Month: January 2020

Financial Accounting Financial statements

Accounting for Leases – IFRS 16

Post author By admin
Post date January 3, 2020

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Some of the key points IFRS 16 requires:

Application:

IFRS 16 “Leases” is effective from 1 January 2019 with earlier adoption permitted. The standard primarily provides accounting treatment on leases for lessees. The impact on lessors is almost nil.

Long term leases:

IFRS 16 classifies leases into two main types. First is the short term lease, these are the leases which are for a period of 1 year or less than that. The second type of leases is long term lease; these are the leases whose duration is more than 1 year. IFRS 16 is applicable on long term leases.

Right of Use assets:

A right of use asset is an asset which is been leased by a lessee on a long-term lease i.e., the lease period is of more than 1-year duration. The right of use means the lessee has effectively rights of use of assets almost similar to that of an owner.

Capitalization of right of use assets:

IFRS 16 requires lessee to recognize a right of use asset in its balance sheet, as non-current asset, for the long-term leases where certain conditions are met. The capitalization of right of use asset shall be done at the present value of lease payments to be made over the life of the lease.

Lease liability:

IFRS 16 requires recognition of lease liability as a corresponding credit entry to recognition of right of use assets. Thus, a lease liability will be booked at present value of lease payments over the life of the lease. The initial recording of asset and liability will be at the same value and the accounting entry for right of use of asset and lease liability will be as follows:

Debit: Right of use asset $5,000

Credit: Lease Liability $5,000

Depreciation of right of use assets:

Once a right of use asset has been capitalized, its useful life shall be assessed. This useful life will become the basis of calculation of depreciation on right of use asset. Thus, although these assets are not legally owned by the lessee, depreciation will be charged on right of use assets, recognized as per requirements of IFRS 16.

Rent Expense:

IFRS 16 does requires that rent expense shall not be reported or recognized in the profit and loss statement (or in the books of accounts). This is because, IFRS 16 is treating this item effectively as an owned asset (i.e., right of use asset). So, there cannot be a rent expense booked for the assets which has been classified as right of use assets. But depreciation on these assets will be booked and presented in P&L, as discussed above.

Unwinding of discount (or interest expense):

After the initial liability is recognized (as stated above) on the implementation of IFRS 16 (or on booking of a new right of use asset), we need to calculate and incorporate interest expense from time to time. This interest expense is for the time period for which the liability remains outstanding. Let’s say that if we recognized a liability of 1 January 2019, we need to book interest expense on this liability once we reach the month end closing on 31 January 2019. The accounting entry for the interest expense will be as follows:

Debit: Interest expense ($5,000 X 5% X 31/365) $ 21.23

Credit: Lease Liability $ 21.23

The above entry would keep increase the liability amount.

Payment of lease liability:

Once the lease liability is paid, the liability will be debited and the bank account will be credited. This is as per normal accounting practices.

Accounting for short term leases:

There will be no recognition of a right of use asset or a lease liability once a lessee enters into a leasing arrangement. Therefore, there is no depreciation charge and no interest charge as well.

Accounting for Lessor:

The lessor shall identify whether it is an operating lease or a finance lease and then will account for it accordingly. A finance lease is a lease which substantially transfers risks and rewards associated with the asset. All other leases are operating leases.

While accounting for a finance lease, lessor shall recognize a lease receivable amounting to net investment in the lease.

Key features of IFRS 16:

IFRS 16 does not provide options. It instructs to follow a single model. If the lease period is more than 1 year, the lessee MUST recognize right of use assets and corresponding long term lease liability. There is no option or choice available. This enhances consistency of financial statement presentation and enhances investors’ confidence on financial reporting.

Materiality, as a basic accounting feature, is still an important factor. If the lease amount is not material then lessee is not burdened with unnecessary recognition of right of use assets and lease liabilities.

Lessor’s are allowed to continue to adopt the same approach of operating lease or a finance lease as it was available under IAS 17 – Leases.

First time adoption of IFRS 16 allows the adoption to be prospective or retrospective. Propsective application is simplified method of IFRS 16 adoption, under which you don’t need to restate the figures of comparative period. In full adoption method, the figures of comparative period of 2018 have also to be complied as if IFRS 16 was in effect from 1 January 2018.

Assets shall be subsequently measured at cost model (or revaluation model if that asset comes under a class which is measured at revaluation model by lessee) or at fair value model if it is an investment property (if the policy of the lessee is to use fair value for investment properties).

