SECTION II. OVERVIEW OF IAS

Transcription

1 SECTION II. OVERVIEW OF IAS A. OVERVIEW International Accounting Standards (IAS) are developed by the International Accounting Standards Board (IASB): Prior to reorganization in 2000, the structure for setting International Accounting Standards was known as the International Accounting Standards Committee (IASC). The IASC issued International Accounting Standards from 1973 through In 2000, the IASC was reorganized and the International Accounting Standards Committee Foundation (IASCF) was established as the parent foundation. The IASCF is a non-profit organization governed by Trustees. Its role is to support the IASB and fund its activities. The IASB is responsible for the development and approval of new standards, which will be called International Financial Reporting Standards (IFRS). The objectives of IASCF and IASB are: To formulate and publish a single set of accounting standards, in the public interest, and to promote their worldwide acceptance. To promote the use and rigorous application of those standards. To bring about convergence of national accounting standards and International Accounting Standards. The IASCF is supported by financial support from professional accounting organizations, companies, financial institutions, accounting firms and other organizations as well as proceeds from publications, which include the International Accounting Standards. CONTACT DETAILS: Office and Mailing address: International Accounting Standards Board 30 Cannon Street London EC4M 6XH United Kingdom Phone: Website: Another important international organization is the International Federation Of Accountants (IFAC). IFAC is an organization of national professional accountancy organizations that represent accountants employed in public practice, business and industry, the public sector and education as well as some specialized groups that interface frequently with the profession. Currently it has 155 member bodies in 113 countries and represents more than 2 million accountants. Mongolia is currently applying for membership in IFAC. IFAC s mission is to develop the profession and harmonize its standards worldwide to provide services of consistently high quality in the public interest. IFAC issues guidance in six key areas: 4

2 Auditing: IFAC issues International Standards on Auditing (ISA), practice statements and discussion papers. Education: IFAC issues International Education Standards and Guidelines for accountants. Ethics: The IFAC Code of Ethics for Professional Accountants serves as a model worldwide. Financial and Management Accounting: IFAC issues International Management Accounting Practice Statements, studies and other publications. Information Technology: IFAC issues guidelines to assist management and accountants in overseeing IT projects. Public Sector Accounting: IFAC issues International Public Sector Accounting Standards, guidelines and studies. Many IFAC publications are available in English free of charge from their website: FUNDING: IFAC is funded primarily from dues paid by member countries. CONTACT DETAILS: General Inquiries to: Maria Hermann IFAC 535 Fifth Avenue, 26 th Floor New York, NY USA Phone: Ext.112 Fax: mariahermann@ifac.org For publications, copyright information: Damarys Gil Phone: Ext damarysgil@ifac.org 5

3 LIST OF CURRENT INTERNATIONAL ACCOUNTING STANDARDS Preface to International Financial Reporting Standards Framework for the Preparation and Presentation of Financial Statements IAS 1 Presentation of Financial Statements IAS 2 Inventories IAS 7 Cash Flow Statements IAS 8 Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies IAS 10 Contingencies and Events Occurring After the Balance Sheet Date (partly superseded by IAS 37) IAS 11 Construction Contracts IAS 12 Income Taxes IAS 14 Reporting Financial Information by Segment IAS 15 Information Reflecting the Effects of Changing Prices IAS 16 Property, Plant and Equipment IAS 17 Accounting for Leases IAS 18 Revenue IAS 19 Employee Benefit Costs IAS 20 Accounting for Government Grants and Disclosure of Government Assistance IAS 21 The Effects of Changes in Foreign Exchange Rates IAS 22 Business Combinations IAS 23 Borrowing Costs IAS 24 Related Party Disclosures IAS 25 Accounting for Investments IAS 26 Accounting and Reporting by Retirement Benefit Plans IAS 27 Consolidated Financial Statements and Accounting for Investments in Subsidiaries IAS 28 Accounting for Investments in Associates IAS 29 Financial Reporting in Hyperinflationary Economies IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions IAS 31 Financial Reporting of Interests in Joint Ventures IAS 32 Financial Instruments: Disclosure and Presentation IAS 33 Earning Per Share IAS 34 Interim Financial Reporting (effective 1 January 1999) IAS 35 Discontinued Operations IAS 36 Impairment of Assets IAS 37 Provisions, Contingent Liabilities, and Contingent Assets IAS 38 Intangible Assets IAS 39 Financial Instruments: Recognition and Measurement IAS 40 Investment Property IAS 41 Agriculture International Accounting Standards issued by the IASB (that is, after 2000) will be designated as International Financial Reporting Standards to more correctly reflect the nature of the standards. Those listed above will, however, continue to be called IAS. 6

