<?page no="0"?> Basics of Accounting Introduction to International Bookkeeping and Financial Accounting 6 th Edition Carsten Berkau <?page no="1"?> Basics of Accounting <?page no="2"?> Professor Dr. Carsten Berkau teaches accounting at Osnabrück University UAS and in South Africa, Malaysia, South Korea and China. Further books: Financial Statements / Bilanzen / Management Accounting. <?page no="3"?> Carsten Berkau Basics of Accounting Introduction to International Bookkeeping and Financial Accounting 6 , revised and extended 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. 5 th , revised Edition 2018 4 th , revised and extended Edition 2018 3 rd , revised Edition 2017 © UVK Verlag 20 21 - ein Unternehmen der Narr Francke Attempto Verlag GmbH + Co. KG , xxDischingerweg 5 · 72070 Tübingen Internet: www.narr.de eMail: info@narr.de Umschlagmotiv : © iStockphoto · matdesign24 Druck und Bindung: CPI books GmbH, Leck ISBN 978-3-7398-3183-1 (Print) ISBN 978-3-7398-8183-6 (ePDF) <?page no="5"?> Berkau: Basics of Accounting 6e 1-5 I Contents I Contents............................................................................................. 1-5 II Introduction..................................................................................... 1-19 1 Conventions ..................................................................................... 1-21 1.1 Accounting Periods ........................................................................................1-21 1.2 Accounting Technical Terms ........................................................................1-21 1.3 Account Names ..............................................................................................1-21 1.4 Alphabetic Order............................................................................................1-21 1.5 Basics................................................................................................................1-21 1.6 Bookkeeping Entries......................................................................................1-21 1.7 Bookkeeping Entry Format ..........................................................................1-21 1.8 Calculations .....................................................................................................1-22 1.9 Case Studies (C/ S)..........................................................................................1-22 1.10 Case Study Text ..............................................................................................1-22 1.11 Cash Flow Separation ....................................................................................1-22 1.12 Companies .......................................................................................................1-22 1.13 Cost-Expense-Congruence............................................................................1-22 1.14 Country ............................................................................................................1-22 1.15 Currency Unit..................................................................................................1-22 1.16 Data Format in Tables ...................................................................................1-23 1.17 Prepayments of Income Taxes .....................................................................1-23 1.18 How it is Done ...............................................................................................1-23 1.19 Income Taxes..................................................................................................1-23 1.20 Financial Statements for Taxation................................................................1-23 1.21 Names ..............................................................................................................1-23 1.22 Language..........................................................................................................1-23 1.23 Learning Objectives and Summaries............................................................1-23 1.24 Legal Forms of a Business.............................................................................1-23 1.25 Length of a Month/ Year...............................................................................1-23 1.26 Level of Precision ...........................................................................................1-23 1.27 Literature .........................................................................................................1-24 1.28 Non-existing Items.........................................................................................1-24 1.29 Online Materials..............................................................................................1-24 1.30 Payment Terms ...............................................................................................1-24 1.31 Presentation of Accounts ..............................................................................1-24 1.32 Proportional Calculation of Depreciation and Interest .............................1-24 1.33 Question Bank ................................................................................................1-25 1.34 Quotation of Law Texts/ Standards .............................................................1-25 1.35 Sequence of Bookkeeping Entries................................................................1-25 1.36 Tax on Capital Returns (Dividend Tax) ......................................................1-25 <?page no="6"?> Berkau: Basics of Accounting 6e 1-6 1.37 Transaction Costs........................................................................................... 1-25 1.38 Value Added Tax, Goods and Service Tax................................................. 1-25 1.39 VAT Reduction .............................................................................................. 1-25 1.40 Working Definition(s) ................................................................................... 1-25 1.41 Work-in-Process Account............................................................................. 1-26 1.42 Writing Management Terms ......................................................................... 1-26 1.43 WWW .............................................................................................................. 1-26 1.44 Youtube Videos.............................................................................................. 1-26 1.45 10-20-30 Rule.................................................................................................. 1-26 2 Cafeteria Example and what is on the Balance Sheet.................... 2-27 2.1 What is in the Chapter? ................................................................................. 2-27 2.2 Learning Objective......................................................................................... 2-27 2.3 Statement of Financial Position ................................................................... 2-27 2.4 Our first Balance Sheet.................................................................................. 2-27 2.5 Accounting Equation..................................................................................... 2-28 2.6 Income Statement .......................................................................................... 2-29 2.7 Reading Financial Statements ....................................................................... 2-30 2.8 C/ S NEWINGTON Ltd.............................................................................. 2-30 2.9 What is on the Balance Sheet’s Asset side? ................................................. 2-30 2.10 What is on the Capital and Liabilities Side of the Balance Sheet? ........... 2-33 2.11 What is on the Income Statement? .............................................................. 2-34 2.12 What is on the Statement of Cash Flows? .................................................. 2-36 2.13 What is on the Statement of Changes in Equity? ....................................... 2-37 2.14 C/ S KENSINGTON.................................................................................... 2-37 2.15 Summary.......................................................................................................... 2-45 2.16 Working Definitions ...................................................................................... 2-45 2.17 Question Bank................................................................................................ 2-46 2.18 Solutions.......................................................................................................... 2-47 3 Shareholders’ View .......................................................................... 3-48 3.1 What is in the Chapter? ................................................................................. 3-48 3.2 Learning Objective: ........................................................................................ 3-48 3.3 McDonald's Corp........................................................................................... 3-48 3.4 Summary.......................................................................................................... 3-53 3.5 Working Definition........................................................................................ 3-53 3.6 Question Bank................................................................................................ 3-54 3.7 Solutions.......................................................................................................... 3-54 4 Legal Aspects of Accounting .......................................................... 4-55 4.1 What is in the Chapter? ................................................................................. 4-55 4.2 Learning Objectives ....................................................................................... 4-55 4.3 Who prepares Financial Statements? ........................................................... 4-55 4.4 How to Establish a German Limited Company ........................................ 4-57 4.5 Necessity to Prepare Financial Statements ................................................. 4-60 <?page no="7"?> Berkau: Basics of Accounting 6e 1-7 4.6 Scope of IFRSs ...............................................................................................4-61 4.7 What are the Standards? ................................................................................4-62 4.8 Difference between HGB and IFRSs ..........................................................4-63 4.9 Summary ..........................................................................................................4-64 4.10 Working Definitions ......................................................................................4-64 4.11 Question Bank ................................................................................................4-64 4.12 Solutions ..........................................................................................................4-65 5 The Excel Accountant..................................................................... 5-66 5.1 What is in the Chapter? .................................................................................5-66 5.2 Learning Objectives .......................................................................................5-66 5.3 Accounting Software......................................................................................5-66 5.4 Accounting with MS-Excel ...........................................................................5-66 5.5 Acc (Accounts) ...............................................................................................5-69 5.6 JL (Journal) ......................................................................................................5-70 5.7 TB (Trial Balance) ..........................................................................................5-71 5.8 BS (Statement of Financial Position) ...........................................................5-72 5.9 Ger BS (German Balance Sheet) ..................................................................5-73 5.10 IS (Statement of Comprehensive Income)..................................................5-74 5.11 Ger-IS (German Income Statement) ...........................................................5-75 5.12 CFS (Statement of Cash Flows)....................................................................5-76 5.13 SCE (Statement of Changes in Equity) .......................................................5-76 5.14 RoA (Register of non-current Assets) .........................................................5-77 5.15 Int&Pay-off (Interest and Pay-off Schedule) ..............................................5-78 5.16 PCB (Petty Cash Book) .................................................................................5-79 5.17 CB (Cash Book) ..............................................................................................5-79 5.18 BankST (Bank statement)..............................................................................5-80 5.19 Cons (Consolidation) .....................................................................................5-81 5.20 BP (Business Plan)..........................................................................................5-81 5.21 Summary ..........................................................................................................5-82 6 Introduction to Balance Sheet and Income Statement .................. 6-83 6.1 What is in the Chapter? .................................................................................6-83 6.2 Learning Objectives .......................................................................................6-83 6.3 Approach to Accounting ...............................................................................6-83 6.4 Asset Side of the Balance Sheet....................................................................6-84 6.5 Capital and Liability Side of the Balance Sheet...........................................6-86 6.6 Income Statement...........................................................................................6-87 6.7 Summary ..........................................................................................................6-89 6.8 Working Definitions ......................................................................................6-89 6.9 Question Bank ................................................................................................6-90 6.10 Solutions ..........................................................................................................6-91 7 Activities on the Asset Side of the Balance Sheet........................... 7-92 7.1 What is in the Chapter? .................................................................................7-92 <?page no="8"?> Berkau: Basics of Accounting 6e 1-8 7.2 Learning Objectives ....................................................................................... 7-92 7.3 Asset Exchanges............................................................................................. 7-92 7.4 C/ S ROHRBACH Ltd.................................................................................. 7-92 7.5 Activity 1: Purchase on Cash ........................................................................ 7-93 7.6 Activity 2: Acquisition of Equipment on Cash .......................................... 7-94 7.7 Activity 3: Cash Sale....................................................................................... 7-95 7.8 Activity 4: Disposal of non-current assets .................................................. 7-96 7.9 Summary.......................................................................................................... 7-97 7.10 Working Definitions ...................................................................................... 7-97 7.11 Question Bank................................................................................................ 7-97 7.12 Solutions.......................................................................................................... 7-98 8 Activities on Both Sides of the Balance Sheet ................................ 8-99 8.1 What is in the Chapter? ................................................................................. 8-99 8.2 Learning Objectives ....................................................................................... 8-99 8.3 Activities Changing Balance Sheet Items .................................................... 8-99 8.4 C/ S EDENVALE AG.................................................................................. 8-99 8.5 Activity 1: Establishment of the Business................................................... 8-99 8.6 Activity 2: Purchase of Goods ................................................................... 8-100 8.7 Activity 3: Borrowing Money from the Bank........................................... 8-101 8.8 Activity 4: Acquisition of non-current Assets .......................................... 8-102 8.9 Activity 5: Payment of Debts ..................................................................... 8-103 8.10 Activity 6: Selling Goods............................................................................. 8-103 8.11 Activity 7: Receipts from Customers......................................................... 8-104 8.12 Activity 8: Payment for Debts .................................................................... 8-105 8.13 Effects of the Activities............................................................................... 8-106 8.14 Summary........................................................................................................ 8-106 8.15 Working Definitions .................................................................................... 8-107 8.16 Question Bank.............................................................................................. 8-107 8.17 Solutions........................................................................................................ 8-108 9 Profit and Loss Activities .............................................................. 9-109 9.1 What is in the Chapter? ............................................................................... 9-109 9.2 Learning Objectives ..................................................................................... 9-109 9.3 Profit Calculation ......................................................................................... 9-109 9.4 C/ S RIVERGATE (Pty) Ltd...................................................................... 9-109 9.5 Taxable Profit ............................................................................................... 9-110 9.6 Retained Earnings ........................................................................................ 9-110 9.7 C/ S PELZERHAGEN (Pty) Ltd. ............................................................. 9-110 9.8 Activity 1: Payment for Rent ...................................................................... 9-111 9.9 Activity 2: Payment for Labour.................................................................. 9-113 9.10 Activity 3: Acquisition on Credit Followed by Depreciation ................. 9-114 9.11 Activity 4: Rendering Service and Cash Receipt ...................................... 9-116 9.12 Income Tax Calculation .............................................................................. 9-116 9.13 Summary........................................................................................................ 9-117 <?page no="9"?> Berkau: Basics of Accounting 6e 1-9 9.14 Working Definitions ................................................................................... 9-117 9.15 Question Bank ............................................................................................. 9-118 9.16 Solutions ....................................................................................................... 9-118 10 Introduction to T-Accounts for Items on the Balance Sheet ...... 10-119 10.1 What is in the Chapter? ............................................................................ 10-119 10.2 Learning Objectives .................................................................................. 10-119 10.3 Overview .................................................................................................... 10-119 10.4 T-Accounts................................................................................................. 10-120 10.5 Balancing-off.............................................................................................. 10-121 10.6 Real and Nominal Accounts .................................................................... 10-123 10.7 Basics-Chart of Accounts ......................................................................... 10-123 10.8 Applying T-Accounts for ROHRBACH Ltd......................................... 10-124 10.9 Applying T-Accounts for EDENVALE AG ........................................ 10-127 10.10 Summary ..................................................................................................... 10-129 10.11 Working Definitions ................................................................................. 10-130 10.12 Question Bank ........................................................................................... 10-130 10.13 Solutions ..................................................................................................... 10-131 11 T-Accounts for Profit and Loss.................................................... 11-132 11.1 What is in the Chapter? ............................................................................ 11-132 11.2 Learning Objectives .................................................................................. 11-132 11.3 Applying Nominal Accounts ................................................................... 11-132 11.4 Closing-off Accounts ................................................................................ 11-133 11.5 C/ S PELZERHAGEN (Pty) Ltd. .......................................................... 11-134 11.6 Calculation of Income Tax....................................................................... 11-138 11.7 Transfer of Profit or Loss to Equity ....................................................... 11-138 11.8 Summary ..................................................................................................... 11-140 11.9 Working Definition ................................................................................... 11-140 11.10 Question Bank ........................................................................................... 11-140 11.11 Solutions ..................................................................................................... 11-141 12 Introduction to Bookkeeping Entries.......................................... 12-142 12.1 What is in the Chapter? ............................................................................ 12-142 12.2 Learning Objectives .................................................................................. 12-142 12.3 Formal Description of Bookkeeping Entries......................................... 12-142 12.4 Double Entry System................................................................................ 12-143 12.5 Common Regulations for Bookkeeping ................................................. 12-144 12.6 Bookkeeping Entries at ROHRBACH Ltd............................................ 12-145 12.7 Bookkeeping Entries at EDENVALE AG ........................................... 12-147 12.8 Bookkeeping Entries at PELZERHAGEN (Pty) Ltd.......................... 12-150 12.9 Summary ..................................................................................................... 12-153 12.10 Working Definitions ................................................................................. 12-154 12.11 Question Bank ........................................................................................... 12-154 12.12 Solutions ..................................................................................................... 12-154 <?page no="10"?> Berkau: Basics of Accounting 6e 1-10 13 Special Asset Accounts................................................................. 13-155 13.1 What is in this Chapter? ............................................................................ 13-155 13.2 Learning Objectives ...................................................................................13-155 13.3 Asset Recognition ...................................................................................... 13-155 13.4 Non-current Assets.................................................................................... 13-156 13.5 Current Assets ............................................................................................13-159 13.6 Summary...................................................................................................... 13-163 13.7 Working Definitions ..................................................................................13-163 13.8 Question Bank............................................................................................ 13-163 13.9 Solutions...................................................................................................... 13-164 14 Special Equity Accounts .............................................................. 14-165 14.1 What is in the Chapter? .............................................................................14-165 14.2 Learning Objectives ...................................................................................14-165 14.3 Equity Section on the Balance Sheet ....................................................... 14-165 14.4 Issued Capital..............................................................................................14-165 14.5 Reserves....................................................................................................... 14-167 14.6 Retained Earnings ......................................................................................14-168 14.7 Summary...................................................................................................... 14-171 14.8 Working Definitions ..................................................................................14-171 14.9 Question Bank............................................................................................ 14-171 14.10 Solutions...................................................................................................... 14-172 15 Special Liability Accounts............................................................ 15-173 15.1 What is in the Chapter? .............................................................................15-173 15.2 Learning Objectives ...................................................................................15-173 15.3 Liabilities ..................................................................................................... 15-173 15.4 Effective Interest Calculation ...................................................................15-173 15.5 Disclosure of Liabilities .............................................................................15-174 15.6 Annuities ..................................................................................................... 15.175 15.7 Bank Loans with constant Pay-offs .........................................................15-178 15.8 Leases........................................................................................................... 15-179 15.9 Bonds...........................................................................................................15-181 15.10 Down Payments and Partial Payments.................................................... 15-181 15.11 Provisions.................................................................................................... 15-183 15.12 Income tax liabilities .................................................................................. 15.184 15.13 Summary...................................................................................................... 15-185 15.14 Working Definitions ..................................................................................15-185 15.15 Question Bank............................................................................................ 15-185 15.16 Solutions...................................................................................................... 15-186 16 Reconciliation Accounts .............................................................. 16-187 16.1 What is in the Chapter? .............................................................................16-187 16.2 Learning Objectives ...................................................................................16-187 <?page no="11"?> Berkau: Basics of Accounting 6e 1-11 16.3 Account Structure...................................................................................... 16-187 16.4 Asset Management .................................................................................... 16-187 16.5 Reconciliation Account............................................................................. 16-187 16.6 C/ S DAGBREEK Ltd. (Asset Management) ....................................... 16-188 16.7 C/ S RETIEF (Pty) Ltd............................................................................. 16-189 16.8 Purchase and Sales Ledger ....................................................................... 16-191 16.9 C/ S DESPATCH Ltd............................................................................... 16-191 16.10 C/ S SCHECKTER Ltd............................................................................ 16-194 16.11 Summary ..................................................................................................... 16-195 16.12 Working Definitions ................................................................................. 16-195 16.13 Question Bank ........................................................................................... 16-195 16.14 Solutions ..................................................................................................... 16-196 17 Depreciation ................................................................................. 17-197 17.1 What is in this Chapter? ............................................................................ 17-197 17.2 Learning objectives.................................................................................... 17-197 17.3 Regulations for Depreciation ................................................................... 17-197 17.4 Depreciation Parameters .......................................................................... 17-197 17.5 Straight-line Method.................................................................................. 17-198 17.6 Recording Depreciation............................................................................ 17-198 17.7 Register of Non-Current Assets .............................................................. 17-200 17.8 C/ S FAIRBRIDGE Ltd........................................................................... 17-201 17.9 Declining Method for Depreciation........................................................ 17-204 17.10 C/ S KROLLER Ltd. ................................................................................ 17-205 17.11 Depreciation Following Asset Deployment........................................... 17-209 17.12 C/ S FLYSCHER Ltd................................................................................ 17-209 17.13 Summary ..................................................................................................... 17-210 17.14 Working Definitions ................................................................................. 17-211 17.15 Question Bank ........................................................................................... 17-211 17.16 Solutions ..................................................................................................... 17-212 18 Further Expenses and Accruals ................................................... 18-213 18.1 What is in the Chapter? ............................................................................ 18-213 18.2 Learning Objectives .................................................................................. 18-213 18.3 Prepaid Expenses ...................................................................................... 18-213 18.4 C/ S SIMONI Ltd...................................................................................... 18-213 18.5 Summary ..................................................................................................... 18-219 18.6 Question Bank ........................................................................................... 18-219 18.7 Solutions ..................................................................................................... 18-220 19 Accounting for Labour ................................................................. 19-221 19.1 What is in the Chapter? ............................................................................ 19-221 19.2 Learning Objectives .................................................................................. 19-221 19.3 Pay-days ...................................................................................................... 19-221 19.4 Components of Labour ............................................................................ 19-221 <?page no="12"?> Berkau: Basics of Accounting 6e 1-12 19.5 Net Salary ....................................................................................................19-222 19.6 Gross Salary ................................................................................................19-222 19.7 Assumptions ...............................................................................................19-222 19.8 Case study SUIDERLAND Ltd. ............................................................. 19-222 19.9 Piecework Labour ...................................................................................... 19-224 19.10 C/ S CLARITON Ltd. ...............................................................................19-224 19.11 Accruals for Piecework Labour................................................................19-229 19.12 Summary...................................................................................................... 19-232 19.13 Working Definitions ..................................................................................19-232 19.14 Question Bank............................................................................................ 19-233 19.15 Solutions...................................................................................................... 19-234 20 Trading Business - (1) Purchases and Returns ......................... 20-235 20.1 What is in the Chapter? .............................................................................20-235 20.2 Learning Objectives ...................................................................................20-235 20.3 Bookkeeping Entries for Trading Business ............................................ 20-235 20.4 C/ S APPLEDENE (Pty) Ltd...................................................................20-236 20.5 Accounting for Returns Outwards ..........................................................20-238 20.6 C/ S KLIPFONTAIN Ltd. .......................................................................20-239 20.7 Summary...................................................................................................... 20-242 20.8 Working Definitions ..................................................................................20-242 20.9 Question Bank............................................................................................ 20-242 20.10 Solutions...................................................................................................... 20-243 21 Trading Business - (1) Purchases and Returns plus VAT..........21-244 21.1 What is in the Chapter? .............................................................................21-244 21.2 Learning Objectives ...................................................................................21-244 21.3 Value Added Tax VAT.............................................................................. 21-244 21.4 How to Calculate input-VAT ...................................................................21-246 21.5 C/ S APPLEDENE (Pty) Ltd...................................................................21-247 21.6 VAT Consideration for Returns Outwards ............................................21-250 21.7 C/ S KLIPFONTEIN Ltd. .......................................................................21-251 21.8 Summary...................................................................................................... 21-254 21.9 Working Definitions ..................................................................................21-255 21.10 Question Bank............................................................................................ 21-255 21.11 Solutions...................................................................................................... 21-256 22 Trading Business - (2) Sales and Returns.................................. 22-257 22.1 What is in the Chapter? .............................................................................22-257 22.2 Learning Objectives ...................................................................................22-257 22.3 Revenue Recognition................................................................................. 22-257 22.4 Trading Account ........................................................................................22-257 22.5 C/ S APENDORP (Pty) Ltd.....................................................................22-258 22.6 C/ S DURANT (Pty) Ltd. ......................................................................... 22-265 22.7 Summary...................................................................................................... 22-273 <?page no="13"?> Berkau: Basics of Accounting 6e 1-13 22.8 Working Definitions ................................................................................. 22-274 22.9 Question Bank ........................................................................................... 22-274 22.10 Solutions ..................................................................................................... 22-275 23 Trading Business - (2) Sales and Returns plus VAT ................. 23-276 23.1 What is in the Chapter? ............................................................................ 23-276 23.2 Learning Objectives .................................................................................. 23-276 23.3 How to Record Output-VAT .................................................................. 23-276 23.4 C/ S APENDORP (Pty) Ltd. ................................................................... 23-277 23.5 C/ S DURANT (Pty) Ltd.......................................................................... 23-283 23.6 Summary ..................................................................................................... 23-292 23.7 Question Bank ........................................................................................... 23-292 23.8 Solutions ..................................................................................................... 23-293 24 Privately-owned Business: Drawings ......................................... 24-294 24.1 What is in the Chapter? ............................................................................ 24-294 24.2 Learning Objectives .................................................................................. 24-294 24.3 Why running a Private Business? ............................................................. 24-294 24.4 Drawings..................................................................................................... 24-295 24.5 Balance Sheet for a privately-owned Company. .................................... 24-295 24.6 How to Record a Drawing ....................................................................... 24-296 24.7 C/ S T.L. vanGuard ................................................................................... 24-299 24.8 C/ S PAROW HOUTBANK................................................................... 24-308 24.9 Summary ..................................................................................................... 24-312 24.10 Working Definitions ................................................................................. 24-313 24.11 Question Bank ........................................................................................... 24-313 24.12 Solutions ..................................................................................................... 24-314 25 Production Firms..........................................................................25-315 25.1 What is in the Chapter? ............................................................................ 25-315 25.2 Learning Objectives .................................................................................. 25-315 25.3 Inventory Valuation and Recording........................................................ 25-315 25.4 C/ S REGENT BIKE (Pty) Ltd. ............................................................. 25-317 25.5 Summary ..................................................................................................... 25-324 25.6 Working Definitions ................................................................................. 25-324 25.7 Question Bank ........................................................................................... 25-324 25.8 Solutions ..................................................................................................... 25-325 26 Inventory Systems ....................................................................... 26-326 26.1 What is in the Chapter? ............................................................................ 26-326 26.2 Learning Objectives .................................................................................. 26-326 26.3 Recall of the Periodic Inventory System ................................................ 26-326 26.4 Perpetual Inventory System ..................................................................... 26-327 26.5 C/ S WITSAND (Pty) Ltd. - Periodic Inventory System ..................... 26-328 26.6 C/ S WITSAND (Pty) Ltd. - Perpetual Inventory System ................... 26-336 <?page no="14"?> Berkau: Basics of Accounting 6e 1-14 26.7 Summary...................................................................................................... 26-349 26.8 Working Definitions ..................................................................................26-350 26.9 Question Bank............................................................................................ 26-350 26.10 Solutions...................................................................................................... 26-351 27 Cost Formulas ............................................................................. 27-352 27.1 What is in the Chapter? .............................................................................27-352 27.2 Learning Objectives ...................................................................................27-352 27.3 Cost Formulas ............................................................................................ 27-352 27.4 C/ S MALGAS (Pty) Ltd. ..........................................................................27-353 27.5 Application of Weighted Average (A) .....................................................27-355 27.6 Application of First-In-First-Out (B) ......................................................27-358 27.7 Application of Last-In-First-Out (C).......................................................27-361 27.8 Summary...................................................................................................... 27-364 27.9 Working Definitions ..................................................................................27-364 27.10 Question Bank............................................................................................ 27-365 27.11 Solutions...................................................................................................... 27-365 28 Income Statement Following the Cost of Sales Format............. 28-366 28.1 What is in the Chapter? .............................................................................28-366 28.2 Learning Objectives ...................................................................................28-366 28.3 Statement of Profit or Loss and Other Comprehensive Income ........ 28-366 28.4 Nature of Expense Method ......................................................................28-367 28.5 Cost of Sales Format .................................................................................28-367 28.6 Similarities/ Differences.............................................................................28-367 28.7 Application of NoE and COS ..................................................................28-368 28.8 C/ S ASHTON Ltd. ................................................................................... 28-368 28.9 C/ S ASHTON Ltd. - Nature of Expense Method (NoE) ..................28-372 28.10 C/ S ASHTON Ltd. - Cost of Sales Format (COS)..............................28-378 28.11 C/ S MONTAGU (Pty) Ltd......................................................................28-385 28.12 Summary...................................................................................................... 28-401 28.13 Working Definitions ..................................................................................28-401 28.14 Question Bank............................................................................................ 28-402 28.15 Solutions...................................................................................................... 28-403 29 Trial Balance ............................................................................... 29-404 29.1 What is in the Chapter? .............................................................................29-404 29.2 Learning Objectives ...................................................................................29-404 29.3 How to Prepare a Trial Balance ............................................................... 29-404 29.4 C/ S PENTZ Ltd........................................................................................29-405 29.5 Step (A): Making Bookkeeping Entries...................................................29-406 29.6 Step (B): Preparing the Trial Balance.......................................................29-412 29.7 Step (C): Checking the Trial Balance ....................................................... 29-413 29.8 Step (D): Making Adjustments .................................................................29-415 29.9 Step (E): Preparing the Adjusted Trial Balance......................................29-419 <?page no="15"?> Berkau: Basics of Accounting 6e 1-15 29.10 Step (F): Deriving Financial Statements ................................................. 29-420 29.11 Summary ..................................................................................................... 29-422 29.12 Working Definitions ................................................................................. 29-422 29.13 Question Bank ........................................................................................... 29-422 29.14 Solutions ..................................................................................................... 29-423 30 Tax Calculation, Profit Appropriation and Equity Changes ..... 30-424 30.1 What is in the Chapter? ............................................................................ 30-424 30.2 Learning Objectives .................................................................................. 30-424 30.3 Profit Appropriation ................................................................................. 30-424 30.4 Auditing ...................................................................................................... 30-425 30.5 C/ S RAATS Ltd. ....................................................................................... 30-425 30.6 Statement of Changes in Equity .............................................................. 30-432 30.7 Summary ..................................................................................................... 30-433 30.8 Working Definitions ................................................................................. 30-433 30.9 Question Bank ........................................................................................... 30-434 30.10 Solutions ..................................................................................................... 30-434 31 Multiple-Period Bookkeeping......................................................31-435 31.1 What is in the Chapter? ............................................................................ 31-435 31.2 Learning Objectives .................................................................................. 31-435 31.3 End of Accounting Period Procedures................................................... 31-435 31.4 Beginning of Accounting Period Procedures ........................................ 31-436 31.5 Timeline for Financial Statements........................................................... 31-436 31.6 C/ S GOUSBLOM Ltd. - 20X7 ............................................................... 31-437 31.7 C/ S GOUSBLOM Ltd. - 20X8 .............................................................. 31-445 31.8 Summary ..................................................................................................... 31-454 31.9 Question Bank ........................................................................................... 31-454 31.10 Solutions ..................................................................................................... 31-455 32 Introduction to Statements of Cash Flows ................................. 32-456 32.1 What is in the Chapter? ............................................................................ 32-456 32.2 Learning Objectives .................................................................................. 32-456 32.3 Cash Flow Statement Requirements in Germany ................................. 32-456 32.4 Cash Flow Statement Requirements by IFRSs ...................................... 32-456 32.5 Categories of Cash Flows ......................................................................... 32-457 32.6 Cash Flow Statement and Value added Tax .......................................... 32-458 32.7 Direct Method............................................................................................ 32-458 32.8 C/ S MANSELL Ltd. ................................................................................ 32-458 32.9 Reconciliation Method.............................................................................. 32-465 32.10 C/ S DEERHURST................................................................................... 32-466 32.11 Formal Procedure for the Reconciliation ............................................... 32-470 32.12 Reconciliation at MANSELL Ltd............................................................ 32-473 32.13 C/ S SUNLANDS AG .............................................................................. 32-477 32.14 Summary ..................................................................................................... 32-482 <?page no="16"?> Berkau: Basics of Accounting 6e 1-16 32.15 Working Definitions ..................................................................................32-482 32.16 Question Bank............................................................................................ 32-483 32.17 Solutions...................................................................................................... 32-483 33 Establishment of a Business and Legal Form Changes ............ 33-484 33.1 What is in the Chapter? .............................................................................33-484 33.2 Learning Objectives ...................................................................................33-484 33.3 C/ S SALDANHA (Part 1: Sole Proprietor)........................................... 33-484 33.4 Requirements to Prepare Financial Statements for Small Business.....33-485 33.5 Bookkeeping Records for a Sole Proprietorship (Case Saldanha) .......33-485 33.6 Calculation of Profits in a Sole Proprietorship (Case Saldanha) ..........33-489 33.7 Change of Legal Form (Case Saldanha) .................................................. 33-495 33.8 Partnerships ................................................................................................33-495 33.9 C/ S SNACKY-TICKY-Shop (Part 2: Partnership) ..............................33-495 33.10 C/ S SNACKY-TICKY-Shop (Part 3: Limited Company) ...................33-508 33.11 Business Activities (C/ S SNACKY-TICKY Ltd.).................................33-511 33.12 Profit and Loss Calculation (C/ S SNACKY-TICKY Ltd.).................. 33-515 33.13 Summary...................................................................................................... 33-521 33.14 Working Definitions ..................................................................................33-522 33.15 Question Bank............................................................................................ 33-522 33.16 Solutions...................................................................................................... 33-523 34 Liquidations................................................................................. 34-524 34.1 What is in the Chapter? .............................................................................34-524 34.2 Learning Objectives ...................................................................................34-524 34.3 Reasons for Liquidations ..........................................................................34-524 34.4 Liquidation Procedures ............................................................................. 34-525 34.5 C/ S MOSSEL SPORTS............................................................................ 34-525 34.6 Tax Implication for a Profit on Liquidation...........................................34-530 34.7 Alternative End for the C/ S MOSSEL SPORTS.................................. 34-530 34.8 Liquidation of Partnerships and Limited Companies............................34-532 34.9 Summary...................................................................................................... 34-533 34.10 Working Definitions ..................................................................................34-533 34.11 Question Bank............................................................................................ 34-533 34.12 Solutions...................................................................................................... 34-534 35 Disposals...................................................................................... 35-535 35.1 What is in the Chapter? .............................................................................35-535 35.2 Learning Objectives ...................................................................................35-535 35.3 Reasons for Disposals ...............................................................................35-535 35.4 Bookkeeping Entries for Disposals .........................................................35-536 35.5 C/ S: WARDRIF Ltd. ................................................................................ 35-537 35.6 Summary...................................................................................................... 35-547 35.7 Working Definitions ..................................................................................35-547 35.8 Question Bank............................................................................................ 35-547 <?page no="17"?> Berkau: Basics of Accounting 6e 1-17 35.9 Solutions ..................................................................................................... 35-548 36 Discounts and Rebates................................................................ 36-549 36.1 What is in the Chapter? ............................................................................ 36-549 36.2 Learning Objectives .................................................................................. 36-549 36.3 Characteristics of Discounts and Rebates .............................................. 36-549 36.4 Recording Discounts and Rebates .......................................................... 36-549 36.5 Impact of Discounts on Financial Statements....................................... 36-550 36.6 Direct Discounts........................................................................................ 36-550 36.7 C/ S MELKBOS Ltd................................................................................. 36-550 36.8 Deferred Discount .................................................................................... 36-551 36.9 C/ S HETKRUIS Ltd. and FIXCARS (Pty) Ltd. - Buyer .................... 36-552 36.10 C/ S HETKRUIS Ltd. and FIXCARS (Pty) Ltd. - Seller .................... 36-555 36.11 Discounts Received in the Next Accounting Period ............................ 36-558 36.12 C/ S BELLICK AG................................................................................... 36-558 36.13 Summary ..................................................................................................... 36-561 36.14 Working Definitions ................................................................................. 36-562 36.15 Question Bank ........................................................................................... 36-562 36.16 Solutions ..................................................................................................... 36-563 37 Cash Book: Reconciliation with the Bank Statement ................ 37-564 37.1 What is in the Chapter? ............................................................................ 37-564 37.2 Learning Objectives .................................................................................. 37-564 37.3 Need for Bank Reconciliation.................................................................. 37-564 37.4 Bank Statements ........................................................................................ 37-564 37.5 C/ S KRAGGA Consultants Ltd. ............................................................ 37-565 37.6 Reconciliation............................................................................................. 37-570 37.7 Summary ..................................................................................................... 37-577 37.8 Working Definitions ................................................................................. 37-577 37.9 Question Bank ........................................................................................... 37-577 37.10 Solutions ..................................................................................................... 37-578 38 Petty Cash Book .......................................................................... 38-579 38.1 What is in the Chapter? ............................................................................ 38-579 38.2 Learning Objectives .................................................................................. 38-579 38.3 Need for a Petty Cash Book .................................................................... 38-579 38.4 Bookkeeping Records for Expenditures Paid from Petty Cash .......... 38-579 38.5 C/ S SWARTKLIP Ltd. ............................................................................ 38-580 38.6 Summary ..................................................................................................... 38-591 38.7 Working Definitions ................................................................................. 38-591 38.8 Question Bank ........................................................................................... 38-591 38.9 Solutions ..................................................................................................... 38-592 39 Books of Original Entry .............................................................. 39-593 39.1 What is in the Chapter? ............................................................................ 39-593 <?page no="18"?> Berkau: Basics of Accounting 6e 1-18 39.2 Learning Objectives ...................................................................................39-593 39.3 Need for Books of Original Entry........................................................... 39-593 39.4 Concept of Books of Original Entry ....................................................... 39-593 39.5 C/ S MUIRFIELD (Pty) Ltd..................................................................... 39-595 39.6 Summary...................................................................................................... 39-605 39.7 Working Definitions ..................................................................................39-605 39.8 Question Bank............................................................................................ 39-605 39.9 Solutions...................................................................................................... 39-606 40 Abbreviations............................................................................... 40-607 41 Table of Figures ........................................................................... 41-611 42 Literature ......................................................................................42-618 <?page no="19"?> Berkau: Basics of Accounting 6e 1-19 II Introduction We published the 1 st edition of Basics of Accounting in 2013. It was an online preparatory course for Financial Accounting classes in Osnabrück. We want to prepare our readers for studying Accounting. After working through this textbook, you can record Bookkeeping entries for standard cases in the academic environment. You will be fit to study Accounting following German law (HGB) and International Accounting Standards IFRSs in English. The focus of the Basics of Accounting lays on Bookkeeping aspects and standard Accounting procedures, like recording acquisitions, discounts, depreciations, disposals etc. The Basics of Accounting has three parts: (A) Introduction to Accounting (selfstudy) in chapters (1) - (5) (B) First Steps in Bookkeeping (selfstudy) in chapters (6) - (15) (C) Special Considerations in Financial Accounting in chapters (16) - (39) The Basics of Accounting teach you the fundamental knowledge of Accounting. References to Standards or to national GAAPs (Generally Accepted Accounting Principles) are kept to a minimum. We teach Accounting for commercial financial statements. This is the same syllabus most international Accounting Schools follow. You can use our textbook to get fit for studies abroad. Basics of Accounting is a textbook for beginners. No Accounting knowledge is expected from you as our readers, but you should bring a good sense for and interest in business. Our approach is teaching with case studies. Almost 70% of the textbook consists of case studies. Therefore, you learn by “observing” Accounting. For the 6 th edition, we revised the wording and simplified some case studies. Furthermore, we adjusted the appearance of all accounts to the format used in the textbooks Bilanzen/ Financial Statements and Management Accounting. New is, that now all chapters end with 5 multiple-choice questions. You can check your knowledge and prepare yourself for oral exams (if necessary). We started producing Accounting tutorial videos which are available on Youtube. They cover our case studies in the self-study parts. We author this textbook as an international team (Germany and South Africa). Most of the case studies are derived from Carsten’s lessons in Osnabrück, Cape Town and Kuantan. Keabetswe is an Accountant and native speaker; she edited the text to make it easily understandable. Thanks to Dr. Jürgen Schechler from UVK-Verlag in Munich, who is our lector. He supports our book projects and always gives us a very nice and friendly atmosphere for our writing. He also manages to keep the textbooks affordable for our students by controlling the printing costs. At www.uvk.digital/ 9783739831831, we uploaded further study materials for our readers. <?page no="20"?> Berkau: Basics of Accounting 6e 1-20 Feel free to follow us on twitter, under: ‘@CBerkau’ and/ or to email us: BOOKS@Prof-Berkau.de. Let us know about your experience in Accounting and give us feedback, so we can improve our books and study materials to your needs! Enjoy the new Basics 6e! Cape Town, in July 2021 Keabetswe and Carsten Berkau <?page no="21"?> Berkau: Basics of Accounting 6e 1-21 1 Conventions The below listed conventions apply merely to simplify the case studies. They are about legal forms, tax rates, formats etc. They apply for this textbook, for our textbooks Bilanzen, Financial Statements and Management Accounting and for all online study materials. At this stage of reading, you might not understand the conventions completely. We only place them at the beginning of the textbook for you to find them upfront. 1.1 Accounting Periods Accounting periods start on 1.01.20XX and end on 31.12.20XX. Furthermore, to keep the examples transferable to later years, we write the decades with an X, as in 20X4. X is followed by Y, then Z. 1.2 Accounting Technical Terms At the end of every chapter, we explain new technical terms. They help you to easily understand the content. These are simple explanations if you are beginners in Accounting. The Accounting technical terms are not as formal and precise as the definitions provided by the IASB. 1.3 Account Names All account names are written in capital letters, like ‘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 in small letters: bank account. We do not make Bookkeeping entries therein, but Deutsche Bank AG does. Only the Cash/ Bank account applicable to calculate the item cash/ bank on the balance sheet is part of our Accounting work. 1.4 Alphabetic Order For all lists, we apply an alphabetic order. 1.5 Basics Our Basics refers to the textbook Berkau: Basics of Accounting. You must read our basics before you start reading our Financial Statements. It introduces you to Bookkeeping and major Accounting concepts without consideration of International Accounting standards IFRSs. We frequently quote the Basics. 1.6 Bookkeeping Entries All Bookkeeping entries are printed in bold and cover a whole page’s width. 1.7 Bookkeeping Entry Format We write debit entries and credit entries. DR stands for debit recorded and CR for credit recorded. See, e.g., a Bookkeeping entry for the acquisition of a motor vehicle: <?page no="22"?> Berkau: Basics of Accounting 6e 1-22 DR Motor Vehicle................ 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR The identifier for Bookkeeping entries in the text, like “Bookkeeping entry (1)” can be found in the accounts as “(1)”, as well. 1.8 Calculations For calculations, we only show the units with the results. E.g., 10 + 20.50 = 30.50 EUR. Furthermore, the figures in calculations come without digits after the decimal point in case they equal zero. Results are printed in bold to find them easily in the text. All calculations are exact to the EURcent or any other currency as 1/ 100amounts. 1.9 Case Studies (C/ S) We keep case studies in this textbook as easy as possible even as they might look unrealistic. Teaching Accounting is our priority. 1.10 Case Study Text We write case studies in a different text format than the normal text (Italic fonts). 1.11 Cash Flow Separation Interest payments in this textbook are always considered to be financing cash flows, even as IAS 7.33 allows their recognition as operating as well as financing cash flows. This applies for all case studies. 1.12 Companies For the textbook, the legal form of companies does not matter. Legal forms are not part of our Accounting syllabus. We only assure that companies prepare financial statements. In contrast to IFRSs, we do not refer to companies as “entities”. Once you read the expression entity in the standards, remember they refer to companies. We apply the technical terms “business”, “firm” and “company”. Most companies are limited companies in this textbook, like GmbH, AG, Pty Ltd., PLC, Inc. etc. 1.13 Cost-Expense-Congruence By default, costs are expenses and vice versa. 1.14 Country All case studies of the Basics take place in Germany or in countries where IFRSs apply for single-entity financial statements. We do not focus on national law as the German Handelsgesetzbuch HGB. 1.15 Currency Unit For all examples, the reporting currency is based on the country of the case study. We use the common 3 letter codes for abbreviations, like ZAR for South African Rand or GBP for British Pound Sterling. <?page no="23"?> Berkau: Basics of Accounting 6e 1-23 1.16 Data Format in Tables In tables, negative figures are shown in brackets. E.g., (7.50) equals -7.50 EUR. 1.17 Prepayments of Income Taxes We assume, that no provisional income tax payments are made to the national revenue service in our case studies. Taxes are calculated at the end of the year and added to short-term liabilities, mostly to the Income Tax Liabilities account. For German companies, § 249 HGB applies, and income taxes are shown as provisions. 1.18 How it is Done (1) You find How-it-is Done sections in this textbook. (2) They offer you very short and clear instructions for your Accounting work. 1.19 Income Taxes For our textbooks and the IFRSs, a simplified income tax model applies. Income taxes amount to 30 % of the pre-tax profit (EBT). 1.20 Financial Statements for Taxation We do not cover tax calculations. Tax statements are relevant for us to determine income taxes (simplified calculation) and deferred taxes. 1.21 Names We name companies and mark them with capital letters. E.g., SCHULZE- BRAMMELKAMP Ltd. No links to actual existing persons or companies are intended. The names work as identifiers, so you can use them for your communication with your classmates. 1.22 Language This textbook is written in South African English. Only our textbook Bilanzen is in German; it is a accurate translation of Financial Statements 5e. 1.23 Learning Objectives and Summaries All chapters start with the learning objectives and end with a summary. We also give you a short overview by our What-is-in-the-Chapter? -paragraphs. 1.24 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 is mentioned, assume the company is privately-owned, such as SANDPIPER BOOKS for a privatelyowned bookstore. 1.25 Length of a Month/ Year 1 month = 21.5 days = 4.3 weeks. 1 year = 12 evenly long months = 365 days = 52 weeks. 1.26 Level of Precision We work accurate to 2 digits after the decimal point. Results from workings are rounded to the nearest cent, too. We calculate mostly in MS-Excel; hence, calculations in the background are more precise than they appear. <?page no="24"?> Berkau: Basics of Accounting 6e 1-24 1.27 Literature The main source of preparing financial statements are the standards issued by the International Accounting Standard Board IASB. At the end of the textbook, we recommend further readings for you. 1.28 Non-existing Items In case something has not been mentioned it does not exist. 1.29 Online Materials The online materials are at the time of printing this textbook 354 exam tasks with solutions. Their names refer to the chapter and contain a counting figure, like Task_B29.7- LUEDGENFELDE, which is linked to the Basics (B), chapter 29 and is the 7 th exam task. As higher the count, as newer the task is. 1.30 Payment Terms In this textbook, payments/ receipts for taxation and for dividends are due in the next following Accounting period. 1.31 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, like Depreciation-20X4. See the accounts for the car acquisition with the Bookkeeping entry (1) therein: 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 1.32 Proportional Calculation of Depreciation and Interest Although given as annual rates, depreciation and interest are calculated on a proportional basis accurate to full months. 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 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 <?page no="25"?> Berkau: Basics of Accounting 6e 1-25 year is: 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, like bank loans, bonds etc. Overdrafts of bank accounts are ignored. An exception is chapter (37) in our Basics. 1.33 Question Bank At the end of each chapter, you find 5 multiple choice questions and their solution to check your learning progress. Expect them to be "tricky". 1.34 Quotation of Law Texts/ Standards Law texts/ standards are quoted like ‘§ 266 HGB’ or ‘IAS 1.68’. We use the original law names. Note, that IFRS paragraphs can be subjected to changes. 1.35 Sequence of Bookkeeping Entries The sequence of Bookkeeping entries comes along the logical process defined by the text. Bookkeeping identifiers, like “(1), (2), (3) …” do not indicate nor prescribe a sequence of recording. 1.36 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 (not companies). 1.37 Transaction Costs We ignore transaction costs, like costs for selling goods/ services, taking or repaying bank loans, issuing shares or bonds etc. 1.38 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 for buying goods or services. In this textbook, we apply one single VAT account for input-VAT and output-VAT. The VAT rate in our textbooks is 20 %. We ignore reduced VAT rates as levied in many countries for food, books etc. 1.39 VAT Reduction It is assumed that every company discussed in this textbook is registered for VAT reduction. They get refunded for input-VAT and collect output-VAT from their customers. 1.40 Working Definition(s) At the end of each chapter, you find short and easily understandable definitions for new Accounting terms. They are merely a glossary and should support your understanding. For enforceable and more precise definitions, study the IFRSs! <?page no="26"?> Berkau: Basics of Accounting 6e 1-26 1.41 Work-in-Process Account We apply the Work-in-Process account as reconciliation account for all job orders and name it Work-in-Process WIP. We also apply a Work-in- Process account for single job orders but then add the job order's ID thereto, like “Work-in-Process 4711” for a job order 4711. 1.42 Writing Management Terms We write academic disciplines, like Accounting, Marketing, Management etc., in capital letters. 1.43 WWW We provide you with a lot of exercises and further materials. Pls., check the website: www. uvk.digital/ 9783739831831. Most of the exercises are exam tasks from Hochschule Osnabrück or its partner universities, in South Africa, China, South Korea and Malaysia. 1.44 Youtube Videos On our Youtube channel (Carsten Berkau) we published video tutorials which are based on the case studies in this textbook. Find their links on Twitter and on the UVK website. 1.45 10-20-30 Rule In this textbook, a 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="27"?> Berkau: Basics of Accounting 6e 2-27 2 Cafeteria Example and what is on the Balance Sheet 2.1 What is in the Chapter? In this chapter, you will achieve a basic understanding of the Accounting work linked to financial statements (balance sheet and income statement). We introduce the Accounting equation. After an explanation what a balance sheet and an income statement are, we read the financial statements of the Australian car rental - case study NEWINGTON Ltd. Later we prepare financial statements for a cafeteria business by studying its operations activity-by-activity. In this chapter, we focus on the major Accounting purpose, to report about the financial position and the performance of a company. We also show how a statement of cash flows and of changes in equity look like. 2.2 Learning Objective After studying this chapter, you have developed a sound understanding of Accounting principles and what Accounting can tell you about a company. Reading financial statements of NEWINGTON Ltd. gives you an idea of what the items on the financial statements are. Preparing financial statements shows you, how business activities change items on the balance sheet, the income statement, the statement of cash flows and the statement of changes in equity. 2.3 Statement of Financial Position A balance sheet (= statement of financial position) shows two lists; one thereof contains the assets and the other one capital and liabilities. Both sides must equal, meaning: the total value of assets equals the total value of equity funds and liabilities. An asset is any resource of a company that meets the recognition criteria (existence of economic benefit and reliable measurement). Equity funding refers to funds owned by the company. It is either money paid in at the time of incorporation or gained from further share issues, or it comes from accumulating profits. It is also called capital: Capital is the amount of funds assigned to the owners of the company. In contrast, liabilities are funds the company owes someone: we call these parties creditors, like a bank a company is borrowing from. A liability represents funds coming from other parties than from the owners of the business. For understanding the company’s financial position, a balance sheet compares the value of all assets to the funds' value. As assets are either bought from own money or financed with liabilities, the totals on the two balance sheet's sides are always the same. Often beginners in Accounting try to connect particular assets to certain items of equity or liabilities. This is not necessary and only works out in the first Accounting lessons. Do not try! Focus on the equality of both sides regarding the totals of values. 2.4 Our first Balance Sheet At the commencement of a company's life, its owners prepare a(n opening) <?page no="28"?> Berkau: Basics of Accounting 6e 2-28 balance sheet which is an addendum to the memorandum of incorporation (MoI). The memorandum of incorporation is a contract set up when a company is established. In some countries this contract is named "the Articles" or in German: "Gründungsvertrag". It is a contract between the owners and their company. Most probably, the MOI requires a notary signing the agreement as a witness. Look at the German company Tulbagh GmbH: TULBAGH GmbH is established with owners’ capital of 100,000.00 EUR, which is deposited in TULBAGH GmbH’s bank account with Deutsche Bank. When preparing the opening balance sheet, the Accountant discloses only two figures: one is on the asset side and refers to the money paid in: 100,000.00 EUR. We name the item on the balance sheet cash/ bank. The other one is the source of funds which is the owners’ capital of 100,000.00 EUR. It is called issued capital or Stammkapital for a German Gesellschaft mit beschränkter Haftung GmbH. The reader of its balance sheet can see that TULBAGH GmbH is established based on 100,000.00 EUR in the bank account which comes from its proprietors. We prepare our first balance sheet as shown in Figure 2.1: A C, L Non-current assets [EUR] Equity [EUR] P, P, E Share capital 100,000.00 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities Total assets 100,000.00 Total equity and liab. 100,000.00 Tulbagh GmbH STATEMENT of FINANCIAL POSITION as at 1.01.20X1 Figure 2.1: TULBAGH GmbH’s opening balance sheet TULBAGH GmbH's balance sheet shows the company's name, the day for which the balance sheet is set up, the reporting currency EURO and the items on the asset side and the items on the credit side. 2.5 Accounting Equation The balance sheet or following International Financial Reporting Standards IFRSs referred to as the statement of financial position represents the Accounting equation: The total of the assets' value is the total of the value of capital and liabilities. The totals on both sides always must be equal. <?page no="29"?> Berkau: Basics of Accounting 6e 2-29 n i m j l k k j i Liability Capital Asset 1 1 1 (with: i = index for assets, i = 1 … n, j = index for capital, j = 1 …m, k = index for liabilities, k = 1 … l) We write in a less formal way: ∑Assets = ∑Capital + ∑Liabilities The equality of assets and equity plus liabilities is easily understandable because every asset is either financed with owners’ equity of by the creditors. A creditor is someone who lends the company money, like a bank, a supplier (who did not receive its money yet), customers (who prepaid some goods/ services, bond holders, the national revenue service etc. 2.6 Income Statement The income statement is the second statement to be introduced: It compares revenue earned by the business to the expenses. Revenue is the total of receipts from customers for goods/ services sold. It does not matter whether money for the revenue is received of a note receivable is recorded. Expenses is the value of consumed resources, such as materials, labour, depreciation etc. Whether a payment is made during an Accounting period is not relevant for the recognition of expenses. Payments also can take place in preceding or later Accounting periods. It is only relevant, for which Accounting period expenses count. There are even expenses without any payments, like depreciation. Depreciation is the loss in value that occurs when assets are deployed. In case the total revenue exceeds the sum of the expenses in an Accounting period, a company earns a profit. Income taxes must be paid based on the income tax rate - study the national tax law for details. We regularly calculate income taxes as earnings before taxes EBT × income tax rate. To keep examples in this textbook as simple as possible, we assume the total income tax rate is 30 %. In the real business world you must replace the 30 % by what the tax professionals calculate. We do not worry about income tax calculations for Accounting and are confident calculating taxes by our simple formula as the IFRSs do. Financial statements are prepared at every end of an Accounting period. In this textbook, all Accounting periods end on the 31.12. To develop a feeling about what the items of the balance sheet tell us, we study the case of NEWINGTON Ltd. <?page no="30"?> Berkau: Basics of Accounting 6e 2-30 2.7 Reading Financial Statements Next, we introduce the case study NEWINGTON Ltd. We use the case study to discuss its financial statements and to understand the items thereon. The case study is our second example for financial statements. We are now the reader of financial statements, like analysts, business partners, creditors, employees etc. 2.8 C/ S NEWINGTON Ltd. NEWINGTON Ltd. is an Australian car rental. The company is classified as a service provider. It rents out cars to private customers. The business is in the legal form of a limited company (Ltd.); the company is based on 100,000 shares. Its reliability is limited to its equity. On 31.12.20X5, NEWINGTON Ltd.’s equity is 474,000.00 AUD. The balance sheet tells us about the financial position of NEWINGTON Ltd. on 31.12.20X5. Note, the company was established prior to the Accounting period we are looking at. That is the reason why its equity exceeds the nominal value of the shares: It contains reserves built from previous profits and retained earnings which contains profit carried forward and the annual surplus from 20X5. At the beginning of the Accounting period 20X5, NEWINGTON Ltd. owns 12 cars: 8 Toyota Corolla and 4 Volkswagen Passat. In compliance with International Accounting Standards, companies must disclose the values for the reporting Accounting period as well as for the previous one. Due to space restriction in the textbook, we show in Figure 2.8 the balance sheet as at 31.12.20X4 (comparative information) and in Figure 2.9 as at 31.12.20X5 (reporting period). 2.9 What is on the Balance Sheet’s Asset side? Following international Accounting, we call the balance sheet a statement of financial position. NEWINGTON Ltd.’s statements of financial position is shown below: A C, L Non-current assets [AUD] Equity [AUD] P, P, E 460,000.00 Share capital 100,000.00 Intangibles 40,000.00 Reserves 260,000.00 Financial assets 18,000.00 Retained earnings 79,000.00 Current assets Liabilities (liab.) Inventory 26,000.00 Long-term liab. 80,000.00 Acc. receivables A/ R 56,000.00 Short-term liab. A/ P 10,000.00 Prepaid expenses 0.00 Provisions 21,000.00 Cash/ Bank (50,000.00) Income tax liab. 0.00 Total assets 550,000.00 Total equity and liab. 550,000.00 Newington Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 (comparative figures) Figure 2.2: NEWINGTON Ltd.’s balance sheet 20X4 <?page no="31"?> Berkau: Basics of Accounting 6e 2-31 A C, L Non-current assets [AUD] Equity [AUD] P, P, E 440,000.00 Share capital 100,000.00 Intangibles 40,000.00 Reserves 260,000.00 Financial assets 18,000.00 Retained earnings 114,000.00 Current assets Liabilities (liab.) Inventory 28,700.00 Long-term liab. 70,000.00 Acc. receivables A/ R 56,000.00 Short-term liab. A/ P 45,692.00 Prepaid expenses 3,000.00 Provisions 21,000.00 Cash/ Bank 39,992.00 Income tax liab. 15,000.00 Total assets 625,692.00 Total equity and liab. 625,692.00 Newington Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 2.3: NEWINGTON Ltd. balance sheet 20X5 We study the balance sheet for 20X5, the previous one is only to compare actual items to the previous Accounting period. It also helps us to understand how values changed during the period under discussion because we know the items' value at the beginning and at the end of 20X5. The header of the balance sheet tells us who is reporting: here it is NEWINGTON Ltd. We must mention the company and its legal form correctly. NEWINGTON Ltd.’s balance sheet is prepared in Australian Dollars (AUD) which is the reporting currency. The balance sheet discloses NEWINGTON Ltd.’s values for assets and for capital/ liabilities as they were on 31.12.20X5. On its asset side, we see the value of all resources in AUD. Note, the balance sheet is not an asset list; it only shows their total values. No single assets are disclosed but the value of items. An item on the balance sheet represents all assets of the same kind. E.g., NEWINGTON Ltd. does not show all its cars separately, but the value of all of them together: 440,000.00 AUD. On top of the asset side, we see non-current assets; those stay for a longer time (> 1 year) in the company. NEWINGTON Ltd.’s item property, plant and equipment (P, P, E) discloses the valuation of its cars. On 31.12.20X5 the company owns 8 Toyota Corolla and 4 Mercedes A-class. The value is: 8 × 30,000 + 4 × 50,000 = 4 440,000.00 AUD. One year before, the value of NEWINGTON Ltd.’s motor vehicles was 460,000.00 AUD. During the Accounting period, the car rental sold its 4 Volkswagen Passat and acquired 4 Mercedes A-class. Hence, the change in valuation results from depreciation of cars which is a value reduction due to their deployment and from new acquisitions (4 Mercedes A-class) and disposals (4 VW Passat). Companies report about their items of property, plant, equipment in more detail by the register of non-current assets. A register of non-current assets discloses the non-current assets with their cost of acquisition, their accumulated depreciation and accumulated impairment loss. The <?page no="32"?> Berkau: Basics of Accounting 6e 2-32 values result in the carrying value of disclosed assets. In contrast to German Accounting, the register of noncurrent assets is prepared on group level. Here, similar cars of the same age from a group. NEWINGTON Ltd. discloses 3 groups of motor vehicles, check Figure 2.4: Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount 8 Toyota Corolla 400,000.00 (160,000.00) 240,000.00 4 Mercedes A-class 200,000.00 200,000.00 4 VW Passat 180,000.00 (60,000.00) n/ a Total 440,000.00 Newington Ltd. REGISTER of NON-CURRENT ASSETS as at 31.12.20X5 Figure 2.4: NEWINGTON Ltd.’s register of non-current assets The register of non-current assets is part of the notes which count as a financial statement along IFRSs. The next item on the asset side of the balance sheet is intangible assets. NEWINGTON Ltd. discloses a franchise contract which is worth 40,000.00 AUD with a car rental brand. NEWINGTON Ltd. makes its business appear as an affiliated branch of AVIS and holds a licence from AVIS worth 40,000.00 AUD. As the license is unlimited, its value does not change. Under financial assets, NEWINGTON Ltd. discloses bonds at a value of 18,000.00 AUD it holds from the Australian Government (AGBs). Bonds are securities where the bond issuer - the Australian government borrows money from the bondholders (investors). The bonds must be paid back at the time of maturity, which is here in 20Y8. NEWINGTON Ltd. receives an interest income - called coupon - of 8 %/ a for lending the money. Further down on the balance sheet, we see the current asset section. In contrast to non-current assets, current assets are held for less than one Accounting period in general. NEWINGTON Ltd. discloses inventories to the extent of 28,700.00 AUD. Before the inventories were worth 26,000.00 AUD. During 20X5, NEWINGTON Ltd. purchased and consumed inventories. Its inventories are spare parts for the cars and office materials. Under accounts receivables the company shows money customers are owing from renting cars. The total value of all receivables is 56,000.00 AUD. Prepaid expenses are expenses for future periods already paid. Since 20X5, NEWINGTON Ltd. must pay its landlord the monthly rent of 3,000.00 AUD in advance. The value disclosed under cash/ bank is NEWINGTON Ltd.’s cash on hand and cash at bank. On 31.12.20X5, NEWINGTON Ltd. holds cash to the extent of 4,992.00 AUD and the bank account with Commonwealth Bank Australia has a balance of 35,000.00 AUD as <?page no="33"?> Berkau: Basics of Accounting 6e 2-33 at 31.12.20X5. Hence, the sum is: 4,992 + 35,000 = 3 39,992.00 AUD. NEWINGTON Ltd.’s assets’ total is amounting to 625,692.00 AUD. These are the resources of the company. 2.10 What is on the Capital and Liabilities Side of the Balance Sheet? We call the right-hand side of the balance sheet its capital/ liabilities. They tell the reader of financial statements where the funds for financing the assets result from. They are either capital (= equity) when they come from the company itself, like profits earned, or from its shareholders or they are liabilities, if the company borrows money from creditors or pays bills delayed to its suppliers. We first look at NEWINGTON Ltd.’s equity. The company discloses 100,000.00 AUD as its issued capital. Companies on shares will call it share capital. NEWINGTON Ltd. issued when established 100,000 ordinary shares at 1.00 AUD/ s. Under earnings reserves, reporting companies disclose profits that stay permanently in the business. NEWINGTON Ltd. earned in the previous Accounting periods 260,000.00 AUD profits which they added to reserves. The item retained earnings shows profits that have not been appropriated yet. At NEWINGTON Ltd., the profit from 20X4 has not been appropriated. Hence, NEWINGTON Ltd. carries it as retained earnings. The profit after taxes in the reporting period 20X5 was 35,000.00 AUD and is added to retained earnings. Therefore, the amount in 20X5 equals: 79,000 + 35,000 = 1 114,000.00 AUD. NEWINGTON Ltd. did not decide about the appropriation of its profits yet. The total of NEWINGTON Ltd.’s equity is amounting to: 100,000 + 260,000 + 114,000 = 4 474,000.00 AUD. Accountants refer to the equity as the book value of the company. If all assets can be sold at their carrying value and all debts can be retired at the same values as disclosed, the company’s shareholders would receive the book value of the company from a liquidation. The amount is only an estimate about the company’s value as in real business life, liquidation values are below the carrying values of the assets and for paying-off debts extra fees or penalties can apply. The latter ones are called transaction costs but get ignored in this textbook to keep Accounting easy. The liability section shows the value of all liabilities (debts) structured along the categories long-term liabilities, shortterm liabilities, provisions and income tax liabilities. Again, the balance sheet does not disclose single debts but values for the debt categories. We look at NEWINGTON Ltd.’s debts: As NEWINGTON Ltd. is based in Australia, the IFRSs apply for their financial statements. In accordance with IAS 1, debts must be classified as either longterm or short-term liabilities. NEWINGTON Ltd. took a bank loan of 120,000.00 AUD on 2.01.20X2. The bank loan’s interest rate is 4.00 %/ a. Additionally, NEWINGTON Ltd. must pay-off 10,000.00 AUD per year. The loan falls under annuities. A An annuity is a loan where the debtor pays a constant amount to the creditor which contains interest and pay-off. See below, the interest and pay-off schedule for the bank loan in Figure 2.5: <?page no="34"?> Berkau: Basics of Accounting 6e 2-34 Year Opening amount Interest Pay-off Rest [AUD] [AUD] [AUD] [AUD] 20X2 120,000.00 4,800.00 10,000.00 110,000.00 20X3 110,000.00 4,400.00 10,000.00 100,000.00 20X4 100,000.00 4,000.00 10,000.00 90,000.00 20X5 90,000.00 3,600.00 10,000.00 80,000.00 20X6 80,000.00 3,200.00 10,000.00 70,000.00 20X7 70,000.00 2,800.00 10,000.00 60,000.00 20X8 60,000.00 2,400.00 10,000.00 50,000.00 20X9 50,000.00 2,000.00 10,000.00 40,000.00 20Y0 40,000.00 1,600.00 10,000.00 30,000.00 20Y1 30,000.00 1,200.00 10,000.00 20,000.00 20Y2 20,000.00 800.00 10,000.00 10,000.00 20Y3 10,000.00 400.00 10,000.00 0.00 Newington Ltd. INTEREST and PAY-OFF PLAN Figure 2.5: NEWINGTON Ltd.’s bank loan schedule At the beginning of the Accounting period 20X5 (31.12.20X4), the bank loan’s value is 90,000.00 AUD. As a portion of 10,000.00 AUD is due in 20X5, the bank loan disclosure is split at an 8: 1 ratio: Hence, 10,000.00 AUD are short-term liabilities, and 80,000.00 AUD are longterm liabilities. The latter ones are often called interest bearing liabilities which is misleading, as NEWINGTON Ltd. pays interest on the short-term liabilities, too. The interest for the bank loan is: 4% × 90,000 = 3 3,600.00 AUD. On 31.12.20X5, NEWINGTON Ltd. pays interest and payoff and is left with 70,000.00 AUD longterm liabilities and 10,000.00 AUD short-term liabilities. Other short-term liabilities result from VAT payables. VAT is a tax levied by the government on consumption. VAT is collected from the sellers/ service providers on behalf of the revenue service. From the output-VAT received from its customers, NEWINGTON Ltd. deducts input-VAT paid on car acquisitions and material purchases. The remainder liability is 35,692.00 AUD. The total value of short-term liabilities is: 10,000 + 35,692 = 45,692.00 AUD. Provisions are liabilities that are uncertain. NEWINGTON Ltd. discloses a pension it owes its chief executive officer (CEO). The pension is part of the work contract and is to be paid for 21 months, once the CEO resigns. As the timing of the payments is uncertain and the CEO does not intend to resign so far, the pension is uncertain and must be disclosed as a provision. The disclosed tax liabilities are for NEWINGTON Ltd. income tax. We apply the simplified tax calculation which follows a 30 % income tax rate based on the profit before tax EBT. The total of capital/ liabilities is 625,692.00 AUD. It equals the total of assets. We later refer to the equality of the totals as the Accounting equation. 2.11 What is on the Income Statement? An income statement (= a statement of profit or loss and other comprehensive income) is a comparison of revenues and expenses. <?page no="35"?> Berkau: Basics of Accounting 6e 2-35 The revenue is money or its equivalent received for goods sold or services rendered. The revenue is the net amount thereof. At NEWINGTON Ltd., revenue results from renting out cars. It is amounting to 390,000.00 AUD. It is disclosed on the top line of the income statement, see Figure 2.6 below: [AUD] Revenue 390,000.00 Other income 33,440.00 423,440.00 Materials (1,600.00) Labour (112,000.00) Depreciation (100,000.00) Other expenses (156,240.00) Earnings before int. & taxes (EBIT) 53,600.00 Interest (3,600.00) Earnings before taxes (EBT) 50,000.00 Income tax expenses (15,000.00) Deferred taxes Earnings after taxes (EAT) 35,000.00 Newington Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X5 Figure 2.6: NEWINGTON Ltd.’s income statement NEWINGTON Ltd. also discloses other income which results from gains that are not linked to its core business, which is renting out cars. The other income comes from the profit on disposal of the 4 VW Passat and from interest income earned from the AGBs (Australian Government Bonds). The other income equals: 32,000 + 1,440 = 3 33,440.00 AUD. From revenues and other income, we deduct all expenses. We disclose the amounts as negative figures. An expense is a consumption of resources which results in an outflow of economic benefits from the company. At NEWINGTON Ltd. the expenses are materials, labour, depreciation, other expenses and income tax expenses. Materials at NEWINGTON Ltd. are for spare parts of cars and are amounting to 1,600.00 AUD. Labour at NEWINGTON Ltd. is for management and service employees to an extent of 112,000.00 AUD. Depreciation is not paid but leads to a value reduction of the cars. The depreciation is recorded for the 8 Toyota Corolla for the entire year and for the 4 VW Passats partially to the Accounting period owned, as they were sold in 20X5. The total depreciation is amounting to 100,000.00 AUD. Other expenses is an item that contains expenses not explicitly shown on the in- <?page no="36"?> Berkau: Basics of Accounting 6e 2-36 come statement. NEWINGTON Ltd. discloses operational expenses and rent as other expenses. The interest is the interest for the bank loan which is 3,600.00 AUD. The pre-tax profit or earnings before taxation EBT is 50,000.00 AUD. After tax reduction, an annual surplus or earnings after taxes remain. The annual surplus is transferred to the balance sheet and is added to retained earnings. The income tax expenses lead to an income tax liability as the taxes are paid in the next Accounting period. 2.12 What is on the Statement of Cash Flows? A statement of cash flows shows the total cash flow of a company split into 3 categories: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. NEWINGTON Ltd.’s statement of cash flow is depicted in Figure 2.7. Cash flow from operating acitivities [AUD] [AUD] Proceeds 468,000.00 Payment for purchases (5,160.00) Payment for operational expenses (191,088.00) Payment for Labour (112,000.00) 159,752.00 Cash flow from investing activities Disposal of cars 182,400.00 Acquisitions (240,000.00) (57,600.00) Cash flow from financing activities Interest income 1,440.00 Interest paid (3,600.00) Pay-off (10,000.00) (12,160.00) Total cash flow 89,992.00 Newington Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X5 Figure 2.7: NEWINGTON Ltd.’s cash flow statement The cash flow from operating activities starts with the proceeds. They are the gross amount of the revenues: 120% × 390,000 = 4 468,000.00 AUD. The other income gives a cash flow from financing activities and leads to an investing cash inflow of the gross selling price of the cars. It is 4 × 38,000 × 120% = 182,400.00 AUD. Further operating cash flows are payments for purchases, for labour and operational expenses. The investing cash flow results from the acquisition of the 4 Mercedes A-class as negative cash flow (gross amounts) and <?page no="37"?> Berkau: Basics of Accounting 6e 2-37 as mentioned from the disposal of the 4 VW Passats. The cash flows from financing activities contain the interest income and expenses as well as the pay-off of the bank loan. 2.13 What is on the Statement of Changes in Equity? The statement of changes in equity shows how the book value of the company changed during the reported Accounting period. The book value is a valuation of a company derived from the balance sheet. It is the difference between assets and liabilities. At the beginning of the Accounting period 20X5, the company disclosed a share capital of 100,000.00 AUD and reserves of 260,000.00 AUD. In the retained earnings, NEWINGTON Ltd. discloses 79,000.00 AUD. Equity in 20X5 at NEWINGTON Ltd. only changes for the profit (after tax) earned to the extent of 35,000.00 AUD. Check the statement of changes in equity in Figure 2.8. Share capital Reserves Retained earnings total [AUD] [AUD] [AUD] [AUD] as at 1.01.20X5 100,000.00 260,000.00 79,000.00 439,000.00 Profit 20X5 35,000.00 35,000.00 as at 31.12.20X5 100,000.00 260,000.00 114,000.00 474,000.00 Newington Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X5 Figure 2.8: NEWINGTON Ltd.’s statement of changes in equity After reading financial statements of NEWINGTON Ltd., we now want to study how to prepare them. We discuss the case study KENSINGTON CAFETERIA below: 2.14 C/ S KENSINGTON On 2.01.20X0, Kartik Kensington starts his own business on campus of the University Malaysia Pahang (UMP). The company is a university cafeteria. Kartik Kensington does not have enough money for financing the cafeteria business alone. He asks his classmates to contribute to his business. He finds 19 fellow students who each supply 3,000.00 MYR to the company (MYR stands for Malaysian Ringgit; assume 5.00 MYR = 1.00 EUR). Kartik himself counts as the 20 th owner contributing another 3,000.00 MYR. Equity adds up to: 20 × 3,000 = 6 60,000.00 MYR. It also is called the owners’ capital. The expression „issued capital” results from companies based on shares. When a company is established by a share issue, portions of the business get assigned to shareholders, who become owners of a share of the business <?page no="38"?> Berkau: Basics of Accounting 6e 2-38 and are entitled to receive a portion of the profit the business earns. In case of the cafeteria the total capital is amounting to 60,000.00 MYR. The funds of 60,000.00 MYR is an asset and is the cafeteria’s cash on hand. It is recognised as cash/ bank item on the balance sheet. The cafeteria’s money is cash and consists of Ringgit-bills and probably coins. We say the company has 60,000.00 MYR in cash/ bank. It does not make a difference whether the money is in the bank account or cash. The next step for Kartik Kensington and his fellows is to get more funds, to finance the assets necessary to run the cafeteria operations. They must spend money on refrigerators, dishwashers, furniture, plates and cutlery and they further must purchase the materials, like bread, butter, Nutella etc. As they realise, their funds contributed so far, are not enough. They decide to borrow money from their house bank, the Maybank 1 in Kuala Lumpur. Banks lend you money but will ask for securities, like property. For a business bank loan, you must present a business plan. Kartik Kensington and his fellows prepare a detailed business plan 2 and pay the local bank branch a visit. A business plan describes the business concept and contains a calculation of how the company earns money and how it is financed. In the case of the cafeteria, the bank approves the business concept and is prepared to lend it 40,000.00 MYR. On 10.01.20X0, the students receive the money which is transferred to the company's bank account at Maybank and assign to cash/ bank in their own recording (Bookkeeping records). The cash/ bank now is amounting to: 60,000 + 40,000 = 1 100,000.00 MYR. We can describe the cafeteria’s situation by the Accounting equation. The Accounting equation is the foundation of Accounting. It states that the total of assets equals the total of capital and liabilities. The simplified form of the Accounting equation is: ∑Assets = ∑Capital + ∑Liabilities Here: 100,000 = 60,000 + 40,000 = 100,000.00 MYR. The Accounting equation can be confirmed with the balance sheet. The total of assets is shown on the left-hand side and capital and liabilities are disclosed on the right-hand side. We name the left side “debit” and the right 1 Malayan Banking Berhad. one “credit”. The balance sheet contains assets on its debit side indicated by a capital A for assets. It contains items of capital and liabilities on the right-hand side, indicated by capital C and capital L - representing capital and liabilities. Note, that the balance sheet only discloses the total values, not single items. 2 See our Management Accounting, chapter (6). <?page no="39"?> Berkau: Basics of Accounting 6e 2.39 Observe the KENSINGTON CAFETERIA’s balance sheet below. The items not relevant for the case study are greyed out in Figure 2.9. A C, L Non-current assets [MYR] Equity [MYR] P, P, E Issued capital 60,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab 40,000.00 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 100,000.00 100,000.00 Kensington Cafeteria STATEMENT of FINANCIAL POSITION as at 10.01.20X0 Figure 2.9: KENSINGTON CAFETERIA’s statement of financial position (balance sheet) In Figure 2.9, the asset side contains cash only. The amount of 100,000.00 MYR is displayed as the cash/ bank item on the asset side (A). The equity is also named owners‘ capital and contains 60,000.00 MYR. The bank loan is disclosed as long-term liabilities, called interest bearing liabilities and is amounting to 40,000.00 MYR. The cafeteria owes the bank 40,000.00 MYR. In general, Accountants assume longterm debts require paying interest. For that reason, long-term liabilities are indicated as interest bearing liabilities. All capital and liabilities are disclosed on the capital and liability side (C, L) of the balance sheet. The Accounting equation is fulfilled if the totals on both sides of the balance sheet equal. From now, we use the balance sheet to check the Accounting equation. We compare the total on the asset side to the total on the capital/ liability side. In Figure 2.9 both sums are 100,000.00 MYR, which proves the Accounting equation is fulfilled. The next step for Kartik Kensington and his partners is to invest in company assets to become capable of running their cafeteria operations. On 25.01.20X0, they buy machinery, in detail: they spend 50,000.00 MYR on a refrigerator and a dishwasher (together). The value of the assets appears on the statement of financial position. This item is called property, plant and equipment (P, P, E). After spending the money on machinery, cash/ bank equals: 100,000 - 50,000 = <?page no="40"?> Berkau: Basics of Accounting 6e 2-40 550,000.00 MYR. KENSINGTON CAFETE- RIA's balance sheet looks now as below in Figure 2.10: A C, L Non-current assets [MYR] Equity [MYR] P, P, E 50,000.00 Issued capital 60,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab 40,000.00 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 50,000.00 Tax liabilities 100,000.00 100,000.00 Kensington Cafeteria STATEMENT of FINANCIAL POSITION as at 25.01.20X0 Figure 2.10: KENSINGTON CAFETERIA’s statement of financial position (2) As you can observe, the balance sheet does not tell what items of P, P, E KENSINGTON CAFETERIA has. You do not see that it is a refrigerator and a dish washer. We trust, there is a list of items and, as we later will see, Bookkeeping entries as proof of these items' value. We show the balance sheet after the business activity occurred. Here, the acquisition of the refrigerator and the dish washer took place on 25.01.20X0; therefore, the balance sheet is recorded on that day after completion of the business activity. As shown in Figure 2.10, cash is now only 50,000.00 MYR after spending money on machinery. There is also a 50,000.00 MYR amount representing the carrying value of the refrigerator and dish washer as value of the items of property, plant and equipment. The Accounting equation is still fulfilled, as the total of assets now is: 50,000 + 50,000 = 1 100,000.00 MYR and the total of capital and liabilities equals: 60,000 + 40,000 = 100,000.00 MYR. Next, we discuss the income statement. It tells us how much profit the cafeteria business earns. KENSINGTON CAFETERIA sells rolls/ sandwiches at 7.50 MYR/ u. (per piece) It sells 1,000 sandwiches on 2,000 school days/ a. Money received from the customers for goods/ services is called revenue and equals: 7.5 × 200 × 1,000 = 1 1,500,000.00 MYR. The material expenses are rolls at 2.00 MYR/ u, butter at 20.00 MYR/ u which lasts for 50 sandwiches (0.40 MYR/ sandwich) and Nutella at 0.60 MYR/ sandwich. Additionally, the cafeteria business pays labour. <?page no="41"?> Berkau: Basics of Accounting 6e 2-41 Labour contains the salary for 2 students buttering rolls and earning 400.00 MYR/ break. They only sell sandwiches during the breaks. There are 2 breaks per school day. Accordingly, labour equals: 2 × 2 × 400 = 1 1,600.00 MYR/ d for buttering the rolls. The students prepare 1,000 sandwiches every school day. For groceries errands, one student is paid 800.00 MYR/ school day. The cafeteria’s manager earns 12,000.00 MYR/ month. Rent for the cafeteria is 10,000.00 MYR/ month and paid into the university's account per bank transfer. Observe the calculation of expenses below: The amount for materials is: (2 + 0.40 + 0.60) × 1,000 × 200 = 6 600,000.00 MYR/ a. Labour adds up to: 1,600 × 200 + 800 × 200 + 12,000 × 12 = 6 624,000.00 MYR/ a. Other operational expenses are for rent. They equal: 10,000 × 12 = 1 120,000.00 MYR/ a. The last item is for interest which is 15.00 % based on the loan’s amount: 15% × 40,000 = 6 6,000.00 MYR/ a. We ignore income taxes and VAT for this chapter. [MYR] Revenue 1,500,000.00 Other income 1,500,000.00 Materials (600,000.00) Labour (624,000.00) Depreciation Other expenses (120,000.00) Earnings before int and taxes (EBIT) 156,000.00 Interest (6,000.00) Earnings before taxes (EBT) 150,000.00 Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) 150,000.00 Kensington Cafeteria STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X0 Figure 2.11: KENSINGTON CAFETERIA’s income statement As it can be seen on the income statement, that the cafeteria earns 150,000.00 MYR in profits in 20X0. After recording the profit, the balance sheet looks as displayed by Figure 2.12. The income statement is linked to the balance sheet as it increases cash/ bank and the profit is added to equity. The item on the balance sheet that represents the capital increases based on 150,000.00 MYR profit and is called retained earnings (R/ E). <?page no="42"?> Berkau: Basics of Accounting 6e 2-42 A C, L Non-current assets [MYR] Equity [MYR] P, P, E 50,000.00 Issued capital 60,000.00 Intangibles Reserves Financial assets R/ E 150,000.00 Current assets Liabilities Inventory Interest bear liab 40,000.00 A/ R A/ P Prepaid expenses Provisions Cash/ Bank 200,000.00 Tax liabilities 250,000.00 250,000.00 Kensington Cafeteria STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 2.12: KENSINGTON CAFETERIA’s statement of financial position (3) The earned profit is transferred straight to the capital section as we ignore income taxes. No tax liabilities are recorded. We assume that all business activities took place on cash. Therefore, cash increases by 150,000.00 EUR. We acknowledge that the Accounting equation is fulfilled. The total of assets equals the total of capital and liabilities. ∑Assets = ∑Capital + ∑Liabilities Now: 50,000 + 200,000 = 210,000 + 40,000 = 250,000.00 MYR. Next, we show that the cafeteria business pays its owners a share of the profit. Owners are entitled to receive a share of the profit proportionally to their ownership. The profit distribution is subject to national law and depends on the legal form of the business. Here, the company decides to pay half of the profit to the owners and the remainder stays in the business for reinvestments. An appropriation of profits requires financial statements preparation, auditing and owner's approval. Auditing means a qualified and certified expert checks the financial statements and calculations/ valuations therein for correctness. Based on the decision about the appropriation of profits in the cafeteria, an amount of: 150,000/ 2 = 7 75,000.00 MYR is dedicated to dividends-“to be paid”. From the company’s point of view the payment obligation of the dividend is a liability. It falls under short-term liabilities which we call payables. It is common practice for Accountants to use the abbreviation A/ P (accounts payables) for short-term liabilities on the balance sheet. The other half of the profit is added to equity. Therefore, it stays in <?page no="43"?> Berkau: Basics of Accounting 6e 2.43 the business. We add the amount to reserves. Reserves fall under owners’ equity. After the appropriation of the profits KENSINGTON CAFETERIA’s statement of financial position looks as below in Figure 2.13: A C, L Non-current assets [MYR] Equity [MYR] P, P, E 50,000.00 Issued capital 60,000.00 Intangibles Reserves 75,000.00 Financial assets R/ E 0.00 Current assets Liabilities Inventory Interest bear liab 40,000.00 A/ R A/ P 75,000.00 Prepaid expenses Provisions Cash/ Bank 200,000.00 Tax liabilities 250,000.00 250,000.00 Kensington Cafeteria STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 2.13: KENSINGTON CAFETERIA’s statement of financial position (4) Still, the Accounting equation is fulfilled. Check Figure 2.13. ∑Assets = ∑Capital + ∑Liabilities Now: 50,000 + 200,000 = 135,000 + 115,000 = 250,000.00 MYR At the end of the first year, KENSINGTON CAFETERIA pays an equal share of the profit to its twenty owners. Every single owner receives 1/ 20 of the distributed profit. All owners hold the same share of equity. The profit per owner equals: 75,000/ 20 = 3 3,750.00 MYR/ owner. In general, the payment of dividends takes place after the 31.12. of the Accounting period. The financial statements must be prepared, audited and approved at first. We here simplify the case and assume the dividends are paid already. Check the balance sheet after payments for dividends in Figure 2.14: <?page no="44"?> Berkau: Basics of Accounting 6e 2.44 A C, L Non-current assets [MYR] Equity [MYR] P, P, E 50,000.00 Issued capital 60,000.00 Intangibles Reserves 75,000.00 Financial assets R/ E 0.00 Current assets Liabilities Inventory Interest bear liab 40,000.00 A/ R A/ P 0.00 Prepaid expenses Provisions Cash/ Bank 125,000.00 Tax liabilities 175,000.00 175,000.00 Kensington Cafeteria STATEMENT of FINANCIAL POSITION as at 31.12.20X0 (after payments for dividends) Figure 2.14: KENSINGTON CAFETERIA’s statement of financial position (5) The Accounting equation is still fulfilled. Observe below the calculation: ∑Assets = ∑Capital + ∑Liabilities Now: 50,000 + 125,000 = 135,000 + 40,000 = 175,000.00 EUR. The total of equity is the book value of a business. It is derived from the Bookkeeping records; that is where the name comes from. The idea is, that in case all assets are sold at carrying values and all liabilities are retired at disclosed values, the remaining value is owned by the proprietors all together. This concept of business evaluation requires carrying all items at their fair values. There are other approaches to determine the value of a business. The book value calculation is one of them and widely common in Accounting. We next assume KENSINGTON CAFETERIA is liquidated after one year of operations. A liquidation means to discontinue all business operations and dispose/ sell all the assets of a company. The company will cease to exist thereafter. As cash is easily exchangeable, Accountants refer to it as more liquid than other assets. In a process of a liquidation, assets get transformed to their most liquid form: cash. In other words, we sell all assets. Furthermore, all debts are retired by paying the amount owing back to the bank or to other creditors. Then the remaining amount on both sides of the balance sheet is equity and can be distributed to the owners if positive. The fridge and the dish washer are sold for 50,000.00 MYR - the same as their carrying value. <?page no="45"?> Berkau: Basics of Accounting 6e 2-45 Cash after the disposal of the refrigerator and the dish washer is: 125,000 + 50,000 = 1 175,000.00 MYR. The cash is used to pay-off the bank loan. After repayment, there is still: 175,000 - 40,000 = 1135,000.00 MYR left. This amount equals the book value of: 60,000 + 75,000 = 1 135,000.00 MYR. We can say KENSINGTON CAFETERIA’s value is 135,000.00 MYR after its first year of business. Consider reserves as equity and increasing the owners’ fortune. For every owner, the share in equity is worth: 135,000/ 20 = 6 6.750.00 MYR. We consider that every owner of KENSINGTON CAFETERIA received a dividend of: 75,000 / 20 = 3 3,750.00 MYR already. Hence, every owner goes away after the cafeteria has been liquidated with: 6,750.00 + 3,750.00 = 1 10,500.00 MYR. The same amount can be derived from the statement of financial position and the income statement. The contribution of owners was 60,000.00 MYR and the profit earned equals 150,000.00 EUR. Accordingly, the owners’ share is: (60,000 + 150,000)/ 20 = 1 10,500.00 MYR/ owner. 2.15 Summary The balance sheet and the income statement indicate the financial situation and performance of the company. The balance sheet gives an overview over the assets' valuation and the financing of the business. The balance sheet represents the Accounting equation: ∑Assets = ∑Capital + ∑Liabilities. The income statement discloses how the company earns profit. The financial statements are reporting tools to inform the stakeholders about the situation of the company. As proved, financial statements can be prepared without making Bookkeeping entries - it is only a lot of extra work and prone to mistakes. 2.16 Working Definitions Accounting Equation: The total of the assets' value is the total of the value of capital and liabilities. Annuity: An annuity is a loan where the debtor pays a constant amount to the creditor which contains interest and pay-off. Asset: An asset is any resource of a company that meets the recognition criteria (existence of economic benefit and reliable measurement). Balance Sheet: A balance sheet (= statement of financial position) shows two lists; one thereof contains the assets and the other one capital and liabilities. Book Value: The book value is a valuation of a company derived from the balance sheet. Business Plan: A business plan describes the business concept and contains a calculation of how the company earns money and how it is financed. Capital: Capital is the amount of funds assigned to the owners of the company. Depreciation: Depreciation is the loss in value that occurs when assets are deployed. Expenses: Expenses is the value of consumed resources, such as materials, labour, depreciation etc. <?page no="46"?> Berkau: Basics of Accounting 6e 2-46 Income Statement: An income statement (= a statement of profit or loss and other comprehensive income) is a comparison of revenues and expenses. Liabilities: A liability represents funds coming from other parties than from the owners of the business. Memorandum of Incorporation: The memorandum of incorporation is a contract set up when a company is established. Register of non-current Assets: A register of non-current assets discloses the non-current assets with their cost of acquisition, their accumulated depreciation and accumulated impairment loss. The values result in the carrying value of disclosed assets. Revenue: Revenue is the total of receipts from customers for goods/ services sold. Statement of Cash Flows: A statement of cash flows shows the total cash flow of a company split into 3 categories: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. Statement of Changes in Equity: The statement of changes in equity shows how the book value of the company changed during the reported Accounting period. 2.17 Question Bank (1) What are items on the income statement? 1. Proceeds, material expenses, depreciation, interest. 2. Revenue, inventories, depreciation, interest. 3. Revenue, material expenses, depreciation, interest. 4. Profit, material expenses, depreciation, income tax liabilities. (2) What is the meaning of the Accounting equation? 1. The total of the balance sheet's asset side equals the total of its capital side. 2. The total of the balance sheet's asset side equals the total of its liability side. 3. The total of the balance sheet's asset side equals the total of its capital and liability side. 4. The total of the balance sheet's asset and liabilities side equals the total of its capital. (3) A company earns a revenue of 100,000.00 EUR which is paid half. The total of expenses is 60,000.00 EUR. How much is profit after taxation and cash flow? 1. 28,000.00 EUR and -10,000.00 EUR . 2. 40,000.00 EUR and -10,000.00 EUR . 3. 28,000.00 EUR and 40,000.00 EUR . 4. 12,000.00 EUR and -22,000.00 EUR . (4) What does the statement of changes in equity not show? 1. The issue price of shares divided in nominal value and premium. 2. The market value of shares. 3. The dividends. 4. The addition to earnings reserves. <?page no="47"?> Berkau: Basics of Accounting 6e 2-47 (5) What is part of a set of financial statements? 1. Balance sheet, income statement, statement of cash flows, statement of liabilities. 2. Balance sheet, income statement, statement of cash flows, statement of changes in equity. 3. Balance sheet, income statement, statement of cash flows, statement of the appropriation of profits. 4. Balance sheet, income statement, list of shareholders, statement of cash flows, statement of changes in equity. 2.18 Solutions 1-3; 2-3; 3-1; 4-2; 5-2. <?page no="48"?> Berkau: Basics of Accounting 6e 3-48 3 Shareholders’ View 3.1 What is in the Chapter? In this chapter we take the point of view of investors. We show how to read financial statements and what information can be derived therefrom to make reasonable economic decisions. We discuss the calculations a shareholder of McDonald's Corp. would make based on financial statements. 3.2 Learning Objective: After studying this chapter, you learned about another perspective of financial statements. You understand reading of financial statements as an investor in a company, not as the reporting party. You furthermore get to know the time value of money concept which enables you to think long-term and consider interest. You will understand what information the shareholders need for making their decisions: keeping or selling shares. This already includes a sort of business evaluation, which is discussed in detail in chapter (5) of the textbook Bilanzen/ Financial Statements. 3.3 McDonald's Corp. McDonald’s Corp. is a company based on shares. We could say the concept of McDonald’s Corp. is comparable to KENSINGTON CAFETERIA discussed in the previous chapter. However, McDonald’s Corp. is much bigger. But once you understand KENSINGTON CAFETERIA, you will be able understand McDonald’s Corp. too. McDonald’s Corp. also is a franchisee. Many restaurants you see are not owned by McDonald’s Corp. but are companies paying a franchise license for selling food under the name of McDonald’s Corp. They operate restaurants and take away facilities which appear in accordance with the corporate identity policy of Mc Donald’s Corp. The McDonald’s Corp. story starts with its founders who found a restaurant producing burgers very quickly (fast food) and selling them successfully at a low price of 0.15 USD. They bought the restaurant in Illinois and sold the burgers under the name McDonald’s Corp. and in a restaurant with the golden arcs. These yellow arcs looking like a huge “M” became the brand symbol for McDonald’s Corp.’s restaurants later. Today, McDonald’s Corporation is a Chicago based company earning a revenue of $21.1 billion in 2019. McDonald’s corporation runs almost 39,700 restaurants worldwide. McDonald’s Corporation is based on 1,660.60 million common shares. At the time of printing this textbook, the McDonald’s Corp. (MCD) share was traded at 234.68 USD/ share on 8.07.2021. Next, we look at McDonald’s Corp. from the investor’s point of view. An investor, here also a shareholder, is someone who owns a portion of a company and expects to receive a portion of its profit as a dividend. A dividend is a payment to the shareholders to share the company's success. The German student Joana bought 1 share of McDonald’s Corporation on 8.04.2008 from a German Bank at a <?page no="49"?> Berkau: Basics of Accounting 6e 3-49 share price of 35.65 EUR/ share - as traded at the New York Stock Exchange (NYSE). The face value of the MCD share is 0.01 USD. (The case is based on true events but has been adjusted for classroom teaching.) The face value is the nominal value of a share and is reported in the capital section on the balance sheet. In contrast, the value traded at a stock exchange is the market value of a share. The latter one represents at what price shareholders buy and sell shares among each other. McDonald’s Corp. does not know how much our investor Joana paid for her share. Neither do the financial statements reveal that information. However, McDonald’s Corp. knows that Joana is a shareholder. McDonald’s Corp. must register its shareholders for two reasons: (1) to invite them to the annual general meetings (AGM) for them to exercise their voting rights and (2) to pay them a dividend. Regarding the dividends, McDonald’s Corporation pays a quarterly dividend to its shareholders that we simplify to be 0.25 EUR/ share on average. Joana sold her share in May 2013 at a share price of 78.10 EUR. We analyse whether the purchase and sale of the share was a good bargain to her. The answer depends on the time value of money concept and the discounting rate applicable. For long-term decisions, we acknowledge that today’s money is worth more than money received in the future. The time value of money is a concept of discounting future payments. The discounting rate for the calculation of the time value of money works as a rate of interest. Why is that so? Money you own today can be invested and then earns an interest. Therefore, 100.00 EUR you hold today is better than 100.00 EUR you will receive in 5 years. The reason is that during a period of 5 years you can pay 100.00 EUR into your bank account and earn interest. As an alternative, you could invest the funds into a business and enjoy the return on your investment, such as Joana does as shareholder of McDonald’s Corp. The return is a share of the company's profit allocated to the shareholder. The company investment alternative includes a risk that a company falls behind expected profits or in worse case even files for bankruptcy. With a bankruptcy, investors most likely will lose their entire investment. In general, we simultaneously check two aspects for our investments: the return and the risk. The returns on the investments in shares must exceed the interest you can earn by saving the money in your bank account as the bank account is saver. As the valuation of the early 100.00 EUR is higher than later ones, we discount money to be received in the future. We here assume, the rate applied for discounting does not change over all five Accounting periods (2008 - 2013). We further assume the rate of interest called i - equals 10 %/ a. We apply compound interest calculation. As at today, the option to receive 100.00 EUR in 5 years’ time is worth: 100 / (1 + 10%) 5 = 62.09 EUR. For checking this evaluation, we assume we invest 62.09 EUR on the capital <?page no="50"?