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Financial Management

WORKING CAPITAL MANAGEMENT

Post author By admin
Post date January 3, 2020

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What is capital

Capital refers to total investment in a business. This capital has usually two components, one is the equity and second is the debt. The equity is owner’s own money invested in the business and debt is the amount of money borrowed by the business (in terms of long term debt or bank loans or bonds or debentures etc).

What is working capital

Now, it is important to understand that working capital is the money taken from the capital and then invested in certain items. Working capital is actually the allocation of the capital in specific assets.

So, the amount of the capital invested in inventories and receivables (netted off by the payables) is called working capital. It is referred to as working capital because this part of the capital would be continuously in the working (or rotating) cycle. The inventories will be sold to customers and customers will pay, this money will be used to pay to creditors and new inventories will be purchased. Thus a cycle of work will continue. The ‘work’ in this scenario refers to core functions of the business i.e., buying goods on credit from suppliers, holding the inventory till it is sold to the customers and then collecting the money from customers against sales. This is the core work of a business. Thus, an investment on this core cycle of the business is referred to as investment in working capital.

Definition of Working Capital

Working capital can be defined as: ‘Working capital is the money which a business has invested in its core operational activity mainly the inventory items which it sells, the receivables which it finances less the payables which are financing the company’.

Thus, by this definition, we understand that there are 3 core components of working capital. First is inventories, second is receivables and third is payables. Inventories and receivables add up to the investment in the working capital and the payables decrease the investment in the working capital. Thus, higher the payables amounts and days, the lower will be the working capital amount and days. Working capital is also referred to as Net Working Capital (NWC).

Formula for calculation of working capital

In order to calculate working capital amount of a business at any given time, we need to add receivables amount and inventory amounts subtracting creditor amount. This formula will give us the answer of working capital amount at any given date.

If we want to calculate average working capital of a business during a year then we need to take sum of average inventory and inventory receivables and subtracting average payables amount. This will provide us the answer of how much was the average working capital during the year for the business in amount.

Inventory + Receivables – Payables = Working Capital

The interesting thing about working capital formula is that it can be applied in two ways. One is that we can use all values in amounts and we’ll get the working capital answer in amounts ($ etc.). The other way is to use all values in number of days and then we will get the answer of working capital in number of days.

For example, if the inventory holding period is 15 days, receivables credit period is 30 days and payables credit period is 20 days, then the average working capital is 25 days.

Example of working capital cycle

Working capital cycle can be better understood in a business dealing in goods (as opposed to a business dealing in services). However, both types of business do have a working capital cycle and an amount invested in their working capital.

Let’s take example of a retail computer shop which purchases different laptops from wholesalers and then sale these units to individual customers. The Elegant Computers (Pvt.) Ltd, a fictitious name, purchases from laptops and then stores them in the shop for display to the customers. The money paid to purchase these inventories is investment on working capital.

Let’s say that at any one given date, the net position of the business is such that total inventories are $5,000, total receivables are $7,000 and total payables are $4,000. If we apply the formula of working capital calculation, adding receivables and inventory and subtracting payables, we’ll arrive at net investment figure of $1,200 for the business (i.e., $5,000 + $7,000 – $4,000).

Why we need to calculate Working Capital

Working capital management is a topic of ‘resource allocation’ or ‘budgeting’. Every company would need to understand its different classifications of expenditures. Studying each class of expenditures helps in correct analysis and allocation of resources. Some famous classifications of expenditures are capital expenditures (a.k.a CAPEX), operating expenditure (a.k.a OPEX) and working capital.

There are multiple reasons of calculating and analyzing working capital, as mentioned below:

Working capital investment requires financing and this financing comes at a cost. We need to analyze our working capital to assess if we are maintaining an optimal level of inventories and receivables.
Financing cost of working capital can be significant sometimes. We need to make decisions on how much credit period to be offered and what is the impact of this credit period on our financing cost and sales. We need to make right decision and therefore, we need to know our investment in working capital and the cost of this investment.
Analysis of working capital can provide key insights into a business. For example, if the inventory number of days is unusually longer than the industry average number of days, then this might suggest some red flats (e.g., that we have either some obsolete inventory or our sales performance is lower than average.
Management would be keen to negotiate best terms with suppliers and thus would need to understanding how much financing is coming from payables for working capital.
It is important for us to understand how much money we need to invest and for how many days. Because, that money (working capital) will be blocked for that period. Similarly, we need to know, how much money will be received and after how many days.

