This summary was written in the year 2013-2014.

1. Introduction to Financial Accounting

Definitions

Accounting has evolved over the years based on a response to different perceived needs in that field. In different countries and in different environments accounting has developed in different ways. Because of this there is not one single definition for the word accounting. Generally speaking, accounting exists to provide service for different types of people dealing with business entities, such as managers, investors, lenders, employees, suppliers, customers, governments, and the public.

There are key words for accounting which are:

• Process
• Information
• Economic nature
• Enable decision making

Managerial accounting (internal)

Managerial accounting targets at management within organizations, therefore no commercially confidential information needs to be kept secret. No external checking is needed for the reporting. Compared with financial reporting, it is more detailed, more frequent, and involving forecasting all the important figures for next year. It is concerned with the provision of information intended to be useful to management within the business

Financial accounting (external)

Accounting for users outside of the business itself (examples are listed in the definition, excluding managers). According to IASB, financial reporting is largely designed to provide investors with useful information, concentrating on immediate past. External checking is needed.

Users of financial statements:

• Investors
• Employees
• Suppliers
• Governments
• Public
• Customers
• Other lenders

Auditing

A control mechanism made to provide both external and independent checks on the published financial statements and reports of organizations.

• Finance: looks at the optimal means of raising money
• Financial management: the optimal means of spending it
• Financial accounting: reporting on the results of having used it

Bookkeeping

Records data and keeping records of money and financially related movements. It is financial and management accounting that takes the raw data, chooses and presents it as appropriate. Therefore, financial accounting acts as the communicating process to those outside the enterprise.

Regulation

Market forces, the 'state' and accountancy profession together determine accounting regulation. The accounting profession is organized in associations. The European Union requires two types of organization: qualifying bodies (exams & technical rules) and regulatory bodies which are under government control. The coordinating organization for the accountancy profession around the world is IFAC (International Federation of Accountants). The purpose of IFAC is “to develop and enhance a coordinated worldwide accountancy profession with harmonized standards”. IASB (International Accounting Standards Board) is independent and has total autonomy in the setting of international standards. The objectives of IASB are listed on page 8 and 9 of “Financial Accounting”. Please notice: the use of accounting terms differs considerably between UK, US and IASB practice.

2. Some Fundamentals

Economic income: The Company’s economic income over a given period of time is equal to the change in the real value of the company. The income is determined by accounting principles and accounting standards. Only when the accounting standards and accounting principles which were used are made known, can the figures be interpreted.

Economic income in a given period is the maximum amount that can be consumed in that period while keeping real wealth unchanged (Haig, Simons, Hicks)

Definition economic income for firms:

A firm’s economic income over a given period of time is equal to the change in the real value of the firm.

Accounting income of the firm is determined on the basis of a set of rules:

• Accounting concepts
• Accounting standards

There are two important observations about the accounting income:

• Different accounting concepts and accounting standards lead to different income figures.
• Reported income figures do not mean anything if you do not know on which accounting concepts and standards they are based.

Balance sheet: is a document of affair statement of an entity at specific date.

A balance sheet consists of two lists:

1. The first list is a list of assets, showing how those sources have been spent at this point in time.

Assets: are resources controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Examples are; cash, accounts receivable, inventory, securities, office equipment, a car, real estate, and other property.

2. The second list states where the assets are from – the monetary amounts of the sources from which the enterprise obtained its present stock of resources

Claims from third parties (outsiders other than the owner) are called liabilities (debt holders). According to the IASB a liability is defined as: a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

Recognition criteria of assets and liabilities:

Assets

When it is probable that future economic benefit will flow to the entity (probability), and when cost or value of the asset can be reliably measured (reliability)

Liability

When it is probable that there will be an outflow of resources to settle a present obligation (probability) and when the outflow can be reliably measured (reliability)

Claims by the owners are not called liabilities but are called owners equity instead. Equity in accounting is also known as the owners’ stake in the enterprise and is the residual interest in the assets of the entity after deducting liabilities

The financial statements may differ according to their content:

• Director’s report
• Statement of financial position (Balance sheet)
• Statement of comprehensive income (Income statement)
• Statement of cash flows
• Statement of changes in equity
• Notes to the financial statements

The capital comes from:

• Equity - firm owners, shareholders
• Liabilities – debtholders

The capital is spent by assets

Income

Increases in economic benefits during the period as there are direct inflows. It is characterized by enhancement of assets and decreases in liabilities

Expense

Decreases in economic benefits during the period as there are direct outflows as well. It is characterized by depletions of assets and incurrence of liabilities.

