Financial Accounting, Appunti di Contabilità Finanziaria

Scarica Financial Accounting e più Appunti in PDF di Contabilità Finanziaria solo su Docsity! RO 5 LD ci i i 9 4a ve 2 4 $ » E E Al O Sale ae | GR <A È i SÉ ò P A FINANCIAL — -STATEMENTS Lea ma ALMA MATER STUDIORUM - UNIVERSITÀ DI BOLOGNA BACHELOR IN ECONOMICS AND FINANCE - CLEF 84552 - ACCOUNTING AND FINANCIAL STATEMENTS (8 CFU) Prof. Luca Baccolini Lectures from September 22, 2021 to December 09, 2021 Essential text: Financial Accounting with International Financial Reporting Standards. Weygandt, Kimmel, and Kieso, 4th ed. Wiley, 2019 [1] 1 Fundamental concepts Company: basically complex systems (group of interrelated elements in a continuous way) of economic (valuable in term of money) elements working together (organized by the company itself) in order to achieve goals (this is how theyre seen in accounting) AII of this different elements are interacting in order to make profit (as much money as possible - maximization of cash). However nowadays making profit isno more enough. They need to comply with ESGs for example ecc... 1. At the very beginning of every company, the first operation made by the shareholders is injecting cash in the company (they invest their money in the company). Usually in big companies the shareholders differs from the managers. 2. Managers uses the money they're provided by shareholders in order to make investments: in other words, purchase factors of production. Factors of production can be either: * Tangible factors of production: any asset that is concrete (raw materials, machines) * Intangible factors of production: assets that cannot be seen (work of employees, license) Factors of production can also be divided in: * Single-use factors of production: raw materials are single-use factors of production since they go away after one use * Multiple-use factors of production: machines are multiple-use factors of production, since the company can continue to use the same machines for times during the produc- tion of many goods. Employees are not multiple-use assets, since the company cannot fully control the employee, and so is not sure whether or not the employee is gonna stay with the company 3. The company is then able to process or manufacture the raw materials, in order to sell goods or services. * Manufacturing companies: they take factors of production in order to obtain a finished good. They use all the raw materials in the production process in order to obtain something different: the finished goods. (ex.: cake factory) * Commercial companies: the physical features of the raw materials are the same before and after the process made by the company. The company moves in space and time the goods without altering their characteristics. (ex.: supermarkets) During the production process, the economic value of the products is moved from the input to the output. Anytime a company uses a factor of production in a production process, the company faces a cost, called consumption cost (a cost for the usage of the production factor). The sum of all ihe consumption costs is basically the economic value of the production factors used in the process from input to output. So any finished good, that is produced by the company, carries the costs of all the factors of production employed by the company to process it. For multiple-use factors of production, the company needs to depreciate their cost (so to spread the cost of the factor of production on the overall processed goods). 4 Operating Cyele ManuPacturing Cyele | Monetary Cuel |, \ ) ary Cale, V V To n Ta 3 n Peer Purchase Payment Processing starting Processing Ends Sale Collecting Recevable Figure 1.1: The operating Cycle of a company 4. At this moment, the company can sell the products at a price that is higher than the consumption cost, in order to make a profit. Usually in business to business deals, the companies don't pay straight away. They usually agree on a deal and ship the payment at a fixed date. The typical operating cycle of a company can be schematized like in 1.1. At the end of the operating cycle the company ends up with more cash available. With this cash the company can decide to invest again in the production and to pay back the shareholders with dividends. The company can also decide to invest in the company again by searching for other sources of finance (ex.: from banks or bondholders). This process is called debt finance. Companies need to repay the holders of debt finance with interest, while they don't need to repay the shareholders. There are two different ways of financing a company: direct and indirect financing: * by direct financing, banks agree in borrowing money to the companies. It is explicit and it requires the payment of a remuneration to the lender (interest). * by indirect financing we intend a situation in which the company is supplied of the raw materials, but pays for it only after selling the finished goods. In this way the supplier is indirectly financing the company. Direct financing is implicit in the terms of the agreement. The interest is included in the purchase price. We can also categorize the different financing types by their action over time: * Short term financing: they're sources of finance that the company needs to pay in the short term. In detail, we can say that a financing is short-term if needs to be repaid in any period between a year or an operating cycle, whichever is longer. It's riskier, but also cheaper for the company, compared to long term financing. * Long term financing: they're sources of finance that a company has to pay in the long term. Long term finance needs to be repaid anytime period that falls after a year or an operating cycle, whichever is longer. Debt finance is a financial resource that is riskier than equity finance. This is because with equity finance the company doesn't have to pay the dividend, although they have an expectation. From an external perspective, providing the company with equity finance is riskier than providing it with debt finance, since in the latter, they know for sure that they're gonna be repaid with the interest. On the other hand, since debt finance is more secure, the retribution for a loan is gonna be less than the retribution to a shareholder who provided the company with equity finance. The company however, needs to decide how to get finances, also based on the quantity of cash they have at disposal. Each source of finance has a cost: the capital cost. The general rule to choose between the overwritten options is that capital cost must be lower that the return on the investment. Singe use assets are repaid back in a short term, while multiple use assets needs many operating cycles to repay the investment. For this reason, short term finances are better to pay single use assets, while long term finances are better to repay the multiple use assets. So there must be a match in the timings. Any company is able to perform its own investments, in order to receive a revenue, regardless of their nature. In fact investments could also be: Non-typical investments: a company can choose to use finance in order to buy assets outside the core business of the company. Ex.: other companies’ stocks or bonds. In non-typical investments the asset itself produces