and groups thereof. The main idea of a multi-level Contribution Margin Accounting is to identify cost objects the fixed costs are for. In case the company casts-off these cost objects, such as product sold on a particular market (PC computers in Austria); the fixed costs (for example: the sales office) can be reduced or cancelled. We study multi-level Contribution Margin Accounting with a case study from Hospitality Management. PEKAN Ltd. is a hotel chain. The hotel runs 4 hotels in Berlin (Charlottenburg, Zehlendorf, Moabit and Lichtenberg). One further hotel is located in Amsterdam Duivendrecht. Three of the German hotels (Charlottenburg, Moabit and Lichtenberg) run a gym and employ an PE-instructor. The other hotels don’t offer that service. Every hotel got a restaurant. The purchases (groceries, kitchen tools etc.) for the restaurants in Berlin is centralized in Charlottenburg. The hotel in Amsterdam-Duivendrecht operates its own purchase department. The human resource department and the chain management for all hotels is located in Berlin Lichtenberg. The Berlin hotels are small hotels with 18 to 36 rooms. The hotel in Amsterdam Duivendrecht is bigger and offers 120 rooms. The net selling prices per overnight stay for one room in Berlin are in a range from 105.00 EUR to 130.00 EUR depending on the district the hotel is located in. The hotel in Amsterdam charges 90.00 EUR/ room × night. For the calculations below, the room number of the hotels does not matter. It is subject to any calculation. Relevant for the profitability analysis is the amount of nights, the guest spend in the hotels. We call the reference unit “stays”. Observe the basic data planned for the Accounting period July 20X6 for the 5 hotels in Figure 51.1. <?page no="644"?> Berkau: BASICS of ACCOUNTING 51-643 Amsterdam Charlottenburg Lichtenberg Moabit Zehlendorf Duivendrecht #-rooms 36 25 18 29 120 net price / stay 130.00 110.00 105.00 130.00 90.00 Stays (nights rented out) 860 560 490 550 3,400 Berlin Figure 51.1: PEKAN Ltd.’s sales information for 7/ 20X6 The revenue is calculated by multiplying the net selling price per room and the amount of stays (given in rooms × nights). For the hotel in Berlin Charlottenburg the revenue equals to: 130 × 860 = 111,800.00 EUR . The proportional costs are given for the PEKAN Ltd. case study. As most of the costs in the hotels are fixed costs, only room cleaning/ preparing costs depend on the stays. The proportional costs in all hotels equal to: 15.00 EUR/ stay. E.g., in the hotel in Charlottenburg, the proportional costs equal to: 15 × 860 = 12,900.00 EUR . The contribution margin-1 is calculated by deducting proportional costs from the revenue. The contribution margin-1 (CM 1) for the hotel in Charlottenburg equals to: 111,800 - 12,900 = 98,900.00 EUR . The contribution margin of all hotels together must cover the fixed costs of the entire chain. The total of the five CM 1s equals to: 98,900 + 53,200 + 44,100 + 63,250 + 255,000 = 514,450.00 EUR . The total overheads for the 5 hotels contain fixed labour, depreciation, fixed expenses for the gym, purchase costs (not for the goods purchased but the cost of the procurement office) and the human resources/ management department costs. The total of the fixed overheads equals to: 213,000 + 127,000 + 13,500 + 41,500 + 56,000 = 451,000.00 EUR . As the two figures tell us, PEKAN Ltd. earns money, as the CM 1s together cover the fixed costs: 514,450 - 451,000 = 63,450.00 EUR . We say: the net profit is 63,450.00 EUR. The idea of a Contribution Margin Accounting is more than to calculate the operating profit. The purpose is more about to assign fixed costs to cost objects in order to understand, what is going to happen, in case the cost objects change or are given up. We study the PEKAN Ltd.’s hotel case more in the details. The fixed costs which can be linked to the 5 hotels directly, are for fixed labour costs, such as hotel employees, depreciation on the hotel building and interior and in some hotels the fixed costs for the gym. The three cost categories can be traced straight to the hotels. In case one hotel has no gym, no gym costs apply. There is no allocation of fixed costs between hotels. The difference between the CM 1s and fixed overheads of the single hotels gives the contribution margins-2 (CM 2s). A negative CM 2 indicates, the hotel is making a loss already. The negative contribution margin represents the loss before further deductions. By the next step, the costs applying for groups of hotels become relevant. The costs of the centralised purchase department are relevant for all Berlin-hotels, e.g. Remember, the hotel in Amsterdam <?page no="645"?> Berkau: BASICS of ACCOUNTING 51-644 Duivendrecht has its own purchase division. In order to calculate the next level of contribution margin, we add up all CM 2s for the Berlin hotels. The amount equals to: 27,400 + 700 - 2,400 - 2,750 = 22,950.00 EUR . The sum of the contribution margins in Berlin have to cover the costs for the purchase department in Berlin, being 23,500.00 EUR. As the calculation reveals, hotels in Berlin do not contribute to profit, because the CM 3 in Berlin is negative: 22,950 - 23,500 = -550.00 EUR . In contrast, the contribution margin-3 for the hotel in Amsterdam, which is calculated CM-2 less purchase department costs in Amsterdam, equals to: 138,000 - 18,000 = 120,000.00 EUR . On the next level, the two CM 3s will be added up to: -550 + 120,000 = 119,450.00 EUR . From this amount, the fixed costs for the central human resource department and central management are deducted and give the contribution margin-4, which is already the net profit of 119,450 - 56,000 = 63,450.00 EUR . Observe the calculation as depicted in Figure 51.2. It summarizes the above multi-level calculation of profits for the 5 hotels. Amsterdam Charlottenburg Lichtenberg Moabit Zehlendorf Duivendrecht Revenue 111,800.00 61,600.00 51,450.00 71,500.00 306,000.00 Prop costs (cleaning) 12,900.00 8,400.00 7,350.00 8,250.00 51,000.00 CM 98,900.00 53,200.00 44,100.00 63,250.00 255,000.00 Labour (fixed) 42,000.00 39,000.00 36,000.00 39,000.00 57,000.00 Depreciation (fixed) 25,000.00 9,000.00 6,000.00 27,000.00 60,000.00 Gym expenses 4,500.00 4,500.00 4,500.00 CM 2 27,400.00 700.00 (2,400.00) (2,750.00) 138,000.00 138,000.00 Purchase 18,000.00 CM 3 120,000.00 HR, management operating profit 56,000.00 63,450.00 Berlin Pekan Ltd.'s CONTRIBUTION MARGIN ACCOUNTING 22,950.00 23,500.00 -550.00 119,450.00 Figure 51.2: PEKAN Ltd.’s multi-level CMA Single costs for particular hotels, such as the gym costs, stay in the Charlottenburg-, Lichtenbergand Moabithotels. They have no impact on the costs for other hotels. However, Contribution Margin Accounting does not divide up costs that result from shared resources. There is no overhead allocation of the fixed costs towards cost objects (hotels). For example, the fixed costs for the purchase department are not distributed to the hotels in Berlin but stay in a cost <?page no="646"?> Berkau: BASICS of ACCOUNTING 51-645 object group that covers the 4 hotels in Berlin. By a Contribution Margin Accounting managers can study the overheads assigned to particular cost objects and to groups thereof. Summary: Contribution Margin Accounting assigns fixed costs to cost objects. No allocation between cost objects takes place. The managers can see what the fixed costs are for, which gives them valuable information for fixed cost management. By a what-if analysis, managers can decide about the changes in the product mix with regard to possible deductions of fixed costs. <?page no="647"?