<?page no="1"?> Financial Statements <?page no="3"?> Carsten Berkau Financial Statements International Accounting (IFRS) 5 Edition UVK Verlag · München Translated by Keabetswe Sylvia Berkau <?page no="4"?> Bibliografische Information der Deutschen Nationalbibliothek Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über <http: / / dnb.dnb.de> abrufbar. 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 20 20 - ein Unternehmen der Narr Francke Attempto Verlag GmbH + Co. KG , xxDischingerweg 5 · 72070 Tübingen Internet: www.narr.de eMail: info@narr.de Druck und Bindung: CPI books GmbH, Leck ISBN 978-3-7398-3093-3 (Print) ISBN 978-3-7398-8093-8 (ePDF) Professor Carsten Berkau teaches Accounting and Managing Accounting at the University of Applied Sciences in Osnabrück and other Universities in South Africa, China and South Korea. <?page no="5"?> Berkau: Financial Statements 5e 1-1 Contents 1. Conventions 1-3 2. Financial Statements based on HGB 2-8 3. Financial Statements based on IFRSs 3-30 4. Accounting for Retailers 4-54 5. Basics of Financial Statement Analysis 5-76 6. Formal Aspects of Financial Statements 6-95 7. Non-current Assets on the Balance Sheet 7-116 8. Business Combinations 8-173 9. Current Assets on the Balance Sheet 9-212 10. Statement of Cash Flows 10-246 11. Equity on the Balance Sheet 11-262 12. Statement of Profit or Loss and Other Comprehensive Income 12-277 13. Statement of Changes in Equity 13-299 14. Liabilities on the Balance Sheet 14-309 15. Abbreviations 15-339 16. Table of Figures 16-345 17. Links 17-349 18. Literature 18-350 <?page no="6"?> Berkau: Financial Statements 5e 1-2 Introduction From this 5 th edition, we publish an English and German version of our textbook Financial Statements/ Bilanzen at the same time. The content of Financial Statements focusses on IFRSs. Only chapter (2) is dedicated to German Accounting. Financial Statements covers the syllabus of an international Accounting class for the bachelor’s or master's degree. It is designed for a 150 hours workload Accounting class. For understanding, knowledge in Bookkeeping is mandatory as covered by our Basics of Accounting. 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. 62 case studies form the major part of our textbook. You as our readers will learn Accounting from case observations and the explanations thereto. From the publisher's website: “www.uvk.digital/ 9783739830933” you can download over 300 exam tasks with complete solutions. We write our textbooks as an international academic team from Germany and South Africa. It is based on our teaching experience in Osnabrück/ Lingen (Ems), Cape Town, Enschede, Grahamstown, Kuantan, Port Elizabeth/ George, Seoul and Shanghai. We thank our colleagues at Hochschule Osnabrück, namely Prof. Dr. Marion Wendehals, and at our partner universities for their great support in developing the syllabus. We are very grateful for the pleasant cooperation with Dr. Jürgen Schechler from UVK-Lucius, who is our lector in Munich. We are enjoying the very friendly and highly efficient cooperation with him for all our textbooks (Basics of Accounting, Bilanzen, Financial Statements and Management Accounting). Finally, we thank our students and readers for their valuable feedback which helps us a lot improving our textbooks and make them study friendly. For sending us comments on our textbooks, pls., write to: BOOK@Prof-Berkau.de. Enjoy our new edition of Financial Statements/ Bilanzen! Cape Town, in July 2020 Keabetswe Sylvia Berkau, Prof. Dr. Carsten Berkau, Dipl.-Ing. <?page no="7"?> Berkau: Financial Statements 5e 1-3 1. Conventions The below listed conventions apply merely to simplify the case. These conventions are about legal forms, tax rates, formats etc. They apply for this textbook, for our Basics of Accounting, for our Management Accounting and for all online study materials. At this stage of studying Accounting, you might not understand the conventions completely. We only put them at the beginning of the textbook for you to find them upfront. Accounting Periods: Accounting periods start on 1.01.20XX and end on 31.12.20XX. Furthermore, to keep the examples transferable to later years, we write the decades with an X, as in 20X4. X is followed by Y, then Z. Accounting Technical Terms: At the end of every chapter, we explain new technical terms. They help you to easily understand the content. These are simple explanations if you are beginners in Accounting. The Accounting technical terms are not as formal and precise as the definitions provided by the IASB. Account Names: All account names are written with capital letters in the text, such as ‘Cash/ Bank account’. However, an account not subjected to our recordings is written in small letters. Assume there is a bank account with Deutsche Bank, and we refer thereto. The writing is with small letters: bank account. We do not make Bookkeeping entries therein, but Deutsche Bank AG does. However, the Cash/ Bank account applicable to calculate the item cash/ bank on the balance sheet is part of our Accounting work. Alphabetic Order: For all lists, we apply an alphabetic order. Basics: Our Basics refers to the textbook Berkau: Basics of Accounting. You must read our basics before you start reading our Financial Statements. It introduces you to Bookkeeping and major Accounting concepts without consideration of International Accounting standards IFRSs. We frequently quote the Basics. Bookkeeping Entries: All Bookkeeping entries are printed in bold and cover a whole page’s width. Bookkeeping Entry Format: We write debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. See, e.g., a Bookkeeping entry for the acquisition of a motor vehicle: DR Motor Vehicle................ 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR <?page no="8"?> Berkau: Financial Statements 5e 1-4 The identifier for Bookkeeping entries in the text, like “Bookkeeping entry (1)” can be found in the accounts as “(1)”, as well. Calculations: For calculations, we only show the units with the results. E.g., 10 + 20.50 = 30.50 EUR. Furthermore, the figures in calculations come without digits after the decimal point in case they equal zero. Results are printed in bold to find calculated figures easily. All calculations are exact to the EURcent or any other currency as 1/ 100amounts. Case Studies: We keep case studies in this textbook as easy as possible even as they might look unrealistic. Teaching Accounting is our priority. Case Study Text: We write case studies in a different text format than the normal text (Italic fonts). Cash Flow Separation: Interest payments in this textbook are always considered financing cash flows, even as IAS 7.33 allows their recognition as operating as well as financing cash flows. This applies for all case studies. Companies: For the textbook, the legal form of companies does not matter. Legal forms are not part of our Accounting syllabus. They are covered by our Basics. We only assure that companies prepare financial statements. This is the attitude of the IASB, too. In contrast to IFRSs, we do not refer to companies as “entities”. Once you read the expression entity in the standards, remember they are referring to companies. We apply the technical terms “business”, “firm” and “company”. Most companies are limited companies in this textbook, like GmbH, AG, Pty Ltd., PLC, Inc. etc. Cost-Expense-Congruence: By default, costs are expenses and vice versa. Country: All cases take place in countries where IFRSs apply for single entity financial statements. For our teaching in Cape Town, many examples refer to South African companies. Currency Unit: For all examples, the reporting currency is based on the country of the case study. We use the common 3 letter codes for abbreviation, like ZAR for South African Rand or GBP for British Pound Sterling. Data Format in Tables: In tables, negative figures are shown in brackets. E.g., (7.50) equals -7.50 EUR. Data Sheets: WWe show the most important data for case studies in their data sheets. Prepayments of Income Taxes: No provisional tax payments are made to the national revenue service in our case studies. Taxes are calculated at the year-end and added to short-term liabilities, mostly to the Income Tax Lia- <?page no="9"?> Berkau: Financial Statements 5e 1-5 bilities account. For German companies, § 249 HGB applies and income taxes are shown as provisions. How it is Done: (1) You find How-it-is Done sections in this textbook. (2) They offer you very short and clear instructions for your Accounting work. Income Taxes: For our textbooks and the IFRSs, a simplified income tax model applies. Income taxes amount to 30 % of the pre-tax profit EBT. Financial Statements for Taxation: We do not cover tax calculations. Tax statements are relevant for us to determine income taxes (simplified calculation) and deferred taxes. Names: We name companies and mark them with capital letters. E.g., SCHULZE- BRAMMELKAMP Ltd. No links to actual existing persons or companies are intended. The names work as identifiers, so you can use them for your communication with your classmates. Language: This textbook is written in South African English. With the 5 th edition, a German version is available, too. The translation from the English text is sentence-by-sentence (not word by word). Learning Objectives and Summaries: Every chapter starts by the learning objectives and ends by a summary. We also give you a short overview by our What is in the Chapter? -paragraphs. Legal Forms of a Business: For this textbook, we use Ltd., (Pty) Ltd., Sdn. Bhd., Bhd., AG, GmbH, UG, PLC, Inc. etc. If no legal form has been mentioned, assume the company is privately-owned, such as SANDPIPER BOOKS for a privatelyowned bookstore. Length of a Month/ Year: 1 month = 21.5 days = 4.3 weeks. 1 year = 12 evenly long months = 365 days = 52 weeks. Level of Precision: We work exact to 2 digits after the decimal point. Results from workings are rounded, too. We calculate sometimes in MS-Excel; hence, calculations in the background are more precise than they appear. All financial statements show figures rounded to the nearest full currency amount. Links: Links in the book direct you to further explanations and readings. Literature: The main source of preparing financial statements are the standards issued by the International Accounting Standard Board IASB. At the end of the textbook, we recommend further readings for you. <?page no="10"?> Berkau: Financial Statements 5e 1-6 Non-existing Items: In case something has not been mentioned it does not exist. Payment Terms: In this textbook, payments/ receipts for taxation and for dividends are due in the next following Accounting period. Presentation of Accounts: Accounts are displayed in the T-format. They have a 3-letter indicator column used for Bookkeeping entry identification or contra-entry references. Nominal accounts show the Accounting periods as a suffix, such as Depreciation-20X4. See the accounts for the car acquisition’s Bookkeeping entry: D C D C (1) 20,000.00 (1) 4,000.00 D C (1) 24,000.00 Cash/ Bank C/ B Property, plant, equipment PPE Value added tax VAT Figure 1.1: Accounts Pro-Rata-Temporis Calculation of Depreciation and Interest: Although given as annual rates, depreciation and interest are calculated on a pro rata temporis (per rate) basis exact to the full month. Monthly depreciation is calculated as annual depreciation divided by 12. In case a company owns an asset for a shorter period than a full year, a month will count for depreciation charge if the asset is owned for the major duration thereof. Interest rates are given per annum (/ a) and compounded annually (no compounded interest calculation within a year). For loans taken for shorter periods than a full year, interest is calculated per rate accurate to the month, too. For a bank loan of 100,000.00 EUR taken on 9.06.20X4 with an annual rate of interest of 10 %/ a, the interest paid at the end of the year equals: 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 to direct your attention thereto, as in 11.06.20X4. By default, pay-off payments take place at the end of the Accounting period. Interest is only calculated for debts, such as bank loans, bonds etc. Overdrafts of bank account are ignored. An exception is chapter (37) in our Basics. Quotation of Law Texts/ Standards: Law texts/ standards are quoted like ‘§ 266 HGB’ or ‘IAS 1.68’. We use the original law names. Note, that IFRS paragraphs can be subjected to changes. <?page no="11"?> Berkau: Financial Statements 5e 1-7 Sequence of Bookkeeping Entries: The sequence of Bookkeeping entries comes along the logical process defined by the text. Bookkeeping identifiers, like “(1), (2), (3) …” do not indicate nor prescribe a sequence of recording. Tax on Capital Returns (Dividend Tax): The tax on capital returns is an income tax. The rate on capital returns is 25 % based on the capital gain for this textbook. Note, the tax on capital returns is no company tax, although it is owed by the company. It is a withholding tax in most countries levied from persons. Value Added Tax, Goods and Service Tax: VAT stands for value added tax and GST for Goods and Service Tax. Except in, e.g., United Arabic Emirates or some U.S. states like Delaware, Alaska etc., consumers pay VAT - or sometimes referred to as sales tax when buying goods or services. In this textbook, we apply one single VAT account for input-VAT and output- VAT. The VAT rate in our textbooks is 20 %. We ignore reduced VAT rates as levied in many countries for food, books etc. VAT Reduction: It is assumed that every company discussed in this textbook is registered for VAT reduction. Work-in-Process Account: We apply the Work-in-Process account as reconciliation account for all job orders and call it Work-in-Process WIP. We also apply a Work-in-Process account for single job orders but then add the job order ID thereto, like “Work-in-Process 4711” for job order 4711. Writing Management Terms: We write academic disciplines, like Accounting, Marketing, Management etc., with capital letters. WWW We provide you with a lot of exercises and further materials. Pls., check the website: www. uvk.digital/ 9783739830933. Most of the exercises are our exam tasks from Hochschule Osnabrück or its partner universities, in South Africa, China, South Korea and Malaysia. 10-20-30 Rule: In this textbook, the 10-20-30 rule applies. If not mentioned otherwise, the interest rate is 10 %/ a, the VAT rate is 20 % and the total income tax rate is 30 %/ a. <?page no="12"?> Berkau: Financial Statements 5e 2-8 2. Financial Statements based on HGB What is in this Chapter? In this first chapter, we look at the German Handelsgesetzbuch HGB and introduce you to legal aspects of Accounting in Germany. We show the preparation of financial statements for the case study KIELING TAXI GmbH 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 textbook Basics of Accounting. 1 Learning Objectives: After studying this chapter (2), you know how to prepare a balance sheet and an income statement for a company in Germany and achieved sufficient communication skills to talk and write about Accounting in a professional environment. You are familiarised with technical terms of German Accounting and achieved knowledge about the major Accounting rules set by the German Handelsgesetzbuch HGB. Regarding legal forms, we distinguish private companies and companies in public ownership. Private companies can be a sole proprietor, a partnership or a privatelyowned limited company. A partnership in Germany is a GbR, short for Gesellschaft bürgerlichen Rechts, 1 See Berkau, C., Berkau, K.S.: Basics of Accounting. check §§ 705 - 741 BGB. Same as a single proprietor, the owners of a GbR are fully and jointly reliable for assets and liabilities of their business. Hence, they can lose their interest and be held reliable for debts. Public companies are limited companies with distributed ownership. (We do not cover public companies that are owned by the state; they follow different Accounting rules.) If a company's shares are traded publicly at a stock exchange everyone can buy shares and become a partial owner. The reliability for a limited company is only related to the loss of equity. Owners are not responsible for its debts. Therefore, the protection of creditors becomes the major reason for preparing financial statements based on HGB in Germany. The creditors are under 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 reinvested profits, either as reserves or retained earnings. Book value means the valuation of the company is derived from Bookkeeping records. Other methods for the valuation of companies are based on its fair market <?page no="13"?> Berkau: Financial Statements 5e 2-9 value or present values of future free cash flows. 2 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 has paragraphs dedicated to retailers as well as to limited companies. In terms of Accounting, the German HGB requires companies keeping Bookkeeping records of their business and preparing 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. This applies for all retailers regardless of their legal form. Retailers classified as small are exempted (from applying §§ 238 - 241 HGB) if earning an annual revenue of less than 600,000.00 EUR/ a for two following years and reporting an annual surplus below 60,000.00 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 apply. GmbHG and AktG are the German companies’ acts. Limited companies in Germany are the Gesellschaft mit beschränkter Haftung GmbH (or as a small cousin thereof an Unternehmergesellschaft UG (haftungsbeschränkt)) and the Aktiengesellschaft AG. AGs are companies 2 See Schmidtlin, N.: Company Valuation and Seppelfricke, P.: Unternehmensbewertungen. based on shares. They are often public corporations. In contrast, a GmbH is a privately owned limited company, such as a PLC or a (Pty) Ltd. Study the laws GmbHG and AktG for details. In this textbook we only cover German companies in the legal form of limited companies. In general, retailers and limited companies keep Bookkeeping records and prepare financial statements following §§ 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 compliance with § 264 HGB. In contrast to the business report, the appendix counts as element of the financial statements, see § 264 HGB. The appendix shows disclosure about the balance sheet and income statement of the company based on § 284 HGB. Next, we study the establishment of a limited company: To establish a limited company in Germany, a first registration is required. The register is kept at local courts. The future representatives of a limited company must appoint an attorney for the registration. The attorney drafts a contract, also known as memorandum of incorporation (MoI) or the articles that amongst other items tell the purpose of the company, its address, the names of legal representatives etc. Here, our Accounting work starts already: One item on the memorandum of incorporation is an opening balance <?page no="14"?> Berkau: Financial Statements 5e 2-10 sheet required by § 240 HGB and prepared in the format according to § 266 HGB. The opening balance sheet most probably only shows the issued capital and cash/ bank (cash, cash on Bundesbank, cash on banks, checks) 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. Thereafter, legal requirements make the company prepare and disclose financial statements for taxation and for commercial purposes. A company prepares two 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. The laws in Germany pursuit different objectives, which makes multi-purpose financial statements for commercial as well as for tax purposes unlikely to happen. Commercial financial statements normally 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 the interface requirements. In Germany, financial statements are transferred based on specific protocols, such as 3 See Schneeloch, D.; Meyering S.; Patek, G.: Betriebliche Steuerlehre. the DATEV format. DATEV is a German organisation that supplies Software for Accounting and Taxation. In this book, we focus on commercial financial statements. We do not study tax law and regulations regarding the preparation of financial statements for Taxation. Before we put aside the tax law, we refer to two aspects: (1) Simplification for income taxes. (2) Value added tax. Ad (1): Income Tax Calculation In your Taxation class you learn the details of national income tax calculations. 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 earns low. The income tax law refers to the capability of the taxpayers to contribute to common welfare. Tax laws include numerous detailed regulations and exceptions made for income tax adjustments, e.g., there are tax free earnings for low income groups, taxpayer classifications based on marriage status and allocation of different tax rates thereto etc. In this textbook, we simplify income tax calculation. We multiply a company’s net profit by a total income tax rate of 30 %. In real business, you must replace our tax formula by a detailed tax calculation. 3 Our tax calculation is consistent with how the IASB calculates income taxes for examples. <?page no="15"?> Berkau: Financial Statements 5e 2-11 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 always the same, no matter 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 along 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. 4 On the other side, from the point of view of companies selling goods and services, collections of output-VAT from their customers on behalf of the revenue service take 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: at a rate of 20 % and in the next following Accounting period. For VAT refunding a company must register which happens as default case together with the establishment in Germany. The local revenue service allocates automatically the tax characteristic registered-for-VAT-reduction to every company. For an exemption, a 4 Along our conventions, we consider annual refunding/ paying. company must prove size-based criteria, linked to revenue and profit. We apply VAT reduction as default case for our textbook case studies and for exercises provided on the website. However, sometimes you might find the sentence “Ignore VAT” 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 resembles the case of KENILWORTH METERED TAXI SERVICE Ltd. discussed in the next chapter (3) for studying international Accounting. This way we show the application of the German HGB and the international Accounting standards at similar cases. Note, we do not intend to compare GAAPs here. For the application of Accounting this does not make sense as the reporting company cannot choose which standards to apply. The KIELING TAXI GmbH case study repeats some basic knowledge of Accounting and gives you a first indication of how to prepare financial statements. We refer to the German HGB and make Bookkeeping entries following the German way. Data Sheet for KIELING TAXI GmbH DDomicile: Germany (Hanover). Reporting currency: EUR. Classification: Service provider. Establishment: 1.01.20X1; owner's contribution: 50,000.00 EUR, 10,000.00 EUR thereof as license. Acquisition of a car: 30,000.00 EUR net amount, taxi equipment 5,000.00 EUR net amount. <?page no="16"?> Berkau: Financial Statements 5e 2-12 DDepreciation: straight-line method over 3 years, residual value 8,000.00 EUR. Relevant Accounting periods 20X1/ 20X2. Revenue: 100,000.00 EUR / 105,000.00 EUR. Labour for drivers: 50,000.00 EUR / 55,000.00 EUR. Operational expenses (VATable): 15,000.00 EUR / 16,000.00 EUR. Appropriation of profits: 20X1: carried forward / 20X2: 10,000.00 EUR payment to owners, 10,000.00 EUR to reserves, remainder carried forward. VAT 20 %. The taxi driver Theo Kieling starts his own business and buys a taxi license in Hanover. His taxi is registered with the taxi-number 43. 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 all together. The establishment of a GmbH company requires conveyance through an attorney and registration at the local court as well as at the German revenue service. Mr Kieling makes an appointment with his attorney Dr. Meppen. The company is based on Mr Kieling’s contribution of 50,000.00 EUR which is partially paid on cash. 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 Commerzbank Hannover and transfers 40,000.00 EUR therein before he meets the attorney. On 27.12.20X0, Mr Kieling pays his attorney a visit and proves his contribution by a stamped bank statement copy and the taxi license issued by the city of Hanover. He also prepares an opening balance sheet in compliance with the formal requirements in § 266 HGB. See the opening balance sheet in Figure 2.1. Based on § 244 HGB, Mr Kieling must submit the balance sheet in German. It must disclose all items in EUR amounts. <?page no="17"?> Berkau: Financial Statements 5e 2-13 Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets II. Capital reserves III. Financial assets III. Earnings reserves IV. Profit/ Loss carried forward B. Current assets V. Annual surplus/ loss I. Inventories II. Receivables and other B. Provisions assets I. Provisions for pension funds III. Securities II. Tax provisions IV. Cash, cash on 40,000 III. Other provisions Bundesbank cash on banks, checks C. Payables C. Accurals on debit side D. Accruals on the credit side D. Deferred taxes on the debit side E. Deferred taxes on the credit side E. Difference of asset offsetting on the asset side 50,000 50,000 Kieling Taxi GmbH BALANCE SHEET as at 1.01.20X1 Figure 2.1: KIELING TAXI GmbH’s opening balance sheet The attorney and notary, Dr. Meppen, prepares the articles by which Theo Kieling get appointed as chief executive officer CEO of the new company KIELING TAXI GmbH. Dr. Meppen submits the articles at the local court in Hanover which triggers two events: (1) KIELING TAXI GmbH is registered at the registrar in Hanover and (2) the company becomes a taxpayer. 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 (2.01.20X1), the taxi business of KIELING TAXI GmbH commences. The company must keep Bookkeeping records and take stock. The company owns at the time of incorporation the license and 40,000.00 EUR at bank. On 4.01.20X1, the KIELING TAXI GmbH buys a preowned Mercedes-Benz at costs of acquisition of 30,000.00 EUR (net amount). For companies that are registered for VAT reduction, the cost of acquisition always is the net amount if the bill discloses VAT, see § 253 HGB and § 15 UStG. The car dealership is registered for VAT reduction too and, thus, shows the input-VAT on the invoice. A private seller cannot disclose VAT on its bills. KIELING TAXI GmbH claims for input-VAT refund on the car acquisition in the next Accounting period. Furthermore, KIELING TAXI GmbH orders a specialised taxi car manufacturer to alter the car for its intended use as metered taxi. The Mercedes-Benz now got a taxi sign on its roof, a radio for communication with the taxi dispatch service, a meter and seat sensors which cost 6,000.00 <?page no="18"?> Berkau: Financial Statements 5e 2-14 EUR (gross amount) all together. The manufacturer discloses input-VAT on its invoice. It is amounting to: 5,000 × 20% = 11,000.00 EUR. Hence, the total cost of acquisition (net amount) 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 § 255 HGB. Depreciation on the taxi car is based on straight-line method over its useful life of 3 years 5 . The depreciation table 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, KIELING TAXI GmbH earns a revenue of 100,000.00 EUR by taxi rides. Due to the registration for VAT reduction, the taxi passengers (all together) pay the gross amount which is: 100,000 × 120% = 120,000.00 EUR. Labour for the drivers equals 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. Operational expenses are VATable because they fall under 3 rd party expenses here. The operational expenses’ net amount is: 18,000 / 120% = 1 15,000.00 EUR/ a. All taxi drivers are freelancers and KIELING TAXI GmbH pays them 50,000.00 EUR/ a which includes the taxi drivers’ taxes, too. Freelancers handle income tax declarations and payments on their own. Observe below the processing of Bookkeeping entries in the format of a journal. To keep this case study simple, we record all annual business activities as aggregated single Bookkeeping entries dated to the middle of the Accounting period 20X1 (30.06.20X1). 5 Based on the German Afa-list motor vehicles are depreciated over five years. However, the Mercedes is pre-owned. <?page no="19"?> Berkau: Financial Statements 5e 2-15 Nr Amount Date Narrative DR CR OV 10,000.00 2.01.20X1 Establishment of business Licenses Issued capital 40,000.00 Cash/ Bank Issued capitall (1) 30,000.00 4.01.20X1 Acquisition of taxi car P, P, E Cash/ Bank 6,000.00 VAT Cash/ Bank (2) 5,000.00 5.01.20X1 Taxi equipment P, P, E Cash/ Bank 1,000.00 VAT Cash/ Bank (3) 9,000.00 31.12.20X1 Depreciation taxi car Depreciation P, P, E (4) 100,000.00 30.06.20X1 Revenue for taxi rides Cash/ Bank Revenue 20,000.00 Cash/ Bank VAT (5) 50,000.00 30.06.20X1 Labour Labour Cash/ Bank (6) 15,000.00 30.06.20X1 Operating expenses Operational exp. Cash/ Bank 3,000.00 VAT Cash/ Bank Kieling Taxi GmbH's JOURNAL 20X1 Figure 2.2: KIELILNG TAXI GmbH’s journal (20X1) 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 as well as the value of cash/ bank. 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 (cash/ bank) 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 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 an income 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 recorded input-VAT equals: 6,000 + 1,000 + 3,000 = 1 10,000.00 EUR. The amounts result from: <?page no="20"?> Berkau: Financial Statements 5e 2-16 - Output-VAT from 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 payment to German revenue service, KIELING TAXI GmbH calculates its VAT liabilities: 20,000 - 10,000 = 1 10,000.00 EUR. The amount is shown 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 following § 267 HGB. The formal requirements for the balance sheet disclosure are based on § 266 HGB. Small limited companies prepare their balance sheets based on a simplified structure, also called an abridged statement of financial position. 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: Link 2.A: KIELING TAXI GmbH Observe below the balance sheet of KIELING TAXI GmbH as at 31.12.20X1 in Figure 2.3. We translated the balance sheet for this textbook to English. Although, § 244 HGB rules a balance sheet in Germany must be prepared in German. <?page no="21"?> Berkau: Financial Statements 5e 2-17 Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets 26,000 II. Capital reserves III. Financial assets III. Earnings reserves IV. Profit/ Loss carried forward B. Current assets V. Annual surplus/ loss 18,200 I. Inventories II. Receivables and other B. Provisions assets I. Provisions for pension funds III. Securities II. Tax provisions 7,800 IV. Cash, cash on 50,000 III. Other provisions Bundesbank cash on banks, checks C. Payables 10,000 C. Accurals on debit side D. Accruals on the credit side D. Deferred taxes on the debit side E. Deferred taxes on the credit side E. Difference of asset offsetting on the asset side 86,000 86,000 Kieling Taxi GmbH BALANCE SHEET as at 31.12.20X1 Figure 2.3: KIELING TAXI GmbH’s abridged balance sheet (20X1) The German law requires to submit financial statements in the format prescribed by §§ 266, 275 HGB at the local court. The formal requirements are strict; all items must be named exactly as shown in the law text and must be listed along the required sequence. A set of financial statements in line with § 264 HGB includes a balance sheet, an income statement and an appendix for limited companies. The company also must prepare a business report. On the balance sheet we see few items that do not apply for KIELING TAXI GmbH. We discuss those but keep our explanations short: (a) Accruals are ruled by § 250 HGB. The reporting company discloses 6 Read our Basics, chapter (18). 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. 6 (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. 7 Same as with (a), it is required that prepayments are relevant for profit or loss at a certain Accounting period. Information about the period and revenue/ expense type is mandatory for recognition. (c) Deferred taxes are income tax considerations for tax income (asset 7 Read our Basics, chapter (15). <?page no="22"?> Berkau: Financial Statements 5e 2-18 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 must 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 most probably exceed the total of assets. Based on § 268 HGB, a company then shows the difference under the item uncovered losses on the asset side of the balance sheet. In these cases, a company has negative equity and faces bankruptcy. Excessive indebtedness requires to cease operations to protect the creditors from further losses. Negative equity means a company can no longer retire its debts. 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 prepared based on the nature of expense format or the cost of sales format. 8 KIELING TAXI GmbH prepares a profit or loss statement based on the nature of expense method. It is shown in Figure 2.4. 8 Read our Basics, chapter (28). <?page no="23"?> Berkau: Financial Statements 5e 2-19 [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 the only owner) and decides the appropriation of profits. In general, companies can either declare a dividend or similar kind of profit distribution to the owners, which depends on the legal form of the company, can add the profit to reserves which means a reinvestment or can carry forward the profit or loss to the next Accounting period. As a matter of fact, the latter alternative postpones the decision about the profit appropriation 9 We keep this case study simple and do not look at dividends yet. We do so for 20X2 further below. for one year. KIELING TAXI GmbH decides to carry forward the profit to the next Accounting period 20X2. 9 Below, we discuss the Accounting period 20X2: At the beginning of the Accounting period 20X2, KIELING TAXI GmbH pays income taxes and its VAT liabilities. After we learned already how to prepare financial statements for KIELING TAXI GmbH, we now cover Bookkeeping entries as well. KIELING TAXI GmbH starts the Accounting period 20X2 with an Opening Balance Sheet account. The <?page no="24"?> Berkau: Financial Statements 5e 2-20 company applies accounts based on the chart of accounts following DATEV-4 format. You can download the DATEV-4 chart of accounts through the Link 2.B below. Link 2.B: DATEV-4 chart of accounts We record 20X2’s business activities of KIELING TAXI GmbH in a format transferable to the taxonomy applicable for electronic data transfer of financial statements to the German revenue service. We do not study software systems here but pretend our MS-Excel based Bookkeeping system can transfer financial statements and prepare them in the therefor 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 prior balance sheet by the 9000-Balancing-Figures account. Study the accounts as of 1.01.20X2 in Figure 2.5. 10 Therein the standard account numbers and names are used but got translated to English. For the opening of accounts, we indicate the contra accounts by their 4 digits code in line with DATEV-4 chart of accounts in the column left to the amount. Some accounts do not carry numbers as they are created by Accounting software and do not belong to the chart of accounts, like the Annual Surplus account. D C D C 2900 50,000.00 0110 10,000.00 9000 10,000.00 2970 18,200.00 0520 26,000.00 3020 7,800.00 1810 50,000.00 3800 10,000.00 86,000.00 86,000.00 9000-Balancing figures EBK 0110 Licences Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X2) 10 Technically, your Bookkeeping software prevents you from changing or translating accounts’ names. <?page no="25"?> Berkau: Financial Statements 5e 2-21 D C D C 9000 26,000.00 9000 50,000.00 0520 Motor vehicles, cars 1810 Bank account Commerzbank D C D C 9000 50,000.00 9000 18,200.00 2900 Issued capital 2970 Profit carried forward D C D C 9000 7,800.00 9000 10,000.00 3020 Tax provisions for income tax 3800 VAT payables Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X2) continued During the Accounting period 20X2, KIELING TAXI GmbH records the business activities below: (A) Payment of income tax for 20X1 to the amount of 7,800.00 EUR. (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 extent of 105,000.00 EUR (net amount). (G) Transfer of cash to the Bank account to the extent of 126,000.00 EUR. KIELING TAXI GmbH processes 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 <?page no="26"?> Berkau: Financial Statements 5e 2-22 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 calculates its 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) considers income tax expenses based on the simplified total income tax rate of 30 %. Based on § 249 HGB, income taxes must be disclosed as provisions. KIELING TAXI GmbH now records the appropriation of profits, too. The distributable amount equals 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: - 10,000.00 EUR additions to reserves. - 10,000.00 EUR payment to owner(s). - 15,700.00 EUR carried forward. The appropriation of profits is recorded 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 show the account 9000 twice. It is the opening account (EBK) and the closing account (SBK). D C D C 2900 50,000.00 0110 10,000.00 EBK 10,000.00 SBK 10,000.00 2970 18,200.00 0520 26,000.00 3020 7,800.00 1810 50,000.00 3800 10,000.00 86,000.00 86,000.00 9000-Balancing figures EBK 0110 Licences Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) <?page no="27"?> Berkau: Financial Statements 5e 2-23 D C D C EBK 26,000.00 (C) 9,000.00 EBK 50,000.00 (A) 7,800.00 SBK 17,000.00 (G) 126,000.00 (B) 10,000.00 26,000.00 26,000.00 (D) 55,000.00 (E) 19,200.00 SBK 84,000.00 176,000.00 176,000.00 0520 Motor vehicles, cars 1810 Bank account Commerzbank D C D C SBK 50,000.00 EBK 50,000.00 (I) 10,000.00 EBK 18,200.00 (J) 8,200.00 18,200.00 18,200.00 2900 Issued capital 2970 Profit carried forward D C D C (A) 7,800.00 EBK 7,800.00 (B) 10,000.00 EBK 10,000.00 SBK 7,500.00 (H) 7,500.00 3800 3,200.00 (F) 21,000.00 15,300.00 15,300.00 SBK 17,800.00 31,000.00 31,000.00 3020 Tax provisions for income tax 3800 Output-VAT D C D C (C) 9,000.00 P&L 9,000.00 (D) 55,000.00 P&L 55,000.00 6222 Depreciation on cars 6010 Labour D C D C (E) 16,000.00 P&L 16,000.00 (E) 3,200.00 3800 3,200.00 6300 Operational expenses 1400 Input-VAT D C D C (F) 126,000.00 (G) 126,000.00 P&L 105,000.00 (F) 105,000.00 1600 Cash 4200 Revenue D C D C 6010 55,000.00 4200 105,000.00 (H) 7,500.00 P&L 7,500.00 6222 9,000.00 6300 16,000.00 EBT 25,000.00 105,000.00 105,000.00 76XX 7,500.00 EBT 25,000.00 A/ S 17,500.00 25,000.00 25,000.00 Profit and Loss 76XX Income tax expenses Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) continued <?page no="28"?> Berkau: Financial Statements 5e 2-24 D C D C (J) 1,800.00 P&L 17,500.00 SBK 10,000.00 (I) 10,000.00 (K) 15,700.00 17,500.00 17,500.00 Annual surplus 3519 Liabilities to owners D C D C SBK 10,000.00 (J) 10,000.00 SBK 15,700.00 (K) 15,700.00 2960 Other earnings reserves Retained earnings D C 0520 17,000.00 2900 50,000.00 0110 10,000.00 2960 10,000.00 1810 84,000.00 R/ E 15,700.00 3519 10,000.00 3020 7,500.00 3800 17,800.00 111,000.00 111,000.00 9000 Balancing figures SBK Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) continued The 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 fulfils the interface format requirements for electronic financial statement transfer. The income statement is displayed in Figure 2.7. <?page no="29"?> Berkau: Financial Statements 5e 2-25 [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) Based on § 276 HGB, small limited companies can combine items (1) - (5) and disclose their gross profit instead. Next, we discuss the balance sheet: A company prepares its balance sheet either before or after the appropriation of profits. In case the appropriation of profits is considered for balance sheet’s items, the company must 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 becomes zero and does not show. In case the company prepares the balance sheet under partial appropriation of profits, the item annual surplus is replaced by retained earnings. The item retained earnings then discloses the profit or loss carried forward. KIELING TAXI GmbH opts for disclosure of the balance sheet under 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 <?page no="30"?> Berkau: Financial Statements 5e 2-26 items have been translated for teaching purposes to English. KIELING TAXI GmbH falls under small limited companies regarding § 267 HGB. Its total of assets and capital/ liabilities does not exceed 6,000,000.00 EUR and its revenue is below 12,000,000.00 EUR/ a. Furthermore, KIELING TAXI GmbH has less than 50 employees. § 267 HGB states that a limited company that does not exceed two of the above-mentioned threshold values for two 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 exemptions and simplifications apply for KIELING TAXI GmbH. Observe the abridged balance sheet as at 31.12.20X2 in Figure 2.8. Debit side [EUR] Credit side [EUR] A. Non-current assets A. Equity I. Intangable assets 10,000 I. Issued capital 50,000 II. Tangable assets 17,000 II. Capital reserves III. Financial assets III. Earnings reserves 10,000 IV. Retained earnings 15,700 B. Current assets I. Inventories B. Provisions II. Receivables and other I. Provisions for pension funds assets II. Tax provisions 7,500 III. Securities III. Other provisions IV. Cash, cash on 84,000 Bundesbank C. Payables 27,800 cash on banks, checks D. Accruals on the credit side C. Accurals on debit side E. Deferred taxes on the credit side D. Deferred taxes on the debit side E. Difference of asset offsetting on the asset side 111,000 111,000 Kieling Taxi GmbH BALANCE SHEET as at 31.12.20X2 Figure 2.8: KIELING TAXI GmbH’s abridged balance sheet (20X2) <?page no="31"?> Berkau: Financial Statements 5e 2-27 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, look at the financial statements of Lufthansa AG below: Link 2.C: Lufthansa AG’s appendix Summary: German trading companies and companies in the legal form of a limited company must prepare and report financial statements based on §§ 242 and 264 HGB. The financial statements in Germany include a balance sheet and an income statement. Limited companies also prepare an appendix and a business report. In case a company participates on the capital market and is not preparing group statements, it must disclose a cash flow statement, too. (§ 264 HGB). We discussed the case study KIELILNG TAXI GmbH, which is a German limited company and prepared its financial statements over two Accounting periods. After the last period, the company decides about the appropriation of its profits. The balance sheet provided shows the 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 date. Appendix: Disclosure of information linked to the financial statements and required by §§ 284 - 288 HGB. German financial statements of limited companies must be enhanced by an appendix. Appropriation of profits: Using profit after tax as either addition to reserves, payment to owners or carrying profit or loss forward to the next Accounting period. Balance sheet: Statement of financial position that discloses assets, equity and liabilities in an aggregated form. Bankruptcy: Situation that triggers legal procedures of liquidation due to over-indebtedness or insolvency. Business report: Disclosure about the situation the company is in at the time of reporting and in the nearby future. The business report is required for limited companies that are not classified as small. DATEV-4 chart of accounts: Standard list of accounts applicable for electronic transfer of financial statements and accounts. Distributable amount: The amount a company can pay as a dividend to its shareholders without dissolving reserves. It includes the profit carried forward and the annual surplus. In case the company carries forward a loss it must deduct the loss carried forward from its annual surplus. Excluded from the distributable amount <?page no="32"?> Berkau: Financial Statements 5e 2-28 are contributions to legal reserves (§ 150 AktG) and preference dividends. Financial statements: In Germany financial statements include: a balance sheet, an income statement and for limited companies an appendix. Limited companies also must prepare a business report. A set of financial statements can include a statement of cash flows, as well. Handelsgesetzbuch HGB: German law for retailers and limited companies that states that financial statements are to be prepared and how to do so. Income statement: Statement of profit or loss that compares income and expenses for profit calculation. Its structure is given by § 275 HGB. Limited company: A company with restrictions regarding liabilities to the amount of its equity. Non-covered loss on the asset side: A loss that exceeds the equity is required 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 losses for assets or groups thereof. Value added tax: Tax levied in most countries on consumption. In this textbook, the common VAT rate is 20 %. No reduced VAT rates apply. Question Bank: (1) A German company in the legal form of a limited company must prepare financial statements which comprise of … 1. … a balance sheet, an income statement, an appendix, and in case of participation on the capital market and no group membership a cash flow statement. 2. … a balance sheet, an income statement, an appendix, a management report and in case of participation on the capital market and group membership a cash flow statement. 3. … a balance sheet, an income statement, an appendix, a management report and in case of participation on the capital market and no group membership a cash flow statement. 4. … a balance sheet, an income statement, a management report and in case of participation on the capital market and group membership a cash flow statement. (2) A German company that earns a pre-tax profit of 80,000.00 EUR, carrying forward a loss of 20,000.00 EUR and adding half of the distributable amount to reserves (no other appropriation of profits) discloses as retained earnings: 1. 38,000.00 EUR. 2. 30,000.00 EUR. 3. 50,000.00 EUR. 4. 18,000.00 EUR. (3) A German company buys a machine and pays a partial amount of 100,000.00 EUR and adds 44,000.00 EUR to payables. How much are the cost of acquisition? 1. 144,000.00 EUR. 2. 120,000.00 EUR. <?page no="33"?> Berkau: Financial Statements 5e 2-29 3. 100,000.00 EUR. 4. 44,000.00 EUR. (4) A German company in the legal form of a limited company earns a revenue of 5,000,000.00 EUR and discloses a total of assets of 10,000,000.00 EUR. No non-covered loss is disclosed on its asset side. The number of employees is 100. How do you classify the company regarding its size based on § 267 HGB? 1. Micro firm. 2. Small limited company 3. Medium-sized limited company. 4. Big corporation. (5) Financial statements in Germany along § 244 HGB are to prepare in… 1. … German, in any currency. 2. … English and in EUR. 3. … German and in EUR. 4. … English and in any currency. Solutions: 1-1, 2-4, 3-2, 4-3, 5-3. <?page no="34"?> Berkau: Financial Statements 5e 3-30 3. Financial Statements based on IFRSs What is in the Chapter? In this chapter (3), we discuss a case similar to KIELING TAXI GmbH in chapter (2); however, we make all its Bookkeeping entries along the international format. We teach how financial statements are prepared following International Financial Reporting Standards IFRSs. Before we focus on the case, we introduce International Accounting Standards to provide you with knowledge of how to find, understand and apply the standards. Thereafter, we discuss the foreign case study KENILWORTH METERED TAXI SERVICE Ltd. for which IFRSs apply. Learning Objectives: After studying this chapter, you can prepare financial statements for easy Accounting cases in compliance with IFRSs. A full set of financial statements 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 (6). Notes are different to the appendix as required by German HGB. The notes are a detailed explanation about applied Accounting policies and contain information regarding disclosure and valuation of items on financial statements. IFRSs are the standards that apply for international Accounting. In Germany, international Accounting applies for group statements of those groups which are participating on the capital market 11 ; all single-entity financial statements must be prepared following German HGB. IFRSs are issued by the International Accounting Standard Board IASB. Prior to the Accounting work, you must know how to get access to the standards. For academic purposes at the university, the IFRS Foundation offers you free access to the standards. You must register and log in with a username and password. For registration, indicate your industry Education/ Academia and your role Student. After registration you can access your IFRS account online and can download the standards. Our access is shown in the screenshot below in Figure 3.1. 11 Read the Basics, chapter (4). <?page no="35"?> Berkau: Financial Statements 5e 3-31 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. The IFRS Foundation does not charge you. You also find additional materials on their 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, <?page no="36"?> Berkau: Financial Statements 5e 3-32 Hong Kong, Australia, Malaysia, Pakistan, GCC countries 12 , Russia, Chile, Philippines, South Africa, Singapore and Turkey, but not in the United States. In this textbook we look at cases with companies headquartered in countries where IFRSs apply. Below, we demonstrate the application of IFRSs with the fictitious case study KENILWORTH METERED TAXI SERVICE Ltd. based in Cape Town. The currency unit for this case study is South African Rand ZAR. You need knowledge about international Bookkeeping and Accounting for this case study. We do not cover basic Accounting knowledge! We sourced out Bookkeeping to the Basics as it is commonly taught in preparatory classes before Accounting. 13 Data Sheet for KENILWORTH METERED TAXI SERVICE Ltd. DDomicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Service provider. Establishment: 1.01.20X1; share capital: 5,000,000.00 ZAR, 10.00 ZAR/ share. Acquisition of 10 cars at 360,000.00 ZAR/ car gross amount, taxi equipment 24,000.00 ZAR/ car net amount. Depreciation: straight-line method over 4 years, no residual value. Relevant Accounting periods: 20X1 / 20X2. Revenue: 12,500,000.00 ZAR / 13,200,000.00 ZAR. Labour for drivers (freelancers): 7,000,000.00 ZAR / 8,000,000.00 ZAR. 12 GCC = Council Cooperation for the Arab states of the Gulf 13 Read the Basics, chapters (6) - (19), (31) and (33). Labour for dispatching and management: 1,650,000.00 ZAR / 1,650,000.00 ZAR. Operational expenses (VATable): 2,000,000.00 ZAR / 2,000,000.00 ZAR. Rent (not VATable): 12,000.00 ZAR/ m / 12,000.00 ZAR/ m, payment one month in advance, from 1.07.20X2 onwards: 13,800.00 ZAR/ m. Appropriation of profits: 20X1: carried forward / 20X2: 30 % dividends, 20 % reserves, 50 % carried forward. VAT 20 %. KENILWORTH METERED TAXI SERVICE Ltd. is a taxi company that provides metered taxi and airport shuttle services and is established in Cape Town by the issue of 500,000 ordinary shares at 10.00 ZAR/ s each. At the time of incorporation, on 1.01.20X1, the company’s share capital is amounting to: 10 × 500,000 = 5 5,000,000.00 ZAR which is the book value at that time. KENILWORTH METERED TAXI Service Ltd. applies IFRSs for its financial statements as it is domiciled in South Africa. The owners pay the amount into KENILWORTH METERED TAXI Service Ltd.’s bank account at FNB Bank 14 . They further set up a memorandum of incorporation and establish the business online through CIPC 15 . At the same time, the company is registered at the South African Revenue Service SARS and the tax characteristic VAT reduction is set. The VAT rate from chapter (1) applies: 20 %. The name of the new company is KENILWORTH METERED TAXI SERVICE Ltd. which we abbreviate as KMTS Ltd. in the text. The opening balance sheet is 14 FNB = First National Bank of South Africa. 15 CIPC = Companies and Intellectual Property Commission, check CIPC.co.za. <?page no="37"?> Berkau: Financial Statements 5e 3-33 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 cars at a purchase price of 360,000.00 ZAR/ car per bank transfer. The price is the gross amount. The Accountant processes Bookkeeping entry (1). Note, we do not distinguish between cash and bank as we later combine both amounts to the item cash/ bank on the balance sheet. A real business keeps these accounts separate from each other. 16 As the case study is not complex, we apply the Property, Plant, Equipment PPE account. Alternatively, KENILWORTH METERED TAXI SERVICE Ltd. could apply a Motor Vehicle account as a subordinated account to the P, P, E account. As we do not follow a standardised chart of accounts for international Accounting, the name of the account is not prescribed. The procedure is simplified in comparison to 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 explicitly that the standard (IAS 1) does not prescribe the order or format of presentation. DR P, P, E Account.............. 3,000,000.00 ZAR DR VAT.......................... 600,000.00 ZAR CR Cash/ Bank.................... 3,600,000.00 ZAR We consider depreciation as part of the adjustments later in this case study. Like in the previous case study, the cars get transformed into metered taxi cars 16 Read our Basics, chapter (37). 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 = <?page no="38"?> Berkau: Financial Statements 5e 3-34 2288,000.00 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 must pay the gross amount which includes output-VAT. It gives a total annual receipt of: 120% × 12,500,000 = 1 15,000,000.00 ZAR. The revenue recognition is recorded 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 taxi drivers at KENILWORTH METERED TAXI SERVICE Ltd. earn 500,000.00 ZAR/ (a × driver). The company employs 14 drivers. All taxi drivers work on a freelancer basis. The labour for taxi drivers equals: 14 × 500,000 = 7,000,000.00 ZAR/ a. Accounting for labour results in Bookkeeping entry (4) below, as recorded on 30.06.20X1. 17 DR Labour....................... 7,000,000.00 ZAR CR Cash/ Bank.................... 7,000,000.00 ZAR The dispatcher at KENILWORTH METERED TAXI SERVICE Ltd. earns 650,000.00 ZAR/ a. The dispatcher works in the headquarters on the radio and answers taxi ride orders on the phone which he assigns to the taxi drivers per radio. The manager at KENILWORTH METERED TAXI SERVICE Ltd. earns 1,000,000.00 ZAR/ a. On 30.06.20X1, labour for dispatcher and manager is recorded as Bookkeeping entry (5). It is amounting to: 650,000 + 1,000,000 = 1,650,000.00 ZAR/ a. DR Labour....................... 1,650,000.00 ZAR CR Cash/ Bank.................... 1,650,000.00 ZAR Operational expenses for the taxis, e.g., for petrol, maintenance, spare parts, repairs etc., cost 2,000,000.00 ZAR/ a. The 17 The consideration as freelancers simplifies the case study. For Accounting for labour, read our Basics, chapter (19). amount is paid to 3 rd party companies and, therefore, is subjected to VAT. Hence, the paid amount is: 120% × <?page no="39"?> Berkau: Financial Statements 5e 3-35 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 by default. 18 IAS 2 and IAS 16 state that cost of purchase/ acquisition for companies registered for VAT reduction are always net amounts. DR Operational Expenses......... 2,000,000.00 ZAR DR VAT.......................... 400,000.00 ZAR CR Cash/ Bank.................... 2,400,000.00 ZAR For the rent of the office building and the garages, KENILWORTH METERED TAXI SERVICE Ltd. pays 12,000.00 ZAR/ m. No input-VAT is included in the rent payments. KENILWORTH METERED TAXI SERVICE Ltd. rents from a private person that is not registered for VAT reduction. 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 is for January 20X2. (All) 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 are not balanced-off yet. 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%] Figure 3.4: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts 18 Read our Basics, chapter (20) to (23). <?page no="40"?> Berkau: Financial Statements 5e 3-36 D C D C (3) 12,500,000.00 (4) 7,000,000.00 (5) 1,650,000.00 Revenue-20X1 REV Labour-20X1 LAB D C D C (6) 2,000,000.00 (7) 156,000.00 Operational expenses-20X1 OEX Rent-20X1 RNT Figure 3.4: KENILWORTH METERED TAXI SERVICE Ltd.'s accounts continued Before profit calculation, KENILWORTH METERED TAXI SERVICE Ltd. processes the adjustments at the end of the Accounting period. The 1 st Bookkeeping entry is for depreciation. Depreciation applies only for the taxis. It is based on straight-line method under consideration of a useful life of 4 years. No residual value applies. Annual depreciation equals: (3,000,000 + 240,000) / 4 = 8 810,000.00 ZAR/ a. Note, that in compliance with IAS 16.16 the taxi alterations are considered cost of acquisition. 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. DR Depreciation................. 810,000.00 ZAR CR Acc. Depr.................... 810,000.00 ZAR Another adjustment is made for accruals. 19 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. To allocate the 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. In contrast to German Accounting, no accrual item (aktivischer Rechnungsabgrenzungsposten) is disclosed. At the beginning of the next Accounting period, KENILWORTH METERED TAXI SERVICE Ltd. will transfer the amount for prepaid expenses 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 initial Bookkeeping entries and making adjustments, we 19 Read our Basics, chapter (13) and (18). <?page no="41"?> Berkau: Financial Statements 5e 3-37 now balance-off all accounts. Observe the accounts at KENILWORTH METERED TAXI SERVICES Ltd. below in Figure 3.5. D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 b/ d 1,452,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C c/ d 12,500,000.00 (3) 12,500,000.00 (4) 7,000,000.00 b/ d 12,500,000.00 (5) 1,650,000.00 c/ d 8,650,000.00 8,650,000.00 8,650,000.00 b/ d 8,650,000.00 Revenue-20X1 REV Labour-20X1 LAB 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 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 Figure 3.5: KMTS Ltd.’s accounts after adjustments (20X1) <?page no="42"?> Berkau: Financial Statements 5e 3-38 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 step is the profit calculation. We close-off all nominal accounts to the Profit and Loss account. You see that nominal accounts are marked with the Accounting period in Figure 3.5. This applies for: - Rent-20X1. - Labour-20X1. - Operational expenses-20X1. - Depreciation-20X1. - Revenue-20X1. To later understand the Profit and Loss account better, 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 are corresponding with the abbreviations shown on the accounts’ headers, like DPR for Depreciation- 20X1 account. The pre-tax profit of KENILWORTH METERED TAXI SERVICE Ltd. equals: 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 of income taxes. Hence, the earnings after taxes EAT (annual surplus A/ S) equal: 896,000 × (1 - 30%) = 6 627,200.00 ZAR. Check the accounts as displayed in Figure 3.6 after adjustments are completed. 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 Figure 3.6: KMTS Ltd.’s accounts after profit calculation (20X1) <?page no="43"?> Berkau: Financial Statements 5e 3-39 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 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 Figure 3.6: KMTS Ltd.’s accounts after profit calculation (20X1) - continued <?page no="44"?> Berkau: Financial Statements 5e 3-40 D C D C ITL 268,800.00 c/ d 268,800.00 c/ d 268,800.00 ITE 268,800.00 b/ d 268,800.00 P&L 268,800.00 b/ d 268,800.00 D C c/ d 627,200.00 P&L 627,200.00 b/ d 627,200.00 Income tax expenses ITE Income tax liabilities ITL Retained earnings R/ E Figure 3.6: KMTS Ltd.’s accounts after profit calculation (20X1) - continued The Profit and Loss account shows the relationship between revenue and expenses. We also see how much the profit after taxation is. In contrast to the Profit and Loss account, IAS 1.81A - 1.82B do not instruct to disclose all single expense items 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: 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. [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 names it the statement of financial position. In the case of KENILWORTH METERED TAXI SERVICE Ltd., only few amounts need calculation <?page no="45"?> Berkau: Financial Statements 5e 3-41 for disclosure, all other items are directly linked to real accounts. 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 = 22,430,000.00 ZAR. The amount for Accounts Payables only includes the difference between output-VAT and input- VAT which is the balancing figure of the Value Added Tax account: 1,452,000.00 ZAR. In contrast to German Bookkeeping, there is only one VAT account. Observe the balance sheet in Figure 3.8. 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. An example for the notes can be found in chapter (6). The cash flow in 20X1 is negative as the closing balance of the Cash/ Bank item is lower than its opening balance. 20 Read our Basics, chapter (32). The cash flow is the difference between balancing figure and opening amount of cash/ bank and gives: 4,906,000 - 5,000,000 = -9 94,000.00 ZAR. So far, KENILWORTH METERED TAXI SERVICE Ltd. burned cash by its business operations, but we consider that the negative cash flow here results from investments. It is not seldom for companies to disclose in the first year negative total cash flows due to payments for their acquisitions. To analyse details of cash flows, a cash flow statement must be prepared. 20 We cover the preparation of a cash flow statement in chapter (10) in more detail. <?page no="46"?> Berkau: Financial Statements 5e 3-42 To understand if and why the book value of the company has 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%. 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 our Accounting work with the next fiscal year 20X2. Applying international Bookkeeping, we continue all real accounts. Therefore, we do not add an Accounting period’s indicator to the names of real accounts. Internationally, no opening nor closing accounts apply. The reason for these accounts in Germany is that 21 Read our Basics, chapter (31). financial statements are considered as elements of the double entry system whereas internationally they are not. Therefore, all nominal accounts are fresh in the new Accounting period because the previous ones were closed-off to the Profit and Loss account. 21 In regard to the case study KENILWORTH METERED TAXI SERVICE <?page no="47"?> Berkau: Financial Statements 5e 3-43 Ltd., we observe how the company continues its business activities and the Accounting work: 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 property owner 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. In 20X2, no investments are made. Once we start the new Accounting period, some preparatory Bookkeeping entries are processed. These initial Bookkeeping entries, in general, can relate to the below listed activities: - Prepaid expenses from last year. - Income tax payments. - VAT payments. - Payments of other short-term liabilities, e.g., resulting from supplies. - Collection of receivables as scheduled. - Payment for dividends. 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). To distinguish Bookkeeping entries from different Accounting periods we alter their identifiers. 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 preparatory Bookkeeping entries are completed in Figure 3.11. As last year’s entries are of no further interest, we grey them out. <?page no="48"?> Berkau: Financial Statements 5e 3-44 D C D C OV 5,000,000.00 (1) 3,600,000.00 c/ d 5,000,000.00 OV 5,000,000.00 (3) 15,000,000.00 (2) 288,000.00 b/ d 5,000,000.00 (4) 7,000,000.00 (5) 1,650,000.00 (6) 2,400,000.00 (7) 156,000.00 c/ d 4,906,000.00 20,000,000.00 20,000,000.00 b/ d 4,906,000.00 (B) 268,800.00 (C) 1,452,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 3,000,000.00 (1) 600,000.00 (3) 2,500,000.00 (2) 240,000.00 c/ d 3,240,000.00 (2) 48,000.00 3,240,000.00 3,240,000.00 (6) 400,000.00 b/ d 3,240,000.00 c/ d 1,452,000.00 2,500,000.00 2,500,000.00 (C) 1,452,000.00 b/ d 1,452,000.00 Property, Plant, Equipment PPE Value added tax VAT [20%] D C D C (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) In 20X2, the Bookkeeping entries below for the business activities of KENILWORTH METERED TAXI SERVICE Ltd. are recorded: (D) Revenue 13,200,000.00 ZAR. The gross amount equals: 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. <?page no="49"?> Berkau: Financial Statements 5e 3-45 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 taxi drivers employed. We also consider the dispatcher and the manager: 16 × 500,000 + 650,000 + 1,000,000 = 9 9,650,000.00 ZAR. Bookkeeping entry (E) for labour is processed on 30.06.20X2. DR Labour....................... 