Types of expenditure
Reporting of financial information falls on business owners to comply with regulations. Each of business statements consists of expenditure in one form or another.
Expenditure can be divided into two parts:
* revenue expenditure, and
* capital expenditure.
Revenue expenditure relates to expenditure incurred in the manufacture of products, provision of services and general conduct of the company. It includes repairs and depreciation of current-assets. The full benefits of this expenditure os recovered within a normal accounting period as the sales must be recognised at the period that they are earned (accruals concept). Some expenditure is not written off in that period and it is called "deferred revenue expenditure".
Capital expenditure relates to costs of acquiring, improving or producing of non-current assets. It is normally much higher in value and follows relevant authorisations within a company. It is generally expected to generate future earnings for the company, protect profit or provide compliance. These items are held and carried forward to subsequent accounting periods until the benefits are derived from it.
The general rule is that if the expenditure is the result of (a) first time acquisition, delivery of non-current assets, or relates to (b) improving the asset from what it was first acquired, then it is a capital expenditure. If the expenditure is neither of those two then it is revenue expenditure.
The expenditures are very important because the prudent and matching concept require to match the income and costs to the period they relate. If for example the expected life of non-current asset is, for example, 5 years then the costs of that asset would be spread over five years to match the realisation of the income it generates. It has an impact on the taxes the company pays.
Quick overview of all financial statements
Balance sheet - the balance sheet summarises the financial position of a business at a moment in time. It is the consequence of everything that has happened up to that time it was prepared. It does not explain how the company goes to that position but shows the results of financial impacts to the balance sheet date.
It consists of relevant categories, i.e assets, liabilities, equity. Assets are debit balances and liabilities and equity are credit balances.
In the balance sheet the total assets equal the shareholders equity and total liabilities.
Income statement - summarises the total of all accounts and in shows the change in the wealth of the business over time. It is called the "book wealth" and it is the amount it is worh to the owners and other stakeholders. The change in wealth is accumulated within the equity section. The increase in equity is the profit and decrease is the loss. Net profit is derived from deducting the expenses incurred from revenues derived through the same period.
In the income statement the revenues and expenses are not necessarily accounted for when cash transfer occurs as cash is not always derived immediately.
The income statement does not take into account all events that impact business financial situation i.e loan or issue of new shares. Therefore profits is not the same as cash flow and the company might get into financial difficulties even if it earned profits.
Statement of cashflows - the balance sheet and income statement do not show some key changes in company's financial position, for example, how much capital expenditure the company has made and how it was funded, what was the extend of the borrowing and how much debt was repaired, how much company need to fund working capital or how much funding was generated by internal and trading activities and how much from external sources. The aim of the statement of cashflows is to summarise the cash inflows and outflows to calculate the net change in the cash position between two pauses ( period in which the income statement and balance sheet is generated).
Balance Sheet formats
IAS 1 - Presentation of financial statements, allows flexibility in the way balance sheet is presented. The Company Act 2006 does not specify the format of financial statements.
Assets and liabilities must be specified as current and non-current. It also requires minimum information that should be presented:
* property, plant and equipment;
* investment property;
* investments ( financial assets, for example shares and loans);
* inventories;
* trade receivables;
* other receivables;
* cash and cash equivalents;
* tade payables;
* other payables;
* provisions;
* tax liabilities;
* equity.
Other subclassifications may be included depending of standards requirements and such information may be included in the notes of the accounts.
What the balance sheet tell us?
The balance sheet should tell us about the company's financial structure and liquidity. It should tell us about the assets held by the company and the extend to which they might be used to meet current obligations.
We need to be careful when analysing the balance sheet as it is a historical document. The information in the balance sheets also do not tell us anything about the quality of the assets, their real worth and their value to the business.
The balance sheet structure
Assets are acquired by a company to generate future benefits and to acquire them they must first raise the money. In doing so the claims and obligations are created in the form of shareholders equity. Along with non-current assets and current liabilities the shareholders equity represent claims on the company to provide obligation to third parties, i.e owners of the business.
Liabilities represent the claims by other persons then the owners. i.e suppliers or banks.
Each balance sheet category may be classified as financial or operational. Equity, borrowings, leases are financial resources and non-current assets, inventories, trade and other receivables, non-current liabilities and current liabilities are operational resources.