> Berkau: BASICS of ACCOUNTING 52-646 52. Activity Based Costing Learning Objectives: Activity based costing (ABC) became a very popular Management Accounting instrument over the last decades. The concept is assigning costs to business processes, which cross departmental borders. The most important aspect about activity based costing is, that costs are allocated via cost drivers. Thus, portions of fixed costs are assigned to business processes, too. Activity based costing is no alternative concept to a marginal Cost Accounting system but to fixed cost management. We introduce an Activity Based Costing system in this chapter and demonstrate its cost allocations. After studying this chapter, you can discuss concepts of activity based costing in comparison with traditional (cost centre based) Accounting systems. You will be able to design an Activity Based Costing system on case study level. The main reason for the introduction of activity based costing is today’s cost structure in the companies. Many overheads are almost completely fixed costs. This change is caused by the kind of work performed in companies. More and more machinery resources are deployed. Product costs nowadays contain less direct work but more costs resulting from machinery deployment, such as depreciation and supervision. The application of a marginal Cost Accounting system with a percentage of variable costs down to 2 …5 % of the total costs, is not helpful for supporting management decisions. Management Accountants look for factors that influence costs. Most costs are caused by activities runs. Accordingly, factors that cause a process run, determine costs, too. E.g., in a procurement department of a manufacturing company, the costs for parts ordering are regarded as fixed costs. They will be fixed labour and fixed office costs, such as depreciation, room costs etc. Only very few costs in the procurement department depend on the output of the goods manufactured by the factory. As they do not depend on the output, no reference units can be found, which is the reason for classifying purchasing costs as fixed. However, costs in the procurement department depend on the amount of business processes. In particular, the amount of orders or the amount of suppliers are regarded as units driving costs. Although the costs do not depend on the output, they can be controlled. The units, which determine the costs in such departments will be referred to as cost drivers in Accounting. A cost driver (CD) is a unit process costs depend on. In contrast to a reference unit, cost drivers do not have a proportional relationship to the output. An Activity Based Costing system assigns costs to cost centres like a traditional cost Accounting system. When we refer to a traditional Cost Accounting system, we mean a structure as described in chapter Structure of Cost Accounting Systems. Unlike a traditional cost Accounting system, there is no internal cost allocation in an Activity Based Costing system. Costs of the cost centre will be <?page no="648"?> Berkau: BASICS of ACCOUNTING 52-647 structured along their cost drivers and allocated to cost pools. A cost pool is a portion of costs which depend on the same cost driver. The allocation of costs to cost pools is often based on the time spent in a cost centre on that particular activity. Later costs allocated to cost pools are divided by the process amounts - measured in cost driver units in order to determine a process cost rate. The currency of the process cost rate is EUR over CD amount. We take a look at an example from the university. Think about costs in a professors’ department. The 1 st cost allocation contains salary, office costs and computer expenses which are allocated to the cost centre. For the allocation to cost pools the Accountant will interview the professors and finds out business processes they contribute to and how much time they spend thereon. The answer could be that the professors tell the Accountant, that for teaching and class preparation they spend 60 % of their workload, 30 % is for research and 10 % is spent on administration work. In that case the Accountant defines three cost pools, (1) for teaching, which depends on the cost driver weekly workload, (2) for research, which depends on the number of research projects, and (3) for administration, which depends on the amount of meetings the professors have to attend. Based on the interview data, the cost pool Teaching gets 60 % of the cost centre costs, e.g. The next step is the calculation of the process cost rate per activity, by dividing the allocated costs by the cost driver amount. A process cost rate is the total of costs assigned to an activity divided by the activity’s CDamount. A process rate represents the costs spent on average on a one-timeexecution of an activity/ business process. We now calculate a process cost rate for a class taught 4 lessons per week: Assume, the costs allocated to the cost centre add up to 500,000.00 EUR/ a. The amount is based on different cost categories such as salary, office and computer costs. Teaching receives: 60% × 500,000 = 300,000.00 EUR. All professors together teach 200 lessons/ semester, which is their workload. The data gives a process cost rate (2 nd cost allocation) for teaching of: 500,000 × 60% / 200 = 1,500 EUR/ semester-lesson. A semester-lesson is the amount of weekly lessons taught per semester. Calculating an Accounting class requires to determine the weekly hours. This is the 3 rd cost allocation. A class taught 4 lessons per week will costs: 4 × 1,500 = 6,000.00 EUR. The number of 4 lessons is the usage factor. The mathematical principle of Activity Based Costing calculations is very similar to traditional cost Accounting systems. However, the meaning of the cost objects differs. Traditional cost Accounting systems are based on proportional cost information. However, the major part of costs in service and administration departments (indirect departments) is classified as fixed costs. The fixed costs, which form the major part of the costs, are closed-off to the Profit and Loss account and won’t be assigned to cost objects. In contrast, an Activity Based Costing system assigns many fixed costs, that <?page no="649"?> Berkau: BASICS of ACCOUNTING 52-648 can be controlled by process triggers, to cost pools. In the cost pools, process cost rates for activities are calculated. Later, the cost rates apply for process calculations. A business process is a sequence of activities in order to serve for a product or service. Examples for business processes are treatment of complaints at a department store, rescheduling at an airline, exam enrolment at the university etc. Activities are the elements of business processes. Actually, the difference between activities and business process is not perfectly clear as it depends on the aggregation level of the process modelling. However, a business process has to have more than one activity at least. How it is done (activity based costing) (1) Record/ Plan costs in cost centres. (1 st cost allocation) (2) Design business process models that contain activities taking place in cost centres. (3) Find cost drivers for activities. (4) Define cost pools which contain activities that all depend on the same cost drivers. The cost pool can cross department borders. (5) Allocate resources to cost pools (2 nd cost allocation). The resource allocation is based on interviews with cost centre responsible managers. In the interviews the workload per cost pool is determined. Use percentages provided by the experts or time measurement in order to determine a cost allocation ratio between cost pools. Allocate costs based on the ratios. (6) Measure/ Plan the activity amounts and express them by cost driver units. (7) Divide the costs per cost pool by the cost driver amounts in order to calculate the process cost rate PCR. The unit of the process cost rate is EUR/ CDamount. (8) Measure/ Plan the cost driver amount per product/ service. Call that cost driver amount the usage factor of an activity. (9) Aggregate activities to business processes based on the business process models. (10) Calculate products/ services that apply the activities/ business process by multiplying the process cost rates × usage factor. (11) Add up process costs of business processes over the activities therein. <?page no="650"?