BUCHAREST ACADEMY OF ECONOMIC STUDIES

ACCOUNTING
CSIE
- lecture notes -

-part I

Mihaela Ionascu
Senior lecturer, PhD

1
 Chapter I. WHAT IS ACCOUNTING? AN INTRODUCTION

Why studying accounting?

Accounting is a necessity for a (small) business owner;

Working in accounting related services:
Designing accounting software;
Implementing, developing or administrating integrated business software systems
(such as SAP);
Information systems audit - technological audits verify that information technologies
are appropriately chosen, configured, and implemented.

What is accounting?

Accounting is a service activity aimed at providing quantitative information, primarily financial in

nature about economic entities that is intended to be useful in making economic decisions, in making
resolved choices among alternative courses of action.

Definition given by the American Institute of Certified Public Accountants (AICPA) in 1970.

Generally accepted
accounting principles
(GAAP)

Accounting Information System

Data
Organizations Managerial
Financial Accounting
Accounting

External Internal
audit Information audit

External Internal
users users

Fig. 1: Accounting as an information system

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ORGANIZATIONS accounting entities

According to their purpose, the organizations may be classified into either:

non-for-profit organizations; and
business organizations.

In turn, business organizations may be further classified according to their legal form into four
major types of business entities:

Proprietorship Partnership Corporation

Two or more
Owners One person Many individuals
individuals
Not a separate legal Not a separate legal A separate legal
Legal status
entity entity entity
Owners personal Owners personal Limited to owners
Risk of
resources are at resources are at investment in the
ownership
stake stake business
Duration of Indefinite, possible
Limited Limited
life unlimited
Transferable by
Transferability
Difficult Difficult means of sale of
of ownership
stock
Accounting Separate economic Separate economic Separate economic
treatment unit unit unit

A limited liability company is, usually, a partnership with all its characteristics, except that it
provides limited liability for all of its members.

Based on the activities performed, business organizations can be grouped into:

service companies;
merchandising companies;
manufacturing companies.

USERS OF ACCOUNTING INFORMATION

Suppliers of funds (most important users):

Owners: investors (actual and potential) for analyzing the viability and profitability of their
investment and determining any future course of action.

Creditors: for determining the credit worthiness of the organization. Terms of credit are set by
creditors according to the assessment of their customers' financial health. Creditors include suppliers
as well as lenders of finance such as banks.

The State:
Tax Authorities: for determining the credibility of the tax returns filed on behalf of the company.
National statistics macro accounting - accounting for the total or aggregate economic activities
of a nation. Macro accounting forms the basis for official statistics that summarize a nation's economic
development and performance (e.g. gross domestic product).

Customers: for assessing the financial position of its suppliers which is necessary for them to
maintain a stable source of supply in the long term.

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Management: for analyzing the organization's performance and position and taking appropriate
measures to improve the company results.

Employees: for assessing company's profitability and its consequence on their future remuneration
and job security.

General Public: General public may be interested in the accounts of the business for social
obligation of business. The public is interested in pollution abatement, community welfare program,
ecological benefits or hazards out of operation of the business. Public is interested to know how the
national resource are being utilized by the organization and their contribution in the economy.

IASB conceptual framework:

The primary users of financial accounting information are present and potential investors, lenders and
other creditors, who use that information to make decisions about buying, selling or holding equity or
debt instruments and providing or settling loans or other forms of credit.

The primary users need information about the resources of the entity not only to assess an entity's
prospects for future cash inflows but also how effectively and efficiently management has discharged
their responsibilities to use the entity's existing resources (i.e., stewardship).

General purpose financial reports cannot provide all the information that users may need to make
economic decisions. They will need to consider pertinent information from other sources as well.

Other parties, including prudential and market regulators, may find general purpose financial reports
useful. Regulators are not considered a primary user and general purpose financial reports are not
primarily directed to regulators or other parties.

POP QUIZ:

The main purpose of financial reporting is to:

a) Help the managers to run the business;
b) Calculate taxable income;
c) Enable investors and other fund suppliers to make economic decisions;
d) Calculate prudently distributable profit;
e) None of the above is correct;

SOURCES OF GAAP

Generally Accepted Accounting Principles (or GAAP for short) - a set of standards, conventions,
rules and methods applied by accountants when producing financial accounting information.

Standards setters/accounting regulators source of GAAP

National standards setters - FASB (Financial Accounting Standards Board) in USA, ASB
(Accounting Standards Board) in UK or the Ministry of Finance in Romania;

Regional standard setters EU Accounting Directives;

International standards setters IASB (International Accounting Standards Board) issue IFRS
(International Financial Reporting Standards)

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ACCOUNTING INFORMATION

Accounting periods: one year long lengths of time for which profit can be calculated (financial
year);

Calendar year - from January 1 to December 31;

Natural business year from February 1 to January 31

Financial statements convey financial information on an entitys resources and claims and
changes in its resources and claims.

Annual report includes financial statements accompanied by auditors letter and management
discussion and analysis.

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Chapter II. FINANCIAL STATEMENTS

A complete set of financial statements includes:

1. Balance sheet (statement of financial position);

2. Statement of comprehensive income;
3. Statement of cash flows;
4. Statement of changes in owners equity;
5. Notes

A simplified set of financial statements includes:

1. Balance sheet (statement of financial position);

2. Income statement;
3. Notes

POP QUIZ:

Financial statements include a balance sheet, an income statement and a statement of changes in
equity. Which two of the following are also included within the financial statements?

a) A directors' report
b) A cash flow statement
c) An auditor's report
d) Notes
e) None of the above is correct

2.1. Balance Sheet (Statement of financial position)

A summary of resources and claims of an entity as of the end of the accounting period - a snap shot
a status report.