profit. While for typical investments, the company needs to combine the work of employees with the raw materials in order to produce a good. There are two times when the company can earn profit by non-typical investiments: 1. Periodical return 2. Return on divestment The general condition at which non-typical investiments are made is the same of typical ones: income has to be higher than the cost of capital. In accounting, there is the need to measure every operation that is analyzed in a quantitative way. The value of an operation is a quantitative description of an operation: * Stock values: the amount of money refer to a point in time Ex.: bank account sale in a certain day (like a snapshot of the bank account) * Periodic values: the amount of money refer to period of time Ex.: the amount of money refer to period of time However, periodic value affect stock values (let's think, for example at how profit earned by the company in the production cycle affects the properties of the shareholders, since the company is growing). Operations can be seen under two different perspectives: 1. Monetary / financial perspective: describes the operation in terms of contribution to the increase or decrease of the amount of cash available to the company. Ex.: if the company pays the supplier, that operation can be seen - under a monetary/financial perspective - as a decrease in cash * If cash increases, there is an inflow * If cash decreases, there is an outflow An increase in cash doesn't always mean an increase in profit, because cash can increase for many reasons (including debt finance). TASB intemational not-Por-profit ization EU listed Finms” consolidated financial reports ore develops TFRS ae IFRS ARC & EFRAG) Figure 2.1: EU-endorsed IFRS It is also relevant, to mention the Organismo Italiano di Contabilità (OIC), which is the standard- setter in Italy.The IASB issues the IFRS (International Financial Reporting Standards), which are discussed in the course. The existence of different financial standards operating in the different geographical areas is not an issue since there is a convergence process, moving all the standards closer one to each other. The IASB issued accounting standards since before 2001. After that year, the accounting standards changed, and so did therir acronyms: * Before 2001 — International Accounting Standards (IAS) — Standard Interpretations Committee (SIC) * After 2001 — International Financial Reporting Standards (IFRS) — International Financial Reporting Interpretations Committee (IFRIC) There's a hierarchy of IFRS, in order to determine what recognition, valuation and disclosures should be used: * IFRS (accounting standards) * IAS (accounting standards) * IFRIC (interpretation) * SIC (interpretation) In absence of a standards or interpretation, the following resources in descending order are used: 1. a guidance regarding the interpretation or standard dealing with similar issues 2. the conceptual framework of IFSR 3. procedures of other standard-setters that use a similar conceptual framework From 2005, all European listed firms have to prepare their consolidated financial statements in compliance with EU-endorsed IRFS 2.1. The other method, used to prevent companies to tamper with financial statements, is financial auditing, that is the process of getting the financial statements of an economic entity examined by an external company or accountani, that is required to express an opinion about the fairness of the presentation of the entity’s financial position, results and operations in cash flows. Auditor is designed to reduce the possibility of a material misstatement. 3 Financial Statements Every company needs to provide investors with a summary of the operations performed over a period of time. This summary is called financial statement. This document is the end product of the process of accounting. In order to assess the company's results, the first step it to associate economic values to each operation that the company has carried out during the reporting period. Every company is required to elaborate, at least once a year a document, the annual report, which is provided to the shareholders and the other interested parties, that contains the financial statements, explanatory notes and management’s discussion and analysis of financial and operating factors that affected the firm together with the report of the external auditors’ examination of the financial statements. The goal of the annual report is to provide information about: * Financial position at the end of the period * Earnings in the period (profit, economic/earning perspective) * Cash flow during the period (monetary/financial perspective) * Investment by and distribution to owners during the period. The financial statements contained in the annual report are: * Statement of financial position (or balance sheet), which * Statement of comprehensive income [i.e. income statement + statement of comprehensive income] * Statement of changes in equity * Statement of cash flows (or cash flows statement) 3.1 Statementof financial position/balance sheet The statement of financial position is basically a list of the entitys resources (assets), obligations (liabilities), and owners’ claim (owners’ equity). The balance sheet is the list of all the company's assets, liabilities and owners equity, at a point in time (usually the 31° December of the year). For this reason, we can only find stock values in any balance sheet, since they refer to a specific time. The Statement of financial position * provides information about resources, obligations to creditors, and equity in net resources * helps in predicting amounts, timing, and uncertainty of future cash flows. Based of the statement of financial position, is useful for: 10 INVESTMENTS = SOURCES OF FINANCE Figure 3.1: Statement of financial position’s structure * Computing rates of return. * Evaluating the capital structure * Assess risk and future cash flows * Assess the company's: — Liquidity — Solvency — Financial flexibility The Statement of financial position is composed by three parts, that can be either placed side to side (accounting form) or listed (report form). This paris are a summary of the company's: * Asset: resource controlled by the company (usually purchased and owned by the company, however the company can control assets without buying them, like leasing companies) derived by a past transaction, from which the company expecis to have benefits. * Liability: a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. The company receives cash in change of a service that is to be provided in the future. * Equity: is the owner’s claim on corporate assets, after deducting all its liabilities. EQUITY = ASSETS - LIABILITIES (3.1) ASSETS = LIABILITIES + EQUITY (3.2) Assets can be classified as: 11 2. Expenses and losses: are decrease in the economic benefits that result from * a decrease in assets (either cash or account receivable) or * the occurrence of liabilities that result in a decrease in equity, different from the distributions to the equity participants (in fact dividends are not used to generate profit). In detail: * expenses: are decreases in equity that arise from the operating activities of the com- pany (Ex.: cost of