4 THE FRAMEWORK FOR THE PREPARATION AND PRESENTATION OF FINANCIAL STATEMENTS The Framework identifies the concepts that form the basis for preparation and presentation of financial statements to users. It is not an IAS, rather it serves as a guide to the IASB, national accounting standard setters, and preparers, auditors and users of financial statements. It is important for accountants to understand the basic concepts underlying IAS in order for them to understand and apply the standards. The language used in the IAS sections of this manual is more technical than that used in the methodology sections. This is intended to help accounts become familiar with the language used in the standards themselves so that they can learn to read, interpret and apply the standards. The framework deals with: The objective of financial statements; The principles of accounting and financial statements; The definition, recognition and measurement of the elements of financial statements. Financial statements form part of the process of financial reporting and include notes, schedules and clarifications that are expected to be read together with the statements. The framework is a guide for all business entities (in both the public and private sectors) when preparing and presenting their financial statements. The framework emphasizes that the management of an enterprise has the primary responsibility for preparing and presenting the enterprise s financial statements. The Objective of Financial Statements The objective of financial statements is to provide information about the financial position, performance and cash flows of an enterprise useful to a wide range of users in making economic decisions. Users of financial statement information must understand certain Characteristics and Limitations pertaining to that information. Financial statements are: Financial representations of transactions The information in financial statements is usually expressed in units of money regardless of changes in purchasing power. Reflect estimates and judgment Accounting information is not exact. It is based on professional judgment. Financial statements appear to be more precise than they are. Historical in Nature Financial statements reflect past transactions rather than current information or future projections. General in Purpose Financial statements are designed for a wide range of users and as such do not provide in depth information required for specialized purposes. 7

5 Involve Cost Costs are involved in financial statement preparation and use. The benefits must exceed the costs to justify their preparation and use. Not all costs or benefits are directly quantifiable. Underlying Assumptions: Financial statements are based on the following assumptions: Accrual Basis The accrual basis of accounting is used. Transactions are recognized when they occur and are recorded and reported in the periods to which they relate. Going Concern For accounting purposes it is assumed that the business will continue to operate. It will not be liquidated in the near future. This assumption provides the rationale for classifications and measurements used in financial accounting. (Examples include the Current vs. long-term classification of assets and liabilities, reporting assets at historical cost.) In order for the information in financial statements to be useful to the users, it must have certain Qualitative Characteristics, which are outlined in the Framework: Understandability Information presented should be understandable to a reasonably well-informed user. Relevance Relevance is the capacity of the information to make a difference to the user of the information in decision making by helping him evaluate past, present or future events or by confirming or correcting his past evaluations. o Materiality is a component of relevance. International Accounting Standards apply to only to material items. There is no single standard for materiality. Information is material if its omission or misstatement could influence the economic decisions made on the basis of the financial statements. Materiality depends not just on the size of the item but also on its nature. o Timeliness is also a component of relevance. Information must be provided in time for it to be useful to users. That means that information may be reported before all aspects are known. Timeliness must be balanced with reliability. Reliability-To be reliable, information must have the qualities of: o Verifiability Information should be based on underlying evidence. o Neutrality Information should be free from bias. It should not be slanted toward a particular outcome or viewpoint. o Representational faithfulness Information should represent faithfully the transactions or economic events that it purports to represent. In order to faithfully represent transactions it is necessary that they are presented and accounted for in accordance with their substance and not just their legal form. The principle of Substance over Form is an important principle underlying financial reporting. o Reliability is affected by the use of estimates and by uncertainties. These uncertainties are dealt with, in part, by disclosure and also by exercising Prudence in preparation of financial statements. Prudence is the inclusion of caution in judgments so that assets or income are not overstated and liabilities or expenses are not understated. This is also known as the principle of Conservatism. o Completeness To be reliable, the information in financial statements should be complete within the bounds of materiality and cost. Comparability The information should be presented in such a way that it can be compared to similar information over time. In addition it should be 8

6 presented in such a way that it can be compared to other entities. Consistency is an important element of comparability. o Consistency Information should be presented in the same manner from period to period. The same methods for measuring and reporting should be used. When there are changes in method, those changes should be disclosed. To provide information that is understandable, relevant, reliable and comparable, accountants must make certain assumptions in addition to the basic assumptions (Accrual basis and Going Concern) mentioned above. These assumptions are inherent in the financial information presented: Separate Entity Economic activities are associated with a specific entity. That may be a business, a segment of a business or a consolidated group. This requires a careful separation of the activities of the business entity from the activities of its owners or other businesses. (NOTE: The name of the entity should appear at the top of financial statements.) Unit of Measure For accounting purposes financial information is reported in the national monetary unit. (In Mongolia the Togrog.) Time Period The economic activity of an entity can be meaningfully reported over arbitrary time periods that are shorter than the life of the entity. (In practice the reporting period may vary but the most common is one year, especially one calendar year. The reporting period should be indicated at the top of each financial statement.) In operational terms accountants must employ certain principles relating to recognizing and reporting assets and liabilities and revenues and expenses. Four fundamental Implementation Principles are: Cost Principle Cost (cash equivalent given up) at time of acquisition (historical cost) is the appropriate basis for initially recording items in the financial statements. The cost principle assumes an arm s-length business transaction. Revenue Principle (including Revenue Measurement) Revenue should be recognized (and recorded in the financial statements) when it is earned and when the amount and timing of the revenue are determinable. Revenue is considered to be earned when ownership transfers or the services are rendered. Revenue is measured by the cash or cash equivalent received or receivable. The Revenue Principle requires that the Accrual Method of Accounting be used. Matching Principle It is necessary to recognize (and record) the costs or expenses incurred in earning revenue in the same period that the revenue is recognized. (Revenues and expenses should be matched.) When it is difficult to identify precisely the connection between revenues and costs, costs should be allocated over several periods on a systematic and rational basis. The Matching Principle requires that the Accrual Method of Accounting be used. Full-Disclosure Principle The financial statements of an entity should disclose all of the relevant economic information required by a reasonably well-informed user in making economic decisions. Some information must be reported on the face of the financial statements; other information may be disclosed in the Notes and Explanations (disclosures). 9