> Berkau: Basics of Accounting 6e 3-50 market at 10 %/ a. The funds are compounded annually: The money we have at the end of the 1 st period is 62.09 EUR plus the return of 62.09 × 10% = 6.21 EUR. The total as at the end of the first Accounting period equals: 62.09 + 6.21 = 68.30 EUR. We repeat the investment by leaving the full amount of 68.30 EUR in the bank account. This makes increase the funds to: 68.30 × (1 + 10%) = 75.13 EUR. In the next year, the funds have increased to: 75.13 × (1 + 10%) = 82.64 EUR. In the next year we have already 90.90 EUR and in the last year we reach 99.99 EUR. As we calculate accurate to the conventions, a little rounding difference applies. Next, we analyse our investment of 62.09 EUR by using MS-Excel. See the design of our Excel sheet for a financial schedule prepared in Figure 3.1. A financial schedule is an annual (represented by columns) plan of investing and financing activities (represented by lines). As the funds are transferred from one to the next period, we determine the final value of the investor’s funds. Here, the final value equals 100.00 EUR in 20X5. (MS-Excel shows figures accurate to 2 digits after the decimal point but calculates exactly. Therefore, no rounding difference applies.). All investments in Figure 3.1 are bank savings accounts which earn an annual interest of 10%/ a which is compounded annually. The additional investments are made for exactly 1 year. Figure 3.1: Calculation of an investment of 62.09 EUR In Figure 3.1, the discount rate is 10 %/ a, which is the usual classroom rate in Accounting. In real businesses, the applied discount rate is based on the average cost of capital WACC. The WACC rate is the average rate of equity cost and costs for debts and is weighted based on the portions of equity and debts. <?page no="51"?> Berkau: Basics of Accounting 6e 3-51 We apply a financial plan like the one in Figure 3.1 to evaluate Joana's McDonald’s Corp. share investment. See below the input data calculations for the financial schedule in Figure 3.2: All payments are linked to years, we ignore the dates when activities take place. Therefore, we must calculate Joana's funds by taking under considerations all payments of the year. E.g., the money needed to buy the share is: 35.65 - 0.25 - 0.25 - 0.25 = 3 34.90 EUR, because she will receive 3 quarterly dividends in the first Accounting period (2008). Joana borrows 20.00 EUR from a bank at an annual rate of interest of 4.50 %/ a. Again, we only calculate accurate to the year but determine interest proportionally to the year. In the first year, she pays interest for the bank loan to the extent of: 20 × 4.5% × (9/ 12) = 0 0.68 EUR. Remember Joana bought the share in April, which requires to lend the money for 9 months in 2008 only. Therefore, her required equity funds (her own money she invests) are: 34.90 + 0.68 - 20 = 1 15.58 EUR. This reflects her equity. Next, we calculate the rate of interest to apply. The weighted average cost of capital WACC is the average of own funds' costs and borrowed money (interest paid). You might ask: Why apply costs for the own funds? Those costs are opportunity costs, meaning, by investing her funds she forfeits the chance to earn a capital gain otherwise. We say, the opportunity cost is the potential benefit from an alternative investment given up. Here, the funds are 15.58 EUR and the interest earned by an alternative investment are the opportunity costs. Joana has 15.58 EUR and borrows 20.00 EUR from the bank at a rate of interest of 4.5 %/ a. The return she could earn with an alternative investment is 3.00 %/ a, such as the return from a Burger King Worldwide Inc. (BKW) share, for example (data adjusted to our calculation). The average cost of her capital is not: (3 + 4.5) / 2 = 3 3.75 %, because Joana’s capital structure is not half-half. Joana’s weighted average cost of capital is amounting to: (15.58 × 3% + 20 × 4.5%) / 35.58 = 3 3.84%. Next, we evaluate whether the investment in McDonald’s Corporation was a good deal under consideration of the time value of money concept. As assumed the return on the MCD share is 0.25 EUR/ quarter as dividends. In 20X8 she receives 3 quarterly dividend payments because she is a registered shareholder on 30.06., on 30.09. and on 31.12. From 2009 until 2012 she is entitled to receive 4 quarterly dividends and she gets one quarterly dividend at the end of March 2013. In the last Accounting period, she sells the share at 78.10 EUR which is the market price at that time. Hence, in 2013, Joana’s share yields: 78.10 + 0.25 = 7 78.35 EUR. It is common in Accounting to disclose timely payments as a vector which represents all payments allocated to their periods. We prepare a vector called McD(t) for the McDonald’s Corporation share payments in EUR which looks as below: McD(t) = {-34.90; 1.00; 1.00; 1.00; 1.00; 78.35} <?page no="52"?> Berkau: Basics of Accounting 6e 3-52 The first element of the vector (here: negative 34.90 EUR) is the payment for the share buy less 3 quarterly dividends received in 2008, the second figure is the dividend for 2009, the third figure the dividend for 2010, the fourth figure the dividend for 2011, the fifth figure the dividend for 2012 and the last figure is the sum of one quarterly dividend and the selling price received. Joana only pays-off the bank loan at the end of the investment and pays every year the remaining money into her savings account with the Sparkasse in Hanover. So, she earns an annual interest of 1.20 %/ a. The interest earned is calculated in the cells indicated as “Investment at Sparkasse”. It reads =-1.012 × “CellToTheLeft”. Hence, the interest earned on 2011’s cash in bank is: 0.30 × 1.012 = 0 0.31 EUR. The Interest for the borrowed funds (bank loan) is: 20 × 4.5% = 0 0.90 EUR/ a. The bank loan is not paid-off before the MCD share is sold. In 2008, the amount is calculated per rate: 9 × 0.90 / 12 = 0.68 EUR, as she took the bank loan on 08.04.2008. In 2013, interest equals: 5 × 0.90 / 12 = 0 0.38 EUR. In all the other Accounting periods, the bank loan’s interest equals 0.90 EUR/ a. Observe the financial schedule for Joana’s MCD share investment below in Figure 3.2. t=2008 t=2009 t=2010 t=2011 t=2012 t=2013 Equity 15.58 Investment at McD's Corp (34.90) 1.00 1.00 1.00 1.00 78.35 Bank loan 20.00 (20.00) Interest on bank loan (0.68) (0.90) (0.90) (0.90) (0.90) (0.38) Investment at Sparkasse (0.10) 0.10 Investment at Sparkasse (0.20) 0.20 Investment at Sparkasse (0.30) 0.31 Investment at Sparkasse (0.41) 0.41 0.00 0.00 0.00 0.00 0.00 58.38 Figure 3.2: Financial schedule for Joana’s McDonald’s Corporation share As it can be seen by the table the dividend earned is sufficient for paying interest on the bank loan. However, the deal becomes profitable, as the share of McDonald’s increased in valuation during the investment period. We call this a capital appreciation. The final value of Joana’s fortune equals 58.38 EUR as at 31.12.2013. Her input was 15.58 EUR on 8.04.2008. The present value of the capital gains is: (58.38 / (1 + 3.84%) 5 ) - 15.58 = 3 32.77 EUR. As you can see, the discount rate applicable is the WACC rate. We say, buying the share of McDonald’s Corporation is worth 32.77 EUR. Any investment with positive present value is profitable and a better option compared to not doing anything. In this textbook we regularly ignore transaction costs. This is a simplification to keep case studies as simple as possible. In real life you must consider that a <?page no="53"?> Berkau: Basics of Accounting 6e 3-53 share buy requires running a depot account at additional administration costs. The example of McDonald’s Corporation shows two ways of how to earn money with shares. Both approaches go together, they are (hopefully) overlapping. (1) The first source of income is based on partial ownership of the company which entitles the shareholder to receive a portion of the annual profit. The payment received is a share's dividend. The dividend is based on the distributable amount and will be decided on the annual general meeting by the shareholders. The available amount for distribution is the profit for the period plus profits carried forward less loss carried from prior Accounting periods. Companies also can distribute funds from dissolving reserves but this does not count as distributable amount then. (2) The other way to earn money with shares is to buy a share and benefit from the increase of its price (capital appreciation). Share prices increases when they are under high demand from potential investors. A company that earns high profits and pays constantly good dividends is more attractive than a company suffering from losses in a weak economy. We acknowledge that the market share price is different to the book value. 3.4 Summary Buying shares of companies allows its investors to participate on the profits of the company by earning a dividend, and to benefit financially from share price increases. In business management, payments in different Accounting periods are compared based on the time value of money concept. This approach is based on compound interest calculations and can best determined by spreadsheet programming. The discount rate applicable reflects the weighted average cost of capital WACC. Investors make decisions based on financial statements provided by the companies. Based on the analysis of financial statements the investors try to foresee a company’s economical value development and to judge the benefit from dividends and their capital appreciation. 3.5 Working Definition Available Amount for Distribution: The available amount for distribution is the profit for the period plus profits carried forward less loss carried from prior Accounting periods. Dividend: A dividend is a payment to the shareholders to share the company's success. Face Value: The face value is the nominal value of a share and will be reported on in the capital section of the balance sheet as issued capital. Investor: An investor, here also a shareholder, is someone who owns a portion of a company and expects to receive a portion of its profit as a dividend. Market Value: The value as traded at a stock exchange is the market value of a share. Time Value of Money: The time value of money is a concept of discounting future payments. <?page no="54"?> Berkau: Basics of Accounting 6e 3-54 Weighted Average Cost of Capital: The WACC rate is the average rate of equity cost and costs for debts and is weighted based on the portions of equity and debts. 3.6 Question Bank (1) A shareholder has 5 ordinary shares of a fast food restaurant. The shares were acquired at 40.00 EUR/ s and have a nominal value of 1.00 EUR/ s. Their fair market value is 45.00 EUR/ s. The company makes a profit of 300,000.00 EUR and carries forward a profit of 75,000.00 EUR. It declares a dividend of 50 % of the distributable amount. There are 100.000 shares outstanding. How much is the fortune of the shareholder? 1. 266.88 EUR . 2. 209.38 EUR . 3. 234.38 EUR . 4. 198.75 EUR . (2) A share gives its investor an annual dividend of 12.00 EUR/ a. The investor bought the share at 100.00 EUR. How much is the present value of the share buy if held for 5 years? The first dividend is paid in the year of acquisition. The market interest rate is 10 %. 1. 136.40 EUR . 2. 150.04 EUR . 3. 160.00 EUR . 4. 50.04 EUR . (3) What is a financial plan? 1. A plan that shows all payments and receipts for the periods and considers the interest earned during the Accounting periods. 2. A schedule that shows all payments to be made in future Accounting periods. 3. A plan that shows all payments for the periods and considers the interest earned between the Accounting periods. 4. A plan that shows all payments and receipts for the periods and considers the interest earned between the Accounting periods. (4) What is the time value of money concept? 1. A method that determines the present value of payments and receipts by deducting the interest paid. 2. A method that determines the present value of payments and receipts by discounting the values to the first period. 3. A method that determines the present value of payments and receipts by deducting interest received. 4. A valuation of the time. (5) When you buy a share what is the price you pay? 1. Book value. 2. Fair market value. 3. Nominal value. 4. Issue price. 3.7 Solutions 1-3; 2-2; 3-4; 4-2; 5-2. <?page no="55"?> Berkau: Basics of Accounting 6e 4-55 4 Legal Aspects of Accounting 4.1 What is in the Chapter? Accounting is no freestyle science. It follows rules set by national laws and by international Accounting standards. In this chapter we explain the major legal aspects we apply in Accounting and show where to find them. 4.2 Learning Objectives The chapter helps you to achieve knowledge about regulations in International Financial Reporting Standards IFRSs and German GAAPs (Handelsgesetzbuch). Furthermore, we refer to the Company’s Act, such as the German Aktiengesetz AktG. After studying this chapter, you will have a good understanding about the laws and standards in Accounting and you know how to access Accounting rules. You will develop a good feeling for Accounting principles; you will be able to distinguish the concept of German and international Accounting. 4.3 Who prepares Financial Statements? The incorporation of a limited company will have two Accounting implications: the need to prepare financial statements for taxation and commercial ones. If an owner of a company runs it as a sole proprietor, her/ his business is no one else’s business. The owner is reliable to her-/ himself and does not prepare commercial financial statements. However, the owner must set up personal tax statements which discloses her/ his business profit. A privately-owned business does not fall under legal entities. Increases of the business value count as increases of the owner’s fortune and are counted as taxable profit. Very often, the owner of a privately-owned business calculates profit by a comparison of income and expenses. The German tax law allows a simplified tax calculation based on §4 III EStG, which is based on a comparison of income and expenditures. See the case study about the law professor Andre Dorp below: Prof. Dr. Andre Dorp is law professor at a state university for tax law. In addition to his academic profession, he runs a consultancy as a tax attorney which he calls DORP's-Tax-Service. The company is privately-owned; hence, no legal form applies. He buys a computer and a software system for preparing tax statements at 9,000.00 EUR. The computer system can be depreciated following the 4-3 profit calculation. His income from the consultancy is amounting to 45,000.00 EUR. He got some operational expenses, like office materials and communication costs which add up to 5,000.00 EUR. His profit calculation considers the income less all expenditures and depreciation on the computer system, the latter being 3,000.00 EUR. Prof. Dorp calculates a profit of: 45,000 - 5,000 - 3,000 = 3 37,000.00 EUR for DORP's-TAX-SERVICE. On his tax statements, Prof. Dorp adds a profit of 37,000.00 EUR from self-employment <?page no="56"?> Berkau: Basics of Accounting 6e 4-56 and submits a form for the profit calculation. We assume Prof. Dorp's personal tax rate is 27.5 %. Hence, the after-tax profit of his privately-owned consultancy is amounting to: (1 - 27.5%) × 37,000 = 2 26,825.00 EUR. No commercial financial statements for his business are required. Neither does he prepare financial statements for tax purposes; he just calculates profit in accordance with the 4-3 method following German tax law. The situation changes once the business falls under trading. A dealership must prepare financial statements based on § 242 I HGB (balance sheet) and based on § 242 II HGB (income statement). The financial statements are based on Bookkeeping records which are required following § 238 I HGB. (Small sole traders as described by § 241a HGB are exempted if they are not operated as a limited company, see below.) The requirement for traders to prepare commercial financial statements (balance sheet and income statement) does not depend on their legal form. In the case of DORP's-TAX-SERVICE, no trading was initially intended. However, after a while, Prof. Dorp changes his mind and begins trading with software for tax calculations. His business is still privately-owned but now falls under dealerships; this requires preparing commercial financial statements (balance sheet and income statement). For his own tax calculation, Prof. Dorp continues preparing profit calculations following the 4-3 method. He does not submit a balance sheet nor an income statement to the German revenue service (Finanzamt) following §18 EStG. A limited company, like an AG, a GmbH or a Ltd., is not in private ownership. No owner will be held reliable for the company. The owners benefit from the profits but do not secure the business with their private assets. The shareholder Joana in the previous chapter, who bought MCD shares, does not cover losses of the company. She only holds a share and receives dividends. Therefore, she is not reliable for actions of the company. All limited companies must prepare commercial reports, called financial statements. In Germany, limited companies are required to prepare financial statements (balance sheet and income statement) in accordance with § 264 I HGB. Additionally, information about the company, its management, the owners etc, must be provided as a report. Limited companies that participate on the capital market - meaning their shares or bonds are traded at a stock exchange or the bond market are public companies. They must prepare a cash flow statement, too. Public companies are AGs or a Ltd. if traded. In contrast, an AG that does not participate on the capital market or a GmbH or a (Pty) Ltd. are limited companies but they do not fall under public companies. We refer to a public company if its shares are available to the public. In contrast, a GmbH and a (Pty) Ltd. company are owned by their proprietors without shares being available to the public. In general, preparing financial statements gives helpful information about a company’s situation and about the way of how the company earns profit. In general, limited companies belong to many owners. The owners are not involved in the daily business. E.g., a <?page no="57"?> Berkau: Basics of Accounting 6e 4-57 shareholder of an AG owns a portion of the company but is not managing its business activities. Ownership and management are separated. Naturally, the owners want to understand how their company is performing and are keen to predict returns on their investments. However, shareholders cannot just drop by at the company’s headquarters to check the business operations or even interfere therewith. Therefore, Joana cannot fly to Illinois and knock at the gate of McDonald’s Corporation to impose a menu change on German McDonald’s restaurants. She only can read the company's financial statements, attend the annual general meeting to exercise her voting rights and can decide to sell or to keep her share. The major source of information for the owners as well as for anyone else interested in the company are the commercial financial statements. The international regulations about preparing financial statements are the International Accounting Standards IAS and International Financial Reporting standards IFRS. Both together are referred to as IFRSs. In compliance with IFRSs, a set of financial statements contains a statement of financial position (the balance sheet), a statement of profit and loss and other comprehensive income (income statement), a statement of cash flows and a statement of changes in equity. Furthermore, notes are required. The information on financial statements is derived from Bookkeeping records. Bookkeeping is required to proof the figures disclosed on financial statements. All transactions in a business that effect its financial position and/ or its profit/ loss must be recorded. In this textbook we teach how to keep Bookkeeping records and how to derive financial statements therefrom. 4.4 How to Establish a German Limited Company You most likely can transfer the knowledge of this paragraph to other countries. Some countries have an easier process in place; in South Africa you can even establish a company online through the CIPC (Companies and Intellectual Property Commission). You are required studying national law of the company’s domicile or consult a law professional for the conveyance of the business. The German law offers two different limited companies, a Gesellschaft mit beschränkter Haftung GmbH (it includes an Unternehmergesellschaft (haftungsbeschränkt) UG) and an AG. The first one(s) follow(s) the GmbHG; for the latter one the German Company's Act (AktG) applies. When you intend to establish a company, you first think about its appropriate legal form. A privately-owned business does not require preparing financial statements if you do not trade. All information about the business stays with you - and between you and the German revenue service (Deutsche Finanzbehörde). The risk of privately-owned businesses is that owners are held responsible with all their private assets for their company's losses. Regarding taxation you must consult your tax attorney: Profits of a privately-owned business is taxable based on the personal income tax rate <?page no="58"?> Berkau: Basics of Accounting 6e 4-58 of the owner which can become quite high due to tax progression. In contrast, a limited company is subjected to taxation itself and pays company taxes. Owners pay a tax on capital returns for the dividends received. All limited companies prepare financial statements twice: one for taxation and another one for commercial financial statements. The commercial financial statements in Germany are ruled by the Handelsgesetzbuch HGB. Mr Joseph Haris establishes a company in Germany in the legal form of an Unternehmergesellschaft (haftungsbeschränkt), UG. The company is a Marketing Consultancy. For the UG German GmbHG applies. This requires from Joseph to contribute the owner’s capital which is at least 1.00 EUR (not recommended). Joseph contributes 10,000.00 EUR paid into a bank account at Sparkasse Osnabrück. The bank sells him a special account which can later be converted into a business account. Later, Joseph pays his attorney, Dr. FRESENBURG, a visit. The attorney prepares a contract between Joseph and his UG, called JOSEPH HARIS MARKETING CONSULTANCY UG (haftungsbeschränkt). The contract is called the memorandum of incorporation and states the ownership of the company, its location, purpose, the date of commencement of activities (1.01.20X1) etc. At this stage, Joseph must submit his first balance sheet which is referred to as the opening balance sheet. Note, even as Joseph is a man of Marketing, his very first business activity is in Accounting! Look at Figure 4.1 or Figure 4.2. The balance sheet is prepared in compliance with German HGB and must be submitted in German and in the reporting currency EUR based on § 244 HGB. However, we provide a translation in Figure 4.2. for teaching purposes. <?page no="59"?> Berkau: Basics of Accounting 6e 4-59 Aktivseite [EUR] Passivseite [EUR] A. Anlagevermögen A. Eigenkapital I. Immaterielle I. Gezeichnetes Kapital 10,000.00 Vermögensgegenstände II. Kapitalrücklage II. Sachanlagen III. Gewinnrücklage III. Finanzanlagen IV. Gewinnvortrag/ Verlustvortrag V. Jahresüberschuß/ -fehlbetrag B. Umlaufvermögen I. Vorräte B. Rückstellungen II. Forderungen und sonstige I. Rückst. für Pensionen Vermögensgegenstände II. Steuerrückstellungen III. Wertpapiere III. sonst. Rückstellungen IV. Kassenbestand, Bundesbankguthaben, C. Verbindlichkeiten Guthaben bei Kreditinstituten 10,000.00 und Schecks D. Rechnungsabgrenzungsposten C. Rechnungsabgrenzungsposten E. Passive latente Steuern D. Aktive latente Steuern E. Aktiver Unterschiedsbetrag aus der Vermögensverrechnung 10,000.00 10,000.00 Joseph Haris Marketing Consultancy UG (haftungsbeschränkt) BILANZ zum 1.01.20X1 Figure 4.1: HMC UG’s opening balance sheet along German HGB A C, L A. non-current assets [EUR] A. Equity [EUR] I. Intangibles I. issued capital 10,000.00 II. tangible assets II. capital reserves III. financial assets III. earnings reserves IV. profit carried forward B. Current assets V. annual surplus I. Inventories II. receivables B. Provisions III. securities C. Liabilities IV. cash/ bank 10,000.00 D. Accrual (RAP) E. Deferred taxes C. Accrual (RAP) D. Deferred taxes E. Difference 4 neg. equity Total assets 10,000.00 Total equity and liab. 10,000.00 Joseph Haris Marketing Consultancy UG (haftungsbeschränkt) BILANZ zum 1.01.20X1 Figure 4.2: HMC UG’s balance sheet in English <?page no="60"?> Berkau: Basics of Accounting 6e 4-60 Next, the attorney Dr. FRESENBURG submits the memorandum of incorporation at the local district court. Joseph receives a confirmation that his company has been added to the commercial registry in Osnabrück under the HRB 48496 number. The chief executive officer (CEO) of the company is Joseph Haris. He furthermore receives a registration confirmation from the revenue service in Osnabrück, which assigns a taxpayer's ID to the company. The German revenue service gives notice about the VAT registration, too. Joseph now must fulfil two obligations: (1) Adhering tax requirements and (2) Obligation to prepare commercial financial statements following German HGB. Ad (1): Financial Statements for Taxation For fulfilling tax requirements, Joseph (as CEO he is the representative of the company) must prepare financial statements for taxation. However, other businesses, like a doctor’s clinic, law firms, artists, engineers, consultants etc., which fall under freelancers (§ 18 EStG) do not prepare financial statements but provide a simplified profit calculation. Tax statements are financial statements, such as balance sheet and income statement prepared for tax calculations. In Germany, companies which prepare financial statements submit those as an electronic balance sheet (E- Bilanz). Joseph must prepare the balance sheet with a Bookkeeping software and/ or with the support of a tax attorney. Ad (2) Commercial Financial Statements German HGB requires JOSEPH HARIS MARKETING CONSULTANCY UG (haftungsbeschränkt) keeping Bookkeeping records to prepare financial statements. The company must publish its financial statements. For a fee of approximately 25.00 EUR, Joseph submits the company's first financial statement at the court and publishes it online. He must do so every Accounting period. This textbook is about the commercial financial statements only! We do not intend to deepen your knowledge in tax law. 4.5 Necessity to Prepare Financial Statements The German HGB requires financial statements. It applies together with the companies’ act, in Germany that is either the GmbHG or AktG. The German HGB applies for any trading firm and for limited companies. § 240 HGB requires that every salesperson must prepare a proper register of land, receivables and payables, money and all further assets and provide exact information about their values as at the beginning of the business. She/ he further must prepare such a register after every Accounting period. § 241a Handelsgesetzbuch allows dealers who run their business under the legal form of a sole dealership and who run a small company (determined by revenue and profit ratios), to not keep Bookkeeping records and to not prepare financial statements. This exemp- <?page no="61"?> Berkau: Basics of Accounting 6e 4-61 tion from keeping Bookkeeping records and preparing financial statements does not apply for a limited company. Special regulations apply for limited companies, further. These regulations are about the form of financial statements, e.g., §§ 266 and 275 HGB apply, which prescribe the structure and naming of items. The German Handelsgesetzbuch is strict about formal aspects. You might ask yourself whether supervision for financial statements exists. Yes, there is. § 315 HGB requires financial statements must be audited (only medium-sized and big and public companies). Auditing is the checking by a qualified and authorised Accounting expert regarding Bookkeeping records and financial statements. Auditors cannot check the financial statements completely. The auditor's opinion is based on drawn samples from the Bookkeeping records and the checking of the financial statements and the procedures of their preparation. Auditors express their judgement in form of a report and a statement. They are not supposed to evaluate businesses. Without auditing, financial statements cannot be approved on the annual general meeting. The approval is precondition for the appropriation of profits, like a declaration of dividends. As a consequence, preparing faulty financial statements less results in a regulatory offense, but in withholding dividends from the shareholders. All companies in Germany provide their financial statements following the Handelsgesetzbuch unless they are exempted by § 241a HGB. In contrast, Group statements follow IFRSs if at least one group company participates on the capital market. The IFRSs do not rule which company must prepare financial statements. National law applies. In case of group statements in Europe, the EU dictates the need for Group Accounting following IFRSs. 4.6 Scope of IFRSs IFRSs apply in Europe for group statements and thus for those single-entity financial statements that are set up in preparation of the group statements. Note, for single-entity financial statements the German law does not require following IFRSs. German Handelsgesetzbuch HGB applies. Nowadays, many international businesses voluntarily prepare additional financial statements in accordance with IFRSs to facilitate the cooperation with international business partners. See below an example: The production firm BLENHEIM GmbH owns an associated company in Poland. The company does not require Group Accounting as BLENHEIM GmbH's interest is only 32 %. Therefore, BLENHEIM GmbH prepares financial statements following German HGB. The sales company in Poland which distributes BLENHEIM GmbH's products in Poland prepares financial statements following Polish law (Accounting Act). The Polish company applies for a bank loan at a local bank. To secure the loan, the bank requires BLENHEIM GmbH to voucher. As the Polish bank is not familiarised with <?page no="62"?> Berkau: Basics of Accounting 6e 4-62 German HGB, BLENHEIM GmbH prepares financial statements following IFRSs to present at the bank. 4.7 What are the Standards? IFRSs are Accounting rules on an international basis. The regulations are partly similar and partly different to the German HGB. The standards are set by the International Accounting Standards Board IASB based in London. We refer to the IASB as the standard setter. For more information about the IASB visit their website: www.ifrs.org. The IASB issues standards to various Accounting aspects - like cash flows, revenue recognition, financial instruments etc. The standards are structured by paragraphs. You can download the standards from the internet, see the textbook Bilanzen/ Financial Statements chapter (3) for the download directives. All standards have numbers and are either called IAS or IFRS. The following standards are relevant: IAS 1 - Presentation of Financial Statements IAS 2 - Inventories IAS 7 - Statements of Cash Flow IAS 8 - Accounting Policies, Changes in Accounting Estimates and Errors IAS 10 - Events after the Reporting Period IAS 12 - Income Taxes IAS 16 - Property, Plant and Equipment IAS 19 - Employee Benefits IAS 20 - Accounting for Government Grants and Disclosure of Government Assistance IAS 21 - The Effects of Changes in Foreign Exchange Rates IAS 23 - Borrowing Costs IAS 24 - Related Party Disclosures IAS 26 - Accounting and Reporting by Retirement Benefit Plans IAS 27 - Separate Financial Statements IAS 28 - Investments in Associates and Joint Ventures IAS 29 - Financial Reporting in Hyperinflationary Economies IAS 32 - Financial Instruments: Presentation IAS 33 - Earnings per Share IAS 34 - Interim Financial Reporting IAS 36 - Impairment of Assets IAS 37 - Provisions, Contingent Liabilities and Contingent Assets IAS 38 - Intangible Assets IAS 39 - Financial Instruments: Recognition and Measurement IAS 40 - Investment Property IAS 41 - Agriculture Standards issued after 2002 are called International Financial Reporting Standards IFRS: <?page no="63"?> Berkau: Basics of Accounting 6e 4-63 IFRS 1 - First-Time Adoption of International Financial Reporting Standards IFRS 2 - Share-Based Payment IFRS 3 - Business Combinations IFRS 4 - Insurance Contracts IFRS 5 - Non-Current Assets Held for Sale and Discontinued Operations IFRS 6 - Exploration for and Evaluation of Mineral Resources IFRS 7 - Financial Instruments: Disclosures IFRS 8 - Operating Segments IFRS 9 - Financial Instruments IFRS 10 - Consolidated Financial Statements IFRS 11 - Joint Arrangements IFRS 12 - Disclosure of Interests in Other Entities IFRS 13 - Fair Value Measurement IFRS 14 - Regulatory Deferral Accounts IFRS 15 - Revenue from Contracts with Customers IFRS 16 - Leases IFRS 17 - Insurance Contracts In addition to the standards, there is a framework which describes the principles of international Accounting. Some countries nowadays apply the international Accounting standards IFRSs completely other ones only comply partly. South Africa, e.g., does not follow national regulations for Accounting anymore and applies the international Accounting standards completely. In contrast, Germany decided not to follow the IFRSs for single-entity financial statements. However, Germans adjusted the HGB, the GmbHG and the AktG, etc., known as BilMoG (BilanzModernisierungsGesetz). Companies preparing group statements and based in Europe must apply IFRSs when participating on the capital market. A group consists of at least 2 companies which have a parent-subsidiary-relationship. Groups prepare financial statements like a single company. Group statements contain a set of financial statements for the whole group that is prepared under the assumption of the group being a single company. Group statements do not exempt their group members from preparing single-entity financial statements. E.g., a group with a parent in Germany and a Dutch subsidiary, with the German parent listed at Frankfurt stock exchange, must prepare singleentity financial statements along Handelsgesetzbuch and the Dutch Woertbook van Koophandel for the two companies and group statements following IFRSs. Group Accounting is covered by chapter (8) of our textbook Bilanzen/ Financial Statements. 4.8 Difference between HGB and IFRSs Most important, in contrast to the German HGB, international Accounting standards follow the true and fair <?page no="64"?> Berkau: Basics of Accounting 6e 4-64 view principle. The reporting purpose is to carry assets and liabilities at the valuation they actually have. The German HGB aims to protect the creditors of the business. They need protection, because they cannot go after the owners' assets to cover the losses of a limited company. Therefore, financial statements following German HGB discloses the business’ situation worse than it is - thus, reducing the creditors' risk. 4.9 Summary Financial statements are prepared following national law. German companies prepare their financial statements in accordance with the German HGB. Other countries apply their national GAAPS or follow international Accounting standards IFRSs for the single-entity financial statements. European groups that participate on the capital market must prepare group statements in compliance with IFRSs. Therefore, all group members must transform (translate) their financial statements to IFRSs in preparation of the group statements. The application of national GAAPs and IFRSs can result in different figures on the financial statements. The recognition criteria and valuations differ. E.g., the German HGB understates the company’s financial position to protect the company's creditors. IFRSs recognition follows the true and fair view principle. 4.10 Working Definitions GAAPs: GAAPs are generally accepted Accounting principles which apply for preparing financial statements and keeping Bookkeeping records. Group: A group consists of at least 2 companies which have a parent-subsidiary-relationship. Group Statements: Group statements contain a set of financial statements for the whole group that is prepared under the assumption of the group being a single company. Handelsgesetzbuch HGB: The commercial financial statements in Germany are ruled by the Handelsgesetzbuch HGB. International Financial Reporting Standards IFRSs: The international regulations about preparing financial statements are the International Accounting Standards IAS and International Financial Reporting standards IFRS (both: IFRSs). Set of Financial Statements: In compliance with IFRSs, a set of financial statements contains a statement of financial position (the balance sheet), a statement of profit and loss and other comprehensive income (income statement), a statement of cash flows and a statement of changes in equity. Furthermore, notes are required. Tax Statements: Tax statements are financial statements, such as a balance sheet and an income statement prepared for tax calculations. 4.11 Question Bank (1) Who prepares financial statements? 1. Only limited companies. 2. Traders and groups, in Germany small traders are exempted. <?page no="65"?> Berkau: Basics of Accounting 6e 4-65 3. Traders and limited companies, in Germany small traders are exempted. 4. Traders, no matter what legal form applies. (2) What is IAS 16 about? 1. IAS 16 rules the acquisition, depreciation and impairment loss of property, plant, equipment. 2. IAS 16 rules the acquisition and depreciation of property, plant, equipment. 3. IAS 16 rules the acquisition, valuation, depreciation and liquidation of property, plant, equipment. 4. IAS 16 rules the acquisition, valuation and depreciation of property, plant, equipment. (3) Which rules for financial statements apply in Germany? 1. HGB. 2. HGB and IFRS for group statements. 3. HGB and IFRS for group statements if group members are traded on the capital market. 4. IFRS. (4) Which standards are linked to non-current assets? 1. IAS 16, IAS 36, IAS 40, IFRS 5. 1. IAS 16, IAS 36, IAS 2, IFRS 5. 1. IAS 16, IAS 38, IAS 40, IFRS 9. 1. IAS 16, IAS 36, IAS 7, IFRS 5. (5) What are group statements? 1. Total of financial statements prepared for a group of companies which are linked to each other by ownership. 2. Financial statements prepared for a group of companies which are linked to each other by ownership. 3. Financial statements prepared for a group of companies which replace the single-entity financial statements. 4. A set of all single financial statements prepared for a group of companies which are linked to each other by ownership. 4.12 Solutions 1-3; 2-4; 3-3; 4-1; 5-2. <?page no="66"?> Berkau: Basics of Accounting 6e 5-66 5 The Excel Accountant 5.1 What is in the Chapter? This chapter does not contain Accounting knowledge. It only introduces an aid to prepare financial statements without Bookkeeping software. We provide you with the spreadsheet used to prepare the books and all exercises. You can use the templates to easily prepare financial statements in the same format as you find it in the study materials. 5.2 Learning Objectives You will be familiarised with the template that helps you to prepare financial statements for Accounting classes. This chapter also contains hints for the use of the templates relevant in succeeding chapters of the textbooks Basics and Bilanzen/ Financial Statements and Management Accounting. 5.3 Accounting Software In a real company, the Accountants and Bookkeepers apply Accounting software. The software supports them making Bookkeeping entries and preparing financial statements. Most Accounting software systems also enable their users to submit financial statements electronically to the national revenue service and support their publication (per interface to Bundesanzeiger in Germany). Before Accounting software is ready to use, its parameters must be set according to the characteristics of the company. Making these settings is referred to as Customising. The market leader for software for enterprise resource planning systems (ERP-systems) is SAP AG in Germany. The software is based on a transaction concept. E.g., when you make a Bookkeeping entry, all data inputs must be completed before the software pre-checks and thereafter makes the Bookkeeping entry. If you interrupt a transaction, nothing will happen on the database. For recording a Bookkeeping entry, the system needs information about the company code, the chart of accounts, etc. Theses are the parameters to be defined by the customizing procedures. We recommend checking the websites of software developers for Accounting software to gain an overview of what their Accounting software is capable of. In the university and at home you most likely make Bookkeeping entries on paper of with MS Excel. In contrast to the real Accounting world, the university teaches Accounting based on simple cases. Therefore, you do not have to work with huge data volumes. Hence, MS Excel can support you for the first steps. Using MS-Excel in online-exams can speed up your Accounting work. 5.4 Accounting with MS-Excel On the website, we provide you with a file called "AccountsAndStandards- FORMAT.xls". This file was used for the preparation of all accounts and financial statements in this textbook and for additional study materials, as well. <?page no="67"?> Berkau: Basics of Accounting 6e 5-67 The spreadsheets have been prepared on an English MS-Excel 2016 system. According to its settings, figures appear in the textbook format (English). You can adjust your MS-Excel system to the English data format, too. However, be aware that this is a computer system setting. If you do not change your settings, the data format in the file will adjust to the data format you normally have in use automatically - most probably the German one with a comma as decimal separator. See Figure 5.1 for the adjustments. Figure 5.1: Excel options for the adjustment of the data format Another setting determines the format data appear in the tables. We apply the format 1,000.00 EUR for a positive amount and (1,000.00 EUR) for a negative one. It is easier to see than a minus sign. Furthermore, we select always nonproportional fonts for figures, such as Courier. This makes the decimals appear at the same space which makes sense when preparing a list. <?page no="68"?> Berkau: Basics of Accounting 6e 5-68 Figure 5.2: Format adjustment (fonts) The file AccountAndStatement- FORMAT.xls provides you with tabs that contain templates for your Accounting work. They are: - Acc (accounts) - JL (journal) - TB (trial balance) - BS (statement of financial position) - German BS - IS (statement of comprehensive income) - German IS - CFS (statement of cash flows) - SCE (statement of changes in equity) - RoA (register of non-current assets) - Int&PayOff (schedule for interest and pay-off scheduling) - PCB (petty cash book) - CB (cash book) - Bank (bank statement) - BP (business plan) <?page no="69"?> Berkau: Basics of Accounting 6e 5-69 5.5 Acc (Accounts) All accounts are prepared as T-accounts. T-accounts help you to understand to which side of the balance sheet items belong. On the left-hand side of every account, there is a D indicating the debit side and on the right-hand side is a C, for credit side. No currency is mentioned; we keep Bookkeeping as simple as possible. For adding the accounts figures, apply the sum function. See the account tab in Figure 5.3. Figure 5.3: Account tab At the end of an Accounting period, you must balance-off accounts. Following the international way of keeping records, the balancing figure is inserted as a balance carried down (c/ d) on the “shorter side” of the account above the sum. The balancing figure is copied to the opposite side and marked balance brought down, indicated by b/ d. The Figure 5.4 shows the account “P, P, E” before (left-hand side) and after its balancing-off. D C D C (1) 100,000.00 (3) 50,000.00 (1) 100,000.00 (3) 50,000.00 (2) 200,000.00 (2) 200,000.00 c/ d 250,000.00 300,000.00 300,000.00 b/ d 250,000.00 P, P, E P, P, E Figure 5.4: Balancing-off an account <?page no="70"?> Berkau: Basics of Accounting 6e 5-70 To balance-off an account in MS Excel calculate the sum on both sides with the sum function. To indicate the sum, format the cell that one line is at the top border and a double line at the bottom border. In Figure 5.4 you get 300,000.00 EUR on the debit side and 50,000.00 EUR on the credit side. Now, you add a “c/ d” on the credit side and write in MS Excel “=D5 - G3" which deducts the 50,000 in the cell G3 from the total in cell D5. Hence you get: 300,000 - 50,000 = 250,000.00 EUR as the balancing figure of the account. This way, you avoid loops. Next, you move the mouse under the sum-line on the debit side and enter "=G4”. This is not only quick it also avoids mistakes. As a precautious measure, check the sums on both sides after balancing-off the account. 5.6 JL (Journal) A journal is a list of Bookkeeping entries. You can record Bookkeeping entries without keeping a journal, but it can help you finding entries. The journal contains a description of all Bookkeeping entries along the timeline of recording. In most study materials we supply, no journal is used. To demonstrate the journal, we look at the following case: The owners of a company deposits 100,000.00 EUR into the company’s bank account. Later, the company acquires machinery on cash to the extent of 34,000.00 EUR. The Bookkeeping entries are: DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR DR P, P, E-Account.............. 34,000.00 EUR CR Cash/ Bank.................... 34,000.00 EUR Figure 5.5: Journal tab <?page no="71"?> Berkau: Basics of Accounting 6e 5-71 If you apply the journal you can copypaste the Nrand Amount-cells into the account tab. See Figure 5.6. Figure 5.6: Accounts linked to the journal 5.7 TB (Trial Balance) The trial balance will be introduced in chapter (29). The trial balance is a list of all accounts and shows the balancing figures thereof. It helps to detect errors in your Bookkeeping records. To prepare a trial balance, copy the names of all accounts into the list and enter the balances brought down either in the column DR or CR. You must enter the balancing figure on the debit side if the account is debit balanced. Make an entry on the credit side for credit balanced accounts. A debit balanced account is one where the balance brought down shows on the debit side. The totals of the two columns on the trial balance must equal. See Figure 5.7 for the trial balance tab. For preparing an adjusted trial balance, copy the initial trial balance by valuecopy function. A common mistake is to enter cell references in the trial balance and then copy the entire trial balance to the adjusted trial balance which will change your cell references if not frozen before (with F4 key). You can avoid that mistake by only copy values to the adjusted trial balance. An adjusted trial balance is prepared after all adjustments at the end of the Accounting period have been completed: e.g., depreciation, accruals, profit calculation, appropriation of profits etc have been recorded. After adjustments, all nominal accounts are closed-off. Therefore, their balancing <?page no="72"?> Berkau: Basics of Accounting 6e 5-72 figure is zero. After copying the unadjusted trial balance, strike through all closed-off accounts and change their values to zero. Also, insert additional lines at the bottom for new accounts, like Retained Earnings account, Income Tax Liability account, Reserves account etc. Again, the total in the debit column must equal the one on the credit side. If not, you made a mistake. A difference indicates that the Accounting equation is not fulfilled and your balance sheet will be faulty. Figure 5.7: Trial balance tab 5.8 BS (Statement of Financial Position) The statement of financial position tab contains a template for a simple balance sheet. It reads Statement of Financial Position such as requested by IAS 1. The total is calculated on the bottom line. You can adjust all items and you can add further lines with the insert line function. You must adjust/ select the statement of financial position depending on the legal form of the business. E.g., a sole dealership will not disclose issued capital, but owner’s equity. See the statement of financial position tab in Figure 5.8. It contains a balance sheet for a limited company on the left-hand side and one for a privately-owned business to the right. As you can see in Figure 5.8, the sum on the debit side is compared to the credit side's one in cell L15 to indicate a violation of the Accounting equation. On the statement in Figure 5.8, there is only one entry in the Property, Plant and Equipment account and the difference is 300,000.00 EUR. Obviously, the credit entry for the acquisition of the item of property, plant, equipment is missing. All financial statements must show the name of the reporting company and its legal form. Furthermore, the date, to <?page no="73"?> Berkau: Basics of Accounting 6e 5-73 which the balance sheet is prepared is to be disclosed in the header (not the date of preparation itself). Adjust the reporting currency if different to the default EUR. Figure 5.8: Statement of financial position tab 5.9 Ger BS (German Balance Sheet) The German Bilanz is for use in German classes when studying Accounting following HGB. To offer the same content for English classes, the balance sheet template is available in English, too. However, consider German companies must submit the balance sheet in German and in EUR. Note, the balance sheet provided is for small companies only: an abridged balance sheet template along § 266 I HGB. However, the balance sheet on the left-hand side contains a more detailed liability section than required by German HGB. <?page no="74"?> Berkau: Basics of Accounting 6e 5-74 Figure 5.9: German balance sheet tab 5.10 IS (Statement of Comprehensive Income) The template for the income statement is provided following the nature of expense format. You easily can adjust it to the cost of sales format if required: Replace the cost items by "Cost of goods sold COS" but keep other expenses for non-manufacturing overheads. In the header, you see STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME, which is not exactly the name required in accordance with IAS 1. IAS 1 replaces the "&" by "or". As in Accounting language the expression profit and loss is widely in use, we stick to the "&". When preparing real financial statements, you should apply the correct name as in IAS 1.10. For data input, pls., key in all figures on the credit side as positive amounts and negative figures for all expenses. The formulas provided together with the statement will then deduct expenses from revenues and calculate the correct taxes. The taxes will become zero for negative pre-tax profits. See below the income statement tab in Figure 5.10: <?page no="75"?> Berkau: Basics of Accounting 6e 5-75 Figure 5.10: Income statement tab 5.11 Ger-IS (German Income Statement) We provide you with an income statement along the German HGB, too. See Figure 5.11. It follows the formal requirements laid out by § 275 II HGB. Figure 5.11: German income statement tab <?page no="76"?> Berkau: Basics of Accounting 6e 5-76 5.12 CFS (Statement of Cash Flows) The statement of cash flows tab contains a template filled with some examples for cash flows. Change the items of cash flows in the MS Excel sheet towards the cash flow statement you are preparing. The formulas linked to the cells add cash flows from operating, investing and financing activities on the right side and calculate the total cash flow, too. All cash inflows (receipts) are positive and cash outflows (payments) are negative figures. The statement of cash flows is introduced in chapter (32). Further instructions and explanations can be found in chapter (10) of the textbook Bilanzen/ Financial Statements. The format in the MS Excel file is based on the reconciliation of profits with operating cash flows on the lefthand side and follows the direct method to the right. IAS 7.18 supports both methods. Compare the total cash flows with the changes recorded in the Cash/ Bank account(s). Figure 5.12: Statement of cash flows tab 5.13 SCE (Statement of Changes in Equity) The statement of changes in equity is covered by chapter (30) and chapter (13) in the textbook Bilanzen/ Financial Statements. The statement of changes in equity contains columns for the items on the balance sheet and lines for changes thereof. Sums are added to the right and to the bottom of the statement. In Figure 5.13 some figures have been entered into the template for illustration purposes. <?page no="77"?> Berkau: Basics of Accounting 6e 5-77 Figure 5.13: Statement of changes in equity tab 5.14 RoA (Register of non-current Assets) The register of non-current assets is required by IFRSs and belongs to the notes. The register of non-current assets is covered by chapter (17) and chapter (7) in the textbook Bilanzen/ Financial Statements. The register of non-current assets is prepared on group levels following IFRSs. This means not every item of property, plant, equipment is disclosed but groups thereof. Every asset (group) is recorded in a line which contains its cost of acquisition, the accumulated depreciation and the accumulated impairment loss. The column at the right border shows the carrying value which is calculated automatically. You must enter the amounts for accumulated depreciation and for accumulated impairment losses as negative figures to calculate the correct carrying value. Some random figures have been entered into the form in Figure 5.9. to illustrate the calculations. For a revaluation, you must adjust the column cost/ revaluation and enter the value assigned to the asset. Add an explanation to the notes too. <?page no="78"?> Berkau: Basics of Accounting 6e 5-78 Figure 5.14: Register of non-current assets tab 5.15 Int&Pay-off (Interest and Pay-off Schedule) For calculation of interest and pay-off of a bank loan use the Int&Pay-off tab. The interest and pay-off schedule provided calculates liabilities per Accounting period. The standard procedure to use this tab is as below: (a) Enter the amount for the annual payment directly. (b) Write the rate of interest above the column interest. In Figure 5.15, the annual interest rate is 10 %. (c) Enter the principal of the bank loan in cell C3. (d) If more lines are needed copy the cells of the table. (e) Adjust figures if shorter periods than a year apply, e.g., if the bank loan is taken in the middle of the year. (f) For bank loans with a constant payoff amount overwrite the cells in column E. <?page no="79"?> Berkau: Basics of Accounting 6e 5-79 Figure 5.15: Interest and pay-off tab 5.16 PCB (Petty Cash Book) The Petty Cash Book can be set up easily by the tab PCB. Make entries for the balancing-off manually. The Petty Cash Book is covered in chapter (38). Figure 5.16: Petty cash book tab 5.17 CB (Cash Book) The Cash Book tab is similar to the one for the Petty Cash Book. You must add the figures for balancing-off as well. In contrast to the other tabs the header has been kept very simple to intentionally give the Cash Book the look of a normal account. The Cash Book is discussed in chapter (37). See Figure 5.17. <?page no="80"?> Berkau: Basics of Accounting 6e 5-80 Figure 5.17: Cash book tab 5.18 BankST (Bank statement) The bank statements come directly from your bank; Accountants do not prepare them. However, we provide you with a simple template for a bank statement you can use for practicing bank reconciliations as covered in chapter (37). Figure 5.18: Bank statement tab <?page no="81"?> Berkau: Basics of Accounting 6e 5-81 5.19 Cons (Consolidation) For Group Accounting the MS-Excelfile provides a consolidation tab. Write the balance sheet figures in the left columns; if more than 2 group companies apply, copy balance sheet columns. The aggregated statement is prepared automatically. To the right, the consolidation worksheet provides columns for certain consolidations, like capital consolidation, allocation of non-controlling interest etc. In the outer right column, the consolidated balance sheet's values are disclosed. The formulas consider the consolidation steps made in the worksheet. The tab is based on a full consolidation. Make adjustments for Joint Venture Accounting accordingly (proportionate consolidation). Figure 5.19: Consolidation tab 5.20 BP (Business Plan) In the textbook Management Accounting, chapter (6) we cover the preparation of a business plan. We provide you with a basic template that makes some calculations based on the formulas entered into the cells. Check the details with the MS-Excel file. <?page no="82"?> Berkau: Basics of Accounting 6e 5-82 Figure 5.20: Business plan tab 5.21 Summary We explained the MS-Excel sheet we provide online to facilitate your Accounting work in the university. <?page no="83"?> Berkau: Basics of Accounting 6e 6-83 6 Introduction to Balance Sheet and Income Statement 6.1 What is in the Chapter? In this chapter, we discuss the statement of financial position (= balance sheet) and the statement of profit and loss and other comprehensive income (= income statement) to explain their meanings and the items disclosed therein. It is intended to present the financial statements as a valuable reporting instrument for all stakeholders (owners, creditors and other parties), who have an interest in the financial position and performance of the company. 6.2 Learning Objectives After studying this chapter, you understand the meaning of the statements and know how the statements look like. 6.3 Approach to Accounting In the common language, people do not distinguish between Accounting and Bookkeeping. Often Accountants are pictured as accurate Bookkeepers who are keen to record everything very much in the details. Accounting differs from Bookkeeping. Accounting is a management task. Managers evaluate their company and must calculate the profit; they share their findings with owners, creditors, employees, business partners and the public. The dimensions of evaluation are: the financial position, the performance and the cash flows. The financial position tells us how much assets a company has for its operations and how the company is financed. The performance tells us the profit a company is earning. The cash flow tells us about the cash generated by the company. In contrast, Bookkeeping is a means to gather and structure information for Accounting. In this textbook, we introduce Accounting free of formal requirements. We start our considerations from a simple format for the balance sheet 3 which we apply for an easy case study. We do not record Bookkeeping entries but observe the changes business operations make on the balance sheet step by step. The statement of financial position as it applies for this textbook looks as below in Figure 6.1. Some Accountants still call it the balance sheet B/ S, so do we in the text. The official name in accordance with IAS 1.10 is statement of financial position and with German Handelsgesetzbuch (§ 266 HGB): Bilanz. 3 The simple structure is not applicable for balance sheets following German HGB. Check for German Accounting: Bilanzen/ Financial Statements, chapter (2). <?page no="84"?> Berkau: Basics of Accounting 6e 6-84 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank Tax liabilities STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 6.1: Statement of financial position The statement of financial position has 2 sides: (1) Asset side and (2) Capital/ liability side. The asset side is the left-hand side of the statement of financial position. It discloses the resources of the company, like machinery, inventories, cash on hand etc. Accountants also call the asset side “debit side of the balance sheet”. The capital/ liability side is the right-hand side of the statement of financial position. It displays where the company’s funds come from: they originate from the owners’ contribution, from profits kept in the business and/ or from borrowing from creditors. Accountants also call it “credit side” or “claims side of the balance sheet”. Next, we study the balance sheet in detail. We start on the asset side and thereafter cover the credit side. 6.4 Asset Side of the Balance Sheet The asset side shows the value of all assets of a company. It is not necessary to disclose single items but to determine the total value of the assets. The asset side is structured by item groups which are the items you see on the balance sheet. E.g., the item of property, plant, equipment P, P, E discloses the total of the carrying values for all assets that fall under P, P, E. The carrying value is what the asset is worth at the time for which the balance sheet is set up. When a company takes stock, it prepares a list of all its items - also referred to as the inventory. To calculate an item on the balance sheet you must know the number and current value of assets the company owns. In general, assets are structured based on how long they are kept in the company, e.g., a business car stays longer in a company than a litre of milk in a grocery store. Non-current assets are assets that are longer than one Accounting period in use. The former expression “fixed assets” is not precise <?page no="85"?> Berkau: Basics of Accounting 6e 6-85 and old-fashioned - we do not use it. Assets deployed for less than a year, are current assets. In contrast to current assets most of non-current assets lose in value by use. They are writtenoff over the time. Depreciation reflects the decrease of an asset’s value as an expense based on the time or the extent of an asset's deployment. Assets that do not deplete, are not subjected to depreciation, like land. The first non-current asset item on the balance sheet is property, plant and equipment (P, P, E). This item can contain buildings, land, machinery and equipment used for business operations. The expression P, P, E originates from the header of IAS 16: Property, Plant and Equipment. Assets are disclosed at their carrying value. In case an asset's value decreases by depreciation, the value of the P, P, E item is to be disclosed at the cost of acquisition less any depreciation and any impairment loss. For now, an impairment loss is an extraordinary depreciation. An impairment loss can be caused by an accident or any other sudden drop in valuation. In compliance with IFRSs, increases in valuation of a non-current asset must be recorded when the asset's fair value increases. This kind of value upgrading is called revaluation in Accounting language. IFRSs require companies to carry all assets at fair value. PEINE Ltd. carries a machine at 1,200.00 EUR. Its fair value equals 1,500.00 EUR. As a result, PEINE Ltd. must increase the machine’s carrying value by 300.00 EUR. The revaluation changes the machine’s value in P, P, E from 1,200 to 1,200 + 300 = 1 1,500.00 EUR. Revaluations are covered in chapter (7) of the textbook Bilanzen/ Financial Statement. PEINE Ltd. also owns a business car bought on 2.01.20X3 at 45,000.00 EUR cost of acquisition. Every year the car's value decreases by 5,000.00 EUR. On the balance sheet date 31.12.20X5, PEINE Ltd.'s business car is carried at: 45,000 - 3 × 5,000 = 3 30,000.00 EUR. The balance sheet item P, P, E considers for the car a carrying value of 30,000.00 EUR. Besides of property, plant and equipment, a balance sheet can contain intangible assets. Intangibles are assets that have no physical nature. Intangibles are rights, patents, etc. Financial assets are mostly linked to financial instruments and contain assets like shares of other companies, bonds or debentures the company is holding. DÖHREN AG buys shares of CAMBS AG at 1,000.00 EUR cost of acquisition. The shares of CAMBS AG are DÖHREN AG’s financial assets. DÖHREN AG recognises the shares at their fair value of 1,000.00 EUR on its balance sheet. The share price of the CAMBS' shares drops during the next year by 10 %, hence, DÖHREN AG must disclose them at 1,000 × (1 - 10%) = 9 900.00 EUR. Current assets are assets that stay for short periods (less than a year) in the business. The first item of current assets on the balance sheet is inventories. Inventories are raw materials, work-in-process (WIP) and finished goods. A production firm that buys materials will disclose them under raw materials inventory. During the manufacturing process, materials allocated to job orders are recognised <?page no="86"?> Berkau: Basics of Accounting 6e 6-86 as work-in-process. Goods manufactured but not yet sold are disclosed as finished goods. In general, companies distinguish three inventory groups on their balance sheets or recognise one total item and describe the single values in the notes. The notes are Accounting explanations required by IFRSs. Further non-current assets are receivables (A/ R). The accounts receivables (A/ R) disclose claims resulting from payments expected from customers, other business partners or the revenue service. The expression A/ R indicates that we record receivables in individualised accounts, e.g., A/ R-LAMPENSCHULTE. An account A/ R-LAMPENSCHULTE would contain receivables the reporting company is entitled to get from their business partner LAMPENSCHULTE. Study the case study below: Company ELZE GmbH lends WORCESTER AG an amount of 100,000.00 EUR. ELZE GmbH’s statement of financial position discloses the expected repayment as accounts receivables. The technical term here is note receivable. Prepaid expenses count as current assets, too. They result from payments made in advance as compensation for a future service. A company that pays rent for the next Accounting period during the current one, will recognise that payment as prepaid expense in accordance with IFRSs. This is done to adhere to the accrual principle of Accounting. It states that a company must allocate expenses to the Accounting period they are for, no matter when the payment is made or cash received. A further item on the list of current assets is securities. Securities are financial instruments held short-term. We call them securities as a company can quickly turn them into cash if more liquidity is required. The item cash/ bank discloses the total of all cash on hand and at bank. In general, a company runs various accounts at different banks and the item cash/ bank adds up all its bank accounts' and cash’s balancing figures. GAMBANG Ltd. banks with 3 banks: the funds recorded therein are: 1,000.00 EUR at Deutsche Bank, 30,000.00 EUR at Commerzbank and 50.00 EUR at Sparkasse Osnabrück. Furthermore, GAMBANG Ltd. holds 3.20 EUR on cash. The cash/ bank item on the balance sheet shows: 1,000 + 30,000 + 50 + 3.20 = 331,053.20 EUR. 6.5 Capital and Liability Side of the Balance Sheet Capital and liabilities contain the owners’ equity (e.g., paid-in contributions, profit added to reserves) and the liabilities which have been paid by the creditors of the business, like banks. The equity section of the balance sheet starts with issued capital. Issued capital is the nominal value of the funds contributed by the owners at the time of incorporation or when fresh shares are issued. If a company is privatelyowned, the equity section on the balance sheet is named owner’s capital and no further subordinated items are disclosed. In contrast, public companies must provide information about their issued capital, reserves and retained earnings (R/ E). Reserves represent funds <?page no="87"?> Berkau: Basics of Accounting 6e 6-87 owned by the owners of the business. They can be paid-out as dividends or stay in the company to finance its operations. Reserves can result from earnings, from share issues or from revaluations. Earnings reserves increase when profit is kept in the company. Capital reserves result from share issues with a premium. A premium is the difference between the issue price and the nominal value of shares, see the case below: The German company HAGEN AG issues 100 shares at 7.80 EUR/ share. The face value of the shares equals 5.00 EUR/ share. The difference between the issue price and the face value is amounting to: 7.80 - 5 = 2 2.80 EUR/ share and is the share premium. Here, HAGEN AG adds: 100 × 2.80 = 2 280.00 EUR to capital reserves. Liabilities are funds, the company owes someone, like bank loans, open bills from supplies and tax liabilities. A company is obliged to pay-off its liabilities. In the liability section of the statement of financial position a company discloses all amounts it is owing its creditors. A long-term bank loan is recognised as interest bearing liability. Bonds are long-term debts, too, and require interest payments. In contrast, short-term liabilities are shown as payables (A/ P). Accounts payables is the item on the balance sheet for short-term debts the company must settle within the next Accounting period. Output-VAT is recorded under accounts payables A/ P, too. As we see below, income tax liabilities are disclosed as an extra item on the balance sheet. Provisions are uncertain liabilities. Examples for provisions are pensions fund payments, provisions for court cases, etc. They are classified as uncertain, because either the value or the time of payment is not clear. Regarding a pension fund, the reporting company does not know for how long the beneficiary receives the pension. Liabilities for income taxes must be disclosed along IAS 12 separately. In contrast to the German Handelsgesetzbuch, no provisions for income taxes are recognised but a liability is shown. 6.6 Income Statement The format for the statement of profit or loss and other comprehensive income (in Accounting slang: the income statement) is given by Figure 6.2: <?page no="88"?> Berkau: Basics of Accounting 6e 6-88 [EUR] Revenue Other income Materials Labour Depreciation Other expenses Earnings before int and taxes (EBIT) Interest Earnings before taxes (EBT) Income tax expenses Deferred taxes Earnings after taxes (EAT) STATEMENT of PROFIT or LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X0 Figure 6.2: Income statement The statement of profit or loss and other comprehensive income compares revenue earned to expenses. The bottom line shows the profit earned during the Accounting period, called earnings after taxes. All amounts on the income statement are net amounts. Revenue is the money or the equivalent thereof, which the company receives for selling goods or rendering services. Some companies earn special income resulting from extraordinary activities, such as a production firm when selling property. We refer to those special incomes as gains. To keep it easy we refer to revenues when the company sells goods or renders services linked to its core business. Any extraordinary income is referred to as a gain. E.g., an airline selling a plane and earning a profit will refer to this profit on disposal as a gain. Expenses represent the consumption of business resources. They contain materials, labour etc. Depreciation is an expense, too, that reflects the reduction of a non-current asset's value because of deployment or depletion. KINDERHAUS GmbH buys a new delivery van at 10,000.00 EUR. The time span KINDERHAUS GmbH intends to use the car is 5 years. Its annual depreciation is: 10,000 / 5 = 2 2,000.00 EUR/ a. Like other income, other expenses are recorded. Other expenses are expenses other than materials, labour and depreciation. For example, rent, fees, insurance rates etc. The IFRSs do not require showing other expenses in detail, we can combine them under other expenses. If the profit is calculated without consideration of expenses for interest, we call it earnings before interest and taxes (EBIT). To calculate the EBIT, simply deduct the expenses like labour, depreciation, materials and other expenses from revenues. After interest is deducted from EBIT, the remainder is earnings before taxes <?page no="89"?> Berkau: Basics of Accounting 6e 6-89 EBT. Some Accountants call it the pre-tax profit or net profit (NP). In the next step, taxes are deducted from EBT which gives the profit for the period called earnings after taxes (EAT) or annual surplus A/ S. The link between the income statement and the balance sheet is that annual surplus is added to the retained earnings and income taxes to income tax liabilities. A company runs its business operations for the owners to earn money. Therefore, the annual surplus added to the equity is used for three kind of appropriations of profit: (1) declaration of a dividend, (2) Addition to earnings reserves and (3) profit/ loss carried forward to the next Accounting period. The activities (1) and (2) will reduce the retained earnings whereas (3) does not change them. We discuss a simple case of appropriation of profits below: In 20X5, the car rental INMOTION Ltd. earns a revenue of 240,000.00 EUR. Its depreciation is amounting to 60,000.00 EUR and operational expenses, including labour and management, add up to 130,000.00 EUR. The pre-tax profit is: 240,000 - 60,000 - 130,000 = 5 50,000.00 EUR. The income taxes calculated by our simplified tax model equal: 30% × 50,000 = 1 15,000.00 EUR. The Earnings after taxes are: 50,000 - 15,000 = 35,000.00 EUR. On its annual general meeting (AGM) the owners of INMOTION Ltd. decide to declare a dividend of 6,000.00 EUR and to add 17,000.00 EUR to earnings reserves. The remainder is carried forward to the next Accounting period 20X5 and is amounting to: 35,000 - 6,000 - 17,000 = 12,000.00 EUR. On the balance sheet as at 31.12.20X5, we notice an increase of earnings reserves by 17,000.00 EUR and in short-term liabilities of 6,000.00 EUR for the dividends payable in the next Accounting period. The retained earnings equal 12,000.00 EUR and represent the company's profit carried forward. 6.7 Summary Companies prepare financial statements to provide their stakeholders (owners, creditors, employees, the government, the public etc.) with information. The major financial statements are the statement of financial position and the statement of profit or loss and other comprehensive income. Before the revision of IAS 1, these statements were called balance sheet and income statement. These expressions are still widely in use in Accounting. The statement of financial position discloses all assets on one side and the capital (=equity) and liabilities on the opposite one. The statement of profit or loss and other comprehensive income reveals how a company earns its profit. All expenses are deducted from the revenues and other comprehensive income. The income statement and the balance sheet are linked together. At the end of the Accounting period, the earnings after taxes are added to the retained earnings on the balance sheet. Income taxes are added to income tax liabilities. 6.8 Working Definitions Accounts payables: Accounts payables (A/ P) is the item on the balance <?page no="90"?> Berkau: Basics of Accounting 6e 6-90 sheet for short-term debts the company must settle within the next Accounting period. Accounts Receivables: The accounts receivables (A/ R) disclose claims resulting from payments expected from customers, other business partners or the revenue service. Asset Side: The asset side is the lefthand side of the statement of financial position. Capital/ Liability Side: The capital/ liability side is the right-hand side of the statement of financial position. Carrying Value: The carrying value is what the asset is worth at the time for which the balance sheet is set up. Cash/ Bank: The item cash/ bank discloses the total of all cash on hand and at bank. Current Assets: Current assets are assets that stay for shorter periods (less than a year) in the business. Impairment loss: An impairment loss is an extraordinary depreciation. Intangible assets: Intangibles are assets that have no physical nature. Intangibles: Intangibles are assets that have no physical structure. Inventories: Inventories are raw materials, work-in-process (WIP) and finished goods. Prepaid Expenses: Prepaid expenses are assets that result from payments in advance as a compensation for a future service. Issued Capital: Issued capital the nominal value of the funds contributed by the owners at the time of incorporation or when fresh shares are issued. Non-current Assets: Non-current assets are assets that are longer than one Accounting period in use. Notes: The notes are explanations of Accounting required by IFRSs. Provisions: Provisions are uncertain liabilities. 6.9 Question Bank (1) The Accounting equation is: 1. Assets + Equity = Liabilities. 2. Assets = Equity - Liabilities. 3. Assets = Equity + Liabilities. 4. Equity = Assets + Liabilities. (2) Which of the items are assets? 1. Motor vehicles, inventories, retained earnings. 2. Property-plant-equipment, cash/ bank. 3. Investments, accounts payables, cash/ bank. 4. Inventories, securities, interest bearing liabilities. (3) Which statement is correct? 1. Machinery is recorded under property, plant, equipment. 2. Purchases are recorded under property, plant, equipment. 3. A bank loan is recorded under interest bearing liabilities. 4. Issued shares are recorded under provisions. (4) Which of the items belong to the income statement? 1. Inventories, other expenses, income tax expenses. 2. Materials, other expenses, income tax liabilities. 3. Materials, other expenses, income tax expenses. <?page no="91"?> Berkau: Basics of Accounting 6e 6-91 4. Inventories, other expenses, income tax liabilities. (5) A company takes a bank loan and receives the money. Which items on its financial statements change? 1. Interest on the income statement and cash/ bank on the balance sheet. 2. Cash/ bank and interest bearing liabilities on the balance sheet. 3. Income tax liabilities on the balance sheet and interest on the income statement. 4. Interest bearing liabilities on the balance sheet and interest on the income statement. 6.10 Solutions 1-3; 2-2; 3-1; 4-3; 5-2. <?page no="92"?> Berkau: Basics of Accounting 6e 7-92 7 Activities on the Asset Side of the Balance Sheet 7.1 What is in the Chapter? In this chapter, we discuss our first major case study ROHRBACH Ltd. The case study only requires making changes on its balance sheet on the left-hand side, which we refer to as the asset side. Hence, we only study changes of assets in this chapter. As we ignore Bookkeeping entries, we only show ROHRBACH Ltd.'s statement of financial position (balance sheet) and record the changes therein. 7.2 Learning Objectives In this chapter, you learn how to record asset exchanges on the balance sheet. You will understand how additions and reductions of assets affect the statement of financial position. 7.3 Asset Exchanges An exchange of assets is the addition or increase of one asset and the disposal or decrease of another one at the same time. Companies disclose their assets on the balance sheet on type-levels. If a company owns 3 cars at 50,000.00 EUR each, it will show on its balance sheet "cars: 150,000.00 EUR". The balance sheet does not tell the reader of financial statements details of the items. It only shows their valuation. When we limit our focus on activities on the asset side, changing one asset results in a change of another one. If we increase one, we must decrease the other one. This results from the Accounting equation. As for now, only the asset side counts; we ignore the credit side of the statement of financial position. Therefore, all capital and liability items are greyedout in the next exhibits. Make yourself familiar with the items on the asset side of the balance sheet. They are structured in 2 sections: noncurrent assets and current assets. The first group contains assets that stay for a longer period in the company, like machinery, store equipment etc. Shortterm or current assets are consumed or sold during the Accounting period. Therefore, they last in general less than a year. Examples are inventories, receivables, cash on hand etc. For studying the balance sheet, we refer to the asset structure on a balance sheet given in Figure 7.1. Non-current assets are: property, plant, equipment, intangibles and financial assets. The current assets are inventories, receivables, prepaid expenses and cash/ bank. We stick to this structure. All items we discuss are allocated to these asset groups. 7.4 C/ S ROHRBACH Ltd. ROHRBACH Ltd. is a cell phone dealer. All values are in EUR. At the beginning of its fiscal year 20X5, ROHRBACH Ltd. has 250,000.00 EUR in cash/ bank. Look at the balance sheet in Figure 7.1 to find the item cash/ bank at 250,000.00 EUR therein. The item cash/ bank on the balance sheet does not reveal how the 250,000.00 EUR look like: it can either be cash on hand or money in a bank account. <?page no="93"?> Berkau: Basics of Accounting 6e 7-93 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 250,000.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.1: ROHRBACH Ltd.’s statement of financial position (asset side) Next, we discuss activities that change ROHRBACH Ltd.'s assets: - Activity 1: purchase on cash. - Activity 2: acquisition of equipment on cash. - Activity 3: cash sale. - Activity 4: disposal of non-current assets. 7.5 Activity 1: Purchase on Cash A purchase is the buy of inventories. On 3.01.20X5, ROHRBACH Ltd. buys from its supplier STEHLE AG 1,000 smart phones at 150.00 EUR/ u each. The supplier bills: 1,000 × 150 = 1 150,000.00 EUR, which are due immediately. The delivery of the smart phones increases the value of inventories by 150,000.00 EUR. At the same time, ROHRBACH Ltd. pays 150,000.00 EUR per bank transfer into the supplier’s bank account. Therefore, cash decreases by 150,000.00 EUR too. It now equals: 250,000 - 150,000 = 1 100,000.00 EUR. Observe the outcome of the changes in Figure 7.2. <?page no="94"?> Berkau: Basics of Accounting 6e 7-94 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 150,000.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.2: ROHRBACH Ltd.’s statement of financial position (asset side) 7.6 Activity 2: Acquisition of Equipment on Cash On 6.02.20X5, ROHRBACH Ltd. buys from another supplier 4 shelves for its phones. Each shelf costs 1,175.00 EUR/ u. All 4 shelves are alike. On the balance sheet we only disclose the value for them together. With the acquisition, the item cash/ bank will change to the same extent. ROHRBACH Ltd. pays its supplier: 4 × 1,175 = 4 4,700.00 EUR. After the shelf buy and its payment, ROHRBACH Ltd.’s cash/ bank item shows: 100,000 - 4,700 = 9 95,300.00 EUR. The shelves fall under property, plant and equipment. Their value is 4,700.00 EUR for all shelves together. An initial valuation is always at the cost of acquisition. Check the balance sheet in Figure 7.3. <?page no="95"?> Berkau: Basics of Accounting 6e 7-95 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 4,700.00 Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 150,000.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 95,300.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.3: ROHRBACH Ltd.’s statement of financial position (asset side) 7.7 Activity 3: Cash Sale On 8.02.20X5, ROHRBACH Ltd. sells 67 phones at 150.00 EUR/ u. The sale results in a decrease of stock and a receipt of money. As we only intend to prepare a balance sheet, we want to know how much inventories ROHRBACH owns after the sale. According to the output, the value of stock (phones) is: 150,000 - 10,050 = 139,950.00 EUR. The sale reduces the number of smartphone by 67 units which means a decrease of 10,050.00 EUR in valuation. We here explain the difference between amount/ number and value. When we talk about an amount or numbers, we refer to the piece count. Here, the number is 67 phones. When we discuss the valuation, the unit is a currency, like EUR, USD, MYR etc. In order to determine the valuation, we need to know the unit costs. For this case study, the unit costs are constant. They are 150.00 EUR/ u. ROHRBACH Ltd. received money from its customers to the extent of: 67 × 150 = 10,050.00 EUR. As the item cash/ bank combines cash on hand and cash on bank, we do not distinguish how payments are made. The effect on the balance sheet remains the same; here we record an increase in the value of cash/ bank which equals 10,050.00 EUR: The value of cash/ bank after the receipt is: 95,300 + 10,050 = 1 105,350.00 EUR. <?page no="96"?> Berkau: Basics of Accounting 6e 7-96 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 4,700.00 Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 139,950.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 105,350.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.4: ROHRBACH Ltd.’s statement of financial position (asset side) 7.8 Activity 4: Disposal of non-current assets A disposal of a non-current asset is its sale or discard. On 22.03.20X5, ROHRBACH Ltd. sells 2 shelves at a price of 1,175.00 EUR. This results in a disposal of a non-current assets. The value of property, plant and equipment changes by: 2 × 1,175 = 2,350.00 EUR. The remaining value of the item P, P, E equals: 4,700 - 2,350 = 2,350.00 EUR. The money paid by the buyer for the shelves is received on cash. According to the cash input, the cash/ bank item now equals: 105,350 + 2,350 = 1 107,700.00 EUR. Check the statement of financial position in Figure 7.5. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 2,350.00 Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 139,950.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 107,700.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 7.5: ROHRBACH Ltd.’s statement of financial position (asset side) <?page no="97"?> Berkau: Basics of Accounting 6e 7-97 After recording the activities, the total value of assets is: 2,350 + 139,950 + 107,700 = 2 250,000.00 EUR. This is the same as at the beginning of the Accounting period. Compare Figure 7.1. Each activity changes 2 asset at the same time. The changes result in a zerosum-game. Activity 1 increases inventory and decreases cash/ bank. Activity 2 increases property, plant and equipment and decreases cash/ bank. Activity 3 increases cash/ bank and decreases inventory. Activity 4 increases cash/ bank and decreases property, plant and equipment. 7.9 Summary Activities limited to the asset side, increase one asset and decrease another one at the same time. 7.10 Working Definitions Asset Exchange: An exchange of assets is the addition or increase of one asset and the disposal or decrease of another one at the same time. Disposal: A disposal of a non-current asset is its sale or discard. Purchase: A purchase is the buy of inventories. 7.11 Question Bank (1) A company records a cash purchase on its balance sheet. Which are the correct changes? 1. Inventories increase, cash/ bank increases. 2. Inventories increase, cash/ bank decreases. 3. Inventories increase, accounts payables increase. 4. Inventories increase, accounts receivables increase. (2) When a company buys an item of property, plant, equipment and pays by bank transfer, which items on the balance sheet are affected? 1. Property-plant-equipment and accounts receivables. 2. Property-plant-equipment and accounts payables. 3. Property-plant-equipment and cash/ bank. 4. Inventories and cash/ bank. (3) Which statement is correct? 1. When a company purchases goods on cash the total of the balance sheet increases. 2. When a company purchases goods on cash the total of the balance sheet decreases. 3. When a company purchases goods on cash the total of the balance sheet does not change. 4. When a company purchases goods and pays by bank transfer the total of the balance sheet increases. (4) When a company sells goods at the same price as purchased on cash how is that activity recorded on its balance sheet? 1. Inventories increase and cash/ bank increase. 2. Inventories decrease and cash/ bank increase. 3. Inventories decrease and cash/ bank remains unchanged. <?page no="98"?> Berkau: Basics of Accounting 6e 7-98 4. Inventories increase and cash/ bank remains unchanged. (5) When selling machinery on cash which figures on the balance sheet change? 1. Motor vehicles, cash/ bank. 2. Property-plant-equipment, cash/ bank. 3. Cash/ bank, sum of the balance sheet. 4. Property-plant-equipment, sum of the balance sheet. 7.12 Solutions 1-2; 2-3; 3-3; 4-2; 5-2. <?page no="99"?> Berkau: Basics of Accounting 6e 8-99 8 Activities on Both Sides of the Balance Sheet 8.1 What is in the Chapter? This chapter is similar to the previous one. The only difference is, that we now consider activities changing items on both sides of the balance sheet. In this chapter, we discuss the business operations at EDENVALE AG a dealership for lawn mowers. 8.2 Learning Objectives After studying this chapter, you are familiarised with activities that change items on the debit side and credit side of the balance sheet. You can record a balance sheet after every activity and prepare a balance sheet at the end of the Accounting period. You will enhance your knowledge about the balance sheet in this chapter. 8.3 Activities Changing Balance Sheet Items Activities affecting both sides of the balance sheet, are most probably purchases and sales of assets on credit or payments linked to receivables or loans. A purchase or sale on credit means the connected payment or receipt of cash takes place in the next Accounting period. We still skip activities linked to profit or loss. Hence, all activities are neutral regarding profit. This means sales are at cost of acquisition. Next, we study the company EDENVALE AG. Before you study the case study, make yourself familiar with the credit side of the balance sheet. It tells you where funds for financing the assets originate from. Equity belongs to the owners. It can either consist of paid-in money or earnings not distributed to owners. Liabilities refer to borrowings from others. A business partner lending the company money is a creditor. Creditors can be banks, suppliers who agreed receiving money in the next Accounting period and the national revenue service, awaiting tax payments. A special kind of liabilities are uncertain liabilities which we call provisions and cover in chapter (15) or chapter (14) of the textbook Bilanzen/ Financial Statements. 8.4 C/ S EDENVALE AG EDENVALE AG is established on 2.01.20X3. The company is a dealership for lawn mowers. A trading business buys goods and sells them to customers. We study the following 8 activities and prepare a balance sheet after each activity: - Activity 1: establishment of the business. - Activity 2: purchase of goods. - Activity 3: borrowing money from the bank. - Activity 4: acquisition of non-current assets. - Activity 5: payment for debts. - Activity 6: selling goods. - Activity 7: receipts from customers. - Activity 8: payment for debts. 8.5 Activity 1: Establishment of the Business At the time of incorporation, the proprietors pay (all together) 500,000.00 EUR <?page no="100"?> Berkau: Basics of Accounting 6e 8-100 into EDENVALE AG’s bank account (2.01.20X3). The contribution of the proprietors is referred to as a share issue and leads to money in the bank. We show that as cash/ bank on the asset side. We disclose the funds also as equity on the credit side. As EDENVALE AG is a company on shares, we refer to the funds as issued capital or share capital. The funds provided by the shareholders represent their claim against the company. The shareholders own the business together. EDENVALE AG issues 50,000 ordinary shares with a face value of 10.00 EUR/ s. All shares represent a portion (= a share) of ownership in the company. A A share issue is par value if funds received equals the nominal values. The item of issued capital shows: 10 × 50,000 = 5 500,000.00 EUR. You learn more about share issues and companies based on shares in chapter (33) and in chapter (11) of the textbook Bilanzen/ Financial Statements. Observe EDENVALE AG’s statement of financial position as at 2.01.20X3 below in Figure 8.1. A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 500,000.00 Tax liabilities 500,000.00 500,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 2.01.20X3 Figure 8.1: EDENVALE AG’s statement of financial position 8.6 Activity 2: Purchase of Goods On 15.02.20X3, the EDENVALE AG orders from its supplier 400 lawn mowers at a purchase price of 230.00 EUR/ u. The money has not yet been paid. EDENVALE AG agrees to pay for the lawn mowers later. Therefore, EDENVALE AG owes its supplier: 400 × 230 = 9 92,000.00 EUR. The lawn mowers are EDENVALE AG’s merchandise goods and must be recognised as inventory. Recognition means to put something on the balance sheet. With no payment having taken place EDENVALE AG owes the supplier 92,000.00 EUR. Any amount owed until the next Accounting period is recognised as payables. The item on the balance sheet is called accounts payables (A/ P). The name of the item refers to all accounts the company is borrowing from. In general, a company uses personalised accounts which carry the name of the <?page no="101"?> Berkau: Basics of Accounting 6e 8-101 creditor and the suffix payables, like SCHULZE-BRAMMELKAMP/ payables if the company owes SCHULZE- BRAMMELKAMP money. Note, all single accounts together will form the purchase ledger; here we only consider the item on the balance sheet called Accounts payables (A/ P). Its valuation is the total of short-term debts. Therefore, you do not see on a balance sheet whom the reporting company owes the money - you only see how much it is in total. Observe the changes made on the statement of financial position in Figure 8.2. A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 92,000.00 Interest bear liab A/ R A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 500,000.00 Tax liabilities 592,000.00 592,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 15.02.20X3 Figure 8.2: EDENVALE AG’s balance sheet 8.7 Activity 3: Borrowing Money from the Bank EDENVALE AG takes a bank loan to equip its show room on 1.03.20X3. The bank loan's nominal value (principal) is 200,000.00 EUR. The money is received in EDENVALE AG’s bank account and becomes visible as an item of cash/ bank on its balance sheet. Now, EDENVALE AG also owes the bank 200,000.00 EUR. Therefore, the loan is recognised as a liability on the credit side. In contrast to the preceding activity, the bank loan is classified as longterm debts. EDENVALE AG does not intend to pay-off the bank loan in 20X3. To indicate when debts must be paid-off, we disclose long-term loans as interest bearing liabilities and short-term debts as accounts payables. The threshold time is one year. As long-term debts normally require paying interest, the item on the balance sheet is named interest bearing liabilities. Check the items cash/ bank and interest bearing liabilities on EDENVALE AG's balance sheet in Figure 8.3. <?page no="102"?> Berkau: Basics of Accounting 6e 8-102 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 92,000.00 Interest bear liab 200,000.00 A/ R A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 700,000.00 Tax liabilities 792,000.00 792,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 1.03.20X3 Figure 8.3: EDENVALE AG’s statement of financial position 8.8 Activity 4: Acquisition of non-current Assets EDENVALE AG buys a new show room interior on 4.03.20X3. An Acquisition is buying a non-current asset. In contrast, buying current assets is called a purchase. The show room interior costs 600,000.00 EUR. EDENVALE AG acquires the equipment but does not yet pay the 600,000.00 EUR. The show room equipment qualifies as item of property, plant and equipment. It is recognised under P, P, E. As EDENVALE AG agrees to pay the price later, the amount it owes the seller is a short-term liability; it is due in a few days. The supplier does not charge interest. Check the balance sheet in Figure 8.4. <?page no="103"?> Berkau: Basics of Accounting 6e 8-103 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 92,000.00 Interest bear liab 200,000.00 A/ R A/ P 692,000.00 Prepaid expenses Provisions Cash/ Bank 700,000.00 Tax liabilities 1,392,000.00 1,392,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 4.03.20X3 Figure 8.4: EDENVALE AG’s statement of financial position 8.9 Activity 5: Payment of Debts On 18.03.20X3, EDENVALE AG pays the seller of the show room equipment 600,000.00 EUR by bank transfer. The payment reduces EDENVALE AG’s cash/ bank and its short-term liabilities. Observe the changes in Figure 8.5. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 92,000.00 Interest bear liab 200,000.00 A/ R A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 792,000.00 792,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 18.03.20X3 Figure 8.5: EDENVALE AG’s statement of financial position 8.10 Activity 6: Selling Goods On 16.05.20X3, EDENVALE AG sells 100 lawn mowers at 230.00 EUR/ u. To keep the case simple, the company sells them at the same price it paid itself. This way, no profit is earned. <?page no="104"?> Berkau: Basics of Accounting 6e 8-104 All customers buy the lawn mowers on credit. Therefore, they owe EDENVALE AG: 100 × 230 = 223,000.00 EUR. Shortterm claims are recorded as receivables. The item on the balance sheet is called accounts receivables (A/ R). The item got the same structure as payables. The accounts are personalised too. The ledger of receivables is called sales ledger and the business partners owing are referred to as debtors. As with the payables, the receivables are only disclosed as a total. We see the sum of what a company expects to receive. (If a debtor becomes incapable of paying its debts a company must dissolve its claims- we say it is recording bed debts which represents an expense.) As the customers of EDENVALE AG agreed to pay for the lawn mowers within a few days, the amount is recorded as receivables. The total value of receivables is disclosed under accounts receivables (A/ R) on the balance sheet. At the same time, the delivered lawn mowers must be released from stock which causes an inventory decrease. The new inventory valuation is: 92,000 - 23,000 = 6 69,000.00 EUR. See both changes on the balance sheet made with the sale of 100 lawn mowers in Figure 8.6. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 69,000.00 Interest bear liab 200,000.00 A/ R 23,000.00 A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 792,000.00 792,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 16.05.20X3 Figure 8.6: EDENVALE AG’s statement of financial position 8.11 Activity 7: Receipts from Customers A receipt is an increase of cash/ bank by taking a payment from a third party. EDENVALE AG’s customers pay for their lawn mowers 23,000.00 EUR (together) on 9.06.20X3. The receipts are deleted from receivables, and the increase of money received is recorded as increase of the item cash/ bank on the balance sheet. Both changes are amounting to 23,000.00 EUR. Observe the balance sheet in Figure 8.7. <?page no="105"?> Berkau: Basics of Accounting 6e 8-105 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 69,000.00 Interest bear liab 200,000.00 A/ R 0.00 A/ P 92,000.00 Prepaid expenses Provisions Cash/ Bank 123,000.00 Tax liabilities 792,000.00 792,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 9.06.20X3 Figure 8.7: EDENVALE AG’s statement of financial position 8.12 Activity 8: Payment for Debts A payment is to give money or transfer money into someone's account. On 11.06.20X3, EDENVALE AG pays the money owing its supplier for lawn mowers by bank transfer. This activity reduces cash/ bank by 92,000.00 EUR, because money is taken out of the bank account. The payment retires the debts. After paying, the remaining amount in cash/ bank equals: 123,000 - 92,000 = 31,000.00 EUR. The short-term liabilities completely have been paid-off. The remainder is zero. Check the balance sheet in Figure 8.8. <?page no="106"?> Berkau: Basics of Accounting 6e 8-106 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 69,000.00 Interest bear liab 200,000.00 A/ R 0.00 A/ P 0.00 Prepaid expenses Provisions Cash/ Bank 31,000.00 Tax liabilities 700,000.00 700,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 11.06.20X3 Figure 8.8: EDENVALE AG’s statement of financial position 8.13 Effects of the Activities The activities at EDENVALE AG affected assets and capital/ liabilities as below: Activity 1 increases cash/ bank and increases issued capital. Activity 2 increases inventory and increases payables. Activity 3 increases cash/ bank and increases interest bearing liabilities. Activity 4 increases property, plant and equipment and increases payables. Activity 5 decreases cash/ bank and decreases payables. Activity 6 decreases inventory and increases receivables. Activity 7 decreases receivables and increases cash/ bank. Activity 8 decreases cash/ bank and decreases payables. The following rule applies: If the activities affect items on the same side of the balance sheet, one item will increase and the other one decreases. The total of the changes will be zero. If the activities effect items on both sides of the balance sheet, both items will decrease or both items will increase. This will change the total of the balance sheet. Check the exhibits in this chapter. You will notice, that at any time of the case study the Accounting equation is fulfilled, e.g., after the acquisition of equipment in Figure 8.4: Assets = 1,392,000 = equity plus liabilities = 500,000 + 892,000 = 1,392,000.00 EUR. 8.14 Summary Activities that change assets and capital/ liabilities, cause changes on items of both sides of the balance sheet. Increases of an asset are combined to an increase of capital/ liability or a decrease of another asset and vice versa. After each activity, the Accounting equation must be fulfilled. <?page no="107"?> Berkau: Basics of Accounting 6e 8-107 8.15 Working Definitions Acquisition: An Acquisition is buying a non-current asset. Creditor: A business partner lending the company money is a creditor. Par value issue: A share issue is par value if funds received equals the nominal values. Payment: A payment is to give money or transfer money into someone's account. Purchase/ Sale on Credit: A purchase or sale on credit means the connected payment or receipt of cash takes place in the next Accounting period. Receipt: A receipt is an increase of cash/ bank by taking a payment from a third party. Recognition: Recognition means to put something on the balance sheet. Acquisition: Acquisition is buying an asset that is recognised as a non-current one. 8.16 Question Bank (1) A company borrows 10,000.00 EUR from the bank. How does the loan change its balance sheet? 1. Cash/ bank increases 10,000.00 EUR; accounts payables increase 10,000.00 EUR. 2. Cash/ bank increases 10,000.00 EUR; interest bearing liabilities increase 10,000.00 EUR. 3. Cash/ bank decreases 10,000.00 EUR; interest bearing liabilities increase 10,000.00 EUR. 4. Cash/ bank increases 10,000.00 EUR; accounts payables decrease 10,000.00 EUR. (2) What items change on the balance sheet when a company pays its debts to suppliers? 1. Interest bearing liabilities, accounts payables. 2. Accounts receivables, cash/ bank. 3. Accounts payables, cash/ bank. 4. Retained earnings, cash/ bank. (3) Which are changes on the balance sheet when a company issues shares? 1. Issued capital decreases, cash/ bank increases. 2. Issued capital increases, cash/ bank decreases. 3. Issued capital decreases, cash/ bank decreases. 4. Issued capital increases, cash/ bank increases. (4) Which statement is wrong? 1. When a company pays its debts cash decreases. 2. When a company sells goods cash/ bank decreases. 3. When a company takes a loan, cash/ bank increases. 4. When a company buys items of property, plant, equipment, cash/ bank decreases. (5) A company buys goods for 5,000.00 EUR and pays half on cash and half by bank transfer. Which is the correct Bookkeeping entry. 1. DR INV 5,000.00 EUR; CR C/ B 2,500.00 EUR; CR A/ P 2,500.00 EUR. 2. DR INV 5,000.00 EUR; CR C/ B 2,500.00 EUR; CR A/ P 2,500.00 EUR. <?page no="108"?> Berkau: Basics of Accounting 6e 8-108 3. DR INV 5,000.00 EUR; CR C/ B 2,500.00 EUR; CR A/ P 2,500.00 EUR. 4. DR INV 5,000.00 EUR; CR C/ B 2,500.00 EUR; CR A/ P 2,500.00 EUR. 8.17 Solutions 1-2; 2-3; 3-4; 4-2; 5-1. <?page no="109"?> Berkau: Basics of Accounting 6e 9-109 9 Profit and Loss Activities 9.1 What is in the Chapter? In this chapter, we continue the series of case studies changing the items on the balance sheet. Now, we add the statement of profit or loss (income statement). This enables us to determine whether a company is earning money from its operations. We learn about the connection between the balance sheet and the income statement. 9.2 Learning Objectives You learn how to prepare a balance sheet for a company that is earning a profit or loss. You get familiarised with activities that determine the profitability. You also understand how a profit (loss) affects the equity section on the balance sheet. 9.3 Profit Calculation An income statement tells us whether a company earns profit or makes a loss. The profit is the difference between income and expenses if positive; otherwise, it is a loss. Income can be a revenue or a gain. Revenues is the compensation received for goods/ services sold. Revenue is linked to the core business of a company. In contrast, extraordinary income is referred to as a gain. E.g., a gain is what is received for selling a non-current asset. We call that kind of gain a profit on disposal. The income statement shows the total of all income (revenue and gains) and deducts all expenses. An expense is recorded when resources are used, like a materials consumption which is called material expenses - or quite often just materials. Typical resources used for business operations are labour, rent and assets (as depreciation). Quite often we refer to operational expenses in case studies or exercises to aggregate expenses and reduce the complexity of the case. On the income statement the profit is calculated by a simple equation: Income less expenses give the profit (if positive) or the loss (if negative). The main purpose of running a business is to earn profit. The profit is transferred from the income statement to the equity section of the balance sheet. This way, a profit increases a company's book value. A loss has the opposite effect: it decreases equity. Hence, the company's value shrinks by a loss. 9.4 C/ S RIVERGATE (Pty) Ltd. RIVERGATE (Pty) Ltd. is a company established on 3.01.20X3. The owners contribute 25,000.00 AUD at the time of founding. In the first Accounting period, RIVERGATE (Pty) Ltd. earns a profit of 10,000.00 AUD. The profit is allocated to the retained earnings. This way, the total of RIVERGATE (Pty) Ltd.'s equity increases and is 35,000.00 AUD at the end of 20X3. In the next year, RIVERGATE (Pty) Ltd. makes a loss of 2,000.00 AUD. The loss is recorded as decrease of retained earnings. The total of equity is now 33,000.00 AUD which is the company's book value. We can say, all revenues (and gains) contribute to the profitability of the <?page no="110"?> Berkau: Basics of Accounting 6e 9-110 company. Expenses decrease it; they are linked to a consumption of resources. The above distinction can help us to determine whether an activity is profit relevant. E.g., a car glass repair shop purchases 1,000 windshields. Is this an expense? No, it is not as the windshields are not consumed. The purchase is just an asset swop. It does not change profit or loss. Next, the car glass repair shop replaces 300 windshields. The windshields are released from stock and consumed by service rendering. Is this an expense? Yes, it is as resources (windshields) are used and the total value of windshields on stock decreases. The windshield consumption is an expense which we must deduct from revenues to calculate the profit of the windshield replacement service. 9.5 Taxable Profit When a company earns profit, it must pay income taxes. Income taxes are taxes levied based on the profit (before taxes). In this textbook we simplify income tax calculations. We replace the income tax calculations by a formula: Income tax is 30 % of the profit before tax. A loss is not taxable. The income taxes show on the income statement as an expense. After deduction of expenses from revenue/ gains, we arrive at the pre-tax profit (earnings before taxation EBT). We then multiply the pre-tax profit by 30 % to calculate the total income tax expenses. Income taxes are deducted from EBT. The remainder gives the earnings after taxes EAT (annual surplus). In a real business case, we let the tax professionals do the income tax calculation. In Accounting there is a difference between expenses and payments. An expense is based on the consumption of resources. A payment is an outflow of money. As shown above, a purchase of materials without consumption leads to a payment but not to an expense. Payments are recorded in the statement of cash flows, see chapter (32) and chapter (10) in the textbook Bilanzen/ Financial Statements. 9.6 Retained Earnings Next, we go through activities linked to revenues and expenses to demonstrate their effects on profit calculations. Thereafter, we transfer the profit to the equity section of the balance sheet (statement of financial position). The item on the balance sheet where we add profit or loss from the income statement to is retained earnings. A profit increases the owners’ equity, because it is credited to retained earnings. A loss is a reduction of equity and must be debited to retained earnings. Retained earnings connect the balance sheet with the income statement. When making a loss, the retained earnings decrease and can even become negative. We study the business activities of the hairdresser salon PELZERHAGEN (Pty.) Ltd.: 9.7 C/ S PELZERHAGEN (Pty) Ltd. PELZERHAGEN (Pty) Ltd. is established on 2.01.20X7 in Melbourne, Australia. <?page no="111"?> Berkau: Basics of Accounting 6e 9-111 The company is a hairdresser salon. The company offers haircuts and receives the money from its customers on cash only. When establishing the company, PELZERHAGEN (Pty) Ltd.’s owners contribute 100,000.00 AUD (all together) and pay it into the company’s bank account at Commonwealth Bank of Australia. Look at the balance sheet in Figure 9.1: A C, L Non-current assets [AUD] Equity [AUD] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 100,000.00 100,000.00 Pelzerhagen (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 9.1: PELZERHAGEN (Pty) Ltd.’s statement of financial position Below, we study the activities below: - Activity 1: payment for rent. - Activity 2: paying for labour. - Activity 3: acquisition of equipment on credit followed by depreciation. - Activity 4: rendering service and cash receipt. 9.8 Activity 1: Payment for Rent PELZERHAGEN (Pty) Ltd. rents a shop in a shopping mall and pays 3,400.00 AUD rent by bank transfer on 2.01.20X7 for the whole year. This payment changes PELZERHAGEN (Pty) Ltd.’s income statement (rent) and the asset side on its balance sheet (cash/ bank). Rent is an expense. After rent is paid, cash/ bank is 3,400.00 AUD less. Cash/ bank now is amounting to: 100,000 - 3,400 = 96,600.00 AUD. On the income statement, rent shows under “other expenses” and is disclosed at 3,400.00 AUD. It is common practice to combine some minor expenses on the income statement. Instead of showing all single expenses separately, companies reduce complexity and avoid revealing details about their costs. <?page no="112"?> Berkau: Basics of Accounting 6e 9-112 [AUD] Revenue Other income 0.00 Materials Labour Depreciation Other expenses (3,400.00) Earnings before int and taxes (EBIT) (3,400.00) Interest Earnings before taxes (EBT) (3,400.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (3,400.00) Pelzerhagen (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 9.2: PELZERHAGEN (Pty) Ltd.’s income statement We look at PELZERHAGEN (Pty) Ltd.’s statement of financial position. It contains the activity recorded on 2.01.20X7. However, the statement shows the date 31.12.20X7, because disclosure of financial statements is required at yearends. Therefore, all activities are recorded on the income statement as at the balance sheet date. We show expenses as negative figures on the statement of profit or loss. A C, L Non-current assets [AUD] Equity [AUD] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings (3,400.00) Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 96,600.00 Tax liabilities 96,600.00 96,600.00 Pelzerhagen (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 9.3: PELZERHAGEN (Pty) Ltd.’s statement of financial position <?page no="113"?> Berkau: Basics of Accounting 6e 9-113 The value for retained earnings is negative, because at this stage PELZERHAGEN (Pty) Ltd. only is recording one expense. Until revenue is recorded, the expenses on the income statement result in a loss. As losses reduce retained earnings, we disclose a loss caused by recognition of rent (only). Note, you must consider that we prepare for teaching reasons an income statement after each business activity. Normally, the income statement is prepared on 31.12.20XX only. At that time, all revenues and expenses are known and are considered. Hence, a single recording of expenses does not apply. 9.9 Activity 2: Payment for Labour PELZERHAGEN (Pty) Ltd. pays the salary for its hairdressers to the extent of 48,000.00 AUD per bank transfer on 30.06.20X7. To keep the case simple, we pretend the payment occurs in the middle of the year. The 48,000.00 AUD are taken from cash/ bank and are expenses at the same time. On the statement of financial position, cash/ bank now equals: 96,600 - 48,000 = 4 48,600.00 AUD. On the income statement we show labour: 48,000.00 AUD. Observe the income statement in Figure 9.4. [AUD] Revenue Other income 0.00 Materials Labour (48,000.00) Depreciation Other expenses (3,400.00) Earnings before int and taxes (EBIT) (51,400.00) Interest Earnings before taxes (EBT) (51,400.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (51,400.00) Pelzerhagen (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 9.4: PELZERHAGEN (Pty) Ltd.’s income statement Check the statement of financial position, too. The temporary loss to the extent of 51,400.00 AUD is disclosed under retained earnings. The value of the item cash/ bank shows the actual value of 48,600.00 AUD because the expenses have been paid for. <?page no="114"?> Berkau: Basics of Accounting 6e 9-114 A C, L Non-current assets [AUD] Equity [AUD] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings (51,400.00) Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 48,600.00 Tax liabilities 48,600.00 48,600.00 Pelzerhagen (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 9.5: PELZERHAGEN (Pty) Ltd.’s statement of financial position 9.10 Activity 3: Acquisition on Credit Followed by Depreciation On 3.01.20X7, PELZERHAGEN (Pty) Ltd. buys salon appliances, like chairs, hair dryer, washing machine etc. at a total cost of acquisition of 50,000.00 AUD. The supplier agrees on a payment in the next year. The balance sheet discloses under property, plant and equipment the total value of the appliances and on its credit side a short-term liability to the same extend. The acquisition is not relevant for profit. However, the deployment of the tools gives an expense called depreciation: Depreciation reflects the loss in valuation of assets when deployed. The appliances at PELZERHAGEN (Pty) Ltd. can be used for the next 5 Accounting periods. Instead of recording the cost of acquisition at the time of purchase, Accountants spread the costs for noncurrent assets over their useful life. Depreciation on the hairdressers' appliances is recorded as 5 equal portions of the cost of acquisition: 50,000 / 5 = 10,000.00 AUD/ a. The company discloses depreciation as an expense on the statement of comprehensive income as at 31.12.20X7 - observe below. <?page no="115"?> Berkau: Basics of Accounting 6e 9-115 [AUD] Revenue Other income 0.00 Materials Labour (48,000.00) Depreciation (10,000.00) Other expenses (3,400.00) Earnings before int and taxes (EBIT) (61,400.00) Interest Earnings before taxes (EBT) (61,400.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (61,400.00) Pelzerhagen (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 9.6: PELZERHAGEN (Pty) Ltd.’s income statement In the temporary statement of financial position, P, P, E is recognised at the cost of acquisition less (accumulated) depreciation, which gives: 50,000 - 10,000 = 40,000.00 AUD. PELZERHAGEN (Pty) Ltd. bought its equipment on credit, therefore, payables of 50,000.00 AUD are shown on the balance sheet. Note, that depreciation leads to a difference of payments and expenses. Here, the total payment is recorded in 20X8. Five equal portions of depreciation are disclosed as expenses for 20X7, 20X8, 20X9, 20Y0, 20Y1 on the income statement. A C, L Non-current assets [AUD] Equity [AUD] P, P, E 40,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings (61,400.00) Current assets Liabilities Inventory Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 48,600.00 Tax liabilities 88,600.00 88,600.00 Pelzerhagen (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 9.7: PELZERHAGEN (Pty) Ltd.’s statement of financial position <?page no="116"?> Berkau: Basics of Accounting 6e 9-116 9.11 Activity 4: Rendering Service and Cash Receipt PELZERHAGEN (Pty) Ltd. renders services (haircuts) and earns 130,000.00 AUD in revenues. We pretend this activity occurs on 31.12.20X7 to simplify the case. All customers pay on cash at the time of service. The value of cash/ bank on the balance sheet increases by the receipts. The final value is: 48,600 + 130,000 = 1 178,600.00 AUD. The revenues are shown on the first line of the income statement. Now, the income statement discloses all activities. However, we must calculate income taxes as the pre-tax profit at PELZERHAGEN (Pty) Ltd. is positive. 9.12 Income Tax Calculation The income statement shows income tax expenses. Income taxes are paid proportionally to profits. The total income tax rate is 30 %. Hence PELZERHAGEN (Pty) Ltd. must pay the Australian revenue service: 30% × 68,600 = 2 20,580.00 AUD income taxes. The payment is due in the next Accounting period (textbook conventions). Hence, PELZERHAGEN (Pty) Ltd. recognises a liability for income taxes to the extent of 20,580.00 AUD on its balance sheet in accordance with IAS 12. In contrast, a German company must record a provision in compliance with § 249 HGB. [AUD] Revenue 130,000.00 Other income 130,000.00 Materials Labour 48,000.00 Depreciation 10,000.00 Other expenses 3,400.00 Earnings before int and taxes (EBIT) 68,600.00 Interest Earnings before taxes (EBT) 68,600.00 Income tax expenses 20,580.00 Deferred taxes Earnings after taxes (EAT) 48,020.00 Pelzerhagen (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 9.8: PELZERHAGEN (Pty) Ltd.’s income statement The profit earned increases PELZERHAGEN (Pty) Ltd.'s equity. It is <?page no="117"?> Berkau: Basics of Accounting 6e 9-117 transferred to retained earnings. This results in an increase of PELZERHAGEN (Pty) Ltd.’s book value. Observe the final statement of financial position for PELZERHAGEN (Pty) Ltd. in Figure 9.9. The value for the property, plant, equipment therein is the cost of acquisition less depreciation for the appliances: 50,000 - 10,000 = 4 40,000.00 AUD. The cash/ bank item equals: 100,000 - 3,400 - 48,000 + 130,000 = 1 178,600.00 AUD. The profit comes from the income statement and is 48,020.00 AUD. The payables result from the amount owing the supplier of the appliances. A C, L Non-current assets [AUD] Equity [AUD] P, P, E 40,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings 48,020.00 Current assets Liabilities Inventory Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 178,600.00 Tax liabilities 20,580.00 218,600.00 218,600.00 Pelzerhagen (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 9.9: PELZERHAGEN (Pty) Ltd.’s statement of financial position 9.13 Summary Activities that affect profit/ loss of a business are shown on the statement of profit or loss and other comprehensive income. The difference between revenue/ gains and expenses is called profit. A negative profit is a loss. Income taxes are based on the pre-tax profit and are calculated in this textbook applying a constant income tax rate of 30 % to keep cases as simple as possible. Losses are income tax-free. The earnings after taxes (EAT) are transferred to retained earnings and increase the equity on the balance sheet if positive. The equity of the balance sheet represents the book value of the business. 9.14 Working Definitions Gain: Extraordinary income is referred to as a gain. Income: Income can be revenue or gain. Income Tax: Income taxes are taxes levied based on the profit (before taxes). Profit: The profit is the difference between income and expenses if positive; otherwise, it is a loss. <?page no="118"?> Berkau: Basics of Accounting 6e 9-118 Retained Earnings: The item on the balance sheet where we add profit or loss from the income statement to is retained earnings. 9.15 Question Bank (1) Which are items on the income statement? 1. Inventories, materials, depreciation. 2. Rent, receivables, depreciation. 3. Revenue, materials, depreciation. 4. Income tax liabilities, materials, depreciation. (2) A company buys an item of property, plant, equipment at 80,000.00 EUR and depreciates it over 4 years following straight-line method. What are the changes on the financial statements? 1. Property, plant, equipment decreases 20,000.00 EUR and retained earnings decreases 20,000.00 EUR. 2. Property, plant, equipment decreases 60,000.00 EUR; cash/ bank increases 80,000.00 EUR and retained earnings decreases 20,000.00 EUR. 3. Property, plant, equipment increases 60,000.00 EUR; cash/ bank decreases 80,000.00 EUR and retained earnings decreases 20,000.00 EUR. 4. Property, plant, equipment increases 20,000.00 EUR and retained earnings decreases 20,000.00 EUR. (3) A company records a revenue 100,000.00 EUR and expenses to the extent of 70,000.00 EUR. How does it disclose income taxes on the income statement? 1. Positive entry of 9,000.00 EUR under income tax liabilities. 2. Negative entry of 30,000.00 EUR under income tax expenses. 3. Negative entry of 9,000.00 EUR under deferred taxes. 4. Negative entry of 9,000.00 EUR under income tax expenses. (4) What are the changes on the balance sheet if a company pays for labour? 1. Reduction of cash/ bank and retained earnings. 2. Labour increases and profit decreases. 3. Increase of liabilities and decrease of profit. 4. Nothing. (5) A company discloses a revenue of 56,000.00 EUR, 20,000.00 EUR for labour and 12,000.00 EUR for rent. How much is the profit after taxes? 1. 56,000.00 EUR . 2. 24,000.00 EUR . 3. 16,800.00 EUR . 4. 22,400.00 EUR . 9.16 Solutions 1-3; 2-3; 3-4; 4-1; 5-3. <?page no="119"?> Berkau: Basics of Accounting 6e 10-119 10 Introduction to T-Accounts for Items on the Balance Sheet 10.1 What is in the Chapter? So far, we discussed how to prepare financial statements after each business activities. However, this procedure is very inconvenient and prone to errors as every balance sheet and income statement is based on its preceding one. Furthermore, preparing financial statements after each business activity might work out in an academic environment but is not suitable for real business Accounting as the workload becomes too high. In this chapter, we simply replace the formulas behind our MS-Excel items for balance sheet and income statement by accounts. We discuss different type of accounts and how to derive financial statements therefrom. 10.2 Learning Objectives After studying this chapter, Accounting work becomes much easier for you. You understand the concept of using accounts for the preparation of financial statements. You will learn to make entries in accounts and to balance and to close them off. Furthermore, you see how the accounts are interlinked with the financial statements. The chapter teaches the double entry system in Accounting. You get familiarised with T-accounts and you can record standard business activities for Accounting. 10.3 Overview We call all accounts and the entries therein our Bookkeeping records. For our Accounting work, we must prepare for each asset item, equity item, liabilities, revenue/ gain and expense an account. In this account we record all additions and deductions of the item's value. In a T-account all additions are made on one side and all deductions are recorded on the opposite side. The left-hand side is called the debit side; the right-hand side is the credit side. The account helps us to record the changes in value of those items on the balance sheet or income statement the account is assigned to. In the previous chapter, we discussed the case study PELZERHAGEN (Pty) Ltd., a hairdresser salon in Australia. Its final value of cash/ bank on the balance sheet in Figure 9.9 is 178,600.00 AUD. It was calculated in MS-Excel as: "=100,000 - 3,400 - 48,000 + 130,000" which gives 178,600.00 AUD. In an account, we calculate the same. We only enter in the Cash/ Bank account the opening amount (here: 100,000.00 AUD) and additions thereto (here: 130,000.00 AUD) on the debit side and write deductions (here: 3,400.00 AUD and 48,000.00 AUD) on the credit side. See PELZERHAGEN (Pty) Ltd.'s Cash/ Bank account in Figure 10.1: <?page no="120"?> Berkau: Basics of Accounting 6e 10-120 D C OV 100,000.00 (1) 3,400.00 (4) 130,000.00 (2) 48,000.00 Cash/ Bank C/ B Figure 10.1: PELZERHAGEN (Pty) Ltd.'s Cash/ Bank account The figures left to the amounts indicate the business activities. (1) is the payment of rent; (2) is paying for labour and (4) stands for rendering service and cash receipt. On the upper part of the account, we notice a "D" and a "C" which indicates the debit side and the credit side, respectively. The debit side is the lefthand side of an account. The credit side is the right-hand side of an account. The name of the account is Cash/ Bank with the 3-letter code for reference as used in this textbook C/ B. Note, in the text we write the account names with capital letters to drag your attention thereto. For the question bank, we use the 3-letter-codes. At the end of every Accounting period, we calculate the final values of all accounts and copy them to the financial statements. E.g., the final value of PELZERHAGEN (Pty) Ltd.’s Cash/ Bank account 178,600.00 AUD is disclosed on the balance sheet as cash/ bank item, see Figure 9.9. This way, the accounts are connected to the items on the financial statements. 