Statement of changes in equity 2012

2011

Equity at the beginning of the year

400

600

Capital increase

200

0

Profit/loss for the year

500

(200)

1,100

400

Equity at the end of the year Table 1.2 Changes in equity

To sum up, the transformation process gives rise to reporting in the form of an income statement stating a period’s profit, calculated as revenues less costs. This process gives rise to a statement of financial position, also called the balance sheet, consisting of assets (the debit side) on the one hand and equity and liabilities (the credit side) on the other hand, as illustrated in Table 1.3. Balance sheet at 31 December 2012 Assets

Equity and liabilities

Equipment

2,100

Equity

1,100

Inventory

1,000

Liabilities

2,300 2,200

Total equity and liabilities

3,300

Cash Total assets

200 3,300

Table 1.3 Statement of financial position or balance sheet

Thus, from the large, multinational corporation down to the local hairdressing salon, every business transforms input to output of higher value, which will have an effect on a company’s financial position in the form of assets, liabilities and equity.

. the accounting equation The accounting equation (or balance sheet equation) offers a simple way to understand how the three amounts relate to each other. The accounting equation, basic accounting equation or balance sheet equation for any business is:

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Assets =

Liabilities +

Owner’s equity

1,200

1,200 (revenue)

1,200 (revenue)

-1,000

-1,000 (cost)

-1,000 (cost)

The asset “cash” is increased by 1,200, and the revenue increases the owner’s equity by 1,200. The asset “inventory” is decreased by 1,000 (the goods are no longer in stock) and the cost of goods sold decreases the owner’s equity. After the above transactions have been recorded, a balance sheet can be prepared to show the financial position of the company at the end of the period (31 December): Balance sheet at 31 December Assets Equipment Inventory

Equity and liabilities 3,000 0

Cash

5,200

Total assets

8,200

Equity

5,200

Liabilities

3,000

Total equity and liabilities

8,200

It should be clear that the net profit for the period increases the owner’s equity. However, the above example shows that the owner paid in 5,000 in order to start operations, which in some cases may be insufficient and in other cases may be too much. The capital requirement for a business start-up depends on the type of business that is being started. This will be elucidated in the next section.

. Business entities Business entities are organised to earn a profit, unlike the public sector and public entities. For this reason, public entities are not included in this sector or, for that matter, this book. Generally, throughout the world, a profit-oriented company will be one of three types, as shown in Figure 1.2.

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on account. At the end of the year, this amount is deducted from the capital account and is at the same time (hopefully) increased by the year’s profit. The tax authorities regard the profits made in a sole proprietorship business as the owner’s profits. These are therefore subject to income tax, payable by the owner. In other words, when the owner prepares his or her tax return for a given year, it will include the profit or loss of the business. There are some advantages to a sole proprietorship, the most important of which is that it is easy to start up and there are no capital requirements. In general, sole proprietorships are subject to few regulations, the owner has full control over the management of the business and it is easy to terminate the business. A sole proprietorship business is not a corporation and does not pay corporate taxes; instead, the owner includes business income on his or her personal income tax return. This may also be viewed as a disadvantage, however, depending on the tax system and the way individuals and corporations are taxed. Thus, the major disadvantage of the sole proprietorship is related to tax issues. The main problem lies in tax rates; if corporate tax rates are lower than personal tax rates, it is obviously a bad idea to carry on a business in the form of sole proprietorship when the business generates substantial profits that could be subject to lower taxes in a corporation, as is the case in most EU countries, Norway and the US (see Table 1.4).

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debt instrument that is not secured by physical assets or collateral, and is backed only by the general creditworthiness and reputation of the issuer (in this case, typically large and listed companies). Loan stock represents a company’s long-term loan, typically through the issue of securities such as debentures or corporate bonds at a fixed rate of interest, usually redeemable on a fixed date.

There are two main kinds of loan stock. The first is broadly termed as unsecured loan stock, which basically means that the company receiving the loan offers no collateral to guarantee that the loan will be paid. In other words, if the company defaults on the loan, the creditor has no right to the company’s property as repayment. This type of loan stock is therefore very much like the unsecured loans individuals can get, and hence has a higher, fixed interest rate than the second kind of loan stock, which is called convertible loan stock or convertible bonds. This offers the company a low, fixed interest rate. The creditor benefits by having the ability to convert the loan stock into actual shares in the company under specified conditions and with a pre-determined conversion rate. Nonetheless, debentures have a fixed rate of interest, and the holders are entitled to their interest before equity and preference shareholders receive their dividends, and the interest must be paid even if there is a loss.

