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Monday 31 December 2007

Various Types of Transactions – Part 3, Collection from Sales or Services Rendered

For profit orientated entities, revenue is the "bloodline" of the businesses. The cash collected from invoicing or billing is vital in keeping the businesses up and running – meeting all sorts of daily expenses. Depending on the nature of the businesses, the sales invoices or bills issued to customers are for the sale of goods or services rendered. Generally the invoices or bills issued could be on cash term (pay on delivery of goods or services performed) or on credit term (e.g. 30 days, 60 days, 90 days etc). I have discussed in length the day book used in recording sales, the sales ledger and posting to the relevant accounts in the general ledger in my post:General Ledger? Journals? Day Books? Debtors Ledger? Creditors Ledger? Trial Balance . The double entry for recording both the cash sales and credit sales are shown below:

Cash Sales

Balance Sheet

Income Statement

DR

CR

DR

CR

Petty cash/cash at bank

XXXX

Sales

XXXX


Credit Sales

  1. Upon Recognition of Revenue

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Trade debtors

    XXXX

    Sales

    XXXX


  1. Upon Receiving Payments from Trade Debtors

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Petty cash/cash at bank

    XXXX

    Trade debtors

    XXXX


The recording of collection from sales or services rendered usually is a straight forward matter. The "grey area" or issue involved usually is associated with when revenue should be recognised. This is because different industries have their own unique ways of conducting the businesses. As stated in the Objective Section of International Accounting Standard (IAS) 18: Revenue, revenue is recognised when it is probable that future economic benefits will flow to the entity and these benefits can be measure reliably.

For a typical business selling goods to its customers, the point of recognising revenue usually is at the point when the substantial risks and rewards associated with the goods have been transferred to its customers – usually when goods is delivered to and accepted by its customers. IAS 18 states the criteria of recognising revenue from sale of goods as follows: -

Revenue from the sale of goods shall be recognised when all the following conditions have been satisfied:

(a) the entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

(b) the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

(c) the amount of revenue can be measured reliably;

(d) it is probable that the economic benefits associated with the transaction will flow to the entity; and

(e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.

For a typical business rendering services to its customers, recognition of revenue is depending on the stage of completion of the services at the measurement point (at the balance sheet date – it could be the end of the month or the end of the year depending on the financial period determined by the entity). Stage of completion is referring to at the measurement point, the percentage of the services completed. For example, if the percentage of completion is 50% and $100,000 is to be invoiced to the customer when the job is completed, $50,000 would be recognised as revenue. Please take note that the cost associated with the revenue should also be recognised using the same percentage of completion method. IAS 18 states the criteria of recognising revenue from services rendered as follows: -

When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction shall be recognised by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied:

(a) the amount of revenue can be measured reliably;

(b) it is probable that the economic benefits associated with the transaction will flow to the entity;

(c) the stage of completion of the transaction at the balance sheet date can be measured reliably; and

(d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

Many small businesses rendering services to their customers would find it very challenging to comply with the requirements of recognising revenue and the costs by way of percentage of completion method. This is because this requires a detailed tracking mechanism of the costs of each job and also the stage of completion throughout the life of each project/job. Some countries may have set their own requirement as to the application of accounting standards by giving exemption to "small entities" in respect of using percentage of completion method in recognising the revenue and costs. If this is the case, revenue and costs would usually be recognised using the completed contract method – i.e. the revenue and the relevant costs would be deferred from being recognised in the income statement until when the job is completed.

I will not discuss in detail the requirements of IAS 18 here as this article is just meant to be an introduction to the recording of revenue. If you are interested to know more about the issues involved regarding revenue, please refer to IAS 18. Appendix 1 of IAS 18 shows examples of different type of sales transactions including "Bill and Hold" sales, goods shipped subject to conditions, lay away sales under which the goods are delivered only when the buyer makes the final payment in a series of instalments, installation fees, servicing fees included in the price of the product, advertising commissions & etc. that are worth reading.

Sunday 23 December 2007

Various Types of Transactions – Part 2, Contribution of Capital from Owners

When owners inject cash into businesses as capital, the double entry to record this type of transactions is: -

 

Balance Sheet

Income Statement

 

DR

CR

DR

CR

     

Petty cash/cash at bank

XXXX

   

Capital

 

XXXX

  

Cash injections could be done by way of contributing "hard cash". If this is the case, the asset account debited is the Petty Cash account. Cash injections could also be done by way of the owners issue cheques. If this is the case, the asset account debited is the Cash at Bank account. Usually, if the amount involved is huge, cheques are issued instead of hard cash.

Following the rule of double entry recording system, whenever there is a debit entry made to an account (the Petty Cash of Cash at Bank account in this illustration), there must also be a credit entry made to an account (the Capital account in this illustration).

Please refer to Debits And Credits and The Accounting Equation if you need further explanations on double entry recording system and the accounting equation. If you need explanation on the difference between balance sheet and income statement, please refer to The Balance Sheet and The Income Statement . .

