<?page no="1"?> Carsten Berkau Financial Statements International Accounting (IFRS) <?page no="3"?> Carsten Berkau Financial Statements International Accounting (IFRS) 4 Edition UVK Verlag · München <?page no="4"?> 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 978-3-7398-3014-8 (Print) ISBN 978-3-7398-8014-3 (E-PDF) 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 Verlag München 2019 - ein Unternehmen der Narr Francke Attempto Verlag GmbH & Co. KG Coverfoto: © iStockphoto - AmazingDream Printed in Germany UVK Verlag Nymphenburger Strasse 48 · 80335 München Tel. 089/ 452174-65 www.uvk.de Narr Francke Attempto Verlag GmbH & Co. KG Dischingerweg 5 · 72070 Tübingen Tel. 07071/ 9797-0 www.narr.de <?page no="5"?> Berkau: Financial Statements 4e 1-1 Contents 1. Conventions 1-4 2. Financial Statements based on HGB 2-11 3. Financial Statements based on IFRSs 3-30 4. Accounting for Retailers 4-53 5. Basics of Financial Statement Analysis 5-73 6. Formal Aspects of Financial Statements 6-92 7. Non-current Assets on the Balance Sheet 7-112 8. Business Combinations 8-164 9. Current Assets on the Balance Sheet 9-203 10. Statement of Cash Flows 10-235 11. Equity on the Balance Sheet 11-253 12. Statement of Profit or Loss and Other Comprehensive Income 12-265 13. Statement of Changes in Equity 13-286 14. Liabilities on the Balance Sheet 14-296 15. Abbreviations 15-323 16. Table of Figures 16-329 17. Links 17-333 18. Literature 18-334 <?page no="6"?> Berkau: Financial Statements 4e 1-2 Introduction This text book is the English version of our book: Berkau: Bilanzen. It replaces its former translation: Berkau/ Lecholo: Accounting-2-Go. To emphasis the link to the German text book we call it Financial Statements. Its syllabus is equivalent to Berkau: Bilanzen (4 th edition, to be published in 2020). We follow the same chapter and figures structure. Both books can be used by German and international students in Accounting classes. The contents of Financial Statements is now more interlinked with IFRSs. Only chapter (2) is dedicated to German Accounting. All IFRSs are quoted as downloaded on 18.02.2019. We do not compare international Accounting standards (IFRSs) with other national Accounting principles (GAAPs), such as the German Handelsgesetzbuch. Reporting companies do not choose between different GAAPs for application, either. Financial Statements covers the syllabus of an international Accounting class for the bachelor’s degree. It is designed for a 150 hours workload Accounting class. Basic knowledge in Accounting is required. Further considerations to deepen and widen Accounting knowledge as required for master’s level are outsourced to online materials and linked to this text book by QR-codes. Our students in Osnabrück asked us to shorten the text book and simplify the cases. We are happy to do that. This keeps the workload for exam preparations in bay and forces to focus on core aspects of international Accounting. We now use smaller cases for better comprehension. We also introduced the How-it-is-Done sections as in our Basics to give clear and short instructions for the Accounting work. We added sections that follow the chapters for newly introduced Accounting technical terms as well as for multiple choice questions. The technical terms are no definitions but explanations to make Accounting easy to understand. Financial Statements teaches you how to report based on IFRSs. We quote all relevant IFRS standards and paragraphs to show where regulations come from. You are motivated to check the standards for a better understanding and further reading. Knowledge required for international Accounting not ruled by IFRSs is covered by our Basics-1 (Berkau: Basics of Accounting, part 1: Bookkeeping and Financial Accounting). We refer to the Basics-1 by footnotes and tell you the chapters where to retrieve the knowledge in international Accounting from. Our Basics-1 are preliminary for this text book. You need a sound understanding of the Basics to follow the IFRS-syllabus laid out in this text book and in class. Links are given also to Managerial Accounting which is covered by our Basics-2 (Berkau: Basics of Accounting, part 2: Managerial Accounting). In general, Managerial Accounting classes <?page no="7"?> Berkau: Financial Statements 4e 1-3 succeed Financial Accounting. However, e.g., for Manufacturing Accounting, you need to know how to calculate. As we focus on commercial financial statements only few details of national taxation are covered. To keep examples simple we assume that income taxes are amounting to 30 % of the pre-tax profit as calculated by financial statements based on IFRSs. The style of this text book Financial Statements is now similar to our Basics. Every chapter explains learning outcomes and has only few knowledge paragraphs linked to IFRSs standards. These learning paragraphs are supplemented by case studies with exam task characteristics in regard to complexity. Case studies form the major part in this text book. You will learn Accounting from cases and the explanations thereto. The cases start easy and become more and more complex within a chapter. We cover as many aspects as required for the syllabus. At the end of each chapter you find the summary, new technical terms and a question bank with solutions. From our website: “www.uvk.digital/ 9783739830148” you can download over 1,000 pages with exam tasks and full solutions. The task numbers refer to the chapters in this text book. We write this text book as an international academic team from Germany and South Africa. It is based on our teaching experience in Osnabrück/ Lingen (Ems) and in Cape Town. We thank our colleagues at Hochschule Osnabrück, Prof. Dr. Marion Wendehals and Dr. Melanie Frieling, and at our partner universities for their valuable support in preparing the syllabus. We are also grateful for the cooperation with Dr. Jürgen Schechler from UVK-Lucius, who is our lector. We enjoy the very pleasant and friendly cooperation with him and thank him to be always open for new ideas! Last but not least, we thank our students in Osnabrück/ Lingen (Ems) and in Cape Town for their feedback which really helps us to improve our text books and makes them studyfriendly. For sending us comments in regard to the text books, pls., write to: BOOK@Prof-Berkau.de. Enjoy our Financial Statements! Cape Town, in July 2019 Keabetswe Sylvia Berkau Prof. Dr. Carsten Berkau, Dipl.-Ing. <?page no="8"?> Berkau: Financial Statements 4e 1-4 1. Conventions The below listed conventions apply in order to simplify case studies. These conventions are about legal forms, tax rates, formats etc. They apply for this text book and examples and exercises you can find online on the UVK- Lucius.de-website. The conventions are the same as in the Basics. At this stage of studying Accounting, you might not understand the conventions completely. We only put them at the beginning of the book for you to find them upfront. They apply for the entire text book. Here, they come in alphabetic order: Accounting Periods: Accounting periods always start on 1.01.20XX and end on 31.12.20XX. Furthermore, to keep the examples transferable to later classes, we indicate the decade by an X, as in 20X4. X is followed by Y and Z. Accounting Technical Terms: At the end of a chapter you find short explanations for new technical terms. They help you to easily understand the content. These are explanations for beginners in Accounting. The Accounting technical terms are not as formal and precise as the definitions provided by the IASB. The Accounting technical terms in the chapters are redundant but consistent. Account Names: All names of accounts in the text book for Bookkeeping entries are written with capital letters in the text, such as ‘Cash/ Bank account’. We intend you to focus the accounts for financial statement preparation. However, an account not subjected to our recordings 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. However, the Cash/ Bank account applicable to calculate the item cash/ bank on the balance sheet is part of our Accounting work. Alphabetic Order: For all lists, we apply an alphabetic order. Basics: The Basics are our text books Berkau: Basics of Accounting, part 1: Bookkeeping and Financial Accounting and Berkau: Basics of Accounting, part 2: Managerial Accounting. They introduce you to Accounting concepts without consideration of International Accounting standards IFRSs. Bookkeeping Entries: All Bookkeeping entries are printed in bold and cover a whole page’s width. This way, we move them into the centre of the page to give them special attention. <?page no="9"?> Berkau: Financial Statements 4e 1-5 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. See, e.g., the Bookkeeping entry for 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, such as Motor Vehicle account. In contrast, when writing ‘The item is added to motor vehicles’ we do not refer to the account but to the assets or the balance sheet item ‘motor vehicles’. The identifier for Bookkeeping entries always comes in brackets, such as Bookkeeping entry (1). You find the identifiers in the accounts, too. Calculations: In calculations, we only show the units with the results. E.g., 10 + 20.50 = 30.50 EUR. Furthermore, the figures in calculations come without digits after the decimal point in case they equal to zero. The final result is printed in bold and comes always with two digits after the decimal point and the currency unit. Printing results bold helps you to find calculated numbers in the text. All calculations are accurate to the EUR-cent or any other currency as 1/ 100-amounts. Case Studies: We keep case studies in this text book as easy as possible. Stories are kept simple in order to focus on Accounting. Sometimes you’ll get the impression the examples are too easy and, thus, unreal. However, our aim is not story-telling and Accounting cases can easily become quite complex anyway. Case Study Text: We write case studies in a different format than normal text (Italic fonts). Cash Flow Separation: An operating cash flow is a cash flow that does not result from investing nor financing activities. Interest payments in this text book are always regarded as financing cash flow, even as IAS 7.33 allows its recognition as operating or financing cash flow. Companies: For the text book, the legal form of companies does not matter much. Legal forms are country-wise different and are not subject to the Accounting syllabus per se. However, in contrast to IFRSs we do not refer to companies as “entities”. The IFRS-expression is chosen for standardisation purpose. Once you the word “entity” in the IFRSs, just remember they are referring to companies. The IFRSs avoid referrals to legal aspects of national law <?page no="10"?> Berkau: Financial Statements 4e 1-6 for a wide validity of a company’s definition. Although the standards always say entity, we apply the technical terms “business”, “firm” and “company” instead and interchangeably to each other. Most companies are limited companies in this text book, such as GmbH, AG, Pty Ltd., PLC, Inc. etc. Country: In this new edition, almost all cases take place in countries where IFRSs apply for single entity financial statements. As a consequence, the currency for the examples is mainly not EUR but a currency that applies in those countries. Currency Unit: For all examples, the currency unit is based on the country in the case study. We use the common 3 letter codes for abbreviations, such as ZAR for South African Rand or GBP for British Pound. Data format in tables: In tables, negative figures are disclosed in brackets. E.g., (7.50) equals to -7.50 EUR. In all tables, the currency is indicated. Deferred Payment of Income Taxes: No deferred payments are made to the revenue service in our case studies. Taxes are calculated at the year-end and are added to short-term liabilities, mostly to the Income Tax Liabilities account. For German companies, § 249 HGB applies and taxes are disclosed as provisions. How it is Done: (1) You find How-it-is Done sections in this text book. (2) They offer you very short and clear instructions for your Accounting work. Income Taxes: A simplified income tax model applies. Income taxes are amounting to 30 % of the pre-tax profit EBT. Financial Statements for Taxation: We do not intend to deepen your knowledge in tax calculations. However, tax statements are relevant to ascertain income taxes liabilities and deferred taxes. We apply a simplified tax calculation model. Group Accounting: For Group Accounting and Joint Venture Accounting, we assume all involved companies prepare financial statements along IFRSs and prepare the single entity financial statements as at 31.12.20XX. Names: We always use names for companies and write them with capital letters. E.g., SCHULZE-BRAMMELKAMP Ltd. No links to actual existing persons or companies are intended. In case we refer to real firms we make that clear in the text. You can search for the case studies by names online. We only use them once for a case study, so they work as identifiers. <?page no="11"?> Berkau: Financial Statements 4e 1-7 Language: This text book is written in South African English. Learning Objectives and Summaries: Every chapter starts by the learning objectives and ends by a summary. Legal Forms of a Business: For this text book, we normally use Ltd., (Pty) Ltd., Sdn. Bhd., Bhd., AG, GmbH, UG, PLC, Inc. etc. If no legal form has been mentioned together with the company’s name you can assume the company is privately-owned, such as SANDPIPER BOOKS for a privately-owned bookstore. Length of a Month/ Year: 1 month = 21.5 days = 4.3 weeks. 1 year = 12 months = 365 days = 52 weeks. Level of Precision: We work accurate to 2 digits after the decimal point. Results from workings are rounded, too. You can use rounded figures to continue calculations, e.g., in examinations or case study workings. Ourselves, we calculate mostly in MS- Excel; hence, calculations in the background are more precise than displayed and visible. Financial statements show figures rounded to the nearest full currency amount. No digits after the decimal point show. Rounding is a minor problem. Literature: The main source of preparing financial statements are the standards issued by the International Accounting Standard Board IASB. We do not compare academic positions on Accounting and, as a consequence, mostly quote the standards. However, at the end of the text book, we advise further readings for you. Non-existing items: In case something has not been mentioned in a case study it won’t exist. Sometimes case studies have been cut short in order to get a point across more clearly. Payment Terms: In this text book, payments and receipts for all kind of taxes and for dividends are due in the next Accounting period. Furthermore, we ignore any consequence on income tax resulting from profits carried forward or backwards. Presentation of Accounts: Accounts are displayed in the easiest format possible, which is the T-format. They contain a 3 letter indicator used for contra-entry references. Nominal accounts show the Accounting periods as a suffix, such as Depreciation-20X4. See the accounts for the car acquisition’s Bookkeeping entry: <?page no="12"?> Berkau: Financial Statements 4e 1.8 D C D C (1) 20,000.00 (1) 4,000.00 D C (1) 24,000.00 Cash/ Bank C/ B Property, plant, equipment PPE Value added tax VAT Figure 1.1: Accounts Abbreviations are listed at the end of this text book. Pro-Rata-Temporis Calculation of Depreciation and Interest: Although given as annual rates, depreciation and interest are calculated on a pro rata temporis (PRT) basis 1 only accurate to the full month. Pro rata temporis is Latin and means proportional to the time. Monthly depreciation is calculated as annual depreciation divided by 12. In case the company is in possession of the asset for a shorter period than a full 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 be relevant for depreciation. If the asset is sold on 28.12.20X1 the December counts for depreciation, too. If the asset is sold on 5.12.20X1, the December won’t be considered for depreciation. Interest rates are given on an annual basis with only annual compounding. For loans taken for shorter periods than a year, interest is calculated on a pro rata temporis basis accurate to the month, too. The monthly rate of interest is the annual rate divided by 12. The interest is 1 per rate compounded annually and paid at the end of the Accounting period. For a bank loan of 100,000.00 EUR taken on 4.06.20X4 with an annual rate of interest of 10 %/ a, the interest paid at the end of the year equals to: 7 × 100,000 × 10%/ 12 = 5,833.33 EUR. If dates are not at the beginning or end of the Accounting period, the month is underlined in order to point thereto, such as 11.06.20X4. In general, pay-off payments take place at the end of the Accounting period. If not, the calculation is to be made in intervals. In case of extra pay-off payments at the end of each quarter the interest has to be calculated for 4 quarterly periods separately. 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 calculate interest thereon. An exception is chapter (37) in the Basics-1 that deals with bank account reconciliations. Overdrawn bank accounts at the end of the Accounting period require a recognition as liability on the statement of financial position. <?page no="13"?> Berkau: Financial Statements 4e 1-9 Interest and pay-off are always paid instantly at the year-ends which means the credit entry is made in the Cash/ Bank account and never in the Accounts Payables account. Quotation of Law Texts/ Standards: Law texts are quoted like ‘§ 266 II HGB’ or ‘IAS 1.68’. We use the original law names and no translations thereof. Hence, the HGB is the German Civic Code, called in German: Handelsgesetzbuch (HGB). In this text book, we quote German law paragraphs mostly without section references but IFRSs standards with paragraph reference. Note, that IFRS paragraphs can be subject to changes. Sequence of Bookkeeping Entries: The sequence of Bookkeeping entries comes along the logical procedure defined by the text structure. Sometimes this differs from the timeline of business activities. However, Bookkeeping identifiers do not tell the sequence of recording. If there is the acquisition of assets and later (31.12.) these assets are writtenoff by recording depreciation, we cover these Bookkeeping entries together in the text, although the acquisition might take place on 2.01.20XX and its depreciation is recorded on 31.12.20XX. Statement of Financial Position: We focus on general purpose balance sheets. Tax Calculations: We follow a very simplified tax calculation model. The total income taxes are calculated by multiplying the pretax profit (=earnings before taxes) with the total income tax rate. In our model the total income tax rate is 30 %. In particular, we ignore any national taxation details, such as untaxable (free) amounts or differences linked to classifications. 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 in this text book. Note, the tax on capital returns is no 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 most countries. Value Added Tax, Goods and Service Tax: VAT stands for value added tax and GST for Goods and Service Tax. Except in, e.g., United Arabic Emirates and some U.S. states such as Delaware, Alaska, consumers pay VAT - or sometimes referred to as sales tax when buying goods or services. In this text book, we apply one single VAT account. This is different to German Bookkeeping, where input-VAT and output-VAT is recorded in separate accounts. The VAT rate in our text books is 20 %. We ignore reduced VAT rates as levied in many countries for food, books etc. <?page no="14"?> Berkau: Financial Statements 4e 1-10 VAT Reduction: It is assumed that every company discussed in this book is registered for VAT reduction. In Germany registration for VAT reduction is the default case. In Germany, only micro companies can opt for no VAT reduction. This requires actively to address that classification at the German revenue service. Work-in-Process account: We apply the Work-in-Process account as reconciliation account for all job orders and call it Work-in-Process. We also apply a Work-in-Process account for single job orders but then add the job order ID thereto. I.e., a Work-in-Process 1234 account represents the job order 1234. Writing Accounting terms: We write Accounting and Bookkeeping as well as methods in Accounting with capital letters. WWW We provide you with a lot of exercises and further materials. Pls., check the website: www.uvk.digital/ 9783739830148. Most of the exercises are exam tasks from Hochschule Osnabrück or its partner universities, mainly in South Africa, China, South Korea and Malaysia, we gave our Accounting students in recent years. 10-20-30 Rule: In this text book, the 10-20-30 rule applies. As long as not mentioned otherwise, the interest rate is 10 %/ a, the VAT rate is 20 % and the total income tax rate is 30 %. <?page no="15"?> Berkau: Financial Statements 4e 2-11 2. Financial Statements based on HGB Learning Objectives: In this first chapter, we focus on the German Handelsgesetzbuch HGB and introduce you to legal aspects of Accounting in Germany. We demonstrate the preparation of financial statements as required by German law. We assume you have basic knowledge about legal company forms in Germany and know the basics of Accounting as laid out in chapters 1 - 15 of our Basics-1. After studying this chapter you know how to prepare a balance sheet and an income statement in Germany and achieved communication competence to talk and write about Accounting in a professional environment. You are familiarised with technical terms of German Accounting and have knowledge about the Handelsgesetzbuch HGB. With regard to legal forms we distinguish private companies and companies in public ownership. Private companies can be a sole proprietor, a partnership or a privately owned limited company. A partnership in Germany is a GbR, short for Gesellschaft bürgerlichen Rechts. Same as a single proprietor, the owners of a GbR are fully reliable for assets and liabilities of their business. Hence, they can lose their interest and be held reliable for debts. In contrast, a limited company’s reliability is only related to the loss of equity. Owners are not responsible for debts. As a consequence, the protection of creditors is the major reason why we prepare financial statements based on HGB in Germany. The parties that lend the company money are in need of protection, as the owners are only reliable for equity. We explain the technical term equity shortly, for now, equity is the owners’ contribution of funds to their business plus all profits kept in the company. For that reason, equity is also called the book value of the company. In other words, a company is worth its initially issued capital plus profits that were reinvested in the business, either as reserves or retained earnings. Book value means the valuation of the company is derived from its Bookkeeping records. Other valuations of companies are based on its fair market value or present values of future free cash flows. In Germany, limited companies as well as retailers apply the German GAAPs (Generally accepted Accounting principles). The German GAAPs are referred to as the German Handelsgesetzbuch HGB. The HGB contains paragraphs dedicated to retailers and to limited companies, such as a Gesellschaft mit beschränkter Haftung GmbH, Unternehmergesellschaft UG or an Aktiengesellschaft AG. In terms of Accounting, the German HGB requires companies to keep Bookkeeping records of their business and to prepare regularly (annually) financial statements. § 242 HGB applies. All retailers shall keep Bookkeeping records based on § 239 HGB and record a register of assets by § 240 HGB. Small retailers are exempted when earning an annual revenue of less than <?page no="16"?> Berkau: Financial Statements 4e 2-12 500,000.00 EUR/ a for two following years and reporting an annual surplus below 50,000.00 EUR/ a, see §241a HGB. The exemption applies only if the company is not limited as per legal form. Besides of retailers, every firm in the legal form of a limited company prepares financial statements based on § 264 HGB. No exemptions based on the company size apply. Note, § 241a HGB only refers to retailers if not in the legal form of a limited company. A small trader has to prepare financial statements if its liability is limited by the GmbHG or AktG in any case, no matter how low revenue and profit are. GmbHG and AktG are the German companies’ acts. Limited companies in Germany are called Gesellschaft mit beschränkter Haftung GmbH (or as a small cousin thereof an Unternehmergesellschaft UG (haftungsbeschränkt)) and Aktiengesellschaft AG. AGs are companies based on shares. They are public corporations. In contrast, a GmbH is similar to a privately owned limited company, such as a PLC or a (Pty) Ltd. Study the laws GmbHG and AktG for details. In general, trading businesses and limited companies keep Bookkeeping records and prepare financial statements along §§ 239, 242 and 264 HGB. Financial statements in Germany include a balance sheet and an income statement (§ 242 HGB). Limited companies additionally prepare an appendix and a business report in accordance with § 264 HGB. In contrast to the business report, the appendix counts as element of the financial statements, see § 264 HGB. The appendix contains disclosures in regard to the balance sheet and income statement of the company based on § 284 HGB. Next, we study the establishment of a limited company: To found a limited company in Germany, an initial registration with the German registrar is required. The register is kept at local courts. The owners-to-be of a limited company appoint an attorney for registration. The attorney drafts the company’s articles, also known as memorandum of incorporation (MoI) or The Articles that amongst other items state the purpose of the company, its address, the names of legal representatives etc. Here, our Accounting work starts: One item on the memorandum of incorporation is an opening balance sheet required by § 240 HGB and prepared in the format according to § 266 HGB. The opening balance sheet most probably only discloses the issued capital and cash/ bank as at the time of incorporation. Frequently, the issued capital is money paid into the company’s bank account. However, a company can be established by assets other than cash/ bank, too. As a result of its establishment, legal requirements make the company prepare and disclose financial statements for taxation and for commercial purposes. The latter one is based on §§ 240, 242 HGB. Together with the tax law, this means, a company prepares 2 sets of financial statements based on different laws. One follows the German HGB and the other one the income tax law in Germany, mainly the Einkommensteuergesetz EStG. Laws in Germany pursuit different objectives, which <?page no="17"?> Berkau: Financial Statements 4e 2-13 makes multi-purpose financial statements for commercial as well as for tax purposes unlikely to work out. Commercial financial statements require publication at the local court. This can be obtained through the website of the Bundesanzeiger Verlag. To submit financial statements for taxation, the German revenue service request financial statements to be submitted electronically, referred to as E- Bilanz (§ 5b EStG). Technically, the standardised financial statement format forces a company to apply certified Bookkeeping software to fulfil interface requirements. In Germany, financial statements are transferred based on specific protocols, such as a DATEV format. DATEV is a German organisation that provides Software for Accounting and Taxation. In this book, we focus on commercial financial statements. We do not study tax law and regulations with regard to the preparation of financial statements for Taxation. Before we put aside the tax law, we refer to 2 details: (1) Simplification for income tax. (2) Value added tax. Ad (1): Income Tax Calculation In Taxation classes you learn the details of national income tax calculation. The income tax law, such as German EStG, aims to a fair levy of income taxes. In terms of tax law, fairness means that a person/ company with high earnings pays higher tax rates than someone who is earning low. The 2 Along our conventions, we consider annual refunding/ paying. income tax law refers to the capability of the tax payers to contribute to common welfare. Tax laws includes a numerous detailed regulations and exceptions made for income tax adjustments, i.e., there are tax free earnings for low incomes, tax payer classifications based on marriage status and allocation of different tax rates thereto etc. In this text book, we simplify income tax calculation. We multiply a company’s net profit by a total income tax rate of 30 %. In real business, you have to replace our tax formula by a detailed tax calculation. Our tax calculation is consistent with how the IASB calculates income taxes for entities, check IAS 12 for the details. Ad (2): Value added tax VAT. Value added tax VAT is a consumer tax and is paid by the buyer of goods or recipient of services. VAT is the same whether the consumer is rich or poor. It does not follow the principle of capability. Whether you buy an expensive sports car or bread with your last EUR, everyone pays the same tax rate. Companies in general are exempted from VAT, as they do not consume but buy goods or services for manufacturing and service rendering purposes. A company buying goods or services will be refunded for its previously paid input-VAT. That way, companies are not levied VAT. The refund is received during the next following Accounting period based on a VAT statement submitted by the company on a monthly basis. 2 On the other side, from the point of view of companies <?page no="18"?> Berkau: Financial Statements 4e 2-14 selling goods and services, collection of output-VAT from its customers on behalf of the revenue service takes place. If the buyer is a company, it will receive a refund, later too. Technically, all companies keep a record of VAT payments and receipts in a VAT account. They pay the excess of output- VAT over input-VAT, here, to a rate of 20 % and in the next following Accounting period. For VAT refunding a company has to register which happens automatically together with the establishment in Germany. For an exemption a company has to fulfil size based requirements. We apply VAT reduction as default case for our text book case studies and for exercises provided on the website. However, sometimes you might find the sentence “Ignore VAT” in the required section of a task which is when value added taxes do not matter, e.g., for Manufacturing Accounting, and for simplifying cases. Below, we discuss the first case study KIELILNG TAXI GmbH. The case study is similar to the case of KENILWORTH METERED TAXI SERVICE Ltd. that is discussed in the next chapter (3) for studying international Accounting. This way we show differences between German HGB and the application of international Accounting. This first case study repeats some basic knowledge of Accounting and gives you a first indication of how to prepare financial statements. We refer to the HGB and make Bookkeeping entries along the German way. The taxi driver Theo Kieling starts his own business and buys a taxi license in Hanover. His taxi is registered under the taxi-number 43. In order to limit financial risks for his taxi business, Mr Kieling establishes a privately owned but limited firm by the name of KIELING TAXI GmbH. A GmbH follows German company’s act GmbH-law (GmbHG) and requires a contribution not less than 25,000.00 EUR from its owners together. The establishment of a GmbH company requires conveyance through an attorney and registration at local court and at German revenue service. Mr Kieling makes an appointment with his attorney Dr. Meppen. The company is based on Mr Kieling’s contribution of 50,000.00 EUR which is partially paid in on cash. The missing portion of the contribution is assigned to the company as taxi license valued at cost of 10,000.00 EUR. Mr Kieling opens an account at his house bank and transfers 40,000.00 EUR therein before he goes to the attorney. On 27.12.20X0, Mr Kieling pays his attorney a visit and provides him with a stamped bank statement as proof of funds. He also prepares an opening balance sheet along the formal requirements of § 266 HGB. See the opening balance sheet in Figure 2.1. Based on § 244 HGB, Mr Kieling has to submit the balance sheet in German. It has to disclose items in EURs. <?page no="19"?> Berkau: Financial Statements 4e 2-15 Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets II. Capital reserves III. Financial assets III. Earnings reserves IV. Profit/ Loss carried forward B. Current assets V. Annual surplus/ loss I. Inventories II. Receivables and other B. Provisions assets I. Provisions for pension funds III. Securities II. Tax provisions IV. Cash, cash on 40,000 III. Other provisions Bundesbank cash on banks, checks C. Payables C. Accurals on debit side D. Accruals on the credit side D. Deferred taxes on the debit side E. Deferred taxes on the credit side E. Difference of asset offsetting on the asset side 50,000 50,000 Kieling Taxi GmbH BALANCE SHEET as at 1.01.20X1 Figure 2.1: KIELING TAXI GmbH’s opening balance sheet The attorney and notary Dr. Meppen prepares the articles which appoints Theo Kieling as chief executive officer CEO of the new company KIELING TAXI GmbH. Dr. Meppen sends the articles to the local court which triggers two events: (1) KIELING TAXI GmbH is registered at the registrar in Hanover and (2) the company becomes a tax payer. Mr Kieling receives an establishment notification from the local court as well as from the local German revenue service in Hanover. The latter one assigns to KIELING TAXI GmbH a company tax ID-number and confirms registration for VAT reduction. Right now, the taxi business of KIELING TAXI GmbH commences. In terms of Accounting, §§ 238, 242 and 264 HGB require KIELING TAXI GmbH to keep Bookkeeping records and prepare financial statements. § 240 HGB says KIELING TAXI GmbH has to take stock. The company owns at the time of incorporation the license and 40,000.00 EUR cash at bank. On 4.01.20X1, the KIELING TAXI GmbH purchases a preowned Mercedes-Benz E220 at costs of acquisition of 30,000.00 EUR (net amount). The car dealership is registered for VAT reduction and, thus, discloses the input-VAT on the invoice. This only works as the seller is registered for VAT reduction as well. A private seller cannot disclose VAT on the bill and, as a consequence, KIELING TAXI GmbH could not claim for VAT refunding. Hence, KIELING TAXI GmbH can request input- VAT refund for the car acquisition. Furthermore, KIELING TAXI GmbH lets a specialised taxi car manufacturer alter the car for its intended use as metered taxi. The Mercedes-Benz E220 now has <?page no="20"?> Berkau: Financial Statements 4e 2-16 a taxi sign on its roof, a radio for communication with the taxi control service, a meter and seat sensors which cost 6,000.00 EUR (gross amount) all together. The manufacturer discloses input-VAT on its invoice. It is amounting to: 5,000 × 20% = 1 1,000.00 EUR. Hence, the total cost of acquisition for the taxi car are: 30,000 + 5,000 = 3 35,000.00 EUR. KIELING TAXI GmbH pays: 35,000 × (1 + 20%) = 4 42,000.00 EUR per bank transfer to the car dealer and for alterations to the taxi manufacturer. The calculation of the costs of acquisition follows § 253 HGB. Depreciation on the taxi car is based on straight-line method over its useful life of 3 years. The depreciation list issued by the German minister of finance applies. KIELING TAXI GmbH plans to sell the car at 8,000.00 EUR (net amount) after 31.12.20X3. The depreciable amount of the taxi car is: 35,000 - 8,000 = 27,000.00 EUR. Annual depreciation charge is amounting to: 27,000 / 3 = 9,000.00 EUR/ a. After making deductions for depreciation, KIELING TAXI GmbH carries its car at a value of: 42,000 / 120% - 9,000 = 2 26,000.00 EUR on 31.12.20X1. Depreciation is recorded at the end of the Accounting period. During the Accounting period 20X1, the KIELING TAXI GmbH earns a revenue of 100,000.00 EUR, net of VAT, by riding taxi. Due to the registration for VAT reduction, the taxi passengers (all together) pay the gross amount which is: 100,000 × 120% = 1 120,000.00 EUR. Labour for the drivers equals to 50,000.00 EUR/ a and KIELING TAXI GmbH pays operational expenses to the extent of 18,000.00 EUR/ a, the latter one is the gross amount. The operational expenses’ net amount is: 18,000 / 120% = 15,000.00 EUR/ a. All taxi drivers are freelancers and KIELING TAXI GmbH pays 50,000.00 EUR which includes the drivers’ taxes, too. Freelancers are responsible for income tax declaration and payments on their own. Observe below the recording of Bookkeeping entries in the format of a journal. To keep this case study simple, we record all annual business activities as single Bookkeeping entries dated on the middle of the Accounting period 20X1. Nr Amount Date Narrative DR CR OV 10,000.00 2.01.20X1 Establishment of business P, P, E Issued capital 40,000.00 Cash/ Bank Issued capitall (1) 30,000.00 4.01.20X1 Acquisition of taxi car P, P, E Cash/ Bank 6,000.00 VAT Cash/ Bank (2) 5,000.00 5.01.20X1 Taxi equipment P, P, E Cash/ Bank 1,000.00 VAT Cash/ Bank (3) 9,000.00 31.12.20X1 Depreciation taxi car Depreciation Acc depr (4) 100,000.00 30.06.20X1 Revenue for taxi rides Cash/ Bank Revenue 20,000.00 Cash/ Bank VAT (5) 50,000.00 30.06.20X1 Labour Labour Cash/ Bank (6) 15,000.00 30.06.20X1 Operating expenses Operational exp. Cash/ Bank 3,000.00 VAT Cash/ Bank Kieling Taxi GmbH's JOURNAL 20X1 Figure 2.2: KIELILNG TAXI GmbH’s journal (20X1) <?page no="21"?> Berkau: Financial Statements 4e 2-17 The profit or loss calculation gives us the pre-tax profit for 20X1, calculated as revenue less labour less operational expenses less depreciation: 100,000 - 50,000 - 15,000 - 9,000 = 2 26,000.00 EUR. The amounts for the profit calculation are: - Revenue: 100,000.00 EUR. - Labour: 50,000.00 EUR. - Operational expenses: 15,000.00 EUR. - Depreciation: 9,000.00 EUR. KIELING TAXI GmbH pays income taxes based on our simplified income tax model to the extent of: 26,000 × 30% = 7,800.00 EUR. We now discuss the balance sheet as at 31.12.20X1. A balance sheet discloses all assets on its left hand side. At KIELING TAXI GmbH, there is the taxi car as noncurrent asset and the taxi license as intangible asset. The taxi car’s value after depreciation is amounting to: 35,000 - 9,000 = 2 26,000.00 EUR. No depreciation on the license applies as it does not expire. It also can be sold on. The closing balance for the Cash/ Bank account is: 40,000 - 36,000 - 6,000 + 120,000 - 50,000 - 18,000 = 5 50,000.00 EUR. The amounts above include VAT and result from: - Contribution: 40,000.00 EUR. - Taxi car acquisition: 36,000.00 EUR. - Taxi alteration: 6,000.00 EUR. - Proceeds: 120,000.00 EUR. - Drivers’ payment: 50,000.00 EUR. - Taxi operation: 18,000.00 EUR. On the credit side of the balance sheet, we see KIELING TAXI GmbH’s equity section which includes issued capital of 50,000.00 EUR and the profit after taxes disclosed as annual surplus to an extent of: 26,000 - 7,800 = 1 18,200.00 EUR. Underneath of equity, the company shows a tax provision that amounts to 7,800.00 EUR. Due to the registration for VAT reduction, KIELING TAXI GmbH considers VAT. The output-VAT results from taxi rides during the Accounting period 20X1 and is collected by the taxi firm on behalf of the German revenue service. The input- VAT recorded is: 6,000 + 1,000 + 3,000 = 10,000.00 EUR. The amounts result from: - Output-VAT for taxi rides: 20,000.00 EUR. - Input-VAT for car acquisition: 6,000.00 EUR. - Input-VAT for taxi car alterations: 1,000.00 EUR. - Input-VAT for operating expenditures: 3,000.00 EUR. In preparation of the VAT transfer to the German revenue service, KIELING TAXI GmbH ascertains its VAT liabilities: 20,000 - 10,000 = 1 10,000.00 EUR. The amount is disclosed on the balance sheet as a short-term liability. We prepare a balance sheet based on the classification of KIELING TAXI GmbH as a small limited company in accordance with § 267 HGB. The formal requirements for the balance sheet disclosure are based on § 266 HGB. The illustrated Bookkeeping entries and the T-accounts for KIELING Taxi GmbH based on German account format are available for download. Pls., scan Link 2.A: <?page no="22"?> Berkau: Financial Statements 4e 2-18 Link 2.A: KIELING TAXI GmbH Observe below the balance sheet of KIELING TAXI GmbH as at 31.12.20X1 in Figure 2.3. We translated the balance sheet for this text book to English. Although, § 244 HGB says a balance sheet in Germany has to be prepared in German language. Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets 26,000 II. Capital reserves III. Financial assets III. Earnings reserves IV. Profit/ Loss carried forward B. Current assets V. Annual surplus/ loss 18,200 I. Inventories II. Receivables and other B. Provisions assets I. Provisions for pension funds III. Securities II. Tax provisions 7,800 IV. Cash, cash on 50,000 III. Other provisions Bundesbank cash on banks, checks C. Payables 10,000 C. Accurals on debit side D. Accruals on the credit side D. Deferred taxes on the debit side E. Deferred taxes on the credit side E. Difference of asset offsetting on the asset side 86,000 86,000 Kieling Taxi GmbH BALANCE SHEET as at 31.12.20X1 Figure 2.3: KIELING TAXI GmbH’s balance sheet 20X1 The German law requires to submit financial statements in the format prescribed by § 266, 275 HGB at the local court which can best be done via the internet website of Bundesanzeiger. A set of financial statements in line with § 264 HGB includes a balance sheet, an income statement and an appendix for limited companies. Furthermore, it is required to prepare a business report which is not regarded as element of the financial statements in Germany. On the balance sheet we observe few items that do not apply for KIELING TAXI GmbH. We discuss but keep our explanations short: (a) Accruals are ruled by § 250 HGB. The reporting company reports on expenses that have been paid already but only become expenses in a later Accounting period. We refer to those items as prepaid expenses. Prepaid rent is a common example. <?page no="23"?> Berkau: Financial Statements 4e 2-19 (b) On the credit side accruals are recorded for income that is revenue in later Accounting periods. These amounts are often advanced payments or deposits received from customers. For the recording of deferred income, study the example KAMPUNG Ltd. in chapter (15) of our Basics-1. Same as with (a), it is required that prepayments are relevant for profit or loss at a certain Accounting period. Time period and expense type information is needed for recognition. (c) Deferred taxes are income tax considerations for tax income (asset side) or expenditures (credit side) that divert from tax payments based on national tax law. § 274 HGB requires the existence of a temporary difference which means, differences have to level out in the future. (d) In a situation when a company discloses losses that are not covered by equity, items on the credit side can exceed the total of assets. Based on § 268 HGB, a company then discloses the difference under the item uncovered losses on the asset side of the balance sheet. In these cases, a company discloses negative equity and has to face bankruptcy. Excessive indebtedness requires to cease operations in order to protect the creditors. Negative equity means a company cannot retire its debts completely anymore. Below, we continue the case study KIELING TAXI GmbH: KIELING TAXI GmbH prepares a profit or loss statement. Its format is prescribed by § 275 HGB. It can be provided based on the nature of expense format or the cost of sales format. 3 KIELING TAXI GmbH prepares a profit or loss statement based on the nature of expense method. It is shown in Figure 2.4. 3 Check our Basics chapter (28) for the preparation of the income statement. <?page no="24"?> Berkau: Financial Statements 4e 2-20 [EUR] 1. Revenue 100,000 2. Increase/ decrease resulting from finisched and semi-finished goods inventory changes 3. Other recognised finished goods 4. Other operating profit 5. Materials (a) Expenses for raw materials, supplies and for other aquired goods (b) Expenses for 3rd party services 6. Labour 50,000 (a) Salaries (b) Expenses for social payments and expenses for pension provisions and for support 7. Depreciation 9,000 (a) on intangible non-current assets and P, P, E as well as for recognised finished goods and for expenses to commence and enhence operating processes (b) on current assets as far as they exceed normal depreciation 8. Other operating expenses 15,000 9. Investment revenue 10. Revenue resulting from other securities and lending financial assets 11. Other interest and similar revenue 12. Depreciation on financial assets and current securities 13. Interest and similar expenses 14. Operating profit 26,000 15. Extraordinary Revenue 16. Extraordinary expenses 17. Extraordinary profit 18. Income taxes (7,800) 19. Other taxes 20. Annual surplus/ loss 18,200 Kieling Taxi GmbH's STATEMENT of PROFIT and LOSS for the year 20X1 Figure 2.4: KIELING TAXI GmbH’s profit and loss statement 20X1 Mr Kieling holds an annual meeting within his company (he is alone) and makes a decision in regard to appropriate profit. In general, companies can either declare a dividend or similar kinds of payment to the owners which depends on the legal form of the company, can add the profit to reserves which is a reinvestment or can carry forward the profit or loss to the next Accounting period. In fact, the latter alternative postpones the decision about the profit appropriation. KIELING TAXI GmbH decides to carry forward the profit to the next Accounting period 20X2. 4 4 We keep this case study simple and do not discuss dividends yet. We do for 20X2 further below. Below, we discuss the Accounting period 20X2: At the beginning of the Accounting period 20X2, KIELING TAXI GmbH pays income tax and VAT liabilities. After we learned already how to prepare financial statements for KIELING TAXI GmbH, we now focus on the Bookkeeping entries as well. KIELING TAXI GmbH starts the Accounting period 20X2 with an Opening Balance Sheet account. The company applies accounts based on the chart of accounts in DATEV-4 format. You can download the DATEV-4 chart of accounts through the Link 2.B below. <?page no="25"?> Berkau: Financial Statements 4e 2-21 Link 2.B: DATEV-4 chart of accounts We record 20X2’s business activities of KIELING TAXI GmbH in a format applicable for electronic data transfer of financial statements to the German revenue service. We do not study software systems here but pretend our MS-Excel based Bookkeeping system can transfer financial statements and prepare them in the required format: DATEV-4 for instance. A company that starts Bookkeeping for a new Accounting period, such as KIELING TAXI GmbH, will carry forward balancing figures for the items on the balance sheet by the 9000-Balancing- Figures account. Study the accounts as of 1.01.20X2 in Figure 2.5. 5 Therein the standard account numbers and names are used but got translated to English. For the opening of accounts we indicate contra account entries by their 4 digits code in line with DATEV-4. D C D C 2900 50,000.00 0110 10,000.00 9000 10,000.00 2970 18,200.00 0520 26,000.00 3020 7,800.00 1810 50,000.00 3800 10,000.00 86,000.00 86,000.00 9000-Balancing-Figures EBK 0110 Licences D C D C 9000 26,000.00 9000 50,000.00 0520 Motor vehicles, cars 1810 Bank account Commerzbank D C D C 9000 50,000.00 9000 18,200.00 2900 Issued capital 2970 Profit carried forward D C D C 9000 7,800.00 9000 10,000.00 3020 Tax provisions for income tax 3800 VAT payables Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X1) During the Accounting period 20X2, KIELING TAXI GmbH records the business activities as below: 5 Technically, your Bookkeeping software prevents you from changing or translating accounts’ names. (A) Payment of income tax for 20X1 to the amount of 7,800.00 EUR. <?page no="26"?> Berkau: Financial Statements 4e 2-22 (B) Payment of VAT payables for 20X1 which are 10,000.00 EUR. (C) Depreciation on the taxi car to the extent of 9,000.00 EUR. (D) Payment for labour which is amounting to 55,000.00 EUR. (E) Operational expenses of 16,000.00 EUR (net amount). (F) Earning revenue from taxi rides to the tune of 105,000.00 EUR (net amount). (G) Transfer of cash to the Bank account to the extent of 126,000.00 EUR. KIELING TAXI GmbH makes the Bookkeeping entries (A) - (F) for the business activities: DR 3020 Tax Provisions ......... 7,800.00 EUR CR 1810 Bank Account CoBa....... 7,800.00 EUR DR 3800 Output-VAT.............. 10,000.00 EUR CR 1810 Bank Account CoBa....... 10,000.00 EUR DR 6222 Depreciation on Cars.... 9,000.00 EUR CR 0520 Motor Vehicles, Cars.... 9,000.00 EUR DR 6010 Labour.................. 55,000.00 EUR CR 1810 Bank Account CoBa....... 55,000.00 EUR DR 6300 Operational Expenses.... 16,000.00 EUR DR 1400 Input-VAT............... 3,200.00 EUR CR 1810 Bank Account CoBa....... 19,200.00 EUR DR 1600 Cash.................... 126,000.00 EUR CR 3800 Output-VAT.............. 21,000.00 EUR CR 4200 Revenue................. 105,000.00 EUR DR 1810 Bank Account CoBa....... 126,000.00 EUR CR 1600 Cash.................... 126,000.00 EUR KIELING TAXI GmbH records the Bookkeeping entries and calculates profit as shown in the accounts below in Figure 2.6. With Bookkeeping entry (G), the amount of cash collected from taxi rides is transferred into the bank account. Bookkeeping entry (H) records income tax expenses based on the simplified total tax rate of 30 %. Based on § 249 HGB, income taxes are disclosed as provisions under German law. KIELING TAXI GmbH records the appropriation of profits. The distributable amount is the profit carried forward from last year plus the annual surplus from 20X2: 18,200 + 17,500 = 3 35,700.00 EUR. The appropriation of profits is decided on the annual general meeting and is amounting as below: <?page no="27"?> Berkau: Financial Statements 4e 2-23 - 10,000.00 EUR additions to reserves. - 10,000.00 EUR payment to owner. - 15,700.00 EUR carried forward. The appropriation of profits is recorded by the Bookkeeping entries (I), (J), (K). DR 2970 Profit c/ f.............. 10,000.00 EUR CR 3519 Liabilities to Owners... 10,000.00 EUR DR 2970 Profit c/ f.............. 8,200.00 EUR DR Annual Surplus............... 1,800.00 EUR CR 2960 Other Earnings Reserves. 10,000.00 EUR DR Annual Surplus............... 15,700.00 EUR CR Retained Earnings............ 15,700.00 EUR Observe the accounts at KIELING TAXI GmbH in Figure 2.6 after the appropriation of profits. For teaching purposes, we disclose the account 9000 twice. It is the opening account (EBK) and the closing account (SBK). You can continue the account 9000 but here, we show one account for opening and another one for closing the Accounting period. Both are indicated by the number 9000. D C D C 2900 50,000.00 0110 10,000.00 EBK 10,000.00 SBK 10,000.00 2970 18,200.00 0520 26,000.00 3020 7,800.00 1810 50,000.00 3800 10,000.00 86,000.00 86,000.00 9000-Balancing figures EBK 0110 Licences D C D C EBK 26,000.00 (C) 9,000.00 EBK 50,000.00 (A) 7,800.00 SBK 17,000.00 (G) 126,000.00 (B) 10,000.00 26,000.00 26,000.00 (D) 55,000.00 (E) 19,200.00 SBK 84,000.00 176,000.00 176,000.00 0520 Motor vehicles, cars 1810 Bank account Commerzbank D C D C SBK 50,000.00 EBK 50,000.00 (I) 10,000.00 EBK 18,200.00 (J) 8,200.00 18,200.00 18,200.00 2900 Issued capital 2970 Profit carried forward Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) <?page no="28"?> Berkau: Financial Statements 4e 2-24 D C D C (A) 7,800.00 EBK 7,800.00 (B) 10,000.00 EBK 10,000.00 SBK 7,500.00 (H) 7,500.00 SBK 21,000.00 (F) 21,000.00 15,300.00 15,300.00 31,000.00 31,000.00 3020 Tax provisions for income tax 3800 Output-VAT D C D C (C) 9,000.00 P&L 9,000.00 (D) 55,000.00 P&L 55,000.00 6222 Depreciation on cars 6010 Labour D C D C (E) 16,000.00 P&L 16,000.00 (E) 3,200.00 SBK 3,200.00 6300 Operational expenses 1400 Input-VAT D C D C (F) 126,000.00 (G) 126,000.00 P&L 105,000.00 (F) 105,000.00 1600 Cash 4200 Revenue D C D C 6010 55,000.00 4200 105,000.00 (H) 7,500.00 P&L 7,500.00 6222 9,000.00 6300 16,000.00 EBT 25,000.00 105,000.00 105,000.00 76XX 7,500.00 EBT 25,000.00 A/ S 17,500.00 25,000.00 25,000.00 Profit and Loss 76XX Income tax expenses D C D C (J) 1,800.00 P&L 17,500.00 SBK 10,000.00 (I) 10,000.00 (K) 15,700.00 17,500.00 17,500.00 Annual surplus 3519 Liabilities to owners D C D C SBK 10,000.00 (J) 10,000.00 SBK 15,700.00 (K) 15,700.00 2960 Other earnings reserves Retained earnings Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) continued <?page no="29"?> Berkau: Financial Statements 4e 2-25 D C 0520 17,000.00 2900 50,000.00 0110 10,000.00 2960 10,000.00 3200 3,200.00 R/ E 15,700.00 1810 84,000.00 3519 10,000.00 3020 7,500.00 3800 21,000.00 114,200.00 114,200.00 9000 Balancing figures SBK Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) continued The accounts are the basis for the preparation of financial statements. KIELING TAXI GmbH prepares an income statement based on the Profit and Loss account. Note, when using a Bookkeeping software system, the income statement is prepared automatically and follows the interface format regulations for electronic financial statement transfer. The income statement is displayed in Figure 2.7. [EUR] 1. Revenue 105,000 2. Increase/ decrease resulting from finisched and semi-finished goods inventory changes 3. Other recognised finished goods 4. Other operating profit 5. Materials (a) Expenses for raw materials, supplies and for other aquired goods (b) Expenses for 3rd party services 6. Labour 55,000 (a) Salaries (b) Expenses for social payments and expenses for pension provisions and for support 7. Depreciation 9,000 (a) on intangible non-current assets and P, P, E as well as for recognised finished goods and for expenses to commence and enhence operating processes (b) on current assets as far as they exceed normal depreciation 8. Other operating expenses 16,000 9. Investment revenue 10. Revenue resulting from other securities and lending financial assets 11. Other interest and similar revenue 12. Depreciation on financial assets and current securities 13. Interest and similar expenses 14. Operating profit 25,000 15. Extraordinary Revenue 16. Extraordinary expenses 17. Extraordinary profit 18. Income taxes (7,500) 19. Other taxes 20. Annual surplus/ loss 17,500 Kieling Taxi GmbH's STATEMENT of PROFIT and LOSS for the year 20X2 Figure 2.7: KIELING TAXI GmbH’s income statement (20X2) <?page no="30"?> Berkau: Financial Statements 4e 2-26 Based on § 276 HGB, small limited companies are allowed to combine items (1) - (5) and disclose gross profit instead. Next, we discuss the balance sheet: A company prepares its balance sheet either before or after the appropriation of profits. In case the appropriation of profits is considered for balance sheet’s items, the company has to follow § 268 HGB. It states that in case the profit has been fully appropriated, which means no profit or loss is carried forward to the next Accounting period, the item annual surplus is nil and does not show. In case the company prepares the balance sheet under partial appropriation of profits, the item annual surplus is replaced by retained earnings. The item retained earnings then discloses the profit or loss carried forward which is the balance of the Retained Earnings account. KIELING TAXI GmbH opts for disclosure of the balance sheet with consideration of appropriation of profits. It replaces the items profit carried forward from 20X1 and annual surplus by the item retained earnings. Retained earnings are amounting to: 18,200 + 17,500 - 10,000 - 10,000 = 1 15,700.00 EUR. Observe the balance sheet below that does not follow exactly the formal requirements set by § 266 HGB because the items have been translated for teaching purposes to English. § 266 HGB says the balance sheet shall disclose items by the sequence and names prescribed in its section 2 and 3. KIELING TAXI GmbH falls under small limited companies in regard to § 267 HGB. Its total of assets and capital/ liabilities does not exceed 4,840,000.00 EUR and its revenue is below 9,680,000.00 EUR/ a. Furthermore, KIELING TAXI GmbH has less than 50 employees. § 267 HGB states that a limited company that does not exceed 2 of the above mentioned threshold values for 2 following Accounting periods is classified as a small limited company. The privilege of small limited companies are: (a) The balance sheet follows an abridged format that requires only the disclosure of items indicated by letters and Roman numerals (§ 266 HGB). (b) Based on § 274a HGB, small limited companies do not prepare a register of non-current assets as otherwise required by § 268 HGB. (c) Small limited companies do not have to explain certain receivables based on § 268 HGB. (d) Small limited companies do not have to explain certain payables based on § 268 HGB. (e) § 274a HGB exempts small limited companies from regulations about accruals and deferred taxes based on §§ 268, 274 HGB. The simplifications above all apply for KIELING TAXI GmbH. Observe the abridged balance sheet as at 31.12.20X2 in Figure 2.8. <?page no="31"?> Berkau: Financial Statements 4e 2-27 Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets 17,000 II. Capital reserves III. Financial assets III. Earnings reserves 10,000 IV. Retained earnings 15,700 B. Current assets I. Inventories B. Provisions II. Receivables and other 3,200 I. Provisions for pension funds assets II. Tax provisions 7,500 III. Securities III. Other provisions IV. Cash, cash on 84,000 Bundesbank C. Payables 31,000 cash on banks, checks D. Accruals on the credit side C. Accurals on debit side E. Deferred taxes on the credit side D. Deferred taxes on the debit side E. Difference of asset offsetting on the asset side 114,200 114,200 Kieling Taxi GmbH BALANCE SHEET as at 31.12.20X2 Figure 2.8: KIELING TAXI GmbH’s balance sheet (20X2) Besides the balance sheet and the income statement, § 264 HGB states that a complete set of financial statements includes an appendix for limited companies. §§ 284 - 288 HGB rule the appendix. For small limited companies an abridged appendix applies based on § 288 HGB. To study a real appendix, take a look at the financial statements of Lufthansa AG below: Link 2.C: Lufthansa AG’s appendix Summary: German trading companies and companies that are in the legal form of a limited company have to prepare and report financial statements based on §§ 242 and 264 HGB. The financial statements in Germany include a balance sheet and an income statement. Limited companies also prepare an appendix and a business report. In case a company participates on the capital market and is no parent nor subsidiary it has to prepare a cash flow statement, too. (§ 264 HGB). We discussed the case study KIELILNG TAXI GmbH, which is a German limited company and showed its financial statements over two Accounting periods. After the last period, the company made a decision about the appropriation of its profits. The <?page no="32"?> Berkau: Financial Statements 4e 2-28 balance sheet provided shows the amounts of items after the appropriation of profits. Accounting Technical Terms: Accruals: Item on the balance sheet that is income or expense for a specific time after the balance sheet. Appendix: Disclosure of information linked to the financial statements and required by §§ 284 - 288 HGB. German financial statements include an appendix for limited companies. Appropriation of profits: Using profit after tax as either addition to reserves, payment to owners or carrying profit or loss forward to the next Accounting period. Balance sheet: Statement of financial position that discloses assets, equity and liabilities in an aggregated form. Bankruptcy: Situation that triggers legal procedures of liquidation due to over-indebtedness or insolvency. Business report: Disclosure about the situation the company is in at the time of reporting and in the nearby future. The business report is required for limited companies that are not classified as small. DATEV-4 chart of accounts: Standard list of accounts applicable for electronic transfer of financial statements and accounts. Distributable amount: The amount a company can pay as a dividend to its shareholders without dissolving reserves. It includes the profit carried forward and the annual surplus. In case the company carries forward a loss it has to deduct the loss carried forward from annual surplus. Not part of the distributable amount is a contribution to legal reserves and preference dividends. Financial statements: In Germany financial statements include: a balance sheet, an income statement, an appendix and a business report. A set of financial statements can include a statement of cash flows, too. For international Accounting, IAS 1.10 applies. Handelsgesetzbuch HGB: German law for retailers and limited companies that requires to prepare and publish financial statements. Income statement: Statement of profit or loss that compares income and expenses for profit calculation. Its structure is given by § 275 HGB. Limited company: A company with restrictions in regard to liabilities. In general, a limited company is established based on its owners’ contribution. The owners are held reliable to the extent of equity only. Non-covered loss on the asset side: A loss that exceeds the equity is required to be disclosed on the asset side of the German balance sheet based on § 266 HGB. Provision: Uncertain liability, e.g., for income taxes or other expenses based on § 249 HGB. Provisions require a present obligation at the time of reporting. Register of non-current assets: List of long-term assets that shows the costs of acquisition as well as accumulated depreciation and accumulated impairment loss for assets or groups thereof. Value added tax: Tax levied in most countries on consumption. In this text book, the common VAT rate is 20 %. No reduced VAT rates apply. <?page no="33"?> Berkau: Financial Statements 4e 2-29 Question Bank: (1) A German company in the legal form of a limited company has to prepare financial statements which comprise of … 1. … a balance sheet, an income statement, an appendix, and in case of participation on the capital market and no group membership a cash flow statement. 2. … a balance sheet, an income statement, an appendix, a management report and in case of participation on the capital market and group membership a cash flow statement. 3. … a balance sheet, an income statement, an appendix, a management report and in case of participation on the capital market and no group membership a cash flow statement. 4. … a balance sheet, an income statement, a management report and in case of participation on the capital market and group membership a cash flow statement. (2) A German company that earns a pre-tax profit of 80,000.00 EUR, carrying forward a loss of 20,000.00 EUR and adding half of the distributable amount to reserves (no other appropriation of profits) discloses as retained earnings: 1. 38,000.00 EUR. 2. 30,000.00 EUR. 3. 50,000.00 EUR. 4. 18,000.00 EUR. (3) A German company buys a machine and pays a partial amount of 100,000.00 EUR and adds 44,000.00 EUR to payables. How much are the cost of acquisition? 1. 144,000.00 EUR. 2. 120,000.00 EUR. 3. 100,000.00 EUR. 4. 44,000.00 EUR. (4) A company in the legal form of a limited company earns a revenue of 5,000,000.00 EUR and discloses a total of 10,000,000.00 EUR. No noncovered loss is disclosed on its asset side. The number of employees is 100. How do you classify the company in regard to its size based on § 267 HGB? 1. Micro firm. 2. Small limited company 3. Medium-sized limited company. 4. Big corporation. (5) Financial statements in Germany along § 244 HGB are to prepare in… 1. … German, in any currency. 2. … English and in EUR. 3. … German and in EUR. 4. … English and in any currency Solutions: 1-1, 2-4, 3-2, 4-3, 5-3. <?page no="34"?> Berkau: Financial Statements 4e 3-30 3. Financial Statements based on IFRSs Learning Objectives: In this chapter (3), we discuss a case similar to KIELING TAXI GmbH of chapter (2) but we make all its Bookkeeping entries along international format. We teach how financial statements are prepared based on International Financial Reporting Standards IFRSs. Before we focus on the case, we introduce International Accounting Standards in order to provide you with knowledge of how to find, understand and apply the standards. Thereafter, we discuss a foreign case study where IFRSs apply. After studying this chapter, you can prepare financial statements for easy Accounting cases that follow IFRSs and include a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity and a statement of cash flows. Notes will be covered later, in chapter (5). IFRSs are the standards that apply for international Accounting. They are issued by the International Accounting Standard Board IASB. Prior to the Accounting work, you have to know how to get hold of the standards. For academic purposes at the university, the IFRS Foundation offers you free access to the standards. You have to register with a username and password. With these you can access your IFRS account. Our one is shown in the screenshot below in Figure 3.1. Figure 3.1: Signing-in to IFRS Foundation.org (example) Once you signed in, you can download unaccompanied standards, meaning actual standards in their original version. They do not charge you. You also <?page no="35"?> Berkau: Financial Statements 4e 3-31 find additional materials on the website. See Figure 3.2. Figure 3.2: IFRS.org: Standards for download International Accounting now applies in many parts of the world, including South Korea, European Union, India, Hong Kong, Australia, Malaysia, Pakistan, GCC countries 6 , Russia, Chile, Philippines, South Africa, Singapore and Turkey, but not in the United States. In this text book we cover cases with company headquartered in countries where IFRSs apply. For the application of IFRSs in Europe, read our Basics-1, chapter (3). Below, we demonstrate the application of IFRSs with the fictitious case study KENILWORTH METERED TAXI SERVICE Ltd. assumed to be based in the Republic of South Africa (RSA). The currency unit in this case study is South African Rand ZAR. 6 GCC = Council Cooperation for the Arab states of the Gulf 7 FNB = First National Bank of South Africa. KENILWORTH METERED TAXI SERVICE Ltd. is a South African taxi company that provides metered taxi service and airport shuttle services and is established in Cape Town by the issue of 500,000 ordinary shares at 10.00 ZAR each. At the time of incorporation, the company’s share capital is amounting to: 10 × 500,000 = 5 5,000,000.00 ZAR which is the book value at that time. The owners pay the amount into KENILWORTH METERED TAXI Service Ltd.’s bank account at FNB bank 7 . They further set up a memorandum of incorporation and establish the business online through CIPC 8 . At the same time, the company is registered at the South African Revenue Service SARS for VAT reduction. The VAT rate from chapter (1) applies: 20 %. The name of the new company is KENILWORTH METERED TAXI 8 CIPC = Companies and Intellectual Property Commission, check CIPC.co.za. <?page no="36"?> Berkau: Financial Statements 4e 3-32 SERVICE Ltd. which we abbreviate as KMTS Ltd. in the text. The opening balance sheet is prepared in accordance with IAS 1.54. It is laid out below in Figure 3.3. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E Share capital 5,000,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities (liab.) Inventory Long-term liab. Acc. receivables A/ R Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 5,000,000 Income tax liab. Total assets 5,000,000 Total equity and liab. 5,000,000 Kenilworth Metered Taxi Service Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X1 Figure 3.3: KMTS Ltd.’s opening balance sheet On 2.01.20X1, KENILWORTH METERED TAXI SERVICE Ltd. buys 10 Toyota taxis at a purchase price of 360,000.00 ZAR/ car per bank transfer. The price is the gross amount. The Accountant makes Bookkeeping entry (1). Note, we do not distinguish here between cash and bank as we later combine both amounts to the item cash/ bank on the balance sheet. For a real business it is recommended to distinguish the accounts. As the case study is fairly simple, we apply the Property, Plant, Equipment PPE account. Alternatively, KENILWORTH METERED TAXI SERVICE Ltd. could use a Motor Vehicle account as a subordinated account towards the P, P, E account. As we do not follow a standardised chart of accounts for international Accounting, the name of the account does not matter. The procedure is simplified in contrast to common Accounting practice. In general, companies apply a standardised chart of accounts. Neither do we follow a specific format for the structure of the balance sheet. IAS 1.57 states that the standard (IAS 1) does not prescribe the order or format of presentation. DR P, P, E Account.............. 3,000,000.00 ZAR DR VAT.......................... 600,000.00 ZAR CR Cash/ Bank.................... 3,600,000.00 ZAR We consider depreciation as part of the adjustments later in this case study. Adjustments are Bookkeeping entries you make at the end of the Accounting period in preparation of the financial statements. <?page no="37"?> Berkau: Financial Statements 4e 3-33 Similar to the previous case study, the cars are transformed into metered taxi cars at a taxi equipment specialist. The alteration costs 24,000.00 ZAR/ car. The amount is net of VAT. Hence, KENILWORTH METERED TAXI SERVICE Ltd. pays: 120% × 24,000 × 10 = 2 288,000.00 ZAR. It is recorded as Bookkeeping entry (2): DR P, P, E ACCOUNT.............. 240,000.00 ZAR DR VAT.......................... 48,000.00 ZAR CR Cash/ Bank.................... 288,000.00 ZAR During the Accounting period 20X1, KENILWORTH METERED TAXI SERVICE Ltd. earns a revenue of 12,500,000.00 ZAR. Due to registration for VAT reduction the passengers pay the gross amount which includes output-VAT. It gives a total annual receipt of: 120% × 12,500,000 = 1 15,000,000.00 ZAR. The revenue recognition is recorded by the Bookkeeping entry (3) below. Again, we assume the Bookkeeping entry is recorded in the middle of the year to keep the case study simple. DR Cash/ Bank.................... 15,000,000.00 ZAR CR VAT.......................... 2,500,000.00 ZAR CR Revenue...................... 12,500,000.00 ZAR The drivers at KENILWORTH METERED TAXI SERVICE Ltd. earn 500,000.00 ZAR/ (a × driver). The company employs 14 drivers. All drivers work on a freelancer basis. The labour for taxi drivers equals to: 14 × 500,000 = 7 7,000,000.00 ZAR/ a. Accounting for labour results in Bookkeeping entry (4) below, as recorded on 30.06.20X1. 9 DR Labour....................... 7,000,000.00 ZAR CR Cash/ Bank.................... 7,000,000.00 ZAR The dispatcher at KENILWORTH METERED TAXI SERVICE Ltd. earns 650,000.00 ZAR/ a. The dispatcher works on the radio and assigns taxi ride orders to the drivers. The manager/ Accountant at KENILWORTH METERED TAXI SERVICE Ltd. earns 1,000,000.00 ZAR/ a. On 30.06.20X1, labour for dispatcher and management/ Accounting is recorded as Bookkeeping entry (5). It is amounting to: 650,000 + 1,000,000 = 1,650,000.00 ZAR. DR Labour....................... 1,650,000.00 ZAR CR Cash/ Bank.................... 1,650,000.00 ZAR 9 The consideration as freelancers simplifies the case study. For Accounting for labour, read our Basics-1, chapter (19). <?page no="38"?> Berkau: Financial Statements 4e 3-34 Operational expenses for the taxi cars, e.g., for petrol, maintenance, spare parts, repairs etc., cost 2,000,000.00 ZAR/ a. The amount is paid to 3 rd party companies and, as a consequence, is subject to VAT. Hence, the paid amount is: 120% × 2,000,000 = 2 2,400,000.00 ZAR/ a. It is recorded as Bookkeeping entry (6) below on 30.06.20X1. At this stage, we acknowledge all amounts paid to other companies or received therefrom include a VAT portion as default case. This rule applies as we assume every company in this text book is in the legal form of a limited company and registered for VAT reduction and has to collect output-VAT from its customers. When KENILWORTH METERED TAXI SERVICE Ltd. buys spare parts from its supplier, the supplier adds VAT to the costs of purchase. All elements linked to the statement of profit or loss and other comprehensive income are net amounts. Hence, whenever you read “cost of” you know the amount is net of VAT. For the calculation of the gross amount multiply by 120 %. DR Operational Expenses......... 2,000,000.00 ZAR DR VAT.......................... 400,000.00 ZAR CR Cash/ Bank.................... 2,400,000.00 ZAR For the rent of the office building and the garages, KENILWORTH METERED TAXI SERVICE Ltd. pays 12,000.00 ZAR/ m. No input-VAT is included in the rent payments. KENILWORTH METERED TAXI SERVICE Ltd. rents from a private person that is not registered for VAT reduction and, as a consequence, does not disclose input-VAT on the contract. Hence, KENILWORTH METERED TAXI SERVICE Ltd. cannot claim VAT for rent from the South African Revenue Service SARS. For the case study, rent is due one month in advance. However, rent for January 20X1 is paid on 2.01.20X1. In total, KENILWORTH METERED TAXI SERVICE Ltd. makes 13 payments for rent in 20X1, the last one for January 20X2. Rent payments are amounting to: 13 × 12,000 = 1 156,000.00 ZAR. For simplification, we make only one Bookkeeping entry, observe below: DR Rent......................... 156,000.00 ZAR CR Cash/ Bank.................... 156,000.00 ZAR Next, we show KENILWORTH METERED TAXI SERVICE Ltd.’s Bookkeeping records in Figure 3.4. The accounts have not been balanced-off yet. <?page no="39"?> Berkau: Financial Statements 4e 3-35 D C D C OV 5,000,000.00 (1) 3,600,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 (2) 48,000.00 (6) 400,000.00 Property, Plant, Equipment PPE Value addedd tax VAT [20%] D C D C (3) 12,500,000.00 (4) 7,000,000.00 (5) 1,650,000.00 Revenue-20X1 REV Labour-20X1 LAB D C D C (6) 2,000,000.00 (7) 156,000.00 Operational expenses-20X1 OEX Rent-20X1 RNT Figure 3.4: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts Before profit calculation, KENILWORTH METERED TAXI SERVICE Ltd. records the adjustments at the end of the Accounting period. Here, the 1 st Bookkeeping entry is for depreciation. Depreciation is calculated only for the taxis. It is based on straight-line method and a useful life of 4 years. No residual value applies. Annual depreciation equals to: 3,240,000 / 4 = 8 810,000.00 ZAR/ a. On 31.12.20X1, the Accountant records depreciation by Bookkeeping entry (8): In contrast to chapter (2), the credit entry now is made in the Accumulated Depreciation account. This is the default account when IFRSs apply in contrast to German Bookkeeping. The reason is the possibility of revaluations as discussed later in chapter (7). DR Depreciation ................. 810,000.00 ZAR CR Acc. Depr.................... 810,000.00 ZAR Another adjustment is made for accruals. 10 The recording of 13 months of rental payments requires to assign the last one to prepaid expenses. The company pays in December 20X1 rent for January 20X2. In order to allocate the 10 Read our Basics-1, chapter (13) and chapter (18). 13 th payment to the business activities in the next year, the Accountant transfers one monthly rent payment of 12,000.00 ZAR into the Prepaid Expenses account. At the beginning of the next Accounting period, KENILWORTH METERED TAXI <?page no="40"?> Berkau: Financial Statements 4e 3-36 SERVICE Ltd. will transfer the amount back into the Rent-20X2 account, see further below in this chapter (3). DR Prepaid expenses............. 12,000.00 ZAR CR Rent......................... 12,000.00 ZAR After completion of original Bookkeeping entries and making some adjustments already, we balance-off all accounts. Observe the balanced-off accounts at KENILWORTH METERED TAXI SERVICES Ltd. below in Figure 3.5. D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 b/ d 1,452,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C c/ d 12,500,000.00 (3) 12,500,000.00 (4) 7,000,000.00 b/ d 12,500,000.00 (5) 1,650,000.00 c/ d 8,650,000.00 8,650,000.00 8,650,000.00 b/ d 8,650,000.00 Revenue-20X1 REV Labour-20X1 LAB D C D C (6) 2,000,000.00 c/ d 2,000,000.00 (7) 156,000.00 (8) 12,000.00 b/ d 2,000,000.00 c/ d 144,000.00 156,000.00 156,000.00 b/ d 144,000.00 Operational expenses-20X1 OEX Rent-20X1 RNT Figure 3.5: KMTS Ltd.’s accounts after adjustments (20X1) <?page no="41"?> Berkau: Financial Statements 4e 3-37 D C D C (7) 810,000.00 c/ d 810,000.00 c/ d 810,000.00 (7) 810,000.00 b/ d 810,000.00 b/ d 810,000.00 Depreciation-20X1 DPR Acc depr ACC D C (8) 12,000.00 c/ d 12,000.00 b/ d 12,000.00 Prepaid expenses PRE Figure 3.5: KMTS Ltd.’s accounts after adjustments (20X1) continued The next following step is the profit or loss calculation. We close-off all nominal accounts to the Profit and Loss account. You see that nominal accounts are indicated by the Accounting period in Figure 3.5. This applies for: - Rent-20X1. - Labour-20X1. - Operational expenses-20X1. - Depreciation-20X1. - Revenue-20X1. In order to later understand the Profit and Loss account easily, we do not use numbers for Bookkeeping entry identification but a 3-letter-code that refers to the contra account. See the Profit and Loss account in Figure 3.6. The codes correspond to the abbreviations shown on the accounts’ headers. The name of the income statement and the Profit and Loss account has changed during the recent years. This was caused by revisions of IAS 1. The first name was income statement, then profit and loss and now it is profit or loss and other comprehensive income. We apply income statement or the official name statement of profit or loss and other comprehensive income but stick to name of the account as Profit and Loss account and its abbreviation P&L. If the year matters we replace & by the year identifier, such as P1L for P&L-20X1. The pre-tax profit of KENILWORTH METERED TAXI SERVICE Ltd. equals to: 12,500,000 - 2,000,000 - 144,000 - 810,000 - 8,650,000 = 8 896,000.00 ZAR. The pre-tax-profit is the earnings before taxation EBT. The amounts for profit calculation are: - Revenue: 12,500,000.00 ZAR. - Operational expenses: 2,000,000.00 ZAR. - Rent: 144,000.00 ZAR. - Depreciation: 810,000.00 ZAR. - Labour: 8,650,000.00 ZAR. Based on our income tax model, 30 % of EBT gives the total income taxes. Hence, the earnings after taxes EAT equal to: 896,000 × (1 - 30%) = 6 627,200.00 ZAR. We refer to that amount as the annual surplus A/ S, as well. Check the accounts as displayed in Figure 3.6 after completion of adjustments. <?page no="42"?> Berkau: Financial Statements 4e 3-38 D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 b/ d 1,452,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C c/ d 12,500,000.00 (3) 12,500,000.00 (4) 7,000,000.00 P&L 12,500,000.00 b/ d 12,500,000.00 (5) 1,650,000.00 c/ d 8,650,000.00 8,650,000.00 8,650,000.00 b/ d 8,650,000.00 P&L 8,650,000.00 Revenue-20X1 REV Labour-20X1 LAB D C D C (6) 2,000,000.00 c/ d 2,000,000.00 (7) 156,000.00 (8) 12,000.00 b/ d 2,000,000.00 P&L 2,000,000.00 c/ d 144,000.00 156,000.00 156,000.00 b/ d 144,000.00 P&L 144,000.00 D C D C (7) 810,000.00 c/ d 810,000.00 c/ d 810,000.00 (7) 810,000.00 b/ d 810,000.00 P&L 810,000.00 b/ d 810,000.00 Operational expenses-20X1 OEX Rent-20X1 RNT Depreciation-20X1 DPR Acc depr ACC Figure 3.6: KMTS Ltd.’s accounts after profit calculation (20X1) <?page no="43"?> Berkau: Financial Statements 4e 3-39 D C D C (8) 12,000.00 c/ d 12,000.00 OEX 2,000,000.00 REV 12,500,000.00 b/ d 12,000.00 RNT 144,000.00 DPR 810,000.00 LAB 8,650,000.00 EBT 896,000.00 12,500,000.00 12,500,000.00 ITE 268,800.00 b/ d 896,000.00 R/ E 627,200.00 896,000.00 896,000.00 Prepaid expenses PRE Profit and Loss-20X1 P&L D C D C ITL 268,800.00 c/ d 268,800.00 c/ d 268,800.00 ITE 268,800.00 b/ d 268,800.00 P&L 268,800.00 b/ d 268,800.00 D C c/ d 627,200.00 P&L 627,200.00 b/ d 627,200.00 Income tax expenses ITE Income tax liabilities ITL Retained earnings R/ E Figure 3.6: KMTS Ltd.’s accounts after profit calculation (20X1) continued The Profit and Loss account gives already a good indication of the relationship between revenue and expenses. We see how much profit is. In contrast to the Profit and Loss account, IAS 1.81A - 1.82B do not instruct to disclose all single items of expenses separately on the statement of profit or loss and other comprehensive income. For instance, KENILWORTH METERED TAXI SERVICE Ltd. can aggregate operational expenses and rent to an item other expenses on the statement of profit or loss and other comprehensive income. Its amount then equals to: 2,000,000 + 144,000 = 2 2,144,000.00 ZAR. Find below the income statement for KENILWORTH METERED TAXI SERVICE Ltd. in Figure 3.7. <?page no="44"?> Berkau: Financial Statements 4e 3-40 [ZAR] Revenue 12,500,000 Other income 12,500,000 Materials Labour (8,650,000) Depreciation (810,000) Other expenses (2,144,000) Earnings before int. & taxes (EBIT) 896,000 Interest Earnings before taxes (EBT) 896,000 Income tax expenses (268,800) Deferred taxes Earnings after taxes (EAT) 627,200 Kenilworth Metered Taxi Service Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X1 Figure 3.7: KMTS Ltd.’s income statement (20X1) The next statement to prepare is the balance sheet. IAS 1.10 calls it the statement of financial position. In the case of KENILWORTH METERED TAXI SERVICE Ltd., only few accounts need to be combined for disclosure, all other items are linked to the real accounts by a 1: 1 relationship. The amount for the item property, plant, equipment is derived from the Property, Plant, Equipment account and the Accumulated Depreciation account and gives: 3,240,000 - 810,000 = 2,430,000.00 ZAR. The value for Accounts Payables only includes the difference between output-VAT and input- VAT which is: 11,452,000.00 ZAR. In contrast to German Bookkeeping, there is only one VAT account. Hence, no further calculation is required once the account is balanced-off. Observe the balance sheet in Figure 3.8. <?page no="45"?> Berkau: Financial Statements 4e 3-41 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 2,430,000 Share capital 5,000,000 Intangibles Reserves Financial assets Retained earnings 627,200 Current assets Liabilities (liab.) Inventory Long-term liab. Acc. receivables A/ R Short-term liab. A/ P 1,452,000 Prepaid expenses 12,000 Provisions Cash/ Bank 4,906,000 Income tax liab. 268,800 Total assets 7,348,000 Total equity and liab. 7,348,000 Kenilworth Metered Taxi Service Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 3.8: KMTS Ltd.’s balance sheet (20X1) IAS 1.10 says a full set of financial statements comprises of a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of cash flows and a statement of changes in equity. Additionally, notes are required. You find both remaining statements below in Figure 3.9 and Figure 3.10. The cash flow in 20X1 is negative as the closing balance of the Cash/ Bank item is lower than its opening balance. The cash flow is the difference between balancing figure and opening amount and gives: 4,906,000 - 5,000,000 = -994,000.00 ZAR. KENILWORTH METERED TAXI SERVICE Ltd. burned cash by its business operations so far, but consider that the negative cash flows results from investments. It is not seldom that companies disclose in the first years negative total cash flows due to payments for their acquisitions. In order to understand whether or not the book value of the company changed, we disclose a company’s equity development by a statement of changes in equity. Here, equity changed by: 5,627,200 - 5,000,000 = 6 627,200.00 ZAR, which results in a return on equity after taxes of 627,200/ 5,000,000 = 1 12.54%. <?page no="46"?> Berkau: Financial Statements 4e 3-42 Cash flow from operating acitivities [ZAR] [ZAR] Proceeds 15,000,000 Operating expenses (2,400,000) Labour (8,650,000) Rent (156,000) 3,794,000 Cash flow from investing activities Investments (3,888,000) (3,888,000) Cash flow from financing activities 0 Total cash flow (94,000) Kenilworth Metered Taxi Service Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X1 Figure 3.9: KMTS Ltd.’s cash flow statement (20X1) Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X1 5,000,000 5,000,000 Profit 20X1 627,200 627,200 as at 31.12.20X1 5,000,000 0 627,200 5,627,200 Kenilworth Metered Taxi Service Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X1 Figure 3.10: KMTS Ltd.’s statement of changes in equity (20X1) After we prepared the first Accounting period’s financial statements, we continue with the next Accounting period 20X2. Applying international Accounting we continue all real accounts. This is why we do not add an Accounting period’s indicator to their names. Internationally, no opening nor closing accounts apply. The reason is that in Germany the financial statements are considered as elements of the double entry system whereas internationally they are not. All nominal accounts are fresh because the previous ones got closed-off to the Profit and Loss account. 11 11 Read our Basics-1, chapter (31). In regard to the case study KENILWORTH METERED TAXI SERVICE Ltd., we observe how the company continues its business: In contrast to the previous Accounting period 20X1, it earns higher revenue, now 13,200,000.00 ZAR and hires 2 new taxi drivers. Furthermore, the landlord increases rent from 1.07.20X2 onwards by 15 %. The new rent is amounting to: (1 + 15%) × 12,000 = 1 13,800.00 ZAR/ m. Otherwise, nothing changes. No investments are made in the new Accounting period 20X2. Once we start the new Accounting period, some initial Bookkeeping entries <?page no="47"?> Berkau: Financial Statements 4e 3-43 are required to record. These initial Bookkeeping entries, in general, can include: - Prepaid expenses from last year. - Income tax payments. - VAT payments. - Payments of other short-term liabilities, e.g., resulting from supplies. - Collection of receivables as scheduled. - Payment of dividends. KENILWORTH METERED TAXI SERVICE Ltd. transfers 12,000.00 ZAR prepaid rent from the Prepaid Expenses account into the Rent-20X2 account. The Bookkeeping entry is (A). In order to distinguish Bookkeeping entries from different Accounting periods we alter the identifier type. We now apply capitals to mark the new Bookkeeping entries for 20X2. DR Rent......................... 12,000.00 ZAR CR Prepaid Expenses............. 12,000.00 ZAR KENILWORTH METERED TAXI SERVICE Ltd. pays income taxes from 20X1 due in the Accounting period 20X2. Another tax payment is for the excess of output-VAT over input-VAT which results in a payment of 1,452,000.00 ZAR. Observe Bookkeeping entries (B) and (C), both recorded on 1.01.20X2. DR Income Tax Liabilities....... 268,800.00 ZAR CR Cash/ Bank.................... 268,800.00 ZAR DR VAT.......................... 1,452,000.00 ZAR CR Cash/ Bank.................... 1,452,000.00 ZAR Observe the accounts after initial Bookkeeping entries we made in Figure 3.11. As last year’s entries are of no further interest, we grey them out in our text book. D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 (B) 268,800.00 (C) 1,452,000.00 Cash/ Bank C/ B Issued capital ISS Figure 3.11: KMTS Ltd.’s accounts (20X2) <?page no="48"?> Berkau: Financial Statements 4e 3-44 D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 (C) 1,452,000.00 b/ d 1,452,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C (8) 12,000.00 c/ d 12,000.00 c/ d 810,000.00 (7) 810,000.00 b/ d 12,000.00 (A) 12,000.00 b/ d 810,000.00 Prepaid expenses PRE Acc depr ACC D C D C c/ d 627,200.00 P&L 627,200.00 c/ d 268,800.00 ITE 268,800.00 b/ d 627,200.00 (B) 268,800.00 b/ d 268,800.00 D C (A) 12,000.00 Rent-20X2 RNT Retained earnings R/ E Income tax liabilities ITL Figure 3.11: KMTS Ltd.’s accounts (20X2) continued In 20X2, the Bookkeeping entries below for business activities are recorded: (D) Revenue 13,200,000.00 ZAR. The gross amount equals to: 120% × 13,200,000 = 1 15,840,000.00 ZAR. All passengers pay on cash. The Bookkeeping entry (D) is recorded on 30.06.20X2. DR Cash/ Bank.................... 15,840,000.00 ZAR CR VAT.......................... 2,640,000.00 ZAR CR Revenue...................... 13,200,000.00 ZAR (E) Labour: There are now 16 drivers employed. We also consider 1 dispatcher and the manager/ Accountant: 16 × 500,000 + 650,000 + 1,000,000 = 9,650,000.00 ZAR. Bookkeeping entry (E) for labour is made on 30.06.20X2. DR Labour....................... 