Government accounting is far more complex as compared to normal accounting that is carried out by businesses. In this aspect, it is important to consider the fact that government accounting holds tantamount value for numerous different reasons.
Governments need to be accountable in terms of the funds they receive since these funds are technically generated from public collections, and therefore, they are accountable for it. Therefore, governmental accounting and fund management is considered to be a highly integral part of organizations.
Government funds are the main source of revenue for any particular government. Similar to any business that operates, governments also establish set accounts in order to achieve certain aims and targets. Therefore, a government fund is defined as a group of funds that the government has received over the course of a fiscal year.
This fund is mainly amalgamated from tax-supported activities that are undertaken by businesses. Government funds include various different heads, and for all these respective fund types, a separate balance sheet is duly maintained.
How do Governmental Funds work?
Government Funds are supposed to be accounted for bearing in mind the blueprint provided by major accounting bodies. All government funds need to be accounted for using this particular premise, and there needs to be a clear understanding regarding these government funds, and how these funds are treated when it comes to accounting-related treatment.
Government Funds are classified into 5 main types. These governmental funds are as following:
Capital Projects Fund
Debt Service Funds
Special Revenue Funds
All these fund types are categorized on the basis of where they gain revenue from, and how this revenue is spent in order to account for it in a different manner. These funds and their respective functions are mentioned in the diagram below:
Further descriptions of these funds are given below:
The general fund, as the name suggests, accounts for the basic activities or the services that are provided by the government. Technically, it is used for all ‘general’ transactions that are not accounted for elsewhere.
The general fund is used as a medium to account for respective different heads that are used in order to note all the related expenses in the respective accounting heads. This is also referred to as the chief operating fund of the government. It includes all the tax-related resources that are not classified elsewhere.
Capital Projects Fund
Capital Projects Fund accounts for financial resources that are mainly related to the construction of major capital-related projects. Therefore, it mainly accounts for infrastructure-related costs that are borne by the government. Therefore, they mainly include costs pertaining to significant capital expenditures that are undertaken, and this fund only holds reserves for this particular cause.
The reason behind creating a special fund behind the construction of major capital outlays lies in the realms of the volume of finance that is directed towards this cause. In the same manner, capital outlays have an inherent cost, and then there are other costs that are associated with the construction. Therefore, it makes sense to have a separate fund for all the capital-related projects, where all the information can be duly managed.
Debt Service Fund
The Debt Service Fund is used to account for and report financial resources that are spent in order to settle different debts. Therefore, this particular type of fund is used in order to account for all debt-related payments and issues within the government.
Hence, a debt service fund is created with the aim and the objective to pay back the long-term debt that has been issued by the government in order to finance specific government-related projects. All the revenue generations by the government, targeted towards debt repayments are collected in this particular fund so that it gets easier to have the required funds upon repayment date. It accounts for both, interest, as well principal repayments.
Special Revenue Funds
Special Revenue Funds are used in order to track the revenue from specific resources that are restricted to specific purposes. It is perhaps the most commonly used fund. It is used in order to undertake special projects by the government.
This particular fund is kept separate because it deals with a couple of different tasks that are specifically designated for a stated cause.
Permanent Funds are referred to as a restricted endowment that is known to generate and subsequently disburse money for a particular cause.
As far as these types of funds are concerned, it can be seen that the return that is generated from these particular funds is supposed to be kept intact in terms of the principal amount. Only the interest that is generated from the principal amount can be disbursed as returns for the cause.
Accounting Treatment of Government Funds
In order to accurately account for government funds, it is important to realize that the objective of government account should inculcate the following tasks and objectives:
Full and accurate disclosure of funds and activities that are present to fully disclose the incoming and outgoing funds from the government reserve. All the transactions should be duly recorded, and then disclosed so that none of the important information is missed out upon.
Determination and subsequent demonstration of proper compliance with finance-related legal as well as contractual positions.
Therefore, it can be seen that the governmental accounting system should be organized in a manner that ensures that all transactions are duly recorded in the system. In this regard, a fund is realized to be defined as a fiscal and accounting entity. The main premise here is to make sure that all cash or non-cash-related transactions are mentioned on the financial statement in order to reduce the chance of any embezzlement or fraudulent activities within the company.
Therefore, these accounts should be properly maintained in proper compliance with the stated rules and regulations, in order to ensure that all the respective tasks and objectives are properly accounted for. The treatment of these funds on the balance sheet is similar to that of any reserve that is undertaken by commercial companies. However, what needs to be inculcated is the fact that it is supposed to be maintained on a perpetual basis because at the end of the day, government accounts also undergo an auditing treatment.
