5.4Exercises on current assets

Exercise 17: Inventories

a) Exercise

Gert Glitz is a jeweller in Pforzheim and at a summer auction purchases gold for €100,000 and diamonds for €50,000. In spring of the following year he prepares his balance sheet. The price for gold increased, so that he could have sold his gold for €120,000 on 31 December. Unfortunately, the diamonds are of minor quality. Their market value decreases continuously: on 31 December they are valued at €40,000, and in February of the following year they are worth only €30,000. How will the gold and diamonds be valued on 31 December in the commercial and the tax balance sheets? Give reasons for your answer.

b) Solution

§ 252 sect. 1 no. 4

§ 253 sect. 4

Because Gert Glitz is a jeweller, it can be assumed that gold and diamonds are current assets for him, i.e. he plans to use them for his own production and wants to sell the related products to customers.

Measurement of the gold:

The value remains at the acquisition costs of €100,000 on the closing date. This corresponds to the realization principle as one part of the principle of prudence: Gains may be recognized only if they are realized. Due to the principle of congruence, this applies to the tax balance sheet as well.

Measurement of the diamonds:

The diamonds must be recognized at the lower market value; this corresponds to the imparity principle as the other part of the principle of prudence. For current assets any decrease in value at the closing date must be recognized as an expense (strict lower-of-cost-or-market principle). In addition, we must apply the closing date principle, i.e. the market conditions on the closing date are relevant. According to this principle, the diamonds must be recognized at €40,000. The even lower value in February can only be used in the following financial statements (if still relevant). If this decrease in value is considered permanent, it can be recognized for tax purposes as well. Only temporary decreases in value must not be recognized for tax purposes.

c) References

Bacher, Chapter 3.3.1.2

Coenenberg et al., 2016 (1), p. 215

Exercise 18: Inventories (2)

a) Exercise

What methods can be used for the initial measurement of acquired inventories according to the Commercial Code? Explain the methods briefly.

b) Solution

§ 240 sect. 3 and 4

§ 256

Acquired inventories must be measured by their acquisition costs. The basic principle to be applied is individual measurement (each part separately). Because this is not practical for large quantities, the following simplifications are possible if they are in line with GAAP:

1. Group measurement of similar inventories:

2. Constant-value approach for raw materials and similar items:

Raw materials and other materials (i.e. not finished or unfinished products) may be recognized at a constant value under strict conditions. Then you can retain the value of the prior year and show all acquisitions directly as expenses.

c) Hints

Conditions for group measurement:

The inventories must be similar. Similarity means similar in kind (e.g. screwdrivers of different sizes) or function (e.g. screws and nails can both be used to fix two things together).

This approach can also be used for moveable non-current assets or moveable current assets other than inventories if they are similar in kind (see above) or similar in value. Similar in value is interpreted as belonging to the same category of asset with a price difference of less than 20%.

Conditions for the constant-value approach:

Raw materials and tangible non-current assets can be measured at a constant value if

An example could be nails and screws for a roofer (if business does not grow and working processes do not change). Another example (for non-current assets) are cutlery, table linen or bed sets for a hotel.

d) References

Bacher, Chapter 3.3.1.2

Coenenberg et al., 2016 (1), p. 215

Exercise 19: Inventories (3)

a) Exercise

Ride-a-Bike GmbH makes bicycles for children. At the balance sheet date the company has 1,800 identical steering bars on stock, which are from different purchases in the business year. It is not possible to allocate the individual parts to the different purchases. Records show the following information:

b) Solution

§ 240 sect. 4

§ 256

Tab. 5.51: Solution to exercise 18.

1If the periodic average is used, one average is calculated for the whole year: All increases and the opening balance are summed up and the total value is divided by the the total amount. This results in an average of €45/pc. This average is applied to the consumption and the closing balance. Thus, the value of the consumption is €355,500 and the value of the closing balance is €81,000.

2.According to Commercial Code, LIFO and FIFO can also be applied (if in line with the GAAP).

When applying LIFO, it is assumed that the latest increases are used first, i.e. the oldest items are still on stock. This results in a value of 85,200: the total amount of the closing balance is 1,800 pc., of which 1,400 pc. are from the opening balance with a value of €67,200, and the remaining 400 pc. are from increase 1 with a value of €18,000. Thus, the total value is €85,200.

When applying FIFO, it is exactly the converse, i.e. it is assumed that the newest items are still on hand: Thus, the closing balance is measured using the price of increase 3, i.e. 1,800 pc. at €46/pc., that is €82,800.

To show as high a profit as possible, the assets should be measured as high as possible, i.e. LIFO should be used.