Resources Sources of resources (claims) Rights Obligations

Internal sources Owners
equity
Assets External sources Liabilities Activul Pasivul
patrimoniului patrimoniului
Total Resources Total Claims
(Assets) (Owners equity + Liabilities)
Activ Pasiv

Economic approach Juridical approach

Fundamental equation of accounting

Assets = Liabilities + Owners Equity

An asset is a resource controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity (Framework Para 49)

Recognition criteria:
i) There is a high probability that future economic benefits will flow to the entity;
ii) the cost/value must be measured reliably.

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A liability is a present obligation of the enterprise arising from past events, the settlement of which is
expected to result in an outflow from the enterprise of resources embodying economic benefits
(Framework Para 49)

Recognition criteria:
i) There is a high probability that future economic benefits will exit the entity;
ii) the cost/value must be measured reliably.

Ownerss equity - residual interest in the assets of the enterprise after deducting all its liabilities.

POP QUIZ:

1. Which of the following are not assets:

a) The human resources of the company;

b) Cash in current accounts of the entity in the amount of 30,000 lei;

c ) A lottery ticket purchased 2 days ago for $ 10;

d ) Expenditure on research conducted for a new product in the amount of 30,000 lei;

e) Goodwill created by the company.

2. Which of the following items are not liabilities:

a) The value of a motor vehicle that the manager intends to purchase in the following year;

b ) The first instalment on a bank loan contracted in the current year payable in the following year .

3. Please indicate (tick ) whether the following items are assets liabilities or owners equity.

Items Assets Liabilities Owners Equity

Cash at bank
Bank loans
Suppliers/Accounts payable
Stamps
Licenses
Customers/Accounts receivable
Advanced payments made to

suppliers
Provisions for litigation
Buildings
Share capital
Equipment
Human resources Not in the b-s
Shares of Co. A
Wages payable

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 Items Assets Liabilities Owners Equity
Office supplies
Advanced payments received from

customers
Land
Merchandise
Raw materials
Finished goods
Consumables
Income tax payable
VAT receivable
Long term bank deposits
Franchise
Bonds of Co. B
Revaluation reserves
Retained earnings
Share premium
Net profit for the year
Goodwill created Not in the b-s
Deferred revenues
Deferred expenses (Prepayments)
Treasury stock (own shares) with minus

Balance-sheet layouts:

a) Horizontal Presentation

The horizontal presentation uses a format that present assets on the left and liabilities and equity on
the right.

Describes: Assets = Liabilities + Owners Equity

(b) Vertical Presentation

The vertical presentation shows the assets followed by liabilities and equity directly below the assets.

Describes:

Assets

Liabilities

Owners Equity

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Assets and liabilities are classified as current and non-current.

Assets are classified in order of their liquidity (In Europe ascending)

Liabilities are classified in order of their maturity (In Europe ascending in horizontal format,
descending in vertical format)

Examples:

ASSETS SHAREHOLDERS' EQUITY

Non-Current Assets (Fixed Assets) Paid-in Capital

Property, Plant and Equipment (PPE) Share Capital (Ordinary Shares, Preference
Less : Accumulated Depreciation Shares)
Investment Securities Share Premium
Intangible Assets (Patent, Copyright, Trademark, Less: Treasury (Own) Shares
etc.) Retained Earnings
Less : Accumulated Amortization Revaluation Reserve
Goodwill Accumulated Other Comprehensive Income
Other Non-Current Assets
LIABILITIES
Current Assets
Cash and Cash Equivalents Non-Current Liabilities (Creditors: amounts
Accounts Receivable (Debtors) falling due after more than one year)
Less : Allowances for Doubtful Accounts Loans Payable
Inventories Issued Debt Securities, e.g. Bonds Payable
Prepaid Expenses Provisions, e.g. Pension Obligations
Investment Securities (Held for trading) Other Non-Current Liabilities, e.g. Lease
Other Current Assets Obligations
Current Liabilities (Creditors: amounts
falling due within one year)
Accounts Payable
Current Income Tax Payable
Current portion of Loans Payable
Short-term Provisions
Other Current Liabilities, e.g. Unearned Revenue,
Security Deposits

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Balance Sheet of XYZ, Inc.
As of 31 December 2014

ASSETS

Non-Current Assets (Fixed Assets)

Property, Plant and Equipment (PPE)
Less : Accumulated Depreciation
Investment Securities
Intangible Assets (Patent, Copyright, Trademark, etc.)
Less : Accumulated Amortization
Goodwill
Other Non-Current Assets

Current Assets
Cash and Cash Equivalents
Accounts Receivable (Debtors)
Less : Allowances for Doubtful Accounts
Inventories
Prepaid Expenses
Investment Securities (Held for trading)
Other Current Assets

LIABILITIES and SHAREHOLDERS' EQUITY

LIABILITIES

Current Liabilities (Creditors: amounts falling due within one year)

Accounts Payable
Current Income Tax Payable
Current portion of Loans Payable
Short-term Provisions
Other Current Liabilities, e.g. Unearned Revenue, Security Deposits

Non-Current Liabilities (Creditors: amounts falling due after more than one year)
Loans Payable
Issued Debt Securities, e.g. Bonds Payable
Provisions, e.g. Pension Obligations
Other Non-Current Liabilities, e.g. Lease Obligations

SHAREHOLDERS' EQUITY

Paid-in Capital
Share Capital (Ordinary Shares, Preference Shares)
Share Premium
Less: Treasury Shares
Retained Earnings
Revaluation Reserve
Accumulated Other Comprehensive Income

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Noncurrent assets are ones the company expects to hold for at least one year.

