INTERNATIONAL ACCOUNTING

1. INTRODUCTION TO ACCOUNTING

1.1 DEFINITION AND ACCOUNTING PRINCIPLES

Accounting could be described as the social science responsible for studying, measuring,
analysing and registering the assets of organisations, companies and individuals. Its
purpose is to help in decision-making and control by presenting information that has
been previously registered in a systematic and useful way for the interested parties.

It provides very valuable quantitative information in a systematic and orderly manner,

which is expressed in monetary units. This information reflects transactions performed
by companies or individuals and certain identifiable and quantifiable economic items
that affect them. Thus, it facilitates information given to the interested public.

The purpose of accounting is to provide information about results obtained during a

certain period of time, which is very useful when it comes to making decisions in a
rational and efficient way, checking previous management decisions and making
estimates and forecasts.

Below are some definitions about accounting.

- Masi V. (1962): It is a scientific discipline whose focus is on corporate assets

considered both from a static & dynamic, qualitative & quantitative perspective.
It is aimed at timely, prudent and adequate economic management of assets.

Apart from this definition, definitions that do not necessarily link accounting to economy
are to be considered, too. Below is the most representative definition in this sense:

- Moisés García (1965): It is science whose goal is the systematic representation

of any quantified reality of a quantitative type expressed in a homogeneous
magnitude. It can be considered from a static or dynamic perspective. It provides
a picture of a specific company situation and its evolution as well as the
consequences of this evolution.

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There are other interesting definitions which focus on the important role played by
accounting as the main source of information for decision-making:

- American Accounting Association (1977): It is a process to identify, measure and

communicate economic information that allows users to make judgments and
decisions.
- Ijiri Y. (1967): Accounting is a system that communicates the economic events of
an entity.
- Cañibano Calvo L. (1979): Accounting is a science of an economic nature that
aims to develop information that enables gaining the past, present and future
knowledge of economic reality in quantitative terms at all organisational levels.
The specific method used is supported by reliable bases to facilitate the adoption
of external financial decisions and those of internal planning and control.
- Requena Rodríguez J. M. (1981): It is an empirical science that enables gaining
the qualitative and quantitative knowledge of the company’s economic reality,
whose generic purpose is to highlight the situation of that company and its
evolution over time.

In conclusion, these are the points that all the definitions explained have in common:

- Accounting usually pursues the knowledge and interpretation of economic issues

whose structure is circulatory.
- When it comes to the formal aspect, the most appropriate methodology to
understand economic reality is used as it is impossible to gain direct knowledge
through observation.
- Its main objective is to provide interested users with information and elements
of judgment for decision-making.

Now that we know the definition of accounting, let us take a look at the accounting
principles.

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Accounting principles

Accounting principles are a set of general rules that serve as an accounting guide in order
to formulate criteria for the measurement of equity and information concerning the
assets and economic elements of an entity. These principles constitute parameters for
the development of financial statements based on uniform methods.

These principles were approved during the 7th Inter-American Conference on

Accounting and the 7th National Assembly of Graduates in Economic Sciences, which
was held in 1965 in Mar de Plata (Argentina).

One of the principles to be highlighted is the principle of the double entry system,
established by Fray Luca Pacioli in 1494. Its statement is based on the following
premises:

- Every debtor implies a creditor and vice versa.

- One or more debit accounts always correspond to one or more creditor accounts
for the same amount.
- Final amount in the debit should be equal to the sum of the credit.
- Losses are debited and profits are credited.
- Assets of the entity are different from those of the owner.
- Resources of an entity equal the value of its shares.
- Asset elements and their results are recorded through accounts that include
notes and settle changes in the item they represent.
- The balance of an account is the account’s monetary value at a given time. This
balance is modified each time an operation has an effect on the components that
it represents.
- Asset and expense accounts are debtor positions and liability, profit accounts
and net equity are creditor positions.
- The sum of debit and credit balances must be the same in every account,
regardless of the number of entries.

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- To cancel an entry, the account to register and the amount will be the same as
the cancellation.
- Every account has two sections; debit and credit.

In relation to the principles on which the accounting is based, they are explained by the
following concepts:

§ Entity: All financial information is recorded and reported separately from the
personal information of the business owner. Thus, a person may own a business
and a house or a car; however, financial records of the business will not include
information about the owner’s properties, i.e., financial records should not be
mixed. The same applies if the owner of a company has several companies. This
way, each entity should be managed independently.
§ Economic goods: Financial statements refer to economic goods, that is, material
and immaterial goods belonging to companies that have economic value and
that can be valued in monetary terms.
§ Unit of measurement: To be able to reflect the assets of a company in the
financial statements, it is necessary to select a currency in order to value assets
through the application of a unit price. In short, it is necessary to have a unit of
measurement in order to value what is needed. The most common is to use the
currency that has legal tender in the country in which the entity or the company
operates. Only economic events are recorded in the accounting books in
monetary terms, excluding those events that cannot be economically valued.
Money is used as a unit of measurement to present financial statements.
§ Companies in progress: This principle refers to the permanence and projection
of the company in the market, thereby the company will not interrupt its
activities, but it must operate indefinitely.
§ Valuation to cost: It implies that the assets of any company must be valued at
the cost of acquisition or production. Regarding this, it should be noted that
currency fluctuations should not affect this principle, as necessary adjustments
will be made to the numerical expression of costs, for instance in the case of
inflation.

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It is important to mention that this is an essential accounting concept, which

implies that assets must be registered at the price paid for their acquisition.
§ Period of time: Every company must measure their management results due to
administrative, legal, fiscal and financial reasons. Usually, it occurs every 12
month period. This period is called fiscal year (FY), accounting period or financial
year.
The study of financial statements should be subject to a short period, so that a
better approach of the company is possible for a more successful future decision-
making.
§ Objectivity: Changes that occur in the assets, liabilities and equity must be
recorded, so that they can be measured in an objective way and so that such
measure can be expressed in monetary terms. It is essential that any
modification is recorded in the inventory, so that records match reality, which
allows an objective and real perspective of the accounting and financial situation
of the company.
§ Caution: When making a decision between two values, the accountant must
always take the lowest value, thus minimising the owner's participation in
accounting operations. This principle can be expressed through the following
statement: "losses are accounted when they are known, but profits are
accounted only when they have been made".
It should be mentioned that a misinterpretation of this principle can lead to an
exaggeration and, consequently, a bad application of the accounting principle.
This may result in an incorrect presentation of the financial situation, even in
modifying the accounting concept of the value. This principle is said to be a
conservative criterion.
§ Uniformity: General principles and particular rules, represented by valuation
principles used for the development of financial statements, must be applied
uniformly in every period. This way, a better comparison of financial statements
from different periods will be possible.

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Any relevant change in the application of the general principles and particular
rules that may affect the presentation of financial statements must be indicated
by means of a clarifying note.
This principle indicates that companies should be consistent when it comes to
the method of presenting financial statements. This way, the information
presented will be uniform in all periodical accounting records of the company.
If there are constant changes in relation to the method of presentation, the
interpretation and comparison of financial statements will be harder and the
results will show notable variations.
§ Relative significance: When applying accounting principles and particular rules,
it is important to do it from a practical perspective. That is, attention should be
paid only to facts or relevant situations. Obviously there is no rule that
determines what facts are important and what facts are not, so the decision will
be made by the person in charge of accounting, considering aspects such as the
company situation, the relative effect on the assets, liabilities, equity or on the
results of operations.
§ Sufficient disclosure: Accounting information in financial statements must be
clear and understandable so that operations and company situation can be
properly assessed and interpreted. In addition, information must be correct and
accurate.
§ Exposure: Financial statements must contain all the basic and additional
information that is necessary for a correct interpretation of the company’s
financial situation as well as its economic results.
§ Accrual: Equity variations that must be considered to establish the economic
result are those that correspond to a fiscal year, without considering whether it
has been collected or paid.

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1.2 NET EQUITY

As indicated, accounting is an empirical science. For this reason, two aspects should be
considered: the theoretical and the practical one. It is very important not to perceive
accounting as a set of calculations since this discipline helps us to provide a whole series
of data and information in relation to our company, explaining the current situation and
the reasons behind it and helping us to make decisions.

Thus, accounting will show us the economic aspect of our company’s reality since the
information that is elaborated will allow us to grasp and transmit the image of such a
reality as well as its evolution.

One of the basic and essential pieces of information that accounting gives us in relation
to our company is what has been gained and lost, and in what way. It also shows us the
elements that make up the company, what we have and what we owe, our investments
and financing. In this way, accounting deals with those elements that make up the
company from an economic point of view. A company is considered a living entity, and
although its nature is artificial, it presents the same development as a natural living
entity. The company is born, then it develops and dies. Throughout its life, the company
relates with the environment, which provides it with certain elements and which is
provided with other elements on the part of the company, while developing certain
processes within it. All these actions produce a value circulation in the company, and
this current takes shape through the accounting.

In this second section, we will focus on the study of business equity, i.e., the focus of
accounting. Business equity is composed of a series of elements necessary for the
company to operate, such as money, merchandise, machinery, etc. All these elements
make up the economic structure of the company.

For this economic structure to be possible, the company will need a series of financial
means for its acquisition. These means constitute the sources of financing or financial
structure of the company. In this way, it can be stated that the assets of the company
are composed of two main elements; on the one hand, assets and rights, which have a

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value and shape the economic structure of the company; on the other hand, financial
means required (financial structure), formed by the obligations of the company either
with the employer or with third parties.

In terms of business equity, regardless of the type of company or organisation, it will

always be composed of a series of heterogeneous elements susceptible to economic
valuation. These elements will belong to one of the following categories:

- Assets or production factors: these can be classified as material goods such as

goods, buildings and machinery, and intangible assets, such as trademarks and
patents. These elements have a value and are used to achieve the objectives of
the company or to be exchanged in the market.

- Rights: they represent situations in which the company is in a position of demand

or remuneration: collection rights against customers, shares in other companies
or loans granted.

- Obligations: they refer to payment obligations arising from legal situations in

which the company is indebted to other economic agents because of a
commitment, such as debits to suppliers, creditors, debits for loans obtained,
debts in favour of the Public Administration such as taxes and Social Security, or
amounts contributed by the employer or partners.

In this way, the set of goods, rights and obligations make up the company's assets.

As explained, a company's assets will be formed by the economic structure and the
financial structure. The economic structure consists of goods and rights, and will be
called ASSETS, while the financial structure will be made up of the obligations and is
called LIABILITY.

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Below an equation expressing it:

GOODS + RIGHTS = OBLIGATIONS

It is important to mention the fact that the company may have obligations with third
parties (liabilities) or with the entrepreneur (net equity). Therefore, it can be said that
business equity is made up of two types of elements: positive elements (goods and
rights) and negative elements (debts and obligations). The difference between them
corresponds to the employer, which is called net equity.

GOODS + RIGHTS – OBLIGATIONS = NET WORTH

Regarding the net equity, it will belong to the owner of the company, which may be
either a natural person or a legal entity. Therefore, the amount will be the one
corresponding to the owner, which is obtained through the formula: goods + rights -
obligations.

In accounting terms, goods and rights make up the assets, while obligations make up the
liabilities. The latter, together with the net equity, are the sources of financing of the
company. Thus:

ASSET = LIABILITY + NET EQUITY

This is the main net equity equation.