sales, wages, depreciation) * losses: are decreases in equity derived from non-operating or non-ordinary factors. Under the rules of IFRS, every company shall present all items of income and expenses recognized in a period, either: 1. in a single statement of comprehensive income 2. in two statements: * the income statement or separate income statement, displaying the vast majority of components of profit and loss, and * the statement of comprehensive income, beginning with profit and loss and display- ing components of other comprehensive income. The net income is one of the most accurate indicators of a company's success or failure in a given period of time. It is the difference between income and expenses recognized in the income statement (or separate income statement): NET INCOME = INCOME — EXPENSES (3.3) There are some specific gains and losses that has to be kept separate from the others and so they are not part of the income statement, but they have to be either separated in the same document or in two different ones. These gains and losses are called components of other comprehensive income (OCI), and are recognized in the statement of comprehensive income. The OCI are grouped into: * Components (gains and losses) that might be reclassified to profit or loss in subsequent periods, after being realized (converted into cash) * Components (gains and losses) that would not ever be reclassified in subsequent periods. The total comprehensive income is the sum of net income and the components of other comprehensive income. The total comprehensive income is the change in the change in the equity of an entity from transactions and other events and circumstances from non-owner sources. The reason why the OCI must be kept separate from the other revenues and expenses can be explained by an example: let's think of two identical companies A and B, that operates the same choices and have the same revenues and expenses from operating sources, and that purchase an identical parcel of land 3.3. However, the parcel of land of company A is declared buildable, while the other one is not. The value of the A company's land increases basically because of luck. The two companies are perfectly identical under the managerial point of view, but their net income 14 COMPANY A COMPANY B Revenues 100 Revenues 100 Expenses 80 Expenses 80 Gain (unrealized) 90 NET INCOME 110 NET INCOME 20 Parcel of land 10 --> 100 Parcel of land 10 --> 10 buildlable non-builtable Figure 3.3: Components of Others Comprehensive Income - OCI is very different, because it doesn't take account only of what happened because of managerial activities. Therefore, in order to provide investors with an accurate summary of the effects of man- agerial operate, there is the need to separate the two categories of gains and losses from the revenues/expenses. Companies generally presents some or all of the sections and totals in the image ?? within the income statement. Companies can also group various entries or add items to the statement, according to IFRS, if it is useful for the comprehension of the financial situation of the company. 15 . Sales or Revenues: is the amount of money raised directly form the sales. . Cost of Goods Sold: is the cost that the company has faced to buy the raw materials. It is the input price of the goods. . Gross Profit: is the difference between revenues and the costs of goods sold. GROSS PROFIT = REVENUES — COST OF GOOD SOLD (3.4) . Operating expenses: are all the expenses faced by the company within the usual operating cycle. They can be presented either classified by their nature: * Cost of material * Depreciation * Delivery expenses * Advertising expenses or by their function: * Cost of good sold * Selling expenses * Administrative expenses . Income from Operations: is the difference between gross profit and operating expenses. . Financing costs: are the costs of finance that the company has payed to external sources (not the shareholders). . Discontinued Operations: are revenues or expenses that the company does not face systematically every year or once in every regular period. They are kept separate because the investors need to know which is their weight on the net income in order to establish if the performance of the company was influenced by unexpected circumstances. They need to be presented net of tax, otherwise the taxation would be counted iwice. . Non controlling interests: in a consolidated statement of comprehensive income, the non controlling interests are the part of net income that is attributed to minority shareholders of a subsidiary. . Earning per share: this data is useful for financial analysis and is the ratio between the net income and the number of outstanding shares. The earning per share value cannot be analyzed on its own, because it is a ratio: if we take two different companies A and B, that have the same earning per share, we cannot assess them based on this data. Moreover, if a company has preferred shareholders, preferred shares have to be excluded from the earning per share calculation. A +3 100€ per share BARNING PER SHARE Both 0.10€ B —> 1000 per share 16 When a company purchases goods or services for a certain value, but does not pay for them in the immediate, in this section the value of the future payment needs to be added to the net income. This is because, in the computation of net income the purchase of those goods or services is listed as an expense, but, since there has been no cash movement yet, in the statement of cash flow, that value need to be balanced. 2. Direct method: simply consists in listing all the inflows and outflows from operating activities (cash collected from customers, cash paid to the suppliers...) The indirect method can be used only to report the cash flows from operating activities, not for financing and investing ones. The advantage of the usage of the indirect method is that, the company does not disclose any more information about its operating activities, because all the items are already listed in the Statement of Comprehensive Income. The direct method, on the other hand, tells exactly how much the company paid in cash for each entry (raw materials, wages...). STATEMENT OF CASH FLOWS Operating Activities - Paied to employees 15) - Colleeted from customers 90 - Payment to suppliers (Cio NET CASH FLOW 45 Investing Activities - Payment for new machinery 160) NET CASH FLOW 160) Financing Activities - Dividends Payment GO) - Cash from bank borrowings 300 NET CASH FLOW 290 Suna - Cash at the beginning of the fiscal period #00 - TOTAL CASH FLOW 165 - Cash at the end of the fiscal period #65 Figure 3.5: Statement of Cash Flows 19 The Annual report, in the end is completed with: * Explanatory Notes, are the longest part of the annual report and are an integral part of the financial statements that contains explanations of accounting policies and descriptions of financial statement details. * Management’s discussion and analysis - MDA or Management Commentary - is a qualitative description of the firm’s activities for the year, including comments about its financial condition and results of operations. Beginning of End of Fiscal period Fiscal period , t a STATEMENTI OA IMPREHANSIVE INCOME E - — LE A Revenues | L - Expenses SFP, — > Netincome — STATEMENT OF CHANGES IN EQUITY Beginning Balance Paid-in capital changes Retained earnings changes Ending balances STATEMENT OF CASH FLOWS Cash used in: - Operating activities - Investing activities - Financing activities Cash in the end Figure 3.6: The timeline model for the financial statements 20 4 The conceptual framework Every reporting standard needs to comply with the conceptual framework (see figure ??). Whenever a standard does not cover, for reasons, a particular operation, the company needs to report it in compliance with the conceptual framework. This one is composed of three levels: the objective, the elements and qualitative characteristics and the implementation. 