9,650,000.00 ZAR CR Cash/ Bank.................... 9,650,000.00 ZAR (F) Rent increases in the middle of the year. As there was a prepayment for 20X2 already, the Bookkeeping entries in total are: 5 × 12,000 + 7 × 13,800 = 156,600.00 ZAR. As the rent for January has already been paid in December <?page no="49"?> Berkau: Financial Statements 4e 3-45 20X1, only 5 rental payments at 12,000.00 ZAR/ m are made. The next following payments are for July 20X2 - January 20X3 and amount to 13,800.00 ZAR/ m each. At the end of the year, the rent for January 20X3 will be transferred into the Prepaid Expenses account. Below, you see the Bookkeeping entry (F) for rent as simplification of 12 single Bookkeeping entries. DR Rent......................... 156,600.00 ZAR CR Cash/ Bank.................... 156,600.00 ZAR (G) Operational expenses are still 2,000,000.00 ZAR/ a. They are recorded on 30.06.20X2. DR Operating Expenses........... 2,000,000.00 ZAR DR VAT.......................... 400,000.00 ZAR CR Cash/ Bank.................... 2,400,000.00 ZAR We also record adjustments, they are made for depreciation and the rent accrual. They give Bookkeeping entries (H) and (I), as recorded on the 31.12.20X2. DR Depreciation ................. 810,000.00 ZAR CR Acc. Depr.................... 810,000.00 ZAR DR Prepaid Expenses............. 13,800.00 ZAR CR Rent......................... 13,800.00 ZAR As in the previous Accounting period, we balance-off all accounts and close-off all nominal accounts for 20X2 to the Profit and Loss account. Based on the recordings we calculate the profit for 20X2. Observe the accounts for 20X2 in Figure 3.12. <?page no="50"?> Berkau: Financial Statements 4e 3-46 D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 (B) 268,800.00 (D) 15,840,000.00 (C) 1,452,000.00 (E) 9,650,000.00 (F) 156,600.00 (G) 2,400,000.00 c/ d 6,818,600.00 20,746,000.00 20,746,000.00 b/ d 6,818,600.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 (C) 1,452,000.00 b/ d 1,452,000.00 (G) 400,000.00 (D) 2,640,000.00 c/ d 2,240,000.00 4,092,000.00 4,092,000.00 b/ d 2,240,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C (8) 12,000.00 c/ d 12,000.00 c/ d 810,000.00 (7) 810,000.00 b/ d 12,000.00 (A) 12,000.00 b/ d 810,000.00 (I) 13,800.00 c/ d 13,800.00 c/ d 1,620,000.00 (H) 810,000.00 25,800.00 25,800.00 1,620,000.00 1,620,000.00 b/ d 13,800.00 b/ d 1,620,000.00 Prepaid expenses PRE Acc depr ACC D C D C c/ d 627,200.00 P&L 627,200.00 c/ d 268,800.00 ITE 268,800.00 b/ d 627,200.00 (B) 268,800.00 b/ d 268,800.00 c/ d 1,036,840.00 P2L 409,640.00 c/ d 175,560.00 ITE 175,560.00 1,036,840.00 1,036,840.00 444,360.00 444,360.00 b/ d 1,036,840.00 b/ d 175,560.00 Retained earnings R/ E Income tax liabilities ITL Figure 3.12: KMTS Ltd.’s accounts after profit calculation (20X2) <?page no="51"?> Berkau: Financial Statements 4e 3-47 D C D C (A) 12,000.00 (I) 13,800.00 c/ d 13,200,000.00 (D) 13,200,000.00 (F) 156,600.00 c/ d 154,800.00 P2L 13,200,000.00 b/ d 13,200,000.00 168,600.00 168,600.00 b/ d 154,800.00 P2L 154,800.00 D C D C (E) 9,650,000.00 c/ d 9,650,000.00 (G) 2,000,000.00 c/ d 2,000,000.00 b/ d 9,650,000.00 P2L 9,650,000.00 b/ d 2,000,000.00 P2L 2,000,000.00 Labour-20X2 LAB Operational expenses-20X2 OEX Rent-20X2 RNT Revenue-20X2 REV D C D C (H) 810,000.00 c/ d 810,000.00 RNT 154,800.00 REV 13,200,000.00 b/ d 810,000.00 P2L 810,000.00 LAB 9,650,000.00 OEX 2,000,000.00 DPR 810,000.00 EBT 585,200.00 13,200,000.00 13,200,000.00 ITE 175,560.00 b/ d 585,200.00 R/ E 409,640.00 585,200.00 585,200.00 D C ITL 175,560.00 c/ d 175,560.00 b/ d 175,560.00 P2L 175,560.00 Depreciation-20X2 DPR Profit and Loss-20X2 P2L Income tax expensess-20X2 ITE Figure 3.12: KMTS Ltd.’s accounts after profit calculation (20X2) continued Investors in companies seek a return on funds they paid into the business. In a company based on shares the payment to the investors as their profit share is called a dividend. KENILWORTH METERED TAXI SERVICE Ltd. did not pay dividends in 20X1. This means shareholders did not receive any returns so far. On the annual general meeting at the beginning of 20X3 when the chief executive officer CEO reports on the previous Accounting period 20X2 and presents and explains the financial statements, the shareholders agree to declare a dividend of 30 % of the distributable amount. The amount distributable for dividend payments is the profit carried forward plus the annual surplus in 20X2. The amount can be reduced for preference dividends. National restrictions might apply too. In the case of KENILWORTH METERED TAXI SERVICE Ltd., the distributable amount shows in the Retained Earnings account, compare Figure 3.13. It is amounting to: 627,200 + 409,640 = 1 1,036,840.00 ZAR. Based on the decision made on the annual general meeting, 30 % is to pay to the shareholders, which equals to: 30% × 1,036,840 = 311,052.00 ZAR. 20 % is to be transferred to the Earnings Reserves account, which equals to: 20% × 1,036,840 = <?page no="52"?> Berkau: Financial Statements 4e 3-48 2207,368.00 ZAR. The remaining amount is carried forward to the next Accounting period and its appropriation will be discussed on the next annual general meeting in 20X4 for profits in 20X3. In general, international corporations prepare financial statements under consideration of the appropriation of profits. KENILWORTH METERED TAXI SERVICE Ltd. records the dividend as payables. They will be paid in 20X3. The account that applies is the Shareholder for Dividend account. It falls under payables (A/ P account). The additions to earnings reserves increase the equity because they remain in the business, e.g., for reinvestments. The remaining amount that is not appropriated according to the decision made on the annual general meeting is carried forward to the next Accounting period. No Bookkeeping entry is required for carrying forward profit or loss as the amount just stays in the Retained Earnings account. An investor who holds 10,000 ordinary shares of KENILWORTH METERED TAXI SERVICE Ltd. receives a dividend of: (10,000/ 500,000) × 311,052 = 6 6,221.04 ZAR. The return on investment is: 6,221.04 / 100,000 = 6 6.22%. The investor also benefits from the increase in equity, as the book value of the company increases by: (1,036,840 - 311,052) / 5,000,000 = 1 14.52%. DR Retained Earnings............ 311,052.00 ZAR CR Shareholders 4 Dividend A/ P.. 311,052.00 ZAR DR Retained Earnings............ 207,368.00 ZAR CR Earnings Reserves............ 207,368.00 ZAR Below, we disclose only accounts relevant for the appropriation of profits. Study Figure 3.13. D C D C c/ d 627,200.00 P&L 627,200.00 c/ d 207,368.00 R/ E 207,368.00 b/ d 627,200.00 b/ d 207,368.00 c/ d 1,036,840.00 P2L 409,640.00 1,036,840.00 1,036,840.00 S4D 311,052.00 b/ d 1,036,840.00 E-R 207,368.00 c/ d 518,420.00 1,036,840.00 1,036,840.00 b/ d 518,420.00 Retained earnings R/ E Earnings reserves E-R Figure 3.13: KMTS Ltd.’s accounts for profit appropriation (20X2) <?page no="53"?> Berkau: Financial Statements 4e 3-49 D C c/ d 311,052.00 R/ E 311,052.00 b/ d 311,052.00 Shareholder for dividend S4D Figure 3.13: KMTS Ltd.’s accounts for profit appropriation (20X2) continued KENILWORTH METERED TAXI SERVICE Ltd. prepares its financial statements based on the appropriation of profits. See below the set of financial statements except of the notes. Observe Figure 3.14, Figure 3.15, Figure 3.16 and Figure 3.17. [ZAR] Revenue 13,200,000 Other income 13,200,000 Materials Labour (9,650,000) Depreciation (810,000) Other expenses (2,154,800) Earnings before int. & taxes (EBIT) 585,200 Interest Earnings before taxes (EBT) 585,200 Income tax expenses (175,560) Deferred taxes Earnings after taxes (EAT) 409,640 Kenilworth Metered Taxi Service Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X2 Figure 3.14: KMTS Ltd.’s income statement (20X2) A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 1,620,000 Share capital 5,000,000 Intangibles Reserves 207,368 Financial assets Retained earnings 518,420 Current assets Liabilities (liab.) Inventory Long-term liab. Acc. receivables A/ R Short-term liab. A/ P 2,551,052 Prepaid expenses 13,800 Provisions Cash/ Bank 6,818,600 Income tax liab. 175,560 Total assets 8,452,400 Total equity and liab. 8,452,400 Kenilworth Metered Taxi Service Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 3.15: KMTS Ltd.’s balance sheet (20X2) <?page no="54"?> Berkau: Financial Statements 4e 3-50 Cash flow from operating acitivities [ZAR] [ZAR] Proceeds 15,840,000 Operating expenses (2,400,000) Labour (9,650,000) Rent (156,600) Tax payments (1,720,800) 1,912,600 Cash flow from investing activities 0 Cash flow from financing activities 0 Total cash flow 1,912,600 Kenilworth Metered Taxi Service Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X2 Figure 3.16: KMTS Ltd.’s cash flow statement (20X2) Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X1 5,000,000 5,000,000 Profit 20X1 627,200 627,200 as at 31.12.20X1 5,000,000 0 627,200 5,627,200 Profit 20X2 409,640 409,640 Dividend 20X2 (311,052) (311,052) Additions Res. 20X2 207,368 (207,368) 0 as at 31.12.20X1 5,000,000 207,368 518,420 5,725,788 Kenilworth Metered Taxi Service Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X2 Figure 3.17: KMTS Ltd.’s statement of changes in equity (20X2) Summary: International Bookkeeping is slightly different to the German way. However, the double entry system applies, too. The preparation of financial statements is based on nominal and real accounts. No opening nor closing accounts apply. In general, companies prepare financial statements under consideration of the appropriation of profits. The appropriation of profits either adds earnings to reserves for reinvestments or to dividends payable in the future. Profit or loss not appropriated is transferred into the next Accounting period and shows as balance brought forward in the Retained Earnings account. IAS 1.10 defines that a full set of financial statements, when ignoring changes in Accounting policies as covered by IAS 8, includes a balance sheet (statement of financial position), an income statement (statement of profit or loss and other comprehensive income), a statement of cash flows, a statement of changes in equity and the notes. <?page no="55"?> Berkau: Financial Statements 4e 3-51 Accounting Technical Terms: Appropriation of profits, under: If financial statements are prepared under the appropriation of profits, dividends and additions to reserves are considered. International Accounting Standards IFRSs: Standards issued by the International Accounting Standard Board that are either an IAS (International Accounting Standard) or an IFRS (International Financial Accounting Standard). Paragraph: Section of a Standard. Paragraphs are identified by numbers. Set of financial statements: In line with IAS 1.10, a set of financial statement comprises a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows and the notes. It can include a further balance sheet if IAS 8 applies in regard to changes in Accounting policies. Standard setter: Organisation that issues the standards. For IFRSs, the standard setter is the International Accounting Standard Board headquartered in Canary Wharf, London. Statement of cash flows: A statement that shows increases and decreases of the cash/ bank item structured by classifications: operative, investing and financing. Statement of changes in equity: A statement that discloses the additions and deductions with regard to equity items on the balance sheet. Statement of financial position: Balance sheet. Statement of profit or loss and other comprehensive income: Income statement based on IFRSs. It discloses operating profits and extraordinary earnings and expenses. Question Bank: (1) A company reporting in accordance with IFRSs has to disclose … 1. .… a statement of financial position, an income statement, a statement of cash flows and notes. 2. … a balance sheet, an income statement, a statement of changes in equity, a statement of cash flows and notes. 3. … a statement of financial position, a statement of profit or loss and other comprehensive income, a cash flow statement, a register of non-current assets and the notes. 4. … a balance sheet, an income statement, a statement of cash flows, a statement of changes of liabilities and notes. (2) A company that prepares financial statements in accordance with IFRSs has to disclose a statement of cash flows … 1. … only if participating on the capital market. 2. … in any case. 3. … when a group member 4. …not as a group member as the parent discloses changes in cash flows already. (3) A company that pays 12,000.00 EUR for labour and makes 1 monthly payment in advance, records labour in the actual Accounting period as below: 1. DR Labour … 12,000.00 EUR, CR Cash/ Bank … 12,000.00 EUR. DR <?page no="56"?> Berkau: Financial Statements 4e 3-52 Prepaid expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 2. DR Labour … 1,000.00 EUR, CR Prepaid expenses … 1,000.00 EUR. DR Labour … 12,000.00 EUR, CR Cash/ Bank … 12,000.00 EUR. DR Prepaid expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 3. DR Prepaid expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. DR Labour … 11,000.00 EUR, CR Cash/ Bank … 11,000.00 EUR. DR Prepaid expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 4. DR Labour … 11,000.00 EUR, CR Cash/ Bank … 11,000.00 EUR. DR Prepaid expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. (4) A company that makes the debit entries (Labour: 10,000.00 EUR, Rent: 1,200.00 EUR, Prepaid insurance: 450.00 EUR, Depreciation on factory building: 600.00 EUR, Depreciation on motor vehicles: 900.00 EUR, Operational expenses 2,400.00 EUR), discloses the expenses below on the statement of profit or loss and other comprehensive income: 1. Labour: 10,000.00 EUR, Rent: 1,200.00 EUR, Prepaid expenses 450.00 EUR, Depreciation: 1,500.00 EUR, Other expenses: 2,400.00 EUR. 2. Labour: 10,000.00 EUR, Rent: 1,200.00 EUR, Depreciation: 1,500.00 EUR, Other expenses: 4,050.00 EUR. 3. Labour: 10,000.00 EUR, Depreciation: 1,500.00 EUR, Other expenses: 3,600.00 EUR. 4. Labour: 10,450.00 EUR, Depreciation: 1,500.00 EUR, Other expenses: 3,600.00 EUR. (5) A company pays for this year’s rent 1,080.00 EUR during this Accounting period and 360.00 EUR in the next one. Rent is subject to VAT. How much is the rent on the income statement? 1. 900.00 EUR. 2. 1,080.00 EUR. 3. 1,200.00 EUR. 4. 1,440.00 EUR. Solutions: 1-2, 2-2, 3-2, 4-3, 5-3. <?page no="57"?> Berkau: Financial Statements 4e 4-53 4. Accounting for Retailers Learning Objectives: This chapter (4) is an introduction to Bookkeeping and the preparation of financial statements for international trading companies. We cover most common instruments in Bookkeeping, such as the Trial Balance and the Trading account T/ A. The chapter becomes important if you are new in Accounting or learned German Bookkeeping entries and now face to make a transition to international Accounting. This chapter gives you a short revision of Bookkeeping techniques and the preparation of financial statements for retailers. Here are the main topics of this chapter: - Gross profit. - Trading Account. - Trial Balance. Most academic Accounting classes start with trading businesses as they are less complicated. No production of goods needs to be considered. We also introduce Manufacturing Accounting and Inventory Valuation only in chapter (9). Retailers prepare a “two-step” profit or loss calculation in order to determine their gross profit. A gross profit is the difference between revenue and material expenses or the cost of goods sold to customers. When we refer to costs we mean the cost of purchase for the parts or goods. This is the net amount of what has been paid. We explain the concept of gross profit calculation by a small case study of a plumber who also sells the parts he builds-in. The plumber DEMANN GmbH is ordered to repair a central heating system in a private house. The repair requires a replacement part costing 120.00 EUR ex VAT. After the repair, DEMANN GmbH bills 600.00 EUR including VAT. This gives a revenue of: 600 / 120% = 5 500.00 EUR. When we analyse the bill we notice an item for the part included thereon. Below, we calculate the customer order from the point of view of DEMANN GmbH. We assume the part costs DEMANN GmbH 120.00 EUR (net amount). When we calculate the profit earned by this customer order, our first step is its gross profit calculation. The gross profit is the revenue (net amount) of 500.00 EUR less the cost of goods purchased (net amounts) of 120.00 EUR. Hence, the gross profit is: 500 - 120 = 380.00 EUR. What does that figure tell the plumber/ seller? It says that this amount has to cover DEMANN GmbH’s total costs, its income taxes and the profit for the heater repair. In other words: The gross profit is the revenue of the company without materials or goods purchased. Hence, the gross profit is for the business activities, for the income tax and for the profit of the company. In contrast, the net profit is the profit before taxes which requires the deduction of the entire other costs from the gross profit. The net profit is what remains for the company and its owners. In order to calculate the customer order’s net profit, DEMANN GmbH further deducts <?page no="58"?> Berkau: Financial Statements 4e 4-54 labour, depreciation on the van the plumber drives to the site with, a portion of the management costs, costs for tools etc. We assume labour is 130.00 EUR, depreciation 10.00 EUR, partial management costs 40.00 EUR and costs for tools are 25.00 EUR. The order’s net profit is amounting to: 380 - 130 - 10 - 40 - 25 = 1 175.00 EUR. This amount is DEMANN GmbH’s pre-tax profit and the company pays income tax thereon. Based on our simplification with regard to the income tax model the income taxes are: 175 × 30% = 5 52.50 EUR. This gives the profit after taxes for DEMANN GmbH to the extent of: 175 - 52.50 = 122.50 EUR. Once we divide this amount by the revenue, we come up with the return on sales to the extent of 122.50 / 500 = 2 24.50 %. We could say, with every Euro received in revenue, the company earns 24.50 EUR-cents after tax. In a trading business, profit is calculated in two steps: We first calculate the gross profit and the net profit thereafter. In order to study the technical terms of profit calculation we look at the order calculation in Figure 4.1. It has the format of an income statement and is very similar to what we saw at the taxi service providers. The only difference is that for retailers, we now pause our profit calculation in order to determine the gross profit. An order calculation is not required to prepare and disclose based on IFRSs. Here, it only illustrates the calculation of profits. [EUR] Revenue 500 Other income 500 Materials (120) Gross profit 380 Labour (130) Depreciation (10) Other expenses (65) Earnings before int. & taxes (EBIT) 175 Interest Earnings before taxes (EBT), Net Profit 175 Income tax expenses (53) Deferred taxes Earnings after taxes (EAT) 123 Demann GmbH's Order's STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME Figure 4.1: DEMANN GmbH’s order calculation Next, we alter the case and assume, the wholesaler for DEMANN GmbH’s part increases its prices by 15 %. It now costs: 120 × (1 + 15%) = 1 138.00 EUR. This is an increase of: 138 - 120 = 1 18.00 EUR. As DEMANN GmbH intends to earn the same gross profit, it has to increase its next invoice as it does not want to earn <?page no="59"?> Berkau: Financial Statements 4e 4-55 less. Hence, a future similar repair will cost the customer: (500 + 18) × 120 % = 6621.60 EUR. This way, the gross profit remains the same: 621.60 / 120% - 138 = 3380.00 EUR. Next, we study the trial balance and the Trading account by the case study of the office material (paper) trader RYNEVELD Ltd. A trial balance is a list of all accounts and their balancing figures. In the old days of Accounting, it was used for checking consistency with the double entry system. So, the Bookkeeper could easily see whether she/ he made a mistake. Nowadays, the trial balance might help you only in an exam at the university as you cannot apply Accounting software. However, in a company it only gives an overview of accounts and helps for data transfer communication. The Trading account is prepared after the original Bookkeeping entries have been checked by the trial balance and is similar to a Profit and Loss account, but it only covers the first steps and stops at the gross profit calculation. The Trading account most likely is based on a periodic inventory system. Under this concept the company takes its stock once per Accounting period. The expenses for materials are calculated based on a comparison of closing stock and opening balances and all stock additions. RYNEVELD Ltd. is incorporated on 1.01.20X6 by an issue of 100,000 ordinary shares at 5.00 ZAR/ s face value. On 2.01.20X6, RYNEVELD Ltd. takes a bank loan of 200,000.00 ZAR. The annual rate of interest is 6.00 %/ a and is due at the end of every year. Pay-off of the bank loan is constantly 40,000.00 ZAR/ a. It is paid together with interest at year-ends. RYNEVELD Ltd. is a trader for office paper. The rent for the shop is 36,000.00 EUR/ a. (no VAT applies) RYNEVELD Ltd. pays the rent one month in advance. The first payment for January is paid on 2.01.20X6, for February on 30.01.20X6 and so on. RYNEVELD acquires store equipment (such as storage shelves, tables etc.) for 240,000.00 ZAR on 2.01.20X6. The price (gross amount) is paid instantly. The store equipment is written-off along straight-line method over 10 years. No residual value is considered for depreciation. RYNEVELD Ltd. buys office paper for 300,000.00 ZAR (gross amount) and pays half of this amount in January and the other half in 20X7. At the end of the Accounting period 20X6, the company takes stock and calculates that 22.4 % (in value) of office materials were not sold yet and are still on stock. During the fiscal year 20X6, RYNEVELD Ltd. earns a revenue of 545,000.00 ZAR. All sale transactions are made on cash. Operational costs, mainly labour, is 15,000.00 ZAR/ m during 20X6. Below, we discuss the initial Bookkeeping entries and prepare a trial balance for RYNEVELD Ltd. Thereafter, we calculate gross and net profit by the Trading account and the Profit and Loss account. We prepare a trial balance for RYNEVELD Ltd. after recording the Bookkeeping entries for the ordinary business activities, see below: At the time of incorporation, RYNEVELD Ltd. issues shares to a total amount of: <?page no="60"?> Berkau: Financial Statements 4e 4-56 100,000 × 5 = 5 500,000.00 ZAR. The Accountant makes Bookkeeping entry (1): DR Cash/ Bank.................... 500,000.00 ZAR CR Issued Capital............... 500,000.00 ZAR When taking the bank loan, RYNEVELD Ltd. receives a payment from the bank to the extent of 200,000.00 ZAR. It is recorded as Bookkeeping entry (2). The interest (Bookkeeping entry (3)) for 20X6 is amounting to: 6% × 200,000 = 12,000.00 ZAR. RYNEVELD Ltd. has to pay-off an amount of 40,000.00 ZAR every year. The pay-off Bookkeeping entry is classified as adjustment and is recorded on 31.12.20X6. We get back to adjustments later. We record adjustments after the first trial balance has been prepared. Observe the Bookkeeping entries (2), (3) below: DR Cash/ Bank.................... 200,000.00 ZAR CR Interest Bearing Liabilities. 200,000.00 ZAR DR Interest..................... 12,000.00 ZAR CR Cash/ Bank.................... 12,000.00 ZAR The rent is not subject to VAT as the landlord is not registered for VATreduction. However, RYNVELD Ltd. is. As a consequence, RYNVELD Ltd. cannot claim a VAT portion from the rent payment as the landlord does not disclose VAT on the contract. Rent is paid in advance except of the January’s rent. RYNEVELD Ltd. has to make 13 rental payments - the last one thereof counts as a prepayment for 20X4. We firstly record the 13 payments as Bookkeeping entry (4), which means we record the payments all together. The accrual is recorded right now, but see it as part of the adjustments. Here, we record it for teaching reasons as Bookkeeping entry (5). In line with IAS 1.27, the income statement is to be prepared under the accrual basis of Accounting. This requires to recognise expenses in the Accounting period they are for. The payment or receipt of cash does not matter for the allocation to Accounting periods. Here, the January 20X7’s rent is to be separated from the rent in 20X6, which makes the accrual in Bookkeeping entry (5) necessary. 12 DR Rent......................... 39,000.00 ZAR CR Cash/ Bank.................... 39,000.00 ZAR DR Prepaid Expenses............. 3,000.00 ZAR CR Rent......................... 3,000.00 ZAR 12 Read our Basics-1, chapter (18). <?page no="61"?> Berkau: Financial Statements 4e 4-57 The acquisition of the store equipment is the next entry. The cost of acquisition (net amount) is 200,000.00 ZAR. IAS 16.16 states that input-VAT is not included in the cost of acquisition if the buying company is registered for VAT reduction. The Bookkeeping (6) entry is: DR P, P, E Account.............. 200,000.00 ZAR DR VAT.......................... 40,000.00 ZAR CR Cash/ Bank.................... 240,000.00 ZAR Depreciation falls under adjustments and will be discussed later. Our next Bookkeeping entry is for the purchase of materials. So far, we only introduced the periodic system for inventory movements which makes us record the materials as an addition to the Purchase account. 13 As the input-VAT is subsequently refundable by the revenue service it is not part of the cost of purchase, see IAS 2.11. Observe Bookkeeping entry (7) below. Note, the payment is split into two parts, one in 20X6 - the remaining portion in 20X7. Do not split VAT! It counts once revenue/ expenses are recognised. So, in no case you should allocate 25,000.00 ZAR VAT claim to 20X6 and the other half one year later. Instead, RYNEVELD Ltd. claims the total amount of input- VAT to the extent of 50,000.00 ZAR in 20X6. DR Purchase..................... 250,000.00 ZAR DR VAT.......................... 50,000.00 ZAR CR Cash/ Bank.................... 150,000.00 ZAR CR Accounts Payables............ 150,000.00 ZAR The closing stock of goods existing at the end of the Accounting period will be considered by the adjustments later on. The stock taking is on or after the balance sheet date and is recorded later. The revenue recognition gives 545,000.00 ZAR. The proceeds are the gross amount thereof and are amounting to: 545,000 × 120% = 6 654,000.00 ZAR. See Bookkeeping entry (8) below: DR Cash/ Bank.................... 654,000.00 ZAR CR VAT.......................... 109,000.00 ZAR CR Revenue...................... 545,000.00 ZAR Operational costs are recorded by Bookkeeping entry (9). 13 In chapter (9), we introduce the perpetual inventory system that records releases from stock, too. <?page no="62"?> Berkau: Financial Statements 4e 4-58 DR Operational Expenses......... 180,000.00 ZAR CR Cash/ Bank.................... 180,000.00 ZAR We observe the Bookkeeping entries made so far which we refer to as ordinary Bookkeeping entries. The next following Bookkeeping entries are made for adjustments. Study the accounts in Figure 4.2 . D C D C (1) 500,000.00 (3) 12,000.00 c/ d 500,000.00 (1) 500,000.00 (2) 200,000.00 (4) 39,000.00 b/ d 500,000.00 (8) 654,000.00 (6) 240,000.00 (7) 150,000.00 (9) 180,000.00 c/ d 733,000.00 1,354,000.00 1,354,000.00 b/ d 733,000.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 200,000.00 (2) 200,000.00 (3) 12,000.00 c/ d 12,000.00 b/ d 200,000.00 b/ d 12,000.00 Interest bearing liabilities IBL Interest-20X6 INT D C D C (4) 39,000.00 (5) 3,000.00 (5) 3,000.00 c/ d 36,000.00 (11) 15,000.00 c/ d 18,000.00 39,000.00 39,000.00 18,000.00 18,000.00 b/ d 36,000.00 b/ d 18,000.00 Rent-20X6 RNT Prepaid expenses PRE D C D C (6) 200,000.00 c/ d 200,000.00 (6) 40,000.00 (8) 109,000.00 b/ d 200,000.00 (7) 50,000.00 c/ d 19,000.00 109,000.00 109,000.00 b/ d 19,000.00 Property, Plant, Equipment PPE Value added tax VAT D C D C (7) 250,000.00 c/ d 250,000.00 c/ d 150,000.00 (7) 150,000.00 b/ d 250,000.00 b/ d 150,000.00 Purchase-20X6 PUR Accounts payables A/ P Figure 4.2: RYNEVELD Ltd.’s accounts before adjustments <?page no="63"?> Berkau: Financial Statements 4e 4-59 D C D C c/ d 545,000.00 (8) 545,000.00 (9) 180,000.00 c/ d 180,000.00 b/ d 545,000.00 b/ d 180,000.00 Revenue-20X6 REV Operational expenses-20X6 OEX Figure 4.2: RYNEVELD Ltd.’s accounts before adjustments continued Next, we prepare a Trial Balance in order to cross-check our results. You see the Trial Balance in Figure 4.3. Compare it with the accounts in Figure 4.2. As the trial balance is here for monitoring purposes we do not round figures to the nearest Rand but disclose figures accurate to the cent. Account Debit entries Credit entries [ZAR] [ZAR] Cash/ Bank 733,000.00 Issued Capital 500,000.00 Interest bearing liabilities 200,000.00 Interest INT 12,000.00 Rent RNT 36,000.00 Prepaid expenses 3,000.00 Property, Plant, Equipment 200,000.00 Value added Tax 19,000.00 Purchase PUR 250,000.00 Accounts payables 150,000.00 Revenue REV 545,000.00 Operational expenses OEX 180,000.00 Total: 1,414,000.00 1,414,000.00 Ryneveld Ltd.'s TRIAL BALANCE as at 31.12.20X6 Figure 4.3: RYNEVELD Ltd.’s trial balance How it is Done (Trial Balance): (1) Make Bookkeeping entries for all business activities in the relevant accounts. Balance-off all accounts. (2) Prepare a list with lines for every account therein. Make two columns, one for debit entries and the other one credit entries. Enter the balances brought down for all accounts in the columns debit entry or credit entry according to the side they belong to. A debit balanced account’s balance is entered on the debit side. A credit balanced account’s balance is entered on the credit side. Focus on the balances b/ d. <?page no="64"?> Berkau: Financial Statements 4e 4-60 (3) Compare the total of the columns debit entries and credit entries. If they are the same your Bookkeeping records are looking good. However, the trial balance does not prove correctness. Adjustments are all Bookkeeping entries made at the end of the Accounting period. For RYNEVELD Ltd., we record the adjustments as below: (a) Depreciation. (b) Pay-off of bank loan. (c) Reclassification of next pay-off. (d) Gross profit calculation. (e) Net profit calculation. (f) Income tax calculation. Ad (a): Depreciation Depreciation expenses at RYNEVELD Ltd. are recorded for the store equipment. Depreciation always is based on net amounts as input-VAT is refunded and, thus, cannot be an expense for RYNEVELD Ltd.: (240,000 / 120%) / 10 = 220,000.00 ZAR. In contrast to the ordinary Bookkeeping entries, we now enter the abbreviation for the contra account in the identifier column of the accounts, such as ACC for accumulated depreciation. DR Depreciation................. 20,000.00 ZAR CR Acc. Depr.................... 20,000.00 ZAR Ad (b): Pay-off of Bank Loan The loan contract with the bank states that RYNEVELD Ltd. has to pay-off 40,000.00 ZAR per annum. The Bookkeeping entry is shown below. DR Interest Bearing Liabilities. 40,000.00 ZAR CR Cash/ Bank.................... 40,000.00 ZAR Ad (c): Reclassification of next Pay-off The upcoming pay-off is amounting to 40,000.00 ZAR, too. IAS 1.56 requires to separate short-term liabilities from long-term ones. The current/ non-current distinction can be found in IAS 1.60 and IAS 1.61. As a consequence, RYNEVELD Ltd. has to reclassify the next year’s payment as short-term liabilities. The Accounts Payables A/ P account applies. Before the pay-off was considered a long-term liability and fell under interest bearing liabilities. The names of the accounts are actually misleading. The fact that an amount is taken out of the Interest Bearing Liabilities account does not mean that no interest payment is required anymore. The interest in 20X7 considers the principal (nominal amount of the bank loan) less the pay-off in 20X6 and, thus, is based on the amount RYNEVELD Ltd. owes its bank as at 1.01.20X7. Interest-20X7 is amounting to: (200,000 - 40,000) × 6% = 9 9,600.00 ZAR. Hence, on the balance sheet as at 31.12.20X6, there are 120,000.00 ZAR in the Interest Bearing Liabilities account and 40,000.00 ZAR in <?page no="65"?> Berkau: Financial Statements 4e 4-61 the Accounts Payables account, both counting for interest calculation in 20X7. DR Interest Bearing Liabilities. 40,000.00 ZAR CR Accounts Payables A/ P ........ 40,000.00 ZAR Ad (d): Gross Profit Calculation For gross profit calculation, the Trading account applies. 14 A Trading account refers to the periodic inventory system. It means we calculate the material expenses by a comparison of opening amounts for inventory, purchases and the closing stock. Further adjustments might become relevant, once a company sends back goods to its supplier or when its customers return goods previously bought. See Figure 4.4 where we entered the elements and the contra accounts’ 3-letter-codes. D C INV Opening stock REV Sales revenue PUR Purchases INV Closing stock R.I. Returns inwards R.O. Returns outwards Trading account-20XX T/ A Figure 4.4: Elements of a Trading account RYNEVELD Ltd. records additions to stock as purchases and takes stock at the beginning and end of the Accounting period. As the company is established in 20X6, no opening stock exists. The total of purchases is the net amount of the price paid which equals to 250,000.00 ZAR. No goods are returned by customers. So, in order to record the debit side of the Trading account we only make one Bookkeeping entry that closes-off the Purchase account to the Trading account: DR Trading Account.............. 250,000.00 ZAR CR Purchase..................... 250,000.00 ZAR In order to prepare the credit side of the Trading account, we close-off the Revenue account and take stock. The revenue is amounting to the net selling price of the goods sold which equals to 545,000.00 ZAR. The stock take gives us an amount of 22.4 % (in value) of the purchased goods 14 Read our Basics-1, chapter (22). which equals to: 22.4% × 250,000 = 556,000.00 ZAR. No goods are returned to suppliers which leaves the Returned Outwards account zero balanced. On the credit side of the Trading account, we make two entries linked to the Bookkeeping entries below: <?page no="66"?> Berkau: Financial Statements 4e 4-62 DR Revenue...................... 545,000.00 ZAR CR Trading Account.............. 545,000.00 ZAR DR Inventories.................. 56,000.00 ZAR CR Trading Account.............. 56,000.00 ZAR The Trading account is displayed in Figure 4.5. Ad (e): Net Profit Calculation For the net profit calculation we deduct all further expenses from the gross profit. At RYNEVELD Ltd., expenses are depreciation, operational expenses, rent, and interest. We close-off the expense accounts to the Profit and Loss account. We further close-off the Trading account to the Profit and Loss account which gives us the gross profit on the credit side. (A gross loss is to be recorded as debit entry in the Profit and Loss account.) Observe the next Bookkeeping entries below. The accounts are shown in Figure 4.6. DR P&L-Account.................. 20,000.00 ZAR CR Depreciation DPR............. 20,000.00 ZAR DR P&L-Account.................. 180,000.00 ZAR CR Operational Expenses OEX..... 180,000.00 ZAR DR P&L-Account.................. 36,000.00 ZAR CR Rent RNT..................... 36,000.00 ZAR DR P&L-Account.................. 12,000.00 ZAR CR Interest INT................. 12,000.00 ZAR DR Trading Account T/ A.......... 351,000.00 ZAR CR P&L-Account.................. 351,000.00 ZAR Ad (f): Income Tax Calculation The calculation of income taxes follows our simplified tax model. The income tax expenses in this text book are 30% of the pre-tax profit (EBT). In real business you should consult a tax professional with regard to national income tax calculations. At RYNEVELD Ltd., income taxes are amounting to: (351,000 - 20,000 - 180,000 - 36,000 - 12,000) × 30% = 103,000 × 30% = 3 30,900.00 ZAR. We make a simplified Bookkeeping entry for the income taxes as below (short cut). The correct Bookkeeping entry for income taxes would be: DR Income Tax Expenses . . . - CR Income Tax Liabilities . . . and then: DR P&L-Account . . . - CR Income Tax Expenses . . . <?page no="67"?> Berkau: Financial Statements 4e 4-63 DR P&L-Account.................. 30,900.00 ZAR CR Income Tax Liabilities ITL... 30,900.00 ZAR After deducting income tax expenses from the pre-tax profit, we get the annual surplus which is closed-off to the Retained Earnings account. At RYNEVELD Ltd., the addition to retained earnings is: 103,000 - 30,900 = 7 72,100.00 ZAR. Observe the Bookkeeping entry below. It would be inverted for recording a loss. In that case no income taxes would apply based on our tax model. DR P&L-Account.................. 72,100.00 ZAR CR Retained Earnings R/ E ........ 72,100.00 ZAR Find below in Figure 4.5 all accounts of RYNEVELD Ltd. after recording adjustments. D C D C (1) 500,000.00 (3) 12,000.00 c/ d 500,000.00 (1) 500,000.00 (2) 200,000.00 (4) 39,000.00 b/ d 500,000.00 (8) 654,000.00 (6) 240,000.00 (7) 150,000.00 (9) 180,000.00 c/ d 733,000.00 1,354,000.00 1,354,000.00 b/ d 733,000.00 IBL 40,000.00 c/ d 693,000.00 733,000.00 733,000.00 b/ d 693,000.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 200,000.00 (2) 200,000.00 (3) 12,000.00 c/ d 12,000.00 C/ B 40,000.00 b/ d 200,000.00 b/ d 12,000.00 P&L 12,000.00 A/ P 40,000.00 c/ d 120,000.00 200,000.00 200,000.00 b/ d 120,000.00 Interest bearing liabilities IBL Interest-20X6 INT D C D C (4) 39,000.00 (5) 3,000.00 (5) 3,000.00 c/ d 3,000.00 c/ d 36,000.00 b/ d 3,000.00 39,000.00 39,000.00 b/ d 36,000.00 P&L 36,000.00 Rent-20X6 RNT Prepaid expenses PRE Figure 4.5: RYNEVELD Ltd.’s accounts after adjustments (20X6) <?page no="68"?> Berkau: Financial Statements 4e 4-64 D C D C (6) 200,000.00 c/ d 200,000.00 (6) 40,000.00 (8) 109,000.00 b/ d 200,000.00 (7) 50,000.00 c/ d 19,000.00 109,000.00 109,000.00 b/ d 19,000.00 Property, Plant, Equipment PPE Value added tax VAT D C D C (7) 250,000.00 c/ d 250,000.00 c/ d 150,000.00 (7) 150,000.00 b/ d 250,000.00 T/ A 250,000.00 b/ d 150,000.00 c/ d 190,000.00 A/ P 40,000.00 190,000.00 190,000.00 b/ d 190,000.00 Accounts payables A/ P Purchase-20X6 PUR D C D C c/ d 545,000.00 (8) 545,000.00 (9) 180,000.00 c/ d 180,000.00 T/ A 545,000.00 b/ d 545,000.00 b/ d 180,000.00 P&L 180,000.00 Revenue-20X6 REV Operational expenses-20X6 OEX D C D C ACC 20,000.00 c/ d 20,000.00 c/ d 20,000.00 DPR 20,000.00 b/ d 20,000.00 P&L 20,000.00 b/ d 20,000.00 Depreciation-20X6 DPR Accumulated depreciation ACC D C D C PUR 250,000.00 REV 545,000.00 OV 0.00 GP 351,000.00 INV 56,000.00 T/ A 56,000.00 c/ d 56,000.00 601,000.00 601,000.00 56,000.00 56,000.00 P&L 351,000.00 b/ d 351,000.00 b/ d 56,000.00 Trading account-20X6 T/ A Inventories INV D C D C DPR 20,000.00 T/ A 351,000.00 c/ d 30,900.00 P&L 30,900.00 OEX 180,000.00 b/ d 30,900.00 RNT 36,000.00 INT 12,000.00 EBT 103,000.00 351,000.00 351,000.00 D C ITL 30,900.00 b/ d 103,000.00 c/ d 72,100.00 P&L 72,100.00 R/ E 72,100.00 b/ d 72,100.00 103,000.00 103,000.00 Retained earnings R/ E Income tax liabilities ITL Profit or Loss-20X6 P&L Figure 4.5: RYNEVELD Ltd.’s accounts after adjustments (20X6) - continued <?page no="69"?> Berkau: Financial Statements 4e 4-65 How it is Done (Trading Account Based on a Periodic Inventory System): (1) Transfer the opening value of the Inventory account to the Trading account. Make a debit entry in the Trading account and a credit entry in the Inventory account. (2) Record all purchases in the Purchase account. Consider VAT. At the end of the Accounting period, closeoff the Purchase account to the Trading account. (3) Record all sales in the Revenue account. Consider VAT. Close-off the Revenue account to the Trading account. (4) In case of returns inwards record the payments made or vouchers granted and record the net portion of the selling price on the debit side of the Returns Inwards account. Alternatively record negative revenues. Closeoff the Returns Inwards account to the Trading account. If goods are received add them to stock or chuck them. If stocked they will be considered for stock taking later. (5) Determine the closing stock of inventories (take stock). Record the closing stock of inventories as a debit entry in the Inventory account and a credit entry in the Trading account. (6) If goods were returned to suppliers record them in the Returns Outwards account and consider VAT based on the cost of purchase. Make a debit entry in the Cash/ Bank account or in the Accounts Receivables or in the Accounts Payables account and in the VAT account. Make a credit entry in the Returns Outwards account or as an alternative in the Purchase account (negative purchase). Close-off the Returns Outwards account to the Trading account. (7) Determine the balancing figure of the Trading account. If the Trading account is debit balanced, the balancing figure is a gross loss. If the Trading account is credit balanced, the balancing figure is a gross profit. Transfer the gross profit or gross loss to the Profit and Loss account by closing-off the Trading account. The adjusted trial balance is prepared once the Bookkeeping entries for adjustments are completed. It is shown in Figure 4.6. As all nominal accounts are closed-off either to the Trading account or the Profit and Loss account they do not show on the adjusted trial balance. The balancing figures of these accounts are amounting to zero. This applies for the Profit and Loss account as well as for the Trading account, too. <?page no="70"?> Berkau: Financial Statements 4e 4-66 Account Debit entries Credit entries [ZAR] [ZAR] Cash/ Bank 693,000.00 Issued Capital 500,000.00 Interest bearing liabilities 120,000.00 Prepaid expenses 3,000.00 Property, Plant, Equipment 200,000.00 Value added Tax 19,000.00 Accounts payables 190,000.00 Accumulated Depreciation 20,000.00 Income Tax Liabilities 30,900.00 Retained earnings 72,100.00 Inventories 56,000.00 952,000.00 952,000.00 Ryneveld Ltd.'s ADJUSTED TRIAL BALANCE as at 31.12.20X6 Figure 4.6: RYNEVELD Ltd.’s adjusted trial balance (20X6) How it is Done (Adjusted Trial Balance): (1) Prepare a trial balance. (2) Record the adjustments for the profit calculation, such as for depreciation, accruals etc. Calculate the earnings before taxes and earnings after taxes. Make Bookkeeping entries for income taxes and retained earnings. In case you prepare financial statements after the appropriation of profit, calculate and record dividends and/ or additions/ reductions to reserves. Balanceoff the Retained Earnings account. In case a company carries forward a profit/ loss, there will be a balance b/ d to be considered for the Retained Earnings account. (3) Transfer the adjustments to the trial balance. We recommend to copy the previous trial balance and make adjustments in the copied version. Hence, delete the nominal accounts that have been closed-off to the Profit and Loss account. Consider that the Trading account as well as the Profit and Loss account are closed-off. No entry in the adjusted trial balance is required for them. After preparing the adjusted trial balance, compare the total of the balancing figures for all listed accounts of the debit column with the credit column. (4) Prepare the income statement based on the information you retrieve from the Trading account and the Profit and Loss account. Prepare the balance sheet based on the real accounts listed on the adjusted trial balance. You might combine accounts for the balance <?page no="71"?> Berkau: Financial Statements 4e 4-67 sheet preparation, such as P, P, E account and the Accumulated Depreciation account. Based on the adjusted trial balance, we can prepare the balance sheet. There only are few changes in order to transform the adjusted trial balance into a statement of financial position. We offset the Property, Plant, Equipment account against accumulated depreciation and add VAT liabilities to the Accounts payables. The P, P, E item on the balance sheet gives us: 200,000 - 20,000 = 1 180,000.00 ZAR and the A/ P item is amounting to: 19,000 + 190,000 = 209,000.00 ZAR. Otherwise, we can copy the items from the adjusted trial balance straight into the balance sheet. Observe the statement of financial position as shown in Figure 4.7. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 180,000 Share capital 500,000 Intangibles Reserves Financial assets Retained earnings 72,100 Current assets Liabilities (liab.) Inventory 56,000 Long-term liab. 120,000 Accounts receivables Short-term liab. A/ P 209,000 Prepaid expenses 3,000 Provisions Cash/ Bank 693,000 Income tax liab. 30,900 Total assets 932,000 Total equity and liab. 932,000 Ryneveld Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X6 Figure 4.7: RYNEVELD Ltd.’s balance sheet (20X6) The Income statement is derived from the Trading account and the Profit and Loss account. It follows the requirements set by IAS 1.82. At RYNEVELD Ltd., no other comprehensive income matters. All revenues and expenses are recorded through profit or loss as they are considered being normal business activities. The income statement is shown in Figure 4.8. <?page no="72"?> Berkau: Financial Statements 4e 4-68 [ZAR] Revenue 545,000 Other income 545,000 Materials (194,000) Labour Depreciation (20,000) Other expenses (216,000) Earnings before int. & taxes (EBIT) 115,000 Interest (12,000) Earnings before taxes (EBT) 103,000 Income tax expenses (30,900) Deferred taxes Earnings after taxes (EAT) 72,100 Ryneveld Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X6 Figure 4.8: RYNEVELD Ltd.’s income statement At this stage of teaching international Accounting, we are not eager to explain RYNEVELD Ltd.’s statement of cash flows and its statement of changes in equity. However, you can download the two statements by Link 4.A below: Link 4.A: RYNEVELD Ltd. The case study TELUK Sdn. Bhd. is about a trading business for office materials and includes return transactions and recording of bad debts as well. Bad debts are recorded, e.g., when a company has reason to assume the debtor is insolvent. TELUK Sdn. Bhd. is more demanding than the case study RYNEVELD Ltd. and should be studied carefully. It can be downloaded by the QR code in the Link 4.B below: Link 4.B: TELUK Sdn. Bhd. We explain below how to prepare financial statements based on a worksheet for the trial balance. We start-off again from where the first trial balance has been prepared. Instead of recording the transactions in accounts, we now make entries directly in the Δ -trial balances. We firstly show the method for depreciation, later we consider all further adjustments. In the Δ -trial bal- <?page no="73"?> Berkau: Financial Statements 4e 4-69 ance we make the entries for depreciation and in the adjusted trial balance we add the amounts from the original trial balance and the Δ -trial balance. Observe the procedure in Figure 4.9 with regard to depreciation. Account Debit entries Credit entries Debit entries Credit entries [ZAR] [ZAR] [ZAR] [ZAR] Cash/ Bank 733,000.00 Issued Capital 500,000.00 Interest bearing liabilities 200,000.00 Interest INT 12,000.00 Rent RNT 36,000.00 Prepaid expenses 3,000.00 Property, Plant, Equipment 200,000.00 Value added Tax 19,000.00 Purchase PUR 250,000.00 Accounts payables 150,000.00 Revenue REV 545,000.00 Operational expenses OEX 180,000.00 Depreciation 20,000.00 20,000.00 Accumulated depreciation 20,000.00 20,000.00 Total: 20,000.00 20,000.00 1,434,000.00 1,434,000.00 Ryneveld Ltd.'s Δ - TRIAL BALANCE as at 31.12.20X6 Ryneveld Ltd.'s ADJUSTED TRIAL BALANCE as at 31.12.20X6 Figure 4.9: Worksheet for adj. trial balance preparation (1 st step) Below, we apply this method for all other adjustments at RYNEVELD Ltd. It covers recording of depreciation, pay-off of bank loan, reclassification of next pay-off amounts, gross profit calculation, net profit calculation and income tax calculation. Cells are overwritten multiple times. <?page no="74"?> Berkau: Financial Statements 4e 4-70 Account Debit entries Credit entries Debit entries Credit entries [ZAR] [ZAR] [ZAR] [ZAR] Cash/ Bank 40,000.00 693,000.00 Issued Capital 500,000.00 Interest bearing liabilities 80,000.00 120,000.00 Interest INT 12,000.00 Rent RNT 36,000.00 Prepaid expenses 3,000.00 Property, Plant, Equipment 200,000.00 Value added Tax 19,000.00 Purchase PUR 250,000.00 Accounts payables 40,000.00 190,000.00 Revenue REV 545,000.00 Operating expenses OEX 180,000.00 Depreciation 20,000.00 20,000.00 Accumulated depreciation 20,000.00 20,000.00 Gross profit 351,000.00 351,000.00 Inventories 56,000.00 56,000.00 Earnings before taxes 103,000.00 103,000.00 Retained earnings 72,100.00 72,100.00 Income tax liabilities 30,900.00 30,900.00 Total: 1,155,000.00 1,155,000.00 952,000.00 952,000.00 Ryneveld Ltd.'s Δ - TRIAL BALANCE as at 31.12.20X6 Ryneveld Ltd.'s ADJUSTED TRIAL BALANCE as at 31.12.20X6 Figure 4.10: Complete worksheet for adj. trial balance preparation You find a further example for the preparation of financial statements via the worksheet method below linked to the case study BINNEVELD Ltd. which is a surf shop. Check Link 4.C. Link 4.C: BINNEVELD Ltd. Summary: In this chapter, we covered the preparation of financial statements based on trial balance and Trading account. The chapter refers to the retailer industry where the gross profit calculation is relevant. For simplification, we assumed that companies apply the periodic inventory system. We also introduced the worksheet method for the preparation of financial statements based on the trial balance. Accounting Technical Terms: Accumulated depreciation account: Account applicable to record an assets lifetime depreciation. Adjusted trial balance: Trial balance after all adjustments have been recorded. Gross profit: Difference between revenue and material expenses. The gross profit calculation is relevant for retailers. <?page no="75"?> Berkau: Financial Statements 4e 4-71 Net profit: Profit after interest and before income taxes. The net profit is the same as earnings before taxation EBT. Periodic inventory system: Inventory system where stock taking is required at the commencement and the end of the Accounting period. Trading account: Section of the Profit and Loss account that only covers revenue and material expenses. The balancing figure is the gross profit which is relevant for retailers. A Trading account is a single account. Trial balance: The trial balance is a list of all accounts in use which shows the balancing figures (Bal. b/ d) thereof. The total of the balancing figures on the debit side shall equal to the total of the balancing figures on the credit side to confirm consistency with the double entry system. Question Bank: (1) Which statement is correct? 1. The Trading Account’s balancing figure is the net profit. 2. The Trading Account compares the revenue and all expenses of the Accounting period. 3. The Trading Account compares the sales and all expenses of the Accounting period. 4. The Trading Account compares the revenue and all material expenses of the Accounting period. (2) A Dutch company records an opening value of inventories of 300.00 EUR. The closing balance is amounting to 100.00 EUR. During the Accounting period, there were two purchases, one at 1,000.00 EUR and the other one at 2,000.00 EUR. The revenue equals to 5,000.00 EUR. How much is the gross profit? 1. 1,200.00 EUR. 2. 1,800.00 EUR. 3. 2,200.00 EUR. 4. 1,600.00 EUR. (3) The items disclosed on the debit side of the Trading Account are: 1. Opening value of finished goods, revenue, labour. 2. Purchases, returns inwards, opening stock. 3. Opening amount of inventories, labour, returns outwards. 4. Closing stock of inventories, revenue, returns inwards. (4) On 2.04.20X4, a French firm buys a machine at 24,000.00 EUR gross amount. The seller offers a 10% discount on the machine on 1.07.20X4. Depreciation commences in April and is based on straight-line method over 5 years. Depreciation in 20X4 is: 1. 1,800.00 EUR. 2. 3,600.00 EUR. 3. 2,700.00 EUR. 4. 2,000.00 EUR. (5) An Austrian company buys goods for 100,000.00 EUR cost of purchase. The opening value of inventories as at the beginning of the year is amounting to 20,000.00 EUR. During the Accounting period, the company sells goods valued at 58,000.00 EUR and returns goods for 18,000.00 EUR. The sales are 150,000.00 EUR. How much is the gross profit: 1. 92,000.00 EUR. 2. 106,000.00 EUR. <?page no="76"?> Berkau: Financial Statements 4e 4-72 3. 86,000.00 EUR. 4. 136,000.00 EUR. Solutions: 1-4; 2-2; 3-2; 4-3; 5-1. <?page no="77"?> Berkau: Financial Statements 4e 5-73 5. Basics of Financial Statement Analysis Learning Objectives: In this chapter (5), we put you in the position to assess a company. We focus on reading financial statements not on the preparation thereof. Actually, we cannot teach financial statement analysis as it also requires profound knowledge about an industry what we cannot assume our readers to have for a particular case. We also intend to demonstrate that the idea of calculating just few ratios and obtaining sufficient knowledge about a company is absolutely wrong. It would be the same as if your doctor always starts his examination with a great blood count which means she/ he tests you on everything possible. We rather prepare certain industry related ratios in order to verify an initial hypothesis about the situation of a company. If you take your car to a car repair shop, you would maybe tell the expert that your car makes some funny noises when driving through a curve and he will test drive your car, check the noise and will later examine your wheel bearings before he tells you his diagnosis and what the repair will cost you. We follow the same procedure for financial statement analysis. In one chapter of an Accounting text book, we cannot discuss all aspects of companies nor can we focus only on particular situations. Hence, we here only present a first approach of financial statement analysis and teach you the basics. As we later study financial statements of the South African airline Comair Limited, we introduce financial statement analysis by a fictive small airline CAPELIFT Ltd. and explain the process. We provide you here with a link to Comair Limited’s financial statements. Take the Comair Limited business report and make yourself familiar with the aviation industry. The Link 5.A takes you to South African aviation. Link 5.A: COMAIR Ltd. We focus on companies that prepare financial statements along IFRSs. We also assume the company’s financial statements have been audited already. Auditing is the process of checking financial statements for correctness. In many countries auditing is required by national law and is a precondition for the appropriation of profits. Auditing is not ruled by IFRSs because it falls under national law. The start for financial statement analysis might be to check basic ratios (such as small blood count) in order to get an overview. Later in financial statement analysis, you’ll follow a specific suspicion and ratios linked thereto. We discuss below an easy example to explain the procedure. ROSENDAHL Ltd. is a production firm for sneakers. We assume already the company is in trouble selling its products because they are ugly. How do we prove <?page no="78"?> Berkau: Financial Statements 4e 5-74 our first idea about the situation ROSENDAHL Ltd. is in? We look for symptoms of low selling. We might see that the item inventories is too high on the balance sheet and check the notes for details in order to find whether the inventory mainly consists of finished goods. For the inventory level of finished goods we expect the company to only have enough stock to deliver on time. If the inventory level exceeds that amount, we can say it is too high. Excessive inventories set off our alarms. We further check the income statement which might show poor revenues and maybe storage costs high and considerably high expenses for innovation and marketing. A revenue is low when the amounts, selling prices or rebates are noticeable different from what you expect. In particular when a company increases stock by producing more goods than can be sold the situation is imbalanced. For our sneaker manufacturer we also monitor the return on sales which might be low, as ROSENDAHL Ltd. tries to clear stock (of its ugly sneakers) by discounts or sale on specials. This way the company tries to “pump the goods into the market”. This might also result in an increase in receivables if the company offers convenient payment conditions to make the sale more attractive for its clients. We assume, in total, ROSENDAHL Ltd. discloses poor profit for the period due to its low sales. However, production and additions to stock does not result in a drop in profit instantly. As the sneakers are added to stock at cost of manufacturing, profitability is still looking good. But the lack in sales and the increased inventories is to be regarded as a risk. If ROSENDAHL Ltd. prepares its income statement along the nature of expense method, an increase of stock additions will be disclosed thereon. We might also detect on ROSENDAHL Ltd.’s VAT statement that output-VAT in comparison to input-VAT is lower than in prior periods. As ROSENDAHL Ltd. now filled its storage rooms by (ugly) sneakers, the production situation is characterised by overcapacity. The firm tries to reduce production as the goods are not selling. As an alternative, the company might start producing different products, such as sneakers in a more popular shape or colour. Production firms often have difficulties to react on demand situations as many costs are fixed, such as depreciation and indirect labour. As a consequence, the overhead allocation rate might increase, too. That will prove overcapacity. As ROSENDAHL Ltd. does not receive enough cash from its sale of sneakers the company might face financial distress. This is caused by a lack in receipts and high capital costs for financing inventories. The operating cash flows will show poor inflows but maybe normal outflows for materials, marketing, consultancy etc. We say the company “is bleeding cash”. As a result of low cash flows the company has to agree on nonfavourable loan conditions which we recognise as high interest rates or at least increases thereof. The ROSENDAHL Ltd. shows that we must look at the full picture before we start with conclusions about single ratios. Never calculate a bunch of standard ratios and try to come up with <?page no="79"?> Berkau: Financial Statements 4e 5-75 a conclusion. This way would be possible but it is far more work than to just analyse 30 ratios. We rather try to gain a first impression and follow a suspicion guided ratio analysis. For the analysis of financial statements no contradictions of ratios are tolerated. If the results are not consistent to one another, continue analysis and maybe check for different symptoms. For a structured financial statement analysis, we follow the steps below: (1) Define information requirements. (2) Formal checks. (3) Horizontal analysis. (4) Vertical analysis. (5) Ratio analysis. Ad (1): Define Information Requirements Financial statement analysis procedures are expensive and consume our capacities with regard to workload. We do not analyse companies for the fun of it but follow special information needs. A reason for financial statement analysis can be to start a business relationship with the company, e.g., as a supplier or as a customer, or we want to invest in the company, e.g., buying shares, or we check a competitor of our own business or we apply for a job in the company of interest. There might be a lot of reasons for financial statement analysis and the information need determines the way we analyse our data. In general, we assume the company we check prepares annual financial statements. We also assume that we have unrestricted access to the financial statements. It can be that financial statements are prepared at special occasions, e.g., for business combinations, liquidation etc. However, in this text book, we only refer to general purpose financial statements. Ad (2): Formal Checks Before we begin with a financial statement analysis we check whether we have got the right financial statements from a reliable source. In general, we prepare financial statement analysis from outside of the business. We normally do not work in the Accounting department and have not unlimited access to the Bookkeeping records. This means, our analysis is limited to the financial statements, in particular no drill down from financial data to the original Bookkeeping entry is possible. We only rely on the information provided by the financial statements and have no chance to, e.g., ask the Accountant questions. In some cases we might find financial statement analysis results online already when other experts share their findings. The information can help us to get a first idea about the situation of the business. Financial statement analysis is mainly an interpretation of financial data, not an objective examination thereof. We cannot rely on financial statements analysis from other parties. For correctness of financial statements, we check whether they were audited and in case they were we study the auditors’ opinion. Only if the auditors confirm the financial statements have been prepared correctly and present fairly the financial position, financial performance and cash flows of the company we should start with the analysis of the financial statements. In con- <?page no="80"?> Berkau: Financial Statements 4e 5-76 trast to financial statement analysis, auditing is a formal check which makes it is more reliable. Auditors do not share their opinion about the wellbeing or chances of a company, as they focus on the correctness of financial statements and the application of laws and standards. Correctness of financial statements is an important precondition for the interpretation of financial data. Do not waste time on faulty financial statements! The financial statements must contain a remark which Accounting standards apply. We here narrow our view on financial statements prepared based on IFRSs. IAS 1.16 states “An entity whose financial statements comply with IFRSs shall make an explicit and unreserved statement of such compliance in the notes […]”. Financial statements prepared in accordance with other national GAAPs may require adjustments for the ratio calculations. E.g., financial statements prepared in Germany require recalculations for items, such as accruals or differences on asset valuations caused by offsetting. I.e., a return on assets requires to consider whether or not prepayments count as assets. In Germany they do not, internationally, prepayments are part of current assets. Those differences change ratio values and require caution with regard to interpretation. Ad (3): Horizontal Analysis A horizontal analysis tells the user of financial statements the timeline of figures. It provides us with hints about the development of ratios in a company, e.g., revenue. It is always a good idea to look at developments under consideration of the common situation in the industry. There might be general changes, such as financial crisis or competition by internet trading for department stores which require that we have to examine the company’s position in a changing industry. We must answer the question whether the whole industry faces a global market situation or whether a competitor is increasing its share of the market on our account. With the horizontal analysis we are able to see a company in different situations and can derive judgement about the company’s ability to react on special situations. Ad (4): Vertical Analysis A vertical analysis helps us to understand the portions of particular items as percentage of the entire object. It can give us information of how much inventory a manufacturing firm records as a percentage of its total assets. For the interpretation of vertical analysis results we need normative information. Normative information means that there is a good or rather best practice percentage known we try to reach. However, we do not follow here the approach of general rules (golden rule of balance sheet), as you might find in many text books for finance. We always should understand the business well to assess whether or not the ratio indicates a good situation or requires changing. Following rules without understanding is never desirable. If we want to illustrate the results of a vertical analysis we normally draw a pie diagram. E.g., it shows how much labour a company pays as a percentage of its total of expenses, which might be an important information if the company <?page no="81"?> Berkau: Financial Statements 4e 5-77 plans to relocate to a country where labour costs are less. Ad (5): Ratio Analysis In general, the financial statements give us already quite good information about the company. The purpose of financial statements is along IAS 1.9: “[…] The objective of financial statements is to provide information about the financial position, financial performance and the cash flows of an entity that is useful for a wide range of users in making economic decisions. […].” The balance sheet provides information about the financial position. The statement of profit or loss and other comprehensive income provides information about the financial performance and how much thereof is repeatable and how much is extraordinary. The statement of cash flows shows the total cash flow and particular cash flows from operating, investing and financing activities. In total, a lot of information needs users of financial statements have is taken care of already. However, for special information purpose, it is helpful to calculate new ratios which are based on a combination of financial data taken from the different financial statements. Very often in Accounting, ratio analysis aims to comparisons. We assess companies, to set up a ranking, find the preferred company for decision making, preparing benchmarks etc. For that reason, we strive to design information to compare characteristics of companies, such as performance, liquidity, capital structure or market value. We later will structure ratio based on these information needs. Not all companies are comparable per se. I.e., different sizes of companies make comparisons difficult. Although the statement of profit or loss and other comprehensive income tells us about the financial performance, we cannot compare companies of different sizes. A 3,000 employee consulting firm earns a higher profit than a startup consultant operating as freelancer from a private home. In order to compare firms that differ in size, we calculate ratio as percentage of figures that tell us the size of the business. The net profit as a percentage of sales shows how much money is earned with every Euro received. The sale in the denominator factors in the company size into the equation. The above example seems to be obvious but sometimes the company’s financial data do not allow us comparisons without making new calculations. We check the companies A, B, C and D below and receive the data as depicted in Figure 5.1. Company Gross profit Sales GP/ Sales A 200,000.00 848,000.00 23.58% B 300,000.00 1,252,000.00 23.96% C* 500,000.00 1,927,500.00 25.94% D 350,000.00 1,468,400.00 23.84% Figure 5.1: Company data <?page no="82"?> Berkau: Financial Statements 4e 5-78 We can easily derive data for gross profit and sales from the income statements. The gross profit tells us how much is revenue less material expenses and it shows how much of profit is left for business activities and profit together. The sales represents the money or its equivalent received from the customers and gives us an idea about the size of the business. Which company is best? Only when we calculate the gross profit as percentage of sales we’ll see which company is most successful at selling its products on the market. We can say, for every 100.00 EUR (input) received, company A earns a gross profit of 23.58 EUR, company B: 23.96 EUR, company C: 25.94 EUR and company D: 23.84 EUR (output). Hence, the best performer is company C. The ratio gross profit as percentage of sales is a yield measurement and gives us an output-over-input-ratio. It tells us how efficient resources are deployed. Ratios are a very common instrument for financial statement analysis. They are calculated based on data we derive from financial statements. Some data depend on the time, others come from the balance sheet. If we take a figure from income statements, such as revenue, it is based on the time, in general on the entire Accounting period (1 year). In contrast, a figure derived from a real account, such as property, plant and equipment is not. It is linked to a particular date, most likely to the balance sheet date. In order to calculate ratios as fractions with figures from income statements and balance sheets, we have to make a decision, which data to apply: (a) the opening amount, (b) the closing amount or (c) the average of the above. In this text book we follow alternative (b). There are good reasons for alternatives (a) and (c), however, we apply the closing amounts, as it is based on one set of financial statements only. In other than academic situations we recommend to calculate the average amount from opening and closing amounts. Below, we classify ratios with regard to the aspects measured and follow these classifications for our following description: - Performance ratios. - Liquidity ratios. - Capital structure ratios. - Market value ratios. In order to explain the most common ratios, we apply them for the fictitious firm CAPELIFT (Pty) Ltd. below. Next, we introduce the firm shortly to provide you with an idea of the business. CAPELIFT (Pty) Ltd.: CAPELIFT (Pty) Ltd. is a small airline that rents out aircrafts and pilots for individual flying. The company operates 2 aircrafts, a Bombardier Lear-jet (jet) and a Mooney Bravo (single piston engine aircraft). The company is based at Cape Town Int’l airport. Both aircrafts are financed by bank loans at a rate of interest of 5.9 %/ a. On its balance sheet, the company shows an issued capital of: 1,000,000 × 7.50 = 7 7,500,000.00 ZAR which is the ordinary share capital. CAPELIFT (Pty) Ltd. owns its aircrafts and discloses them as assets under P, P, <?page no="83"?> Berkau: Financial Statements 4e 5-79 E. It records a bank loan for their financing, too. CAPELIFT (Pty) Ltd. has some commercial licensed pilots who are stand-by staff and work on a freelancer basis, meaning they bill CAPELIFT (Pty) Ltd. for their flights per flight time (Hobbs-hours) and charge travel expenses for stop-overs. CAPELIFT (Pty) Ltd. passes the pilots’ bills to its customers without further charge. CAPELIFT (Pty) Ltd.’s customers are mostly business people and private travellers who hire the aircrafts for business trips (jet) and to reach small domestic airfields with the Mooney. See below the financial statements for the Accounting period 20X8. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 60,000,000 Share capital 7,500,000 Intangibles Reserves 6,000,000 Financial assets Retained earnings 7,000,000 Current assets Liabilities (liab.) Inventory Long-term liab. 50,000,000 Acc. receivables A/ R 10,000,000 Short-term liab. A/ P 16,500,000 Prepaid expenses 2,000,000 Provisions Cash/ Bank 18,000,000 Income tax liab. 3,000,000 Total assets 90,000,000 Total equity and liab. 90,000,000 CapeLift (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 5.2: CAPELIFT (Pty) Ltd.’s balance sheet 20X8 [ZAR] Revenue 50,000,000 Other income 50,000,000 Materials Labour (14,000,000) Depreciation (2,500,000) Other expenses (20,550,000) Earnings before int. & taxes (EBIT) 12,950,000 Interest (2,950,000) Earnings before taxes (EBT) 10,000,000 Income tax expenses (3,000,000) Deferred taxes Earnings after taxes (EAT) 7,000,000 CapeLift (Pty) Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 5.3: CAPELIFT (Pty) Ltd.’s income statement (20X8) <?page no="84"?> Berkau: Financial Statements 4e 5-80 Ad (5.1): Performance Ratios Financial performance is the ability to be successful in business. It is an indicator whether a company reaches its monetary goals, most prominent, whether it earns money by its business operations. In order to achieve success, a company has to work efficiently. We frequently measure financial success by the monetary equivalent received when selling goods or services to customers. It is compared with the effort a company has to make to produce goods or render services. Performance ratios measure the yield and are based on the comparison between input and output. In terms of Mathematics, performance gives us either a difference or a percentage. The primary source for financial performance measurement is the statement of profit or loss and other comprehensive income. It compares the revenue received with expenses for goods production or service rendering and the sale thereof. Hence, the pure financial performance can be measured by profit calculation already. Profit is simply the difference of output and input and expressed as a figure with a currency unit, such as 7,000,000.00 ZAR. The interpretation suffers from being periodical, normally linked to a certain year, month or quarter. In addition to the pure profit calculation, financial performance ratios frequently compare profit with inputs, such as capital, sales or investments. In general, we try to exclude the influence of misleading bias from performance measurement, such as national taxes, bank loans’ interest or dividends. For the interpretation, we should be aware there are major differences which depend on the business model of a company with regard to return figures. I.e., a consultancy’s input is not capital but human resources. For that reason, production firms and other capital intensive industries, such as airlines, earn a significant lower return on capital than companies that earn money based on human capital. As a consequence, inter-industry comparisons normally do not work out. Below, we introduce the most common financial performance ratios: - Fixed Asset Turnover. - Inventory Turnover. - Return on Capital Employed. - Return on Assets. - Return on Shareholders’ Fund. - Return as Percentage of Sales - Earnings per Share. - Economic Value Added. Fixed Asset Turnover: The Fixed Asset Turnover measures the revenue as a percentage of the noncurrent assets. The revenue is the proceeds calculated after deducting discounts, VAT and further selling costs, such as transport, from the proceeds. Dividing the revenue by the non-current assets tells us whether a company made good investment decisions. A Fixed Asset Turnover is difficult to read when the company offers a lot of products/ services which are produced on the same machinery. If you can allocate revenue to certain investments you should do so. This gives you an investment based Fixed Asset Turnover. The ratio allows to assess investments <?page no="85"?> Berkau: Financial Statements 4e 5-81 and applies for asset management decisions. Fixed Asset Turnover is based on carrying amounts. Hence, a service rendered with a deployment of old machinery that leads to the same sales amount gives a higher Fixed Asset Turnover. CAPELIFT (Pty) Ltd. could obtain a high Fixed Asset Turnover by flying old aircrafts as long as customers accept this and the authorities certify the planes airworthy. However, if customers request fancy new aircrafts and are not prepared to fly with old ones, profit will decrease and the Fixed Asset Turnover goes down with it. The Fixed Asset Turnover for an airline depends mostly on the utilisation rate. Aircrafts only earn money when airborne. As longer the aircraft flies, as higher becomes the Fixed Asset Turnover. For that reason, many airlines compare the flight time which is the time when the aircraft initially moves with intention of taking-off on its own power until completion of next landing with the total period. Hence, the aim is to spend as less time on the ground and to prepare the aircraft for the next flight as quick as possible. Long haul flights have a higher Fixed Asset Turnover than domestic flights. As passengers are intolerant to delays and cancellations, airlines must keep resources stand-by. Hence, the total utilisation rate and Fixed Asset Turnover is traded off to a reliable service. It is reduced by keeping buffer aircraft reserves to compensate operating delays. Weather and traffic problems cannot be completely controlled by airlines either and reduce the Fixed Asset Turnover. CAPELIFT (Pty) Ltd. calculates a Fixed Asset Turnover of 50,000,000/ 60,000,000 = 883.33%. The ratio indicates low performance because CAPELIFT (Pty) Ltd. has a low utilisation rate. Its customers expect an aircraft availability that matches their travel plans. In order to boost its Fixed Asset Turnover, CAPELIFT (Pty) Ltd. could think of buying slower aircrafts and replace the expensive Mooney. Its Marketing department has to research whether customers are prepared to accept longer flight times for lower prices. We discuss below the plans to acquire an additional Cessna Caravan C172. Inventory Turnover: The Inventory Turnover is a performance ratio for production firms and trading companies. It measures how often stock is virtually replaced completely during an Accounting period. This tells us how often (frequency) a company sells its complete stock. The ratio applies in Logistics to identify fast moving and slow moving goods. In Accounting it is regarded as a performance measurement to calculate how quick goods are sold. A high Inventory Turnover makes a company flexible as it does not take long to clear stock, in particular when goods depend on fashion trends, such as in clothing industry. Inventory Turnover is very high where companies sell every day’s goods, such as groceries in discounters. The ratio is low for specialised companies that seek to offer a high variety of goods to its customers, such as KaDeWe selling a huge variety of, e.g., chocolate brands, in Berlin’s central department store. Also, a highly specialised business, such as companies selling no household brands face low Inventory <?page no="86"?> Berkau: Financial Statements 4e 5-82 Turnovers, such as companies selling high-end and pricy electronic equipment. In Accounting, we consider the quick selling of goods as good performance. A company selling quickly its goods will pay relatively low inventory and capital costs. For our case study CAPELIFT (Pty) Ltd. inventories are less important. The company does not even hold inventories for aviation gas nor for spare parts as the aircrafts are maintained at a wharf in the airport vicinity. We do not even calculate an Inventory Turnover for CAPELIFT (Pty) Ltd. Return on Capital Employed: Return on Capital Employed refers to the portion of equity and liabilities that is invested in the company’s business. In contrast, short-term liabilities are not regarded as investment and cost of capital are mostly covered by the creditors. Hence, only capital the company pays for - either by dividends or as interest - is considered to be employed capital. To calculate capital employed we add the total of equity and all longterm liabilities on the credit side of the balance sheet. The nominator is the pre-tax profit in order to keep the ratio free of income tax bias and make it comparable between different countries where other tax rates apply. CAPELIFT (Pty) Ltd.’s Return on Capital Employed equals to: 10,000,000 / (7,500,000 + 6,000,000 + 7,000,000 + 50,000,000) = 1 14.18 %. For interpretation, we have to compare the Return on Capital Employed with the rate of interest in South Africa which is at approximately 9 %/ a. Hence, the business model and the risk taking works out in comparison to interest expectations for financial instruments and under consideration of the inflation rate. Return on Assets: The Return on Assets measures the profit before interest and taxes (EBIT) as a percentage of all assets at carrying values. In line with IFRSs, the denominator is simply the total of the balance sheet. For the nominator, taxes and interest are not deducted to consider the full performance of the company with regard to productivity or service rendering. Taxes and interest do not matter. One major problem of the Return on Assets is that old machinery makes the ratio increase even if the production/ service does not change. An UBER driver who drives the same amount of rides every Accounting period will experience an increase in performance expressed as Return on Assets only due to decreasing carrying amounts because the car depreciates. The Return on Assets often applies in companies and groups in order to rank the productivity of certain plants, branches or subsidiaries. It is free of tax and interest bias and easily to calculate from the financial statements. CAPELIFT (Pty) Ltd.’s Return on Assets is amounting to: 12,950,000/ 90,000,000 = 14.39%. In case we compare the Return on Assets with the rate of interest for loans we get an indication of the pre-tax profit margin of the business in case the company would be financed completely by loans. <?page no="87"?> Berkau: Financial Statements 4e 5-83 Return on Shareholders’ Fund: Return on Shareholders’ Fund ROSF (= Return on Equity) is a ratio that represents the benefit that flows to investors. So far, we only focussed on performance from the point of view of the company or plant manager in terms of productivity or the yield for rendering service. We next look from the investor’s side. Return on Equity represents the owners’ return which results in possible earnings from investing funds in the company. The possibility of earnings refers to the pending dividend decision made by managers/ owners on the annual general meeting. To use the Return on Shareholders’ Funds as a performance ratio, we try to cancel out the influence of the dividend decision. Also company taxes are to be deducted as they are not available for dividends. The ROSF is calculated as EAT divided by the total of equity. We do not consider the actual dividends which can be also based on profits carried forward from previous Accounting periods. A Return on Shareholders’ Funds does not only measure performance but also can depend on the leverage effect. We discuss the leverage with the ratios on capital structure later in this chapter. CAPELIFT (Pty) Ltd.’s Return on Shareholders’ Funds is amounting to: 7,000,000 / (7,500,000 + 6,000,000 + 7,000,000) = 3 34.15%. The amount is extremely high as the company is deep in debts and is achieving a good performance above the rate of interest based on its Return on Assets. Return as the Percentage of Sales: Return as Percentage of Sales determines the gross profit or the net profit over sales. Both ratios tell us how much money is earned - either as gross profit or net profit - if the company sells its products. E.g., we want to know how much profit earns the airline when we buy a ticket that costs 100.00 EUR. A high percentage indicates the sale of innovative products and effective sales/ service/ production. It also shows us the market position of the firm. A service provider in a monopoly situation will achieve a high Return as Percentage of Sales. This is not the case in a highly competitive market, such as for car manufacturers who have to innovate their products in order to keep or expand their share of the market. The Net Return as Percentage of Sales for CAPELIFT (Pty) Ltd. is amounting to: 7,000,000/ 50,000,000 = 1 14%. This means the airliner earns an annual surplus of 14.00 ZAR for every 100.00 ZAR received from its customers. We consider the amount as low as it does not contain the pilot’s and crew’s salary and stop-over travel expenses which need to be deducted, too. Earnings per Share: Earnings per Share EPS is the only ratio that is subject to standardisation by IFRSs. The standard setter dedicated IAS 33 to EPS. We discuss Earnings per Share as a performance measurement. Performance should not be biased by dividend decisions made by the company’s management or by its owners on the annual general meeting. Once we factor in the decision about <?page no="88"?> Berkau: Financial Statements 4e 5-84 dividend declaration, the ratio won’t measure performance anymore. Hence, EPS measures the earnings for a full dividend paid to ordinary shareholders divided by the amount of ordinary shares. In contrast to real dividend calculations, it does not include a profit carried forward but is only based on actual earnings. IAS 33.10 defines the calculations. Some items are to be deducted before earnings are distributable to ordinary shareholders: (a) preference dividends and (b) in Germany, additions to legal reserves, compare with IAS 33.14. The calculation of earnings is ruled by IAS 33.12. The amount that is distributable to the ordinary shareholders is divided by the number of ordinary shares based on IAS 33.19. Changes in the amount of shares with or without payments are ruled by procedures along IAS 33.26 - IAS 33.29. CAPELIFT is based on 1,000,000 ordinary shares. Its earnings are amounting to 7,000,000.00 ZAR which gives Earnings per Share of: 7,000,000/ 1,000,000 = 77.00 ZAR/ s. The Earnings per Share ratio is mostly known from the denominator for the Price-Earnings ratio that compares the market share price of shares with the earnings per share. For further considerations with regard to EPS calculations follow the link below. Link 5.B: EPS calculations Economic Value Added: The Economic Value Added is the increase of the company’s value due to its earnings. For Economic Value Added calculation, the net operating profit after taxes is compared with the difference between assets and shortterm liabilities, the latter one multiplied by the Weighted Average Cost of Capital WACC. The difference between assets and short term liabilities represents the capital employed by the investors. My multiplying the capital employed with the WACC, we determine the profit that can be earned by an alternative investment under consideration of actual interest and cost of equity. This way, we compare net operating profits with its opportunity costs. The result is a difference on how much the shareholders’ company’s value increases measured in the currency unit and applicable under consideration of income taxes by a so called tax shield, here (1 - 30%). For CAPELIFT (Pty) Ltd. the Weighted Average Cost of Capital require to calculate average bank loan interest. The absolute interest payments are taken from the income statement and divided by the interest bearing liabilities to determine the interest rate. The pay-off portion of the bank loan for the next Accounting period is disclosed as accounts payables but requires payments of interest. We assume the pay-off for the bank loans is 5 % which matches to a useful life of 20 years of the aircrafts. The assumption here is that the bank loan finances the aircraft over their entire useful life. As a consequence, interest payments are divided by: (1 + 5%) × 50,000,000 = 52,500,000.00 ZAR. The rate of interest is accordingly to our above calculation: <?page no="89"?> Berkau: Financial Statements 4e 5-85 2,950,000 / 52,500,000 = 5 5.62%. We expect a minimum return to shareholders of 10 % as a dividend and calculate the WACC to: [10% × (7,500,000 + 6,000,000 + 7,000,000) + 5.62% × 52,500,000] / 73,000,000 = 6 6.85%. The EVA compares the net operating profit with the interest that could be earned on the capital market as opportunity costs. In order to compare the figures, we multiply the calculated WACC rate by the tax shield, which is amounting to: (1 - 30%) for this text book. The tax shield considers our virtual interest earnings being taxable expenses. Hence, the Economic Value Added calculation is: 7,000,000 - 6.85% × (1 - 30%) × (90,000,000 - 16,500,000 - 3,000,000) = 33,619,525.00 ZAR. The company increased its value by 3.62 million ZAR in comparison to an investment on the capital market based on the calculated WACC rate. Ad (5.2): Liquidity Ratios Liquidity is the ability to turn assets into an easily exchangeable form, preferably cash. Liquidity ratios tell us how quick a company’s assets can be transformed. In general, long-term assets, such as machinery or property is difficult to exchange. In contrast, the item cash/ bank is already in a liquid status. When we liquidate a company, we transform all assets into cash and take the money, e.g., to pay-off debts. Liquidity ratios tell us how quick cash can be generated by selling assets in order to retire liabilities. We distinguish the liquidity ratios below: - Current Ratio. - Quick Ratio. - Cash Ratio. - Debtors’ Collection Days. Current Ratio: The Current Ratio is current assets divided by current liabilities. A current ratio of 100 % means that all current liabilities are financed by short-term liabilities. In that case, the financing of the business is at low risks as non-current assets are financed with long-term liabilities or equity and current assets with short-term liabilities. At CAPELIFT (Pty) Ltd., the Current Ratio is: 30,000,000 / 19,500,000 = 1 153.85%. The Current Ratio tells us that CAPELIFT (Pty) Ltd. has enough current assets to pay-off its short-term liabilities. However, the Current Ratio does not tell us how the Financing for long-term assets is like. We do not know whether it is financed by equity or long-term debts. Quick Ratio: In contrast to the Current Ratio, the Quick Ratio only includes current assets that can be sold on short notice. We assume that inventories and prepayments are not quickly convertible and deduct them from current assets in order to determine the Quick Ratio. It is (current assets - inventories - prepayments) divided by short-term liabilities. A Quick Ratio of 100 % means that the easily sellable assets cover short-term debts. At CAPELIFT (Pty) Ltd., the Quick Ratio is: 28,000,000 / 19,500,000 = 1 143.59%. Hence, the quickly sellable current assets are sufficient in order to pay-off short-term liabilities. <?page no="90"?