The first part of this equation, the asset, represents the set of elements that the
company will use for the development of its activity. The second part of the equation,
liabilities and equity, refer to the way investments are financed. It may be done through
resources contributed by third parties (liabilities) which need to be repaid, or through
the owners of the company (equity). In this way, liabilities and net equity are the sources

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of financing, providing information on the origin of the resources or financial means

available to the company to make investments, thus constituting the financial structure.

In view of these considerations, let us now look in more detail at the elements that make
up the economic and financial structure as well as its main characteristics.

1.2.1 Economic structure

The economic structure refers to investments, capital in operation and the destination
of financial resources.

Every company, for its normal operation, needs to acquire and maintain assets. These
assets are called the economic structure of the company and are divided into two
groups: fixed assets and current assets.

- Fixed assets: They are also called non-current assets. They represent long-lasting
investments of the company, such as buildings or machinery. In other words,
they refer to those investments that are going to remain related to the company
for a long period of time.
- Current assets: They are also known as working assets, and comprise short-term
investments, such as inventories or raw materials. They are made up by elements
linked to the working cycle of the company, that is, those elements that are
required in order to start up investments of a permanent nature.

Let us move on to discuss these two groups in more detail:

§ Fixed asset

Fixed assets or non-current assets, as indicated, consist of those elements or assets that
remain in the company for a long period (usually longer than a year). These elements
are buildings or machinery and determine the productive capacity of the company or
organisation.

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Fixed or non-current assets are also known as immovable assets since they are the most
solid part of the company and are represented by elements that remain in the company
for a long period and ensure its subsistence. That is why it is necessary that these
elements are financed by permanent resources, that is, funds that constitute equity and
fixed liabilities (required in the long term).

Within the fixed assets, the following subtypes are identified: tangible assets, intangible
assets and long-term investments in equity instruments.

Tangible assets

They constitute physical assets, both movable and immovable property. Tangible assets
are necessary for the development of the productive activity of the company and are
intended for sale in the normal course of operations. The elements that make up
tangible fixed assets have a liquidation value and are tangible in nature. For instance,
machinery, transport elements, buildings, etc.

Intangible assets

These are rights with an economic value which are necessary for the productive activity
of the company but are not intended to be sold in the normal course of operations.

They include elements such as trademarks and patents or rights of transfer.

Long term investments in equity instruments

They are investments in assets of a financial nature, representing property or credit

rights over other economic units, usually with a purpose of controlling them. These
investments are usually meant to control other companies, in order to expand the
business area, diversify the risk, etc., for instance; long-term holdings, long-term
financial investments in equity instruments, long-term loans, etc.

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§ Current assets

Elements that make up current or working assets are characterised by a relatively short
period of time to be consumed. It is about elements or assets that are likely to become
cash within less than one year, such as stocks or raw materials.

In this way, current assets can be said to comprise those elements that are replaced
once or several times throughout the fiscal year, so they must be financed by capital
with a short repayment term, i.e., funds belonging to current liabilities.

Due to their nature, they are elements that undergo continuous changes depending on
the company's activity. For instance, assets acquired for subsequent sale, raw materials
used to manufacture a product, accounts receivable or cash.

In this way, current assets are made up of:

- Assets expected to be sold, consumed or realised during a normal operating cycle

that usually does not exceed one year.
- Assets whose maturity, disposal or realisation is expected to occur in the short
term.
- Financial assets classified as held for trading.
- Cash, consisting of tangible cash and bank accounts.
- Other equivalent liquid assets.

As indicated, current assets represent investments in operating assets that remain in the
company for a short period of time (less than one year). They are constituted by rights,
assets or credits that are liquid or that can be turned into cash in less than one year.

The operating cycle can be taken as a reference for them to be identified (operating
cycle = time needed by the company to complete its production capacity: purchasing,
manufacturing, selling and collecting payments). However, the annual period is used for
practical purposes.

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When current assets of a company are studied and analysed, they are usually divided
into two subtypes: liquid and realisable assets.

Liquid assets

This first subtype integrates asset elements consisting of money which is immediately
available. In this way, it is made up of cash and cash equivalents, for example, cash in
hand and bank deposits that are instantly accessible.

Realisable assets

Realisable assets can be cash assets or they may convert into cash through operating
activities. Cash assets are made up of elements whose transformation into money does
not depend on the production process, such as collection rights; the rest of realisable
assets consist of elements that require the production process to be carried out for
conversion into money, such as raw materials.

Let us see in a more detailed way the elements that make up both types of realisable
assets.

- Cash assets

Below we can see the elements that constitute cash assets:

- Customer: It encompasses balances in favour of the company resulting from

sales on credit due to operations related to the main activity of the company.
- Debtor: It encompasses balances in favour of the company resulting from sales
on credit due to operations not related to the main activity of the company. For
example, debts in favour of the company for the rental of premises to third
parties, provided that this activity is not the main activity of the company.
- Bills receivable from customers: It encompasses credits with clients in the form
of accepted commercial papers. They become cash or another financial asset at
maturity. These bills are trade documents in which the company obliges the

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customer to pay the holder of the bill a certain amount of money in a specific
place and on a specific date.
The principal security is the bill of exchange. This document incorporates the
right of collection, which can be transferred even if the expiration date is not due
yet. Thus, it can be used as a means of payment or transferred to a third party.
It can also be discounted at a financial institution to receive the amount in
advance without waiting for the expiration.
- Credits granted by the company and short-term investments in equity
instruments: These investments pursue obtaining interest and profiting from
cash surpluses or diversifying the risk. They also include short-term investments
in other companies, short-term loans and temporary financial investments.

- Realisable assets consisting of elements that require the production process to

be carried out for conversion into money

Next, elements making up these assets:

- Stocks: It is about goods that the company acquires to sell and transform in the
normal course of exploitation. Thus, goods, raw materials, finished and semi-
finished products are stocks.
- Itemised expenses: It is about those supplies or services necessary to carry out
the production of goods or provision of services. Some of these expenses are
electricity, water or telephone supplies, rents or insurance premiums.

1.2.2 Financial structure

Some financial resources are necessary to acquire those elements which constitute the
economic structure of our company. These financial resources make up the financial
structure of our company.

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The financial structure reflects the different sources of origin of resources used to make
investments in the economic structure possible.

In this way, the following can be stated:

Financial structure (liability and equity) represents the financial capital of the
company as well as its debts and obligations.

There are two groups of accounts within the financial structure: permanent resources
and current liabilities.

§ Permanent resources

There are two elements that form permanent resources: equity and non-current
liability.

Equity includes the company's own resources, consisting of capital, reserves and the
results of operations.

Non-current liabilities are those financial resources with long-term enforceability,

generally, longer than one year.

§ Current liabilities

On the other hand, current liabilities are composed of financial resources whose
enforceability is considered in the short term, generally in less than one year.

The financial structure includes financial resources used by the company at a specific
time. In other words, it includes all the debts and obligations of the company, classifying
them according to their origin and term, indicating whether resources are internal or
external, short or long term.

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Financial resources

Regarding resources of a financial nature, it is important to know the available funding

sources, both at the internal and external level.

- Internal financial resources

Internal financial resources are generated throughout the development of the

company’s own activity. These resources are called self-financing, and can be divided
into the following categories:

- Self-financing of maintenance: benefits retained to maintain the productive

capacity of the company. They constitute allocations made for provisions and
amortisations.
- Self-financing obtained from profits: profits retained to undertake new
investments that lead to the company’s growth. They consist of reserves.

- External financial resources

External financial resources are generated by the business activity itself.

These can be divided into the following categories:

- Own resources: These resources are contributed by the company’s owners and
constitute the equity capital of the company.
- Third-party resources: They are provided by individuals other than the owners,
either natural or legal. These resources can be:
o Long-term third-party resources: the term of enforceability is longer than
one year.
o Short-term third-party resources: the term of enforceability is equal to or
less than one year.

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Below a series of long-term third-party resources:

- Bank credits and loans: A loan operation occurs when a bank provides a certain
amount of money to a company, which must be returned together with its
corresponding interests, in a specific time frame. When it comes to credit
operations, the bank makes available to the company a maximum amount of
money, which can be arranged according to the financial needs of the company
at any time, and only the interest corresponding to the amount provided is to be
paid.
- Leasing: A financial leasing is an operation in which a person, company, etc., pays
to use land, a vehicle, etc. for a particular period of time by paying instalments
previously stipulated. When the contract is over, the leased item can be
purchased, returned or leased again.
- Issuance of securities: It refers to a loan divided into small parts or obligations,
distributed among different creditors.

With regard to short-term third-party resources, it is important to know the following

typologies:

- Trade credits: They refer to spontaneous financing granted by suppliers when

payment is agreed on purchases 30, 60 or 90 days after receipt.
- Bank financing: They are short-term credits and loans so they have the same
characteristics as long-term loans and credits. However, trade discounts must
also be included, thereby a financial institution puts at its customers’ disposal
the amount of one or more bills before expiration and after the deduction of a
series of expenses.
- Factoring: It is a financial transaction in which a company sells its accounts
receivable to a third party (called a factor) at a discount. This operation allows
the company to obtain immediate liquidity and prevents the administrative work
of collecting a deferred sale.

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As we have just seen, company’s assets have two structures: economic structure and
financial structure which implies that the balance between investments and financing
is of utmost importance.

In order to avoid solvency risk, i.e., not enough funds to meet payments when due, it is
very important that there is a certain correspondence between the liquidity of the asset
and the enforceability of the liability.

Therefore, it is desirable that long-term investments (fixed assets) are financed by

permanent resources (equity and fixed liabilities). This means that there must be a
relation between the duration of the asset and the term in which funds used to finance
it must be returned. That is, there must be a balance between investments and their
financing.

However, sometimes that is not possible. Therefore, it is advisable to have a security

fund, also called revolving fund, in case collections generated by current assets greatly
differ from payments derived from current liabilities. It is recommended that in every
company the current assets are higher than the current liabilities. This implies that
revenues within one year are higher than payments made during that same year.

Indeed, if our company finances all current assets with current liabilities, any mismatch
in collections, such as customer default or loss of stocks, would cause a compromising
situation due to the difficulties in fulfilling our commitments with our creditors. That is
why it is important to have a revolving fund to help us achieve and maintain financial
balance.

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1.3 FINANCIAL ACCOUNTING

1.3.1 Conceptual framework of financial accounting

It has been said that accounting is a social science, which implies that it is a non-exact
science which, in turn, entails some problems, because there is not a single way to
capture reality. That is why a group of regulatory bodies have created a series of
standards and guidelines that users must follow for the development and analysis of
accounting information, ensuring consensus in relation to concepts, basic qualities that
such information must meet, recognition and assessment criteria of different elements,
so that they are understood by all users.

This set of norms and guidelines is called a conceptual framework, and its objective is to
guarantee a consistent theoretical basis to develop rules and regulations that should be
followed. These conceptual frameworks are aimed at providing a greater scientific and
methodological foundation to the process of setting accounting standards so that they
are not arbitrary, but derive from the objectives and purposes set for accounting.

Gabás (1991) defines conceptual framework as "an accounting theory of a general

nature that suggests a logical-deductive structure of accounting knowledge and defines
a basic orientation for the body responsible for drafting binding accounting standards".