1. MAINOBJECTIVE: this is the "why", the purpose of accounting. As it has already been said, the objective of the reporting process is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions about providing resources to the entity. Of course, the information provided needs a discrete knowledge of financial accounting to be read and to be able to help in the decision-making. 2. ELEMENTS AND QUALITATIVE CHARACTERISTICS: this is a bridge between the purpose and the implementation of the accounting process. The elements are assets, liabilities, equity, income and expenses. The qualitative characteristics that each accounting information shall satisfy in order to be useful for the decision-making are stated by IASB: * Fundamental qualities — Relevance: an information is relevant if it is capable of making the difference in a decision. We define information as material if omitting it results in a different decision for the user. — Faithful representation: means that the number in the statements are real and related to events that actually happened. We define information as neutral if it is not selected to set an interest of any type. * Enhancing qualities — Comparability: since the standards followed by companies are the same, their statements can be compared. — Verifiability: information provided can be verified by different accountants using the same methods and evaluations. This is basically what auditors do. — Timeliness: means that information needs to be provided (and so disclosed by the company) when it is still relevant for the decision of the investors. — Understandability: is the quality of information that lets the reasonably informed user see its significance. 3. IMPLEMENTATION: is, as the name tells, the practical act of gather and measure, elaborate and report accounting data. * Assumptions — Economic Entity: the company needs to report its activities as separated from the activities of third parties (shareholders, management...) — Going Concern: the company needs to fulfill the objectives of solvency and prof- itability in order to continue existing — Monetary Unit: information must be measured in terms of money — Periodicity: the continuous activity of the company needs to be reported in periods 21 5 Consolidation It is a process regarding the financial statements of companies that are composed of a parent company (holding) and dependent entities (subsidiaries), that consist in gathering data from dependent entities and aggregating data to the parent company. This is a process present in all the IFRS, which are made for companies that consolidates their statements. R_ 100 e s0 A NI 20 shareholders HOLDING, Require information of the whole group R__100 R_ 100 R e 50 Cc E 80 I SUBSIDIARY | MI 20 II SUBSIDIARY | MI 20 Figure 5.1: Consolidation process CONSOLIDATED STATEMENT Revenues 300 Expenses 240 NET INCOME 60 Attributable to se commer of the parent Attributable to 2 non controlling interests Figure 5.2: Consolidation process If we think of three companies: a holding A, and two subsidiaries, B, 90% controlled by the holding, and C fully controlled by the same, we can easily imagine that the shareholders of the parent company are interested in the information on the overall group theyre investing in, so they need to be provided with a comprehensive statement, reporting the overall condition of the group 5.1. This one is called the consolidated statement 5.2 24 6 The Bookkeeping Process and Transaction Analysis In the first part of the course has been discussed the role of accounting information and its purpose and the outcome of the accounting process. The second part of the course will focus on the methods of associating values to the company's operations, that is, how to prepare financial statements. 6.1 The Horizontal Model The "golden rule" of accounting, that is, the basic accounting equation, defined in the Statement of Financial Position states that assets are equal to stockholder's equity plus liabilities: ASSETS = EQUITY + LIABILITIES (6.1) We can analyze the effects of a company's operations on every term of this equation. The basic accounting equation can be expanded in order to include other elements: * Since cash is an asset that has an own financial statement dedicated, it is useful to see the effects of company's operations on cash using the equation CASH + OTHER ASSETS = LIABILITIES + EQUITY (6.2) * we also know that, in order to prepare the Statement of Changes in Equity, we need to divide stockholder’s equity into paid-in capital and retained earnings. So we can expand the equation again: C+0A=L+ PIC + RE (6.3) * again, since the retained earnings are composed of the retained earnings accumulated from the moment of the incorporation and the net income of the company for the year (which is revenues less expenses), we can rewrite the 6.3 as: C +0A=L+PIC+RE;.y +R-E (6.4) * lastly, we can add to the previous equation, the other comprehensive income items, in order to obtain: C +0A=L+PIC+0CI+ RE,., +R-E (6.5) This equation is called the horizontal model. Notwithstanding this tool is not used by the companies and is not mandatory by law or by the IFRS, is quite more straightforward to analyze the effects of company's operations. Thus, it is convenient to see an example of how the transactions of a company impact on the items in the accounting equation: * A - The stockholders invested $2,000. * B - The company borrowed $6,000 from a bank. * C - Equipment costing $10,000 was purchased for $2,000 cash and signing a note payable for $8,000. 25 * D - Equipment that cost $3,000 was sold for $3,000. The $3,000 will be received within 30 days. * E - The company provided services for $8,000 and received cash. * F - Wages of $2,000 were paid in cash. ° «EI e 5090 (a) A - The stockholders invested $2,000. (b) B- The company borrowed $6,000 from a bank. * 3,000 42000) = _ $ so TRENI (a) C - Equipment costing $10,000 was purchased for $2,000 cash and signing a note payable for $8,000. $ 3; el (b) D - Equipment that cost $3,000 was sold for $3,000. The $3,000 will be received within 30 days. 0 = E MiO ae mpanI provided services for $6,000 and (b) F - Wages of $2,000 were paid in cash. $ 2,000 If we report all the data of the diagrams into the horizontal model we obtain the table 6.4. Here we notice that that every transaction has at least two effects on the equation. Since the equation represents the structure of the Statement of Financial Position, which is based on the basic accounting equation, we can say that every transaction has at least two effects on the financial position of the company. 