Download - 1 and 2 -Fundamentals of Accounting
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1Financial Accounting 2010 - Helena Isidro
Financial Accounting
An Introduction
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Topics covered by the course1 - The background of accounting
Background of financial reporting
Users of accounting information
International harmonization of financial reporting
2 - Fundamental accounting concepts and financial reports
Characteristics and components of financial information
The concept of profit and the income statement
The concepts of asset and liability and the balance sheet
Recording business transactions The double-entry bookkeeping
Cash versus accrual
Impairment and provisions
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Topics covered by the course
3 Current and non-current assets
The concept of inventory The perpetual and permanent system of recording inventory transactions Cost of sales under different cost flow assumptions
The concept of non-current asset Depreciation Disposal of non-current assets
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Assessement
Exam 80%
Class participation and exercise preparation 20%
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The power of accounting numbers
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Accounting and business
Business
Resources:Materials, labour, services
Cash out:Payment of resourcesacquired
Outputs:Products, services
Cash in:Receipt for goodsand services soldDecisions & Actions
Accounting:Help making decisions about business
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Accounting definitionsDefinition of accounting
Accounting is a decision-support tool for users:
Identifies, measures and communicates financial information about anentity to permit informed judgements and decisions by users of theinformation
Two types of accounting
Financial accounting: designated to users external to the entity Managerial accounting: designated to users internal to the entity
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Accounting regulationAccounting regulation (standards)
Set of rules defining how to measure and report information about theentity economic activity
GAAP Generally accepted accounting principle is a generic term thatrefers to the set of rules and standards issued by various regulatory
bodies which companies are expected to comply with
Why do we need accounting standards?
For efficient decision-making investors, creditors, auditors and users ingeneral must have reliable, transparent and comparable financialinformation
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Accounting regulationAccounting standards have two objectives:
Define how to record individual business transactions. What methods touse
Define how to summarise these transactions into a form understandable
and useful to users. This involves the definition of:
Types and formats for financial statements, namely for the balancesheet and profit and loss account (income statement)
Disclosure requirements of relevant information
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Accounting regulationWho sets the rules? Economic and business conditions evolved differently in different countries and
consequently accounting systems of rules have also evolved differently acrosscountries
Sources of accounting regulation:
Legislation such as Commercial Code, Tax Code, Companies Act Rules issued by departments of the government (e.g. Ministry of Finance) Rules from the stock exchange entity (e.g. CMVM) Accounting standards issued by the accountancy profession Accounting standards issued by private organisations acting for the public
bodies
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Accounting standard setting In most countries accounting regulation is set through: code/law and a
standard setting body
Examples of standard setting bodies:
Portugal: Comissao Normalizacao Contabilistica www.cnc.min-financas.pt The
U.S.: Financial Accounting Standards Board (FASB) www.fasb.orgInternational Accounting Standard Board (IASB) www.iasb.org
http://www.fasb.org/http://www.iasb.org/http://www.iasb.org/http://www.fasb.org/ -
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Accounting standards. Does it matter?
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Accounting standards. Does it matter?
In 2002, Is BCP profitable?
If an investor wants to compare ROE from BCP with other investments.How much is ROE?
The business is unique. Different rules result in different performances?