Calculation of Debtors Days, Creditors Days and Inventory Days

In order to calculate working capital in days, we need to add inventory days and receivables days and subtract payables days. The formulas for the inventory days, receivables days and payables days are given below.

In order to calculate average inventory, we can add opening and closing inventory in a year and then divide it by two. Alternatively, we can use closing inventory figure if average inventory figure is not available.

Receivables days can be calculated by dividing average receivables with annual sales. Average receivables are calculated by adding opening receivables figures and closing receivables figure and then dividing it by two.

Payables day can be calculated by dividing average payables in a year with cost of sales. Average payables are calculated by taking average of opening and closing payables for the year. If average payables figure is not available, then closing payables figure can be used in the formula of payables days.

Here we have used 365 days in the formula but in practice, some companies may use 360 days (keeping fix 30 days for 12 months).

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Financial Management

ROCE – Return on Capital Employed

Post author By admin
Post date January 3, 2020

[vc_row][vc_column][vc_column_text]ROCE is one of the tools in the tool box of a financial analyst. This is a useful ratio which would calculate the performance of a particular investment or can be applied on different investments. It can be used for one period as well as for multiple periods.

Return on Capital Employed (ROCE) = Profit Before Interest and Tax (PBIT)

Capital Employed

Capital employed means total assets minus current liabilities. From an investor’s perspective, a higher ratio is better. An investor can compare two ROCE on two investments and find out which one performed better.

The formula is quite simple and interesting, all you have to do is to divide the profit on your capital employed, phew, you’ll get your ROCE (Return on Capital Employed).

So, take a basic example first, let’s say that you commenced a trading business with your life-long saving of $50,000. This business earned you a PBIT (Profit before interest and tax) of $10,000. So, how was much was your return on capital employed.

ROCE = $10,000 / $50,000 * 100 = 20%

Thus, Return on Capital Employed is 20% for one year. Now, question is, if you run the same business for 5 years, and you earn $20,000 each year, how much will be your ROCE and how to calculate it.

If we need to calculate 5 year’s ROCE, then we need to calculate as follows:

Year	Return ($) in present value	ROCE (on investment of $50,00)
1	10,000	20%
2	12,000	24%
3	8,000	16%
4	15,000	30%
5	8,000	16%
Total	53,000	106%

In the above table, we can see that ROCE ratio has been calculated for each of the 5 years. However, if we want to calculate average Return on Capital Employed in the five years, we can take an average by dividing 106% by 5 resulting in answer of 21.2% average annual Return on Capital Employed (ROCE).

Key features of ROCE ratio:

The formula for ROCE is simple to understand and calculate. You don’t need to be a CFA charterholder in order to calculate ROCE. An investor can easily calculate this ratio.
ROCE is easy to understand and explain. An investor can himself identify a better investment by calculating ROCE of two investments. For example, if Return on Capital Employed of company A is 20% and the ROCE for company B is 15%, then the company A is a wise investment choice.
ROCE can be used across different sectors and industries and even across different geographies. This measure work in almost all organization types. You don’t need to make changes for making two investments comparable.
It is a good performance measurement tool and performance of different products, divisions, companies and countries can be calculated and compared easily. Therefore, the ROCE ratio is used for multiple purposes.
Minimum data input is required for calculation of Return on Capital Employed. The profit figure is mostly available from the annual report or published condensed financial statements of companies.

Draw backs of ROCE ratio:

ROCE does not itself take into account time value of money. However, an analyst needs to first calculate present value of the returns before using them in the formula of Return on Capital Employed. For this purpose, cash flows need to be discounted using Net Present Value (NPV) method.
ROCE would not indicate how long is the payback period of a particular investment. For that, payback period method will have to be used. Does not depict what is the payable period.
Accounting policies may be different for different companies and industries. This may lead to distorted comparison of ROCE. For example, a company may be using revaluation method for its fixed assets while another company may be using cost method. Different methodologies will result in different figures for profit and assets.
ROCE ratio does not take into account various non-cash factors like depreciation, provisions, amortization etc. More meaningful comparison may be made by calculating EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) ratio.

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Financial Accounting

Implementation of IFRS 17 – Insurance Contracts

Post author By admin
Post date January 3, 2020

[vc_row][vc_column][vc_column_text]IFRS 17 is a major transformation in the way insurance companies are currently accounting. This standard will bring many changes in the insurance industry. The items which are significantly going to be affected are the provisioning for the receivables, booking of earned premium, recognition of claims, estimating reserves, actuarial estimates, provisioning for IBNR, reinsurance claims and reinsurance premium.