> Berkau: BASICS of ACCOUNTING 52-649 We study an Activity Based Costing system by an airline example. TORQUAY Ltd. is an airline. It runs a traditional cost Accounting system. The flight department’s cost allocation is based on the reference unit seat-kilometers (number of seats available × distance measured in km). TORQUAY Ltd. applies a marginal Cost Accounting system, at first. We refer to the Cost Accounting system as traditional system in order to distinguish it from the Activity Based Costing system. TORQUAY daily (30 days/ month) operates two routes: - Route Europe: 468 km, sells per month 6,000 tickets at 400.00 EUR/ flight. The aircraft is a Dreamliner (250-seater). - Route FarEast: 5,349 km, sells per month 11,500 tickets at 900.00 EUR/ flight. The aircraft is a Tripel-7 (400-seater). The revenue equals to the amounts provided by Figure 52.1. Europe Far East Revenue 2,400,000.00 10,350,000.00 Figure 52.1: TORQUAY Ltd.’s revenue Monthly depreciation on both aircrafts (together) equals to 1,100,000 EUR/ month. Labour equals to 40,000 EUR/ month for the pilots and 80,000.00 EUR/ month for the rest of the crew. The airport fees amount to 50,000.00 EUR per take-off. Fuel costs equal to 20,000 EUR/ flight on route Europe and 70,000.00 EUR/ flight on route FarEast. The ticket sales office charges 2,000,000.00 EUR per month (Tkt). The airport company charges 120 EUR per check-in. We take this cost information and calculate the Europe and the FarEast route. At first, we apply a traditional cost Accounting system. Later we calculate based on an Activity Based Costing system the cost for the ticket sales office. Traditional Cost Accounting System Observe direct costs and overheads in Figure 52.2. The flight calculation contains airport company expenses (checkin-service) and fuel expenses as direct costs. The airport company costs (AC) for the Europe flight equal to: 6,000 × 120 = 720,000.00 EUR . For the FarEast flight, the airport company charges 11,500 × 120 = 1,380,000.00 EUR . The fuel costs (FUE) are for the total month, which counts as 30 days: 30 × 20,000 = 600,000.00 EUR for the Europe flight and: 30 × 70,000 = 2,100,000.00 EUR for the FarEast flight. The overheads are recorded in the Overhead account. They contain depreciation (Dpr), take-off costs (airport fee AP), ticket sales office expenses (Tkt) and labour (Lab) for the pilots and the crew. The total overheads equal to: 1,100,000 + 3,000,000 + 2,000,000 + 120,000 = 6,220,000.00 EUR . The overhead allocation is based on the seat-km-value. TORQUAY operates on the Europe route a 250 seater aircraft. The seat-kmamount equals to: 468 × 250 = 117,000 seat-km . The FarEast flight with a 400 seater aircraft gets: 5,349 × 400 = <?page no="651"?> Berkau: BASICS of ACCOUNTING 52-650 2,139,600 seat-km . The overheads are split up to flights by the seat-km-values. The overheads for the Europe flight equal to: (117,000 / (117,000 + 2,139,600)) × 6,220,000 = 322,494.02 EUR . The Overhead allocation for the FarEast flight gives: (2,139,600 / (117,000 + 2,139,600)) × 6,220,000 = 5,897,505.98 EUR. D C D C Dpr 1,100,000.00 Eur 322,494.02 AC 720,000.00 AP 3,000,000.00 FE 5,897,505.98 FUE 600,000.00 Tkt 2,000,000.00 OH 322,494.02 c/ d 1,642,494.02 Lab 120,000.00 1,642,494.02 1,642,494.02 6,220,000.00 6,220,000.00 b/ d 1,642,494.02 D C AC 1,380,000.00 FUE 2,100,000.00 OH 5,897,505.98 c/ d 9,377,505.98 9,377,505.98 9,377,505.98 b/ d 9,377,505.98 Overheads WIP Europe Eur WIP FarEast FE Figure 52.2: TORQUAY Ltd.’s accounts The flight calculation is displayed by Figure 52.3. As the net operating profit indicates, the two flights seem to be equally profitable. Europe Far East Revenue 2,400,000.00 10,350,000.00 direct costs: - Check-in expenses 720,000.00 1,380,000.00 - Fuel expenses 600,000.00 2,100,000.00 Overheads 322,494.02 5,897,505.98 Net operating profit 757,505.98 972,494.02 Figure 52.3: TORQUAY Ltd.’s calculation based on a traditional cost Accounting system The product manager of the FarEast line considers the overhead allocation based on seat-km-values as unfair. Due to the longer distance the FarEast flight has to cover an inappropriate high portion of the overheads. This contradicts the way overheads are determined. Many overheads, such as ticket sale costs, take-off <?page no="652"?> Berkau: BASICS of ACCOUNTING 52-651 costs and check-in expenses, actually do not depend on the flight distance. Thus, they make the FarEast flight look too expensive and the performance of its product manager look weak. Activity Based Costing (partial) TORQUAY Ltd. now establishes a partial Activity Based Costing system. The ticket sales office is turned into an activity based-cost center. To implement ABCcosting only in certain areas is common in Accounting. The cost allocations along a marginal Cost Accounting system in many departments are quite effective and do not need an additional activity based costing. Only in departments, where managers do not find sufficient direct costs but good cost drivers, an Activity Based Costing system is in order. At TORQUAY Ltd., the Accountant determines the cost centre costs and defines cost pools. With regard to the cost allocation, the process costs are allocated based on the operation time spent on activities. The activity analysis reveals that 60 % of the time in the ticket sales office is for flight bookings. The cost driver is the amount of tickets booked (not available seats! ). 20 % of the time in the ticket sales office is spent on trip rescheduling. Every month, there are 500 reschedules for the Europe route and 1,100 for the FarEast route. 20 % of the time in the Ticket Sales Office is spent on offers. The amount of offers is 2,000 per month. The amount of offers is equally distributed over the routes Europe and FarEast. TORQUAY Ltd. defines three cost pools for the ticket sales office cost centre. The cost pool Ticketing depends on the amount of sold tickets. The cost pool Rescheduling depends on the cost driver rescheduled trips. The third cost pool Advertising depends on the offers made to customers. The total costs of the ticket sales office are still 2,000,000.00 EUR. The allocation of the overheads to the cost pools gives: 60% × 2,000,000 = 1,200,000.00 EUR for the cost pool Ticketing, 20% × 2,000,000 = 400,000.00 EUR for Rescheduling and another 400,000.00 EUR for Advertising. The cost driver amounts are the sold tickets, which equal to: 6,000 + 11,500 = 17,500 sold tickets . The amount of rescheduled trips equals to: 500 + 1,100 = 1,600 rescheduled trips and 2,000 offers are made every month. Observe the calculation of the process cost rates for the activities Ticketing, Rescheduling and Advertising in Figure 52.4. The calculation of the process cost rate for the activities is based on process costs over CD-amount. The process cost rate for Ticketing equals to: 1,200,000/ 17,500 = 68.57 EUR/ sold ticket . The process cost rate for Rescheduling equals to: 400,000/ 1,600 = 250 EUR/ rescheduled trips and the process cost rate for Advertising equals to: 400,000/ 2,000 = 200 EUR/ offer . Cost pool Costs CD PCR Ticketing 1,200,000.00 17,500.00 68.57 Rescheduling 400,000.00 1,600.00 250.00 Advertising 400,000.00 2,000.00 200.00 Figure 52.4: TORQUAY Ltd.’s ABC cost centre Sales Office <?page no="653"?