Journal Entry for Government Funds
As mentioned earlier, it can be seen that government funds normally comprise funds collected from taxes and other various incomings. These ‘incomings’ are assumed to be the revenue for these government funds. In order to record this particular revenue, the following journal entry is made:
Revenue (Tax Incoming)
In the same manner, as far as expenses are concerned, they are recorded in the following journal entry.
For all the subsequent entries, it can be seen that all journal entries are duly recorded in terms of ensuring that all commercial activities are recorded in a proper manner. All respective accounting entries are supposed to be recorded so that they are not missed out upon. Therefore, these journal entries are maintained following which financial statements are subsequently drawn for all the respective years.
For all the different fund types, separate financial statements are maintained, and this helps to analyze and audit all the different funds accordingly. Eventually, all these different categories of funds are amalgamated to get a holistic view of the performance of the government in terms of funds received, and the relevant expenses associated with these different heads.
Fiduciary Funds are used in governmental accounting in order to account for assets that are held in trust for others. In other words, these are the funds that are held by the government as a trustee. They are held on behalf of others, and therefore, they cannot be used to fund the government’s own expenses.
Governments continue to receive funds from the general public on various different grounds. These funds are mostly used for specific purposes, and therefore, governments are not supposed to use these funds to fund government-related projects.
Given the fact that fiduciary funds are utilized by governments in order to account for assets that are held and maintained by governments as a trustee, or an agent of entities, they are often referred to as Trust Funds. Trust relationships are mostly created through formal trust agreements.
Fiduciary Funds are normal for every government, and they are specially categorized under different heads because they tend to serve different objectives. Therefore, it is important to classify separately so that they are duly accounted for with respect to their source.
Types of Fiduciary Funds
There are four main types of fiduciary funds that are accounted for. The types of fiduciary funds are mentioned below:
Investment Trust Funds
Pension and Employment Benefit Trust Funds
Private-Purpose Trust Funds
Subsequent explanation of these fiduciary funds is given below:
Explanation of the Fund
Also referred to as custodial funds, they are only held by the government in custodian capacity. They are not supposed to be actively managed but just held on to.
Investment Trust Funds
Investment Trust Funds are investments of government, as well as other governments. They are mainly established for a particular cause, and as a gesture of goodwill by one government towards another.
Private-Purpose Trust Fund
Funds arranged for a specific cause. They can be either expendable, or non-expendable.
Agency Funds are also referred to as custodial funds. This type of fiduciary fund is held in a custodial capacity. This implies that the funds are received on a temporary basis, after which they might be temporarily invested and then subsequently remitted to other parties.
Therefore, these particular funds include resources that are not held in a trust agreement that meets specific criteria. Since they are disclosed in a custodial capacity, these funds are matched by subsequent liabilities to the owner of the assets. Agency Funds are only used for assets that are held for the benefit of others.
The funds that are held in agency funds can be used for pass-through grants, payroll deduction and payments, as well as for settling the interest checking account.
Investment Trust Funds
As far as Investment Trust Funds are concerned, it can be seen that Investment Trust Funds are used to report the external portion of an investment pool that is mainly managed by the government. In other words, investment trust funds exist when the government sponsors various different multi-government investment pools and accounts for the external portion of those particular assets.
Investment Trust Funds are also used in cases where government invests their own money, as well as resources that have been received from other governments.
Pension and Employment Benefit Trust Funds
Pension and employee benefit trust fund exists when the government takes place as the trustee for a designated pension fund. This might also include the case where the government takes charge of different employment-related funds that are created in this regard.
The government in this regard is defined as a qualifying trust where the government is not considered as a beneficiary of the pension fund itself.
This means that the government is just supposed to act as a trustee in managing those funds in order to ensure that the funds are safe to be dispersed when needed by the rightful owner of those funds. In most cases, Pension Trust Funds are said to be the fast-growing trust fund for most governments. They are managed at a state level mostly.
Private-Purpose Trust Funds
Private Purpose Trust results when a contributor, as well as a government, agrees that principal or income that is derived from trust assets should be directed towards the betterment of individuals, organizations, or other governments.
In this aspect, it is important to consider the fact that as suggested by the name, Private-Purpose Trust Funds are reserved for a specific purpose only. As with other types of fiduciary funds, they cannot be used for any other purpose by the government.
Private Purpose Trust funds can either be expendable or nonexpendable. Expendable Private Purpose Trust Fund implies that principal and earnings might be spent. On the other hand, as far as the nonexpendable private purpose trust fund is concerned, the principal must be maintained at all times. However, earnings from this principle might be expendable or non-expendable.
Characteristics of Fiduciary Funds
Fiduciary Funds play a very important role in safeguarding the interests of the stakeholders at large. Therefore, they are supposed to undertake several different characteristics. These characteristics are given below:
Duty of Care
Duty of Care implies that the government is supposed to ensure that they are able to take care of these funds with proper ease. In this regard, the board has the full right to investigate the stated decisions and ensure that they are able to avoid any such decisions that might risk these funds.