Negative market reaction in the US market to BCP earningsannouncement. The company decided to delist
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Accounting standards. Does it matter?Portugal's biggest bank to drop Wall Street listing
11 January 2003Agence France-Presse
Portugal's largest private bank, Banco Comercial Portugues (BCP), will delistfrom the New York Stock Exchange because differences between US and European
accounting rules require it to present different sets of financial results, BCP presidentJorge
Jardim Goncalves said in an interview published on Saturday."In some circumstances we had to present reports and numbers which, no matter how many explanations were offered, were disturbing
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Accounting harmonisation European (EC) Directives (4 th, 1978 and 7 th,1983)
European Commission gave support to the increasingly important IASBby requiring listed f irms to prepare consolidated financial statements inaccordance with IFRS, from 1 January 2005 onwards
Currently, there are two major international sets of rules: IFRS and US GAAP
- Likely to converge
- November 2007, SEC (Securities and Exchange Commission) announcedthe decision to eliminate the reconciliation requirement for IFRS companies(effective March 2008)
- IFRS is expected to be mandatory in the US in the near future (3-5 years)
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Objective of financial informationAccounting standards identify usefulness to users as the main
objective of financial reporting
Provide information about the financial position, performance and changesin the financial position of an enterprise that is useful to a wide range ofusers in making economic decisions
IASB, framework
Provide information that is useful to present and potential investors,
creditors and other users in making rational investment, credit and similardecisions
FASB, Statement of Financial Accounting Concepts No 1
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Characteristics of financial information
Understandability Relevance Reliability Comparability
Predictivevalue
Feed-backvalue
Materiality
Substance over form
Neutrality
Faithful representation
Prudence
Completeness
Consistency
Timeliness Balancebenefit/costConstrains on reliable and relevant
information
According to IASB framework, useful financial information has the following attributes:
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Components of financial reporting Narrative information (e.g. auditors report, directors report, governance
report)
Financial statements (IAS 1)
Balance Sheet Profit and Loss Account/Income Statement
Cash Flow Statement Notes Statement of Movements in Shareholders Funds
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Balance sheet A balance sheet is a summary of the financial position of the
business at a particular point in time
It is a list of the business resources (assets) and the financingof those resources (liabilities and equity)
Resources / Investments
Sources / Financing
Cash in bank100,000 Own money100,000
Example: open a bank account to start a mobile-phone business
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Balance sheet
Resources /
Investments
Sources /
financingCash in bank100,000
Own money100,000
Inventory20,000
Credit to invent supplier20,000
Buy inventory (mobile-phones) to the business on credit
AssetsEquity
Liabilities
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Balance sheet equation
Resources /
Investments
Sources /
financingCash in bank100,000
Own money100,000
Inventory20,000
Credit to invent supplier20,000
AssetsEquity
Liabilities
Investments Financing
Assets = Equity + Liabilities
100,000 + 20,000 = 100,000 + 20,000
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Balance sheet equation
Assets = Equity + Liabilities
The fundamental accounting equation is
Assets - Liabilities = Equity
Or
In other words, Equity (Shareholders funds) is a residual interest whichis a claim on all assets after meeting the business liabilities
Total investments are financed by own capital and borrowed capital
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Brisa
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Brisa
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Balance sheet elementsAssets
(a) Resources controlled by the business as a result of past events (b) fromwhich future economic benefits are expected to flow to the business (c) can bemeasure with reliability
Current versus non-current (fixed) assets
Are these assets?
Brisa has built highways that will revert to the State at the end of theconcession contract without any compensation (note 2.6)
Brisa is developing an environmental project with Companhia dasLezirias to create bird observation zone in Ponta da Erva/Salinas deSaragoca (Environmental report note 6)
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Balance sheet elementsLiabilities
(a) present obligation of the entity arising from past events, (b) the settlementof which is expected to result in an outflow of resources, (c) measured withreliability
Current versus non current liabilities
Is this a liability?
The group (Brisa) has assumed the commitment to provide its employees withretirement pensions supplement under a defined benefits plan, havingconstituted autonomous pension funds for the purpose (note 2.16)
Equity
Residual interest in the assets of the entity after deducting all its liabilities
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Profit concept
Assets Equity
Cash in bank 100,000 +35,000 Share capital 100,000Profit +15,000
115,000
Liabilities
Inventory 20,000 -20,000 Accounts payable 20,000135,000 135,000
Sell all inventory to clients by 35,000 cash
Profit (15,000) is the difference between revenues (35,000) and expenses
(20,000)
Profit is the income generated by the business activity and it is part of ownersfunds (equity)
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Income statement The income statement (or profit and loss account) is a
summary of the financial performance of the business overa particular period in time
I/S reports the detailed elements of profit: Revenues (gains)
Sales turnover, interest revenue, extraordinary gains Expenses (costs)
Cost of sales, personnel expenses, interest expense, extraordinarylosses, tax expense
Profit = Revenues - Expenses
Brisa
