Introduction to financial accounting : concepts, cases and exercises [2 ed.] 9788892120068, 8892120069

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Introduction to Financial Accounting Concepts, Cases and Exercises

Simone Domenico Scagnelli Melchior Gromis Di Trana Francesco Venuti

Introduction to Financial Accounting Concepts, Cases and Exercises Second Edition

G. Giappichelli Editore

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ISBN/EAN 9788892181878 (ebook)

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Le fotocopie per uso personale del lettore possono essere effettuate nei limiti del 15% di ciascun volume/ fascicolo di periodico dietro pagamento alla SIAE del compenso previsto dall’art. 68, commi 4 e 5, della legge 22 aprile 1941, n. 633. Le fotocopie effettuate per finalità di carattere professionale, economico o commerciale o comunque per uso diverso da quello personale possono essere effettuate a seguito di specifica autorizzazione rilasciata da CLEARedi, Centro Licenze e Autorizzazioni per le Riproduzioni Editoriali, Corso di Porta Romana 108, 20122 Milano, e-mail [email protected] e sito web www.clearedi.org.

If you want an accounting of your worth, count your friends (M. BROWN, American Athlete 1891-1971)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

VII

Table of Contents

Table of Contents

page

Introduction

1. The accounting system 1. 2. 3. 4. 5. 6. 7.

What to account for? How to account for? The double entry method Where to account for? 3.1. General Ledger book 3.2. Journal book Chart of accounts When to account for? The accounting cycle Financial Statements 7.1. The Balance Sheet 7.2. The Income Statement 7.3. The cash flow statement

XI

1 2 5 10 11 13 15 16 16 18 19 21 22

2. Accounting for ordinary business transactions

25

1.

25 31 33 39 40 45 47 48 49 51

2. 3. 4. 5.

Purchases and sales of goods and services 1.1. VAT and Sales tax 1.2. Purchases and Sales with VAT 1.3. Purchases and sales not liable to VAT Advance payments Discounts Returns Import and export 5.1. Importing goods from the EU 5.2. Importing goods from outside the EU

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Introduction to Financial Accounting. Concepts, Cases and Exercises

page 5.3. Export VAT settlement Payroll Non-Current assets 8.1. Tangible assets 8.1.1. Sale of fixed assets 8.2. Intangible assets 9. Financing 9.1. Loans 9.2. Bonds 9.3. Factoring 9.4. Leases 10. Shareholder’s Equity 10.1. Incorporation of the company 10.2. Issuance of new shares (or common stock)

53 56 58 63 63 67 69 71 71 73 76 77 82 83 85

3. Adjusting and closing entries

87

6. 7. 8.

1. 2.

3. 4.

Trial balance Adjustments 2.1. Accrued revenues and expenses 2.2. Payroll accruals 2.3. Unearned revenue and prepaid expenses 2.4. Inventory 2.5. Depreciation 2.6. Amortization 2.7. Impairment 2.8. Bad Debts 2.9. Commitments, contingencies and provisions Closing entries Advanced operations 4.1. Recognition of net profit (or loss)

88 90 92 97 98 103 110 113 114 115 117 118 120 120

4. Preparing Financial Statements

123

1. 2.

125 128

The Balance Sheet The Income Statement

Table of Contents

IX page

5. Cases and exercises

131

1. 2.

131 138 138 140 144 146 147 151 153 155 159 160 162 166 167 168 169 171 173 175 175 177 178 179 181 184 187 188

3.

4. 5.

Questions and exercises on the Accounting System (chapter 1) Questions and exercises on the Accounting System (chapter 2) 2.1. Purchases and sales 2.2. Purchases with VAT 2.3. Sales with VAT 2.4. Purchases and Sales not liable to VAT 2.5. Advance payment 2.6. Discounts 2.7. Returns 2.8. Import 2.9. Export 2.10. VAT settlement 2.11. Payroll 2.12. Non-Current Assets 2.13. Loans 2.14. Bonds 2.15. Factoring 2.16. Leasing 2.17. Equity Questions and exercises on the Adjusting and closing entries (chapter 3) 3.1. Accrued receivable and accrued payable 3.2. Accrued interest 3.3. Payroll accruals 3.4. Unearned revenues and prepaid expenses 3.5. Inventory 3.6. Depreciation and Amortization 3.7. Bad debs 3.8. Provisions Questions and exercises on the preparation of Financial Statements (chapter 4) Final exercises Case One Case Info Case Alpha Case Tera Case KEY Case Trials Case Kar

189 194 194 194 195 197 198 199 199

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Introduction to Financial Accounting. Concepts, Cases and Exercises

page Case SGV Case Melfra Ltd. Case ABC Factory

201 202 203

Appendix A. Companies’ Cases of Financial Statements

207

1. 2. 3. 4.

208 211 214 217

Fiat Chrysler Automobiles (in € million) Apple Inc. Form 10-K 2018 (in € million) Facebook Inc. (in € million) Auchan (in € million)

References

221

Introduction

This book is designed to provide introductory concepts in Financial Accounting. Accounting can be defined as “the process of identifying, measuring and communicating economic information to permit informed judgments and business decisions by users of the information” 1 and “The provision of Information to managers and owners so that they can make business decisions.” 2. Indeed, in the business field, the success or failure of a company is measured in financial terms, and is recorded and reported using accounting information. Specifically, according to the purpose of the accounting reports, we can define two main categories of “accounting”: – Financial accounting; – Management accounting. Financial accounting is suited to provide general purpose information about the business to external users such as shareholders, banks, creditors, government, suppliers, customers, financial advisors, financial press, financial analysts, etc. To understand the role of financial accounting, consider a large corporation such as Google (Alphabet Inc.). The owners of business organisations can be referred to as shareholders, and Google has several thousand shareholders. Of course, each shareholder cannot participate and is not involved directly in the activity of Google; moreover, because Google needs to maintain trade secrets, its shareholders are not permitted to access such information. Because of this, shareholders delegate most of their decision making power to the board of directors and managers of the corporation. However, shareholders require information to evaluate the performance of the business 1

AMERICAN ACCOUNTING ASSOCIATION, Committee to Prepare a Statement of Basic Accounting: A statement of basic accounting theory, American Accounting Association, Evanston, IL, 1966. 2 WARREN C.S., REEVE J.M. e DUCHAC J., Accounting, 15th, Cengage Learning, Boston, MA, 2017, p. 25.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

and to make decision about retaining their investment or not in the company. Therefore, financial accounting provides some of the information according to such decision making processes; furthermore, potential shareholders who are considering investing into the business may also use this information. Creditors (i.e. banks, bond holders, suppliers, etc.) are another stakeholders’ category that can use financial accounting information to know about the probability of seeing back the money they have lent to the company. Financial accounting will usually provide at least some of the information needed by these “external” decision makers. Therefore, common questions that financial accounting users ask themselves are: – Should I invest money in this business? – Will the business be able to repay money lent to it? – What are the business’s earning prospects? – Is the business financially sound? – How much income tax has been paid? Given the typology of external users that can get useful information from the financial accounting activity, we can see financial accounting as a kind of service activity that can be useful for companies and corporations, partnerships, clubs, associations, the Government and families. On the other hand, Management Accounting (also known as Managerial Accounting) provides information primarily to support internal management’s decision making 3. Managers have to deal with a great amount of decisions which may include for example, whether to purchase new machinery, how much to spend on advertising, research and development, whether to lease or buy equipment and facilities, whether to manufacture or buy component parts for inventory production, or whether to sell a certain product. Therefore, common questions, that management accounting procedures are designed to answer are: – How much profit is being earned? – What products should be produced? – What resources are available? – What is the most efficient production process? – What is the cost to reduce carbon emissions? 3

HORNGREN C.T., Management accounting: this century and beyond, in Management Accounting Research, Vol. 6, 1995, pp. 281-286.

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Introduction

– What will be the effect of increasing or decreasing selling prices? – How much profit is owing to outsiders? – Will cash be available to pay debts as they fall due? – What are benefits of owning vs leasing? Management accounting information is usually more detailed and more tailor-made than financial accounting information. Furthermore, management accounting procedures are proprietary because the information is not disclosed to external parties outside of the company. Although separating between financial and management accounting can be convenient for teaching purposes, practically, the distinction is somewhat blurred. For example, financial accounting provides information about the performance of a company to external users but because this information is essentially a performance’s report on management, indeed managers are interested in and influenced by the process of preparing such type of information. The aim of this book is to provide an introduction to financial accounting procedures with the purpose of understanding the basis of preparation of financial statements. Specifically, the focus will be devoted to the following areas: • Post/journalize transactions; • Prepare Trial balance; • Make Adjustments & Closing; • Preparation of Financial statements. Theoretical discussions are supported by case studies, examples and as well excerpts from real companies’ annual reports. Financial statements’ preparation is discussed according to a common international perspective. Although this book is the outcome of the authors’ collaborative jointwork, Chapters 1 and 2 can be mainly referenced to Simone D. Scagnelli, Chapters 3 and 5 to Melchior Gromis di Trana and Chapter 4 to Francesco Venuti. The objective of this collective work is to support students, faculty, and practitioners in understanding, learning and practising the basics of financial accounting. THE AUTHORS

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Introduction to Financial Accounting. Concepts, Cases and Exercises

1. The accounting system

The main goal of accounting is to measure, record and classify every transaction related to the business activity in order to provide useful information to interested stakeholders. This requires a systematic approach, regardless of whether the recordings are done by hand or by using computers; this approach is what we call the “accounting process” and can be defined by the following steps: 1. identify the business transactions; 2. measure these transactions in monetary terms; 3. record, classify and summarize the data in the accounting books; 4. communicate the information in accounting reports called “financial statements”; 5. interpret and analyse the information provided in the reports in order to support one’s decision-making process. A summary of this process is presented in Exhibit 1. Exhibit 1 – The Accounting Process Identification

Measurement

Recording

Communication

Business Transactions

Quantification in monetary terms

Recording, classification, summarisation

Financial Statements

Decision Making

Analysis and interpretation

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Specifically, this chapter clarifies the accounting process by answering the following questions: – what to account for? – how to account for it? – where to account for it? – when to account for it? Generally speaking, recording and classifying business transactions in a systematic way according to the double-entry method is called “bookkeeping”. Accounting is a broader term than bookkeeping and encompasses bookkeeping procedures. Accounting sets the rules and the principles that have to be used, the procedures that have to be followed in bookkeeping. Bookkeeping is the day-by-day recording and classification of the transactions according to the methods and the principles determined by accounting. The designing of the whole system, the presentation of the financial statements, its analysis and interpretation are all functions of accounting.

1. What to account for? As stated previously, the role of accounting is to systematically record and track business transactions in order to provide information which will be used in the preparation of financial statements (composed by documents such as the balance sheet, the income statement, the statement of cash flow and the notes). Accounting information is expressed and, consequently, recorded in monetary terms. However, there is not a need to account everything that happens in the business activity of a company. Therefore, to understand which business’ transaction should be accounted let us examine the Inputs/Outputs diagram that depicts the relationships between a business entity (i.e. a company) and its environment/market.

3

The accounting system

Exhibit 2 – The company and the market’s exchanges MARKET

INPUTs • Raw materials • Capital • Word force •…

MARKET

GOODs/SERVICEs

GOODs/SERVICEs

Company €

€

OUTPUT • Goods • Service • Innovation •…

Business transactions

In the previous exhibit, the relationships between the company and its markets’ input/outputs show what we can call “business transactions” or “market exchanges”. These transactions involve an exchange of what the company gives and what the company receives from the markets in its business activity. In order to purchase (receive) production elements from the market, a company needs to give (pay) money; on the other hand, a company also needs to collect money in order to sell (give) goods and services to the market 1. Let us take an example about our personal life; in order to take notes during the lectures you need stationary, so you go to your local retailer to purchase a pencil which price is 1,00 Euro. You look into your wallet and with your right hand you take out a 1,00 Euro coin and give it to the retailer, with your left hand you take the pencil. Clearly, an exchange takes place, because if you want the goods you must pay, and specifically, you pay right away. But what happens if you forgot to bring your wallet with you? Let us assume you have known the retailer for many years and, therefore, you take the pencil with your left hand and consequently you say “Tomorrow I will pay and bring you 1 Euro”; from this moment on, you owe money to the retailer, that is what we call “account payable”, in other words, it reminds you that you are committed to giving money to someone. This example can be transferred to the business activity, where companies and other organisations buy and sell “on credit”, which means they do not pay right away for what they purchase, but agree to pay in the future the supplier and, on the other hand, they don’t collect right away the amounts 1

When goods/services are exchanged for other goods/services and not for money, a historical process called a “barter” system takes place.

4

Introduction to Financial Accounting. Concepts, Cases and Exercises

related to what they have sold but agree with the client to collect it later. When a company makes a purchase and does not pay right away the supplier but agrees to pay the amount in the future (before or on a certain date), an account payable arises. When a company sells something and its customer does not pay straight away, the company owns the right to collect the amount in the future (before or on a certain date), an account receivable arises. To summarise: – accounts payable are money due to suppliers; – accounts receivable are money customers owe to the company. According to such credit perspective, we can start structuring of the main flows involved in basic market exchanges/transactions, please see the following Exhibit. Exhibit 3 – Typical business transaction flows BUSINESS TRANSACTIONS PURCHASES

SALES

PAY MONEY

COST

RECEIVE MONEY

Present

Future

Present

Future

Cash payment

Accounts payable

Cash receipt

Accounts receivable

REVENUE

FINANCIAL VIEW FINANCIAL FLOWS ECONOMIC VIEW ECONOMIC FLOWS

In the previous Exhibit you can see that if we focus on the term of payment of the exchange, we are dealing with the financial view of the transaction, if we focus on the goods/services exchanged (purchased or sold) we are dealing with the economic (or income) view of the transaction. The financial view is related to the financial flows interesting the company business while

The accounting system

5

the economic view is related to the income flows. The accounting system must measure and record the information related to these two different views. In general, business transactions involve at least one financial flow (cash flow, change in accounts receivable or accounts payable, debts, etc.). Specifically, in order to account for transactions during the activity we need to identify and measure the amounts involved within the financial flows – namely, the exchange of money – as well as the amounts related to the flows that affect the income – namely exchange of good, services and other economic resources. Business transactions that do not involve financial flows (i.e. moving goods from inventory stock to the production process within the same company) shall not be accounted under this accounting perspective. Hence, the following business events can be related to business transactions that shall be recorded by the accounting system: – purchases/sales of goods and services; – payments/receipts of cash; – payment of salaries; – purchase of assets; – financing operations; – tax payments; – etc. …

2. How to account for? The double entry method Almost every company in the World adopts a specific methodology to account for such business transactions, a process called “double entry method”. This method has a long history and its roots date back to the Assyrians and Babylonians empires; however, the first “modern” book which documented the double-entry method was written in 1494 by an Italian monk called Luca Pacioli. The name “double entry” relates to the fact that each transaction is analysed under at least two different perspectives and, consequently, is entered at least twice, recognizing both the “giving” and “receiving” aspects of the exchange according to the different types of views and flows that can be identified and measured. In other words, the double-entry method recognizes the two-fold character of every single transaction, in other words, the two different views we have discussed in the previous section.

6

Introduction to Financial Accounting. Concepts, Cases and Exercises

Every entry is posted into an “account”, it is like a “T” drawn on a piece of paper, identifying two different sections. It is regarded as the main device/tool of financial accounting (“T-account”). The name of the account is written across the top, and each side of the account is used to contain amounts measured in local currencies, for example, the Euro (€) 2. Exhibit 4 – The “T Account”

T-Accounts are kept in a book called the “ledger book” (see next part of this chapter). Therefore, each business transaction is posted in at least two separate accounts in a simultaneous and opposite way into the accounts of the ledger book. The sum of the amounts posted on the left-hand side of one or more T accounts (“debit” side) shall always be equal to the sum of the amounts posted on the right-hand side of one or more T accounts (“credit” side). This means you enter figures into different accounts (at least two), but you must remember to achieve a balance between the total sums you have posted within the accounts. In order to understand this logic, the following are examples regardless of the real meaning of the transactions: 2

Amounts presented in Euro in the following examples and cases use a comma as a decimal separator and a dot as a thousand separator (Latin European system).

7

The accounting system

– transaction nr.1: € 100 on the left-hand side of the account “A”, € 100 on the right side of the account “B”, total balance = 100; – transaction nr.2: € 100 on the left side of the account “C”, € 70 on the right-hand side of the account “D”, € 30 on the right side of the account “E” total balance = € 100; – transaction nr.3: € 5 on the right-hand side of the account “B”, € 2 on the left-hand side of the account “A”, € 3 on the left-hand side of the account “C” total balance = € 5. The graphical and numerical effects of the previous 3 transactions on the T accounts are presented below: Account “A” nr. 1 nr. 3

Account “C” nr. 2 nr. 3

100 3

Account “B”

100 2

100 5

Account “D” 70

nr. 1 nr. 3

Account “E” nr. 2

30

nr. 2

Now, we have learned how the double entry logic works, we still need to understand what kind of accounts should be used and how they should be posted according to the different types of transactions. The purpose of accounting is to measure and record the flows/amounts recognizable in a business transaction knowing that each flow/amount shall be recorded in a separate account. Therefore, the accounts to be posted accordingly depend on the type of views/flows involved within the transaction: – financial flows (i.e. cash payment/receipt) related to the financial information/view recognizable in the transaction shall be posted into “financial” T accounts; – economic flows (i.e. costs, revenues) related to the economic information/view recognizable in the transaction shall be posted into economic T accounts. Economic flows represent the increase or decrease in the company wealth (the Equity), which can be provided by different types of transactions and for this motivation, they can be divided into: – income flows: increases/decreases of company wealth, related to the business and operations, and due to revenues or gains and costs or losses;

8

Introduction to Financial Accounting. Concepts, Cases and Exercises

– equity flows: increases/decreases of company wealth related to operations of the shareholder Equity, for example, increase in company capital by issuing of new shares, retained profits of the periods; In the financial statements at the end of the year, the difference between revenues and costs, called the profit or loss of the period, is entered using an equity account as an increase of Equity. The relationship between the type of information to record and the type of T accounts to be used for is reported in the following Exhibit 5. Exhibit 5 – Type of information and use of accounts

Usually financial accounts are named to state the way in which the payment was made (i.e. cash/bank) or to remember the area the company needs to pay/receive money (i.e. accounts receivable, accounts payable, loans, etc.); economic accounts are named according to the nature or typology of the economic resource purchased and sold (i.e. cost of goods, costs for raw materials, services expense , merchandise, workforce salaries, sales of finished products revenue, interest expense, tax expense, etc.). Now, we need to learn which of the different types of flows/information of a business transaction shall be posted on the left-hand side and which ones on the right-hand side of a T account. These are simply conventional rules related to what the merchants were doing in ancient days during the commerce activity. The main and first conventional rule is that the cash receipt is entered on the left-hand side and the cash paid on the right hand side of the T account entitled to cash, therefore, as a consequence all other entries are made knowing that each posting shall involve at least two accounts and

9

The accounting system

it shall be a balance between the amounts posted on the left and the amounts posted on the right-hand side of the T accounts. Some examples of applying the conventional rules follow: 1) Sale of 100 Euro of finished products, outright cash collection: Cash 100

Sales revenues 100

In the previous transaction, as stated by the main conventional rules, we have posted € 100 to the left-hand side of the financial account called “Cash” to record the financial flow/information relating to the cash collection; on the other hand, to record the economic flow/information and, in order to achieve a balance, we have posted the value of the finished being goods € 100 to right-hand side of the Sales revenue account. 2) Purchase of 80 Euro of raw materials, immediate cash payment: Cash 80

Purchase costs 80

In previous transaction 2), as stated by the main convention, we have posted € 80 to the right-hand side of the financial account entitled “Cash” to record the financial flow/information relating to the cash payment; on the other hand, to record the economic flow/information, and in order to achieve the balance, we have posted the value of the raw materials purchased, €80 as expense, to the left-hand side of an economic/income account entitled “Purchase costs”. As a rule of thumb we can say that everything received (or is going to be received in the future) or used by the company in its activity (i.e. cash receipt, accounts receivable, costs for raw materials, services, workforce, machinery, plant, trademarks, etc.) should be accounted for in the left hand side (debit side) of an account; whilst on the other hand everything that is given out (or is going to be given in the future) by the company (i.e. cash payment,

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Introduction to Financial Accounting. Concepts, Cases and Exercises

accounts payable, sales of goods/services, etc.) should be accounted for in the right-hand side (credit side) of an account. Hence, the following Exhibit 6 reports a table encompassing the rules of how the double entry method should be applied according to the different types of information involved in business transactions. Exhibit 6 – The DOUBLE ENTRY bookkeeping method Information

Flows

Type of accounts

Type of ENTRIES LEFT HAND SIDE RIGHT HAND SIDE

+ Cash + Bank Financial Financials Financial accounts + Accounts receivable – Accounts payable + Cost Income Accounts – Revenue Economic Economics Equity Accounts – Equity

– Cash – Bank – Accounts receivable + Accounts payable + Revenue – Cost + Equity

3. Where to account for? Once we learned how the double entry method works, we need to understand where to record the entries and where to find all the accounts a company can use. Nowadays, financial accounting is almost totally based on computer systems, and accounts are simply stored in electronic databases; however, due to specific countries’ regulations, the use of accounting books is mandatory in most companies and these books are softcopies visible on PC’s monitors or hardcopies periodically printed. The typical accounting books a company uses, despite the support, are: – General Ledger book; – Journal book; – Inventory book; – Fixed assets book; – VAT books; – etc. Given the aim of this course, we will focus only on the general ledger and Journal books, of which the following paragraphs present the basics.

The accounting system

11

3.1. General Ledger book As we have seen before each business transaction shall be recorded using at least two different T accounts. During handwritten accounting days, all T accounts were written into one book which was called the “Ledger book”. The use of computer-based accounting systems dematerialized paper and today ledger books are simply electronic databases which can be displayed/printed on the employees PC monitors. All the available accounts a company can use are listed in the chart of accounts which is a support explained later. Therefore, business transactions are recorded in the General ledger book on a systematic way and every account describes what had happened according to a different business item (i.e. cash, bank, accounts payables, purchases of raw materials, etc.). Exhibit 7 – Ancient ledger book’s view

12

Introduction to Financial Accounting. Concepts, Cases and Exercises

Exhibit 8 – Modern ledger view

Applying the double entry method to record transactions in the ledger book is called “posting”. Furthermore, is important to understand how to compute the “balance” of an account which means answering how much is the amount in it (i.e. how many Euros are in cash?); specifically, the process to figure out the balance of an account is: a) find all the amounts on the left-hand side (debit side) and sum them to get the left-hand side total; b) find all the amounts on the right-hand side (credit side) and add them to obtain the right-hand side total; c) compare the two totals, and subtract the larger one with the smaller, that is the account balance; cross a line on the account and post this difference on whichever side the larger amount was. Below is an example of this process.

13

The accounting system

Exhibit 9 – Computing the balance of a T account

How much is there in cash?

Cash 100 200 60 20 30

Figuring out the Total Balance

1) 3)

Cash 100 200 60 20 30 320 90 230

2)

3.2. Journal book In order to post transactions into the accounts, it is necessary to transform them into a form that can be captured by the financial accounting system and to really understand what accounts we need to move to the left/right-hand sides and for what amounts. This process is called “journalizing” as it is done in an accounting book called the “Journal book”. On each page of the journal you can find a summary of all the transactions that have occurred on a day to day basis, pointing out which accounts were posted in the ledger and for what amounts. A Journal book entry normally use the following structure or some variation of it:

The structure of the journal book is explained in the following Exhibit 10.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Exhibit 10 – Journal Book Structure

Therefore, the transactions presented in the previous section shall be recorded with the following journal entries: 1) Sale of 100 Euro of finished products, outright cash collection: Left (DR) A.

Cash

R.

Right (CR)

100,00 Sales Revenues

100,00

This journal recording states that on May 23rd we had a cash receipt for € 100 that had been posted to the left-hand side of the account entitled “Cash” and, on the other hand, we had a revenue for selling products valued € 100 which had been posted on the right-hand side of an account entitled “Sales Revenues”; the total balance (total amount posted on the left-hand side equal to total amounts posted on the right-hand side) is € 100. 2) Purchase of 80 Euro of raw materials, immediate cash payment: Left (DR) A.

Cash R. Sales Revenues

Right (CR)

100,00 100,00

This journal states that on May 24th we had paid € 80 cash which had been posted to the right-hand side of the account entitled “Cash” and on the other hand we sustained the cost, or expense, for purchasing raw materials

The accounting system

15

of € 80 which had been posted on the left-hand side of an account entitled “Purchase Cost”; the total balance (total amount posted on the left-hand side equal to total amounts posted on the right side) is € 100. The data/information which is journalized is the same data posted in the ledger book but presented in a different way; in the journal the key is the business transaction indeed you will find recording for each business transaction in chronological order, while in the ledger there is a change of perspective, indeed the key is the account and you will find the effects produced by these business transactions account by account. In practice, a transaction is first of all journalized and then reported in the ledger according to hand-written bookkeeping.

4. Chart of accounts The chart of accounts is the list of all the accounts an organization can use to record its business transactions. To find the proper account to use, each account available in the list is identified by a unique number which is called a “code” (somewhat like an address book of all the accounts that can be used by the company). However, when accounting was administered by hand, the unique number was referred to by the page of the ledger book, but nowadays with computer-based bookkeeping, the number is a code usually referred to the positioning of the account in financial statements. Usually, in Europe, each company can develop its own chart of accounts, although companies belonging to a Group may find it useful to use a common system to aid the consolidation and budgeting process. For instance, in France companies have to use a regulated chart of accounts depending on the incorporation type and industry sector. Only for the purpose of this book and in order to facilitate the understanding of the bookkeeping process, we will use a classification where the “initial or prefix” codes of the T accounts refer to their position in financial statements. The following exhibit provides this type of codification.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Exhibit 11 – Initial codes used in the following book’s chapters Initial Account prefix code A… L… E… R… C…

Referring to.. Accounts representing Assets to be included in the Balance sheet Accounts representing Liabilities to be included on the Balance sheet Accounts representing Equity components to be included in the Balance sheet Accounts representing Revenues to be included in the Income Statement Accounts representing Costs to be included in the Income Statement

Initial/prefix codes are entered in the two first rows of the journal entry.