For sole proprietorships and partnerships, the account to be credited whenever there are capital injections is called the "Capital Account". Please take note that for many sole proprietorships and partnerships (especially for partnerships), there could be another account called "Current Account" maintained to record those transactions between the business and the partners such as profit attributable to each partner during the year, salary, interest on capital contributions, drawings OTHER THAN the capital transactions. Please refer to my post: Three Most Common Types of Small Businesses for an example of income statement and balance sheet of a partnership. Do not be confused with the current account opened with banking institutions. They are different. Capital Accounts and Current Accounts are maintained for each partner to show the capital position of each partner and their other dealings with the business.

For sole proprietorships, the importance of maintaining a separate Capital Account and Current account is not as apparent if compared to that of partnerships because all the transactions recorded in the Capital Account and the Current Account are attributable to only one person i.e. the owner. You may have come across many instances of the balance sheets prepared for sole proprietors with no separate Capital Account and Current Account maintained. In this case, all the transactions in the Capital Account and Current Account are recorded in one single account named "Capital Account". Example of the equity section of the balance sheet of a sole proprietor using this method of recording is as follows: -

Capital:

$

Balance at beginning of year

5,178

Add: Additional capital injections during the year

15,000

Add: Profit for the year

3,152

Less: Net drawings during the year

(8,000)

Balance as at end of year

15,330

Some partnerships may choose this method of recording. However, the drawback is that there is no ready information available on how much is the accumulated capital amount that has been contributed by each partner. There could also be situations whereby the net drawings of some partners exceeded the capital amount that they have contributed and nobody realise this!

For private limited companies, whenever there are capital injections, the account to be credited is called "Share Capital Account". Some call it "Paid-up Share Capital Account". This is because there could be instances of unpaid capital by shareholders. I will explain this in another topic. The main difference if compared with the balance sheet of sole proprietorships or partnerships is no separate current account maintained. Any withdrawal or advance of money to private limited companies by shareholders are recorded separately in the balance sheet account called Amount due by Shareholder (current asset) or Amount due to Shareholder (current liability) depending on whether it is the Company who owe the shareholder money or the other way round. The amount owing usually is classified as current asset or current liability because the nature of the transactions is short term in nature. Even though there are instances where the amount due to or due by shareholders remained unpaid/unsettled for more than a year because there was no repayment fixed in the first place, it is deemed to be repayable on demand and is therefore classified as current asset or current liability.

Please take note that it may not be a straight forward matter for a company to give or obtain loan or advances from shareholders or in fact any other parties because it is the board of directors that has the power to manage the business of the company and make decisions on the company's behalf – Not the shareholders. A shareholder may not sit on the board of directors and even though he or she does in fact sit on the board of directors, the decision making power lies with the board of directors, not on individual directors. Therefore, in making a decision whether the company should give or receive advance or loan from any party including shareholders, the board of directors has a duty to ensure that it is done on the company's best interest is taken care of. It should also be noted that shareholders are not "powerless" entirely. They usually are given the power in the articles of association of the company such as to elect directors, set their remuneration in members' annual general meetings and also on matters that would alter the capital of the company.

Saturday 22 December 2007

Three Most Common Types of Small Businesses – Sole Proprietorship, Partnership and Private Limited Company

Sole Proprietorship

This is the type of business which legally the business entity is not separated from the owner. However, do not get yourself confused with the Separate Entity Concept in accounting. Usually the business is registered with government under a trade name (either with some association with the name of the owner or a different name altogether) and this trade name will represent the business entity in the conduct of its business activities.

Partnership

This is the type of business with more than one owner. All the owners are called partners. In general all the partners contribute capital to the business and share common objectives of making the business successful and share the profits generated. Generally in law, the partners may have joint liability or joint and several liabilities. However, some countries may allow partnerships in which the liabilities of partners are limited. A partnership agreement could be used to set the terms and conditions among the partners.

Private Limited Companies

Some countries allow single member limited companies to be incorporated and some require minimum two members. The clear distinction of private limited companies from sole proprietorship and partnership is the liability of members is limited to the capital invested. Another distinct feature of limited private companies is that the governing body of the companies are the board of directors. The company incorporated carries its own identity under law and can sue and be sued by others. Of course when a company is found to have guilty legally, financial penalties are imposed because it is meaningless to impose jail terms on companies. In these circumstances, the relevant individuals behind the company (usually the directors) may be penalised financially, with jail terms or both. The relationship between the companies, the members/shareholders and the directors is unique and also can be a complex one whenever there are disputes between the company with third parties or disputes between members/shareholders or among the members of the board of directors. There are relevant sections in the Companies Act or Corporations Act of each country touching on this and of course there are common laws which have set down the legal principles since centuries ago.

You could find a lot of reading materials on the legal aspects of the above three types of business entities. Therefore, I only described them briefly in this post.