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The fundamental equation revisitedRecall the fundamental accounting equation:
Assets = Liabilities + Equity
Assets = Liabilities + [ Capital&OthEquity + Profit ]
Extending equity into components:
For each individual transaction this relation is also true
Assets = Liabilities + [ Capital&OthEquity + Revenues Expenses ]
Assets = Liabilities + [Capital&OthEquity + Revenues Expenses ]
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Recording transactionsPaul&Mary FineFood restaurant
Transaction 1:Paul and Mary deposit 1,000 in a bank account to start the business
Assets = Liabilities + Equity
+ 1000 (Bank) = + 1000 (Share capital)
Assets = Liabilities + Equity
+ 250 (Inventory)- 250 (Bank)
Transaction 2:Purchase of 250 cash of goods for stock
Corresponds to the exchange of one asset (cash in bank) by another (inventory)
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Recording transactions
Transaction 3:Purchase of restaurant equipment on credit for 300
Assets = Liabilities + Equity
+ 300 (Fixed assets) = + 300 (Accounts payable)
Assets = Liabilities + Equity
- 240 (Bank) = - 240 (Accounts payable)
Transaction 4:Payment of 80% of the equipment bill
Part of accounts payable (liabilities) disappear from the balance sheet
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Recording transactionsTransaction 5:
Sale of meals for 150 cash which cost 100 Assets = Liabilities + Equity
- 100 (Inventory)
+ 150 (Bank)
= + 50 (profit)
Assets = Liabilities + Equity
- 30 (Bank) = - 30 (profit)
Transaction 6:Weekly salaries of 30 are paid to Paul and Mary
In Income Statement:
Sales revenue 150Cost of sales (100)
Profit 50
In Income Statement:
Salaries expense (30)
Profit (30)
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ASSETS = LIABI-LITIES
EQUITY
Transactions FixedAssets
Stock Cash&Bank
AccountsPayable
ShareCapital
RetainedProfit
Profit(I/S)
Initial capital 1 +1000 +1000Purchase pizzas 2 +250 -250Purchase of equi 3 +300 +300Payment equip 4 -240 -240Sales pizzas 5 +150 +150Cost of sales 5 -100 -100
Salaries 6 -30 -30
Closing balances 300 150 630 60 1000
Recording transactions in a worksheet
Use profitcolumn toprepare theincomestatement
Use this column toprepare the cash flowstatement
Use closing balancerow to preparebalance sheet
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Profit retention Profit retention means that profit should be transferred from the
income statement to the balance sheet
Specifically, the profit is transferred from profit for the year , a I/Saccount, and stocked in retained profit , which as an account withinequity
Sometimes this is recorded at year (U.K, U.S.) sometimes in the
following year (European countries)
Equity
Retained profit
Profit for the year
+20
-20
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ASSETS = LIABI-LITIES +
EQUITY
Transactions FixedAssets Inventory
Cash&Bank
AccountsPayable
ShareCapital
RetainedProfit
Profit(I/S)
Initial capital 1 +1000 +1000Purchase pizzas 2 +250 -250Purchase of equi 3 +300 +300Payment equip 4 -240 -240Sales pizzas 5 +150 +150
Cost of sales 5 -100 -100Salaries 6 -30 -30
Transfer toRetained profit
+20 -20
Closing balances 300 150 630 60 1000 +20
Profit retention
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Accounting principlesIn order to achieve the financial reporting objectives of providing useful information
for economic decision, financial statements must be prepared in accordance withfundamental accounting principles (IASB framework)
Going Concern
Assumes that business will continue to operate for the foreseeable future
Accrual Basis
Revenues and expenses are recognised when earned/incurred, not when moneyis received/paid
In most cases this will be achieved through matching revenues withcorresponding expenses
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Accrual principle: Cash and ProfitWhy is Cash different from Profit ?
Accounting numbers focus on the concept of economic profit
Income statement provides information on generation and consumptionof economic resources rather than on cash generation and expenditure
Timing of receipt/payment of income/expense is irrelevant - whatmatters is when revenue (income) and expenses are recognised
In one reporting period:
PROFITS AND CASH ARE NOT THE SAME
Brisa (2007)Profit = 255 mCash = 103 m
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Cash and Accounting ProfitExample:
Period 1 purchase of merchandise worth 10,000 on cash
Period 2 sale of all merchandise on credit for 15,000
Period 3 receipt of 15,000 from client
f
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Cash and Accounting ProfitPeriod 1 Period 2 Period 3 End of businessPurchase
merchandise on cash
Salemerchandise
on credit
Receiptfromclient
Revenue 15,000 15,000
Expense 10,000 10,000
Profit - 5,000 - 5,000Cash inflow 15,000 15,000
Cash outflow 10,000 10,000
Net cash (10,000) - 15,000 5,000
P r of i t =
C a s h
A t en
d of
t h e b u s i n
e s s
In individual periods cash is not equal to profit
d (C i )
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Prudence (Conservatism) A degree of caution should be applied in exercising judgment and making the
necessary estimates
In particular, gains should be treated as realized only when realized in the form ofcash. Losses are recognized faster (in profit) than gains
Examples :Doubts about the capability of a client to pay
Reduce profit immediately as if the client would not pay
Stocks bought for 1,000 have now a market value of 1,500
Do not recognize the gain until stock is actually sold
D f l d l
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Deferrals and accrualsFour major transactions create differences between cash and profits:
1. Expenses paid but not consumed
Prepayment or deferred expense
2. Expenses consumed but not paid
Accrued expense3. Revenues/income received in cash but not earned
Unearned revenue/income or deferred revenue/income
4. Revenues/income earned but not received in cash
Accrued revenue/income
P (d f d )
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Prepayments (deferred expenses) Prepayment is generated when a cash payment is made (or any other
asset given up) for an expense, which relates to a future accountingperiod
Example :Suppose that on 1 September 2008, a company pays an insurance
premium of 1.200 for the year ending 30 August 2009. If the companyproduces accounts with a year-end of 31 December, how should thisitem be treated?