Specific Danish issues On 29 May 2009 the new Danish Companies Act was passed as a result of the EU’s Second Company Directive. The Danish Companies Act came into force in phases, the first parts on 1 March 2010, and the second parts on 1 March 2011. For this reason, the public register of shareholders is not yet effective, and this is expected to come into effect at the end of 2013. A new feature of the Companies Act is that the requirements regarding share capital have been changed for private limited companies. Public limited companies (A/S) must have a minimum share capital corresponding to DKK 500,000, and private limited companies (ApS) must have a minimum share 50,000 capital corresponding to DKK 80,000.

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50,000 must An amount equal to 25% of the share capital, but not less than DKK 80,000, be paid up at all times. The company’s central governing body may call for the non-paid share capital with two weeks’ notice. The articles of association may provide a longer notice for the payment, but this must not exceed four weeks. In other words, a private limited company (ApS) has to pay in the minimum capital 50,000 at once; it is only the public limited company (A/S) that may be of DKK 80,000 established with a paid-in capital of DKK 125,000. However, the non-paid capital gives rise to certain accounting issues, as the non-paid capital must be recognised as a receivable (the gross method) and the non-paid capital must be shown at a special equity line or account termed “Reserve for non-paid capital”. Alternatively, the non-paid capital may be deducted from the equity in a distinct manner (the net method). The two methods are illustrated below by the use of the accounting equation. This is based on the formation of a public limited company (A/S) with minimum share capital of DKK 500,000 and only paying up 25%.

The gross method Assets =

Liabilities +

Owner’s equity

Receivables + 375,000

No effect

Share capital + 500,000

Cash + 125,000

No effect

Reserve for non-paid capital + 375,000

No effect

Retained earnings – 375,000

Total assets + 500,000

Total equity + 500,000

An amount equal to the non-paid capital must be transferred from the item “Retained earnings” to the item “Reserve for non-paid capital” even though the item “Retained earnings” becomes negative. The basic idea is to show the share capital at its nominal value regardless of how the payment is taking place, but also to prevent the company from paying out dividends until the company’s financial resources are equal to the share capital. The reserve for non-paid capital is an undistributable reserve, meaning it is not allowed to be the basis for the payment of dividends. In other words, dividends cannot be paid before the retained earnings figure is positive.

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Example Hans Hansen A/S started business operations on 1 January. Additional operating facts for the first quarter are as follows: 1.

Cash furniture sales totalled DKK 600,000 during the first quarter. In addition, the firm provided furniture to firms for which payments totalling DKK 300,000 will not be received until next quarter. 2. By 31 March, the firm had paid salaries and wages for the first quarter totalling DKK 120,000. In addition, DKK 30,000 in salaries and wages for work done during March remained unpaid as of 31 March. These will be paid on the first payday in April. 3. During the first quarter, the firm purchased furniture to the value of DKK 500,000, which has to be paid at next delivery. During the first quarter, Hans Hansen A/S paid the remaining DKK 300,000 in cash. 4. Miscellaneous cash expenditures totalling DKK 10,000 were made for heat, light and so on during the first three months. 5. At the beginning, the inventory amounted to DKK 900,000. 6. During the first quarter, the firm paid DKK 150,000 for rent. 7. At the end of the first three months, an inventory count showed that DKK 1,000,000 worth of furniture remained on hand. 8. Depreciation for the first quarter was DKK 25,000. 9. Interest costs for the first three months were 3% of DKK 1,000,000 (i.e. DKK 30,000). 10. Taxes for the first quarter were DKK 45,000. 37,500

First, the cost of goods sold must be calculated as shown in Table 2.3. DKK Beginning of goods for resale

900,000

+

Purchase of goods for resale

500,000

=

Costs of goods for resale available

1,400,000

–

Ending of goods for resale

1,000,000

=

Cost of goods sold

400,000

Table 2.3: Cost of goods sold

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Then the income statement is prepared as shown in Table 2.4. DKK Sales/net turnover