Duty to Act in Good Faith
Since fiduciary funds are held by the government as trust funds, it is important for governments to realize the fact that they are supposed to act in good faith when it comes to these funds.
If any actions need to be taken by the company, they should be aligned with the best interests of those who are directly impacted by these funds. For example, ensuring that pension funds are safe and secure, and employment-related benefits are distributed in due time is an important metric that needs to be accounted for by the custodians of these funds.
Duty of Loyalty
Even though these funds cannot be used to fund any private projects, yet the funds should still be managed to avoid any fraudulent activity that might have a detrimental impact on the existing loyalty of the business, to say the least.
Accounting Treatment for Fiduciary Funds
Accounting for Fiduciary Funds is considered to be an important task in terms of ensuring that all disclosures have been properly accounted for. In this regard, the following accounting steps need to be accounted for when it comes to accounting for fiduciary funds:
Proper identification of all government-related fiduciary activities: All activities should be included, and they should not be missed out upon.
Determination of the respective type of fiduciary fund to categorize it in the correct fiduciary activity.
Presentation of financial statements that disclose fiduciary funds in an appropriate manner.
Governmental accounting requires all incoming and outgoing funds to be accounted for. In this regard, it is important to consider the fact that for fiduciary statements too, financial statements need to be drawn. The following financial statements are subsequently used when it comes to treating fiduciary funds. They are as follows:
Statement of Fiduciary Net Position – This involves companies having a full accrual basis accounting statement that is representative of all the assets, liabilities, and balances of the fiduciary activities.
Statement of Changes in Fiduciary Net Position – This financial statement shows how the net position of the fund has changed over the course of the year.
The modern-day business dynamic is considered to be quite different on a number of grounds. In this regard, it can be seen that almost all businesses work on credit. This implies that they sell, or purchase goods at an earlier date, and the subsequent payment for that particular date is made at a later date.
This is the general norm of almost all business entities, and it is something that is highly unavoidable for almost all business concerns. It has a number of accounting implications that organizations need to be wary about.
However, before getting to that, it is important to understand what ‘credit’ really is, and why is it unavoidable.
What is Credit and why is Credit unavoidable?
Business Credit is referred to as payment leverage that is offered by one business to another. This is because businesses need time to process raw materials, and then send them to the market so that they can be sold.
Therefore, their suppliers tend to give them leverage pertaining to payments. Business credit is considered to be a normal practice. It cannot be avoided because it is normal and the general practice of businesses.
Credit is unavoidable because it takes considerable time for products to be in a sellable condition, and in the meantime, they might not have the resources to pay their suppliers upfront. Therefore, they need credit as a breathing space that can help them to achieve the respective job descriptions.
However, when it comes to credit, credit can be owed to customers and they can also be owed from customers. These are two different terminologies, and hence, they include a number of technicalities that need to be considered in this regard.
Credit Due to Customers
As far as Credit Due to Customers is concerned, it implies that the business has taken advance from their customers, and the subsequent transaction has still not be made. It is also referred to as ‘unearned revenue’. This is because it implies that the revenue for the particular transaction has been collected, but goods (or services) against this collected revenue have not been processed. Therefore, this is the form of liability from the perspective of the company.
Credit that is due from customers is a current liability, which needs to be processed by companies in order to recognize that as an earned revenue in their financial statements. Unless the goods or services against that amount have been processed, it will continue to be classified as a current liability, because the organization is liable to process these orders in order to properly classify them as a legitimately earned revenue.
There might be a number of different reasons as to why credit might be due from customers. A lot of businesses tend to work on advance payments as security deposits from their customers. As a result, they categorize customer advances as unearned revenue, because they have collected money, and the order has still not been processed as yet.
Is Amount Due to Customers same as Accounts Payable?
Amount Due to customers is NOT the same as accounts payable. This is because accounts payable is the term that is used to denote the amount that is payable to suppliers of the company. On the contrary, the amount due to customers is a current liability, in the form of unearned revenue.
Unearned revenue needs to be settled in the form of goods and services, whereas accounts payable generally settled via cash or bank. Regardless of the fact that both are current liabilities, yet their notation is different in terms of what they actually represent.
Accounting Treatment and Journal Entry for Credit Due to Customers
The accounting treatment for credit that is due from customers is similar to that of a current liability. Therefore it is treated as a Current Liability in the Balance Sheet. In the Income Statement too, it is classified as revenue, but it is mentioned too that this particular revenue stands to be unearned, and it needs to be processed so that it is duly classified as n earned revenue.