Example of a Balance Sheet:

The Balance Sheet

Accounting equation: Equity(t) = Total Assets (t) – Total liabilities (t)

Income statement: (also called profit and loss account) shows the flow of revenues and expenses of a period (where as the balance sheet showed the position of the firm at a given date).

Accounting income over a given period of time is equal to the change in equity net of any capital contributions / distributions by/to shareholders.

Accounting equation 2: Income (t) = Equity (t) – Equity (t-1) – Net capital contributions (t)/Distributions

The income statement is therefore built up of Expenses on one side (debit) and Revenues on the other side (credit)

The two approaches of accounting standards are therefore the income statement approach and the Balance sheet approach.

3. Frameworks and Concepts

The potential users of financial statements including: managers, owners, potential investors, lenders (i.e. banks), suppliers, customers, tax authorities, employees, governments and competitors.

The purpose of the Framework is to:

• Ensure the consistency of IFRSs
• Assist the IASB in the development of future IFRSs and in its review of existing standards
• Assist national standard setting bodies in developing national standards
• Assist preparers and users in preparing and interpreting IFRS financial statements and with issues not covered by standards

This book is especially concerned with financial reporting published by commercial entities for users who are external to the entity, based on a published conceptual framework:
The main targets are investors. The main objective is to make economic decisions.
Prediction on entity’s future cash flows is needed. Financial report should be understandable, relevant, reliable and comparable for the mentioned purpose.

Business entity has an identity and existence that is separated from its owners. The Accounting period should also be taken into consideration. Profit takes place over a period of time and we therefore cannot speak of profits until the period of time can be established. The maximum length usually used is one year. It is become more common that businesses report on a half year or a quarterly basis externally. The internal report is usually provided on a monthly basis.

The overall objective is to give a fair presentation of the state of affairs and performance of a firm. This then allows the users to make good decisions.

Accruals: transactions should be recognized when they occur, and not when the receipt or payment of cash has occurred.

Therefore, cash receipt of last year may be revenues of this year. In a reverse situation, cash receipts related to this year but only received the following year may result a deduction of receipts due from the revenue of the following year.

The relation between revenues and expenses is called Matching.

Valuation Methods includes valuation by assets. The historical cost and the current value are then taken into consideration. By the current value “fair value”, “replacement cost”, “net realized value” and “ economic value” should be taken into consideration.

Measurement of elements of financial statements

Measurement bases:

• Historical cost

• Current cost

• Realizable (settlement) value

• Present value

• Fair value

There is a trade-off between relevance and reliability:

4. The Regulation of Accounting

In this section we will pay special attention to how accounting can be regulated. There is no regulation which is deemed appropriate for management accounting. Each firm chooses what is most appropriate for them. The taxable profits have to be strictly regulated however. In most countries it is not necessary to regulate bookkeeping. In just a few countries however, bookkeeping is regulated in detail (e.g: France and Belgium) There are a number of ways in which financial accounting could be regulated:

• Legislation

• Rules used by departments of governments

• Rules from governmental regulators of stock exchanges

• Accounting guidelines or standards issued by committees of the accountancy profession

• Accounting guidelines or standards issued by independent private-sector bodies

International Financial Reporting Standards (IFRSs) include:

• IFRSs issued by the International Accounting Standards Board (IASB)
• IASs issued by the International Accounting Standards Committee (IASC) or revisions thereof issued by the IASB
• Interpretations issued by the Standards Interpretation Committee (SIC) or International Financial Reporting Interpretations Committee (IFRIC)
• Bold- and plain-type paragraphs have equal authority
• IFRSs are for general purpose financial reporting by profit-oriented entities

Depending on the form of an enterprise there may be certain types of regulations required. In the table below an overview is provided of the various forms an enterprise may choose to take.