10.4 T-Accounts We introduce T-accounts because they give us an idea of where entries are made on the balance sheet. Like a balance sheet, the T-accounts have a debit side (left) and credit side (right). Where we must enter figures, depends on the item the account is representing. All asset accounts show the opening value and all increases on the debit side, whereas the opposite side (credit side) is for entries that reduce the account's value. The accounts for equity and liabilities are mirrored; record the opening value on the credit side as well as increases but debit deductions. Every account carries a name shown on the top of the “T”. In general, names are linked to ID numbers. A chart of accounts is a list of all names and IDs for the accounts in use or to be used. A standard chart of accounts forces companies to apply the same account names and IDs. Companies that belong to a group, apply the same chart of accounts to support a later aggregation of their financial statements. Another advantage for the application of a chart of accounts lays in working together with a tax attorney for preparing financial statements. The statements are later transmitted to the revenue service through a standard interface. In Germany, the DATEV chart of accounts applies for financial statements for taxation. For teaching purposes, we do not apply standard charts of accounts. We just allocate one account to each item on the balance sheet and each item on <?page no="121"?> Berkau: Basics of Accounting 6e 10-121 the income statement. That becomes our simplified training-chart of accounts. There is a P, P, E account, an Intangible Asset account, a Financial Instrument account, an Inventory account etc. The account’s name Error! Reference source not found.in Figure 10.1 is Cash/ Bank C/ B. This account is linked to the item cash/ bank on the balance sheet. In chapter (16) we learn that multiple accounts can be linked to one item on the financial statements. E.g., when a company banks with various banks, e.g., with Sparkasse Osnabrück, Commerzbank etc. As a result, all accounts’ balancing figures are added to calculate the value for cash/ bank on the balance sheet. A balancing figure is the residual value of an account. It is the difference between entries on the debit and on the credit side. 10.5 Balancing-off At the end of the Accounting period, we must, e.g., determine how much money is in PELZERHAGEN (Pty) Ltd.’s Cash/ Bank account. We name the final value of the account its balancing figure. Here, it is amounting to 178,600.00 AUD. To balance-off an account means to calculate the balancing figure of an account. A balancing-off does not change the valuation of an account. The procedure is neutral regarding the figures. We can balance-off an account at any time and as often as necessary. The account’s value does not change, as for balancing-off we make a debit entry and a corresponding credit entry in the same account to the same value. Technically, these 2 entries cancel out one another. When we balance-off the Cash/ Bank account at PELZERHAGEN (Pty) Ltd., we insert its balancing figure (here: 178,600.00 AUD) on the credit side under the reference “balance carried down“, “Bal c/ d“ or just “c/ d“. By that entry, the sum on both sides become the same. Before balancingoff the Cash/ Bank account, its total on the debit side is: 100,000 + 130,000 = 230,000.00 AUD. The total on the credit side was: 3,400 + 48,000 = 51,400.00 AUD. We say the credit side is "shorter". Next, we add the balancing figure to the shorter side of the account which is here the credit side. Now, the sums on both sides equal: 100,000 + 130,000 = 230,000.00 AUD as well as: 3,400 + 48,000 + 178,600 = 230,000.00 AUD. By inserting the balance carried down on the credit side, we violated the Accounting equation. Further action must be taken. We enter the same amount of 178,600.00 AUD on the debit side. We indicate the second entry “balance brought down”, “Bal b/ d” of just “b/ d”. Now the Accounting equation is fulfilled again. Check the balancing-off procedure in Figure 10.2 below: <?page no="122"?> Berkau: Basics of Accounting 6e 10-122 D C OV 100,000.00 (1) 3,400.00 (4) 130,000.00 (2) 48,000.00 c/ d 178,600.00 230,000.00 230,000.00 b/ d 178,600.00 Cash/ Bank C/ B Figure 10.2: PELZERHAGEN (Pty) Ltd.’s Cash/ Bank account (2) In Figure 10.2, the balance brought down is recorded on the debit side. This means the final value of cash/ bank is positive. Accountants call accounts with the balancing figure on the debit side debit-balanced and accounts with the balance brought down on the credit side credit balanced. In general, expect accounts connected to the asset side of the balance sheet debit-balanced and accounts for equity and liabilities to be credit-balanced. It reflects positive values. However, an Accounts Receivables A/ R accounts can be credit balanced if, e.g., the reporting company grants its debtor a voucher. On the balance sheet, we only accept positive amounts, the items retained earnings and deferred tax liabilities are exempted. If the Cash/ Bank account is credit balanced, the company is owing, and the amount must be disclosed as a liability. Then, cash/ bank on the balance sheet becomes zero and the accounts payables (A/ P) show the liability resulting from the bank account's overdraft. How it is Done (Balancing-off an Account): (1) Check whether your account is a (a) real or (b) nominal account. (2a) If the account is a real account, that belongs to the debit side of the balance sheet, make Bookkeeping entries for increases on the debit side and Bookkeeping entries for decreases on the credit side. If the account is a real account on the credit side of the balance sheet, make Bookkeeping entries for increases on the credit side and Bookkeeping entries for decreases on the debit side. (2b) If the account is a nominal account, make Bookkeeping entries for revenues on the credit side and Bookkeeping entries for expenses on the debit side. (3) Add up both sides of the account. (4) Insert a figure on the “shorter” side in order to make the sums on the debit side and on the credit side equal. (5) Name the inserted figure balance carried down and indicate this in the account by “Bal c/ d” or only “c/ d”. <?page no="123"?> Berkau: Basics of Accounting 6e 10-123 (6) Write under the figures of the Bookkeeping entries and the balance carried down the sums. Double underline the totals. (7) Transfer the amount of the balance carried down to the opposite side. If the balance carried down is on the debit side, make an entry underneath the sum on the credit side. If the balance carried down is on the credit side, make an entry underneath the sum on the debit side. (8) Name the entry of step (7) balance brought down and indicate the figure by “Bal b/ d” or “b/ d”. 10.6 Real and Nominal Accounts All accounts connected to the balance sheet are called real accounts. Accounts linked to the income statement are called nominal accounts. The latter ones can be regarded as subordinated accounts to retained earnings. The Retained Earnings (R/ E) account is assigned to the credit side. Hence, increases of equity indicate the company earns a profit that will increases the book value of the business; decreases of retained earnings indicate a loss. In this textbook we add the Accounting period to the name of nominal accounts, like “Labour-20X3 LAB”. This prevents us from making entries in accounts assigned to wrong Accounting periods. We discuss those aspects in chapter (18). 10.7 Basics-Chart of Accounts Our chart of accounts for training purposes contains the below listed accounts: (1)Property, plant and equipment PPE (2) Intangible Assets INA (3) Financial assets FAS (4) Inventory INV (5) Accounts receivables A/ R (6) Prepaid expenses PRE (7) Cash/ Bank C/ B (8) Issued capital ISS (9) Reserves RES (10) Retained earnings R/ E (11) Interest bearing liabilities IBL (12) Accounts payables A/ P (13) Value added tax VAT (14) Provisions PRO (15) Tax liabilities ITL (16) Revenue REV (17) Other income OTH (18) Materials MAT (19) Labour LAB (20) Depreciation DPR (21) Operational Expenses OEX (22) Other expenses OTE (23) Interest INT (24) Income tax expenses ITE (25) Deferred tax expenses DTE In next following chapters, we will assign more accounts to items on financial statements, which results in a structure of superior and subordinated accounts. A superior account is referred to as reconciliation account and is linked directly to the item on the financial statements. Chapter (16) is dedicated to reconciliation accounts. All accounts based on the chart of accounts define the general ledger. A general ledger contains the basic <?page no="124"?> Berkau: Basics of Accounting 6e 10-124 accounts without subordinated accounts. 10.8 Applying T-Accounts for ROHRBACH Ltd. Next, we make all entries for ROHRBACH Ltd. as discussed in chapter (6): ROHRBACH Ltd. has the below listed asset accounts in use: - Property, plant and equipment, PPE. - Inventory INV - Cash/ Bank C/ B An asset account is an account which records the values for an asset item on the balance sheet. We prepare ROHRBACH Ltd.’s accounts and record the opening value of 250,000.00 EUR in the Cash/ Bank account. Note, as the case study focusses on the asset side of the balance sheet we greyout the Issued Capital account for now. D C D C D C D C OV 250,000.00 OV 250,000.00 Cash/ Bank C/ B Issued capital ISS Property, Plant, Equipment PPE Inventory INV Figure 10.3: ROHRBACH Ltd.‘s accounts The activities are as follows: (1) Purchase of 1,000 smart phones and payment by bank transfer of 150,000.00 EUR on 3.01.20X5. (2) Acquisition of 4 shelves at 4,700.00 EUR and payment thereof on 6.02.20X5. (3) Sale of 67 phones and receiving money 10,050.00 EUR on 8.02.20X5. (4) Disposal of 2 shelves on 22.03.20X5. The money obtained is amounting to 2,350.00 EUR. Note, the shelves are sold at the same price as they have been bought at. In chapter (6) we avoided the consideration of profits due to learning purposes. For making entries in accounts, it is widely common to record the date and the relevant contra account(s). This information is called narrative. A contra account is the account in which the Bookkeeping entries of the same business activity are recorded in, but on the opposite side. Regarding activity (1), ROHRBACH Ltd. makes an entry in the Inventory account and the Cash/ Bank account. Hence, the Cash/ Bank account is the contra account for the Inventory account and vice versa. The accounts look as displayed in Figure 10.4: <?page no="125"?> Berkau: Basics of Accounting 6e 10-125 D C Cash/ Bank 6.02.20X5 4,700.00 Cash/ Bank 22.03.20X5 2,350.00 Bal c/ d 31.12.20X5 2,350.00 4,700.00 4,700.00 Bal b/ d 1.01.20X6 2,350.00 D C Cash/ Bank 3.01.20X5 150,000.00 Cash/ Bank 8.02.20X5 10,050.00 Bal c/ d 31.12.20X5 139,950.00 150,000.00 150,000.00 Bal b/ d 1.01.20X6 139,950.00 D C OV 1.01.20X5 250,000.00 Inventory 3.01.20X5 150,000.00 Inventory 8.02.20X5 10,050.00 P,P,E 6.02.20X5 4,700.00 P,P,E 22.03.20X5 2,350.00 Bal c/ d 31.12.20X5 107,700.00 262,400.00 262,400.00 Bal b/ d 1.01.20X6 107,700.00 Inventory Cash/ Bank P,P,E Figure 10.4: ROHRBACH Ltd.’s accounts We simplify the accounts’ display. Our Bookkeeping entries only show a Bookkeeping number, here: (1) ... (4). The Bookkeeping entry’s date is listed in the journal or in the text. No need to write that into the accounts. Same applies for the contra account(s). The accounts appear much easier that way! A journal is a list of all Bookkeeping entries which also includes the narrative . It is useful to keep an overview over Bookkeeping entries and helps to search certain entries. Check ROHRBACH Ltd.’s journal in Figure 10.5. Bookkeeping dates can differ from the time of transaction. Nr Amount Date Narrative DR CR (1) 150,000.00 3.01.20X5 Purchase of 1,000 smart phones and payment by bank transfer of 150,000.00 EUR on 3.01.20X5 Inventory Cash/ Bank (2) 4,700.00 6.02.20X5 Acquisition of 4 shelves at 4,700.00 EUR and payment thereof on 6.02.20X5 P, P, E Cash/ Bank (3) 10,050.00 8.02.20X5 Sales of 67 phones and receiving money 10,050.00 EUR on 8.02.20X5 Cash/ Bank Inventory (4) 2,350.00 22.03.20X5 Disposal of 2 shelves on 22.03.20X5. The money obtained amounts to 2,350.00 EUR Cash/ Bank P, P, E Rohrbach Ltd. JOURNAL 20X5 Figure 10.5: ROHRBACH Ltd.’s journal <?page no="126"?> Berkau: Basics of Accounting 6e 10-126 We simplify ROHRBACH Ltd.’s accounts and they then look as in Figure 10.6: D C D C (2) 4,700.00 (4) 2,350.00 (1) 150,000.00 (3) 10,050.00 c/ d 2,350.00 c/ d 139,950.00 4,700.00 4,700.00 150,000.00 150,000.00 b/ d 2,350.00 b/ d 139,950.00 Property, Plant, Equipment PPE Inventory INV D C D C OV 250,000.00 (1) 150,000.00 c/ d 250,000.00 OV 250,000.00 (3) 10,050.00 (2) 4,700.00 b/ d 250,000.00 (4) 2,350.00 c/ d 107,700.00 262,400.00 262,400.00 b/ d 107,700.00 Cash/ Bank C/ B Issued capital ISS Figure 10.6: ROHRBACH Ltd.’s accounts Note, no law prescribes how to make Bookkeeping entries. Comparing the balancing figures in ROHRBACH Ltd.’s accounts (check the balances brought down), you will find the same values as disclosed on its balance sheet in Figure 10.7. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 2,350.00 Issued capital 250,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 139,950.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 107,700.00 Tax liabilities 250,000.00 250,000.00 Rohrbach Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X5 Figure 10.7: ROHRBACH Ltd.’s statement of financial position (asset side) <?page no="127"?> Berkau: Basics of Accounting 6e 10-127 10.9 Applying T-Accounts for EDENVALE AG In contrast to ROHRBACH Ltd., EDENVALE AG applies equity and liability related accounts. For this case study, we introduce equity and liability accounts. Capital/ liability accounts are linked to equity or to liabilities; they show the opening values on the credit side. In comparison to asset accounts, these accounts appear mirrored. Equity and Liabilities accounts are real accounts as they are connected to items on the balance sheet. Therein, increases show on the credit side and decreases are recorded on their debit side. EDENVALE AG records 8 activities: (1) Share issue of 50,000 ordinary shares on 2.01.20X3. The issued shares amount to 500,000.00 EUR. (2) Purchase of 400 lawn mowers on credit 92,000.00 EUR on 15.02.20X3. (3) Taking a bank loan 200,000.00 EUR on 1.03.20X3. (4) On 4.03.20X3, EDENVALE buys a new show room interior at 600.000,00 EUR and agrees to pay later. (5) On 18.03.20X3, EDENVALE AG pays the amount due for the show room into the seller’s bank account. It is 600,000.00 EUR. (6) EDENVALE AG sells 100 lawn mowers on credit on 16.05.20X3. The amount is 23,000.00 EUR. (7) On 9.06.20X3, EDENVALE AG’s customers pay 23,000.00 EUR for the lawn mowers into the company’s bank account. (8) On 11.06.20X3, EDENVALE AG pays the amount of 92,000.00 EUR it owes the lawn mower supplier into his bank account. The accounts applied in the EDENVALE AG case study are: - Property, plant and equipment PPE - Inventory INV - Accounts receivables A/ R - Cash/ Bank C/ B - Issued capital ISS - Interest bearing liabilities IBL - Accounts payables A/ P Observe EDENVALE AG’s journal and the accounts with the entries therein in Figure 10.8 and 10.9 below. Note, that in the case of EDENVALE AG, the share issue at the time of incorporation counts as Bookkeeping entry (1). In general, we record the initial issue of shares as opening values if the incorporation took place in the preceding Accounting period. If the share issue falls into the first Accounting period, we count the Bookkeeping entry as the first one of the year. <?page no="128"?> Berkau: Basics of Accounting 6e 10-128 Nr Amount Date Narrative DR CR (1) 500,000.00 2.01.20X3 Share issue of 50,000 ordinary shares on 2.01.20X3. The issued shares amount to 500,000.00 EUR Cash/ Bank Issued Capital (2) 92,000.00 15.02.20X3 Purchase of 400 lawn mowers on credit 92,000.00 EUR on 15.02.20X3 Inventory A/ P (3) 200,000.00 1.03.20X3 Taking a bank loan 200,000.00 EUR on 1.03.20X3 Cash/ Bank IBL (4) 600,000.00 4.03.20X3 On 4.03.20X3, EDENVALE AG buys a new show room interior at 600.000,00 EUR and agrees to pay later P, P, E A/ P (5) 600,000.00 18.03.20X3 On 18.03.20X3, EDENVALE AG pays the amount due for the show room into the seller’s bank account. It is 600,000.00 EUR A/ P Cash/ Bank (6) 23,000.00 16.05.20X3 EDENVALE AG sells 100 lawn mowers on credit on 16.05.20X3. The amount is 23,000.00 EUR A/ R Inventory (7) 23,000.00 9.06.20X3 On 9.06.20X3, EDENVALE AG’s customers pay 23,000.00 EUR for the lawn mowers into the company’s bank account Cash/ Bank A/ R (8) 92,000.00 11.06.20X3 On 11.06.20X3, EDENVALE AG pays 92,000.00 EUR it owes the lawn mower supplier into his bank account A/ P Cash/ Bank Edenvale AG JOURNAL 20X3 Figure 10.8: EDENVALE AG’s journal D C D C (4) 600,000.00 c/ d 600,000.00 c/ d 500,000.00 (1) 500,000.00 b/ d 600,000.00 b/ d 500,000.00 D C D C (2) 92,000.00 (6) 23,000.00 c/ d 200,000.00 (3) 200,000.00 c/ d 69,000.00 b/ d 200,000.00 92,000.00 92,000.00 b/ d 69,000.00 Inventory INV Interest bearing liabilities IBL Property, Plant, Equipment PPE Issued Capital ISS D C D C (6) 23,000.00 (7) 23,000.00 (5) 600,000.00 (2) 92,000.00 (8) 92,000.00 (4) 600,000.00 692,000.00 692,000.00 Accounts receivables A/ R Accounts payables A/ P Figure 10.9: EDENVALE AG’s accounts <?page no="129"?> Berkau: Basics of Accounting 6e 10-129 D C (1) 500,000.00 (5) 600,000.00 (3) 200,000.00 (8) 92,000.00 (7) 23,000.00 c/ d 31,000.00 723,000.00 723,000.00 b/ d 31,000.00 Cash/ Bank C/ B Figure 10.9: EDENVALE AG’s accounts (continued) Compare the balancing figures in the accounts to the balance sheet items. In order to provide a better overview, the asset accounts have been placed to the left-hand side and the equity and liability accounts to the right-hand side in Figure 10.9. Note, we offer the service of placing accounts only in the first chapters of the textbook; normally, the sequence of accounts is as mentioned in the text. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 600,000.00 Issued capital 500,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 69,000.00 Interest bear liab 200,000.00 A/ R 0.00 A/ P 0.00 Prepaid expenses Provisions Cash/ Bank 31,000.00 Tax liabilities 700,000.00 700,000.00 Edenvale AG STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 10.10: EDENVALE AG’s statement of financial position 10.10 Summary Accounts are used to record business activities. They have a debit and a credit side. Accounts are linked to items on the balance sheet or items on the income statements. The first ones are real accounts; we refer to the latter ones as nominal accounts. We make entries in accounts depending on where the accounts belong to. For Asset accounts, we record opening values and increases on the debit side. Deductions are made on the credit side. Equity and liabilities accounts appear mirrored: We show the opening values and increases on their credit side and make entries on the debit side for decreases. Balancing-off an account means to enter the balance carried down and opposite thereof the balance brought <?page no="130"?> Berkau: Basics of Accounting 6e 10-130 down to calculate the balancing figure. It is copied to the balance sheet and gives the final value of the item. 10.11 Working Definitions Balancing Figure: A balancing figure is the residual value of an account. It is the difference between entries on the debit and on the credit side. Balancing-off an Account: To balance-off an account means to calculate the balancing figure of an account. Chart of Accounts: A chart of accounts is a list of all names and IDs for the accounts in use or to be used. Credit Side: The credit side is the right-hand side of an account. Debit Balanced/ Credit Balanced Account: Accountants call accounts with the balancing figure on the debit side debit-balanced and accounts with the balance brought down on the credit side credit balanced. Debit Side: The debit side is the lefthand side of an account. General Ledger: All accounts based on the chart of accounts define the general ledger. A general ledger contains the basic accounts without subordinated accounts. Journal: A journal is a list of all Bookkeeping entries which also includes the narrative. Nominal Account: Accounts linked to the income statement are called nominal accounts. Asset Account: An asset account is an account which records the values for an asset item on the balance sheet. Capital/ Liability Account: Capital/ liability accounts are linked to capital or to liabilities; they show the opening values on the credit side. Real Account: Accounts which are linked to the balance sheet are called real accounts. 10.12 Question Bank (1) Which of the following accounts are real accounts? 1. Interest, VAT, Cash/ Bank. 2. Depreciation, Rent, Cash/ Bank. 3. Property-Plant-Equipment, VAT, Cash/ Bank. 4. Accounts receivables, depreciation, Cash/ Bank. (2) A company sells an item of property, plant, equipment on cash. What is the correct Bookkeeping entry? 1. DR A/ R; CR PPE. 2. DR PPE; CR C/ B. 4. DR PPE; CR A/ P. 4. DR C/ B; CR PPE. (3) An account shows 3 debit entries of 200.00 EUR, 400.00 EUR and 350.00 EUR. On the credit side there is only one entry: 500.00 EUR. What is the balancing figure? 1. b/ d on the debit side: 550.00 EUR. 2. b/ d on the credit side: 450.00 EUR. 3. c/ d on the credit side: 450.00 EUR. 4. c/ d on the debit side: 450.00 EUR. (4) A company sells goods to a customer for 3,000.00 EUR on credit. The goods were bought for 3,000.00 EUR recently. Which is the correct Bookkeeping entry? <?page no="131"?> Berkau: Basics of Accounting 6e 10-131 1. DR C/ B 3,000.00 EUR; CR INV 3,000.00 EUR. 2. DR A/ R 3,000.00 EUR; CR INV 3,000.00 EUR. 3. DR A/ P 3,000.00 EUR; CR INV 3,000.00 EUR. 4. DR INV 3,000.00 EUR; CR A/ P 3,000.00 EUR. (5) A company buys items of property, plant, equipment and sells them at the same price on credit. Which accounts are involved? 1. PPE, C/ B, A/ R. 2. INV, C/ B, A/ R. 3. PPE, C/ B, A/ P. 4. INV, C/ B, A/ R. 10.13 Solutions 1-3; 2-4; 3-3; 4-2; 5-1. <?page no="132"?> Berkau: Basics of Accounting 6e 11-132 11 T-Accounts for Profit and Loss 11.1 What is in the Chapter? This chapter is about nominal accounts. We introduce T-accounts for profit or loss and discuss the case study PELZERHAGEN (Pty) Ltd. again - now making entries in T-accounts. 11.2 Learning Objectives You are going to develop an understanding about revenue/ gains and expenses and how to record them in Taccounts. After studying this chapter, you can prepare a statement of profit or loss and are familiarised with the Bookkeeping entries thereto. You also will know how to record a Profit and Loss account. Regarding the technical aspects of Accounting, we introduce closing-off of accounts. 11.3 Applying Nominal Accounts In the previous chapter, we introduced T-accounts for real accounts only. No profit and loss calculation took place. The case study companies ROHRBACH Ltd. and EDENVALE AG did not earn a profit, nor did they make a loss. This could happen, because both companies sold their goods and disposed non-current assets at their cost of purchase/ acquisition. No profit was earned by asset selling. Furthermore, no expenses were discussed. Both companies did not spend on labour, did not write-off assets, did not pay rent etc. By this, both case studies appear to be very unrealistic. In the real business world, companies are established, and their business operations must earn money. To say it more accurate: Companies strive to be successful. A successful company earns a profit if the total of revenues/ gains exceeds the sum of expenses. The earnings are used to increase the company’s book value and/ or to declare a dividend to the shareholders. Therefore, we must learn how to record revenue and expense and how to calculate profit. We also discuss how profit is transferred to equity by adding the profit after taxes to the Retained Earnings account and the income taxes to the Income Tax Liabilities account. For our considerations, we focus on retained earnings. It is an item of equity. Therefore, adding earnings after taxes to retained earnings increases equity. Transferring a loss to retained earnings will reduce equity. All equity accounts are on the credit side of the balance sheet where increases are recorded by credit entries and deductions by debit entries. Hence, all revenues/ gains must be recorded on the credit side of T-accounts and all expenses must be debited thereto. All revenue/ gain and expense accounts fall under nominal accounts. Examples for nominal accounts are Sales, Interest Income, Labour, Depreciation account. We mark those accounts by adding the Accounting period to the name to distinguish them from real accounts. Hence, the name of the account for sales is Sales-20XX <?page no="133"?> Berkau: Basics of Accounting 6e 11-133 account, for depreciation it is Depreciation-20XX account etc. In contrast to real accounts, nominal accounts are not continued after the balance sheet date. All nominal accounts are closed-off to the Profit and Loss account. The Profit and Loss account is closed-off to the Retained Earnings account on the balance sheet too. Hence, nominal accounts exist one Accounting period only. We get rid of them by closing them off. 11.4 Closing-off Accounts Closing-off an account to another one means to transfer the balancing figure of the source account to the target account. By closing-off an account, its balancing figure in the source account becomes zero; the account is invalidated that way. The previous balancing figure appears as an entry in the target account. Closing-off an account is regarded as a Bookkeeping entry in accordance with the double entry system of Accounting. Below, we study an example of an account balanced-off. We study PELZERHAGEN (Pty) Ltd.’s Rent- 20X7 account. After payment of 4 quarterly payments for rent to the extent of 850.00 AUD/ q the balancing figure is 3,400.00 AUD. We balanceoff the Rent-20X7 account to calculate the balancing figure. Later, rent is transferred to profit and loss. Therefore, we make a credit entry to the extent of 3,400.00 AUD in the Rent-20X7 account, and we also make a debit entry in the Profit and Loss- 20X7 account. That way, the rent “moves” from the Rent-20X7 account to the Profit and Loss-20X7 account. As a closing-off is no original Bookkeeping entry, we do not indicate the entry by a Bookkeeping ID but by the 3-letter code of its contra account. In case of the rent closing-off the 3letter codes RNT for rent and P7L for Profit and Loss-20X7 account apply. Check Figure 11.1: D C D C (a) 850.00 RNT 3,400.00 (b) 850.00 (c) 850.00 (d) 850.00 c/ d 3,400.00 3,400.00 3,400.00 b/ d 3,400.00 P7L 3,400.00 Rent-20X7 RNT Profit & Loss-20X7 P7L Figure 11.1: Closing-off rent How it is Done (Closing-off an Account to another One) (1) Determine which source account should be closed-off to which target account. (2) Balance-off the source account. (3) In the source account, record an entry opposite to the balance brought down to the same extent than the balance brought down. Mark the entry by the 3letter code for the target account. <?page no="134"?> Berkau: Basics of Accounting 6e 11-134 (4) Make the contra entry in the target account. Indicate the entry by the source account’s 3-letter code. (5) You might cross out the source account after step (4) as it does not have a value anymore. In the class room, we grey out closed-off accounts in MS- Excel. 11.5 C/ S PELZERHAGEN (Pty) Ltd. PELZERHAGEN (Pty) Ltd. includes business activities that are relevant for profit and loss. Hence, nominal accounts apply. Next, we record all revenues and expenses and close-off all nominal accounts to the Profit and Loss-20X7 account. Thereafter, we calculate the profit in the Profit and Loss-20X7 account. The balancing figure of the P7L account is the profit for the period 20X7 (Earnings before taxation). We deduct income tax expenses and arrive at the annual surplus (earnings after taxes) which we transfer to the Retained Earnings account on the balance sheet. This is recorded by balancing-off the Profit and Loss-20X7 account to the Retained Earnings account. To recall the case study, here comes an overview of PELZERHAGAN (Pty) Ltd. with its 4 activities that follow the establishment based on an owners’ contribution of 100,000.00 AUD indicated as opening values OV: (1) Paying 4 × 850 = 3 3,400.00 EUR rent by bank transfer on 2.01.20X7, 1.04.20X7, 1.07.20X7 and 1.10.20X7. (2) Paying salaries of 48,000.00 EUR by bank transfer on 30.06.20X7. (3a) Acquisition of equipment for 50,000.00 EUR on credit on 3.01.20X7 and (3b) Depreciation on equipment on 31.12.20X7. (4) Earning revenue of 130,000.00 EUR on 31.12.20X7. PELZERHAGEN (Pty) Ltd. applies the following accounts: - Property, plant and equipment PPE - Cash/ Bank C/ B. - Issued capital ISS. - Revenue REV - Other expenses (rent) OEP. - Salaries LAB. - Profit and Loss account P7L. - Income tax expenses ITE - Income tax liabilities ITL. At the beginning of the Accounting period 20X7, PELZERHAGEN (Pty) Ltd.’s balance sheet looks as displayed in Figure 11.2: <?page no="135"?> Berkau: Basics of Accounting 6e 11-135 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 100,000.00 Tax liabilities 100,000.00 100,000.00 Pelzerhagen (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 11.2: PELZERHAGEN (Pty) Ltd.’s statement of financial position The first step is the transfer of opening values to the accounts. This gives us the opening values (OV). In the case PELZERHAGEN (Pty) Ltd., there are opening values for the Cash/ Bank account and for the Issued Capital account. Compare the opening values in PELZERHAGEN (Pty) Ltd.’s accounts in Figure 11.3 to the balance sheet as shown in Figure 11.2. D C D C OV 100,000.00 (1a) 850.00 c/ d 100,000.00 OV 100,000.00 (4) 130,000.00 (1b) 850.00 b/ d 100,000.00 (1c) 850.00 (1d) 850.00 (2) 48,000.00 c/ d 178,600.00 230,000.00 230,000.00 b/ d 178,600.00 D C D C (3a) 50,000.00 (3b) 10,000.00 (1a) 850.00 c/ d 40,000.00 (1b) 850.00 50,000.00 50,000.00 (1c) 850.00 b/ d 40,000.00 (1d) 850.00 c/ d 3,400.00 3,400.00 3,400.00 b/ d 3,400.00 P7L 3,400.00 Property, plant, equipment P,P,E Rent-20X7 RNT Cash/ Bank Issued Capital Figure 11.3: PELZERHAGEN (Pty) Ltd.’s accounts <?page no="136"?> Berkau: Basics of Accounting 6e 11-136 D C D C (2) 48,000.00 c/ d 48,000.00 c/ d 50,000.00 (3a) 50,000.00 b/ d 48,000.00 P7L 48,000.00 b/ d 50,000.00 Salaries-20X7 LAB Accounts payables A/ P D C D C c/ d 130,000.00 (4) 130,000.00 LAB 48,000.00 Rev 130,000.00 P7L 130,000.00 b/ d 130,000.00 DPR 10,000.00 RNT 3,400.00 EBT 68,600.00 130,000.00 130,000.00 ITE 20,580.00 b/ d 68,600.00 R/ E 48,020.00 68,600.00 68,600.00 Revenue-20X7 REV Profit and Loss-20X7 P7L D C D C c/ d 48,020.00 P7L 48,020.00 c/ d 20,580.00 ITE 20,580.00 b/ d 48,020.00 b/ d 20,580.00 D C D C (3b) 10,000.00 c/ d 10,000.00 ITL 20,580.00 c/ d 20,580.00 b/ d 10,000.00 P7L 10,000.00 b/ d 20,580.00 P7L 20,580.00 Retained earnings R/ E Income tax liabilities ITL Depreciation-20X7 DPR Income tax expenses-20X7 ITE Figure 11.3: PELZERHAGEN (Pty) Ltd.'s accounts (continued) Nr Amount Date Narrative DR CR (1a) 850.00 2.01.20X7 Paying 3,400.00 EUR rent by bank transfer on 2.01.20X7 Rent Cash/ Bank (1b) 850.00 1.04.20X7 Paying 3,400.00 EUR rent by bank transfer on 1.04.20X7 Rent Cash/ Bank (1c) 850.00 1.07.20X7 Paying 3,400.00 EUR rent by bank transfer on 1.07.20X7 Rent Cash/ Bank (1d) 850.00 1.10.20X7 Paying 3,400.00 EUR rent by bank transfer on 1.10.20X7 Rent Cash/ Bank (2) 48,000.00 30.06.20X7 Paying salaries of 48,000.00 EUR by bank transfer on 30.06.20X7 Labour Cash/ Bank (3a) 50,000.00 3.07.20X7 Acquisition of equipment for 50,000.00 EUR on credit on 3.07.20X7 P, P, E A/ P (3b) 10,000.00 31.12.20X7 Depreciation on equipment on 31.12.20X7 Depr P, P, E (4) 2,350.00 31.12.20X7 Earning revenue of 130,000.00 EURon 31.12.20X7 Cash/ Bank Revenue Pelzerhagen (Pty) Ltd. JOURNAL 20X7 Figure 11.4: PELZERHAGEN (Pty) Ltd.’s journal <?page no="137"?> Berkau: Basics of Accounting 6e 11-137 All Bookkeeping entries are listed in the journal in the sequence of recording. They can be identified by the activity IDs (1) ... (4). After making the Bookkeeping entries, all real accounts are balancedoff and their balancing figures are copied to the statement of financial position. This is shown Figure 11.7, e.g., the Cash/ Bank account’s balance is 178,600.00 EUR. We close-off all nominal accounts to the Profit and Loss-20X7 account. Note, closing-off accounts falls under adjustments and is not shown in the journal. PELZERHAGEN (Pty) Ltd. closes-off the Rent-20X7 account, Salary-20X7 account, Revenue-20X7 account and Depreciation-20X7 account to the Profit and Loss-20X7 account. The Profit and Loss-20X7 account receives all revenues (credit side) and expenses (debit side). PELZERHAGEN (Pty) Ltd.’s pre-tax profit is calculated by deducting all expenses from revenue. The profit before taxes equals: 130,000 - 3,400 - 48,000 - 10,000 = 6 68,600.00 EUR. The amount is the balance in the Profit and Loss-20X7 account. Due to space restrictions in the exhibits, the Profit and Loss account shows the pretax profit as EBT, meaning earnings before taxation - not as c/ d. However, the balance brought down is indicated as b/ d. A Profit and Loss account gives us all information to set up an income statement (Our MS-Excel template calculates the income tax expenses automatically.). Compare the account to the income statement as shown in Figure 11.5: [EUR] Revenue 130,000.00 Other income 130,000.00 Materials Labour (48,000.00) Depreciation (10,000.00) Other expenses (3,400.00) Earnings before int and taxes (EBIT) 68,600.00 Interest Earnings before taxes (EBT) 68,600.00 Income tax expenses (20,580.00) Deferred taxes Earnings after taxes (EAT) 48,020.00 Pelzerhagen (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 11.5: PELZERHAGEN (Pty) Ltd.’s income statement <?page no="138"?> Berkau: Basics of Accounting 6e 11-138 11.6 Calculation of Income Tax For the tax calculation, we look at the statement of profit or loss an other comprehensive income, before we study the accounts. Income taxes are deducted from the earnings before taxes (= pre-tax profit). Following our conventions in chapter (1), the total income tax rate is 30 % and is multiplied with the pre-tax profit: 30 % × 68,600 = 20,580.00 EUR. On the income statement the income taxes are deducted from earnings before taxes. This gives the annual surplus also known as earnings after taxes EAT. We now continue the Profit and Loss account that shows a “b/ d” underneath of its first sum to the extent of 68,600.00 EUR. Our next debit entry in the Profit and Loss-20X7 account is for income tax expenses, here: 20,580.00 EUR. The contra entry is made in the Income Tax Liabilities account. Thereafter, the Income Tax Expense-20X7 account is closed-off to the Profit and Loss-20X7 account. In all our textbooks and study materials, we simplify these entries. Instead of the entries made in Figure 11.3, we make a debit entry in the Profit and Loss-20X7 account referring to ITL. The contra entry is recorded in the Income Tax Liabilities account. Hence, we skip the Income Tax Expense-20X7 account. Check Figure 11.6 for the alternative recording of income taxes: D C D C c/ d 130,000.00 (4) 130,000.00 LAB 48,000.00 Rev 130,000.00 P7L 130,000.00 b/ d 130,000.00 DPR 10,000.00 RNT 3,400.00 EBT 68,600.00 130,000.00 130,000.00 ITL 20,580.00 b/ d 68,600.00 R/ E 48,020.00 68,600.00 68,600.00 Revenue-20X7 REV Profit and Loss-20X7 P7L D C D C c/ d 48,020.00 P7L 48,020.00 c/ d 20,580.00 P7L 20,580.00 b/ d 48,020.00 b/ d 20,580.00 D C D C (3b) 10,000.00 c/ d 10,000.00 ITL 20,580.00 c/ d 20,580.00 b/ d 10,000.00 P7L 10,000.00 b/ d 20,580.00 P7L 20,580.00 Retained earnings R/ E Income tax liabilities ITL Depreciation-20X7 DPR Income tax expenses-20X7 ITE Figure 11.6: Simplified entries for income taxes (selected accounts only) 11.7 Transfer of Profit or Loss to Equity After recording income taxes, the Profit and Loss-20X7 account is closed-off to the Retained Earnings account in Figure 11.3 and 11.6. You find a debit entry marked “R/ E”. The amount transferred <?page no="139"?> Berkau: Basics of Accounting 6e 11-139 to equity therein is the annual surplus. It equals: 68,600 - 20,580 = 4 48,020.00 EUR and appears on the balance sheet as retained earnings. There is an entry in the Retained Earnings account on the credit side with the reference P&L. See the statement of financial position as it is displayed in Figure 11.7: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 40,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings 48,020.00 Current assets Liabilities Inventory Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 178,600.00 Tax liabilities 20,580.00 218,600.00 218,600.00 Pelzerhagen (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 11.7: PELZERHAGEN (Pty) Ltd.’s statement of financial position How it is Done (Profit Calculation within the Profit and Loss Account) (1) Make debit entries for all expenses in the relevant nominal accounts. (2) Make credit entries for revenues/ gains in the relevant nominal accounts. (3) Close-off all nominal accounts to the Profit and Loss account. (4) Calculate the pre-tax profit as the balancing figure of the Profit and Loss account. The balancing figure c/ d can be (a) on the debit side or (b) on the credit side. (5a) If the balancing figure c/ d of the Profit and Loss account is on the debit side, the business earns a profit. Determine income taxes by multiplying the total income tax rate with EBT. Determine earnings after taxes by deducting income taxes from EBT. Make credit entries in the Income Tax Liability account and in the Retained Earnings account. (5b) If the balancing figure c/ d of the Profit and Loss account is on the credit side, the business makes a loss. Close-off the Profit and Loss account to the Retained Earnings account by making a debit entry in the Retained Earnings account and a credit entry <?page no="140"?> Berkau: Basics of Accounting 6e 11-140 in the Profit and Loss account. Income taxes do not apply. 11.8 Summary Accounts support the preparation of financial statements. The accounts are linked to items on the balance sheet and to items on the income statement. The income statement is prepared by the Profit and Loss account. All accounts linked to revenues/ gains and all accounts for expenses are closed-off to profit or loss. After profit calculation, the earnings after taxes are transferred to the Retained Earnings account. Income tax expenses are credited to the Income Tax Liability account on the balance sheet. 11.9 Working Definition Closing-off: Closing-off an account to another account means to transfer the balancing figure of the source account in the target account. 11.10 Question Bank (1) A company records depreciation. What is the correct entry in the account? 1. Enter depreciation on the debit side of the Depreciation account. 2. Enter depreciation on the credit side of the Depreciation account. 3. Enter depreciation on the debit side of the Property, Plant, Equipment account. 4. Enter negative depreciation on the credit side of the Property, Plant, Equipment account. (2) Which of the below accounts are nominal accounts? 1. Depreciation, property-plantequipment, interest, insurance fees. 2. Accumulated depreciation, rent, interest, revenue. 4. Depreciation, motor vehicle, interest, insurance fees. 4. Depreciation, rent, interest, insurance fees. (3) Which event increases profit? 1. Revenue recognition. 2. Depreciation. 3. Rent paid to landlord. 4. Consumption of materials. (4) A company records revenue 40,000.00 EUR, material expenses 14,000.00 EUR, depreciation 3,500.00 EUR and labour 9,000.00 EUR. How do you record income tax expenses? 1. Crediting the Profit and Loss account with 4,050.00 EUR. 2. Crediting the Income Tax Expense account with 4,050.00 EUR. 3. Debiting the Profit and Loss account with 4,050.00 EUR. 4. Debiting the Income Tax Liabilities account with 4,050.00 EUR. (5) A company makes a loss of 130,000.00 EUR. What is the Bookkeeping entry to transfer the loss to equity? 1. DR P&L 130,000.00 EUR; CR R/ E 130,000.00 EUR. <?page no="141"?> Berkau: Basics of Accounting 6e 11-141 2. DR R/ E 130,000.00 EUR; CR P&L 130,000.00 EUR. 3. DR R/ E 130,000.00 EUR; CR P&L 91,000.00 EUR, CR ITL 39,000.00 EUR. 4. DR P&L 130,000.00 EUR; CR P&L 91,000.00 EUR; CR ITL 39,000.00 EUR. 11.11 Solutions 1-1; 2-4; 3-1; 4-3; 5-2. <?page no="142"?> Berkau: Basics of Accounting 6e 12-142 12 Introduction to Bookkeeping Entries 12.1 What is in the Chapter? We introduce Bookkeeping entries in this chapter. We explain the format in which we describe them and explain the double entry system. Thereafter, we demonstrate Bookkeeping based on the three case studies ROHRBACH Ltd., EDENVALE AG and PELZERHAGEN (Pty) Ltd. by which we show Bookkeeping entries for assets as first - followed by Bookkeeping entries for equity and liabilities and thereafter linked to nominal accounts. 12.2 Learning Objectives Talking about business operations referring to Bookkeeping entries is Accountants’ and managers’ language, because it indicates the impact on financial statements. After studying this chapter, you can better communicate in the business world and know the major Bookkeeping entries. You learn a standard description for Bookkeeping entries which shows debit and credit entries as DR and CR. After studying this chapter, you can describe the recording of the business operations in a professional way. 12.3 Formal Description of Bookkeeping Entries In the previous chapters, we made Bookkeeping entries in real and in nominal accounts. We also made Bookkeeping entries for the adjustments. A Bookkeeping entry is the recording of a business activity by making at least one entry on the debit side of an account and at least one on the credit side of another account. To formally describe Bookkeeping entries, we introduce the DR-CR-format. Bookkeeping entries contain information about: (1) which accounts the Bookkeeping entry is made in, (2) on which side of an account the Bookkeeping entry is recorded (debit or credit side), (3) which amount(s) is (are) added or deducted from an account and (4) when the Bookkeeping entry is made (date). Below, we refer to the first business activity in the ROHRBACH Ltd. case study. On 3.01.20X5, ROHRBACH Ltd. buys 1,000 smart phones at 150.00 EUR/ u each. See below the Bookkeeping entry’s formal description we refer to in the next paragraphs. DR Inventories.................. 150,000.00 EUR CR Cash/ Bank.................... 150,000.00 EUR <?page no="143"?> Berkau: Basics of Accounting 6e 12-143 Ad (1): Account’s Name The account name is written into the Bookkeeping entry. When a chart of accounts applies, the ID number for the account is mentioned as well. The account name must be exact and spelled in the same way as it appears in the accounts. At ROHRBACH Ltd. the accounts for the first business operation are the Inventories account and the Cash/ Bank account. Ad (2): Indicating Debit or Credit Side We indicate by writing debit entry or credit entry on which side of the account the Bookkeeping entry is made. Bookkeeping entries are always added to accounts. Deductions or deletions are prohibited. We add either on the debit or on the credit side. A debit entry is marked as “DR” for debit recorded; a credit entry is marked by “CR” for credit recorded. ROHRBACH Ltd. adds the phones to its inventories which requires debiting the Inventories account. By making a bank transfer towards the supplier’s bank account, ROHRBACH Ltd. deducts money from its own bank account. We add a credit entry to the Cash/ Bank account which results in a decrease of its balancing figure. Ad (3): Amount Recorded We write the amount of the Bookkeeping entry correctly and in full. No rounding is allowed! Bookkeeping entries disclose the amount exact to the nearest cent (two digits after the decimal point). The currency is part of the valuation and must be disclosed. ROHRBACH Ltd. records 150,000.00 EUR. Ad (4): Date The date of the Bookkeeping entry is mentioned next to the Bookkeeping entry. The date is exact to the day. No timely information is required for recording. If you apply Bookkeeping software, your software will add a time stamp to your Bookkeeping entry, which will help you to distinguish Bookkeeping entries made on the same day. For the textbook, we only mention the date in the text and in the journal. In the text we allocate a number to the Bookkeeping entry which shows in the accounts. The purchase of the cell phones carries the Bookkeeping number “(1)”. 12.4 Double Entry System Recording a business activity leads to at least one debit and one credit entry per Bookkeeping entry. This is for fulfilling the Accounting equation. When we record an asset swop, one asset account increases and the other one decreases to the same extent. We must record one debit entry and a credit entry. The same applies for recording changes between equity and liability accounts. When we record activities on both sides of the balance sheet - like an acquisition on credit, both sides of the balance sheet increase. We record a debit entry to increase the asset side and we make a credit entry to increase capital/ liabilities. When we reduce both sides of the balance sheet, like when paying for debts, we decrease the debts account by recording <?page no="144"?> Berkau: Basics of Accounting 6e 12-144 a debit entry and we decrease cash/ bank by making a credit entry. For all activities that affect the nominal accounts, we make similar Bookkeeping entries. Keep in mind that the profit is later transferred to retained earnings. Hence, increase of profit is recorded as a credit entry and decreases as debit entries. When we record an expense paid for, like rent, we record the expense on the debit side of the Rent account and we make a credit entry in the Cash/ Bank account as the payment is deducted. When we sell goods on credit, we record the increase in receivables on the debit side and the sales revenue as a credit entry. We do not discuss all Bookkeeping entries, but we acknowledge that the fulfilment of the Accounting equation requires every Bookkeeping entry to be recorded with one debit entry and one credit entry at least. Further below, we get back to the Accounting equation and check it for the cases ROHRBACH Ltd. and EDENVALE AG. Some Bookkeeping entries contain more than one entry on the debit and/ or credit side. Those Bookkeeping entries are classified as compound Bookkeeping entries. A compound Bookkeeping entry is one that contains more than one debit entry and/ or more than one credit entry. The sum of debit entries equals the total of credit entries in a compound Bookkeeping entry. An example for a compound Bookkeeping entry is a purchase with a partial payment. Assume, ROHRBACH Ltd. pays its cell phones only half and agrees to pay the remainder in the next Accounting period. This gives a compound Bookkeeping entry as below: DR Inventories.................. 150,000.00 EUR CR Accounts payables A/ P........ 75,000.00 EUR CR Cash/ Bank.................... 75,000.00 EUR 12.5 Common Regulations for Bookkeeping A recorded Bookkeeping entry never can be changed/ adjusted or deleted! This comes from the old days, when Bookkeeping entries were made with ink on paper. In order to guarantee the correctness of recording, it is not allowed to delete or manipulate Bookkeeping entries. This rule applies for software, too. You cannot delete or change Bookkeeping entries after their recording. Software systems pre-check Bookkeeping entries before recording. This avoids making formally faulty entries. In case, something must be changed, a follow-up Bookkeeping entry to cancel/ correct the faulty one is recorded. Both entries stay in the system. For Bookkeeping entry reference, it is common practice to name the debit entry at first. The debit entry is followed by the credit entry. In case of compound Bookkeeping entries, all debit entries are called out followed by credit entries. <?page no="145"?> Berkau: Basics of Accounting 6e 12-145 In this textbook, we display Bookkeeping entries always in bold. However, due to the format of this textbook, we do not indent credit entries, such as below: DR Inventory 150,000.00 EUR CR Cash/ Bank 150,000.00 EUR All entries made with regard to activities are identified by a reference number, such as (1), (2), (3) etc. In general, we change the type of reference numbers when changing the Accounting period to avoid misunderstandings. Hence, some Bookkeeping entries are identified by caps, like (A), (B), (C) etc. The Bookkeeping description in the textbook contains the date of recording; hence, we do not disclose it in the accounts. All adjustments are recorded on 31.12.20XX. Adjustments consider depreciation, accruals, balancingand closing-off accounts, income tax calculation etc. Bookkeeping entries made when preparing financial statements and which are not linked to ordinary business activities are adjustments. Adjustments do not carry a reference number in this textbook. Instead, we show in the accounts the 3-letter-code for the contra account. Adjustments rarely result in compound Bookkeeping entries. Therefore, this procedure only results in a short reference. Adjustments are very seldom written down as Bookkeeping entries as they are standard procedures. In general, we show the Adjustments (only) in the exhibits. We easily can identify them by the 3letter-codes. Next, we cover all Bookkeeping entries for the case studies ROHRBACH Ltd., EDENVALE AG and PELZERHAGEN (Pty) Ltd. The paragraph starting with the (ID) is the narrative for the Bookkeeping entry (no sentence): 12.6 Bookkeeping Entries at ROHRBACH Ltd. Before the operations commence, ROHRBACH Ltd. has 250,000.00 EUR in its bank account. The share issue is not part of our considerations as it took place prior to 1.01.20X5. The first activity (1) is the purchase of cell phones on 3.01.20X5. The purchase increases stock and gives a reduction of cash/ bank. The Bookkeeping entry is as below: (1) Purchase of materials on 3.01.20X5. DR Inventory.................... 150,000.00 EUR CR Cash/ Bank.................... 150,000.00 EUR The second activity is the shelves acquisition. The shelves fall under property, plant and equipment. Therefore, the Property, Plant, Equipment account increases. ROHRBACH Ltd. pays for the acquisition, hence, we must record a credit entry in the Cash/ Bank account. See below the Bookkeeping entry (2): <?page no="146"?> Berkau: Basics of Accounting 6e 12-146 (2) Acquisition of shelves 4,700.00 EUR on 6.02.20X5. DR P, P, E Account.............. 4,700.00 EUR CR Cash/ Bank.................... 4,700.00 EUR The third entry is the sale. ROHRBACH Ltd. sells 67 phones at 150.00 EUR/ u. The total amount equals: 67 × 150 = 110,050.00 EUR. We consider a reduction in inventories and an increase of cash/ bank to the extent of 10,050.00 EUR. See below the Bookkeeping entry (3): (3) Sale of cell phones on 8.02.20X5. DR Cash/ Bank.................... 10,050.00 EUR CR Inventory.................... 10,050.00 EUR The last Bookkeeping entry at ROHRBACH Ltd. is the disposal of two shelves on 22.03.20X5. The buyer pays 2 × 1,175 = 2 2,350.00 EUR. ROHBACH Ltd. does not earn a profit by the disposal as it paid the same price at the time of acquisition. The disposal reduces property, plant and equipment and the receipt increases the balance in the cash/ bank account. The Bookkeeping entry (4) is: (4) Disposal of shelves on 22.03.20X5. DR Cash/ Bank.................... 2,350.00 EUR CR P, P, E-Account.............. 2,350.00 EUR These are all Bookkeeping entries made in chapter (7). Compare them to the journal in Figure 12.1 below. Note, the date of recording can differ (later) from the business transaction date: Nr Amount Date Narrative DR CR (1) 150,000.00 3.01.20X5 Purchase of 1,000 smart phones and payment by bank transfer of 150,000.00 EUR on 3.01.20X5 Inventory Cash/ Bank (2) 4,700.00 8.02.20X5 Acquisition of 4 shelves at 4,700.00 EUR and payment thereof on 6.02.20X5 P, P, E Cash/ Bank (3) 10,050.00 8.02.20X5 Sales of 67 phones and receiving money 10,050.00 EUR on 8.02.20X5 Cash/ Bank Inventory (4) 2,350.00 25.03.20X5 Disposal of 2 shelves on 22.03.20X5. The money obtained amounts to 2,350.00 EUR Cash/ Bank P, P, E Rohrbach Ltd.'s JOURNAL 20X5 Figure 12.1: ROHRBACH Ltd.’s journal <?page no="147"?> Berkau: Basics of Accounting 6e 12-147 12.7 Bookkeeping Entries at EDENVALE AG In addition to the Bookkeeping entries, we now check the Accounting equation after each business activity. The Bookkeeping entries for EDENVALE AG consider the asset side as well as the credit side (for capital and liabilities). In the case study EDENVALE AG, the share issue counts as Bookkeeping entry (1) as it takes place during the first Accounting period 20X3. On 2.01.20X3, EDENVALE AG issues 50,000 ordinary shares at 10.00 EUR/ s. / s stands for per share. The money receipt for the share issue increases the Cash/ Bank account by: 50,000 × 10 = 5 500,000.00 EUR. At the same time, equity increases to the same extent. The Issued Capital account is credited. Note, that the item on the balance sheet is called share capital but the credited account it the Issued Capital account. The Bookkeeping entry (1) is as below: (1) Share issue 500,000.00 EUR on 2.01.20X3. DR Cash/ Bank.................... 500,000.00 EUR CR Issued Capital............... 500,000.00 EUR Next, we check the Accounting equation: The total of assets is amounting to 500,000.00 EUR. So is the total of equity and liabilities. The second Bookkeeping at EDENVALE AG is the inventory purchase. EDENVALE AG buys 400 lawn mowers at 230 EUR/ u on credit. "On credit" refers to the corresponding entry on the credit side of the balance sheet where we record the payment obligation. Here, the value for current assets (lawn mowers) increases by: 400 × 230 = 9 92,000.00 EUR and the short-term liabilities increases to the same extent. See below the Bookkeeping entry (2): (2) Purchase of inventory 92,000.00 EUR on 15.02.20X3. DR Inventory.................... 92,000.00 EUR CR Accounts Payables A/ P ........ 92,000.00 EUR Again, we check the Accounting equation: Now, the total of assets is amounting to: 92,000 + 500,000 = 5 592,000.00 EUR. The total of equity and liabilities equals: 500,000 + 92,000 = 5 592,000.00 EUR. The Accounting equation is fulfilled. The third business activity is about EDENVALE AG taking a bank loan. The payment is received in its bank account, and we must record a future payment obligation. Therefore, the Cash/ Bank account increases to the extent of the receipt and the long-term liabilities increase, too. (3) Taking a bank loan 200,000.00 EUR on 1.03.20X3. DR Cash/ Bank.................... 200,000.00 EUR CR Interest Bearing Liabilities. 200,000.00 EUR <?page no="148"?> Berkau: Basics of Accounting 6e 12-148 We check again the Accounting equation. Now, the total of assets is: 92,000 + 700,000 = 7 792,000.00 EUR. The total on the credit side of the balance sheet equals: 500,000 + 200,000 + 92,000 = 792,000.00 EUR. The Accounting equation is fulfilled. Following the fourth business activity, EDENVALE AG buys a show room interior. This falls under non-current assets and is recorded as an item of property, plant and equipment. The acquisition is on credit; therefore, it increases assets and payables. See below the Bookkeeping entry (4): (4) On credit acquisition of the show room interior at 600,000.00 EUR on 4.03.20X3. DR P, P, E Account.............. 600,000.00 EUR CR Accounts Payables A/ P........ 600,000.00 EUR Once more, we check the Accounting equation. The total of assets is: 600,000 + 92,000 + 700,000 = 1 1,392,000.00 EUR. The total of equity and liabilities equals: 500,000 + 200,000 + 692,000 = 1,392,000.00 EUR. On 18.03.20X3, EDENVALE AG pays the amount it owes the show room interior seller by bank transfer. This transaction reduces the amount of money in the Cash/ Bank account. We record a credit entry. The payment dissolves the shortterm liabilities which leads to a debit entry because the Accounts Payables account is on the credit side of the balance sheet. See the Bookkeeping entry (5) as below: (5) Pay-off of the short-term liabilities for the show room interior on 18.03.20X3. DR Accounts Payables A/ P........ 600,000.00 EUR CR Cash/ Bank.................... 600,000.00 EUR The Accounting equation is fulfilled: The total asset value is: 600,000 + 92,000 + 100,000 = 7 792,000.00 EUR. The total of equity and liabilities is amounting to: 500,000 + 200,000 + 92,000 = 792,000.00 EUR. Next, EDENVALE AG sells 100 lawn mowers at 230.00 EUR/ u on credit. Do not get confused by the expression “on credit”. It should be named “on debit” but the technical term in Accounting for a non-cash deal always is “on credit”. EDENVALE AG makes a debit entry in the Accounts Receivables account. The Accounts Receivables account is an asset, because it represents a claim against the customers. The lawn mowers are released from stock to be sold to the clients. We record a credit entry in the Inventory account to the extent of 100 × 230 = 23,000.00 EUR. Look at the Bookkeeping entry (6): (6) Sale of goods on 16.05.20X5 for 23,000.00 EUR on credit. <?page no="149"?> Berkau: Basics of Accounting 6e 12-149 DR Accounts Receivables......... 23,000.00 EUR CR Inventory.................... 23,000.00 EUR The Accounting equation is still fulfilled after recording Bookkeeping entry (6). The total of assets is: 600,000 + 69,000 + 23,000 + 100,000 = 7 792,000.00 EUR. The total of the equity and liability accounts equals: 500,000 + 200,000 + 92,000 = 7 792,000.00 EUR. As activity (7), the money for the lawn mowers is paid by EDENVALE AG’s customers on 9.06.20X3. This gives an increase in the Cash/ Bank account as the Accounts Receivables account is closedoff thereto. The cash/ bank increase means a debit entry in the Cash/ Bank account; the closing-off of the Accounts Receivables account requires crediting the amount. Observe Bookkeeping entry (7) below: (7) Receipt of 23,000.00 EUR from customers on 9.06.20X3. DR Cash/ Bank.................... 23,000.00 EUR CR Accounts Receivables......... 23,000.00 EUR The Accounting equation is fulfilled. The value of all assets is: 600,000 + 69,000 + 123,000 = 7 792,000.00 EUR. The total of equity and liability accounts equals: 500,000 + 200,000 + 92,000 = 792,000.00 EUR. The last Bookkeeping entry for EDENVALE AG is the payment to the supplier of the lawn mowers. The payment retires EDENVALE AG’s short-term debts. Paying money means a decrease of cash/ bank recorded by a credit entry; the closing-off of the Accounts Payables account requires a debit entry. Check below the Bookkeeping entry (8): (8) Paying-off debts 92,000.00 EUR on 11.06.20X3. DR Accounts Payables............ 92,000.00 EUR CR Cash/ Bank.................... 92,000.00 EUR Now, the Accounting equation looks as follows: 600,000 + 69,000 + 31,000 = 500,000 + 200,000 = 7 700,000.00 EUR. The total of assets is on the left-hand side of the equation and the total of equity and liabilities is on the right-hand side. Compare the Bookkeeping entries made in this chapter to the accounts displayed in Figure 10.9 and the journal in Figure 12.2. <?page no="150"?> Berkau: Basics of Accounting 6e 12-150 Nr Amount Date Narrative DR CR (1) 500,000.00 2.01.20X3 Share issue of 50,000 ordinary shares on 2.01.20X3. The issued shares amount to 500,000.00 EUR Cash/ Bank Issued Capital (2) 92,000.00 15.02.20X3 Purchase of 400 lawn mowers on credit 92,000.00 EUR on 15.02.20X3 Inventory A/ P (3) 200,000.00 1.03.20X3 Taking a bank loan 200,000.00 EUR on 1.03.20X3 Cash/ Bank IBL (4) 600,000.00 4.03.20X3 On 4.03.20X3, EDENVALE AG buys a new show room interior at 600.000,00 EUR and agrees to pay later P, P, E A/ P (5) 600,000.00 18.03.20X3 On 18.03.20X3, EDENVALE AG pays the amount due for the show room into the seller’s bank account. It is 600,000.00 EUR A/ P Cash/ Bank (6) 23,000.00 16.05.20X3 EDENVALE AG sells 100 lawn mowers on credit on 16.05.20X3. The amount is 23,000.00 EUR A/ R Inventory (7) 23,000.00 9.06.20X3 On 9.06.20X3, EDENVALE AG’s customers pay 23,000.00 EUR for the lawn mowers into the company’s bank account Cash/ Bank A/ R (8) 92,000.00 11.06.20X3 On 11.06.20X3, EDENVALE AG pays 92,000.00 EUR it owes the lawn mower supplier into his bank account A/ P Cash/ Bank Edenvale AG JOURNAL 20X3 Figure 12.2: EDENVALE AG’s journal Checking the Accounting equation makes us trust our Bookkeeping entries are correct as far as we record them in accordance with the double entry system. 12.8 Bookkeeping Entries at PELZERHAGEN (Pty) Ltd. The next case study PELZERHAGEN (Pty) Ltd. contains Bookkeeping entries which involve nominal accounts. Furthermore, we now must prepare Bookkeeping entries for adjustments. See below: At the beginning of its fiscal year 20X7, PELZERHAGEN (Pty) Ltd. has 100,000.00 AUD in cash/ bank resulting from the owners’ contribution. The same amount is in issued capital. The amounts are opening values for the case study and are marked by OV. At PELZERHAGEN (Pty) Ltd., the establishment of the company does not count as Bookkeeping entry for the Accounting period 20X7; it took place before. PELZERHAGEN (Pty) Ltd.‘s first activity is paying 3,400.00 AUD for rent. The quarterly rent to an extent of 850.00 AUD is paid on 2.01.20X7, again on 1.04.20X7, again on 1.07.20X7 and the last one on 1.10.20X7. Rent is an expense and decreases profit. We make debit entries in the Rent account. As the rent is paid by bank transfer, the Cash/ Bank account is credited. Observe the four Bookkeeping entries (1a) … (1d). (1) Rent to a total of 3,400.00 AUD is paid by bank transfer on 2.01.20X7, on 1.04.20X7, on 1.07.20X7 and on 1.10.20X7. DR Rent......................... 850.00 AUD CR Cash/ Bank.................... 850.00 AUD <?page no="151"?> Berkau: Basics of Accounting 6e 12-151 DR Rent......................... 850.00 AUD CR Cash/ Bank.................... 850.00 AUD DR Rent......................... 850.00 AUD CR Cash/ Bank.................... 850.00 AUD DR Rent......................... 850.00 AUD CR Cash/ Bank.................... 850.00 AUD On 30.06.20X7, PELZERHAGEN (Pty) Ltd. pays 48,000.00 AUD for salaries. Labour as an expense, too. The labour gives a debit entry in the Labour account. The Cash/ Bank account is credited because PELZERHAGEN (Pty) Ltd. pays the salaries into their employees’ accounts. Check the Bookkeeping entry below: (2) Paying for labour on 30.06.20X7. DR Salaries..................... 48,000.00 AUD CR Cash/ Bank.................... 48,000.00 AUD The next business activity is linked to non-current assets. We make two Bookkeeping entries. The first one is for the acquisition of equipment and the second one is for the depreciation thereof. At first, we focus on the acquisition. PELZERHAGEN (Pty) Ltd.’s buys the appliances on credit. This requires making a debit entry in the Property, Plant and Equipment account and crediting the Accounts Payables (A/ P) account. Observe Bookkeeping entry (3a): (3a) Acquisition of the equipment on 3.07.20X7. DR P, P, E Account.............. 50,000.00 AUD CR Accounts Payables A/ P ........ 50,000.00 AUD After PELZERHAGEN (Pty) Ltd. bought the equipment, its value decreases by deployment. PELZERHAGEN (Pty) Ltd. writes-off the amount for equipment by Bookkeeping entry (3b). The date for that Bookkeeping entry is 31.12.20X7, because depreciation falls under adjustments. Depreciation is an expense; hence, we make a debit entry in the Depreciation account. For now, we record the contra entry on the credit side of the Property, Plant and Equipment account. In the textbook Bilanzen/ Financial Statement we recommend crediting the Accumulated Depreciation account instead. Observe the (old fashioned) depreciation Bookkeeping entry below: (3b) Depreciation on appliances on 31.12.20X7. DR Depreciation ................. 10,000.00 AUD CR P, P, E Account.............. 10,000.00 AUD <?page no="152"?> Berkau: Basics of Accounting 6e 12-152 On 31.12.20X7, PELZERHAGEN (Pty) Ltd. also recognises revenue. Revenue increases the profit and leads to a credit entry in the Revenue account. PELZERHAGEN (Pty) Ltd. earns all revenue on cash. Therefore, we make a debit entry in the Cash/ Bank account. This entry indicates a cash receipt and the increase of cash/ bank. See below the Bookkeeping entry (4): (4) Cash-revenue recognition on 31.12.20X7. DR Cash/ Bank.................... 130,000.00 AUD CR Revenue...................... 130,000.00 AUD By now, all original business activities were recorded. Observe the journal in Figure 12.3: Nr Amount Date Narrative DR CR (1a) 850.00 2.01.20X7 Paying 3,400.00 EUR rent by bank transfer on 2.01.20X7 Rent Cash/ Bank (1b) 850.00 1.04.20X7 Paying 3,400.00 EUR rent by bank transfer on 1.04.20X7 Rent Cash/ Bank (1c) 850.00 1.07.20X7 Paying 3,400.00 EUR rent by bank transfer on 1.07.20X7 Rent Cash/ Bank (1d) 850.00 1.10.20X7 Paying 3,400.00 EUR rent by bank transfer on 1.10.20X7 Rent Cash/ Bank (2) 48,000.00 30.06.20X7 Paying salaries of 48,000.00 EUR by bank transfer on 30.06.20X7 Labour Cash/ Bank (3a) 50,000.00 3.07.20X7 Acquisition of equipment for 50,000.00 EUR on credit on 3.07.20X7 P, P, E A/ P (3b) 10,000.00 31.12.20X7 Depreciation on equipment on 31.12.20X7 Depr P, P, E (4) 2,350.00 31.12.20X7 Earning revenue of 130,000.00 EURon 31.12.20X7 Cash/ Bank Revenue Pelzerhagen (Pty) Ltd. JOURNAL 20X7 Figure 12.3: PELZERHAGEN (Pty) Ltd.’s journal Depreciation and all the next Bookkeeping entries fall under adjustments. At this stage, all expense accounts, such as the Rent, Labour and Depreciation account, are debit balanced. All income/ revenue accounts, like the Revenue account, are credit balanced. We close-off all nominal accounts to the Profit and Loss account. The Bookkeeping entries for adjustments are as follows and are recorded on 31.12.20X7: DR P&L-ACCOUNT.................. 3,400.00 AUD CR Rent......................... 3,400.00 AUD <?page no="153"?> Berkau: Basics of Accounting 6e 12-153 DR P&L-Account.................. 48,000.00 AUD CR Salaries..................... 48,000.00 AUD DR P&L-Account.................. 10,000.00 AUD CR Depreciation ................. 10,000.00 AUD DR Revenue...................... 130,000.00 AUD CR P&L-Account.................. 130,000.00 AUD In the Profit and Loss account you can observe the contra entries. Using numbers for identification is not suitable as we later want to read the Profit and Loss account. With the reference indicating the source accounts, we easily can see what revenues and expenses are for. “RNT” stands for rent, “LAB” stands for salaries (= labour; we avoid “SAL” to not confuse it with sales! ), “DPR” stands for Depreciation and “REV” stands for Revenue. The balancing figure in the Profit and Loss account is called earnings before taxes because the tax expenses are still to be deducted from profit. Here, earnings before taxes equal: 130,000 - 3,400 - 48,000 - 10,000 = 6 68,600.00 AUD. The balance brought down is marked by “b/ d”. We apply the textbook standard income tax rate of 30 % and multiply it with EBT. As a result, the income taxes are amounting to: 0.3 × 68,600 = 2 20,580.00 AUD. The remainder is earnings after taxes EAT: 68,600 - 20,580 = 4 48,020.00 AUD. In case of a loss, we debit it to the Retained Earnings account; it then decreases the company’s equity. Note, the income tax recording refers to the abridged method with skipping the Income Tax Expense account as we introduced in chapter (11). See Figure 11.6. for the accounts! DR P&L-Account.................. 20,580.00 AUD CR Income Tax Liabilities....... 20,580.00 AUD DR P&L-Account.................. 48,020.00 AUD CR Retained Earnings............ 48,020.00 AUD Now, the adjustment Bookkeeping entries are completed. All nominal accounts are closed-off to the Profit and Loss account. The Profit and Loss account itself is closed-off to the Income Tax Liability account and to the Retained Earnings account. As PELZERHAGEN (Pty) Ltd. earns a profit after taxes of 48,020.00 AUD in 20X7, its equity increases. 12.9 Summary Bookkeeping entries come with a debit entry and a credit entry. Compound Bookkeeping entries contain multiple debit and/ or credit entries. Every Bookkeeping entry follows the double entry system to fulfil the Accounting equation. A Bookkeeping entry is noted by DR/ CR, the account name, the <?page no="154"?> Berkau: Basics of Accounting 6e 12-154 amount including the currency unit and the date of recording. We make Bookkeeping entries for the original business activities and for adjustments on 31.12.20XX. In this textbook we identify Bookkeeping entries for original business activities by IDs. Adjustment Bookkeeping entries are marked in the T-accounts by the 3-letter code of the contra account. 12.10 Working Definitions Bookkeeping Entry: A Bookkeeping entry is the recording of a business activity by making at least one entry on the debit side of an account and at least one on the credit side of another account. Compound Bookkeeping Entry: A compound Bookkeeping is one entry that contains more than one debit entry and/ or more than one credit entry. Adjustments: Bookkeeping entries made when preparing financial statements and which are not linked to ordinary business activities are adjustments. 12.11 Question Bank (1) On 3.02.20X1, a company buys inventories for 1,000.00 EUR on credit. What is the Bookkeeping entry? 1. DR C/ B 1,000.00 EUR; CR INV 1,000.00 EUR. 2. DR INV 1,000.00 EUR; CR C/ B 1,000.00 EUR. 3. DR INV 1,000.00 EUR; CR A/ P 1,000.00 EUR. 4. DR A/ R 1,000.00 EUR; CR INV 1,000.00 EUR. (2) Which are debit entries? 1. Increase of inventories due to purchase. 2. Debt collection in the Accounts Receivables account. 3. Payment recorded in the Cash/ Bank account. 4. Revenue recognition in the Revenue account. (3) What are expense accounts? 1. Inventories, interest, rent. 2. Depreciation, revenue, rent. 3. Depreciation, interest, rent. 4. Cash/ bank, interest, rent. (4) A company buys machinery on credit. What is the correct Bookkeeping entry? 1. DR INV; CR C/ B. 2. DR PPE; CR C/ B. 3. DR PPE; CR A/ P. 4. DR PPE; CR A/ R. (5) When closing-off depreciation to the Profit and Loss account, what is the correct Bookkeeping entry? 1. DR P&L; CR ACC. 2. DR P&L; CR DPR. 3. DR DPR; CR P&L. 4. DR DPR; CR ACC. 12.12 Solutions 1-3; 2-1; 3-3, 4-3; 5-2. <?page no="155"?> Berkau: Basics of Accounting 6e 13-155 13 Special Asset Accounts 13.1 What is in this Chapter? In this chapter, we introduce further cases about asset accounts to familiarise you with more kind of assets and Bookkeeping entries related thereto. We follow the asset structure on the balance sheet. The chapter covers property, plant and equipment, intangibles and investments as well as inventories, securities and cash/ bank. 13.2 Learning Objectives After studying this chapter, you have gained more experience with the recording of assets. You know special assets and their Accounting specialities. We do not yet focus on the valuation of assets but on their recognition. 13.3 Asset Recognition To put an asset on the balance sheet is referred to as asset recognition. It is necessary that the object meets the asset definitions and fulfils all recognition criteria: The IFRSs stimulate an asset is a resource from which future economic benefit is expected to flow to the company. A future economic benefit can be created from the asset’s deployment, from renting it out or from its sale. The second recognition criteria states that the costs of the asset must be determinable reliably. In this chapter, we pretend we know the cost of the asset which is the price. All assets are disclosed on the statement of financial position. The standards do not require their single disclosure on the statements but in the accounts. The total value of asset groups is shown on the balance sheet. A company that owns two motor vehicles at a value of 30,000.00 EUR/ u each will disclose under P, P, E a value of: 2 × 30,000 = 60,000.00 EUR on the balance sheet. It might run two separate Motor Vehicle accounts for each car. We call a system where every item of property, plant and equipment is recorded in a separate account Asset Management. Assets are either non-current or current assets. The statement of financial position discloses asset in separate sections. A non-current asset is intended to stay in the company for more than one Accounting period, like machinery. Non-current assets normally are depreciated which reflects their loss in valuation by use. However, some noncurrent assets, like land or investments, are not written-off, because they do not deplete. Examples for non-current assets are machinery, cars, rights, investments, financial instruments and investment property. There is a distinction between investments and investment property. An investment is an interest in another company exceeding 20 % of the voting rights. It can be an associated company or a subsidiary whereas investment property is land and/ or buildings rented out or held for capital appreciation. In contrast to non-current assets, current assets are consumed during the Accounting period. Current assets are inventories of materials, work-in-pro- <?page no="156"?> Berkau: Basics of Accounting 6e 13-156 cess or finished goods, receivables, securities, prepaid expenses and cash/ bank. Some items are prohibited from recognition, e.g., self-generated goodwill or items, a company cannot control, like customer lists or sun light (for a solar energy provider). When assets are acquired, they are recognised instantly, which means the asset is debited to an asset account instantly. No delay in recognition is accepted. The recognition takes place once the deal is closed. We record assets in separate accounts, meaning one account per item - even as the IFRSs do not prescribe. (You could record all assets in one account: P, P, E-Account; however, it is going to give you a hard time distinguishing your assets later; so: you rather avoid mixing assets.) Hence, even as we refer in the next paragraphs to the P, P, E-Account, consider it to be a specialised account, like the P, P, E-Account for a car licensed as CAA 237·334, or P, P, E- Account for a particular CNC machine etc. Next, we study: - Non-current asset and - Current asset recognition 13.4 Non-current Assets When a company buys tangible noncurrent assets, like land, machinery, interior, cars etc., a debit entry is recorded in the Property, Plant and Equipment account. The contra-entry is made on the credit side of the Cash/ Bank account if paid instantly, otherwise in the Accounts Payables account. In general, it is intended to deploy assets for business operations. On 1.08.20X6, PAHANG Ltd. acquires a manufacturing machine. The costs of acquisition equal 89,000.00 EUR and are paid by bank transfer instantly. The Accountant makes a Bookkeeping entry as below on 1.08.20X6: DR P, P, E Account.............. 89,000.00 EUR CR Cash/ Bank.................... 89,000.00 EUR Note, we only consider value added tax from chapter (21) onwards to keep the first Accounting chapters simple. If a company buys land or building for renting out, this counts as investment property following IAS 40. Investment property is land and/ or buildings that are for renting out or held to earn a profit by capital appreciation. Capital appreciation means buying an asset cheap and to expect making a profit by selling it at a higher price in the future. Investment property differs from P, P, E. If land/ buildings are deployed for business operations, like production or administration, it counts as P, P, E - if rented out or held for capital appreciation, it is investment property. Investment property is assigned to a special account named Investment Property account. POLLOK Ltd. buys land with an office block which is built on the plot. The costs of acquisition are 1,000,000.00 EUR. The land and the building are rented out. The <?page no="157"?> Berkau: Basics of Accounting 6e 13-157 Accountant makes the Bookkeeping entry as below on 3.05.20X4. DR Investment Property.......... 1,000,000.00 EUR CR Cash/ Bank.................... 1,000,000.00 EUR Most tangible assets are for the use in the company and recorded as property, plant, equipment: On 4.02.20X6, LINTON Ltd. acquires a business car on cash. The car is intended for use in the business. The car is bought from the local car dealership at 25,000.00 EUR. The car is a tangible asset and therefor recorded under property, plant and equipment. The Accountant makes a Bookkeeping entry as below on 4.02.20X6. DR P, P, E Account.............. 25,000.00 EUR CR Cash/ Bank.................... 25,000.00 EUR NEWTON (Pty) Ltd. buys office furniture on 3.03.20X4. The costs of acquisition are 13,500.00 EUR. The furniture is bought on credit. It is agreed that NEWTON (Pty) Ltd. pays the amount in the next following Accounting period 20X5. The furniture is for use in the business. NEWTON (Pty) Ltd.‘s Bookkeeper records the furniture on the debit side of the Property, Plant and Equipment account on 3.03.20X4 by the Bookkeeping entry below: DR P, P, E Account.............. 13,500.00 EUR CR Accounts Payables............ 13,500.00 EUR When a company manufactures a product under license, they must buy rights of manufacturing and recognise them as intangible asset. The right's use can be limited for a certain period according to the agreement. An intangible asset is an asset without physical nature. Examples for intangible assets are licenses, warranties, patents, software, franchise agreements etc. Some intangible assets are prohibited from recognition, e.g., customer lists, patient data, etc. A company only can recognise assets it can control. Therefore, customer lists, soccer players, sun light for a solar energy provider, nice view for a hotel etc., are exempted from recognition. MISSIONVALE Ltd. intends to produce staplers. There is a patent held by another company for a special needle bending mechanism. To manufacture the staplers, MISSIONVALE Ltd. acquires a license from the patent holder at 10,000.00 EUR on 6.02.20X3. The license is paid by bank transfer. The Bookkeeping entry is made in the Intangible Asset account as it falls under rights. The Bookkeeping entry is made on 6.02.20X3. <?page no="158"?> Berkau: Basics of Accounting 6e 13-158 DR Intangible Assets............ 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR There are also financial assets. Financial instruments are contracts leading to an asset at one party and to an equity or liability item at the other one. When a company issues shares, the shareholder discloses them as a financial asset (1 st party) and the issuer will recognise an item of issued capital (2 nd party). KABEGA Ltd. buys shares of McDonald’s Corporation on 24.11.20X6. The company intends to hold the shares for more than one Accounting period to benefit from the dividends quarterly declared by McDonald’s Corporation. The shares are bought at a share price of 72.00 EUR/ s. KABEGA Ltd. buys 2,000 shares. Although the face value of the McDonald’s Corporation’s share is 0.01 USD/ s, the price KABEGA Ltd. paid for the share matters for its initial recognition. The shares' value equals: 2,000 × 72 = 1 144,000.00 EUR. The Bookkeeper records the shares in the Financial Instruments account on 24.11.20X6. DR Financial Instruments........ 144,000.00 EUR CR Cash/ Bank.................... 144,000.00 EUR Once a company sells an asset it must credit the relevant asset account. The cash or its equivalent received is added to the Cash/ Bank account as it is a cash inflow. SCHAUDER Ltd. owns a truck. The carrying amount equals 67,000.00 EUR as disclosed on the statement of financial position. SCHAUDER Ltd. sells the vehicle at a net selling price of 67,000.00 EUR on 4.01.20X6. The money from the buyer is received on cash. The Accountant at SCHAUDER Ltd. makes a Bookkeeping entry for the disposal of the truck on 4.01.20X6. DR Cash/ Bank.................... 67,000.00 EUR CR P, P, E-Account.............. 67,000.00 EUR An alternative Bookkeeping approach for disposals is the application of the Realisation account. This splits the above Bookkeeping entry in smaller multiple entries. In Accounting classes, the Realisation account is helpful to avoid Bookkeeping errors when the asset is disclosed in a P, P, E-Account and in accumulated depreciation. In case of SCHAUDER Ltd., the Bookkeeping entries based on the Realisation account are: DR Cash/ Bank.................... 67,000.00 EUR CR Realisation.................. 67,000.00 EUR <?page no="159"?> Berkau: Basics of Accounting 6e 13-159 DR Realisation .................. 67,000.00 EUR CR P, P, E-Account.............. 67,000.00 EUR In case a company buys an asset and receives a discount on acquisition, the discount must be deducted from the purchase price. Learn more about discounts in chapter (36). DUNOON Ltd. buys a drilling machine from its supplier on 5.04.20X8. The supplier allows a discount of 5 % on the net selling price of 100.00 EUR. The costs of acquisition are: 100 × (1 - 5%) = 9 95.00 EUR. The Accountant makes the Bookkeeping entry below on 5.04.20X8. DR P, P, E ACCOUNT.............. 95.00 EUR CR Cash/ Bank.................... 95.00 EUR 13.5 Current Assets Non-current assets are assets, the company does not intend to keep longer than one Accounting period. Current assets are inventories, receivables, securities, prepaid expenses and cash/ bank. We apply various accounts for different inventories, for receivables, for securities, for prepaid expenses and for cash/ bank. When a company buys inventory, its costs are referred to as the purchase costs. In chapter (21), we introduce a special Purchase account for inventories. When purchasing inventories, the debit entry is made in the Purchase account or directly in the Inventory account, both is correct. The Bookkeeping entry depends on the inventory movement system in use. At first, we refer to the perpetual system and debit inventories to the Inventory accounts. Further considerations are made in chapter (20) and (26). The contra entry is recorded in cash/ bank or accounts payables if the purchase is on credit. We check our first case study for recording inventories in a production firm: GOVAN Ltd. is a tablecloth manufacturer. On 3.02.20X1, GOVAN Ltd. buys from its supplier fabric for 15,000.00 EUR on cash. The Bookkeeping entry for the purchase takes place on 3.02.20X1 as below: DR Inventory (Materials)........ 15,000.00 EUR CR Cash/ Bank.................... 15,000.00 EUR For now, we skip the production process details and assume GOVAN Ltd. sells finished goods (the manufactured tablecloths) on 5.04.20X1 to a wholesaler at 35,000.00 EUR. The money is received owe bank transfer on the same day. <?page no="160"?> Berkau: Basics of Accounting 6e 13-160 DR Cash/ Bank.................... 35,000.00 EUR CR Inventory (Finished Goods)... 35,000.00 EUR How it is Done (Asset Recognition): (1) Distinguish between current and non-current assets. (2) Choose the correct asset account. (3) Determine the cost of acquisition or cost of purchase by deducting discounts and input-VAT. (4) Debit the cost of acquisition or cost of purchase to the asset account. (5) Credit the payment or the payables to the Cash/ Bank account or add the amount to the Accounts Payables (A/ P) account if the buy was on credit. When companies pay for service in advance - so called prepayments and the service paid for is delivered after the balance sheet’s day, we must recognise the service paid for under prepaid expenses. Prepaid expenses are expenses for a specific Accounting period in the future that is paid for during the actual Accounting period. Prepaid expenses are not paid for assets; this would be a down payment. Examples for prepaid expenses are rent, labour, insurances, etc., paid for the next Accounting period. We study this concept in detail in chapter (18). Note, that the German Handelsgesetzbuch requires the recognition of accruals under an extra item on the balance sheet: Aktivischer Rechnungsabgrenzungsposten. This is to separate (abgrenzen) payments made for future services from current assets. In contrast, IFRSs consider prepaid expenses as current assets. We study ALBANS Ltd. who buys a magazine and pays in advance: ALBANS Ltd. orders a magazine online. The magazine is published every month. The magazine is paid one year in advance. The total costs for one year are 120.00 EUR. ALBANS Ltd. buys the magazines on 1.07.20X4 and pays for them instantly. The magazine contract commences on 1.07.20X4 and ends on 30.06.20X5. When ALBANS Ltd. prepares its financial statements on 31.12.20X4, the paid magazines issued in 20X5 are classified as prepaid expenses. Therefore, the contract for the magazine must be recorded by two Bookkeeping entries on 1.07.20X4 and 31.12.20X4: DR Magazine Expenses............ 120.00 EUR CR Cash/ Bank.................... 120.00 EUR DR Prepaid Expenses............. 60.00 EUR CR Magazine Expenses............ 60.00 EUR The second Bookkeeping entry falls under adjustments at the end of the Accounting period, on 31.12.20X4. The Prepaid Expenses account belongs to the current asset section on the balance sheet. <?page no="161"?> Berkau: Basics of Accounting 6e 13-161 When a company buys financial instruments and does not intend to hold them for a longer period, we call them securities. The IFRSs use a special criterion to distinguish long-term investments and securities. If the intention is to receive regular payments for interest and pay-off, we assume the financial instruments belong to non-current assets. If a company holds them "ready to sell", the allocation is towards securities. The name securities indicates that they are available for exchange to cash at any time. Hence, we say: Securities are financial instruments held ready for sale. In order to stress their purpose, we also could say "ready for liquidation" which makes clear, securities are held for earning interest, but they can be turned into cash at any time if necessary. Study the case below: WATERVILLE Ltd. is a car dealership. On 3.05.20X6, WATERVILLE Ltd. has 78,000.00 EUR cash on hand. To invest its funds, WATERVILLE Ltd. buys 2,000 shares of McDonald's corporation at 39.00 EUR/ s. WATERVILLE Ltd. is prepared to sell the shares once in need of cash or once a high share price is traded at the NYSE (New York Stock Exchange). The shares are classified as securities. The Bookkeeping entry after acquisition of the shares is made on 3.05.20X6: DR Securities................... 78,000.00 EUR CR Cash/ Bank.................... 78,000.00 EUR On 30.08.20X6, the MCD-shares are traded at 45.00 EUR/ s. WATERVILLE Ltd. decides to sell all its shares and records a profit on disposal. The Bookkeeping entry on 30.08.20X6 is as below: DR Cash/ Bank.................... 90,000.00 EUR CR Securities................... 78,000.00 EUR CR Gain on Securities........... 12,000.00 EUR The last item on the current asset section is cash/ bank. For our studies, we normally only refer to one item: cash/ bank and ignore that a company has different bank accounts. Although, most companies have more than one bank account. To calculate the total of cash at bank, we add the balancing figures of all cash and bank accounts. This leads to the item cash/ bank we disclose on the balance sheet. Companies also want to compare their internal Bookkeeping records to the bank statements received from their bank(s). This comparison is called bank reconciliation and will be discussed in chapter (37). For a reconciliation of the Bank account with the bank statements, companies mirror their bank account to one account in their Bookkeeping records. We strive to distinguish those accounts properly. We call an account with a bank, like with Captic Bank or Commerzbank, a bank account, written with a lower "b". In contrast, an account which belongs to the company’s Bookkeeping records is called a Bank account - written with capital letter "B". This complies <?page no="162"?> Berkau: Basics of Accounting 6e 13-162 with the rule along which we write every account's name in this textbook in capital letters. When a company has different bank accounts and/ or runs various cash accounts, its Cash/ Bank account will be split into subordinated Cash accounts and Bank accounts. Observe the next case study. SCHOENMAKERSKOP Ltd. banks with Deutsche Bank and Sparkasse Osnabrück. Furthermore, SCHOENMAKERS- KOP Ltd. applies one Cash account. On 2.01.20X6, the opening value for the bank account with Deutsche Bank is 54,000.00 EUR and for the account with Sparkasse Osnabrück is 4,000.00 EUR. The company has 300.00 EUR cash on hand. On the statement of financial position, SCHOENMAKERSKOP Ltd. shows: 54,000 + 4,000 + 300 = 5 58,300.00 EUR. On 23.01.20X6, SCHOENMAKERSKOP Ltd. receives 6,000.00 EUR from a customer who owed the amount from a previous sale. The receivables previously were disclosed in the Accounts Receivables A/ R account. The customer transfers the money to SCHOENMAKERSKOP Ltd.‘s Deutsche Bank account. Later, SCHOENMAKERSKOP Ltd. withdraws 500.00 EUR and keeps it in cash. Observe the Bookkeeping entries made on 23.01.20X6 and 25.01.20X6 as below: DR Deutsche Bank account........ 6,000.00 EUR CR Accounts Receivables......... 6,000.00 EUR DR Cash......................... 500.00 EUR CR Deutsche Bank account........ 500.00 EUR The transfers can be studied by the T-accounts below: D C D C OV 54,000.00 (2) 500.00 OV 4,000.00 c/ d 4,000.00 (1) 6,000.00 c/ d 59,500.00 b/ d 4,000.00 60,000.00 60,000.00 b/ d 59,500.00 D C D C OV 300.00 OV 6,000.00 (1) 6,000.00 (2) 500.00 c/ d 800.00 800.00 800.00 b/ d 800.00 Cash Accounts receivables A/ R Bank account with Deutsche Bank Bank account with Sparkasse Osnarbrück Figure 13.1: SCHOENMAKERSKOP Ltd.‘s accounts <?page no="163"?> Berkau: Basics of Accounting 6e 13-163 The amount to be displayed on the statement of financial position equals: 59,500 + 4,000 + 800 = 6 64,300.00 EUR. 13.6 Summary Asset accounts are for non-current and current assets. Asset accounts increase by debit entries and decrease by credit entries. In the accounts and for the financial statements, companies distinguish non-current and current assets. In general, non-current assets are kept for more than one Accounting period. The technical Accounting terms for buying non-current assets are "acquisition" and for current assets "purchase". The classification applies generally. A company that produced a gear box according to a customer's special request and has it still on stock, will keep it under inventories of finished goods, even as the gear box sits there since years. The recognition criteria for assets in accordance with IFRSs are (1) existence of future economic benefit resulting from the asset and (2) reliable measurement of the costs. The asset accounts we apply follow the structure of the asset section on the balance sheet. Hence, we apply P, P, E-accounts, Intangible accounts, Investment accounts, Investment Property accounts and Financial Asset accounts for non-current assets. For inventories we apply Inventory accounts, Accounts Receivables A/ R accounts, Security accounts, Prepaid Expenses account and the Cash/ Bank account. 13.7 Working Definitions Asset: Assets are resources from which a future economic benefit is expected to flow to the company. Asset Management: We call a system where every item of property, plant and equipment is recorded in a separate account Asset Management. Capital Appreciation: Capital appreciation means buying an asset cheap and to expect making a profit by selling it at a higher price in the future. Financial Instruments: Financial instruments are contracts which lead to an asset at one party and to an equity or liability item at the other one. Investment: An investment is an interest in another company exceeding 20 % of the voting rights. Investment Property: Investment property is land and/ or buildings rented out or held for capital appreciation. Intangible Assets: An intangible asset is an asset without physical nature. Prepaid expenses: Prepaid expenses are expenses for a specific Accounting period in the future that is paid for during the actual Accounting period. Recognition Criteria: It is necessary that the object meets the asset definitions and fulfils all recognition criteria: The IFRSs stipulate an asset is a resource from which future economic benefit is expected to flow to the company. The second recognition criteria states that the costs of the asset must be determinable reliably. Securities: Securities are financial instruments held ready for sale 13.8 Question Bank (1) What are non-current assets? 1. Machinery, cars, land. <?page no="164"?> Berkau: Basics of Accounting 6e 13-164 2. Business cars, materials, equipment. 3. Financial instruments, cash/ bank, receivables. 4. Machinery, investments, inventory. (2) What is the Bookkeeping entry for the recognition of a machine bought half on cash and half on credit? 1. DR PPE; CR A/ P. 2. DR PPE; DR A/ R; CR C/ B. 3. DR PPE; CR A/ P; CR C/ B. 4. DR PPE; DR A/ P; CR C/ B. (3) What are the criteria for the recognition of an asset? 1. Value of the asset; reliable measurement. 2. Future economic benefit; reliable measurement. 3. Future economic benefit; ownership. 4. Ability to sell the asset; reliable measurement. (4) A company buys 2,000 shares of McDonald's that have a face value of 0.01 USD/ s at 113.00 EUR/ s with the intention to sell them on and earning a profit. How does it record the share purchase? 1. DR SEC 226,000.00 EUR; CR C/ B 224,000.00 EUR; CR ISS 2,000.00 EUR. 2. DR SEC 226,000.00 EUR; CR ISS 226,000.00 EUR. 3. DR C/ B 226,000.00 EUR; CR ISS 226,000.00 EUR. 4. DR SEC 226,000.00 EUR; CR C/ B 226,000.00 EUR. (5) A trading company buys goods for 200,000.00 EUR and sells 60 % thereof at a selling price that is double of the cost of purchase. How much is the profit? 1. 120,000.00 EUR . 2. 240,000.00 EUR . 3. 40,000.00 EUR . 4. 160,000.00 EUR . 13.9 Solutions 1-1; 2-3; 3-2; 4-4; 5-1. <?page no="165"?> Berkau: Basics of Accounting 6e 14-165 14 Special Equity Accounts 14.1 What is in the Chapter? In this chapter, we discuss some special equity accounts to provide an overview about the equity section on the balance sheet. We cover issued capital and reserves for limited companies. Companies in private ownership are discussed in chapter (24). Additionally, the most common Bookkeeping entries for the Retained Earnings account are discussed. 14.2 Learning Objectives After studying this chapter, you will understand the equity section of the balance sheet. In particular, you see how funds are brought into the business at the time of incorporation and how profit and loss affect the total of equity. You also learn how to calculate the book value for companies which is the sum of their equity. 14.3 Equity Section on the Balance Sheet The equity section on the balance sheet is divided in three major parts: - Issued Capital, - Reserves and - Retained Earnings. The issued capital is the face value of the shares. This is also called the nominal value and is the amount the company at least is held responsible for. It reflects the owners’ contribution to the company. At the time of the share issue, the amount is credited to the Issued Capital account. We call the equity instruments shares, however a company that is in the legal form of a (Pty) Ltd. or a German GmbH (Gesellschaft mit beschränkter Haftung) will not call them shares but title of partial of ownership. For equity disclosure a simple rule applies: The issued capital always reflects the nominal value of the shares. Reserves belong to the equity of a company as well. They result from earnings, a share issue's premium or from revaluations. Additions to or deductions from reserves increase/ decrease the equity; therefore, they change the book value of a company. All earnings (after taxation) in the Profit and Loss account are closed-off to the Retained Earnings account. The retained earnings can contain profits/ losses carried forward from prior Accounting periods. When a company declares a dividend or adds earnings to reserves the Retained Earnings account is debited. Below, we discuss case studies to learn about the three equity items. Mostly, more than one thereof is involved in transactions. Therefore, the next following chapters are overlapping. 14.4 Issued Capital At the time of incorporation, the proprietors contribute funds to their business. The amount often is determined by the company’s act, such as 50,000.00 EUR for the establishment of a German company on shares - in accordance with § 7 AktG. The issued capital only changes, when fresh shares are issued or if shares are bought back (treasury share stock) or redeemed. The issued capital must be recognised <?page no="166"?> Berkau: Basics of Accounting 6e 14-166 at face values in the Issued Capital account. In general, fresh shares are issued at an issue price higher than the face value. The reason is, that shares represent a portion of the company's equity. Any share issue with an issue price exceeding the face value requires adding the premium - which is the amount by which the issue price exceeds the face value - to capital reserves. We study the case of PLEASANT (Pty) Ltd. The company is a limited company but not based on shares. PLEASANT (Pty) Ltd. is established by its proprietors contributing 50,000.00 EUR (all together) on 2.01.20X1. The money is paid into PLEASANT (Pty) Ltd.’s Bank account and credited to the Issued Capital account. DR Cash/ Bank.................... 50,000.00 EUR CR Issued Capital............... 50,000.00 EUR Next, we study a company based on shares: ARLINGTON Corp. is based on shares. The company is established on 2.01.20X5 by a share issue of 20,000 shares at 5.00 USD/ s. The issued capital equals: 20,000 × 5 = 1 100,000.00 USD. DR Cash/ Bank.................... 100,000.00 USD CR Issued Capital............... 100,000.00 USD The following case study is about a share issue with a premium. Hence, we now must consider capital reserves. MALABAR PLC is a British public limited company based on shares. The company is established on 2.01.20X3 by an issue of 100,000 ordinary shares. The face value per share is 1.00 GBP/ s. The face value of a share is its nominal value. The issue price per share is 1.34 GBP. The value contributed by the shareholders equals: 100,000 × 1.34 = 1 134,000.00 GBP. As this amount exceeds the face value of the shares, the premium is credited to the Share Premium account. T The premium is the portion by which the issue price exceeds the nominal value of a share. It is added to the Share Premium account and later transferred to capital reserves. DR Cash/ Bank.................... 134,000.00 GBP CR Issued Capital............... 100,000.00 GBP CR Share Premium................ 34,000.00 GBP The application of share premiums depends on national law. Mostly, the premium is transferred straight to the capital reserves. Do not mix capital reserves with issued capital. MALABAR PLC. closes-off its share premium to capital reserves. <?page no="167"?> Berkau: Basics of Accounting 6e 14-167 DR Share Premium ................ 34,000.00 GBP CR Capital Reserves............. 34,000.00 GBP The valuation for issued capital does not depend on the earnings of a company. Even in cases when the company makes losses, the value of shares remains disclosed at face values. If shares of a company are traded publicly, its fair market value is the price its shares are traded at a stock exchange. The fair market value does not affect the issued capital on the balance sheet. We study a case of a public company: VANSTADENS Ltd. is established on 2.01.20X5 by a share issue of 50,000 ordinary shares at a face value of 1.00 EUR/ s. The issue price was 1.70 EUR/ s. On 31.12.20X5, the shares are traded at the national stock exchange at 2.50 EUR/ s. The issued capital is amounting to: 50,000 × 1.00 = 5 50,000.00 EUR. The capital reserves contain the share premium which equals: (1.70 - 1.00) × 50,000 = 3 35,000.00 EUR. At the time of incorporation, the Accountant credits the Issued Capital account and the Share Premium account, followed by closing-off the Premium account to the Capital Reserves account. DR Cash/ Bank.................... 85,000.00 EUR CR Issued Capital............... 50,000.00 EUR CR Share Premium ................ 35,000.00 EUR DR Share Premium ................ 35,000.00 EUR CR Capital Reserves............. 35,000.00 EUR Although the fair market value of shares increased to 2.50 EUR/ s at the end of the Accounting period, both, the Issued Capital account and the Capital Reserves account, remain unchanged at 50,000.00 EUR and 35,000.00 EUR. On 31.12.20X5, VANSTADENS Ltd.'s book value is: 50,000 + 35,000 = 85,000.00 EUR. Its fair market value is amounting to: 50,000 × 2.50 = 125,000.00 EUR. Investors are prepared to pay a price that exceeds the book value of a company per share when they expect the company to be prosperous. We acknowledge that the financial statements of the shares issuing company do not show fair market values of shares as traded at a stock exchange. However, in Financial Statement Analysis we calculate the market book ratio to evaluate the company. Companies with low share prices are at risk to be taken over because they are easy (cheap) to buy and to gain their voting rights. An investor (group) holding the majority of the voting rights controls the company. Mergers and Acquisitions are covered in the textbook Management Accounting, chapter (11). 14.5 Reserves We already studied capital reserves. Besides of them, a company can disclose revaluation reserves and earnings reserves. <?page no="168"?> Berkau: Basics of Accounting 6e 14-168 A revaluation reserve is recorded when a company re-values its assets at a carrying amount that exceeds the acquisition costs. The increase in valuation is recorded as equity and added to revaluation reserves. For the Basics, we ignore revaluations. Revaluations are discussed in detail in the textbook Bilanzen/ Financial Statements, chapter (7). Earnings reserves are recorded/ credited if a company decides to keep its profit. Alternatives for keeping earnings are to carry them forward to the next Accounting period as retained earnings or to add them to earnings reserves. A further possibility is to declare a dividend to the shareholders. We check the case of WINDLASS Ltd. The Australian company earns a profit after taxes of 30,000.00 AUD. The amount is transferred to its Retained Earnings account. On the Annual General Meeting (AGM), the shareholders of WINDLASS Ltd. opt for adding the profit after taxes to earnings reserves. The Bookkeeping entry for WINDLASS Ltd.'s appropriation of profits is: DR Retained Earnings............ 30,000.00 AUD CR Earnings Reserves............ 30,000.00 AUD 14.6 Retained Earnings A business that earns profits over the years will increase its equity. The Retained Earnings account is credited for each profit after taxes. If the company decides to reinvest the funds, it will add retained earnings to reserves. Therefore, an increase is recorded in the Earnings Reserves account and a debit entry is made in the Retained Earnings account. The transfer does not change the book value of the business. It is purely an equity swop. In general, the appropriation of profits is either (1) adding earnings to the Reserves account, (2) paying a dividend to the shareholders or (3) carrying forward the profit. The three options can be mixed. For German companies § 58 AktG caps the addition to earnings reserves. In case the company does not appropriate its profits, the earnings remain in the Retained Earnings account and get carried forward to the next Accounting period. Similar procedures apply for a loss. SLOVO Ltd. earned a profit after taxes in 20X5 of 400,000.00 ZAR. The company decides to keep the earnings for future investments. That way, the profit increases the company’s equity. On 31.12.20X5, SLOVO Ltd.‘s Accountant makes the Bookkeeping entries as below: DR P&L-Account.................. 400,000.00 ZAR CR Retained Earnings............ 400,000.00 ZAR DR Retained Earnings............ 400,000.00 ZAR CR Earnings Reserves............ 400,000.00 ZAR <?page no="169"?> Berkau: Basics of Accounting 6e 14-169 A company that declares a dividend to its shareholders decreases equity. Declaring a dividend means to pay the profit to shareholders or to record a short-term liability for doing so in the next following Accounting period. The payables account that applies for dividends is called Shareholder for Dividend account. To declare a dividend results in a transfer of earnings from equity to liabilities. This results in a reduction of the book value of the company. The British company BRAMHOPE PLC. earns a profit after taxes of 100,000.00 GBP in 20X4. The amount is declared as a dividend to BRAMHOPE PLC.‘s shareholders. On 31.12.20X4, BRAMHOPE PLC.‘s Accountant adds the profit to the Accounts Payables account. As a result, the profit cannot increase BRAMHOPE PLC.'s equity. DR P&L-Account.................. 100,000.00 GBP CR Retained Earnings............ 100,000.00 GBP DR Retained Earnings............ 100,000.00 GBP CR A/ P (ShD).................... 100,000.00 GBP In the next case study, the company ARCADIA Ltd. keeps the profit earned in the Retained Earnings account. This way, it carries profits forward to the next Accounting period. ARCADIA Ltd. earns a profit after taxes of 30,000.00 EUR in 20X6. The amount is displayed on the bottom line of the income statement as earnings after taxes. On 31.12.20X6, the Accountant transfers the amount to the equity section of the statement of financial position by closing-off the Profit and Loss account to retained earnings. As no further Bookkeeping entry is made, the profit remains in the Retained Earnings account. That is where the name “Retained Earnings“ comes from. A company can carry forward its earnings and decide about the appropriation thereof in future Accounting periods. It can even carry forward the profit for more than one Accounting period. The latter one deprives the shareholders of their dividends. This is not recommended as it can affect the share price. DR P&L-ACCOUNT .................. 30,000.00 EUR CR Retained Earnings............ 30,000.00 EUR If a company makes a loss, its equity decreases. In general, we always assume a company is worth at least its issued capital. This assumption is wrong. A public company in the legal form of a GmbH that is established with 25,000.00 EUR and makes a loss of 10,000.00 EUR is worth 15,000.00 EUR. Hence, it is now only reliable to that amount. <?page no="170"?> Berkau: Basics of Accounting 6e 14-170 We next discuss the case of RENSBURG Ltd., which makes a loss. RENSBURG Ltd. got the following opening values for its accounts: Issued Capital account: 100,000.00 EUR, Earnings Reserves account: 200,000.00 EUR and Retained Earnings account: 100,000.00 EUR, which results from previous Accounting periods. RENSBURG Ltd. makes a loss in 20X7 to the extent of 45,000.00 EUR. It results from a revenue of 200,000.00 EUR, labour 100,000.00 EUR, depreciation 55,000.00 EUR and rent 90,000.00 EUR. The loss equals: 200,000 - 100,000 - 55,000 - 90,000 = - -45,000.00 EUR. The amount appears on the bottom line of the income statement. No income taxes apply for RENSBURG Ltd. due to the loss. As the balancing figure of RENSBURG Ltd.‘s Profit and Loss account is on the credit side, the Bookkeeping entry now appears “inverted”, because the loss is debited to the Retained Earnings account. This decreases the profit carried forward from previous Accounting periods: DR Retained Earnings............ 45,000.00 EUR CR P&L-Account.................. 45,000.00 EUR A debit entry in the Retained Earnings account decreases the equity of the business. After making the Bookkeeping entries, RENSBURG Ltd.‘s equity equals: 100,000 + 200,000 + 55,000 = 3 355,000.00 EUR. In the previous Accounting period, it was 400,000.00 EUR. See RENSBURG Ltd.‘s accounts below: D C D C c/ d 100,000.00 OV 100,000.00 c/ d 200,000.00 OV 200,000.00 b/ d 100,000.00 b/ d 200,000.00 D C D C P&L 45,000.00 OV 100,000.00 Lab 100,000.00 Rev 200,000.00 c/ d 55,000.00 Dpr 55,000.00 100,000.00 100,000.00 Rnt 90,000.00 EBT 45,000.00 b/ d 55,000.00 245,000.00 245,000.00 b/ d 45,000.00 R/ E 45,000.00 Retained earnings R/ E Profit and Loss-20X7 P&L Issued Capital ISS Earnings Reserves RES Figure 14.1: RENSBURG Ltd.‘s accounts Note, companies applying the German Handelsgesetzbuch (HGB) apply the Annual Surplus account differently from retained earnings. See § 266 III HGB for the structure of the balance sheet and rules for equity recognition. <?page no="171"?> Berkau: Basics of Accounting 6e 14-171 How it is Done (Appropriation of Profits) (1) If positive, credit the profit for the period to the Retained Earnings account. If negative, make a debit entry in the Retained Earnings account. (2) Decide about the appropriation of profits or parts thereof: (a) carrying forward, (b) transferring to reserves and/ or (c) declaring a dividend. (3a) Nothing needs to be done. Leave the amount in the Retained Earnings account. (3b) Take the amount for reserves out of the Retained Earnings account by a debit entry and credit it to the Earnings Reserves account. (3c) Take the amount to be declared as a dividend out of the Retained Earnings account and credit the amount to the Shareholder for Dividend account. Close-off the Shareholder for Dividend account to the Accounts Payables account. (4) You might go for partial appropriations of profits by combining (a), (b) and (c). Furthermore, check the national law for amounts capped. 14.7 Summary Equity contains issued capital, reserves and retained earnings. Issued capital is the nominal amount resulting from share issues. Profits and losses change the total value of a company’s equity. They are added to/ deducted from retained earnings. A company that intends to reinvest the profit, will transfer it to the earnings reserves. A declaration of a dividend reduces the retained earnings and adds the earnings to the Shareholder for Dividend account. 14.8 Working Definitions Face value: The face value of a share is its nominal value. Fair Market Value: If shares of a company are traded publicly, its fair market value is the price its shares are traded at a stock exchange. Issued Capital: The issued capital is the value of shares. Premium: The premium is the portion by which the issue price exceeds the nominal value of a share. Reserves: Reserves belong to the equity of a company as well. They result from earnings, a share issue's premium or from revaluations. 14.9 Question Bank (1) Which are items of equity? 1. Issued capital, dividends, capital reserves. 2. Bonds, revaluation reserves, profit carried forward. 3. Issued capital, Provisions, retained earnings. 4. Share premiums, earnings reserves, retained earnings. <?page no="172"?> Berkau: Basics of Accounting 6e 14-172 (2) A company issues 500,000 ordinary shares with a face value of 5.00 EUR/ s at 8.35 EUR/ s. What is the correct Bookkeeping entry? (SPA = Share Premium Account) 1. DR ISS 4,175,000.00 EUR; CR C/ B 2,500,000.00 EUR; CR SPA 1,675,000.00 EUR. 2. DR C/ B 4,175,000.00 EUR; CR ISS 2,500,000.00 EUR; CR SPA 1,675,000.00 EUR. 3. DR C/ B 2,500,000.00 EUR; CR ISS 2,500,000.00 EUR. 4. DR C/ B 4,175,000.00 EUR; DR ISS 2,500,000.00 EUR; CR SPA 1,675,000.00 EUR. (3) Define distributable amount! 1. Number of shares to be allocated to shareholders. 2. Profit of the period that can be paid to the shareholders. 3. Amount in the Retained Earnings account that can be declared as a dividend. 4. Annual surplus that can be added to equity. (4) A company carries forward a loss of 34,000.00 EUR. In the actual Accounting period, the pre-tax profit is amounting to 100,000.00 EUR. How much is the distributable amount? 1. 36,000.00 EUR . 2. 66,000.00 EUR . 3. 134,000.00 EUR . 4. 104,000.00 EUR . (5) A company records a profit carried forward of 45,000.00 EUR and a profit after taxation of 200,000.00 EUR. It declares a dividend of 0.80 EUR/ s to its 100,000 shareholders and adds 75,000.00 EUR to earnings reserves. What is the correct Bookkeeping entry? 1. DR R/ E 245,000.00 EUR; CR A/ P 80,000.00 EUR; CR RES 75,000.00 EUR; CR C/ B 90,000.00 EUR. 2. DR R/ E 155,000.00 EUR; CR A/ P 80,000.00 EUR; CR RES 75,000.00 EUR. 3. DR P&L 155,000.00 EUR; CR A/ P 80,000.00 EUR; CR RES 75,000.00 EUR. 2. DR R/ E 155,000.00 EUR; DR A/ P 80,000.00 EUR; CR RES 245,000.00 EUR. 14.10 Solutions 1-4; 2-2; 3-3; 4-1; 5-2. <?page no="173"?> Berkau: Basics of Accounting 6e 15-173 15 Special Liability Accounts 15.1 What is in the Chapter? In this chapter, we introduce particular liability accounts and give examples for Bookkeeping entries linked thereto. The aim is to widen your Accounting experience by some further examples and to familiarise you with the liability section on the balance sheet. We also give you examples about bank loans and the calculation of interest and payoff. You need that knowledge once it comes to financing a business with loans. Detailed information about the calculation and disclosure of bank loans and further liability instruments is given in the textbook Bilanzen/ Financial Statements in chapter (14). 15.2 Learning Objectives The aim is that you will be able to calculate bank loans and know the basic bookkeeping entries for their recording. In this chapter, we provide you with easy examples of liabilities that are common in business. 15.3 Liabilities Not all companies finance their business with their own funds. Most of them borrow money from the bank (as a loan) or from the public (as a bond). A liability is an obligation to pay an amount of money or its equivalent or to deliver goods/ services in the future. The obligation must exist at the time of recording. An expected outflow of money does not qualify for a liability recognition. A liability exists once the debtor (the party that owes the money) takes the bank loan. The value of the loan is the principal. The principal is the amount the borrower owes and must disclose as liability in the first place. By payingoff liabilities their value decreases over the time. The IFRSs require disclosing long-term and short-term liabilities separately. The reason is that longterm liabilities need to meet special disclosure requirements, like a valuation by the effective interest method or must be recorded at fair values (bonds). In contrast, short-term liabilities are shown on the balance sheet at settlement values. The settlement value is the amount of money that is to be paid-off. In general, the settlement amount is the principal. 15.4 Effective Interest Calculation The effective interest method will be introduced in chapter (14) of Bilanzen/ Financial Statements. If settlement amounts equate the principal of the loan (nominal value) and payments are made annually, the effective interest rate is the same as the nominal rate of interest. If interest is paid monthly, the effective rate of interest exceeds the annual rate i. The effective rate of interest is then: i eff = (1 + i/ 12) 12 - 1. MALIBONGWE Ltd. takes a bank loan of 500,000.00 EUR. The rate of interest is 3.5 %/ a. Interest is paid monthly. The effective rate of interest equals: i eff = (1 + 3.5%/ 12) 12 - 1 = 33.56%/ a. The payments made are still 3.5%/ 12. This means, MALIBONGWE Ltd. pays every month: 500,000 × 3.5%/ 12 = 1 1,458.33 EUR. The higher effective rate of interest results <?page no="174"?> Berkau: Basics of Accounting 6e 15-174 from the bank earning a compound interest on received payments during the year. No higher payments (based on the effective interest rate) are made. In this textbook, we assume all payments for interest are made at the end of the Accounting period. Furthermore, we simplify the calculation by assuming that no bank fees apply, and the total of pay-off equates the principal. Hence, the effective rate of interest equals the nominal one. 15.5 Disclosure of Liabilities Although we do not apply the effective interest method for now, we must disclose long-term and short-term liabilities separately. Long-term liabilities are recorded in the Interest Bearing Liability account. Short-term liabilities are recorded in the Accounts Payables (A/ P) account. A company buying goods on credit will disclose the liability as short-term payables because the payment is due in the next Accounting period. If it is agreed to settle the debts later, e.g., in 2 years’ time, the loan will be classified as long-term liability and disclosed under interest bearing liabilities - even as no interest is agreed to pay. JEGESVILLE Ltd. buys a business car Mercedes c-class on credit at a purchase price of 60,000.00 EUR on 18.05.20X3. The price is paid later. JEGESVILLE Ltd.‘s Accountant makes a Bookkeeping entry for the asset recognition and for the short-term liability on 18.05.20X3. DR P, P, E Account.............. 60,000.00 EUR CR Accounts Payables............ 60,000.00 EUR On 30.05.20X3, JEGESVILLE Ltd. pays the amount due by bank transfer. This way, the payment obligation is settled, and the liability is dissolved. DR Accounts Payables............ 60,000.00 EUR CR Cash/ Bank.................... 60,000.00 EUR Liabilities that require paying interest normally are long-term liabilities and must be recorded in the Interest Bearing Liabilities account. SLAMMERT Ltd. takes a bank loan on 1.07.20X5. The amount the bank lends SLAMMERT Ltd. is 100,000.00 EUR. It is agreed that SLAMMERT Ltd. pays-off the loan in 10 years’ time in one lump sum. The Accountant at SLAMMERT Ltd. makes the following Bookkeeping entry on 1.07.20X5 which indicates that the business received the amount of 100,000.00 EUR in their bank account and records a payment obligation at the same time. DR Cash/ Bank.................... 100,000.00 EUR CR Interest Bearing Liabilities. 100,000.00 EUR <?page no="175"?> Berkau: Basics of Accounting 6e 15-175 The bank requires a rate of interest of 6 %/ a based on the owed amount which is an expense for the actual Accounting period. The amount is to be paid at the end of the Accounting period as agreed by the bank loan contract and falls under expenses for 20X5. We calculate the interest per rate if the period is shorter than one Accounting period. As SLAMMERT Ltd. takes the bank loan in the middle of the year, interest is half of its annual rate. SLAMMERT Ltd. pays: 100,000 × 6% / 2 = 3 3,000.00 EUR. The bank deducts the interest from SLAMMERT Ltd.’s bank account. DR Interest..................... 3,000.00 EUR CR Cash/ Bank.................... 3,000.00 EUR 15.6 Annuities A bank loan with a constant payment for interest and pay-off (together) is called an annuity. With an annuity, the debtor agrees to pay a constant amount that contains interest and payoff. If the rate of interest is constant, the absolute amount for interest decreases over the time as the debtor pays-off the loan. Interest is calculated based on the annual rate and the remainder of the owed amount. When a bank loan requires pay-offs in the next upcoming Accounting period, the next pay-off payment is considered as a short-term liability because it is due in less than one year. As a result, next year's pay-off must be disclosed under short-term liabilities. It must be transferred from the Interest Bearing Liabilities account to the Accounts Payables A/ P account. Note, that this means the amount disclosed under accounts payables is still relevant for interest calculation. CHATTY Ltd. takes an annuity from its local bank of 25,000.00 EUR on 2.01.20X3. The loan contract states that the rate of interest is 4.5 %/ a and the annuity is 2,500.00 EUR/ a - to be paid at the end of a year. When the bank loan is received, the Bookkeeper makes the Bookkeeping entry below: DR Cash/ Bank.................... 25,000.00 EUR CR Interest Bearing Liabilities. 25,000.00 EUR To overview the payments, we prepare a payment schedule for CHATTY Ltd.‘s bank loan. Observe the payment schedule as depicted in Figure 15.1: <?page no="176"?> Berkau: Basics of Accounting 6e 15.176 0.045 Year Opening amount Interest Pay-off Annuity Rest 20X3 25,000.00 1,125.00 1,375.00 2,500.00 23,625.00 20X4 23,625.00 1,063.13 1,436.88 2,500.00 22,188.13 20X5 22,188.13 998.47 1,501.53 2,500.00 20,686.59 20X6 20,686.59 930.90 1,569.10 2,500.00 19,117.49 20X7 19,117.49 860.29 1,639.71 2,500.00 17,477.77 20X8 17,477.77 786.50 1,713.50 2,500.00 15,764.27 20X9 15,764.27 709.39 1,790.61 2,500.00 13,973.67 20Y0 13,973.67 628.81 1,871.19 2,500.00 12,102.48 20Y1 12,102.48 544.61 1,955.39 2,500.00 10,147.09 20Y2 10,147.09 456.62 2,043.38 2,500.00 8,103.71 20Y3 8,103.71 364.67 2,135.33 2,500.00 5,968.38 20Y4 5,968.38 268.58 2,231.42 2,500.00 3,736.96 20Y5 3,736.96 168.16 2,331.84 2,500.00 1,405.12 20Y6 1,405.12 63.23 1,405.12 1,468.35 (0.00) Figure 15.1: CHATTY Ltd.‘s annuity payment schedule The amount of interest in 20X3 is: 25,000 × 4.5% = 1 1,125.00 EUR. As per contract, the amount paid is 2,500.00 EUR and contains interest and pay-off. The pay-off amount in 20X3 equals: 2,500 - 1,125 = 1 1,375.00 EUR. On 31.12.20X3, the Accountant makes Bookkeeping entries for interest and pay-off. DR Interest..................... 1,125.00 EUR DR Interest Bearing Liability... 1,375.00 EUR CR Cash/ Bank.................... 2,500.00 EUR At this stage, the balancing figure in the Interest Bearing Liabilities account is 25,000 - 1,375 = 2 23,625.00 EUR. In the next year, PATTY Ltd. owes 23,625.00 EUR which is the value for the calculation of interest. Hence, the payment for interest in 20X4 equals: 23,625 × 4.5% = 1 1,063.13 EUR. The pay-off increases compared to the previous year. It is now: 2,500 - 1,063.13 = 1 1,436.88 EUR. With the adjustments and following IAS 1.60, the Accountant transfers the short-term liability for pay-off to the Accounts Payables (A/ P) account. The recording takes place on 31.12.20X3. DR Interest Bearing Liabilities. 1,436.88 EUR CR Accounts Payables............ 1,436.88 EUR No actual payment has been made regarding the annuity for 20X4. We only made an account swop: The amount for pay-off-20X4 has been moved from long-term to short-term liabilities. To understand CHATTY Ltd.‘s annuity, check the accounts below in Figure 15.2: <?page no="177"?> Berkau: Basics of Accounting 6e 15-177 D C D C (1) 25,000.00 (2) 2,500.00 (2) 1,125.00 P&L 1,125.00 c/ d 22,500.00 25,000.00 25,000.00 b/ d 22,500.00 D C D C (2) 1,375.00 (1) 25,000.00 c/ d 1,436.88 (3) 1,436.88 (3) 1,436.88 b/ d 1,436.88 c/ d 22,188.12 25,000.00 25,000.00 b/ d 22,188.12 Interest bearing liabilities IBL Accounts payables A/ P Cash/ Bank C/ B Interest-20X3 INT Figure 15.2: CHATTY Ltd.‘s accounts How it is Done (Liability Recognition) (1) Determine the amount of the liability. This amount is the most probable settlement amount for the liability. (2) Distinguish between (a) short-term liabilities and (b) long-term liabilities and (c) liabilities that contain long-term and short-term portions. (3a) If the liability is a short-term liability, credit the amount to the relevant short-term liability account. You may credit the Accounts Payables A/ P account. (3b) If the liability is a long-term liability, credit the relevant long-term liability account. You may take the Interest Bearing Liabilities account or a Bond/ Debenture account. (3c) If the liability contains long-term portions and short-term portions, you may set up a liability schedule for calculating the short-term liabilities at first. Transfer the whole liability into the relevant long-term liability account and make a debit entry for the short-term portion and credit that amount to the relevant short-term liability account. <?page no="178"?> Berkau: Basics of Accounting 6e 15-178 A mistake frequently made in Accounting exams, is miscalculating interest when the loan is derived from the balance sheet. For demonstration purpose, we look at CHATTY Ltd.'s bank loan on 1.01.20X7. CHATTY Ltd.'s annuity is disclosed on the balance sheet (as at 31.12.20X6) with 17,477.77 EUR long-term liabilities and 1,639.71 EUR short-term debts. Here comes the tricky part: Often, the item accounts payables on a balance sheet mixes VAT liabilities, debts to suppliers etc. with short-term loan debts. Hence, the short-term liabilities linked to the loan easily get unnoticed. 45 out of 100 students would calculate the interest as: 17,477.77 × 4.5 % = 7 786.50 EUR - wrong! The correct calculation requires consideration of short-term interest bearing liabilities as well. Hence, the correct interest in 20X7 equals: (17,477.77 + 1,639.71) × 4.5 % = 8 860.29 EUR. 15.7 Bank Loans with constant Pay-offs In case the bank loan comes with a constant pay-off amount the calculation is easy. Here, we also consider that the loan is taken in April which causes a per rate interest calculation for the first period. On 1.04.20X2, FOLCROFT (Pty) Ltd. takes a bank loan from its house bank. The principal is 75,000.00 EUR. FOLCROFT (Pty) Ltd. agrees to pay-off an amount of 5,000.00 EUR every year end. The annual rate of interest is 3.10 %/ a. Look at the schedule depicted by Figure 15.3. 0.031 Year Opening amount Interest Pay-off Remainder 20X2 75,000.00 1,743.75 5,000.00 70,000.00 20X3 70,000.00 2,170.00 5,000.00 65,000.00 20X4 65,000.00 2,015.00 5,000.00 60,000.00 20X5 60,000.00 1,860.00 5,000.00 55,000.00 20X6 55,000.00 1,705.00 5,000.00 50,000.00 20X7 50,000.00 1,550.00 5,000.00 45,000.00 20X8 45,000.00 1,395.00 5,000.00 40,000.00 20X9 40,000.00 1,240.00 5,000.00 35,000.00 20Y0 35,000.00 1,085.00 5,000.00 30,000.00 20Y1 30,000.00 930.00 5,000.00 25,000.00 20Y2 25,000.00 775.00 5,000.00 20,000.00 20Y3 20,000.00 620.00 5,000.00 15,000.00 20Y4 15,000.00 465.00 5,000.00 10,000.00 20Y5 10,000.00 310.00 5,000.00 5,000.00 20Y6 5,000.00 38.75 5,000.00 0.00 Figure 15.3: FOLCROFT (Pty) Ltd.’s bank loan schedule <?page no="179"?> Berkau: Basics of Accounting 6e 15.179 The first recognition of the bank loan is for the financial statements as at 31.12.20X2. The Bookkeeping entry when taking the loan (1.04.20X2) is: DR Cash/ Bank.................... 75,000.00 EUR CR Interest Bearing Liabilities. 75,000.00 EUR The amount for the first interest payment is based on the duration of how long FOLCROFT (Pty) Ltd. owes the money. The bank loan was taken on 1.04.20X2. Hence, the time span is 9 months. As a result, the amount for 20X2’s interest equals: 9 × 75,000 × 3.1% / 12 = 1 1,743.75 EUR. The amount for pay-off has been agreed to 5,000.00 EUR every year. The agreement does not rule shorter periods; hence, the pay-off amount of 5,000.00 EUR applies. The Accountant records the payment to the extent of: 1,743.75 + 5,000 = 6 6,743.75 EUR on 31.12.20X2. At the same time, the next pay-off payment for 20X3 is classified as short-term liability and therefore is transferred to the Accounts Payables (A/ P) account. DR Interest..................... 1,743.75 EUR DR Interest Bearing Liabilities. 5,000.00 EUR CR Cash/ Bank.................... 6,743.75 EUR DR Interest Bearing Liabilities. 5,000.00 EUR CR Accounts Payables ........... 5,000.00 EUR In 20X3, interest equals: 3.1% × 70,000 = 22,170.00 EUR. The amount for pay-off is 5,000.00 EUR as agreed. The last Bookkeeping entry for FOLCROFT (Pty) Ltd.’s bank loan takes place on 31.03.20Y6. The final payment is 14 years later, not at the end of the year. Therefore, interest is calculated only for 3 months: 5,000 × 3.1%/ 4 = 38.75 EUR. DR Interest..................... 38.75 EUR DR Accounts Payables............ 5,000.00 EUR CR Cash/ Bank.................... 5,038.75 EUR 15.8 Leases A special form of asset financing is leasing. Leasing is a contract between a lessor (the party that provides the asset) and a lessee (the party that uses the asset and pays for it). Leasing has been changed recently by IFRS 16. A contract is a lease if it conveys the right to control the use of an identified asset for a period in exchange for consideration. We study leasing from the point of view of the lessee. She/ he must recognise a rightsof-use asset (RUA) and a lease liability at the commencement of the lease. The RUA is calculated at costs. The costs are the present value of the future lease payments discounted with the lease rate or - if not available - the <?page no="180"?