Typical examples of long-term assets are property, plant, and equipment currently in use by the
company in day-to-day operations.

Fixed tangible assets: This category is the companys property, plant, and equipment.
Includes long-lived assets, such as a car, land, buildings, office equipment, and computers.

Long-term (financial) investments: These are assets held by the company, such as
bonds, stocks, or notes.

Intangible assets: These assets lack a physical presence (you cant touch or feel them).
Patents, trademarks, and goodwill classify as noncurrent assets.

Current assets are assets reasonably expected to be sold, consumed, or exhausted through the
normal operations of a business within the current accounting period or operating cycle (whichever
period is longer).

Examples of current assets are cash, receivables, short term (financial) investments, and inventory.

Inventory (stock) refers to the goods and materials that a company holds.

Raw materials - materials and components scheduled for use in making a product.

Work in process - materials and components that have begun their transformation to finished
goods.

Finished goods - goods ready for sale to customers.

Merchandise- goods held for resale.

Receivables: claims that are expected to be collected. For example, accounts receivable
(customers): Business A sells merchandise to Business B with the agreement that B pays for the
merchandise within 30 business days.

Short term (financial) investments short term bank deposits, marketable securities

Cash: Cash includes:

companys operating checking/current account, which the business uses to receive customer
payments and pay business expenses, or
petty cash - a small amount of discretionary fund in the form of cash used for expenditures
where it is not sensible to make any disbursement by cheque, because of the inconvenience
and costs of writing, signing, and then cashing the cheque.

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Prepaid expenses: are any expense the business pays for in advance, such as rent, insurance, office
supplies, postage, travel expense, or advances to employees. They also list as current assets, as long
as the company envisions receiving the benefit of the prepaid items within 12 months of the balance
sheet date. It is recorded as an asset until delivery is made, at which time it is converted into
expenses.

Long-term liabilities
Long-term liabilities are debts due in more than 12 months.
Loans Payable: This account tracks any long-term loans, such as a mortgage on your
business building. Most businesses have separate loans payable accounts for each of their long-
term loans.
Notes Payable: Some businesses borrow money from other businesses using notes, a
method of borrowing that doesnt require the company to put up an asset, such as a mortgage on
a building or a car loan, as collateral. This account tracks any notes due.
In addition to any separate long-term debt you may want to track in its own account, you may also
want to set up an account called Other Liabilities that you can use to track types of debt that are so
insignificant to the business that you dont think they need their own accounts.

Current liabilities are debts due in the next 12 months.

Accounts Payable: This account tracks money the company owes to vendors, contractors,
suppliers, and consultants that must be paid in less than a year. Most of these liabilities must be
paid in 30 to 90 days from initial billing.
Sales Tax Collected (VAT payable): You may not think of sales tax as a liability, but
because the business collects the tax from the customer and doesnt pay it immediately to the
government entity, the taxes collected become a liability tracked in this account. A business usually
collects sales tax throughout the month and then pays it to the local, state, or federal government
on a monthly basis.
Accrued Payroll Taxes: This account tracks payroll taxes collected from employees to pay
state, local, or federal income taxes as well as Social Security and Medicare taxes. Companies dont
have to pay these taxes to the government entities immediately, so depending on the size of the
payroll, companies may pay payroll taxes on a monthly or quarterly basis.

Deferred income also known as deferred revenue, unearned revenue, or unearned income)
is money received for goods or services which have not yet been delivered. It is recorded as a liability
until delivery is made, at which time it is converted into revenue.

Owners equity accounts

Every business is owned by somebody. Equity accounts track owners contributions to the business as
well as their share of ownership. For a corporation, ownership is tracked by the sale of individual
shares of stock because each stockholder owns a portion of the business.
Here are the basic equity accounts that appear in the Chart of Accounts:
Common Stock (Share capital): This account reflects the value of outstanding shares of
stock sold to investors. A company calculates this value by multiplying the number of shares issued
by the par value of each share of stock.
Net Profit for the year Revenues Expenses.
Retained Earnings: This account tracks the profits or losses accumulated since a business
was opened. At the end of each year, the profit or loss calculated on the income statement is used
to adjust the value of this account.
- Reserves other comprehensive income revaluation reserve:

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 POP QUIZ:

1. Tangible assets on the balance sheet should include:

a. equipment
b. taxes payable
c. trademarks
d. bonds payable
e. none of the answers are correct

2. The current asset section of the balance sheet should include:

a. land
b. trademarks
c. investment in C Company (for purposes of control)
d. dividends payable
e. work in process inventory

3. The current liability section of the balance sheet should include:

a. buildings
b. goodwill
c. land held for speculation purposes
d. accounts payable
e. none of the answers are correct

4. Which of the following is not a current asset?

a. marketable securities
b. material inventory
c. unearned rent income
d. prepaid interest
e. prepaid insurance

5. Treasury stock is best classified as:

a. a current asset
b. a long-term investment
c. a contra liability
d. a reduction of stockholders' equity
e. a reduction of retained earnings

6. Which of the following is a current liability?

a. prepaid insurance
b. account receivable
c. unearned rent revenue
d. building
e. common stock

7. Which of the following accounts would not be classified as an intangible?

a. franchises
b. research costs
c. patent
d. trademarks
e. Goodwill acquired

TRUE/FALSE

1.Current assets are listed on the balance sheet in order of liquidity.