> Berkau: Financial Statements 4e 5-86 Cash Ratio: The Cash Ratio is a further step into the direction of short-term liquidation. It tells us how much cash and cash equivalents a company owns in order to pay-off the liabilities instantly, or within a few banking days. A Cash Ratio of 100 % means the company holds the short-term liabilities on cash or in a bank account. This gives a high liquidity. At CAPELIFT (Pty) Ltd., the Cash Ratio is amounting to: 18,000,000 / 19,500,000 = 992.31%. The amount is still very high and indicates that CAPELIFT (Pty) Ltd. holds a huge amount of cash. It is required by the situation in the aviation industry that labour, fuel and airport fees are payable prior to departure. A high liquidity is not per se a good indicator as it reduces performance. A liquidity reserve does not support business operations and drags down the performance of a company. Debtors’ Collection Days: The amount of receivables is considered for the liquidity and receivables are indicated as difficult to collect on short notice. However, in different industries there are different times for debt collection. In order to consider the time span of debt collection the Debtors’ collection Days divides the (total of receivables × 365) by the sales on credit. We assume that at CAPELIFT (Pty) Ltd. half of the customers pay on cash and the remaining ones delayed. This gives a Debtors Collection Days of 10,000,000 × 365 / 25,000,000 = 1 146 days. In other words, it takes the debtors on average 40 % of the year to pay their outstanding bills. Hence, 40 % of sales on credit are currently in the receivables. Ad (3): Capital Structure Ratios We can derive the capital structure straight from the statement of financial position. Its credit side tells us where the company’s funds originate from, in particular whether the company is financed by equity or liabilities. With regard to liabilities we also want to know the payment terms, in particular, whether a company’s debts are classified long-term or short-term. In general, we prefer financing where long-term assets are financed by longterm debts and short-term assets are financed short-term. In contrast, it is risky to finance long-term assets you depend on by funds that are due on short notice. When we analyse debts for companies that report in line with IFRSs we have to consider that long-term liabilities are disclosed at fair values or at amortised costs. For amortised cost calculation we measure the liability’s value by the effective interest method based on IFRS 9.5.4.1. that levels out volatility in measurement. We can assume the values applied for disclosure on the balance sheet represents the true and fair measurement of debts. In comparison, the German HGB overrates liabilities which results in the disclosure of higher than actual borrowings. Short-term liabilities are always disclosed at settlement values. We discuss below only few ratios as a lot of ratio for gearing provide us with the same information about the capital structure. It is important to understand why to analyse capital structure. It is <?page no="91"?> Berkau: Financial Statements 4e 5-87 for the leverage effect and liquidity decisions, as you will learn below. We cover: - Debt to Equity ratio D2E. - Working Capital. - Interest Coverage. Debt to Equity ratio: The Debt to Equity ratio is the relationship between liabilities and the total of equity. At CAPELIFT (Pty) Ltd., the Debt-to-Equity D2E ratio is: (90,000,000 - 20,500,000) / 20,500,000 = 3 3.39 or we say it is 339 %. This indicates that the company is high in debts which is understandable for a highly capital intensive industry, such as aviation. We also check the coverage of long-term assets by the debt structure. CAPELIFT (Pty) Ltd. has long-term funds which is part of its equity and long-term debts resulting from bank loans to the total extent of: 7,500,000 + 6,000,000 + 50,000,000 = 6 63,500,000.00 ZAR in order to finance the property, plant and equipment carried at 60,000,000.00 ZAR. 15 We consider the coverage as sufficient to keep the business operations going on. In Accounting and Finance, the leverage effect applies. This effect can increase the Return on Shareholders’ Funds basically by high borrowing. The formula for the ROSF reads: ROSF = RoA + D2E × (RoA i); therein is RoA Return on Assets, as profit plus interest divided by the total of assets, D2E is the Debt to Equity 15 For our calculations, we do not consider retained earnings as long-term as it is subject to claims of shareholders every year. ratio and is calculated as Liabilities over Equity and i is the (average) rate of interest for long-term debts. A company that is in debts can increase its Return on Shareholders’ Fund by growing and increasing its liabilities as long as the Return on Assets stays above the rate of interest. Very often the leverage effect is shown in diagrams where returns and interest is a steady line and shown as a function of borrowing. This implicates that any value for the Debt to Equity ratio can be realised. But that is wrong, we have to calculate returns and interest based on certain investment scenarios. Even investments on the capital market are not dividable to a minimum and, as a consequence, no steady return function actually applies. For that reason, we refuse to draw return over borrowing diagrams. Instead, we calculate single scenarios for decision making as below. We prepared the calculation of returns for CAPELIFT (Pty) Ltd. when acquiring an additional aircraft Cessna Caravan C172 as in order to expand its flying operations. Follow the QR-code below in Link 5.C for further considerations in regard to our mini airline. Link 5.C: CAPELIFT (Pty) Ltd. <?page no="92"?> Berkau: Financial Statements 4e 5-88 Ratios with regard to capital structure are often referred to as gearing. The expression comes from Engineering where a gear box is transforming torque and revolutions per minute RPM. The performance is a result of the relationship between the gear wheels to one another. A similar principle applies in business. The transformation is based on the debt to equity ratio if Return on Assets and the rate of interest remain constant. Caution, the leverage effect works both ways. It amplifies the return on shareholders’ funds in a positive and in a negative way. This means, borrowing can become risky, too. Working Capital: Working Capital is an absolute amount measured in currency units. It originates from Finance and is the difference between short-term assets and short-term liabilities. In Finance, we need to know the Working Capital in order to make a decision about the funds required to run a business. Besides the funds for investing in machinery, a company need funds to keep the business going, such as for inventories, e.g., spare parts or goods to sell, and for receivables in case customers are offered convenient payment methods. In case the supplier offers shortterm debts, such as pay next month or when goods have been sold, the shortterm liabilities offered reduce the funds requirements. Working Capital requires funds to run the business in addition to investments. Running consignment stock can reduce the Working Capital but it often is combined with higher material expenses. CAPELIFT (Pty) Ltd. discloses a Working Capital that consists of receivables, prepaid expenses, cash/ bank less shortterm liabilities (without the long-term debts’ pay-off portion) and tax liabilities. As at 31.12.20X8, the Working Capital is amounting to: 10,000,000 + 2,000,000 + 18,000,000 - (16,500,000 - 2,500,000) - 3,000,000 = 1 13,000,000.00 ZAR. In general, companies try to keep Working Capital as low as possible. They try to keep inventories low and hold as less cash as they can. In aviation industry a high cash portion is required in order to prepay operational expenses, such as fuel and labour. As CAPELIFT (Pty) Ltd. offers convenient payment to its customers, the receivables are considerably high. Interest Coverage: Interest Coverage measures how much the net profit before interest is able to cover the interest. The calculation is EBIT/ interest. The Interest Coverage at CAPELIFT (Pty) Ltd. is: 12,950,000 / 2,950,000 = 4 4.39. The amount is low which proves CAPELIFT (Pty) Ltd. is financed to a high extent. In contrast to the other ratios for gearing, Interest Coverage considers the costs for borrowing. If inverted and multiply it by 365 the Interest Coverage tells you how many days per year it takes to pay for borrowing. At CAPELIFT (Pty) Ltd. it takes 365 / 4.39 = 8 83.14 days. This means, the company works until 22 nd of March for the banks. Ad (5.4): Market Value Ratios We only can calculate market value ratios when a company is listed at a stock exchange. In those cases, the share <?page no="93"?> Berkau: Financial Statements 4e 5-89 price is accessible online and can be used on order to compare the fair market value with the valuation calculated by Accounting. The below listed market value ratios apply: - Price/ Earnings Ratio. - Dividend Yield. - Market Book Ratio. No fair market value is available for CAPELIFT (Pty) Ltd. as its shares are not traded publically. However, for this chapter, we assume that shares are traded at 15.00 ZAR/ s. We also assume that CAPELIFT (Pty) Ltd. declares a dividend of 50 % of its earnings for the Accounting period 20X8. Price Earnings Ratio P/ E: The Price Earnings Ratio compares the fair market price of a share with the Earnings per Share. Hence, it calculates the market price paid for a share over its annual earnings. As we divide the market price by the EPS, the Price Earnings Ratio gives the amount of periods to break even with a share buy, if the company always declares a dividend to 100 % of its earnings. At CAPELIFT (Pty) Ltd., the Price Earnings Ratio is: 25 / (7,000,000/ 1,000,000) = 33.57. Hence, an investor has to wait almost 4 years before he breaks even with the shares bought and dividends received. It is assumed, the company always declares a dividend to the highest possible amount. Dividend Yield: The dividend yield is the dividend paid divided by the fair market price of the share. It is a kind of return figure that shows the return on investment for the shareholder. We have to reduce our statement above to the wording “a kind of” as the payment for the shares is only assumed to be at the actual share market price. We can also calculate the Dividend Yield per share or for all shares, it won’t make a difference. At CAPELIFT (Pty) Ltd. the Dividend Yield is amounting to: (7,000,000 / 2) / (25 × 1,000,000) = 1 14%. Market Book Ratio: The Market Book Ratio of a share determines the fair market value as traded at a stock exchange as a percentage of the book value. The Market Book Value shows the confidence of investors in the company to increase the shareholders’ value as they are prepared to pay a price above the book value. The book value is more appropriate in case the company is bought to be liquidated at fair values. We assume the Market Book Value to be above 100 %. At CAPELIFT (Pty) Ltd., the Market Book Value is: 25 / ((7,500,000 + 6,000,000 + 7,000,000)/ 1,000,000) = 1 121.95%. Summary: We admit that in a short chapter of an Accounting text book we are not able to cover Financial Statement Analysis to satisfaction. Even though, we introduced the basics of the Financial Statement Analysis for companies that prepare their financial statements along IFRSs. The Financial <?page no="94"?> Berkau: Financial Statements 4e 5-90 Statement Analysis should only be undertaken if financial statements can be trusted, best after being audited. The Financial Statement Analysis contains a horizontal analysis, a vertical analysis and a ratio analysis. Most common ratios are linked to performance, liquidity and gearing. For publically listed companies, market value ratios shall be calculated. Accounting Technical Terms: Financial Statement Analysis: Evaluation of a company based on its financial statements. Gearing: Ratio of equity and liabilities amounts. Based on the leverage effect, gearing is a factor to amplify performance to a higher return on equity. Liquidity: Ability of a company to retire its debts on short notice. For payoff of liabilities, assets are to be sold. Market Value Ratios: Ratios that compare the share price of a company with Accounting data derived from financial statements. A market value ratio tells the investor whether the share price is valuable. Performance: Ability of a company to be productive in regard to goods manufacturing or rendering of services. Ratio: In Accounting, a ratio is a figure calculated from amounts taken from financial statements. Question Bank: (1) A company discloses a Return on Assets of 20 %. The equity is 100,000.00 EUR and the liabilities are 120,000.00 EUR. 1. The gross profit is 44,000.00 EUR. 2. The net profit is 44,000.00 EUR. 3. The net profit is 30,800.00 EUR. 4. The net profit is 20,000.00 EUR. (2) A company discloses inventories of 40,000.00 EUR, receivables of 10,000.00 EUR, cash/ bank of 20,000.00 EUR. The short-term liabilities are amounting to 50,000.00 EUR. 1. The cash ratio is 29 %. 2. The current ratio is 60 %. 3. The quick ratio is 60 %. 4. The cash ratio is 40 %. (3) A company shows 40 % liabilities at an interest rate of 4 %/ a and 60 % of equity. Its shareholders expect a return of 10 %. How much are the weighted average cost of capital? 1. 7.0%. 2. 7.6 %. 3. 4.0 %. 4. 6.4 %. (4) A company with 10,000 ordinary shareholders and 5,000 preference shareholders earns a pre-tax profit of 25,000.00 EUR. It declares a dividend of 50 % of the distributable amount to its ordinary shareholders. The preference dividend is 5,000.00 EUR. How much are its Earnings per Share if all shares have the same nominal value? 1. 1.50 EUR. 2. 1.25 EUR. 3. 0.70 EUR. 4. 0.63 EUR. (5) A company earns an operating profit before taxes of 100,000.00 EUR. The weighted average cost of capital are 5 %/ a. The assets are amounting to 1,000,000.00 EUR and the liabilities are 400,000.00 <?page no="95"?> Berkau: Financial Statements 4e 5-91 EUR. How much is the Economic Value Added? 1. 70,000.00 EUR. 2. 49,000.00 EUR. 3. 40,000.00 EUR. 4. 50.000.00 EUR. Solutions: 1-2, 2-4, 3-2, 4-4, 5-2. <?page no="96"?> Berkau: Financial Statements 4e 6-92 6. Formal Aspects of Financial Statements Learning Objectives: In this chapter you learn the formal requirements for the presentation of financial statements as set by the IASB. After studying chapter (6) you are familiarised with IAS 1 and can prepare financial statements formally correct. We teach you the concept of presenting financial statements and its underlaying assumptions. We cover the notes as well. We explain and demonstrate formal aspects by the case of BATHURST Ltd. in Australia. The company is a car rental based on shares. The currency is Austrian Dollars AUD. BATHURST Ltd. prepares financial statements according to IFRSs. IAS 1.16 requires that a company preparing financial statements that comply with IFRSs have to make an unreserved and explicit statement about that compliance. They normally do so in the notes, as you can see in Figure 6.8 for BATHURST Ltd. For general purpose financial statements, a company has to prepare a full set of financial statements at least annually. General purpose financial statements are statements a company prepares at the end of every Accounting period. No special occasions, such as mergers or liquidations, trigger the reporting. In accordance with our conventions, general purpose financial statements are prepared as at 31.12.20XX. Special circumstances can require reporting in shorter intervals, such as a listing at the New York Stock Exchange which makes companies prepare financial statements quarterly. The frequency of reporting is ruled by IAS 1.36. It also says how to prepare financial statements in cases the Accounting period is shorter, e.g., due to an establishment of the company in the middle of the year. In line with IAS 1.10, a full set of financial statements comprises a statement of financial position (balance sheet), a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows and the notes. The notes are required in order to disclose applied accounting policies and explanatory information. Based on IAS 1.38 and IAS 1.38A, all financial statements have to disclose comparative information for the preceding Accounting period which leads to a double set of financial statements, one for the reporting period and another one for the previous one. In case a company changes Accounting policies or parameters thereof, such as altering depreciation parameters, it has to prepare a balance sheet for the balance sheet date two Accounting periods prior to the day when the reporting period ends, which means the company discloses then in total three balances sheets, see IAS 1.40A. Financial statements follow Accounting principles, such as: (a) Fair presentation (IAS 1.15). (b) Going concern principle (IAS 1.25). (c) Accrual basis of Accounting (IAS 1.27). <?page no="97"?> Berkau: Financial Statements 4e 6-93 (d) Materiality and aggregation (IAS 1.29). (e) Prohibition of offsetting (IAS 1.32). (f) Consistency of presentation (IAS 1.45). Ad (a): Fair Presentation A basic principle of international Accounting is fair presentation. IAS 1.9 defines that the objective of financial statements is to provide information useful to a wide range of users in order for them to make economic decisions. This includes that no user group is prioritised, such as creditors by the German HGB. The information provided by financial statements is linked to the financial position, the profitability and the cash flows. In order to serve the needs of all users of financial statements, a company shall not bias information. IAS 1.15 states the fair presentation requires the faithful representation in regard to definitions and recognition criteria for assets, liabilities, income and expenses. F.OC12 (framework) states that information shall be complete, neutral and free from errors. Ad (b): Going Concern The going concern principle of Accounting requires that the user of financial statements can trust the company to go on with its operations for the foreseeable future. The company has to be able to continue its business if not stated otherwise. If the management of the reporting company does not intend or cannot continue its business or sees significant uncertainties to continue its business operations, it has to disclose these circumstances and may prepare financial statements under disclosure of liquidation values. Ad (c): Accrual Basis of Accounting Dynamic Accounting theory says that the purpose of financial statements is to inform the users about the financial performance. This requires to ascertain that income and expenses are recorded for the Accounting periods they belong to. The accrual basis of Accounting is required by F.44 (framework) and states that under this principle allocations are to be made towards the Accounting periods they are for and not as cash or its equivalent is paid or received. As a consequence, a cash flow statement cannot follow the accrual basis of accounting. See IAS 1.27 and F.OB17. In contrast to the statement of cash flows, the income statements strictly follows the accrual principle. This leads among other aspects to the disclosure of prepaid expenses and to the recording of depreciation on assets etc. Ad (d): Materiality and Aggregation Materiality in terms of Accounting means importance. IAS 1.29 requires that important items shall be presented separately unless the items are immaterial. Hence, if an item on the balance sheet is not material the reporting company shall not omit the item but can choose an aggregated disclosure together with other items. <?page no="98"?> Berkau: Financial Statements 4e 6-94 Ad (e): Prohibition of Offsetting IAS 1.32 says no offsetting is allowed except permitted by a special standard. Offsetting means to deduct negative amounts from positive ones and only disclose the difference thereof. We do so when we consider depreciation on assets of pay-off amounts for liabilities. However, offsetting liabilities and receivables for a business partner is not accepted under the above mentioned standard. 16 However, it is common to offset inputand output-VAT as we apply one VAT account only. Ad (f): Consistency of Presentation IAS 1.45 requires to continue the presentation formats and classifications of items from one period to the next one. Hence, we cannot change the presentation or classification of items. The standard defines that changes are only accepted if the company needs items to be presented differently in order to provide better information that is reliable and more relevant to users of financial statements and the revised structure is likely to be continued. Financial statements have to follow identification requirements in line with IAS 1.49. The standard says how a statement header looks like and what information must be included. IAS 1.51 defines how financial statements are identified. The header shall show the name of the reporting company, the date/ period the statement is for, the reporting currency and the level of rounding. In particular, for single-entity financial statements the 16 An exception is in IAS 7.22. name of the reporting company is disclosed together with its legal form, e.g., KIELING Taxi GmbH. The legal form disclosure indicates that the financial statements are no group statements nor separate financial statements based on IAS 27. Below we study the car rental business BATHURST Ltd. We prepare a full set of financial statements including notes for a 2 years Accounting period. The financial statements are discussed as at the balance sheet date 31.12.20X6. So, we cover the time from 1.01.20X5 until 31.12.20X6, which includes 2 full Accounting periods. BATHURST Ltd. is based on 50,000 ordinary shares 5.00 AUD/ s. The company is a car rental. The company is established on 1.01.20X4. At the beginning of the Accounting period 20X5, BATHURST owns three cars Mercedes-Benz C-class. All cars are one year old. Depreciation is calculated along straight-line method over four years, the residual value per car is 5,000.00 AUD/ car. Costs of acquisition are 65,000.00 AUD/ car. The company operates its business from an office which is bought at 150,000.00 AUD. The office has been written-off by 12,500.00 AUD as at 1.01.20X5. For financing the office, BATHURST Ltd. took a bank loan on 1.01.20X4. The bank loan’s principle is 150,000.00 AUD and the annual rate of interest is 2.5 %/ a. Every year, BATHURST Ltd. pays-off an amount of 15,000.00 AUD. At the time of 1.01.20X5, the amount owing is amounting to: 150,000 - 15,000 = 1135,000.00 AUD. Figure 6.1 gives you <?page no="99"?> Berkau: Financial Statements 4e 6-95 the pro-forma balance sheet of BATHURST Ltd. as at 1.01.20X5. 17 An explanation about the calculation of the opening balance sheet and the application of the effective interest method for the bank loan disclosure can be downloaded below through Link 6.A. The effective rate of interest is 3.12 %/ a: Link 6.A: BATHURST Ltd. A C, L Non-current assets [AUD] Equity [AUD] P, P, E 287,500 Share capital 250,000 Intangibles Reserves Financial assets Retained earnings (61,596) Current assets Liabilities (liab.) Inventory Long-term liab. 120,346 Accounts receivables Short-term liab. A/ P 15,000 Prepaid expenses Provisions Cash/ Bank 36,250 Income tax liab. Total assets 323,750 Total equity and liab. 323,750 Bathurst Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X5 Figure 6.1: BATHURST Ltd.’s balance sheet (20X4) BATHURST Ltd. rents out the cars at a rate of 100.00 AUD/ d (ex VAT). During the Accounting period 20X5, BATHURST Ltd. rents out the cars for 850 days. Hence, BATHURST Ltd.’s revenue is: 850 × 156 = 1 132,600.00 AUD. The revenue is recorded as Bookkeeping entry (1). In 20X5 and in 20X6, depreciation on the cars is 15,000.00 AUD/ (a × car). The total annual depreciation is amounting to: 3 × 15,000 = 4 45,000.00 AUD/ a. Depreciation in 20X5 is recorded as Bookkeeping entry (2a). Depreciation on the office is 12,500.00 AUD/ a and recorded as Bookkeeping entry (2b). 17 This balance sheet is not subject to our considerations in regard to formal aspects. Only financial statements for 20X6 are. The interest is based on the amount owing which is: 120,000 + 15,000 = 135,000.00 AUD. Based on the effective interest method, the expenses are calculated with an effective rate of interest of 3.12 %/ a. For 20X5, this gives an effective interest of: 116,970.52 × 3.12 0395 % = 33,649.94 AUD in 20X5. The interest paid for the bank in 20X5 is amounting to: (150,000 - 15,000) × 2.5% = 3 3,375.00 AUD. See below the Bookkeeping entries (3a) and (3b) made for the bank loan. The effective interest rate is calculated by iteration and guarantees the final amount is nil after settlement of scheduled payments. <?page no="100"?> Berkau: Financial Statements 4e 6-96 DR Interest..................... 3,649.94 AUD CR Interest Bearing Liabilities. 3,649.94 AUD DR Interest Bearing Liabilities. 3,375.00 AUD CR Cash/ Bank.................... 3,375.00 AUD The pay-off of the bank loan is 15,000.00 AUD/ a and reduces short-term liabilities. See Bookkeeping entry (4) for the pay-off in 20X5. The pay-off amount for 20X6 is transferred into the Short-term Liabilities account by Bookkeeping entry (5). Operational costs in 20X5 are 48,000.00 AUD. (Bookkeeping entry (6)). BATHURST Ltd.’s pre-tax profit in 20X5 is amounting to: 132,600 - 45,000 - 12,500 - 3,649.94 - 48,000 = 2 23,450.06 AUD. After tax reduction an amount of: (1 - 30%) × 23,450.06 = 1 16,415.04 AUD remains for the annual surplus. BATHURST Ltd. declares a dividend of 0.10 AUD/ s payable in the next Accounting period 20X6. Observe the accounts in Figure 6.2. D C D C OV 345,000.00 c/ d 345,000.00 OV 57,500.00 b/ d 345,000.00 (2a) 45,000.00 c/ d 115,000.00 (2b) 12,500.00 115,000.00 115,000.00 b/ d 115,000.00 Property, plant and equipment PPE Acc depr ACC D C D C (5) 15,000.00 OV 120,345.52 (4) 15,000.00 OV 15,000.00 (3b) 3,375.00 (3a) 3,649.94 c/ d 15,000.00 (5) 15,000.00 c/ d 105,620.46 30,000.00 30,000.00 123,995.46 123,995.46 b/ d 15,000.00 b/ d 105,620.46 Interest bearing liabilities IBL Short-term liabilities A/ P D C D C (2a) 45,000.00 P5L 57,500.00 (3a) 3,649.94 P5L 3,649.94 (2b) 12,500.00 57,500.00 57,500.00 Depreciation-20X5 DPR Interest-20X5 INT Figure 6.2: BATHURST Ltd.’s accounts (20X5) <?page no="101"?> Berkau: Financial Statements 4e 6-97 D C D C P5L 132,600.00 (1) 132,600.00 c/ d 26,520.00 (1) 26,520.00 b/ d 26,520.00 Revenue-20X5 REV Value added tax VAT D C D C OV 36,250.00 (3b) 3,375.00 (6) 48,000.00 P5L 48,000.00 (1) 159,120.00 (4) 15,000.00 (6) 48,000.00 c/ d 128,995.00 195,370.00 195,370.00 b/ d 128,995.00 Cash/ Bank C/ B Operational expenses-20X5 OEX D C D C DPR 57,500.00 REV 132,600.00 c/ d 7,035.02 ITL 7,035.02 INT 3,649.94 b/ d 7,035.02 OEX 48,000.00 EBT 23,450.06 132,600.00 132,600.00 ITL 7,035.02 b/ d 23,450.06 R/ E 16,415.04 23,450.06 23,450.06 Profit and Loss-20X5 P5L Income tax liabilities ITL D C D C OV 61,595.52 P5L 16,415.04 c/ d 5,000.00 R/ E 5,000.00 DIV 5,000.00 c/ d 50,180.48 b/ d 5,000.00 66,595.52 66,595.52 b/ d 50,180.48 Retained earnings R/ E Dividends/ p DIV Figure 6.2: BATHURST Ltd.’s accounts (20X5) continued In 20X6, BATHURST Ltd. pays income taxes by Bookkeeping entry (A), VAT liabilities (B) and dividends (C). Depreciation on cars (D) is again 45,000.00 AUD and depreciation on the office (E) equals to 12,500.00 AUD. The interest is based on the effective rate of interest and equals to 3,202.16 AUD. The interest amount paid to the bank is: (105,000 + 15,000) × 2.5% = 3 3,000.00 AUD. Interest is recorded by Bookkeeping entries (F1) and (F2). The pay-off amount reduces the short-term liabilities to the extent of 15,000.00 AUD, see Bookkeeping entry (G). Again, pay-off for the next upcoming Accounting period 20X7 is transferred from the Interest Bearing Liabilities account into short-term liabilities (H). The revenue is recognised as: 860 × 175 = 1 150,500.00 AUD. Observe Bookkeeping entry (I). Operational expenses are amounting to 65,000.00 AUD. They are not VATable and recorded by Bookkeeping entry (J). In order to make use of the cash reserves, BATHURST Ltd. invests 200,000.00 AUD in bonds with an annual coupon rate of 4 %/ a on 2.01.20X6 <?page no="102"?> Berkau: Financial Statements 4e 6-98 (K). The bonds’ interest earned (coupon) is recorded as Bookkeeping entry (L) and is amounting to: 200,000 × 4% = 88,000.00 AUD. You find the amount on the credit side of the Coupon account. The investment leads to an overdraft of the bank account. As a consequence, the balancing figure of the Cash/ Bank account is disclosed as short-term liability on the balance sheet to the extent of 3,960.02 AUD. After profit calculation, BATHURST Ltd. suggests its investors to declare a dividend of 0.15 AUD/ s. The financial statements are prepared under the appropriation of profits and show a dividend claim of its shareholders to the extent of: 50,000 × 0.15 = 7 7,500.00 AUD. We show BATHURST Ltd.’s accounts as at 31.12.20X6 in Figure 6.3. D C D C OV 345,000.00 c/ d 345,000.00 OV 57,500.00 b/ d 345,000.00 (2a) 45,000.00 c/ d 115,000.00 (2b) 12,500.00 115,000.00 115,000.00 b/ d 115,000.00 (D) 45,000.00 c/ d 172,500.00 (E) 12,500.00 172,500.00 172,500.00 b/ d 172,500.00 Property, plant, equipment PPE Acc depr ACC D C D C (5) 15,000.00 OV 120,345.52 (4) 15,000.00 OV 15,000.00 (3b) 3,375.00 (3a) 3,649.94 c/ d 15,000.00 (5) 15,000.00 c/ d 105,620.46 30,000.00 30,000.00 123,995.46 123,995.46 (G) 15,000.00 b/ d 15,000.00 (H) 15,000.00 b/ d 105,620.46 c/ d 15,000.00 (H) 15,000.00 (F2) 3,000.00 (F1) 3,202.16 30,000.00 30,000.00 c/ d 90,822.62 b/ d 15,000.00 108,822.62 108,822.62 b/ d 90,822.62 Interest bearing liabilities IBL Short-term liabilities A/ P D C D C (D) 45,000.00 P6L 57,500.00 (F1) 3,202.16 P6L 3,202.16 (E) 12,500.00 57,500.00 57,500.00 Depreciation-20X6 DPR Interest-20X6 INT D C D C P6L 150,500.00 (I) 150,500.00 (B) 26,520.00 b/ d 26,520.00 c/ d 30,100.00 (I) 30,100.00 56,620.00 56,620.00 b/ d 30,100.00 Revenue-20X6 REV Value added tax VAT Figure 6.3: BATHURST Ltd.’s accounts (20X6) <?page no="103"?> Berkau: Financial Statements 4e 6-99 D C D C OV 36,250.00 (3b) 3,375.00 (J) 65,000.00 P6L 65,000.00 (1) 159,120.00 (4) 15,000.00 (6) 48,000.00 c/ d 128,995.00 195,370.00 195,370.00 b/ d 128,995.00 (A) 7,035.02 REV 180,600.00 (B) 26,520.00 (L) 8,000.00 (C) 5,000.00 (F2) 3,000.00 (G) 15,000.00 (J) 65,000.00 ´c/ d 3,960.02 (K) 200,000.00 321,555.02 321,555.02 b/ d 3,960.02 Cash/ Bank C/ B Operational expenses-20X6 OEX D C D C DPR 57,500.00 REV 150,500.00 c/ d 7,035.02 ITL 7,035.02 INT 3,202.16 CPN 8,000.00 (A) 7,035.02 b/ d 7,035.02 OEX 65,000.00 c/ d 9,839.35 P6L 9,839.35 EBT 32,797.84 16,874.37 16,874.37 158,500.00 158,500.00 b/ d 9,839.35 ITL 9,839.35 b/ d 32,797.84 R/ E 22,958.49 32,797.84 32,797.84 Profit and loss-20X6 P6L Income tax liabilities ITL D C D C OV 61,595.52 P5L 16,415.04 c/ d 5,000.00 R/ E 5,000.00 DIV 5,000.00 c/ d 50,180.48 (C) 5,000.00 b/ d 5,000.00 66,595.52 66,595.52 c/ d 7,500.00 R/ E 7,500.00 b/ d 50,180.48 P6L 22,958.49 12,500.00 12,500.00 DIV 7,500.00 c/ d 34,721.99 b/ d 7,500.00 57,680.48 57,680.48 b/ d 34,721.99 Retained earnings R/ E Dividends/ p DIV D C D C (K) 200,000.00 c/ d 200,000.00 P6L 8,000.00 (L) 8,000.00 b/ d 200,000.00 Financial instruments FIN Interest earned-20X6 CPN Figure 6.3: BATHURST Ltd.’s accounts (20X6) continued Below, we prepare the annual financial statements for 20X6 in which we disclose comparative information for 20X5 in the left column. BATHURST Ltd. prepares annual financial statements every year on its balance sheet date 31 st December. The annual reporting is a requirement resulting from IAS 1.36. Annual financial state- <?page no="104"?> Berkau: Financial Statements 4e 6-100 ments meet the needs of general purpose financial statements based on IAS 1.7. BATHURST Ltd.’s 20X6’s financial statements show comparative information for 20X5 in line with the Framework F.QC20 and IAS 1.38. Along with IAS 1.10, a set of financial statements comprises of: (1) Statement of financial position. (2) Statement of profit of loss and other comprehensive income. (3) Statement of changes in equity. (4) Statement of cash flows. (5) Notes. Ad (1): Statement of Financial Position The statement of financial position is the balance sheet. In F.4.4, the IASB defines the elements of financial position as assets, liabilities and equity. Definitions for the elements are given as: - An asset is a resource controlled by the company as result of past events and from which future economic benefits are expected to flow to the company. 18 - A liability is a present obligation of the company arising from past events the settlement of which is expected to result in an outflow from the company of resources embodying economic benefits. 19 - Equity is the residual interest in the assets of the company after deducting all its liabilities. 20 The equity definition is referring to the difference of assets and liabilities. We can easily verify the evaluation of equity when we think of a liquidation. A company that sells all its assets at fair values and retires its debts at fair values and without transaction costs makes equity its remaining company value. We refer to the amount as the book value of the business as it is derived from the Bookkeeping records. At BATHURST Ltd., the book value of the company is amounting to 215,278.01 AUD. This is a book value of every share of: 215,278.01 / 50,000 = 4 4.31 AUD/ s. The book value is below the face value of the shares - this is normally a bad sign but here it results from not considering revenues in 20X4 for the case study. BATHURST Ltd. prepares the balance sheet as disclosed in Figure 6.4 for 20X6. 18 Read in the Framework: F4.8 - 4.14. 19 Read in the Framework: F.15 - F.19. 20 Read in the Framework: F.20 - F.23. <?page no="105"?> Berkau: Financial Statements 4e 6-101 A 20X6 20X5 20X6 20X5 C, L Non-current assets [AUD] [AUD] Equity [AUD] [AUD] P, P, E 172,500 230,000 Share capital 250,000 250,000 Intangibles Reserves Financial assets 200,000 Retained earnings (34,722) (50,180) Current assets Liabilities (liab.) Inventory Long-term liab. 90,823 105,620 Accounts receivables Short-term liab. A/ P 56,560 46,520 Prepaid expenses Provisions Cash/ Bank 0 128,995 Income tax liab. 9,839 7,035 Total assets 372,500 358,995 Total equity and liab. 372,500 358,995 Bathurst Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X6 Figure 6.4: BATHURST Ltd.’s balance sheet (20X6) In contrast to the previous balance sheets, we notice that comparative information for 20X5 is provided. In line with IAS 1.51, BATHURST Ltd.’s has to clearly identify its financial statements. It discloses the name (BATHURST Ltd.), indicates whether it is a single-entity financial statement, separate financial statement or a group statement by disclosure of the legal form (Ltd.), shows the balance sheet-date (31.12.20X6) the financial statement represents figures for, indicates the reporting currency (AUD for Australian Dollars) and gives the rounding level (AUD for full Australian Dollars). The requirements for the statement of financial position are laid out by IAS 1.54. BATHURST Ltd.’s financial statements disclose all required items of assets, liabilities and equity. IAS 1.56 makes companies disclose current and non-currents assets and liabilities separately. BATHURST Ltd. shows long-term assets, such as cars and property, and 21 See below in this chapter (6). cash/ bank as short-term assets. The single amounts are not shown on the balance sheet but in the notes in the register of non-current assets. 21 With regard to liabilities, the disclosure is more difficult as the bank loan contains a shortterm portion, which is the pay-off amount for the next Accounting period, as well as a long-term portion due in more than one Accounting period. The distinction of liabilities is covered by IAS 1.69. In contrast to short-term liabilities, long-term ones are disclosed in accordance with the effective interest method required by IFRS 9.5.3.1 and IFRS 9.4.2.1. As the bank loan is kept until settlement a valuation based on the effective interest method applies. As at 31.12.20X6, BATHURST Ltd. discloses the long-term liabilities resulting from the bank loan at 90,822.63 AUD and the short-term liabilities at 15,000.00 AUD; the latter one are due on 31.12.20X7. The item short-term liabilities is disclosed as accounts payables (A/ P) on the balance sheet and includes <?page no="106"?> Berkau: Financial Statements 4e 6-102 the short-term bank loan portion, VAT liabilities and claims of the shareholders for the dividend as well as the bank account overdraft. The tax liabilities require an extra item according to IAS 1.54 in combination with IAS 12. The item only shows income tax liabilities. No VAT liabilities should be disclosed under this header. For VAT payables we apply the item short-term liabilities A/ P. BATHURST Ltd.’s equity is amounting to: 372,500 - 90,822.63 - 56,560.02 - 9,839.35 = 2 215,278.00 AUD. It includes one kind of shares (ordinary shares) and negative retained earnings. Ad (2): Statement of Profit or Loss and Other Comprehensive Income The statement of profit or loss and other comprehensive income shows profit or loss and extraordinary items for gains and losses. IAS 1.81A - IAS 1.105 specify the disclosure of profit or loss and other comprehensive income. The Framework F.4.24 specifies that the financial performance depends directly on income and expenses. In line with F.5.25, income is defined as increases in economic benefits during the Accounting period as inflows and enhancements of assets or decreases of liabilities that lead to an increase in equity - other than equity changes linked to owners, such as share issues. In contrast, expenses are seen as decreases of economic benefits during the Accounting period in form of outflows or depletion of assets or incurrences of liabilities resulting in a decrease of equity - again: other than equity changes linked to owners. Income can be revenue and gains - based on F.4.29. Revenue is the funds received in exchange for business activities, F.4.29 lists items, such as sales, fees, interest, dividends, royalties and rent. F.4.31 does not define gains but gives examples. Along those, gains can be seen as extraordinary income, such as sales of non-current assets. Gains shall be disclosed separately from revenues and very often are reported net of expenses. BATHURST Ltd. discloses the statement of profit or loss and other comprehensive income as displayed in Figure 6.5. <?page no="107"?> Berkau: Financial Statements 4e 6-103 20X6 20X5 [AUD] [AUD] Revenue 150,500 132,600 Other income 8,000 158,500 132,600 Depreciation (57,500) (57,500) Other expenses (65,000) (48,000) Earnings before int. & taxes (EBIT) 36,000 27,100 Interest (3,202) (3,650) Earnings before taxes (EBT) 32,798 23,450 Income tax expenses (9,839) (7,035) Earnings after taxes (EAT) 22,958 16,415 Bathurst Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X6 Figure 6.5: BATHURST Ltd.’s income statement (20X6) BATHURST Ltd. has to disclose the revenue from renting out cars separately from interest earned by its bonds, based on IAS 1.82. At BATHURST Ltd., the income adds up to 158,500.00 AUD in 20X6. The expenses include depreciation and other expenses, which are here the operational expenses. An income statement does not have to show all single items of expenses, only as detailed as required by IAS 1.82. An income statement is more aggregated as a Profit and Loss account. A company can prepare the income statement based on the nature of expenses (IAS 1.102) or based on the cost of sales (IAS 1.103). It is common Accounting practice to disclose the earnings before interest and taxes EBIT in a separate line. IAS 1.82 requires the disclosure of finance costs separately which is shown for BATHURST Ltd. as interest item and is based on the bank loan. After deduction of income taxes, which are calculated by the income statement based on national tax law, the annual profit or also called earnings after taxes are disclosed on the bottom line. Ad (3): Statement of Changes in Equity In line with IAS 1.106, equity changes either by profit or loss, by other comprehensive income or by transactions with the owners. The standard requires companies to prepare a statement of changes in equity, which, e.g., shows columns for components of equity and lines at the beginning and end of the Accounting period as well as changes of equity during the Accounting period, see IAS 1.108 and IAS 1.109. Below in Figure 6.6, we show BATHURST Ltd.’s statement of changes in equity for the Accounting periods 20X5 and 20X6. <?page no="108"?> Berkau: Financial Statements 4e 6-104 Share capital Reserves Retained earnings total [AUD] [AUD] [AUD] [AUD] as at 1.01.20X5 250,000 (61,596) 188,404 Profit 20X5 (EAT) 16,415 16,415 Dividend 20X5 (5,000) (5,000) as at 31.12.20X5 250,000 0 (50,180) 199,820 Profit 20X6 (EAT) 22,958 22,958 Dividend 20X6 (7,500) (7,500) as at 31.12.20X6 250,000 0 (34,722) 215,278 Bathurst Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X6 Figure 6.6: BATHURST Ltd.’s statement of changes in equity (20X6) BATHURST Ltd. changed the equity by the profits earned in 20X5 and 20X6 as well as by paying a dividend for both years. The statement of changes in equity discloses how the book value of the company changes due to profit or loss and transactions with owners. Ad (4): Statement of Cash Flows The cash flow statement is required by IAS 1.10 and its calculation is covered by IAS 7 as laid out in IAS 1.111. 20X6 20X6 20X5 20X5 [AUD] [AUD] [AUD] [AUD] Cash flow from operating acitivities Proceeds 180,600 159,120 Operating expenses (65,000) (48,000) Income tax payment (7,035) VAT payment (26,520) 82,045 111,120 Cash flow from investing activities Bond investment (200,000) 0 (200,000) 0 Cash flow from financing activities Dividend paid (5,000) Coupon received 8,000 Interest paid (3,000) (3,375) Pay-off bank loan (15,000) (15,000) (15,000) (18,375) Total cash flow (132,955) 92,745 Bathurst Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X6 Figure 6.7: BATHURST Ltd.’s statement of cash flows (20X6) <?page no="109"?> Berkau: Financial Statements 4e 6-105 The statement of cash flows discloses comparative information for the previous Accounting period, too. The cash flow statement shall present the cash flows of the reporting Accounting period classified in operating, investing and financing activities, based on IAS 7.10. IAS 7.14 gives examples of operating cash flows. IAS 7.16 lists possible cash flows from investing activities and IAS 7.17 shows examples for financing cash flows. For the calculation of operating cash flows, a company can either apply the direct method or reconcile the operating cash flow with the earnings after taxes. Both methods comply with IAS 7.18. BATHURST Ltd. calculates its operating cash flow based on the direct method. Cash flows are taken straight from the Cash/ Bank account. Interest earned as well as paid are considered being cash flows from financing activities in accordance with IAS 7.33. Interest paid for the bank loan and received from the bonds are reported separately, see IAS 7.31. No offsetting is allowed. The dividend is classified as financing cash flow following IAS 7.34. The income tax payment is disclosed as operating cash flow which is consistent with IAS 7.35. Ad (5): Notes In contrast to German Accounting, notes are a more detailed description of Accounting policies. IAS 1.112 requires the notes to give present information about the basis of preparation of financial statements and the Accounting policies applied as well as to show information required by IFRSs that is not disclosed in other financial statements, e.g., the register of noncurrent assets. IAS 1.113 states that notes shall be presented in a systematic manner 22 in order to make them understandable and comparable. A company shall prepare notes. IAS 1.10 says that the notes are an element of a full set of financial statements. BATHURST Ltd. prepares the notes based on the information below: (a) Accounting policies. (b) Equity. (c) Non-current interest bearing liabilities. (d) Tangible assets. (e) Inventory. (f) Tax liabilities. (g) Dividends. (h) Revenue. (i) Expenses. See below the notes of BATHURST Ltd. linked to the financial statements as at 31.12.20X6 in Figure 6.8. 22 Examples of systematic ordering gives IAS 1.114. <?page no="110"?> Berkau: Financial Statements 4e 6-106 Bathurst Ltd.’s NOTES to FINANCIAL STATEMENTS as at 31.12.20X6 (a) Accounting Policy These annual financial statements are prepared in accordance to IFRSs and the Company’s Act in Australia. The international standards below apply: - IAS 1, - IAS 7, - IAS 12, - IAS 16, - IAS 32, - IFRS 7, - IFRS 9, - IFRS 13, - IFRS 15. The company was established on 2.01.20X4 in the legal form of a limited company (Ltd.) under Australian law. Its balance sheet date is 31.12. BATHURST Ltd. is registered for VAT reduction. The board of directors as at 31.12.20X6 is: - Chief executive officer (CEO), chairman: Peter Lansfield (holding 10,000 ordinary shares) - Chief financial officer (CFO): Patricia Glenroy (holding 5,000 ordinary shares) - Chief operations officer (COO): Hank McKay (holding 6,000 ordinary shares) The financial statements have been audited by the independent Australian auditing firm SAFETRUST Ltd. on 5.02.20X7. The statement of auditors discloses that in their opinion, the financial statements present fairly, in all material respects, the financial position of BATHURST Ltd. as at 31 December 20X6, and its financial performance and cash flows for the year then ended in accordance with International Financial Reporting Standards and the requirements of the company’s act in Australia. The Accounting period 20X6 started on 1.01.20X6 and ended on 31.12.20X6. Comparative information is given for the fiscal year 20X5 as at 31.12.20X5. The financial statements are prepared on historical cost basis. Tangible assets are valued at cost less accumulated depreciation. Depreciation method is straight-line method for tangible assets. <?page no="111"?> Berkau: Financial Statements 4e 6-107 Liabilities are reported on amortised costs applying the effective interest method in accordance to IFRS 9. ((b) Equity Issued capital: BATHURST Ltd. was established on 2.01.20X3 by a par value share issue of 50,000 ordinary shares at 5.00 AUD/ s. Authorised shares: 100,000 ordinary shares at 5.00 AUD/ s nominal amount Issued shares: 50,000 ordinary shares at 5.00 AUD/ s nominal amount Reserves: - Capital reserves: n/ a. - Earnings reserves: n/ a. - Revaluation reserves: n/ a. Retained earnings: Retained earnings result from the valuation of liabilities and annual surplus of prior Accounting periods. (c) Interest bearing liabilities The non-current interest bearings liabilities result from a bank loan with COMMONWEALTH BANK. The bank loan is a mortgage with an annual rate of interest of 2.5 %/ a. The principal is 150,000.00 AUD. The annual pay-off amount is 15,000.00 AUD/ a. The bank loan is secured by the office building, a separate title office located in 3141 Melbourne, 193 Toorak Rd. The bank loan is valuated based on amortised costs. The effective interest method applies. The present value of loans is: 105,822.63 AUD. The short-term liability portion thereof is 15,000.00 AUD. The settlement amount for the bank loan is: 105,000.00 AUD. There are no further bank loans. (d) Tangible assets Tangible assets are 1 office, separate titled in an office block and 3 cars Mercedes-Benz C-class. The office was transferred to Bathurst Ltd. on 5.01.20X4. The address is 193 Toorak Rd, 3141 Melbourne. The floor size of the office is 47 m 2 . The purchase price plus cost of conveyance (total costs of acquisition) are 150,000.00 AUD. The office is financed by a bank loan (mortgage) of 150,000.00 AUD. The cars are disclosed on the register of non-current assets as a group of cars. The cars have been purchased at 65,000.00 AUD/ car on 2.01.20X4. The residual value of the cars is estimated to be: 3 × 5,000 = 1 15,000.00 AUD. Depreciation is over a period of 4 years along straight-line method. Depreciation costs on motor vehicles are 15,000.00 AUD/ a. <?page no="112"?> Berkau: Financial Statements 4e 6-108 Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount Office (Toorak Rd, Melbourne) 150,000 (37,500) 0 112,500 Cars 3 Mercedes-Benz C-class 195,000 (135,000) 0 60,000 Total 172,500 Bathurst Ltd.'s REGISTER of NON-CURRENT ASSETS as at 31.12.20X6 The reconciliation of opening amounts with closing amounts is displayed on group level below: Cars Office total [AUD] [AUD] [AUD] opening amount 20X5 150,000 137,500 287,500 additions 0 disposal 0 depreciation (45,000) (12,500) (57,500) impairment loss 0 revaluations 0 closing amount 20X5 105,000 125,000 230,000 additions 0 disposal 0 depreciation (45,000) (12,500) (57,500) impairment loss 0 revaluations 0 closing amount 20X6 60,000 112,500 172,500 Bathurst Ltd.'s RECONCILIATION of OPENING VALUES with CLOSING VALUES as at 31.12.20X6 ((e) Inventory Bathurst Ltd. does not carry inventories as at 31.12.20X6. (f) Tax liabilities Income taxes (IAS 12) All income tax liabilities along IAS 12 are resulting from income taxes. The income taxes are for the earnings from 20X6 and are amounting to 9,839.35 AUD. No prepayments for income taxes were made. The amount for income tax is due on 15.01.20X7. Income taxes are disclosed as short-term liabilities on the balance sheet under income tax liabilities. VAT payables The revenue earned by renting out motor vehicles is VATable at a VAT rate of 20 %. The VAT payables are amounting to: 30,100.00 AUD. It is net of input-VAT claims. The amount is disclosed as short-term liability under the item accounts payables A/ P. VAT payables are due on 15.01.20X7. <?page no="113"?> Berkau: Financial Statements 4e 6-109 ((g) Dividends BATHURST Ltd. declared a dividend to its registered shareholders to an extent of 0.15 AUD/ s. The total of dividends is amounting to: 50,000 × 0.15 = 7,500.00 AUD. The proposed payment of dividends needs approval on the annual meeting held on 30.05.20X7. The dividend is due on 15.06.20X7. The dividend will be paid to shareholders registered on 1.06.20X6. (h) Revenue Car rental (core business) BATHURST Ltd. earned a revenue of 150,500.00 AUD by renting out motor vehicles in Australia. All revenue was cashed-in by immediate bank transfers (card payments or cash payments). No discounts have been allowed. No receivables result from business operations. Financial revenue A coupon revenue of 8,000.00 AUD was earned from holding 2,000 bonds of Bank of Queensland. 23 The bonds will mature on 6.11.20Y9 and their nominal value is 100.00 AUD/ bond. The annual coupon rate is 4 %/ a. The bonds are traded at 100.00 AUD/ b as at 31.12.20X6. (i) Expenses Total expenses at BATHURST Ltd. are amounting to 125,125.00 AUD. The expenses in detail are listed below: - Depreciation on cars and office: 57,500.00 AUD. - Interest on bank loan: 3,202.16 AUD (effective rate of interest: 3.12 %/ a). - Operational expenses, such as: labour, maintenance, cleaning: 65,000.00 AUD. Melbourne, in January 20X7 Peter Lansfield ______________________ (CEO - BATHURST Ltd.) Figure 6.8: BATHURST Ltd.’s notes (20X6) The notes are in line with IAS 1. The notes are signed by the chief executive officer (CEO) of BATHURST Ltd., Mr P. Lansfield. 23 Fictitious information. <?page no="114"?> Berkau: Financial Statements 4e 6-110 Summary: In this chapter (6) we covered the formal aspects of reporting. We mostly discussed implications resulting from the Framework, IAS 1 and IAS 7. We provided a full set of financial statements for the case BATHURST Ltd., a car rental shop in Melbourne. The financial statements include a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows and the notes. Accounting Technical Terms: Accounting period: The time span financial statements are prepared for. In this text book, the Accounting period is always 1 year. Amortised costs: To keep an asset or liabilities at amortised costs is a simplification of its measurement accepted for financial instruments that are intended to keep until maturity. It replaces a fair value presentation. The calculation of amortised costs is based on the effective interest method. Effective interest method: Valuation of a liability or financial instrument measured by a payment vector with revaluation of its elements based on internal rate of return calculation. The effective rate of interest calculation requires iteration. Notes: Disclosure of Accounting policies and explanation of items on financial statements. Question Bank: (1) A Malaysian company is established on 15.03.20X4. Its balance sheet date is 31 st of December. How does the company disclose its first financial statements? 1. One 15 days period and 3 quarterly reports. 2. One 3.5 months long period and 1 half year report. 3. A shortened report for the period 15.03.-31.12.20X4. 4. A full Accounting period with zero amounts for the time between 1.01.- 14.03.20X4. (2) A statement of changes in equity discloses: 1. Opening amount of equity, issued capital, all reserves, profits, cash flows, dividends paid. 2. Opening amount of equity, closing amount of equity, dividend payments, additions to reserves, revaluations. 3. Opening amount of equity, profit before taxation, dividend declarations, revaluations, resolving reserves, closing equity. 4. Opening amount of equity, profit after taxation, dividend declared, revaluations, closing amount of equity. (3) A company reports in its notes: 1. The standards applied, the address of the company, the register of noncurrent assets and the remuneration of auditors. 2. All standards, the address of the company and all its subsidiaries, the register of current assets, the position of the board of directors, the total of assets. 3. All applied standards, the method of depreciation and the register of non-current assets, the reconciliation of opening and closing amounts for non-current assets, the <?page no="115"?> Berkau: Financial Statements 4e 6-111 valuation of inventory, dividends declared. 4. All applied standards, the method of depreciation and the register of current assets, the reconciliation of opening and closing amounts for current assets, the valuation of inventory, dividends declared. (4) The financial statements’ header show: 1. The name of the reporting company, the time when the financial statements are prepared, the currency unit, the rounding of figures. 2. The name of the reporting company, its legal form, the balance sheet date or the reporting period’s ending, the currency unit, the rounding of figures. 3. The name of the reporting company and its legal form, the balance sheet date or the reporting period’s ending, the currency unit, the data format. 4. The name of the reporting company, an indication of group nongroup statement, the time for which the financial statements are prepare, the currency unit, the rounding of figures, the international standards and paragraphs applicable. (5) Which standards apply for assets? 1. IAS 16, IAS 2, IFRS 9. 2. IAS 17, IAS 2, IFRS 18. 3. IAS 37, IAS 16, IFRS 9. 4. IAS 33, IAS 16, IAS 2. Solutions: 1-3, 2-4, 3-3, 4-2, 5-1. <?page no="116"?> Berkau: Financial Statements 4e 7-112 7. Non-current Assets on the Balance Sheet Learning Objectives: Non-current assets are resources, such as machinery, land and buildings, a company deploys for production and service rendering and that it carries in general longer than one year. This chapter (7) familiarises you with the recognition of non-current assets. Referring to IAS 1.60 an entity must present current and non-current assets separate from each other. Hence, there are items on the balance sheet for noncurrent asset disclosure and other ones for current assets. IAS 1.66 defines current assets as expected to be realised in a normal operating cycle or within the next twelve months, held for sale or falling under cash/ cash equivalents. All other assets are classified as non-current assets and are discussed in this chapter (7). You learn about the initial recognition, subsequent valuations and about the disposal of assets. You get to know special assets to be disclosed on the statement of financial position, too. One main aspect of this chapter is measurement, which means you determine the values the assets are carried at. We consider it important to clearly understand Bookkeeping entries for initial asset recognition, subsequent valuation and finally the disposal of assets in order to understand and predict assets’ impacts on financial statements and ratios derived therefrom. In this chapter, we mainly focus on IAS 16 and IAS 36. IAS 16 deals with the recognition and measurement of property, plant and equipment and IAS 36 contains regulations for impairments as one special kind of subsequent valuation. We structure this chapter based on the timeline of asset recording in initial recognitions, subsequent valuation and disposal of assets. This chapter also covers special assets, such as intangible assets (IAS 38), investment property (IAS 40), leases (IFRS 16), financial instruments (IAS 32, IAS 39, IFRS 7 and IFRS 9) and capitalisation of borrowing costs (IAS 23). Next following, we discuss the topics below: (1) Initial recognition. (2) Subsequent valuation. (3) Disposal of assets. (4) Investment property and assets held for sale. (5) Intangible assets. (6) Leases. (7) Financial instruments. Ad (1): Initial Recognition Based on F.4.4 an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. The IFRSs mainly focus on economic benefits and make the recognition and valuation of assets depend thereon. F.4.8 defines a future economic benefit as the contribution to cash flows into a company. This can be based on an asset’s potential to con- <?page no="117"?> Berkau: Financial Statements 4e 7-113 tribute to production or service rendering or on its convertibility to cash in case of a sale. Assets are controlled by the reporting company. If a company cannot control the asset it shall not disclose it on its balance sheet. I.e., a doctor who considers his patients as a potential to earn profit cannot disclosed them on the balance sheet, e.g., as a patient list, as she/ he does not control them. Neither does a good reputation or a well-known brand, such as Coca Cola, qualify for disclosure on financial statements as the reputation and the resulting activities of the customers are not controllable. The requirement of existence of a past event is necessary to define how the company got in the possession of the asset and determines the measurement, i.e., an asset can be added by acquisition, donation, leasing etc. IAS 16 further rules how to recognise assets. Recognition (F.4.37) is adding an item on the balance sheet (or income statement). When we say to recognise an asset we mean to put an asset on the balance sheet and assign a value thereto. For the first asset recognition, the reporting company has to measure the asset. Hence, the task of recognition requires both, the decision whether or not to disclose the asset on its financial statements and its measurement. With regard to recognition requirements, IAS 16.7 rules that economic benefits must be associated with the asset and that its costs can be measured reliably. Initial valuation is always at costs of acquisition. In case an asset includes major spare parts, such as the interior of an aircraft or its engines, assets shall be recognised separately as single items based on IAS 16.8. An aircraft regularly is disclosed as a set of single assets, such as fuselage, engines and interior even as these assets are physically mounted by bolts, screws etc. Different depreciation parameters might apply for its components. IAS 16.14 says also major inspections shall be added to its cost of acquisition. At first, we discuss the initial recognition of assets. For initial valuation the cost model applies. It means, the asset is measured based at its cost of acquisition. IAS 16.15 states: An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its costs. IAS 16.16 names 3 different kind of costs for asset valuation. They are to be added for the total costs of an asset. (a) Acquisition price, including import duties, non-refundable VAT, less discounts and rebates. (b) Directly attributable costs. (c) Cost of dismantling the asset. Find below the small case study of GETEN (Pty) Ltd.: GETEN (Pty) Ltd. is a production firm and buys a saw at a price of 24,000.00 ZAR. This gross selling price includes VAT. The seller offers GETEN (Pty) Ltd. a discount of 5 % on the saw. In order to recognise the saw, GETEN (Pty) Ltd. calculates the cost of acquisition to be: (24,000/ 120%) × (1 - 5%) = 119,000.00 ZAR. We record the discount as a received discount and make the Bookkeeping entries below. <?page no="118"?> Berkau: Financial Statements 4e 7-114 DR P, P, E Account.............. 20,000.00 ZAR DR VAT.......................... 4,000.00 ZAR CR Cash/ Bank.................... 24,000.00 ZAR DR Cash/ Bank.................... 1,200.00 ZAR CR Discount Received............ 1,200.00 ZAR DR Discount Received............ 1,200.00 ZAR CR VAT.......................... 200.00 ZAR CR P, P, E Account.............. 1,000.00 ZAR The Bookkeeping entries can be recorded simpler when directly based on the calculated reduced cost of acquisition. After recording the saw, its initial recognition is completed and the value of the saw is 19,000.00 ZAR. In case an asset needs changes or further steps of manufacturing in order to be used as intended, qualifying costs may apply and are added to the asset’s value. They fall under directly attributable costs, compare with IAS 16.16. A taxi company buying a car and installing a distance meter for fare calculations will alter the motor vehicle for its intended use as a metered taxi. Costs for the taxi appliances, such as the distance meter, marking, GPS radio etc., are added to the costs of acquisition of the car and are written-off together with the taxi. Adding expenses to the cost of acquisition applies for interest in order to finance the asset’s qualifying, too. IAS 23.8 requires the reporting company to capitalise borrowing costs. Hence, a taxi company taking a bank loan to finance the car’s alterations adds the interest thereof to the cost of acquisition for the taxi. IAS 23.10 sets out requirements for the capitalisation of borrowing costs. In contrast, other interest or repairs, i.e., assembling a replacement part or changing tyres, falls under regular expenses and is recorded through profit or loss in the Accounting period when they occur. We study the case of LANGDAM Bhd.: LANGDAM Bhd. is a consultancy based on shares in Malaysia. The company buys the computer software ADMACC for administration of its customer orders, e.g., for billing hours. The net purchase price for ADMACC software is 340,000.00 MYR. In addition to the software purchase, a computer specialist customises LANGDAM Bhd.’s software, which means she/ he makes software settings and defines the master data. The software specialist charges 100,000.00 MYR for the service. The customising service falls under directly attributable costs based on IAS 16.16. Hence, the initial recognition of the software ADMACC is recorded as below: <?page no="119"?> Berkau: Financial Statements 4e 7-115 DR P, P, E Account.............. 340,000.00 MYR DR VAT.......................... 68,000.00 MYR CR Cash/ Bank.................... 408,000.00 MYR DR P, P, E Account.............. 100,000.00 MYR DR VAT.......................... 20,000.00 MYR CR Cash/ Bank.................... 120,000.00 MYR The software ADMACC is measured at 440,000.00 MYR. This is the amount for initial recognition. 24 Assets can also be acquired based on exchanges of goods and/ or can lead to delayed payments which adds an interest portion to the cost of acquisition. We do not cover these cases in the text book but prepared case study materials for download. Study the special case studies accessible by Link 7.A and Link 7.B in order to enhance your knowledge about initial valuations. Link 7.A: RAVENWOOD GmbH Link 7.B: OTZE AG How it is Done (Initial Recognition): (1) Determine the asset to be disclosed. Check whether the recognition criteria are met. The asset must provide an economical benefit and its valuation has to be reliable. (2) Apply the cost model. Based on the cost model, the cost of acquisition along IAS 16.16 apply. (3) A company that is registered for VAT reduction has to deduct input-VAT. (4) In case the company pays import duties, such as when importing the asset from a foreign country, add import duties to the net value. Calculate target country-specific input-VAT for the new net amount. (5) If the company receives rebates or discounts it is obliged to deduct them. This also applies for deferred discounts. 24 Recommended further reading: IAS 16.15 - IAS 16.28. <?page no="120"?> Berkau: Financial Statements 4e 7-116 (6) In case the seller includes an interest portion in the deal, disclose interest separately. If the company capitalises borrowing costs, no separation becomes necessary. (7) Make a debit entry in the Property, Plant and Equipment account for the cost of acquisition, another debit entry for the input-VAT in the VAT account and credit the Cash/ Bank account or the Accounts Payables account as required. (8) If an interest component applies, make a debit entry for interest. Ad (2): Subsequent Valuation A subsequent valuation is any valuation that follows the initial one. A valuation determines the value at which the asset is carried and is referred to as the carrying amount. Assets that do not change in valuation, such as land, are carried at costs. However, many assets change their values due to usage or when prices change. For subsequent valuations, IAS 16.29 states that a company has to value assets either based on the cost model or on valuation. A subsequent valuation based on the cost model as stated in IAS 16.30 includes the initial costs of acquisition and all following adjustments, such as (a) Depreciation. (b) Impairment loss. (c) Reversal of an impairment loss. A valuation based on the revaluation model in line with IAS 16.31 refers to the fair value which can be based on: (a) Current values. (b) Net realisable values. (c) Values in use. In general, revaluations apply when assets are understated on the balance sheet meaning the correct fair value exceeds the amount the assets are carried at. If an asset is overrated, an impairment loss is recorded based on IAS 36.8. In this section, we discuss a few case studies that cover: depreciation, impairment loss and revaluations. Below, we repeat initial valuation and study then subsequent valuations by the South Korean company GELLENDORFF LLC. On 2.01.20X1, GELLENDORF LLC buys a business car Kia Sorento and pays the car dealer the demanded price of 72,000,000.00 KRW. KRW is the abbreviation for Korean Won which is the currency in South.Korea. We work in 1,000s of Won, hence, our currency unit is tKRW = 1,000 Won. The net amount equals to: 72,000/ 120% = 660,000.00 tKRW which is the cost of acquisition. Depreciation is based on straight-line method and after its useful life of 5 years the car can still be sold at 10,000.00 tKRW which is the estimated future net selling price. IAS 16.6 defines the residual value as the amount a company would currently obtain from its disposal. Relevant costs of disposal are to be deducted. <?page no="121"?> Berkau: Financial Statements 4e 7-117 The initial recognition of the business car follows the cost model and is at its cost of acquisition of 60,000.00 tKRW. DR P, P, E @cost Account........ 60,000.00 tKRW DR VAT.......................... 12,000.00 tKRW CR Cash/ Bank.................... 72,000.00 tKRW After the first Accounting period, the Kia Sorento is written-off to an extent of 1/ 5 of its depreciable amount. The depreciable amount is the loss in value over the useful life (5 years). It considers that assets lose value due to the time. In case an asset is written-off based on the time and it is not used, depreciation must continue. The depreciable amount along IAS 16.6 is the cost of an asset less its residual value. Applying straight-line method you divide the depreciable amount by the useful life. Here, the annual depreciation cost is amounting to: (60,000 - 10,000) / 5 = 110,000.00 tKRW. The Bookkeeping entry for depreciation at GELLENDORFF LLC is shown below. We make the credit entries for depreciation in the Accumulated Depreciation account: DR Depreciation-20X1 ............ 10,000.00 tKRW CR Acc. Depr.................... 10,000.00 tKRW The carrying amount of the Kia Sorento as at 31.12.20X1 equals to: 60,000 - 10,000 = 5 50,000.00 tKRW. Besides regular depreciation, an asset’s value can drop due to extraordinary events, such as an accident. An unscheduled loss in valuation is referred to as an impairment loss. IAS 36 deals with impairment losses and rules its measurement and once applicable its reversal. We record an impairment loss when it happens. Other reasons for impairment losses are that assets are out of fashion or are traded lower due to technical progress. Below, we study two different cases for GELLENDORFF LLC. In case 25 For case i, all Bookkeeping entries are indicated by ‘. (i), the Kia Sorento is crashed and repaired immediately. In case (ii), the business car is crashed and repaired a few months later. An impairment loss is the amount by which an asset is actually overrated. It is defined as the difference between the recoverable amount and the carrying amount. As a consequence, the current value has to be reduced in order to assign its fair value to the asset. Case (i): Impairment Loss and Immediate Repair 25 with a Reversal of the Impairment Loss On 4.04.20X4, GELLENDORFF LLC’s business car is crashed. Depreciation before the accident is recorded by Bookkeeping <?page no="122"?> Berkau: Financial Statements 4e 7-118 entry (1’). The carrying amount prior to the accident was: 60,000 - 3 × 10,000 - 2,500 = 2 27,500.00 tKRW. The repair costs 8,400.00 tKRW (gross amount) and is recorded by Bookkeeping entry (2’). After the repair, a qualified expert evaluates the car at 24,040.00 tKRW. The drop in value is regarded as an impairment loss. IAS 36.59 states that in case the carrying amount (actual measurement without impairment) exceeds the recoverable amount, the carrying amount shall be reduced to its recoverable amount. IAS 36.6 says, a recoverable amount is the lower of the value the asset can be sold at on an active market (fair value) and the value in use, which is the discounted cash flows resulting of the deployment of an asset. We do not worry too much about the value in use here as it mostly applies for cash generating business units. For a normal tangible asset, we simply compare the carrying amount with the fair value. If the carrying amount exceeds the fair value, we record an impairment loss to the extent of the excess. In case of the car accident, the valuation is taken from the expert’s measurement. The company records an impairment loss to the extent of: 27,500 - 24,040 = 3,460.00 tKRW by Bookkeeping entry (3’), observe below: DR Impairment Loss.............. 3,460.00 tKRW CR Acc. Impairment Loss......... 3,460.00 tKRW IAS 36.63 rules depreciation after an impairment loss. Depreciation charge shall be adjusted to the asset’s revised amount for future periods. A residual value is to be considered for calculation of the depreciable amount, if it exists. An asset that is depreciated based on the time does not stop to lose value due to damages. Depreciation shall be continued at adjusted amounts, as stated above. After the repair and recording of the impairment loss, depreciation is resumed on 10.04.20X4. Monthly depreciation charge now is: 24,040 / 33 = 7 728.49 tKRW/ m. Depreciation for the remaining Accounting period is amounting to: 9 × 728.49 = 6 6,556.41 tKRW and recorded by Bookkeeping entry (4’). GELLENDORFF LLC insured the Kia Sorento and confirms the insurance company its VAT registration. Hence, the insurance refunds the damage based on net amounts. The payment of the insurance company covers the repair and the loss in valuation. It is amounting to: 8,400/ 120% + (27,500 - 24,040) = 10,460.00 tKRW. The insurance’s payment is recorded as Bookkeeping entry (5’). Observe the accounts in Figure 7.1. DR Cash/ Bank.................... 10,460.00 tKRW CR Insurance Refund............. 10,460.00 tKRW <?page no="123"?> Berkau: Financial Statements 4e 7-119 D C D C OV 60,000.00 c/ d 60,000.00 OV 30,000.00 b/ d 60,000.00 (1') 2,500.00 c/ d 39,530.41 (4') 6,556.41 39,530.41 39,056.41 b/ d 39,530.41 D C D C (3') 3,460.00 c/ d 3,460.00 c/ d 3,460.00 (3') 3,460.00 b/ d 3,460.00 b/ d 3,450.00 Impairment loss-20X4 IL Acc Impairment Loss AIL Property, plant, equipment PPE Acc depr ACC D C D C (1') 2,500.00 (2') 7,000.00 c/ d 7,000.00 (4') 6,556.41 c/ d 9,056.41 b/ d 7,000.00 9,056.41 9,056.41 b/ d 9,056.41 D C D C (2') 1,400.00 c/ d 1,400.00 (5') 10,460.00 (2') 8,400.00 b/ d 1,400.00 c/ d 2,060.00 10,460.00 10,460.00 b/ d 2,060.00 Depreciation-20X4 DPR Repair-20X4 RPR Value added tax VAT Cash/ Bank C/ B D C c/ d 10,460.00 (5') 10,460.00 b/ d 10,460.00 Insurance-20X4 INS Figure 7.1: GELLENDORFF LLC’s accounts (i) How it is Done (Recording an Impairment Loss): (1) Determine an overrating of the non-current asset (or group of assets) by comparing the carrying amount with the recoverable amount. (2) If the carrying amount exceeds the recoverable amount, calculate the difference. It is the measurement for the impairment loss. (3) Record an impairment loss as a debit entry in the Impairment Loss account and a credit entry in the Accumulated Impairment Loss account. (4) Resume depreciation by calculating depreciation charge based on the altered valuation. <?page no="124"?> Berkau: Financial Statements 4e 7-120 How it is Done (Reverse an Impairment Loss): (1) After recording an impairment loss, monitor the valuation of the previously impaired asset. (2) Determine the fair value of the asset as the recoverable amount. (3) In case the asset is underrated, check how much the valuation of the asset would have been without impairment loss recording in preceding Accounting periods. This amount is the maximum for reversing the impairment loss. Note, that a repair can trigger the reversal of a reversal of an impairment loss but its amount does not determine the reversal. (4) Reverse the impairment loss to its recoverable amount but do not exceed the maximum of valuation. Record a debit entry in the Accumulated Impairment Loss account and a credit entry in the Impairment Loss account. For monitoring, apply an Accumulated Impairment Loss account for each asset (or asset group) impaired. (5) Close-off the Impairment Loss account to the Profit and Loss account at the end of the Accounting period. Ad (ii): Impairment Loss, delayed repair and Reversal of Impairment Loss We next repeat the case of GELLENDORFF LLC again but slightly alter the story. We consider the Kia Sorento is repaired 3 months after the accident. As the repair causes a decrease of the damage, GELLENDORFF LLC asks the expert to estimate the damage after repair and as a result of the evaluation reverses the prior recorded impairment loss to the extent as indicated by the estimate. Reversing an impairment loss in general applies when the value of the asset increases after an impairment loss. Here, the increase of the car’s value is caused by measurement after the repair. A company is obliged to check changes of assets subjected to impairment losses based on IAS 36.110. This means to check whether indications that led to an impairment loss recognised in prior Accounting periods still exists or possibly decreased. A change of the recoverable amount shall reverse or change the impairment loss along IAS 36.114. In no case the repair itself leads to an increase in valuation. We cannot just take the bill of the car repair and add it to the car’s value. The repair costs do not imply an increase of the asset’s valuation to the same extent. Below, we study again the business car at GELLENDORFF LLC and reverse the case study to the point where the accident occurs. We alter the case study with regard to the timeline of the case study. We now postpone the repair. […] On 4.04.20X4, the business car is involved in the crash. Depreciation prior to the accident is recorded by Bookkeeping entry (1’’). The carrying amount before the accident was: 60,000 - 3 × 10,000 - <?page no="125"?> Berkau: Financial Statements 4e 7-121 2,500 = 2 27,500.00 tKRW. After the accident, the car’s valuation dropped to 19,450.00 tKRW as estimated by the expert 26 . Hence, the decrease in valuation caused by the accident is: 27,500 - 19,450 = 8 8,050.00 tKRW. An impairment loss is recorded (2’’). It reflects a reduction of an asset’s carrying amount due to the damage which causes an overrating. Overrating means that the actual carrying amount, here: 27,500.00 tKRW, exceeds the fair value of the car which is the amount obtained if the car is sold at its measured value of 19,450.00 tKRW after the accident. GELLENDORFF LLC’s Bookkeeper records the impairment loss as below on 6.04.20X4, directly after the accident happened. The residual value of the car does not change in this case study to keep calculations simple. DR Impairment Loss-20X4......... 8,050.00 tKRW CR Acc. Impairment Loss......... 8,050.00 tKRW Three months later, on 3.07.20X4, GELLENDORFF LLC repairs the damaged Kia Sorento and pays the penal beater 8,400.00 tKRW (gross amount). Check Bookkeeping entry (3’’). In general, a repair does not change the value of the car. The repair is an expense within the Accounting period and recorded through profit or loss. We cannot add repair costs to the asset, it would be a breach with IAS 16.16. DR Repair....................... 7,000.00 tKRW DR VAT ......................... 1,400.00 tKRW CR Cash/ Bank.................... 8,400.00 tKRW After the impairment loss, depreciation is resumed. Depreciation does not depend on the repair nor on its completion. The remaining useful life is 21 months. Monthly depreciation equals to: (19,450 - 10,000) / 21 = 4 450.00 tKRW/ m. GELLENDORFF LLC depreciates the business car over the next 3 months based on the reduced value. After that period, a new expertise is prepared which will change the valuation after the repair. The Bookkeeping entry’s amount for 3 months of depreciation is: 3 × 450 = 1,350.00 tKRW. Check Bookkeeping entry (4’’). DR Depreciation-20X4 ............ 1,350.00 tKRW CR Acc. Depr.................... 1,350.00 tKRW Again, GELLENDORFF LLC checks whether or not the recoverable amount remains after the impairment loss and the repair. It does not. The repair caused 26 The damage is slightly different to the previous case (i). a change in the estimate of the cars measurement. We refer now to the valuation model, assuming that on <?page no="126"?> Berkau: Financial Statements 4e 7-122 3.07.20X4 a qualified expert evaluates the business car at 24,040.00 tKRW. The fact, that the business car’s value is 24,040.00 tKRW on 3.07.20X4 indicates an increase in value. It requires a Bookkeeping entry we refer to as reversal of impairment loss. Read IAS 36.109 - 125 for the details. The reversal of the impairment loss is recorded as an inverse impairment loss Bookkeeping entry (5’’) with a debit entry made in the Accumulated Impairment Loss account and a credit entry in the Impairment Loss account. Reversal impairment losses are capped by IAS 36.117 to the amount that would apply without prior impairment loss recognition. Hence, no increase in valuation can be recorded through profit or loss. We calculate the maximum value attributable to GELLENDORFF LLC’s business car in line with IAS 36.117: Without accident, the Kia Sorento’s value on 3.07.20X4 would have been: 60,000 - 3.5 × (60,000 - 10,000)/ 5 = 225,000.00 tKRW. The reversal of the impairment loss is within the limits set by IAS 36.117. The value of 20,040.00 tKRW is below 25,000.00 TKRW. The Bookkeeping entry (5’’) is made on 10.07.20X4 to the extent of: 24,040 - (19,450 - 1,350) = 5 5,940.00 tKRW. DR Acc Impairment Loss.......... 5,940.00 tKRW CR Impairment Loss (rev)........ 5,940.00 tKRW After recording the partial reversal of the impairment loss, GELLENDORFF LLC resumes depreciation. Monthly depreciation now is: (24,040 - 10,000) / 18 = 780.00 tKRW/ m. Bookkeeping entry (6’) records depreciation for the remaining Accounting period and is amounting to: 6 × 780 = 4 4,680.00 tKRW. For a better understanding of the case study GELLENDORFF LLC check the accounts for 20X4 in Figure 7.2. In general, assets, such as cars, machinery or buildings, are insured for damages and losses. The insurance company pays for the damage which is the repair and the loss in valuation. The situation of GELLENDORFF LLC is altered below in regard to insurance existence for the damaged car. IAS 16.65 requires to record compensation from third parties for P, P, E items through profit or loss when the compensation is receivable. This means once compensation is granted. It is then credited to the Profit and Loss account. The time of payment does not matter as a recording of receivables indicates compensation already. For illustration purposes, we record the insurance refunding and study dealing with VAT included therein. The repair of 8,400.00 tKRW is fully covered. However, the insurance company only pays the net amount because GELLENDORFF LLC is registered for VAT reduction and claims input-VAT itself. The loss in valuation is based on the impairment loss and the reversal thereof which is amounting to: 8,050 - 5,940 = 2,110.00 tKRW. GELLENDORFF LLC receives a compensation of: 8,400 - 1,400 + 2,110 = 9 9,110.00 tKRW from the insurance company recorded as Bookkeeping entry (7’’). No adjustment for VAT is relevant. The Insurance-20X4 account is closed-off to the Profit and Loss account. <?page no="127"?> Berkau: Financial Statements 4e 7-123 In the end, GELLENDORFF LLC is left with 710.00 tKRW on cash and a repaired as well as impaired car. We add the VAT claim receivable in the next Accounting period and calculate the drop in value of: 710 + 1,400 = 2 2,110.00 tKRW. Hence, the cash received covers the value decrease and the repair expenses. The regulations in IAS 16.65 result in a zero-sum game because the impairment, the repair and the compensation are all recorded through profit or loss. In order to understand the business activities at GELLENDORFF LLC, study the accounts as shown in Figure 7.2. D C D C OV 60,000.00 c/ d 60,000.00 OV 30,000.00 b/ d 60,000.00 (1'') 2,500.00 (4'') 1,350.00 c/ d 38,530.00 (6'') 4,680.00 38,530.00 38,530.00 b/ d 38,530.00 Property, plant, equipment PPE Acc depr ACC D C D C (2'') 8,050.00 (5'') 5,940.00 (5'') 5,940.00 (2'') 8,050.00 c/ d 2,110.00 c/ d 2,110.00 8,050.00 8,050.00 8,050.00 8,050.00 b/ d 2,110.00 b/ d 2,110.00 Impairment loss-20X4 IL Acc Impairment Loss AIL D C D C (1'') 2,500.00 (3'') 7,000.00 c/ d 7,000.00 (4'') 1,350.00 b/ d 7,000.00 (6'') 4,680.00 c/ d 8,530.00 8,530.00 8,530.00 b/ d 8,530.00 D C D C (3'') 1,400.00 c/ d 1,400.00 (7'') 9,110.00 (3'') 8,400.00 b/ d 1,400.00 c/ d c/ d 710.00 9,110.00 9,110.00 b/ d 9,110.00 Depreciation-20X4 DPR Repair-20X4 RPR Value added tax VAT Cash/ Bank C/ B D C c/ d 9,110.00 (7'') 9,110.00 b/ d 9,110.00 Insurance-20X4 INS Figure 7.2: GELLENDORFF LLC’s accounts (ii) A company has to report in the notes about the valuation of its non-current assets. In general, a register of noncurrent assets and a reconciliation <?page no="128"?> Berkau: Financial Statements 4e 7-124 statement are prepared. We show these statements for GELLENDORFF LLC in Figure 7.3 and Figure 7.4 linked to case (ii): Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount [tKRW] [tKRW] [tKRW] [tKRW] Mercedes-Benz E220 60,000 (38,530) (2,110) 19,360 . . . Gellendorff LLC's REGISTER of NON-CURRENT ASSETS as at 31.12.20X4 Figure 7.3: GELLENDORF LLC’s register of non-current assets 20X4 20X3 [tKRW] [tKRW] OV as at 1.01. 30,000 40,000 Depreciation (7,180) (10,000) Adjusted depreciation (1,350) Impairment loss (8,050) Reversal impairment loss 5,940 Revaluation Value at 31.12. 19,360 30,000 Gellendorff LLC's P, P, E-RECONCILIATION STATEMENT as at 31.12.20X4 Figure 7.4: GELLENDORFF LLC’s asset-reconciliation statement When declining method for depreciation applies and an impairment loss is reversed you must check by extra calculation whether or not a revaluation applies or the changes in valuation only results in the reversal of an impairment loss. IAS 16.117 applies. A reversal of an impairment loss is recorded through profit or loss. Any valuation that exceeds the prior valuation leads to a revaluation which is recorded based on fair values and results in a revaluation reserve on the equity section. A company has to determine the quote between the reversal of an impairment loss and the exceeding increase of valuation due to revaluation. The case GROOTVLEI BV covers declining method and reversing a prior impairment loss. Check case study GROOTVLEI BV that is available online through Link 7.C. Link 7.C: GROOTVLEI BV. <?page no="129"?> Berkau: Financial Statements 4e 7-125 In case depreciation parameters or the method of depreciation is altered, IAS 8.22 and IAS 1.10 require disclosure of changes as if made one Accounting period prior to the reporting period in order to adjust the comparative information as required by IAS 1.38. Study as an example for altered depreciation parameters case study TYGERVALLEY Ltd. IAS 8 applies. Link 7.D: TYGERVALLEY Ltd. Revaluations are recorded once an asset’s value exceed its carrying amount. The situation is the opposite of what leads to an impairment loss. The carrying amount now indicates an understated asset. Revaluations are always subsequent valuations. Even a company that buys an asset below its current fair value, a so called lucky buy, recognises the asset at its costs. IAS 16.31 states that an asset which is an item of property, plant and equipment shall be carried at its revalued amount which is its fair value, such as the net realisable value. The precondition for the revaluation model is a reliable valuation of the amount. It only applies for subsequent valuation as the initial valuation is always at costs. 27 As an example for the revaluation model, we study TINNEN K.K. in Japan. The company’s legal form is a kabushiki kaisha and the currency unit for this case study is Japanese Yen (JPY). Tax rates apply as disclosed in chapter (1). Ihe income taxes are amounting to 30 % of the pre-tax profit. Income taxes become now relevant, as deferred taxes apply when assets are revalued. We study revaluations in detail with the next case study TINNEN K.K. On 2.01.20X3, TINNEN K.K. buys a welding machine at costs of 800,000.00 JPY (net amount). The useful life of the welding machine is 5 years and depreciation is based on declining method. A depreciation rate of 1.67%/ m applies. 28 We record the acquisition and depreciation for the Accounting period 20X3. The acquisition price paid is the gross amount: 800,000 × 120% = 9 960,000.00 JPY. We assume TINNEN K.K. pays the total amount instantly. Check the Bookkeeping entry (1). DR P, P, E @COST ............... 800,000.00 JPY DR VAT.......................... 160,000.00 JPY CR Cash/ Bank.................... 960,000.00 JPY Depreciation along declining method is fairly easy to calculate if you determine the carrying amount at first. It is: 800,000 × (1 - 1.67%) 12 = 6653,615.67 27 Recommended further readings: IAS 16.31-42. JPY. The difference between the carrying amount on 2.01.20X3 and 31.12.20X3 is the annual depreciation charge. Depreciation here equals to: 800,000 - 28 Read our Basics-1, chapter (17). <?page no="130"?