P t
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Prepayments
1 Sept 31 Dec 2008 1 Jan 30 Aug 2009
Insurance usage/expense1,200/12 months x 4 = 400
Payment = 1,200
Prepayment/deferred = 800expense
Insurance usage/expense1,200/12 months x 8 = 800
Payment = -
Cancel prepayment = 800
A ti g f t
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Accounting for prepayments
Assets Equity
Deferredexpenses Cash Profit(I/S)2008Payment of insurance (1,200) (1,200)Defer to 2008 800 800
Closing balance 2008 800 (1,200) (400)2009
Opening balance 800 (1,200)Insurance expense (800) (800)
Closing balance 2009 0 (1,200) (800)
In the B/S worksheet
current assets
Acco nting for prep ments
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Accounting for prepaymentsIn the journal (excl. profit appropriation)
Dr insurance expense 1,200Cr cash 1,200
Dr deferred expense 800Cr insurance expense 800
Year 2008
Dr insurance expense 800Cr deferred expense 800
Year 2009
Accrued expenses
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Accrued expenses The accrual principle requires that we record a liability for all expenses
which have been incurred but not paid
If a bill/invoice is received, usual to classify liability as a trade
creditor/accounts payable if no bill/invoice received, classify as an accrued expense/liability
Example:
Company A closes account on 31 Dec. At the end of December2008, the company received the electricity bill for Nov/Dec 2008which will be paid in January 2009, in the amount of 500.
Company A did not received the telephone bill for the last quarterof 2008 but estimates a cost of 1,000
Accounting for accrued expenses
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Accounting for accrued expenses
Assets Liabilities EquityCash Accounts
payableProfit(I/S)
2008Electricity expense 500 (500)
2009
Payment of bill (500) (500)
Electricity bill
Accounting for accrued expenses
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Accounting for accrued expenses
Assets Liabilities EquityCash Accrued
expenseAccountspayable
Profit(I/S)
2008
Telephone expense 1,000 (1,000)
2009Receipt of bill (1,000) 1,000
Payment of bill (1,000) (1,000)
Telephone expense
current liabilities
Accounting for accrued expenses
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Accounting for accrued expenses
What if the telephone bill is 1,100?
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Unearned or deferred revenue
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Unearned or deferred revenue Cash received prior to the goods/service have been provided
We need to record the cash receipt but not the revenue in the I/S,as the accrual principle requires revenue to be recognised when
earned not when receipt occurs The way to do this is to set up a category of liability called
unearned or deferred revenue (income)
Example:
Homes plc, a letting agency, closes accounts on 31 Dec. At end ofDecember 2008, the company received rents of Jan and Feb 2009in the amount of 2,000
Accounting for deferred revenue
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Assets Liabilities Equity
Cash Deferred
revenue
Profit
(I/S)2008
Receipt of 2009 rents 2,000 2,000
2009
Rents revenue of2009
(2,000) 2,000
Accounting for deferred revenue
Accrued revenue
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Accrued revenue Revenue is earned but cash will be received only in future periods
Following the accrual principle, we recognise revenue but a cashinflow cannot be recorded
The way to do this is to set up a category of asset called accruedrevenue (income)
Example:
At 1 Oct 2008, Gameover plc invested 100,000 in GovernmentBonds. The bonds pay annual interests at 5% rate every 30 Sept.
The company prepares annual reports at 31 Dec.