2.Long-term investments, usually stocks and bonds of other companies, are often held to maintain a business
relationship or exercise control.

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2.2. The income statement and the companys performance

Revenues Expenses = +/- Profit/Loss (Net income)

Revenues are increases in economic benefits during the accounting period in the form
of inflows or enhancements of assets or decreases of liabilities that result in increases
in equity, other than those relating to contributions from equity participants.

Expenses are decreases in economic benefits during the accounting period in the form
of outflows or depletions of assets or increases of liabilities that result in decreases in
equity, other than those relating to distributions to equity participants.

Example 1. A company sold merchandise which was previously purchased for 500 lei to a customer
for 700 lei cash.

Assets = Liabilities + Owners Equity-P* + Profit

+ 200 + 200
* Owners Equity-P = the remaining owners equity items after profit deduction

Assets = Liabilities + Owners Equity-P* + Revenue Expense

s s
+ 700 + 700
500 +500
* Owners Equity-P = the remaining owners equity items after profit deduction

Example 2. On December 4, a company purchased raw materials from a foreign supplier in amount
of 100 Euros. At that date the exchange rate was 1 Euro = 3,8 lei. Thus, a liability was recorded in
amount of 380 lei. At the end of the year, the exchange rate was 1 Euro = 3,5 lei. Accordingly, the
liability decreased with 30 lei, from 380 to 350 lei.

Assets = Liabilities + Owners Equity-P* +

Revenue Expense
s s
30 lei + 30 lei
* Owners Equity-P = the remaining owners equity items after profit deduction

Contrariwise, had the exchange rate at the end of the year been 1 Euro = 4 lei, the liability would
have increased with 20 lei, from 380 lei to 400 lei, resulting in a decrease in profit in amount of 20:

Assets = Liabilities + Owners Equity-P* + Revenue Expense

s s
+ 20 lei + 20 lei
* Owners Equity-P = the remaining owners equity items after profit deduction

Example 3. Mary and John Power operated and ice-cream shop in the park for one summer, renting
all the necessary facilities for 30,000 lei. During the summer, they purchased merchandise (ice-cream)
in amount of 150,000 lei, and sold it to customers for 300,000 lei.

Revenues
Less expenses
Merchandise
Wages
Rental
Other costs
Profit (net income)

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Example 4:
A manufacturing companys typical activities:
June 22, 2007:
July 12, 2007:
November 2, 2007:
December 5, 2007:
January 15, 2008:
February 4, 2008:
When should the revenue be recognized?
Purchase raw materials, store them
Start work on processing the raw materials
Finish goods, store them
Receive order for goods, order accepted
Goods delivered, invoice issued
The customer pays the invoice for the goods delivered

Revenue recognition criteria:

Earned. A revenue shall not be recognized until it is earned, that is, when the entity has
substantially accomplished what it must do to be entitled to the benefits represented by the
revenues.

High probability of obtaining economic benefits. A revenue shall be recognized only when it is
realized (cashed) or realizable (i.e. it has a high probability of realization). Revenues are
realized when products (goods or services), merchandise, or other assets are exchanged for
cash or claims to cash. Revenues and gains are realizable when related assets received or
held are readily convertible to known amounts of cash or claims to cash.

Reliable measurement. A revenue shall be recognized when there is a reliable way to measure
the economic benefits that it represents.

After the revenue recognition, all expenses incurred should be matched against those revenues.

Expenses recognition criteria:

Direct matching: the revenues and expenses effects of a given event should be recorded in the
same accounting period.

Example 1. December 13, 2008, All Mark Ltd. purchased merchandise in amount of
300 lei. Half of the merchandise was sold on January 11, 2009, for a price of 500 lei, and
half on February 2010 for 600 lei.

Years 2008 2009 2010

Balance-Sheet/ Assets - Merchandise Revenues 500 Revenues 600
Income Statement (recognized at acquisition cost: Expenses 150 Expenses 150
items 300 lei) Assets (merchandise) only 150 Assets (merchandise) 0.

Costs of the period: costs associated with activities of the period are expenses of the period . Some
items of expenses are associated with a specific accounting period, although they cannot be
linked to a certain revenue recognized in that period. These expenses generally refer to the
costs of being in business, and they are usually called period costs.

Example 1. The accountants salary is reported as an expense in the period in which

he/she works. The amount of his/her salary is not affected by the volumes of sales, and,
consequently, there is no direct relationship between the sales revenues and the salaries
cost. The accountants salary is one of the costs of operating the business, and in that
sense, it is only indirectly related to the revenues of the period.

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Costs not associated with future periods: costs that cannot be associated with revenues of
future periods are expenses of the current period. If an item of cost is not directly (direct
matching) or indirectly (costs of the period) related to the operations of the period, it can still
be recognized as an expense during the financial year if it cannot be associated with future
economic benefits. An item of cost is either an assets or an expense. In order to be an asset,
it has to be expected to generate future economic benefits. In absence of the prospect of
future economic benefits, the item of cost is recognized as an expense.

Example 2. On December 1, 2008, a coffee shop purchases chocolate cookies to serve

to its customers. When the cookies were purchased, they were recognized as assets, as
they were expected to be sold. However, if the cookies are not consumed within 10 days
(i.e. their expiry period), they will be recognized as expenses for the year 2008, as they are
not expected to generate any future economic benefits.