9,650,000.00 ZAR CR Cash/ Bank.................... 9,650,000.00 ZAR (F) Rent increases in mid 20X2. As there was a prepayment for 20X2 already, the Bookkeeping entries for rent in total amount to: 5 × 12,000 + 7 × 13,800 = 156,600.00 ZAR. As the rent for January has already been paid in December 20X1, only 5 rental payments at 12,000.00 ZAR/ m are made. The next following payments are for July/ 20X2 - January/ 20X3 and 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 an aggregation for 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 <?page no="50"?> Berkau: Financial Statements 5e 3-46 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. 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 Figure 3.12: KMTS Ltd.’s accounts after profit calculation (20X2) <?page no="51"?> Berkau: Financial Statements 5e 3-47 D C D C c/ d 627,200.00 P&L 627,200.00 c/ d 268,800.00 ITE 268,800.00 b/ d 627,200.00 (B) 268,800.00 b/ d 268,800.00 c/ d 1,036,840.00 P2L 409,640.00 c/ d 175,560.00 ITE 175,560.00 1,036,840.00 1,036,840.00 444,360.00 444,360.00 b/ d 1,036,840.00 b/ d 175,560.00 Retained earnings R/ E Income tax liabilities ITL D C D C (A) 12,000.00 (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 The owners seek a return on the funds they invested into the business. In a company based on shares the payment to the owners for their profit share is called a dividend. KENILWORTH METERED TAXI SERVICE Ltd. did not pay dividends for 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 or chief financial officer CFO reports on the previous Accounting period 20X2 and presents and explains the financial statements, the shareholders of KENILWORTH METERED TAXI SERVICE Ltd. agree to declare a dividend of 30 % <?page no="52"?> Berkau: Financial Statements 5e 3-48 of the distributable amount. The amount distributable for dividend payments contains 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: 30% × 1,036,840 = 311,052.00 ZAR. 20 % is to be transferred to the Earnings Reserves account, which equals: 20% × 1,036,840 = 207,368.00 ZAR. The remainder is carried forward to the next Accounting period; about its appropriation will be decided on the next annual general meeting in 20X4. In general, international corporations prepare financial statements under consideration of the appropriation of profits. KENILWORTH METERED TAXI SERVICE Ltd. records the dividend as payables to shareholders. They will be paid in 20X3. The account applicable is the Shareholder for Dividend account. It falls under payables (A/ P account). The additions to earnings reserves do not affect the total of equity because they remain in the business, e.g., for reinvestments. The non-appropriated remainder 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 holding 10,000 ordinary shares of KENILWORTH METERED TAXI SERVICE Ltd. receives a dividend of: (10,000/ 500,000) × 311,052 = 6 6,221.04 ZAR. 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. <?page no="53"?> Berkau: Financial Statements 5e 3-49 D C D C c/ d 627,200.00 P&L 627,200.00 c/ d 207,368.00 R/ E 207,368.00 b/ d 627,200.00 b/ d 207,368.00 c/ d 1,036,840.00 P2L 409,640.00 1,036,840.00 1,036,840.00 S4D 311,052.00 b/ d 1,036,840.00 E-R 207,368.00 c/ d 518,420.00 1,036,840.00 1,036,840.00 b/ d 518,420.00 Retained earnings R/ E Earnings reserves E-R D C c/ d 311,052.00 R/ E 311,052.00 b/ d 311,052.00 Shareholder for dividend S4D Figure 3.13: KMTS Ltd.’s accounts for profit appropriation (20X2) KENILWORTH METERED TAXI SERVICE Ltd. prepares its financial statements under the consideration of the appropriation of profits. See below the set of financial statements except of the notes. Observe Figure 3.14, Figure 3.15, Figure 3.16 and Figure 3.17. [ZAR] Revenue 13,200,000 Other income 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) <?page no="54"?> Berkau: Financial Statements 5e 3-50 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) 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) <?page no="55"?> Berkau: Financial Statements 5e 3-51 Summary: International Bookkeeping is not much different to the German way. Both Accounting systems apply the double entry system. The preparation of financial statements is based on nominal and real accounts. Internationally, no opening nor closing accounts apply. IAS 1.10 defines that a full set of financial statements, 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. In general, companies prepare financial statements with consideration of the appropriation of profits. The appropriation of profits either adds earnings to reserves for reinvestments or to dividends payable in the next fiscal year. Profit or loss not appropriated is transferred into the next Accounting period and shows as balance brought forward in the Retained Earnings account. 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: Accounting Standards issued by the International Accounting Standard Board that are either an IAS (International Accounting Standard) or an IFRS (International Financial Accounting Standard). Paragraph: Section of a Standard. Paragraphs are identified by numbers. Set of financial statements: In line with IAS 1.10, a set of financial statement comprises a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows and the notes. It can include a further balance sheet if IAS 8 applies regarding changes in Accounting policies. Standard setter: Organisation that issues standards. For IFRSs, the standard setter is the International Accounting Standard Board headquartered in Canary Wharf, London. Statement of cash flows: A statement that shows increases and decreases of the cash/ bank item structured by classifications: operative, investing and financing. Statement of changes in equity: A statement that discloses the additions to and deductions from equity items on the balance sheet. Statement of financial position: Balance sheet that compares the total of assets to equity and liabilities. Statement of profit or loss and other comprehensive income: Income statement based on IFRSs. It discloses operating profits and extraordinary earnings and expenses. Question Bank: (1) A company reporting in accordance with IFRSs must disclose … 1. .… a statement of financial position, an income statement, a statement of cash flows and notes. <?page no="56"?> Berkau: Financial Statements 5e 3-52 2. … a balance sheet, an income statement, a statement of changes in equity, a statement of cash flows and notes. 3. … a statement of financial position, a statement of profit or loss and other comprehensive income, a cash flow statement, a register of non-current assets and the notes. 4. … a balance sheet, an income statement, a statement of cash flows, a statement of changes of liabilities and notes. (2) A company that prepares financial statements in accordance with IFRSs must disclose a statement of cash flows … 1. … only if participating on the capital market. 2. … in any case. 3. … when a group member. 4. …not as a group member as the parent discloses changes in cash flows in the group statements already. (3) A company that pays 12,000.00 EUR for labour and makes 1 monthly payment in advance, records labour in the actual Accounting period as below: 1. DR Labour … 12,000.00 EUR, CR Cash/ Bank … 12,000.00 EUR. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 2. DR Labour … 1,000.00 EUR, CR Prepaid Expenses … 1,000.00 EUR. DR Labour … 12,000.00 EUR, CR Cash/ Bank … 12,000.00 EUR. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 3. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. DR Labour … 11,000.00 EUR, CR Cash/ Bank … 11,000.00 EUR. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. 4. DR Labour … 11,000.00 EUR, CR Cash/ Bank … 11,000.00 EUR. DR Prepaid Expenses … 1,000.00 EUR, CR Labour … 1,000.00 EUR. (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 subjected 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. <?page no="57"?> Berkau: Financial Statements 5e 3-53 4. 1,440.00 EUR. Solutions: 1-2, 2-2, 3-2, 4-3, 5-3. <?page no="58"?> Berkau: Financial Statements 5e 4-54 4. Accounting for Retailers What is in the Chapter? This chapter (4) is an introduction to the preparation of financial statements following IFRSs for retailers. We cover most common instruments in Bookkeeping, like the Trial Balance and the Trading account T/ A. Accounting in trading companies is simple because no production and no material flows must be considered. Therefore, we start with dealers. This chapter gives you a short revision of Bookkeeping. Here are the main topics: - Gross profit calculation. - Trading Account. - Trial Balance. Learning Objectives: After studying this chapter (4), you can prepare financial statement for retailers in compliance with IFRSs. You are familiar with the profit calculation and can apply a Trading Account and a Trial Balance. We start Accounting for retailers with very basic knowledge. We purport the application of a period inventory movement system 22 and that all goods are bought at the same purchase price per unit. Under these conditions, we start this chapter with the profit calculation for trading companies. Retailers prepare a two-step profit or loss calculation to determine their gross and net profit. A gross profit is 22 Read our Basics, chapter (26). the difference between revenue and material expenses. Revenue is the compensation received from customers for goods and services. 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. IAS 2 and IAS 16 apply. We explain the concept of gross profit calculation by a small case study of a plumber who also sells the parts he builds-in to his customers. By this, the plumber becomes a retailer and repair service provider as well. Data Sheet for DEMANN GmbH DDomicile: Germany (Lingen (Ems)). Reporting currency: EUR. Classification: Repair. Accounting period: n/ a. Order revenue: 500.00 EUR. Order costs: material: 120.00 EUR labour: 130.00 EUR; partial depreciation: 10.00 EUR; partial Management costs 40.00 EUR and tool expenses: 25.00 EUR. Material increases to 138.00 EUR. VAT 20 %. The plumber DEMANN GmbH in the Emsland (Germany) is called to repair a central heating system in a private house. The repair requires a replacement pump costing 120.00 EUR ex VAT. After the repair, DEMAN GmbH bills 600.00 EUR including VAT. This gives for DEMANN GmbH a revenue of: 600 / 120% = 5 500.00 EUR. <?page no="59"?> Berkau: Financial Statements 5e 4-55 When we analyse the bill, we notice an item for the pump included as material expenses thereon. Below, we calculate the customer order from the point of view of DEMANN GmbH. We know the pump costs for DEMANN GmbH 120.00 EUR (net amount). For the profit calculate regarding 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 sold (net amounts) of 120.00 EUR for the pump. Hence, the gross profit is: 500 - 120 = 3 380.00 EUR. What does that figure tell the plumber/ seller? It says that the gross profit must cover DEMANN GmbH’s total customer order costs, 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 sold. In contrast, the net profit is the profit before taxes which requires the deduction of the entire operational costs from the gross profit. Based on the net profit - or: pre-tax profit - we calculate income taxes. The net profit is what remains for the company, its owners and the revenue service. To calculate the customer order’s net profit, DEMANN GmbH further deducts labour, depreciation on the van the plumber drives to the site with, a portion of Management costs, costs for tools etc. We assume labour is 130.00 EUR, proportionate depreciation 10.00 EUR, proportionate 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 taxes thereon. Based on our simplification about the income tax model the income taxes equal: 175 × 30% = 552.50 EUR. This gives a profit after taxes for DEMANN GmbH to the extent of: 175 - 52.50 = 1 122.50 EUR. Once we divide this amount by the revenue, we come up with the net profit as percentage on sales being: 122.50 / 500 = 24.50 %. We could say, with every Euro received in revenue, the company earns 0.25 EUR after taxes. To study the technical terms of profit calculation we 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 with the taxi service providers. The only difference is that for retailers, we interrupt the profit calculation and determine the gross profit. An order calculation is not required by IFRSs. Here, it only illustrates the calculation of gross profit. <?page no="60"?> Berkau: Financial Statements 5e 4-56 [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 Prof 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 study and assume, the wholesaler selling spare parts to DEMANN GmbH increases its prices by 15 %. The pump 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 as before, it must pass on the price increase for its spare parts to its customers and increase its next invoice by a net amount of 18.00 EUR. Therefore, a future similar repair will cost the customer: (500 + 18) × 120 % = 6 621.60 EUR. This way, the gross profit remains the same: 621.60 / 120% - 138 = 3 380.00 EUR. Next, we study the application of the trial balance and the Trading account by the case study of the office material trader RYNEVELD Ltd. in George (South Africa). The company deals with printer paper. 23 Read our Basics, chapter (10) - (12). A trial balance is a list of all accounts and their balancing figures. In the old days of Bookkeeping, Accountants used it for checking consistency with the double entry system. So, the Bookkeeper could easily see whether she/ he made a mistake. On a Trial Balance, the total of the debit balanced accounts (b/ d on the debit side) must equal the total of the credit balanced ones (b/ d on the credit side). 23 Nowadays, Accounting software pre-checks all Bookkeeping entries before recording, which prevents us from making faulty entries. However, the trial balance might help you in an exam at the university to detect errors as you cannot apply Accounting software in the exam venue. In a company, the trial balance only gives an overview of accounts and their balancing figures as well as it supports Bookkeeping data transfer, e.g. between group members, <?page no="61"?> Berkau: Financial Statements 5e 4-57 and Accounting communication purposes. The Trading account is prepared after the original Bookkeeping entries have been checked by the trial balance and resembles a Profit and Loss account, but it only covers the first steps thereof and stops at the gross profit calculation. The Trading account pairs with 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. Data Sheet for RYNEVELD Ltd. DDomicile: South Africa (George). Reporting currency: ZAR. Classification: Retailer. Accounting period: 20X6. Share issue: 100,000 × 5.00 ZAR/ s. Financing: bank loan 200,000.00 ZAR; interest 6.00 %/ a, pay-off: 40,000.00 ZAR/ a. Rent: 36,000.00 ZAR/ a; payment one month in advance. Store equipment (P, P, E): 200,000.00 ZAR; depreciation: straight-line method over 10 years. Purchases: 250,000.00 ZAR. Closing stock: 22.4 % Revenue: 545,000.00 ZAR. Operational costs (non-VATable): 15,000.00 ZAR/ m, payable one month in advance. VAT 20 %. RYNEVELD Ltd. is incorporated on 1.01.20X6 by an issue of 100,000 ordinary shares at 5.00 ZAR/ s face value. On 2.01.20X6, RYNEVELD Ltd. takes a bank loan of 200,000.00 ZAR. The annual rate of interest is 6.00 %/ 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. The rent for the shop is 36,000.00 ZAR/ a; no VAT applies therefor. RYNEVELD Ltd. pays the rent one month in advance. The first payment for January is paid on 2.01.20X6, for February on 30.01.20X6 and so on. RYNEVELD Ltd. acquires store equipment 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 applies 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 trading company takes stock and calculates that 22.4 % (in value) of paper are not sold yet and are still on stock. During the fiscal year 20X6, RYNEVELD Ltd. earns a revenue of 545,000.00 ZAR. All customers pay on cash. Operational costs, mainly labour, is 15,000.00 ZAR/ m during 20X6. As the expenses are mostly internal costs, we do not consider VAT for operational expenses. Below, we discuss the Bookkeeping entries for the business activities and prepare a trial balance for RYNEVELD Ltd. Thereafter, we calculate gross and net profit in the Trading account and in the Profit and Loss account. We prepare a trial balance for RYNEVELD Ltd. after recording all business activities. We cover business activities separately: <?page no="62"?> Berkau: Financial Statements 5e 4-58 At the time of incorporation, RYNEVELD Ltd. issues ordinary shares at a total amount of: 100,000 × 5 = 5 500,000.00 ZAR. See Bookkeeping entry (1): DR Cash/ Bank.................... 500,000.00 ZAR CR Issued Capital............... 500,000.00 ZAR When 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. must pay-off an amount of 40,000.00 ZAR every year. The pay-off Bookkeeping entry falls under adjustments and is recorded on 31.12.20X6. We record adjustments after the preparation of the first trial balance. Observe the Bookkeeping entries (2) and (3) below: DR Cash/ Bank.................... 200,000.00 ZAR CR Interest Bearing Liabilities. 200,000.00 ZAR DR Interest..................... 12,000.00 ZAR CR Cash/ Bank.................... 12,000.00 ZAR The rent is not subjected to VAT as the property owner is not registered for VAT-reduction. Rent is paid in advance except of January’s rent. RYNEVELD Ltd. must make 13 rental payments - the last one thereof counts as a prepayment for 20X4. We firstly record the 13 payments as aggregated Bookkeeping entry (4). The accrual is recorded later as part of the adjustments. DR Rent......................... 39,000.00 ZAR CR Cash/ Bank.................... 39,000.00 ZAR The acquisition of the store equipment is the next business activity. The cost of acquisition (net 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 (5) entry is: DR P, P, E Account.............. 200,000.00 ZAR DR VAT.......................... 40,000.00 ZAR CR Cash/ Bank.................... 240,000.00 ZAR Depreciation on the interior falls under adjustments and will be discussed later. Our next Bookkeeping entry is for the purchase of materials. As we apply the <?page no="63"?> Berkau: Financial Statements 5e 4-59 periodic system for inventory movements we record the materials as an addition to the Purchase account. 24 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 (6) below. Note, the payment is split into two parts, one in 20X6 - the remainder in 20X7. Never split VAT! VAT applies when the Bookkeeping entry is made which is the day of closing the deal. It counts once revenue/ expenses are recognised. RYNEVELD Ltd. claims the total amount of input-VAT to the extent of 50,000.00 ZAR immediately. DR Purchase..................... 250,000.00 ZAR DR VAT.......................... 50,000.00 ZAR CR Cash/ Bank.................... 150,000.00 ZAR CR Accounts Payables............ 150,000.00 ZAR The closing stock of goods at the end of the Accounting period will be considered by the adjustments later. The stock taking is on or after the balance sheet date and is recorded at that time. 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 (7) 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 (8). DR Operational Expenses......... 180,000.00 ZAR CR Cash/ Bank.................... 180,000.00 ZAR We observe the Bookkeeping entries made so far which we derived from the business activities. The next following Bookkeeping entries fall under adjustments. Study the accounts in Figure 4.2. 24 Read the Basics, chapter (26). <?page no="64"?> Berkau: Financial Statements 5e 4-60 D C D C (1) 500,000.00 (3) 12,000.00 c/ d 500,000.00 (1) 500,000.00 (2) 200,000.00 (4) 39,000.00 b/ d 500,000.00 (7) 654,000.00 (5) 240,000.00 (6) 150,000.00 (8) 180,000.00 c/ d 733,000.00 1,354,000.00 1,354,000.00 b/ d 733,000.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 200,000.00 (2) 200,000.00 (3) 12,000.00 c/ d 12,000.00 b/ d 200,000.00 b/ d 12,000.00 Interest bearing liabilities IBL Interest-20X6 INT D C D C (4) 39,000.00 c/ d 39,000.00 39,000.00 39,000.00 b/ d 39,000.00 Rent-20X6 RNT Prepaid expenses PRE D C D C (5) 200,000.00 c/ d 200,000.00 (5) 40,000.00 (7) 109,000.00 b/ d 200,000.00 (6) 50,000.00 c/ d 19,000.00 109,000.00 109,000.00 b/ d 19,000.00 Property, Plant, Equipment PPE Value added tax VAT D C D C (6) 250,000.00 c/ d 250,000.00 c/ d 150,000.00 (6) 150,000.00 b/ d 250,000.00 b/ d 150,000.00 Purchase-20X6 PUR Accounts payables A/ P D C D C c/ d 545,000.00 (7) 545,000.00 (7) 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 Next, we prepare a trial balance to cross-check our Bookkeeping entries regarding the double entry system. You see the trial balance in Figure 4.3. Compare it to the accounts in Figure 4.2. As the trial balance serves monitoring purposes, we do not round figures to the nearest Rand but disclose figures accurate to the cent. <?page no="65"?> Berkau: Financial Statements 5e 4-61 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 39,000.00 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 always on balances b/ d. (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. We continue our Accounting work with the adjustments. Adjustments are all Bookkeeping entries made in preparation of financial statements and are therefore recorded at the end of the Accounting period. For RYNEVELD Ltd., we record the adjustments as below: (a) Depreciation. (b) Pay-off of bank loan. (c) Reclassification of next pay-off. (d) Accruals for rent (e) Gross profit calculation. (f) Net profit calculation. (g) Income tax calculation. <?page no="66"?> Berkau: Financial Statements 5e 4-62 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 considered as expenses. Depreciation on the interior at RYNEVELD Ltd. is: (240,000 / 120%) / 10 = 220,000.00 ZAR. In contrast to the Bookkeeping entries for business activities, we now enter the abbreviation for the contra account in the identifier column of the accounts, such as ACC for Accumulated Depreciation account ACC. 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. must pay-off 40,000.00 ZAR per annum. The Bookkeeping entry is shown below. DR Interest Bearing Liabilities. 40,000.00 ZAR CR Cash/ Bank.................... 40,000.00 ZAR Ad (c): Reclassification of next Pay-off The upcoming repayment in 20X7 is amounting to 40,000.00 ZAR, as well. IAS 1.56 requires separating short-term liabilities from long-term ones. The current/ non-current distinction can be found in IAS 1.60 and IAS 1.61. Therefore, RYNEVELD Ltd. must reclassify the next year’s repayment as shortterm liabilities. The Accounts Payables A/ P account applies. Before the reclassification, pay-off was considered a longterm liability and fell under interest bearing liabilities. The names of the accounts can be misleading. The fact that an amount is taken out of the Interest Bearing Liabilities account does not mean that no interest payment is required therefor 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. The interest calculation does not depend on the account the owing amount is allocated to. Therefore, on the balance sheet as at 31.12.20X6, there are 120,000.00 ZAR in the Interest Bearing Liabilities account and 40,000.00 ZAR in the Accounts Payables account; both figures count for interest calculation in 20X7. DR Interest Bearing Liabilities. 40,000.00 ZAR CR Accounts Payables A/ P........ 40,000.00 ZAR <?page no="67"?> Berkau: Financial Statements 5e 4-63 Ad (d): Accruals (Rent) In compliance with IAS 1.27, the income statement is to be prepared under the accrual basis of Accounting. This requires recognising expenses in the Accounting period they are for. The payment or receipt of cash does not matter for the allocation to Accounting periods. Here, January 20X7’s rent is to be separated from the rent in 20X6, which makes the accrual in Bookkeeping entry (5) necessary. 25 The last payment for rent is for January 20X7. Hence, we take the amount out of the income statement and make a debit entry in the Prepaid Expense account. That way, we “park” the expenses and transfer them only in the next Accounting period to the expense account: Rent- 20X7 account. For the Accounting period 20X6, we only transfer the portion of rent for the next year to prepaid expenses. This give an asset on the balance sheet and a reduction towards rent expenses for the actual Accounting period. See the Bookkeeping entry below: DR Prepaid Expenses ............ 3,000.00 ZAR CR Rent......................... 3,000.00 ZAR Ad (e) Gross Profit Calculation For gross profit calculation, the Trading account applies. 26 A Trading account pairs with a 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 only 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 periods. As the company is established in 20X6, there is no opening stock. The total of purchases is the net amount of the price paid which equals 25 Read our Basics, chapter (18). 250,000.00 ZAR. No goods are returned by customers. Thus, recording the debit side of the Trading account we only make one Bookkeeping entry that closes-off the Purchase account to the Trading account: 26 Read our Basics, chapter (22). <?page no="68"?> Berkau: Financial Statements 5e 4-64 DR Trading Account.............. 250,000.00 ZAR CR Purchase..................... 250,000.00 ZAR To prepare the credit side of the Trading account, we close-off the Revenue account and take stock. The revenue is amounting to the net selling price of the goods sold which equals 545,000.00 ZAR. The stock taking results in an amount of 22.4 % of the purchased goods which equals: 22.4% × 250,000 = 5 56,000.00 ZAR. No goods are returned to suppliers which leaves the Returned Outwards account zero balanced. On the credit side of the Trading account, we make two entries linked to the Bookkeeping entries below: DR Revenue...................... 545,000.00 ZAR CR Trading Account.............. 545,000.00 ZAR DR Inventories.................. 56,000.00 ZAR CR Trading Account.............. 56,000.00 ZAR The Trading account is displayed in Figure 4.5. Ad (f): Net Profit Calculation For the net profit calculation (earnings before taxation), we deduct all remaining expenses from the gross profit. At RYNEVELD Ltd., those 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 net profit as balancing figure on the debit side. A net loss would give us a balancing figure on the credit side of the Profit and Loss account. Observe the next Bookkeeping entries. The related 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 <?page no="69"?> Berkau: Financial Statements 5e 4-65 DR Trading Account T/ A .......... 351,000.00 ZAR CR P&L-Account.................. 351,000.00 ZAR Ad (g): Income Tax Calculation The calculation of income taxes follows our simplified tax model. The income tax expenses are 30% of the pretax profit (EBT). At RYNEVELD Ltd., income taxes are 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 . . . 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. An Annual Surplus account (Jahresüberschusskonto) or Retained Earnings account (Bilanzgewinn- oder -verlustkonto) as along the German HGB (§ 268 HGB) does not exist for international Accounting. There is only one single Retained Earnings account that differs from the German Bilanzgewinn- und -verlustkonto. At RYNEVELD Ltd., the addition to retained earnings is: 103,000 - 30,900 = 72,100.00 ZAR. Observe the Bookkeeping entry below. It would be inverted for loss recording. In that case, no income taxes would apply based on our tax model. DR P&L-Account.................. 72,100.00 ZAR CR Retained Earnings R/ E ........ 72,100.00 ZAR Find below in Figure 4.5 all accounts of RYNEVELD Ltd. after recording adjustments. <?page no="70"?> Berkau: Financial Statements 5e 4-66 D C D C (1) 500,000.00 (3) 12,000.00 c/ d 500,000.00 (1) 500,000.00 (2) 200,000.00 (4) 39,000.00 b/ d 500,000.00 (7) 654,000.00 (5) 240,000.00 (6) 150,000.00 (8) 180,000.00 c/ d 733,000.00 1,354,000.00 1,354,000.00 b/ d 733,000.00 IBL 40,000.00 c/ d 693,000.00 733,000.00 733,000.00 b/ d 693,000.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 200,000.00 (2) 200,000.00 (3) 12,000.00 c/ d 12,000.00 C/ B 40,000.00 b/ d 200,000.00 b/ d 12,000.00 P&L 12,000.00 A/ P 40,000.00 c/ d 120,000.00 200,000.00 200,000.00 b/ d 120,000.00 Interest bearing liabilities IBL Interest-20X6 INT D C D C (4) 39,000.00 PRE 3,000.00 RNT 3,000.00 c/ d 3,000.00 c/ d 36,000.00 b/ d 3,000.00 39,000.00 39,000.00 b/ d 36,000.00 P&L 36,000.00 Rent-20X6 RNT Prepaid expenses PRE D C D C (5) 200,000.00 c/ d 200,000.00 (5) 40,000.00 (7) 109,000.00 b/ d 200,000.00 (6) 50,000.00 c/ d 19,000.00 109,000.00 109,000.00 b/ d 19,000.00 Property, Plant, Equipment PPE Value added tax VAT D C D C (6) 250,000.00 c/ d 250,000.00 c/ d 150,000.00 (6) 150,000.00 b/ d 250,000.00 T/ A 250,000.00 b/ d 150,000.00 c/ d 190,000.00 A/ P 40,000.00 190,000.00 190,000.00 b/ d 190,000.00 Accounts payables A/ P Purchase-20X6 PUR Figure 4.5: RYNEVELD Ltd.’s accounts after adjustments (20X6) <?page no="71"?> Berkau: Financial Statements 5e 4-67 D C D C c/ d 545,000.00 (7) 545,000.00 (8) 180,000.00 c/ d 180,000.00 T/ A 545,000.00 b/ d 545,000.00 b/ d 180,000.00 P&L 180,000.00 Revenue-20X6 REV Operational expenses-20X6 OEX D C D C ACC 20,000.00 c/ d 20,000.00 c/ d 20,000.00 DPR 20,000.00 b/ d 20,000.00 P&L 20,000.00 b/ d 20,000.00 Depreciation-20X6 DPR Accumulated depreciation ACC D C D C PUR 250,000.00 REV 545,000.00 OV 0.00 GP 351,000.00 INV 56,000.00 T/ A 56,000.00 c/ d 56,000.00 601,000.00 601,000.00 56,000.00 56,000.00 P&L 351,000.00 b/ d 351,000.00 b/ d 56,000.00 Trading account-20X6 T/ A Inventories INV D C D C DPR 20,000.00 T/ A 351,000.00 c/ d 30,900.00 P&L 30,900.00 OEX 180,000.00 b/ d 30,900.00 RNT 36,000.00 INT 12,000.00 EBT 103,000.00 351,000.00 351,000.00 D C ITL 30,900.00 b/ d 103,000.00 c/ d 72,100.00 P&L 72,100.00 R/ E 72,100.00 b/ d 72,100.00 103,000.00 103,000.00 Retained earnings R/ E Income tax liabilities ITL Profit or Loss-20X6 P&L Figure 4.5: RYNEVELD Ltd.’s accounts after adjustments (20X6) - continued How it is Done: (Trading Account Based on a Periodic Inventory System) (1) Transfer the opening value of the Inventory account to the Trading account. Make a debit entry in the Trading account and a credit entry in the Inventory account. (2) Record all purchases in the Purchase account. Consider input-VAT. At the end of the Accounting period, close-off the Purchase account to the Trading account. (3) Record all sales in the Revenue account. Consider output-VAT. Close-off the Revenue account to the Trading account. (4) In case of returns inwards, 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. Close-off the Returns Inwards account to the Trading <?page no="72"?> Berkau: Financial Statements 5e 4-68 account. If goods are received add them to stock or dump 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 credit the VAT account. Make a credit entry in the Returns Outwards account or as an alternative in the Purchase account (negative purchase). Close-off the Returns Outwards account to the Trading account. (7) Determine the balancing figure of the Trading account. If the Trading account is debit balanced (b/ d), the balancing figure is a gross loss. If the Trading account is credit balanced, the balancing figure is a gross profit. Transfer the gross profit or gross loss to the Profit and Loss account by closing-off the Trading account thereto. The adjusted trial balance is prepared once the Bookkeeping entries for adjustments are complete. It is shown in Figure 4.6. As all nominal accounts are closed-off either to the Trading account or the Profit and Loss account they do not show on the adjusted trial balance anymore. 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. <?page no="73"?> Berkau: Financial Statements 5e 4-69 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 profits, calculate and record dividends and/ or additions/ reductions to reserves. Balance-off the Retained Earnings account. In case a company carries forward a profit/ loss, there will be a balance b/ d to be considered for the Retained Earnings account. (3) Transfer the adjustments to the trial balance. We recommend copying the previous trial balance and adjust the copied version. 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, too. No entry in the adjusted trial balance is required for them. After preparing the adjusted trial balance, compare the total of the balancing figures for all listed accounts of the debit column to the credit column. (4) Prepare the income statement based on the information you retrieve from the Trading account and the Profit and Loss account. Prepare the balance sheet based on the real accounts listed on the adjusted trial balance. You might combine accounts for the balance <?page no="74"?> Berkau: Financial Statements 5e 4-70 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 for RYNEVELD Ltd. There only are few changes necessary to transform the adjusted trial balance towards 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 = 2 209,000.00 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 fulfils the requirements in 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 normal business activities. The income statement is shown in Figure 4.8. <?page no="75"?> Berkau: Financial Statements 5e 4-71 [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 We are not eager to explain RYNEVELD Ltd.’s statement of cash flows and its statement of changes in equity here. It would be a repetition of chapter (3). 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 belief that its debtor is insolvent and thus the debts become irrecoverable. It can be downloaded by the QR code in the Link 4.B below: Link 4.B: TELUK Sdn. Bhd. We explain now 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 for RYNEVELD Ltd. In the Δ -trial balance, we make the entries for depreciation. For processing the adjusted trial balance, we add the amounts from the original trial <?page no="76"?> Berkau: Financial Statements 5e 4-72 balance and the Δ -trial balance. Observe the procedure in Figure 4.9 about depreciation only. Account Debit entries Credit entries Debit entries Credit entries [ZAR] [ZAR] [ZAR] [ZAR] Cash/ Bank 733,000.00 Issued Capital 500,000.00 Interest bearing liabilities 200,000.00 Interest INT 12,000.00 Rent RNT 39,000.00 Prepaid expenses 0.00 Property, Plant, Equipment 200,000.00 Value added Tax 19,000.00 Purchase PUR 250,000.00 Accounts payables 150,000.00 Revenue REV 545,000.00 Operational expenses OEX 180,000.00 Depreciation 20,000.00 20,000.00 Accumulated depreciation 20,000.00 20,000.00 Total: 20,000.00 20,000.00 1,434,000.00 1,434,000.00 Ryneveld Ltd.'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. Note that cells are overwritten multiple times. <?page no="77"?> Berkau: Financial Statements 5e 4-73 Account Debit entries Credit entries Debit entries Credit entries [ZAR] [ZAR] [ZAR] [ZAR] Cash/ Bank 40,000.00 693,000.00 Issued Capital 500,000.00 Interest bearing liabilities 80,000.00 120,000.00 Interest INT 12,000.00 Rent RNT 39,000.00 Prepaid expenses 3,000.00 3,000.00 Property, Plant, Equipment 200,000.00 Value added Tax 19,000.00 Purchase PUR 250,000.00 Accounts payables 40,000.00 190,000.00 Revenue REV 545,000.00 Operating expenses OEX 180,000.00 Depreciation 20,000.00 20,000.00 Accumulated depreciation 20,000.00 20,000.00 Gross profit 351,000.00 351,000.00 Inventories 56,000.00 56,000.00 Earnings before taxes 103,000.00 103,000.00 Retained earnings 72,100.00 72,100.00 Income tax liabilities 30,900.00 30,900.00 Total: 1,158,000.00 1,158,000.00 952,000.00 952,000.00 Ryneveld Ltd.'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 trading industry where the gross profit calculation is important. 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="78"?> Berkau: Financial Statements 5e 4-74 Net profit: Profit after interest and before income taxes. The net profit equals earnings before taxation EBT. Periodic inventory system: Inventory system where stock taking is required at the beginning and the end of the Accounting period. Trading account: Section of the Profit and Loss account that only deals with revenue and material expenses. The balancing figure is the gross profit. Trial balance: The trial balance is a list of all accounts in use which shows the balancing figures (Bal. b/ d) thereof. The total of the balancing figures on the debit side shall equal the total of the balancing figures on the credit side to confirm consistency with the double entry system. Question Bank: (1) A company got an opening value for inventories of 56,000.00 EUR. During the Accounting period, the company purchases goods for 300,000.00 EUR and later for 350,000.00 EUR. At the end of the Accounting period, stock taking reveals that there are goods for 100,000.00 EUR left. The sales are amounting to 850,000.00 EUR. Depreciation on the store equipment is 40,000.00 EUR. How much is the company's gross profit? 1. 244,000.00 EUR. 2. 204,000.00 EUR. 3. 144,000.00 EUR. 4. 104,000.00 EUR. (2) A company records an opening value of inventories of 300.00 EUR. The closing balance is amounting to 100.00 EUR. During the Accounting period, there were two purchases, one at 1,000.00 EUR and the other one at 2,000.00 EUR (net amounts). The revenue equals 5,000.00 EUR. How much is the gross profit? 1. 1,200.00 EUR. 2. 1,800.00 EUR. 3. 2,200.00 EUR. 4. 1,600.00 EUR. (3) The items disclosed on the debit side of the Trading Account are: 1. Opening value of finished goods, revenue, labour. 2. Purchases, returns inwards, opening stock. 3. Opening value of inventories, labour, returns outwards. 4. Closing stock of inventories, revenue, returns inwards. (4) On 2.04.20X4, a company buys a machine at 24,000.00 EUR gross amount. The seller offers a 10% trade discount on the machine on 1.07.20X4. Depreciation commences in April and is based on straight-line method over 5 years. Depreciation expenses for 20X4 are: 1. 1,800.00 EUR. 2. 3,600.00 EUR. 3. 2,700.00 EUR. 4. 2,000.00 EUR. (5) A company buys goods for 100,000.00 EUR cost of purchase. The opening value of inventories as at the beginning of the year is amounting to 20,000.00 EUR. During the Accounting period, the company sells goods valued at 58,000.00 EUR and returns goods for 18,000.00 EUR. The sales are <?page no="79"?> Berkau: Financial Statements 5e 4-75 150,000.00 EUR. How much is the gross profit? 1. 92,000.00 EUR. 2. 106,000.00 EUR. 3. 86,000.00 EUR. 4. 136,000.00 EUR. Solutions: 1-1; 2-2; 3-2; 4-3; 5-1. <?page no="80"?> Berkau: Financial Statements 5e 5-76 5. Basics of Financial Statement Analysis What is in the Chapter? We cover the basics of financial statement analysis. For the preparation of a genuine financial statement analysis you need more knowledge than we can teach you in a textbook. Therefore, we only refer to the major ratios regarding performance, liquidity, capital structure and market valuation and explain their general meaning and apply them for CAPELIFT Ltd., a fictitious firm in Aviation. Learning Objectives: After studying this chapter, you know the most important aspects of financial statement analysis and you will understand the meaning of most important ratios. This will give you a head-start for the preparation of your first real financial statement analysis. For a real financial statement analysis, you need knowledge about the industry. We assume everyone knows how an airline works. 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. We intend to demonstrate that the idea of calculating just few ratios and obtaining sufficient knowledge about a company is wrong. It would be the same as if your doctor always starts her/ his examination with a great blood count which means the laboratory tests your sample on every possible disease. A better approach is to prepare certain industry related ratios to verify an initial hypothesis made 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. Most probably the repair agent would not check the lamps in that situation, because he/ she starts with an idea about what the reason is: wheel bearings. We follow the same process for financial statement analysis. We here present a first approach of financial statement analysis and teach you the basics. As we later intend to study financial statements of the South African airline COMAIR Limited, we introduce financial statement analysis by a fictitious small airline CAPELIFT Ltd. We provide you here with a link to COMAIR Limited’s financial statements. Take the COMAIR Limited business report and make yourself familiar with Aviation. The Link 5.A takes you to COMAIR Limited. Link 5.A: COMAIR Limited. <?page no="81"?> Berkau: Financial Statements 5e 5-77 We focus on companies that prepare financial statements along IFRSs. We also assume the company’s financial statements have been audited already. Auditing checks financial statements for correctness. In many countries auditing is required by national law and is a precondition for the approval of financial statements and so for the appropriation of profits. Auditing is not ruled by IFRSs because it falls under national law. The start for financial statement analysis might be to check basic ratios to gain an overview. Later in financial statement analysis, you will follow a specific suspicion and ratios linked thereto. We discuss below an easy example to support this procedure. ROSENDAHL Ltd. is a production firm for sneakers. We assume already the company is in trouble selling its products because they are out of fashion. How do we prove our first idea about the situation ROSENDAHL Ltd. is in? We look for symptoms of low selling. We might see that the item inventories is too high on the balance sheet and check the notes for details to find whether the inventory mainly consists of finished goods. Regarding the inventory level of finished goods, we expect the company to only have enough stock to deliver its customers on time. If the inventory level exceeds that amount, we can say it is too high. Excessive inventories set off our alarms. Another indicator can be the increase of stock levels over the time. We further check the income statement which might show poor revenues and 27 Read our Basics, chapter (28). high storage costs and high expenses for Innovation Management and Marketing. A revenue is low when the amounts, selling prices or rebates are noticeable different from their estimates. When a company increases stock by producing more goods than can be sold the situation is noticeable. For our sneaker manufacturer, we also monitor the return on sales which might be low, as ROSENDAHL Ltd. tries to clear stock (of its ugly sneakers) by trade discounts or sale on specials. A return on sales tells you how much a company earns per currency unit received, for example the profit per cashed-in EUR. With temporary price reductions, a company tries to “pump goods into the market” without changing its market position or its prices on the long run. This might also result in an increase of receivables if the company offers convenient payment conditions to make the sale more attractive for its customers. We assume, in total, ROSENDAHL Ltd. discloses poor profit for the period due to its low sales. However, overstocking does not result in a drop in profit instantly. As the sneakers are added to stock at cost of manufacturing, profitability might still be looking good. But the lack in sales and the increased inventories are 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 directly. 27 We might also detect on ROSENDAHL Ltd.’s VAT statement that output-VAT in comparison to input-VAT is lower than in prior periods. <?page no="82"?> Berkau: Financial Statements 5e 5-78 As ROSENDAHL Ltd. now filled its storages with (ugly) sneakers, the production situation is characterised by overcapacity. The firm tries to reduce production or to take promotional measures as the goods are currently not selling. As an alternative, the company might start launching different products, such as sneakers in a more popular shape or colour. Production firms often have difficulties to react to changes on demand as most costs are fixed, such as depreciation and indirect labour. Therefore, the overhead allocation rate becomes too high. As ROSENDAHL Ltd. does not generate enough cash from its sale of sneakers the company might have gone into financial distress. This is caused by a lack in receipts and high capital costs for financing inventories. The operating cash flows will show poor inflows but normal outflows for materials, Marketing, consultancy etc. As a result of low cash inflows, the company accepted unfavourable loan conditions which we recognise as high interest rates or at least increases thereof. The story of ROSENDAHL Ltd. shows that we must look at the full picture before we start with conclusions about single ratios. Never calculate a bunch of standard ratios and try to come up with a quick conclusion. Rather try to gain a first impression from basic ratios and thereafter follow a hypothesis driven ratio analysis. For the analysis of financial statements do not tolerate contradicting conclusions. If the results are not consistent, continue analysing and check alternative symptoms. For a structured financial statement analysis, we follow the steps below: (1) Defining information requirements. (2) Formal checks. (3) Horizontal analysis. (4) Vertical analysis. (5) Ratio analysis. Ad (1): Defining Information Requirements The 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 etc. There might be a lot of reasons for financial statement analysis and the information need determines the way we analyse our data. Ad (2): Formal Checks Before we begin with a financial statement analysis, we check whether we have gotten 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 no access to the Bookkeeping records. This means, our analysis is limited to the published financial statements and no drill down from financial data towards access to the original Bookkeeping entry is possible. Hence, we only rely on the information provided by the financial statements and have no chance to, e.g., ask the Accountant questions. In some cases, we might even find finan- <?page no="83"?> Berkau: Financial Statements 5e 5-79 cial 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 an interpretation of financial data, not a neutral examination thereof. Therefore, we cannot rely on financial statements analysis from others. For correctness of financial statements, we check whether they were audited and in case they were we study the auditors’ opinion. 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 contrast to financial statement analysis, auditing is a formal check which makes it is more reliable. Auditors do not share their opinion about the wellbeing or chances of a company, as they focus on the correctness of financial statements and the 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. E.g., a return on assets requires to consider whether prepayments count as assets. In Germany they do not, internationally, prepayments are part of the current assets. Those differences change ratio values and require caution regarding interpretation. Ad (3): Horizontal Analysis A horizontal analysis tells the reader of financial statements the timeline of figures. It provides us with hints about the development of ratios in a company, e.g., revenue history. It is always a good idea to look at developments under consideration of the common situation in the industry. There might be general changes, such as a financial crisis or competition by internet trading which require that we must 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 can see a company in different situations and can assess the company’s ability to react on special situations. Ad (4): Vertical Analysis A vertical analysis helps us to understand the proportions of single items of the whole. 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 <?page no="84"?> Berkau: Financial Statements 5e 5-80 normative information. Normative information means that there is a good or best practice percentage known we try to achieve. However, we do not follow the approach of general rules (golden rule for balance sheet), as you might find in many textbooks for finance. We always should understand the business well enough to decide whether the ratio indicates a good situation or requires changes. Following a rule 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 plans to relocate production facilities to a country where labour costs less. Ad (5): Ratio Analysis In general, the financial statements give us already quite good information about a 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 repetitive and how much is extraordinary. The statement of cash flows shows the total cash flow and single cash flows from operating, investing and financing activities. In total, a lot of information needs users of financial statements have, are covered already. However, for special information purpose, it is helpful to determine 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 a suitable company for given selection criteria, preparing benchmarks etc. For that reason, we strive to calculate information to compare characteristics of companies, such as performance, liquidity, capital structure or market value. We later will structure ratio based analysis following these four information needs. Not all companies are comparable per se. E.g., different sizes of companies get in the way of making comparisons. 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 start-up consultant operating as freelancer from a private home and alone. To compare firms that differ in size, we calculate ratios as percentages 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. We check the companies A, B, C and D below and receive the data as depicted in Figure 5.1. <?page no="85"?> Berkau: Financial Statements 5e 5-81 Company Gross profit Sales GP/ Sales A 200,000.00 848,000.00 23.58% B 300,000.00 1,252,000.00 23.96% C* 500,000.00 1,927,500.00 25.94% D 350,000.00 1,468,400.00 23.84% Figure 5.1: Company data We can easily derive data for gross profits and sales from the income statements. The gross profit tells us how much revenue is left after deduction of material expenses and it shows how much of profit is left for business activities and profit together. The sales represent 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 will see which company is most successful at selling its products on the market. Therefore, we divide gross profit by the revenue. We can say, for every 100.00 EUR (input) received, company A earns a gross profit of 23.58 EUR, company B: 23.96 EUR, company C: 25.94 EUR and company D: 23.84 EUR (output). Hence, the best performer is company C. The ratio profit as percentage of sales POS measures the yield it gives us an output-over-input-ratio. It tells us about the efficiency resources are deployed. Ratios are a very common instrument for financial statement analysis. Many are calculated based on data we derive from financial statements. Some data depend on the Accounting period, 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 date, most likely to the balance sheet date. In order to calculate ratios as fractions with nominators/ denominators from income statements and balance sheets, we have to make a decision, which data from which balance sheet apply: (a) the opening value, (b) the closing value or (c) the average of the above. In this textbook we follow alternative (b). There are good reasons for alternatives (a) and (c), however, we apply the closing values, as we can derive all from one set of financial statements. In other than academic situations we recommend calculating the average value from opening and closing figures. Below, we classify ratios regarding aspects they measure and follow these classifications for our following description: - Performance ratios. - Liquidity ratios. - Capital structure ratios. - Market value ratios. To explain the most common ratios, we apply them for the fictitious firm CAPELIFT (Pty) Ltd. below. Below, we introduce the firm shortly. <?page no="86"?> Berkau: Financial Statements 5e 5-82 Data Sheet for CAPELIFT (Pty) Ltd. DDomicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Aviation. Issued capital: 7,500,000.00 ZAR. Accounting period: 20X8. Fleet: 1 jet, 1 piston engine aircraft. Financing: bank loans; 5.9 %/ a. Pilots: Freelancers. VAT: 20 %. CAPELIFT (Pty) Ltd.: CAPELIFT (Pty) Ltd. is a small airline that offers charter flights. The company operates two aircrafts, a Bombardier Learjet (jet) and a Mooney Bravo (single piston engine aircraft). The company is based at Cape Town Int’l airport. Both aircrafts are financed by bank loans at a rate of interest of 5.9 %/ a. On its balance sheet, the company discloses an issued capital of: 1,000,000 × 7.50 = 7,500,000.00 ZAR which is the ordinary share capital. CAPELIFT (Pty) Ltd. owns its aircrafts and carries them as assets under P, P, E. It records a bank loan for their financing, 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 lay-overs. CAPELIFT (Pty) Ltd. passes the pilots’ bills to its customers without further surcharge. CAPELIFT (Pty) Ltd.’s clients are mostly business-people who charter the planes for business trips to small domestic airfields. 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) <?page no="87"?> Berkau: Financial Statements 5e 5-83 [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) 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. To achieve success, a company must work efficiently. We frequently measure financial success by the monetary equivalent received when selling goods or services to customers. It is compared to the effort a company must take to produce goods or render services. Performance ratios measure the yield (efficiency) and are based on the comparison between input and output. In terms of Mathematics, performance gives us either a difference or a percentage. The primary source for financial performance measurement is the statement of profit or loss and other comprehensive income. It compares the revenue received to expenses for goods production or service rendering and the sale thereof. Hence, profit calculation can measure the total financial performance already. Profit is merely the difference between output and input and gets expressed as a figure with a currency unit, such as 7,000.00 EUR. In addition to the pure profit calculation, financial performance ratios frequently compare profit to input, 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 etc. For the comparison of performance, we should be aware there are major differences which depend on the business model of a company. E.g., a consultancy’s input is not capital but human resources. For that reason, production firms and other capital intensive industries, such as airlines, earn a significant lower return on capital than companies that earn money based on <?page no="88"?> Berkau: Financial Statements 5e 5-84 human capital, like law firms. Therefore, inter-industry comparisons normally do not make sense. Below, we introduce the most common financial performance ratios: - Fixed Asset Turnover. - Inventory Turnover. - Return on Capital Employed. - Return on Assets. - Return on Shareholders’ Funds. - Return as Percentage of Sales - Earnings per Share. - Economic Value Added. Fixed Asset Turnover: The Fixed Asset Turnover measures the revenue as a percentage of the noncurrent assets. The revenue is the proceeds calculated after deducting trade discounts, VAT and further selling costs, 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 different products/ services which are produced by the same resources. Hence, if you can allocate revenue to single investments, you should do so. This gives you an investment based Fixed Asset Turnover. The ratio allows to assess investments and applies for Asset Management decisions. Fixed Asset Turnover is based on carrying values. Hence, a service rendered by deployment of highly depreciated machinery that leads to the same sales as obtainable with new machines gives a higher Fixed Asset Turnover. CAPELIFT (Pty) Ltd. could obtain a high Fixed Asset Turnover by flying old aircrafts if customers accept this, and the authorities certify 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 and load factor. A load factor is the occupation per seat capacity. Aircrafts only earn money when airborne. Many airlines compare the flight time to the total period. Hence, the aim is to spend as less time on the ground (on taxiways and at the ramps) as possible. Long haul flights result in higher Fixed Asset Turnover than domestic flights if flown by the same aircrafts. As passengers are intolerant for delays and cancellations, carriers must keep transportation capacity stand-by. Hence, the total utilisation rate and Fixed Asset Turnover is traded off to a reliability of service. CAPELIFT (Pty) Ltd. calculates a Fixed Asset Turnover of: 50,000,000 / 60,000,000 = 8 83.33%. The ratio indicates low performance because CAPELIFT (Pty) Ltd. has a low utilisation rate. The company does not fly line but it charges high prices. Its customers expect an aircraft availability that matches their travel plans. To boost its Fixed Asset Turnover, CAPELIFT (Pty) Ltd. could think of replacing the fast, but expensive Mooney. Its Marketing department must research whether customers are prepared to accept longer flight times for lower prices. We discuss below the plans to acquire an additional Cessna Caravan C172. <?page no="89"?> Berkau: Financial Statements 5e 5-85 Inventory Turnover: The Inventory Turnover is a performance ratio for production firms and trading companies. It measures how often stock is virtually replaced/ sold completely during an Accounting period. The ratio applies in Logistics to identify fast moving and slow moving goods. In Accounting it is regarded as a performance measurement to calculate how quick goods are sold. A high Inventory Turnover makes a company flexible as it does not take long to clear stock, when goods depend on fashion trends, such as in clothing industry, or are perishable. 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. In Accounting, we consider the quick selling of goods as good performance. A company selling its goods quickly will pay low inventory and capital costs. For our case study CAPELIFT (Pty) Ltd. inventories are less important. The company does not hold inventories for aviation gas/ kerosene 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 long-term liabilities that is invested in the company. In contrast, short-term liabilities are not regarded as investment and its costs of capital are mostly covered by the creditors. Hence, only capital the company actually 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 long-term liabilities on the credit side of the balance sheet. The nominator is the pre-tax profit to keep the ratio free of income tax bias and make it comparable between different countries where other tax rates apply. CAPELIFT (Pty) Ltd.’s Return on Capital Employed equals: 10,000,000 / (7,500,000 + 6,000,000 + 7,000,000 + 50,000,000) = 1 14.18 %. For interpretation, we must compare the Return on Capital Employed to the rate of interest in South Africa which is approximately 9 %/ a. Hence, the business model 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 regarding productivity or service rendering. Taxes and interest matter. One major problem of the Return on Assets is that highly depreciated machinery makes the ratio increase even if production/ service amounts do not change. An UBER driver who drives <?page no="90"?> Berkau: Financial Statements 5e 5-86 the same amount of rides every Accounting period will experience an increase in performance only due to decreasing carrying values for the car because it depreciates. The Return on Assets often applies in companies and groups to rank the productivity of certain plants, branches or subsidiaries. It is free of tax and interest bias and easily to calculate from the financial statements. CAPELIFT (Pty) Ltd.’s Return on Assets is amounting to: 12,950,000 / 90,000,000 = 114.39%. In case we compare the Return on Assets to 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. Return on Shareholders’ Funds: Return on Shareholders’ Funds ROSF (= Return on Equity) is a ratio that represents the benefit that flows to investors. So far, we only focussed on performance from the point of view of the company or plant manager. We next look from the investor’s side. Return on Equity represents potential return to the owners from, e.g. dividends. The possibility of earnings refers to the pending dividend decision made by managers/ owners on the annual general meeting. To use the Return on Shareholders’ Funds as a performance ratio, we must cancel out the influence of the decision about the appropriation of profits. 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. We consider the equity increased by the earnings. 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 based on its Return on Assets which is above the rate of interest for bank loans. Return as the Percentage of Sales (Return of Sales): Return as Percentage of Sales determines the annual surplus over sales. The ratio tells us how much money is earned as annual surplus when the company sells its products. E.g., we want to know how much profit 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 business processes. 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 and offer their customers trade discounts in order to keep or to expand their share of the market. The <?page no="91"?> Berkau: Financial Statements 5e 5-87 net profit as percentage of sales is often related to operative earnings only. Taxation and interest do not have an impact on the Return as a Percentage on Sales. We do not follow the German classification in gross and net return on sales here with the gross return on sales being linked to the pre-tax profit and also includes non-operative profits, as the translation to English leads to the term gross profit which is something different. The Return as Percentage of Sales (or Return on Sales ROS) for CAPELIFT (Pty) Ltd. is amounting to: 7,000,000 / 50,000,000 = 1 14%. This means the airline earns an annual surplus of 14.00 ZAR for every 100.00 ZAR received from its customers. 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 dividend declaration, the ratio will no longer measure performance. Hence, EPS measures the earnings for a full dividend payable to ordinary shareholders divided by the number of ordinary shares. In contrast to dividend calculations, it does not include profits carried forward but is only based on actual earnings. IAS 33.10 defines the calculations. Some items are to be deducted before earnings are distributable to ordinary shareholders: (a) preference dividends and (b) in Germany, additions to legal reserves, compare with IAS 33.14. IAS 33.12 rules the calculation of earnings: The amount that is distributable to the ordinary shareholders is divided by the number of ordinary shares based on IAS 33.19. Changes in the number of shares with or without payment receipts are ruled by calculation procedures along IAS 33.26 - IAS 33.29. CAPELIFT (Pty) Ltd. 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 = 7 7.00 ZAR/ s. The Earnings per Share ratio is mostly known from the denominator for the Price-Earnings ratio that compares the market share price of shares to the earnings per share. For further considerations about EPS calculations follow the link below. Link 5.B: EPS calculations Economic Value Added TM : The Economic Value Added is the increase of the company’s value due to its earnings. (Economic Value Added is a trademark of Steward Stern Management Services). For Economic Value Added calculation, the net operating profit after taxes is compared to the difference between assets and <?page no="92"?> Berkau: Financial Statements 5e 5-88 short-term liabilities, the latter one multiplied by the Weighted Average Cost of Capital WACC. The WACC is a rate and is disclosed as percentage per annum. The difference between assets and short term liabilities represents the capital employed by the investors. Short-term liabilities are deducted to consider their financing by the company's creditors. By multiplying the capital employed by WACC, we determine the profit that can be earned with an alternative investment under consideration of actual interest and cost of equity. This way, EVA compares net operating profits to its opportunity costs. The result is a difference on how much the shareholders’ company’s value increases more than an alternative investment and is measured in the currency unit and applicable under consideration of income taxes by a so called tax shield, here (1 - 30%). The tax shield considers that the alternative investment would be taxable income. For CAPELIFT (Pty) Ltd. the Weighted Average Cost of Capital requires calculating the 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 %/ a 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. Therefore, interest payments are 28 Read our Basics, chapter (34) and (35). divided by: (1 + 5%) × 50,000,000 = 552,500,000.00 ZAR. The rate of interest is accordingly to our above calculation: 2,950,000 / 52,500,000 = 5 5.62%/ a. We expect a return to shareholders of 10 %/ a as a dividend and calculate the WACC to: [10% × (7,500,000 + 6,000,000 + 7,000,000) + 5.62% × 52,500,000] / 73,000,000 = 6 6.85%/ a. The EVA compares the net operating profit with the interest income that could be earned on the capital market as opportunity costs. To compare the figures, we multiply the calculated WACC rate by the tax shield, which is amounting to: (1 - 30%) for this textbook. 