> Berkau: BASICS of ACCOUNTING 52-652 The new Accounting system for the ticket sales office changes the profit calculation for the flights. The overheads now do not contain the ticket sales office’s overheads any longer. The reduction of 2,000,000.00 EUR makes seatkm-based allocated overheads shrink. The overheads allocated to the Europe flight now equal to: (6,220,000 - 2,000,000) × ((117,000 / (117,000 + 2,139,600)) = 218,798.19 EUR . The FarEast flight receives: (6,220,000 - 2,000,000) × ((2,139,600 / (117,000 + 2,139,600)) = 4,001,201.81 EUR The costs for the Ticket Sales Office now are spit up under the consideration of cost driver consumption. The Europe flight’s Ticketing’s costs equal to: 6,000 × 68.57 = 411,428.57 EUR . The FarEast flight’s Ticketing’s costs equal to: 11,500 × 68.57 = 788,571.43 EUR . The calculation of the Rescheduling and Advertising costs follows the same structure and is disclosed by Figure 52.5. Europe Far East Revenue 2,400,000.00 10,350,000.00 Direct costs: - Check-in expenses 720,000.00 1,380,000.00 - Fuel expenses 600,000.00 2,100,000.00 ABC: - Ticketing 411,428.57 788,571.43 - Rescheduling 125,000.00 275,000.00 - Advertising 200,000.00 200,000.00 Overheads 218,798.19 4,001,201.81 Net profit 124,773.24 1,605,226.76 Figure 52.5: TORQUAY Ltd.’s flight calculation on a partial ABC system As a result of the ABC costing, the net operational profit structure changes. However, the total profit over both flights remains unchanged. In both cases, it equals to 1,730,000.00 EUR. Only the allocation to flights is modified by the application of the Activity Based Costing system. A calculation based on activity based costing does not follow the cost-bycause principle. However, the cost information provided by activity based costing is closer to the business process characteristics and the activity trigger mechanism. The new profits prove, the FarEast flights earns a higher net operational profit than the Europe flights. This will have a noticeable impact on management decisions with regard to the product mix (flight destinations offered by the airline). Caution! Activity Based Costing provides cost rates for activities, which make you think, more activities will lead to higher costs and less activity runs will reduce costs. This is not the <?page no="654"?> Berkau: BASICS of ACCOUNTING 52-653 case. As the cost rates of an activity only contain allocated fixed costs, a change of process amounts does not change the costs automatically. For cost management based on an ABC system, costs must be changed by decisions, followed by a new ABC calculation. Activity Based Management (ABM) is a management process based on Activity Based Costing information. In Activity Based Management, cost decisions come at first. After making a decision about costs, cost pooling, calculation of process cost rates for activities and business process calculation follows. This procedure is different to marginal Cost Accounting system. In a marginal Cost Accounting system, the manager has to change the business process, for instance, avoiding double work, re-runs of activities etc. Costs, then will change automatically according to the process amounts. Twice the amount of processes will cause double of its costs. In contrast, with an Activity Based Management system, business process runs and cost occurrences are not interrelated. If the manager ceteris paribus halves the process runs, but does not make any cost decision, the cost per process will double. An increase of process runs will reduce costs per process, known as its process cost rate. The reason is, that activity based costing calculations are based on the average principle. Process cost rates reflect the capacity situation in the operating cost pools. This aspect of Activity Based Costing is important for the understanding of Activity Based Management. For this reason, we add an activity based management example for TORQUAY Ltd., which makes the activity based management concept more clear. TORQUAY Ltd. asks a consultancy for giving Accounting advises. The consultants suggest to charge the passenger 190.00 EUR for every trip rescheduling. Furthermore, they suggest to transfer the advertising activities (making offers) to a marketing agency. The agency would charge the customer 100.00 EUR per offer. Accordingly, they want to cut total costs by 15 % in the ticket sales office and reduce the ticket prices by 3 %. We consider for activity based costing a 6 : 2 ratio for Ticketing and Rescheduling costs. There are no cost allocations for Advertising. The question is, whether TORQUAY should follow these changes. In order to decide, TORQUAY Ltd. runs an activity based management/ costing analysis considering cost cuts and activity changes suggested therein. The basis for the decision is the total of profits (based on both routes). This example is a typical situation in ABM. Note, costs will follow decisions - not the other way around. In order to assess the new plans, TORQUAY Ltd. prepares an alternative cost plan. The cost calculation starts in the ticket sales office cost centre. Its total costs will be: (1 - 15%) × 2,000,000 = 1,700,000.00 EUR . The costs are divided at a 6 : 2 ratio, which assigns: (6/ 8) × 1,700,000 = 1,275,000.00 EUR to Ticketing and: 1,700,000 - 1,275,000 = 425,000.00 EUR to Rescheduling. Observe the changes in the process cost rates for activities depicted by Figure 52.6. <?page no="655"?> Berkau: BASICS of ACCOUNTING 52-654 cost pool Costs CD PCR Ticketing 1,250,000.00 17,500.00 71.43 Rescheduling 425,000.00 1,600.00 265.63 Advertising 0.00 Figure 52.6: TORQUAY Ltd.’s alternative activity analysis The Profitability Analysis now is based on the adjusted ticket prices. The revenue decreases by 3 % and then equals to: 2,400,000 × (1 - 3%) = 2,328,000.00 EUR for the Europe route and 10,350,000 × (1 - 3%) = 10,039,500 EUR for the FarEast route. The reschedule fees amount to 190.00 EUR. According to the amounts, there is revenue from rescheduling fees for the Europe route of: 500 × 190 = 95,000.00 EUR . The fees for the FarEast flight add up to: 1,100 × 190 = 209,000.00 EUR . The alternative profitability analysis is displayed by Figure 52.7. Therein, the total profit for both routes equals to: 227,817.88 + 1,444,682.12 = 1,672,500.00 EUR . Previously, it was 1,730,000.00 EUR. The question is, whether TORQUAY Ltd. has to run an alternative profitability analysis for the decision. The answer is no, as the total of profit does not depend on the cost allocations. Europe Far East Revenue 2,328,000.00 10,039,500.00 Reschedule fees 95,000.00 209,000.00 direct costs: - Check-in expenses 720,000.00 1,380,000.00 - Fuel expenses 600,000.00 2,100,000.00 ABC: - Ticketing 428,571.43 821,428.57 - Rescheduling 132,812.50 292,187.50 - Advertising 0.00 0.00 Overheads 218,798.19 4,001,201.81 Net operating profit 227,817.88 1,444,682.12 Figure 52.7: TORQUAY Ltd.’s alternative profitability analysis An activity based costing here only is required in order to assess the process cost rates. The Accountant must decide together with the ticket sales office manager, whether or not the process cost rates for the activities are acceptable. As the cost rates are higher as before, the Ticketing and Rescheduling have more resources available for their activities. Let’s acknowledge, the ticket sales office employees got an easier job and TORQUAY Ltd. is losing money! Thus, <?page no="656"?> Berkau: BASICS of ACCOUNTING 52-655 TORQUAY Ltd. should not follow the consultants’ advice. TORQUAY Ltd. makes a further amendment to the business concept and now cuts costs in the ticket sales office by 25 % (2 nd amendment). In this case the process cost rates for the activities will drop below the previous level, as shown in Figure 52.8. Cost pool Costs CD PCR Ticketing 1,125,000.00 17,500.00 64.29 Rescheduling 375,000.00 1,600.00 234.38 Advertising 0.00 Figure 52.8: TORQUAY Ltd.’s process cost rates, 2 nd amendment Now, the employees in the Sales Ticket Office get less resources for their work. Less resources means for example, there is one clerk less working for the hotline and the other colleagues must take over his/ her calls. The question of whether the higher workload works out, cannot be answered by the Accountant. The Accountant only computes the process cost rates. This is a measurement. The decision about the acceptance of the minimum of process cost rates is no question of Accounting, but subject to decisions made by department management. However, the process cost rate tells how much costs are assigned to a one-timeexecution of one Ticketing or Rescheduling activity. In many companies - in particular in affiliated companies - process cost rates are compared between departments. If the process cost rate in one department is doable, it should be possible to run the activity at that same rate somewhere else, too. Time related comparisons also apply. (Note, if the process cost rate for opening a bank account in Frankfurt, branch Auf der Zeil is 10.00 EUR, the rate in Bad Soden should be 10.00 EUR, too.) TORQUAY Ltd. decides to go for the 25 % cost cut in the ticket sales office and measures the profit for both routes. Observe Figure 52.9: <?page no="657"?