Two main legal systems have been widely used in the developed world: Roman codified law and common law:

In Roman law countries, such as France, Belgium, Spain, Portugal and Greece, accounting tends to be under control by governments and lawyers through “accounting plans”.

In common law countries, such as Italy, Germany, accounting rules can be changed more easily and often by accountants in order to be commercially useful.

Apart from those codified systems, many other countries use the English legal system based on a limited amount of statute law.

Objective of financial statements:

• Provide information about the financial position, performance, and changes in the financial position of an entity

• Useful to a wide range of users in making economic decisions

The sole trader has full liability for the debts of the business, Personal income tax has to be paid based on the profits. As the business grows larger, a partnership can be set up and formalised by a contract between partners with specific rights and duties. Furthermore, the owners are separated from their business completely by setting up a company. Private companies are not allowed to create a public market in its shares, while public companies can trade their shares on markets.

5. International Differences and Harmonization

Contributions by Countries

Here you will find a brief overview of how certain countries has had an influence in the creation of financial accounting as we now know it. In history it can be found that the Romans had developed a sophisticated form of single entry accounting. The double entry system emerged in late medieval when the complexity of business had increased in northern Italy.

Later on, when wealthy merchants were in need of large investments for major projects it became necessary to have public listings in seventeenth-century Holland. In nineteenth century Britain in became more and more common to have management and ownership separate in business and this led to the development of the audit system.

Some other countries which also contributed to the development of accounting as we now know it were France, Scotland and Germany. The latter provided standardized formats for financial statements. France played a major role in the legal control over accounting and in Scotland the accountancy profession was born. The countries that were leading in commercial success in their time have subsequently been contributors and innovators in the accounting profession. Some countries can be placed into groups based on similarities in accounting.

Classifications

In the past various types of classification were criticized for having a lack of precision in the definition of what was to be classified, for the lack of having a model to compare results, for having a lack of a hierarchical system and also for a lack of judgement of what was to be determined as being important or not. This led to the Nobes’ classification which is possible to be criticized for:

• Lack of precision in the definition of what is to be classified

• Lack of model with which to compare the statistical results

• Lack of hierarchy what would add more subtlety to the portrayal of the size of differences between countries

• Lack of judgement

Measurement and valuation determines the size of the profit figures, capital, assets and so on. This was necessary to international companies when it became necessary to report to their shareholders, creditors, tax agencies and management. Two types of financial reporting existed in Europe during the 1980’s: micro/professional and the macro/uniform.

Micro/professional

Accountants in individual companies work no presenting fair information without constraints of detailed law or tax rules but with the standards created by accountants. Typical countries in such category are Netherlands, UK and US as the Netherlands has fewer rules than the other countries.

The micro division is further split into two categories: Business economics/ Social Census/ Extreme Judgemental (the Netherlands only) and Business practice/ Private sector rules/ British origin (the rest)

Macro/uniform

Accounting mainly exists as a servant of the state for taxation purposes. Most European countries and Japan fall into this category. The subgroups are Code-based (Italy), Plan-based (France, Belgium and Spain), Statue-based (Germany and Japan) and Economic control (Sweden).

Updated Classifications

After the fall of communism the classification had to be updated. Countries such as Russia and China were also added to the group which would report their financial activities. This was the 1983 classification. In 1998 Nobes published a revised classification which solved some of the complex issues in accounting that had developed over the years. It was built up of two main classes (class A and class B). Class A was also called “Strong equity” and class B “Weak equity). These categories were further split into families and systems.