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 land is difficult to exchange. In contrast, the item cash/ bank is already in a liquid state. When we liquidate a company, we transform all assets to cash and take the money, e.g., to retire the debts. 28 Liquidity ratios tell us how quick cash can be generated by selling assets to repay liabilities. <?page no="93"?> Berkau: Financial Statements 5e 5-89 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 assets are financed by short-term liabilities. In that case, the financing of the business is at low risk 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. As the value exceeds 100 %, we know that some current assets are financed longterm. However, the Current Ratio does not tell us how the Financing for longterm assets is like. We do not know whether it is financed by equity or longterm debts. Quick Ratio: In contrast to the Current Ratio, the Quick Ratio only includes current assets that can be sold on short notice. We assume that inventories and prepayments are not quickly convertible and deduct them from current assets in the nominator 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 the short-term debts. A company can repay its short-term liabilities without problems on short notice. At CAPELIFT (Pty) Ltd., the Quick Ratio is: 28,000,000 / 19,500,000 = 1 143.59%. Hence, the quickly sellable current assets are sufficient for paying-off shortterm liabilities. Cash Ratio: The Cash Ratio is a further step into the direction of short-term liquidation. It tells us how much cash and cash equivalents a company owns to payoff the liabilities instantly, or within a few banking days. A Cash Ratio of 100 % means the company holds the shortterm liabilities on cash or in a bank account. This indicates 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 in Aviation paying for labour, fuel and airport fees close or before to departure. A high liquidity is not per se a good indicator as it reduces performance. A liquidity reserve does not support business operations of a company and lowers its average performance. Debtors’ Collection Days: The value of receivables is considered for the liquidity; receivables are considered as difficult to collect on short notice. However, in different industries there are different durations for <?page no="94"?> Berkau: Financial Statements 5e 5-90 debt collection. To consider the average time span of debt collection the Debtors’ collection Days divides the (total of receivables × 365) by the sales on credit. We assume that at CAPELIFT (Pty) Ltd. half of the customers pay on cash and the remainder ones pay 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. This is not a good sign in a country where the rate of interest is at 9 %/ a, because CAPELIFT (Pty) Ltd. must finance the receivables for more than 3 months as working capital. Ad (5.3): 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, whether the company is financed by equity or liabilities. Regarding liabilities we also want to know the payment terms, in particular we strive to learn, 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 must 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 represent the true and fair measurement of debts. In comparison, the German HGB overrates liabilities which results in the disclosure of higher values than actual borrowings. Short-term liabilities are always disclosed at settlement values in Germany. We discuss below only few ratios as a lot of ratios for gearing provide us with identical information about the capital structure. It is important to understand why to analyse capital structure at first. It is for the leverage effect and financing decisions, as you will learn below. We cover: - Debt to Equity ratio D2E. - Working Capital. - Interest Coverage. Debt to Equity ratio: The Debt to Equity ratio is the relationship between liabilities and the total of equity. At CAPELIFT (Pty) Ltd., the Debt-to-Equity D2E ratio is: (90,000,000 - 20,500,000) / 20,500,000 = 3 3.39 or we say it is 339 %. This indicates that the company is highly indebted which is understandable for a capital intensive industry, such as Aviation. We also check the coverage of long-term assets by the debt structure. CAPELIFT (Pty) Ltd. has long-term funds which is part of its equity and long-term debts resulting from bank loans to the total extent of: 7,500,000 + 6,000,000 + <?page no="95"?> Berkau: Financial Statements 5e 5-91 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. 29 We consider the coverage rate 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 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 i. Very often the leverage effect is shown in diagrams where returns and interest are a steady function of borrowing shown as a line. This pretends that any value for the Debt to Equity ratio can be realised. But that is wrong, we must calculate returns and interest based on certain investment and financing scenarios. Even investments on the capital market do not come in any quantities and, therefore, no steady return function over debt ratios actually applies. For that reason, we refuse to draw return over borrowing diagrams. Instead, we calculate single scenarios for decision making as below. 29 For our calculations, we do not consider retained earnings as long-term as it is subjected to claims of shareholders every year. We prepared the calculation of returns for CAPELIFT (Pty) Ltd. when acquiring an additional aircraft Cessna Caravan C172 to expand its fleet. Follow the QR-code below in Link 5.C for further considerations about our micro airline. Link 5.C: CAPELIFT (Pty) Ltd. Ratios about capital structure are often referred to as gearing. The expression comes from Engineering where a gear box is transforming torque and revolutions per minute RPM. The performance is a result of the relationship between the gear wheels to each other. 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 is risky. Working Capital: Working Capital is an absolute asset value measured in currency units. It originates from Finance and is the difference between short-term assets and short-term liabilities. In Finance, we need to know the Working Capital to <?page no="96"?> Berkau: Financial Statements 5e 5-92 decide about the funds required to run a business. Besides the funding of 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 suppliers offer short-term borrowing, such as pay next month or after goods have been sold, the shortterm liabilities offered reduce the funding needs. Therefore, we deduct short-term liabilities when calculating the Working Capital. Running consignment stock can reduce the Working Capital but it often is combined with higher material prices asked for by the supplier. 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 minimise their Working Capital. They try to keep inventories low and hold as less cash as possible. Interest Coverage: Interest Coverage measures how much the net profit before interest can cover the interest expenses. The calculation is EBIT divided by interest. The Interest Coverage at CAPELIFT (Pty) Ltd. is: 12,950,000 / 2,950,000 = 4 4.39. The amount is low which proves 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 multiplied by 365 the Interest Coverage tells us how many days per year it takes to pay for borrowing. At CAPELIFT (Pty) Ltd. it takes: 365 / 4.39 = 8 83.14 days. This means, the company works until 22 nd of March for its banks. Ad (5.4): Market Value Ratios We only can calculate market value ratios when a company is listed. In those cases, the share price is accessible to the public and can be compared to the valuation derived from Accounting. The below listed market value ratios apply: - Price/ Earnings Ratio. - Dividend Yield. - Market Book Ratio. No fair market value is available for CAPELIFT (Pty) Ltd. as its shares are not traded publicly. However, for this chapter, we pretend 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, we calculate the market price paid for a share divided by its annual earnings. As we divide the market price by the EPS, the Price Earnings Ratio gives the number of periods it takes to break even if the company always declares a dividend of 100 % of its earnings. <?page no="97"?> Berkau: Financial Statements 5e 5-93 At CAPELIFT (Pty) Ltd., the Price Earnings Ratio is: 25 / (7,000,000 / 1,000,000) = 33.57. Hence, an investor must wait 4 years before he breaks even with the shares bought by dividends received. The Price-Earnings-Ratio is used for company comparisons and tells us about the confidence of the investors in the profitability of the company. Dividend Yield: The dividend yield is the dividend paid divided by the fair market price per share. It is a kind of return figure that shows the return on investment for the shareholder. We must weaken 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. 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 merely reflects the case when a company is acquired to be liquidated at fair values. We assume the Market Book Value normally to be above 100 % as its benefits exceed the yield obtainable in a liquidation. At CAPELIFT (Pty) Ltd., the Market Book Value is: 25 / ((7,500,000 + 6,000,000 + 7,000,000) / 1,000,000) = 1 121.95%. Summary: We introduced the basics of the Financial Statement Analysis for companies that prepare their financial statements along IFRSs. The Financial Statement Analysis should only be undertaken if financial statements can be trusted, best after being audited. The Financial Statement Analysis contains a horizontal analysis, a vertical analysis and a ratio analysis. Most common ratios are linked to performance, liquidity and gearing. For listed companies, market value ratios can be calculated. A financial statement analysis requires knowledge about the industry the company is in. Accounting Technical Terms: Financial Statement Analysis: Evaluation of a company based on its financial statements. Liquidity: Ability of a company to retire its debts on short notice. For paying-off liabilities, assets must be sold. Market Value Ratios: Ratios that compare the share price of a company with Accounting data derived from financial statements. A market value ratio tells the investor whether the share price is valuable. Performance: Ability of a company to be productive regarding goods manufacturing or rendering of services. Ratio: In Accounting, a ratio is a figure calculated from amounts taken from financial statements. <?page no="98"?> Berkau: Financial Statements 5e 5-94 Question Bank: (1) A company discloses a Return on Assets of 20 %. The equity is 100,000.00 EUR and the liabilities are 120,000.00 EUR. 1. The gross profit is 44,000.00 EUR. 2. The net profit is 44,000.00 EUR. 3. The net profit is 30,800.00 EUR. 4. The net profit is 20,000.00 EUR. (2) A company discloses inventories of 40,000.00 EUR, receivables of 10,000.00 EUR and a balancing figure of cash/ bank of 20,000.00 EUR. The short-term liabilities are amounting to 50,000.00 EUR. Which statement is correct? 1. The cash ratio is 29 %. 2. The current ratio is 60 %. 3. The quick ratio is 60 %. 4. The cash ratio is 40 %. (3) A company shows 40 % liabilities at an interest rate of 4 %/ a and 60 % of equity. Its shareholders expect a return of 10 %. How much are the weighted average cost of capital? 1. 7.0%. 2. 7.6 %. 3. 4.0 %. 4. 6.4 %. (4) A company with 10,000 ordinary shareholders and 5,000 preference shareholders earns a pre-tax profit of 25,000.00 EUR. It declares a dividend of 50 % of the distributable amount to its ordinary shareholders. The preference dividend is 5,000.00 EUR. How much are its Earnings per Share if all shares have the same nominal value? 1. 1.50 EUR. 2. 1.25 EUR. 3. 0.70 EUR. 4. 0.63 EUR. (5) A company earns an operating profit before taxes of 100,000.00 EUR. The weighted average costs of capital are 5 %/ a. The assets are amounting to 1,000,000.00 EUR and the short-term liabilities are 400,000.00 EUR. How much is the Economic Value Added? 1. 70,000.00 EUR. 2. 49,000.00 EUR. 3. 40,000.00 EUR. 4. 50,000.00 EUR. Solutions: 1-2, 2-4, 3-2, 4-4, 5-2. <?page no="99"?> Berkau: Financial Statements 5e 6-95 6. Formal Aspects of Financial Statements What is in the Chapter? This chapter deals with the application of IAS 1. We discuss the presentation of financial statements following IFRSs. Here, we cover the notes as well. We explain and demonstrate formal Accounting aspects by the fictitious case of BATHURST Ltd. in Australia. The company is a car rental based on shares. BATHURST Ltd. prepares financial statements in compliance with IFRSs. 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. 30 IAS 1.16 requires that a company preparing financial statements that comply with IFRSs must make an unreserved and explicit statement in the notes about compliance with IFRS. Companies normally do so in the notes, as you can see in Figure 6.8 for our case study BATHURST Ltd. For general purpose financial statements, a company must prepare a full set of financial statements along IAS 1.10 at least annually. General purpose financial statements are those statements a company normally prepares at the end of every Accounting period. No special occasions, such as mergers 30 Read the Basics, chapter (4). or liquidations, trigger the reporting. In accordance with our conventions in chapter (1), general purpose financial statements are prepared as at 31.12.20XX. Special circumstances can require reporting in shorter intervals, such as a listing at the New York Stock Exchange which makes companies prepare financial statements quarterly. IAS 1.36 rules the frequency of reporting. It also says how to prepare financial statements in cases the Accounting period is shorter, e.g., if the establishment of the company takes place in mid year. In compliance with IAS 1.10, a full set of financial statements comprises a statement of financial position (balance sheet), a statement of profit or loss and other comprehensive income, a statement of changes in equity, a statement of cash flows and the notes. The notes are required to disclose applied Accounting policies and explanatory information for certain items on the financial statements. Based on IAS 1.38 and IAS 1.38A, all financial statements must disclose comparative information about the preceding Accounting period. In case a company changes Accounting policies or parameters thereof, like altering depreciation parameters, it must prepare a balance sheet for the balance sheet date two Accounting periods prior to the day when the reporting period ends, which means the company presents in total three balances sheets, see IAS 1.40A. <?page no="100"?> Berkau: Financial Statements 5e 6-96 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). (d) Materiality and aggregation (IAS 1.29). (e) Prohibition of offsetting (IAS 1.32). (f) Consistency of presentation (IAS 1.45). Ad (a): Fair Presentation A basic principle of international Accounting is fair presentation. IAS 1.9 defines that the objective of financial statements is to provide information useful to a wide range of users to support their economic decisions. This includes that no user group is prioritised, like creditors by the German HGB. The information provided by financial statements is about the financial position, the profitability and the cash flows. To serve the needs of all users of financial statements, a company shall not bias information. IAS 1.15 states the fair presentation requires the faithful representation in regard to the framework’s 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 must be able to continue its business if not stated otherwise. If the management of the reporting company does not intend or cannot continue its business or sees significant uncertainties to do so, it must disclose these circumstances and prepare financial statements under disclosure of liquidation values. 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 ascertaining that income and expenses are recorded in 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. Therefore, a cash flow statement naturally cannot follow the accrual basis of Accounting. See IAS 1.27 and F OB17. In contrast to the statement of cash flows, the income statement 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 refers to importance. IAS 1.29 requires that important items shall be presented separately unless the items are immaterial regarding Accounting objectives. Hence, if an item on the balance sheet is not material the reporting company <?page no="101"?> Berkau: Financial Statements 5e 6-97 shall not omit the item but choose an aggregated disclosure together with other items. Ad (e): Prohibition of Offsetting IAS 1.32 says no offsetting is allowed except permitted by a special standard. Offsetting means to deduct negative amounts from positive ones and only disclose the difference thereof. We do so when we consider depreciation on assets or pay-off amounts for liabilities. However, offsetting notes payables and receivables for a business partner is not accepted under the above-mentioned standard. 31 However, it is common to offset inputand output-VAT as we only apply one VAT account. Ad (f): Consistency of Presentation IAS 1.45 requires continuing the presentation formats, classifications of items and valuations from one period to the next one. Hence, we cannot change the presentation or classification of items. The standard defines that changes are only acceptable if the company needs items to be presented differently in order to provide better information that is reliable and more relevant to users of the financial statements and if the revised structure is likely to be continued. Financial statements must follow identification requirements in line with IAS 1.49. The standard says how a statement header looks like and what information must be included therein. Following IAS 1.51, the header shall show 31 An exception is in IAS 7.22. the name of the reporting company, the date/ period the statement is for, the reporting currency and the level of rounding. For single-entity financial statements, the name of the reporting company is disclosed together with its legal form, e.g., KIELING Taxi GmbH. The legal form disclosure indicates that the financial statements do not fall under no group statements nor separate financial statements along IAS 27. Below, we study the car rental business BATHURST Ltd. in Melbourne. We prepare a full set of financial statements including notes for a two years Accounting period. The financial statements discussed are as at the balance sheet date 31.12.20X6. So, we cover the period from 1.01.20X5 until 31.12.20X6, which is two full years. Data sheet for BATHURST Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: Service provider. Accounting periods: 20X5 / 20X6. Share issue: 50,000 × 5.00 AUD/ s. Financing: bank loan 150,000.00 AUD; interest 2.5 %/ a. Assets: 3 cars; 65,000.00 AUD/ car; depreciation 15,000.00 AUD/ car; residual value: 5,000.00 AUD/ car; office: 150,000.00 AUD; depreciation on office: 12,500.00 AUD/ a. Output: 850 days / 860 days. Net renting price per car: 156.00 AUD/ d. Operational expenses: 48,000.00 AUD / 65,000.00 AUD. Bonds (2.01.20X6): face value: 200,000.00 AUD; coupon rate 4 %/ a (annually) VAT 20 %. <?page no="102"?> Berkau: Financial Statements 5e 6-98 BATHURST Ltd. is based on 50,000 ordinary shares at 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 (one year later), BATHURST Ltd. owns three cars Mercedes-Benz C-class. All cars are one year old. Depreciation is calculated following 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. Its 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. On 1.01.20X5, the amount owing is amounting to: 150,000 - 15,000 = 1 135,000.00 AUD. Figure 6.1 gives you the pro-forma balance sheet of BATHURST Ltd. as at 1.01.20X5. 32 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 2.50 %/ 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 (61,250) Current assets Liabilities (liab.) Inventory Long-term liab. 120,000 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 its cars at a rate of 156.00 AUD/ d (ex VAT). During the Accounting period 20X5, BATHURST 32 This balance sheet is not subjected to our considerations about formal aspects. Only financial statements for 20X6 are. Ltd. rents out the cars for 850 days. Hence, BATHURST Ltd.’s revenue is: 850 × 156 = 1 132,600.00 AUD. The revenue is <?page no="103"?> Berkau: Financial Statements 5e 6-99 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). The interest is based on the amount owing which is on 1.01.20X5: 120,000 + 15,000 = 1 135,000.00 AUD. Based on the effective interest method applicable due to IFRS 9, the expenses are calculated with an effective rate of interest of 2.50 %/ a. For 20X5, this gives an effective interest expense of: 135,000.00 × 2.50 % = 3,375.00 AUD. The interest actually paid for the bank loan in 20X5 is amounting to: (150,000 - 15,000) × 2.5% = 3 3,375.00 AUD (the same). See below the Bookkeeping entries (3a) and (3b) processed for the bank loan. The effective interest rate is calculated by iteration and guarantees the final amount of the bank loan becomes zero after settlement of all scheduled payments. For the calculation of effective interest we apply a payment vector and assume unlimited small periods; hence, the payment vector for the loan is: L(t) = {150,000; (18,750); (18,375); (18,000); (17,625); (17,250); (16,875); (16,500); (16,125); (15,750); (15,325)}. The internal rate of return of the payments gives us 2.50 %/ a. Here, the effective rate of interest equals the nominal interest rate. DR Interest..................... 3,375.00 AUD CR Interest Bearing Liabilities. 3,375.00 AUD DR Interest Bearing Liabilities. 3,375.00 AUD CR Cash/ Bank.................... 3,375.00 AUD The pay-off amounts for the bank loan in the next following year are amounting to 15,000.00 AUD/ a and are classified as short-term liabilities on the balance sheet date of the previous Accounting periods. When paid, the amount 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)). They are not VATable. BATHURST Ltd.’s pre-tax profit in 20X5 equals: 132,600 - 45,000 - 12,500 - 3,375 - 48,000 = 2 23,725.00 AUD. After tax reduction an amount of: (1 - 30%) × 23,725 = 1 16,607.50 AUD remains as annual surplus. BATHURST Ltd.'s shareholders declares a dividend of 0.10 AUD/ s payable in the next Accounting period 20X6. Observe the accounts in Figure 6.2. <?page no="104"?> Berkau: Financial Statements 5e 6-100 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 120,000.00 (4) 15,000.00 OV 15,000.00 (3b) 3,375.00 (3a) 3,375.00 c/ d 15,000.00 (5) 15,000.00 c/ d 105,000.00 30,000.00 30,000.00 123,375.00 123,375.00 b/ d 15,000.00 b/ d 105,000.00 Interest bearing liabilities IBL Short-term liabilities A/ P D C D C (2a) 45,000.00 P5L 57,500.00 (3a) 3,375.00 P5L 3,375.00 (2b) 12,500.00 57,500.00 57,500.00 Depreciation-20X5 DPR Interest-20X5 INT 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 7,117.50 ITL 7,117.50 INT 3,375.00 b/ d 7,117.50 OEX 48,000.00 EBT 23,725.00 132,600.00 132,600.00 ITL 7,117.50 b/ d 23,725.00 R/ E 16,607.50 23,725.00 23,725.00 Profit and Loss-20X5 P5L Income tax liabilities ITL Figure 6.2: BATHURST Ltd.’s accounts (20X5) <?page no="105"?> Berkau: Financial Statements 5e 6-101 D C D C OV 61,250.00 P5L 16,607.50 c/ d 5,000.00 R/ E 5,000.00 DIV 5,000.00 c/ d 49,642.50 b/ d 5,000.00 66,250.00 66,250.00 b/ d 49,642.50 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 to its shareholders (C). Depreciation on cars (D) is again 45,000.00 AUD and depreciation on the office (E) equals 12,500.00 AUD. The interest is based on the effective rate of interest amounting to 3,000.00 AUD. The interest amount paid to the bank is: (105,000 + 15,000) × 2.5% = 3,000.00 AUD. Interest is recorded by Bookkeeping entries (F1) and (F2). The pay-off amount reduces the short-term liabilities by 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 to shortterm liabilities, see Bookkeeping entry (H). Now, the revenue resulting from renting out cars for 860 days is recognised as: 860 × 175 = 1 150,500.00 AUD. Observe Bookkeeping entry (I). Operational expenses in 20X6 are 65,000.00 AUD. They are not VATable and recorded by Bookkeeping entry (J). 33 Read our Basics, chapter (37). For use its cash reserves efficiently, BATHURST Ltd. invests 200,000.00 AUD in bonds with an annual coupon rate of 4 %/ a on 2.01.20X6 - Bookkeeping entry (K). The bonds’ interest earned (coupon) is recorded as Bookkeeping entry (L) and is amounting to: 200,000 × 4% = 8,000.00 AUD. You find the amount on the credit side of the Coupon account. The investment leads to an overdraft of the bank account. Therefore, the balancing figure of the Cash/ Bank account is disclosed as short-term liability on the balance sheet to the extent of 4,042.50 AUD. 33 After profit calculation, BATHURST Ltd. suggests its shareholders to declare a dividend of 0.15 AUD/ s. The financial statements are prepared under the suggested appropriation of profits and show a dividend claim of its shareholders to the extent of: 50,000 × 0.15 = 7,500.00 AUD disclosed as short-term liabilities. We show BATHURST Ltd.’s accounts as at 31.12.20X6 in Figure 6.3. <?page no="106"?> Berkau: Financial Statements 5e 6-102 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 120,000.00 (4) 15,000.00 OV 15,000.00 (3b) 3,375.00 (3a) 3,375.00 c/ d 15,000.00 (5) 15,000.00 c/ d 105,000.00 30,000.00 30,000.00 123,375.00 123,375.00 (G) 15,000.00 b/ d 15,000.00 (H) 15,000.00 b/ d 105,000.00 c/ d 15,000.00 (H) 15,000.00 (F2) 3,000.00 (F1) 3,000.00 30,000.00 30,000.00 c/ d 90,000.00 b/ d 15,000.00 108,000.00 108,000.00 b/ d 90,000.00 Interest bearing liabilities IBL Short-term liabilities A/ P D C D C (D) 45,000.00 P6L 57,500.00 (F1) 3,000.00 P6L 3,000.00 (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="107"?> Berkau: Financial Statements 5e 6-103 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) 7,117.50 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 4,042.50 (K) 200,000.00 321,637.50 321,637.50 b/ d 4,042.50 Cash/ Bank C/ B Operational expenses-20X6 OEX D C D C DPR 57,500.00 REV 150,500.00 c/ d 7,117.50 ITL 7,117.50 INT 3,000.00 CPN 8,000.00 (A) 7,117.50 b/ d 7,117.50 OEX 65,000.00 c/ d 9,900.00 P6L 9,900.00 EBT 33,000.00 17,017.50 17,017.50 158,500.00 158,500.00 b/ d 9,900.00 ITL 9,900.00 b/ d 33,000.00 R/ E 23,100.00 33,000.00 33,000.00 Profit and loss-20X6 P6L Income tax liabilities ITL D C D C OV 61,250.00 P5L 16,607.50 c/ d 5,000.00 R/ E 5,000.00 DIV 5,000.00 c/ d 49,642.50 (C) 5,000.00 b/ d 5,000.00 66,250.00 66,250.00 c/ d 7,500.00 R/ E 7,500.00 b/ d 49,642.50 P6L 23,100.00 12,500.00 12,500.00 DIV 7,500.00 c/ d 34,042.50 b/ d 7,500.00 57,142.50 57,142.50 b/ d 34,042.50 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 following IFRSs. 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 statements meet the needs of general-purpose financial statements based on IAS <?page no="108"?> Berkau: Financial Statements 5e 6-104 1.7. BATHURST Ltd.’s 20X6’s financial statements show comparative information for 20X5 in line with the Framework F QC20 and IAS 1.38. Below, we cover the financial statements in detail: (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. 34 Due to different definitions, an asset is not the same as a Vermögensgegenstand on a German balance sheet. Definitions in the tax law might differ, too. - 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. 35 - Equity is the residual interest in the assets of the company after deducting all its liabilities. 36 The equity definition is referring to the difference of assets and liabilities. We can easily verify the evaluation of equity when we think about liquidations. A company that sells all its assets at fair values and retires its debts at fair values and without transaction costs determines equity its remaining company value. This is called book value of the business as we derive it from Bookkeeping records. At BATHURST Ltd., the book value of the company is amounting to 215,957.50 AUD as at 31.12.20X6. This is a book value per share of: 215,957.50 / 50,000 = 44.32 AUD/ s. The book value is below the face value of the shares - this is normally rising flags but here it purely results from not considering revenues in 20X4 to keep our case study simple. Hence, there was a loss in the first year carried forward to the next one. BATHURST Ltd. prepares the balance sheet as disclosed in Figure 6.4 for 20X6. 34 Read in the Framework: F 4.8 - 4.14. 35 Read in the Framework: F 15 - F 19. 36 Read in the Framework: F 20 - F 23. <?page no="109"?> Berkau: Financial Statements 5e 6-105 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 (34,043) (49,643) Current assets Liabilities (liab.) Inventory Long-term liab. 90,000 105,000 Accounts receivables Short-term liab. A/ P 56,642.50 46,520 Prepaid expenses Provisions Cash/ Bank 0 128,995 Income tax liab. 9,900 7,118 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 now provide comparative information for 20X5. 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 (IAS 27) or a group statement by disclosure of the legal form (Ltd.), shows the balance sheet-date (31.12.20X6), indicates the reporting currency (AUD for Australian Dollars) and gives the rounding level (AUD for full Australian Dollars). The requirements for the statement of financial position are laid out by IAS 1.54. BATHURST Ltd.’s financial statements disclose all required items of assets, liabilities and equity. IAS 1.56 makes reporting companies disclose current and non-currents assets and liabilities separately. BATHURST Ltd. shows long-term assets, like cars and property, and cash/ bank as short-term assets. The single amounts are not shown on the balance sheet but in the notes by the register of non-current assets (see below). With regard to liabilities, the disclosure is more difficult as the bank loan contains a short-term 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. IAS 1.69 covers the distinction of liabilities. In contrast to short-term liabilities, long-term ones are disclosed in accordance with the effective interest method required 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 its long-term liabilities resulting from the bank loan at 90,000.00 AUD and short-term liabilities at 15,000.00 AUD; the latter ones are due on 31.12.20X7. Short-term liabilities are disclosed as accounts payables (A/ P) on the balance sheet and include the shortterm bank loan repay, VAT liabilities and claims of the shareholders for the dividend as well as BATHURST Ltd.’s bank account overdraft. <?page no="110"?> Berkau: Financial Statements 5e 6-106 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 (see above). BATHURST Ltd.’s equity is calculated by deducting liabilities from the total of assets and then is amounting to: 372,500 - 90,000 - 56,642.50 - 9,900 = 2215,957.50 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. (Payment of dividends is no expense.) Income can be revenue and gains - based on F 4.29. Revenue is the funds received in exchange for business activities; F 4.29 lists items, such as sales, fees, interest, dividends, royalties and rent. F 4.31 does not define gains but gives examples. Along those, gains are 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="111"?> Berkau: Financial Statements 5e 6-107 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 (3,000) (3,375) Earnings before taxes (EBT) 33,000 23,725 Income tax expenses (9,900) (7,118) Earnings after taxes (EAT) 23,100 16,608 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. must disclose the revenue from renting out cars separately from interest received from 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 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 than a Profit and Loss account. A company can prepare the income statement based on the nature of expenses (IAS 1.102) or based on the cost of sales (IAS 1.103). 37 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 resulting from the bank loan. After deduction of income taxes, which are calculated by 37 Read our Basics, chapter (28). 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 compliance with IAS 1.106, equity changes either by profit or loss, by other comprehensive income or by transactions with the owners, like share issues. The standard requires companies preparing a statement of changes in equity, which, e.g., shows columns for components of equity and lines at the beginning and end of the Accounting period as well as lines for changes of equity during the Accounting period, see IAS 1.108 and IAS 1.109. Below in Figure 6.6, we show BATHURST Ltd.’s statement of changes in equity for the Accounting periods 20X5 and 20X6. <?page no="112"?> Berkau: Financial Statements 5e 6-108 Share capital Reserves Retained earnings total [AUD] [AUD] [AUD] [AUD] as at 1.01.20X5 250,000 (61,250) 188,750 Profit 20X5 (EAT) 16,608 16,608 Dividend 20X5 (5,000) (5,000) as at 31.12.20X5 250,000 0 (49,643) 200,358 Profit 20X6 (EAT) 23,100 23,100 Dividend 20X6 (7,500) (7,500) as at 31.12.20X6 250,000 0 (34,043) 215,958 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 its 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, as laid out in IAS 1.111, IAS 7 covers the calculation thereof. 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 (7,118) VAT payment (26,520) 81,963 111,120 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 (133,038) 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="113"?> Berkau: Financial Statements 5e 6-109 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 cash flows from investing activities and IAS 7.17 shows examples for financial cash flows. For the calculation of operating cash flows, a company can either apply the direct method or reconcile the operating cash flow from the earnings after taxes. Both methods comply with IAS 7.18. 38 BATHURST Ltd. calculates its operating cash flow based on the direct method. We read out the Cash flows straight from the Cash/ Bank account. Interest earned as well as paid are considered 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 applies. The dividend payments are classified as financial cash flow following IAS 7.34. The income tax payment is disclosed as operating cash flow which is consistent with IAS 7.35. Ad (5): Notes In contrast to German Accounting, notes are a more detailed description of Accounting policies. IAS 1.112 requires the notes to giving information about the basis of preparation of financial statements and the Accounting policies applied as well as showing information required by IFRSs that is not disclosed in other financial statements, e.g., the register of non-current assets. IAS 1.113 states that notes shall be presented in a systematic manner to make them understandable and comparable. Often the financial statements contain figures referring to paragraphs in the notes - similar to footnotes. Every company must prepare notes. The notes are an element of a full set of financial statements. BATHURST Ltd. prepares the notes based on the information below: (a) Accounting policies. (b) Equity. (c) Non-current interest bearing liabilities. (d) Tangible assets. (e) Inventory. (f) Tax liabilities. (g) Dividends. (h) Revenue. (i) Expenses. The notes of BATHURST Ltd. are following, linked to the financial statements as at 31.12.20X6 in Figure 6.8. 38 Read our Basics, chapter (32). <?page no="114"?> Berkau: Financial Statements 5e 6-110 Bathurst Ltd.’s NOTES to FINANCIAL STATEMENTS as at 31.12.20X6 (a) Accounting Policy These annual financial statements are prepared in accordance with IFRSs and the Company’s Act in Australia. The international standards below apply: - IAS 1, - IAS 7, - IAS 12, - IAS 16, - IAS 32, - IFRS 7, - IFRS 9, - IFRS 13, - IFRS 15. The company was established on 2.01.20X4 in the legal form of a limited company (Ltd.) under Australian law. Its balance sheet date is 31.12. BATHURST Ltd. is registered for VAT reduction. The board of directors as at 31.12.20X6 is: - Chief executive officer (CEO), chair: Peter Lansfield (holding 10,000 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="115"?> Berkau: Financial Statements 5e 6-111 Liabilities are reported on amortised costs applying the effective interest method in accordance with IFRS 9. ((b) Equity Issued capital: BATHURST Ltd. was established on 2.01.20X3 by a par value share issue of 50,000 ordinary shares at 5.00 AUD/ s. Authorised shares: 100,000 ordinary shares at 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, as separate title property, 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: 105,000.00 AUD. The short-term liability portion thereof is 15,000.00 AUD. The settlement amount for the bank loan is: 105,000.00 AUD. There are no further bank loans. (d) Tangible assets Tangible assets are 1 office, separate titled in an office block and 3 cars Mercedes-Benz C-class. The office was transferred to Bathurst Ltd. on 5.01.20X4. The address is 193 Toorak Rd, 3141 Melbourne. The floor size of the office is 47 m 2 . The purchase price plus cost of conveyance (total costs of acquisition) are 150,000.00 AUD. The office is financed by a bank loan (mortgage) of 150,000.00 AUD. Depreciation on the building is based on straight line method and is amounting to 12,500.00 AUD/ y. The cars are disclosed on the register of non-current assets as a group of cars. The cars have been purchased at 65,000.00 AUD/ car on 2.01.20X4. The residual value of the cars is estimated to be: 3 × 5,000 = 1 15,000.00 AUD. Depreciation is over a period of 4 years along straight-line method. Depreciation costs on motor vehicles are 15,000.00 AUD/ a. <?page no="116"?> Berkau: Financial Statements 5e 6-112 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 9,900.00 AUD. No prepayments for income taxes were made. The amount for income tax is due on 15.01.20X7. Income taxes are disclosed as short-term liabilities on the balance sheet under income tax liabilities. VAT payables The revenue earned by renting out motor vehicles is VATable at a VAT rate of 20 %. The VAT payables are amounting to: 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="117"?> Berkau: Financial Statements 5e 6-113 ((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 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 trade discounts have been allowed. No receivables result from business operations. Financial revenue A coupon revenue of 8,000.00 AUD was earned from holding 2,000 bonds of Bank of Queensland. The bonds will mature on 6.11.20Y9 and their nominal value is 100.00 AUD/ bond. The annual coupon rate is 4 %/ a. The bonds are traded at 100.00 AUD/ b as at 31.12.20X6. (i) Expenses Total expenses at BATHURST Ltd. are amounting to 125,125.00 AUD. The expenses in detail are listed below: - Depreciation on cars and office: 57,500.00 AUD. - Interest on bank loan: 3,000.00 AUD (effective rate of interest: 2.5 %/ a). - Operational expenses, such as: labour, maintenance, cleaning: 65,000.00 AUD. Melbourne, in January 20X7 Peter Lansfield ______________________ (CEO - BATHURST Ltd.) Figure 6.8: BATHURST Ltd.’s notes (20X6) The notes above are in line with IAS 1. The notes are signed by the chief executive officer (CEO) of BATHURST Ltd., Mr P. Lansfield. 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 <?page no="118"?> Berkau: Financial Statements 5e 6-114 provided a full set of financial statements for the case study 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 textbook, the Accounting period is always one year. Effective interest method: Valuation of a liability or financial instrument measured by a payment vector with revaluation of its elements based on internal rate of return. The effective rate of interest calculation requires 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 postal address of the company, the register of non-current assets and the remuneration of auditors. 2. All standards, the address of the company and all its subsidiaries, the register of current assets, the position of the board of directors, the total of assets. 3. All applied standards, the method of depreciation and the register of non-current assets, the reconciliation of opening and closing amounts for non-current assets, the valuation of inventory, dividends declared. 4. All applied standards, the method of depreciation and the register of current assets, the reconciliation of opening and closing amounts for current assets, the valuation of inventory, dividends declared. <?page no="119"?> Berkau: Financial Statements 5e 6-115 (4) The financial statements’ header shows: 1. The name of the reporting company, the time when the financial statements are prepared, the currency unit, the rounding of figures. 2. The name of the reporting company, its legal form, the balance sheet date or the reporting period’s ending, the currency unit, the rounding of figures. 3. The name of the reporting company and its legal form, the balance sheet date or the reporting period’s ending, the currency unit, the data format. 4. The name of the reporting company, an indication of group/ single entity statement, the time for which the financial statements are prepared, the currency unit, the rounding of figures, the international standards and paragraphs applicable. (5) Which standards apply for assets? 1. IAS 16, IAS 2, IFRS 9. 2. IAS 17, IAS 2, IFRS 18. 3. IAS 37, IAS 16, IFRS 9. 4. IAS 33, IAS 16, IAS 2. Solutions: 1-3, 2-4, 3-3, 4-2, 5-1. <?page no="120"?> Berkau: Financial Statements 5e 7-116 7. Non-current Assets on the Balance Sheet What is in the Chapter? This chapter (7) familiarises you with the recognition and measurement of non-current assets. You learn about the initial recognition, subsequent valuations and about the disposal of assets. We focus on IAS 16 and IAS 36. IAS 16 deals with the recognition and measurement of property, plant and equipment, and IAS 36 contains regulations for impairments as special form of subsequent valuations. This chapter also covers certain assets, like intangible assets (IAS 38), investment property (IAS 40), leases (IFRS 16), financial instruments (IAS 32, IAS 39, IFRS 7 and IFRS 9) and capitalisation of borrowing costs (IAS 23). Learning Objectives: After studying this chapter (7), you know how to recognise and evaluate non-current assets. You can record non-current assets at initial valuation and know when and how to apply the cost model and revaluation model for any subsequent valuation. You know how to record selling or disposals of non-current assets and are aware of special aspects based on IFRS 5 for assets held for sale. You also understand Accounting work for leases, investment property and financial instruments. 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 (framework) an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. The IFRSs focus on economic benefits and make the recognition and valuation of assets 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 contribute to production or service rendering or on its convertibility to cash in case of a disposal. The reporting company must control its assets. If a company cannot control an asset it shall not disclose it on its balance sheet. E.g., a doctor who considers his patient base a potential to earn profit cannot disclosed it on the balance sheet, e.g., as a patient list, as she/ he is not in control thereof. 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 customer behaviour are not controllable. The requirement of existence of a past event is to define how the reporting <?page no="121"?> Berkau: Financial Statements 5e 7-117 company obtained possession of the asset and determines the measurement thereof, e.g., an asset can be added to the company by acquisition, donation, leasing etc. IAS 16 further rules how to recognise assets. Recognition (F 4.37) means to add an item to the non-current assets on the balance sheet. For recognition, we decide whether and where to put an asset on the balance sheet and assign a value thereto. For the first-time asset recognition, the reporting company must measure it. Hence, the task of recognition requires both, the decision whether to disclose the asset on its financial statements and its measurement. In terms of 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 power plants, 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 apply for its components. IAS 16.14 also says regular maintenance (major part inspections, checks) shall be added to its cost of acquisition. At first, we discuss the initial recognition of assets. IAS 16.15 states: An item of property, plant and equipment that qualifies for recognition as an asset shall be measured at its costs. IAS 16.16 names 3 different kind of cost categories for asset valuation. We must add them for the calculation of an asset's total costs. (a) Acquisition price, including import duties, non-refundable VAT 39 , less trade discounts and rebates. (b) Directly attributable costs. (c) Cost of dismantling the asset. Find below the small case study of GETEN (Pty) Ltd.: Data Sheet for GETEN (Pty) Ltd. DDomicile: South Africa (Port Elizabeth). Reporting currency: ZAR. Classification: Manufacturing. Acquisition of a saw: 24,000.00 ZAR gross purchase price. Trade discount 5 %. VAT 20 %. GETEN (Pty) Ltd. is a production firm and buys a saw at a price of 24,000.00 ZAR. This is the gross purchase price and includes 20 % input-VAT. The seller offers GETEN (Pty) Ltd. a trade discount of 5 % on the saw. The saw is an item of property, plant and equipment. To recognise the saw, GETEN (Pty) Ltd. calculates the cost of acquisition as: (24,000/ 120%) × (1 - 5%) = 119,000.00 ZAR. We record the trade discount as a received trade discount and make the Bookkeeping entries accordingly. 39 Only applicable if no VAT registration applies. <?page no="122"?> Berkau: Financial Statements 5e 7-118 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 far easier if directly based on the reduced cost of acquisition. After recording the saw, its initial recognition is complete, and the value of the saw is 19,000.00 ZAR. In case an asset needs changes or further steps of manufacturing for intended deployment, qualifying costs may apply and are added to the asset’s value in compliance 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, markings, GPS, radio etc., are added to the costs of acquisition of the car and are written-off together with the taxi in later Accounting periods. Adding expenses to the cost of acquisition applies for interest to finance the asset’s qualifying, as well. 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 costs of acquisition for the taxi. IAS 23.10 sets out requirements for the capitalisation of borrowing costs. In contrast, other (non-specific) interest expenses or repairs, e.g., exhauster replacements or tyre exchanges, falls under regular operational expenses and is recorded through profit or loss in the Accounting period when they occur. We study the case of LANGDAM Bhd. in Kuala Lumpur: Data Sheet for LANGDAM Bhd. DDomicile: Malaysia (Kuala Lumpur). Reporting currency: MYR. Classification: Service provider. Acquisition of software: 340,000.00 MYR net purchase price. Customising costs: 100,000.00 MYR. VAT 20 %. LANGDAM Bhd. is a consultancy based on shares in Malaysia. The company buys the computer software ADMACC for administration of its customer orders, e.g., for hours billing. The net purchase price for ADMACC software is 340,000.00 MYR. In addition to the software purchase, a computer specialist customises LANGDAM Bhd.’s software, which means she/ he makes software settings and defines the master data. The software specialist charges 100,000.00 MYR for her/ his service. <?page no="123"?> Berkau: Financial Statements 5e 7-119 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: 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. 40 Assets can also be acquired based on exchanges of goods and/ or can lead to delayed payments which adds an interest portion to the cost of acquisition. We do not cover these cases in the textbook but prepared case study material for download. Study the special case studies accessible 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 Asset Recognition) (1) Determine the asset to be disclosed. Check whether the recognition criteria are fulfilled. The asset must provide an economical benefit and its valuation must be reliable. (2) Apply the cost model. Based on the cost model, the cost of acquisition along IAS 16.16 apply. (3) A company that is registered for VAT reduction must 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 coun- 40 See: IAS 16.15 - IAS 16.28. <?page no="124"?> Berkau: Financial Statements 5e 7-120 try-specific input-VAT for the new gross amount payable. Deduct VAT if the importing company is registered for VAT reduction for recognition. (5) If the company receives rebates or trade discounts it must deduct them. This also applies for deferred trade discounts. (6) In case the seller includes an interest portion in the deal, disclose interest separately. If the company capitalises borrowing costs, no separation is necessary. (7) Make a debit entry in the Property, Plant and Equipment account for the cost of acquisition, another debit entry for the input-VAT in the VAT account and credit the Cash/ Bank account or the Accounts Payables account as required. (8) If an interest component applies, make a debit entry for interest. 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 value. Assets that do not change in valuation, such as land, are carried at costs. However, many assets change their valuation by usage or when prices change. For subsequent valuations, IAS 16.29 states that a reporting company must evaluate assets either based on the cost model or at valuation. A subsequent valuation based on the cost model in compliance with IAS 16.30 includes the initial costs of acquisition and all 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 underrated on the balance sheet. This means the 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 case studies covering: depreciation, impairment loss and revaluations. Below, we repeat initial valuations and thereafter study impairment losses and depreciations by the South Korean company GELLENDORFF LLC. Data Sheet for GELLENDORFF LLC. DDomicile: South Korea (Seoul). Reporting currency: KRW × 10 3 . Classification: n/ a. Acquisition of a motor vehicle at 72,000.00 tKRW. Accounting periods: 20X1 - 20X5. Depreciation: straight-line method over 5 years, residual value: 10,000.00 tKRW. <?page no="125"?> Berkau: Financial Statements 5e 7-121 OOn 4.04.20X4: impairment loss due to accident towards, case (i): 24,040.00 tKRW; case (ii): 19,450.00 tKRW. Repair: 8,400.00 tKRW gross amount. Evaluation after repair in case (ii): 3 months later at 24,040.00 tKRW). VAT 20 %. On 2.01.20X1, GELLENDORF LLC buys a business car Kia Sorento and pays the car dealer the demanded gross 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 = 1,000.00 Won. The net amount equals: 72,000/ 120% = 60,000.00 tKRW which is the cost of acquisition. Depreciation is based on straight-line method and after its useful life of 5 years the car is expected to be sold at 10,000.00 tKRW which is today's best estimated future net selling price. IAS 16.6 defines the residual value as the amount a company would currently obtain from its disposal. Relevant costs of the disposal are deducted. 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 expected loss in value over the entire useful life (5 years). It considers that assets lose value over the time. In case an asset is written-off based on the time and it is not in use for a while, depreciation is continued. 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 charge is amounting to: (60,000 - 10,000) / 5 = 1 10,000.00 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 value of the Kia Sorento as at 31.12.20X1 equals: 60,000 - 10,000 = 50,000.00 tKRW. Besides regular depreciation, an asset’s value can drop because of 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 reversals thereof. We record an impairment loss in the period when it happens. Other reasons for impairment losses are that assets become out of fashion or are traded lower as result of technical progress. <?page no="126"?> Berkau: Financial Statements 5e 7-122 Below, we study two different cases for GELLENDORFF LLC. In case (i), the Kia Sorento is crashed and repaired immediately. In case (ii), the business car is crashed as well but the repair takes place a few months later. The main difference between the cases is the depreciation between accident and repair which applies despite of the car not being in use for three months. An impairment loss is the amount by which an asset is overrated. It is defined as the difference between the obtainable recoverable amount and the carrying value. Therefore, the current value must be reduced to assign the fair value to the asset. Ad (i): Impairment Loss and Immediate Repair 41 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 entry (1’). The carrying value prior to the accident was: 60,000 - 3 × 10,000 - 2,500 = 2 27,500.00 tKRW. The repair costs 8,400.00 tKRW (gross amount) and is recorded by Bookkeeping entry (2’). After the repair, a qualified appraiser evaluates the car at 24,040.00 tKRW. The drop in valuation is regarded as impairment loss. IAS 36.59 states that in case the carrying value (actual measurement without impairment) exceeds the recoverable amount, the carrying value shall be reduced to its recoverable amount. IAS 36.6 says, a recoverable amount is the lower of the value the asset can be sold at on an active market (fair value) and its value in use, which is the total discounted cash flows resulting from deployment. We do not worry too much about the value in use here as it mostly applies for cash generating business units. A value in use is, for instance, future and discounted rental income from property. For a normal tangible asset, we simply compare the carrying amount to the fair value derived from an expertise (appraiser). If the carrying value exceeds the fair value, we record an impairment loss to the extent of the excess. In case of GELLENDORFF LLC's car accident, the valuation is taken from the expert’s evaluation. The company records an impairment loss to the extent of: 27,500 - 24,040 = 3 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 valuation for future periods. A residual value is to be considered for calculation of the depreciable value if it exists. 41 For case i, all Bookkeeping entries are indicated by ‘. A residual value is to check, e.g. a reporting company must determine, whether a motor vehicle that was previously damaged by a car accident can be sold after its useful life at the same price as a car without damage history. <?page no="127"?> Berkau: Financial Statements 5e 7-123 An asset that is depreciated based on the time does not stop to lose value because of damages. Depreciation shall be continued at adjusted amounts, as stated above. After the repair and processing of the impairment loss, depreciation for GELLENDORFF LLC's car is resumed on 10.04.20X4. Monthly depreciation charge now is: (24,040 - 10,000) / 21 = 6668.57 tKRW/ m. Note, that depreciation is accurate to the month. Depreciation for the remaining Accounting period equals: 9 × 668.57 = 6 6,017.14 tKRW and is recorded by Bookkeeping entry (4’). In general, assets, such as cars, machinery or buildings, are insured against damages and losses. The insurance company pays for the damage which is here the repair and the loss in valuation. GELLENDORFF LLC insured the Kia Sorento and confirms to 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 lasting loss in valuation. It is amounting to: 8,400/ 120% + (27,500 - 24,040) = 1 10,460.00 tKRW. The insurance’s payment is recorded as Bookkeeping entry (5’). Observe the accounts in Figure 7.1. DR Cash/ Bank.................... 10,460.00 tKRW CR Insurance Compensation ....... 10,460.00 tKRW D C D C OV 60,000.00 c/ d 60,000.00 OV 30,000.00 b/ d 60,000.00 (1') 2,500.00 c/ d 38,517.14 (4') 6,017.14 38,517.14 38,517.14 b/ d 38,517.14 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') 6,017.14 c/ d 8,517.14 b/ d 7,000.00 8,517.14 8,517.14 b/ d 8,517.14 Depreciation-20X4 DPR Repair-20X4 RPR Figure 7.1: GELLENDORFF LLC’s accounts (i) <?page no="128"?> Berkau: Financial Statements 5e 7-124 D C D C (2') 1,400.00 c/ d 1,400.00 (5') 10,460.00 (2') 8,400.00 b/ d 1,400.00 c/ d 2,060.00 10,460.00 10,460.00 b/ d 2,060.00 Value added tax VAT Cash/ Bank C/ B D C c/ d 10,460.00 (5') 10,460.00 b/ d 10,460.00 Insurance-20X4 INS Figure 7.1: GELLENDORFF LLC's accounts (i) continued 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 value to the recoverable amount. (2) If the carrying value exceeds the recoverable amount, calculate the difference. It is the measurement for the impairment loss. (3) Record an impairment loss as a debit entry in the Impairment Loss account and a credit entry in the Accumulated Impairment Loss account. (4) Resume depreciation by calculating depreciation charge based on the altered valuation. Ad (ii): Impairment Loss, Delayed Repair and Partial Reversal of an Impairment Loss 42 We next repeat the case of GELLENDORFF LLC but slightly alter the story. We consider the Kia Sorento is repaired 3 months after the accident. As the repair causes a decrease of the damage, GELLENDORFF LLC orders the expert to estimate the damage after repair again and as a result of the evaluation reverses the prior recorded impairment loss to the extent indicated by the expertise. Reversing an impairment loss in general applies when the value 42 We mark Bookkeeping entries by ‘’. of the asset increases after an impairment loss. Here, the increase of the car’s value is caused by the measurement following the repair. A reporting company is obliged to check changes of assets subjected to impairment losses based on IAS 36.110. This means to check whether indications for the recognised impairment loss in prior Accounting periods are still valid or possibly decreased. An increase of the recoverable amount shall reverse or change the impairment loss following IAS 36.114. In no case the repair itself causes an increase in valuation. We cannot just <?page no="129"?> Berkau: Financial Statements 5e 7-125 take the bill of the car repair and add it to the car’s value in the P, P, E account. 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's and rewind the case study to the point where the accident occurs. We alter the case study then regarding its timeline: the repair is postponed to 3.07.20X4. […] On 4.04.20X4, the business car at GELLENDORFF LLC is involved in a crash. Depreciation prior to the accident is recorded by Bookkeeping entry (1’’). The carrying value before the accident was: 60,000 - 3 × 10,000 - 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 43 . Hence, the decrease in valuation caused by the accident is: 27,500 - 19,450 = 8 8,050.00 tKRW. An impairment loss is processed (2’’). It reflects a reduction of the asset’s carrying value due to the damage which results in overrating. Overrating means that the actual carrying value, here: 27,500.00 tKRW, exceeds the fair value of the car which is its recoverable amount if sold at 19,450.00 tKRW. GELLENDORFF LLC’s Bookkeeper records the impairment loss as below on 6.04.20X4 shortly 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’’). The repair is an expense within the Accounting period and recorded through profit or loss. We cannot add repair costs to property, plant, equipment, it would mean 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 in April/ 20X4 und is recorded until July/ 20X4. Depreciation does not depend on the repair nor on its completion. The remaining useful life is 21 months. Monthly depreciation equals: (19,450 - 10,000) / 21 = 4 450.00 tKRW/ m. GELLENDORFF LLC depreciates the business car over the next three 43 The damage is slightly different to the previous case (i). months based on the reduced value. After that period, a new expertise is prepared which will determine the valuation after the repair. The Bookkeeping entry’s amount for 3 months of depreciation is: 3 × 450 = 1 1,350.00 tKRW. Check Bookkeeping entry (4’’). <?page no="130"?> Berkau: Financial Statements 5e 7-126 DR Depreciation-20X4............ 1,350.00 tKRW CR Acc. Depr.................... 1,350.00 tKRW Again, GELLENDORFF LLC checks whether the recoverable amount remains after the impairment loss and the repair. It does not. The repair caused a change to the estimate of the cars' measurement. We refer now to the valuation model, assuming that on 3.07.20X4 a qualified appraiser 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. IAS 36.109 - 36.125 apply. The reversal of the impairment loss is processed 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 value that would apply without prior impairment loss recognition. If the value is higher, a revaluation following IAS 16.31 will apply. 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 valuation of 20,040.00 tKRW is lower than 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. The valuation increase can be recorded as reversal of impairment loss. DR Acc Impairment Loss.......... 5,940.00 tKRW CR Impairment Loss (rev)........ 5,940.00 tKRW After recording the partial reversal of the impairment loss, GELLENDORFF LLC resumes regular depreciation. Monthly depreciation now is: (24,040 - 10,000) / 18 = 7 780.00 tKRW/ m. Bookkeeping entry (6’’) records depreciation for the remainder of the Accounting period and is amounting to: 6 × 780 = 4 4,680.00 tKRW. The situation of GELLENDORFF LLC is altered below again regarding insurance existence for the damaged car. IAS 16.65 requires recording compensation from third parties for P, P, E items through profit or loss when the compensation is receivable. This means once compensation is granted. It is then credited to the Profit and Loss account. The time of payment does not matter as a recording of receivables indicates compensation already. For illustration purposes, we record the insurance compensation and study again 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 <?page no="131"?> Berkau: Financial Statements 5e 7-127 GELLENDORFF LLC is registered for VAT reduction and claims input-VAT from the revenue service itself. The loss in valuation is based on the recorded impairment loss and the partial reversal thereof which is amounting to: 8,050 - 5,940 = 2 2,110.00 tKRW. GELLENDORFF LLC receives a compensation of: 8,400 - 1,400 + 2,110 = 9 9,110.00 tKRW from its 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. In the end, GELLENDORFF LLC is left with 710.00 tKRW on cash and a repaired but 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 fully 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. 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 Depreciation-20X4 DPR Repair-20X4 RPR Figure 7.2: GELLENDORFF LLC’s accounts (ii) <?page no="132"?> Berkau: Financial Statements 5e 7-128 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 Value added tax VAT Cash/ Bank C/ B D C c/ d 9,110.00 (7'') 9,110.00 b/ d 9,110.00 Insurance-20X4 INS Figure 7.2: GELLENDORFF LLC's accounts (ii) continued How it is Done: (Reversing an Impairment Loss) (1) After recording an impairment loss, monitor the valuation of the previously impaired asset. (2) Determine the fair value of the asset as the recoverable amount. (3) In case the asset is underrated, check how much the valuation of the asset would have been without impairment loss recorded in preceding Accounting periods. This amount is the maximum for reversing the impairment loss. Note, that a repair can trigger the reversal of an impairment loss, but its amount does never determine the reversal itself. (4) Reverse the impairment loss to its recoverable amount but do not exceed the limit of valuation. Record a debit entry in the Accumulated Impairment Loss account and a credit entry in the Impairment Loss account. For monitoring, apply a separate Accumulated Impairment Loss account for every 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. A company must report in the notes about the valuation of its non-current assets. In general, a register of noncurrent assets and a reconciliation statement are prepared based on asset groups. We show these statements for GELLENDORFF LLC in Figure 7.3 and Figure 7.4 linked to case (ii): <?page no="133"?> Berkau: Financial Statements 5e 7-129 Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount [tKRW] [tKRW] [tKRW] [tKRW] Kia Sorento 60,000 (38,530) (2,110) 19,360 . . . Gellendorff LLC's REGISTER of NON-CURRENT ASSETS as at 31.12.20X4 Figure 7.3: GELLENDORFF LLC’s register of non-current assets 20X4 20X3 [tKRW] [tKRW] OV as at 1.01. 30,000 40,000 Depreciation (7,180) (10,000) Adjusted depreciation (1,350) Impairment loss (8,050) Reversal impairment loss 5,940 Revaluation Value at 31.12. 