3.According to tax law, periodic average and LIFO are possible (LIFO only if the real sequence of consumption does not contradict LIFO).

c) Hints

The moving average could be used from a legal perspective, but it cannot be used in practice here because the exact timing of the consumption/usage of the parts is not known.

For accounting policy, you must keep in mind that these simplifications apply only to the initial measurement. If the market value at year end is lower, the lower value must be recognized (independently of the method chosen for the initial measurement – strict lower-of-cost-or-market principle).

d) References

Bacher, Chapter 3.3.1.2

Coenenberg et al., 2016 (1), p. 213

Exercise 20: Inventories (4)

a) Exercise

A carpenter has a steady business. His total assets amount to €100,000, of which €3,000 is for glues and colours.

At the closing date of 31 December 20X1 he wants to simplify the preparation of his financial statements, and he wants to use the constant-value approach for the glues and colours.

Is that possible? What is the consequence?

b) Solution

§ 240 sect 3.

The constant-value approach can be used if

The first two criteria are fulfilled. The two additional criteria need to be fulfilled as well; only if all criteria are fulfilled can the constant-value approach be used.

If the constant-value approach is used, the consequence is that for these assets a constant value is used, i.e. the book value no longer changes and acquisitions of new material are directly shown as expenses.

c) Hints

The constant-value approach is also a simplification for stock taking because a physical stock taking must be done only after 3 years, not every year.

d) References

Beck’scher Bilanzkommentar, § 240, nos. 71–126

Coenenberg et al., 2016 (1), p. 222

Exercise 21: Measurement of receivables

a) Exercise

Maria Heilig owns a wholesaling business for statues of saints and other devotional items. On 31 December 20X1, her trade receivables amount to €520,625. The following specific information is available:

In March 20X2, Maria prepares her financial statements. What will be the value of the receivables in the balance sheet? What will be the amount of valuation allowance in the income statement?

b) Solution

§ 253 sect. 4

Tab. 5.52: Solution to exercise 20.

The measurement of receivables according to German laws follows a three-step approach:

For the “Italian” shop and Mr Meier, a complete loss of the receivable is very probable; therefore 100% of the receivable (including the VAT) is deducted.

For Hillbilly GmbH, only a partial loss is probable: Mariawill receive 40%, i.e. she will lose 60%; therefore 60% of the net receivable are deducted.

A general valuation of 2% of all receivables for which no specific valuation allowance has been recognized:

Therefore, the receivables shown in the balance sheet on 31 December 20X1 amount to €494,355. The valuation allowances recognized in the income statement amount to €23,990.

c) References

Bacher, Chapter 3.3.1.2

Beck’scher Bilanzkommentar, § 253, nos. 558–608

Coenenberg et al., 2016 (1), p. 256

5.5Exercises on equity

Exercise 22: Accounting for equity

a) Exercise

Explain how capital increases of a corporation are accounted for. What do partial payment and agio mean in this context?

b) Solution

§ 272 sect. 1 and 2

The equity of a corporation is split into shares that have a nominal value (for a stock company the nominal value of all shares must be identical). The subscribed capital is the sum of the nominal value of all shares.

If the equity of a company is increased, this is often done by issuing new shares. The nominal value of these new shares is added to the subscribed capital. If the investors who buy the new shares pay in more than the nominal value, i.e. they pay an agio or a premium, this agio is recognized as capital reserve.

Under German company law, it is possible to found a corporation with only partial payment of subscribed capital.

The minimum equity of a limited liability company (GmbH) is €25,000. Of this €25,000, 50% must be paid in upon founding of the company. The rest can be called up later by the company.

The minimum equity of a stock company (AG) is €50,000, of which 25% must paid in when founding the company.

Nevertheless, the shareholders of the company are required to pay in the complete subscribed capital in the case of insolvency. Thus, in the financial statements the subscribed capital is reported with the complete amount, and the part that has not been paid in and is not called up is deducted, i.e. the effectively paid-in or called-up capital is calculated openly in the balance sheet and called “Paid-in/called-up capital”.

For an agio, partial payment is not possible. If the company is founded with partial payment of the nominal capital, a possible agio must always be paid in full.

c) References

Bacher, Chapter 3.3.2

Beck’scher Bilanzkommentar, § 272

Coenenberg et al., 2016 (1), p. 331

Exercise 22: Accounting for equity

a) Exercise

What is the difference between capital reserves and revenue reserves in accounting and in financing?

b) Solution

§ 272 sect. 2 and 3

A capital reserve is an additional capital contribution of shareholders that does not increase the nominal capital (and therefore typically does not increase voting rights). It often occurs together with a capital increase if an agio is paid. The nominal value of the capital increase increases the subscribed capital, while the agio, i.e. the additionally paid-in capital, increases the capital reserves.