Efforts to establish unity in accounting standards between the EU has been moving forward but at a low pace. This is a result of the time and difficulty it takes to reach common ground on the Relevant EU Directives. The fourth Directive involves formats and rules of accounting. The seventh, for example, was adopted in 1983 and focuses on consolidating accounting. The efforts to harmonize have lead to many options and blank spaces in the Directives. The EU currently endorses the idea of the use of international standards.

Legal systems

It was suggested that many countries in the world ca be put into one of two categories with respect to their main legal system: common law or Roman law

Taxation

The degree to which taxation regulations determine accounting measurements is important. In Germany the tax accountants should be the same as the commercial accounts. In contrast, the UK, USA and the Netherlands there are many differences between tax numbers and financial reporting numbers.

International Influences

• Several African countries that are members of the British Commonwealth have accounting systems based on those of the British Companies Act of 1929 or 1948

• The French plan comptable general was introduced in France in the 1940s based closely on a German precedent

• The Japanese accounting system consists largely of a commercial code borrowed from Germany

6. The contents of financial statements (newly added chapter)

Basic Financial statements:

• Balance Sheet

• Income Statements

Balance Sheet – require analysis by liquidity, distinguishing current and non-current (fixed) assets, current and long-term liabilities and owner’s equity.

For Europe, the balance sheet is required to present current and non-current assets and current and non-current liabilities as separate classifications on the face of the balance sheet. It is a general practice in Europe that the assets end with cash but in North America, Japan and Australia they start with cash.

According to IAS 1, an asset is classified as current when it:

• Is expected to be realized in, or held for sale or consumption in

• Is held primarily for trading purposes

• Is expected to be realized within twelve months of the balance sheet date or

• Is cash or a cash equivalent that is not restricted in its use

According to IAS 1, a liability is classified as a current when it:

• Is expected to be settles in the normal course of the entity’s operating cycle or

• Is due to be settled within twelve months of the balance sheet date

According to IAS 1, a number of items, if material, should be shown as separate totals on the face of the balance sheet:

• Property, plant and equipment

• Investment property

• Intangible assets

• Financial assets

• Investment accounted for using the equity method

• Inventories and more

Objective of financial statements:

• Provide information about the financial position, performance, and changes in the financial position of an entity

• Useful to a wide range of users in making economic decisions

Income Statement – can be horizontal or vertical in format and it is analyzed by function or by nature of expense.

According to IAS 1, the income statement should include line items presenting these amounts:

• Revenues

• Finance costs

• Share of after-tax profits and loses of associates and joint ventures

• Pre-tax gain or loss on disposal of assets/liabilities

• Tax expense, profit or loss, minority interest and net profit or loss

Notes to the financial statements – present information about the basis of preparation of the financial statements and the specific accounting policies, provide additional information and disclose information that is not included elsewhere.

The notes need to be presented systematically, with each item on the face of the balance sheet.

General Disclosure requirements:

Segment reporting – understanding the past and potential performance of a company requires understanding of the separate component parts

The primary segment reporting format includes:

• Segment revenue

• Segment result

• Segment assets and segment liabilities

Discounting operation – a relatively large component that is either being disposed

completely or substantially, or is being abandoned.

Qualitative characteristics of financial statement that lead to fair presentation: materiality, faithful representation, substance over form, neutrality, prudence, completeness, consistency

Constraints on relevant and reliable information:

• Timeliness

• Balance between benefit and cost

• Balance between qualitative characteristics

8. Recognition and measurement of the elements of financial statements

Applications of resources are all recorded as ‘debits’ in the double-entry system.

Examples of these applications are:

• Repairs

• Improvements

• Replacements of parts

• Extensions

• Decorating or re-decorating

These costs do not generate assets and are recorded as expenses, such as repairs.

Costs:

• Assets

• Expenses

Hierarchy of decisions

International Accounting Standards Board (IASB):

1.Does a transaction give rise to an asset or liability?

2. If yes, should the asset or liability be recognized on the balance sheet?

• Recognition criteria

3 .If yes, how should the value of the asset or liability be measured?

