Financial Accounting Department of Accounting - Peder Fredslund Møller Issues for discussion / learning objectives Understanding of the difference between

Financial Accounting

Department of Accounting - Peder Fredslund Møller

Issues for discussion /learning objectives

• Understanding of the difference between cash flow basis of accounting and accrual basis of accounting.

• Understanding of why accrual basis of accounting usually gives a better picture of a company’s earnings capacity.

• Understanding of crucial criteria for income recognition and the related criteria for expense recognition.

• Understanding of the difference between the profit and loss account classified by expenditure and classified by function



The income statement

1. Reports operating performance for a period.2. Net income = Revenues - Expenses.3. Revenue = Turnover + other revenue 4. Turnover: The resources (gross) received by a comp. for it

goods or services to others (rise in economic advantages).5. Expenses: The resources (gross) , which are used to create

the revenue for the period (fall in economic advantages)6. A part of the annual accounts.

Copyright 2000 by Harcourt Inc. All rights reserved.



The accounting period• Almost always 12 months in preparation of annual

accounts cf. DCAA §15.• Other periods are used dependent on the purpose. For

instance semi-annual accounts, monthly accounts, and accounts for a specific activity.

• The Copenhagen Stock Exchange: Amplified recommendations of publication of interim accounts.




The realized result for a period

Two potential approaches:

(a) Accounts prepared on cash basis of accounting.(b) Accounts prepared on accrual basis of accounting

(a) Accounts prepared on cash basis of accounting– Benefits are recognized in the period when cash inflows occur.– “Costs” are reported in the period when cash outflow occur.




Allens´ Hardware StoreSet up (finished on 1/1):

20.000 Share capital

12.000 6 months’ loan (rate of interest 8% p.a.)

Operations in January:

4.000 Rent payment for January and February

2.400 Premium payment (for one year)

40.000 Purchase of goods (26.000 cash 14.000 on credit)

50.000 Sale of goods (34.000 cash, 16.000 on credit)

5.000 payroll costs and salary payments in January

At the end of December:

18.000 Inventory at cost price



Allens´ Hardware Store Accounts prepared on cash basis for

JanuaryPayments received total …………………………………..Payments made for:

Purchase of goods ……………… Salaries ………………………….

Rent ….……………Premium………………

Payments made total ..………………………….Net payments received ……………...…………………...



Statement of the result of the period

(a) Accounts prepared on cash basis of accounting.– Advantages:

• Easy to state• Shows objective cash flow

– Weaknesses:• Inadequately match of “revenues” and “expenses” with performance• Unnecessarily delays in the recognition of revenues• Provides opportunities to manipulate the measurement of operating

performance.




Statement of the result of the period (continued..)

(b) Accounts prepared on the accrual basis of accounting (value movements)– Revenue is recognized in the period in which

performance is accomplished.Expenses are costs matched to revenues on cause-

and-effect-relationship – cost are allocated to matched with the recognized revenues that the costs were incurred to attain.



Income from sales…………………………………..Costs for:

Cost of sales ………………………….. Salaries …………………………. ……

Rent for January….……………….……Premium for January ……………...……Interest costs for January………………..

Total costs..………………………….Net result ……………...…………………...

Allens´ Hardware Store Accounts prepared on accrual basis for

January



Statement of the result of the period (continued...)

(b) Accounts prepared on accrual basis of accounting.– Advantages:

• Closer relation between performance and result = better reflection of the companies long-term earnings capacity.

– Disadvantages:• Statements are slightly subjective (estimates are involved).• Some possibility of manipulation (choice of time of

recognition and allocation of costs etc.).



The Danish Company Accounts Act § 13, sub section. 1, no. 6

• transactions, events, and incidents must be recognized when they occur regardless of the time of payment

• I.e. APPLY ACCOUNTS BASED ON ACCRUAL BASIS OF ACCOUNTING



Accrual based accounts• When are revenues/expenses to be

recorded?• The amount of revenue/expense

recognition?



Turnover – revenue recognition?• The following criteria must be met in relation to operating

activity (contrary to a ”purely” financial activity)1. The critical event in order to obtain the turn over must have

occurred - the company has accomplished all - or virtually all – its performance.

2. The benefit that is supposed to be received in return will fairly certainly be obtained and it can be estimated/measured with a very high certainty (measurable)

It is important that both criteria are met.

The criterion in relation to “purely” financial activity:The market price has changed.




Critical event

• Typically a highly objective event is the threshold , which release the recognition of revenue from operating activity



Measurable

• Turnover is to be measured with high certainty.

• I.e. objectively, verifiably, and quantifiably.



Examples• Sale of subscription for a sum of DKK 3000 over

the next three years. • Production of 1000 cars, not sold.

Turnover is included in the accounts at the earliest time possible where both criteria are met.

In praxis typically ant the time of the sale (explored in detail in chapter 6).



Recognition of expenses- Matching

1. If use of assets can be related directly to turnover then use of that asset (= the cost) is included in the period, period where the turnover is included (e.g. use of goods on stock) = matching.

2. If a direct relation between use/value fall of the asset and the turn over does not exist then the cost is included over a period time where the company obtains the advantage of the reduction in the service potential of the asset (e.g. use of PCs in the accounting department or similar).




Relation between income statement and balance sheet

Assets = Liabilities + Contributedcapital +

Retained earnings

Beginningof period

+ Revenue - Expenses - Dividendsfor period

Assets = Liabilities + Contributedcapital + Retained

earnings

Assets = Liabilities +Shareholders’

equity

Assets = Liabilities + Contributedcapital +

Retained earnings

Beginningof period

+Net result of

the period - Dividendsfor period


Documents

Financial Accounting Department of Accounting - Peder Fredslund Møller Issues for discussion / learning objectives Understanding of the difference between