5. When to account for? In order to post/journalize entries related to business events, we need to understand when a particular transaction is settled; therefore, we need a definitive proof which provides information about it. Hence, business transactions shall be recorded when the company issues or receives a proofing document and most common accounting documents used as proofs are listed below: – bills; – receipts; – invoices; – checks; – bank statements; – customs declarations; – income tax returns; – etc.

6. The accounting cycle The process of collecting, recording, processing and disclosing the accounting information of a company can be described as a cyclical series of steps that is called “the accounting cycle”. It’s called a cycle because it is a circular process, starting again every accounting period. The accounting cycle begins with identifying and analyzing business transactions and events. As discussed in pre-

The accounting system

17

vious chapters, not all transactions are entered into the accounting system. Accounting transactions may include the sale of a product, the purchase of supplies, a bank transfer or another payment or any other activity that involves the exchange of the company’s assets, liability or equity with external parties. The accounting process starts with the collection of source documents that provide evidence and identify the business transactions. The accounting information is based on the receipt of invoices, bills, bank statements, recognition of a sale or completion of other economic events. Each business transaction has to be analyzed in order to define which aspect is involved and to make sure that the basic accounting equation is kept in balance after each transaction. After collecting and analyzing the information, it is entered in the journal and posted to the ledger, which is organized by account. At the end of the accounting period, unadjusted trial balance is prepared to check that the books are in balance (the total debits must equal the total credits in the financial records). Then, adjusting entries are made, creating a worksheet. Adjusting entries are made in order to prepare the financial statements. With the preparation of financial statements, the entity closes all the accounts. Then, with the preparation of financial records for the start of a new period, the cycle starts again.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

7. Financial Statements The accounting information, which is collected, analyzed, processed and recorded thanks to the double-entry method, is finally presented in a set of financial statements. General purpose financial statements are a set of reports, tables and explanatory notes presented periodically by the management of the company to disclose information about the performance and the financial position of the business. Financial statements are the final product of the entire financial accounting process. Thousands of business transactions occurred during the accounting period (i.e. one year) are collected and processed, then assembled, summarized and presented in a synthetic way in specific reports called financial statements. These financial statements are the principal source of information for external stakeholders about a company’s operations and financial position. Therefore, the information has to be presented accurately, fairly, truly and understandably. Financial statements constitute probably the most important part of accounting. Here they are illustrated and discussed very briefly, just to provide the basic elements and intuitions underlying the entire accounting process. The objective of this part is to give a general overview of the end products of bookkeeping and the “accounting process”. The form and the accounting principles adopted to disclose financial information in the financial statements may differ according to the selected set of rules (accounting principles and financial reporting standards) as well as the legal form of the business organization. Individual proprietorships, partnerships and corporations are required to provide different types of financial statements. At the same time, there are widely accepted theories, principles, rules, standards and practices concerning the form and content of the financial statements, often named General Accepted Accounting Principles (GAAPs). Business organizations may prepare their financial statements according to local GAAPs or to other accounting standards (i.e. the IFRS – International Financial Reporting Standards) that provide a common set of rules and principle concerning the recognition, measurement, presentation and disclosure requirements of business transactions 3. No matter what set of rules is adopted, organizations are usually required to prepare three basic periodic reports: 3

ZEFF S.A., The evolution of the IASC into the IASB, and the challenges it faces, 2012; ZEFF S.A., Forging Accounting Principles in Five Countries, in, pag. -1, 2015

The accounting system

19

1. the statement of financial position, usually referred to as the balance sheet (BS); 2. the income statement, also referred to as the profit and loss statement (P&L); 3. the statement of cash flow. Additionally, companies have to publish also the explanatory notes, that provide detailed information on accounts, criteria and evaluation methods, and other documents (such as the management report and the auditors’ report - if required). Many companies (for example all the company listed on stock exchanges) have to publish annual and interim financial reports. These reports are usually available through the internet as they can be downloaded directly from the companies’ websites (typically in the “Investor relations” area), from the regulators websites (like the SEC in US), from financial websites (Bloomberg, Yahoo Finance, Morningstar ...) or from the website of the stock exchange where the company is listed (for example, for Italy, Borsa Italiana spa).

7.1. The Balance Sheet The balance sheet (or statement of financial position) is a list, at a specific date of the ASSETS owned or controlled by the organization, the LIABILITIES, namely the claims against the business’ assets by creditors (payables, loans, etc.), and the EQUITY, the owner residual claims’ into the business organization.

The balance sheet reports amounts of financial items as at a specified date. The balance sheet is like a snapshot of the financial position of the company. It discloses information about the amount and the types of resources and obligations of the company at a specified moment of time (usually the end of the year). The balance sheet can be presented in two alternative formats, the account format (a table with two sides) or a list (vertical) format, where liabilities are subtracted from the assets in order to show the Equity amount. The following table presents the balance sheet of Google (Alphabet Inc.) at December 31st 2017 (source: http://financials.morningstar.com), which uses an account format.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Alphabet Inc. (Google) Balance Sheet @ December 31st, 2017 - USD in Million Assets Liabilities and Equity NON-CURRENT ASSETS EQUITY Goodwill 16.747 Common stock 40.247 Intangible assets Property, plant and equipment Investments Other long-term assets Total non-current assets CURRENT ASSETS Inventories Receivables Other current assets Cash Total current assets

TOTAL ASSETS

2.692

Retained earnings

42.383

Other comprehensive income Total Stockholders’ equity

7.813 3.352 72.987 749 18.336 3.352 101.871

113.247 – 992 152.502

NON-CURRENT LIABILITIES Long-term debt 3.969 Deferred taxes liabilities 430 Deferred revenues 340 Other long-term liabilities 15.871 Total non-current liabilities

CURRENT LIABILITIES Accounts payable Taxes payable Accrued liabilities Deferred revenues Total current liabilities TOTAL LIABILITIES AND 197.295 OWNERS’ EQUITY

20.610

124.308

3.137 881 18.733 1.432 24.183 197.295

Observe that the heading of the balance sheet shows the name of the company, the name of the statement and the date. Alphabet is a corporation and this is evident because the balance sheet shows in the equity the amount of “Common stock” (or Share Capital, as only corporations issue capital stock and, consequently, their owners are called stockholders). Owners’ equity is suitable as a general term (sometimes it is also called “net equity” or “net worth”), but if the business is a corporation, stockholders’ equity would be more suitable. The assets are the resources (objects, claims and other rights) owned by the company. These resources represent potential sources of future revenues for the company. On the right side of the balance sheet the sources that provided the company’s assets are displayed. There are two general types of funds sources: liabilities (amounts owed to creditors) and owners’ equity. The fact that total assets must equal (balance) total liabilities plus owners’ equity provides the name “balance sheet” to this statement. This is another way to express the basic accounting equation: ASSETS = LIABILITIES + OWNERS’ EQUITY This equality always exists, unless a mistake has been made in recording

The accounting system

21

the transactions. But the economic meaning of this equation can be understood rewriting the equation as: INVESTING ACTIVITIES = FINANCING ACTIVITIES Considering that funds may come from creditors or from the owners, the balance sheet equation can also be written as: INVESTMENTS = SHAREHOLDERS FINANCING + CREDITORS FINANCING Finally, in order to show the fact that owners’ equity is a residual claim, the same equation can also be written as: NET EQUITY = ASSETS – LIABILITIES If we consider the Alphabet balance sheet as of December 31st 2017, we can see that the total amount of resources invested in the company were equal to USD 197 295 million. Of this amount, USD 44 793 million were creditors’ claims, while the remaining USD 152 502 million represented claims of stockholders.

7.2. The Income Statement The income statement lists revenues, expenses, gains and losses of a company over a period of time.

One of the purposes of a business is to create value or, in other words, to produce income. The income statement quantifies the income produced by a business in a certain period of time (typically one year) and lists how this income has been earned. The bottom line of the income statement is always the net income and it shows the increase (or decrease, if negative) in the net equity of the business, before considering possible distributions to the owners. The income statement is a report of flow variables over an interval of time. Therefore, revenues, expenses, gains, profit and losses would be measured per unit of time (say a year). Following is the income statement of Google (Alphabet Inc.) for the year 2017 (source: http://financials.morningstar.com).

22

Introduction to Financial Accounting. Concepts, Cases and Exercises Alphabet Inc. (Google) Income Statement for the Year 2017 - USD in Million Sales Revenues – Cost of Sales GROSS PROFIT

110.855 – 45.583 65.272

– Operating Expenses Sales, General and Administrative Exp.

– 19.765

Research and Development Exp.

– 16.625

Other Operating Expenses OPERATING PROFIT

– 2.736 26.146

– Interest Expense

– 109

Other income

1.156

INCOME BEFORE TAXES

27.193

Provision for income taxes Net profit (loss) of the period

14.531 12.662

There is no international standard format for an income statement. Different systems in different countries adopt different models. Typically, the income statement has a vertical form. Besides that, the basic income statement equation is: REVENUES – EXPENSES = NET INCOME In other words, from the revenues earned during the period, the expenses which are properly assignable to the same period are deducted to arrive at net income (or net profit). We shall defer a more detailed analysis of the income statement until the last chapter of the book, as a conclusion of the accounting cycle.

7.3. The cash flow statement The cash flow statement is a document that provides information about the cash flows of the period, showing in which area the business has absorbed or produced cash in a specific period of time.

Even though this statement is not directly affected by ledger and journal recordings of the business transactions, it is a very relevant report because it provides additional information on the financial position of the company. In-

23

The accounting system

formation reported in the cash flow statement derives largely from data in the other financial statements. No additional entries or accounts need to be registered. Cash flows reported in the cash flow statement are classified in: 1. Cash flows from operating activities 2. Cash flows from investing activities 3. Cash flows from financing activities The following table provides the condensed cash flow statement of Google (Alphabet Inc.) for the year 2017 (source: http://financials.morningstar.com). Alphabet Inc. (Google) Cash Flow Statement for the Year 2017 - USD in Million Cash Flows From Operating Activities Cash Flows From Investing Activities Cash Flows From Financing Activities NET CHANGE IN CASH Cash at beginning of the period Cash at end of the period NET CHANGE IN CASH

37.496 – 31.401 – 8.298 – 2.203 12.918 10.715 – 2.203

In the first part of the statement, we can see that, during the year 2017, Alphabet operating activities provided USD 37.496 million, while investing activities used USD 31.401 million and financing activities used USD 8.298 million. The total amount of cash at the beginning of the year was USD 12.918 million and at the end of the year it was USD 10.715 million, with a net decrease in cash by USD 2.203 million. The information for the cash flow statement is not taken directly from the accounts, but it is derived indirectly from the balance sheet and the income statement, with a quite complex method that we are not going to describe here.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

2. Accounting for ordinary business transactions

Every day a company performs many business transactions, and in this chapter we will analyze how the main business transactions are accounted for on a normal day to day activity. The most part these transactions will be presented by posting both the ledger and journal books. Furthermore, for particular transactions, the financial statements effect will be provided as well (balance sheet, income statement and cash flow statement). The accounting entries for the closing activity related to financial statements preparation are discussed in the next chapter.

1. Purchases and sales of goods and services Let us do a brief recap of what we have seen in the previous chapter, by accounting for a company that purchases on April 1st some raw materials for a total value of € 3,000 and assume it pays immediately by cash. On the one hand, in order to recognize the cost (economic view/flow) and the cash payment (financial view/flow), the ledger must be posted as follows: Raw materials expenses 3.000

Cash 3.000

And the related journal entry is: Left (DR) C. A.

Raw materials expenses Cash

Right (CR)

3.000,00 3.000,00

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Introduction to Financial Accounting. Concepts, Cases and Exercises

The correct analysis that has to be conducted in order to record the transaction is reported in the following table: Date April 1st 20...

Transaction

Analysis

Pays € 3.000 for purchases of raw materials

Cash is decreased and a period expense is incurred. “Cash” is credited and “Raw Material Expenses” is debited. + Expenses (Debit) – Cash (Credit)

On the other hand, if the company, on April 3rd, sells some finished products to a customer and the customer pays immediately by cash for a total amount of € 5.000, in order to recognize the cash receipt (financial view/flow) and the related revenue (economic view/flow), the ledger must be posted as follows: Cash 5.000

Sales revenues 5.000

And the journal entry is: Left (DR) A.

Cash

R.

Right (CR)

5.000,00 Sales revenues

5.000,00

The correct analysis that has to be conducted in order to record properly the transaction is reported in the following table: Date April

3rd

20...

Transaction

Analysis

Receives € 5.000 for product Cash is received and a period revenue is sales. earned. The asset “Cash” is increased (debited) and “Sales revenues” credited. + Cash (Debit) + Revenues (Credit)

Usually, companies use a bank account in order to pay or receive money, the only difference with the previous entries is in the name of the account used to record the financial flows, as stated below:

27

Accounting for ordinary business transactions Left (DR) C. A.

Raw materials expenses

3.000,00

Bank account

3.000,00 Left (DR)

A. R.

Bank account

Right (CR)

Right (CR)

5.000,00

Sales revenues

5.000,00

In many countries (Italy, France, Spain), national regulations fix a limit for cash payment. For instance, in Italy you cannot pay more than 3.000 euros using cash. This obliges companies, involved in payment superior to that limit, to pay using the bank account. As individuals, in our personal life, we are used to paying for things when we buy them, but companies act quite differently. For the most part, the business is based on credit because customers prefer deferring their payments. Credit transactions enable purchasers to use their cash for a longer period of time before paying the seller. Moreover, credit transactions permit the purchaser to inspect and actually use the goods prior to payment. As seen previously, the credit sales to customers give rise to accounts receivable (also called “trade receivables”). The purchase on a credit basis from suppliers gives rise to accounts payable (also called “trade payables”). As an example, we now consider the data of the previous purchase and sale without immediate cash payment and receipt. In the case of a purchase, we must again recognize the cost for raw materials but as an account payable instead of a cash payment; it is useful to remember the fact that the company owes money to its supplier. So to enable this purchase on credit, the ledger and journal entries are: Raw materials expenses 3.000

Accounts payable 3.000

Left (DR) C. L.

Raw materials expenses Account payable

Right (CR)

3.000,00 3.000,00

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Introduction to Financial Accounting. Concepts, Cases and Exercises

The correct analysis that has to be conducted in order to record properly the transaction is reported in the following table: Date ../..

Transaction

Analysis

Purchases raw materials on account from a supplier for € 3.000.

A period expense is incurred and a liability is increased. Debit “Raw materials expenses” and credit “Accounts payable”. + Expenses (Debit) + Liabilities (Credit)

Effects on financial statements: Balance sheet + Liabilities

Income statement + Costs

Cash Flow Statement none

When the cash is ultimately paid, the balance in cash (or in the bank account) is decreased (right-hand side), and the accounts payable balance is decreased (left-hand side). Below are the entries (ledger entries in bold italic): Cash

Accounts payable 3.000

3.000

3.000

Left (DR) L. A.

Account payable

Right (CR)

3.000,00

Cash

3.000,00

The correct analysis that has to be conducted in order to record properly the transaction is reported in the following table: Date ../..

Transaction

Analysis

Pays the supplier in full of account for € 3.000.

The liability is decreased by this transaction. Cash is paid, therefore decreased. Debit “Accounts payable” and credit “Cash”. – Liabilities (Debit) – Cash (Credit)

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Accounting for ordinary business transactions

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement

Cash Flow Statement – Cash from operations

none

In the case of a sale, we have to post the revenue for the finished product sale, but as an account receivable instead of the cash receipt; here it is useful to remember the fact that the company owes money by its customer. Subsequently, for this sale on credit, the ledger and journal entries are: Accounts receivable

Sales revenues

5.000

5.000

Left (DR) A. R.

Account receivable

Right (CR)

5.000,00

Sales revenues

5.000,00

The correct analysis that has to be conducted in order to record properly the transaction is reported in the following table: Date ../..

Transaction

Analysis

Sales finished products for € 5.000, billing the customer.

Revenue has been earned, even though cash has not been collected yet. Revenues are increased and recorded as credits. The asset “Accounts Receivable” is increased and debited. + Assets (Debit) + Revenues (Credit)

Effects on financial statements: Balance sheet + Assets

Income statement + Revenues

Cash Flow Statement none

When the cash is ultimately collected, the balance in cash (or in the bank account) is increased (left-hand side), and the accounts receivable balance is decreased (right-hand side). The related entries follow (ledger entries in bold italic):

30

Introduction to Financial Accounting. Concepts, Cases and Exercises Accounts receivable

Cash

5.000 5.000

5.000

Left (DR) A. R.

Cash

Right (CR)

5.000,00 Account receivable

5.000,00

The correct analysis that has to be conducted in order to record properly the transaction is reported in the following table: Date ../..

Transaction

Analysis

Receives € 5.000 from customer in full of account.

Received Cash from a customer. Cash is increased and the Accounts Receivables decreased. + Cash (Debit) – Account Receivables (Credit)

Effects on financial statements: Balance sheet – Assets + Cash

Income statement none

Cash Flow Statement + Cash from operations

Notice that revenue (or the cost) is recognized when the sale (or the purchase) is made. The collection of cash does not result in the recognition of revenue. Rather, it merely transforms one asset (accounts receivable) into another (cash or bank). It could happen that the amount received is less than the full amounts owed, in this case you simply record the amount of the actual payment rather than the full amount owed. The difference between the two amounts is the amount still owed by the customer. Remember that before making a credit sale, the credit standing of the customer should be assessed. Credit rating is an important consideration in making a credit sale because it bears directly on a potential customer’s ability and willingness to ultimately make payment. Various information agencies (such as Dun & Bradstreet, Lince, etc.) provide credit ratings and other data specifically for this purpose.

Accounting for ordinary business transactions

31

Selling only to clients with a high rating, however, will not necessarily maximize earnings. Although such a policy would minimize receivables that prove to be uncollectible, a number of potentially profitable sales might be eliminated and the profit on these sales may well overshadow the expense of uncollectible accounts. Thus, a firm must decide how much credit to grant and to whom credit should be offered. Selecting a credit-rating cut-off in some middle range is probably optimal.

1.1. VAT and Sales tax Accounting for business transactions is sometimes influenced by taxes. According to the different countries where the company is established these taxes can alternatively be in the form of Sales Tax or Value Added Tax. The final goal for both of these types of taxes is to charge the final consumption of goods and services, however, the difference between them is the application. Both taxes are intended as indirect taxes because they affect the expression of wealth (the use of money for consumption of goods/services), although VAT is considered to be an actual indirect tax in its application as it is collected from someone who does not bear the entire cost of the tax despite the case of the sale tax which is collected directly from the final consumer. Where sales tax is levied on the total value of the transaction at each stage (usually only the final stage of the production of goods/services), the VAT is neutral in respect to the number of passages between the producer and the final consumer because it charges only the value added at each stage of production, the result for VAT application is a cascade (downstream taxes levied on upstream taxes). The following is an example of a simplified production chain: Without any taxes: A tailor spends € 100 on raw materials and uses them to make a suit. The suit is sold wholesale to a clothing shop for € 120 leaving a profit of € 20. The clothing retailer then sells the suit to a customer for € 150, making a profit of € 30, we should assume that this customer is the final consumer, meaning he will use the suit for personally.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

With a 10% sales tax system: The tailor pays € 100 for the raw materials, certifying he is not the final consumer. The tailor charges the retailer € 120, checking that the retailer is also not a consumer, leaving the same profit of € 20. The retailer charges the customer € 165 (150 + 150 x 10%) and pays the government € 15, leaving the same profit of € 30. Hence, the consumer has paid 10% (15) extra, compared to the no taxation scheme, and the government has collected this amount in taxation. The tailor and the retailer have not lost anything directly to the tax, however the retailers have the extra paperwork to complete in order to correctly pass on to the government the sales tax they collect and the suppliers and manufacturers have the administrative burden of supplying correct certifications, and checking that their customers (retailers) are not the consumers. With a 10% value added tax system: The tailor pays € 110 (100 + 100 x 10%) for the raw materials, and the seller of the raw materials pays the government € 10. The tailor charges the retailer € 132 (120 + 120 x 10%) and pays the government €2 (12 minus 10), leaving the same profit of € 20. The retailer charges the consumer € 165 (150 + 150 x 10%) and pays the government € 3 (15 minus 12), leaving the profit of € 30 (165-132-3). Hence, the consumer has paid 10% (15) extra, compared to the no taxation scheme, and the government has collected this amount in taxation. The businesses have not lost anything directly to the tax. They do not need to request certifications from purchasers who are not final consumers, but they do have the extra accounting to verify that they correctly pass on to the government the difference between what they collect in VAT (output VAT, a 10% more of their income) and what they spend in VAT (input VAT, a 10% more of their expenditure). Note that in each stage of the transaction the VAT paid is equal to 10% of the profit, or value added. One of the advantages of the VAT system over the sales tax system is that companies cannot hide consumption by certifying that they are not the final consumer. While some countries, for example the US, apply the sales tax system (formerly the Goods and Services Tax, GST); other countries, for example most European countries, apply the VAT system.

Accounting for ordinary business transactions

33

The different rates and typologies of these taxes for some common countries are reported in the following table. Exhibit 1 – Main countries consumption taxes Country Italy France UK Spain Nordic EU Countries USA Canada Australia

Type of tax VAT (IVA) VAT (TVA) VAT VAT (IVA) VAT (MOMS) GST GST GST

Standard Rate 22% 20% 20% 21% 22%-25% 0%-11% 5% 10%

Every specific VAT or sales tax is applied for consumptions made in each country. Exports are usually not subject to VAT because by definition they are consumed abroad; the VAT charged under such circumstances is usually refundable (i.e. “Tax free shopping” ads for tax refunds when you go abroad). Please, note that in the following sections of this book we adopt a 20% VAT rate.

1.2. Purchases and Sales with VAT VAT is applied to every business transaction which involves a purchase or a sale of goods and/or service liable to VAT. Usually, some specific goods/services (i.e. medicines, health care services, financial services, etc.) are exempt from VAT application whereas other items are charged with reduced VAT rates (i.e. food, books, etc.). VAT is applied when an invoice or a bill is issued by the seller; below is an example of a blank invoice.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Exhibit 2 – Invoice structure example

When a business purchases goods/services liable for VAT, this tax is recorded as a receivable amount because it must be returned back to the Government. The VAT on purchases is posted to the account called “Input VAT”. When a business sells goods/services liable for VAT, this tax is recorded as a payable amount because it is owed to the government. The VAT on sales is posted to the account called “Output VAT”. The final amount of VAT owed to/by the Government arises from the

35

Accounting for ordinary business transactions

difference between the balance of the Input and Output VAT accounts (see herein after). Example 1 A company receives the following invoice, dated 10th January, from a supplier: INVOICE …..

….. ….. Raw Materials

5.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

5.000 1.000 6.000

The payment is due within 30 days from the invoice date; this should be stated on the invoice as “Net 30”. The related entries are: Accounts payable

Raw materials expenses

6.000

Input VAT

5.000

1.000

Left (DR)

Right (CR)

C.

Raw materials expenses

5.000,00

A.

Input VAT

1.000,00

L.

Accounts payable

6.000,00

Effects on financial statements: Balance sheet Assets (VAT) + Liabilities

Income statement + Costs

Cash Flow Statement none

On 10th February, the account payable is closed and the cash payment is completed: Accounts payable 6.000 6.000

Bank 6.000

36

Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR) L.

Accounts payable

A.

Right (CR)

6.000,00

Bank

6.000,00

Effects on financial statements: Balance sheet – Cash/Bank – Liabilities

Income statement

Cash Flow Statement – Cash from operation

none

Example 2 A company receives the following invoice, dated 15th February, from a supplier: INVOICE …..

….. ….. Merchandise Shipping

7.000 500

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

7.500 1.500 9.000

The payment is due within 45 days from the receipt of goods; this should be stated on the invoice as “ROG 45”. The related accounting entries are: Cost for merchandise 7.000

Accounts payable 9.000

Shipping expenses 500

Left (DR) C.

Merchandise expenses

C.

Shipping expenses

A.

Input VAT

L.

Input VAT 1.500

Right (CR)

7.000,00 500,00 1.500,00

Accounts payable

9.000,00

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Accounting for ordinary business transactions

On 30th March, the account payable is closed and the cash payment is completed (similar to previous Example 1): Left (DR) L.

Accounts payable

Right (CR)

9.000,00

A.

Bank

9.000,00

Example 3 On 1st February a company issues the following invoice and bills the customer: INVOICE …..

….. ….. Finished products

10.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

10.000 2.000 12.000

Payment shall be due within 15 days from the end of the month of invoice’s issue, this should be stated on the invoice as “EOM 15”. The related accounting entries are: Accounts receivable 12.000

Sales revenues

Output VAT

10.000

2.000

Left (DR) A.

Account receivable

Right (CR)

12.000,00

R.

Sales revenues

10.000,00

L.

Output VAT

2.000,00

Effects on financial statements: Balance sheet + Assets + Liabilities (VAT)

Income statement + Revenues

Cash Flow Statement none

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Introduction to Financial Accounting. Concepts, Cases and Exercises

On 15th March, the account receivable is closed and the cash collected and banked: Accounts receivable

Bank 12.000

12.000 12.000

Left (DR) A.

Bank

A.

Right (CR)

12.000,00 Account receivable

12.000,00

Effects on financial statements: Balance sheet – Assets + Cash/Bank

Income statement none

Cash Flow Statement + Cash from operations

Example 4 On 1st February a company issues the following invoice and bills it to the client: INVOICE …..

….. ….. Merchandise Packaging

15.000 1.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

16.000 3.200 19.200

Payment shall be due within 15 days from the date of issue of the invoice; this should be stated on the invoice as “Net 15”. Related accounting entries are: Accounts receivable 19.200

Sales revenues 15.000

Packaging repayment 1.000

Output VAT 3.200

39

Accounting for ordinary business transactions Left (DR) A.

Account receivable

Right (CR)

19.200,00

R.

Sales revenues

15.000,00

R.

Packaging repayment

1.000,00

L.

Output VAT

3.200,00

On 15th February, the accounts receivable is closed and the cash collected and banked (similar to the previous example): Left (DR) A.

Bank

A.

Right (CR)

19.200,00 Account receivable

19.200,00

1.3. Purchases and sales not liable to VAT VAT is a charged on the consumption of goods/services, for this reason the different worldwide governments may state some exemptions to VAT application, usually they are related to essential life goods/services: medicines, welfare services, healthcare services, charity, goods/services to disabled people, etc. Accounting for transactions involving such items simply implies not to record VAT because VAT is at 0% in the invoices/bills. Another reason not to apply VAT on sales, is when the goods are a sale to a foreign country (export activity) for the reason that by definition, they are consumed abroad. This matter is presented in a following paragraph of this chapter. Example 5 On 1st February a company issues the following invoice and bills the customer:

INVOICE …..