There are two interesting references that we can extract from this definition:

First, the application of a logical-deductive rationality in the formulation of accounting

standards. This way, rules applicable in the practice can be obtained based on basic
concepts that support the accounting discipline.

Secondly, the fact that the conceptual framework is a tool at the service of the
organisation that carries out the standardisation. This implies that it serves as guidance
in the development of new accounting standards or in the revision of existing ones, also
helping accounting and auditing professionals by providing them with substance and
elements of judgment for their professional activity.

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With regard to the conceptual framework, it is important that it responds to the

following elements:

- Defining basic purposes and objectives of the accounting information.

- Determining what qualities must be met by accounting information to reach
previously set objectives.
- Proposing a structured outline of basic accounting principles, coordinated with
the identification of financial statements, integrating elements and general
standards of recognition and measurement.
- Designing a coordination mechanism between accounting standards and the
qualities and objectives of accounting information in order to establish which
accounting alternative is the best to meet the set objectives.

It is important to mention that conceptual frameworks can be considered from a double

perspective: as a process and as a product. As a process: when looking at the logic and
deductive reasoning that is followed in the work methodology; as a product: when
looking at the result that is obtained once the methodology is applied, which is usually
specified in one or several documents that make up the conceptual framework itself.

Thus, the structure of conceptual frameworks consists of the following elements:

- Basic conceptual structure:

o Objectives
o Qualitative characteristics of accounting information
o Basic accounting hypotheses and basic accounting principles
- Conceptual components of operational nature:
o Financial statements
o Elements from financial statements
o Accounting recognition criteria
o Accounting measurement criteria

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- Accounting standards:
o Specific accounting regulation

Given these considerations, let us talk about the financial information necessary to
consider when dealing with accounting in our company.

1.3.2 Financial information

In terms of definition, financial information refers to quantitative information that is

expressed in an economic manner and that is generally provided by accounting. It is a
set of data that is obtained through financial or economic activities carried out by an
organisation. It expresses the relationship between rights and obligations that a
company has in a specific period or date. Its main objective is to show the performance
of a company for correct and effective decision-making.

The first element that must be considered when developing the financial information of
our company is to choose the observation perspective of the accounting subject, e.g.,
the company.

Here the following theories will be considered:

- Theory of the owner: It takes capital owners as an observation perspective of

the information. Following this theory, financial information is developed so that
owners can control the management of their resources on the part of
administrators. The tool to do so is the accounting. From this perspective, the
protection of corporate assets is a priority. In this case, information includes
asset elements from the perspective of the owner and how he/she is affected by
the activity carried out by the company. This way, it reflects whether their assets,
rights and obligations increase or decrease, or if the risk varies, among other
aspects.

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- Theory of the company: It considers that the accounting subject is the economic
unit in charge of managing a set of financial resources, regardless of their origin
and ownership. The company is considered as an autonomous entity that
manages its resources. Unlike the previous one, this approach not only considers
the owners of the corporate assets, but also considers all those who provide
financing and other users interested in the company's assets and their
development and evolution. Based on this theory, financial statements must
provide information that allows evaluating and judging the present and future
situation of the company. This approach focuses on the capacity of assets to
generate return in the future and ensure return over time, although it is about
different assets. Thus, it does not try to protect assets, but the market of the
company, providing such company with enough information so that it can make
its decisions.

As observed, the point is to decide whether the focus will be on the owner's vision or,
on the contrary, on the company.

Once the financial information is determined, then objectives, purposes and users of
such information will be determined. That is, our goals when developing financial
information of our company must be determined as well as the recipients of it.

That means that the goals of the information will vary depending on the target users.
Possible goals of accounting information are, for instance, accountability, decision-
making, social welfare or an optimal allocation of resources. Thus, these objectives
include different areas, as well as different systems of accounting and policies, which
should be considered when determining target users.

In relation to goals, they are also related to environmental conditions, according to the
social nature of accounting science. This implies that it is necessary to specify the
environment in which the accounting information will be developed before a concrete
definition of objectives.

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As indicated, set goals will be closely related to users who receive the accounting
information since these goals should be established according to their information
needs.

With regard to these users, their classification is made according to their information
needs. Usually, classification is used to differentiate internal users who have some
control over the accounting information system and who perform planning,
management and control tasks over the activity carried out by the company. Whereas,
external users have limited access to this information and cannot set criteria for the
development of financial information.

Let us take a look at the following table which shows users of accounting information,
considering the relationship they have with this information.

INTERNAL USERS Planning and control tasks - Top management

- Middle management
- Board of management
- Owner and potential investors
and shareholders
EXTERNAL USERS
Resource suppliers - Staff
- Non-trade creditors and credit
institutions
- Trade creditors
Recipient of goods and services -Bodies regulating taxes,
Indirect interests accountancy, stock market and
currency board
- Business associations
- Securities brokers
- Government, regions and local
councils
-Trade associations, public and
private statistical centres
- Lawmakers and political parties

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- Customers and consumers, and

general target
Tasks related to information control - Auditors

Now let us move on to different information needs of different users:

- Top management: Information pursues control goals. It allows monitoring the

current situation of the company, analysing changes and making necessary
corrections.
- Owners: They are interested in the return and value of their financial
investments, as well as the management performed by administrators.
- Banks and creditors: They are interested in liquidity, return and solvency. Their
goal is to expose the risk incurred by operations performed by the company.
- Board of management: They are interested in results, which is essential in terms
of tax payment and the financial-economic situation for macroeconomic
analyses.
- Other users: For instance, potential investors, workers, customers, financial
analysts, NGOs and other groups of interest. Each type of user requires
information with different goals.

§ Requirements of financial information

After setting goals and purposes of financial information, qualitative requirements must
ensure its usefulness.

Below is a series of requirements:

- Relevance: It is about the ability of information to provide adequate data for

decision-making. That is, it involves presenting information that is useful at the
time of making an economic decision. This implies that such information is able

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to show and predict consequences of past, present and future events as well as
confirm or correct assessments made previously.
- Reliability: It implies ensuring that the information faithfully represents what it
claims to represent and is reasonably free from bias, that is, it is neutral
information and without errors.
- Completeness: The information will be complete when it contains all the data
that can influence decision-making, without any omission of significant
information.
- Comparability: It refers to the possibility of users to compare financial
statements of a company over time, in order to identify the trends of the
financial situation or the company's performance, and also to compare different
companies, so that different situations and profitability can be contrasted.
- Clarity: It implies that assessment and decisions are easy to be carried out by
users, based on a reasonable knowledge of economic operations, finance and
accounting, through a detailed examination of the information provided.

In addition to these five requirements, it is important to add a sixth requirement, which

arises as a final result of the application of these requirements and accounting
principles. This requirement is faithful representation.

1.3.3 Essential concepts and principles

Finally, let us briefly explain the accounting principles included in the General
Accounting Plan:

- Ongoing concern principle

It determines that financial statements are usually developed considering that the
company is in operation and will continue operating in the future. Thus, it is accepted
that the company has no intention or need to liquidate or limit the level of activity.

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Thus, when a company is in the process of closing, it must communicate the non-
application of this principle, since this will only apply to those companies that will
continue to develop their activity.

In relation to this principle, it is important to present some characteristics in order to

better understand the concept. These characteristics are:

- A company must be managed for a long period of time.

- The main objective of this principle is that if a company is in a situation of
uncertainty, it can apply the appropriate principles in order to avoid the end of
their economic activities.

The importance of this principle lies in the fact that it provides the opportunity for the
company to remain active. This implies that the company must evaluate all possible
options that can be used to continue carrying out its principal activity and avoid stopping
their activities in the face of difficult situations.

In practical terms, if a company struggles to find a solution to a crisis situation, it

operates according to the ongoing concern principle; however, if the company ceases
operations without even trying to find a solution, it will not act according to such
principle.

- Principle of accrual

This principle implies that the temporary imputation of income and expenses is carried
out when actual expenses and revenues occur, not based on the moment in which the
monetary or financial flow derived from them takes place.

Expenses of a company will be considered accrued when the company has complied
with the process of consumption of products or services. In some cases, it will be
necessary to estimate the amount of expenses which will have to be calculated in
accordance with the reliability requirement.

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As far as income is concerned, they must have been realised to be recognised. That is,
the money must have been collected. Regarding this, something must have been
delivered or done in exchange, including collection rights.

The effects of transactions are recorded when they are performed, not when the cash
or its equivalent of the transaction is received or paid, regardless of the date of payment
or collection.

To better understand this principle, below there are a couple of examples:

- A distributor of transport vehicles sold 5 trucks in December of year 1; the

customer will pay at the end of year 2. In spite of this, the sale must be accounted
for this year (1) since it is when it occurs.
- If a company hires an advertising agency to carry out a marketing campaign and
such services were rendered in November of year 1, the corresponding invoice
was issued then. However, the contract signed between the company and the
advertising agency determines that the payment will be made three months
after the issuance of this invoice, that is, in February of year 2. Despite this, the
principle of accrual determines that transaction recording is based on the
moment when operations occur, not necessarily when the collection or payment
takes place. Therefore, the accounting record of the hiring of this advertising
service must be done in year 1, not at the time of payment, which is in February
of year 2.

- Principle of uniformity

It implies that the adopted norms must remain unchanged over time and be applied
uniformly without variation in every period. Thus, it will be possible to interpret and
compare information from different financial statements, which will allow making right
decisions based on changes they reflect.

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In the event that criteria adopted previously need to be modified, circumstances

resulting in the change will be recorded in the report, indicating the quantitative and
qualitative impact of the variation on the annual accounts.

The importance of this principle lies in the possibility of comparing different financial
statements. In this way, if criteria are changed every year regarding financial statements,
it will be very hard to compare data from different periods. Therefore, an assessment of
the performance of our company will be difficult, too, since different aspects will be
valued every year.

- Principle of caution

It is important to be cautious when making estimates and assessments under conditions

of uncertainty.

Caution implies a certain degree of good judgment since estimates are made in
situations of uncertainty. In this way, it is expected that assets or income are not
overrated, while expenses and obligations are expected to not be underestimated.

This principle does not allow the deliberate undervaluation of assets or income, nor
conscious overestimation of obligations and expenses.

According to this principle only benefits obtained at the closing date of the year will be
accounted for, unless otherwise stated at the regulatory level. Otherwise, all risks are
taken into account as soon as they are known (occurred in the current or last year), even
if they were only known between the closing date of annual accounts and the date on
which accounts were developed. In both cases, full information will be reported.

- Principle of no-netting

Unless regulation indicates otherwise, asset and liability entries or those of expenses
and income cannot be offset, and the elements that make up the annual accounts will
be valued separately.

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The main peculiarity of this principle is that all accounts must be represented with their
actual balance at the given time. Only in this way will the objective of no-netting
principle be fulfilled since the financial situation will be reflected as it is, without results
and financial statements being partially altered.

Basically, it is about presenting accounts and results as they are, in a real and transparent
way. For example, our company has a certain balance on the suppliers account. This
balance indicates amounts pending payment for the received purchases or services,
worth €4,000. In addition, our company also has a certain balance in the customer
account, implying that there are €5,000 pending collection for sales or services.

Based on this situation, the principle of no-netting implies that those outstanding
balances may not be offset. Thus, if we have a balance of €4,000 pending payment and
a balance of €5,000 pending collection, and both balances are offset, the balance of
payments would be zero and the balance of charges would be €1,000 in our favour.
However, this would distort the accounting reality of the company because there are
unpaid invoices, although the amount in collections is higher. Thus, we must stick to
reality and avoid distorting the accounting.