Revenue reserves are profits of either the current period or former periods that are kept in the company and formally transferred to the revenue reserves, i.e. they are not paid out as dividends or other form of profit distribution.

From a financing perspective, a change of capital reserves is external financing because there is cash flow from the outside to the company. On the other hand, revenue reserves are internal financing because the additional capital is generated by the business process of the company.

c) References

Bacher, Chapter 3.3.2

Beck’scher Bilanzkommentar, § 272

Coenenberg et al., 2016 (1), p. 331

Exercise 23: Accounting for a company’s own shares

a) Exercise

The price for shares of High Tech AG decreased in recent months. Therefore, the executive board decided to purchase company shares to stabilize the price. On 31 December 20X1 the equity was shown as follows:

On 30 November 20X2, the company buys one million shares with a nominal value of €1/share for a total price of €12 million. How does this transaction have to be shown in the balance sheet as of 31 December 20X2?

On 15 January 20X3 the company is able to sell the shares again for a price of €15 million. How should this be accounted for in the upcoming balance sheet?

b) Solution

§ 272 sect. 1a and 1b

Tab. 5.53: Solution to exercise 23.

If a corporation acquires its own shares (typically it is a listed stock company that purchases its own shares on a stock exchange, but the logic applies to any acquisition by a company of its own shares), the value of these shares must be deducted openly from equity.

More precisely: The acquired nominal amounts must be deducted from subscribed capital, and any agio that has been paid must be deducted from revenue reserves (see column 3, “acquisition”).

If the shares are sold again, the original deduction must be reversed. If an additional gain is made, this gain is shown as capital reserve (because it has been paid in additionally by third parties; see column 5, “resale”).

c) Hints

The presentation of a company’s own shares as financial assets would be misleading: On the one hand, there is an asset because the shares could be sold again and – usually – were acquired against cash. On the other hand, equity would be overstated in doing this: To the extent the company acquired its own shares, the company belongs to itself; in the case of insolvency, not all equity would be available for creditors because the shares would be worthless. Therefore, to present the value of equity that is available to third parties, the company’s own shares are netted with equity.

Any expenses incurred during the acquisition are not treated as an incidental acquisition cost but as expenses from the period.

d) References

Beck’scher Bilanzkommentar, § 272, nos. 131–150

Coenenberg et al., 2016 (1), p. 358

5.6Exercises on provisions

Exercise 24: Important differences between provisions and debt

a) Exercise

What is the difference between a provision and a debt in accounting? Give one example for each case.

b) Solution

§ 249

Provisions are liabilities, i.e. they are based on an obligation to a third party (e.g. customers, suppliers, employees). Unlike debt, they are uncertain to some extent: The reason or the settlement amount can be uncertain (or both). Nevertheless, the obligation and its fulfilment must be probable.

Examples for provisions

Pension provision: A company promises employees (all or only some) to pay additional retirement benefits. There is a lot of uncertainty in this promise: Which employees will reach retirement within the company? What is their salary at that time? What will the retirement benefit be in the future (based on, for example, price changes or salary increases)? Nevertheless, it is probable that there will be future payments, and therefore a provision must be recognized.

Warranty provision: Some products of a company may be faulty or damaged. In that case, customers will make use of warranty services. Insofar as the expenses incurred by the warranty services are probable and predictable, a provision for warranties must be recognized.

Examples for debt

Bank loan: The loan agreement with the bank states clearly what the obligation is and how and when it must be fulfilled. There is very little uncertainty – thus, it is a debt, not a provision.

Trade payables: When a company receives an invoice from a supplier and it has received the goods or services, there is very little uncertainty regarding what amount must be paid and when.

c) Hints

The obligation to recognize provisions results from the realization principle and the imparity principle: Probable and predictable losses must be recognized when known, not when realized (i.e. as early as possible). If there is a concrete connection from future expenses to a past event, the realization principle (matching principle) requires the recognition of a provision for uncertain liabilities. If future expenses are not covered by future income, but cannot be avoided because of an existing contract, a provision for onerous contracts must be recognized; it is based on the imparity principle. Apart from provisions for uncertain liabilities and onerous contracts, § 249 requires the recognition of another category of provisions: In two specific circumstances, expense provisions must be recognized:

d) References

Bacher, Chapter 3.3.3.2

Beck’scher Bilanzkommentar, § 249

Coenenberg et al., 2016 (1), p. 429

Exercise 25: Recognition of provisions

a) Exercise

Please determine in which of the following cases is the recognition of a provision required by the Commercial Code, and classify the type of provision.