Accounting for accrued revenue
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Interests earned in 2008 = (100,000 x 5%) / 12 x 3 = 1,250
Interests earned in 2009 = (100,000 x 5%) / 12 x 9 = 3,750
Assets EquityCash Accrued
revenueProfit(I/S)
2008
Interests earned 1,250 1,250
2009
Receipt of interestsearned in 2008
1,250 (1,250)
Interests earned andreceived in 2009 3,750 3,750
Accounting for accrued revenue
Impairment
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Impairment
Recall the prudence concept: A degree ofcaution/conservantism should be applied in exercising judgment
and making the necessary estimates An asset is impaired and impairment losses are incurred if there
is objective evidence of a loss event that has an impact on the
estimated future cash flows
Impairment of receivables
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Impairment of receivablesFor receivables, consider the following events:
(a) significant financial difficulty of borrower
(b) a breach of contract, such as a default or delinquency in interest orprincipal payments
(c) the lender granted to the borrower a concession that the lender wouldnot otherwise consider
(d) becomes probable that the borrower will enter bankruptcy or other
financial re-organisation
Impairment of receivables
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Impairment of receivablesConsider the following example:
In period X1, company Zett plc sold goods to a client in the amount of 15,000,giving the client three-month credit
During X1, the client paid only 14,000. Despite being contacted several times bythe company the client did not to pay the remaining 1,000
At X2, the client reported financial difficulties and the debt was declared difficult tocollect
When should the loss be recognised in Zett plc accounts? In X2 only?
Recognition of the expense only in X2 and doing nothing in X1 is not a prudent
attitude. As a consequence, accounts in period X1 would reflect:- Overstatement of assets (accounts receivable) by 1,000
- Overstatement of profit (no recognition of the loss) by 1,000
Impairment of receivables
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p
Assets EquityCash Impairment
ofreceivables(*)
Accreceivable
Profit(I/S)
Period X1
Sale 15,000 15,000
Receipt from sales 14,000 (14,000)
Impairment (1,000) (1,000)
Closing balance 14,000 (1,000) 1,000 14.000
The accounting entries are:
(*) also referred to as provision for doubtful debts
Impairment of receivables
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p Note that in the B/S the impairment reduces the accounts receivable
account. Sometimes is referred to as adjustment to asset or contra-asset
Note also that in the I/S the impairment loss is a separate operationalexpense and is not deducted from sales revenue
Accounts receivable 1,000
Less
Impairment (1,000)
Sales revenue 15,000
Impairment loss (1,000)
Impairment of receivables
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pWhat happens in period X2?
Client financial troubles are resolved and he agrees to pay 60% of the debt.
The remaining 40% will not be collected (becoming a bad debt)
The credit is solved and there no need to keep the impairment in the B/S:
reverse the impairment loss
Reverse impairment loss
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p
Assets EquityCash Impairment Acc
receivableProfit(I/S)
Retainedprofit
Period X2
Opening balance 14,000 (1,000) 1,000 14,000
Cash received 600 (1,000) (400)Reversion impair. 1,000 1,000
Part of the credit is collected (600), part is transferred to bad debt expense(400), the B/S allowance for impairment is cancelled (1,000) against the I/S(revenue)
Bad debt expenseOperational revenue
Provisions
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Provisions are represented in B/S as liabilities. These include: Restructuring provisions (e.g. future termination of a line of business, a
business in a country)
Environmental provisions (e.g. environmental liabilities, such as remediationcosts, related to past mining activities)
Decommissioning provisions (e.g. oil rig or nuclear power station needs to bedismantled at the end of its life)
Litigation and other legal claims
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Provisions for legal disputes
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Assets Liabilities EquityCash Provision Profit
(I/S)Retained
profit
2005Recognition provision 100.000 (100.000)
Closing balance 100,000 (100.000)
2006Opening balance 100.000Settlement / cancelprovision (90.000) (100.000) 10.000
Closing balance (90.000) 0 (90.000)
Provisions: British Airways plc
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LONDON: British Airways PLC was fined almost US$550 million(400 million) on Wednesday by U.S. and British regulators after theairline admitted to colluding with rival Virgin Atlantic over fuelsurcharges on long-haul flights
The Associated PressPublished: August 1, 2007
Suppose BA has recognized a provision of US$450 million in 2006 accountsconcerning these overcharge penalties. What accounting entries should BA do in2007 accounts (after regulators issued the fines of $US550)?
Provisions: British Airways plc
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The Associated PressPublished: August 1, 2007
What accounting entries should BA do in 2007 accounts in light of the prudenceprinciple?
In addition, U.S. officials said BA and Korean Air Lines were involved in aconspiracy with German carrier Lufthansa AG to fix charges for internationalcargo shipments."When British Airways, Korean Air and their co-conspirators got together andagreed to raise prices for passenger and air cargo fares, American consumersand businesses ended up picking up the tab for their illegal conduct," said ActingAssociate Attorney General William W. Mercer.In May, British Airways set aside US$710 million to pay for any possible fines as aresult of the investigations