The first stage is about asking “Is there an asset/liability? However, not all assets and liabilities should be recognized.

The second stage: recognition is to ask whether an asset/liability should be recognized in the balance sheet, given asset recognition criteria that future economics benefit is highly probable as well as cost or value of the item can be reliably measured.

Measurement

After it has been decided that an asset or liability should be recognized, it is necessary to measure its value before it can be put into a balance sheet and the initial recognition usually takes place at the cost. The cost of an asset should include not only the invoice price of the asset but both the purchase cost and all the other cost relating to get the asset into the right location and condition where it can be productive.

Accured expenses - arise when an expense is recognized on the income statement before the corresponding cash payment occurs

•Accrued expenses => “accounts payable”

•Interest payable

•Wages payable

•Warranty provisions

Deferred expenses - arise when a cash payment occurs before the corresponding expense is recognized in the income statement

•Investment in property, plant and equipment

•Purchase of raw materials

•Direct manufacturing costs

Accrued revenues - arise when revenue is recognized on the income statement before the corresponding cash receipt occurs

• Accrued revenues => “accounts receivable”

• Interest receivable

• Rent receivable

Valuation methods

There are two main valuation methods. One is regarding the present value of the whole business, and the second is done through valuation by assets.

Valuation by assets consist of two methods. The first method is concerned with the historical cost of the asset. The second method is regarding the current value of the asset.

Regarding the current value of the assets the following bases could be used;

• Replacement cost, this is the amount it would cost to replace an asset at current prices.

• Fair value, this is the amount at which an asset could be exchanged, or a liability settled. This asset valuation assumes that the business is neither buying or selling.

• Net realizable value, this is defined as the expected sales receipts minus any costs to finish and to sell.

• Economic value (value in use), this is value of an asset deriving from its ability to generate income.

Income recognition

Income should be recognized in the income statement when it is realized. The sale of goods is recognized when control and risks have passed to the customer. Service provided is recognized when both the revenue and the stage of completion can be measured reliably.

9. The Intangible and tangible fixed assets

Asset - a resource controlled by an entity as a result of a past event and from which future economic benefits are expected to flow to the entity

Fixed asset

One that is expected to be used continuously in the business

Intangible asset: is something of value that cannot be physically touched. Examples of intangible assets; goodwill, brand, payments on account, costs of research and development, patent.

Tangible assets, are assets that have a physical existence. Examples are; cash, equipment, real estate, plant and machinery.

Tangible items or Property, plant and equipment (PPE):

• Held for production or supply of goods or services, or rental toothers, or for administrative purposes
• Expected to be used during more than one period

PPE is recognised as an asset when:

• Future economic benefits are probable
• Cost can be measured reliably

Criteria apply to all costs when incurred, including:

• Initial acquisition or construction costs
• Subsequent costs (covered later)
• PPE is measured initially at cost

Goodwill

The balance of the purchase cost in excess of the identified net assets which is assumed to be an asset.

Finance leases, are leases recognized as assets and liabilities of the lessee. The lease payments to the lessor are treated as partly a reduction in lease liability and partly a finance expense.

Operational leases, are leases that are not capitalized but treated as rentals

There are two categories in which an asset may be used up or become less useful for a variety of predictable reasons;

1. Economic reasons, if the asset becomes obsolescence or the product that it makes.

2. Physical reason, wearing out or deterioration. An example would be; the exhaustion of a mine or the expiration of a lease.

Accountants allocate the cost to expense over the life of the asset and recognize that the asset losses value over time. The useful economic life takes into account the fact that a machine may be obsolete before it is worn out.

Important to note is that the useful life relates to the use of the asset in the enterprise, not its total life, which may be longer. This expense is labelled as depreciation. Which is a non-cash expense that reduces the value of an asset, as a result of the following; wear and tear, age, or obsolescence. Important to notice is that depreciation is a process of allocation, and not valuation.