….. ….. Healthcare services

3.000

TOTAL Liable to VAT VAT 0% TOTAL DUE ….

3.000

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Introduction to Financial Accounting. Concepts, Cases and Exercises

The related journal entry is: Left (DR) A.

Account receivable

R.

Right (CR)

3.000,00

Sales revenues

3.000,00

Example 6 On 1st February a company receives the following invoice related to a donation: INVOICE …..

….. ….. Charity donation

1.000

TOTAL Liable to VAT VAT 0% TOTAL DUE ….

1.000

The related journal entry is: Left (DR) C. A.

Other expenses Bank

Right (CR)

1.000,00 1.000,00

2. Advance payments In many industries, some customers pay in advance for goods and services to be provided at future dates. Consulting, transportation, magazine publishing, advertising, and construction are all examples of industries where advance customer payments are often required. Sometimes when the credit rate standing of a new customer is not available, the company may ask for an advance payment from its customer prior to selling him the goods/services. Advance payments collected from customers are handled in bookkeeping

41

Accounting for ordinary business transactions

such as accounts payable because if the customer is not going to purchase the goods or services paid for in advance, the company needs to return the money collected in advance (sometimes some fees are withheld). On the one hand, when a company collects an advance payment there is no economic view/flow at all and there are only two financial flows (cash receipt and arise of a payable), it is almost like the customer is financing the company for the production of the goods/services. On the other hand, advance payments paid to a supplier for a future purchase is considered as accounts receivable because if the company is not going to purchase the goods or services paid in advance, the supplier needs to return the money received in advance (sometimes some fees are withheld). When a company pays in advance there is no economic flow at all since there are only two financial flows (cash payment and arise of a receivable), it is almost like the company is financing the supplier for the production of the goods/services. In some Countries (i.e. in Italy) advance payment amounts are liable for VAT. Let us consider the following examples: Example 7 On March the 1st, a company pays € 10.000 in advance to a supplier for a future purchase of merchandise “X”, this amount is liable for VAT being the object of the future purchase. Advance payments to suppliers

Input VAT

10.000

Bank

2.000

12.000

Left (DR) A.

Advance payment to suppliers

A.

Input VAT

A.

Right (CR)

10.000,00 2.000,00

Bank

12.000,00

Effects on financial statements: Balance sheet – Cash + Assets

Income statement none

Cash Flow Statement – Cash from operations

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Example 8 Fifteen days later, the supplier sells the company the merchandise part payment made in advance, the invoice is the following: INVOICE …..

….. ….. Merchandise "X" -Advance 1st march TOTAL Liable to VAT VAT 20% TOTAL DUE ….

100.000 (10.000) 90.000 18.000 108.000

The advance payment account is closed as it has been subtracted from the total amount due (account payable), then the cost for merchandise and the receivable for VAT are normally accounted for and the related entries follow (ledger entries in bold italic):

Cost for marchandise

Input VAT

Accounts payable

2.000 18.000

100.000

10.000 108.000

Left (DR) C. A.

Advance payments to suppliers

Cost for merchandise

10.000

Right (CR)

100,000,00

Input VAT

18.000,00

A.

Advance payment to suppliers

L.

Account payable

10.000,00 108.000,00

Effects on financial statements: Balance sheet – Assets + Liabilities

Income statement + Costs

Cash Flow Statement none

The subsequent payment of the invoice total is recorded as follows (ledger entries in italic not bold):

43

Accounting for ordinary business transactions Accounts payable

Bank 12.000

108.000 108.000

108.000 Left (DR)

L.

Accounts payable

A.

Right (CR)

108.000,00

Bank

108.000,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement none

Cash Flow Statement – Cash from operations

Example 9 On 2nd April, a company collects € 20.000 as an advance payment from a customer for a future sale of products “T”, this amount is liable for VAT being the object of the future sale. Advance payments from customers

Bank 24.000

Output VAT

20.000

4.000

Left (DR) A.

Bank

Right (CR)

24.000,00

L.

Advance payment from customers

20.000,00

L.

Output VAT

4.000,00

Effects on financial statements: Balance sheet + Cash + Liabilities

Income statement none

Cash Flow Statement + Cash from operations

Ten days later the company sells the customer products “T”, the issued invoice is as follows:

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Introduction to Financial Accounting. Concepts, Cases and Exercises

INVOICE …..

….. ….. Products "T" -Advance 2nd April TOTAL Liable to VAT VAT 20% TOTAL DUE ….

150.000 (20.000) 130.000 26.000 156.000

The advance payment account is closed because it has been subtracted from the total amount to be collected from the customer (account receivable), then the revenue for the sale and the payable for VAT are normally accounted for, and the related entries follows (ledger entries in bold italic): Advance payments from customers

Accounts receivable

Sales revenues

Output VAT

20.000 156.000

20.000

150.000

Left (DR) A.

Accounts receivable

L.

Advance payments from customers

4.000 26.000

Right (CR)

156,000,00 20.000,00

R.

Sales revenues

150.000,00

L.

Output VAT

26.000,00

Effects on financial statements: Balance sheet + Assets – Liabilities

Income statement + Revenues

Cash Flow Statement none

The collection of the invoice total is recorded as follows (in italic not bold): Bank

Accounts receivable

24.000 156.000 156.000

156.000

45

Accounting for ordinary business transactions Left (DR) A.

Bank

156.000,00 Account receivable

A.

Right (CR)

156.000,00

Effects on financial statements: Balance sheet + Assets – Cash

Income statement none

Cash Flow Statement + Cash from operations

3. Discounts Many companies when selling on credit, offer purchase discounts related to early payments and such discounts are offered primarily for two reasons. First, early payment by the customer enables the business to have access to fresh cash and second, the sooner an account is paid, the less opportunity there is for non payment. Typical purchase discount terms are 2/10, net 30. This indicates that a 2% discount will be granted if payment is made within 10 days of sale; otherwise, full payment is due within 30 days of sale. This particular discount offers a significant enticement for early payment. In order to understand what decision should be made as general best practice, the cost/value of capital should be assessed. In other words, it should be understood that if the discount obtained (or granted) is higher than the interest bearing on investing (or paid by financing) the invoice’s total amount before the invoice’s deadline. From the accounting perspective, a discount represents an economic loss for the seller and an economic gain for the customer. The following examples present the way discounts are accounted for. Example 10 A company decides to apply for the 2/100 discount granted by a supplier on an invoice total due of € 12.000. The invoice has been previously recorded in the company’s books and includes 20% VAT. As you can see by the following entries (ledger entries in bold italic), the accounts payable stating the amount due to supplier is closed for its total balance by paying the 2% in less with the bank (€ 11.760), the difference between the two en-

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Introduction to Financial Accounting. Concepts, Cases and Exercises

tries is an economic gain related to the discount. Because the original invoice was including VAT the discount has been computed on the total amount VAT included and, therefore, the company instead of decreasing Input VAT by € 40, post the same amount on the right-hand side of the Output VAT account: Accounts payable

Purchase discount

Bank

12.000 12.000

240

11.760 Left (DR)

L.

Accounts payable

A.

Bank

R.

Purchase discount

Right (CR)

12.000,00 11.760,00 240,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement + Revenue

Cash Flow Statement – Cash from operations

Example 11 A company issues a sale invoice to a customer; the payment term on the invoice grants a 1/20 discount on the invoice total due of € 36.000. The invoice issued has been previously recorded in the company’s books and includes 20% VAT. As you can see by the following entries (ledger entries in bold italic), the accounts receivable stating the amount to be collected from the customer is closed for its total balance by receiving the 5% less in the bank (€ 34.200), the difference between the two entries is the economic loss relating to the granted discount: Bank

Sales discount

Accounts receivable 36.000

34.200

1.800

36.000

Left (DR) A.

Bank

C.

Sales discount

A.

Right (CR)

34.200,00

Accounts receivable

1.800,00 36.000,00

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Accounting for ordinary business transactions

4. Returns During the business activity, it may occur that customers return goods previously sold by the company, or the company may return to suppliers some goods previously purchased; the reason could be linked to faulty products, non compliant products, etc. According to the different VAT regulations a justifying document may be issued for the returns. Sales returns appear in the income statement as a reduction of sales revenues whether purchase returns appear as a reduction of operating costs. Example 12 Some products previously sold in error to the wrong customer were returned to the company. As stated on the original invoice, those products were sold and accounted for at € 5.000 + 20% VAT. The purpose of the accounting entries is to override the previously recorded sales and related receivables and VAT; however, in doing so thus leaving a trace in the books; using a specific account for returns instead of removing the amounts directly from the original sales revenues account (related ledger entries in bold italic). Sales revenues

Sales retums

Input VAT

Output VAT

5.000

1.000 5.000

1.000

6.000 6.000

Left (DR)

Right (CR)

R.

Sales return

5.000,00

A.

Input VAT

1.000,00

A.

Accounts receivable

Accounts receivable

6.000,00

Effects on financial statements: Balance sheet – Assets – Liabilities (VAT)

Income statement – Revenue

Cash Flow Statement none

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Example 13 On 25th February, the company realizes that some of the merchandise purchased ten days before (see Example 2) are faulty, so it decides to return them to the supplier. The value of the merchandise returned is € 2.000 + 20% VAT. The purpose of the accounting entries is to override a part of the previously recorded purchase and related payables and VAT; however, doing it by leaving a trace in the books by using a specific account for returns instead of removing the amounts directly from the original “cost for raw materials” account (related ledger entries in bold italic). Accounts payable 8.400

Cost for merchandise

Purchase returns

Output VAT

7.000

2.400

2.000

400

Left (DR) L.

Account payable

C.

Purchase returns

L.

Output VAT

Input VAT 1.400

Right (CR)

2.400,00 2.000,00 240,00

Effects on financial statements: Balance sheet – Liabilities + Libilities (VAT)

Income statement – Costs

Cash Flow Statement none

5. Import and export Today companies’ business is often based on importing and exporting goods from other countries. The establishment of the European Union (EU) and the use of Euro within the Economic Monetary Union of the European Union (EMU) deeply developed in the last years such types of exchanges. Issues in accounting for these operations are mainly related to the following: – difference between the currency used in the exchange and the currency used in bookkeeping; – VAT implication on importing goods from the EU or from outside the EU. These issues are presented in the following paragraphs.

Accounting for ordinary business transactions

49

5.1. Importing goods from the EU The European Single Market refers to the European Union as one territory without any internal borders or other regulatory obstacles to the free movement of goods and services. It stimulates competition and trade, improves efficiency, raises quality, and helps cut prices. It uses a standardized system of laws which apply in all member states, guaranteeing the freedom of movement of people, goods, services and capital. For these reasons the border check-points and customs were removed among the EU Countries. Exhibit 3 – The EU Countries 1

However a unique fiscal system has not yet been developed and the VAT on EU trades remains an issue difficult to standardize because of the different rates and rules involved. 1

Source: http://europa.eu/abc/european_countries/index_en.htm.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

At this moment, some transitory rules are applied which state that: “VAT is applied on the Country of the destination of goods”. This means that when a company (i.e. an Italian company) purchases goods from an EU supplier (e.g. in France) the invoice billed by the Country of origin does not contain the VAT, but it is the purchasing company that applies its own VAT on the received invoice (i.e. Italian VAT). The purchasing company, by applying itself the VAT on the EU purchases, acts as if it were the seller. As you can see from the following example, accounting for VAT in such a way is neutral, but companies need to act in this way because they have to produce some reports used by the Government to understand what is the value of VAT at an EU level. An example could clarify better this concept. Example 14 On 12th April, an italian company purchased some merchandise from a French supplier. The received invoice did not include VAT, but the italian company applied its own VAT (i.e. 20%) by writing on that invoice:

The italian company acts as a seller by applying VAT (usually recorded as payable in the account “Output VAT”) but at the same time is also the real purchaser and this VAT is also a receivable (usually recorded as “Input VAT”), on the other hand this VAT isn’t paid to anyone because the French supplier only wanted to collect € 20.000; these facts are taken into account as follows:

EU Accounts payable 20.000

Cost for merchandise 20.000

Input VAT 4.000

Output VAT 4.000

51

Accounting for ordinary business transactions Left (DR) C.

Merchandise

A.

Input VAT

Right (CR)

20.000,00 4.000,00

L.

EU Account payable

20.000,00

L.

Output VAT

4.000,00

Effects on financial statements: Balance sheet + Liabilities + Assets (VAT) + Libilities (VAT)

Income statement + Costs

Cash Flow Statement none

At the time of payment the italian company simply closes the related accounts payable by giving the French supplier what it’s due: EU Accounts payable

Bank

20.000 20.000

20.000 Left (DR)

L. A.

EU Account payable

Right (CR)

20.000,00

Bank

20.000,00

Also in these types of purchases (Intra-EU) there could be the issue related to the different currency the supplier might want to be paid in; as a matter of fact not all countries in EU are in the European Monetary Union (EMU), so not all EU countries adopted the Euro. The EU countries which are not members of the EMU are: Denmark, Sweden, the United Kingdom, Bulgaria, the Czech Republic, Hungary, Lithuania, Poland and Romania. The currency exchange issues explained in the following “Importing goods from Outside the EU” paragraph might be applied also in Intra-EU purchases when these are not settled in Euro.

5.2. Importing goods from outside the EU The first issue related to importing goods from a foreign country outside the EU is that probably the supplier might want to be paid in a currency dif-

52

Introduction to Financial Accounting. Concepts, Cases and Exercises

ferent from the accounting currency the company uses in its books (i.e. in Italy the Euro). When the transaction currency is different from the accounting currency, the company needs to apply a currency exchange rate in order to account for the operation in its books. As is better explained in the next part of this paragraph, invoices/bills from foreign suppliers do not contain VAT/Taxes. Example 15 A French company purchases some merchandise from a USA supplier. The supplier sends the goods by air. Although this is a fast way for shipment, the related invoice is received on 15th April before the goods arrival, this invoice does not contain VAT or other taxes: INVOICE …..

….. ….. Merchandise

$ 100.000

TOTAL DUE

$ 100.000

….

As you can see the invoice is in US Dollars (USD) and for accounting purposes, the company needs to convert the total amount due in its current currency, the Euro (EUR), on the 15th April EUR-USD exchange rate is 1,25 (1 Euro equal 1,25 US Dollars). The total amount of $ 100.000 is equal to € 80.000 using that exchange rate (called hereinafter the “historic” rate) and is computed by dividing 100.000 by 1,25. The company shall enter the amount of € 80.000 Foreign Accounts payable 80.000

Cost for merchandise 80.000

Left (DR) C. L.

Cost for merchandise Foreign Account Payable

Right (CR)

80.000,00 80.000,00

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Accounting for ordinary business transactions

Ten days later, after checking the merchandise arrival (see next Example) the company decides to pay but the value of the Euro will most likely have varied. The supplier wants to collect $ 100.000 regardless of the Euro value of this amount, so the company goes to the Bank and requests $ 100.000, on 25th April the EUR-USD exchange rate is 1,2651 (1 Euro worth is 1,2651 US Dollars). At that exchange rate (called the effective rate in contrast to the historic rate) the company paid € 79.045 (100.000/1,2651) instead of € 80.000. The fluctuation of the exchange rate made all the richer for € 955; this difference is a positive economic flow and it is called a “currency gain” and will be presented on the income statement as financial revenues. The related entries are as follows: Foreign Accounts payable

Bank

Currency gains

80.000 80.000

79.045

955

Left (DR) L.

Foreign Accounts payable

A.

Bank

R.

Currency gains

Right (CR)

80.000,00 79.045,00 955,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement + Financial Revenue

Cash Flow Statement – Cash from operations

But what might happen if the EUR-US exchange rate was 1,24? The company is going to pay € 80.645 (100.000/1,24), so it’s paying more for € 645 which is considered a currency loss. These related entries are as follows: Foreign Accounts payable

Bank

Currency Iosses

80.000 80.000

80.645

645

Left (DR) L.

Foreign Accounts payable

C.

Currency losses

A.

Right (CR)

80.000,00 645,00

Bank

80.645,00

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement – Financial Revenue

Cash Flow Statement – Cash from operations

The second issue is that goods imported from a supplier established in a foreign country outside the EU are liable to the country’s specific VAT/Taxes when they clear the check-point at the Customs border control (probably you can remember the sign “Nothing to declare” when you passed a foreign country’s Customs point or when you returned to your own country by air; or if you have ever purchased an item on Ebay from outside the EU, you may remember you paid VAT and duties when the goods arrived). Of course the outside-EU supplier doesn’t want to deal with the country of goods’ destination VAT and for this reason it issues an invoice without any tax. Then, VAT/Taxes are applied by the Customs offices when the goods enter the company’s country, also some duties can be applied depending of on the type of goods (i.e. alcoholics, tobacco, etc.). Usually it is the shipper of the goods who does all the customs clearing procedures (VAT and duties); then the shipper will bill the company for his services plus the amount paid as VAT and duties by attaching to his invoice to the Customs declaration form. Example 16 Using the data of the US purchase developed in the previous example; On 20th April, the merchandise arrives in France by air and is cleared by Customs at Charles De Gaulle Paris Airport as the company is based in Northern France. In this case, the clearance it’s done by a shipper (i.e. DHL, TNT, Fedex, etc.) who also transport the goods from Customs to the company’s site. The company receives the invoice from the shipper related to its services; the invoice also includes the VAT amount and duties paid by the shipper at the customs offices instead of the company:

….. …..

INVOICE …..

Shipping Duties to reimbourse*

5.000 800

TOTAL Liable to VAT VAT 20% VAT to reimbourse** TOTAL DUE

5.800 1.160 16.000 22.960

*i.e. 1% of the goods value *20% of the goods value

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Accounting for ordinary business transactions

Duties are accounted as an additional value to the merchandise cost, all VAT amounts are receivables from the government and the shipping is a service expense; the total of these items is the accounts payable to the shipper. The related entries are (ledger entries in bold italic): Transport expenses

Import duties

5.000

800

Input VAT

Accounts payable

17.160

22.960

Left (DR) C.

Transportation expenses

C.

Import duties

A.

Input VAT

L.

Right (CR)

5.000,00 800,00 17.176,00

Accounts payable

22.960,00

Effects on financial statements: Balance sheet + Assets (VAT) + Liabilities

Income statement + Costs

Cash Flow Statement none

The invoice payment is a normal closing of an accounts payable: Left (DR) L.

Account payable

A.

Right (CR)

22.960,00 Bank

22.960,00

5.3. Export In all export transactions (EU or Outside-UE) VAT is not applied at all. Therefore, from an accounting point of view export transactions are like normal goods’ sales but without VAT. Sometimes it can occur that due to some agreements with foreign customers the invoice may be issued in a different currency from the accounting currency of the issuer, thus making arise of possible fluctuations. There is no difference in accounting for these operations from what has been previously presented on currency gains and losses treatment in imports. The typical accounting recording of an export invoice is as follows:

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Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

A.

Foreign Account receivable

R.

Right (CR) …

Foreign sales revenues

…

6. VAT settlement Periodically (i.e. monthly) companies need to remit to the government the difference between the VAT paid to suppliers, and the tax charged and receipted by customers. In other words, the company needs to set out its VAT position. Under an accounting perspective, this is done by comparing the balance of the two accounts “Input VAT” and “Output VAT”, and the VAT position is recorded into a new account called “VAT settlement” with the two previous balances. Usually if the company owes the VAT difference to the government, it should disburse what is due in that date. If there is a credit position (VAT paid on purchases is more than VAT receipted from sales) with the government, the company needs to be refunded; usually companies in this situation wait until the next VAT settlement or ask for a refund which normally can take a long time. Example 17 A company VAT accounts balance are as follows: Output

Input VAT …

…

30.000

50.000

The company states its VAT position by reversing the previous accounts into the account called “VAT settlement” (related ledger entries are in bold italic): Input VAT

Output VAT

… 80.000 30.000

50.000 30.000

VAT Settlement

… 50.000

30.000 50.000 20.000

57

Accounting for ordinary business transactions Left (DR) L.

VAT settlement

A.

Right (CR)

30.000,00

Input VAT

30.000,00 Left (DR)

L.

Output VAT

L.

Right (CR)

50.000,00

VAT settlement

50.000,00

Effects on financial statements: Balance sheet – Assets (VAT) – Liabilities (VAT) + Liabilities (VAT)

Income statement none

Cash Flow Statement none

The VAT owed to the Government is € 20.000; the payment is done with the bank: Bank

VAT Settlement 20.000 20.000

20.000

Left (DR) L.

VAT settlement

A.

Right (CR)

20.000,00 Bank

20.000,00

Effects on financial statements: Balance sheet – Liabilities (VAT)

Income statement

Cash Flow Statement – Cash from operations

Example 18 A company’s VAT account states as follows: Input VAT … 80.000

Output … 50.000

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Introduction to Financial Accounting. Concepts, Cases and Exercises

The company states its VAT position by reversing the previous accounts into the account called “VAT settlement” (related ledger entries are in bold italic): Input VAT

Output VAT

…

VAT Settlement

…

80.000

50.000 80.000

80.000 50.000 30.00

50.000

Left (DR) L.

VAT settlement

A.

Right (CR)

80.000,00

Input VAT

80.000,00 Left (DR)

L.

Output VAT

L.

Right (CR)

50.000,00

VAT settlement

50.000,00

The VAT to be refund by the government is € 30.000; the company decides to wait and carry on this amount to the next VAT settlement. Effects on financial statements: Balance sheet – Assets (VAT) – Liabilities (VAT) + Assets (VAT)

Income statement none

Cash Flow Statement none

7. Payroll Frequently, at the end of any month a company will owe its employees some wages and salaries. Employees work activity is a resource used by the company and for this reason represents a monthly cost. However, every month the company will not only account for the employees’ wages but will account also for other items such as allowances and deductions. Allowances are major amounts due to certain employees for a variety of specific reasons (i.e. family checks, bonuses, earnings compensations, etc.). Deductions are items withheld from the employees’ gross pay related to taxes and welfare contributions owed by the employee; the company acts

59

Accounting for ordinary business transactions

as a substitute of some fiscal and welfare institutions and charges every employee these applicable amounts in the form of direct deductions from their pay. The report used to account for payroll is a synthesis (a sum) of all the pay sheets given to the employees and it states the total amounts mainly relating to: – gross pay; – allowances; – deductions; – net paid to employees; Example 19 A company’s payroll synthetic document at the 28th February states as below:

PAYROLL REPORT February Gross PAY Family checks Tax deductions Welfare deductions NET PAY

100.000 3.000 (10.000) (14.000) 79.000

The first thing the company shall account for is the gross pay, that is the sum of the wages and salaries owed to employees by the employer in relation to the month’s working activity. Hence, the gross pay is a cost that should be paid to employees near the end of the month (i.e. 1st march). The related entries are reported below. Wages and Salaries 10.000

Employees payable 10.000

Left (DR) C. L.

Wages and salaries Employees payable

Right (CR)

100.000,00 100.000,00

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Effects on financial statements: Balance sheet + Liabilities

Income statement + Costs

Cash Flow Statement none

Subsequently, the company shall account for the different possible allowances that some employees have a right to receive; the types of those depends on the country’s specific rules, for example, welfare bonuses such as family checks (granted to family with new births), healthcare benefits, etc. Welfare allowances are paid by the company to the employees but are not a cost to the company because they are owed by the different welfare institutions involved (i.e. in the US the Social Security, in the UK the Department for Work and Pension, in Italy the Istituto Nazionale di Previdenza Sociale, etc.); thus, the company acts only as a middle-man between those institutions and the workers. For this reason allowances increase the payable amount to the employees and on the other hand are recorded as an account receivable by the specific welfare institutions involved. The related entries are (ledger entries in bold italic): Employees payable 100.000 3.000

Welfare institutions 3.000

Left (DR) L. L.

Welfare institutions

Right (CR)

3.000,00

Employees payable

3.000,00

Effects on financial statements: Balance sheet + Liabilities – Liabilities

Income statement none

Cash Flow Statement none

Payroll taxes and welfare contributions withheld from employees’ wages and salaries are liabilities of the employer towards the government. The amounts withheld are really the employees’ money that the employer is required by law to withhold and remit to the government. In other words, the employer is acting as an agent by withholding and remitting the employees’ money. These taxes are not expenses of the company withholding them. They are a liability until the money is remitted to the government. So on the one hand the company needs to reduce the employees payable and on the other hand increase the payable towards welfare institutions and the government. The entries are (ledger entries in bold italic):

61

Accounting for ordinary business transactions Employees Payable

Walfare institutions

… 100.000 24.000 3.000 79.000

Tax payble

3.000 14.000

10.000

Left (DR) L.

Employees payable

L.

Welfare institutions

L.

Right (CR)

24.000,00 14.000,00

Tax payable

10.000,00

Effects on financial statements: Balance sheet – Liabilities + Liabilities

Income statement none

Cash Flow Statement none

Hence the net paid in wages and salaries to employees is stated by the total balance of the account “employees payable”. On 1st March wages and salaries for February are paid (entries in bold italic): Employees payable

Bank

100.000 3.000 24.000 79.000 79.000

79.000 Left (DR)

L. A.

Employees payable

Right (CR)

79.000,00

Bank

79.000,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement none

Cash Flow Statement – Cash from operations

Payroll taxes and welfare contributions which are not withheld from the employees’ gross pay are expenses of the employer. As a matter of fact the company shall contribute for its own part to the welfare of its employees

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Introduction to Financial Accounting. Concepts, Cases and Exercises

(i.e. in Italy the employer welfare contribution is almost 2 times the employee contribution and it is mainly due to the INPS; in the US these expenses are almost all related Social Security, Medicare taxes and the state and federal unemployment taxes). Since these are to be paid by the employer, these are expenses. They are also liabilities until the employer remits the required amounts to the welfare institutions. Usually the amounts related to each month have to be paid before the end of the next month. Example 20 A company’s own contribution for its employees’ welfare related to February’s working activity is € 28.000. This amount shall be recorded as an expense and shall increase the payable to welfare institutions (related ledger entries in bold italic): Walfare contribution

Welfare institutions 3.000 14.000 28.000

28.000

39.000

Left (DR) C.

Welfare contribution

L.