> Berkau: Basics of Accounting 6e 15-180 incremental borrowing rate of the lessee. Leasing and IFRS 16 are discussed in chapter (7) of the textbook Bilanzen/ Financial Statements. We here cover a simple case of a lease by the case study COSSAL Ltd. COSSAL Ltd. leases from the local car dealership a Mercedes 300 DE for 3 years, commencing on 2.01.20X4. The value of the car is 70,000.00 EUR and the monthly leasing rates are 850.00 EUR/ m which gives: 10,200.00 EUR/ a. To simplify the case, calculations are based on annual payments, made at year ends. The lease rate is 5 %/ a. For the initial recognition of the lease, we must discount the lease rates which gives us their present value: PV = 10,200 × ((1 + 5%) 3 - 1)/ (5% × (1 + 5%) 3 ) = 227,777.13 EUR. COSSAL Ltd. records the lease by the Bookkeeping entry below: DR RUA Asset.................... 27,777.13 EUR CR Lease Liability.............. 27,777.13 EUR After the initial recognition, the RUA is depreciated at a rate of: 27,777.13 / 3 = 9,259.04 EUR/ a and the lease liability is paid-off. The pay-off amount equals: 850 × 12 = 1 10,200.00 EUR/ a. The lease liability is revalued every year through the Retained Earnings account. Before the first pay-off payment for 20X4, the lease liability is increased by 5.00 %: 27,777.13 × 1.05 = 2 29,165.99 EUR. From the lease liability, the first payment is made which reduces the lease liability by 10,200.00 EUR. The new valuation is: 29,165.99 - 10,200 = 1 18,965.99 EUR. At the end of the next Accounting period, the lease liability is increased by 5.00 % again: 18,965.99 × 1.05 = 1 19,914.29 EUR. The agreed payment is made and reduces the lease liability by 10,200.00 EUR: 19,914.29 - 10,200 = 9 9,714.29 EUR. In the last Accounting period 20X6, the lease liability is increased and gives us: 9,714.29 × 1.05 = 1 10,200.00 EUR. The payment of 10,200.00 EUR is paid-off which dissolves the lease liability. The Bookkeeping entries as at the first yearend are shown below: The increase in absolute EUR of the lease liability is: 29,165.99 - 27,777.13 = 1 1,388.86 EUR. The amount is recorded as interest on lease. The total expenses for the lessee are depreciation and the increase of interest on lease which gives in the first Accounting period: 9,259.04 + 1,388.86 = 1 10,647.90 EUR. DR Depreciation ................ 9,259.04 EUR CR Accumulated Depreciation..... 9,259.04 EUR DR Interest on Lease............ 1,388.86 EUR CR Lease Liability.............. 1,388.86 EUR DR Lease Liability.............. 10,200.00 EUR CR Cash/ Bank.................... 10,200.00 EUR <?page no="181"?> Berkau: Basics of Accounting 6e 15-181 15.9 Bonds A bond is a long-term liability recorded as a financial instrument. The bond issuer borrows money from the public (bond holders). A bond is paid-off completely at its end, referred to as maturity. The interest rate of a bond is called coupon rate and is based on the nominal value of the bond (principal). Bonds can be traded publicly. In that case, the purchase price of a bond can differ from the principal. On 2.01.20X0, KILDARE Ltd. issues 5,000,000 bonds at 10.00 EUR each. The coupon rate is 4.00 %/ a. The time to maturity is 15 years. The investor Bill Elmwood buys 1,000 bonds. We first look at the bond holder, Mr. Elmwood. He buys 1,000 bonds which he discloses as a financial instrument. The nominal amount is: 1,000 × 10 = 110,000.00 EUR. The bond's valuation is based on the future coupons received and the repayment of the bonds after 15 years. The bond is worth: 400 × ((1 + 4%) 15 - 1) / (4% × (1 + 4%) 15 ) + 10,000 / (1 + 4%) 15 = 110,000.00 EUR. The bond valuation depends on the rate of interest, here 4.00 %. When the market interest rate increases, the bond's valuation decreases and vice versa. As bond valuation can change and bonds can be traded at a bond market, bond valuations are likely to become volatile. The valuation of a bond depends on the market interest rate in comparison to the bond rate and on the trust towards the bond issuer, in particular on its capability to pay coupons and/ or to repay the bond at the time to maturity. A A junk bond is a bond that most probably will be declared void as it is unlikely that the bond issuer can pay it off. We here only consider bonds where the coupon rate equates the market rate of interest. 4 Bill Elmwood records the bond and the receipt of the bond's coupon as below: DR Bonds Fin Instruments........ 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR DR Cash/ Bank.................... 400.00 EUR CR Interest Received (Coupon)... 400.00 EUR The bond issuer, KILDARE Ltd. keeps the bonds until one year before maturity in the Interest Bearing Liabilities account. Thereafter the pay-off is short-term and recorded in the Accounts payables (A/ P) account. In accordance with our bond valuation the bonds are recorded and maintained at: 5,000,000 × 10.00 EUR = 50,000,000.00 EUR. The annual coupons 4 Check Bilanzen/ Financial Statements chapter (7) and (14) for bond valuations. are: 4% × 50,000,000 = 2 2,000,000.00 EUR/ a. 15.10 Down Payments and Partial Payments All liabilities due within the next Accounting period are classified as short- <?page no="182"?> Berkau: Basics of Accounting 6e 15-182 term liabilities and recorded in the Accounts Payables (A/ P) account (see above). In some cases, a business takes a down payment from a customer to secure a deal. Down payments do not fall under proceeds. Proceeds is a technical term in Accounting for received cash in return for an earned revenue. Down payments received not counting as proceeds means, the deal has not been closed yet and, no revenue recognition is allowed. Hence, the down payment is a liability. Once revenue is recorded the sales transaction has been processed and the Bookkeeping entry becomes tax relevant for income taxes (through the Profit and Loss account) and for output-VAT. We distinguish down payments from partial payments (proceeds) made in advance. The Bookkeeping entries differ as well as legal and tax obligations do. A partial payment legally causes a deal's signification. If someone pays an amount as part of the settlement of the deal, the deal is closed by the payment - no matter how big the portion of that payment is. The payment signifies the deal, and a revenue recognition must follow including a credit entry for the output-VAT. We study the car dealership KAMPUNG Ltd. - our next case study to learn about the difference between down payment and partial payments. KAMPUNG Ltd. offers a Mercedes A180 cdi at a selling price of 33,000.00 EUR. The customer Scofield is interested in the car and wants to secure his acquisition. Unfortunately, he only carries 1,000.00 EUR on cash when visiting KAMPUNG Ltd. for car inspection. Mr Scofield signs the sales contract at KAMPUNG Ltd.’s sales office and makes a payment of 1,000.00 EUR, which is considered a partial payment. For KAMPUNG Ltd., the deal is closed as Mr Scofield signed the contract and paid a portion of the price. The company expects Mr Scofield to pay the remainder by the end of the week. Hence, the Accountant at KAMPUNG Ltd. makes a Bookkeeping entry as below: DR Cash/ Bank.................... 1,000.00 EUR DR Accounts Receivables......... 32,000.00 EUR CR Revenue...................... 33,000.00 EUR Mr Scofield brings the money as promised a few days later and the Accountant records the final payment as below: DR Cash/ Bank.................... 32,000.00 EUR CR Accounts Receivables......... 32,000.00 EUR In contrast to a partial payment, a down payment does not signify a deal. Down payments are made to ensure the deal is closed in the future, but they do not prove a deal. We study a similar case with the car dealership KAMPUNG Ltd. <?page no="183"?> Berkau: Basics of Accounting 6e 15-183 KAMPUNG Ltd. offers another customer Mr Burrows a Mercedes C180 Kompressor at a selling price of 42,000.00 EUR. Mr Burrows only can see the car on a photo, because the car stands in an affiliated showroom of the car dealership KAMPUNG Ltd. As Mr Burrows is very keen to buy the car, KAMPUNG Ltd. offers him to bring the car in for inspection. To make sure, Mr Burrows is serious about buying the car, KAMPUNG Ltd. asks him for a down payment of 100.00 EUR. The amount is paid on cash and the agreement is, that the 100.00 EUR will be deducted from the selling price later, when and if Burrows buys the car. Mr Burrows pays 100.00 EUR, and the Accountant makes the Bookkeeping entry for the down payment below: DR Cash/ Bank.................... 100.00 EUR CR Deferred Income.............. 100.00 EUR A few days later, Mr Burrows buys the Mercedes C180 Kompressor. The Accountant now makes a Bookkeeping entry for the sale as below: DR Cash/ Bank.................... 41,900.00 EUR DR Deferred Income.............. 100.00 EUR CR Revenue...................... 42,000.00 EUR The down-payment does not cause a revenue recognition, because the sale was not closed at the time of receipt. If Mr Burrows changed his intentions about the car, the deferred income will be added to revenue. This way the car dealership covers its cost for moving the car. The recorded revenue is a customer service paid for. 15.11 Provisions If a business has a payment obligation that is uncertain, it must recognise a provision. A provision is an uncertain liability. Uncertainty can exist regarding the amount, the date of payment(s) or even regarding the event at all. An example for a provision is a payment resulting from a pending law case. Pensions are also subjected to provisions as the length and the number of payments to the beneficiary are unknown. For more examples, check IAS 37! Next, we study below the case of ALBANS Ltd. which is sued for a patent infringement. ALBANS Ltd. manufactures a product another business holds a patent on. The penalty expected as outcome from the lawsuit, is 200,000.00 EUR - in the event ALBANS Ltd. is found guilty. The Accountant estimates the probability of conviction to be 50 %. The amount of 200,000.00 EUR does not qualify for a liability recognition, because the payment is uncertain regarding its occurrence and the amount. The court case is expected to be decided on 13.02.20X8, which falls into the next Accounting period. Therefore, ALBANS Ltd. recognises <?page no="184"?> Berkau: Basics of Accounting 6e 15-184 a provision on the balance sheet date of 31.12.20X7. The value is based on the expected fine: 50% × 200,000 = 1 100,000.00 EUR. DR Other Expenses............... 100,000.00 EUR CR Provision.................... 100,000.00 EUR The provision must be dissolved after the verdict. If the court rules in ALBANS Ltd.‘s favour, the provision is dissolved. Otherwise, if found guilty, ALBANS Ltd. also must dissolve the provision but must pay the fine of 200,000.00 EUR. In the latter case, the Accountant makes the Bookkeeping entries as below: DR Provision.................... 100,000.00 EUR DR Other Expenses............... 100,000.00 EUR CR Cash/ Bank.................... 200,000.00 EUR 15.12 Income tax liabilities Income taxes are disclosed in Germany as a provision. In contrast, the IFRSs require the disclosure of an income tax liability. See the case of ESTERHUIZEN Ltd. below: ESTERHUIZEN Ltd. earns a pre-tax profit of 450,000.00 EUR in 20X8. The amount for income taxes is: 450,000 × 30% = 135,000.00 EUR. The amount is shortterm because it is due within one year. As part of the adjustments, ESTERHUIZEN Ltd. credits the income taxes to a special account in compliance with IAS 12. We call this account Income Tax Liabilities account. The correct name is Liabilities and Assets for Income Taxes along IAS 12 account. Do not disclose VAT liabilities as income tax liabilities! They are ruled by the VAT law and not by the income tax law. Disclose VAT liabilities as accounts payables and VAT claims as accounts receivables. Observe below the Bookkeeping entry at ESTERHUIZEN Ltd. Be aware that the tax calculation in this textbook is simplified following the conventions in chapter (1). In a real company, the tax professionals/ attorneys determine income tax liabilities. DR P&L-ACCOUNT.................. 135,000.00 EUR CR Income Tax Liabilities....... 135,000.00 EUR Once ESTERHUIZEN Ltd. pays its income taxes, the Income Tax Liability account is closed-off to the Cash/ Bank account. The Bookkeeping entry made on 10.01.20X9 by ESTERHUIZEN Ltd. is: DR Income Tax Liabilities....... 135,000.00 EUR CR Cash/ Bank.................... 135,000.00 EUR <?page no="185"?> Berkau: Basics of Accounting 6e 15-185 15.13 Summary Liabilities can be of short-term and long-term nature. They are recorded in separate accounts. In case a liability is uncertain, a provision must be disclosed. When a liability is dissolved or reduced, we make a debit entry in the liability account. Long-term liabilities are disclosed at fair values, following the effective interest method (= amortised costs) or at settlement values. 15.14 Working Definitions Annuity: A bank loan coming with a constant payment for interest and payoff (together) is called an annuity. Bond: A bond is a long-term liability recorded as a financial instrument. The bond issuer borrows money from the public (bond holders). Junk Bond: A junk bond is a bond that most probably will be declared void as it is unlikely that the bond issuer can pay it off. Leasing: Leasing is a contract between a lessor (the party that provides the asset) and a lessee (the party that uses the asset and pays for it). Liability: A liability is an obligation to pay an amount of money or to deliver goods/ services in the future. Principal: The principal is the amount the borrower owes and must disclose as liability in the first place. Provision: A provision is an uncertain liability. Settlement amount: The settlement value is the amount of money that is to be paid-off. 15.15 Question Bank (1) A company takes a bank loan which is an annuity. The principal of the bank loan is 100,000.00 EUR. The rate of interest is 2.5 % and the annuity is amounting to 5,000.00 EUR. What are the Bookkeeping entries in the 2 nd Accounting period following IAS 1.60? 1. DR A/ P 2,562.50 EUR; CR C/ B 2,562.00 EUR, DR C/ B 2,437.50 EUR; CR INT 2,437.50 EUR and DR IBL 2,626.56 EUR; CR A/ P 2,626.56 EUR. 2. DR A/ P 2,562.50 EUR; CR C/ B 2,562.00 EUR, DR INT 2,437.50 EUR; CR C/ B 2,437.50 EUR and DR A/ P 2,626.56 EUR; CR IBL 2,626.56 EUR. 3. DR A/ P 2,562.50 EUR; CR C/ B 2,562.00 EUR, DR INT 2,437.50 EUR; CR C/ B 2,437.50 EUR and DR IBL 2,626.56 EUR; CR A/ P 2,626.56 EUR. 4. DR C/ B 2,562.50 EUR; CR A/ P 2,562.00 EUR, DR INT 2,437.50 EUR; CR C/ B 2,437.50 EUR and DR IBL 2,626.56 EUR; CR A/ P 2,626.56 EUR. (2) A company takes a bank loan of 200,000.00 EUR. The annual rate of interest is 4.00 %/ a. The bank requires paying interest monthly. How much is the effective rate of interest? 1. 4.07 %/ a . 2. 4.00 %/ a . 3. 4.06 %/ a . 4. 4.08 %/ a . (3) A company leases a business car that has a value of 30,000.00 EUR. The leasing rates are amounting to 8 %/ a. The leasing contract is for 3 <?page no="186"?> Berkau: Basics of Accounting 6e 15-186 years. How does the company record the lease initially? 1. DR RUA 7,200.00 EUR; CR IBL 7,200.00 EUR. 2. DR INT 2,400.00 EUR; CR C/ B 2,400.00 EUR. 3. DR PPE 30,000.00 EUR; CR IBL 30,000.00 EUR. 4. DR RUA 6,679.84 EUR; CR IBL 6,679.84 EUR. (4) What are reasons to rise a provision? 1. Bank loans; tax repayments. 2. Uncertain penalties resulting from a law case. 3. Customer receivables that are doubtful. 4. Income tax liabilities following IAS 12. (5) A bondholder holds a bond with a principal of 10,000.00 EUR bought at 9,000.00 EUR. The coupon rate is 6.00 % and the bond matures in 5 years. What is the value of the bond if the rate of interest is 5.00 %/ a according to Mathematics (Do not apply amortised costs)? 1. 9,168.63 EUR . 2. 10,000.00 EUR . 3. 10,432.95 EUR . 4. 9,000.00 EUR . 15.16 Solutions 1-3; 2-1; 3-4; 4-2; 5-3. <?page no="187"?> Berkau: Basics of Accounting 6e 16-187 16 Reconciliation Accounts 16.1 What is in the Chapter? This chapter introduces superand subordinated accounts. With this Bookkeeping technique you can design an account hierarchy. 16.2 Learning Objectives We deepen your knowledge in Bookkeeping. You will understand hierarchical account structures and can apply subsidiary ledgers. 16.3 Account Structure For our Accounting work, subsidiary ledgers can help structuring the accounts. E.g., a company that has different goods on stock will organise the Inventory accounts based on its types of goods. The total of subordinated accounts linked to an item on the financial statements is its subsidiary ledger. So far, we only applied accounts directly linked to items on the statement of financial position or the statement of profit or loss and other comprehensive income. Those accounts fall under the general ledger. The general ledger is a set of accounts on the level of the chart of accounts (here: on statement level) without subordinated accounts. The subordinated accounts ware replaced by reconciliation accounts in general ledgers. Balance sheet items frequently divided and represented by subsidiary ledgers are: property, plant and equipment, intangibles, financial instruments, inventories, accounts receivables, securities, cash/ bank, issued capital, reserves, interest bearing liabilities, accounts payables, provisions, other income, labour, materials and other expenses. 16.4 Asset Management Asset Management requires maintaining single accounts for each item of property, plant and equipment to determine their particular values, e.g., in preparation of a register of non-current assets. Asset Management is a subsidiary ledger where instead of making Bookkeeping entries in one P, P, E account every item of property, plant and equipment is represented by its own subordinated account. To calculate the total value for the complete number of items of P, P, E, we must maintain a summary account. This account is referred to as the reconciliation account. 16.5 Reconciliation Account A reconciliation account is a summary account for a subsidiary ledger. It shows the total amount for all subordinated items. The reconciliation account for Asset Management is the Property, Plant and Equipment account. Its balancing figure is disclosed on the balance sheet as the value of P, P, E. <?page no="188"?> Berkau: Basics of Accounting 6e 16-188 How it is Done (Subsidiary Ledger) (1) Define subordinated accounts for objects and create a reconciliation account. (2) Make Bookkeeping entries in subordinated accounts only. (3) At the year end, determine the balancing figure of all subordinated accounts. (4a) Close-off all subordinated accounts to the reconciliation account. Here, we recommend a more student friendly procedure because in academia we make Bookkeeping entries on paper or with MS-Excel. Therefore, closing-off accounts would delete the information about single items; this is what we do not want. Consider, we run subsidiary ledgers for maintaining information in the subordinated accounts and want to continue these accounts in the next following Accounting period. Therefore, we prefer to regard the reconciliation account as a temporary copy outside of the double entry system. As a result, we modify our “how-it-is-done-paragraph” as below: … Avoid step (4a) and continue by (4b)! (4b) Leave the subordinated accounts unchanged. (5) For calculation of the total of the subordinated accounts, add their balancing figures. (6) If the subordinated accounts are real accounts, continue keep them up. 16.6 C/ S DAGBREEK Ltd. (Asset Management) We explain the Asset Management concept and the Bookkeeping entries therein by the case study of DAGBREEK Ltd. The company applies subordinated accounts for its motor vehicles. The total of the motor vehicles' value is disclosed under the item property, plant and equipment on the statement of financial position. DAGBREEK Ltd. has a business car in use. The car’s license plate reads OS-S 2344. DAGBREEK Ltd. identifies motor vehicles by their licences plate numbers. The car’s carrying value is 12,000.00 EUR on 2.01.20X7. DAGBREEK Ltd.’s accounts for motor vehicles carry their IDs, e.g., “P, P, E - OS-S 2344 account”. The latter car account is a subordinated account to the P, P, E account (DAGBREEK Ltd.’s only items of property, plant and equipment are motor vehicles.). On 28.01.20X7, DAGBREEK Ltd. buys another business car and pays for it instantly. The car gets licensed under: OS- B 4095. The costs of acquisition for the new car are 53,000.00 EUR. We make the following Bookkeeping entry on 1.02.20X7 in the subordinated P, P, E account, named: P, P, E - OS-B 4095: <?page no="189"?> Berkau: Basics of Accounting 6e 16-189 (1) Acquisition of the car OS-B 4095 on 1.02.20X7. DR P, P, E - OS-B 4095.......... 53,000.00 EUR CR Cash/ Bank.................... 53,000.00 EUR DAGBREEK Ltd. applies 2 motor vehicle accounts named according to their license plates. The reconciliation account is “P, P, E account” in Figure 16.1. Note, its amounts are greyed out, as it does not belong to the double entry system but is only a copy. Only subordinated accounts apply. Once DARGBREEK Ltd. applies its account “Property, Plant and Equipment account” it must invalidate the subordinated accounts as part of the closing-off procedure. This means detailed information about the single cars gets lost. As long as DAGBREEK Ltd.’s subordinated accounts have not been closedoff, the P, P, E account only represents a copy of the debit entries made the subordinated accounts. See Figure 16.1 for the details! D C D C OV 12,000.00 (1) 53,000.00 D C D C OV ... (1) 53,000.00 OV 12,000.00 (1) 53,000.00 Cash/ Bank P,P,E P,P,E - OS-S 2344 P,P,E - OS-B 4095 Figure 16.1: DAGBREEK Ltd.‘s accounts as at 1.02.20X7 Note, the accounts are not balanced-off yet because no depreciation has been recorded. The reconciliation account represents the total value of its subordinated accounts. We regard the reconciliation account as an instrument to calculate the total for the balance sheet disclosure. We recommend maintaining subordinated accounts. DAGBREEK Ltd. keeps the P, P, E - OS 2344 account and the P, P, E - OS 4095 account alive and only adds their balances for recognition on the balance sheet. See the next example RETIEF (Pty) Ltd. below for further consideration: 16.7 C/ S RETIEF (Pty) Ltd. RETIEF (Pty) Ltd. is a transport business. The company runs 4 trucks (A, B, C and D), all bought in 20X4. The values of the trucks as at 2.01.20X7 are 120,000.00 EUR/ u. On 5.01.20X7, RETIEF (Pty) Ltd. acquires a new truck (E) at cost of acquisition of 230,000.00 EUR. RETIEF (Pty) Ltd. applies an Asset Management. We assume there are no further items of property, plant and equipment. The new truck (E) replaces truck (A), which is sold at 120,000.00 EUR on <?page no="190"?> Berkau: Basics of Accounting 6e 16-190 20.01.20X7. In order to maintain information about the single trucks, the Accountant makes entries in the subsidiary ledger. Observe below: (1) Acquisition of truck (E) on 5.01.20X7. DR P, P, E - Truck (E).......... 230,000.00 EUR CR Cash/ Bank.................... 230,000.00 EUR (2) Disposal of truck (A) on 20.01.20X7. DR Cash/ Bank.................... 120,000.00 EUR CR P, P, E - Truck (A).......... 120,000.00 EUR After the last Bookkeeping entry, the account Property, Plant and Equipment - truck (A) is closed. Its balance is zero. We delete the account after the Accounting period. In order to understand the concept of Asset Management and the application of subordinated accounts, check RETIEF (Pty) Ltd.‘s accounts below as at 20.01.20X7, which is after the disposal of truck (A). Observe the figures in Figure 16.2. D C D C OV 120,000.00 (2) 120,000.00 OV 120,000.00 D C D C OV 120,000.00 OV 120,000.00 D C D C OV 480,000.00 (2) 120,000.00 OV ... (1) 230,000.00 (1) 230,000.00 c/ d 590,000.00 (2) 120,000.00 710,000.00 710,000.00 b/ d 590,000.00 D C (1) 230,000.00 P,P,E - Truck (A) P, P, E - Truck (B) P,P,E Cash/ Bank P,P,E - Truck (E) P, P, E - Truck (C) P,P,E - Truck (D) Figure 16.2: RETIEF (Pty) Ltd.‘s accounts The Property, Plant and Equipment account (P, P, E account) is the reconciliation account. The opening value is the amount retrieved from all subordinated accounts. It considers the Trucks (A) … (D) and equals: 120,000 + 120,000 + 120,000 + 120,000 = 4 480,000.00 EUR. <?page no="191"?> Berkau: Basics of Accounting 6e 16-191 After the Bookkeeping entries for the acquisition of truck (E) and the disposal of truck (A), its value is: 0 + 120,000 + 120,000 + 120,000 + 230,000 = 5590,000.00 EUR. The accounts are not balanced-off yet as depreciation has not been recorded. The reconciliation account is redundant to the subordinated accounts. The same concept applies for computer software. When asset recognition is activated, the software starts making parallel entries. For this reason, you have to define the reconciliation account when customizing the Accounting software regarding subsidiary ledgers. 16.8 Purchase and Sales Ledger The same concept of subsidiary ledgers applies for receivables and payables. Their name on the balance sheet indicates already that these items are linked to reconciliation accounts because they are named “Accounts Receivables (A/ R)” and “Accounts Payables (A/ P)”. Note the plural in the account names! The Accounts Receivables account is the reconciliation account for all debtors’ accounts. The singular accounts for receivables are linked to the name or ID of the business partners and are therefore referred to as individualised accounts. We call the ledger the sales ledger because most receivables result from sales to customers. On the credit side, the item Accounts Payables is linked to the purchase ledger. Most short-term liabilities result from goods and service orders. However, also VAT payables and further payment obligations, like shortterm bank loan liabilities are recorded as accounts payables. Next, we study the sales ledger at DESPATCH Ltd.: 16.9 C/ S DESPATCH Ltd. DESPATCH Ltd. is a dealer for printer/ fax machines/ scanners. At the beginning of 20X2, the business has inventory to a value of 100,000.00 EUR on stock. DESPATCH Ltd. sells its goods on credit. To keep track of their receivables, DESPATCH Ltd. maintains a sales ledger. The accounts therein carry the name of the customers. On 2.03.20X2, DESPATCH Ltd. sells 20 printers to its customer HEUWEL at a selling price of 130.00 EUR/ u. It further sells 1 fax machine (at 255.00 EUR/ u) to CAMPHER on 4.05.20X2 and 12 scanners to BORUS on 29.06.20X2 at 138.00 EUR/ u. Observe the Bookkeeping entries in 20X2 recorded in the sales ledger: (1) Printers sold to HEUWEL on 2.03.20X2: 20 × 130 = 2 2,600.00 EUR. DR A/ R - HEUWEL ................. 2,600.00 EUR CR Inventory.................... 2,600.00 EUR (2) Fax machine sold to CAMPHER on 4.05.20X2. <?page no="192"?> Berkau: Basics of Accounting 6e 16-192 DR A/ R - CAMPHER................ 255.00 EUR CR Inventory.................... 255.00 EUR (3) Scanners sold to BORUS at: 12 × 138 = 11,656.00 EUR, on 29.06.20X2. DR A/ R - BORUS ................. 1,656.00 EUR CR Inventory.................... 1,656.00 EUR See all accounts in Figure 16.3. D C D C OV 100,000.00 (1) 2,600.00 (1) 2,600.00 c/ d 2,600.00 (2) 255.00 b/ d 2,600.00 (3) 1,656.00 c/ d 95,489.00 100,000.00 100,000.00 b/ d 95,489.00 D C D C (2) 255.00 c/ d 255.00 (3) 1,656.00 c/ d 1,656.00 b/ d 255.00 b/ d 1,656.00 D C (1) 2,600.00 (2) 255.00 (3) 1,656.00 c/ d 4,511.00 4,511.00 4,511.00 b/ d 4,511.00 Accounts receivables A/ R A/ R - CAMPHER A/ R - BORUS Inventory A/ R - HEUWEL Figure 16.3: DESPATCH (Pty) Ltd.’s accounts The accounts A/ R - HEUWEL, A/ R - CAMPHER and A/ R - BORUS belong to DESPATCH (Pty) Ltd.’s sales ledger. The sales ledger is a subsidiary ledger to the Accounts Receivables account. It contains individualised accounts which in general are linked to the names of the customer/ debtors. In the next year, DESPATCH (Pty) Ltd.’s customers pay their open bills. The Bookkeeping entries are: (A) Cash receipt from HEUWEL on 2.03.20X3. DR Cash/ Bank.................... 2,600.00 EUR CR A/ R - HEUWEL................. 2,600.00 EUR (B) Cash receipt from CAMPHER on 4.05.20X3. <?page no="193"?> Berkau: Basics of Accounting 6e 16-193 DR Cash/ Bank.................... 255.00 EUR CR A/ R - CAMPHER ................ 255.00 EUR (C) Cash receipt from BORUS on 29.06.20X3. DR Cash/ Bank ................... 1,656.00 EUR CR A/ R - BORUS .................. 1,656.00 EUR The identifiers for 20X3 are (A), (B) and (C) to distinguish them from the previous ones. Note, that no closing-off of the receivables took place on the balance sheet date 31.12.20X2. Observe the accounts as at 31.12.20X3: D C D C OV 100,000.00 (1) 2,600.00 (1) 2,600.00 c/ d 2,600.00 (2) 255.00 b/ d 2,600.00 (A) 2,600.00 (3) 1,656.00 c/ d 95,489.00 100,000.00 100,000.00 b/ d 95,489.00 D C D C (2) 255.00 c/ d 255.00 (3) 1,656.00 c/ d 1,656.00 b/ d 255.00 (B) 255.00 b/ d 1,656.00 (C) 1,656.00 D C D C (1) 2,600.00 OV ... (2) 255.00 (A) 2,600.00 (3) 1,656.00 c/ d 4,511.00 (B) 255.00 4,511.00 4,511.00 (C) 1,656.00 b/ d 4,511.00 (A) 2,600.00 (B) 255.00 (C) 1,656.00 4,511.00 4,511.00 Accounts receivables A/ R Cash/ Bank A/ R - CAMPHER A/ R - BORUS Inventory A/ R - HEUWEL Figure 16.4: DESPATCH (Pty) Ltd.’s accounts The concept described works for the purchase ledger in the same way. Its reconciliation account is the Accounts Payables (A/ P) account. The purchase ledger is a subsidiary ledger for the Accounts Payables account. It contains accounts named after the suppliers. <?page no="194"?> Berkau: Basics of Accounting 6e 16-194 16.10 C/ S SCHECKTER Ltd. SCHECKTER Ltd. is a production firm. On 4.07.20X5, SCHECKTER buys 2 drilling machines on credit from its supplier VALLEISIG at 3,500.00 EUR/ u. Additionally, SCHECKTER Ltd. orders materials from supplier DeMIST at 50,000.00 EUR on 8.09.20X5. The supplier allows SCHECKTER Ltd. to pay half of the amount immediately and the remainder later. On 10.10.20X5, SCHECKTER Ltd. pays 63,000.00 EUR owing its supplier KRUIS from last year. The amount of inventory is no longer in the Inventory account as the materials have been sold already. We record the Bookkeeping entries below: (1) The acquisition of drilling machines gives: 2 × 3,500 = 7 7,000.00 EUR (purchased from VALLEISIG on credit) on 4.07.20X5. DR P, P, E Account.............. 7,000.00 EUR CR A/ P - VALLEISIG.............. 7,000.00 EUR (2) Purchase of materials from DeMIST half/ half on 8.09.20X5 at 50,000.00 EUR. Half thereof equals: 50,000/ 2 = 25,000.00 EUR. DR Inventory.................... 50,000.00 EUR CR A/ P - DeMIST................. 25,000.00 EUR CR Cash/ Bank.................... 25,000.00 EUR (3) Payment of the amount SCHECKTER Ltd owed KRUIS, on 10.10.20X5. DR A/ P - KRUIS ................. 63,000.00 EUR CR Cash/ Bank.................... 63,000.00 EUR Observe SCHECKTER Ltd.‘s accounts as at 31.12.20X5. D C D C (3) 63,000.00 OV 63,000.00 (3) 63,000.00 OV 63,000.00 (1) 7,000.00 c/ d 32,000.00 (2) 25,000.00 95,000.00 95,000.00 b/ d 32,000.00 D C D C (1) 7,000.00 c/ d 7,000.00 (2) 50,000.00 c/ d 50,000.00 b/ d 7,000.00 b/ d 50,000.00 P, P, E Inventory A/ P - KRUIS Accounts payables A/ P Figure 16.5: SCHECKTER Ltd.‘s accounts <?page no="195"?> Berkau: Basics of Accounting 6e 16-195 D C D C c/ d 7,000.00 (1) 7,000.00 c/ d 25,000.00 (2) 25,000.00 b/ d 7,000.00 b/ d 25,000.00 A/ P - VALLEISIG A/ P - DeMIST D C OV ... (2) 25,000.00 (3) 63,000.00 Cash/ Bank Figure 16.5: SCHECKTER Ltd.'s accounts (continued) A company running accounts with different banks will use the Cash/ Bank account as reconciliation account, too. Recall the example SCHOENMAKERSKOP Ltd. in chapter (13) Special Asset Accounts of this textbook. 16.11 Summary Reconciliation accounts are summary accounts. We run them additionally to the double entry system. A subsidiary ledger keeps information about single items, like assets, bank accounts, debtors etc. 16.12 Working Definitions Subsidiary Ledger: The total of subordinated accounts linked to an item on the financial statements is its subsidiary ledger. General Ledger: The general ledger is a set of accounts on the level of the chart of accounts (here: on statement level) without subordinated accounts. Reconciliation Account: A reconciliation account is a summary account for a subsidiary ledger. Sales Ledger: The sales ledger is a subsidiary ledger for the Accounts Receivables account. Purchase Ledger: The purchase ledger is a subsidiary ledger to the Accounts Payables account. 16.13 Question Bank (1) Which statement is wrong? 1. A reconciliation account gives additional information about the total of subordinated accounts. 2. A reconciliation account is recorded to transfer figures to the balance sheet. 3. A reconciliation account is a summary account. 4. A reconciliation account represents the total of the subordinated accounts’ balancing figures. (2) A company runs an Asset Management. The various PPE accounts show balancing figures of 400.00 EUR, 300.00 EUR and 350.00 EUR. The Accumulated Depreciation accounts disclose all 50.00 EUR each. How much is the balancing figure of the PPE Reconciliation account? 1. 350.00 EUR and 250.00 EUR and 300.00 EUR . 2. -150.00 EUR . <?page no="196"?> Berkau: Basics of Accounting 6e 16-196 3. 1,050.00 EUR . 4. 900.00 EUR . (3) A company discloses on its reconciliation account a value of 120,000.00 EUR. The 2 subordinated accounts show cost of acquisition of 75,000.00 EUR each. Depreciation on one of the assets is 15,000.00 EUR. How much is depreciation on the other one? 1. 10,000.00 EUR . 2. 15,000.00 EUR . 3. 20,000.00 EUR . 4. 25,000.00 EUR . (4) What is the correct Bookkeeping entry to close-off PPE accounts to the Reconciliation (REC) account? 1. DR REC; CR PPE. 2. DR PPE; CR REC. 3. DR REC; CR C/ B. 4. DR C/ B; CR REC. (5) A company buys a new item of property, plant, equipment for 100,000.00 EUR. At the end of the Accounting period, it runs 2 other PPE accounts with balancing figures of 80,000.00 EUR and 55,000.00 EUR respectively. What is the Bookkeeping entry for the acquisition and the reconciliation? 1. DR PP3 100,000.00 EUR; CR C/ B 100,000.00 EUR and DR PP1 80,000.00 EUR; DR PP2 55,000.00 EUR; DR PP3 100,000.00 EUR; CR REC 235,000.00 EUR. 2. DR PP3 100,000.00 EUR; CR C/ B 100,000.00 EUR and DR REC 235,000.00 EUR; CR PP1 80,000.00 EUR; CR PP2 55,000.00 EUR; CR PP3 100,000.00 EUR. 3. DR PP3 100,000.00 EUR; CR C/ B 100,000.00 EUR and DR PP1 80,000.00 EUR; DR PP2 55,000.00 EUR; DR PP3 100,000.00 EUR; CR REC 225,000.00 EUR. 4. DR PP3 100,000.00 EUR; CR C/ B 100,000.00 EUR and DR REC 225,000.00 EUR; CR PP1 80,000.00 EUR; CR PP2 55,000.00 EUR; CR PP3 100,000.00 EUR. 16.14 Solutions 1-2; 2-4; 3-2; 4-1; 5-2. <?page no="197"?> Berkau: Basics of Accounting 6e 17-197 17 Depreciation 17.1 What is in this Chapter? In this chapter, we deal with a special expense: depreciation. We deepen our knowledge about depreciation and show how to record depreciation. In contrast to the previous chapters, we now introduce the Accumulated Depreciation account as the contra account for depreciation expenses. We also cover impairment losses which are recorded similar to depreciation. Regarding financial statements, we introduce the register of non-current assets which is disclosed as part of the notes. It discloses carrying amounts for a company’s assets and their calculation. 17.2 Learning objectives After studying this chapter, you will be familiar with Bookkeeping entries for depreciation, you understand the methods of calculating depreciation and you can prepare a register of noncurrent assets that shows cost of acquisition, accumulated depreciation and accumulated impairment losses for the items therein. The only thing you cannot handle regarding asset valuations are revaluations following IAS 16 which are subjected to chapter (7) of the textbook Bilanzen/ Financial Statements. 17.3 Regulations for Depreciation Depreciation is a technical term in Accounting for an expense that reflects a non-current asset’s loss in valuation due to its age or deployment. Most of the assets lose their value due to deployment. However, it is more common/ easy to depreciate assets by the time. However, some companies measure their asset deployment exactly, like airlines recording the total engine runtime of their aircrafts as the HOBBS time which is recorded by the hobbs-meter. Although the technical possibilities exists, most companies calculate depreciation based on the time. Depreciation is then recorded proportional to the asset's useful life. The useful life is the estimated time an asset can be deployed. In Germany standard values for the useful time are published as Afa-tables which are published for the depreciation following German EStG. (Afa = Absetzung für Abnutzung) A company that operates a business car with a useful life of 6 years and applying a constant depreciation will depreciate its car to an extent of: 1/ 6 = 16.67% of the depreciable amount per year. This means, the car loses its value by the elapsed time. In contrast, some assets are not depreciated at all. E.g., there is no depreciation on land, as land does not deplete by use/ deployment. The tax law in Germany allows to write off assets of minor value completely within the year of acquisition. We ignore that option for this textbook as it is not in compliance with IFRSs. 17.4 Depreciation Parameters At first, we apply one single depreciation method, which is straight-line method. This method is simple and leads to depreciation that is constant over the time, in other words: every <?page no="198"?> Berkau: Basics of Accounting 6e 17-198 year’s depreciation is to the same extent. Straight-line method makes the curve of the asset’s carrying amount over its time appear as a straight-line. As the slope of the carrying value curve is constant, depreciation over the useful life is too. The depreciable amount is the value that depletes by use. Some assets have a remainder value at which the asset can be sold after its useful life. We deduct the rest - also called salvage value or residual value - from the cost of acquisition to calculate the depreciable amount. The residual value of an asset is its total value less the depreciable value. 17.5 Straight-line Method The straight-line method of depreciation leads to a straight line for the asset's value over the time. This happens as depreciation is constant over the time. Calculation of depreciation per period along straight-line method works as below: We divide the amount of the cost of acquisition by the number of periods the asset is deployed according to its estimated useful life. In case the asset is used for partial periods, depreciation is calculated per rate (PRT). See further considerations about depreciation methods in chapter (7) of the textbook Bilanzen/ Financial Statements. DODD Ltd. acquires a saw at 120,000.00 EUR on 3.02.20X4. The saw is paid by bank transfer. The useful life of the saw is 5 years. Depreciation follows straightline method and is: 120,000/ 5 = 224,000.00 EUR/ a. In accordance with the conventions in this textbook, we apply depreciation accurate to the month. Hence, a month will count for depreciation if the asset is more than half of the month in use. A month counts for depreciation if the asset is bought before its 15 th day or sold after the middle of the month. DODD Ltd.’s saw is deployed 11 months in 20X4. As a result, depreciation equals: 11 × 24,000/ 12 = 2 22,000.00 EUR in 20X4. 17.6 Recording Depreciation In contrast to the PELZERHAGEN (Pty) Ltd. case study from chapter (9, 11, 12), we modify the Bookkeeping entries for depreciation from here onwards: We apply the Accumulated Depreciation account. The Accumulated Depreciation account is the contra account for depreciation expenses. The Accumulated Depreciation account records all depreciation expenses over the useful life of an asset. The carrying value of an asset is the value disclosed on the financial statements (balance sheet). It reflects the actual value. The carrying value is calculated by deducting any (accumulated) depreciation and any (accumulated) impairment loss from the cost of acquisition. Impairment losses are discussed further below, for now we see them as extraordinary once-off depreciation. The carrying value of an asset is the difference of the cost of acquisition as recognised in the Property, Plant and Equipment account less the balancing figure of the Accumulated Depreciation and Accumulated Impairment Loss account. Companies applying Asset Management keep an Accumulated Depreciation account for each asset they record. You will learn this concept by the following case studies in <?page no="199"?> Berkau: Basics of Accounting 6e 17-199 detail. Note, although there is no legal requirement for Asset Management, it applies in almost every company. The next following case studies familiarise you with straight-line method and declining method for depreciation and with impairment losses. You also learn about the register of non-current assets which is required in accordance with IAS 1. DODD Ltd. makes a Bookkeeping entry when it buys the saw which is based on Asset Management requirements: (1) Saw acquisition at 120,000.00 EUR on 3.02.20X4. DR P, P, E - Saw Machine........ 120,000.00 EUR CR Cash/ Bank.................... 120,000.00 EUR (2) Depreciation on the saw at 24,000.00 EUR on 31.12.20X4. DR Depreciation ................. 22,000.00 EUR CR Acc. Depr. - Saw Machine..... 22,000.00 EUR The Accumulated Depreciation account supports the preparation of the register of non-current assets. The register of non-current assets is a list of all items of P, P, E that discloses every item’s cost of acquisition, its date of acquisition, its accumulated depreciation, its accumulated impairment losses and its carrying value as at the time indicated. The statement is required on group levels for all depreciable noncurrent assets following IAS 1. E.g., a car rental that operates different cars will show similar motor vehicles, like Toyota Yaris, as one group if acquired at the same time. In order to demonstrate the Accumulated Depreciation account, we also make a Bookkeeping entry for DODD Ltd.’s 20X5 Accounting period. As we apply straight-line method for depreciation, the amount for depreciation is 24,000.00 EUR in 20X5, too. (A) Depreciation on the saw to the expense of 24,000.00 EUR on 31.12.20X5. DR Depreciation ................. 24,000.00 EUR CR Acc. Depr. - Saw Machine..... 24,000.00 EUR We check the accounts after two Accounting periods. We display the Depreciation-20X4 account for illustration purpose in Figure 17.1. <?page no="200"?> Berkau: Basics of Accounting 6e 17-200 D C D C (1) 120,000.00 c/ d 120,000.00 c/ d 22,000.00 (2) 22,000.00 b/ d 120,000.00 b/ d 22,000.00 c/ d 46,000.00 (A) 24,000.00 46,000.00 46,000.00 b/ d 46,000.00 P,P,E saw Acc depr saw D C D C (2) 22,000.00 P&L 22,000.00 (A) 24,000.00 P&L 24,000.00 D C OV ... (1) 120,000.00 Cash/ Bank Depreciation 20X4 Depreciation 20X5 Figure 17.1: DODD Ltd.’s accounts as at 31.12.20X5 As we can read from the accounts, the carrying value for the saw is the value in the Property, Plant and Equipment account less accumulated depreciation: 120,000 - 46,000 = 7 74,000.00 EUR. Following international Bookkeeping conventions, it makes no sense to close-off the Accumulated Depreciation account to the Property, Plant and Equipment account. 17.7 Register of Non-Current Assets Companies prepare the register of non-current assets as part of the notes. In the right-hand column of the register of non-current assets, the carrying value is disclosed. The carrying value is the amount the asset is to be recognized at on the balance sheet. DODD Ltd.’s saw is valued at 74,000.00 EUR. The initial valuation of 120,000.00 EUR has been decreased by depreciation of: 22,000 + 24,000 = 4 46,000.00 EUR. The register of non-current assets for DODD Ltd. looks as below, with the only item being the “saw machine” therein: Asset Cost of acquisition Acc. depr. Acc. impairm. losses Carrying amount Saw machine 120,000.00 (46,000.00) 74,000.00 74,000.00 Dodd Ltd. REGISTER of NON-CURRENT ASSETS as at 31.12.20X5 Figure 17.2: DODD Ltd.’s register of non-current assets <?page no="201"?> Berkau: Basics of Accounting 6e 17-201 Another reason for the decrease of an asset’s value is an impairment loss. An impairment loss is a reduction of the carrying value that is caused by extraordinary and unscheduled events, like an accident. Under consideration of impairment losses, the carrying value is calculated as the cost of acquisition less any accumulated depreciation and less any accumulated impairment loss. In the textbook Bilanzen/ Financial Statements, chapter (7), we discuss fair value recognition that leads to revaluations as required by IAS 16. A revaluation is an increase of an asset’s carrying value to its fair value. One could say, the revaluation is the opposite of an impairment loss, however, its Bookkeeping entries are different because an impairment loss is recorded through the income statement whereas a revaluation changes equity and deferred tax liabilities. Bookkeeping entries for depreciation are made at the end of the Accounting period as adjustments. Even if an asset is disposed before the year end, a proportional depreciation expense is recorded. Observe the FAIRBRIDGE Ltd. case study below: 17.8 C/ S FAIRBRIDGE Ltd. FAIRBRIDGE Ltd. is a pizza delivery service. The delivery vehicles are VW Polos. The VW Polo with license plates reading OS-FB 222 is in use since 2.07.20X0. The useful life for all delivery vehicles is 4 years. The VW Polo was bought at 18,000.00 EUR. The annual depreciation on the VW Polo is: 18,000 / 4 = 4 4,500.00 EUR/ a. Hence, the monthly depreciation is: 4,500 / 12 = 3 375.00 EUR/ m. Its carrying amount as at 2.01.20X4 is: 18,000 - 15,750 = 2 2,250.00 EUR. The Polo licensed under OS-FB 333, was bought on 2.01.20X2 at 18,000.00 EUR. The useful life is the same as for the other VW Polo (OS-FB 222). On the 2.01.20X4, the car OS-FB 333 is 2 years old. Its carrying value is: 18,000 - 9,000 = 99,000.00 EUR. See FAIRBRIDGE Ltd.’s register of noncurrent assets as at 2.01.20X4: Asset Cost of acquisition Acc. depr. Acc. impairm. losses Carrying amount VW Polo OS-FB 222 18,000.00 (15,750.00) 2,250.00 VW Polo OS-FB 333 18,000.00 (9,000.00) 9,000.00 11,250.00 Fairbridge Ltd. REGISTER of NON-CURRENT ASSETS as at 31.12.20X3 Figure 17.3: FAIRBRIDGE Ltd.’s register of non-current assets as at 31.12.20X3 FAIRBRIGDE Ltd. continues with the deployment of the VW Polo OS-FB 222 until 31.03.20X4. The car has been used 3 years and 9 months by then. Its carrying value then is: 18,000 - 16,875 = 1,125.00 EUR. FAIRBRIDGE Ltd. sells the <?page no="202"?> Berkau: Basics of Accounting 6e 17-202 car at 1,125.00 EUR on 31.03.20X4. On 1.04.20X4, FAIRBRIDGE Ltd. buys a new VW Polo at 20,000.00 EUR. Its useful life is 4 years, too. The new car is licensed under OS-FB 444. The annual depreciation of the new VW Polo is: 20,000 / 4 = 5 5,000.00 EUR/ a. Depreciation only applies for 9 months in 20X4: (3/ 4) × 5,000 = 3 3,750.00 EUR. The Bookkeeping entries for FAIRBRIDGE Ltd.’s VW Polos in 20X4 are as follows: (1) Depreciation on VW Polo “OS-FB 222”, recorded on 31.12.20X4 (for 3 months). DR Depreciation................. 1,125.00 EUR CR Acc. Depr. OS-FB 222......... 1,125.00 EUR (2) Sale of the VW Polo OS-FB 222 on 31.03.20X4 at 1,125.00 EUR. DR Cash/ Bank.................... 1,125.00 EUR DR Acc. Depr. OS-FB 222......... 16,875.00 EUR CR P, P, E - OS-FB 222.......... 18,000.00 EUR (3) Acquisition of the new VW Polo OS- FB 444 on 1.04.20X4. DR P, P, E - OS-FB 444.......... 20,000.00 EUR CR Cash/ Bank.................... 20,000.00 EUR (4) Depreciation on the new VW Polo for 9 months on 31.12.20X4. Depreciation in 20X4 is amounting to: 9 × 20,000 / (4 × 12) = 3 3,750.00 EUR. DR Depreciation................. 3,750.00 EUR CR Acc. Depr. - OS-FB 444....... 3,750.00 EUR (5) Depreciation on the VW Polo OS-FB 333 for one year on 31.12.20X4: DR Depreciation................. 4,500.00 EUR CR Acc. Depr. - OS-FB 333....... 4,500.00 EUR Observe FAIRBRIDGE Ltd.’s accounts as at 31.12.20X4 below in Figure 17.4: <?page no="203"?> Berkau: Basics of Accounting 6e 17-203 D C D C OV 18,000.00 (2) 18,000.00 (2) 16,875.00 OV 15,750.00 (1) 1,125.00 16,875.00 16,875.00 P, P, E OS-FB 222 Acc depr OS-FB 222 D C D C OV 18,000.00 c/ d 18,000.00 OV 9,000.00 b/ d 18,000.00 c/ d 13,500.00 (5) 4,500.00 13,500.00 13,500.00 b/ d 13,500.00 P, P, E OS-FB 333 Acc depr OS-FB 333 D C D C (3) 20,000.00 c/ d 20,000.00 c/ d 3,750.00 (4) 3,750.00 b/ d 20,000.00 b/ d 3,750.00 D C D C (1) 1,125.00 P&L 9,375.00 OV ... (3) 20,000.00 (4) 3,750.00 (2) 1,125.00 (5) 4,500.00 9,375.00 9,375.00 P, P, E OS-FB 444 Acc depr OS-FB 444 Depreciation 20X4 Cash/ Bank D C D C OV 36,000.00 (2) 18,000.00 (2) 16,875.00 OV 24,750.00 (3) 20,000.00 c/ d 38,000.00 (1) 1,125.00 56,000.00 56,000.00 (4) 3,750.00 b/ d 38,000.00 c/ d 17,250.00 (5) 4,500.00 34,125.00 34,125.00 b/ d 17,250.00 P, P, E (summary) Acc depr (summary) Figure 17.4: FAIRBRIDGE Ltd.’s accounts We prepare the register of non-current assets for FAIRBRIDGE Ltd.’s delivery cars as at the year end of the next Accounting period. Observe Figure 17.5: <?page no="204"?> Berkau: Basics of Accounting 6e 17-204 Asset Cost of acquisition Acc. depr. Acc. impairm. losses Carrying amount VW Polo OS-FB 222 disposed disposed disposed VW Polo OS-FB 333 18,000.00 (13,500.00) 4,500.00 VW Polo OS-FB 444 20,000.00 (3,750.00) 16,250.00 38,000.00 (17,250.00) 0.00 20,750.00 Fairbridge Ltd. REGISTER of NON-CURRENT ASSETS as at 31.12.20X4 Figure 17.5: FAIRBRIDGE Ltd.’s register of non-current assets as at 31.12.20X3 As you can observe in Figure 17.4, the totals of the cost of acquisition and of the accumulated depreciation equal the values recorded in the reconciliation accounts. 17.9 Declining Method for Depreciation An alternative to straight-line method is the declining method. It always applies in cases when the depletion is higher at the commencement of the asset's use than at the end of the useful life. Declining method of depreciation applies depreciation that is lower than depreciation in the previous period. With declining method, depreciation is calculated as a percentage of the carrying value at the beginning of the Accounting period, e.g., 20 %/ a. As the carrying value decreases, depreciation decreases as well. Assume a company buys an asset at a cost of acquisition of 25,000.00 EUR. Depreciation in the first year would be: 25,000 × 20% = 5,000.00 EUR/ a. In the second Accounting period, depreciation would be lower as the carrying amount decreased by the first year’s depreciation. In the second Accounting period, depreciation equals: (25,000 - 5,000) × 20% = 4,000.00 EUR/ a. If depreciation rate is constant the formula for the carrying amount CA calculated based on declining method is: CA T = CA 0 × (1 - depr) T (with: CA = carrying amount at the time t, depr = depreciation per period, t = 0 … T, 0 indicates the initial period, T the last one.) If declining method applies, there is a difference between monthly depreciation and annual depreciation divided by 12. This matters if we depreciate an asset for a shorter period than a full Accounting period. We then depreciate the asset per rate (PRT). We normally provide you with a monthly depreciation rate due to our conventions in chapter (1). <?page no="205"?> Berkau: Basics of Accounting 6e 17-205 We assume that an asset bought at 25,000.00 EUR (see above) is depreciated based on a 2 %/ m rate. The depreciation for the first Accounting period (1 year) equals: 25,000 - 25,000 × (1 - 2%) 12 = 5,382.08 EUR/ a. The amount is significantly below: 12 × 2% × 25,000 = 6,000.00 EUR which would be the result if we calculate depreciation following the monthly-rateequal-to-annual-rate-divided-by-12. In the next Accounting period, depreciation based on a monthly rate of 2 %/ m will be: 19,617.92 - 19,617.92 × (1 - 2%) 12 = 4,223.41 EUR/ a and so on. In this textbook and for all website cases, monthly depreciation applies. In case declining method applies, the monthly rate must be given. Another aspect to be considered together with depreciation is an impairment loss. According to IAS 36, an impairment loss occurs once the carrying value overstates the asset's valuation. The reason can be price changes, accidents, unscheduled depletion etc. An impairment loss is an unforeseeable depreciation which assigns the fair value to an asset that is overstated. An impairment loss is recorded similar to deprecation. The Bookkeeping entry is: DR Impairment Loss account - CR Accumulated Impairment Loss account. After an impairment loss, depreciation does not come to a stop. However, adjustments are required for depreciation because the depreciable amount will be lower as before. The new depreciable amount (after recording an impairment loss) is the asset’s value over its (remaining) useful life. Adjustments after an impairment loss apply for straight-line method as well as for declining method. To study depreciation, we look at the case of KROLLER Ltd. below: 17.10 C/ S KROLLER Ltd. KROLLER Ltd. is a restaurant based on a franchise contract. At the beginning of the Accounting period 20X0, KROLLER Ltd. has 200,000.00 EUR cash at bank. The interior of the restaurant is installed on 1.04.20X0 at 180,000.00 EUR. Depreciation on the interior is based on declining method at a monthly rate of 2.5%/ m. The calculation of depreciation is accurate to the month. In the first Accounting period, depreciation is recorded for 9 months, commencing in April 20X0. The acquisition of interior is recorded by the following Bookkeeping entry (1) on 1.04.20X4: DR P, P, E ACCOUNT.............. 180,000.00 EUR CR Cash/ Bank.................... 180,000.00 EUR For the depreciation during the last 9 months of 20X0, we calculate the annual depreciation as: 180,000 - 180,000 × (1 - 2.5%) 9 = 336,677.61 EUR. The carrying amount equals: 180,000 - 36,677.61 = 143,322.39 EUR. <?page no="206"?> Berkau: Basics of Accounting 6e 17-206 D C D C (1) 180.000,00 c/ d 180.000,00 OV 200.000,00 (1) 180.000,00 b/ d 180.000,00 c/ d 20.000,00 200.000,00 200.000,00 b/ d 20.000,00 D C D C (2) 36.677,61 c/ d 36.677,61 c/ d 36.677,61 (2) 36.677,61 b/ d 36.677,61 b/ d 36.677,61 Depreciation - 20X0 Acc depr P, P, E Cash/ Bank Figure 17.6: KROLLER Ltd.’s accounts 20X0 In the next Accounting period, on 4.06.20X1, 20 % of the interior is damaged in a fight among guests. The interior is overstated as it got damaged. KROLLER Ltd. pays 4,500.00 EUR for dismounting the damaged parts and sells them at 10,000.00 EUR to a local pub. We take the selling price as indicator for the asset valuation after the impairment loss. On 31.12.20X1, KROLLER Ltd. records depreciation on interior from 1.01.20X1 until 31.05.20X1 as Bookkeeping entry (A): 143,322.39 - 143,322.39 × (1 - 2.5%) 5 = 117,041.65 EUR. The carrying value equals: 143,322.39 - 17,041.65 = 126,280.74 EUR. DR Depreciation................. 17,041.65 EUR CR Acc. Depr.................... 17,041.65 EUR On the same day, KROLLER Ltd. records depreciation on the intact interior which is 4/ 5 of the interior’s amount. This depreciation, recorded as (B), equals: 80% × 126,280.74 - 80% × 126,280.74 × (1 - 2.5%) 7 = 116,407.24 EUR. The carrying value equals: 101,024.59 - 16,407.24 = 84,617.35 EUR. DR Depreciation................. 16,617.35 EUR CR Acc. Depr.................... 16,617.35 EUR Disassembling of the damaged interior falls under expenses. It has no impact on the asset valuation. The expense of 4,500.00 EUR is recorded on 6.06.20X1 by Bookkeeping entry (C) as a repair: DR Repair....................... 4,500.00 EUR CR Cash/ Bank.................... 4,500.00 EUR The selling price of the interior indicates its fair value. Accordingly, the Accountant records the impairment loss to an extent of: 20% × 126,280.74 - 10,000 = 15,256.15 EUR. The Bookkeeping entry (D) is made on 31.12.20X1 for the impairment loss: <?page no="207"?> Berkau: Basics of Accounting 6e 17-207 DR Impairment Loss.............. 15,256.15 EUR CR Acc. Impairment Loss......... 15,256.15 EUR (R) The sale of the damaged interior is recorded on 8.06.20X1 as: DR Cash/ Bank.................... 10,000.00 EUR DR Acc. Depr. .................. 10,743.85 EUR DR Acc. Impairment Loss......... 15,256.15 EUR CR P, P, E ...................... 36,000.00 EUR Very often, impairment losses are recorded following an accident, e.g., with a business car. We cover those impairment losses and insurance refunding in chapter (7) of the textbook Bilanzen/ Financial Statements. In chapter (35), a Realisation account is introduced for disposals. For that reason, we named the above Bookkeeping entry (R). It contains the received cash to an extent of 10,000.00 EUR which is the selling price. The debit entry in the Bookkeeping entry (R) for the Accumulated Depreciation account is based on 1/ 5 of the interior. The accumulated depreciation equals: 20% × (36,677.61 + 17,041.65) = 1 10,743.85 EUR. At the same time, accumulated depreciation is dissolved. The amount equals 15,256.15 EUR as calculated above. The reduction on property, plant, equipment is based on 1/ 5, as well. The amount is: 20% × 180,000 = 3 36,000.00 EUR. On 11.06.20X1, KROLLER Ltd. buys new interior at 40,000.00 EUR and receives a discount from its supplier to the extent of 5.00 %. The discount instantly reduces the cost of acquisition. Therefore, the value is: 95% × 40,000 = 3 38,000.00 EUR. The same depreciation method and parameters as before apply for the new interior. On 12.06.20X1, KROLLER Ltd. makes the Bookkeeping entry (E) for the acquisition of the new parts of the interior: DR P, P, E (new)................ 38,000.00 EUR CR Cash/ Bank.................... 38,000.00 EUR The depreciation on the replacement parts of the interior equals: 38,000 - 38,000 × (1 - 2.5%) 7 = 66,171.52 EUR. The remaining value is: 38,000 - 6,171.52 = 31,828.48 EUR. KROLLER Ltd. records depreciation on the replacement interior on 31.12.20X1 as Bookkeeping entry (F): DR Depreciation ................. 6,171.52 EUR CR Acc. Depr. (new)............. 6,171.52 EUR It makes sense, to dedicate an extra account to the new interior as it simplifies our calculation of depreciation and helps us with the preparation of the register of non-current assets. Observe the <?page no="208"?> Berkau: Basics of Accounting 6e 17-208 accounts for KROLLER Ltd. as disclosed below in Figure 17.7: D C D C (1) 180.000,00 c/ d 180.000,00 OV 200.000,00 (1) 180.000,00 b/ d 180.000,00 (R) 36.000,00 c/ d 20.000,00 c/ d 144.000,00 200.000,00 200.000,00 180.000,00 180.000,00 b/ d 20.000,00 (E) 38.000,00 b/ d 144.000,00 (R) 10.000,00 c/ d 8.000,00 38.000,00 38.000,00 b/ d 8.000,00 P, P, E Cash/ Bank D C D C c/ d 36,677.61 (2) 36,677.61 (A) 17,041.65 (R) 10,743.85 b/ d 36,677.61 (B) 16,407.24 (A) 17,041.65 (F) 6,171.52 c/ d 39,620.41 c/ d 59,382.65 (B) 16,407.24 39,620.41 39,620.41 70,126.50 70,126.50 b/ d 39,620.41 b/ d 59,382.65 D C D C (C) 4,500.00 c/ d 4,500.00 (D) 15,256.15 c/ d 15,256.15 b/ d 4,500.00 b/ d 15,256.15 D C D C c/ d 15,256.15 (D) 15,256.15 (E) 38,000.00 c/ d 38,000.00 (R3) 15,256.16 b/ d 15,256.15 b/ d 38,000.00 D C c/ d 6,171.52 (F) 6,171.52 b/ d 6,171.52 Acc depr Depreciation - 20X1 Repair Impairment loss - 20X1 Acc IL P, P, E new Acc depr new Figure 17.7: KROLLER Ltd.’s accounts in 20X1 Based on the calculations above, KROLLER Ltd. prepares a register of noncurrent assets as shown in Figure 17.8. Be aware the entire interior's value is the total of the old and the new parts. <?page no="209"?> Berkau: Basics of Accounting 6e 17-209 Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount [EUR] [EUR] [EUR] [EUR] Interior old 144,000.00 (59,382.65) 84,617.35 Interior new 38,000.00 (6,171.52) 31,828.48 Total 116,445.83 Kroller Ltd. REGISTER of NON-CURRENT ASSETS as at 31.12.20X1 Figure 17.8: KROLLER Ltd.’s register of non-current assets 17.11 Depreciation Following Asset Deployment Depreciation following the asset deployment is a depreciation method that reduces an asset's value to the percentage it has been in used based on its total use estimated. In cases when expenses for depreciation depend on the use of assets, the deployment over the entire useful life and for the actual Accounting period must be known. The actual deployment requires measurement. For depreciation on aircrafts the hobbsmeter in the cockpit records the time when the engine is running. The hobbs-time 5 actually is recorded to measure the flight time in Aviation. Depreciation is calculated based on an hourly basis. See below the example of the aircraft rental FLYSCHER Ltd. in Melbourne which also considers costs of major inspections added to the aircraft's carrying value in accordance with IAS 16.14. 17.12 C/ S FLYSCHER Ltd. FLYSCHER Ltd. is an aircraft rental and runs aircrafts of the types Cessna 152, 172 and 182. The customers are 5 Named after John Weston Hobbs. charged based on the hobbs-meter readings as recorded in the aircraft's logbook. At the beginning of the Accounting period 20Z1, the hobbs-meter in the Cessna 172 reads 8,450.2 hours. On 31.12.20Z1 the mechanic at FLYSCHER Ltd. records a hobbs-time of 8,878.4 hours. The useful life of the aircraft in is estimated to be 12,000 hours. The cost of acquisition of the aircraft was 300,000.00 USD. At the time of acquisition - on 6.02.20X1 the exchange rate to the US-Dollar was: 1.00 AUD = 0.55 USD. Hence, the costs of acquisition are: 300,000 / 0.55 = 5 545,454.55 AUD. In the previous year, on 31.12.20Z0, the Cessna 172 received a major inspection for 40,000.00 AUD. At that time, the hobbs-meter reading was 8,450.2 hours. Following IAS 16.14, the costs for major inspections must be added to the carrying value of the aircraft. The carrying value after the (only) major inspection was: ((12,000 - 8,450.2) / 12,000) × 545,454.55 + 40,000 = 201,354.55 AUD. The HOBBS-time flown in 20Z1 is: 8,878.4 - 8,450.2 = 4 428.2 hours. Depreciation is calculated based on the de- <?page no="210"?> Berkau: Basics of Accounting 6e 17-210 ployment as percentage of the remaining useful life and equals: (428.2 / (12,000 - 8,450.2)) × 201,354.55 = 224,288.70 AUD. The following Figure 19.7 shows FLYSCHER Ltd.'s register of non-current assets regarding the Cessna 172: Asset P, P, E @ cost / @ valuation Acc. depr. Acc. impairment loss Carrying amount [AUD] [AUD] [AUD] [AUD] Cessna 172 201,354.55 (24,288.70) 177,065.85 Flyscher Ltd. REGISTER of NON-CURRENT ASSETS as at 31.12.20Z1 Figure 17.9: FLYSCHER Ltd.'s register of non-current assets How it is Done (Depreciation based on Deployment of Assets) (1) Calculate the cost of acquisition (e.g., following IAS 16.16 or § 255 HGB). (2) Calculate the depreciable value under consideration of a salvage value is applicable. (3) Determine the useful life of the assets in deployment units, such as km, miles, hours etc. (4) Determine for the period the deployment as percentage of the useful life. (5) Determine the asset's decrease in valuation based on the calculated percentage of deployment multiplied with the actual carrying amount. (6) Record the valuation decrease as depreciation (DR Depreciation account - CR Accumulated Depreciation account. (7) Determine the new carrying value as the opening valuation less depreciation. (8) If impairment losses apply, calculate accordingly. (9) If the value of the asset increases, determine the new carrying amount and the remainder of the useful life. Start-off at step (3). 17.13 Summary Depreciation is an expense that reflects the reduction of a non-current asset’s value due to its use. Most of non-current assets lose their value by use or by elapsed time. The contra account for depreciation is the Accumulated Depreciation account. An overview of a company’s carrying amounts is provided by the register of non-current assets for all depreciable non-current assets. The register of non-current assets is required by IFRSs on group <?page no="211"?> Berkau: Basics of Accounting 6e 17-211 level. A loss in value that occurs accidently or irregularly is referred to as an impairment loss. The contra account for impairment losses is the Accumulated Impairment Loss account. 17.14 Working Definitions Accumulated Depreciation account: The Accumulated Depreciation account is the contra account for depreciation expenses. Carrying Value: The carrying value of an asset is the value disclosed on the financial statements (balance sheet). Declining Method: Declining method of depreciation applies depreciation that is lower than depreciation in the previous period. Depreciation: Depreciation is an expense that reflects a non-current asset’s loss in valuation due to its age or its deployment. Depreciation Following the Asset Deployment: Depreciation following the asset deployment is a depreciation method that reduces an asset's value to the percentage it has been in used based on its total use estimated. Impairment Loss: An impairment loss is an unforeseeable depreciation which assigns the fair value to an asset that is overstated. Register of non-current Assets: The register of non-current assets is a list of all items of P, P, E that discloses every item’s cost of acquisition, its date of acquisition, its accumulated depreciation, its accumulated impairment losses and its carrying value as at the date indicated. Residual Value: The residual value of an asset is its total value less the depreciable value. Revaluation: A revaluation is an increase of an asset’s carrying value to its fair market value. Straight-line Method of Depreciation: The straight-line method of depreciation leads to a straight line for the asset's value over the time. Useful life: The useful life is the estimated time an asset can be deployed. 17.15 Question Bank (1) On 30.06.20X4, a company buys a business car at 20,000.00 EUR. Its useful life is 5 years. The residual value is 2,000.00 EUR. How much is straight-line depreciation in 20X4? 1. 4.000.00 EUR . 2. 2,000.00 EUR . 3. 1,800.00 EUR . 4. 3,600.00 EUR . (2) What is the correct Bookkeeping entry for depreciation of a motor vehicle to the extent of 3,000.00 EUR? 1. DR MVA 3,000.00 EUR; CR DPR 3,000.00 EUR. 2. DR DPR 3,000.00 EUR; CR ACC 3,000.00 EUR. 3. DR ACC 3,000.00 EUR; CR DPR 3,000.00 EUR. 4. DR DPR 3,000.00 EUR; CR C/ B 3,000.00 EUR. (3) A machine is bought at 100,000.00 EUR. Depreciation follows declining method at an annual rate of 25 %/ a. How much is depreciation in the second Accounting period? 1. 16,000.00 EUR . <?page no="212"?> Berkau: Basics of Accounting 6e 17-212 2. 25,000.00 EUR . 3. 20,000.00 EUR . 4. 18,750.00 EUR . (4) Which statement is correct? 1. The Depreciation account is a real account and is closed-off to the Profit and Loss account. 2. The Accumulated Depreciation account is a real account and must be closed-off to the Property, Plant, Equipment account. 3. The Depreciation account is a nominal account and is closed-off to the Profit and Loss account. 4. The Accumulated Depreciation account is a nominal account and is never closed-off before the disposal of the asset. (5) The depreciation for an aircraft follows the HOBBS time. At the beginning of the Accounting period, the HOBBS reading is 2,460 hrs. The total useful life of the aircraft is 50,000 hrs. The cost of acquisition of the aircraft is 280,000.00 EUR. At the end of the Accounting period the HOBBS meter shows 5,100 hrs. How much is depreciation accurate to the nearest EUR? 1. 12,784 EUR . 2. 13,784 EUR . 3. 14,784 EUR . 4. 15,784 EUR . 17.16 Solutions 1-3; 2-2; 3-4; 4-3; 5-3. <?page no="213"?> Berkau: Basics of Accounting 6e 18-213 18 Further Expenses and Accruals 18.1 What is in the Chapter? In this chapter, we refer to the dynamic Accounting theory and the accrual principle of Accounting. We demonstrate how to assign costs for an upcoming period to prepaid expenses and how to dissolve prepaid expenses in the next Accounting period. 18.2 Learning Objectives After studying this chapter, you have gained more knowledge about nominal accounts. You further know how to apply the accrual principle. You know when and which expenses you must assign to the income statement. 18.3 Prepaid Expenses Prepaid expenses are expenses paid in one Accounting period but relevant for another (future) Accounting period. Accounting follows the accrual principle of Accounting. This requires assigning expenses to the Accounting period they are for. It is irrelevant when payments are made or received. The Bookkeeping procedure is to record the expenses at first like normal expenses which allocates them to the Accounting period of payment. All expenses are recognised in accounts for labour, rent, depreciation, internet fees, etc. After recording as expenses, prepaid expenses are transferred to the Prepaid Expense account. The Prepaid Expense account is like a waiting area for expenses. The costs are deducted from the nominal accounts, like labour, rent etc., and a debit entry is made in the Prepaid Expenses account. This step prevents the prepaid expenses from counting for the actual Accounting period as expense. They now are recorded as prepaid expenses under current assets. Their character is the one of claims. In the next following Accounting period, prepaid expenses are dissolved and are allocated to the relevant nominal account, like prepaid labour is recorded in the Labour account. The Bookkeeping entry then is: DR Labour; CR Prepaid Expenses. Below, we study the case study of SIMONI Ltd. which records rent as prepaid expenses. The Bookkeeping entry is made together with the adjustments for its Accounting period 20X1. 18.4 C/ S SIMONI Ltd. SIMONI Ltd. is a dealership for computer games. The business rents a sales room in a mall and pays 1,500.00 EUR/ m monthly rent. The rental payments are due before the month starts. On 2.01.20X4 SIMONI Ltd. has 75,000.00 EUR cash at bank and commences its selling operations. It pays rent on 2.01.20X4. Next payments must be made on the 28th of the previous month as stated in the rental contract. SIMONI Ltd. pays rent by bank transfer. It activates a stop-order for rental payments. A stop-order makes constant payments until it gets stopped. That is where the name comes from. SIMONI Ltd.’s first payment made by the stop-order takes <?page no="214"?> Berkau: Basics of Accounting 6e 18-214 place on 28.01.20X4. The very first payment is delayed to the fact that the company did not exist before 20X4. As the 1.01.20X4 is no banking day, the first possible payment was on 2.01.20X4. In 20X4, SIMONI Ltd. records rent as below - for us, it does not matter whether payments are made by stop-order, bank transfer or cash: (1) Recording January’s rent on 2.01.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (2) Recording February’s rent on 28.01.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (3) Recording March’s rent on 28.02.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (4) Recording April’s rent on 28.03.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (5) Recording May’s rent on 28.04.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (6) Recording June’s rent on 28.05.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (7) Recording July’s rent on 28.06.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (8) Recording August’s rent on 28.07.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR <?page no="215"?> Berkau: Basics of Accounting 6e 18-215 (9) Recording September’s rent on 28.08.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (10) Recording October’s rent on 28.09.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (11) Recording November’s rent on 28.10.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (12) Recording December’s rent on 28.11.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (13) Recording January 20X5’s rent on 28.12.20X4. DR Rent-20X4.................... 1,500.00 EUR CR Cash/ Bank.................... 1,500.00 EUR Hopefully, the last Bookkeeping entry irritates you! SIMONI Ltd. paid 20X5’s rent in 20X4 and recorded the rent as expense for the Accounting period 20X4. This gives a mismatch. The dynamic Accounting theory strives to calculate profits for the periods. Once we allocate expenses or revenues/ gains from other periods to the income statement, we change the profit. Here, we decrease profit by adding next Accounting period’s rent to the expenses. Therefore, the profit at SIMONI Ltd. is too low. Look at the Rent account and at the Cash/ Bank account in Figure 18.1. <?page no="216"?> Berkau: Basics of Accounting 6e 18-216 D C D C (1) 1,500.00 OV 75,000.00 (1) 1,500.00 (2) 1,500.00 (2) 1,500.00 (3) 1,500.00 (3) 1,500.00 (4) 1,500.00 (4) 1,500.00 (5) 1,500.00 (5) 1,500.00 (6) 1,500.00 (6) 1,500.00 (7) 1,500.00 (7) 1,500.00 (8) 1,500.00 (8) 1,500.00 (9) 1,500.00 (9) 1,500.00 (10) 1,500.00 (10) 1,500.00 (11) 1,500.00 (11) 1,500.00 (12) 1,500.00 (12) 1,500.00 (13) 1,500.00 (13) 1,500.00 c/ d 55,500.00 75,000.00 75,000.00 b/ d 55,500.00 Rent-20X4 RNT Cash/ Bank C/ B Figure 18.1: SIMONI Ltd.’s accounts Due to the prepayment, the total amount paid exceeds the rent for the Accounting period 20X4. The amount in the Rent accounts shows: 13 × 1,500 = 19,500.00 EUR. Once SIMONI Ltd. closes-off the Rent account to its Profit and Loss account the January 20X5’s rent becomes an expense for 20X4. This gives a mismatch between expenses and Accounting periods. To avoid misallocations, we must accrue the rent for January 20X5. The amount gets “parked” in a special Prepaid Expense account on the balance sheet. The Bookkeeping entry (14) transfers the rent for January 20X5 to that account. Accrues fall under adjustments and are recorded on the last day of the Accounting period (31.12.). (14) Transfer of next year’s rent into the Prepaid Expenses account on 31.12.20X4. DR Prepaid Expenses............. 1,500.00 EUR CR Rent......................... 1,500.00 EUR We look at the accounts in Figure 18.2 after recording prepaid expenses. <?page no="217"?> Berkau: Basics of Accounting 6e 18-217 D C D C (1) 1,500.00 PRE 1,500.00 OV 75,000.00 (1) 1,500.00 (2) 1,500.00 (2) 1,500.00 (3) 1,500.00 (3) 1,500.00 (4) 1,500.00 (4) 1,500.00 (5) 1,500.00 (5) 1,500.00 (6) 1,500.00 (6) 1,500.00 (7) 1,500.00 (7) 1,500.00 (8) 1,500.00 (8) 1,500.00 (9) 1,500.00 (9) 1,500.00 (10) 1,500.00 (10) 1,500.00 (11) 1,500.00 (11) 1,500.00 (12) 1,500.00 (12) 1,500.00 (13) 1,500.00 c/ d 18,000.00 (13) 1,500.00 19,500.00 19,500.00 c/ d 55,500.00 b/ d 18,000.00 P&L 18,000.00 75,000.00 75,000.00 b/ d 55,500.00 D C D C Rnt 18,000.00 NL 18,000.00 RNT 1,500.00 c/ d 1,500.00 b/ d 18,000.00 R/ E 18,000.00 b/ d 1,500.00 D C D C P&L 18,000.00 c/ d 18,000.00 c/ d 75,000.00 OV 75,000.00 b/ d 18,000.00 b/ d 75,000.00 Rent-20X4 RNT Cash/ Bank C/ B Retained earnings R/ E Issued Capital ISS Profit and Loss-20X4 P4L Prepaid expenses PRE Figure 18.2: SIMONI Ltd.’s accounts At the beginning of the next Accounting period 20X5, SIMONI Ltd. dissolves the accrual. Prepaid expenses are transferred to the expense account (of the actual Accounting period). This is recorded as Bookkeeping entry (A): DR Rent-20X5.................... 1,500.00 EUR CR Prepaid Expenses............. 1,500.00 EUR Observe SIMONI Ltd.’s statement of financial position as at 31.12.20X4 below: <?page no="218"?> Berkau: Basics of Accounting 6e 18-218 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 75,000.00 Intangibles Reserves Financial assets R/ E (18,000.00) Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses 1,500.00 Provisions Cash/ Bank 55,500.00 Tax liabilities 57,000.00 57,000.00 Simoni Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 18.3: SIMONI Ltd.’s statement of financial position as at 31.12.20X4 SIMONI Ltd.’s statement of profit or loss and other comprehensive income for 20X4 looks as in Figure 18.4. In particular, it shows the rent for 12 months correctly and in accordance with the accrual principle to the value of: 12 × 1,500 = 1 18,000.00 EUR. [EUR] Revenue Other income 0.00 Materials Labour Depreciation Other expenses (18,000.00) Earnings before int and taxes (EBIT) (18,000.00) Interest Earnings before taxes (EBT) (18,000.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (18,000.00) Simoni Ltd. STATEMENT of PROFIT & LOSS and other COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 18.4: SIMONI Ltd.’s income statement for 20X4 <?page no="219"?> Berkau: Basics of Accounting 6e 18-219 How it is Done (Accruals): (1) Make all Bookkeeping entries for business activities including all payments. (2) Check whether expense have been recorded, which belong to a future Accounting period. (3) In case step (2) is positive, transfer future expenses to the Prepaid Expenses account. Credit their value to the relevant expense account for isolation purpose. (4) Prepare financial statements. (5) At the beginning of the next Accounting period, close-off the Prepaid Expenses account to the relevant expense account. 18.5 Summary Expenses, like rent, insurance, labour, etc. can be paid for in advance. The payment initiates a Bookkeeping entry in the Accounting period of payment. In order to allocate these expenses to the correct income statement, we record accruals. In compliance with the accrual principle of Accounting, expenses are allocated to the Accounting period they belong to and not to the period of their payment. This supports the dynamic Accounting theory along which financial statements are prepared in order to determine the profit/ loss for Accounting periods. 18.6 Question Bank (1) Which statement is correct? 1. Prepaid expenses are expenses. 2. Prepaid expenses are assets. 3. Prepaid expenses are debts. 4. Prepaid expenses are gains. (2) A company pays rent one month in advance. At the beginning of the Accounting period, the prepaid expenses are amounting to 1,200.00 EUR. The landlord increases rent from 1.07. onwards to 1,500.00 EUR. How much rent is paid during the year by the Bookkeeping entry: DR RNT; CR C/ B. 1. 18,000.00 EUR . 2. 14,400.00 EUR . 3. 16,500.00 EUR . 4. 16,200.00 EUR . (3) A company pays insurance in advance. The monthly payment is 730.00 EUR. What is the correct Bookkeeping entry in December? 1. DR INS 730.00 EUR; CR C/ B 730.00 EUR and DR PRE 730.00 EUR; CR INS 730.00 EUR. 2. DR C/ B 730.00 EUR; CR INS 730.00 EUR and DR PRE 730.00 EUR; CR INS 730.00 EUR. 3. DR INS 730.00 EUR; CR PRE 730.00 EUR and DR PRE 730.00 EUR; CR C/ B 730.00 EUR. 4. DR PRE 730.00 EUR; CR INS 730.00 EUR and DR INS 730.00 EUR; CR PRE 730.00 EUR. (4) What is the difference between receivables and prepaid expenses? <?page no="220"?> Berkau: Basics of Accounting 6e 18-220 1. Receivables must be collected in the next Accounting period. 2. Prepaid expenses are always net amounts and receivables are always gross amounts. 3. Prepaid expenses are settled by service whereas receivables are paid. 4. Prepaid expenses do not fall under current assets. (5) What is the correct Bookkeeping entry to dissolve prepaid expenses of 100.00 EUR for fees (FEE-account)? 1. DR PRE 100.00 EUR; CR C/ B 100.00 EUR. 2. DR FEE 100.00 EUR; CR PRE 100.00 EUR. 3. DR PRE 100.00 EUR; CR FEE 100.00 EUR. 4. DR C/ B 100.00 EUR; CR PRE 100.00 EUR. 18.7 Solutions 1-2; 2-3; 3-1; 4-3; 5-2. <?page no="221"?> Berkau: Basics of Accounting 6e 19-221 19 Accounting for Labour 19.1 What is in the Chapter? In this chapter, we discuss how to record Bookkeeping entries for labour. Labour is paid to employees of the company which requires the consideration of payroll tax. Furthermore, we cover how to make payments for labour in advance or delayed and we show how to make Bookkeeping entries in accounts for overtime, incentives and vacation. 19.2 Learning Objectives After studying Accounting for labour, you will have detailed knowledge of payroll Accounting. You learn Accounting in more detail than we apply it in most of Accounting classes. Many case studies in academia pretend that workers are employed on a freelancer basis, which allows to skip most of the procedures you learn in this chapter. 19.3 Pay-days In general, labour is paid in advance - at least to a certain extent. In order to keep cases simple, we assume labour is paid on the 15th of every month for the month it counts for. Therefore, a company pays 50 % of labour in advance and the other half after the job has been done. 19.4 Components of Labour For the Accounting work in academia, two options apply for labour. (A) We make Bookkeeping entries for the complete labour in the Labour account and credit the amount to the Cash/ Bank account. This way, we assume that labour includes payroll tax, contribution to social securities and net salary. (B) We record all components of labour separately. Then we must determine payroll tax, contribution to social securities and net salary at first, as we discuss in this chapter (19): By national law, labour payments are combined with contributions to social securities and payroll tax. For teaching purposes, we apply simplified percentages for social securities and payroll tax. Social securities include contributions to the unemployment fund, to the state pension funds (if applies) and for healthcare plans. You must study national law for the details. You find further information in the national Social Security Code. Payroll tax is an income tax levied on income achieved from work as an employee. Note, that we simplify the payroll tax calculation for the purpose of teaching, e.g., we exclude church taxes, and we make an assumption of a constant payroll tax rate. We are only interested in making Bookkeeping entries for labour, not in the calculation thereof. Labour contains the net salary as well as a payroll tax and social security contributions. Payroll tax is deducted directly from the salary. This concept is known as a withholding tax. A withholding tax is kept away from the taxpayer but paid directly into the revenue service's account. The company transfers the payroll taxes to the revenue service. Although the company pays <?page no="222"?> Berkau: Basics of Accounting 6e 19-222 the payroll tax (on behalf of its employees), payroll tax does not fall under company taxes. Note, that by law the company owes payroll taxes and is reliable for its on-time payment. This means employees do not get hold of the payroll tax and are not involved in making the payments either. In many countries, social securities payments are shared between the employee and the company - in Germany at a half : half ratio. Next, we introduce two technical terms for labour. net salary and gross salary. 19.5 Net Salary The net salary is the money paid into the employee’s account. We say it is the take-home money. The net salary does not contain payroll tax nor social security. Those components have been deducted. 19.6 Gross Salary The gross salary is the salary allocated to the employee before deductions of her/ his social security contribution and the payroll taxes are made. If written as a formula the gross salary is: net salary plus payroll tax plus the employee's contribution to social securities. As payroll tax depends on the employee’s characteristics, like whether she/ he is a church goer, her/ his marriage status, amount of kids etc., salary comparisons should be made referring to the gross salary. Contributions for social securities are split between the company and the employee. The portion covered by the employee is called employee’s contribution to social securities. It is included in the gross salary. The company owes the other half of the social securities. The company’s contribution is not part of the gross salary as company is obliged to pay its portion. Therefore, the total of labour costs includes the gross salary plus the company’s contribution to social securities. In other words: Labour is net salary plus payroll taxes, plus employee’s contribution to social securities (50%) and plus employer’s contribution to social securities (50%). 19.7 Assumptions The calculation of payroll tax and social security contribution follows national law and requires consideration of various characteristics. For this textbook, we make assumptions regarding the amounts as follows: Full social securities (in the meaning of both halves of social security contributions) is 25 % of the gross salary and payroll tax is amounting to 20 % of the gross salary. Therefore, the entire expenses for labour are: 25/ 2 + 100 = 112.5 % of the gross salary. 19.8 Case study SUIDERLAND Ltd. The calculation for labour is explained by the following case: SUIDERLAND Ltd. employs Mr LAMPEN-KÖTTER on its payroll, who earns a monthly gross salary of 3,500.00 EUR/ m. The payroll tax included therein is deducted and the social security contribution is calculated by 25 % of the gross salary divided by 2, because Mr LAMPEN-KÖTTER has to contribute a 50 % portion thereto. Mr LAMPEN-KÖTTER’s net salary is what he <?page no="223"?> Berkau: Basics of Accounting 6e 19-223 receives after deduction of payroll tax and half of the social security payments. LAMPEN-KÖTTER’s net salary is amounting to: 3,500 - 20% × 3,500 - 25% × 3,500 / 2 = 3,500 × (1 - 20% - 25% / 2) = 22,362.50 EUR/ m. The payroll tax equals: 20% × 3,500 = 7 700.00 EUR/ m. Half of his social security gives: 25 % × 3,500 × (1/ 2) = 4437.50 EUR/ m. We assume, the net salary is paid on the 15th of every month and social security payments and payroll taxes are due at month ends. SUIDERLAND Ltd. makes the Bookkeeping entries in January for LAMPEN- KÖTTER’s salary: (1) Recording net salary and transferring payroll tax and (50 % of) social security contribution to accounts payables on 15.01.20X3. DR Labour....................... 3,500.00 EUR CR A/ P (Payroll Tax)............ 700.00 EUR CR A/ P (Social Security 50%).... 437.50 EUR CR Cash/ Bank.................... 2,362.50 EUR (2) On 31.01.20X3, we add SUIDERLAND Ltd.’s contribution to LAMPEN-KÖTTER’s social securities to the Accounts Payables account. DR Labour....................... 437.50 EUR CR A/ P (Social Security 50%).... 437.50 EUR (3) SUIDERLAND Ltd. pays payroll taxes and social securities on 31.01.20X3. DR A/ P (Taxes on Labour)........ 700.00 EUR DR A/ P (Social Security 100%)... 875.00 EUR CR Cash/ Bank.................... 1,575.00 EUR Observe the accounts for the payments in Figure 19.1: D C D C (1) 3,500.00 (3) 875.00 (1) 437.50 (2) 437.50 P&L 3,937.50 (2) 437.50 3,937.50 3,937.50 875.00 875.00 D C D C (3) 700.00 (1) 700.00 OV ... (1) 2,362.50 (3) 1,575.00 Payroll taxes payables PTP Cash/ Bank C/ B Labour-20X3 LAB Social securities payables SSP Figure 19.1: SUIDERLAND Ltd.’s accounts <?page no="224"?> Berkau: Basics of Accounting 6e 19-224 How it is Done (Labour Payment): (1) Calculate the gross salary. There might be accruals to consider (see below). (2) Debit the gross salary to the Labour account and credit the payroll tax (as withholding tax) and the employee’s contribution to social security to payables and pay the net salary. (3 credit entries! ) (3) Debit the amount for the employer’s contribution to social security to labour and credit the amount to payables, too. (4) Pay social contribution by debiting the employer’s and employee’s contribution to social security to the payables and make a credit entry in the Cash/ Bank account. (5) Pay payroll tax by making a debit entry in the payables account. (! ) Never mix payroll tax with income tax. Payroll tax are no income taxes for the company. 19.9 Piecework Labour Accounting for labour and the calculation of the gross salary become complicated, if the contract for labour is based on an hourly basis or by completion of work. The latter one is called piecework labour. Piecework labour is a salary calculated based on the amount of work completed by the employee. If the recipient of piecework labour is not employed, we call the agreement between the company and service provider a contract for work labour. In terms of Accounting that does not make much of a difference except that the service provider is obliged to pay income taxes on her/ his own. When a contract for work labour applies, the parties agree on a certain workload; the payment thereof is due after its completion. Contracts for work labour apply e.g., in cases, when the service provider writes an expertise or paints goods with a payment based on the work completed. We explain piecework labour by the case study CLARITON Ltd. below. The case study also covers recording of incentives and vacation claims. At CLARITON Ltd. all workers are employees of the company. 19.10 C/ S CLARITON Ltd. CLARITON Ltd. is a production firm for baseball caps. The business runs a division for cap manufacturing, where it employs 1 manager and 3 operators. The manager receives an annual salary of 50,400.00 EUR/ a which is the gross salary. Following national law, a withholding tax on labour applies. For this case study the payroll tax rate is 20 % based on the gross salary. The gross salary and a 25 % portion for social securities thereof are paid at month ends. At CLARITON Ltd. the 3 operators in the production division are employed based on a piecework contract. They are paid based on the baseball caps finished. The <?page no="225"?> Berkau: Basics of Accounting 6e 19-225 contract states they receive a gross salary of 1.50 EUR/ baseball cap. Furthermore, they receive an incentive of 0.50 EUR/ baseball cap per additional baseball cap, once their daily production exceeds an amount of 60 baseball caps. Working night shifts or weekend shifts pays an operator 150 % of her/ his normal salary. Every operator is entitled to a paid leave of 10 days per annum. Payday is on every 25 th day of the month. We start with the manager’s salary: The gross salary is 50,400.00 EUR/ a. The payroll tax on the gross salary is: 20% × 50,400 = 1 10,080.00 EUR/ a. Social securities are: 25% × 50,400 = 1 12,600.00 EUR/ a. CLARITON Ltd. pays half of the social securities which is: 12,600 / 2 = 6,300.00 EUR/ a. Every month end, CLARITON Ltd. makes the Bookkeeping entries as follows for its manager. The monthly gross salary is: 50,400 / 12 = 4 4,200.00 EUR/ m, payroll tax is amounting to: 10,080 / 12 = 840.00 EUR/ m and social security contribution equals: 6,300 / 12 = 5 525.00 EUR/ m. The manager’s net salary is: 4,200 - 840 - 525 = 2 2,835.00 EUR/ m. (1, … 12) Recording the manager’s salary. DR Labour....................... 4,200.00 EUR CR Payroll Tax/ p................ 840.00 EUR CR Social Security/ p ............ 525.00 EUR CR Cash/ Bank.................... 2,835.00 EUR (13 … 24) Recording payroll tax. DR Payroll Tax/ p................ 840.00 EUR CR Cash/ Bank.................... 840.00 EUR (25 … 48) Recording the payment of social security. DR Labour....................... 525.00 EUR CR Social Security/ p ............ 525.00 EUR DR Social Security/ p ............ 1,050.00 EUR CR Cash/ Bank.................... 1,050.00 EUR The next Bookkeeping entries are for the 3 operators in the manufacturing division. For Bookkeeping entries in December, we assume all workers complete 60 baseball caps per working day and 2 of the operators took their annual leave already. Figure 19.2 illustrates the calendar for the relevant period. Consider 25 December 20X8 as a public holiday. Therefore, the payday in December is the 24.12.20X8. CLARITON Ltd. does not pay a Christmas bonus. As every operator’s contract includes a claim of 2 weeks paid leave, their actual salary per cap increases by a 50 : 2 ratio. <?page no="226"?> Berkau: Basics of Accounting 6e 19-226 Hence, the gross salary per baseball cap is: 52 × 1.50/ 50 = 1 1.56 EUR/ u. For every finished baseball cap 1.50 EUR is added to their salaries and 0.06 EUR to a worker-specific Vacation account. The Vacation account is used for leave pay once the employee takes it. The weekend shifts’ premiums are extra shifts and do not contribute to the Vacation account. Mo Tu We Th Fr Sa Su Mo Tu We Th Fr Sa Su 1 2 1 2 3 4 5 6 7 3 4 5 6 7 8 9 8 9 10 11 12 13 14 10 11 12 13 14 15 16 15 16 17 18 19 20 21 17 18 19 20 21 22 23 22 23 24 25 26 27 28 24 25 26 27 28 29 30 29 30 31 November 20X8 December 20X8 Figure 19.2: Calendar November 20X8 and December 20X8 During December 20X8, CLARITON Ltd. runs extra shifts on 3 Saturdays, which are: 6.12.20X8, 13.12.20X8 and 20.12.20X8. To study the impact on the salaries, we observe the 3 operators GÜNTER, WERNER and Margret. GÜNTER: GÜNTER worked in November on 3 days after payday (26, 27 and 28 November) and produced every day 60 baseball caps. He is entitled to a salary of: 3 × 60 × 1.50 = 2 270.00 EUR resulting from 3 working days in November 20X8. Furthermore, he works on 18 regular daily shifts in December. (1.-5.12.20X8, 8.- 12.12.20X8, 15.-19.12.20X8, 22.- 24.12.20X8) This pays him a gross salary of: 18 × 60 × 1.50 = 1 1,620.00 EUR. Additionally, GÜNTER works 3 extra shifts, which gives him an add-on salary of: 3 × 60 × 150% × 1.50 = 4 405.00 EUR. Thus, GÜNTER’s gross salary for December 20X8 is amounting to: 270 + 1,620 + 405 = 2 2,295.00 EUR. (49) Payment for GÜNTER’s salary on 24 December 20X8: GÜNTER’s payroll tax is: 20% × 2,295 = 459.00 EUR. His entire (100%) social security payment is: 25% × 2,295 = 5 573.75 EUR. GÜNTER’s contribution is half of it: 573.75 / 2 = 2 286.88 EUR. This gives GÜNTER’s a net salary of: 2,295 - 459 - 286.88 = 1 1,549.12 EUR. See below the Bookkeeping entry for GÜNTER’s salary in December 20X8: DR Labour....................... 2,295.00 EUR CR Payroll Tax/ p................ 459.00 EUR CR Social Security/ p............ 286.88 EUR CR Cash/ Bank.................... 1,549.12 EUR (50 … 52) Labour tax and social securities are paid on 31.12.20X8. <?page no="227"?> Berkau: Basics of Accounting 6e 19-227 DR Payroll Tax/ p................ 459.00 EUR CR Cash/ Bank.................... 459.00 EUR DR Labour....................... 286.87 EUR CR Social Security/ p ............ 286.87 EUR DR Social Security/ p ............ 573.75 EUR CR Cash/ Bank.................... 573.75 EUR GÜNTER works normal shifts on 3 days in November 20X8 and on 18 days in December 20X8. These days are credited towards his Vacation account. A claim of 0.06 EUR/ baseball cap is added to GÜNTER’s Vacation account. CLARITON Ltd. makes a Bookkeeping entry for: 0.06 × 60 × (3 + 18) = 7 75.60 EUR. (53) CLARITON Ltd. adds the claim to December’s labour expenses on 24.12.20X8. DR Labour....................... 75.60 EUR CR Vacation GÜNTER .............. 75.60 EUR The Vacation account is an account that serves for GÜNTER’s paid leave. We assume GÜNTER works 50 weeks and produces every day 60 baseball caps adding: 50 × 60 × 5 × 0.06 = 9 900.00 EUR to the vacation account per year. The amount of 900.00 EUR is the salary paid during GÜNTER’s leave of 2 weeks. His leave pay is (was, as he took the leave already): 2 × 5 × 60 × 1.50 = 9 900.00 EUR. WERNER WERNER takes the first 2 weeks in December off. He worked on 3 days in November 20X8, same as GÜNTER. He takes the Saturday shift on 20.12.20X8. His salary is (for 3 November working days plus paid leave plus 8 December working days plus 1 Saturday shift): 3 × 60 × 1.50 + 900 + 8 × 60 x 1.50 + 1 × 60 × 2.25 = 2 2,025.00 EUR. (54 … 57) Bookkeeping entries for WERNER’s salary on 24.12.20X8 and 31.12.20X8 are as follows: The tax payments are: 20% × 2,025 = 4 405.00 EUR and social securities contribution is: 25% × 2,025 = 5 506.25 EUR. Half of the latter amount is WERNER’s contribution to social securities: 506.25 / 2 = 2 253.13 EUR. His net salary equals: 2,025 - 405 - 253.13 = 1 1,366.87 EUR. For WERNER’s gross salary, CLARITON Ltd. deducts 900.00 EUR from his Vacation Account. Observe the Bookkeeping entries for WERNER below: DR Vacation Account............. 900.00 EUR DR Labour....................... 1,125.00 EUR CR Payroll Tax/ p................ 405.00 EUR CR Social Security/ p ............ 253.13 EUR CR Cash/ Bank.................... 1,366.87 EUR The payments for labour tax and for social securities follow below: <?page no="228"?> Berkau: Basics of Accounting 6e 19-228 DR Payroll Tax/ p................ 405.00 EUR CR Cash/ Bank.................... 405.00 EUR DR Labour....................... 253.12 EUR CR Social Security/ p............ 253.12 EUR DR Social Security/ p............ 506.25 EUR CR Cash/ Bank.................... 506.25 EUR (58) CLARITON Ltd. makes a Bookkeeping entry in WERNER’s Vacation account on 24.12.20X8. He worked on 3 November and on only 8 December shifts relevant for his Vacation account. The amount is: 60 × 0.06 × (3 + 8) = 3 39.60 EUR. DR Labour....................... 39.60 EUR CR Vacation WERNER.............. 39.60 EUR MARGRET MARGRET always produces 20 extra baseball caps per shift and does not work on Saturday. Her salary in December is based on 3 days worked in November and on 18 working days in December. Her gross salary is: (3 + 18) × (80 × 1.50 + 20 × 0.50) = 2 2,730.00 EUR. (59) MAGRET’s gross salary is the basis for payroll taxes and social securities. Her payroll tax gives: 20% × 2,730 = 546.00 EUR. Social Security is amounting to: 0.25 × 2,730 = 6 682.50 EUR. MARGRET’s contribution to social securities is: 682.50 / 2 = 3 341.25 EUR. Therefore, MARGRET’s net salary is: 2,730 - 546 - 341.25 = 1 1,842.75 EUR. CLARITON Ltd. records labour for MARGRET on 24.12.20X8: DR Labour....................... 2,730.00 EUR CR Payroll Tax/ p................ 546.00 EUR CR Social Security/ p............ 341.25 EUR CR Cash/ Bank.................... 1,842.75 EUR (60 … 62) On 31.12.20X8, CLARITON Ltd. records the payments for payroll tax and for social security: DR Payroll Tax/ p................ 546.00 EUR CR Cash/ Bank.................... 546.00 EUR DR Labour....................... 341.25 EUR CR Social Security/ p............ 341.25 EUR <?page no="229"?> Berkau: Basics of Accounting 6e 19-229 DR Social Security/ p ............ 682.50 EUR CR Cash/ Bank.................... 682.50 EUR MARGRET’s claim on paid leave is for 2 weeks at a weekly workload of 60 baseball caps, same as for her co-workers. Extra baseball caps do not count for leave. Therefore, CLARITON Ltd. transfers to MARGRET’s Vacation account: 60 × 0.06 × (3 + 18) = 7 75.60 EUR. (63) CLARITON Ltd. records her vacation claim on 31.12.20X8. DR Labour....................... 75.60 EUR CR Vacation Account............. 75.60 EUR When an incentive applies (in MARGRET’s case) we cannot keep the incentive premiums in the Labour account. This would increase expenses for the extra baseball caps in the calculation thereof. We cannot sell those baseball caps at a higher price, because they have earned the operator an incentive. As a result, CLARITON deducts expenses for MARGRET’s incentives from the Labour account. (64) Reallocation of the incentive on 24.12.20X8: 20 × 0.5 × (3 +18) = 2 210.00 EUR: DR Incentive.................... 210.00 EUR CR Labour....................... 210.00 EUR The latter internal Bookkeeping entry does not mean the incentive gets excluded from expenses. The reason for the cost separation is the calculation of unit costs. We can make a similar Bookkeeping entry for the Saturday shifts. However, CARITON Ltd. regards the weekend shifts as regular operations which increase the unit costs per baseball cap. Hence, the extra shift premiums stay in the Labour account. 19.11 Accruals for Piecework Labour Besides the special amounts for labour as discussed above, the piecework labour gives us another challenge. As we learned by chapter (18), accruals can apply. With the pay-day at the end of the month, piecework labour does not create prepaid expenses, but there is a future payment obligation we must consider. All operators worked 3 shifts in November they are paid for in December. They also work 4 days in December which gives them a receipt in the next Accounting period’s January. We’ll start our recording for labour accruals with the work delivered in December. (The dissolving of November accruals is explained further below.) GÜNTER, WERNER and MARGRET work on 4 days in December, which is on 26.12.20X8, 29.12.20X8, 30.12.20X8 and 31.12.20X8. The workload is considered as a liability for CLARITON Ltd. We assume GÜNTER and WERNER work on normal capacity: 60 baseball caps/ shift. Therefore, the salary transferred to liabilities on 31.12.20X8 equals: 4 × 60 × 1.50 = 3 360.00 EUR for each operator. At <?page no="230"?> Berkau: Basics of Accounting 6e 19-230 this stage of Accounting, no taxes or social securities become relevant. Tax expense will be considered in January. (65, 66) Transfer of last December day’s work to liabilities. DR Labour....................... 360.00 EUR CR Salary GÜNTER/ p.............. 360.00 EUR DR Labour....................... 360.00 EUR CR Salary WERNER/ p.............. 360.00 EUR (67) MARGRET’s work in December is based on normal capacity plus extra achievements and equals: 4 × 80 × 1.50 + 4 × 20 × 0.5 = 5 520.00 EUR. She completed 80 baseball caps per day. CLARITON Ltd. records the transfer on 31.12.20X8. DR Labour....................... 520.00 EUR CR Salary MARGRET/ p............. 520.00 EUR Similar to Bookkeeping entry (64), we isolate incentives from labour. The transfer is amounting to: 4 × 20 × 0.50 = 40.00 EUR. DR Incentives................... 40.00 EUR CR Labour....................... 40.00 EUR According to the transfers made in December, the amount taken out of the accounts in December for the work delivered in November is for GÜNTER and WERNER: 3 × 60 × 1.50 = 2 270.00 EUR each. For MARGRET the amount is: 3 × 80 × 1.50 + 3 × 20 × 0.50 = 3 390.00 EUR. The amount is to be taken out of the Labour account in December as it belongs to November 20X8. (a … c) The Bookkeeping entries are: DR Salary GÜNTER/ p.............. 270.00 EUR CR Labour....................... 270.00 EUR DR Salary WERNER/ p.............. 270.00 EUR CR Labour....................... 270.00 EUR DR Salary MARGRET/ p............. 390.00 EUR CR Labour....................... 390.00 EUR To keep the case study as simple as possible, we only show the accounts as at 1.12.20X8 and record the Bookkeeping entries for December 20X8. The opening values in exhibit 19.3 are as follows: - Vacation-4-GÜNTER account. GÜNTER took vacation already. As a result, the account’s balancing figure <?page no="231"?> Berkau: Basics of Accounting 6e 19-231 is: -21 × 60 × 0.06 = - -75.60 EUR. (We apply a reverse calculation assuming the year has 52 weeks with 5 working days. We ignore public holidays.) - The Vacation-4-WERNER account got an opening value of: 900 - 11 × 60 × 0.06 = 8 860.40 EUR. The account is credit balanced. - The Vacation-4-MARGRET account got an opening value of -75.60 EUR, same as GÜNTER’s account. - The opening value for the Labour (workers) account results from the work in November and paid in December. D C D C (12) 4,200.00 (24) 840.00 (12) 840.00 (36) 525.00 c/ d 4,725.00 (50) 459.00 (49) 459.00 4,725.00 4,725.00 (55) 405.00 (54) 405.00 b/ d 4,725.00 (60) 546.00 (59) 546.00 2,250.00 2,250.00 Labour manager-20X8 LAM Payroll tax / p PTP D C D C (48) 1,050.00 (12) 525.00 (12) 2,835.00 (52) 573.75 (36) 525.00 (24) 840.00 (57) 506.25 (49) 286.88 (48) 1,050.00 (62) 682.50 (51) 286.87 (49) 1,549.12 (54) 253.13 (50) 459.00 (56) 253.12 (52) 573.75 (59) 341.25 (54) 1,366.87 (61) 341.25 (55) 405.00 2,812.50 2,812.50 (57) 506.25 (59) 1,842.75 (60) 546.00 (62) 682.50 Social securities / p SSP Cash/ Bank C/ B D C D C OV 75.60 (53) 75.60 (54) 900.00 OV 860.40 (58) 39.60 900.00 900.00 D C D C OV 75.60 (63) 75.60 (64) 210.00 c/ d 250.00 (67) 40.00 250.00 250.00 b/ d 250.00 Vacation-4-GÜNTER V4G Vacation-4-WERNER V4W Vacation-4-MARGRET V4M Incentives INC Figure 19.3: CLARITON Ltd.’s accounts <?page no="232"?> Berkau: Basics of Accounting 6e 19-232 D C D C (a) 270.00 OV 270.00 (b) 270.00 OV 270.00 c/ d 360.00 (65) 360.00 c/ d 360.00 (66) 360.00 630.00 630.00 630.00 630.00 b/ d 360.00 b/ d 360.00 Labour GÜNTER / p A/ P Labour WERNER / p A/ P D C D C (c) 390.00 OV 390.00 OV 930.00 (a) 270.00 c/ d 520.00 (67) 520.00 (49) 2,295.00 (b) 270.00 910.00 910.00 (51) 286.87 (c) 390.00 b/ d 520.00 (53) 75.60 (64) 210.00 (65) 360.00 (67) 40.00 (54) 1,125.00 (56) 253.12 (58) 39.60 (66) 360.00 (59) 2,730.00 (61) 341.25 (63) 75.60 (67) 520.00 c/ d 8,212.04 9,392.04 9,392.04 b/ d 8,212.04 Labour MARGRET / p A/ P Labour-20X8 LAB Figure 19.3: CLARITON Ltd.’s accounts (continued) 19.12 Summary We discussed the components of labour for employees. The company pays for the net salary, for social security contributions and for payroll taxes. We studied piecework labour and calculated regular labour, incentives, vacation and premiums for extra shifts. In cases an employee works after payday, the accrual principle of Accounting requires the recording of a liability for the salary earned after pay-day. In many cases of our textbook Bilanzen/ Financial Statements, we avoid complex Accounting work for labour. We simply pretend labour includes taxes and social securities already (one payment), or labour is paid on a freelancer basis. The latter one implies that the workers are not employed by the company and, thus, are considered third parties who bill their hours. We further pretend that freelancers do not claim VAT. 19.13 Working Definitions Gross Salary: The gross salary is the salary allocated to the employee before deduction of her/ his social security portion and the payroll tax are made. Net Salary: The net salary is the money paid into the employee’s account. Payroll Tax: Payroll tax is an income tax levied on income achieved from work as an employee. Piecework Labour: Piecework labour is a salary calculated based on the <?page no="233"?> Berkau: Basics of Accounting 6e 19-233 amount of work completed by the employee. Social Security Contributions: Social securities include contributions to the unemployment fund, to the state pension funds (if applies) and for healthcare plans. Withholding Tax: A withholding tax is kept away from the taxpayer but paid directly into the revenue service's account. 19.14 Question Bank (1) A company employs a worker, and her gross salary is amounting to 85,000.00 EUR/ a. Pay-roll tax is 20% and the social securities are amounting to 25 % (both) of the gross salary. How much is the total of labour per annum? 1. 85,000.00 EUR/ a . 2. 106,250.00 EUR/ a . 3. 102,000.00 EUR/ a . 4. 68,000.00 EUR/ a . (2) Which statement is wrong? 1. The gross salary includes the employer’s social security contribution. 2. The pay-roll tax is paid by the employer as she/ he only get paid the net salary. 3. The net salary includes pay-roll tax but not the employer’s contribution to social security. 4. The total of labour is the gross salary plus social security contribution of the company. (3) A company pays for piecework on the 15 th day of the month. After 15.12.20X3, the employees work for 10 days. The daily workload is paid 240.00 EUR/ d for. What is the Bookkeeping entry at the end of the Accounting period 20X3? 1. DR LAB 2,400.00 EUR; CR A/ P 2,400.00 EUR. 2. DR LAB 2,400.00 EUR; CR C/ B 2,400.00 EUR. 3. DR LAB 5,160.00 EUR; CR A/ P 5,160.00 EUR. 4. DR C/ B 2,400.00 EUR; CR LAB 2,400.00 EUR. (4) What is a freelancer? 1. Someone living an easy life. 2. Someone working for a company and charging it for her/ his work by billing the hours or piecework. 3. Someone working under contract for a company and paying pay-roll tax and half of the social securities. 4. A student working as an intern. (5) A company pays its worker per piecework. The salary to be paid per day is amounting to 135.00 EUR/ d. The employee has a claim on 4 weeks of vacation. The year got 52 weeks (= 260 working days). What is the Bookkeeping entry for January, if the employee worked for 4 weeks (= 20 working days) and did not take a day off? The Vacation Account’s 3-letter-code is VAC. 1. DR LAB 2,700.00 EUR; DR VAC 225.00 EUR; CR C/ B 2,925.00 EUR. 2. DR C/ B 2,700.00 EUR; DR VAC 225.00 EUR; CR LAB 2,925.00 EUR. 3. DR LAB 2,700.00 EUR; CR VAC 225.00 EUR; CR C/ B 2,475.00 EUR. <?page no="234"?> Berkau: Basics of Accounting 6e 19-234 4. DR LAB 2,925.00 EUR; CR VAC 225.00 EUR; CR C/ B 2,700.00 EUR. 19.15 Solutions 1-2; 2-3; 3-1; 4-2; 5-4. <?page no="235"?> Berkau: Basics of Accounting 6e 20-235 20 Trading Business - (1) Purchases and Returns 20.1 What is in the Chapter? In this chapter we discuss two case studies about trading businesses. At first, we only introduce the purchase side in chapters (20) and (21). The first case study APPLEDEEN (Pty) Ltd. covers a grocery dealer. We observe its purchases and record further expenses. The second case is about a kitchen appliance store. In addition to the 1 st case study, we then cover returns outwards, when the dealership sends back goods to its supplier. In both case studies we ignore VAT. In the next following chapter, we repeat the case studies, but then, we apply VAT at a VAT rate of 20 %. In the chapters (22) and (23) we extend our considerations to sales - in chapter (22) without VAT; in chapter (23) including VAT. 20.2 Learning Objectives After studying this chapter, you are familiarised with the Purchase account and can calculate profit/ loss for a trading business. You furthermore learn the application of the Returns Outwards account. We ignore VAT for this chapter (20). 20.3 Bookkeeping Entries for Trading Business All dealerships record normal business activities, like paying for rent, for insurance, for labour, depreciation etc. as covered in the previous chapters. Now, we add Bookkeeping entries for inventory movements of goods the company trades with. The core activities of a dealer consist of purchasing goods from suppliers and selling them to customers. A business that buys goods makes debit entries in its Purchase account. The Purchase account is an intermediate account for goods bought. Together with the adjustments at the end of the Accounting period, the Purchase account is closed-off to the Trading account. The Trading account is an account for the gross profit calculation which only considers revenues and material expenses. For now, consider the Trading account as a part of the Profit and Loss account. The application of a Purchase account depends on the inventory system in use. We get back to inventory systems in chapter (26). Here, we apply a periodic system and record additions to inventories but no stock releases. A periodic inventory system records material inputs only and calculates material expenses by comparison between opening values and closing stock. Therefore, we must take stock at the end of each Accounting period. To calculate the costs of goods sold (material expenses) we compare the opening value plus all inputs and deduct the closing stock. The application of a periodic inventory system is simple as Bookkeeping entries are only recorded for purchases. All purchases are recorded in the Purchase account. The Bookkeeping entry for cash purchases is as: <?page no="236"?> Berkau: Basics of Accounting 6e 20-236 DR Purchase..................... CR Cash/ Bank.................... In case the purchases are made on credit, the Bookkeeping entry below applies: DR Purchase..................... CR Accounts Payables............ 20.4 C/ S APPLEDENE (Pty) Ltd. APPLEDENE (Pty) Ltd. is a grocery store. The business buys fruits, meats, breads, etc. from its suppliers and sells them to its customers. Think of APPLEDENE (Pty) Ltd. as a corner-shop. On 2.01.20X7, APPLEDENE (Pty) Ltd. is founded, and the proprietors pay a contribution that totals 80,000.00 EUR into its bank account. The Accountant makes the Bookkeeping entry below: (1) Establishment of the business on 2.01.20X7. DR Cash/ Bank.................... 80,000.00 EUR CR Issued Capital............... 80,000.00 EUR APPLEDENE (Pty) Ltd. rents a shop. The rental contract states that on every 3.01.20XX, the annual rent must be paid into the landlord’s bank account. Rent is amounting to 24,000.00 EUR/ a. We make a Bookkeeping entry as follows. (2) Payment for the annual rent on 3.01.20X7. DR Rent......................... 24,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR Every week, APPLEDENE (Pty) Ltd. buys bread from a bakery and pays for it per bank transfer. The weekly purchases are for 250.00 EUR/ w. We record 52 Bookkeeping entries as below: (3) … (54) Weekly purchase of bread at 250.00 EUR/ w. DR Purchase..................... 250.00 EUR CR Cash/ Bank.................... 250.00 EUR Furthermore, APPLEDENE (Pty) Ltd. buys fruits on cash. In the first week, the fruit purchases are for 400.00 EUR. Accordingly, we make the Bookkeeping entry as follows: (55) Purchase of fruits on 5.01.20X7. <?page no="237"?> Berkau: Basics of Accounting 6e 20-237 DR Purchase..................... 400.00 EUR CR Cash/ Bank.................... 400.00 EUR APPLEDENE (Pty) Ltd. buys fruits every week in 20X7 to the same amount. The Bookkeeping entries (56) … (106) are identical to Bookkeeping entry (55). The contract with the local butchery states that APPLEDENE (Pty) Ltd. receives daily meat deliveries and has to pay for them on the weekends. A daily delivery costs 100.00 EUR/ d. We record Bookkeeping entries as below: (107) Daily meat purchases; as the payments follow, the credit entry must be credited to accounts payables. DR Purchase..................... 100.00 EUR CR Accounts Payables............ 100.00 EUR (138) Payment for the meat. Consider the 1 st day being a Monday. DR Accounts Payables............ 700.00 EUR CR Cash/ Bank.................... 700.00 EUR At the end of the year, APPLEDENE (Pty) Ltd. takes stock and records bread for 250.00 EUR and meat for 1,400.00 EUR. This is its closing stock. No fruits are left over. The material expenses for the groceries equate to all purchases less the closing stock. APPLEDENE (Pty) Ltd.’s material expenses are amounting to: 52 × 250 + 52 × 400 + 365 × 100 - 250 - 1,400 = 6 68,650.00 EUR. This amount is disclosed on the statement for profit or loss and other comprehensive income as materials. Observe all accounts at APPLEDENE (Pty) Ltd. as depicted in Figure 20.1. D C D C (1) 80,000.00 (2) 24,000.00 c/ d 80,000.00 (1) 80,000.00 (3-...) 13,000.00 b/ d 80,000.00 (55-..) 20,800.00 c/ d 14,200.00 ( ) 36,400.00 94,200.00 94,200.00 b/ d 14,200.00 D C D C (2) 24,000.00 c/ d 24,000.00 (3-...) 13,000.00 P&L 70,300.00 b/ d 24,000.00 P&L 24,000.00 (55-..) 20,800.00 ( ) 36,500.00 70,300.00 70,300.00 Cash/ Bank C/ B Issued capital ISS Rent-20X7 RNT Purchase-20X7 PUR Figure 20.1: APPLEDENE (Pty) Ltd.’s accounts <?page no="238"?> Berkau: Basics of Accounting 6e 20-238 D C D C ( ) 36,400.00 ( ) 36,500.00 PUR 70,300.00 INV 250.00 c/ d 100.00 RNT 24,000.00 INV 1,400.00 36,500.00 36,500.00 ... b/ d 100.00 D C P&L 250.00 P&L 1,400.00 c/ d 1,650.00 1,650.00 1,650.00 b/ d 1,650.00 Accounts payables A/ P Profit and Loss-20X7 P&L Inventory INV Figure 20.1: APPLEDENE (Pty) Ltd.'s accounts (continued) The Profit and Loss account shows material expenses for: 70,300 - 250 - 1,400 = 668,650.00 EUR and the rent amounting to 24,000.00 EUR. The closing stock of inventories results from taking stock at the end of the Accounting period. With a periodic system, material expenses are recorded as Bookkeeping entries for opening values, purchases and the closing stock. In this chapter we do not consider sales. Therefore, we avoid balancing-off the Profit and Loss account. The case study APPLEDENE (Pty) Ltd. is closed here, but it is not complete. 20.5 Accounting for Returns Outwards Sometimes, buyers send back goods to their supplier. If this occurs after goods have been added to stock, we must record a return outward. A Returns Outwards account works like a negative Purchase account and applies when goods are sent back to suppliers. The Returns Outwards account must be closed-off to the Trading account when applying a periodic inventory system. The contra entry for a return is made in the Cash/ Bank account if the buyer is refunded on cash. However, more likely, a supplier grants a voucher or reduces the amount the buyer owes. In the latter cases, the buyer debits the voucher to the Accounts Receivables account or makes a debit entry in its Accounts Payables account resulting in a reduction of the supplier’s claims. How it is Done (Returns Outwards): (1) Make Bookkeeping entries for all purchases. (2) In case goods are faulty or do not meet the requirements, send them back to the supplier. (3) Credit the amount for returned goods to the Returns Outwards account and make a debit entry in the Cash/ Bank account, if cash is received, or in the <?page no="239"?> Berkau: Basics of Accounting 6e 20-239 Accounts Payables, if the bill is reduced by the supplier or in the Accounts Receivables to record a voucher received. (4) With periodic inventory system close-off the Returns Outwards account to the Trading account. 20.6 C/ S KLIPFONTAIN Ltd. KLIPFONTEIN Ltd. is established on 2.01.20X5 and is a dealer for kitchen appliances. The business is established by a share issue to the extent of 100,000.00 EUR. (1) Establishing KLIPFONTEIN Ltd. with an ordinary share issue of 100,000.00 EUR on 2.01.20X5. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR KLIPFONTEIN Ltd. orders from a pot factory 130 5l-pots with glass lid at 23.00 EUR/ u each. It pays for the pots by bank transfer on 2.01.20X5. The payment is amounting to: 130 × 23 = 2 2,990.00 EUR. Again, we apply the Purchase account because KLIPFONTEIN Ltd.’s records inventory movement following the periodic system. (2) Purchase of 5l-pots with glass lid on 2.01.20X5. DR Purchase..................... 2,990.00 EUR CR Cash/ Bank.................... 2,990.00 EUR Half of the 5l-pots with glass lid have scratches on the lid. KLIPFONTEIN Ltd. calls the supplier’s manager and sends back all damaged pots (not only the lids, but the entire pots). The supplier immediately pays half of the purchase price, 2,990 / 2 = 1 1,495.00 EUR, into KLIPFONTEIN Ltd.’s bank account on 9.01.20X5. We apply the Returns Outwards account. As an alternative, we could credit the Purchase accounts. (3) Return of 65 damaged 5l-pots with glass lid on 9.01.20X5. DR Cash/ Bank.................... 1,495.00 EUR CR Returns Outwards............. 1,495.00 EUR On 10.01.20X5, KLIPFONTEIN Ltd. orders from another supplier 200 26cm-pans at 31.00 EUR/ u. It is agreed that KLIPFONTEIN Ltd. pays the purchase price of: 200 × 31 = 6 6,200.00 EUR on 1.02.20X5. Therefore, the credit entry is recorded in the short-term liabilities account named Accounts Payables account. (4) Purchase of 26cm-pans on 10.01.20X5 on credit. <?page no="240"?> Berkau: Basics of Accounting 6e 20-240 DR Purchase..................... 6,200.00 EUR CR Accounts Payables............ 6,200.00 EUR The quality management detects one box carrying 6 pans with smaller pans (only 22 cm of size). KLIPFONTEIN Ltd. contacts its supplier and announces it will return the 6 too small pans. The supplier offers to adjust KLIPFONTEIN Ltd.’s invoice to make up for the return. The owing amount is reduced to: 6,200 - 6 × 31 = 6 6,014.00 EUR. The Bookkeeping entry to make is for the returns outwards only. The returns are worth: 6 × 31 = 186.00 EUR. The amount is debited to the Accounts Payables account as agreed with the supplier. (5) Return of 6 too small pans on 15.01.20X5. DR Accounts Payables............ 186.00 EUR CR Returns Outwards............. 186.00 EUR KLIPFONTEIN Ltd. pays its supplier on 1.02.20X5 6,014.00 EUR. (6) Payment of the adjusted purchase price on 1.02.20X5. DR Accounts Payables............ 6,014.00 EUR CR Cash/ Bank.................... 6,014.00 EUR On 3.02.20X5, KLIPFONTEIN Ltd. orders 500 24-piece-cutlery sets at 19.50 EUR/ u from its supplier and pays the price into the supplier’s bank account. The cutlery sets are delivered a few days later. The quality management detects that all sets only contain 18 pieces because all teaspoons are missing. KLIPFONTEIN Ltd. returns the whole delivery and receives a voucher from the supplier. The voucher is debited to the Accounts Receivables account. Observe the Bookkeeping entries (7) and (8) for the order and its return. (7) Order of 24-piece-cutlery sets at: 500 × 19.50 = 9 9,750.00 EUR on 3.02.20X5. DR Purchase..................... 9,750.00 EUR CR Cash/ Bank.................... 9,750.00 EUR (8) Return of all cutlery sets on 7.02.20X5. DR Accounts Receivables......... 9,750.00 EUR CR Returns Outwards............. 9,750.00 EUR On 23.02.20X5, KLIPFONTEIN Ltd. orders 120 exclusive 12-steak-knife-sets from its cutlery supplier. The 12-steak-knifesets cost 36.00 EUR/ u. The price for all sets is: 120 × 36 = 4 4,320.00 EUR. KLIPFONTEIN Ltd. uses a portion of its voucher as payment. After deduction of the costs for the 12-steak-knife-sets the remaining voucher is worth: 9,750 - 4,320 = 5 5,430.00 EUR. We make Bookkeeping entry (9): <?page no="241"?> Berkau: Basics of Accounting 6e 20-241 (9) Purchase of 120 12-steak-knife-sets on 23.02.20X5. DR Purchase..................... 4,320.00 EUR CR Accounts Receivables......... 4,320.00 EUR On 3.04.20X5, KLIPFONTEIN Ltd. orders 450 stainless-steel salad bowls at 25.00 EUR/ u from the cutlery/ steak knife supplier. The bowls cost: 450 × 25 = 111,250.00 EUR. The price is paid partly with the remainder of the voucher and by money transfer on 5.04.20X5. KLIPFONTEIN Ltd. pays into its supplier’s bank account: 11,250 - 5,430 = 5 5,820.00 EUR. The purchase leads to a compound Bookkeeping entry as the payment is made by dissolving the voucher and by a bank transfer. (10) Purchase of stainless-steel bowls on 5.04.20X5: DR Purchase..................... 11,250.00 EUR CR Accounts Receivables......... 5,430.00 EUR CR Cash/ Bank.................... 5,820.00 EUR For checking all Bookkeeping entries, look at KLIPFONTEIN Ltd.’s accounts below in Figure 20.2: D C D C (1) 100,000.00 (2) 2,990.00 c/ d 100,000.00 (1) 100,000.00 (3) 1,495.00 (6) 6,014.00 b/ d 100,000.00 (7) 9,750.00 (10) 5,820.00 c/ d 76,921.00 101,495.00 101,495.00 b/ d 76,921.00 Cash/ Bank C/ B Issued Capital ISS D C D C (2) 2,990.00 (3) 1,495.00 (4) 6,200.00 (5) 186.00 (7) 9,750.00 c/ d 11,431.00 (8) 9,750.00 (9) 4,320.00 11,431.00 11,431.00 (10) 11,250.00 c/ d 34,510.00 b/ d 11,431.00 34,510.00 34,510.00 b/ d 34,510.00 Purchase-20X5 PUR Returns Outwards R.O. Figure 20.2: KLIPFONTEIN Ltd.’s accounts in 20X5 <?page no="242"?> Berkau: Basics of Accounting 6e 20-242 D C D C (5) 186.00 (4) 6,200.00 (8) 9,750.00 (9) 4,320.00 (6) 6,014.00 (10) 5,430.00 6,200.00 6,200.00 9,750.00 9,750.00 Accounts Payables A/ P Accounts Receivables A/ R Figure 20.2: KLIPFONTEIN Ltd.’s accounts in 20X5 (continued) No goods are left on stock at KLIPFONTEIN Ltd. on 31.12.20X5. The material expenses are calculated as purchase costs less returns outwards. The total material expenses equal: 34,510 - 11,431 = 2 23,079.00 EUR. In order to double check the expenses, we calculate the purchased which have not been sent back to the suppliers: 1,495 + 6,014 + 4,320 + 11,250 = 23,079.00 EUR. 20.7 Summary A trading company records debit entries in the Purchase account for buying goods. Returns are recorded by credit entries in the Returns Outwards account. We make the debit entry for returns either in the Cash/ Bank account (for cash refunds), in the Accounts Payables account (for bill reduction) or in the Accounts Receivables account (for a granted voucher). The total value of goods received is the difference between the Purchase account and the balance in the Returns Outwards account. Both, the Purchase account and the Returns Outwards account are closed-off to the Trading account. The Trading account is the first part of the Profit and Loss account for the Accounting period and is discussed in chapter (22). 20.8 Working Definitions Periodic Inventory System: A periodic inventory system records material inputs only and calculates material expenses by comparison between opening values and closing stock. Purchase Account: The Purchase account is an intermediate account for goods bought. Returns Outwards Account: A Returns Outwards account works like a negative Purchase account and applies when goods are sent back to suppliers. Trading Account: The Trading account is an account for the gross profit calculation which only considers revenues and material expenses. 20.9 Question Bank (1) The Bookkeeping entry for a return inward is… 1. DR R.I.; CR C/ B. 2. DR C/ B; CR R.O. 3. DR A/ R; CR R.I. 4. DR R.I.; CR A/ P. (2) A trading company records an opening value of 100,000.00 EUR and makes 3 purchases at 50,000.00 EUR. The latter one is on credit. During the Accounting period goods for 12,000.00 EUR are returned to the supplier. At the end of the Accounting period, the closing <?page no="243"?> Berkau: Basics of Accounting 6e 20-243 stock is amounting to 30,000.00 EUR. How much are material expenses (= cost of goods sold)? 1. 188,000.00 EUR . 2. 220,000.00 EUR . 3. 238,000.00 EUR . 4. 208,000.00 EUR . (3) Which statement is correct? 1. A Purchase account is a real account. 2. A purchase is credited to the Purchase account and thereafter transferred to material expenses. 3. A purchase on credit gives a credit entry in the Accounts Receivables account. 4. The purchase of goods through the Purchase account gives a debit entry in the Purchase Account and a debit entry in the Cash/ Bank account. (4) A company receives the money after it returned goods to the supplier. What is the correct Bookkeeping entry? 1. DR A/ R; CR C/ B. 2. DR C/ B; CR A/ R. 3. DR C/ B; CR A/ P. 4. DR C/ B; CR R.I. (5) A trading company has an opening value of stock of 30,000.00 EUR. During the Accounting period 20X4, it buys 12 times goods for 45,000.00 EUR. On 1.10.20X4, the company returns goods bought at 5,000.00 EUR to its supplier. What is the Bookkeeping entry to close-off the Purchase account? 1. DR P&L 570,000.00 EUR; CR PUR 570,000.00 EUR. 2. DR PUR 535,000.00 EUR; CR P&L 535,000.00 EUR. 3. DR P&L 540,000.00 EUR; CR PUR 540,000.00 EUR. 4. DR P&L 545,000.00 EUR; CR PUR 545,000.00 EUR. 20.10 Solutions 1-3; 2-4; 3-4; 4-2; 5-3. <?page no="244"?> Berkau: Basics of Accounting 6e 21-244 21 Trading Business - (1) Purchases and Returns plus VAT 21.1 What is in the Chapter? In this chapter, we discuss value added tax (VAT). As we only cover purchases, we limit our studies to input- VAT. The opposite portion of VAT are the output-VAT liabilities which we discuss in chapter (23). In order to keep this chapter simple, the same case studies as in the previous chapter (20) apply: APPLEDENE (Pty) Ltd. and KLIPFONTEIN Ltd. The figures remain the same. In detail, the costs of purchases remain unchanged. Hence, we add input-VAT to the prices. 21.2 Learning Objectives After studying this chapter, you understand the concept of value added tax VAT and you can record purchases and returns under consideration of input-VAT. 21.3 Value Added Tax VAT In almost every country, they charge you a consumer tax. Exceptions are the United Arabic Emirates and some US states, like Alaska and Delaware etc. The consumer tax is levied on all purchases and is based on their values; therefore, we call it value added tax VAT. It is charged on goods and services. A consumer tax based on the net amount of purchased goods/ services is a value added tax. In some countries VAT is called a goods&service tax GST. The value without VAT is the net amount. The gross amount is the price including VAT. Every consumer must pay VAT, no matter whether the buyer is rich or poor, got citizenship or is a foreigner. VAT is calculated as purchase costs multiplied with the VAT rate. In many countries a lower VAT rate applies for groceries, flowers, books etc. In this textbook, we ignore lower VAT rates to keep our Accounting work as simple as possible. VAT is collected at the point of sale by the seller or the services provider. The goods/ services selling company must add VAT to the net amounts. Customers pay the gross selling price. At month ends the seller must submit a VAT declaration and pay received VAT to the revenue service. We can say, the seller collects VAT on behalf of the revenue service. The seller can reduce its VAT payables by the input VAT paid, hence it only pays the difference. In different countries, different VAT rates apply. Germany’s tax rate is 19 %, Malaysia has 17 % and in South Africa the VAT rate is 15 %. In general, the price tags disclose gross amounts. An exception is the USA. Therefore, you pay VAT additional to the price printed on the price tag. In this textbook, the standard VAT rate is 20 %. See below how to calculate net and gross amounts: <?page no="245"?