> Berkau: BASICS of ACCOUNTING 52-656 Europe Far East Revenue 2,328,000.00 10,039,500.00 Reschedule fees 95,000.00 209,000.00 Direct costs: - Check-in expenses 720,000.00 1,380,000.00 - Fuel expenses 600,000.00 2,100,000.00 ABC: - Ticketing 385,714.29 739,285.71 - Rescheduling 117,187.50 257,812.50 - Advertising 0.00 0.00 Overheads 218,798.19 4,001,201.81 Net profit 286,300.02 1,561,199.98 Figure 52.9: TORQUAY Ltd.’s profitability analysis, 2 nd amendment The total profit equals to: 286,300.02 + 1,561,199.98 = 1,847,500.00 EUR and exceeds the previous and the initial amounts. TORQUAY Ltd.’s manager should go for the changes along the 2 nd amendment. However, we see further, that the profit relationship between the routes has changed. Along the initial profitability analysis the profit ratio was 44% : 56% between the routes. After the application of activity based costing, it became 7% : 93% and after the cost cut along the 2 nd amendment it is 15% : 85 % as Europe flight : FarEast flight. The latter change with regard to the profit portions is not caused by the Activity Based Costing, but by the price cut and shows in the revenue figures. A 3 % price cut on the FarEast route means 10,350,000 - 10,039,500 = 310,500.00 EUR . At the same time, the costs are changed for both routes at the same portion. This results in an imbalance of profit changes. A further aspect to be considered is the marketing perspective of the product changes. An activity based management that changes business process the customer does not see, is not critical and does not need further consideration. However, here TORQUAY Ltd. changed the price and rescheduling terms of its products. The marketing director is in charge to check whether these changes will change the customers’ booking behaviour. Summary: Activity based costing and activity based management are concepts that are based on the assignment of fixed costs to business processes activities. This gives the company transparency of its activities’ cost structure. The cost allocation along an activity based costing is helpful for the management of fixed costs. Decisions about the business processes and resource allocations thereto, should be based on activity based costing if there are only few proportional costs. However, activity based costing does not work as an alternative to a marginal Cost Accounting system. As activity based <?page no="658"?> Berkau: BASICS of ACCOUNTING 52-657 costing allocates fixed costs to products, it should not be applied for product/ service calculations. Activity based management focusses on changes of processes and products/ services based on activity based costing information. Working Definitions: Cost Driver: A cost driver is a unit process costs depend on. In contrast to a reference unit, cost drivers do not have a proportional relationship to the output. Cost Pool: A cost pool is a portion of costs which depend on the same cost driver. Process Cost Rate: A process cost rate is the total of costs assigned to an activity divided by the activity’s CDamount. Business Process: A business process is a sequence of activities in order to serve for a product or service. Activity: Activities are the elements of business processes. Activity Based Management: Activity Based Management is a management process based on Activity Based Costing information. <?page no="659"?> Berkau: BASICS of ACCOUNTING 53-658 53. Abbreviations ABC Activity Based Costing ABM Activity Based Management AC Airport company costs (for check-in) Acc Accounting Acc Accumulated Acc Depr Accumulated Depreciation, in accounts: AcD Acc IL Accumulated Impairment Loss AP Airport fees A/ P Accounts Payables A/ R Accounts Receivables / a per annum, per year Bal Balance BCE Business Car Expenses BE Break-even BoE Books of original Entry BOM Bill of materials b/ d Balance brought down B/ S Balance Sheet C Costs (total) C Credit CaE Catering Expenses, Business Entertainment Expenses CapRes Capital Reserves CB Cash Book C-BE Cash-Break-even C/ B Cash/ Bank CC Cost Centre CD Cost Driver CEO Chief Executive Officer c/ d Balance carried down c/ f carried forward (Profit) CFO Chief Financial Officer, Accountant CFS Statement of Cash Flows CM Contribution Margin CMA Contribution Margin Accounting CMRatio Contribution Margin Ratio COS Cost of Sales, Cost of Goods Sold CR Credit Recorded, Credit Entry CVP Cost Volume Profit CVPA Cost Volume Profit Analysis, CVP-analysis D Debit / d per day DcE Decoration Expenses <?page no="660"?> Berkau: BASICS of ACCOUNTING 53-659 Dep Department Depr, Dpr Depreciation DOL Degree of Operating Leverage DR Debit Recorded, Debit Entry EarnRes Earnings Reserves EAT Earnings After Taxes EBIT Earnings Before Interest and Taxes EBT Earnings Before Taxes Eur Europe EUR Euro FA Financial Accounting F-BE Financial Break-even FC Fixed Costs fCF Cash Flow from Financing Activities FE FarEast FG Finished Goods Fin Finance FUE Fuel costs GP Gross Profit GR Garden Route 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 iCF Cash Flow from Investing Activities ID Identifier, Identification Number IFRS International Financial Reporting Standards IL Impairment Loss Inv Inventory I/ S Income Statement IT Income Taxes ITL Income Tax Liabilities JO Job Order ky kayak, #ky = number of kayaks KL Kuala Lumpur Lab Labour Liab Liability, Liabilities Ltd. Limited company LoD Loss on Disposal MA Management Accounting Mat Materials, Material Expenses McD McDonals’s Corporation MG Merchandise Goods MOH Manufacturing Overheads, also: Manufacturing Overheads account <?page no="661"?> Berkau: BASICS of ACCOUNTING 53-660 / m per month MoS Margin of Safety, MoS unit is based on units, MoS % is based on sales portions NoE Nature of Expense method NP Net Profit NPO Non-Profit Organisation NSP Net Selling Price oCF Cash Flow from Operating Activities OE Owners Equity OTH Other Expenses P&L Profit and Loss PC Proportional costs PCB Petty Cash Book PoD Profit on Disposal P, P, E Property, Plant and Equipment Prh Purchases PRT Pro Rata Temporis (Pty) Ltd. Privately limited company R/ D Refer to Drawer R/ E Retained Earnings Res Reserves Rev Revenue, Sales RM Malaysian Ringgit (currency in Malaysia) Rnt Rent RoA Register of non-current Assets RU Reference Unit Sal Salary SCap Share Capital SCE Statement of Changes in Equity SCF Statement of Cash Flows SCI Statement of Comprehensive Income SFP Statement of Financial Position ShD Shareholder for Dividend SOH Service Overheads, Service Overheads account StE Stationary Expenses T/ A Trading Account Tkt Ticketing TS Tax Statement (used in a case study as reference unit) TT Time Ticket / u per unit VAT Value Added Tax WIP Work in Progress, Work in Process <?page no="662"?