Right (CR)

28.000,00

Welfare institutions

28.000,00

Effects on financial statements: Balance sheet + Liabilities

Income statement + Costs

Cash Flow Statement none

By the end of March, all the amounts due to welfare institutions and the government shall be paid (related ledger entries in bold italic): Welfare institutions

Tax payable

Bank

3.000 14.000 28.000 39.000 39.000

10.000 10.000

79.000 49.000

63

Accounting for ordinary business transactions Left (DR)

Right (CR)

L.

Welfare institutions

39.000,00

L.

Tax payable

10.000,00

A.

Bank

49.000,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement none

Cash Flow Statement – Cash from operations

8. Non-Current assets Non-current assets are items held in the business for use rather than for resale and can be regarded as long-term assets to be used for more than one period. This means assets that are relatively permanent and are needed for the production or sale of goods or services. Usually non current assets are divided in two categories: – tangibles: assets with physical substance (you can touch them) directly involved in the production of goods and serviced (i.e. property, plant, machinery, etc.) – intangibles: those assets with no physical substance (i.e. patents, copyright’s, brands’ ownership, etc.)

8.1. Tangible assets Tangible assets are usually termed: property, plant, and equipment. These assets are not held for sale in the ordinary course of business. The broad group is usually separated into classes according to the physical characteristics of the items, for example land, buildings, machinery, equipment, furniture, vehicles, etc. The initial value of a tangible asset is recognized at cost which includes all the amounts necessary to get the asset ready for use and provide service to the company. Ongoing payments for maintaining and operating the assets are not part of its cost although they increase the usability and the features of the asset. The whole cost of an asset shall be accounted for in the assets side of the

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Introduction to Financial Accounting. Concepts, Cases and Exercises

balance sheet and does not represent a cost for the period to be included in the income statement. This is because a non current asset may participate to production of revenues for more than one year, its cost has to be spread over the years that will benefit from its use; the means to transfer the asset contribution to revenues in the income statement is called “depreciation”. This aspect is explained better in the next chapter because it represents a closing entry. Example 21 A company purchases machinery to use in its production cycle. The invoice received from the machinery’s seller is: INVOICE …..

….. ….. Machinery "X"

20.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

20.000 4.000 24.000

The company accounts for the cost of machinery, which represents the asset value to be presented on the balance sheet as non current assets and doesn’t have a direct influence on profit or loss. Machinery 20.000

Input VAT

Accounts payable

4.000

24.000

Left (DR)

Right (CR)

A.

Machinery

20.000,00

A.

Input VAT

4.000,00

L.

Accounts payable

24.000,00

Effects on financial statements: Balance sheet + Assets + Liabilities

Income statement none

Cash Flow Statement none

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Accounting for ordinary business transactions

Then the supplier is paid (ledger entries are in bold italic), this payment is considered cash out-flow for investing activity because is related to a non-current asset’s purchase: Accounts payable

Bank

24.000 24.000

24.000

Left (DR) L.

Accounts payable

A.

Bank

Right (CR)

24.000,00 24.000,00

Effects on financial statements: Balance sheet – Liabilities

Income statement none

Cash Flow Statement – Cash from investing

As explained before, the cost of fixed assets shall include all expenditures necessary to put the assets into position and make them ready for use; for example: legal fees, title insurance costs, shipping, installation and other costs paid at closing. Example 22 The company receives the bill from the supplier who transported and installed the previous machinery in the company’s plant:

INVOICE ….. ….. In relation to Machinery "X" Transport 3.000 Installation 3.500 TOTAL Liable to VAT VAT 20% TOTAL DUE ….

6.500 1.300 7.800

The transportation and installation expenses make the machinery useful, thus they are charged to the machinery account. Related entries are (ledger entries in bold italic):

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Introduction to Financial Accounting. Concepts, Cases and Exercises Machinery 20.000 6.500

Input VAT

Accounts payable

4.000 1.300

7.800 Left (DR)

Right (CR)

A.

Machinery

6.500,00

A.

Input VAT

1.300,00

L.

Accounts payable

7.800,00

Effects on financial statements: Balance sheet + Assets + Liabilities

Income statement none

Cash Flow Statement none

A brief description of some common tangible assets is presented in the following paragraphs. Land Land is accounted for as the cost of raw land or, if there is a building on it when it’s acquired, it is accounted for at the portion of the total price allocated to the land. If there is a building on the land that is intended to be raised (knocked down) once the land is acquired, the cost of raising the building is added to the cost of the land. Moreover, the cost of getting it ready for its intended use is considered in the initial cost of the land. Land Improvements Land improvements are activities completed to land with discrete useful life. These can include fencing, grading (changing the slope of the land), paving, and lighting. Usually these improvements are recorded and accounted for separately from that of the land to which they are related. Real estate Usually real estate is referred to as investments in buildings; buildings can be built or purchased. If a building is built, the cost includes the architect’s fees, payments to contractors, and the cost of permits and inspections. If the building is purchased, the amount debited to the asset account includes the cost of the building, legal fees, survey costs, title insurance costs, and

Accounting for ordinary business transactions

67

most costs paid at closing. Most repairs completed on the building will be either charged to expenses (for the usual, ordinary items) or set up as a separate asset account (such as a roof replacement or the purchase of a new boiler). Equipment and Machinery Equipment and machinery (sometimes recorded in separate accounts) are major tools and implements used in the operation of the business. For a service company, these can include computers, copiers, telephone systems, and any electronic gear. For a manufacturing company, inclusions can be drill presses, lathe machines, sanders, and other large tools. Furniture Furniture includes items such as desks, chairs, file cabinets, lamps, couches, and tables. Fixtures Fixtures are items such as store lighting, signage and display cases. Vehicles Vehicles are the cars, trucks, and all other transportation equipment that are owned and used by the company in its business activity. Leasing or rental improvements A company may rent or lease some assets that are used in its activity but that are not owned by the company, under specific circumstances (i.e. financial or capital lease) the assets and the related improvements can be accounted for as assets in a separate assets account. 8.1.1. Sale of fixed assets Companies frequently sell fixed assets when needs change or when assets age or become obsolete due to technological advances. Another common reason for fixed asset sales is the need for money due to financial problems. Regardless of the underlying motivation, a sale of an asset is recorded by eliminating its cost and its accumulated depreciation from the related accounts. The difference between the asset cost and its accumulated depreciation is called the asset book value.

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Introduction to Financial Accounting. Concepts, Cases and Exercises

If the amount obtained by the sale is more than the asset book value a “gain on sale” is generated otherwise if the amount obtained by the sale is less than the asset book value a “loss on sale” is generated. Gains and losses on sales of fixed assets are included in the income statement of the period in which the sale takes place. Example 23 On 1st March a company sells used machinery for € 8.000. The used machinery initial cost is € 50.000 and its accumulated depreciation is € 45.000 as seen from the following account. The machinery book value is € 5.000 which compared with the sale price of € 8.000 makes arise of gain on sales by € 3.000. We record the price as the amount to collect from the purchaser, we close the asset cost and its accumulated depreciation and we account for the revenue related to the gain on sales (ledger entries are in bold italic): Left (DR) A.

Account receivable

A.

Accumulated machinery dep.

Right (CR)

8.000,00 45.000,00

A

Machinery

50.000,00

R.

Gain on sales

3.000,00

If the receivable is collected the overall effect on financial statements would be: Effects on financial statements: Balance sheet – Assets – Equity + Cash

Income statement + Revenue

Cash Flow Statement + Cash from investing

Example 24 Let us take the data from the previous example, and let us assume that the sale price of the machinery was € 1.000, in this case the company incurs a loss on sales of € 4.000 (ledger entries are in italic bold):

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Accounting for ordinary business transactions Left (DR) A.

Account receivable

A.

Accumulated machinery dep.

C.

Losses on sales

A.

Right (CR)

1.000,00 45.000,00 4.000,00

Machinery

50.000,00

If the receivable is collected the overall effect on financial statements would be: Effects on financial statements: Balance sheet – Assets – Equity + Cash

Income statement + Costs

Cash Flow Statement + Cash from investing

When a company sells an asset during the accounting period it must remember to take the partial year’s depreciation for that last year of use. The examples we have used thus far do not include the partial calculation of depreciation in the year of sale. Furthermore, a sale of an asset can be subjected to VAT or other taxes depending on the fiscal rules of the company’s country. If there is VAT, then this is accounted for as a normal VAT of sale on the account “Output VAT” and represents an amount to be refunded by the government.

8.2. Intangible assets Non-current assets with no physical substance are called intangibles assets, or just “intangibles”. In general these items are rights privileges of some sort. Typically these can be represented by copyrights, patents, trademarks, software licenses, franchises, etc. Intangibles can either be purchased or internally developed and initially recorded at cost. This cost is not the real value of the intangible but only the amount spent to acquire or develop it (i.e. engineers’ salaries, consultancies, etc.). Any amount spent to defend the underlying interest of the intangible asset is added to its cost (i.e. the cost we may spent for a lawsuit to sue a company that uses a name that’s too similar to ours). The cost of intangible assets is recognized in the assets side of the balance sheet and it’s subject to the amortization process is very similar to that of the depreciation process used for tangible assets. The amortization pro-

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cess is used to recognize in the income statement, the part of the intangible which ideally is used by the company to contribute to the period specific revenues. In the next chapter we’ll explain how to account for amortization. Example 25 The company receives the invoice from a communication agency which developed the company’s brand:

INVOICE …..

….. Brand design Brand registering

3.000 2.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

5.000 1.000 6.000

The brand represents an intangible asset which can be used by the company for many years in order to improve his competitive position. Therefore, the cost is accounted for as a non-current asset: Brand

Input VAT

5.000

Accounts payable

1.000

6.000

Left (DR)

Right (CR)

A.

Brand

5.000,00

A.

Input VAT

1.000,00

L.

Accounts payable

6.000,00

Effects on financial statements: Balance sheet + Assets + Liabilities

Income statement none

Cash Flow Statement none

Then the agency is paid, this payment is considered cash out-flow for investing activity because it is related to a fixed asset’s purchase:

71

Accounting for ordinary business transactions Left (DR) L.

Accounts payable

A.

Right (CR)

6.000,00

Bank

6.000,00

Effects on financial statements: Balance sheet – Liabilities

Income statement none

Cash Flow Statement – Cash from investing

9. Financing Is now time to turn our attention to the company sources of funds, which means focusing on where the money used by the company (i.e. to purchase fixed assets) comes from, i.e. from items different to the sales transactions. With the term “financing” we consider the capital that is provided to the company outside from its commercial activity (i.e. accounts payable to suppliers), the two main type of financed capital are: – Borrowed capital: is the amount of capital the company has received by some entities (i.e. banks) which has to be repaid, with interest, at a future date. It is represented by financial liabilities such as short term-liabilities (i.e. overdrawn bank account, factoring, etc.) or mid and long term liabilities (loans, mortgage, leasing, bonds, etc.). – Equity capital: is the amount risked by the owners/investors of the company and is provided to the company when shares or stocks are issued to new shareholders or investors. Equity capital is not a liability to be repaid at a future date because shareholders are not lending money to the company but are risking this money in the company and expecting results in terms of profits. In the following paragraphs we present the accounting for major borrowings operations, while transactions affecting the Equity are presented in the next section.

9.1. Loans Loans are the monies borrowed by a company from a bank, the formal legal document that sets forth the term of the loan.

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The note should state the conditions to repay the money to the bank: – the amount borrowed (called the face amount or the principal); – the maturity dates (when the loan shall be repaid); – the interest rate applied and it’s type (fixed or floating). At each maturity date the company shall pay to the bank an installment formed by part of the principal component to repay and the interest matured on the outstanding debt. A loan granted by a real estate investment (i.e. a plant or a building) with a long term payment term is called a mortgage. Example 26 On 1st march a company takes out a loan from a bank for € 100.000. This loan lasts for 5 years and matures every 3 months and has an annual fixed interest rate of 6%. From an accounting point of view, when the loan is collected there are two financial flows: a cash receipt and a liability arise. Bank

Loan

10.000

10.000

Left (DR) A. L.

Bank

Right (CR) …

Loan

…

Effects on financial statements: Balance sheet + Cash + Liabilities

Income statement none

Cash Flow Statement + Cash from financing

On the first maturity date, the 1st of June, the installment to be paid is formed by: – Flat Principal: 5.000 (100.000  5 years  4 maturity dates per year) – Interest: 1.500 (6% x 3/12 x 100.000) The quoted annual interest rate of 6% is actually 1,5% each three-month period because the installments are paid each three months. The total installment due to the bank is 6.500; the interest is the cost of the loan whilst the principal is a decrease in the outstanding debt (related ledger entries in bold italic):

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Accounting for ordinary business transactions Brank

Loan

Interest expense on Loans

100.000 6.500

5.000

1.500

Left (DR)

Right (CR)

L.

Loan

5.000,00

C.

Interest expense on loans

1.500,00

A.

Bank

6.500,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement + Financial costs

Cash Flow Statement – Cash from financing

The installment due on 1st September takes into account the outstanding face of the debt (100.000- 5.000) and it is formed by: – Flat Principal: 5.000 (100.000  5 years  4 maturity dates per year) – Interest: 1.425 (6% x 3/12 x 95.000) The total installment due to the bank is 6.425. The structure of the accounting entries is the same as the previous one but with a different amount of interest given the lower amount of outstanding debt: Left (DR) L.

Loan

5.000,00

C.

Interest expense on loans

1.425,00

A.

Bank

Right (CR)

6.425,00

9.2. Bonds Bonds are notes, issued mainly to individual investors (i.e. private citizens) usually through financial institutions offering services. For a variety of reasons, managers may prefer to issue bonds to investors rather than borrowing directly from financial institutions. Bond financing can also offer advantages in terms of the availability and cost of borrowing and the managers’ subsequent flexibility in making business decisions. For example, the amount that financial institutions are willing to loan to a single firm may be limited because the bank wants to diversify its risks by loaning smaller amounts to many different entities. The issue of bonds,

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Introduction to Financial Accounting. Concepts, Cases and Exercises

on the other hand, enables the borrower to obtain access to much larger amounts of borrowed funds from large institutional investors and also from thousands of individual investors. Bond’s markets in Anglo-Saxon countries are more developed than in some European countries (i.e. Italy, Spain, etc.). Bonds obligate the borrower (the issuing company) to make periodic interest payments, usually every six months, and to pay the principal or face value of the bond at the bond’s expiration. The established interest rate is the coupon rate (also called the face rate or nominal rate) that is contained in the bond contract. This rate, in conjunction with the face value, determines the cash interest to be paid periodically to bondholders. The price at which a bond is trading is usually quoted as a percentage of the bond’s par value, so that a bond that sells at par has a price of 100. In order to make the bonds more attractive the company may decide to issue bonds under par, which means that bondholders will pay the bond less than the face value of 100 and they’ll receive at expiration the full value of 100. Example 27 On 1st January, a company issues bonds at par with a principal amount of € 1.000.000, to be repaid in 10 years and a 12% coupon rate of interest payable semiannually. The related entries are: Bonds

Bank 1.000.000

1.000.000

Left (DR) A. L.

Bank

Right (CR)

1.000.000,00 Bonds

1.000.000,00

Effects on financial statements: Balance sheet + Cash + Liabilities

Income statement none

Cash Flow Statement + Cash from financing

The bond contract obligates the company to make the following payments: – Principal: 1.000.000 due after in 10 years

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Accounting for ordinary business transactions

– Interest: 60.000 due at the end of each six-month period, for 10 years (1.000.000 x 12% x 6/12). The quoted annual interest rate of 12% is actually 6% each six-month period because the bonds pay interest every six months. Every six months for 10 years, the company recognizes interest expense and pays 60.000 to the bondholders each 30th June and 31st December: Interest expense on Bonds

Bank 60.000

60.000

Left (DR) C.

Interest expense on bonds

A.

Right (CR)

60.000,00

Bank

60.000,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement + Financial costs

Cash Flow Statement – Cash from financing

After 10 years, at the bond’s expiration date, the company shall return the principal to bondholders: Bonds

Bank

1.000.000 1.000.000

1.000.000 Left (DR)

L. A.

Bonds

Right (CR)

1.000.000,00 Bank

1.000.000,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement none

Cash Flow Statement – Cash from financing

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9.3. Factoring In some industries, sellers extend very generous credit terms to their customers. For example, car retailers sometimes do not require any payment until six months after the sale. To obtain cash more quickly, these companies sell (factor) their receivables. In most cases, the receivables are factored to a financial institution that charges a fee as compensation for the cost of collection, the delayed receipt of the cash, and potentially uncollectible accounts. Factoring is a short-term financial transaction whereby a company sells its accounts receivable (i.e., invoices) at a discount. Factoring differs from a loan in three main ways. First of all, the focus is on the value of the receivables, not the company’s credit rating; secondly, factoring is the purchase of an asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three (the company, the financial institution, the client). Example 28 A company has previously made a credit sale for € 12.000: Accounts receivable

Sales Revenues

Output VAT

10.000

2.000

12.000

If the receivable is subsequently factored for € 11.000, cash would increase by 11.000, accounts receivable would decrease by € 12.000, and a € 1.000 expense would be incurred (related ledger entries in bold italic): Brank

Factoring fees

Accounts receivable 12.000

11.000

1.000

12.000

Left (DR) A.

Bank

C.

Factoring fee

A.

Right (CR)

11.000,00

Account receivable

1.000,00 12.000,00

Accounting for ordinary business transactions

77

Effects on financial statements: Balance sheet + Cash + Equity – Assets

Income statement + Costs

Cash Flow Statement + Cash from operations

9.4. Leases Usually companies obtain the right to use property, plant, and equipment by means of either a purchase or a lease contract. Leasing is an increasingly common used operation of obtaining business assets. A leasing is an agreement between an owner (the leasing company also called the lessor) and a renter (the user’s company also called the lessee) that conveys the right to use the leased property for a designated future period (typically several years). The lessee makes periodic payments, usually of the same amount each time, over the term of the leasing. Leasing can be relatively short term, such as three or four years, or can extend over the entire economic life of the leased asset. From a lessee’s perspective (the asset’s user company), there are many potential advantages to leasing, rather than purchasing, an asset. Some of these advantages are based on sound economic incentives, and others are based on the methods used to report leases in financial statements. Leasing is simply a way to finance an asset, just like a specific loan granted on an asset, but unlike loan agreements it does not impose considerable restrictions on borrowers. Loan restrictions may concern key financial ratios, profitability requirements, dividend payments, and other financial actions. Leasing operations, on the other hand, do not generally give the leaser the right to impose such restrictions. Instead, the leaser’s claim is secured by the leased asset. Leasing can also reduce the lessee’s risks of equipment obsolescence. A leaser can have less risk than a lessee if the asset has a welldeveloped secondary market so that the leaser can resell or re-lease the used equipment. Leasing operations can reduce financial risk as well. Unlike some forms of debt financing that carry variable interest rates, lease payments normally are uniform each month or year. This feature insulates the company from the effects of interest rate increases. On the other hand, the company does not benefit if interest rates decline. If a company decides to lease an asset, the impact on the financial statements depends on how the lease is classified according to the rules established by the accounting body of its Country (i.e. for the US the Financial Accounting Standards Board, for EU the International Accounting Standards

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Board, for the UK the Accounting Standards Board, for Italy the Organismo Italiano di Contabilità, etc.). For the most part, the related accounting issues follow the typology of leasing operation: operating or capital leasing. An operating lease, is interpreted as an ordinary rental, whereas the asset is merely used by the lessee and periodical renting fees are paid to the supplier. Operating leases do not increase non-current assets and debt. Instead, the lease payments are merely reported as a rent expense. Exhibit 4 – Operating Lease impact on financial statements Effects on financial statements: Balance sheet – Cash

Income statement + Costs

Cash Flow Statement – Cash from operations

A capital lease, on the other hand, is interpreted as if it is essentially a purchase of an asset, financed by a specific loan to be repaid by periodical installments. This operation affects the financial statements in the same way a purchase financed by loans would. It increases the amounts of reported fixed assets and long-term liabilities. Exhibit 5 – Capital Lease impact on financial statements Effects on financial statements: Balance sheet + Assets + Liabilities

Income statement none

Cash Flow Statement none

A lease is classified as a capital one if it meets one or more of the following criteria: 1. it transfers ownership of the property to the company by the end of the lease (that’s called the redemption option); 2. it gives the company an option to purchase the leased asset at a bargain price; 3. the leasing term is equal to 75 percent or more of the estimated economic life of the leased property; 4. the risk and the benefits related to the assets use are transferred to the asset’s user.

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Note that any of these criteria recognize that ownership rights have, in substance, been transferred from the company to the leasing company. Only if a leasing meets none of these four criteria will it be classified as an operating one. While operating leasing is accounted for in the books of the asset’s user company as a normal rental (every payment is fully an expense), capital leasing, is reported in financial statements depending on the accounting standards used by the country where the company is established. In particular capital leasing can be either accounted for as a normal renting by focusing on its formal form, or better accounted for as a specific asset’s financing by focusing on its substantial form. For example, companies reporting under Italians GAAP 2 shall report capital leasing as rental expenses and only provides in the notes the effect on financial statements items of the substantial asset’s financial form; on the other hand companies accounting under IAS/IFRS 3 shall account for leasing by focusing the substantial form of asset’s specific financing. Example 29 The company made a capital leasing related to machinery. The features of the capital leasing contract are: Machinery cost: € 100.000; Leasing length: 5 years; Installment paid: every year; Fixed installment amount: € 22.000; Redemption price = 10% of the initial machinery value. If the company accounts for the leasing by focusing on its formal form (like a rental) it simply records the periodic installment as a paid rental expense: Leasing expenses 22.000

Bank 22.000

Left (DR) C. A.

2 3

Leasing expenses

Right (CR)

22.000,00 Bank

General Accepted Accounting Principles. Actually, IAS 17 is applied for leasing recognition in financial statements.

22.000,00

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Effects on financial statements: Balance sheet – Cash

Income statement + Costs

Cash Flow Statement – Cash from operations

At the end of the leasing period the company decides to apply for the machinery’s redemption, so it pays € 10.000 (10% of 100.000) and by the accounting point it becomes only now, the formal owner of the machinery: Machinery

Bank

10.000

10.000

Left (DR) A.

Machinery

Right (CR)

10.000,00

A.

Bank

10.000,00

Effects on financial statements: Balance sheet + Assets – Cash

Income statement none

Cash Flow Statement – Cash from investing

Afterwards the company will start to depreciate that fixed asset amount.

Example 30 Let’s take the data from the previous example. If the company accounts for the lease by focusing on its substantial form (an asset’s financing) it records the present value of the lease obligation, which is the same as the value accounted for the machinery as a non-current asset. In order to avoid actuarial assumptions, let’s consider the lease obligation is 110.000: Machinery 110.000

Bank 110.000

Left (DR) A. L.

Machinery

Right (CR)

110.000,00 Leasing obligation

110.000,00

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Accounting for ordinary business transactions Effects on financial statements: Balance sheet + Assets + Liabilities

Income statement none

Cash Flow Statement none

When each lease installment is paid, the company records a partial decrease of the lease obligation for € 20.000 (i.e. debt of 100.000  nr. 5 installments) and the part of the installment which can be assumed as the interest (i.e. € 2.000). The related entries are (ledger entries are in bold italic): Leasing obligation

Interest expenses on leasing

Bank

110.000 20.000

2.000

22.000

Left (DR) L.

Leasing obligation

C.

Interest expense on leasing

A.

Right (CR)

20.000,00 2.000,00

Bank

22.000,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement + Financial costs

Cash Flow Statement – Cash from financing

At the end of each year the company will account for the contribution the machinery has provided to revenues, for example by using a depreciation rate of 15%. For the depreciation’s explanation see the next chapter. Left (DR) C. A.

Machinery depreciation

Right (CR)

16.500,00

Accumulated depreciation

16.500,00

Effects on financial statements: Balance sheet – Assets

Income statement + Costs

Cash Flow Statement none

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Introduction to Financial Accounting. Concepts, Cases and Exercises

At the end of the leasing period if the company decides to apply for the machinery’s redemption, it pays € 10.000 (10% of 100.000) and it closes the outstanding part of its lease obligation (ledger entries are in bold italic): Leasing obligation

Bank

110.000 … … 10.000

10.000 Left (DR)

L. A.

Lease obligation

Right (CR)

10.000,00 Bank

10.000,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement none

Cash Flow Statement + Cash from financing – Cash from investing – Cash from financing

10. Shareholder’s Equity A company is an entity that is owned by its shareholders and raises equity capital by issuing shares (also called “stocks” in the American way) to investors. Equity capital is an ownership interest in the company and each share represents a fractional interest in the issuing entity. Most important company shares are traded on major stock exchanges like the NYSE (New York Stock Exchange), the London Stock Exchange, the Milan Stock Exchange, etc. Although raising equity capital by the issuing of new shares is a form of financing the company, it is important to note that equity is not a liability to be repaid at a future date. Shareholders are not lending money to the company but are risking this money in the company, for such reason they expect to earn returns from their investments in the form of dividends and capital gains. Dividends are the distributions of company profits to its shareholders. Capital gains (or losses) result from the sale of the shares at a certain market

Accounting for ordinary business transactions

83

price. Neither the payment of dividends nor the appreciation of stock prices is guaranteed to the equity investor. Instead, the capability of a company to generate cash through profitable operations determines its capability to pay dividends and also influences the market price of its shares. Shareholders’ equity comes primarily from two sources: – invested (paid-in) capital – retained earnings.

Invested capital is the amount received by the company after the issue of its stock to investors. Hence, a company comes into existence when it is founded (or incorporated) at the date its initial equity capital is undersigned and paid by the founder shareholders. Usually, issuing of subsequent equity capital includes two components: share value (or par value) and premium price (or additional paid-in capital). Retained earnings are the amounts of prior profits that the company has reinvested in the business, that is the portion that has not been paid to shareholders as dividends. Usually companies’ equity capital is formed by normal shares, also called “common stocks”. In addition to common stock, the company often issues “preferred stock”, which has a priority claim over common stock in respect to dividends. In addition, if the company should liquidate its assets and cease to exist, preferred shareholders’ claims would be satisfied before any assets were distributed to the common stockholders. Three basic transactions account for most of the changes that occur in shareholders’ Equity: – Establishment of the company; – Issuance of new shares; – Recognition of periodic net profit or loss; – Payment of dividends to shareholders.

In this chapter we will focus on the first two transactions, the other transactions will be explained in the following chapter.