Depreciation:

•Systematic allocation of cost to profit or loss over useful life

•Depreciable amount determined after deducting residual value

•Review at least at each balance sheet date:

• Residual value

• Useful life

• Depreciation method

Depreciation methods:

Straight-line method

•Depreciation expense is the same for each period during useful life

Reducing balance method

•Depreciation expense is decreasing during useful life

Usage method

•Depreciation expense depends on usage of fixed asset

The straight-line method depreciation

The straight-line method takes the useful economic life into account and the value of the asset when purchased. Each year a certain amount is allocated as an expense for the depreciation.

An example of the straight-line method depreciation:

A machine is bought for $100,000 and is estimated to last for ten years and to be worth nothing at the end of these ten years.

A simple calculation shows that $10,000 should be allocated as an expense each year for depreciation ($100,000 / 10 years = $10,000). If this machine is bought on the first of January 2007 then at the 31^st of December 2007 it would provide the following information:

1 January 2007 Purchase: Machine + 100,000

Cash - 100,000

31 December 2007 Depreciation Machine - 10,000

Profit - 10,000

The net book value (NBV), or also called the carrying value would be:

$100,000 - $10,000 = $90,000.

There are three main aspects where depreciation should not be used for;

1. Valuation, A clear example would be the lost of value when a car is being used for the first month. When a car is being used for the first month it loses its value rapidly, but does not generally means that the car becomes less useful to the business so rapidly.

2. Replacement, Depreciation does not provide funds for the replacement of the depreciating asset.

3. Tax purposes

Declining charge methods

Some assets have increasing repairs and maintenance. Therefore a reasonably constant total charge for an asset’s services has to be charged in the income statement. In order to do this, three methods are appropriate. The reducing balance method takes a constant percentage of the NBV as depreciation. In order to find this appropriate percentage the following formula is used to find the declining charges:

Another method for producing systematically declining charges for depreciation is conducted through the sum of digits method. For example, the useful life is 7 years, the sum digits is 7+6+5+4+3+2+1 = 28. The charge for year 1 will be 7/28

The third method is the double declining-balance method. In this method is the straight-line depreciation rate worked out and then doubled and used on a reducing basis.

Usage method

Another method of depreciation is based on usage. The depreciation charge is based on the amount of units produced.

Impairment assessment

• Assess at each balance sheet date indicators of impairment;

The revaluation method

In this method is the set of similar assets valuated at the beginning of the year, added to this are the assets purchased and a valuation of the set deducted at the end of the year. This provides a measure of the using-up of the type of asset, which is charged to the P&L (profit and loss) account under depreciation. In the balance sheet is the year-end valuation recorded as a fixed asset.

Out of all the different depreciation methods, declining charge, usage and straight-line, is the straight-line depreciation method most commonly used, particular for buildings.

It is in general difficult to estimate the life of an intangible asset, therefore is assumed that the estimation of life will not exceed 20 years. Buildings have an estimated 20-40 years, machinery and equipment 3-15 years, and land and water are not being depreciated.

When an asset is purchased part way through an accounting year, there are two main options for depreciation:

1. The appropriate proportion (by weeks, or month) of one year’s depreciation is charged in the years of disposal and acquisition

2. A whole year’s depreciation is charged for those assets that are on hand at the end of the year.

Recoverable amount

In case of any indication of impairment of an asset, the company need to compare the asset’s carrying value with what it is worth to the company. This recoverable amount, for a fixed asset, is the future benefits from using it.

The impairment is the difference between depreciated cost and the recoverable amount, and is charged against income.

Revaluation

Revaluation is allowed for various assets, this is because current valuation could provide more relevant information. The revaluation gains should not be recorded in the income statement, as this gain is not yet realized.

Gains on sale

The gain on sale treats the revealed amount of the asset as its new cost.