> Berkau: Financial Statements 4e 7-126 653,615.67 = 1 146,384.33 JPY. The depreciation is recorded as Bookkeeping entry (2). How it is Done (Declining method) (1) Determine the depreciable amount. It equals to the cost of acquisition less residual value. (2) Calculate the depreciation charge rate r applicable for the Accounting period, e.g., the monthly or annual depreciation charge rate. (3) Determine the periods of depreciation, e.g., x months. (4) Calculate the carrying amount as at the end of the depreciation period by multiplying the actual carrying amount by the factor (1 r) x . (5) In order to calculate the absolute depreciation charge, deduct the new carrying amount from the previous one. The difference is the depreciation charge. (6) Make a debit entry in the Depreciation account and a credit entry for accumulated depreciation. Besides of depreciation, TINNEN K.K. records operating expenses (3) to the extent of 600,000.00 JPY (assumingly VAT free) and earns a revenue (4) of 1,400,000.00 JPY. Observe below the profit calculation as shown in Figure 7.5. TINNEN K.K. carries the profit forward to the next Accounting period 20X4. In the next year, on 1.07.20X4, a qualified expert estimates the welding machine’s value to be 750,000.00 JPY. At first, we check at which value the welding machine is carried on 30.06.20X4 which is before the revaluation takes place: 653,615.67 × (1 - 1.67%) 6 = 5590,797.56 JPY. Hence, the value determined by the expert leads to a higher valuation and results in a revaluation ruled by IAS 16.31. The estimate of the qualified expert is considered a reliable measurement for the fair value of the welding machine. A revaluation Bookkeeping entry is similar to recording replacements. A replacement is recorded when major parts of an assets are exchanged, e.g., the engines of an aircraft. For that reason we call Bookkeeping entries made for revaluations Replacement Bookkeeping entries. Follow our QR code for checking ordinary replacement Bookkeeping entries with the case study CORAL Ltd. Link 7.E: CORAL Ltd. In contrast to a Replacement Bookkeeping entry, we now only virtually replace the (entire) asset for revaluation. We do not add value to the <?page no="131"?> Berkau: Financial Statements 4e 7-127 asset’s carrying amount, but we remove the asset that is carried at costs and replace it by the revalued one in our Bookkeeping records. In order to distinguish valuations, we indicate the valuation by an account name suffix: @VALUATION. We apply the P, P, E @COST account for assets measured by the cost model and a P, P, E @(RE)VALUATION account for assets carried at fair values based on the revaluation model. Two options are given for the measurement based on fair values: net replacement method and gross replacement method. In general, a net replacement method applies if the asset is evaluated by an expert. The revaluation is recorded at the time of the valuation. In contrast, the gross replacement method applies when the revaluation is based on an increase of prices for the same assets and pulls forward the revaluation to the time of acquisition. In the case study TINNEN K.K., the net replacement method applies but we provide you with a link to the gross replacement method at the end of the case study, so you can study both methods and compare them with each other. Before the revaluation of the welding machine, TINNEN K.K. records depreciation for the time period 1.01.20X4 until 30.06.20X4: Depreciation is amounting to: 653,615.67 - 590,797.56 = 662,818.11 JPY. We use capital letters for Bookkeeping entry identification. Depreciation is recorded by Bookkeeping entry (C). The next step is to record the (virtual) replacement due to the increase in value. The valuation is not covered here as the Accountant relies on the expert who estimated the welding machine’s measurement. The Bookkeeping entry (R) is shown below: DR P, P, E @REVALUATION ........ 750,000.00 JPY DR Acc. Depr.................... 209,202.44 JPY CR P, P, E @COST................ 800,000.00 JPY CR Revaluation Reserves......... 159,202.44 JPY As a consequence, the revalued asset increases the item property, plant and equipment on der debit side of the balance sheet as well as causes a revaluation reserve on the credit side. Revaluations are not permitted on financial statements for taxation. Those follow national tax law. From the point of view of the income tax law, an immediate sale of the welding machine after revaluation causes a taxable profit of: 750,000.00 - 590,797.56 = 1 159,202.44 JPY as this is the difference between the expected fair selling price and the carrying amount on the balance sheet for taxation. This is considered as a sale in excess of the carrying amount in the records for taxation. As 750,000.00 JPY is the fair value, the amount is the most likely net selling price to obtain for the welding machine. With regard to our simplified tax model, the profit most probably earned by an immediate sale of the welding machine results in income taxes of: 159,202.44 × 30% = 4 47,760.73 JPY. <?page no="132"?> Berkau: Financial Statements 4e 7-128 IAS 12 deals with income tax recognition. IAS 12 does not interfere with the national tax law but describes the disclosure of income taxes. Based on IAS 12.18, revaluations cause temporary tax differences between the financial statements for taxation and IFRSs. Those temporary differences result in deferred tax recognition based on IAS 12.15. As a consequence, TINNEN K.K. shall recognise the estimated income taxes based on the revaluation as a deferred tax liability. The Bookkeeping entry is directly linked to the revaluation, hence, we indicate it by (R’). DR Revaluation Reserves......... 47,760.73 JPY CR Deferred Tax Liabilities..... 47,760.73 JPY The deferred tax liabilities are recorded as a liability based on IAS 12.15. In order to get the full picture, study the accounts in Figure 7.5. When a revaluated asset is depreciated, the revaluation reserves and the deferred taxes are partially closed-off to equity, in particular to the Retained Earnings account. Take a look at the second half of Accounting period 20X4 with regard to case study TINNEN K.K. TINNEN K.K. writes-off the welding machine after revaluation. Depreciation is based on the revalued carrying amount of 750,000.00 JPY. Hence, depreciation for the months July/ 20X4 until December/ 20X4 is amounting to: 750,000 - 750,000 × (1 - 1.67%) 6 = 772,081.48 JPY. The depreciation as percentage of the entire depreciable amount equals to: 72,081.48 / 750,000 = 9 9.61%. As a consequence, TINNEN K.K. dissolves 9.61 % of the deferred tax liabilities: 9.61% × 47,760.73 = 4 4,589.81 JPY and of the initially recorded revaluation reserves: 9.61% × 159,202.44 = 1 15,299.35 JPY. The Bookkeeping entries (D’) and (D’’) are based on IAS 16.41 and are shown below. DR Deferred Tax Liabilities..... 4,589.81 JPY CR Revaluation Reserves......... 4,589.81 JPY DR Revaluation Reserves......... 15,299.35 JPY CR Retained Earnings............ 15,299.35 JPY Next, we calculate the earnings before taxation at TINNEN K.K. In 20X4, the operating expenses and the revenue are at the same amounts as in 20X3. The net profit in 20X4 is amounting to: 1,400,000 - 134,899.59 - 600,000 = 655,100.41 JPY. The financial statements for taxation strive to a fair tax levy based on national tax law. For that reason, the tax law, e.g., allows the tax payer to deduct tax free amounts which do not apply for IFRSs. <?page no="133"?> Berkau: Financial Statements 4e 7-129 We here follow our simplified tax calculation which is based on the total income tax rate of 30 % the EBT are multiplied with. In the case of TINNEN K.K., the tax calculation refers to an asset valuation based on the cost model. As a consequence, depreciation for the tax calculation deviates from depreciation based on revalued amounts as IFRSs apply. At TINNEN K.K., the tax calculation is based on depreciation that ignores the revaluation. Tax-depreciation is amounting to: 653,615.67 - 653,615.67 × (1 - 1.67%) 12 = 1119,598.86 JPY. The income tax calculation gives: (1,400,000 - 119,598.86 - 600,000) × 30% = 204,120.34 JPY. The income taxes apply for the profit calculation along IFRSs, too. This means, income tax expenses are copied from the Tax-Profit and Loss account into the IFRS-Profit and Loss account. As a result, the copied income tax expenses are too high if compared with TINNEN K.K.’s profit calculation along IFRSs. This means that EBT IFRS multiplied by 30 % gives lower income tax expenses. The difference in tax calculation to the extent of: 204,120.34 - 655,100.41 × 30% = 7 7,590.22 JPY is recorded as deferred tax income, which means it is effectively deducted from actual taxes but not paid back. Deferred taxes only means there is a tax reduction to be expected in the future. The difference in taxation only is temporary. It is the tax portion of the higher depreciation caused by writing-off the revalued welding machine at TINNEN K.K.: (134,899.59 - 119,598.86) × 30% = 4,590.22 JPY. The contra entry is in the Retained Earnings account shown as Bookkeeping entry (G). D C D C (1) 800,000.00 c/ d 800,000.00 (1) 160,000.00 (4) 280,000.00 b/ d 800,000.00 (R) 800,000.00 c/ d 120,000.00 280,000.00 280,000.00 (B) 120,000.00 b/ d 120,000.00 (F) 280,000.00 PPE @COST Value added tax VAT D C D C (4) 1,680,000.00 (1) 960,000.00 (2) 146,384.33 P3L 146,384.33 (3) 600,000.00 c/ d 120,000.00 1,680,000.00 1,680,000.00 b/ d 120,000.00 (A) 196,084.70 (F) 1,680,000.00 (B) 120,000.00 (E) 600,000.00 c/ d 883,915.30 1,800,000.00 1,800,000.00 b/ d 883,915.30 Cash/ Bank C/ B Depreciation-20X3 DPR Figure 7.5: TINNEN K.K.’s accounts (20X4) <?page no="134"?> Berkau: Financial Statements 4e 7-130 D C D C c/ d 146,384.33 (2) 146,384.33 (3) 600,000.00 P3L 600,000.00 (R) 209,202.44 b/ d 146,384.33 (C) 62,818.11 209,202.44 209,202.44 c/ d 72,081.48 (D) 72,081.48 b/ d 72,081.48 Acc depr ACC Operational expenses-20X3 OEX D C D C P3L 1,400,000.00 (4) 1,400,000.00 DPR 146,384.33 REV 1,400,000.00 OEP 600,000.00 NP3 653,615.67 1,400,000.00 1,400,000.00 ITL 196,084.70 b/ d 653,615.67 R/ E 457,530.97 653,615.67 653,615.67 Revenue-20X3 REV Profit and Loss-20X3 P3L D C D C c/ d 196,084.70 P3L 196,084.70 c/ d 457,530.97 P3L 457,530.97 (A) 196,084.70 b/ d 196,084.70 (G) 4,590.22 b/ d 457,530.97 c/ d 204,120.34 ITL 204,120.34 (D'') 15,299.35 400,205.04 400,205.04 c/ d 933,810.39 P4L 465,570.29 b/ d 204,205.04 938,400.61 938,400.61 b/ d 933,810.39 Income tax liabilities ITL Retained earnings R/ E D C D C (C) 62,818.11 (R) 750,000.00 c/ d 750,000.00 (D) 72,081.48 c/ d 134,899.59 b/ d 750,000.00 134,899.59 134,899.59 b/ d 134,899.59 P4L 134,899.59 Depreciation-20X4 DPR PPE @VALUATION D C D C (R') 47,760.73 (R) 159,202.44 (D') 4,589.81 (R') 47,760.73 (D'') 15,299.35 (D') 4,589.81 c/ d 43,170.92 c/ d 100,732.17 47,760.73 47,760.73 163,792.25 163,792.25 b/ d 43,170.92 b/ d 100,732.17 Revaluation reserves R-R Deferred tax liabilities DTL D C D C (E) 600,000.00 P4L 600,000.00 P4L 1,400,000.00 (F) 1,400,000.00 Operational expenses-20X4 OEX Revenue-20X4 REV Figure 7.5: TINNEN K.K.’s accounts (20X4) continued <?page no="135"?> Berkau: Financial Statements 4e 7-131 D C DPR 134,899.59 REV 1,400,000.00 OEX 600,000.00 NP4 665,100.41 1,400,000.00 1,400,000.00 ITL 204,120.34 b/ d 665,100.41 R/ E 465,570.29 (G) 4,590.22 669,690.63 669,690.63 Profit and Loss-20X4 P4L Figure 7.5: TINNEN K.K.’s accounts (20X4) continued Before we discuss tax deferrals we summarise revaluations by a How-itis-Done paragraph. We consider you have one P, P, E account per asset with regard to the Bookkeeping entries as recommended below: How it is Done (Revaluations, Net Replacement Method): (1) Determine the actual fair value, e.g., by an expertise. (2) Create a new P, P, E @VALUATION account and enter the new value on the debit side. (3) Make a credit entry in the previous P, P, E @COST account in order to close it off. (4) Close-off the Accumulated Depreciation account by making a debit entry. (5) If the revaluation follows an impairment loss close off the Accumulated impairment loss after reversing the impairment loss completely through profit or loss. (6) Record the difference in valuation on the credit side of the Revaluation Reserves account. (7) In case of the most probable situation that the national tax law prohibits revaluations, deduct the tax portion from revaluations reserves and add them to the Deferred Tax Liabilities account. How it is Done (Depreciation of Revalued Assets): (1) Determine depreciation based on IFRS values. Depreciation is based on the revalued amount. (2) Make a debit entry in the Depreciation account and credit the amount to the Accumulated Depreciation account. (3) Calculate the percentage of depreciation based on the depreciable amount. (4) Dissolve the same percentage of the deferred tax liabilities by making a debit entry in the Deferred Tax <?page no="136"?> Berkau: Financial Statements 4e 7-132 Liability account and a credit entry in the Revaluation Reserves account. (5) Dissolve the same percentage of the ordinary revaluation reserves by debiting the Revaluation Reserves account and making a credit entry in the Retained Earnings account. This credits deferred tax liabilities to equity. (6) Calculate earnings before taxes along IFRSs. (7) Calculate earnings before taxes by following national tax law and determine income tax expenses. (8) Copy the income tax expenses into the IFRS-Profit and Loss account. (9) As the income taxes exceed the EBT IFRS × 30% tax calculation determine the difference and deduct it from the income taxes. The resulting taxes (tax expenses less deferred taxes) mix with the EBT IFRS × 30% tax calculation. (10) Calculate the annual surplus (EAT) and transfer it to equity. (11) Make a Bookkeeping entry for the deferred tax income as credit entry in the Profit and Loss account and a debit entry in the Retained Earnings account. In regard to deferred taxes along IAS 12 we summarise: A revaluation gives us two reasons for deferred tax disclosure. The first one is based on the potential to sell the revalued asset at a higher price (fair value) which includes a chance for taxable profit. The temporary difference decreases by depreciation as the above mentioned potential shrinks. The second one is a temporary difference in profits caused by different depreciation charges. This gives us in general a deferred tax income. In case we compare the increases in equity on the balance sheet, we have to acknowledge that a revaluation does not increase/ decrease equity more than carrying the asset at cost. This is caused by depreciation resulting in a partial dissolving of deferred taxes recorded in the Revaluation Reserves account. The latter one is also dissolved and the amount is credited to equity (Retained Earnings account). At the same time, the difference in depreciation leads to an income tax deviation that is compensated by deferred tax income. The contra entry for the deferred tax income again is in equity (Retained Earnings account). The two entries cancel out each other. As a consequence, equity along tax law has the same value as based on IFRSs under application of fair value disclosure for assets. Hence, the revaluation never changes the book value of the company but it assures that assets are disclosed at their fair values. In the case of TINNEN K.K. the increase of equity based on IFRSs calculations equals to: 933,810.39 - 457,530.97 = 4476,279.42 JPY. The equity increase based on the tax-profit calculation - with no consideration of revaluation is <?page no="137"?> Berkau: Financial Statements 4e 7-133 amounting to the same: (1,400,000 - 119,598.86 - 600,000) × (1 - 30%) = 4476,280.80 JPY. Here, the minor difference of 1.20 JPY is caused by rounding differences due to declining method for depreciation. An alternative to the net replacement method is the gross replacement method. It applies in cases when the revaluation is caused by an increase in costs of acquisition. Follow below the Link 7.F to the case study JANSSENS Ltd. Link 7.F: JANSSENS Ltd. Ad (3): Disposal of Assets The disposal of an asset is recorded through the Realisation account. 29 In case an item of property, plant and equipment is disposed after prior revaluation, the revaluation reserves and deferred tax liabilities are to be dissolved. Only the proceeds from derecognition and the carrying amount are closed-off to the Realisation account. What is recorded in the Realisation account goes through profit or loss. IAS 16.67 states that a de-recognition is caused by disposal or when no further benefits are expected from the asset. A profit (referred to as a gain) or loss on disposal are to be added to the Profit and Loss account based on IAS 16.68. A gain should not be considered a revenue. The distinction made is in order to not mix gains on disposals with revenues that result from operating activities. We study the case of YSTERFONTEIN Ltd. YSTERFONTEIN Ltd. is a construction company in South Africa. On 4.01.20X1, YSTERFONTEIN Ltd. buys a plot of 300 m 2 intended to use as parking lot for its business cars. The cost of acquisition are 225,000.00 ZAR. For the conveyancing, YSTERFONTEIN Ltd. pays 50,000.00 ZAR. 30 The total cost of acquisition are: 225,000 + 50,000 = 2 275,000.00 ZAR. On 5.07.20X5, the municipality declares the land which includes YSTERFONTEIN Ltd.’s parking lot an industrial zone and, as a consequence the property price increases to 3,000.00 ZAR/ m 2 . As a result of the price increase, YSTERFONTEIN Ltd. revaluates its parking lot. The new value is: 300 × 3,000 + 50,000 = 950,000.00 ZAR. The cost for conveyancing are still included in the property value. The Bookkeeping entry for the revaluation is disclosed below: DR P, P, E @VALUATION ........... 950,000.00 ZAR CR P, P, E @COST................ 275,000.00 ZAR CR Revaluation Reserves......... 675,000.00 ZAR 29 Read our Basics-1, chapters (34) and (35). 30 In South Africa, no acquisition tax for property applies. <?page no="138"?> Berkau: Financial Statements 4e 7-134 DR Revaluation Reserves......... 202,500.00 ZAR CR Deferred Tax Liabilities..... 202,500.00 ZAR On 30.11.20X6, YSTERFONTEIN Ltd. sells the plot to a neighbour at 1,000,000.00 ZAR. The sale of the plot is transferred by the attorney Dr BOKPUNT. After the deal, YSTERFONTEIN receives the selling price per bank transfer from its attorney. The Bookkeeping entries are made through the Realisation account. YSTERFONTEIN Ltd. makes the Bookkeeping entries as below: DR Deferred Tax Liabilities..... 202,500.00 ZAR CR Revaluation Reserves......... 202,500.00 ZAR DR Revaluation Reserves......... 675,000.00 ZAR CR Retained Earnings............ 675,000.00 ZAR DR Cash/ Bank.................... 1,000,000.00 ZAR CR Realisation.................. 1,000,000.00 ZAR DR Realisation.................. 950,000.00 ZAR CR P, P, E @VALUATION........... 950,000.00 ZAR Check YSTERFONTEIN Ltd.’s accounts which only contain business activities with regard to the plot (due to simplification). D C D C OV 950,000.00 (4) 950,000.00 OV 472,500.00 (2) 675,000.00 (1) 202,500.00 675,000.00 675,000.00 PPE @VALUATION Revaluation Reserves R-R D C D C (1) 202,500.00 OV 202,500.00 DTI 202,500.00 (2) 675,000.00 c/ d 507,500.00 P&L 35,000.00 710,000.00 710,000.00 b/ d 507,500.00 Deferred tax liabilities DTL Retained earnings R/ E Figure 7.6: YSTERFONTEIN Ltd.’s accounts <?page no="139"?> Berkau: Financial Statements 4e 7-135 D C D C (4) 950,000.00 (3) 1,000,000.00 (3) 1,000,000.00 . . . (5) 50,000.00 1,000,000.00 1,000,000.00 Realisation-20X6 REA Cash/ Bank C/ B D C D C P&L 50,000.00 (5) 50,000.00 EBT 50,000.00 GoD 50,000.00 ITL 217,500.00 b/ d 50,000.00 R/ E 35,000.00 DTI 202,500.00 252,500.00 252,500.00 Gain on disposal-20X6 GoD Profit and Loss-20X6 P&L D C D C c/ d 217,500.00 P&L 217,500.00 EBT 725,000.00 GoD 725,000.00 b/ d 217,500.00 ITL 217,500.00 b/ d 725,000.00 R/ E 507,500.00 725,000.00 725,000.00 Income tax liabilities ITL Profit and Loss for Taxation PLT Figure 7.6: YSTERFONTEIN Ltd.’s accounts continued How it is Done (Disposal of an Asset): (1) Record all depreciation or impairment losses up to the time of disposal. If the asset is carried at revaluation model, dissolve reserves and deferred tax liabilities. (2) Create a Realisation account for the disposal. (3) Record payments received as a debit entry in the Cash/ Bank account and a credit entry in the Realisation account. For receivables make Bookkeeping accordingly. (4) Record VAT collected together with the disposal as a debit entry in the Realisation account and a credit entry in the VAT account. (5) Close-off the P, P, E account to the Realisation account. (6) Close-off the Accumulated Depreciation account and, if it exists, the Accumulated Impairment Loss account to the Realisation account. (7) Determine the balancing figure of the Realisation account. If the Realisation account is debit balanced the balancing figure is a loss on disposal. If the Realisation account is credit balanced the balancing figure is a gain/ profit on disposal. (8) Close-off the Realisation account to the Profit and Loss account. <?page no="140"?> Berkau: Financial Statements 4e 7-136 The Profit and Loss for Taxation account is greyed-out to indicate that it is not part of the commercial Bookkeeping entries based on IFRSs. YSTERFONTEIN Ltd. applies a Realisation account in order to calculate the gain on disposal. It is amounting to: 1,000,000 - 950,000 = 5 50,000.00 ZAR. From the point of view of taxation which applies for the calculation of income taxes, the profit on disposal equals to: 1,000,000 - 275,000 = 725,000.00 ZAR. As a consequence, the income taxes are amounting to: 725,000 × 30% = 217,500.00 ZAR. As we compare the amount with the ones that are expected from a gain of 50,000.00 ZAR, the income taxes are higher to the extent of: 217,500 - 15,000 = 2 202,500.00 ZAR. YSTERFONTEIN Ltd. records a deferred tax income to the same extent as prior deferred tax liabilities. Hence, YSTERFONTEIN Ltd.’s equity increases as if no revaluation has ever been recorded. YSTERFONTEIN Ltd. case study is simple as plots are not depreciable. Furthermore, no VAT applies for property sales. Ad (4): Investment Property and Assets held for Sale Investment property is land and buildings held for earning rental income or for capital appreciation. IAS 40 applies. IAS 40.5 states that investment property is never land and buildings held for goods production, service rendering or administration. In those cases, IAS 16 applies instead. IAS 40.5 states further that investment property does not apply for assets held for sale. A company that buys land/ buildings as a property manager does not apply IAS 40 but IFRS 5 instead. IAS 40.7 says that investment property is in general independent from other ordinary business of the company. IAS 40.10 allows property to be separated in owner occupied items and items of investment property. Owner-occupation also applies if the owner rents out rooms as a hotel. The service is significant and makes the whole hotel fall under property, plant and equipment ruled by IAS 16. Below, we study the case of MERSEBURG Ltd.: On 1.01.20X7, MERSEBURG Ltd. buys an office block with 42 offices in Grahamstown, South Africa. The cost of acquisition are amounting to 21,000,000.00 ZAR. Additional costs for the transfer apply. They are amounting to 21,000.00 ZAR. One of the offices is used for the administration of the remaining 41 offices. The offices are separable as laid out in IAS 40.10. We assume, all offices are of the same size and value. MERSEBURG Ltd. has to account for the offices separately. The owner-occupied office is regarded as property, plant and equipment and falls under IAS 16 whereas the other offices are investment property as defined in IAS 40.5. At the time of acquisition, MERSEBURG Ltd. records the office block by the Bookkeeping entry below under the assumption that the conveyance costs can be divided at equal shares, too: <?page no="141"?> Berkau: Financial Statements 4e 7-137 DR Investment Property.......... 20,520,500.00 ZAR DR P, P, E @COST................ 500,500.00 ZAR CR Cash/ Bank.................... 21,021,000.00 ZAR MERSEBURG Ltd. rents out 41 offices and receives a monthly rental income therefrom. In case the fair value of the offices changes, IAS 40.35 requires to record the amounts as gain or loss in the period they arise in. This is different to revaluations along IAS 16.39. We show the difference with regard to MERSEBURG Ltd.’s offices: In 20X7, MERSEBURG Ltd. applies the cost model and writes-off the offices to an extent of 420,420.00 ZAR (all together). The offices are carried at a valuation of: 21,021,000 - 420,420 = 2 20,600,580.00 ZAR at the end of the Accounting period 20X7. On 1.01.20X8, MERSEBURG Ltd. acknowledges that the fair office values increased from 20,600,580.00 ZAR to 25,200,000.00 ZAR. The self-occupied office requires a revaluation. The carrying amount was 490,490.00 ZAR and the new amount equals to 600,000.00 ZAR. It is recorded as the Bookkeeping entry below: DR P, P, E @VALUATION ........... 600,000.00 ZAR DR Acc. Depr.................... 10,010.00 ZAR CR P, P, E @COST................ 500,500.00 ZAR CR Revaluation Reserves......... 109,510.00 ZAR DR Revaluation Reserves......... 32,853.00 ZAR CR Deferred Tax Liabilities..... 32,853.00 ZAR The increase in value for the investment property is recorded through profit or loss and disclosed as a gain on revaluation of investment property. It is amounting to: 41 × (600,000 - 490,490) = 4 4,489,910.00 ZAR see the Bookkeeping entry below for details: DR Investment Property.......... 4,489,910.00 ZAR CR Gain on Reval. of InvProp.... 4,489,910.00 ZAR In cases a company holds non-current assets for sale, IFRS 5 applies. A requirement for non-current assets to be classified as held for sale is that there is a plan to sell the asset based on IFRS 5.8 which makes the sale highly probable. Non-current assets for sale shall be valued at the lower of carrying costs and fair value less cost to sell (IFRS 5.15.). We emphasise here that assets along IFRS 5 are no inventories. They merely represent non-current assets of the company that are to be disposed due to discontinued operations or that they have no economic benefit left and are to be discarded. A company shall not depreciate a non-current asset while it is classified as held for sale <?page no="142"?> Berkau: Financial Statements 4e 7-138 based on IFRS 5.25. IFRS 5.38 requires separate disclosure of non-current assets held for sale. We explain the concept behind IFRS 5 by the case study OVERBERG (Pty) Ltd. OVERBERG (Pty) Ltd. is a surf shop in the Western Cape of South Africa. The business sells surf equipment in Cape Town and runs a kite surfing training centre at Camps Bay’s waterfront. For the kite surfing training centre, OVERBERG (Pty) Ltd. bought 15 kites and surfboards we refer to as KSU (kite surfing unit). The KSUs are acquired at unit costs of 20,000.00 ZAR/ u on 2.01.20X4. Depreciation on the KSUs is along straight-line method over their useful life of 4 years. The residual value per KSU is amounting to 8,000.00 ZAR/ u. On 1.10.20X6, OVERBERG (Pty) Ltd. intends to close down the kite surfing training centre and to turn it into a surf shop. As a consequence, the training centre falls under discontinued operations at OVERBERG (Pty) Ltd.’s. No training classes are offered after the 1.11.20X6. OVERBERG (Pty) Ltd. offers to sell the KSUs at 10,000.00 ZAR. No additional selling costs become relevant, as OVERBERG (Pty) Ltd. sells the KSUs in its own surf shop in Camps Bay. At the beginning of the Accounting period 20X8, the KSUs are carried at 14,000.00 ZAR/ u each. Depreciation for the period 1.01.20X6 until 31.10.20X6 is amounting to: 10 × (14,000 - 8,000) / 24 = 22,500.00 ZAR/ u. When OVERBERG (Pty) Ltd. stops its kite surfing training on 1.11.20X6, it carries each KSU at 14,000 - 2,500 = 1 11,500.00 ZAR/ u. IFRS 5.15 requires the valuation of the KSUs at the lower of the carrying amount and the fair value less costs to sell. OVERBERG (Pty) Ltd.’s intention to sell the KSUs at 10,000.00 ZAR determines the fair value thereof. Hence, the KSUs are classified as held for sale and written-down in accordance with IFRS 5.20. OVERBERG (Pty) Ltd. makes the Bookkeeping entry below: DR Disposals.................... 150,000.00 ZAR DR Acc. Depr.................... 127,500.00 ZAR DR IL on Discontinued Operations 22,500.00 ZAR CR P, P, E ACCOUNT KSU.......... 300,000.00 ZAR After classifying the KSUs as assets held for sale, OVERBERG (Pty) Ltd. suspends depreciation. At the end of Accounting period 20X6, OVERBERG (Pty) Ltd. manages to sell 5 of the KSUs at a net selling price of 10,000.00 ZAR/ KSU. See Bookkeeping entry (3). The remaining KSUs are still in its possession on 31.12.20X6. Observe in Figure 7.7 the accounts as at 31.12.20X6. <?page no="143"?> Berkau: Financial Statements 4e 7-139 D C D C OV 300,000.00 (2) 300,000.00 (2) 127,500.00 OV 90,000.00 (1) 37,500.00 127,500.00 127,500.00 P, P, E (KSU) Acc depr ACC D C D C (1) 37,500.00 P&L 37,500.00 (2) 150,000.00 (3) 50,000.00 c/ d 100,000.00 150,000.00 150,000.00 b/ d 100,000.00 Depreciation-20X6 DPR Disposals DIS D C D C (2) 22,500.00 P&L 22,500.00 (3) 60,000.00 c/ d 60,000.00 b/ d 60,000.00 Impairment Loss on discontinued op ILD Cash/ Bank C/ B D C D C c/ d 10,000.00 (6) 10,000.00 DPR 37,500.00 b/ d 10,000.00 ILD 22,500.00 NL 60,000.00 60,000.00 60,000.00 b/ d 60,000.00 R/ E 60,000.00 Value added tax VAT Profit and Loss P&L D C P&L 60,000.00 c/ d 60,000.00 b/ d 60,000.00 Retained earnings R/ E Figure 7.7: OVERBERG (Pty) Ltd.’s accounts Ad (5): Intangible Assets Intangible assets are assets without physical substance, e.g., licenses, rights, warranties, patents, design costs, goodwill etc. Intangible assets are ruled by IAS 38. In general, there are differences with regard to intangible asset regulations to German law. The recognition of intangible assets can significantly change the financial statements if amounts are material. This makes us study intangibles carefully. IAS 38.4 states that in some cases, intangible assets are linked to assets with physical substance, e.g., software comes with an installation kit box and manual. It is necessary to assess which component of the asset is more significant. In the case of software, the intangible portion is the major component, hence, software is classified as intangible. Although cash and its equivalents may in general be regarded as intangible, it is always recorded as noncurrent asset or as financial instrument. IAS 38.12 requires the intangible asset to be identifiable which means it shall <?page no="144"?> Berkau: Financial Statements 4e 7-140 be separable and exchangeable between individuals or it results from contractual or legal rights. Along IAS 38.13, intangible assets shall be in the control of the company. We discuss our next case PAARDEBERG. Dr. Paardeberg is a dentist and intents to buy a clinic in Hamburg. He buys the clinic from a doctor who wants to relocate to Asia. The value of the clinic is obviously higher than the assets linked thereto, such as the surgery room, the waiting area equipment, computer systems etc. The main value that determines the selling price for the clinic is the patients list. Although there is a huge economic benefit when taking over the clinic due to the patients still coming, the patients are not in control of the business. As a consequence, the acquisition of the clinic cannot be based on the recognition of the patients list. The patients are legally not bound to the clinic and can change their dentist as they please. Hence, no patients list is put on the balance sheet as an intangible asset. In case Dr. Paardeberg pays a price for the clinic that exceeds the tangible assets’ total the difference between cost of acquisition and the sum of tangible assets is regarded as goodwill. Goodwill is derived from the clinic’s acquisition and, hence, an identifiable intangible asset because it is derived from contractual rights. We consider the acquisition of the clinic is in exchange of 750,000.00 EUR, 80,000.00 EUR thereof being linked to tangible assets. PAARDEBERG makes the Bookkeeping entry below: DR P, P, E Account.............. 80,000.00 EUR DR Goodwill..................... 670,000.00 EUR CR Cash/ Bank.................... 750,000.00 EUR After initial recognition of intangible assets at cost, the subsequent valuation is based on depreciation over the useful life or on the valuation model, the latter one requires a regular impairment/ revaluation test. In the case of the dentist’s clinic PAARDEBERG, the goodwill resulting from the excellent reputation and the regular patients depends on the doctor’s ability and friendliness. Hence, the goodwill as derived from the contract is subject to changes. PAARDEBERG shall check the economic benefit resulting from its patients regularly. In case patients stay away, an impairment loss is to be recorded in regard to the valuation of derived goodwill. The cost of development are subject to intangible assets, as well. The costs are based on the cost calculation and shall be written-off over the period, the goods are produced - which means whilst there is an economic benefit resulting from development. Special requirements apply in order to consider design costs as cost of development based on IAS 38.54 - 64. Particular recognition criteria for classification as development are laid out. The first phase of the product design process when new knowledge is obtained, is referred to as research. Its costs cannot be allocated as intangible asset but shall be recorded through profit or loss for the year, research is undertaken. They are recorded as expense. Once the design process comes to its next <?page no="145"?> Berkau: Financial Statements 4e 7-141 phase “development”, the reporting company should demonstrate it meets the criteria laid out in IAS 38.57, e.g., feasibility, intention and ability of marketing the product, the potential of producing the goods etc. Read IAS 38.57 for the details. In no case, self-generated brands, customer lists etc., should be recognised as intangible assets. WESPOORT Ltd. is a South African company that produces lawnmowers. For the new season, WESPOORT Ltd. designs a new cordless lawn mower. It undertakes a marketing research and runs tests with rechargeable batteries. Thereafter, on 3.03.20X4, WESPOORT Ltd. starts to design the new lawn mower model and spends 600,000.00 ZAR in the engineering process thereof. The development phase results in labour costs, depreciation on design software and further product tests. WESPOORT Ltd. demonstrates the fulfilment of the requirements with regard to IAS 38.57 as at 3.03.20X4. WESPOORT Ltd. plans to produce 96,000 units of the new lawn mower during the period June 20X4 until May 20X6. The development is completed on 31.05.20X4 and production starts right thereafter. WESPOORT Ltd. records development costs to the extent of 600,000.00 ZAR as intangible asset and depreciates them at the year-end according to the amount of lawn mowers produced. The production amounts of lawn mowers is equally distributed over the entire production period. Hence, the partial development cost depreciation for the production period of 7 months in 20X4 equals to: 7 × 600,000 / 24 = 1 175,000.00 ZAR. Observe below the Bookkeeping entries for the recognition and writing-off of development expenses as intangible assets: DR Intangible Assets............ 600,000.00 ZAR CR Depreciation ................. 100,000.00 ZAR CR Labour....................... 350,000.00 ZAR CR Other Expenses (Testing)..... 150,000.00 ZAR DR Depreciation ................. 175,000.00 ZAR CR Intangible Assets............ 175,000.00 ZAR Ad (6): Leases A lease is a contract between a lessee and a lessor about an identified asset’s use for a period of time in exchange for consideration (payment) that is in the ownership of the lessor. Although, the asset is in control of the lessee. The conveyance of the asset is an essential part of the contract and leads to its recognition. The fact that the lessee controls the asset makes it distinguishable from other kind of services where - in contrast the supplier makes decisions about the asset’s use. The lessee shall recognise the leased asset as a right-to-control-the-use of an asset (also termed right-to-use asset RUA) and a lease liability, both at present values. The right to use asset can either be disclosed as item of property, plant and equipment or as a special item on the balance sheet, i.e., as rightto-use-assets. Lease liabilities are rec- <?page no="146"?> Berkau: Financial Statements 4e 7-142 orded and disclosed similar to other financial liabilities. In accordance to IFRS 16, the lessee discloses all leased assets on the financial statements which has an impact on ratios, e.g., the Return on Assets. Very short-term leases and leases of minor value are exempted from recognition and are recorded as an expense, see IFRS 16.5. An example for recording a service is a car rented for a few days which is recorded as a short-term service through profit or loss but not as a lease contract. Recording a lease commences with the conveyance of the asset. IFRS 16.9 requires that at inception of a contract, a company shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration. […]. The lessee recognises the right to use asset and the lease liability at the commencement of the lease. The costs of the right to use asset contain the measurement of the lease liability, plus prior payments made, direct costs and estimated restoring costs, as required by IFRS 16.24. For the recognition of the lease liability, IFRS 16.26 requires that lease liabilities shall be measured at present values. Hence, future payments linked to the lease liability must be discounted. If the discount rate cannot be taken from the lease contract itself, the incremental borrowing rate of the lessee applies. Incremental borrowing rate means a rate of interest required by a creditor for an additional loan, under consideration of the current debt situation of the lessee. In order to understand leases, we discuss the case study KRIGE (Pty) Ltd. Mr Krige is an UBER driver and runs his business in the Johannesburg vicinity. He establishes KRIGE (Pty) Ltd. and prepares financial statements along IFRSs. KRIGE (Pty) Ltd. closes a lease contract about the taxi car with the local Toyota dealer for a 2 years period, starting on 2.01.20X3 and ending 31.12.20X4. The KRIGE (Pty) Ltd. case is easy as for a 2 years contract the time value of money is not material. Hence, we can measure the lease liability at payments and do not have to worry about the calculation of present values. A case study (VLAEBERG K.K.) follows, where the duration of the lease period is longer. KRIGE (Pty) Ltd. pays 120,000.00 ZAR/ a leasing fees and will receive a final amount of 100,000.00 ZAR at the end of the lease period in return for the car. Furthermore, KRIGE (Pty) Ltd. estimates the restoring cost of the car for repairing small scratches and dents to be 50,000.00 ZAR. Under consideration of these payments, the payment vector for the taxi car (in ZAR) equals to: TC(t) = {- 120,000; (100,000 - 120,000 - 50,000)} = {{-120,000; -70,000}. The measurement of the total lease liability is: 120,000 + 70,000 = 1 190,000.00 ZAR. KRIGE (Pty) Ltd. records the lease as shown in the Bookkeeping entry (1) below on 2.01.20X3: DR P, P, E @LEASE............... 190,000.00 ZAR CR Lease Liability.............. 190,000.00 ZAR <?page no="147"?> Berkau: Financial Statements 4e 7-143 We record the lease liability for the financial statements as at 31.12.20X3. On the balance sheet date, the payment for 20X3 has been paid already and the next payment is classified as a short-term liability. No adjustments apply. On 31.12.20X3, KRIGE (Pty) Ltd. retires the remaining lease liability. Observe the Bookkeeping entries (2), (3) below. DR Lease Liability IBL.......... 120,000.00 ZAR CR Cash/ Bank.................... 120,000.00 ZAR DR Lease Liability IBL.......... 70,000.00 ZAR CR Short-term Liabilities....... 70,000.00 ZAR Depreciation of the car (right to use asset) is based on straight-line method with no residual value, as the right to use asset is measured based on all payments including of 100,000.00 ZAR received at the end of the lease period. Hence, depreciation costs are amounting to: 190,000 / 2 = 9 95,000.00 ZAR. They are recorded by Bookkeeping entry (4). DR Depreciation ................. 95,000.00 ZAR CR Acc. Depr.................... 95,000.00 ZAR To provide you with the full picture, we show the accounts at KRIGE (Pty) Ltd. in Figure 7.8. D C D C (1) 190,000.00 c/ d 190,000.00 (2) 120,000.00 (1) 190,000.00 b/ d 190,000.00 (3) 70,000.00 190,000.00 190,000.00 PPE @LEASE Lease liability IBL D C D C c/ d 120,000.00 (2) 120,000.00 c/ d 70,000.00 (3) 70,000.00 b/ d 120,000.00 b/ d 70,000.00 Cash/ Bank C/ B Short-term liabilities A/ P D C D C (4) 95,000.00 P3L 95,000.00 c/ d 95,000.00 (4) 95,000.00 b/ d 95,000.00 Depreciation-20X3 DPR Acc depr ACC Figure 7.8: KRIGE (Pty) Ltd.’s accounts (20X3) <?page no="148"?> Berkau: Financial Statements 4e 7-144 D C D C DPR 95,000.00 NL 95,000.00 P3L 95,000.00 c/ d 95,000.00 b/ d 95,000.00 R/ E 95,000.00 b/ d 95,000.00 Profit and Loss-20X3 P3L Retained earnings R/ E Figure 7.8: KRIGE (Pty) Ltd.’s accounts (20X3) continued In the next Accounting period 20X4, KRIGE (Pty) Ltd. depreciates the car by Bookkeeping entry (A) and pays the agreed 70,000.00 ZAR which are calculated based on the last lease rate, the return value and the restoring costs. The payment is recorded as Bookkeeping entry (B). The disposal of the car is recorded as Bookkeeping entries (D’, D’’). DR Depreciation................. 95,000.00 ZAR CR Acc. Depr.................... 95,000.00 ZAR DR Short-term Liabilities (A/ P). 70,000.00 ZAR CR Cash/ Bank.................... 70,000.00 ZAR DR Realisation.................. 190,000.00 ZAR CR P, P, E @LEASE............... 190,000.00 ZAR DR Acc. Depr.................... 190,000.00 ZAR CR Realisation.................. 190,000.00 ZAR As shown in Figure 7.9, the Realisation account is balanced-off already, hence, no further transfer to profit or loss is necessary. The total expenses are depreciation costs and the total lease costs to the extent of 190,000.00 ZAR. The latter ones are accumulated in the Retained Earnings account. D C D C (1) 190,000.00 c/ d 190,000.00 P3L 95,000.00 c/ d 95,000.00 b/ d 190,000.00 (D') 190,000.00 b/ d 95,000.00 P4L 95,000.00 c/ d 190,000.00 190,000.00 190,000.00 b/ d 190,000.00 P, P, E @LEASE PPE Retained earnings R/ E Figure 7.9: KRIGE (Pty) Ltd.’s accounts (20X4) <?page no="149"?> Berkau: Financial Statements 4e 7-145 D C D C c/ d 120,000.00 (2) 120,000.00 c/ d 70,000.00 (3) 70,000.00 b/ d 120,000.00 (B) 70,000.00 b/ d 70,000.00 c/ d 190,000.00 (B) 70,000.00 190,000.00 190,000.00 b/ d 190,000.00 Cash/ Bank C/ B Short-term liabilities A/ P D C D C (A) 95,000.00 P4L 95,000.00 c/ d 95,000.00 (4) 95,000.00 b/ d 95,000.00 (D'') 190,000.00 (A) 95,000.00 190,000.00 190,000.00 Depreciation-20X4 DPR Acc depr ACC D C D C DPR 95,000.00 NL 95,000.00 (D') 190,000.00 (D'') 190,000.00 b/ d 95,000.00 R/ E 95,000.00 Profit and Loss-20X4 P4L Realisation REA Figure 7.9: KRIGE (Pty) Ltd.’s accounts (20X4) continued IFRS 16.23 requires to carry a lease at cost. As the costs are in general unknown, IFRS 16.26 applies. It states that the initial costs are the present value of the lease rates. For discounting the interest rate implicit in the lease applies. By the regulations for initial recognition at present values based on the same rate of interest than the lease rates, the IASB mandates to measure leases always by the effective interest method. We explain this method below with the case VLAEBERG K.K. in detail. For subsequent valuation on the debit side, the right-to-use-asset is depreciated based on an appropriate depreciation method and its parameters. How it is Done (Recording a Lease): (1) Examine whether or not a lease applies. (2) Determine the value of the right to use asset. It is the asset’s fair value or most probably the present value of all lease rates. For present value calculation use the discount rate implicit in the lease. (3) Adjust the asset calculation for all payments linked to the lease. Such payments can be fees and payments for restoring the leased asset. (4) Record the leased asset as a right to use asset and as a lease liability at the same time. (5) Record depreciation on the leased asset as depreciation on the right to use asset. <?page no="150"?> Berkau: Financial Statements 4e 7-146 (6) Record the lease liability changes based on the lease valuation based either following the effective interest method or present value calculations. (7) The carrying amount of the right to use asset and the lease liability can differ due to different methods of measurements. (8) At the end of the lease term, record a disposal of the asset and the retirement of the lease liabilities. Consider all payments linked to the termination of the lease. On 2.01.20X4, the Japanese company VLAEBERG K.K. closes a contract with a car dealer about the lease of a VW Polo for a period of 3 years. The lease payments of 1,240,000.00 JPY/ a are due at the end of every year: in 20X4, in 20X5 and in 20X6. VLAEBERG K.K. estimates restoring vehicle costs for the removal of scratches and cleaning to be 800,000.00 JPY. These costs are referred to as residual value guarantee costs. The car is intended to be returned in exchange of an amount of 1,000,000.00 JPY on 31.12.20X6. As an option, VLAEBERG K.K. can buy the car at this amount. The car dealer (lessor) does not reveal the car’s cost of acquisition. Hence, the measurement of the right to use asset is based on the present value of lease payments and estimated restoring costs. IFRS 16.23 and IFRS 16.24 apply. The value of the VW Polo is calculated as the present value of the lease payments including the restoring and return payments. The payment vector for the lease is: L(t) = {-1,240,000; -1,240,000; -1,040,000}. The last vector element includes the other costs: -1,240,000 - 800,000 + 1,000,000 = -1 1,040,000.00 JPY. IFRS 16.26 requires to calculate the present value of all not yet paid lease rates. No payment has been made on 1.01.20X4. For discounting, we apply the interest rate implicit in the lease, which is 5 %/ a. The present value is amounting to: -1,240,000 × ((1 + 5%) 3 - 1) / ((5% × (1 + 5%) 2 ) + (1,000,000 - 800,000) × (1 +5%) -2 = 33,384,263.04 JPY. For our calculation we applied a present value formula with payments due in advance (this explains why the exponent in the denominator is 2). Next, we show the present values in a finance schedule for the lease. It proves that the lease valuation results in a present value of zero for the right to use asset together with the lease liability. See Figure 7.10. <?page no="151"?> Berkau: Financial Statements 4e 7-147 0.05 20X4 20X5 20X6 [JPY] [JPY] [JPY] Lease rates (1,240,000.00) (1,240,000.00) (1,240,000.00) Return compensation 1,000,000.00 Restoring costs (800,000.00) RUA 3,364,263.04 valuation 5% (2,124,263.04) 2,230,476.19 valuation 5% (990,476.19) 1,040,000.00 0.00 0.00 0.00 VLAEBERG K.K.'s LEASE LIABILITY VALUATION PLAN (20X4 - 20X6) Figure 7.10: VLAEBERG K.K.’s finance schedule for the lease On 31.12.20X4, VLAEBERG K.K. pays the 1 st leasing rate and re-values the lease liability. At the same time, the right to use asset is depreciated. Depreciation is along straight-line method under consideration of a residual value of 1,000,000.00 JPY. The revaluation of the lease liability requires the deduction of the lease payment. The new amount is: 3,364,263.04 - 1,240,000 = 2 2,124,263.04 JPY. Depreciation costs on the right to use asset in 20X4 are amounting to: (3,364,263.04 - 1,000,000 + 800,000) / 3 = 1 1,054,754.35 JPY. The new carrying amount of the right to use asset is: 3,364,263.04 - 1,054,754.35 = 22,309,508.69 JPY. Observe below the Bookkeeping entries (1) - (4) made by VLAEBERG K.K.’s Accountant on 31.12.20X4. They are for the initial recognition of the right to use asset, for the recognition of the lease liability and for the lease rate paid as well as the transfer to short-term liabilities. DR RUA asset.................... 3,364,263.04 JPY CR Lease Liability IBL.......... 3,364,263.04 JPY DR Depreciation ................. 1,054,754.35 JPY CR Acc. Depr (RUA).............. 1,054,754.35 JPY DR Lease Liability IBL.......... 1,240,000.00 JPY CR Cash/ Bank.................... 1,240,000.00 JPY DR Lease Liability IBL.......... 1,240,000.00 JPY CR Short-term liabilities A/ P ... 1,240,000.00 JPY You can already check the accounts in Figure 7.11 which prove that the lease liability is measured at: 1,240,000 + 884,263.04 = 2 2,124,263.04 JPY. Add the lease liabilities and its short-term liabilities portion. In the next Accounting period 20X5, VLAEBERG K.K. depreciates the right to <?page no="152"?> Berkau: Financial Statements 4e 7-148 use asset again by the same charges of 1,054,754.35 JPY/ a. For the valuation of the lease liability we calculate in 2 steps. At first, we revalue the lease liability: 2,124,263.04 × (1 + 5%) = 2 2,230,476.19 JPY. The revaluation is amounting to: 2,230,476.18 - 2,124,263.04 = 106,213.15 JPY. For the lease measurement it does not matter that a portion of the lease liability is disclosed as shortterm liability. The right to use asset and the lease liability are disclosed temporary at different amounts. Next, the payment of 1,240,000.00 JPY is made and the next one transferred to the short-term liabilities. Bookkeeping entries (A) - (D) are recorded on 31.12.20X5. DR Depreciation................. 1,054,754.35 JPY CR Acc. Depr (RUA) ............. 1,054,754.35 JPY DR Interest on Lease............ 106,213.15 JPY CR Lease Liabilities IBL........ 106,213.15 JPY DR Short-term Liabilities A/ P... 1,240,000.00 JPY CR Cash/ Bank.................... 1,240,000.00 JPY DR Lease Liabilities IBL........ 1,240,000.00 JPY CR Short-term Liabilities A/ P... 1,240,000.00 JPY We check again the lease liability valuation in Figure 7.11 Figure 7.11. The lease liability is carried on 31.12.20X5 at: 1,240,000 - 249,523.82 = 9 990,476.18 JPY. In the next Accounting period, VLAEBERG K.K. pays the lease rate of 1,240,000.00 JPY, the restoring costs of 800,000.00 JPY and receives the residual value amount to the extent of 1,000,000.00 JPY. The restoring costs are added to the right to use asset as the expenses are considered for the calculation of depreciation charge. With regard to the lease liability, we record a revaluation based on 5 %/ a rate of interest and make the lease payment. The interest on the lease is amounting to: 5% × 990,476.18 = 4 49,523.81 JPY. VLAEBERG K.K. records depreciation on the right to use asset, too. Find the Bookkeeping entries (I) - (V) below as recorded on 31.12.20X6. DR Short-term liabilities....... 1,240,000.00 JPY CR Cash/ Bank.................... 1,240,000.00 JPY DR RUA.......................... 800,000.00 JPY CR Cash/ Bank.................... 800,000.00 JPY <?page no="153"?> Berkau: Financial Statements 4e 7-149 DR Cash/ Bank.................... 1,000,000.00 JPY CR Profit on Disposal........... 1,000,000.00 JPY DR Interest on Lease ............ 49,523.81 JPY CR Lease Liability IBL.......... 49,523.81 JPY DR Depreciation ................. 1,054,754.35 JPY CR Acc. Depr.................... 1,054,754.35 JPY The right to use asset is dissolved through the Realisation account. Check Figure 7.11 for the details. The total of payments is consistent with the accumulated losses resulting from the lease. Observe VLAEBERG K.K. accounts below: D C D C (1) 3,364,263.04 c/ d 3,364,263.04 (3) 1,240,000.00 (1) 3,364,263.04 b/ d 3,364,263.04 (4) 1,240,000.00 (II) 800,000.00 RLS 4,164,263.04 c4d 884,263.04 4,164,263.04 4,164,263.04 3,364,263.04 3,364,263.04 (D) 1,240,000.00 b/ d 884,263.04 (B) 106,213.14 c5d 249,523.82 1,240,000.00 1,240,000.00 b/ d 249,523.82 (IV) 49,523.82 RLS 200,000.00 249,523.82 249,523.82 Right-to-use-asset RUA Lease liability IBL D C D C (2) 1,054,754.35 P4L 1,054,754.35 c4d 1,054,754.35 (2) 1,054,754.35 b/ d 1,054,754.35 c5d 2,109,508.70 (A) 1,054,754.35 2,109,508.70 2,109,508.70 b/ d 2,109,508.70 RLS 3,164,263.05 (III) 1,054,754.35 3,164,263.05 3,164,263.05 Depreciation-20X4 DPR Acc depr (RUA) ACC Figure 7.11: VLAEBERG K.K.’s accounts (20X4 - 20X6) <?page no="154"?> Berkau: Financial Statements 4e 7-150 D C D C . . . (3) 1,240,000.00 c4d 1,240,000.00 (4) 1,240,000.00 c4d 1,240,000.00 (C) 1,240,000.00 b/ d 1,240,000.00 1,240,000.00 1,240,000.00 c5d 1,240,000.00 (D) 1,240,000.00 b/ d 1,240,000.00 2,480,000.00 2,480,000.00 c5d 2,480,000.00 (C) 1,240,000.00 (I) 1,240,000.00 b/ d 1,240,000.00 2,480,000.00 2,480,000.00 (III) 1,000,000.00 b/ d 2,480,000.00 (I) 1,240,000.00 c6d 3,520,000.00 (II) 800,000.00 4,520,000.00 4,520,000.00 b/ d 3,520,000.00 Cash/ Bank C/ B Short-term liabilities A/ P D C D C DPR 1,054,754.35 R/ E 1,054,754.35 P4L 1,054,754.35 c4d 1,054,754.35 b/ d 1,054,754.35 R/ E 1,160,967.49 c5d 2,215,721.84 2,215,721.84 2,215,721.84 b/ d 2,215,721.84 R/ E 1,304,278.17 c6d 3,520,000.00 3,520,000.01 3,520,000.00 b/ d 3,520,000.00 Profit and Loss-20X4 P4L Retained earnings R/ E D C D C (A) 1,054,754.35 P5L 1,054,754.35 (B) 106,213.14 P5L 106,213.14 Depreciation-20X5 DPR Interest on lease-20X5 INT D C D C DPR 1,054,754.35 (III) 1,054,754.35 P6L 1,054,754.35 INT 106,213.14 R/ E 1,160,967.49 1,160,967.49 1,160,967.49 Profit and Loss-20X5 P5L Depreciation-20X6 DPR D C D C RUA 4,164,263.04 (III) 1,000,000.00 DPR 1,054,754.35 R/ E 1,304,278.17 IBL 200,000.00 ACC 3,164,263.05 INT 49,523.82 LoD 200,000.00 LoD 200,000.00 4,364,263.04 4,364,263.05 1,304,278.17 1,304,278.17 Realisation REA Profit and Loss-20X6 P6L D C (IV) 49,523.82 P6L 49,523.82 Interest on lease-20X6 INT Figure 7.11: VLAEBERG K.K.’s accounts (20X4 - 20X6) continued <?page no="155"?> Berkau: Financial Statements 4e 7-151 The case study of VLAEBERG K.K. shows that the measurement of the leased asset and the lease liability is different, except of for initial valuation. The reason is the consideration of the car refund and the residual value guarantee costs based on IFRS 16.36. They increase the lease liability to 200,000.00 JPY excess over the total of the lease pay-off payments. However, even without these expenses for restoring and refunds the valuation during the lease time is different due to diverse measurements. The lease liability’s value is changed by compound interest calculation whereas the right to use asset is written-off based on straight-line method. Leases can also be short-term and then be recorded as an expense. See below the case study JONKERS GmbH, a consultancy in Germany. The company regularly visits its clients and bills the travel expenses directly without further charges. With regard to JONKERS GmbH, only short-term leases apply which are considered as an expense and recorded straight through profit or loss. On 6.06.20X7, JONKERS GmbH visits a client in Saarbrücken. From the local car rental, JONKERS GmbH hires an Audi A4. The car is returned on 9.06.20X7, which results in a rental expense for 4 days: 4 × 135 = 5 540.00 EUR. Although the risk of accident is transferred to JONKERS GmbH, no lease contract applies. JONKERS GmbH insures the car and adds the insurance to its travel expenses. Insurance is amounting to: 4 × 40 = 1 160.00 EUR. Later, JONKERS GmbH charges its client the total travel costs to the extent of: 540 + 160 = 7 700.00 EUR. This is not recorded as a revenue but as a credit entry in the Travel Expense account. Short-term rent of the car does not fall under leases. It is a service of the car rental although JONKERS GmbH has the full use of the car and can, e.g., decide where to drive. However, it cannot not sell the car. In case of JONKERS GmbH, IFRS 16.5 applies as the lease is shortterm and of minor value. JONKERS GmbH records the cost by 2 Bookkeeping entries: (1) for the car rental and (2) for the refunding by its client. DR Travel Expenses (OEP)........ 700.00 EUR CR Cash/ Bank.................... 700.00 EUR DR Cash/ Bank.................... 700.00 EUR CR Travel Expenses (OEP)........ 700.00 EUR Ad (7): Financial Instruments For studying financial instruments, we refer to IAS 32, (Financial Instruments, Presentation), IFRS 7: (Financial Instruments, Disclosure) and IFRS 9: (Financial Instruments). Financial instruments are defined by IAS 32.11. A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. Details of financial assets and financial liabilities are given by IAS 32.11. A financial asset is, e.g., a right to receive cash whereas a financial liability can be a contractual obligation to deliver cash. <?page no="156"?> Berkau: Financial Statements 4e 7-152 In this text book, long-term financial instruments are covered in this chapter (7) on the debit side as financial assets and on the credit side as financial liabilities in chapter (14). The measurement is based on the same standards. Below we discuss a few case studies which result in different recognitions and measurements. We cover different instruments in order to provide you with a generic knowledge of how to recognise and measure financial instruments. In order to give you an overview over the next pages, we list the financial assets and the case study names below: (a) Cross-border investment in another company, based on ordinary shares - HAWKINS Ltd. / STEYN GmbH. (b) Bonds traded at a bond market - HAVENGA Ltd. (c) Bonds held to maturity - NATBERGEN (Pty) Ltd. (d) Preference Shares, Held at FVTOCI and later Sold - DORRINGTON Ltd. / ROTTMAN Ltd. (e) Derivatives, call option to buy copper - MOLLENBERG Ltd. IAS 32 defines financial instruments but does not deal with their recognition or measurement but IFRS 7 and IFRS 9 do. All aspects of how to disclose financial instruments have been moved to IFRS 7: Financial Instruments, Disclosure. Measurement now is found in IFRS 9. IAS 39 also mandates how to value financial instruments and reporting companies can choose whether to apply IAS 39 or IFRS 9. We here in chapter (7) only focus on IFRS 9 as IAS 39 is superseded shortly. The valuation of financial instruments depends on their classification. This requires to deal with classification of financial instruments at first. We focus on financial assets. Financial assets result from investments, shares, bonds, receivables, currency futures, call options etc. We are only able to provide you with a selection of examples of how to record and measure financial assets. We cover the major differences and measurement methods. The main rule for the disclosure of financial instruments is to initially study the business model of the holding company. Business model is a technical term in Accounting which refers to what the holding company is about to do with its financial assets. In particular, we separate financial assets held until maturity from those held for trading purpose. If a company holds bonds until redemption (until they mature), the bonds shall be disclosed at amortised costs. If a shareholder intends to sell its stock whenever a good price can be obtained we allocate them to the current asset section. The valuation is most likely based on fair value fair values then. We focus on that situation in chapter (9). We discuss below the case of HAWKINS Ltd., a South African company reporting in accordance with IFRSs. Ad (7a): Cross-border Investment in another Company, Based on Ordinary Shares - HAWKINS Ltd. / STEYN GmbH HAWKINS Ltd. holds 8 % of STEYN GmbH in Germany. STEYN GmbH is an internet <?page no="157"?> Berkau: Financial Statements 4e 7-153 tyre dealer in Hamburg and based on issued capital of 100,000.00 EUR. The company’s book value is amounting to 245,000.00 EUR at the time of HAWKINS Ltd. buying 8 % of the German firm at 19,600.00 EUR. The share price is justified by the book value of STYN GmbH which is amounting to 245 % of the issued capital. The book value of 8,000.00 EUR in shares is: 8,000 × 245% = 119,600.00 EUR. No fresh shares are issued for the deal as HAWKINS Ltd. buys its shares from another shareholder. The currency exchange rate at the time of acquisition on 2.07.20X3 is: 15.00 ZAR = 1.00 EUR. HAWKINS Ltd. pays: 15 × 19,600 = 2 294,000.00 ZAR. We ignore transaction costs as stated in chapter (1). Based on IAS 32.11, a financial asset applies for HAWKINS Ltd., as stock falls under equity instruments of another company, which is STEYN GmbH in Germany. IFRS 9.5.1.1 requires the initial recognition at 294,000.00 ZAR which is the cost of acquisition. HAWKINS Ltd. records the buy as Bookkeeping entry (1), shown below: DR Financial Asset STEYN ........ 294,000.00 ZAR CR Cash/ Bank.................... 294,000.00 ZAR You might assume HAWKINS Ltd. has to record an investment like a subsidiary. It does not have to as the investment is below 20 % of the total of shares. As no associate nor subsidiary applies, HAWKINS Ltd. is supposed to disclose a financial asset. There is no need to prepare group nor separate financial statements. The initial valuation is at cost. For the subsequent valuation of the shares their EUR value and the exchange rate matter. We assume the shares are still worth 19,600.00 EUR on 31.12.20X3. At the end of the Accounting period 20X3, the currency exchange rate has changed in HAWKINS Ltd.’s favour due to a weak South African Rand ZAR. The South African Rand has depreciated against the Euro. The exchange rate now is: 15.50 ZAR = 1.00 EUR on 31.12.20X3. As the financial asset’s valuation is based on EUR amounts, HAWKINS Ltd. shares are worth: 19,600 × 15.50 = 3 303,800.00 ZAR. Does HAWKINS Ltd. has to adjust the valuation? Yes, it does. Fair value presentation applies. Amortised costs do not apply for the shares. The business model of HAWKINS Ltd. determines a fair value presentation, here, through other comprehensive income. HAWKINS Ltd. considers the increase in share values a gain due to currency exchange rate changes to the extent of: 19,600 × 15.50 - 294,000 = 9 9,800.00 ZAR. HAWKINS Ltd. records the currency gain together with the profit share as shown below in Bookkeeping entry (3). The company HAWKINS Ltd. is no broker or bank and as a company that does not focus on investments and stock/ bond trading as major activity all income due to stock is considered a gain and shall be recorded through other comprehensive income. We now check the dividend and get back to the currency gain thereafter. STEYN GmbH earned a net profit of 25,000.00 EUR during the Accounting period 20X3. The company pays half of its earnings after taxes to its shareholders and adds <?page no="158"?> Berkau: Financial Statements 4e 7-154 the other half to earnings reserves. Hence, the profit share to be received by HAWKINS Ltd. is amounting to: 8% × 25,000 × (1 - 30%) / 2 = 7 700.00 EUR which is equivalent to: 700 × 15.50 = 10,850.00 ZAR. STEYN GmbH adds an amount of: 25,000 × (1 - 30%) / 2 = 8 8,750.00 EUR to its earnings reserves which results in an increases of its equity. As a consequence, STEYN GmbH’s book value increases. The shares are not traded publically. So, we do not have any other indication for the valuation of shares than the company’s book value. Hence, the fair value of the financial asset at HAWKINS Ltd. is adjusted through other comprehensive income and now is amounting to: 8% × (245,000 + 8,750) × 15.50 = 3 314,650.00 ZAR. HAWKINS Ltd. records the adjustment of: 314,650 - 294,000 = 2 20,650.00 ZAR through other comprehensive income. The profit share assigned to HAWKINS Ltd. is: 700 × 15.50 = 1 10,850.00 ZAR. Observe the Bookkeeping entries (2) and (3). Due to IFRS 9.5.7.10, HAWKINS Ltd. records the currency gain separately. It is amounting to: 8% x (245,000 + 8750) x (15.50 - 15) = 1 10,150.00 ZAR. Hence, the gain due to equity increase equals to: 20,650 - 10,150 = 1 10,500.00 ZAR. The other comprehensive income is transferred to profit or loss once the financial asset is de-recognised. DR Cash/ Bank.................... 10,850.00 ZAR CR Other Comprehensive Income... 10,850.00 ZAR DR Financial Asset STEYN........ 20,650.00 ZAR CR Gain on Currency Rate........ 10,150.00 ZAR CR Other Comprehensive Income... 10,500.00 ZAR In terms of return figures, the amount gives a: (10,850 + 10,150 + 10,500) / 0.5 × (294,000 + 314,650) = 1 10.35 % return on investment. On HAWKINS Ltd.’s balance sheet, the financial asset is now disclosed at 314,650.00 ZAR. Other comprehensive income is amounting to: 10,850 + 20,650 = 3 31,500.00 ZAR. Special reporting requirements apply for HAWKINS Ltd. due to IFRS 7, such as credit and market risk disclosure. Changes in measurement of financial assets cause volatility on the balance sheet of the holder of financial assets. Fluctuations in assets make a company’s ratios appear unstable, something investors do not like. It means returns get unpredictable which Accountants describe as risky. Hence, companies prefer to disclose financial instruments without permanent changes in valuation. IFRSs allow a valuation at amortised cost instead of making adjustments every Accounting period. IFRS 9.4.1.2 requires carrying financial assets at amortised costs, in case the company’s business model is to keep the assets and to receive regular cash flows on specific dates. A company that holds bonds until they mature shall disclose them at amortised costs, too. Carrying financial assets at amortised costs is the exception to fair value recognition. <?page no="159"?> Berkau: Financial Statements 4e 7-155 The regular case is keeping shares/ bonds ready to sell which requires a presentation at fair values through either profit or loss or through other comprehensive income. The rule how to carry financial instrument lays in the business concept. Held until maturity allows amortised costs - held for sale or being prepared to sell leads to a fair value presentation through profit and loss or other comprehensive income. Ad (7b): Bonds traded at a bond market - HAVENGA Ltd. HAVENGA Ltd. buys bonds which are traded at the bond market. The bonds have a face value of 5,000,000.00 ZAR and got a time to maturity of 25 years. They were issued on 2.01.20X2. This is when HAVENGA Ltd. acquired them. The coupon rate of the bonds (yield) is 11 %/ a. Observe the Bookkeeping entry (1) at the time of acquisition below which is linked to the cost model: DR Financial Assets............. 5,000,000.00 ZAR CR Cash/ Bank.................... 5,000,000.00 ZAR On 31.12.20X3, HAVENGA Ltd. receives the coupon which is amounting to: 5,000,000 × 11% = 5 550,000.00 ZAR. The Bookkeeping entry (2) for the coupon receipt shows the bonds’ income which is added to other comprehensive income as HAVENGA Ltd. is not a bank nor a bond trader: DR Cash/ Bank.................... 550,000.00 ZAR CR Bond Income .................. 550,000.00 ZAR For further information about HAVENGA Ltd.’s bond valuation check the link below: Link 7.G: Bond valuation During the next years, the bonds’ value fluctuates and at the balance sheet dates, the value as traded at the bond market is: - 20X3: 6,306,624.27 ZAR - 20X4: 6,164,191.10 ZAR - 20X5: 5,961,479.99 ZAR - 20X6: 6,095,205.27 ZAR - 20X7: 6,532,126.03 ZAR Based on IFRS 9.4.1.2, HAVENGA Ltd. records the bonds based on amortised costs. Hence, HAVENGA Ltd. can ignore the changes in bond values. HAVENGA Ltd.’s bonds are disclosed constantly at 5,000,000.00 ZAR which results in an underrating. HAVENGA Ltd.’s business model is to keep the bonds until they mature. At the date of redemption it will receive 5,000,000.00 ZAR no matter what the bond price might be. It actually will get more and more close to the amount as no one pays more than received on redemption. <?page no="160"?> Berkau: Financial Statements 4e 7-156 We discuss the unlikely event of HAVENGA Ltd. breaching its business model and now selling its bonds on 31.12.20X7. HAVENGA Ltd. then records a profit on disposal through other comprehensive income to the extent of: 6,532,126.03 - 5,000,000 = 1 1,532,126.03 ZAR as well as the coupon rate received of 550,000.00 ZAR through other comprehensive income. Observe for that alteration of the case Bookkeeping entry (A) to be made: DR Cash/ Bank.................... 6,532,126.03 ZAR CR Financial Assets............. 5,000,000.00 ZAR CR Other Comprehensive Income... 1,532,126.03 ZAR DR Cash/ Bank.................... 550,000.00 ZAR CR Other Comprehensive Income... 550,000.00 ZAR We go back to the initial case without the early sale of the bonds. The valuation at HAVENGA Ltd. was at the cost of acquisition because the company bought the bonds at face value and the redemption takes place at face value as well. Hence, the measurement at amortised costs is simple. In case a holder buys bonds at a different price than face value the effective interest method applies in line with IFRS 9.4.1.2 and IFRS 9.5.4.1. We demonstrate the measurement at amortised costs by the next case study NATBERGEN (Pty) Ltd. Ad (7c): Bonds Held to Maturity - NATBERGEN (Pty) Ltd. On 3.01.20X3, NATBERGEN (Pty) Ltd. buys bonds 5 years before maturity at 350,000.00 AUD. The face value is 400,000.00 AUD. We say, the acquisition was at a discount. The coupon rate of the bonds is 8 %/ a which makes the holder receive an annual coupon of: 8% × 400,000 = 3 32,000.00 AUD/ a. Dividend and interest in general are recorded through profit or loss or other comprehensive income. The bonds are recorded initially at 350,000.00 AUD cost of acquisition. See the Bookkeeping entry below: DR Investment held to maturity.. 350,000.00 AUD CR Cash/ Bank.................... 350,000.00 AUD NATBERGEN (Pty) Ltd.’s business model is to keep the bonds until maturity and to benefit from bond payments. The bond payments are linked to interest (coupon) and repayment of principal. Payments like this are called solely payments of principal and interest SPPI. Measurement at amortised costs applies. The calculation of the amortised costs shall include all changes in valuation of the bonds without fluctuations. Volatility is caused by changing bond market prices. The effective interest method considers NATBERGEN (Pty) Ltd. buys the bonds at 350,000.00 AUD but receives at the time of redemption (on 31.12.20X7) 400,000.00 AUD. Amortised costs shall cover the increase in val- <?page no="161"?> Berkau: Financial Statements 4e 7-157 uation by systematic and stepwise adjustments. The effective rate of interest reflects the increase in valuation net of coupon payments received. The coupons for NATBERGEN (Pty) Ltd.’s bonds are amounting to 32,000.00 AUD which is to be deducted from the interest rate to revalue the bonds in order to consider the discount upon purchase. We calculated the bond measurement by the goal seek function in Figure 7.12. The detailed calculation steps are introduced in chapter (14). For effective interest rate calculation we determine the internal rate of return based on a finance schedule. Figure 7.12 only shows the result of the calculation. In order to understand the figures, download the MS- Excel sheet below through Link 7.H. Link 7.H: NATBERGEN (Pty) Ltd. Period Opening amount Eff. interest Coupon received Carrying amount 20X3 350,000.00 39,962.10 32,000.00 357,962.10 20X4 357,962.10 40,871.19 32,000.00 366,833.29 20X5 366,833.29 41,884.08 32,000.00 376,717.37 20X6 376,717.37 43,012.62 32,000.00 387,729.99 20X7 387,729.99 44,270.01 32,000.00 400,000.00 Natbergen (Pty) Ltd.'s BOND VALUATION PLAN (20X3 - 20X7) Figure 7.12: Bond measurement at effective interest The effective interest calculated in Figure 7.12 is rounded to 11.42 %. 31 Hence, on 31.12.20X3, NATBERGEN (Pty) Ltd. adjusts bond valuation by adding a gain of: 357,962.10 - 350,000 = 7 7,962.10 AUD to its bonds. The coupon is received in cash. NATBERGEN (Pty) Ltd. offsets the coupon from the revaluation gain, e.g., in 20X5: 366,833.29 × 11.42% - 32,000 = 9 9,892.36 AUD. Hence, the new value is amounting to: 366,833.29 + 9,892.36 = 3 376,725.65 AUD. The exact increase in valuation is taken from Figure 7.12 which is based on a MS-EXCELexact calculation and gives: 376,717.37 - 366,833.29 = 9 9,884.08 AUD. NATBERGEN (Pty) Ltd. makes two Bookkeeping entries based on the calculations: DR Interest (Coupon) received... 32,000.00 AUD CR Cash/ Bank.................... 32,000.00 AUD 31 The amount is rounded up from 11.4177425 %. <?page no="162"?> Berkau: Financial Statements 4e 7-158 DR Interest (coupon) received... 9,884.08 AUD CR Investment held to maturity . 9,884.08 AUD At the end when the bonds mature, NATBERGEN (Pty) Ltd. has increased the bonds incrementally to a valuation of 400,000.00 AUD which is the settlement amount for redemption. We discuss below another case study DORRINGTON Ltd. which is about redeemable preference shares. Ad (7d): Preference Shares, Held at FVTOCI and later Sold - DORRING- TON Ltd. / ROTTMAN Ltd. Preference shares have in general no voting rights but the dividend is based on a percentage of their face value. We firstly focus on the company that issues the preference shares, which is DORRINGTON Ltd. Later, we discuss the shareholders’ side (ROTTMAN Ltd.) where the preference shares are recognised as financial assets and carried at fair value through other comprehensive income. DORRINGTON Ltd.’s preference shares’ dividend is 12 %/ a based on the nominal value. The privilege of a constant and high dividend compensates the lack in voting rights. Along the definition of IAS 32.11, redeemable preference shares are classified as a financial liability at the issuing company because an unfavourable contractual obligation to pay a fixed amount of cash for dividends and settlement of the preference dividend results. Hence, DORRINGTON Ltd. classifies the preference shares as financial liability on its balance sheet. DORRINGTON Ltd. is based on 100,000 ordinary shares at 10.00 ZAR/ s. The issued capital is amounting to: 100,000 × 10 = 1 1,000,000.00 ZAR before the issue of preference shares. On 2.01.20X7, DORRINGTON Ltd. issues 10,000 preference shares at 11.23 ZAR/ s which is the issue price. The face value of the preference shares is 10.00 ZAR/ s. In order to record the preference shares, we study IAS 32.15. By the share issue, DORRINGTON Ltd. agreed in a contract that make it receive cash to the extent of: 10,000 × 11.23 = 1 112,300.00 ZAR and results in future payment obligations to the extent of 10 times: 12% × 10 × 10,000 = 1 10 times 12,000.00 ZAR. At DORRINGTON Ltd., The preference shares are recorded as equity instruments at nominal values. The premium paid upon issue is added to capital reserves. We analyse one shareholder, ROTTMAN Ltd. that owns 1,000 preference shares bought at 11.23 ZAR/ s on 2.01.20X7. ROTTMAN Ltd.’s intention is not to keep the preference shares until redemption but to sell them in the nearby future - but not in the first Accounting period. As a consequence, the preference shares are initially recorded at cost: 1,000 × 11.23 = 1 11,230.00 ZAR. Observe Bookkeeping entry (I) recorded in the Bookkeeping records of ROTTMAN Ltd. (the shareholder). DR Financial Assets ............ 11,230.00 ZAR CR Cash/ Bank.................... 11,230.00 ZAR <?page no="163"?> Berkau: Financial Statements 4e 7-159 At the end of the year, the preference shares are traded at 10.90 ZAR/ s at the Johannesburg Stock Exchange JSE. As the shareholder, ROTTMAN Ltd., classified the preference shares to be carried at fair value the preference shares are disclosed at fair market prices which results in the recording of an impairment loss to the extent of: (11.23 - 10.90) × 1,000 = 3 330.00 ZAR to be deducted from other comprehensive income. ROTTMAN Ltd. has to record the impairment loss through other comprehensive income, as share trading is not its core business. The preference dividend received by ROTTMAN Ltd. is based on the face value of the preference shares and is amounting to: 12% × 10,000 = 1 1,200.00 ZAR. It is an addition to dividend income recorded through other comprehensive income, observe Bookkeeping entries (II), (III) at the preference shareholder’s side below: DR Impairment Loss FA ........... 330.00 ZAR CR Financial Assets............. 330.00 ZAR DR Cash/ Bank.................... 1,200.00 ZAR CR Dividend Income.............. 1,200.00 ZAR ROTTMAN Ltd., the preference shareholder, sells its 1,000 preference shares on 30.03.20X8 at 11.00 ZAR/ s. After the fair value disclosure as at the previous balance sheet date (31.12.20X7), the selling price results in a gain on disposal through other comprehensive income to the extent of: (11 - 10.90) × 1,000 = 100.00 ZAR. Observe Bookkeeping entry (A): To keep the case study simple, we do not consider that the preference shares earned an interest claim of: 25% × 12% × 1,000 × 10 = 3 300.00 ZAR from January until March 20X8. With regard to a cuminterest sale the earned preference dividend claim would be added to the price at which shares are sold at. We here assume, that the selling price of 11.00 ZAR/ s considered the interest earned already. DR Cash/ Bank.................... 11,000.00 ZAR CR Financial Assets............. 10,900.00 ZAR CR Other Comprehensive Income... 100.00 ZAR In line with IFRS 9.5.2.1, the following rule applies: A shareholder who keeps shares carries them at amortised costs but can opt for recognition at fair values through other comprehensive income FVTOCI. If the intention is to hold shares for trading, the valuation is based on fair value through profit or loss FVTPL. Regardless to measurement, dividends received are recorded through profit or loss. We discuss another case study online which contains a financial liability as a result of writing a call option for a specific amount of ordinary shares. That leads to recognition of an equity instrument. See the case study HELWAN AIRWAYS Ltd. which <?page no="164"?> Berkau: Financial Statements 4e 7-160 buys the rights for a route in return of a call option linked to its own shares online. You reach the case through Link 7.I. Link 7.I: HELWAN AIRWAYS Ltd. A special form of financial instruments are derivatives. They are often bought for hedging purpose. Derivatives are financial instruments where the financial obligation of the issuer depends on a particular price, e.g., a commodity. The valuation of derivatives is based on fair value through profit or loss. It is the intention of the holder of derivatives to benefit from changes in valuation. We discuss next the case of electro manufacturer MOLLENBERG Ltd. Ad (7e): Derivatives, call option to buy copper - MOLLENBERG Ltd. MOLLENBERG Ltd. buys a call option for copper. The copper price fluctuates and MOLLENBERG Ltd. buys an option to pay for copper 3.60 AUD/ lb on 31.12.20X9. The option is purchased on 14.05.20X5 when the copper price was 2.50 USD/ lb. The currency exchange rate to the USdollar was at that time: 69 USD = 100 AUD. MOLLENBERG Ltd. pays for the call option an amount of 10,000.00 AUD. The copper amount agreed on is 100,000 lbs. The initial valuation is on 14.05.20X5. MOLLENBERG Ltd. records the option as shown below by the Bookkeeping entry (1) at costs: DR Call Option (FA) ............ 10,000.00 AUD CR Cash/ Bank.................... 10,000.00 AUD If on 31.12.20X5, the copper price is below 3.60 AUD/ lb the option becomes void as MOLLENBERG Ltd. can buy copper without its call option. However, a drop in copper price won’t impair the financial asset (call option) as MOLLENBERG Ltd. does not know the price as at 31.12.20X9 when recording financial statements for 20X5. We assume, on 31.12.20X5, the copper price is 2.65 USD/ lb and the exchange rate is: 72 USD = 100 AUD. For the fair value calculation of the call option, we calculate the temporary gain related to the purchase price. On 31.12.20X5, 100,000 lbs copper cost: 100,000 × 2.65 / 0.72 = 3 368,055.56 AUD. Due to the call option, MOLLENBERG Ltd. can buy the copper at 360,000.00 AUD. Hence, the fair value of the financial instrument is: 368,055.56 - 360,000 = 8 8,055.56 AUD. This is a drop in valuation compared with the cost of acquisition to the extent of: 10,000 - 8,055.56 = 1 1,944.44 AUD. MOLLENBERG Ltd. who measures the call option at fair value through other comprehensive income adjusts the valuation by Bookkeeping entry (2): <?page no="165"?> Berkau: Financial Statements 4e 7-161 DR Other Comprehensive Income... 1,944.44 AUD CR Call Option (FA)............. 1,944.44 AUD In the next following Accounting periods, MOLLENBERG Ltd. has to adjust its option’s measurement based on copper price and the exchange rate to the USD again. If the price is below 360,000.00 AUD on 31.12.20X9, the option is void and MOLLENBERG records an impairment loss. If the option is used for the purchase of copper, the option is dissolved and added to the cost of purchase for MOLLENBERG Ltd.’s copper. So far, we discussed financial instruments held for longer periods that are classified as non-current assets. Companies can hold, shares or bonds or other financial instruments, e.g., receivables resulting from sale or currency futures, short-term, too. In that case we allocate them to the security item on the balance sheet which is in the current asset section. You find these cases covered in chapter (9). How it is Done (Recording Financial Assets as non-Current Assets): (1) Determine whether or not the financial asset is held short-term or long-term. For short-term check chapter (9) in this text book. (2) If the financial asset is held long-term recognise the financial asset at costs as non-current asset. (3) For subsequent valuation check the business model of the company holding. It determines the valuation of the financial asset. (4) If the financial asset is held to maturity apply the effective interest method. If the financial asset is held ready to sell apply fair value presentation through either profit or loss or through other comprehensive income. (5) For subsequent valuation apply the measurement applicable. (6) For the disposal of financial assets apply the Realisation account. (7) Record a gain or loss on disposal through either profit or loss or through other comprehensive income. Summary: Non-current assets are property, plant, equipment or intangible assets or financial instruments. A special recognition is required for leases which is based on a right to use asset that falls under intangibles and a liability at the same time. As non-current assets are held for a longer time than an Accounting period, changes in valuation become relevant. Examples for measurement are depreciation, impairment loss and revaluations. In contrast, financial instruments are measured at amortised <?page no="166"?> Berkau: Financial Statements 4e 7-162 costs or fair value model. De-recognitions of non-current assets is either recorded in profit or loss or other comprehensive income. Accounting Technical Terms: Amortised costs: To keep an asset or liabilities at amortised costs is a simplification of its measurement accepted for financial instruments that are intended to keep until maturity. It replaces a fair value presentation. The calculation of amortised costs is based on the effective interest method. Call option: Right but not an obligation to buy assets at an agreed price. Carrying amount: Measurement of an asset at which it is disclosed on the financial statements. Cost of acquisition: Based on the conventions of this text book in chapter (1) with regard to VAT reduction, the net price for buying an asset less all discounts and including all attributable costs. Fair value: Measurement at market prices which are obtained when an asset is sold. Financial assets: Shares, bonds, options, bought in order to keep them for more than one Accounting period. Gross replacement method: Method of recording a valuation based most probably on a change in cost of acquisition for new assets. Adjustments are recorded as if the asset was bought at a higher price. Impairment loss: Difference between a carrying amount and a subsequent valuation that is regarded as extraordinary. Intangible asset: Asset without physical nature. Investment: Ownership or a portion of another business, i.e., holding more than 20 % or its shares. In general, investments are subsidiaries for associates or result from joint ventures. Investment property: In general land or buildings held for renting out or capital appreciation. Lease: Contract to use an asset and taking control by paying its owner a certain consideration for an agreed time span. The duration of the lease has to be material. Lessee: Party that leases an asset from its owner. Lessor: Party that leases out an asset. Net replacement Bookkeeping entries: Method to record a revaluation based on most probably an expertise at the time of adjustment of measurement. Put option: Right but no obligation to sell an asset at an agreed price. Realisation account: Account to record the disposal of assets. The Realisation account is closed-off to the profit or loss or to other comprehensive income. Recoverable amount: Obtainable selling price or value in use - whatever is higher. Revaluation: Assigning a value to an asset that exceeds its carrying amount. Value in use: Valuation of an asset based on received cash flows. Questions Bank: (1) Which IFRS standards rule depreciation and impairment loss? 1. IAS 14, IAS 36. 2. IAS 16, IAS 36. 3. IAS 16, IAS 38. 4. IAS 14, IAS 38. <?page no="167"?> Berkau: Financial Statements 4e 7-163 (2) Which statement is correct with regard to the cost of an item of property, plant, equipment? 1. The cost of an item of property, plant and equipment comprises of the purchase price, less import duties, plus non-refundable purchase tax, less discounts, less rebates. 2. The cost of an item of property, plant and equipment comprises of the purchase price, incl. import duties, plus non-refundable purchase tax, less discounts, less rebates. 3. The cost of an item of property, plant and equipment comprises of the purchase price, incl. import duties, less non-refundable purchase tax, less discounts, less rebates. 4. The cost of an item of property, plant and equipment comprises of the purchase price, incl. import duties, incl. non-refundable purchase tax, plus discounts, plus rebates. (3) The Realisation Account shows: 1. The net selling price on the credit side and the carrying amount of the sold asset on the debit side. 2. A profit on disposal on the credit side. 3. The output-VAT on the credit side. 4. The gross selling price on the credit side, the output-VAT on the debit side, the P, P, E amount on the debit side, the total of accumulated depreciation on the credit side and the total of accumulated impairment loss on the debit side. (4) The reversal of an impairment loss … 1. … requires the disclosure of a revaluation reserve on the credit side of the balance sheet and a provision for deferred taxes on the debit side. 2. … leaves always the Accumulated Impairment Loss account balanced-off. 3. … requires the disclosure of a revaluation reserve on the credit side of the balance sheet and a provision for deferred taxes on the credit side. 4. … is recorded through the Profit and Loss account. The maximum amount is the carrying amount disclosed for regular depreciation ignoring a prior impairment loss. (5) A company buys a machine on 2.03.20X3 at 5,000.00 EUR net amount. The useful life is 5 years and depreciation is based on the declining method at 2%/ m. How much is the carrying amount of the machine as at 31.12.20X4? 1. 4,085.36 EUR. 2. 3,205.85 EUR. 3. 3,000.00 EUR. 4. 3,078.90 EUR. Solutions: 1-2; 2-2; 3-1; 4-4; 5-2. <?page no="168"?> Berkau: Financial Statements 4e 8-164 8. Business Combinations Learning Objectives: In this chapter (8), we discuss Group Accounting which is about the disclosure of investments in separate financial statements as well as about the presentation of financial statements for business combinations, such as groups or joint ventures and their consolidations. A group is a set of companies that are linked to each other by controlling relationships, meaning one company holds power over another one, most probably by rights of ownership. If company A owns companies B and C, all companies together are considered a group in terms of Accounting. In Accounting, groups prepare financial statements in addition to single-entity financial statements of each group member. Hence, a group of 3 companies with one parent and 2 subsidiaries prepares 4 financial statements, 3 single-entity financial statements for each member and 1 for the entire group. A parent is a company executing the control power, a subsidiary is the dependent company. We here also cover the preparation and presentation of separate financial statements along IAS 27. Same as the IASB by IAS 27.3, we do not cover why separate financial statements are required but in case they are prepared we show how to do it. Nowadays, many companies are involved in group, either as parent or as subsidiary. It is the aim of this chapter to provide you with a sound knowledge about Group Accounting and consolidations techniques. Consolidation is an Accounting technical term for calculations made for the preparation of group statements that cancel out double or multiple considerations of items caused by the process of adding financial statements for Group Accounting. We are aware of Group Accounting being highly demanding as the calculations are complicated and we also have to describe more than on company per case. Hence, we familiarise you with our case studies step by step. We start with separate financial statements along IAS 27, cover initial consolidations and subsequent consolidations based on IFRS 3 and IFRS 10 and discuss Joint Venture Accounting along IFRS 11 at the end of the chapter. We teach the major methods, such as the acquisition method, equity method and show Bookkeeping entries for consolidations. Always keep in mind groups never record Bookkeeping entries. Hence, making consolidation Bookkeeping entries does not fall under genuine Bookkeeping work. Group statements are derived from single-entity financial statements of the group members. You’ll see the difference further below. This chapter refers to the file CH5.xls that provides you with an MS-Excel sheet for consolidation Bookkeeping entries. Keep it handy when you study this chapter. Relevant standards for Group Accounting are IAS 27: Separate Financial Statements, IAS 28: Investments in Associates and Joint ventures, IFRS 3: Business Combinations, IFRS 10: Consolidated Financial Statements, <?page no="169"?