10.1. Incorporation of the company A company is incorporated or founded when all the future partners agree to undersign its equity capital and then by owning a part of it by purchasing the shares of its equity capital. The money provided by shareholders in terms of equity capital represents

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Introduction to Financial Accounting. Concepts, Cases and Exercises

their interests and rights into the company as it is not a liability to be returned at a specific date. Usually, when the company is incorporated and it first raises its equity capital, the share par value is equal to the share price. Par value is an arbitrary amount that is assigned to each share by the company, it has no relationship to market value but it serves to state the voting right of shareholders. Example 31 Shareholders invest € 100.000 by undersigning the equity capital of a new company called “Alpha Ltd.”, nr. 100.000 shares with a par value of € 1,00 equal to the initial price of each share that is € 1,00. This operation represents the first transaction a company records in its books. The equity capital is raised by the undersigning of its shares from the stakeholders; undersigning is the shareholder’s financial commitment to pay the received shares and in the company’s books it is entered as a receivable. Shareholders receivable

Equity capital

100.000

100.000

Left (DR) A. E.

Shareholders receivable

Right (CR)

100.000,00

Equity capital

100.000,00

Effects on financial statements: Balance sheet + Assets + Equity

Income statement none

Cash Flow Statement none

In the meantime shareholders pay the shares and the related receivable is closed (ledger entries are in bold italic). Bank

Shareholders receivable 100.000

100.000

100.000

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Accounting for ordinary business transactions Left (DR) A. A.

Bank

Right (CR)

100.000,00 Shareholders receivable

100.000,00

Effects on financial statements: Balance sheet – Assets + Cash

Income statement none

Cash Flow Statement + Cash from financing

Usually, the issue of shares is immediately followed by many other transactions where the money is used for some business purposes. Managers would immediately put these funds to work to earn returns for the shareholders, such as investing in additional tangible and intangible assets. Sometimes, non-cash items can be received instead of money when shares are issued to investors. Examples include non-cash assets, such as plant, buildings machinery or intangible assets.

10.2. Issuance of new shares (or common stock) During the development of its business a company may require further funds in order to sustain its development. These funds can be raised either as liabilities (loans, bonds, etc.) or as equity capital. Managers should decide what is the most appropriate way to raise funds in order to maintain an optimal financial structure. If the equity way is chosen it is carried out by issuing new shares 4 and raising the capital. When a company decides to trade its shares on a financial market it, usually it issues new shares/stocks with an operation called IPO (Initial Public Offering). Issuance of new shares is usually done by requesting more than the par value because of the higher market value of the shares; the difference between the issue price and the par value represents the additional paid-in capital (also called share premium) and it is accounted as an item of equity.

4

In the USA shares are often reffeerd to as common stock.

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Example 32 Company “Alpha” decides to raise its equity capital by issuing nr. 100.000 new shares with par value € 1,00 at a price of € 1,50 each. In this case the company will account for a bank receipt (or the shareholders receivable) by € 150.000 (€ 1,50 price x nr. 100.000 new shares) and on the other hand it raises the equity capital by € 100.000 (€ 1,00 par value x nr. 100.000 shares) because the € 50.000 are for additional paid-in capital or share premium (ledger entries are in bold italic). Brank

Equity capital

Additional paid-in capital

100.000 100.000

150.000

50.000

Left (DR) A.

Bank

Right (CR)

150.000,00

E.

Equity capital

100.000,00

E.

Additional paid-in capital

50.000,00

Effects on financial statements: Balance sheet + Cash + Equity

Income statement none

Cash Flow Statement + Cash from financing

3. Adjusting and closing entries

During its business activity a company performs different transactions; invoices will be sent and received, checks will come in, bank transfers will be accounted for, pay sheets will be issued, etc. Companies according to their available resources will put in place standard ways of handling these events. As seen in the first chapter, business transactions are recorded when there is at least one financial flow (cash/bank payment or receipt; arises of receivables or payables, etc.) which has been proved by a document, this means that during the year, transactions are recorded on a cash basis. At the end of each accounting period (i.e. the calendar year), financial statements should be prepared and it includes the balance sheet (also called the statement of financial position), the income statement (also called the statement of comprehensive income), the cash flow statement and the notes, and might include as well a statement of the changes in equity. The balance sheet reports assets, liabilities, and owners’ equity at a specific date (i.e. the end of the reporting period) while the income statement summarizes revenue and expense transactions that occur over the period. Since revenue and expense transactions affect shareholders’ equity, net income explains most of the change that takes place in equity during a period. The income statement is prepared on an accrual basis. The accrual basis of accounting records revenue when goods or services have been delivered or provided, regardless of when cash is received. The part of the changes in equity not related to the effect of the profit or loss is due to other comprehensive income items (i.e. revaluation of assets, or change in actuarial assumption for employees retirement benefits). Furthermore, as part of the financial statements process, the company will prepare a trial balance, in order to perform the adjusting entries that are

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necessary. Actually, the adjusting entries are required to transform some items recorded with a cash basis on items recorded with an accrual basis, for the reason that costs and revenues will be recognized in the income statement regardless of the underlying financial flows. The preparation process of financial statements is reported in the following scheme: Exhibit 1 – The preparation of financial statements process 1) BOOKEEPING/RECORDING OF TRAN SACTIONS 2) First TRIAL BALANCE 31th december CASH BASIS 3) Adjustments and closing entriel 4) Second TRIAL BALANCE 31th december 5) Financial Statements (balance sheet, income statement, notes)

During the period

At the end of the period

ACCRUAL BASIS

In this chapter, we will focus on points from 2 to 4.

1. Trial balance The trial balance is a listing of all the accounts and their balances. Usually, there are two columns on the trial balance, one for LEFT-HAND SIDE balances (also called “debit side”) and one for RIGHT-HAND SIDE balances (also called “credit side”). The trial balance is prepared by going through the ledger book, taking the balance from each page (with each page being a different account), and listing those balances. When you are finished, you total LEFT column and you total RIGHT column, and hopefully they will be equal! An example of a trial balance is reported below:

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Adjusting and closing entries

Exhibit 2 – Trial balance example Trial Balance at …/…/… Code A.. A.. A.. A.. E.. L.. L.. L.. L.. R.. C.. C.. C.. C..

ACCOUNTS

LEFT

Machinery Accounts Receivable Cash Bank Equity capital Accounts Payable Loans Welfare institutions Tax payable Sales Revenues Cost for merchandise Cost for raw materials Wages and salaries Interest expenses on loans TOTAL

RIGHT

600 400 200 400 200 600 900 80 75 865 230 600 200 90 2.720

2.720

It is not possible to prepare a correct set of financial statements if you do not begin with a trial balance that balances. One reason the trial balance may not balance is that you forgot to list an account; you might also have listed an account in the wrong column or entered an incorrect amount. However, if a balance is achieved it is not a proof of numerical accuracy, and it does not prove we’ve entered amounts in the right accounts; it is also possible to enter an identical incorrect amount in both accounts. The trial balance makes it easy to subsequently prepare the financial statements as it is a convenient list of the accounts and the balances to be reported on the different statements (balance sheet and income statement). For this reason, the first step in preparation of financial statements is to calculate the first trial balance at the end of the accounting period (i.e. 31st December) after all business transactions occurrence; then the adjusting and closing entries are made to derive the second trial balance with all the accounts ready to be reported in the financial statement.

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Exhibit 3 – 1st and 2nd Trial balance working sheet 1st Trial Balance 31st December Code

ACCOUNTS

A.. A.. A.. A.. E.. L.. L.. L.. L.. R.. C.. C.. C..

Machinery Accounts Receivable Cash Bank Equity capital Accounts Payable Loans Welfare institutions Tax payable Sales Revenues Cost for merchandise Cost for raw materials Wages and salaries Interest expenses on C.. loans TOTAL

Adjustments

LEFT

RIGHT

LEFT

RIGHT

2nd Trial Balance 31th December LEFT

RIGHT

600 400 200 400 200 600 900 80 75 865 230 600 200 90 2.720

2.720

The adjustment and the closing entries explained in the next paragraphs are entered into the journal, the ledger and the trial balance worksheet.

2. Adjustments The purpose of financial statements is to report a company’s financial position and assess the causes that steered it to that position during the period. In order to provide the necessary information, financial statements are composed of the balance sheet, the income statement, the cash flow statement, the notes and other related documents. The balance sheet reports the financial position as assets, liabilities, and owners’ equity at a moment in time. The income statement summarizes revenue and expense transactions that occur during a period. Since revenue and expense transactions affect shareholders’ equity, net income explains most of the changes that take place in equity during a period. Net income for the period (profit or loss) is the difference between all the revenues and costs recognized in that accounting period. Hence, an important aspect of accounting is to decide when to record revenue and ex-

Adjusting and closing entries

91

pense transactions occurring during the accounting period. Although during the accounting period, business transactions (and related revenues and expenses) are accounted for on a cash basis, financial statements are prepared on an accrual basis; this means focusing on revenues regardless of when cash is received. On the one hand, the cash basis of accounting records revenues or costs when cash is received or paid (in the immediate or in the future). On the other hand, the accrual basis of accounting states that revenues are recognized when goods or services have been delivered or provided, regardless of when cash is received, and all resources (expenses and costs) consumed in generating such revenues shall be recognized with those revenues. To accrue means to collect or accumulate; revenue is recognized when earned, regardless of when cash is actually collected and the expenses are matched to that revenue, regardless of when cash is paid. As a matter of fact the last part of this sentence refers to the matching principle, which states that all costs that were incurred to generate the revenue appearing on a given period’s income statement should appear as an expense on the same income statement. Revenues are firstly recognized in income statement and expenses are then matched with those revenues. By doing this, the income statement contains measures of both accomplishment (revenue) and effort (expenses), thereby enabling an assessment of firm performance. As stated previously, most of the revenue is earned when goods or services are delivered. At this time, ownership of the goods or services is transferred and a legal obligation to pay for such goods or services is created. The legal obligation arises from the transaction document (bill, invoice, etc.), therefore during the year the accounting system focus is on that obligation, meaning it works on a cash basis. Normally, during the period the accounting systems automatically record sales revenues when invoices are issued, and costs and expenses when invoices or other bills are received. Some of these revenues and cost although recorded on a cash basis are recognized in the income statement as well as being in line with the accrual basis and matching principles whilst some others are not. If a company by the end of the year N, ships products to a customer without issuing an invoice (it is Christmas time therefore companies and people have many commitments to manage), does the company account for

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this revenue in the income statement of N? The answer using the accrual basis is YES. If a confectionery manufacturing company by the end of the year N, purchases and uses € 1.000 of sugar in order to produce candy which is sold previous to the end of the year, does the company account for this expense in the income statement of N although it has not yet received the related purchase invoice? The answer using the accrual basis is YES. Some revenue (i.e. rental income) is recognized on a time basis, and is earned when the specified period of time has passed. For example, a company knows that on 1st February N it should receive € 3.000 for rental income related to the period 1st November N-1-1st February N, does the company account for this revenue in the income statement of N1? The answer using the accrual basis is YES, the company must account for a part of this revenue (in particular only € 2.000 as 3.000  3 months x 2 months). For all of these reasons companies need to transform some transactions recorded on a cash basis in transactions recorded on an accrual basis and to account for transactions which have not been yet been recorded on a cash basis but which will be recorded on an accrual basis. The adjusting entries mainly related to these topics are referred to: – Accrued revenues and expenses – Payroll accruals – Unearned revenues and prepaid expenses – Inventory

For the accurate preparation of financial statements other entries are also carried out by companies and are referred to: – Depreciation – Amortization – Impairment – Bad debts – Commitments, contingencies and risks

All of these topics are presented in the following paragraphs

2.1. Accrued revenues and expenses Some business transactions, which occurred during the closing accounting period, might be recorded by the accounting system (on a cash basis) in the next period; the related revenue and expenses should be rec-

93

Adjusting and closing entries

ognized in the income statement of the closing period. Therefore, there is no trace of these transactions in the accounts as well as in the 1st trial balance. The company will recognize those transactions by entering them in the accounts and subsequently by presenting them in the second trial balance in preparation for the financial statements presentation. These adjustments on one hand consist of recording revenue or expenses and on the other hand the estimated amount to receive or pay during the following accounting period. Specific adjustments entries refer to: – Invoices to be issued or received – Accrued revenues and expenses

By the end of the accounting period, it may happen that some sales or purchases are completed (goods are delivered and services are finished) but related justifying documents (i.e. invoices, bills, etc.) have not yet been issued nor received (specific fiscal rules may allow that); an adjustment to inscribe the revenue or cost of the transaction shall be made. In these cases, the whole revenue or cost of the transaction, which will be justified by the document issued or received in the next period, affects the income of the closing period. Example 1 On 23rd December N a company sells (and ships) some finished products for € 10.000 to a customer, the invoice will be issued in N+1. In the 1st trial balance at 31st December there is no evidence of this transaction. The company shall recognize this further sale revenue and inscribe an estimated receivable in the account called “accrued receivables” (ledger entries are in bold italic). Accrued receivables 10.000

Sales revenues 640.000 10.000 Left (DR)

A. R.

Accrued receivables Sales revenues

Right (CR)

10.000,00 10.000,00

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Introduction to Financial Accounting. Concepts, Cases and Exercises 1st Trial Balance 31/12/08

ACCOUNTS Code A.. Accrued receivables R.. Sales revenues

LEFT

RIGHT -

…

640.000

Adjustments LEFT 10.000

RIGHT

2nd Trial Balance 31/12/08 LEFT 10.000

10.000

RIGHT 650.000

…

Effects on financial statements: Balance sheet + Assets

Income statement + Revenues

Cash Flow Statement none

In N+1, when the invoice is issued, the company reverses the “accrued receivables” to the usual “accounts receivable”. Specific fiscal rules for the VAT and sales tax application may apply; in this case the company records VAT when the invoice is issued (ledger entries are in bold italic): Accounts receivable

Accrued receivables

Output VAT

10.000 12.000

10.000

2.000

Left (DR) A.

Accounts receivable

A.

Accrued receivables

L.

Right (CR)

12.000,00 10.000,00

Output VAT

2.000,00

Example 2 On 16th December N a company purchases and uses some raw materials for a total value of € 5.000, at the 31st December the related invoice is still not received. The company shall recognize this further cost and note an estimated liability in the account called “accrued payables” (ledger entries are in bold italic). Raw materials expenses 240.000 5.000

Accrued payables 5.000

95

Adjusting and closing entries Left (DR) C.

Raw materials expenses

L.

Right (CR)

5.000,00

Accrued payables

5.000,00 1st Trial Balance 31/12/08

ACCOUNTS Code L.. Accrued payables C.. Costs for raw material …

LEFT

Adjustments

RIGHT

240.000

LEFT -

RIGHT 5.000

5.000

2nd Trial Balance 31/12/08 LEFT

RIGHT 5.000

245.000

…

Effects on financial statements: Balance sheet + Liabilities (VAT)

Income statement + Costs

Cash Flow Statement none

In N+1 when the invoice is received, the company reverses the “accrued payables” to the usual “accounts payable”. Specific fiscal rules for the VAT and sales tax application may apply; in this case, the company records VAT when the invoice is received: Accrued payables

Accounts payable

Inut VAT

5.000 5.000

6.000

1.000

Left (DR) L.

Accrued payables

5.000,00

A.

Input VAT

1.000,00

L.

Accounts payable

Right (CR)

6.000,00

It could happen that only a part of the revenue or expenses, which will be normally accounted for in the following accounting period, shall be accrued in the closing period. These items make rise to accrued revenues and expenses; an adjustment must be made to recognize the part of the revenue (or the expense) and the related right (or obligation) at the balance sheet date. Common business transactions resulting in adjustments of these types are those related to interests or utility services (i.e. electricity, water, gas, etc.). Interest is the cost associated with the use of borrowed money. Usually some installment, which should be paid in the next accounting period, includes a part of the interest related to the closing period. There may not be a

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bill received at the end of the accounting period demonstrating how much interest expense was incurred during that year; the company will require to compute this amount itself and accrue it into the income statement as a financial expense and in the balance sheet as an estimated liability. If it is the company that lends money to someone else, the situation is simply reversed. Example 3 On 1st December N a company collected a loan for € 200.000, installments are paid quarterly commencing 1st March N+1 with a fixed annual interest of 6%. The first installment of € 13.000 paid 1st March will include an interest expense for € 3.000 which in part is matured between the 1st December N and the 31st December, and by taking the time method, it accounts for € 1.000 (computed as € 3.0003 months x 1 month). This part of the interest expense shall be recognized in the income statement and as an estimated liability to the balance sheet as at 31st December N. Accrued interest

Interest expenses 1.000

1.000

Left (DR) C. L.

Interest expenses

Right (CR)

1.000,00

Accrued interest

1.000,00 1st Trial Balance 31/12/08

ACCOUNTS Code L.. Accrued interest C.. Interest expenses ……

LEFT

Adjustments

RIGHT -

LEFT -

1.000

RIGHT 1.000

2nd Trial Balance 31/12/08 LEFT

RIGHT 1.000

1.000

Effects on financial statements: Balance sheet + Liabilities

Income statement + Financial Costs

Cash Flow Statement none

On 1st March N+1 the installment is paid and only the part of the interest related to N+1 (€ 2.000) is recorded, whilst the accrued interest expense is closed (related ledger entries are in bold italic).

97

Adjusting and closing entries Bank 13.000

Loan 200.000 10.000

Accrued interest 1.000 1.000 Left (DR)

Interest expenses 1.000 2.000 Right (CR)

L.

Loan

10.000,00

L.

Accrued interest

1.000,00

C.

Interest expenses

2.000,00

A.

Bank

13.000,00

Effects on financial statements: Balance sheet – Cash – Liabilities

Income statement + Financial Costs

Cash Flow Statement – Cash from financing

2.2. Payroll accruals In most companies there is a lag between the end of the payroll period (i.e. 31st December N) and the pay date (i.e. 5th January N+1); this is a whole cost accounted normally in the system in the next period and it should be accounted for in the income of the closing period. Besides other elements such as compensation benefits, salaries earned and unpaid 1 or vacation and holiday pay are whole costs related to the closing period which, usually, have not been as yet accounted for at the closing date. Under IAS/IFRS accounting rules company’s obligations for employees benefits are estimated year by year and on an actuarial basis. In order to match revenues and costs, an adjusting entry to accrue all these elements is carried out by looking at the payroll items that matured in the closing period and have not been paid at 31st December. Example 4 On 31st December N a company’s employees’ matured compensation for the year N is estimated to be € 43.000. This cost needs to be recognized in the income statement at 31st December N by notation of an estimated accrued liability.

1

In some Countries (i.e. Italy) a part of wages and salaries earned during the year is paid only at the end of the overall working period of the employees.

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Introduction to Financial Accounting. Concepts, Cases and Exercises Accrued compensation

Compensation expenses 43.000

43.000

Left (DR) C. L.

Compensation expense

Right (CR)

43.000,00

Accrued compensation

43.000,00 1st Trial Balance 31/12/08

Code ACCOUNTS L.. Accrued compensation C.. Compensation expense ……

LEFT

Adjustments

RIGHT -

LEFT -

RIGHT 43.000

43.000

2nd Trial Balance 31/12/08 LEFT

RIGHT 43.000

43.000

Effects on financial statements: Balance sheet + Liabilities

Income statement + Costs

Cash Flow Statement none

2.3 Unearned revenue and prepaid expenses During the year some transactions might have been recorded on a cash basis that is in contrast with the accrual basis and matching principle used to prepare financial statements. The accrual concept demands that expenses be kept in step with revenue, so that each period sees only that period’s expenses applied against the revenue for that period. To adjust expense or income items that have already been recorded but are not totally or partially related to the accounting period, a reclassification is required; that is, amounts previously recorded as revenues or expenses in the period need to be transferred totally or partially to one or more the next periods they are related to. This completed by utilizing some of the temporary balance sheet accounts. Revenue already recorded but not related with the closing accounting period are totally or partially transferred to the next one or more periods by writing amounts in an asset account in order to remove their influence on net income; usually theses specific asset accounts are called “unearned revenue”. Costs and expenses already recorded but not related to the closing ac-

99

Adjusting and closing entries

counting period that do not match with the revenues, are totally or partially transferred to the next one or more periods by writing amounts in a liability account in order to remove their influence on net income; usually theses specific liabilities accounts are called “prepaid expense”. The following examples will show how adjusting entries are made for the principal types of recorded revenues and expenses that must be partially transferred to next periods. Particular items of costs which should be totally transferred to next periods are those related to inventory and will be advised in the following specific paragraph of this chapter. Example 5 Let’s assume that on 1st September N, a magazine company collected € 6.000 from customers for annual magazine subscriptions (nr. 12 issues per year). The magazines are issued on a monthly basis at the beginning of each month. This transaction was accounted for on a cash basis and the related subscription revenue was totally noted in the N accounts. At the end of the accounting period (31st December N), only nr. 4 issues of the magazine have been published and delivered to customers; this means that only 4/12 of the total revenue accounted for prior is effectively earned, that is € 2.000. Revenue is recognized in the income statement on the accrual basis, hence, an adjustment has to be made: temporarily remove the part of the revenue related to issues not already published and delivered, that is € 4.000 (€ 6.000 less € 2.000 or just 8/12 of € 6.000), and transfer it to N+1 by moving through the balance sheet to the account “unearned revenue” (ledger entries are in bold italic): Unearned revenue

Sales revenues 6.000

4.000

4.000 2.000 Left (DR)

R. L.

Sales revenues Unearned revenue

Right (CR)

4.000,00 4.000,00

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Introduction to Financial Accounting. Concepts, Cases and Exercises

ACCOUNTS Code L.. Unearned revenue R.. Sales revenue ……

1st Trial Balance 31/12/08

Adjustments

LEFT

LEFT

-

RIGHT 6.000

RIGHT 4.000

4.000

2nd Trial Balance 31/12/08 LEFT

RIGHT 4.000 2.000

Effects on financial statements: Balance sheet + Liabilities

Income statement – Revenue

Cash Flow Statement none

Thus, € 2.000 would affect the N income statement as a revenue from subscriptions and the amount of € 4.000 would be shown as unearned revenue on the liability side of the N balance sheet. At 1st January N+1, the company shall re-take the unearned revenue that will be temporary “stocked” in the N balance sheet and that will be earned in N+1 through publishing and delivering the other nr. 8 issues of the magazines; so it reverses the account “unearned revenue” to the revenue for N+1 subscription (ledger entries are in bold italic). Unearned revenue

Sales revenues

4.000 4.000

4.000

Left (DR) L.

Unearned revenue

R.

Sales revenues

Right (CR)

4.000,00 4.000,00

Example 6 Assume that on 1st April N, a company paid a € 1.200 premium for one year’s insurance (i.e. for fire risk) in advance. This has been recorded as a cost in the period when the payment was done. At the end of the accounting period (31st December N), only nine-twelfth of the € 1.200, that is € 900, has expired; in simplified words, only 9/12 of the cost was used to cover the risk of fire while producing revenues with the business activity; in particular the part of cost related to revenue from 1st April N to 31st December N.

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In order to pursue the matching principle, an adjustment has to be made by temporary subtracting the part of the accounted cost which has not provided revenues that is € 300 (€ 1.200 less € 900 or just 3/12 of € 1.200) and transferring it to N+1 by passing through the balance sheet to the account “Prepaid insurance”. The related entries follow (ledger entries are in bold italic): Prepaid insurance

Insurance expense 1.200

300

300 900 Left (DR)

A. C.

Prepaid insurance

Right (CR)

300,00

Insurance expense

300,00

1st Trial Balance 31/12/08 ACCOUNTS Code A.. Prepaid insurance C.. Insurance expense ……

LEFT 1.200

Adjustments

RIGHT -

LEFT 300

RIGHT 300

2nd Trial Balance 31/12/08 LEFT 300 900

RIGHT

Effects on financial statements: Balance sheet + Assets

Income statement – Cost

Cash Flow Statement none

Thus, € 900 would be shown as an insurance expense in the N income statement and the amount of € 300 would be shown as part of a prepaid expense in the asset side of the N balance sheet. At 1st January N+1, the company shall retake the part of the cost that is related to N+1 and was temporary stocked in the balance sheet of N by closing the account “prepaid insurance” and recording again the part of the expense which will be “used” in N+1 to produce revenue (ledger entries are in bold italic). Prepaid insurance

Insurance expense

300 300

300

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Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

C.

Insurance expense

A.

Right (CR)

300,00

Prepaid insurance

300,00

Example 7 On 1st November N, a company paid € 3.600 to cover the rent for the next three months. The full amount has been recorded as a normal expense of the period. Since there is a three-month period involved, the rent expense each month is € 1.200. At the end of the accounting period (31st December N), only the rent expense related to November and December, that is € 2.400, has supported business in revenue production. In order to pursue the matching principle, an adjustment has to be made by removing the part of the accounted rent expense which has not been used in N that is € 1.200 (€ 3.600 less € 1.200 or just 1/3 of € 3.600) and transferring it to N+1 by passing through the balance sheet with the account “Prepaid rent”. The related entries follow: Rent expense

Prepaid rent

3.600 1.200

1.200 2.400 Left (DR)

A. C.

Prepaid rent

Right (CR)

1.200,00 Rent expense

1.200,00 1st Trial Balance 31/12/08

ACCOUNTS Code A.. Prepaid rent C.. Rent expense ……

LEFT 3.600

Adjustments

RIGHT -

LEFT 1.200

RIGHT 1.200

2nd Trial Balance 31/12/08 LEFT 1.200 2.400

RIGHT

Effects on financial statements: Balance sheet + Assets

Income statement – Cost

Cash Flow Statement none

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Adjusting and closing entries

Thus, € 1.200 would be shown as rent expense in the N income statement and the amount of € 1.200 would be shown as part of prepaid expense on the asset side of the N balance sheet. At 1st January N+1, the company shall retake the part of the cost that is related to N+1 and was temporary stocked on the balance sheet of N by closing the account “prepaid rent” and posting again the part of the expense which will be “used” in N+1 to produce revenue (ledger entries are in bold italic).

Prepaid rent

Rent expense

1.200 1.200

1.200

Left (DR) C.

Rent expense

A.