Gain on sale = proceeds of sale – NB.V

A mix of values

There is a mixture of valuation methods which end up in the same balance sheet for different assets:

• Cost

• Revaluation, substituted for cost

• Depreciated cost

• Depreciated revaluation

• Value in use

• Net selling price

10. Inventories

Inventory

Inventories are tangible in nature, current assets, and will become part of the product sold by the company. The valuation of inventory directly affects the income statement and the balance sheet. Inventory is split into three categories; raw materials, work-in-progress and finished goods.

Inventories are assets:

•Held for sale in the ordinary course of business,

•In the process of production for such sale, or

•In the form of materials and supplies to be consumed in the production process or in the rendering of services

The valuation of inventory is very important because it directly affects the profit figure at the end of an accounting period. Notice: The total profits of all accounting period are not affected by the valuation of inventory, as one years’ closing inventory is next years’ opening inventory. However, the profit of any individual year is affected therefore shows influence on the performance over years.

Counting inventory

There are two main methods to estimate the quantity of inventory on hand at a year end:

1. Periodic counts, the inventory is physically counted and all items are recorded that are present at the premises. Auditor’s assistance is usually needed.

2. Perpetual inventory, all the movements of items are kept in a record as they occur. This method more quickly and helps in signalling that a re-order of inventory is necessary.

Inventory is mostly commonly valued on an input basis of historical cost. The cost of inventories should include all costs of purchase, costs of conversion and other costs incurred, as transportation costs of the inventory. Direct cost can clearly defined, but overhead allocation involves assumptions and approximations. For financial reporting purpose, costs should include the correct proportion of production overheads, such as: direct/indirect manufacturing overheads. Other overheads should not be included, such as administrative overheads of the rest of the company, selling over heads.

It is rather difficult to determine the costs of particular sold or remaining units, when several identical items have been made or purchased at different times. This will result in different costs per unit.

Inventory flow

• Unit cost, the actual physical units that have moved in or out, are recorded by e.g. serial number. All the recorded costs of the units sold are added up which gives the cost of sales, and of those units left to give inventory.

• First in, first out, the units moving out are the ones that have been in stock the longest.

• Last in, first out, the units that came in most recently are moving out first.

• Weighted average, the average cost of purchases over an entire period at the different cost levels is used as an estimation to the true weighted average.

• Base inventory, a minimum level of inventory is determined by the management, what remains at is original cost, and the remainder of the inventory above the minimum level is treated, as inventory, by one of the above methods.

aluation of inventory using output values:

• Discounted money receipts are used when there is a definite amount and time of receipt. Except for contracts of supply this would seldom be the case

• Current selling prices are used if there is a definite price and no significant selling costs or delays (valuating the inventory of gold)

• Net realizable value is the estimated current selling price in the course of business, less costs of completion and less costs to be incurred in marketing (general administration or profit should not be deducted).

Sometimes a contract, e.g. construction contract, last for a long period of time. This could be longer than one accounting period. There are two alternative approaches to allocate the total profit over the various accounting periods during which the constructing takes place:

1. Completed contract method

2. The percentage of completion method

11. Financial assets, liabilities and equity

The following table provides a clear overview of the main headings in a balance sheet;

The IASB has two important standards on financial assets and liabilities: IAS 32 (on disclosure and presentation issues) and IAS 39 (on recognition and measurement).

Cash and receivables

Cash consist of currency and ‘coins’ on hand, this also includes bank balances, negotiable money orders and checks.

Receivables are amounts of money due from persons or entities other than financial institutions. The short-term receivables are valued at the expected receiving amounts, after making allowances for possible bad debts. This can be done by identifying debtors who are unlikely to pay due to bankruptcy or other reasons (specific allowance) or calculating percentage based on the past years’ experiences (general allowance).

Allowances against receivables

Allowances for doubtful receivables is provided at the maximum amount which could be charged to income under Japanese income tax regulations, as adjusted to correspond to receivables after eliminating intercompany balances.

Financial investments

The main financial investments that companies have are;

• Deposits with banks

• Holdings of the debt securities of other companies (debentures)

• Equity securities of other companies (shares)

Investments can be divided into fixed and current; but is based on the intention of directors, and which could be changed what makes it rather difficult to audit.