> Berkau: Financial Statements 4e 8-165 IFRS 11: Joint Arrangements and IFRS 12: Disclosure of Interest in other Entities. 32 IAS 27 now rules the Accounting for separate financial statements. A separate financial statement is a statement of a parent or a joint venture investor that covers investments either at costs or at fair values in accordance with IFRS 9 or based on Equity Accounting as ruled by IAS 28 (IAS 27.10). It covers Accounting requirements for the disclosure of dividends and further disclosure aspects. IAS 27 does not mandate whether or not a company has to prepare separate financial statements, see IAS 27.3. IAS 28 refers to associated companies and to joint ventures. In particular, the equity method is subject to the regulations of IAS 28.10 and following paragraphs. IFRS 3 contains regulations about business combinations based on the acquisition method. IFRS 10 covers consolidated financial statements. Consolidated financial statements are financial statements of a group. A group includes a parent and all its subsidiaries. In consolidated financial statements the assets, liabilities, equity, income, expenses and cash flows of the parents and the subsidiaries are presented as those of a single economic entity. IFRS 11 regulates joint arrangements which mostly is a company controlled collectively by more than one investor or a joint operation. IFRS 12 requires companies to disclose information about nature, risks and interest in other companies. It 32 The standards IAS 27 together with IFRS 10 replace the previous IAS 27(2008). helps the user of financial statements to evaluate the impacts thereof on the financial position, on the financial performance and on cash flows of business combinations. In general, Group Accounting is about the combination of businesses. A business combination exists if one company dominates another one by taking over control. This often is linked to ownership rights. For the application of Accounting procedures, the percentage of control is relevant. Three threshold percentages are to be considered. Commonly, (1) < 20 % of control does not imply any impact on the (partly) owned company. The owner most probably discloses the investment as financial instrument in line with IFRS 9 which is initially at cost and for subsequent measurement at fair values through profit or loss or through other comprehensive income. 33 (2) 20 % … 50 % of control defines an investment in an associated company with substantial influence executed by the owner. For the valuation of the associated company, the equity method applies where an increase/ decrease of the investment’s value is calculated proportionally to the rate its book value increases or decreases. Hence, an associated company that increases 12 % in book value will increase in value on the balance sheet of its owner by 12 %, too. An owner of associate companies prepares separate financial 33 These cases are covered in chapter (7) and in chapter (9). <?page no="170"?> Berkau: Financial Statements 4e 8-166 statements in line with IAS 27. In detail, IAS 27.6 applies. (3) > 50% of control requires the preparation of group statements. Group statements are financial statements of the entire group which cover all subsidiaries of the group. This includes also subsidiaries of subsidiaries in multi-level group structures. The percentages of control can differ from what you normally expect to be the portion of ownership. They are based on taking full control or nothing when it comes to calculate the influence on a subsidiary. Before we continue with percentages of control in multi-level groups we define the technical terms control, parent and subsidiary. Control refers to the power to govern the financial and operating policies of a company in order to obtain benefits from its activities (IFRS 10, appendix A). Criteria of control are defined by IFRS 10.7. A parent is a company that controls one or more subsidiaries (IFRS 10, appendix A). A subsidiary is a company that is controlled by another company (IFRS 10, appendix A). In a multi-level group, a company can be a subsidiary and parent at the same time. The calculation of influence is based on control criteria. Company A that owns 60 % of B, whereas B owns 55 % of C, is considered to control both companies B and C, even as the calculated ownership is amounting to only: 60% × 55% = 33%. It only matters that A controls B which defines full power and counts as 100 %. Next, B fully controls C as it holds 55 % of its shares. Hence, B controls C completely, and we consider the percentage of control to be 100 %. As a consequence, here, A has to present consolidated financial statements that cover the companies A, B and C. Company B does not prepare consolidated financial statements for B and C, as this is covered by Group Accounting of A. IFRS 10.31 applies and rules that company B is an investment company and measures its subsidiary C for separate financial statements along IFRS 9 initially at cost and later at fair values through profit or loss. We could say, in terms of the control hierarchy in the group the highest parent shields its lower investment companies from preparing extra group statements. Only the top parent prepares group statements and includes all companies below in terms of the control hierarchy. The percentage replacement of 60 % by full control (100 %) is caused by the full consolidation principle. It means that companies of a group are always considered to an extent of 100 % for consolidated financial statements. This makes sense, as the only company that considers a subsidiary for its consolidated financial statements is the parent. There is not such a thing as 2 parents in the control hierarchy of Accounting. Hence, if two companies hold another one at 70 % and 30 % only the one that gains major (70 %) power over the company includes it in its Group Accounting. The other one is considered to be a non-controlling interest holder therein. Besides of 1 : 1 relationships, joint ventures are companies owned by more <?page no="171"?> Berkau: Financial Statements 4e 8-167 than one company collectively. Jointly control is mostly ruled by contracts, such as both investors have to agree together. We cover those aspects at the end of the chapter, but take caution of the fact that those contracts might exists and must be taken into consideration. For Group Accounting all subsidiaries are considered no matter where in the world they are based in. Hence, Group Accounting ignores geographical borders. Accounting rules apply based on the jurisdiction of the parent. In this text book we assume that all companies prepare single entity-financial statements and group Accounting along IFRSs. We discuss Group Accounting in three steps: (1) Separate financial statements. (2) Consolidated financial statements. (3) Joint Venture Accounting. Ad (1): Separate Financial Statements Separate financial statements are ruled by IAS 27. Separate financial statements look similar to group statements. The major difference is that they do not follow the regulations of IFRS 10. Hence, no consolidation is calculated nor recorded. This results in a measurement based on the portion a parent or investor is holding. This is the major difference to consolidations, see further below. The decision whether or not to prepare separate financial statements is ruled by national law. IAS 27 does not mandate whether or not to prepare separate financial statements see IAS 27.3 as mentioned above. Here comes a case for teaching separate financial statements. BRENO Ltd. owns 36.5 % of SANBONA Ltd. and 9 % of SUURENBERG Ltd. SANBONA Ltd. is an associated company and the investment in SUURENBERG Ltd. is a financial asset. The characteristics for holding an associated company (SANBONA Ltd.) are significance of influence and are fulfilled. In line with IAS 28.5, a company has significant influence when it holds 20 % or more of the voting power. BRENO Ltd. does not apply group statements but prepares separate financial statements and discloses SUURENBERG Ltd. as a financial asset and SANBONA Ltd. as an associated company. See below in Figure 8.1 the statement of financial position for BRENO Ltd as at the beginning of the Accounting period 20X5. <?page no="172"?> Berkau: Financial Statements 4e 8-168 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 800,000 Share capital 500,000 Investments 73,000 Reserves 300,000 Financial assets 27,000 Retained earnings 140,000 Current assets Liabilities (liab.) Inventory 34,000 Long-term liab. Accounts receivables Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 66,000 Income tax liab. 60,000 Total assets 1,000,000 Total equity and liab. 1,000,000 Breno Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X5 Figure 8.1: BRENO Ltd.’s balance sheet (1.01.20X5) On the balance sheet, the associated company SABONA Ltd. is disclosed as an investment in associates and the interest in SUURENBERG Ltd. is disclosed as financial asset. For the measurement of SABONA Ltd., IAS 28 applies, and for the valuation of SUURENBERG Ltd., IFRS 9 is applicable. During the Accounting period 20X5, the 3 companies earn the below listed profits and make payments to their owners as disclosed there, as well. To keep the case study simple, we assume dividends are paid based on the annual surplus, hence, no profit carried forward nor loss carried forward exists. - BRENO Ltd.: profit after taxes (so far): 280,000.00 ZAR, dividend: 40 % of the final profit after taxes after consideration of investments in associates and financial assets. - SUURENBERG Ltd.: profit after taxes 34,000.00 ZAR, dividend 25 % thereof. - SABONA Ltd.: profit after taxes: 24,000.00 ZAR, dividend 15 % thereof. The dividend receipts from investments are not yet included in the income statement of BRENO Ltd. No appropriation of profits has been considered so far. Observe BRENO Ltd.’s income statement as shown in Figure 8.2 below: <?page no="173"?> Berkau: Financial Statements 4e 8-169 [ZAR] Revenue 750,000 Other income 750,000 Materials (10,000) Labour (120,000) Depreciation (80,000) Other expenses (260,000) Earnings before int. & taxes (EBIT) 280,000 Interest 0 Earnings before taxes (EBT) 280,000 Income tax expenses (84,000) Deferred taxes Earnings after taxes (EAT) 196,000 Breno Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X5 Figure 8.2: BRENO Ltd.’s income statement (20X5) SUURENBERG Ltd. is disclosed as financial asset along IFRS 9 on BRENO Ltd.’s balance sheet. SUURENBERG Ltd. is listed at the Johannesburg Stock exchange JSE. At the time of acquisition, the share price per 1.00 ZAR/ s ordinary share was 3.00 ZAR/ s. BRENO Ltd. holds 9,000 shares. The cost of acquisition of the shares was: 3 × 9,000 = 2 27,000.00 ZAR. This is the amount disclosed on the balance sheet in Figure 8.1. BRENO Ltd. initially recorded the shares at fair values in accordance with IFRS 9.5.1.1. The share price of 3.00 ZAR/ s is the fair value at the time of acquisition. With the profit earned in the Accounting period 20X5, the share price increases as at 31.12.20X5 by 0.18 ZAR/ s as traded at Johannesburg Stock Exchange. This results in an increase of: 0.18 / 3 = 6 6%. As a consequence, BRENO Ltd. increases the value of its shares. It carries the shares at fair value through other comprehensive income based on IFRS 9.5.2.1. The increase of the share is amounting to: 6% × 27,000 = 1 1,620.00 ZAR. BRENO Ltd. makes the Bookkeeping entry below: DR Financial Asset ............. 1,620.00 ZAR CR Other Comprehensive Income... 1,620.00 ZAR The profit share of the dividend declared by SUURENBERG Ltd. is linked to 9 % of ownership and is amounting to: 9% × 34,000 × 25% = 7 765.00 ZAR. BRENO Ltd. records the dividend received as other comprehensive income. <?page no="174"?> Berkau: Financial Statements 4e 8-170 DR Cash/ Bank.................... 765.00 ZAR CR Other Comprehensive Income... 765.00 ZAR For the investment in the associated company SABONA Ltd., BRENO Ltd. applies the equity method from IAS 28.10. The equity method increases the measurement of an investment based on profits earned by the associated company reduced by dividends received therefrom. IAS 27.12 requires to record dividends in profit or loss unless the equity elects to use the equity method. SABONA Ltd. earned an annual surplus of 24,000.00 ZAR in 20X5. Linked to the total of equity, this is a portion of: 24,000 / (73,000/ 36.5%) = 1 12%. The dividend paid to SABONA Ltd.’s owners is 15 % thereof and is to be deducted along IAS 28.10 and IAS 27.12. The reason is that the book value of SABONA Ltd. decreases by the dividend payment as it results in a credit entry in its Retained Earnings account. Hence, the increase in equity is amounting to: 12% × (1 - 15%) = 1 10.2%. The value of the associated company SABONA Ltd. increases by: 73,000 × 10.2% = 7 7,446.00 ZAR. Furthermore, the dividend of: 15% × 24,000 × 36.5% = 1 1,314.00 ZAR is received and recorded through other comprehensive income. Observe the Bookkeeping entries below: DR Investment @equity........... 7,446.00 ZAR CR Other Comprehensive Income... 7,446.00 ZAR DR Cash/ Bank.................... 1,314.00 ZAR CR Other Comprehensive Income... 1,314.00 ZAR With regard to the dividend, IAS 27.12 requires the dividend is to be deducted from the value of the investment. Hence, the reduction for dividends of the associate’s valuation is amounting to: (12 % - 10.2%) × 73,000 = 1 1,314.00 ZAR. With regard to the dividend, we can say it is a zero-sum-game as the associate’s value decreases by the same amount as dividend income is received through other comprehensive income. We here ignore the impact of tax on capital returns. We show the financial statements of BRENO Ltd. after the appropriation of profits in Figure 8.3 and Figure 8.4. The profit before taxes is amounting to 291,255.00 ZAR. See the income statement in Figure 8.4. The dividend portion of this amount is: 40% × 291,145 × (1 - 30%) = 8 81,520.60 ZAR. The amount is recorded as a liability against shareholders and disclosed as a short-term debt on the balance sheet. <?page no="175"?> Berkau: Financial Statements 4e 8-171 A Non-current assets [ZAR] Equity [ZAR] P, P, E 720,000 Share capital 500,000 Investments 80,446 Reserves 300,000 Financial assets 28,620 Retained earnings 262,358 Current assets Liabilities (liab.) Inventory 34,000 Long-term liab. Accounts receivables Short-term liab. A/ P 81,521 Prepaid expenses Provisions Cash/ Bank 368,079 Income tax liab. 87,377 Total assets 1,231,145 Total equity and liab. 1,231,255 Breno Ltd.'s SEPARATE STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 8.3: BRENO Ltd.’s balance sheet (separate F/ S) [ZAR] Revenue 750,000 Other income 9,525 759,525 Materials (10,000) Labour (120,000) Depreciation (80,000) Other expenses (248,380) Earnings before int. & taxes (EBIT) 301,145 Interest (10,000) Earnings before taxes (EBT) 291,145 Income tax expenses (87,344) Deferred taxes Earnings after taxes (EAT) 203,802 Breno Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X5 Figure 8.4: BRENO Ltd.’s income statement (separate F/ S) In many countries, such as in Germany, the disclosure of an equity instrument increasing/ decreasing with price fluctuations and the application of the equity method is prohibited for single-entity financial statements as the measurement includes unrealised profits. Profit only is considered as realised once the assets, here: the investments, have been sold. Then, the investment does not show on the balance sheet. How it is Done (Separate Financial Statements): <?page no="176"?> Berkau: Financial Statements 4e 8-172 (1) Determine whether separate financial statements are to be prepared (IAS 27). National law applies. (2) If separate financial statements apply, prepare them for the holder of the investment / for the parent. (3) Recognise financial assets at cost or at fair values through either profit or loss or through other comprehensive income based on IFRS 9. (4) Disclose held investments in associates or joint ventures along Equity Accounting as laid out in IAS 28. (5) Record an investment in subsidiaries initially at costs and later at fair values through other comprehensive income. (6) Record dividends received from investments through either profit or loss or through other comprehensive income. (7) When applying the equity method, a dividend paid by the associate or joint venture reduces the investment’s valuation. Record a deduction accordingly. Ad (2): Consolidated Financial Statements Consolidated financial statements are referred to as derived financial statements because groups do not record business activities by Bookkeeping entries. As a consequence, group statements are based on single-entity financial statements. This will give us some work with regard to the preparation of subsequent group statements as the initial consolidations are kept. This technically means, we have to repeat the initial capital consolidation every Accounting period. We start with some considerations about consolidations and prepare group statements thereafter. For consolidated financial statements, all single-entity financial statements are “added” item-wise. The calculations require financial statements to be uniform with regard to formal aspects. The same as the addition of fractions, e.g., 1/ 3 + 1/ 2 = 5/ 6, requires to find a common denominator, the addition of financial statements requires the application of the same principles, reporting currency, reference to the same balance sheet date etc. E.g., a group that includes a Dutch and South African company with the South African one being the parent, has firstly to transfer the financial statements prepared in the Netherlands under the Woertbook van Koophandel into IFRSs and has to revalue assets measured in EURs to South African Rand ZAR figures. Only then, financial statements can be added. Addition means, we add every item separately, such as: PPE Dutch + PPE SAn = PPE Group . The addition of financial statements’ items causes items to count double, such as the interest in the subsidiary and its assets. In order to avoid multiple considerations of items, consolidations eliminate intra-group balances, transactions, income and expenses. That is what we refer to as consolidations. <?page no="177"?> Berkau: Financial Statements 4e 8-173 For our discussion of consolidations we assume that all group companies follow the same standards, have the same reporting currency, the same balance sheet date etc. Keep in mind, assuring conformity can cause a lot of Accounting work for real Group Accounting. We study the case of the GAMKA/ SWARTBERG group below and introduce the acquisition method along IFRS 3.4. It requires to identify the acquirer (GAMKA Ltd.), to determine the acquisition date (1.01.20X4), to recognise and measure all assets, liabilities and non-controlling interest (see below) and to measure and recognise goodwill. Later we discuss another case of PORTERVILLE Ltd. and its subsidiary HENDERSON Ltd. to learn about profit consolidations. On 1.01.20X4, GAMKA Ltd. buys 80 % of the ordinary shares of SWARTBERG Ltd. As a result of the acquisition, the companies form a group. GAMKA Ltd. is the owner of 80 % of the ordinary shares of SWARTBERG Ltd. takes over control of SWARTBERG Ltd. By taking control power GAMKA Ltd. becomes the parent; SWARTBERG Ltd. is the subsidiary. GAMKA Ltd. and SWARTBERG Ltd. have each to prepare single-entity financial statements and financial statements for the entire group. The group statements disclose a full set of financial statements for the entire group considering all group members as departments of a single entity. This means that all assets of GAMKA Ltd. and SWARTBERG Ltd. are disclosed on the balance sheet of GAMKA Group. Note, that the group does not have a legal form. A full set of financial statement refers to IAS 1.10 and comprises in general a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of cash flows, a statement of changes in equity and the notes. The paragraph applies for group statements, too. To determine the items on the GAMKA Group’s statement of financial position the Accountant adds all items for the group companies. For recognition and measurement the fair value as on acquisition date apply (IFRS 3.18). E.g., PPE GAMKA + PPE SWARTBERG = 230,000 + 40,000 = 2 270,000.00 ZAR. We took the amounts from the balance sheets shown in Figure 8.5 and Figure 8.6. For the group’s balance sheet a capital consolidation applies as there are double counting for items: GAMKA Ltd.’s investment in SWARTBERG Ltd. counts as an asset. Also, the assets of SWARTBERG Ltd. are considered as assets. This results in a double recognition of the subsidiary. The same applies for the subsidiary’s equity. It represents the book value of the acquired company and is added to the equity section of the group. In order to “clear” Group Accounting from the above mentioned double counts, the group records a capital consolidation. In general, a consolidation is either a capital consolidation, a consolidation of receivables/ payables or a profit consolidation. A capital consolidation is a calculation that eliminates the investment in subsidiaries and their equity from group statements. A consolidation of receivables and payables removes all mutual debts and receivables between group members. A profit consolidation results in the deduction of intra-group profits on the group’s <?page no="178"?> Berkau: Financial Statements 4e 8-174 statement of profit or loss and other comprehensive income and the equity section of the group’s balance sheet. For consolidations, we distinguish between initial consolidation and subsequent ones. An initial consolidation is recorded at acquisition date in general when the group is defined by the parent taking control power over the subsidiary. Any subsequent consolidation is undertaken later and refers to initial consolidations. Accountants call the calculations made “consolidation Bookkeeping entries” but no Bookkeeping entries are actually made in the Bookkeeping records of any group member. Consider further that initial consolidation Bookkeeping entries are unchangeable but not recorded in the books. Hence, we must repeat the initial consolidations every year in order to carry them forward from Accounting period to Accounting period. An exception only applies when the group situation changes, e.g., by acquisition of further portions of a subsidiary. Consolidated financial statements do not affect payments. No tax payments or dividends depend on the group statements. The only purpose of Group Accounting is providing information. Below, we study the GAMKA GROUP in order to get familiarised with the basics of calculations and how consolidation Bookkeeping entries are made. The companies provide the financial statements on 31.12.20X3 as below: A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 230,000 Share capital 300,000 Intangibles Reserves Financial assets Retained earnings 70,000 Current assets Liabilities (liab.) Inventory 170,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 50,000 Prepaid expenses Provisions Cash/ Bank 100,000 Income tax liab. 30,000 Total assets 500,000 Total equity and liab. 500,000 Gamka Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.5: GAMKA Ltd.’s statement of financial position <?page no="179"?> Berkau: Financial Statements 4e 8-175 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 40,000 Share capital 50,000 Intangibles Reserves Financial assets Retained earnings 28,000 Current assets Liabilities (liab.) Inventory 30,000 Long-term liab. Accounts receivables Short-term liab. A/ P 10,000 Prepaid expenses Provisions Cash/ Bank 30,000 Income tax liab. 12,000 Total assets 100,000 Total equity and liab. 100,000 Swartberg Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.6: SWARTBERG Ltd.’s statement of financial position The single-entity financial statements in Figure 8.5 and Figure 8.6 are indicated by the name of the group member. You can observe the legal form disclosed on the header. All items on the balance sheets are measured at fair values and have been prepared under IFRSs. The reporting currency is South African Rand ZAR. The financial statements of both group members are prepared without consideration of appropriation of profits, for simplification we assume all profits are carried forward to the next Accounting period 20X4. When GAMKA Ltd. buys 80 % of SWARTBERG Ltd. in the next year on 1.01.20X4 its book value is: 50,000 + 28,000 = 7 78,000.00 ZAR. The book value of GAMKA Ltd.’s investment is 80 % thereof: 80% × (50,000 + 28,000) = 62,400.00 ZAR. GAMKA Ltd. pays the (previous) owners an amount of 65,000.00 EUR in exchange of 80 % of the company SWARTBERG Ltd. This means, the payment exceeds the book value of the acquired portion of the company. As a consequence, the statement of financial position now discloses an investment in the subsidiary at cost of 65,000.00 ZAR and a reduced item cash/ bank compared to the situation before acquisition. The cash/ bank item now shows: 100,000 - 65,000 = 3 35,000.00 ZAR. GAMKA Ltd. bought the subsidiary at a price above book value. The reason might be strategic intentions, e.g., with regard to the present market position of SWARTBERG Ltd., or the acquirer bets on a high potential of the business in the future etc. GAMKA Ltd. makes the Bookkeeping entry below which indicates that the subsidiary is recorded at cost. See below in Figure 8.7 the balance sheet for GAMKA Ltd. on 1.01.20X4 after the acquisition was made. <?page no="180"?> Berkau: Financial Statements 4e 8-176 DR Investment Subsidiary........ 65,000.00 ZAR CR Cash/ Bank.................... 65,000.00 ZAR A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 230,000 Share capital 300,000 Intangibles Reserves Investment 65,000 Retained earnings 70,000 Current assets Liabilities (liab.) Inventory 170,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 50,000 Prepaid expenses Provisions Cash/ Bank 35,000 Income tax liab. 30,000 Total assets 500,000 Total equity and liab. 500,000 Gamka Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X4 Figure 8.7: GAMKA Ltd.’s SFP after acquisition On the single-entity financial statements, GAMKA Ltd.’s investment in the subsidiary is disclosed at cost of acquisition to the extent of 65,000.00 ZAR. This is the amount of transferred consideration, here the price paid for the acquisition (IFRS 3.37). For the group statements, we “add” all items on both balance sheets. Note, that the balance sheet for SWARTBERG Ltd. did not change by the partial transfer in ownership. It only shows now the balance sheet date 1.01.20X4. By the acquisition of 80 % of SWARTBERG Ltd., GAMKA Ltd. is the parent and SWARTBERG Ltd. the subsidiary. Both companies still prepare singleentity financial statements. We now prepare the group statements. They are indicated as GAMKA GROUP statements. Adding the financial statements is best supported by a consolidation worksheet as shown below in Figure 8.8. <?page no="181"?> Berkau: Financial Statements 4e 8-177 PARENT SUBSIDIARY AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 230,000 40,000 270,000 Int. assets 0 Investments 65,000 65,000 Goodwill 0 cur Assets Inventory 170,000 30,000 200,000 Receivables 0 Prepaid exp. 0 Cash 35,000 30,000 65,000 500,000 100,000 600,000 SH's capital Issued capital (300,000) (50,000) (350,000) Reserves 0 Reval. Reserves 0 Retained ear. (70,000) (28,000) (98,000) Non-ctrl. int 0 Liabilities Int. bear. liab. (50,000) (50,000) Payables (50,000) (10,000) (60,000) Provisions 0 Def. income 0 Tax liabilities (30,000) (12,000) (42,000) (500,000) (100,000) (600,000) Figure 8.8: Consolidation chart (1) The consolidation chart adds the singleentity financial statements for GAMKA Ltd. and SWARTBERG Ltd. item-wise. The sum is shown as aggregated balance sheet (AGGR) which is the group balance sheet before consolidations. E.g., the item for property, plant and equipment in the aggregated financial statements gives: 230,000 + 40,000 = 270,000.00 ZAR. The downside of automatically adding financial statements is that the aggregated financial statements now disclose the investment of 65,000.00 ZAR and all its assets and all items on the credit side. The book value of the acquired company is the total of its assets less its liabilities: 100,000 - (10,000 + 12,000) = 7 78,000.00 ZAR. This means SWARTBERG Ltd. now counts more than double on the group statements, it is actually more than 180 %. More refers to the goodwill not yet disclosed but included in the amount of 65,000.00 ZAR. 100% is the result of a full consolidation, even though only 80 % is the percentage of ownership. The multiple consideration gives misleading information for the user of the group statements. In order to avoid double and multiple considerations of subsidiaries a capital consolidation is recorded. The aim is to cancel out the investment and the book value of SWARTBERG Ltd. and to disclose the excess of payment as goodwill. 80 % of SWARTBERG Ltd.’s value equals to: 80% × 78,000 = 6 62,400.00 ZAR. The overpayment is amounting to 65,000 - 62,400 = 2 2,600.00 ZAR. We make a Bookkeeping entry as shown in the column for capital consolidation (CAP.CONS). This is ruled by IFRS 3.32. Observe the capital consolidation as shown in the next consolidation chart in Figure 8.9 under CAP.CONS. <?page no="182"?> Berkau: Financial Statements 4e 8-178 PARENT SUBSIDIARY AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 230,000 40,000 270,000 270,000 Int. assets 0 0 Investments 65,000 65,000 (65,000) 0 Goodwill 0 2,600 2,600 cur Assets Inventory 170,000 30,000 200,000 200,000 Receivables 0 0 Prepaid exp. 0 0 Cash 35,000 30,000 65,000 65,000 500,000 100,000 600,000 (62,400) 0 0 537,600 SH's capital Issued capital (300,000) (50,000) (350,000) 40,000 10,000 (300,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (70,000) (28,000) (98,000) 22,400 5,600 (70,000) Non-ctrl int 0 (10,000) (5,600) (15,600) Liabilities Int. bear. liab. (50,000) (50,000) (50,000) Payables (50,000) (10,000) (60,000) (60,000) Provisions 0 0 Def. income 0 0 Tax liabilities (30,000) (12,000) (42,000) (42,000) (500,000) (100,000) (600,000) 62,400 0 0 (537,600) Figure 8.9: Consolidation chart (2) The consolidation procedure contains 2 steps. The first one eliminates the investment and the over-payment together with the acquired portion of share capital and retained earnings: 2,600 + 40,000 + 22,400 = 6 65,000.00 ZAR. The second step allocates the portion of 20 % of issued capital and retained earnings to the other owners of SWARTBERG Ltd. (not GAMKA Ltd.). We refer to them as non-controlling interest. The equity section of a consolidated balance sheet comes with an item called non-controlling interest. For the GAMKA Group, this amount now contains 20 % of shares and 20 % of the retained earnings at the time of acquisition. This gives 20% × 50,000 = 1 10,000.00 ZAR and 20% × 28,000 = 5 5,600.00 ZAR. These initial capital consolidation bookkeeping entries won’t change for subsequent consolidations. For subsequent consolidations, they have to be repeated as the consolidation is based on single-entity financial statements which means that consolidation Bookkeeping entries are not saved. We show a subsequent consolidation for this case study further below. This would be the consolidation as at 31.12.20X4. The consolidated statement of financial position for GAMKA GROUP is displayed in Figure 8.10. It is derived from the right column in the consolidation chart. <?page no="183"?> Berkau: Financial Statements 4e 8-179 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 270,000 Share capital 300,000 Intangibles Reserves Investment Retained earnings 70,200 Goodwill 2,600 Non-ctrl interest 15,400 Current assets Liabilities (liab.) Inventory 200,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 60,000 Prepaid expenses Provisions Cash/ Bank 65,000 Income tax liab. 42,000 Total assets 537,600 Total equity and liab. 537,600 Gamka Group's consolidated STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.10: Consolidated balance sheet For further considerations, we combine the initial consolidation Bookkeeping entries in order to disclose them in one column on the consolidation chart. The consolidation bookkeeping entry would be: DR Goodwill..................... 2,600.00 ZAR DR Issued Capital............... 50,000.00 ZAR DR Retained Earnings............ 28,000.00 ZAR CR Investments.................. 65,000.00 ZAR CR Non-ctrl. Interest........... 15,600.00 ZAR For the initial consolidation, no consolidation of receivables/ payables nor for intra-group profit applies. We study the next year’s consolidated financial statements for GAMKA Ltd. and SWARTBERG Ltd.: The companies disclose the income statements as below for the period ended on 31.12.20X4: <?page no="184"?> Berkau: Financial Statements 4e 8-180 [ZAR] Revenue 200,000 Other income (10,000) 190,000 Materials (14,000) Labour (100,000) Depreciation (16,000) Other expenses Earnings before int. & taxes (EBIT) 60,000 Interest Earnings before taxes (EBT) 60,000 Income tax expenses (18,000) Deferred taxes Earnings after taxes (EAT) 42,000 Gamka Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 8.11: GAMKA Ltd.’s income statement (20X4) A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 214,000 Share capital 300,000 Intangibles Reserves Investment 65,000 Retained earnings 112,000 Current assets Liabilities (liab.) Inventory 160,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 50,000 Prepaid expenses Provisions Cash/ Bank 91,000 Income tax liab. 18,000 Total assets 530,000 Total equity and liab. 530,000 Gamka Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 8.12: GAMKA Ltd.’s balance sheet (20X4) For the understanding of the statement of financial position, we provide you with some background information which is not relevant for consolidation. You can skip this paragraph if happy with the balance sheet and continue reading where the * is. The item property, plant, equipment is reduced due to depreciation: 230,000 - 16,000 = 2 214,000.00 ZAR. Goods have been released from stock which gives a reduction of 10,000.00 ZAR in the Inventory account: 170,000 - 10,000 = 160,000.00 ZAR. We assume all business activities are on cash. GAMKA Ltd. pays 30,000.00 ZAR to the revenue service for income tax liabilities resulting from 20X3. The cash revenue of 200,000.00 ZAR is deducted for labour and materials as well. Hence, the item cash/ bank equals to: 35,000 + 200,000 - 14,000 - 100,000 - 30,000 = 9 91,000.00 ZAR. On <?page no="185"?> Berkau: Financial Statements 4e 8-181 the credit side, there is no change in issued capital and the earnings after tax are added to retained earnings: 70,000 + 42,000 = 1 112,000.00 ZAR. In the liability section, the only change is in the Income Tax Liability account: 30,000 - 30,000 + 18,000 = 1 18,000.00 ZAR. We now study the subsidiary, SWARTBERG Ltd. in Figure 8.13 and Figure 8.14. [ZAR] Revenue 35,000 Other income 35,000 Materials (15,000) Labour Depreciation (10,000) Other expenses Earnings before int. & taxes (EBIT) 10,000 Interest Earnings before taxes (EBT) 10,000 Income tax expenses (3,000) Deferred taxes Earnings after taxes (EAT) 7,000 Swartberg Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 8.13: SWARTBERG Ltd.’s income statement 20X4 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 30,000 Share capital 50,000 Intangibles Reserves Financial assets Retained earnings 35,000 Current assets Liabilities (liab.) Inventory 30,000 Long-term liab. Accounts receivables Short-term liab. A/ P 10,000 Prepaid expenses Provisions Cash/ Bank 38,000 Income tax liab. 3,000 Total assets 98,000 Total equity and liab. 98,000 Swartberg Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.14: SWARTBERG Ltd.’s balance sheet 20X4 We repeat the explanation of the single-entity financial statements for SWARTBERG Ltd. Again, if you are happy with the financial statements you can skip this paragraph and continue reading at the *. The amount for property, plant, equipment on SWARTBERG Ltd.’s statement <?page no="186"?> Berkau: Financial Statements 4e 8-182 of financial position results from the previous amount less depreciation, no acquisition nor revaluation takes place: 40,000 - 10,000 = 3 30,000.00 ZAR. Inventories do not change. The amount of cash/ bank is based on the assumption that all business activities are on a cash basis. They comprise of income tax payment, revenue and material payments. The item cash/ bank is amounting to: 30,000 + 35,000 - 15,000 - 12,000 = 38,000.00 ZAR. There are no changes in issued capital and the item retained earnings equals to: 28,000 + 7,000 = 35,000.00 ZAR. Short-term liabilities remain unchanged and the income tax liabilities are based on the payment of 20X3’s debts. The item tax liabilities is amounting to: 12,000 - 12,000 + 3,000 = 3 3,000.00 ZAR. * The consolidation procedures are based on the MS-Excel file CH5.xls again. After we enter the figures for the single-entity balance sheets we see the aggregated balance sheet already. On the consolidation chart, the initial consolidation bookkeeping entries are given. We apply the comprehensive Bookkeeping entry for capital consolidation as discussed above. Observe the consolidation chart in Figure 8.15. PARENT SUBSIDIARY AGGR. 1st CONS CONS. F/ S N-cur Assets P,P,E 214,000 30,000 244,000 244,000 Int. assets 0 0 Investments 65,000 65,000 (65,000) 0 Goodwill 0 2,600 2,600 cur Assets Inventory 160,000 30,000 190,000 190,000 Receivables 0 0 Prepaid exp. 0 0 Cash 91,000 38,000 129,000 129,000 530,000 98,000 628,000 (62,400) 0 0 565,600 SH's capital Issued capital (300,000) (50,000) (350,000) 50,000 (300,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (112,000) (35,000) (147,000) 27,800 (119,200) M.I. 0 (15,400) (15,400) Liabilities Int. bear. liab. (50,000) (50,000) (50,000) Payables (50,000) (10,000) (60,000) (60,000) Provisions 0 0 Def. income 0 0 Tax liabilities (18,000) (3,000) (21,000) (21,000) (530,000) (98,000) (628,000) 62,400 0 0 (565,600) Figure 8.15: GAMKA Group’s consolidation chart (20X4.1) No changes in the valuation of the investments nor in the percentage of ownership apply. The only adjustment required is for the profit and the portion belonging to the non-controlling interest holders thereof. The profit of the subsidiary equals to 7,000.00 ZAR. We take this figure from the income statement. A portion of 80 % belongs to the group and the remaining 20 % are assigned to the non-controlling interest holders. Hence, we allocate: <?page no="187"?> Berkau: Financial Statements 4e 8-183 80% × 7,000 = 5 5,600.00 ZAR to the controlling interest holders and: 7,000 - 5,600 = 1 1,400.00 ZAR to the non-controlling interest holders. This is firstly disclosed at the bottom lines of the income statement, see Figure 8.16. [ZAR] Revenue 35,000 Other income 35,000 Materials (15,000) Labour Depreciation (10,000) Other expenses Earnings before int. & taxes (EBIT) 10,000 Interest Earnings before taxes (EBT) 10,000 Income tax expenses (3,000) Deferred taxes Earnings after taxes (EAT) 7,000 EAT controlling interest holders (5,600) EAT non-ctrl interest holders (1,400) 0 Swartberg Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 8.16: Prolonged income statement for SWARTBERG Ltd. 20X4 The next step of consolidation is to allocate the profit to controlling interest holders and non-controlling-interest holders on the balance sheet. We make the consolidation bookkeeping entry as below: DR Retained Earnings............ 1,400.00 ZAR CR Non-ctrl Interest............ 1,400.00 ZAR Observe the bookkeeping entry made on the consolidation chart and the resulting consolidated balance sheet in Figure 8.17 and Figure 8.18. <?page no="188"?> Berkau: Financial Statements 4e 8-184 PARENT SUBSIDIARY AGGR. 1st CONS non-ctrl INT CONS. F/ S N-cur Assets P,P,E 214,000 30,000 244,000 244,000 Int. assets 0 0 Investments 65,000 65,000 (65,000) 0 Goodwill 0 2,600 2,600 cur Assets Inventory 160,000 30,000 190,000 190,000 Receivables 0 0 Prepaid exp. 0 0 Cash 91,000 38,000 129,000 129,000 530,000 98,000 628,000 (62,400) 0 0 565,600 SH's capital Issued capital (300,000) (50,000) (350,000) 50,000 (300,000) Reserves 0 0 Reval. Reserves 0 0 Retained ear. (112,000) (35,000) (147,000) 28,000 1,400 (117,600) non-ctrl int. 0 (15,600) (1,400) (17,000) Liabilities Int. bear. liab. (50,000) (50,000) (50,000) Payables (50,000) (10,000) (60,000) (60,000) Provisions 0 0 Def. income 0 0 Tax liabilities (18,000) (3,000) (21,000) (21,000) (530,000) (98,000) (628,000) 62,400 0 0 (565,600) Figure 8.17: GAMKA Group’s consolidation chart (20X4.2) A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 244,000 Share capital 300,000 Intangibles Reserves Investment Retained earnings 117,600 Goodwill 2,600 Non-ctrl interest 17,000 Current assets Liabilities (liab.) Inventory 190,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 60,000 Prepaid expenses Provisions Cash/ Bank 129,000 Income tax liab. 21,000 Total assets 565,600 Total equity and liab. 565,600 GAMKA GROUP's consolidated STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 8.18: GAMKA Group’s consolidated balance sheet 20X4 The consolidated income statement is straight forward in this case. No intragroup profit has been recorded. Hence, the income statements are only added. See the result in Figure 8.19. <?page no="189"?> Berkau: Financial Statements 4e 8-185 [ZAR] Revenue 235,000 Other income (10,000) 225,000 Materials (29,000) Labour (100,000) Depreciation (26,000) Other expenses 0 Earnings before int. & taxes (EBIT) 70,000 Interest Earnings before taxes (EBT) 70,000 Income tax expenses (21,000) Deferred taxes Earnings after taxes (EAT) 49,000 EAT controlling interest holders (47,600) EAT non-ctrl interest holders (1,400) 0 Gamka Group's STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 8.19: GAMKA Group’s consolidated income statement (20X4) The statement of changes in equity requires additions with regard to the profit distribution between controlling interest and non-controlling interest holders. See below the statement of changes in equity for the group as at 31.12.20X4 in Figure 8.20. Share capital Non-ctrl interest Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X4 300,000 15,600 70,000 385,600 Profit 20X4 49,000 49,000 Profit allocation 1,400 (1,400) 0 as at 31.12.20X0 300,000 17,000 117,600 434,600 Gamka Group's STATEMENT of CHANGES in EQUITY as at 31.12.20X4 Figure 8.20: Consolidated statement of changes in equity (20X4) A full set of financial statement includes a statement of cash flows, too. Below, we discuss the statement of cash flows. We assume that all activities are on cash - depreciation exempted. We prepare the statement of cash flows based on the reconciliation method. <?page no="190"?> Berkau: Financial Statements 4e 8-186 Cash flow from operating acitivities [ZAR] [ZAR] EBT 70,000 add Interest paid 0 add Depreciation 26,000 96,000 changes in working capital changes in A/ R 0 changes in inventory 10,000 changes in A/ P (42,000) changes in VAT/ r only materials 0 changes in VAT/ p 0 64,000 Cash flow from investing activities Investments 0 0 Cash flow from financing activities Financial activities 0 0 Total cash flow 64,000 Gamka Group's STATEMENT of CASH FLOWS for the period ended 31.12.20X4 Figure 8.21: GAMKA Group’s consolidated SCF 20X4 The amount of total cash flows equals to the aggregated cash flows of the group companies: 91,000 + 38,000 - 30,000 - 35,000 = 6 64,000.00 ZAR. How it is Done (Consolidated Financial Statements): (1) Determine whether consolidated financial statements apply. (2) Determine the companies to be considered for consolidated financial statements. Generally, a company is included when the control power is executed by the parent. (3) Copy single-entity financial statements for preparation of Group Accounting. Make adjustments in the copies of the financial statements in regard to the reporting currency, the reporting balance sheet date etc. Make further adjustments to alignment the copies with IFRSs if they have been prepared along other GAAPs. (This can result in massive Accounting work! ) (4) Add all financial statements item-wise. Call the resulting financial statement the aggregated financial statements. Best apply a consolidation worksheet as provided by the file CH5.xls in academia or Bookkeeping software for real Accounting work. <?page no="191"?> Berkau: Financial Statements 4e 8-187 (5) Run a capital consolidation based on the acquisition method. Make the consolidation Bookkeeping entries in the consolidation worksheet. The capital consolidation is recorded as at the time of acquisition. (6) Run a profit consolidation. Cancel out any intragroup profit and make adjustments to assets dependent on intra-group profits, e.g., with regard to the measurement of assets that have been traded between group members. Enter the consolidation Bookkeeping entries in the consolidation worksheet. (7) Run a consolidation of payables/ receivables. Cancel out any intra-group liabilities and receivables. Enter the consolidation Bookkeeping entries in the consolidation worksheet. (8) In case dividends are considered, cancel out intragroup dividend payment/ receipt portions. Enter the consolidation Bookkeeping entries in the consolidation worksheet. (9) Prepare consolidated financial statements based on the figures on the consolidation worksheet. Below, we discuss profit consolidations and its impact on the valuation of inventories as well as profit and dividend implications. For this we introduce another case study which is PORTERSVILLE Ltd. owning 80 % of its supplier HENDERSON Ltd. All shares at PORTERSVILLE Ltd. as well as at HENDERSON Ltd. have a face value of 1.00 AUD/ s. On 3.01.20X2, PORTERSVILLE Ltd. bought its shares of HENDERSON Ltd. when its retained earnings were 100,000.00 AUD. No reserves were disclosed on the balance sheet at that time. Find below the balance sheets of both companies as at 31.12.20X5. In the inventories of PORTERSVILLE Ltd., there are goods for 100,000.00 AUD, bought from HENDERSON Ltd. HENDERSON Ltd. bought the goods itself for 65,000.00 AUD from another company. HENDERSON Ltd. pays a dividend of 0.15 AUD/ s for the Accounting period 20X5. The dividend is not considered for the financial statements as disclosed in Figure 8.22 and Figure 8.23. No profit/ loss carried forward applies for the financial statements for PORTERSVILLE Ltd. nor HENDERSON Ltd. <?page no="192"?> Berkau: Financial Statements 4e 8-188 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 2,300,000 Share capital 1,000,000 Intangibles Reserves 300,000 Investments 520,000 Retained earnings 700,000 Non-ctrl interest Current assets Liabilities (liab.) Inventory 260,000 Long-term liab. 1,000,000 Accounts receivables Short-term liab. A/ P 220,000 Prepaid expenses Provisions Cash/ Bank 440,000 Income tax liab. 300,000 Total assets 3,520,000 Total equity and liab. 3,520,000 Portersville Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 8.22: PORTERSVILLE Ltd.’s balance sheet (parent) A C, L Non-current assets [AUD] Equity [AUD] P, P, E 1,300,000 Share capital 500,000 Intangibles Reserves 300,000 Investments Retained earnings 210,000 Non-ctrl interest Current assets Liabilities (liab.) Inventory 300,000 Long-term liab. 800,000 Accounts receivables Short-term liab. A/ P 300,000 Prepaid expenses Provisions Cash/ Bank 600,000 Income tax liab. 90,000 Total assets 2,200,000 Total equity and liab. 2,200,000 HENDERSON Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 8.23: HENDERSON Ltd.’s balance sheet (subsidiary) Firstly, we repeat capital consolidations: The capital consolidation as at the time of acquisition on 3.01.20X2 considers a buy of 400,000 ordinary shares of HENDERSON Ltd. at 520,000.00 AUD. The total equity of HENDERSON Ltd. at that time was: 500,000 + 100,000 = 600,000.00 AUD. The book value of the shares at the time of acquisition was: 80% × 600,000 = 4 480,000.00 AUD. The consolidation Bookkeeping entry is shown below: DR Goodwill..................... 40,000.00 AUD DR Issued Shares................ 400,000.00 AUD DR Retained Earnings............ 100,000.00 AUD CR Non-ctrl. Interest........... 20,000.00 AUD CR Investment................... 520,000.00 AUD <?page no="193"?> Berkau: Financial Statements 4e 8-189 The capital consolidation does not change. As a consequence, we enter the amounts into the consolidation worksheet below. The only alteration we make is that we now consider the retained earnings as additions to the earnings reserves. Hence, the debit entry is no longer in the Retained Earnings account but in the Earnings Reserves account. PARENT SUBSIDIARY AGGR. CAP. CONS CONS. F/ S N-cur Assets P,P,E 2,300,000 1,300,000 3,600,000 3,600,000 Int. assets 0 0 Investments 520,000 520,000 (520,000) 0 Goodwill 0 40,000 40,000 cur Assets Inventory 260,000 300,000 560,000 560,000 Receivables 0 0 Prepaid exp. 0 0 Cash 440,000 600,000 1,040,000 1,040,000 3,520,000 2,200,000 5,720,000 (480,000) 0 5,240,000 SH's capital Issued capital (1,000,000) (500,000) (1,500,000) 400,000 (1,100,000) Reserves (300,000) (300,000) (600,000) (600,000) Retained ear. (700,000) (210,000) (910,000) 100,000 (810,000) Non-ctrl. int 0 (20,000) (20,000) Liabilities Int. bear. liab. (1,000,000) (800,000) (1,800,000) (1,800,000) Payables (220,000) (300,000) (520,000) (520,000) Provisions 0 0 Tax liabilities (300,000) (90,000) (390,000) (390,000) (3,520,000) (2,200,000) (5,720,000) 480,000 0 (5,240,000) Figure 8.24: Consolidation worksheet for PORTERSVILLE Group (1) Given that no profit/ loss is carried forward, we know that between 3.01.20X2 and 31.12.20X4, HENDERSON Ltd. increased its equity by: 800,000 - 600,000 = 2200,000.00 AUD. The amount is allocated to the group and the non-controlling interest holders at a 4 : 1 ratio and gives us the next column in the Consolidation worksheet. We split the earnings reserves in a 4 : 1 ratio which gives 160,000 : 40,000. We transfer the 40,000.00 AUD for the non-controlling interest holders into the required account. For layout reasons we hide the single company columns as you can observe in Figure 8.25. <?page no="194"?> Berkau: Financial Statements 4e 8-190 AGGR. CAP. CONS non-CTRL CONS. F/ S N-cur Assets P,P,E 3,600,000 3,600,000 Int. assets 0 0 Investments 520,000 (520,000) 0 Goodwill 0 40,000 40,000 cur Assets Inventory 560,000 560,000 Receivables 0 0 Prepaid exp. 0 0 Cash 1,040,000 1,040,000 5,720,000 (480,000) 0 0 0 5,240,000 SH's capital Issued capital (1,500,000) 400,000 (1,100,000) Reserves (600,000) 100,000 40,000 (460,000) Retained ear. (910,000) (910,000) Non-ctrl. int 0 (20,000) (40,000) (60,000) Liabilities Int. bear. liab. (1,800,000) (1,800,000) Payables (520,000) (520,000) Provisions 0 0 Tax liabilities (390,000) (390,000) (5,720,000) 480,000 0 0 0 (5,240,000) Figure 8.25: Consolidation worksheet for PORTERSVILLE Group (2) The inventories disclosed on the balance sheet of PORTERSVILLE Ltd.’s balance sheet contain an intra-group related profit which is correctly disclosed on the single-entity financial statements. Although, the group statements have to consider the asset valuation at cost of acquisition of the group which is the purchase costs, here amounting to 65,000.00 AUD. This is: 100,000 - 65,000 = 3 35,000.00 AUD less than disclosed on the balance sheet of PORTERSVILLE Ltd. At the same time, we acknowledge that the sales profit, HENDERSON Ltd. recorded is an unrealised profit from the point of view of Group Accounting. Hence, we have to deduct HENDERSON Ltd.’s profit in the Retained Earnings account as well as in the Income Tax Liabilities account by 35,000.00 AUD. This gives: 35,000 × (1 - 30%) = 2 24,500.00 AUD deductions with regard to retained earnings and: 35,000 × 30% = 1 10,500.00 AUD income tax deduction. Although, Group Accounting has no impact on taxation we record a deduction of income tax liabilities. Find below the next step in consolidation work for the PORTERSVILLE Group in Figure 8.26. <?page no="195"?> Berkau: Financial Statements 4e 8-191 AGGR. CAP. CONS non-CTRL Profit.CONS CONS. F/ S N-cur Assets P,P,E 3,600,000 3,600,000 Int. assets 0 0 Investments 520,000 (520,000) 0 Goodwill 0 40,000 40,000 cur Assets Inventory 560,000 (35,000) 525,000 Receivables 0 0 Prepaid exp. 0 0 Cash 1,040,000 1,040,000 5,720,000 (480,000) 0 (35,000) 0 5,205,000 SH's capital Issued capital (1,500,000) 400,000 (1,100,000) Reserves (600,000) 100,000 40,000 (460,000) Retained ear. (910,000) 24,500 (885,500) Non-ctrl. int 0 (20,000) (40,000) (60,000) Liabilities Int. bear. liab. (1,800,000) (1,800,000) Payables (520,000) (520,000) Provisions 0 0 Tax liabilities (390,000) 10,500 (379,500) (5,720,000) 480,000 0 35,000 0 (5,205,000) Figure 8.26: Consolidation worksheet for PORTERSVILLE Group (3) In the next step, we show the profit appropriation of the subsidiary HENDERSON Ltd. The company pays a dividend of 0.15 AUD/ s. The total dividend is: 0.15 × 500,000 = 7 75,000.00 AUD. A portion of: 80% × 75,000 = 60,000.00 AUD is an intra-group dividend and does not require consideration. The other portion of: 75,000 - 60,000 = 1 15,000.00 AUD is a payment to non-controlling interest holders which are considered as group-outsiders. Hence, a dividend payment is recorded as a cash reduction of 15,000.00 AUD. We also have to consider how much of the retained earnings is left and allocate a 20 % portion to the non-controlling interest holders. The retained earnings of HENDERSON Ltd. were 210,000.00 AUD on the balance sheet. We deducted 24,500.00 AUD for intra-group profits and another 75,000.00 AUD for dividends. Hence, the remaining retained earnings are: 210,000 - 24,500 - 75,000 = 1 110,500.00 AUD. A 20 % portion of this amount is assigned to the non-controlling interest holders. It results in a transfer of: 110,500 × 20% = 222,100.00 AUD. See below in Figure 8.27 the last column filled in the consolidation worksheet for PORTERSVILLE Group and in Figure 8.28 the consolidated balance sheet. To keep the case simple we ignored the tax on capital return for the dividends’ calculation. <?page no="196"?> Berkau: Financial Statements 4e 8-192 AGGR. CAP. CONS non-CTRL Profit.CONS Dividends CONS. F/ S N-cur Assets P,P,E 3,600,000 3,600,000 Int. assets 0 0 Investments 520,000 (520,000) 0 Goodwill 0 40,000 40,000 cur Assets Inventory 560,000 (35,000) 525,000 Receivables 0 0 Prepaid exp. 0 0 Cash 1,040,000 (15,000) 1,025,000 5,720,000 (480,000) 0 (35,000) (15,000) 5,190,000 SH's capital Issued capital (1,500,000) 400,000 (1,100,000) Reserves (600,000) 100,000 40,000 (460,000) Retained ear. (910,000) 24,500 37,100 (848,400) Non-ctrl. int 0 (20,000) (40,000) (22,100) (82,100) Liabilities Int. bear. liab. (1,800,000) (1,800,000) Payables (520,000) (520,000) Provisions 0 0 Tax liabilities (390,000) 10,500 (379,500) (5,720,000) 480,000 0 35,000 15,000 (5,190,000) Figure 8.27: Consolidation worksheet for PORTERSVILLE Group (4) A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 3,600,000 Share capital 1,100,000 Intangibles Reserves 460,000 Investment Retained earnings 848,400 Goodwill 40,000 Non-ctrl interest 82,100 Current assets Liabilities (liab.) Inventory 525,000 Long-term liab. 1,800,000 Accounts receivables Short-term liab. A/ P 520,000 Prepaid expenses Provisions Cash/ Bank 1,025,000 Income tax liab. 379,500 Total assets 5,190,000 Total equity and liab. 5,190,000 Portersville GROUP's CONSOLIDATED STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 8.28: PORTERSVILLE Group’s balance sheet Ad (3): Joint Venture Accounting Joint Venture Accounting applies when joint arrangements exist. IFRS 11.4 defines a joint arrangement as an arrangement of which two or more parties have joint control. For joint control unanimous consent is required for all decisions as laid out by IFRS 11.7. One or more companies having control power over another one requires Equity Accounting based on IAS 28 or a disclosure along IFRS 9 based on IFRS 11.24 and IFRS 11.25. <?page no="197"?> Berkau: Financial Statements 4e 8-193 The IASB distinguishes between joint operations and joint ventures and instructs the investor per IFRS 11.14 to determine its type of joint arrangement. In line with IFRS 11.15, a joint operation is a joint arrangement where the controlling parties have the rights to their own assets and an obligation for their own liabilities. In general, this means that two companies cooperate and every company keeps its assets. The companies share profit and costs based on their holdings. No new company needs to be established. In line with IFRS 11.16, a joint venture is a joint arrangement where the controlling parties have the rights to the assets. This normally leads to the establishment of a limited company which is accounted for based on the Equity Accounting. Based on IFRS 11.20 and IFRS 11.24, a joint operator prepares in relation to their interest consolidated statements and a joint venturer recognises his arrangements based on the equity method along IAS 28. Below, we demonstrate both kind of joint arrangements: (1) joint venture and (2) joint operation. Ad (1): Joint Operations On 1.01.20X7, the security firms QICKARMS Ltd. and RESPONSE (Pty) Ltd. decide to run a patrol service together. There is a third partner FIRE Ltd. which contributes 10 %. The contract states that only unanimous decisions of the three parties can be made. Hence, FIRE Ltd. can block a motion even with its 10 % of holding. In a joint arrangement every partner can execute a veto control. This means, if no unanimous consent can be established nothing will happen. The joint arrangement of the joint patrol service is classified as joint operation along IFRS 11.15. The investors have joint responsibility in regard to deployed assets and for the liabilities. In their financial statements, QUICKARMS Ltd., RESPONSE (Pty) Ltd. as well as FIRE Ltd. consider the assets (cars, weapons) for the joint patrol service to the extent of 150,000.00 ZAR as asset portions linked to their holdings: QUICKARMS Ltd. and RESPONSE (Pty) Ltd. to an extend of 45 % and FIRE Ltd. of 10 %. Hence, QUICKARMS Ltd. discloses: 45% × 150,000 = 6 67,500.00 ZAR. Special disclosure requirements based on IFRS 11.20 apply. It is agreed that RESPONSE (Pty) Ltd. receives the revenues and pays the operational costs of the joint patrol service. At the year-ends, RESPONSE (Pty) Ltd. passes the share of the profit on to the other joint operators. Look at the balance sheet of QUICKARMS Ltd. in Figure 8.29. It shows the assets for the joint control as share in joint assets. <?page no="198"?> Berkau: Financial Statements 4e 8-194 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 300,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 67,500 Retained earnings Current assets Liabilities (liab.) Inventory Long-term liab. 115,000 Accounts receivables Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 247,500 Income tax liab. Total assets 615,000 Total equity and liab. 615,000 QuickArms Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 8.29: QUICKARMS Ltd.’s balance sheet (20X6) During the Accounting period 20X7, the revenue for the joint patrol service is 700,000.00 ZAR. The consumption of materials is 80,000.00 ZAR and labour is 500,000.00 ZAR, both are paid on cash. The profit of the joint patrol service is: 700,000 - 80,000 - 500,000 = 120,000.00 ZAR. The income taxes thereon are: 120,000 × 30% = 3 36,000.00 ZAR. At the end of the Accounting period 20X7, QUICKARMS Ltd. is entitled to receive a profit share of: 45% × (120,000 - 36,000) = 3 37,800.00 EUR from its partner RESPONSE (Pty) Ltd. QUICKARMS Ltd. has to add depreciation on its assets deployed for the joint patrol service to the extent of: 45% × (150,000 / 3) = 22,500.00 ZAR. For our calculations we start with the income statement of QUICKARMS Ltd. It does not include any items concerning the joint patrol service yet. Observe the income statement in Figure 8.30. See below also the balance sheet without consideration of the joint patrol service impact. It is shown in Figure 8.31. <?page no="199"?> Berkau: Financial Statements 4e 8-195 [ZAR] Revenue 1,300,000 Other income 1,300,000 Materials (35,000) Labour (700,000) Depreciation (50,000) Other expenses (43,000) Earnings before int. & taxes (EBIT) 472,000 Interest Earnings before taxes (EBT) 472,000 Income tax expenses (141,600) Deferred taxes Earnings after taxes (EAT) 330,400 QuickArm Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 8.30: QUICKARM Ltd.’s income statement A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 67,500 Retained earnings 530,400 Current assets Liabilities (liab.) Inventory Long-term liab. 115,000 Accounts receivables Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 969,500 Income tax liab. 141,600 Total assets 1,287,000 Total equity and liab. 1,287,000 QuickArms Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.31: QUICKARM Ltd.’s balance sheet (20X7) For QUICKARMS Ltd.’s financial statements we consider the share of the profit on the joint patrol service as receivables. We further add the depreciation on the assets for the joint patrol service to the expenses. We make the Bookkeeping entries as below for the profit share of 37,800.00 ZAR and for the depreciation on the deployed assets to the extent of: 22,500.00 ZAR: <?page no="200"?> Berkau: Financial Statements 4e 8-196 DR Depreciation................. 22,500.00 ZAR CR Acc. Depr. (joint)........... 22,500.00 ZAR DR Receivables.................. 37,800.00 ZAR CR Other Comprehensive Income... 37,800.00 ZAR After recording the above Bookkeeping entries and considering an income tax addition of 4,590.00 ZAR, the financial statements look as below: [ZAR] Revenue 1,300,000 Other income (joint) 37,800 1,337,800 Materials (35,000) Labour (700,000) Depreciation (50,000) Depreciation (joint) (22,500) Other expenses (43,000) Earnings before int. & taxes (EBIT) 487,300 Interest Earnings before taxes (EBT) 487,300 Income tax expenses (146,190) Deferred taxes Earnings after taxes (EAT) 341,110 QuickArm Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 8.32: QUICKARM Ltd.’s income statement A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 45,000 Retained earnings 541,110 Current assets Liabilities (liab.) Inventory Long-term liab. 115,000 Accounts receivables 37,800 Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 969,500 Income tax liab. 146,190 Total assets 1,302,300 Total equity and liab. 1,302,300 QuickArms Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.33: QUICKARM Ltd.’s balance sheet (20X7) <?page no="201"?> Berkau: Financial Statements 4e 8-197 How it is Done (Accounting for Joint Operations): (1) Mark assets assigned for the joint operations on the balance sheet for extra disclosure. (2) Calculate the profit of the joint operations before taxation. (3) Transfer the pre-tax profit to the other joint operator(s) or receive it from the other joint operator(s) and consider it as other comprehensive income. (4) Consider depreciation and other expenses linked to joint operations separately on the income statement. (5) Prepare financial statements. The case study is below repeated for the situation, the joint arrangement is regarded as a joint venture. The case study slightly changes. It is not intended to compare the figures in order to evaluate the most profitable structure. Ad (2): Joint Venture If the three companies agree in a joint venture, a company is established. The three investors control the new company CLOSE-WATCH (Pty) Ltd. jointly. IFRS 11.24 requires to disclose the joint venture on the balance sheet of the investor’s financial statement. Find below the balance sheet of CLOSE- WATCH (Pty) Ltd. in Figure 8.34. The company CLOSE-WATCH (Pty) Ltd. is established with 200,000.00 ZAR. 150,000.00 ZAR therefrom is invested in assets, such as cars and weapons. The company further lends from QUICKARMS Ltd. 25,000.00 ZAR. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 150,000 Share capital 200,000 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. A/ P 25,000 Prepaid expenses Provisions Cash/ Bank 75,000 Income tax liab. Total assets 225,000 Total equity and liab. 225,000 Close-Watch (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 8.34: CLOSE-WATCH (Pty) Ltd.’s opening balance sheet During the Accounting period 20X7, CLOSE-WATCH (Pty) Ltd. records a profit <?page no="202"?> Berkau: Financial Statements 4e 8-198 of 49,000.00 ZAR after taxes. No dividend has been declared. The short-term liabilities of 25,000.00 ZAR are paid-off. [ZAR] Revenue 700,000 Other income 700,000 Materials (80,000) Labour (500,000) Depreciation (50,000) Other expenses Earnings before int. & taxes (EBIT) 70,000 Interest Earnings before taxes (EBT) 70,000 Income tax expenses (21,000) Deferred taxes Earnings after taxes (EAT) 49,000 Close-Watch (Pty) Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 8.35: CLOSE-WATCH (Pty) Ltd.’s income statement A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 100,000 Share capital 200,000 Intangibles Reserves Financial assets Retained earnings 49,000 Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. A/ P 0 Prepaid expenses Provisions Cash/ Bank 170,000 Income tax liab. 21,000 Total assets 270,000 Total equity and liab. 270,000 Close-Watch (Pty) Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.36: CLOSE-WATCH (Pty) Ltd.’s balance sheet (20X7) QUICKARM Ltd. and RESPONSE (Pty) Ltd. show the investment at costs to the extent of 90,000.00 ZAR. FIRE Ltd. discloses a financial asset at cost of 20,000.00 ZAR. At the time of acquisition, QUICKARMS Ltd. discloses separate financial statements which show its portion of the joint venture at cost based on Equity Accounting. <?page no="203"?> Berkau: Financial Statements 4e 8-199 For the main investors, Equity Accounting along IAS 28.10 applies. QUICKARMS Ltd.’s separate financial statements as at 1.01.20X7 are shown below in Figure 8.37. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 300,000.00 Share capital 400,000.00 Intangibles Reserves 100,000.00 Investment (joint) 90,000.00 Retained earnings Current assets Liabilities Inventory Interest bear liab 115,000.00 Accounts receivables 25,000.00 Accounts payables Prepaid expenses Provisions Cash/ Bank 200,000.00 Tax liabilities Total assets 615,000.00 Total equity and liab. 615,000.00 QuickArm / Close-Watch JOINT VENTURE SEPARATE STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 8.37: QUICKARM/ CLOSE-WATCH joint venture’s balance sheet At the end of the Accounting period 20X4, the value of CLOSE-WATCH (Pty) Ltd. increased by: (249,000 - 200,000) / 200,000 = 2 24.5%. As no dividend has been declared by CLOSE-WATCH (Pty) Ltd., the investments on the balance sheet at QUICKARM Ltd. and RESPONSE (Pty) Ltd. increase by 24.5 %, too. The new valuation is: (1 + 24.5%) × 90,000 = 112,050.00 ZAR. The contra entry for the increase in valuation is made in the Revaluation Reserves account. Below, the balance sheet for the joint venturer QUICKARMS Ltd. is displayed in Figure 8.38 as separate financial statement. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000.00 Share capital 400,000.00 Intangibles Reserves 122,050.00 Investment (joint) 112,050.00 Retained earnings 330,400.00 Current assets Liabilities Inventory Interest bear liab 115,000.00 Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 747,000.00 Tax liabilities 141,600.00 Total assets 1,109,050.00 Total equity and liab. 1,109,050.00 Quickarm / Close-Watch JOINT VENTURE SEPARATE STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.38: QUICKARM/ CLOSE-WATCH joint venture balance sheet <?page no="204"?> Berkau: Financial Statements 4e 8-200 As no indication for an increase in valuation exists for the financial asset at FIRE Ltd., the valuation stays at 20,000.00 ZAR. The fair value does not change due to the increase in equity as the company’s shares are not traded publically. Note, due to the application of the equity method based on IAS 28.10, the intra-joint venture lending and service rendering has no impact on the valuation. No consolidation takes place. How it is Done (Joint Venture Accounting): (1) Prepare financial statements for the joint venture and the joint venturer(s). Check whether the joint venture is a financial asset or requires Equity Accounting. (2a) If the joint venture is recorded as financial asset, apply valuation at cost or subsequently at fair values through profit or loss or through other comprehensive income. (2b) If the joint venture requires Equity Accounting, check whether separate financial statements are required initially or subsequently. (3a) If the separate financial statements are initially required, recognise the joint venture proportionally at costs. (3b) If the separate financial statements are subsequently required, recognise the joint venture proportionally based on the equity method. (4b) Record dividends received through profit and loss or through other comprehensive income. Deduct dividends paid from the valuation of the joint venture proportionally. (5) Prepare separate financial statements for the joint venturer and the joint venture. Summary: Group Accounting is linked to the preparation of separate financial statements along IAS 27, to consolidated financial statements along IFRS 3 or to joint arrangements along IFRS 11. Minor investments are disclosed as financial instruments along IFRS 9. Investments with significant influence are measured based on the equity method based on IAS 28. Group Accounting aims to provide the user of financial statements with additional information. It has no impact on the need and the way how single companies prepare and present their single-entity financial statements. No payments depend on Group Accounting. In Europe, Group Accounting based on IFRSs is required once one group member participates in the public capital market. Technical Accounting Terms: Acquisition method: Method of Group Accounting. The items of the acquired company are valued as at the <?page no="205"?> Berkau: Financial Statements 4e 8-201 time of achieving ownership. The acquisition method is subject of IFRS 3.5. Associated company: An associated company is a company the investor holds between 20 and 50 % from. A significance of influence is characteristic. At Equity: Measurement of associates and joint ventures based on the changes of the book value. The equity method is ruled by IAS 28.10. Capital consolidation: A calculation that cancels out the double counting of the acquisition of a subsidiary. The investment and equity linked to the group are discarded. In case of an investment exceeding the book value of a subsidiary the difference is disclosed as goodwill. Consolidated financial statements: Statements of a group in which items are shown as those of a single entity. Control: Power to determine the strategy and operating decisions of another company. In order to exercise control power over another company, ownership generally is assumed to exceed 50 %. Equity Accounting: Measurement of an investment in associates or for joint ventures under application of the equity method along IAS 28. Group Accounting: Preparation of financial statements for business combinations. Holding: When we say based on holding we mean proportional to the amount of shares held by a party. Investment: Ownership or a portion of another business, i.e., holding more than 20 % or its shares. In general, investments are subsidiaries for associates or result from joint ventures.. Joint arrangements: Obtaining or keeping collectively control power over an investment. For joint arrangements, a contract is required that states that control can only be executed by investors together. An unanimous consent is required. Profit consolidation: Cancelation of intra-group profits and adjustment of valuations for goods linked thereto. Separate financial statements: Statements prepared by a parent/ investor that show the proportional interest in subsidiaries, associates and joint operations based on IAS 27. Question Bank: (1) A Ltd. buys 210 shares of B Ltd. which is based on 300 shares at 10.00 EUR. At the time of acquisition the Retained Earnings Account at B Ltd. is 1,000.00 EUR. The costs of the investment are 2,900.00 EUR. How much is the goodwill? 1. Nil. 2. 100.00 EUR. 3. 200.00 EUR. 4. (120.00 EUR). (2) L Ltd. buys 550 shares of S Ltd. which is based on 1,000 shares at 5.00 EUR. At the time of acquisition the Retained Earnings account is 1,500.00 EUR. At the beginning of the fiscal year, the opening balance for S Ltd.’s Retained Earnings account is 5,000.00 EUR. How much is the non-controlling interest to be disclosed on the consolidated balance sheet? 1. 5,175.00 EUR. 2. 5,000.00 EUR. <?page no="206"?> Berkau: Financial Statements 4e 8-202 3. 6,325.00 EUR. 4. 4,500.00 EUR. (3) Which statement is correct? 1. An investment in an associate is one that is below 20 % of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 28. 2. An investment in an associate is one that is more than 20 % of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 28. 3. An investment in an associate is one that is more than 20% of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 27. 4. An investment in an associate is one that is more than 25% of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 27. (4) On 1.01.20X2, Y Ltd. buys 50 shares of C Ltd. which is based on 200 ordinary shares at 10.00 EUR/ s. The total costs of acquisition are 500.00 EUR. At the time of acquisition, the Retained Earnings account of C Ltd. is zero balanced. On 31.12.20X7, the closing balance of Y Ltd.’s Retained Earnings account is 2,000.00 EUR and of C Ltd.’s one it is amounting to 1,000.00 EUR. What is the disclosure of the investment in C Ltd. on Y Ltd.’s single entity statement of financial position? 1. 1,250.00 EUR. 2. 1,000.00 EUR. 3. 750.00 EUR. 4. 500.00 EUR. (5) On 1.01.20X2, A (Pty) Ltd. buys 60 % of the shares of P Ltd. The opening balance of P Ltd.’s Retained Earnings account is 1,000.00 EUR. The subsidiary declares a dividend of 600.00 EUR. The closing balance of the Retained Earnings account (after appropriation of profits) is 1,500.00 EUR on the single entity financial statements. How much is the increase of P Ltd.’s equity due to profit/ dividend on the consolidated financial statements (non-controlling portion)? 1. 660.00 EUR. 2. 200.00 EUR. 3. 360.00 EUR. 4. 900.00 EUR. Solutions: 1-2, 2-4, 3-2, 4-3, 5-2. <?page no="207"?> Berkau: Financial Statements 4e 9-203 9. Current Assets on the Balance Sheet Learnings Objectives: Based on our balance sheet structure, current assets are inventories, receivables, securities and cash/ bank. In contrast to German HGB, prepaid expenses are classified as current assets, too. They meet the characteristics for assets set by the Framework F.4.8 - F.4.13. In this chapter (9), we teach recognition and measurement of current assets. As inventories include raw materials, work in process as well as of finished goods we introduce Manufacturing Accounting 34 for finished goods calculation in production firms. For current assets, we mainly focus on the perpetual system for inventory movements and show differences to the period system which we applied before for retailers in chapter (4). As financial instruments can be held short-term this chapter also considers their recognition and measurement, such as receivables and securities. We continue the discussion of financial instruments started in chapter (7). Current assets are disclosed separately to long-term ones based on IAS 1.60 except when a reporting company prepares financial statements along liquidity aspects. IAS 1.61 states that items should be distinguished based on a 12 months rule. IAS 1.66 defines current assets as assets that are realised, sold, consumed within a normal operating cycle of most probably 12 months, 34 Read for Manufacturing Accounting our Basics-1, chapter (25) and regarding Job Order Costing and Process Costing: Basics-2, chapter (18), (19). merchandised goods or cash. All other items are classified as non-current. The above classification is not strict for every single item of inventory but applies in general. I.e., a production firm that manufactures a gear boxes and has one finished special gear box on stock for 2 years does not change its classification towards non-current assets. For the gear box, the general classification as inventory stays: The minimum of inventory turnover is assumed to be 1/ 365d. As companies intend to keep inventories for a shorter periods than a year no depreciation on inventories applies. However, extraordinary depreciation can happen. In those cases, we do not call it an impairment loss but record an inventory decrease or loss in valuation. Similar rules apply for bad debts. Bad debts are receivables a company considers uncollectable. They are written-off against expenses, the account’s name is the Bad Debts account that is closed-off to profit or loss at year-ends. Current assets on the balance sheet are: (1) Inventories. (2) Receivables. (3) Securities. (4) Prepaid expenses. (5) Cash/ bank. <?page no="208"?> Berkau: Financial Statements 4e 9-204 Ad (1): Inventories Inventories are assets a company trades with or assets needed for its operations, i.e., for production or service rendering. They are important assets when they are high in values, such as in retailer companies or in production firms. In contrast, service rendering companies, such as consultancies, law firms or software developers, carry only low levels of stock. Inventories are defined by IAS 2.6: They are assets held for sale, for production purposes, such as materials, or materials and supplies consumed in the process of production or of rendering services. Our considerations start with the case of the South African trading company GREENACRES Ltd. For retailers, inventories are mostly merchandise goods purchased and later sold to their customers. The case study GREENACRES Ltd. explains the difference between two alternative inventory systems 35 , the periodic and the perpetual system. We explain the Bookkeeping entries for both systems. For retailers, the Trading account applies. Accounting for inventories depend on the inventory system in use. For a periodic inventory system, a company has to take stock once per Accounting period, in general on 31.12.20XX. Additions to inventories are recorded in the Purchase account. No Bookkeeping entries for stock releases are made. A company only calculates its consumption of inventories when stock has been taken. A periodic system for inventory movements applies seldom and most likely in cases when inventory values are low. The 35 Read our Basics-1, chapter (26). problem is that the company only knows its stock levels on balance sheet dates. In contrast, a perpetual inventory system records inputs and outputs of stock. So, the company knows at any time its amounts of inventories. No matter what inventory system is used, the valuation of inventory is always based on cost of purchase. The cost of purchase are defined by IAS 2.11 and comprises of the net price less discounts and rebates. Also attributable costs, such as for transport and handling, can be added to inventories. In cases when goods’ values change, the valuation is at cost of purchase or at net realisable value, whatever is less. See IAS 2.9: Inventories shall be measured at the lower of cost and net realisable value which is the estimated selling price less cost of completion and less costs to make the deal (IAS 2.6). The rule is strict, which means there is no choosing: Once the value decreases, the lower amount counts. In cases of an increase in valuation (after purchase) the purchase price applies. No revaluations, such as for non-current assets apply. This is defined by IAS 2.9 as the paragraph only allows a valuation at the lower of cost and net realisable value. This is to be understood as: if the net realisable value is higher, valuation will be at cost of purchase. If the net realisable value is lower, it applies. The net realisable value is defined by IAS 2.6 as the estimated selling price less estimated cost of completion and selling costs. Commonly, we can say it <?page no="209"?> Berkau: Financial Statements 4e 9-205 is the fair value of inventories which is defined by IFRS 13.6 as the price that would been received when selling the asset in an orderly transaction. Writing down inventories from costs to net realisable values measures inventory not higher than what can be realised from sale or use (IAS 2.28). The case study GREENACRES is about a company dealing with lamps. GREENACRES Ltd. discloses an opening amount of inventories at 168,000.00 ZAR which is 140 lamps at 1,200.00 ZAR/ u on stock as purchased on 31.12.20X4. In the Accounting period 20X5, GREENACRES Ltd. buys 1,000 further lamps at 1,200.00 ZAR/ u. At first, we apply a periodic system for inventory movements. The valuation of the lamps is at costs. No writing down to net realisable values applies as the lamp prices are constant. The Bookkeeping entry (1) for the purchase of lamps is shown below. DR Purchase..................... 1,200,000.00 ZAR DR VAT.......................... 240,000.00 ZAR CR Cash/ Bank.................... 1,440,000.00 ZAR During the Accounting period 20X5, GREENACRES Ltd. sells 800 lamps at a net selling price of 2,000.00 ZAR/ u. The Bookkeeping entry (2) is for the revenue and shown below: DR Cash/ Bank.................... 1,920,000.00 ZAR CR VAT.......................... 320,000.00 ZAR CR Revenue...................... 1,600,000.00 ZAR No inventory movements are recorded regarding the sales within a periodic system. At the end of the Accounting period 20X5, GREENACRES Ltd. takes stock of lamps being: 340 × 1,200 = 4 408,000.00 ZAR. Only at the end of Accounting period 20X5, GREENACRES Ltd. records the closing stock with reference to the Trading account as Bookkeeping entry (3). The valuation of closing stock is at its cost of purchase. Observe the Bookkeeping entry below and the gross profit calculation in Figure 9.1. DR Inventories.................. 408,000.00 ZAR CR Trading Account.............. 408,000.00 ZAR D C D C OV 168,000.00 T/ A 168,000.00 OV . . . (1) 1,440,000.00 (3) 408,000.00 c/ d 408,000.00 (2) 1,920,000.00 576,000.00 576,000.00 b/ d 408,000.00 Inventories (lamps) INV Cash/ Bank C/ B Figure 9.1: GREENACRES Ltd. accounts (periodic system) <?page no="210"?> Berkau: Financial Statements 4e 9-206 D C D C (1) 1,200,000.00 T/ A 1,200,000.00 (1) 240,000.00 (2) 320,000.00 c/ d 80,000.00 320,000.00 320,000.00 b/ d 80,000.00 Purchase-20X5 PUR Value added tax VAT D C D C T/ A 1,600,000.00 (2) 1,600,000.00 T/ A 168,000.00 REV 1,600,000.00 PUR 1,200,000.00 (3) 408,000.00 GP 640,000.00 2,008,000.00 2,008,000.00 b/ d 640,000.00 Revenue-20X5 REV Trading account-20X5 T/ A Figure 9.1: GREENACRES Ltd. accounts (periodic system) continued We repeat the case study GREENACRES Ltd., but now we apply a perpetual system for the inventory movements. Under a perpetual system, a company adds purchases to the Inventory account immediately and records releases from stock, as well. This helps the company to know its stock levels at any time. Retailers frequently use bar codes or RFID technology 36 for tracking their stock movements and checking inventory levels. Logistics needs inventory levels for order management. Bookkeeping entries with a perpetual inventory system slightly change in comparison to the periodic system. We also alter the case study GREENACRES Ltd. slightly and apply a perpetual system for inventory movements. The alteration is in regard to the sales amounts. Instead of one sale we now consider 3 separate sales that add up to the same amount as in the previous case, 800 lamps. GREENACRES Ltd. buys 1,000 lamps and records Bookkeeping entry (A). After acquisition, Bookkeeping entry (B) adds the lamps’ value straight to its Inventory account. You also can combine the Bookkeeping entries (A) and (B) and then make the first debit entry in the Inventory account. DR Purchase..................... 1,200,000.00 ZAR DR VAT.......................... 240,000.00 ZAR CR Cash/ Bank.................... 1,440,000.00 ZAR DR Inventories.................. 1,200,000.00 ZAR CR Purchase..................... 1,200,000.00 ZAR In contrast to the previous scenario, revenue is now earned by three single sales, 36 RFID = radio frequency identification. at 400 lamps, at 250 lamps and at 150 lamps. All lamps are sold at a net selling <?page no="211"?> Berkau: Financial Statements 4e 9-207 price of 2,000.00 ZAR/ u. The total amount of lamps sold is again: 400 + 250 + 150 = 8800 lamps. Hence, the revenue (C 1 ) is: 400 × 2,000 = 8 800,000.00 ZAR, revenue (C 2 ) is: 250 × 2,000 = 500,000.00 ZAR and revenue (C 3 ) is: 150 × 2,000 = 3 300,000.00 ZAR. GREENACRES Ltd. now also records three Bookkeeping entries (D 1 … D 3 ) for the inventory movements of the lamps. Bookkeeping entries (D 1 … D 3 ) are debit entries for material expenses and credit entries in the Inventory account. The expense account now is the Cost of Goods Sold account. The extra Cost of Goods Sold account keeps our Trading account clear of too many entries for stock movements. One could say the Cost of Goods Sold account fulfils a buffer role in terms of Bookkeeping. The expense recognition for sold inventories follows IAS 2.34 and shall be recorded in the Accounting period the sale takes place. Writing down inventories requires expense recognition in the period the value decreases, too. At GREENACRES Ltd., inventory movement Bookkeeping entries are based on the cost of purchase which is here constantly 1,200.00 ZAR/ u. Observe the Bookkeeping entries (C 1 ) - (D 3 ) below: DR Cash/ Bank.................... 960,000.00 ZAR CR VAT.......................... 160,000.00 ZAR CR Revenue...................... 800,000.00 ZAR DR Cost of Goods Sold........... 480,000.00 ZAR CR Inventory.................... 480,000.00 ZAR DR Cash/ Bank.................... 600,000.00 ZAR CR VAT.......................... 100,000.00 ZAR CR Revenue...................... 500,000.00 ZAR DR Cost of Goods Sold........... 300,000.00 ZAR CR Inventory.................... 300,000.00 ZAR DR Cash/ Bank.................... 360,000.00 ZAR CR VAT.......................... 60,000.00 ZAR CR Revenue...................... 300,000.00 ZAR DR Cost of Goods Sold........... 180,000.00 ZAR CR Inventory.................... 180,000.00 ZAR With a perpetual system, GREENACRES Ltd. knows at any time its stock level of lamps, e.g., after the 2 nd sale: 168,000 + 1,200,000 - 480,000 - 300,000 = 588,000.00 ZAR. GREENACRES Ltd. does not have to take stock, as the Accounting system knows the inventory levels already. Study the accounts for GREENACRES Ltd. in Figure 9.2. When applying a perpetual inventory movement system, a company makes two Bookkeeping entries per sale, one for the revenue based on the selling price and <?page no="212"?