Accounting Training Curriculum Module 1 PDF

The Accounting Training Curriculum Fundamentals of Accounting Module 1: Basic Principles of Business Accounting http:...

The Accounting Training Curriculum Fundamentals of Accounting Module 1: Basic Principles of Business Accounting http://www.flickr.com/photos/37054091@N06/ HRB3  Training developed for the European Commission by DEMOS under the terms of a framework contract. www.demos.fr www.demosgroup.com This training manual complies with EMAS rules. 2 3  TABLE OF CONTENTS 1. ACCOUNTING: A CORPORATE LANGUAGE OR A JARGON?............................................ 6 1.1Accounting as a way to record transactions along the value chain........................................ 6 1.2 Accounting as the language to measure and control performance........................................ 7 1.3 Accounting, a language spoken with every user of the corporate information..................... 8 1.4 Financial accounting vs. Management accounting................................................................ 9 1.5 Accounting, a language that is evolving............................................................................. 10 2. AN INTRODUCTION TO FINANCIAL STATEMENTS.................................................... 15 2.1. The fundamental identity of accounting: a first definition of the balance sheet................ 15 2.2 Building a balance sheet by recording all transactions of a company................................. 16 2.3. Building the Profit and loss statement (or income statement), P&L.................................. 18 2.4. Building a simple cash flow statement............................................................................... 19 3. DEFINING AND EXPLORING FINANCIAL STATEMENTS.............................................. 22 3.1. Balance sheet or statement of financial position................................................................ 22 3.2. The Income Statement (or Profit and Loss P&L account)................................................. 28 4. ACCOUNTING PRINCIPLES................................................................................ 36 Historical cost concept.............................................................................................................. 36 Annuality or accounting period................................................................................................. 36 Going concern........................................................................................................................... 36 Consistency............................................................................................................................... 36 The accruals concept (or matching concept)............................................................................. 37 Prudence.................................................................................................................................... 37 Separate determination (no netting).......................................................................................... 37 Substance over form.................................................................................................................. 37 Materiality................................................................................................................................. 38 5. THE ACCOUNTING PROCESS.............................................................................. 39 The Journal or book of original entry........................................................................................ 40 Classifying and transferring transactions to the ledger............................................................. 40 Balancing off the accounts........................................................................................................ 49 Preparation of financial statements from the trial balance........................................................ 51 4 Who should participate to this module?  Staff with little knowledge of accounting and financial reporting and who need to acquire or refresh the essential concepts, principles and practices of financial accounting  Financial agents who want to initiate part or the whole of the Accounting curriculum proposed at the Commission  Operational agents, both at initiating or verifier levels, who want to get prepared in order to asses the financial viability of counterparts. This module is a necessary step prior to attending the course on “Assessing the financial viability of counterparts” Learning expected outcomes:  To acquire basic understanding of accounting principles and the key steps of the accounting chain  To discover financial statements (Balance sheet, income statement & cash flow statement) in corporate sectors and being able to draw key lessons from their reading  To build the essential skills necessary to assimilate later on the financial analytical tools necessary to assess financial viability of counterparts In this first module, we will introduce accounting as a language used to record and measure the performance of an organiation. Then, we will focus on the reporting process of financial accounting and start building the main deliverables, the balance sheet, the income statement and the cash flow statement. In a third section, these financial statements will be detailed and explored. The fourth section will list and define the main accounting principles. In the last section of this module, we will get a first intuition of the recording process in accounting, and the use of debit and credit accounts. In this module, accounting is introduced in the context of the profit orientated sector producing and delivering goods and services. Module 2 will take a similar approach to describe and illustrate essentials of accounting in the context of the European Commission. Some quick references to public sector’s accounting will however be made in the present module. This symbol is used for illustrative examples This symbol is used for cases to solve 1. Accounting: a corporate language or a jargon? Learning objectives: This section should allow you to understand:  That accounting is a language that records and measures the performance of a business’ activities along its value chain  That accounting is a language spoken to different users of the corporate financial information  The differences between financial and management accounting  That accounting has been evolving over time and that the accounting principles differ across countries. 1.1 Accounting as a way to record transactions along the value chain In order to understand what accounting is, it is essential to raise the very basic following question: « How does an organization create value? » It is a matter of fundamental importance to companies, because it addresses the economic logic of why the organisation exists in the first place. Manufacturing companies create value by acquiring raw materials and using them to produce something useful. Retailers bring together a range of products and present them in a way that's convenient to customers, sometimes supported by services such as fitting rooms or personal shopper advice. Transportation companies, utilities or insurance companies are other examples of service providers. A business is about generating revenues by transforming resources into products or services. The use of these resources will generate expenses. Profit will rise from the difference between those revenues and expenses. All companies can portray their activities along a value chain. Goods Buy Suppliers Make Services Sell Clients Figure 1: The value chain of a business 6 A value chain is a set of activities that an organization carries out to create value for its customers. Michael Porter, a Harvard Professor, proposed a general-purpose value chain that companies can use to examine all of their activities, and see how they're connected. The way in which value chain activities are performed determines costs and affects profits, so this tool can help understand the sources of value for any organization. All transactions along the value chain (between suppliers and the firm or between the firm and its customers, or the transformation process itself) need to be recorded. Accounting can be seen as the recording of transactions in a systematic and controlled way: financial and non-financial information such as the number of units produced or their weight. Recording economic transactions of an organization is a process that must follow strict principles and rules. This process follows a logic where every transaction within an activity is recorded in the books of account twice – once as a debit entry (on the left hand side of the page) and once as a credit entry (on the right hand side of the page). This system is known as double entry bookkeeping and is operated the same way around the world. 1.2 Accounting as the language to measure and control performance Recording transactions is the first “activity” of accounting. But for many stakeholders of an organisation, accounting is primarily about financial reporting. On a regular basis (monthly, quarterly, annually) an organisation will take all of the transactions that they have recorded and use these to produce financial statements. These financial statements are designed to demonstrate to the users the economic performance of the organization over a period of time. The users of the financial statements may be the managers, owners, controllers, authorities, employees, customers, suppliers etc. In the public sector they are called service recipients and resource providers. The terminology adapted to the public sector is introduced in Module 2. The objective of the financial statements are to give a “true and fair” view or the operational performance of a business over a period of time and to show what the business actually owns and owes at the end of that period. The two primary financial statements are the:  Balance Sheet or Statement of Financial Position  Income Statement (sometimes referred to as the Profit and Loss Account) The Balance Sheet is designed to show everything the entity either owns or owes at a specific point in time (normally the 31st December). I.e. it is a statement of its Assets & Liabilities at this time. These terms will be defined below. The Income Statement shows for a period of time (normally the calendar year) the total Income of an organization less its Expenses. For a commercial organization if it its income (sales or revenue) is more than its expenses then it makes a profit. If its expenses are more then its income it makes a loss. Similarly, in the public sector a deficit arises when the cost of provision of services exceeds revenues. In both cases the numbers that go in to the Balance Sheet and the Income Statement are derived directly from the accounting records – they are ultimately a summary of all the transactions recorded. Larger organisations also produce a third financial statement – the Cash Flow Statement - which explains how a company has generated and used its cash during the year. The Cash Flow Statement can be generated from the Income Statement and the Balance Sheet 1.3 Accounting, a language spoken with every user of the corporate information A company’s stakeholders are people or organizations that have an interest or a concern in that company. Owners or shareholders, customers, suppliers, government, banks, local communities, staff members, managers are all stakeholders of a company. The stakeholders of a company use financial reporting (the financial statements introduced in the previous section) either to measure the performance or to manage it. All users of that information have their own perspective and their own issues at the moment of reading that information. Figure 2: Accounting is used by different stakeholders  Shareholders are the owners of a company. They invest in the business and take the entrepreneurial risk of that business. They expect a return proportional to the risk they have been taking. Shareholders read the income statement to measure and control the profit or income that the company generates periodically. They use the balance sheet to appreciate where the company invested the resources provided, as well as the net value of their ownership.  