26 Each transaction needs to be based on source documents that attest that the transaction has happened. A source document can be an invoice, a bank receipt or any other document testifying the transaction. Generally (though there are exceptions) if there are no source documents, the transaction shouldn’t be reported as an entry in the journal. After a transaction is recorded in the journal, is posted to individual accounts in the ledger (that is, the collection of all the items’ T-accounts). To sum up, the bookkeeping process consists in three passages: 1. the accountants collect the source documents and analyze transactions 2. then transactions are reported in the journal 3. eventually, the transactions are posted in the ledger SOURCE DOCUMENTS RECORDED IN THE JOURNAL. POSTED ON THE LEDGER a DI DR > Figure 6.6: The Bookkeeping process phases Exercise: preparation of the journal entries from the following list of transactions: 1. On January 1, the stockholders invested $2,000. 2. On January 15, the company borrowed $6,000 from a bank. 3. On February 1, equipment costing $10,000 was purchased for $2,000 cash and signing a note payable for $8,000. 4. On February 15, equipment that cost $3,000 was sold for $3,000. The $3,000 will be received within 30 days. 5. On February 20, the company provided services for $8,000 and received cash. 6. On February 25, wages of $2,000 were paid in cash. GENERAL JOURNAL 29 Date Description Debit Credit Jan, 1 Cash 2,000 Paid-in capital 2,000 Jan, 15 Cash 6,000 Notes payable 6,000 Feb, 1 Equipment 10,000 Cash 2,000 Notes payable 8,000 Feb, 15 Account receivable 3,000 Equipment 3,000 Feb, 20 Cash 8,000 Revenue 8,000 Feb, 25 Wages expense 2,000 Cash 2,000 6.4 Preparation of the Financial Statements Based on the transactions listed in section 6.3 we can now prepare the financial statements of the company, assuming, for simplify, that the transactions listed before are the only transactions occurred. at December 2021 Current liabilities 12000|Notes payable 3000 TOTAL LIABILITIES 7000 Paid-in capital Current assets Cash [Account receivable INon-current assets Equipment ‘Retained earnings [TOTAL EQUITY [TOTAL ASSETS LIABILITIES EQUITY 22000|TOTAL EQUITY and LIABILITY Figure 6.7: Statement of Financial Position Top compile the Statement of Financial Position we look at the ledger and take the T-account for each element (asset, equity, liability, revenues and expenses) and we report the total amount of the T-account under the correspondent entry in the Balance Sheet. 30 for the year 2021 Revenues from services 8000 |Wages -2000 NET INCOME 6000 Figure 6.8: Statement of Comprehensive Income for the year 2021 [Paid-in capital Retained Earnings Net Income Beginning amount 0 o o Investment by the shareh 2000 Net income 6000 ENDING AMOUNTS 2000 o 6000 Figure 6.9: Statement of Changes in Stockholder”s Equity for the year 2021 Operating Activities Cash flow from customers Wages Investing Activities Equipement Financing Activities Shareholder's investments Bank borrowings CASH AT THE BEGINNING ‘TOTAL CASH FLOW CASH IN THE END Figure 6.10: Statement of Cash Flows EXAMPLE: . if the company draws up an insurance policy at September 1, 2021, and, the same day, pays in advance €12,000, for one year coverage (up to August 31, 2021), there is the need of an adjusting entry, because the effects of the transaction exceed the duration of an accounting period. At the time of payment, and so when the journal entry is recorded, the company cannot claim it has incurred in an expense, because it didn’t receive any service at that moment. The only thing that is received is the "promise" to receive a service in the future. This is called prepayment and is classified as an asset (see figure 6.13). ì € 4,000 I € 8,000 t_ T 1 Sept 1, 2021 Dec 31, 2021 Aug 31, 2022 Insurance policy Annual Report End of coverage € 12,000 Figure 6.13: Timeline of reclassification adjusting entries example Horizontal Model for 2021 adjusting entry c OA L PIC OCI R -E (12,000) 12,000 Journal entry for insurance policy Date Description Debit Credit Prepaid expense (insurance) 12,000 Sept 1, 2021 Cash 12,000 Anytime there is a prepayment for receiving a service or a good in the future, the payer obtains an asset that represents the "promise of payment". In the Statement of Financial Position at December 31, 2021, the company has to report an expense for the received services for insurance coverage. Since in 2021 the company received four months of services, namely € 4,000 worth of insurance coverage, this item shall be reclassified as an expense. So the company needs to reclassify some value (€ 4,000 of the prepayment) from an element (assets) to another one (revenues/expenses). Horizontal Model for insurance policy adjusting entry c OA L PIC OCI R -E (12,000) 12,000 (4,000) 4,000 Journal adjusted entry for insurance policy in 2021 Date Description Debit Credit Insurance expense 4,000 Dec 31, 2021 Prepaid insurance expense 4,000 In the journal we recognize two effects: * the four months of service received are recognized as an expense (debited) * the prepayment (as an asset) decreases of the same value (credited). The company needs, of course, to report the reclassification in the financial statements: Income Statement Statement of Financial Position for the year 2021 at December 31, 2021 Prepaid Insurance/Expense 12,000 4,000 8,000 Figure 6.14: Financial Statements in the 2021 Annual Report During following year, the company, will receive the rest of the coverage for a € 8,000 amount. Therefore, in the Financial Statements of the 2022 annual report, the company will report * a € 8,000 insurance expense * zero prepayments for insurance. Journal adjusted entry for insurance policy in 2022 Date Description Debit Credit Insurance expense 8,000 Dec 31, 2021 Prepaid insurance expense 8,000 If a company has to provide services or deliver products and has received cash in advance, the ‘amount received is called unearned revenue. 35 Income Statement for the year 2022 Statement of Financial Position at December 31, 2022 Prepaid Insur 8,000 o TW 8,000 Figure 6.15: Financial Statements in the 2022 Annual Report 6.6 Closing the books At the end of the accounting period, the company makes the accounts ready for the next period. At this moment there is a distinction to take in consideration: * Temporary accounts: refer to a single accounting period, therefore, their balance starts at zero at the beginning of each accounting period. Temporary accounts include: — Revenues — Expenses — Dividends * Permanent accounts: refer to the entire period of time the company is operative, there- fore, their balance starts always from the Permanent accounts include: — Assets — Liabilities — Equity 36 balance of the previous accounting period. When the accountants have to prepare the journal entry, they cannot establish which item has been sold, to report the cost at which it was purchased, so they assume that it is the one in the inventory that was brought earlier, in this case, on November 1. 