As mentioned earlier, it can be seen that credit due to customers is considered as a current liability. Therefore, when the advance for the sale is made, the journal entry that is made in the income statement and balance sheet for credit that is due to customers is as following:
Bank (Unearned Revenue)
Credit Due From Customers
Just like situations where businesses get credit from external sources, it can be seen that credit can also be extended to customers.
This accounts for instances where the goods (or services) have been provided to the customers. This is the amount that needs to be collected or received from the customers.
Credit that is due from customers is still classified as revenue because it has already been processed, and the respective amount needs to be collected from the customer to complete the sale process. It is considered to be an integral part, and this is something that should ideally be included in the financial statement.
Credit that is due from the customers is considered to be highly crucial because it is the amount that the company has not yet been paid for. Therefore, a proper account needs to be kept of the amount that is due from customers, so that the relevant collections can duly be made.
Accounting Treatment and Journal Entries for Credit due from Customers
Credit that is due from customers is considered to be a current asset. This is because the company has already serviced this order (in terms of processing the relevant goods and services). The amount that is due from customers is also referred to as Accounts Receivable. This is the representation of the debtors that the company has at a given point in time. However, the corresponding amount for this particular order has still not been received.
As a result, it is important to realize that the amount that is due from customers is a current asset, and should be mentioned as such on the balance sheet. The relevant journal entry for credit that is due from customers is as follows:
Bank (Earned Revenue)
Therefore, it can be seen that credit that is due from customers is considered as a current asset. In the income statement, it is described as revenue. Therefore, these journal entries are created in order to showcase the amount that is due from customers.
Given the fact that both these terms are fairly similar, yet there is a very notable difference between the amount due to and the amount due from customers. One is the amount that the company needs to receive (i.e. amount due from customers), whereas the other is the amount that the company needs to pay the customers in the form of goods and services (i.e. amount due to customers).
In the same manner, the accounting treatment for both is also different, since one of them is considered to be a current asset, whereas the other one is a current liability. Therefore, they are represented as such in the financial statements prepared at the year-end. These differences are encapsulated in the table below:
Going concerned is an important accounting principle. It is an accounting term that explains that a company is financially strong and stable to carry on future business activities. Another term that closely relates to the going concern is the continued business operations.
Continued business operations are those activities that are the main operations of any business. We can call it the core business activities of any entity. More comprehensively, the continuing operations are all the activities of a business except the ones which have been discontinued.
The income from continued operations is calculated by subtracting all the operating expenses and tax on the operating income. It shows the company’s after-tax operating income, and most people confuse the income from continued operations with the operating income. We will also talk about this argument.
In this blog, we will talk about the continued and discontinued operations, income from continued operations, and why income from continued operations is so important for any business’s financial position.
What is Income From Continued Operations?
The income from the continued operation can be defined as,
The income for continued operations is the net income generated from the regular business activities of any entity. The income from continued operations is derived by subtracting all the operating expenses and tax on the operating income from the total revenues.’
IFRS 8 of the International Financial Reporting Standards has defined the operating segments and all the disclosure requirements for their incomes. It requires disclosure of revenues from all the contracts with the customers, internal customers, or intersegment customers. Besides, the standards require the entities to define their methods for defining an operating and non-operating segment.
The IFRS 8.22 requires business entities to disclose different types of products and services from which they generate their operating revenues. Different clauses under IFRS 8 regulates the financial reporting of operating segments.
Let’s see what a company’s continuing and discontinuing operations are.
Continuing Operations Or Operating Segments
All the operations except those that have been discontinued will be reported under continuing operations of a business. Let’s formally define continuing operations of the business.
For a continuing operation, two basic assumptions must hold.
That operation must be normal, i.e., related to the nature of the business and profitable
That operation must be expected to continue in the near future.
If these two assumptions hold for any business operation, it will be considered as a continuing operation or operating segment for that particular business. We can explain the concept of continuing operations with the help of examples.
Example 1: ABC Limited is a mobile manufacturing company
So, ABC limited is mobile manufacturing, and its plant is located in China. The company has once been a market leader for 2G and 3G mobile phones. As the new technologies of 4G and then 5G were introduced, their older versions became obsolete for the new market needs. They discontinued manufacturing 2g and 3g phones and entered the business of 4G and 5G devices.
From this case, we can easily identify that the company no more manufactures the 2G and 3G mobile phones. Therefore, they have been excluded from the category of continued operations. The 4G and 5G devices have taken over the place in the continued operations. All the revenues from the sales and manufacturing of 4G and 5G devices will come under continuing operations because these hold two assumptions of normal business and are expected to continue in the future.