Bankers and other lenders take the credit risk, or the risk of not being fully repaid on time. They use financial statements to check the capacity of the company to meet their obligations.  Suppliers of a particular company are also interested in assessing the creditworthiness of a business; they want to be reassured that their customers will pay them and that they can build with them a lasting relationship. 8   Customers are interested in the quality of the goods produced or services offered by a company. In addition they need to know that commitments will be honoured. Adverse information regarding a company’s financial performance might result in customers going elsewhere  Employees are interested in their entity’s performance primarily from a job security perspective. If profits show an upward trend and forecasts indicate that this is likely to continue, employees can feel fairly secure and, in addition, can expect an increase in salaries, wages and other benefits.  A very significant part of the accounting information remains inside the organization: managers responsible for a business segment report to their superiors, take decisions based on accounting information, to allocate resources, fix a price for their products, invest in new equipment…In fact, this accounting information used internally should be distinguished from the information reported externally: management accounting is different from financial accounting. This point is developed in the next section Why would Commission staff use corporate financial reports? Thousands of companies – for profit and non-profit organizations- interact every year with the Commission, either as providers of goods and services or as beneficiaries of grants. In all cases, the internal procedures of the Commission will recommend or impose the assessment of the financial capacity of the counterparts. Financial initiators and verifiers would then use the financial reports in order to take a judgement on the financial viability of the counterpart. In many other situations, EU Commission’s staff will use accounting information to evaluate the relevance of a project (e.g. DG MOVE) or to assess the competitive behaviour of a company (DG Comp) 1.4 Financial accounting vs. Management accounting Financial accounting reports are prepared for external parties such as shareholders and creditors, whereas managerial accounting reports are prepared for managers inside the organization. There are a number of major differences between financial and managerial accounting, even though they often rely on the same underlying financial data. Table 1 contrasts both disciplines. First, it is essential to see that financial accounting is mandatory and must comply with well-defined principles and rules; that is, it must be done and follow a prescribed script. Various outside parties such as regulators and tax authorities require periodic financial statements. Managerial accounting, on the other hand, is not mandatory. A company is completely free to do as much or as little as it wishes. No regulatory bodies or other outside agencies specify what is to be done, or, for that matter, whether anything is to be done at all.  Financial Accounting Management Accounting External focus Internal focus Imposed rules No mandatory rules Objective financial information Financial and non-financial information, possibly subjective Historical orientation Emphasis on the future Information about the firm as a whole Internal evaluation and decision, based on detailed information (segment, product, customer) Single discipline Multidisciplinary Table 1 Comparison between Financial Accounting and Management Accounting Since managerial accounting is completely optional, the important question is always, “Is the information useful?” rather than, “Is the information required?” For internal uses managers want information that is relevant even if it is not completely objective or verifiable. Relevant information means appropriate for the problem at hand, future- oriented, and flexible enough to provide whatever data are relevant for a particular decision. Contrary to financial accounting information that provides historical data, management accounting information helps managers to make forward looking decisions on costing a product, pricing a services, making producing a good rather than purchasing it or investing in a new equipment. Obviously for those reasons, management accounting information, which might be very detailed –by product lines, sales territories, divisions, departments-, is sensitive and remains typically undisclosed outside the organization. 1.5 Accounting, a language that is evolving Accounting, an ancient “language” that (together with its techniques) can be traced back to the oldest civilisations, evolved with the birth of money and then according to its users and their needs, which are in turn linked to the development of trade and industry.  Initially, the simple recording of accounts including expenditure, receipts and the cash balance.  In the middle ages, the development of credit linked to that of money as a value in itself (it becomes productive, it is lent). The accounts of persons and goods, and the monitoring of links between them and money, require the creation of a more sophisticated accounting system: double entry (it is thought to have been introduced in 1340, in Genoa).  1494, Luca Pacioli – Italian mathematician and monk - (involuntarily assisted by Gutenberg, who has just invented the printing machine) – circulates a treaty setting the fundamental principles of this new system. 10 Today, there are essentially only two main forms of accounting: cash based and accruals based. Cash accounting: a system of accounting in which transactions are recognised when cash has been received or paid In cash based accounting transactions are recorded when cash is actually paid out or received – where money has actually changed hands. However the majority of business is conducted on credit. Customers are given time to pay their invoices, suppliers give credit. Recoding these transactions only when payment was made would give an incomplete picture of an entity’s financial position because it would tend to understate the things a company owns (assets) and money it owes (liabilities). For example; Tom is in business and in December he purchases some office equipment for €2,000. His supplier gives him 90-day credit – so he won’t have to pay until March. The equipment is delivered on December 10th. He inspects it; signs to accept it and the supplier sends him an invoice. Tom is now effectively the owner of that equipment. He can use it in his business and he has to maintain it and to insure it. However under cash based accounting, Tom would record the transaction until he paid the bill in March. Anybody looking at Tom’s accounts at the end of December would neither see that he owned an asset or had a debt to pay of €2,000. Accruals based accounting (recording the transaction upon the legal basis) would show the true situation firstly that Tom owned some office equipment that he has clearly purchased and that he has a debt that will have to be paid in the future. Accrual accounting: a system of accounting in which revenue is recognised when it is earned and expenses are recognised as they are incurred Therefore accruals based accounting gives a complete picture of an organisation’s financial position and performance. Double entry bookkeeping is a method of recording financial transactions developed to facilitate accruals accounting. Double entry bookkeeping is the method of recording transactions to achieve accruals accounting that is now adopted universally across the planet in the private sector. Commercial companies, non-profit organizations and institutions such as the Commission use it. However, many national governments use still a cash based accounting system for their financial statements. Implications of accruals accounting:  Economic flows are recorded at the time economic value is created, transformed, exchanged, transferred, or extinguished, irrespective whether cash was received or paid, or was due to be received or paid.  All data recorded are either flows or stocks. Stocks refer to holdings of assets / liabilities at a specific time.  Net worth is computed as total assets less total liabilities.   Capital assets are reported on the financial statements  Non-cash transactions – depreciation, amortization, provisions, accruals, and receivables are recorded.  