- Principle of relative importance

This principle determines whether a non-strict application of some accounting principles

and criteria will be acceptable, especially when the relative importance produced is not
of much significance and does not alter the faithful representation of information.

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1.4 FINANCIAL STATEMENTS

Financial statements are a set of informative documents that make up the output of the
external accounting information process. They summarise the economic events and
transactions that have taken place over a period of time, as well as the situation resulting
from these operations.

In this section we will focus on the elements that make up the financial statements, but
before that we will briefly discuss the concept of capital and its maintenance.

1.4.1 The concept of capital

The concept of capital will be an important element in the development of financial

statements. In addition, it is essential to know its evolution when analysing the
performance of the company, which is why the capital maintenance capacity of the
company must be analysed.

In order to evaluate the capital maintenance capacity of our company, it will be

necessary to define the income generated. In this case, we usually distinguish between
assets and income.

Hicks’ definition (1968) of income is quite interesting. This author defines this concept
as "the maximum value that a person can consume during a week and whose situation
will remain the same after such period".

According to this definition, the calculation of income is about determining how much
can be consumed without getting poor, so that we operate in a responsible and cautious
manner.

This concept has been adopted by Fernández Pirla (1977) to define the profit of the
company, doing so under the assumption of capital maintenance. Considering this, the
author upholds that profit will be subject to a series of conditions that limit its
distribution in order to avoid a decapitalisation or impoverishment of the economic unit.

The conditions established by Fernández Pirla are:

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- Maintenance of the chance to obtain similar profits in subsequent years.

- Maintenance of the service capacity of the company.
- Maintenance of the liquidation value of company capital in real terms.

In this way, it is about the correct management of the company, thus implying that the
income generated in the course of economic activity should ensure the continuity of the
company and the generation of benefits. It should also maintain the capital invested by
shareholders, free of inflation. When these conditions have been fulfilled, the rest of
income is considered as profit that can be distributed among the owners.

Consequently, capital maintenance is directly linked to the following two elements:

- Accountability to owners about the management done with resources that have
financed the organisation.
- Determination of the profit made by the company, in order to evaluate the
possibilities of compensation to owners.

1.4.2 Elements of financial statements

Elements that make up financial statements depend on the objectives of the financial
information, as well as the capital and its maintenance.

These elements are classified into two types:

- Elements linked to the economic-financial situation, which make up the balance

sheet à assets, liabilities and equity.
- Elements related to the activity à expenses, income and bottom line.

Although these elements have already been presented during the first part of this topic,
they will be briefly reviewed again in a summarised way.

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- Asset: includes the goods, rights and other resources under economic control
of the company as a result of past events, which are expected to generate profits
in the future.
It is important to note that the notion of ownership is not related to the concept
of asset, but the notion of control is. Concepts of control and ownership are often
presented together, control is the key element here. In this way, an element over
which the company has control but lacks ownership will be considered as an
asset, but it will not be considered as such if it is owned but the company has no
control over it.
It should also be noted that if profits cannot be made in the future, that item will
not be considered as an asset either, for example, if an item has become obsolete
and is no longer profitable. Regarding this topic, it should be mentioned that
human capital cannot be considered as one of the company’s assets because
there is no reliable system to assign a value, although it contributes to generating
cash flows.
Finally, in addition to these basic elements that define the asset (control, the
probability of future returns and the result derived from past transactions), it is
important to mention other elements that present a series of non-essential
characteristics of the asset such as the form of procurement (purchase,
manufacture or donation), tangibility of elements and legal ownership
(ownership, rental…)
Next, a series of company assets: buildings, machinery, real estate, stocks,
collection rights, etc.
- Liability: is made up of current obligations arising as a result of past transactions
or events that require the company to deploy resources or provide services that
may produce benefits or economic returns in the future (payment in cash or in
kind) . Provisions are included here, too.
In addition to this main characteristic of the liability, other non-essential features
must be mentioned as well: an obligation may be difficult to quantify if subject
to some conditions, such as a compensation pending legal decision as well as the
existence of a due date or not. This operation is performed through provisions.

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The most common way to generate liabilities is through the acquisition of goods
and services based on external financing or through the transformation of other
liabilities.
The following items are considered liabilities of a company: their own funds and
debts owed by the company to third parties such as suppliers, banks or other
creditors.
- Shareholders’ equity (Net equity): is the residual part of the assets of the entity
that belongs to their owners once all liabilities have been deducted.
Contributions made by their owners or partners either at the establishment of
the company or at a later stage are also included here, as well as accumulated
results or other variations that affect them.
As observed, this definition is closely related to the valuation made of assets and
liabilities of the company. That implies that eventual changes in the value of
assets or liabilities will involve variations in shareholders’ equity. Such variations
will be addressed later, when learning about income and expenses.
- Income: can be described as an increase in resources of the company, provided
that its amount can be determined reliably. In this way, recognising an income
implies recognising the increase in an asset or the disappearance or decrease in
a liability and, sometimes, an expense.
Income is defined based on the effect it has on a company's assets. For instance,
according to the Spanish General Accounting Plan, an income is described as an
increase in the shareholders’ equity of the company during the fiscal year, either
in the form of an increase in the value of assets or in the form of a decrease in
liabilities, provided that they do not derive from monetary contributions or in
kind from partners or owners.

In relation to income, there are two types of possible gains: realised and
unrealised gains.

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o Realised gains: they are made up of revenues resulting from an operation

carried out by the company, such as the delivery of goods in a sale
operation or the provision of a service.
Realised gains consist of the ordinary income, arising from ordinary
activities of the company such as sales, interest and rent, and gains,
which also imply an increase in the economic benefits of the company,
but they are not derived from ordinary activities.
o Unrealised gains: are about gains that have not been materialised, such
as the sale of merchandise that will be charged within a period of time.
Operations collected in advance are also considered unrealised gains,
because the economic transaction has not yet been carried out.

- Expenses: are defined as the decrease in the shareholders’ equity of the

company during the fiscal year, either through the decrease in the value of assets
or through the increase in the value of liabilities, provided that it is not about
monetary or distributions in kind to partners or owners. The recognition of an
expense occurs as a consequence of a decrease in the resources of the company,
provided that its amount can be valued or estimated easily. Thus, recognising an
expense implies the partial or total decrease in the value of an asset, an increase
in the value of a liability and, sometimes, the recognition of an income or an
equity item.

As for expenses, normal expenses are to be considered. For instance, sales costs,
salaries, etc. Losses incurred are also to be considered, which are related to
decreases in economic benefits and have the same nature as normal expenses
and may arise, for example, from the sale of a non-current asset or a loss, among
other reasons.

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In addition, unrealised losses will also be considered. Some of them are linked to
variations in the value of certain assets, such as unrealised income, are charged
directly to shareholders’ equity and are not registered in the income statement.
Others have simply not taken place yet.
- Bottom line: is usually made up of the income obtained in a fiscal year, whether
from ordinary activities or extraordinary profits, minus expenses, whether they
have incurred or not.

In addition to presenting the elements that make up financial statements, it is important

to note that conceptual frameworks determine a series of conditions that elements
must meet in order to be incorporated into financial statements. These conditions are
known as accounting recognition criteria. They are derived from compliance with basic
characteristics of the information, that is, relevance and reliability- in the case of income
and expenses, the application of the principle of accrual and, whenever appropriate, the
correlation between income and expenditure.

Accounting recognition criteria are defined as the process through which those
elements that make up annual accounts are incorporated into the balance sheet, the
profit and loss account or the statement of changes in equity, according to registration
norms ruling each one of them.

Conditions for such recognition are:

- Expectations of resource realisation representing possible elements of financial

statements must be true or it must be possible to ensure that they will occur
with a reasonable degree of probability.
- The item must have a cost or value that can be measured reliably.

These criteria are established in line with the qualities of relevance and reliability, taking
into account also the uncertainty that characterises the environment in which the
economic units act.

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This recognition requires assigning a monetary amount to the element in question, so

assessment criteria to be used should be set.

Assessment criteria

With regard to these assessment criteria, we will present below those criteria which are
most used at the time of recording the elements in the accounting, as well as valuation
concepts that need to be developed in order to reflect those realities of different
elements as long as they remain in the company.

Let us take a look at different assessment criteria that should be considered.

- Historical price or historical cost: this has always been one of the main
assessment criteria. Historical cost of an asset refers to its acquisition price or
production cost. Acquisition price is the amount paid or pending payment, plus
the fair value of other considerations occurring at the time of acquisition (when
applicable), which must be directly related to the acquisition. It also should be a
necessary element to set the asset in operating conditions. Thus, the acquisition
price is the one stated on the invoice along with all additional expenses occurring
until goods are located in our facilities or are in conditions of commissioning.
With regard to the cost of production, it includes the acquisition price of raw
materials and other consumables, as well as the price of production factors
directly attributable to the asset and the corresponding part of production
expenses indirectly related to the asset. These indirect costs will be related to
the period of production, construction or manufacture, and will be based on the
level of utilisation of the normal working capacity of the means of production. In
this way, the cost of production will be the sum of the purchase price of raw
materials, direct costs and indirect costs.

The historical cost of a liability refers to the value that corresponds to the
counterpart obtained in exchange for incurring the debt.

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- Fair value: it refers to the amount for which an asset can be acquired or a
liability settled between interested and duly informed parties who carry out a
mutually independent transaction.
The value resulting from a forced, urgent transaction or an involuntary situation
or settlement will not be considered as a fair value.

In general, this value will be calculated with reference to a reliable market value.
In this sense, the quoted price in an active market will be the best reference of
the fair value. Below the conditions to consider a market as active:

o Goods or services exchanged in the market are homogeneous.

o Buyers and sellers can be found for a specific good or service at all times.
o Prices of goods or services are known and easily accessible to the public.
In addition, the prices reflect real, current and regularly produced market
transactions.
- Capitalisation value: is a method of discounting cash flows and is applicable to
the valuation of assets that generate an income. The value of the good is
obtained through the application of this valuation technique, capitalising the
income that this good will generate during the time in question. For example,
the capitalisation value of a fruit tree plantation would be the sum of the value
of all the crops that the trees of these plantations will produce until the end of
their productive life.

- Expert assessment: this criterion is used when it is difficult to objectively value

an asset. In this case, it is necessary to consult an expert in the specific subject
to get a proper assessment. This criterion of valuation is very common in the
purchase of art works or when properties must be valued.

- Net realisable value: the net realisable value of an asset is the amount that can
be obtained through selling it in the market after deducting the estimated costs
necessary to perform the sale as well as in the case of the raw materials and the

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products in progress, the estimated costs necessary to complete their

production, construction or manufacture.
In relation to this criterion, assets are valued by the amount of cash and other
liquid items that could be obtained through the non-forced sale of the asset at
the current time. As for liabilities, they are worth their redemption values, that
is, the amounts of cash or other liquid items that are expected to fulfil payment
obligations in the normal course of operation at the present time.

- Current value: refers to the amount of cash flows to be received or paid in the
normal course of business, which are updated at an appropriate discount rate.
This value is obtained through the financial update of the value of the good when
its expiration is later than the present day. This criterion is usually applied to
rights or obligations that will be effective over time.