Discontinued Operations or Non-Operating Segments
Discontinued operations of any business entity are those which have stopped generating normal income for a business. The IFRS 5 regulates the financial reporting of the discontinued operations and assets for sales.
We can formally define discontinued operations as,
Discontinued operations is an accounting term that refers to a business’s operations, which were once part of continuing operations. These are core parts of any entity’s product line that has been shut down or divested due to market needs or non-profitability.
The important principle of going concern has to be followed by the business entities to stay alive in the markets. The emergence of the discontinued operations in any business is not an abnormal event because companies have to adapt themselves to changing market needs.
For instance, a launch of new technology might make an older plant obsolete. In that case, the company will have to shut down the plant and move to new technology for survival.
For an operation to be declared as a discontinued operation following conditions must be met:
The elimination of an operation from the cashflows and regular operations of the business
The company’s rights of involvement in the day-to-day activities of the operation are ceased
The concept of discontinued operations can be well understood with an example.
Example 2: XYZ Limited has sold one of its product lines
XYZ Limited has sold one of its product lines to a retailer by an agreement. The agreement states that the retailer will pay 7% royalty to XYZ Limited on any sales related to that product line for the next three years.
If we analyze the situation, XYZ Limited will have no direct involvement in the product line’s operations and no cashflows from regular operations. It will be a discontinued operation for XYZ Limited.
Is Income From Continuing Operations Same As Operating Income
At most places, you will find a statement saying that income from the continuing operation is also called operating income. It is true to a certain point, but we can declare it as a fact. Let’s see how the income from continuing operations is different from operating income.
If we see the formula of income from continuing operations, it is earnings after tax but before discontinuing operations.
Both terms are the same thing, but their use is different.
The operating income translates the operating efficiency of an entity which is more like an internal metric.
Whereas the income from continuing operations is the most critical figure, it shows any business entity’s current financial health. The shareholders and investors use this information to assess their investment’s worth.
How To Calculate Income From Continuing Operations?
Now let’s see how we will calculate income from continuing operations of a business entity.
According to the Accounting Principals Board(APB) 30, the income statement will look like the table given below.
For the Year Ending Dec 31st, XXXX
(-) Cost Of Goods Sold
(-) Operating Expenses
(-) Administrative Expenses
Operating Profit/Income From Operations Before Interest And Tax
(-) Interest Expense
Earnings Before Tax
(-) Tax Expense
Income From Continuing Operations
Let’s describe some of the direct costs included in the cost of goods sold, operating costs, and administrative costs.
Cost Of Goods Sold
Direct material –procurement of the raw material for the production
Direct labor –the direct manpower and total labor hours involved
Factory Overhead Costs –water, electricity, gas consumption
Professional Fees – these are costs of delivering services, and it is more relevant to a service-based business
Operating Costs or Indirect Costs
Salaries of the employees like production managers and quality assurance staff
Depreciation and Amortizations
Utilities that are not directly consumed for manufacturing
Rent of the plant
Salaries of corporate staff and managers
Depreciation of office building
Insurance and amortization
Importance Of Income From Continuing Operations
Income from the continuing operations represents the true financial health of the company. It represents the future prospects of the company’s profits. Therefore, the investors can assess the expected return from their investment in the business entity.
Besides, the income from continuing operations is also important from a disclosure point of view. In the multistep income statement, the income from continuing operations shows the results of the business’s normal operations. According to the ruling of IFRS and GAAP, the entity should disclose the sources of income.
For instance, if a company is in car selling, but most of its income is coming from insurance, it will be a red flag. Therefore, disclosing the income for continuing operations is necessary from the compliance point of view.
Another reason the income from continuing operations is necessary is related to the management. Since it is close enough to the operating income, in fact, in most cases, income from continuing information. Therefore it is an important measure of operational efficiency. The internal management can have a better idea of their operations.
We have discussed the income from the continuing operations and discontinued operations. Since continuing operations are the primary source of income for any business entity, income from such operations is the true picture of financial position. Therefore, the income from continuing operations is important for the internal purposes and the external users of information.
We hope the article’s information will clear your concepts regarding the income from continuing operations and operating income.
Any company’s capital structure has two most important parts. Equity and debt collectively make the capital structure of the firm. A company can get capital by equity financing or debt financing. The ratio of equity and debt in the overall capital represents the information about the firm’s capital structure.
In the case of equity financing, the money is owned by the company owners, who are shareholders. They are entitled to a profit in the company’s earnings up to the percentage of their investment.
However, in debt financing, the company involves third parties to finance its capital. Therefore, it creates a lender and borrower relationship.
The company has to pay the cost of borrowing money or what we generally call interest on the loan. The loan can be taken from financial institutions like banks or borrowed from the public through bonds.