Recognition of employee benefits (retirement and pension benefits, accumulated leave) in the financial statements  Double entry system mandatory in accrual based accounts. International Financial Reporting Standards International Financial Reporting Standards (IFRS) is a set of accounting standards developed by an independent, not-for-profit organization called the International Accounting Standards Board (IASB). The goal of IFRS is to provide a global framework for how companies prepare and disclose their financial statements. IFRS provides general guidance for the preparation of financial statements, rather than setting rules for industry-specific reporting. Having an international standard is especially important for large companies that have subsidiaries in different countries. Adopting a single set of world-wide standards will simplify accounting procedures by allowing a company to use one reporting language throughout. A single standard will also provide investors and auditors with a cohesive view of finances. Currently, over 100 countries permit or require IFRS for public companies, with more countries expected to transition to IFRS by 2015. Proponents of IFRS as an international standard maintain that the cost of implementing IFRS could be offset by the potential for compliance to improve credit ratings. IFRS has been replacing IAS (International Accounting Standards), but older IAS rules are still in force until they are replaced by IFRS rules on a given topic. Principles and rules governing companies’ accounts in the European Union may vary across countries for non-listed companies, but common standards apply for listed companies. In 2002, the European Union adopted legislation requiring all listed companies to prepare their consolidated financial statements using IFRS (International Financial Reporting Standards) since 2005, becoming the first major capital market to require IFRS. In 2009 the IASB published simplified norms applicable for non-listed companies in the world. The International Accounting Standards Board (IASB), created in 1973, was founded  to establish acceptable common international standards that require high quality, transparent and comparable information in financial statements to help participants in the world's capital markets and other users make economic decisions,  to promote the use and rigorous application of those standards and  to bring about convergence of national accounting standards and International Financial Reporting Standards to high quality solutions No doubt that the existence of common standards greatly improves the quality of financial analysis when assessing the financial capacity of an entity. Financial ratios and other analytical tools are more relevant if comparable and consistent accounting rules and principles were used to prepare the reports. 12 According to IFRS, five financial reports are required:  The balance sheet or statement of financial position  The income statement or statement of financial activities  The cash flow statement  The statement of changes in equity  The notes to the financial statements In the context of this first module, we will primarily use the balance sheet and the income statement, but we will also introduce the cash flow statement, as it is a very powerful source of information when it is available). International Public Sector Accounting Standards and the reform of accounting in the European Union Since early 2000 the European Union (EU) has been engaged in a modernization effort devoted to improve its functioning and enhance its accountability towards Member States and the European citizenship. The modernisation of its accounting system is an important, integral part of this overall effort. The renewed accounting system addresses the financial accounting and reporting by the European Union (EU), including consolidated accounts. Eighteen accounting rules stand at the core of this reformed system: following the European Financial Regulation, these rules draw upon IPSAS (International Public Sector Accounting Standards) and are based on accrual accounting, even if cash accounting has been maintained, thanks to an integrated accounting process (dual system). The reform was based on the belief that accruals accounting is an information system that provides a complete and reliable picture of the financial and economic position and performance of a public entity by capturing in full the assets and liabilities as well as revenue and expenses of an entity, over the period covered by the accounts and at the moment they are closed. National accounting regulations: still a reality Although there is a widespread adoption of international standards and significant benefits to implementing international accounting standards there are still many challenges to further development and authoritative implementation. To best understand these challenges one must look at the factors that influence the development of accounting regulations. Nobes and Parker in their authoritative contribution on the topic (1) conclude that such factors can include, social and cultural values; political and legal systems; business activities and economic conditions; standard setting processes; capital markets and forms of ownership; and finally cooperative efforts by nations. Today, many countries may exhibit at least two systems of financial reporting, in addition to accounting that may be done for tax or other private purposes. For example, in France, the consolidated statements of listed companies use International Financial Reporting Standards (IFRS) whereas individual French companies, whether members of a group or not, use French national rules. The bulk of financial reporting (i.e. all unconsolidated obes,.. and Parker, R. (200 ) ’ omparative International Accounting , ondon Prentice Hall 1 statements and some consolidated statements) in many countries still follows domestic rules. So, international differences are still important. ommission staff confronted with company’s financial statements across the Union will be reading financial statements using national and international standards At the end of this first section, we may note that financial statements include many terms that are reasonably clear and straightforward, like cash, fixed assets or revenue. However, financial statements also use words like retained earnings, accumulated depreciation, goodwill or accrued expenses. In his renowned book, “Accounting for Dummies”, John Tracy notes that the accounting language is quite often a jargon, requiring definitions and clarifications. Corporate language, yes, but requesting a translation in most cases, in order to be understood by managers and other kinds of users. This first module should help the participant to better understand accounting terminology 14 2. An introduction to financial statements Learning objectives: This section should allow you to understand:  The fundamental equation or identity of a balance sheet  How basic transactions can always be recorded as a change in a balance sheet  Why the income statement is a necessary extension and complement of the balance sheet 2.1. The fundamental identity of accounting: a first definition of the balance sheet The balance sheet is a statement of an entity’s assets and liabilities at a moment in time (normally 31st December). It is typically described as the “financial picture” of a company/entity at the end of the year. It is called a balance sheet since the mechanics of accruals accounting means that what the entity owns always equals what it owes. A TYPICAL BALANCE SHEET EQUITY €40 or Shareholder’s funds PLANT EQUIPMENT €50 BANK DEBT €30 INVENTORTY €15 RECEIVABLES €30 PAYABLES €15 ADVANCES €7 CASH €5 TAX €8 Total Liabilities & Total Assets €100 Equity €100  Assets: what the company owns or has the right to use. Assets are the resources that the company will use to generate value for their customers: e.g. Equipment, inventories of products, claims on customers, cash  Liabilities and Equity: the “right hand side” of the balance sheet provides the funding sources of the assets, expressed as commitments or obligations vis-à- vis the third parties (like bankers and suppliers) and shareholders. Clearly, the funding side of the balance sheet is made of two different sources of financing: the owners of the firm, who have been taking the entrepreneurial risk, and the creditors, lenders, suppliers, tax administration…who did provide a credit to the entity. If the value of the assets has to be always equal to the sources of funding (the two sides of the financial position must balance), the balance sheet can also be seen as the company’s net worth – i.e. what the company actually “owes” to its shareholders, which is the number that effectively makes the balance sheet balance.  Example a company recording 650 million € of assets (equipment, inventory, cash) and 450 million € of liabilities (to banks, suppliers and tax administration), shows a net asset value of 200 million € the owners’ equity or their net worth. The amount that the company owes to its shareholders is known as “equity” and is in fact a calculated number. It is equivalent to the actual investment that the shareholders have made in the company plus the profits that the company has made since inception that haven’t yet been given back to the shareholders through dividends. These profits are known as retained earnings. Equity is shareholders’ fund, but the company has no commitment to pay this money back to the shareholders; the commitment is to generate an adequate return on shareholders’ funds. The fundamental equation of accounting states that assets must be funded by either liabilities (owed to third parties) or by shareholders' equity. In other terms, the assets of a company must equal the claims over those assets. Assets Liabilities Owners’ Equity = + Figure 3: The fundamental accounting equation 2.2 Building a balance sheet by recording all transactions of a company We can take a simple case to illustrate how a balance sheet can be used to record any transaction made by a company and to verify that after every transaction, the fundamental equation is validated. Any transaction will have an impact on the balance sheet and the following situations can be observed:  an increase in one asset is matched by a decrease of another asset  an increase in a liability offset by a decrease in another liability  an increase in an asset offset by an increase in shareholders' equity and/or in a liability Here is the case: Tom is the founder of a company that sells paints for the used car market. We will track the first period of operation of that company, and record all transactions made over that period. T1: Tom creates the company with a capital of 10,000 paid cash to the new company’s bank account. This is the first transaction of any company. It provides the initial funding to start operating, while it recognises the shareholders’ ownership rights. T2: Tom purchases 6000 of equipment (painting equipment) and pays cash on delivery. Tom needs that equipment to start the business. Total balance sheet is unchanged, with a shift in assets: an increase in equipment and a decrease in cash. 16  T3: Tom obtains a 5 year loan of 4000 from the bank. Interest charged is 5%. The money is available in the bank account: cash increases and bank debt goes up by the same amount. Interest is due at the end of the year. T4: Tom purchases 5000 of stock tools (paints and painting) on credit. Tom acquires a new asset, paints to sell to his customers. He manages to obtain a credit from the suppliers, which means that the asset created is funded by an increase in liabilities. T5: Tom sells 2000 of stock for 4000. Payment made cash, on delivery. The company sells for 4000 paid cash on delivery, paints that cost them 2000. The profit of 2000 belongs to the shareholder. For the first time, a transaction is creating value for the shareholder. T1 to T4 were all transactions that allowed the company acquiring assets or getting the financing to invest and operate. This transaction is generating a profit that is allocated to the shareholder in the balance sheet, as a retained earning. How does this transaction impact the balance sheet?  