> Berkau: Financial Statements 4e 9-208 one for stock movements based on inventory valuation at either cost of purchase or net realisable values. D C D C OV 168,000.00 (D 1 ) 480,000.00 OV . . . (A) 1,440,000.00 (B) 1,200,000.00 (D 2 ) 300,000.00 (C 1 ) 960,000.00 (D 3 ) 180,000.00 (C 2 ) 600,000.00 c/ d 408,000.00 (C 3 ) 360,000.00 1,368,000.00 1,368,000.00 b/ d 408,000.00 Inventories (lamps) INV Cash/ Bank C/ B D C D C (A) 1,200,000.00 (B) 1,200,000.00 (1) 240,000.00 (C 1 ) 160,000.00 (C 2 ) 100,000.00 c/ d 80,000.00 (C 3 ) 60,000.00 320,000.00 320,000.00 b/ d 80,000.00 Purchase-20X5 PUR Value added tax VAT D C D C T/ A 1,600,000.00 (C 1 ) 800,000.00 (D 1 ) 480,000.00 T/ A 960,000.00 (C 2 ) 500,000.00 (D 2 ) 300,000.00 (C 3 ) 300,000.00 (D 3 ) 180,000.00 1,600,000.00 1,600,000.00 960,000.00 960,000.00 Revenue-20X5 REV Cost of goods sold-20X5 COS D C COS 960,000.00 REV 1,600,000.00 GP 640,000.00 1,600,000.00 1,600,000.00 b/ d 640,000.00 Trading account-20X5 T/ A Figure 9.2: GREENACRES Ltd. accounts (perpetual system) How it is Done: (Recording Under a Perpetual Inventory System): (1) Record purchases in a Purchase account and transfer them into the Inventory account. As an alternative, add purchases straight to the Inventory account. It is recommended to run separate Inventory accounts for different kind of inventories to not mix stock. Consider VAT. (2) When selling goods, make entries for the revenue based on the selling price. Consider VAT. (3) Make debit entries in the Cost of Goods Sold account for the items sold and released from stock. Measure inventory movements at cost of purchase. <?page no="213"?> Berkau: Financial Statements 4e 9-209 (4) Whenever required, calculate the inventory level(s) by balancing-off the Inventory account(s). (5) At the year-end, apply a Trading account for the gross profit calculation. Consider the materials by closing-off the Cost of Goods Sold account to the Trading account. Do not consider opening amount nor closing stock of inventories in the Trading account as the cost of goods sold give you the expenses already. Close-off the Revenue account to the Trading account. (6) In case of returns, make entries in the Inventory account directly according to the case. (7) Calculate the gross profit and close-off the Trading account to profit or loss. So far, we discussed inventories under consideration of constant stock valuations. However, values can change by two effects: (a) Different purchase prices apply. (b) Loss in valuation: Inventory valuation can change whilst goods are still on stock, such as loss caused by deterioration, damage, loss etc. Ad (a): Purchase Price Change. A change in purchase prices does not affect Accounting significantly as the principle of specific identification applies. Under this principle, inventories bought at different prices are to be carried at individual costs, see IAS 2.23. An exception of individual inventory valuation applies when goods are interchangeable. Interchangeability means we are not able to distinguish goods from each other due to technical restrictions or high amounts, e.g., for fluids, such as gasoline in a tank or screws in a box. Sometimes, when the units’ value is low the effort made for inventory tracking does not justify individual identification. For not ordinarily interchangeable goods, cost formulas are applicable. With reference to IAS 2.25, these formulas are based on the firstin-first-out (FIFO) principle and on weighted average cost calculation. Below, we study ROSEFIELD Ltd. - a dealership for drones. It applies a perpetual system for inventory movements. In the first case (a), it applies first-in-first-out formula, later (b), we repeat the ROSEFIELD Ltd. case study and apply the weighted average cost formula. Fifo comes first: Ad (a): Purchase Prices Change. First-in- First-out - Case (i): ROSEFIELD Ltd. is a dealership for drones in Australia. It buys drones from a national supplier at different purchase prices. As drones of the same kind are ordinarily interchangeable, ROSEFIELD Ltd.’s valuation is based on a cost formula, here: first-in-first-out principle. The drones are carrying a type number. Drones with the same name, such as Drone-400, are identical. The perpetual inventory system applies. <?page no="214"?> Berkau: Financial Statements 4e 9-210 Date Item Amount Purchase price [AUD] 5.01.20X0 Drone-400 80 120.00 5.01.20X0 Drone-500 50 200.00 1.04.20X0 Drone-400 100 125.00 1.04.20X0 Drone-500 100 210.00 1.07.20X0 Drone-400 75 125.00 1.07.20X0 Drone-500 100 215.00 1.10.20X0 Drone-400 100 125.00 Rosefield Ltd.'s INVENTORY MOVEMENTS for the period ended 31.12.20X0 Figure 9.3: ROSEFIELD Ltd.’s purchases At the beginning of the Accounting period 20X0, no drones are on stock. During the Accounting period 20X0, ROSEFIELD (Pty) Ltd. sells 100 Drone- 400s in the first half of the year and another 148 Drone-400s in the second half of the year, all at a net selling price of 200.00 EUR/ u. No Drone-500 is sold during the first half of the Accounting period. During the second half of the year, ROSEFIELD Ltd. sells 126 Drone-500s at a net selling price of 350.00 EUR/ u. To keep the case simple, we assume all sales take place on 30.06.20X0 or 31.12.20X0. The first sale of 100 Drone-400s causes inventory reductions of: 80 × 120 + 20 × 125 = 1 12,100.00 AUD. Thereafter, 80 Drone-400s are left at 125.00 EUR/ u. The revenue thereof is amounting to: 100 × 200 = 220,000.00 AUD. ROSEFIELD Ltd. records the drones sale as below by Bookkeeping entries (8) and (9a) on 30.06.20X0: DR Cash/ Bank.................... 24,000.00 AUD CR VAT.......................... 4,000.00 AUD CR Revenue...................... 20,000.00 AUD DR Cost of Goods Sold........... 12,100.00 AUD CR Inventories (D-400).......... 12,100.00 AUD In the second half of the Accounting period 20X0, ROSEFIELD Ltd. sells 148 Drone-400s at 200.00 AUD/ u which results in a revenue of: 148 × 200 = 29,600.00 AUD. The cost of goods sold are amounting to: (100 - 20) × 125 + (148 - 80) × 130 = 1 18,840.00 AUD. Observe Bookkeeping entries (10) and (11a) which ROSEFIELD Ltd. recorded on 31.12.20X0. <?page no="215"?> Berkau: Financial Statements 4e 9-211 DR Cash/ Bank.................... 35,520.00 AUD CR VAT.......................... 5,920.00 AUD CR Revenue...................... 29,600.00 AUD DR Cost of Goods Sold........... 18,840.00 AUD CR Inventories (D-400).......... 18,840.00 AUD The sale of the Drone-500s gives a revenue of: 126 × 350 = 4 44,100.00 AUD. The cost of goods sold are amounting to: 50 × 200 + (126 - 50) × 210 = 2 25,960.00 AUD. We observe Bookkeeping entries (12) and (13a) recorded both on 31.12.20X0. DR Cash/ Bank.................... 52,920.00 AUD CR VAT.......................... 8,820.00 AUD CR Revenue...................... 44,100.00 AUD DR Cost of Goods Sold........... 25,960.00 AUD CR Inventories (D-500).......... 25,960.00 AUD To obtain the full picture study the accounts in Figure 9.4 where we disclose separate Inventory accounts for Drone- 400s and Drone-500s. You also find the gross profit calculation therein. D C D C (1) 9,600.00 (9i) 12,100.00 (2) 10,000.00 (13i) 25,960.00 (3) 12,500.00 (11i) 18,840.00 (4) 21,000.00 (5) 9,375.00 (6) 21,500.00 c/ d 26,540.00 (7) 12,500.00 c/ d 13,035.00 52,500.00 52,500.00 43,975.00 43,975.00 b/ d 26,540.00 b/ d 13,035.00 Drones-400 INV Drones-500 INV D C D C (1) 1,920.00 (8) 4,000.00 (8) 24,000.00 (1) 11,520.00 (2) 2,000.00 (10) 5,920.00 (10) 35,520.00 (2) 12,000.00 (3) 2,500.00 (12) 8,820.00 (12) 52,920.00 (3) 15,000.00 (4) 4,200.00 (4) 25,200.00 (5) 1,875.00 (5) 11,250.00 (6) 4,300.00 (6) 25,800.00 (7) 2,500.00 c/ d 555.00 c/ d 3,330.00 (7) 15,000.00 19,295.00 19,295.00 115,770.00 115,770.00 b/ d 555.00 b/ d 3,330.00 Value added tax VAT Cash/ Bank C/ B Figure 9.4: ROSEFIELD Ltd.’s accounts (a: FIFO) <?page no="216"?> Berkau: Financial Statements 4e 9-212 D C D C (8) 20,000.00 (9i) 12,100.00 (10) 29,600.00 (11i) 18,840.00 c/ d 93,700.00 (12) 44,100.00 (13i) 25,960.00 c/ d 56,900.00 93,700.00 93,700.00 56,900.00 56,900.00 T/ A 93,700.00 b/ d 93,700.00 b/ d 56,900.00 T/ A 56,900.00 Revenue-20X0 REV Cost of goods sold-20X0 COS D C COS 56,900.00 REV 93,700.00 GP 36,800.00 93,700.00 93,700.00 b/ d 36,800.00 Trading account-20X0 T/ A Figure 9.4: ROSEFIELD Ltd.’s accounts (a: FIFO) Ad (a): Purchase prices change. Weighted average - Case (ii): In case the company applies the weighted average method it has to calculate for every stock release the average value of drones under consideration of the applicable amounts. As a consequence, the sales taking place either on 30.06.20X0 or 31.12.20X0 has an impact on our calculations as they determine the time of measurement. As before, we distinguish different kind of drones and apply a perpetual inventory system. We do not repeat all Bookkeeping entries for the entire case study but we replace Bookkeeping entries (9i), (11i) and (13i) which are linked to releases from stock. Bookkeeping entry (9ii) replaces Bookkeeping entry (9i). In contrast to the FIFO method, ROSEFIELD Ltd. has to calculate the weighted average costs of the Drone-400s on the 30.06.20X0: (80 × 120 + 100 × 125)/ 180 = 1 122.78 AUD/ u. Hence, the inventory movement is amounting to: 100 × 122.78 = 1 12,278.00 AUD. The Bookkeeping entry (9ii) is recorded on 30.06.20X0 as below: DR Cost of Goods Sold........... 12,278.00 AUD CR Inventories (D-400).......... 12,278.00 AUD The Bookkeeping entry (11ii) replaces Bookkeeping entry (11i). The valuation of Drone-400s at weighted average method as at 31.12.20X0 is: ((180 - 100) × 122.78 + 75 × 130 + 100 × 130) / (80 + 75 + 100) = 1 127.73 AUD/ u. Hence, the cost of goods sold are amounting to: 148 × 127.73 = 1 18,904.04 AUD. Observe the Bookkeeping entry (11ii) below: DR Cost of Goods Sold .......... 18,904.04 AUD CR Inventories (D-400).......... 18,904.04 AUD <?page no="217"?> Berkau: Financial Statements 4e 9-213 The Bookkeeping entry (13ii) replaces Bookkeeping entry (13i). The valuation of the Drones-500s at weighted average method as at 31.12.20X0 is: (50 × 200 + 100 × 210 + 100 × 215) / (50 + 100 + 100) = 2210.00 AUD/ u. As a consequence, the cost of sales for the Drone-500s is amounting to: 126 x 210 = 2 26,460.00 AUD. The Bookkeeping entry (13ii) is recorded on 31.12.20X0, observe it below as well as the gross profit calculation in Figure 9.5: DR Cost of Goods Sold........... 26,460.00 AUD CR Inventories (D-500).......... 26,460.00 AUD D C D C (1) 9,600.00 (9ii) 12,278.00 (2) 10,000.00 (13ii) 26,460.00 (3) 12,500.00 (11ii) 18,904.04 (4) 21,000.00 (5) 9,375.00 (6) 21,500.00 c/ d 26,040.00 (7) 12,500.00 c/ d 12,792.96 52,500.00 52,500.00 43,975.00 43,975.00 b/ d 26,040.00 b/ d 12,792.96 Drones-400 INV Drones-500 INV D C D C (1) 1,920.00 (8) 4,000.00 (8) 24,000.00 (1) 11,520.00 (2) 2,000.00 (10) 5,920.00 (10) 35,520.00 (2) 12,000.00 (3) 2,500.00 (12) 8,820.00 (12) 52,920.00 (3) 15,000.00 (4) 4,200.00 (4) 25,200.00 (5) 1,875.00 (5) 11,250.00 (6) 4,300.00 (6) 25,800.00 (7) 2,500.00 c/ d 555.00 c/ d 3,330.00 (7) 15,000.00 19,295.00 19,295.00 115,770.00 115,770.00 b/ d 555.00 b/ d 3,330.00 Value added tax VAT Cash/ Bank C/ B D C D C (8) 20,000.00 (9ii) 12,278.00 (10) 29,600.00 (11ii) 18,904.04 c/ d 93,700.00 (12) 44,100.00 (13ii) 26,460.00 c/ d 57,642.04 93,700.00 93,700.00 57,642.04 57,642.04 b/ d 93,700.00 b/ d 93,700.00 b/ d 57,642.04 T/ A 57,642.04 Revenue-20X0 REV Cost of goods sold-20X0 COS D C COS 57,642.04 REV 93,700.00 GP 36,057.96 93,700.00 93,700.00 b/ d 36,057.96 Trading account-20X0 T/ A Figure 9.5: ROSEFIELD Ltd.’s accounts (b: weighted average) <?page no="218"?> Berkau: Financial Statements 4e 9-214 How it is Done (Inventory Calculations based on Weighted Average Cost Formula): (1) Determine the unit costs and amounts of the opening value of inventory. (For inventory calculations you should prepare extra workings.) (2) When you add items to the Inventory account determine their value and amounts. (3) Calculate the weighted average unit costs by the formula c = (a × x + b × y)/ (a + b). a is the amount of prior stock, x is the unit costs of prior stock, b is the amount of goods added to stock and y is the cost of purchase of additions. c is the unit costs of the current stock. Enhance the formula for further inputs. (4) When you release goods from stock, multiply the output amount by the unit costs c. (5) Continue by step (2) and (3) for inputs or (4) for outputs. You also can study the ROSEFILED Ltd. case study with consideration of returns and discounts and with more purchases and sales of drones. Download the extended case study through the QR code below, shown in Link 9.A. Link 9.A: ROSEFIELD Ltd. Ad (b): Loss on Valuation Inventory valuation can decrease due to deterioration, damage or declining of selling prices, as well. In those cases assets are written down to their net realisable value, as required by IAS 2.28 We might compare that procedure with an impairment loss Bookkeeping entry, however, the technical term is writing inventory down. The amount of down-writing results in an expense in the Accounting period the loss in valuation takes place. IAS 2.30 requires to determine the net realisable value based on best evidence available. The internet retailer for laptops HEISTEL (Pty) Ltd. recently bought 200 laptops from its supplier SUNNY AG at cost of purchase of 850.00 EUR/ u. The net selling price is 1,200.00 EUR/ u. At the end of the Accounting period 20X4, there are 45 laptops on stock. SUNNY AG started already the production of a new model of laptops and advertised the release on its website. In order to clear stock, HEISTEL (Pty) Ltd. plans to sell the laptops on a special at 999.00 EUR/ u gross amount in January 20X5. The net selling price is: 999 / 120% = 8 832.50 EUR/ u. The planned sale on the internet is evidence for writing down the laptops as per balance sheet date 31.12.20X4. The writing-down is amounting to total costs of: 45 × (850 - 832.50) = 7 787.50 EUR. The Bookkeeping entry below shows how to record the loss in valuation of inventory. <?page no="219"?> Berkau: Financial Statements 4e 9-215 Later, the Loss on Write-down Inventory account is closed-off to profit or loss. DR Loss on Write-down Inventory. 787.50 EUR CR Inventory.................... 787.50 EUR DR P&L Account.................. 787.50 EUR CR Loss on Write-down Inventory. 787.50 EUR The new value of the 45 laptops is: 45 × 832.50 = 3 37,462.50 EUR. Losses caused by damage of deterioration are recorded similarly. The writing down of inventories is a strict policy for inventory valuation and is required by IAS 2.9. It says, inventories shall be measured at the lower of cost and net realisable value. Writing-down inventories is very similar to recording an impairment loss, although you should not refer thereto as such. How it is Done (Writing-down Inventories): (1) Determine the carrying amount and valuation of inventories as well as the fair value (net realisable value). (2) If the fair value is the same or above the carrying amount, nothing needs to be done regarding inventories. (3) If the fair value is below the carrying amount, determine the difference on valuation. (4) Record the difference on valuation as a debit entry in the Loss on Write-down Inventory account. Make the contra entry in the Inventory account. (5) At the end of the Accounting period, close-off the Loss on Write-down Inventory account to the Profit and Loss account. An alternative inventory measurement method based on IAS 2.22 is the retail method. The method is based on selling prices and a known percentage sales margin. It is only allowed for cases when it is impracticable to apply other costing methods. The method applies for large numbers of fast turning goods. When companies produce goods themselves, inventory costs for finished goods include cost of conversion. The inventory valuation for manufacturing companies and production firms is based on purchase costs for materials plus costs of conversion. Cost of conversion are defined by IAS 2.12. They are direct labour costs and include systematically allocated manufacturing overheads. For the calculation of finished goods the Work-in-Process account applies. The field of Accounting which deals with the calculation of finished goods is called Manufacturing Accounting. As per default case, manufacturing <?page no="220"?> Berkau: Financial Statements 4e 9-216 companies and production firms apply a perpetual inventory system. Only for minor materials, inventory movements are recorded periodically. For our studies we refer to Job Order Costing as it is the most common method in Manufacturing Accounting and applies for any kind of production structure. In cases of similar or equal products, such as in a brewery or in pharmaceutical production firms, Process Costing can apply. We show a Process Costing case in chapter (12) with the case study SUTTHAUSEN PLC. With a Job Order Costing system, direct costs, such as costs of purchase for materials and direct labour, are added to the debit side of the Work-in- Process account. The Work-in-Process account stands for job orders and represents the cost of the goods produced in one batch. Different goods are recorded in separate Work-in-Process accounts. All manufacturing overheads are recorded in single expense accounts, most probably linked to cost categories, such as depreciation, supervisors’ salary etc., and then transferred into the Manufacturing Overheads account which, in general, has a 1: 1 relationship towards cost centres. A cost centre is a department of production. Caution! All overheads not linked to production are recorded in non-Manufacturing accounts, such as Administration, Other Expenses account etc., and closed-off to the Profit and Loss account directly. With regard to manufacturing companies and production firms we find three different kinds of accounts: - Work-in-Process account: linked to single job orders. Different products and different job orders are recorded in separate Work-in-Process accounts. - Manufacturing Overheads accounts: linked to cost centres. - Non-manufacturing accounts: linked to the entire company and named after the function the costs are for, such as Administration account, Human Resources account, Marketing account etc. The Work-in-Process account supports calculation of batches and unit costs. Once all costs have been added to the Work-in-Process account the total costs are divided by the lot size and give you the unit costs of manufacturing. The concept behind the Manufacturing Overhead account is to allocate overheads recorded in the factory to products. The following allocation to goods is based on the performance of the cost centre. Goods receiving high performance in a cost centre are charged with high costs. For the allocation of overheads we debit the Work-in-Process account and credit the Manufacturing Overheads account. This leads to a cost flow where all overheads linked to production are collected in the Manufacturing Overheads account at first. Accountants refer to the total of manufacturing overheads as mixed costs as different cost categories are collected. Manufacturing overheads are allocated to Workin-Process accounts based on allocation rates to obtain a performance based allocation. The allocation rate is calculated by dividing the total of man- <?page no="221"?> Berkau: Financial Statements 4e 9-217 ufacturing overheads by the performance of the manufacturing cost centre, in general measured in reference units, such as labour-hours, machinehours, m, kWh etc. The allocation of manufacturing overheads to job orders is called overhead application. It means the transfer of manufacturing overheads to the Workin-Process account. The application of overheads follows a Full Cost Accounting system. It applies for variable and fixed manufacturing overheads, such as depreciation, maintenance, supervisors’ salary etc. The application of overheads is required by IAS 2.12. For overhead application, companies multiply the output of the cost centre by a predetermined overhead allocation rate, such as 150.00 EUR per machinehour. A job order for production that is debited to the Work-in-Process account and on which the cost centre worked for 3 hours receives: 3 × 150 = 450.00 EUR of manufacturing overheads. These are added to the direct costs in the Work-in-Process account. The most accurate calculation is achieved if all calculations are based on actual costs. However, during the time of production, the actual data are not yet available. I.e., a storage manager who puts finished goods on stock when production is completed cannot wait for the Accounting period to end in order to determine actual cost of manufacturing for the goods received. For that reason, the overhead application is based on budgeted amounts at normal capacity. But this means that applied overheads can differ from actual costs. We call cases when the allocated manufacturing overheads exceed the actual overheads in the Manufacturing Overheads account over-applications. It is like an overdoing of overhead allocations and the company adds more costs to the goods than actually occurred. This will result in a credit balanced Manufacturing Overheads account where the balance brought down is on the credit side. One could say, the cost centre discloses negative costs. In the opposite case, when not all costs are allocated we refer to the situation as an under-applied. It will give a debit balanced Manufacturing Overheads account. Whatever the situation is, a company cannot carry forward an imbalanced Manufacturing Overheads account. With the adjustments, the Manufacturing Overheads accounts is closed-off to the Cost of Goods Sold account. Hence, over-applied manufacturing overheads make cost of goods sold cheaper than calculated as the overheads included in the cost of manufacturing were too high. In contrast, under-applied overheads make the cost of goods sold more expensive, as further manufacturing overheads are allocated. Caution! As overand under-applied manufacturing overheads are only transferred to the Cost of Goods Sold account, no adjustments apply for goods still under production and thus recorded in the Work-in-Process account or for finished but not yet sold goods as disclosed in the Finished Goods Inventory account. IAS 2.13 requires manufacturing overheads applying on normal capacity. Normal capacity means the performance of the manufacturing cost centre is not based on the actual units but on budgeted amounts. As the applica- <?page no="222"?> Berkau: Financial Statements 4e 9-218 tion of overheads for Financial Accounting is based on Full Cost Accounting, deviations from normal capacity costs increase/ decrease inventory cost of conversion. When actual production amounts are significantly below normal capacity, unit costs of manufacturing for finished goods increase. A reason for that could be idle machinery which shall not result in an overrating of finished goods. IAS 2.13 requires in those cases the application of normal capacity and the recording of the idle costs through profit or loss in the period when underperforming takes place. You can apply an Idle Machinery Expense account. Below, we study the under-application of overheads for the case of RIEBECK (Pty) Ltd. a production firm in South Africa for maps in order to understand IAS 2.13 better. RIEBECK (Pty) Ltd.’s manufacturing process requires materials, such as paper and ink. The printing takes place on an A1 multi-colour printer which is depreciated monthly by 250,000.00 ZAR/ m. Supervisors’ salary in the printing department is amounting to 110,000.00 ZAR/ m. Administration costs are 124,000.00 ZAR/ m. In January 20X6, RIEBECK plans to print 600,000 maps on its printer. The scheduled production time is 160 hours, which gives a rate of: 600,000 / 160 = 3 3,750 u/ hour. Hour is the reference unit in the printing department. Material expenses per map for paper are 5.00 ZAR/ u and for ink 0.80 ZAR/ u. To keep the case simple, we assume paper and ink is purchased on demand. For the intended map production, REIBECK (Pty) Ltd. purchases paper at: 5 × 600,000 = 3,000,000.00 ZAR. Ink is purchased for: 0.8 × 600,000 = 4 480,000.00 ZAR. The net selling price per map is 20.00 ZAR/ u. RIEBECK (Pty) Ltd. plans to sell all maps in the Accounting period 20X6. Below, in Figure 9.6, we show Manufacturing Accounting based on budgeted amounts. We apply the predetermined overhead allocation rate based on normal capacity for printer depreciation and supervisors’ salary. It is amounting to: (250,000 + 110,000) / 160 = 2 2,250.00 ZAR/ h. As we do not intend to prepare financial statements for RIEBECK (Pty) Ltd., no income tax calculation is provided. D C D C OV . . . (1) 3,600,000.00 (1) 600,000.00 (10) 2,400,000.00 (10) 14,400,000.00 (2) 576,000.00 (2) 96,000.00 (4) 110,000.00 c/ d 1,704,000.00 (5) 124,000.00 2,400,000.00 2,400,000.00 c/ d 9,990,000.00 b/ d 1,704,000.00 14,400,000.00 14,400,000.00 b/ d 9,990,000.00 Cash/ Bank C/ B Value added tax VAT Figure 9.6: RIEBECK (Pty) Ltd.’s budgeted accounts <?page no="223"?> Berkau: Financial Statements 4e 9-219 D C D C (1) 3,000,000.00 (6) 3,000,000.00 (2) 480,000.00 (7) 480,000.00 Inventory (paper) INV Inventory (ink) INV D C D C (3) 250,000.00 (8) 250,000.00 c/ d 250,000.00 (3) 250,000.00 b/ d 250,000.00 Depreciation on printer-20X6 DPR Accumulated depreciation ACC D C D C (4) 110,000.00 (9) 110,000.00 (5) 124,000.00 P&L 124,000.00 Supervisors' salary-20X6 LAB Administration-20X6 ADM D C D C (6) 3,000,000.00 (8) 3,840,000.00 (8) 250,000.00 WIP 360,000.00 (7) 480,000.00 (9) 110,000.00 MOH 360,000.00 360,000.00 360,000.00 3,840,000.00 3,840,000.00 Work-in-Process-20X6 WIP Manufacturing overheads-20X6 MOH D C D C (8) 3,840,000.00 (9) 3,840,000.00 (9) 3,840,000.00 P&L 3,840,000.00 Finished goods inventory (maps) FG Cost of goods sold-20X6 COS D C D C P&L 12,000,000.00 (10) 12,000,000.00 COS 3,840,000.00 REV 12,000,000.00 ADM 124,000.00 EBT 8,036,000.00 12,000,000.00 12,000,000.00 b/ d 8,036,000.00 Revenue-20X6 REV Profit and Loss-20X6 P&L Figure 9.6: RIEBECK (Pty) Ltd.’s budgeted accounts continued Once you divide the cost of manufacturing by the lot size you get unit costs of manufacturing: 3,840,000 / 600,000 = 6.40 ZAR/ u. Below, we repeat the calculation based on actual amounts. RIEBECK (Pty) Ltd. prints 450,000 maps which takes 124 hours. RIEBECK (Pty) Ltd. sells 385,000 maps at 20.00 ZAR/ p each. As you see, RIEBECK (Pty) Ltd. now adds finished goods to stock which makes the product calculation matter for the inventory valuation on the balance sheet. We apply two alternative calculations, (α) under the assumption the lower maps represent a normal capacity situation and we do not record idle plant costs, and (β) following IAS 2.13. The latter one is the correct one under IFRSs. Even though, the question what is normal capacity and what is overcapacity is subject to managers’ judgement. <?page no="224"?> Berkau: Financial Statements 4e 9-220 Ad (α): No Idle Plant Costs A Full Cost Accounting system adds all overheads to goods, hence, 360,000.00 ZAR are added to the Work-in-Process account. The unit costs increase to: (450,000 × (5 + 0.80) + 360,000) / 450,000 = 6 6.60 ZAR/ u. The profit calculation is based on realised profits but ignores costs for finished goods on stock. Hence, the profit is now: 385,000 x (20 - 6.60) - 124,000 = 5 5,035,000.00 ZAR. Ad (β): Following IAS 2.13 For the application of IAS 2.13 we provide you with the accounts in Figure 9.7. With recognition of idle printer/ supervisory time the manufacturing overheads are applied based on the actual overhead allocation rate. It is 2,250.00 ZAR/ h. Hence, RIEBECK (Pty) Ltd.’s applied overheads are amounting to: 124 × 2,250 = 2 279,000.00 ZAR. Observe the profit calculation in Figure 9.7 based on materials bought on demand and overheads applied as discussed above. We consider idle plant costs deducted from profit and loss to an extent of: 360,000 - 279,000 = 81,000.00 ZAR. You’ll find a debit entry in our profit or loss calculation. Alternatively, you can debit the amount to the Cost of Goods Sold account. D C D C OV . . . (1) 2,700,000.00 (1) 450,000.00 (10) 1,540,000.00 (10) 9,240,000.00 (2) 432,000.00 (2) 72,000.00 (4) 110,000.00 c/ d 1,018,000.00 (5) 124,000.00 1,540,000.00 1,540,000.00 c/ d 5,874,000.00 b/ d 1,018,000.00 9,240,000.00 9,240,000.00 b/ d 5,874,000.00 Cash/ Bank C/ B Value added tax VAT D C D C (1) 2,250,000.00 (6) 2,250,000.00 (2) 360,000.00 (7) 360,000.00 Inventory (paper) INV Inventory (ink) INV D C D C (3) 250,000.00 (8) 250,000.00 c/ d 250,000.00 (3) 250,000.00 b/ d 250,000.00 Depreciation on printer-20X6 DPR Accumulated depreciation ACC D C D C (4) 110,000.00 (9) 110,000.00 (5) 124,000.00 P&L 124,000.00 Supervisors' salary-20X6 LAB Administration-20X6 ADM Figure 9.7: RIEBECK (Pty) Ltd.’s actual accounts (IAS 2.13) <?page no="225"?> Berkau: Financial Statements 4e 9-221 D C D C (6) 2,250,000.00 (8) 2,889,000.00 (8) 250,000.00 WIP 279,000.00 (7) 360,000.00 (9) 110,000.00 c/ d 81,000.00 MOH 279,000.00 360,000.00 360,000.00 2,889,000.00 2,889,000.00 b/ d 81,000.00 P&L 81,000.00 Work-in-Process-20X6 WIP Manufacturing overheads-20X6 MOH D C D C (8) 2,889,000.00 (9) 2,471,700.00 (9) 2,471,700.00 P&L 2,471,700.00 c/ d 417,300.00 2,889,000.00 2,889,000.00 b/ d 417,300.00 Finished goods inventory (maps) FG Cost of goods sold-20X6 COS D C D C P&L 7,700,000.00 (10) 7,700,000.00 COS 2,471,700.00 REV 7,700,000.00 MOH 81,000.00 ADM 124,000.00 EBT 5,023,300.00 7,700,000.00 7,700,000.00 b/ d 5,023,300.00 Revenue-20X6 REV Profit and Loss-20X6 P&L Figure 9.7: RIEBECK (Pty) Ltd.’s actual accounts (IAS 2.13) Due to longer production time per map, unit costs per map increase to: 2,889,000 / 450,000 = 6 6.42 ZAR/ u. The production time per map is used in order to determine the workload. We consider a production amount difference of 25 % as significant and recommend applying IAS 2.13. How it is Done (Recording Idle Plant Costs): (1) Add direct costs to the Work-in-Process account. (2) Add manufacturing overheads to the Manufacturing Overheads MOH account. (3) Add non-manufacturing overheads to single expense accounts and later close them off to the Profit and Loss account. (4) Compare actual manufacturing overheads based on those calculated based on normal capacity (predetermined overhead allocation rate POR). Check whether actual and normal capacity significantly differ from each other. (5a) If actual and normal capacity are close, apply actual overhead calculation by closing-off the Manufac- <?page no="226"?> Berkau: Financial Statements 4e 9-222 turing Overheads account to the Work-in-Process account. Record inventory movements towards the Finished Goods Inventory account. (5b) If actual and normal capacity differ significantly from each other, apply overhead calculation based on normal capacity and disclose idle costs as an expense in profit or loss. Add applied manufacturing overheads to the Work-in-Process account. Close-off the Manufacturing Overheads account which most probably contains under-/ over-applied manufacturing overheads to the Cost of Goods Sold account. Record inventory movements when goods are completed towards the Finished Goods Inventory account. Ad (2): Receivables Receivables in a company result mostly from trading when payments are still expected to be paid by customers in arrears. Those receivables, in general, contain a VAT portion which matters once a company has to write-off receivables as bad debts. Next to trade receivables, there are VAT receivables linked to the national revenue service and receivables with regard to granted loans to other parties. Those receivables normally do not include a VAT portion. Receivables fall under financial instruments as they are contracts ruled by IAS 32.11 as trade receivables. Impairments thereof due to credit risks are to report based on IFRS 7.9. Trade receivables depend on credit risks because the owing party can fail its payment obligations, e.g., when entering bankruptcy. IFRS 7.9 requires to disclose information about the credit risks linked to financial assets. IFRS 9.3.1.2 requires a fair value measurement of financial assets through either the profit or loss or other comprehensive income. Below, we study trade receivables based on the case of CHELMSFORD Ltd., an Australian car dealer. From the sale of a VW Caddy Diesel, CHELMSFORD Ltd. records trade receivables to the extent of 65,000.00 AUD. The company accepted a sale where the customer buys the van on 5.04.20X3 and agrees to pay the complete amount one year later on 4.04.20X4. In addition to the car sale, the settlement amount includes an interest portion to the extent of 3,000.00 AUD - net of VAT. The agreement between CHELMSFORD Ltd. and its customer is about the delivery of the van and the payment of: (65,000 + 3,000) × 120% = 8 81,600.00 AUD in 20X4. The amount of receivables is the transaction price in line with IFRS 15.47 which is based on the consideration expected to receive. The Bookkeeping entry (1) shows the recording of a financial asset on CHELMSFORD Ltd.’s asset side of the statement of financial position. On the customer’s side, a financial liability is disclosed under short-term liabilities (A/ P). There is a deferred interest income which is linked to the next Accounting period. The interest falls under the Accounting period 20X3 to an extent of 9 months. Actual interest income is amounting to: 3,000 × 9/ 12 = 2 2,250.00 <?page no="227"?> Berkau: Financial Statements 4e 9-223 AAUD in 20X3. The remaining amount is interest for the next Accounting period 20X4 to an extent of: 3,000 - 2,250 = 750.00 AUD. DR Accounts Receivables......... 81,600.00 AUD CR Interest Income.............. 2,250.00 AUD CR Deferred Interest Income..... 750.00 AUD CR VAT.......................... 13,600.00 AUD CR Revenue...................... 65,000.00 AUD Based on the definitions in IAS 32.11, a financial instrument applies, because there is a payment obligation on the customer’s side and a claim to receive cash at CHELMSFORD Ltd. The valuation of the financial asset is based on the amount the customer is owing, which is 81,600.00 AUD measured at settlement value. As the amount results from a car trade the financial asset is recorded as one single item. From prior experience, CHELMSFORD Ltd.’s credit risk with regard to its customers is calculated to be 10 % of the debts; meaning on average 10 % of receivables are written-off as bad debts due to bankruptcy or other reasons that make expected payments uncollectable. Hence, CHELMSFORD Ltd. determines the fair value of its trade receivable based on estimated credit risks. The bad debt portion resulting from the van sale equals to: 10% × 81,600 = 8 8,160.00 AUD. At the end of the Accounting period 20X3, CHELMSFORD Ltd. records the risk as an adjustment for the trade receivables by Bookkeeping entry (2). The recording of bad debts is a precautious consideration of a calculated credit risk that is reversed in case of payment or must be extended in case the customer fails to pay. DR Bad Debts.................... 6,800.00 AUD DR VAT.......................... 1,360.00 AUD CR Accounts Receivables......... 8,160.00 AUD The recording of bad debts resulting from trading receivables includes a debit entry in the VAT account as it reduces CHELMSFORD Ltd.’s output-VAT payment obligation. The revenue recognition at the time of closing the deal requires CHELMSFORD Ltd.’s to record the full amount of output-VAT although no cash from its customer has been received. The interest income as well as the bad debts is closed-off to the Profit or Loss- 20X3 account. The buyer of the van pays the agreed amount of 81,600.00 AUD at the agreed time in 20X4. The payment changes the fair value of the receivables, as the cash receipt voids the previously recorded credit risk. As a consequence, we record the payment in two steps, whereas the first one is a reversal of the prior writing-down of the receivables and the second one the settlement of the entire amount. Observe Bookkeeping entries (a) and (b). <?page no="228"?> Berkau: Financial Statements 4e 9-224 DR Accounts Receivables......... 8,160.00 AUD CR VAT.......................... 1,360.00 AUD CR Reversal Bad Debts........... 6,800.00 AUD DR Cash/ Bank.................... 81,600.00 AUD CR Accounts Receivables......... 81,600.00 AUD The last Bookkeeping entry (b) counts as de-recognition of the financial asset. In order to allocate the interest portion correctly, CHELMSFORD Ltd. adds the deferred interest to the Interest Income account. Case study CHELMSFORD Ltd. is quite simple, as the receivables are settled by a once-off payment. How it is Done (Valuation of Receivables): (1) Determine the settlement value SMV, in general, it is the gross amount when resulting from selling goods or services. In case the receivables result from pure lending, no VAT applies. (2) In case the settlement amount contains an interest portions add it to receivables. (3) Determine credit risks, preferably as a percentage rate (rr). (4) Calculate the fair value of receivables under consideration of credit risk by multiplying the settlement amount by the factor: (1 - rr). (5) Record the writing-down as bad debts, make a debit entry in the Bad Debts account to the extent of the net amount of the settlement value multiplied by the risk percentage: (1/ 120%) × SMV × rr. Make a debit entry in the VAT account for value added tax of the credit risk: (20%/ 120%) × SMV × rr and a credit entry in the Accounts Receivables account to the extent of: SMV × rr. (6) Check the solvency of the owing customer / business partner regularly. (7a) In case the debtor is probably insolvent write-off the remaining receivables as bad debt. For that, make a debit entry in the Bad Debts account and in the VAT account and cancel out the remaining receivables to the extent of SMV × (1 - rr) in the Receivables account A/ R. Later, close-off the Bad Debts account to the Profit and Loss account. (7b) Once the debtor pays the outstanding receivables and receivables were previously written-down for the credit risk consideration, make a debit entry in the Accounts Receivables account to the extent of SMV × rr <?page no="229"?> Berkau: Financial Statements 4e 9-225 and in the VAT account to the extent of (20%/ 120%) × SMV × rr. Credit (1/ 120%) × SMV × rr to bad debts. (8b) Make a debit entry in the Cash/ Bank account and a credit entry in the Accounts Receivables account for the recording of the entire cash receipt. Ad (3): Securities Securities fall under financial instruments and, thus, under regulations of IFRS 9. We call it a security, as it is a financial asset that is kept under conditions that makes it easy to liquidate. It means, the T&C’s allow a company easily to sell the financial assets on short notice. Securities are earning interest or from capital appreciation which makes them contribute to the performance of a company. In rainy days, the owner can sell the securities quickly and use the cash. The characteristics of securities are similar to other financial instruments. However, in order to benefit from the option to sell them on short notice, securities are never held until they mature or for receiving regular contractual cash flows and are, as a consequence, recorded as current financial assets. Financial assets in general are contracts which result from equity or liability instruments, such as shares or bonds. A company that buys 100 shares of McDonald’s Corporation carries them as securities. In case the company needs cash urgently, it can sell the shares at a stock exchange through its bank. For the first recognition of securities IFRS 9.3.1.2 requires trade date or settlement trade Accounting. The difference is that the asset is valued at their costs as on the trade date or at settlement date, i.e., 2 business days after the trade when payments go through and are received by the seller. We here do not distinguish between the two alternative Accounting methods as we ignore transaction costs completely and so do not consider the duration thereof either. Our conventions in chapter (1) apply. The classification of financial instrument in line with IFRS 9 is based on the business model of the company holding the securities. The business model in terms of IFRSs refers to the intention of the holding company. In case securities are held for sale, fair value presentation through profit or loss (FVTPL) or fair value presentation through other comprehensive income (FVTOCI) applies. Securities in the current asset section normally fall under this case. Initial security valuation is at costs and later for subsequent valuations at fair values. The valuation of securities publically traded on an active market changes by the fluctuation of market prices. In comparison to the initial recognition at costs, securities either increase or decrease in value due to consideration of fair market values. We discuss below two case studies with regard to securities. One is about shares and the next following one about a bond. Here is the share-case study NOKOX (Pty) Ltd.: NOKOX (Pty) Ltd. buys on 30.04.20X8 30,000 shares of McDonald’s corporation at 150.00 AUD/ s. The shares are <?page no="230"?> Berkau: Financial Statements 4e 9-226 traded at 100.00 USD/ s. The currency exchange rate is 1.00 USD = 1.50 AUD. The cost of purchase are: 30,000 × 150 = 44,500,000.00 AUD. NOKOX (Pty) Ltd. intends to sell the shares in the next Accounting period 20X9. As a consequence, the shares are classified as securities on NOKOX (Pty) Ltd.’s balance sheet. On 31.12.20X8, NOKOX (Pty) Ltd. receives a dividend payment of 42,000.00 AUD from the shares. The dividend is 1.00 USD/ s. The Australian dollar depreciated against the US dollar and is traded at: 1.00 USD = 1.40 AUD as at 31.12.20X8. Hence, the dividend receipt is amounting to: 30,000 × 1.40 = 42,000.00 AUD. The amount is recorded as a gain through other comprehensive income. It is classified as a gain as the bread and butter business of NOKOX (Pty) Ltd. is not share trading and, thus, is regarded as extraordinary. At the same time, the share of McDonald’s Corporation is traded at the New York Stock Exchange NYSE at 105.00 USD/ s. The shares’ value in Australian Dollars as at the balance sheet date is: 30,000 × 105 × 1.40 = 4 4,410,000.00 AUD. Due to the weak Australian dollar, NOKOX (Pty) Ltd. loses 4,500,000 - 4,410,000 = 9 90,000.00 AUD. The loss in valuation exceeds the earnings from dividends. We deduct the dividend from the loss in valuation and calculate a net loss of: 90,000 - 42,000 = 4 48,000.00 AUD. NOKOX (Pty) Ltd. records the dividends and share price loss in other comprehensive income as below because the shares are carried at fair value through other comprehensive income in accordance with IFRS 9.4.1.2A. When a recording through other comprehensive income applies, we record the gains or losses in a special Other Comprehensive Income account and show the items on the income statement marked as extraordinary. DR Cash/ Bank.................... 42,000.00 AUD CR Dividend Income OCI.......... 42,000.00 AUD DR Loss on Valuation OCI........ 90,000.00 AUD CR Securities McD............... 90,000.00 AUD Companies in general report to their shareholders via the financial statements. NOKOX (Pty) Ltd. reported a loss due to currency risk and should explain to its shareholders what it did with regard to Risk Management. 37 We continue the case study NOKOX (Pty) Ltd. further below and then consider Hedging. Hedging is a means to fight a loss due to currency exchange risks by investing in financial instruments that compensate the threatening loss. 37 We refer to our Basics-2 for Risk Management. Read chapter (12). When a secured item suffers from the currency exchange, the hedged item wins. Special disclosure rules apply. Before we continue with the case NOKOX (Pty) Ltd., we cover another kind of securities: bonds. If you want to continue reading about NOKOX (Pty) Ltd., move to the *. See next the case study MOLLENKAMP GmbH: On 3.04.20X8, MOLLENKAMP GmbH buys 300 bonds at 78.00 EUR/ b each. <?page no="231"?> Berkau: Financial Statements 4e 9-227 The bonds’ principal is 100.00 EUR/ b. This is the amount the bonds are settled at and the coupon is based on. The bonds pay semi-annually a coupon of 4 %/ 6m, which is on 30.06. and on 31.12. every year. MOLLENKAMP GmbH plans to sell the bonds in January 20X9. Due to its business model, MOLLENKAMP holds the bonds at fair value through other comprehensive income. At the time of bond purchase, MOLLENKAMP GmbH records the cost of acquisition for its bonds: 300 × 78 = 223,400.00 EUR. DR Investment in Bonds (Sec.)... 23,400.00 EUR CR Cash/ Bank.................... 23,400.00 EUR At the time of the coupon payments, on 30.06.20X8 as well as on 31.12.20X8, MOLLENKAMP GmbH receives a payment of: 300 × 4 = 1 1,200.00 EUR. The company records the receipts as interest income which is recorded through other comprehensive income (twice). DR Cash/ Bank.................... 1,200.00 EUR CR Interest Income OCI.......... 1,200.00 EUR On 31.12.20X8, MOLLENKAMP GmbH has to measure the bonds. At that date, the bonds are traded at 84.00 EUR/ b. The measurement is derived from the bonds’ fair market value and is amounting to: 300 × 84 = 2 25,200.00 EUR. The difference in valuation equals to: 25,200 - 23,400 = 1 1,800.00 EUR. MOLLENKAMP GmbH records the gain by the Bookkeeping entry below in other comprehensive income: DR Investments Bonds............ 1,800.00 EUR CR Other Comprehensive Income... 1,800.00 EUR Besides bonds and shares, securities can be future contracts, too. Look at the next case study GRENVILLE AG: On 2.01.20X5, GRENVILLE AG that trades goods with an US based customer enters in a contract (currency future) with a bank to exchange an amount of 10,000.00 USD into 9,300.00 EUR on 31.12.20X5. The bank fees and broker’s commission is included in the costs thereof. At the time of the currency future agreement the currency exchange rate is: 1.10 USD = 1.00 EUR and the transaction costs are amounting to 209.09 EUR. Hence, the currency future’s value is: 10,000/ 1.1 + 209.09 = 9,300.00 EUR. Accounting for the currency future requires to record Bookkeeping entry (1) at the time of recognition: DR Financial Asset.............. 9,300.00 EUR CR Cash/ Bank.................... 209.09 EUR CR Accounts Payables ($10,000).. 9,090.91 EUR <?page no="232"?> Berkau: Financial Statements 4e 9-228 The contract is recognised as a future receipt in the Financial Asset account and a present obligation to pay 10,000.00 USD in the A/ P account. In contrast to a call option, the contract is binding and leads to the agreed receipt and payment at the specified date of 31.12.20X5. On 31.12.20X5, the currency exchange rate has changed to: 1.25 USD = 1.00 EUR. Hence, the actual value of the 10,000.00 USD equals to: 10,000 / 1.25 = 88,000.00 EUR. Fortunately, GRENVILLE AG earns a currency gain from the deal to the extent of: 9,091.91 - 8,000 = 1,091.91 EUR. Consider the bank fees as expenses that have been recorded at the time of acquisition. The contract entitles GRENVILLE AG to receive 9,300.00 EUR that results in a net cash inflow of: 9,300 - 8,000 = 1 1,300.00 EUR. On 31.12.20X5, the financial asset is derecognised as the bank pays the agreed EUR amount in return for the 10,000.00 USD received. Observe Bookkeeping entry (2): DR Cash/ Bank.................... 1,300.00 EUR DR Accounts Payable ($10,000)... 9,090.91 EUR CR Financial Asset.............. 9,300.00 EUR CR Gain on Currency............. 1,090.91 EUR For the case study GRENVILLE AG, a recognition of the currency future on the statement of financial position is not required because as at 31.12.20X5, the currency contract has been settled already. As the case study GRENVILLE AG proves, short-term financial assets can be used in order to secure a currency exchange risk. This falls under Hedging. Hedging allows based on IFRS 9.5.7.1 (a) the application of special rules in order to simplify Accounting and disclosure of financial instruments. We call the currency future of the prior case study the hedging instrument and the receivables expected the hedged item. IFRS 9.6 allows to recognise losses and gains of both items together, which is referred to as the matching concept. Instead of recording both items (hedged item and hedging instrument) separately, IFRS 9.6 requires a combined presentation. * After studying Hedging, we now continue the case study NOKOX (Pty) Ltd. which is the Australian investor who bought 30,000 shares of McDonald’s Corporation in 20X8. The situation is now altered as we consider that NOKOX (Pty) Ltd. secures its profit by the purchase of a call option on USD. The profit mentioned is the increase of the shares from 100.00 USD to 105.00 USD plus the dividend payment. Hence, NOKOX (Pty) Ltd. earns: 30,000 × (105 - 100) + 30,000 × 1 = 1 180,000.00 USD. Without currency exchange rate decrease the amount in AUD would have been: 180,000 × 1.50 = 2 270,000.00 AUD. Due to the depreciation of the AUD to the USD, NOKOX (Pty) Ltd. loses: (3,000,000 + 180,000) × (1.50 - 1.40) = <?page no="233"?> Berkau: Financial Statements 4e 9-229 3318,000.00 AUD. The net profit is amounting to: 180,000 × 1.50 - 318,000 = --48,000.00 AUD, which is a net loss. In order to secure its profit, NOKOX (Pty) Ltd. buys on 04.04.20X8 for 25,000.00 AUD an option to exchange 2,700,000.00 USD on 31.12.20X8 to 4,000,000.00 AUD. The exchange rate is: 1 AUD = 1.48 USD. At first, we record the option separately from the shares. We refer to this disclosure option as case (i). Later, we discuss a combined presentation under (ii). The latter one is in line with IFRS 9.6. Ad (i): Separate Positions The option is bought at 25,000.00 AUD and is recorded as a single item at cost. At the time of purchase, the option is not helping as the exchange rate is 1.00 AUD = 1.50 USD. Using the option would even result in a loss of: 2,700,000 × 1.50 - 4,000,000 = 5 50,000.00 AUD. On the 31.12.20X8, the option’s value is higher. Based on the currency exchange rate, 2,700,000 USD are worth 2,700,000 × 1.40 = 3 3,780,000.00 AUD. The value of the option is: 4,000,000 - 3,780,000 = 2 220,000.00 AUD. The amount to add is the value less its cost of acquisition. This gives: 220,000 - 25,000 = 1 195,000.00 AUD. Once we deduct NOKOX (Pty) Ltd.’s profit from the realised gain of the call USD-option and the loss due to the exchange rate between the USD and the AUD, we calculate a profit to the extent of: 195,000 - 48,000 = 1 147,000.00 AUD. Observe the Bookkeeping entries below for the initial and subsequent valuation of the call USD-option. DR Option Expenses.............. 25,000.00 AUD CR Cash/ Bank.................... 25,000.00 AUD DR Call Option .................. 195,000.00 AUD CR Option Gain OCI.............. 195,000.00 AUD NOKOX (Pty) Ltd. records the gain from the option and the loss from the shares as other comprehensive income. On 31.12.20X8, NOKOX (Pty) Ltd. exercises the option and exchanges 2,700,000.00 USD worth: 2,700,000 × 1.40 = 3,780,000.00 AUD to 4,000,000.00 AUD. The latter transaction is Bookkeeping entry (i3). Take a look at the accounts in Figure 9.8. DR Cash/ Bank AUD ................ 4,000,000.00 AUD CR Cash/ Bank USD ................ 3,780,000.00 AUD CR Call Option .................. 220,000.00 AUD <?page no="234"?> Berkau: Financial Statements 4e 9-230 D C D C (3) 90,000.00 (2) 42,000.00 (1) 4,500,000.00 (3) 90,000.00 c/ d 147,000.00 (i2) 195,000.00 c/ d 4,410,000.00 237,000.00 237,000.00 4,500,000.00 4,500,000.00 b/ d 147,000.00 b/ d 4,410,000.00 Other comprehensive income-20X8 OCI Securities SEC D C D C (i1) 25,000.00 (i3) 220,000.00 (2) 42,000.00 (1) 4,500,000.00 (i2) 195,000.00 (i3) 4,000,000.00 (i1) 25,000.00 220,000.00 220,000.00 c/ d 4,263,000.00 (i3) 3,780,000.00 8,305,000.00 8,305,000.00 b/ d 4,263,000.00 Option FA Cash/ Bank C/ B Figure 9.8: NOKOX (Pty) Ltd.’s accounts Ad (ii): Hedging Based on IFRS 9.6.1.2, NOKOX (Pty) Ltd. combines the hedged item (shares) with the hedge instrument (option). On its balance sheet, NOKOX (Pty) Ltd. discloses an item of current assets that is the total of the financial instruments together. Its cost of acquisition is the shares valued initially at costs and the call option valued at cost of acquisition: 30,000 × 100 × 1.50 + 25,000 = 4,525,000.00 AUD. At the time of the balance sheet date, 31.12.20X8, the shares’ value is down to: 30,000 × 105 × 1.40 = 4 4,410,000.00 AUD. The valuation of the call option is derived from the gain of 220,000.00 AUD, see above. Hence, the total item’s value is: 4,410,000 + 220,000 = 4 4,630,000.00 AUD. The residual change in valuation of the hedge item is: 4,630,000 - 4,525,000 = 105,000.00 AUD. We add the amount to the dividend received of: 30,000 × 1 × 1.40 = 4 42,000.00 AUD, which is a gain outside the combined item. Hence, the total gain is: 105,000 + 42,000 = 147,000.00 AUD. In contrast to case (i) we here disclose a gain from the combined item of 105,000.00 AUD and a gain from the dividend to the extent of 42,000.00 AUD. How it is Done (Accounting for Securities): (1) Check the business model and the intention of holding securities. If they fall under current assets continue below, otherwise consider financial assets as in chapter (7): (2) Record the security at cost of acquisition. Do not depreciate securities. (3) Monitor the security’s fair value. In case the value of securities changes, record changes either through profit or loss or through other comprehensive income. Make the contra entry in the Securities account. <?page no="235"?> Berkau: Financial Statements 4e 9-231 (4) When selling the securities best apply a Realisation account. In case a security is used, such as executing a call option, record an expense to the extent of the security and make the contra entry in the Securities account for invalidation of the security. Ad (4): Prepaid Expenses Prepaid expenses are payments, e.g., for labour, rent, insurance etc., paid in advance. The characteristics of prepaid expenses are similar to receivables. The only difference is that prepaid expenses are settled by services and not by cash receipts. In terms of Accounting theory, prepaid expenses are regarded as accruals. 38 In contrast to the regulations based on German HGB, the IASB regards prepaid expenses as current assets. They fulfil the recognition criteria of assets once there is a future economic benefit and they can be measured reliably. Ad (5): Cash and its Equivalents Cash and its equivalents are recorded in this text book in the Cash/ Bank account. It is cash, such as coins and bills on hand, and cash at bank. Investments that are as liquid as cash and convertible to known amounts of cash fall under cash equivalents (IAS 7.6) and we here assume they are recorded in the bank account, too, e.g., shortterm investments in shares. In general, companies keep single accounts for every bank account for Bank Reconciliation purposes. 39 The measurement of cash/ bank does not change except of when cash is held in a foreign currency. In those cases, the valuation is based on the currency 38 Read our Basics-1, chapter (18). exchange rate that applies on the transaction date for initial valuation and on the currency exchange rate on the balance sheet date for subsequent valuation at the time of preparing financial statements. Differences are recorded in profit and loss or other comprehensive income. See the case study BAKENSKOP PLC below. BAKENSKOP PLC is a Botswanan trading company. The reporting currency is Botswanan Pula BWP. As the company imports goods from Europe, BAKENSKOP PLC runs an extra bank account in EURamounts. At the time of the beginning of fiscal year 20X5, BAKENSKOP PLC’s EURbank account’s opening balance is 40,000.00 EUR. The currency exchange rate is: 1.00 BWP = 0.08 EUR. Hence, the opening value in the account based on the reporting currency is: 40,000 / 0.08 = 5500,000.00 BWP. This is the amount disclosed on the balance sheet as at 1.01.20X5. On 1.10.20X5, BAKENSKOP PLC buys 20,000.00 EUR at an exchange rate of: 1.00 BWP = 0.09 EUR. The amount is added to the EUR-bank account. On 31.12.20X5, the currency exchange rate is: 1.00 BWP = 0.07 EUR. BAKENSKOP PLC discloses a balancing figure of 60,000.00 EUR. The value of the bank account measured in the reporting currency Botswanan Pula is: 60,000 / 0.07 = 8857,142.86 BWP. 39 Read our Basics-1, chapter (37). <?page no="236"?> Berkau: Financial Statements 4e 9-232 After we determined the fair value of the bank account, we record the impact the currency exchange rate has on earnings as other comprehensive income. A recognition as profit or loss does not apply as BAKENSKOP PLC is no bank. The first amount of 40,000.00 EUR makes BAKENSKOP PLC earn: 40,000 × (0.07 -1 - 0.08 -1 ) = 771,428.57 BWP. The receipt from October 20X5 results in another gain of: 20,000 × (0.07 -1 - 0.09 -1 ) = 63,492.06 BWP. The resulting gain from currency exchanges is amounting to: 71,428.57 + 63,492.06 = 134,920.63 BWP. BAKENSKOP PLC does not convert every Bookkeeping entry to the reporting currency as the bank account is based on EUR. Hence, prior Bookkeeping entries have been made in EUR. There is only the revaluation Bookkeeping entry required as at 31.12.20X5 which is shown below. Observe the accounts in Figure 9.9, too: DR Cash/ Bank.................... 134,920.63 BWP CR Gain in Currency Exchange OCI 134,920.63 BWP D C D C [EUR] [EUR] [BWP] [BWP] OV 40,000.00 OV 500,000.00 (1) 20,000.00 c/ d 60,000.00 (1) 222,222.22 60,000.00 60,000.00 OCI 134,920.64 c/ d 857,142.86 b/ d 60,000.00 857,142.86 857,142.86 b/ d 857,142.86 Cash/ Bank EUR Cash/ Bank BWP D C [BWP] [BWP] c/ d 134,920.64 BWP 134,920.64 b/ d 134,920.64 Other comprehensive income-20X5 OCI Figure 9.9: BAKENSKOP PLC’s foreign currency bank accounts Summary: The current assets include inventories, receivables, securities, prepaid expenses and cash/ bank. The valuation of inventories is at the lower of cost and net realisable value. For the valuation of finished goods, Manufacturing Accounting applies. Receivables are measured at settlement amounts but an adjustment for credit risks applies. These adjustments as well as a complete payment failure of the debtor is recorded as bad debts. Securities are short-term financial instruments held at fair value through profit and loss or through other comprehensive income as per default case. IFRS 9 applies for valuation. In contrast to the German Handelsgesetzbuch, prepaid expenses are considered as current assets. Accounting Technical Terms: Bad debts: Expense account for uncollectable receivables. It is closed-off to profit or loss. <?page no="237"?> Berkau: Financial Statements 4e 9-233 Hedging: Carrying two financial instruments with opposite risks, such as a receivable in USD and a future contract in USD. Idle costs: Expenses for unused production facilities. Inventories: Asset held for sale or for support of production or for service rendering. Work-in-Process account: Account in Manufacturing Accounting that represents a job order. The Work-in-Process account is the reconciliation account for multiple Job Order accounts. See also the conventions in chapter (1). Manufacturing Accounting: Accounting for finished goods valuation in manufacturing companies and production firms. Manufacturing Accounting is based on Work-in-Process accounts and Manufacturing Overheads accounts. Manufacturing Overheads account: An account to gather all overheads linked to production. Net realisable value: Measurement at fair value at which an asset can be sold among knowledgeable, willing and independent parties (orderly transaction). Overhead application: Allocation of manufacturing overheads to job orders by making a debit entry in the Workin-Process account and a credit entry in the Manufacturing Overheads account. Securities: Short-term financial instruments. Question Bank: (1) An over-application of overheads is recorded as: 1. DR Manufacturing Overheads … - CR Cost of Sales … 2. DR Cost of Sales … - CR Manufacturing Overheads … 3. DR Manufacturing Overheads … - CR Work-in-Process. 4. DR Work-in-Process … - CR Manufacturing Overheads… (2) A company records the following additions to stock. 100 at 34.00 EUR, 200 at 33.00 EUR, 150 at 35.00 EUR. Based on a weighted average cost formula, how much is a stock release of 25 units? 1. 841.67 EUR. 2. 850.00 EUR. 3. 847.22 EUR. 4. 875.00 EUR. (3) A company buys 400 pullovers at 96.00 EUR/ u gross amount. The dealer offered a discount of 10 % which has been considered for the price already. How much are unit cost of purchase before discount deduction? 1. 88.00 EUR. 2. 88.89 EUR. 3. 106.67 EUR. 4. 72.72 EUR. (4) A company has a receivable from selling goods to the extent of 1,500.00 EUR. The customer is most probably (80 % probability) insolvent. How much are recorded bad debts? 1. 0.00 EUR. 2. 1,000.00 EUR. 3. 1,250.00 EUR. 4. 1,500.00 EUR. (5) On 4.05.20X5, a company buys 50 bonds that mature in the next Accounting period (30.06.20X6). The purchase price is 246.00 <?page no="238"?> Berkau: Financial Statements 4e 9-234 EUR/ b and the principal of the bond is 250.00 EUR/ b. On 31.12.20X5, the coupon at 5.4 %/ a is paid. At which value are the bonds disclosed on the balance sheet as at 31.12.20X5? 1. 12,964.20 EUR. 2. 12,171.37 EUR. 3. 12,500.00 EUR. 4. 12,300.00 EUR. Solutions: 1-1, 2-3, 3-2, 4-2, 5-4. <?page no="239"?> Berkau: Financial Statements 4e 10-235 10. Statement of Cash Flows Learning Objectives: A statement of cash flows is required by IAS 1.10 as part of a full set of financial statements. Users of financial statements assess a company’s liquidity situation by analysing the cash/ bank item on the balance sheet together with the statement of cash flows. We strive to predict future liquidity and cash amounts and ask whether or not a cash flow repeats itself in the future. In contrast to our Basics-1, we here focus mainly on regulations based on IAS 7. In this chapter (10) we introduce the statement of cash flows as ruled by IFRSs. A cash flow is a change of the cash/ bank item on the balance sheet during an Accounting period. A statement of cash flows looks very similar to a liquidity plan or cash budget 40 . There are only 2 major differences: (1) A liquidity plan starts at the opening amount of cash/ bank and ends with the closing balance of the cash/ bank item whereas the statement of cash flows only shows changes in cash/ bank and as a consequence starts at zero and ends with the total cash flow. (2) A cash flow statement classifies types of cash flows to better support estimations of future cash/ bank items. The following assumption applies: Cash flows resulting from operating activities are likely to repeat whereas a cash flow from financing or investing is a single event. 40 Read our Basics-2, chapter (6). We explain the direct and indirect method of calculating the operating cash flow and cover the most important regulations for the preparation and disclosure of statements of cash flows along IAS 7. The derivative method is explained online. You’ll reach it by our QR-code which takes you to the linked additional materials. In contrast to international Accounting, a company reporting based on German law (HGB) only prepares a statement of cash flows if participating on the capital market in line with § 264d HGB, e.g., when its shares are traded publically at a stock exchange, and if does not prepare group statements as a parent company. No statement of cash flows is required for parent companies as in Germany the group statements include a statement of cash flows (for the group). § 264 HGB applies. For international Accounting, IAS 1.10 defines that the statement of cash flows is always an element of a set of financial statements. All reporting companies applying IFRSs shall prepare and disclose a statement of cash flows. Think about a company that is profitable but only generates low amounts of cash with its activities. How can this happen? If a company is incapable of collecting cash, its revenues from sales are recorded as: <?page no="240"?> Berkau: Financial Statements 4e 10-236 DR Accounts Receivables......... DR VAT.......................... CR Revenue...................... As a consequence, the company’s cash/ bank item stays low and cannot increase by operations. Assume further, our company always pays for its own bills on time. In this case, the company most probably is even left with a negative cash flow, meaning its cash/ bank item on the balance sheet decreases. In common language, we say the business is bleeding cash. This bankrupts it sooner or later because companies need to stay solvent for going concern. The user of financial statements has to assess a company’s financial situation. For the calculation of the total cash flow, no extra financial statement is needed as we can read out the difference of the cash/ bank item on the balance sheet for two following Accounting periods. However, for predicting cash flows we have to know more than its total. For the preparation of a statement of cash flows we separate its cash flows. In line with IAS 7.10, a cash flow statement discloses at least a cash flow from operating activities, from investing activities and from financing activities. You are free to classify in a more detailed manner but the three categories cash flow statement is the minimum requirement set out by IAS 7.10: The statement of cash flows shall report cash flows during the period classified by operating, investing and financing activities. The IASB dedicates the complete standard IAS 7 to cash flows. IAS 1.111 simply states that IAS 7 lays out requirements for presentation and disclosure of cash flow information. Cash flow information is necessary in order to assess the liquidity of a company. For checking solvency of a company, detailed cash flow information and the amount of the cash/ bank item need to be analysed. The cash flow statement separates annual cash flows in order to determine particular cash flows the user of financial statements has to understand. In particular, investors try to estimate whether cash generation can be repeated in the next Accounting periods. This is likely to happen for operating cash flows which result from ordinary business activities. A manufacturing firm generating cash flows from selling its finished goods on the market is likely to generate the same cash flows in the future again. In contrast, a production firm that sells its property, such as houses previously built for its own employees, only can do that once. Cash inflows from selling non-current assets are limited to assets in possession. Commonly, we refer to that situation as selling silverware. The main purpose of the statement of cash flows is to separate the cash flows into single cash flows as instructed to by IAS 7.10. The classifications below are required to disclose: - Cash flow from operating activities. - Cash flows from investing activities. - Cash flows from financing activities. It is always a good idea to analyse cash flows separately. We do not want to <?page no="241"?> Berkau: Financial Statements 4e 10-237 mix operating cash flows with investing cash flows. A favourable cash flow is a high operating cash flow as it tells us that the business activities generate cash. Furthermore, a good investing cash flow should be negative as it indicates the company is investing in future activities and thus is creating and/ or increasing its potential to generate cash and being profitable. Once an investing cash flow becomes positive, the company most probably is under liquidation, at least it sells non-current assets to a higher extent than it is investing in new assets. We consider this as a bad sign. Hence, a high positive operating cash flow is favourable but a high positive investing cash flow is not. An offsetting of operating and investing cash flows might cancel out single cash flows and can even result in a zero which does not tell you anything. You are destroying valuable information for the user of financial statements when combining single cash flows. This is the main reason, why a cash flow statement always shows three separate cash flows. Before we continue our considerations, we insert a small paragraph about what we actually measure. IAS 7 always refers to the expression cash and its equivalents. By the definitions of IAS 7.6 cash is cash on hand and demand positions. Cash equivalents are short-term, highly liquid investments readily convertible to cash not under risk of changes. In order to get familiar with cash flow statements and liquidity planning, we now discuss the basic case study EIMKE Ltd. EIMKE Ltd. is a retailer in Australia. It discloses the statement of financial position at the end of the previous Accounting period as shown in Figure 10.1. A C, L Non-current assets [AUD] Equity [AUD] P, P, E 75,000 Share capital 30,000 Intangibles Reserves Financial assets Retained earnings 70,000 Current assets Liabilities (liab.) Inventory 20,000 Long-term liab. 20,000 Accounts receivables 5,000 Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 50,000 Income tax liab. 30,000 Total assets 150,000 Total equity and liab. 150,000 Eimke Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 10.1: EIMKE Ltd.’s balance sheet (20X7) At first, we prepare a liquidity plan for EIMKE Ltd.’s next Accounting period 20X8. EIMKE Ltd. plans the below listed business activities: <?page no="242"?> Berkau: Financial Statements 4e 10-238 (1) Payment of income tax liabilities to an extent of 30,000.00 AUD. (2) Purchase and payment of goods at cost of purchase of 50,000.00 AUD. (3) Depreciation to the extent of 20,000.00 AUD. (4) Collection of half of the receivables disclosed on the balance sheet in Figure 10.1. (5) Payment of interest 1,000.00 AUD and pay-off 2,000.00 AUD for its bank loan. (6) Earning revenue of 120,000.00 AUD which is paid by customers to an extent of 90 %, the remainder is paid in later Accounting periods. (7) Payment of 60,000.00 AUD for material consumption in production. From the above business activities, only (1), (2), (4), (5) and (6) are cash relevant. The Accountant prepares a liquidity plan for EIMKE Ltd. as shown below in Figure 10.2. [AUD] Opening value 50,000 Collection of receivables (4) 2,500 Proceeds (6) 129,600 Income tax payment (1) (30,000) Purchase (2) (60,000) Interest payment (5) (1,000) Pay-off payment (5) (2,000) Liquidity 89,100 Eimke Ltd.'s LIQUIDITY PLAN for the period 20X8 Figure 10.2: EIMKE Ltd.’s liquidity plan (20X8) How it is Done (Liquidity Plan): (1) Determine the opening value of the cash/ bank item. (2) Calculate all additions to cash/ bank. Consider gross amounts for receipts when VAT applies. (3) Deduct all payments. Consider gross amounts when VAT applies. (4) Add all items on the liquidity plan in order to ascertain the closing balance of cash/ bank. We acknowledge that at EIMKE Ltd. liquidity increases. It was 50,000.00 AUD on 31.12.20X7 and now it is 89,100.00 AUD as estimated for 31.12.20X8. The cash flow is amounting to: 89,100 - 50,000 = 3 39,100.00 AUD. EIMKE Ltd. planned a positive cash flow for its Accounting period 20X8. In order to transform our liquidity plan into a statement of cash flows, we classify cash flows. Operating activities at EIMKE Ltd. are the tax payment (1), the purchase (2), the collection of the receivables (4) and the proceeds (6). There is a financing activity which is the pay-off payment for the bank loan (5) and the payment of interest (5). Interest can be <?page no="243"?> Berkau: Financial Statements 4e 10-239 classified as operating or financial cash flow. We follow our conventions and always consider interest payment as a finance activity. Observe below the statement of cash flows in Figure 10.3. Cash flow from operating acitivities [AUD] [AUD] Proceeds 129,600 Purchase payment (60,000) Collection of receivables 2,500 Tax payment (30,000) 42,100 Cash flow from investing activities Investments 0 0 Cash flow from financing activities Interest payment (1,000) Pay-off payment (2,000) (3,000) Total cash flow 39,100 Eimke Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X8 Figure 10.3: EIMKE Ltd.’s statement of cash flows (20X8) How it is Done (Cash Flow Statement): (1) Determine all payments relevant for the Accounting period, either from planning or from the Cash/ Bank account. (2) Classify cash flows into categories: operating, investing and financing cash flows. (3) Operating cash flows result from the normal operations of the business, such as purchases, labour, rent, taxes etc. (4) Investing cash flows come from acquisitions and sales of non-current assets linked to the core business, such as buying machinery or sales thereof at time of disposal. (5) Financing cash flows are linked to the finance of the business and frequently change debt items on the balance sheet. Examples are taking bank loans, issue of shares and bonds as well as paying dividends, interest and coupons and payments to retire debts. (Conventions in chapter (1) apply.) (6) Calculate operating, investing and financing cash flow by adding single receipts and deducting single payments. <?page no="244"?> Berkau: Financial Statements 4e 10-240 (7) Add all cash flow categories for total cash flow calculation. Cash flow information is required in order to analyse payments and determine the ability of a company to fulfil future payment obligations. A company that is unable to pay its bills is regarded insolvent and has to file for bankruptcy. We divide the user of financial statements into 2 groups: shareholders and creditors. In general, a shareholder is interested in profit and liquidity in order to estimate the dividend to receive. It depends on the profit plus profit carried forward and the ability of the company on shares to make dividend payments. A creditor, such as a bank or bondholder, is more focussed on cash flows. Profitability is less relevant as long as the debtor meets its payment obligations. Assume you are holding bonds of a company. You might wonder whether or not the company you lend your money to is able to pay for the bond redemption. In this situation you become curious about the item cash/ bank on the balance sheet and even more about its cash flow statement. Other occasions for a profound cash flow statement analysis are banks who want to know whether a company can pay-off its loans, or a supplier wondering whether the customer can pay debts resulting from its purchases. Also employees want to know whether there is enough liquidity for salary payments. Cash/ bank and future cash flows are considered to assess a company’s potential for investments to create potential for the enhancement of its business operations. For analysing cash flows we keep in mind that liquidity requirements depend on the industry the company is in and the business model it pursuits. A production company with a need for expensive machinery, huge energy consumption and high innovation requirements needs more cash than a consultancy or law firm which is more linked to its human capital. The cash flow statement can be prepared by three methods. - Direct method. - Indirect method (reconciliation of profits with operating cash flows and calculating investing and financing cash flows directly). - Derivative method. The method derives cash flows from information provided by a balance sheet, an income statement, a register of noncurrent assets and the profit appropriation. It allows a cash flow statement preparation from “outside of the company”. IAS 7.18 focusses on the operating cash flow and only refers to the direct method based on cash receipts and payments and the indirect method that reconciles profits with operating cash flows. The investing and financing cash flow are to be determined directly. We here apply the methods’ designation from IAS 7.18: direct and indirect method. Ad (1): Direct Method (Cash Flow Statement) For the direct method, we start with the Cash/ Bank account and classify all <?page no="245"?> Berkau: Financial Statements 4e 10-241 entries therein in operating, investing and financing payments/ receipts. The cash flow categories are defined in IAS 7.6.: Operating activities of a company aim to earn revenues and are not linked to investing nor financing of the business. Examples for operating cash flows can be found in IAS 7.14. Investing activities are the acquisition and disposal of non-current assets and investments. Examples are mentioned in IAS 7.16. Financing activities change equity and/ or long-term liabilities. Find examples in IAS 7.17. We also consider all payments that are linked to the latter ones, such as interest payments and pay-off of liabilities as financing activities. IAS 7.33 applies. IAS 7.33 allows to disclose interest payments and receipts as operating or financing cash flow. There are good reasons for classifying interest as operating cash flow. However, we stick to our conventions from chapter (1) and always classify interest as financing activity - no matter whether liabilities are long-term or short-term. The application of the direct method is pretty simple. We check the Cash/ Bank account and classify the entries therein in operating, investing and financing receipts and payments. EIMKE Ltd.’s Cash/ Bank and Accounts Receivables account for 20X8 are displayed in Figure 10.4. It is assumed that actual receipts and payments are the same as planned in the liquidity plan. D C D C OV 50,000.00 (1) 30,000.00 OV 5,000.00 (4) 2,500.00 (4) 2,500.00 (2) 60,000.00 (6) 14,400.00 c/ d 16,900.00 (6) 129,600.00 (5) 3,000.00 19,400.00 19,400.00 c/ d 89,100.00 16,900.00 182,100.00 182,100.00 b/ d 89,100.00 Cash/ Bank C/ B Short-term liabilities A/ R Figure 10.4: EIMKE Ltd.’s accounts (20X8) We classify cash flows as follows: (1), (2), (4) and (6) are operative cash flows, (5) is financing cash flow with regard to interest and pay-off portion. The statement of cash flows is the same as shown in Figure 10.3. Ad (2): Indirect Method The indirect method determines operating cash flows by reconciliation of profits with operating cash flows and the investing and financing cash flows directly. As indirect and financing cash flows have been already covered under the direct method we only focus on the operating cash flow. It is not possible to derive the financing nor investing cash flow from profit or loss. There is simply no information available, as the income statement only refers to operational business activities. Taking a bank loan, e.g., leads to an interest expense on the statement of profit or loss and other comprehensive income but no bank loan’s principle can be calculated. The same applies for invest- <?page no="246"?> Berkau: Financial Statements 4e 10-242 ments that cause the disclosure of depreciation. However, depreciation does not tell us the cost of acquisition nor the residual value. Hence, for investing and financing activities only the direct method applies. In contrast to investing and financing cash flows, the operating cash flow requires a recording of operating activities similar to the income statement. We benefit from the following situation: A Profit and Loss account records business activities for profit calculation purposes. Thus, the recording is focussed on profitability figures, such as revenue and expenses. A statement of (operating) cash flows needs the same recordings, the only difference is that it is focussed on payments and receipts instead of revenue and expenses. As we want to know cash flows we have to adjust the profit for those activities that (1) are relevant for profitability but not for cash flows and (2) vice versa, for activities relevant for cash but not for profitability. Activities that fall under (1): relevant for profitability but not for cash are e.g.: depreciation, additions to provisions etc. Activities that fall under (2): relevant for cash but not for profitability are e.g.: purchase and payment for materials but not using it which leads to stock increases, payments which induce receivables or payables, prepaid expenses, VAT receivables and payables. A company that buys materials on credit but does not use the materials in production or service rendering does not record material expenses. It records an increase in inventories and in payables. As a consequence, we record a cash flow adjustment for the increase in inventories as a negative cash flow (payment) and an adjustment for an increase of payables as a positive cash flow (receipt). This means we split the activity of buying on credit in a portion of purchase-on-cash and another one of receiving cash from a loan. Here, both cash flows cancel out on the reconciliation statement. The advantage of the reconciliation method is that the calculation of operating cash flows is not based on numerous Bookkeeping entries but on only few items on the balance sheet. This gives us a low workload. Additionally, the cash flow statement preparation always requires the same amount of calculations no matter how many business activities take place and how many Bookkeeping entries are recorded. A factory’s cash flow statement is as complicated as your next door corner store’s one - provided the latter one has to prepare financial statements at all. The indirect method starts-off with the profit copied from the income statement. We are not interested in profitability but in cash payments and receipts. In order to not prepare a second calculation we use the result of the profit or loss calculation to ascertain cash flows by reconciling profit with operating cash flows. Here is how it works: We start with the profit and make two kinds of adjustments. (1) For all activities that determine profit but do not cause payments or receipts in the actual Accounting period, such as partial receipts from customers or depreciation. (2) We make more adjustments for all payments and receipts which are not relevant for profit calculation, such <?page no="247"?> Berkau: Financial Statements 4e 10-243 as purchases of materials which have not been used for production and remain on stock. The method is fairly simple and follows the structure as you can see in Figure 10.7 for our case study EIMKE Ltd. The following How-it-is-Done paragraph refers to the structured approach. Thereafter, we explain the single steps in detail. How it is Done (Reconciliation of Profits with Operating Cash flows): (1) Calculate profit for the period as the earnings after taxes. (2) Add expenses for operating activities that do not cause payments, such as depreciations, expenses for provisions, interest payments etc. (3) Deduct earned interest as it counts as a financing cash flow. (4) Add decreases of receivables, deduct increases thereof. (5) Add decreases of prepaid expenses, deduct increases thereof. (6) Add decreases of inventory, deduct increases thereof. (7) Add increases of short-term liabilities, deduct decreases of short-term liabilities and provisions. (8) Add increases of income tax liabilities, deduct decreases thereof. (9) Add decreases of VAT receivables (input-VAT refund receipt), deduct increases thereof (input-VAT paid). (10) Add increases of VAT payables (output-VAT collected from customers), deduct decreases thereof (output-VAT paid to revenue service). (11) Add earnings after taxes and adjustments from steps (2) - (10). It is the operating cash flow. (12) Calculate investing and financing cash flow by adding single receipts and deducting single payments. (13) Add all cash flow categories for total cash flow calculation. The procedure of reconciliation most probably gives you difficulties with regard to comprehension. For that reason, we provide you with some explanations. If you want to skip them, proceed to the case study EIMKE Ltd. further below and continue reading where the ** is. Why Step (1)? The profit for the period is the result of a comparison of revenue and expenses and gives us the profitability of the company. However, it needs adjustments as all items on the income statements have been considered regardless of payments or receipts. Starting from the profit results in a short- <?page no="248"?> Berkau: Financial Statements 4e 10-244 cut of calculations and is less Accounting work than classifying all Bookkeeping entries in the Cash/ Bank account. Why step (2)? Expenses without payment in the same Accounting period are not cash relevant. As we aim to the cash flow statement preparation these expenses are irrelevant but have been considered for the profit or loss calculation. As a consequence we have to take them out. What we actually do is excluding these expenses from the income statement. E.g., a depreciation is not cash relevant as the Bookkeeping entry is: DR Depreciation................. CR Accumulated Depreciation..... Another example is an expense recorded together with an increase in provisions. Those expenses are relevant for profit in the actual Accounting period but the payments take place in the future. Hence, we cancel these expenses as no payment is made in the actual Accounting period. 41 Interest results in a payment but this one is classified as financing cash flow. As a consequence, we add paid interest to the operating cash flow and consider it for financing cash flows in step (12). In case you feel unsafe whether you should add or deduct the amounts, simply think of cancelling items out. I.e., if depreciation has been deducted for profit calculation and it needs to be undone, you do the opposite: you add depreciation. Why Step (3)? A received interest is classified as financing cash flow. The receipt is deleted for operating cash flow calculations and added to financial cash flows by step (12). 41 Check step (7), too. Why Step (4)? We analyse step (4) regardless of Bookkeeping entries. Any decrease of receivables is considered a payment where the debtor paid its liability. Hence, we consider a cash receipt. In the opposite case when receivables increase, we make a payment and the recipient of the money has the obligation to pay-off the amount in the future. This means we disclose a receivable on the balance sheet. What counts here is the fact that money is paid and it gives a negative operating cash flow. Note, that only the cash flow implication matters. In Figure 10.7, the numbers shown are cash flows, not receivables, interest or anything else. Hence, an increase of receivables is recorded in the reconciliation statement as an outflow of cash. Why Step (5)? In terms of cash flow calculation, we make no difference between receivables or prepaid expenses. A receivable <?page no="249"?> Berkau: Financial Statements 4e 10-245 is a (paid) claim for repayment and prepaid expenses is a (paid) claim for service, such as rent, insurance, work etc. Why Step (6)? Inventories represent current assets payments have been made for. For inventories all categories are relevant. It does not matter whether inventories are raw materials, supplies of finished goods. In general, we consider an increase of inventories as a payment which results in a negative cash flow. A decrease of inventory is a cash receipt in exchange for delivered goods. Be aware, that all changes in inventories are based on cost of acquisition or cost of manufacturing - never on selling prices. The impact inventory has on cash flows also applies when the calculation of finished goods considers not paid expenses, e.g., depreciation. This means, that depreciation as production overheads has been recorded in the Manufacturing Overheads account. If a company applies the nature of expense method, changes in inventories of finished goods are disclosed on the income statement and can be copied therefrom. For that reason, it is always a good idea to apply the nature of expense method for profit calculation when you later want to derive the cash flow from operating activities by reconciliation. Why Step (7)? Short-term payables and provisions are not linked to financial cash flows. When they are recorded, the expense has been considered in the income statement already or by other cash flow considerations. I.e., when materials are purchased the increase of inventory has been recorded as a negative cash flow in step (6). As we (the buyer) do not pay we compensate the deduction in step (6) by adding cash in step (7) for a granted loan. This means the purchase-on-credit-transaction is split into a paid buy and a granted cash-loan thereafter. The loan received is recorded by this step (7) as a cash receipt. When a company pays for short-term debts the transaction is not recorded on the income statement as the pay-off has no impact on profitability. As it is a cash outflow we record the retirement of short-term debts as negative cash flow indicated by a deduction of short-term liabilities. A reversal of provisions results in negative expenses which cancel out the ordinary recorded expenses on the income statement. This means, the expense is initially recorded in a nominal account and when the provision is dissolved, we debit provisions and make a credit entry in the expenses. As a consequence, dissolving a provision is not recorded as expense and as a consequence it is not profit relevant, either. However, when a provision is dissolved payments are made and are considered in the cash flow statement in the period of payment. We take a closer look at provisions. We observe a company that dissolves a provision for rework. When the provision is recorded, the expenses for rework are added to the income statement to make the present obligation count for the actual Accounting period. When the provision is added the Accountant makes a Bookkeeping entry (1) such as below. It results in pulling forward an expense with no payment taking place. <?page no="250"?