7.1.2 Average-cost The items sold are assumed to be purchased by the company at a constant price which is the weighted average of the costs in the inventory for that particular item. __ total cost of items available in inventory IA — — — w total units available in inventory (7.1) 7.1.3 Last-in, first-out (LIFO) Every time an item is sold, the company assumes that the cost of that item is the cost of the last analogous item brought: the last item purchased is assumed to be the first to be sold. Date Description Quantity Price November 1 Ist Books purchase | 100 € 15 November 2 2nd Books purchase | 100 € 20 Total quantity and cost 200 € 3,500 November 10 1st Sale 60 € 20 2nd Sale 60 November 15 40 € 20 20 € 15 Sales revenue € 2,300 This assumption is not allowed to be made by companies using IFRS. This is because it leads to report an outdated value for the ending inventory in the SFP. Since the company registers as cost of goods sold the price at which an item was purchased the last time, the ending inventory’s value will be the value of the oldest purchased items, so its value can represent the value of items brought even one year earlier. Since in the conceptual framework of IFRS, the timeliness of the accounting information is an enhancing quality, outdated values cannot be accepted in the statements. 7.1.4 Classifying and Determining Inventory - conclusions To sum up, the cost of goods sold reported in the statements changes as the assumptions on cost flow changes, even though the purchases are the same. Continuing with the aforementioned examples: FIFO WA LIFO CGS € 1,900 € 2,100 € 2,300 Ending inventory € 2,600 € 2,400 € 2,200 Profit t f [ Total assets Lt [ L | [ Taxation Lt [ Li | 39 This happens in periods of rising prices. We always have to take in consideration the method use to evaluate inventory because it can influence the profit of the company, the assets value and the taxation reported in the financial statements. For example, in periods of rising prices, the FIFO method leads to an increase in profit and assets value, which can influence the judgement about the company analyzed. 7.2 Recognition of current assets Inventories are assets the the company holds: * to sell in the ordinary course of business * to use in the production process * in the form of materials to be consumed in the production process or rendering of services Inventories are different from the supplies, as the supplies are not used directly in the production process, nor part of the finished goods that the company sells. Assets shall be recognized at the moment the company controls them. The old IFRS rule to establish whether or not a company could claim to control an asset looked if the company was baring the full risk of loosing its value. Nowadays, according to IFRS, we establish this by looking at whether or not the company can dispose freely of that specific asset, and so decide freely about its usage. 7.2.1 Passageoftitle The concept of passage of title is used in the assets’ recognition process during transactions between two entities. When a good is in transit: usually, the two entities sign a contract containing specific clauses called covenants to determine the passage of title. There are two types of covenants: * Free on board (FOB) shipping point: is applied when the tile passes when the company A shipment arrives to the agent (B)7.2 * Free on board (FOB) destination: the title passes when the buyer receives the shipment. This is used when the shipment comports a higher risk. B|__-> C Seller Agent Buyer Figure 7.2: Passage of title through an agent 40 7.2.2 Consigned Goods Revenues Figure 7.3: Consigned goods case When a company that delegates the selling process to a selling agent has to prepare the financial statement, and so has to register the inventory, all the merchandise that has shipped to the agent to be sold, and so that is out of inventory, is still considered part of it, as property of the company (see figure 7.3). 7.2.3 Repurchase agreement Payment later Repurchase Goods sold Payment Figure 7.4: Repurchase agreement case When a company sells an inventory to another and a the same time agrees with the same to repurchase that inventory later, after a fixed period of time, the company is using the inventory as a collateral to borrow money from the other one. The company A has still control of the inventory, and should report it, even though incurs in a liability. 7.2.4 Rights of return In this situation, a company transfers an inventory to a selling agent, which has the right to return back the inventory that was not sold (usually this is the case of newspapers). The publisher A, should estimate the number of items that the seller will return, and recognize: 41 2021 I 2022 2023 , | | Sales revenue The company tries The company records to collect receivables bad debt expense Bad debt expense € 1000 2023 Account receivables € 1000 Figure 7.6: Direct write-off method's timeline 7.5.2 Allowance method The allowance method consists in making estimates to account for losses due to uncollectible receivables at the end of each accounting period. In this way the bad debt expenses and the sales revenues referring to the same operations are reported in the same period (see figure 7.7. \ 2021 ; 2022 | 2023 I i di pu Sales revenue The company tries to collect receivables Estimates loss Bad debt expense € 1000 Dec 31, 2021 | Allowance for doubtful accounts € 1000 Figure 7.7: Allowance method's timeline Losses can be estimated as: * a percentage of sales: this means that the company forecasts an amount of uncollectibles measured out of revenues. Thus, if a company made € 100,000 of revenues, and estimates the uncollectibles at 1%, the estimated loss will be € 1,000. This method emphasizes the match between revenues and expenses. * a percentage of receivables: that is, the company measures uncollectibles out of the outstanding receivables for the year. So, if a company made € 100,000 of revenues, of which € 50,000 are account receivables, and estimates the uncollectibles at 1%, the 44 estimated loss will be © 500. This method, conversely, does not focus on the match between revenues and expenses, but on the amount of cash that the company will be able to get in the future. IFRS encourages the accounting of allowance as a percentage of receivables, since this method expresses the uncollectibles out of the receivables themselves, and so how much of the account receivables the company will be able to collect (the cash realizable value), and so this results in a more precise evaluation of the future cash flow. The word "allowance", however, indicates that the company has estimated the value of uncol- lectibles, otherwise, the word accounts receivable would have been used. If the customer that the company expected not to be able to pay (let's suppose for € 1,000), actually repays the company, which had previously written-off the account, there is the need of two adjusting entries: Adjustment of previously accounted allowance Date Description Debit Credit Dat Accounts receivables € 1,000 ate Allowance for doubiful accounts € 1,000 Adjustment for cash payment Date Description Debit Credit Cash € 1,000 Accounts receivables € 1,000 Date 45 8 Accounting for and presenting non-current assets - PPE Property, plant and equipment (PPE) are tangible non-current assets that take part in the production process for many operating cycles. 