Inventory is reduced by 2000  Cash increases by 4000  Retained earnings i.e. equity increases by 2000 T6: Payment of operating costs of 1500 in cash Tom had to pay for travel expenses, car servicing, and computer maintenance. Cash is reduced by 1500 and those expenses reduce the profit of the company. Shareholder funds are smaller, as retained earnings are reduced. T7: Sale of 1000 of stock for 2200, on credit. Tom established a business contact with a retailer of car parts and equipment. He sells them 2200 and gives them 45 days to pay the invoice. There are two movements on the assets side: inventory goes down by 1000 and a claim on the customer (a receivable) of 2200 is recorded. Assets increase by 1200. The company makes a profit of 1200, posted as an increase in retained earnings. Again, the balance sheet balances. T8 The company pays Tom a salary of 800 The salary is an operating expense that recognises the use of Tom's time and skills to generate revenues and manage the company. Any expense reduces profit and retained earnings. The payment of the salary reduces the assets (the cash position) by the same amount. T9 Charging interest rate: An interest of 5% on the bank loan is charged and paid. The interest charged, 200 reduces retained earnings and the payment reduces the cash position. This small case allows us to draw number of important conclusions:  The balance sheet shows an entity's financial position at any moment in time  Every transaction will be impacting the balance sheet of a company and we could build the financial position of an entity after each transaction  The fundamental equation of the balance sheet is verified at any moment in time.   Any sale or operating revenue increases the net assets (equity) of a company and any operating expense (e.g.; materials, wages, utilities) reduces net assets  An entity / company makes profit when it sells to their customers a product / service at a price higher than what it cost it to buy, produce and distribute this product / service. The profit is allocated to the shareholder under the heading retained earnings, and raises shareholders' equity.  If there is no dividend distributed and no increase in capital, the change in net assets or equity over a given period of time (one month in our simple case) gives the profit generated by a company over that period. Tom’s company : Balance Sheet Assets Liabilities & Equity Equipment 6000 Equity ◦ 10700 Receivable 2200 Fin. Debt 4000 Inventory 2000 Payable 5000 Cash 9500 Total 19700 Total 19700 2.3. Building the Profit and loss statement (or income statement), P&L From this simple case, we could reach the conclusion that the balance sheet would be the only financial statement necessary to portray the financial position and performance of a company. As any change in either revenues or expenses is impacting the net assets of the company, the change in net assets between two balance sheets (i.e. between two moments in time) measures the profit or loss. The reality is far more complex, though. Any real case would show a large number of transactions affecting the profit of any entity, and the change in the balance sheet approach would not provide any sufficient level of detail to assess the performance of that entity. We need to build the profit and loss statement, by expanding the change in retained earnings and providing the detail of revenues and expenses. If the balance sheet would provide a reasonably good picture of a company at the end of the year, the income statement is the movie that allows depicting all movements during the year. In the case of Tom’s company, the assumption we are making a simple assumption at this point: there is no income tax; the owner will earn all the income earned. We also assume there is no dividend. Tom's Company: Income Statement Sales 6200 Materials -3000 Salaries -800 Other operating costs -1500 Operating income 900 Interests expenses -200 Net Income 700 18 We can conclude from this simple case that the P&L or income statement explains the generation of the profit or earnings of an entity; all earnings - profit or loss - will be retained as shareholders' funds in a first instance and impact the equity in the balance sheet. As we will discuss it later on, the decision to distribute part of these earnings as dividend to the owners will be taken only once a year. 2.4. Building a simple cash flow statement “ ash is king” is often quoted. Any company should monitor and manage carefully its cash position, understand and anticipate how cash is generated. Again, the balance sheet would record any change in cash over a given period of time; and the change is cash between two dates would provide the net cash generated (or consumed) over that period. But it is extremely powerful to use a specific financial statement to explain and detail where the cash has been coming from and where it has been consumed. The cash flow statement responds to that concern by expanding the sources and use of cash. The cash flow statement groups all cash impacting transactions along three main headings, describing the three business activities of a company: ash flows are reported based on the three business activities of any company  Operating activities: payments received and made in relation to business’ operations. In the case of Tom’s company, this included the payment of materials, wages or any other operating expenses, and the receipt of cash by customers.  Investing activities: acquisitions and divestitures of long-term assets. For our company, this was the payment made when purchasing the equipment.  Financing activities: issuances and payments toward equity, borrowings, and long-term liabilities. In this case, this meant issuing shares and borrowing from the bank. Tom's Company: Cash Flow Statement Receipts from customers 4000 Payment of materials 0 Payment of salaries -800 Payment of other op. Costs -1500 Operating cash flow 1700 Equipment -6000 Investment cash flow -6000 Interest payments -200 Bank loan 4000 Issue in capital 10000 Financing cash flow 13800 Total cash flow 9500  Transaction: Tom's Assets = Liabilities + Equity company 1 The company is created Cash 10000 Share capital 10000 with a capital of 10000 10000 10000 2 Tom purchases Equipment 6000 Share capital 10000 machinery for 6000 Cash 4000 10000 0 10000 3 Tom gets a 4000 loan Equipment 6000 Bank loan 4000 Share capital 10000 from the bank Cash 8000 14000 4000 10000 4 Equipment 6000 Bank loan 4000 Share capital 10000 Tom purchases 5000 of Inventory 5000 Supplier 5000 products (in inventory) Cash 8000 19000 9000 10000 5 Equipment 6000 Bank loan 4000 Share capital 10000 Tom sells 2000 of stock Retained 2000 for 4000. Payment made cash, on delivery Inventory 3000 Supplier 5000 Earnings Cash 12000 21000 9000 12000 6 Equipment 6000 Bank loan 4000 Share capital 10000 Payment of operating Retained 500 costs of 1500 in cash Inventory 3000 Supplier 5000 Earnings Cash 10500 19500 9000 10500 7 Equipment 6000 Bank loan 4000 Share capital 10000 Sale of 1000 of stock for Customer 2200 Retained 1700 2200, on credit Inventory 2000 Supplier 5000 Earnings Cash 10500 20700 9000 11700 8 Equipment 6000 Bank loan 4000 Share capital 10000 The company pays Tom Customer 2200 Retained 900 a monthly salary of 800 Inventory 2000 Supplier 5000 Earnings Cash 9700 19900 9000 10900 9 Equipment 6000 Bank loan 4000 Share capital 10000 Interest payments on Customer 2200 Retained 700 the bank loan Inventory 2000 Supplier 5000 Earnings Cash 9500 19700 9000 10700 20 3. Defining and exploring financial statements Learning objectives: This section should allow you to discover:  The building blocks and the terminology of the balance sheet and the income statement  A detailed description of each item of financial statements  An intuitive introduction to the cash flow statement  How the balance sheet, the income statement and the cash flow statement are interrelated, by using an integrated case 3.1. Balance sheet or statement of financial position Now that we have defined and built a balance sheet, we can provide a more detailed view of the different items that are typically shown to depict the financial position of a company. This exploration will also allow us to define some technical accounting terms. We first explain the distinction between current and non-current assets and liabilities, and then explore respectively the asset and the liabilities and equity side of the balance sheet. Current vs. non-current assets and liabilities To aid the user to understand the balance sheet, assets and liabilities that are expected to remain on the balance sheet for more than or less then 12 months are clearly separated: BALANCE SHEET Equity Non Current or Shareholder’s funds assets Non Current Liabilities Current Assets Current Liabilities Total Liabilities & Total Assets Equity For example, in the case of a building, one would expect it to be owned for more than 12 months, so it should be classified as non-current asset, whereas in the case of a customer who owes money one might expect him to pay his invoice in 30 or 60 days – so this claim would be a current asset. The distinction between non-current and current assets is normally time – greater or less than 12 months after the balance sheet date: non-current assets are resources not 22 supposed to be sold or fully consumed during the following year, while current assets refer to resources normally expected to be sold or consumed within twelve months. However another way of looking at it is that non-current assets normally represent the business’s investment in its infrastructure, buildings, vehicles, equipment, computers, long-term investments etc. whereas current assets are normally operational in nature: inventories for resale, claims on customers, short-term financial assets i.e. cash. In the same way that a company’s assets are divided between long term and short term, so are its liabilities. Current liabilities are short-term debts payable in less than one year. Normally these are operational debts – money owed to suppliers or short-term financial debt. Non-current liabilities are normally related to money borrowed to fund the business’s infrastructure and are normally repayable in more than 12 months after the balance sheet date. A detailed exploration of the balance sheet: what are the main assets of an entity? Assets are the resources that the company will use to generate value for their customers, users or beneficiaries. According to IFRS, an asset is defined as a resource controlled by the entity as a result of a past event, from which future economic benefits are expected to flow to the entity. The emphasis is nowadays on the use of an asset that an entity controls, rather than on its ownership. This is why a leased building (under a financial lease contract) will be typically recorded as an asset, even if the entity is not the owner of that building. Assets are subdivided into sub-groups. Within the current vs. non-current distinction, Figure 4 shows typical main headlines of the