> Berkau: BASICS of ACCOUNTING 54-661 54. Table of Figures Figure 1.1: Accounts 1.8 Figure 2.1: KENSINGTON CAFETERIA’s statement of financial position (balance sheet) 2.17 Figure 2.2: KENSINGTON CAFETERIA’s statement of financial position (2) 2.18 Figure 2.3: KENSINGTON CAFETERIA’s statement of comprehensive income 2.19 Figure 2.4: KENSINGTON CAFETERIA’s statement of financial position (3) 2-20 Figure 2.5: KENSINGTON CAFETERIA’s statement of financial position (4) 2-21 Figure 2.6: KENSINGTON CAFETERIA’s statement of financial position (5) 2.22 Figure 3.1: Calculation of an investment of 62.09 EUR 3-26 Figure 3.2: Financial schedule for Joana’s McDonald’s Corporation share 3-28 Figure 5.1: Excel options for the adjustment of the data format 5-38 Figure 5.2: Format adjustment (fonts) 5-39 Figure 5.3: Account tab 5-40 Figure 5.4: Trial balance tab 5-41 Figure 5.5: Statement of financial position tab 5-42 Figure 5.6: Statement of comprehensive income tab 5-43 Figure 5.7: Statement of cash flows tab 5-44 Figure 5.8: Statement of changes in equity tab 5-45 Figure 5.9: Register of non-current assets tab 5-46 Figure 5.10: Interest and pay-off tab 5-47 Figure 5.11: Petty cash book tab 5-48 Figure 5.12: Cash book tab 5-49 Figure 5.13: Bank statement tab 5-49 Figure 6.1: Statement of financial position 6-53 Figure 6.2: Statement of comprehensive income 6-57 Figure 7.1: ROHRBACH Ltd.’s statement of financial position (asset side) 7-59 Figure 7.2: ROHRBACH Ltd.’s statement of financial position (asset side) 7-60 Figure 7.3: ROHRBACH Ltd.’s statement of financial position (asset side) 7-61 Figure 7.4: ROHRBACH Ltd.’s statement of financial position (asset side) 7-61 Figure 7.5: ROHRBACH Ltd.’s statement of financial position (asset side) 7-62 Figure 8.1: FLASSKAMP AG’s statement of financial position 8-64 Figure 8.2: FLASSKAMP AG’s balance sheet 8-65 Figure 8.3: FLASSKAMP AG’s statement of financial position 8-66 Figure 8.4: FLASSKAMP AG’s statement of financial position 8-67 Figure 8.5: FLASSKAMP AG’s statement of financial position 8-67 Figure 8.6: FLASSKAMP AG’s statement of financial position 8-68 Figure 8.7: FLASSKAMP AG’s statement of financial position 8-69 Figure 8.8: FLASSKAMP AG’s statement of financial position 8-69 Figure 9.1: PELZERHAGEN (Pty) Ltd.’s statement of financial position 9-72 Figure 9.2: PELZERHAGEN (Pty) Ltd.’s statement of comprehensive income 9-73 Figure 9.3: PELZERHAGEN (Pty) Ltd.’s statement of financial position 9-73 Figure 9.4: PELZERHAGEN (Pty) Ltd.’s statement of comprehensive income 9-74 Figure 9.5: PELZERHAGEN (Pty) Ltd.’s statement of financial position 9-75 Figure 9.6: PELZERHAGEN (Pty) Ltd.’s income statement 9-76 Figure 9.7: PELZERHAGEN (Pty) Ltd.’s statement of financial position 9-76 <?page no="663"?> Berkau: BASICS of ACCOUNTING 54-662 Figure 9.8: PELZERHAGEN (Pty) Ltd.’s statement of comprehensive income 9-77 Figure 9.9: PELZERHAGEN (Pty) Ltd.’s statement of financial position 9-78 Figure 10.1: T-Account „Cash“ 10-80 Figure 10.2: T-account format for the Cash account 10-81 Figure 10.3: T-Account „Cash“ 10-81 Figure 10.4: Cash amount displayed on the balance sheet. 10-82 Figure 10.5: ROHRBACH Ltd.‘s accounts 10-83 Figure 10.6: ROHRBACH Ltd.’s accounts 10-84 Figure 10.7: ROHRBACH Ltd.’s accounts 10-84 Figure 10.8: ROHRBACH Ltd.’s statement of financial position (asset side) 10-85 Figure 10.9: Liability account 10-86 Figure 10.10: FLASSKAMP AG’s accounts 10-88 Figure 10.11: FLASSKAMP AG’s statement of financial position 10-89 Figure 11.1: PELZERHAGEN (Pty) Ltd.’s statement of financial position 11-91 Figure 11.2: PELZERHAGEN (Pty) Ltd.’s accounts 11-92 Figure 11.3: PELZERHAGEN (Pty) Ltd.’s statement of comprehensive income 11-94 Figure 11.4: PELZERHAGEN (Pty) Ltd.’s statement of financial position 11-95 Figure 13.1: SCHOENMAKERSKOP Ltd.‘s accounts 13-112 Figure 14.1: RENSBURG Ltd.‘s accounts 14-117 Figure 15.1: CHATTY Ltd.‘s annuity payment schedule 15.122 Figure 15.2: CHATTY Ltd.‘s accounts 15-123 Figure 15.3: FOLCROFT (Pty) Ltd.’s bank loan schedule 15-125 Figure 16.1: DAGBREEK Ltd.‘s accounts as at 1.02.20X7 16-132 Figure 16.2: RETIEF (Pty) Ltd.‘s accounts 16-133 Figure 16.3: DESPATCH (Pty) Ltd.’s accounts 16-135 Figure 16.4: DESPATCH (Pty) Ltd.’s accounts 16-136 Figure 16.5: WINTERHOEK Ltd.‘s accounts 16-137 Figure 17.1: DODD Ltd.’s accounts as at 31.12.20X5 17-141 Figure 17.2: DODD Ltd.’s register of non-current assets 17-141 Figure 17.3: FAIRBRIDGE Ltd.’s register of non-current assets as at 31.12.20X3 17-142 Figure 17.4: FAIRBRIDGE Ltd.’s accounts 17-143 Figure 17.5: FAIRBRIDGE Ltd.’s register of non-current assets as at 31.12.20X3 17-144 Figure 18.1: SIMONI Ltd.’s accounts 18-148 Figure 18.2: SIMONI Ltd.’s accounts 18-149 Figure 18.3: SIMONI Ltd.’s statement of financial position as at 31.12.20X4 18-150 Figure 18.4: SIMONI Ltd.’s statement of comprehensive income for 20X4 18-150 Figure 19.1: SUIDERLAND Ltd.’s accounts 19-153 Figure 19.2: Calendar Nov 20X8 and Dec 20X8 19-156 Figure 19.3: CLARITON Ltd.’s accounts 19-160 Figure 20.1: APPLEDENE (Pty) Ltd.’s accounts 20-165 Figure 20.2: KLIPFONTEIN Ltd.’s accounts in 20X5 20-169 Figure 21.1: APPLEDENE (Pty) Ltd.’s accounts after 54 bookkeeping entries 21-174 Figure 21.2: APPLEDENE (Pty) Ltd.’s accounts (aggregated) 21-175 Figure 21.3: KLIPFONTEIN Ltd.’s accounts 21-179 Figure 22.1: CORNFLOWER Ltd.’s accounts 22-184 Figure 22.2: CORNFLOWER Ltd.’s accounts 22-186 Figure 22.3: CORNFLOWER Ltd.’s statement of comprehensive income for 20X9 22-188 <?page no="664"?> Berkau: BASICS of ACCOUNTING 54-663 Figure 22.4: CORNFLOWER Ltd.’s statement of financial position as at 31.12.20X9 22-188 Figure 22.5: DURANT (Pty) Ltd.’s statement of financial position 22-189 Figure 22.6: DURANT (Pty) Ltd.’s accounts 22-190 Figure 22.7: DURANT (Pty) Ltd.’s accounts 22-192 Figure 22.8: DURANT (Pty) Ltd.’s accounts 22-194 Figure 22.9: DURANT (Pty) Ltd.’s statement of financial position 22-195 Figure 22.10: DURANT (Pty) Ltd. statement of comprehensive income 22-196 Figure 23.1: CORNFLOWER Ltd.’s accounts 23-200 Figure 23.2: CORNFLOWER Ltd.’s accounts 23-202 Figure 23.3: CORNFLOWER Ltd.’s statement of comprehensive income for 20X9 23-203 Figure 23.4: CORNFLOWER Ltd.’s statement of financial position as at 31.12.20X9 23-204 Figure 23.5: DURANT (Pty) Ltd.’s statement of financial position 23-205 Figure 23.6: DURANT (Pty) Ltd.’s accounts 23-205 Figure 23.7: DURANT (Pty) Ltd.’s accounts 23-208 Figure 23.8: DURANT (Pty) Ltd.’s accounts 23-209 Figure 23.9: DURANT (Pty) Ltd.’s statement of financial position 23-211 Figure 23.10: DURANT (Pty) Ltd. statement of comprehensive income 23-211 Figure 24.1: VANGUARD’s statement of financial position 24-216 Figure 24.2: VANGUARD’s accounts 24-217 Figure 24.3: VANGUARD’s accounts 24-220 Figure 24.4: VANGUARD’s accounts 24-221 Figure 24.5: VANGUARD’s statement of comprehensive income 24-223 Figure 24.6: VANGUARD’s statement of financial position 24-223 Figure 25.1: REGENT BIKE (Pty) Ltd.’s accounts 25-229 Figure 25.2: REGENT BIKES (Pty) Ltd.’s accounts 25-232 Figure 25.3: REGENT BIKE (Pty) Ltd.’s statement of comprehensive income 25-233 Figure 25.4: REGENT BIKES (Pty) Ltd.’s statement of financial position 25-233 Figure 26.1: WITSAND (Pty) Ltd.’s statement of financial position 26-237 Figure 26.2: WITSAND (Pty) Ltd.’s accounts 26-237 Figure 26.3: WITSAND (Pty) Ltd.’s accounts 26-240 Figure 26.4: WITSAND (Pty) Ltd.’s accounts 26-242 Figure 26.5: WITSAND (Pty) Ltd.’s statement of financial position 26-244 Figure 26.6: WITSAND (Pty) Ltd.’s statement of comprehensive income 26-244 Figure 26.7: WITSAND (Pty) Ltd.’s accounts 26-245 Figure 26.8: WITSAND (Pty) Ltd.’s accounts 26-249 Figure 26.9: WITSAND (Pty) Ltd.’s accounts 26-252 Figure 26.10: WITSAND (Pty) Ltd.’s accounts 26-255 Figure 26.11: WITSAND (Pty) Ltd.’s statement of financial position 26-258 Figure 26.12: WITSAND (Pty) Ltd.’s statement of comprehensive income 26-258 Figure 27.1: MALGAS (Pty) Ltd.’s statement of financial position 27-261 Figure 27.2: MALGAS (Pty) Ltd. accounts (A) 27-264 Figure 27.3: MALGAS (Pty) Ltd.’s statement of comprehensive income (A) 27-265 Figure 27.4: MALGAS (Pty) Ltd.’s statement of financial position (A) 27-265 Figure 27.5: MALGAS (Pty) Ltd.’s accounts (B) 27-267 Figure 27.6: MALGAS (Pty) Ltd.’s statement of comprehensive income (B) 27-268 Figure 27.7: MALGAS (Pty) Ltd.’s statement of financial position (B) 27-268 Figure 27.8: MALGAS (Pty) Ltd.’s accounts (C) 27-269 <?page no="665"?