Equity
Equity represents the total investments of the shareholders in the company, the total book wealth of the business. The cost of shareholders equity is related to dividends paid to shareholders. The level of those will depend on how the company performs during the period.
Share capital - the value of a share is the value of each share. The nominal value is the same, for example 25p, 50p, or £1. The share capital is the number of shares multiplied by the nominal value of the shares. Each share is the title to the ownership of the assets of the company.
Retained earnings - is the final element of the equity of the company. The profit or net income generated from operations belongs to shareholders of the company and distributes to the shareholders as dividends, the balance being held as retained earnings and reinvested in the business. The retained earnings of the company are increased by the annal net profit less then the dividends payable. They are part of the company wealth and therefore appear within the equity of the company.
Liabilities
Current liabilities
Current liabilities - items that are expected to become payable within one year from the balance sheet date, for example borrowings of leases, tax liabilities and provisions.
Borrowings and financial leases - for example, bank overdrafts, loans and leases that are payable within one year.
Trade and other payables - dividends and interests, trade payables are sometimes considered free of such costs. Trade payables, the accounts payable to suppliers net of any adjustments such as credit notes due are not a free source of finance. Other payables include employee and social costs within one year of the balance sheet date but for which no invoices have been yet processed through the accounts. Expenses should be recognised immediately they are known about. For example, telephone or electricity bills. On the other side, revenues and profits should not be recognised until they are learned.
Current tax liabilities - tax assessed on the current year profit is shown as liability for tax to be paid within one year following the balance sheet date.
Provisions - it is a current liability in the amount charged against profit to provide for an expected liability or loss even if the expected liability is uncertain.
Non-current liabilities
Non-current liabilities - items that are expected to become payable after one year from the balance sheet date i.e leases, trade and other payables, deferred tax liabilities and other provisions.
Borrowings and finance leases - items included within non-current liabilities are not payable within a year, but after that year. And the company may borrow money for a short period of time to which the company needs to pay interest regardless of whether they have made profit or not.
Trade and other payables - compromise accounts payable to suppliers of goods and services, for example a project taking place over an extended period of time with stage payments agreed.
Deferred tax liabilities - it is the difference between the tax payable on the profits and the actual amount of tax payable for the same accounting period.
Provisions - as non-current liability is the amount charged against profit to provide for expected liability or loss even if the amount is uncertain.
Assets
Assets are acquired by the business to generate future benefits. They also provide the benefits from transactions and must be able to be measured in monetary units and business must have the exclusive control over those assets.
The liabilities generally show where money came from and assets show where the money has been used.
Non-current assets
Non-current assets include land and buildings, equipment, machinery, furniture, fittings, computers, software, motor vehicles which company has purchased to meet its strategic objectives. Non-current assets have generally longer then a year life cycle and they are consumed on a day-to-day basis. the measure of this consumption is called depreciation. Non-current assets comprise:
* tangible non-current assets;
* intangible non-current assets;
* long-term investments.
Tangible non-current assets - long term assets that one can touch, for example, land, buildings, equipment, machinery, computers, fixtures. Their costs can depreciate over time.
Intangible non-current assets - long-term assets that one cannot touch, for example computer software, patents, trademarks and goodwill. The business will need to define whether the life on intangible asset is finite or infinite. If the life is finite, then the cost are amoritzed over the estimated economic life of the asset. Goodwill is assumed to have infinite life. Both finite and infinite assets should be subject to annual impairment results.
Investments - are long-term financial assets that include loans to another companies, investments in associate companies and non-associated companies.
Current assets
Current assets - next to long-term investments, company also invests additional funds in its operating circle. It involves management of current assets and current liabilities. The operating circle is the period of time from starting the operating circle and the collection of cash from the customers who have been supplied the finished product. Current assets comprise inventories, trade and other receivables, cash and cash equivalent.
Inventories - generally include raw materials, work in progress and finished goods. But also may include stationary, replacement parts, spare pats and cleaning materials if there is any significant value.
Trade and other receivables - include accounts receivable, net of the doubtful debt provision due from customers and other subsidiaries. They also include prepayments for services not yet used: rent, insurance, subscriptions, electricity charges in advance.