7 EXERCISE 1 - Accounting Principles For each of the following circumstances, give the letter item indicating the accounting principle and/or qualitative characteristics involved: a) Timeliness b) Consistency c) Full disclosure d) Conservatism/Prudence e) Cost principle f) Materiality List all appropriate answers. Some may involve more than one principle or characteristic. 1. All payments out of petty cash are debited to Miscellaneous Expense 2. A note describing the company s possible liability in a lawsuit is included with the financial statement even though no formal liability exists at the balance sheet date. 3. Long term investments are valued at historical cost 4. A retail store uses estimates rather than a complete physical count of its inventory for purposes of preparing monthly financial statements. 5. Inventories are valued at the lower of cost or net realizable value. 6. The same inventory valuation method is applied in 2000 and Inexpensive spare parts used by a large manufacturing firm are recorded as an expense when purchased. 10

8 The Framework defines the elements of financial statements and criteria for measurement and recognition of each. Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These broad classes are termed the elements of financial statements. The elements directly related to the measurement of financial position (Balance Sheet) are: Assets Liabilities Equity Assets Economic resources controlled by the entity received as a result of past transactions and from which future economic benefits are expected to be obtained. Key concepts are: o Future economic benefits o Control o Past transactions In order to be classified as an asset, an item must meet this definition of an asset and must also meet the criteria for recognition. Liabilities Obligations of the entity from past transactions, which will probably result in future sacrifices of economic benefits (the transfer or use of assets, or the provision of services). Key concepts are: o Future economic sacrifices o Obligations o Past transactions In order to be classified as a liability, an item must meet this definition of a liability and must also meet the criteria for recognition. Equity The residual interest in the assets of the entity, which remain after deducting its liabilities. The central equation of the Balance Sheet is: Assets = Liabilities + Equity Restated algebraically, the equation is Assets - Liabilities = Owners Equity That is the definition of Equity. The elements directly related to the measurement of performance (Income Statement) are: Income (including Gains) Expenses (including Losses) Income increases in economic benefits during the accounting period in the form of inflows or increases to assets or decreases in liabilities except for those relating to contributions from owners. Includes: 11

9 o Revenues, which are sales of goods or provision of services and other activities that constitute the entity s major operations. o Gains, which are inflows from transactions that are peripheral to the main activity of the entity. Expenses decreases in economic benefits during the accounting period in the form of outflows or decreases in assets or increases in liabilities except for those relating to distributions to owners. Includes: o Expenses, which are outflows from the activities that constitute the entity s major operations. o Losses, which are outflows from transactions that are peripheral to the main activity of the entity. Recognition For an item that meets the definition of an element to be recognized in the financial statements it must satisfy the criteria for recognition: It is probable that the future economic benefit associated with the item will flow to or from the enterprise; and The item s cost or value can be reliably measured. Measurement of financial statement elements involves selection of a basis of measurement: Historical cost the most common basis used. It is usually combined with other measurement bases. (For example, inventories are carried on the Balance Sheet at the lower of cost or net realizable value.) Current cost Net realizable value Present value 12

10 CASE STUDIES ACCOUNTING CONCEPTS AND PRINCIPLES For each of the scenarios below, answer the following questions: 1. Who is right, Accountant A or Accountant B? 2. What underlying accounting concept or principle did you consider in determining your answer to question 1? Scenario 1 Mongol Furniture Company needed a truck in which to make furniture deliveries to its customers. They purchased a truck from UB Truck Company and signed an agreement that included payment terms. According to the agreement, Mongol Furniture Company will make monthly payments to UB Truck Company for 36 months. At the end of that time, Mongol Furniture Company will own the truck. The title of the agreement reads "Rental Agreement". Mongol Furniture Company's "Accountant A" believes they should record the truck as an asset (Equipment) with a corresponding liability for the total of the payments to be made to UB Truck Company. "Accountant B" believes that Mongol Furniture Company should not record the truck as an asset but should record rent expense each month, because the agreement is called a rental agreement. Scenario 2 Good Times Newspaper Company is suing a competitor, alleging that the competitor illegally used advertising designs that belonged to Good Times. The attorneys for Good Times believe that Good Times will win the lawsuit and have estimated that the company will receive a damage award of Tog 50 million. The case will not be decided through the legal system, however, for another 12 months at a minimum. "Accountant A" believes that Good Times should accrue the Tog 50 million in income, based on the best estimate of their attorneys. "Accountant B" believes that the income should not be accrued because there is an uncertainty about the ultimate outcome of the case. 13