> Berkau: BASICS of ACCOUNTING 54-664 Figure 27.9: MALGAS (Pty) Ltd.’s statement of comprehensive income (C) 27-271 Figure 27.10: MALGAS (Pty) Ltd.’s statement of financial position (C) 27-271 Figure 28.1: ASHTON Ltd.’s accounts 28-278 Figure 28.2: ASHTON Ltd.’s accounts 28-281 Figure 28.3: ASHTON Ltd.’s statement of comprehensive income (NoE) 28-283 Figure 28.4: ASHTON Ltd.’s statement of financial position 28-284 Figure 28.5: ASHTON Ltd.’s accounts 28-287 Figure 28.6: ASHTON Ltd.’s statement of comprehensive income (COS) 28-290 Figure 28.7: ASHTON Ltd.’s income statement based on Contribution Margin Accounting) 28-290 Figure 28.8: MONTAGU Ltd.’s inventory movements for punchers 28-292 Figure 28.9: MONTAGU Ltd.’s inventory movements for staplers 28-292 Figure 28.10: MONTAGU Ltd.’s inventory movements for punchers 28-293 Figure 28.11: MONTAGU Ltd.’s inventory movement for staplers 28-298 Figure 28.12: MONTAGU Ltd.’s accounts 28-303 Figure 28.13: MONTAGU Ltd.’s statement of comprehensive income 28-305 Figure 28.14: MONTAGU Ltd.’s statement of financial position 28-305 Figure 28.15: MONTAGU Ltd. statement of comprehensive income along the NoE format 28-306 Figure 29.1: PENTZ Ltd.’s accounts 29-314 Figure 29.2: PENTZ Ltd.’s trial balance 29-316 Figure 29.3: A good trial balance 29-317 Figure 29.4: PENTZ Ltd.’s accounts 29-319 Figure 29.5: PENTZ Ltd.’s adjusted trial balance 29-322 Figure 29.6: PENTZ Ltd.’s statement of financial position 29-323 Figure 29.7: PENTZ Ltd.’s statement of comprehensive income 29-324 Figure 30.1: RAATS Ltd.’s statement of financial position 30-326 Figure 30.2: RAATS Ltd.’s accounts 30-327 Figure 30.3: RAATS Ltd.’s trial balance 30-328 Figure 30.4: RAATS Ltd.’s accounts 30-329 Figure 30.5: RAATS Ltd. adjusted trial balance 30-330 Figure 30.6: RAATS Ltd.’s accounts 30-331 Figure 30.7: RAATS Ltd.’s prolonged statement of comprehensive income 30-333 Figure 30.8: RAATS Ltd.’s statement of financial position after appropriation of profit 30-334 Figure 30.9: RAATS Ltd.’s statement of changes in equity. 30-335 Figure 31.1: GOUSBLOM Ltd.’s accounts 20X7 31-338 Figure 31.2: GOUSBLOM Ltd.’s trial balance 20X7 31-339 Figure 31.3: GOUSBLOM Ltd.’s accounts 20X7 31-340 Figure 31.4: GOUSBLOM Ltd.’s adjusted trial balance 31-341 Figure 31.5: GOUSBLOM Ltd.’s accounts 20X7 31-342 Figure 31.6: GOUSBLOM Ltd.’s statement of financial position 31-344 Figure 31.7: GOUSBLOM Ltd.’s statement of comprehensive income 31-344 Figure 31.8: GOUSBLOM Ltd.’s accounts 20X8 31-347 Figure 31.9: GOUSBLOM Ltd.’s trial balance 31-348 Figure 31.10: GOUSBLOM Ltd.’s accounts 20X8 31-349 Figure 31.11: GOUSBLOM Ltd.’s adjusted trial balance 31-351 Figure 31.12: GOUSBLOM Ltd.’s statement of financial position 31-351 Figure 31.13: GOUSBLOM Ltd.’s statement of comprehensive income 31-352 Figure 32.1: MANSELL Ltd.’s accounts 32-358 <?page no="666"?> Berkau: BASICS of ACCOUNTING 54-665 Figure 32.2: MANSELL Ltd.’s trial balance 32-359 Figure 32.3: MANSELL Ltd.’s accounts 32-359 Figure 32.4: MANSELL Ltd.’s adjusted trial balance 32-361 Figure 32.5: MANSELL Ltd.’s statement of comprehensive income 32-362 Figure 32.6: MANSELL Ltd.’s statement of financial position 32-362 Figure 32.7: MANSELL Ltd.’s statement of cash flows 32-363 Figure 32.8: PARKLANDSMAIN’s accounts 32-366 Figure 32.9: PARKLANDSMAIN’s statement of cash flows 32-367 Figure 32.10: PARKLANDSMAIN’s income statement 32-368 Figure 32.11: PARKLANDSMAIN’s reconciliation statement 32-369 Figure 32.12 PARKLANDSMAIN’s statement of cash flows 32-371 Figure 32.13: MANSELL Ltd.’s statement of comprehensive income (as above) 32-372 Figure 32.14: MANSELL Ltd.’s statement of financial position (as above) 32-372 Figure 32.15: MANSELL Ltd.’s half of the reconciliation statement 32-373 Figure 32.16: MANSELL Ltd.’s (full) reconciliation statement 32-374 Figure 32.17: MANSELL Ltd.’s statement of cash flows 32-374 Figure 32.18: SUNLANDS Ltd.’s income statement for 20X3 32-376 Figure 32.19: SUNLANDS Ltd.’s accounts 32-378 Figure 32.20: SUNLANDS Ltd.’s statement of comprehensive income 32-381 Figure 32.21: SUNLANDS Ltd.’s statement of financial position 32-381 Figure 32.22: SUNLANDS Ltd.’s statement of cash flows 32-383 Figure 32.23: Reconciliation statement 32-384 Figure 32.24: SUNLANDS Ltd.’s statement of cash flows 32-385 Figure 33.1: SALDANHA’s accounts 33-391 Figure 33.2: Stephen Saldanha’s trial balance 33-392 Figure 33.3: SALDANHA’s accounts 33-394 Figure 33.4: SALDANHA’s adjusted trial balance 33-396 Figure 33.5: SALDANHA’s accounts 33-397 Figure 33.6: SNACKY-TICKY-shop’s statement of financial position 33-400 Figure 33.7: SNACKY-TICKY-shop’s accounts 33-401 Figure 33.8: SNACKY-TICKY-shop’s accounts 33-404 Figure 33.9: SNACKY-TICKY-shop’s trial balance 33-406 Figure 33.10: SNACKY-TICKY shop’s accounts 33-407 Figure 33.11: SNACKY-TICKY-shop’s adjusted trial balance 33-410 Figure 33.12: SNACKY-TICKY-shop’s statement of financial position 33-411 Figure 33.13: SNACKY-TICKY-shop’s statement of comprehensive income 33-412 Figure 33.14: SNACKY-TICKY Ltd.‘s accounts 33-415 Figure 33.15: SNACKY-TICKY Ltd.’s statement of financial position 33-416 Figure 33.16: SNACKY-TICKY Ltd.’s accounts 33-419 Figure 33.17: SNACKY-TICKY Ltd.’s trial balance 33-420 Figure 33.18: SNACKY-TICKY Ltd.’s accounts 33-422 Figure 33.19: SNACKY-TICKY Ltd.’s adjusted trial balance 33-425 Figure 33.20: SNACKY-TICKY Ltd.’s statement of financial position 33-426 Figure 33.21: SNACKY-TICKY Ltd.’s statement of comprehensive income 33-427 Figure 33.22: SNACKY-TICKY Ltd.’s statement of cash flows 33-428 Figure 33.23: SNACKY-TICKY Ltd.’s statement of changes in equity 33-428 Figure 34.1: MOSSEL SPORTS’ statement of financial position 34-431 <?page no="667"?> Berkau: BASICS of ACCOUNTING 54-666 Figure 34.2: MOSSEL SPORTS’ accounts 34-431 Figure 34.3: MOSSEL SPORTS’ accounts 34-434 Figure 34.4: MOSSEL SPORTS’ accounts 34-435 Figure 34.5: MOSSEL SPORTS accounts in case of profit on asset sale 34-436 Figure 35.1: WARDRIF Ltd.’s register of non-current assets 35-440 Figure 35.2: WARDRIF Ltd.’s accounts 35-441 Figure 35.3: WARDRIF Ltd.’s accounts 35-447 Figure 35.4: WARDRIF Ltd.’s register of non-current assets 35-449 Figure 35.5: WARDRIF Ltd.’s statement of comprehensive income 35-450 Figure 36.1: FIXCARS (Pty) Ltd.’s accounts 36-455 Figure 36.2: FIXCARS (Pty) Ltd.’s accounts 36-456 Figure 36.3: HETKRUIS Ltd.’s accounts 36-458 Figure 36.4: HETKRUIS Ltd.’s accounts 36-459 Figure 36.5: BELLICK AG’s accounts as at 31.12.20X7 36-460 Figure 36.6: BELLICK AG’s accounts as at 31.12.20X8 36-462 Figure 37.1: KRAGGA CONSULTANTS (Pty) Ltd.’s bank statement 37-465 Figure 37.2: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts 37-468 Figure 37.3: KRAGGA CONSULTANTS (Pty) Ltd.’s Cash/ Bank account 37-470 Figure 37.4: KRAGGA CONSULTANTS (Pty) Ltd.’s bank statement 37-470 Figure 37.5: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts 37-472 Figure 37.6: KRAGGA CONSULTANTS (Pty) Ltd.’s accounts 37-474 Figure 37.7: KRAGGA CONSULTANTS (Pty) Ltd.’s statement of comprehensive income 37-475 Figure 37.8: KRAGGA CONSULTANTS (Pty) Ltd.’s statement of financial position 37-476 Figure 38.1: SWARTKLIP Ltd.‘s Petty Cash Book (1) 38-481 Figure 38.2: SWARTKLIP Ltd.’s petty cash book (2) 38-482 Figure 38.3: SWARTKLIP Ltd.’s petty cash book (3) 38-482 Figure 38.4: SWARTKLIP Ltd.’s petty cash book (4) 38-483 Figure 38.5: SWARTKLIP Ltd.’s accounts 38-484 Figure 38.6: SWARTKLIP Ltd.’s accounts 38-487 Figure 38.7: SWARTKLIP Ltd.’s statement of comprehensive income 38-489 Figure 38.8: SWARTKLIP Ltd.’s statement of financial position 38-489 Figure 39.1: MUIRFIELD (Pty) Ltd.’s Cash Book 39-493 Figure 39.2: MUIRFIELD (Pty) Ltd.‘s purchase journal 39-495 Figure 39.3: MUIRFIELD (Pty) Ltd.‘s cash book 39-498 Figure 39.4: MUIRFIELD (Pty) Ltd.’s accounts (Cash Book in figure 39.3) 39-498 Figure 39.5: MUIRFIELD (Pty) Ltd.‘s accounts (cash book in figure 40.3) 39-500 Figure 39.6: MUIRFIELD (Pty) Ltd.