asset side of a balance sheet Figure 4: The asset side of the balance sheet Non-current assets Non-current assets are assets that are expected to produce economic benefits for more than one year. These assets are of three types: tangible, intangible and financial. Tangible assets include: items such as land, buildings, machines, and furniture, collectively called property, plant, and equipment (PP&E) Intangible assets are “rights” and include items such as patents, trademarks, copyrights, and goodwill. Long-term financial assets, such as shares in other companies and loans extended to other firms. Tangible assets - property, plant, and equipment (PP&E) PP&E are reported at their historical cost, which is, the price the firm paid for building, acquiring and installing them. The value at which a fixed asset is reported in the balance sheet is its net book value: their purchase price, reported in the balance sheet as the gross value of fixed assets, is systematically reduced (or written down) over their expected useful life (this periodic and systematic value-reduction process is called depreciation). If the firm applies the historical or acquisition cost principle to value its fixed assets, then the net book value of a fixed asset is equal to its acquisition price less the accumulated depreciation since that asset was bought If an entity acquired and installed for 2 M€ a new equipment that is supposed to have an expected lifetime of 8 years, the depreciation for the first year will be 250,000€, and the net value of the asset after a year of usage, will be 1.75 M€. Intangible assets Intangible assets include “rights” such as patents, copyrights, property rights, franchises, licenses, concession rights but also internally developed computer software. Intangible assets are recorded at cost, i.e. at the cost of acquiring or developing them, less amortisation. As in the case of tangible assets, their value is usually gradually reduced over the lifetime of the underlying “contract” or useful time. This cost reduction process, called amortisation, follows the same principles as depreciation for tangible assets. Amortisation will be a cost line in the Profit and Loss statement. There is a real difference between the intangibles that a successful company creates (by innovating or building a customer base) and the limited recognition of these intangibles (like brand or the result of innovation) in the balance sheet. We will come back to that issue in Module 4, but we can already anticipate that research expenditures will always be expensed in the profit and loss statement while development expenditures might, under specific criteria, be considered as an asset that will generate future income. 24 Intangible assets also include the goodwill. When one company acquires the net assets of another for a price higher than the net book value in the acquired firm's balance sheet, this difference is goodwill. In IFRS, goodwill is the positive difference between the purchase cost and the fair market value of the assets and liabilities acquired with a company. Financial assets: long term investments Long Term investments are investments a company intends to hold for more than one year. They can consist of stocks and bonds of other companies, and the intention is to hold them for a while, typically because a strategic link exists between the investor and the investee. Current assets Operating assets Inventories are goods held by the firm for future sales (finished goods) or for use in the manufacturing of goods to be sold at a later date (raw materials and work in process). A manufacturing firm normally has three inventory accounts: Materials or supplies to be used in the production for sale Work in process: in the process of production for sale Finished goods. Accounts Receivable: they are invoices that have not yet been paid by customers at the date of the balance sheet, as most firms do not receive immediate cash payments for their sales of goods or services. They usually let their customers pay their invoices at a later date. Accounts receivable will be converted into cash when customers pay their bills. Prepaid Expenses recorded on a balance sheet are payments made by the firm for goods or services it will receive after the date of the balance sheet. They are also claims, typically on suppliers of goods or services, although not cash claims, but claims released on the delivery of the product or service. Example of a prepaid expense is the payment for an insurance policy that will provide protection for a period of time that extends beyond the date of the balance sheet. Cash (short term financial assets) Includes cash and cash equivalents Defined as: – Cash – Demand deposits – Short-term, liquid investments readily convertible to a known cash amount To conclude this explanation of the asset side of the balance sheet, it is important to stress that an asset is recognized when it is probable that any future economic benefit associated with the item will flow to the entity and the item has a cost or value that can be measured with reliability. The following table describes how each category of assets are typically used in businesses and the form of future economic benefits a company could expect from each kind of asset. Figure 5: Assets and their expected benefits A detailed exploration of the balance sheet: Liabilities are an entity's obligations A liability is defined as a present obligation arising from a past event, the settlement of which is expected to lead to an outflow of future economic benefits from the entity. Liabilities contribute to the funding of the entity: a supplier who delivers a product and gets paid 60 days after delivery, is contributing to the short term financing of that entity. On a similar note, when a bank grants a loan to that same entity, it creates an obligation for that entity and contributes to its funding. It is essential to make the difference, within all liabilities, between operating liabilities that are linked to the operating cycle, and financial liabilities. 26  Liabilities Non-current Current Provisions & Financial non financial Financial Operating Figure 6 The liability side of the Balance Sheet Operating liabilities  Accounts payable: they are liabilities due to the firm's suppliers of goods and services. Payable arise because the firm does not usually pay its suppliers immediately for the goods and services received. They get some short term credit that helps funding the operating cycle. The amount of accounts payable are simply equal to the € value of the invoices the firm has received from its suppliers but has not yet paid at the date of the balance sheet.  Accrued expenses: they are liabilities other than short-term debt and accounts payable that are associated with the firm's operations. They arise from the lag between the date at which these expenses have been incurred and the date at which they are paid. The allocation of expenses to the accrued expenses account in the balance sheet is another application of the matching principle. Financial liabilities: bank and capital market raised debt This debt bears interest rates – or the cost of debt – and as such is called interest bearable debt. Long-term debt is mostly financial: long term credit provided by banks or bond markets and on which the borrower pays interest that will be reported as financial expenses in the P&L statement. Short-term financial debt includes bank overdrafts, drawings on lines of credit, and short- term promissory notes. The portion of any long-term debt due within a year is also a short- term obligation and is recorded in the balance sheet as short-term borrowings. Provisions Provision: a present obligation that satisfies the rest of the definition of a liability, even if the amount of the obligation is uncertain and has to be estimated. Provisions reflect an increase in the company’s liabilities in the shorter or longer term relating to a charge that has not yet been incurred by the financial year-end, but is likely to arise and is connected with operations carried out during the year. Provision for employee benefits and pensions include severance payments, early retirement and related payments, special retirement plans. Equity or Net Assets Owners’ equity is essentially made of all the capital (funding) brought by shareholders (Common Shares) and by all accumulated – or retained – earnings that have not been distributed as dividends to shareholders. Note that owners' equity at the date of the balance sheet is simply the difference between the book value of the firm's assets and liabilities at that same date: equity is equal to the net assets of a company. Transactions other than those recorded in the income statement affect owners' equity. When a firm declares a cash dividend is paid to its owners, the book value of owners' equity in the firm's balance sheet decreases by the amount of the declared dividend. Thus, the net increase in owners' equity is the difference between earnings after tax and dividends. This difference is called retained earnings. When a firm sells (issues) new shares during the accounting period, the amount raised, less issuance costs, increases the firm's owners' equity. Figure 7: The accumulated profit/loss equation 3.2. The Income Statement (or Profit and Loss P&L account) The P&L account is a statement of the total operating activity of an entity for a given period of time – normally 12 months. It shows the total income of the business generated through the sale of its goods and services. Offset against this are the total expenses of the business for the same period. The purpose of the income statement, also called the profit and loss or P&L statement, is to present a summary of the revenues (sales or turnover) of a company, and all its expenses or costs. We usually expect that a company would generate profit: in fact the P&L reports the operating and financial transactions that have contributed to the change in the firm's owners' equity during the accounting period. The accounting period is usually one year, but limited versions of the income statement can be produced more frequently, as often as quarterly. 28 The distinction we made earlier when introducing the cash flow statement is also relevant for the income statement: among all transactions likely to generate profit, we can identify three kind of activities: operating, investing and financing activities. For most industrial or service companies, operating activities do represent the most significant driver of profitability and the largest share of their revenues and expenses. We first describe the operating revenues and expenses. Operating revenues For companies producing or distributing goods or services, revenues are primarily made of sales of these products or services. But companies might also book revenues generated by their asset base, like renting a property, royalties from patents or fees from licensing. In all cases, revenue is recognized and booked when the product is delivered, when the service is rendered. Operating expenses When talking about expenses, we should pay attention to two important distinctions:  The distinction between recording and communicating capital and current expenses fundamental to accounting.  