Accounting-Knowledge | resources for students and professionals

May 20, 2012
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Due diligence and it’s deeper meaning

A due diligence is part of many of today’s transactions of companies. It may be differentiated in buy side due diligence and vendors due diligence regarding the motive for the transaction. Another differentiation can be made because of the function of a due diligence. Important examples for the latter are financial, tax and legal due diligences.

These are the most important reasons for a due diligence:

Buy Side Due Diligence

initiated by the buyer of a company
what are the chances and risks of the company
exposing possible dealbreakers

Vendors Due Diligence

Initiated by the seller of a company
prepare the company for the buy side due diligence
more complex than buy side due diligence because of divergent buyer interests

Financial Due Diligence

auditing net assets, financial position and results of operations
what are the specific chances and risks
inherent part of each transaction of a company

A due diligence may take up to six months of time and the due diligence teams may be pretty large consisting of auditors, tax and legal experts, IT-professionals and many others. To evaluate chances and risks of a company the teams look close at future sustained cash flows, accounting valuation margins and the plausibility of business plans.

May 19, 2012
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IFRS balance structure

Relevant paragraphs for preparing an IFRS balance are

§§ 51-77 IAS 1.

Following these norms an IFRS balance could have this form

IFRS

What is most important about this balancing approach is ordering by maturity. Long-term assets e.g. would be tangible fixed assets, current assets would be inventories and so on. But in practice different orders of balance posts would also be possible, because the IFRS give companies a lot more freedom to choose a specific order than most national accounting norms do.

May 18, 2012
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Financing of current assets: Working Capital

Working Capital is that part of current assets, which does not finance current liabilities. Therefore Working Capital has explanatory power for

1. a company‘s liquidity

2. the expansive force of a company.

Working Capital is calculated as follows:

Working Capital = current assets – current liabilities

Liquidity: Especially important concerning liquidity is the ratio of current assets to current liabilities

WCR (Working Capital Ratio) should not be below 1, otherwise a part of current liabilities would not be covered by current assets. In this case it could be even necessary to sell long-term assets.

Expansive force: In general companies try to decrease working capital, so that the new liquidity may be used for further investments. This is especially true for companies with a WCR above 1, because in this case a part of current assets is financed by long-term liabilities which is not necessary. Here comes the cash-to-cash-cycle into play: The longer the time span is between cash outflow for pre-products of suppliers and cash inflow for selling the finished product, the more working capital the company will have. Therefore companies will aim to reduce the cash-to-cash-cycle.

May 17, 2012
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Relationship between balance sheet, income statement and cash flow statement

Profits and losses are the result of the income statement and are booked to the equity account. Equity is a passive account on the right side of the balance.

-> the result of the income statement increases or decreases equity

Without the income statement the balance sheet could not be prepared. The cash flow statement instead uses the results from the balance sheet and the income statement.

So what is the main difference between income and cash flow statement? In the income statement profits (or losses) are the result of the comparison of

expenditures and revenues

but the cash flow statement instead compares

cash outflow and cash inflow.

A company may have made profits regarding the income statement and still not have generated enough cash for paying bills. This is because not all expenditures and revenues are resulting in cash outflows and cash inflows. Depreciation e.g. does not lead to a real cash outflow.

-> therefore the cash flow statement is important for liquidity planning

May 16, 2012
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Components of financial statements

Financial statements may be differentiated in individual financial statements and consolidated financial statement:

1. Components of all financial statements:

I. balance sheet

II. income statement

III. notes

IV. statement of stockholders’ equity

V. cash flow statement

2. Additional component for companies that are listed on the stock exchange

VI. segment reporting

This list of components follows the rules of the IFRS (International Financial Reporting Standards).

May 15, 2012
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Accounting records: A simple system

Accounting records do not have to be memorized, if this simple system has been learned:

1. Which accounts are affected?

2. On which side oft the balance are these accounts to be found?

3. Are these accounts increased or decreased?

After these simple considerations the accounting record can be made:

Accounting record scheme

Example: A bill has to be paid. Therefore a payment has to be made from the bank account.

1. Which accounts are affected?

Because in this example debt is being paid, the account liabilities is affected. The bank account is also affected, because this is were the payment is made from.

2. On which side oft the balance are these accounts to be found?

This determination if an account is active or passive has to be made, because of the following reason: Active accounts are increased on the debit side, but passive accounts are increased on the credit side. If a payment into the bank account is made, the account stands on the debit side of the record (see „accounting record scheme“ above). If liabilities increase, the account liabilities stands on the credit side of the record.

3. Are these accounts increased or decreased?

Because a liabilities has to be paid, the account liabilities has to be decreased. At the same time some amount of money is removed from the bank account, because the account bank has to be decreased as well.

-> create the record

Bank is an account from the active side oft the balance and therefore is increased on the debit side. But in this example is has to be decreased, and therefore it stays on the credit side of the record. Liabilities instead is a passive account and is increased on the credit side. But because it is decreased in this example as well, it stays in the debit side of the record:

May 14, 2012
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New valuation of financial instruments: IFRS 9 and IAS 39

The International Accounting Standards Board (IASB) plans to replace IAS 39 with a new standard. IFRS 9 will play an important role for the valuation of financial instruments.

1. Only two valuation methods remaining:

I. fair value

II. amortised cost

The fair value method will be the proper standard for the valuation of financial instruments in the future. As an exception from this rule amortised costs may be used as well, but only in compliance with several requirements.

2. Revision of impairment rules

Impairment does mean a test of the recoverability of assets, so that these are not valuated above their recoverable amount. The revision of the old standard IAS 39 plans to introduce the

Expected Loss Model

as a replacement for the

Incurred Loss Model.

One of the most important aspects of the new model is to consider interest gains based on expected cash flows and the change of default expectations for valuation. If the present value lies below book value, there has to be an impairment. The Incurred Loss Model of IAS 39 in comparison based on the principle, that it is not allowed to account for not already realised losses.

3. New Hedge-Accounting regulation

Hedge-Accounting does mean special accounting rules for underlying transactions and their corresponding hedging transactions (the transaction that hedges the risk of the underlying transaction). To buy inventory e.g. may be considered as an underlying transaction whith which a certain price risk may be associated (lower prices in the future). If the company buys a sell option (option to sell inventories in the future for todays price), that would be the corresponding hedging transaction.

With new hedging-accounting rules, it should be easier to represent these corresponding transactions through accounting in a risk management sense. With IFRS 9 there is no more distinction between financial and non-financial underlying transactions.

Example: A company wants to buy jet fuel. Fuel has two price components: crude oil price and refinery margin. Before IFRS 9 it would not have been possible to make a distinction between these two components and e.g. use crude oil alone as a risk component. But IFRS 9 allows this and therefore supports a stronger distinction of risk components in general.

The three above explained changes coming with IFRS 9 are mainly made in reaction of the IASB to the global financial crisis. IAS 39 was said to be overall too complex and allowed imparirments, that were made too late.

May 14, 2012
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Difference between accruals and provisions

Accruals, provisions and hidden reserves have different meanings regarding accounting and therefore have to be clearly differentiated:

1. Attribution

Provisions and hidden reserves belong to the equity, accruals to the liabilities.

2. Purpose

Provisions are used for impending losses, their future occurance is not certain.

Accruals are part of the liabilities, their future occurance is certain, but not their exact amount or point in time.

Hidden reserves on the contrary are the result of an undervaluation of assets or an overvaluation of liabilities (book value < real value). Hidden reserves do not show up on the balance.

While hidden reserves are the result of a cautios valuation, provisions are gained from profits and accruals are used for future pension payments and similar obligations which are already certain.