19,360 30,000 Gellendorff LLC'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 workings whether a revaluation applies or the changes in valuation only results in an reversal of an impairment loss. IAS 36.117 applies. A reversal of an impairment loss is recorded through profit or loss. Any valuation that exceeds the valuation based on regular depreciation leads to a revaluation which is recorded based on fair values and results in a revaluation reserve on the equity section. When a revaluation follows an impairment loss, a company must determine which portion exceeds the reversal of an impairment loss and counts for revaluation. The case GROOTVLEI Ltd. covers declining method and reversing a prior impairment loss. Check case study GROOTVLEI Ltd. that is accessible online through Link 7.C. Link 7.C: GROOTVLEI Ltd. 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 pe- <?page no="134"?> Berkau: Financial Statements 5e 7-130 riod 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 exceeds its carrying value. The situation is the opposite of what triggers an impairment loss. The carrying value now indicates an underrated 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. As example for the application of the revaluation model, we study TINNEN K.K. in Japan. The company’s currency unit is Japanese Yen (JPY). Tax rates apply as disclosed in chapter (1). The total income taxes are amounting to 30 % based on the pre-tax profit. Income taxes become now relevant, as deferred taxes apply when assets are revalued. We will study revaluations in detail. In contrast to other case studies, we first describe the calculations, show how-it-is-done-paragraphs and thereafter explain the concept by referring to the calculated amounts in the case study. Data Sheet for TINNEN K.K. DDomicile: Japan (Tokyo). Reporting currency: JPY. Classification: Manufacturing. Accounting periods: 20X3 - 20X4. Item of property, plant and equipment: welding machine. Cost of acquisition: 800,000.00 JPY on 2.01.20X3. Depreciation: declining method at 1.67 %/ m. Revaluation at 1.07.20X4: 750,000.00 JPY. In both Accounting periods: other revenue: 1,400,000.00 JPY and other expenses: 600,000.00 JPY. VAT 20 %. On 2.01.20X3, TINNEN K.K. buys a welding machine at costs of 800,000.00 JPY (net amount). The useful life of the welding machine is 5 years and depreciation follows declining method. A depreciation rate of 1.67%/ m applies. 44 We record the acquisition and depreciation for the Accounting period 20X3. The paid acquisition price is the gross amount: 800,000 × 120% = 9 960,000.00 JPY. TINNEN K.K. pays the total amount instantly. Check the Bookkeeping entry (1). 44 Read our Basics, chapter (17). <?page no="135"?> Berkau: Financial Statements 5e 7-131 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 easy to calculate if you determine the carrying value at first. It is: 800,000 × (1 - 1.67%) 12 = 6653,615.67 JPY. The difference between the carrying value on 2.01.20X3 and 31.12.20X3 is the annual depreciation charge. Depreciation here equals: 800,000 - 653,615.67 = 146,384.33 JPY/ a. The depreciation is recorded as Bookkeeping entry (2). How it is Done: (Declining method) (1) Determine the depreciable amount. It equals 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. The annual depreciation rate is the monthly one in the power of 12. (3) Determine the periods of depreciation, e.g., x months. (4) Calculate the carrying value as at the end of the depreciation period by multiplying the actual carrying value by the factor (1 r) x . (5) In order to calculate the absolute depreciation charge, deduct the new carrying value 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 appraiser estimates the welding machine’s value to be 750,000.00 JPY. At first, we check at which value the welding machine is carried on 30.06.20X4 which is before the revaluation takes place: 653,615.67 × (1 - 1.67%) 6 = 5590,797.56 JPY. Hence, the value determined by the expert leads to a higher valuation and results in a revaluation ruled by IAS 16.31. The estimate of the qualified appraiser is considered a reliable measurement for the fair value of the welding machine. A revaluation Bookkeeping entry is like recording replacements. A replacement is processed 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. <?page no="136"?> Berkau: Financial Statements 5e 7-132 Follow our QR code for checking on ordinary replacement Bookkeeping entries with the case study CORAL Ltd. Link 7.E: CORAL Ltd. In contrast to a genuine replacement Bookkeeping entry, we now only virtually replace the (entire) asset for revaluation. We do not add figures to the asset’s carrying value, but we remove the asset that is carried at costs and replace it by the revalued one in our Bookkeeping records. To distinguish valuations, we indicate the valuation by suffix added to the account name: @VALUATION. We apply the P, P, E @COST account for assets measured following the cost model and a P, P, E @(RE)VALUATION account for assets carried at fair values based on the revaluation model. Two alternatives are given for the measurement based on fair values: net replacement method and gross replacement method. In general, a net replacement method applies if an appraiser evaluates the asset. 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 kind of assets and pulls the revaluation forward 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. Before the revaluation of the welding machine, TINNEN K.K. records depreciation for the period from 1.01.20X4 until 30.06.20X4: Depreciation is 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 of the asset due to its increase in value. The valuation is not covered here as the Accountant relies on the qualified appraiser who estimated the welding machine’s measurement. The Bookkeeping entry (R) 45 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 45 R = Revaluation. <?page no="137"?> Berkau: Financial Statements 5e 7-133 As a consequence of the revaluation, 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 to the same extent. 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 best estimate for the net selling price and the carrying value on the balance sheet for taxation. This counts as sale above carrying values for the tax records. As 750,000.00 JPY is the fair value, the amount is the most likely recoverable net selling price for the welding machine. In Accounting, this one is referred to as the recoverable amount. Regarding 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% = 47,760.73 JPY. IAS 12 deals with income tax recognition. In compliance with IAS 12.20 TINNEN K.K. shall recognise the income taxes resulting from revaluation and following disposal as a deferred tax liability. The Bookkeeping entry is directly linked to the revaluation; therefore, we indicate it by (R’). DR Revaluation Reserves......... 47,760.73 JPY CR Deferred Tax Liabilities..... 47,760.73 JPY The deferred tax liabilities are recorded as a liability based on IAS 12.15. To get the full picture, study the accounts in Figure 7.5. When a revaluated asset is depreciated, the revaluation reserves and the deferred taxes are proportionally closedoff to the Retained Earnings account. Regarding the case study TINNEN K.K., we look at the second half of the Accounting period 20X4, when the welding machine is depreciated: TINNEN K.K. writes-off the welding machine after revaluation. Depreciation is based on the revalued carrying value 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: 72,081.48 / 750,000 = 9 9.61%. Therefore, TINNEN K.K. also dissolves 9.61 % of the deferred tax liabilities: 9.61% × 47,760.73 = 4 4,590.22 JPY and of the initially recorded revaluation reserves: 9.61% × 159,202.44 = 1 15,300.73 JPY. The Bookkeeping entries (D’) and (D’’) are based on IAS 16.41 and are shown below. DR Deferred Tax Liabilities..... 4,590.22 JPY CR Revaluation Reserves......... 4,590.22 JPY <?page no="138"?> Berkau: Financial Statements 5e 7-134 DR Revaluation Reserves......... 15,300.73 JPY CR Retained Earnings............ 15,300.73 JPY Next, we calculate the earnings before taxation at TINNEN K.K. In 20X4, the operating expenses and the revenue are the same as in 20X3. The net profit in 20X4 is amounting to: 1,400,000 - 134,899.59 - 600,000 = 6 655,100.41 JPY. It considers depreciation of the revalued welding machine as expenses to the extent of 134,899.59 JPY. We here follow our simplified tax calculation which is based on the total income tax rate of 30 % the EBT are multiplied with. In the case of TINNEN K.K., the tax calculation refers to an asset valuation based on the cost model. Therefore, the depreciation for the tax calculation deviates from depreciation following IFRSs. At TINNEN K.K., the 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 are transferred to the IFRSs financial statements which means we copy them from the Tax-Profit and Loss account into the IFRS-Profit and Loss account. As a result, the copied income tax expenses seem too high in comparison to the profit calculation based on IFRSs. This means that EBT IFRS multiplied by 30 % gives lower income tax expenses of: 665,100.41 × 30% = 1 199,530.12 JPY. The difference in tax calculation to the extent of: 204,120.34 - 665,100.41 × 30% = 4 4,590.22 JPY is recorded as deferred tax income, which is deducted from actual taxes but not paid back by the revenue service. The contra entry is in the Retained Earnings account shown as Bookkeeping entry (G). 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="139"?> Berkau: Financial Statements 5e 7-135 D C D C c/ d 146,384.33 (2) 146,384.33 (3) 600,000.00 P3L 600,000.00 (R) 209,202.44 b/ d 146,384.33 (C) 62,818.11 209,202.44 209,202.44 c/ d 72,081.48 (D) 72,081.48 b/ d 72,081.48 Acc depr ACC Operational expenses-20X3 OEX D C D C (1) 800,000.00 c/ d 800,000.00 (1) 160,000.00 (4) 280,000.00 b/ d 800,000.00 (R) 800,000.00 c/ d 120,000.00 280,000.00 280,000.00 (B) 120,000.00 b/ d 120,000.00 (F) 280,000.00 PPE @COST Value added tax VAT D C D C P3L 1,400,000.00 (4) 1,400,000.00 DPR 146,384.33 REV 1,400,000.00 OEP 600,000.00 NP3 653,615.67 1,400,000.00 1,400,000.00 ITL 196,084.70 b/ d 653,615.67 R/ E 457,530.97 653,615.67 653,615.67 Revenue-20X3 REV Profit and Loss-20X3 P3L D C D C c/ d 196,084.70 P3L 196,084.70 c/ d 457,530.97 P3L 457,530.97 (A) 196,084.70 b/ d 196,084.70 (G) 4,590.22 b/ d 457,530.97 c/ d 204,120.34 ITL 204,120.34 (D'') 15,300.73 400,205.04 400,205.04 c/ d 933,811.77 P4L 465,570.29 b/ d 204,205.04 938,401.99 938,401.99 b/ d 933,811.77 Income tax liabilities ITL Retained earnings R/ E D C D C (C) 62,818.11 (R) 750,000.00 c/ d 750,000.00 (D) 72,081.48 c/ d 134,899.59 b/ d 750,000.00 134,899.59 134,899.59 b/ d 134,899.59 P4L 134,899.59 Depreciation-20X4 DPR PPE @VALUATION Figure 7.5: TINNEN K.K.’s accounts (20X4) continued <?page no="140"?> Berkau: Financial Statements 5e 7-136 D C D C (R') 47,760.73 (R) 159,202.44 (D') 4,590.22 (R') 47,760.73 (D'') 15,300.73 (D') 4,590.22 c/ d 43,170.51 c/ d 100,731.20 47,760.73 47,760.73 163,792.66 163,792.66 b/ d 43,170.51 b/ d 100,731.20 Revaluation reserves R-R Deferred tax liabilities DTL D C D C (E) 600,000.00 P4L 600,000.00 P4L 1,400,000.00 (F) 1,400,000.00 Operational expenses-20X4 OEX Revenue-20X4 REV D C D C DPR 134,899.59 REV 1,400,000.00 DPR 119,598.86 REV 1,400,000.00 OEX 600,000.00 OEX 600,000.00 NP4 665,100.41 NP4 680,401.14 1,400,000.00 1,400,000.00 1,400,000.00 1,400,000.00 ITL 204,120.34 b/ d 665,100.41 ITL 204,120.34 b/ d 680,401.14 R/ E 465,570.29 (G) 4,590.22 R/ E 476,280.80 669,690.63 669,690.63 680,401.14 680,401.14 Profit and Loss-20X4 P4L Tax-Profit and Loss-20X4 P4L Figure 7.5: TINNEN K.K.’s accounts (20X4) continued Before we discuss tax deferrals, we summarise revaluations by a How-itis-Done-paragraph. For the Bookkeeping entries, we below consider you apply one P, P, E account per asset. Carrying items of property, plant and equipment in separate accounts is referred to as Asset Management. 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 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. <?page no="141"?> Berkau: Financial Statements 5e 7-137 (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 expenses based on IFRS values. Depreciation is based on the revalued amount. (2) Make a debit entry in the Depreciation account and credit the amount to the Accumulated Depreciation account. (3) Calculate the percentage of depreciation based on the depreciable amount. (4) Dissolve the same percentage of the deferred tax liabilities by making a debit entry in the Deferred Tax Liability account and a credit entry in the Revaluation Reserves account. (5) Dissolve the same percentage of the ordinary revaluation reserves by debiting the Revaluation Reserves account and making a credit entry in the Retained Earnings account. This credits the deferred tax liabilities portion for depreciation towards 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 income) match to 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. About deferred taxes following IAS 12, we acknowledge: A revaluation is only recorded on the financial statements based on IFRSs. It gives us an increase on both sides of the balance sheet. There is a higher amount in property, plant and equipment and an increase in equity and in liabilities for deferred taxes. Both sides increase by the same total amounts. In case of TINNEN K.K. this is by 159,202.44 JPY. The increase is recorded in three accounts: In the Property, Plant and Equipment account, in the Revaluation Reserves account and in the account for deferred tax liabilities. IAS <?page no="142"?> Berkau: Financial Statements 5e 7-138 16.39 states that a revaluation is not recorded through profit or loss. As the recoverable amount of a revalued asset is its carrying value, a potentially higher net selling price can be expected. IAS 12.20 requires recognising the income taxes resulting from the potential profit earned on disposal as deferred tax liabilities. The disclosure of deferred taxes is a temporary occurrence. By depreciation of the revalued assets the deferred taxes are dissolved step by step in the future Accounting periods. This applies for disposals as well. In the case of TINNEN K.K., the deferred taxes for the entire welding machine equal 47,760.73 JPY. In the Accounting period 20X4, a 9.61 % portion thereof is dissolved which gives an amount of 4,590.22 JPY. 46 Over the useful life of the welding machine including its disposal - the entire deferred tax liabilities are dissolved. In general, deferred taxes are disclosed when the tax profit differs from the profit calculated by IFRSs. Here, the profits are different, because the profit and loss calculation based on IFRSs considers higher depreciation due to the revalued welding machine. Depreciation based on tax calculations is 119,598.86 JPY and based on IFRSs it is 134,899.59 JPY. Therefore, the profit before taxation based on tax calculations differs to the extent of: 134,899.59 - 119,598.86 = 680,401.14 - 665,100.41 = 15,300.73 JPY. Note, that the tax calculation is the correct one. The pre-tax profit based on IFRSs is lower because the revalued asset is depreciated higher. 46 We calculate by the fraction: 72,081.48/ 750,000 = 9.61 0864 %. The tax liabilities based on the tax profit and loss calculations are paid to the revenue service in the next Accounting period, which is 20X5. The tax impact of revaluations should be zero. However, the profit calculation based on IFRSs is too low which implies lower income taxes than calculated by the tax statements. Based on IFRS calculations, the taxes should be: 665,100.41 × 30 % = 199,530.12 JPY. This is below the income taxes. The difference is: 204,120.34 - 199,530.12 = 4,590.22 JPY. We can crosscheck the amount by multiplying the difference on depreciation by the total income tax rate: 15,300.73 × 30 % = 4,590.22 JPY. To keep the revaluation neutral regarding profit or loss, we must adjust the IFRS-income statement for the tax difference. The difference in taxation is deducted from the actual and paid income taxes and is shown as deferred tax income. Note, the deferred tax income is no payment. It is not recorded in tax liabilities either. The contra entry for the deferred tax income is recorded on the debit side of the Retained Earnings account. That marks an equity reduction. Why can a tax income decrease equity? The reason is an overrating of depreciation for revalued assets. Due to revaluation depreciation is higher to the extent of: 134,899.59 - 119,598.86 = 15,300.73 JPY. This includes an income tax portion of: 15,300.73 × 30 % = 4,590.22 JPY. The effect of depreciating revalued assets lays in the transfer of revaluation <?page no="143"?> Berkau: Financial Statements 5e 7-139 reserves to the Retained Earnings account. TINNEN K.K. dissolves in 20X4 15,300.73 JPY of revaluation reserves. The amount is transferred to retained earnings. The income tax portion thereof is 4,590.22 JPY (see above). Making a debit entry in the Retained Earnings account for deferred tax income reduces dissolving of the revaluation reserves for the welding machine to its after-tax amount. The resulting dissolution of the revaluation reserves is: 15,300.73 · (1 - 30%) = 10,710.51 JPY. We come up with the same amount if we offset the Bookkeeping entries (D’’) and (G) in the Retained Earnings account: 15.300,73 - 4.590,22 = 10.710,51 JPY. In total, the increase of the Retained Earnings account is due to higher depreciation (after taxes). This means, a company that revalues its assets does not record a revaluation gain nor the succeeding higher depreciation thereof through profit or loss and does not pay income taxes on revaluations nor on higher depreciation either. At the end of the useful life of a revalued asset, the increase in valuation was at first added to revaluation reserves and got later completely transferred to retained earnings by depreciation and/ or disposal. As depreciation and profits on disposal are income tax relevant, the higher depreciation and/ or gains of the revalued asset are adjusted for the tax portion by recording a deferred tax income. This way, the revalued asset does not affect income taxes. Note, a revaluated asset does not cause free taxes or tax refunds for the reporting company. The expression tax income might suggest such an effect. 47 Read our Basics, chapters (34) and (35). However, it is only a partial (at 30 %) compensation for a previously recorded gross amounts. 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. 47 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 completely. Only the proceeds from de-recognition and the carrying value (Property, Plant, Equipment account, Accumulated Depreciation account and Accumulated Impairment Loss account) are closed-off to the Realisation account. What is recorded in the Realisation account goes later through profit or loss or other comprehensive income. 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 <?page no="144"?> Berkau: Financial Statements 5e 7-140 Profit and Loss account based on IAS 16.68. A gain on disposal of non-current assets should not be considered a revenue. The distinction made is to not mix gains on disposals with revenues that result from operating activities. We study the case of YSTERFONTEIN Ltd. YSTERFONTEIN Ltd. is a construction company in Johannesburg. Data Sheet for YSTERFONTEIN Ltd. DDomicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Construction. Accounting period: 20X1 - 20X6. Plot: 300 m 2 ; cost of acquisition 225,000.00 ZAR plus conveyancing fees 50,000.00 ZAR. Revaluation to 3,000.00 ZAR/ m 2 . Sale on 30.11.20X6 at 1,000,000.00 ZAR. VAT n/ a. On 4.01.20X1, YSTERFONTEIN Ltd. buys a plot of 300 m 2 intended to use as parking lot for its business cars and construction vehicles. The purchase price is 225,000.00 ZAR. For conveyancing, YSTERFONTEIN Ltd. pays 50,000.00 ZAR. 48 The total costs of acquisition are: 225,000 + 50,000 = 2 275,000.00 ZAR. On 5.07.20X5, the municipality declares the land which includes YSTERFONTEIN Ltd.’s parking lot an industrial zone and, therefore, the property price increases to 3,000.00 ZAR/ m 2 . YSTERFONTEIN Ltd. revaluates its parking lot. The new value is: 300 × 3,000 + 50,000 = 9 950,000.00 ZAR. The costs for conveyancing are still included in the property valuation. The Bookkeeping entry for the revaluation is disclosed below: DR P, P, E @VALUATION........... 950,000.00 ZAR CR P, P, E @COST................ 275,000.00 ZAR CR Revaluation Reserves......... 675,000.00 ZAR DR Revaluation Reserves......... 202,500.00 ZAR CR Deferred Tax Liabilities..... 202,500.00 ZAR On 30.11.20X6, YSTERFONTEIN Ltd. sells the plot to a neighbour at 1,000,000.00 ZAR. The sale of the plot is transferred by the attorney Dr BOKPUNT. After the deal, YSTERFONTEIN Ltd. receives the selling price per bank transfer. The Bookkeeping entries are made through the Realisation account. YSTERFONTEIN Ltd. makes the Bookkeeping entries as below: DR Deferred Tax Liabilities..... 202,500.00 ZAR CR Revaluation Reserves......... 202,500.00 ZAR DR Revaluation Reserves......... 675,000.00 ZAR CR Retained Earnings............ 675,000.00 ZAR 48 In South Africa, no acquisition tax for property applies. <?page no="145"?> Berkau: Financial Statements 5e 7-141 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 about the plot (simplification). D C D C OV 950,000.00 (4) 950,000.00 OV 472,500.00 (2) 675,000.00 (1) 202,500.00 675,000.00 675,000.00 PPE @VALUATION Revaluation Reserves R-R D C D C (1) 202,500.00 OV 202,500.00 DTI 202,500.00 (2) 675,000.00 c/ d 507,500.00 P&L 35,000.00 710,000.00 710,000.00 b/ d 507,500.00 Deferred tax liabilities DTL Retained earnings R/ E D C D C (4) 950,000.00 (3) 1,000,000.00 (3) 1,000,000.00 . . . (5) 50,000.00 1,000,000.00 1,000,000.00 Realisation-20X6 REA Cash/ Bank C/ B 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 <?page no="146"?> Berkau: Financial Statements 5e 7-142 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, 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 entries accordingly. (4) Record output-VAT collected with the disposal as a debit entry in the Realisation account and a credit entry in the VAT account. (5) Close-off the P, P, E account to the Realisation account. (6) Close-off the Accumulated Depreciation account and, if existing, the Accumulated Impairment Loss account to the Realisation account. (7) Determine the balancing figure of the Realisation account. If the Realisation account is debit balanced the balancing figure is a loss on disposal. If the Realisation account is credit balanced the balancing figure is a gain/ profit on disposal. (8) Close-off the Realisation account to the Profit and Loss account. The Profit and Loss for Taxation account is greyed-out in Figure 7.6 to indicate that it is not part of the Bookkeeping entries based on IFRSs. YSTERFONTEIN Ltd. applies a Realisation account to calculate its gain on disposal of the land. It is amounting to: 1,000,000 - 950,000 = 5 50,000.00 ZAR. From the point of view of taxation, the profit on disposal equals: 1,000,000 - 275,000 = 725,000.00 ZAR. Therefore, the income taxes are amounting to: 725,000 × 30% = 2 217,500.00 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 = 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 <?page no="147"?> Berkau: Financial Statements 5e 7-143 states further that investment property does not apply for assets held for sale. A company that buys land/ buildings as a property dealer does not apply IAS 40 but IFRS 5 instead. IAS 40.7 says that investment property is in general independent from other ordinary business of the company. IAS 40.10 allows property to be separated in owner occupied items and items of investment property. Owner-occupation also applies if the owner rents out rooms as a hotel. The service characteristics are dominant and make the whole hotel fall under property, plant and equipment ruled by IAS 16. Below, we study the case study of MERSEBURG Ltd.: Data Sheet for MERSEBURG Ltd. DDomicile: South Africa (Grahamstown). Reporting currency: ZAR. Classification: Service provider. Investment property: 21,021,000.00 ZAR; office block with 42 offices, bought on 1.01.20X7. Depreciation: 420,420.00 ZAR. Revaluation to 25,200,000.00 ZAR on 1.01.20X8. VAT n/ a. On 1.01.20X7, MERSEBURG Ltd. buys an office block with 42 single offices in Grahamstown, South Africa. The costs 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 other 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. must 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 with partial allocated conveyancing costs: DR Investment Property.......... 20,520,500.00 ZAR DR P, P, E @COST................ 500,500.00 ZAR CR Cash/ Bank.................... 21,021,000.00 ZAR MERSEBURG Ltd. rents out its 41 offices and receives a monthly rental income therefrom. In case the offices' fair value changes, IAS 40.35 requires recording the amounts as gain or loss in the Accounting period changes take place. This is different to revaluations along IAS 16.39. We show the distinction regarding MERSEBURG Ltd.’s offices: In 20X7, MERSEBURG Ltd. applies the cost model and writes-off the offices to an extent of 420,420.00 ZAR (all together). The offices are carried then at a valuation of: 21,021,000 - 420,420 = 20,600,580.00 ZAR at the end of the Accounting period 20X7. On 1.01.20X8, MERSEBURG Ltd. acknowledges that the office values increased from 20,600,580.00 ZAR to 25,200,000.00 ZAR. The self-occupied office requires a revaluation based on <?page no="148"?> Berkau: Financial Statements 5e 7-144 IAS 16. The carrying value was 490,490.00 ZAR and the new amount equals 600,000.00 ZAR. The revaluation is recorded by the Bookkeeping entries below: DR P, P, E @VALUATION........... 600,000.00 ZAR DR Acc. Depr.................... 10,010.00 ZAR CR P, P, E @COST................ 500,500.00 ZAR CR Revaluation Reserves......... 109,510.00 ZAR DR Revaluation Reserves......... 32,853.00 ZAR CR Deferred Tax Liabilities..... 32,853.00 ZAR The value increase for the investment property 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: 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 more likely than unlikely (> 50 %). Non-current assets held for sale shall be valued at the lower of carrying costs and fair value less cost to sell (IFRS 5.15.). We emphasise here that assets along IFRS 5 are no inventories. They merely represent non-current assets of the company that are to be disposed due to discontinued operations or that they have no economic benefit left and are to be discarded. This applies also for replaced assets, like a taxi company that bought a new motor vehicle and intends to sell the old one. A company shall not depreciate a non-current asset while it is classified as held for sale based on IFRS 5.25. IFRS 5.38 requires separate disclosure of non-current assets held for sale. We explain the concept behind IFRS 5 by the case study OVERBERG (Pty) Ltd., a surf shop at the Atlantic Ocean in Cape Town. Data Sheet for OVERBERG (Pty) Ltd. Domicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: Service provider. Assets for sale: 15 kite surfing units, cost of acquisition: 20,000.00 ZAR/ KSU on 2.01.20X4; useful life: 4 years; residual value: 8,000.00 ZAR/ KSU. Intention to sell from 1.10.20X5 due to discontinued operations; selling price 10,000.00 ZAR/ KSU. On 31.12.20X6, 10 kite surfing unites are left. VAT 20 %. OVERBERG (Pty) Ltd. is a surf shop in the Western Cape of South Africa. The business sells surf equipment in Cape Town and runs a kite surfing training centre at Camps Bay’s waterfront. For the kite surfing training centre, OVERBERG (Pty) <?page no="149"?> Berkau: Financial Statements 5e 7-145 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 the kite surfing training centre and to turn it into a surf shop. Therefore, the training centre falls under discontinued operations at OVERBERG (Pty) Ltd.’s. No training classes are offered after 1.11.20X6. OVERBERG (Pty) Ltd. plans to sell the KSUs at 10,000.00 ZAR/ u (ex VAT). No additional selling costs become relevant, as OVERBERG (Pty) Ltd. sells the KSUs in its own surf shop in Camps Bay. At the beginning of the Accounting period 20X6, the KSUs are carried at 14,000.00 ZAR/ u each. Depreciation for the period 1.01.20X6 until 31.10.20X6 is amounting to: 10 × (14,000 - 8,000) / 24 = 2 2,500.00 ZAR/ KSU. When OVERBERG (Pty) Ltd. stops its kite surfing training on 1.11.20X6, it carries each KSU at 14,000 - 2,500 = 1 11,500.00 ZAR/ KSU. IFRS 5.15 requires the valuation of the KSUs at the lower of the carrying value and the fair value less costs to sell. OVERBERG (Pty) Ltd.’s intention to sell the KSUs at 10,000.00 ZAR/ u determines the fair value thereof. Hence, the KSUs are classified as held for sale and written-down in accordance with IFRS 5.20 from 11,500.00 ZAR/ KSU to 10,000.00 ZAR/ KSU. OVERBERG (Pty) Ltd. makes the Bookkeeping entry below. We name the account for assets held for sale Disposals Account: DR Disposals.................... 150,000.00 ZAR DR Acc. Depr.................... 127,500.00 ZAR DR IL on Discontinued Operations 22,500.00 ZAR CR P, P, E ACCOUNT KSU .......... 300,000.00 ZAR After classifying the KSUs as assets held for sale, OVERBERG (Pty) Ltd. suspends depreciation. At the end of Accounting period 20X6, OVERBERG (Pty) Ltd. manages to sell five of the KSUs at a net selling price of 10,000.00 ZAR/ u. 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. 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 Figure 7.7: OVERBERG (Pty) Ltd.’s accounts <?page no="150"?> Berkau: Financial Statements 5e 7-146 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 continued Ad (5): Intangible Assets Intangible assets are assets without physical substance, e.g., licenses, rights, warranties, patents, design costs, goodwill etc. IAS 38 rules intangible assets. In general, there are differences to German law regarding intangible asset regulations. IAS 38.4 states that in some cases, intangible assets are linked to assets with physical substance, e.g., software comes with an installation-CD and a manual. It is then necessary to assess which component of the asset is more significant. In the case of software, the intangible portion is the major part, hence, we classify software as intangible. Although cash and its equivalents may in general be regarded as intangible, it is always recorded as non-current asset under cash/ bank or as financial instruments. IAS 38.12 requires the intangible assets to be identifiable which means they shall be separable and exchangeable between individuals or they result from contractual or legal rights. Along IAS 38.13, intangible assets shall be in the control of the reporting company. We discuss our next case PAARDEBERG: Data Sheet for Dr. Paarderberg. Domicile: Germany (Hamburg) Reporting currency: EUR. Classification: Doctor’s clinic. Cost of acquisition: 750,000.00 EUR. Assets’ value: 80,000.00 EUR <?page no="151"?> Berkau: Financial Statements 5e 7-147 VVAT n/ a. 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 patient base. Although there is a material economic benefit when taking over the clinic due to the patients still visiting, the patients are not in control of the business. Therefore, 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 patient base can be recorded as intangible asset. In case Dr. Paardeberg pays a price for the clinic that exceeds the tangible assets’ total the difference between cost of acquisition and the sum of tangible assets is regarded as goodwill. Goodwill is derived from the clinic’s acquisition and, thus, an identifiable intangible asset because it is derived from contractual rights. 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 valuations, 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 future patients’ visits depends on the doctor’s ability and friendliness. Hence, the goodwill is subjected to changes. PAARDEBERG shall check the economic benefit resulting from goodwill regularly. In case patients stay away, an impairment loss is to be recorded regarding the derived goodwill valuation. The costs of development are subjected 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 the development. Special requirements apply to consider design costs as cost of development based on IAS 38.54 - 38.64. There, special recognition criteria for the classification as development are laid out: The first phase of the product design process when new knowledge is obtained, is 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 transitions to its next phase “development”, the reporting company should demonstrate that it fulfils the criteria laid out in IAS 38.57, e.g., feasibility, intention and <?page no="152"?> Berkau: Financial Statements 5e 7-148 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. As a case for the recording of design costs we study the case of WESPOORT Ltd. in East London. Data Sheet for WESPOORT Ltd. DDomicile: South Africa (East London). Reporting currency: ZAR. Classification: Manufacturing. Design costs: 600,000.00 ZAR. Fulfilment of criteria along IAS 38.57 on 3.03.20X4. Production commences on 31.05.20X4. Production amount: 96,000 lawnmowers over 2 years. VAT n/ a. WESPOORT Ltd. is a company that produces lawnmowers in the Eastern Cape province. For the next 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 for the engineering process thereof. The development phase causes labour costs, depreciation on design software (CAD) and further product tests. WESPOORT Ltd. demonstrates the fulfilment of the requirements regarding 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 commences right thereafter. WESPOORT Ltd. records development costs to the extent of 600,000.00 ZAR as intangible asset and depreciates them at the year-end according to the amount of lawn mowers produced. The production quantities of lawn mowers are evenly distributed over the entire production period. Hence, the partial development cost depreciation for the production period of 7 months in 20X4 equals: 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 time period 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 factor 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 <?page no="153"?> Berkau: Financial Statements 5e 7-149 - in contrast the supplier still makes decisions about the asset’s use, like in a car rental shop. The lessee shall recognise the leased asset as a right-of-control-the-use of an asset (also termed right-of-use asset RUA) and a lease liability, both at present values. The right of use asset can either be disclosed as item of property, plant and equipment or as a special item on the balance sheet, e.g., under rights. Lease liabilities are recorded and disclosed like other financial liabilities. In accordance with IFRS 16.22, the lessee discloses all leased assets on the financial statements which has an impact on its performance 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. Recording a lease commences with the conveyance of the asset. IFRS 16.9 requires that at inception of a lease contract, a reporting 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 of use asset and the lease liability at the commencement of the lease. The costs of the right of 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. If the discount rate cannot be derived from the lease contract itself, the incremental borrowing rate for 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. For understanding leasing, we discuss the case study KRIGE (Pty) Ltd. Data Sheet for KRIGE (Pty) Ltd. DDomicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Transportation, UBER. Leasing object: Toyota car for 2 years. Leasing rates: 120,000.00 ZAR/ a. Restoring costs: 50,000.00 ZAR. Final repayment at return: 100,000.00 ZAR. VAT ignored. Mr Krige is an UBER driver and runs his business in the Johannesburg vicinity. He establishes KRIGE (Pty) Ltd. and prepares financial statements following IFRSs. KRIGE (Pty) Ltd. closes a lease contract about the taxi car with the local Toyota dealer for a 2 years period, commencing on 2.01.20X3 and ending 31.12.20X4. The KRIGE (Pty) Ltd. case study is easy as for a 2-years contract the time value of money is not material. The lease is disclosed on 31.12.20X3 for the first time when it has a remaining time of one year. Hence, we can measure the lease liability at settlement values (payments) and do not have to worry about discounting values. 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 <?page no="154"?> Berkau: Financial Statements 5e 7-150 these payments, the payment vector for the taxi car (in ZAR) equals: 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. The valuation for the car is unknown, therefore, KRIGE (Pty) Ltd. recognises the lease object at the present value of the lease rates which is here 190,000.00 ZAR - no discounting applies (s.a.). 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 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 made already and the next payment is classified as a shortterm liability. No adjustments for valuation apply. On 31.12.20X4, KRIGE (Pty) Ltd. retires the remaining lease liability. Observe the Bookkeeping entries (2) and (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 of use asset) is based on straight-line method with no residual value, as the right of use asset is measured based on all payments including of 100,000.00 ZAR received and 50,000.00 ZAR paid at the end of the lease period. Hence, depreciation is amounting to: 190,000 / 2 = 9 95,000.00 ZAR. It gets 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 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 Figure 7.8: KRIGE (Pty) Ltd.’s accounts (20X3) <?page no="155"?> Berkau: Financial Statements 5e 7-151 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 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 (C’) and (C’’). 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 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. <?page no="156"?> Berkau: Financial Statements 5e 7-152 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 (C') 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 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 (C'') 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 (C') 190,000.00 (C'') 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) How it is Done: (Recording Leases) (1) Examine whether a lease applies. (2) Determine the value of the lease object or the right of use asset. It is the asset’s fair value or if unknown the present value of all lease rates. For present value calculation use the discount rate implicit in the lease. (3) Adjust the asset calculation for all lease 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 of use asset and as a lease liability at the same time. (5) Record depreciation on the leased asset as depreciation on the right of use asset. <?page no="157"?> Berkau: Financial Statements 5e 7-153 (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 value of the right of use asset and the lease liability can differ due to different measurement methods. (8) At the end of the lease term, record a disposal of the asset and the retirement of the lease liabilities. Consider all payments linked to the termination of the lease. Below we study the case of VLAEBERG K.K: Data Sheet for VLAEBERG K.K: DDomicile: Japan (Tokyo). Reporting currency: JPY. Classification: n/ a. Leasing object: VW Polo for 3 years (20X4 - 20X6). Leasing rates: 1,240,000.00 JPY/ a. Leasing rate of interest: 5 %/ a. Restoring costs: 800,000.00 JPY. Final repayment at return: 1,000,000.00 JPY. Option to purchase the car included. VAT ignored. On 2.01.20X4, the Japanese company VLAEBERG K.K. agrees on 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 1,000,000.00 JPY on 31.12.20X6. As an option, VLAEBERG K.K. obtains the right to purchase the car at this amount. The car dealer (lessor) does not reveal the car’s cost of acquisition. Hence, the measurement of the right of use asset is based on the present value of all lease payments: rates, receipt on return and estimated restoring payments. IFRS 16.23 and IFRS 16.24 apply. The value of the VW Polo is derived from the payment vector for the lease: 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 calculating the sum of present values 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 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 of use asset together with the lease liability. See Figure 7.10. <?page no="158"?> Berkau: Financial Statements 5e 7-154 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 of use asset is depreciated. Depreciation is along straight-line method under consideration of a residual value of 1,000,000.00 JPY. The subsequent valuation of the lease liability requires the deduction of the lease payment. The new amount is: 3,364,263.04 - 1,240,000 = 22,124,263.04 JPY. Depreciation on the right of use asset in 20X4 amounts to: (3,364,263.04 - 1,000,000 + 800,000) / 3 = 1 1,054,754.35 JPY. The new carrying value of the right of use asset is: 3,364,263.04 - 1,054,754.35 = 2,309,508.69 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 of use asset, for the recognition of the lease liability, for the lease rate paid as well as for the reclassification of the next payment and its 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 <?page no="159"?> Berkau: Financial Statements 5e 7-155 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. Therefore, add the lease liabilities and its short-term liabilities portion. In the next Accounting period 20X5, VLAEBERG K.K. depreciates the right of use asset again by the same charges of 1,054,754.35 JPY/ a. For the valuation of the lease liability we calculate in two steps. At first, we revalue the lease liability: 2,124,263.04 × (1 + 5%) = 2,230,476.19 JPY. The revaluation is amounting to: 2,230,476.18 - 2,124,263.04 = 1 106,213.15 JPY. For the lease measurement it does not matter that a portion of the lease liability is disclosed as short-term liability. The right of 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) to (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. The lease liability is carried on 31.12.20X5 at: 1,240,000 - 249,523.82 = 9 990,476.18 JPY. In the last 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 to the extent of 1,000,000.00 JPY. The restoring costs are added to the right of use asset as the expenses are considered for the calculation of depreciation. Regarding the lease liability, we record a revaluation based on a 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 of 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 <?page no="160"?> Berkau: Financial Statements 5e 7-156 DR RUA.......................... 800,000.00 JPY CR Cash/ Bank.................... 800,000.00 JPY 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 of use asset is dissolved through the Realisation account. Check Figure 7.11 for the details. Observe VLAEBERG K.K. accounts: 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="161"?> Berkau: Financial Statements 5e 7-157 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="162"?> Berkau: Financial Statements 5e 7-158 The case study VLAEBERG K.K. shows that the measurement of the leased asset and the lease liability differ, except of for the 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 changes by compound interest calculation whereas the right of use asset is written-off following straightline method. Leases can also be short-term and then must be recorded as expenses. See below the case study JONKERS GmbH, a consultancy in Osnabrück. The company regularly visits its clients and bills the travel expenses directly without further surcharges. At JONKERS GmbH, only short-term leases apply which are considered as an expense and recorded through profit or loss. Data Sheet for JONKERS GmbH: DDomicile: Germany (Osnabrück). Reporting currency: EUR. Classification: Consultancy. Rent of an Audi A4 car on 6.06.20X7 for 4 days. Leasing rates: 135.00 EUR/ d. Insurance rate: 40.00 EUR/ d. VAT ignored. On 6.06.20X7, JONKERS GmbH visits a client in Saarbrücken. From the local car rental, JONKERS GmbH hires an Audi A4. It returns the car on 9.06.20X7, which results in a rental expense for 4 days: 4 × 135 = 5 540.00 EUR. Although the risk of accident is transferred to JONKERS GmbH, no lease contract applies. JONKERS GmbH insures the car and adds the insurance costs to its travel expenses. Insurance is 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. The refund 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 sell the car. In case of JONKERS GmbH, IFRS 16.5 applies as the lease is short-term and of minor value. JONKERS GmbH records the cost by two Bookkeeping entries: (1) for the car rental and (2) for the refunding received from its client. DR Travel Expenses (OEP)........ 700.00 EUR CR Cash/ Bank.................... 700.00 EUR DR Cash/ Bank.................... 700.00 EUR CR Travel Expenses (OEP)........ 700.00 EUR <?page no="163"?> Berkau: Financial Statements 5e 7-159 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). IAS 32.11 defines financial instruments. 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. If a company buys fresh shares, it shows these shares as an item of noncurrent assets and the emitting corporation discloses the shares as issued capital and most probably under capital reserves as well. IAS 32.11 gives details of financial assets and financial liabilities. A financial asset is, e.g., a right to receive cash whereas a financial liability can be a contractual obligation to deliver cash. In this textbook, long-term financial instruments are covered in this chapter (7) on the debit side as financial assets and on the credit side as financial liabilities in chapter (14). The measurements are based on the same standards. Below we discuss case studies which result in different recognitions and measurements of financial instruments. We cover different financial instruments to provide you with a wide knowledge of how to recognise and measure financial instruments. As an overview over the next pages, we list the discussed financial assets together with their 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. 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 follow IAS 39 or IFRS 9. We only focus on IFRS 9 as IAS 39 will be superseded shortly. The valuation of financial instruments depends on their classification. This requires dealing with the classification of financial instruments at first. We focus on the owners' side of financial assets. Financial assets are investments, ownership of 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. The main rule for the disclosure of financial instruments is to first study the business model of the holding company. Business model is a technical term in Accounting language which refers to what the owner intends to do with its financial assets. We separate financial assets held until maturity from those held for trading purpose. If, e.g., <?page no="164"?> Berkau: Financial Statements 5e 7-160 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 the shares to the current asset section. The valuation is then based on fair market values. Note, as shares do not mature this is the default case. We focus on that kind of financial assets in chapter (9). Here, in chapter (7) we only look at financial assets on the non-current asset section of the balance sheet. 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 - HAWKINS Ltd. / STEYN GmbH Below, we show an overview of the case study: Data Sheet for HAWKINS Ltd. DDomicile: South Africa (Upington). Reporting currency: ZAR. Classification: n/ a. Investment: 8 % in STYN GmbH, issued capital 100,000.00 EUR; book value: 245,000.00EUR. Currency exchange rate 15.00 ZAR : 1.00 EUR, later: 15.50 ZAR : 1.00 EUR. STEYN GmbH's profit: 25,000.00 EUR, dividend half thereof. VAT ignored. HAWKINS Ltd. holds 8 % of STEYN GmbH in Germany. STEYN GmbH is an internet tyre dealer in Hamburg and based on an 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 STEYN GmbH which is amounting to 245 % of the issued capital. The book value of the acquired shares with a nominal value of 8,000.00 EUR equals: 8,000 × 245% = 19,600.00 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 in its home currency: 15 × 19,600 = 294,000.00 ZAR. We ignore transaction costs. Based on IAS 32.11, a financial asset applies for HAWKINS Ltd., as stock of another company falls under equity instruments, which is STEYN GmbH in Germany. HAWKINS Ltd.'s business model indicates that the investment is timely unlimited. This supports the disclosure of the investment as non-current financial assets. 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), see below: DR Financial Asset STEYN........ 294,000.00 ZAR CR Cash/ Bank.................... 294,000.00 ZAR One could assume HAWKINS Ltd. has to record its shares in STEYN GmbH as an investment like a subsidiary or an associated company. It does not have to as <?page no="165"?> Berkau: Financial Statements 5e 7-161 the investment is below 20 % of the total of ordinary shares. As no associate nor subsidiary applies, HAWKINS Ltd. is supposed to disclose its shares as a financial asset following IFRS 9. There is no need to prepare group statements nor separate financial statements following IAS 27. The initial valuation is at cost (see above). 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 the balance sheet date of 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 of STEYN GmbH are now worth: 19,600 × 15.50 = 3 303,800.00 ZAR. Does HAWKINS Ltd. have to adjust the valuation? Yes, it does. Fair value presentation applies. In general, amortised costs do not apply for the shares as they can be sold at any time. The business model of HAWKINS Ltd. determines a fair value presentation, here, through other comprehensive income. HAWKINS Ltd. considers the increase in share values being a gain because of currency exchange rate changes to the extent of: 19,600 × 15.50 - 294,000 = 9,800.00 ZAR. HAWKINS Ltd. records the currency gain together with the profit share as shown below in Bookkeeping entry (3). Therein, the increase of the shares due to equity increase (see below) is considered, which makes the difference of the equity exchange rate exceed 9,800.00 ZAR towards 10,150.00 ZAR. 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 dividends received and get back to the currency gain thereafter. STEYN GmbH earned a net profit (EBT) of 25,000.00 EUR during the Accounting period 20X3. The company pays half of its earnings after taxes to its shareholders and adds the other half to earnings reserves. Hence, the profit share receivable by HAWKINS Ltd. is amounting to: 8% × 25,000 × (1 - 30%) / 2 = 7 700.00 EUR which equals: 700 × 15.50 = 1 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 increase of its equity. Therefore, STEYN GmbH’s book value increases. The shares are not traded publicly. 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. This kind of measurement is referred to as ad-equity-valuation. It is the default measurement for associated companies and ruled by IAS 28. HAWKINS Ltd. records the value adjustment of: 314,650 - 294,000 = 2 20,650.00 ZAR through other comprehensive income. The profit share (portion of the profit appropriation) assigned to <?page no="166"?> Berkau: Financial Statements 5e 7-162 HAWKINS Ltd. is: 700 × 15.50 = 110,850.00 ZAR. As STEYN GmbH is no company based on shares, we do not call that amount a dividend. 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% × (245,000 + 8,750) × (15.50 - 15) = 1 10,150.00 ZAR. Hence, the gain due to equity increase equals: 20,650 - 10,150 = 1 10,500.00 ZAR. DR Cash/ Bank.................... 10,850.00 ZAR CR Other Comprehensive Income... 10,850.00 ZAR DR Financial Asset STEYN........ 20,650.00 ZAR CR Gain on Currency Rate........ 10,150.00 ZAR CR Other Comprehensive Income... 10,500.00 ZAR In terms of return figures, the amount gives a: (10,850 + 10,150 + 10,500) / 0.5 × (294,000 + 314,650) = 1 10.35 % return on investment for HAWKINS Ltd. On HAWKINS Ltd.’s balance sheet, the financial asset is now disclosed at 314,650.00 ZAR. Other comprehensive income is 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 and gains/ expenses on the income statement of the holder of financial assets. IFRSs allow a valuation at amortised cost to prevent the balance sheet from oscillating value disclosures. IFRS 9.4.1.2 requires carrying financial assets at amortised costs if the company’s business model is to keep the assets and to receive regular cash flows on specific dates. Those cash flows can result from interest, pay-off and redemption payments, but not from capital appreciation. A valuation at amortised costs means a systematic approximation of the initial valuation to the final value. If both amounts equal, amortised costs are constant, such as in the case of BATHURST Ltd. in chapter (6). A company that holds bonds until they mature shall disclose them at amortised costs, too. Carrying financial assets at amortised costs is an alleviation in contrast to volatile fair value recognition. Only those financial instruments held until maturity allow disclosure at amortised costs - what is held for sale requires 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 are issued on 2.01.20X2. This is when HAVENGA Ltd. acquires them. The coupon rate of the bonds (yield) is 11 %/ a. Observe the Bookkeeping entry (1) at the time of acquisition below which is linked to the cost model: <?page no="167"?> Berkau: Financial Statements 5e 7-163 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: 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 listed at the bond market is: - 20X3: 6,306,624.27 ZAR - 20X4: 6,164,191.10 ZAR - 20X5: 5,961,479.99 ZAR - 20X6: 5,095,205.27 ZAR - 20X7: 5,000,000.00 ZAR Based on IFRS 9.4.1.2, HAVENGA Ltd. records the bonds at 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 have been in between. The valuation at HAVENGA Ltd. was constantly at the cost of acquisition because the company bought the bonds at face value and the redemption took place at face value, too. Hence, the measurement at amortised costs is simple. In case a holder buys bonds at another price than at par and the bonds are held to maturity, the effective interest method applies in line with IFRS 9.4.1.2 and IFRS 9.5.4.1. which will approximate the bond valuation consequently towards its redemption value. We demonstrate the measurement at amortised costs by the next case study NATBERGEN (Pty) Ltd. Ad (7c): Bonds Held to Maturity - NATBERGEN (Pty) Ltd. Below we show the data sheet for NATBERGEN (Pty) Ltd. Data Sheet for NATBERGEN (Pty) Ltd. Domicile: Australia (Brisbane). Reporting currency: AUD. Classification: n/ a. Bonds at 400,000.00 AUD, cost of acquisition: 350,000.00 on 3.01.20X3. Bonds mature on 31.12.20X7. <?page no="168"?> Berkau: Financial Statements 5e 7-164 CCoupon rate: 8 %/ a, 32,000.00 AUD/ a. VAT ignored. 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 (below-par). A listing of bonds below their principal results from an interest rate at the bond market that exceeds the coupon rate or from investors not trusting the issuer being capable to pay coupons and for redemption. The coupon rate of the bonds is 8 %/ a which makes the holder receive an annual coupon of: 8% × 400,000 = 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. 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 process the increase in valuation by making systematic adjustments. The effective rate of interest reflects the increase in valuation. Payments for coupons and redemption are deducted from the bond valuation. Check the valuation of NATBERGEN (Pty) Ltd.’s bonds in Figure 7.12. We calculate the effective rate of interest with the payment vector B(t) = {(350,000); 32,000; 32,000; 32,000; 32,000; 432,000}. It gives 11.42 %/ a. An alternative approach to determine the effective rate of interest is to prepare a financial schedule and apply the goal seek function, see Link 7.H. Link 7.H: NATBERGEN (Pty) Ltd. <?page no="169"?> Berkau: Financial Statements 5e 7-165 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 At maturity, NATBERGEN (Pty) Ltd. has increased the bonds incrementally to a valuation of 400,000.00 AUD which is the settlement amount at 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. This counts as an advantage as the dividend does not depend on the performance of the issuing company and, therefore, is free of risks. In case of a liquidation of the company, preference shareholders rank between creditors and ordinary shareholders. This counts as a further advantage, however, only if anything is left for distribution. In case of a liquidation due to an Accounting insolvency (meaning: the liabilities exceed the assets) nothing is distributable. By default, preference shares are cumulative, meaning an open preference dividend from previous years must be paid first before dividends can be declared to ordinary shareholders. 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 carried at fair value with adjustments made through other comprehensive income. Data Sheet for DORRINGTON Ltd. and ROTTMAN Ltd. Domicile: South Africa (Kimberly). Reporting currency: ZAR. Classification: n/ a. Issued capital: 100,000 ordinary shares at 10.00 ZAR/ s. Issue of 10,000 preference shares, dividend: 12 %/ a based on principal, issue price 11.23 ZAR/ s on 2.01.20X7. ROTTMAN Ltd. holds 1,000 preference shares. Share price on 31.12.20X7: 10.90 ZAR/ s. ROTTMAN Ltd. sells 1,000 preference shares on 30.03.20X8 at the market price of 11.00 ZAR/ s. VAT ignored. In the case study, DORRINGTON Ltd. issues preference shares. The preference <?page no="170"?> Berkau: Financial Statements 5e 7-166 shares’ dividend is 12 %/ a based on the nominal value of 10,00 ZAR/ s. DORRINGTON Ltd.'s preference shares are redeemable. 49 Redeemable preference shares are bought back at the time when they mature at their market price. Along international policy, DORRINGTON Ltd. discloses its preference shares under issued capital and capital reserves on the equity section of 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. For the recording of the preference shares, we apply IAS 32.15. At DORRINGTON Ltd., the preference shares are recorded as equity instruments at nominal values. The premium paid upon issue is added to capital reserves. Next, we analyse one preference shareholder, ROTTMAN Ltd. that owns 1,000 preference shares bought at 11.23 ZAR/ s on 2.01.20X7. ROTTMAN Ltd.’s intention is not to keep the preference shares until redemption but to sell them in the nearby future - but not in the first Accounting period. Therefore, 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 preference shareholder). DR Financial Assets ............ 11,230.00 ZAR CR Cash/ Bank.................... 11,230.00 ZAR At the end of the fiscal year 20X7, the preference shares are traded at 10.90 ZAR/ s at the Johannesburg Stock Exchange JSE. As the preference shareholder, ROTTMAN Ltd., classifies the preference shares to be carried at fair values (FVTOCI) the preference shares are disclosed at fair market prices which results in the recording of an impairment loss to the extent of: (11.23 - 10.90) × 1,000 = 3 330.00 ZAR to be deducted from other comprehensive income. ROTTMAN Ltd. must record the impairment loss through other comprehensive income, as share trading is not its core business. The preference dividend received by ROTTMAN Ltd. is based on the face value of its shares and is 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 49 This is not allowed in Germany. <?page no="171"?> Berkau: Financial Statements 5e 7-167 DR Cash/ Bank.................... 1,200.00 ZAR CR Dividend Income.............. 1,200.00 ZAR The owner, ROTTMAN Ltd., sells its 1,000 preference shares on 30.03.20X8 at 11.00 ZAR/ s. After the fair value disclosure as at the previous balance sheet date (31.12.20X7), the selling price results in a gain on disposal through other comprehensive income to the extent of: (11 - 10.90) × 1,000 = 1 100.00 ZAR. Observe Bookkeeping entry (A): To keep the case study simple, we do not consider that the preference shares earned an interest claim of: 25% × 12% × 1,000 × 10 = 3 300.00 ZAR from January/ 20X8 until March/ 20X8. Regarding a cum-interest sale the earned preference dividend claim would be added to the price at which shares are sold at. We here assume, that the selling price of 11.00 ZAR/ s consideres 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 preference shareholder who keeps shares carries them at amortised costs but can opt for recognition at fair values through other comprehensive income FVTOCI. If the intention is holding shares for trading purposes, the valuation is based on fair values through profit or loss FVTPL. Regardless to measurement, preference dividends received are recorded through profit or loss. We discuss another case study online which contains a financial liability resulting from writing a call option for a specific number of ordinary shares. That leads to recognition of an equity instrument. See the case study HELWAN AIRWAYS Ltd. which buys the rights for a route in return of a call option linked to its own shares. You reach the case through Link 7.I. Link 7.I: HELWAN AIRWAYS Ltd. A special form of financial instruments are derivatives. They are often bought for hedging purposes. Derivatives are financial instruments where the financial obligation of the issuer depends on a particular price, e.g., a commodity. Derivatives are futures, swaps and options. The valuation of derivatives is based on fair value through profit or loss. We discuss next the case of electro manufacturer MOLLENBERG Ltd. who buys a call option for copper to secure its profitability at volatile commodity prices. A call option is a contract where the option holder receives a contractual right to buy commodities or financial <?page no="172"?> Berkau: Financial Statements 5e 7-168 instruments at a certain time or within a certain period for a fixed strike price by paying a premium (fee). Options can be sold on. As the option holder has more alternatives as the seller (option writer), we describe his situation as the long position. The option writer is in the short position respectively. In case the market price falls under the stroke price when the option is exercised the option becomes futile, we say "out of the money" and the option holder is left with the expenses for the premium. No obligation to exercise the option applies. If the market price is above the strike price (in the money), the option holder benefits from the price difference. However, the profit is reduced by the premium previously paid. Call options make sense if the holder expects the market prices to increase. Options can be linked to purchases (calls) or sales (puts). In the case of MOLLENBERG Ltd. the company takes a long call position. Ad (7e): Derivatives, call option to buy copper - MOLLENBERG Ltd. We discuss the case MOLLENBERG Ltd. that buys a call option on copper for 10,000.00 AUD. Below, we show the data sheet for MOLLENBERG Ltd. Data Sheet for MOLLENBERG Ltd. DDomicile: Australia (Perth). Reporting currency: AUD. Classification: Manufacturing. Call option: 100,000 lbs. copper at 360,000 AUD. Copper prices: 2.50 USD/ lb ; 2.65 UDS/ lb. Currency exchange rates: 69.00 USD = 100.00 AUD; 72.00 USD = 100.00 AUD. Premium: 10,000.00 AUD. VAT ignored. MOLLENBERG Ltd. needs copper for its production. The copper price fluctuates and MOLLENBERG Ltd. expects the purchase prises to increase in the future. It buys a call 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 is 2.50 USD/ lb. The currency exchange rate to the US-dollar was at that time: 69.00 USD = 100.00 AUD. MOLLENBERG Ltd. pays for the premium 10,000.00 AUD. The copper amount agreed on is 100,000 lbs. The initial valuation is on 14.05.20X5. MOLLENBERG Ltd. records the option as financial asset 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 temporarily void as MOLLENBERG Ltd. can buy copper without exercising its call option. However, a drop in copper price will not impair the call option as MOLLENBERG Ltd. does not know the price on 31.12.20X9 yet. The valuation of the call option as at balances sheet date 20X5 is at fair value through other comprehensive income. The reason is that there is a chance to sell on the call option. <?page no="173"?> Berkau: Financial Statements 5e 7-169 We assume, on 31.12.20X5, the copper price is 2.65 USD/ lb and the exchange rate is: 72.00 USD = 100.00 AUD. For the fair value calculation of the call option, we calculate the temporary gain related to 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 to the cost of acquisition for the premium to the extent of: 10,000 - 8,055.56 = 1,944.44 AUD. MOLLENBERG Ltd. who measures the call option at fair value through other comprehensive income adjusts its valuation by Bookkeeping entry (2). The valuation considers that the advantage in buying cheap is reduced by the premium. DR Other Comprehensive Income... 1,944.44 AUD CR Call Option (FA)............. 