b) Solution

§ 249

c) Hints

In the last case, a factual accounting option exists: Depending on the timing (within the first quarter, after the first quarter) it is a recognition requirement or prohibition. If the timing is flexible, it can be used for accounting policy. But keep in mind that the correctness can be checked easily afterwards – thus, if this is to be used for the accounting policy, the timing must be precise and kept constant.

d) References

Bacher, Chapter 3.3.3.2

Beck’scher Bilanzkommentar, § 249

Coenenberg/Haller/Schultze, p. 429

Exercise 26: Discounting of provisions

a) Exercise

Customers of a production company were not satisfied with the quality of the products and claimed damages. The company does not accept the claims and seeks a legal decision in court; nevertheless, the company expects that it will probably have to pay €12 million in damages in about 3 years after closing date (the decision of the court in all instances will take that amount of time).

The German central bank published the following rates according to § 253 sect. 2:

Tab. 5.54: Exercise 26.

What is the value of the provision at the closing date? What is the value 1 year later assuming that nothing has changed (same settlement amount and same interest rates)?

b) Solution

§ 253 sect. 2

At closing date

The expected settlement amount must be discounted for 3 years by the corresponding interest rate:

The value to be recognized is €11,374,647, i.e. the effect of discounting is €625,353.

One year later

The maturity is reduced by 1 year because settlement is now expected in 2 years, and the interest rate must be adjusted according to the changed maturity. The increase must be shown as interest expense because it stems from the changes in maturity and interest rate (if there were any changes in the settlement amount, these would be recognized as operating expenses or income); the corresponding journal entry is as follows:

c) References

Beck’scher Bilanzkommentar, § 253, nos. 180–190

Coenenberg et al., 2016 (1), p. 434

5.7Exercises on debt

Exercise 27: Presentation of tax liabilities

a) Exercise

A company must recognize a tax liability of €100,000 at the closing date. How is this transaction presented in the three cases? What is the exact balance sheet item in each case and the recognized amount?

b) Solution

§ 266

c) References

Beck’scher Bilanzkommentar, § 247 and § 266

Exercise 28: Accounting for a disagio

a) Exercise

Your company needs a loan of €100,000 for an investment. Your bank offers a loan at a 7% annual interest rate. As an alternative, it offers a low-rate variant (5% interest) with a discount of 6%, i.e. outpayment is 94%. The term of the loan is 3 years and is to be repaid in full at the end of the term. You choose the discount alternative; the outpayment is in early January.

How can this loan be accounted for (under the Commercial Code and German tax law)? What is the interest expense in each year and in total?

b) Solution

§ 250 sect. 3

Commercial Code

§ 250 sect. 3 provides an accounting option for a disagio: It can be recognized as an expense in the first period or be recognized as a deferred expense and be distributed over the term of the loan.

Expense in first period

Values in €

Thus, in the first year €11,000 in interest expense are recognized, and in the two following years only €5,000, in total €21,000.

Recognition of deferred expense

Thus, using the deferred expenses, the interest expenses are spread equally over all periods (€7,000 each), again in total €21,000.

Tax law:

Only the second alternative is acceptable.

c) Hints

The effects of any accounting options are neutral when you look at the total period: In total €21,000 of interest were paid over 3 years, just the distribution between the years varies. The use of accounting options does not produce additional profits or gains; it can only influence the accounting for these profits and gains and in particular when they must be shown.

Only if an accounting option is tax deductible and results in lower tax payments today and higher tax payments in the future can there be a positive interest effect (more liquidity today, i.e. more interest income or less interest expense) that is not neutral, but an additional profit.

d) References

Bacher, Chapter 3.3.3

Beck’scher Bilanzkommentar § 250

Coenenberg et al., 2016(1), p. 477

5.8Exercises on deferred items and deferred taxes

Exercise 29: Accounting for deferrals and accruals

a) Exercise

When is the recognition of a deferral or an accrual necessary? Give an example for each possible case.

b) Solution

§ 250 and § 252 sect. 1 no. 5

Deferrals and accruals must be recognized when payment (cash in-/ outflow or proceeds/expenditure) and received or rendered service occur in different reporting periods and must refer to a specific time period. This is a consequence of accrual accounting (in contrast to cash accounting), which requires income and expenses to be recognized when they occur (and not when they are paid).

Four cases can be distinguished:

Cash outflow/expenditure now, expense in next period: In this case, a deferred expense must be recognized (if an asset is acquired, the asset is recognized; here we are discussing services we will receive and that cannot be recognized as an asset). A typical example is prepaid rent or prepaid insurance premiums.