Assets Cost incurred during

as of January 1, 2008 the year 2007

Expenses of the year 2008:

Was there a direct
relationship with Yes
Example: Cost of merchandise sold
the revenues of the
period?

No

Was there an
association with Yes
Example: Office expenses
activities of the
period?

No

Can the item be

associated with No
Example: Obsolete merchandise
revenues of future
periods?

Yes

Assets
as of December 31, 2008

Criteria for expenses recognition

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 Income statement layouts

Companies are required to analyze expenses either by their nature or by function, accordingly
there are two layouts for the income statement:

(1). income statement with expenses classified by nature (i.e. their economic nature: raw
materials, staff costs, depreciation, etc.), and

(2). income statement with expenses classified by function (i.e. the function of an enterprise:
production, distribution, administrative, research and development etc.)

Income statement with expenses classified by function

Revenue (Sales/Turnover) 1
Cost of sales/Cost of goods sold 2
Gross margin 3=1-2
Other operating revenues 4
Distribution costs 5
Administrative expenses 6
Research and development cost 7
Other operating expenses 8
Profit or loss from operating activities 9=3+4-5-6-7-8
Financial revenues 10
Finance costs 11
Other financial expenses 12
Profit or loss from financial activities 13=10-11-12
Profit or loss for the year 14=9+13
Income tax 15
Net profit or loss for the year 16=14-15

Income statement with expenses classified by nature

Revenue (Sales/Turnover) 1
Other operating revenues 2
Total operating revenues 3=1+2
Variation in inventories 4
Capitalized cost of tangible non-current assets 5
Expenses with raw materials and consumables used 6
Personnel expenses/Staff costs 7
Depreciation and amortization expenses 8
Other operating expenses 9
Total operating expenses 10=4+5+6+7+8+9
Profit or loss from operating activities 11=3-10
Financial revenues 12
Finance costs 13
Other financial expenses 14
Profit or loss from financial activities 15=12-13-14
Profit or loss for the year 16=11+15
Income tax 17
Net profit or loss for the year 18=16-17

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 Comments about the items listed in the two layouts are given below.

Revenues: the total invoice price of the goods sold and services rendered less any sales returns and
allowances, sale or trade discounts. Sales returns are the sales value of goods returned by
customers and allowances are payments made to customers because the goods were
defective or for some other reasons. Trade discounts are percentage deductions from the
list/catalog price granted in order to increase the volume of sales (e.g. 2% discount for a
purchased quantity exceeding 100 units). Sales discounts percentage deductions from the
list/catalog price granted in order to encourage early payments (e.g. 3% discount offered to
customers who pay within 10 days from the date of the invoice). The item is usually termed
net sales (or just sales) or net turnover.

Cost of sales: because of the matching principle, when the profit is increased with the value of
goods sold and services rendered, it is also decreased by the cost of those goods or services.
The cost of goods or services sold is called the cost of sales. In manufacturing companies
and retailing business the item is often called cost of goods sold. This item only appears in
an income statement with expenses classified by function.

Gross margin: the difference between revenues from sales and cost of sales. It only appears in an
income statement with expenses classified by function.

Other revenues: revenues earned from activities not associated with the sale of the companys
goods and services, such as rental revenue for an auto manufacturer.

Expenses: they may be analyzed by nature (staff cost, raw materials used etc.) or by the function
of the enterprise in which they were incurred (administration, distribution etc.). For instance,
the administrative costs subsume all the costs incurred for administration purposes regardless
of their nature. Contrariwise, staff costs include all personnel cost regardless of whether the
employs were involved in production, administrative or distribution activities. Finance cost is
the amount of expenses incurred in financing the companys activities and it is mainly
composed of interest and other fees paid to various creditors. Nearly all companies report a
pretax profit amount before subtracting the income tax expense.

Profit or loss from operating activities: a company that shows an operating profit in the income
statement wants to distinguish the profit generated by its primary operating activities from its
non-operating revenues and expenses. However, many companies reject this distinction,
considering that, for instance, the interest expense reflects cost of financing assets used in its
operations and therefore should not be presented in a way that suggests it is a non-operating
item. Instead of the operating - non-operating distinction, the ordinaryextraordinary
one was required. Ordinary profit is the one earned in the normal course of business, whereas
extraordinary items of revenues or expenses are generated by an unusual, infrequently
occurring event or transaction, such as an earthquake, a hurricane, or an expropriation.
Neither of the two distinctions are any longer required by the international accounting
standards, although both of them are enforced by the Romanian accounting regulations.

Variation in inventories: an amount which only appears in an income statement with expenses
classified by nature in order to offset the part of the productions cost which was recognized
as an expense although the revenues from sales was not yet earned and recorded. According
to the matching principle, which was explained above, expenses related to the production of
goods or rendering of services should not be recognized until the revenues form sales are
recorded. However, in an income statement with expenses classified by nature, all expenses
are recorded regardless of whether they are associated with revenues from sales or not.
Consequently, an adjustment has to be made, so that only the cost of goods sold could be
taken into account when computing the net profit for the year. More exactly, the information
regarding the beginning and ending balance of inventory is employed as follows:

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 Inventories as of the beginning of the year
+ Costs of inventory produced during the year,
(classified by their nature:
Raw materials used
Other consumables used
Wages paid to manufacturing workers
Depreciation of equipments, etc.)
- Cost of inventory sold during the year
= Inventories as of the end of the year

Since in an income statement with expenses classified by nature, all the costs of inventories
produced during the year are recognized as expenses and presented by their nature, variation in
inventories (that is: Inventories as of the end of the year Inventories as of the beginning of the
year) is also presented in the income statement, so that the expenses recognized by their nature
could be adjusted in order to have only the cost of goods sold matched against revenues from sales.