11 Scenario 3 MN Commercial Bank made a loan to a customer with an interest rate of 24% per year. Interest payments must be made monthly, and the principle amount of the loan is due in 12 months. The customer will be out of town for three months and decided to prepay the first three months' interest before he left town. Therefore, the customer paid the bank Tog 60,000 (representing the first three months' interest) on the same day that the bank funded the loan. The Bank's "Accountant A" believes that the bank should record a liability for 60,000 because the Bank has not yet earned the interest. "Accountant B" believes that the 60,000 should be recorded as income on the date the bank received it from the customer. Scenario 4 Magic Flowers has average monthly sales of Tog 2,500,000 and average monthly net income of Tog 500,000. The company specializes in arranging and selling bouquets. Bouquets are wrapped up in decorative paper and bound with rubber rings. Magic Flower's purchasing department orders 20,000 rubber rings at a cost of Tog 0.5 each. This is a large amount of rings and will be sufficient to last an estimated period of 6 months. "Accountant A" believes that the rings should be recorded as an asset and depreciated over the estimated period of 6 months that they will be used. "Accountant B" believes that the rings should be recorded as an expense rather than an asset. 14

12 B. FINANCIAL STATEMENTS IAS 1: Presentation of Financial Statements defines the four general-purpose financial statements: Balance Sheet Income Statement Statement of Changes in Equity Cash Flow Statement Integral to the financial statements are the Accounting Policies and Explanatory Notes, or Disclosures, which should accompany the financial statements. The five elements: Assets, Liabilities, Owners Equity, Income and Expense are reported in the financial statements according to the following equations: In the Balance Sheet: Assets = Liabilities + Owners Equity And in the Income Statement: Income Expenses = Net Income or Loss These are the central equations underlying financial accounting based on IAS principles. IAS 1 states that application of IAS and proper disclosure will result in financial statements that present fairly the financial position, performance and cash flows of the enterprise. The Accounting Policies (paragraphs 20-22) make clear that management has the responsibility to develop policies to insure that financial statement information is relevant and reliable. Many of the rules regarding financial statements as detailed in International Accounting Standards are included in the Methodology for Financial Statement Preparation and Presentation, Ministry of Finance Part 1, paragraph 7 lists Principles of financial statement preparation. Principle vii states that offsetting of assets and liabilities is not allowed. IAS 1, paragraphs address the prohibition against offset for all elements of the financial statements and describe the limited instances in which offset is allowed for income and expense items. To aid communication, items on the Balance Sheet and Income Statement are usually grouped according to common characteristics. Assets are grouped in decreasing order of liquidity; liabilities are grouped by time of maturity and owners equity in decreasing order of permanence. Some classifications and methods of presenting information in the financial statements are defined by IAS but IAS also allows some flexibility so different companies will present similar information in different ways. However, by following the conceptual framework and requirements outlined in IAS for presentation and disclosure, the informed user can compare 15

13 financial statements of different companies. Classification (grouping) is strongly influenced by characteristics of particular industries for example banks. The Balance Sheet and Income Statement of a bank look different from those of a nonregulated manufacturing company or service business. But there are similarities as well and ALWAYS the basic accounting equations are followed. Presented in this manual as an example are the financial statements of Rainbow Company. (The financial statements include the Balance Sheet, Income Statement, Statement of Changes in Equity, Cash Flow Statement and Notes to the Financial Statements.) Rainbow company s financial statements were converted to comply with IAS under one of the previous projects of the Asian Development Bank for upgrading Mongolia s accounting system. Balance Sheet The Balance Sheet is also called the Statement of Financial Position because it shows the financial position of an entity at a particular point in time. The particulars concerning the format, method of presenting the elements and many of the necessary disclosures of additional information for enterprises are set forth in the Methodology for the Financial Statement Preparation and Presentation (attachment to the Resolution # 215 of Finance Minister, 1999). All Financial Statements should have a heading including: The entity name Whether the statements cover the individual enterprise or group of enterprises The title of the financial statement presented The period covered by the statement The reporting currency The level of precision (e.g. 000 Togrogs) NOTE: The Balance Sheet is not prepared for a period, it is prepared as of one particular date most often this is the last day of the entity s year. In Mongolia it is December 31. Remember: THE BALANCE SHEET IS A SNAPSHOT OF BUSINESS AT A POINT IN TIME Important concepts underlying the Balance Sheet are: Going Concern Assumption Cost Principle 16

14 Rainbow Company Balance Sheet at 31 December 1995 (in thousands of Togrogs) ASSETS Current Assets Cash 3,943 7,922 Accounts Receivable 156,749 82,839 Other Receivables 3,763 4,718 Receivable from Employees 5, less Allowance for Doubtful Accounts (13,542) - 151,979 87,599 Inventory 409, ,070 Prepayments to Suppliers 199,860 94,210 Prepaid Expenses 4,385 7,558 Total Current Assets 769, ,359 Non Current Assets Tangible Assets Property Plant and Equipment 177, ,353 Less Accumulated Depreciation (15,360) (13,916) 162, ,437 Construction in Process - Hotel 5,645 5,172 Construction in Process - Factory 75,469 68,016 Total Tangible Assets 243, ,625 Investment 1,600 1,600 Total Non Current Assets 244, ,225 TOTAL ASSETS 1,014, ,584 LIABILITIES Accounts Payable 371, ,681 Advances from Customers 14,623 18,708 Payable to Government 42,794 5,297 Interest Payable 121,379 19,544 Short Term portion of Long Term Debt 291,581 66,728 Other Short Term Payables 2,509 8,129 Total Short Term Liabilities 843, ,087 Long Term Notes Payable 982, ,126 Total Long Term Liabilities 982, ,126 TOTAL LIABILITIES 1,826,432 1,214,213 OWNERS' EQUITY Common Stock (404,830 shares, par value 100 tog) 40,483 40,483 Retained Earnings (852,192) (398,112) Total Equity (811,709) (357,629) TOTAL LIABILITIES AND OWNERS EQUITY 1,014, ,584 17