> Berkau: Basics of Accounting 6e 21-245 How it is Done (Calculating input-VAT) (1) Determine net amounts by dividing the gross amount by 120 %. (2) Determine gross amount by multiplying the net amount by 120 %. (3) Calculate VAT by multiplying the net amount by 20 %. Alternatively, divide by 5. VAT applies for all purchased goods and for all services received from 3 rd parties (from other companies). No VAT is levied on interest (money supply is no service) and on property acquisitions. Keep in mind that VAT is a consumer tax. A company that buys materials does not consume them. The same applies for received services, e.g., production support. As everyone pays VAT in the first place, the revenue service must refund input-VAT paid by companies in Accounting periods that follow the purchase. Input-VAT is VAT paid by the buyer. To receive a VAT refund, a company must register for VAT reduction. Normally, companies register for VAT reduction automatically when they are established. An exemption is made for very small businesses - however, we do not cover that situation in this textbook as it is very seldom. Therefore, every company is registered for VAT reduction in this textbook. Technically, companies keep a record of paid input-VAT and claim back the amount at the end of the Accounting period. For recording input-VAT, a company makes debit entries in the VAT account. On the other side, when companies collect output-VAT from their customers they must make credit entries in the VAT account. Output- VAT is VAT collected from buyers/ customers and must be passed through to the revenue service. Some technical terms regarding costs apply in accordance with IFRSs: The cost of purchase and the cost of acquisition are net amounts; a discount allowed must be deducted. For a price, we must indicate whether we mean the net price or gross price. Note, this is relevant for exams: If you read the expression "cost of" it tells you that it is about the net amount. VAT refunds and claims do not depend on payments. Although someone buys a product on credit, she/ he is entitled to claim input-VAT - even if the price has not been paid in full or not at all. Keep in mind: we never split VAT! VAT is recorded in full together with the purchase or revenue recognition activities! As Accountants we could say: a VAT claim exists once the Bookkeeping entry has been made. Furthermore, VAT considerations do not depend on the kind of business activities. In particular, VAT is not limited to the core business: E.g., a restaurant that is registered for VAT reduction and sells its delivery van must charge VAT thereon. To claim input-VAT, the buyer must prove the deal by a bill that discloses input VAT. E.g., a VAT registered restaurant that buys kitchen appliances from a private (not VAT registered) <?page no="246"?> Berkau: Basics of Accounting 6e 21-246 seller cannot claim the input-VAT. The reason is that the seller does not pay the VAT to the revenue service either. How it is done (Recording input-VAT) (1) For purchases make a debit entry in the Purchase account for the net amount. (2) Make a debit entry for input-VAT in the VAT account. (3) Credit the gross amount to the Cash/ Bank account and/ or Accounts Payables. Partial payments might apply. 21.4 How to Calculate input-VAT Next, we want to apply input-VAT recordings to illustrate the How-It-Is- Done section above. We study the case of BRASELTON Ltd. which is a bookstore registered for VAT reduction. Once BRASELTON Ltd. makes an acquisition or a purchase, it pays the gross amount that includes input-VAT to its supplier. At the end of the Accounting period, it submits a VAT statement to the revenue service for refund. We pretend that BRASELTON Ltd. only records three business activities in 20X4: On 3.01.20X4, BRASELTON Ltd. buys 45 bookshelves at a net value of 260.00 EUR/ u. The net purchase price is 45 × 260 = 1 11,700.00 EUR. To calculate the gross price which includes 20 % of VAT we multiply with: (1 + 20%) = 120% = 1 1.2. The gross amount is: 11,700 × 1.2 = 14,040.00 EUR. To calculate the VAT, we must multiply the net amount by 20%. VAT equals: 11,700 × 20% = 2 2,340.00 EUR. The net amount plus input-VAT gives the gross amount: 11,700 + 2,340 = 114,040.00 EUR. The Accountant records the purchase of the shelves as below: DR P, P, E-Account.............. 11,700.00 EUR DR VAT.......................... 2,340.00 EUR CR Cash/ Bank.................... 14,040.00 EUR The input VAT is recorded in the VAT account on the debit side as it counts as a receivable to be cashed in from the revenue service later. Next, BRASELTON Ltd. buys a cash register at a gross price of 1,440.00 EUR on 8.01.20X4. In order to determine the net amount, we divide by 120%, see below: 1,440 / 1.2 = 1 1,200.00 EUR. To calculate the input-VAT when the gross amount is given, divide by 1.2 and then multiply the net amount by 20 %. If you reduce the fraction 20% / 120% you will come up with 1/ 6. Hence, we divide the gross amount by 6 to calculate input-VAT; here: 1,440 / 6 = 2 240.00 EUR. Observe the Bookkeeping entry below: <?page no="247"?> Berkau: Basics of Accounting 6e 21-247 DR P, P, E-Account ................. 1,200.00 EUR DR VAT ............................. 240.00 EUR CR Cash/ Bank ....................... 1,440.00 EUR Input VAT does not depend on the payment. We study a purchase of 100 Accounting textbooks at 35.00 EUR/ u (net amount) that took place on 12.05.20X4. BRASELTON Ltd. pays down 40 % of the due amount and the remainder in the next Accounting period. Therefore, the payables must be recorded as shortterm debts in the Accounts Payables account. The net amount is: 100 × 35 = 3 3,500.00 EUR. VAT is amounting to: 20% × 3,500 = 7 700.00 EUR. The gross amount is: 3,500 + 700 = 4 4,200.00 EUR. Check the Bookkeeping entry below for the partial payment: DR Purchase..................... 3,500.00 EUR DR VAT.......................... 700.00 EUR CR Cash/ Bank.................... 1,680.00 EUR CR Accounts payables............ 2,520.00 EUR At the end of the Accounting period, BRASELTON Ltd. claims: 2,340 + 240 + 700 = 3 3,280.00 EUR from its revenue service. Note, a buyer can claim for VAT even if she/ he has not yet paid the seller (completely). After the payment from the revenue service is received, the Accountant records the Bookkeeping entry below (in the next Accounting period): DR Cash/ Bank.................... 3,280.00 EUR CR VAT.......................... 3,280.00 EUR 21.5 C/ S APPLEDENE (Pty) Ltd. Next, we repeat the case study APPLEDENE (Pty) Ltd. and consider VAT. This is a complete repetition of the case studies in chapter (20) but under consideration of input-VAT at a VAT rate of 20 %. The case study text mostly is a copy from the previous chapter but got extended for VAT considerations. APPLEDENE (Pty) Ltd. is a grocery shop and got registered for VAT reduction. The Bookkeeping entry for founding the business is not affected by VAT. On 2.01.20X7, APPLEDENE (Pty) Ltd.’s Accountant makes the Bookkeeping entry below: (1) Establishment of the business on 2.01.20X7. DR Cash/ Bank.................... 80,000.00 EUR CR Issued Capital............... 80,000.00 EUR <?page no="248"?> Berkau: Basics of Accounting 6e 21-248 APPLEDENE (Pty) Ltd. rents a shop. If its landlord is not registered for VAT reduction, rent is not subjected to VAT. Rent between companies becomes VATable, if and only if both parties are registered for VAT reduction. APPLEDENE (Pty) Ltd.’s landlord is a private owner. We make the same Bookkeeping entry as in chapter (20). (2) Payment for annual rent on 3.01.20X7. DR Rent......................... 24,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR Every week APPLEDENE (Pty) Ltd. buys bread from a bakery for which it pays per bank transfer. The bakery is VAT registered. It sells the bread at the gross price to APPLEDENE (Pty) Ltd. The weekly purchases are: 250 × (1 + 20%) = 250 + 50 = 3 300.00 EUR/ w. The debit entry in the Purchase account is amounting to 250 EUR. The input-VAT is: 250 × 20% = 5 50.00 EUR and is recorded on the debit side of the VAT account. The contra entry in the Cash/ Bank account is: 250 × 120% = 3 300.00 EUR. (3) … (54) Weekly purchase of bread at 300.00 EUR. DR Purchase..................... 250.00 EUR DR VAT.......................... 50.00 EUR CR Cash/ Bank.................... 300.00 EUR Check APPLEDENE (Pty) Ltd.’s accounts. D C D C (1) 80,000.00 (2) 24,000.00 (1) 80,000.00 (3) 300.00 (4) 300.00 ... (54) 300.00 D C D C (2) 24,000.00 (3) 250.00 (4) 250.00 ... (54) 250.00 D C (3) 50.00 (4) 50.00 ... (54) 50.00 Value added tax VAT Rent-20X7 RNT Purchase-20X7 PUR Cash/ Bank C/ B Issued Capital ISS Figure 21.1: APPLEDENE (Pty) Ltd.’s accounts after 54 Bookkeeping entries <?page no="249"?> Berkau: Basics of Accounting 6e 21-249 Every week, APPLEDENE (Pty) Ltd. buys fruits on cash. In the first week, the purchases are at 400.00 EUR. The gross amount is: 400 × 120% = 4 480.00 EUR. Input-VAT equals: 400 × 20% = 8 80.00 EUR. The price to be paid is: 400 + 80 = 4 480.00 EUR. Accordingly, the Accountant makes the Bookkeeping entry as follows: (55) … (106) Purchase of fruits on 5.01.20X7. DR Purchase..................... 400.00 EUR DR VAT.......................... 80.00 EUR CR Cash/ Bank.................... 480.00 EUR APPLEDENE (Pty) Ltd. receives daily meat deliveries and pays at the end of every week. The daily delivery is at 100.00 EUR/ d. The gross amount is: 100 + 20 = 1 120.00 EUR/ d. We make the Bookkeeping entries as below: (107) Daily purchase of meat. DR Purchase..................... 100.00 EUR DR VAT.......................... 20.00 EUR CR Accounts Payables............ 120.00 EUR (138) Meat payment per week equals: 7 × 120 = 8 840.00 EUR. DR Accounts Payables............ 840.00 EUR CR Cash/ Bank.................... 840.00 EUR We pretend that the first day is a Monday. This gives us 365 meat deliveries and 52 payments. Accordingly, there is an amount of: 100 × 120% = 1 120.00 EUR outstanding. Observe the A/ P Account. At the end of the year, APPEDENE (Pty) Ltd. takes stock and detects bread for 250.00 EUR and meat for 1,400.00 EUR. There are no fruits left over. The amounts are net amounts as they are derived from the Purchase account. As you wil see, the amounts in the asset accounts, like inventory and property, plant and equipment always are net amounts. The expenses for groceries are the total of purchases less closing stock. APPLEDENE (Pty) Ltd. got expenses for goods which equal: 52 × 250 + 52 × 400 + 365 × 100 - 250 - 1,400 = 6 68,650.00 EUR. This is the same value as in chapter (20). Figure 21.2 shows all accounts on an annual basis under consideration of VAT. Observe that the Profit and Loss account has not changed by the VAT consideration. <?page no="250"?> Berkau: Basics of Accounting 6e 21-250 D C D C (1) 80,000.00 (2) 24,000.00 c/ d 80,000.00 (1) 80,000.00 (3-...) 15,600.00 b/ d 80,000.00 (55-..) 24,960.00 c/ d 28,240.00 ( ) 43,680.00 108,240.00 108,240.00 b/ d 28,240.00 D C D C (2) 24,000.00 c/ d 24,000.00 (3-...) 13,000.00 P&L 70,300.00 b/ d 24,000.00 P&L 24,000.00 (55-..) 20,800.00 ( ) 36,500.00 70,300.00 70,300.00 Cash/ Bank C/ B Issued capital ISS Rent-20X7 RNT Purchase-20X7 PUR D C D C ( ) 43,680.00 ( ) 43,800.00 Pch 70,300.00 Inv 250.00 c/ d 120.00 Rnt 24,000.00 Inv 1,400.00 43,800.00 43,800.00 ... b/ d 120.00 D C D C P&L 250.00 (3-...) 2,600.00 P&L 1,400.00 c/ d 1,650.00 (55-..) 4,160.00 1,650.00 1,650.00 ( ) 7,300.00 c/ d 14,060.00 b/ d 1,650.00 14,060.00 14,060.00 b/ d 14,060.00 Accounts payables A/ P Profit and Loss-20X7 P&L Inventory INV Value added tax VAT Figure 21.2: APPLEDENE (Pty) Ltd.’s accounts (aggregated) 21.6 VAT Consideration for Returns Outwards When companies return goods to their supplier (returns outwards) we must record an adjustment in the VAT account. This is required for correct VAT calculations. Returns outwards are considered as negative purchases. How it is Done (Returns Outwards with VAT Consideration): (1) Determine the net amount and the gross amount of goods to be returned to the supplier. (2) Check whether (a) or not (b) your company applies a Returns Outwards account. (3) Make a debit entry for the gross amount in the Accounts Payables, if the purchase has not been paid yet. Make a debit entry for the gross amount in the Accounts Receivables, if the seller grants you a <?page no="251"?> Berkau: Basics of Accounting 6e 21-251 voucher. Make a debit entry for the gross amount in the Cash/ Bank account, if money is transferred back. Consider combinations for partial payments. (4) Adjust the input-VAT claim by making a credit entry in the VAT account for the input-VAT linked to the returns. (5a) Make a credit entry in the Returns Outwards account for the net amount of returns. (6a) Close-off the Purchase account and the Returns Outwards account to the Trading Account. (5b) Make a credit entry in the Purchase account for the net amount of the returns. (6b) Close-off the Purchase account to the Trading Account. (! ) Note, in case a company applies a perpetual inventory system, you must reduce stock for the returns instead of the purchase account. 21.7 C/ S KLIPFONTEIN Ltd. KLIPFONTEIN Ltd. is established on 2.01.20X5. (1) Establishing KLIPFONTEIN Ltd. by share issue on 2.01.20X5. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR KLIPFONTEIN Ltd. orders from a pot factory 130 5l-pots with a glass lid at 23.00 EUR/ u. The price is the net amount. In order to calculate the gross selling price, we multiply the cost of purchase by 120 %: 23 × 120% = 2 27.60 EUR/ u. The gross selling price to be paid is: 130 × 27.60 = 3,588.00 EUR. (2) Purchase of 5l-pots with glass lid on 2.01.20X5. DR Purchase..................... 2,990.00 EUR DR VAT.......................... 598.00 EUR CR Cash/ Bank.................... 3,588.00 EUR Half of the 5l-pots with glass lid are returned. The supplier instantly transfers half of the purchase price (gross amount) to KLIPFONTEIN Ltd.’s bank account on 9.01.20X5. KLIPFONTEIN Ltd. makes an adjustment for input-VAT. The refund is: 65 × 23 × 120% = 1 1,794.00 EUR. (3) Return of 65 damaged 5l-pots with glass lid on 9.01.20X5. DR Cash/ Bank.................... 1,794.00 EUR CR VAT.......................... 299.00 EUR CR Returns Outwards............. 1,495.00 EUR <?page no="252"?> Berkau: Basics of Accounting 6e 21-252 On 10.01.20X5, KLIPFONTEIN Ltd. orders from another supplier 200 26cm-pans at 31.00 EUR/ u (purchase cost) each. The gross purchase price is: 31 × 120% = 337.20 EUR/ u. It is agreed that KLIPFONTEIN Ltd. pays the total purchase price of: 200 × 37.20 = 7 7,440.00 EUR on 1.02.20X5. (4) Purchase of 26cm-pans on 10.01.20X5 on credit. DR Purchase..................... 6,200.00 EUR DR VAT.......................... 1,240.00 EUR CR Accounts Payables............ 7,440.00 EUR KLIPFONTEIN Ltd.’s returns 6 pans due to a wrong size. The supplier adjusts the bill sent to KLIPFONTEIN Ltd. The amount due thereafter is: 7,440 - 6 × 37.20 = 7 7,216.80 EUR. The Bookkeeping entry for the returns is amounting to: 6 × 37.20 = 2 223.20 EUR. KLIPFONTEIN Ltd. does not record inventory movements, because it applies a periodic inventory system. When taking stock, we see that the reduction of 6 pans results in a lower stock level. (5) Return of 6 pans on 15.01.20X5. DR Accounts Payables............ 223.20 EUR CR VAT.......................... 37.20 EUR CR Returns Outwards............. 186.00 EUR KLIPFONTEIN Ltd. pays the due amount to its supplier on 1.02.20X5. (6) Payment of the adjusted gross purchase price on 1.02.20X5. DR Accounts Payables............ 7,216.80 EUR CR Cash/ Bank.................... 7,216.80 EUR On 3.02.20X5, KLIPFONTEIN Ltd. orders 500 24-piece-cutlery sets at cost of purchase of 19.50 EUR/ u from its supplier and pays: 500 × 19.5 × 120 % = 11,700.00 EUR into the supplier’s bank account by electronic bank transfer EFT. The cutlery sets are delivered a few days later. The quality management detects that all sets only contain 18 pieces, because they are short of teaspoons. KLIPFONTEIN Ltd. returns the whole delivery and receives a voucher. (7) Order of 24-piece-cutlery sets at 11,700.00 EUR on 3.02.20X5. DR Purchase..................... 9,750.00 EUR DR VAT.......................... 1,950.00 EUR CR Cash/ Bank.................... 11,700.00 EUR (8) Return of all cutlery sets on 7.02.20X5. <?page no="253"?> Berkau: Basics of Accounting 6e 21-253 DR Accounts Receivables......... 11,700.00 EUR CR VAT.......................... 1,950.00 EUR CR Returns Outwards............. 9,750.00 EUR On 23.02.20X5, KLIPFONTEIN Ltd. orders 120 exclusive 12-steak-knife-sets from its cutlery supplier. The 12-steak-knifesets are sold at a net selling price of 36.00 EUR/ u. The price for the 12-steakknife-sets is: 120 × 36 × 120% = 5 5,184.00 EUR. The price is not paid because KLIPFONTEIN Ltd. uses a portion of its voucher. The remainder value of the voucher is: 11,700 - 5,184 = 6 6,516.00 EUR. The Bookkeeper makes the Bookkeeping entry (9): (9) Purchase of 120 12-steak-knife-sets on 23.02.20X5. DR Purchase..................... 4,320.00 EUR DR VAT.......................... 864.00 EUR CR Accounts Receivables......... 5,184.00 EUR On 3.04.20X5, KLIPFONTEIN Ltd. orders 450 stainless-steel salad bowls at 25.00 EUR/ u (net amount) from its cutlery supplier. The gross purchase price is: 450 × 25 × 120% = 1 13,500.00 EUR. The amount is paid partly by the voucher and by money transfer on 5.04.20X5. The money paid into the supplier’s bank account is: 13,500 - 6,516 = 6 6,984.00 EUR. (10) Purchase of stainless-steel salad bowls on 5.04.20X5. DR Purchase..................... 11,250.00 EUR DR VAT.......................... 2,250.00 EUR CR Accounts Receivables......... 6,516.00 EUR CR Cash/ Bank.................... 6,984.00 EUR In order to understand all Bookkeeping entries, look at KLIPFONTEIN Ltd.’s accounts in Figure 21.3: D C D C (1) 100,000.00 (2) 3,588.00 c/ d 100,000.00 (1) 100,000.00 (3) 1,794.00 (6) 7,216.80 b/ d 100,000.00 (7) 11,700.00 (10) 6,984.00 c/ d 72,305.20 101,794.00 101,794.00 b/ d 72,305.20 Cash/ Bank C/ B Issued capital ISS Figure 21.3: KLIPFONTEIN Ltd.’s accounts <?page no="254"?> Berkau: Basics of Accounting 6e 21-254 D C D C (2) 2,990.00 (3) 1,495.00 (4) 6,200.00 (5) 186.00 (7) 9,750.00 c/ d 11,431.00 (8) 9,750.00 (9) 4,320.00 11,431.00 11,431.00 (10) 11,250.00 c/ d 34,510.00 b/ d 11,431.00 34,510.00 34,510.00 b/ d 34,510.00 D C D C (5) 223.20 (4) 7,440.00 (8) 11,700.00 (9) 5,184.00 (6) 7,216.80 (10) 6,516.00 7,440.00 7,440.00 11,700.00 11,700.00 Accounts Payables A/ P Accounts Receivables A/ R Purchase-20X5 PUR Returns outwards R.O. D C (2) 598.00 (3) 299.00 (4) 1,240.00 (5) 37.20 (7) 1,950.00 (8) 1,950.00 (9) 864.00 (10) 2,250.00 c/ d 4,615.80 6,902.00 6,902.00 b/ d 4,615.80 Value added tax VAT Figure 21.3: KLIPFONTEIN Ltd.'s accounts (continued) At the end of the Accounting period, no goods are left on stock. The material expenses are calculated as purchases less returns outwards. The total material expenses are: 34,510 - 11,431 = 2 23,079.00 EUR. In order to check the amount, we calculate purchases, that were not returned: 1,495 + 6,014 + 4,320 + 11,250 = 23,079.00 EUR. Note, the amounts are the same as in chapter (20). 21.8 Summary VAT is a tax based on the cost of purchase of goods bought and services received. In the textbook the VAT rate is 20 % no reduced tax rates apply. The net amount is the gross amount divided by 120 %. The gross amount is the net amount multiplied by 120 %. VAT registered companies claim back input-VAT at the end of the Accounting period. In the textbook this only is recorded once per year; in reality, VAT claims are recorded every month. When buying goods companies debit input-VAT to the VAT account. When returning goods to suppliers, companies have to adjust the VAT claim by making credit entries in the VAT account for input-VAT compensation due to returns outwards. When refunded for input-VAT, a company makes a debit entry in the Cash/ Bank account and a credit entry in the VAT account. <?page no="255"?> Berkau: Basics of Accounting 6e 21-255 21.9 Working Definitions Cost of Purchase/ Acquisition: The cost of purchase and the cost of acquisition are net amounts; a discount allowed must be deducted. Value Added Tax: A consumer tax based on the net amount of purchased goods/ services is a value added tax. Input-VAT: Input-VAT is VAT paid by the buyer. Output-VAT: Output-VAT is VAT collected from buyers/ customers and must be passed over to the revenue service. 21.10 Question Bank (1) A trading company buys stock for 120,000.00 EUR gross amount. The opening value was 40,000.00 EUR. The company records material expenses for 75,000.00 EUR. How much is closing stock? 1. 85,000.00 EUR . 2. 75,000.00 EUR . 3. 65,000.00 EUR . 4. 45,000.00 EUR . (2) A trading company buys inventories for cost of purchase of 10,000.00 EUR and returns 10 % thereof for a voucher. What is the correct Bookkeeping entry? 1. DR A/ R 1,200.00 EUR; CR VAT 200.00 EUR; CR R.O. 1,000.00 EUR. 2. DR A/ P 1,200.00 EUR; CR VAT 200.00 EUR; CR R.O. 1,000.00 EUR. 3. DR A/ R 1,200.00 EUR; CR VAT 200.00 EUR; CR R.I. 1,000.00 EUR. 4. DR R.O. 1,000.00 EUR; DR VAT 200.00 EUR; CR A/ P 1,200.00 EUR. (3) A company discloses an opening value of stock of 35,000.00 EUR. It purchases goods for 100,000.00 EUR (net amount). It returns goods worth 10,000.00 EUR to the supplier. If all business activities are recorded through the Cash/ Bank account, how much cash is received (+) or paid (-)? 1. +12,000.00 EUR . 2. -108,000.00 EUR . 3. +10,000.00 EUR . 4. -150,000.00 EUR . (4) Which statement is correct? 1. When recording a return outward, a debit entry is made in the Value added tax account. 2. A return outward is recorded on the credit side. 3. When recording a return outward, a credit entry is made in the Value Added Tax account. 4. The contra entry for a return outward is a credit entry in the Cash/ Bank account. (5) Which statement is correct? 1. Material expenses are opening value of stock plus purchases less returns inwards. 2. Material expenses are opening value of stock plus purchases plus returns inwards. 3. Material expenses are opening value of stock plus purchases less returns outwards. <?page no="256"?> Berkau: Basics of Accounting 6e 21-256 4. Material expenses are opening value of stock less purchases plus returns outwards. 21.11 Solutions 1-3; 2-1; 3-2; 4-3; 5-3. <?page no="257"?> Berkau: Basics of Accounting 6e 22-257 22 Trading Business - (2) Sales and Returns 22.1 What is in the Chapter? In this chapter, we enhance our trading business studies and discuss purchases and sales together. We cover the most common Bookkeeping entries for revenue recognition and for returns inwards. As the chapter is about traders, revenue is referred to as sales. All transactions are still based on a periodic inventory system. In this chapter, we apply the Trading account for the gross profit calculation. It is continued by the Profit and Loss account for net profits. Bookkeeping for traders is explained by two case studies: APENDORP (Pty) Ltd. is a car dealer and DURANT (Pty) Ltd. is a shop for photo equipment. For the case studies in this chapter, we ignore VAT. We repeat the case studies in chapter (23) under consideration of VAT. 22.2 Learning Objectives After studying this chapter, you can record business operations for a trading company. You learn how to record sales and returns inwards. Furthermore, you understand gross profit and net profit calculation. You can apply a Trading Account and prepare an income statement. 22.3 Revenue Recognition Next, we add the second perspective of trading business considerations: sales and returns inwards. Sales falls under revenue; a sale is a revenue linked to the trading of goods. Recording sales means we credit the Sales account (= Revenue Account) and make a debit entry in the Cash/ Bank account and/ or in the Accounts Receivables account. When we record the adjustments, we close-off the Sales account to profit or loss. A return inward occurs when a customer sends back goods to the seller. Recording a return inward is similar to returns outwards but consider that the return inward is based on selling prices whereas the valuation of returns outwards is based on purchase prices. To calculate the profit for the Accounting period, we must deduct material expenses (cost of goods sold) from sales. We must deduct further expenses, like labour, depreciation etc., too. 22.4 Trading Account In a trading company, the profit or loss calculation is divided into two steps. The first one only considers sales and costs for the sold goods and gives the gross profit. The gross profit is sales less material expenses. Returns must be taken into consideration. After the calculation of gross profit, further expenses are deducted to calculate the net profit which we call earnings before taxes. The net profit is the profit after all expenses have been deducted except of income tax expenses. For the two steps in profit calculation, we apply two accounts: (1) Trading account and (2) Profit and Loss account. If you are not interested in the gross profit calculations, feel free to combine both steps and apply only one <?page no="258"?> Berkau: Basics of Accounting 6e 22-258 Profit and Loss account. The entries described below for the Trading account are then recorded in the Profit and Loss account. For traders, the gross profit is an important figure. Under consideration of returns the gross profit is calculated as the difference between sales less returns inwards and less material expenses. A negative gross profit is called a gross loss. For gross profit calculation, the Trading account applies. How it is Done (Calculating Gross Profits): (1) Calculate sales (net amount) (2) If there are any returns inwards deduct them from sales. (3) Deduct purchases and opening values of stock. (4) Add closing stock and returns outwards if there are any. (5) Close-off the Sales, Returns Inwards, Purchases, Inventories (for opening values) and Returns Outwards accounts to the Trading account. Balance-off the Trading account. Its balance is the gross profit. (6) Close-off the Trading account to the Profit and Loss account. A gross profit is transferred to the credit side of the Profit and Loss account. A gross loss is transferred to the debit side of the Profit and Loss account. (7) Continue with the net profit calculation. 22.5 C/ S APENDORP (Pty) Ltd. APENDORP (Pty) Ltd. is a car dealership. The business is established on 2.01.20X9 by the owners contributing 100,000.00 EUR. We record the establishment of the company by making a debit entry in cash/ bank and a credit entry in the Issued Capital account. (1) Deposit of the owners’ contribution on 2.01.20X9. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR APENDORP (Pty) Ltd. sells cars in a rented showroom. The rent is paid for the full year at the beginning of the Accounting period. No accruals apply. The rent for the show room equals 36,000.00 EUR/ a. APENDORP (Pty) Ltd. pays for rent per bank transfer on 2.01.20X9. (2) Rent payment on 2.01.20X9. <?page no="259"?> Berkau: Basics of Accounting 6e 22-259 DR Rent......................... 36,000.00 EUR CR Cash/ Bank.................... 36,000.00 EUR On 2.01.20X9, the procurement manager buys 3 pre-owned VW Polos built in 20X7 at 16,000.00 EUR/ u each. The seller is a car dealer too and receives the money via electronic fund transfer EFT. The Accountant makes the Bookkeeping entry below: (3) Purchase of VW Polos at: 3 × 16,000 = 4 48,000.00 EUR. DR Purchase..................... 48,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR On 12.01.20X9, APENDORP (Pty) Ltd. sells one of the VW Polos at 17,500.00 EUR. The sale is on cash. We record the sale on the credit side of the Sales account. (4) Sale of the VW Polo at 17,500.00 EUR on 12.01.20X9. DR Cash/ Bank.................... 17,500.00 EUR CR Sales........................ 17,500.00 EUR On 14.01.20X9, APENDORP (Pty) Ltd. buys a Mercedes B-class at 20,000.00 EUR. The deal is on credit and APENDORP (Pty) Ltd. pays the agreed price during the next week to the trader. (5) Purchase of a Mercedes B-class on 14.01.20X9. DR Purchase..................... 20,000.00 EUR CR Accounts Payables............ 20,000.00 EUR APENDORP (Pty) Ltd. pays one week later the purchase price for the Mercedes B-class. (6) Payment for Mercedes B-class on 22.01.20X9. DR Accounts Payables............ 20,000.00 EUR CR Cash/ Bank.................... 20,000.00 EUR The next day, the Mercedes B-class is sold at 22,000.00 EUR. The customer pays a portion of the price to the extent of 5,000.00 EUR on cash and agrees to pay the remainder within 3 days. This partial payment signifies the sale, and APENDORP (Pty) Ltd. recognises the revenue. Although only a partial payment is made, the sale is recorded to its full extent. (7) Sale of Mercedes B-class on 21.01.20X9. <?page no="260"?> Berkau: Basics of Accounting 6e 22-260 DR Cash/ Bank.................... 5,000.00 EUR DR Accounts Receivables......... 17,000.00 EUR CR Sales........................ 22,000.00 EUR On 24.01.20X9, the buyer of the Mercedes B-class pays the remaining amount into APENDORP (Pty) Ltd.’s bank account. (8) Receipt of 17,000.00 EUR from the Mercedes B-class sale on 24.01.20X9. DR Cash/ Bank.................... 17,000.00 EUR CR Accounts Receivables......... 17,000.00 EUR Before the gross profit calculation in the Trading account, we look at the accounts at this stage in Figure 22.1. Note, the nominal accounts are not yet balanced-off. D C D C (1) 100,000.00 (2) 36,000.00 c/ d 100,000.00 (1) 100,000.00 (4) 17,500.00 (3) 48,000.00 b/ d 100,000.00 (7) 5,000.00 (6) 20,000.00 (8) 17,000.00 c/ d 35,500.00 139,500.00 139,500.00 b/ d 35,500.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 36,000.00 (3) 48,000.00 (5) 20,000.00 Rent-20X9 RNT Purchase-20X9 PUR D C D C (4) 17,500.00 (6) 20,000.00 (5) 20,000.00 (7) 22,000.00 D C (7) 17,000.00 (8) 17,000.00 Sales Revenue-20X9 REV Accounts payables A/ P Accounts receivables A/ R Figure 22.1: APENDORP (Pty) Ltd.’s accounts Revenue is the money or its equivalent flowing into the company for selling goods/ services. In a trading business, revenue is called sales. Its total is amounting to: 17,500 + 22,000 = 39,500.00 EUR. The gross profit for a dealership is calculated as revenues minus material expenses (= cost of goods sold). Here, the cost of goods sold are the purchase costs for one Polo and the Mercedes B-class bought at: 16,000 + 20,000 = 3 36,000.00 <?page no="261"?> Berkau: Basics of Accounting 6e 22-261 EEUR. Accordingly, the gross profit of the cars yields: 39,500 - 36,000 = 3 3,500.00 EUR. It is: 17,500 - 16,000 = 1 1,500.00 EUR for the VW Polo and it is: 22,000 - 20,000 = 2 2,000.00 EUR for the Mercedes B-class. The total gross profit calculation gives: 1,500 + 2,000 = 3 3,500.00 EUR. Although APENDORP (Pty) Ltd. earns a positive gross profit, its net profit is negative, because we have to deduct the show room rent. APENDORP (Pty) Ltd.’s makes a net loss to the extent of: 3,500 - 36,000 = - -32,500.00 EUR. This is called earnings before tax. As no income taxes apply for a loss, the amount of - 32,500.00 EUR is the earnings after taxes (annual surplus) as well. Now, we study the accounts and how to calculate gross and net profits. For the gross profit calculation, we apply the Trading account (T/ A). The Trading account is an account that displays on the debit side the opening value of inventory, all purchases and all returns inwards. On the credit side, there is sales, closing stock and all returns outwards. The balancing figure of the Trading account is the gross profit. In case the Trading account is credit balanced the company earns a gross profit. If the balancing figure (balance b/ d) of the Trading account is on the debit side the company makes a gross loss. How it is Done (Gross Profit Calculation): (1) Make Bookkeeping entries for all purchases and revenue recognition. (2) Transfer the opening value of inventories to the debit side of the Trading account by closing-off the Inventory account to the Trading account. (3) Close-off the Purchase account to the Trading account. (4) Close-off the Sales/ Revenue account to the Trading account. (5) Take stock. Make a debit entry for closing stock in the Inventory account and credit the amount to the Trading account. (6) Close-off the Returns Inwards account to the Trading account. (7) Close-off the Returns Outwards account to the Trading account. (8) Balance-off the Trading account for gross profit calculation. A gross profit results from a credit balanced Trading account. A gross loss results from a debit balanced Trading account. (9) Close-off the Trading account to the Profit and Loss account. APENDORP (Pty) Ltd.’s Trading account does not show an opening value of inventories. There are no cars on stock at the time of incorporation. The total of purchases equals the cost of all purchases (3 VW Polos and 1 Mercedes B- <?page no="262"?> Berkau: Basics of Accounting 6e 22-262 class): 3 × 16,000 + 20,000 = 6 68,000.00 EUR. On its credit side, the Trading account discloses the total of sales, 39,500.00 EUR. The closing stock of cars is the cost of purchase of the 2 VW Polos which have not been sold yet: 2 × 16,000 = 332,000.00 EUR. The balancing figure in the Trading account is the gross profit. It is: 39,500 + 32,000 - 68,000 = 3 3,500.00 EUR. The gross profit is disclosed as balance carried down on the debit side of the Trading account. This indicates a positive gross profit. As we apply a periodic inventory system, we did not record stock releases for the sales. We debit the closing stock of 32,000.00 EUR to the Inventory account. The Bookkeeping entry is made on 31.12.20X9 and falls under adjustments. DR Inventory.................... 32,000.00 EUR CR Trading Account.............. 32,000.00 EUR Observe again APENDORP (Pty) Ltd.’s accounts in Figure 22.2 after the calculation of profits: D C D C (1) 100,000.00 (2) 36,000.00 c/ d 100,000.00 (1) 100,000.00 (4) 17,500.00 (3) 48,000.00 b/ d 100,000.00 (7) 5,000.00 (6) 20,000.00 (8) 17,000.00 c/ d 35,500.00 139,500.00 139,500.00 b/ d 35,500.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 36,000.00 c/ d 36,000.00 (3) 48,000.00 b/ d 36,000.00 P&L 36,000.00 (5) 20,000.00 c/ d 68,000.00 68,000.00 68,000.00 b/ d 68,000.00 T/ A 68,000.00 Rent-20X9 RNT Purchase-20X9 PUR D C D C (4) 17,500.00 (6) 20,000.00 (5) 20,000.00 c/ d 39,500.00 (7) 22,000.00 39,500.00 39,500.00 T/ A 39,500.00 b/ d 39,500.00 Sales Revenue-20X9 REV Accounts payables A/ P Figure 22.2: APENDORP (Pty) Ltd.’s accounts <?page no="263"?> Berkau: Basics of Accounting 6e 22-263 D C D C (7) 17,000.00 (8) 17,000.00 PUR 68,000.00 REV 39,500.00 GP 3,500.00 INV 32,000.00 71,500.00 71,500.00 P&L 3,500.00 b/ d 3,500.00 Accounts receivables A/ R Trading account-20X9 T/ A D C D C T/ A 32,000.00 c/ d 32,000.00 RNT 36,000.00 T/ A 3,500.00 b/ d 32,000.00 NL 32,500.00 36,000.00 36,000.00 b/ d 32,500.00 R/ E 32,500.00 D C P&L 32,500.00 c/ d 32,500.00 b/ d 32,500.00 Inventory Inv Profit and Loss-20X9 P&L Retained earnings R/ E Figure 22.2: APENDORP (Pty) Ltd.'s accounts (continued) The net profit calculation is described in detail below. All Bookkeeping entries are made on 31.12.20X9: After balancing-off all accounts, the Sales account is closed-off to the Trading account: DR Sales Revenue................ 39,500.00 EUR CR Trading Account.............. 39,500.00 EUR The total of purchases is transferred to the Trading account too: DR Trading Account.............. 68,000.00 EUR CR Purchase..................... 68,000.00 EUR In this example, stock count is easy. There are 2 VW Polos left in the show room at a total value of: 2 × 16,000 = 32,000.00 EUR. The balancing figure of the Trading account gives the gross profit. The amount is displayed as GP. The Trading account is closed-off to the Profit and Loss account by the next Bookkeeping entry. DR Trading Account.............. 3,500.00 EUR CR Profit and Loss.............. 3,500.00 EUR In the Profit and Loss account, Bookkeeping entries resulting from further activities (non-trading activities), like rent, are considered. We close-off the Rent account to the Profit and Loss account. <?page no="264"?> Berkau: Basics of Accounting 6e 22-264 DR Profit and Loss.............. 36,000.00 EUR CR Rent......................... 36,000.00 EUR Next, the Profit and Loss account is balanced-off. The account is debit balanced. This indicates a net loss to the extent of: 3,500 - 36,000 = - -32,500.00 EUR. Net loss is the technical term for a negative profit. Our simplified tax model does not consider any tax deferrals; hence, the net loss is the net loss after taxes, too. In contrast, a net profit stands for a positive amount. A net profit is the sales less all expenses (income tax expenses exempted) that occurred during the Accounting period. A net profit is the same as earnings before taxes. APENDORP (Pty) Ltd.’s net loss equals 32,500.00 EUR. The amount is transferred into the Retained Earnings account by closing-off the Profit and Loss account thereto: DR Retained Earnings............ 32,500.00 EUR CR Profit and Loss.............. 32,500.00 EUR Observe the financial statements for APENDORP (Pty) Ltd. in Figure 22.3. [EUR] Revenue 39,500.00 Other income 39,500.00 Materials (36,000.00) Labour Depreciation Other expenses (36,000.00) Earnings before int and taxes (EBIT) (32,500.00) Interest Earnings before taxes (EBT) (32,500.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (32,500.00) Apendorp (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X9 Figure 22.3: APENDORP (Pty) Ltd.’s income statement for 20X9 <?page no="265"?> Berkau: Basics of Accounting 6e 22-265 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (32,500.00) Current assets Liabilities Inventory 32,000.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 35,500.00 Tax liabilities 67,500.00 67,500.00 Apendorp (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X9 Figure 22.4: APENDORP (Pty) Ltd.’s statement of financial position as at 31.12.20X9 For the valuation of goods on stock IAS 2 and § 255 HGB apply: The valuation is at cost of purchase (net amount). No additions are allowed. How it is Done (Calculation of Net Profit): (1) Determine gross profit in the Trading account. (2) Close-off the Trading account to the Profit and Loss account. (3) Make debit entries for all further expenses, including interest. (4) Balance-off the Profit and Loss account. (5) At this stage, the balancing figure in the Profit and Loss account represents the net profit. We call it earnings before taxes (= EBT). A debit balanced Profit and Loss account indicates a net loss. Note, the expressions earnings before and after taxes (EBT, EAT) are less prone to misinterpretation. Therefore, we mostly avoid the term net profit and say EBT instead. 22.6 C/ S DURANT (Pty) Ltd. In the next case study DURANT (Pty) Ltd. amounts are less easy to oversee, which applies for most trading companies. Furthermore, we now consider returns inwards and returns outwards. We record all Bookkeeping entries at first and thereafter we calculate the gross profit in the Trading account. <?page no="266"?> Berkau: Basics of Accounting 6e 22-266 DURANT (Pty) Ltd. provides the statement of financial position at the beginning of 20X7. It is depicted below in Figure 22.5: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 80,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 35,000.00 Current assets Liabilities Inventory 59,000.00 Interest bear liab A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 61,000.00 Tax liabilities 15,000.00 200,000.00 200,000.00 Durant (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 22.5: DURANT (Pty) Ltd.’s statement of financial position DURANT (Pty) Ltd. is a dealership for photo equipment. The company trades with digital cameras, action cameras, tripods, photo frames, photo printers, etc. The figures disclosed on the balance sheet result from previous years; check the details below: (a) Property, plant and equipment: DURANT (Pty) Ltd. bought a shop in a mall at 100,000.00 EUR. The shop has been depreciated by 20,000.00 EUR. (b) Inventory results from 65 digital cameras at 536.00 EUR/ u, from 52 action cameras at 254.00 EUR/ u, from 304 photo frames at 19.00 EUR/ u and from 8 photo printers at 647.00 EUR/ u. The value for all inventory items together is: 65 × 536 + 52 × 254 + 304 × 19 + 8 × 647 = 559,000.00 EUR. (c) DURANT (Pty) Ltd. has 61,000.00 EUR cash on bank. (d) Issued capital: DURANT (Pty) Ltd. was founded by a contribution of its owners of 100,000.00 EUR. (e) Retained earnings: The company earned 35,000.00 EUR profit after taxes in the last Accounting period. (f) Accounts payables: DURANT (Pty) Ltd. owes its suppliers 50,000.00 EUR. (g) The income tax liabilities are 15,000.00 EUR. At first, we transfer the values from the balance sheet to the real accounts. The amounts are marked as opening values OV; observe Figure 22.6. <?page no="267"?> Berkau: Basics of Accounting 6e 22-267 D C D C OV 100,000.00 OV 20,000.00 D C D C OV 59,000.00 OV 61,000.00 D C D C OV 100,000.00 OV 35,000.00 Property, plant, equipment PPE Accumulated depreciation ACC Issued capital ISS Retained earnings R/ E Inventory INV Cash/ Bank C/ B D C D C OV 50,000.00 OV 15,000.00 Accounts payables A/ P Income tax liabilities ITL Figure 22.6: DURANT (Pty) Ltd.’s accounts The value for property, plant and equipment of 80,000.00 EUR goes to 2 accounts: Property, Plant, Equipment account and the Accumulated Depreciation account, both linked to the shop. On 2.01.20X7, DURANT (Pty) Ltd. pays its income tax liabilities from the last Accounting period 20X6. (1) Payment for income taxes on 2.01.20X7. DR Income Tax Liabilities....... 15,000.00 EUR CR Cash/ Bank.................... 15,000.00 EUR On 3.01.20X7, DURANT (Pty) Ltd. paysoff short-term debts to its digital camera supplier. The payment is: 65 × 536 = 334,840.00 EUR. (2) Pay-off of short-term liabilities on 3.01.20X7. DR Accounts Payables............ 34,840.00 EUR CR Cash/ Bank.................... 34,840.00 EUR On 14.01.20X7, DURANT (Pty) Ltd. sells 12 digital cameras at 700.00 EUR/ u on cash. (3) Cash sale: 12 × 700 = 8 8,400.00 EUR on 14.01.20X7. DR Cash/ Bank.................... 8,400.00 EUR CR Sales........................ 8,400.00 EUR On 15.01.20X7, DURANT (Pty) Ltd. sells 34 photo frames at 30.00 EUR/ u on credit. The customer agrees to pay the price within the next days per EFT. <?page no="268"?> Berkau: Basics of Accounting 6e 22-268 (4) Sale on credit: 34 × 30 = 1 1,020.00 EUR on 15.01.20X7. DR Accounts Receivables......... 1,020.00 EUR CR Sales........................ 1,020.00 EUR The money from the customer who bought the frames is received on 18.01.20X7. (5) Receipt of 1,020.00 EUR from frames customer on 18.01.20X7. DR Cash/ Bank.................... 1,020.00 EUR CR Accounts Receivables......... 1,020.00 EUR After she paid her bill, the customer with the frames returns one frame, because its glass is broken. The customer receives a voucher in return. DURANT (Pty) Ltd. does not repair the frame but discards it. Discharging items of stock results in an expense. Therefore, the item does not count when taking inventory at the Accounting period’s end, see below. (6) The Accountant records a return inward of one frame and the voucher on 23.01.20X7. DR Returns Inwards.............. 30.00 EUR CR Accounts Payables............ 30.00 EUR On 1.02.20X7, DURANT (Pty) Ltd. orders 100 tripods from its supplier at 134.00 EUR/ u. The deal is on credit. The purchase price is: 100 × 134 = 1 13,400.00 EUR. (7) Purchase of 100 tripods on 1.02.20X7. DR Purchase..................... 13,400.00 EUR CR Accounts Payables............ 13,400.00 EUR On 4.02.20X7, DURANT (Pty) Ltd. sells 22 action cameras at 320.00 EUR/ u on cash. (8) Sale of 22 action cameras: 22 × 320 = 7 7,040.00 EUR on 4.02.20X7. DR Cash/ Bank.................... 7,040.00 EUR CR Sales........................ 7,040.00 EUR One of the tripods ordered from the supplier has a jammed leg. DURANT (Pty) Ltd.’s quality manager detects the faulty tripod and returns it to the supplier. The supplier adjusts the bill by making a 134.00 EUR-reduction. (9) Return outwards of one tripod on 6.02.20X7. <?page no="269"?> Berkau: Basics of Accounting 6e 22-269 DR Accounts Payables............ 134.00 EUR CR Returns Outwards............. 134.00 EUR On 8.02.20X7, DURANT (Pty) Ltd. pays the amount owing its tripod supplier by EFT. The purchase price is: 13,400 - 134 = 113,266.00 EUR. (10) Payment of the tripod-bill on 8.02.20X7. DR Accounts Payables............ 13,266.00 EUR CR Cash/ Bank.................... 13,266.00 EUR On 31.12.20X7, DURANT (Pty) Ltd. depreciates the store by 2,000.00 EUR. This is an adjustment Bookkeeping entry. (11) Depreciation on the store on 31.12.20X7. DR Depreciation ................. 2,000.00 EUR CR Accumulated Depreciation..... 2,000.00 EUR After recording the Bookkeeping entries above, the accounts look in Figure 22.7. D C D C OV 100,000.00 c/ d 100,000.00 OV 20,000.00 b/ d 100,000.00 c/ d 22,000.00 DPR 2,000.00 22,000.00 22,000.00 b/ d 22,000.00 Property, plant, equipment PPE Accumulated depreciation ACC D C D C OV 59,000.00 OV 61,000.00 (1) 15,000.00 (3) 8,400.00 (2) 34,840.00 (5) 1,020.00 (10) 13,266.00 (8) 7,040.00 c/ d 14,354.00 77,460.00 77,460.00 b/ d 14,354.00 Inventory INV Cash/ Bank C/ B Figure 22.7: DURANT (Pty) Ltd.’s accounts <?page no="270"?> Berkau: Basics of Accounting 6e 22-270 D C D C c/ d 100,000.00 OV 100,000.00 OV 35,000.00 b/ d 100,000.00 D C D C (2) 34,840.00 OV 50,000.00 (1) 15,000.00 OV 15,000.00 (9) 134.00 (6) 30.00 (10) 13,266.00 (7) 13,400.00 c/ d 15,190.00 63,430.00 63,430.00 b/ d 15,190.00 Issued capital ISS Retained earnings R/ E Accounts payables A/ P Income tax liabilities ITL D C D C (3) 8,400.00 (4) 1,020.00 (5) 1,020.00 (4) 1,020.00 c/ d 16,460.00 (8) 7,040.00 16,460.00 16,460.00 b/ d 16,460.00 Sales Revenue REV Accounts receivables A/ R D C D C (6) 30.00 c/ d 30.00 (7) 13,400.00 c/ d 13,400.00 b/ d 30.00 b/ d 13,400.00 D C D C c/ d 134.00 (9) 134.00 ACC 2,000.00 c/ d 2,000.00 b/ d 134.00 b/ d 2,000.00 Returns outwards R.O. Depreciation-20X7 DPR Returns inwards R.I. Purchases-20X7 PUR Figure 22.7: DURANT (Pty) Ltd.’s accounts (continued) In preparation of its Trading account, DURANT (Pty) Ltd. takes stock. It counts: 53 digital cameras, 30 action cameras, 270 photo frames, 99 tripods and 8 photo printers. The inventory valuation gives a total stock to the extent of: 53 × 536 + 30 × 254 + 270 × 19 + 99 × 134 + 8 × 647 = 5 59,600.00 EUR. Observe the gross profit and net profit calculations in Figure 22.8: <?page no="271"?> Berkau: Basics of Accounting 6e 22-271 D C D C OV 100,000.00 c/ d 100,000.00 OV 20,000.00 b/ d 100,000.00 c/ d 22,000.00 DPR 2,000.00 22,000.00 22,000.00 b/ d 22,000.00 D C D C OV 59,000.00 T/ A 59,000.00 OV 61,000.00 (1) 15,000.00 T/ A 59,600.00 c/ d 59,600.00 (3) 8,400.00 (2) 34,840.00 118,600.00 118,600.00 (5) 1,020.00 (10) 13,266.00 b/ d 59,600.00 (8) 7,040.00 c/ d 14,354.00 77,460.00 77,460.00 b/ d 14,354.00 Property, plant, equipment PPE Accumulated depreciation ACC Inventory INV Cash/ Bank INV D C D C c/ d 100,000.00 OV 100,000.00 OV 35,000.00 b/ d 100,000.00 c/ d 36,234.80 P&L 1,234.80 36,234.80 36,234.80 b/ d 36,234.80 D C D C (2) 34,840.00 OV 50,000.00 (1) 15,000.00 OV 15,000.00 (9) 134.00 (6) 30.00 c/ d 529.20 P&L 529.20 (10) 13,266.00 (7) 13,400.00 15,529.20 15,529.20 c/ d 15,190.00 b/ d 529.20 63,430.00 63,430.00 b/ d 15,190.00 D C D C (3) 8,400.00 (4) 1,020.00 (5) 1,020.00 (4) 1,020.00 c/ d 16,460.00 (8) 7,040.00 16,460.00 16,460.00 T/ A 16,460.00 b/ d 16,460.00 Sales Revenue-20X7 REV Accounts receivables A/ R Issued capital ISS Retained earnings R/ E Accounts payables A/ P Income tax liabilities ITL D C D C (6) 30.00 c/ d 30.00 (7) 13,400.00 c/ d 13,400.00 b/ d 30.00 T/ A 30.00 b/ d 13,400.00 T/ A 13,400.00 Returns inwards R.I. Purchases-20X7 PUR Figure 22.8: DURANT (Pty) Ltd.’s accounts <?page no="272"?> Berkau: Basics of Accounting 6e 22-272 D C D C c/ d 134.00 (9) 134.00 ACC 2,000.00 c/ d 2,000.00 T/ A 134.00 b/ d 134.00 b/ d 2,000.00 P&L 2,000.00 D C D C INV 59,000.00 REV 16,460.00 DPR 2,000.00 T/ A 3,764.00 PUR 13,400.00 INV 59,600.00 EBT 1,764.00 R.I. 30.00 R.O. 134.00 3,764.00 3,764.00 GP 3,764.00 R/ E 1,234.80 b/ d 1,764.00 76,194.00 76,194.00 ITL 529.20 P&L 3,764.00 b/ d 3,764.00 1,764.00 1,764.00 Return outwards R.O. Depreciation-20X7 DPR Trading account-20X7 T/ A Profit and Loss-20X7 P&L Figure 22.8: DURANT (Pty) Ltd.’s accounts (continued) The financial statements for DURANT (Pty) Ltd. follow, see Figure 22.9 and Figure 22.10 below. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 78,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 36,234.80 Current assets Liabilities Inventory 59,600.00 Interest bear liab A/ R A/ P 15,190.00 Prepaid expenses Provisions Cash/ Bank 14,354.00 Tax liabilities 529.20 151,954.00 151,954.00 Durant (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 22.9: DURANT (Pty) Ltd.’s statement of financial position <?page no="273"?> Berkau: Basics of Accounting 6e 22-273 [EUR] Revenue 16,430.00 Other income 16,430.00 Materials (12,666.00) Labour Depreciation (2,000.00) Other expenses Earnings before int and taxes (EBIT) 1,764.00 Interest Earnings before taxes (EBT) 1,764.00 Income tax expenses 529.20 Deferred taxes Earnings after taxes (EAT) 1,234.80 DURANT (Pty) Ltd. STATEMENT of PROFIT & LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 22.10: DURANT (Pty) Ltd. income statement On the statement of profit and loss and other comprehensive income, the revenue is calculated as: sales minus return inward: 16,460 - 30 = 1 16,430.00 EUR. The material expenses are: opening value for inventory plus purchases less closing stock of inventories less return outwards: 59,000 + 13,400 - 59,600 - 134 = 1 12,666.00 EUR. To prove correctness of our calculations, we calculate the profit directly below. The gross profit is the sum of the number of goods sold multiplied with their difference between sales prices and costs of purchases. In particular, DURANT (Pty) Ltd. sold 12 digital cameras, 34 - 1 = 3 33 photo frames and 22 action cameras. One photo frame was damaged and had to be expensed, because it got discarded. The purchase of tripods is not relevant for the profit calculation. The same applies for the returns outwards thereof. The gross profit is: 12 × (700 - 536) + 33 × (30 - 19) - 19 + 22 × (320 - 254) = 3 3,764.00 EUR. The net profit is the gross profit less further expenses. In this case study, only depreciation is considered as non-trading expense, therefore, the earnings before taxation are: 3,783 - 2,000 = 1,764.00 EUR. The income tax liabilities are deducted from the net profit to calculate DURANT (Pty) Ltd.’s annual surplus: 1,764 × (1 - 30%) = 1 1,234.80 EUR. 22.7 Summary In a trading business, the gross profit is calculated as the balancing figure of the Trading account. The Trading account considers opening values of inventories, purchases, returns inwards on its debit side and revenues, closing stock and returns outwards on the credit side. The net profit is calculated <?page no="274"?> Berkau: Basics of Accounting 6e 22-274 in the Profit and Loss account. It is the gross profit less non-trading expenses. 22.8 Working Definitions Gross Profit: The gross profit is sales less material expenses. Returns must be taken into consideration. Net Profit: The net profit is the profit after deduction of all expenses except of income taxes. Return Inward: A return inward occurs when a customer sends back goods to the seller. Trading Account: The Trading account is an account that displays on the debit side the opening value of inventory, all purchases and all returns inwards. On the credit side, there is sales, closing stock and all returns outwards. 22.9 Question Bank (1) A company buys goods for 350,000.00 EUR and sells half thereof at a selling price which is 180 % of the cost of purchase. Other operating expenses are depreciation at 80,000.00 EUR and labour at 50,000.00 EUR. How much is the gross profit? 1. 300,000.00 EUR . 2. 500,000.00 EUR . 3. 140,000.00 EUR . 4. 150,000.00 EUR . (2) A trading business records an opening value of 300.00 EUR and two purchases at 500.00 EUR. At the end of the Accounting period, there are goods valued at 150.00 EUR on stock. The revenue is amounting to 1,300.00 EUR. How much are material expenses? 1. 1,300.00 EUR . 2. 1,150.00 EUR . 3. 1,000.00 EUR . 4. 1,450.00 EUR . (3) Which statement is wrong? 1. A return inward happens when a customer sends back goods. 2. A return inward is recorded based on the purchase price. 3. A return outward is a negative purchase. 4. A return inward must be deducted from purchases when calculating the gross profit. (4) A trader buys good for 3,000.00 EUR and returns 25 % thereof to its supplier. The remainder is sold at 4,500.00 EUR. How much is the gross profit? 1. 750.00 EUR . 2. 1,250.00 EUR . 3. 1,500.00 EUR . 4. 2,250.00 EUR . (5) A trading company receives goods returned by its customer. The selling price was 5,000.00 EUR. The goods are added to stock. The initial purchase costs were 3,000.00 EUR. What are the Bookkeeping entries? 1. DR R.I. 5,000.00 EUR; CR C/ B 5,000.00 EUR and DR INV 3,000.00 EUR; CR COS 3,000.00 EUR. 2. DR C/ B 5,000.00 EUR; CR R.O. 5,000.00 EUR and DR INV <?page no="275"?> Berkau: Basics of Accounting 6e 22-275 3,000.00 EUR; CR COS 3,000.00 EUR. 3. DR R.I. 3,000.00 EUR; CR C/ B 3,000.00 EUR and DR INV 3,000.00 EUR; CR COS 3,000.00 EUR. 4. DR C/ B 5,000.00 EUR; CR R.O. 5,000.00 EUR and DR COS 3,000.00 EUR; CR INV 3,000.00 EUR. 22.10 Solutions 1-3; 2-2; 3-2; 4-4; 5-1. <?page no="276"?> Berkau: Basics of Accounting 6e 23-276 23 Trading Business - (2) Sales and Returns plus VAT 23.1 What is in the Chapter? In this chapter, we repeat the cases of APENDORP (Pty) Ltd. and DURANT (Pty) Ltd. from the previous chapter, but we now consider VAT for purchases and sales. 23.2 Learning Objectives By going through the case studies, you will understand that VAT does not change a business’s profit, but it changes payments/ receipts and payables/ receivables on the balance sheet. After studying this chapter, you can record activities in a trading company including inputand output-VAT Bookkeeping entries. We start with our, for VAT extended case study repetition by APENDORP (Pty) Ltd., the car dealer: 23.3 How to Record Output-VAT The calculation of output-VAT is the same as for input-VAT. If the net amount is given, multiply by 20% (or divide by 5 whatever you prefer) to get the VAT. If the gross amount is provided you must divide by 6. The net amount plus VAT gives the gross amount. Every company that is registered for VAT reduction must collect output VAT from its customers. This also applies when non-current assets are disposed. We refer to your case study BRASELTON Ltd. from chapter (21). BRASELTON Ltd. acquired shelves at 11,700.00 EUR (net amount) and a cash register at 1,200.00 EUR (net amount). The bookstore purchased Accounting textbooks at 3,500.00 EUR (net amount). Its VAT claim is amounting to: (11,700 + 1,200 + 3,500) × 20% = 3,280.00 EUR. We now extend the case of BRASELTON and study the sale of the textbooks and the disposal of 5 shelves. On 4.08.20X4, BRASELTON Ltd. sells 46 of the Accounting textbooks at a gross selling price of 54.00 EUR/ u. The revenue is the net amount of the sales: 46 × 54 / 120% = 22,070.00 EUR. The output- VAT collected from the customers is: 2,070 × 20% = 4 414.00 EUR. Hence the received cash for book selling is: 2,070 + 414 = 2 2,484.00 EUR. Observe the Bookkeeping entry made: DR Cash/ Bank.................... 2,484.00 EUR CR VAT.......................... 414.00 EUR CR Revenue...................... 2,070.00 EUR The output-VAT is recorded on the credit side of the VAT account because it is to be paid to the revenue service. This makes it a short-term liability. Next, we study the disposal of 5 shelves at a net selling price of 10.00 EUR/ u on 14.10.20X4. Although selling shelves is not the core business of BRASELTON Ltd., the bookstore must collect output- VAT from the buyer. The output-VAT for <?page no="277"?> Berkau: Basics of Accounting 6e 23-277 the 5 shelves gives: 5 × 10 × 20% = 1 10.00 EUR. We record the money paid by the buyer as a gain as it counts as other income. BRASELTON Ltd. must deduct the carrying value therefrom to calculate the loss (or profit) on disposal on its income statement. Observe the Bookkeeping entry at BRASELTON Ltd. below: DR Cash/ Bank.................... 60.00 EUR CR VAT.......................... 10.00 EUR CR Gain on Disposal............. 50.00 EUR The output-VAT reduces BRASELTON Ltd.’s VAT claim by: 414 + 10 = 4 424.00 EUR. The difference between inputand output VAT is: 3,280 - 424 = 2 2,856.00 EUR to be claimed from the revenue service as the input-VAT exceeds output- VAT. The situation is not looking good, as BRASELTON Ltd. is buying more than selling. Normally, a business records more output-VAT than input-VAT and is obliged to pay the different into the revenue service’s bank account. 23.4 C/ S APENDORP (Pty) Ltd. APENDORP (Pty) Ltd. is established on 2.01.20X9 by a deposit of 100,000.00 EUR in the company’s bank account. No VAT applies for a company establishment. (1) Deposit on 2.01.20X9 to an extent of: 100,000.00 EUR. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR The annual rent for the show room is: 36,000.00 EUR/ a. Both, APENDORP (Pty) Ltd. and its landlord are registered for VAT reduction. The owner of the show room is a company. Therefore, rent is subjected to VAT. APENDORP (Pty) Ltd. pays the gross amount for rent to the extent of: 36,000 × 120% = 4 43,200.00 EUR per bank transfer on 2.01.20X9. (2) Rent payment on 2.01.20X9. DR Rent......................... 36,000.00 EUR DR VAT.......................... 7,200.00 EUR CR Cash/ Bank.................... 43,200.00 EUR On 2.01.20X9, the procurement manager buys 3 pre-owned VW Polos at cost of purchase (net amount) of 16,000.00 EUR/ u. IAS 2 defines cost of purchase for inventories. It is always the net amount for a VAT registered company. As APENDORP (Pty) Ltd. buys the cars from another VAT registered company, APENDORP (Pty) Ltd. must increase its payment for input-VAT: 16,000 × 120% = 1 19,200.00 EUR/ u. The seller gets paid by APENDORP (Pty) Ltd. transferring the amount into their bank account via EFT. To be entitled to claim a VAT refund, the seller must disclose the input-VAT on its invoice. <?page no="278"?> Berkau: Basics of Accounting 6e 23-278 The Accountant makes the Bookkeeping entry below: (3) Purchase of VW Polos at: 3 × 16,000 × 120% = 5 57,600.00 EUR on 2.01.20X9. DR Purchase..................... 48,000.00 EUR DR VAT.......................... 9,600.00 EUR CR Cash/ Bank.................... 57,600.00 EUR On 12.01.20X9, APENDORP (Pty) Ltd. sells one VW Polos at a net selling price of 17,500.00 EUR. It is a cash sale. The buyer pays: 17,500 × 120% = 2 21,000.00 EUR. If a VAT registered company sells assets, it must collect output-VAT on behalf of the revenue service. It does not matter whether the buyer is a company, anyone must pay the gross amount - also a private buyer. The collection of output-VAT results at APENDORP (Pty) Ltd. in a credit entry in the VAT account. Hence, the receipt from the buyer of the VW Polo is now increased by 20% for output-VAT. (4) Sale of the VW Polo at 21,000.00 EUR on 12.01.20X9. DR Cash/ Bank.................... 21,000.00 EUR CR VAT.......................... 3,500.00 EUR CR Sales........................ 17,500.00 EUR On 14.01.20X9, APENDORP (Pty) Ltd. buys a Mercedes B-class at 20,000.00 EUR (net amount). The deal is on credit and APENDORP (Pty) Ltd. must pay within the next week the gross amount of: 20,000 × 120% = 2 24,000.00 EUR. Note, the purchase on credit results in the Bookkeeping entry below. Therefore, even as no payment has been made, APENDORP (Pty) Ltd. recorded input- VAT which results in a refund claim. (5) Purchase of Mercedes B-class on 14.01.20X9. DR Purchase..................... 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Accounts Payables............ 24,000.00 EUR One week later, APENDORP pays the purchase price for the Mercedes B-class (gross amount). The payment is at the agreed price. No VAT applies for this Bookkeeping entry. (6) Payment for Mercedes B-class on 21.01.20X9. DR Accounts Payables............ 24,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR The next day, the Mercedes B-class is sold at a 22,000.00 EUR net selling price. The price to be received from the buyer is: 22,000 × 120% = 2 26,400.00 EUR. The customer pays a portion of the price on cash (5,000.00 EUR) and agrees to pay the remaining price within 3 days. <?page no="279"?> Berkau: Basics of Accounting 6e 23-279 Although the business receives the amount for the car later, the credit entry in the VAT account is made to the full extent. See the 3 rd entry (CR VAT: 4,400.00 EUR) below. The reason for this entry is, that the partial payment signifies the deal. APENDORP (Pty) Ltd. must record the revenue and the output-VAT. Hence, upon this moment, APENDORP (Pty) Ltd. is obliged to pay the output VAT liabilities to the revenue service. (7) Sale of Mercedes B-class on 22.01.20X9. DR Cash/ Bank.................... 5,000.00 EUR DR Accounts Receivables......... 21,400.00 EUR CR VAT.......................... 4,400.00 EUR CR Sales........................ 22,000.00 EUR On 24.01.20X9, the buyer of the Mercedes B-class pays the remaining price into APENDORP (Pty) Ltd.’s bank account. (8) Receipt of payment to the extent of 21,400.00 EUR from the Mercedes Bclass buyer on 24.01.20X9. DR Cash/ Bank.................... 21,400.00 EUR CR Accounts Receivables......... 21,400.00 EUR Before we explain the profit calculation, we look at the accounts at this stage; see Figure 23.1. D C D C (1) 100,000.00 (2) 43,200.00 c/ d 100,000.00 (1) 100,000.00 (4) 21,000.00 (3) 57,600.00 b/ d 100,000.00 (7) 5,000.00 (6) 24,000.00 (8) 21,400.00 c/ d 22,600.00 147,400.00 147,400.00 b/ d 22,600.00 D C D C (2) 36,000.00 (3) 48,000.00 (5) 20,000.00 D C D C (4) 17,500.00 (6) 24,000.00 (5) 24,000.00 (7) 22,000.00 Cash/ Bank C/ B Issued capital ISS Sales Revenue-20X9 REV Accounts payables A/ P Rent-20X9 RNT Purchase-20X9 PUR Figure 23.1: APENDORP (Pty) Ltd.’s accounts <?page no="280"?> Berkau: Basics of Accounting 6e 23-280 D C D C (7) 21,400.00 (8) 21,400.00 (2) 7,200.00 (4) 3,500.00 (3) 9,600.00 (7) 4,400.00 (5) 4,000.00 c/ d 12,900.00 20,800.00 20,800.00 b/ d 12,900.00 Accounts receivables A/ R Value added tax VAT Figure 23.1: APENDORP (Pty) Ltd.'s accounts (continued) Note, besides of the higher payments recorded in cash/ bank and the recording of VAT, the nominal accounts are the same as in the previous chapter! We now calculate APENDORP (Pty) Ltd.’s profit. After balancing-off all accounts, the Sales account is closed-off to the Trading account: DR Sales........................ 39,500.00 EUR CR Trading Account.............. 39,500.00 EUR The Purchase account is closed-off to the Trading account, too. DR Trading Account.............. 68,000.00 EUR CR Purchase..................... 68,000.00 EUR APENDORP (Pty) Ltd. runs a periodic inventory system, therefore, it closes-off the Inventory account to the Trading account. There are two cars left at this stage, worth 16,000.00 EUR/ u each. The closing stock is amounting to: 2 × 16,000 = 3 32,000.00 EUR. This amount is not changed by VAT as inventory is always valued at net amounts. DR Inventory.................... 32,000.00 EUR CR Trading Account.............. 32,000.00 EUR The balancing figure of the Trading account is the gross profit. The Trading account is closed-off to the Profit and Loss account. DR Trading Account.............. 3,500.00 EUR CR Profit and Loss.............. 3,500.00 EUR In the Profit and Loss account, further entries resulting from non-trading activities are considered. Here, only rent applies. The Rent account is closed-off to the Profit and Loss account. <?page no="281"?> Berkau: Basics of Accounting 6e 23-281 DR Profit and Loss.............. 36,000.00 EUR CR Rent......................... 36,000.00 EUR Next, the Profit and Loss account is balanced-off. APENDORP (Pty) Ltd.’s net loss is 32,500.00 EUR. The Profit and Loss account is closed-off to retained earnings: DR Retained Earnings............ 32,500.00 EUR CR Profit and Loss.............. 32,500.00 EUR D C D C (1) 100,000.00 (2) 43,200.00 c/ d 100,000.00 (1) 100,000.00 (4) 21,000.00 (3) 57,600.00 b/ d 100,000.00 (7) 5,000.00 (6) 24,000.00 (8) 21,400.00 c/ d 22,600.00 147,400.00 147,400.00 b/ d 22,600.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 36,000.00 c/ d 36,000.00 (3) 48,000.00 b/ d 36,000.00 P&L 36,000.00 (5) 20,000.00 c/ d 68,000.00 68,000.00 68,000.00 b/ d 68,000.00 T/ A 68,000.00 Rent-20X9 RNT Purchase-20X9 PUR D C D C (4) 17,500.00 (6) 24,000.00 (5) 24,000.00 c/ d 39,500.00 (7) 22,000.00 39,500.00 39,500.00 T/ A 39,500.00 b/ d 39,500.00 D C D C (7) 21,400.00 (8) 21,400.00 (2) 7,200.00 (4) 3,500.00 (3) 9,600.00 (7) 4,400.00 (5) 4,000.00 c/ d 12,900.00 20,800.00 20,800.00 b/ d 12,900.00 Sales Revenue-20X9 REV Accounts payables A/ P Accounts receivables A/ P Value added tax VAT Figure 23.2: APENDORP (Pty) Ltd.’s accounts <?page no="282"?> Berkau: Basics of Accounting 6e 23-282 D C D C PUR 68,000.00 REV 39,500.00 RNT 36,000.00 T/ A 3,500.00 GP 3,500.00 INV 32,000.00 NL 32,500.00 71,500.00 71,500.00 36,000.00 36,000.00 P&L 3,500.00 b/ d 3,500.00 b/ d 32,500.00 R/ E 32,500.00 D C D C P&L 32,500.00 c/ d 32,500.00 T/ A 32,000.00 c/ d 32,000.00 b/ d 32,500.00 b/ d 32,000.00 Retained earnings R/ E Inventory INV Trading account T/ A Profit and Loss-20X9 P&L Figure 23.2: APENDORP (Pty) Ltd.'s accounts (continued) Observe the financial statements for APENDORP (Pty) Ltd. in Figure 23.3. [EUR] Revenue 39,500.00 Other income 39,500.00 Materials (36,000.00) Labour Depreciation Other expenses (36,000.00) Earnings before int and taxes (EBIT) (32,500.00) Interest Earnings before taxes (EBT) (32,500.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (32,500.00) Apendorp (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X9 Figure 23.3: APENDORP (Pty) Ltd.’s income statement for 20X9 The statement of profit or loss and other comprehensive income is not changed by our VAT consideration. All amounts are net amounts. Compare this statement to Figure 22.3! There are only few changes in comparison to the previous chapter’s statement of financial position regarding the Cash/ Bank account and the Accounts Receivables account. The VAT account is debit balanced. APENDORP (Pty) Ltd. claims a VAT refund. On the face of the statement of financial position this is disclosed under receivables. <?page no="283"?> Berkau: Basics of Accounting 6e 23-283 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (32,500.00) Current assets Liabilities Inventory 32,000.00 Interest bear liab A/ R 12,900.00 A/ P Prepaid expenses Provisions Cash/ Bank 22,600.00 Tax liabilities 67,500.00 67,500.00 Apendorp (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X9 Figure 23.4: APENDORP (Pty) Ltd.’s statement of financial position as at 31.12.20X9 APENDORP (Pty) Ltd. prepares a VAT statement at the end of the Accounting period 20X9 and claims for a VAT refund. The Bookkeeping entry for the VAT refund receipt is recorded in the next Accounting period 20Y0. Hence, the Bookkeeping ID is marked by a capital letter: (A) VAT refund on 1.01.20Y0. DR Cash/ Bank.................... 12,900.00 EUR CR VAT.......................... 12,900.00 EUR Next, we study DURANT (Pty) Ltd. with consideration of VAT. This example contains returns which require to make adjustments for VAT, too. 23.5 C/ S DURANT (Pty) Ltd. DURANT (Pty) Ltd. trades with digital cameras, action cameras, tripods, photo frames, photo printers, etc. The figures provided come from the statement of financial position as at the beginning of 20X7: <?page no="284"?> Berkau: Basics of Accounting 6e 23-284 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 80,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 35,000.00 Current assets Liabilities Inventory 59,000.00 Interest bear liab A/ R 10,000.00 A/ P 60,000.00 Prepaid expenses Provisions Cash/ Bank 61,000.00 Tax liabilities 15,000.00 210,000.00 210,000.00 Durant (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X7 Figure 23.5: DURANT (Pty) Ltd.’s statement of financial position The opening values are the same as in the previous chapter (22) and get transferred to the accounts. The only opening figures that were changed in the accounts are the accounts payables which are based on the gross amount now. At the same time, we debit the input-VAT for the last Accounting period’s purchases on the debit side as input- VAT/ receivables. These changes are based on the assumption that DURANT (Pty) Ltd. bought goods for cost of purchases of 50,000.00 EUR on credit during the last Accounting period. See Figure 23.6: D C D C OV 100,000.00 OV 20,000.00 D C D C OV 59,000.00 OV 61,000.00 Inventory INV Cash/ Bank C/ B Property, plant, equipment PPE Accumulated depreciation ACC D C D C OV 100,000.00 OV 35,000.00 Issued capital ISS Retained earnings R/ E Figure 23.6: DURANT (Pty) Ltd.’s accounts <?page no="285"?> Berkau: Basics of Accounting 6e 23-285 D C D C OV 60,000.00 OV 15,000.00 D C OV 10,000.00 Accounts payables A/ P Income tax liabilities ITL Value added tax VAT Figure 23.6: DURANT (Pty) Ltd.'s accounts (continued) On 2.01.20X7, DURANT (Pty) Ltd. pays its income tax liabilities and receives a VAT refund from the previous Accounting period. These Bookkeeping entries are not subjected to VAT. (1) Payment for income taxes on 2.01.20X7. (1’) Receipt of VAT from the revenue service on 2.01.20X7. DR Income Tax Liabilities....... 15,000.00 EUR CR Cash/ Bank.................... 15,000.00 EUR DR Cash/ Bank.................... 10,000.00 EUR CR VAT Account.................. 10,000.00 EUR On 3.01.20X7, DURANT (Pty) Ltd. paysoff short-term debts owing its digital camera supplier. The payment is: 34,840 × 120% = 4 41,808.00 EUR. (2) Pay-off of short-term liabilities on 3.01.20X7. DR Accounts Payables............ 41,808.00 EUR CR Cash/ Bank.................... 41,808.00 EUR On 14.01.20X7, DURANT (Pty) Ltd. sells 12 digital cameras at 700.00 EUR/ u on cash. As DURANT (Pty) Ltd. is registered for VAT reduction it sells at gross amounts: Those contain output-VAT. (3) The cash sale results in a payment of: 12 × 700 × 120% = 1 10,080.00 EUR on 14.01.20X7. DR Cash/ Bank.................... 10,080.00 EUR CR VAT.......................... 1,680.00 EUR CR Sales........................ 8,400.00 EUR On 15.01.20X7, DURANT (Pty) Ltd. sells 34 photo frames at 36.00 EUR/ u gross selling price on credit. For revenue recognition we must calculate the net amount for the sales as: 34 × 36/ 120% = 1,020.00 EUR. VAT according to this calculation equals: 1,020 × 20% = 2 204.00 EUR. The customer agrees to pay the outstanding amount within the next days per bank transfer. <?page no="286"?> Berkau: Basics of Accounting 6e 23-286 (4) Sale on credit at a gross selling price of: 34 × 30 × 120% = 1 1,224.00 EUR on 15.01.20X7. DR Accounts Receivables......... 1,224.00 EUR CR VAT.......................... 204.00 EUR CR Sales........................ 1,020.00 EUR The payment from the customer, who bought the frames, is received on 18.01.20X7. (5) Receipt of 1,224.00 EUR from the frames customer on 18.01.20X7. DR Cash/ Bank.................... 1,224.00 EUR CR Accounts Receivables......... 1,224.00 EUR The customer with the frames returns one with the glass broken. The customer receives a voucher in return, which is amounting to the gross selling price. DURANT (Pty) Ltd. does not repair the frame but throws it away. The refund is subjected to VAT; however, the discard is not (inventory movement). (6) Return inwards of one frame and granting a voucher as customer compensation on 23.01.20X7. DR Returns Inwards.............. 30.00 EUR DR VAT.......................... 6.00 EUR CR Accounts Payables............ 36.00 EUR DURANT (Pty) Ltd. orders 100 tripods from its supplier at 134.00 EUR/ u. The amount of 134.00 EUR/ u reflects the unit cost of purchase. The money to be paid for each tripod is: 134 × 120% = 160.80 EUR/ u. The purchase is on credit: it takes place on 1.02.20X7. The amount is: 100 × 134 × 120% = 1 16,080.00 EUR. (7) Purchase of tripods on 1.02.20X7. DR Purchase..................... 13,400.00 EUR DR VAT.......................... 2,680.00 EUR CR Accounts Payables............ 16,080.00 EUR On 4.02.20X7, DURANT (Pty) Ltd. sells 22 action cameras at a net selling price of 320.00 EUR/ u on cash. (8) Sale of 22 action cameras at a gross selling price of: 22 × 320 × 120% = 8,448.00 EUR on 4.02.20X7. DR Cash/ Bank.................... 8,448.00 EUR CR VAT.......................... 1,408.00 EUR CR Sales........................ 7,040.00 EUR <?page no="287"?> Berkau: Basics of Accounting 6e 23-287 DURANT returns one tripod ordered from its supplier due to a damage. The supplier modifies the bill for a 160.80 EUR reduction. (9) Return outwards of one tripod on 6.02.20X7. DR Accounts Payables............ 160.80 EUR CR VAT.......................... 26.80 EUR CR Returns Outwards............. 134.00 EUR On 8.02.20X7, DURANT (Pty) Ltd. pays its debts to the tripod supplier by bank transfer. The adjusted bill is amounting to: 16,080 - 160.80 = 1 15,919.20 EUR. (10) Payment of the tripod-bill on 8.02.20X7. DR Accounts Payables............ 15,919.20 EUR CR Cash/ Bank.................... 15,919.20 EUR On 31.12.20X7, DURANT (Pty) Ltd. records depreciation on its store for 2,000.00 EUR. Depreciation is not subjected to VAT as it is a reduction of the net values of items of property, plant and equipment. (11) Store depreciation on 31.12.20X7. DR Depreciation ................. 2,000.00 EUR CR Accumulated Depreciation..... 2,000.00 EUR After making the Bookkeeping entries, DURANT (Pty) Ltd.’s accounts look as disclosed in Figure 23.7. D C D C OV 100,000.00 c/ d 100,000.00 OV 20,000.00 b/ d 100,000.00 c/ d 22,000.00 DPR 2,000.00 22,000.00 22,000.00 b/ d 22,000.00 Property, plant, equipment PPE Accumulated depreciation ACC D C D C c/ d 100,000.00 OV 100,000.00 OV 59,000.00 b/ d 100,000.00 Issued capital ISS Inventory INV Figure 23.7: DURANT (Pty) Ltd.’s accounts <?page no="288"?> Berkau: Basics of Accounting 6e 23-288 D C D C (2) 41,808.00 OV 60,000.00 (1) 15,000.00 OV 15,000.00 (9) 160.80 (6) 36.00 (10) 15,919.20 (7) 16,080.00 c/ d 18,228.00 76,116.00 76,116.00 b/ d 18,228.00 Accounts payables A/ P Income tax liabilities ITL D C D C c/ d 134.00 (9) 134.00 ACC 2,000.00 c/ d 2,000.00 b/ d 134.00 b/ d 2,000.00 D C D C OV 35,000.00 (1') 10,000.00 OV 10,000.00 (6) 6.00 (3) 1,680.00 (7) 2,680.00 (4) 204.00 (8) 1,408.00 c/ d 632.80 (9) 26.80 13,318.80 13,318.80 b/ d 632.80 D C D C OV 61,000.00 (1) 15,000.00 (6) 30.00 c/ d 30.00 (1') 10,000.00 (2) 41,808.00 b/ d 30.00 (3) 10,080.00 (10) 15,919.20 (5) 1,224.00 (8) 8,448.00 c/ d 18,024.80 90,752.00 90,752.00 b/ d 18,024.80 Cash/ Bank C/ B Returns inwards R.I. Returns outwards R.O. Depreciation-20X7 DPR Value added tax VAT Retained earnings R/ E Figure 23.7: DURANT (Pty) Ltd.'s accounts (continued) In preparation of the gross profit calculation in the Trading account, DURANT (Pty) Ltd. takes stock. There are 53 digital cameras, 30 action cameras, 270 photo frames, 99 tripods and 8 photo printers in its store. The inventory valuation gives the closing stock of: 53 × 536 + 30 × 254 + 270 × 19 + 99 × 134 + 8 × 647 = 5 59,600.00 EUR. The amount is the same as in chapter (22), because inventories are valued at net amounts. Observe the calculation of gross profit and net profit in Figure 23.8: <?page no="289"?> Berkau: Basics of Accounting 6e 23-289 D C D C OV 100,000.00 c/ d 100,000.00 OV 20,000.00 b/ d 100,000.00 c/ d 22,000.00 DPR 2,000.00 22,000.00 22,000.00 b/ d 22,000.00 D C D C OV 10,000.00 (1') 10,000.00 OV 61,000.00 (1) 15,000.00 (6) 6.00 (3) 1,680.00 (1') 10,000.00 (2) 41,808.00 (7) 2,680.00 (4) 204.00 (3) 10,080.00 (10) 15,919.20 (8) 1,408.00 (5) 1,224.00 c/ d 632.80 (9) 26.80 (8) 8,448.00 c/ d 18,024.80 13,318.80 13,318.80 90,752.00 90,752.00 b/ d 632.80 b/ d 18,024.80 D C D C c/ d 100,000.00 OV 100,000.00 OV 59,000.00 T/ A 59,000.00 b/ d 100,000.00 T/ A 59,600.00 c/ d 59,600.00 118,600.00 118,600.00 b/ d 59,600.00 D C D C (2) 41,808.00 OV 60,000.00 (1) 15,000.00 OV 15,000.00 (9) 160.80 (6) 36.00 c/ d 529.20 P&L 529.20 (10) 15,919.20 (7) 16,080.00 15,529.20 15,529.20 c/ d 18,228.00 b/ d 529.20 76,116.00 76,116.00 b/ d 18,228.00 Cash/ Bank C/ B Property, plant, equipment PPE Accumulated depreciation ACC Issued capital ISS Inventory INV Accounts payables A/ P Income tax liabilities ITL Value added tax VAT D C D C (3) 8,400.00 (4) 1,224.00 (5) 1,224.00 (4) 1,020.00 c/ d 16,460.00 (8) 7,040.00 16,460.00 16,460.00 T/ A 16,460.00 b/ d 16,460.00 Sales Revenue-20X7 REV Accounts receivables A/ R D C D C (6) 30.00 c/ d 30.00 (7) 13,400.00 c/ d 13,400.00 b/ d 30.00 T/ A 30.00 b/ d 13,400.00 T/ A 13,400.00 Returns inwards R.I. Purchases-20X7 PUR Figure 23.8: DURANT (Pty) Ltd.’s accounts <?page no="290"?> Berkau: Basics of Accounting 6e 23-290 D C D C c/ d 134.00 (9) 134.00 ACC 2,000.00 c/ d 2,000.00 T/ A 134.00 b/ d 134.00 b/ d 2,000.00 P&L 2,000.00 Returns outwards R.O. Depreciation-20X7 DPR D C D C OV 35,000.00 INV 59,000.00 REV 16,460.00 b/ d 36,234.80 P&L 1,234.80 PUR 13,400.00 INV 59,600.00 36,234.80 36,234.80 R.I. 30.00 R.O. 134.00 b/ d 36,234.80 GP 3,764.00 76,194.00 76,194.00 P&L 3,764.00 b/ d 3,764.00 D C DPR 2,000.00 T/ A 3,764.00 EBT 1,764.00 3,764.00 3,764.00 R/ E 1,234.80 b/ d 1,764.00 ITL 529.20 1,764.00 1,764.00 Profit and Loss-20X7 P&L Trading account-20X7 T/ A Retained earnings R/ E Figure 23.8: DURANT (Pty) Ltd.’s accounts (continued) The financial statements for DURANT (Pty) Ltd. are displayed in Figure 22.9 and Figure 22.10. The VAT balance is added to payables, as output-VAT exceeds input-VAT. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 78,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 36,234.80 Current assets Liabilities Inventory 59,600.00 Interest bear liab A/ R A/ P 18,860.80 Prepaid expenses Provisions Cash/ Bank 18,024.80 Tax liabilities 529.20 155,624.80 155,624.80 Durant (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 23.9: DURANT (Pty) Ltd.’s statement of financial position <?page no="291"?> Berkau: Basics of Accounting 6e 23-291 There are no changes regarding the income statement in comparison to chapter (22): [EUR] Revenue 16,430.00 Other income 16,430.00 Materials (12,666.00) Labour Depreciation (2,000.00) Other expenses Earnings before int and taxes (EBIT) 1,764.00 Interest Earnings before taxes (EBT) 1,764.00 Income tax expenses (529.20) Deferred taxes Earnings after taxes (EAT) 1,234.80 DURANT (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 23.10: DURANT (Pty) Ltd. income statement In the next Accounting period, DURANT (Pty) Ltd. pays the amount it is owing the revenue service for VAT. (A) Payment for VAT payables from last year on 2.01.20X8. DR VAT.......................... 632.80 EUR CR Cash/ Bank.................... 632.80 EUR How it is Done (Recording output-VAT): (1) Determine the gross and the net amount of the sales or revenue. (2) Make a debit entry for the gross amount in the Cash/ Bank account or Accounts Receivables. Consider partial payments accordingly. (3) Credit output-VAT to the VAT account. (4) Credit the net amount to the Sales/ Revenue account. How it is Done (Claiming VAT): (1) Make all entries in the VAT account for input-VAT and output-VAT. (2) Balance-off the VAT account. <?page no="292"?> Berkau: Basics of Accounting 6e 23-292 (3) Prepare a VAT statement and send it to the revenue service. (4) If output-VAT exceeds input-VAT transfer the difference into the revenue service’s bank account once it is due. If input-VAT exceeds output-VAT, expect the authorities to refund you the difference. 23.6 Summary VAT registered companies have to credit output-VAT to the VAT account at the time of revenue recognition. The output-VAT is collected from buyers/ customers by the company on behalf of the revenue service. Returns inwards are recorded when a customer returns goods previously bought. They require to debit the VAT account. The consideration of VAT affects the Cash/ Bank account, receivables and payables. The statement of profit or loss and other comprehensive income is not change by VAT considerations if net selling prices equal the no-VAT values. 23.7 Question Bank (1) A VAT registered company buys goods for 3,000,000.00 EUR (net amount). There are goods for 1,500,000.00 EUR on stock. The company sells 80 % of the goods and earns a revenue of 8,400,000.00 EUR. How much are VAT payables? 1. 800,000.00 EUR . 2. 780,000.00 EUR . 3. 1,080,000.00 EUR . 4. 500,000.00 EUR . (2) A VAT registered company returns goods to its supplier (net value = 200.00 EUR) and receives a cash refund. What is the correct Bookkeeping entry? 1. DR C/ B 240.00 EUR; CR R.I 200.00 EUR; CR VAT 40.00 EUR 2. DR C/ B 200.00 EUR; CR R.O. 3. DR C/ B 240.00 EUR; CR R.O 200.00 EUR; CR VAT 40.00 EUR. 4. DR C/ B 200.00 EUR; DR VAT 40.00 EUR; CR R.O 240.00 EUR. (3) Which statement is wrong? 1. VAT equates Revenue multiplied by 20 %. 2. VAT equates Revenue divided by 5. 3. VAT equates Proceeds divided by 6. 4. VAT equates Revenue divided by 6. (4) A VAT registered company accepts a sale of 500.00 EUR with the customer paying half of the price instantly and the other half one year later. Which is the correct Bookkeeping entry? 1. DR C/ B 300.00 EUR; DR A/ R 300.00 EUR; CR VAT 100.00 EUR; CR REV 500.00 EUR. 2. DR C/ B 250.00 EUR; DR A/ R 250.00 EUR; CR REV 500.00 EUR. <?page no="293"?> Berkau: Basics of Accounting 6e 23-293 3. DR C/ B 300.00 EUR; DR A/ R 250.00 EUR; CR VAT 50.00 EUR; CR REV 500.00 EUR. 4. DR C/ B 350.00 EUR; DR A/ R 250.00 EUR; CR REV 500.00 EUR; CR VAT 100.00 EUR. (5) A company sells goods it purchased at 400,000.00 EUR in the same period (net amount) at a gross selling price of 1,020,000.00 EUR. 10 % of the goods are returned by the customers in the same Accounting period. How much are VAT payables? 1. 103,600.00 EUR . 2. 73,000.00 EUR . 3. 90,000.00 EUR . 4. 93,000.00 EUR . 23.8 Solutions 1-3; 2-3; 3-4; 4-1; 5-2. <?page no="294"?> Berkau: Basics of Accounting 6e 24-294 24 Privately-owned Business: Drawings 24.1 What is in the Chapter? In this chapter, we introduce financial statements for privately-owned companies. We do not discuss who prepares financial statements as the IFRSs don’t do either. We only explain how financial statements look like if the company is no limited company. In particular, we explain Bookkeeping entries for drawings which can be compared to dividends declared by public companies. In this chapter, we discuss the pie baking store of Mr T.L. Van- Guard located in a mall. We also describe the effect of shared assets (between the owner and her/ his company) and the impact on VAT thereof. 24.2 Learning Objectives In the previous chapters, we discussed how traders earn their profit. We now discuss, how the owner of a private business takes out an income by withdrawing money or goods. The appropriation of profits for limited companies will be explained in chapter (30). After studying this chapter, you understand how to record shared assets and taking out goods/ funds under consideration of VAT. You get familiarised with the financial statements for privately-owned companies. 24.3 Why running a Private Business? A privately-owned business is either a sole proprietorship or a partnership. There can be a lot of reasons 6 Read the case study SCHLUCHMAN in our Management Accounting, chapter (6) to understand the tax implications! for running a privately-owned business. One of these reasons can be tax implications. Instead of company taxes, a privately-owned company is taxed through the owner based on her/ his income tax rate. As the income tax rate increases with profits, companies might change their legal form once the personal income tax rate exceeds company taxes. 6 Another reason for running a privately-owned business lays in the reliability. An owner is held reliable for a private company. Another reason is that privately-owned companies are less formal regarding the operations. In some countries privately-owned businesses are not obliged to prepare commercial financial statements. We here adhere to IFRSs regulations and prepare financial statements for privately-owned companies, like small trading companies, handicraft enterprises, law firms, doctors’ clinics etc. For this textbook, we also assume that all privatelyowned companies keep Bookkeeping records. Under privately-owned companies we also discuss partnerships. From the Accounting point of view, they look similar, however, there is more than one owner, and the assets and profits must be split amongst them. E.g., in a law firm, the assets can be split between the partners (lawyers) according to the share of ownership, but the profit is allocated based on case values or proceeds receipt from clients. See the case study PAROW <?page no="295"?> Berkau: Basics of Accounting 6e 24-295 HOUTBANK further down in this chapter. We further consider that there is always a clean cut between company assets and private ones. In particular, the company must run a separate bank account. 24.4 Drawings Companies based on shares either distribute their profits to shareholders (dividends) or they reinvest them (reserves). Privately-owned companies do not declare dividends, nor do they disclose reserves on their balance sheet (see below). If the owner does not take funds/ goods out, the company’s equity will increase. To participate from the profit, an owners must make drawings. A drawing is the taking out of assets (e.g., materials or cash) or to use business assets for private purposes. Once the drawing is linked to assets other than cash, the company must consider VAT if registered for VAT reduction. Drawings decrease the company’s equity. Therefore, drawings are recorded on the debit side of the equity account. For privately-owned businesses, we apply a special Drawings account. It is linked to the equity section. 24.5 Balance Sheet for a privately-owned Company. The equity section for privately-owned businesses is simple as there is only one owner. The balance sheet only discloses one item: owners’ equity. The Drawings account will reduce the owners’ capital. Find below in Figure 24.1 the format of the balance sheet for a privatelyowned business. A C, L Non-current assets [EUR] Equity [EUR] P, P, E Owners' capital Intangibles Financial assets Current assets Liabilities Inventory Interest bear liab Accounts receivables Accounts payables Prepaid expenses Provisions Cash/ Bank Total assets Total equity and liab. STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 24.1: Structure of the balance sheet for privately-owned companies Note, the asset side looks the same as for a limited company. The equity section does not show separate accounts as there is no share capital. No income tax liabilities are disclosed on the liabilities section either, because the owner pays taxes for her/ his company. Therefore, no corporate taxes apply. <?page no="296"?> Berkau: Basics of Accounting 6e 24-296 24.6 How to Record a Drawing It is important to understand that drawings do not show on the income statement. Drawings do not change the profitability of the business. Drawings and privately deployment of business assets are not recorded through profit or loss. Hence, drawings do not fall under business expenses. We acknowledge that drawings must be credited in an Equity account. To keep the Bookkeeping records clearly arranged, we apply a Drawings account subordinated to the Owner’s Equity account. On the debit side a drawing reduces company assets. A company must record adjustments to VAT when drawings are linked to assets subjected to input-VAT. A private use of company assets is not eligible for VAT reduction, as it does not fall under business operations. Hence, an owner taking/ using company assets is regarded as a consumer. Therefore, no or partially no VAT refund is applicable. Think of a company owner whose business is registered for VAT reduction and who buys a new car for 84,000.00 EUR. The car is licensed on the name of the company. As a consequence, the company claims input- VAT. Although the car’s owner is the company and it is supposed to be used for business purpose only, we assume the car is frequently driven privately. In this case the owner’s claims of input-VAT to the extent of: 20% × (84,000/ 120%) = 14,000.00 EUR becomes illegal as it leads to VAT evasion punishable by national tax law. See below how to record a cash drawing and thereafter how to record a private use of company assets. How it is Done (Cash Drawing): (1) Record taking-out money of the Cash/ Bank account for private purpose as drawing. It gives a debit entry in the Drawings account and a credit entry in the Cash/ Bank account. (2) At the end of the Accounting period, close-off the Drawings account to the Owners’ Capital account. How it is Done (Drawing based on Goods Withdrawal or Deployment of Company Assets): (1) Determine the net and gross amount of the goods withdrawn or calculate the value of the privately deployed resources. (Can be complicated! ) (2) When taking out the goods or using the company resources, make a debit entry in the Drawings account to the extent of the gross value of the goods/ service withdrawn. <?page no="297"?> Berkau: Basics of Accounting 6e 24-297 (3) Adjust the VAT account: Credit the input-VAT recorded to the VAT account. This cancels out or reduces the input-VAT claim. (4a) For withdrawn goods, credit the net amount to the related Inventory account or Purchase account. If the asset is a non-current asset, make the credit entry in the relevant account, like the P, P, E account. (4b) When using company resources privately, make a credit entry in the related expense account (depreciation). You might have to consider adjustments for VAT as well. (5) Close-off the Drawings account to the Owners’ Capital account. We apply the procedure for the business car example above. When buying the car, the owner of the business adds the car to the P, P, E account: DR P, P, E ACCOUNT.............. 70,000.00 EUR DR VAT.......................... 14,000.00 EUR CR Cash/ Bank.................... 84,000.00 EUR When taking the car out of the company completely, the owner must record a drawing and a VAT adjustment: DR Drawings..................... 84,000.00 EUR CR VAT.......................... 14,000.00 EUR CR P, P, E ...................... 70,000.00 EUR Later, the Drawings account is closed off to the Owners’ Capital account: DR Owner’s Capital.............. 84,000.00 EUR CR Drawings..................... 84,000.00 EUR Now the situation has been cleared: The car initially bought by the company has been transferred to the owner and the VAT claim got dissolved. Next, we modify the situation and discuss a partly (50 %) private deployment. The car now remains in the Bookkeeping records. We ignore further motor vehicle costs, like insurance and petrol, to keep the case simple. The Bookkeeping entry for the car’s acquisition is the same as above. As a business car, it is subjected to depreciation. The car is written-off following straight-line method over its useful life of 5 years. Depreciation on the car for a full year is amounting to: 70,000 / 5 = 14,000.00 EUR. <?page no="298"?> Berkau: Basics of Accounting 6e 24-298 DR Depreciation................. 14,000.00 EUR CR Acc. Depr.................... 14,000.00 EUR Half of the expenses for a one-yearcar-deployment equal: 14,000.00 / 2 = 7,000.00 EUR. Hence, the private use of the company car for half of a year costs the same. The owner makes the Bookkeeping entry below for the drawing. DR Drawings .................... 7,000.00 EUR CR Depreciation................. 7,000.00 EUR At this stage of Bookkeeping, the privately use of half of the company car is free of VAT. However, a percentage of 50 % is regarded as significant and requires further adjustments for VAT. If the car is permanently in private use, we have to adjust: 50% × 20% × 84,000 / 120% = 7,000.00 EUR of the refunded input-VAT. An equal distribution of the amount over 5 years results in a further drawing of: 7,000 / 5 = 1,400.00 EUR/ a. We record the drawing as below and then close-off the Drawings account to the Owner’s Equity account: DR Drawings..................... 1,400.00 EUR CR VAT.......................... 1,400.00 EUR DR Owner’s Capital.............. 8,400.00 EUR CR Drawings..................... 8,400.00 EUR After the Bookkeeping entries in the first Accounting period, the input- VAT claim is reduced based on the drawing and the expense account for depreciation is reduced by 50 %. According to the drawing, the owner’s equity is now 8,400.00 EUR less which is the equivalent to the gross value of the car's deployment per annum. Observe the balance sheet below in Figure 24.2: <?page no="299"?> Berkau: Basics of Accounting 6e 24-299 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 56,000.00 Owners' capital (15,400.00) Intangibles Drawing 0.00 Financial assets Current assets Liabilities Inventory Interest bear liab Accounts receivables 12,600.00 Accounts payables 84,000.00 Prepaid expenses Provisions Cash/ Bank 0.00 Total assets 68,600.00 Total equity and liab. 68,600.00 STATEMENT of FINANCIAL POSITION as at 31.12.20X0 Figure 24.2: Balance sheet of a company when using a car 50 % privately On the balance sheet, the item for property, plant, equipment is the business car after depreciation: 70,000 - 14,000 = 56,000.00 EUR. The receivables are linked to the remainder of the VAT claim amounting to: 14,000 - 1,400 = 12,600.00 EUR. The value for cash/ bank is negative 84,000.00 EUR resulting from the acquisition of the car. The negative cash/ bank balance is disclosed as a short-term liability as a bank overdraft means debts. The equity is amounting to negative depreciation to an extent of 50 % and the drawing: -7,000 - 8,400 = (15,400.00 EUR). Next, we discuss drawings by the case of VANGUARD: 24.7 C/ S T.L. vanGuard VANGUARD is established in 20X5 by its owner T.L. vanGuard. VANGUARD is privately-owned. All company assets come from T.L. vanGuard. Profit earned with the company will increase T.L. van- Guard’s fortune. Accordingly, he has to submit a private income statement to the revenue service. He must declare the company profit as his own one. Income taxes are based on T.L. VanGuard’s individual tax rate. The company VANGUARD (to be more precise: T.L. VanGuard) is registered for VAT reduction. On 2.01.20X5, T.L. vanGuard opens a bank account in the name of his company and deposits 60,000.00 EUR as his investment. T.L. vanGuard is personally reliable for the bank account. The firm VANGUARD is a pie baking and selling business. The company is located in a shopping mall. The business concept is baking and selling pies (different fillings: steak & kidney, chicken & mushroom, etc.). VANGUARD operates a pie oven and a heater lamp. The shop is rented. On 31.12.20X8, VANGUARD presents the statement of financial position as in Figure 24.3. At that time, the company is 1 year old. Following national lay, VANGUARD must prepare commercial financial statements, although it is not a limited company. <?page no="300"?> Berkau: Basics of Accounting 6e 24-300 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 54,000.00 Owner's capital 100,000.00 Intangibles Financial assets Current assets Liabilities Inventory 10,000.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 36,000.00 100,000.00 100,000.00 VANGUARD STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 24.3: VANGUARD’s statement of financial position No issued capital is disclosed on VANGUARD’s statement of financial position. There was no issue of shares at the time of incorporation. Hence, we refer to the equity as owner’s capital. With a partnership, we would write “owners’ capital” in order to indicate that there is more than one owner. The initial contribution of T.L. vanGuard of 60,000.00 EUR is no share capital but a transfer of his private assets to his company. The owner’s equity is increased by profits in 20X8 and now equals 100,000.00 EUR. For our Bookkeeping records, we transfer the opening amounts (OV = opening values) for 20X9 to the company’s accounts, observe Figure 24.4: D C D C OV 90,000.00 OV 36,000.00 D C D C OV 10,000.00 OV 36,000.00 D C D C OV 60,000.00 OV 40,000.00 Property, plant, equipment PPE Accumulated depreciation ACC Owner's capital OWN Retained earnings R/ E Inventories INV Cash/ Bank C/ B Figure 24.4: VANGUARD’s accounts <?page no="301"?> Berkau: Basics of Accounting 6e 24-301 The oven and the heat lamp were bought at 90,000.00 EUR cost of acquisition (together). The annual depreciation expenses are 9,000.00 EUR/ m. VANGUARD’s landlord is registered for VAT reduction. Therefore, we must consider VAT for rental payments. The annual rent is 30,000.00 EUR/ a (net amount). The full rent is paid by bank transfer on 7.01.20X9. The gross amount is: 30,000 × 120% = 3 36,000.00 EUR. (2) Rent payment on 7.01.20X9. DR Rent......................... 30,000.00 EUR DR VAT.......................... 6,000.00 EUR CR Cash/ Bank.................... 36,000.00 EUR VANGUARD further purchases materials as puff pastry and pie fillings. The material expenses are 55,200.00 EUR (ex VAT). The purchase is paid by bank transfer on 9.01.20X9 and is amounting to: 55,200 × 120% = 6 66,240.00 EUR. (3) Purchase of materials on 9.01.20X9 DR Purchase..................... 55,200.00 EUR DR VAT.......................... 11,040.00 EUR CR Cash/ Bank.................... 66,240.00 EUR The shop assistant earns 28,800.00 EUR/ a. This amount includes pay-roll taxes and social securities contribution. The amount is paid on 15.01.20X9 by bank transfer in advance for the full year. (4) Labour payment on 15.01.20X9. Observe the simplified Bookkeeping entry and check labour Accounting in chapter (19). DR Labour....................... 28,800.00 EUR CR Cash/ Bank.................... 28,800.00 EUR VANGUARD bakes all pies regardless of the filling at 2.00 EUR/ u cost of manufacturing. These costs do not contain the salary for the shop assistant. Selling expenses in general are non-manufacturing expenses. The net selling price per pie is 3.50 EUR/ u. The gross amount is 3.50 × 120% = 44.20 EUR/ u. Per year, VANGUARD sells 48,960 pies. All customers pay on cash as VANGUARD does not offer a credit card service. The simplified Bookkeeping entry for the revenue is made on 30.06.20X9 for the annual amount (simplification for this case study). The gross amount of cash receipts is: 48,960 × 3.50 × 120% = 2 205,632.00 EUR. (5) Revenue recognition for all pie sales on 30.06.20X9. The net amount gives: 205,632 / 120% = 1 171,360.00 EUR. <?page no="302"?> Berkau: Basics of Accounting 6e 24-302 DR Cash/ Bank.................... 205,632.00 EUR CR VAT.......................... 34,272.00 EUR CR Sales........................ 171,360.00 EUR On 1.07.20X9, T.L. VanGuard withdraws money from the company. He pays himself 30,000.00 EUR every 6 months. The withdrawal of cash is no expense of the company. It is not recorded through profit or loss. We apply the Drawings account. (6) Drawing of 30,000.00 EUR on 1.07.20X9. DR Drawings..................... 30,000.00 EUR CR Cash/ Bank.................... 30,000.00 EUR On 31.12.20X9, VANGUARD records depreciation. The amount is 9,000.00 EUR/ a. The cost of acquisition (net amount) for the oven and the heat lamp are 90,000.00 EUR and their useful life is 10 years. Straight-line method applies. (7) Depreciation expenses as recorded on 31.12.20X9: DR Depreciation................. 9,000.00 EUR CR Accumulated Depreciation..... 9,000.00 EUR T.L. vanGuard likes his own pies and eats 4 pies per day himself. He works in the shop for 260 days/ a. Hence, he eats: 4 × 260 = 1 1,040 pies per Accounting period. All costs for pie baking are VATable. The appliances (oven and lamp), ingredients and rent are subjected to input-VAT. Although depreciation is not VATable, the adjustment requires reducing the input- VAT claim on the kitchen appliances bought by T.L. VanGuard. 7 Labour for the shop assistant is not relevant for the pies. Sales and distribution costs never are part of cost of manufacturing. The unit costs per pie are 2.00 EUR/ u. The expenses for the pies consumed by the owner are: 260 × 4 × 2 = 2,080.00 EUR. We consider a credit entry in the VAT account to reduce the amount of input-VAT paid on acquisition, purchase and rent. Therefore, gross 7 We would not record that in a real business as the self-consumption is low, however, we explain here for teaching purposes. amount for the pies eaten by T.L. van- Guard is: 2,080 × 120% = 2 2,496.00 EUR. Note, that we do not calculate the VAT based on the sales price but on the cost of manufacturing. For the drawing Bookkeeping entry, VANGUARD calculates its pies (We know the unit cost already: 2.00 EUR/ u). The costs of baking pies contain: depreciation on oven and heat lamp, materials and rent: 9,000 + 61,000 + 30,000 = 100,000.00 EUR. 8 The company sells every year 48,960 pies and T.L. van- Guard eats 1,040 ones. The total production amount is: 48,969 + 1,040 = 50,000 pies. This gives: 100,000 / 50,000 = 22.00 EUR/ pie. The materials amount is not the same as purchases, because VANGUARD had an amount of 10,000.00 EUR in the Inven- 8 61,000.00 EUR for materials is given. <?page no="303"?> Berkau: Basics of Accounting 6e 24-303 tory account at the beginning of the Accounting period. Check the balance sheet in Figure 24.3. A calculation 9 is required for the valuation of drawings when withdrawing finished goods. Recording the drawing considers the gross value of the cost of manufacturing for the withdrawn pies at 2,496.00 EUR. The amount of input-VAT is to be reduced by: 1,040 × 2 × 20% = 4 416.00 EUR. VANGUARD also reduces the expenses for the 1,040 eaten pies. The single adjustments are for depreciation: 1,040 × 9,000 / 50,000 = 1 187.20 EUR; for materials: 1,040 × 61,000 / 50,000 = 1 1,268.80 EUR and for rent: 1,040 × 30,000 / 50,000 = 6 624.00 EUR. VANGUARD reduces the costs of manufacturing to an extent of: 187.20 + 1,268.80 + 624 = 2,080.00 EUR. (8) Bookkeeping entry for taking-out pies on 31.12.20X9. DR Drawings..................... 2,496.00 EUR CR VAT.......................... 416.00 EUR CR Depreciation ................. 187.20 EUR CR Materials.................... 1,268.80 EUR CR Rent......................... 624.00 EUR At the end of the year, T.L. VanGuard withdraws another 30,000.00 EUR. (9) Drawing of 30,000.00 EUR on 31.12.20X9: DR Drawings..................... 30,000.00 EUR CR Cash/ Bank.................... 30,000.00 EUR We check VANGUARD’s accounts: D C D C OV 90,000.00 c/ d 90,000.00 OV 36,000.00 b/ d 90,000.00 c/ d 45,000.00 (7) 9,000.00 45,000.00 45,000.00 b/ d 45,000.00 Property, plant, equipment PPE Accumulated depreciation ACC D C D C OV 10,000.00 OV 36,000.00 (1) 12,000.00 (5) 205,632.00 (2) 36,000.00 (3) 66,240.00 (4) 28,800.00 (6) 30,000.00 (9) 30,000.00 c/ d 38,592.00 241,632.00 241,632.00 b/ d 38,592.00 Inventories INV Cash/ Bank C/ B Figure 24.5: VANGUARD’s accounts 9 Check chapter (25) in this textbook. <?page no="304"?> Berkau: Basics of Accounting 6e 24-304 D C D C (8) 1,268.80 (2) 30,000.00 (8) 624.00 c/ d 29,376.00 30,000.00 30,000.00 b/ d 29,376.00 D C D C (2) 6,000.00 (5) 34,272.00 (3) 55,200.00 c/ d 55,200.00 (3) 11,040.00 (8) 416.00 b/ d 55,200.00 c/ d 17,648.00 34,688.00 34,688.00 b/ d 17,648.00 Rent-20X9 RNT Value added tax VAT Purchase-20X9 PUR Material expenses-20X9 MAT D C D C (4) 28,800.00 c/ d 28,800.00 c/ d 171,360.00 (5) 171,360.00 b/ d 28,800.00 b/ d 171,360.00 Labour-20X9 LAB Sales-20X9 REV D C D C (6) 30,000.00 (7) 9,000.00 (8) 187.20 (8) 2,496.00 c/ d 8,812.80 (9) 30,000.00 c/ d 62,496.00 9,000.00 9,000.00 62,496.00 62,496.00 b/ d 8,812.80 b/ d 62,496.00 Drawings Drw Depreciation-20X9 DPR D C c/ d 100,000.00 OV 100,000.00 b/ d 100,000.00 Owner's capital OWN Figure 24.5: VANGUARD’s accounts (continued) The material expenses might require explanation. As VANGUARD applies a periodic inventory system, material expenses are only calculated after stock taking. That calculation is discussed below. So far, we only made an adjustment on the credit side for the material expenses of 1,040 pies to the extent of 2,496.00 EUR. See below the profit calculation at VANGUARD: VANGUARD takes stock. The value of materials left on stock is 4,200.00 EUR. <?page no="305"?> Berkau: Basics of Accounting 6e 24-305 The amount was expected as there was an opening value of 10,000.00 EUR and VANGUARD made purchases for 55,200.00 EUR. We know already that the materials are 61,000.00 EUR. Hence, the closing stock gives: 10,000 + 55,200 - 61,000 = 4 4,200.00 EUR. To calculate profit easily, VANGUARD applies a Trading account as we introduced in chapter (22). The profit is calculated in 2 steps. At first, we determine sales and the material expenses. Materials are calculated by a comparison of available and closing stock which gives the gross profit. Therefrom we deduct further expenses, like rent, depreciation etc., to calculate the profit. No company taxes must be recorded for a privatelyowned business. Note, that we do not prepare a Retained Earnings account but make all entries in the Owner’s Capital account. D C D C OV 90,000.00 c/ d 90,000.00 OV 36,000.00 b/ d 90,000.00 c/ d 45,000.00 (7) 9,000.00 45,000.00 45,000.00 b/ d 45,000.00 D C D C OV 10,000.00 T/ A 10,000.00 OV 36,000.00 (2) 36,000.00 T/ A 4,200.00 c/ d 4,200.00 (5) 205,632.00 (3) 66,240.00 14,200.00 14,200.00 (4) 28,800.00 b/ d 4,200.00 (6) 30,000.00 (9) 30,000.00 c/ d 50,592.00 241,632.00 241,632.00 b/ d 50,592.00 Inventories INV Cash/ Bank C/ B Property, plant, equipment PPE Accumulated depreciation D C D C (3) 55,200.00 c/ d 55,200.00 (2) 30,000.00 (8) 624.00 b/ d 55,200.00 T/ A 55,200.00 c/ d 29,376.00 30,000.00 30,000.00 b/ d 29,376.00 P&L 29,376.00 D C D C (2) 6,000.00 (5) 34,272.00 T/ A 1,268.80 (8) 1,268.80 (3) 11,040.00 (8) 416.00 c/ d 17,648.00 34,688.00 34,688.00 b/ d 17,648.00 Purchase-20X9 PUR Rent-20X9 RNT Value added tax VAT Materials-20X9 MAT Figure 24.6: VANGUARD’s accounts <?page no="306"?> Berkau: Basics of Accounting 6e 24-306 D C D C (4) 28,800.00 c/ d 28,800.00 c/ d 171,360.00 (5) 171,360.00 b/ d 28,800.00 P&L 28,800.00 T/ A 171,360.00 b/ d 171,360.00 D C D C (6) 30,000.00 (7) 9,000.00 (8) 187.20 (8) 2,496.00 c/ d 8,812.80 (9) 30,000.00 c/ d 62,496.00 9,000.00 9,000.00 62,496.00 62,496.00 b/ d 8,812.80 P&L 8,812.80 b/ d 62,496.00 D C D C INV 10,000.00 REV 171,360.00 DPR 8,812.80 T/ A 111,628.80 PUR 55,200.00 INV 4,200.00 LAB 28,800.00 GP 111,628.80 MAT 1,268.80 RNT 29,376.00 176,828.80 176,828.80 NP 44,640.00 P&L 111,628.80 b/ d 111,628.80 111,628.80 111,628.80 OWN 44,640.00 b/ d 44,640.00 44,640.00 44,640.00 Drawings DRW Depreciation-20X9 DPR Labour-20X9 LAB Sales-20X9 REV Trading account-20X9 T/ A Profit and Loss-20X9 P&L D C OV 100,000.00 c/ d 144,640.00 P&L 44,640.00 144,640.00 144,640.00 b/ d 144,640.00 Owner's capital OWN Figure 24.6: VANGUARD’s accounts (continued) VANGUARD’s financial statements are displayed in Figure 24.7 and Figure 24.8: The income statement is free of expenses for T.L. vanGuard’s drawings (money and eaten pies). Observe below: <?page no="307"?> Berkau: Basics of Accounting 6e 24-307 [EUR] Revenue 171,360.00 Other income 171,360.00 Materials (59,731.20) Labour (28,800.00) Depreciation (8,812.80) Other expenses (29,376.00) Earnings before int and taxes (EBIT) 44,640.00 Interest Earnings before taxes (EBT) 44,640.00 Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) 44,640.00 Vanguard STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X9 Figure 24.7: VANGUARD’s income statement The amount for materials on the income statement equals: 61,000 - 1,268.80 = 59,731.20 EUR. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 45,000.00 Owner's capital 144,640.00 Intangibles Drawings (62,496.00) Financial assets Current assets Liabilities Inventory 4,200.00 Interest bear liab A/ R A/ P 17,648.00 Prepaid expenses Provisions Cash/ Bank 50,592.00 99,792.00 99,792.00 VANGUARD STATEMENT of FINANCIAL POSITION as at 1.01.20X9 Figure 24.8: VANGUARD’s statement of financial position Although, drawings represent an item of the equity section, companies offset drawings from owners’ capital. Therefore, they only recognise one item for <?page no="308"?> Berkau: Basics of Accounting 6e 24-308 owner’s capital: 144,640 - 62,496 = 882,144.00 EUR. Next, we cover a case study about a partnership. The company is a law firm, and all its partners are attorneys working for it. Besides of the partners, the law firm employs other attorneys. We explain the difference between partners and employees and show how to make Bookkeeping entries for an employee appointed as a partner. 24.8 C/ S PAROW HOUTBANK The law firm PAROW HOUTBANK is a partnership. Each founding partner (there are 4) contributes 250,000.00 EUR/ partner on 1.01.20X7. Although the partners provide money, the company’s liability is not limited to its equity. Legally all partners are jointly responsible for the firm. (1) The establishment of the firm is recorded in the Cash/ Bank and Owners’ Capital account. The amount is: 4 × 250,000 = 1 1,000,000.00 EUR. DR Cash/ Bank.................... 1,000,000.00 EUR CR Owners’ Capital.............. 1,000,000.00 EUR The law firm PAROW HOUTBANK employs 10 attorneys and 5 paralegals. The attorneys earn 60,000.00 EUR/ a as regular (non-partner) attorneys. 4 of the attorneys are partners. Those do not receive salary payments but are entitled to withdraw from the company’s profit. They pay taxes on the entire profit (together) regardless of whether they withdraw or not at an equal share. The annual salary of a paralegal is 30,000.00 EUR/ a. All labour costs include payrolltax and social securities contributions. In 20X7, PAROW HOUTBANK appoints one of their employed attorneys as a partner. It is agreed that he contributes 250,000.00 EUR on 30.06.20X7. Upon that day, his remuneration is based on the law firm’s profit. The distribution of profits and taxation thereof is based on the equity portion held of the company. It is equal to the founding partners and in 20X7 proportionate to the time of partnership. Hence, the new appointed partner earns half of the profit in comparison to the founding partners in 20X7 and pays 1/ 9 of the taxes accordingly. Although he now is a partner, he got paid his salary for the first half of the Accounting period 20X7. The total labour payment for the company is recorded as Bookkeeping entry (2) on 30.06.20X7. The amount for labour is: (6 - 0.5) × 60,000 + 5 × 30,000 = 480,000.00 EUR. The factor 0.5 considers the appointment in the new partner and takes his salary for the period July - December 20X7 out of the equation. DR Labour....................... 480,000.00 EUR CR Cash/ Bank.................... 480,000.00 EUR PAROW HOUTBANK rents offices in an office block. The monthly rent for the furnished offices is 12,000.00 EUR/ m and is paid one month in advance. The rent for January 20X7 is paid on 2.01.20X7. Rent is not VATable. Rent is recorded as Bookkeeping entry (3) and (4) on 31.12.20X7. The latter one is for <?page no="309"?> Berkau: Basics of Accounting 6e 24-309 the prepayment. The rental payment covers 13 months: 13 × 12,000 = 1 156,000.00 EUR. The rent for January 20X8 of 12,000.00 EUR is accrued. DR Rent......................... 156,000.00 EUR CR Cash/ Bank.................... 156,000.00 EUR DR Prepaid Expenses............. 12,000.00 EUR CR Rent......................... 12,000.00 EUR PAROW HOUTBANK pays for office materials every year 24,000.00 EUR/ a. The price includes VAT at a VAT rate of 20 %. The material expenses are recorded as Bookkeeping entry (5) on 31.12.20X7. DR Office Materials............. 20,000.00 EUR DR VAT.......................... 4,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR In 20X7, PAROW HOUTBANK works on 2,000 cases and earns per case a fee of 1,200.00 EUR/ case including output- VAT. On average, the 90 % of the bills are paid instantly by the clients. The remainder is expected to be received in 20X8. Overdue payments are recorded as receivables. The proceeds are: 2,000 × 1,200 = 2 2,400,000.00 EUR. The cash receipts thereof are: 90% × 2,400,000 = 2,160,000.00 EUR. DR Cash/ Bank.................... 2,160,000.00 EUR DR Accounts Receivables......... 240,000.00 EUR CR VAT.......................... 400,000.00 EUR CR Revenue...................... 2,000,000.00 EUR On 31.12.20X7, the 4 founding partners withdraw an amount of 200,000.00 EUR/ partner and the new partner gets 100,000.00 EUR. The drawings of the partners are recorded as one Bookkeeping entry (7) to the extent of: 4.5 × 200,000 = 900,000.00 EUR. They have no impact on the profit calculation as they do not count as expenses. The Drawings account is closed-off to the Owners‘ Capital account later. DR Drawings..................... 900,000.00 EUR CR Cash/ Bank.................... 900,000.00 EUR On 1.07.20X7, the Accountant of PAROW HOUTBANK records the contribution of the new partner to the extent of 250,000.00 EUR. <?page no="310"?> Berkau: Basics of Accounting 6e 24-310 DR Cash/ Bank.................... 250,000.00 EUR CR Owners’ Equity............... 250,000.00 EUR Observe the accounts in Figure 24.9: D C D C (1) 1,000,000.00 (2) 480,000.00 DRW 900,000.00 (1) 1,000,000.00 (6) 2,160,000.00 (3) 156,000.00 (8) 250,000.00 (8) 250,000.00 (5) 24,000.00 c/ d 1,706,000.00 P&L 1,356,000.00 (7) 900,000.00 2,606,000.00 2,606,000.00 c/ d 1,850,000.00 b/ d 1,706,000.00 3,410,000.00 3,410,000.00 b/ d 1,850,000.00 D C D C (2) 480,000.00 P&L 480,000.00 (3) 156,000.00 (4) 12,000.00 P&L 144,000.00 156,000.00 156,000.00 D C D C (4) 12,000.00 c/ d 12,000.00 P&L 2,000,000.00 (6) 2,000,000.00 b/ d 12,000.00 D C D C (6) 240,000.00 c/ d 240,000.00 (5) 4,000.00 (6) 400,000.00 b/ d 240,000.00 c/ d 396,000.00 400,000.00 400,000.00 b/ d 396,000.00 D C D C (5) 20,000.00 P&L 20,000.00 (7) 900,000.00 OWN 900,000.00 Office materials-20X7 MAT Drawings DRW Prepaid expenses PRE Revenue-20X7 REV Accounts receivables A/ R Value added tax VAT Cash/ Bank C/ B Owners' capital OWN Labour-20X7 LAB Rent-20X7 RNT D C LAB 480,000.00 REV 2,000,000.00 RNT 144,000.00 MAT 20,000.00 NP 1,356,000.00 2,000,000.00 2,000,000.00 OWN 1,356,000.00 b/ d 1,356,000.00 Profit and Loss Figure 24.9: PAROW HOUTBANK’s accounts <?page no="311"?> Berkau: Basics of Accounting 6e 24-311 The balancing figures of the real accounts are transferred to the balance sheet. This is shown in Figure 24.10. A C, L Non-current assets [EUR] Equity [EUR] P, P, E Owners' cap 1,706,000.00 Intangibles Financial assets Current assets Liabilities Inventory Interest bear liab A/ R 240,000.00 A/ P 396,000.00 Prepaid expenses 12,000.00 Provisions Cash/ Bank 1,850,000.00 2,102,000.00 2,102,000.00 Parow Houtbank STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 24.10: PAROW HOUTBANK’s statement of financial position The income statement for PAROW HOUTBANK is disclosed in Figure 24.11. There is no item for income taxes, as PAROW HOUTBANK is no taxpayer. The firm is no legal entity. However, the partners pay taxes based on their share and calculated with their individual income tax rates. PAROW HOUTBANK’s memorandum of incorporation states all partners receive an equal share of the profit and per rate regarding the duration of partnership during the Accounting period. Therefore, the new partner earns half of the profit of the founding partners’ one. The profit calculation does not depend on the drawings. The profit on the statement of comprehensive income counts. It is: 1,356,000.00 EUR in total. The share of the founding partners equals: 1,356,000 / 4.5 = 3 301,333.33 EUR. The profit of the new partner is: 301,333.33 / 2 = 150,666.67 EUR. <?page no="312"?> Berkau: Basics of Accounting 6e 24-312 [EUR] Revenue 2,000,000.00 Other income 2,000,000.00 Materials (20,000.00) Labour (480,000.00) Depreciation 0.00 Other expenses (144,000.00) Profit before int 1,356,000.00 Interest 0.00 Profit 1,356,000.00 Parow Houtbank STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 24.11: PAROW HOUTBANK’s statement of comprehensive income The income tax calculation is based on progressive tax rates. A person earning high profits pays based on higher tax rates than low-level income taxpayers. See below the outcome of the tax progression system for PAROW HOUTBANK’s partners: For the case study PAROW HOUTBANK, we simplify the tax scheme and assume the following tax rates: For incomes from 0.00 to 20,000.00 EUR, no taxes are paid. For income from 20,001.00 to 30,000.00 EUR the tax rate is 20 %, for income from 30,001.00 to 40,000.00 EUR the tax rate is 25 %, for income from 40,001.00 to 50,000.00 EUR the tax rate is 30 %, for income from 50,001.00 to 60,000.00 EUR the tax rate is 35 %, and for income that exceeds 60,001.00 EUR the top tax rate of 40 % applies. Each founding partner pays taxes as: 20,000 × 0 + 10,000 × 20% + 10,000 × 25% + 10,000 × 30% + 10,000 × 35% + (301,333.33 - 60,001) × 40% = 107,532.93 EUR. The average tax rate per founding partner equals: 107,532.93 / 301,333.33 = 3 35.69%. The fresh partner’s taxes are based on his income of 60,000 + 150,666.67 = 210,666.67 EUR. His income taxes are: 20,000 × 0 + 10,000 × 20% + 10,000 × 25% + 10,000 × 30% + 10,000 × 35% + (210,666.67 - 60,001) × 40% = 71,266.27 EUR. His average tax rate equals: 71,266.27 / 210,666.67 = 33.83%. 24.9 Summary Withdrawing assets from a business is referred to as a drawing. Drawings must be separated from expenses. Drawings do not change a company’s profit. In the event of assets other than cash are taken out, input-VAT is to be adjusted to the extent of goods/ services withdrawn - if material. The Drawings account get closed-off to the Owners’ Capital account. <?page no="313"?> Berkau: Basics of Accounting 6e 24-313 Financial statements for privatelyowned business are similar to those of limited companies. In contrast, their equity section only contains the item owners’ equity. No income taxes are disclosed on the statement of financial position nor on the statement of profit or loss and other comprehensive income. Income taxes are paid by the owners based on their personal income tax rate. For financing the taxation of profits, drawings must be made. 24.10 Working Definitions Drawing: A drawing is taking out assets (e.g., materials or cash) of a business or to use business assets for private purposes. Privately-owned Business: A privately-owned business is either a sole proprietorship or a partnership. 24.11 Question Bank (1) Which statement is correct? 1. A drawing is an expense for the company. 2. A drawing is a reduction of a privately-owned company’s equity. 3. A drawing is a withdrawal from the company’s bank account. 4. Using company assets is not a drawing. (2) A company buys a business car at costs of acquisition of 96,000.00 EUR. The amount is the gross amount. Depreciation follows straight-line method over 4 years - no residual value is to be considered. The owner uses the car privately to an extent of 40 %. Which Bookkeeping entry is correct? 1. DR DRW 12,000.00 EUR; CR DPR 12,000.00 EUR. 2. DR DPR 8,000.00 EUR; CR DRW 8,000.00 EUR. 3. DR DRW 8,000.00 EUR; CR DPR 8,000.00 EUR. 4. DR DRW 8,000.00 EUR; CR ACC 8,000.00 EUR. (3) On 1.10.20X4, a partnership with a book value of 1,200,000.00 EUR makes one of its employees who earns a salary of 90,000.00 EUR/ a partner. She becomes the 6 th partner of the firm and pays a contribution of 240,000.00 EUR. During the Accounting period 20X4, the distributable profit is 540,000.00 EUR. How much is the income for the fresh partner if the partners withdraw per time and share? 1. 108,000.00 EUR . 2. 93,214.29 EUR . 3. 180,000.00 EUR . 4. 90,000.00 EUR . (4) What is the difference of a balance sheet for a privately-owned company to the one of a limited company? 1. Legal form in the header, equity must show drawings. 2. Legal form in the header, no income tax liabilities. 3. Nothing. 4. Taxes are deducted from equity by the weighted average income tax rate of the owners. <?page no="314"?> Berkau: Basics of Accounting 6e 24-314 (5) Who is liable for a partnership’s debts? 1. The partnership only. 2. All partners to the extent of their ownership. 3. All partners jointly. 4. The founding partners. 24.12 Solutions 1-2; 2-3; 3-2; 4-2; 5-3. . <?page no="315"?> Berkau: Basics of Accounting 6e 25-315 25 Production Firms 25.1 What is in the Chapter? In production firms, Accounting must also record and valuate the manufacturing process. Materials and Overheads are consumed to produce finished goods. In preparation of Manufacturing Accounting, that is covered in the textbook Management Accounting in detail, we introduce in this chapter the fundamentals of how to calculate products and how to make Bookkeeping records for manufacturing. We introduce the Work-in-Process account and demonstrate the calculation of unit costs of manufacturing. What is missing in this chapter? We skip aspects of overhead application and keep the explanation of the Manufacturing Overheads accounts short. This is possible by a one single job order consideration for the case study REGENT BIKE (Pty) Ltd. That way, we pretend that overheads, like rent, can be recorded as direct costs of manufacturing. Study the details of Manufacturing Accounting in the textbook Management Accounting, chapters (18) and (19). 25.2 Learning Objectives After studying this chapter, you understand how to record the movements of materials/ goods in a factory and how to allocate manufacturing overheads to products. You further know how to calculate the cost of manufacturing per unit. You are aware, that at the end of the Accounting period, every production firm must recognise the value of finished goods and work-in-process on its balance sheet as current assets. You learn about the inventory valuation of finished goods in this chapter and understand the cost flow in production firms. 25.3 Inventory Valuation and Recording For the valuation of assets, we must distinguish goods that have been produced in the company and those that are bought from other ones. In general, we assume non-current assets are bought from other companies. Therefore, any non-current asset is recognised at cost of acquisition less accumulated depreciation and accumulated impairment loss. In some cases, revaluations apply. In contrast, the costs for an asset produced in a factory are to be disclosed at costs of manufacturing. The costs of manufacturing contain direct costs, like materials and labour, and portions of manufacturing overheads. All costs linked to the production process, like materials, labour, depreciation on production facilities, supervisor’s salary etc., fall under costs of manufacturing. Costs not linked to production, like administration and sales-and-distribution-costs, cannot be considered for the calculation of products. The costs of conversion are all cost of manufacturing except of materials. They include direct labour and manufacturing overheads. In production firms, at least 3 kind of stock accounts apply: raw materials, <?page no="316"?> Berkau: Basics of Accounting 6e 25-316 work-in-process and finished goods. The material flow is: raw materials → work-in-process → finished goods. Purchases are debited straight to the Raw Material Inventory account. Once materials are released from stock, because they are consumed in the production process, we add them to the job order. A job order is an internal order in a factory and is linked to a product. We gather all costs of manufacturing for a product in its Job Order account. Once the job order is finished, it contains the total of costs of manufacturing on its debit side. The reconciliation account for all job orders in a factory is called Work-inprocess WIP account - it represents the value of all products under production. We name the account for a specific job order WIP account and add the job order number thereto as a suffix. Hence, the job order 90684 is recorded in the WIP-90684 account. We debit WIP accounts for direct costs and for applied overheads. Overheads are costs we cannot allocate to products directly, like depreciation, supervisor’s salary etc. At first, we assign all production related overheads to manufacturing departments and thereafter we allocate them to job orders based on the consumption of resources. This way, the overhead application charges job orders for their consumption of resources in departments. In general, an overhead allocation rate is calculated in advance and applies for the allocation of actual overheads. 10 After the completion of the manufacturing process, all costs are found on the debit side of the job order account. The finished goods are added to stock. We close-off WIP-XXX account to the Finished Goods Inventory account. When a company sells its finished goods, it releases them from stock (credit entry in the Finished Goods Inventory account) and records an expense. The expense account is the Cost of Sales COS account also called Cost of Goods Sold COS account. The cost of sales/ cost of goods sold are the expenses for all products sold based on their cost of manufacturing. At the end of the Accounting period, all Cost of Goods Sold accounts are closed-off to the Profit and Loss account. The field in Accounting that deals with the calculation in production firms is called Manufacturing Accounting. It is linked to Financial Accounting (for inventory valuation) as well as to Management Accounting. How it is Done (To Expense Finished Goods): (1) Assign purchases to an Inventory account. Best is to apply a Raw Materials Inventory account subordinated to the Inventory account. (2) When a job order requests a release from stock assign the materials to its job order. Make a debit 10 In this chapter, we simplify the overhead allocation. It is covered in the textbook Bilanzen/ Financial Statements in chapter (9) and in Management Accounting in chapters (18) and (19). <?page no="317"?> Berkau: Basics of Accounting 6e 25-317 entry in the Job Order account and credit the amount to the Raw Materials Inventory account. Call the Job Order XXX account WIP-XXX account. (3) Assign further expenses to the job order. Do that either directly or by overhead allocation. Other expenses can be direct labour, depreciation, material overheads etc. (4) Once a job order is completed, add the goods manufactured to the Finished Goods Inventory account. Close-off the job order account (WIP-XXX account) to the Finished Goods Inventory account. (5) Consider a sale of finished goods as expense. Debit the amount to the Cost of Sales (COS) account. (6) Close-off the Cost of Sales account to the Profit and Loss account for profit calculation. We explain the basic Bookkeeping entries in this chapter by the case study REGENT BIKE (Pty) Ltd. 25.4 C/ S REGENT BIKE (Pty) Ltd. REGENT BIKE (Pty) Ltd. is a bicycle assembling firm. The company is established on 2.01.20X2 when the proprietors (all together) pay 50,000.00 EUR into the company’s bank account. (1) Establishment of the company on 2.01.20X2. DR Cash/ Bank.................... 50,000.00 EUR CR Issued Capital............... 