Costs of inventory produced during the year,

(presented in the income statement as expenses classified by their nature:
Raw materials used
Other consumables used
Wages paid to manufacturing workers
Depreciation of equipments, etc.)
Variation in inventories (Inventories at the end of the year
Inventories at the beginning of the year)
= Cost of inventory sold during the year

Capitalized cost of tangible non-current assets: an amount which only appears in an income
statement with expenses classified by nature in order to offset the costs of producing
tangible or intangible assets which were recognized as expenses by their nature although no
revenues were yet earned and recorded. The purpose of this item is similar to the one played
by variation in inventories in the case of goods manufactured and services rendered.

Example 1. The following information is available at the end of the year N:

Revenues and expenses:

(lei) N N-1
(a) Revenues from the sale of finished goods 5,800,000 5,600,000
(b) Raw materials used 2,000,000 1,800,000
(c) Consumables used for: 2,000,000 1,700,000
(c).1 production purposes 1.000.000 800.000
(c).2 administrative purposes 500.000 400.000
(c).3 distribution purposes 300.000 150.000
(c).4 research and development activities 200.000 350.000
(d) Personnel expenses 1.700.000 1.500.000
related to employees involved in:
(d).1 production activities 600.000 500.000
(d).2 administrative activities 300.000 250.000
(d).3 distribution activities 500.000 400.000
(d).4 research and development activities 300.000 350.000
(e) Depreciation and amortization expenses 1.100.000 900.000
related to assets used in
(e).1 production activities 400.000 300.000
(e).2 administrative activities 200.000 200.000
(e).3 distribution activities 130.000 110.000

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 (e).4 research and development activities 370.000 290.000
(f) Impairment losses related to buildings 100.000
employed in the administrative sector
(g) Interest expense 200.000 300.000
(h) Interest revenue 170.000 60.000
(i) Water expenses 30.000 20000
(related to production activities)
(j) Other financial revenues 160.000 220.000
(k) Other financial expenses 140.000 310.000
(l) Variation in inventories 1.200.000 900.000
(m) Income tax expense 10.000 50.000
Finished goods at the beginning of the year 2008: 1,200,000 lei

Based on the information given, the income statement may be drawn up either with
expenses classified by nature or by function, as follows:

Income statement with expenses classified by nature

N N-1
Sales (a)
Variation in inventories (l)
Raw materials and consumables used (b) + (c)
Staff costs (d)
Depreciation and amortization expenses (e)
Impairment losses (f)
Other expenses (i)
Interest revenue (h)
Interest expense (g)
Net finance cost
Other financial revenues (j)
Other financial expenses (k)
Profit for the year
Income tax expense (m)
Net profit for the year

For the income statements with expenses classified by function, the cost of goods sold has to be
computed:

N N-1
Finished goods as of the beginning of the year
+ Production cost of goods finished during the year:
Raw materials (b)
Consumables (c).1
Staff costs (d).1
Depreciation and amortization (e).1
Water (i)
(*)
Finished goods as of the end of the year
= Cost of goods sold
(*)
Finished goods as of the end of the yearN =
= Finished goods as of the beginning of the year N + Variation in inventoriesN

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 Income statement with expenses classified by function

Sales (a)
Cost of goods sold
Gross margin
Distribution costs (c).3+(d).3+(e).3
Administrative expenses (c).2+(d).2+(e).2 +(f)
Research and development cost
(c).4+(d).4+(e).4
Interest revenue (h)
Interest expense (g)
Net finance cost
Other financial revenues (j)
Other financial expenses (k)
Profit for the year
Income tax expense (m)
Net profit for the year

Other concepts of profit

Taxable income: many business entities calculate their taxable income and pay taxes bases
on this income. However, although the amounts of revenues and expenses used to determine this
kind of income are very similar to the ones measured in accordance with the accounting regulations,
they are not identical with them, and the differences between the profit for the year and the taxable
income are sufficiently significant.

Comprehensive income: Accounting profit focuses on actual transactions, but the wealth of
the company may as well be generated by unrealized changes in the value of the companys assets
and liabilities. For instance, the value of the companys patens and brand names may increase or
decrease, as well as the value of the companys buildings, equipments or securities, depending on the
supply and demand operating on the market. This kind of unrealized changes are recognized in the
companys reserves rather than taken into account when the profit is computed. Accordingly
companies report a comprehensive income which takes into account all their gains and losses, that
is: both the profit for the year and the unrealized changes in the value of their assets and liabilities,
the latter items being called other comprehensive income.

Example 1. On January 2, 2008, a company purchased 2000 square feet of land

amounting to 300,000 lei. At the end of the year, the value of the land increased to 400,000
lei. The unrealized change in the value of the land (100,000 lei = 400,000 lei 300,000 lei)
is recorded as a revaluation reserve in owners equity, although no transaction occurred.
The profit for the year was 2,000,000 lei. Accordingly, the comprehensive income for the
year 2008 amounts to: 2,100,000 lei = 2,000,000 lei (profit for the year) + 100,000 lei
(other comprehensive income).