15 Income Statement The Income Statement is also known as the Statement of Operations in some countries but it shows more than just income and expenses from the main activity of the entity. It provides the link between the entity s Balance Sheet at the beginning and end of the accounting period. The particulars concerning the format, method of presenting the elements and many of the necessary disclosures of additional information for enterprises are set forth in the Methodology for the Financial Statement Preparation and Presentation (attachment to the Resolution # 215 of Finance Minister, 1999). The Income Statement illustrates the second basic accounting equation: Revenues - Expenses = Profit Like the Balance Sheet, the Income Statement should have a heading including: The entity name Whether the statements cover the individual enterprise or group of enterprises The title of the financial statement presented The period covered by the statement The reporting currency The level of precision (e.g. 000 Togrogs) NOTE: The Income Statement covers a particular period of time. Most often this is a calendar year. The period ending date coincides with the date on which the Balance Sheet is prepared. Remember: THE INCOME STATEMENT PRESENTS THE RESULTS OF THE OPERATIONS OF A BUSINESS OVER A PERIOD OF TIME. Important concepts underlying the Income Statement: Time Period Assumption Revenue and Matching Principles The simplest form of Income Statement presents the equation above in tabular form as: less REVENUES EXPENSES PROFIT (LOSS) The SIMPLE form is appropriate for some service companies. But the form that shows gross profit on sales before subtracting general and administrative expenses is more useful and is required for manufacturing or retail entities. 18

16 The expanded form as used in Mongolia is: REVENUES less less COST OF GOODS SOLD GROSS INCOME OPERATING EXPENSES OPERATING INCOME (LOSS) Usual Activity plus NON-OPERATING INCOME less NON-OPERATING EXPENSES INCOME FROM ORDINARY ACTIVITY plus EXTRAORDINARY GAINS less EXTRAORDINARY LOSSES INCOME BEFORE TAX Very Unusual Events less INCOME TAXES NET INCOME (LOSS) 19

17 Rainbow Company Income Statement for the year ended 31 December 1995 (in thousands of Togrogs) REVENUES Sales of Manufactured Goods 866,812 1,033,530 Sales of Merchandise 196, ,460 Net Sales 1,063,164 1,370,990 Cost of Goods Sold- Manufactured Goods 765, ,006 Cost of Goods Sold- Merchandise 180, ,671 Total Cost of Goods sold 946,225 1,194,677 Gross Profit 116, ,313 OPERATING EXPENSES Selling Expense 9,033 5,155 Administrative Expense 43,255 28,979 Employee Benefits 63,463 34,033 Total Operating Expense 115,751 68,167 Operating Income (Loss) 1, ,146 NON-OPERATING EXPENSE Net Interest Expense 210,869 8,355 Foreign Exchange Loss 244, , , ,727 Income (loss) before Taxes (454,080) (168,581) Income Taxes - - Net Income (loss) for the period (454,080) (168,581) 20

18 Statement of Changes in Equity The Statement of Changes in Equity describes the changes in an entity s retained earnings during the accounting period. This statement provides a concrete link between the Income Statement and the Balance Sheet. NOTE: The Statement of Changes in Equity, like the Income Statement, covers a period of time the same time period covered by the Income Statement. As with the Income Statement, the period ending date coincides with the date on which the Balance Sheet is prepared. Like the previous two general-purpose financial statements, this statement includes: the entity name, whether the statement is for an individual enterprise or group, the title of the statement, the period covered, the currency and level of precision. The Statement of Changes in Equity lists: Balance of Equity at the beginning of the period Changes during the period Changes in Accounting Policy Revaluation Currency translation differences Net gains and losses not shown on the Income Statement Net income for the period Dividends Issuance of Share Capital Resulting Balance of Equity at the end of the period. Furthermore, these are shown for each of the components of Equity: Share Capital Share Premium Revaluation Translation Reserve Accumulated Profit The format for the Statement of Changes in Equity used in Mongolia matches the one in IAS 1, Appendix. 21

19 Rainbow Company Statement of Changes in Equity for year ended 31 December 1995 (in thousands of Togrogs) ITEM Share capital Share premium Revaluation Translation reserve Accumulated profit Total Balance at 31 December ,483 (216,341) (175,858) Change in accounting policy Restated balance Surplus on revaluation of properties Deficit on revaluation of investment Currency translation difference Net gains and losses not recognized in the Income Statement Net income for the period (168,581) (168,581) Dividend (13,190) (13,190) Issue of share capital Balance at 31 December, year of ,483 (398,112) (357,629) Deficit on revaluation of properties Surplus on revaluation of investments Currency translation difference Net gains and losses not recognized in the Income Statement Net profit for the period (454,080) (454,080) Dividend Issue of share capital Balance at 31 December, year of ,483 (852,192) (811,709) 22