Right (CR)

1.200,00 Prepaid rent

1.200,00

2.4. Inventory Inventory represents the value of goods on hand at either the beginning or the end of the accounting period. The opening balance of the inventory is the same amount as the ending balance of the previous period. At the end of each accounting period companies need to evaluate, under a cost-flow assumption (i.e. average, LIFO, FICO, etc.), their final stocks and/in inventories. Usually items like the following represent these stocks: – Merchandise; – Raw materials, auxiliary goods; – Goods in process; – Finished goods. In merchandising companies inventory is merchandise that is held for resale; hence, it will ordinarily be converted into cash in less than a year and is thus a current asset. In manufacturing companies, there will usually be inventories of raw materials and goods in process in addition to an inventory of finished goods; these goods usually will be transformed or transferred to the market and then converted into cash in less than one year (or a cycle of production) thus they represent current assets. Regardless of the type of inventory and the type of classification used by

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the company’s income statement (classification by sales and cost of goods sold or by value of production and cost of that production), inventory represents purchase costs (merchandise or raw materials) or production costs (products in process or finished products) that in the closing period, have not provided revenue. This is because the goods in inventory have not been sold in the market (this regards finished goods and merchandise) or incorporated into goods sold in the market (this regards raw materials, auxiliary goods and goods in process). Hence, for the matching principle, inventory’s items represent expenses to be totally transferred to the future periods where they can provide revenues; for this reason values of final inventory’s stocks represent current assets deriving from adjustment entries which have subtracted these expenses from the income statement. Although the specific accounts and type of adjustments used may vary amongst the different accounting cultures the resulting adjustment aims at subtracting expenses from the income statement and “stocking” these amounts in the asset side of the balance sheet as current assets. In this book we write the final value of inventories using the “changes in inventory” method; in other words the final inventory value (at the end of the accounting period) is subtracted from an income account that was initially charged with the initial inventory value (at the beginning of the accounting period), the final balance of this account is the change in inventories from the beginning to the end of the period and represents the net production or usage of inventory items in relation to the revenue of the period. The following examples will show how adjusting entries are made for the main types of inventory’s items. Example 8 The inventory of a sugar trading company at the end of its first year of activity (i.e. 31st December N) is represented by 10.000 kg of sugar; during the year the total amount of sugar purchased was 70.000 Kg with an average purchase price of € 1,00/Kg for a total purchase cost of € 70.000. Using this simplified method, the inventory value is € 10.000 (10.000 Kg x € 1,00). Thus, the 1st trial balance at 31st December N contains the purchasing expenses for 70.000 Kg of sugar at a total amount of € 70.000; however a part of this sugar, in particular 10.000 Kg, has not been sold, in other words, a part of the € 70.000 expense, in particular € 10.000, has not provided revenue in N. By recognizing the value of the final merchandise inventory for € 10.000 the company adjusts the economic accounts for pursuing the matching principle. The adjustment entry makes use of the economic account called “changes in merchandise inventory” in order to subtract unemployed expenses from the income

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Adjusting and closing entries

statement in an indirect way that is not from their original account (ledger entries in bold italic). Changes in merchandise inventory

Costs for merchandise 70.000

Merchandise inventory

10.000 10.000

10.000

Left (DR) A. C.

Merchandise inventory

Right (CR)

10.000,00

Change in merchandise inv.

10.000,00

1st Trial Balance 31/12/08 Code ACCOUNTS A.. Merchandise inventory

LEFT -

C.. Costs for merchandise C.. Changes in merchandise inventory … …

70.000 -

RIGHT -

Adjustments LEFT 10.000

RIGHT

2nd Trial Balance 31/12/08 LEFT 10.000

RIGHT

70.000 -

10.000

10.000

Effects on financial statements: Balance sheet + Assets

Income statement – Cost

Cash Flow Statement none

The final balance of the change in inventory account is equal to the final stocks in inventory because the initial period’s stocks were zero (N is the first year of activity). At the beginning of the next accounting period, 1st January N+1, the company retakes the value of the inventory that should provide sales revenue in N+1; to do that it closes the asset account used for the inventory final value in N and it charges a new economic account called again “changes in merchandise inventory” which became the value of initial inventory for N+1 (related ledger entries are in bold italic). Merchandise inventory

Changes in merchandise inventory

10.000 10.000

10.000

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Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

C.

Change in merchandise inv.

A.

Right (CR)

10.000,00

Merchandise inventory

10.000,00

Assume that at 31st December N+1, sugar inventory is 15.000 kg; during N+1, the company purchased 90.000 Kg of sugar at an average price of € 1,00/Kg. This means either that only 5.000 Kg of that sugar purchased in N+1 was not sold (the other 10.000 Kg of stock derives from N) or that 15.000 Kg of that sugar purchased in N+1 was not sold and 10.000 kg of the sugar deriving from N stocks was completely sold. Regardless of what the company actually does, we need to transfer the amount of the final value of N+1 inventory that is € 15.000 (15.000 Kg x 1,00 €) to the future periods where the sugar may be sold by recognizing the value of the inventory as a current asset. The adjusting entry structure is the same as the one completed before at the end of N, the aim is transferring the final inventory’s value from the income statement to the balance sheet (related ledger entries are in bold italic): Changes in merchandise inventory

Costs for merchandise 90.000

Merchandise inventory

10.000 15.000 5.000

15.000

Left (DR) A. C.

Merchandise inventory

Right (CR)

15.000,00

Change in merchandise inv.

15.000,00

1st Trial Balance 31/12/09 ACCOUNTS Code A.. Merchandise inventory

LEFT -

C.. Costs for merchandise C.. Changes in merchandise inventory … …

90.000 10.000

RIGHT -

Adjustments LEFT 15.000

RIGHT

2nd Trial Balance 31/12/09 LEFT 15.000

RIGHT

90.000 -

15.000

5.000

Effects on financial statements: Balance sheet + Assets

Income statement – Cost

Cash Flow Statement none

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Adjusting and closing entries

This time the difference is in the balance of the “changes in merchandise inventory” account because it was charged with the initial inventory value of N+1, the balance of 5.000 in the right side means that inventories rose by 5.000 in N+1 and thus, affects the income statements with “less” expenses by € 5.000. It’s like that only 5.000 of the final stocks were related to purchases done in N+1 which haven’t provided revenue (the other part of the stock was purchased in N).

The adjustment constructed for raw materials inventory is equivalent to that one seen for merchandise inventory; the reasoning is the same, the only difference is that raw material inventory value has to be transferred to future periods because it was not used or transformed and not because it wasn’t sold as in what occurred with the merchandise. Example 9 The inventory value of a car’s manufacturing company at the end of its first year of activity (i.e. 31st December N) is € 125.000 (the value of cars computed 2, for example, at their production cost). Thus, the 1st trial balance at 31st December N contains production costs (labour, raw materials, services, etc.) for € 125.000 that have not provided revenue in N because the related cars were not sold. By recognizing the value of the final cars inventory for € 125.000 the company adjusts the economic accounts for pursuing the matching principle. The adjustment entry makes use of the economic account called “changes in finished products inventory” to subtract the production expense from the income statement in an indirect way (not from their original account): Finished products inventory 125.000

Changes in finished products inventory 125.000

Left (DR) A. C.

2

Finish products inventory

Right (CR)

125.000,00

Change in finish prod. inv.

See chapter 5 for further information about inventory’s evalution.

125.000,00

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Introduction to Financial Accounting. Concepts, Cases and Exercises 1st Trial Balance 31/12/08

ACCOUNTS Code A.. Finished products inventory C.. Changes in finish. prod. inventory … …

LEFT -

Adjustments

RIGHT -

LEFT 125.000

RIGHT 125.000

2nd Trial Balance 31/12/08 LEFT 125.000

RIGHT 125.000

Effects on financial statements: Balance sheet + Assets

Income statement – Cost

Cash Flow Statement none

The final balance of the change in inventory account is equal to the final stocks in inventory because the initial stocks were zero (N is the first year of activity). At the beginning of the next accounting period, 1st January N+1, the company retakes the value of the inventory that should provide sales revenue in N+1; to do that it closes the asset account used for the inventory final value in N and it charges a new economic account called again “changes in finished products inventory” which becomes the value of the cars’ initial inventory for N+1 (related ledger entries are in bold italic). Finished products inventory

Changes in finished products inventory

125.000 125.000

125.000

Left (DR) C. A.

Change in finish prod. inv. Finish products inventory

Right (CR)

125.000,00 125.000,00

At 31st December N+1, the cars’ inventory value is € 140.000. This means either that only € 15.000 of the cars produced in N+1 were not sold (the other € 125.000 of cars’ stock derives from N) or that € 135.000 of the cars produced in N+1 were not sold at all but € 125.000 of the cars produced in N and stocked at the end of the year were completely sold in N+1. Regardless of what the company actually has done, we need to transfer the amount of the final value of the N+1 inventory that is € 135.000 to the future periods were the cars might be sold and therefore recognize the value of the cars’ inventory as a current asset. The adjusting entry structure is the same as one at the end of N, transferring the value of the final inventory from the income statement to the balance sheet (related ledger entries are in bold italic):

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Adjusting and closing entries Finished products inventory

Changes in finished products inventory 125.000

135.000

135.000 15.000 Left (DR)

A. C.

Finished products inventory

Right (CR)

135.000,00

Change in finish prod. inv.

135.000,00

1st Trial Balance 31/12/09 ACCOUNTS Code A.. Finished products inventory C.. Changes in finish. prod. inventory … …

LEFT 125.000

RIGHT -

Adjustments LEFT 135.000

RIGHT 135.000

2nd Trial Balance 31/12/09 LEFT 135.000

RIGHT 10.000

Effects on financial statements: Balance sheet + Assets

Income statement – Cost

Cash Flow Statement none

This balance by € 15.000, the “changes in finished products inventory” states that the cars’ in inventory rose by 5.000 in N+1 and thus it affects the income statements with “less” expenses of € 15.000. Hence, only 15.000 of the final cars’ stock was produced in N+1 and therefore it has not provided N+1 revenue and influenced N+1 net income (the other part of the stock was produced in N).

Example 10 What happens if, with the data of the previous example, the cars’ stock at 31st December N+1 is only € 100.000? The adjusting entry structure is always the same (related ledger entries are in bold italic): Finished products inventory

Changes in merchandise inventory 125.000

135.000

135.000 15.000

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Left (DR) A. C.

Finished products inventory

Right (CR)

100.000,00

Change in finish prod. inv.

100.000,00

1st Trial Balance 31/12/09 ACCOUNTS Code A.. Finished products inventory C.. Changes in finish. prod. inventory … …

LEFT 125.000

RIGHT -

Adjustments LEFT 100.000

RIGHT 100.000

2nd Trial Balance 31/12/09 LEFT 100.000 25.000

RIGHT

The resulting effects on financial statements after the charging of initial and final inventory value are: Effects on financial statements: Balance sheet + Assets

Income statement + Cost

Cash Flow Statement none

However the results meaning is very different than before. The resulting accounts indicate that the company sold all the cars produced in N+1 and also € 25.000 of those produced in N. In order to match those major revenues with the cost of that revenue the adjustment should add into the income statement the production cost of those € 25.000 cars produced in N but sold in N+1. For this reason the final “changes in finished products inventory” balance appears on the left-hand side.

2.5. Depreciation As reviewed in the previous chapter, when a company purchases a tangible asset the related cost is capitalized as an asset item on the balance sheet. A common denominator amongst all tangible assets is that they last longer than one year and therefore participate in generating many years’ revenue. One of the accounting principles used in financial statements preparation is related to matching revenues with costs/expenses; for this reason, at the end of the accounting period the company should match a part of the cost of its fixed assets to the revenues earned in that period. That is where the concept of depreciation comes in: taking the initial cost of an asset (or its recognized initial value) and spreading it over the years which are benefiting from that asset.

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Adjusting and closing entries

The most common method to depreciating an asset is the straight-line method. To apply depreciation three things must be recognized (or estimated): – the cost of the asset (or other recognizable value, i.e. its fair value); – the depreciation method; – the useful life; – the residual value at the end of its useful life (the scrap value). Straight-line depreciation is simple to understand, the company shall take the cost of the asset less the potential residual value and divide it by the years of the asset’s useful life. The purpose of that process is to periodically subtract value from the asset and put it in the income statement as a cost matched to that year’s revenues. It’s a common practice to record the asset’s value subtraction not in the original asset account but in a “contra-account” called “accumulated depreciation”; this means each tangible asset account will have its own associated accumulated depreciation account. On the balance sheet, each tangible asset is grouped at a value net from accumulated depreciation. The notes on the financial statements report the specific amount of depreciation allocated to each category of assets. Example 11 On 1st January N a company purchased machinery for € 50.000 with an estimated useful life of 5 years, there’s no residual value. Hence, the annual depreciation to account at the end of each accounting period is 10.000 (50.000-0)5. The annual depreciation is the amount to subtract each year and put as an expense in the income statement. The entries to record depreciation at the end of the first year of the machinery’s use are (ledger entries in bold italic): Machinery

Accumulated machinery depreciation

Machinery depreciation

50.000 10.000

10.000

Left (DR) C.

Machinery depreciation

A.

Accumulated machinery dep.

Right (CR)

10.000,00 10.000,00

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1st Trial Balance 31/12/08 ACCOUNTS Code A.. Machinery

LEFT 50.000

A.. Accumulated. machinery deprec. C.. Machinery depreciation … …

-

2nd Trial Balance 31/12/08

Adjustments

RIGHT -

LEFT

RIGHT

LEFT 50.000

10.000 10.000

RIGHT 10.000

10.000

Effects on financial statements: Balance sheet – Assets

Income statement + Cost

Cash Flow Statement none

At the end of the second year of machinery’s usage (N+1) regardless of other events the related depreciation entries are (ledger entries in italic bold): Machinery

Accumulated machinery depreciation

50.000

Machinery depreciation

10.000 10.000

10.000

Left (DR) C.

Machinery depreciation

A.

Accumulated machinery dep.

10.000,00 10.000,00

1st Trial Balance 31/12/09 Code ACCOUNTS A.. Machinery A.. Accumulated. machinery deprec. C.. Machinery depreciation … …

Right (CR)

LEFT 50.000

-

RIGHT

10.000 -

Adjustments LEFT

RIGHT

2nd Trial Balance 31/12/09 LEFT 50.000

10.000 10.000

RIGHT

20.000 10.000

In the previous example, we have assumed that the company acquires the asset on the first day of the accounting period (1st January) but that was a simplified example. Real companies act in two ways. The first way is to account for the first year’s depreciation in a strictly proportionally base linked on how much of the year is left (i.e. purchase on 1st March: the amount of

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yearly depreciation x 10/12). The second way is to apply half of the yearly depreciation amount regardless of when the asset it’s purchased over the initial year. Both methods are acceptable as long as the selected method is consistently applied.

2.6. Amortization Intangible assets also contribute to the production of revenues during the accounting period, but instead of being depreciated they are subject to a process called “amortization” that is very similar to depreciation. Since intangible assets are mainly rights, often there are legal limits on how long the company can use such rights. Hence, the amortization period for intangible assets is the shorter between: – the legal life; – the useful life. The annual amortization is computed by taking the cost of the intangible asset and dividing it by the shorter between the useful life or the legal life. It’s a frequently used practice to record the amortization directly in the asset account but we prefer to use a separate account for subtracting value from the intangible asset. This makes it easier to know how much was paid for each asset and how to associate the amortization taken, should an item be sold. Note that under some accounting rules (i.e. IAS/IFRS) specific intangibles may have no defined useful life (i.e. goodwill) and for this reason are subject to an impairment process. Example 12 On 1st January a company spent € 10.000 to obtain a patent filed and granted. The legal life for the patent in the company’s specific country is 20 years. The annual amortization of € 500 is computed by taking € 10.000 and dividing it by 20 years. Patents

Accumulated patents amortization

Machinery depreciation

10.000 500

500

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Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

C. A.

Patents depreciation

Right (CR)

500,00

Accumulated patents dep.

500,00

1st Trial Balance 31/12/08 Code ACCOUNTS A.. Patents A.. Accumulated. patents deprec. C.. Patents depreciation … …

LEFT 10.000 -

RIGHT 500 -

Adjustments LEFT

RIGHT

2nd Trial Balance 31/12/08 LEFT 10.000

500 500

RIGHT 500

500

Effects on financial statements: Balance sheet – Assets

Income statement + Cost

Cash Flow Statement none

2.7. Impairment Only intangible assets with definite useful lives are subject to the amortization process, intangible assets with an indefinite useful life shall be subject to an impairment test 3. Under IAS/IFRS accounting principles, the goodwill arising from an M&A operation is an example of intangible assets with indefinite useful life. The impairment test is the procedure aimed at verifying the recoverable value of an asset. Usually the asset is considered recoverable when the future cash flows provided exceed its carrying amount. Depending on the adopted accounting principles and by the type of intangible, the potential loss on impairment may be recognized as a cost in the income statement of the closing period or as a decrease in an equity component. If the loss on impairment is written in the income statement the overall effect on financial statements would be:

3

In an international perspective, it’s the IAS nr. 36 which states the impairment test application, see chapter 6 for further explanations.

Adjusting and closing entries

115

Effects on financial statements: Balance sheet – Assets

Income statement + Cost

Cash Flow Statement none

If the loss on impairment is inscribed in income statement the overall effect on financial statements would be: Effects on financial statements: Balance sheet – Assets – Equity

Income statement none

Cash Flow Statement none

2.8. Bad Debts As previously mentioned, revenue is recognized at the time a sale transaction is made, regardless of its payment date (immediate or future). Revenue recognition increases a company’s assets and net income. However, given that some of the receivables may ultimately prove to be uncollectible (also called “bad debts”), assets and net income may be overstated, for instance if there is a good chance a customer is going bankrupt or the accounts receivable is three years old. To avoid this possibility, companies make year-end adjustments to recognize that some of their accounts receivable will probably not be collected. Because company’s managers are unlikely to know which particular accounts will prove to be uncollectible, the amount of the adjustment is an estimate. This estimate is based on a company’s past experience, industry norms and current trends. The related adjustment does not directly reduce the accounts receivable. Instead, a negative (contra) asset, allowance for uncollectible accounts, is used. An expense is also recorded, which is consistent with the matching principle. One cost of generating sales is the receivables that will ultimately prove to be uncollectible. This cost (even though it must be estimated) should affect the income statement of the period where this uncollectible estimate is made. The net difference between the balances in accounts receivable and the allowance for uncollectible accounts is net accounts receivable, which is included in the total assets on the balance sheet.

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Example 13 At the end of the first year of activity of a company (the 31st December N) the overall balance of accounts receivables is € 1.000.000. The company estimates that 2% of its outstanding credits (€ 20.000) are related to customers with a high probability to going into bankruptcy and 5% (€ 50.000) are related to customers with financial problems. Thus, the company estimates to not collect the 90% from the bankruptcy customers and to not collect the 50% of the customers with financial constraints, hence it recorded an allowance for uncollectible accounts by 43.000 (90% of 20.000 plus 50% of 50.000) and a cost in the income statement of the same amount (ledger entries are in bold italic). Accounts receivable

Allowances for uncollectible accounts

Uncollectible accounts’ expense

1.000.000 43.000

43.000

Left (DR) C. A.

Uncollectible acc. expenses

Right (CR)

43.000,00

Allowance for uncoll. acc.

43.000,00

1st Trial Balance 31/12/08 Code ACCOUNTS A.. Accounts receivables Allowances for uncollectible A.. accounts

LEFT 1.000.000

C.. Uncollectible accounts' expense … …

RIGHT

-

-

-

-

Adjustments LEFT

RIGHT

2nd Trial Balance 31/12/08 LEFT 1.000.000

43.000 43.000

RIGHT

43.000 43.000

Effects on financial statements: Balance sheet – Assets

Income statement + Cost

Cash Flow Statement none

When a company ascertains that a particular customer will not pay, that customer’s account is written off. This is done by reducing the balances in accounts receivable and in the allowance for uncollectible accounts. If the

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allowance for uncollectible accounts does not cover the whole amount of the write off an expense is recorded in the income statement. Example 14 At 4th May, a company’s customer goes out of business; the company related uncollected receivables is € 50.000; the allowances for uncollectible accounts are € 43.000. The company closes the receivables for that customer and the overall allowances for uncollectible accounts, hence it records an expense for € 7.000 (ledger entries are in bold italic). Accounts receivable

Allowances for uncollectible accounts

1.000.000

Losses on accounts write-off

43.000 50.000

43.000

7.000

Left (DR) A.

Allowance for uncollect. acc.

C.

Loss on accounts write-off

A.

Right (CR)

43.000,00 7.000,00

Accounts receivable

50.000,00

Effects on financial statements: Balance sheet – Assets

Income statement + Cost

Cash Flow Statement none

2.9. Commitments, contingencies and provisions Commitments are company’s agreements with suppliers, customers, employers, or other entities that have not yet completed transactions and consequently have not been recognized in the accounts. If such agreements are significant, they should be disclosed in the notes to the financial statements. Contingencies are existing conditions whose resulting gains and losses are currently uncertain, but will be resolved by the occurrence of future events. Most companies are exposed to a wide variety of market risks. These can include changes in the future costs of acquiring materials and supplies, changes in the market values of financial assets and liabilities, effects on future revenues and expenses of swings in foreign exchange rates, potential

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effects of defaults on accounts receivables from major customers, and many other risks. In some cases, managers insulate themselves from some of these risks by using risk management strategies. Commitments, contingencies, and provisions may be referenced in either the current or the non-current liability sections, depending on when they are likely to require payment, or they may only be disclosed in the notes. At the end of the year, the company shall estimate commitencies and provisions and recognize the related present value of possible future losses in the financial statements. Example 15 During the year of N, a damage in the anti-pollution system of a manufacturing company leads to a minimal river pollution. The company estimates the possibility to be charged from the city county for the environmental damage, hence it recognizes a provision for environmental risk of € 24.000 that should affect the N income statement. Left (DR) C. L.

Cost for environment risk

Right (CR)

24.000,00

Provision for risk and changes

24.000,00

Effects on financial statements: Balance sheet + Liabilities

Income statement + Cost

1st Trial Balance 31/12/08 ACCOUNTS Code L.. Provisions for risk and charges C.. Cost for environmental risk … …

LEFT

RIGHT

Cash Flow Statement none

Adjustments LEFT 24.000

RIGHT 24.000

2nd Trial Balance 31/12/08 LEFT

RIGHT 24.000

24.000

3. Closing entries After the 2nd trial balance has been fully prepared, the final step in the process is to close the books by using a closing entry. This closing entry takes all the income and expense accounts and makes their balance zero.

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Adjusting and closing entries

Since the revenue and expense transactions, which really affect the change in equity due to net profit (or loss), were not recorded in that account, the balance sheet will not balance. Therefore, the amounts in the revenue and expense accounts must be transferred to retained earnings. Note that after posting the closing entries, the balance of each revenue and expense account is zero. This is why they are called temporary (or nominal) accounts since their balance is reset to zero each year. Balance sheet accounts are known as permanent accounts, since their balances carry over to different accounting periods. The process of making closing entry is very simple: all the accounts with a left-hand side (debit balance) are closed by posting the same balance amount on the right-hand side, and on the left-hand side is entered the same amount in the “net profit (or loss)” account; all the accounts with a righthand side balance (credit balance) are closed by posting the same balance amount on the left-hand side and on the right-hand side is entered the same amount in the “net profit (or loss)” account. Some examples entries are reported below. Left (DR) E.

Net profit (or loss)

Right (CR) …

C.

Raw materials expenses

…

C.

Service expenses

…

C.

Wages and salaries

…

C.

Change in raw material inv.

…

C.

Machinery depreciation

…

C.

Interest expenses

…

…

…

…

…

Left (DR) E.

Right (CR)

Net profit (or loss)

…

C.

Sales revenues

…

C.

Shipping refunds

… …

…

…

…

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4. Advanced operations In this section some particular transactions are explained, we call those transactions “advanced operations” because these in part arise from the financial statement preparation, for example the recognition of the net profit (or loss) of the period, or because those simply involve data resulting either from normal and adjusting entries, for example, the sale of fixed assets.

4.1. Recognition of net profit (or loss) Companies must periodically determine the amount of net profit (or loss) from their activities. Net profit (loss) represents an increase (or decrease) in the shareholders’ equity, or net assets, due to its revenues, expenses, gains, and losses during the period. At the end of the period, the related net profit or loss needs to be recognized and then, at the annual company report meeting, shareholders should decide what to do with the net income (or loss). In the presence of an income, the two main ways to follow and usually co-exist are: – distribute the profit (usually only a part of it) to shareholders as dividends; – retain the profit as an equity reserve (i.e. “retained earnings”). In case of a loss, the choice is only where to take the funds from to cover it: from new shareholders funds or existing equity items (i.e. reserves). Example 16 On 30th May at the company annual report meeting the net income of € 350.000 is approved and the 10% is retained as equity, the remaining part is assigned to shareholders as dividend payments. On that date, the net profit is decreased and the liabilities increased due to shareholders’ dividend payments. Left (DR) E.

Net profit (or loss)

Right (CR)

350.000,00

E.

Retained earnings

35.000,00

L.

Shareholders’ dividends

315.000,00

After a few days, dividends are paid to shareholders.

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Adjusting and closing entries Left (DR) L.

Shareholders’ dividends

A.

Right (CR)

315.000,00

Bank

315.000,00

The resulting effect on financial statements is: Effects on financial statements: Balance sheet + Equity – Cash – Equity

Income statement

Cash Flow Statement – Cash from financing

none

Example 17 On 30th April at the company annual report meeting financial statements are approved with a net loss of € -100.000. Shareholders decide to cover this loss with previous years’ retained earnings (of which a total balance is € 70.000) and the additional paid-in capital (which total balance is € 50.000). The retained earnings balance is used in total whilst the additional paid-in capital is used only for € 30.000 Left (DR) E.

Right (CR)

Net Loss

100.000,00

E.

Retained earnings

70.000,00

E.

Additional paid-in capital

30.000,00

After this entry, there is no overall change in the total amount of company equity as the losses were already accounted for in equity with a minus sign and the funds to cover it were taken up by the equity itself. Effects on financial statements: Balance sheet

Income statement none

Cash Flow Statement none

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4. Preparing Financial Statements At the end of the accounting period (i.e. at December 31st) financial statements should be prepared. Adjusting entries are required to transform some items recorded with a cash basis on items recorded with an accrual basis and to bring the accounting records up to date for the preparation of financial statements. After the adjusting entries have been properly figured out, financial statements may be prepared from the adjusted trial balance by selecting the accounts that appear in each of the financial statements and placing them in proper order. Sometimes a worksheet may be used as a good method of sorting the accounts. Modern software prepares the financial statements automatically, but analyzing the worksheet is still useful for a better understanding of the underlying process and to facilitate the preparation of the financial statements. Following, a simplified example of a worksheet is reported. It shows the process that led from the (adjusted) trial balance to the financial statements. ACCOUNTS

Adjusted trial balance Dr.