1,944.44 AUD In the next following Accounting periods, MOLLENBERG Ltd. must adjust its option’s measurement based on copper price and the exchange rate to the USD again. The valuation reflects its profit under consideration of the premium. If the price is below 360,000.00 AUD on 31.12.20X9, the call option is out of the money and MOLLENBERG Ltd. records an impairment loss. If the call option is processed for the purchase of copper, the option is dissolved and added to the cost of purchase for MOLLENBERG Ltd.’s copper. To keep the case study short, we assume that the valuation of 8,055.56 AUD from 20X5 stays (no further copper price changes) and the price for the desired copper amount is 365,000.00 AUD on 31.12.20X9. The costs of purchase now are: 360,000 + 8,055.56 = 3 368,055.56 AUD. Consider that we recorded in 20X5 expenses to the extent of 1,944.44 AUD which are allocated towards the Accounting period 20X5 as the impairment loss occurred already then. The above shown values apply for all copper prices in excess of 360,000.00 AUD. If the copper price falls below 360,000.00 AUD, the call option will not be exercised. We now assume (as an alternative scenario) the copper price is 355,000.00 AUD on 31.12.20X9. MOLLENBERG Ltd. forfeits the call option, buys copper at 355,000.00 AUD and records an impairment loss on the call option. Thus, the costs of purchase are amounting to: 355,000.00 AUD and the impairment loss is 8,055.56 AUD. In comparison to not buying the call option the expenses increase by: 8,055.56 + 1,944.44 = 10,000.00 AUD. These are the costs for the premium. So far, we discussed financial instruments held for longer periods that are classified as non-current assets. Companies can hold, shares or bonds or other financial instruments short-term, too. In that case we allocate them to the security item on the balance sheet which is found in the current asset section. We cover these cases in chapter (9). <?page no="174"?> Berkau: Financial Statements 5e 7-170 How it is Done: (Recording Financial Assets as non-Current Assets) (1) Determine whether the financial asset is held short-term or long-term. For short-term recognition check chapter (9) in this textbook. (2) If the financial asset is held long-term recognise the financial asset at costs as a non-current asset. (3) For subsequent valuation check the business model of the company holding. It determines the valuation of the financial asset. (4) If the financial asset is held to maturity apply the effective interest method. If the financial asset is held ready for sale apply fair value presentation through either profit or loss or through other comprehensive income. (5) For the disposal of financial assets apply the Realisation account. (6) Record a gain or loss on disposal through either profit or loss or through other comprehensive income. 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 of 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 subsequent measurement are depreciation, impairment loss and revaluations. In contrast, financial instruments are measured at amortised costs or fair value model. De-recognitions of non-current assets are 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 in the future. Carrying value: Measurement of an asset at which it is disclosed on the financial statements. Cost of acquisition: Based on the conventions of this textbook in chapter (1) about VAT reduction: the net price for buying an asset less all discounts and including all attributable costs. Fair value: Measurement of an asset/ liability as it is transferred at on an active market, e.g., a bond price. Financial asset: Shares, bonds, options etc., bought to keep them for more than one Accounting period. Gross replacement method: Method of recording a valuation based most <?page no="175"?> Berkau: Financial Statements 5e 7-171 probably on a change of cost of acquisition for new assets. Adjustments are recorded as if the asset was bought at the increased price. Impairment loss: Difference between a carrying value and a subsequent, lower valuation that is regarded as extraordinary. Intangible asset: Asset without physical nature. Investment: Ownership of a portion of another business, e.g., holding more than 20 % or its shares. In general, investments are subsidiaries, partial ownership in associated companies or result from joint ventures. Investment property: In general, land or buildings held for renting out or capital appreciation. Lease: Contract to use an asset and taking control by paying its owner a certain consideration for an agreed time span. The duration of the lease must be material. Lessee: Party that leases an asset from its owner. Lessor: Party that leases out an asset. Net replacement Bookkeeping entries: Method to record a revaluation based on most probably an expertise at the time of adjustment of measurement. Put option: Right but no obligation to sell an asset at an agreed price in the future. Realisation account: Account to record the disposal of assets. The Realisation account is closed-off to the profit or loss or to other comprehensive income. Recoverable amount: Obtainable selling price or value in use - whatever is higher. Revaluation: Assigning a value to an asset that exceeds its carrying value. 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. (2) A car is acquired at a price of 78,000.00 EUR (gross amount) and is fetched from Stuttgart for 1,200.00 EUR gross amount. The dealership offers a trade discount of 10 % for the car. How much are the resulting cost of acquisition? 1. 71,400.00 EUR. 2. 59,500.00 EUR. 3. 59,400.00 EUR. 4. 58,500.00 EUR. (3) The Realisation Account shows: 1. The net selling price on the credit side and the carrying value of the sold asset on the debit side. 2. A profit on disposal on the credit side. 3. The output-VAT on the credit side. 4. The gross selling price on the credit side, the output-VAT on the debit side, the P, P, E amount on the debit side, the total of accumulated depreciation on the credit side and the total of accumulated impairment loss on the debit side. (4) A machine is carried at 80,000.00 EUR at the beginning of the Accounting period 20X1. Its depreciable amount is 70,000.00 EUR and there are 5 years remaining for <?page no="176"?> Berkau: Financial Statements 5e 7-172 depreciation. On 1.04.20X2 the machine is damaged and the remaining amount is 55,000.00 EUR. Depreciation is resumed a few days later. How many expenses do you record in 20X2? 1. 21,500.00 EUR. 2. 22,000.00 EUR. 3. 7,500.00 EUR. 4. 20,000.00 EUR. (5) A company buys a machine on 2.03.20X3 at 5,000.00 EUR net amount. The useful life is 5 years and depreciation is based on the declining method at 2%/ m. How much is the carrying value of the machine as at 31.12.20X4? 1. 4,085.36 EUR. 2. 3,205.85 EUR. 3. 3,000.00 EUR. 4. 3,078.90 EUR. Solutions: 1-2; 2-2; 3-1; 4-4; 5-2. <?page no="177"?> Berkau: Financial Statements 5e 8-173 8. Business Combinations What is in the Chapter? In this chapter (8), we look at Group Accounting which is about the disclosure of investments in separate financial statements following IAS 27 as well as about the presentation of financial statements for business combinations, like 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 three companies together form group in terms of Accounting. A joint venture is a company that is controlled by other companies together. If the companies X and Y control Z together, then Z is the joint venture and X and Y are the investors. Learning Objectives: After studying this chapter, you understand the basics of consolidations and know how to prepare financial statements for business combinations. You will know and understand the major regulations issued by the IASB. You can prepare group statements on case study level and can apply a consolidation worksheet as provided by our CH5-file on the publisher's website. In Accounting, groups prepare financial statements in addition to single-entity financial statements of each group member. Hence, a group of three companies with one parent and two subsidiaries prepares four financial statements, three single-entity financial statements for each member and one for the entire group. A parent is a company executing the control power, a subsidiary is the dependent company. We also cover the preparation and presentation of separate financial statements along IAS 27, if companies hold investments in other companies. Same as the IASB, stated in 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. Separate financial statements are single entity financial statements which consider the reporting company holding investments in subsidiaries. Nowadays, many companies are involved in groups, either as 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 in group statements to remove double or multiple considerations of items caused by the process of adding financial statements for Group Accounting. Group Accounting is demanding as its calculations are complex, and we must describe several companies per case study. We start with separate financial statements along IAS 27, cover initial and subsequent consolidations based on IFRS 3 and IFRS 10 and discuss Joint <?page no="178"?> Berkau: Financial Statements 5e 8-174 Venture Accounting following 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 process 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 will 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. The file follows the procedure recording consolidations based on software solutions. Relevant standards for Group Accounting are IAS 27: Separate Financial Statements, IAS 28: Investments in Associates and Joint ventures, IFRS 3: Business Combinations, IFRS 10: Consolidated Financial Statements, IFRS 11: Joint Arrangements and IFRS 12: Disclosure of Interest in other Entities. IAS 27 rules the Accounting for separate financial statements. A separate financial statement is a statement of a parent or a joint venture investor that covers investments either at costs or at fair values in accordance with IFRS 9 or based on Equity Accounting as ruled by IAS 28 (IAS 27.10). A company that does not hold investments does not prepare separate financial statements, check IAS 27.7. IAS 27 does not mandate whether a company must 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 regulations in IAS 28.10 and following paragraphs. IFRS 3 contains regulations about business combinations based on the acquisition method. A business combination applies if acquired assets and liabilities constitute a business. This can apply for subsidiaries, associated companies and joint ventures. E.g., if you only buy all buses of a travel service provider, this will not constitute a group, see IFRS 3.3. IFRS 10 covers consolidated financial statements. Consolidated financial statements are financial statements for groups. A group includes a parent and all its subsidiaries. In consolidated financial statements, the assets, liabilities, equity, income, expenses and cash flows of the parents and all subsidiaries are presented as those of a single economic entity. IFRS 11 regulates joint arrangements which mostly is a company controlled collectively by more than one investor (joint venture), or a joint operation. Joint control requires the existence of an agreement between the owners about jointly making decisions. IFRS 12 requires companies to disclose information about nature, risks and interest in other companies. It 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 busi- <?page no="179"?> Berkau: Financial Statements 5e 8-175 ness combination exists if one company dominates another one by taking over control. This often is linked to the rights of ownership. For Accounting, the percentage of control matters. Two threshold percentages are to be considered, 20 % and 50 %. Commonly, (1) < 20 % of control does not imply any impact on the (partly) owned company. The owner discloses the investment as financial instrument in line with IFRS 9 which is initially at cost and for subsequent measurement at fair values through profit or loss or through other comprehensive income. 50 (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 by 12 % in book value will increase in value on the balance sheet of its owner by 12 %, too. An owner of associate companies prepares separate financial statements in line with IAS 27. In detail, IAS 27.6 applies. (3) > 50% of control requires the preparation of group statements. Group statements are financial statements of the entire group which cover all subsidiaries of the group. This also includes subsidiaries of subsidiaries if multi-level group structures exist. 50 We cover these cases in chapter (7) and (9). 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 term control. Control refers to the power to govern the financial and operating policies of a company to obtain benefits from its activities (IFRS 10, appendix A). Criteria of control are defined by IFRS 10.7. In a multi-level group, a company can be a subsidiary and parent at the same time. The calculation of influence is based on control power. 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 for C 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 well. 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 already. IFRS 10.31 applies and rules that company B is an investment and evaluates its subsidiary C for separate financial statements following <?page no="180"?> Berkau: Financial Statements 5e 8-176 IFRS 9 initially at cost and later at fair values through profit or loss. We could say, in terms of the control hierarchy in the group the highest parent shields its lower investment companies from preparing extra group statements. Only the top parent prepares group statements and includes all companies below in terms of the control hierarchy. In Accounting slang this is referred to as the Christmas tree principle, because with a Christmas tree the upper branches protect lower ones against rain. The percentage replacement of 60 % towards full control (100 %) in the example 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 completely. The other one is considered as non-controlling interest holder therein. In terms of Group Accounting, control cannot be shared. For Group Accounting all subsidiaries are considered regardless of where they are domiciled (global consolidation principle). Hence, Group Accounting ignores geographical borders. Accounting rules apply based on the parent's jurisdiction. In this textbook we assume that all companies prepare single entity-financial statements and Group Accounting along IFRSs. Besides of hierarchical control relationships, there are joint ventures which are companies owned and controlled by more than one company collectively. Jointly control is mostly ruled by contracts, such as both investors must agree together. We cover those aspects at the end of the chapter. We discuss Group Accounting in three steps: (1) Separate financial statements. (2) Consolidated financial statements. (3) Joint Venture Accounting. Ad (1): Separate Financial Statements IAS 27 rules separate financial statements. Separate financial statements look similar to group statements. The major difference is that they do not follow the regulations of IFRS 10. Therefore, no consolidation is calculated nor recorded. This results in a measurement based on the portion a parent or investor is holding. Here comes a case for teaching separate financial statements. Data Sheet for BRENO Ltd. DDomicile: South Africa (Bloemfontein). Reporting currency: ZAR. Classification: n/ a. Investments: 36.5 % of SANBONA Ltd.; 9 % of SUURENBERG Ltd. Profits (EAT): BRENO Ltd.: 280,000.00 ZAR / SUURENBERG Ltd.: 34,000.00 ZAR / SABONA Ltd.: 24,000.00 ZAR. Dividends: 40 % / 25 % / 15 %. Share price SUURENBERG Ltd.: at acquisition 3.00 ZAR/ s, later increase 6 %. VAT ignored. <?page no="181"?> Berkau: Financial Statements 5e 8-177 BRENO Ltd. owns 36.5 % of SABONA Ltd. and 9 % of SUURENBERG Ltd. SABONA Ltd. is an associated company and the investment in SUURENBERG Ltd. is a financial asset. The characteristics for holding an associated company (SABONA Ltd.) are significance of influence 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 SABONA Ltd. as an associated company (investments) thereon. See below in Figure 8.1 the statement of financial position for BRENO Ltd. as at the beginning of the Accounting period 20X5. 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, IAS 28 applies for the valuation of the share in SABONA Ltd.; for the valuation of the financial instrument SUURENBERG Ltd., IFRS 9 is applicable. During the Accounting period 20X5, the three companies earn the below listed profits and make payments to their owners as disclosed there, as well. To keep the case study simple, we assume dividends are paid based on the annual surplus, hence, we pretend 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 and after revaluation of investments in associates and financial assets. - SUURENBERG Ltd.: profit after taxes 34,000.00 ZAR, dividend 25 % thereof. - SABONA Ltd.: profit after taxes: 24,000.00 ZAR, dividend 15 % thereof. The dividend receipts from investments are not yet included in the income statement and balance sheet of BRENO Ltd. No appropriation of profits has been considered so far. Observe BRENO Ltd.’s income statement as shown in Figure 8.2 below: <?page no="182"?> Berkau: Financial Statements 5e 8-178 [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) We assume dividends are paid during the Accounting period they are for. The shares on SUURENBERG Ltd. are 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 by BRENO Ltd., its share price per 1.00 ZAR/ s ordinary share was 3.00 ZAR/ s. BRENO Ltd. holds 9,000 shares. The costs of acquisition of the shares were: 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 cost 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 for SUURENBERG Ltd. 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%. Therefore, BRENO Ltd. increases the value of its shares, as well. 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. <?page no="183"?> Berkau: Financial Statements 5e 8-179 BRENO Ltd. records the dividend received as other comprehensive income. DR Cash/ Bank.................... 765.00 ZAR CR Other Comprehensive Income... 765.00 ZAR For the investment in the associated company SABONA Ltd., BRENO Ltd. applies the equity method following IAS 28.10. The equity method increases the measurement of an investment based on profits earned by the associated company reduced by dividends received therefrom. IAS 27.12 requires recording dividends through profit or loss unless the entity elects to use the equity method. SABONA Ltd. earned an annual surplus of 24,000.00 ZAR in 20X5. Linked to the total of equity, this is a portion of: 24,000 / (73,000/ 36.5%) = 1 12%. The denominator calculates the equity based on the disclosure on BRENO Ltd.'s balance sheet. We assume the share issue was par value. 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 debit 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 Regarding the dividend, IAS 27.12 requires deducting dividends from the value of the investment. Hence, the reduction for dividends from the associate’s valuation is amounting to: (12 % - 10.2%) × 73,000 = 1 1,314.00 ZAR. About the dividend, we can say it is a zero-sumgame as the associate’s value decreases to the same extent as dividend income is received through other comprehensive income. Therefore, based on the equity method, dividend payments do not matter to the investor. As BRENO Ltd. is a company based on shares, no dividend tax applies. We show the financial statements of BRENO Ltd. after the appropriation of profits in Figure 8.3 and Figure 8.4. The profit before taxes is 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 to shareholders and disclosed as short-term debt on the <?page no="184"?> Berkau: Financial Statements 5e 8-180 balance sheet. We assume the dividends are paid in 20X6 (simplification). 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 due to price fluctuations and the application of the equity method are prohibited for single-entity financial statements as the measurement includes unrealised profits. Profit only is considered as realised once the assets, here: the investments, have been sold. Then, the investment does not show on the balance sheet anymore. <?page no="185"?> Berkau: Financial Statements 5e 8-181 How it is Done: (Separate Financial Statements) (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. (3) Recognise financial assets at cost or at fair values through either profit or loss or through other comprehensive income based on IFRS 9. (4) Disclose investments in associates or joint ventures following Equity Accounting as laid out in IAS 28. (5) Record an investment in subsidiaries initially at costs and later at fair values through other comprehensive income. (6) Record dividends received from investments through either profit or loss or through other comprehensive income. (7) When applying the equity method, a dividend paid by the associate or joint venture reduces the investment’s valuation. Record a deduction of assets accordingly. Ad (2): Consolidated Financial Statements Consolidated financial statements are referred to as derived financial statements because groups do not keep Bookkeeping records. Group statements are based only on single-entity financial statements. This will give us some work regarding the preparation of subsequent group statements as we must keep up the initial consolidations. This technically means, we must repeat the initial capital consolidation every Accounting period. This is no problem once you apply Accounting software. In contrast to financial statements along IAS 27, Group Accounting considers consolidations. We start our discussion with explaining consolidations and prepare group statements thereafter for two case studies. For consolidated financial statements, all single-entity financial statements of the group members are “added-up” per item. The calculations require financial statements to be uniform regarding formal aspects. The same as the addition of fractions, e.g., 1/ 3 + 1/ 2 = 5/ 6, requires finding 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 following the Dutch Woertbook van Koophandel into IFRSs and has to transform assets measured in EURs to South African Rand ZAR figures. Only then, financial statements can be added. Addition means, we add every item separately, like: PPE Dutch + PPE SAn = PPE Group . <?page no="186"?> Berkau: Financial Statements 5e 8-182 Adding financial statements causes items to count double, such as the interest in the subsidiary and its assets. To avoid multiple considerations of items, consolidations eliminate intragroup balances, transactions, income and expenses. For our discussion of consolidations, we assume that all group companies follow the same standards, apply the same reporting currency, the same balance sheet date etc. Keep in mind, assuring conformity can cause a lot of Accounting work to be done for genuine 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 PORTERSVILLE Ltd. and its subsidiary HENDERSON Ltd. to learn about profit consolidations. Data Sheet for GAMKA/ SWARTBERG DDomicile: South Africa (Cape Town). Reporting currency: ZAR. Classification: n/ a. Investment: GAMKA Ltd. holds 80 % of SWARTBERG Ltd. Acquisition date: 1.01.20X4. Acquisition method applies. VAT ignored. On 1.01.20X4, GAMKA Ltd. buys 80 % of the ordinary shares of SWARTBERG Ltd. 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. and takes over control of SWARTBERG Ltd. By gaining control power, GAMKA Ltd. becomes the parent; SWARTBERG Ltd. is the subsidiary. GAMKA Ltd. and SWARTBERG Ltd. have both to prepare single-entity financial statements and financial statements for the group. The group statements contain a full set of financial 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 carry a legal form. This helps us to distinguish group statements from single-entity financial statements. A full set of financial statement comprises in general of a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of cash flows, a statement of changes in equity and the notes. IAS 1.10 applies for group statements, too. To determine the items on the GAMKA Group’s statement of financial position the Accountant adds all balance sheet items for the group companies. For recognition and measurement, fair values as on acquisition date apply (IFRS 3.18). E.g., PPE GAMKA + PPE SWARTBERG = 230,000 + 40,000 = 2 270,000.00 ZAR. 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 group assets. This results in a double recognition of the subsidiary. To “clear” Group Accounting <?page no="187"?> Berkau: Financial Statements 5e 8-183 from the above-mentioned double counting, the group records a capital consolidation by which the investment and the total subsidiary’s equity are cancelled out. In general, a consolidation is either a capital consolidation, a consolidation of receivables/ payables or a profit consolidation. All seek to eliminate double counting or effects of intergroup business transactions. A capital consolidation is a calculation that eliminates the investment in subsidiaries and their equity from group statements. As the subsidiary valuation is based on the acquisition method and equity valuations are based on nominal values, a difference might result which forms either a goodwill or a negative goodwill. If only a percentage of a subsidiary is acquired, the equity portion linked to ownership is cancelled out against the cost of acquisition. The equity portion that does not belong to the group is disclosed as non-controlling interest in the equity section of the group statement of financial position. 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 statement of profit or loss and other comprehensive income and the equity section of the group’s balance sheet. A profit consolidation can cause asset revaluations, when, e.g., one group member sells goods to another one and earns a profit thereby. The elimination of the inter-group profits requires evaluating the goods at the cost of acquisition of the seller within the group. So far, on the aggregated statements, they are still disclosed at cost of acquisition that occurred at the buyer. The goods stay group assets, but it is required to measure them at cost of acquisition at which they entered the group at first, that is when they were bought by the first group member. About consolidations, we distinguish initial consolidation and subsequent ones. An initial consolidation is recorded at acquisition date in general when the group is defined by the parent gaining control power over the subsidiary. Any subsequent consolidation is undertaken later and refers to the initial consolidation. Accountants call the calculations made “consolidation Bookkeeping entries” but no Bookkeeping entries are actually made, neither in the Bookkeeping records of the group nor of group members. Consider further that initial consolidation Bookkeeping entries are maintained. Hence, we must repeat the initial consolidation every year to carry them forward from Accounting period to Accounting period. An exception only applies when the group situation changes, e.g., by acquisition of a further share in a subsidiary. Consolidated financial statements do not affect payments. No company tax payments nor dividends depend on the group statements. The only purpose of Group Accounting is providing information. Below, we study consolidations for the GAMKA GROUP. The two group members provide the financial statements on 31.12.20X3 as below. This is before the acquisition date (1.01.20X4): <?page no="188"?> Berkau: Financial Statements 5e 8-184 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 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 names of the group members. You can observe the legal form disclosed on their headers. 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. Here comes the capital consolidation: When GAMKA Ltd. buys 80 % of SWARTBERG Ltd. on 1.01.20X4, its book value is: 50,000 + 28,000 = 7 78,000.00 ZAR. The book value of GAMKA Ltd.’s investment is 80 % thereof: 80% × (50,000 + 28,000) = 6 62,400.00 ZAR. <?page no="189"?> Berkau: Financial Statements 5e 8-185 GAMKA Ltd. pays the (previous) owners an amount of 65,000.00 EUR in exchange of 80 % of SWARTBERG Ltd.’s ordinary shares. This means, the payment exceeds the book value of the acquired share in the company. Because of the acquisition, the statement of financial position now discloses an investment at cost of 65,000.00 ZAR and a reduced item cash/ bank compared to the situation before the acquisition took place. The cash/ bank item now shows: 100,000 - 65,000 = 3 35,000.00 ZAR. GAMKA Ltd. bought the subsidiary at a price above its book value. The reason might be strategic intentions, e.g., regarding the present market position of SWARTBERG Ltd., or the acquirer expects a high potential of the business in the future etc. 51 GAMKA Ltd. makes the Bookkeeping entry below which indicates that the subsidiary is recorded at cost. See in Figure 8.7 the balance sheet for GAMKA Ltd. on 1.01.20X4 after the acquisition. DR Investment Subsidiary........ 65,000.00 ZAR CR Cash/ Bank.................... 65,000.00 ZAR A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 230,000 Share capital 300,000 Intangibles Reserves Investment 65,000 Retained earnings 70,000 Current assets Liabilities (liab.) Inventory 170,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 50,000 Prepaid expenses Provisions Cash/ Bank 35,000 Income tax liab. 30,000 Total assets 500,000 Total equity and liab. 500,000 Gamka Ltd.'s STATEMENT of FINANCIAL POSITION as at 1.01.20X4 Figure 8.7: GAMKA Ltd.’s balance sheet after acquisition On the single-entity financial statements, GAMKA Ltd.’s investment in the subsidiary is disclosed at cost of acquisition 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. 51 Read our Management Accounting, chapter (11). did not change by the transfer of ownership. It only shows now the balance sheet date 1.01.20X4 (balance sheet not disclosed). By the acquisition of 80 % of SWARTBERG Ltd., GAMKA Ltd. becomes the parent and SWARTBERG Ltd. the subsidiary. Both companies still prepare single-entity financial statements. <?page no="190"?> Berkau: Financial Statements 5e 8-186 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. 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 worksheet (1) The consolidation worksheet adds the single-entity financial statements for GAMKA Ltd. and SWARTBERG Ltd. per item. The sum is shown as aggregated balance sheet (AGGR) which is the group balance sheet before consolidations. E.g., the item for property, plant and equipment in the aggregated financial statements gives: 230,000 + 40,000 = 270,000.00 ZAR. By adding financial statements, the investment of 65,000.00 ZAR and all its assets are disclosed on the debit side. The book value of the acquired company is the total of its assets less its liabilities: 100,000 - (10,000 + 12,000) = 78,000.00 ZAR. This means SWARTBERG Ltd. now counts more than 180 % on the group statements. "More" refers to the goodwill not yet disclosed but included in the amount of 65,000.00 ZAR. 100% is the result of a full consolidation, even though only 80 % is the percentage of ownership. The multiple consideration of the subsidiary would give the user of the group statements misleading information. To avoid multiple consideration of subsidiaries a capital consolidation is recorded. The aim is to cancel out the investment and the partial book value of SWARTBERG Ltd. and to disclose the excess of payment as a goodwill. 80 % of SWARTBERG Ltd.’s value equals: 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. <?page no="191"?> Berkau: Financial Statements 5e 8-187 Observe the capital consolidation as shown in the next consolidation chart in Figure 8.9 under CAP.CONS. 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 worksheet (2) The capital consolidation procedure contains two steps. The first one eliminates the acquisition costs of the investment and its partial book value (issued capital and retained earnings) and discloses the goodwill: 2,600 + 40,000 + 22,400 = 6 65,000.00 ZAR. This one, we completed already. The second step allocates the portion of 20 % of the shares’ nominal value and retained earnings to the other owners of SWARTBERG Ltd. (not GAMKA Ltd.). We refer to them as non-controlling interest holders. The equity section of a consolidated balance sheet comes with an item called non-controlling interest. For the GAMKA Group, this item contains 20 % of the shares at nominal values and 20 % of the retained earnings at the time of acquisition. This gives: 20% × 50,000 = 10,000.00 ZAR and: 20% × 28,000 = 5,600.00 ZAR. These initial capital consolidation bookkeeping entries are maintained for subsequent consolidations. For subsequent consolidations, they must be repeated as the consolidation is based on single-entity financial statements which means that consolidation Bookkeeping entries are not saved. The consolidated statement of financial position for GAMKA GROUP is displayed in Figure 8.10. It is derived from the right column in the consolidation worksheet. <?page no="192"?> Berkau: Financial Statements 5e 8-188 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 1.01.20X4 Figure 8.10: Consolidated balance sheet For further considerations (subsequent consolidations), we combine the initial consolidation Bookkeeping entries 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 consolidated financial statements for GAMKA Ltd. and SWARTBERG Ltd. one year later: The companies disclose the income statements as below for the period ended on 31.12.20X4: <?page no="193"?> Berkau: Financial Statements 5e 8-189 [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 these explanations if happy with the given 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 - except of depreciation 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: 35,000 + 200,000 - 14,000 - 100,000 - <?page no="194"?> Berkau: Financial Statements 5e 8-190 30,000 = 9 91,000.00 ZAR. On the credit side, there is no change in issued capital and the earnings after tax are added to retained earnings: 70,000 + 42,000 = 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 31.12.20X4 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 without further explanation, you can skip this paragraph and continue reading at the *. The amount for property, plant, equipment on SWARTBERG Ltd.’s statement <?page no="195"?> Berkau: Financial Statements 5e 8-191 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. For the amount of cash/ bank, we assume that all business activities - depreciation exempted 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 = 3 38,000.00 ZAR. There are no changes in issued capital and the item retained earnings equals: 28,000 + 7,000 = 3 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 consolidation worksheet again. After we enter the figures for the single-entity balance sheets we will see the aggregated balance sheet already. On the consolidation worksheet, the initial consolidation bookkeeping entries are given. We apply the comprehensive Bookkeeping entry for capital consolidation as discussed above. Observe the consolidation worksheet 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 worksheet (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. No inter-group profits apply. The profit of the subsidiary equals 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 <?page no="196"?> Berkau: Financial Statements 5e 8-192 holders. Hence, we allocate: 80% × 7,000 = 5 5,600.00 ZAR to the group and: 7,000 - 5,600 = 1 1,400.00 ZAR to the noncontrolling 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 consolidations 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 worksheet and the resulting consolidated balance sheet in Figure 8.17 and Figure 8.18. <?page no="197"?> Berkau: Financial Statements 5e 8-193 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 worksheet (20X4.2) A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 244,000 Share capital 300,000 Intangibles Reserves Investment Retained earnings 117,600 Goodwill 2,600 Non-ctrl interest 17,000 Current assets Liabilities (liab.) Inventory 190,000 Long-term liab. 50,000 Accounts receivables Short-term liab. A/ P 60,000 Prepaid expenses Provisions Cash/ Bank 129,000 Income tax liab. 21,000 Total assets 565,600 Total equity and liab. 565,600 GAMKA GROUP'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 for the group companies are just added. See the result in Figure 8.19. <?page no="198"?> Berkau: Financial Statements 5e 8-194 [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 for the profit distribution between controlling interest and non-controlling interest holders. See below the statement of changes in equity for the group as at 31.12.20X4 in Figure 8.20. 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: We assume that all activities are on cash - depreciation exempted. We prepare the statement of cash flows for the group based on the reconciliation method as explained in detail in chapter (10). The cash flow calculation for this case is easy. <?page no="199"?> Berkau: Financial Statements 5e 8-195 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 the aggregated cash flows as we can derive from the single balance sheets 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. A company is included to consolidated financial statements once the parent executes the control power. (3) Copy single-entity financial statements for preparation of Group Accounting. Make adjustments in the copies of the financial statements about the reporting currency, the reporting balance sheet date etc. Make further adjustments to align the copies with IFRSs if they have been prepared following other GAAPs. (This can result in massive Accounting work! ) (4) Add all financial statements per item. Call the resulting financial statement the aggregated financial statements. Best apply a consolidation worksheet as provided by the file CH5.xls in academia or use Bookkeeping software for real Accounting work. <?page no="200"?> Berkau: Financial Statements 5e 8-196 (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 profits and make adjustments to assets dependent on inner-group profits, e.g., regarding the measurement of goods that have been traded between group members. Enter the consolidation Bookkeeping entries in the consolidation worksheet. (7) Run a consolidation of receivables/ payables. Cancel out any intra-group receivables and liabilities. 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 (right column). Below, we discuss a profit consolidation and its impact on the valuation of inventories as well as dividend effects on group statements. For this, we introduce another case study which is PORTERSVILLE Ltd. buying 80 % of its supplier HENDERSON Ltd. HENDERSON Ltd. is a trading business. All shares of PORTERSVILLE Ltd. as well as of HENDERSON Ltd. have a face value of 1.00 AUD/ s. Data Sheet for PORTERSVILLE/ HENDERSON DDomicile: Australia (Sydney). Reporting currency: AUD. Classification: n/ a. Investment: PORTERSVILLE Ltd. holds 80 % of HENDERSON Ltd. Acquisition date: 3.01.20X2, acquisition costs 520,000.00 AUD for 400,000 ordinary shares. Book value of HENDERSON Ltd. at that time: 600,000.00 AUD. Acquisition method applies. Actual Accounting period: 20X5 Dividend at HENDERSON Ltd.: 0.15 AUD/ s. Inventories at PORTERSVILLE Ltd.: goods for 100,000.00 AUD bought from HENDERSON Ltd. Cost of acquisition at HENDERSON Ltd.: 65,000.00 AUD. VAT ignored. On 3.01.20X2, PORTERSVILLE Ltd. bought its share in HENDERSON Ltd. when its retained earnings were 100,000.00 AUD. No reserves were disclosed on the HENDERSON Ltd.’s balance sheet at that time. Find below the balance sheets of both companies as at 31.12.20X5 - three years later. PORTERSVILLE Ltd.'s stock inventories include goods for 100,000.00 AUD, bought from HENDERSON Ltd. HENDERSON Ltd. bought the goods itself for 65,000.00 AUD from a supplier. <?page no="201"?> Berkau: Financial Statements 5e 8-197 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. 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: <?page no="202"?> Berkau: Financial Statements 5e 8-198 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 The capital consolidation remains unchanged. Therefore, 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. This results from the appropriation of profits in the year of acquisition. 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) 100,000 (500,000) Retained ear. (700,000) (210,000) (910,000) (910,000) 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 at a 4 : 1 ratio which gives 160,000 : 40,000. We transfer the <?page no="203"?> Berkau: Financial Statements 5e 8-199 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. 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 was correctly disclosed on the single-entity financial statements. PORTERSVILLE Ltd. bought the goods at 100,000.00 AUD from HENDERSON Ltd. and discloses them at cost. Although, the group statements must consider the asset valuation at cost of acquisition of the group which is the purchase costs for HENDERSON Ltd., 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 recorded by HENDERSON Ltd. is an unrealised profit from the point of view of Group Accounting. The goods have been sold within the group. Hence, we have to deduct HENDERSON Ltd.’s profit in the Retained Earnings account as well as in the Income Tax Liabilities account by a total of 35,000.00 AUD. This gives: 35,000 × (1 - 30%) = 2 24,500.00 AUD deductions for retained earnings and: 35,000 × 30% = 1 10,500.00 AUD for income taxes. Although, Group Accounting has no impact on taxation we record a deduction of income tax liabilities. Find below the next consolidation step for the PORTERSVILLE Group in Figure 8.26. <?page no="204"?> Berkau: Financial Statements 5e 8-200 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 on consolidated financial statements. The other portion of: 75,000 - 60,000 = 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 pretend the dividend is paid in 20X5 already to simplify the case study. We also consider how much of the retained earnings is left as a profit carried forward towards 20X6 and allocate a 20 % portion thereof towards the non-controlling interest holders. The retained earnings of HENDERSON Ltd. were 210,000.00 AUD on the singleentity-balance sheet. We deducted 24,500.00 AUD for intra-group profits and another 75,000.00 AUD for dividends. Hence, the remaining retained earnings are: 210,000 - 24,500 - 75,000 = 1 110,500.00 AUD. A 20 % portion of this amount is assigned to the non-controlling interest holders. It results in a transfer of: 110,500 × 20% = 2 22,100.00 AUD to the equity item non-controlling interest holders. See below in Figure 8.27 the last column filled in the consolidation worksheet for the PORTERSVILLE Group and in Figure 8.28 the consolidated balance sheet. <?page no="205"?> Berkau: Financial Statements 5e 8-201 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 agreement where 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. The IASB distinguishes between joint operations and joint ventures and instructs the investor per IFRS 11.14 to <?page no="206"?> Berkau: Financial Statements 5e 8-202 determine the type of joint arrangement. In line with IFRS 11.15, a joint operation is a joint arrangement 52 where the controlling parties keep the rights on their own assets and an obligation for their own liabilities. The companies share profit and costs proportionally to their holdings. No new company is established. In line with IFRS 11.16, a joint venture is a joint arrangement where the controlling parties have the rights to the assets of the joint arrangement. This normally leads to the establishment of a limited company which is accounted for based on Equity Accounting on the financial statements of the investors. Based on IFRS 11.20 and IFRS 11.24, a joint operator recognises proportionate to its interest its assets, liabilities, profits, gain portions and expenses. A joint venturer recognises its arrangement as investment. Below, we demonstrate both kinds of joint arrangements based on comparable case studies: (1) Joint operation. (2) Joint venture. Ad (1): Joint Operations On 1.01.20X7, the security firms QUICKARMS Ltd. and RESPONSE (Pty) Ltd. decide to run a suburb patrol service together. There is a third partner involved: FIRE Ltd. which contributes 10 %. 52 The expression arrangement is very abstract. You rather think of a joint project, even as some characteristics of Project Management are not met. Data Sheet for QUICKARMS- RESONSE-FIRE operations DDomicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Security Service. Partners: QUICKARMS Ltd., RESPONSE (Pty) Ltd., FIRE Ltd. Portions: 45 % / 45 % / 10 %. Assets all together: 150,000.00 ZAR. Joint revenue: 700,000.00 ZAR. Joint costs: materials: 80,000.00 ZAR; labour: 500,000.00 ZAR. VAT ignored. The contract states that only unanimous decisions of the three parties can be made. Therefore, FIRE Ltd. can block a motion even with its 10 % of holding. In a joint arrangement every partner can execute a veto control. The joint arrangement about the joint patrol service is classified as joint operation following IFRS 11.15. The investors have joint responsibility for deployed assets and for the liabilities. In their financial statements, QUICKARMS Ltd., RESPONSE (Pty) Ltd. as well as FIRE Ltd. consider the assets (cars, weapons) for the joint patrol service to the extent of 150,000.00 ZAR as asset portions calculated proportionate to their holdings: QUICKARMS Ltd. and RESPONSE (Pty) Ltd. to an extend of 45 % each and FIRE Ltd. of 10 %. Hence, e.g. QUICKARMS Ltd. discloses: 45% × 150,000 = 6 67,500.00 ZAR of the deployed assets. The partners pay for the acquisition of joint assets based on their share. The disclosure requirements based on IFRS 11.20 apply. Depreciation applies based on straight-line method over three years. <?page no="207"?> Berkau: Financial Statements 5e 8-203 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 on the share in profits 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. They equal: 45 % × 150,000 = 6 67,500.00 ZAR. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 300,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 67,500 Retained earnings Current assets Liabilities (liab.) Inventory Long-term liab. 115,000 Accounts receivables Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 247,500 Income tax liab. Total assets 615,000 Total equity and liab. 615,000 QuickArms Ltd.'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, all are paid on cash. The profit of the joint patrol service is: 700,000 - 80,000 - 500,000 = 120,000.00 ZAR. At the end of the Accounting period 20X7, QUICKARMS Ltd. is entitled to receive a profit share of: 45% × 120,000 = 54,000.00 EUR from its partner RESPONSE (Pty) Ltd. QUICKARMS Ltd. 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. As QUICKARMS Ltd. discloses a portion of the joint assets on its financial statements, it must depreciate them itself. For our calculations, we start with the income statement of QUICKARMS Ltd. It does not include any items 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. It is shown in Figure 8.31. <?page no="208"?> Berkau: Financial Statements 5e 8-204 [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 QuickArms Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 8.30: QUICKARMS Ltd.’s income statement A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 67,500 Retained earnings 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: QUICKARMS Ltd.’s balance sheet (20X7) For QUICKARMS Ltd.’s financial statements, we consider the share in profit of the joint patrol service as receivables. We further add the depreciation on the assets for the joint patrol service to the expenses. We process the Bookkeeping entries as below for the profit share of 54,00.00 ZAR and for the depreciation on the deployed assets to the extent of: 22,500.00 ZAR: DR Depreciation................. 22,500.00 ZAR CR Acc. Depr. (joint)........... 22,500.00 ZAR <?page no="209"?> Berkau: Financial Statements 5e 8-205 DR Receivables.................. 54,000.00 ZAR CR Other Comprehensive Income... 54,000.00 ZAR After recording the above Bookkeeping entries and considering an income tax increase of: (54,000 - 22,500) × 30% = 9 9,450.00 ZAR, the financial statements look as below: [ZAR] Revenue 1,300,000 Other income (joint) 54,000 1,354,000 Materials (35,000) Labour (700,000) Depreciation (50,000) Depreciation (joint) (22,500) Other expenses (43,000) Earnings before int. & taxes (EBIT) 503,500 Interest Earnings before taxes (EBT) 503,500 Income tax expenses (151,050) Deferred taxes Earnings after taxes (EAT) 352,450 QuickArms Ltd.'s STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 8.32: QUICKARMS Ltd.’s income statement A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000 Share capital 400,000 Intangibles Reserves 100,000 Share in joint assets 45,000 Retained earnings 552,450 Current assets Liabilities (liab.) Inventory Long-term liab. 115,000 Accounts receivables 54,000 Short-term liab. A/ P Prepaid expenses Provisions Cash/ Bank 969,500 Income tax liab. 151,050 Total assets 1,318,500 Total equity and liab. 1,318,500 QuickArms Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.33: QUICKARMS Ltd.’s balance sheet (20X7) <?page no="210"?> Berkau: Financial Statements 5e 8-206 How it is Done: (Accounting for Joint Operations) (1) Mark assets assigned for the joint operations on the balance sheet for extra disclosure. (2) Calculate the profit of the joint operations before taxation. (3) Transfer the pre-tax profit to the other joint operator(s) or receive it from the other joint operator(s) and consider it as other comprehensive income. (4) Consider depreciation and other expenses linked to joint operations separately on the income statement. (5) Prepare single-entity financial statements. The case study is repeated below for the joint arrangement classified as joint venture. This requires the establishment of a new company CLOSE- WATCH (Pty) Ltd. The content of the case study below is slightly different to the previous one. It is not intended to compare the figures to evaluate joint arrangement forms. We only demonstrate the Accounting work and do not consider tax or legal aspects. 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 partly disclose the joint venture on the balance sheet of the investor’s financial statement as investment. Data Sheet for CLOSE-WATCH (Pty) Ltd. DDomicile: South Africa (Johannesburg). Reporting currency: ZAR. Classification: Security Service. Established: 1.01.20X7. Owners: QUICKARMS Ltd., RESPONSE (Pty) Ltd., FIRE Ltd. Share: 45 % / 45 % / 10 %. Issued capital: 200,000.00 ZAR. Lending 25,000.00 ZAR from QUICKARM Ltd. Property, Plant, Equipment: 150,000.00 ZAR. Revenue: 700,000.00 ZAR. Materials: 80,000.00 ZAR; labour: 500,000.00 ZAR. VAT ignored. Find below the balance sheet of CLOSE- WATCH (Pty) Ltd. in Figure 8.34. 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 borrows from QUICKARMS Ltd. 25,000.00 ZAR. <?page no="211"?> Berkau: Financial Statements 5e 8-207 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 of 49,000.00 ZAR after taxes. No dividend has been declared. The short-term liabilities of 25,000.00 ZAR have been repaid by then. [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 <?page no="212"?> Berkau: Financial Statements 5e 8-208 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: 45% × 200,000 = 9 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 share in the joint venture at cost based on the equity method. 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. Therein, the receivables are disclosed, too. 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 QuickArms / Close-Watch JOINT VENTURE SEPARATE STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 8.37: QUICKARMS/ CLOSE-WATCH (JV)’s balance sheet (IAS 27) At the end of the Accounting period 20X7, the value of CLOSE-WATCH (Pty) Ltd. increased by: (249,000 - 200,000) / 200,000 = 2 24.5%. As no dividend has been declared by CLOSE-WATCH (Pty) Ltd., the investments on the balance sheet at QUICKARM Ltd. and RESPONSE (Pty) Ltd. increase by 24.5 %, too. The <?page no="213"?> Berkau: Financial Statements 5e 8-209 new valuation is: (1 + 24.5%) × 90,000 = 1112,050.00 ZAR. The contra entry for the increase in valuation is made in the Investment Income account. Below, the balance sheet for the joint venturer QUICKARMS Ltd. is displayed in Figure 8.38 as separate financial statement. The profit and loss calculation as reported in Figure 8.30 without consideration of the joint venture applies and got adjusted for the investment income to disclose separate financial statements. A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 250,000.00 Share capital 400,000.00 Intangibles Reserves 100,000.00 Investment (joint) 112,050.00 Retained earnings 352,450.00 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 Quickarms / Close-Watch JOINT VENTURE SEPARATE STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 8.38: QUICKARM/ CLOSE-WATCH joint venture balance sheet As no indication for an increase in valuation exists for the financial asset at FIRE Ltd., the valuation stays at 20,000.00 ZAR. Note, due to the application of the equity method based on IAS 28.10, the borrowing between the joint venture and one of its investors has no impact on the valuation: no consolidation applies. How it is Done: (Joint Venture Accounting) (1) Prepare financial statements for the joint venture and the joint venturers. Check whether the joint venture is a financial asset or requires Equity Accounting. (2a) If the joint venture is recorded as financial asset, apply valuation at cost or subsequently at fair values through profit or loss or through other comprehensive income. (2b) If the joint venture requires Equity Accounting, check whether separate financial statements are required. (3a) If the separate financial statements are initially required, recognise the joint venture proportionally and at costs. <?page no="214"?> Berkau: Financial Statements 5e 8-210 (3b) If the separate financial statements are subsequently required, recognise the joint venture proportionally based on the equity method. (4b) Record dividends received through profit or loss or through other comprehensive income. Deduct dividends paid from the valuation of the joint venture. (5) Prepare separate financial statements for the 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 actively in the public capital market. Accounting Technical Terms: Acquisition method: Method of Group Accounting. The items of the acquired company are valued as at the time of gaining ownership. Associated company: An associated company is a company the investor holds between 20 and 50 % from. A significance of influence is characteristic. Capital consolidation: A calculation that cancels out the double counting of the acquisition of a subsidiary. Consolidated financial statements: Statements of a group in which items are shown as those of a single entity. Control: Power to determine the strategy and operating decisions of another company. To exercise control power over another company, ownership is assumed to exceed 50 %. Equity Method: Measurement of associates and joint ventures based on the changes of the book value. IAS 28.10 rules the equity method. Group Accounting: Preparation of financial statements for business combinations. Joint arrangements: Joint operations or joint ventures. Profit consolidation: Cancelation of intra-group profits and adjustment of valuations for assets linked thereto. Separate financial statements: Statements prepared by a parent/ investor that show the proportionate share in subsidiaries, associates and joint operations based on IAS 27. Question Bank: (1) A Ltd. buys 210 shares of B Ltd. which is based on 300 shares at 10.00 EUR/ s. At the time of acqui- <?page no="215"?> Berkau: Financial Statements 5e 8-211 sition, the Retained Earnings Account at B Ltd. is 1,000.00 EUR. The costs of the investment are 2,900.00 EUR. How much is the goodwill? 1. Nil. 2. 100.00 EUR. 3. 200.00 EUR. 4. (120.00 EUR). (2) L Ltd. buys 550 shares of S Ltd. which is based on 1,000 shares at 5.00 EUR/ s. At the time of acquisition, the Retained Earnings account is 1,500.00 EUR. At the beginning of the fiscal year, the opening balance for S Ltd.’s Retained Earnings account is 5,000.00 EUR. How much is the non-controlling interest disclosed on the consolidated balance sheet? 1. 5,175.00 EUR. 2. 5,000.00 EUR. 3. 6,325.00 EUR. 4. 4,500.00 EUR. (3) Which statement is correct? 1. An investment in an associate is one that is below 20 % of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 28. 2. An investment in an associate is one that is more than 20 % of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 28. 3. An investment in an associate is one that is more than 20% of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 27. 4. An investment in an associate is one that is more than 25% of ownership and is initially disclosed at cost. The subsequent valuation is based on the equity method along IAS 27. (4) On 1.01.20X2, Y Ltd. buys 50 shares of C Ltd. which is based on 200 ordinary shares at 10.00 EUR/ s. The total costs of acquisition are 500.00 EUR. At the time of acquisition, the Retained Earnings account of C Ltd. is zero balanced. On 31.12.20X7, the closing balance of Y Ltd.’s Retained Earnings account is 2,000.00 EUR and C Ltd.’s one equals 1,000.00 EUR. What is the disclosure of the investment in C Ltd. on Y Ltd.’s single entity statement of financial position? 1. 1,250.00 EUR. 2. 1,000.00 EUR. 3. 750.00 EUR. 4. 500.00 EUR. (5) On 1.01.20X2, A (Pty) Ltd. buys 60 % of the shares of P Ltd. The opening balance of P Ltd.’s Retained Earnings account is 1,000.00 EUR. The subsidiary declares a dividend of 600.00 EUR. The closing balance of the Retained Earnings account (after appropriation of profits) is 1,500.00 EUR on the single entity financial statements. How much is the increase of P Ltd.’s equity due to profit/ dividend on the consolidated financial statements (non-controlling portion)? 1. 660.00 EUR. 2. 200.00 EUR. 3. 360.00 EUR. 4. 900.00 EUR. Solutions: 1-2, 2-4, 3-2, 4-3, 5-2. <?page no="216"?> Berkau: Financial Statements 5e 9-212 9. Current Assets on the Balance Sheet What is in the chapter? Following 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 finished goods we introduce Manufacturing Accounting 53 for the calculation of finished goods. We focus on the perpetual system for inventory movements but also show differences to the period system as known from chapter (4). As financial instruments can be held short-term this chapter also considers their recognition and measurement, such as receivables and securities. Thus, we continue here the discussion about financial instruments started in chapter (7). Learning Objectives: In this chapter you get an insight of the recognition and measurement of short-term assets as ruled by IAS 2. You also get familiarised with the calculation of finished goods applying Work-in-Process Accounts and the Manufacturing Overheads Accounts. You further learn Accounting for receivables and securities. After studying the chapter (9), you are fit to disclose 53 Read for Manufacturing Accounting our Basics, chapter (25) and regarding Job Order Costing and evaluate current assets following IAS 2 and financial instruments based on IFRS 9. Current assets are disclosed separately from long-term ones based on IAS 1.60 except when a reporting company prepares financial statements following liquidity aspects. IAS 1.61 states that items should be classified 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, merchandise goods, or cash/ bank. All other items are classified as non-current. The above classification is not strict for every single item of inventory but applies in general. E.g., a production firm that manufactures gear boxes and has one finished gear box that has been produced based on a customer’s specifications on stock for 2 years does not change its classification towards noncurrent assets. For the gear box, the general classification as inventory stays: The minimum of inventory turnover is assumed to be 1/ 365d. As companies intend to keep inventories for a shorter period 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 irrecoverable. They are allocated and Process Costing: Basics-2, chapter (18), (19). <?page no="217"?> Berkau: Financial Statements 5e 9-213 against expense accounts; the Bad Debts account applies. It is closed-off to profit or loss at year-ends as part of adjustments. Current assets on the balance sheet are: (1) Inventories. (2) Receivables. (3) Securities. (4) Prepaid expenses. (5) Cash/ bank. Ad (1): Inventories IAS 2.6 defines inventories: They are assets a company trades with or assets needed for its operations, e.g., for production or service rendering. They can be high in values, such as in the retailing industry or in production firms. In contrast, service rendering companies, such as consultancies, law firms or software developers, carry only low levels of stock. Our considerations start-off with the case of the South African trading company GREENACRES Ltd. For retailers, inventories are merely merchandise goods purchased and later sold on to their customers. The case study GREENACRES Ltd. explains the difference between two alternative inventory systems 54 , the periodic and the perpetual system. We explain the Bookkeeping entries for both systems by the same example. At first, we explain the already known periodic system followed by the application of the perpetual system for the same case. For retailers, like GREENACRES Ltd., the Trading account applies for 54 Read our Basics, chapter (26). gross profit calculation. Accounting for inventories depends on the inventory system in use. With a periodic inventory system in use, a company must take stock once per Accounting period, in general on 31.12.20XX. Additions to inventories are recorded in the Purchase account. No Bookkeeping entries for stock releases are processed. A company only determines its consumption of inventories when stock has been taken. Nowadays, a periodic system for inventory movements applies seldom and only when inventory values are low. The problem is that a company only knows its stock levels on balance sheet dates. In contrast, a perpetual inventory system records both: inputs and outputs of stock. Hence, a company knows its amounts of inventories at any time. No matter what inventory system is used, the valuation of inventory is always based on cost of purchase. The costs of purchase are defined by IAS 2.11 and comprises of the net price less trade discounts and rebates. Also, attributable costs, such as for transportation 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 for valuation is strict, which means there is no choosing: Once the value decreases, the lower amount will <?page no="218"?> Berkau: Financial Statements 5e 9-214 apply. In cases of an increase in valuation (after purchase) the purchase price is always the highest possible amount. No revaluations, like for noncurrent assets, apply. This is defined by IAS 2.9 as the paragraph only allows a valuation at the lower of costs and net realisable values. 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. IAS 2.6 defines the net realisable value. Commonly, we can say it is the fair value of inventories which is defined by IFRS 13.6 as the price that would been received when selling the asset in an orderly transaction. Writing down inventories from costs to net realisable values measures inventory never above what can be obtained from sale or use (IAS 2.28). The case study GREENACRES Ltd. is about a company dealing with lamps. See below the data sheet for the case study: Data sheet for GREENACRES Ltd. DDomicile: South Africa (Port Elizabeth). Reporting currency: ZAR. Classification: Retailer. Opening value: 168,000.00 ZAR; Purchase 120,000.00 ZAR; unit costs: 1,200.00 ZAR/ u; net selling price: 2,000.00 ZAR/ u. Sales amount: 800 units (400 + 250 + 150). VAT ignored. GREENACRES Ltd. discloses an opening value of inventories 168,000.00 ZAR which is 140 lamps at 1,200.00 ZAR/ u on stock 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 of purchase. The prices for the lamps are constant in this case study. 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 sales if the periodic system applies. At the end of the Accounting period 20X5, GREENACRES Ltd. takes stock of its lamps, which equals: 340 × 1,200 = 408,000.00 ZAR. Only at the end of Accounting period 20X5, GREENACRES Ltd. records the closing stock with reference (3-digit-code for the contra account: T/ A) to the Trading account as <?page no="219"?> Berkau: Financial Statements 5e 9-215 Bookkeeping entry (3). The valuation of closing stock is based on 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 D C D C (1) 1,200,000.00 T/ A 1,200,000.00 (1) 240,000.00 (2) 320,000.00 c/ d 80,000.00 320,000.00 320,000.00 b/ d 80,000.00 Purchase-20X5 PUR Value added tax VAT D C D C T/ A 1,600,000.00 (2) 1,600,000.00 INV 168,000.00 REV 1,600,000.00 PUR 1,200,000.00 (3) 408,000.00 GP 640,000.00 2,008,000.00 2,008,000.00 b/ d 640,000.00 Revenue-20X5 REV Trading account-20X5 T/ A Figure 9.1: GREENACRES Ltd.’s accounts (periodic system) Next, 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 for tracking their stock movements and checking inventory levels. Logistics uses inventory levels for supporting 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. a bit for the application of a perpetual system for inventory movements. The alteration is about the sales amounts: Instead of one single sale we now consider three separate sales that add up to the same amount as in the previous case. <?page no="220"?