Implementation of IFRS 17 cannot be done single handedly or by a single person. It would require a collaborative effort of experts of different disciplines. Management needs to understand and decide on strategic nature issues of the transformation process. Actuaries will provide guidance on changes to the reserving methodologies. I.T teams need to assess the capability of existing infrastructure and its compatibility with the requirement of IFRS 17. Finance needs to ensure correct transition at the time of system upgrade and ensure correct accounting rules application.

The implementation date is 1 January 2022 and it is two years away from now. Many organizations have not yet taken concrete steps in the implementation of IFRS 17. Some are in the process of negotiating with a implementation partner while others are still having intermittent internal discussion. Some of the organizations are quite fast and they have already signed agreements and things are set in place to start working on the designing and implementation of IFRS 17.

Regulators of insurance sector, all around the world, are also taking special interest in the implementation journey of IFRS 17. Since, the new standard is going to significantly impact the insurance industry and regulators have to ensure that the interest of the policy holders are protected appropriately, they need to monitor the compliance with IFRS and its impact on financial stability and solvency of the insurance companies.

A change in the existing accounting systems is a must in order to meet with the requirements of new standard. There are several functionalities which are required but not available in the legacy systems of insurance companies. The changes to the systems, their testing and the final implementation is going to cost significantly in terms of money, time and effort.

All these challenges are bringing lots of opportunities as well, especially in the job market, many new positions are about to be created. Organizations would need project managers, implementation partners, consultants, IFRS experts, actuaries, database administrators, data anlysts, financial analysts and investment advisors. IFRS 17 implementation would require a handful expertise from different disciplines. This is the right time to acquire these skills and pitch for these positions in the insurance sector.

How will the shareholders of insurance companies be affected by the implementation of IFRS 17. This is a big question mark and there are different aspects which can lead to different directors. For example, the increased cost of the compliance would initially result in higher expenses and thus will decrease the profits. Increased requirements for solvency, strict criteria for booking provision and recognition of the provisions for receivables at the early stage of policy booking would all lead to lower net profits. However, on the other side, the new standard would enhance investors’ confidence on the financial reporting. It would also provide additional opportunities of financing and funding insurance companies and thus trading would boost.[/vc_column_text][/vc_column][/vc_row]

Financial Accounting Financial statements

Cash and trade discounts explained intelligently

Post author By admin
Post date January 3, 2020

[vc_row][vc_column][vc_column_text]A discount is kind of a concession or waiver from the original obligation.

For example, if a prisoner is jailed for four years but is released after four years, he has got a discount of one year. Now, this example is not in business context, but to explain the discount.

In a business context, if a company had to pay $100 to a supplier and the supplier offered to make payment of $95 only against full settlement, it means that the supplier has given a discount of $5.

Trade Discount (or bulk discount)

A trade discount is a discount which is given at the time of trading (i.e., the discount given at the time of making the deal).

For example, you get a quotation from a car dealer for annual maintenance contract of the car at a price of $500. Now, you want them to lower their price as if you feel that it is high. If they agree to bring it down to, say, $450, it means that you have been given a trade discount.

Normally trade discount is offered when a bulk purchase is made. For example, if standard price of a watch is $100 and you want to purchase ten such watches, you might be offered a bulk purchase discount of 10% on total price. In this case, you will have to pay only $900 (instead of $1,000) for ten watches.

Another reason of offering a trade discount is the long term relation between customer and supplier. If there is a longstanding customer, the supplier may be willing to sale products at a discounted price than standard rate.

Some suppliers who are relatively new in business would consider offering trade discounts to new customers as well in order to make long term relations with them.

Accounting entries for trade discounts:

The general ledger entries done by bookkeepers for trade discounts or bulk discounts is usually, not recorded in the books of accounts of the company. This is because sales value has to be booked as per the contractual terms agreed between customer and seller.

For example, if a company sells a trolley bag at a price of $45 whose standard price is $50, it means that the company has offered a trade discount of $5 to its customer. Now, the deal is done at $45 and therefore, applicable accounting standards would require sales amount to be booked at the value of the consideration agreed between parties. The accounting entry for this sale will be as follows:

Debit: Customer account $45

Credit: Sales Account $45

As you can see above, there is no space available for the discount to be recorded as account double entry is of equal amounts on debit and credit sides.