50,000.00 EUR REGENT BIKE (Pty) Ltd. registers for VAT reduction. REGENT BIKE (Pty) Ltd. rents a workshop at 1,000.00 EUR/ m and pays rent in advance for the entire year on 2.01.20X2. Rent is not VATable for REGENT BIKE (Pty) Ltd. The rent is paid by bank transfer into the landlord’s bank account. (2) Rent payment on 2.01.20X2. DR Rent......................... 12,000.00 EUR CR Cash/ Bank.................... 12,000.00 EUR On 3.01.20X2, REGENT BIKE (Pty) Ltd. buys 40,000 wheels at 21.00 EUR/ u (net amount) each. Furthermore, REGENT BIKE (Pty) Ltd. buys 30,000 frames at 56.00 EUR/ u (net amount) each. The net amount for all purchases is: 40,000 × 21 + 30,000 × 56 = 2 2,520,000.00 EUR. The amount including VAT is: 2,520,000 × 120% = 33,024,000.00 EUR. REGENT BIKE (Pty) Ltd. pays the full prices into the suppliers’ bank accounts. (3) Purchase of wheels and frames on 3.01.20X2. <?page no="318"?> Berkau: Basics of Accounting 6e 25-318 DR Purchase..................... 2,520,000.00 EUR DR VAT.......................... 504,000.00 EUR CR Cash/ Bank.................... 3,024,000.00 EUR The purchases are transferred to the Raw Materials Inventory account. REGENT BIKE (Pty) Ltd. applies special Inventory accounts: for raw materials, for WIP and for finished goods. (4) Adding materials to the Raw Materials Inventory account on 3.01.20X2. DR Raw Materials Inventory...... 2,520,000.00 EUR CR Purchase..................... 2,520,000.00 EUR REGENT BIKE (Pty) Ltd. pays salaries for its assembling team. Labour contains payroll tax and social securities contributions and is amounting to 96,000.00 EUR/ a. REGENT BIKE (Pty) Ltd. records the payment in the middle of the year. 11 (5) Payment for labour on 1.07.20X2. DR Labour....................... 96,000.00 EUR CR Cash/ Bank.................... 96,000.00 EUR In 20X2, REGENT BIKE (Pty) Ltd. produces 20,000 bicycles. All Bookkeeping entries for production are debited to the WIP account. Labour is 96,000.00 EUR; rent 12 is 12,000.00 EUR. We consider 40,000 wheels and 20,000 frames as material expenses. The total of materials is: 40,000 × 21 + 20,000 × 56 = 1 1,960,000.00 EUR. Note, there are materials left on stock. (6) Production of 20,000 bicycles as recorded in the WIP account, on 2.02.20X2. DR WIP.......................... 2,068,000.00 EUR CR Raw Materials................ 1,960,000.00 EUR CR Labour....................... 96,000.00 EUR CR Rent......................... 12,000.00 EUR All bicycles are finished on 4.12.20X2 and added to inventory. This means the bicycles are physically taken into the storage room and recorded in the Finished Goods Inventory account. (7) Completion of 20,000 bicycles on 4.12.20X2. DR Finished Goods Inventory..... 2,068,000.00 EUR CR WIP.......................... 2,068,000.00 EUR 11 This is a simplification. 12 As there is only one job order in this case, we can consider rent as direct costs (simplification). <?page no="319"?> Berkau: Basics of Accounting 6e 25-319 The calculation of unit costs for a bicycle requires dividing all cost of manufacturing by the lot size. T The lot size is the number of goods manufactured by one job order. Here, the unit costs are: 2,068,000 / 20,000 = 1 103.40 EUR/ u. During the Christmas sale, REGENT BIKE (Pty) Ltd. sells 17,500 bicycles at a net selling price of 200.00 EUR/ u to a wholesaler on cash. The net amount is: 17,500 × 200 = 3 3,500,000.00 EUR. The gross amount equals: 3,500,000 × 120% = 4,200,000.00 EUR. (8) Sale of 17,500 bicycles on 6.12.20X2. DR Cash/ Bank.................... 4,200,000.00 EUR CR VAT.......................... 700,000.00 EUR CR Sales........................ 3,500,000.00 EUR The previous Bookkeeping entry only considers the payments received for the sale. No costs of sales have been recorded yet. Next, we must record the material flows for the bicycles when delivered to customers. We make a debit entry in the Cost of Goods Sold account. The credit entry is recorded in the Finished Goods Inventory account (stock release). The valuation of the inventory movements is at unit costs of 103.40 EUR/ u. The total costs of sales are: 103.40 × 17,500 = 1,809,500.00 EUR. (9) Releasing 17,500 bicycles from stock on 6.12.20X4. DR Cost of Goods Sold (COS)..... 1,809,500.00 EUR CR Finished Goods Inventory..... 1,809,500.00 EUR The cost for distribution and for administration are amounting to 10,000.00 EUR/ a and 30,000.00 EUR/ a, respectively. They fall under non-manufacturing costs. We cannot add them to workin-process. (10), (11) Distribution and administration expenses recorded on 31.12.20X2. DR Distribution ................. 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR DR Administration............... 30,000.00 EUR CR Cash/ Bank.................... 30,000.00 EUR Before we calculate REGENT BIKE (Pty) Ltd.’s profit, we check the accounts. Observe Figure 25.1. <?page no="320"?> Berkau: Basics of Accounting 6e 25-320 D C D C (1) 50,000.00 (2) 12,000.00 c/ d 50,000.00 (1) 50,000.00 (8) 4,200,000.00 (3) 3,024,000.00 b/ d 50,000.00 (5) 96,000.00 (10) 10,000.00 (11) 30,000.00 c/ d 1,078,000.00 4,250,000.00 4,250,000.00 b/ d 1,078,000.00 D C D C (2) 12,000.00 (6) 12,000.00 (3) 2,520,000.00 (4) 2,520,000.00 Rent-20X2 RNT Purchase-20X2 PUR Cash/ Bank C/ B Issued capital ISS D C D C (3) 504,000.00 (8) 700,000.00 (4) 2,520,000.00 (6) 1,960,000.00 c/ d 196,000.00 c/ d 560,000.00 700,000.00 700,000.00 2,520,000.00 2,520,000.00 b/ d 196,000.00 b/ d 560,000.00 Value added tax VAT Raw materials inventory RMI D C D C (5) 96,000.00 (6) 96,000.00 (6) 2,068,000.00 (7) 2,068,000.00 D C D C (7) 2,068,000.00 (9) 1,809,500.00 (8) 3,500,000.00 c/ d 258,500.00 2,068,000.00 2,068,000.00 b/ d 258,500.00 D C D C (10) 10,000.00 (11) 30,000.00 D C (9) 1,809,500.00 Distribution-20X2 DIS Administration-20X2 ADM Finished goods inventory FGI Sales Revenue-20X2 REV Cost of goods sold-20X2 COS Labour-20X1 LAB Work-in-process WIP Figure 25.1: REGENT BIKE (Pty) Ltd.’s accounts <?page no="321"?> Berkau: Basics of Accounting 6e 25-321 Some of the accounts have been balanced-off already. Here, we do not take stock as all inventory movements have been recorded by the Accounting system already. The closing stock of the raw materials inventories is 560,000.00 EUR. This amount represents 10,000 frames left on stock: 10,000 × 56 = 5 560,000.00 EUR. The balancing figure in the Cost of Goods Sold (COS) account results from 2,500 bicycles at their unit costs of manufacturing: 2,500 × 103.40 = 2 258,500.00 EUR. Next, we close-off the Cost of Goods Sold (COS) account to the Profit and Loss account. In the Profit and Loss account, the pretax profit is calculated by deducting costs of goods sold (COS), distribution costs and administration costs from revenues: 3,500,000 - 1,809,500 - 10,000 - 30,000 = 1 1,650,500.00 EUR. A company that applies the Cost of Goods Sold (COS) account presents its income statement in the cost of sales format - check Figure 25.3. See the profit calculation as described above in Figure 25.2: D C D C (1) 50,000.00 (2) 12,000.00 c/ d 50,000.00 (1) 50,000.00 (8) 4,200,000.00 (3) 3,024,000.00 b/ d 50,000.00 (5) 96,000.00 (10) 10,000.00 (11) 30,000.00 c/ d 1,078,000.00 4,250,000.00 4,250,000.00 b/ d 1,078,000.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 12,000.00 (6) 12,000.00 (3) 2,520,000.00 (4) 2,520,000.00 D C D C (3) 504,000.00 (8) 700,000.00 (4) 2,520,000.00 (6) 1,960,000.00 c/ d 196,000.00 c/ d 560,000.00 700,000.00 700,000.00 2,520,000.00 2,520,000.00 b/ d 196,000.00 b/ d 560,000.00 D C D C (5) 96,000.00 (6) 96,000.00 (6) 2,068,000.00 (7) 2,068,000.00 Value added tax VAT Raw materials inventory RMI Labour-20X2 LAB Work-in-process WIP Rent-20X2 RNT Purchase-20X2 PUR Figure 25.2: REGENT BIKES (Pty) Ltd.’s accounts <?page no="322"?> Berkau: Basics of Accounting 6e 25-322 D C D C (7) 2,068,000.00 (9) 1,809,500.00 P&L 3,500,000.00 (8) 3,500,000.00 c/ d 258,500.00 2,068,000.00 2,068,000.00 b/ d 258,500.00 D C D C (10) 10,000.00 c/ d 10,000.00 (11) 30,000.00 c/ d 30,000.00 b/ d 10,000.00 P&L 10,000.00 b/ d 30,000.00 P&L 30,000.00 Finished goods inventory FGI Sales Revenue-20X2 REV Administration-20X2 ADM Distribution-20X2 DIS D C D C (9) 1,809,500.00 P&L 1,809,500.00 COS 1,809,500.00 REV 3,500,000.00 c/ d 1,690,500.00 3,500,000.00 3,500,000.00 DIS 10,000.00 b/ d 1,690,500.00 ADM 30,000.00 EBT 1,650,500.00 1,690,500.00 1,690,500.00 R/ E 1,155,350.00 b/ d 1,650,500.00 ITL 495,150.00 1,650,500.00 1,650,500.00 Cost of goods sold-20X2 COS Profit and Loss-20X2 P&L D C D C c/ d 1,155,350.00 P&L 1,155,350.00 c/ d 495,150.00 P&L 495,150.00 b/ d 1,155,350.00 b/ d 495,150.00 Retained earnings R/ E Income tax liabilities ITL Figure 25.2: REGENT BIKE (Pty) Ltd.’s accounts (continued) The financial statements for REGENT BIKE (Pty) Ltd. follow, see Figure 25.3 and Figure 25.4: <?page no="323"?> Berkau: Basics of Accounting 6e 25-323 [EUR] Revenue 3,500,000.00 Other income 3,500,000.00 Cost of goods sold (1,809,500.00) Margin 1,690,500.00 Distribution (10,000.00) Administration (30,000.00) Earnings before int and taxes (EBIT) 1,650,500.00 Interest Earnings before taxes (EBT) 1,650,500.00 Income tax expenses (495,150.00) Deferred taxes Earnings after taxes (EAT) 1,155,350.00 Regent Bike (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X2 Figure 25.3: REGENT BIKE (Pty) Ltd.’s income statement The valuation of inventories on the balance sheet results from raw materials and finished goods: 560,000 + 258,500 = 818,500.00 EUR. A C, L Non-current assets [EUR] Equity [EUR] P, P, E Issued capital 50,000.00 Intangibles Reserves Financial assets R/ E 1,155,350.00 Current assets Liabilities Inventory 818,500.00 Interest bear liab A/ R A/ P 196,000.00 Prepaid expenses Provisions Cash/ Bank 1,078,000.00 Tax liabilities 495,150.00 1,896,500.00 1,896,500.00 Regent Bikes (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X2 Figure 25.4: REGENT BIKES (Pty) Ltd.’s statement of financial position <?page no="324"?> Berkau: Basics of Accounting 6e 25-324 25.5 Summary In a production firm, we must consider the manufacturing process. We apply the Work-in-Process account for job orders and the Manufacturing Overheads account for indirect costs and their allocation to job orders. Production firms apply three special Inventory accounts: Raw Materials Inventory account, Work-in-process account and a Finished Goods Inventory account. Cost for the goods still in the manufacturing process are represented by the WIP account until the production process is completed. Once production is completed, the costs are added to the Finished Goods Inventory account. Finished goods are expensed, once they are sold. For expensing finished goods, the Cost of Goods Sold (COS) account is debited and Finished Goods Inventory account is credited. The calculation of goods manufactured is based on the Work-in-Process account. The field that deals with the recording and valuation of finished goods is called Manufacturing Accounting. 25.6 Working Definitions Costs of Manufacturing: The costs of manufacturing contain direct costs, such as materials and labour, and portions of overheads for resources deployed in the manufacturing process. Costs of Conversion: The costs of conversion are all cost of manufacturing except of materials. Job Order: A job order is an internal order in a factory and is linked to a product. WIP account: The reconciliation account for all job orders is the Work-inprocess WIP account - it represents the value of all products under production. Cost of Sales/ Cost of Goods Sold: The cost of sales/ cost of goods sold are the expenses for all products sold based on their cost of manufacturing. Lot Size: The lot size is the number of goods manufactured by one job order. Overheads: Overheads are costs we cannot allocate to products directly, like depreciation, supervisor’s salary etc. 25.7 Question Bank (1) A company records WIP to an extent of 130,000.00 EUR labour and 60,000.00 EUR materials and adds 45,000.00 EUR depreciation. The lot size is 10,000 units. 500 units are faulty and casted away. How much are the unit cost of manufacturing? 1. 20.00 EUR . 2. 19.00 EUR . 3. 23.50 EUR . 4. 22.38 EUR . (2) What are items to be added to a WIP account? 1. Direct labour, indirect labour, direct materials. 2. Direct labour, direct materials. 3. Depreciation, direct labour, direct materials. 4. Administration, direct materials, depreciation. (3) Which Bookkeeping entry assigns costs to a job order correctly? 1. DR LAB; CR WIP. 2. DR WIP; CR LAB, CR ADM. <?page no="325"?> Berkau: Basics of Accounting 6e 25-325 3. DR WIP; CR LAB, CR DPR. 4. DR WIP; CR LAB, CR MAT. (4) A company records 100,000.00 EUR labour and 50,000.00 EUR materials for a job order. The administration expenses are 5,000.00 EUR. The company produces 1,000 products and sells half thereof at a net selling price of 200 EUR/ u. How much is the pre-tax profit? 1. 22,500.00 EUR . 2. 20,000.00 EUR . 3. 25,000.00 EUR . 4. 27,500.00 EUR . (5) Which statement is wrong? 1. Manufacturing Accounting helps to calculate goods. 2. Manufacturing Accounting adds direct costs to job orders. 3. Manufacturing Accounting supports the valuation of inventories or finished goods. 4. Manufacturing Accounting allocates direct costs and general costs of administration to products. 25.8 Solutions 1-3; 2-2; 3-4; 4-2; 5-4. <?page no="326"?> Berkau: Basics of Accounting 6e 26-326 26 Inventory Systems 26.1 What is in the Chapter? In this chapter, we discuss 2 approaches of how to record inventory movements in trading and production firms. We discuss the periodic system and the perpetual system by the same case study WITSAND (Pty) Ltd. which is a seller for beds. We stress the differences between the inventory movement systems and teach which one is appropriate for a certain situation. 26.2 Learning Objectives After studying this chapter, you can record inventory movements following the periodic and the perpetual system. You can decide which inventory movement system is appropriate for a certain situation. 26.3 Recall of the Periodic Inventory System For the calculation of gross profit in a trading business, we applied the Purchase account and closed it off to the Trading account at the end of the Accounting period. We computed the material expenses as opening value of the inventories plus all purchases and deducted closing stock and returns inwards. To determine the closing value of inventories, a company must take stock. The fact that stock taking only happens at the end of the Accounting period gives the inventory movement system its name: periodic system. A periodic inventory system records material consumption based on debit entries for opening values and for purchases and deducts closing stock. It requires stock taking at the end of the Accounting period. Find below a How-it-is-Done paragraph to recall the steps of gross profit calculation based on a periodic inventory system. How it is Done (Periodic Inventory System): (1) Prepare Inventory accounts for particular kind of stock like materials, work-in-process and finished goods. Distinguish inventory accounts according to the kind of stock, e.g., for different materials e.g. (2) The opening amount of inventory must be transferred to the debit side of the Trading account. (3) Record all purchases (net amounts) and transfer them to the Trading account’s debit side at the end of the Accounting period. Credit the Purchases account accordingly. (4) Do not make Bookkeeping entries for stock releases (materials, finished goods). <?page no="327"?> Berkau: Basics of Accounting 6e 26-327 (5) Take stock as part of the adjustments. Record them on the balance sheet date. Credit the closing stock in the Trading account and make a debit entry in the various Inventory accounts if you distinguish stock accounts according to different materials. Calculate material expenses by deducting closing stock from the total of opening inventory values plus purchases. Consider returns outwards, if required. (6) Consider special situations for disposals, impairment losses, value adjustments, discounts etc. regarding inventory. (7) Calculate the gross profit by deducting material expenses from revenues. The recording with a periodic inventory system is simple. Instead of recording stock releases we consider the closing stock that is calculated once per year. However, the simplicity of the calculation is a trade-off for the poor information obtained about actual stock levels. With a periodic system for inventory movements in use, companies only know their stock at the beginning and at the end of the Accounting period. Many companies need to know the current level of their goods/ materials at real-time. E.g., a wine seller needs to know the number of South African Pinotage bottles available for sale to decide when to re-order bottles from its supplier. For that reason, most of the companies prefer the perpetual inventory system. 26.4 Perpetual Inventory System With a perpetual inventory system in use, we must record stock releases. This gives us more Bookkeeping work but we gain permanent information about the inventory levels. When we shop in a department store, we can observe that the shops operate scanners at their cash points. The scanners or bar code readers make the cashiers’ lives more comfortable because they do not have to learn and key in the prices. However, the main reason for the scanner or barcode reader application is that the goods sold get identified and counted. Therefore, not only the price is captured but also the stock release of goods is recorded and used to calculate inventory levels and cost of goods sold. At the same time as the cashier scans the product, a debit entry is initiated in the Cost of Goods Sold account. A perpetual inventory system records inventory movements in real-time, based on stock inputs and stock releases. With a perpetual inventory system, no stock taking is necessary anymore. Nowadays, most companies apply the perpetual inventory system at least for their important goods/ materials. Only less important inventory movements, like for office materials, are still recorded following the periodic system. As you will see a company can apply a perpetual system parallel to a periodic system, e.g., uses the perpetual system <?page no="328"?> Berkau: Basics of Accounting 6e 26-328 for certain goods and the periodic system for other ones. Find below a How-it-is-Done section that helps you to record inventory movements following the perpetual system. How it is Done (Perpetual Inventory System): (1) Prepare Inventory accounts for particular kind of stock like materials, work-in-process and finished goods. Distinguish inventory accounts according to the kind of stock, e.g., for different materials e.g. (2) The opening value of inventory is disclosed on the debit side of the Inventory account. (3) Debit all purchases (net amounts) to the Inventory account instantly. Credit the Purchases account accordingly. (It is fine to skip the Purchase account and e.g., make a Bookkeeping entry: DR Inventories, DR VAT - CR Cash/ Bank.) (4) For releases from stock (materials, finished goods) make a debit entry in the Material Expense account or in the Cost of Goods Sold (COS) account and credit the amount to the relevant Inventory account. Note that this Bookkeeping entry is based on the cost of purchase/ manufacturing. (5) To know the stock level at any time, balance-off the Inventory account. (6) When preparing financial statements on the balance sheet date, balance-off all Inventory accounts and disclose the total of all stock levels (for different goods) under the inventory item on the balance sheet. (7) Consider special situations that might occur, like disposals, impairment losses, value adjustments, discounts etc. (8) Calculate the gross profit by deducting material expenses from revenues. Next, we study the case of the furniture dealer WITSAND (Pty) Ltd. At first, we cover the periodic system and thereafter we repeat the case study for the perpetual inventory system. 26.5 C/ S WITSAND (Pty) Ltd. - Periodic Inventory System WITSAND (Pty) Ltd. is a bed store. It sells various kind of beds: double beds (160 × 200), queen size beds (140 × 200), single beds (90 × 200) and cots (80 × 150). The purchase prices (net amounts) for the beds are: 200.00 EUR/ u for a double bed, 190.00 EUR/ u for a queen size bed, <?page no="329"?> Berkau: Basics of Accounting 6e 26-329 180.00 EUR/ u for a single bed and 150.00 EUR/ u for a cot. At the beginning of the Accounting period 20X3, WITSAND (Pty) Ltd. has 3 double beds and 14 cots on stock. The opening value for inventories is amounting to: 3 × 200 + 14 × 150 = 2 2,700.00 EUR. Check the inventory item on the opening statement of financial position for WITSAND (Pty) Ltd. in Figure 26.1. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 25,000.00 Issued capital 50,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 2,700.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 22,300.00 Tax liabilities 50,000.00 50,000.00 Witsand (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X3 Figure 26.1: WITSAND (Pty) Ltd.’s statement of financial position At first, we transfer the values disclosed on the balance sheet to the accounts - observe Figure 26.2. The Inventory account shows the value of all beds on stock, no matter what kind of bed. Note, that we apply a single Inventory account for all beds together for the periodic system only. D C D C OV 25,000.00 OV 2,700.00 Property, plant, equipment PPE Inventory INV D C D C OV 22,300.00 OV 50,000.00 Cash/ Bank C/ B Issued capital ISS Figure 26.2: WITSAND (Pty) Ltd.’s accounts WITSAND (Pty) Ltd. purchases beds in January (4.01.20X3). It buys 15 double beds at costs of purchase of 200.00 EUR/ u, 20 queen size beds at 190.00 EUR/ u, 30 single beds at 180.00 EUR/ u and 25 cots at 150.00 EUR/ u. All prices are net amounts. The payments are made by bank transfer. <?page no="330"?> Berkau: Basics of Accounting 6e 26-330 (1) Purchase of 15 double beds on 4.01.20X3 at cost of purchase of: 15 × 200 = 3 3,000.00 EUR. DR Purchase..................... 3,000.00 EUR DR VAT.......................... 600.00 EUR CR Cash/ Bank.................... 3,600.00 EUR (2) Purchase of 20 queen size beds on 4.01.20X3 at cost of purchase of: 20 × 190 = 3 3,800.00 EUR. DR Purchase..................... 3,800.00 EUR DR VAT.......................... 760.00 EUR CR Cash/ Bank.................... 4,560.00 EUR (3) Purchase of 30 single beds on 4.01.20X3 at cost of purchase of: 30 × 180 = 5 5,400.00 EUR. DR Purchase..................... 5,400.00 EUR DR VAT.......................... 1,080.00 EUR CR Cash/ Bank.................... 6,480.00 EUR (4) Purchase of 25 cots on 4.01.20X3 at cost of purchase of: 25 × 150 = 3 3,750.00 EUR. DR Purchase..................... 3,750.00 EUR DR VAT.......................... 750.00 EUR CR Cash/ Bank.................... 4,500.00 EUR Next, we record sales. The net selling prices at WITSAND (Pty) Ltd. are as below: double bed: 350.00 EUR/ u, queen size bed: 300.00 EUR/ u, single bed 250.00 EUR/ u, cot 200.00 EUR/ u. On 8.01.20X3, WITSAND (Pty) Ltd. sells 2 double beds, 5 queen size beds and 10 cots on cash. The Bookkeeping entries are as below: (5) Sale of 2 double beds, 5 queen size beds and 10 cots on 8.01.20X3 at a net selling price of: 2 × 350 + 5 × 300 + 10 × 200 = 4 4,200.00 EUR. The gross amount thereof equals: 4,200 × 120% = 5 5,040.00 EUR. As we apply a periodic inventory system, only the payment is recorded. <?page no="331"?> Berkau: Basics of Accounting 6e 26-331 DR Cash/ Bank.................... 5,040.00 EUR CR VAT.......................... 840.00 EUR CR Sales........................ 4,200.00 EUR On 9.02.20X3, WITSAND (Pty) Ltd. sells 8 double beds, 7 queen size beds and 15 single beds at a net selling price of: 8 × 350 + 7 × 300 + 15 × 250 = 8 8,650.00 EUR. The gross amount is: 8,650 × 120% = 10,380.00 EUR. (6) Sale of beds on 9.02.20X3. DR Cash/ Bank.................... 10,380.00 EUR CR VAT.......................... 1,730.00 EUR CR Sales........................ 8,650.00 EUR On 7.03.20X3, WITSAND (Pty) Ltd. orders 20 double beds and pays 240.00 EUR/ u (gross amount) on cash. The total net amount of the purchases is: 20 × 240/ 120% = 4 4,000.00 EUR. The gross amount equals: 4,000 × 120% = 4,800.00 EUR. (7) Purchase of 20 double beds on 7.03.20X3. DR Purchase..................... 4,000.00 EUR DR VAT.......................... 800.00 EUR CR Cash/ Bank.................... 4,800.00 EUR On 9.07.20X3, WITSAND (Pty) Ltd. sells 24 double beds, 8 queen size beds, 5 single beds and 29 cots on cash. The net selling price is: 24 × 350 + 8 × 300 + 5 × 250 + 29 × 200 = 1 17,850.00 EUR. The gross amount equals: 17,850 × 120% = 21,420.00 EUR. (8) Sale of beds on 9.07.20X3. DR Cash/ Bank.................... 21,420.00 EUR DR VAT.......................... 3,570.00 EUR CR Sales........................ 17,850.00 EUR We only consider rent for operational expenses at WITSAND (Pty) Ltd.: the company pays 2,000.00 EUR rent per bank transfer. Rent is not VATable for this case study. (9) Rent for the shop (31.12.20X3). DR Rent......................... 2,000.00 EUR CR Cash/ Bank.................... 2,000.00 EUR Next, we balance-off all accounts, see Figure 26.3. <?page no="332"?> Berkau: Basics of Accounting 6e 26-332 D C D C OV 25,000.00 c/ d 25,000.00 OV 2,700.00 c/ d 2,700.00 b/ d 25,000.00 b/ d 2,700.00 D C D C OV 22,300.00 (1) 3,600.00 c/ d 50,000.00 OV 50,000.00 (5) 5,040.00 (2) 4,560.00 b/ d 50,000.00 (6) 10,380.00 (3) 6,480.00 (8) 21,420.00 (4) 4,500.00 (7) 4,800.00 (9) 2,000.00 c/ d 33,200.00 59,140.00 59,140.00 b/ d 33,200.00 Property, plant, equipment PPE Inventory INV Cash/ Bank C/ B Issued capital ISS D C D C (1) 600.00 (5) 840.00 (1) 3,000.00 (2) 760.00 (6) 1,730.00 (2) 3,800.00 (3) 1,080.00 (8) 3,570.00 (3) 5,400.00 (4) 750.00 (4) 3,750.00 (7) 800.00 (7) 4,000.00 c/ d 19,950.00 c/ d 2,150.00 19,950.00 19,950.00 6,140.00 6,140.00 b/ d 19,950.00 b/ d 2,150.00 D C D C (5) 4,200.00 (9) 2,000.00 c/ d 2,000.00 (6) 8,650.00 b/ d 2,000.00 c/ d 30,700.00 (8) 17,850.00 30,700.00 30,700.00 b/ d 30,700.00 Value added tax VAT Purchase-20X3 PUR Sales Revenue-20X3 REV Rent-20X3 RNT Figure 26.3: WITSAND (Pty) Ltd.’s accounts Although the accounts are balanced-off, the balancing figure of the Inventory account shows still the opening value as at the beginning of the Accounting period: 2,700.00 EUR. At the end of the Accounting period 20X3, WITSAND (Pty) Ltd. takes stock. This is required when applying a periodic inventory system. It reveals that there are still: 3 + 15 - 2 - 8 + 20 - 24 = 4 4 double beds on stock. There are: 20 - 5 - 7 - 8 = 00 queen size beds left. The number of single beds is: 30 - 15 - 5 = 10 single beds and there are no cots left: 14 + 25 - 10 - 29 = 0 0 cots. As a result, the closing stock’s value is: 4 × 200 + 10 × 180 = 2 2,600.00 EUR. <?page no="333"?> Berkau: Basics of Accounting 6e 26-333 WITSAND (Pty) Ltd. calculates its gross profit in the Trading account. The opening values of inventory, all purchases and the closing stock are transferred to the Trading account. These figures are required to calculate material expenses. Furthermore, the Sales account is closed-off to the Trading account. DR T/ A .......................... 2,700.00 EUR CR Inventory.................... 2,700.00 EUR DR T/ A .......................... 19,950.00 EUR CR Purchase..................... 19,950.00 EUR DR Inventory.................... 2,600.00 EUR CR T/ A .......................... 2,600.00 EUR The latter Bookkeeping entry is based on stock taking. The next Bookkeeping entry transfers the sales to the Trading account. We close-off the Sales account to the Trading account. DR Sales........................ 30,700.00 EUR CR T/ A .......................... 30,700.00 EUR The gross profit at WITSAND (Pty) Ltd. is: 30,700 + 2,600 - 2,700 - 19,950 = 110,650.00 EUR. This amount is transferred to the Profit and Loss account by closing-off the Trading account thereto. DR T/ A .......................... 10,650.00 EUR CR Profit and Loss.............. 10,650.00 EUR The Rent account is closed-off to the Profit and Loss account, too. Rent is no inventory movement and for that reason irrelevant for the gross profit calculation. DR Profit and Loss.............. 2,000.00 EUR CR Rent......................... 2,000.00 EUR The earnings before taxes are: 10,650 - 2,000 = 8 8,650.00 EUR. The amount for income taxes is: 8,650 × 30% = 2 2,595.00 EUR and for retained earnings we calculate: 8,650 - 2,595 = 6 6,055.00 EUR. The amounts are transferred to the Income Tax Liability account and to the Retained Earnings account. <?page no="334"?> Berkau: Basics of Accounting 6e 26-334 DR P&L-ACCOUNT.................. 2,595.00 EUR CR Income Tax Liabilities....... 2,595.00 EUR DR P&L-ACCOUNT.................. 6,055.00 EUR CR Retained Earnings............ 6,055.00 EUR Observe the accounts Figure 26.4. D C D C OV 25,000.00 c/ d 25,000.00 OV 2,700.00 c/ d 2,700.00 b/ d 25,000.00 b/ d 2,700.00 T/ A 2,700.00 T/ A 2,600.00 c/ d 2,600.00 5,300.00 5,300.00 b/ d 2,600.00 Property, plant, equipment PPE Inventory INV D C D C OV 22,300.00 (1) 3,600.00 c/ d 50,000.00 OV 50,000.00 (5) 5,040.00 (2) 4,560.00 b/ d 50,000.00 (6) 10,380.00 (3) 6,480.00 (8) 21,420.00 (4) 4,500.00 (7) 4,800.00 (9) 2,000.00 c/ d 33,200.00 59,140.00 59,140.00 b/ d 33,200.00 Cash/ Bank C/ B Issued capital ISS D C D C (1) 600.00 (5) 840.00 (1) 3,000.00 (2) 760.00 (6) 1,730.00 (2) 3,800.00 (3) 1,080.00 (8) 3,570.00 (3) 5,400.00 (4) 750.00 (4) 3,750.00 (7) 800.00 (7) 4,000.00 c/ d 19,950.00 c/ d 2,150.00 19,950.00 19,950.00 6,140.00 6,140.00 b/ d 19,950.00 T/ A 19,950.00 b/ d 2,150.00 D C D C (5) 4,200.00 (9) 2,000.00 c/ d 2,000.00 (6) 8,650.00 b/ d 2,000.00 P&L 2,000.00 c/ d 30,700.00 (8) 17,850.00 30,700.00 30,700.00 T/ A 30,700.00 b/ d 30,700.00 Value added tax VAT Purchase-20X3 PUR Sales Revenue-20X3 REV Rent-20X3 RNT Figure 26.4: WITSAND (Pty) Ltd.’s accounts <?page no="335"?> Berkau: Basics of Accounting 6e 26-335 D C D C INV 2,700.00 Rev 30,700.00 RNT 2,000.00 T/ A 10,650.00 PUR 19,950.00 Inv 2,600.00 EBT 8,650.00 GP 10,650.00 10,650.00 10,650.00 33,300.00 33,300.00 ITL 2,595.00 b/ d 8,650.00 P&L 10,650.00 b/ d 10,650.00 R/ E 6,055.00 8,650.00 8,650.00 Trading account-20X3 T/ A Profit and Loss-20X3 P&L D C D C c/ d 2,595.00 P&L 2,595.00 c/ d 6,055.00 P&L 6,055.00 b/ d 2,595.00 b/ d 6,055.00 Income tax liabilities ITL Retained earnings R/ E Figure 26.4: WITSAND (Pty) Ltd.’s accounts (continued) Observe the financial statements as at 31.12.20X3 for WITSAND (Pty) Ltd. in Figure 26.5 and Figure 26.6. The amount for payables on the statement of financial position results from VAT payables. It is the amount output-VAT exceeds input-VAT: 6,140 - 3,990 = 2,150.00 EUR. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 25,000.00 Issued capital 50,000.00 Intangibles Reserves Financial assets R/ E 6,055.00 Current assets Liabilities Inventory 2,600.00 Interest bear liab A/ R A/ P 2,150.00 Prepaid expenses Provisions Cash/ Bank 33,200.00 Tax liabilities 2,595.00 60,800.00 60,800.00 Witsands (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X3 Figure 26.5: WITSAND (Pty) Ltd.’s statement of financial position The statement of profit or loss and other comprehensive income shows material expenses resulting from the opening value of stock plus the purchases and less closing stock which gives: 2,700 + 19,950 - 2,600 = 2 20,050.00 EUR. <?page no="336"?> Berkau: Basics of Accounting 6e 26-336 [EUR] Revenue 30,700.00 Other income 30,700.00 Materials (20,050.00) Labour Depreciation Other expenses (2,000.00) Earnings before int and taxes (EBIT) 8,650.00 Interest 0.00 Earnings before taxes (EBT) 8,650.00 Income tax expenses (2,595.00) Deferred taxes Earnings after taxes (EAT) 6,055.00 Witsand (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 26.6: WITSAND (Pty) Ltd.’s income statement 26.6 C/ S WITSAND (Pty) Ltd. - Perpetual Inventory System When applying a perpetual inventory system, the Bookkeeping entries for material inputs remain the same. In contrast to a periodic inventory system, Bookkeeping entries for stock releases must be made. This tells us the levels of stock at any time. The number of the Bookkeeping entries increase for this case study WITSAND (Pty) Ltd due to the application of the perpetual inventory system. We identify Bookkeeping entries in this part of the case study by references in low letters. The accounts at the beginning of the Accounting period look like those in Figure 26.2. However, we now apply special accounts for the various bed types. With a perpetual inventory system, a splitting of the Inventory account makes more sense, because we want to know stock levels per goods, e.g., of queen size beds. WITSAND (Pty) Ltd. keeps an Inventory account for double beds, for queen size beds, for single beds and for cots. The opening values for double beds are: 3 × 200 = 600.00 EUR and for cots: 14 × 150 = 2,100.00 EUR. No other beds are on stock at the beginning of the Accounting period 20X3. <?page no="337"?> Berkau: Basics of Accounting 6e 26-337 D C D C OV 25,000.00 OV 600.00 D C D C OV 0.00 OV 0.00 Property, plant, equipment PPE Inventory double beds IDD Inventory queen size beds IQZ Inventory single beds ISB D C D C OV 2,100.00 OV 22,300.00 Inventory cots I-C Cash/ Bank C/ B D C OV 50,000.00 Issued capital ISS Figure 26.7: WITSAND (Pty) Ltd.’s accounts When recording inventory movements with a perpetual system, their amounts are either debited (additions) or credited (releases) to the Inventory accounts. Note, this gives two Bookkeeping entries per movement: A purchase is recorded in the Purchase account at first and thereafter it get transferred to the Inventory account. A sale is recorded as revenue recognition which is linked to the selling prices. A second Bookkeeping entry is made for the expenses which is recorded in the Cost of Goods Sold account with a credit entry made in inventories for the stock release. We repeat the case of WITSAND (Pty) Ltd. now applying the perpetual inventory system: WITSAND (Pty) Ltd. purchases 15 double beds at 200.00 EUR/ u, 20 queen size beds at 190.00 EUR/ u, 30 single beds at 180.00 EUR/ u and 25 cots at 150.00 EUR/ u. All amounts are net amounts. Payments are made by bank transfer. (a, b) Purchase of 15 double beds on 4.01.20X3 at a cost of purchase of: 15 × 200 = 3 3,000.00 EUR. DR Purchase..................... 3,000.00 EUR DR VAT.......................... 600.00 EUR CR Cash/ Bank.................... 3,600.00 EUR DR Inventory - Double Bed ....... 3,000.00 EUR CR Purchase..................... 3,000.00 EUR <?page no="338"?> Berkau: Basics of Accounting 6e 26-338 (c, d) Purchase of 20 queen size beds on 4.01.20X3 at a cost of purchase of: 20 × 190 = 3 3,800.00 EUR. DR Purchase..................... 3,800.00 EUR DR VAT.......................... 760.00 EUR CR Cash/ Bank.................... 4,560.00 EUR DR Inventory - Queen Size....... 3,800.00 EUR CR Purchase..................... 3,800.00 EUR (e, f) Purchase of 30 single beds on 4.01.20X3 at a cost of purchase of: 30 × 180 = 5 5,400.00 EUR. DR Purchase..................... 5,400.00 EUR DR VAT.......................... 1,080.00 EUR CR Cash/ Bank.................... 6,480.00 EUR DR Inventory - Single Bed....... 5,400.00 EUR CR Purchase..................... 5,400.00 EUR (g, h) Purchase of 25 cots on 4.01.20X3 at a cost of purchase of: 25 × 150 = 3,750.00 EUR. DR Purchase..................... 3,750.00 EUR DR VAT.......................... 750.00 EUR CR Cash/ Bank.................... 4,500.00 EUR DR Inventory - Cots............. 3,750.00 EUR CR Purchase..................... 3,750.00 EUR When selling the beds, WITSAND (Pty) Ltd. records the revenue recognition and the goods' expense. Accountants call the transfer of goods to the Cost of Goods Sold account “to expense goods”. The valuation for the inventory movements is at their costs of purchase (for traders). In a production firm, the valuation of products is based on costs of manufacturing, which contain direct costs, like materials and labour, and applied manufacturing overheads. Calculations as in chapter (25) apply. Next, we record the sales: On 8.01.20X3, WITSAND (Pty) Ltd. sells 2 double beds, 5 queen size beds and 10 cots on cash. The Bookkeeping entries are as below: (i, j) Sale of 2 double beds at a net selling price of: 2 × 350 = 7 700.00 EUR. The gross amount is: 700 × 120% = 8 840.00 EUR. The release of the 2 double beds from stock reduces inventories to an extent of: 2 × 200 = 4 400.00 EUR. We expense the amount, see below. <?page no="339"?> Berkau: Basics of Accounting 6e 26-339 DR Cash/ Bank.................... 840.00 EUR CR VAT.......................... 140.00 EUR CR Sales........................ 700.00 EUR DR Cost of Goods Sold........... 400.00 EUR CR Inventory - Double Bed ....... 400.00 EUR (k, l) Sale of 5 queen size beds at a net selling price of: 5 × 300 = 1 1,500.00 EUR on 8.01.20X3. The gross amount equals: 1,500 × 120% = 1 1,800.00 EUR. The release of 5 queen size beds reduces inventories to an extent of: 5 × 190 = 950.00 EUR. DR Cash/ Bank.................... 1,800.00 EUR CR VAT.......................... 300.00 EUR CR Sales........................ 1,500.00 EUR DR Cost of Goods Sold........... 950.00 EUR CR Inventory - Queen Size ....... 950.00 EUR (m, n) Sale of 10 cots on 8.01.20X3 at a net selling price of: 10 × 200 = 2 2,000.00 EUR: The gross amount equals: 2,000 × 120% = 2 2,400.00 EUR. The release of 10 cots from stock decreases inventories by: 10 × 150.00 EUR = 1 1,500.00 EUR. DR Cash/ Bank.................... 2,400.00 EUR CR VAT.......................... 400.00 EUR CR Sales........................ 2,000.00 EUR DR Cost of Goods Sold........... 1,500.00 EUR CR Inventory - Cots............. 1,500.00 EUR On 9.02.20X3, WITSAND (Pty) Ltd. sells 8 double beds, 7 queen size beds and 15 single beds. (o, p) Sale of 8 double beds on 9.02.20X3 at a net selling price of: 8 × 350 = 2,800.00 EUR. The gross amount equals: 2,800 × 120% = 3 3,360.00 EUR. The release of 8 double beds from stock results in a decrease of inventories of double beds to an extent of: 8 × 200.00 EUR = 1 1,600.00 EUR. DR Cash/ Bank.................... 3,360.00 EUR CR VAT.......................... 560.00 EUR CR Sales........................ 2,800.00 EUR DR Cost of Goods Sold........... 1,600.00 EUR CR Inventory - Double Bed ....... 1,600.00 EUR <?page no="340"?> Berkau: Basics of Accounting 6e 26-340 (q, r) Sale of 7 queen size beds on 9.02.20X3 at a net selling price of: 7 × 300 = 2 2,100.00 EUR. The gross amount is: 2,100 × 120% = 2 2,520.00 EUR. The release of 7 queen size beds from stock reduces inventories to an extent of: 7 × 190.00 EUR = 1 1,330.00 EUR. DR Cash/ Bank.................... 2,520.00 EUR CR VAT.......................... 420.00 EUR CR Sales........................ 2,100.00 EUR DR Cost of Goods Sold........... 1,330.00 EUR CR Inventory - Queen Size....... 1,330.00 EUR (s, t) Sale of 15 single beds on 9.02.20X3 at a net selling price of: 15 × 250 = 3,750.00 EUR. The gross amount equals: 3,750 × 120% = 4 4,500.00 EUR. The release of 15 single beds from stock reduces inventories by: 15 × 180.00 EUR = 22,700.00 EUR. DR Cash/ Bank.................... 4,500.00 EUR CR VAT.......................... 750.00 EUR CR Sales........................ 3,750.00 EUR DR Cost of Goods Sold........... 2,700.00 EUR CR Inventory - Single Bed....... 2,700.00 EUR At this stage, we want to know about all stock levels; we therefore balance-off the inventory accounts. Check Figure 26.8, in particular study the balancing figures of the Inventory accounts for the beds therein. D C D C OV 25,000.00 c/ d 25,000.00 OV 600.00 (j) 400.00 b/ d 25,000.00 (b) 3,000.00 (p) 1,600.00 c/ d 1,600.00 3,600.00 3,600.00 b/ d 1,600.00 D C D C OV 0.00 (l) 950.00 OV 0.00 (t) 2,700.00 (d) 3,800.00 (r) 1,330.00 (f) 5,400.00 c/ d 2,700.00 c/ d 1,520.00 5,400.00 5,400.00 3,800.00 3,800.00 b/ d 2,700.00 b/ d 1,520.00 Property, plant, equipment PPE Inventory double beds IDD Inventory queen size beds IQZ Inventory single beds ISB Figure 26.8: WITSAND (Pty) Ltd.’s accounts <?page no="341"?> Berkau: Basics of Accounting 6e 26-341 D C D C OV 0.00 (l) 950.00 OV 0.00 (t) 2,700.00 (d) 3,800.00 (r) 1,330.00 (f) 5,400.00 c/ d 2,700.00 c/ d 1,520.00 5,400.00 5,400.00 3,800.00 3,800.00 b/ d 2,700.00 b/ d 1,520.00 Inventory queen size Inventory single bed D C D C OV 2,100.00 (n) 1,500.00 OV 22,300.00 (a) 3,600.00 (h) 3,750.00 c/ d 4,350.00 (i) 840.00 (c) 4,560.00 5,850.00 5,850.00 (k) 1,800.00 (e) 6,480.00 b/ d 4,350.00 (m) 2,400.00 (g) 4,500.00 (o) 3,360.00 (q) 2,520.00 (s) 4,500.00 c/ d 18,580.00 37,720.00 37,720.00 b/ d 18,580.00 Inventory cots I-C Cash/ Bank C/ B D C D C c/ d 50,000.00 OV 50,000.00 (a) 3,000.00 (b) 3,000.00 b/ d 50,000.00 (c) 3,800.00 (d) 3,800.00 (e) 5,400.00 (f) 5,400.00 (g) 3,750.00 (h) 3,750.00 15,950.00 15,950.00 D C D C (a) 600.00 (i) 140.00 (i) 700.00 (c) 760.00 (k) 300.00 (k) 1,500.00 (e) 1,080.00 (m) 400.00 (m) 2,000.00 (g) 750.00 (o) 560.00 (o) 2,800.00 (q) 420.00 (q) 2,100.00 (s) 750.00 c/ d 12,850.00 (s) 3,750.00 c/ d 620.00 12,850.00 12,850.00 3,190.00 3,190.00 b/ d 12,850.00 b/ d 620.00 Value added tax VAT Sales Revevenue-20X3 REV Issued capital ISS Purchase-20X3 PUR D C (j) 400.00 (l) 950.00 (n) 1,500.00 (p) 1,600.00 (r) 1,330.00 (t) 2,700.00 c/ d 8,480.00 8,480.00 8,480.00 b/ d 8,480.00 Cost of goods sold-20X3 (COS) Figure 26.8: WITSAND (Pty) Ltd.’s accounts (continued) <?page no="342"?> Berkau: Basics of Accounting 6e 26-342 The balancing figures in the inventory accounts tell WITSAND (Pty) Ltd. about the values of beds on stock. In case of constant purchase costs, we can divide the values by the unit costs to calculate the number of goods. At WITSAND (Pty) Ltd.: 1,600/ 200 = 8 8 double beds, 1,520/ 190 = 8 8 queen size beds, 2,700/ 180 = 1 15 single beds and 4,350/ 150 = 2 29 cots are available for sale. The procedure of calculating the number of beds looks somehow clumsy. In the university, you can write the number of beds next to the values (recommended) e.g., in an exam. In the real business world, the information available from Accounting refers to valuations, e.g., 1,600.00 EUR for double beds. Note, in general, purchase prices vary if resulting from different purchases. However, Bookkeeping software records both, numbers and values, so the stock levels are known. At this time, WITSAND (Pty) Ltd.’s sales manager considers the stock level of double beds too low and orders further beds. On 7.03.20X3, WITSAND (Pty) Ltd. orders 20 double beds and pays the gross purchase price of 240.00 EUR/ u on cash. The total net amount of the purchase is: 20 × 200 = 4 4,000.00 EUR. The gross amount equals: 4,000 × 120% = 4 4,800.00 EUR. (u, v) Purchase of 20 double beds on 7.03.20X3. The new beds are added to stock. DR Purchase..................... 4,000.00 EUR DR VAT.......................... 800.00 EUR CR Cash/ Bank.................... 4,800.00 EUR DR Inventory - Double Bed....... 4,000.00 EUR CR Purchase..................... 4,000.00 EUR On 9.07.20X3, WITSAND (Pty) Ltd. sells 24 double beds, 8 queen size beds, 5 single beds and 29 cots on cash. (w, x) Sale of 24 double beds on 9.07.20X3 at a net selling price of: 24 × 350 = 8 8,400.00 EUR. The gross amount equals: 8,400 × 120% = 1 10,080.00 EUR. The release of 24 double beds from stock reduces inventories by: 24 × 200.00 EUR = 4 4,800.00 EUR. DR Cash/ Bank.................... 10,080.00 EUR CR VAT.......................... 1,680.00 EUR CR Sales........................ 8,400.00 EUR DR Cost of Goods Sold........... 4,800.00 EUR CR Inventory - Queen Size....... 4,800.00 EUR (y, z) Sale of 8 queen size beds on 9.07.20X3 at a net selling price of: 8 × 300 = 2 2,400.00 EUR. The gross amount equals: 2,400 × 120% = 2 2,880.00 EUR. The release of 8 queen size beds from stock reduces inventories to an extent of: 8 × 190.00 EUR = 1 1,520.00 EUR. <?page no="343"?> Berkau: Basics of Accounting 6e 26-343 DR Cash/ Bank.................... 2,880.00 EUR CR VAT.......................... 480.00 EUR CR Sales........................ 2,400.00 EUR DR Cost of Goods Sold........... 1,520.00 EUR CR Inventory - Queen Size ....... 1,520.00 EUR With the last Bookkeeping entry, all queen size beds are sold. The balancing figure in the Inventories of Queen Size Beds is zero. (Note, we continue Bookkeeping entry identification in capital letters.) (A, B) Sale of 5 single beds on 9.07.20X3 at a net selling price of: 5 × 250 = 11,250.00 EUR. The gross amount equals: 1,250 × 120% = 1 1,500.00 EUR. The release 5 single beds from stock reduces inventories by: 5 × 180.00 EUR = 9 900.00 EUR. DR Cash/ Bank.................... 1,500.00 EUR CR VAT.......................... 250.00 EUR CR Sales........................ 1,250.00 EUR DR Cost of Goods Sold........... 900.00 EUR CR Inventory - Queen Size ....... 900.00 EUR (C, D) Sale of 29 cots on 9.07.20X3 at a net selling price of: 29 × 200 = 5 5,800.00 EUR. The gross amount equals: 5,800 × 120% = 6 6,960.00 EUR. The release of 29 cots from stock reduces inventories to an extent of: 29 × 150.00 EUR = 4 4,350.00 EUR. DR Cash/ Bank.................... 6,960.00 EUR CR VAT.......................... 1,160.00 EUR CR Sales........................ 5,800.00 EUR DR Cost of Goods Sold........... 4,350.00 EUR CR Inventory - Cots............. 4,350.00 EUR By this Bookkeeping entry, the Inventory - Cots account is closed-off to the Cost of Goods sold COS account. This means its balancing figure is zero. WITSAND (Pty) Ltd. pays 2,000.00 EUR rent per bank transfer. (E) Rent on the shop (31.12.20X3) is recorded as adjustment. DR Rent......................... 2,000.00 EUR CR Cash/ Bank.................... 2,000.00 EUR Observe the balanced-off accounts in Figure 26.9. <?page no="344"?> Berkau: Basics of Accounting 6e 26-344 D C D C OV 25,000.00 c/ d 25,000.00 OV 600.00 (j) 400.00 b/ d 25,000.00 (b) 3,000.00 (p) 1,600.00 c/ d 1,600.00 3,600.00 3,600.00 b/ d 1,600.00 (x) 4,800.00 (v) 4,000.00 c/ d 800.00 5,600.00 5,600.00 b/ d 800.00 Property, plant, equipment PPE Inventory double beds IDD D C D C OV 0.00 (l) 950.00 OV 0.00 (t) 2,700.00 (d) 3,800.00 (r) 1,330.00 (f) 5,400.00 c/ d 2,700.00 c/ d 1,520.00 5,400.00 5,400.00 3,800.00 3,800.00 b/ d 2,700.00 (B) 900.00 b/ d 1,520.00 (z) 1,520.00 c/ d 1,800.00 2,700.00 2,700.00 b/ d 1,800.00 Inventory queen size beds IQZ Inventory single bed - ISB D C D C OV 2,100.00 (n) 1,500.00 OV 22,300.00 (a) 3,600.00 (h) 3,750.00 c/ d 4,350.00 (i) 840.00 (c) 4,560.00 5,850.00 5,850.00 (k) 1,800.00 (e) 6,480.00 b/ d 4,350.00 (D) 4,350.00 (m) 2,400.00 (g) 4,500.00 (o) 3,360.00 (q) 2,520.00 (s) 4,500.00 c/ d 18,580.00 37,720.00 37,720.00 b/ d 18,580.00 (u) 4,800.00 (w) 10,080.00 (E) 2,000.00 (y) 2,880.00 (A) 1,500.00 (C) 6,960.00 c/ d 33,200.00 40,000.00 40,000.00 b/ d 33,200.00 Inventory cots I-C Cash/ Bank C/ B D C D C c/ d 50,000.00 OV 50,000.00 (a) 3,000.00 (b) 3,000.00 b/ d 50,000.00 (c) 3,800.00 (d) 3,800.00 (e) 5,400.00 (f) 5,400.00 (g) 3,750.00 (h) 3,750.00 15,950.00 15,950.00 (u) 4,000.00 (v) 4,000.00 Issued capital ISS Purchase-20X3 PUR Figure 26.9: WITSAND (Pty) Ltd.’s accounts <?page no="345"?> Berkau: Basics of Accounting 6e 26-345 D C D C (a) 600.00 (i) 140.00 (i) 700.00 (c) 760.00 (k) 300.00 (k) 1,500.00 (e) 1,080.00 (m) 400.00 (m) 2,000.00 (g) 750.00 (o) 560.00 (o) 2,800.00 (q) 420.00 (q) 2,100.00 (s) 750.00 c/ d 12,850.00 (s) 3,750.00 c/ d 620.00 12,850.00 12,850.00 3,190.00 3,190.00 b/ d 12,850.00 b/ d 620.00 (w) 1,680.00 (w) 8,400.00 (u) 800.00 (y) 480.00 (y) 2,400.00 (A) 250.00 (A) 1,250.00 c/ d 2,150.00 (C) 1,160.00 c/ d 30,700.00 (C) 5,800.00 3,570.00 3,570.00 30,700.00 30,700.00 b/ d 2,150.00 b/ d 30,700.00 Value added tax VAT Sales Revenue-20X3 REV D C D C (j) 400.00 (E) 2,000.00 c/ d 2,000.00 (l) 950.00 b/ d 2,000.00 (n) 1,500.00 (p) 1,600.00 (r) 1,330.00 (t) 2,700.00 c/ d 8,480.00 8,480.00 8,480.00 b/ d 8,480.00 (x) 4,800.00 (z) 1,520.00 (B) 900.00 (D) 4,350.00 c/ d 20,050.00 20,050.00 20,050.00 b/ d 20,050.00 Cost of goods sold-20X3 COS Rent-20X3 RNT Figure 26.9: WITSAND (Pty) Ltd.’s accounts (continued) At the end of the Accounting period 20X3, WITSAND (Pty) Ltd. calculates gross profit in the Trading account. At first, we close-off the Cost of Goods Sold COS account to the Trading account. Then the Sales account get closed-off to the Trading account. DR T/ A .......................... 20,050.00 EUR CR Cost of Goods Sold........... 20,050.00 EUR DR Sales........................ 30,700.00 EUR CR T/ A .......................... 30,700.00 EUR <?page no="346"?> Berkau: Basics of Accounting 6e 26-346 The gross profit at WITSAND (Pty) Ltd. is: 30,700 - 20,050 = 1 10,650.00 EUR. This amount is transferred to the Profit and Loss account. We close-off the Trading account to profit and loss. DR T/ A.......................... 10,650.00 EUR CR Profit and Loss.............. 10,650.00 EUR Next, the Rent account is closed-off to the Profit and Loss account. DR Profit and Loss.............. 2,000.00 EUR CR Rent......................... 2,000.00 EUR The earnings before taxes are: 10,650 - 2,000 = 8 8,650.00 EUR. Income taxes are: 8,650 × 30% = 2 2,595.00 EUR. The annual surplus is: 8,650 - 2,595 = 6 6,055.00 EUR and gets transferred to the Retained Earnings account. DR P&L-ACCOUNT.................. 2,595.00 EUR CR Income Tax Liabilities....... 2,595.00 EUR DR P&L-ACCOUNT.................. 6,055.00 EUR CR Retained Earnings............ 6,055.00 EUR Observe the accounts in Figure 26.10. D C D C OV 25,000.00 c/ d 25,000.00 OV 600.00 (j) 400.00 b/ d 25,000.00 (b) 3,000.00 (p) 1,600.00 c/ d 1,600.00 3,600.00 3,600.00 b/ d 1,600.00 (x) 4,800.00 (v) 4,000.00 c/ d 800.00 5,600.00 5,600.00 b/ d 800.00 D C D C OV 0.00 (l) 950.00 OV 0.00 (t) 2,700.00 (d) 3,800.00 (r) 1,330.00 (f) 5,400.00 c/ d 2,700.00 c/ d 1,520.00 5,400.00 5,400.00 3,800.00 3,800.00 b/ d 2,700.00 (B) 900.00 b/ d 1,520.00 (z) 1,520.00 c/ d 1,800.00 2,700.00 2,700.00 b/ d 1,800.00 Property, plant, equipment PPE Inventory double beds IDD Inventory queen size beds IQZ Inventory single beds ISB Figure 26.10: WITSAND (Pty) Ltd.’s accounts <?page no="347"?> Berkau: Basics of Accounting 6e 26-347 D C D C OV 2,100.00 (n) 1,500.00 OV 22,300.00 (a) 3,600.00 (h) 3,750.00 c/ d 4,350.00 (i) 840.00 (c) 4,560.00 5,850.00 5,850.00 (k) 1,800.00 (e) 6,480.00 b/ d 4,350.00 (D) 4,350.00 (m) 2,400.00 (g) 4,500.00 (o) 3,360.00 (q) 2,520.00 (s) 4,500.00 c/ d 18,580.00 37,720.00 37,720.00 b/ d 18,580.00 (u) 4,800.00 (w) 10,080.00 (E) 2,000.00 (y) 2,880.00 (A) 1,500.00 (C) 6,960.00 c/ d 33,200.00 40,000.00 40,000.00 b/ d 33,200.00 Inventory cots I-C Cash/ Bank C/ B D C D C c/ d 50,000.00 OV 50,000.00 (a) 3,000.00 (b) 3,000.00 b/ d 50,000.00 (c) 3,800.00 (d) 3,800.00 (e) 5,400.00 (f) 5,400.00 (g) 3,750.00 (h) 3,750.00 15,950.00 15,950.00 (u) 4,000.00 (v) 4,000.00 D C D C (a) 600.00 (i) 140.00 (i) 700.00 (c) 760.00 (k) 300.00 (k) 1,500.00 (e) 1,080.00 (m) 400.00 (m) 2,000.00 (g) 750.00 (o) 560.00 (o) 2,800.00 (q) 420.00 (q) 2,100.00 (s) 750.00 c/ d 12,850.00 (s) 3,750.00 c/ d 620.00 12,850.00 12,850.00 3,190.00 3,190.00 b/ d 12,850.00 b/ d 620.00 (w) 1,680.00 (w) 8,400.00 (u) 800.00 (y) 480.00 (y) 2,400.00 (A) 250.00 (A) 1,250.00 c/ d 2,150.00 (C) 1,160.00 c/ d 30,700.00 (C) 5,800.00 3,570.00 3,570.00 30,700.00 30,700.00 b/ d 2,150.00 T/ A 30,700.00 b/ d 30,700.00 Value added tax VAT Sales Revenue-20X3 REV Issued capital ISS Purchase-20X3 PUR Figure 26.10: WITSAND (Pty) Ltd.’s accounts (continued) <?page no="348"?> Berkau: Basics of Accounting 6e 26-348 D C D C (j) 400.00 (E) 2,000.00 c/ d 2,000.00 (l) 950.00 b/ d 2,000.00 (n) 1,500.00 (p) 1,600.00 (r) 1,330.00 (t) 2,700.00 c/ d 8,480.00 8,480.00 8,480.00 b/ d 8,480.00 (x) 4,800.00 (z) 1,520.00 (B) 900.00 (D) 4,350.00 c/ d 20,050.00 20,050.00 20,050.00 b/ d 20,050.00 T/ A 20,050.00 D C D C COS 20,050.00 REV 30,700.00 RNT 2,000.00 T/ A 10,650.00 GP 10,650.00 EBT 8,650.00 30,700.00 30,700.00 10,650.00 10,650.00 P&L 10,650.00 b/ d 10,650.00 ITL 2,595.00 b/ d 8,650.00 R/ E 6,055.00 8,650.00 8,650.00 Cost of goods sold-20X3 COS Rent-20X3 RNT Trading account-20X3 T/ A Profit and Loss-20X3 P&L D C D C c/ d 2,595.00 P&L 2,595.00 c/ d 6,055.00 P&L 6,055.00 b/ d 2,595.00 b/ d 6,055.00 Income tax liabilities ITL Retained earnings R/ E Figure 26.10: WITSAND (Pty) Ltd.’s accounts (continued) Observe WITSAND (Pty) Ltd.’s financial statements in Figure 26.11 and Figure 26.12. Inventories are linked to the closing stock of different bed types and add up to: 800 + 1,800 = 2 2,600.00 EUR. <?page no="349"?> Berkau: Basics of Accounting 6e 26-349 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 25,000.00 Issued capital 50,000.00 Intangibles Reserves Financial assets R/ E 6,055.00 Current assets Liabilities Inventory 2,600.00 Interest bear liab A/ R A/ P 2,150.00 Prepaid expenses Provisions Cash/ Bank 33,200.00 Tax liabilities 2,595.00 60,800.00 60,800.00 Witsands (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X3 Figure 26.11: WITSAND (Pty) Ltd.’s statement of financial position The statement of comprehensive income shows cost of goods sold of 20,050 EUR. [EUR] Revenue 30,700.00 Other income 30,700.00 Cost of goods sold (20,050.00) Other expenses (2,000.00) Earnings before int and taxes (EBIT) 8,650.00 Interest 0.00 Earnings before taxes (EBT) 8,650.00 Income tax expenses (2,595.00) Deferred taxes Earnings after taxes (EAT) 6,055.00 Witsand (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 26.12: WITSAND (Pty) Ltd.’s income statement 26.7 Summary Companies applying a perpetual inventory system do not have to take stock. The perpetual inventory system provides information about stock levels and their valuation at any time. This real-time information is useful for Logistics. In contrast, with a periodic <?page no="350"?> Berkau: Basics of Accounting 6e 26-350 inventory system stock levels are known only on the balance sheet date. The system often applies for less important goods/ parts. We discussed the Bookkeeping entries made for both inventory movement systems by the same case study WITSAND (Pty) Ltd. 26.8 Working Definitions Periodic Inventory System: A periodic inventory system records material consumption based on debit entries for opening values and for purchases and deducts closing stock. It requires stock taking at the end of the Accounting period. Perpetual Inventory System: A perpetual inventory system records inventory movements in real-time, based on inputs and stock releases. 26.9 Question Bank (1) A company runs a periodic system for inventory movements. The opening value for goods is 450.00 EUR. During the Accounting period, 3 purchases at 500.00 EUR took place. The closing stock is 100.00 EUR. How much are material expenses? 1. 1,500.00 EUR . 2. 1,950.00 EUR . 3. 1,850.00 EUR . 4. 2,050.00 EUR . (2) What is the Bookkeeping entry for a stock release if a perpetual inventory movement system applies? 1. DR INV; CR COS. 2. DR COS; CR INV. 3. DR COS; DR VAT; CR INV. 4. DR INV; DR VAT; CR COS. (3) A trading company sells goods it purchased at 230.00 EUR at 500.00 EUR net selling price. How much are the cost of goods sold? 1. 230.00 EUR . 2. 276.00 EUR . 3. 500.00 EUR . 4. 600.00 EUR . (4) Which statement is correct? 1. A production company must apply a perpetual inventory system. 2. A production firm should apply a perpetual inventory system. 3. A production firm must apply a periodic inventory system. 4. A production firm should apply a periodic inventory system. (5) A trading company sells 20 goods with cost of purchase of 340.00 EUR at a gross selling price of 600.00 EUR. What is the Bookkeeping entry? 1. DR C/ B 500.00 EUR; DR VAT 100.00 EUR; CR REV 600.00 EUR and DR COS 340.00 EUR; CR INV 340.00 EUR. 2. DR C/ B 408.00 EUR; CR VAT 680.00 EUR; CR REV 340.00 EUR and DR COS 600.00 EUR; CR INV 600.00 EUR. 3. DR C/ B 600.00 EUR; CR VAT 100.00 EUR; CR REV 500.00 EUR and DR COS 340.00 EUR; CR INV 340.00 EUR. 4. DR C/ B 408.00 EUR; CR VAT 680.00 EUR; CR REV 340.00 EUR <?page no="351"?> Berkau: Basics of Accounting 6e 26-351 and DR COS 500.00 EUR; CR INV 500.00 EUR. 26.10 Solutions 1-3; 2-2; 3-1; 4-2; 5-3. <?page no="352"?> Berkau: Basics of Accounting 6e 27-352 27 Cost Formulas 27.1 What is in the Chapter? So far in this textbook, we assumed goods are released from stock following the same sequence as they were added. In this chapter, we discuss the most common cost formulas by the case study MALGAS (Pty) Ltd.: First- In-First-Out, Last-In-First-Out and Weighted Average formula. In Accounting, the principle of single identification and separate valuation applies. Cost formulas only are allowed, if a company stores similar goods which all look alike. The cost formulas differ regarding the assumption made about the release sequence. We demonstrate that the application of different cost formulas changes the inventory valuations and profit calculations. 27.2 Learning Objectives After studying this chapter, you can apply the most common cost formulas applicable in accordance with IFRSs. You further can discuss their effect on inventories and profit. 27.3 Cost Formulas In Accounting, we must value every single asset individually. Only if an individual valuation is not feasible or economically not reasonable, companies are allowed to valuate similar goods together without recording the actual sequence of stock releases. A cost formula is an assumption about the sequence of stock releases if actual releases are not recorded and goods are ordinarily interchangeable. The stock release sequence matters if goods are purchased at different prices. This is the default case. Think about a box of screws in a workshop. Although the screws might have been bought at different purchase prices, they are alike (ordinarily interchangeable). Whenever the workshop purchases a new package of screws, they are put into the same box. After a while, the screws inside of the box are mixed and it is impossible to determine at which price a particular screw has actually been purchased. A similar situation applies if you fill a liquid into a tank, e.g., petrol into your car tank. You never know which litre of petrol at which costs of purchase is burned inside the engine of your car. A cost formula is an assumption made about the sequence goods are released from stock regardless of actual movements. The most common cost formulas are first-in-first-out and weighted average. Although not mentioned by IFRSs, we cover last-in-first-out, too. The first-in-first-out cost formula is based on the assumption that items are released from stock in the same sequence as they were added to stock before. The application of the first-in-first-out (FIFO) cost formula is permitted by IFRS standards and the German Handelsgesetzbuch. Last-infirst-out (LIFO) cost formula records inventory valuations based on the reverse sequence as they were added to stock before. It pretends that goods are piled and are released from stock as if taken from the top of the stack (like pancakes on the breakfast table). Lastin-first-out only applies in cases when <?page no="353"?> Berkau: Basics of Accounting 6e 27-353 the actual order of consumption really follows this sequence. If a production firm piles heavy steel sheets in its yard, it is unlikely, that sheets are taken from the bottom of the stack. The weighted average cost formula values inventory movements at their average cost of purchase. The average is weighted based on the numbers/ amounts. Weighted average method requires calculating the average costs per item for every release. The weighted average method mostly applies for liquids and gases. The average is weighted as besides of prices the amounts of purchases and releases are considered. We discuss all cost formulas for the fashion store MALGAS (Pty) Ltd. in the next paragraph. In Accounting, we are not allowed to change cost formulas over the time. That would breach the consistency principle of financial statements. Cost formulas can only be changed for a good reason and if you do so for all assets of a similar kind. You cannot apply FIFO for screws and LIFO for nuts. In this textbook, we assume changes of cost formulas do not happen. If they did, IAS 8 would apply. Next, we discuss the case study MALGAS (Pty) Ltd. and apply the 3 cost formulas. We repeat the case twice with different cost formulas in use. We demonstrate identical inventory movements and show how valuations and profit calculations change. 27.4 C/ S MALGAS (Pty) Ltd. MALGAS (Pty) Ltd. is a fashion store and discloses the statement of financial position as provided in Figure 27.1: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 100,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory 7,000.00 Interest bear liab 0.00 A/ R A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 43,000.00 Tax liabilities 150,000.00 150,000.00 Malgas (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 27.1: MALGAS (Pty) Ltd.’s statement of financial position The opening value of inventories represents 10 dresses bought at a purchase price of 700.00 EUR/ u each. On 2.02.20X4, MALGAS (Pty) Ltd. purchases 50 further dresses at 710.00 EUR/ u net of VAT on cash. The dresses are identical <?page no="354"?> Berkau: Basics of Accounting 6e 27-354 to the ones on stock. Their net amount is: 50 × 710 = 3 35,500.00 EUR. The gross amount equals: 35,500 × 120% = 42,600.00 EUR. (1) Purchase of 50 dresses on 2.02.20X4. DR Purchase..................... 35,500.00 EUR DR VAT.......................... 7,100.00 EUR CR Cash/ Bank.................... 42,600.00 EUR The dresses are added to stock; MALGAS (Pty) Ltd. applies a perpetual inventory system. (2) Transfer of purchases to stock on 2.02.20X4. DR Inventory.................... 35,500.00 EUR CR Purchase..................... 35,500.00 EUR On 4.04.20X4, MALGAS (Pty) Ltd. sells 28 dresses at a net selling price of 990.00 EUR/ u on cash. See Bookkeeping entry (3) below. The Bookkeeping entry (4) for the cost of goods sold expense depends on the cost formula. The Bookkeeping number will indicate which cost formula applies. At first, we only record the revenue recognition (3). The sale is amounting to: 28 × 990 = 27,720.00 EUR. The gross amount equals: 27,720 × 120% = 3 33,264.00 EUR. (3) Sale of 28 dresses on 4.04.20X4. For now, we skip the stock release in Bookkeeping entry (4). DR Cash/ Bank.................... 33,264.00 EUR CR VAT.......................... 5,544.00 EUR CR Sales........................ 27,720.00 EUR On 5.05.20X4, MALGAS (Pty) Ltd. purchases another 50 dresses at 720.00 EUR/ u. They are the same dresses as the ones on stock. The net value is: 50 × 720 = 3 36,000.00 EUR. Their gross amount equals: 36,000 × 120% = 4 43,200.00 EUR. (5) Purchase of 50 dresses on 5.05.20X4 on cash. DR Purchase..................... 36,000.00 EUR DR VAT.......................... 7,200.00 EUR CR Cash/ Bank.................... 43,200.00 EUR (6) We add the purchased dresses to stock on 5.05.20X4. DR Inventory.................... 36,000.00 EUR CR Purchase..................... 36,000.00 EUR On 6.06.20X4, MALGAS (Pty) Ltd. sells 53 dresses at a net selling price of 990.00 EUR/ u on cash. The sales value is: 53 × 990 = 5 52,470.00 EUR. The gross <?page no="355"?> Berkau: Basics of Accounting 6e 27-355 amount equals: 52,470 × 120% = 662,964.00 EUR. (7) Sale of 53 dresses on 6.06.20X4. For now, we ignore Bookkeeping entry (8) that is linked to the release of dresses from stock. DR Cash/ Bank.................... 62,964.00 EUR CR VAT.......................... 10,494.00 EUR CR Sales........................ 52,470.00 EUR For the above purchases and revenue recognitions, the applied cost formulas do not matter. Only stock releases vary with the application of different cost formulas. Next, we demonstrate 3 scenarios A, B and C, which are linked to the three different cost formulas. These formulas are (A) weighted average method, (B) first-in-first-out and (C) last-in-first-out. The scenarios differ regarding stock releases - when sold dresses must be expensed. Above we skipped the Bookkeeping entries (4) and (8). Next, we discuss the Bookkeeping entries (A4), (A8), (B4), (B8), (C4) and (C8) which depend on the cost formulas and are linked to the scenarios A, B and C. 27.5 Application of Weighted Average (A) With MALGAS (Pty) Ltd. applying the weighted average method, the sold dresses on 4.04.20X4 are valued at their average purchase price. We consider that different numbers were purchased. The weighted average cost formula values inventory movements at their average cost of purchase. The average is called weighted, as prices count according to their amounts. How it is Done (Weighted Average Cost Formula): (1) Determine the number and value of goods on stock. Calculate the average costs. (2) When goods are added to stock, calculate the average unit costs by unit cost of opening stock multiplied with the opening number plus input amount times unit costs of purchase. Divide the total by the total number of goods on stock. (3) When stock is released, determine the stock release multiplying the output number with the weighted average unit costs of purchase (as described above). (4) Continue the procedure based on additions to and releases from stock. MALGAS (Pty) Ltd.’s unit costs per dress after the first purchase are: (10 × 700 + 50 × 710) / 60 = 7 708.33 EUR/ u. Therefore, the stock release of 28 dresses is valued at: 28 × 708.77 = 1 19,833.33 EUR. (A4) Release of dresses from stock on 4.04.20X4. <?page no="356"?> Berkau: Basics of Accounting 6e 27-356 DR Cost of Goods Sold........... 19,833.33 EUR CR Inventory.................... 19,833.33 EUR The value of the dresses sold on 6.06.20X4 is: 53 × (((60 - 28) × 708.33 + 50 × 720) / ((60 - 28) + 50)) = 3 37,918.63 EUR. One dress sold is worth: ((57 - 28) × 708.77 + 50 × 720) / ((57 - 28) + 50) = 715.45 EUR/ u. (A8) Releases from stock on 6.06.20X4. DR Cost of Goods Sold........... 37,918.63 EUR CR Inventory.................... 37,918.63 EUR Next, we balance-off all accounts and prepare the Profit and Loss account. Observe the accounts in Figure 27.2: D C D C OV 100,000.00 c/ d 100,000.00 OV 7,000.00 (A4) 19,833.33 b/ d 100,000.00 (2) 35,500.00 (A8) 37,918.63 (6) 36,000.00 c/ d 20,748.04 78,500.00 78,500.00 b/ d 20,748.04 D C D C OV 43,000.00 (1) 42,600.00 c/ d 100,000.00 OV 100,000.00 (3) 33,264.00 (5) 43,200.00 b/ d 100,000.00 (7) 62,964.00 c/ d 53,428.00 139,228.00 139,228.00 b/ d 53,428.00 D C D C c/ d 50,000.00 OV 50,000.00 (1) 35,500.00 (2) 35,500.00 b/ d 50,000.00 (5) 36,000.00 (6) 36,000.00 71,500.00 71,500.00 D C D C (1) 7,100.00 (3) 5,544.00 (3) 27,720.00 (4) 7,200.00 (7) 10,494.00 c/ d 80,190.00 (7) 52,470.00 c/ d 1,738.00 80,190.00 80,190.00 16,038.00 16,038.00 P&L 80,190.00 b/ d 80,190.00 b/ d 1,738.00 Property, plant, equipment PPE Inventory INV Cash/ Bank C/ B Issued capital ISS Accounts payables A/ P Purchase-20X4 Value added tax VAT Sales Revenue-20X4 REV Figure 27.2: MALGAS (Pty) Ltd. accounts (A) <?page no="357"?> Berkau: Basics of Accounting 6e 27-357 D C D C (A4) 19,833.00 COS 57,751.63 REV 80,190.00 (A8) 37,918.63 c/ d 57,751.63 EBT 22,438.37 57,751.63 57,751.63 80,190.00 80,190.00 b/ d 57,751.63 ITL 6,731.51 b/ d 22,438.37 R/ E 15,706.86 22,438.37 22,438.37 D C D C c/ d 6,731.51 P&L 6,731.51 c/ d 15,706.86 P&L 15,706.86 b/ d 6,731.51 b/ d 15,706.86 Cost of goods sold-20X4 COS Profit and Loss-20X4 P&L Income tax liabilities ITL Retained earnings R/ E Figure 27.2: MALGAS (Pty) Ltd. accounts (A) (continued) Observe the statement of profit and loss and other comprehensive income in Figure 27.3: [EUR] Revenue 80,190.00 Other income 80,190.00 COS (57,751.96) Earnings before int and taxes (EBIT) 22,438.04 Interest 0.00 Earnings before taxes (EBT) 22,438.04 Income tax expenses (6,731.41) Deferred taxes Earnings after taxes (EAT) 15,706.63 Malgas (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 27.3: MALGAS (Pty) Ltd.’s income statement (A) The statement of financial position is shown in Figure 27.4. The value for inventories depends on the cost formula applied. Here, the value for the remaining dresses equals: (10 + 50 - 28 + 50 - 53) × 715.45 = 2 20,748.05 EUR. <?page no="358"?> Berkau: Basics of Accounting 6e 27-358 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 100,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 15,706.63 Current assets Liabilities Inventory 20,748.04 Interest bear liab 0.00 A/ R A/ P 51,738.00 Prepaid expenses Provisions Cash/ Bank 53,428.00 Tax liabilities 6,731.41 174,176.04 174,176.04 Malgas (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 27.4: MALGAS (Pty) Ltd.’s statement of financial position (A) 27.6 Application of First-In-First-Out (B) When the first-in-first-out formula applies, the dresses first sold are assumed to be the ones on stock at the beginning of the Accounting period. The valuation is at unit costs; here 700.00 EUR/ u. After MALGAS (Pty) Ltd. sold the initial stock of dresses, the ones from the first purchase of the Accounting period are taken, then from the next purchase and so on. The first-in-first-out cost formula assumes that items are released in the same sequence as added. For its application we need to know the purchase history of the goods that are on stock at the beginning of the Accounting period. We do not take an average as derived from the opening balance sheet! How it is Done (First-In-First-Out): (1) Determine the opening number and value of goods on stock regarding all previous inputs (You must know the sequence, value and number of all previous intakes of materials on stock). (2) When material is added to stock, make a Bookkeeping entry and keep in mind the number of materials and the unit cost of purchase. (3) When materials are released from stock, record inventory movements under the assumption that the opening stock has been released at first, followed by the first purchase, then the next one etc. (4) Continue with further purchases and stock releases. <?page no="359"?> Berkau: Basics of Accounting 6e 27-359 At MALGAS (Pty) Ltd., the first dresses are valued at unit cost of purchase of 700.00 EUR/ u and the next ones at 710.00 EUR/ u. The costs of goods sold for the sale on 4.04.20X4 are: 10 × 700 + 18 × 710 = 1 19,780.00 EUR/ u. (B4) Release of dresses from stock on 4.04.20X4. DR Cost of Goods Sold........... 19,780.00 EUR CR Inventory.................... 19,780.00 EUR After the release, there are still 32 dresses at 710.00 EUR/ u on stock. For the second release of 53 dresses, the cost of goods sold equal: 32 × 710 + (53 - 32) × 720 = 3 37,840.00 EUR. (B8) Inventory movements for the release of 53 dresses from stock on 6.06.20X4. DR Cost of Goods Sold........... 37,840.00 EUR CR Inventory.................... 37,840.00 EUR Observe the accounts for MALGAS (Pty) Ltd. in Figure 27.5. D C D C OV 100,000.00 c/ d 100,000.00 OV 7,000.00 (B4) 19,780.00 b/ d 100,000.00 (2) 35,500.00 (B8) 37,840.00 (6) 36,000.00 c/ d 20,880.00 78,500.00 78,500.00 b/ d 20,880.00 D C D C OV 43,000.00 (1) 42,600.00 c/ d 100,000.00 OV 100,000.00 (3) 33,264.00 (5) 43,200.00 b/ d 100,000.00 (7) 62,964.00 c/ d 53,428.00 139,228.00 139,228.00 b/ d 53,428.00 D C D C c/ d 50,000.00 OV 50,000.00 (1) 35,500.00 (2) 35,500.00 b/ d 50,000.00 (5) 36,000.00 (6) 36,000.00 71,500.00 71,500.00 Property, plant, equipment PPE Inventory INV Cash/ Bank C/ B Issued capital ISS Accounts payables A/ P Purchase-20X4 PUR Figure 27.5: MALGAS (Pty) Ltd.’s accounts (B) <?page no="360"?> Berkau: Basics of Accounting 6e 27-360 D C D C (1) 7,100.00 (3) 5,544.00 (3) 27,720.00 (4) 7,200.00 (7) 10,494.00 c/ d 80,190.00 (7) 52,470.00 c/ d 1,738.00 80,190.00 80,190.00 16,038.00 16,038.00 P&L 80,190.00 b/ d 80,190.00 b/ d 1,738.00 Value added tax VAT Sales Revenue-20X4 REV D C D C (B4) 19,780.00 COS 57,620.00 REV 80,190.00 (B8) 37,840.00 c/ d 57,620.00 EBT 22,570.00 57,620.00 57,620.00 80,190.00 80,190.00 b/ d 57,620.00 ITL 6,771.00 b/ d 22,570.00 R/ E 15,799.00 22,570.00 22,570.00 D C D C c/ d 6,771.00 P&L 6,771.00 c/ d 15,799.00 P&L 15,799.00 b/ d 6,771.00 b/ d 15,799.00 Cost of goods sold-20X4 COS Profit and Loss-20X4 P&L Income tax liabilities ITL Retained earnings R/ E Figure 27.5: MALGAS (Pty) Ltd.’s accounts (B) (continued) The statement of profit and loss and other comprehensive income discloses a higher profit compared to the scenario A which was based on weighted average method for stock releases. Observe the profit calculation below in Figure 27.6. [EUR] Revenue 80,190.00 Other income 80,190.00 COS (57,620.00) Earnings before int and taxes (EBIT) 22,570.00 Interest 0.00 Earnings before taxes (EBT) 22,570.00 Income tax expenses (6,771.00) Deferred taxes Earnings after taxes (EAT) 15,799.00 Malgas (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 27.6: MALGAS (Pty) Ltd.’s income statement (B) <?page no="361"?> Berkau: Basics of Accounting 6e 27-361 Observe the statement of financial position in Figure 27.7. The value of closing stock on the statement of financial position is for scenario B (first-in-first-out): 29 × 720 = 2 20,880.00 EUR. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 100,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 15,799.00 Current assets Liabilities Inventory 20,880.00 Interest bear liab 0.00 A/ R A/ P 51,738.00 Prepaid expenses Provisions Cash/ Bank 53,428.00 Tax liabilities 6,771.00 174,308.00 174,308.00 Malgas (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 27.7: MALGAS (Pty) Ltd.’s statement of financial position (B) 27.7 Application of Last-In-First-Out (C) The last-in-first-out formula normally does not apply. It only can be used exceptionally and with good arguments. Here, the sequence for releasing dresses from stock, does not give reasons to apply the last-in-first-out formula. However, we demonstrate the calculations and the effect on inventory valuations and profit calculation. The last-in-first-out cost formula records inventory valuations based on the reverse sequence of how items were added to stock. For its application, we need to know the purchase history of the goods that are on stock at the beginning of the Accounting period. How it is Done (Last-In-First-Out): (1) Determine the opening number and value of goods on stock regarding all previous inputs (You must know the sequence, value and number of all previous intakes of materials on stock). (2) When material is added to stock, make a Bookkeeping entry and keep in mind the number of materials and the unit cost of purchase. (3) When materials are released from stock, record stock releases according to unit costs as if the <?page no="362"?> Berkau: Basics of Accounting 6e 27-362 last input got released at first, then the previous one etc. (4) Continue with recording additions to and releases from stock. At MALGAS (Pty) Ltd., we pretend the first stock releases on 4.04.20X4 are taken from the recent input on 2.02.20X4. Hence, the stock release is amounting to: 28 × 710 = 1 19,880.00 EUR. (C4) Release of 28 dresses on 4.04.20X4. DR Cost of Goods Sold........... 19,880.00 EUR CR Inventory.................... 19,880.00 EUR The second release is taken from the second purchase and to the extent of 3 dresses from the first one. The value of the inventory movement when selling 53 dresses on 6.06.20X4 is: 50 × 720 + 3 × 710 = 3 38,130.00 EUR. (C8) Second release of 53 dresses on 6.06.20X4. DR Cost of Goods Sold........... 38,130.00 EUR CR Inventory.................... 38,130.00 EUR Observe the accounts in Figure 27.8. D C D C OV 100,000.00 c/ d 100,000.00 OV 7,000.00 (C4) 19,880.00 b/ d 100,000.00 (2) 35,500.00 (C8) 38,130.00 (6) 36,000.00 c/ d 20,490.00 78,500.00 78,500.00 b/ d 20,490.00 Property, plant, equipment PPE Inventory INV D C D C OV 43,000.00 (1) 42,600.00 c/ d 100,000.00 OV 100,000.00 (3) 33,264.00 (5) 43,200.00 b/ d 100,000.00 (7) 62,964.00 c/ d 53,428.00 139,228.00 139,228.00 b/ d 53,428.00 Cash/ Bank C/ B Issued capital ISS D C D C c/ d 50,000.00 OV 50,000.00 (1) 35,500.00 (2) 35,500.00 b/ d 50,000.00 (5) 36,000.00 (6) 36,000.00 71,500.00 71,500.00 Accounts payables A/ P Purchase-20X4 PUR Figure 27.8: MALGAS (Pty) Ltd.’s accounts (C) <?page no="363"?> Berkau: Basics of Accounting 6e 27-363 D C D C (1) 7,100.00 (3) 5,544.00 (3) 27,720.00 (4) 7,200.00 (7) 10,494.00 c/ d 80,190.00 (7) 52,470.00 c/ d 1,738.00 80,190.00 80,190.00 16,038.00 16,038.00 P&L 80,190.00 b/ d 80,190.00 b/ d 1,738.00 D C D C (C4) 19,880.00 COS 58,010.00 REV 80,190.00 (C8) 38,130.00 c/ d 58,010.00 EBT 22,180.00 58,010.00 58,010.00 80,190.00 80,190.00 b/ d 58,010.00 ITL 6,654.00 b/ d 22,180.00 R/ E 15,526.00 22,180.00 22,180.00 D C D C c/ d 6,654.00 P&L 6,654.00 c/ d 15,526.00 P&L 15,526.00 b/ d 6,654.00 b/ d 15,526.00 Income tax liabilities ITL Retained earnings R/ E Cost of goods sold-20X4 COS Profit and Loss-20X4 P&L Value added tax VAT Sales Revenue-20X4 REV Figure 27.8: MALGAS (Pty) Ltd.’s accounts (C) (continued) Applying last-in-first-out cost formula, the profit of MALGAS (Pty) Ltd. is lowest. Observe the statement of profit or loss and other comprehensive income in Figure 27.9: [EUR] Revenue 80,190.00 Other income 80,190.00 COS (58,010.00) Earnings before int and taxes (EBIT) 22,180.00 Interest 0.00 Earnings before taxes (EBT) 22,180.00 Income tax expenses (6,654.00) Deferred taxes Earnings after taxes (EAT) 15,526.00 Malgas (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 27.9: MALGAS (Pty) Ltd.’s income statement (C) <?page no="364"?> Berkau: Basics of Accounting 6e 27-364 On the balance sheet, the closing stock of inventories is calculated as opening value of 7,000.00 EUR plus the value for dresses left from the first purchase. The number of goods is: 50 - 28 - 3 = 1 19 dresses. The value of closing stock is: 10 × 700 + 19 × 710 = 2 20,490.00 EUR. A C, L Non-current assets [EUR] Equity [EUR] P, P, E 100,000.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E 15,526.00 Current assets Liabilities Inventory 20,490.00 Interest bear liab 0.00 A/ R A/ P 51,738.00 Prepaid expenses Provisions Cash/ Bank 53,428.00 Tax liabilities 6,654.00 173,918.00 173,918.00 Malgas (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 27.10: MALGAS (Pty) Ltd.’s statement of financial position (C) The last-in-first-out method reduces the profit when prices increase. Cost formulas do not depend on the inventory movement system applied. If a company applies a periodic inventory system, we must determine the value of closing stock, in the same way as we did above. 27.8 Summary When items of inventory are similar or not distinguishable and/ or the goods flow is not traceable (liquids, gases) or the effort for a separate valuation is unreasonably high, cost formulas apply for inventory movement calculations. The most common formulas are weighted average method, first-infirst-out and exceptionally applicable: last-in-first-out formula. The cost formulas lead to different inventory valuations and profit calculations. We demonstrated in this chapter the application and the effect of cost formulas by the case study MALGAS (Pty) Ltd. which is a fashion store. 27.9 Working Definitions Cost Formula: A cost formula is an assumption about the sequence of stock releases if actual releases are not recorded and goods are ordinarily interchangeable. First-in-First-out Cost Formula: The first-in-first-out cost formula is based on the assumption that items are released from stock by the same sequence they were added to stock before. <?page no="365"?> Berkau: Basics of Accounting 6e 27-365 Last-in-First-out Cost Formula: The last-in-first-out cost formula records inventory valuations based on the reverse sequence as they were added to stock before. Weighted Average Cost Formula: The weighted average cost formula values inventory movements at their average cost of purchase. The average is weighted based on the numbers/ amounts. 27.10 Question Bank (1) A company buys goods at 30.00 EUR/ u, then at 32.00 EUR/ u and thereafter at 34.00 EUR/ u. The purchase amounts are always 100 units. The closing stock is 76 units. How much is the valuation of stock if the company applies FIFO? 1. 2,432.00 EUR . 2. 2,584.00 EUR . 3. 2,280.00 EUR . 4. 2,736.00 EUR . (2) Which statement is correct? 1. When prices decrease, the FIFO method results in the highest stock valuation. 2. When prices increase, the FIFO method results in the highest stock valuation. 3. When prices increase, the weighted average method results in the highest stock valuation. 4. When prices decrease, the weighted average method results in the highest stock valuation. (3) A driver calculates the costs of a distance of 300 km. The car’s consumption is 6.0 l/ 100 km. In the tank was 20 litre petrol bought at 1.45 EUR/ l. The driver gassed up for 40 litres and paid 1.50 EUR/ l. How much are the travel costs regarding petrol? 1. 26.70 EUR . 2. 26.55 EUR . 3. 26.10 EUR . 4. 27.00 EUR . (4) Which statement is correct? 1. A company must apply the FIFO cost formula for gases and liquids. 2. A company can apply any cost formula that maximises profits. 3. A company must apply the FIFO cost formula for goods that are stackable like steel mats. 4. A company must apply the cost formula that is closest to the consumption of goods pattern, like FIFO for perishable goods. (5) A company has 35 goods at 107.00 EUR/ u on stock. It buys on 1.04.20X3 100 goods at 110.00 EUR/ u and on 1.08.20X3 further 100 goods at 115.00 EUR/ u. Weighted average cost formula applies. On 1.06.20X3, 81 goods are sold. How much are the cost of sales? 1. 9,046.15 EUR . 2. 8,847.00 EUR . 3. 8,805.00 EUR . 4. 8,788.50 EUR . 27.11 Solutions 1-2; 2-2; 3-1; 4-4; 5-2. <?page no="366"?> Berkau: Basics of Accounting 6e 28-366 28 Income Statement Following the Cost of Sales Format 28.1 What is in the Chapter? This chapter introduces another format for the statement of profit or loss and other comprehensive income that is linked to the calculation of products. In contrast to the expense view (nature of expense method) we now prepare income statements that are based on goods sold. This format is called cost of sales method and requires allocating expenses to cost objects (products) following functional criteria. We demonstrate the preparation of the income statement following both approaches: (1) the nature of expense method, followed by (2) cost of sales format for the same case study: the wine farm ASHTON Ltd. that produces red wines: Pinotage and Merlot. We also cover MONTAGUE (Pty) Ltd. as a comprehensive case study. 28.2 Learning Objectives After studying this chapter, you can apply both methods for the income statement. You develop an awareness of the advantages of the nature of expense method and the cost of sales format. You further will understand the advantage of the cost of sales format as reporting instrument for making product mix decisions. We applied the cost of sales format for the income statement in the REGENT BIKE (Pty) Ltd. case study in chapter (25) already but now explain the format in more details. This chapter deepens your knowledge about the cost of sales format, and you can discuss the impact of the format on the profitability analysis in Management Accounting. You can make reasonable decisions about the application of an appropriate format for the income statement in real business cases. 28.3 Statement of Profit or Loss and Other Comprehensive Income In general, a statement of profit or loss and other comprehensive income compares revenue to expenses. Companies use the information derived therefrom for reporting about their profitability and to support management decisions, like about their product mix. A product mix decision determines which numbers of which products a company produces. If the number of products manufactured and sold equals, the profit calculation is simple. The profit calculation gets a little more demanding once finished goods are added to or released from stock. This causes a timely mismatch between revenues and costs because revenues are recorded when goods are sold whereas expenses are allocated to the period of manufacturing. Therefore, the stored goods’ costs of manufacturing are added to inventories and get charged once the products get sold. Think of this effect as a waiting room for costs to be considered (if stock is added). There are two ways of how to prepare an income statement if the production amount differs from sales amount: - NoE: the nature of expense method and - COS: the cost of sales format. <?page no="367"?> Berkau: Basics of Accounting 6e 28-367 Both formats calculate the same net profit and annual surplus. 28.4 Nature of Expense Method The income statement following the nature of expense format calculates profit starting with the revenue and deducting all costs for the period; it requires adjustments for costs of manufacturing for stock increases/ decreases of finished goods. The income statement following the nature of expense format discloses all cost categories and supports the prediction of how profit changes as a result of increases/ decreases of cost categories. In general, the application of the nature of expense method is easy as all expense accounts are closed-off to profit or loss. 28.5 Cost of Sales Format In contrast, the income statement following the cost of sales format starts with the revenue and deducts costs for only the goods/ services sold and thereafter deducts further, non-manufacturing expenses. The income statement along the cost of sales format shows with which products the company earns its profit and which products lead to a loss. It is a powerful management instrument for making decisions about the products to manufacture. The downside of the method is, that it requires more Accounting work. In order to determine the cost of goods sold, the Accountant must allocate costs to cost objects, like products or services. Therefore, an income statement following the cost of sales format requires making product calculations. Calculating products/ services requires allocating costs to cost objects, e.g., determining with how many manufacturing overheads a certain product is charged. 28.6 Similarities/ Differences Any format for profit calculation requires the calculation of products. For the nature of expense method, calculations are required in order to calculate the changes in inventories of finished goods. For the cost of sales format, the calculation is for the cost of sales. With the cost of sales format, the calculation is derived from the accounts. In contrast, if the nature of expense method applies, we must calculate products outside of the Bookkeeping records. In general, an income statement compares revenues to expenses. For this purpose, they both must be linked to the same number of products. In case the company increases or decreases inventories of finished goods and/ or work-in-process, a comparison between revenue and expenses needs adjustments. The nature of expense method adjusts revenues by changes in inventories of finished goods. These represent negative costs to keep the cost of manufacturing of not sold goods/ services away from profit or loss. In contrast, the cost of sales format adjusts the total expenses for an Accounting period by cost allocations and only takes expenses for the goods sold into consideration. As you might have noticed, the principle is the same. The nature of expense method takes all costs and deducts costs for stock additions whereas the cost of sales format only considers costs of goods sold. <?page no="368"?> Berkau: Basics of Accounting 6e 28-368 28.7 Application of NoE and COS Next, we demonstrate the profit calculation for the case study ASHTON Ltd. The company is a wine farm and discloses profit margins assigned to different red wines (Merlot and Pinotage). We will see by making which wine ASHTON Ltd. earns more profit. In total, ASHTON Ltd. produces more wines than it sells during the Accounting period 20X4. Therefore, ASHTON Ltd. must store some wines. We first prepare the income statement following the nature of expense method. Thereafter, we prepare the same statement following the cost of sales format. For efficiency reasons, we start-off with recording only those Bookkeeping entries that apply for both methods. Then, we split the case study and (1) make Bookkeeping entries for the nature of expense method (NoE) followed by (2) the cost of sales format (COS). 28.8 C/ S ASHTON Ltd. ASHTON Ltd. is a wine maker in the Western Cape in South Africa. The company produces Pinotage and Merlot wines. The business is established on 2.01.20X4 when its shareholders invest 1,000,000.00 EUR. Note, all amounts are calculated in EUR for this case study. (1) Incorporation of ASHTON Ltd. on 2.01.20X4. DR Cash/ Bank.................... 1,000,000.00 EUR CR Issued Capital............... 1,000,000.00 EUR The simplified business concept is to plant vines on the farm, harvest the grapes, put them into barrels and fill them into bottles. The wine making process requires resources, like land, labour and materials. In our simplified case study, production requires only vines (the plants), land, bottles and barrels. On 3.01.20X4, ASHTON Ltd. takes a bank loan. The principal is 500,000.00 EUR. The rate of interest is 5 %/ a and the payoff amount is 50,000.00 EUR every year. Interest and pay-off are due at yearends. (2) Taking 500,000.00 EUR from the bank on 3.01.20X4. DR Cash/ Bank.................... 500,000.00 EUR CR Interest Bearing Liabilities. 500,000.00 EUR (3, 4a) Paying interest and pay-off for the bank loan on 31.12.20X4. Interest is: 5% × 500,000 = 2 25,000.00 EUR. The amount for pay-off is 50,000.00 EUR. DR Interest..................... 25,000.00 EUR CR Cash/ Bank.................... 25,000.00 EUR DR Interest Bearing Liabilities. 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR <?page no="369"?> Berkau: Basics of Accounting 6e 28-369 In compliance with IFRSs requirements, short-term liabilities must be recognized separately. ASHTON Ltd. transfers the next year’s pay-off amount to the Shortterm Liabilities account, which is its Accounts Payables account (4b). DR Interest Bearing Liabilities. 50,000.00 EUR CR Account Payables............. 50,000.00 EUR ASHTON Ltd. buys land and vines for 2,000,000.00 EUR (net amount). The land is 40 % of the total acquisitions (in value): 40% × 2,000,000 = 8 800,000.00 EUR. ASHTON Ltd. pays for the Pinotage vines 40 % more than for the Merlot vines although the number of plants is the same. We never depreciate land as it does not deplete. The vines are depreciated following straight-line method over 10 years. (5) Acquisition of land and vines on 5.01.20X4, the land is recorded at first. No VAT applies for the acquisition of land. In South Africa, no land purchase tax applies either. DR P, P, E - Land............... 800,000.00 EUR CR Cash/ Bank.................... 800,000.00 EUR Buying vines at a 140 : 100 ratio means at: 7 : 5. The Pinotage vines cost: 7 × 60% × 2,000,000/ 12 = 7 700,000.00 EUR. The Merlot vines cost: 700,000 / 140% = 500,000.00 EUR. (6, 7) Acquisition of vines on 5.01.20X4. DR P, P, E - Pinotage........... 700,000.00 EUR DR VAT.......................... 140,000.00 EUR CR Cash/ Bank.................... 840,000.00 EUR DR P, P, E - Merlot............. 500,000.00 EUR DR VAT ......................... 100,000.00 EUR CR Cash/ Bank.................... 600,000.00 EUR Depreciation on Pinotage vines gives: 700,000 / 10 = 7 70,000.00 EUR/ a. Depreciation on Merlot vines equals: 500,000 / 10 = 550,000.00 EUR/ a. (8, 9) Depreciation on vines as recorded on 31.12.20X4. DR Depreciation ................. 70,000.00 EUR CR Acc. Depr. - Pinotage........ 70,000.00 EUR DR Depreciation ................. 50,000.00 EUR CR Acc. Depr. - Merlot.......... 50,000.00 EUR ASTHON Ltd. buys 10 barrels (volume: 50,000 litres each) at cost of acquisition of 400,000.00 EUR (all together) on 6.01.20X4. The barrels can be used for a <?page no="370"?> Berkau: Basics of Accounting 6e 28-370 period of 20 years. The depreciation method is straight-line method without residual value consideration. (10) Acquisition of barrels on 6.01.20X4. DR P, P, E - Barrels............ 400,000.00 EUR DR VAT.......................... 80,000.00 EUR CR Cash/ Bank.................... 480,000.00 EUR The depreciation on the barrels is: 400,000 / 20 = 2 20,000.00 EUR/ a. (11) Depreciation on barrels on 31.12.20X4. DR Depreciation................. 20,000.00 EUR CR Acc. Depr. - Barrels......... 20,000.00 EUR ASHTON Ltd. produces 500,000 litres wine and spends 250,000.00 EUR on the harvesting process and filling the barrels (all of them). The litre-number of Pinotage is the same as for Merlot. The harvesting and filling expenses are split at a 50 : 50 ratio. To keep the case study simple, we record labour in the middle of the Accounting period. (12) Paying for labour on 30.06.20X4. Here, labour includes pay-roll tax and social security contributions. DR Labour....................... 250,000.00 EUR CR Cash/ Bank.................... 250,000.00 EUR ASHTON fills the wines into bottles (during the same Accounting period), labels and corks them. ASHTON Ltd. spends on the bottle filling/ labelling/ corking-process 150,000.00 EUR for labour and buys 500,000 1-litre-glass bottles at 0.36 EUR/ u (gross amount). (13) Paying labour on 30.06.20X4. DR Labour....................... 150,000.00 EUR CR Cash/ Bank.................... 150,000.00 EUR The purchase costs for bottles are: 500,000 × 0.36 / 120% = 1 150,000.00 EUR. The gross amount equals: 150,000 × 120% = 1180,000.00 EUR. (14) Purchase of bottles on 30.01.20X4. DR Purchase..................... 150,000.00 EUR DR VAT.......................... 30,000.00 EUR CR Cash/ Bank.................... 180,000.00 EUR ASHTON Ltd. sells 230,000 bottles of Merlot wine at a net selling price of 4.80 EUR/ u on a bulk sale and 180,000 bottles of Pinotage wine at 5.10 EUR/ u through their own shop. We calculate the net selling prices for the sale: The Merlot wine is sold at: 230,000 × 4.80 = <?page no="371"?> Berkau: Basics of Accounting 6e 28-371 11,104,000.00 EUR and the Pinotage wine at: 180,000 × 5.10 = 9 918,000.00 EUR. (15) Sale of Merlot as recorded on 31.12.20X4. DR Cash/ Bank.................... 1,324,800.00 EUR CR VAT.......................... 220,800.00 EUR CR Sales........................ 1,104,000.00 EUR (16) Sale of Pinotage on 31.12.20X4. DR Cash/ Bank.................... 1,101,600.00 EUR CR VAT.......................... 183,600.00 EUR CR Sales........................ 918,000.00 EUR This entire process of wine making takes one Accounting period only. Look at ASHTON Ltd.’s accounts so far in Figure 28.1. The accounts have not yet been balanced-off, because we still continue the case study. D C D C (1) 1,000,000.00 (3) 25,000.00 (1) 1,000,000.00 (2) 500,000.00 (4a) 50,000.00 (15) 1,324,800.00 (5) 800,000.00 (16) 1,101,600.00 (6) 840,000.00 (7) 600,000.00 (10) 480,000.00 D C (12) 250,000.00 (4b) 50,000.00 (13) 150,000.00 (14) 180,000.00 Cash/ Bank C/ B Issued capital ISS Accounts payables A/ P D C D C (4a) 50,000.00 (2) 500,000.00 (3) 25,000.00 (4b) 50,000.00 D C D C (5) 800,000.00 (6) 140,000.00 (15) 220,800.00 (7) 100,000.00 (16) 183,600.00 (10) 80,000.00 (14) 30,000.00 Property, plant, equipment (land) PPE Value added tax VAT Interest bearing liabilities IBL Interest-20X4 INT Figure 28.1: ASHTON Ltd.’s accounts <?page no="372"?> Berkau: Basics of Accounting 6e 28-372 D C D C (6) 700,000.00 (8) 70,000.00 D C D C (7) 500,000.00 (9) 50,000.00 D C D C (8) 70,000.00 (10) 400,000.00 (9) 50,000.00 (11) 20,000.00 D C D C (12) 250,000.00 (11) 20,000.00 (13) 150,000.00 D C D C (15) 1,104,000.00 (14) 150,000.00 (16) 918,000.00 Property, plant, equipment (Merlot) PPM Accumulated depreciation (Merlot) ACM Property, plant, equipment (Pinotage) PPP Accumulated depreciation (pinotage) ACP Depreciation-20X4 DPR Property, plant, equipment (barrels) PPB Labour-20X4 LAB Accumulated depreciation (barrels) ACB Sales Revenue-20X4 Purchase-20X4 PUR Figure 28.1: ASHTON Ltd.’s accounts (continued) Next, we prepare the income statement following the nature of expense method (NoE). Thereafter, we start over (from this point) and prepare the Bookkeeping entries and the financial statements following the cost of sales format (COS). * (We mark this location in the text for later reference.) 28.9 C/ S ASHTON Ltd. - Nature of Expense Method (NoE) For the profit calculation at ASHTON Ltd., we apply a Trading account and a Profit and Loss account. With the nature of expense method in use, all nominal accounts are closed-off to either the Trading account or to the Profit and Loss account. The Purchase account and the Sales account are closed-off to the Trading account. This requires calculating the closing stock in the Inventory account. All further nonmanufacturing expense accounts are closed-off to the Profit-and-Loss account. <?page no="373"?> Berkau: Basics of Accounting 6e 28-373 How it is Done (Profit and Loss Following the Nature of Expense Format): (1) Make Bookkeeping entries for revenues and expenses. (2) Close-off all Revenue and Expense accounts to the Trading account and/ or the Profit and Loss account. (3) If there is an increase or decrease of finished goods, calculate stored products. (4) Calculate profit by adding increases of finished goods to revenues and deduct decreases. Deduct all further expenses. To determine material expenses, apply the Trading account. For ASHTON Ltd., we calculate the profit in one step. We close-off all nominal accounts to the Trading account and Profit and Loss account. This is done by the Bookkeeping entries below: DR Profit and Loss.............. 25,000.00 EUR CR Interest..................... 25,000.00 EUR DR Profit and Loss.............. 140,000.00 EUR CR Depreciation ................. 140,000.00 EUR DR Profit and Loss.............. 400,000.00 EUR CR Labour....................... 400,000.00 EUR DR Sales........................ 2,022,000.00 EUR CR Trading Account.............. 2,022,000.00 EUR DR Trading Account.............. 150,000.00 EUR CR Purchase..................... 150,000.00 EUR All Bookkeeping entries are made without allocating expenses to wines (Pinotage or Merlot). On the debit side, the Trading account shows the purchases. The credit side discloses sales revenue and the closing stock of wines (in bottles). There is a closing stock of 70,000 bottles Pinotage and 20,000 bottles Merlot. To know the number of bottles isn’t sufficient to calculate closing stock. ASHTON Ltd. must calculate the wines’ unit costs of manufacturing (per bottle). We calculate wines outside from the Bookkeeping records, meaning we prepare an auxiliary calculation. The calculation of the unit costs covers portions of labour, depreciation and the glass bottles. Interest is regarded as a non-manufacturing expense and therefore must not be included in the unit costs of manufacturing. The bottle costs per Pinotage are: 400,000/ 500,000 + (70,000 + 10,000) / 250,000 + 0.30 = 0.80 + 0.32 + 0.30 = 1 1.42 EUR/ u. Labour is relevant for all wines to the same extent. Depreciation is considered for Pinotage vines separately. The 10,000.00 EUR additional depreciation result from half of the barrels <?page no="374"?> Berkau: Basics of Accounting 6e 28-374 because the litre-number of wines is the same. The closing stock of Pinotage is calculated as: 70,000 × 1.42 = 9 99,400.00 EUR. The costs of manufacturing per bottle of Merlot are: 400,000/ 500,000 + (50,000 + 10,000) / 250,000 + 0.30 = 0.80 + 0.24 + 0.30 = 1 1.34 EUR/ u. Labour is relevant for all wines to the same extent. Depreciation is considered for the Merlot vines separately. The 10,000.00 EUR additional depreciation come from half of the barrels because the litre-number of wines is the same. The closing stock of Merlot is: 20,000 × 1.34 = 2 26,800.00 EUR. As ASHTON Ltd. is established in 20X4, the closing stock of finished goods, 99,400 + 26,800 = 1 126,200.00 EUR, is an increase of inventory. The closing stock of finished goods is recorded by the next following Bookkeeping entries. DR Inventory.................... 99,400.00 EUR CR Trading Account.............. 99,400.00 EUR DR Inventory.................... 26,800.00 EUR CR Trading Account.............. 26,800.00 EUR The gross profit for ASHTON is: 2,022,000 + 99,400 + 26,800 - 150,000 = 11,998,200.00 EUR and is transferred to the Profit and Loss account by closingoff the Trading account. DR Trading Account.............. 1,998,200.00 EUR CR Profit and Loss.............. 1,998,200.00 EUR The balancing figure of the Profit and Loss account gives the pre-tax profit: 1,998,200 - 400,000 - 140,000 - 25,000 = 11,433,200.00 EUR. The income taxes are calculated based on an income tax rate of 30 % and equal: 1,433,200 × 30% = 4 429,960.00 EUR. The annual surplus is: 1,433,200 - 429,960 = 1 1,003,240.00 EUR. Observe ASHTON Ltd.’s accounts to get the full picture. They are displayed in Figure 28.2. <?page no="375"?> Berkau: Basics of Accounting 6e 28-375 D C D C (1) 1,000,000.00 (3) 25,000.00 c/ d 1,000,000.00 (1) 1,000,000.00 (2) 500,000.00 (4a) 50,000.00 b/ d 1,000,000.00 (15) 1,324,800.00 (5) 800,000.00 (16) 1,101,600.00 (6) 840,000.00 (7) 600,000.00 (10) 480,000.00 (12) 250,000.00 D C (13) 150,000.00 c/ d 50,000.00 (4b) 50,000.00 (14) 180,000.00 b/ d 50,000.00 c/ d 551,400.00 3,926,400.00 3,926,400.00 b/ d 551,400.00 Cash/ Bank C/ B Issued capital ISS Accounts payables A/ P D C D C (4a) 50,000.00 (2) 500,000.00 (3) 25,000.00 c/ d 25,000.00 (4b) 50,000.00 b/ d 25,000.00 P&L 25,000.00 c/ d 400,000.00 500,000.00 500,000.00 b/ d 400,000.00 D C D C (5) 800,000.00 c/ d 800,000.00 (6) 140,000.00 (15) 220,800.00 b/ d 800,000.00 (7) 100,000.00 (16) 183,600.00 (10) 80,000.00 (14) 30,000.00 c/ d 54,400.00 404,400.00 404,400.00 b/ d 54,400.00 Property, plant, equipment (land) PPL Value added tax VAT Interest bearing liabilities IBL Interest-20X4 INT D C D C (6) 700,000.00 c/ d 700,000.00 c/ d 70,000.00 (8) 70,000.00 b/ d 700,000.00 b/ d 70,000.00 D C D C (7) 500,000.00 c/ d 500,000.00 c/ d 50,000.00 (9) 50,000.00 b/ d 500,000.00 b/ d 50,000.00 Property, plant, equipment (merlot) PPM Accumulated depreciation (merlot) ACM Property, plant, equipment (pinotage) PPP Accumulated depreciation (pinotage) ACP Figure 28.2: ASHTON Ltd.’s accounts <?page no="376"?> Berkau: Basics of Accounting 6e 28-376 D C D C (8) 70,000.00 (10) 400,000.00 c/ d 400,000.00 (9) 50,000.00 b/ d 400,000.00 (11) 20,000.00 c/ d 140,000.00 140,000.00 140,000.00 b/ d 140,000.00 P&L 140,000.00 D C D C (12) 250,000.00 c/ d 20,000.00 (11) 20,000.00 (13) 150,000.00 c/ d 400,000.00 b/ d 20,000.00 400,000.00 400,000.00 b/ d 400,000.00 P&L 400,000.00 D C D C (15) 1,104,000.00 (14) 150,000.00 c/ d 150,000.00 c/ d 2,022,000.00 (16) 918,000.00 b/ d 150,000.00 T/ A 150,000.00 2,022,000.00 2,022,000.00 T/ A 2,022,000.00 b/ d 2,022,000.00 Sales Revenue-20X4 REV Purchase-20X4 PUR Depreciation-20X4 DPR Property, plant, equipment (barrels) PPB Labour-20X4 LAB Accumulated depreciation (barrels) ACB D C D C PUR 150,000.00 REV 2,022,000.00 INT 25,000.00 T/ A 1,998,200.00 INV 99,400.00 DPR 140,000.00 GP 1,998,200.00 INV 26,800.00 LAB 400,000.00 2,148,200.00 2,148,200.00 EBT 1,433,200.00 P&L 1,998,200.00 b/ d 1,998,200.00 1,998,200.00 1,998,200.00 ITL 429,960.00 b/ d 1,433,200.00 R/ E 1,003,240.00 1,433,200.00 1,433,200.00 Trading account-20X4 T/ A Profit and Loss-20X4 P&L D C D C T/ A 99,400.00 c/ d 429,960.00 P&L 429,960.00 T/ A 26,800.00 c/ d 126,200.00 b/ d 429,960.00 126,200.00 126,200.00 b/ d 126,200.00 D C c/ d 1,003,240.00 P&L 1,003,240.00 b/ d 1,003,240.00 Inventory INV Income Tax Liabilities ITL Retained earnings R/ E Figure 28.2: ASHTON Ltd.’s accounts (continued) Check the statement of profit or loss and other comprehensive income following <?page no="377"?> Berkau: Basics of Accounting 6e 28-377 the nature of expense method and the statement of financial position below in Figure 28.3 and Figure 28.4. [EUR] Revenue 2,022,000.00 Changes in inventory 126,200.00 2,148,200.00 Materials (150,000.00) Labour (400,000.00) Depreciation (140,000.00) Other expenses 0.00 Earnings before int and taxes (EBIT) 1,458,200.00 Interest (25,000.00) Earnings before taxes (EBT) 1,433,200.00 Income tax expenses (429,960.00) Deferred taxes Earnings after taxes (EAT) 1,003,240.00 Ashton Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 28.3: ASHTON Ltd.’s income statement (NoE) The value of changes in inventory is the closing stock of wines: 99,400 + 26,800 = 1126,200.00 EUR. The inventory valuation follows strictly the calculation of cost of manufacturing in accordance with IAS 2. The consideration of the changes in inventory of finished goods (wines) means to exclude the expenses for unsold wines from the profit calculation. With an income statement prepared following the nature of expense method, no contribution of different products (Pinotage and Merlot) to the profit is recognisable. <?page no="378"?> Berkau: Basics of Accounting 6e 28-378 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 2,260,000.00 Share capital 1,000,000.00 Intangibles Reserves Financial assets R/ E 1,003,240.00 Current assets Liabilities Inventory 126,200.00 Interest bear liab 400,000.00 A/ R A/ P 104,400.00 Prepaid expenses Provisions Cash/ Bank 551,400.00 Tax liabilities 429,960.00 2,937,600.00 2,937,600.00 Ashton Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 28.4: ASHTON Ltd.’s statement of financial position On the balance sheet, the amount for property, plant and equipment is the total value of land, vines and barrels: 800.000 + 630,000 + 450,000 + 380,000 = 22,260,000.00 EUR. The receivables result from the VAT account. Next, we replace the profit calculation by the income statement based on the cost of sales format. Regarding the text structure, we rewind to our marking * *. 28.10 C/ S ASHTON Ltd. - Cost of Sales Format (COS) When preparing an income statement following the cost of sales format, we allocate costs according to their use for different cost objects (functional view). We apply subordinated Work-in-Process accounts and Manufacturing Overhead accounts as discussed in chapter (25). We apply Manufacturing Accounting. At ASHTON Ltd., the two subordinated Work-in-Process accounts are dedicated to Pinotage and Merlot. How it is Done (Profit Calculation following the Cost of Sales Method): (1) Make all Bookkeeping entries for revenues and expenses. (2) Run a Manufacturing Accounting and apply Work-in- Process accounts for direct costs of the products and Manufacturing Overhead accounts for indirect costs. Consider only manufacturing expenses. Apply the overheads. This includes the transfer of underor over-applied overheads into the Cost of Goods Sold (COS) account, too. Dedicate single Work-inprocess accounts to products. (3) Once production is finished, close-off the relevant Work-in-Process account to the Inventory of Fin- <?page no="379"?> Berkau: Basics of Accounting 6e 28-379 ished Goods account. Apply cost formulas for inventory movements if goods are ordinarily interchangeable or intermingle, like liquids or gases. (4) Once products are sold, transfer the expenses to the Cost of Goods Sold (COS) account and credit the Inventory of Finished Goods account. (5) Calculate profit by deducting cost of goods sold from revenue. Deduct further non-manufacturing expenses, like general administration or interest. At ASHTON Ltd., bottles are direct costs. They are recorded in inventories at first, and later, we add them to the dedicated Work-in-Process accounts. DR Inventory - Bottles.......... 150,000.00 EUR CR Purchase..................... 150,000.00 EUR DR WIP - Pinotage............... 75,000.00 EUR CR Inventory - Bottles.......... 75,000.00 EUR DR WIP - Merlot................. 75,000.00 EUR CR Inventory - Bottles.......... 75,000.00 EUR As the vines are for one product only (no blended wines, pls! ), we can transfer them straight to the Work-in-Process accounts. (In terms of Management Accounting, depreciation is classified as overheads. Their allocation to manufacturing overheads followed by an application to the WIP accounts gives us the same result. Hence, we are making a shortcut in our Bookkeeping procedure here.) DR WIP - Pinotage............... 70,000.00 EUR CR Depreciation ................. 70,000.00 EUR DR WIP - Merlot................. 50,000.00 EUR CR Depreciation ................. 50,000.00 EUR Labour and depreciation on the barrels are manufacturing overheads. In contrast, interest is a non-manufacturing expense. Therefore, we close-off labour and bottle depreciation to the Manufacturing Overheads account. We only apply one Manufacturing Overhead account for the entire wine making process. DR Manufacturing Overheads...... 420,000.00 EUR CR Depreciation ................. 20,000.00 EUR CR Labour....................... 400,000.00 EUR <?page no="380"?> Berkau: Basics of Accounting 6e 28-380 The manufacturing overheads serve both products (Pinotage and Merlot) to the same extent. Hence, overheads are split based on a half : half ratio to the Work-in-Process accounts for Merlot and Pinotage. No idle costs apply; we do not experience over-capacity regarding labour or bottles. The portion for each product equals: 420,000 / 2 = 2 210,000.00 EUR. DR WIP - Pinotage............... 210,000.00 EUR CR Manufacturing Overheads...... 210,000.00 EUR DR WIP - Merlot................. 210,000.00 EUR CR Manufacturing Overheads...... 210,000.00 EUR The Work-in-Process accounts for Pinotage and Merlot are closed-off to the Inventory of Finished Goods account once production is completed. We now apply two different Inventory of Finished Goods accounts - one for Pinotage and the other one for Merlot. DR FG Inventory - Pinotage...... 355,000.00 EUR CR WIP - Pinotage............... 355,000.00 EUR DR FG Inventory - Merlot........ 335,000.00 EUR CR WIP - Merlot................. 335,000.00 EUR When ASHTON Ltd. sells its wines, it makes Bookkeeping entries for the release of the sold bottles from stock. The portion of Pinotage wines (sold) is: (180,000 / 250,000) × 355,000 = 255,600.00 EUR. The contra entry is recorded in the Cost of Goods Sold account. DR Cost of Goods Sold........... 255,600.00 EUR CR FG Inventory - Pinotage...... 255,600.00 EUR Like Pinotage, the portion of sold Merlots is calculated based on the cost of manufacturing: (230,000 / 250,000) × 335,000 = 3 308,200.00 EUR. DR Cost of Goods Sold........... 308,200.00 EUR CR FG Inventory - Merlot........ 308,200.00 EUR We apply one Cost of Goods Sold (COS) account for both wines at ASHTON Ltd. The costs of goods sold cover all manufacturing expenses for the wines sold. For profit calculation, we close-off sales, cost of goods sold and interest to the Profit and Loss account. See the Bookkeeping entries below. DR Sales........................ 2,022,000.00 EUR CR Profit and Loss.............. 2,022,000.00 EUR <?page no="381"?> Berkau: Basics of Accounting 6e 28-381 DR Profit and Loss.............. 563,800.00 EUR CR Cost of Goods Sold........... 563,800.00 EUR DR Profit and Loss.............. 25,000.00 EUR CR Interest..................... 25,000.00 EUR The pre-tax profit is exactly the same as the one we calculated following the nature of expense method. Observe the accounts in Figure 28.5. D C D C (1) 1,000,000.00 (3) 25,000.00 c/ d 1,000,000.00 (1) 1,000,000.00 (2) 500,000.00 (4a) 50,000.00 b/ d 1,000,000.00 (15) 1,324,800.00 (5) 960,000.00 (16) 1,101,600.00 (6) 840,000.00 (7) 600,000.00 (10) 480,000.00 D C (12) 250,000.00 c/ d 50,000.00 (4b) 50,000.00 (13) 150,000.00 b/ d 50,000.00 (14) 180,000.00 c/ d 391,400.00 3,926,400.00 3,926,400.00 b/ d 391,400.00 Cash/ Bank C/ B Issued capital ISS Accounts payables A/ P D C D C (4) 50,000.00 (2) 500,000.00 (3) 25,000.00 c/ d 25,000.00 (4b) 50,000.00 b/ d 25,000.00 P&L 25,000.00 c/ d 400,000.00 500,000.00 500,000.00 b/ d 400,000.00 Interest bearing liabilities IBL Interest-20X4 INT D C D C (5) 800,000.00 c/ d 800,000.00 (5) 160,000.00 (15) 220,800.00 b/ d 800,000.00 (6) 140,000.00 (16) 183,600.00 (7) 100,000.00 (10) 80,000.00 (14) 30,000.00 c/ d 105,600.00 510,000.00 510,000.00 b/ d 105,600.00 Property, plant, equipment (land) PPE Value added tax VAT Figure 28.5: ASHTON Ltd.’s accounts <?page no="382"?> Berkau: Basics of Accounting 6e 28-382 D C D C (6) 700,000.00 c/ d 700,000.00 c/ d 70,000.00 (8) 70,000.00 b/ d 700,000.00 b/ d 70,000.00 D C D C (7) 500,000.00 c/ d 500,000.00 c/ d 50,000.00 (9) 50,000.00 b/ d 500,000.00 b/ d 50,000.00 D C D C (8) 70,000.00 (10) 400,000.00 c/ d 400,000.00 (9) 50,000.00 b/ d 400,000.00 (11) 20,000.00 c/ d 140,000.00 140,000.00 140,000.00 b/ d 140,000.00 WPP 70,000.00 WMP 50,000.00 c/ d 20,000.00 140,000.00 140,000.00 b/ d 20,000.00 MOH 20,000.00 Property, plant, equipment (merlot) PPM Accumulated depreciation (merlot) ACM Property, plant, equipment (pinotage) PPP Accumulated depreciation (pinotage) ACP Depreciation-20X4 DPR Property, plant, equipment (barrels) PPB D C D C (12) 250,000.00 c/ d 20,000.00 (11) 20,000.00 (13) 150,000.00 c/ d 400,000.00 b/ d 20,000.00 400,000.00 400,000.00 b/ d 400,000.00 MOH 400,000.00 Labour-20X4 LAB Accumulated depreciation (barrels) ACB D C D C (15) 1,104,000.00 (14) 150,000.00 c/ d 150,000.00 c/ d 2,022,000.00 (16) 918,000.00 b/ d 150,000.00 Inv 150,000.00 2,022,000.00 2,022,000.00 P&L 2,022,000.00 b/ d 2,022,000.00 Sales Revenue-20X4 REV Purchase-20X4 PUR D C D C INB 75,000.00 INB 75,000.00 DPR 70,000.00 DPR 50,000.00 MOH 210,000.00 c/ d 355,000.00 MOH 210,000.00 c/ d 335,000.00 355,000.00 355,000.00 335,000.00 335,000.00 b/ d 355,000.00 FG 355,000.00 b/ d 335,000.00 FG 335,000.00 Work-in-process (pinotage) WPP Work-in-process (merlot) WMP Figure 28.5: ASHTON Ltd.’s accounts (continued) <?page no="383"?> Berkau: Basics of Accounting 6e 28-383 D C D C PUR 150,000.00 WPP 75,000.00 DPR 20,000.00 WMP 75,000.00 LAB 400,000.00 c/ d 420,000.00 150,000.00 150,000.00 420,000.00 420,000.00 b/ d 420,000.00 WMP 210,000.00 WPP 210,000.00 420,000.00 420,000.00 D C D C WIP 355,000.00 COS 255,600.00 WIP 335,000.00 COS 308,200.00 c/ d 99,400.00 c/ d 26,800.00 355,000.00 355,000.00 335,000.00 335,000.00 b/ d 99,400.00 b/ d 26,800.00 D C D C FGM 308,200.00 COS 563,800.00 REV 2,022,000.00 FGP 255,600.00 c/ d 563,800.00 INT 25,000.00 563,800.00 563,800.00 EBT 1,433,200.00 b/ d 563,800.00 P&L 563,800.00 2,022,000.00 2,022,000.00 ITL 429,960.00 b/ d 1,433,200.00 R/ E 1,003,240.00 1,433,200.00 1,433,200.00 Inventory bottles INB Manufacturing Overheads MOH Finished goods inventory (pinotage) FGP Finished goods inventory (merlot) FGM Cost of goods sold (COS) Profit and Loss-20X4 P&L D C D C c/ d 429,960.00 P&L 429,960.00 c/ d 1,003,240.00 P&L 1,003,240.00 b/ d 429,960.00 b/ d 1,003,240.00 Income tax liabilities ITL Retained earnings R/ E Figure 28.5: ASHTON Ltd.’s accounts (continued) Figure 28.6 discloses the statement of profit and loss and other comprehensive income based on the cost of sales format. <?page no="384"?> Berkau: Basics of Accounting 6e 28-384 [EUR] Revenue 2,022,000.00 Other income 2,022,000.00 Cost of goods sold (563,800.00) Earnings before int and taxes (EBIT) 1,458,200.00 Interest (25,000.00) Earnings before taxes (EBT) 1,433,200.00 Income tax expenses (429,960.00) Deferred taxes Earnings after taxes (EAT) 1,003,240.00 Ashton Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 28.6: ASHTON Ltd.’s income statement (COS) The statement of financial position is the same as in Figure 28.4. The advantage of the cost of sales format lays in the option to disclose margins product-wise. The margin is calculated as revenue minus cost of goods sold. We repeat the income statement with now a separate disclosure of revenues and costs of goods sold for Pinotage and Merlot. This way, the income statement tells us how ASHTON Ltd. earns its money (which product has the highest margin). This information should not always be shared with the public. Therefore, such an income statement should better be prepared for internal use than for publication as financial statement. See the more detailed format of the income statement at ASHTON Ltd. in Figure 28.7. <?page no="385"?> Berkau: Basics of Accounting 6e 28-385 [EUR] Pinotage Merlot Revenue 918,000.00 1,104,000.00 Other income 918,000.00 1,104,000.00 Cost of goods sold (308,200.00) (255,600.00) Contribution margin 609,800.00 848,400.00 Total EBIT Interest Earnings before taxes (EBT) Income tax expenses Deferred taxes Earnings after taxes (EAT) Ashton Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 1,003,240.00 1,458,200.00 (25,000.00) 1,433,200.00 (429,960.00) Figure 28.7: ASHTON Ltd.’s income statement enhanced In the last three chapters, we covered inventory movements, cost formulas and income statements based on different formats. The next case study MONTAGU (Pty) Ltd. summarises these aspects. 28.11 C/ S MONTAGU (Pty) Ltd. MONTAGU (Pty) Ltd. is a dealership for office appliances. The company is established on 2.01.20X8 by a contribution of owners to the extent of 10,000.00 EUR. MONTAGU (Pty) Ltd. pays 12,000.00 EUR for rent and 36,000.00 EUR for labour (sales staff) during the Accounting period 20X8. MONTAGU (Pty) Ltd.’s purchases/ sales are as follows for its products puncher and stapler. All purchase costs are net amounts. In this case study, VAT applies. - 5.01.20X8: Purchase of 1,000 punchers at 2.30 EUR/ u and purchase of 5,600 staplers at 5.10 EUR/ u. - 5.04.20X8: Purchase of 1,200 punchers at 2.20 EUR/ u and purchase of 6,000 staplers at 5.50 EUR/ u. - 5.07.20X8: Purchase of 500 punchers at 2.50 EUR/ u and purchase of 10,000 staplers at 4.90 EUR/ u. - 5.10.20X8: Purchase of 900 punchers at 2.38 EUR/ u and purchase of 15,000 staplers at 4.30 EUR/ u. All punchers and all staplers are alike. MONTAGU (Pty) Ltd. applies weighted average cost formula for its inventory movements. Consider a discount allowed by the stapler supplier on all staplers bought during a year after the purchase amount exceeds 25,000 staplers. The discount received is 10 % (off). A 10 % discount applies for the 25,001 st and any further staplers. The discount is not yet considered for the purchase prices disclosed above. <?page no="386"?> Berkau: Basics of Accounting 6e 28-386 During 20X8, all punchers are sold at a net selling price of 5.00 EUR/ u and all staplers at 10.00 EUR/ u. The selling date is in the middle of the quarter to keep the case study simple: - 15.02.20X8: Sale of 850 punchers and 4,012 staplers. - 15.05.20X8: Sale 600 punchers and 7,050 staplers. - 15.08.20X8: Sale of 750 punchers and 8,750 staplers. 10 staplers thereof are returned within a month and put on stock as they are not damaged. The customers are refunded on cash. - 15.11.20X8: Sale of 1,000 punchers and 15,988 staplers. All transactions are on cash. Below, we record the Bookkeeping entries for MONTAGU (Pty) Ltd. and set up a Profit and Loss account in preparation of the income statement and the balance sheet. Observe the Bookkeeping entries below: (1) Incorporation on 2.01.20X8. DR Cash/ Bank.................... 10,000.00 EUR CR Share Capital................ 10,000.00 EUR (2) Payment for rent by bank transfer on 2.01.20X8. DR Rent......................... 12,000.00 EUR CR Cash/ Bank.................... 12,000.00 EUR (3) Payment for labour by bank transfer on 31.12.20X8. DR Labour....................... 36,000.00 EUR CR Cash/ Bank.................... 36,000.00 EUR We prepare a table for the purchases and sales of punchers and staplers - one per product. We exceed the tables later to the right to record inventory valuations. The tables contain at first only the above given information. “+” stands for an increase of stock, “-“ for decreases. We extend the tables below in the text. <?page no="387"?> Berkau: Basics of Accounting 6e 28-387 Item Price paid/ u Amount Date + punchers 2.30 1,000 5.01.20X8 punchers (850) 15.02.20X8 + punchers 2.20 1,200 5.04.20X8 punchers (600) 15.05.20X8 + punchers 2.50 500 5.07.20X8 punchers (750) 15.08.20X8 Return of punchers sold in July. Punchers are put on stock. 10 15.09.20X8 + punchers 2.38 900 5.10.20X8 punchers (1,000) 15.11.20X8 Figure 28.8: MONTAGU (Pty) Ltd.’s inventory movements for punchers Item Price paid/ u Amount Date + stapler 5.10 5,600 5.01.20X8 stapler (4,012) 15.02.20X8 + stapler 5.50 6,000 5.04.20X8 stapler (7,050) 15.05.20X8 + stapler 4.90 10,000 5.07.20X8 stapler (8,750) 15.08.20X8 + stapler 4.30 15,000 5.10.20X8 stapler (15,988) 15.11.20X8 Figure 28.9: MONTAGU (Pty) Ltd.’s inventory movements for staplers For the following Bookkeeping entries, we calculate the number and value of punchers/ staplers on stock by applying the weighted average cost formula. See details of the inventory valuation in Figure 28.10. It is recommended to re-calculate these figures on your own to understand them better. Build your own MS-Excel sheet! <?page no="388"?> Berkau: Basics of Accounting 6e 28-388 Item Price paid/ u Amount Stock Value Change Stock level + punchers 2.30 1,000 1,000 2.30 2,300.00 2,300.00 punchers (850) 150 2.30 (1,955.00) 345.00 + punchers 2.20 1,200 1,350 2.21 2,640.00 2,985.00 punchers (600) 750 2.21 (1,326.67) 1,658.33 + punchers 2.50 500 1,250 2.33 1,250.00 2,908.33 punchers (750) 500 2.33 (1,745.00) 1,163.33 Return of punchers sold in July. Punchers are put on stock. 10 510 2.33 23.27 1,186.60 + punchers 2.38 900 1,410 2.36 2,142.00 3,328.60 punchers (1,000) 410 2.36 (2,360.71) 967.89 Figure 28.10: MONTAGU (Pty) Ltd.’s inventory movements for punchers 1 st line: MONTAGU (Pty) Ltd. buys 1,000 punchers on 5.01.20X8. The number on stock is 1,000 then. Their value is 2.30 EUR/ u or all together: 2,300.00 EUR. 2 nd line: After selling 850 punchers, the stock level is down to: 1,000 - 850 = 1 150 punchers. The costs per unit are still 2.30 EUR/ u. The level of stock in EUR is: 150 × 2.30 = 3 345.00 EUR. 3 rd line: MONTAGU (Pty) Ltd. purchases 1,200 punchers on 5.04.20X8 at 2.20 EUR/ u. The stock increase is: 2.20 × 1,200 = 2 2,640.00 EUR. The stock level in numbers is: 150 + 1,200 = 1 1,350 punchers. The costs per unit of the punchers are calculated by weighted average cost formula. There are 150 punchers bought at 2.30 EUR/ u and 1,200 punchers purchased at 2.20 EUR/ u. Hence, the unit costs are: (150 × 2.30 + 1,200 × 2.20) / (150 + 1,200) = 2 2.21 EUR/ u. (The amount is rounded off. Although, in Figure 28.10 values are rounded to the nearest cent, they are calculated accurately.) The value of the punchers is: 1,350 × 2.21 = 2 2,983.50 EUR. The exact value is 2,985.00 EUR. 4 th line: When MONTAGU (Pty) Ltd. sells 600 punchers, its stock decreases based on the calculated unit costs: 2.21 EUR/ u. The stock level in numbers is: 1,350 - 600 = 7750 punchers. The reduction in EUR is: 600 × 2.21 = 1 1,326.00 EUR. The accurate amount is 1,326.67 EUR. Now the stock level is amounting to: 750 x 2.21 = 1 1,657.50 EUR. The exact value is 1,658.33 EUR. 5 th line: The next purchase of 500 punchers takes place on 5.07.20X8. The punchers cost 2.50 EUR/ u per unit. The increase of punchers leads to a stock level of: 750 + 500 = 1 1,250 punchers. The increase of stock in terms of values is: 500 × 2.50 = 1 1,250.00 EUR. After this input, the level on stock is: 1,658.33 + 1,250 = 2,908.33 EUR. The weighted average costs per puncher are: 2,908.33 / 1,250 = 22.33 EUR/ u. 6 th line: MONTAGU (Pty) Ltd. sells 750 punchers on 15.08.20X8. The stock level after the sale is: 1,250 - 750 = 5 500 punchers. The value of stock reduction is based on the weighted average costs per puncher: 2.33 EUR/ u. The stock reduction is: 750 × 2.33 = 1 1,747.50 EUR. <?page no="389"?> Berkau: Basics of Accounting 6e 28-389 The exact value is 1,745.00 EUR. Accordingly, the new stock level equals: 2,908.33 - 1,745 = 1 1,163.33 EUR. 7 th line: 10 customers return their punchers bought on 15.08.20X8. Every customer bought one puncher. After the returns inwards, MONTAGU (Pty) Ltd. adds the returned punchers to stock. The value per returned puncher is 2.33 EUR/ u. The punchers are returned within a month which means they are the last ones sold by MONTAGUE Ltd. For the last sales, the weighted average costs are 2.33 EUR/ u. According to this calculation, the increase of stock in numbers is 10 punchers. The stock level after the returns inwards is: 500 + 10 = 5 510 punchers. The level of stock in terms of the EUR amounts is: 1,163.33 + 10 × 2.33 = 1 1,186.63 EUR. The accurate value is 1,186.60 EUR. 8 th line: On 5.10.20X8, MONTAGU (Pty) Ltd. buys 900 punchers at 2.38 EUR/ u each. The increase of stock is 900 punchers. The stock level after the purchase in numbers is: 510 + 900 = 1 1,410 punchers. The increase of the puncher stock level in EUR amounts is: 900 × 2.38 = 2 2,142.00 EUR. The new balancing figure of the stock account is: 1,186.60 + 2,142 = 3,328.60 EUR. The weighted unit costs per puncher equal: 3,328.60 / 1,410 = 2.36 EUR/ u. The value is rounded off. 9 th line: When MONTAGU (Pty) Ltd. sells 1,000 punchers, the stock level drops to: 1,410 - 1,000 = 4 410 punchers. The stock reduction in EUR amounts is: 1,000 × 2.36 = 2 2,360.00 EUR. The accurate value is 2,360.71 EUR. The closing balance of the Inventory - Puncher account is: 3,328.60 - 2,360.71 = 9 967.89 EUR. Next, we make the Bookkeeping entries for punchers based on the inventory movements calculated above. (4) Purchase of 1,000 punchers on 5.01.20X8. DR Purchase..................... 2,300.00 EUR DR VAT.......................... 460.00 EUR CR Cash/ Bank.................... 2,760.00 EUR (5) We apply goods related inventory accounts. MONTAGU (Pty) Ltd. records the increase of punchers on 5.01.20X8 in the Inventory Punchers account. DR Inventory Punchers........... 2,300.00 EUR CR Purchase..................... 2,300.00 EUR (6) Sale of 850 punchers at 5.00 EUR/ u net selling price on 15.02.20X8. The revenue is 4,250.00 EUR. The price paid by the customers including VAT is: 4,250 × 120 % = 5 5,100.00 EUR. DR Cash/ Bank.................... 5,100.00 EUR CR VAT.......................... 850.00 EUR CR Revenue...................... 4,250.00 EUR <?page no="390"?> Berkau: Basics of Accounting 6e 28-390 (7) Inventory movement linked to the sale of 850 punchers on 15.02.20X8. The valuation is at costs: 850 × 2.30 = 11,955.00 EUR. DR Cost of Sales (COS).......... 1,955.00 EUR CR Inventory Punchers........... 1,955.00 EUR (8) Purchase of 1,200 punchers at 2.20 EUR/ u on 5.04.20X8. The gross amount is: 2,640 × 120% = 3 3,168.00 EUR. DR Purchase .................... 2,640.00 EUR DR VAT.......................... 528.00 EUR CR Cash/ Bank.................... 3,168.00 EUR (9) Transfer of purchases to inventories on 5.04.20X8. DR Inventory Punchers........... 2,640.00 EUR CR Purchase..................... 2,640.00 EUR (10) Sale of 600 punchers on 15.05.20X8. The gross amount is: 600 × 5 × 120% = 3 3,600.00 EUR. DR Cash/ Bank.................... 3,600.00 EUR CR VAT.......................... 600.00 EUR CR Revenue...................... 3,000.00 EUR (11) Inventory movement for the puncher sale on 15.05.20X8. The costs are taken from Figure 28.10 - Changecolumn directly. The amount is better than the calculation based on rounded unit costs, and gives: 600 × 2.21 = 1,326.00 EUR. DR Cost of Sales (COS).......... 1,326.67 EUR CR Inventory Punchers........... 1,326.67 EUR (12) Purchase of 500 punchers at 2.50 EUR/ u on 5.07.20X8. The gross amount is: 1,250 × 120% = 1 1,500.00 EUR. DR Purchase .................... 1,250.00 EUR DR VAT.......................... 250.00 EUR CR Cash/ Bank.................... 1,500.00 EUR (13) Transfer of purchases to inventories on 5.07.20X8. <?page no="391"?> Berkau: Basics of Accounting 6e 28-391 DR Inventory Punchers........... 1,250.00 EUR CR Purchase..................... 1,250.00 EUR (14) Sale of 750 punchers on 15.08.20X8. The gross amount is: 750 × 5 × 120% = 4 4,500.00 EUR. DR Cash/ Bank.................... 4,500.00 EUR CR VAT.......................... 750.00 EUR CR Revenue...................... 3,750.00 EUR (15) Inventory movement for the puncher sale on 15.08.20X8. The amount of 1,745.00 EUR is taken from Figure 28.10 - Change-column directly. DR Cost of Sales (COS).......... 