There are two ways to present operating expenses in the income statement, either "by function" or "by nature". Capital and current expenses The distinction between capital and current expenses is fundamental to accounting. Expenses are classified into two types: Capital expenses Capital expenses are purchase or improvement of non-current assets, which are assets that will provide benefits to the business in more than one accounting period. We know that the cost of purchased non-current assets is not charged in full to the statement of financial performance for the period in which the purchase occurs. Instead, the non-current asset is gradually depreciated over a number of accounting periods. Capital expenses on non-current assets result in the appearance of a non-current asset in the statement of financial position of the business. Examples of non-current assets are computers for the office, delivery vans and factory machines. Suppose an entity acquires a new computer for 2,000€ that has an economic life of 4 years. At the end of the first year, the balance sheet will record a fixed tangible asset for 2000€ less a depreciation of 500€ - if the computer has been used for the full year- while the profit and loss will record a depreciation expense of 500€. The 2000€ of the computer purchase represent the capital expenditures.  Current expenses Current expenses are expenses incurred for the purpose of the activity or to maintain non-current assets. An important concept to grasp is that current expenses are charged to the statement of financial performance for a period if it relates to the trading activity and sales of that particular period. Presentation by nature or by function For operating expenses, there are two possible presentations of the income statement: it is possible to classify expenses either "by function" or "by nature". Presentation by nature Whereas the "by function" breakdown groups all expenses whatever their type according to their function (or "purpose or "destination") in the business, the "by nature" breakdown groups them by nature of expenses: this enables total costs to be calculated of raw materials and consumables, wages and salaries, depreciation and other items defrayed by the business as an economic unit. Items for "change in stocks and work in progress" and " own work capitalised" are also shown explicitly reported in the accounts presented by nature of expenses. + Sales 1000 - Materials 300 - Wages and salaries 400 - Services 90 - Depreciation and amortization 80 - Change in inventories 30 - Other operating revenues and charges 10 = Current operating income 90 Figure 8: Income statement by nature of expenses Depreciation expenses are the depreciation charges such as previously defined in this documentation (page 24). They represent the portion of the cost of fixed assets that is allocated to the accounting period. Presentation by function or destination The breakdown "by function" distinguishes between the "cost of sales", namely all costs uniquely identified with generating revenues in business activity, and marketing and sales costs, R&D costs and administration expenses which are the period costs. + Sales 1000 - Cost of Sales 600 - R&D expenses 150 - Sales and marketing expenses 100 - Administrative expenses 50 - Other current revenues and expenses 10 = Current operating income 90 Figure 9: Income statement by destination of expenses The cost of sales or the cost of goods sold represents the production or purchasing costs that a company incurs when selling. COS includes the costs of materials, labour and production associated with producing goods or providing services. These costs may be fixed or variable costs; they can be matched with revenues. The cost of sales does not only include the manufacturing costs during a given period, it integrates the change in inventory during that period, in order to isolate 30  the cost of producing what the company sold. To calculate the cost of sales (or the cost of goods sold COGS):  We deduct the end of the current year's value of inventories from the cost of goods available for sale.  To calculate the cost of goods available for sale, we add the cost of goods produced during the year to the preceding year's end-of- year inventories. COGS = Inventory (Beginning of period) + Cost of Goods manufactured - Inventory (End of period) Figure 9 shows that the cost of sales of 600 is the outcome of a manufacturing cost of 500 and the use of inventory for 100. The cost to produce the inventory represents the cost of goods manufactured during previous periods. Figure 10: Calculation of the Cost of Goods Sold Selling, general, and administrative expenses (SG&A's) or overhead expenses are the expenses incurred by the firm that relate to the sale of its products and the running of its operations during the accounting period. Many companies identify separately R&D expenses. To practice the concepts just defined, look at the two examples below: Buying and selling on items A business buys ten steel bars for €200 (€20 each) and sells eight of them during an accounting period. It therefore has two steel bars left in inventory at the end of the period. The full €200 is current expenditure, but only €160 is a cost of goods sold during the period. The remaining €40 (the cost of two units) will be included as an inventory in the balance sheet, that is, as a current asset valued at €40.  Purchasing and extending a building A business purchases a building for €300 000. It then adds an extension to the building at a cost of €100 000. The building needs to have a few broken windows mended, its floors polished and some missing roof tiles replaced. These cleaning and maintenance jobs cost €9 000. Here, the original purchase (€300 000) and the cost of the extension (€100 000) are capital expenditures because they are incurred to acquire and then improve a non-current asset. The other costs of €9 000 are current expenditure because these merely maintain the building and thus the earning capacity’ of the building. Financial revenues and expenses Interest and dividends received from investments held by the business, typically long-term investments in companies they have a strategic partnership with. Capital income is the proceeds from the sale of non-trading assets (that is, proceeds from the sale of non-current assets, including long-term investments). The profits (or losses) from the sale of non-current assets are included in the statement of financial performance for a business for the accounting period in which the sale takes place. For instance, the business may sell vehicles or machinery that it no longer needs - the proceeds will be capital income. Finally, it is worth highlighting that, rather than using the concepts of extraordinary revenues and expenses, IFRS would distinguish, within the operating revenues and expenses, between the recurring and the non-recurring flows. Typically, restructuring charges, impairment of fixed assets (like goodwill) will be accounted as non-recurring items. The concept of “current operating income” represents the recurring income or profit that a company generates from its normal operations. The different forms of calculating and communicating earnings Companies tend to communicate with their different stakeholders about their performance. As financial profitability is a key driver of business performance, the communication of earnings takes alternative forms and acronyms that are worth already considering at this point. Earnings before Interest & Tax (known as EBIT) is the profit line that many investors are interested in since it represents the day-to-day operational performance of the entity. Different businesses may be funded in different ways (thereby affecting the amount on interest they pay), different businesses may fall under different tax regimes (thereby affecting the amount on tax they pay), By looking at EBIT investors can actually see how efficient a business actually was at conducting their operational activity and this view remains uncorrupted by the effect of the interest or tax they pay. 32 EBITDA as “earnings before interest and other financing costs, taxes, depreciation of tangible fixed assets and before amortization of intangible assets”. EBITDA is much used because investors and lenders consider it, to be an important supplemental measure of companies’ performance and it is frequently used by securities, analysts, investors and other interested parties in the evaluation of companies in many industries. EBITDA is an appropriate supplemental measure of debt service capacity because cash expenditures on interest are, by definition, available to pay interest, and tax expense is inversely correlated to interest expense because tax expense goes down as deductible interest expense goes up. Depreciation and amortization are non-cash charges. To help the understanding of the cost structure of the business these expenses are normally split between those that directly relate to the actual provision of the product or service, and those which relate to the business as a whole but are only indirectly related to a specific product. These costs are often known as overheads. Net Income or Earnings after tax, is calculated by deducting the firm's income tax expense from its reported pre-tax profits, or earnings before tax (EBT) Earnings after tax are a measure of the net change in owners' equity resulting from the transactions recorded in the income statement during the accounting period. At the end of the year if a business’ expenses are less than its income it creates a deficit – a loss. This loss will effectively reduce the value of the shareholders investment so will be reflected in the accounts as a reduction in value of the equity in the Balance Sheet. If the business's revenue is more than its expenses then this generates a surplus – a profit - and one of two things can happen to this profit. Either it can be given back to the shareholders – this is called a dividend – or it can be retained in the business to fund future growth. In this case it is known as retained earnings/profits and increases the value of the equity in the Balance Sheet. Case: Producing the financial statements of Consultores Barca  Consultores Barca is a company created on 1/1/2012 by two associates Dieter Wolf and Ana Maria Hernandez with a capital of 50,000 Euros.  Half of that amount had been invested in computer and telecom equipment required to run the business. That equipment was paid after 1 month.  The company sells and installs computer equipment, mostly for legal and notary offices.  The company generated sales of 240,000 € in 2012. It purchased 95,000€ value of computer equipment to install on clients’ sites in 2012.   