> Berkau: Financial Statements 5e 9-216 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) making the debit entry in the Inventory account directly. DR Purchase..................... 1,200,000.00 ZAR DR VAT.......................... 240,000.00 ZAR CR Cash/ Bank.................... 1,440,000.00 ZAR DR Inventories.................. 1,200,000.00 ZAR CR Purchase..................... 1,200,000.00 ZAR In contrast to the previous scenario, revenue is now earned by three single sales, at 400 lamps, at 250 lamps and at 150 lamps. All lamps are sold at a net selling price of 2,000.00 ZAR/ u. The total amount of lamps sold is again: 400 + 250 + 150 = 8 800 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 from too many entries for the 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 would require expense recognition in the period the value changes, 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 <?page no="221"?> Berkau: Financial Statements 5e 9-217 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 = 5 588,000.00 ZAR. GREENACRES Ltd. does not have to take stock anymore, as the Accounting system knows the inventory levels already. Study the accounts at 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 one for stock movements based on inventory valuation at either cost of purchase or if lower: at net realisable values. D C D C OV 168,000.00 (D 1 ) 480,000.00 OV . . . (A) 1,440,000.00 (B) 1,200,000.00 (D 2 ) 300,000.00 (C 1 ) 960,000.00 (D 3 ) 180,000.00 (C 2 ) 600,000.00 c/ d 408,000.00 (C 3 ) 360,000.00 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 (A) 240,000.00 (C 1 ) 160,000.00 (C 2 ) 100,000.00 c/ d 80,000.00 (C 3 ) 60,000.00 320,000.00 320,000.00 b/ d 80,000.00 Purchase-20X5 PUR Value added tax VAT D C D C T/ A 1,600,000.00 (C 1 ) 800,000.00 (D 1 ) 480,000.00 T/ A 960,000.00 (C 2 ) 500,000.00 (D 2 ) 300,000.00 (C 3 ) 300,000.00 (D 3 ) 180,000.00 1,600,000.00 1,600,000.00 960,000.00 960,000.00 Revenue-20X5 REV Cost of goods sold-20X5 COS Figure 9.2: GREENACRES Ltd.’s accounts (perpetual system) <?page no="222"?> Berkau: Financial Statements 5e 9-218 D C COS 960,000.00 REV 1,600,000.00 GP 640,000.00 1,600,000.00 1,600,000.00 b/ d 640,000.00 Trading account-20X5 T/ A Figure 9.2: GREENACRES Ltd.'s accounts (perpetual system) continued How it is Done: (Recording Under a Perpetual Inventory System) (1) Record purchases in a Purchase account and transfer them into the Inventory account. As an alternative, add purchases straight to the Inventory account. It is recommended running separate Inventory accounts for different kind of inventories to avoid stock mixing. Consider input-VAT. (2) When selling goods, make entries for the revenue based on the selling price. Consider output-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 or net realisable values. (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 amounts 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: (1a) Different purchase prices apply. (1b) Loss in valuation: Inventory valuation can change whilst goods are on stock, such as loss caused by deterioration, damage etc. Ad (1a): Purchase Price Change. A change to purchase prices does not affect Accounting significantly as the principle of specific identification applies. Following 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 <?page no="223"?> Berkau: Financial Statements 5e 9-219 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 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 (i), it applies first-in-first-out formula, later (ii), we repeat the ROSEFIELD Ltd. case study and apply the weighted average cost formula. FIFO comes first: First-in-First-out - Case (i): ROSEFIELD Ltd. is a dealership for drones in Melbourne. Find below its data sheet. Data Sheet for ROSEFIELD Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: Retailer. Opening value: zero. Purchases: see Figure 9.3. Sales: I-VI/ 20X0: 100 × Drone-400s; VII- XII/ 20X0: 148 × Drone-400s; 126 × Drone-500s. Net selling prices: Drone-400: 200.00 AUD/ u; Drone-500: 350.00 AUD/ u. VAT ignored. ROSEFIELD Ltd. buys its drones from an Australian supplier at different purchase prices. As drone types 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. Date Item Amount Purchase price [AUD] 5.01.20X0 Drone-400 80 120.00 5.01.20X0 Drone-500 50 200.00 1.04.20X0 Drone-400 100 125.00 1.04.20X0 Drone-500 100 210.00 1.07.20X0 Drone-400 75 130.00 1.07.20X0 Drone-500 100 215.00 1.10.20X0 Drone-400 100 130.00 Rosefield Ltd.'s PURCHASE LEDGER for the period ended 31.12.20X0 Figure 9.3: ROSEFIELD Ltd.’s purchases At the beginning of the Accounting period 20X0, no drones are on stock. During the Accounting period 20X0, ROSEFIELD Ltd. sells 100 Drone-400s in the first half of the year and another 148 <?page no="224"?> Berkau: Financial Statements 5e 9-220 Drone-400s in the second half of the year; all at a net selling price of 200.00 AUD/ 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 AUD/ u. To keep the case simple, we assume all sales take place either 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 AUD/ u. The revenue thereof is amounting to: 100 × 200 = 2 20,000.00 AUD. ROSEFIELD Ltd. records the sale of drones as below by Bookkeeping entries (8) and (9i) on 30.06.20X0: DR Cash/ Bank.................... 24,000.00 AUD CR VAT.......................... 4,000.00 AUD CR Revenue...................... 20,000.00 AUD DR Cost of Goods Sold........... 12,100.00 AUD CR Inventories (D-400).......... 12,100.00 AUD In the second half of the Accounting period 20X0, ROSEFIELD Ltd. sells 148 Drone-400s at 200.00 AUD/ u which results in a revenue of: 148 × 200 = 29,600.00 AUD. The cost of goods sold are amounting to: (100 - 20) × 125 + (148 - 80) × 130 = 1 18,840.00 AUD. Observe Bookkeeping entries (10) and (11i) which ROSEFIELD Ltd. recorded on 31.12.20X0. 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 (13i) recorded both on 31.12.20X0. DR Cash/ Bank.................... 52,920.00 AUD CR VAT.......................... 8,820.00 AUD CR Revenue...................... 44,100.00 AUD DR Cost of Goods Sold........... 25,960.00 AUD CR Inventories (D-500).......... 25,960.00 AUD <?page no="225"?> Berkau: Financial Statements 5e 9-221 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) 9,750.00 (6) 21,500.00 c/ d 26,540.00 (7) 13,000.00 c/ d 13,910.00 52,500.00 52,500.00 44,850.00 44,850.00 b/ d 26,540.00 b/ d 13,910.00 Drones-400 INV Drones-500 INV D C D C (1) 1,920.00 (8) 4,000.00 (8) 24,000.00 (1) 11,520.00 (2) 2,000.00 (10) 5,920.00 (10) 35,520.00 (2) 12,000.00 (3) 2,500.00 (12) 8,820.00 (12) 52,920.00 (3) 15,000.00 (4) 4,200.00 (4) 25,200.00 (5) 1,950.00 (5) 11,700.00 (6) 4,300.00 (6) 25,800.00 (7) 2,600.00 c/ d 730.00 c/ d 4,380.00 (7) 15,600.00 19,470.00 19,470.00 116,820.00 116,820.00 b/ d 730.00 b/ d 4,380.00 Value added tax VAT Cash/ Bank C/ B D C D C (8) 20,000.00 (9i) 12,100.00 (10) 29,600.00 (11i) 18,840.00 c/ d 93,700.00 (12) 44,100.00 (13i) 25,960.00 c/ d 56,900.00 93,700.00 93,700.00 56,900.00 56,900.00 T/ A 93,700.00 b/ d 93,700.00 b/ d 56,900.00 T/ A 56,900.00 Revenue-20X0 REV Cost of goods sold-20X0 COS D C COS 56,900.00 REV 93,700.00 GP 36,800.00 93,700.00 93,700.00 b/ d 36,800.00 Trading account-20X0 T/ A Figure 9.4: ROSEFIELD Ltd.’s accounts (i: FIFO) Weighted Average - Case (ii): In case the company applies the weighted average method, it must calculate for every stock release the average value of drones under consideration of the actual amounts. Therefore, 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 kinds of drones and apply a perpetual inventory system. <?page no="226"?> Berkau: Financial Statements 5e 9-222 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. now must calculate the weighted average costs of the Drone-400s on the 30.06.20X0: (80 × 120 + 100 × 125) / 180 = 1122.78 AUD/ u. Hence, the inventory movement is amounting to: 100 × 122.78 = 1 12,278.00 AUD. The exact amount is 12,277.78 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. The exact amount is 18,904.44 AUD. Observe the Bookkeeping entry (11ii) below: DR Cost of Goods Sold .......... 18,904.04 AUD CR Inventories (D-400).......... 18,904.04 AUD The Bookkeeping entry (13ii) replaces Bookkeeping entry (13i). The valuation of the Drone-500s at weighted average method as at 31.12.20X0 is: (50 × 200 + 100 × 210 + 100 × 215) / (50 + 100 + 100) = 2210.00 AUD/ u. Therefore, 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) 12,277.78 (2) 10,000.00 (13ii) 26,460.00 (3) 12,500.00 (11ii) 18,904.66 (4) 21,000.00 (5) 9,750.00 (6) 21,500.00 c/ d 26,040.00 (7) 13,000.00 c/ d 13,667.56 52,500.00 52,500.00 44,850.00 44,850.00 b/ d 26,040.00 b/ d 13,667.56 Inventory Drone-400 INV Inventory drone-500 INV Figure 9.5: ROSEFIELD Ltd.’s accounts (ii: weighted average) <?page no="227"?> Berkau: Financial Statements 5e 9-223 D C D C (1) 1,920.00 (8) 4,000.00 (8) 24,000.00 (1) 11,520.00 (2) 2,000.00 (10) 5,920.00 (10) 35,520.00 (2) 12,000.00 (3) 2,500.00 (12) 8,820.00 (12) 52,920.00 (3) 15,000.00 (4) 4,200.00 (4) 25,200.00 (5) 1,950.00 (5) 11,700.00 (6) 4,300.00 (6) 25,800.00 (7) 2,600.00 c/ d 730.00 c/ d 4,380.00 (7) 15,600.00 19,470.00 19,470.00 116,820.00 116,820.00 b/ d 730.00 b/ d 4,380.00 Value added tax VAT Cash/ Bank C/ B D C D C (8) 20,000.00 (9ii) 12,277.78 (10) 29,600.00 (11ii) 18,904.66 c/ d 93,700.00 (12) 44,100.00 (13ii) 26,460.00 c/ d 57,642.44 93,700.00 93,700.00 57,642.44 57,642.44 b/ d 93,700.00 b/ d 93,700.00 b/ d 57,642.44 T/ A 57,642.44 Revenue-20X0 REV Cost of goods sold-20X0 COS D C COS 57,642.44 REV 93,700.00 GP 36,057.56 93,700.00 93,700.00 b/ d 36,057.56 Trading account-20X0 T/ A Figure 9.5: ROSEFIELD Ltd.'s accounts (ii: weighted average) continued 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 amount 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 multiple 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 trade discounts and with more purchases and sales of drones. <?page no="228"?> Berkau: Financial Statements 5e 9-224 Download the extended version of the 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 or off (if destroyed completely). The amount of down-writing results in an expense in the Accounting period the loss in valuation takes place. IAS 2.30 requires determining the net realisable value based on best evidence available. Below we study the case of HEISTEL (Pty) Ltd. regarding a decrease in valuation. Data Sheet for HEISTEL (Pty) Ltd. DDomicile: Germany (Saarbrücken). Reporting currency: EUR. Classification: Retailer. Opening value: 38,250.00 EUR (45 laptops at 850.00 EUR/ u. Net selling price: 1,200.00 EUR/ u. New gross selling price (on special): 999.00 EUR/ u. VAT 20 %. The internet retailer for laptops HEISTEL (Pty) Ltd. recently bought 200 laptops from its supplier SUNNY AG at cost of purchase of 850.00 EUR/ u. The net selling price is 1,200.00 EUR/ u. At the end of the Accounting period 20X4, there are 45 laptops on stock. SUNNY AG started already the production of a new model of laptops and advertised the release on its website. To clear stock, HEISTEL (Pty) Ltd. plans to sell the laptops on a special at 999.00 EUR/ u gross selling price in January/ 20X5. The net selling price is: 999 / 120% = 8 832.50 EUR/ u. The planned sale on the internet is sufficient evidence for writing down the laptops as per balance sheet date 31.12.20X4. The decrease in valuation is amounting to costs of: 45 × (850 - 832.50) = 7 787.50 EUR. The Bookkeeping entry below shows how to process the loss in valuation of inventory. Later, the Loss on Write-down Inventory account will be closed-off to profit or loss. DR Loss on Write-down Inventory. 787.50 EUR CR Inventory.................... 787.50 EUR DR P&L Account.................. 787.50 EUR CR Loss on Write-down Inventory. 787.50 EUR The new value of the 45 laptops on the statement of financial position is: 45 × <?page no="229"?> Berkau: Financial Statements 5e 9-225 832.50 = 3 37,462.50 EUR. Losses caused by damage of deterioration are recorded similarly. How it is Done: (Writing-down Inventories) (1) Determine the carrying value and valuation of inventories as well as the fair value (net realisable value). (2) If the fair value is the same or above the carrying value, nothing needs to be done regarding inventories. (3) If the fair value is below the carrying value, determine the difference on valuation. (4) Record the difference on valuation as a debit entry in the Loss on Write-down Inventory account. Make the contra entry in the Inventory account. (5) At the end of the Accounting period, close-off the Loss on Write-down Inventory account to the Profit and Loss account. An alternative inventory measurement method based on IAS 2.22 is the retail method. The method is based on selling prices and a known percentage sales margin. It is only allowed for cases when it is impracticable to apply other costing methods. The retail method applies for large numbers of fast turning goods (inventories with high turnover). If companies produce goods themselves, inventory costs for finished goods will include cost of conversion. The inventory valuation for manufacturing companies and production firms is based on purchase costs for materials plus costs of conversion for the production process. IAS 2.12 defines cost of conversion. They are direct labour costs and include systematically allocated manufacturing overheads as well. 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 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 <?page no="230"?> Berkau: Financial Statements 5e 9-226 are recorded in separate Work-in-Process accounts. The procedure of Accounting for production starts with the recording of expenses. At first, all manufacturing overheads are recorded in single expense accounts, most probably linked to cost categories, such as depreciation, supervisors’ salary etc., and then transferred to the Manufacturing Overheads account which represents a cost centre. For us, a cost centre is merely 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. In manufacturing companies and production firms, there are three different kinds of accounts: - Work-in-Process account: directly linked to single job orders. Different products and different job orders are recorded in separate Workin-Process accounts. - Manufacturing Overheads accounts: linked to cost centres or cost centre groups in production. We record overheads linked to production therein. - Non-manufacturing accounts: linked to the entire company but not to production and named after their function, such as Administration 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 including applied overheads, the total costs are divided by the lot size and result in 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 centres. Goods receiving high performance in a cost centre are charged with high portions of its costs. For the allocation of manufacturing 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 and distributed all together. Manufacturing overheads are allocated to Work-in-Process accounts based on allocation rates to obtain a performance-based allocation. The allocation rate is calculated by dividing the total of manufacturing overheads by the performance of the manufacturing cost centre, in general measured in reference units, such as labour-hours, machine-hours, m, kWh etc. The allocation of manufacturing overheads to job orders is called overhead application. It means the transfer of manufacturing overheads from cost centres to job orders (Work-in-Process account). In Financial Accounting, the application of overheads follows a Full Cost Accounting system. It applies for variable and fixed manufacturing overheads together. IAS 2.12 requires the application of overheads. For overhead application, we multiply the utilised output of the cost centre by a predetermined overhead allocation rate, <?page no="231"?> Berkau: Financial Statements 5e 9-227 such as 150.00 EUR per machinehour. A job order for which the cost centre worked 3 hours would receive: 3 × 150 = 450.00 EUR of manufacturing overheads. These are added to the direct costs on the Work-in-Process account’s debit side. The most accurate calculation is achieved if all calculations are based on actual costs. However, during production, the actual data are not yet available. E.g., a storage manager who puts finished goods on stock when production is completed cannot wait for the Accounting period to end to determine actual cost of manufacturing for the goods received. For that reason, the overhead application is based on budgeted amounts at normal capacity. This means that applied overheads can differ from actual costs. We call cases when all allocated manufacturing overheads of a cost centre exceed the actual overheads in the Manufacturing Overheads account over-applications. It is merely an overdoing of overhead allocations and the company adds more costs to the goods than occurred. This will result in a credit balanced Manufacturing Overheads account where the balance brought down is on the credit side. One could think, 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 to the next Accounting period. Together 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 because the overheads included in the cost of manufacturing were too high. In contrast, under-applied overheads make all 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 carried 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 is the average capacity in the past under consideration of usual interruptions caused by maintenance and impairments. Normal capacity application means the cost allocations in the manufacturing cost centre is not based on the actual units but on budgeted amounts. As the application 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 occurrence could be idle machinery which shall not result in an overrating of the finished goods. IAS 2.13 requires in those cases the application of normal capacity and the recording and closing-off of idle costs through profit or loss in the period when underperforming takes <?page no="232"?> Berkau: Financial Statements 5e 9-228 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, to understand IAS 2.13 better. Data Sheet for RIEBECK (Pty) Ltd. DDomicile: South Africa (Langebaan). Reporting currency: ZAR. Classification: Manufacturer. Periods: Jan 20X6 budgeted / Jan 20X6 actual. Overheads: depreciation: 250,000.00 ZAR/ m; supervisors’ salary: 110,000.00 ZAR/ m; administration: 124,000.00 ZAR/ m. Production: 600,000 maps in 160 hrs / 450,000 maps in 124 hrs. Materials: paper 5.00 ZAR/ u; ink 0.80 ZAR/ u (both on demand). Net selling price: 20.00 ZAR/ u. VAT 20 %. 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 (Pty) Ltd. plans to print 600,000 maps. 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 for 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 (12) 2,400,000.00 (12) 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="233"?> Berkau: Financial Statements 5e 9-229 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 (10) 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 (10) 3,840,000.00 (11) 3,840,000.00 (11) 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 (12) 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 arrive at the unit costs of manufacturing: 3,840,000 / 600,000 = 6 6.40 ZAR/ u. Budgeted amounts are based on full capacity and the sales of all maps. Below, we repeat the calculation based on actual amounts. Now, RIEBECK (Pty) Ltd. only prints 450,000 maps which takes 124 hours. RIEBECK (Pty) Ltd. sells 385,000 maps at 20.00 ZAR/ u each. As you see, RIEBECK (Pty) Ltd. now adds finished goods to stock which makes the product calculation serve for the inventory valuation on the balance sheet. We apply two alternative calculations, (α) under the assumption the lower <?page no="234"?> Berkau: Financial Statements 5e 9-230 maps amount 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 answer to the question what normal capacity is and what overcapacity means, is subject to judgement of the reporting entity. (α): No Idle Plant Costs A Full Cost Accounting system adds all overheads to finished goods, hence, 360,000.00 ZAR are added to the Workin-Process account. The unit costs increase in comparison to budgeted values to: (450,000 × (5 + 0.80) + 360,000) / 450,000 = 6 6.60 ZAR/ u. The profit now gives: 385,000 × (20 - 6.60) - 124,000 = 5,035,000.00 ZAR. (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: 360,000 / 160 = 22,250.00 ZAR/ h. Hence, RIEBECK (Pty) Ltd.’s applied overheads equal: 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 to an extent of: 360,000 - 279,000 = 881,000.00 ZAR as expenses. You will find a debit entry in the Profit and Loss account and a credit entry in the Manufacturing Overheads account. 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 (12) 1,540,000.00 (12) 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 Figure 9.7: RIEBECK (Pty) Ltd.’s actual accounts (IAS 2.13) <?page no="235"?> Berkau: Financial Statements 5e 9-231 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) 2,250,000.00 (10) 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 (10) 2,889,000.00 (11) 2,471,700.00 (11) 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 (12) 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 for workload measurement. We consider a production amount difference of 25 % as significant and recommend following IAS 2.13. How it is Done: (Recording Idle Plant Costs) (1) Add direct costs to the Work-in-Process account. (2) Add manufacturing overheads to the Manufacturing Overheads account. (3) Add non-manufacturing overheads to single expense accounts and later close them off to the Profit and Loss account. (4) Compare actual manufacturing overheads to those calculated based on normal capacity (via predetermined <?page no="236"?> Berkau: Financial Statements 5e 9-232 overhead allocation rate POR). Check whether actual and normal capacity significantly differ from each other. (5a) If actual and normal capacity are close, apply actual overhead calculation by closing-off the Manufacturing Overheads account to the Work-in-Process accounts. Record inventory movements towards the Finished Goods Inventory account. (5b) If actual and normal capacity differ significantly from each other, apply overhead calculation based on normal capacity and disclose idle costs as an expense in profit or loss. Add applied manufacturing overheads to the Work-in-Process accounts. Close-off the Manufacturing Overheads account which most probably contains under-/ over-applied manufacturing overheads to the Cost of Goods Sold account. Record inventory movements when goods are completed towards the Finished Goods Inventory account. Ad (2): Receivables Receivables in a company result mostly from trading when payments are still expected to be paid by the customers in arrears. Those receivables, in general, contain a VAT portion which matters once a company has to writeoff receivables as bad debts. Besides of trade receivables, there are input-VAT receivables linked to the national revenue service and receivables resulting from 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. Possible impairments thereof due to credit risks must be reported based on IFRS 7.9. Trade receivables depend on credit risks because the owing party can fail its payment obligations, e.g., when entering a bankruptcy procedure. 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. Data Sheet for CHELMSFORD Ltd. DDomicile: Australia (Sydney). Reporting currency: AUD. Classification: dealership. Periods: 20X3 / 20X4. Sale of car: 65,000.00 AUD (net amount) on 5.04.20X3 payable on 4.04.20X4 Interest: 3,000.00 AUD (net amount) VAT 20 %. 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 (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. <?page no="237"?> Berkau: Financial Statements 5e 9-233 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). For CHELMSFORD Ltd., there is a deferred interest income which is linked to the next Accounting period. The interest falls under the actual Accounting period 20X3 to an extent of 9 months. Actual interest income is amounting to: 3,000 × 9/ 12 = 2 2,250.00 AUD in 20X3. The remainder is deferred interest income for the next Accounting period 20X4 to an extent of: 3,000 - 2,250 = 750.00 AUD. DR Accounts Receivables......... 81,600.00 AUD CR Interest Income.............. 2,250.00 AUD CR Deferred Interest Income..... 750.00 AUD CR VAT.......................... 13,600.00 AUD CR Revenue...................... 65,000.00 AUD The valuation of the financial asset is based on the amount the customer is owing, which is 81,600.00 AUD measured at settlement value. As the entire amount results from one car deal the financial asset is recorded as one single item of receivables. 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 because the expected payments become irrecoverable. 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: 10% × 81,600 = 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 here a precautious consideration of a calculated credit risk that is reversed in case of payment or must be extended to the full amount 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 (not shown). The buyer of the van pays the agreed amount of 81,600.00 AUD on time (in 20X4). The payment changes the fair value of the receivables, as the cash receipt voids the previously recorded credit risk. As a consequence, we record the payment in <?page no="238"?> Berkau: Financial Statements 5e 9-234 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). DR Accounts Receivables......... 8,160.00 AUD CR VAT.......................... 1,360.00 AUD CR Reversal Bad Debts........... 6,800.00 AUD DR Cash/ Bank.................... 81,600.00 AUD CR Accounts Receivables......... 81,600.00 AUD The last Bookkeeping entry (b) counts as de-recognition of the financial asset. To allocate the interest portion correctly, CHELMSFORD Ltd. adds the deferred interest to the Interest Income account. 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 risks 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 becomes insolvent write-off the remaining receivables as bad debts. In order to do so, make a debit entry in the Bad Debts account and in the VAT account and cancel out the remaining receivables to the extent of SMV × (1 - rr) in the Receivables account A/ R. Later, close-off the Bad Debts account to the Profit and Loss account. <?page no="239"?> Berkau: Financial Statements 5e 9-235 (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 and in the VAT account to the extent of: (20%/ 120%) × SMV × rr. Credit (1/ 120%) × SMV × rr to bad debts. (8b) Make a debit entry in the Cash/ Bank account and a credit entry in the Accounts Receivables account for the entire cash receipt. Ad (3): Securities Securities fall under financial instruments and, thus, under regulations of IFRS 9. We call them securities, as they are financial asset kept under conditions that makes it easy to liquidate them. Securities are earning interest or gains from capital appreciation. In rainy days, the owner can sell the securities quickly and use the cash to increase its liquidity. 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. The classification of financial instrument in line with IFRS 9.4.1.2 is based on the business model of the owner. The business model in terms of IFRS 9 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. The terms including the preposition “through” refer to the way how adjustments from the current valuation towards fair values are processed. Securities in the current asset section normally fall under this classification (FVTPL or FVTOCI). Financial assets held for the receipt of contractual cash flows are valued at amortised costs along IFRS 9.4.1.2. The latter does not apply for securities but for non-current assets and is covered in chapter (7). In compliance with IFRS 9.5.1.1, initial security valuation is at costs and later for subsequent valuations at fair values (IFRS 9.5.7). The valuation of securities publicly traded changes with 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 three case studies about securities. The first one is about shares and the next following ones about bonds and futures. Here is the share-case study NOKOX (Pty) Ltd.: <?page no="240"?> Berkau: Financial Statements 5e 9-236 Data Sheet for NOKOX (Pty) Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: n/ a. Period: 20X8. Purchase of 30,000 shares of MCD at 150.00 AUD/ s on 30.04.20X8 Dividend: 1.00 USD/ s. Currency exchange rate 1.00 USD : 1.50 AUD / 1.00 USD : 1.40 AUD. Share price at NSE: 105.00 USD/ s on 31.12.20X8 VAT n/ a. * Call option: 2,700,000 USD at 4,000,000 AUD on 31.12.20X8. Acquisition: 4.04.20X8. Fee: 25,000.00 AUD. Currency exchange rate 1.00 USD : 1.48 AUD. NOKOX (Pty) Ltd. buys on 30.04.20X8 30,000 shares of McDonald’s corporation at 150.00 AUD/ s. The shares are traded at 100.00 USD/ s. The currency exchange rate is 1.00 USD = 1.50 AUD. The cost of purchase is: 30,000 × 150 = 4,500,000.00 AUD. NOKOX (Pty) Ltd. intends to sell the shares in the next Accounting period 20X9. Therefore, 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 = 4 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 through other comprehensive income as below because the shares are carried at fair values 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 disclose these 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 By its financial statements, NOKOX (Pty) Ltd. reported a loss caused by currency exchange rate and should explain to its shareholders what it did <?page no="241"?> Berkau: Financial Statements 5e 9-237 with regard to Risk Management. We continue the case study NOKOX (Pty) Ltd. further below and then consider Hedging. Hedging is an instrument to fight a loss due to currency exchanges by investing in financial instruments that compensate the threatening loss. Special disclosure rules apply. Before we continue with the case NOKOX (Pty) Ltd., we cover another type of securities: bonds. If you prefer to continue reading about NOKOX (Pty) Ltd. and are already familiarised with options, move to the *. We there look at hedging the shares by a call option. See next the case study TRAGER GmbH: Data Sheet for TRAGER GmbH DDomicile: Germany (Münster). Reporting currency: EUR. Classification: n/ a. Period: 20X8. Purchase of 300 Bonds at 78.00 EUR/ b. Nominal amount: 100.00 EUR/ b. Coupon: 4 %/ 6m. Bond listing on 31.12.20X4 at 84 (%). VAT n/ a. On 3.04.20X8, TRAGER GmbH buys 300 bonds at 78.00 EUR/ b each (price as traded at the bond market). The bonds’ principal is 100.00 EUR/ b. This is the amount the bonds mature at settlement date and the coupon is based on. The bonds pay semi-annually a coupon of 4%/ 6m, which is on 30.06. and on 31.12. every year. TRAGER GmbH plans to sell its bonds in January/ 20X9. Due to its business model, TRAGER GmbH holds the bonds at fair values through other comprehensive income. At the time of bond purchase, TRAGER GmbH records the cost of acquisition for its bonds: 300 × 78 = 2 23,400.00 EUR. DR Investment in Bonds (Sec.)... 23,400.00 EUR CR Cash/ Bank.................... 23,400.00 EUR At the time of the coupon payments, on 30.06.20X8 as well as on 31.12.20X8, TRAGER GmbH receives coupon payments to the extent of: 300 × 4 = 1,200.00 EUR. The company records the receipts as interest income which is recorded through other comprehensive income twice. DR Cash/ Bank.................... 1,200.00 EUR CR Interest Income OCI.......... 1,200.00 EUR On 31.12.20X8, TRAGER GmbH must evaluate its bonds at their fair market values. At that date, the bonds are traded at 84.00 EUR/ b. We say alternatively, the bonds are listed at 84 (percent). The bonds are to be disclosed at: 300 × 84 = 2 25,200.00 EUR. The difference in valuation equals: 25,200 - 23,400 = 1 1,800.00 EUR. TRAGER GmbH records the gain by the Bookkeeping entry below as other comprehensive income: <?page no="242"?> Berkau: Financial Statements 5e 9-238 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: Data Sheet for GRENVILLE AG DDomicile: Germany (Essen). Reporting currency: EUR. Classification: n/ a. Period: 20X5. Exchange of 10,000.00 USD towards 9,300.00 EUR on 31.12.20X5. Currency exchange rate: on 2.01.20X5: 1.10 USD = 1.00 EUR / on 31.12.20X5: 1.25 USD = 1.00 EUR. VAT n/ a. On 2.01.20X5, GRENVILLE AG that trades goods with an US based customer enters in a contract (currency future) with Deutsche Bank to exchange an amount of 10,000.00 USD into 9,300.00 EUR on 31.12.20X5. At the time of closing the deal, no payment takes place. The bank's transaction fees are included in the costs. The future is to secure an expected payment of 10,000.00 USD from the customer at the year-end. 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 9,300.00 EUR. Accounting for the currency future requires to record Bookkeeping entry (1) at the time of recognition (2.01.20X5): DR Financial Asset.............. 9,300.00 EUR CR Cash/ Bank.................... 209.09 EUR CR Accounts Payables ($10,000).. 9,090.91 EUR 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: 10,000 / 1.25 = 8,000.00 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 makes GRENVILLE AG 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 Deutsche Bank pays the agreed EUR amount in return for the 10,000.00 USD received. Observe Bookkeeping entry (2): <?page no="243"?> Berkau: Financial Statements 5e 9-239 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 to secure a currency exchange risk. This falls under Hedging. Hedging allows based on IFRS 9.5.7.1 (a) the application of special rules to simplify Accounting and disclosure of financial instruments. We call the currency future in the prior case study the hedging instrument and the receivables expected from the customer 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 MCD shares in 20X8. The situation is now altered as we consider that NOKOX (Pty) Ltd. secures its profit by the purchase of a call option on USD. The profit mentioned above is the increase of the shares from 100.00 USD to 105.00 USD plus the dividend payment. Hence, NOKOX (Pty) Ltd. earns: 30,000 × (105 - 100) + 30,000 × 1 = 1 180,000.00 USD. Without currency exchange rate decrease, the amount in AUD would have been: 180,000 × 1.50 = 2 270,000.00 AUD. Due to the depreciation of the AUD against the USD, NOKOX (Pty) Ltd. loses: (3,000,000 + 180,000) × (1.50 - 1.40) = 318,000.00 AUD. The difference is amounting to: 180,000 × 1.50 - 318,000 = --48,000.00 AUD, which is a net loss. To secure its profit, NOKOX (Pty) Ltd. buys on 4.04.20X8 at costs of 25,000.00 AUD an option to exchange 2,700,000.00 USD on 31.12.20X8 to 4,000,000.00 AUD. The exchange rate on 4.04.20X8 is: 1.00 USD = 1.48 AUD. At first, we record the option separately from the shares. We refer to this variant of recognition as case (i). Later, we discuss a combined presentation under case (ii). The latter one is in line with IFRS 9.6. (i): Separate Positions The option is bought at 25,000.00 AUD and is recorded as a single item at cost. At the time of purchasing the MCD shares, the option is not helping as the exchange rate is: 1.00 AUD = 1.50 USD. Using the option would even result in a loss of: 2,700,000 × 1.50 - 4,000,000 = 50,000.00 AUD. On the 31.12.20X8, the option’s value is higher. Based on the currency exchange rate, 2,700,000.00 USD are worth: 2,700,000 × 1.40 = 3 3,780,000.00 AUD. The value of the option is: 4,000,000 - 3,780,000 = 2 220,000.00 AUD. The amount to add is the value less its cost <?page no="244"?> Berkau: Financial Statements 5e 9-240 of acquisition. This gives: 220,000 - 25,000 = 1 195,000.00 AUD. Once we deduct NOKOX (Pty) Ltd.’s loss from currency exchange rate from the realised gain of the call option, we arrive at 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 option. DR Call Option.................. 25,000.00 AUD CR Cash/ Bank.................... 25,000.00 AUD DR Call Option.................. 195,000.00 AUD CR Option Gain OCI.............. 195,000.00 AUD NOKOX (Pty) Ltd. records the gain from the call option and the loss from the shares as other comprehensive income. On 31.12.20X8, NOKOX (Pty) Ltd. exercises the option and exchanges 2,700,000.00 USD worth: 2,700,000 × 1.40 = 3 3,780,000.00 AUD to 4,000,000.00 AUD. The latter transaction is shown as Bookkeeping entry (i3). See 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 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 (ii): Hedging In compliance with IFRS 9.6.1.2, NOKOX (Pty) Ltd. combines the hedged item (shares) with the hedge instrument (call option). On its balance sheet, NOKOX (Pty) Ltd. discloses an item of current assets that <?page no="245"?> Berkau: Financial Statements 5e 9-241 combines the two financial instruments. Its initial valuation is based on the shares valued at costs and the call option valued at cost of acquisition: 30,000 × 100 × 1.50 + 25,000 = 4 4,525,000.00 AUD. At the time of the balance sheet date, on 31.12.20X8, the shares’ value is down to: 30,000 × 105 × 1.40 = 4,410,000.00 AUD. The valuation of the call option is derived from the cost of acquisition and the gain: 25,000 + 195,000 = 2 220,000.00 AUD, see above. Hence, the total item’s value is: 4,410,000 + 220,000 = 4 4,630,000.00 AUD. The residual valuation change of the hedge item is: 4,630,000 - 4,525,000 = 105,000.00 AUD. We add the amount to the dividend received: 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 = 1 147,000.00 AUD. In contrast to case (i) we here disclose a gain from the combined item of 105,000.00 AUD and a gain from the dividend receipt to the extent of 42,000.00 AUD. How it is Done: (Accounting for Securities) (1) Check the business model and the intention of holding securities. If they fall under current assets continue below with step (2), otherwise consider financial assets as in chapter (7). (2) Record the securities at cost of acquisition. Do not depreciate securities. (3) Monitor the securities’ fair value; this is normally the fair market price at the bond market. In case the value of securities changes, record changes either through profit or loss or through other comprehensive income. Make the contra entry in the Securities account. (4) 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 the invalidation of the security. Ad (4): Prepaid Expenses Prepaid expenses are payments, e.g., for labour, rent, insurance etc., dedicated to certain future periods, i.e. January of the next Accounting period and 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 55 Read our Basics, chapter (18). of Accounting theory, prepaid expenses are regarded as accruals, meaning they are recorded when paid and disclosed as current assets on the balance sheet. 55 In contrast to the regulations based on German HGB, the IASB is regarding prepaid expenses as current assets. They fulfil the recognition criteria of assets once there is a future economic <?page no="246"?> Berkau: Financial Statements 5e 9-242 benefit and they can be measured reliably. German HGB shows an extra item outside of the current asset section, referred to as Rechnungsabgrenzungsposten (separate item). Ad (5): Cash and its Equivalents We record cash and its equivalents 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. In general, companies keep separate records for every bank account for Bank Reconciliation purposes. 56 The measurement of cash/ bank does not change except of when cash is held in a foreign currency. In those cases, the valuation is based on the currency exchange rate that applies on the transaction date for initial valuation and on the currency exchange rate on the balance sheet date for 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. Data Sheet for BAKENSKOP PLC DDomicile: Botswana (Gaborone). Reporting currency: BWP. Classification: trader. Period: 20X5. Opening value: 500,000.00 BWP. Addition: 20,000.00 EUR. Currency exchange rate 1.00 BWP : 0.09 EUR / 1.00 BWP : 0.07 EUR. VAT n/ a. 56 Read our Basics, chapter (37). BAKENSKOP PLC is a Botswanan trading company. Its reporting currency is Botswanan Pula BWP. As the company imports goods from Europe, BAKENSKOP PLC runs an extra bank account in EURamounts. At the beginning of fiscal year 20X5, BAKENSKOP PLC’s EUR-bank 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 = 500,000.00 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 on its bank account. The value of the bank account measured in the reporting currency Botswanan Pula is: 60,000 / 0.07 = 8 857,142.86 BWP. After we determined the fair value of the bank account’s balancing figure, we record the impact the currency exchange rate has on earnings in other comprehensive income. A recognition as profit or loss does not apply as BAKENSKOP PLC is no bank (business model). The first 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. <?page no="247"?> Berkau: Financial Statements 5e 9-243 BAKENSKOP PLC does not convert every Bookkeeping entry to the reporting currency as the bank account is based on EUR. Therefore, prior Bookkeeping entries have been made in EUR. There is only the revaluation Bookkeeping entry required as at 31.12.20X5 which is shown below. Observe the accounts in Figure 9.9: 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 values. For the valuation of finished goods, Manufacturing Accounting applies. Receivables are measured at settlement amounts but an adjustment for credit risks might apply. 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 values through profit and loss or through other comprehensive income as by default. 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 irrecoverable receivables. Hedging: Carrying two financial instruments with opposite risks, such as a receivable in USD and a future in USD. Idle costs: Expenses for unused production facilities. Inventories: Asset held for sale or for support of production or for service rendering. Work-in-Process account: Account in Manufacturing Accounting that rep- <?page no="248"?> Berkau: Financial Statements 5e 9-244 resents a job order. The Work-in-Process account is the reconciliation account for multiple Job Order accounts. See also the conventions in chapter (1). Manufacturing Accounting: Accounting for finished goods valuation in manufacturing companies and production firms. Manufacturing Accounting is based on Work-in-Process accounts and Manufacturing Overheads accounts. Manufacturing Overheads account: An account to gather all overheads linked to production. Net realisable value: Measurement at fair value at which an asset can be sold among knowledgeable, willing and independent parties (orderly transaction). Overhead application: Allocation of manufacturing overheads to job orders by making a debit entry in the Workin-Process account and a credit entry in the Manufacturing Overheads account. Securities: Short-term financial instruments. Question Bank: (1) A company records as manufacturing overheads: 30,000.00 EUR depreciation, 55,000.00 EUR indirect labour and 6,000.00 EUR insurance expenses. The planned output is 100,000 kg. The predetermined overhead allocation rate is 0.86 EUR/ kg. The actual performance is only 60,000 kg. How much are the applied overheads following IAS 2.13, if normal capacity applies and idle costs are recorded? 1. 51,600.00 EUR. 2. 54,600.00 EUR. 3. 86,000.00 EUR. 4. 91,000.00 EUR. (2) A company records the following additions to stock. 100 at 34.00 EUR, 200 at 33.00 EUR, 150 at 35.00 EUR. Based on a weighted average cost formula, how much is a stock release of 25 units? 1. 841.67 EUR. 2. 850.00 EUR. 3. 847.22 EUR. 4. 875.00 EUR. (3) A company buys 400 pullovers at 96.00 EUR/ u gross amount. The dealer offered a trade discount of 10 % which has been considered for the price already. How much are unit costs of purchase before trade discount deduction? 1. 88.00 EUR. 2. 88.89 EUR. 3. 106.67 EUR. 4. 72.72 EUR. (4) A company carries a note receivable from selling goods to the extent of 1,500.00 EUR. The customer is most probably (80 % probability) insolvent. How much are the recorded bad debts? 1. 0.00 EUR. 2. 1,000.00 EUR. 3. 1,250.00 EUR. 4. 1,500.00 EUR. (5) On 4.05.20X5, a company buys 50 bonds that mature in the next Accounting period (30.06.20X6). The purchase price is 246.00 EUR/ b and the principal of the bond is 250.00 EUR/ b. On 31.12.20X5, the coupon at 5.4 %/ a is paid. At which value are the bonds <?page no="249"?> Berkau: Financial Statements 5e 9-245 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="250"?> Berkau: Financial Statements 5e 10-246 10. Statement of Cash Flows What is in the Chapter? This chapter (10) is an introduction how to prepare cash flow statements in compliance with IFRSs. It covers the direct method as applied for KENILWORTH METERED TAXI Ltd. in chapter (3) and the reconciliation of profits with the operating cash flows. The derivative method is covered, too; however, we put it into the online material section accessible via QR codes links. We discuss in this chapter the liquidity planning and the cash flow statement preparation step by step following the case study EIMKE Ltd. Learning Objectives: After studying cash flows in this chapter (10), you understand the need to report on cash flows from different types of activities and you can apply the direct method and the reconciliation method for calculating cash flows from operating activities. You understand the steps which are required for the transition of earnings after taxes to operating cash flows in detail. You also are familiarised with the regulations about cash flow statements in IAS 7. A statement of cash flows 57 is required by IAS 1.10 as part of a full set of financial statements. Users of financial 57 Read our Basics, chapter (32). statements can assess a company’s liquidity situation by analysing the cash/ bank item on the balance sheet together with the statement of cash flows. They strive to predict future liquidity and cash flows and ask whether a cash flow is likely to repeat in the future. A cash flow is a change of the cash/ bank item on the balance sheet during an Accounting period. 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. The latter means the valuation does not change due to transfer. A statement of cash flows resembles a liquidity plan (cash budget) 58 . A liquidity plan determines the future balance of cash/ bank. There are only three major formal differences: (1) A liquidity plan starts with the opening amount of cash/ bank and ends with the closing balance of the cash/ bank item (liquidity) whereas the statement of cash flows only discloses 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 estimates of future receipts/ payments. The following assumption applies: Cash flows resulting from operating activities are likely to repeat if the business model is kept up, whereas a 58 Read our Management Accounting, chapter (6). <?page no="251"?> Berkau: Financial Statements 5e 10-247 cash flow from financing or investing activities forms a singular event. (3) The cash flow statement refers to the past. 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 or bonds are traded publicly at a stock exchange or bond market, and if it does not prepare group statements as a parent. § 264 HGB applies. For international Accounting, IAS 1.10 defines that the statement of cash flows is always an element of a complete set of financial statements. Hence, all reporting companies applying IFRSs shall prepare and disclose a statement of cash flows. Below, we discuss the benefits of preparing cash flow statements: Think about a company that is profitable but only generates low amounts of cash by its activities. How can this happen? If a company is incapable of collecting cash, its revenues from sales are recorded as receivables, such as: DR Accounts Receivables......... DR VAT.......................... CR Revenue...................... Because of lacking cash collections, the company’s cash/ bank item remains low and cannot increase by the company's operations. Assume further, our company always pays for its own bills, like from its suppliers, on time. In this situation, the company most probably will be left with a negative cash flow, meaning its cash/ bank item on the balance sheet decreases. This bankrupts it sooner or later because companies need maintain solvency for going concern. The user of financial statements must be able to assess a company’s financial situation from the financial statements. For the calculation of the total cash flow, no extra financial statement would be necessary 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 must know more than its total. 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 be disclosed: - Cash flows 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 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. In contrast, 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 <?page no="252"?> Berkau: Financial Statements 5e 10-248 and profit. 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 will cancel out singular cash flows. To get familiarised with cash flow statements and liquidity planning, we now discuss the case study EIMKE Ltd. in Melbourne. Data Sheet for EIMKE Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: production firm. Period: 20X8. Opening values: see balance sheet as a 31.12.20X7. Activities in 20X8: paying income tax 30,000.00 AUD, buying goods 60,000.00 AUD (gross amount), depreciation 20,000.00 AUD, collecting receivables 2,500.00 AUD, bank loan payment 3,000.00 AUD, revenue 120,000.00 AUD, materials 60,000.00 AUD. VAT 20 %. EIMKE Ltd. is a 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 the next Accounting period 20X8. EIMKE Ltd. plans the below listed business activities: (1) Payment of income tax liabilities to an extent of 30,000.00 AUD. (2) Purchase and payment of materials at cost of purchase of 50,000.00 AUD (gross amount: 60,000.00 AUD). (3) Depreciation to the extent of 20,000.00 AUD. (4) Collection of half of the receivables disclosed on the balance sheet in Figure 10.1. <?page no="253"?> Berkau: Financial Statements 5e 10-249 (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) Material consumption of 60,000.00 AUD in production. From the above business activities, only (1), (2), (4), (5) and (6) are cash relevant. The Accountant prepares a liquidity plan for EIMKE Ltd. as shown in Figure 10.2. In the liquidity plan the closing balance of the Cash/ Bank account is calculated by adding cash flows to the opening value. [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 item cash/ bank. (2) Calculate all additions to cash/ bank. Consider gross amounts for receipts when output-VAT applies. (3) Deduct all payments. Consider gross amounts when input-VAT applies. (4) Add all items on the liquidity plan to determine 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 one year later it is 89,100.00 AUD as estimated for 31.12.20X8. The cash flow equals: 89,100 - 50,000 = 3 39,100.00 AUD. EIMKE Ltd. planned a positive cash flow. To transform our liquidity plan to a statement of cash flows, we pretend all activities follow the plan. We now must delete the opening value and classify the cash flows. Operating activities at EIMKE Ltd. are the tax payment (1), the purchase (2), the collection of receivables (4) and the proceeds (6). There are financing activities for the pay-off payment of the bank loan (5) and the payment of interest expenses (5). In line with IAS 7.33, interest can be classified as operating or financial cash flow. We follow our conventions (chapter (1)) and consider all interest payments as finance activities. No investments apply for EIMKE Ltd. in 20X8. <?page no="254"?> Berkau: Financial Statements 5e 10-250 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 - Direct Method) (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 payments for purchases, labour payments, rent payments, tax payments, sales etc. (4) Investing cash flows come from acquisitions and sales of non-current assets like buying machinery or 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, issuing 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. (7) Add all cash flow categories for total cash flow calculation. <?page no="255"?> Berkau: Financial Statements 5e 10-251 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. This 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 refers to the direct method based on cash receipts and payments. The indirect method reconciles profits with operating cash flows. The investing and financing cash flow are determined directly. We here apply the methods’ designation from IAS 7.18: direct and indirect method. Ad (1): Direct Method (Cash Flow Statement) The direct method starts from the Cash/ Bank account and classifies all entries therein in operating, investing and financing payments/ receipts. The cash flow categories are defined in IAS 7.6.: Operating activities of a company aim to earn revenues and are not linked to investing nor financing of the business. Examples for operating cash flows can be found in IAS 7.14. Investing activities are the acquisition and disposal of non-current assets. Examples are mentioned in IAS 7.16. Financing activities change equity and/ or long-term liabilities. Find examples in IAS 7.17. We also consider all payments that are linked to the latter ones, like interest payments and repayments of liabilities as financing activities. IAS 7.33 applies. The application of the direct method is simple. We check the Cash/ Bank account and classify the entries therein in operating, investing and financing receipts and payments. With a high number of entries in the Cash/ Bank account, the cash flow work becomes too high. EIMKE Ltd.’s Cash/ Bank and Accounts Receivables account for 20X8 are displayed in Figure 10.4. Actual receipts and payments are the same as scheduled. 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) <?page no="256"?> Berkau: Financial Statements 5e 10-252 We classify cash flows as follows: (1), (2), (4) and (6) are operative cash flows, (5) is financing cash flow regarding the interest and pay-off portions. The statement of cash flows is the same as shown in Figure 10.3. Ad (2): Indirect Method (Reconciliation of Profits with Operating Cash Flows and Calculating Investing and Financing Cash Flows Directly) The indirect method determines operating cash flows by reconciliation of profits with operating cash flows and the investing and financing cash flows directly. It is not possible to derive non-operating cash flows from profit or loss. There is merely 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 but a bank loan’s principle cannot be derived from profit calculations. The same applies for investments that cause 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 an income statement. A Profit and Loss account records business activities for profit calculation purposes. Thus, the recording refers to profitability figures, like revenue and expenses. A statement of (operating) cash flows requires recordings of the same activities but is based on receipts and payments. As we want to derive cash flows from profit calculations, we must adjust profits for those activities that (1) are relevant for profitability but do not impact cash flows and (2) vice versa. Business activities that fall under (1) are relevant for profitability but neutral towards cash, e.g. depreciation, additions to provisions etc. Business activities that fall under (2) are relevant for cash but do not change profitability, e.g. purchase and payment for materials without using them in production, which leads to an increase of stock, payments in connection to receivables or payables, prepaid expenses, VAT receivables and payables etc. A company that buys materials on credit but does not use them in production does not record material expenses through profit or loss. It records an increase in inventories and in payables. Therefore, we record in the reconciliation process a cash outflow for the increase in inventories (payment) and for the increase of payables a positive cash flow (receipt). The advantage of the reconciliation method is that the calculation of operating cash flows is not based on numerous, singular Bookkeeping entries but on only few adjustments for the income statement based on balance sheet items. This limits the workload for the preparation of the cash flow statement significantly. The following How-it-is-Done paragraph shows the approach. Thereafter, we explain the single steps in detail for EIMKE Ltd.'s cash flow statement. <?page no="257"?> Berkau: Financial Statements 5e 10-253 How it is Done: (Reconciliation of Profits with Operating Cash flows) (1) Calculate profit for the period as earnings after taxes. (2) Add expenses for 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 and provisions, deduct decreases thereof. (8) Add increases of income tax liabilities, deduct decreases thereof. (9) Add decreases of VAT receivables (input-VAT refund receipt), deduct increases thereof (input-VAT paid to suppliers). (10) Add increases of VAT payables (output-VAT collected from customers), deduct decreases thereof (output-VAT paid to revenue service). (11) Add earnings after taxes and adjustments from steps (2) to (10). The sum is already the operating cash flow. (12) Calculate investing and financing cash flow by adding singular receipts and deducting single payments. (13) Add all cash flow categories for total cash flow calculation. The procedure of reconciliation probably will give you difficulties of comprehension. For that reason, we explain the steps below. If you prefer 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 revenues and expenses and gives us the profitability of the company. However, it needs adjustments as all items on the income statement have been considered regardless of payments or receipts. Starting from profit results in a short-cut of calculations; it is less Accounting work to copy existing profit and loss calculations and modifying them, than classifying all Bookkeeping entries in the Cash/ Bank account. The profit calculation is already a complete analysis based on all Bookkeeping entries. The reconciliation copies all existing data of business activities and adjusts a few thereof. <?page no="258"?> Berkau: Financial Statements 5e 10-254 Why step (2)? Expenses without payment in the same Accounting period are not cash relevant. As we aim for the cash flow statement preparation these expenses are irrelevant but have been considered for the profit or loss calculation. Therefore, we must cut them out. What we are doing is to exclude these expenses from the calculation of cash flows. E.g., depreciation is not cash relevant as its Bookkeeping entry is: DR Depreciation................. CR Accumulated Depreciation..... Another example is an expense recorded together with provisions. Those expenses are relevant for profit in the actual Accounting period, but the payments take place in the future. Therefore, we delete these expenses. 59 Interest results in payments but they must be classified as financing cash flow. Therefore, we add paid interest to the operating profit and consider it for financing cash flows in step (12). In case you feel unsafe whether you should add or deduct amounts, just think of cancelling items out. E.g., 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). Step (3) is just a reclassification. Why Step (4)? We analyse step (4) regardless of singular Bookkeeping entries. Any decrease of receivables is considered a 59 Check step (7), too. payment where the debtor paid its liability. Hence, we consider a reduction in receivables a cash receipt. In the opposite case when receivables increase, we consider a payment and the recipient of the money is obliged to repay the amount in the future. What counts here is the fact that money is paid, and that it is giving us a negative operating cash flow. Note, that only the cash flow implication matters. In Figure 10.7, all numbers shown are cash flows not receivables, interest etc. Therefore, an increase of receivables is always recorded in the reconciliation statement as cash outflow. Why Step (5)? In terms of cash flow calculations, we make no difference between receivables or prepaid expenses. A receivable is a (paid) claim for repayment and prepaid expenses is a (paid) claim for service delivery, such as rent, insurance, work etc. Why Step (6)? Inventories represent current assets payments have been made for. It does not matter whether inventories are raw materials, supplies of finished goods. In general, we consider an increase of <?page no="259"?> Berkau: Financial Statements 5e 10-255 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 valued 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 unpaid expenses, e.g. partial depreciation included in costs of conversion of finished goods. If a company applies the nature of expense method, changes in inventories of finished goods are disclosed on the income statement already and can be copied therefrom. For that reason, it is always a good idea to apply the nature of expense method for profit calculations when you later intend to derive the cash flow from operating activities by reconciliation. Why Step (7)? Changes in short-term payables and provisions are not linked to financial cash flows. When payables to suppliers are recorded, the expense has been considered either in the income statement or by other cash flow considerations already. E.g., when materials are purchased the increase of inventory has been recorded as a negative cash flow in step (6). If the buyer does not pay, we compensate the deduction in step (6) by adding cash in step (7) for a granted supplier 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 cash receipt. When a company pays for short-term debts the transaction is not recorded on the income statement as the repayment does not affect profitability. As this is a cash outflow, we record the retirement of short-term debts as negative cash flow indicated by a deduction of short-term liabilities. Distinguish short-term and long-term liabilities! Any change of long-term liabilities must be recorded as financial cash flow. The dissolving of provisions results in negative expenses which compensates the ordinary recorded expenses (at the time of recognition) on the income statement. This means, the expense is initially recorded in a nominal account and when the provision is dissolved, we debit provisions and make a credit entry in the expenses. The credit entry neutralises the previously recorded expense. Therefore, dissolving a provision is not recorded as expense and therefore it is not relevant for profit, either. However, when a provision is dissolved payments are made and are considered in the cash flow statement in the period, they take place. 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. When the provision is added the Accountant makes a Bookkeeping entry (1) such as below. It results in pulling forward an expense with no payments taking place. DR Rework Expenses.............. CR Provisions................... <?page no="260"?> Berkau: Financial Statements 5e 10-256 In the period when the provision is dissolved the Bookkeeping entry (A) for the rework is initially and cash-relevant recorded as: DR Rework Expenses.............. CR Cash / Bank................... As the expenses have been considered in the previous Accounting period, the dissolving the provision cancels out the expenses pulled forward. It can be done by recording a Bookkeeping entry (B), such as: DR Provisions................... CR Rework Expenses.............. Because of the above debit entry and the following credit entry in the Rework Expenses account, no rework is reported on the income statement. It should not as it has been considered one Accounting period before which is actually the purpose of provision recognitions. 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 - as payment that is no expense. 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 inequality is that the consideration 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 on 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. To not get confused, rather reconcile from the annual surplus in particular for 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 discuss input-VAT paid together with the Bookkeeping entry for the purchase. It does not matter whether the payment for the purchase has been made in full 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 segregate input-VAT payments for investments later. Hence, it is likely to disclose VAT receivables for operating and investing activities together if investments are not material. Regarding very expensive investments, input-VAT is classified as material and should be considered as cash flow from investing activities. Otherwise, we assume that companies only <?page no="261"?> Berkau: Financial Statements 5e 10-257 run one VAT account and do not distinguish what VAT is paid for. In case you record investing cash flows based on gross amounts, delete input- VAT payments from the VAT account before you process step (9). You can do so with input-VAT refunds too but in general it is acceptable to consider all input-VAT refunds as operating activity no matter whether resulting from purchases, received services or acquisitions. Based on our conventions in chapter (1), which states that we consider VAT payments in the next Accounting period (year), we record cash flows always based on gross amounts. Why Step (10)? Output-VAT is collected from customers and buyers on behalf of the revenue service and results in cash inflows. Therefore, output-VAT is 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) to (13) are standard procedure and do not require further explanation. Below, we study the reconciliation method for our case study EIMKE Ltd. The reconciliation is calculated on the statement of cash flows as shown in Figure 10.7. The calculations refer to the figures on its balance sheet and the income statement disclosed in Figure 10.5 and Figure 10.6. * After the Accounting period 20X8, EIMKE Ltd. discloses the balance sheet and income statement as shown in Figure 10.5 and Figure 10.6. 