1,745.00 EUR CR Inventory Punchers........... 1,745.00 EUR On 15.09.20X8, 10 punchers get returned. No damage is detected. As a result, MONTAGU (Pty) Ltd. puts the punchers on stock. The puncher input is based on the unit costs per puncher when they were released from stock at the time of sales. (16) The puncher buyers are refunded. The total refund is: 5 × 10 × 120% = 60.00 EUR. Instead of applying a Returns Inwards account, MONTAGUE Ltd. records a negative sale/ revenue. DR Revenue...................... 50.00 EUR DR VAT.......................... 10.00 EUR CR Cash/ Bank.................... 60.00 EUR (17) The increase of stock for the returned punchers is linked to a reduction in the Cost of Sales (COS) account. This means, the expenses for selling the goods are reduced to the extent of 10 punchers, because these goods were returned. The value is taken directly from Figure 28.10 - Change-column directly. DR Inventory Punchers........... 23.27 EUR CR Cost of Sales (COS).......... 23.27 EUR (18) Purchase of 900 punchers at 2.38 EUR/ u on 5.10.20X8. The gross amount is: 2,142 × 120% = 2 2,570.40 EUR. DR Purchase .................... 2,142.00 EUR DR VAT.......................... 428.40 EUR CR Cash/ Bank.................... 2,570.40 EUR <?page no="392"?> Berkau: Basics of Accounting 6e 28-392 (19) Transfer of purchases to inventories on 5.10.20X8. DR Inventory Punchers........... 2,142.00 EUR CR Purchase..................... 2,142.00 EUR (20) Sale of 1,000 punchers on 15.11.20X8. The gross amount is: 1,000 × 5 × 120% = 6 6,000.00 EUR. DR Cash/ Bank.................... 6,000.00 EUR CR VAT.......................... 1,000.00 EUR CR Revenue...................... 5,000.00 EUR (21) Inventory movement for the puncher sales on 15.11.20X8. The value is taken from Figure 28.10 - Change-column directly. DR Cost of Sales (COS).......... 2,360.71 EUR CR Inventory Punchers........... 2,360.71 EUR In Figure 28.12, the closing stock of punchers is 967.89 EUR as calculated in the table in Figure 28.10. Below, the stapler inventory movements are shown in Figure 28.11. The table is based on the same format as in Figure 28.10. In contrast, no stapler return applies. However, special attention is given to the discount allowed by the stapler supplier. Item Price paid/ u Amount Stock Value Change Stock level + stapler 5.10 5,600 5,600 5.10 28,560.00 28,560.00 stapler (4,012) 1,588 5.10 (20,461.20) 8,098.80 + stapler 5.50 6,000 7,588 5.42 33,000.00 41,098.80 stapler (7,050) 538 5.42 (38,184.84) 2,913.96 + stapler 4.90 10,000 10,538 4.93 49,000.00 51,913.96 stapler (8,750) 1,788 4.93 (43,105.63) 8,808.33 + stapler 4.30 15,000 16,788 4.37 64,500.00 73,308.33 Discount (4,988.00) 68,320.33 stapler (15,988) 800 4.07 (65,064.65) 3,255.67 Figure 28.11: MONTAGU (Pty) Ltd.’s inventory movement for staplers 1 st line: On 5.01.20X8, MONTAGU (Pty) Ltd. purchases 5,600 staplers at purchase costs of 5.10 EUR/ u. The total purchase value (net amount) is: 5,600 × 5.10 = 2 28,560.00 EUR. 2 nd line: In the next quarter (on 15.02.20X8), MONTAGU (Pty) Ltd. sells 4,012 staplers. The remaining number of staplers on stock is: 5,600 - 4,012 = 1,588 staplers. The unit costs for staplers <?page no="393"?> Berkau: Basics of Accounting 6e 28-393 are 5.10 EUR/ u. The decrease of stock is: 4,012 × 5.10 = 2 20,461.20 EUR. The new stock level is: 28,560 - 20,461.20 = 8,098.80 EUR. 3 rd line: On 5.04.20X8, MONTAGU (Pty) Ltd. purchases 6,000 staplers at 5.50 EUR/ u. The increase of stock equals: 6,000 × 5.50 = 3 33,000.00 EUR. The new stapler level is: 8,098.80 + 33,000 = 41,098.80 EUR. The stapler number is: 1,588 + 6,000 = 7 7,588 staplers. The average costs per stapler are: 41,098.80 / 7,588 = 5 5.42 EUR/ u. 4 th line: During the next quarter on 15.05.20X8, MONTAGU (Pty) Ltd. sells 7,050 staplers. The new stock level is: 7,588 - 7,050 = 5 538 staplers. The decrease of stock by selling 7,050 staplers is: 7,050 × 5.42 = 3 38,211.00 EUR. The exact value is 38,184.84 EUR. The absolute rounding difference regarding the staplers is considerably high, because the stapler number per inventory movement is high. MONTAGU (Pty) Ltd. orders and sells thousands of staplers. The new stock level is: 41,098.80 - 38,184.84 = 2,913.96 EUR. 5 th line: On 5.07.20X8 MONTAGU (Pty) Ltd. buys 10,000 staplers at a net purchase price of 4.90 EUR/ u. The increase of stock is: 10,000 × 4.90 = 4 49,000.00 EUR. The stock level of staplers is: 2,913.96 + 49,000 = 5 51,913.96 EUR. The number of staplers on stock now is: 538 + 10,000 = 1 10,538 staplers. The weighted average costs per stapler are: 51,913.96 / 10,538 = 4 4.93 EUR/ u. 6 th line: During the third quarter of 20X8 on the 15.08.20X8, MONTAGU (Pty) Ltd. sells 8,750 staplers. The number of staplers after sales is: 10,538 - 8,750 = 1,788 staplers. The decrease of stock is amounting to: 8,750 × 4.93 = 4 43,137.50 EUR. The exact value based on our MS- Excel calculation in Figure 28.11 is: 43,105.63 EUR. The stock level after the sales is: 51,913.96 - 43,105.63 = 8,808.33 EUR. 7 th line: On 5.10.20X8, MONTAGU (Pty) Ltd. orders 15,000 staplers at purchase costs of 4.30 EUR/ u. The number of staplers on stock increases and now is: 1,788 + 15,000 = 1 16,788 staplers. The increase is: 15,000 × 4.30 = 6 64,500.00 EUR. The closing stock after this purchase is: 8,808.33 + 64,500 = 7 73,308.33 EUR. The weighted average unit costs are: 73,308.33/ 16,788 = 4 4.37 EUR/ u. 8 th line: With the previous purchase, MONTAGU (Pty) Ltd. qualifies for the discount offered by its stapler supplier. The terms and conditions stipulate: If MONTAGU (Pty) Ltd. exceeds an order amount of 25,000 staplers a discount of 10 % for all following staplers (= 25,001 + x) is granted. During the Accounting period 20X8, MONTAGU (Pty) Ltd. ordered: 5,600 + 6,000 + 10,000 + 15,000 = 336,600 staplers. Hence, the costs for 11,600 staplers resulting from the last delivery on 5.10.20X8 are reduced by 10 %. The discount is: 11,600 × 4.30 × 10% = 44,988.00 EUR. This amount is ex VAT. The full discount received by MONTAGU (Pty) Ltd. includes VAT and is amounting to: 4,988 × 120% = 5 5,985.60 EUR. Costs of purchase are calculated as purchase price minus VAT and minus discounts. As a result, MONTAGU (Pty) Ltd.’s inventory of staplers is reduced by 4,988.00 EUR. The closing stock equals: 73,308.33 - 4,988 = 6 68,320.33 EUR. The average unit costs per stapler change by the discount. The unit costs now are amounting to: 68,320.33 / 16,788 = 4 4.07 EUR/ u. The VAT account is adjusted for the discount received, too. <?page no="394"?> Berkau: Basics of Accounting 6e 28-394 9 th line: MONTAGU (Pty) Ltd. sells 15,988 staplers during the last quarter of 20X8 on 15.11.20X8. The stock decrease of staplers due to the sale is: 15,988 × 4.07 = 6 65,071.16 EUR. The accurate value is 65,064.65 EUR. The closing stock on the balance sheet date is: 68,320.33 - 65,064.65 = 3 3,255.68 EUR. The MS-Excel-accurate value is 3,255.67 EUR. Below, all Bookkeeping entries for the stapler movements are shown: (22) Purchase of staplers on 5.01.20X8. The gross amount is: 28,560 × 120% = 34,272.00 EUR. DR Purchase..................... 28,560.00 EUR DR VAT.......................... 5,712.00 EUR CR Cash/ Bank.................... 34,272.00 EUR (23) The purchases are transferred to the Inventory Staplers account. DR Inventory Staplers........... 28,560.00 EUR CR Purchase..................... 28,560.00 EUR (24) Sale of 4,012 staplers at 10.00 EUR/ u net selling price each. The revenue is: 4,012 × 10 = 4 40,120.00 EUR. The gross amount is: 40,120 × 120% = 48,144.00 EUR. DR Cash/ Bank.................... 48,144.00 EUR CR VAT.......................... 8,024.00 EUR CR Revenue...................... 40,120.00 EUR (25) The inventory reduction is taken from Figure 28.11 and is 20,461.20 EUR. DR Cost of Sales (COS).......... 20,461.20 EUR CR Inventory Staplers........... 20,461.20 EUR (26) Purchase of staplers on 5.04.20X8. The gross amount is: 33,000 × 120% = 39,600.00 EUR. DR Purchase..................... 33,000.00 EUR DR VAT.......................... 6,600.00 EUR CR Cash/ Bank.................... 39,600.00 EUR (27) The purchases are transferred to the Inventory Staplers account. <?page no="395"?> Berkau: Basics of Accounting 6e 28-395 DR Inventory Staplers........... 33,000.00 EUR CR Purchase..................... 33,000.00 EUR (28) Sale of 7,050 staplers at 10.00 EUR/ u net selling price each. The revenue is: 7,050 × 10 = 7 70,500.00 EUR. The gross amount is: 70,500 × 120% = 84,600.00 EUR. DR Cash/ Bank.................... 84,600.00 EUR CR VAT.......................... 14.100.00 EUR CR Revenue...................... 70,500.00 EUR (29) The inventory reduction is taken from Figure 28.11 and is amounting to 38,184.84 EUR. DR Cost of Sales (COS).......... 38,184.84 EUR CR Inventory Staplers........... 38,184.84 EUR (30) Purchase of staplers on 5.07.20X8. The gross amount is: 49,000 × 120% = 58,800.00 EUR. DR Purchase..................... 49,000.00 EUR DR VAT.......................... 9,800.00 EUR CR Cash/ Bank.................... 58,800.00 EUR (31) The purchases are transferred to the Inventory Staplers account. DR Inventory Staplers........... 49,000.00 EUR CR Purchase..................... 49,000.00 EUR (32) Sale of 8,750 staplers at 10.00 EUR/ u net selling price each. The revenue is: 8,750 × 10 = 8 87,500.00 EUR. The gross amount is: 87,500 × 120% = 105,000.00 EUR. DR Cash/ Bank.................... 105,000.00 EUR CR VAT.......................... 17,500.00 EUR CR Revenue...................... 87,500.00 EUR (33) The inventory reduction is derived from Figure 28.11 and is amounting to 43,105.63 EUR. <?page no="396"?> Berkau: Basics of Accounting 6e 28-396 DR Cost of Sales (COS).......... 43,105.63 EUR CR Inventory Staplers........... 43.105.63 EUR (34) Purchase of staplers on 5.10.20X8. The gross amount is: 64,500 × 120% = 777,400.00 EUR. DR Purchase..................... 64,500.00 EUR DR VAT.......................... 12,900.00 EUR CR Cash/ Bank.................... 77,400.00 EUR (35) The purchases are transferred to the Inventory Staplers account. DR Inventory Staplers........... 64,500.00 EUR CR Purchase..................... 64,500.00 EUR (36) The stapler supplier offers a discount of 10 % on all staplers bought after purchases exceed 25,000 staplers. 11,600 staplers are marked down by 10 % according to the discount received. The discount’s gross amount is: 11,600 × 4.30 × 10% × 120% = 5 5,985.60 EUR. The net amount of the discount is: 5,985.60 / 120% = 4 4,988.00 EUR. The discount is recorded after the purchase what we refer to as a deferred discount. The contra account for the discount received is the Cash/ Bank account. MONTAGU (Pty) Ltd. records the discount on 6.10.20X8 (one day after the purchase). DR Cash/ Bank.................... 5,985.60 EUR CR Discount..................... 5,985.60 EUR (37) According to IAS 2, the costs of purchase must be adjusted. MONTAGU (Pty) Ltd. makes a credit entry in the Inventory Staplers account. Furthermore, the VAT claim is decreased due to the discount as MONTAGU (Pty) Ltd. did not pay the full price, but only 90 % thereof. On 6.10.20X8, MONTAGU (Pty) Ltd. records the discount received from its supplier. DR Discount..................... 5,985.60 EUR CR VAT.......................... 997.60 EUR CR Inventory Staplers........... 4,988.00 EUR (38) Sale of 15,988 staplers at 10.00 EUR/ u net selling price each. The revenue is: 15,988 × 10 = 1 159,880.00 EUR. The gross amount equals: 159,880 × 120% = 1 191,856.00 EUR. <?page no="397"?> Berkau: Basics of Accounting 6e 28-397 DR Cash/ Bank.................... 191,856.00 EUR CR VAT.......................... 31,976.00 EUR CR Revenue...................... 159,880.00 EUR (39) The inventory reduction is taken from Figure 28.11: 65,064.65 EUR. DR Cost of Sales (COS).......... 65,064.65 EUR CR Inventory Staplers........... 65,064.65 EUR Observe the closing stock of the Inventory Staplers account being the same as in Figure 28.11 on the bottom line. The profit calculation can be studied in Figure 28.12. D C D C (1) 10,000.00 (2) 12,000.00 c/ d 10,000.00 (1) 10,000.00 (6) 5,100.00 (3) 36,000.00 b/ d 10,000.00 (10) 3,600.00 (4) 2,760.00 (14) 4,500.00 (8) 3,168.00 (20) 6,000.00 (12) 1,500.00 (24) 48,144.00 (16) 60.00 (28) 84,600.00 (18) 2,570.40 (32) 105,000.00 (22) 34,272.00 (36) 5,985.60 (26) 39,600.00 (38) 191,856.00 (30) 58,800.00 (34) 77,400.00 c/ d 196,655.20 464,785.60 464,785.60 b/ d 196,655.20 D C D C (2) 12,000.00 P&L 12,000.00 (3) 36,000.00 P&L 36,000.00 Cash/ Bank C/ B Share capital ISS Rent-20X8 RNT Labour-20X8 LAB Figure 28.12: MONTAGU (Pty) Ltd.’s accounts <?page no="398"?> Berkau: Basics of Accounting 6e 28-398 D C D C (4) 2,300.00 (5) 2,300.00 (4) 460.00 (6) 850.00 (8) 2,640.00 (9) 2,640.00 (8) 528.00 (10) 600.00 (12) 1,250.00 (13) 1,250.00 (12) 250.00 (14) 750.00 (18) 2,142.00 (19) 2,142.00 (16) 10.00 (20) 1,000.00 (22) 28,560.00 (23) 28,560.00 (18) 428.40 (24) 8,024.00 (26) 33,000.00 (27) 33,000.00 (22) 5,712.00 (28) 14,100.00 (30) 49,000.00 (31) 49,000.00 (26) 6,600.00 (32) 17,500.00 (34) 64,500.00 (35) 64,500.00 (30) 9,800.00 (37) 997.60 183,392.00 183,392.00 (34) 12,900.00 (38) 31,976.00 c/ d 39,109.20 75,797.60 75,797.60 b/ d 39,109.20 D C D C (5) 2,300.00 (7) 1,955.00 (16) 50.00 (6) 4,250.00 (9) 2,640.00 (11) 1,326.67 (10) 3,000.00 (13) 1,250.00 (15) 1,745.00 (14) 3,750.00 (17) 23.27 (21) 2,360.71 (20) 5,000.00 (19) 2,142.00 c/ d 967.89 (24) 40,120.00 8,355.27 8,355.27 (28) 70,500.00 b/ d 967.89 (32) 87,500.00 P&L 373,950.00 (38) 159,880.00 374,000.00 374,000.00 Purchase-20X8 PUR Value added tax VAT Inventory punchers INP Revenue-20X8 REV D C D C (7) 1,955.00 (17) 23.27 (23) 28,560.00 (25) 20,461.20 (11) 1,326.67 (27) 33,000.00 (29) 38,184.84 (15) 1,745.00 (31) 49,000.00 (33) 43,105.63 (21) 2,360.71 (35) 64,500.00 (37) 4,988.00 (25) 20,461.20 (39) 65,064.65 (29) 38,184.84 c/ d 3,255.68 (33) 43,105.63 175,060.00 175,060.00 (39) 65,064.65 P&L 174,180.43 b/ d 3,255.68 174,203.70 174,203.70 D C D C (37) 5,985.60 (36) 5,985.60 LAB 36,000.00 REV 373,950.00 RNT 12,000.00 COS 174,180.43 EBT 151,769.57 373,950.00 373,950.00 IT 45,530.87 b/ d 151,769.57 R/ E 106,238.70 151,769.57 151,769.57 Cost of Sales-20X8 COS Inventory staplers INS Discount received DIS Profit and Loss-20X8 P&L Figure 28.12: MONTAGU (Pty) Ltd.’s accounts (continued) <?page no="399"?> Berkau: Basics of Accounting 6e 28-399 D C D C c/ d 45,530.87 P&L 45,530.87 c/ d 106,238.70 P&L 106,238.70 b/ d 45,530.87 b/ d 106,238.70 Income tax liabilities ITL Retained earnings R/ E Figure 28.12: MONTAGU (Pty) Ltd.’s accounts (continued) The income statement is prepared following the cost of sales format. Observe Figure 28.13 below. [EUR] Revenue 373,950.00 Other income 373,950.00 Cost of sales (COS) (174,180.43) Labour (36,000.00) Depreciation 0.00 Other expenses (12,000.00) Earnings before int and taxes (EBIT) 151,769.57 Interest 0.00 Earnings before taxes (EBT) 151,769.57 Income tax expenses (45,530.87) Deferred taxes Earnings after taxes (EAT) 106,238.70 MONTAGU (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 28.13: MONTAGU (Pty) Ltd.’s statement of comprehensive income The balance sheet is displayed in Figure 28.14: <?page no="400"?> Berkau: Basics of Accounting 6e 28-400 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 0.00 Share capital 10,000.00 Intangibles Reserves Financial assets R/ E 106,238.70 Current assets Liabilities Inventory 4,223.57 Interest bear liab A/ R A/ P 39,109.20 Prepaid expenses Provisions Cash/ Bank 196,655.20 Tax liabilities 45,530.87 200,878.77 200,878.77 Montagu (Pty) Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 28.14: MONTAGU (Pty) Ltd.’s statement of financial position The income statement following the nature of expense method would have been easier to prepare after all calculations in Figure 28.10 and Figure 28.11 have been made. The changes in inventory are the closing stocks of punchers and staplers as no opening values are considered for this case study. The values are taken from the bottom line of our calculations: 967.89 + 3,255.67 = 4 4,223.56 EUR. The total of purchases is: 2,300 + 2,640 + 1,250 + 2,142 + 28,560 + 33,000 + 49,000 + 64,500 = 1 183,392.00 EUR. The material expenses are: 183,392 - 4,223.56 - 4,988 = 1 174,180.44 EUR. The income statement following the nature of expense method looks as in Figure 28.15: <?page no="401"?> Berkau: Basics of Accounting 6e 28-401 [EUR] Revenue 373,950.00 Other income 373,950.00 Materials (174,180.44) Labour (36,000.00) Depreciation 0.00 Other expenses (12,000.00) Earnings before int and taxes (EBIT) 151,769.56 Interest 0.00 Earnings before taxes (EBT) 151,769.56 Income tax expenses (45,530.87) Deferred taxes Earnings after taxes (EAT) 106,238.69 MONTAGU (Pty) Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 28.15: MONTAGU (Pty) Ltd. income statement along the NoE format 28.12 Summary Companies can prepare the statement of profit or loss and other comprehensive income following the nature of expense method or the cost of sales format. Both formats calculate the same profit. The nature of expense method considers all expenses and makes adjustments to the revenue by changes in inventory. The cost of sales format is based on the revenue less cost for goods sold during the Accounting period. The cost of sales format is often used for Management Accounting purposes as it provides information about the contribution margin of products, customers, marketing segments, etc. IFRSs and Handelsgesetzbuch do not prescribe any method for income statement calculation. 28.13 Working Definitions Product Mix Decision: A product mix decision determines which numbers of which products a company produces. Statement of Profit or Loss and Other Comprehensive Income Following the Nature of Expense Method: The income statement following the nature of expense format calculates profit starting with the revenue and deducting all costs for the period; it requires adjustments for costs of manufacturing for stock increases/ decreases of finished goods. Statement of Profit or Loss and Other Comprehensive Income Following the Cost of Sales Format: The income statement along the cost of sales format starts with the revenue <?page no="402"?> Berkau: Basics of Accounting 6e 28-402 and deducts costs for only the goods/ services sold and thereafter deducts further, non-manufacturing expenses. 28.14 Question Bank (1) A company records revenues 300,000.00 EUR, labour 100,000.00 EUR, depreciation 20,000.00 EUR and materials 80,000.00 EUR. Furthermore, the company sells finished goods that were on stock for 50,000.00 EUR. No other changes in inventories apply. How much is the profit before taxation? 1. 150,000.00 EUR . 2 . 50,000.00 EUR . 3. 100,000.00 EUR . 4. 70,000.00 EUR . (2) Which statement is correct? 1. The income statement following the cost of sales format requires an addition for stock releases of finished goods. 2. The income statement following the cost of sales format allocates costs following the categories. 3. The income statement following the nature of expenses format assigns costs according to their function. 4. The income statement following the cost of sales format assigns costs according to their function. (3) Which statement is wrong? 1. The profit calculated by the nature of expense format is always the same as following the cost of sales format. 2. The gross profit calculated by the nature of expense format is higher than following the cost of sales format. 3. The profit calculation following the cost of sales format is best when applying Work-in-Process and Manufacturing Overhead accounts. 4. The international Accounting standards allow a company to prepare the statement of profit or loss and other comprehensive income along both formats: cost of sales format as well as nature of expense method. (4) A company records in the production department direct costs of 300,000.00 EUR and manufacturing overheads of 150,000.00 EUR for the production of 30,000 goods. The sales amount is 80 % of the amount of production. What is the correct Bookkeeping entry? 1. DR FGI 90,000.00 EUR; CR T/ A 90,000.00 EUR. 2. DR FGI 90,000.00 EUR; DR VAT 15,000.00 EUR; CR T/ A 75,000.00 EUR. 3. DR T/ A 90,000.00 EUR; CR FGI 90,000.00 EUR. 4. DR T/ A 90,000.00 EUR; CR VAT 15,000.00 EUR; CR INV 75,000.00 EUR. (5) Which statement is correct? 1. When preparing a statement of profit or loss following the nature of expense method, a company must disclose material, labour, depreciation, manufacturing overheads and expenses for administration. <?page no="403"?> Berkau: Basics of Accounting 6e 28-403 2. A company that prepares the statement of profit or loss and other comprehensive income must disclose various products following a classification explained in the notes. 3. The international Accounting standards IFRSs do not require a disclosure of stock increases of finished goods classified along product categories. 4. A company that prepares the statement of profit or loss and other comprehensive income following the nature of expense method must give information about the product calculation if stock of finished goods is changed. 28.15 Solutions 1-2; 2-4; 1-2; 4-1; 5-3. <?page no="404"?> Berkau: Basics of Accounting 6e 29-404 29 Trial Balance 29.1 What is in the Chapter? Next, we introduce the trial balance which we prepare after the initial Bookkeeping entries for business activities have been completed as well as after we calculated the profit. This gives us two trial balances. The trial balance is a list of all accounts where their balancing figures are allocated either to the debit or credit side. The initial concept behind the trial balance is to check the Bookkeeping entries regarding the double entry system. For that reason, we add all balances on the debit and credit column and check for equality. We explain in this chapter how to set up a trial balance and discuss the case study PENTZ Ltd. which produces surfboards and runs a fashion store for surfing attire. For the case PENTZ Ltd. we cover/ repeat the entire procedure of preparing financial statements commencing with recording Bookkeeping entries and ending with the preparation of financial statements. The process includes two trial balances: one after making initial Bookkeeping entries and another one after profit calculation. 29.2 Learning Objectives After studying this chapter, you can prepare a trial balance and can check your Bookkeeping records. You understand the message that a trial balance gives you: If all Bookkeeping entries have been recorded according to the double entry system, the total on both columns of your trial balances must equal. If they do not match, your Accounting work is faulty, but your trial balance helps you finding your Bookkeeping error(s). However, the equality of column totals does not guarantee correctness of Bookkeeping as you can also make a mistake on both sides at the same time, e.g., by miscalculating depreciation or ignoring a discount etc. 29.3 How to Prepare a Trial Balance The procedure with the trial balance is simple: After making Bookkeeping entries, we balance-off all accounts. We enter the balancing figures on the trial balance and compare the totals on the debit to the credit side. We must enter a debit balanced account in the column for debit and a credit balanced account in the column for credit. A debit balanced account is an account where the balance brought down (b/ d) is on the debit side. A credit balanced account is an account with the balance brought (b/ d) down on the credit side. If both sums on your trial balance are the same, the Bookkeeping records are likely to be consistent with the double entry system. You can prepare a trial balance at any stage of recording. In general, we prepare a trial balance after we finished the recording for business activities and then after completion of adjustments which means when profit has been calculated. You also can prepare one after the appropriation of profits, however, that is seldomly made in Accounting. <?page no="405"?> Berkau: Basics of Accounting 6e 29-405 Check how a trial balance works with the how-it-is-done-paragraph below: How it is Done (Trial Balance): (1) Record for all business activities. Balance-off all accounts. (2) Prepare a list with lines for every account you have. Make two columns, one for debit balanced and the other one for credit balanced accounts. Enter the balances brought down for all accounts in the columns debit or credit according to the side they belong to. A debit balanced account’s balance is entered on the debit side. A credit balanced account’s balance is entered on the credit side. (3) Compare the totals of debit entries and credit entries. If they are the same your Bookkeeping records are looking good. (4) Record the adjustments, like depreciation, accruals, interest and pay-off, profit calculation etc. Calculate the earnings before taxes and earnings after taxes. Make Bookkeeping entries for income tax liabilities and retained earnings. In case you prepare financial statements after the appropriation of profits calculate and record dividends, additions/ reductions to reserves. With a profit/ loss carried forward, you must consider the balancing figure for the Retained Earnings account, too. (5) Enter the changes resulting from adjustments in the trial balance. We recommend copying the previous trial balance and overwrite figures for adjustments. Therefore, delete all nominal accounts that have been closed-off for profit calculation. Most likely you must consider new accounts, like for prepaid expenses, inventories, income tax liabilities etc. Check whether totals on debit and credit side equal. (6) If the adjusted trial balance is OK, prepare financial statements. Derive the balance sheet from the adjusted trial balance. If the sums are different, start looking for Bookkeeping errors. 29.4 C/ S PENTZ Ltd. Next, we prepare financial statements for the case study PENTZ Ltd. The procedure is shown below. Trial balances are included in the process - at step (B) and (E). <?page no="406"?> Berkau: Basics of Accounting 6e 29-406 - Step (A): Making Bookkeeping entries. - Step (B): Preparing the trial balance. - Step (C): Checking the trial balance - Step (D): Making adjustments. - Step (E): Preparing the adjusted trial balance. - Step (F): Deriving financial statements. 29.5 Step (A): Making Bookkeeping Entries PENTZ Ltd. is a production firm for surfboards. Furthermore, the company runs a surf shop and sells surfing equipment, like protection bags, sunglasses, wet suits etc. PENTZ Ltd. is established on 2.01.20X4 by a contribution of its shareholders of 100,000.00 EUR. All figures have been transferred to the EUR for teaching purpose. The issued capital equals: 20,000 × 5 = 1 100,000.00 EUR. (1) Deposit of the owners’ contribution at the time of incorporation on 2.01.20X4. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR PENTZ Ltd. rents a shop at the beach front. Although PENTZ Ltd. is a VAT registered company, rent is not VATable because the landlord is a private person. Quarterly rent is amounting to 5,000.00 EUR/ q and must be paid in advance. In 20X4, the rental payment dates are: 2.01.20X4, 31.03.20X4, 30.06.20X4, 30.09.20X4 and 31.12.20X4. The last payment is for the first quarter of 20X5. Therefore, PENTZ Ltd. makes 5 payments in 20X4 with the last one allocated to prepaid expense (adjustment). PENTZ Ltd. pays for the rent by bank transfers. (2) … (6) Payment for rent on 2.01.20X4, 31.03.20X4, 30.06.20X4, 30.09.20X4 and 31.12.20X4. DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR DR Rent......................... 5,000.00 EUR CR Cash/ Bank.................... 5,000.00 EUR <?page no="407"?> Berkau: Basics of Accounting 6e 29-407 On 3.01.20X4, PENTZ Ltd. acquires a workshop for surfboard shaping and painting. (Think of the production process as starting with a huge polyethylene block that is cut, shaped and later pained.) The workshop contains a workbench and tools, like sanding machine, brushes and spray paint equipment. The workshop costs 21,500.00 EUR (net amount). The workshop is paid half by bank transfer and the other half is bought on credit. (7) Acquisition of the workshop on 3.01.20X4. DR P, P, E Account.............. 21,500.00 EUR DR VAT.......................... 4,300.00 EUR CR Cash/ Bank.................... 12,900.00 EUR CR Accounts Payables............ 12,900.00 EUR The workshop is deployed until 31.12.20X7. Therefore, its useful life is 4 years. PENTZ Ltd. applies straight-line method for depreciation without salvage value. Depreciation for 20X4 is: 21,500 / 4 = 5 5,375.00 EUR/ a. Although depreciation counts as adjustment, PENTZ Ltd. makes a Bookkeeping entry for depreciation, instantly. This is made for the consideration of depreciation for the calculation of unit costs per surfboard. However, we record depreciation on the balance sheet date: 31.12.20X4. (8) Depreciation on workshop on 31.12.20X4. DR Depreciation ................. 5,375.00 EUR CR Acc. Depr.................... 5,375.00 EUR PENTZ Ltd. purchases materials for its surfboard production. The materials for surfboards are the raw polyethylene body (not yet shaped), water resistant resin and paint. PENTZ Ltd. buys 150 bodies at a net purchase price of 200.00 EUR/ u, 100 litre resin at 1,350.00 EUR (net amount) and 400 paint cans (500ml) at 7.00 EUR/ u (net amount). The materials are paid by bank transfer on 14.01.20X4. The prices (gross amounts) for the bodies are: 150 × 200 × 120% = 3 36,000.00 EUR, for the resin: 1,350 × 120% = 1 1,620.00 EUR and for the paint: 400 × 7 × 120% = 3 3,360.00 EUR. (9) … (11) Material purchases on 14.01.20X4. DR Purchase..................... 30,000.00 EUR DR VAT.......................... 6,000.00 EUR CR Cash/ Bank.................... 36,000.00 EUR DR Purchase..................... 1,350.00 EUR DR VAT.......................... 270.00 EUR CR Cash/ Bank.................... 1,620.00 EUR <?page no="408"?> Berkau: Basics of Accounting 6e 29-408 DR Purchase..................... 2,800.00 EUR DR VAT.......................... 560.00 EUR CR Cash/ Bank.................... 3,360.00 EUR For manufacturing, PENTZ Ltd. applies Raw Material Inventory accounts (RMI) linked to the materials. The accounts are dedicated to the materials like polyethylene bodies, resin and paint. PENTZ Ltd. applies a periodic inventory system as inventory levels are easily observable in the small workshop. On 15.01.20X4, the Accountant makes the Bookkeeping entries (12) … (14). (12) … (14) Allocation of materials to raw materials inventories on 15.01.20X4. DR RMI-Bodies................... 30,000.00 EUR CR Purchase..................... 30,000.00 EUR DR RMI-Resin.................... 1,350.00 EUR CR Purchase..................... 1,350.00 EUR DR RMI-Paint.................... 2,800.00 EUR CR Purchase..................... 2,800.00 EUR PENTZ Ltd. plans to produce 125 surfboards during the Accounting period 20X4. Next, we calculate their unit costs of manufacturing. Depreciation per board is: 5,375/ 125 = 4 43.00 EUR/ u. The amount of resin is 500 ml per board. As a result, resin expenses per board are: 0.5 × 1,350 / 100 = 6 6.75 EUR/ u. PENTZ Ltd. uses 2 paint cans per board. The paint costs per board are amounting to: 2 × 7 = 1 14.00 EUR/ u. Labour linked to manufacturing is for a famous surfer, who works exclusively for PENTZ Ltd. He charges 350.00 EUR/ u for the shaping of one surfboard. In the Accounting period 20X4, PENTZ Ltd. produces 125 boards and pays labour for the specialist: 125 × 350 = 43,750.00 EUR. To keep the case simple, we assume the surfboard expert gets paid on cash in the middle of the year. (15) Accounting for labour on 30.06.20X4. DR Labour....................... 43,750.00 EUR CR Cash/ Bank.................... 43,750.00 EUR PENTZ Ltd. adds the manufacturing cost for 125 surfboards to their WIP account. Direct labour is amounting to 43,750.00 EUR. Depreciation is 5,375.00 EUR. The direct materials are for bodies: 125 × 200 = 2 25,000.00 EUR, for resin: 125 × 6.75 = 8 843.75 EUR and for paint: 125 × 14 = 1 1,750.00 EUR. The total costs of manufacturing add up to: 43,750 + 5,375 + 25,000 + 843.75 + 1,750 = 76,718.75 EUR. As PENTZ Ltd. only produces one kind of product, no manufacturing overheads apply. (16) Manufacturing expenses are debited to the WIP account on 1.07.20X4. <?page no="409"?> Berkau: Basics of Accounting 6e 29-409 DR Work-in-process.............. 76,718.75 EUR CR Labour....................... 43,750.00 EUR CR Depreciation ................. 5,375.00 EUR CR RM-Bodies.................... 25,000.00 EUR CR RM-Resin..................... 843.75 EUR CR RM-Paint..................... 1,750.00 EUR On 30.09.20X4, PENTZ Ltd. completes all surfboards and adds them to stock. (17) The Bookkeeping entry for the transfer of completed surfboards to the Finished Goods Inventory account is recorded on 30.09.20X4. DR Finished Goods Inventory..... 76,718.75 EUR CR Work-in-process.............. 76,718.75 EUR The unit costs of manufacturing are: 76,718.75 / 125 = 6 613.75 EUR/ u. As all costs of manufacturing are direct costs, PENTZ Ltd. can easily confirm the unit cost calculation by the cross-check calculation below: 200 + 350 + 43 + 6.75 + 14 = 6613.75 EUR/ u. On 2.11.20X4, PENTZ Ltd. sells 100 surfboards. Half of the customers pay on cash and the other half buys on credit. The net selling price per surfboard is 1,100.00 EUR/ u. Hence, sales are amounting to: 100 × 1,100 = 1 110,000.00 EUR. The gross amount equals: 110,000 × 120% = 1132,000.00 EUR. (18) Sale of 100 surfboards on 2.11.20X4. DR Cash/ Bank.................... 66,000.00 EUR DR Accounts Receivables......... 66,000.00 EUR CR VAT.......................... 22,000.00 EUR CR Sales........................ 110,000.00 EUR When selling the surfboards, PENTZ Ltd. records those surfboards that are released from stock as expenses. The Bookkeeping entry for the inventory movements is based on the cost of manufacturing. The absolute costs are the unit costs multiplied with the number of surfboards sold. The valuation for the sold surfboards is: 100 × 613.75 = 61,375.00 EUR. (19) We record the surfboard release from stock as a debit entry in the Costs of Goods Sold account and a credit entry in the Inventory of Finished Goods account on 2.11.20X4. DR Cost of Goods Sold (COS)..... 61,375.00 EUR CR Finished Goods Inventory..... 61,375.00 EUR Besides of manufacturing surfboards, PENTZ Ltd. is a trader. E.g., the company buys wet suits and sells them to its customers. On 3.11.20X4, PENTZ Ltd. buys <?page no="410"?> Berkau: Basics of Accounting 6e 29-410 50 wet suits at 76.00 EUR/ u (net amount) and pays them by bank transfer. The costs of purchase are: 50 × 76 = 33,800.00 EUR. The gross amount equals: 3,800 × 120% = 4 4,560.00 EUR. To avoid mingling materials for production with merchandise goods, PENTZ Ltd. applies an extra Merchandise Goods Inventory account. (20, 21) Purchase of merchandise goods on 3.11.20X4. DR Purchase..................... 3,800.00 EUR DR VAT.......................... 760.00 EUR CR Cash/ Bank.................... 4,560.00 EUR DR Merchandise Goods............ 3,800.00 EUR CR Purchase..................... 3,800.00 EUR On 15.11.20X4, PENTZ sells 20 wet suits on cash. The net selling price per wet suit is 230.00 EUR/ u. The sale is amounting to: 20 × 230 = 4 4,600.00 EUR. PENTZ Ltd. received cash to the extent of: 4,600 × 120% = 5 5,520.00 EUR. (22) Cash sales on 15.11.20X4. DR Cash/ Bank.................... 5,520.00 EUR CR VAT.......................... 920.00 EUR CR Sales........................ 4,600.00 EUR PENTZ Ltd. pays its sales manager 90,000.00 EUR salary on 2.12.20X4. (23) Salary payment for the sales manager on 2.12.20X4. DR Labour....................... 90,000.00 EUR CR Cash/ Bank.................... 90,000.00 EUR PENTZ Ltd. balances-off its accounts. We look at the accounts as displayed in Figure 29.1. <?page no="411"?> Berkau: Basics of Accounting 6e 29-411 D C D C (1) 100,000.00 (2) 5,000.00 c/ d 100,000.00 (1) 100,000.00 (18) 66,000.00 (3) 5,000.00 b/ d 100,000.00 (22) 5,520.00 (4) 5,000.00 (5) 5,000.00 (6) 5,000.00 (7) 12,900.00 (9) 36,000.00 (10) 1,620.00 (11) 3,360.00 (15) 43,750.00 (20) 4,560.00 c/ d 45,190.00 (23) 90,000.00 216,710.00 217,190.00 b/ d 45,670.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 5,000.00 (7) 21,500.00 c/ d 21,500.00 (3) 5,000.00 b/ d 21,500.00 (4) 5,000.00 (5) 5,000.00 (6) 5,000.00 c/ d 25,000.00 25,000.00 25,000.00 b/ d 25,000.00 Rent-20X4 RNT Property, plant, equipment PPE D C D C (7) 4,300.00 (18) 22,000.00 c/ d 12,900.00 (7) 12,900.00 (9) 6,000.00 (22) 920.00 b/ d 12,900.00 (10) 270.00 (11) 560.00 (20) 760.00 c/ d 11,030.00 22,920.00 22,920.00 b/ d 11,030.00 D C D C (8) 5,375.00 (16) 5,375.00 c/ d 5,375.00 (8) 5,375.00 b/ d 5,375.00 Value added tax VAT Accounts payables A/ P Depreciation-20X4 DPR Accumulated depreciation ACC Figure 29.1: PENTZ Ltd.’s accounts <?page no="412"?> Berkau: Basics of Accounting 6e 29-412 D C D C (9) 30,000.00 (12) 30,000.00 (12) 30,000.00 (16) 25,000.00 (10) 1,350.00 (13) 1,350.00 c/ d 5,000.00 (11) 2,800.00 (14) 2,800.00 30,000.00 30,000.00 (20) 3,800.00 (21) 3,800.00 b/ d 5,000.00 37,950.00 37,950.00 Purchase-20X4 PUR Raw materials inventory (body) INB D C D C (13) 1,350.00 (16) 843.75 (14) 2,800.00 (16) 1,750.00 c/ d 506.25 c/ d 1,050.00 1,350.00 1,350.00 2,800.00 2,800.00 b/ d 506.25 b/ d 1,050.00 D C D C (15) 43,750.00 (16) 43,750.00 (16) 76,718.75 (17) 76,718.75 Labour (production)-20X4 LAP Work in process WIP Raw materials inventory (resin) INR Raw materials inventory (paint) INP D C D C (17) 76,718.75 (19) 61,375.00 (18) 110,000.00 c/ d 15,343.75 c/ d 114,600.00 (22) 4,600.00 76,718.75 76,718.75 114,600.00 114,600.00 b/ d 15,343.75 b/ d 114,600.00 Finished goods inventory FGI Sales Revenue-20X4 REV D C D C (18) 66,000.00 c/ d 66,000.00 (19) 61,375.00 c/ d 61,375.00 b/ d 66,000.00 b/ d 61,375.00 D C D C (21) 3,800.00 c/ d 3,800.00 (23) 90,000.00 c/ d 90,000.00 b/ d 3,800.00 b/ d 90,000.00 Accounts receivables A/ R Cost of goods sold-20X4 COS Merchandise goods inventory MGI Labour (sales person)-20X4 LAS Figure 29.1: PENTZ Ltd.’s accounts (continued) 29.6 Step (B): Preparing the Trial Balance The Bookkeeping entries and the accounts are complex enough to proof the benefit of the trial balance application. At this stage of recording, we are uncertain, whether our Bookkeeping entries are still correct and in compliance with the double entry system. To check the recordings, we prepare the trial balance. A trial balance is an account list that shows their balancing figures in a way that debit balanced accounts are added to the debit column <?page no="413"?> Berkau: Basics of Accounting 6e 29-413 and credit balanced accounts to the credit column. At the bottom line of both columns, the totals are shown. They must be the same. Any difference would indicate a breach of the double entry system procedures which means faulty recording. Figure 29.2 displays PENTZ Ltd.’s trial balance: Account Debit entries Credit entries Cash/ Bank C/ B 45,670.00 Issued Capital ISS 100,000.00 Rent-20X4 RNT 25,000.00 Property, Plant, Equipment PPE 21,500.00 Value added tax VAT 11,030.00 Accounts Payables A/ P 12,900.00 Depreciation-20X4 DPR 0.00 0.00 Accumulated Depreciation ACC 5,375.00 Purchase-20X4 PUR 0.00 0.00 Raw Materials Inventory (Body) INB 5,000.00 Raw Materials Inventory (Resin) INR 506.25 Raw Materials Inventory (Paint) INP 1,050.00 Labour (Production)-20X4 LAP 0.00 0.00 Work in Process WIP 0.00 0.00 Finished Goods Inventory FGI 15,343.75 Sales Revenue-20X4 REV 114,600.00 Accounts Receivables A/ R 66,000.00 Cost of Goods Sold-20X4 COS 61,375.00 Merchandise Goods Inventory MGI 3,800.00 Labour (Sales Person)-20X4 LAS 90,000.00 Total: 289,575.00 289,575.00 Pentz Ltd. TRIAL BALANCE as at 31.12.20X4 Figure 29.2: PENTZ Ltd.’s trial balance The balancing figures for the manufacturing expense accounts are zero as these accounts are already closed-off to the Work-in-process (WIP) account. This applies for labour (production), purchases and depreciation. The sales manager’s labour is no manufacturing expense; therefore, it is shown as expense on the trial balance (debit column). As all surfboards have been completed during the Accounting period 20X4, no closing stock of surfboards under production is disclosed in the WIP account. PENTZ Ltd. transferred the costs of all surfboards to the Finished Goods Inventory account. Thereafter, the workshop is empty and the WIP account is zero-balanced. 29.7 Step (C): Checking the Trial Balance We only continue with the process of preparing financial statements if the <?page no="414"?> Berkau: Basics of Accounting 6e 29-414 trial balance indicates correct recordings. Otherwise, we should start looking for Bookkeeping errors. Correctness means the total of the debit entry column and the total of the credit entry column are the same. Furthermore, we check criteria as indicated by Figure 29.3. Account Debit entries Credit entries non-current assets (e.g. PPE) x Accumulated Depreciation x current assets (e.g. Inventory) x Accounts Receivables x (x) Cash/ Bank x x Capital (e.g. Issued Capital) x Retained/ Earnings -x x Liabilities (e.g. IBL) x Accounts Payables (x) x Expenses (e.g. Labour) x Revenue x Total: sum sum TRIAL BALANCE as at 31.12.20X0 Figure 29.3: A good trial balance Besides equality of the totals, we make run further checks - this is also useful to find faulty Bookkeeping entries when the totals do not equal. Balancing amounts (b/ d) for assets should always be on the debit side. This indicates the accounts are debit balanced. There can be exceptions for Cash/ Bank and for Accounts Receivables. Once asset accounts are linked to objects of physical nature, they cannot become negative. A credit balanced Accounts Receivables account can result from returns. A negative bank account indicates an account overdraft. The amount for the balancing figure of the Accumulated Depreciation account always is on the credit side. The values for the accounts on the credit side of the balance sheet must be shown on the credit side of the trial balance. This means the accounts are credit balanced. No negative capital is possible. The only exception is a negative balanced Retained Earnings account in a loss case or when a loss is carried forward. In general, liabilities are credit balanced, too. There can be an exception for accounts payables. A debit balanced Account Payables account can result from suppliers in debts. That happens if a supplier compensates for a return with a voucher. In case these exceptions occur, you should be already aware of their impact on the trial balance. Otherwise, take those occurrences as hint for a Bookkeeping error. In case the totals do not fit, it often helps to calculate the difference to get an idea of what went wrong. Double the amount for the case you made a <?page no="415"?> Berkau: Basics of Accounting 6e 29-415 debit entry instead of a credit entry or vice versa. 29.8 Step (D): Making Adjustments Although depreciation was pulled forward for Manufacturing Accounting purposes, we must still record further adjustments. We mark them with the 3letter-codes for the contra accounts. PENTZ Ltd. recorded the 5 payments for rent already. The adjustment Bookkeeping entry for the 5 th rent (1 st quarter I/ 20X5) is now debited to prepaid expenses and deducted from rent. Accrual of quarter I/ 20X5’s rent on 31.12.20X4. DR Prepaid Expenses............. 5,000.00 EUR CR Rent......................... 5,000.00 EUR Next, we start with the profit calculation by recording a Trading account for the shop activities. The Merchandise Goods Inventory account is closed-off to the Trading account. The merchandise goods are linked to purchases and cannot result from the Inventory of Finished Goods as PENTZ Ltd. keeps shop and manufacturing activities separate from each another. DR Trading Account.............. 3,800.00 EUR CR Merchandise Goods............ 3,800.00 EUR The closing stock of merchandise goods is calculated based on stock taking. On 31.12.20X4, PENTZ Ltd. records 30 wetsuits, worth 76.00 EUR/ u each. The inventory valuation is based on the cost of purchase. The closing stock equals: 30 × 76 = 2 2,280.00 EUR. Furthermore, all sales resulting from the shop are transferred to the Trading account. Sales on wetsuits are amounting to: 20 × 230 = 4 4,600.00 EUR. DR Sales........................ 4,600.00 EUR CR Trading Account.............. 4,600.00 EUR The closing stock of Merchandise Goods is transferred to the Trading account. DR Merchandise Goods............ 2,280.00 EUR CR Trading Account.............. 2,280.00 EUR The gross profit earned with the shop is: 4,600 + 2,280 - 3,800 = 3 3,080.00 EUR. After the gross profit calculation, the Trading account is closed-off to profit and loss: <?page no="416"?> Berkau: Basics of Accounting 6e 29-416 DR Trading Account.............. 3,080.00 EUR CR Profit and Loss.............. 3,080.00 EUR For the profit calculation, PENTZ Ltd. closes-off surfboard sales, cost of goods sold, labour for the salesperson and rent to profit and loss. Only labour for the salesperson is relevant because labour in Production is included in the cost of goods sold (surfboards) already. DR Sales........................ 110,000.00 EUR CR Profit and Loss.............. 110,000.00 EUR DR Profit and Loss.............. 61,375.00 EUR CR Cost of Goods Sold........... 61,375.00 EUR DR Profit and Loss.............. 90,000.00 EUR CR Labour....................... 90,000.00 EUR DR Profit and Loss.............. 20,000.00 EUR CR Rent......................... 20,000.00 EUR After completion of adjustments, PENTZ Ltd. can calculate its net profit (earnings before taxation). It gives: 3,080 + 110,000 - 61,375 - 90,000 - 20,000 = - -58,295.00 EUR. The net loss is transferred to the Retained Earnings account. No income taxes are recorded due to the negative profit. DR Retained Earnings............ 58,295.00 EUR CR Profit and Loss.............. 58,295.00 EUR Observe the Profit and Loss account in Figure 29.4: <?page no="417"?> Berkau: Basics of Accounting 6e 29-417 D C D C (1) 100,000.00 (2) 5,000.00 c/ d 100,000.00 (1) 100,000.00 (18) 66,000.00 (3) 5,000.00 b/ d 100,000.00 (22) 5,520.00 (4) 5,000.00 (5) 5,000.00 (6) 5,000.00 (7) 12,900.00 (9) 36,000.00 (10) 1,620.00 (11) 3,360.00 (15) 43,750.00 (20) 4,560.00 c/ d 45,670.00 (23) 90,000.00 217,190.00 217,190.00 b/ d 45,670.00 Cash/ Bank C/ B Issued capital ISS D C D C (2) 5,000.00 (7) 21,500.00 c/ d 21,500.00 (3) 5,000.00 b/ d 21,500.00 (4) 5,000.00 (5) 5,000.00 (6) 5,000.00 c/ d 25,000.00 25,000.00 25,000.00 b/ d 25,000.00 PRE 5,000.00 P&L 20,000.00 25,000.00 25,000.00 Rent-20X4 RNT Property, plant, equipment PPE D C D C (7) 4,300.00 (18) 22,000.00 c/ d 12,900.00 (7) 12,900.00 (9) 6,000.00 (22) 920.00 b/ d 12,900.00 (10) 270.00 (11) 560.00 (20) 760.00 c/ d 11,030.00 22,920.00 22,920.00 b/ d 11,030.00 D C D C (8) 5,375.00 (16) 5,375.00 c/ d 5,375.00 (8) 5,375.00 b/ d 5,375.00 Value added tax VAT Accounts payables A/ P Depreciation-20X4 DPR Accumulated depreciation ACC Figure 29.4: PENTZ Ltd.’s accounts <?page no="418"?> Berkau: Basics of Accounting 6e 29-418 D C D C (9) 30,000.00 (12) 30,000.00 (12) 30,000.00 (16) 25,000.00 (10) 1,350.00 (13) 1,350.00 c/ d 5,000.00 (11) 2,800.00 (14) 2,800.00 30,000.00 30,000.00 (20) 3,800.00 (21) 3,800.00 b/ d 5,000.00 37,950.00 37,950.00 Purchase-20X4 PUR Raw materials inventory (body)-20X4 INB D C D C (13) 1,350.00 (16) 843.75 (14) 2,800.00 (16) 1,750.00 c/ d 506.25 c/ d 1,050.00 1,350.00 1,350.00 2,800.00 2,800.00 b/ d 506.25 b/ d 1,050.00 D C D C (15) 43,750.00 (16) 43,750.00 (16) 76,718.75 (17) 76,718.75 Labour (production)-20X4 LAP Work in process WIP Raw materials inventory (resin) INR Raw materials inventory (paint) INP D C D C (17) 76,718.75 (19) 61,375.00 (18) 110,000.00 c/ d 15,343.75 c/ d 114,600.00 (22) 4,600.00 76,718.75 76,718.75 114,600.00 114,600.00 b/ d 15,343.75 T/ A 4,600.00 b/ d 114,600.00 P&L 110,000.00 114,600.00 114,600.00 Finished good inventory FGI Sales Revenue-20X4 REV D C D C (18) 66,000.00 c/ d 66,000.00 (19) 61,375.00 c/ d 61,375.00 b/ d 66,000.00 b/ d 61,375.00 P&L 61,375.00 D C D C (21) 3,800.00 c/ d 3,800.00 RNT 5,000.00 c/ d 5,000.00 b/ d 3,800.00 T/ A 3,800.00 b/ d 5,000.00 T/ A 2,280.00 c/ d 2,280.00 6,080.00 6,080.00 b/ d 2,280.00 Accounts receivables A/ R Cost of goods sold-20X4 COS Merchandise goods inventory MGI Prepaid expenses PRE Figure 29.4: PENTZ Ltd.’s accounts (continued) <?page no="419"?> Berkau: Basics of Accounting 6e 29-419 D C D C (23) 90,000.00 c/ d 90,000.00 MGI 3,800.00 REV 4,600.00 b/ d 90,000.00 P&L 90,000.00 GP 3,080.00 MGI 2,280.00 6,880.00 6,880.00 P&L 3,080.00 b/ d 3,080.00 D C D C COS 61,375.00 T/ A 3,080.00 P&L 58,295.00 c/ d 58,295.00 LAS 90,000.00 REV 110,000.00 b/ d 58,295.00 RNT 20,000.00 EBT 58,295.00 171,375.00 171,375.00 b/ d 58,295.00 R/ E 58,295.00 Labour (sales person)-20X4 LAS Trading Account-20X4 T/ A Profit and Loss-20X4 P&L Retained earnings R/ E Figure 29.4: PENTZ Ltd.’s accounts (continued) 29.9 Step (E): Preparing the Adjusted Trial Balance After the loss calculation, we prepare our second trial balance. This one now is called the adjusted trial balance. A trial balance prepared after adjustments is an adjusted trial balance. Therein, all nominal accounts show a zero-balance as they are closed-off to the Trading account or to the Profit and Loss account. Observe the adjusted trial balance for PENTZ Ltd. in Figure 29.5. <?page no="420"?> Berkau: Basics of Accounting 6e 29-420 Account Debit entries Credit entries Cash/ Bank C/ B 45,670.00 Issued Capital ISS 100,000.00 Rent-20X4 RNT 0.00 0.00 Property, Plant, and Equipment PPE 21,500.00 Value added tax VAT 11,030.00 Accounts Payables A/ P 12,900.00 Depreciation-20X4 DPR 0.00 0.00 Accumulated Depreciation ACC 5,375.00 Purchase-20X4 PUR 0.00 0.00 Raw Materials Inventory (Body) INB 5,000.00 Raw Materials Inventory (Resin) INR 506.25 Raw Materials Inventory (Paint) INP 1,050.00 Labour (Production)-20X4 LAP 0.00 0.00 Work in Process WIP 0.00 0.00 Finished Goods Inventory FGI 15,343.75 Sales Revenue-20X4 REV 0.00 0.00 Accounts Receivables A/ R 66,000.00 Cost of Goods Sold-20X4 COS 0.00 0.00 Merchandise Goods Inventory MGI 2,280.00 Prepaid Expenses PRE 5,000.00 Labour (Sales Person)-20X4 LAS 0.00 0.00 Retained Earnings R/ E 58,295.00 Total: 174,975.00 174,975.00 Pentz Ltd. ADJUSTED TRIAL BALANCE as at 31.12.20X4 Figure 29.5: PENTZ Ltd.’s adjusted trial balance The value for merchandise inventory has been adjusted to its actual value. The new wet suits’ value is 2,280.00 EUR. The figure for retained earnings is shown on the debit side as PENTZ Ltd. made a loss. 29.10 Step (F): Deriving Financial Statements In the last step, we prepare the financial statements. The adjusted trial balance comes close to the statement of financial position already. It only contains entries for the real accounts. Some minor adjustments are necessary for the financial statements, in particular some accounts are combined, like property, plant, equipment and accumulated depreciation. Further combinations apply for short-term liabilities. At PENTZ Ltd., the value for property, plant and equipment is calculated by two accounts: Property, Plant and Equipment account and Accumulated Depreciation account. The carrying value is: 21,500 - 5,375 = 1 16,125.00 EUR. This is the figure, we disclose on the balance sheet under property, plant, equipment. <?page no="421"?> Berkau: Basics of Accounting 6e 29-421 The balancing figure in PENTZ Ltd.’s Cash/ Bank account is negative: It equals -45,670.00 EUR. In general, no negative values are disclosed on a statement of financial position, retained earnings and deferred taxes exempted. The balance of the Cash/ Bank account - which indicates a bank overdraft - requires a disclosure as short-term liability. We do not record a real Bookkeeping entry, because we intend to continue the Cash/ Bank account in the next Accounting period, but we must consider the situation for the disclosure on the financial statements. As a consequence, PENTZ Ltd.’s payables contain output-VAT, debts to suppliers plus the bank overdraft. The short-term liabilities add up to: 11,030 + 12,900 + 45,670 = 6 69,600.00 EUR. The value for inventories contains all raw materials, merchandise goods and finished goods). It equals: 5,000 + 506.25 + 1,050 + 2,280 + 15,343.75 = 24,180.00 EUR. Observe PENTZ Ltd.’s statement of financial position as below: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 16,125.00 Issued capital 100,000.00 Intangibles Reserves Financial assets R/ E (58,295.00) Current assets Liabilities Inventory 24,180.00 Interest bear liab A/ R 66,000.00 A/ P 69,600.00 Prepaid expenses 5,000.00 Provisions Cash/ Bank 0.00 Tax liabilities 0.00 111,305.00 111,305.00 PENTZ Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 29.6: PENTZ Ltd.’s statement of financial position The statement of profit and loss and other comprehensive income can directly be derived from the Trading and Profit and Loss account. The value for merchandise goods sold is the cost of purchase for all wetsuits less the closing stock: 3,800 - 2,280 = 1 1,520.00 EUR. The value represents 20 wet suits bought at 76.00 EUR/ u: 20 × 76 = 1 1,520.00 EUR. <?page no="422"?> Berkau: Basics of Accounting 6e 29-422 [EUR] Revenue 114,600.00 Other income 114,600.00 Cost of goods sold (61,375.00) Merchandise goods used (1,520.00) Labour (sales person) (90,000.00) Other expenses (20,000.00) Earnings before int and taxes (EBIT) (58,295.00) Interest Earnings before taxes (EBT) (58,295.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (58,295.00) PENTZ Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 29.7: PENTZ Ltd.’s statement of comprehensive income 29.11 Summary The trial balance is a list of all applied accounts and provides us with a comparison of their balancing figures' (b/ d) total. A trial balance helps us to detect Bookkeeping errors regarding the double entry system. Although the time when we needed to check Bookkeeping entries is gone in times of Accounting software systems, many companies apply the trial balance to provide an overview about their accounts after balancing them off and before financial statements are prepared. It is a common communication instrument for the preparation of consolidated financial statements. 29.12 Working Definitions Credit Balanced Account: A credit balanced account is an account with the balance brought (b/ d) down on the credit side. Debit Balanced Account: A debit balanced account is an account where the balance brought down (b/ d) is on the debit side. Trial Balance: The trial balance is a list of all accounts where their balancing figures are allocated either to the debit or credit side. Adjusted Trial Balance: A trial balance prepared after adjustments is an adjusted trial balance. 29.13 Question Bank (1) What are possible entries on a trial balance (before adjustments)? 1. Debit: PPE; Debit: INV; Debit RNT; Credit: REV; Debit: ACC. 2. Debit: PPE; Debit RNT; Credit: REV; Credit: ACC; Credit INV. <?page no="423"?> Berkau: Basics of Accounting 6e 29-423 3. Debit: PPE; Debit: INV; Debit R/ E; Debit RNT; Credit: REV; Credit: ACC. 4. Debit: PPE; Debit: INV; Debit DPR; Debit RNT; Credit: REV; Credit: ACC. (2) Which statement is correct? 1. A trial balance is required by international Accounting Standards IFRSs. 2. A trial balance can be used to exchange balancing figures between group members before financial statements are prepared. 3. A trial balance discloses the profit as difference between debit and credit entry totals. 4. The adjusted trial balance discloses the same figures than the statement of profit or loss and other comprehensive income. (3) A trial balance discloses the values below: Debit: PPE: 100,000.00 EUR; RNT: 10,000.00 EUR; C/ B: 50,000.00 EUR; Credit: ISS: 50,000.00 EUR; REV: 30,000.00 EUR; ACC: 50,000.00 EUR; A/ P: 30,000.00 EUR. The adjusted trial balance could be: 1. Debit: PPE: 90,000.00 EUR; DPR: 10,000.00 EUR; C/ B: 50,000.00 EUR; Credit: ISS: 50,000.00 EUR; R/ E: 7,000.00 EUR; ACC: 60,000.00 EUR; A/ P: 30,000.00 EUR; ITL: 3,000.00 EUR. 2. Debit: PPE: 100,000.00 EUR; C/ B: 50,000.00 EUR; Credit: ISS: 50,000.00 EUR; R/ E: 7,000.00 EUR; ACC: 50,000.00 EUR; A/ P: 30,000.00 EUR; ITL: 3,000.00 EUR. 3. Debit: PPE: 100,000.00 EUR; C/ B: 40,000.00 EUR; Credit: ISS: 50,000.00 EUR; R/ E: 14,000.00 EUR; ACC: 60,000.00 EUR; A/ P: 30,000.00 EUR; ITL: 6,000.00 EUR. 4. Debit: PPE: 100,000.00 EUR; C/ B: 50,000.00 EUR; Credit: ISS: 50,000.00 EUR; R/ E: 7,000.00 EUR; ACC: 60,000.00 EUR; A/ P: 30,000.00 EUR; ITL: 3,000.00 EUR. (4) Which statement about the initial (not adjusted) trial balance is correct? 1. The entry about cash/ bank must be on the debit side. 2. The entry about depreciation is always on the debit side. 3. The entry about issued capital is always on the credit side. 4. There is never an entry for retained earnings. (5) An adjusted trial balance is given as follows: Debit entries: PPE: 6,000.00 EUR; A/ R: 3,000.00 EUR; PRE: 1,000.00 EUR; C/ B: (5,000.00 EUR); Credit entries: ISS: 10,000.00 EUR; ACC: 2,000.00 EUR; R/ E: (7,000.00 EUR). How much is the total of the balance sheet? 1 . 8,000.00 EUR . 2. 17,000.00 EUR . 3. 15,000.00 EUR . 4 . 3,000.00 EUR . 29.14 Solutions 1-3; 2-2; 3-4; 4-3; 5-1. <?page no="424"?> Berkau: Basics of Accounting 6e 30-424 30 Tax Calculation, Profit Appropriation and Equity Changes 30.1 What is in the Chapter? A company that earns a profit increases its value, because we add profits to retained earnings. The investors seek to participate in the profit distribution. To get a return on their investments, the shareholders must receive a dividend, which is a share of the profit paid-out to the owners. From the company’s perspective, a dividend means an equity reduction as it is paid from retained earnings. Hence, there is a natural conflict between management and owners about the appropriation of profits. In this chapter, we demonstrate the three major alternatives of profit appropriation: declaration of dividends, additions to reserves and carrying forward of profits. We cover the calculation of the profit after taxes, the recording of income tax liabilities and the appropriation of the profits. We focus on the Retained Earnings account which applies for financial statements in accordance with IFRSs. The chapter is based on the case study RAATS Ltd. In contrast to German law, no prolonged income statements (§ 158 AktG) applies but the IFRSs require the preparation of a statement of changes in equity instead. We do not discuss the income tax calculations but replace it again by our simplified income tax rate of 30 %. Income taxes should be discussed with a tax professional experienced in national income tax law. 30.2 Learning Objectives After studying this chapter, you can calculate and record income taxes and make Bookkeeping entries for the appropriation of profits. You understand how to record changes in the equity section of the balance sheet. You further know how to calculate dividends and you can prepare financial statements after the appropriation of profits including a statement of changes in equity. 30.3 Profit Appropriation Owners of a company invest their money and expect a return. The company pays its shareholders a portion of its profit related to their share of ownership. Dividend payments follow national law. We call the allocation of earnings to owners and/ or to reserves the appropriation of profits. The appropriation of profits is its distribution as dividends, additions to reserves and/ or carrying forward to the next Accounting period. The distributable amount is the profit after taxes plus a profit carried forward from previous Accounting periods less a loss carried forward. Further deductions can apply for preference shares. Although a company can decide to dissolve reserves for profit appropriation, this does not count as distributable amount. When preparing financial statements under the consideration of profit appropriation, we make provisional Bookkeeping entries. Therefore, the balance sheet shows dividends as short-term liabilities and additions to reserves. However, the final decision <?page no="425"?> Berkau: Basics of Accounting 6e 30-425 about the appropriation of profits is made on the annual general meeting by the shareholders. This is after financial statements have been prepared and audited. 30.4 Auditing The Auditing of the financial statements means a check of the Bookkeeping records and the financial statements conducted by an independent Accounting expert (Auditor). In general, the checks are based on samples which must be planned before the Auditing procedures begin. The outcome of the auditing process is the opinion about the correctness of the financial statements. Auditors do not evaluate a business like analysts they purpose is limited to the independent checking of financial statements and related documents. Unrestricted access to financial records and further documents, like minutes of annual general meetings or board meetings, Bookkeeping records etc. must be given to the auditors. Before financial statements are audited, no financial statements can be approved; therefore, no dividend is payable before the auditors finished their examinations. Check national law with regard to Auditing procedures - it is not ruled by IFRSs. In Germany, HGB applies. We refer in this chapter to the case study RAATS Ltd. As we follow international Bookkeeping, we apply the Retained Earnings account. The German recordings following German HGB are discussed in chapter (2) of the textbook Bilanzen/ Financial Statements. 30.5 C/ S RAATS Ltd. RAATS Ltd. is a company based on shares. The company is established by an issue of 100,000 ordinary shares at 1.50 EUR/ s each. See the financial statements as at 31.12.20X6 for RAATS in Figure 30.1: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 158,000.00 Issued capital 150,000.00 Intangibles Reserves 20,000.00 Financial assets R/ E 70,000.00 Current assets Liabilities Inventory Interest bear liab A/ R 22,000.00 A/ P Prepaid expenses Provisions Cash/ Bank 90,000.00 Tax liabilities 30,000.00 270,000.00 270,000.00 Raats Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X6 Figure 30.1: RAATS Ltd.’s statement of financial position <?page no="426"?> Berkau: Basics of Accounting 6e 30-426 As we focus on the appropriation of profits, we cut short the business activities of RAATS Ltd.: At first, RAATS Ltd. pays for its income tax liabilities 30,000.00 EUR. (1) Payment of income tax liabilities on 2.01.20X7. DR Income Tax Liabilities....... 30,000.00 EUR CR Cash/ Bank.................... 30,000.00 EUR RAATS Ltd. earns a cash revenue of 260,000.00 EUR and spends 150,000.00 EUR on operations. We record both activities as if they took place in the middle of the Accounting period. Both amounts are net values. The gross amounts are: 260,000 × 120% = 3 312,000.00 EUR and: 150,000.00 × 120% = 1 180,000.00 EUR. No opening value for value added tax applies. (2, 3) Earning a cash revenue of 260,000.00 EUR and spending 150,000.00 EUR on operational expenses on 1.07.20X7. DR Cash/ Bank.................... 312,000.00 EUR CR VAT.......................... 52,000.00 EUR CR Sales........................ 260,000.00 EUR DR Operational Expenses......... 150,000.00 EUR DR VAT.......................... 30,000.00 EUR CR Cash/ Bank.................... 180,000.00 EUR Observe below RAATS Ltd.’s accounts in Figure 30.2. D C D C OV 158,000.00 c/ d 158,000.00 OV 22,000.00 c/ d 22,000.00 b/ d 158,000.00 b/ d 22,000.00 D C D C OV 90,000.00 (1) 30,000.00 c/ d 150,000.00 OV 150,000.00 (2) 312,000.00 (3) 180,000.00 b/ d 150,000.00 c/ d 192,000.00 402,000.00 402,000.00 b/ d 192,000.00 Property, plant, equipment PPE Accounts receivables A/ R Cash/ Bank C/ B Issued capital ISS Figure 30.2: RAATS Ltd.’s accounts <?page no="427"?> Berkau: Basics of Accounting 6e 30-427 D C D C OV 20,000.00 OV 70,000.00 Earnings reserves RES Retained earnings R/ E Figure 30.2: RAATS Ltd.'s accounts (continued) We prepare a trial balance as shown in Figure 30.3: Account Debit entries Credit entries Property, Plant, Equipment PPE 158,000.00 Accounts Receivables A/ R 22,000.00 Cash/ Bank C/ B 192,000.00 Issued Capital ISS 150,000.00 Earnings reserves RES 20,000.00 Retained Earnings R/ E 70,000.00 Income Tax Liabilities ITL 0.00 0.00 Value added tax VAT 22,000.00 Sales-20X7 REV 260,000.00 Operational Expenses-20X7 OEX 150,000.00 Total: 522,000.00 522,000.00 Raats Ltd. TRIAL BALANCE as at 31.12.20X7 Figure 30.3: RAATS Ltd.’s trial balance Next, we calculate RAATS Ltd.’s profit: The company earns a pre-tax profit of: 260,000 - 150,000 = 1 110,000.00 EUR. In general, the calculation of income taxes follows the national tax law. For RAATS Ltd., the value of the total income taxes is: 110,000 × 30% = 3 33,000.00 EUR. Observe the profit calculation for RAATS Ltd. in Figure 30.4: D C D C (1) 30,000.00 OV 30,000.00 (3) 30,000.00 (2) 52,000.00 c/ d 22,000.00 52,000.00 52,000.00 b/ d 22,000.00 D C D C c/ d 260,000.00 (2) 260,000.00 (3) 150,000.00 c/ d 150,000.00 b/ d 260,000.00 b/ d 150,000.00 Income tax liabilities ITL Value added tax VAT Sales-20X7 REV Operational expenses-20X7 OEX <?page no="428"?> Berkau: Basics of Accounting 6e 30-428 D C D OV 158,000.00 c/ d 158,000.00 OV 22,000.00 c/ d 22,000.00 b/ d 158,000.00 b/ d 22,000.00 D C D OV 90,000.00 (1) 30,000.00 c/ d 150,000.00 OV 150,000.00 (2) 312,000.00 (3) 180,000.00 b/ d 150,000.00 c/ d 192,000.00 402,000.00 402,000.00 b/ d 192,000.00 D C D c/ d 20,000.00 OV 20,000.00 OV 70,000.00 b/ d 20,000.00 c/ d 147,000.00 P&L 77,000.00 147,000.00 147,000.00 b/ d 147,000.00 Property, plant, equipment PPE Accounts receivables A/ R Earnings reserves RES Retained earnings R/ E Cash/ Bank C/ B Issued capital ISS D C D C (1) 30,000.00 OV 30,000.00 (3) 30,000.00 (2) 52,000.00 c/ d 33,000.00 P&L 33,000.00 c/ d 22,000.00 63,000.00 63,000.00 52,000.00 52,000.00 b/ d 33,000.00 b/ d 22,000.00 D C D C c/ d 260,000.00 (2) 260,000.00 (3) 150,000.00 c/ d 150,000.00 P&L 260,000.00 b/ d 260,000.00 b/ d 150,000.00 D C OEX 150,000.00 REV 260,000.00 EBT 110,000.00 260,000.00 260,000.00 ITL 33,000.00 b/ d 110,000.00 R/ E 77,000.00 110,000.00 110,000.00 Sales-20X7 REV Operational expenses-20X7 OEX Profit and Loss-20X7 P&L Income tax liabilities ITL Value added tax VAT Figure 30.4: RAATS Ltd.’s accounts Check the adjusted trial balance after preparation and closing-off the Profit and Loss account to the Retained Earnings account in Figure 30.5: <?page no="429"?> Berkau: Basics of Accounting 6e 30-429 Account Debit entries Credit entries Property, Plant, Equipment PPE 158,000.00 Accounts Receivables A/ R 22,000.00 Cash/ Bank C/ B 192,000.00 Issued Capital ISS 150,000.00 Earnings Reserves RES 20,000.00 Retained Earnings R/ E 147,000.00 Income Tax Liabilities ITL 33,000.00 Value added tax VAT 22,000.00 Sales-20X7 REV 0.00 Operational Expenses-20X7 OEX 0.00 Total: 372,000.00 372,000.00 Raats Ltd. ADJUSTED TRIAL BALANCE as at 31.12.20X7 Figure 30.5: RAATS Ltd. adjusted trial balance The maximum amount payable to shareholders as a dividend, is the balancing figure in the Retained Earnings account. In the case of RAATS Ltd., no profit is carried forward in the Retained Earnings account. Dissolving reserves is not an option, either. RAATS Ltd. declares a dividend based on the retained earnings of 147,000.00 EUR. The dividend is 40 % of the distributable amount - proposed by RAATS Ltd.’s executive board. The dividends are paid in the next Accounting period; therefore, we must add them to short-term liabilities; we apply the Shareholder for Dividend account. The dividend amount at RAATS Ltd. (including the tax on capital returns) is: 40% × 147,000 = 5 58,800.00 EUR. The dividends are not paid yet to shareholders and the revenue service (dividend tax) before the financial statements are audited and approved. (4) Crediting the dividend to Dividends Payables ShD account on 31.12.20X7. DR Retained Earnings............ 58,800.00 EUR CR Dividends Payables ShD ....... 58,800.00 EUR RAATS Ltd. considers adding 35 % of the distributable amount to the Earnings Reserves account and to carry forward the remainder of 25 % to the next Accounting period. Carrying profits forward does not lead to a Bookkeeping entry. The amount stays in the Retained Earnings account. (5) Adding: 35% × 147,000 = 5 51,450.00 EUR to the Earnings Reserves account on 31.12.20X7 as below: <?page no="430"?> Berkau: Basics of Accounting 6e 30-430 DR Retained Earnings............ 51,450.00 EUR CR Earnings Reserves............ 51,450.00 EUR Observe the accounts after the appropriation of profits in Figure 30.6. D C D C OV 158,000.00 c/ d 158,000.00 OV 22,000.00 c/ d 22,000.00 b/ d 158,000.00 b/ d 22,000.00 D C D C OV 90,000.00 (1) 30,000.00 c/ d 150,000.00 OV 150,000.00 (2) 312,000.00 (3) 180,000.00 b/ d 150,000.00 c/ d 192,000.00 402,000.00 402,000.00 b/ d 192,000.00 Property, plant equipment PPE Accounts receivables A/ R Cash/ Bank C/ B Issued capital ISS D C D C OV 20,000.00 OV 70,000.00 c/ d 71,450.00 R/ E 51,450.00 c/ d 147,000.00 P&L 77,000.00 71,450.00 71,450.00 147,000.00 147,000.00 b/ d 71,450.00 ShD 58,800.00 b/ d 147,000.00 Res 51,450.00 c/ d 36,750.00 147,000.00 147,000.00 b/ d 36,750.00 Earnings reserves RES Retained earnings R/ E D C D C (1) 30,000.00 OV 30,000.00 (3) 30,000.00 (2) 52,000.00 c/ d 33,000.00 P&L 33,000.00 c/ d 22,000.00 63,000.00 63,000.00 52,000.00 52,000.00 b/ d 33,000.00 b/ d 22,000.00 D C D C c/ d 260,000.00 (2) 260,000.00 (3) 150,000.00 c/ d 150,000.00 P&L 260,000.00 b/ d 260,000.00 b/ d 150,000.00 Income tax liabilities ITL Value added tax VAT Sales-20X7 REV Operational expenses OEX Figure 30.6: RAATS Ltd.’s accounts <?page no="431"?> Berkau: Basics of Accounting 6e 30-431 D C D C Oth 150,000.00 Rev 260,000.00 c/ d 58,800.00 R/ E 58,800.00 EBT 110,000.00 b/ d 58,800.00 260,000.00 260,000.00 ITL 33,000.00 b/ d 110,000.00 R/ E 77,000.00 110,000.00 110,000.00 Profit and Loss-20X7 P&L Dividend payable ShD Figure 30.6: RAATS Ltd.’s accounts (continued) In general, companies prepare their financial statements under the consideration of the appropriation of profits. The financial statements for RAATS Ltd. after appropriation of profits look as depicted in Figure 30.7, Figure 30.8 and Figure 30.9: [EUR] Revenue 260,000.00 Other income 260,000.00 Materials Labour Depreciation Other expenses (150,000.00) Earnings before int and taxes (EBIT) 110,000.00 Interest Earnings before taxes (EBT) 110,000.00 Income tax expenses (33,000.00) Deferred taxes Earnings after taxes (EAT) 77,000.00 Raats Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 30.7: RAATS Ltd.’s income statement The statement of financial position is displayed in Figure 30.8. <?page no="432"?> Berkau: Basics of Accounting 6e 30-432 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 158,000.00 Issued capital 150,000.00 Intangibles Reserves 71,450.00 Financial assets R/ E 36,750.00 Current assets Liabilities Inventory Interest bear liab A/ R 22,000.00 A/ P 80,800.00 Prepaid expenses Provisions Cash/ Bank 192,000.00 Tax liabilities 33,000.00 372,000.00 372,000.00 Raats Ltd. STATEMENT of FINANCIAL POSITION after appropriation of profit as at 31.12.20X7 Figure 30.8: RAATS Ltd.’s statement of financial position after appropriation of profit The value in the Earnings Reserves account is the opening amount plus the portion added: 20,000 + 51,450 = 71,450.00 EUR. The value for accounts payables contains liabilities for VAT and the dividend claims of the shareholders: 22,000 + 58,800 = 8 80,800.00 EUR. 30.6 Statement of Changes in Equity In compliance with IFRSs, the equity section of the balance sheet gets further attention. Equity changes must be disclosed in an extra statement of changes in equity. The statement is prepared in the (DR)CR format - meaning debit entries are negative. RAATS Ltd.’s equity changes as a result of the profit earned and its appropriation thereof. RAATS Ltd. earns a profit of 110,000.00 EUR before taxes. The portion that increases equity in the first place is: (1 - 30%) = 7 70% thereof and is called the earnings after taxes EAT. It is amounting to: 110,000 × 70% = 7 77,000.00 EUR. The addition to reserves is 51,450.00 EUR and transferred to the Earnings Reserves account. Further 58,800.00 EUR are declared as gross dividend, which is added to the Dividend Payables ShD account completely. T The net dividend is the gross dividend less the dividend tax which is paid on behalf of the domestic shareholders to the revenue service. As we are only interested in the total of debts of RAATS Ltd., we do not distinguish dividend payment obligations from tax payment obligations. For that reason, we only focus on the gross dividends here. Their transfer to the liability section reduces RAATS Ltd.’s equity. RAATS Ltd. owes the revenue service the dividend tax as it is a withholding tax. A withholding dividend tax is paid by the company on behalf of their private and domestic shareholders. <?page no="433"?> Berkau: Basics of Accounting 6e 30-433 In contrast, additions to earnings reserves do not reduce equity. Additions to reserves are just equity swops. A profit carried forward is no change in equity. Share capital Reserves R/ E total as at 1.01.20X7 150,000.00 20,000.00 70,000.00 240,000.00 Profit 20X7 77,000.00 77,000.00 Dividend 20X7 (58,800.00) (58,800.00) Addition to res 51,450.00 (51,450.00) 0.00 as at 31.12.20X7 150,000.00 71,450.00 36,750.00 258,200.00 Raats Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X7 Figure 30.9: RAATS Ltd.’s statement of changes in equity. 30.7 Summary Companies have to pay income taxes based on their pre-tax profit (simplified tax calculation). Here, the rate for the total income tax is 30 % for limited companies. The appropriation of profits can result in paying dividends to shareholders plus paying dividend tax on their behalf to the revenue service, in additions to earnings reserves and/ or in carrying forward profit to the next Accounting period. Companies prepare financial statements under consideration of their appropriation of profits. The appropriation of profits requires the approval of financial statements on the annual general meeting which requires an Auditing of financial statements before. The statement of changes in equity discloses increases or decreases of equity accounts. A shareholder can check how the book value of her/ his company changes. The total of equity determines a company’s book value. National law applies for income tax calculation, auditing and the appropriation of profits. 30.8 Working Definitions Auditing: The Auditing of the financial statements means a check of the Bookkeeping records and the financial statements conducted by an independent Accounting expert (Auditor). Appropriation of Profit: The appropriation of profits is its distribution as dividends, additions to reserves and/ or carrying forward to the next Accounting period. Net Dividend: The net dividend is the gross dividend less the dividend tax which is paid on behalf of the domestic shareholders to the revenue service. Distributable amount: The distributable amount is the profit after taxes plus a profit carried forward from previous Accounting periods less a loss carried forward. Further deductions can apply for preference shares. Withholding Dividend Tax: A withholding dividend tax is payable by the <?page no="434"?> Berkau: Basics of Accounting 6e 30-434 company on behalf of the shareholders. 30.9 Question Bank (1) A company carries forward a loss from the previous Accounting period of 5,000.00 EUR and earns a profit before taxation of 12,000.00 EUR. It decides to declare a dividend of half of its distributable amount to its 10,000 shareholders. How much is the dividend per share? 1. 0.67 EUR/ s . 2. 0.35 EUR/ s . 3 . 0.17 EUR/ s . 4. 0.34 EUR/ s . (2) A limited company declares a dividend of 0.20 EUR/ s to its 100,000 shareholders and adds 50,000.00 EUR to the earnings reserves. The remainder of the distributable amount of 100,000.00 EUR is carried forward to the next Accounting period. What are the Bookkeeping entries? 1. DR R/ E 70,000.00 EUR; CR C/ B 20,000.00 EUR; CR RES 50,000.00 EUR. 2. DR R/ E 52,000.00 EUR; CR C/ B 2,000.00 EUR; CR RES 50,000.00 EUR. 3. DR R/ E 52,000.00 EUR; CR S4D 2,000.00 EUR; CR RES 50,000.00 EUR. 4. DR R/ E 70,000.00 EUR; CR S4D 20,000.00 EUR; CR RES 50,000.00 EUR. (3) What is the requirement for a declaration of dividends? 1. The financial statements are correct, and the retained earnings are credit balanced. 2. A decision made on the general annual meeting AGM by the majority of the shareholders. 3. The financial statements are audited and approved. 4. A decision made on the general annual meeting AGM by 75 % of the shareholders. (4) Which statement is wrong about the tax on capital gains (dividend tax). 1. The tax on capital gains is owed by the company. 2. The tax on capital gains is a company tax. 3. The tax on capital gains is withdrawn from the dividend. 4. The tax on capital gains is paid to foreign investors as part of the gross dividend. (5) A company carries forward a profit of 30,000.00 EUR. In the actual Accounting period, the company records a loss of 15,000.00 EUR. How much is the maximum of dividend that can be declared for its 100,000 shareholders? 1. 0.45 EUR/ s . 2. 0.15 EUR/ s . 3. 0.35 EUR/ s . 4. 0.00 EUR/ s . 30.10 Solutions 1-3; 2-4; 3-3; 4-2; 5-2. <?page no="435"?> Berkau: Basics of Accounting 6e 31-435 31 Multiple-Period Bookkeeping 31.1 What is in the Chapter? So far in this textbook, we only covered Accounting for one period. We normally start the case studies with the establishment of the company and discuss only the first Accounting period in a company’s life. In real business, the default case is, that we look at a running company. Therefore, opening values in accounts must be derived for the items on the balance sheet. In this chapter, we discuss a company (GOUSBLOM Ltd.) for a period of 2 Accounting periods to demonstrate the transition from one Accounting period to the next one. We also discuss the timeline of preparing financial statements and explain why taxation and dividend payments always take place in the next following financial year. Note, this chapter is different to German Bookkeeping procedures. The disclosure on the equity section on the statement of financial position here is based on the application of the Retained Earnings account. 31.2 Learning Objectives In this chapter, you will learn that for international Accounting, real accounts are continued over the Accounting periods. You will see the difference to the German system, where the accounts are closed-off to the Endof-Period accounts (= Schlussbilanzkonto) at the end of the Accounting period. The reason for that procedure is that the End-of-Period account and the balance sheet are part of the double entry system. In contrast, international Accounting is based on accounts only and the values for financial statements are copied therefrom. After studying this chapter, you learned how to maintain real accounts over multiple Accounting periods. You are enabled to keep Bookkeeping recordings for periods longer than one year and you know how to start Bookkeeping procedures when an opening balance sheet is given. Furthermore, you develop a feeling of the timing of preparing financial statements, their Auditing and approval on the annual general meeting AGM. 31.3 End of Accounting Period Procedures We distinguish real and nominal accounts. Real accounts are linked to the balance sheet. As we do not apply a formal chart of Accounts, our real accounts carry names equal or similar to items on the balance sheet. Some items thereon are linked to more than one account, like the P, P, E account and the Accumulated Depreciation account which both are connected to the item property, plant and equipment on the statement of financial position. Nominal accounts are closed-off the Profit and Loss account. By closing them off they are dissolved. For the next Accounting period, fresh nominal accounts must be defined. In this textbook, we add the Accounting period to the account name, like Depreciation-20X5 account. At the end of the Accounting period, the Profit and Loss account, which is a <?page no="436"?> Berkau: Basics of Accounting 6e 31-436 nominal account, is closed-off to retained earnings. In case of a profit another contra account is the Income Tax Liability account. As an effect of this procedure, the adjusted trial balance only discloses real accounts. In case the business makes an assumption regarding the appropriation of profits, amounts from the Retained Earnings account are transferred to reserves and to payables (dividends). A closing value in the Retained Earnings accounts indicates a profit/ loss carried forward to the next Accounting period. In general, we prepare financial statements after the appropriation of profits. 31.4 Beginning of Accounting Period Procedures When we begin recording, opening values for the real accounts exist. If the company is established in the actual Accounting period, opening values only exist for the establishment of the business, like cash/ bank and issued capital. The establishment also can be part of the Accounting period’s Bookkeeping entries, then the first record is a debit entry in the Cash/ Bank account and the credit entry is recorded in the Issued Capital Account. If the issue price exceeds the face value, the Capital Reserves Account applies, too. In case a company is continued from the previous Accounting period, we must continue all real accounts. This means, the opening value is the balance brought down from the last Accounting period. Note, that the date of the balance brought down is then the first day of the new Accounting period. If no accounts exist, we must derive the opening values from the balance sheet. It might be necessary to study the register of non-current assets to find the values for the Property, Plant, Equipment account and Accumulated Depreciation Account in detail. We mark the opening values in the accounts by OV, for opening value. In compliance with our conventions, some initial Bookkeeping entries apply. Those entries are linked to the payment of income taxes, value added tax and/ or dividends. Regarding our conventions, all tax liabilities and dividends are due at the beginning of the new Accounting period. Further initial Bookkeeping entries might become relevant for prepaid expenses and short-term receivables/ payables. 31.5 Timeline for Financial Statements In this textbook, all Accounting periods end on 31 December. This is the last date for recording business activities. Thereafter the accounts are prevented from further entries (closed) and the trial balance is prepared. Thereafter, the adjustments take place in preparation of the financial statements. The date of the financial statements is always (following our conventions) the 31.12.20XX. The financial statements of most limited companies are subjected to Auditing. National law applies. Qualified and independent Accountants (the certified Auditors) are appointed to check the financial statements for correct application of the Accounting standards, here: IFRSs. After the Auditing process is completed, the Auditors express their <?page no="437"?> Berkau: Basics of Accounting 6e 31-437 opinion about the financial statements. The opinion reads like: “We have audited the financial statements for the year then ended on 31.12.20XX. In our opinion, the financial statements present fairly, in all material respects, the financial position, the financial performance and cash flows for the period in accordance with International Financial Reporting Standards IFRSs and the requirements of the Companies Act.” The opinion also can point out weaknesses or faults of the financial statements. The Auditors sign their opinion which makes the Auditing results enforceable. The Auditing is a precondition for the approval of the financial statements on the annual general meeting AGB. It often is held in the middle of the year that follows the Accounting period. On the AGB, the shareholders also decide about the appropriation of the profits. Only after their decision, dividends can be apportioned to shareholders. According to this timeline, dividends must always be recorded as payables. No dividends can be paid directly as the financial statements must first be prepared, audited and approved. Next, we discuss the case study GOUSBLOM Ltd. to learn about the Bookkeeping entries made at the yearends and at the beginnings of the following Accounting period. 31.6 C/ S GOUSBLOM Ltd. - 20X7 GOUSBLOM Ltd. is a consultancy established on 2.01.20X7 by a share issue of 500,000.00 EUR. (1) Incorporation of the company by the issue of ordinary shares to the extent of 500,000.00 EUR on 2.01.20X7. DR Cash/ Bank.................... 500,000.00 EUR CR Issued Capital............... 500,000.00 EUR GOUSBLOM Ltd. is registered for VAT reduction. The company rents an office block. On 2.01.20X7, GOUSBLOM Ltd. pays rent for the Accounting period 20X7 and for the Accounting period 20X8 in advance. No VAT applies for rent, because the landlord is not registered for VAT reduction. Rent is amounting to 48,000.00 EUR/ a and paid by bank transfer. The next year’s rent is due in December 20X7 to its full extent. The second payment for rent requires recording an accrual (see adjustments). (2) Payment for 20X7’s rent on 2.01.20X7. DR Rent......................... 48,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR (3) Payment of Accounting period 20X8’s rent on 20.12.20X7. <?page no="438"?> Berkau: Basics of Accounting 6e 31-438 DR Rent......................... 48,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR GOUSBLOM Ltd. buys 36 laptops for its employees at purchase costs of 4,000.00 EUR/ u. All laptops are acquired on 8.01.20X7 and GOUSBLOM Ltd. intends to use the computers for 4 years. The depreciation based on straight-line method (no residual values) gives an annual depreciation of: 4,000 / 4 = 1 1,000.00 EUR/ (a × computer). At the date of acquisition, we make Bookkeeping entry (5): (4) Acquisition of laptops at a gross amount of: 36 × 4,000 × 120% = 172,800.00 EUR. DR P, P, E Account.............. 144,000.00 EUR DR VAT.......................... 28,800.00 EUR CR Cash/ Bank.................... 172,800.00 EUR At GOUSBLOM Ltd., labour for its 30 consultants is amounting to 1,500,000.00 EUR. Payroll tax and social securities payments are included therein. To keep the case simple, the full payment is made in the middle of the year. (5) Payment for labour on 1.07.20X7. DR Labour....................... 1,500,000.00 EUR CR Cash/ Bank.................... 1,500,000.00 EUR The company earns a revenue calculated based on billable consultation days to the extent of 4,000,000.00 EUR and receives payments from its clients on 30.06.20X7. (6) Revenue recognition on 30.06.20X7. DR Cash/ Bank.................... 4,800,000.00 EUR CR VAT.......................... 800,000.00 EUR CR Revenue...................... 4,000,000.00 EUR At the end of the first Accounting period 20X7, we balance-off all accounts and prepare a trial balance as displayed in Figure 31.1 and Figure 31.2. Note, we now write cd7 (short for: c/ d 31.12.20X7) to indicate the accounts are balanced-off on 31.12.20X7. Accordingly, we write bd8 (short for: b/ d 1.01.20X8) for a balance brought down to 1.01.20X8. This only applies for real accounts. A balanced-off nominal account shows the balancing figure as c/ d or b/ d. <?page no="439"?> Berkau: Basics of Accounting 6e 31-439 D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (6) 4,800,000.00 (3) 48,000.00 bd8 500,000.00 (4) 172,800.00 (5) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 D C D C (2) 48,000.00 (4) 144,000.00 cd7 144,000.00 (3) 48,000.00 c/ d 96,000.00 bd8 144,000.00 96,000.00 96,000.00 b/ d 96,000.00 D C D C (4) 28,800.00 (6) 800,000.00 (5) 1,500,000.00 c/ d 1,500,000.00 cd7 771,200.00 b/ d 1,500,000.00 800,000.00 800,000.00 bd8 771,200.00 Cash/ Bank C/ B Issued capital ISS Value added tax VAT Labour-20X7 LAB Rent-20X7 RNT Property, plant, equipment PPE D C c/ d 4,000,000.00 (6) 4,000,000.00 b/ d 4,000,000.00 Revenue-20X7 REV Figure 31.1: GOUSBLOM Ltd.’s accounts 20X7 Observe the trial balance in Figure 31.2. Account Debit entries Credit entries Cash/ Bank C/ B 3,531,200.00 Issued Capital ISS 500,000.00 Rent-20X7 RNT 96,000.00 Property, Plant, and Equipment PPE 144,000.00 Value added tax VAT 771,200.00 Labour-20X7 LAB 1,500,000.00 Revenue-20X7 REV 4,000,000.00 Total: 5,271,200.00 5,271,200.00 Gousblom Ltd. TRIAL BALANCE as at 31.12.20X7 Figure 31.2: GOUSBLOM Ltd.’s trial balance 20X7 <?page no="440"?> Berkau: Basics of Accounting 6e 31-440 As adjustments, we record prepaid expenses for rent and depreciation. Annual depreciation equals: 1,000 × 36 = 3 36,000.00 EUR/ a. The Bookkeeping entry is shown below: Depreciation on computers on 31.12.20X7. DR Depreciation................. 36,000.00 EUR CR Acc. Depr.................... 36,000.00 EUR The accrual of 20X8’s rent is recorded as an adjustment on 31.12.20X7, too. DR Prepaid Expenses............. 48,000.00 EUR CR Rent......................... 48,000.00 EUR Next, we calculate the profit. The pre-tax profit is amounting to: 4,000,000 - 48,000 - 36,000 - 1,500,000 = 2,416,000.00 EUR. The Accountant closes-off the expense and revenue accounts, like rent, depreciation, labour and revenues, to the Profit and Loss account on 31.12.20X7. DR Profit and Loss.............. 48,000.00 EUR CR Rent......................... 48,000.00 EUR DR Profit and Loss.............. 36,000.00 EUR CR Depreciation................. 36,000.00 EUR DR Profit and Loss.............. 1,500,000.00 EUR CR Labour....................... 1,500,000.00 EUR DR Revenue...................... 4,000,000.00 EUR CR Profit and Loss.............. 4,000,000.00 EUR Income taxes are: 2,416,000 × 30% = 724,800.00 EUR. The amount is debited to profit and loss and added to the Income Tax Liabilities account on the credit side. The remainder of the pre-tax profit is transferred to equity, where it is added to the Retained Earnings account as annual surplus. DR Profit and Loss.............. 724,800.00 EUR CR Income Tax Liabilities....... 724,800.00 EUR DR Profit and Loss.............. 1,691,200.00 EUR CR Retained Earnings............ 1,691,200.00 EUR We set up an adjusted trial balance after recording the above discussed <?page no="441"?> Berkau: Basics of Accounting 6e 31-441 Bookkeeping entries for the profit calculation. Observe the accounts and the resulting adjusted trial balance in Figure 31.3 and Figure 31.4: D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (6) 4,800,000.00 (3) 48,000.00 bd8 500,000.00 (4) 172,800.00 (5) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 D C D C (2) 48,000.00 PRE 48,000.00 RNT 48,000.00 cd7 48,000.00 (3) 48,000.00 c/ d 48,000.00 bd8 48,000.00 96,000.00 96,000.00 b/ d 48,000.00 P&L 48,000.00 Cash/ Bank C/ B Issued capital ISS Rent-20X7 RNT Prepaid expenses PRE D C D C (4) 144,000.00 cd7 144,000.00 (4) 28,800.00 (6) 800,000.00 bd8 144,000.00 cd7 771,200.00 800,000.00 800,000.00 bd8 771,200.00 D C D C ACC 36,000.00 c/ d 36,000.00 cd7 36,000.00 DPR 36,000.00 b/ d 36,000.00 P7L 36,000.00 bd8 36,000.00 D C D C (5) 1,500,000.00 c/ d 1,500,000.00 c/ d 4,000,000.00 (6) 4,000,000.00 b/ d 1,500,000.00 P7L 1,500,000.00 P7L 4,000,000.00 b/ d 4,000,000.00 Labour-20X7 LAB Revenue-20X7 REV Property, plant, equipment PPE Value added tax VAT Depreciation - 20X7 Dpr Accumulated depreciation ACC Figure 31.3: GOUSBLOM Ltd.’s accounts 20X7 <?page no="442"?> Berkau: Basics of Accounting 6e 31-442 D C D C RNT 48,000.00 Rev 4,000,000.00 cd7 1,691,200.00 P7L 1,691,200.00 DPR 36,000.00 bd8 1,691,200.00 LAB 1,500,000.00 EBT 2,416,000.00 4,000,000.00 4,000,000.00 ITL 724,800.00 b/ d 2,416,000.00 R/ E 1,691,200.00 2,416,000.00 2,416,000.00 D C cd7 724,800.00 P7L 724,800.00 bd8 724,800.00 Income tax liabilities ITL Profit and Loss-20X7 P7L Retained earnings R/ E Figure 31.3: GOUSBLOM Ltd.’s accounts 20X7 (continued) The values for the balances brought down are shown on the trial balance in Figure 31.4. Account Debit entries Credit entries Cash/ Bank C/ B 3,531,200.00 Issued Capital ISS 500,000.00 Rent-20X7 RNT 0.00 0.00 Prepaid Expenses PRE 48,000.00 Property, Plant, and Equipment PPE 144,000.00 Value added tax VAT 771,200.00 Depreciation-20X7 DPR 0.00 0.00 Accumulated Depreciation ACC 36,000.00 Labour-20X7 LAB 0.00 0.00 Revenue-20X7 REV 0.00 0.00 Income Tax Liabilities ITL 724,800.00 Retained Earnings R/ E 1,691,200.00 Total: 3,723,200.00 3,723,200.00 Gousblom Ltd. ADJUSTED TRIAL BALANCE as at 31.12.20X7 Figure 31.4: GOUSBLOM Ltd.’s adjusted trial balance GOUSBLOM Ltd. intends to pay its owners a dividend for 20X7 to the extent of 250,000.00 EUR. Furthermore, 1,000,000.00 EUR are added to earnings reserves. <?page no="443"?> Berkau: Basics of Accounting 6e 31-443 The reinvestment of 1,000,000.00 EUR is transferred to the Earnings Reserves account. The remainder of: 1,691,200 - 250,000 - 1,000,000 = 4 441,200.00 EUR is carried forward to the next Accounting period 20X8 and is kept in the Retained Earnings account. Observe the Bookkeeping entries made for the appropriation of profits: DR Retained Earnings............ 250,000.00 EUR CR Dividends Payables (A/ P)..... 250,000.00 EUR DR Retained Earnings............ 1,000,000.00 EUR CR Earnings Reserves............ 1,000,000.00 EUR D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (6) 4,800,000.00 (3) 48,000.00 bd8 500,000.00 (4) 172,800.00 (5) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 D C D C (2) 48,000.00 PRE 48,000.00 RNT 48,000.00 cd7 48,000.00 (3) 48,000.00 c/ d 48,000.00 bd8 48,000.00 96,000.00 96,000.00 b/ d 48,000.00 P7L 48,000.00 D C D C (4) 144,000.00 cd7 144,000.00 (4) 28,800.00 (6) 800,000.00 bd8 144,000.00 cd7 771,200.00 800,000.00 800,000.00 bd8 771,200.00 D C D C ACC 36,000.00 c/ d 36,000.00 cd7 36,000.00 DPR 36,000.00 b/ d 36,000.00 P7L 36,000.00 bd8 36,000.00 Cash/ Bank C/ B Issued capital ISS Property, plant, equipment PPE Value added tax VAT Depreciation-20X7 DPR Accumulated depreciation ACC Rent-20X7 RNT Prepaid expenses PRE D C D C (5) 1,500,000.00 c/ d 1,500,000.00 c/ d 4,000,000.00 (6) 4,000,000.00 b/ d 1,500,000.00 P7L 1,500,000.00 P7L 4,000,000.00 b/ d 4,000,000.00 Labour-20X7 LAB Revenue-20X7 REV Figure 31.5: GOUSBLOM Ltd.’s accounts 20X7 <?page no="444"?> Berkau: Basics of Accounting 6e 31-444 D C D C RNT 48,000.00 Rev 4,000,000.00 c/ d 1,691,200.00 P7L 1,691,200.00 DPR 36,000.00 S4D 250,000.00 b/ d 1,691,200.00 LAB 1,500,000.00 RES 1,000,000.00 EBT 2,416,000.00 cd7 441,200.00 4,000,000.00 4,000,000.00 1,691,200.00 1,691,200.00 ITL 724,800.00 b/ d 2,416,000.00 bd8 441,200.00 R/ E 1,691,200.00 2,416,000.00 2,416,000.00 Profit and Loss-20X7 P7L Retained earnings R/ E D C D C cd7 724,800.00 P7L 724,800.00 cd7 250,000.00 R/ E 250,000.00 bd8 724,800.00 bd8 250,000.00 D C cd7 1,000,000.00 R/ E 1,000,000.00 bd8 1,000,000.00 Income tax liabilities ITL Dividends payables (S4D) Earnings Reserves RES Figure 31.5: GOUSBLOM Ltd.’s accounts 20X7 (continued) Observe the financial statements prepared under the consideration of the appropriation of profits in Figure 31.6 and Figure 31.7. For this case study, we only focus on the balance sheet and the income statement: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 108,000.00 Issued capital 500,000.00 Intangibles Reserves 1,000,000.00 Financial assets Retained earnings 441,200.00 Current assets Liabilities Inventory Interest bear liab A/ R A/ P 1,021,200.00 Prepaid expenses 48,000.00 Provisions Cash/ Bank 3,531,200.00 Tax liabilities 724,800.00 3,687,200.00 3,687,200.00 Gousblom Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X7 Figure 31.6: GOUSBLOM Ltd.’s statement of financial position On the face of the statement of financial position, the value for property, plant <?page no="445"?> Berkau: Basics of Accounting 6e 31-445 and equipment is the cost of acquisition minus accumulated depreciation: 144,000 - 36,000 = 1 108,000.00 EUR. The value for the payables contains the dividend plus VAT liabilities. It equals: 250,000 + 771,200 = 1 1,021,200.00 EUR. Observe the statement of profit or loss and other comprehensive income in Figure 31.7: [EUR] Revenue 4,000,000.00 Other income 4,000,000.00 Materials Labour (1,500,000.00) Depreciation (36,000.00) Other expenses (48,000.00) Earnings before int and taxes (EBIT) 2,416,000.00 Interest Earnings before taxes (EBT) 2,416,000.00 Income tax expenses (724,800.00) Deferred taxes Earnings after taxes (EAT) 1,691,200.00 Gousblom Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 31.7: GOUSBLOM Ltd.’s income statement 31.7 C/ S GOUSBLOM Ltd. - 20X8 In the next Accounting period 20X8, all real accounts are continued. In contrast, the 20X7’s nominal accounts are closedoff to profit and loss and do not appear in our exhibits anymore. We consider beginning-of-the-period- Bookkeeping entries in the new Accounting period before we record business operations in 20X8. Those starter- Bookkeeping entries are about income tax and VAT payments, dividend payments and dissolving prepaid expenses. Further payments might apply for debts as agreed in contracts, bank loan payments, rent due and insurances, but those do not apply for this case study. At the beginning of 20X8, (on 2.01.20X8) GOUSBLOM Ltd. dissolves its prepaid expenses. The amount is transferred to the Rent-20X8 account and thus becomes an expense. GOUSBLOM Ltd. again pays rent for 20X9 in advance, check Bookkeeping entry (B). Note, that again, we record the accrual together with the adjustments at the end of the Accounting period. All Bookkeeping entries for 20X8 are indicated in capital letters to distinguish them from the ones of the previous Accounting period. <?page no="446"?> Berkau: Basics of Accounting 6e 31-446 (A) Dissolving prepaid expenses on 2.01.20X8 gives the Bookkeeping entry below. (B) Payment of rent in advance for 20X9 on 2.01.20X8. DR Rent......................... 48,000.00 EUR CR Prepaid Expenses............. 48,000.00 EUR DR Rent......................... 48,000.00 EUR CR Cash/ Bank.................... 48,000.00 EUR GOUSBLOM Ltd. pays the income taxes, VAT and the dividends to the revenue service and to its owners. The latter amount includes the dividend tax. For the sake of simplicity, we assume here that all shareholders are foreigners. A consent of the shareholders as declared on the annual general meeting AGM is required for declaring dividends and paying them out. (C) Payment for income taxes on 10.01.20X8. DR Income Tax Liabilities....... 724,800.00 EUR CR Cash/ Bank.................... 724,800.00 EUR (D) Payment for VAT on 10.01.20X8. DR VAT.......................... 771,200.00 EUR CR Cash/ Bank.................... 771,200.00 EUR (E) Payment of dividends to shareholders which takes place on 2.06.20X8. DR Dividends Payables (S4D)..... 250,000.00 EUR CR Cash/ Bank.................... 250,000.00 EUR The payment for labour in 20X8 is 1,700,000.00 EUR. We pretend it is paid on 1.07.20X8 by bank transfer. (F) Payment for labour is recorded on 1.07.20X8. DR Labour....................... 1,700,000.00 EUR CR Cash/ Bank.................... 1,700,000.00 EUR During the Accounting period 20X8, GOUSBLOM Ltd. earns a revenue of 4,100,000.00 EUR. All customers pay on cash. The payments add up to: 4,100,000 × 120% = 4 4,920,000.00 EUR. (G) For the sake of simplification, we record 20X8’s revenue on 30.06.20X8. <?page no="447"?> Berkau: Basics of Accounting 6e 31-447 DR Cash/ Bank.................... 4,920,000.00 EUR CR VAT.......................... 820,000.00 EUR CR Revenue...................... 4,100,000.00 EUR Next, we balance-off all accounts and prepare the first trial balance for 20X8. Figure 31.8 shows the accounts, and the next following Figure 31.9 contains the trial balance as at 31.12.20X8. D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (6) 4,800,000.00 (3) 48,000.00 cd8 500,000.00 bd8 500,000.00 (4) 172,800.00 bd9 500,000.00 (5) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 (B) 48,000.00 (G) 4,920,000.00 (C) 724,800.00 (D) 771,200.00 (E) 250,000.00 (F) 1,700,000.00 cd8 4,957,200.00 8,451,200.00 8,451,200.00 bd9 4,957,200.00 D C D C (A) 48,000.00 (4) 48,000.00 cd7 48,000.00 (B) 48,000.00 c/ d 96,000.00 bd8 48,000.00 (A) 48,000.00 96,000.00 96,000.00 b/ d 48,000.00 D C D C (4) 144,000.00 cd7 144,000.00 (4) 28,800.00 (6) 800,000.00 bd8 144,000.00 cd8 144,000.00 cd7 771,200.00 bd9 800,000.00 800,000.00 (D) 771,200.00 bd8 771,200.00 cd8 820,000.00 (G) 820,000.00 1,591,200.00 1,591,200.00 bd9 820,000.00 Cash/ Bank C/ B Issued capital ISS Property, plant, equipment PPE VAT Rent-20X8 RNT Prepaid expenses D C D C (F) 1,700,000.00 c/ d 1,700,000.00 c/ d 4,100,000.00 (G) 4,100,000.00 b/ d 1,700,000.00 b/ d 4,100,000.00 Labour-20X8 LAB Revenue-20X8 REV Figure 31.8: GOUSBLOM Ltd.’s accounts 20X8 <?page no="448"?> Berkau: Basics of Accounting 6e 31-448 D C D C cd7 250,000.00 R/ E 250,000.00 c/ d 1,691,200.00 P7L 1,691,200.00 (E) 250,000.00 bd8 250,000.00 S4D 250,000.00 b/ d 1,691,200.00 RES 1,000,000.00 cd7 441,200.00 1,691,200.00 1,691,200.00 bd8 441,200.00 D C D C cd7 724,800.00 P7L 724,800.00 cd7 1,000,000.00 R/ E 1,000,000.00 (C) 724,800.00 bd8 724,800.00 bd8 1,000,000.00 D C cd7 36,000.00 DPR 36,000.00 bd8 36,000.00 Income tax liabilities ITL Earnings reserves RES Accumulated depreciation ACC Dividends payables ShD Retained earnings R/ E Figure 31.8: GOUSBLOM Ltd.’s accounts 20X8 (continued) The trial balance is derived from the accounts. Compare the balancing figures of the accounts to the entries on the trial balance in Figure 31.9: Account Debit entries Credit entries Cash/ Bank C/ B 4,957,200.00 Issued Capital ISS 500,000.00 Rent-20X8 RNT 96,000.00 Prepaid Expenses PRE 0.00 0.00 Property, Plant, and Equipment PPE 144,000.00 Value added tax VAT 820,000.00 Accumulated Depreciation ACC 36,000.00 Labour-20X8 LAB 1,700,000.00 Revenue-20X8 REV 4,100,000.00 Income Tax Liabilities ITL 0.00 0.00 Retained Earnings R/ E 441,200.00 Earnings Reserves RES 1,000,000.00 Total: 6,897,200.00 6,897,200.00 Gousblom Ltd. TRIAL BALANCE as at 31.12.20X8 Figure 31.9: GOUSBLOM Ltd.’s trial balance <?page no="449"?> Berkau: Basics of Accounting 6e 31-449 Next, we record depreciation and the prepaid expenses for 20X8 (adjustments). The values are the same as in the previous Accounting period 20X7 as depreciation and rental expenses did not change. DR Depreciation ................. 36,000.00 EUR CR Accumulated depreciation..... 36,000.00 EUR DR Prepaid expenses............. 48,000.00 EUR CR Rent......................... 48,000.00 EUR We calculate the pre-tax profit to be: 4,100,000 - 48,000 - 36,000 - 1,700,000 = 2 2,316,000.00 EUR. All Bookkeeping entries for adjustments are made on 31.12.20X8. DR Profit and Loss.............. 48,000.00 EUR CR Rent......................... 48,000.00 EUR DR Profit and Loss.............. 36,000.00 EUR CR Depreciation ................. 36,000.00 EUR DR Profit and Loss.............. 1,700,000.00 EUR CR Labour....................... 1,700,000.00 EUR DR Revenue...................... 4,100,000.00 EUR CR Profit and Loss.............. 4,100,000.00 EUR Observe the accounts in Figure 31.10. <?page no="450"?> Berkau: Basics of Accounting 6e 31-450 D C D C (1) 500,000.00 (2) 48,000.00 cd7 500,000.00 (1) 500,000.00 (6) 4,800,000.00 (3) 48,000.00 cd8 500,000.00 bd8 500,000.00 (4) 172,800.00 bd9 500,000.00 (5) 1,500,000.00 cd7 3,531,200.00 5,300,000.00 5,300,000.00 bd8 3,531,200.00 (B) 48,000.00 (G) 4,920,000.00 (C) 724,800.00 (D) 771,200.00 (E) 250,000.00 (F) 1,700,000.00 cd8 4,957,200.00 8,451,200.00 8,451,200.00 bd9 4,957,200.00 D C D C (A) 48,000.00 c/ d 48,000.00 (4) 48,000.00 cd7 48,000.00 (B) 48,000.00 PRE 48,000.00 bd8 48,000.00 (A) 48,000.00 96,000.00 96,000.00 RNT 48,000.00 cd8 48,000.00 b/ d 48,000.00 P8L 48,000.00 96,000.00 96,000.00 bd9 48,000.00 Cash/ Bank C/ B Issued capital ISS Rent-20X8 RNT Prepaid expenses PRE D C D C (4) 144,000.00 cd7 144,000.00 (4) 28,800.00 (6) 800,000.00 bd8 144,000.00 cd8 144,000.00 cd7 771,200.00 bd9 144,000.00 800,000.00 800,000.00 (D) 771,200.00 bd8 771,200.00 cd8 820,000.00 (G) 820,000.00 1,591,200.00 1,591,200.00 bd9 820,000.00 D C D C ACC 36,000.00 c/ d 36,000.00 cd7 36,000.00 DPR 36,000.00 b/ d 36,000.00 P&L 36,000.00 bd8 36,000.00 cd8 72,000.00 DPR 36,000.00 72,000.00 72,000.00 bd9 72,000.00 Property, plant, equipment PPE Value added tax VAT Depreciation-20X8 DPR Accumulated depreciatioon ACC Figure 31.10: GOUSBLOM Ltd.’s accounts 20X8 <?page no="451"?> Berkau: Basics of Accounting 6e 31-451 D C D C (F) 1,700,000.00 c/ d 1,700,000.00 c/ d 4,100,000.00 (G) 4,100,000.00 b/ d 1,700,000.00 P8L 1,700,000.00 P8L 4,100,000.00 b/ d 4,100,000.00 Labour-20X8 LAB Revenue-20X8 REV D C D C cd7 250,000.00 R/ E 250,000.00 c/ d 1,691,200.00 P7L 1,691,200.00 (E) 250,000.00 bd8 250,000.00 S4D 250,000.00 b/ d 1,691,200.00 RES 1,000,000.00 cd7 441,200.00 1,691,200.00 1,691,200.00 bd8 441,200.00 cd8 2,062,400.00 P8L 1,621,200.00 2,062,400.00 2,062,400.00 bd9 2,062,400.00 D C D C cd7 724,800.00 P7L 724,800.00 cd7 1,000,000.00 R/ E 1,000,000.00 (C) 724,800.00 bd8 724,800.00 cd8 1,000,000.00 bd8 1,000,000.00 cd8 694,800.00 P8L 694,800.00 bd9 1,000,000.00 1,419,600.00 1,419,600.00 bd9 694,800.00 Income tax liabilities ITL Reserves Dividends payables ShD Retained earnings R/ E D C RNT 48,000.00 Rev 4,100,000.00 DPR 36,000.00 LAB 1,700,000.00 EBT 2,316,000.00 4,100,000.00 4,100,000.00 ITL 694,800.00 b/ d 2,316,000.00 R/ E 1,621,200.00 2,316,000.00 2,316,000.00 Profit and Loss-20X8 P8L Figure 31.10: GOUSBLOM Ltd.’s accounts 20X8 (continued) Figure 31.11 shows the adjusted trial balance as at 31.12.20X8: <?page no="452"?> Berkau: Basics of Accounting 6e 31-452 Account Debit entries Credit entries Cash/ Bank C/ B 4,957,200.00 Issued Capital ISS 500,000.00 Rent-20X8 RNT 0.00 0.00 Prepaid Expenses PRE 48,000.00 0.00 Property, Plant, and Equipment PPE 144,000.00 Value Added Tax VAT 820,000.00 Depreciation-20X8 DPR 0.00 0.00 Accumulated Depreciation ACC 72,000.00 Labour-20X8 LAB 0.00 0.00 Revenue-20X8 REV 0.00 0.00 Income Tax Liabilities ITL 694,800.00 Retained Earnings R/ E 2,062,400.00 Earnings Reserves RES 1,000,000.00 Total: 5,149,200.00 5,149,200.00 Gousblom Ltd. ADJUSTED TRIAL BALANCE as at 31.12.20X8 Figure 31.11: GOUSBLOM Ltd.’s adjusted trial balance GOUSBLOM Ltd. decides to carry forward the full profit to the next Accounting period. Therefore, no Bookkeeping entries are required for the appropriation of profits. The statement of financial position as at 31.12.20X8 is depicted in Figure 31.12. Check also the income statement in Figure 31.13: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 72,000.00 Issued capital 500,000.00 Intangibles Reserves 1,000,000.00 Financial assets R/ E 2,062,400.00 Current assets Liabilities Inventory Interest bear liab A/ R A/ P 820,000.00 Prepaid expenses 48,000.00 Provisions Cash/ Bank 4,957,200.00 Tax liabilities 694,800.00 5,077,200.00 5,077,200.00 Gousblom Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X8 Figure 31.12: GOUSBLOM Ltd.’s statement of financial position <?page no="453"?> Berkau: Basics of Accounting 6e 31-453 [EUR] Revenue 4,100,000.00 Other income 4,100,000.00 Materials Labour (1,700,000.00) Depreciation (36,000.00) Other expenses (48,000.00) Earnings before int and taxes (EBIT) 2,316,000.00 Interest Earnings before taxes (EBT) 2,316,000.00 Income tax expenses (694,800.00) Deferred taxes Earnings after taxes (EAT) 1,621,200.00 Gousblom Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X8 Figure 31.13: GOUSBLOM Ltd.’s income statement For an explanation of the changes of the book value of the company, IAS 1.10 requires preparing a statement of changes in equity. Look at Figure 31.14 to familiarise yourself with the situation of GOUSBLOM Ltd.’s valuation. Share capital Reserves Retained earnings total [EUR] [EUR] [EUR] [EUR] as at 1.01.20X7 500,000.00 500,000.00 Profit 20X7 1,691,200.00 1,691,200.00 Dividend 20X7 (250,000.00) (250,000.00) Additions to reserves 1,000,000.00 (1,000,000.00) 0.00 as at 31.12.20X7 500,000.00 1,000,000.00 441,200.00 1,941,200.00 Profit 20X8 1,621,200.00 1,621,200.00 as at 31.12.20X8 500,000.00 1,000,000.00 2,062,400.00 3,562,400.00 Gousblom Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X8 Figure 31.14: GOUSBLOM Ltd.’s statement of changes in equity In Figure 31.14, the profit carried forward to the next Accounting period is 2,062,400.00 EUR. It contains the profit carried forward from 20X7 as well as from 20X8: 1,621,200 + 441,200 = 2,062,400.00 EUR (retained earnings). <?page no="454"?> Berkau: Basics of Accounting 6e 31-454 How it is Done (Multi-period Bookkeeping Records): (1) Make Bookkeeping entries for all business activities in the relevant accounts. (2) Balance-off all accounts. (3) Close-off all nominal accounts to the Trading account/ Profit and Loss account whichever applies. (4) Prepare financial statements. (5) Consider the balances brought down in the real accounts as their opening values for the next Accounting period. (I) Make Bookkeeping entries for all business activities in the relevant accounts. (II) Balance-off all accounts. . . . 31.8 Summary In contrast to German Bookkeeping, real accounts are continued in the next Accounting period for international Accounting. At the yearend, we balance-off all accounts and close-off nominal accounts to profit and loss. We keep all real accounts. After preparing the income statement, we consider the appropriation of profits as covered in chapter (30). The outcome is recorded in the real accounts, like the Retained Earnings account, the Shareholders for Dividend account and the Earnings Reserves account. In the next following Accounting period, real accounts are continued whereas nominal accounts must be defined again. Special Bookkeeping entries apply for the transition from one Accounting period to the next one: accruals, tax payments, dividend payments etc. For German Accounting, an End-of- Period account (Schlussbilanzkonto) and Start-of-Period account (Eröffnungsbilanzkonto) apply. The equity disclosure is ruled in § 268 HGB. 31.9 Question Bank (1) Which statement is correct? 1. At the time of transition to the next Accounting period, all nominal accounts are continued; all real accounts are closed-off to profit or loss. 2. At the time of transition to the next Accounting period, all real accounts are continued; all nominal accounts are balanced-off. 3. At the time of transition to the next Accounting period, all real accounts are continued; all nominal accounts are closed-off to profit or loss. 4. At the time of transition to the next Accounting period, all real accounts are closed-off; all nominal accounts are continued. (2) What are typical Bookkeeping entries for the beginning of an Accounting period? 1. Payment of income taxes, payment of VAT receivables, transfer of prepaid expenses to expenses. <?page no="455"?> Berkau: Basics of Accounting 6e 31-455 2. Payment of income taxes, payment of VAT liabilities, transfer of prepaid expenses to expenses. 3. Payment of prepaid expenses, payment of income taxes, payment of VAT liabilities. 4. Payment of interest and pay-off, payment of VAT liabilities, transfer of prepaid expenses to expenses. (3) A company discloses on its balance sheet a value for property, plant, equipment of 6,000.00 EUR. What could be the correct balancing figures (b/ d) in its accounts? 1. PPE: debit balanced 10,000.00 EUR; ACC credit balanced 6,000.00 EUR. 2. PPE: credit balanced 10,000.00 EUR; ACC debit balanced 4,000.00 EUR. 3. PPE: credit balanced 10,000.00 EUR; ACC debit balanced 6,000.00 EUR. 4. PPE: debit balanced 10,000.00 EUR; ACC credit balanced 4,000.00 EUR. (4) A company balances-off its Bank account credit balanced. What is required to do at the end of the Accounting period? 1. The balancing figure must be recorded as short-term liabilities. 2. The balancing figure must be disclosed as short-term liabilities on the balance sheet. No Bookkeeping entry is required. 3. The balancing figure must be paid before preparing financial statements. 4. The balancing figure must be transferred to a debit balance. (5) What is the Bookkeeping entry for prepaid rent at the beginning of the fresh Accounting period? 1. DR RNT; CR PRE. 2. DR RNT; CR C/ B. 3. DR PRE; CR RNT. 4. DR C/ B; CR PRE. 31.10 Solutions 1-3; 2-2; 3-4; 4-2; 5-1. <?page no="456"?> Berkau: Basics of Accounting 6e 32-456 32 Introduction to Statements of Cash Flows 32.1 What is in the Chapter? Besides profitability, companies strive to generate cash with their operations as well as with their investing and financing activities. The international Accounting standards IFRSs require preparing a statement of cash flows, which is part of a complete set of financial statements for all reporting companies. A cash flow is the increases or decreases of cash/ bank. The statement of cash flows shows the entire cash flow of a company classified as cash flows from business operations and from investing and financing activities. In this chapter, we discuss the preparation of cash flow statements. Two different methods apply: direct method and reconciliation method for operating activities. We discuss both methods for the same case study MANSELL Ltd. which is a bookstore. That way, we can demonstrate the differences between both approaches. Thereafter, we prepare a cash flow statement for a production firm which considers changes of inventories of finished goods. 32.2 Learning Objectives After reading this chapter, you can prepare a statement of cash flows following the direct method and the reconciliation method. You will see that a cash flow statement is similar to a liquidity plan. You learn how to read and analyse cash flow statements. E.g., you understand that a cash flow from operations should be positive and high whereas a positive cash flow from investing activities can indicate that the reporting company is under liquidation. You will understand the need to disclose different cash flows and to not mix them to avoid offsetting cash flows. 32.3 Cash Flow Statement Requirements in Germany In Germany, a statement of cash flows is not compulsory for single-entity financial statements (Handelsgesetzbuch). A single-entity financial statement is a set of financial statements prepared for one company only. In contrast, group statements in Europe must be prepared in accordance with IFRSs and must contain a consolidated statement of cash flows. As by default case for German companies, no cash flow statement is prepared. The statement of cash flows is only required if a single company participates on the public capital market. See § 264 HGB. 32.4 Cash Flow Statement Requirements by IFRSs All financial statements prepared in compliance with IFRSs contain a statement of cash flows. This is ruled by IAS 1.10. The International Accounting Standards Board dedicated IAS 7 to cash flow statements. A cash flow statement discloses the total of payment activities classified by their nature of payment. At least, the statement of cash flow must disclose the cash flows from operations, the cash flows from investing activities <?page no="457"?> Berkau: Basics of Accounting 6e 32-457 and the cash flow from financing activities. IAS 7 states that 2 methods for the cash flow from operations apply. Direct method and reconciliation Method. The direct method classifies all cash flow into operating, investing or financing cash flows based on the entries in the Cash/ Bank account. As an alternative, IAS 7 offers to derive the cash flow from operations by reconciliation of profits with cash flows. The reconciliation method calculates the cash flow from operations by adjusting profit for expenses/ revenues that are not cash relevant and thereafter for payments/ receipts that do not count for profit or loss. Here, we introduce the direct method at first. Later we cover the reconciliation method for the same case study. 32.5 Categories of Cash Flows For a cash flow statement, all cash flows are classified into: - Cash flows from operations, - Cash flows from investing activities and - Cash flows from financing activities. The cash flow separation makes sense as different categories of cash flows can compensate each other, e.g., a positive cash flow from operations can offset a negative cash flow from investing and results in a zero total cash flow. However, we want to know the partial cash flows to evaluate the business and to predict future liquidity. In general, we expect a cash flow from operating activities to be positive which means the reporting company generates cash with its operations. Note, that when we talk about cash in this chapter, we refer to cash/ bank; therefore, any bank transfer counts as cash flow, too. A cash flow from investments should be negative. This means the company expands and buys, e.g., machinery at a higher value than it disposes (depreciated) non-current assets. The financing cash flow is linked to payments from investors and creditors. If positive, it means the company is trustworthy. A negative financing cash flow indicates the business is paying-off its debts. Following this explanation, we cannot generally judge a company based on its financing cash flows. It mostly depends on the situation a company is in, e.g., what is cash flow needed for. A company that expands and issues shares will show a high financing cash flow which is needed to pay for its growth. The separation of cash flows in three categories is required by IAS 7. This standard rules cash flow classifications and provides definitions: Cash flows from operating activities are all cash flows not linked to financing activities or investing activities. This residual definition is helpful, as cash flows from investing and financing activities are easily identifiable. Cash flows from investing activities result from payments for acquisitions and disposals of non-current assets. Cash flows from financing activities are linked to contributions from owners, like share issues, and loan payments/ receipts, like bank loans or bonds. Furthermore, all payments linked to equity and liability instruments, like dividends, interest/ coupons and payoffs are regarded as cash flows from <?page no="458"?> Berkau: Basics of Accounting 6e 32-458 financing activities. A hint to identify cash flows from financing activities is, that they cause changes on the credit side of the balance sheet, either as equity instruments (shares) or as liability instruments (loans, bonds). For the calculation of cash flows, we acknowledge that cash flows from investing and financing activities must always be determined directly. The reconciliation method only applies for cash flows from operations. 32.6 Cash Flow Statement and Value added Tax In general, cash flow statements are based on net amounts. In a real company, VAT is refunded/ paid in the next following month, except of payments made in December. However, in this textbook, all VAT payments and receipts to and from the revenue service are due in the next Accounting period as per our conventions in chapter (1). This means a VAT receipt or the payment of VAT liabilities take place in the next year. As a consequence, all our cash flow calculations are based on gross amounts followed by payments to and receipts from the revenue service in the next Accounting period. 32.7 Direct Method Next, we explain the direct method. Discussing the direct method, we focus on the Cash/ Bank account. All cash relevant activities are recorded therein either as a receipt on the debit side or a payment on the credit side. Therefore, we can go through all entries and classify them either into operating, investing or financing cash flows. No cash flow can be left-over due to the residual definition of operating cash flows. We cover below the case study of the bookstore MANSELL Ltd., starting with the explanation of the direct method, as it is the easier one. 32.8 C/ S MANSELL Ltd. On 2.01.20X4, MANSELL Ltd. issues ordinary shares for 100,000.00 EUR. This Bookkeeping entry is cash relevant; hence, we make a debit entry in the Cash/ Bank account. The money flow into the business is a positive cash flow from financing activities because the shareholders buy shares of the company and MANSELL Ltd. is the recipient of the funds. Therefore, we record a debit entry in cash/ bank. (1) Issued capital: 100,000.00 EUR on 2.01.20X4. DR Cash/ Bank.................... 100,000.00 EUR CR Issued Capital............... 100,000.00 EUR On 3.01.20X4, MANSELL Ltd. takes a bank loan. It borrows 40,000.00 EUR from the bank. The annual rate of interest is 4.25 %/ a. The bank loan requires paying-off every year 2,000.00 EUR. MANSELL Ltd. pays for interest: 4.25% × 40,000 = 1 1,700.00 EUR and for pay-off 2,000.00 EUR at the end of the Accounting period 20X4. The Bookkeeping entries are: (2) Taking the bank loan on 3.01.20X4 is a cash/ bank receipt. <?page no="459"?> Berkau: Basics of Accounting 6e 32-459 DR Cash/ Bank.................... 40,000.00 EUR CR Interest Bearing Liabilities. 40,000.00 EUR The debit entry in the Cash/ Bank account is a cash flow from financing activities. The same classification applies for the interest and the pay-off payment. As payments are made, the Cash/ Bank account is credited. (3) Paying interest on 31.12.20X4. DR Interest..................... 1,700.00 EUR CR Cash/ Bank.................... 1,700.00 EUR (4) Paying-off loan debts on 31.12.20X4. DR Interest Bearing Liabilities. 2,000.00 EUR CR Cash/ Bank.................... 2,000.00 EUR In compliance with IAS 1, MANSELL Ltd. must disclose short-term liabilities and long-term debts separately. The pay-off for 20X5 is classified as a short-term liability. The remainder of the bank loan is a long-term liability. Therefore, MANSELL Ltd. transfers liabilities which are due in the next Accounting period to short-term liabilities (A/ P). (5) Transfer of next year’s pay-off to short-term liabilities on 31.12.20X4. The transfer is no cash flow. DR Interest Bearing Liabilities. 2,000.00 EUR CR Accounts Payables............ 2,000.00 EUR MANSELL Ltd. rents a shop from a private person. The rent is non-VATable. Rent of 24,000.00 EUR is paid for the full year and must be classified as cash flow from operations. Payments for rent are no investment nor are they linked to the financing of the business. (6) Payment for rent on 4.01.20X4. DR Rent......................... 24,000.00 EUR CR Cash/ Bank.................... 24,000.00 EUR Next, MANSELL Ltd. buys 26 bookshelves at 535.00 EUR/ u each (the amount is ex VAT). The bookshelves are intended to be used for more than one year and are considered as acquisitions. The Property, Plant, Equipment account applies. Cash/ bank payments for non-current assets are investments. MANSELL Ltd. is registered for VAT reduction. As per agreement with the seller of the shelves, MANSELL Ltd. pays half of the purchase price (gross amount). This payment is amounting to: 26 × 535 × 120% / 2 = 8 8,346.00 EUR. The remainder is due in the next Accounting period 20X5. The payment for the bookshelves falls under investing cash flows. The acquisition is recorded on 5.01.20X4. (7) Acquisition of bookshelves: 26 × 535 × 120% = 1 16,692.00 EUR on 5.01.20X4. <?page no="460"?> Berkau: Basics of Accounting 6e 32-460 DR P, P, E Account.............. 13,910.00 EUR DR VAT.......................... 2,782.00 EUR CR Cash/ Bank.................... 8,346.00 EUR CR Accounts Payables............ 8,346.00 EUR MANSELL Ltd. depreciates the bookshelves over 10 years. Their annual depreciation is: 13,910 / 10 = 1 1,391.00 EUR/ a. Depreciation is not cash flow relevant. (8) Depreciation on bookshelves on 31.12.20X4. DR Depreciation................. 1,391.00 EUR CR Acc. Depr.................... 1,391.00 EUR On 8.01.20X4, MANSELL Ltd. buys 4,000 novels at a purchase price of 8.16 EUR/ u each. The amount includes VAT. The total payment is: 4,000 × 8.16 = 3 32,640.00 EUR. The net amount thereof is: 32,640 / 120% = 227,200.00 EUR. The purchase of books is a cash deal. The books are added to inventories. A purchase of merchandise articles is an operating activity. Therefore, the payment of 32,640.00 EUR is a cash flow from operations. (9) Purchase of books on 8.01.20X4. DR Purchase..................... 27,200.00 EUR DR VAT.......................... 5,440.00 EUR CR Cash/ Bank.................... 32,640.00 EUR On 5.04.20X4, MANSELL Ltd. sells 2,900 books at a net selling price of 14.50 EUR/ u on cash. The net amount of the sales gives: 2,900 × 14.50 = 4 42,050.00 EUR. The proceeds received from customers equal: 42,050 × 120% = 50,460.00 EUR. The cash flow from the sale is a cash flow from operations. (10) Cash sale on 5.04.20X4. DR Cash/ Bank.................... 50,460.00 EUR CR VAT.......................... 8,410.00 EUR CR Sales........................ 42,050.00 EUR We look at MANSELL Ltd.’s accounts at this stage. Check Figure 32.1: <?page no="461"?> Berkau: Basics of Accounting 6e 32-461 D C D C (1) 100,000.00 (3) 1,700.00 c/ d 100,000.00 (1) 100,000.00 (2) 40,000.00 (4) 2,000.00 b/ d 100,000.00 (10) 50,460.00 (6) 24,000.00 (7) 8,346.00 (9) 32,640.00 c/ d 121,774.00 190,460.00 190,460.00 b/ d 121,774.00 D C D C (4) 2,000.00 (2) 40,000.00 (3) 1,700.00 c/ d 1,700.00 (5) 2,000.00 b/ d 1,700.00 c/ d 36,000.00 40,000.00 40,000.00 b/ d 36,000.00 D C D C (5) 2,000.00 (6) 24,000.00 c/ d 24,000.00 c/ d 10,346.00 (7) 8,346.00 b/ d 24,000.00 10,346.00 10,346.00 b/ d 10,346.00 D C D C (7) 13,910.00 c/ d 13,910.00 (7) 2,782.00 (10) 8,410.00 b/ d 13,910.00 (9) 5,440.00 c/ d 188.00 8,410.00 8,410.00 b/ d 188.00 Cash/ Bank C/ B Issued Capital ISS Accounts payables A/ P Rent-20X4 RNT Property, plant, equipment PPE Value added tax VAT Interest bearing liabilities IBL Interest-20X4 INT D C D C (8) 1,391.00 c/ d 1,391.00 c/ d 1,391.00 (8) 1,391.00 b/ d 1,391.00 b/ d 1,391.00 D C D C (9) 27,200.00 c/ d 27,200.00 c/ d 42,050.00 (10) 42,050.00 b/ d 27,200.00 b/ d 42,050.00 Purchase-20X4 PUR Sales Revenue-20X4 REV Depreciation-20X4 DPR Accumulated depreciation ACC Figure 32.1: MANSELL Ltd.’s accounts In preparation of its profit calculation, MANSELL Ltd. takes stock. There is a closing stock of 1,100 novels at: 1,100 × 8.16 / 120% = 7 7,480.00 EUR. Observe the <?page no="462"?> Berkau: Basics of Accounting 6e 32-462 profit calculation in the Trading account and the Profit and Loss account in Figure 32.2: D C D C (1) 100,000.00 (3) 1,700.00 c/ d 100,000.00 (1) 100,000.00 (2) 40,000.00 (4) 2,000.00 b/ d 100,000.00 (10) 50,460.00 (6) 24,000.00 (7) 8,346.00 (9) 32,640.00 c/ d 121,774.00 190,460.00 190,460.00 b/ d 121,774.00 Cash/ Bank C/ B Issued Capital ISS D C D C (4) 2,000.00 (2) 40,000.00 (3) 1,700.00 c/ d 1,700.00 (5) 2,000.00 b/ d 1,700.00 P&L 1,700.00 c/ d 36,000.00 40,000.00 40,000.00 b/ d 36,000.00 Interest bearing liabilities IBL Interest-20X4 INT D C D C (5) 2,000.00 (6) 24,000.00 c/ d 24,000.00 c/ d 10,346.00 (7) 8,346.00 b/ d 24,000.00 P&L 24,000.00 10,346.00 10,346.00 b/ d 10,346.00 D C D C (7) 13,910.00 c/ d 13,910.00 (7) 2,782.00 (10) 8,410.00 b/ d 13,910.00 (9) 5,440.00 c/ d 188.00 8,410.00 8,410.00 b/ d 188.00 D C D C (8) 1,391.00 c/ d 1,391.00 c/ d 1,391.00 (8) 1,391.00 b/ d 1,391.00 P&L 1,391.00 b/ d 1,391.00 Accounts payables A/ P Rent-20X4 RNT Property, plant, equipment PPE Value added tax VAT Depreciation-20X4 DPR Accumulated depreciation ACC Figure 32.2: MANSELL Ltd.’s accounts <?page no="463"?