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.
F i n a n c i a l s tat e m e n t s
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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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