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 distinction following IAS 1.60. <?page no="262"?> Berkau: Financial Statements 5e 10-258 [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. At first, we must add interest, as interest is a cash flow, but it is linked to financing activities. The cash flow so far is: 27,300 + 1,000 = 2 28,300.00 AUD. The adjustments for activities that are expenses/ revenue but have no relevance for cash applies for depreciation. As depreciation is deducted in the income statement, we must add its amount to the reconciliation statement. Hence, we come up with an operating cash flow after recording adjustments for depreciation to an extent of: 28,300 + 20,000 = 48,300.00 AUD. The next adjustment is for activities that are cash/ bank-relevant but are not recorded on the income statement. At EIMKE Ltd., we observe a decrease of inventories: 10,000 - 20,000 = -1 10,000.00 AUD. A decrease of inventories is regarded for the cash flow reconciliation 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: 48,300 + 10,000 = 5 58,300.00 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: 58,300 - 11,900 = 4 46,400.00 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 to repayment. Hence, increases in payables are regarded as receiving cash. Therefore, we add the amount to our cash flow calculation: 46,400 + 14,000 = 6 60,400.00 AUD. <?page no="263"?> Berkau: Financial Statements 5e 10-259 The tax liabilities are payables as well. We determine 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: 60,400 - 18,300 = 4 42,100.00 AUD. The amount of 18,300.00 AUD is shown in the line for income tax liabilities. The financing cash flow can be derived 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. Furthermore, we must deduct interest paid. Hence, the total cash flow for EIMKE Ltd. is amounting to: 42,100 - 2,000 - 1,000 = 39,100.00 AUD. Observe the cash flow statement based on the indirect method (= reconciliation method) in Figure 10.7. [AUD] [AUD] Cash flow from operating acitivities Earnings after taxes EAT 27,300 add Interest 1,000 add Depreciation 20,000 48,300 changes in working capital changes in inventory 10,000 changes in A/ R (11,900) changes in prepaid expenses 0 changes in A/ P, not ITL 0 changes in income tax liabilities IT (18,300) changes in VAT/ r only materials (10,000) changes in VAT/ p 24,000 42,100 Cash flow from investing activities Investments 0 0 Cash flow from financing activities Interest (1,000) Pay-off (2,000) (3,000) Total cash flow 39,100 Eimke Ltd.'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 do not consider single business activities but calculate the cash flow based on changes on the balance sheet. <?page no="264"?> Berkau: Financial Statements 5e 10-260 The resulting cash flow is the same, but the Accounting work is far 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 German financial statements following HGB are given. 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: Link 10.B: EIMKE Ltd. Summary: Statements of cash flows are part of the financial statements. The cash flow statements show changes in the cash/ bank item on the balance sheet and 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 income statement and the balance sheet. Accounting Technical Terms: Cash equivalent: Short-term assets that are as liquid as cash and which are certain in terms of valuation. Cash flow: Changes in the Cash/ Bank account. Reconciliation method: Calculation of operating cash flows by adjusting the profit after taxes regarding revenue/ expenses without payments/ receipts and payments/ receipts irrelevant for profit or loss calculation. 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) Which are financial cash flows? 1. Bank loan repayment, trade discount, interest. 2. Bond issue, interest, bond redemption. 3. Bank loan principle, bank <?page no="265"?> Berkau: Financial Statements 5e 10-261 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. (5) Which statement is correct? 1. A company only prepares a statement of cash flows when it is a group member, regardless to whether being parent or subsidiary. 2. Along IFRSs every company prepares a statement of cash flows. 3. Along IFRSs only listed public companies must prepare a statement of cash flows. 4. Based on § 264 I HGB companies participating on the public capital market do not have to prepare a cash flow statement. Solutions: 1-2, 2-2, 3-2, 4-2, 5-2. <?page no="266"?> Berkau: Financial Statements 5e 11-262 11. Equity on the Balance Sheet What is in the Chapter? In this chapter (11), we cover the equity section on the balance sheet that comprises of the issued capital, reserves and the item retained earnings. With the case study YARRA Ltd., we show all material aspects of recognition and measurement of equity items. The chapter is structured by the major items in the equity section: (1) Issued capital. (2) Reserves. (3) Retained earnings. Learnings Objectives: After studying this chapter, you are familiarised with the equity section and can measure and disclose equity on the statement of financial position. You also understand how special transactions with the owners work, in particular share issues of ordinary and preference shares and share redemptions. You learn about the profit appropriation as well and can determine the book value of a company. You know the difference between earnings and profit following IAS 33. In contrast to other chapters, the equity refers to regulations based on national Company's Acts more than on international Accounting IFRSs. The reason for that occurrence is that the equity disclosure depends on the legal form of a company. 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 cover general knowledge about legal forms of companies and distinguish private 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 and 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. Legal forms for companies based on shares are corporations Corp., Inc. (in the US), public limited companies PLC, Ltd (UK), Stock companies AG (Germany), and public companies Ltd. (Commonwealth, South Africa). No matter whether a limited company is publicly traded at stock markets, the Accounting principles to record equity remain 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 textbook, we call all portions 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. Trading and selling on shares do not affect equity. 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 meet- <?page no="267"?> Berkau: Financial Statements 5e 11-263 ing. In contrast, preference shares offer the holder a preference dividend which is often a percentage based on the nominal value of the share but do not allow the preference shareholders to vote. The fixed dividends are a trade-off for the lack in voting rights. A fixed dividend claim is regarded as favourable as it does not depend on the profit. We say the investors’ risk is low 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 declared, either. If preference shares are cumulative, the missed dividend must be paid in future Accounting periods. The process of share issuing is based on the Allotment account. 60 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. Capital 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 a contribution. We study the case of YARRA Ltd. a limited public company based in Durban. The case covers a period of three years. Data Sheet for YARRA Ltd. DDomicile: South Africa (Durban). Reporting currency: ZAR. Classification: n/ a. Ordinary shares: 1,000,000 shares, nominal value 1.00 ZAR/ s. Profit before taxation (20X0): 200,000.00 ZAR. Preference share capital: 500,000.00 ZAR; cumulative preference shares; dividend claim: 5 %/ a; issued on 30.06.20X0. Preference dividend: 12,500.00 ZAR. Shareholder: 90,000 ordinary shares. Share issue 500,000 ordinary shares on 1.07.20X1 at 1.24 ZAR/ s. Share price on 1.07.20X1: 1.60 ZAR/ s. Share price on 1.10.20X1: 1.03 ZAR/ s. Share redemption: 200,000 shares. Share price on 1.11.20X1: 1.00 ZAR/ s. Share redemption: 100,000 shares. Profit (20X1): 0.00 ZAR. Profit (20X2): 192,500.00 ZAR. Appropriation of profits: 200,000.00 ZAR to reserves, ordinary dividend: 0.04 ZAR/ s, preference dividend 25,000.00 ZAR. VAT n/ a. On 2.01.20X0, YARRA Ltd. issues 1,000,000 ordinary shares at 1.00 ZAR/ s each. The share issue is at nominal amounts which we refer to as par-valueissue. 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 60 Read our Basics, chapter (33). Capital account instead of the Issued Capital account. <?page no="268"?> Berkau: Financial Statements 5e 11-264 Later, on 30.06.20X0, YARRA Ltd. issues 500,000 preference shares at 1.00 ZAR/ s. The preference shares come with a fixed dividend of 5 %/ a based on their nominal value. Preference shares only pay a dividend proportionate to the time the shares are outstanding. At YARRA Ltd., the preference shares are issued in the middle of the Accounting period. Hence, only 50 % of the annual preference dividend is paid for the first year. The preference shareholders receive: 50% × 500,000 × 1 × 5% = 1 12,500.00 ZAR. YARRA Ltd.'s preference shares are cumulative. The preference dividends are recorded in the issued capital preference shares account. Ad (2): Reserves Building reserves in a company is similar to what private households do when the save money for rainy days. They put aside money previously earned. The reserves as shown on the balance sheet are: - 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 the appropriation of profits and revaluation reserves apply when a company re-values its non-current assets along IAS 16.31. We start 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. To understand the concept, we explain capital reserves by the case study YARRA Ltd. We look from the point of view of an investor who owns 90,000 ordinary shares. In 20X0, YARRA Ltd. buys non-current assets at 500,000.00 ZAR and earns a profit after taxation of 140,000.00 ZAR. The company prepares the balance sheet as in Figure 11.1. No dividend has been declared so far. In the notes, YARRA Ltd. explains that its ordinary share capital is 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 the 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: 140,000 - 12,500 = 1 127,500.00 ZAR. The preference dividends are disclosed as short-term debts in the liability section on the statement of financial position; observe below in Figure 11.1. <?page no="269"?> Berkau: Financial Statements 5e 11-265 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 500,000 Share capital 1,500,000 Intangibles Reserves Financial assets Retained earnings 127,500 Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. 12,500 Prepaid expenses Provisions Cash/ Bank 1,200,000 Income tax liab. 60,000 Total assets 1,700,000 Total equity and liab. 1,700,000 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 11.1: YARRA Ltd.’s balance sheet (20X0) The balance sheet tells us the book value of YARRA Ltd. of: 1,700,000 - 60,000 - 12,500 = 1 1,627,500.00 ZAR. This results in a book value per ordinary or preference share of: 1,627,500 / 1,500,000 = 1.09 ZAR/ s. A few months 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 an issue price of 1.24 ZAR/ s. The shares’ nominal value is 1.00 ZAR/ s. The premium is: 1.24 - 1.00 = 0 0.24 ZAR/ s. To raise capital, a company can, e.g., take a loan or issue bonds or fresh shares. When a company issues fresh shares, the issue price in general exceeds the book value per share. This reflects that book values per share 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 number 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. In case shares are traded publicly, e.g., 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 <?page no="270"?> Berkau: Financial Statements 5e 11-266 to be prosperous in the nearby future. More precisely: The company's value is higher than its parts (Assets - Liabilities). 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 issuance. No one is prepared to buy fresh shares if existing shares are offered at a cheaper price. A share issue would fail in such a case. We look at the case of YARRA Ltd. On 1.07.20X1, YARRA Ltd.’s shares are traded at 1.60 ZAR/ s. Hence, the issue price of 1.24 ZAR/ s is below the fair market value. The weighted average share price for all shares after the share issue is: (1,500,000 × 1.60 + 500,000 × 1.24) / 2,000,000 = 1 1.51 ZAR/ s. Therefore, an existing shareholder will lose: 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 precisely at fair market prices? A fresh share issue is announced in advance when the market share price is yet unknown for the day of issuance. Precautionary, the issue share price is calculated and announced below the expected market share price as a share issue will fail if the price for fresh shares exceeds the fair market value of existing shares. Even when calculating prudently the problem of a loss 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 compensates 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 three existing shares one fresh share is issued. The difference between estimated fair market value and average share price after issuance is: 1.60 - 1.51 = 00.09 ZAR/ s. YARRA Ltd. compensates every existing ordinary and preference shareholder by one purchase right per three shares holding. The right's value is 0.27 ZAR/ right. The issuing company does not pay for the rights. 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 got two alternatives: - Selling on the rights results in 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 = 1144,000.00 ZAR. - Investing in fresh shares requires buying the fresh shares and paying 1.24 ZAR per fresh share and using the purchase right. 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 the share price at the <?page no="271"?> Berkau: Financial Statements 5e 11-267 day of share issue. To confirm, we check the valuation 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 Bookkeeping entries for a share issue. Issued capital always 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 of 1.24 ZAR/ s exceeding the nominal value of 1.00 ZAR/ s. The nominal portion of the share price is allocated towards issued capital. The premium portion is the difference between issue price and nominal value multiplied by the number of issued shares, in case of YARRA Ltd.: (1.24 - 1.00) × 500,000 = 1 120,000.00 ZAR. See the entire Bookkeeping (C) entry below: DR Cash/ Bank.................... 620,000.00 ZAR CR Issued Capital............... 500,000.00 ZAR CR Capital Reserves............. 120,000.00 ZAR How it is Done: (Share Issue) (1) Determine the nominal value of shares. (2) Multiply the number of shares issued 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 in the equity section on 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. Note, that these are two steps. Share buy backs are a means to change voting right proportions and/ or to control share prices because the number of shares available for trading decreases. We study YARRA Ltd. again and consider as at 1.10.20X1 the equity as below: Its 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 preference share issue. The Retained Earnings are amounting to 127,500.00 ZAR. The share price on 1.10.20X1 is down to 1.03 ZAR/ s (given). In this situation, YARRA Ltd. buys back 200,000 of its own ordinary shares. Based on IAS 32.33 we refer to these own shares as treasury shares. We record them in the Treasury Stock account by Bookkeeping entry (D). 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 <?page no="272"?> Berkau: Financial Statements 5e 11-268 profit or loss. This means we debit the issued capital and the capital reserves. Observe Bookkeeping entries (D) and (E). In 20X1, YARRA does not earn a profit and it does not declare dividends. The Bookkeeping entry at YARRA Ltd. for the share buy-back and their redemption is displayed below: DR Treasury Stock............... 206,000.00 ZAR CR Cash/ Bank.................... 206,000.00 ZAR DR Issued Capital............... 200,000.00 ZAR DR Capital Reserves............. 6,000.00 ZAR CR Treasury Stock Account....... 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 1.00 ZAR/ s. In this situation, YARRA Ltd. buys back another 100,000 of its own shares. The Bookkeeping entry below does not consider a loss as the share acquisition is recorded at nominal values. The Bookkeeping entry (F) is shown below. Note, YARRY Ltd. does not yet invalidate these treasury shares and will not do so in the next Accounting period either. DR Treasury Stock Account....... 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 127,500 Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. Prepaid expenses Provisions Cash/ Bank 1,441,500 Income tax liab. Total assets 1,941,500 Total equity and liab. 1,941,500 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X1 Figure 11.2: YARRA Ltd.’s balance sheet (20X1) <?page no="273"?> Berkau: Financial Statements 5e 11-269 How it is Done: (Share Redemption) (1) Determine the number of shares to redeem. (2) Record shares bought back based on the market value, as paid for. (3) Record a debit entry for the treasury shares and a credit entry in the Cash/ Bank account. Treasury shares are valued at cost (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 treasury 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 recording an immediate redemption. (7) National Company’s Act regulations might apply. Check beforehand. Below, we discuss earnings reserves. Earnings reserves can 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 of profits which can result in additions to earnings reserves, declaring dividends to its shareholders and/ or carrying forward profit or loss to following Accounting periods. In the case of an approval for additions to earnings reserves the amount decided on is transferred from retained earnings to earnings reserves. Special national rules apply for the appropriation of profits and additions to reserves as well as for deductions/ dissolving of reserves. We continue the case study YARRA Ltd. and discuss its fiscal year 20X2. In 20X2, YARRA Ltd. earns a profit after taxes of 192,500.00 ZAR (on cash as we want to ignore depreciation for the sake of simplification of the balance sheet in this case study). The amount is added to the Retained Earnings account and the income tax liabilities. The income tax liabilities on the balance sheet are amounting to: 30% × 192,500 / (1 - 30%) = 8 82,500.00 ZAR after income taxes are recorded. For the item cash/ bank we disclose at this stage of calculation: 1,441,500 + 192,500 / (1 - 30%) = 11,716,500.00 ZAR. In retained earnings we observe an amount of: 127,500 + 192.500 = 3 320,000.00 ZAR which includes the profit carried forward from 20X0. There is no extra account for profit/ loss carried forward. We refer to the amount in the Retained Earnings account as the distributable amount, as it is transferable to the owners by dividend payments. An investor’s portion of the profit is proportionate to her/ his holdings. Thus, a shareholder <?page no="274"?> Berkau: Financial Statements 5e 11-270 who owns 4 % of the company has a claim on her/ his share of the total dividends to the extent of 4 %. If the company decides to add the profit or portions thereof to the reserves a debit entry is made in the 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 × 1,200,000 = 448,000.00 ZAR. Treasury shares do not participate in the appropriation of profits. The total preference dividend includes the pending one from the previous year 20X1 and is: 2 × 500,000 × 5% = 5 50,000.00 ZAR. The remainder of the distributable amount is carried forward to the Accounting period 20X3. Dividends to the extent of: 48,000 + 50,000 = 9 98,000.00 ZAR are added to shortterm liabilities. The earnings reserves are combined with capital reserves for the disclosure on the balance sheet. However, in the notes, YARRA Ltd. discloses the singular items and explains them by the statement of changes in equity, as well. Find below the Bookkeeping entries made for the appropriation of profits on 31.12.20X2. The recordings anticipate the decision on the annual general meeting as the distribution was only suggested by YARRA Ltd.’s board of directors when preparing the financial statements. It still needs approval which also requires the auditing of the financial statements. DR P&L-Account.................. 192,500.00 ZAR CR Retained Earnings............ 192,500.00 ZAR DR Retained Earnings............ 98,000.00 ZAR CR Shareholders Dividend A/ P.... 98,000.00 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="275"?> Berkau: Financial Statements 5e 11-271 A C, L Non-current assets [ZAR] Equity [ZAR] P, P, E 500,000 Share capital 1,700,000 Intangibles Reserves 314,000 Financial assets Retained earnings 22,000 Current assets Liabilities (liab.) Inventory Long-term liab. Accounts receivables Short-term liab. 98,000 Prepaid expenses Provisions Cash/ Bank 1,716,500 Income tax liab. 82,500 Total assets 2,216,500 Total equity and liab. 2,216,500 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 11.3: YARRA Ltd.’s balance sheet (20X2) On the balance sheet, the total reserves are 114,000.00 ZAR in capital reserves and 200,000.00 ZAR in earnings reserves. At YARRA Ltd., no revaluations of assets apply. We covered revaluation reserves in chapter (7) already. 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, IAS 33 defines earnings. 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 contain amounts of preceding years, too. This means profit/ loss carried forward does not count for the calculation of earnings. The item retained earnings is used for profit additions to equity and for the appropriations thereof. The additions to reserves give us credit entries for reserves 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 the appropriation thereof are not repeated but some further considerations regarding 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 <?page no="276"?> Berkau: Financial Statements 5e 11-272 account and credit short-term liabilities to shareholders. The account is the Shareholders for Dividend account which is linked to the item short-term liabilities on the balance sheet. The owners expect dividend payments as they represent their share of the profit because they are partial owners of the company. Dividend payments are irreversible. This means once the dividend has been paid out shareholders do not give them back. Additions/ deductions to earnings reserves fall under financing activities. Funds added to reserves stay in the company. Reductions of reserves and their dissolving are limited in many countries by national law, such as the Company’s Act AktG in Germany, and require in general a majority decision on the annual general meeting. A carrying forward of profits in the Retained Earnings account results in a postponement of the profit appropriation decision. The funds then stay in the equity section for the next Accounting period and are automatically added to the distributable amount in the next following year. This way, carrying forward profits compromise company’s interest of reinvesting 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 dissolve 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 1,300,000 1,000,000 ordinary treasury shares R1 (100,000) preference shares R1 500,000 500,000 Reserves Capital reserves 114,000 Earnings reserves 0 Retained earnings 127,500 127,500 Yarra Ltd.'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="277"?> Berkau: Financial Statements 5e 11-273 20X2 20X1 C, L [ZAR] Equity [ZAR] [ZAR] . . . Share capital ordinary shares R1 1,300,000 1,300,000 ordinary treasury stock R1 (100,000) (100,000) preference shares R1 500,000 500,000 Reserves Capital reserves 114,000 114,000 Earnings reserves 200,000 0 Retained earnings 22,000 127,500 Yarra Ltd.'s STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 11.5: Detailed equity section on YARRA Ltd.’s B/ S (20X2) Below, we provide the accounts for YARRA Ltd. Therein, the Bookkeeping entries in 20X0 are identified by numbers, in 20X1 by caps and in 20X2 by small letters. D C D C (1) 1,000,000.00 (5) 500,000.00 c/ d 1,000,000.00 (1) 1,000,000.00 (2) 500,000.00 1,000,000.00 1,000,000.00 (3) 200,000.00 c/ d 1,200,000.00 (E) 200,000.00 b/ d 1,000,000.00 1,700,000.00 1,700,000.00 c/ d 1,300,000.00 (C) 500,000.00 b/ d 1,200,000.00 (A) 60,000.00 1,500,000.00 1,500,000.00 (C) 620,000.00 (B) 12,500.00 b/ d 1,300,000.00 (D) 206,000.00 (F) 100,000.00 c/ d 1,441,500.00 1,820,000.00 1,820,000.00 b/ d 1,441,500.00 (a) 275,000.00 c/ d 1,716,500.00 1,716,500.00 1,716,500.00 b/ d 1,716,500.00 Cash/ Bank C/ B Issued capital ordinary shares ISO D C D C c/ d 500,000.00 (2) 500,000.00 c/ d 60,000.00 (3) 60,000.00 500,000.00 500,000.00 (A) 60,000.00 b/ d 60,000.00 b/ d 500,000.00 c/ d 82,500.00 (a) 82,500.00 b/ d 82,500.00 Issued capital preference shares ISP Income tax liabilities ITL Figure 11.6: YARRA Ltd.'s accounts <?page no="278"?> Berkau: Financial Statements 5e 11-274 D C D C c/ d 12,500.00 (4) 12,500.00 (4) 12,500.00 (3) 140,000.00 (B) 12,500.00 b/ d 12,500.00 c/ d 127,500.00 (b) 48,000.00 140,000.00 140,000.00 c/ d 98,000.00 (c) 50,000.00 (b) 48,000.00 b/ d 127,500.00 98,000.00 98,000.00 (c) 50,000.00 (a) 192,500.00 b/ d 98,000.00 (d) 200,000.00 c/ d 22,000.00 298,000.00 320,000.00 b/ d 22,000.00 Shareholders for Dividend A/ P Retained earnings R/ E D C D C (5) 500,000.00 c/ d 500,000.00 c/ d 60,000.00 (3) 60,000.00 b/ d 500,000.00 (B) 60,000.00 b/ d 60,000.00 c/ d 82,500.00 (a) 82,500.00 b/ d 82,500.00 Property, plant, equipment P, P, E Income tax liabilities ITL D C D C (D) 206,000.00 (E) 206,000.00 (E) 6,000.00 (C) 120,000.00 (F) 100,000.00 c/ d 100,000.00 c/ d 114,000.00 306,000.00 306,000.00 120,000.00 120,000.00 b/ d 100,000.00 b/ d 114,000.00 D C c/ d 200,000.00 (d) 200,000.00 b/ d 200,000.00 Treasury stock account TSA Capital Reserves RES Earnings reserves RES Figure 11.6: YARRA Ltd.'s accounts continued Summary: Equity is the book value of the business. You calculate the equity on a balance sheet prepared under IFRSs by deducting all debts from the total of assets. The total of equity changes based on transactions with owners, such as share issues, share redemptions or declarations of dividend payments. It also increases or decreases by 61 See chapter (2). earnings and the appropriation thereof. Revaluations are recorded through equity, too. National law, in particular the Company’s act, includes special rules for items in the equity section on the balance sheet. The earnings are recorded based on German HGB in the Annual Surplus account and Retained Earnings account. 61 <?page no="279"?> Berkau: Financial Statements 5e 11-275 Accounting Technical Terms: Equity: Difference between assets and liabilities. We refer to equity as the book value of the company. Shares: Partial ownership of a company. It is disclosed at its nominal value on the equity section under issued capital or share capital. We translate portions of ownership on a (Pty) Ltd. or a German GmbH by shares, too. Preference shares: Shares without voting right but with a privileged rank regarding dividends and liquidation. Reserves: Portions of equity resulting from appropriations of after-tax profits, share issues with a premium or revaluations. Earnings per share ratio: After-tax profit cleared of preference dividends, if applicable, divided by the amount of outstanding ordinary shares. IAS 33 applies. Redemption of shares: Shares bought back by the company to keep them as treasury shares or for invalidation. Share premium: Positive difference between issue price and nominal value per share. The share premium is added to capital reserves. In Germany, § 272 HGB applies. Statement of changes in equity: Statement as element of financial statements that discloses the additions to and reductions from equity. See chapter (13). Treasury shares: Shares bought back buy the issuing company. Treasury shares are carried in a negative Equity account or get deducted from Equity accounts. This is referred to as contraequity account. Treasury shares cannot participate in dividend or liquidation claims. Question Bank: (1) A company issues 10,000 fresh ordinary shares at 6.70 EUR/ s. The nominal value per share is 5.00 EUR/ s. What does the Bookkeeping entry look like? 1. DR Cash/ Bank … 50,000.00 EUR - CR Issued Capital … 50,000.00 EUR. 2. DR Cash/ Bank … 67,000.00 EUR - CR Issued Capital … 50,000.00 EUR, CR Earnings Reserves … 17,000.00 EUR. 3. DR Cash/ Bank … 67,000.00 EUR - CR Issued Capital … 50,000.00 EUR, CR Capital Reserves … 17,000.00 EUR. 4. DR Issued Capital … 67,000.00 EUR - CR Cash/ Bank … 50,000.00 EUR, CR Capital Reserves … 17,000.00 EUR. (2) On 1.10.20X3, a company issues 50,000 preference shares at an issue price of 1.30 EUR/ s. The premium is 0.30 EUR/ s. The preference dividend is 4.5 %/ a based on the nominal value. The company is based on 100,000 ordinary shares at 1.00 EUR/ s face value. The profit before taxes is 25,000.00 EUR. It is decided to declare a dividend of the entire profit. How much is the ordinary dividend rounded down to the nearest EUR-cent? 1. 0.22 EUR/ s. 2. 0.15 EUR/ s. 3. 0.14 EUR/ s. 4. 0.16 EUR/ s. (3) A company got 200,000 ordinary shareholders. The fair market value per share is 3.45 EUR/ s. The company decides to issue 50,000 ordinary shares at 3.00 EUR/ s based on <?page no="280"?> Berkau: Financial Statements 5e 11-276 a rights issue. How much is the value for one purchase right (for one fresh share issued)? 1. 0.09 EUR/ r. 2. 0.36 EUR/ r. 3. 0.45 EUR/ r. 4. 0.23 EUR/ r. (4) A company earns a pre-tax profit of 100,000.00 EUR. The preference dividend is 6,000.00 EUR and got declared for the Accounting period. In the retained earnings a profit is carried forward to the extent of 50,000.00 EUR. How much are earnings based on IAS 33? 1. 64,000.00 EUR. 2. 94,000.00 EUR. 3. 114,000.00 EUR. 4. 144,000.00 EUR. (5) A company carries forward a loss of 26,000.00 EUR. In the actual Accounting period, it earns a profit after taxes of 75,000.00 EUR. At the end of June, the company issued 50,000 preference shares at 5.50 EUR/ s which is 0.50 EUR/ s above face value per share. The preference dividend is 4 %/ a based on the nominal amount of the shares. How much is the distributable amount to (all) ordinary shareholders? 1. 43,500.00 EUR. 2. 39,000.00 EUR. 3. 44,000.00 EUR. 4. 49,000.00 EUR. Solutions: 1-3, 2-4, 3-2, 4-1, 5-3. <?page no="281"?> Berkau: Financial Statements 5e 12-277 12. Statement of Profit or Loss and Other Comprehensive Income What is in the Chapter? Profit is the difference between revenue and expenses. In line with IAS 1.99, a company can either prepare the income statement following the nature of expense method or the cost of sales format. It can be 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 commonly in use 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 Accounting 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 application types. We also discuss the most important regulations regarding IFRSs. Learning Objectives: After studying this chapter, you can prepare a statement of profit or loss and other comprehensive income. You can apply the cost of sales format and the nature of expense method and understand their differences. You further know what information a reporting company must present in the notes depending on which format it applies for the statement. You understand the difference between profit and gains and between ordinary expenses and other expenses, too. An income statement compares income with expenses, see IAS 1.88. The technical terms are defined by the framework. F 4.29 explains why the IASB does not distinguish properly between revenue and gains. Both are referred to as income. For teaching purposes, we hold it like this: Revenue results from ordinary business, such as selling/ producing goods or service rendering; a gain is classified as extraordinary, like a profit on disposal of non-current assets or interest gains in companies other than banks. 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 salary, wages, materials etc. Extraordinary expenses are e.g. a water damage, except for an insurance company that covers those events. Profit or loss as disclosed by an income statement is the difference between all income and all expenses dur- <?page no="282"?> Berkau: Financial Statements 5e 12-278 ing 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 singular items of income and expenses does. The detailed income and expenses explain how the company earns its money. The statement of profit or loss and other comprehensive income can follow a structure based on the nature or on the function of items. 62 - 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 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 regarding 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. IAS 1.103 covers the cost of sales format. In the previous chapters we always applied the nature of expense method because the Bookkeeping entries are simpler. About the decision which format a company should apply, IAS 1.99 only 62 Read our Basics, chapter (28). states the company shall choose the format that provides more reliable information and is more relevant. 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 rent and administration being disclosed together as other expenses. This meets the requirements in IAS 1.81. For this textbook, we follow a standard structure for the income statement, as shown in Figure 12.3 for the NoEformat and in Figure 12.9 for the COSformat. We always apply the same format. For the income statement the accrual principle of Accounting always applies. To calculate the profit or loss for the period, it is necessary to allocate income and expenses to the Accounting period they are for. This requires calculating profit irrespectively from when payments are made or received. A train ticket bought and paid today but travelled in the next Accounting period counts as a next Accounting period’s expense. We refer to the underlying principle as the accrual basis of Accounting. When we make Bookkeeping entries, the payment date is relevant for recording. After processing Bookkeeping entries linked to activities, the Accountant must make adjustments to make sure, all income and expenses are <?page no="283"?> Berkau: Financial Statements 5e 12-279 linked to the correct Accounting period before the income statement can be prepared. 63 An extended income statement as applicable for companies based on shares in Germany based on § 158 AktG does not apply for international Accounting. An appropriation of profits is disclosed in the statement of changes in equity, instead. Below, we compare the two different methods for the income statement: (a) Nature of expense method (NoE). (b) Cost of sales format (COS). We do so by two case studies: (A) ABINGTON Ltd., an Australian law firm. (B) SUTTHAUSEN PLC, a British coffee machine producer in the UK. We choose two different company types for the case studies as the income statement for manufacturers covers finished goods produced in the company. The goods are used 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. Therefore, we start our considerations with the case of the law firm ABINGTON Ltd. in Adelaide. Data Sheet for ABINGTON Ltd. DDomicile: Australia (Adelaide). Reporting currency: AUD. Classification: service provider. Employees: 6 attorneys, 20 paralegals. Salary: attorney 85,000.00 AUD/ a; paralegal: 38,000.00 AUD/ a. 63 Read our Basics, chapter (18). Direct costs for conveyancing: 680.00 AUD/ mandate attorney labour. Operational costs: 160,500.00 AUD/ a. Rent: 5,000.00 AUD/ m due one month in advance. Manufacturing overheads: paralegal labour and operational expenses. Non-manufacturing overheads: Administration and rent. Accounting period: 20X4. Performance: 700 conveyances at 3,600.00 AUD/ mandate. VAT 20 % Ad (aA): Nature of Expense Method, ABINGTON Ltd. ABINGTON Ltd. is a law firm and specialised in conveyancing property. ABINGTON Ltd. is residing in a rented office in Adelaide and employs 6 attorneys and 20 paralegals. In 20X4, ABINGTON Ltd. transferred 700 houses and earned a revenue of 3,600.00 AUD per mandate. An attorney at ABINGTON Ltd. earns 85,000.00 AUD/ a and a paralegal earns 38,000.00 AUD/ a. Further operational costs linked to conveyancing are 160,500.00 AUD/ a, like lease rates for computer systems, office material, internet access etc. Operational expenses are VATable. The rent for the offices is amounting to 5,000.00 AUD/ m and paid one month in advance. At the beginning of the Accounting period 20X4, the Prepaid Expense account shows an opening value of 5,000.00 AUD. No VAT applies for rent. 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. <?page no="284"?> Berkau: Financial Statements 5e 12-280 (5) Operational expenses (VATable). (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 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) Before profit can be calculated, an adjustment regarding prepaid rent is required. That way, ABINGTON Ltd. makes sure the accrual principle of Accounting is followed for its income statement. See the Bookkeeping entry below for recording prepaid rent. To distinguish this Bookkeeping entry from the first one, we indicate the adjustment by the contra account ID. PRE for prepaid expenses <?page no="285"?> Berkau: Financial Statements 5e 12-281 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. 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 in the Profit and Loss account to income statement items, such as different labour categories that 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. <?page no="286"?> Berkau: Financial Statements 5e 12-282 [AUD] Revenue 2,520,000 Changes in inventory 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) We continue the case study ABINGTON Ltd. below for the cost of sales format after introducing the income statement along the nature of expense method for a production firm. Our case study for Manufacturing is SUTTHAUSEN PLC in York. Data Sheet for SUTTHAUSEN PLC Domicile: Great Britain (York). Reporting currency: GBP. Classification: Manufacturing. Product: coffee machines. Bill of Materials BOM: 1 water pump, 1 coffee capsule dispense unit CCDU. 1 box for shipping. Materials: see Figure 12.5; opening value for inventories: 42,000.00 GBP. Production amount (20X4): 30,000 units. Sales amount (20X4): 28,500 units; net selling price: 60.00 GBP/ u. Depreciation: 28,000.00 GBP/ a in Assembling; 1,000.00 GBP/ a in Cleaning; 2,000.00 GBP/ a in Shipping. Labour: 40,000 GBP/ a in Assembling; 30,000.00 GBP in Cleaning; 25,000.00 GBP/ a in Shipping; 55,000.00 GBP in Management/ Administration. VAT 20 % Ad (aB): Nature of Expense Method, SUTTHAUSEN PLC With regard to income statements, a production firm requires further Bookkeeping work, as a production firm adds self-manufactured goods to stock, which results in an increase of assets and reduction of expenses in the Accounting period when it manufactures these goods. When the inventories are decreased, inverted Bookkeeping entries apply. We discuss below the income statement for the coffee machine manufacturer SUTTHAUSEN PLC. 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 much different to non-manufacturing companies. However, once the value <?page no="287"?> Berkau: Financial Statements 5e 12-283 of finished goods inventories increases the additional stock is added to finished goods inventories and negative expenses are recorded through profit or loss. This means, we make a debit entry in the Finished Goods Inventory account and an entry in the Profit and Loss account on the credit side. Hence, we cancel out the expenses for the cost of manufacturing regarding the increase of finished goods. Therefore, producing goods and not selling them has no impact on profit or loss. For the recording of inventory movements, a periodic system is sufficient. We already recorded changes of inventories this way by making a “closing stock”-entry on the credit side of RYNEVELD (Pty) Ltd.’s Trading account in chapter (4). Caution! The consideration of changes in closing stock requires to make an entry for the opening value and the closing stock in the Trading account at the same time. This way the changes (and not the closing stock) in inventory are recorded through profit or loss. In the case of RYNEVELD (Pty) Ltd. the opening value is zero. The measurement of inventory changes in finished goods is based on the costs of manufacturing which include the purchase cost of materials plus all costs of conversion. Conversion costs are direct labour and 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 as non-manufacturing related and are excluded from the calculation of finished goods. For the recording of finished goods and the deferring of their manufacturing costs, look at case study ANKYO Ltd. You reach the case study via the Link 12.A. Link 12.A: ANKYO Ltd. Below, we apply the nature of expense method for SUTTHAUSEN PLC. SUTTHAUSEN PLC is a manufacturer for espresso machines in York. An espresso machine contains a water pump and a coffee-capsule-dispense-unit CCDU. For shipping, the espresso machines are 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. <?page no="288"?> Berkau: Financial Statements 5e 12-284 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. 64 At first, the espresso machines are assembled in the Assembling department. The next step is a cleaning process followed by packing. All espresso machines are packed, even those not yet sold. Hence, finished goods are espresso machines in a box. SUTTHAUSEN PLC runs three departments: Assembling, Cleaning and Shipping. During the Accounting period 20X4, SUTTHAUSEN Ltd. purchases the materials below: Item Date of purchase Amount Unit costs Cost of purchase [GBP] [GBP] CCDU 2.01.20X4 30,000 14.00 420,000.00 Water pump 3.01.20X4 20,000 9.50 190,000.00 boxes 6.01.20X4 30,000 1.00 30,000.00 Water pump 14.01.20X4 20,000 10.50 210,000.00 cleaning soap for 100 machines 15.01.20X4 300 10.00 3,000.00 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. In 20X4, SUTTHAUSEN PLC records 28,000.00 GBP/ a depreciation on the Assembling department, 1,000.00 64 Read our Management Accounting, chapter (17). GBP/ a depreciation on the Cleaning department and 2,000.00 GBP/ a depreciation on the Shipping department. Labour is 40,000.00 GBP/ a in the Assembling department, 30,000.00 GBP/ a in the Cleaning department and 25,000.00 GBP/ a in the Shipping department. <?page no="289"?> Berkau: Financial Statements 5e 12-285 There is a further 55,000.00 GBP/ a labour in the Management/ Administration department. In 20X4, SUTTHAUSEN PLC sells 28,500 espresso machines at 60.00 GBP/ u 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. This keeps Accounting workload low, as we only measure how much materials are left on stock at the end of the fiscal year. There are only CCDUs (I.CC), water pumps (I.WP) and espresso machines (FGI) left. The threedigit codes represent the contra accounts to the Profit and Loss account. We do not need further inventory accounts when we apply a periodic system. The recorded business activities are: (1) Purchase of CCDUs. (2) Purchase of water pumps. (3) Purchase of boxes. (4) Purchase of water pumps. (5) Purchase of soap. (6) Depreciation Assembling. (7) Depreciation Cleaning. (8) Depreciation Shipping. (9) Accounting for labour in Assembling. (10) Accounting for labour in Cleaning. (11) Accounting for labour in Shipping. (12) Accounting for labour in Management/ Administration. (13) Revenue recognition. At the end of 20X4, there are: 3,000 × 14 = 4 42,000.00 GBP CCDUs on stock. There are further water pumps to the value of: 10,000 × (20,000 × 9.50 + 20,000 × 10.50) / 40,000 = 1 100,000.00 GBP on stock. SUTTHAUSEN PLC carries a stock of 1,500 espresso machines which have not yet been sold. The value per espresso machine requires calculations with consideration of the weighted average cost formula for materials. This means, the left espresso machines are calculated on yearly average purchase costs. As the nature of expense method does not support calculations, we calculate the unit cost of manufacturing per finished goods by a working: The unit cost of manufacturing are the materials plus depreciation and manufacturing overheads for labour which gives us 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/ u. Hence, the closing stock 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 Figure 12.6: SUTTHAUSEN PLC’s accounts (NoE) <?page no="290"?> Berkau: Financial Statements 5e 12-286 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 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 Figure 12.6: SUTTHAUSEN PLC’s accounts (NoE) continued <?page no="291"?> Berkau: Financial Statements 5e 12-287 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 [GBP] Revenue 1,710,000 Changes in inventory 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. The increase in finished goods is based on a calculation of the cost of manufacturing which are here <?page no="292"?> Berkau: Financial Statements 5e 12-288 deducted from the total expenses, which results in an addition on the income statement. Releases from stock of finished goods would be added to expenses. Next, we discuss the cost of sales format. We start again with the case study ABINGTON Ltd. Ad (bA): Cost of Sales Format, ABINGTON Ltd. We repeat the preparation of the income statement but apply the alternative method: the cost of sales COSformat. As expenses are only disclosed for goods/ services sold, no changes in closing stock of inventories are added to income due to cost adjustments. At the first glance, this sounds easy, but it is not. The cost of sales format compels us to allocate costs to goods/ services which results in extra Accounting work. These cost allocations provide the user of financial statements with better product information. An income statement based on the cost of sales format for a one-service company is easier than for a manufacturing firm with a lot of different goods produced in plenty of batches. You can reach such a more complicated case study about a production firm for garden tools through the Link 12.B. Link 12.B: HEUNING Ltd. ABINGTON Ltd. only renders one service: the legal transfer of property. The costs are either linked to the service, which we refer to as manufacturing costs, or are common costs which are disclosed separately on the income statement. The latter ones are non-manufacturing costs. Do not worry about the technical terms in Accounting, they are derived from Industrial Management. Manufacturing here means property conveyancing. We do not repeat the first business activities but start-off after initial Bookkeeping entries have been completed as shown in Figure 12.1. This is before profit calculations. The cost of sales format requires a product calculation, here, the calculation per property transfer. The Work-in-Process account and the Manufacturing Overhead account apply. For the sake of avoidance of Industrial Management terms, we rename the Manufacturing Overheads account and call it the Conveyance Overheads Account COH. All direct costs are closed-off to the WIP account. Attorney’s costs are direct costs as the attorney represents the buyer of property legally in court. The direct costs are 680.00 AUD/ mandate (given). We add: 680 × 700 = 4 476,000.00 AUD to the WIP account. Attorneys’ costs to an extent of 34,000.00 AUD are <?page no="293"?> Berkau: Financial Statements 5e 12-289 for administration purpose and are prohibited for allocation towards mandates. Consider those costs for consultation when, e.g. hiring staff. 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 assigned to the mandates. The same applies for the operational costs. Both are transferred to the Conveyance Overheads account. Those costs count as overheads as the paralegals do not work for specific mandates but share the work based on functions, like corresponding with the deeds’ office, email work, keeping customer contacts etc. 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 (given). 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 is closedoff to the Profit and Loss account by 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. 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 12.8: ABINGTON Ltd.’s accounts (COS) <?page no="294"?> Berkau: Financial Statements 5e 12-290 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 COH 160,500.00 Labour Paralegals-20X4 LAP Operational expenses-20X4 OEX D C D C c/ d 2,520,000.00 (6) 2,520,000.00 (5) 32,100.00 (6) 504,000.00 P&L 2,520,000.00 b/ d 2,520,000.00 c/ d 471,900.00 504,000.00 504,000.00 b/ d 471,900.00 Revenue-20X4 Value added tax VAT D C D C LAA 476,000.00 COS 1,396,500.00 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 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 <?page no="295"?> Berkau: Financial Statements 5e 12-291 [AUD] Revenue 2,520,000 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 total expenses attributable to conveyancing services and as other expenses costs for administration and rent. A company can disclose single items for different services and goods, however, IAS 1.81A does not explicitly require. Only in cases a company works in different industries, such as a software design company that offers consultancy, it must 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. We now prepare a profit calculation based on three WIP accounts and three Manufacturing Overhead accounts - for each department two accounts as we follow a Process Costing. The Bookkeeping entries (1) to (12) are the same as for the nature of expense method. As we now apply the cost of sales format, the inventory movement system changes to the perpetual system. Therefore, we add purchases to the stock accounts for CCDUs, water pumps, boxes and cleaning soap. We observe the handling of CCDUs. The purchases are transferred to the Inventory CCDU account. CCDUs released from stock are: 30,000 × 14 = 420.000.00 GBP. They are added to the WIP Assembling account. Observe the Bookkeeping entries below about the CCDUs. DR Inventory CCDU ............... 420,000.00 GBP CR Purchase..................... 420,000.00 GBP <?page no="296"?> Berkau: Financial Statements 5e 12-292 DR WIP Assembling............... 420,000.00 GBP CR Inventory CCDU............... 420,000.00 GBP Other materials are recorded 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: 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 the same way. In a Process Costing system, the costs of manufacturing are transferred from one department to the next one. Therefore, 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 By a similar Bookkeeping entry, the completed goods are transferred from the last step of production (Shipping department) to the Finished Goods Inventory account. After 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 <?page no="297"?> Berkau: Financial Statements 5e 12-293 According to the perpetual inventory system, we make two Bookkeeping entries to record a sale. One is for the cash receipt and another one is for the inventory movement. Inventory movement requires to add 28,500 espresso 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/ u. 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 together, to keep the case simple. We skip the Cost of Goods Sold account but we identify the Bookkeeping entry for inventory movements by the 3-letter code COS. You find the contra entry in the Profit and Loss account. See below both Bookkeeping entries: 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 After the sale, we prepare a Profit and Loss account and only consider expenses for the goods sold plus non-manufacturing expenses for Management / Administration. The profit is the same as calculated above applying the nature of expense method. Observe the profit calculation based on the accounts displayed in Figure 12.10. D C D C OV 100,000.00 c/ d 100,000.00 (1) 420,000.00 I.CC 420,000.00 b/ d 100,000.00 (2) 190,000.00 I.WP 400,000.00 (3) 30,000.00 I.BX 30,000.00 (4) 210,000.00 I.SP 3,000.00 (5) 3,000.00 853,000.00 853,000.00 Property, Plant, Equipment Purchase-20X4 PRC D C D C c/ d 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 Figure 12.10: SUTTHAUSEN PLC’s accounts (COS) <?page no="298"?> Berkau: Financial Statements 5e 12-294 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 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 Figure 12.10: SUTTHAUSEN PLC’s accounts (COS) continued <?page no="299"?> Berkau: Financial Statements 5e 12-295 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 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 right. However, this only matters if you do Accounting in the university on paper or by MS-Excel. In real Accounting, your Bookkeeping software processes all calculations. After customizing your Accounting system, a few more accounts will not do any harm. The advantage of the cost of sales format lays in the calculation of goods/ services inside of the accounts. You do not need a working sheet for <?page no="300"?> Berkau: Financial Statements 5e 12-296 calculations as you do for the nature of expense method. However, in the end, the reporting company decides what information is provided by the financial statements, either cost categories by the nature of expense method or good/ service costs by the cost of sales format. 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 reporting 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 about labour and depreciation in the notes. [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 on the statement of profit or loss and other comprehensive income. IAS 1.99 requires a reporting company presenting an analysis of recognised expenses either based on nature of expenses or cost of sales, whatever information is better for the reader of financial statements. Hence, the 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 income statement result in the same profit or loss and other comprehensive income figure. Accounting Technical Terms: Accrual basis of Accounting: Principle by which income and expenses are <?page no="301"?> Berkau: Financial Statements 5e 12-297 assigned to the period they are for, irrespectively of when payments or receipts take place. Costs: Expenses that are linked to the ordinary business of a company. In this textbook, we purport that costs equal expenses and vice versa. Cost of sales: Format for the presentation of a statement of profit or loss which classifies expenses based on functions. Allocations of expenses apply to assign costs to objects, such as certain goods or services. Gain: Extraordinary revenue. Income: Increase of economic benefits during an Accounting period. Income can result from sales revenue or gains. Income statement: Statement of profit or loss and other comprehensive income. In the old days, an income statement was net of other comprehensive income. Nowadays, we apply the name income statement for a statement that includes ordinary and extraordinary profits/ gains and expenses. IAS 1.81 applies. Nature of expense: Format for the presentation of a statement of profit or loss which classifies expenses based on cost categories. Other comprehensive income: Revenue that does not result from continued operations, such as profit on disposals of non-current assets. Product: Finished good or service. Revenue: Net amount of proceeds which are received as compensation for the sale of goods/ services. Question Bank: (1) A company records an opening value of finished goods of 350.00 EUR and a closing stock of 120.00 EUR. The revenue is amounting to 1,000.00 EUR. Operational expenses are 200.00 EUR. How much is the profit before income taxes? 1. 1,030.00 EUR. 2. 680.00 EUR. 3. 570.00 EUR. 4. 1,150.00 EUR. (2) Which statement is correct? 1. The COS-format applies allocations to assign expenses to cost categories. 2. The NoE-format records expenses based on its function for the entity. 3. The NoE-format uses cost allocations to assign expenses to cost objects. 4. The NoE-format records expenses based on characteristics and not along its function. (3) Which of the below listed items are disclosed on the statement of profit or loss and other comprehensive income that is prepared along the COS-format? 1. Revenue, cost of services rendered, administration expenses, interest. 2. Revenue, gain, cost of goods sold, depreciation, interest. 3. Profit, gain, labour, manufacturing depreciation, interest. 4. Revenue, dividend income, labour, interest. (4) A company spends 50,000.00 EUR on materials (net amount) and 70,000.00 EUR on direct labour. The applied overheads are 40,000.00 EUR. This is an over-application of overheads to the extent of 10 % based on the applied amount. During the Accounting <?page no="302"?> Berkau: Financial Statements 5e 12-298 period, 800 goods are manufactured. 100 thereof are faulty and disposed. The company sells 622 of the goods. How much are the cost of sales? 1. 124,400.00 EUR. 2. 125,974.68 EUR. 3. 128,400.00 EUR. 4. 120,400.00 EUR. (5) Which accounts are required to prepare a statement of profit or loss and other comprehensive income following the nature of expense format? 1. Revenue account, Purchase account, Trading account, Manufacturing Overheads account. 2. Revenue account, Purchase account, Inventory of Finished Goods account and Administration account. 3. Trading account, Purchase account, Finished Goods Inventory account, Manufacturing Overheads account. 4. Revenue account, Cost of Sales account, Manufacturing Overheads account, Work-in-Process account. Solutions: 1-3, 2-4, 3-1, 4-4, 5-2. <?page no="303"?> Berkau: Financial Statements 5e 13-299 13. Statement of Changes in Equity What is in the Chapter? The statement of changes in equity tells the user of financial statements how the book value of the company changed during the reporting period. That information helps investors to make reasonable economic decisions. 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 Port Elizabeth. We cover different situations that change its equity: Share issue and treasury shares, dividend receipts, earning 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 of changes in equity and the information to be disclosed in the notes. Learning Objectives: After studying this chapter, you can read and prepare a statement of changes in equity. You know what needs to be reported by the statement of changes in equity and can determine how certain business activities change the book value of a company. You get familiarised with the major IFRS standards ruling the statement of equity and know about the disclosure requirements in the notes for equity. No IFRS standard is directly assigned to the statement of changes in equity. The most important regulations result from IAS 1.106 -1.110. Therein, the IASB mandates that a reporting company must prepare a statement of changes in equity as it is part of a full set of financial statements. 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 must provide a detailed view on other comprehensive income and on dividends - either in the notes or in the statement of changes in equity. In Germany, no statement of changes in equity is required following HGB regulations. However, § 158 AktG makes companies based on shares extend their income statements for disclosure of their profits' appropriation. Below, we accompany BELMONT Ltd. with its preparation of the statement of changes in equity step by step. The statement of changes in equity considers: (1) Share issue/ treasury shares. (2) Profit or loss. (3) Other comprehensive income. (4) Revaluations of assets. (5) Appropriation of profits. For our case study, we assume all changes occur in one Accounting period and prepare the statement of changes in equity after each of the above 5 steps. In the end we disclose the entire statement for BELMONT Ltd. <?page no="304"?> Berkau: Financial Statements 5e 13-300 Data Sheet for BELMONT Ltd. DDomicile: South Africa (Port Elizabeth). Reporting currency: ZAR. Classification: service provider. Reporting period: 20X7. Issued capital: 1,000,000 ordinary shares at 1.00 ZAR/ s. Issue of 500,000 preference shares at 1.00 ZAR/ s on 31.03.20X7, issue price: 1.50 ZAR/ s; dividend: 7 %; rights issue. Share buy-back: on 1.10.20X7: 200,000 ordinary shares at 2.05 ZAR/ s. Profit after taxes (20X7): 490,000.00 ZAR. Other comprehensive income (20X7): gain on disposal before taxation 100,000.00 ZAR. Investment income from cafeteria ownership (20X7): 32,000.00 ZAR. Asset revaluation: increase of cafeteria's value by 150,000.00 ZAR. Appropriation of profits: preference dividends; 0.05 ZAR/ s ordinary dividend; 100,000.00 ZAR added to reserves. VAT n/ a. BELMONT Ltd. is a gym in 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. 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 provides 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 to compensate the loss from the previous year(s) but does not have to. In the case of BELMONT Ltd., the reserves shown are completely earnings reserves which could have been dissolved at the discretion of the company. The owners' approval 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 prepara- <?page no="305"?> Berkau: Financial Statements 5e 13-301 tion of the statement of changes in equity line by line 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. 65 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. As the shares’ issue price exceeds the nominal value a premium of: 1.50 - 1.00 = 0 0.50 ZAR/ preference share is added to capital reserves. This gives: 500,000 × 0.50 = 250,000.00 ZAR. The simplified Bookkeeping entry for the share issue is shown below: 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 excludes them from dividend payments. A share brought back is no asset as the company cannot be its own shareholder. Treasury shares are 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 of remaining shares. IAS 32.33 rules treasury shares. 65 Read our Basics, chapter (33). The shares are to be deducted from equity at values derived from the consideration paid. On 1.10.20X7, BELMONT Ltd. buys 200,000 of its own (ordinary) shares. The paid share price is 2.05 ZAR/ s. The cost method applies following IAS 32.33 which means the treasury shares are carried at their cost of re-acquisition. As the ordinary shares do not have an impact on the capital reserves due to their par-value issue, no changes of capital reserves apply. BELMONT Ltd. does not intend to redeem the treasury shares in the nearby future. No profit or loss is recorded. <?page no="306"?> Berkau: Financial Statements 5e 13-302 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 add one line in the statement of changes in equity per transaction. 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. See in Figure 13.3 the statement of changes in equity for BELMONT Ltd. as far as discussed at this stage. 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 earnings after taxes exceed the loss carried forward. At the same time, the income taxes for the profit are added to the Income Tax Liability account. Observe the Bookkeeping entries below. The income tax calculation results in a tax liability of: 30% × 490,000 / (1 - 30%) = 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 profit details already. See the statement of changes in equity at this stage of the preparation in Figure 13.4. <?page no="307"?> Berkau: Financial Statements 5e 13-303 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) 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, therefore, it 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: 100,000 - 30,000 = 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. holds shares of a cafeteria on its premises which was previously sourced out. BELMONT Ltd. owns 40 % 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% = 32,000.00 ZAR. The amount is classified as other comprehensive income resulting from investments. Income taxes have been deducted already. At BELMONT Ltd., the Accountant makes the Bookkeeping entry as below; no dividend tax applies for BELMONT Ltd. as it is a company. DR Cash/ Bank.................... 32,000.00 ZAR CR Subsidiary Income (OCI)...... 32,000.00 ZAR <?page no="308"?> Berkau: Financial Statements 5e 13-304 See below the statement of changes in equity at BELMONT Ltd. in Figure 13.5 at this stage. 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 investment. The cafeteria is a subsidiary and is worth 400,000.00 ZAR on 1.01.20X7. Without further explanation of the reasons, 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 recognition of the revaluation reserves and reduction for deferred tax liabilities. <?page no="309"?