According to the International Standards Of Financial Reporting, any business entity must do accounting for the interest paid on the funds borrowed. We will do an in-depth analysis of interest expense, its accounting nature, and accounting treatment.
What Is Interest Expense?
Interest expense is the cost an entity has to pay for the borrowed funds. The interest expense is recorded in the income statement as a non-operating expense. We cannot attribute all kinds of borrowing costs under the head of interest expense.
The formal definition of Interest Expense as of IFRS 23 is,
Any borrowing cost except the ones attributable to the acquisition, installation, or production of the qualifying asset is treated as the interest expense.
In the definition, there are two important terms, qualifying asset and interest expense. We will breakdown the definition to get a better understanding.
Breaking Down Interest Expense
According to the IFRS, an interest expense is defined and calculated under the IAS 39. It is a subset of the borrowing costs any entity bears. The interest expense is calculated under the effective interest method under IAS 39.
The second term discussed in the definition is a qualifying asset. According to IFRS 23.5, a qualifying asset is an asset that requires a substantial amount of time to become completely operational.
The assets measured at a fair value like biological assets are excluded from the scope of IFRS 23. Besides, the inventories that are manufactured repetitively are also excluded from its scope.
The interest expense is calculated on the borrowed funds of an entity. The interest is payable on the bonds, convertible bonds, bank loans, and lines of credit. The total interest expense of the company is calculated on the net borrowings.
The effective interest rate is also calculated for the net amount under IFRS 39.
For example, a company has borrowed $1000000 from ABC bank at the interest rate of 10% p.a. The interest is paid after every year. So the company’s interest expense for a financial year will be 10% of the amount borrowed. It will be around $100000 per annum.
We will closely look at the calculations for the interest expense in the following sections.
Accounting Treatment Of Interest Expense
Interest expense is a non-operating expense for any entity. Therefore, it is recorded in the income statement as an expense. Most commonly, the interest expense is subtracted from EBIT(Earnings before Interest and Tax).
EBIT is also called pre-tax and pre-interest income, as well as operating profit for any entity.
The interest expense is the interest that the company has paid or due on the date of financial statement preparation. The main principle is that interest expense is added once the interest has become due, either paid or unpaid.
The formula for the calculation of interest expense is as follows:
Interest Expense = Principle Amount Of Loan X Interest Rate X (Days for which fund was borrowed÷ 365)
How To Calculate Interest?
Let’s see how to calculate the interest expense. We need to follow the following steps to calculate the interest expense for any entity.
You need to ascertain the principal amount of borrowed money for the measurement period of interest expense.
In the documents of any entity, the annualized interest rate is mentioned. We need that interest rate for calculation.
The time period of the interest expense measurement is determined. It can be annual, monthly, semi-annual, or quarterly.
Finally, we will put the values in the formula of the interest expense.
Let’s look at this example.
Suppose that the company has a total outstanding loan of 2500000 on December 31st. The company follows the normal financial year starting from January 1st to December 31st. The annualized interest rate of the company, as mentioned in the documents, is 8%. We need to calculate the interest expense for the last year.
We have the formula
Interest Expense = Principle Amount Of Loan X Interest Rate X (Days for which fund was borrowed÷ 365)
Interest Expense= 2500000 X 8% X 365/365
Interest Expense = $200000
For the same example, let’s suppose the company calculates the interest quarterly.
We have the formula
Interest Expense = Principle Amount Of Loan X Interest Rate X (Days for which fund was borrowed÷ 365)
Interest Expense= 2500000 X 0.08 X 91/365
Interest Expense = $2500000 X 0.08 X 0.25
Interest Expense= $50000
Similarly, you can calculate the interest expense monthly and semi-annually
Cash Interest Vs. Interest Expense
While going through any entity’s income statements, you will get to know two terms of cash interest and interest expense.
There is often a query that why sometimes interest expense is greater than the cash interest. Or if the cash interest is the same as the interest expense?
Let’s answer this question.
An expense should be recorded in the company’s financial statement in the accrual-based accounting system once it’s realized. This recording should be irrespective of the fact that cash has been paid or not.
The same concept applies to the cash interest vs. interest expense. Cash interest is the amount of interest expense that the entity has paid to the creditors. Or we can say it is the proportion of interest expense that has been settled.
Whereas the interest expense is the total interest expense of the company. It is the total amount due for a certain financial period.
Let’s understand with a small example. We can take the data from the above-solved example. The total interest expense of the company was $200000 for one year. On December 31st, when the financial statements were prepared, $150000 for the first three quarters had already been settled. However, $50000 was due on December 31st, but it was still to be paid.
So the total interest expense was $200000, but cash interest accounted for $150000.
Interest Payable Vs. Interest Expense
The interest payable vs. interest expense concept is quite similar to the cash interest vs. interest expense.