Cash inflow/proceeds now, income the next period: In this case a deferred income must be recognized. A typical example is prepaid rent when the landlord receives payment in advance.

Deferrals are also called transitory items because they are recognized in the balance sheet, even if they are not an asset or a liability, just to shift the expense and income to the correct period in the future.

Expense now, cash outflow/expenditure in next period: In this case, the expense must be recognized now (must be accrued now) and a corresponding other liability is recognized. A typical example is when rent is paid at the end of the rental period or when interest is paid at the end of the borrowing period.

Income now, cash inflow/proceeds in next period: In this case, the income must be recognized now (must be accrued now) and a corresponding other receivable is recognized. A typical example is when rent is received at the end of the rental period.

Accruals are also called anticipative items because the income or expenses are recognized before payments are due (i.e. shifted to the current period).

c) References

Bacher, Chapter 3.3.4

Beck’scher Bilanzkommentar, § 250 and § 252, nos. 51–54

Coenenberg et al., 2016 (1), p. 477

Exercise 30: Accounting for deferrals and accruals

a) Exercise

Identify the balance sheet positions, on 31 December 20X1, of the following transactions and journalize them:

b) Solution

§ 250 and § 252 sect. 1 no. 5

c) References

Bacher, Chapter 3.3.4

Beck’scher Bilanzkommentar, § 250 and § 252, nos. 51–54

Coenenberg et al., 2016 (1), p. 477

Exercise 31: Deferred taxes

a) Exercise

In the balance sheet of Karlsruhe Beteiligungs GmbH, a provision for onerous contracts in the amount of €100,000 is recognized. The income tax rate at the time the difference will even out (trade tax, corporation tax, solidarity surcharge) is 30%.

b) Solution

c) References

Bacher, Chapter 3.3.5

Beck’scher Bilanzkommentar, § 274

Coenenberg et al., 2016 (1), p. 495

5.9Exercises on income statement and cash flow statement

Exercise 32: Income statement

a) Exercise

Explain the differences between the total-cost format and cost-of-sales format.

b) Solution

§ 275

According to § 275, two alternative formats for the preperation of the income statement are possible for corporations. Partnerships and sole proprietorships have no specific formats but can use any structure that satisfies GAAP (the concepts of § 275 can be viewed as best practices, which are often used by partnerships or sole proprietorships as well, but often with less detail).

Total-cost format

In the total-cost format, the change in inventory, i.e. the increase or decrease in finished and unfinished products, is reported as a separate income item. The expenses are structured according to the type of expense, e.g. material expenses, personnel expenses, depreciation and amortization.

Cost-of-sales format

In the cost-of-sales format, the change in inventory is netted with the cost of goods sold, i.e. this income or expense is not shown separately. In addition, the expenses are structured according to the functional area in which they occur, e.g. cost of goods sold, distribution costs, research and development costs, administrative costs.

c) Hints

The net result is necessarily the same in both formats. The differences concern only the way the information is presented, not the substance of the transaction.

For example, personnel expenses in the total-cost format include all personnel expenses of the company: e.g. for production, for distribution, for administration, whereas, for example, the distribution costs according to the cost-of-sales format include all material and personnel expenses as well as depreciation that were incurred for the distribution department (marketing, sales and sales logistics).

d) References

Bacher, Chapter 3.4

Beck’scher Bilanzkommentar, § 275

Coenenberg et al., 2016 (1), p. 531

Exercise 33: Income statement

a) Exercise

For a company the following information is available:

Tab. 5.55: Exercise 33.

What does the income statement look like according to the total-cost format and according to the cost-of-sales format?

b) Solution

§ 275

Total-cost format (values in T€):

Cost-of-sales format (values in T€):

c) References

Bacher, Chapter 3.4

Beck’scher Bilanzkommentar, § 275

Coenenberg et al., 2016 (1), p. 531

Exercise 34: Cash flow statement

a) Exercise

b) Solution

DRS 21

c) References

DRS 21

Coenenberg et al., 2016 (1), p. 818

Exercise 35: Cash flow statement

a) Exercise

Example AG shows the following balance sheet and income statement for the business year 20X1 (values in €):

Tab. 5.56: Exercise 35 balance sheet.

In the change in non-current assets are included – apart from the depreciation – expenditures for investments of €130,000 and proceeds from the disposal of assets of €40,000.

The change in bank loans results from proceeds of €70,000 due to new loans and repayments of €20,000. In addition, a dividend of €70,000 was paid for the previous year.

The balance sheet items inventories, trade receivables, bank loans and trade payables do not include any changes that are non-cash-oriented.

Tab. 5.57: Exercise 35 income statement.