8.1 Measurement at recognition An item of PPE can be acquired: * through a separate purchase * as part of a basket purchase, so with a business combination (for example, if the company buys a building and the land underneath) * asa self-constructed asset (a construction company can build its own plant) * in an exchange (old computers can be exchanged with newer ones). At the time the company gets the full control over the asset (so at recognition7.2), the asset needs to be reported in the journal at its cost. 8.1.1 Separately purchased items The cost of separately purchased items comprises 1. its purchase price, including import duties and non-refundable purchase taxes, after deduct- ing trade discounts and rebates 2. any costs directly related to bringing the asset to the location and condition necessary for itto be capable of operating in the manner intended by management the costs that can be included are, for example: * costs of employee benefits arising directly from the construction or acquisition of the item of PPE; costs of site preparation; initial delivery and handling costs; installation and assembly costs; costs of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition (such as samples produced when testing equipment); professional fees. on the other hand are excluded costs as: * costs of opening a new facility; * costs of introducing a new product or service (including costs of advertising and promotional activities) 4 * Diminishing-charge methods or accelerated methods The depreciation method should reflect the pattern in which the asset's future economic benefits are expected to be consumed by the company. Activity-based method: the company calculates the depreciation based on the number of units of use or units of output produced. However, this computation is not always efficient, as ithas a massive cost constraint, and cannot be applied to all the PPE assets (for example buildings). Cost — Residual Value - Units this year Depreciation expense = - — P P Total estimated units (8.9) Straight-line method: the company accounts the depreciation of the asset each year as the depreciable amount out of its useful life. So the company assumes that each year the asset depreciates of the same amount. However, this method fails to recognize the different usage of an asset at the beginning and at the endoof its useful life. In fact, usually assets are employed more when they are new. Cost — Residual Value D iati = Era gli == epreciation expense Estimated life service (8.4) Diminishing-charge or accelerated methods: this method takes in account that an asset depreciates differently at the beginning and at the end of its useful life. The accelerated depreciation methods can be: * Sum-of-the-digits method: consists in depreciating the asset every year of a fraction of its depreciable amount, that has as denominator the sum of the years digits, and as numerator the number of years of useful life that has already passed. * Declining-balance or diminishing-charge method: consists in using a depreciation rate (in percentage) that is a multiple of the straight-line method’s rate. The rate has to be applied to the net book value, that is the cost less the accumulated depreciation Remaining Book Depreciation Life in Depreciation Depreciation Value, End Year Base Years Fraction Expense of Year 1 $450,000 5 5/15 $150,000 $350,000 2 450,000 4 4/15 120,000 230,000 3 450,000 3 3/15 90,000 140,000 4 450,000 2 2/15 60,000 80,000 5 450,000 ll 1/15 30,000 50,000° 15 15/15 $450,000 “Residual value. Figure 8.2: Sum-of-the-year's-digits method 49 Book Value Rate on Balance Book of Asset First Declining Depreciation Accumulated Value, End Year of Year Balance? Expense Depreciation of Year 1 $500,000 40% $200,000 ‘$200,000 $300,000 2 300,000 40% 120,000 320,000 180,000 3 180,000 40% 72,000 392,000 108,000 4 108,000 40% 43,200 435,200 64,800 5 64,800 40% 14,800° 450,000 50,000 “Based on twice the straight-line rate of 20% ($90,000/$450,000 — 20%; 20% x 2 = 40%). Limited to $14,800 because book value should not be less than residual value. Figure 8.3: Accelerated depreciation method 8.2.2 Effects of depreciation methods on the Financial Statements If the company chooses to report the depreciation expenses with a method or another, this could influence the values reported in the Financial Statements. In fact, since depreciation is an expense, the way it is calculated can influence net income, moreover, as depreciation is related to non- current assets, the method used can influence also the total asset value reported in the Balance Sheet. Depreciationi ‘expense Accelerated Aclivity-based method depreciation method Straightline method Time (years) 1 2 3 4 5 Figure 8.4: Depreciation method's comparison To sum up: For the first years of useful life Straight line | Accelerated depreciation Net income | Higher value Lower value Total asset | Higher value Lower value 50 For the last years of useful life Straight line | Accelerated depreciation Net income | Lower value Higher value Total asset | Lower value Higher value The amount of accumulated depreciation cannot exceed the depreciable amount. There- fore, the depreciation process stops when the accumulated depreciation is equal to the depreciable amount. Component depreciation : is a method used to compute the depreciation of assets that are composed of a number of components with a different useful life, that need to be depreciated separately. This method is used for assets like airplanes, where the engines depreciates at a different rate in comparison with wings, the aircraft or other components. The company computes the depreciation of all the components and then sums the depreciation of each component to obtain the depreciation expense of the entire asset. 8.3 Revaluation model Another way to present the property, plant and equipment items is by using the revaluation model. It's optional for companies, that however, if they choose to use it for one item, they need to use it for all the non-current assets of the same class (for example, if the company decide to use the revaluation model to account for a building, it needs to use it to report for every real estate), so whenever an item of PPE is revalued, every item in the same class shall be revalued. The item of PPE has to be presented at its revaluated amount, that is, its fair value at the moment of revaluation, that needs to be measured reliably, less any subsequent accumulated depreciation and less any accumulated impairment loss. So with revaluation model: REVALUED AMOUNT - ACCUMULATED DEPRECIATION - ACCUMULATED IMPAIRMENT LOSSES =CARRYING AMOUNT Revaluations shall be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the end of the reporting period. 