Liabilities

Liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits

Creditors

Amounts that the company owes to a creditor. This could be a bank loan or an unpaid invoices from suppliers.

Debenture loans

These are amounts due at a fixed date and a fixed value to creditors who have lent money to the company. This acknowledgement is written on paper and can be passed from one person to another. These debentures can be traded on a stock exchange.

Provisions

Provisions are liabilities of uncertain timing or amount. E.g. pensions, lawsuits, warranty policies. Estimations needs to be made by accountants and to revise them at each balance sheet date to receive more accurate information.

Liabilities - present obligations from a past

event expected to result in an outflow of

Accruals - liabilities to pay for goods or services received or supplied but not yet paid or invoiced

Contingent liability

A liability that is based on some future event. E.g. a parent company might agree to guarantee the debt of a subsidiary should the subsidiary fail to pay the debt. A contingent liability is a legal obligation, but will almost not be called upon.

Subscribed capital

Each company must have ordinary shares, which are the residual equity in the company after all other more specific claims have been considered. These shareholders receive dividends only if distributable profits are available in the company.

Share premium

This is the amount of money paid (or promised to be paid) by a shareholder for a share is credited to, only if the shareholder paid more than the cost of the share.

Revaluation reserve

These are additional claims caused when assets are revalued without the gain being taken to income.

Legal reserve

These are undistributable reserves that are required to be set up by particular laws within a country. A legal reserve is mainly used to protect the creditors.

Profit and loss reserve

This includes undistributed profits that are not shown under the other headings of equity.

12. Cash flow statements

A financial instrument is a contract that gives rise to:

• a financial asset of one entity

• a financial liability or equity instrument of another entity

Financial asset:

• Cash

• Equity instrument of another entity

• Contractual right to receive cash or another financial asset or to exchange financial assets or liabilities under potentially favourable conditions

• Certain contracts settled in the entity’s own equity

Financial liability:

• Contractual obligation to deliver cash or another financial asset or to exchange financial asset or liabilities under potentially unfavourable conditions

• Certain contracts settled in the entity’s own equity

Equity instrument:

• Contract evidencing a residual interest in the assets of an entity after deducting all of its Liabilities

Types of contracts:

• Interest rate swap

• Currency futures

• Commodity forward

• Credit swap

• Purchased or written stock option (call or put)

Cash flow statements

Cash flow statements focuses on cash movements over the reporting period and therefore assist in predicting possible or likely cash movements in the future. And is a measurement of a company’s financial health.

Cash flow statements distinguish cash flows under three different specifications:

1. Operating activities, Cash paid or received as a result of the business operations. These are all transactions and events that normally enter into the determination of operating income. It includes income from items as interest and dividends, cash receipts from providing services or selling goods, cash payments such as inventory, payroll, taxes, utilities, interest, and rent.

2. Investing activities, Cash paid or received as a result of the capital expenditures.

3. Financing activities, Cash paid or received as a result of equity, loans or dividends. These activities result into changes in the composition and size of the equity capital and borrowings of the company.

There are two methods that enterprises are allowed to use to analyze and report cash flows from operating activities:

1. Direct method, gross cash receipts and gross cash payments are disclosed

2. Indirect method, takes the reported net profit and removes non-cash items

Both methods produce the same results, but the indirect method is more commonly used as it shows the difference between net income and the net cash flow provided by operations.

Benefits of the cash flow information

A statement of cash flows, when used in conjunction with the rest of the

financial statements, provides information to:

• Evaluate changes in net assets and financial structure (including liquidity + solvency)
• Assess its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities
• Assess the ability of the entity to generate cash and cash equivalents
• Enables users to develop models to assess and compare the present value of the future cash flows of different entities
• Enhance the comparability of operating performance by different entities
• Historical cash flow information is often used to:
• Indicate the amount, timing and certainty of future cash flows
• Check the accuracy of past assessments of future cash flows
• Examine the relationship between profitability and net cash flow (and the impact of changing prices