- Value in use: is a type of valuation that arises as a result of the application of

updating flows as indicated above. Thus, the value in use of an asset or a cash-
generating unit can be said to be the present value of expected future cash flows
through its use in the normal course of business, which are updated at an
appropriate discount rate. For instance, the value in the use of a machine is its
production capacity without wearing down.

- Sales costs: refer to those incremental costs directly attributable to the sale of
an asset in which the company would not have incurred if it had not made the
decision to sell. Here, financial expenses and taxes on benefits are excluded,
although necessary legal expenses need to be included so as to face transfer
taxes.
- Amortised cost: is that accumulated portion of the recorded cost of a fixed asset
that has been charged to expense through either depreciation or amortisation,
plus or minus adjustments for any purchase discounts or premiums associated
with the purchase of the asset or security.

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- Transaction costs of a financial asset or liability: this refers to the incremental

costs directly attributable to the purchase, issuance, or other disposal of a
financial asset, as well as the issue or assumption of a financial liability, resulting
from the transaction performed.

These costs include fees and commissions paid to agents, consultants and
intermediaries, such as brokering, notary fees and others, as well as taxes and
other rights derived from the transaction. Premiums or discounts obtained in the
purchase or issue, financial expenses, maintenance costs and internal
administrative costs are excluded.

- Book value: this is the net amount for which an asset or liability is recorded in
the balance sheet after deducting, in the case of assets, accumulated
depreciation and any accumulated impairment correction that has been
recorded.

- Residual value: this is the amount that the company estimates for an asset if it
is sold or disposed of at the current time after deducting estimated costs for its
realisation and taking into account that the asset had reached the end of its
useful life. Thus, the residual value of a good is the value of the item once it is
fully amortised, that is, at the end of its useful life.

- Replacement value: refers to the cost of the asset when it must be replaced.
Regarding assets, it is defined as the amount of liquidity that should be paid if
the same asset that we previously owned or a similar one is acquired. In relation
to liabilities, they are valued considering the liquidity that would be needed to
pay the obligation at the current time.

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1.5 THE ACCOUNTING PROCESS

Finally, this introductory section on accounting will finish with a description of the
accounting process.

As indicated, the main objective of accounting is to gather, process and transmit the
appropriate information to the decision-making process in the business or
organisational field. Such objective requires performing the so-called accounting
process.

In general terms, accounting carries out this processing and development of information
in the following way:

- Information is obtained from the company through a series of operations, such

as collection, symbolisation, measurement, assessment, representation,
coordination and aggregation. They allow us to obtain the so-called financial
statements, which contain information on those aspects that make up the
economic reality of the company.
- Information extracted from financial statements is analysed and interpreted in
order to make solid conclusions that help us to make decisions.
- It will be necessary to carry out verification and consolidation tasks so that the
information obtained shows a truthful and complete image of the company and
its economic situation.

In order for accounting to meet its objective, two types of instruments are necessary.
These are:

- Accounts, which are conceptual elements to represent real elements.

- Financial statements, which are conceptual elements that collect elements that
make up corporate assets, or show generated income, or cash variations.
- Some material elements, such as books, files or computer equipment, that allow
us to make this representation.

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In other words, accounting needs conceptual and material tools to be able to carry out
the representation of reality.

Account

An account is one of the instruments through which accounting can fulfil its own
purposes, which are to highlight the situation of the economic unit, specifically of each
of the assets that make up the company, and its evolution in time.

It serves three functions:

- Classifying function: it allows differentiating and discriminating elements. Each

account merges and represents real, homogeneous elements that constitute an
equivalence class.
- Historical function: it refers to the fact that an account includes every record and
event caused by the management as a consequence of economic transactions
that affect the item in question. The whole process of an item is thus recorded
in the account throughout the period considered.
- Numeric function: positive and negative variations (debit and credit) of the item
are recorded. The difference between them is a number (balance), which is
representative of the item’s state at a given time.

In addition to these three functions, the account fulfils an important measurement and
assessment function in the accounting process. It also facilitates the development of
representation and aggregation functions.

The representative function of the account is manifested through the individualisation

of the different economic, real and financial objects that are linked to an economic unit,
as well as the variations that they experience as a consequence of transactions in which
they intervene. Thus, the representation of each of the elements that make up the
company is done through an account.

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In regard to the aggregative function, the account can be conceptualised as aggregate.

That is, economic objects are aggregated on the basis of economic criteria and classified
by accounts according to certain equivalences. This function symbolises a set of real
magnitudes, allowing the easy representation and interpretation of a complex world. It
unites what is complex and diverse within a company in a single simplifying entity.

As a general rule, accounts can be grouped into:

- Accounts representing active assets.

- Accounts representing liabilities and shareholders’ equity.

In relation to the representation of the account, this is schematically done through a T

that represents an open book in which debit is represented on the left and credit on the
right hand side. In economic terms, to debit is to make an entry in the debit of the
account, while to credit is to make it in the credit. Debits and credits made in the
accounts arise due to variations experienced by corporate assets as a consequence of
economic operations that are carried out.

DEBIT CREDIT

Accounts are collected in the so-called General Ledger, in which each sheet corresponds
to an account that represents an asset, liability or a piece of shareholder’s equity. Data
resulting from economic operations according to a conventional criterion will be
recorded in the accounts. Each operation is represented through what is known as an
accounting entry.

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X A Account to B Account X

As shown, at least two accounts are affected in each operation or transaction. In this
example, the sheet containing “A” account would register a debit, whereas “B” account
would register a credit.

Regarding the accounts, the analytical representation must be mentioned, too. It is

expressed as follows: D (debit) - C (credit) = B (balance). The balance is the difference
between the debit and the credit, so the balance of an account can be:

- Debit balance: Debit > Credit

- Credit balance: Debit < Credit
- Zero balance: Debit = Credit

As it will be explained later, to settle an account is to make it have a zero balance, so a

note will be made to reflect the increase or decrease in the balance. This operation, as
a general rule, will be carried out at the end of the fiscal year.

This way, let us consider an account with the following characteristics:

ACCOUNT

DEBIT CREDIT

100 75
150

250 75

175

As observed in the example, the account has a debit balance of: 250 - 75 = 175. In this
case, to bring the account into balance an entry of an amount equal to 175 should be
made in the Credit (in order to obtain a zero balance).

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Thus:

ACCOUNT

DEBIT CREDIT

100 75
150

250 75

175 175

The use of the accounts is based on the following principles:

- Principle of disaggregation: implies that every account can be broken down into
other subaccounts. For example, the cash account can be divided into two sub-
accounts: "cash in euros" and "foreign currency cash"; at the same time, this
account could be divided into other subaccounts such as "cash in dollars," "cash
in yens," "cash in Norwegian kroners," etc.
- Principle of integration: this law is correlative to the previous one, and refers to
the fact that accounts can be integrated into another account of a higher level,
which are called representative accounts. For example, “A” client, “B” client, etc.,
can be collected in a single generic account called Clients.
- Principle of connection: implies that each account can interrelate with one or
several accounts and also with itself.
- Principle of elimination: implies that when an account intervenes with a
different sign in the same operation, it can be eliminated. Indeed, regular
registration activity is based on this principle. Let us see it in the following
example:

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10 Merchandise to Net 10

10 Net to Cash 10

If the principle of elimination is applied, it would be represented as follows:

10 Merchandise to Cash 10

It is important to mention that it is one of the most controversial principles since it can
involve losing information. Therefore, it is used in very few cases in business practice.
Normally it is used in the cash sale of merchandise.

Before addressing the accounting cycle, we should mention economic events and
accounting events.

Operations that may occur in the economic activity are of a very diverse nature. When
such operations have economic consequences, they are called economic events.
However, these operations do not always affect business assets, as will be the case of
the development of a budget, the request for an offer for the acquisition of a good or
service or hiring an employee, among others. Therefore, they lack accounting
significance. On the contrary, when economic events quantitatively or qualitatively
affect equity, the so-called accounting events arise, which must be known and recorded
by the accounting, in order to give information about them and highlight their impact
on the equity business.

In this way, accounting events can be defined as legal or economic events, which are
likely to be represented by accounting because they affect or may affect the equity
business. The accounting event is thus described as any movement or equity alteration
that will be represented later through the accounting. These facts can affect the equity
balance.

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There are three types of accounting events:

- Permutative: those accounting events that do not cause quantitative changes in

shareholders’ equity, but only qualitative ones.

Let us suppose that our company acquires machinery, paying for it in cash through the
bank:

Machinery to Bank

In this case, our company will not be worth more or less because of carrying out these
operations, since all it did was simply to exchange one asset it had available (banks), for
a new asset (machinery).

However, it may happen that machinery is not paid for immediately, but there is a
pending payment left:

Machinery to Suppliers of fixed assets

In this case, the asset is acquired but the payment is not made in cash, however the
company incurs a debt for the same value. Here, the equity value of the company neither
increases nor decreases.

- Amending: those accounting events that cause quantitative changes in

shareholders’ equity.

Now imagine that partners of the company decide to contribute a certain amount of
money at a certain time:

Banks to Equity capital

Thanks to this contribution, the value of the company's equity has increased so it has
undergone a modification.

Another example of an amending accounting event is when a company hires an

advertising service:

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Advertising to Banks

In this case, a decrease in our assets takes place, though this does not imply an increase
in another asset or a decrease in another liability.

- Joint: it is about both permutative and amending account events.

Our company has decided to sell the machinery that it previously acquired. Initially the
purchase was over €2,000 euros, and now the company sells it for €2,500:

2,000 Banks to Machinery 2,500

to Profit 500

In this example, it can be observed that there is a change between assets (Banks and
Machinery) and, on the other hand, there is an increase in value in the company's equity,
since this change is a profit.

Once the accounting events are explained, we will move on to see how they are
recorded by accounting. The most common method is the so-called double entry
bookkeeping system.

The double-entry method emerges as a natural evolution of the simple entry, which is a
method that collects the variations of a specific asset. For instance, money and its
corresponding conceptual element, which is the cash account, considering only inputs
or outputs of money, not the origin of collections nor payment destination.

In order to enrich the information provided by the simple entry, the double entry is used,
which is elaborated based on the idea that any variation in the equity composition or
value affects simultaneously two dimensions. When recording events, the accounting
searches information in them and represents the double aspect of cause and effect.

The use of the double entry is based on the accounting identity:

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ASSET – LIABILITY = SHAREHOLDERS’ EQUITY

ASSET = LIABILITY + SHAREHOLDERS EQUITY

The sum of the economic structure must always coincide with the sum of the financial
structure, and any double-entry must preserve that identity.

The conceptual basis of the double-entry method is called the principle of duality. It
allows a specific way of perceiving accounting events according to which two equity
components are identified in each accounting event. A cause and effect relationship is
established between them, which is precisely what accounting intends to record or
reveal. In all accounting events there is an origin of funds or financing and an application
of these funds or investment. Therefore, in every accounting event a double angle can
be detected, so that its registration considers this double cause and effect aspect.

The way to record accounting events through accounting is by means of the accounting
entries made in the Log book. They are done accordingly:

↑A ↓E or ↓L A Account to B Account ↓A ↑E or ↑L

A = Asset

L = Liability

E = Shareholders’ Equity

Thus, every input implies an output, and vice versa. For example, if goods are acquired,
there is an input of products and an outflow of money. On the other side, if goods are
sold, there will be an output of products and an inflow of money.