Needs for recording trade discounts:

However, from a management reporting point of view, financial analysts would want to know how much trade discount was offered to the customers during a particular month or a year. Similarly, to which customers trade discount was offered and by how much. From an internal and external audit point of view, auditors would want to check if the approvals for trade discounts were properly obtained. From an internal controls point of view, management would be keen to ensure that no unauthorized approvals are given for the trade discounts.

All of above requirements (management information system, audits, internal controls, performance measurement, sales performance etc.) require that trade discounts should be recorded and reported appropriately.

Recording trade discounts:

Although we cannot record trade discounts in our accounting books as this is prohibited by GAAP. But we can incorporate this in our management information system (MIS). A good MIS would have standard price of each product in the system. Any trade discount offered by sales team (after due approvals) would be entered in system and system would keep the record of trade discount offered. Later on, a report can be extracted from system for performing various types of analysis on discounts offered. However, this discount will not be reported in the company’s income statement.

Cash discount or Settlement Discount

Cash discount (or settlement discount) is an incentive offered to the customer for making early payment.

For example, if a customer has a credit period of 30 days for payment of $1,000, you can offer them an early settlement discount (or cash discount) of 2% if they make the payment within 10 days of the sale.

It is important to understand that cash discount does not necessarily require a ‘cash’ payment. The real objective of cash discount is to incentivize early settlement of the outstanding amount. Payment can be made using any mode like cash, cheque, bank transfer or credit card etc. As long as payment is made within the required time period, the customer will be eligible for the discount. Therefore, the cash discount may also be referred to as cheque discount, bank transfer discount, credit card discount, paypal discount etc. However, these terms are not common.

Accounting for Cash discount:

The cash discount shall be recorded in the books of accounts of the company as an expense. The cash discount will be booked as debit entry in the cash discount expense account and the respective credit will be provided to client’s account.

Cash discount is an expect for the company and thus will be classified in P&L as discount expense. In profit and loss account gross sales shall be reported as a top line. The discount given shall be then subtracted to arrive at net sales revenue figure.

Comprehensive example for cash discount:

Let’s say that Company A purchases 50 units of leather jackets at a credit period of 30 days, from an online retailer of leather jackets (i.e., www.smartleatherjackets.com). The standard price of these jackets is $100 per jacket. The supplier agrees to provide a 10% trade discount and additionally offers to provide 5% of settlement discount if payment is made within 5 days. Assuming that Company A makes payment within 5 days and avails cash discount. The accounting entries shall be recorded as follows in the books of supplier.

Deciding when to provide cash discount

When a company would want to offer cash discount is not an easy question. Financial analysts have to make carefully opportunity cost analysis to find out whether it is worthwhile offering cash discount or not. A cash discount offered will help in faster collection of receivables and thus interest cost of financing working capital (receivables) can be lowered. On the other hand, the amount of discount offered will be expense for the company. So, a cost benefit analysis has to be done. If the company is spending significantly on working capital investment and the early collection benefit is higher than the amount of discount offered, then offering discount is worthwhile. On the other hand, if the company is not incurring significant cost of financing working capital and there is no hurry to collect money from the customer, then offering discount will be expensive for the company. These decisions require significant study and analysis.

Practices of discounts in different industries

Retail or FMCG Sector

In retail sector, trade discount is most common. As an ordinary customer, if you enter a retail store, you might find some products on discount. Often in a sales promotion, you might get upto 50% off or 75% off etc. All this is practical example of trade discount.

There is no cash/settlement discount, usually, in retail sector for retail customers. However, corporate customers may still obtain a cash/settlement discount, in addition to trade discount.

Real estate sector

Cash discount/ settlement discount is quite common when it comes to buying a property. Many project plans offer 10% off or 5% off on full settlement of property price. This is a good practical example of cash/settlement discount in real estate sector.

Financial / banking sector

Often banks offer a settlement discount if you choose to close your mortgage by making a full payment of the total outstanding liability. This is an example of cash/settlement discount. However, this policy varies from place to place. Some banks charge a penalty for early settlement as well.

Electronics industry

If you are ordering bulk quantities of electronics equipement (say mobiles, headsets, chargers, powerbanks etc.) from China, you are likely to receive good trade discount. This means that you’ll get, say, 20% or 30% off on the standard product retail price. Trade discount is common across industries when it comes to buying in bulk quantities.

Conclusion

Understanding trade and cash discounts is relatively a simple topic. By now, you would be aware of nature of discounts, accounting entries and application of discounts in different industries. Providing discounts is an important economic phenome and it there are psychological implications of discounts as well. We will cover further details about discounts in more articles.[/vc_column_text][/vc_column][/vc_row]