In order to offer investors a better perspective on their performance, companies publish

information about their comprehensive income either as:
a single financial statement: statement of comprehensive income, which disclose
both revenues and expenses for the year and items of other comprehensive income; or
two financial statements: an income statement (disclosing the revenues and expense
for the year) and a statement of comprehensive income (starting with the profit
for the year and further disclosing the items of other comprehensive income).

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A single financial Two financial
statement statements

comprehensive
Statement of Revenues Income
Expenses statement
income = Net profit or loss for the year
Statement of
Other comprehensive income comprehensive
= Total comprehensive income income

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2.3. The statement of cash flows and the companys liquidity

The statement of cash flows analyses changes in cash and cash equivalents during an
accounting period.

Cash and cash equivalents as of the beginning of the year

+ Cash inflows
Cash outflows
= Cash and cash equivalents as of the end of the year

Cash and cash equivalents comprise cash on hand and demand deposits, together with
short-term, highly liquid investments that are readily convertible to a known amount of cash, and that
are subject to an insignificant risk of changes in value.

An investment normally meets the definition of a cash equivalent when it has a maturity of
three months or less from the date of acquisition.

The inflows and outflows of cash are presented in gross amounts, that is cash inflows and
cash outflows cannot be set off against each other in order to present a net inflow or outflow of cash.

Example: For instance, if a company receives a bank loan of 100 lei, and pays the first installment
amounting to 20 lei in the same accounting period, then the statement of cash flows cannot disclose a
net inflow of 80 lei. The correct solution is disclosing the gross amounts, as follows:

Cash received form amounts borrowed 100 lei

- Cash repayments of amounts borrowed (20) lei

The cash flows are analyzed between their generating activities, that is between operating,
investing and financing activities:

operating activities: are the main revenue-producing activities of the enterprise that are
not investing or financing activities, so operating cash flows include cash received from
customers and cash paid to suppliers and employees;

investing activities: are the acquisition and disposal of long-term assets and other
investments that are not considered to be cash equivalents;

financing activities: are activities that alter the equity capital and borrowing structure of
the enterprise.

Statement of cash flows for the year N

Cash flows from operating activities X

Cash flows from investing activities X
Cash flow from financing activities X
Net increase/ (decrease) in cash and cash equivalents during period X
Cash and cash equivalents at the beginning of period X
Cash and cash equivalents at end of period X

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Operating activities

Cash flows from operating activities are normally those arising from transactions relating to
trading activities.

Examples of cash flows from operating activities are:

cash receipts from the sale of goods and the rendering of services;
cash receipts from royalties, fees, commissions and other revenue;
cash payments to suppliers for goods and services;
cash payments to and on behalf of employees;
cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities;
dividends and interest paid, unless they are presented in financing activities;
dividends and interest received, unless they are disclosed in investing activities.

The information on cash flows from operating activities are a key indicator in assessing a
companys ability to generate sufficient cash for reimbursing loans, maintaining its productive
capacity, paying dividends and making investments without relying on external financing sources.
A net outflow from operating activities shows a difficult position in terms of cash
management, as the cash receipts from sales are insufficient for making operating payments. In such
cases, an entity has to rely on external sources of cash (which imply additional costs) or on
divestment activities (which may decrease the companys production capacity).

Investing activities

The information on cash flows arising from investing activities is important because the cash
flows represent the extent to which expenditures have been made for resources intended to generate
future economic benefits.
Examples of cash flows arising from investing activities are:
cash payments to acquire property, plant and equipment, intangibles and other long-term
assets;
cash receipts from sales of property, plant and equipment, intangibles and other long term
assets;
cash payments to acquire equity or debt instruments;
cash advances and loans made to other parties;
cash receipts from sales of equity or debt instruments of other entities (i.e. shares or bonds);
cash receipts from the repayment of advance and loans made to other parties;
dividends and interest received, unless they are disclosed in operating activities.

A net inflow from investing activities may indicate either a lack of liquid resources needed for
operating activities, or restructuring operations.

Financing activities

The separate disclosure of cash flows arising from financing activities is important because it
is useful in predicting claims on future cash flows by providers of capital.
Examples of cash flows arising from financing activities:
cash proceeds from issuing shares or other equity instruments;
cash payments to owners to acquire or redeem the equitys shares;
cash proceeds from issuing debentures, loans, notes, bonds, mortgages and other short or
long term borrowings;
cash repayments of amounts borrowed;
cash payments by a lessee for the reduction of the outstanding liability relating to a finance
lease;
dividends and interest paid, unless they are presented in operating activities.

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 A net inflow generated by financing activities may indicate that, during the accounting period,
the company drew on either internal (equity) or external (debt) sources of cash in order to support a
net outflow from operations or to uphold investing activities.

Interest and dividends received and paid may be classified as operating, investing, or
financing cash flows, provided that they are classified consistently from period to period. While cash
flows arising from taxes on income are normally classified as operating, unless they can be specifically
identified with financing or investing activities.

Example: ABC Inc. has cash and cash equivalents amounting to 80.000 lei, as of the beginning of the
year 2008. During the year 2008, the following transactions occurred:
1) land amounting to 20,000 lei was purchased on credit;
2) finished goods were sold for 500,000 lei, on cash;
3) 100,000 lei were borrowed from a bank;
4) Salaries amounting to 50,000 lei were paid;
5) Payments amounting to 1,000 lei were made for the interest on a long term bank loan;
6) a license was sold for 40,000 lei on credit;
7) payments were made to suppliers of services in amount of 20,000 lei;
8) a piece of equipment was sold for 20,000 lei, on cash;
9) a loan amounting to 50,000 lei was grated to a subsidiary;
10) stamps were purchased in amount of 30,000 lei;
11) rental payments were received in advance amounting to 10,000 lei;
12) dividends paid: 30,000 lei;
13) income tax paid: 10.000.