When recording accounting events, the following criteria are followed:

- Monetary or value increases of the asset accounts, which appear on the left side
of the accounting entry, are recorded by means of new entries on the left side of
the accounts, i.e., on the debit side; decreases, however, appear on the right side
of the account (credit).

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- Monetary or value increases of liability and equity accounts appear on the right
side of the accounting entry and are also recorded by means of new entries on
the right side of the accounts (credits), whereas decreases are recorded on the
left side (debit) of the accounting entry.

Each account is represented on a sheet of the General Ledger and shows the value of
the item at a certain moment of time.

- Increases in asset accounts (goods or rights) will be recorded in the debit, while
decreases will be in the credit.
- Increases in liabilities and equity accounts will be recorded in the credit, whereas
decreases will be in the debit.

Given these considerations, let us now turn to the accounting cycle and the different
phases that comprise it.

1.5.1 Accounting cycle

There are three phases within the accounting cycle:

- Start phase.
- Registration of accounting events.
- Closing of the fiscal year.

Let us now see the activities and documentation to be considered in each of these
phases.

§ Start phase

The accounting process in every company begins with a reckoning of all the assets,
liabilities and shareholders’ equity that it has available. All this is included in the
document called inventory.

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Thus, the inventory is defined as the detailed and complete listing of goods, rights and
obligations that constitute the equity business at a given time.

Through the inventory, the extent of the net situation of the company may be
determined, which arises as a result of the difference between the set of goods and
rights and the set of obligations with third parties. Thus, the inventory will include the
description of all the elements that make up the economic structure of the company as
well as the sources of financing that make up the financial structure.

In relation to the inventory, it is important to differentiate it from the balance. As

indicated, the inventory includes detailed information about each element that makes
up the structure of the company, while the balance does not describe these elements in
detail.

Example:

Inventory:

10 kg crops (10 m.u./kg) 200 m.u.

30 kg barley (10 m.u./kg) 150 m.u.

Balance:

Merchandise 350 m.u.

Inventory:

Chair in X colour & Y model 10 m.u.

Table in T colour & X model 5 m.u.

Balance:

Furniture 15 m.u.

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For its part, balance is essential to monitor the equity and financial situation of the
company, allowing us to know whether or not the company is in financial equilibrium.
Thus, the balance provides the following information:

- The situation of the company at a specific time and its evolution.

- The economic potential and the operational capacity of the company.
- The degree of financial equilibrium of the company or creditworthiness, that is,
the ability of the company to meet payment obligations, from a static point of
view.

Regarding the types of balance sheets, we can identify:

- Account balance: it arises as a result of calculating differences between the total

debit and credit of each account. It presents a detailed list of all the accounts
that have intervened in the registration process, adding all the entries made in
the debit and credit
- Trial balance: A trial balance is a bookkeeping worksheet in which the balances
of all ledgers are compiled into debit and credit account column totals that are
equal.
- Balance of inventory: this balance will be obtained once we have performed the
operations corresponding to the accrual and regularisation. In this balance all the
accounts included in a balance will appear, but without considering whether it is
about assets, liabilities or equity. Accounts are divided into two columns:
economic structure and financial structure.
- Balance sheet: this balance will be obtained when the accounts included in the
previous balance are classified into: assets, liabilities and equity. This represents
the general situation of the company.
Regarding the content that should be included in the balance sheet, each
company must include those contents that are necessary to reflect its economic
and financial situation. However, there is a whole series of minimum content
required by the General Accounting Plan. These are:
o Property, plant and equipment.

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o Real estate investments.

o Intangible assets.
o Rentals and similar operations.
o Financial instruments: financial assets and liabilities.
o Non-current assets held for sale.
o Stocks.
o Trade debtors and other receivables.
o Cash and cash equivalents.
o Trade creditors and other payables.
o Provisions and contingencies.
o Liabilities linked to non-current assets held for sale.
o Deferred tax assets and liabilities.
o Shareholders’ equity.

In relation to these elements, it is necessary to differentiate between those that are part
of the assets, liabilities and shareholders’ equity.

The following elements can be found within the assets:

- Property, plant and equipment: permanent equipment for the development of

the activity. These are elements that will remain in the company in a lasting way
and have a tangible nature, such as land and natural assets, buildings, technical
facilities, machinery, tools, furniture, IT equipment, transportation elements and
goods leased.
- Intangible assets: rights that can be valued economically. These are identifiable
assets of a non-monetary and immaterial nature which the company has control
over. These elements include: research and development expenses,
administrative concessions, industrial property, goodwill, transfer rights and
computer applications.
- Long-term investments in equity instruments: those assets that have the right
by themselves to receive cash or other cash equivalent means. These elements
are not related to the operation of the company, but to the financial

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management of the company so they are financial in nature. They are grouped
under the generic term of financial investments.
- Stocks: those assets to be sold in the normal course of operations of the
company or that are in production to be sold; it is also about materials or supplies
to be consumed in the process of production of goods and provision of services.
Thus, goods, finished products, products in progress, semi-finished products, raw
materials, fuel and office supplies are considered stocks.
- Trade debtors and other receivables: these express the right of the company to
demand fulfilment of a commitment or obligation, usually as a result of trade
credits. Here customers, debtors, trade bills and credits to personnel need to be
taken into consideration.
- Cash and cash equivalents: cash and highly liquid short-term investments that
include financial investments convertible into cash, with a maturity not
exceeding three months from the acquisition date.

Regarding the liability, the following must be considered:

- Trade creditors and other payables: in this first group we must consider
suppliers, bills of exchange payable, creditors and unpaid remunerations.
- Provisions and contingencies: they refer to those events originated before the
closing of the fiscal year, but whose final outcome depends on certain future and
uncertain events. These are facts about which there is uncertainty as far as the
final amount or the due date is concerned.
- Financial liabilities: these are debts contracted with financial entities or other
companies for loans granted to the entity, debt securities issued by the company
and liabilities arising from contracts or derivative instruments. Some of the
elements considered as financial liabilities are obligations and simple bonds,
short and long-term debts with credit institutions, debts for discounted effects
and short and long-term bonds.

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Finally, there are those corresponding to the shareholders equity, which are included in
the balance sheet. They constitute the residual part of the assets of the entity, i.e., they
belong to their owners once all their liabilities have been deducted.

Its basic functions are to finance the permanent or non-current asset structure and a
reasonable part of current assets and be used as a collateral against third parties.
Shareholders’ equity is made up of the company’s own funds, adjustments due to
changes in value and subsidies, donations and bequests received.

When the inventory and initial balances are done, asset, liability and shareholders’
equity values will be available. Then, the first or opening entry will be made in the so-
called Log book and the General Ledger will be started.

Thus, all the initial values of all the accounts with debit balance corresponding to asset
elements will be written down in the debit; on the other hand, all the initial values of
the accounts with credit balance corresponding to liability elements and to
shareholders’ equity will be written down in the credit.

§ Recording accounting events

As accounting events occur, they will be written down in the Log book and general ledger
with the corresponding entries.

In order to carry out this task, it is necessary to carry out an analysis prior to the
accounting of the event. In order to better understand this process, we will rely on the
following basic accounting sheet:

Element Type of Financial Variation Entry Amount

element group

Equity Good, right Asset, liability Increase or Debit or Sum

element or or decrease credit
obligation shareholders’
equity

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According to the information obtained here and applying the double entry bookkeeping
system, accounting entries that correspond to transactions that take place in the
company are compiled in the Log book. Then, this information will be transferred to the
General Ledger.

In order to verify if the recording process has been carried out correctly, the information
must be controlled; this way, it can be guaranteed that it is correct. Thus, the first control
of the information is performed through the trial balance, which must provide the same
results both in debit and in credit balances. It will be balanced when columns of debit
and credit sums equal, as well as columns of debit and credit balances. This premise is
necessary for the recording process to be correct, although it is not enough since errors
or undetected omissions in the recording may occur.

Let us have a look at accounting event records:

- Credit purchase of merchandise worth 10 m.u.

10 Merchandise to Suppliers 10

- Cash payment to creditors 20 m.u.

20 Creditors to Cash 20

- Collects 25 m.u. from customers

25 Cash to Customers 25

This is how it would be recorded in the Log book. Each of these entries will have their
corresponding entries in the General Ledger:

CASH

DEBIT CREDIT

25 20

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MERCHANDISE

10

SUPPLIERS

10

CREDITORS

20

CUSTOMERS

25

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§ Closing of the fiscal year

Finally, when the accounting events for the corresponding period are recorded, the fiscal
year can be closed. A series of phases are necessary when closing the fiscal year, just like
when opening it.

Essentially, the Log book is closed by the closing entry, which is then moved to the
General Ledger so all the accounts will be closed as well. Thus, accounts will be settled,
and a final balance sheet will be developed at the end of the year.

The closing entry is made with the information contained in the General Ledger. It
contains accounts with debit balance and others with credit balance, which must be laid
like this (see below) so that they are closed:

Credit balance accounts to Debit balance accounts

When this entry is done, the information will be transferred to the General Ledger to
settle all the accounts and develop the final balance of the year. Indeed, if we take a
careful look at the closing entry, it usually contains asset accounts with a debit balance
and liability and shareholders’ equity accounts with a creditor balance.

At the end of the closing year, all the accounts of the General Ledger will be settled and
the information on the different elements will be included in the final balance sheet and
in the profit & loss account, together with the other financial statements.

Considering this, let us now get familiar with the operations that will be carried out
during the closing phase of the exercise.

It is important to focus on those operations that are necessary to obtain the yearly
results and those operations that affect the balance. The yearly result is obtained by
calculating the difference between yearly income and expenses necessary to obtain this
income. To obtain the yearly results, operations to balance speculative accounts will be
necessary, as well as value adjustments and accrual of income and expenses. At the end

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of the fiscal year, it will also be necessary to carry out operations to reclassify accounts
that affect the balance.

Balance of speculative accounts

Speculative accounts can be described as those accounts including results, in addition

to recording the variations of the element to which they refer.

If the speculative procedure is followed at the time of recording transactions, the

information contained in the balances of the accounts will not represent the asset
situation of the element. Thus, in the balancing process the balances of speculative
accounts represent the asset situation of the element in question.

Accounts following a speculative procedure are characterised because operations are

charged at cost price and paid at the sale price so an integral part and a specific part are
mixed. Thus, it is about separating both aspects, leaving in the account only the integral
part and taking the specific part to a differential account (operating income).

Below is an example:

MERCHANDISE

Si S

Key:

Si = Initial Stocks

P = Purchases

S = Sales

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According to the speculative procedure, data on final stocks (Sf) will be obtained in an
extra-accounting way, that is, by means of the physical count of the stocks that remain
in the warehouse.

Thus, if willing to calculate the result of the year, regular expenditure (RE) will be
subtracted from regular income (RI). Considering this example:

R = RI – RE = S – P + Sf – Si = (C – D) + Sf

Key: RE = Si + P - Sf

Therefore, the calculation of RE requires the physical count of the stocks in order to
know what the final stocks are since the balance of the merchandise account does not
correspond to the reality.

Below the entries that need to be made in the Log book prior to the closing entry:

- If the bottom line is positive:

Merchandise to Operating results

This way the corresponding account is balanced.