Furniture Patent Supplies (inventories) Accounts receivable Cash

Cr.

Balance Sheet Dr.

120.300

120.300

55.000

55.000

36.000

36.000

82.500

82.500

5.600

5.600

Cr.

Income Statement Dr.

Cr.

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Equity Capital

200.000

200.000

54.850

54.850

Notes payable

2.535

2.535

Sales revenues

94.800

Account Payable

Service expenses

94.800

6.650

6.650

32.145

32.145

25.450

25.450

Interest expenses

3.540

3.540

Depreciations

1.500

1.500

Raw materials purchases Wages and salaries

Accumulated depreciation

16.500 368.685

368.685

16.500 299.400

Net income 299.400

273.885

69.285

25.515

25.515

299.400

94.800

94.800

94.800

The table shows the list of all the accounts appearing in the adjusted trial balance. In the first two columns appear the balances of all open accounts in the ledger with the adjusted trial balance amounts (i.e. the trial balance after adjusting entries have been recorded properly). The next two columns are used for the amounts that will appear in the balance sheet, while in the last two columns are shown the amounts that will appear in the income statement. At the bottom of the table the net income (or net loss) is showed. It is always reported twice: both as a debit and a credit. If the revenues exceed the expenses, the net income will be shown in the debit column of the income statement, to make them balance. At the same time, this amount will be shown on the credit side of the balance sheet columns, to make these two columns balance. In the example provided, we can see that, for the period considered, the revenues earned are € 94.800 (recorded on the credit side of the income statement) while the expenses incurred are equal to € 69.285 (recorded on the debit side of the income statement). The difference is the net income of the period, equal to € 25.515. This amount is a sort of “value” created by the company with its activities during the accounting period and increases the equity of the business. Since net income is an increase in capital, this amount must be added to the balance sheet on the credit side, to make the two columns balance.

Preparing Financial Statements

125

The worksheet contains the information required for preparing the financial statements. The accounts merely need to be arranged in the correct format for financial statement presentation. The balance sheet and the income statement include the same items as shown in the worksheet, but they need to be re-arranged in a systematic form. As discussed in the first chapter, financial statements are made of three major reports: the balance sheet, the income statement and the cash flow statement. The preparation and the disclosure of financial statements are deeply affected by the use of different sets of rules and also different formats.

1. The Balance Sheet Although each individual account could conceivably be listed separately on the financial statements, it is much more informative to group related items into wider account categories. There is no fixed pattern or universally accepted standard as to the number of such categories. As previously stated, typically the balance sheet is presented in account form, which means with the asset on the on the left and the liabilities and owners’ equity on the right. Frequently, the classification of the items in the balance sheet is one of timing: timing the use of assets and the payment of liabilities. Assets are usually listed in decreasing order of their liquidity and divided in current assets and noncurrent assets. Current assets include cash and all the other assets that are expected to be realized in cash or sold or consumed within one year. Among the current assets, we can list: – Cash: funds already available in spendable form. It could be cash on hand available for daily operations or checking accounts in banks. – Temporary investments and marketable securities: – Net accounts receivables: they are the amount owed to the entity by its customers. The allowance for doubtful accounts (i.e. the amount that probably will NOT be collected) is subtracted from the balance of the accounts receivables on the balance sheet. The net value reported on the balance sheet represents the real estimate of the amount of accounts receivables expected to be collected. Similar to the accounts receivables are also the notes receivables. – Inventories: items that are held for sale, in process of production or held to be used in the production process.

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– Prepaid expenses: normally they are such things as rent and insurance premiums which are paid in advance (for one year or less). Since the prepayments are for short periods of time, they will be used up in the near future. Noncurrent assets are all the other assets, that are expected to be realized in cash or sold or consumed in more than one year. Among the noncurrent assets, we can list: – Property, plant and equipment, sometimes also called fixed assets. They are tangible long-term assets as they have physical existence and last for long periods of time. This category also includes land, even if land is shown separately because it is not depreciated, as are buildings, plants and equipment. These assets are reported at their historical cost less the accumulated depreciation. – Intangible assets are nonphysical things controlled by the company. They include patents, copyrights, trademarks and goodwill. – Investments are securities (like stocks or bonds) of other companies bought by the company with the intention of of keeping them for long periods. Similarly, liabilities are divided in current liabilities and noncurrent liabilities. Current liabilities are obligations that are expected to be satisfied or extinguished within one year. The most relevant current liabilities are: – Accounts payable are the claims of suppliers that have furnished goods or services and have not been paid yet. Similar to the accounts payable are also the notes payable. – Taxes payable represent the amount that is owed to the government for taxes. – Accrued expenses show the amounts that have been earned by third parties but have not been paid by the company yet. Typically they refer to interests (earned, but not paid yet), wages, commissions, rents, royalties, etc. … – Deferred or unearned revenues are liabilities arising from advance payments received by the company for future services. – Current portion of long-term debt. – Loss contingencies. Noncurrent liabilities are other liabilities classified as long-term debt. They are mainly obligations that are not due within one year. Examples of noncurrent liabilities are:

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127

– Bonds issued by the company. – Mortgages and other long term loans. – Financial leases. Owners’ equity: represents the owners’ investment in the business. The items in this classification depend on the legal form of the business (proprietorship, partnership or corporation). For a corporation, the major items are: – Capital Stock, which is the “par” value of the stock of the company times the number of stock outstanding. – Additional paid-in capital: the excess over the stated value paid by investors. – Retained earnings: the part of the total earnings that have been reinvested in the company. Exhibit 1 – Examples of owners’ equity in different forms of organization Sole Proprietorship: Owners’ Equity: Mr. John Smith, Capital

100.000

Partnership: Owners’ Equity: Mr. John Smith, Capital Mr. Adam Moore, Capital Mrs. Jennie Foster, Capital

100.000 200.000 150.000

Corporation: Owners’ Equity: Capital Stock Retained Earnings

300.000 120.000

The balance sheet can be represented as follow: BALANCE SHEET Assets Non-current assets

Liabilities Equity

Goodwill

Common stock

Intangible assets

Retained earnings

Property, plant and equipment

Other comprehensive income next page

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Investments Other long-term assets Total non-current assets

Non-current liabilities Long-term debts Bods

Current assets

Financial leases

Inventories Receivables

Current liabilities

Prepaid expenses

Accounts payable

Cash

Taxes payable

Total current assets

Accrued expenses Deferred revenues Loss contingencies

TOTAL ASSETS

TOTAL LIABILITIES AND OWNERS’ EQUITY

2. The Income Statement The income statement shows the amounts of the revenues earned and the expenses incurred in a particular period of time (i.e. one year). The information of the income statement may be presented in a variety of ways. There is, in fact, a large considerable variety in the formats and degree of detail used in income statements. Usually a multiple-step vertical income statement is adopted, in order to develop the final net income in a series of calculations designed to highlight subdivisions (the gross margin, operating income, income before taxes, etc…) and interim calculations. Every income statements always start with the net sales revenues, computed in the following way: Gross sales Less:

sales returns and allowances sales discounts = Net sales revenues

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129

From the net sales revenues the cost of goods sold (or cost of sales) should be deducted. The difference between the net sales revenues and the related cost of sales is called gross profit (or gross margin). Net sales revenues Less:

cost of goods sold = Gross profit

From the gross profit, other operating expenses are deducted in order to get to the operating profit: – Selling expenses (like sales personnel wages and salaries, advertising, etc. …); – General and Administrative Expenses (Office salaries, manager’s salaries, heath, light, power, telephone, etc. …); – Research and Development Expenses (R&D); – Depreciation and amortization; – Other Operating Expenses. From the operating income, the interest expenses (the cost of financing) are subtracted and other nonoperating revenues are added to get to the income before taxes (pre-tax profit). Finally, from the pre-tax profit the income tax expenses are subtracted to find the net income (or net loss), which is the “bottom line” of the income statement. Sometimes, the “earnings per share” value is reported after the net income. It is the ratio between net income and the number of common stock. The structure of the income statement is the following:

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Gross sales – Sales returns and allowances – Sales discounts = Net sales revenues – Cost of goods sold = – – – – –

Gross profit Selling expenses General and Administrative Expenses Research and Development Expenses Depreciation and amortization Other Operating Expenses

= – + –

Operating Income Interest expenses Nonoperating revenues Nonoperating expenses

= Income before taxes – Income taxes = Net Profit (Net loss)

After the balance sheet and the income statement, the cash flow statement has to be prepared. It does not directly and immediately come from the ledger accounts. Moreover, the techniques used to prepare this statement are complex and require more specific explanations that are not included in the purposes of this book.

5. Cases and exercises

1. Questions and exercises on the Accounting System (chapter 1) Q1: Describe the Accounting process identifying its main steps

____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ Q2: What is the Accounting process target?

____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ Q3: Define a business transaction

____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________

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Q4. Describe the differences between the economic and the financial flows. Support your answer with an example

____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ Q5. Explain the practice motivation at the base of the double entry method

____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ Q6. Describe the accounting equation

____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ Q7. Bring out the differences between the ledger and the journal book

____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________

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Cases and exercises

Q8. Describe the chart of accounts and their role in the recordings

____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ Q9. Describe the main accounting documents and reports

_____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ ____________________________________________________________ E1. Complete the table (put + or –) Left (DS)

Right (CS)

Financial view … Bank … Cash … Receivables … Liabilities

… Bank … Cash … Receivables … Liabilities

… Cost … Revenues

… Cost … Revenues

Economic view

E2. Complete the following T charts (title and amount) The company receives cash for 50 euro

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Introduction to Financial Accounting. Concepts, Cases and Exercises

The company pays 100 euro by bank transfer

The company reduces accounts payable for 300 euro

The company increases accounts receivable for 300 euro

The company pays 200 euro with a credit card

135

Cases and exercises

E3. Identify the nature of the account Financial

Income

Chart of accounts

Raw material expenses Bank Insurance expenses Sales revenues Debt Accounts receivable Payroll Costs for merchandise Accounts payable

E4. Record the follow business transactions Purchase of raw materials for a total value of 2.000 euro.

Left (DR)

Sale of finished products for a total amount of 5.000 euro.

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

Right (CR)

E5. Analyse the following transaction giving details on the accounts that has to be debited/credited, as in the example.

Date

Transaction

Analysis

../..

Receives € 5.000 from customer in full of account.

../..

Pays € 500 for rent of office for June 20.

../..

Purchases supplies for € 1.000 on account from Alpha Corp.

../..

Pays the monthly telephone bill for € 200.

../..

Receives a bill of € 300 from ABC Electric Power for electricity. The bill is not paid yet.

../..

Receives € 1.000 from a customer in full of account for final products previously sold.

../..

Receives a € 3.000 check from a customer in full of account for final products previously sold.

Received Cash from a customer. Cash is increased and the Accounts Receivables decreased. + Cash (Debit) – Account Receivables (Credit) ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... ....................................................... .......................................................

MC1. There are four steps in the accounting process. Which of the steps is most concerned with the classification and summarisation of financial data? a. b. c. d.

Identification Recording Measurement Communication

Cases and exercises

137

MC2. Which of these is not an economic decision? a. b. c. d.

Choosing a utility provider Taking out a loan Purchasing a mobile phone Supporting a sports team

MC3. Accounting is defined as the process of identifying, measuring, recording and __________ economic information to permit informed judgments and economic decisions by users of the information. a. b. c. d.

observing communicating processing certifying

MC4. Accounting is a profession that has evolved in response to society’s need for economic information to help people make: a. b. c. d.

products progress decisions money

MC5. The term used to describe the economic events which are the inputs of the accounting information system is: a. b. c. d.

contracts transactions deals agreements

MC6. The term ‘special purpose financial statements’ refers to the fact that the information in the reports is: a. b. c. d.

Available to everybody who requires specialised information Useful for special purposes but not in making specific decisions Prepared for users who have specialised needs and have the authority to obtain the required information Prepared to provide general information for use by all users

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Introduction to Financial Accounting. Concepts, Cases and Exercises

MC7. Who of the following is not an external decision maker? a. b. c. d.

Government regulator Shareholder Creditor Managing director

MC8. Which of the four stages of the accounting process is considered to require the most extensive training, experience and judgment? a. b. c. d.

Identifying Measuring Communicating Planning

MC9. The two broad branches into which accounting is divided are: a. b. c. d.

Cash and accrual Management and financial Taxation and financial Commercial and non-commercial

MC10. Financial accounting is the area of accounting concerned with providing information to ___________ decision makers of the organisation. a. b. c. d.

Advisory External Important Internal

2. Questions and exercises on the Accounting System (chapter 2) 2.1. Purchases and sales E1. Purchase of merchandise for a total value of 500 euro.

139

Cases and exercises Left (DR)

Right (CR)

Left (DR)

Right (CR)

The payment is made by cash

E2. Purchase of raw materials for a total value of 4.000 euro.

Left (DR)

Right (CR)

Left (DR)

Right (CR)

The payment is made by bank transfer

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Introduction to Financial Accounting. Concepts, Cases and Exercises

E3. Sale of final products for a total amount of 12.500 euro.

Left (DR)

Right (CR)

Left (DR)

Right (CR)

The payment is made by bank

2.2. Purchases with VAT E4. Record the following received invoice: INVOICE …..

….. ….. Raw Materials

10.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

10.000 2.000 12.000

141

Cases and exercises Left (DR)

Right (CR)

E5. Record the following invoice: INVOICE …..

….. ….. Merchandise Shipping

4.000 500

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

4.500 900 5.400

Left (DR)

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

E6. Record the following invoice: INVOICE …..

….. ….. Raw materials Shipping

4.000 500

TOTAL Liable to VAT VAT 10% TOTAL DUE ….

4.500 450 4.950

Left (DR)

E7. Record the following invoice:

….. ….. Raw materials Shipping Packaging TOTAL Liable to VAT VAT 20% TOTAL DUE ….

INVOICE ….. 4.000 500 300 4.800 960 5.760

Right (CR)

143

Cases and exercises

Left (DR)

E8. Record the following invoice. The company is the final consumer. INVOICE …..

….. ….. Wine

5.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

5.000 1.000 6.000

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Left (DR)

Right (CR)

2.3. Sales with VAT E9. Record the following invoice: INVOICE …..

….. ….. Finished products

30.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

30.000 6.000 36.000

Left (DR)

Right (CR)

145

Cases and exercises

E10. Record the following invoice: INVOICE …..

….. ….. Product B Packaging

18.000 1.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

19.000 3.800 22.800

Left (DR)

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

2.4. Purchases and Sales not liable to VAT E11. Record the following received invoice: INVOICE …..

….. ….. Healthcare services

700

TOTAL Liable to VAT VAT 0% TOTAL DUE ….

700

Left (DR)

E12. Record the following invoice issued: INVOICE …..

….. ….. Healthcare services

2.500

TOTAL Liable to VAT VAT 0% TOTAL DUE ….

2.500

Right (CR)

147

Cases and exercises Left (DR)

Right (CR)

2.5. Advance payment To a supplier E13. Record the following invoice. The payment is immediate.

….. ….. Advance payment for raw materials

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

INVOICE …..

5.000

5.000 1.000 6.000

Left (DR)

Right (CR)

148

Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

Right (CR)

E14. Record the following invoice. INVOICE …..

….. ….. Raw materials -Advance payment TOTAL Liable to VAT VAT 20% TOTAL DUE ….

100.000 (5.000) 95.000 19.000 114.000

Left (DR)

Right (CR)

149

Cases and exercises

From a customer E15. Record the following invoice. The payment is immediate.

….. ….. Advance payment for Product "A"

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

INVOICE …..

40.000

40.000 8.000 48.000

Left (DR)

Right (CR)

Left (DR)

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

E16. Record the following invoice. INVOICE …..

….. ….. Products "A" -Advance payment TOTAL Liable to VAT VAT 20% TOTAL DUE ….

75.000 (40.000) 35.000 7.000 42.000

Left (DR)

Right (CR)

151

Cases and exercises

2.6. Discounts E17. Record the following received invoice. INVOICE …..

….. ….. Merchandise Shipping

12.000 500

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

12.500 2.500 15.000

Left (DR)

Our supplier grants a 5% discount

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

Right (CR)

E18. Record the following issued invoice. INVOICE …..

….. ….. Merchandise Shipping

12.000 500

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

12.500 2.500 15.000

Left (DR)

Right (CR)

153

Cases and exercises

Our company decides to apply a 10% discount.

Left (DR)

Right (CR)

2.7. Returns E19. Record the following received invoice. INVOICE …..

….. ….. Product "C"

5.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

5.000 1.000 6.000

Left (DR)

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

The products were faulty and our company return them to the supplier.

Left (DR)

Right (CR)

E20. Record the following issued invoice. INVOICE …..

….. ….. Product "X" Product "Y"

15.000 20.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

35.000 7.000 42.000

Left (DR)

Right (CR)

155

Cases and exercises

Product “Y” is wrongly purchased and the costumer return goods.

Left (DR)

2.8. Import From EU E21. Record the following received invoice from a French supplier. INVOICE …..

….. ….. Product "X"

20.000

TOTAL DUE

20.000

………………………………………

Right (CR)

156

Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

Right (CR)

From a Extra-UE country E22. Record the following received invoice from a Mexican supplier. The transaction is dealt in euros. INVOICE …..

….. ….. Merchandise

40.000

TOTAL DUE

40.000

Left (DR)

The transporter invoice is the following:

….. …..

INVOICE …..

Shipping Duties to reimbourse*

1.000 400

TOTAL Liable to VAT VAT 20% VAT to reimbourse** TOTAL DUE

1.400 280 8.000 9.680

*i.e. 1% of the goods value **20% of the goods value

Right (CR)

157

Cases and exercises

Left (DR)

Right (CR)

E23. Record the following received invoice from an US supplier. The invoice is in US dollars (EUR-USD 1.25). INVOICE …..

….. ….. Raw materials

10.000

TOTAL DUE

10.000

Left (DR)

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Our company pays with a EUR-USD exchange rate of 1.27.

Left (DR)

The transporter invoice is the following:

….. …..

INVOICE …..

Shipping Duties to reimbourse*

1.000 100

TOTAL Liable to VAT VAT 20% VAT to reimbourse** TOTAL DUE

1.100 220 2.000 3.320

*i.e. 1% of the goods value **20% of the goods value

Right (CR)

159

Cases and exercises Left (DR)

Right (CR)

2.9. Export E24. Record the following issued invoice to a Spanish costumer. INVOICE …..

….. ….. Raw materials

10.000

TOTAL DUE

10.000

Left (DR)

Right (CR)

E25. Record the following issued invoice to a Chinese costumer. The invoice is in euros. INVOICE …..

….. ….. Merchandise

40.000

TOTAL DUE

40.000

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Left (DR)

Right (CR)

2.10. VAT settlement E26. At the end of the December the VAT accounts are the following: Input VAT

Output VAT

22.000

43.000

The company states its VAT position

Left (DR)

Right (CR)

Left (DR)

Right (CR)

161

Cases and exercises Left (DR)

Right (CR)

E27. At the end of the April the VAT accounts are the following: Input VAT

Output VAT

55.000

30.000

The company states its VAT position

Left (DR)

Right (CR)

Left (DR)

Right (CR)

At the end of the May the VAT accounts are the following: Input VAT 12.000

Output VAT 70.000

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Introduction to Financial Accounting. Concepts, Cases and Exercises

The company states its VAT position

25.000

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

2.11. Payroll E28. Record the following payroll document: PAYROLL REPORT January Gross PAY Tax deductions Welfare deductions NET PAY

80.000 (15.000) (18.000) 47.000

The company’s own contribution for its employees’ welfare is 15.000.

163

Cases and exercises

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

164

Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

Right (CR)

Left (DR)

Right (CR)

E29. Record the following payroll document: PAYROLL REPORT January Gross PAY Family checks Tax deductions Welfare deductions NET PAY

50.000 3.000 (10.000) (12.000) 31.000

The company’s own contribution for its employees’ welfare is 12.000.

165

Cases and exercises

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

166

Introduction to Financial Accounting. Concepts, Cases and Exercises

2.12. Non-Current Assets E30. Record the following received invoice. INVOICE …..

….. ….. Machinery "A"

120.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

120.000 24.000 144.000

Left (DR)

Right (CR)

Left (DR)

Right (CR)

The supplier is paid by bank transfer.

167

Cases and exercises

E31. Record the following received invoice.

….. ….. Machinery "A" Shipping Installation TOTAL Liable to VAT VAT 20% TOTAL DUE ….

INVOICE ….. 120.000 5.000 2.500 127.500 25.500 153.000

Left (DR)

Right (CR)

2.13. Loans E32. On 1st July a company takes out a loan from a bank for 200.000 euro. Istalments

Left (DR)

Right (CR)

The installments due to the bank are biannual for a total amount of 20.000. The annual interest rate is of 4%.

168

Introduction to Financial Accounting. Concepts, Cases and Exercises

31.12.N

Left (DR)

Right (CR)

Left (DR)

Right (CR)

01.07.N + 1

2.14. Bonds E33. On 1st January a company issues bonds at par for a total amount of 500.000 euro. It is repaid in 15 years and the coupon rate of 10% is paid semi-annual. 01.01.N

169

Cases and exercises Left (DR)

Right (CR)

Left (DR)

Right (CR)

30.06.N

2.15. Factoring E34. Record the following received invoice: INVOICE …..

….. ….. Merchandise Shipping

4.000 500

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

4.500 900 5.400

170

Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

Right (CR)

Hp1. The receivable is factored (pro-soluto) for 1.500 euro.

Left (DR)

Right (CR)

Hp2. The receivable is factored (pro-solvendo) for 4.000 euro.

Left (DR)

Right (CR)

171

Cases and exercises

2.16. Leasing E35. The company made a capital leasing related to a machinery. The features of the contract are: Machine cost: 200.000 euro Leasing length: 5 years Installments paid every year Fixed installment amount: 50.0000 + VAT 22% euro Redemption price: 5% of the initial machine value

Hp1. Formal perspective Installment:

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Redemption:

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Hp2. Substantial perspective Deal

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Installment

Depreciation

173

Cases and exercises

2.17. Equity E36. Shareholders undersign the equity capital for a par value of 50.000 euro.

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Shareholders pay the shares.

E37. Shareholders undersign the equity capital by issuing 100.000 new shares for a par value of 2 euro and a price of 3 euro.

Left (DR)

Right (CR)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Hp1. Shareholders pay the minimum amount fixed by law.

Left (DR)

Right (CR)

Hp2. Shareholders pay the total amount for the shares.

Left (DR)

Right (CR)

E38. Do the following accounts usually have debit balances or credit balances? For each account given, put a tick () in the proper column. ACCOUNTS Raw materials expenses Bank Accounts Receivable Advance payment from customers Sales revenues Sales return Interest expenses on loans Equity capital Wages and salaries Input VAT

Left (DR)

Right (CR)

175

Cases and exercises Machinery Shareholders receivable Employees payable Accumulated machinery depreciation Accounts payable Additional paid-in capital

3. Questions and exercises on the Adjusting and closing entries (chapter 3) 3.1. Accrued receivable and accrued payable E1. A company sales finished products in December N but the invoice is issued in January N+1. The issued invoice is the following: INVOICE …..

….. ….. Product A

22.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

22.000 4.400 26.400

31.12.N

Left (DR)

Right (CR)

176

Introduction to Financial Accounting. Concepts, Cases and Exercises

05.01.N+1

Left (DR)

Right (CR)

E2. A company buys merchandise in December N but the invoice is received in January N+1. The received invoice is the following: INVOICE …..