> Berkau: Financial Statements 4e 10-246 DR Rework Expenses.............. CR Provisions................... In the period when the provision is dissolved the Bookkeeping entry (A) for the rework is initially recorded as: DR Rework Expenses.............. CR Cash / Bank................... As the expenses have been considered in the previous Accounting period, the Provision is dissolved which cancels out the expenses. It can be done by recording a Bookkeeping entry (B), such as: DR Provisions................... CR Rework Expenses.............. As a consequence of the above debit entry and the following credit entry in the Rework Expenses account, no rework is disclosed on the income statement. It shouldn’t as it has been considered one Accounting period before which is actually the purpose of provision recognition. However, the payment took place in the period when the provision is dissolved and got recorded as Bookkeeping entry (B). Hence, it counts for the statement of cash flows in the year of dissolving the provision. For our reconciliation procedure, keep in mind: rising a provision is covered by step (1) and (2) and dissolving by step (7). The reason for this unequal occurrence is that the treatment depends on what you see. A provision recorded is an expense as disclosed on the income statement. In contrast, a provision dissolved is cancelled out for the income statement and must be derived from the balance sheet. Dissolving provisions for expenses gives a negative cash flow. Why Step (8)? Income taxes are treated as short-term liabilities. In case you start the cash flow reconciliation by the earnings before taxes ignore current income tax liability increases. In order to not get confused, rather reconcile from earnings after taxes in particular in cases when prepayments for income taxes are made. Why Step (9)? The step can be combined with step (4) as VAT receivables fall under receivables. We deal with input-VAT paid together with the Bookkeeping entry for purchase. It does not matter whether or not the payment has been made in full as a partial payment results in short-term liabilities and will be covered by step (7). A company will record VAT receivables for purchases and acquisition in one account together which makes it difficult to separate the input-VAT payments later. Hence, it is likely to <?page no="251"?> Berkau: Financial Statements 4e 10-247 disclose VAT receivables for operating and investing activities together as long as investments are not material. Regarding expensive investments, such as an aircraft acquisition for a commercial airliner, input-VAT is classified as material and should considered as cash flow from investing activities. Otherwise, we assume that companies only run one VAT account and do not distinguish what VAT is paid for. In case you record investing cash flow based on gross amounts, delete input- VAT payments from the VAT account before you make step (9). You can do so with input-VAT refunds too but in general it is accepted to consider all input-VAT refunds as operating activity no matter whether resulting from purchases, services or acquisitions. An exception applies if input-VAT refunds from investments are material, see above. Based on our conventions in chapter (1), which states that we consider VAT payments in the next Accounting period (year), we record cash flows based on gross amounts of purchases and acquisitions. In real business this only applies for VAT relevant cash flows in December as VAT payments take place in the next following month. Why Step (10)? Output-VAT is collected from customers and buyers and results in cash inflows. As a consequence, output- VAT is dealt with as positive cash flow at the time of collection and negative cash flow when paid to the revenue service. Same as for step (9) applies to material sales of non-current assets. The next following steps (11) - (13) are standard procedure and do not require further explanation. Below, we study the reconciliation method with our case study EIMKE Ltd. The reconciliation is calculated on the statement of cash flows as shown in Figure 10.7. The calculations refer to the balance sheet and the income statement disclosed in Figure 10.5 and Figure 10.6. ** After the Accounting period 20X8, EIMKE Ltd. discloses the balance sheet and income statement as shown in Figure 10.5 and Figure 10.6. <?page no="252"?> Berkau: Financial Statements 4e 10-248 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 55,000 Share capital 30,000 Intangibles Reserves Financial assets Retained earnings 97,300 Current assets Liabilities (liab.) Inventory 10,000 Long-term liab. 18,000 Accounts receivables 16,900 Short-term liab. A/ P 14,000 Prepaid expenses Provisions Cash/ Bank 89,100 Income tax liab. 11,700 Total assets 171,000 Total equity and liab. 171,000 Eimke Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 10.5: EIMKE Ltd.’s balance sheet (20X8) Due to simplicity we record the bank loan completely as interest bearing liabilities instead of making a proper current/ non-current separation along IAS 1.60. [AUD] Revenue 120,000 Other income 120,000 Materials (60,000) Labour Depreciation (20,000) Other expenses Earnings before int. & taxes (EBIT) 40,000 Interest (1,000) Earnings before taxes (EBT) 39,000 Income tax expenses (11,700) Deferred taxes Earnings after taxes (EAT) 27,300 Eimke Ltd.'s STATEMENT of PROFIT & LOSS and other COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 10.6: EIMKE Ltd.’s income statement (20X8) The cash flow statement calculation by reconciliation starts with the earnings after taxes which is amounting to 27,300.00 AUD. The adjustments for activities that are expenses/ revenue but no cash is for depreciation. As depreciation is deducted in the income statement we have to add its amount to the reconciliation statement for compensation. Hence, we <?page no="253"?> Berkau: Financial Statements 4e 10-249 come up with an operating cash flow after making adjustments for depreciation to an extent of: 27,300 + 20,000 = 447,300.00 AUD. The next adjustment is for activities that are cash/ bank-relevant but not recorded on the income statement. At EIMKE Ltd., we observe a decrease of inventories: 10,000 - 20,000 = -1 10,000.00 AUD. A decrease of inventories is regarded as cash sale, hence, the decrease of inventory counts as a positive cash flow to the extent of 10,000.00 AUD. Our cash flow calculation so far is: 47,300 + 10,000 = 5 57,300.00 AUD. The next item is the Accounts Receivables account. We observe an increase of: 16,900 - 5,000 = 1 11,900.00 AUD. An increase of receivables is seen as payment which results in a claim to get the money back. A payment is a negative cash flow and needs to be deducted in our cash flow calculation. The cash flow so far is: 57,300 - 11,900 = 4 45,400.00 AUD. The next item is the changes in payables. We notice an increase of 14,000.00 AUD which results from VAT. We show an extra item for VAT payables for teaching purposes. Any increase of payables is considered a receipt which causes an obligation of pay-back. Hence, increases in payables are seen as receiving cash/ bank. As a consequence, we add the amount to our cash flow calculation: 45,400 + 14,000 = 5 59,400.00 AUD. The tax liabilities are payables as well. We compare the changes in income tax liabilities which gives us: 11,700 - 30,000 = - -18,300.00 AUD. Here, the liability decreases. A reduction of liabilities is seen as a payment and is deducted for the cash flow calculation: 59,400 - 18,300 = 4 41,100.00 AUD. The amount of 18,300.00 AUD is shown in the line for income tax liabilities. The financing cash flow can be taken from the changes in the Interest Bearing Liabilities account. The change of interest bearing liabilities gives: 20,000 - 18,000 = 2 2,000.00 AUD. The reduction of liabilities indicates a payment and is a negative cash flow. Hence, the total cash flow for EIMKE Ltd. is amounting to: 41,100 - 2,000 = 3 39,100.00 AUD. Observe the cash flow statement based on the indirect method (= reconciliation method) in Figure 10.7. We show the items in a detailed way, however, often items are combined, such as accounts payables, VAT payables and income tax liabilities. Then, only cash flow from changes in payables are disclosed. <?page no="254"?> Berkau: Financial Statements 4e 10-250 [AUD] [AUD] Cash flow from operating acitivities Earnings after taxes EAT 27,300 add Depreciation 20,000 47,300 changes in working capital changes in inventory 10,000 changes in A/ R (11,900) changes in prepaid expenses 0 changes in A/ P, not ITL 0 changes in income tax liabilities ITL (18,300) changes in VAT/ r only materials (10,000) changes in VAT/ p 24,000 41,100 Cash flow from investing activities Investments 0 0 Cash flow from financing activities Pay-off (2,000) (2,000) Total cash flow 39,100 Eimke Ltd.'s STATEMENT of CASH FLOWS for the period ended 31.12.20X8 Figure 10.7: EIMKE Ltd.’s cash flow statement (20X8) In contrast to the direct method, we did not consider single business activities but calculated the cash flow based on balance sheet items. The resulting cash flow is the same but the Accounting work is less and the method is more reliable. In order to see the application of the indirect method for the RYNEVELD Ltd. case study as covered in chapter (4) go online to Link 10.A below. Link 10.A: RYNEVELD Ltd. A higher sophisticated method in cash flow calculation is the derivative method which can be applied even when no Bookkeeping records are available but only the financial statements. Feel free to download the explanation and cash flow calculation based on the derivative method for the case EIMKE Ltd. below through Link 10.B: <?page no="255"?> Berkau: Financial Statements 4e 10-251 Link 10.B: EIMKE Ltd. Summary: Statements of cash flows are part of the financial statements. The cash flow statements shows changes in the cash/ bank item on the balance sheet and separates the total cash flow in single cash flows resulting from operating, investing and financing activities. For cash flow calculation, direct method and indirect method apply. The latter one is recommended as it does not reflect on the single Bookkeeping entries but can be prepared based on amounts taken from the balance sheet. Accounting Terms: Cash equivalent: short-term assets that are almost as liquid as cash and which are certain in terms of valuation. Cash flow: Changes in the Cash/ Bank account. Reconciliation method: Calculation of operating cash flows by making adjustments for the profit after taxes with regard to revenue/ expenses without payments/ receipts and to payments/ receipts irrelevant for profit or loss calculation. Question Bank: (1) How is an increase of a shortterm liability resulting from supplies considered in the cash flow statement? 1. Not at all. 2. As a cash inflow. 3. As a cash outflow to its full extent. 4. As a partial cash outflow based on the portion of payment. (2) What are financial cash flows? 1. Bank loan pay-off, discount, interest. 2. Bond issue, interest, bond redemption. 3. Bank loan principle, bank overdraft, VAT. 4. Interest, coupon, insurance fees. (3) Which statement about the reconciliation statement is incorrect? 1. Depreciation is added to earnings after taxes. 2. Interest earned is added to earnings before taxes. 3. Increases of VAT payables are added to earnings after taxes. 4. Prepaid expenses are deducted from earnings before taxes. (4) A company earns a profit after taxes of 381,500.00 AUD. Depreciation is 60,000.00 AUD. Interest income is 45,000.00 AUD. How much is the operating cash flow? 1. 510,950.00 AUD. 2. 560,000.00 AUD. 3. 530,000.00 AUD. 4. 396,500.00 AUD. <?page no="256"?> Berkau: Financial Statements 4e 10-252 (5) Which statement is correct? 1. A company only prepares a statement of cash flows when it is a group member, regardless whether parent or subsidiary. 2. Along IFRSs every company prepares a statement of cash flows. 3. Along IFRSs only listed public companies have to prepare a statement of cash flows. 4. Based on § 264 I HGB companies participating on the public capital market do not have to prepare a cash flow statement. Solutions: 1-2, 2-2, 3-2, 4-2, 5-2. <?page no="257"?> Berkau: Financial Statements 4e 11-253 11. Equity on the Balance Sheet Learning Objectives: In this chapter (11), we cover the equity section of the balance sheet that comprises of the issued capital, reserves and retained earnings. With the case study YARRA Ltd., we show all material aspects of recognition and measurement of items of equity. Although many cases of changes in equity are linked to more than one item at the same time, the chapter is structured by the major items on the equity section: (1) Issued capital. (2) Reserves. (3) Retained earnings. In contrast to other chapters, the equity section refers to regulations based on the National Company's act more than to international Accounting. Next, we discuss the above listed items of the equity section. Here comes issued capital: Ad (1): Issued Capital Issued capital depends mostly on national law. We here only cover basic knowledge about legal forms of companies and distinguish companies with a limited liability, such as limited liability companies LLC (in the US), limited liability corporations LLC (UK), companies with limited liability GmbH (Germany), proprietary limited companies (Pty) Ltd. (in the Commonwealth, South Africa) from public companies based on shares. Companies go public by an initial public offering IPO and are often listed at a stock exchange with their shares or at a bond market with their bonds. Legal forms for companies based on shares are corporations Corp., Inc. (in the US), public limited companies PLC, Ltd (UK), Stock companies AG (Germany), and public companies Ltd. (South Africa). No matter whether a limited company is publically traded at stock/ bond markets, the Accounting principles to record equity are the same. When a company issues capital it receives funds which are added to the Cash/ Bank account and makes a credit entry in the Issued Capital account. In this text book, we call all fractions of issued capital shares. Hence, a share issue means that partial ownership of the company is legally transferred to investors who add funds to the company in return. Shares can be ordinary shares or preference shares. Ordinary shares come with the common rights of ownership, such as a claim on dividends and voting rights on the annual general meeting. In contrast, preference shares offer the holder a preference dividend which is often a percentage based on the nominal value of the share but don’t allow the preference shareholders to vote. The fixed dividend are a trade-off for the lack in voting rights. A fixed dividend is regarded as favourable as it does not depend on the profit. We say, the investors’ risk is low as the dividend amount is predictable. However, a company can decide to not pay a preference dividend on its annual general meeting. In this case, no dividends to ordinary shareholders cannot paid, either. <?page no="258"?> Berkau: Financial Statements 4e 11-254 The process of share issuing is based on the Allotment account. 42 In order to keep Accounting simple, we here only cover simplified Bookkeeping entries: When a company is established as an incorporated enterprise owners pay their contribution into the company’s bank account and we make a credit entry in the equity section for issued capital. As you see below, reserves can apply. A company based on shares will call this process a share issue. In case the company is a privately owned limited company we refer to this as paying contribution. We study the case of YARRA Ltd. a limited public company based in Johannesburg. On 2.01.20X0, YARRA Ltd. issues 1,000,000 ordinary shares at 1.00 ZAR/ s each. The share issue is at nominal amounts which we refer to as a par value issue. The Bookkeeping entry is as below: DR Cash/ Bank.................... 1,000,000.00 ZAR CR Issued Capital............... 1,000,000.00 ZAR As YARRA Ltd. is a company based on shares it is common to apply a Share Capital account instead of the Issued Capital account. Later, on 30.06.20X0, YARRA issues 500,000 preference shares at 1.00 ZAR/ s. The preference shares come with a fixed dividend of 5 % based on the nominal value. Preference shares only pay a dividend proportional to the time the shares are outstanding. At YARRA Ltd., the shares are issued in the middle of the Accounting period. Hence, only 50 % of the annual preference dividend is paid. The preference shareholders receive: 50% × 500,000 × 1 × 5% = 112,500.00 ZAR. Ad (2): Reserves Building up reserves in a company is similar to as what private households do when the save money for rainy days. They put aside money previously earned or received. The reserves as shown on the balance sheet are: 42 Read our Basics-1, chapter (33). - Capital reserves. - Earnings reserves. - Revaluation reserves. The name of the Reserves accounts is linked to the origin of funds added thereto. Hence, capital reserves result from share issues, earnings reserves come from profits and revaluation reserves apply when a company re-values its non-current assets along IAS 16.31. We start our explanations with capital reserves: A capital reserve is an account where the difference between the issue price of shares and the nominal value is added to. This amount is called a premium. In order to understand the concept properly, we explain the situation by the case study YARRA Ltd. Look at an investor who owns 90,000 ordinary shares. In 20X0, YARRA Ltd. earns a profit of 150,000.00 ZAR. The company prepares <?page no="259"?> Berkau: Financial Statements 4e 11-255 the balance sheet as in Figure 11.1. No dividend has been declared so far. In the notes, YARRA Ltd. explains that ordinary share capital is amounting to: 1,000,000 × 1 = 11,000,000.00 ZAR and preference share capital to: 500,000 × 1 = 500,000.00 ZAR. The separation is required by IAS 1.79. On its annual general meeting, the shareholders declare a preference dividend of 12,500.00 ZAR. No further dividends are declared. In particular, no profit portion is distributed to ordinary shareholders. The remainder is carried forward to the next Accounting period. The balance sheet has been prepared after the appropriation of profits which gives retained earnings of: 150,000 - 12,500 = 1 137,500.00 ZAR. The preference dividends are disclosed as shortterm debts in the liability section on the statement of financial position, observe below in Figure 11.1. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 500,000 Share capital 1,500,000 Intangibles Reserves Financial assets Retained earnings 137,500 Current assets Liabilities (liab.) Inventory 695,000 Long-term liab. Accounts receivables Short-term liab. A/ P 12,500 Prepaid expenses Provisions Cash/ Bank 500,000 Income tax liab. 45,000 Total assets 1,695,000 Total equity and liab. 1,695,000 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 11.1: YARRA Ltd.’s balance sheet (20X0) The balance sheet gives us the book value of YARRA Ltd. of: 1,695,000 - 45,000 - 12,500 = 1 1,637,500.00 ZAR. This results in a book value per share of: 1,637,500/ 1,500,000 = 1 1.09 ZAR/ s. Half a year later, on 2.05.20X1, YARRA Ltd.’s shareholders decide on the annual general meeting to issue 500,000.00 ordinary shares. The fresh shares are issued on 1.07.20X1 at a price of 1.24 ZAR/ s. The shares’ nominal value is 1.00 ZAR/ s. The premium is 0.24 ZAR/ s. In order to raise capital the company can take a loan or issue bonds or shares. When a company issues fresh shares, the share price in general exceeds the nominal share value. This reflects that book values are higher than nominal ones due to adding earned profits to equity in the past. The book value per share is the total amount of equity divided by the amount of shares. Existing shareholders become reluctant to sell a portion of their company below the book value of their own shares. This would result in sharing the profit previously earned with the new owners. <?page no="260"?> Berkau: Financial Statements 4e 11-256 In case shares are traded publically, i.e., at a stock exchange, the situation is slightly different. The share price is determined by supply and demand and results in the (fair) market value. Ordinary and preference shares are traded separately from each other. We ignore this for YARRA Ltd. and consider a share market price that is the same for ordinary and preference shares. Now, we get a book value and a market value which are most likely different. The ratio for the proportion between the fair market price and the book value is called the Market Book Ratio. It is most probably above 100 % which indicates the shares are traded above book value. This proves that share buyers are prepared to overpay the price derived from Bookkeeping records because they expect the company to be prosperous in the nearby future. Existing shareholders who agree on a fresh share issue suffer from any issue price below the fair market value as the fresh shares will lower the average share valuation. However, this situation becomes very likely as an issue price cannot exceed the market price at the time of issue. No one is prepared to buy fresh shares if existing shares are offered at a cheaper price. Selling even below book values would burn shareholders fortune and is not subject to our considerations here. We take a look at YARRA Ltd. On 1.07.20X1, YARRA Ltd.’s shares are traded at 1.60 ZAR/ s. Hence, the weighted average share price for all shares after the share issue is: (1,500,000 × 1.60 + 500,000 × 1.24) / 2,000,000 = 1 1.51 ZAR/ s. As a consequence, an existing shareholder will experience a loss of: 1.60 - 1.51 = 0 0.09 ZAR/ s and the buyer of fresh shares wins: 1.51 - 1.24 = 0 0.27 ZAR/ s. You might ask yourself: Why can a company not issue fresh shares at market prices? A fresh share issue is announced in advance when the market share price is unknown for the day of issue. As a means of caution, the issue share price is calculated and announced below the expected market share price as a share issue fails once existing shares decline and become cheaper than the fresh shares. Even when calculating prudently the problem for existing shareholders stays. A common instrument to avoid losses due to falling share prices caused by fresh shares is a rights issue. With a rights issue, all owners of the existing shares receive a purchase right which is tradable and reflects the expected loss in share valuation. This motivates existing shareholders to agree on a fresh share issue. We check a rights issue for YARRA Ltd. On 1.07.20X1, YARRA Ltd. issues the fresh shares at a 1: 3 ratio, meaning: per 3 existing shares 1 share is freshly issued. The difference between (expected) fair market value and price on issue is 1.60 - 1.51 = 0 0.09 ZAR/ s. YARRA Ltd. gives every existing ordinary and preference shareholder 1 purchase right per 3 shares holding. A shareholder with 90,000 shares on hand receives 30,000 purchase rights at: 3 × 0.09 = 0 0.27 ZAR/ right. Now, the shareholder has 2 options: - Selling the rights earns a gain of: 30,000 × 0.27 = 8 8,100.00 ZAR. Hence, the total fortune is then amounting to: 8,100 + 90,000 × 1.51 = 144,000.00 ZAR. <?page no="261"?> Berkau: Financial Statements 4e 11-257 - Investing in fresh shares requires to buy the fresh shares by paying 1.24 ZAR per fresh share and using the purchase right. The shareholder’s fortune then is amounting to: 120,000 × 1.51 - 30,000 × 1.24 = 1 144,000.00 ZAR. The procedure based on a rights issue is fair as it offers existing shareholders a zero sum game with regard to their fortune as long as the expected market share price equals to the share price at the day of share issue. In order to confirm, we check the value of the shares before the share issue. The fortune of our exemplary shareholder was before: 90,000 × 1.60 = 1 144,000.00 ZAR. We next study the Bookkeeping entries for a share issue. Issued capital is disclosed at nominal values. When shares are issued at a premium, the premium is added to capital reserves. At YARRA Ltd., we consider an issue price exceeding the nominal value. The nominal amount of capital is disclosed as issued capital. Hence, we split the fresh share issue in a nominal and a premium portion. The latter one is the difference between issue price and nominal value multiplied by the amount of issued shares, in case of YARRA Ltd.: (1.24 - 1.00) × 500,000 = 1 120,000.00 ZAR. See the entire Bookkeeping entry below: DR Cash/ Bank.................... 620,000.00 ZAR CR Issued Capital............... 500,000.00 ZAR CR Capital Reserves............. 120,000.00 ZAR How it is Done (Share Issue): (1) Determine the nominal value of shares. (2) Multiply the amount of shares issued by the nominal value per share. Add the nominal value to the issued capital. (3) Check the issue price. If the issue price exceeds the nominal value of the shares, record a share premium on the equity section of the balance sheet. Apply the Capital Reserves account. (4) Make a debit entry in the Cash/ Bank account. Next, we study the opposite of a share issue. A company can also buy its own shares back and redeem them thereafter. This is a means to change voting right ratios and/ or to control share prices because the amount of shares available for trading decreases. The same applies for the dividends. We study YARRA Ltd. again and consider as at 1.10.20X1 the equity as below: Share capital is amounting to: 1,500,000 + 500,000 = 2 2,000,000.00 ZAR. In the Capital Reserves account, YARRA Ltd. discloses 120,000.00 ZAR from the share issue. The Retained Earnings are amounting to 137,500.00 ZAR. <?page no="262"?> Berkau: Financial Statements 4e 11-258 The share price on 1.10.20X1 is down to 1.03 ZAR/ s. In this situation, YARRA Ltd. buys back 200,000 of its own shares. Based on IAS 32.33 we refer to these own shares as treasury shares. YARRA Ltd.’s intention is to invalidate these equity instruments to the extent of: 200,000 × 1.03 = 2 206,000.00 ZAR. IAS 32.33 instructs to record the share redemption in equity and not through profit or loss. This means we debit capital reserves. The Bookkeeping entry at YARRA Ltd. with regard to the share buy-back and their redemption is as displayed below: DR Issued Capital............... 200,000.00 ZAR DR Capital Reserves............. 6,000.00 ZAR CR Cash/ Bank.................... 206,000.00 ZAR We further assume, that YARRA Ltd.’s shares further drop in valuation and on 1.11.20X1, the fair market value of the shares is then 1.00 ZAR/ s. In this situation, YARRA Ltd. buys back another 100,000 of its own shares. The Bookkeeping entry below does not consider a loss as the share acquisition is recorded at nominal values. The Bookkeeping entry is: DR Issued Capital............... 100,000.00 ZAR CR Cash/ Bank.................... 100,000.00 ZAR YARRA Ltd.’s equity situation after the share issue and share redemption is shown in Figure 11.2. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 500,000 Share capital 1,700,000 Intangibles Reserves 114,000 Financial assets Retained earnings 137,500 Current assets Liabilities (liab.) Inventory 695,000 Long-term liab. Accounts receivables Short-term liab. A/ P 12,500 Prepaid expenses Provisions Cash/ Bank 814,000 Income tax liab. 45,000 Total assets 2,009,000 Total equity and liab. 2,009,000 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 11.2: YARRA Ltd.’s balance sheet (20X1) <?page no="263"?> Berkau: Financial Statements 4e 11-259 How it is Done (Share Redemption): (1) Determine the amount of shares to redeem. (2) Record shares bought back based on the market value, as paid for. (3) Record a debit entry for the treasured shares and a credit entry in the Cash/ Bank account. Treasured shares are valued at cost (the fair market price paid). (4) Redeem shares by making a debit entry in the Issued Capital account. Dissolve capital reserves to the extent the cost for treasured shares exceed their nominal value. Make a debit entry in the Capital Reserves account. (5) Record a credit entry in the Treasury Shares account. (6) You might combine Bookkeeping entries (3) to (5) by record an immediate redemption. (7) National Company’s Act regulations might apply. Check beforehand. Below, we study earnings reserves. Earnings reserves result from profit earned during the Accounting period and profits carried forward from prior ones. After profit calculation, the profit after taxes is added to the Retained Earnings account. The company decides on the annual general meeting about the appropriation thereof which can result in additions to reserves, paying dividends and/ or carrying forward profit or loss to the next Accounting period. If added to reserves the amount is transferred from retained earnings to earnings reserves. Special national rules apply for the appropriation of profits and additions to reserves as well as for deductions/ dissolving of reserves. We continue the case study YARRA Ltd. In 20X2, YARRA Ltd. earns a profit of 192,500.00 ZAR (on cash as we want to ignore depreciation for this case). The amount is added to the Retained Earnings account and the income tax liabilities. The income tax liabilities are amounting to: 45,000 - 45,000 + 30% × 192,500 / (1 - 30%) = 8 82,500.00 ZAR after income taxes from previous year are paid and new income taxes are recorded. In the item cash/ bank we disclose at this stage of calculation: 814,000 - 45,000 + 192,500 / (1 - 30%) = 1,044,000.00 ZAR. In retained earnings we observe an amount of: 137,500 + 192.500 = 3 330,000.00 ZAR which includes the profit carried forward from 20X1. We refer to the latter amount as the distributable amount, as it is transferable to the owners as a dividend. An investor’s portion of the profit is proportional to her/ his holdings. Hence, a shareholder who owns 4 % of the company has a claim on her/ his share of the total dividends to the extent of 4 %, too. If the company decides to add the profit or portions thereof to the reserves a debit entry is made in the <?page no="264"?> Berkau: Financial Statements 4e 11-260 Retained Earnings account and the amount is credited to earnings reserves. Once added to earnings reserves, funds can only be released from there if the company decides to do so. This requires consent on the annual general meeting. Special national rules might apply. YARRA Ltd. holds an annual general meeting on 4.04.20X3 and decides to add 200,000.00 ZAR to earnings reserves and to pay a dividend of 0.04 ZAR/ s to its ordinary shareholders. The total amount of dividends to ordinary shareholders is: 0.04 × 1,700,000 = 668,000.00 ZAR. The total preference dividend is amounting to: 500,000 × 5% = 25,000.00 ZAR. The remaining amount is carried forward to the Accounting period 20X3. Dividends to the extent of: 68,000 + 25,000 = 9 93,000.00 ZAR are added to short-term liabilities in the Accounts payables account. The earnings reserves are added to capital reserves on the balance sheet. However, in the notes, YARRA Ltd. discloses the single items and explains them by the statement of changes in equity, too. Find below the Bookkeeping entries made for the appropriation of profits on 31.12.20X2. The recordings anticipate the decision on the annual general meeting as the distribution decided on was only suggested by YARRA Ltd.’s board of directors when preparing the financial statements. It still needs approval. DR P&L-Account.................. 192,500.00 ZAR CR Retained Earnings............ 192,500.00 ZAR DR Retained Earnings............ 68,000.00 ZAR CR Shareholders Dividend A/ P.... 68,000.00 ZAR DR Retained Earnings............ 25,000.00 ZAR CR Shareholders Dividend A/ P.... 25,000.00 ZAR DR Retained Earnings............ 200,000.00 ZAR CR Earnings Reserves............ 200,000.00 ZAR After making the Bookkeeping entries above, YARRA Ltd. prepares its balance sheet after appropriation of profits as you can observe in Figure 11.3. <?page no="265"?> Berkau: Financial Statements 4e 11-261 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 500,000 Share capital 1,700,000 Intangibles Reserves 314,000 Financial assets Retained earnings 37,000 Current assets Liabilities (liab.) Inventory 695,000 Long-term liab. Accounts receivables Short-term liab. A/ P 105,500 Prepaid expenses Provisions Cash/ Bank 1,044,000 Income tax liab. 82,500 Total assets 2,239,000 Total equity and liab. 2,239,000 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 11.3: YARRA Ltd.’s balance sheet (20X2) On the balance sheet, the reserves are 114,000.00 ZAR capital reserves and 200,000.00 ZAR earnings reserves. At YARRA Ltd., no revaluations of assets apply. We covered revaluation reserves in chapter (7). Ad (3): Retained Earnings Earnings is the portion of annual profit that is distributable to owners. It is calculated based on the profit after taxes as determined by the statement of profit or loss and other comprehensive income. Portions for preference dividends or, in Germany, for legal reserves, do not contribute to earnings. As earnings also is an amount relevant for the earnings per share ratio earnings are defined by IAS 33. IAS 33.12 stipulates that earnings are profit or loss from continuing operations and profit or loss to parent adjusted for after-tax amounts for preference dividends or settlements or other effects of preference dividends. IAS 33 refers to the earnings of the Accounting period whereas the retained earnings can result from preceding years. The item retained earnings is used mainly for profit additions to equity and for the appropriations thereof. The additions give us credit entries whereas the appropriation of profits leads to debit entries in the Retained Earnings account. A loss is recorded as debit entry in the Retained Earnings account. A company that carries forward a profit or loss discloses a balancing figure in retained earnings. We studied YARRA Ltd.’s Bookkeeping entries for profit recording and appropriations above. Bookkeeping entries for profit and appropriation thereof are not repeated but some further considerations to the appropriation of profits are following: In case a company declares a dividend, the equity is reduced because we make a debit entry in the Retained Earnings account and credit short-term liabilities to shareholders. The account is the Shareholders for Dividend account which is linked to the item short-term <?page no="266"?> Berkau: Financial Statements 4e 11-262 liabilities on the balance sheet. Shareholders expect dividend payments as they represent her/ his share of the profit as they are partial owners of the company. Dividend payments are irreversible. It means once the dividend has been paid out shareholders do not pay them back. Additions/ deductions to earnings reserves fall under financing activities. Funds added to reserves stay in the company. Dividend reductions and dissolving are limited in many countries by national law, such as the Company’s Act, and require in general a majority decision on the annual general meeting. A carrying forward of profits in the Retained Earnings account can be seen as a postponement of the profit appropriation. The funds then stay in the equity section for the next Accounting period and are automatically added to the distributable amount in the next year. Hence, carrying forward profits compromise company’s interest of reinvest funds with the shareholders request on dividend payments. By carrying forward a profit the distributable amount in the next Accounting period increases. The distributable amount is the after-tax profit of the period plus the profits carried forward less losses carried forward from prior Accounting periods. Carrying forward a loss is an alternative to dissolving reserves. There are tax and reserves implications a company should consider based on national tax law and/ or Company’s Act. In Germany, § 150 AktG applies. The disclosure of equity can either result in a detailed equity section on the balance sheet or providing explanatory information in the notes. Below, we show an extended disclosure of the equity section for YARRA Ltd.’s balance sheet as at 31.12.20X1. 20X1 20X0 C, L [ZAR] Equity [ZAR] [ZAR] . . . Share capital ordinary shares R1 1,200,000 1,000,000 preference shares R1 500,000 500,000 Reserves Capital reserves 114,000 Earnings reserves 0 Retained earnings 137,500 137,500 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 11.4: Detailed equity section on YARRA Ltd.’s B/ S (20X1) <?page no="267"?> Berkau: Financial Statements 4e 11-263 20X2 20X1 C, L [ZAR] Equity [ZAR] [ZAR] . . . Share capital ordinary shares R1 1,200,000 1,200,000 preference shares R1 500,000 500,000 Reserves Capital reserves 114,000 114,000 Earnings reserves 200,000 0 Retained earnings 37,000 137,500 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 11.5: Detailed equity section on YARRA Ltd.’s B/ S (20X2) Summary: Equity is the book value of the business. You calculate the equity by deducting all debts from the total of assets. Equity changes based on transactions with owners, such as share issue, share redemption or dividend payments. It also increases or decreases by profit or loss and the appropriation thereof. Revaluations are recorded through equity, too. National law, in particular the Company’s act, includes special rules for items of the equity section on the balance sheet. Technical Accounting Terms: Equity: Difference between assets and liabilities. We often refer to equity as the book value of the company. Shares: Partial ownership of a company. It is disclosed at its nominal value on the equity section under issued capital or share capital. Preference shares: Shares without voting right but with a privilege regarding dividends and liquidation. Reserves: Portions of equity resulting from after-tax profits, share issues or revaluations. Earnings per share ratio: After-tax profit cleared of preference dividends, if applicable, divided by the amount of outstanding ordinary shares. IAS 33 applies. Redemption of shares: Shares bought back by the company in order to keep them as treasury shares or for invalidation. Share premium: Positive difference between issue price and nominal value. The share premium is added to capital reserves. Statement of changed in equity: Statement as element of financial statements that discloses the additions/ reductions of equity. See chapter (13). Treasury shares: Shares bought back buy the issuing company. Treasury shares are carried in a negative Equity account. This is referred to as contraequity account. <?page no="268"?> Berkau: Financial Statements 4e 11-264 Question Bank: (1) A company issues 10,000 fresh ordinary shares at 6.70 EUR/ s. The nominal value per share is 5.00 EUR/ s. What is the Bookkeeping entry? 1. DR Cash/ Bank … 50,000.00 EUR - CR Issued Capital … 50,000.00 EUR. 2. DR Cash/ Bank … 67,000.00 EUR - CR Issued Capital … 50,000.00 EUR, CR Earnings Reserves … 17,000.00 EUR. 3. DR Cash/ Bank … 67,000.00 EUR - CR Issued Capital … 50,000.00 EUR, CR Capital Reserves … 17,000.00 EUR. 4. DR Issued Capital … 67,000.00 EUR - CR Cash/ Bank … 50,000.00 EUR, CR Capital Reserves … 17,000.00 EUR. (2) On 1.10.20X3, a company issues 50,000 preference shares at an issue price of 1.30 EUR/ s. The premium is 0.30 EUR/ s. The preference dividend is 4.5 % based on the nominal value. The company has 100,000 ordinary shares at 1.00 EUR/ s. The profit before taxes is 25,000.00 EUR. It is decided to declare a dividend of the entire profit. How much is the ordinary dividend rounded down to the nearest EURcent? 1. 0.22 EUR/ s. 2. 0.15 EUR/ s. 3. 0.14 EUR/ s. 4. 0.16 EUR/ s. (3) A company has 200,000 ordinary shareholders. The fair market value per share is 3.45 EUR/ s. The company decides to issue 50,000 ordinary shares at 3.00 EUR/ s based on a rights issue. How much is the value for one purchase right? 1. 0.09 EUR/ r. 2. 0.36 EUR/ r. 3. 0.45 EUR/ r. 4. 0.23 EUR/ r. (4) A company earns a pre-tax profit of 100,000.00 EUR. The preference dividend is 6,000.00 EUR and got declared for the Accounting period. In the retained earnings is a profit carried forward to the extent of 50,000.00 EUR. How much are earnings based on IAS 33? 1. 64,000.00 EUR. 2. 94,000.00 EUR. 3. 114,000.00 EUR. 4. 144,000.00 EUR. (5) A company carries forward a loss of 26,000.00 EUR. In the actual Accounting period, it earns a profit after taxes of 75,000.00 EUR. At the end of June the company issued 50,000 preference shares at 5.50 EUR which is 0.50 EUR above face value. The preference dividend is 4 %/ a based on the nominal amount of the shares. How much is the distributable amount to the ordinary shareholders? 1. 43,500.00 EUR. 2. 39,000.00 EUR. 3. 44,000.00 EUR. 4. 49,000.00 EUR. Solutions: 1-3, 2-4, 3-2, 4-1, 5-3. <?page no="269"?> Berkau: Financial Statements 4e 12-265 12. Statement of Profit or Loss and Other Comprehensive Income Learning Objectives: Profit is the difference between income and expenses. In line with IAS 1.99, a company can either prepare the income statement along the nature of expense method or along the cost of sales format. It can be accompanied by a single statement of other comprehensive income (OCI) or other comprehensive income is included in the statement of profit or loss and other comprehensive income. For the disclosure of profit, a company shall prepare a statement of profit and loss and other comprehensive income for the Accounting period. This statement was previously called the income statement. The name is still common between Accountants. The statement of profit or loss and other comprehensive income is part of a full set of financial statements along IAS 1.10. It contains income, such as revenues and gains, and all expenses for the period no matter when payments are made or received. In this chapter (12), we teach you how to prepare the statement of profit and loss and other comprehensive income for service providers and production firms. We cover both formats for both cases in order to explain the details. We also discuss the most important regulations in IFRSs standards. An income statement compares income with expenses. The technical terms are defined by the framework. IAS 4.29 explains why the IASB does not distinguish properly between revenue and gains. Both are referred to as income. For our teaching purposes, we keep it like this: Revenue results from ordinary business, such as selling/ producing goods or service rendering, whereas gain is classified as extraordinary, such as a profit on disposal from a non-current asset or interest gains. See examples given by F.4.31. An expense is based on F.4.33 a loss or consumption of resources due to ordinary business, such as sales, wages, materials etc. Profit or loss as disclosed by an income statement is simply the calculation of the difference between all income and all expenses during an Accounting period. IAS 1.81 defines disclosure requirements for the income statement. As the user of financial statements analyses the statement of profit or loss and other comprehensive income in order to understand the business, not only pure profit or loss figures matter but a more detailed view on single items of income and expenses does. The detailed income and expenses explain how the company earns its money. The statement of profit or loss and other comprehensive income can follow a structure based on the nature or on the function of items. - If the income statement follows the nature of the expenses, the expenses are classified based on cost categories, such as labour, depreciation, materials etc. No cost allocations are made. The structure is referred <?page no="270"?> Berkau: Financial Statements 4e 12-266 to as the nature of expense format. The income statement along the nature of expense format is exemplified in IAS 1.102. - If the income statement is structured along the function of expenses, it is prepared with distinguishing different calculation objects and cost allocations thereto. Cost objects can be goods sold or services rendered. Commonly, we call that format the cost of sales format. The cost of sales format is covered by IAS 1.103. In regard to the decision which format a company should apply, IAS 1.99 only states the company shall choose the format that provides more reliable information and is more relevant. 43 The formal income statement requirements are based on IAS 1.81. Reporting companies normally do not provide a more detailed view than required. This means technically, that when preparing the income statement based on the Profit and Loss account, the Accountants summarise entries for the preparation of the income statement, such as combining expenses for rent and administration to be disclosed together as other expenses. This meets the requirements as prescribed in IAS 1.81. For this text book, we follow a standard structure for the income statement, as shown in Figure 12.3 for the NoEformat and in Figure 12.9 for the COSformat. We always apply the same format. 43 Read the ASHTON Ltd. case in our Basics-1, chapter (28). For the income statement the accrual principle of Accounting applies. In order to calculate the profit or loss for the period, it is necessary to allocate income and expenses to the Accounting period they are for. This is required in order to calculate the profit irrespectively from when payments are made. A flight ticket bought and paid today but flown in the next Accounting period counts as a next Accounting period’s expense. We refer to the underlying principle as the accrual basis of Accounting. When we make Bookkeeping entries, the payment date becomes relevant at first. After recording original Bookkeeping entries the Accountant has to make adjustments in order to make sure, all income and expenses are linked to the correct Accounting period, before the income statement is prepared. An extended income statement as applicable for AGs in Germany based on § 158 AktG does not apply for international Accounting. The appropriation of profits is disclosed in the statement of changes in equity, instead. Below, we compare the 2 different methods for the income statement: (a) Nature of expense method (NoE). (b) Cost of sales format (COS). We do so by 2 case studies: (A) ABINGTON Ltd., an Australian law firm. <?page no="271"?> Berkau: Financial Statements 4e 12-267 (B) SUTTHAUSEN PLC, a coffee machine producer in the UK. We choose 2 different company types for the case studies as the income statement for manufacturers covers finished goods that have been produced in the company. The goods are taken as cost objects and give us a classification of expenses based on the function for the company. In contrast, an income statement for a service provider is simpler. This is why we start our considerations with the case of the law firm ABINGTON Ltd. Ad (aA): Nature of Expense Method, ABINGTON Ltd. An income statement based on the nature of expense format is easy to prepare and does not require an allocation of expenses to Work-in-Process accounts. We explain the nature of expense format by ABINGTON Ltd. below. ABINGTON Ltd. is a law firm and specialised on conveyances of property. ABINGTON Ltd. is based in a rented offices and employs 6 attorneys and 20 paralegals. In 20X4, ABINGTON Ltd. transferred 700 houses and earned a revenue of 3,500.00 AUD per mandate. Between house conveyance and mandate is a 1: 1 relationship. An attorney at ABINGTON Ltd. earns 85,000.00 AUD/ a and a paralegal 38,000.00 AUD/ a. Further operational costs are 160,500.00 AUD/ a, such as for lease rates of computers, office material, internet access etc. The rent for the offices is amounting to 5,000.00 AUD/ m and paid one month in advance. Before ABINGTON Ltd. calculates profit or loss, we look at the accounts after recording the below listed activities: (1) Allocating prepaid rent. (2) Rental payment (no VAT considered). (3) Labour for attorneys. (4) Labour for paralegals. (5) Operational expenses (VATable 44 ). (6) Revenue recognition (VATable). Find in Figure 12.1 the accounts with the activities recorded in. The identifiers above are corresponding with the Bookkeeping entry reference numbers. D C D C . . . (2) 60,000.00 OV 5,000.00 (1) 5,000.00 (6) 3,024,000.00 (3) 510,000.00 RNT 5,000.00 (4) 760,000.00 (5) 192,600.00 c/ d 1,501,400.00 3,024,000.00 3,024,000.00 b/ d 1,501,400.00 Cash/ Bank C/ B Prepaid expenses PRE Figure 12.1: ABINGTON Ltd.’s accounts (20X4) 44 The expression means value added tax applies. <?page no="272"?> Berkau: Financial Statements 4e 12-268 D C D C (1) 5,000.00 (3) 510,000.00 c/ d 510,000.00 (2) 60,000.00 c/ d 65,000.00 b/ d 510,000.00 65,000.00 65,000.00 b/ d 65,000.00 PRE 5,000.00 c/ d 60,000.00 65,000.00 65,000.00 b/ d 60,000.00 Rent-20X4 RNT Labour Attorneys-20X4 LAA D C D C (4) 760,000.00 c/ d 760,000.00 (5) 160,500.00 c/ d 160,500.00 b/ d 760,000.00 b/ d 160,500.00 Labour Paralegals-20X4 LAP Operational expenses-20X4 OEX D C D C c/ d 2,520,000.00 (6) 2,520,000.00 (5) 32,100.00 (6) 504,000.00 b/ d 2,520,000.00 c/ d 471,900.00 504,000.00 504,000.00 b/ d 471,900.00 Revenue-20X4 REV Value added taxes VAT Figure 12.1: ABINGTON Ltd.’s accounts (20X4) continued Before profit can be calculated, an adjustment with regard to prepaid rent is required. That way, ABINGTON Ltd. makes sure the accrual principle of Accounting applies. See the Bookkeeping entry below for recording prepaid rent. In order to distinguish this Bookkeeping entry from the first one, we indicate the adjustment by the contra account ID. PRE for prepaid expenses and RNT for rent. You find the entries for the adjustments in Figure 12.1 already. DR Prepaid Expenses............. 5,000.00 AUD CR Rent......................... 5,000.00 AUD The Profit and Loss account reveals ABINGTON Ltd.’s profit of 720,650.00 AUD after taxation. <?page no="273"?> Berkau: Financial Statements 4e 12-269 D C D C RNT 60,000.00 REV 2,520,000.00 c/ d 308,850.00 P&L 308,850.00 LAA 510,000.00 b/ d 308,850.00 LAP 760,000.00 OEX 160,500.00 EBT 1,029,500.00 2,520,000.00 2,520,000.00 D C ITL 308,850.00 b/ d 1,029,500.00 c/ d 720,650.00 P&L 720,650.00 R/ E 720,650.00 b/ d 720,650.00 1,029,500.00 1,029,500.00 Profit and Loss-20X4 P&L Income tax liabilities ITL Retained earnings R/ E Figure 12.2: ABINGTON Ltd.’s Profit and Loss calculation (NoE) ABINGTON Ltd. prepares an income statement and combines certain entries of the Profit and Loss account to income statement items, such as different labour categories are summarised for the item labour and rent and operational expenses are added for the item other expenses. See the income statement prepared based on the nature of expense format below in Figure 12.3. [AUD] Revenue 2,520,000 Other income 0 2,520,000 Materials 0 Labour (1,270,000) Depreciation 0 Other expenses (220,500) Earnings before int. & taxes (EBIT) 1,029,500 Interest Earnings before taxes (EBT) 1,029,500 Income tax expenses (308,850) Deferred taxes Earnings after taxes (EAT) 720,650 Abington Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 12.3: ABINGTON Ltd.’s income statement (NoE) In regard to the name of the statement, we apply the previous writing Profit & Loss instead of Profit or Loss. The IASB changed the name when adding the other comprehensive income in order to avoiding the double “and” in the name. We also call the account Profit & Loss P&L in this text book. We continue the case study ABINGTON below for the cost of <?page no="274"?> Berkau: Financial Statements 4e 12-270 sales format after introducing the income statement along the nature of expense method for a production firm. 45 Ad (aB): Nature of Expense Method, SUTTHAUSEN PLC With regard to income statements, a production firm requires further consideration, as a producer adds selfmanufactured goods to stock, which results in an increase of assets and reduction of expenses in the Accounting period when it manufactures the goods. We discuss below the income statement for the coffee machine manufacturer SUTTHAUSEN PLC in order to explain the statement of profit or loss and other comprehensive income. SUTTHAUSEN PLC adds finished goods to stock at the end of the Accounting period 20X4. In terms of most expenses, the income statement of a production firm is not different from non-manufacturing companies. However, once the amount of finished goods inventories increases the difference is added to the asset side and recorded as negative expenses through profit or loss. This means, we make a debit entry in the Finished Goods Inventory account and an entry in the Profit and Loss account on the credit side. Hence, we cancel out the expenses for the cost of manufacturing that have been added to the Inventory of Finished Goods account. As a consequence, producing goods and not selling them has no impact on profit or loss. We already recorded changes of inventories this way 45 You also can skip the production firms and proceed straight to paragraph (bA): COS at ABINGTON Ltd. by making a “closing stock”-entry on the credit side of RYNEVELD (Pty) Ltd.’s Trading account in chapter (4). 46 Caution! The consideration of closing stock requires to make an entry for the opening value in the Trading account, too. This way the changes (and not the closing stock) in inventory are recorded. The measurement of inventory changes is based on the cost of manufacturing which includes the purchase cost of materials plus all costs of conversion. Conversion costs are direct labour and manufacturing overheads. The latter ones must be linked to production, such as depreciation on factory building, machinery, and can include allocated portions of production management, maintenance costs etc. In contrast, common Administration, such as Accounting or Marketing are considered non-manufacturing related and are excluded from finished goods calculation. As discussed in chapter (9), cost of manufacturing can be adjusted by overor under-applied overheads. Once the goods are sold they become expenses and are recorded through profit or loss, meaning we make a debit entry in the Cost of Goods Sold account which later is closed-off to the Profit and Loss account. This means, goods become only an expense when sold and not when they are manufactured. As finished goods most likely contain fixed costs, selling goods in a later period results in a deferral of overheads in inventories and once sold later, manufacturing overheads are released from inventories. 46 The entry is: “INV: 56,000.00” on the T/ A’s credit side in Figure. <?page no="275"?> Berkau: Financial Statements 4e 12-271 For the deferring and releasing of manufacturing costs, look at case study ANKYO Ltd. You reach the case study via the Link 12.A. Link 12.A: ANKYO Ltd. Below, we apply the nature of expense method for SUTTHAUSEN PLC. SUTTHAUSEN PLC is a manufacturer for espresso machines in the UK. An expresso machine contains a water pump and a coffee-capsule-dispense-unit CCDU. For shipping, the espresso machine is packed into a box. At the beginning of the Accounting period 20X4, SUTTHAUSEN PLC has 3,000 CCDUs at 14.00 GBP/ p on stock. Look at SUTTHAUSEN PLC.’s balance sheet in Figure 12.4. A C, L Non-current assets [GBP] Equity [GBP] P, P, E 100,000 Share capital 50,000 Intangibles Reserves 10,000 Financial assets Retained earnings Current assets Liabilities (liab.) Inventory 42,000 Long-term liab. Accounts receivables Short-term liab. A/ P 90,000 Prepaid expenses Provisions Cash/ Bank 8,000 Income tax liab. Total assets 150,000 Total equity and liab. 150,000 Sutthausen PLC.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X4 Figure 12.4: SUTTHAUSEN PLC’s balance sheet (20X3) The production process of the espresso machines follows a Process Costing. 47 At first, the expresso machines are assembled in the Assembling department. The next step is a cleaning process followed by packing. SUTTHAUSEN PLC operates three departments: Assembling, Cleaning and Packing. During the Accounting period 20X4, SUTTHAUSEN Ltd. purchases the materials below: 47 Read our Basics-2, chapter (17). <?page no="276"?> Berkau: Financial Statements 4e 12-272 Item Date of purchase Amount Unit costs Cost of purchase [GBP] [GBP] CCDU 2.01.20X4 30,000 14.00 420,000.00 Water pump 3.01.20X4 20,000 9.50 190,000.00 boxes 6.01.20X4 30,000 1.00 30,000.00 Water pump 14.01.20X4 20,000 10.50 210,000.00 cleaning soap for 100 machines 15.01.20X4 400 10.00 4,000.00 SUTTHAUSEN PLC's PURCHASE LEDGER for the period ended 31.12.20X4 Figure 12.5: SUTTHAUSEN PLC’s purchase ledger During the Accounting period 20X4, SUTTHAUSEN PLC produces 30,000 espresso machines. 48 In 20X4, SUTTHAUSEN PLC records 28,000.00 GBP depreciation on the Assembling department, 1,000.00 GBP depreciation on the Cleaning department and 2,000.00 GBP depreciation on the Shipping department. Labour is 40,000.00 GBP/ a in the Assembling department, 30,000.00 GBP/ a in the Cleaning department and 25,000.00 GBP/ a in the Shipping department. There is a further 55,000.00 GBP labour in the Management/ Administration department. In 20X4, SUTTHAUSEN Ltd. sells 28,500 espresso machines at 60.00 GBP net selling price. We make the Bookkeeping entries as below and follow at first a periodic inventory system based on the weighted average cost formula. (1) Purchase of CCDUs. (2) Purchase of water pumps. (3) Purchase of boxes. (4) Purchase of water pumps. (5) Purchase of soap. (6) Depreciation Assembling. (7) Depreciation Cleaning. (8) Depreciation Shipping. 48 To keep this case simple, we assume there is only one batch. (9) Accounting for labour Assembling. (10) Accounting for labour Cleaning. (11) Accounting for labour Shipping. (12) Accounting for labour, Management/ Administration. (13) Revenue recognition. At the end of 20X4, there are: 3,000 × 14 = 442,000.00 GBP CCDUs on stock. There are further: 10,000 × (20,000 × 9.50 + 20,000 × 10.50)/ 40,000 = 1 100,000.00 GBP water pumps on stock. SUTTHAUSEN PLC has 1,500 espresso machines on stock which have not yet been sold. The value per espresso machine requires calculations based on the weighted average cost formula. This means, left espresso machines are calculated on yearly average purchase costs. As the nature of expense method does not support calculations, we calculate the finished goods by a working: The unit cost of manufacturing are the materials plus depreciation and manufacturing overheads for labour which gives in total: 14 + (20,000 × 9.50 + 20,000 × 10.50) / 40,000 + 1 + 0.10 + (31,000 + 95,000) / 30,000 = 14 + 10 + 1 + 0.1 + 4.2 = 2 29.30 GBP/ p. Hence, the closing stock <?page no="277"?> Berkau: Financial Statements 4e 12-273 of 1,500 espresso machines is amounting to: 29.30 × 1,500 = 4 43,950.00 GBP. Find below SUTTHAUSEN PLC’s accounts and the income statement in Figure 12.6 and Figure 12.7. D C D C OV 100,000.00 c/ d 100,000.00 (1) 420,000.00 P&L 853,000.00 b/ d 100,000.00 (2) 190,000.00 (3) 30,000.00 (4) 210,000.00 (5) 3,000.00 853,000.00 853,000.00 Property, Plant, Equipment PPE Purchase-20X4 PRC D C D C c/ d 90,000.00 OV 90,000.00 OV 42,000.00 P&L 42,000.00 b/ d 90,000.00 I.CC 42,000.00 c/ d 42,000.00 84,000.00 84,000.00 b/ d 42,000.00 Accounts payables A/ P Inventory CCDU I.CC D C D C P&L 100,000.00 c/ d 100,000.00 P&L 43,950.00 c/ d 43,950.00 b/ d 100,000.00 b/ d 43,950.00 Inventory water pump I.WP Finished goods inventory FGI D C D C (1) 84,000.00 (13) 342,000.00 OV 8,000.00 (1) 504,000.00 (2) 38,000.00 (13) 2,052,000.00 (2) 228,000.00 (3) 6,000.00 (3) 36,000.00 (4) 42,000.00 (4) 252,000.00 (5) 600.00 (5) 3,600.00 c/ d 171,400.00 (9) 40,000.00 342,000.00 342,000.00 (10) 30,000.00 b/ d 171,400.00 (11) 25,000.00 (12) 55,000.00 c/ d 886,400.00 2,060,000.00 2,060,000.00 b/ d 886,400.00 Value added tax VAT Cash/ Bank C/ B D C D C c/ d 50,000.00 OV 50,000.00 c/ d 10,000.00 OV 10,000.00 b/ d 50,000.00 b/ d 10,000.00 Share capital ISS Reserves RES Figure 12.6: SUTTHAUSEN PLC’s accounts (NoE) <?page no="278"?> Berkau: Financial Statements 4e 12-274 D C D C P&L 1,710,000.00 (13) 1,710,000.00 (12) 55,000.00 P&L 55,000.00 1,710,000.00 1,710,000.00 Sales revenue-20X4 REV Management/ Admin-20X4 M/ A D C D C (6) 28,000.00 P&L 31,000.00 (6) 28,000.00 (7) 1,000.00 (7) 1,000.00 (8) 2,000.00 c/ d 31,000.00 (8) 2,000.00 31,000.00 31,000.00 31,000.00 31,000.00 b/ d 31,000.00 Depreciation-20X4 DPR Acc depr ACC D C D C (9) 40,000.00 P&L 95,000.00 (12) 55,000.00 P&L 55,000.00 (10) 30,000.00 (11) 25,000.00 95,000.00 95,000.00 Labour-20X4 LAB Management/ Admin-20X4 M/ A D C D C I.CC 42,000.00 Rev 1,710,000.00 c/ d 573,965.00 R/ E 573,965.00 PRC 853,000.00 FGI 43,950.00 b/ d 573,965.00 M/ A 55,000.00 I.CC 42,000.00 LAB 95,000.00 I.WP 100,000.00 DPR 31,000.00 EBT 819,950.00 1,895,950.00 1,895,950.00 D C ITL 245,985.00 b/ d 819,950.00 c/ d 245,985.00 P&L 245,985.00 R/ E 573,965.00 b/ d 245,985.00 819,950.00 819,950.00 Income tax liabilities ITL Profit and Loss-20X4 P&L Retained earnings R/ E Figure 12.6: SUTTHAUSEN PLC’s accounts (NoE) continued <?page no="279"?> Berkau: Financial Statements 4e 12-275 [GBP] Revenue 1,710,000 Other income 43,950 1,753,950 Materials (753,000) Labour (150,000) Depreciation (31,000) Other expenses 0 Earnings before int. & taxes (EBIT) 819,950 Interest Earnings before taxes (EBT) 819,950 Income tax expenses (245,985) Deferred taxes Earnings after taxes (EAT) 573,965 Sutthausen PLC's STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 12.7: SUTTHAUSEN PLC’s income statement (NoE) On SUTTHAUSEN PLC’s statement of profit or loss and other comprehensive income, aggregated costs are disclosed, such as labour (for manufacturing as well as for management/ administration), depreciation (on all machinery) etc. Ad (bA): Cost of Sales Format, ABINGTON Ltd. We now repeat the preparation of the income statement but apply the alternative method: the cost of sales COSformat. As goods are only disclosed for goods/ services sold, no closing stock of inventories is shown in order to adjust costs to income. At the first glance, this sounds fairly easy, but it is not. The cost of sales format makes us allocate costs to goods/ services which results in extra Accounting work. The allocations provide the user of financial statements with better product information. Following the nature of expense method, we only close-off the nominal accounts to the Trading/ Profit and Loss account. In contrast, the cost of sales format allocates every cost to goods/ services and only shows cost of goods/ services once sold. Hence, costs for goods still on stock do not show on the statement of profit and loss and other comprehensive income. An income statement based on the cost of sales format for a one-service company is easier than for a manufacturing firm with a lot of different goods produced in batches. At ABINGTON Ltd. there is only one service rendered: the transfer of property. The costs are either linked to the service which we refer to as manufacturing costs, or are common costs which are disclosed separately on the income statement. The latter ones are non-manufacturing costs. <?page no="280"?> Berkau: Financial Statements 4e 12-276 We repeat the major characteristics of ABINGTON Ltd.: Law firm, employing 6 attorneys (salary 85,000.00 AUD/ (a × e) and 20 paralegals (38,000.00 AUD/ (a × e). In 20X4, ABINGTON Ltd. conveys 700 houses at a revenue of 3,500.00 AUD/ mandate. 160,500.00 AUD/ a operational expenses apply. We start-off after initial Bookkeeping entries have been made as shown in Figure 12.1 which is before profit calculation begins. The cost of sales format requires a product calculation, here, the calculation per property transfer. The Work-in-Process account and the Manufacturing Overhead account apply. At ABINGTON Ltd., we can change the name of the latter account and call it the Conveyance Overhead COH account. All direct costs are closed-off to the WIP account. Here, the direct costs are the attorney’s costs which are amounting to 680.00 AUD/ mandate. We add: 680 × 700 = 4 476,000.00 AUD to the WIP account. Attorneys’ costs to an extent of 34,000.00 AUD are for administration purpose and as a consequence are prohibited for allocation to mandates. Observe the Bookkeeping entries below. DR WIP-Account.................. 476,000.00 AUD CR Labour Attorneys............. 476,000.00 AUD DR Administration............... 34,000.00 AUD CR Labour Attorneys............. 34,000.00 AUD The labour of paralegals is completely for the mandates. The same applies for the operational costs. Both are transferred to the Conveyance Overheads account. DR COH-Account.................. 760,000.00 AUD CR Labour Paralegals............ 760,000.00 AUD DR COH-Account.................. 160,500.00 AUD CR Operational Expenses......... 160,500.00 AUD The application of overheads is based on normal capacity which results in a cost rate of 1,315.00 AUD/ mandate. 49 We allocate: 700 × 1,315 = 9 920,500.00 AUD, meaning we add them to the Work-in- Process account and credit the amount to the Conveyance Overheads account. This results in a closing-off of the Conveyance Overheads account. The Work-in-Process account can be closed-off directly to the Profit and Loss account or through the Cost of Goods Sold account. Observe below the calculation of the conveyance service in the Work-in-Process account and the income statement as displayed in Figure 12.8 and Figure 12.9. 49 The amount is given. <?page no="281"?> Berkau: Financial Statements 4e 12-277 D C D C . . . (2) 60,000.00 OV 5,000.00 (1) 5,000.00 (6) 3,024,000.00 (3) 510,000.00 RNT 5,000.00 (4) 760,000.00 (5) 192,600.00 c/ d 1,501,400.00 3,024,000.00 3,024,000.00 b/ d 1,501,400.00 Cash/ Bank C/ B Prepaid expenses PRE D C D C (1) 5,000.00 (3) 510,000.00 c/ d 510,000.00 (2) 60,000.00 c/ d 65,000.00 b/ d 510,000.00 WIP 476,000.00 65,000.00 65,000.00 ADM 34,000.00 b/ d 65,000.00 PRE 5,000.00 510,000.00 510,000.00 c/ d 60,000.00 65,000.00 65,000.00 b/ d 60,000.00 P&L 60,000.00 Rent-20X4 RNT Labour Attorneys-20X4 LAA D C D C (4) 760,000.00 c/ d 760,000.00 (5) 160,500.00 c/ d 160,500.00 b/ d 760,000.00 COH 760,000.00 b/ d 160,500.00 P&L 160,500.00 Labour Paralegals-20X4 LAP Operational expenses-20X4 OEX D C D C c/ d 2,520,000.00 (6) 2,520,000.00 (5) 32,100.00 (6) 504,000.00 P&L 2,520,000.00 b/ d 2,520,000.00 c/ d 471,900.00 504,000.00 504,000.00 b/ d 471,900.00 Revenue-20X4 Value added tax VAT D C D C LAA 476,000.00 COS 1,396,500.00 LAP 760,000.00 WIP 920,500.00 COH 920,500.00 OEX 160,500.00 1,396,500.00 1,396,500.00 920,500.00 920,500.00 Work-in-Process-20X4 WIP Conveyance overheads-20X4 COH D C D C LAA 34,000.00 P&L 34,000.00 WIP 1,396,500.00 P&L 1,396,500.00 Administration-20X4 ADM Cost of Sales-20X4 COS Figure 12.8: ABINGTON Ltd.’s accounts (COS) <?page no="282"?> Berkau: Financial Statements 4e 12-278 D C D C COS 1,396,500.00 REV 2,520,000.00 c/ d 308,850.00 P&L 308,850.00 ADM 34,000.00 b/ d 308,850.00 RNT 60,000.00 EBT 1,029,500.00 2,520,000.00 2,520,000.00 ITL 308,850.00 b/ d 1,029,500.00 D C R/ E 720,650.00 c/ d 720,650.00 P&L 720,650.00 1,029,500.00 1,029,500.00 b/ d 720,650.00 Profit and Loss-20X4 P&L Income tax liabilities ITL Income tax liabilities ITL Figure 12.8: ABINGTON Ltd.’s accounts (COS) continued [AUD] Revenue 2,520,000 Other income 0 2,520,000 COS (1,396,500) Other expenses (94,000) Earnings before int. & taxes (EBIT) 1,029,500 Interest Earnings before taxes (EBT) 1,029,500 Income tax expenses (308,850) Deferred taxes Earnings after taxes (EAT) 720,650 Abington Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 12.9: ABINGTON Ltd.’s income statement (COS) The income statement now only shows the cost attributable to services and as other expenses for administration and rent. A company can disclose single items for different services and products, however, IAS 1.81A does not request in particular. Only in cases a company works in different industries, such as a software design company that offers consultancy, has to disclose revenue and expenses linked to its products as segment reporting. Ad (bB): Cost of Sales Format, SUTTHAUSEN PLC We now study the income statement for SUTTHAUSEN PLC again and deal with 1,500 espresso machines added to stock in 20X4, again. In order to review the case, we give you the major characteristics of SUTTHAUSEN PLC below: In 20X4, SUTTHAUSEN PLC manufactures 30,000 espresso machines and sells 28,500 thereof at 60.00 GBP net selling price. There are 3 production steps: Assembling (labour: 40,000.00 GBP, depreciation: 28,000.00 GBP), <?page no="283"?> Berkau: Financial Statements 4e 12-279 Cleaning (labour: 30,000.00 GBP, depreciation: 1,000 GBP) and Shipping (labour: 25,000.00 GBP, depreciation: 2,000.00 GBP). In the entire company, there are 55,000.00 GBP for Management in 20X4. The cost of purchase for the materials are given by Figure 12.5. The consumption of opening stock for CCDUs (42,000) and the purchases of CCDUs, water pumps, boxes and cleaning soap are based on the production of 30,000 espresso machines. We now prepare a profit calculation based on 3 WIP accounts and 3 Manufacturing Overhead accounts - for each department. The Bookkeeping entries (1) to (12) are the same as along the nature of expense method. As we now apply the cost of sales format, the inventory movement system changes to the perpetual system, too. Hence, we add purchases to the stock accounts for CCDUs, water pumps, boxes and cleaning soap. We observe the handling of CCDUs. The purchase are transferred to the Inventory CCDU account. CCDUs released from stock are: 30,000 × 14 = 4 420.000.00 GBP. They are added to the WIP Assembling account. Observe the Bookkeeping entries below with regard to the CCDUs. DR Inventory CCDU ............... 420,000.00 GBP CR Purchase..................... 420,000.00 GBP DR WIP Assembling............... 420,000.00 GBP CR Inventory CCDU ............... 420,000.00 GBP Other materials are recorded in the same way. The overheads, such as labour and depreciation are added to the Manufacturing Overhead accounts. See below the additions to the Manufacturing Overheads-Assembling account. DR MOH Assembling MOA ........... 40,000.00 GBP CR Labour....................... 40,000.00 GBP DR MOH Assembling MOA ........... 28,000.00 GBP CR Depreciation ................. 28,000.00 GBP Labour and depreciation are allocated to the Cleaning and Shipping department similarly. The application of overheads does not cause overnor under-applications. Hence, all overheads are transferred to the Work-in-Process accounts. See, e.g., the application of overheads in the Assembling department. <?page no="284"?> Berkau: Financial Statements 4e 12-280 DR WIP Assembling WIA........... 68,000.00 GBP CR MOH Assembling MOA........... 68,000.00 GBP The application of manufacturing overheads in the other departments is recorded in the same way. In a Process Costing system, the cost of manufacturing are transferred from one department to the next one. As a consequence, the Bookkeeping entries below apply: DR WIP Cleaning WIC............. 788,000.00 GBP CR WIP Assembling WIA........... 788,000.00 GBP DR WIP Shipping WIS............. 822,000.00 GBP CR WIP Cleaning WIC............. 822,000.00 GBP In a similar Bookkeeping entry, the completed goods are transferred from the last step of production (Shipping department) to the Finished Goods Inventory account. When the goods production is completed the storage manager initiates the Bookkeeping entry below to add them to the Finished Goods Inventory account: DR FG Inventory................. 879,000.00 GBP CR WIP Shipping WIS............. 879,000.00 GBP According to the perpetual inventory system, we make two Bookkeeping entries to record a sale of goods. One is for the cash receipt and another one is for the inventory movement. Inventory movement requires to add 28,500 expresso machines to the Cost of Goods Sold account based on a valuation of cost of manufacturing. The cost of manufacturing per batch can easily be calculated by dividing all costs of manufacturing by the lot size, here it gives: 879,000 / 30,000 = 2 29.30 GBP. Hence, the inventory movement is: 29.30 × 28,500 = 835,050.00 GBP. At SUTTHAUSEN PLC, there is only one sale for all espresso machines, to keep the case simple. We skip the Cost of Goods Sold account but identify the Bookkeeping entry for inventory movements by the 3-letter code COS. You find the contra entry in the Profit and Loss account. See below both Bookkeeping entries: DR Cash/ Bank.................... 2,052,000.00 GBP CR VAT.......................... 342,000.00 GBP CR Revenue...................... 1,710,000.00 GBP DR P&L-Account.................. 835,050.00 GBP CR FG Inventory................. 835,050.00 GBP <?page no="285"?> Berkau: Financial Statements 4e 12-281 After the sale, we prepare a Profit and Loss account and only consider expenses for the sale of goods plus non-manufacturing expenses for Management / Administration therein. The profit is the same as calculated above under the nature of expense method. Observe the profit calculation based on the accounts displayed in Figure 12.10. D C D C OV 100,000.00 c/ d 100,000.00 (1) 420,000.00 I.CC 420,000.00 b/ d 100,000.00 (2) 190,000.00 I.WP 400,000.00 (3) 30,000.00 I.BX 30,000.00 (4) 210,000.00 I.SP 3,000.00 (5) 3,000.00 853,000.00 853,000.00 Property, Plant, Equipment Purchase-20X4 PRC D C D C c/ d 90,000.00 OV 90,000.00 OV 42,000.00 WI.A 420,000.00 b/ d 90,000.00 PRC 420,000.00 c/ d 42,000.00 462,000.00 462,000.00 b/ d 42,000.00 Accounts payables A/ P Inventory CCDU I.CC D C D C PRC 400,000.00 WI.A 300,000.00 PRC 30,000.00 WI.C 30,000.00 c/ d 100,000.00 400,000.00 400,000.00 b/ d 100,000.00 Inventory water pump I.WP Inventory box I.BX D C D C PRC 3,000.00 WI.C 3,000.00 WIS 879,000.00 COS 835,050.00 c/ d 43,950.00 879,000.00 879,000.00 b/ d 43,950.00 Inventory soap I.SP Finished goods inventory FG Figure 12.10: SUTTHAUSEN PLC’s accounts (COS) <?page no="286"?> Berkau: Financial Statements 4e 12-282 D C D C (1) 84,000.00 (13) 342,000.00 OV 8,000.00 (1) 504,000.00 (2) 38,000.00 (13) 2,052,000.00 (2) 228,000.00 (3) 6,000.00 (3) 36,000.00 (4) 42,000.00 (4) 252,000.00 (5) 600.00 (5) 3,600.00 c/ d 171,400.00 (9) 40,000.00 342,000.00 342,000.00 (10) 30,000.00 b/ d 171,400.00 (11) 25,000.00 (12) 55,000.00 c/ d 886,400.00 2,060,000.00 2,060,000.00 b/ d 886,400.00 Value added tax VAT Cash/ Bank C/ B D C D C c/ d 50,000.00 OV 50,000.00 c/ d 10,000.00 OV 10,000.00 b/ d 50,000.00 b/ d 10,000.00 Share capital SCP Reserves RES D C D C P&L 1,710,000.00 (13) 1,710,000.00 (12) 55,000.00 P&L 55,000.00 1,710,000.00 1,710,000.00 Sales revenue-20X4 REV Management/ Admin-20X4 M/ A D C D C (6) 28,000.00 MOA 28,000.00 (6) 28,000.00 (7) 1,000.00 MOC 1,000.00 (7) 1,000.00 (8) 2,000.00 MOS 2,000.00 c/ d 31,000.00 (8) 2,000.00 31,000.00 31,000.00 31,000.00 31,000.00 b/ d 31,000.00 Depreciation-20X4 DPR Acc depr ACC D C D C (9) 40,000.00 MOA 40,000.00 (12) 55,000.00 P&L 55,000.00 (10) 30,000.00 MOC 30,000.00 (11) 25,000.00 MOS 25,000.00 95,000.00 95,000.00 Labour-20X4 LAB Management/ Admin-20X4 M/ A D C D C I.CC 420,000.00 WIC 788,000.00 LAB 40,000.00 WIA 68,000.00 I.WP 300,000.00 DPR 28,000.00 MOA 68,000.00 68,000.00 68,000.00 788,000.00 788,000.00 WIP Assembling WIA MOH Assembling MOA Figure 12.10: SUTTHAUSEN PLC’s accounts (COS) continued <?page no="287"?> Berkau: Financial Statements 4e 12-283 D C D C I.SP 3,000.00 WIS 822,000.00 LAB 30,000.00 WIC 31,000.00 WIA 788,000.00 DPR 1,000.00 MOC 31,000.00 31,000.00 31,000.00 822,000.00 822,000.00 WIP Cleaning WIC MOH Cleaning MOC D C D C I.BX 30,000.00 FG 879,000.00 LAB 25,000.00 WIS 27,000.00 WIC 822,000.00 DPR 2,000.00 MOS 27,000.00 27,000.00 27,000.00 879,000.00 879,000.00 WIP Shipping WIS MOH Shipping MOS D C D C COS 835,050.00 Rev 1,710,000.00 c/ d 573,965.00 R/ E 573,965.00 M/ A 55,000.00 b/ d 573,965.00 EBT 819,950.00 1,710,000.00 1,710,000.00 ITL 245,985.00 b/ d 819,950.00 R/ E 573,965.00 D C 819,950.00 819,950.00 c/ d 245,985.00 P&L 245,985.00 b/ d 245,985.00 Profit and Loss-20X4 P&L Retained earnings R/ E Income tax liabilities Figure 12.10: SUTTHAUSEN PLC’s accounts (COS) continued If you get the impression the cost of sales format is more Accounting work you are absolutely right. However, this only matters if you do Accounting in the university on paper or by MS- Excel. In real Accounting, your Bookkeeping software does all the calculations. After customizing your system, a few more accounts won’t do any harm. The advantage of the cost of sales format lays in the calculation of goods/ services within the accounts. You do not need a working sheet for calculations as you do for the nature of expense method. However, the reporting company decides what information is provided by the financial statements, either cost categories by the nature of expense method or product/ service costs by the cost of sales format. Below, you’ll find the income statement based on the cost of sales format: As the cost of sales format does not support information about expense types and is based on allocations, a company preparing the income statement based on the cost of sales format shall provide additional information with regard to the nature of expenses as stated in IAS 1.105. In case of SUTTHAUSEN PLC, the income statement as displayed in Figure 12.11 may require further disclosure for labour and depreciation. <?page no="288"?> Berkau: Financial Statements 4e 12-284 [GBP] Revenue 1,710,000 Cost of goods sold (835,050) Other expenses (55,000) Earnings before int. & taxes (EBIT) 819,950 Interest Earnings before taxes (EBT) 819,950 Income tax expenses (245,985) Deferred taxes Earnings after taxes (EAT) 573,965 Sutthausen PLC's STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 12.11: SUTTHAUSEN PLC’s income statement (COS) Summary: IAS 1.82 determines what to disclose in the profit and loss section of the statement of profit or loss and other comprehensive income. IAS 1.99 requires a company to present an analysis of recognised expenses either based on nature of expense or cost of sales, whatever information is more reliable and/ or more relevant. Hence, the judgement of how to prepare the income statement is with the reporting company’s Accountant. The presentation of profit or loss is in the income statement. A structure for the nature of expense method is provided by IAS 1.102, one for the cost of sales format follows in IAS 1.103. Both formats for the statement of profit or loss and other comprehensive income result in the same profit or loss. Accounting Technical Terms: Accrual basis of Accounting: Principle by which income and expenses are assigned to the period they are for, irrespectively of when payments or receipts take place. Cost of sales: Format for the presentation of a statement of profit or loss which classifies expenses based on functions for the company. Allocations of expenses apply in order to assign costs to objects, such as certain goods or services. Gain: Extraordinary revenue. Income statement: Statement of profit or loss and other comprehensive income. In the old days, an income statement was net of other comprehensive income. Nowadays, we apply the name income statement for a statement that includes ordinary and extraordinary profits/ gains and expenses. IAS 1.81 applies. Nature of expense: Format for the presentation of a statement of profit or loss which classifies expenses based on cost categories. Other comprehensive income: Revenue that is not from continued operations, such as profit on disposals of <?page no="289"?> Berkau: Financial Statements 4e 12-285 non-current assets. The expression is also in use for extraordinary expenses. Question Bank: (1) A company records an opening value of finished goods of 350.00 EUR and a closing stock of 120.00 EUR. The revenue is amounting to 1,000.00 EUR. Operational expenses are 200.00 EUR. How much is the profit before income taxes? 1. 1,030.00 EUR. 2. 680.00 EUR. 3. 570.00 EUR. 4. 1,150.00 EUR. (2) Which statement is correct? 1. The COS-format applies allocations in order to assign expenses to cost categories. 2. The NoE-format records expenses based on its function for the entity. 3. The NoE-format uses cost allocations in order to assign expenses to cost objects. 4. The NoE-format records expenses based on characteristics and not along its function. (3) Which of the below listed items are disclosed on the statement of profit or loss and other comprehensive income that is prepared along the COS-format? 1. Revenue, cost of services rendered, administration expenses, interest. 2. Revenue, gain, cost of goods sold, depreciation, interest. 3. Profit, gain, labour, depreciation, interest. 4. Revenue, dividend income, labour, interest. (4) A company spends 50,000.00 EUR on materials and 70,000.00 EUR on direct labour. The applied overheads are 40,000.00 EUR. This is an over-application of overheads to the extent of 10 % based on the applied amount. During the Accounting period, 800 goods are manufactured. 100 thereof are faulty and chucked away. The company sells 622 of the goods. How much are the cost of sales? 1. 124,400.00 EUR. 2. 125,974.68 EUR. 3. 128,400.00 EUR. 4. 120,400.00 EUR. (5) Which accounts are required in order to prepare a statement of profit or loss and other comprehensive income along the nature of expense format? 1. Revenue account, Purchase account, Trading account, Manufacturing Overheads account. 2. Revenue account, Purchase account, Cost of Goods Sold account and Administration account. 3. Trading account, Purchase account, Finished Goods Inventory account, Manufacturing Overheads account. 4. Revenue account, Cost of Sales account, Manufacturing Overheads account, Work-in-Process account. Solutions: 1-3, 2-4, 3-1, 4-4, 5-2. <?page no="290"?> Berkau: Financial Statements 4e 13-286 13. Statement of Changes in Equity Learning Objectives: The statement of changes in equity tells the user of financial statements how and for what reasons the book value of the company increases or decreases. The information is important to make reasonable decisions about investments in a company. In some countries, such as Germany, no statement of changes in equity is required. Although, § 158 AktG makes companies based on shares extend their income statements in order to disclose the appropriation of profits. In this chapter (13), we cover the preparation of a statement of changes in equity by the case study BELMONT Ltd., a share based gym in South Africa. We cover all kind of situations that might change the equity section: Share issue and treasury shares, dividend receipts, profit and its appropriation as well as a revaluation of investments. We further refer to the major IFRS standards and paragraphs for the preparation and disclosure of the statement in equity and the information disclosed by the notes. No IFRS standard is directly dedicated to the statement of changes in equity. The main regulations result from IAS 1.106 to IAS 1.110. Therein, the IASB mandates that a company has to prepare a statement of changes in equity as it is part of a full set of financial statements based on IAS 1.10. IAS 1.106 requires the disclosure of information, such as income, effects of changes linked to IAS 8, and reconciliations for profit and loss, other comprehensive income as well as transactions with owners. Along IAS 1.106A and IAS 1.107, a company has to provide a detailed view on other comprehensive income and on dividends - either in the notes or in the statement of changes in equity. We below discuss the preparation of the statement of changes in equity step by step for BELMONT Ltd. The statement of changes in equity shows the steps below: (1) Share issue/ treasury shares. (2) Profit or loss. (3) Other comprehensive income. (4) Revaluations of assets. (5) Appropriation of profits. BELMONT Ltd. is a gym in Port Elizabeth. The company is based on 1,000,000 ordinary shares at 1.00 ZAR/ s. As at 1.01.20X7, BELMONT Ltd. discloses the balance sheet shown in Figure 13.1. <?page no="291"?> Berkau: Financial Statements 4e 13-287 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 800,000 Share capital 1,000,000 Intangibles Reserves 400,000 Investment 400,000 Retained earnings (150,000) Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables 200,000 Short-term liab. A/ P 250,000 Prepaid expenses Provisions Cash/ Bank 100,000 Income tax liab. Total assets 1,500,000 Total equity and liab. 1,500,000 Belmont Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 13.1: BELMONT Ltd.’s balance sheet (20X6) The equity section of the balance sheet gives already the first line for the statement of changes in equity. Equity is amounting to: 1,000,000 + 400,000 - 150,000 = 1 1,250,000.00 ZAR. The amount includes a loss carried forward. BELMONT Ltd. could have dissolved reserves in order to compensate the loss from the previous year(s), but does not have to. In the case of BELMONT Ltd., the reserves shown are entirely earnings reserves which could have been dissolved at the discretion of the company. Approval of shareholders on the annual general meeting is required for such a transaction. BELMONT Ltd. carries forward the loss into the Accounting period 20X7. Observe below in Figure 13.2 the first line of the statement of changes in equity for BELMONT Ltd. The header indicates that the statement of changes in equity is prepared for disclosure on 31.12.20X7. We continue the preparation of the statement of changes in equity line item by line item in this chapter. The number in brackets at the end of the caption tells you the progress of preparation. Here comes step (1): Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Belmont Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.2: BELMONT Ltd.’s statement of changes in equity (1) Ad (1): Share Issue/ Treasury Shares On 31.03.20X7, BELMONT Ltd. issues 500,000 preference shares at 1.00 ZAR/ s. The preference shares come with a 7 %/ a dividend based on their nominal value. BELMONT Ltd. issues the shares at a price of 1.50 ZAR/ s. The issue price is above face value. Hence, the issue is <?page no="292"?> Berkau: Financial Statements 4e 13-288 at a premium of 0.50 ZAR/ s. BELMONT Ltd.’s ordinary shares are traded at Johannesburg Stock Exchange JSE at 1.80 ZAR/ s on 31.03.20X7. To keep the case simple we assume that the share prices of ordinary shares and preference shares do not differ although the shares are traded separately. The share price has no impact on the company’s equity. BELMONT Ltd. makes a rights issue. The rights given to the existing shareholders are worth: 1.80 - (1.50 × 500,000 + 1.80 × 1,000,000) / 1,500,000 = 0 0.10 ZAR/ s. An investor needs one right to buy one fresh preference share. This gives a right’s value of: (1,000,000 / 500,000) × 0.10 = 0 0.20 ZAR/ right. As the shares’ issue price exceeds the nominal value a premium of: 1.50 - 1.00 = 0 0.50 ZAR/ fresh share is added to capital reserves. This gives: 500,000 × 0.5 = 2 250,000.00 ZAR. The simplified 50 Bookkeeping entry for the share issue is shown below: DR Cash/ Bank.................... 750,000.00 ZAR CR Issued Capital (pref. shares) 500,000.00 ZAR CR Capital Reserves............. 250,000.00 ZAR Next, we discuss a share buy-back. Repurchasing own shares takes the shares of the market and no dividend is received for treasury shares. A share brought back is no asset as the company cannot be its own shareholder. It is to be considered as a negative equity item on the balance sheet as well as on the statement of changes in equity. Treasury shares change performance ratios, such as the Return on Assets or the Earnings per Share and might affect the share price. IAS 32.33 rules treasury shares. The shares are to be deducted from equity measured based on the consideration paid. On 1.10.20X7, BELMONT Ltd. buys 200,000 of its own (ordinary) shares. The share price paid is 2.05 ZAR/ s. The cost method applies based on IAS 32.33 which means the treasury shares are carried at their cost of re-acquisition. As the ordinary shares have no effect on the capital reserves, no changes thereof apply. BELMONT Ltd. does not intend to redeem the treasury shares in the nearby future. No profit or loss is recorded. DR Issued Capital - Treasury.... 410,000.00 ZAR CR Cash/ Bank.................... 410,000.00 ZAR The statement of changes in equity is disclosed as below in Figure 13.3 after the share issue and the share buy-back as at the end of the Accounting period. We record one line in the statement of changes in equity per transaction. 50 Read our Basics-1, chapter (33). The fair market value of BELMONT Ltd.’s shares (ordinary and preference shares) does not matter for the financial statements and the disclosure of equity. Find below in Figure 13.3 the statement of changes in equity. <?page no="293"?> Berkau: Financial Statements 4e 13-289 Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Treasury shares (410,000) (410,000) Belmont Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.3: BELMONT Ltd.’s statement of changes in equity (2) Ad (2): Profit or Loss BELMONT Ltd. earns a profit after deduction of income taxes to the extent of 490,000.00 ZAR. The amount is added to equity through the Retained Earnings account. The amount exceeds the loss carried forward. At the same time, the taxes for the profit are added to the Income Tax Liability account. Observe the Bookkeeping entries below. The tax calculation is simplified based on the conventions in chapter (1). The income tax calculation gives a tax liability of: 30% × 490,000 / (1 - 30%) = 2 210,000.00 ZAR. DR P&L Account.................. 