> Berkau: Financial Statements 5e 13-305 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) Ad (5): Appropriation of Profits An appropriation of profits is the distribution of profits between owners and the company. There are three options: (a) declaration of a dividend, (b) addition to earnings reserves or (c) postponement of the decision with carrying forward the profit. To be more precise, it is not the profit but the distributable amount that is subjected 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. To pay its ordinary shareholders a dividend, BELMONT Ltd. must declare a preference dividend, as well. 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 discounted by 25 % as the preference share issue took place on 31.03.20X7. The distributable amount to ordinary shareholders is: 442,000 - 26,250 = 415,750.00 ZAR. BELMONT Ltd. declares a dividend of 0.05 ZAR/ ordinary share. The total ordinary dividend is: 0.05 × 1,000,000 = 50,000.00 ZAR. On the annual general meeting, the owners of BELMONT Ltd. decide to add an amount of 100,000.00 ZAR to earnings reserves and to carry forward the remainder of the distributable amount to the next Accounting period. 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 regarding tax on capital returns themselves. In real Accounting, the company is owing the tax on capital returns for its inland residing shareholders. 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 reductions. This simplification does not mean a big difference for Accounting as the dividends as well as resulting tax liabilities thereof are recorded as short-term liabilities on <?page no="310"?> Berkau: Financial Statements 5e 13-306 the balance sheet. It does not matter for the statement of changes in equity. 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 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 singular items or prepare an aggregated statement of changes in equity 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 buy-backs/ redemptions and make entries in the issued capital column and in the capital reserves column accordingly. (5) Add a line for profit or loss. Enter the profit after taxation in the retained earnings column. <?page no="311"?> Berkau: Financial Statements 5e 13-307 (6) Add a line for other comprehensive income. Enter other comprehensive income after taxation in the retained earnings column. (7) Add a line for the appropriation of profits. Change retained earnings and make additions to reserves if applicable. Deal with dissolving reserves the other way around. (8) Add a line for preference dividends. Reduce the retained earnings for the declaration of dividends. (9) In case of a revaluation, make additions to the Revaluation Reserves account. If revalued assets are depreciated disclose a reduction of revaluation reserves and enter adjustments for retained earnings. (10) Add all line items and disclose the sum per line in the right column. (11) Add all column lines and disclose the total in the bottom line. The bottom-line figures must be consistent with the balancing figures in the related accounts and with the balance sheet. Summary: The statement of changes in equity is required in IAS 1.10. It shows the additions and reductions in the equity section on the balance sheet. The columns represent the equity items and lines the yearly 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 yearly additions and reductions of equity items on the balance sheet. 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. <?page no="312"?> Berkau: Financial Statements 5e 13-308 (3) A company based on shares discloses a profit carried forward of 25,000.00 EUR. In the reporting period, the profit before taxation is 100,000.00 EUR. On its annual general meeting the shareholders declare a dividend of 50 % of the distributable amount. There are 10,000 ordinary shares. How much is the dividend per share? 1. 6.25 EUR. 2. 5.00 EUR. 3. 4.75 EUR. 4. 7.00 EUR. (4) A company re-values its noncurrent assets that are recorded at 100,000.00 EUR by 40 %. How is the revaluation disclosed on the statement of changes in equity? 1. Increase of reserves by 40,000.00 EUR and increase of retained earnings by 40,000.00 EUR. 2. Increase of reserves by 28,000.00 EUR and increase of retained earnings by 28,000.00 EUR. 3. Increase of reserves by 40,000.00 EUR. 4. Increase of reserves by 28,000.00 EUR. (5) A company issues 200,000 shares at 5.50 EUR/ s which 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 changes in equity (total)? 1. 1,160,000.00 EUR. 2. 1,060,000.00 EUR. 3. 1,165,000.00 EUR. 4. 1,190,000.00 EUR. Solutions: 1-2, 2-3, 3-3, 4-4, 5-3. <?page no="313"?> Berkau: Financial Statements 5e 14-309 14. Liabilities on the Balance Sheet What is in the Chapter? In this last chapter (14), we cover the valuation and presentation of liabilities. In general, liabilities fall under financial instruments which are disclosed on the borrowers’ balance sheet on the credit side. We repeat some aspects discussed already in chapter (7) and chapter (9) from the creditors' perspective. However, we now look from the opposite side (debtors’ perspective) at financial instruments. Learning Objectives: After studying this chapter (14) you know the major group of liabilities: certain liabilities, provisions and contingent liabilities and you know their measurement. We teach you how to carry liabilities at amortised costs and how to apply the effective interest method. Furthermore, you develop an understanding for provisions and learn how to disclose them at present values. You will get to know the major IFRSstandards and paragraphs applicable for the disclosure of liabilities and provisions. 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 means making a payment or providing goods or services in return for the settlement of a 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, therefore, is to be disclosed as a liability. See IAS 1.16. 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 compliance 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. Uncertain liabilities are provisions or contingent liabilities. Uncertainty means, at least one of the characteristics of the liability is undetermined, such as payment terms (amount or date) or whether a payment is to be made at all. A provision applies, e.g., when a company agrees to the payment of a pension for its manager. Then, a present obligation exists due to the contract but the future payment and it terms are uncertain. It depends on the beneficiary, whether she/ he will be alive when payments are due to receive them. In cases where no present obligation exists a contingent liability applies. In general, neither contingent assets nor contingent liabilities should be 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 complicated IAS 39 in the nearby future, we focus <?page no="314"?> Berkau: Financial Statements 5e 14-310 on IFRS 9 for reporting liabilities only. This determines e.g. 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 disclosure at present values. 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 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 66 Read Appendix B of IFRS 9: IFRS 9.B4.1.2.9. amount at which assets are exchanged or liabilities are transferred in an orderly transaction. The term orderly transaction refers to normal business transactions, whereas, e.g., a liquidation is not considered being orderly. In cases, when the valuation of liabilities fluctuates, e.g., when bonds are traded publicly, a company holding bonds or a company that issued the 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 of market prices would cause permanent changes in the valuation of the liability. In cases of determined settlement amounts, such as for bonds or granted loans, the entire fair value measurement and all adjustments through profit calculations until maturity 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, financial instruments should be carried at amortised costs. Bonds or loan assets (holder’s 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 changes in fair values but to stick to the settlement amounts 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. For debt valuation at amortised costs the effective interest method applies. 66 <?page no="315"?> Berkau: Financial Statements 5e 14-311 The effective interest method approximates the liability valuation continuously towards its settlement value. Therefor, the liability must be revalued by the effective rate of interest every year. In the case of BATHURST Ltd. in chapter (6) where the loan is paid out and redeemed at its nominal value the effective rate of interest equals the nominal one. Thus, the loan is revalued by the effective interest and the paid interest is deducted. In this case, that leads to a loan valuation that stays always at nominal values. However, a company that buys a bond at a discount (below-pari) experiences a difference between effective and nominal interest rate, which leads to the effective rate of interest exceeding the nominal one. Hence, the bond increases by the difference between effective interest and paid coupons. The bond valuation then increases step by step and ends at maturity at the settlement value. This follows the pattern along which bonds are traded. We explain the effective interest method in detail by most of the next following case studies. For the sake of teaching, we initially explain the technical term effective interest: In Finance, the effective interest rate is the rate of interest applicable under consideration of monthly compounded interest. To determine the effective rate of interest when the annual interest rate is known, we apply the formula i eff = (1 + i a / 12) 12 - 1. We assume the annual rate of interest is 2.4 %/ a. Hence, the effective rate of interest equals: (1 + 0.2%) 12 - 1 = 2.43%/ a. The effective rate of interest further can consider additional costs, such as bank fees, as interest portions. We show this by the case of MEUL Ltd. further below. Next, we discuss four liability cases: (1a) Buying goods on credit (shortterm liability case). (1b) Taking a bank loan at a discount and paying closing fees to the bank (at amortised cost). (1c) Bonds (at amortised costs). (1d) Annuity with extra repayments agreed on (at amortised costs). In this chapter (14), we do not cover cases with long-term liabilities carried at volatile fair values as they seldom apply. It would require permanently transferring the liabilities. Ad (1b): Buying Goods on Credit Buying goods on credit results in general in a payment obligation due in the nearby future. IAS 1.56 instructs a company to classify its debts as shortterm liability if due within a year. Therefore, we do not revalue shortterm debts and carry them at initial valuation which is the settlement amount. Here is an example: Data Sheet for WARWICK Ltd. DDomicile: Australia (Adelaide). Reporting currency: AUD. Classification: n/ a. Short-term payables: 120,000.00 AUD from purchases. Purchase date: 3.01.20X5. Repayment: 3.01.20X6. Interest: n/ a. VAT 20 %. WARWICK Ltd. buys goods from its supplier on 3.01.20X5 and agrees to pay the purchase price of 120,000.00 AUD on <?page no="316"?> Berkau: Financial Statements 5e 14-312 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 linked to the purchase as receivables. Ad (1b): Taking a bank loan as an annuity We repeat the case study BATHURST Ltd. from chapter (6). The effective rate of interest is 2.5 %/ a. At first, we analyse the bank loan in terms of mathematics. The representation of the bank loan is by a payment vector in arrears: L(t) = {150,000; (18,750); (18,375); (18,000); (17,625); (17,250); (16,875); (16,500); (16,125); (15,750); (15,325)}. This is correct as BAHTURST Ltd. pays interest and pay-off on 31.12. every fiscal year. However, the bank loan’s pay-out took place on 1.01.20X4 - almost one year before the first payment for interest and pay-off is due. We pull the first payment (a few hours) forward which puts it on 31.12.20X3. For the financial plan, payments during the first Accounting period start with an opening value of 150,000.00 AUD. The effective interest method launches an increase of the value in 20X4 based on the effective rate of interest, which gives: 150,000 × 2.5% = 3,750.00 AUD. Thereafter, the paid interest and the pay-off amount are deducted which gives the closing amount. In 20X4, the increase in valuation is the same as the interest paid to the bank. In fact, only pay-off are deducted. Hence, the closing value of the bank loan is: 150,000 + 3,750 - 3,750 - 15,000 = 135,000.00 AUD, of which 15,000.00 AUD are classified as shortterm liabilities. In 20X5, the closing value of the bank loan equals: 135,000 + 3,375 - 3,375 - 15,000 = 120,000.00 AUD. Again, 15,000.00 AUD thereof are recorded as the short-term liabilities. The bank loan shows at: 120,000 - 15,000 = 105,000.00 AUD as you can observe in Figure 6.4. Below, we change the payment terms. The bank now requires paying the interest monthly - in 20X4 to an extent of: 3,750 / 12 = 312.50 AUD/ m. The pay-off of the bank loan is due on 31.12.20X4 to the full extent of 15,000.00 AUD. This now gives us a monthly payment vector for the first period: B m (t) = {150,000; (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (312.50); (15,312.50)}. We calculate the internal rate of return for the above-given payment vector and come up with 0.20 83 %/ m which gives an annual rate of 2.52 88 %/ a (compound interest calculation). If we apply the formula discussed earlier in this <?page no="317"?> Berkau: Financial Statements 5e 14-313 chapter, we get the same result: (1 + 2.5%/ 12) 12 - 1 = 2.52 88 %/ a. What is the impact of monthly payments on financial statements? Nothing! We do not report monthly and report the total of paid interest on the income statement. However, from the point of view of calculations, monthly payments make the loan a bit more expensive, which is approximately 2.06 AUD/ m. That is the reason banks must disclose the annual effective rate of interest in their terms and conditions T&Cs. Another reason for the effective interest rate to exceed the nominal one is a discount regarding the pay-out of the bank loan. We consider a 1,000.00 AUD in closing fees paid by BATHURST Ltd. upon loan issuance. The amount reduces the receipt from the bank in 20X4. The bank only pays 149,000.00 AUD on 1.01.20X4 for a bank loan with a principal of 150,000.00 AUD. Regarding the payment vector, only the first element changes, as interest and pay-off are based on the principal and thus remain unchanged. The internal rate of return for the vector now increases to 2.63 42 %/ a. The increase in valuation is: 149,000 × 2.63% = 3,925.00 AUD. The value of the bank loan on 31.12.20X4 is: 149,000 + 3,925 - 3,750 - 15,000 = 134,175.00 AUD. One year later, it is: 134,175 + 3,534.48 - 3,375 - 15,000 = 119,334.48 AUD. From the closing amounts, a portion of 15,000.00 AUD is to be classified as short-term debt and does not show as interest bearing liabilities. Under application of the effective interest method, the final value of the loan is zero and the total of effective interest and the sum of paid interest and fees are the same. We deliberately uploaded Link 6.A as an MS-Excel file for you to experiment with the figures. Next, we explain the Bookkeeping entries for a loan valuation at amortised cost by the bank loan taken by MEUL Ltd. in Mossel Bay. Data Sheet for MEUL Ltd. DDomicile: South Africa (Mossel Bay). Reporting currency: ZAR. Classification: n/ a. Bank loan: 1,000,000.00 ZAR at a discount of 5 % and transaction fees of 20,000.00 ZAR. Rate of interest: 3 %/ a due at year-ends. Pay-out: 31.12.20X2. Pay-off: 250,000.00 ZAR at year-ends. Payment periods: 20X1 - 20X5. VAT n/ a. On 31.12.20X1, MEUL Ltd. takes a bank loan of 1,000,000.00 ZAR at an annual rate of interest of 3 %/ a from FNB 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%) = 9950,000.00 ZAR. Even though the received amount is less than the principal, all interest and repayments are based on the principal, here: 1,000,000.00 ZAR. MEUL Ltd. pays the service fees to the bank instantly. The bank loan’s annual rate of interest is 3 %/ a payable at yearends. The bank loan is to be paid-off <?page no="318"?> Berkau: Financial Statements 5e 14-314 every year by 250,000.00 ZAR/ a, commencing on 31.12.20X2. We calculate the annual payments in preparation of a payment vector for the entire loan. On 31.12.20X1, MEUL Ltd. receives the loan to the 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 = 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: 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 to repayments, interest expenses are 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 valuation, 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 the 4 th degree polynomial for the rate of interest; therefore, we take 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 interest 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. To recalculate the figures, we offer you the spreadsheet through Link 14.A for download: <?page no="319"?> Berkau: Financial Statements 5e 14-315 Link 14.A: MEUL Ltd. MEUL Ltd. increases the liability by 6.15 % every year and pays interest and paysoff amounts which retires the entire bank loan on 31.12.20X5. The settlement amount, calculated as the future value, of MEUL Ltd.’s bank loan as at 31.12.20X5 is approximately 67 zero if we consider the payment received in 20X1 for the calculation, as well: 930,000 × (1 + 6.15%) 4 - 280,000 × (1 + 6.15%) 3 - 272,500 × (1 + 6.15%) 2 - 265,000 × (1 + 6.15%) - 257,500 = 0 0.00 ZAR. There is a rounding difference of 15.68 ZAR as we calculate with 6.15% instead the precise 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, loan 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. 67 The rate of internal return equals to 6.14 94104 %. <?page no="320"?> Berkau: Financial Statements 5e 14-316 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 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 Figure 14.2: MEUL Ltd.’s accounts (20X1 - 20X5) <?page no="321"?> Berkau: Financial Statements 5e 14-317 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 repayments. E.g., interest-20X2 is amounting to: 1,000,000 × 3% = 30,000.00 ZAR, and in 20X3: (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 repayments. As at 31.12.20X5, the balancing figure is amounting to: 950,000 - 20,000 - 75,000 - 4 × 250,000 = - -145,000.00 ZAR. We like to explain why we deduct interest from the bank loan, e.g., by Bookkeeping entry (e), (v), (E) and (IV). What we are actually doing is, we consider the paid interest and the loan adjustment through profit or loss. In 20X2, the interest paid is 30,000 ZAR and the net increase of the bank loan 27,289.52 ZAR (Bookkeeping entries (b) and (e). Both amounts are relevant for profit and loss, which requires to add paid interest and revaluation of the bank loan: 30,000 + 27,289.52 = 5 57,289.52 ZAR to expenses. Alternatively, we can calculate the effective interest without consideration of the actual interest payments. It would result in a payment vector being: EB’(t) = {930,000; (250,000); (250,000); (250,000); (250,000)}. The effective rate of interest of the vector EB’ is 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 in Figure 14.3 almost the same valuation for the bank loan as before. The differences are only caused by rounding. <?page no="322"?> Berkau: Financial Statements 5e 14-318 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 becomes zero. If handy, take 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 payments (you must enter the vectors). Consider released free funds as investments revalued based on the internal rate of return and paid back in the next following Accounting period. (We call that “Eff. Int.” in financial plans.) (6) Make Bookkeeping entries for payments. Consider short-term payments as debit entries in short-term liabilities. (7) Record effective interest as expense through profit or loss. As effective interest covers paid interest, credit paid interest to the Interest Bearing Liabilities account. Hence, the liability only increases by revaluation and repayments. Why does international Accounting require applying the effective interest method? It enables a valuation that approximates the settlement value at maturity systematically. Hence, a bank loan that initially is underrated due to e.g. bank fees or other transaction costs is revalued step by step up to its settlement amount - which is the principal. <?page no="323"?> Berkau: Financial Statements 5e 14-319 With a bank loan the effect is not as obvious as for bonds, as bonds are only repaid at maturity to their full amount. Ad (1d): Bonds Issue Lending through bonds is an alternative financing to shares. A bond is a financial instrument where the bond issuer borrows from its bondholders and pays interest as a coupon. In contrast to a private loan, bonds are publicly issued. We classify bonds as a liability instrument which results in a bond disclosure on the credit side of the borrower's balance sheet. In general, companies and public entities, such as countries or states, borrow from numerous investors through an intermediary, like 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 regularly 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, interest expenses (coupon) are constant over the time. Most of bonds come with a 6 months -1 frequency of payments for coupons, such as paying the coupon on 30.06. and 31.12. every year. Alternatively, bonds can pay interest annually or quarterly. In terms of Mathematics, a bond at a nominal value of 10,000.00 EUR and a time to maturity of 20 years with a coupon rate of 5 %/ a is worth: 10,000 × (1 + 5%) -20 + 500 × ((1 + 5%) 20 - 1) / ((1 + 5%) 20 × 5%) = 10,000.00 EUR. The bond valuation is based on the present value of its redemption value plus the discounted coupons received until time to maturity. For the bondholder, the valuation changes with the difference between coupon rate and market interest rate. If both rates are the same, the bond’s value is exactly at 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. The market interest rate is the average rate for bonds. We take the bond above and calculate its value based on a market interest rate of 6 %/ a. Its value is then: 10,000 × (1 + 6%) -20 + 500 × ((1 + 6%) 20 - 1) / ((1 + 6%) 20 × 6%) = 8,853.01 EUR. As bonds are listed at a percentage of the nominal value, we say the value is 88.53 (%). We now assume the market interest rate drops to 4 %/ a: The bond’s value is now: 10,000 × (1 + 4%) -20 + 500 × ((1 + 4%) 20 - 1) / ((1 + 4%) 20 × 4%) = 11,359.03 EUR. Hence, the bond would be listed at 113.59 (%). Bonds can be traded publicly at a bond market. 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 - or below-pari. A bond issued at a higher value than its principal comes with a premium - or we say: it is above-pari. If the bond is sold at 9,000.00 EUR, the discounted bond’s value is 10% less than the principal. Even though, the bondholder receives 10,000.00 EUR for its redemption. As closer the maturity day gets, as more the listing of a bond approximates 100 (%). In Link 7.G we describe bond return figures for our case study HAVENGA Ltd. <?page no="324"?> Berkau: Financial Statements 5e 14-320 So far, we covered a bond valuation from the perspective of its holder. Based on IFRS 9.4.1.2, bonds are held at amortised costs if the business model of the bond holders indicates the bonds are not traded and payments received are for redemption or coupon only. In all other cases, IFRS 9.4.1.4 mandates a 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 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 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, fails paying the regular coupons, either. When a company issues a bond, it records a liability. A present obligation exists to redeem the bond and a future obligation 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. Same as with loans, we 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 Melbourne. Data Sheet for BRIZA Ltd. DDomicile: Australia (Melbourne). Reporting currency: AUD. Classification: n/ a. Bonds: 10,000,000.00 AUD. Pay-out: 31.12.20X3. Payment periods: 20X3 - 20X8. Redemption at 4 % premium. Annual coupon: 6 %/ a. Transaction fee: 25,000.00 AUD. VAT n/ a. On 31.12.20X3, BRIZA Ltd. issues 1,000,000 bonds at 10.00 AUD/ 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 %. Thus, the payment when the bonds mature is: (1 + 4%) × 10,000,000 = 110,400,000.00 AUD. During the time to maturity, BRIZA Ltd. pays annually a coupon of 6 %/ a based on the principal, 600,000.00 AUD/ a. BRIZA Ltd. carries the bonds at amortised costs. There is no intention/ possibility 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 = 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 for its interest rate r. The iteration comes to an effective interest rate of 6.76 %/ a (rounded). <?page no="325"?> Berkau: Financial Statements 5e 14-321 Figure 14.4: Effective interest calculation at BRIZA Ltd. <?page no="326"?> Berkau: Financial Statements 5e 14-322 The bond is measured at an 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 table 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. The valuation starts with 9,975,000.00 AUD and approximates 10,400,000.00 AUD within five years. 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 coupon payment have been processed. The bond is redeemed with a premium. That is why the bondholders in total receive an amount of: 10,000,000 × (1 + 4%) = 1 10,400,000.00 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 in chapter (1) 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. Next, we discuss an annuity at MEMEL PLC in Manchester. Data Sheet for MEMEL PLC Domicile: Great Britain (Manchester). Reporting currency: GBP. Classification: n/ a. Bank loan (annuity): 100,000.00 GBP. Pay-out: 2.01.20X2. Payment periods: 20X2 - 20X4. Rate of interest: 4 %/ a. Extra pay-off: 1.07.20X3; 1.07.20X4. VAT n/ a. <?page no="327"?> Berkau: Financial Statements 5e 14-323 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 25,000.00 GBP/ a due at the end of the Accounting periods. 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. 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 interest is calculated in 20X3 and 20X4 in 6 months intervals. That is why we disclose two lines per period for 20X3 and 20X4. The interest in the first half of 20X3 is 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 current value which gives us the amount MEMEL PLC is owing on 1.07.20X3: 79,000 - 7,500 = 7 71,500.00 GBP. The debts reduced by the extra payment determine interest for the 2 nd half of 20X3 to the extent of: 71,500 × 4%/ 2 = 11,430.00 GBP. As the bank loan is an annuity, the interest calculated is included in the 25,000.00 GBP/ a due at the end of 20X3. Accordingly, the pay-off amount is: 25,000 - 1,580 - 1,430 = 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. Below, we discuss the disclosure of the bank loan on MEMEL PLC’s balance sheet. For its disclosure as at 31.12.20X2, the payments for 20X2 do not matter as they have been paid already. The pay-off portion of the annuity including the extra pay-off in 20X3 to the extent of: 21,990 + 7,500 = 2 29,490.00 GBP are disclosed as short-term liabilities. As MEMEL PLC will not transfer the liabilities, we apply the effective interest method and carry the loan at amortised costs. It is always a good idea, to determine a vector for the future payments as it provides an overview and allows internal rate of return calculations in MS-Excel. The vector is in arrears in terms of Mathematics. Therefore, we allocate the payment of 100,000.00 GBP to 20X1, which <?page no="328"?> Berkau: Financial Statements 5e 14-324 means on 31.12.20X1 - a few hours earlier than actually paid. In 20X2, MEMEL PLC pays the annuity of 25,000.00 GBP/ a. In 20X3 and 20X4, the paid amounts are: 25,000 + 7,500 = 332,500.00 GBP each. In 20X5, the payment adds up to only: 18,840.40 + 753.62 = 1 19,594.02 GBP. The vector for the annuity is: A(t) = {100,000; (25,000); (32,500); (32,500); (19,594.02)}. With the vector we get 4 periods of interest, as the vector considers unlimited short periods and thus considers interest for the transition of periods (in between). We calculate an internal rate of return by MS-Excel and get a rounded percentage of 3.88 %/ a. 68 See the financial schedule for the annuity in Figure 14.7. 20X1 20X2 20X3 20X4 20X5 [GBP] [GBP] [GBP] [GBP] [GBP] A(t) 100,000.00 (25,000.00) (32,500.00) (32,500.00) (19,594.02) eff. int. (100,000.00) 103,881.29 eff. int. (78,881.29) 81,942.91 eff. int. (49,442.91) 51,361.93 eff. int. (18,861.93) 19,594.02 0.00 0.00 0.00 0.00 0.00 MEMEL PLC's FINANCIAL SCHEDULE (20X1 - 20X5) Figure 14.7: MEMEL PLC’s financial plan In 20X2, we consider the valuation based on the effective rate of interest. The actual payment is the annuity and we take out an amount of 29,490.00 GBP for short term-liabilities at the end of the year. As a result, the bank loan is disclosed in 20X2 at: 100,000 + 3,881.29 - 25,000 - 29,490 = 4 49,391.29 GBP. The measurement of the loan in the following Accounting periods can be read from Figure 14.8. c/ d Eff int. Annuity Short-term liab. b/ d [GBP] [GBP] [GBP] [GBP] [GBP] 20X2 100,000.00 3,881.29 (25,000.00) (29,490.00) 49,391.29 20X3 78,881.29 3,061.61 (32,500.00) (30,669.60) 18,773.31 20X4 49,442.91 1,919.02 (32,500.00) (18,840.40) 21.53 20X5 18,861.93 732.09 (19,594.02) 0.00 0.00 MEMEL PLC's BANK LOAN CALCULATION (20X1 - 20X5) Figure 14.8: MEMEL PLC’s disclosure of annuity 68 You might be surprised that the effective rate of interest drops below the nominal interest. The reason is that in 20X3 and 20X4 interest is calculated accurate to 6 months, but the vector places the pay-off payment to the end of the year. <?page no="329"?> Berkau: Financial Statements 5e 14-325 Observe the accounts at MEMEL PLC in Figure 14.9. Check the profit and loss calculations as it indicates a valuation of the bank loan at fair value through profit and loss. We consider effective interest but do not disclose paid interest amounts therein, which in fact records a revaluation difference plus actual interest expenses in the Profit and Loss account. 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) 29,490.00 (5) 3,881.29 c2d 75,000.00 (6) 4,000.00 100,000.00 100,000.00 c2d 49,391.29 b/ d 75,000.00 (A) 29,490.00 103,881.29 103,881.29 (B) 3,010.00 (D) 3,010.00 b/ d 49,391.29 c3d 42,500.00 (E) 30,669.60 (C) 3,061.61 75,000.00 75,000.00 c3d 18,773.31 b/ d 42,500.00 (a) 30,669.60 49,442.91 52,452.91 (b) 1,830.40 (d) 1,830.40 b/ d 18,773.31 c4d 10,000.00 (e) 18,840.40 (c) 1,919.02 42,500.00 42,500.00 c4d 21.53 b/ d 10,000.00 (i) 18,840.40 20,692.33 20,692.33 c5d 9,594.02 (ii) 753.62 (iv) 753.62 b/ d 21.53 19,594.02 19,594.02 (iii) 732.09 b/ d 9,594.02 753.62 753.62 Cash/ Bank Interest bearing liabilities IBL D C D C c2d 29,490.00 (4) 29,490.00 (2) 4,000.00 (6) 4,000.00 (A) 29,490.00 b/ d 29,490.00 c3d 30,669.60 (E) 30,669.60 60,159.60 60,159.60 (a) 30,669.60 b/ d 30,669.60 c4d 18,840.40 (e) 18,840.40 49,510.00 49,510.00 (i) b/ d 18,840.40 Short-term liabilities A/ P Interest-20X2 IN2 D C D C (B) 3,010.00 (D) 3,010.00 (b) 1,830.40 (d) 1,830.40 Interest-20X3 IN3 Interest-20X4 IN4 Figure 14.9: MEMEL PLC’s accounts (20X2 - 20X5) <?page no="330"?> Berkau: Financial Statements 5e 14-326 D C D C (ii) 753.62 (iv) 753.62 P2L 3,881.29 c2d 3,881.29 b/ d 3,881.29 P3L 3,061.61 c3d 6,942.91 6,942.91 6,942.91 b/ d 6,942.91 P4L 1,919.02 c4d 8,861.93 8,861.93 8,861.93 b/ d 8,861.93 P5L 732.09 c5d 9,594.02 9,594.02 9,594.02 b/ d 9,594.02 Interest-20X5 IN5 Retained earnings R/ E D C D C (5) 3,881.29 P2L 3,881.29 LX2 3,881.29 R/ E 3,881.29 Loan expenses-20X2 LX2 Profit and Loss-20X2 P2L D C D C (C) 3,061.61 P3L 3,061.61 LX3 3,061.61 R/ E 3,061.61 Loan expenses-20X3 LX3 Profit and Loss-20X3 P3L D C D C (c) 1,919.02 P4L 1,919.02 LX4 1,919.02 R/ E 1,919.02 Loan expenses-20X4 LX4 Profit and Loss-20X4 P4L D C D C (iii) 732.09 P4L 732.09 LX4 732.09 R/ E 732.09 Loan expenses-20X5 LX5 Profit and Loss-20X5 P5L Figure 14.9: MEMEL PLC’s accounts (20X2 - 20X5) continued Ad (2): Provisions Following IFRSs, provisions fall under liabilities, too. IAS 37.10 defines provisions as liabilities of uncertain timing and/ or amount. Besides of uncertainty, a provision requires a present obligation, such as resulting from a contract, derived from a pending lawsuit etc. IAS 37.13 states that provisions are based on a present obligation that exists at the time of reporting. In compliance with IAS 37.27, contingent liabilities are not recognised on financial statements. A contingent liability is caused by future event(s). Its definition criteria are weaker than 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 cannot be measured reliably. An example for a contingent liability is to voucher for another company, e.g., for a subsidiary. IAS 37.13 <?page no="331"?> Berkau: Financial Statements 5e 14-327 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 to settle the present obligation as known at the time of reporting. A company shall calculate the value of a provision as its best estimate, see the case in IAS 37.39. We here provide you with a similar example for a manufacturing company. Data Sheet for SEENA Ltd. DDomicile: Netherlands (Enschede). Reporting currency: EUR. Classification: Production. Output: 500,000 backpacks Minor damage 5.00 EUR; probability 10 %. Major damage: 37.00 EUR; probability 3 %. VAT n/ a. The production firm SEENA Ltd. produces backpacks. Faulty products are returned and reworked. SEENA Ltd. knows if minor defects, such as not properly closing zippers, emerge during the next Accounting period 20X9, the damage per backpack will be 5.00 EUR/ backpack. If a major defect occurs, e.g., a belt is not fixed properly or the fabric tears off, the damage will be 37.00 EUR/ backpack. SEENA Ltd. produces 500,000 backpacks and knows from own experience that the probability for minor defects is 10 % and for major defects 3 %. At the balance sheet date 31.12.20X8, SEENA Ltd. calculates the best estimate for rework. It is amounting to: 500,000 × (10% × 5 + 3% × 37) = 8 805,000.00 EUR in the next Accounting period. Therefore, SEENA Ltd. recognises a provision of 805,000.00 EUR on the balance sheet date 20X8. The Bookkeeping entry is as below: DR Repair....................... 805,000.00 EUR CR Provisions................... 805,000.00 EUR In 20X9, SEENA Ltd. reworks backpacks at an expense of 750,000.00 EUR. As the previously recorded provisions for rework during the Accounting period 20X9 are no longer required they 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 when the reason for the provision comes to light. SEENA Ltd. makes the Bookkeeping entry below in 20X9. DR Provisions................... 805,000.00 EUR CR Repairs...................... 55,000.00 EUR CR Cash/ Bank.................... 750,000.00 EUR <?page no="332"?> Berkau: Financial Statements 5e 14-328 The credit entry in the Repairs account cancels out the overrated expenses recorded together with the provision in the previous Accounting period. Dissolving a provision works like a negative expense recognition, because the expenses have been considered in the previous Accounting period’s income statement already. In general, provisions reduce operating profits in the Accounting period of their recognition. Therefore, IAS 37.17 allows a recognition of provisions only if there is an obligation event, such as a contract enforceable by law or an action creating justified expectations by other parties regarding a probable and future outflow of economic benefits. IAS 37.18 emphasis that any provision or liability requires a present obligation existing at the reporting Accounting period’s end. In contrast, future expenses, such as upcoming interest payments for a bank loan, do not cause provisions because no obligation exists at the time of reporting. In line with IAS 37.19, a provision must be unavoidable for the reporting company. The paragraph describes a future obligation to build-in filters for a certain kind of factory as avoidable because the company can change its process of manufacturing. In contrast, an already existing environmental damage caused by operating a power plant rectifies a provision as the damage has been done and requires future clean-up costs. 69 69 Read our Basics, chapter (15). 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 lawsuits based on unlawful or probably unlawful activities in the past. - Deferred taxes. - Clean-up costs or dismantling costs. - Claims resulting from postponed vacation of employees. - Onerous contracts. - Restructuring costs, e.g., when operations are discontinued or changed. - . . . In a textbook we are unable to cover all cases for provisions. Although, we bring forward three examples below, which explain aspects of measurement and disclosure of provisions. (2a) Provision for pension funds. (2b) Provision for rework/ re-calls. (2c) Provision due to onerous contracts. Ad (2a): Provision for Pension Funds On 3.01.20X2, HADRA (Pty) Ltd. in Stellenbosch adds a paragraph to the labour contract with its chief operating officer COO, Mrs Gartner, to pay her a pension after her board membership 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 assumed that Mrs Gartner resigns at the end of 20X5. <?page no="333"?> Berkau: Financial Statements 5e 14-329 Data Sheet for HADRA (Pty) Ltd. DDomicile: South Africa (Stellenbosch). Reporting currency: ZAR. Classification: n/ a. Pension plan: 4 × 100,000.00 ZAR/ a. Pension periods: 20X6, 20X7, 20X8, 20X9. At the time of filing the agreement, Mrs Gartner’s career plans or circumstances are uncertain. The agreement is uncertain in terms of the time. There is a present obligation as the contract is enforceable. A provision applies. IAS 37.45 requires the provision being measured by its discounted best estimate. Present value disclosure applies if the discounting is material. IAS 37.47 defines the discount rate to be the pre-tax market rate for such a liability. We consider the market rate to be 10 %/ a. As the agreement between HADRA (Pty) Ltd. and Mrs Gartner, has been filed in 20X2, a provision applies to be disclosed on 20X2 financial statements. 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 payments are discounted for 3 periods (20X2 to 20X5), as the present value is initially calculated by the annuity as at 31.12.20X5. Provisions and liabilities are treated differently by IFRSs. Liabilities are carried at fair values or, in case they are kept to maturity (default case), they must be disclosed at amortised costs. In contrast, a provision must be measured at present values which is the valuation at present time. Due to compound interest calculation, provisions are measured below settlement amounts. In accordance with IAS 37.59, a reporting company must review provisions annually. If the estimated time of Mrs Gartner’s retirement changes, the provision needs to be adjusted. In case Mrs Gartner dies or signs a waiver declaration in favour of HADRA (Pty) Ltd., the provision shall be dissolved. Next, we discuss a provision’ measurement as subsequent valuation. Ad (2b): Provision of rework/ recalls DUMMOND (Pty) Ltd. is obliged to make annual payments of 100,000.00 ZAR/ a for a period of 4 years due to an estimated rework plan for delivered and sold faulty goods produced in the past. The annual payment of 100,000.00 ZAR/ a is an estimate and hence, the liability is classified as uncertain. It requires the disclosure of a provision. <?page no="334"?> Berkau: Financial Statements 5e 14-330 Data Sheet for DUMMOND (Pty) Ltd. DDomicile: South Africa (Atlantis). Reporting currency: ZAR. Classification: n/ a. Rework plan: 4 × 100,000.00 ZAR/ a. Provision disclosed in 20X2. On 2.01.20X2, DUMMOND (Pty) Ltd. in Atlantis learns that it must pay 400,000.00 ZAR for a 4 years period to fulfil re-work obligations. DUMMOND (Pty) Ltd. must recognise a provision on 31.12.20X2. DUMMOND (Pty) Ltd. dissolves 100,000.00 ZAR of the re-work provision every year. We assume payments are due on every 31.12.20XX. We apply a spreadsheet based on the CH5.xls file. As the provision is recorded in January for the first time, it is initially shown on the financial statements as at 31.12.20X2. Until that time, no discounting is calculated. Link 14.B: DUMMOND (Pty) Ltd. See below in Figure 14.10 the calculation for the provision and the first payment in 20X2. Note, that payments have been made before the provision is recognised. 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) The dissolving of a portion of 100,000.00 ZAR results in a payment to the customers involved. You find the Bookkeeping entries (1) to (3) below. DR Re-work Expenses............. 100,000.00 ZAR CR Cash/ Bank.................... 100,000.00 ZAR DR Re-work Expenses............. 300,000.00 ZAR CR Provision.................... 300,000.00 ZAR <?page no="335"?> Berkau: Financial Statements 5e 14-331 After the above transactions, DUMMOND (Pty) Ltd. is left with 300,000.00 ZAR in provisions in 20X2. How it is Done: (Rising Provisions for Rework) (1) Determine whether a provision applies: Is there a present obligation at the time of reporting? Does the obligation result in a future outflow of resources? Can the rework obligation be measured reliably? If the above questions are answered by (3 ×) yes, continue: (2) Calculate the obligation based on the best estimate. Derive probabilities from experiences made in preceding Accounting periods. Consider the actual amounts of goods to be reworked on. (3) Calculate an expense vector for rework expected. (4) Make a debit entry for the rework in the Rework account and a credit entry in the Provisions account. (5) If the time value of money is material for valuation, discount provisions as shown further below. The measurement of the provisions is based on present values if the time value is material for valuation. E.g., the time value of money matters when the rate of interest is high and/ or the period of rework is long, 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 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. To determine the fair value of the settlement amount, DUMMOND (Pty) Ltd. cannot simply disclose 300,000.00 ZAR in debts. For the consideration of the time value of money, a lower, discounted amount applies. For the interest calculation, we apply the textbook rate of interest being 10 %/ a. In a real company, you must 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 to factor in the increased risk for the lender. Here, it is sufficient if DUMMOND (Pty) ltd. measures the 20X3’s payment at: 100,000/ (1 + 10%) -1 = 990,909.09 ZAR. In the spreadsheet in Figure 14.11 we calculate present values for the remaining two payments reserved for 20X4’s and 20X5’s re-work. <?page no="336"?> Berkau: Financial Statements 5e 14-332 Year Opening amount Pay-off Discount Present value [ZAR] [ZAR] 10% [ZAR] 20X2 400,000.00 100,000.00 paid 20X3 300,000.00 100,000.00 1 0.91 90,909.09 20X4 200,000.00 100,000.00 2 0.83 82,644.63 20X5 100,000.00 100,000.00 3 0.75 75,131.48 Dummond (Pty) Ltd.'s PROVISION PLAN (20X2 - 20X5) Figure 14.11: DUMMOND (Pty) Ltd.’s provisions (2) For the measurement of the provision, DUMMOND (Pty) Ltd. must discount it as at 31.12.20X2. The provisions’ fair value is its present value: 90,909.09 + 82,644.63 + 75,131.48 = 2 248,685.20 ZAR. There is a gap between the re-work expenses due and the provisons’ fair value of: 400,000 - 100,000 - 248,685.20 = 51,314.80 ZAR. The difference is deducted from provisions and temporarily carried in the Retained Earnings account. See the Bookkeeping entry (3) below: 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. must revalue the provisions. It also must check the estimated measurement for re-work and whether the need for disclosing the provision is still valid. It could change, e.g., if the customers do not claim. We here assume, the estimated payment obligation for reworking the goods remains, only the revaluation of the provisions 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 paid 20X3 300,000.00 100,000.00 1 dissolved 20X4 200,000.00 100,000.00 1 0.91 90,909.09 20X5 100,000.00 100,000.00 2 0.83 82,644.63 3 Dummond (Pty) Ltd.'s PROVISION PLAN (20X3 - 20X5) Figure 14.12: DUMMOND (Pty) Ltd.’s provisions (3) <?page no="337"?> Berkau: Financial Statements 5e 14-333 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 remainder provision for future payments is revalued, too. The amount for 20X4 and 20X5 are multiplied by the factor (1 + 10%) and result in: 82,644.63 × (1 + 10%) = 9 90,909.09 ZAR and: 75,131.48 × (1 + 10%) = 882,644.63 ZAR respectively. The entire revaluation adds value to the provisions to the extent of: (100,000 - 90,909.09) + (90,909.09 - 82,644.63) + (82,644.63 - 75,131.48) = 2 24,868.52 ZAR. We make a Bookkeeping entry for all revaluations together as below (a): DR Retained Earnings............ 24,868.52 ZAR CR Interest Bearing Liabilities. 24,868.52 ZAR Bookkeeping entry (b) and (c) are for dissolving of 20X3’s provision. You find all Bookkeeping entries for the Accounting periods 20X2 - 20X5 in Figure 14.13. Check below in Figure 14.13 the recalculation of DUMMOND (Pty) Ltd.’s provisions in 20X4. Year Opening amount Pay-off Discount Present value [ZAR] [ZAR] 10% [ZAR] 20X2 400,000.00 100,000.00 paid 20X3 300,000.00 100,000.00 dissolved 20X4 200,000.00 100,000.00 1 dissolved 20X5 100,000.00 100,000.00 1 0.91 90,909.09 3 Dummond (Pty) Ltd.'s PROVISION PLAN (20X4 - 20X5) Figure 14.13: DUMMOND (Pty) Ltd.’s provisions (4) Note, that the re-work expenses are only disclosed in 20X2. That is the year when the obligation for re-work was detected. No expenses are recorded in the years thereafter as the provisions are dissolved profitand loss-neutral. It results from the fact that the estimated costs at the time of rising the provision are as high as later the actual ones. For that reason, you will not find Profit and Loss accounts for 20X3 - 20X5 in Figure 14.14. <?page no="338"?> Berkau: Financial Statements 5e 14-334 D C D C (1) 100,000.00 P2L 400,000.00 (c) 100,000.00 (b) 100,000.00 (2) 300,000.00 (C) 100,000.00 (B) 100,000.00 400,000.00 400,000.00 (III) 100,000.00 (II) 100,000.00 Re-work-20X2 REW Short-term liabilitiy A/ P D C D C (3) 51,314.80 (1) 300,000.00 . . . (1) 100,000.00 c/ d 248,685.20 c/ d 100,000.00 300,000.00 300,000.00 100,000.00 100,000.00 (b) 100,000.00 b/ d 248,685.20 c/ d 100,000.00 c/ d 173,553.72 (a) 24,868.52 c/ d 200,000.00 (c) 100,000.00 273,553.72 273,553.72 200,000.00 200,000.00 (B) 100,000.00 b/ d 173,553.72 b/ d 200,000.00 c/ d 90,909.09 (A) 17,355.37 c/ d 300,000.00 (C) 100,000.00 190,909.09 190,909.09 300,000.00 300,000.00 (II) 100,000.00 b/ d 90,909.09 b/ d 300,000.00 (I) 9,090.91 c/ d 400,000.00 (III) 100,000.00 100,000.00 100,000.00 400,000.00 400,000.00 Provision PRO Cash/ Bank C/ B 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) How it is Done: (Discounting Provisions) (1) Calculate the payment vector elements of the provision based on best estimates at the time of initial recognition. (2) Decide whether time value of money is material for the valuation of the provision. Only if this is the case continue with step (3). Otherwise recognise the provision without discounting. (3) Determine the discount rate dr. <?page no="339"?> Berkau: Financial Statements 5e 14-335 (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 disclosure for provisions. (6) If the provision has been recorded before, make an adjustment in valuation by a Bookkeeping entry: DR Provisions . . . - CR Retained Earnings . . . In the next Accounting period: (A) Dissolve the provisions to the extent they are relevant for the Accounting period (payment). (B) Revalue the remaining payment vector elements by multiplication by the factor (1 + dr). (C) Calculate the difference of actual and prior measurement of provisions. (D) Make a Bookkeeping entry for revaluation as: DR Retained Earnings account . . . - CR Provisions . . . 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. We study the case of the airline SALMAN Ltd., who scheduled a flight and sold tickets already. Due to an increase of costs the contract with the passengers becomes onerous for SALMAN Ltd. Data Sheet for SALMAN Ltd. CClassification: Aviation (Sydney). Flight SM050 on 10.05.20X5 PER-MEL Expected revenue: 75,000.00 AUD Costs: 400.00 AUD/ p. - 200 passengers Increase of costs: 10,000.00 AUD Provision disclosed: 31.12.20X2. VAT n/ a. SALMAN Ltd. is an airline headquartered in Sydney. To compete with other aviation service providers, SALMAN Ltd. offers tickets for sale one year in advance. For its flight SM050 scheduled for 10.05.20X5 with an Airbus A321 from Perth to Melbourne, SALMAN Ltd. calculated a ticket price of 400.00 AUD/ passenger. The aircraft is a 200 seater and is 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 are calculated to be 75,000.00 AUD. Due to an increase of airport landing fees in Melbourne, the scheduled and sold flight becomes 10,000.00 AUD more expensive. On 31.12.20X4, SALMAN Ltd. records a provision due to an onerous contract to the extent of: 75,000 + 10,000 - 80,000 = 5,000.00 AUD. The flight has not yet taken place; hence, no certain liability exists. The contract between the passen- <?page no="340"?> Berkau: Financial Statements 5e 14-336 gers and the 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 to Adelaide due to airport fees is not possible but might become inevitable if pilots decide on short notice to divert the flight to the alternative airport Adelaide as filed in the flight plan due to under limit weather conditions. This means the higher costs are still regarded uncertain. SALMAN Ltd. makes the Bookkeeping entry below: DR Loss on Onerous Flight....... 5,000.00 AUD CR Provisions................... 5,000.00 AUD The provision is necessary as the user of SALMAN Ltd.’s financial statements shall be informed about the potential loss, caused by actions and events in 20X4 which lead to an onerous flight contract in the next Accounting period. A present obligation to operate the flight exists based on the ticket sales. The flight costs are not certain but are calculated based on best estimates. 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 contractual obligations as to your best estimate at the time of recording. (3) Make a debit entry in the Loss on Onerous Contract account and a credit entry in the Provisions account. (4) Check whether discounting of the provision applies. 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 item accounts payables A/ P 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 pass on (certain) liabilities, they are carried at amortised costs. In contrast, provisions are measured at present values if the time value of money is material - which in most of the cases applies. Liabilities are to be explained in the notes <?page no="341"?> Berkau: Financial Statements 5e 14-337 where further debt information, like securities, is provided. Accounting Technical Terms: Annuity: Bank loan with a constant payment for interest and pay-off. Amortised costs: To carry an asset or liabilities at amortised costs is a simplification of its measurement accepted for financial instruments that are intended to keep until maturity. It replaces a fair value presentation. The calculation of amortised costs is based on the effective interest method. Bond: Financial instrument that pays the holder a regular coupon and is repaid in a lump sum when it matures. Contingent liability: Liability that is uncertain, not present and/ or does not fulfil recognition requirements. Effective interest method: Valuation of a liability or financial instrument measured by a payment vector with revaluation of its elements based on internal rate of return calculation. The effective rate of interest calculation requires iteration. Fair value: Measurement of an asset/ liability as it is transferred at on an active market, e.g., a bond price. Liabilities: Present obligation that results in future outflow of economic benefits. Onerous contract: A contract a loss is most probably expected to result from, as it is likely that expenses exceed revenues. Present obligation: An obligation that exists at the reporting date (31.12.20XX). Present value: Valuation where discounted values apply for measurement. Provision: Uncertain liability which is uncertain regarding time and/ or contractual settlement (mostly payment). Also, the provision can be uncertain of occurrence. IAS 37 rules provisions. Provisions require a present obligation at the time of reporting. Question Bank: (1) The effective rate of interest for a bank loan that is paid weekly and for which the annual interest rate is 4.5 %/ a is amounting to … 1. 4.5000 %/ a. 2. 4.6008 %/ a. 3. 4.5940 %/ a. 4. 4.6025 %/ a. (2) A company expects to be fined based on a pending court case by 100,000.00 EUR. The probability to pay the penalty is 40 %. What is the correct Bookkeeping entry at the year-end? 1. DR Expenses … 60,000.00 EUR - CR Provisions … 60,000.00 EUR. 2. DR Expenses … 100,000.00 EUR - CR Provisions … 100,000.00 EUR. 3. DR Expenses … 50,000.00 EUR - CR Provisions … 50,000.00 EUR. 4. DR Expenses … 40,000.00 EUR - CR Provisions … 40,000.00 EUR. (3) A company issued bonds at 1,000,000.00 EUR with a discount of 10 %. The coupon rate is 5 %/ a. The bank charges 50,000.00 EUR issue fees and the effective rate of interest is 6.4 %. How much are expenses to be recorded in the first Accounting period? 1. 100,000.00 EUR. 2. 64,000.00 EUR. 3. 54,400.00 EUR. <?page no="342"?> Berkau: Financial Statements 5e 14-338 4. 57,600.00 EUR. (4) A parent vouches for a subsidiary in another country and provides the bank with its financial statements following IFRSs. The agreement is that the parent will pay for the liabilities of its subsidiary in case the subsidiary becomes insolvent. How is the situation disclosed on the financial statements of the parent? 1. Contingent liability. 2. Provision. 3. Liability. 4. N/ a. (5) On 1.01.20X3, a company takes a bank loan of 100,000.00 EUR with a 3 % discount. The bank loan comes with a rate of interest of 5 %/ a and a fixed pay-off amount of 25.000.00 EUR/ a. What is the payment vector B(t) for the Accounting periods 20X3 - 20X6 if interest and pay-off is paid at the year-ends? 1. {70,000; (28,750); (27,500); (26,260)}. 2. {67,000; (28,750); (27,500); (26,250)}. 3. {75,000; (25,000); (25,000); (25,000)}. 4. {72,850; (28,900); (27,650); (26,400)}. Solutions: 1-2, 2-4, 3-3, 4-4, 5-2. <?page no="343"?> Berkau: Financial Statements 5e 15-339 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, Carrying Value 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="344"?> Berkau: Financial Statements 5e 15-340 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="345"?> Berkau: Financial Statements 5e 15-341 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 e.g. 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="346"?> Berkau: Financial Statements 5e 15-342 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 JV Joint Venture KaDeWe Kaufhaus des Westens, Departement Store in Berlin K.K. Kaushik 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 <?page no="347"?> Berkau: Financial Statements 5e 15-343 MOS Manufacturing Overheads-Shipping Account 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 <?page no="348"?> Berkau: Financial Statements 5e 15-344 ROA Return on Assets 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 of Use Asset Sal Salary SAn South African 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 private 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="349"?> Berkau: Financial Statements 5e 16-345 16. Table of Figures Figure 1.1: Accounts 1.6 Figure 2.1: KIELING TAXI GmbH’s opening balance sheet 2-13 Figure 2.2: KIELILNG TAXI GmbH’s journal (20X1) 2-15 Figure 2.3: KIELING TAXI GmbH’s abridged balance sheet (20X1) 2-17 Figure 2.4: KIELING TAXI GmbH’s profit and loss statement (20X1) 2-19 Figure 2.5: KIELING TAXI GmbH’s accounts (1.01.20X2) 2-20 Figure 2.6: KIELING TAXI GmbH’s accounts (20X2) 2-22 Figure 2.7: KIELING TAXI GmbH’s income statement (20X2) 2-25 Figure 2.8: KIELING TAXI GmbH’s abridged balance sheet (20X2) 2-26 Figure 3.1: Signing-in to IFRS Foundation.org (example) 3-31 Figure 3.2: IFRS.org: Standards for download 3-31 Figure 3.3: KMTS Ltd.’s opening balance sheet 3-33 Figure 3.4: KENILWORTH METERED TAXI SERVICE Ltd.’s accounts 3-35 Figure 3.5: KMTS Ltd.’s accounts after adjustments (20X1) 3-37 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) 3-44 Figure 3.12: KMTS Ltd.’s accounts after profit calculation (20X2) 3-46 Figure 3.13: KMTS Ltd.’s accounts for profit appropriation (20X2) 3-49 Figure 3.14: KMTS Ltd.’s income statement (20X2) 3-49 Figure 3.15: KMTS Ltd.’s balance sheet (20X2) 3-50 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 4-56 Figure 4.2: RYNEVELD Ltd.’s accounts before adjustments 4-60 Figure 4.3: RYNEVELD Ltd.’s trial balance 4-61 Figure 4.4: Elements of a Trading account 4-63 Figure 4.5: RYNEVELD Ltd.’s accounts after adjustments (20X6) 4-66 Figure 4.6: RYNEVELD Ltd.’s adjusted trial balance (20X6) 4-69 Figure 4.7: RYNEVELD Ltd.’s balance sheet (20X6) 4-70 Figure 4.8: RYNEVELD Ltd.’s income statement 4-71 Figure 4.9: Worksheet for adj. trial balance preparation (1 st step) 4-72 Figure 4.10: Complete worksheet for adj. trial balance preparation 4-73 Figure 5.1: Company data 5-81 Figure 5.2: CAPELIFT (Pty) Ltd.’s balance sheet (20X8) 5-82 Figure 5.3: CAPELIFT (Pty) Ltd.’s income statement (20X8) 5-83 Figure 6.1: BATHURST Ltd.’s balance sheet (20X4) 6-98 Figure 6.2: BATHURST Ltd.’s accounts (20X5) 6-100 Figure 6.3: BATHURST Ltd.’s accounts (20X6) 6-102 Figure 6.4: BATHURST Ltd.’s balance sheet (20X6) 6-105 Figure 6.5: BATHURST Ltd.’s income statement (20X6) 6-107 <?page no="350"?> Berkau: Financial Statements 5e 16-346 Figure 6.6: BATHURST Ltd.’s statement of changes in equity (20X6) 6-108 Figure 6.7: BATHURST Ltd.’s statement of cash flows (20X6) 6-108 Figure 6.8: BATHURST Ltd.’s notes (20X6) 6-113 Figure 7.1: GELLENDORFF LLC’s accounts (i) 7-123 Figure 7.2: GELLENDORFF LLC’s accounts (ii) 7-127 Figure 7.3: GELLENDORFF LLC’s register of non-current assets 7-129 Figure 7.4: GELLENDORFF LLC’s asset-reconciliation statement 7-129 Figure 7.5: TINNEN K.K.’s accounts (20X4) 7-134 Figure 7.6: YSTERFONTEIN Ltd.’s accounts 7-141 Figure 7.7: OVERBERG (Pty) Ltd.’s accounts 7-145 Figure 7.8: KRIGE (Pty) Ltd.’s accounts (20X3) 7-150 Figure 7.9: KRIGE (Pty) Ltd.’s accounts (20X4) 7-152 Figure 7.10: VLAEBERG K.K.’s finance schedule for the lease 7-154 Figure 7.11: VLAEBERG K.K.’s accounts (20X4 - 20X6) 7-156 Figure 7.12: Bond measurement at effective interest 7-165 Figure 8.1: BRENO Ltd.’s balance sheet (1.01.20X5) 8-177 Figure 8.2: BRENO Ltd.’s income statement (20X5) 8-178 Figure 8.3: BRENO Ltd.’s balance sheet (separate F/ S) 8-180 Figure 8.4: BRENO Ltd.’s income statement (separate F/ S) 8-180 Figure 8.5: GAMKA Ltd.’s statement of financial position 8-184 Figure 8.6: SWARTBERG Ltd.’s statement of financial position 8-184 Figure 8.7: GAMKA Ltd.’s balance sheet after acquisition 8-185 Figure 8.8: Consolidation worksheet (1) 8-186 Figure 8.9: Consolidation worksheet (2) 8-187 Figure 8.10: Consolidated balance sheet 8-188 Figure 8.11: GAMKA Ltd.’s income statement (20X4) 8-189 Figure 8.12: GAMKA Ltd.’s balance sheet (20X4) 8-189 Figure 8.13: SWARTBERG Ltd.’s income statement (20X4) 8-190 Figure 8.14: SWARTBERG Ltd.’s balance sheet (20X4) 8-190 Figure 8.15: GAMKA Group’s consolidation worksheet (20X4.1) 8-191 Figure 8.16: Prolonged income statement for SWARTBERG Ltd. (20X4) 8-192 Figure 8.17: GAMKA Group’s consolidation worksheet (20X4.2) 8-193 Figure 8.18: GAMKA Group’s consolidated balance sheet (20X4) 8-193 Figure 8.19: GAMKA Group’s consolidated income statement (20X4) 8-194 Figure 8.20: Consolidated statement of changes in equity (20X4) 8-194 Figure 8.21: GAMKA Group’s consolidated SCF (20X4) 8-195 Figure 8.22: PORTERSVILLE Ltd.’s balance sheet (parent) 8-197 Figure 8.23: HENDERSON Ltd.’s balance sheet (subsidiary) 8-197 Figure 8.24: Consolidation worksheet for PORTERSVILLE Group (1) 8-198 Figure 8.25: Consolidation worksheet for PORTERSVILLE Group (2) 8-199 Figure 8.26: Consolidation worksheet for PORTERSVILLE Group (3) 8-200 Figure 8.27: Consolidation worksheet for PORTERSVILLE Group (4) 8-201 Figure 8.28: PORTERSVILLE Group’s balance sheet 8-201 Figure 8.29: QUICKARMS Ltd.’s balance sheet (20X6) 8-203 Figure 8.30: QUICKARMS Ltd.’s income statement 8-204 Figure 8.31: QUICKARMS Ltd.’s balance sheet (20X7) 8-204 Figure 8.32: QUICKARMS Ltd.’s income statement 8-205 <?page no="351"?> Berkau: Financial Statements 5e 16-347 Figure 8.33: QUICKARMS Ltd.’s balance sheet (20X7) 8-205 Figure 8.34: CLOSE-WATCH (Pty) Ltd.’s opening balance sheet 8-207 Figure 8.35: CLOSE-WATCH (Pty) Ltd.’s income statement 8-207 Figure 8.36: CLOSE-WATCH (Pty) Ltd.’s balance sheet (20X7) 8-208 Figure 8.37: QUICKARMS/ CLOSE-WATCH (JV)’s balance sheet (IAS 27) 8-208 Figure 8.38: QUICKARM/ CLOSE-WATCH joint venture balance sheet 8-209 Figure 9.1: GREENACRES Ltd.’s accounts (periodic system) 9-215 Figure 9.2: GREENACRES Ltd.’s accounts (perpetual system) 9-217 Figure 9.3: ROSEFIELD Ltd.’s purchases 9-219 Figure 9.4: ROSEFIELD Ltd.’s accounts (i: FIFO) 9-221 Figure 9.5: ROSEFIELD Ltd.’s accounts (ii: weighted average) 9-222 Figure 9.6: RIEBECK (Pty) Ltd.’s budgeted accounts 9-228 Figure 9.7: RIEBECK (Pty) Ltd.’s actual accounts (IAS 2.13) 9-230 Figure 9.8: NOKOX (Pty) Ltd.’s accounts 9-240 Figure 9.9: BAKENSKOP PLC’s foreign currency bank accounts 9-243 Figure 10.1: EIMKE Ltd.’s balance sheet (20X7) 10-248 Figure 10.2: EIMKE Ltd.’s liquidity plan (20X8) 10-249 Figure 10.3: EIMKE Ltd.’s statement of cash flows (20X8) 10-250 Figure 10.4: EIMKE Ltd.’s accounts (20X8) 10-251 Figure 10.5: EIMKE Ltd.’s balance sheet (20X8) 10-257 Figure 10.6: EIMKE Ltd.’s income statement (20X8) 10-258 Figure 10.7: EIMKE Ltd.’s cash flow statement (20X8) 10-259 Figure 11.1: YARRA Ltd.’s balance sheet (20X0) 11-265 Figure 11.2: YARRA Ltd.’s balance sheet (20X1) 11-268 Figure 11.3: YARRA Ltd.’s balance sheet (20X2) 11-271 Figure 11.4: Detailed equity section on YARRA Ltd.’s B/ S (20X1) 11-272 Figure 11.5: Detailed equity section on YARRA Ltd.’s B/ S (20X2) 11-273 Figure 11.6: YARRA Ltd.'s accounts 11-273 Figure 12.1: ABINGTON Ltd.’s accounts (20X4) 12-280 Figure 12.2: ABINGTON Ltd.’s Profit and Loss calculation (NoE) 12-281 Figure 12.3: ABINGTON Ltd.’s income statement (NoE) 12-282 Figure 12.4: SUTTHAUSEN PLC’s balance sheet (20X3) 12-284 Figure 12.5: SUTTHAUSEN PLC’s purchase ledger 12-284 Figure 12.6: SUTTHAUSEN PLC’s accounts (NoE) 12-285 Figure 12.7: SUTTHAUSEN PLC’s income statement (NoE) 12-287 Figure 12.8: ABINGTON Ltd.’s accounts (COS) 12-289 Figure 12.9: ABINGTON Ltd.’s income statement (COS) 12-291 Figure 12.10: SUTTHAUSEN PLC’s accounts (COS) 12-293 Figure 12.11: SUTTHAUSEN PLC’s income statement (COS) 12-296 Figure 13.1: BELMONT Ltd.’s balance sheet (20X6) 13-300 Figure 13.2: BELMONT Ltd.’s statement of changes in equity (1) 13-301 Figure 13.3: BELMONT Ltd.’s statement of changes in equity (2) 13-302 Figure 13.4: BELMONT Ltd.’s statement of changes in equity (3) 13-303 Figure 13.5: BELMONT Ltd.’s statement of changes in equity (4) 13-304 Figure 13.6: BELMONT Ltd.’s statement of changes in equity (5) 13-305 Figure 13.7: BELMONT Ltd.’s statement of changes in equity (6) 13-306 Figure 14.1: Effective interest method at MEUL Ltd. 14-314 <?page no="352"?> Berkau: Financial Statements 5e 16-348 Figure 14.2: MEUL Ltd.’s accounts (20X1 - 20X5) 14-316 Figure 14.3: Alternative calculation of the loan at MEUL Ltd. 14-318 Figure 14.4: Effective interest calculation at BRIZA Ltd. 14-321 Figure 14.5: BRIZA Ltd.’s bond calculation 14-322 Figure 14.6: MEMEL PLC’s annuity (20X2) 14-323 Figure 14.7: MEMEL PLC’s financial plan 14-324 Figure 14.8: MEMEL PLC’s disclosure of annuity 14-324 Figure 14.9: MEMEL PLC’s accounts (20X2 - 20X5) 14-325 Figure 14.10: DUMMOND (Pty) Ltd.’s provisions (1) 14-330 Figure 14.11: DUMMOND (Pty) Ltd.’s provisions (2) 14-332 Figure 14.12: DUMMOND (Pty) Ltd.’s provisions (3) 14-332 Figure 14.13: DUMMOND (Pty) Ltd.’s provisions (4) 14-333 Figure 14.14: DUMMOND (Pty) Ltd.’s accounts (20X2 - 20X5) 14-334 <?page no="353"?> Berkau: Financial Statements 5e 17-349 17. Links Link 2.A: KIELING TAXI GmbH 2-16 Link 2.B: DATEV-4 chart of accounts 2-20 Link 2.C: Lufthansa AG’s appendix 2-27 Link 4.A: RYNEVELD Ltd. 4-71 Link 4.B: TELUK Sdn. Bhd. 4-71 Link 4.C: BINNEVELD Ltd. 4-73 Link 5.A: COMAIR Limited. 5-76 Link 5.B: EPS calculations 5-87 Link 5.C: CAPELIFT (Pty) Ltd. 5-91 Link 6.A: BATHURST Ltd. 6-98 Link 7.A: RAVENWOOD GmbH 7-119 Link 7.B: OTZE AG 7-119 Link 7.C: GROOTVLEI Ltd. 7-129 Link 7.D: TYGERVALLEY Ltd. 7-130 Link 7.E: CORAL Ltd. 7-132 Link 7.F: JANSSENS Ltd. 7-139 Link 7.G: Bond valuation 7-163 Link 7.H: NATBERGEN (Pty) Ltd. 7-164 Link 7.I: HELWAN AIRWAYS Ltd. 7-167 Link 9.A: ROSEFIELD Ltd. 9-224 Link 10.A: RYNEVELD Ltd. 10-260 Link 10.B: EIMKE Ltd. 10-260 Link 12.A: ANKYO Ltd. 12-283 Link 12.B: HEUNING Ltd. 12-288 Link 14.A: MEUL Ltd. 14-315 Link 14.B: DUMMOND (Pty) Ltd. 14-330 <?page no="354"?> Berkau: Financial Statements 5e 18-350 18. Literature Berkau, C.; Berkau, K.S. [2018]: Basics of Accounting. 5 th Edition. Konstanz, Munich. 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