20 Cash Flow Statement The Cash Flow Statement provides valuable information not apparent from the Balance Sheet or Income Statement. IAS requires companies to report activity on the accrual basis. Therefore, revenue is recognized when it is earned, not when it is received; and expenses are recognized when incurred, not when they are paid. The Income Statement does not show the users what kind of cash position the enterprise is in; the Balance Sheet shows the cash balance, but only at one point in time. An enterprise that is growing rapidly may have a Balance Sheet and Income Statement that look good and yet be close to insolvency. One definition of insolvency is that liabilities exceed assets; another definition is the inability of a company to meet its obligations on time. Many rapidly growing companies do have cash flow problems because when there is rapid growth, cash often flows out faster than it flows in. This information is made easier for users to see by presentation of the Cash Flow Statement. IAS 7 Cash Flow Statements describes the statement in detail and gives examples. For purposes of this statement: Cash is defined as cash on hand and demand deposits. Cash equivalents are defined as short-term, highly liquid investments that are readily converted to known amounts of cash and for which there is an insignificant risk of change in their value. Cash flows are inflows and outflows of cash and cash equivalents. The Cash Flow Statement reports cash flows from three types of activities: Operating Activities: The activities performed in the normal course of operating the business. This portion includes the cash inflows and outflows associated with the Income Statement and the Balance Sheet accounts related to the Income Statement (e.g. Accounts Receivable, Inventory, Accounts Payable, Accrued Expenses Payable, etc.). Investing Activities: The activities associated with the business's investment in long-term Assets (e.g. Land, Machinery, Shares or Bonds of other companies held for investment). Financing Activities: The activities associated with investors and creditors (e.g. Short and Long term Loans, Dividends Paid, Issuance of Shares, etc.). The Cash Flow Statement basically converts accrual basis numbers into cash basis numbers. IAS 7 defines two ways of reporting cash flows from Operating Activities: Direct method in which information from the accounting records is used to show the major classes of gross cash receipts and gross cash payments. IAS 7 suggests that this method provides the most useful information to users. Indirect method in which net profit (from the Income Statement) is adjusted for non-cash transactions. (For example, depreciation and amortization expense are added back to net income because they were non-cash deductions taken in arriving at net income.) The Cash Flow Statement form for Mongolia follows the Indirect Method. When applying the Indirect Method to report cash flows from Operating Activities (the first section of the Cash Flow Statement) the effect that current assets and current liabilities have on cash flow is not easy to see at first glance. It is important to 23

21 remember that cash comes from decreasing an asset or increasing a liability and that cash is used when increasing an asset or decreasing a liability. The basic rules are: Cash flow increases if: o Current assets decrease, or o Current liabilities increase Cash flow decreases if: o Current assets increase, or o Current liabilities decrease In developing cash flow from Operating Activities, since the starting point is net profit, it is necessary to adjust for investing activities that have been already included in this figure. The form for the statement includes lines for these adjustments. 24

22 Rainbow Company Cash Flow Statement for the year ended 31 December 1995 (in thousands of Togrogs) ITEM Cash flows from operating activities Net income (454,080) (168,581) Depreciation expenses 1,444 4,185 Loss on sale of fixed asset, investment Gain on sale of fixed asset and investment Increase in receivable, inventory, prepaid expenses (170,985) (60,950) Decrease in receivable, inventory, prepaid expenses 27,559 Increase in short term liabilities, unearned revenue 400,757 53,492 Decrease in short term liabilities, unearned revenue (9,705) (19,261) Net cash flows from operating activities (205,010) (191,115) Cash flows from Investment activities Proceeds from sale of fixed asset Purchase of fixed asset (20,136) (181,040) Proceeds from investment sold Purchase of investment Net cash flow from investment activities (20,136) (181,040) Cash flows from financing activities Bank loan received 224, ,241 State Financing received Donations received Repayment of loan (3,686) Repayment of Current portion of long term debt Issued stock Stocks re purchased in cash Payment of dividend (13,190) Net cash flow from financing activities 221, ,051 TOTAL NET CASH FLOW (3,979) (27,104) Beginning balance of cash and cash equivalents 7,922 35,026 Ending balance of cash and cash equivalents 3,943 7,922 25

23 EXERCISE 2 - CASH FLOW Fill in the blanks to indicate where the various items would appear on the Cash Flow Statement. Use: O for operating activity, I for investing activity or F for financing activity. Hint: Usually transactions involving Current Assets are Operating Activities; transactions involving Non-current Assets are Investing Activities; and transactions involving Non-current Liabilities and Owners Equity are Financing Activities. sale of shares factory sale of equipment used in the increase in accounts receivable depreciation net income payment of dividends taking out a five-year bank loan purchase of building gain on the sale of equipment payable decrease in accrued expenses Solutions are included at the end of the chapter. 26