490,000.00 ZAR CR Retained Earnings............ 490,000.00 ZAR DR P&L Account.................. 210,000.00 ZAR CR Income Tax Liabilities....... 210,000.00 ZAR Below, we show the statement of changes in equity after profit recording. A more detailed analysis of the profit is not required for the statement of changes in equity, as the income statement discloses details of profit already. See the statement of changes in equity at this stage of the preparation in Figure 13.4. Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Ord. share redemption (410,000) (410,000) Profit 20X7 490,000 490,000 Belmont Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.4: BELMONT Ltd.’s statement of changes in equity (3) <?page no="294"?> Berkau: Financial Statements 4e 13-290 Ad (3): Other Comprehensive Income During the fiscal year 20X7, BELMONT Ltd. sells 4 used treadmills at a total profit on disposal of 100,000.00 ZAR before income taxes. The profit on disposal is not linked to the ordinary business of BELMONT Ltd. and is regarded as a gain. However, the gain is taxable and leads to income tax liabilities of: 100,000.00 × 30% = 3 30,000.00 ZAR. Hence, the addition to equity resulting from the net amount of the gain equals to: 100,000 - 30,000 = 7 70,000.00 ZAR. BELMONT Ltd.’s Bookkeeper makes the entries below in the accounts: DR Cash/ Bank.................... 100,000.00 ZAR CR Gain on Disposal (OCI)....... 100,000.00 ZAR DR Gain on Disposal (OCI) ...... 70,000.00 ZAR CR Retained Earnings............ 70,000.00 ZAR DR Gain on Disposal (OCI)....... 30,000.00 ZAR CR Income Tax Liabilities....... 30,000.00 ZAR BELMONT Ltd. owns a cafeteria on its premises which was previously sourced out. BELMONT Ltd. owns 60 % of BELMONT-DINER (Pty) Ltd. and its former cafeteria chef owns the remainder. He runs the restaurant. BELMONT- DINER (Pty) Ltd. pays a 40 % portion of its profit to BELMONT Ltd. which is amounting to: 80,000 × 40% = 3 32,000.00 ZAR. The amount is classified as other comprehensive income resulting from subsidiary. Taxes have been deducted already. At BELMONT Ltd., the Accountant makes the Bookkeeping entry as below: DR Cash/ Bank.................... 32,000.00 ZAR CR Subsidiary Income (OCI)...... 32,000.00 ZAR See below the next step of our preparation of the statement of changes in equity at BELMONT Ltd. in Figure 13.5. <?page no="295"?> Berkau: Financial Statements 4e 13-291 Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Ord. share redemption (410,000) (410,000) Profit 20X7 490,000 490,000 OCI gain on disposal 70,000 70,000 OCI cafeteria dividend 32,000 32,000 Belmont Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.5: BELMONT Ltd.’s statement of changes in equity (4) Ad (4): Revaluations of Assets BELMONT Ltd. records a revaluation of its cafeteria business. The cafeteria is a subsidiary and is worth 400,000.00 ZAR as at 1.01.20X7. Without further explanation of details, we increase the cafeteria’s value by 150,000.00 ZAR - observe the simplified Bookkeeping entry below and keep in mind that there is no depreciation for the cafeteria investment. DR Investment @valuation........ 550,000.00 ZAR CR Investment @cost............. 400,000.00 ZAR CR Revaluation Reserves......... 105,000.00 ZAR CR Deferred Tax Liabilities..... 45,000.00 ZAR As we can see, the revaluation of the cafeteria business makes equity increase by 105,000.00 ZAR. See below in Figure 13.6 the statement of changes in equity after adding the revaluation reserve increase. Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Ord. share redemption (410,000) (410,000) Profit 20X7 490,000 490,000 OCI gain on disposal 70,000 70,000 OCI cafeteria dividend 32,000 32,000 Revaluation B-DINER 105,000 105,000 Belmont Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X7 . . . Figure 13.6: BELMONT Ltd.’s statement of changes in equity (5) <?page no="296"?> Berkau: Financial Statements 4e 13-292 Ad (5): Appropriation of Profits An appropriation of profits is the distribution of profits between owners and the company. There are 3 options: (a) declaration of a dividend, (b) addition to earnings reserves or (c) postponement of the decision and carrying forward the profit. In order to be more precise, it is not the profit but the distributable amount that is subject to appropriation. The distributable amount is the profit or loss carried forward from prior Accounting periods and the earnings after taxes from the reporting period. In BELMONT Ltd.’s case, the distributable amount is: -150,000 + 490,000 + 70,000 + 32,000 = 4 442,000.00 ZAR. In order to pay the shareholders a dividend, BELMONT Ltd. has to declare a preference dividend, too. We adjust the distributable amount to ordinary shareholders by deduction of the preference dividends. The preference dividend at BELMONT Ltd. is amounting to: 75% × 7% × 500,000 = 2 26,250.00 ZAR. The annual preference dividend is devalued by 25 % as the share issue took place on 31.03.20X7. The distributable amount to ordinary shareholders is: 442,000 - 26,250 = 4 415,750.00 ZAR. BELMONT Ltd. declares a dividend of 0.05 ZAR/ ordinary share. The total ordinary dividend is: 0.05 × 1,000,000 = 50,000.00 ZAR. On the annual general meeting, BELMONT Ltd. decides to add an amount of 100,000.00 ZAR to earnings reserves and to carry forward the remaining of the distributable amount. See below the Bookkeeping entries and the final statement of changes in equity in Figure 13.7. It is assumed that BELMONT Ltd. pays its shareholders the gross dividend. Here, dividend recipients take care of taxation in regard to tax on capital returns themselves. In real Accounting, the company is owing the tax on capital returns for its shareholders residing inland. As we do not know the domicile of BELMONT Ltd.’s shareholders we assume they are all foreigners and make the company pay the gross dividend without tax deductions. DR Retained Earnings............ 176,250.00 ZAR CR Pref. Dividends/ p............ 26,250.00 ZAR CR Ord. Dividends/ p............. 50,000.00 ZAR CR Earnings Reserves............ 100,000.00 ZAR <?page no="297"?> Berkau: Financial Statements 4e 13-293 Share capital Reserves Retained earnings total [ZAR] [ZAR] [ZAR] [ZAR] as at 1.01.20X7 1,000,000 400,000 (150,000) 1,250,000 Pref. share issue 500,000 250,000 750,000 Ord. share redemption (410,000) (410,000) Profit 20X7 490,000 490,000 OCI gain on disposal 70,000 70,000 OCI cafeteria dividend 32,000 32,000 Revaluation of B-DINER 105,000 105,000 Pref. dividends (26,250) (26,250) Ord. dividends (50,000) (50,000) Additions to earn. res. 100,000 (100,000) 0 as at 31.12.20X7 1,090,000 855,000 265,750 2,210,750 Belmont Ltd.'s STATEMENT of CHANGES in EQUITY as at 31.12.20X7 Figure 13.7: BELMONT Ltd.’s statement of changes in equity (6) How it is Done (Statement of Changes in Equity): (1) Prepare a table that shows columns for every kind of equity item. Choose either a detailed statement of single items or prepare an aggregated statement and disclose further information in the notes. (2) Determine and enter the equity figures for the beginning of the Accounting period in the first line. Make all entries in the statement of changes in equity based on the Bookkeeping records. (3) Add a line for share issues and make the entries in the issued capital column. Make further entries in the capital reserves column if shares are issued at a premium. (4) Add a line item for share redemptions and make entries in the issued capital column and in the capital reserves column. (5) Add a line for profit or loss. Enter the profit after taxation in the retained earnings column. (6) Add a line for other comprehensive income. Enter other comprehensive income after taxation in the retained earnings column. (7) Add a line for the appropriation of profit or loss. Change retained earnings and make additions to reserves if applicable. Do similar for dissolving reserves. (8) Add a line for preference dividends. Reduce the retained earnings accordingly to the declaration of dividends. <?page no="298"?> Berkau: Financial Statements 4e 13-294 (9) In case of a revaluation, make additions to the Revaluation Reserves account. If revalued assets are depreciated disclose the reduction of revaluation reserves. (10) Add all line items and disclose the sum in the right column. (11) Add all column lines and disclose the total in the bottom line. The bottom line figures have to be consistent with the balancing figures of the related accounts. Summary: The statement of changes in equity is required based on IAS 1.10. It shows the additions and deductions of the equity section on the balance sheet. The columns represent the equity items and lines the transactions changing equity. In case a reporting company combines items a detailed explanation in the notes is required. Accounting Technical Terms: Statement of changes in equity: A statement that discloses the additions and deductions with regard to equity items on the balance sheet. Treasury shares: Shares bought back buy the issuing company. Treasury shares are carried in a negative Equity account. This is referred to as contraequity account. Question Bank: (1) A company repurchases 20,000 of its ordinary shares at 34.00 EUR/ s. The face value is 10.00 EUR/ s. How does the company show the treasury shares on its balance sheet? 1. As an asset measured at 680,000.00 EUR. 2. As a negative capital of 680,000.00 EUR. 3. As an asset measured at 200,000.00 EUR. 4. As a negative capital of 200,000.00 EUR. (2) A company declares a dividend of 100,000.00 EUR from a distributable amount of 160,000.00 EUR. How is the transaction disclosed on the statement of changes in equity? 1. Deduction of 100,000.00 EUR from totals. 2. Addition of 60,000.00 EUR to retained earnings. 3. Deduction of 100,000.00 EUR from retained earnings. 4. Deduction of 160,000.00 EUR from retained earnings and addition of 100,000.00 EUR to earnings reserves. (3) A company issues 100,000 fresh shares at a premium of 20 % to its face value. The face value per share is 5.00 EUR/ s. How is the share issue disclosed on the statement of changes in equity? 1. Increase of issued capital at 500,000.00 EUR and of 100,000.00 EUR in reserves. 2. Increase of issued capital at 600,000.00 EUR. <?page no="299"?> Berkau: Financial Statements 4e 13-295 3. Increase of issued capital at 500,000.00 EUR. 4. Increase of issued capital at 600,000.00 EUR and decrease of reserves at 100,000.00 EUR. (4) A company re-values its noncurrent assets that are recorded at 100,000.00 EUR by 40 %. How is the revaluation disclosed on the statement of changes in equity? 1. Increase of reserves by 40,000.00 EUR and increase of retained earnings by 40,000.00 EUR. 2. Increase of reserves by 28,000.00 EUR and increase of retained earnings by 28,000.00 EUR. 3. Increase of reserves by 40,000.00 EUR. 4. Increase of reserves by 28,000.00 EUR. (5) A company issues 200,000 shares at 5.50 EUR/ s which includes a premium of 0.50 EUR/ s. It earns a pre-tax profit of 100,000.00 EUR. It re-values its non-current assets by 50,000.00 EUR and declares a dividend of 0.20 EUR/ s. How much is its equity as disclosed on the statement of equity under totals? 1. 1,160,000.00 EUR. 2. 1,060,000.00 EUR. 3. 1,165,000.00 EUR. 4. 1,190,000.00 EUR. Solutions: 1-2, 2-3, 3-1, 4-4, 5-3. <?page no="300"?> Berkau: Financial Statements 4e 14-296 14. Liabilities on the Balance Sheet Learning Objectives: Liabilities result from present obligations which is a duty or a responsibility to act in a certain way (IAS 1.15). In a certain way most likely means to make a payment or to exchange goods or services in return for the settlement of the liability. The IASB distinguishes between present and future obligations, the latter ones are no liabilities, such as interest to be paid in later Accounting periods. In contrast, an obligation of a debt settlement already exists at the date of reporting and, as a consequence, is to be disclosed as a liability. See IAS 1.16. In this last chapter (14) of the text book, we cover the measurement and presentation of liabilities. In general, liabilities fall under financial instruments which are disclosed on the borrowers’ balance sheet on the credit side. We here repeat some aspects discussed already in chapter (7) and chapter (9). However, we now take a view from the opposite side which we refer to as the debtors’ perspective. Below, we start-off with classifying liabilities which is relevant for Accounting as their measurement depends thereon. The classification of liabilities determines the structure for this chapter, too. In line with IAS 1.46, liabilities are disclosed on the credit side of the balance sheet once it is likely that an outflow of resources results from the settlement thereof and the amount can be measured reliably. There are certain liabilities and uncertain ones. A certain liability is, e.g., a bank loan or a lease obligation. Uncertainty means, one of the characteristics of the liability is not determined yet, such as payment terms (amount or date) or whether a payment is to be made at all. For uncertain liabilities we disclose a provision. A provision applies, e.g., when a company offers its manager a pension. By this, a present obligation exists due to the contract but the future payment and it terms are not certain. It depends on the beneficiary’s life, in particular whether she/ he will be alive in order to receive the pension payments. In cases where no present obligation exists a contingent liability applies. In general, contingent assets and liabilities are not disclosed on financial statements. For financial instruments, IAS 32, IAS 39, IFRS 7, IFRS 9 apply. IFRS 13 rules the measurement. As IFRS 9 replaces the more complicated IAS 39 in the nearby future, we mainly focus on IFRS 9 for reporting liabilities. This determines loan valuations. For provisions, there is an extra standard IAS 37. Below, we discuss recognition, measurement and presentation of liabilities in two steps: (1) Certain liabilities. (2) Provisions. The major difference in terms of measurement is given by IFRS 9 and IAS 37. Certain liabilities are measured at amortised costs or fair values whereas provisions require discounting. <?page no="301"?> Berkau: Financial Statements 4e 14-297 Ad (1): Certain Liabilities In the easiest case, a liability is just a payment obligation. Whether you buy goods on credit or take a bank loan, you define a liability already. It most likely results in future payments or other transactions, such as asset transfer or rendering of service, meaning economic benefits are flowing out of the owing company. There is no special standard dedicated to debts. The IASB covers liabilities together with financial instruments for supporting an Accounting match, where liabilities are measured at the same values on the creditors’ side (assets) as on the borrowers’ side (liabilities). IFRS 9.5.2.1 distinguishes financial instruments held at amortised costs and those that are carried at fair value. In general, a fair value presentation is the first choice for measurement. Fair value presentation discloses the amount at which assets are exchanged or liabilities are transferred in an orderly transaction. The term orderly transaction refers to normal business transaction, whereas, e.g., a liquidation is not considered being orderly. In cases, when the valuation of liabilities fluctuates, i.e., when bonds are traded publically, a company holding bonds would be obliged to adjust the fair value permanently through profit or loss or through other comprehensive income - depending on its business concept. The fluctuation causes a permanent up and down of the liability valuation. In order to follow a recognition at fair values, adjustments are to be made in every Accounting period. Sometimes, we even use those changes in valuation when holding derivatives, i.e., we buy commodity call options, such as for gold with the intention to benefit/ suffer from increases/ decreases of the gold price above/ below the option price. In cases of determined settlement amounts, such as for bonds or granted loans, the entire fair value measurement and all adjustments through profit or loss until maturity day eventually result in a zero-sum-game. This is caused by the settlement amount not depending on fair market values but on the principal of the bond or the bank loan. In those cases, carrying financial instruments at amortised costs is applicable. Bond or loan assets (on the creditors’ side) with the intention to be held until maturity shall be carried at amortised costs based on IFRS 9.5.2.1. Carrying at amortised costs means to not follow fair values but to stick to the settlement amount at which the bond or loan is paid off. On the borrower’s side, the debt classification results to a liability measurement at amortised costs per default. IFRS 9.4.2.1 lists exceptions. IFRS 9.4.2.2 in combination with IFRS 9.4.3.5 allows a classification of derivatives at fair value with adjustment through profit or loss. In contrast to amortised costs, fair value presentation in terms of liabilities means to carry a liability at their fair market values. IFRS 13.9 defines the fair value of a liability as the value paid to transfer a liability in an orderly transaction between market participants at the measurement date. For fair value measurement three levels apply with a descending order in reliability. - Level 1: Market approach. - Level 2: Income approach. <?page no="302"?> Berkau: Financial Statements 4e 14-298 - Level 3: Cost approach. A fair value presentation normally refers to market prices. Bonds traded at a bond market lead to a situation where the bond market provides you permanently with actual bond prices. In case market prices are not available (no active market existence or no sufficient trade volume applies), IFRS 13.38 mandates to apply other valuation techniques such as present value measurement or quoted prices for similar liabilities. Below, we focus on bonds and loans. A bonds issuing company does not permanently follow the bond price development at a bond market (if even traded publically, otherwise of similar bonds) for possible bond transfer decisions. Neither does a loan borrower check alternative loan opportunities at all times. The reason not to do so are transaction costs and prepayment penalties which we ignore for this text book based on our conventions in chapter (1) but which become relevant in real business. They make loan/ bond hopping expensive and, thus, unfavourable for the borrower. Loan hopping means a borrower retires its debts by lending from another bank. In most real cases, the borrower is dedicated to follow its obligation of bond redemption at maturity and/ or of paying-off loans in full at contractual agreed payoff dates. As the default case, a bond issuer or a loan borrower who is keen to transfer liabilities does not matter for our considerations on the borrower’s side. As a consequence, we can always measure bonds and liabilities at 51 As seldom relevant, we do not worry too much about liabilities held at fair value. We also refer to amortised costs no matter what the debtors’ business model is like. IFRS 9.4.2.1 applies. 51 For debt valuation at amortised costs the effective interest method applies. 52 The measurement is based on the borrowed amount (= principal) net of discounts/ premiums as well as transaction costs, the effective interest, and interest and pay-off-payments. The time value of money is considered for compound interest calculations. The effective interest method required for carrying liabilities at amortised costs is the standard method, we cover in this chapter in detail by most of the next following cases. Below, we discuss four liability cases where a company is…: (1a) Buying goods on credit (shortterm liability case). (1b) Taking a bank loan at a discount and paying bank fees (at amortised cost). (1c) Issuing bonds (at amortised costs). (1d) Taking an annuity with extra repayments agreed on (at amortised costs). We do not cover a case with measurement at fair values as they seldom apply for liabilities and as we discussed fair value presentation of derivatives in chapter (9) from the holders’ perspective already. Ad (1a): Buying Goods on Credit Buying goods on credit results in general in a payment obligation due in the IFRS 9.4.4.2 which prohibits reclassifications of liabilities. 52 Read Appendix B of IFRS 9: IFRS 9.B4.1.2.9. <?page no="303"?> Berkau: Financial Statements 4e 14-299 nearby future. IAS 1.56 instructs a company to classify its debts as shortterm liability if due within a year. As a consequence, we do not revalue debts and carry them at initial valuation which is the settlement amount. Here is an example: WARWICK Ltd. buys goods from its supplier on 3.01.20X5 and agrees to pay the purchase price of 120,000.00 AUD on 3.01.20X6. We make the Bookkeeping entry below: DR Purchase..................... 100,000.00 AUD DR VAT.......................... 20,000.00 AUD CR Accounts Payables A/ P ........ 120,000.00 AUD In the next Accounting period, WARWICK Ltd. receives the input-VAT from the revenue service and pays the bill to its supplier. The liability shows on the statement of financial position as at 31.12.2005 to the extent of 120,000.00 AUD. At the same time, WARWICK Ltd. discloses an input-VAT claim of 20,000.00 AUD based on the purchase as receivable. Ad (1b): Bank Loan with Fees and Discount The effective interest method applies for bank loan valuation. It measures liabilities at amortised costs. The effective interest method calculates the internal rate of return based on the payment vector of the bank loan. The vector contains the initial payment of the borrowed amount net of discount and transfer costs, the interest and pay-off payments. We explain amortised cost measurement below by the bank loan taken by MEUL Ltd. On 31.12.20X2, MEUL Ltd. takes a bank loan of 1,000,000.00 ZAR at an annual rate of interest of 3 %/ a from its house bank. The bank loan is granted with a discount of 5 % and transaction costs (service fees of the bank) to the extent of 20,000.00 ZAR. A discount in connection with a bank loan means the bank pays the borrower a reduced amount based on the agreed discount rate. Here, the money received by MEUL Ltd. is amounting to: 1,000,000 × (1 - 5%) = 9 950,000.00 ZAR. Even though the received amount is less than the principal, all interest and pay-off payments are based on the principal, here: 1,000,000.00 ZAR. MEUL Ltd. agrees to instantly pay all service fees to the bank. The bank loan’s annual rate of interest is 3 %/ a payable at the year-ends. The bank loan is to pay-off every year by 250,000.00 ZAR/ a, commencing on 31.12.20X2. Next, we calculate the annual payments in preparation of a payment vector for the entire loan. The vector is written as a set of payments, one per year. On 31.12.20X1, MEUL Ltd. receives the borrowings to the amount of: 1,000,000 × (1 - 5%) = 9 950,000.00 ZAR. It also pays associated transaction costs of 20,000.00 ZAR which further reduces the received amount to: 950,000 - 20,000 = 9 930,000.00 ZAR. The initial valuation is at net proceeds upon issue of debts to the extent of 930,000.00 ZAR. See the Bookkeeping entries below: <?page no="304"?> Berkau: Financial Statements 4e 14-300 DR Cash/ Bank.................... 950,000.00 ZAR CR Interest Bearing Liabilities. 950,000.00 ZAR DR Transaction Costs............ 20,000.00 ZAR CR Cash/ Bank.................... 20,000.00 ZAR The payments in the next following Accounting periods contain interest and pay-off. The latter one is constantly 250,000.00 ZAR. In contrast, interest is always 3 %/ a based on the owing amount which is calculated as principal less accumulated pay-offs. The bank loan vector is: BL(t) = {-930,000; - 280,000; -272,500; -265,000; -257,500} For loan measurement, we apply the effective interest rate method and calculate the internal rate of return for the vector BL(t) which is already the effective rate of interest. The determination is quite complicated as it requires to solve a 4 th degree polynomial; hence, we go the more convenient interpolation route. We calculate a rate of 6.15 %/ a by the goal seek function of MS-Excel. See below the result of the calculation in Figure 14.1: 20X1 20X2 20X3 20X4 20X5 [ZAR] [ZAR] [ZAR] [ZAR] [ZAR] Interest (30,000.00) (22,500.00) (15,000.00) (7,500.00) loan and pay-off 930,000.00 (250,000.00) (250,000.00) (250,000.00) (250,000.00) eff. interest yield (930,000.00) 987,189.52 eff. interest yield (707,189.52) 750,677.50 eff. interest yield (478,177.50) 507,582.60 eff. interest yield (242,582.60) 257,500.00 0.00 0.00 0.00 0.00 0.00 Meul Ltd.'s BANK LOAN VALUATION CHART (20X1 - 20X5) Figure 14.1: Effective interest method at MEUL Ltd. In order to recalculate the figures, download the spreadsheet online through Link 14.A: Link 14.A: MEUL Ltd. 53 The rate of internal return equals to 6.1494104 %. MEUL Ltd. increases the liability by 6.15 % every year and pays-off the bank loan in order to retire the entire bank loan as at 31.12.20X5. The settlement amount, calculated as the future value, of MEUL Ltd.’s bank loan as at 31.12.20X5 is approximately 53 zero if we consider the payment received in 20X1 for the calculation, as well: <?page no="305"?> Berkau: Financial Statements 4e 14-301 930,000 × (1 + 6.15%) 4 - 280,000 × (1 + 6.15%) 3 - 272,500 × (1 + 6.15%) 2 - 265,000 × (1 + 6.15%) - 257,500 = 0 0.00 ZAR. There is a rounding difference of 15.68 ZAR as we calculate with 6.15% instead with the accurate percentage. After the first Accounting period as at 31.12.10X2, the Bookkeeping entries are: DR Short-term Liabilities A/ P ... 250,000.00 ZAR CR Cash/ Bank.................... 250,000.00 ZAR DR Loan Expenses................ 57,189.52 ZAR CR Interest Bearing Liabilities. 57,189.52 ZAR DR Interest Bearing Liabilities. 250,000.00 ZAR CR Short-term Liabilities A/ P ... 250,000.00 ZAR DR Interest-20X2................ 30,000.00 ZAR CR Cash/ Bank.................... 30,000.00 ZAR DR Interest Bearing Liabilities. 30,000.00 ZAR CR Interest-20X2................ 30,000.00 ZAR Below, we show the accounts for interest bearing liabilities, short-term liabilities, expenses and cash/ bank for the Accounting periods 20X1 until 20X5. The total of the expenses is amounting to: 57,189.52 + 43,487.98 + 29,405.10 + 14,917.40 = 1 145,000.00 ZAR. D C D C (3) 250,000.00 (1) 950,000.00 (2) 20,000.00 (4) 20,000.00 (4) 20,000.00 c1d 680,000.00 950,000.00 950,000.00 (c) 250,000.00 b/ d 680,000.00 (e) 30,000.00 (b) 57,189.52 c2d 457,189.52 737,189.52 737,189.52 (ii) 250,000.00 b/ d 457,189.52 (v) 22,500.00 (iii) 43,487.98 c3d 228,177.50 500,677.50 500,677.50 (B) 250,000.00 b/ d 228,177.50 (E) 15,000.00 (C) 29,405.10 c4d 7,417.40 265,000.00 265,000.00 b/ d 7,417.40 (II) 14,917.40 (IV) 7,500.00 14,917.40 14,917.40 Interest bearing liabilities IBL Bank fees-20X1 FEE Figure 14.2: MEUL Ltd.’s accounts (20X1 - 20X5) <?page no="306"?> Berkau: Financial Statements 4e 14-302 D C D C (1) 950,000.00 (2) 20,000.00 c1d 250,000.00 (3) 250,000.00 c1d 930,000.00 (a) 250,000.00 b/ d 250,000.00 950,000.00 950,000.00 c2d 250,000.00 (c) 250,000.00 b/ d 930,000.00 (a) 250,000.00 500,000.00 500,000.00 (d) 30,000.00 (i) 250,000.00 b/ d 250,000.00 c2d 650,000.00 c3d 250,000.00 (ii) 250,000.00 930,000.00 930,000.00 500,000.00 500,000.00 b/ d 650,000.00 (i) 250,000.00 (A) 250,000.00 b/ d 250,000.00 (iv) 22,500.00 c4d 250,000.00 (B) 250,000.00 c3d 377,500.00 500,000.00 500,000.00 650,000.00 650,000.00 (I) 250,000.00 b/ d 250,000.00 b/ d 377,500.00 (A) 250,000.00 (D) 15,000.00 c4d 112,500.00 377,500.00 377,500.00 b/ d 112,500.00 (I) 250,000.00 c5d 145,000.00 (III) 7,500.00 257,500.00 257,500.00 b/ d 145,000.00 Cash/ Bank C/ B Short-term liabilities A/ P D C D C (b) 57,189.52 P&L-20X2 (d) 30,000.00 (e) 30,000.00 Loan expenses-20X2 LE2 Interest-20X2 IN2 D C D C (iii) 43,487.98 P&L-20X3 (iv) 22,500.00 (v) 22,500.00 Loan expenses-20X3 LE3 Interest-20X3 IN3 D C D C (C) 29,405.10 P&L-20X4 (D) 15,000.00 (E) 15,000.00 Loan expenses-20X4 LE4 Interest-20X4 IN4 D C D C (II) 14,917.40 P&L-20X5 (III) 7,500.00 (IV) 7,500.00 Loan expenses-20X5 Interest-20X5 IN5 Figure 14.2: MEUL Ltd.’s accounts (20X1 - 20X5) continued Interest is paid and calculated based on the principal of the bank loan which is amounting to 1,000,000.00 ZAR less regular pay-off payments. I.e., interest- 20X2 is amounting to: 1,000,000 × 3% = 30,000.00 ZAR, interest-20X3 equals to: (1,000,000 - 250,000) × 3% = 2 22,500.00 ZAR etc. In the end, the Cash/ Bank account’s balance in Figure 14.2 considers all payments from previous years: the received amount, all interest and pay-off payments. The balancing figure is amounting to: 950,000 - 20,000 - 75,000 - 4 × 250,000 = - -145,000.00 ZAR. <?page no="307"?> Berkau: Financial Statements 4e 14-303 It might look strange to deduct interest from the bank loan, e.g., by Bookkeeping entry (e), (v), (E) and (IV). This is because of the effective interest method calculation where we consider interest as relevant for the calculation of the internal rate of return. As interest is no present obligation at the time of taking the bank loan we can alternatively calculate the effective interest without consideration of the actual interest payment. It would result in an payment vector of: EB’(t) = {-930,000; -250,000; -250,000; -250,000; -250,000}. The internal rate of return of EB’ is calculated as its internal rate of return. It gives the equation: 0 = 930,000 - 250,000 × ((1 + i’) 4 - 1)/ (i’ × (1 + i’) 4 ). The resulting internal rate of return for the equation is: i’ = 2.96 73 %. We enter the internal rate of return into the effective interest calculation and calculate almost the same valuation for the bank loan as in Figure 14.3. 20X1 20X2 20X3 20X4 20X5 [ZAR] [ZAR] [ZAR] [ZAR] [ZAR] Interest 0.00 0.00 0.00 0.00 loan and pay-off 930,000.00 (250,000.00) (250,000.00) (250,000.00) (250,000.00) eff. interest yield (930,000.00) 957,596.61 eff. interest yield (707,596.61) 728,593.67 eff. interest yield (478,593.67) 492,795.35 eff. interest yield (242,795.35) 250,000.00 0.00 0.00 0.00 0.00 0.00 Meul Ltd.'s BANK LOAN VALUATION CHART (20X1 - 20X5) Figure 14.3: Alternative calculation of the loan at MEUL Ltd. How it is Done (Effective Interest Method): (1) Make sure the liability is held at amortised costs to rectify the application of the effective interest method. (2) Gather all payment-relevant information about the liability, such as discounts, fees, premiums, interest, pay-off payments. (3) Determine the payment vector for the liability. Consider long-term as well as short-term payments. (4) Calculate the internal rate of return for the entire payment vector. Determine the interest that applies if the present value of the payment vector is amounting to zero. If handy, go the iteration route, e.g., as provided by goal seek-function in MS-Excel (5) Prepare a financial schedule with columns for the Accounting periods and lines for payment (vectors). Consider released free funds as an investment revalued based on the internal rate of return and paid back in the next following Accounting period. (We call that “Eff. Int.” in financial valuation plans.) <?page no="308"?> Berkau: Financial Statements 4e 14-304 (6) Make Bookkeeping entries for payments. Consider short-term payments as deductions from the liabilities value. (7) Record effective interest as expense through profit or loss after deduction of interest paid. Ad (1c): Bonds Lending through bonds is an alternative to raising funds by share issues. A bond is a financial instrument where the bond issuer borrows from its bondholders. We classify bonds as a liability instrument which results in a bond disclosure on the credit side of the balance sheet of the borrower. In general, companies and public entities, such as countries or states, borrow from multiple investors through an intermediary, such as a bank. Bonds are paid-off in a lump sum completely after a certain time we refer to as time to maturity. Until bonds mature, the bond issuer pays an agreed amount of interest, called the coupon. The coupon rate is often fixed over the entire time to maturity. As the bond issuer only pays-off at redemption the interest (coupon) expenses for the bond issuer are constant amounts over the time. Most of bonds come with a 6 months interval of payments for coupons, such as paying a coupon on 30.06. and 31.12. every year. Alternatively, bonds pay interest annually or quarterly. A bond that comes with a nominal value of 10,000.00 EUR and a time to maturity of 20 years with a coupon rate of 5 %/ a is worth to its holder: 10,000 × (1 + 5%) -20 + 500 × ((1 + 5%) 20 - 1) / ((1 + 5%) 20 × 5%) = 10,000.00 EUR. The bond valuation is based on the present value of its redemption value plus the present value of coupons received until time to maturity. For the bondholder the valuation depends on the difference between coupon rate and market interest rate. As long as both rates are at the same value as the market rate, the bond’s value is exactly its nominal value, referred to as principal. If the market rate of interest decreases below the coupon rate, the value of the bond increases and vice versa. We take the bond above and calculate its value based on an interest rate of 6%. Its value is then: 10,000 × (1 + 6%) -20 + 500 × ((1 + 6%) 20 - 1) / ((1 + 6%) 20 × 6%) = 8,853.01 EUR. We now assume the market interest rate drops to 4 %: The bond’s value is now: 10,000 × (1 + 4%) -20 + 500 × ((1 + 4%) 20 - 1) / ((1 + 4%) 20 × 4%) = 11,359.03 EUR. Bonds can be traded publically at a bond market. An issue price below the nominal value, say for our above discussed example at 9,000.00 EUR, makes an investor buy the bond at a discount. A bond traded at a higher value than its principal comes with a premium. When sold at 9,000.00 EUR, the discounted bond’s value is 10% less as the principal. Even though, the bondholder receives 10,000.00 EUR for its redemption. So far, we covered a bond valuation from the perspective of its holder. Based on IFRS 9.4.1.2, bonds are held at amortised costs if the business model indicates the bonds are not traded and payments received are for redemption or coupon only. In all other cases, IFRS 9.4.1.4 mandates a <?page no="309"?> Berkau: Financial Statements 4e 14-305 bond valuation based on fair values either through profit or loss or through other comprehensive income. Below, we look at the bond issuer (borrower): In general, a company issues bonds in order to raise funds and only agrees on payment obligations with its bondholders. In contrast to shareholders, a bondholder lends the company money but has no say in the matter of the company’s business. A bondholder lends a company her/ his money but cannot decide what the company spends the funds on and how risky the business gets. The major risk for the bondholder is that the bond issuer does not pay-off the principal at maturity or, even worse, cannot pay the regular coupons, either. We focus on the disclosure of bonds from the point of view of the bond issuer (borrower). When a company issues a bond it is recorded as a liability. A present obligation exists to redeem the bond and to pay the coupons. The disclosure on the credit side does not reflect the market value at which bonds are traded, but the settlement value net of premium/ discounts and coupons. Same as with loans, we usually carry bonds at amortised costs. For bond recognition and disclosure on the borrower’s side, we discuss the case study BRIZA Ltd., a production firm in Australia. On 31.12.20X3, BRIZA Ltd. issues 1,000,000 bonds at 10.00 AUD/ bond with a time to maturity of 5 years. The redemption of the bonds is agreed to take place on 31.12.20X8 at a premium of 4 %. Hence, the payment when bonds mature is 10,400,000 AUD for redemption. During the time to maturity, BRIZA Ltd. pays annually a coupon of 6 %/ a based on the principal. Every Accounting period, BRIZA Ltd. pays a coupon of 600,000.00 AUD. BRIZA Ltd. carries the bonds at amortised costs. There is no intention to transfer on the bonds. The bond’s payment in the last Accounting period on 31.12.20X8 is amounting to: 10,400,000 + 600,000 = 1 11,000,000.00 AUD. For the bond issue, BRIZA Ltd.’s bank charges a service fee of 25,000.00 AUD. The bond’s payment vector is: {9,975,000; -600,000; … ; -600,000; - 11,000,000}. We calculate the internal rate of return by solving the equation 0 = 9,975,000 - (600,000 × ((1 + r) 5 - 1)/ (r × (1 + r) 5 ) - (10,000,000 + 400,000) × (1 + r) -5 towards its interest rate r. The iteration comes to an effective interest rate of 6.76 % (rounded). <?page no="310"?> Berkau: Financial Statements 4e 14-306 Figure 14.4: Effective interest calculation at BRIZA Ltd. <?page no="311"?> Berkau: Financial Statements 4e 14-307 The bond is measured at initial valuation on 31.12.20X3 at net proceeds of: 10,000,000 - 25,000 = 9 9,975,000.00 AUD. For the following Accounting periods, we prepare a bond calculation as shown in Figure 14.5. For teaching purposes, we disclose the bond’s valuation before redemption. After redemption, the value of the bond is zero as the bond is de-recognised. No bond is disclosed on BRIZA Ltd.’s statement of financial position as at 31.12.20X8. Previous valuation b/ d Effective interest Coupon Bond value c/ d [AUD] [AUD] [AUD] [AUD] 20X4 9,975,000.00 674,259.09 (600,000.00) 10,049,259.09 20X5 10,049,259.09 679,278.63 (600,000.00) 10,128,537.72 20X6 10,128,537.72 684,637.46 (600,000.00) 10,213,175.18 20X7 10,213,175.18 690,358.52 (600,000.00) 10,303,533.70 20X8 10,303,533.70 696,466.30 (600,000.00) 10,400,000.00 Briza Ltd.'s BOND CALCULATION (20X4 - 20X8) Figure 14.5: BRIZA Ltd.’s bond calculation When bonds mature on 31.12.20X8, BRIZA Ltd. records the payments to its bondholders as displayed below after the payment of due coupons have been made. The bond is redeemed with a premium. That is why the bondholders in total receive an amount of: 10,000,000 × (1 + 4%) = 110,400,000.00 AUD. DR Short-term Liabilities....... 10,400,000.00 AUD CR Cash/ Bank.................... 10,400,000.00 AUD Ad (1d): Annuity and Extra Repayments An annuity is a bank loan with a constant payment which includes interest and pay-off. Interest is to be paid based on the amount owed as at the beginning of the interest bearing period. Our conventions state that interest compounds annually. However, an interest period of less than 1 year is calculated pro rata temporis (per rate) accurate to a month. On 2.01.20X2, MEMEL PLC takes a bank loan of 100,000.00 GBP. The loan is an annuity with an annual payment of 20,000.00 GBP/ a at the end of the Accounting period 31.12. In the years 20X3 and 20X4, an extra pay-off amount of 7,500.00 GBP is required on 1.07 as by the bank loan contract. The annual rate of interest for the bank loan is 4 %/ a. We prepare an interest and pay-off schedule for MEMEL PLC’s bank loan. It is displayed in Figure 14.6. <?page no="312"?> Berkau: Financial Statements 4e 14-308 Year Opening amount Interest Pay-off Annuity Rest [GBP] [GBP] [GBP] [GBP] [GBP] 20X2 100,000.00 4,000.00 21,000.00 25,000.00 79,000.00 1-6/ 20X3 79,000.00 1,580.00 7,500.00 71,500.00 7-12/ 20X3 71,500.00 1,430.00 21,990.00 25,000.00 49,510.00 1-6/ 20X4 49,510.00 990.20 7,500.00 42,010.00 7-12/ 20X4 42,010.00 840.20 23,169.60 25,000.00 18,840.40 20X5 18,840.40 753.62 18,840.40 19,594.02 (0.00) Memel PLC's INTEREST and PAY-OFF SCHEDULE as at 31.12.20X2 Figure 14.6: MEMEL PLC’s annuity (20X2) The annuity comes with a fixed payment of 7,500.00 GBP/ a extended by an extra re-payment in the middle of 20X3 and 20X4. The interest is calculated in 20X3 and 20X4 for 6 months. That is why we disclose 2 lines each for the periods 20X3 and 20X4. Hence, the interest in the first half of 20X3 is amounting to: 79,000 × 4%/ 2 = 11,580.00 GBP. Despite of its calculation in two steps, the interest payment only takes place on 31.12.20X3. The extra pay-off amount is deducted from the bank loan’s principle which gives us the amount MEMEL PLC is owing on 1.07.20X3: 79,000 - 7,500 = 71,500.00 GBP. The reduced debts make us recalculate interest for the 2 nd half of 20X3 to the extent of: 71,500 × 4%/ 2 = 1,430.00 GBP. As the bank loan is an annuity, the interest calculated is part of the 25,000.00 GBP/ a due at the end of 20X3. Accordingly, the pay-off amount is: 25,000 - 1,580 - 1,430 = 2 21,990.00 GBP. The calculation in 20X4 is similar. In 20X5, MEMEL PLC only pays-off 18,840.40 GBP which is the remainder. No extra re-payment is scheduled. Next, we take care of the disclosure of the bank loan on MEMEL PLC’s balance sheet. For its disclosure as at 31.12.20X2, the amounts for 20X2 do not matter as they have been paid already. The pay-off portion of the annuity including the extra pay-off in 20X3 to the extent of: 21,990 + 7,500 = 2 29,490.00 GBP are disclosed as short-term liabilities. We only calculate the measurement of the loan for its long-term liability portion. MEMEL PLC won’t transfer the liabilities which makes us apply the effective interest method and carry the loan at amortised costs. It is always a good idea, to determine the future payments as a vector as it provides an overview of the payments. MEMEL PLC receives a payment from the bank of 100,000.00 GBP on 2.01.20X2. It also pays the annuity of 25,000.00 GBP/ a. Hence, the resulting payment is amounting to: 100,000 - 25,000 = 7 75,000.00 GBP. In 20X3 and 20X4, the amounts paid are: 25,000 + 7,500 = 3 32,500.00 GBP each. In 20X4, the payment adds up to only: 18,840.40 + 753.62 = 1 19,594.02 GBP. The vector for the annuity is: A(t) = {75,000; -32,500; -32,500; -19,594.02}. We calculate an internal rate of return to a rounded percentage of 6.81%. See the financial schedule for the annuity in Figure 14.7. <?page no="313"?> Berkau: Financial Statements 4e 14-309 20X2 20X3 20X4 20X5 [GBP] [GBP] [GBP] [GBP] A(t) 75,000.00 (32,500.00) (32,500.00) (19,594.02) eff. int. (75,000.00) 80,105.00 eff. int. (47,605.00) 50,845.32 eff. int. (18,345.32) 19,594.02 0.00 0.00 0.00 (0.00) Memel PLC's BANK LOAN VALUATION CHART (20X2 - 20X5) Figure 14.7: MEMEL PLC’s annuity plan (20X2) We take out an amount of 32,500.00 GBP for short term-liabilities and interest as at the end of 20X2. As a result, the annuity is disclosed in 20X2 at: 75,000 - 32,500 = 4 42,500.00 GBP. The measurement of the annuity in the following Accounting periods is given by the calculation in Figure 14.8. c/ d Eff int. Short-term liab. b/ d [GBP] [GBP] [GBP] [GBP] 20X2 75,000.00 5,105.00 (32,500.00) 47,605.00 20X3 47,605.00 3,240.31 (32,500.00) 18,345.32 20X4 18,345.32 1,248.70 (19,594.02) (0.00) 20X5 0.00 0.00 0.00 0.00 Memel PLC's BANK LOAN CALCULATION (20X2 - 20X5) Figure 14.8: MEMEL PLC’s disclosure of annuity (20X2) Observe the accounts at MEMEL PLC in Figure 14.9: <?page no="314"?> Berkau: Financial Statements 4e 14-310 D C D C (1) 100,000.00 (2) 4,000.00 (3) 21,000.00 (1) 100,000.00 (3) 21,000.00 (4) 32,500.00 (5) 5,105.00 c2d 75,000.00 (6) 4,000.00 100,000.00 100,000.00 c2d 47,605.00 b/ d 75,000.00 (A) 32,500.00 105,105.00 105,105.00 c3d 42,500.00 (B) 32,500.00 b/ d 47,605.00 75,000.00 75,000.00 c3d 18,345.31 (C) 3,240.31 b/ d 42,500.00 (a) 32,500.00 50,845.31 50,845.31 c4d 10,000.00 (b) 19,594.02 b/ d 18,345.31 42,500.00 (c) 1,248.70 b/ d 10,000.00 (i) 19,594.02 c4d 0.01 c5d 9,594.02 19,594.02 19,594.02 19,594.02 19,594.02 b/ d 0.01 b/ d 9,594.02 Cash/ Bank Interest bearing liabilities IBL D C D C c2d 32,500.00 (4) 32,500.00 (2) 4,000.00 (6) 4,000.00 (A) 32,500.00 b/ d 32,500.00 c3d 32,500.00 (B) 32,500.00 65,000.00 65,000.00 (a) 32,500.00 b/ d 32,500.00 c4d 19,594.02 (b) 19,594.02 52,094.02 52,094.02 (i) 19,594.02 b/ d 19,594.02 Short-term liabilities A/ P Interest-20X2 INT D C D C (5) 5,105.00 P2L 5,105.00 LX2 5,105.00 R/ E 5,105.00 Loan expenses-20X2 LX2 Profit and Loss-20X2 P2L D C D C (C) 3,240.31 P3L 3,240.31 LX3 3,240.31 R/ E 3,240.31 Loan expenses-20X3 LX3 Profit and Loss-20X3 P3L D C D C (c) 1,248.70 P4L 1,248.70 LX4 1,248.70 R/ E 1,248.70 Loan expenses-20X4 LX4 Profit and Loss-20X4 P4L Figure 14.9: MEMEL PLC’s accounts (20X2-20X5) <?page no="315"?> Berkau: Financial Statements 4e 14-311 D C P2L 5,105.00 c2d 5,105.00 b/ d 5,105.00 P3L 3,240.31 c3d 8,345.31 8,345.31 8,345.31 b/ d 8,345.31 R/ E 1,248.70 c4d 9,594.01 9,594.01 9,594.01 b/ d 9,594.01 Retained earnings R/ E Figure 14.9: MEMEL PLC’s accounts (20X2-20X5) Ad (2): Provisions A provision falls under liabilities. IAS 37.10 defines provisions as liabilities of uncertain timing or amount. E.g., the reporting company does not know exactly when the liability occurs or to what extent an obligation exists. Besides of uncertainty, a provision requires a present obligation, such as resulting from a contract, derived from a threatening law suit etc. IAS 37.13 states that provisions are based on a present obligation that exists at the time of reporting. In line with IAS 37.27, contingent liabilities are not recognised on financial statements. A contingent liability is confirmed by future event(s). Its definition criteria are weaker than for provisions, meaning a contingent liability is either only a predicted future obligation or a present obligation that does not result in an outflow of future economic benefits or that cannot be measured reliably. An example for a contingent liability is vouchering for another company, e.g., for a subsidiary. IAS 37.13 compares provisions with contingent liabilities. The recognition criteria for provisions are set by IAS 37.14: existence of a present obligation, probability of an outflow of economic benefit and reliable measurement. Based on IAS 37.41, the measurement of a provision is the best estimate of the pre-tax amount of the expenses in order to settle the present obligation as known when reporting. A company shall calculate the value of a provision as its expected value, see the case in IAS 37.39. We here provide you with a similar example for a manufacturing company. The production firm SEENA Ltd. produces backpacks. Faulty products are returned and reworked. SEENA Ltd. knows if minor defects, such as not properly closing zippers, occur during the next Accounting period 20X9, the damage per backpack will be 5.00 EUR/ backpack. If a major defect occurs, e.g., a belt is not fixed properly or the fabric tears off, the damage will be 37.00 EUR/ backpack. SEENA Ltd. produces 500,000 backpacks and knows that the probability for minor defects is 10 % and for major defects 3 %. At the balance sheet date 31.12.20X8, SEENA Ltd. calculates the expected value of rework. It is amounting to: 500,000 × (10% × 5 + 3% × 37) = 805,000.00 EUR in the next Accounting period. Hence, SEENA Ltd. recognises a <?page no="316"?> Berkau: Financial Statements 4e 14-312 provision of 805,000.00 EUR at the reporting date. The Bookkeeping entry is as below: DR Repair....................... 805,000.00 EUR CR Provisions................... 805,000.00 EUR In 20X9, SEENA Ltd. reworks backpacks to the extent of 750,000.00 EUR. As the previously recorded provisions for rework during the Accounting period 20X9 are no longer required they are dissolved. IAS 37.61 requires that provisions shall only be used for expenditures they have been recognised for. The reason is that provisions are future, but uncertain liabilities. Provisions reduce the taxable profit as they lead to a disclosure of expenses in the Accounting period the reason for the provision comes to light. Even if the name might be misleading, provisions are not provisional tax free reserves to cover future risks. SEENA Ltd. makes the Bookkeeping entry below in 20X9. DR Provisions................... 805,000.00 EUR CR Repairs...................... 55,000.00 EUR CR Cash/ Bank.................... 750,000.00 EUR The credit entry in the Repairs account cancels out the overrated expenses recorded together with the provision in the previous Accounting period. Dissolving a provision works similar to a negative expense recognition, as the expenses have been considered in the previous Accounting period’s income statement already. A provision is recognised for a present obligation resulting in most probably future expenses. Provisions lead to a debit entry in an expense account in the Accounting period, when the provision is recognised. Hence, a provision is a precautious pulling forward of detected expenses measured by expectation values. This happens to make users of financial statements aware of outflows of economic benefits in upcoming Accounting periods. In general, provisions reduce operating profits in the Accounting period of their recognition. IAS 37.17 allows a recognition of provisions only if there is an obligation event, such as a contract enforceable by law or an action creating valid expectations for a probable and future outflow of economic benefits. IAS 37.18 emphasis that any provision or liability require a present obligation to exist as at the Accounting period’s end. In contrast, future expenses, such as upcoming interest payments for a bank loan, do not cause provisions as at the time of reporting no obligation exists. In line with IAS 37.19, a provision has to be unavoidable for the reporting company. The standard describes a future obligation to build-in filters for a <?page no="317"?> Berkau: Financial Statements 4e 14-313 certain kind of factory as avoidable because the company can change its operations, such as the method of manufacturing. In contrast, already existing environmental damage caused by operating a power plant rectifies a provision as the damage has been done and requires future clean-up costs. 54 Situations that require the recognition of provisions are, e.g.: - Agreement between a company and its employee to pay a pension. - Rework of products - even without enforceable legal lever. - Pending law suits based on unlawful or probably unlawful activities in the past. - Deferred taxes. - Clean-up costs or dismantling costs. - Claims resulting from postponed vacation of employees. - Onerous contracts. - Restructuring costs, i.e., when operations are discontinued or changed. - . . . In this text book we are unable to cover all cases for provisions. Although, we cover two examples below and explain the measurement and reasons for disclosure thereby. (a) Provision for pension funds. (b) Provision due to onerous contracts. Ad (2a): Provision for Pension Funds On 3.01.20X2, HADRA (Pty) Ltd. in South Africa adds a paragraph to the labour contract with its chief operating officer COO, Mr Gartner, to pay him a pension after his board membership terminates for the next following 4 years to the extent of annually 1,000,000.00 ZAR/ a, payable at the end of every year. It is most likely that Mr Gartner resigns in 20X5. At the time of filing the agreement, Mr Gartner’s career plans or circumstances are uncertain. The agreement is uncertain in terms of the time. There is a present obligation as the contract is enforceable. A provision applies. IAS 37.45 requires the provision to be measured by its most likely present value. IAS 37.47 defines the discount rate to be the pre-tax market rate for such a liability. We consider the market rate to be 10 %/ a. As the agreement has been made in 20X2, the full provision applies. On 31.12.20X2, HADRA (Pty) Ltd. recognises a provision to the extent of: (1 + 10%) -3 × 1,000,000 × ((1 + 10%) 4 - 1) / ((1 + 10%) 4 × 10%) = 2 2,381,566.83 ZAR. HADRA (Pty) Ltd. makes the Bookkeeping entry as below: DR Labour....................... 2,381,556.83 ZAR CR Provisions................... 2,381,556.83 ZAR The provision is based on an annuity of 4 payments at the end of 20X6 - 20X9. The 54 Read our Basics-1, chapter (15). <?page no="318"?> Berkau: Financial Statements 4e 14-314 payments are discounted for 3 periods, as the present value is calculated as at 31.12.20X5. In accordance with IAS 37.59, a reporting company has to review provisions annually. If the estimated time of Mr Gartner’s retirement changes, the provision needs to be adjusted. In case Mr Gartner signs a waiver declaration in favour of HADRA (Pty) Ltd., the provision shall be dissolved. Next, we discuss a provision measurement as at a subsequent valuation. In the case of DUMMOND (Pty) Ltd., the company is obliged to make annual payments of 100,000.00 ZAR/ a for a period of 4 years due to an estimated rework plan for delivered faulty goods produced and sold in the past. The annual payment of 100,000.00 ZAR/ a is an estimate and hence, the liability is classified uncertain. It requires the disclosure of a provision. Provisions are disclosed at present values if the time value of money is material. See IAS 37.45. IAS 37.47 defines how to determine the discount rate. On 2.01.20X2, DUMMOND (Pty) Ltd. records a provision of 400,000.00 ZAR for a 4 years period of re-work obligation. DUMMOND (Pty) Ltd. dissolves 100,000.00 ZAR of the re-work provision every year. To keep the case study simple, we assume payments are due on every 31.12.20XX. We apply a spreadsheet, such as provided by the CH5.xls file on our website. Link 14.B: DUMMOND (Pty) Ltd. See below in Figure 14.10 the calculation for the provision and the first payment in 20X2. Note, the provision is partially dissolved already. Year Opening amount Pay-off Rest [ZAR] [ZAR] [ZAR] 20X2 400,000 100,000 300,000 20X3 300,000 100,000 200,000 20X4 200,000 100,000 100,000 20X5 100,000 100,000 0 Dummond (Pty) Ltd.'s PROVISION PLAN (20X2 - 20X5) Figure 14.10: DUMMOND (Pty) Ltd.’s provisions (1) <?page no="319"?> Berkau: Financial Statements 4e 14-315 On its financial statements, the provision is disclosed on 1.01.20X2 for the first time. At the time of recognition of the provision, DUMMOND (Pty) Ltd. discloses the full amount as provision and adjusts the amount for discounting thereafter. Furthermore, the dissolving of an amount of 100,000.00 ZAR results in a payment to the customers involved. You find the Bookkeeping entries (1) to (3) below. DR Re-work Expenses............. 400,000.00 ZAR CR Provision.................... 400,000.00 ZAR DR Provision.................... 100,000.00 ZAR CR Short-term Liabilities....... 100,000.00 ZAR DR Short-term Liabilities ...... 100,000.00 ZAR CR Cash/ Bank.................... 100,000.00 ZAR After the above transaction, DUMMOND (Pty) Ltd. is left with 300,000.00 ZAR in provisions in 20X2. How it is Done (Rising Provisions for Rework): (1) Determine whether a provision applies: Is there a present obligation at the time of reporting? Does the obligation result in a future outflow of resources? Can the rework obligation be measured reliably? If the above questions are answered by (3 ×) yes, continue: (2) Calculate the obligation based on the expected value. Derive probabilities from experiences made in preceding Accounting periods. Consider the actual amounts of goods to be reworked on. (3) Calculate an expense vector for rework expenses expected. (4) Make a debit entry for the rework in the Rework account and a credit entry in the Provisions account. (5) If the time value of money is material, discount provisions as shown further below. The measurement of the provisions is based on present values. This makes us consider the time value of money. IAS 37.45 states that the expenses to settle the obligation are disclosed at present values if the time value of money is material. I.e., the time value of money matters when the rate of interest is high and/ or the period of rework is long, such as several years. Below we calculate the discounted amounts for the rework provisions at DUMMOND (Pty) Ltd. The provision is resulting in three future payments of 100,000.00 ZAR, together <?page no="320"?> Berkau: Financial Statements 4e 14-316 they are amounting to 300,000.00 ZAR. We call this amount the settlement amount, as the amounts are due on 31.12.20X3, 31.12.20X4, 31.12.20X5 to pay-off the estimated re-work obligations. In order to determine the fair value of the settlement amount, DUMMOND (Pty) Ltd. does not disclose 300,000.00 ZAR in debts. For the consideration of the time value of money, a lower, discounted amount applies. The disclosed amount for the provisions has still some time to earn interest before DUMMAND (Pty) Ltd. fulfils its payment obligations. The first 100,000.00 ZAR due on 31.12.20X3 got still 1 year to earn interest. For the interest calculation, we apply the text book rate of interest being 10 %/ a. In a real company, you have to calculate with the average rate of interest that applies for the next additional bank loan. The IASB calls this rate the incremental borrowing rate. It considers a company being already in debts is charged higher interest rates in order to factor in the higher risk for the lender. As a consequence, it is sufficient to measure the 20X3’s payment at: 100,000/ (1 + 10%) -1 = 990,909.09 ZAR. In the next Accounting period (20X3), the funds earn: 90,909.09 × 10% = 9 9,090.91 ZAR which adds up to an amount of: 90,909.09 + 9,090.91 = 1 100,000.00 ZAR as required for pay-off. We call the initial amount of 90,909.09 ZAR the present value. In the spreadsheet in Figure 14.11 we calculate present values for the remaining two payments estimated for 20X4’s and 20X5’s re-work. Year Opening amount Pay-off Discount Present value [ZAR] [ZAR] 10% [ZAR] 20X2 400,000.00 100,000.00 dissolved 20X3 300,000.00 100,000.00 1 0.91 90,909.09 20X4 200,000.00 100,000.00 2 0.83 82,644.63 20X5 100,000.00 100,000.00 3 0.75 75,131.48 Dummond (Pty) Ltd.'s PROVISION PLAN (20X2 - 20X5) Figure 14.11: DUMMOND (Pty) Ltd.’s provisions (2) For the measurement of remaining provisions, DUMMON (Pty) Ltd. has to revalue its provisions due in 20X3 - 20X5 as at on 31.12.20X2. The provisions of 300,000.00 ZAR are measured at present values discounted based on the annual rate of interest of 10 %/ a. They result in a fair provisions’ value of: 90,909.09 + 82,644.63 + 75,131.48 = 248,685.20 ZAR. There is a gap between the re-work expense of 400,000.00 ZAR and the paid expenses in 20X2 together with the (20X3 - 20X5) provisons’ fair value of: 400,000 - 100,000 - 248,685.20 = 51,314.80 ZAR. The difference is deducted from provisions and temporary kept in the Retained Earnings account. See the Bookkeeping entry (4) below: <?page no="321"?> Berkau: Financial Statements 4e 14-317 DR Interest Bearing Liabilities. 51,314.80 ZAR CR Retained Earnings............ 51,314.80 ZAR The difference in provision measurement is temporary as in the next Accounting period, DUMMON (Pty) Ltd. has to revalue the provisions based on the changed time situation. It also has to check the estimated measurement for re-work and whether the need for disclose of the provision is still valid. It could change, i.e., if the customers don’t claim. We here assume, the estimated payment obligation for reworking the goods remains, only the valuation of the provisions due to discounting matters. See below the calculation of the provisions’ present value as at 31.12.20X3 in Figure 14.12. Year Opening amount Pay-off Discount Present value [ZAR] [ZAR] 10% [ZAR] 20X2 400,000.00 100,000.00 dissolved 20X3 300,000.00 100,000.00 1 dissolved 20X4 200,000.00 100,000.00 1 0.91 90,909.09 20X5 100,000.00 100,000.00 2 0.83 82,644.63 3 Dummond (Pty) Ltd.'s PROVISION PLAN (20X3 - 20X5) Figure 14.12: DUMMOND (Pty) Ltd.’s provisions (3) In 20X3, the payment obligation for 20X3 is due and 100,000.00 ZAR in provisions are dissolved for the payment. We firstly transfer the amounts to shortterm liabilities and make payments on 31.12.20X3. Before the payment, the provisions are revalued at: 90,909.09 × (1 + 10%) = 1 100,000.00 ZAR. The remaining provisions for future payments are revalued, too. The amount for 20X4 and 20X5 are multiplied by the factor (1 + 10%) and give amounts of: 82,644.63 × (1 + 10%) = 9 90,909.09 ZAR and: 75,131.48 × (1 + 10%) = 8 82,644.63 ZAR respectively. The entire revaluation adds value to the extent of: (100,000 - 90,909.09) + (90,909.09 - 82,644.63) + (82,644.63 - 75,131.48) = 2 24,868.52 ZAR. We make a Bookkeeping entry for all revaluations together as below (a): DR Retained Earnings............ 24,868.52 ZAR CR Interest Bearing Liabilities. 24,868.52 ZAR Bookkeeping entry (b) and (c) are for dissolving of 20X3’s provision. You find all Bookkeeping entries for the Accounting periods 20X2 - 20X5 in Figure 14.13. Check below in Figure 14.13 the recalculation of DUMMOND (Pty) Ltd.’s provisions in 20X4. <?page no="322"?> Berkau: Financial Statements 4e 14-318 Year Opening amount Pay-off Discount Present value [ZAR] [ZAR] 10% [ZAR] 20X2 400,000.00 100,000.00 dissolved 20X3 300,000.00 100,000.00 dissolved 20X4 200,000.00 100,000.00 1 dissolved 20X5 100,000.00 100,000.00 1 0.91 90,909.09 3 Dummond (Pty) Ltd.'s PROVISION PLAN (20X4 - 20X5) Figure 14.13: DUMMOND (Pty) Ltd.’s provisions (4) Study the accounts below for measurement of provisions at DUMMOND (Pty) Ltd. Note, that the re-work expenses are only disclosed in 20X2. That is the year when the obligation for re-working was detected. No expenses are recorded in the years thereafter as the provisions are dissolved neutral to profit and loss. It means the estimated costs at the time of rising the provision are as high as the actual ones. For that reason, you won’t find Profit and Loss accounts for 20X3 - 20X5. D C D C (1) 400,000.00 P2L 400,000.00 (3) 100,000.00 (2) 100,000.00 (c) 100,000.00 (b) 100,000.00 (C) 100,000.00 (B) 100,000.00 (III) 100,000.00 (II) 100,000.00 Re-work-20X2 REW Short-term liabilitiy A/ P D C D C (2) 100,000.00 (1) 400,000.00 . . . (3) 100,000.00 (4) 51,314.80 c/ d 100,000.00 c/ d 248,685.20 100,000.00 100,000.00 400,000.00 400,000.00 c/ d 100,000.00 (b) 100,000.00 b/ d 248,685.20 c/ d 200,000.00 (c) 100,000.00 c/ d 173,553.72 (a) 24,868.52 200,000.00 200,000.00 273,553.72 273,553.72 b/ d 200,000.00 (B) 100,000.00 b/ d 173,553.72 c/ d 300,000.00 (C) 100,000.00 c/ d 90,909.09 (A) 17,355.37 300,000.00 300,000.00 190,909.09 190,909.09 b/ d 300,000.00 (II) 100,000.00 b/ d 90,909.09 c/ d 400,000.00 (III) 100,000.00 (I) 9,090.91 400,000.00 400,000.00 100,000.00 100,000.00 b/ d 400,000.00 Provision PRO Cash/ Bank C/ B Figure 14.14: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) <?page no="323"?> Berkau: Financial Statements 4e 14-319 D C D C P2L 400,000.00 (4) 51,314.80 REW 400,000.00 R/ E 400,000.00 c/ d 348,685.20 400,000.00 400,000.00 b/ d 348,685.20 (a) 24,868.52 c/ d 373,553.72 373,553.72 373,553.72 b/ d 373,553.72 (A) 17,355.37 c/ d 390,909.09 390,909.09 390,909.09 b/ d 390,909.09 (I) 9,090.91 c/ d 400,000.00 400,000.00 400,000.00 b/ d 400,000.00 Retained earnings R/ E Profit and loss-20X2 P2L Figure 14.14: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) continued How it is Done (Discounting Provisions): (1) Calculate the payment vector elements of the provision based on best estimates at the time of recognition. (2) Decide whether time value of money is material for the provision. Only if it applies continue with step (3). Otherwise recognise the provision without discounting. (3) Determine the discount rate dr. (4) Multiply every payment vector element by the factor (1 + dr) -n . n is the number of periods between the payment period and the reporting period. (5) Add all discounted payment vector elements. The sum is the measurement of the provision disclosure. (6) If the provision has been recorded before make an adjustment in valuation by a Bookkeeping entry DR Provisions . . . - CR Retained Earnings . . . In the next Accounting period: (A) Dissolve the provision to the extent it is relevant for the Accounting period. (B) Revalue the remaining payment vector elements by multiplication with the factor (1 + dr). (C) Calculate the difference of actual and prior measurement. (D) Make a Bookkeeping entry for revaluation as DR Retained Earnings account . . . - CR Provisions . . . <?page no="324"?> Berkau: Financial Statements 4e 14-320 Ad (2b): Provisions due to Onerous Contracts An onerous contract (IAS 27.66) requires a provision to the extent of the present obligation which is the loss resulting from the contract. An onerous contract only exists if both parties are bound to the contract. IAS 37.68 defines the contact to become onerous, if unavoidable costs resulting from the contract exceed economic benefits thereof. SALMAN Ltd. is an airliner in Australia. In order to compete with other aviation service providers, SALMAN Ltd. offers tickets for sale one year in advance. For a flight on 10.05.20X5 with an Airbus 321 from Perth to Melbourne, SALMAN Ltd. calculated costs of 400.00 AUD/ passenger. The aircraft is a 200 seater and is booked out on 31.12.20X4. The expected revenue is amounting to: 400 × 200 = 8 80,000.00 AUD. Operational flight expenses include crew labour, airport fees, fuel and depreciation. The total costs for the flight were calculated to be 75,000.00 AUD. Due to an increase of airport landing fees, the scheduled and sold flight becomes 10,000.00 AUD more expensive. On 31.12.20X4, SALMAN Ltd. records a provision due to the onerous contract to the extent of: 75,000 + 10,000 - 80,000 = 5 5,000.00 AUD. The flight has not yet been flown, hence, no certain liability exists. The contract between passengers and airline is a binding agreement and SALMAN Ltd. cannot avoid the airport fees as the flight is scheduled on the route Perth- Melbourne. A deviation of the flight due to airport fees is not applicable but might become inevitable due to reasons of dangerous weather conditions if emergency avoiding action are to be taken by the pilot. This means the higher costs are still uncertain. SALMAN Ltd. makes the Bookkeeping entry below: DR Loss on Onerous Flight....... 5,000.00 AUD CR Provisions................... 5,000.00 AUD The Bookkeeping entry is required as the user of SALMAN Ltd.’s financial statements shall be informed about a loss, caused by actions and events in 20X4 which lead to an onerous flight in the next Accounting period. A present obligation to operate the flight exists based on the ticket sales as well as on the threatening reputation loss a flight cancellation would cause. The flight costs are not certain but are calculated based on the expected values. The expenses for the onerous contract are recorded in the reporting Accounting period 20X4 through profit or loss. How it is Done (Provisions for Onerous Contracts): (1) Determine whether an onerous contract exists. Is the contract binding? Does it probably lead to a loss? (2) Calculate the loss expected from fulfilling the contract obligations as to your best estimate at the time of recording. <?page no="325"?> Berkau: Financial Statements 4e 14-321 (3) Make a debit entry in the Loss on Onerous Contract account and a credit entry in the Provisions account. (4) Check whether discounting of the provision applies. Summary: Liabilities are present obligations that result in an outflow of economic benefits, most likely in a cash outflow. Short-term liabilities are due within one Accounting period and are disclosed as the accounts payables A/ Pitem on the balance sheet. They are measured by the present obligation, e.g., the amount of money owed. With regard to long-term debts, IFRSs distinguish three kinds of liabilities: certain liabilities, such as bank loans or bonds, uncertain liabilities, mostly provisions, and contingent liabilities which have no present obligations or do not fulfil requirements of debt disclosure. The latter ones are not recognised on financial statements. As most companies do not intend to transfer (certain) liabilities, they are carried at amortised costs. In contrast, provisions are measured at present values if time value of money is material - which in most of the cases applies. Liabilities are to be explained in the notes where further debt information is provided. Accounting Technical Terms: Annuity: Bank loan with a constant payment for interest and pay-off. Amortised costs: To keep an asset or liabilities at amortised costs is a simplification of its measurement accepted for financial instruments that are intended to keep until maturity. It replaces a fair value presentation. The calculation of amortised costs is based on the effective interest method. Bond: Financial instrument that pays the holder a regular coupon and is paid-off in a lump sum when it matures. Call option: Right to buy something, e.g., commodities, stock, bonds etc. Contingent liability: Liability that is uncertain and/ or does not fulfil recognition requirements. Derivative: A financial instrument of which the price or redemption value depends on external factors, e.g., on a future commodity price. Effective interest method: Valuation of a liability or financial instrument measured by a payment vector with revaluation of its elements based on internal rate of return calculation. The effective rate of interest calculation requires iteration. Fair value: Measurement an asset/ liability is transferred at on an active market, i.e., a stock price. Liabilities: Present obligation that results in future outflow of economic benefits. Onerous contract: A contract a loss is most probably expected to result from as it is likely that expenses exceed revenues. Present obligation: An obligation that exists at the reporting date (31.12.20XX). Present value: Valuation where discounted values apply for measurement. <?page no="326"?> Berkau: Financial Statements 4e 14-322 Provision: Uncertain liability which is uncertain in regard to time and/ or payment. Also the provision can be uncertain of occurrence. Provisions are ruled by IAS 37. Provisions require a present obligation at the time of reporting. Question Bank: (1) A company carries a bank loan. Which is the correct method for subsequent measurement? 1. Present value. 2. Fair value through profit or loss 3. Amortised costs. 4. Fair value through other comprehensive income. (2) A company expects to be fined based on a pending court case by 100,000.00 EUR. The probability to pay the penalty is 40 %. What is the correct Bookkeeping entry at the year-end? 1. DR Expenses … 60,000.00 EUR - CR Provisions … 60,000.00 EUR. 2. DR Expenses … 100,000.00 EUR - CR Provisions … 100,000.00 EUR. 3. DR Expenses … 50,000.00 EUR - CR Provisions … 50,000.00 EUR. 4. DR Expenses … 40,000.00 EUR - CR Provisions … 40,000.00 EUR. (3) A company issued bonds at 1,000,000.00 EUR with a discount of 10 %. The coupon rate is 5 %/ a. The bank charges 50,000.00 EUR issue fees and the effective rate of interest is 6.4 %. How much are expenses to be recorded in the first Accounting period? 1. 100,000.00 EUR. 2. 64,000.00 EUR. 3. 54,400.00 EUR. 4. 57,600.00 EUR. (4) A parent vouchers for a subsidiary in another country and provides the bank with its financial statements. The agreement is that the parent will pay for the liabilities of its subsidiary in case the subsidiary becomes insolvent. How is the situation disclosed on the financial statements of the parent? 1. Contingent liability. 2. Provision. 3. Liability. 4. N/ a. (5) On 1.01.20X3, a company takes a bank loan of 100,000.00 EUR with a 3 % discount. The bank loan comes with a rate of interest of 5 %/ a and a pay-off amount of 25.000.00 EUR/ a. What is the payment vector B(t) for the Accounting periods 20X3 - 20X6 if interest and pay-off is paid at the year-end? 1. {70,000; -28,750; -27,500; -26,260}. 2. {67,000; -28,750; -27,500; -26,250}. 3. {75,000; -25,000; -25,000; -25,000}. 4. {72,850; -28,900; -27,650; -26,400}. Solutions: 1-3, 2-4, 3-3, 4-4, 5-2. <?page no="327"?> Berkau: Financial Statements 4e 15-323 15. Abbreviations Acc Accounting Acc. Accumulated ACC Accumulated Depreciation account Acc Depr Accumulated Depreciation, in accounts: AcD Acc IL Accumulated Impairment Loss ADM Administration Expense Account adj. Adjusted aggr. Aggregated AGM Annual General Meeting AIL Accumulated Impairment Loss AP Airport fees A/ P Accounts Payables A/ R Accounts Receivables A/ S Annual Surplus AUD Australian Dollars / a per annum, per year Bal Balance BCE Business Car Expenses BE Break-even bear. Bearing Bhd Berhad, legal form or a public limited company in Malaysia BL(t) Vector of the Bank Loan BoE Books of original Entry BOM Bill of materials b/ d Balance brought down B/ S Balance Sheet BV Besloten vennootschap met beperkte aansprakelijkheid, legal form of a limited company in the Netherlands BWP Botswanan Pula, currency in Botswana / b per Bond C Costs (total) C Credit CA Carrying Amount Cap Capital CapRes Capital Reserves CB Cash Book C/ B Cash/ Bank CC Cost Centre CCDU Coffee Capsule Dispense Unit CD Cost Driver CEO Chief Executive Officer c/ d Balance carried down <?page no="328"?> Berkau: Financial Statements 4e 15-324 c1d Balance carried down in 20X1 CF Cash Flow c/ f carried forward (Profit) CFO Chief Financial Officer, Accountant CFS Statement of Cash Flows CGG Council Cooperation for the Arab states in the Gulf CH5.xls Chapter-5 MS-Excel file CIPC Companies and Intellectual Property Commission C, L Capital, Liabilities CM Contribution Margin CMA Contribution Margin Accounting CMRatio Contribution Margin Ratio CoBa Commerzbank COH Conveyance Overheads Account Cons. Consolidation COO Chief Operating Officer Corp. Corporation COS Cost of Sales, Cost of Goods Sold CPN Coupon, Interest Earned by Bond Holding CR Credit Recorded, Credit Entry ctrl. Controlling cur Current CVP Cost Volume Profit CVPA Cost Volume Profit Analysis, CVP-analysis D Debit / d per day DcE Decoration Expenses Dep Department Depr, Dpr Depreciation DIV Dividend DPR Depreciation account DPS Disposal Account DOL Degree of Operating Leverage dr Discount Rate DR Debit Recorded, Debit Entry Drw Drawing Dst Distribution DTI Deferred Tax Income D2E Debt-to-Equity Ratio EarnRes Earnings Reserves EAT Earnings after Taxes EBIT Earnings before Interest and Taxes EBK Eröffnungsbilanzkonto, opening account EBT Earnings before Taxes eff. Effective <?page no="329"?> Berkau: Financial Statements 4e 15-325 e.g. Exempli gratia, Lat: for example EPS Earnings per share E-R Earnings Reserves Account EStG German income tax law, Einkommensteuergesetz Eur Europe EUR Euro EVA Economic Value Added exp. Expense F. Framework FA Financial Accounting FA Financial Assets Account fCF Cash Flow from Financing Activities FG Finished Goods FGI Finished Goods Inventory account FI Financial Instruments Account Fin Finance FNB First National Bank South Africa F/ S Financial Statements FSA Financial Statement Analysis Fue Fuel Costs FV Fair Value FVTPL Fair Value through Profit or Loss FVTOCI Fair Value through other Comprehensive Income GBP British Pound GmbH Gesellschaft mit beschränker Haftung (German legal form) GoD Gain on Disposal GP Gross Profit GST Goods and Service Tax, same as Value Added Tax VAT HGB Handelsgesetzbuch IAS International Accounting Standards IASB International Accounting Standards Board IBL Interest Bearing Liabilities I.BX Inventory Box Account I.CC Inventory Coffee Capsule Dispense Unit Account iCF Cash Flow from Investing Activities ID Identifier, Identification Number i.e. It est, lat: that is IFG Inventory of finished goods IFRS International Financial Reporting Standards IL Impairment Loss ILD Impairment Loss Account for Discontinued Operations Inc. Incorporation INS Insurance Account INT Interest Account INV Inventory Account <?page no="330"?> Berkau: Financial Statements 4e 15-326 InvProp Investment Property IPO Initial Public Offering IRM Inventory of raw materials I/ S Income Statement I.SP Inventory Soap Account ISS Issued Capital Account IT Income Taxes ITE Income Tax Expenses Account ITL Income Tax Liabilities Account JO Job Order JPY Japanese Yen JSE Johannesburg Stock Exchange KaDeWe Kaufhaus des Westens, department store in Berlin K.K. kabushiki kaisha (Japanese legal form) KMTS Kenilworth Metered Taxi Service Ltd. KRW Korean Won (South Korean currency) KSU Kite Surfing Unit kWh Kilo Watt Hours LAA Attorney Labour Account Lab Labour LAB Labour account LAP Paralegal Labour Account Lat. Latin / lb per Pound lbs Pound l-h Labour Hours Liab Liability, Liabilities LLC Limited Liabilities Company Ltd. Limited Company LoD Loss on Disposal MA Management Accounting M/ A Management and Administration Expense Account Mat Materials, Material Expenses MAT Materials account McD McDonals’s Corporation MG Merchandise Goods m-h Machine Hours MOA Manufacturing Overheads-Assembling Account MOC Manufacturing Overheads-Cleaning Account Moh Manufacturing Overheads MOH Manufacturing Overheads account MoI Memorandum or Incorporation / m per month MoP Manufacturing Overheads-Production Account MOS Manufacturing Overheads-Shipping Account <?page no="331"?> Berkau: Financial Statements 4e 15-327 MS Mircosoft Mtn Maintenance n/ a Not Applicable NoE Nature of Expense method NP Net Profit NPO Non-Profit Organisation NSP Net Selling Price oCF Cash Flow from Operating Activities OCI Other Comprehensive Income OE Owners Equity OEX Operational expenses op Operation ord. Ordinary OTH Other Expenses OV Opening value P Profit P&L Profit and Loss account, profit or loss P1L Profit and Loss account-20X1 PLC Public Limited Company PLT Profit and Loss Account for Taxation PoD Profit on Disposal PPE Property, Plant and Equipment PUR Purchases PRE Prepaid Expenses account pref. Preference PRT Pro Rata Temporis (Pty) Ltd. Proprietary limited company QR Quick Response r Rate Rd Road R/ E Retained Earnings REA Realisation Account Rec/ Pay Receipts and Payments, received or paid Res Reserves RES Reserves Account Rev Revenue, Sales REV Revenue Account Reval Revaluation RFID Radio Frequency Identification R.I Returns Inwards Account RM Malaysian Ringgit (currency in Malaysia) RNT Rent R.O Returns Outwards Account RoA Register of non-current Assets ROA Return on Assets <?page no="332"?> Berkau: Financial Statements 4e 15-328 ROCE Return on Capital employed ROSF Return on Shareholders Fund RPM Revolutions per Minute RPR Repair Account rr Risk Rate R-R Revaluation Reserves Account RSA Republic of South Africa RUA Right to Use Asset Sal Salary SAn South Afrcian SARS South African Revenue Service SBK Schlussbilanzkonto, Closing Account SCap Share Capital SCE Statement of Changes in Equity SCF Statement of Cash Flows SCI Statement of Comprehensive Income SEC Security Account SEC Security Exchange Commission (US) Sdn Bhd Sendirian Berhad, legal form of a privat limited company in Malaysia SFP Statement of Financial Position ShD, S4D Shareholder for Dividend SMV Settlement Value SOH Service Overheads, Service Overheads account SPL Statement of Profit or Loss and Other Comprehensive Income SPPI Solely Payments of Principal and Interest / s per Share t Tons, 1,000 T/ A Trading Account T/ B Trial balance TC(t) Vector of the Taxi Car Business T&C Terms and Conditions UK United Kingdom USD US dollar / u per unit VAT Value Added Tax VIU Value in Use WACC Weighted Average Cost of Capital WIA Work in Process-Assembling Account WIP Work in Progress, Work in Process, Work-in-Process Account WIC Work in Process-Cleaning Account WIS Work in Process-Shipping Account ZAR South African Rand <?page no="333"?> Berkau: Financial Statements 4e 16-329 16. Table of Figures Figure 1.1: Accounts 1.8 Figure 2.1: KIELING TAXI GmbH’s opening balance sheet 2-15 Figure 2.2: KIELILNG TAXI GmbH’s journal (20X1) 2-16 Figure 2.3: KIELING TAXI GmbH’s balance sheet 20X1 2-18 Figure 2.4: KIELING TAXI GmbH’s profit and loss statement 20X1 2-20 Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X1) 2-21 Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) 2-23 Figure 2.7: KIELING TAXI GmbH’s income statement (20X2) 2-25 Figure 2.8: KIELING TAXI GmbH’s balance sheet (20X2) 2-27 Figure 3.1: Signing-in to IFRS Foundation.org (example) 3-30 Figure 3.2: IFRS.org: Standards for download 3-31 Figure 3.3: KMTS Ltd.’s opening balance sheet 3-32 Figure 3.4: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts 3-35 Figure 3.5: KMTS Ltd.’s accounts after adjustments (20X1) 3-36 Figure 3.6: KMTS Ltd.’s accounts after profit calculation (20X1) 3-38 Figure 3.7: KMTS Ltd.’s income statement (20X1) 3-40 Figure 3.8: KMTS Ltd.’s balance sheet (20X1) 3-41 Figure 3.9: KMTS Ltd.’s cash flow statement (20X1) 3-42 Figure 3.10: KMTS Ltd.’s statement of changes in equity (20X1) 3-42 Figure 3.11: KMTS Ltd.’s accounts (20X2) 3-43 Figure 3.12: KMTS Ltd.’s accounts after profit calculation (20X2) 3-46 Figure 3.13: KMTS Ltd.’s accounts for profit appropriation (20X2) 3-48 Figure 3.14: KMTS Ltd.’s income statement (20X2) 3-49 Figure 3.15: KMTS Ltd.’s balance sheet (20X2) 3-49 Figure 3.16: KMTS Ltd.’s cash flow statement (20X2) 3-50 Figure 3.17: KMTS Ltd.’s statement of changes in equity (20X2) 3-50 Figure 4.1: DEMANN GmbH’s order calculation 4-54 Figure 4.2: RYNEVELD Ltd.’s accounts before adjustments 4-58 Figure 4.3: RYNEVELD Ltd.’s trial balance 4-59 Figure 4.4: Elements of a Trading account 4-61 Figure 4.5: RYNEVELD Ltd.’s accounts after adjustments (20X6) 4-63 Figure 4.6: RYNEVELD Ltd.’s adjusted trial balance (20X6) 4-66 Figure 4.7: RYNEVELD Ltd.’s balance sheet (20X6) 4-67 Figure 4.8: RYNEVELD Ltd.’s income statement 4-68 Figure 4.9: Worksheet for adj. trial balance preparation (1 st step) 4-69 Figure 4.10: Complete worksheet for adj. trial balance preparation 4-70 Figure 5.1: Company data 5-77 Figure 5.2: CAPELIFT (Pty) Ltd.’s balance sheet 20X8 5-79 Figure 5.3: CAPELIFT (Pty) Ltd.’s income statement (20X8) 5-79 Figure 6.1: BATHURST Ltd.’s balance sheet (20X4) 6-95 Figure 6.2: BATHURST Ltd.’s accounts (20X5) 6-96 Figure 6.3: BATHURST Ltd.’s accounts (20X6) 6-98 <?page no="334"?> Berkau: Financial Statements 4e 16-330 Figure 6.4: BATHURST Ltd.’s balance sheet (20X6) 6-101 Figure 6.5: BATHURST Ltd.’s income statement (20X6) 6-103 Figure 6.6: BATHURST Ltd.’s statement of changes in equity (20X6) 6-104 Figure 6.7: BATHURST Ltd.’s statement of cash flows (20X6) 6-104 Figure 6.8: BATHURST Ltd.’s notes (20X6) 6-109 Figure 7.1: GELLENDORFF LLC’s accounts (i) 7-119 Figure 7.2: GELLENDORFF LLC’s accounts (ii) 7-123 Figure 7.3: GELLENDORF LLC’s register of non-current assets 7-124 Figure 7.4: GELLENDORFF LLC’s asset-reconciliation statement 7-124 Figure 7.5: TINNEN K.K.’s accounts (20X4) 7-129 Figure 7.6: YSTERFONTEIN Ltd.’s accounts 7-134 Figure 7.7: OVERBERG (Pty) Ltd.’s accounts 7-139 Figure 7.8: KRIGE (Pty) Ltd.’s accounts (20X3) 7-143 Figure 7.9: KRIGE (Pty) Ltd.’s accounts (20X4) 7-144 Figure 7.10: VLAEBERG K.K.’s finance schedule for the lease 7-147 Figure 7.11: VLAEBERG K.K.’s accounts (20X4 - 20X6) 7-149 Figure 7.12: Bond measurement at effective interest 7-157 Figure 8.1: BRENO Ltd.’s balance sheet (1.01.20X5) 8-168 Figure 8.2: BRENO Ltd.’s income statement (20X5) 8-169 Figure 8.3: BRENO Ltd.’s balance sheet (separate F/ S) 8-171 Figure 8.4: BRENO Ltd.’s income statement (separate F/ S) 8-171 Figure 8.5: GAMKA Ltd.’s statement of financial position 8-174 Figure 8.6: SWARTBERG Ltd.’s statement of financial position 8-175 Figure 8.7: GAMKA Ltd.’s SFP after acquisition 8-176 Figure 8.8: Consolidation chart (1) 8-177 Figure 8.9: Consolidation chart (2) 8-178 Figure 8.10: Consolidated balance sheet 8-179 Figure 8.11: GAMKA Ltd.’s income statement (20X4) 8-180 Figure 8.12: GAMKA Ltd.’s balance sheet (20X4) 8-180 Figure 8.13: SWARTBERG Ltd.’s income statement 20X4 8-181 Figure 8.14: SWARTBERG Ltd.’s balance sheet 20X4 8-181 Figure 8.15: GAMKA Group’s consolidation chart (20X4.1) 8-182 Figure 8.16: Prolonged income statement for SWARTBERG Ltd. 20X4 8-183 Figure 8.17: GAMKA Group’s consolidation chart (20X4.2) 8-184 Figure 8.18: GAMKA Group’s consolidated balance sheet 20X4 8-184 Figure 8.19: GAMKA Group’s consolidated income statement (20X4) 8-185 Figure 8.20: Consolidated statement of changes in equity (20X4) 8-185 Figure 8.21: GAMKA Group’s consolidated SCF 20X4 8-186 Figure 8.22: PORTERSVILLE Ltd.’s balance sheet (parent) 8-188 Figure 8.23: HENDERSON Ltd.’s balance sheet (subsidiary) 8-188 Figure 8.24: Consolidation worksheet for PORTERSVILLE Group (1) 8-189 Figure 8.25: Consolidation worksheet for PORTERSVILLE Group (2) 8-190 Figure 8.26: Consolidation worksheet for PORTERSVILLE Group (3) 8-191 Figure 8.27: Consolidation worksheet for PORTERSVILLE Group (4) 8-192 Figure 8.28: PORTERSVILLE Group’s balance sheet 8-192 <?page no="335"?> Berkau: Financial Statements 4e 16-331 Figure 8.29: QUICKARMS Ltd.’s balance sheet (20X6) 8-194 Figure 8.30: QUICKARM Ltd.’s income statement 8-195 Figure 8.31: QUICKARM Ltd.’s balance sheet (20X7) 8-195 Figure 8.32: QUICKARM Ltd.’s income statement 8-196 Figure 8.33: QUICKARM Ltd.’s balance sheet (20X7) 8-196 Figure 8.34: CLOSE-WATCH (Pty) Ltd.’s opening balance sheet 8-197 Figure 8.35: CLOSE-WATCH (Pty) Ltd.’s income statement 8-198 Figure 8.36: CLOSE-WATCH (Pty) Ltd.’s balance sheet (20X7) 8-198 Figure 8.37: QUICKARM/ CLOSE-WATCH joint venture’s balance sheet 8-199 Figure 8.38: QUICKARM/ CLOSE-WATCH joint venture balance sheet 8-199 Figure 9.1: GREENACRES Ltd. accounts (periodic system) 9-205 Figure 9.2: GREENACRES Ltd. accounts (perpetual system) 9-208 Figure 9.3: ROSEFIELD Ltd.’s purchases 9-210 Figure 9.4: ROSEFIELD Ltd.’s accounts (a: FIFO) 9-211 Figure 9.5: ROSEFIELD Ltd.’s accounts (b: weighted average) 9-213 Figure 9.6: RIEBECK (Pty) Ltd.’s budgeted accounts 9-218 Figure 9.7: RIEBECK (Pty) Ltd.’s actual accounts (IAS 2.13) 9-220 Figure 9.8: NOKOX (Pty) Ltd.’s accounts 9-230 Figure 9.9: BAKENSKOP PLC’s foreign currency bank accounts 9-232 Figure 10.1: EIMKE Ltd.’s balance sheet (20X7) 10-237 Figure 10.2: EIMKE Ltd.’s liquidity plan (20X8) 10-238 Figure 10.3: EIMKE Ltd.’s statement of cash flows (20X8) 10-239 Figure 10.4: EIMKE Ltd.’s accounts (20X8) 10-241 Figure 10.5: EIMKE Ltd.’s balance sheet (20X8) 10-248 Figure 10.6: EIMKE Ltd.’s income statement (20X8) 10-248 Figure 10.7: EIMKE Ltd.’s cash flow statement (20X8) 10-250 Figure 11.1: YARRA Ltd.’s balance sheet (20X0) 11-255 Figure 11.2: YARRA Ltd.’s balance sheet (20X1) 11-258 Figure 11.3: YARRA Ltd.’s balance sheet (20X2) 11-261 Figure 11.4: Detailed equity section on YARRA Ltd.’s B/ S (20X1) 11-262 Figure 11.5: Detailed equity section on YARRA Ltd.’s B/ S (20X2) 11-263 Figure 12.1: ABINGTON Ltd.’s accounts (20X4) 12-267 Figure 12.2: ABINGTON Ltd.’s Profit and Loss calculation (NoE) 12-269 Figure 12.3: ABINGTON Ltd.’s income statement (NoE) 12-269 Figure 12.4: SUTTHAUSEN PLC’s balance sheet (20X3) 12-271 Figure 12.5: SUTTHAUSEN PLC’s purchase ledger 12-272 Figure 12.6: SUTTHAUSEN PLC’s accounts (NoE) 12-273 Figure 12.7: SUTTHAUSEN PLC’s income statement (NoE) 12-275 Figure 12.8: ABINGTON Ltd.’s accounts (COS) 12-277 Figure 12.9: ABINGTON Ltd.’s income statement (COS) 12-278 Figure 12.10: SUTTHAUSEN PLC’s accounts (COS) 12-281 Figure 12.11: SUTTHAUSEN PLC’s income statement (COS) 12-284 Figure 13.1: BELMONT Ltd.’s balance sheet (20X6) 13-287 Figure 13.2: BELMONT Ltd.’s statement of changes in equity (1) 13-287 Figure 13.3: BELMONT Ltd.’s statement of changes in equity (2) 13-289 <?page no="336"?> Berkau: Financial Statements 4e 16-332 Figure 13.4: BELMONT Ltd.’s statement of changes in equity (3) 13-289 Figure 13.5: BELMONT Ltd.’s statement of changes in equity (4) 13-291 Figure 13.6: BELMONT Ltd.’s statement of changes in equity (5) 13-291 Figure 13.7: BELMONT Ltd.’s statement of changes in equity (6) 13-293 Figure 14.1: Effective interest method at MEUL Ltd. 14-300 Figure 14.2: MEUL Ltd.’s accounts (20X1 - 20X5) 14-301 Figure 14.3: Alternative calculation of the loan at MEUL Ltd. 14-303 Figure 14.4: Effective interest calculation at BRIZA Ltd. 14-306 Figure 14.5: BRIZA Ltd.’s bond calculation 14-307 Figure 14.6: MEMEL PLC’s annuity (20X2) 14-308 Figure 14.7: MEMEL PLC’s annuity plan (20X2) 14-309 Figure 14.8: MEMEL PLC’s disclosure of annuity (20X2) 14-309 Figure 14.9: MEMEL PLC’s accounts (20X2-20X5) 14-310 Figure 14.10: DUMMOND (Pty) Ltd.’s provisions (1) 14-314 Figure 14.11: DUMMOND (Pty) Ltd.’s provisions (2) 14-316 Figure 14.12: DUMMOND (Pty) Ltd.’s provisions (3) 14-317 Figure 14.13: DUMMOND (Pty) Ltd.’s provisions (4) 14-318 Figure 14.14: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) 14-318 <?page no="337"?> Berkau: Financial Statements 4e 17-333 17. Links Link 2.A: KIELING TAXI GmbH 2-18 Link 2.B: DATEV-4 chart of accounts 2-21 Link 2.C: Lufthansa AG’s appendix 2-27 Link 4.A: RYNEVELD Ltd. 4-68 Link 4.B: TELUK Sdn. Bhd. 4-68 Link 4.C: BINNEVELD Ltd. 4-70 Link 5.A: COMAIR Ltd. 5-73 Link 5.B: EPS calculations 5-84 Link 5.C: CAPELIFT (Pty) Ltd. 5-87 Link 6.A: BATHURST Ltd. 6-95 Link 7.A: RAVENWOOD GmbH 7-115 Link 7.B: OTZE AG 7-115 Link 7.C: GROOTVLEI BV. 7-124 Link 7.D: TYGERVALLEY Ltd. 7-125 Link 7.E: CORAL Ltd. 7-126 Link 7.F: JANSSENS Ltd. 7-133 Link 7.G: Bond valuation 7-155 Link 7.H: NATBERGEN (Pty) Ltd. 7-157 Link 7.I: HELWAN AIRWAYS Ltd. 7-160 Link 9.A: ROSEFIELD Ltd. 9-214 Link 10.A: RYNEVELD Ltd. 10-250 Link 10.B: EIMKE Ltd. 10-251 Link 12.A: ANKYO Ltd. 12-271 Link 14.A: MEUL Ltd. 14-300 Link 14.B: DUMMOND (Pty) Ltd. 14-314 <?page no="338"?> Berkau: Financial Statements 4e 18-334 18. Literature Berkau, C. [2013]: Bilanzen, 3. Aufl. Konstanz, Munich. Berkau, C.; Berkau, K.S. [2018]: Basics of Accounting. 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