Cash and cash equivalent - include bank balances and deposits in addition to actual cash held in the form of notes and coins.
Other financial assets - current assets may also include short term financial assets such as foreign exchange contracts, currency swaps and other derivatives.
Valuation of assets
Valuation of assets would be choosing the most accurate method relating to non-current assets, inventories and receivables to give true and fair value. This relates to both current assets such as inventories and non-current assets such as buildings.
Difference in the evaluation method may have a significant impact on the results reported in the income statement. We may see it in non-current assets and depreciation, inventories evaluation and costs of sales, valuation of trade payables denominated by foreign currencies, provisions of doubtful debts. The rules for validation of assets are included in the accounting standards. The rules allow companies to prepare their financial statements based on historical cost convention and include some as current cost. If a reduction in value of any non-current assets is expected to be permanent then provision for this must be made.
Non-current assets with finite lives are subject to depreciation changes. There is an element of choice between different valuation methods that may be adopted by a business.
A valuation problem arises with regards to non-current assets because such assets have been consumed over time and will currently be worth less then at the time of acquisition.
Brad names - some companies provide brand names in their balance sheets as intangible assets thus inflating the total of their balance sheets as it is permitted under IAS38. Non-purchased brands, however are forbidden from being capitalised.
Goodwill - is the difference between a purchased price and the fair value of the asset acquired. It can only appear on the balance sheet if business has been acquired at value of cash or shares, so a company cannot capitalise internally generated goodwill. If the value of an asset acquired in greater then the purchase price then the gain is recognised immediately as a bargain purchase in the profit and loss statements. Goodwill is not amortised over its useful economic life but it is tested for impairment annually or more frequently, depending on circumstances. Impairment requires the goodwill to be evaluated to see if the value of the balance sheet is greater then the net income that could be derived from the goodwill either from use of the item or its sale.
Research and development costs - development costs do not include research costs. A development cost is defined as an intangible asset as it contributes to plan production of new improved materials, devices, products, processes, systems or services for future commercial benefits for either increased profits or reduced costs. Development costs are matched for future revenues. Once an intangible asset resulting from development has been recognised it is capitalised as an intangible asset in the balance sheet. The cost of the intangible asset is then charged in proportion to the revenues derived from this development activity period by period over the life of the project. Examples of development activities may include: design, construction and testing of prototype, design of equipment that uses new technology, a pilot project including design, construction and operation of new plant.
Research costs are defined as costs of original and planned investigation undertaken with the prospect of gaining new scientific and technical knowledge and understanding, such as: activities aimed at obtaining new knowledge, research for applications and other knowledge, research for alternatives for materials, devices, products, processes, systems or services.
The costs of research should be charged to the profit or loss as they are incurred.
Inventories - various issues can arise during validation of inventories. Firstly, homogenous items within various categories are purchased continuously and consumed continuously during the manufacturing process. They purchase price may vary, therefore the general rule is that the inventories must be valued at the lower of purchase cost and their net realisable value. Secondly, materials may be purchased from a variety of geographical locations and additional costs such as duties, freight and insurance may be incurred. The cost of inventories should comprise the expenditure that has been incurred in bringing the product or service to its present location and condition. Third, as materials, packaging and other consumable items are used during the production processes and companies must adopt relevant policies in respect to inventories and work in progress.
Trade receivables - these are paid to the company according to contractual terms of trading agreed at the outset of each customer. Trade receivables may need to be reduced by an assessment of individual accounts receivable that will definitely not be paid (bad debts) or individual accounts that are unlikely ever to be paid (doubtful debts). The trading terms may be for example 30 days.
Foreign currency transactions - one factor that may impact the evaluation of assets is foreign currency exchange rate risk. If a sales invoice is rendered in foreign currency it is required to be valued at an exchange rate on the date of the transaction. Exchange rate specified in the contract should be used. At the end of each accounting period, all receivables denominated in foreign currency should be translated, or revalued using the rate of exchange ruling at the period end-date or rates fixed under the terms of relevant transactions. A similar treatment should be applied to all monetary assets and liabilities denominated in foreign currencies i.e cash, bank loans and amount payable and receivable.
Bibliography:
Davies T., 2011, "Business Accounting and Finance", Harlow, Financial times Prentice Hall, Chapter 3 pp. 70-104
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