‘s statement of financial position 39-502 Figure 39.7: MUIRFIELD (Pty) Ltd.‘s statement of comprehensive income 39-502 Figure 40.1: KIRSTENBOSCH Ltd.’s revenue plan 40.510 Figure 40.2: KIRSTENBOSCH Ltd.’s interest and pay-off schedule 40.511 Figure 40.3: KIRSTENBOSCH Ltd.’s cost plan 40.511 Figure 40.4: KIRSTENBOSCH Ltd.’s profitability plan 40-512 Figure 40.5: KIRSTENBOSCH Ltd.’s liquidity plan 40.513 Figure 40.6: KIRSTENBOSCH Ltd.’s pro-forma balance sheet 40.515 Figure 40.7: KIRSTENBOSCH Ltd.’s statement of cash flows 40.516 Figure 40.8: McTOY GmbH’s revenue plan 40.517 Figure 40.9: McTOY GmbH’s master data sheet 40-518 <?page no="668"?> Berkau: BASICS of ACCOUNTING 54-667 Figure 40.10: McTOY GmbH’s cost plan (partial) 40-519 Figure 40.11: McTOY GmbH’s routing information (1) 40.519 Figure 40.12: McTOY GmbH’s routing information (2) 40.520 Figure 40.13: McTOY GmbH’s cost plan (partial) 40-520 Figure 40.14: McTOY GmbH’s bank loan 40-521 Figure 40.15: McTOY GmbH’s aggregated cost plan 40.522 Figure 40.16: McTOY GmbH’s profit plan 40-523 Figure 40.17: McTOY GmbH’s liquidity plan 40-524 Figure 40.18: McTOY GmbH’s budgeted balance sheet 40-526 Figure 41.1: DANNING Ltd.’s cost volume records 41-530 Figure 41.2: DANNING Ltd.’s cost separation by scatter graph method 41-531 Figure 41.3: Workings for regression analysis 41-532 Figure 42.1: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (1) 42-535 Figure 42.2: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (2) 42-536 Figure 42.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (3) 42-536 Figure 42.4: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (base case) 42-537 Figure 42.5: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (internet) 42-537 Figure 42.6: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (bungee jumping) 42-538 Figure 42.7: DEERFIELD TOURS (Pty) Ltd.’s calculation of the adjusted net selling price 42-539 Figure 42.8: Observations 42-540 Figure 42.9: DEERFIELD TOURS (Pty) Ltd.’s break-even point (internet campaign) 42-541 Figure 42.10: Standard normal distribution table 42-542 Figure 42.11: DEERFIELD TOURS (Pty) Ltd. 2-product statement 42-543 Figure 42.12: DEERFIELD TOURS (Pty) Ltd.’s 2-product statement (2) 42-544 Figure 42.13: Goal seek function break-even point calculation 42-545 Figure 42.14: DEERFIELD TOURS 2-product statement (3) 42-545 Figure 43.1: DEERFIELD TOURS (Pty) Ltd. break-even point 43-547 Figure 43.2: DEERFIELD TOURS (Pty) Ltd.’s profit calculation (1 additional traveller) 43-548 Figure 43.3: DEERFIELD TOURS (Pty) Ltd.’s contribution income statement (11 travellers) 43-549 Figure 43.4: EMS KAYAK Ltd.’s profit and cash flow calculation (1) 43-552 Figure 43.5: EMS KAYAK Ltd.’s Accounting break-even point 43-552 Figure 43.6: EMS KAYAK Ltd.’s profit and cash flow calculation (2) 43-553 Figure 43.7: EMS KAYAK Ltd.’s cash break-even point 43-554 Figure 43.8: EMS KAYAK Ltd.’s financial break-even point 43-555 Figure 43.9: EMS KAYAK Ltd.’s financial break-even point 43-555 Figure 43.10: EMS KAYAK Ltd.’s profit and cash flow calculation (3) 43-556 Figure 43.11: EMS KAYAK Ltd.’s profit and cash flow calculation (4) 43-557 Figure 43.12: EMS KAYAK Ltd.’s profit and cash flow calculation (5) 43-558 Figure 43.13: EMS KAYAK Ltd. profit and cash flow calculation (6) 43-558 Figure 43.14: EMS KAYAK Ltd.’s profit and cash flow calculation (7) 43-559 Figure 43.15: EMS KAYAK Ltd.’s break-even point 43-560 Figure 44.1: Management Accounting system 44-563 Figure 44.2: GIULIO’s PIZZA&PASTA Ristorante’s BOM 44-566 Figure 44.3: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs based on products 44-567 Figure 44.4: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (1) 44-569 Figure 44.5: GIULIO’S PIZZA&PASTA RISTORANTE’s direct costs 44-570 Figure 44.6: GIULIO’S PIZZA&PASTA RISTORANTE Management Accounting system (2) 44-571 <?page no="669"?> Berkau: BASICS of ACCOUNTING 54-668 Figure 44.7: GIULIO’S PIZZA&PASTA RISTORANTE Management Accounting system (3) 44-572 Figure 44.8: GIULIO’S PIZZA&PASTA RISTORANTE’s Manufacturing accounts (1) 44-573 Figure 44.9: GIULIO’S PIZZA&PASTA RISTORANTE’s Manufacturing accounts (2) 44-574 Figure 44.10: GIULIO’S PIZZA&PASTA RISTORANTE’s Manufacturing accounts (3) 44-575 Figure 44.11: GIULIO’S PIZZA&PASTA RISTORANTE’s Manufacturing accounts (4) 44-577 Figure 44.12: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (4) 44-578 Figure 44.13: GIULIO’S PIZZA&PASTA RISTORANTE’s Management Accounting system (5) 44-579 Figure 45.1: GIULIO’s PIZZA&PASTA RISTORANTE’s ManAcc system with flexible costing 45-584 Figure 45.2: GIULIO’s PIZZA&PASTA RISTORANTE’s Management Accounting system 45-587 Figure 45.3: GIULIO’s PIZZA&PASTA RISTORANTE’s profit planning 45-588 Figure 45.4: LOGA (Pty) Ltd.’s Profitability Analysis based on Absorption Costing 45-590 Figure 45.5: LOGA (Pty) Ltd.’s Profitability Analysis based on Marginal Costing 45-591 Figure 46.1: SALISBURY Ltd’s cost variance in April 20X6 46-594 Figure 46.2: SALISBURY Ltd’s variance in May 20X6 46-595 Figure 47.1: CLYDBANK Ltd.’s cost centre characteristics 47-599 Figure 47.2: CLYDBANK Ltd.’s accounts 47-600 Figure 47.3: CLYBANK Ltd.’s cost allocations to cost centres 47-602 Figure 47.4: CLYDBANK Ltd.’s accounts after internal cost allocations 47-603 Figure 47.5: CLYDBANK Ltd.’s spreadsheet with internal cost allocations 47-604 Figure 47.6: CLYDBANK Ltd.’s cost centre rates 47-605 Figure 47.7: HEISFELD Ltd.’s performance structure 47-608 Figure 47.8: HEISFELD Ltd.’s primary costs 47-608 Figure 47.9: HEISFELD Ltd.’s cost centre support structure 47-610 Figure 47.10: HEISFELD Ltd.’s iteration process 47-611 Figure 48.1: LEBUHRAYA (Pty) Ltd.’s opening amounts 48-614 Figure 48.2: LEBUHRAYA (Pty) Ltd.’s accounts 48-616 Figure 48.3: LEBUHRAYA (Pty) Ltd.’s statement of COS 48-618 Figure 48.4: LEBUHRAYA (Pty) Ltd.’s profitability analysis 48-620 Figure 49.1: MAHKOTA AG’s accounts 49-627 Figure 49.2: MAHKOTA AG’s profitability analysis 49-629 Figure 49.3: MAHKOTA AG’s pro-forma balance sheet 49-629 Figure 50.1: EDEWECHT Ltd.’s accounts 50-633 Figure 50.2: EDEWECHT Ltd.’s accounts 50-635 Figure 50.3: EDEWECHT Ltd.’s WIP accounts 50-637 Figure 50.4: EDEWECHT Ltd.’s accounts 50-639 Figure 51.1: PEKAN Ltd.’s sales information for 7/ 20X6 51-643 Figure 51.2: PEKAN Ltd.’s multi-level CMA 51-644 Figure 52.1: TORQUAY Ltd.’s revenue 52-649 Figure 52.2: TORQUAY Ltd.’s accounts 52-650 Figure 52.3: TORQUAY Ltd.’s calculation based on a traditional cost Accounting system 52-650 Figure 52.4: TORQUAY Ltd.’s ABC cost centre Sales Office 52-651 Figure 52.5: TORQUAY Ltd.’s flight calculation on a partial ABC system 52-652 Figure 52.6: TORQUAY Ltd.’s alternative activity analysis 52-654 Figure 52.7: TORQUAY Ltd.’s alternative profitability analysis 52-654 Figure 52.8: TORQUAY Ltd.’s process cost rates, 2 nd amendment 52-655 Figure 52.9: TORQUAY Ltd.’s profitability analysis, 2 nd amendment 52-656 <?page no="670"?> Berkau: BASICS of ACCOUNTING 55-669 55. 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Wood, F.; Sangster, A. [2015]: Business Accounting 1. 12 th edition, Harlow et al. Wood, F.; Sangster, A. [2015]: Business Accounting 2. 13 th edition. Harlow et al. <?page no="672"?> Das Must-have für Studierende Rödiger Voss Wissenschaftliches Arbeiten ... leicht verständlich! 2015, 200 Seiten, Broschur ISBN 978-3-8252-8649-1 Bei der Planung und Bearbeitung wissenschaftlicher Arbeiten treten eine Vielzahl von Fragen auf, wie z. B. »Wie finde ich ein passendes wissenschaftliches Thema? «, »Wie gehe ich mit Wikipedia als Quelle richtig um? « oder »Wie kann ich aus meiner wissenschaftlichen Arbeit einen Vortrag gestalten? «. Das vorliegende Buch bietet Ihnen deswegen eine umfassende Grundlage für die inhaltliche und formale Gestaltung einer wissenschaftlichen Arbeit, das Zeitmanagement, die wissenschaftliche Recherche, effiziente Lesetechniken sowie die Darstellung wissenschaftlicher Vorträge. 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