As a first step, all transaction which do not generate cash flows have to be eliminated, that is
transactions (1) and (6), as payments will occur at a later date, and transaction (10) which is a
movement inside cash and cash equivalents.
Afterwards, all cash flows will be classified between operating, investing and financing activities, as
follows:
- lei -
Cash flows from operating activities
Cash receipts from customers (2)
Rent receipts (11)
- Payments made to suppliers (7)
- Payments made to employees (4)
- Interest paid (5)
- Dividends paid (12)
- Income tax paid (13)
= Net cash flow from operating activities (I)

Cash receipts from sale of equipment (8)

- Payments for loans made to subsidiaries (9)
= Net cash flow from investing activities (II)

Cash received from a long term bank loan (3)

= Net cash flow from investing activities (III)

Total net cash flow (IV) = (I) + (II) + (III)

Cash and cash equivalents as of 01.01.2008(V)

Cash and cash equivalents as of 31.12.2008 (VI) = (IV) + (V)

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2.4. Statement of Changes in Equity

Statement of Changes in Equity, often referred to as Statement of Retained Earnings in U.S. GAAP,
details the change in owners' equity over an accounting period by presenting the movement in
reserves comprising the shareholders' equity.

Comprises the following elements:

Effect of correction of prior period error

Increase or decrease in share capital reserves

Dividend payments to shareholders

Total comprehensive income:

Net profit or loss during the accounting period attributable to shareholders

+ Gains and losses recognized directly in equity

Example:

Co X Inc. Has the following items of owners equity:

- share capital: 20.000 c.u.;
- reserves:4.000 c.u.
- retained earnings 12.000 c.u.
- revaluation reserve: 3.000 c.u.
During the year N, the following transactions and events occurred:
a) - 1.000 shares were issued for 1,2 c.u., par value 1 c.u.;
b) dividends distributed to shareholders amounting to 600 c.u.;
c) Reserves amounting to 2.000 c.u. incorporated in share capital;
d) a piece of land was revalued with an acquisition cost of 4.000 c.u., fair value 6.000 c.u.
e) correction of errors: in year N-1 a sale invoise was misrecorded: 100 c.u. instead of 1.000
c.u.
f) Net profit for the year N 5.000 c.u.

26
Statement of changes in equity

27
3.5. Notes to the financial statements

The notes provide additional information that is not supplied by the other financial
statements, such as the bases of the preparation of financial statements (i.e. the relevant regulations
applied), the accounting policies applied, details of the make-up of balance-sheet figures etc.

The international regulations suggest that the notes should normally be presented in the
following order:

1. a statement of compliance with the relevant accounting regulations;

2. a summary of significant accounting policies applied;

3. supporting information for items presented on the face of the balance sheet, income
statement, statement of changes in equity, and cash flow statement, in the order in which
each statement and each line item is presented; and

4. other disclosures.

1) The statement of compliance with relevant accounting regulations

All companies have to state in their notes the relevant regulations on which they based the
drafting of their financial statements. For instance, the BAYER GROUP included the following
statement in the notes to in order to declare that its financial statements were drafted in accordance
with IFRS:

The (...) financial statements of the Bayer Group as of December 31, 2007 have been
prepared pursuant to Article 315a of the German Commercial Code according to the
International Financial Reporting Standards (IFRS) of the International Accounting
Standards Board (IASB), London, and the Interpretations of the International Financial
Reporting Interpretations Committee (IFRIC), which are endorsed by the European Union,
in effect at the closing date.

2) Summary of significant accounting policies applied

As different policies applied may lead to different results, all companies have to explain in
their notes all policies applied for the recognition and measurement of their items of assets, liabilities,
owners equity, revenues or expenses.
For example, companies are allowed to present their items of tangible fixed assets either at
their cost (e.g. acquisition cost) or at a revalued amount, that takes into account the current market
conditions. Accordingly, all entities have to disclose in their notes which of the two accounting policy
was chosen.
BRITISH AIRWAYS GROUP explained in its notes the accounting policies applied for the
valuation and depreciation of its tangible fixed assets as follows:

Property, plant and equipment is held at cost. The Group has a policy of not revaluing
property, plant and equipment. Depreciation is calculated to write off the cost less
estimated residual value, on a straight-line basis, over the useful life of the asset.
Residual values, where applicable, are reviewed annually against prevailing market
values for equivalently aged assets and depreciation rates adjusted accordingly on a
prospective basis.

3) Supporting information for items presented on the face of the other financial
statements

Some items disclosed in the financial statement are further detailed in the notes. For this
reason, notes are usually cross-referenced from the face of the financial statements to the relevant

28
note. For instance, inventory in amount of 400,000 lei presented in the balance-sheet may have a
note as follows:

Balance-Sheet as of December 31, 2008

Ref. # lei
()
Current assets
Inventories 8 400,000
Receivables 10 38,000
()
Notes to financial statements
()
Note # 8: Inventories

Raw materials 200,000

Work in progress 30,000
Finished goods 100,000
Merchandise 70,000
Total 400,000

4) Other disclosures

A company may provide different other information considered useful for the decision making process.
For instance companies may provide information on resources of the entities not recognizes as assets,
or they may draw attention to the existence of related party transactions etc.

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