….. ….. Merchandise Shipping

7.000 500

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

7.500 1.500 9.000

31.12.N

Left (DR)

Right (CR)

177

Cases and exercises

12.01.N+1

Left (DR)

Right (CR)

3.2. Accrued interest E3. On 1st November a company collected a loan for 300.000 euro. The installments are paid every four months (1st March/1st July/1st November) with a fixed interest rate of 3.5%. The installment is equal to 15.000 euros. 01.11.N

Left (DR)

31.12.N

Right (CR)

178

Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

Right (CR)

Left (DR)

Right (CR)

01.03.N+1

3.3. Payroll accruals E4. On 31st December employees matured compensation in the accounting year for 50.000 euro.

Left (DR)

Right (CR)

179

Cases and exercises

3.4. Unearned revenues and prepaid expenses E5. On October the 1st a gym collected an annual membership fee for 1.000 euro + VAT 22%. The fee is paid in cash. 01.10.N

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

31.12.N

01.01.N+1

180

Introduction to Financial Accounting. Concepts, Cases and Exercises

E6. On February the 1st a company paid in advance a 3.000 euro premium for one year insurance. 01.02.N

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

31.12.N

01.01.N+1

181

Cases and exercises

3.5. Inventory E7. The inventory at the end of the first year of activity consists of Raw materials: 22.000 euro Merchandise: 15.000 euro Finished products: 40.000 euro 31.12.N

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

182

Introduction to Financial Accounting. Concepts, Cases and Exercises

Show the effects on the financial statement Balance sheet

Income statement

Cash Flow Statement

The inventory at the end of the second year is composed of Raw materials: 10.000 euro Merchandise: 25.000 euro Finished products: 50.000 euro 01.01.N+1

Left (DR)

Right (CR)

183

Cases and exercises Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Left (DR)

Right (CR)

31.12.N+1

184

Introduction to Financial Accounting. Concepts, Cases and Exercises

Left (DR)

Show the effects on the financial statement

Balance sheet

Income statement

Cash Flow Statement

3.6. Depreciation and Amortization E8. Record the following received invoice. INVOICE 01/01/N

….. ….. Machinery "X"

75.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

75.000 15.000 90.000

Right (CR)

185

Cases and exercises

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Estimated useful life: 10 years. 31.12.N

E9. Record the following received invoice. Be careful to the date. INVOICE 01/07/N

….. ….. Machinery "X" Shipping

50.000 1.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

51.000 10.200 61.200

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Left (DR)

Right (CR)

Left (DR)

Right (CR)

Estimated useful life: 12 years. 31.12.N

E10. Record the following received invoice. INVOICE 01/01/N

….. Brand design Brand registering

7.000 500

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

7.500 1.500 9.000

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Cases and exercises

Left (DR)

Right (CR)

Left (DR)

Right (CR)

Estimated useful life: 5 years. 31.12.N

3.7. Bad debts E11. At the end of the year the overall balance of accounts receivable is 200.000 euro. Directors estimate that the 10% are outstanding credits because related to bankrupt customers. The company expects not to collect all of those. The previous allowance for uncollectible accounts is null. 31.12.N

188

Introduction to Financial Accounting. Concepts, Cases and Exercises Left (DR)

Right (CR)

E12. At the end of the year the overall balance of accounts receivable is of 300.000 euro. Directors estimate that the 15% are outstanding credits because related to bankrupt customers. The company estimates to not collect the 100% of those. The previous allowance for uncollectible accounts amount to 5.000 euro. 31.12.N

Left (DR)

Right (CR)

3.8. Provisions E13. The company in involved in a trial for problems regarding the quality of their products. The lawyer estimates that is probable that the company will pay 150.000 euro for damages. 31.12.N

Left (DR)

Right (CR)

189

Cases and exercises

4. Questions and exercises on the preparation of Financial Statements (chapter 4) E1. Determine the amounts of the current liabilities and the non-current assets from the following information: Total assets: Owners’ Equity Current Assets Long-term Liabilities

€ 560.000 € 262.500 € 175.000 € 157.500

E2. Determine the amounts of the current assets and the owners’ equity from the following information: Total assets: Current liabilities Long term liabilities Intangible assets Property, plant and equipment

€ 1.609.725 € 193.950 € 450.000 € 157.500 € 947.100

E3. From the following account balances, prepare the balance sheets as of Jan. 1st and Dec. 31st in proper format. Accounts payable Accounts receivable Accrued wages payable Accumulated depreciation on building Accumulated depreciation on equipment Building Capital stock Cash Equipment Inventories Land Note receivable Notes payable Other noncurrent assets Other noncurrent liabilities Prepaid rent Retained earnings Tax payable Net Income

Jan. 1st 2.980 7.629 691 54.600 1.856 204.750 136.500 12.244 4.641 12.388 31.395 4.095 2.935 1.700 858 1.102 76.329 1.995 1.200

Dec. 31st 7.460 9.277 771 55.282 2.075 204.750 136.500 25.331 13.831 12.702 31.391 10.238 1.843 858 989 77.529 2.529 6.872,00

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E4. Alpha’s Corp. Trial balance at the end of the year is presented below. Prepare classified financial statements. Cash Accounts receivable Prepaid expenses Supplies (Inventories) Equipment Accumulated depreciation Accounts payable Unearned revenues Loan payable Capital stock Retained earnings Temporary investments Revenues Selling expenses Interest expense Salaries expense Maintenance and supplies expense Depreciation expense

Dr 3.336.884 1.383.636 183.148 266.660 12.036.000

Cr

4.888.796 2.176.760 1.820.000 4.000.000 2.240.000 915.568 200.000 9.493.608 1.905.780 320.000 2.710.668 891.956 2.300.000 25.534.732

25.534.732

E5. Classify the following accounts into Assets, Liabilities, Owners’ Equity, Revenue or Expense. For each account given, put a tick () in the proper column. Accounts Common Stock Accounts Payable Accounts Receivables Accumulated depreciation Cash Depreciation Electric Power Expenses Equipment Inventory Land Marketable Securities Notes Payable Paid-in Capital Patent

Assets

Liability

Equity

Revenue

Expense

Cases and exercises

191

Prepaid expenses Raw materials purchases Retained earnings Salaries Expense Salaries Payable Sales returns Sales revenues Trademarks Unearned Revenues Wages

E6. Match each of the following accounts on the left column to its proper balance sheet classification in the right column. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

Accumulated depreciation Bonds payable Buildings Capital stock Dividends payable Goodwill Investment in long-term bonds Marketable Securities Merchandise inventory Mortgage payable (due in 3 years) Notes receivable Office equipment Paid-in Capital Prepaid Insurance Prepaid Rent Retained earnings Salaries Payable Social security tax payable Unearned interests Unearned sales revenue

A. B. C. D. E.

CURRENT ASSETS NONCURRENT ASSETS OWNERS’ EQUITY CURRENT LIABILITIES NONCURRENT LIABILITIES

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E7. The trial balance of Company Alpha at 31/12/n is the following: Accounts

Left

Accumulated building depreciation Bank VAT settlement Foreign Revenues Building Building depreciation Foreign Accounts receivables Share capital TOTAL

Right 15,000 410,000

110,000 80,000 500,000 15,000 80,000 705,000

200,000 705,000

1. Identify the business transactions that led the above balances and record the related entries in the ledger and in the journal (assume VAT 22%). 2. Prepare simplified Balance Sheet and Income Statement of Company Alpha at 31/12/n.

E8. The trial balance of Company ALOC-C at June, 30th is the following: Account Bank Shareholders’ Equity Additional Paid-in capital Loans Machinery Input VAT Account payable Output VAT Costs for raw materials Interests expenses TOTAL

Left

Right

635,000 300,000 200,000 450,000 250,000 80,000 0 30,000 0 15,000 980,000

980,000

1. Identify the business transactions that led the above balances and record the related entries just in the journal book (assume VAT 20%). 2. Record just the Bank T-account in the ledger for the previous transactions 3. Prepare simplified Balance Sheet and Income Statement of Company ALOC-C at 30/06/t.

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Cases and exercises

E9. The trial balance of Company ELPPA at September, 30th is the following: Account

Left

Right

Bank

X

Shareholders’ Equity

600,000

Shareholders Receivable

150,000

Advance payment from customers

50,000

Costs for Raw Materials

40,909

Account Payable

35,500

Foreign Account Receivable

15,000

Revenues for finished products

15,000

Costs for Healthcare Services

5,500

VAT Settlement Payable

Y 211,409 + X

TOTAL

300,500 + Y

1. Identify the business transactions that led the above balances and record the related entries just in the journal book (assume VAT 10%) 2. Record the Bank and the VAT related (input, output, settlement) T-accounts in the ledger for the previous transactions and determine the balance of Bank and VAT Settlement Payable accounts Bank (X) = ___________ VAT Settlement Payable (Y) = ___________ 3. Prepare simplified Balance Sheet and Income Statement of Company ELPPA at 30/09/t.

E10. The trial balance of Company MIA at 31/12/n is the following: Account Accumulated building depreciation Shareholders’ Equity Bank Building Accounts payable VAT settlement Foreign Revenues Building depreciation TOTAL

Left

Right 21,000 300,000 37,000

700,000 427,000 154,000 90,000 21,000 875,000

875,000

1. Identify the business transactions that led the above balances and record the related entries just in the journal book (assume VAT 22%).

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2. Record just the Bank T-account in the ledger for the previous transactions. 3. Prepare simplified Balance Sheet and Income Statement of Company MIA at 31/12/n.

5. Final exercises Case One One Ltd. is a company established in Italy. A) The student accounts (in the journal and in the ledger) for the following business transactions regarding this company: 1) Sale of finished products for € 10.000 (outright cash receipt). 2) Purchase of merchandise for € 3.000 (outright cash payment). 3) Purchase of raw materials for € 5.000 (outright bank payment). 4) Sale on credit of finished products for € 34.000. 5) Purchase on credit of raw materials for € 10.000. 6) Payment with bank for the 60% of the amount due to supplier related to n. 5. 7) Cash collection of the sale on n. 4. B) How much is the balance in cash resulting from all the previous transactions? Cash

Case Info Info Ltd. is a clothing company established in the UK. A) Please define the different info/flows underlying these transactions: 1. Sale of garments to customers for € 14.000 (outright cash receipt). 2. Purchase of fabrics from suppliers for € 5.000 (outright cash payment). 3. Receipt of the phone bill for € 3.000 (outright cash payment). 4. Transfer of fabric crates (total value € 4.000) from Warehouse A to Warehouse C. 5. Sale of coats for € 1.000 (outright bank collection). 6. Sale of winter garments to Client A for € 3.000 (future bank collection). 7. Purchase of merchandise from supplier Z for € 2.000 (future cash payment). B) Please, account on the ledger and journal books for the previous transactions. C) By considering just the previous transactions prepare financial statements (income statement, balance sheet and cash flow) of Info Ltd., given that the shareholders invested € 50.000 at the incorporation date. D) Define the amount of profit/loss for the period.

Cases and exercises

195

Case Alpha Alpha Ltd. is a tires’ manufacturing company established in Italy some years ago. The student helps Alpha Ltd. in accounting (in the journal and in the ledger) for the following business transactions and tries to define also the effect on financial statements of each operation: 1. Receipt of the following purchase invoice:

2. 3. 4. 5. 6. 7.

Zeta Corp.

INVOICE

….. …..

Alpha Ltd. Rubber grains shipping

15.000 1.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

16.000 3.200 19.200

Receipt of purchase invoice n. 136669/A reported in the following Exhibit. Purchase of merchandise not liable to VAT for € 4.000. Bank payment of the invoice at n. 1). Obtaining a discount from the supplier for the amount of € 4.000,00 (+ VAT 20%). Return of faulty material to a supplier for € 2.000 (+ 20% VAT). Issue of the following invoice: Alpha Ltd. INVOICE …..

….. ….. Finished products packaging

15.000 3.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

18.000 3.600 21.600

8. Advance payment to a supplier for a future purchase of plastic for € 5.000 (+ VAT 20%). 9. Advance’s receipt from a customer for € 10.000 (+ 20% VAT) relating a future sales of tyres “XX”. 10. Receipt of the following purchase invoice:

196

Introduction to Financial Accounting. Concepts, Cases and Exercises INVOICE

AXI Corp. ….. …..

Alpha Ltd. Plastics "X" -Advance payment

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

40.000 (5.000) 35.000 7.000 42.000

11. Issue of the following purchase invoice: Alpha Ltd. ….. …..

INVOICE Mechanic Ltd.

Tyres "XX" -Advance payment TOTAL Liable to VAT VAT 20% TOTAL DUE ….

80.000 (10.000) 70.000 14.000 84.000

12. Periodic VAT settlement regarding all the previous transactions and payment (if due).

197

Cases and exercises

Exhibit 1 – Purchase invoice n. 136669/A Original c opy for the customer

Un it ed S h ippin g Lt d . Type of document

INVOICE N° 136669/AS12th dec '09

Bill to:

Refers to:

Company name

Alpha Ltd.

Adress City Tel. Number

Via Unione Sovietica 218bis Torino +39.011.1234567

Item Cod. Shipping A01 Shipping EU01

Prov. TO

Items DESCRIPTION Shiiping n.234556 (route Torino-Milano) Shipping n.234557 (route Chiasso-Lubeck)

Payment terms

VAT Codes Ord Ni

Purchase Ord. 516745 Date Ordered 5/12/09 ZIP 10134

Unit Price Eur

VAT Cod.

QTY

Ord

2

3.000,00

Ni

1

2.500,00

Bank Transfer Net 30

VAT Cod. Ord Ni

TOTAL Eur

6.000,00 2.500,00

TOTAL

8.500,00

VAT TOTAL INVOICE

1.200,00

VAT details Amont Liable 6.000,00 2.500,00

9.700,00 VAT Amounts 1.200,00 -

Description Liable to 20% VAT Not Liable to VAT - Italian law: art. 8, 8-bis DPR n. 633, 23 ottobre 1972

Notes :

Page 1 of 1

United Shipping Ltd - 10144 Torino - Via Orte, 24 - tel.+39.011.12345 - fax +39.011.1234544 Share capital € 120.000,00 - Companies registry and VAT Code IT 99883311003

Case Tera Tera Ltd. is a car manufacturing company established in Italy some years ago. The student helps Tera Ltd. accounting (on the journal and on the ledger) for the following business transactions and tries to define also the effect on financial statements of each operation:

198 1.

Introduction to Financial Accounting. Concepts, Cases and Exercises

Receipt of the following purchase invoice: INVOICE …..

….. ….. Iron bars

4.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

4.000 800 4.800

2. Receipt of the following purchase invoice: INVOICE …..

….. ….. Rubber seals Shipping

6.000 500

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

6.500 1.300 7.800

3. Issue of the following invoice: Tera Ltd. INVOICE …..

….. …..

4. 5. 6. 7.

Finished products

8.000

TOTAL Liable to VAT VAT 20% TOTAL DUE ….

8.000 1.600 9.600

Cash collection of the total amount related to n. 3). Obtaining a discount from the supplier for the amount of € 4.000,00 (+ VAT 20%). Return of faulty materials to a supplier for € 2.000 (+ 20% VAT). Periodic VAT settlement regarding all the previous transactions and payment (if due).

Case KEY Please, record on the journal and on the ledger the following transactions regarding KEY Corp:

199

Cases and exercises

1. Purchase of computer systems for 50.000 Euro + VAT 20%. 2. Receipt of the invoice related to the integration of the computers for 2.000 Euro + VAT 20%. 3. The useful life of the computer sys. is planned to be 5 years, please apply straight line depreciation for the first year (no residual value). 4. Collection of a loan from a bank for the amount of € 100.000; afterwards payment of 1st installment: Principal € 10.000 Interest € 1.500 5. Incorporation of the company by issuing nr. 10.000 shares, par value is € 1,00 (shareholders invest 12.000 € by bank transfer). Please, prepare KEY Corp. financial statements according to the previous transactions.

Case Trials A) Select and describe the correct financial statements’ position for the following accounts: Position in: ACCOUNTS

Balance sheet

Income statement

Accrued interests Accumlated depreciation for Machinery Addtional paid-in capital Bank Cash Changes in inventory of finished products Changes in inventory of raw materials Accounts payables Accounts receivables Machinery Mortgage Mortgage interests Software Provision for employees' leaving indemnity Provisions for risks Raw material costs Rent Salaries Sales Service expenses Share capital Welfare Institutions payable Welfare expenses

Case Kar A) Kar Ltd. 1st trial balance at 31st December 2014 is reported below, the student accounts for these adjustment while filling the 2nd trial balance:

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1. The depreciation rates are: Plant 12% Machinery 10% 2. An annual rent was paid in advance on 1st September for an amount of € 24.000. 3. On the 1st may 2014 will be paid an annual mortgage rate as follow: Capital share € 20.000 Interests € 16.000 4. The allocation for employees indemnity is € 15.000 5. During the year products were sold with a 2 years warranty, the estimated risk of warranty claim is 12.000 €. 6. The accrual for income taxes is € 40.000 7. Inventory at 31st December is: Raw materials € 5.000 Fished products € 30.000 B) Prepare balance sheet and income statement of KAR Ltd. based on the 2nd trial balance. Exhibit 2 – KAR Ltd. 1st Trial balance 1st Trial Balance ACCOUNTS

LEFT 980.000

Plant Accumulated depreciation for Plant Machinery Accumlated depreciation for Machinery Commercial receivables Cash Bank Share capital Reteined earnings Provision for employees' leaving indemnity Mortgage Commercial payables Welfare debits VAT Sales Changes in inventory of finished products Raw material costs Service expenses Rent Salaries Welfare expenses Changes in inventory of raw materials Mortgage interests

12.000 1.100.000 80.000 36.000 960.000 320.000 10.000 3.000

TOTAL

4.996.000

RIGHT

Adjustments LEFT RIGHT

2nd Trial balance LEFT RIGHT

110.000 660.000 80.000 701.000 9.000 125.000 200.000 10.000 20.000 500.000 250.000 150.000 30.000 3.646.000

4.996.000

-

-

-

-

Cases and exercises

201

Case SGV A) The student accounts (in the journal and in the ledger) for the following business transactions regarding SGV Ltd. during year N: 1. Shareholders undersign and pay for no. 55.000 company’s issued shares with a par value of € 1,00. 2. On 1st September, the company collects a mortgage of € 100.000; installments are paid quarterly starting from the 1st December 2014 with a fixed annual interest rate of 6%; each installment’s principal is € 10.000. 3. Payment of the first mortgage’s installment. 4. Receipt of a purchase invoice regarding a fixed asset: Machinery type “Z” Delivery expenses Taxable amount VAT 20% Total amount

€ € € € €

140.000,00 10.000,00 150.000,00 30.000,00 180.000,00

€ € € €

20.000,00 20.000,00 4.000,00 26.000,00

5. Receipt of this purchase invoice: Raw materials Taxable amount VAT 20% Total amount

6. Receipt of a shipping expense’s invoice for € 2.000 (+ VAT 20%). 7. Issue of this sale invoice: Finished goods Transport charges Taxable amount VAT 20% Total amount

€ € € € €

150.000,00 2.000,00 152.000,00 30.400,00 180.400,00

€ € € € €

30.000,00 6.000,00 36.000,00 7.200,00 43.200,00

8. Issue of this sale invoice: Merchandise Shipping charges Taxable amount VAT 20% Total amount

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9. Collection by bank transfer of the receivable related to n. 7. 10. Payment of the supplier related to n. 4. 11. Payment of gross wages and salaries for € 60.000 by withholding € 6.000 due to employees’ welfare contribution. 12. On 1st November 2014 the company pays an annual rent for € 12.000 (covering twelve the months starting from November 2014). B) Figure out the SGV Ltd’s 1st trial balance at 31st December 2014 arising from the previous transactions. C) Adjust the 1st trial balance at 31st December 2014 by taking into account the following data: 1. Machinery useful life is 10 years, no residual value. 2. On 1st March 2015 the second installment on the mortgage will be paid. 3. The annual rent paid in advance on 1st November 2014. 4. Raw materials inventory’s final stock is € 5.000; finished products inventory’s final stock is € 30.000. D) Prepare the balance sheets and the income statement at 31st December 2014 for IRI Ltd.

Case Melfra Ltd. A) Melfra Ltd. 1st trial balance at 31st December 2008 is reported below, make the following adjustment and figure out the 2nd trial balance: 1. An annual rent was paid in advance at 1st June for an amount of € 36.000. 2. At 1st October 2009 an annual mortgage rate of € 72.000 will be paid (face value: € 50.000; interests: 12.000). 3. The depreciation expense for Plant is € 25.000 and for machinery is € 10.000. 4. The annual allocation for employees indemnity is € 14.000. 5. Inventory at 31st December 2008 is: Raw materials € 25.000 Fished products € 10.000

203

Cases and exercises

Exhibit 3 – ITS Ltd. 1st Trial Balance 1st Trial Balance - 31st dec'08 ACCOUNTS Plant Accumulated depreciation for Plant Machinery Accumlated depreciation for Machinery Commercial receivables VAT Cash Bank Share capital Reteined earnings Provision for employees' leaving indemnity Mortgage Commercial payables Welfare debits Sales Changes in inventory of finished products Raw material costs Service expenses Rent Salaries Welfare expenses Changes in inventory of raw materials Mortgage interests Prepaid expense Accrued interests on mortgages Plant depreciation Machinery depreciation Employees indemnity Raw materials Finished Products TOTAL

LEFT 1.000.000

RIGHT

Adjustments LEFT RIGHT

120.000

25.000

70.000

10.000

700.000 800.000 40.000 9.000 125.000 618.000 10.000 20.000 500.000 250.000 150.000 3.646.000 50.000 1.200.000 80.000 36.000 960.000 320.000 55.000 9.000

14.000

10.000

15.000

25.000 3.000 15.000

2nd Trial balance LEFT RIGHT 1.000.000 145.000 700.000 80.000 800.000 40.000 9.000 125.000 618.000 10.000 34.000 500.000 250.000 150.000 3.646.000 40.000 1.200.000 80.000 21.000 960.000 320.000 30.000 12.000 15.000

3.000

5.384.000

5.384.000

25.000 10.000 14.000 25.000 10.000 102.000

102.000

3.000 25.000 10.000 14.000 25.000 10.000 5.436.000

5.436.000

Case ABC Factory The adjusted trial balance for ABC Factory is provided below. Prepare the necessary closing entries. Narrations not required. ABC Factory Adjusted Trial Balance June 30, 2015 Debit Cash Accounts receivable Merchandise inventory Office supplies Store equipment Accumulated depreciation – store equipment Office equipment Accumulated depreciation – office equipment

Credit $ 18 800 50 000 72 000 1800 150 000 $ 44 000 120 000 30 000

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Accounts payable Notes payable F. Worker, Capital F. Worker, Withdrawals Sales Sales discounts Sales returns and allowances Cost of goods sold Sales salaries expense Depreciation expense – store equipment Depreciation expense – office equipment Office supplies expense Interest expense Totals

84 000 20 000 221 400 96 000 650 000 12 000 33 000 390 000 65 000 22 000 15 000 2600 1200 $ 1 049 400

$ 1 049 400

a. Prepare a e balance sheet for the company as of June 30, 2015, Classify each balance sheet item into one of the following categories: current assets, noncurrent assets, current liabilities, noncurrent liabilities, and shareholders’ equity.

(10 marks) ABC Factory Balance Sheet as at June 30 2015 ASSETS

LIABILITIES

EQUITY

Cases and exercises

b. Prepare an income statement for the business for the year ended 30 June 2015. ABC Factory Income Statement for the year ended 30 June 2015 INCOME

EXPENSES

PROFIT (LOSS)

205

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Appendix A Companies’ Cases of Financial Statements For teaching purpose, financial statements of some worldwide companies are reported in the following pages. In particular these are related to: 1. Fiat Chrysler Automobiles 2017 2. Apple Inc. 10-K 2018 3. Facebook Inc. 2017 4. Auchan 2017

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Introduction to Financial Accounting. Concepts, Cases and Exercises

1. FIAT CHRYSLER AUTOMOBILES (in € million) Exhibit 1 – FCA Consolidated Statement of financial position 2017 (€ m)

Appendix A. Companies’ Cases of Financial Statements

Exhibit 2 – FCA Consolidated Income statement 2017 (€ m)

209

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Exhibit 3 – FCA Consolidated Statement of cash flows 2017 (€ m)

Appendix A. Companies’ Cases of Financial Statements

2. APPLE INC. FORM 10-K 2018 (in € million) Exhibit 43 – Apple Inc. Statement of financial position 2018 (€ m)

211

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Exhibit 54 – Apple Inc. Income statement 2018 (€ m)

Appendix A. Companies’ Cases of Financial Statements

Exhibit 6 – Apple Inc. Cash-flow Statement 2018 (€ m)

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3. FACEBOOK INC. (in € million) Exhibit 7 – Facebook Inc. Statement of Financial Position 2017 (€ m)

Appendix A. Companies’ Cases of Financial Statements

Exhibit 8 – Facebook Inc. Income Statement 2017 (€ m)

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Exhibit 9 – Facebook Inc. Cash-flow Statement 2017 (€ m)

Appendix A. Companies’ Cases of Financial Statements

4. AUCHAN (in € million) Exhibit 10 – Auchan Consolidated Statement of financial position 2017 (€ m)

217

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Introduction to Financial Accounting. Concepts, Cases and Exercises

Exhibit 11 – Auchan Consolidated Income Statement 2017 (€ m)

Appendix A. Companies’ Cases of Financial Statements

Exhibit 12 – Auchan Consolidated Statement of cash flows 2017 (€ m)

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References

AA.VV., La contabilità aziendale, Il Sole 24 ore, Milano, 2007. ACCA, Advanced corporate reporting, FTc Foulks Lynch, Middlesex, 2004. ALFREDSON K. e others, Applying international accounting standards, Wiley, New York, 2005. ALFREDSON K., LEO K., PICKER R., PACTER P. e RADFORD J., Applying international accounting standards, Wiley, New York, 2005. AMERICAN ACCOUNTING ASSOCIATION, Committee to Prepare a Statement of Basic Accounting: A statement of basic accounting theory, American Accounting Association, Evanston, IL, 1966. BEAMS F. A., Advanced Accounting, Prentice-Hall, Upper Saddle River, 1992. BIANCONE P.P., Le attività immateriali, l’avviamento e l’impairment nei bilanci, Giuffré, Milano, 2006. BLINE D.M., FISCHER M.-L. e SKEKEL T.D., Advanced accounting, Wiley, New York, 2004. BONHAM M., CURTIS M., DAVIES M. e OTHERS, International GAAP 2007, LexisNexis, London, 2006. BRAGG M.S., Accounting best practices, Wiley, New York, 2004. CAMPRA M., Il bilancio. Francia, Germania, Regno Unito, Spagna, Italia., Giuffré, Milano, 1998. CAMPRA M. e CANTINO V., Contabilità e bilancio d'esercizio, casi ed esercizi, Giappichelli, Torino, 2000. DIAMOND M.A., STICE E.K. e STICE J.D., Financial Accounting: Reporting and Analysis, Thomson South-Western, Cincinnati, 2000. EPSTEIN B.J. e JERMAKOWICZ E.K., Interpretation and Application of International Accounting and Financial Reporting Standards 2008, Wiley, New York, 2008. ERNST&YOUNG, IFRS/US GAAP Comparison, LexisNexis, London, 2005. ERNST&YOUNG, International Gaap 2008, Wiley, London, 2008. FERRERO G., DEZZANI F., PISONI P., PUDDU L. e CAMPRA M., Contabilità e bilancio d’esercizio, Giuffré, Milano, 2004.

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HORNGREN C.T., Management accounting: this century and beyond, in Management Accounting Research, Vol. 6, 1995, pp. 281-286. IASCF, International Reporting Standards (IFRSs) – Bound Volume, IASCF, London, 2008. LERNEL J.J., Bookkeping and accounting, crash course, McGraw-Hill, New York, 2004. MCGEE R.W., Accounting reform in transition and developing economies, Springer, New York, 2008. MURRAY D., NEUMANN B.R. e ELGERS P., Using financial accounting, an introduction, Thomson South-Western, Cincinnati, 1999. NOBES C. e PARKER R., Comparative International Accounting, Prentice Hall, Upper Saddle River, 1998. PISONI P., BIANCONE P.P., BUSSO D. e CISI M., Il bilancio consolidato IAS/IFRS, Giuffré, Milano, 2007. SALE J.T., Advances in international accounting, Elsevier Science, Amsterdam, 2001. WARREN C.S., REEVE J.M. e DUCHAC J., Accounting, 15th, Cengage Learning, Boston, MA, 2017. ZEFF S.A., The evolution of the IASC into the IASB, and the challenges it faces, 2012. ZEFF S.A., Forging Accounting Principles in Five Countries, 2015, p. 1.

Appendix A. Companies’ Cases of Financial Statements

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Appendix A. Companies’ Cases of Financial Statements

Finito di stampare nel mese di febbraio 2019 nella Stampatre s.r.l. di Torino Via Bologna, 220

225

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