Example of Income Statement and Balance Sheet of a Sole Proprietor

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

- 90,875

Gross profit

68,395

Other income: -

Interest income

2,356

Operating expenses: -

Accountancy fee

- 800

Depreciation of property, plant and equipment

- 2,500

Donation

- 500

Electricity & water

- 3,340

Insurance premium

- 2,000

Printing & stationery

- 1,697

Rental of premises

- 12,000

Salaries

- 35,579

Upkeep of office

- 3,547

Telephone charges

- 1,285

Travelling, petrol & toll charges

- 2,648

- 65,896

Net profit for the year

4,855

Retained profits B/F

27,654

Retained profits C/F

32,509

Balance Sheet as at 31 December 2006

$

Non-current assets

Property, plant and equipment

15,000

Current assets

Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Cash and bank balances

10,639

25,297

Current liabilities

Trade payables

- 3,588

Other payables and accruals

- 2,575

- 6,163

Net current assets

19,134

34,134

Financed by: -

Capital

15,000

Retained profits

32,509

Net drawings

- 13,375

34,134

Example of Income Statement and Balance Sheet of a Partnership

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

- 90,875

Gross profit

68,395

Other income: -

Interest income

2,356

Operating expenses: -

Accountancy fee

- 800

Depreciation of property, plant and equipment

- 2,500

Donation

- 500

Electricity & water

- 3,340

Insurance premium

- 2,000

Printing & stationery

- 1,697

Rental of premises

- 12,000

Salaries

- 35,579

Upkeep of office

- 3,547

Telephone charges

- 1,285

Travelling, petrol & toll charges

- 2,648

- 65,896

Profit for the year

4,855

Add: -

Interest on partner's drawings

Partner A

1,500

Partner B

2,000

3,500

Less: -

Partner's salary

Partner A

- 15,000

Partner B

- 20,000

- 35,000

Partner's commision

Partner A

- 3,000

Partner B

- 2,000

- 5,000

Interest charged on partner's capital

Partner A

- 2,500

Partner B

- 3,500

- 6,000

Net loss for the year

- 37,645

Shared as follows: -

Partner A - 60%

- 22,587

Partner B - 40%

- 15,058

- 37,645

Analysed as follows: -

Partner A

Partner B

Total

$

$

$

Shared net loss for the year

- 22,587

- 15,058

- 37,645

Less: -

Interest on partner's drawings

- 1,500

- 2,000

- 3,500

Add: -

Partner's salary

15,000

20,000

35,000

Partner's commision

3,000

2,000

5,000

Interest charged on partner's capital

2,500

3,500

6,000

Net profit for the year

- 3,587

8,442

4,855

Note 1

Note 1

Balance Sheet as at 31 December 2006

$

Non-current assets

Property, plant and equipment

15,000

Current assets

Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Cash and bank balances

10,639

25,297

Current liabilities

Trade payables

- 3,588

Other payables and accruals

- 2,575

- 6,163

Net current assets

19,134

34,134

Financed by: -

Partner A

Partner B

Total

$

$

$

Capital account

9,000

6,000

15,000

Current account

Balance B/F

45,874

24,280

70,154

Shared net loss for the year

- 22,587

- 15,058

- 37,645

Net drawings during the year

- 12,000

- 5,000

- 13,375

Balance C/F

11,287

4,222

19,134

20,287

10,222

34,134


Note 1: the net loss for the year for Partner A of $3,587 and net profit of Partner B of $8,422 were derived by calculating from the share of net loss for the year of $37,645, taken into account of the interest on capital, interest on drawings, salary and commission of each partner. You would not be able to know how much is each partner's share of profit or loss directly from the net profit of $4,855.

Example of Income Statement and Balance Sheet of a Private Limited Company

Income Statement for the year ended 31 December 2006

$

Sales

159,270

Cost of Sales

- 90,875

Gross profit

68,395

Other income: -

Interest income

2,356

Operating expenses: -

Accountancy fee

- 800

Depreciation of property, plant and equipment

- 2,500

Donation

- 500

Electricity & water

- 3,340

Insurance premium

- 2,000

Printing & stationery

- 1,697

Rental of premises

- 12,000

Salaries

- 35,579

Upkeep of office

- 3,547

Telephone charges

- 1,285

Travelling, petrol & toll charges

- 2,648

- 65,896

Net profit for the year

4,855

Retained profits B/F

27,654

Retained profits C/F

32,509

Balance Sheet as at 31 December 2006

$

Non-current assets

Property, plant and equipment

15,000

Current assets

Inventories

5,200

Trade receivables

6,000

Other receivables, deposits & prepayments

3,458

Amount due by shareholders

13,375

Note 2

Cash and bank balances

10,639

38,672

Current liabilities

Trade payables

- 3,588

Other payables and accruals

- 2,575

- 6,163

Net current assets

32,509

47,509

Financed by: -

Share capital

15,000

Retained profits

32,509

47,509


Note 2: in this example, the net drawings of the owner in the example of a Sole Proprietor has been shown as amount due by shareholders for comparison purposes

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