- If the bottom line is negative:

Operating results to Merchandise

This way the corresponding account is balanced.

Value adjustments

At the time of closing the year, it is necessary to adjust the value of those elements that
lost value throughout the year.

As for these adjustments, actual losses and depreciation will be studied here.

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- Actual losses

Equity elements of the company are subject to certain risks: fixed assets may be
damaged and customers may not pay their debts, for instance. Such situations cause
equity elements to lose value; this way, if said value is unrecoverable, it must be
corrected and subsequent accounting updates must be made indicating the loss.

In the case of non-current assets, an account with atypical values will be used, i.e., with
a debit balance in case of losses and a credit balance in case of profits.

The imputation of certain losses can be made at the end of the year, provided that it has
not been made when it occurred.

For example, in case a customer finally goes bankrupt, the entry would be as follows:

Losses associated to non-cashable loans to doubtful customers.

- Depreciation

Depreciation can be described as the accounting tool to reflect the loss of value of
certain elements of the company. These elements are, as a general rule, non-current
fixed assets, both tangible and intangible.

Such loss of value or depreciation derives from three main reasons:

- The wear on non-current asset elements as a result of them being used

throughout the operation cycle. This wear is called functional depreciation.
Example: a van that is used every day to distribute products wears out because
it is used on a daily basis.
- Aging as a consequence of the passage of time, causing the element to lose
qualities and value. This wear is called aging or physical depreciation. An
example: a van that is parked in the garage loses value as time goes by, even if it
is not used.
- The emergence of new techniques can cause a reduction in the efficiency of an
element, which results in a loss of value of capital elements used. Variations in

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demand must be considered, too; changes in fashion and tastes, also if a product
or service becomes outdated, it may be replaced. This loss of value is called
obsolescence, aging or economic depreciation. An example: machinery at our
facilities has gone obsolete due to new and faster machinery available in the
market.

Before learning about methods of depreciation, it is important to comment on the fact

that there are some elements that are not depreciable, such as land. They are not
depreciated as they do not wear out, do not age and do not become obsolete.

There are two methods of depreciation: direct and indirect.

- Direct method

Depreciation is quantified, then the reduction in value is performed directly on the non-
current asset account representing the depreciated asset.

An entry is made in the account of the depreciation of tangible assets. To make the
accounting entry, a charge is made in the depreciation of the tangible fixed assets
account or the one specified for each item, which is the expense account, and the asset
account representative of the item that loses value is paid.

Example: our company registers 10 m.u. in the concept of depreciation of buildings. The
entry in the Log book would be the following:

10 Depreciation of property, plant and equipment to Buildings 10

It would be represented like this in the General Ledger:

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DEPRECIATION OF PROPERTY, PLANT & EQUIPMENT BUILDINGS

10 100 10

Depreciation account of property, plant and equipment would represent the loss of
value of buildings and is considered to be the part that is applied to the production
process.

At the end of each accounting period, said account must be paid. The account is settled
by using funds from the bottom line.

10 Bottom line to Depreciation of property, plant & equipment 10

DEPRECIATION OF PROPERTY, PLANT & EQUIPMENT BOTTOM LINE

10 10 10

BUILDINGS

100 10

90

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Building account will be credited to the year-end closing entry for the remaining amount
after deducting the depreciation from the initial value, in this case 90 m.u.

This procedure involves a loss of information, because the acquisition value of the
building cannot be known nor the amount depreciated so far, so that the asset is shown
according to its book value.

In order to overcome these limitations, we use the indirect method.

- Indirect depreciation method

According to this method, the expense account that represents the depreciation of the
item is also the depreciation account of property, plant & equipment. However, the
account that is credited in this case will be the accumulated depreciation of property,
plant equipment account, which will indicate the depreciated amount up to the
moment.

The book entry in the Log book will be as follows:

10 Depreciation of to Accumulated depreciation 10
Property, plant & equipment of property, plant & equipment

The accumulated depreciation of property, plant and equipment account is a special

asset correction account, which operates similarly to liability or equity accounts.

This account includes the amount of depreciations that will occur periodically in the
depreciated asset. Each year the depreciated amount is added, so that it is possible to
check its balance at any time and know its amount. In this case, the book value of the
equity element depreciated will result from the difference between the balance of the
asset account (buildings, goods, etc.) and that of the accumulated depreciation of
property, plant and equipment account.

The accumulated depreciation account will remain in the accounting book until the asset
is fully depreciated, as long as it remains in the company. This account has a credit
balance and is a compensating or corrective account of the asset. The information is

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used to determine the amount of fixed assets that must be included in the balance
sheet. There, fixed assets must appear in the net of depreciation, that is, the difference
between the acquisition price and the current accumulated depreciation. Information
on accumulated depreciation is recorded in another financial statement: the annual
report.

BUILDINGS ACCUMULATED DEPRECIATION

OF PROPERTY, PLANT & EQUIPMENT

100

10

As in the previous case, the balance from the depreciation of property, plant &
equipment is taken to the bottom line.

10 Bottom line to Depreciation of property, plant & equipment 10

As in the previous case, the building is worth 90 m.u, but this method allows keeping the
information about the acquisition value and the amount that has been depreciated so
far.

This amount is called book value (BV).

BV = Initial value (V0) – Accumulated depreciation (AD) = 100 – 10 = 90

It may be noted that book value does not have to match the market value of the building.

The following year, it will be necessary to make an entry that includes the corresponding
depreciation.

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In the accumulated depreciation account yearly entries will be made for the
depreciation amount, which will imply a gradual increase in the balance until the good
is fully depreciated. Thus, when the accumulated depreciation equals the depreciable
value of the asset, the equity element will be derecognised.

The entry to be made is as follows:

100 Accumulated depreciation to Buildings 100

of property, plant and equipment

In this way, the accounts of buildings and accumulated depreciation of property, plant
and equipment will disappear from the accounting, since they will be settled.

Given the two methods of amortisation, let us now turn to depreciation systems.

As indicated, equity elements lose value as they are used, whether due to wear and tear,
aging or obsolescence. This loss of value can occur in several ways; indeed, there are
equity elements that depreciate intensely in the first moments of their life and slowly at
the end of it, and vice versa. There may also be a uniform loss of value throughout the
economic life of the item.

Accounting aims to reflect in the books of the company the real value of equity elements
of the company throughout time. To do this, it will be necessary to find the most
adequate way to calculate the depreciation of non-current assets.

Different depreciation systems will be presented here. However, before that it is

important to define a series of concepts:

- Initial value (V0): refers to the cost price or value at source of the equity element
that is going to be depreciated.
- Residual value (Vr): also known as salvage value, it is the value of an equity
element after its economic life, that is, once its depreciation process is over. This
denomination also refers to the value that the equity element has at the end of
each period, after the depreciation corresponding to that fiscal year has been

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made. In this way, we can talk about the residual value of the year 2XX1, 2XX2,
etc. For each of these years, it can also be called book value and value pending
depreciation.
- Depreciation rate: the coefficient applied yearly (or the corresponding time unit)
in which depreciation is calculated, expressed in the form of percent.
- Depreciation base: also known as depreciation value, it is the amount or value
to which the depreciation rate is applied in order to obtain the depreciation fee.
- Depreciation fee: monetary expression of the consumption of the equity
element depreciated.
- Depreciation time: also known as useful life of the item, it is about the number
of years that the depreciation process lasts.
- Depreciation period: refers to the temporary elements making up depreciation
time. In this way, depreciation period can be annual, semi-annual, quarterly, etc.

Given the definitions of these concepts, let us familiarise ourselves with the
classification of the different depreciation systems.

Depreciation systems can be financial or non-financial.

- Non-financial amortisation systems: these depreciation systems do not take

into account the financial performance that can be obtained with the resources
produced as a result of depreciation. Financial depreciation systems are:

o Linear (constant instalments): depreciation is constant throughout time.

Every instalment to be paid is the same.
o Non-linear (depending on the level of activity): this system is used for
assets in which depreciation is closely linked to the level of activity. Such
depreciation is expressed in terms of the use or duration of the good
measured in units produced, working hours, operation hours, kilometres
travelled, or any other unit of measurement in which the activity and
consumption of the item is expressed.

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o Fixed depreciation rate on the initial value: implies determining the

percentage periodically taken on the pending value of depreciation at the
beginning of each fiscal year.
o Digit numbers: refer to the distribution of depreciable value. It is about
dividing this value by the sum of digits (each year of the useful life of the
element a digit is assigned), giving rise to the rate. The amount
corresponding to each instalment is obtained by multiplying the ratio by
one digit in increasing or decreasing order, depending on whether a
system of increasing or decreasing depreciation is chosen, respectively.
o Arithmetic and geometric progression: the variation of annual
depreciation instalments is calculated according to an arithmetic or
geometric progression.

- Financial amortisation systems: these amortisation systems take into account

the return obtained as a result of the investment of depreciation funds. They may
be:

o Simple: they take into account the performance, but imply that the
depreciable value is recovered at the end of the useful life.
o Compound: they take into account the performance and reconstruct the
capitalised depreciation value of the moment, that is, they take into
account the interest generated by the investment of the funds coming
from the depreciation.

Accrued income and expenditure

Companies are obliged to allocate the income and expenses that correspond to the
specific year or time period considered, regardless of the financial flow that derives from
them. That means that the moment when revenues are collected and expenses are paid
is not considered.

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The main objective of accounting accrual is to determine the amounts of the different
magnitudes of income and expenses corresponding to the current year. The bottom line
of the company will be obtained by the difference between revenue streams and
expenses that correspond to the period. There are some income and expenses that,
despite occurring in the given year, do not correspond to that specific year or vice versa;
the accrual is performed to delimit these magnitudes.

To carry out a process of accrual, the following steps will be followed:

- Detection of economic accounts in the General Ledger, distinguishing them from

financial accounts.
- Separation of the economic accounts referred to income (provision of goods and
services) from those referred to expenses (acquisition of goods and services).
- Distinguishing the part of every income and expense that belongs to a specific
fiscal year (regular expenses and income), regardless of whether or not they have
occurred in said period. Magnitude of the period is what occurs in it, whether or
not it corresponds to it. Periodic Magnitude is the one that corresponds to the
period, whether or not it has occurred in it. This second magnitude is the one
that will be taken to the bottom line.
An example: Our company has contracted an annual insurance policy on October
1st, 2XX1 worth 12,000 m.u. The expense for the period would be 18,000 m.u.,
as well as the periodic expense of the year. That is, it would be the part that has
already been consumed or, the part corresponding to October, November and
December of the year 2XX1. Thus, the regular expense would be:
12,000/12 = 1,000 x 3 = 3,000 m.u.
The rest of the expense of the policy (9,000 m.u.) will correspond to the 2XX2
exercise.
- When we have calculated the amounts of the period, we will proceed to the
development of the income statement. To do this, we will make the following
double entry based on regular expenses and income:

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Bottom line of the year to Regular expenses

Regular income to Bottom line of the year

Reclassification of accounts

Finally, the last operation that we should consider at the end of the year is the
reclassification of accounts.

It seeks to leave the accounts with their true amounts and meaning because sometimes
during the year mistakes can be made in the allocation of concepts or amounts, or the
circumstances that affect certain headings may vary.