24 Accounting Policies and Explanatory Notes The notes to the financial statements are not optional additions that enterprises can choose to include or not include with financial statements. They are an integral part of general-purpose financial statements. Both IAS and guidance issued by Ministry of Finance and Economics in Mongolia specify in detail what disclosures are required. According to IAS 1, the notes should: Present information about the basis on which the financial statements are presented and specific accounting policies followed; Disclose information required by IAS; Provide any additional information not presented on the face of the financial statements that is necessary for fair presentation. Notes are normally presented in the following order: Statement of compliance with IAS if this is the case. NOTE: Financial statements should not be described as complying with International Accounting Standards unless they comply with all the requirements of each applicable Standard and each applicable interpretation of the Standing Interpretations Committee. Statement of accounting policies and measurement bases used by the enterprise. Supporting information for items presented on the face of the financial statements (properly cross-referenced). Other information Enterprises vary in how they present information in the notes, but the objective is to provide descriptive explanations regarding various items included and not included in the body of the statements that are deemed to be potentially meaningful to users. The information is narrative and the readers use the information to assist in the understanding of the numeric of the body of the statements. (The Notes to Rainbow Company financial statements include valuable information about company activities.) The Guidelines for Preparing Disclosures to Financial Statements approved in Resolution No. 64 by Mongolia s MOFE in 2000 specify the basic disclosure issues applicable to Mongolian enterprises. According to the Resolution, the following components and sequence are to be used to prepare disclosures to financial statements: 1. Operations and organizational structure of an enterprise; 2. Accounting policies; 3. Additional disclosures to financial statements. In the section for Accounting Policies, both general and specific policies should be described. Additional disclosures are to be made not less than once a year to the following main parts of financial statements using approved forms: 27

25 1. Cash 2. Accounts receivable 3. Inventory 4. Tangible assets 5. Intangible assets 6. Long-term investments and receivables 7. Short-term liability 8. Owners equity 9. Revenue and expenses. The Resolution allows enterprises to customize the approved disclosure forms to match the business characteristics of enterprises. The following are examples taken from various European companies that report in compliance with IAS. They are presented to illustrate how information is presented in the Notes. They are not all from the same company. Examples of Footnotes from Financial Statements of European Companies for 2000 Financial Statements Inventories Inventories are valued at purchase or manufacturing cost, using FIFO method. Any valuations that are too high compared with lower market values at the Balance Sheet date are marked down to the appropriate level. Inventories included in the Balance Sheet at their lower net realizable value totaled 66 million euro at December 31, 2000 (1999: 60 million euro). Detail of Inventories: Dec. 31, 1999 Dec. 31, 2000 Raw materials & supplies Work in Process Finished products and merchandise ,535 3,742 Trade Accounts Receivable Specific risks associated with trade accounts receivable are covered by appropriate valuation allowances. Company policy requires that an allowance of at least 50 percent be provided on accounts that are more than 90 days overdue. Accounts that are 180 days overdue are provided for in full. A total of 24 million euro has been provided in the form of valuation allowances in 2000 (1999: 45 million euro). Tangible Fixed Assets Tangible fixed assets are shown in the Balance Sheet at their historical cost. Depreciation is provided on the straight-line method so as to amortize the initial cost over the estimated useful lives, which are as follows: Buildings Machinery & Equipment Tools, furniture, information technology Vehicles years years 3-8 years 5 years 28

26 Impairment of Assets The company periodically reviews fixed assets for impairment by comparing the carrying value of the assets with their estimated discounted cash flows. If it is determined that an impairment loss has occurred, the loss is recognized during that period. Contingent Assets and Liabilities The company is exposed to contingent liabilities amounting to about 290 million EURO representing potential litigation. An amount of about 150 million EURO could result in liabilities. Contingent assets for litigation claims in favor of the company amount to about 190 million EURO. Events occurring after the Balance Sheet date The values of assets and liabilities at the Balance Sheet date are adjusted if there is evidence that subsequent events warrant a modification of those values. Related Party Transactions The company has loaned approximately 26 million EURO to various executive officers of the Company. Certain notes are non-interest bearing and others have interest rates ranging from 4.2% to 7.2%. The remaining outstanding balance as of December 31, 2000 was approximately 12 million EURO. The complete set of financial statements of the Rainbow company (Balance Sheet, Income Statement, Statement on Changes in Equity, Cash Flow Statement, and Disclosures to the Financial Statements) is given below. 29

27 Rainbow Company Balance Sheet at 31 December 1995 (in thousands of Togrogs) ASSETS Current Assets Cash 3,943 7,922 Accounts Receivable 156,749 82,839 Other Receivables 3,763 4,718 Receivable from Employees 5, less Allowance for Doubtful Accounts (13,542) - 151,979 87,599 Inventory 409, ,070 Prepayments to Suppliers 199,860 94,210 Prepaid Expenses 4,385 7,558 Total Current Assets 769, ,359 Non Current Assets Tangible Assets Property Plant and Equipment 177, ,353 Less Accumulated Depreciation (15,360) (13,916) 162, ,437 Construction in Process - Hotel 5,645 5,172 Construction in Process - Factory 75,469 68,016 Total Tangible Assets 243, ,625 Investment 1,600 1,600 Total Non Current Assets 244, ,225 TOTAL ASSETS 1,014, ,584 LIABILITIES Accounts Payable 371, ,681 Advances from Customers 14,623 18,708 Payable to Government 42,794 5,297 Interest Payable 121,379 19,544 Short Term portion of Long Term Debt 291,581 66,728 Other Short Term Payables 2,509 8,129 Total Short Term Liabilities 843, ,087 Long Term Notes Payable 982, ,126 Total Long Term Liabilities 982, ,126 TOTAL LIABILITIES 1,826,432 1,214,213 OWNERS' EQUITY Common Stock (404,830 shares, par value 100 tog) 40,483 40,483 Retained Earnings (852,192) (398,112) Total Equity (811,709) (357,629) TOTAL LIABILITIES AND OWNERS EQUITY 1,014, ,584 30