8.3.1 Gain If an asset’s carrying amount is increased as a result of a revaluation (if, for example a parcel of land went from € 10,000 to € 100,000), the increase shall be recognised: * as an OCI in the Statement of Comprehensive Income and * accumulated in the equity section in the Statement of Financial Position under the entry fair value reserve 51 8.3.3 Loss If an asset's carrying amount is decreased as a result of a revaluation, but there is no pre-existing revaluation surplus, or its balance is zero (if, for example a company purchases a parcel of land for € 10,000 and the following year its fair value goes to € 6,000), the company has to report the loss: * in Profit or Loss, because IFRS follows the conservative approach, that results in consid- ering a loss more relevant for investors, and so needs to be reported under the operating expenses * no change in equity because there is no fair value reserve. In the journal, as a consequence there will be no revaluation surplus, but an impairment loss: To accouni for loss after revaluation Date Description Debit Credit Impairment loss € 4,000 D ate Land € 4,000 Figure 8.9: Impairment loss in the Statement of Comprehensive Income 8.3.4 Gain with pre-existing impairment loss If the fair value of an item of PPE, which had decreased with in an impairment loss in the previous year, increases the following one, resulting in a revaluation surplus (for example, the fair value of the parcel of land previously fallen to © 6,000 from € 10,000 increases again up to € 30,000), the company reports: * part of the surplus to reverse the previous year's impairment loss * the rest is an OCI (unrealized gain). The journal entry will be the same as for a normal gain: To account for gain after revaluation Date Description Debit Credit Land € 24,000 Date ; Revaluation surplus € 24,000 54 ul — ul | E Figure 8.10: Gain due to revaluation surplus in the Statement of Financial Position Figure 8.11: Gain with previous impairment loss in Profit or Loss and in the Statement of Compre- hensive Income Of the total € 24,000 of revaluation surplus, € 4000 will be recorded as reversal of impair- ment loss in Profit or Loss and € 20,000 will go as revaluation surplus in the Statement of Comprehensive Income. 8.3.5 Derecognition with revaluation model When the item is derecognized, the revaluation surplus included in equity for that item of PPE can be transferred directly to retained earnings, bypassing Profit or Loss. So if the company sells the parcel of land purchased at € 10,000 whose fair value increased of € 90,000 up to € 100,000, at the moment of derecognition reports: 55 To account for the sale of the land Date Description Debit Credit Cash € 100,000 Land € 100,000 Date . Fair value reserve € 90,000 Retained Earnings € 90,000 When the sale is performed the company has realized the gain, which was already accounted as an OCI under the Statement of Comprehensive Income and as fair value reserve in equity. So the company doesn't have to record a gain in the Statement of Comprehensive Income, but transfers the already recorded fair value reserve into retained earnings. REVALUATION RETAINED EARNINGS Figure 8.12: Realized gain 8.3.6 Impairmeni test - IAS 36 IAS 36 sets out the principles and methodologies for impairments of non-current assets. Impairment of an asset (or a cash generating unit - CGU - if assets are grouped) occurs when the carrying ‘amount of the asset (or CGU) is greater than its recoverable amount. Therefore, the impairment loss is the amount of which the carrying amount of the asset or the CGU exceeds the recoverable amount. The impairment test is required under IFRS for every single non-current asset or, if it is not possible to test them individually, for every CGU, that is, the smallest possible group of non-current assets that function together to generate cash. The recoverable amount is established as the higher of: * Fair value less cost of disposal: the amount of money that the company would receive by selling out the asset, namely, its fair value less all the costs related to the disposal of the asset; * Value-in-use: is the present value of the future cash inflow expected from the use of the asset or CGU in the production process. In other words is the estimated inflow that the company would get by the usage of the asset or CGU measured at the present conditions. The impairment test, so, consists in comparing the carrying amount (book value) and the 56 9 Financial Liabilities This section will focus on non-trading lial Ss, Which are non-derivative financial liabilities that are not classified as held-for-trading financial instruments. These are: 1. Notes payable 2. Accounts payable 3. Bonds payable 4. Loans payable These can be either current or non-current liabilities, depending on the deadlines for payments or the part of the loan or bond that is to be repaid after one year. A note or bond or loan should be initially measured at: FAIR VALUE — TRANSACTION COST. (9.1) For transaction cost we intend any fee, commission or other charge directly attributable to the issue of the liability that represent a cost for the company incurring it. So, for example: € 100,000 Fair value of the loan € 1,000 Transaction costs € 99,000 — Initial measurement of the liability The company will report in the journal: To account for new liability Date Description Debit Credit Date Cash € 99,000 Notes Payable € 99,000 This is consistent with the reality, because the amount that the company actually receives is € 99,000. However, at the end of the liability's life the company will have to return € 100,000 back, so the company will have to account for the difference of € 1,000. This is done with the subsequent measurement, which is performed when the company has to present the liability in the Financial Statements. The liability shall be presented at its amortised cost: AMORTISED COST = AMORTISED COST AT THE END OF PREVIOUS YEAR + EFFECTIVE INTEREST EXPENSE - INTEREST PAYMENTS DURING THE YEAR The amortised cost technique is basically a method for presenting the liability in the Financial Statements. The purpose of this technique is to account for the € 1,000 difference. Under IFRS that cost is seen as part of the interest expense. What the amortised cost method does is to spread the amount of transaction’s costs over the whole life of the liability. To do that, the interest expense must be computed using the effective interest method. This is the method in which the € 1,000 of liabilities are spread on the entire period of the liability. It requires the use of the effective interest rate. 59 The effective interest rate is the interest rate that makes equal all the cash outflows with all the cash inflows at the present time. In other words, is the rate that exactly discounts the estimated future payments for the liability to its amortised cost (see figure 9.1). Effective interest rate 37 € 99,000 € 2,210/year € 100,000 > Initial measurement 5 years Deadline Figure 9.1: Effective interest rate diagram Example: if a company has issued bonds for € 100,000, and faced a transaction cost of € 1,000, the initial measurement of the liability is € 99,000. Amortised cost | Effective Inter-| Interest Payment | Amortised cost at year's begin-| est Expense at year's end ning YEAR 0 € 99,000 YEAR 1 € 99,000 + € 2,188 - € 2,000 = € 99,188 YEAR 2 € 99,188 + 2,192 - € 2,000 = € 99,380 Notice that the amortised cost is increasing. So, during the first year the company pays € 2,000 of interests: Horizontal Model for the liability at year 1 c OA L OCI R -E (99,000) (99,000) (2,000) (188) (2188) 60 Statement of Fiancial Position at Dec 31, YEAR 1 Statement of Fiancial Position at Dec 31, YEARO ———__—_________________»-» Notes Payable 99,000 188 € 99,188 Statement of Fiancial Position Statement of Fiancial Position at Dec 31, YEAR at Dec 31, YEAR 6 “The company pays © company pays the loan with no extra interests Figure 9.2: Liability in the Financial Statements 61