The company paid Ana Maria, fees of 4 ,000 € and had other operating expenses (rent, electricity…) of 22,000 €.  At the end of the year, customers had only paid 65% of the invoices. 1 ,000€ were still due to suppliers. Inventories’ value was 15,000€.  Depreciation of fixed assets was made at a rate of 25%.  Tax rates on profits are 33%. Taxes were not paid until the following year. Dividends of 3,000€ were distributed to each shareholder. One third of the dividends were paid as interim dividends. 1. Establish the income statement (by nature of expenses), the cash flow statement for 2012, and build the balance sheet at the end of the same year. What would have happened if?  Ana Maria had received 60,000€ of fees instead of 4 ,000€?  Customers had paid 80% of their invoices?  Equipment had been depreciated over 5 years?  Dividends had been 12,000€ 2. What would be the impact of each of these changes on the income statement, the cash flow statement and the balance sheet? 34 Case: Reading the financial statements of Cap Gemini for 2010-2012 Read in the following order, the financial statements of Cap Gemini, a consulting company  Income Statement  Statement of financial position  Statement of cash flow Questions you might like to answer and discuss with your instructor while exploring the published information:  Is the company profitable? Where can you see this?  Has the company been growing over the period 2010-2012?  What is the Cost of service rendered?  What are the main assets of the company?  Has the company made acquisitions in the past?  Is the amount of trade receivables at an acceptable level?  Is the company much indebted?  Is the amount “ ustomers advances” giving a positive or a negative signal to the company? 4. Accounting principles Learning objectives: This section should allow you to identify:  Number of important principles applicable to profit-orientated entities as well as public sector institutions in the context of accruals accounting  The systematic presentation of concepts discovered when reading financial statements in the previous section IFRS and IPSAS are 'principle' based and not 'rule' based. The primary difference between these two bases is that matters are more specifically defined when in presence of rule based principles, whereas exercise of judgement is involved when rules are principle based. learly defined principles provide many advantages as a basis of accounting, including allowing accountants the ability to consider the best way to account for and report a transaction, increased comparability among companies with similar transactions no matter the industry and the ability to defend positions based on the principles followed. Disadvantages include an increased ability to manipulate transactional accounting, increased variations in accounting approaches for similar transactions, and fewer bright lines to consider in determining how to account for a transaction. Historical cost concept It is essential that transactions are valued in a consistent manner. To ensure that this happens, a number of transactions are normally recorded at their original (or historic) cost. This means that the market value of a business might be significantly different to that shown in the statement of financial position. Annuality or accounting period Financial statements are prepared on a regular basis (usually every 12 months). Notice that management accounts, which are for internal use, are usually produced on a more regular basis. Going concern When preparing financial statements we assume, unless told otherwise, that the entity will continue to operate for the foreseeable future. Thus if we were preparing financial statements for an airline company we would do so on the basis that it was to continue to operate as an airline. This is important because if there were plans to sell the business in the near future, the value at which assets would be shown in the statement of financial position might be very different. For example, if the company were to leave the airline sector it might not realise the full value of its planes and other assets. Consistency It is essential that the judgements used in the preparation of financial statements are applied consistently from one accounting period to another. In this way financial statements for the current period can be compared with previous years. Hence, if the airline company chooses to depreciate its planes at 10% per annum, using the reducing balance method, this should not be changed without good reason - the different depreciation methods will be explained in a later session. 36 The accruals concept (or matching concept) During an accounting period, income should be matched against the expenses incurred in generating it. This is regardless of whether all cash relating to these transactions has been received or paid by the end of the accounting period. As a consequence, where cash has not been paid by the end of the period, an accrual is necessary. In the same way, a prepayment is required to reflect any payments made that relate to the next accounting period. In this way, the profit reported should reflect the true value of transactions that have taken place during the period. Returning to our earlier example, when preparing its statement of financial performance for the year ended 31 December 2010, the airline company should include the cost of all fuel used during the previous 12 months. This is despite the fact that at 31 December it is unlikely that the airline company will have paid its suppliers for all fuel received during that accounting period. This means that the airline company will have to accrue all amounts owing to fuel suppliers for fuel used up to 31 December 2010. Prudence The preparation of financial statements is based upon a number of judgements and estimates. These include depreciation, allowance for debts and accruals. Prudence requires that these judgements are not over optimistic. As a consequence, when preparing financial statements, it is considered prudent to recognise in full any potential losses that might arise, whilst anticipated profits are not recorded until fully realised. For example, at 31 March 2010 Everpool Housing Association has receivables of €100 000 and based on past experience, 5% of these will not pay what they owe. It might be that all outstanding debts will be collected, however, prudence suggests that, based on past experience, the Housing Association should include an allowance for receivables of €5 000 in its accounts for the year ended 31 March 2010. Separate determination (no netting) An entity cannot net off potential liabilities against potential gains. For example, if an entity is being sued by a customer for €20 000 and it is likely that the customer will win the case the entity should include €20 000 as a liability in its financial statements. The same entity might itself be suing a supplier for €15 000 and legal advice indicates that it is likely to win the case. The separate determination concept does not allow the entity to net off these two amounts and show a liability for €5 000 in the financial statements. Instead, €20 000 will appear as a liability in the financial statements and, in accordance with the prudence concept, we will not record the income from the supplier until realised. Substance over form The legal form of a transaction may sometimes differ from the commercial substance. If this is the case, the financial statements should show the commercial substance of the transaction and its impact on the entity. For example, an entity might purchase a motor vehicle costing €50 000 through a finance lease. Under the terms of the lease agreement the entity will pay €10 000 each year for five years and legal title of the vehicle will only pass to the entity after the final lease payment is made. In this case, in order for the financial statements to show a fair view, commercial substance must override legal title. Although the entity does not legally own the vehicle until the final lease payment is made, it has all the benefits and risks associated with ownership. As a result, commercial substance suggests that from the day that the entity first receives the vehicle, it should be treated as a non-current asset, with the corresponding lease payments recorded as a non-current liability. Materiality Financial statements should be materially correct. For example, to a small business the purchase of a coffee maker costing €500 is a significant amount that may be recorded as a non current asset. For a large multi-national corporation, with a turnover of several hundred million euros, €500 does not represent a significant amount. An entity of this size might only capitalise those items costing more than €5 000. Materiality suggests that the basic accounting rules should not be rigidly applied to insignificant items. 38 5. The Accounting Process Learning objectives: This section should allow you to get introduced to:  The accounting documents that are the books of original entry  The general ledger and its systematic organisation around a chart of accounts  The process of recording individual transactions and using the T accounts  The closing of accounts and its link to the production of the financial statements In this section, we explore the accounting chain, i.e. the entire process in hands of the accountant, and its different activities. So far, we have concentrated our attention to the last part of the process, the communication of the company's performance, through financial statements, as it is the most important part for a “user” of the accounting information. Therefore, we will briefly cover this topic in the context of this first module, and spend much more time and practice in the subsequent modules. The whole financial accounting process involves the following activities: recording, classifying, summarising and communicating. Journal Recording transactions Books of original entry General Ledger Transferring to the Ledger Chart of accounts Trial balance Balancing off the accounts Income statement Balance Sheet Generating the inancial stements Cash flow statement Figure 11: The accounting process It is worth bearing this progression in mind as we look at different transactions, processes, re-conciliations, statements, etc. The order is important – i.e. we tend to deal first with recording a specific transaction (e.g. the purchase of some equipment), in recording it we decide where it should be recorded and therefore how the items are classified (e.g. equipment should be classified as an asset and in which account to post it), and at some point we need to summarise that information in a way that is suitable for communicating to users in a meaningful way (e.g. in a statement). The Journal or book of original entry When a transaction takes place, we need to record as many of the details of the transaction as possible. For example, if an entity purchased a computer on credit from a particular company for €750, they would want to record that the purchase had been made, the date, the