Interest expense is the total interest expense due for a certain financial period. Interest payable is the proportion of the total interest expense that is due and payable.
The interest expense is recorded in the income statement of the business. However, the interest payable is recorded in the liabilities section of the balance sheet.
Suppose a company has a total interest expense of $149000 for a financial year; however, they have only paid $100000 by the time of financial statement preparation. Following the accrual accounting system, the interest expense of $149000 will be recorded in the income statement, and $49000 will be added to the liabilities as interest payable.
Is Interest Expense Debit Or Credit?
We all know that all the expenses are of a debit nature. The interest on the outstanding debt is an expense for the business entity. Therefore, it will be treated as an expense and will be debited in the financial records.
Let’s explain it with an example. A company has a total interest expense of $150000 for a financial period. At the time of interest payment, a journal entry for the interest expense is made. The interest expense is an expense that is debited, whereas cash is going out, so it is credited.
Is Interest Expense Financing Activity?
Interest is a non-operating expense because it is not related to an entity’s day-to-day business activities. All the expenses that do not relate to day-to-day operations are regarded as non-operating expenses.
However, there is a lot of confusion about the recording of interest in the cash flow statement. There is an argument about the recording of interest as operating activity or financing activity in cash flows.
There is a difference between International Financial Reporting Standards and the US Generally Accepted Accounting Principles. The latter one is more strict in the standards of reporting.
According to the IFRS, the interest paid as an expense can be recorded under financing or operating activities. Whereas the US GAAP restricts the recording of interest expense under the head of operating cash flow.
Therefore, we can say that interest expense is more like an operating cashflow than financing.
In this blog, we have tried to explain the concept of interest expense in detail. The accounting nature of interest, treatment, calculation, and general rules regarding the recording of interest expense has been discussed.
A company’s balance sheet comprises the three most critical categories: Assets, Liabilities, and Equities.
There are different subcategories of assets and liabilities. These can be long-term or short-term.
When you hear about the term monetary asset, the question might come to your mind if all the assets aren’t of some monetary value?
Well, the answer to this question is a bit technical. The term monetary item is a highly dedicated term used in accounting and finance. If we analyze the term monetary only, it delivers the meaning of ‘something having a monetary value.’ However, in accounting, a monetary asset is such an asset whose value stays unaffected by inflation or any other economic event.
In any market or business, liquidity is critical to assets’ values or the market or entity’s financial health. If we talk about a stock market, liquidity is the ability of any stock to be sold to get cash quickly.
If we talk about the banking sector, they define liquidity as the measure of how quickly they can satisfy customers’ due claims. And for any business entity, liquidity is the ability of a company to pay its short-term obligations immediately.
The concept of monetary assets is closely related to liquidity. The liquidity of any business entity, market or bank is calculated by its monetary assets. In this article, we will closely look at the monetary assets and how they contribute to the overall liquidity.
What Are Monetary Assets
We can define the monetary assets in different ways. Let’s make one comprehensive definition of a monetary asset.
Every asset has a certain economic value. A monetary asset is a tangible asset that has a fixed convertible dollar value. Such an asset stays unaffected by any macroeconomic event like inflation, exchange rate fluctuations, decreased purchasing power, or demand-supply difference.
The best example to explain the concept of monetary asset is cash. A 100-dollar note will always be a 100$ note. No matter if the inflation increases, purchasing power decreases, the interest rate fluctuates, you will always be the owner of a $100.
The value in terms of purchasing power might decrease. You might not be able to buy the same stuff with that 100$ that you could buy a year before. But, if you give 100$ to someone, you will receive the value of $100.
Examples of Monetary Assets Owned By a Business Entity
Some of the common monetary assets owned by a business include
Cash in Hand: Cash always has the value as stated on the face of a currency note. Cash is the most liquid asset and comes under monetary assets.
Cash Convertibles: Cash convertibles or cash equivalents are those monetary assets that can be readily converted into cash or used as cash in the market. The cash convertibles include notes receivables or trade receivables having a certain face value.
Cash In Bank: Your cash deposits in your bank account are also your monetary asset.
Short-Term Loans: The investments of a business in the short-term debt instruments are also a monetary asset that can be easily converted into cash.
Characteristics Of Monetary Assets
So far, we have understood that monetary assets are liquid, and their face value doesn’t change. Let’s discuss some characteristics of monetary assets as described by International Financial Reporting Standards and GAAP.
Following are two main characteristics that define a monetary asset.
Change In Real Terms
We have explained the character of the monetary asset that its face value remains the same. The first one of the two characteristics is that the monetary asset’s dollar value never changes, which means it’s static. However, such an asset might fluctuate in value in real terms.