> Berkau: Basics of Accounting 6e 32-463 D C D C (9) 27,200.00 c/ d 27,200.00 c/ d 42,050.00 (10) 42,050.00 b/ d 27,200.00 T/ A 27,200.00 T/ A 42,050.00 b/ d 42,050.00 D C D C PUR 27,200.00 REV 42,050.00 T/ A 7,480.00 c/ d 7,480.00 GP 22,330.00 INV 7,480.00 b/ d 7,480.00 49,530.00 49,530.00 P&L 22,330.00 b/ d 22,330.00 Trading account-20X4 T/ A Inventory INV Purchase-20X4 PUR Sales Revenue-20X4 REV D C D C INT 1,700.00 T/ A 22,330.00 c/ d 4,761.00 P&L 4,761.00 RNT 24,000.00 b/ d 4,761.00 DPR 1,391.00 NL 4,761.00 27,091.00 27,091.00 b/ d 4,761.00 R/ E 4,761.00 Profit and Loss P&L Retained earnings R/ E Figure 32.3: MANSELL Ltd.’s accounts (continued) MANSELL Ltd. makes a loss in 20X4. Its financial statements - like the balance sheet and the income statement are presented in Figure 32.3 and Figure 32.4. No appropriation of profits for this Accounting period is recorded. Note, with regard to the profit calculation: The material expenses recognised on the income statement are purchased books minus closing stock. Materials equal: 27,200 - 7,480 = 1 19,720.00 EUR. <?page no="464"?> Berkau: Basics of Accounting 6e 32-464 [EUR] Revenue 42,050.00 Other income 42,050.00 Materials (19,720.00) Labour Depreciation (1,391.00) Other expenses (24,000.00) Earnings before int and taxes (EBIT) (3,061.00) Interest (1,700.00) Earnings before taxes (EBT) (4,761.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (4,761.00) Mansell Ltd. STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 32.3: MANSELL Ltd.’s income statement The statement of financial position is shown below in Figure 32.4: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 12,519.00 Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings (4,761.00) Current assets Liabilities Inventory 7,480.00 Interest bear liab 36,000.00 A/ R A/ P 10,534.00 Prepaid expenses Provisions Cash/ Bank 121,774.00 Tax liabilities 141,773.00 141,773.00 Mansell Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 32.4: MANSELL Ltd.’s statement of financial position MANSELL Ltd.’s balance sheet requires further attention: The item for property, plant and equipment is the value taken from the Property, Plant and Equipment account minus its accumulated depreciation. It equals: 13,910 - 1,391 = 12,519.00 EUR. The accounts payables contain how much MANSELL Ltd. owes its supplier, the short-term liabilities <?page no="465"?> Berkau: Basics of Accounting 6e 32-465 from the bank loan and the output-VAT. The total is: 2,000 + 8,346 + 188 = 110,534.00 EUR. The total cash flow is the total of changes in cash/ bank. At the beginning of the Accounting period, the Cash/ Bank account was zero-balanced. Therefore, the total cash flow is the closing balance of: 121,774.00 EUR. MANSELL Ltd.’s statement of cash flows shows which activities the total cash flow results from. Observe below MANSELL Ltd.’s statement of cash flows in Figure 32.5: Cash flow from operating acitivities Materials bought (32,640.00) Sales 50,460.00 Rent (24,000.00) (6,180.00) Cash flow from investing activities Investment in book shelves (8,346.00) (8,346.00) Cash flow from financing activities Share issue 100,000.00 Bank loan paid 40,000.00 Interest (1,700.00) Pay-off (2,000.00) 136,300.00 121,774.00 Mansell Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X4 Figure 32.5: MANSELL Ltd.’s statement of cash flows The cash flow statement does not require recording extra Bookkeeping entries. It is derived straight from the Cash/ Bank account which we refer to as the direct method. The statement of cash flows assigns all cash flows to the categories: operations, investing activities and financing activities. For the calculation of the total cash flow, we do not need a cash flow statement. The total cash flow can be read out from the Cash/ Bank account. It is the difference between the closing balance and the opening one, here: 121,774.00 EUR. Therefore, the total cash flow can also be calculated by comparison of statements of financial position at different balance sheet dates. The statement of cash flows illustrates where the cash flow results from. At MANSELL Ltd., the cash flow mostly comes from financial inputs reduced by a negative cash flow from operations (purchase and selling books) and investments. 32.9 Reconciliation Method Now, we focus on the cash flows from operations. The reconciliation method <?page no="466"?> Berkau: Basics of Accounting 6e 32-466 avoids the problem of the direct method: To classify the cash flows from the Cash/ Bank account, a company must analyse all entries in the Cash/ Bank account. In academia this does not seem to be a problem. However, companies record thousands of cash/ bank relevant Bookkeeping entries per hour or per minute. Therefore, analysing each payment and receipt results in a lot of work. The efficiency of the cash flow calculation by the direct method becomes poor if huge numbers of cash flows need be considered. Instead of classifying every single cash/ bank record, almost all companies apply a reconciliation of profits with the operating cash flow. This works out as both, the cash flow calculation as well as the profit calculation are based on the same activities. Although cash flow calculation is based on payments/ receipts and the profit calculation is based on income and expenses, the recorded operations overlap for cash flows that are congruent to revenue/ expenses. Instead of calculating cash flows from scratch on, we can adjust the profit and loss calculation. We copy the profit and consider activities that are relevant for profit but do not give us a cash flow, like depreciation. Furthermore, we make adjustments for payments/ receipts without relevance for profit, like purchases without consumption in the same period. The reconciliation method starts from the profit copied from the income statement and requires adjustments for the above-described cases. However, the cash flow from investing and financing activities cannot be derived from the profit calculation for below discussed reasons: No indication is given for investing or financing cash flows by the income statement. Consider taking a bank loan: No evidence for taking a bank loan or paying it off is found on the income statement. The interest expenses do not tell us the principal and how much debts are paid back. The same applies for share or bond issues. The income statement might recognise dividends or coupons, but that information does not give us the number of shares, the principal of bonds nor the price paid for their acquisition. Therefore, the reconciliation method is limited to operating cash flows. The other cash flows must be calculated directly. This does not result in a big problem as for most companies, the number of investing and financing activities is significantly lower than for operations. Next, we apply the reconciliation method for two case studies. We insert the case study DEERHURST to introduce the basics. After we understand the method, we continue the case study MANSELL Ltd. to compare direct method and reconciliation method. Below, we discuss a trivial case study (DEERHURST) about a painter to demonstrate the reconciliation method's concept. 32.10 C/ S DEERHURST DEERHURST is a painter. He runs his privately-owned business. Therefore, no legal form indicator is added to the firm’s name. At the time of incorporation, the owner Mike Deerhurst pays 5,000.00 EUR into the Cash/ Bank account. <?page no="467"?> Berkau: Basics of Accounting 6e 32-467 DEERHURST buys a ladder for 600.00 EUR and paint for 1,000.00 EUR. DEERHURST is not registered for VAT reduction. DEERHURST makes the following Bookkeeping entries on 2.01.20X7. Note, we use Roman figures for the identification of Bookkeeping entries to distinguish them from the (open) MANSELL Ltd. case. (I) Establishment of the business by contribution of 5,000.00 EUR. DR Cash/ Bank.................... 5,000.00 EUR CR Owner’s Capital.............. 5,000.00 EUR (II) Buying the ladder. DR P, P, E ACCOUNT.............. 600.00 EUR CR Cash/ Bank.................... 600.00 EUR (III) Buying paint. DR Inventory ................... 1,000.00 EUR CR Cash/ Bank.................... 1,000.00 EUR In January 20X7, DEERHURST only works at one construction site. A payment of labour for the painter of 400.00 EUR applies. Furthermore, one quarter of the paint is used, and we record a revenue of 1,200.00 EUR. The customer pays only half of the bill. The remainder is due in the next year. (IV) Recording labour on 31.01.20X7. DR Labour....................... 400.00 EUR CR Cash/ Bank.................... 400.00 EUR (V) Bookkeeping entry for paint on 31.01.20X7. DR Material Expenses............ 250.00 EUR CR Inventory.................... 250.00 EUR (VI) Revenue recognition on 31.01.20X7. DR Cash/ Bank.................... 600.00 EUR DR Accounts Receivables......... 600.00 EUR CR Revenue...................... 1,200.00 EUR (VII) At the yearend, the ladder is written-off to an extent of 50 %. This gives: 600 / 2 = 3 300.00 EUR. Depreciation on the ladder is recorded on 31.12.20X7 as adjustment. <?page no="468"?> Berkau: Basics of Accounting 6e 32-468 DR Depreciation................. 300.00 EUR CR Acc. Depr.................... 300.00 EUR We look at the accounts at this stage. Check Figure 32.6: D C D C (I) 5,000.00 (II) 600.00 c/ d 5,000.00 (I) 5,000.00 (VI) 600.00 (III) 1,000.00 (IV) 400.00 c/ d 3,600.00 5,600.00 5,600.00 b/ d 3,600.00 D C D C (II) 600.00 c/ d 600.00 (III) 1,000.00 (V) 250.00 b/ d 600.00 c/ d 750.00 1,000.00 1,000.00 b/ d 750.00 D C D C (IV) 400.00 P&L 400.00 (V) 250.00 P&L 250.00 D C D C (VI) 600.00 c/ d 600.00 P&L 1,200.00 (VI) 1,200.00 b/ d 600.00 D C D C (VII) 300.00 P&L 300.00 c/ d 300.00 (VII) 300.00 b/ d 300.00 Depreciation-20X7 DPR Accumulated depreciation ACC Labour-20X7 LAB Material expenses-20X7 MAT Accounts Reveivables A/ R Revenue-20X7 REV Cash/ Bank C/ B Owner's Capital O/ C Property, plant, equipment PPE Inventory (paint) INV D C D C LAB 400.00 Rev 1,200.00 c/ d 250.00 P&L 250.00 MAT 250.00 b/ d 250.00 DPR 300.00 P 250.00 1,200.00 1,200.00 R/ E 250.00 b/ d 250.00 Profit and Loss-20X7 P&L Retained earnings R/ E Figure 32.6: DEERHURST’s accounts <?page no="469"?> Berkau: Basics of Accounting 6e 32-469 As DEERHURST is a privately-owned business, it does not disclose income taxes on its income statement. The increase of value of the business is subjected to the private tax declaration of the owner, Mike Deerhurst. Therefore, in the Profit and Loss account, profit is not “before” or “after” taxation. We just call it P for Profit. We notice a difference between profit and cash flow. Profit is 250.00 EUR, and the cash flow equals 3,600.00 EUR. The total cash flow contains operating cash flows, the investing cash flow for the ladder and a financing cash flow resulting from the owner’s contribution. Observe below the cash flow statement as prepared following the direct method for DEERHURST: Cash flow from operating acitivities Materials bought (1,000.00) Sales 600.00 Labour (400.00) (800.00) Cash flow from investing activities Investment in book shelves (600.00) (600.00) Cash flow from financing activities Owner's contribution 5,000.00 5,000.00 3,600.00 Deerhurst STATEMENT of CASH FLOWS for the period ended 31.12.20X7 Figure 32.7: DEERHURST’s statement of cash flows The operating cash flow results from the purchase of paint at 1,000.00 EUR, from the labour paid, 400.00 EUR, and from the portion (50 %) of the received proceeds. Proceeds are the receipts resulting from revenue; in contrast to the revenue, proceeds are the gross amounts. In this case study, the proceeds are to the same amount as the revenue, as the company is not registered for VAT reduction. In total, the business discloses a negative cash flow from operations. The cash flow from investing activities results from the acquisition of the ladder and is negative 600.00 EUR. There is only one positive cash flow: the cash flow from financing the business when the owner contributed 5,000.00 EUR. <?page no="470"?> Berkau: Basics of Accounting 6e 32-470 [EUR] Revenue 1,200.00 Other income 1,200.00 Materials (750.00) Labour (400.00) Depreciation (300.00) Other expenses Earnings before int and taxes (EBIT) (250.00) Interest 0.00 Earnings before taxes (EBT) (250.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (250.00) Deerhurst STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X7 Figure 32.8: DEERHURST’s income statement In this case study, we can identify easily the reason for the difference between profit and cash flow from operations. It results from the customer not paying the full amount and from the paint left-over which was paid for but not used. The depreciation on the ladder does not lead to a payment but the acquisition does (investing cash flow). Next, we adjust the profit to calculate the operating cash flow by reconciliation. We start from 250.00 EUR profit. At first, we adjust it for depreciation. Depreciation got deducted for the profit calculation as expense. As it does not result in a cash flow, we reverse the deduction. This gives us for the cash flow calculation: 250 + 300 = 5 550.00 EUR, profit before depreciation. Next, we consider that the firm bought more paint than it needed. Only the used paint was deducted for profit calculation. For our cash flow calculation, we deduct the closing stock of paint to an extent of 750.00 EUR from profit because DEERHURST paid for the entire purchase. After deducting the 750.00 EUR “overpaid” paint, the cash flow equals: 550 - 750 = - -200.00 EUR. The last step is about lending its customer 600.00 EUR by accepting a delayed payment. The service on credit creates receivables. We deduct the receivables of: 1,200 / 2 = 600.00 EUR for our cash flow calculation. The operating cash flow equals now: -200 - 600 = - -800.00 EUR. This is also the cash flow calculated by the direct method in Figure 32.7. Above, we demonstrated that we can reconcile the profit with the operating cash flows. 32.11 Formal Procedure for the Reconciliation Next, we illustrate the reconciliation in a more formal display shown in Figure 32.9. We call this calculation a reconciliation statement as it is a transition <?page no="471"?> Berkau: Basics of Accounting 6e 32-471 from profit towards an operating cash flow. Profit for the period 250.00 add: depreciation 300.00 550.00 add: interest for bank loan 0.00 550.00 Changes in working capital (1a) Changes in A/ R (600.00) (1b) Changes in prepayments 0.00 (2) Changes in inventory (750.00) (3a) Changes in A/ P 0.00 (3b) Changes in income tax 0.00 (4) Changes in VAT (op) 0.00 (5) Changes in tax liabilities 0.00 Operating cash flow (800.00) Deerhurst RECONCILIATION of EARNINGS before TAXATION with CFoA for year ended 31.12.20X7 Figure 32.9: DEERHURST’s reconciliation statement In general, the reconciliation statement starts from the profit for the period. Depreciation is added. Similar procedures apply for interest. Interest is a payment, but it does not fall under operating cash flows. This means, payments for interest must be added to the profit. On the cash flow statement, interest is recorded as cash flow from financing activities. Adding interest to the profit for the operating cash flow calculation prevents us from deducting interest twice. Note, that an interest income must be deducted accordingly. Next, we discuss changes regarding the working capital. The working capital is a technical term from Finance. It is the total of current assets minus short-term liabilities. When financing a business, the investor must provide (finance) the funds to pay for the working capital as it is required for operations as well as the investment in machinery. To understand the concept of reconciliation, we assume that every change in the working capital is recorded directly towards the Cash/ Bank account. A company that increases receivables, assumes all added receivables result from lending money to other parties through its Cash/ Bank account. Hence, any increase in receivables results in a payment (negative cash flow). A reduction of receivables is a receipt on cash and counts as a positive cash flow. Prepaid expenses are similar to <?page no="472"?> Berkau: Basics of Accounting 6e 32-472 receivables. They result in a payment for a service received in the future, like labour, rent, insurance etc. Therefore, we treat prepaid expense increases the same way as increases of other receivables. Any (raw materials, work-in-process, finished goods) inventory increase is regarded as purchase recorded towards the Cash/ Bank account. Following this assumption, increases of stock are negative cash flows. In contrast, a decrease of inventory is a cash receipt for a sale. All changes in payables mean that someone lends the company money. This leads to an obligation to pay the money back. Therefore, each increase in payables is a positive cash flow. Changes in VAT are special receivables, if the VAT account is debit balanced, and become payables, if the VAT account is credit balanced. If the reconciliation statement starts from profit after taxes (EAT on the first line) an increase in tax liabilities is likely. This must be added to cash flow from operations. Caution, prepayments of income taxes and tax payments for the preceding Accounting period can cause tax liability deductions. Changes of tax liabilities are regarded as operating cash flows. The advantage of the reconciliation statement is that changes in working capital can be derived from the balance sheet. Therefore, the cash flow calculation is not based on single business activities but is processed on an aggregated level of financial statements. As a result, the workload for the operating cash flow calculation is low and remains the same, irrespectively of how many business activities are recorded. How it is Done (Reconciliation of Profit with Operating Cash Flows): (1) Take the profit after taxes from the income statement and copy it into the reconciliation statement’s first line. (2) Add depreciation. (3) Add interest paid and deduct interest received. (4) Check the balance sheet for changes in receivables. Deduct the total of increases of receivables or add the total of decreases thereof. Consider prepaid expenses like receivables. (5) Check all inventory accounts. Deduct increases of inventory or add decreases thereof. (6) Check the balance sheet for changes in payables. Add the total of increases of payables or deduct the total of decreases thereof. This step includes income tax liabilities. (7) Check the VAT account if not already included in payables or receivables. Deduct increases of VAT receivables or add decreases of VAT receivables. Add increases of VAT payables or deduct decreases <?page no="473"?> Berkau: Basics of Accounting 6e 32-473 of VAT. Only consider VAT receivables from materials or services rendered as operating activities. Input VAT for investments is a cash flow from investing activities. (8) Add increases of income taxes or deduct decreases thereof. (9) Transfer the operating cash flow to the statement of cash flows. (10) Consider adjustments for separating investing cash flow. (! ) Note, a mistake often made in exams is that the working capital is considered as an absolute amount instead of the changes thereof. Therefore, focus on its changes. DEERHURST transfers the operating cash flow to the statement of cash flows as depicted in Figure 32.10. Cash flow from operating acitivities as by reconciliation (800.00) (800.00) Cash flow from investing activities Investment in book shelves (600.00) (600.00) Cash flow from financing activities Owner's contribution 5,000.00 5,000.00 3,600.00 Deerhurst STATEMENT of CASH FLOWS for the period ended 31.12.20X7 Figure 32.10 DEERHURST’s statement of cash flows After studying the easy case of DEERHURST, we take our cash flow considerations to the next level. We next prepare a reconciliation statement for MANSELL Ltd. Note, that we now must consider VAT. 32.12 Reconciliation at MANSELL Ltd. As we prepared already financial statements for MANSELL Ltd., we start with the reconciliation statement. We calculate the operating cash flow by reconciliation of the profit from the income statement. From our previous calculations we know the operating <?page no="474"?> Berkau: Basics of Accounting 6e 32-474 cash flow equals -6,180.00 EUR. We expect to calculate the same cash flow from operations by reconciliation. For the reconciliation method, we only need to know about the income statement and the statement of financial position. There is no need to discuss single activities nor their Bookkeeping entries. We recall the two financial statements of the bookstore MANSELL Ltd., the income statement and the balance sheet - check Figure 32.11 and Figure 32.12: [EUR] Revenue 42,050.00 Other income 42,050.00 Materials (19,720.00) Labour Depreciation (1,391.00) Other expenses (24,000.00) Earnings before int and taxes (EBIT) (3,061.00) Interest (1,700.00) Earnings before taxes (EBT) (4,761.00) Income tax expenses 0.00 Deferred taxes Earnings after taxes (EAT) (4,761.00) Mansell Ltd. STATEMENT of COMPREHENSIVE INCOME for the year ended 31.12.20X4 Figure 32.11: MANSELL Ltd.’s income statement (as above) A C, L Non-current assets [EUR] Equity [EUR] P, P, E 12,519.00 Issued capital 100,000.00 Intangibles Reserves Financial assets Retained earnings (4,761.00) Current assets Liabilities Inventory 7,480.00 Interest bear liab 36,000.00 A/ R A/ P 10,534.00 Prepaid expenses Provisions Cash/ Bank 121,774.00 Tax liabilities 141,773.00 141,773.00 Mansell Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X4 Figure 32.12: MANSELL Ltd.’s statement of financial position (as above) <?page no="475"?> Berkau: Basics of Accounting 6e 32-475 We copy the loss of 4,761.00 EUR from the income statement and transfer it to the reconciliation statement’s first line. Next, we add depreciation of 1,391.00 EUR and interest of 1,700.00 EUR. Observe the first steps for the reconciliation statement as displayed in Figure 32.13 (items to follow further below are temporarily greyed-out therein): Profit for the period (4,761.00) add: depreciation 1,391.00 (3,370.00) add: interest for bank loan 1,700.00 (1,670.00) Changes in working capital (1) Changes in A/ R (2) Changes in inventory (3) Changes in A/ P (4) Changes in VAT (op) (5) Changes in tax liabilities Operating cash flow Mansell Ltd. RECONCILIATION of EARNINGS before TAXATION with CFoA for year ended 31.12.20X4 Figure 32.13: MANSELL Ltd.’s half of the reconciliation statement The next procedure steps are about adjustments to the working capital. The balance sheet is for the first Accounting period of the bookstore. In order to determine the changes, we only deduct an “empty” balance sheet. No change in receivables apply. The changes in inventories are: 4,780 - 0 = 44,780.00 EUR. An increase of inventory results in a negative cash flow. The increase of payables is: 10,534 - 0 = 10,534.00 EUR. This counts as a receipt of cash. Here, receivables/ payables include VAT already (MANSELL Ltd.’s balance sheet does not show extra items for VAT.) We must consider that the amount for VAT payables got reduced by 2,782.00 EUR input-VAT for the acquisition of the bookshelves. The acquisition of the bookshelves falls under investing cash flow - so does the input-VAT thereof. Therefore, we add the amount to payables on the reconciliation statement: 10,534 + 2,782 = 1 13,316.00 EUR. Furthermore, an amount of 8,346 EUR is included in payables which results from the bookshelves (investment), too. This liability increase is to be deducted from payables as it counts for investments. A further deduction is in order, as the 20X5-pay-off amount of 2,000.00 EUR for the bank loan was added to shortterm liabilities. The latter one is linked to financing activities and is deducted, too. The value of changes in payables is: 10,534 + 2,782 - 8,346 - 2,000 = 2,970.00 EUR. Because of the loss, no changes in income tax liabilities apply. Observe the completed reconciliations in Figure 32.14. <?page no="476"?> Berkau: Basics of Accounting 6e 32-476 Profit for the period (4,761.00) add: depreciation 1,391.00 (3,370.00) add: interest for bank loan 1,700.00 (1,670.00) Changes in working capital (1a) Changes in A/ R 0.00 (1b) Changes in prepayments (2) Changes in inventory (7,480.00) (3a) Changes in A/ P 2,970.00 (3b) Changes in income tax (4) Changes in VAT (op) 0.00 (5) Changes in tax liabilities 0.00 Operating cash flow (6,180.00) Mansell Ltd. RECONCILIATION of EARNINGS before TAXATION with CFoA for year ended 31.12.20X4 Figure 32.14: MANSELL Ltd.’s (full) reconciliation statement The operating cash flow by reconciliation leads to the same statement of cash flows as following the direct method - only the item for operating cash flows is here marked differently (“as per reconciliation”): Cash flow from operating acitivities as per reconciliation (6,180.00) (6,180.00) Cash flow from investing activities Investment in book shelves (8,346.00) (8,346.00) Cash flow from financing activities Share issue 100,000.00 Bank loan paid 40,000.00 Interest (1,700.00) Pay-off (2,000.00) 136,300.00 121,774.00 Mansell Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X4 Figure 32.15: MANSELL Ltd.’s statement of cash flows Next, we present another case study about a production firm applying the reconciliation method. We now demonstrate how to calculate stock of finished goods and how to deal with <?page no="477"?> Berkau: Basics of Accounting 6e 32-477 income taxes because SUNLANDS AG earns a profit. 32.13 C/ S SUNLANDS AG SUNLANDS AG is a production firm for canvas chairs. The chairs consist of a frame (30.00 EUR/ u) and fabric (7.50 EUR/ u). The costs of materials as given in brackets are net amounts. On 2.01.20X3, SUNLANDS AG issues 50,000 ordinary shares with a face value of 5.00 EUR/ share. The issue price is amounting to 8.35 EUR/ share. On 1.07.20X3 SUNLANDS AG issues bonds: 100 bonds at 1,000.00 EUR/ bond face value. The bonds will be redeemed after 30 years. Hence, for our short-term considerations, no pay-off applies. The coupon rate is 2.70 % per half year and paid every 6 months. A A coupon rate is the rate of interest for a bond. Furthermore, SUNLANDS AG takes a bank loan on 2.01.20X3. The principal is 80,000.00 EUR. The rate of interest is 4.65 %/ a and is paid as part of the annuity (5,000.00 EUR/ a) at the end of the Accounting periods. T The annuity is a classification of a bank loan or (here) the payment to the bank transferred every year. At SUNLANDS AG, interest is regarded as a non-manufacturing expense. SUNLANDS AG pays for the acquisition of machinery 48,000.00 EUR (gross amount) on 2.01.20X3 and depreciates the machines along straight-line method over a useful life 5 years under consideration of a residual value of 10,000.00 EUR. Therefore, the depreciable amount in accordance with IAS 16 is: 48,000 / 120% - 10,000 = 3 30,000.00 EUR. At the beginning of the Accounting period 20X3, SUNLANDS AG buys materials for 10,000 canvas chairs and pays labour for the production of 10,000 canvas chairs to the extent of 113,000.00 EUR. 45 % of the purchase price (gross amount) for materials is paid to the supplier, the remainder will be paid in the next upcoming year 20X4. The production amount in 20X3 is 10,000 canvas chairs. SUNLANDS AG sells 8,467 canvas chairs at 103.20 EUR/ u (gross amount) during 20X3. The rest of canvas chairs is kept in the inventories of finished goods. All sales at SUNLANDS AG are transactions on cash. Next, we prepare a balance sheet and an income statement for 20X3 and derive an operating cash flow by reconciliation. We prepare a full cash flow statement. No appropriation of profits applies. For an income statement preparation, 2 methods apply: Nature of expense method and the cost of sales format. We here start with the nature of expense method as it is easy and reduces the number of Bookkeeping entries. After profit calculation, we make Bookkeeping entries following the cost of sales format, too. Thereafter, we set up the balance sheet and the statement of profit or loss and other comprehensive income. At last, we determine the operating cash flow via reconciliation method. The income statement following the nature of expense method requires calculating the revenue and the value of closing stock. The revenue is: 8,467 × 103.20 / 120% = 728,162.00 EUR. <?page no="478"?> Berkau: Basics of Accounting 6e 32-478 For the recording of closing stock of finished goods, a product calculation is required. The unit costs per canvas chair contain materials, labour and depreciation. The unit costs are: (30 + 7.50) + 113,000 / 10,000 + (48,000 / 120% - 10,000) / (5 × 10,000) = 4 49.40 EUR/ u. The profit before taxation is calculated as revenue plus changes in inventory of finished goods minus all materials, less depreciation and less interest for the bonds and the bank loan and gives: 728,162 + (10,000 - 8,467) × 49.40 - (30 + 7.50) × 10,000 - 113,000 - (48,000 / 120% - 10,000) / 5 - 100 × 1,000 × 2.7% - 80,000 × 4.65% = 3 303,472.20 EUR. Observe SUNLANDS AG’s income statement following the nature of expense method. [EUR] Revenue 728,162.00 Changes in FG-inventories 75,730.20 803,892.20 Materials (375,000.00) Labour (113,000.00) Depreciation (6,000.00) Other expenses 0.00 Earnings before int & taxes (EBIT) 309,892.20 Interest (6,420.00) Earnings before taxes (EBT) 303,472.20 Income tax expenses (91,041.66) Deferred taxes Earnings after taxes (EAT) 212,430.54 Sunlands AG STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 32.16: SUNLANDS AG’s income statement for 20X3 We prepare the statement of financial position as displayed in Figure 32.17. The income taxes are 30 % of the earnings before taxes which gives: 303,472.20 × 30% = 9 91,041.66 EUR. <?page no="479"?> Berkau: Basics of Accounting 6e 32-479 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 34,000.00 Share capital 250,000.00 Intangibles Reserves 167,500.00 Financial assets Retained earnings 212,430.54 Current assets Liabilities Inventory 75,730.20 Interest bear liab 177,380.48 A/ R 8,000.00 A/ P 319,471.92 Prepaid expenses Provisions Cash/ Bank 1,100,094.40 Tax liabilities 91,041.66 1,217,824.60 1,217,824.60 Sunlands AG STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 32.17: SUNLANDS AG’s statement of financial position The amounts on the statement of financial position are explained as below: The carrying value of the machinery is cost of acquisition less depreciation: 40,000 - 6,000 = 3 34,000.00 EUR. The value of inventory is the canvas chairs left on stock calculated based on their unit costs of manufacturing: (10,000 - 8,467) × 49.40 = 7 75,730.20 EUR. SUNLANDS AG runs two VAT accounts. One of the VAT accounts is for VAT resulting from investments. The acquisition of machinery gives SUNLANDS AG a claim for the paid input-VAT of: 40,000 × 20% = 88,000.00 EUR. Other VAT payments/ receipts results from operations and are recorded in the second VAT account. To apply two accounts makes sense for the cash flow separation. Note, here comes a small curiosity: we separate input-VAT when we pay it for operations or investments. In contrast, when input-VAT is refunded, we cannot classify the cash inflows received from the revenue service into cash flow categories as the VAT refund depends on collected output-VAT, too. This means, if a company only invests in machinery, its input-VAT is a cash outflow from investments, but the refund thereof is seen as a positive cash flow from operations. The value in cash/ bank is the balancing figure of the Cash/ Bank account. The issued capital results from the face value of the ordinary shares issued at the time of incorporation. The value of reserves results from capital reserves recognised at the time of the share issue. The amount in the Retained Earnings account is the profit after taxes. It is: 303,472.20 × (1 - 30%) = 2 212,430.54 EUR. Interest bearing liabilities are long-term debts. Here, they result from the bank loan and the bonds. The value is: 78,720 - 1,339.52 + 100,000 = 1 177,380.48 EUR. The payables contain short-term liabilities to the extent of how much SUNLANDS AG owes its suppliers from <?page no="480"?> Berkau: Basics of Accounting 6e 32-480 purchases, operating VAT and the shortterm portion of the bank loan. The amount is: 247,500 + 70,632.40 + 1,339.52 = 3 319,471.92 EUR. Check the second summand: The VAT only considers VAT from operations; this is output- VAT from sales 145,632.40 EUR minus input-VAT from material purchases 75,000.00 EUR. The 8,000.00 EUR input- VAT resulting from investments is separated (2 accounts, see above) and shows on the balance sheet as accounts receivables. The income taxes are calculated based on 30 % of the earnings before taxes which equals: 303,472.20 × 30% = 91,041.66 EUR. Next, we calculate the cash flows. The total cash flow can be derived easily from the statement of financial position. It is: 1,100,094.40 - 0 = 1 1,100,094.40 EUR. The cash flow calculation following the direct method is derived from the Cash/ Bank account and shown in the statement of cash flows in Figure 32.18. Cash flow from operating acitivities Materials paid (202,500.00) Sales incl. VAT 873,794.40 Labour (113,000.00) 558,294.40 Cash flow from investing activities Investments (48,000.00) (48,000.00) Cash flow from financing activities Share issue at issue price 417,500.00 Bonds issued 100,000.00 Bank loan received 80,000.00 Interest for bond (2,700.00) Annuity for bank loan (5,000.00) 589,800.00 1,100,094.40 Sunlands AG STATEMENT of CASH FLOWS for the period ended 31.12.20X3 Figure 32.18: SUNLANDS AG’s statement of cash flows For the calculation of cash flows from operations, we next apply the reconciliation method. The reconciliation of profits and operating cash flows is shown in Figure 32.19. <?page no="481"?> Berkau: Basics of Accounting 6e 32-481 Profit for the period 212,430.54 add: depreciation 6,000.00 218,430.54 add: interest for bank loan 3,720.00 add: interest for bonds 2,700.00 224,850.54 Changes in working capital (1) Changes in A/ R 0.00 (2) Changes in inventory (75,730.20) (3) Changes in A/ P 247,500.00 (4) Changes in VAT (op) 70,632.40 (5) Changes in tax liabilities 91,041.66 Operating cash flow 558,294.40 Sunlands AG RECONCILIATION of EARNINGS before TAXATION with CFoA for year ended 31.12.20X3 Figure 32.19: Reconciliation statement The profit for the period is given as the earnings after taxes. We add depreciation to EAT and add interest, too. The result is: 212,430.54 + 6,000 + 2,700 + 3,720 = 2 224,850.54 EUR. Below, we discuss the changes of the working capital: The changes of receivables are nil, as the increase of input-VAT receivables results from the acquisition of the machine and is regarded as an investing cash flow. The further changes result from the increase of inventory of finished goods (canvas chairs) to an extent of: 49.40 × 1,533 = 7 75,730.20 EUR. The increase of payables is the amount SUNLANDS Ltd. is owing its suppliers. It equals: 10,000 × (30 + 7.50) × 120 % × 55% = 2 247,500.00 EUR. The VAT account for operating activities is credit balanced which indicates an increase of VAT payables. The amount is the difference between output-VAT from sales and input-VAT from purchases of materials. The increase in income tax liabilities results from the profit. The new statement of cash flows looks as in Figure 32.20: <?page no="482"?> Berkau: Basics of Accounting 6e 32-482 Cash flow from operating acitivities as by reconciliation 558,294.40 558,294.40 Cash flow from investing activities Investments (40,000.00) Input VAT for investments (8,000.00) (48,000.00) Cash flow from financing activities Share issue at issue price 417,500.00 Bonds issued 100,000.00 Bank loan received 80,000.00 Interest for bond (2,700.00) Annuity for bank loan (5,000.00) 589,800.00 1,100,094.40 Sunlands AG STATEMENT of CASH FLOWS for the period ended 31.12.20X3 Figure 32.20: SUNLANDS AG’s statement of cash flows 32.14 Summary A full set of financial statements in compliance with IAS 1.10 contains a statement of cash flows. The cash flow results from changes in the Cash/ Bank account. It can be derived directly from the Cash/ Bank account, or it is calculated by a reconciliation of profits with the operating cash flows. We discussed the preparation of the cash flow statement for MANSELL Ltd. and the production firm SUNLANDS AG. 32.15 Working Definitions Annuity: The annuity is a classification of a bank loan or (here) the payment to the bank transferred every year. Cash Flow: A cash flow is the increases or decreases of cash/ bank. Cash Flow from Operating Activities: Cash flows from operating activities are all cash flows not linked to financing activities or investing activities. Cash Flow from Investing Activities: Cash flows from investing activities result from payments for acquisitions and disposals of non-current assets. Cash Flow from Financing Activities: Cash flows from financing activities are linked to contributions from owners, like share issues, and loan payments/ receipts, like bank loans or bonds. Furthermore, all payments linked to equity and liability instruments, like dividends, interest/ coupons and pay-offs are regarded as cash flows from financing activities. Coupon Rate: A coupon rate is the rate of interest for a bond. Direct Method: The direct method classifies all cash flow into operating, investing or financing cash flows based on the entries in the Cash/ Bank account. <?page no="483"?> Berkau: Basics of Accounting 6e 32-483 Proceeds: Proceeds are the receipts resulting from revenue; in contrast to the revenue, proceeds are the gross amounts. Reconciliation Method: The reconciliation method calculates the cash flow from operations by adjusting profit for expenses/ revenues that are not cash relevant and thereafter for payments/ receipts that do not count for profit or loss. Single-Entity Financial Statement: A single-entity financial statement is a set of financial statements prepared for one company. Statement of Cash Flows: A cash flow statement discloses the total of payment activities classified by their nature of payment. Working Capital: The working capital is a technical term from Finance. It is the total of current assets minus short-term liabilities. 32.16 Question Bank (1) A company records the payments below: Materials: 420.00 EUR, Labour: 360.00 EUR, Depreciation 200.00 EUR, Purchase of machinery 3,300.00 EUR, interest 6.80 EUR. How much is the cash flow from operations? 1. -786.80 EUR . 2. -650.00 EUR . 3. -780.00 EUR . 4 . 780.00 EUR . (2) A cash flow from operative activities can be calculated by the following method… 1. By reduction of the balancing figure of the Cash/ Bank account for depreciation. 2. By multiplying the expenses with 120 %. 3. Reconciliation with the income tax liabilities. 4. Reconciliation with the profit after taxation. (3) Which item is no cash flow from financing activities? 1. Interest for a bank loan. 2. Payment of a coupon for bonds. 3. Settlement of debts to suppliers. 4. Pay-off of a bank loan. (4) A company earns a profit after taxes of 490.00 EUR. Depreciation is 100.00 EUR. Material expenses are 160.00 EUR (net amount). How much is the cash flow from operations? 1. 800.00 EUR . 2. 590.00 EUR . 3. 750.00 EUR . 4. 443.00 EUR . (5) Which statement is correct? 1. The statement of cash flows is based on net amounts. 2. The statement of cash flows is based on revenue and expenses adjusted for prepayments. 3. The statement of cash flows is based on payments (gross amounts). 4. The statement of cash flows considers profits plus prepayments. 32.17 Solutions 1-3; 2-4; 3-3; 4-1; 5-3. <?page no="484"?> Berkau: Basics of Accounting 6e 33-484 33 Establishment of a Business and Legal Form Changes 33.1 What is in the Chapter? We discuss in this chapter the establishment of a privately-owned company and thereafter two changes of its legal form towards a limited company. We focus on aspects from the point of view of Accounting. We discuss the business concept of SALDANHA, which is a tuck shop in a university (business selling snacks and drinks) and demonstrate its transition to a partnership and to a limited company. Study national law to extend your knowledge about legal forms and their consequences regarding responsibilities, tax regulation impacts and the appropriation of profits. 33.2 Learning Objectives After studying this chapter, you have developed an awareness for legal forms of a company and got an understanding of the Accounting work for founding a business and changing its legal form. 33.3 C/ S SALDANHA (Part 1: Sole Proprietor) Julia Saldanha is an Accounting student. As she always feels hungry during class, she plans to open a tuck shop (= South African slang for a shop that sells small snacks as chips, energy bars and drinks at schools). She requests permission from the president of her university to sell snacks on campus. Her idea gets approved because the business faculty supports start-ups. Julia Saldanha agrees on a rent contract with the university along which she pays 100.00 EUR/ month rent. Julia Saldanha buys a small sales booth on a trailer and inventory of snacks for one month. By these activities, she started already her own privatelyowned business. Julia Saldanha plans to earn enough revenue during the first month to finance the purchases for at least the snacks in the next month. Her business is a sole proprietorship. A A sole proprietorship is a company that is owned by a single private person and does not form a legal entity. No legal action for the establishment is required, that means she does not formally establish the company. She owns all business assets herself. All profit earned with the snack shop falls under her personal income. Increases in company assets count as growth of her personal fortune. Any profit earned is regarded as her personal taxable income. She must declare on her tax refund forms for the revenue service her profit from self-employment. Julia Saldanha is fully liable for the business with all her personal assets. In a case her shop underperforms and cannot pay-off debts, Julia Saldanha is held responsible for the company’s loss and for the on-time payoff of loans. Her creditors, like banks and suppliers, can go after her personal property. Note, Julia Saldanha is a trader, therefore commercial law applies, here IFRSs. The tuck shop trailer costs 6,000.00 EUR including VAT. Julia Saldanha pays for the vending trailer on cash. She further purchases the snacks, like energy bars, <?page no="485"?> Berkau: Basics of Accounting 6e 33-485 sweets, crackers, etc. for 3,000.00 EUR (gross amount). On 5.01.20X1, Julia Saldanha commences trading. She sells the snacks at double of their costs. To be more precise: the gross selling price is double of the goods’ purchase costs. Following IAS 2, purchase costs always are net amounts. As an Accounting student, Julia Saldanha keeps a detailed record of her business activities. She keeps financial records by making Bookkeeping entries for revenues, investments, snack purchases and all further expenses. 33.4 Requirements to Prepare Financial Statements for Small Business In some countries, like in Germany, small companies fulfilling certain criteria are exempted from keeping financial records and from preparing financial statements. § 241a HGB applies. Other countries have similar exemptions in place. We assume such an Accounting leeway for Julia Saldanha’s tuck shop, too. Therefore, no financial statements are required. However, Julia Saldanha must prepare tax statements for her profit calculation. 33.5 Bookkeeping Records for a Sole Proprietorship (Case Saldanha) Before commencing her business activity, Julia Saldanha counts her money at the bank. She has 9,000.00 EUR in her private bank account which she uses for the snack shop. For separating private assets from the tuck shop, Julia Saldanha opens an extra bank account for her shop. Although the account is in her name: Julia Saldanha, she only makes payments and records receipts linked to the tuck shop. (1) Julia Saldanha makes a Bookkeeping entry on 2.01.20X1 for the contribution to her business to the extent of 9,000.00 EUR. No legal regulations about making contributions apply for her shop. DR Cash/ Bank.................... 9,000.00 EUR CR Owner’s Capital.............. 9,000.00 EUR Julia Saldanha registers her tuck shop for VAT reduction. A A registration for VAT reduction means setting a tax characteristic in the database of the revenue service which enables the taxpayer to deduct input-VAT from purchases and acquisitions and obliges her/ him to collect output-VAT from customers and pay it to the revenue service. Julia Saldanha now can deduct the input-VAT paid together with purchases and investments for her business. On the other hand, she must collect output-VAT on behalf of the revenue service from her student customers. The output-VAT makes her snacks more expensive than snacks sold from someone who is not registered for VAT reduction. Consider that the students who buy snacks from Julia Saldanha are not registered for VAT reduction. When Julia Saldanha acquires the sales trailer, she makes a Bookkeeping entry as below: (2) Investment into the sales trailer on 2.01.20X1. Julia Saldanha pays 6,000.00 EUR. The net amount equals: 6,000 / 120% = 5 5,000.00 EUR. Julia Saldanha pays the seller the price per bank transfer. <?page no="486"?> Berkau: Basics of Accounting 6e 33-486 DR P, P, E Account.............. 5,000.00 EUR DR VAT.......................... 1,000.00 EUR CR Cash/ Bank.................... 6,000.00 EUR (3 … 14) Julia Saldanda purchases goods every month. In the first month, she orders snacks at a total purchase price of 3,000.00 EUR including VAT. In the following months, the snack orders are lower (2,400.00 EUR) to keep stock at a safety level of 500.00 EUR. Julia Saldanha sells every month snacks at costs of 2,000.00 EUR (net amount, cost of purchase). The higher purchases in the first month result in a constant safety stock level of 500.00 EUR. DR Purchase .................... 2,500.00 EUR DR VAT.......................... 500.00 EUR CR Cash/ Bank.................... 3,000.00 EUR The following 11 purchases are recorded from 1.02.20X1 to 1.12.20X1. Julia Saldanha does not prepay purchases. She always orders stock on the 1 st of the month for the month when she sells them. DR Purchase .................... 2,000.00 EUR DR VAT.......................... 400.00 EUR CR Cash/ Bank.................... 2,400.00 EUR The amount of rent is free of VAT because the university is the landlord. Julia Saldanha pays: 12 × 100 = 1 1,200.00 EUR rent on 30.06.20X1. This follows the rental contract with the university president. (15) Payment for rent on 30.06.20X1. DR Rent......................... 1,200.00 EUR CR Cash/ Bank.................... 1,200.00 EUR In the first month, Julia Saldanha sells 80 % of the goods. Their value equals: 80% × 3,000/ 120% = 2 2,000.00 EUR. The sales amount remains constant during the Accounting period. As intended, she keeps her stock at a level of 500.00 EUR in value. She purchases in February … December goods at 2,400.00 EUR/ month (gross amount) which she sells completely. Sales are amounting for all months together to: 12 × 2,000 × 200% = 4 48,000.00 EUR. The net amount equals: 48,000 / 120% = 4 40,000.00 EUR. Obviously, Julia Saldanha does not keep January’s inventory the whole year. Her inventory movements follow a first-infirst-out policy. For the sake of simplification, we record one Bookkeeping entry for all sales together: (16) Sale of snacks on 31.12.20X1. <?page no="487"?> Berkau: Basics of Accounting 6e 33-487 DR Cash/ Bank.................... 48,000.00 EUR CR VAT.......................... 8,000.00 EUR CR Sales........................ 40,000.00 EUR Observe the accounts for Julia Saldanha’s tuck shop as covered so far in Figure 33.1. D C D C (2) 5,000.00 c/ d 5,000.00 c/ d 9,000.00 (1) 9,000.00 b/ d 5,000.00 b/ d 9,000.00 D C D C (1) 9,000.00 (2) 6,000.00 (2) 1,000.00 (16) 8,000.00 (16) 48,000.00 (3) 3,000.00 (3) 500.00 (4) 2,400.00 (4) 400.00 (5) 2,400.00 (5) 400.00 (6) 2,400.00 (6) 400.00 (7) 2,400.00 (7) 400.00 (8) 2,400.00 (8) 400.00 (9) 2,400.00 (9) 400.00 (10) 2,400.00 (10) 400.00 (11) 2,400.00 (11) 400.00 (12) 2,400.00 (12) 400.00 (13) 2,400.00 (13) 400.00 (14) 2,400.00 (14) 400.00 (15) 1,200.00 c/ d 2,100.00 c/ d 20,400.00 8,000.00 8,000.00 57,000.00 57,000.00 b/ d 2,100.00 b/ d 20,400.00 Property, plant, equipment PPE Owner's capital OWC Cash/ Bank C/ B Value added tax VAT Figure 33.1: SALDANHA’s accounts <?page no="488"?> Berkau: Basics of Accounting 6e 33-488 D C D C (3) 2,500.00 (16) 40,000.00 (4) 2,000.00 (5) 2,000.00 (6) 2,000.00 (7) 2,000.00 (8) 2,000.00 (9) 2,000.00 (10) 2,000.00 (11) 2,000.00 (12) 2,000.00 (13) 2,000.00 (14) 2,000.00 c/ d 24,500.00 24,500.00 24,500.00 b/ d 24,500.00 Purchase-20X1 PUR Sales-20X1 REV D C (15) 1,200.00 Rent-20X1 RNT Figure 33.1: Julia Saldanha’s accounts (continued) As we see, the company’s revenue exceeds the total of purchases. All business activities are on cash. Even with prepayments for purchases, a positive cash flow results from operating business activities (material purchases and sales of goods). The company (Julia Saldanha as its representative) must pay the difference between outputand input-VAT to the revenue service in the next following Accounting period. Julia Saldanha prepares a trial balance and checks her records for consistency with the double entry system. The trial balance gives a good overview about the tuck shop’s operations. Observe Figure 33.2: Account Debit entries Credit entries Property, Plant, Equipment PPE 5,000.00 Owner's Capital OWC 9,000.00 Cash/ Bank C/ B 20,400.00 Value added tax VAT 2,100.00 Purchase-20X1 PUR 24,500.00 Sales-20X1 REV 40,000.00 Rent-20X1 RNT 1,200.00 Total: 51,100.00 51,100.00 SALDANHA TRIAL BALANCE as at 31.12.20X1 Figure 33.2: Julia Saldanha’s trial balance <?page no="489"?> Berkau: Basics of Accounting 6e 33-489 Julia Saldanha records the adjustments at the end of the first Accounting period. She makes Bookkeeping entries for depreciation, profit calculation and drawings. 33.6 Calculation of Profits in a Sole Proprietorship (Case Saldanha) When Julia Saldanha takes inventory on 31.12.20X1, it reveals that there are still snacks at 500.00 EUR of value on stock. This is the intended safety level. Next, we study the profit calculation based on a periodic inventory system for Julia Saldanha’s tuck shop. Therefore, we must take stock at the end of the Accounting period. The cost of goods sold are calculated as opening value of inventory plus all purchases and less the closing stock of goods. No returns took place. As part of the adjustments, Julia Saldanha records the closing stock of inventory at 500.00 EUR on 31.12.20X1. DR Inventory.................... 500.00 EUR CR Trading Account.............. 500.00 EUR Furthermore, the Purchase account and the Sales account are closed-off to the Trading account. DR Trading Account.............. 24,500.00 EUR CR Purchase..................... 24,500.00 EUR DR Sales........................ 40,000.00 EUR CR Trading Account.............. 40,000.00 EUR The Trading account tells us the gross profit and is closed-off to the Profit and Loss account. The gross profit earned by Julia Saldanha equates sales minus material expenses (= purchase less closing stock) and gives: 40,000 - 24,000 = 116,000.00 EUR. The cost of goods sold are 24,000.00 EUR, because we must deduct the value of the closing stock from the purchases: 24,500 - 500 = 24,000.00 EUR. The Trading account is closed-off to the Profit and Loss account on 31.12.20X1 by the Bookkeeping entry below. DR Trading Account.............. 16,000.00 EUR CR Profit and Loss.............. 16,000.00 EUR Julia Saldanha must record depreciation on the trailer. She intends to use the trailer 5 years and writes it off to an extent of: 5,000 / 5 = 1 1,000.00 EUR/ a. On 31.12.20X1 she depreciates the tuck shop trailer. <?page no="490"?> Berkau: Basics of Accounting 6e 33-490 DR Depreciation................. 1,000.00 EUR CR Accumulated Depreciation..... 1,000.00 EUR The remainder of expenses are considered for the profit calculating below. Here, other expenses are rent only. DR Profit and Loss.............. 1,200.00 EUR CR Rent......................... 1,200.00 EUR DR Profit and Loss.............. 1,000.00 EUR CR Depreciation................. 1,000.00 EUR We check the accounts to evaluate Julia Saldanha performance. In particular, we look at her Trading account and the Profit and Loss account. As the tuck shop is privately-owned, Julia Saldanha declares personal income taxes based on the profit earned with her tuck shop. The profit is amounting to: 16,000 - 1,000 - 1,200 = 1 13,800.00 EUR. Julia Saldanha transfers the profit to the Owner’s Capital account. DR Profit and Loss.............. 13,800.00 EUR CR Owner’s Capital.............. 13,800.00 EUR We observe the accounts after the profit calculation in Figure 33.3: D C D C (2) 5,000.00 c/ d 5,000.00 c/ d 9,000.00 (1) 9,000.00 b/ d 5,000.00 b/ d 9,000.00 c/ d 22,800.00 P&L 13,800.00 22,800.00 22,800.00 b/ d 22,800.00 Property, plant, equipment PPE Owner's capital OWC Figure 33.3: SALDANHA’s accounts <?page no="491"?> Berkau: Basics of Accounting 6e 33-491 D C D C (1) 9,000.00 (2) 6,000.00 (2) 1,000.00 (16) 8,000.00 (16) 48,000.00 (3) 3,000.00 (3) 500.00 (4) 2,400.00 (4) 400.00 (5) 2,400.00 (5) 400.00 (6) 2,400.00 (6) 400.00 (7) 2,400.00 (7) 400.00 (8) 2,400.00 (8) 400.00 (9) 2,400.00 (9) 400.00 (10) 2,400.00 (10) 400.00 (11) 2,400.00 (11) 400.00 (12) 2,400.00 (12) 400.00 (13) 2,400.00 (13) 400.00 (14) 2,400.00 (14) 400.00 (15) 1,200.00 c/ d 2,100.00 c/ d 20,400.00 8,000.00 8,000.00 57,000.00 57,000.00 b/ d 2,100.00 b/ d 20,400.00 Cash/ Bank C/ B Value added tax VAT D C D C (3) 2,500.00 PUR 24,500.00 INV 500.00 (4) 2,000.00 GP 16,000.00 REV 40,000.00 (5) 2,000.00 40,500.00 40,500.00 (6) 2,000.00 P&L 16,000.00 b/ d 16,000.00 (7) 2,000.00 (8) 2,000.00 (9) 2,000.00 (10) 2,000.00 (11) 2,000.00 (12) 2,000.00 (13) 2,000.00 (14) 2,000.00 c/ d 24,500.00 24,500.00 24,500.00 b/ d 24,500.00 T/ A 24,500.00 Purchase-20X1 PUR Trading account-20X1 T/ A D C D C (15) 1,200.00 c/ d 1,200.00 T/ A 40,000.00 (16) 40,000.00 b/ d 1,200.00 P&L 1,200.00 D C D C T/ A 500.00 c/ d 500.00 ACC 1,000.00 c/ d 1,000.00 b/ d 500.00 b/ d 1,000.00 P&L 1,000.00 Rent-20X1 RNT Sales-20X1 REV Inventory INV Depreciation-20X1 DPR Figure 33.3: SALDANHA’s accounts (continued) <?page no="492"?> Berkau: Basics of Accounting 6e 33-492 D C D C c/ d 1,000.00 Dpr 1,000.00 DPR 1,000.00 T/ A 16,000.00 b/ d 1,000.00 RNT 1,200.00 NP 13,800.00 16,000.00 16,000.00 OWC 13,800.00 b/ d 13,800.00 Accumulated depreciation ACC Profit and Loss-20X1 P&L Figure 33.3: SALDANHA’s accounts (continued) The adjusted trial balance is shown below in Figure 33.4 below: Account Debit entries Credit entries Property, Plant, Equipment PPE 5,000.00 Owner's Capital OWC 22,800.00 Cash/ Bank C/ B 20,400.00 Value added tax VAT 2,100.00 Purchase-20X1 PUR 0.00 0.00 Sales-20X1 REV 0.00 0.00 Rent-20X1 RNT 0.00 0.00 Depreciation-20X1 DPR 0.00 0.00 Inventory INV 500.00 Accumulated Depreciation ACC 1,000.00 Total: 25,900.00 25,900.00 SALDANHA ADJUSTED TRIAL BALANCE as at 31.12.20X1 Figure 33.4: SALDANHA’s adjusted trial balance Julia Saldanha records a drawing of 10,000.00 EUR. DR Drawings..................... 10,000.00 EUR CR Cash/ Bank.................... 10,000.00 EUR The drawing fulfils 2 purposes: (1) Julia Saldanha wants to benefit from the profit earned and (2) she must pay her personal income taxes. We pretend that her personal income tax rate is con- 13 The calculation of income taxes under a tax progression system is covered in chapter (6) of our textbook Management Accounting. stantly 22.5 %. We calculate taxes following a simplified tax model and ignore tax progression. 13 Therefore, the amount she owes the revenue service equals: 22.5% × 13,800 = 3 3,105.00 EUR. She must declare the full tuck shop profit <?page no="493"?> Berkau: Basics of Accounting 6e 33-493 on her tax return form no matter, how much the drawing is. The profit falls under her personal income. Julia Saldanha does not make a Bookkeeping entry for the tax payment, because it takes place outside of the tuck shop business. Furthermore, Julia Saldanha must pay VAT liabilities in the next year 20X2. For the VAT liabilities, she makes another drawing of 2.100.00 EUR. She uses that money for paying VAT liabilities at the beginning of the next Accounting period. Note, the company itself is not registered for VAT reduction, but Julia Saldana is. After the drawings, the accounts look as below in Figure 33.5: D C D C (2) 5,000.00 c/ d 5,000.00 c/ d 9,000.00 (1) 9,000.00 b/ d 5,000.00 b/ d 9,000.00 c/ d 22,800.00 P&L 13,800.00 22,800.00 22,800.00 Drw 12,100.00 b/ d 22,800.00 c/ d 10,700.00 22,800.00 22,800.00 b/ d 10,700.00 D C D C (1) 9,000.00 (2) 6,000.00 (2) 1,000.00 (16) 8,000.00 (16) 48,000.00 (3) 3,000.00 (3) 500.00 (4) 2,400.00 (4) 400.00 (5) 2,400.00 (5) 400.00 (6) 2,400.00 (6) 400.00 (7) 2,400.00 (7) 400.00 (8) 2,400.00 (8) 400.00 (9) 2,400.00 (9) 400.00 (10) 2,400.00 (10) 400.00 (11) 2,400.00 (11) 400.00 (12) 2,400.00 (12) 400.00 (13) 2,400.00 (13) 400.00 (14) 2,400.00 (14) 400.00 (15) 1,200.00 c/ d 2,100.00 c/ d 20,400.00 8,000.00 8,000.00 57,000.00 57,000.00 b/ d 2,100.00 b/ d 20,400.00 DRW 10,000.00 DRW 2,100.00 c/ d 8,300.00 20,400.00 20,400.00 b/ d 8,300.00 Property, plant, equipment PPE Owner's capital OWC Cash/ Bank C/ B Value added tax VAT Figure 33.5: SALDANHA’s accounts <?page no="494"?> Berkau: Basics of Accounting 6e 33-494 D C D C (3) 2,500.00 PUR 24,500.00 INV 500.00 (4) 2,000.00 GP 16,000.00 REV 40,000.00 (5) 2,000.00 40,500.00 40,500.00 (6) 2,000.00 P&L 16,000.00 b/ d 16,000.00 (7) 2,000.00 (8) 2,000.00 (9) 2,000.00 (10) 2,000.00 (11) 2,000.00 (12) 2,000.00 (13) 2,000.00 (14) 2,000.00 c/ d 24,500.00 24,500.00 24,500.00 b/ d 24,500.00 T/ A 24,500.00 D C D C (15) 1,200.00 c/ d 1,200.00 T/ A 40,000.00 (16) 40,000.00 b/ d 1,200.00 P&L 1,200.00 D C D C T/ A 500.00 c/ d 500.00 ACC 1,000.00 c/ d 1,000.00 b/ d 500.00 b/ d 1,000.00 P&L 1,000.00 D C D C c/ d 1,000.00 DPR 1,000.00 DPR 1,000.00 T/ A 16,000.00 b/ d 1,000.00 RNT 1,200.00 NP 13,800.00 16,000.00 16,000.00 OWC 13,800.00 b/ d 13,800.00 D C C/ B 10,000.00 C/ B 2,100.00 c/ d 12,100.00 12,100.00 12,100.00 b/ d 12,100.00 OWC 12,100.00 Drawings DRW Accumulated depreciation ACC Profit and Loss-20X1 P&L Purchase-20X1 PUR Trading account-20X1 T/ A Rent-20X1 RNT Sales-20X1 REV Inventory INV Depreciation-20X1 DPR Figure 33.5: Julia Saldanha’s accounts (continued) <?page no="495"?> Berkau: Basics of Accounting 6e 33-495 33.7 Change of Legal Form (Case Saldanha) Julia Saldanha is happy with the performance of her business. She considers expanding the tuck shop and plans to sell snacks at all faculties of the university. In total, she plans to open 6 new tuck shops during the next Accounting period. Julia Saldanha shares her plans with her classmates and asks them to join her business. They are willing to contribute to her tuck shop business. In particular, they want to partner with Julia Saldanha - meaning to establish a partnership together with her. The deal works that way, that Julia Saldana sells them 2 thirds of her company which they turn into the legal form of a partnership. The two friends offer Julia Saldanha 12,800.00 EUR each for 33.33 % of the (new) company. The business concept of the company is to sell snacks to students in the university same as before. The 3 partners reserve a name for the new company. Instead of Saldanha the name of the new established partnership is SNACKY-TICKY-shop. They submit the name to the authorities and receive approval a few days later. 33.8 Partnerships A partnership is a company owned by more than one proprietor who are jointly reliable for their company. The incorporation of a partnership or the transition from a sole proprietorship to a partnership does not create a legal and taxable entity. In a partnership all partners are owners of the business together, and each partner takes unlimited responsibility for the debts of the business, or for any other damage caused by the partnership. The partners can be held responsible for the business by their private assets. E.g., if the SNACKY-TICKY-shop becomes unable to repay its debts, creditors can claim personal assets from any partner. This concept of being liable alone to the full extent for a common business is referred to as a jointly and severally liability. This means any partner can be sued for all debts of the whole business or for any other payment obligation resulting from the business, like fines or fees. This becomes also relevant, if the business fails to fulfil its duties, like tax declarations or payment of salaries and social securities for its employees etc. Note, claims against one partner are not limited to the share she/ he is holding. A partner who owns 33.33 % of the company can be held liable for all debts. Creditors tend to legally go after the “strongest” partner when collecting outstanding payments. Therefore, a partnership's liability is similar to a marriage in community of property. Check your partners thoroughly! In a partnership, every partner represents the company and can sign contracts on behalf of the business as long as this is following the business purpose. Further regulations are subjected to a partnership agreement to be set up between the partners at the time of incorporation. 33.9 C/ S SNACKY-TICKY-Shop (Part 2: Partnership) Julia Saldanha and her 2 partners prepare a business contract. This agreement signifies the contribution of the two new partners to the same extent as Julia Saldanha’s one. Julia Saldanha puts in her old business and all assets linked <?page no="496"?> Berkau: Basics of Accounting 6e 33-496 thereto: the tuck shop trailer with a carrying value of 4,000.00 EUR, the goods of 500.00 EUR (safety stock) and the cash which equals 8,300.00 EUR. The total of her contribution is: 4,000 + 500 + 8,300 = 1 12,800.00 EUR. The amounts are derived from the balance sheet and represent the book value of the tuck shop. Julia Saldanha does not deduct VAT payables because she withdrew money from the business with the intention to payoff her VAT liabilities before. Therefore, cash/ bank decreases to the extent of the VAT payables. She pays the VAT liabilities in January 20X2. The other partners contribute 12,800.00 EUR on cash each. They pay their deposit into the partnership’s bank account opened under the name SNACKY-TICKY-shop. Note, the owners of the bank account are the partners. The total of deposits is: 3 × 12,800 - 4,000 - 500 = 3 33,900.00 EUR. As Julia Saldanha contributes the tuck shop, equity of the SNACKY-TICKY-shop is not paid in as cash completely. Besides of cash to the extent of 33,900.00 EUR, other assets are amounting to: 4,000 + 500 = 4 4,500.00 EUR. See the balance sheet in Figure 33.6. The partnership’s incorporation contract states how profits are shared among the partners. Profit must equally be shared between them. Hence, every partner receives 1/ 3 of the business’s income. As the partnership is no legal entity every partner must pay income taxes for her/ his share of the profit based on her/ his personal income tax rate. The partners decide that all profits are paid out at the end of every year. All investments are made at an equal share and are regarded as extra contributions of the partners. No partner works for SNACKY-TICKYshop as an employee. If they want to, a special contract must be signed. The agreement states further, that leaving the partnership and new partners joining requires an unrestricted approval of all remaining partners. The SNACKY-TICKY-shop prepares financial statements in order to provide the partners with transparent information. On 2.01.20X2, the partners prepare a statement of financial position as shown in Figure 33.6: <?page no="497"?> Berkau: Basics of Accounting 6e 33-497 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 4,000.00 Partners' capital 38,400.00 Intangibles Financial assets Current assets Liabilities Inventory 500.00 Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 33,900.00 38,400.00 38,400.00 SNACKY-TICKY-Shop STATEMENT of FINANCIAL POSITION as at 1.01.20X2 Figure 33.6: SNACKY-TICKY-shop’s statement of financial position The partners’ capital is the total of the partners’ contributions: 3 × 12,800 = 38,400.00 EUR. The Bookkeeping records are prepared based on the statement of financial position. See below, how its opening values are transferred to the accounts of the SNACKY-TICKY-shop. Due to the change of legal form, accounts of Julia Saldanha’s snack shop are not continued. The opening values from the balance sheet are added to the accounts. Regarding the recognition of asset, we focus on the tuck shop trailer brought-in by Julia Saldanha: It is recorded by a debit entry in the P, P, E account at a valuation of 4,000.00 EUR. The trailer is regarded as a preowned asset at a cost of acquisition of 4,000.00 EUR. The partnership has to consider a (remaining) useful life of 4 years for the tuck shop trailer. VAT does not apply, as the partnership legally continues the previous sole proprietorship with its assets transferred to the partnership. D C D C OV 4,000.00 OV 38,400.00 D C D C OV 500.00 OV 33,900.00 Property, plant, equipment PPE Partners' capital P/ C Inventory INV Cash/ Bank C/ B Figure 33.7: SNACKY-TICKY-shop’s accounts In 20X2, the following transactions are recorded. The SNACKY-TICKY-shop takes a bank loan of 20,000.00 EUR. The rate of interest is 5 %/ a. The pay-off payments are 2,000.00 EUR/ a, interest and <?page no="498"?> Berkau: Basics of Accounting 6e 33-498 pay-off are payable at the end of the year. (1) Taking the bank loan of 20,000.00 EUR on 2.01.20X2. DR Cash/ Bank.................... 20,000.00 EUR CR Interest Bearing Liabilities. 20,000.00 EUR The Bookkeeping entries for interest and pay-off and for transferring the pay-off amount for 20X3 to short-term liabilities, are as below: (2) Paying interest on 31.12.20X2. DR Interest .................... 1,000.00 EUR CR Cash/ Bank.................... 1,000.00 EUR (3) Pay-off payment on 31.12.20X2. DR Interest Bearing Liabilities. 2,000.00 EUR CR Cash/ Bank.................... 2,000.00 EUR (4) Transferring 20X3’s pay-off to shortterm liabilities on 31.12.20X2. DR Interest Bearing Liabilities. 2,000.00 EUR CR Short-term Liabilities....... 2,000.00 EUR The SNACKY-TICKY-shop buys 6 new sales trailers at 5,400.00 EUR/ u (gross amount) each. The costs of acquisition are: 6 × 5,400 / 120% = 2 27,000.00 EUR. (5) Making an investment to new sales trailers on 2.01.20X2. DR P, P, E Account.............. 27,000.00 EUR DR VAT.......................... 5,400.00 EUR CR Cash/ Bank.................... 32,400.00 EUR Depreciation on the trailers is 1,000.00 EUR/ a for the old trailer (cost of acquisition of 4,000.00 EUR and remaining useful life of 4 years) and: 6 × 5,400 / (120% × 5) = 5,400.00 EUR/ (a × u) for the new ones. Depreciation on each new sales trailer is: 5,400 / 6 = 9 900.00 EUR/ u. (6) Depreciation on the sales trailers is amounting to: 1,000 + 6 × 900 = 6,400.00 EUR. DR Depreciation................. 6,400.00 EUR CR Accumulated Depreciation..... 6,400.00 EUR The SNACKY-TICKY-shop does not apply an Asset Management for its trailers. Depreciation and property, plant, equipment are recorded for all assets together in 2 accounts. <?page no="499"?> Berkau: Basics of Accounting 6e 33-499 The rent contract with the university is continued and gets extended to the new locations at even better conditions. The university requests 500.00 EUR/ m as monthly payment for all locations together. The rent is paid in the middle of the year. (7) Payment for rent: 12 × 500 = 6 6,000.00 EUR on 30.06.20X2. DR Rent......................... 6,000.00 EUR CR Cash/ Bank.................... 6,000.00 EUR The purchase of goods is similar to Julia Saldanha’s snack shop. The first purchase is higher than the next following ones to build up a safety stock of 500.00 EUR at all points of sale. These stock levels are maintained over the entire Accounting period. According to this plan, the SNACKY-TICKY-shop orders sweets, crackers and energy bars for: 2,400 + 6 × 3,000 = 2 20,400.00 EUR in January and for: 7 × 2,400 = 1 16,800.00 EUR in the following months. The prices are gross amounts. The previous location of Julia Saldanha’s business is continued by the SNACKY- TICKY-shop and takes over the safety stock. (8 … 20) Cash purchases on 3.01.20X2 and later from 1.02.20X2 … 31.12.20X2. Note, the SNACKY-TICKY-shop now buys goods in advance which leads to 13 orders in 20X2. DR Purchase..................... 17,000.00 EUR DR VAT.......................... 3,400.00 EUR CR Cash/ Bank.................... 20,400.00 EUR And later (12 ×): DR Purchase..................... 14,000.00 EUR DR VAT.......................... 2,800.00 EUR CR Cash/ Bank.................... 16,800.00 EUR The new SNACKY-TICKY-shop sells goods at a gross selling price amounting to 220 % of the costs (of purchase). The SNACKY-TICKY-shop sells snacks at 369,600.00 EUR. To keep the case study simple, we only record one Bookkeeping entry for all sales together. (21) Sale of snacks at a gross amount of: 7 × 2,000 × 12 × 220% = 3 369,600.00 EUR on 1.07.20X2. DR Cash/ Bank.................... 369,600.00 EUR CR VAT.......................... 61,600.00 EUR CR Sales........................ 308,000.00 EUR The SNACKY-TICKY-shop employs students to sell the snacks on a freelancer basis. During the Accounting period 20X2, the partnership pays 24,100.00 EUR on labour. No payroll tax, nor social <?page no="500"?> Berkau: Basics of Accounting 6e 33-500 security is paid, as the students work as freelancers. (22) Payment of students on 31.12.20X2. DR Labour....................... 24,100.00 EUR CR Cash/ Bank.................... 24,100.00 EUR At the end of the Accounting period, a trial balance is prepared. Observe the accounts and the trial balance in Figure 33.8 and Figure 33.9. D C D C OV 4,000.00 c/ d 38,400.00 OV 38,400.00 (5) 27,000.00 c/ d 31,000.00 b/ d 38,400.00 31,000.00 31,000.00 b/ d 31,000.00 Property, plant, equipment PPE Partners' capital P/ C D C D C OV 500.00 c/ d 500.00 OV 33,900.00 (2) 1,000.00 b/ d 500.00 (1) 20,000.00 (3) 2,000.00 (21) 369,600.00 (5) 32,400.00 (7) 6,000.00 (8) 20,400.00 (9) 16,800.00 (10) 16,800.00 (11) 16,800.00 (12) 16,800.00 (13) 16,800.00 (14) 16,800.00 (15) 16,800.00 (16) 16,800.00 (17) 16,800.00 (18) 16,800.00 (19) 16,800.00 (20) 16,800.00 (22) 24,100.00 c/ d 136,000.00 423,500.00 423,500.00 b/ d 136,000.00 Inventory INV Cash/ Bank C/ B D C D C (3) 2,000.00 (1) 20,000.00 (2) 1,000.00 c/ d 1,000.00 (4) 2,000.00 b/ d 1,000.00 c/ d 16,000.00 20,000.00 20,000.00 b/ d 16,000.00 Interest bearing liabilities IBL Interest-20X2 INT Figure 33.8: SNACKY-TICKY-shop’s accounts <?page no="501"?> Berkau: Basics of Accounting 6e 33-501 D C D C c/ d 2,000.00 (4) 2,000.00 (5) 5,400.00 (21) 61,600.00 b/ d 2,000.00 (8) 3,400.00 (9) 2,800.00 (10) 2,800.00 (11) 2,800.00 (12) 2,800.00 (13) 2,800.00 (14) 2,800.00 (15) 2,800.00 (16) 2,800.00 (17) 2,800.00 (18) 2,800.00 (19) 2,800.00 (20) 2,800.00 c/ d 19,200.00 61,600.00 61,600.00 b/ d 19,200.00 Short-term liabilities A/ P Value added tax VAT D C D C (6) 6,400.00 c/ d 6,400.00 c/ d 6,400.00 (6) 6,400.00 b/ d 6,400.00 b/ d 6,400.00 D C D C (7) 6,000.00 c/ d 6,000.00 (8) 17,000.00 b/ d 6,000.00 (9) 14,000.00 (10) 14,000.00 (11) 14,000.00 (12) 14,000.00 (13) 14,000.00 (14) 14,000.00 (15) 14,000.00 (16) 14,000.00 (17) 14,000.00 (18) 14,000.00 (19) 14,000.00 (20) 14,000.00 c/ d 185,000.00 185,000.00 185,000.00 b/ d 185,000.00 Rent-20X2 RNT Purchase-20X2 PUR Depreciation-20X2 DPR Accumulated depreciation ACc D C D C c/ d 308,000.00 (21) 308,000.00 (22) 24,100.00 c/ d 24,100.00 b/ d 308,000.00 b/ d 24,100.00 Sales-20X2 REV Labour-20X2 LAB Figure 33.8: SNACKY-TICKY-shop’s accounts (continued) <?page no="502"?> Berkau: Basics of Accounting 6e 33-502 Account Debit entries Credit entries Property, Plant, Equipment PPE 31,000.00 Partners' Capital P/ C 38,400.00 Inventory INV 500.00 Cash/ Bank C/ B 136,000.00 Interest Bearing Liabilities IBL 16,000.00 Interest-20X2 INT 1,000.00 Short-term Liabilities A/ P 2,000.00 Value added tax VAT 19,200.00 Depreciation-20X2 DPR 6,400.00 Accumulated Depreciation ACC 6,400.00 Rent-20X2 RNT 6,000.00 Purchase-20X2 PUR 185,000.00 Sales-20X2 REV 308,000.00 Labour-20X2 LAB 24,100.00 Total: 390,000.00 390,000.00 Snacky-Ticky-Shop TRIAL BALANCE as at 31.12.20X2 Figure 33.9: SNACKY-TICKY-shop’s trial balance Note, the trial balance in Figure 33.9 was prepared after recording depreciation and recording interest and pay-off for the bank loan. Next, we make Bookkeeping entries for the adjustments: At the end of the Accounting period 20X2, the SNACKY-TICKY-shop takes inventory. There are goods on stock worth: 7 × 500 + 14,000 - 500 = 17,000.00 EUR. Snacks are short to an extent of 500.00 EUR. Those goods expired during the Accounting period and had to be discarded. With a periodic inventory movement system, goods missing only come to light at the time of stock taking. Observe the below Bookkeeping entries for profit calculation. The opening value for the inventories is 500.00 EUR, as taken over from Julia Saldanha’s tuck shop. The total of purchases equal 185,000.00 EUR. The revenue is: 7 × 12 × 2,000 × 220% / 120% = 308,000.00 EUR. The closing stock is 17,000.00 EUR. DR Trading Account.............. 500.00 EUR CR Inventory.................... 500.00 EUR DR Trading Account.............. 185,000.00 EUR CR Purchase..................... 185,000.00 EUR <?page no="503"?> Berkau: Basics of Accounting 6e 33-503 DR Sales........................ 308,000.00 EUR CR Trading Account.............. 308,000.00 EUR DR Inventory.................... 17,000.00 EUR CR Trading Account.............. 17,000.00 EUR DR Trading Account.............. 128,500.00 EUR CR Profit and Loss.............. 128,500.00 EUR DR Profit and Loss.............. 1,000.00 EUR CR Interest..................... 1,000.00 EUR DR Profit and Loss.............. 6,400.00 EUR CR Depreciation ................. 6,400.00 EUR DR Profit and Loss.............. 6,000.00 EUR CR Rent......................... 6,000.00 EUR DR Profit and Loss.............. 24,100.00 EUR CR Labour....................... 24,100.00 EUR DR P&L-ACCOUNT .................. 102,000.00 EUR CR Partners’ Capital............ 102,000.00 EUR The 3 partners share the profit equally. The portion each partner receives is: 102,000 / 3 = 3 34,000.00 EUR. The partners record 3 drawings at 34,000.00 EUR. DR Drawings..................... 34,000.00 EUR CR Cash/ Bank.................... 34,000.00 EUR Eventually, the Drawings account is closed-off to the Partners’ Capital account on 31.12.20X2. DR Partners’ Capital............ 102,000.00 EUR CR Drawings..................... 102,000.00 EUR Observe the accounts. <?page no="504"?> Berkau: Basics of Accounting 6e 33-504 D C D C OV 4,000.00 c/ d 38,400.00 OV 38,400.00 (5) 27,000.00 c/ d 31,000.00 Drw 102,000.00 b/ d 38,400.00 31,000.00 31,000.00 c/ d 38,400.00 P&L 102,000.00 b/ d 31,000.00 140,400.00 140,400.00 b/ d 38,400.00 Property, plant, equipment PPE Partners' Capital P/ C D C D C OV 500.00 c/ d 500.00 OV 33,900.00 (2) 1,000.00 b/ d 500.00 T/ A 500.00 (1) 20,000.00 (3) 2,000.00 T/ A 17,000.00 c/ d 17,000.00 (21) 369,600.00 (5) 32,400.00 17,500.00 17,500.00 (7) 6,000.00 b/ d 17,000.00 (8) 20,400.00 (9) 16,800.00 (10) 16,800.00 (11) 16,800.00 (12) 16,800.00 (13) 16,800.00 (14) 16,800.00 (15) 16,800.00 (16) 16,800.00 (17) 16,800.00 (18) 16,800.00 (19) 16,800.00 (20) 16,800.00 (22) 24,100.00 c/ d 136,000.00 423,500.00 423,500.00 b/ d 136,000.00 DRW 34,000.00 DRW 34,000.00 DRW 34,000.00 c/ d 34,000.00 136,000.00 136,000.00 b/ d 34,000.00 D C D C (3) 2,000.00 (1) 20,000.00 (2) 1,000.00 c/ d 1,000.00 (4) 2,000.00 b/ d 1,000.00 P&L 1,000.00 c/ d 16,000.00 20,000.00 20,000.00 b/ d 16,000.00 Interest bearing liabilities IBL Interest-20X2 INT Inventory INV Cash/ Bank C/ B Figure 33.10: SNACKY-TICKY shop’s accounts <?page no="505"?> Berkau: Basics of Accounting 6e 33-505 D C D C c/ d 2,000.00 (4) 2,000.00 (5) 5,400.00 (21) 61,600.00 b/ d 2,000.00 (8) 3,400.00 (9) 2,800.00 (10) 2,800.00 (11) 2,800.00 (12) 2,800.00 (13) 2,800.00 (14) 2,800.00 (15) 2,800.00 (16) 2,800.00 (17) 2,800.00 (18) 2,800.00 (19) 2,800.00 (20) 2,800.00 c/ d 19,200.00 61,600.00 61,600.00 b/ d 19,200.00 D C D C (6) 6,400.00 c/ d 6,400.00 c/ d 6,400.00 (6) 6,400.00 b/ d 6,400.00 P&L 6,400.00 b/ d 6,400.00 Depreciation-20X2 DPR Accumulated depreciation ACC Short-term liabilities A/ P Value added tax VAT D C D C (7) 6,000.00 c/ d 6,000.00 (8) 17,000.00 b/ d 6,000.00 P&L 6,000.00 (9) 14,000.00 (10) 14,000.00 (11) 14,000.00 (12) 14,000.00 (13) 14,000.00 (14) 14,000.00 (15) 14,000.00 (16) 14,000.00 (17) 14,000.00 (18) 14,000.00 (19) 14,000.00 (20) 14,000.00 c/ d 185,000.00 185,000.00 185,000.00 b/ d 185,000.00 T/ A 185,000.00 D C D C c/ d 308,000.00 (21) 308,000.00 (22) 24,100.00 c/ d 24,100.00 T/ A 308,000.00 b/ d 308,000.00 b/ d 24,100.00 P&L 24,100.00 Sales-20X2 REV Labour-20X2 LAB Rent-20X2 RNT Purchase-20X2 PUR Figure 33.10: SNACKY-TICKY-shop’s accounts (continued) <?page no="506"?> Berkau: Basics of Accounting 6e 33-506 D C D C INV 500.00 REV 308,000.00 INT 1,000.00 T/ A 139,500.00 PUR 185,000.00 INV 17,000.00 DPR 6,400.00 GP 139,500.00 RNT 6,000.00 325,000.00 325,000.00 LAB 24,100.00 P&L 139,500.00 b/ d 139,500.00 NP 102,000.00 139,500.00 139,500.00 P/ C 102,000.00 b/ d 102,000.00 D C C/ B 34,000.00 C/ B 34,000.00 C/ B 34,000.00 c/ d 102,000.00 102,000.00 102,000.00 b/ d 102,000.00 P/ C 102,000.00 Drawings DRW Trading account-20X2 T/ A Profit and Loss-20X2 P&L Figure 33.10: SNACKY-TICKY-shop’s accounts (continued) Observe the adjusted trial balance for SNACKY-TICKY-shop in Figure 33.11. Account Debit entries Credit entries Property, Plant, Equipment PPE 31,000.00 Partners' Capital P/ C 38,400.00 Inventory INV 17,000.00 Cash/ Bank C/ B 34,000.00 Interest Bearing Liabilities IBL 16,000.00 Interest -20X2 INT 0.00 0.00 Short-term Liabilities A/ P 2,000.00 Value added tax VAT 19,200.00 Depreciation-20X2 DPR 0.00 0.00 Accumulated Depreciation ACC 6,400.00 Rent-20X2 RNT 0.00 0.00 Purchase-20X2 PUR 0.00 0.00 Sales-20X2 REV 0.00 0.00 Labour-20X2 LAB 0.00 0.00 Total: 82,000.00 82,000.00 Snacky-Ticky-shop ADJUSTED TRIAL BALANCE as at 31.12.20X2 Figure 33.11: SNACKY-TICKY-shop’s adjusted trial balance Each partner receives a profit portion of 34,000.00 EUR. They have to pay taxes <?page no="507"?> Berkau: Basics of Accounting 6e 33-507 on their income according to their own tax return form and applicable personal income tax rate. The following Figure 33.12 and Figure 33.13 show the financial statements (balance sheet and income statement) for SNACKY-TICKY-shop: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 24,600.00 Partners' capital 38,400.00 Intangibles Financial assets Current assets Liabilities Inventory 17,000.00 Interest bear liab 16,000.00 A/ R A/ P 21,200.00 Prepaid expenses Provisions Cash/ Bank 34,000.00 75,600.00 75,600.00 SNACKY-TICKY-shop STATEMENT of FINANCIAL POSITION as at 1.01.20X2 Figure 33.12: SNACKY-TICKY-shop’s statement of financial position In contrast to the case study VANGUARD, we only apply one account for equity. The value for the payables results from VAT (19,200.00 EUR) payable in the next Accounting period and from short-term liabilities (2,000.00 EUR) resulting from the pay-off amount of the bank loan for 20X3. [EUR] Revenue 308,000.00 Other income 308,000.00 Materials (168,500.00) Labour (24,100.00) Depreciation (6,400.00) Other expenses (6,000.00) Earnings before interest (EBIT) 103,000.00 Interest (1,000.00) Earnings (EBT) 102,000.00 Snacky-Ticky-shop STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X2 Figure 33.13: SNACKY-TICKY-shop’s income statement <?page no="508"?> Berkau: Basics of Accounting 6e 33-508 The materials on the income statement result from the opening amount plus purchases less closing stock: 500 + 185,000 - 17,000 = 1 168,500.00 EUR. The other expenses contain rent only. The disposal of snacks to the extent of 500.00 EUR is considered as material expenses already. The income statement for a partnership does not show income tax liabilities, because taxes must be paid by the owners themselves. 33.10 C/ S SNACKY-TICKY-Shop (Part 3: Limited Company) The partners are content with the profitability of their business and plan to expand it. They want to become a country wide university snack provider. They have already an offer for snack vending machines at cost of 12,800.00 EUR/ u. The vending machines sell the same number of snacks as the salespersons do. The business concept is to sell snacks in all universities countywide and in all their faculties. After visiting the universities, they prepare a business plan based on 56 locations for the vending machines. The rent for one location is 35.00 EUR/ m. For the extension of their business, investments of: 56 × 12,800 × 120% = 8 860,160.00 EUR (for the vending machines) are necessary. Furthermore, an initial (monthly) snack purchase of 56 × 2,500 × 120% = 1 168,000.00 EUR for the initial filling of the vending machines is required. The next following top-up purchases can be financed by the cash flows from the previous months. The total funds required are: 860,160 + 168,000 = 1,028,160.00 EUR. The partnership SNACKY-TICKY-shop cannot afford these 14 Liquidations are covered in the next following chapter (34) in this textbook. investments. Therefore, the partners must go public, which means they turn the business into a company based on shares. For that reason, they issue 100,000 ordinary shares at 10.00 EUR/ s each. The share issue is par value. A A par value share issue is a share issue at the nominal amount of the shares. A company based on shares is in ownership of the shareholders who are liable for their company only to their shares’ value. A public company is a company based on shares of which everyone (the public) can buy shares from. Before the share issue, the founders liquidate the partnership SNACKY-TICKYshop. 14 Every partner obtains: 38,400 / 3 = 112,800.00 EUR from the liquidation which they invest in the new business. We discuss liquidations in the next following chapter (34). Note, that for this case study, the VAT liabilities and loan are paid-off without transaction costs. Assets are sold at carrying values. After liquidation, each partner buys: 3,840 / 3 = 1 1,280 shares of the new company financed by their previous ownership of the SNACKY-TICKY-shop. As the shares have a face value of 10.00 EUR/ s, the contribution of the previous SNACKY-TICKY-shop owners is amounting to their profit on liquidation, which is: 1,280 × 10 = 1 12,800.00 EUR/ investor. All previous partners use private assets resulting from the shared profit in 20X2 to buy more shares. Everyone buys 2,350 further shares. This is the number of shares they can buy after deducting their personal income taxes (here: 22.5 <?page no="509"?> Berkau: Basics of Accounting 6e 33-509 %) from the drawings they made. A dividend tax does not apply, because the SNACKY-TICKY-shop was a partnership. The number of shares bought is based on the previous Accounting period’s profit and gives additional number of shares held by the founders: 102,000 × (1 - 22.5%) / (3 x 10) = 2 2,635 shares. The total number of: (1,280 + 2,635) x 3 = 11,745 shares gives the previous owners of the SNACKY-TICKY-shop a 11.74 % portion of the new business’ voting rights. Hence, the 3 partners lost control of their business to the new shareholders by going public. After the preparation of the share issue for SNACKY-TICKY Ltd., the shares are offered to the public (through a bank). The issue price is the nominal value of the shares. The shares are applied by the subscribers paying the money into the bank account. After the company receives the applications, the shares are allotted to applicants. When SNACKY-TICKY Ltd. is founded, 100,000 shares are applied for. The money is received, and the first Bookkeeping entry is made on 2.01.20X3: (1) Cash received from applicants of shares on 2.01.20X3. DR Cash/ Bank.................... 1,000,000.00 EUR CR Application and Allotment.... 1,000,000.00 EUR In case of SNACKY-TICKY Ltd., there is no underor over-subscription of shares. Under-subscription of shares occurs if less shares are applied for than offered to the public. Oversubscription is a share issue with more applicants than share offers. In the event of over-subscription, the money paid by rejected applicants must be refunded. A par value share issue is a share issue at the nominal value of the shares. Share issues at an issue price exceeding the nominal value require adding the premium to the Capital Reserves account. 15 As all applicants are accepted, the Application and Allotment account is closedoff to the Issued Capital account. (2) Shares allotted to subscribers and added to the Share Capital account on 2.01.20X3. DR Application and Allotment.... 1,000,000.00 EUR CR Share Capital................ 1,000,000.00 EUR Observe the accounts of the new company in Figure 33.14. 15 Share issues are discussed in chapter (11) of our textbook Bilanzen/ Financial Statements. <?page no="510"?> Berkau: Basics of Accounting 6e 33-510 D C D C (1) 1,000,000.00 (2) 1,000,000.00 (1) 1,000,000.00 D C (2) 1,000,000.00 Cash/ Bank C/ B Application and allotment AAA Share capital ISS Figure 33.14: SNACKY-TICKY Ltd.‘s accounts How it is done (Share Issue): (1) When shares are issued the applicants pay the share’s issue price into the Cash/ Bank account (through a bank). Credit the Application and Allotment account respectively. (2) In case of oversubscription pay back the amounts to rejected applicants. (3) Allot shares to subscribers by debiting the value of the issue price × number to the Application and Allotment account. (4) Credit the nominal value of issued shares to the Issued Capital account. (5) If the issue price exceeds the face value of shares credit the premium to the Share Premium account. (6) Close-off the Share Premium account to the Capital Reserves account. At the time of incorporation, the opening statement of financial position looks as depicted in Figure 33.15. <?page no="511"?> Berkau: Basics of Accounting 6e 33-511 A C, L Non-current assets [EUR] Equity [EUR] P, P, E Share capital 1,000,000.00 Intangibles Reserves Financial assets R/ E Current assets Liabilities Inventory Interest bear liab A/ R A/ P Prepaid expenses Provisions Cash/ Bank 1,000,000.00 Tax liabilities 1,000,000.00 1,000,000.00 Snacky-Ticky Ltd. STATEMENT of FINANCIAL POSITION as at 1.01.20X3 Figure 33.15: SNACKY-TICKY Ltd.’s statement of financial position The board of directors is elected, and Julia Saldanha becomes the new chief executive officer (CEO). The company SNACKY-TICKY Ltd. is registered for VAT reduction. 33.11 Business Activities (C/ S SNACKY-TICKY Ltd.) The vending machines get acquired and are installed at the 56 university locations. The vending machines are bought on 10.01.20X3 at a gross purchase price of: 56 × 12,800 × 120% = 8 860,160.00 EUR. The price includes the installation of the vending machines by the seller. (3) Acquisition of vending machines on 10.01.20X3. DR P, P, E Account.............. 716,800.00 EUR DR VAT.......................... 143,360.00 EUR CR Cash/ Bank.................... 860,160.00 EUR The company takes a bank loan which is to be paid-off at the end of the year. The amount is 50,000.00 EUR. The rate of interest is 6.00 %/ a. As the bank loan is to be paid back within the first Accounting period, the loan is classified as shortterm liability. The relevant account is the Accounts Payables account. (4) Taking a bank loan on 11.01.20X3 with a principal of 50,000.00 EUR. DR Cash/ Bank.................... 50,000.00 EUR CR Short-term Liabilities....... 50,000.00 EUR (5) Payment of interest on 31.12.20X3. <?page no="512"?> Berkau: Basics of Accounting 6e 33-512 DR Interest..................... 3,000.00 EUR CR Cash/ Bank.................... 3,000.00 EUR (6) On 31.12.20X3, the company retires the bank loan. This does not show on the statement of financial position. DR Short-term Liabilities....... 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR SNACKY-TICKY Ltd. negotiated with the snack supplier a delivery of the goods directly to the vending machines including their refill. The purchase price does not change. SNACKY-TICKY Ltd. orders the January’s snacks at a purchase price of: 56 × 2,500 = 1 140,000.00 EUR. (7) Purchase of snacks on 12.01.20X3. DR Purchase..................... 140,000.00 EUR DR VAT.......................... 28,000.00 EUR CR Cash/ Bank.................... 168,000.00 EUR For the other months, SNACKY-TICKY Ltd. again orders a lower amount of 2,000.00 EUR/ m and per machine. The purchase price is: 56 × 2,000 = 112,000.00 EUR/ month. (8 …18) Purchase of snacks on 1.02.20X3 … 1.12.20X3. Consider, there are only 11 orders following the initial one and no purchase is made in advance. DR Purchase..................... 112,000.00 EUR DR VAT.......................... 22,400.00 EUR CR Cash/ Bank.................... 134,400.00 EUR The rent is paid in the middle of the year. According to the offer, rent is 35.00 EUR/ (m × location) per month and location. The total rent for the Accounting period 20X3 is: 56 × 35 × 12 = 2 23,520.00 EUR. Rent is not subjected to VAT. (19) Payment of rent on 30.06.20X3. DR Rent......................... 23,520.00 EUR CR Cash/ Bank.................... 23,520.00 EUR SNACKY TICKY Ltd. sells snacks at a gross selling price of 180 % of costs (of purchase). SNACKY TICKY Ltd.’s revenue during each month and per location is amounting to: 2,000 × 180% = 3 3,600.00 EUR/ m. During the first month, SNACKY- TICKY only sells 80 % of the snacks purchased to build up the safety stock. Therefore, the purchases in January exceed the following months' ones. The revenue is constant over the whole Accounting period 20X3. <?page no="513"?> Berkau: Basics of Accounting 6e 33-513 The level of stock remains constant after January 20X3. The total of annual sales is recorded on 1.07.20X3 to keep the case study simple: 3,600 × 12 × 56 = 22,419,200.00 EUR. (20) Sale of snacks at a net selling price of: 2,419,200 / 120% = 2 2,016,000.00 EUR is recorded on 31.12.20X3. DR Cash/ Bank.................... 2,419,200.00 EUR CR VAT.......................... 403,200.00 EUR CR Sales........................ 2,016,000.00 EUR SNACKY-TICKY Ltd.’s writes-off the vending machines following straight-line method over their useful life of 5 years. Annual depreciation is: 56 × 12,800 / 5 = 143,360.00 EUR. No residual value is considered for the vending machines. (21) Depreciation on vending machines on 31.12.20X3. DR Depreciation ................. 143,360.00 EUR CR Accumulated Depreciation..... 143,360.00 EUR The Accountant of SNACKY-TICKY Ltd. balances-off all accounts and prepares the trial balance. Observe in the following Figure 33.16 and Figure 33.17 the accounts of SNACKY-TICKY Ltd. and its trial balance. D C D C (1) 1,000,000.00 (3) 860,160.00 (2) 1,000,000.00 (1) 1,000,000.00 (4) 50,000.00 (5) 3,000.00 (20) 2,419,200.00 (6) 50,000.00 (7) 168,000.00 (8) 134,400.00 (9) 134,400.00 (10) 134,400.00 (11) 134,400.00 (12) 134,400.00 (13) 134,400.00 (14) 134,400.00 (15) 134,400.00 (16) 134,400.00 (17) 134,400.00 (18) 134,400.00 (19) 23,520.00 c/ d 886,120.00 3,469,200.00 3,469,200.00 b/ d 886,120.00 Cash/ Bank C/ B Application and allotment AAA Figure 33.16: SNACKY-TICKY Ltd.’s accounts <?page no="514"?> Berkau: Basics of Accounting 6e 33-514 D C D C c/ d 1,000,000.00 (2) 1,000,000.00 (3) 716,800.00 c/ d 716,800.00 b/ d 1,000,000.00 b/ d 716,800.00 Share capital ISS Property, plant, equipment PPE D C D C (3) 143,360.00 (20) 403,200.00 (7) 140,000.00 (7) 28,000.00 (8) 112,000.00 (8) 22,400.00 (9) 112,000.00 (9) 22,400.00 (10) 112,000.00 (10) 22,400.00 (11) 112,000.00 (11) 22,400.00 (12) 112,000.00 (12) 22,400.00 (13) 112,000.00 (13) 22,400.00 (14) 112,000.00 (14) 22,400.00 (15) 112,000.00 (15) 22,400.00 (16) 112,000.00 (16) 22,400.00 (17) 112,000.00 (17) 22,400.00 (18) 112,000.00 c/ d 1,372,000.00 (18) 22,400.00 c/ d 14,560.00 1,372,000.00 1,372,000.00 417,760.00 417,760.00 b/ d 1,372,000.00 b/ d 14,560.00 Value added tax VAT Purchase-20X3 PUR D C D C (6) 50,000.00 (4) 50,000.00 (5) 3,000.00 c/ d 3,000.00 b/ d 3,000.00 D C D C (19) 23,520.00 c/ d 23,520.00 c/ d 2,016,000.00 (20) 2,016,000.00 b/ d 23,520.00 b/ d 2,016,000.00 D C D C (21) 143,360.00 c/ d 143,360.00 c/ d 143,360.00 (21) 143,360.00 b/ d 143,360.00 b/ d 143,360.00 Depreciation-20X3 DPR Accumulated depreciation ACC Short-term liabilities A/ P Interest-20X3 INT Rent-20X3 RNT Sales-20X3 REV Figure 33.16: SNACKY-TICKY Ltd.’s accounts (continued) <?page no="515"?> Berkau: Basics of Accounting 6e 33-515 Account Debit entries Credit entries Cash/ Bank C/ B 886,120.00 Applicants and Allotment AAA 0.00 0.00 Share Capital ISS 1,000,000.00 Property, Plant, Equipment PPE 716,800.00 VAlue added tax VAT 14,560.00 Purchase-20X3 PUR 1,372,000.00 Short-term Liabilities-A/ P 0.00 0.00 Interest-20X3 INT 3,000.00 Rent-20X3 RNT 23,520.00 Sales-20X3 REV 2,016,000.00 Depreciation-20X3 DPR 143,360.00 Accumulated Depreciation ACC 143,360.00 Total: 3,159,360.00 3,159,360.00 Snacky-Ticky Ltd. TRIAL BALANCE as at 31.12.20X3 Figure 33.17: SNACKY-TICKY Ltd.’s trial balance 33.12 Profit and Loss Calculation (C/ S SNACKY-TICKY Ltd.) The Accountant makes the following adjustments at the end of the Accounting period 20X3: The profit calculation follows a periodic inventory movement system. At the end of the Accounting period 20X3, the stock’s value is: 56 × 500 = 2 28,000.00 EUR. The amount is transferred to the Trading account. DR Inventory.................... 28,000.00 EUR CR Trading Account.............. 28,000.00 EUR The gross profit is calculated in the Trading account. DR Trading Account.............. 1,372,000.00 EUR CR Purchase..................... 1,372,000.00 EUR DR Sales........................ 2,016,000.00 EUR CR Trading Account.............. 2,016,000.00 EUR The gross profit earned in 20X3 by SNACKY-TICKY Ltd. is amounting to: 2,016,000 - (1,372,000 - 28,000) = 672,000.00 EUR. The Trading account is closed-off to the Profit and Loss account. DR Trading Account.............. 672,000.00 EUR CR Profit and Loss.............. 672,000.00 EUR <?page no="516"?> Berkau: Basics of Accounting 6e 33-516 Calculating the profit, we debit interest, rent and depreciation to the Profit and Loss account. Observe the calculation below: DR Profit and Loss.............. 3,000.00 EUR CR Interest..................... 3,000.00 EUR DR Profit and Loss.............. 23,520.00 EUR CR Rent......................... 23,520.00 EUR DR Profit and Loss.............. 143,360.00 EUR CR Depreciation................. 143,360.00 EUR The pre-tax profit equals: 672,000 - 3,000 - 23,520 - 143,360 = 5 502,120.00 EUR. As legal entity, SNACKY-TICKY Ltd. must pay income taxes. The total income tax rate in this textbook is 30 %. The income tax liabilities are amounting to: 502,120 × 30% = 1 150,636.00 EUR. The remaining value is: 502,120 - 150,636 = 3 351,484.00 EUR and is transferred to the Retained Earnings account. DR Profit and Loss.............. 150,636.00 EUR CR Income Tax Liabilities....... 150,636.00 EUR DR Profit and Loss.............. 351,484.00 EUR CR R/ E.......................... 351,484.00 EUR On the annual meeting, SNACKY-TICKY Ltd.’s shareholders agree on a dividend of 0.50 EUR/ share. The total amount of: 0.50 × 100,000 = 5 50,000.00 EUR is transferred to the Shareholder for Dividend account. DR R/ E.......................... 50,000.00 EUR CR Shareholder for Dividend..... 50,000.00 EUR Based on the shareholders’ decision the amount of 200,000.00 EUR is transferred to the Earnings Reserves account. DR R/ E.......................... 200,000.00 EUR CR Earnings Reserves............ 200,000.00 EUR The remainder is carried forward to the next Accounting period 20X4. It equals: 351,484 - 50,000 - 200,000 = 101,484.00 EUR. Check SNACKY-TICKY Ltd.’s accounts as displayed in Figure 33.18. <?page no="517"?> Berkau: Basics of Accounting 6e 33-517 D C D C (1) 1,000,000.00 (3) 860,160.00 (2) 1,000,000.00 (1) 1,000,000.00 (4) 50,000.00 (5) 3,000.00 (20) 2,419,200.00 (6) 50,000.00 (7) 168,000.00 (8) 134,400.00 (9) 134,400.00 (10) 134,400.00 (11) 134,400.00 (12) 134,400.00 (13) 134,400.00 (14) 134,400.00 (15) 134,400.00 (16) 134,400.00 (17) 134,400.00 (18) 134,400.00 (19) 23,520.00 c/ d 886,120.00 3,469,200.00 3,469,200.00 b/ d 886,120.00 D C D C c/ d 1,000,000.00 (2) 1,000,000.00 (3) 716,800.00 c/ d 716,800.00 b/ d 1,000,000.00 b/ d 716,800.00 D C D C (3) 143,360.00 (20) 403,200.00 (7) 140,000.00 (7) 28,000.00 (8) 112,000.00 (8) 22,400.00 (9) 112,000.00 (9) 22,400.00 (10) 112,000.00 (10) 22,400.00 (11) 112,000.00 (11) 22,400.00 (12) 112,000.00 (12) 22,400.00 (13) 112,000.00 (13) 22,400.00 (14) 112,000.00 (14) 22,400.00 (15) 112,000.00 (15) 22,400.00 (16) 112,000.00 (16) 22,400.00 (17) 112,000.00 (17) 22,400.00 (18) 112,000.00 c/ d 1,372,000.00 (18) 22,400.00 c/ d 14,560.00 1,372,000.00 1,372,000.00 417,760.00 417,760.00 b/ d 1,372,000.00 T/ A 1,372,000.00 b/ d 14,560.00 Cash/ Bank C/ B Application and allotment AAA Value added tax VAT Purchase-20X3 PUR Share capital ISS Property, plant, equipment PPE Figure 33.18: SNACKY-TICKY Ltd.’s accounts <?page no="518"?> Berkau: Basics of Accounting 6e 33-518 D C D C (6) 50,000.00 (4) 50,000.00 (5) 3,000.00 c/ d 3,000.00 b/ d 3,000.00 P&L 3,000.00 Short-term liabilities A/ P Interest-20X3 INT D C D C (19) 23,520.00 c/ d 23,520.00 c/ d 2,016,000.00 (20) 2,016,000.00 b/ d 23,520.00 P&L 23,520.00 T/ A 2,016,000.00 b/ d 2,016,000.00 D C D C (21) 143,360.00 c/ d 143,360.00 c/ d 143,360.00 (21) 143,360.00 b/ d 143,360.00 P&L 143,360.00 b/ d 143,360.00 D C D C PUR 1,372,000.00 INV 28,000.00 T/ A 28,000.00 c/ d 28,000.00 GP 672,000.00 REV 2,016,000.00 b/ d 28,000.00 2,044,000.00 2,044,000.00 P&L 672,000.00 b/ d 672,000.00 Depreciation-20X3 DPR Accumulated depreciation ACC Rent-20X3 RNT Sales-20X3 REV Trading account-20X3 T/ A Inventory-20X3 INV D C D C INT 3,000.00 T/ A 672,000.00 c/ d 150,636.00 P&L 150,636.00 RNT 23,520.00 b/ d 150,636.00 DPR 143,360.00 EBT 502,120.00 672,000.00 672,000.00 ITL 150,636.00 b/ d 502,120.00 R/ E 351,484.00 502,120.00 502,120.00 D C D C ShD 50,000.00 P&L 351,484.00 c/ d 50,000.00 P&L 50,000.00 RES 200,000.00 b/ d 50,000.00 c/ d 101,484.00 351,484.00 351,484.00 b/ d 101,484.00 Profit and Loss-20X3 P&L Income tax liabilities ITL Retained earnings R/ E Shareholders for dividend (ShD) Figure 33.18: SNACKY-TICKY Ltd.’s accounts (continued) <?page no="519"?> Berkau: Basics of Accounting 6e 33-519 D C c/ d 200,000.00 R/ E 200,000.00 b/ d 200,000.00 Earnings reserves RES Figure 33.18: SNACKY-TICKY Ltd.’s accounts (continued) The adjusted trial balance after appropriation of profits is shown in Figure 33.19. Account Debit entries Credit entries Cash/ Bank C/ B 886,120.00 Applicants and Allotment AAA 0.00 0.00 Share Capital ISS 1,000,000.00 Property, Plant, Equipment PPE 716,800.00 Value added tax VAT 14,560.00 Purchase-20X3 PUR 0.00 Short-term Liabilities A/ P 0.00 0.00 Interest-20X3 INT 0.00 Rent-20X3 RNT 0.00 0.00 Sales-20X3 REV 0.00 0.00 Depreciation-20X3 DPR 0.00 0.00 Accumulated Depreciation ACC 143,360.00 Inventory INV 28,000.00 Retained Earnings R/ E 101,484.00 Income Tax Liabilities ITL 150,636.00 Earnings Reserves RES 200,000.00 Shareholders for Dividend (A/ P) 50,000.00 Total: 1,645,480.00 1,645,480.00 Snacky-Ticky Ltd. TRIAL BALANCE as at 31.12.20X3 Figure 33.19: SNACKY-TICKY Ltd.’s adjusted trial balance As public company, SNACKY-TICKY Ltd. must publish a full set of financial statements in compliance with IAS 1 which contains a statement of financial position, a statement of profit or loss and comprehensive income, a statement of cash flows and a statement of changes in equity. See the Figures 33.20 to 33.23. Note, we do not prepare notes for this case study. 16 16 Notes are discussed in chapter (6) of our textbook Bilanzen/ Financial Statements. <?page no="520"?> Berkau: Basics of Accounting 6e 33-520 A C, L Non-current assets [EUR] Equity [EUR] P, P, E 573,440.00 Share capital 1,000,000.00 Intangibles Reserves 200,000.00 Financial assets R/ E 101,484.00 Current assets Liabilities Inventory 28,000.00 Interest bear liab 0.00 A/ R 14,560.00 A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 886,120.00 Tax liabilities 150,636.00 1,502,120.00 1,502,120.00 Snacky-Ticky Ltd. STATEMENT of FINANCIAL POSITION as at 31.12.20X3 Figure 33.20: SNACKY-TICKY Ltd.’s statement of financial position The value for property, plant and equipment equals: 716,800 - 143,360 = 573,440.00 EUR. The accounts receivable result from the claim on input-VAT. [EUR] Revenue 2,016,000.00 Other income 2,016,000.00 Materials (1,344,000.00) Labour Depreciation (143,360.00) Other expenses (23,520.00) Earnings before int and taxes (EBIT) 505,120.00 Interest (3,000.00) Earnings before taxes (EBT) 502,120.00 Income tax expenses (150,636.00) Deferred taxes Earnings after taxes (EAT) 351,484.00 SNACKY-TICKY Ltd. STATEMENT of PROFIT and LOSS and OTHER COMPREHENSIVE INCOME for the year ended 31.12.20X3 Figure 33.21: SNACKY-TICKY Ltd.’s income statement The calculation of the cash flows follows the direct method. <?page no="521"?> Berkau: Basics of Accounting 6e 33-521 Cash flow from operating acitivities [EUR] [EUR] Materials bought (1,646,400.00) Sales 2,419,200.00 Rent (23,520.00) 749,280.00 Cash flow from investing activities Investments (860,160.00) (860,160.00) Cash flow from financing activities Share issue 1,000,000.00 Bank loan received 50,000.00 Interest (3,000.00) Pay-off (50,000.00) 997,000.00 886,120.00 Snacky-Ticky Ltd. STATEMENT of CASH FLOWS for the period ended 31.12.20X3 Figure 33.22: SNACKY-TICKY Ltd.’s statement of cash flows Share capital Reserves R/ E total as at 1.01.20X3 1,000,000.00 0.00 0.00 1,000,000.00 Profit 20X3 351,484.00 351,484.00 Dividend 20X3 (50,000.00) (50,000.00) Reserves 200,000.00 (200,000.00) 0.00 as at 31.12.20X3 1,000,000.00 200,000.00 101,484.00 1,301,484.00 Snacky-Ticky Ltd. STATEMENT of CHANGES in EQUITY as at 31.12.20X3 Figure 33.23: SNACKY-TICKY Ltd.’s statement of changes in equity In case the shareholder Julia Saldanha wants to valuate her fortune, she adds the book value of her shares and her dividend income. She owns: 2,635 × ((1,301,484 / 100,000) + 0.50) = 35,611.60 EUR. 33.13 Summary Companies can operate under different legal forms. The legal form has consequences on the liability of the owners, tax payments and the appropriation of profits. We observed a similar business of a tuck shop as a sole trader, a partnership and a public com- <?page no="522"?> Berkau: Basics of Accounting 6e 33-522 pany. The public company is a legal entity and thus must pay income taxes and prepare financial statements following IFRSs. 33.14 Working Definitions Company Based on Shares: A company based on shares is in ownership of the shareholders who are liable for their company only to their shares’ value. Par Value Share Issue: A par value share issue is a share issue at the nominal amount of the shares. Partnership: A partnership is a company owned by more than one proprietor who are jointly reliable for their company. Public Company: A public company is a company based on shares of which everyone (the public) can buy shares from. Registration for VAT Reduction: A registration for VAT reduction means setting a tax characteristic in the database of the revenue service which enables the taxpayer to deduct input-VAT from purchases and acquisitions and obliges her/ him to collect output- VAT from customers and pay it to the revenue service. Sole proprietorship: A sole proprietorships is a company that is owned by a single private person and does not form a legal entity. Underand over Subscription: Under-subscription of shares happens when less shares are applied for than offered. Over-subscription is a share issue with more applicants than share offers. 33.15 Question Bank (1) Which statement is wrong? 1. A sole proprietorship is in ownership of one private person. Its activities are limited to trading. The person is reliable with all her/ his personal assets for the company. 2. A sole proprietorship is in ownership of one private person. The person is reliable with all her/ his personal assets for the company. The tax liability is with the owner. 3. A sole proprietorship is in ownership of one private person. The person is reliable with all her/ his personal assets for the company. Increases of the company’s value are taxable profit for the owner. 4. A sole proprietorship is in ownership of one private person. The person is reliable with all her/ his personal assets for the company. The establishment does not require legal action. (2) A partnership has 3 partners (A / B / C) who contributed 30,000.00 EUR / 20,000.00 EUR and 25,000.00 EUR. The partnership is in debts and cannot pay-off its liabilities of 40,000.00 EUR from a bank loan. 1. The bank can sue A for a payment of max 25,000.00 EUR. 2. The bank can sue A for a payment of max 30,000.00 EUR. 3. The bank can sue A for a payment of max 40,000.00 EUR. 4. The bank cannot sue A for a payment at all. <?page no="523"?> Berkau: Basics of Accounting 6e 33-523 (3) Which statement is wrong? 1. A company based on shares must prepare financial statements. 2. For the establishment of a limited company the owners must pay their contribution. 3. A partnership comes with joint liability of the partners. 4. A sole proprietorship must prepare a balance sheet and an income statement. (4) A limited company has 3 shareholders (A, B, C) who hold 50 % and 25 % and 25 % percent of the shares. The company earns a cash profit of 40,000.00 EUR before taxation and declares to pay 50 % thereof to the shareholders. Which statement is correct? 1. A receives a dividend of 14,000.00 EUR. 2. A receives a dividend of 7,000.00 EUR. 3. A receives a dividend of 10,000.00 EUR. 4. A receives a dividend of 20,000.00 EUR. (5) Which statement is correct? 1. A partnership pays 30 % income tax on its profits. 2. A partner must make a drawing for the payments of income taxes. 3. A partnership does not pay income tax on its profits. 4. The partners of a partnership must pay-in the income taxes for their company into the partnership’s bank account. 33.16 Solutions 1-1; 2-3; 3-4; 4-2; 5-3. <?page no="524"?> Berkau: Basics of Accounting 6e 34-524 34 Liquidations 34.1 What is in the Chapter? Liquidations are not ruled by the International Accounting Standards IFRSs. We introduce in this chapter how to dissolve a company which is referred to as a liquidation. A liquidation are all business activities of selling all assets and paying-off all debts in order to terminate the company. In general, we classify assets following their ability to be sold or exchanged. The easiest transferrable assets are items of cash/ bank which is why we regard them as "liquid". Therefore, the liquidation procedure includes the transfer of assets to cash: selling them. For a complete liquidation of a company, we must sell all its assets. The cash is be used to settle liabilities and in case there is still money left, this belongs to the owners. If a company is sold completely as a whole with the new owners continuing its operations, no liquidation takes place. If someone takes-over, e.g., Lufthansa AG as a company, and continues the flight operations, no liquidation took place. In contrast, if Lufthansa sells all its aircrafts and the company gets dissolved thereafter, a liquidation takes place. As we see, a liquidation requires selling all assets after which the company does not exist anymore. In this chapter, we introduce the procedure for a liquidation. We explain the Bookkeeping entries made by the case of MOSSEL SPORTS. Note, not all companies that are liquidated are bankrupt. Liquidation only means to dissolve the company for whatever reasons. Limited and public companies require taking legal actions for closing-down (not covered in this textbook). 34.2 Learning Objectives We discuss liquidations from the Accounting point of view. After studying this chapter, you developed an understanding for liquidations, and you can understand and make Bookkeeping entries on the level of academic case studies. You learn about the application of the Liquidation account. 34.3 Reasons for Liquidations Liquidations are required if the business operations are no longer continued. Assets are taken out of service and most probably sold or discarded. In general, the company cease to exist after its liquidation. This does not always mean the business must file for bankruptcy, it also can happen that, e.g., a partnership is dissolved, because one or more owners withdraw their funds, maybe because of a disagreement between partners or to buy another business. Or, e.g., the owners liquidate their firm because they intend to relocate. Bankruptcy means a business must close-down, because debts exceed its equity (Accounting insolvency) or it becomes unable to make payments (illiquidity). <?page no="525"?> Berkau: Basics of Accounting 6e 34-525 34.4 Liquidation Procedures In Accounting, the characteristic liquid means, that an asset is easy to exchange. E.g., cash or shares are more liquid than a digging machine. The expression liquid actually is slang, but the word liquidation made it to a commonly accepted Accounting technical term. A liquidation of a business requires converting all assets to cash. Cash is seen as the easiest exchangeable asset. It is often unavoidable to terminate business operations before liquidating a firm, otherwise assets cannot be sold. The liquidation procedures are different once legal action is taken due to bankruptcy. In that case, a business rescuer or an insolvency advisor takes matters in her/ his hand to minimise damage and to protect the interest of all creditors and further involved parties. We assume, a business is overindebted. In that case it would be unfair if the CEO pays its employee and only thereafter informs its creditors about the Accounting insolvency. That would mean to prioritise the employee by withholding debt re-payments from the other creditors. This is, why an insolvency advisor takes matters in her/ his hand. In almost all cases, a liquidation leads to the sale of (all) assets of a business. After selling assets, cash generated from the liquidation is used to retire the liabilities. Note, this involves transaction costs, like fees/ penalties, which we ignore for this textbook following our conventions in chapter (1). The remainder of assets after settlement of liabilities is shared among owners and is referred to as the profit on liquidation. The memorandum of incorporation determines how owners distribute liquidation profits, in general proportional to the share of ownership. How it is Done (Liquidation): (1) After the decision for liquidation has been made stop all ordinary business operations. (2) Sell all assets preferably on cash. (3) Settle all outstanding liabilities by payments. (4) In case the cash/ bank item thereafter exceeds liabilities, distribute the remaining amount to the owners according to their share of the business. In case cash/ bank item is not sufficient for settlement of liabilities, the company must file for bankruptcy. (5) In general, preference shareholders are prioritised with regard to the pecking order of distribution amongst shareholders. Next, we observe a liquidation where the owner closes down his business as his personal plans have changed. No bankruptcy applies. 34.5 C/ S MOSSEL SPORTS MOSSEL SPORTS is a gym. The company is privately-owned by Marco Mossel and is not registered for VAT reduction. <?page no="526"?> Berkau: Basics of Accounting 6e 34-526 MOSSEL SPORTS voluntarily prepares a statement of financial position as shown below in Figure 34.1: A C, L Non-current assets [EUR] Equity [EUR] P, P, E 120,000.00 Owner's capital 120,000.00 Intangibles R/ E 35,000.00 Financial assets Current assets Liabilities Inventory Interest bear liab 15,000.00 A/ R 10,000.00 A/ P 50,000.00 Prepaid expenses Provisions Cash/ Bank 90,000.00 220,000.00 220,000.00 MOSSEL SPORTS STATEMENT of FINANCIAL POSITION as at 1.01.20X5 Figure 34.1: MOSSEL SPORTS’ statement of financial position The value for property, plant and equipment on the balance sheet results from treadmills bought on 3.01.20X1 and written-off by an annual depreciation of 20,000.00 EUR/ a. Their carrying value equals: 200,000 - 20,000 - 20,000 - 20,000 - 20,000 = 1 120,000.00 EUR. The balancing figure in the Property, Plant and Equipment account is 200,000.00 EUR and the balance of the Accumulated Depreciation account is 80,000.00 EUR. The receivables result from claims against customers who must still pay their annual membership fees for 20X5. MOSSEL SPORTS' equity contains the owner’s contribution at the time of incorporation plus reinvested earnings. The amount in the Retained Earnings account is its last year’s profit. Figure 34.3 displays the accounts for MOSSEL SPORTS. D C D C OV 200,000.00 OV 80,000.00 D C D C OV 10,000.00 OV 90,000.00 Property, plant, equipment PPE Accumulated depreciation ACC Accounts receivables A/ R Cash/ Bank C/ B D C D C OV 120,000.00 OV 35,000.00 Owner's capital OWC Retaines earnings R/ E Figure 34.2: MOSSEL SPORTS’ accounts <?page no="527"?> Berkau: Basics of Accounting 6e 34-527 D C D C OV 15,000.00 OV 50,000.00 Interest bearing liabilities IBL Accounts payables A/ P Figure 35.2: MOSSEL SPORTS’ accounts (continued) The owner of MOSSEL SPORTS wants to close down his gym, grab the money and to start-over with buying a scuba diving school in Mauritius. The company is to be liquidated at the earliest day possible in 20X5. We describe the liquidation Bookkeeping entries below. We apply the Liquidation account. The Liquidation account is a temporary account for recording all liquidation activities. In the end, all accounts are closed-off to the Liquidation account and, as a result, the company does not exist any longer. No further legal actions are necessary as the owner runs his gym as a sole proprietor. The date for MOSSEL SPORTS’ liquidation is 3.01.20X5. No operations are continued after that day. MOSSEL SPORTS sells its treadmills carried at a value of 120,000.00 EUR for 105,000.00 EUR. All payables are settled completely. The bank loan is paid-off, too. All outstanding exercising fees (A/ R) are claimed from the customers. They are collected to an extent of 80 %. MOSSEL SPORTS does not go after the customers with outstanding fees, because the effort exceeds the uncertain outcome. Marco Mossel writes the receivables off as bad debts. Bad debts are receivables that a business most probably cannot collect. Writing-off receivables as bad debts means to consider them as expenses and to record them through the Profit and Loss account. We close-off the remainder of receivables to the Bad Debts account. The Bad Debts account later is closed-off to the Profit and Loss account. At the time of liquidation on 3.01.20X5, the owner (Marco Mossel) records the Bookkeeping entries below, all interlinked with the Liquidation account. The Bookkeeping entries for the liquidation and the profit or loss resulting therefrom are made separately. The difference between the settlement value and carrying value results in either a loss or a profit on liquidation. (1a,1b) Disposal of treadmills on 3.01.20X5 at 105,000.00 EUR leads to a loss on liquidation. DR Accumulated Depreciation..... 80,000.00 EUR DR Liquidation .................. 120,000.00 EUR CR P, P, E Account.............. 200,000.00 EUR <?page no="528"?> Berkau: Basics of Accounting 6e 34-528 DR Cash/ Bank.................... 105,000.00 EUR DR Loss on Disposal............. 15,000.00 EUR CR Liquidation.................. 120,000.00 EUR (2a, 2b) Dissolving the Accounts Receivables account on 3.01.20X5 with cash receipt from clients. The payment from clients is not sufficient to cover the receivables. This results in a loss on settlement; we record bad debts. DR Liquidation.................. 10,000.00 EUR CR Accounts Receivables......... 10,000.00 EUR DR Cash/ Bank.................... 8,000.00 EUR DR Loss on Settlement........... 2,000.00 EUR CR Liquidation.................. 10,000.00 EUR Note, if MOSSEL SPORTS was VAT registered, the bad debts would become VAT relevant: an output-VAT reduction, recorded as input VAT, would be recorded. On the other side (of the balance sheet), MOSSEL SPORTS settles its liabilities to their full settlement amount. (3) Settlement of the bank loan liabilities on 3.01.20X5. DR Interest Bearing Liabilities. 15,000.00 EUR CR Cash/ Bank.................... 15,000.00 EUR (4) Settlement of outstanding payables on 3.01.20X5. DR Accounts Payables............ 50,000.00 EUR CR Cash/ Bank.................... 50,000.00 EUR To analyse the situation at MOSSEL SPORTS, we look at the accounts after recording the Bookkeeping entries. See Figure 34.3: D C D C OV 200,000.00 (1a) 200,000.00 (1a) 80,000.00 OV 80,000.00 D C D C OV 10,000.00 (2a) 10,000.00 OV 90,000.00 (3) 15,000.00 (1b) 105,000.00 (4) 50,000.00 (2b) 8,000.00 c/ d 138,000.00 203,000.00 203,000.00 b/ d 138,000.00 Accounts receivables A/ R Cash/ Bank C/ B Property, plant, equipment PPE Accumulated depreciation ACC Figure 34.3: MOSSEL SPORTS’ accounts <?page no="529"?> Berkau: Basics of Accounting 6e 34-529 D C D C OV 120,000.00 OV 35,000.00 D C D C (3) 15,000.00 OV 15,000.00 (4) 50,000.00 OV 50,000.00 D C D C (1a) 120,000.00 (1b) 120,000.00 (1b) 15,000.00 (2a) 10,000.00 (2b) 10,000.00 130,000.00 130,000.00 D C (2b) 2,000.00 Loss on settlement-20X5 LSM Owner's capital OWC Retained earnings R/ E Interest bearing liabilities IBL Accounts payables A/ P Liquidation-20X5 LQD Loss on sale-20X5 LOS Figure 34.3: MOSSEL SPORTS’ accounts (continued) At this stage of the liquidation procedure, the balance of the Cash/ Bank account is 138,000.00 EUR. This is the amount which is transferable to the owner. Marco Mossel acknowledges that this amount is lower than the previous book value of his gym. The difference is amounting to: 155,000 - 138,000 = 1 17,000.00 EUR. Therefore, the liquidation of MOSSEL SPORTS is a loss. The total of MOSSEL SPORTS equity equates the total of owner’s capital and retained earnings minus the loss on disposals and settlements. It gives: 120,000 + 35,000 - 15,000 - 2,000 = 1 138,000.00 EUR. (5) The final liquidation Bookkeeping entry is made on 3.01.20X5 by closing-off the Liquidation account to cash/ bank. DR Owner’s Capital.............. 120,000.00 EUR DR Retained Earnings............ 35,000.00 EUR CR Loss on Disposal............. 15,000.00 EUR CR Loss on Settlement........... 2,000.00 EUR CR Cash/ Bank.................... 138,000.00 EUR The credit entry in the Cash/ Bank account shows, that Marco Mossel withdraws 138,000.00 EUR. Observe in Figure 34.4 all accounts being balancedand closed-off after the liquidation process is completed. <?page no="530"?> Berkau: Basics of Accounting 6e 34-530 D C D C OV 200,000.00 (1a) 200,000.00 (1a) 80,000.00 OV 80,000.00 D C D C OV 10,000.00 (2a) 10,000.00 OV 90,000.00 (3) 15,000.00 (1b) 105,000.00 (4) 50,000.00 (2b) 8,000.00 c/ d 138,000.00 203,000.00 203,000.00 b/ d 138,000.00 (5) 138,000.00 D C D C (5) 120,000.00 OV 120,000.00 (5) 35,000.00 OV 35,000.00 D C D C (3) 15,000.00 OV 15,000.00 (4) 50,000.00 OV 50,000.00 D C D C (1a) 120,000.00 (1b) 120,000.00 (1b) 15,000.00 (5) 15,000.00 (2a) 10,000.00 (2b) 10,000.00 130,000.00 130,000.00 D C (2b) 2,000.00 (5) 2,000.00 Property, plant, equipment PPE Accumulated depreciation ACC Loss on settlement-20X5 LSM Owner's capital OWC Retained earnings R/ E Interest bearing liabilities IBL Accounts payables A/ P Accounts receivables A/ R Cash/ Bank C/ B Liquidation-20X5 LQD Loss on disposal-20X5 LOD Figure 34.4: MOSSEL SPORTS’ accounts At this time, MOSSEL SPORTS does not exist anymore. Marco Mossel has 138,000.00 EUR on cash that he can take to start-over with his new life as a scuba diving instructor in Mauritius. 34.6 Tax Implication for a Profit on Liquidation In cases a company sells its assets with a profit, it generates taxable income and must record the profit on disposal through the Profit and Loss account. Income tax liabilities must be settled as part of the liquidation procedure. 34.7 Alternative End for the C/ S MOSSEL SPORTS Next, we assume MOSSEL SPORTS is liquidated as before. However, as alteration of the case study, the treadmills now are sold at 124,000.00 EUR (in the previous case, the selling price was only 105,000.00 EUR). Furthermore, we change the money collected from customers to be 7,500.00 EUR (in the previous case, the settlement amount was 8,000.00 EUR). Based on these data, the <?page no="531"?> Berkau: Basics of Accounting 6e 34-531 profit on liquidation for the treadmills exceeds the loss on disposal for bad debts. Therefore, Bookkeeping entries 1b and 2b would be as below: DR Cash/ Bank.................... 124,000.00 EUR CR Profit on Disposal........... 4,000.00 EUR CR Liquidation .................. 120,000.00 EUR DR Cash/ Bank.................... 7,500.00 EUR DR Loss on Disposal............. 2,500.00 EUR CR Liquidation .................. 10,000.00 EUR This alternative end of the case study leads to the accounts’ balances as below in Figure 34.5: D C D C OV 200,000.00 (1a) 200,000.00 (1a) 80,000.00 OV 80,000.00 D C D C OV 10,000.00 (2a) 10,000.00 OV 90,000.00 (3) 15,000.00 (1b) 124,000.00 (4) 50,000.00 (2b) 7,500.00 c/ d 156,500.00 221,500.00 221,500.00 b/ d 156,500.00 (5) 450.00 c/ d 156,050.00 156,500.00 156,500.00 b/ d 156,050.00 (6) 156,050.00 D C D C (6) 120,000.00 OV 120,000.00 c/ d 35,000.00 OV 35,000.00 (6) 36,050.00 b/ d 35,000.00 P&L 1,050.00 36,050.00 36,050.00 Property, plant, equipment PPE Accumulated depreciation ACC Owner's capital OWC Retained earnings R/ E Accounts receivables A/ R Cash/ Bank C/ B D C D C (3) 15,000.00 OV 15,000.00 (4) 50,000.00 OV 50,000.00 Interest bearing liabilities IBL Accounts payables A/ P Figure 34.5: MOSSEL SPORTS accounts in case of profit on asset sale <?page no="532"?> Berkau: Basics of Accounting 6e 34-532 D C D C (1a) 120,000.00 (1b) 120,000.00 c/ d 4,000.00 (1b) 4,000.00 (2a) 10,000.00 (2b) 10,000.00 P&L 4,000.00 b/ d 4,000.00 130,000.00 130,000.00 D C D C (2b) 2,500.00 c/ d 2,500.00 LSM 2,500.00 POD 4,000.00 b/ d 2,500.00 P&L 2,500.00 b/ d 1,500.00 4,000.00 4,000.00 ITL 450.00 b/ d 1,500.00 R/ E 1,050.00 1,500.00 1,500.00 D C (5) 450.00 P&L 450.00 Income tax liabilities ITL Loss on settlement-20X5 LSM Profit and Loss-20X5 P&L Liquidation-20X5 LQD Profit on disposal-20X5 POD Figure 34.5: MOSSEL SPORTS accounts in case of profit on asset sale (continued) With this alternative end of the case study, the profit resulting from sales and settlement would be positive and taxable. The income tax liabilities would be due and are paid as part of the liquidation procedures. We pretend MOSSEL SPORTS is a limited company and would pay income taxes straight away. (In reality, the gym is privately-owned, and Marco Mossel pays taxes on the profit on liquidation based on his personal income tax rate.) The Bookkeeping entry (5) is: DR Income Tax Liabilities....... 450.00 EUR CR Cash/ Bank.................... 450.00 EUR The final Bookkeeping entry (6) is: DR Owner’s Capital.............. 120,000.00 EUR DR Retained Earnings............ 36,050.00 EUR CR Cash/ Bank.................... 156,050.00 EUR Now, Marco Mossel moves to Mauritius with more money: 156,050.00 EUR on cash. 34.8 Liquidation of Partnerships and Limited Companies Liquidations of partnerships and of public companies work similar. In contrast to MOSSEL SPORTS, the liquidation of a public company pays an agreed share of the profit (depending <?page no="533"?> Berkau: Basics of Accounting 6e 34-533 on the shares held) to the proprietors/ shareholders based on the regulations signified in the memorandum of corporation. If a company’s liquidation results in negative equity (liabilities cannot be settled) national law applies with regard to the obligation to file for bankruptcy. In this case, the managers of the company are not allowed making settlement payments themselves, to guarantee a fair share of liquidation proceeds to all creditors. In a situation of bankruptcy, shareholders lose their complete interest in the company (the shares are valued at zero), but they are not held liable for the debts of their (former) company. In the event of a liquidation loss, managers or in companies based on shares the CEO and CFO (= chief financial officer) can be held liable for losses, resulting from mistakes/ misconducts provable and usable against them. Even shareholders can sue "their" own managers for losses from losing their shares. Be aware, the common perception that a limited company is always safe for the managers, is wrong. 34.9 Summary Liquidation is the process of dissolving a business. All assets are sold and converted into cash. All debts are paid-off. The difference between liquidation proceeds and settled liabilities is paid to owners - if positive. The amount is most probably below the previous book value of the company because in a liquidation, assets are often sold below their carrying values. We discussed a liquidation of a privately-owned gym that is closed-down due to personal plans of the owner and demonstrated the liquidation procedures based on the Liquidation account. 34.10 Working Definitions Bad Debts: Bad debts are receivables that a business most probably cannot collect. Bankruptcy: Bankruptcy means a business must close-down, because debts exceed its equity (Accounting insolvency) or it becomes unable to make payments (illiquidity). Liquidation: A liquidation are all business activities of selling all assets and paying-off all debts in order to terminate the company. Liquidation Account: The Liquidation account is a temporary account for recording all liquidation activities. 34.11 Question Bank (1) A company based on shares discloses a share capital of 100,000.00 EUR. In the reserves section, there are capital reserves of 30,000.00 EUR and earnings reserves of 20,000.00 EUR. The retained earnings are amounting to 50,000.00 EUR. On the general annual meeting the shareholders declare a dividend of 0.25 EUR/ s. The nominal value per share is 1.00 EUR/ s. The shares are traded at a stock exchange at 2.30 EUR/ s. How much is the book value of the company? 1. 175,000.00 EUR . 2. 100,000.00 EUR . 3. 200,000.00 EUR . 4. 230,000.00 EUR . <?page no="534"?> Berkau: Basics of Accounting 6e 34-534 (2) A company on shares is liquidated. There are 100,000 ordinary shareholders and 50,000 preference shareholders. The nominal value per share is 1.00 EUR/ s. The proceeds from liquidation are 170,000.00 EUR. The company discloses 50,000.00 EUR debts from a bank loan. How much is the liquidation payments per ordinary shareholder? 1. 0.80 EUR/ s . 2. 1.00 EUR/ s . 3. 0.70 EUR/ s . 4. 1.70 EUR/ s . (3) A company carries machines at 50,000.00 EUR and receivables at 10,000.00 EUR. The value of cash is 20,000.00 EUR. The company has a bank loan which is recorded at 20,000.00 EUR. The company is able to sell its non-current assets at 90% of the carrying value and to collect 80% of the receivables. How much are its liquidation proceeds? 1. 45,000.00 EUR . 2. 53,000.00 EUR . 3. 33,000.00 EUR . 4. 40,000.00 EUR . (4) A company records receivables to an extent of 45,000.00 EUR resulting from sales. 40 % of the receivables can be collected. The remainder is written off as bad debts. What it the correct Bookkeeping entry? 1. DR B/ D: 27,000.00 EUR; CR A/ R: 27,000.00 EUR. 2. DR B/ D: 22,500.00 EUR; DR VAT: 4,500.00 EUR; CR A/ R: 27,000.00 EUR. 3. DR B/ D: 37,500.00 EUR; DR VAT: 7,500.00 EUR; CR A/ R: 45,000.00 EUR. 4. DR B/ D: 27,500.00 EUR; CR VAT: 4,500.00 EUR; CR A/ P: 27,000.00 EUR. (5) A courier service is liquidated. Its PPE account shows cars at 240,000.00 EUR which are depreciated to an extent of 60%. The cars are sold at 90 % of their carrying value. The company shows 42,000.00 EUR receivables from customers and 25,000.00 EUR o