amount involved (including any analysis of taxes) and the date of the transaction. Some entities would also record information such as the identity of the individual or company supplying the computer. Accounting transactions are recorded on source documents. Whenever a business transaction takes place involving sales or purchases, receiving or paying money, owing or being owed money, it is usual for the transaction to be recorded on a document. These documents are the source of all information recorded by a business. In its simplest form, such a document is called the journal. It is a sequential record of events and their effects on the entity. It is based on double-entry principle (that we need to define further) and each operation requires separate registration (an entry per invoice, or per payment). We can anticipate already that groups of operations before accounting operations are practically only allowed for cash retail sales. More generally, we will be talking about books of original entry, where an entity would first record transactions. Separate books can be maintained for each kind of transaction. In a computerised system, these of course would not be books, but would be different segments of the system. Main books of original entry include:  sales day book – for credit sales  purchase day book – for credit purchases  sales returns day book – for returns inwards  purchases returns day book – for returns outwards  cash book – for receipts and payments of cash Classifying and transferring transactions to the ledger Entries from the books of original entry are then summarised, and using double entry bookkeeping the summarised information is entered into accounts. A separate account is used for each asset, liability, revenue, expense, gain, loss and capital. These accounts are kept in books conventionally referred to as ledgers. A ledger entry is made for every transaction. When recording business transactions most businesses use a system known as double entry bookkeeping. We need to define and illustrate two important concepts: how does double entry bookkeeping work and what is a (general) ledger? Double-entry bookkeeping We have already seen that financial accounting is based upon the accounting equation: Assets – Liabilities = Equity 40 As the name suggests, double entry bookkeeping is based upon the premise that every transaction impacts twice upon an entity. That is, every transaction will comprise both a debit and a credit entry. This is known as the duality concept and it means that both sides of our accounting equation will always remain equal. There are various ways of developing this understanding. The following two tables basically contain the same information, but look at it from different angles. You might find one table more helpful than the other in terms of assisting your understanding. You should find that these tables are relevant for any transaction you need to record. Category Usually Asset Debit Equity Credit Liability Credit Revenue Credit Expense Debit For example, the asset account for inventory is usually a debit balance, whereas the liability account for a bank loan is usually a credit balance. Looking at this from the point of view of the impact that a single transaction has on each account category, it is helpful to ask whether the item is increasing or decreasing, as shown in the next table. Category Increase Decrease Asset Debit Credit Equity Credit Debit Liability Credit Debit Revenue Credit Debit Expense Debit Credit In order to understand the logic of this table, it is essential to remind the fundamental equation: revenues increase retained earnings – and equity- while expenses reduce retained earnings or equity. Figure 12: Breakdown of the fundamental accounting equation In order to illustrate this process in a simple way, let’s get back to the example of Tom’s company and proceed step by step for each of the first transaction of that company/ Illustration Transaction: Tom started his company with a capital issue of 10,000 in cash. Ask yourself the following questions: 1. Which two “accounts” are affected by this transaction? Answer: cash or the bank account and capital 2. How do I categorize these two items? Answer: cash is an asset and capital is part of equity Double entry rule: Assets accounts increase with a debit and usually show a debit balance Capital usually a credit balance 3. What is the effect of the transaction on these two items? Was there any increase or decrease? Answer: cash has increased, and capital has increased 4. What entries do I need (you may need to refer to the tables above to answer this)? Firstly: to increase the asset of cash? Answer: debit Secondly: to increase capital? Answer: credit So, the accounting entry for this transaction is: Dr ash €10 000 42  r apital €10 000 Transaction: Tom purchases 5000 of stock (paints and painting) tools on credit 1. Which two “accounts” are affected by this transaction? Answer: inventory (an asset) and a trade payable to supplier (liability) 2. What is the effect of the transaction on these two items? Was there any increase or decrease? Answer: inventory has increased, and payable has increased 4. What entries do I need? Firstly: to increase the asset of inventory? Answer: debit Secondly: to increase a liability? Answer: credit So, the accounting entry for this transaction is: Dr Inventory €5 000 Cr Payable €5 000 Transaction: The company pays Tom a salary of 800 1. Which two “accounts” are affected by this transaction? Answer: wage expenses and cash or the bank account 2. How do I categorize these two items? Answer: cash is an asset and wages are expenditures Double entry rule: Assets accounts increase with a debit and usually show a debit balance Expenses reduce the equity and show a credit balance 3. What is the effect of the transaction on these two items? Was there any increase or decrease? Answer: cash has decreased, and expenses have increased 4. What entries do I need ? Firstly: to decrease the asset of cash? Answer: credit Secondly: to increase expenses or to decrease capital?  Answer: debit So, the accounting entry for this transaction is: Dr age expenditures € 00 Cr Cash € 800 Ledger We just saw that all transactions are recorded in the ledger using the double entry booking principle. Each transaction will result in one account having a debit entry and another account having a credit entry. In order to organise the large number of accounts that any accounting system requires to record business transactions, we need a chart of accounts. The chart of accounts is the structured list of the company’s general ledger accounts. The list is used to prepare financial reports for authorities and owners. The accounts are grouped into types of accounts and further aggregated into larger categories. At the most general level, the accounts are grouped as revenues and costs (operating accounts) and assets and liabilities (balance accounts). A chart of accounts is an approved set of items of revenues, expenses, assets and liabilities that an entity (or group of entities) requires in order to satisfy its regular, normal accounting requirements. It is systematised so that the same set of items is utilised by all those involved in recording financial transactions and will usually contain a set of codes that represent the approved list of revenue and expense items. The list can be numerical, alphabetic, or alpha-numeric identifiers. However in many computerized environments, only numerical are allowed. The structure and headings of accounts should assist in consistent posting of transactions. Each nominal ledger account is unique to allow its ledger to be located. The list is typically arranged in the order of the customary appearance of accounts in the financial statements, balance sheet accounts followed by profit and loss accounts. Example of Chart of Accounts (Higher level of aggregation) Balance Sheet accounts: Class 1 capital, reserves and financial debt Class 2 fixed assets Class 3 inventory Class 4 third parties: clients, suppliers, staff… Class 5 financial items/banks Income account: Class 6 expenses Class 7 revenue 44 The charts of accounts can be in some countries defined by the accountant from a standard chart of accounts general layout, in some regulated by law. Many countries have no national standard charts of accounts, public or privately organised, and specific OA’s are developed by sector or industry. In several countries there are general guidelines, and in France and Belgium the guidelines have been codified in law. In Module 2,we will see that the COA used at the Commission is consistent with the COA used in France and Belgium. The following transactions relate to Fred Elliot who has recently stated a business of catering and event organization: Debit (Dr) Credit (Cr) 1) Fred started the business with €5 000 cash 2) He rented a shop paying €500 cash 3) He bought equipment for the shop costing €1 000 4) He purchased €600 of food on credit from Norman Watts 5) He made sales of €1 200 6) He paid Norman Watts the cash owing Requirements  Use the grid above to show the accounts affected by of each of the above transactions.  Use the accounts below to record the transactions. 46 Dr Cash Cr Dr Capital Cr € € € € Dr Rent Cr Dr Equipment Cr € € € € Dr Supplier Cr Dr Purchases Cr € Watts € € - Food € Dr Sales Cr Dr Cr € € € € 48 Balancing off the accounts After a short period of time, the various ledger accounts will each contain a number of debits and credits representing all the business transactions that have taken place. For a large entity that has thousands of transactions every day, this will mean that each ledger account will soon contain hundreds or even thousands of entries. In this form, it is not easy to ascertain how well a business has performed and we therefore need to summarise the contents of each ledger account. On a periodic basis (usually monthly or at least annually), an entity balances off all the ledger accounts and summarises the results in a trial balance. This will enable the preparation of meaningful financial statements in the form of an income statement/statement of financial performance and statement of financial position/balance sheet. Let us refer back to our earlier example of Fred Elliot. Although we have recorded all transactions that relate to Fred’s business, we cannot easily determine  Whether the business has made a profit.  Its assets and liabilities. In order to ascertain this information we need to close down each ledger account and summarise the results in a trial balance.  Extracting a trial balance from ledger accounts At the end of an accounting period and prior to the preparation of financial statements, a company will usually prepare a trial balance. This is a check on the accuracy of the double entry and simply lists the balance on each account in a debit or credit column. A trial balance can be used to test the accuracy of the accounting records. Total debits should equal total credits. Once we have balanced ou