For example, if we use the year as a criterion to differentiate the long term from the
short term for debts, in the case that we have a loan to repay within two years (long
term), when the first year has elapsed, there will be one more year for the maturity of
the debt so it will be necessary to change the debt from the long term to the short term.
This would be through the following entry:

Long-term debts to Short-term debts

with loan entities with loan entities

In this way, we reduce long-term debt and increase short-term debt.

Finally, when we have completed the closing operations, we will have the information
that will enable us to prepare the accounting results which will summarise the company
situation reached until the end of the year.

The documents that will come out of the year-end are: the balance sheet, the profit and
loss account or income statement, the statement of changes in equity, the statement of
cash flows and the report. Here we will focus on the profit and loss account, also called
the income statement. However, in the last chapter of this section, we will talk in more
detail about these documents.

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Profit and loss account or income statement

When we talk about the result obtained by the company, it is important to point out
that the actual result can only be known at the end of its life, due to the fact that at that
moment there are no more risks, the commitments have been fulfilled and it is no longer
necessary to ensure the maintenance of the capital. This result is called the total result
and it is obtained by calculating the difference between the amount invested at the time
the company was incorporated and the value of the closing, that is, the value resulting
from deducting the funds obtained from the sale of our product or service, the necessary
resources for the cancellation of existing debts.

However, companies, of course, need to determine their results in a more regular way,
in order to help them in decision-making. This is why we must prepare the periodic
result. This result will not only help us to make decisions and establish strategic
objectives, but it will also serve as a source of information for investors or creditors of
the company’s operation. Moreover, it will help set the remuneration to the
shareholders, know the entity’s potential and create new business lines. Finally, for tax
reasons, companies must present the figure of the income statement to the different
public administrations, as a general rule, on an annual basis, so as to establish the taxes
that it must pay.

Thus, we can state that the periodic result, also called the taxable year’s outcome, refers
to an economic year or a fraction of the company’s life, which is normally done annually.

The calculation of this result makes it necessary to adopt certain hypotheses in order to
be able to recognise and allocate the expenses and income to the different years.

According to Spanish regulations, the result of the accounting year is calculated by

comparing income and expenses. This implies that when determining the result, the real
flow of income and expenses is taken into account, that is, the right to collection and
the obligation to pay. On the other hand, it is important to note that the result obtained
is equivalent to the increase or decrease in net worth for all concepts, except for
relations with owners. At this time, the income and expenses that are directly charged

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to equity are not considered and are included in the statement of changes in equity,
since we are referring to the calculation of the result.

Based on this, we can perform the calculation of the periodic result by two methods:

- Static method: we obtain the result by comparison between two consecutive net
equity situations, considering that the efficiency of the company's capital and its
productive capacity remain unchanged. Thus, the periodic result is obtained by
means of the difference between the net asset value at the end of the fiscal year
and that at the beginning of it.
- In this way, the initial net situation is represented by the following formula:
- N0 = A0 – P0
While the final net situation is represented:
N1 = A1 – P1
A is the value of the assets and P the value of the liabilities.
In this way, the periodic result will be calculated by the following formula:
R = N1 - N0 = (A1 – P1) – (A0 – P0) = (A1 – A0) – (P1 – P0)
It is important to mention that, in the event that throughout the fiscal year there
are variations in the capital contributed by the partners of the company, the new
contributions will be subtracted from the previous formula, or the withdrawals
of funds will be added by these.
Finally, we should note that this method is little used because it requires the
presentation of information about the result of the period with a clear
identification of income and expenditure flows, both by legal requirement and
by its greater information capacity.
- Dynamic method: using this method, the result is calculated by establishing the
difference between income and the amount of income required to obtain the
income corresponding to a specific accounting year. The result we obtain must
coincide with the net variation that occurs in net worth during this period, that
is, with what we have obtained when calculating it by the static method.
- So: R = periodic income - expenses necessary to obtain such income

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- In this way, the accrual of income and expenses is necessary, as well as the
existence of a clear causal relationship between them.
Let us bear in mind that this is the calculation method adopted by Spanish
legislation.
§ Income and expenses

As we already know, at an entrepreneurial level, an income implies an entrance of

money, while an expense implies an exit.

In relation to income and in order to obtain more accounting information, it is important

to differentiate between income from ordinary operations and income that has arisen
as a result of transactions or atypical events. This will help us in making decisions, since
it is essential that we know if the results obtained come from the ordinary or usual
activity of the company or if, on the contrary, they come from the sale of facilities or
other properties of the company. If the results come from the main activity of the
company, we will ensure the continuity of the business activity.

To value the income, as a general rule it is valued at the current value at the time of the
sale of the assets, which may be goods or services, or liabilities related to the income in
question. Consequently, this value has several meanings depending on the conditions in
which the collection of sales is made. Which may be:

- When it is cash, the income coincides with the cash received.

- When a deferral is granted, the income will be the cash equivalent of the assets
that will be received, excluding the interests that have been incorporated in the
operation. Considering this, the returns, the commercial discounts and any other
type of reduction in the sale price should appear in the profit and loss account
or in the results minus the income to which they refer, and they should not be
reflected as expenses.
- When the collection is made in kind, the valuation of the income will be made
through the valuation of the consideration received.

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With regard to expenses, it is vital to note the following characteristics:

- These are expressions of monetary facts that are derived from the use of goods
and services in the process of income generation by the company.
- For the use of goods and services by the company to be considered an expense,
it must involve a cost for the entity, so here the goods and services received free
of charge will be excluded.
- Expenses are when the good or service used has contributed to the generation
of income. Otherwise, they would be considered losses and named as such.

When recognizing expenses, we have three basic principles. These are:

- Identification of a cause-effect relationship: every economic transaction

generates, simultaneously, income and expenses. For example, when we sell
merchandise, before generating the income from that sale, we had to face the
expense of acquiring said merchandise so that later we could sell it. On this
principle, it is important to say that it cannot be considered as a principle of
generalised application since it is not possible to establish a cause-effect
relationship for all the items of the company, as is the case of the salary of the
CEO.
- Temporary allocation: we must assign to each financial year both the income
associated with the assets used and the proportional part of the cost of the
aforementioned assets. An example of this would be the cost of non-current
assets; of the amortisations.
- Immediate recognition: when the expenses cannot be related to a specific
income, but it is necessary to incur them in order to obtain income that
materialises in the same year, we must recognise them in the period in which
they occur. An example are the advertising expenses, whose income or benefit
will not enter the company until a later time and will do so periodically.

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To finish this first chapter on the introduction to accounting, we will now see the
different types of results that we can obtain in our company so that we can classify them
correctly.

Classification of results

In addition to the two types of results we have presented; the total result and the
periodic income statement, we can establish complementary classifications that will
help us in our strategic decision-making.

As a general rule, it is said that the periodic result of a company can come from three
different sources. These are:

- Specific activities that constitute the main object of the exploitation of the
company.
- Regular activities, but of an accessory nature to the main one.
- Sporadic or occasional activities and, therefore, of an irregular nature.

Based on this, we can differentiate the different types of results:

- Ordinary results: are those results of a regular, cyclical and repetitive nature that
are characterised by their regularity. They encompass those results that come
from the main activity of the company (result of exploitation) and those activities
that the company performs on a regular basis, although they do not constitute
its main activity, since its nature is incidental, that is, they have some results alien
to exploitation.
- Atypical results: they are occasional, non-recurrent and irregular results that
occur sporadically, at certain times, being impossible to identify a constant
frequency of occurrence. These usually include the gains and losses caused by
unusual actions, such as operations with non-current assets or due to a natural
disaster.

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On the other hand, taking into account the nature of the flows to which the operations
are linked, the results may be:

- Operational or operating result: this corresponds to the real flows of goods and
services in the entity, arising from the development of the main activity that the
company performs.
- Financial result: it is the result linked to the financial flows derived from the
management of capital and investments of the company.

The sum of operating and non-operating results, including financial results, gives rise to
ordinary results.

Depending on whether the presentation of these results is done before or after having
deducted the tax expense, two types of results will be discussed:

- Result before taxes: refers to the result from which the amount of taxes has not
yet been reduced. This type of result enables making decisions without taking
into account the fiscal policy that can change and alter the tax rates. When this
result is a loss and, therefore, the company does not have to pay taxes, it will
coincide with the net result of the year. If the result is a gain, it will be obtained
after deducting the tax.
- Result after taxes or results for the year: refers to the result once all income and
expenses have been considered.

Following the General Accounting Plan, the following classification of the types of results
is made:

- Operating income: this includes the expenses and income related to the
operation, not related to the operation that does not have a financial nature and
the atypical ones.
- Financial result: is established by the difference between income and expenses
of a financial nature.

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- Profit before taxes: is obtained by adding the result of the operation and the
financial result.
- Result of the year from continuing operations: is obtained by the difference
between the result before taxes and the income tax.
- Profit for the year from discontinued operations: includes after-tax results of
discontinued operations. It is considered an interrupted activity when, for
example, a line of business or a geographical area of activity that can be
considered isolated from the rest, that is, a dependent company acquired by its
subsequent sale, is disposed of.

To finish this topic let us take a look at the classification of the elements that make up
the income and expenses.

Income

Bearing in mind the link between the income and the normal activities of the company,
we must consider:

- Ordinary income: are those revenues of a regular, cyclical or repetitive nature

that are connected either to the actual flows of goods and services delivery, or
to the financial flows derived from the management of capital or investments of
the company.
- Atypical income: is the income that is not recurrent or does not come from the
normal activities of the company.

Considering the nature of the operations that give rise to the income, it can be classified
into:

- Income from the sale of goods that are the object of the company's traffic: it is
the income derived from the sale of goods, which is understood as the delivery
of the elements subject to the company's traffic in exchange for a consideration.

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- Income from the rendering of services: it is the one derived from the operations
of the exploitation activity of the company, when it is dedicated to providing a
service in exchange for remuneration to other companies or individuals.
- Income derived from the use or transfer of capital: refers to the counterparts or
prices obtained by the assignment of the use or enjoyment of a good, unless it is
free of charge. The most characteristic income of this type is the result of the
remuneration of financial capital ceded by the company.
- Income from subsidies: subsidies are defined as transfers of resources or other
benefits received from public entities or private persons for free.
- Other income: the rest of the income that is not included in the previous
categories.

Expenses

Considering the connection of the expenses with the activities of the company, we can
distinguish between:

- Ordinary expenses: are those expenses of a regular, cyclical or repetitive nature

that are linked either to the actual flows of consumption of goods or services, or
to the financial flows derived from the resources contributed to the company.
- Atypical expenses: are those unusual or recurrent expenses which come mainly
from disposals of fixed assets or due to natural catastrophes.

Considering the nature of the expenses, we can distinguish between:

- Expenses for the supply of storable short-cycle goods: short-term stored goods
consist of goods, raw materials, products and the rest of storable supplies, such
as auxiliary materials, packaging, office supplies, etc.
- Expenses for external services and other items: these expenses include
expenses corresponding to factors of production acquired from other
companies, other than supplies, which derive from the company's own operating
activities. An example: repair of machinery.

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- Financial expenses: these are derived from the use of foreign financial capital for
a specific period of time, regardless of the legal manner in which the transfer is
made; bank loans, loans, financial leasing or other, and regardless of the type of
consideration agreed, whether in cash or any other modality. In any case, the
dividends or profits distributed by the company that constitute remunerations
of the owners of the capital are not included as expenses, but as distribution of
results.

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