For instance, an economic event of an increase in inflation will negatively affect money’s purchasing power. The worth of 1000$ will remain the same; however, you might not be able to buy as many goods from that 1000 dollar.
Restatement In Financial Statements
The second differentiating characteristic of the monetary assets is their disclosure in the financial statements. Everyone who has been associated with accounting will know that the values of the assets change. If you own a building, its value will change due to depreciation and many different reasons.
The plant, machinery, goodwill, and all other assets experience a fluctuation in their value. Therefore, in every year’s financial statement, the value of assets is updated.
However, a monetary asset doesn’t experience the value restatement in the financial statement. A trade receivable will be recorded at 1000 dollars one year before and now. So, the monetary assets do not require a restatement of value every now and then.
What Are Non-Monetary Assets?
We have deeply explained the monetary assets, but we should also define the non-monetary assets for a better comparison and understanding.
It is an understood fact that non-monetary assets are just the opposite of monetary assets. We can define the non-monetary assets based on more or less the same characteristics as monetary assets have.
The value of non-monetary assets doesn’t necessarily remain the same. The value of such an asset is affected by micro and macroeconomic factors, and its face value fluctuates over time.
For instance, you bought a property for $200000 in a nearby town. After one year, the government announced to develop a dry port in that town.
Therefore, this announcement is a signal of new opportunities, increasing the worth of land in that area. Your property bought for $200000 has worth $400000 now. It’s an example of a non-monetary asset.
2) Change in Real Term
The value of non-monetary assets can vary in real terms as well as dollar terms.
3) Financial Restatement
The non-monetary assets are expected a regular restatement of value in the financial statement. We can give examples of a plant and building.
The depreciation and wear of tear of the plant are regularly fluctuating the price. Hence it requires restatement of financial value in the balance sheet.
4) Cash Conversion
The non-monetary assets are not readily or quickly convertible in cash. You cannot sell a piece of land overnight.
The monetary assets require some time to be sold against cash. Therefore, it is also a characteristic that must be noticed.
Examples of Non-Monetary Assets
Here are the examples of non-monetary assets an entity usually owns:
Building and Plant
Monetary Assets Vs. Non-Monetary Asset
Let’s understand the difference between the two types of assets. Here the key differences between the two.
The monetary assets are more liquid than non-monetary assets and are readily converted into cash.
2) Cash Value
The cash value of monetary assets remains the same and doesn’t fluctuate. However, the value of the non-monetary assets is impacted by different internal as well as external factors.
The monetary assets are the liquid assets and therefore are used to appropriate the company’s working capital. The non-monetary assets are mostly the fixed assets and contribute to the fixed capital constituency of the company.
For instance, the cash and cash convertibles are used to pay the short-term liabilities or acquiring raw material. However, plants and machinery are used for manufacturing and production.
According to the International Financial Reporting Standards, a monetary asset must be reported on the closing exchange rate in case of any fluctuations.
However, the non-monetary fixed assets can be reported at their historic value irrespective of exchange rate fluctuations.
5) Tax implications
For the disposal of the monetary assets, there is not any additional tax implication. They are treated under the head of general profit and loss.
For instance, if the company’s debtors are settled off at less than the book value of debtors, the difference will be bad debts or discounts. These discounts and bad debts will be deductible from income.
However, if an event occurs where disposal of non-monetary assets happens, the rules and regulations bound the entity to report any gain or loss under a separate head of “capital gains and losses.’ For instance, if a property is sold at a profit after a holding period of 5 years, it is taxable under capital gains.
Why Are Monetary Assets Important?
The monetary assets of any business entity are the measure of its liquidity. If we divide the monetary assets by the current liabilities, our ratio is termed as a quick ratio.The quick ratio is the most accurate measure of an entity’s liquidity.
The higher the ratio, the better the company’s liquidity position. It means a company is in a good position to pay its short-term loans. In other words, the short-term liabilities of the company are backed up by the current assets.
Some Assets That Can Be Either Monetary or Non-Monetary
Some assets can be treated as either monetary or non-monetary. The prepaid payments can be treated as a monetary or non-monetary asset based on the contract’s nature.
If the prepaid payment to the third party is made under the non-refundable payment clause, there is no chance of getting cash back. In that case, it will be treated as a non-monetary asset.
We can treat the investment in preferred shares as monetary assets depending on the contract. If the contract has the clause of redemption by the issuing entity in the future, there is an expectation of inward cash flow. Therefore, it can be treated as a monetary asset for the business.
To conclude, we can say that monetary assets are critical to the company’s overall liquidity. Holding too many monetary assets can be equally hazardous for the entity’s profitability as holding too few monetary assets.
In the case of excessive monetary assets, the company is trading off many investing activities to bring in big amounts of profit for an entity.