900,000

–

Cost of goods sold

400,000

–

Other external costs Miscellaneous expenditures Rent for 3 months

10,000 150,000

=

Gross profit

340,000

–

Cost of staff

150,000

=

Profit before depreciation

190,000

–

Depreciation

=

Profit from primary operations

–

Interest payable

=

Profit before tax and extraordinary items

–

Tax on ordinary income

45,000 37,500

=

Profit for the period

90,000 97,500

25,000 165,000 30,000 135,000

Table 2.4: Income statement

Income statement classified by function According to financial accounting, a manufacturing company can be divided into three functions: production, distribution (sales) and administration. Therefore, when they are shown on the income statement, costs should be allocated to production, distribution, administration and interest. The previous section used the income statement in report form classified by nature for trading companies. In this section, the income statement in report form classified by function will be used in connection with manufacturing companies. Bear in mind that any kind of company can use income statements classified either by nature or by function.

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1−

(

n

Salvage value −÷ cost

)

where “n” refers to the useful lifetime. The annual depreciation that will be charged to the income statement is thus: Depreciation = Rate of depreciation x net book value at the beginning of the year.

The method gives a decreasing annual charge for depreciation over the useful life of the asset. It is therefore most appropriate for fixed assets that deteriorate primarily as a result of usage that is greater in the earlier years of their life. However, usage in the sense that assets have been worn out has to be seen not only in physical terms but also, more and more frequently, as technical obsolescence. This is particularly the case for computerised plants and machinery, motor vehicles and so on. Some of the tangible assets of the company are outworn technologically before they become unfit for use economically. In these situations, the declining balance method contributes to a more true and fair view of the financial position. Likewise, the declining balance method is said to be a more realistic measure of the reduction in the market value of fixed assets, since this is likely to be greater in the earlier years of an asset’s lifetime than later years. However, it is extremely questionable, as the net book value of an asset is not at all intended to be a reflection of its market value. On the contrary, it is intended to reflect the company’s ability to generate future economic benefits. Profit and losses on disposal of fixed assets Almost without exception, disposal of a fixed asset during (or at the end of) its useful lifetime gives rise to a gain or a loss. If the proceeds are less than the net book value of the asset, this is referred to as a loss on sale. Where the proceeds are greater than the net book value of the asset, this is referred to as a profit on sale. This can be illustrated by the following example.

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Valued added tax (VAT)

6

In the examples shown so far, value added tax (VAT) has been ignored. VAT, or goods and services tax (GST), is a consumption tax (CT) levied on any value that is added to a product. The aim of a consumption tax such as VAT is to tax private individuals’ consumption of goods and services. Private consumption is everything that is not related to business or commercial activities. A consumption tax can be levied either directly on the individual consumer or indirectly. VAT is an indirect tax, meaning that it is not imposed on the person who has to pay the tax but is levied on the person who supplies the goods and services to the consumer. The tax is transferred to the final consumer through an increase in the price of the goods or services. In Denmark Scandinavia, VAT is generally applied at one rate, and with few exceptions is not split into two or more rates as in other countries (e.g. Germany, Norway, Sweden and the UK), where reduced rates apply to essential goods such as foodstuffs. The current (2011) indirect tax or standard VAT rates in some European countries and the US are shown in Table 6.1.

Va lu e d a d d e d ta x ( VAT )

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0410

Cash over and short

Equity

0430

Premises expense

13110

Company capital/Share capital

0440

Salary

13440

Reserves provided by the articles of association

0450

Office expense

13450

Other reserves

0460

Depreciation of buildings

13510

Retained earnings

0470

Depreciation of equipment

Liabilities

0490

Sundry cost

15100

Loan secured in property

0510

Costs of staff

15200

Bank overdraft (maximum)

0520

ATP pension

15300

Trade creditors

0590

Distribution/allocation of wages

15600

Corporation tax, payable

0610

Interest revenue

15710

Input VAT

15720

Output VAT

15730

VAT payable

15740

Payable A-taxes

15750

Payable ATP

15760

Other creditors

15770

Payable wages

15775

Dividends for the year

15800

Accruals and deferred income

0650 Interest expenses 0620 0710

250

Corporation tax on ordinary income

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