28 Rainbow Company Income Statement for the year ended 31 December 1995 (in thousands of Togrogs) REVENUES Sales of Manufactured Goods 866,812 1,033,530 Sales of Merchandise 196, ,460 Net Sales 1,063,164 1,370,990 Cost of Goods Sold- Manufactured Goods 765, ,006 Cost of Goods Sold- Merchandise 180, ,671 Total Cost of Goods sold 946,225 1,194,677 Gross Profit 116, ,313 OPERATING EXPENSES Selling Expense 9,033 5,155 Administrative Expense 43,255 28,979 Employee Benefits 63,463 34,033 Total Operating Expense 115,751 68,167 Operating Income (Loss) 1, ,146 NON-OPERATING EXPENSE Net Interest Expense 210,869 8,355 Foreign Exchange Loss 244, , , ,727 Income (loss) before Taxes (454,080) (168,581) Income Taxes - - Net Income (loss) for the period (454,080) (168,581) 31

29 Rainbow Company Statement of Changes in Equity For year ended 31 December 1995 (in thousands of Togrogs) ITEM Share capital Share premium Revaluation Translation reserve Accum. profit Balance at 31 December ,483 (216,341) (175,858) Change in accounting policy Restated balance Surplus on revaluation of properties Deficit on revaluation of investment Currency translation difference Net gains & losses not recognized in the Inc. St. Net income for the period (168,581) (168,581) Dividend (13,190) (13,190) Issue of share capital Balance at 31 December, year of ,483 (398,112) (357,629) Deficit on revaluation of properties Surplus on revaluation of investments Currency translation difference Net gains & losses not recognized in the Inc. St. Net profit for the period (454,080) (454,080) Dividend Issue of share capital Balance at 31 December, year of ,483 (852,192) (811,709) Total 32

30 Rainbow Company Cash Flow Statement for the year ended 31 December 1995 (in thousands of Togrogs) ITEM Cash flows from operating activities Net income (454,080) (168,581) Depreciation expenses 1,444 4,185 Loss on sale of fixed asset, investment Gain on sale of fixed asset and investment Increase in receivable, inventory, prepaid expenses (170,985) (60,950) Decrease in receivable, inventory, prepaid expenses 27,559 Increase in short term liabilities, unearned revenue 400,757 53,492 Decrease in short term liabilities, unearned revenue (9,705) (19,261) Net cash flows from operating activities (205,010) (191,115) Cash flows from Investment activities Proceeds from sale of fixed asset Purchase of fixed asset (20,136) (181,040) Proceeds from investment sold Purchase of investment Net cash flow from investment activities (20,136) (181,040) Cash flows from financing activities Bank loan received 224, ,241 State Financing received Donations received Repayment of loan (3,686) Repayment of Current portion of long term debt Issued stock Stocks re purchased in cash Payment of dividend (13,190) Net cash flow from financing activities 221, ,051 TOTAL NET CASH FLOW (3,979) (27,104) Beginning balance of cash and cash equivalents 7,922 35,026 Ending balance of cash and cash equivalents 3,943 7,922 33

31 SOLONGO Company Notes to the financial statements December The company was established to produce furniture and also to engage in trading activities. 1. Accounting policies Financial statements are prepared in accordance with IAS. Accounting policies are summarized below. a. Cash and cash equivalents Cash represents cash on hand and in bank that is available for use on demand b. Receivables The company records sales and accounts receivable when the finished goods are issued from warehouse for delivery to the buyer. It is common practice that the customers pay in advance for the goods. This advance payment is recorded as advance from customers and reported in short-term liabilities. The company also may pay for inventory in advance. This amount is recorded as advance to suppliers and reported as a current asset. c. Inventory Inventories are reported at lower of net realizable value or weighted average cost. Cost of work in process and finished goods consists of direct material, direct labor, and production overhead. An allowance (write off) has been provided for the low turnover inventory and spoiled goods when necessary. Net realizable value is the sales price less the sales and marketing cost to complete the goods and sale. d. Investment The company reports long-term investment at the cost, which is lower than net realizable value. Investment is the investment in stock of other companies. Temporary reduction in the value of long-term investments is recorded when it has actually occurred. e. Revenue Revenue represents net amount after the sales returns and allowances billed by the customer. Revenue is recognized when goods are delivered to customers and right of ownership is passed to the customer. f. Fixed asset Fixed assets are reported at historical cost less accumulated depreciation. Capitalized spare parts are included in the cost of machinery and equipment and depreciated at the same rate. Depreciation is based on the depreciation rates mandated by the Cabinet of the government. Annual depreciation rates are as follows: Land None Building 1.2% Equipment 9.0% Furniture 8.33% Vehicles 12.5% 34