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Vat reporting & impacts on financial statements.

The implementation of Value Added Tax (VAT) in Saudi Arabia has introduced significant changes to the financial landscape for businesses. VAT not only affects cash flows and compliance requirements but also has implications for financial reporting. 

We will explore the impact of VAT on financial reporting in Saudi Arabia, focusing on how it affects the preparation of financial statements and the key considerations businesses need to keep in mind.

VAT and Balance Sheet:

• VAT Receivable and Payable: VAT collected from customers (output VAT) and VAT paid to suppliers (input VAT) are recorded as VAT receivable and VAT payable respectively on the balance sheet. These accounts represent the VAT amounts due to be remitted to the tax authority or recoverable from the tax authority.
• Reconciliation of VAT Accounts: Businesses must reconcile VAT receivable and payable accounts with their VAT returns to ensure accuracy and compliance. Reconciliations help identify any discrepancies or errors that need to be rectified.

VAT and Income Statement:

• VAT on Sales: VAT collected from customers is not considered revenue for businesses but rather a liability to be remitted to the tax authority. Therefore, businesses must present revenue net of VAT on the income statement.
• VAT on Purchases: VAT paid to suppliers on purchases (input VAT) is generally not considered an expense but rather a recoverable amount. Therefore, businesses should exclude VAT from the cost of goods sold or expenses when calculating the gross profit or operating profit.

VAT and Cash Flow Statement:

• VAT Payments and Refunds: VAT payments made to the tax authority should be classified as operating cash outflows, while VAT refunds received should be classified as operating cash inflows on the cash flow statement.

Disclosure and Presentation:

• VAT Policies and Accounting Policies: Businesses should disclose their VAT policies, including the method of accounting for VAT, any material judgments made, and the impact of VAT on financial statements.
• Presentation of VAT-related Figures: It is important to clearly present VAT-related figures on the financial statements, such as VAT receivable and payable balances, to provide transparency and ensure stakeholders can understand the financial impact of VAT on the business.

Auditing and Internal Controls:

• Auditing Considerations: Auditors need to review the accuracy and completeness of VAT-related accounts and disclosures. They will also assess the effectiveness of internal controls related to VAT processes to ensure compliance and accurate financial reporting.
• Internal Controls for VAT: Businesses should establish robust internal controls to manage VAT processes effectively, including proper recording of VAT transactions, reconciliation of VAT accounts, and compliance with VAT regulations.

Potential Impact on Financial Ratios:

• The introduction of VAT may affect financial ratios, such as gross profit margin, net profit margin, and current ratio, as VAT amounts are excluded from revenue and expenses. Businesses should be aware of these potential impacts and consider providing additional disclosures or adjusting financial ratios for better comparability.

The implementation of VAT in Saudi Arabia has significant implications for financial reporting. Businesses need to understand the impact of VAT on financial statements, including the balance sheet, income statement, and cash flow statement. It is crucial to establish proper internal controls, reconcile VAT accounts, and clearly disclose VAT policies and figures.

Collaboration with auditors and professional advisors is essential to ensure compliance, accuracy, and transparency in financial reporting. By considering the impacts of VAT on financial statements, businesses can effectively navigate the challenges and opportunities arising from the VAT regime in Saudi Arabi

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The classification of VAT

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• 24 August 2022

Questions have been raised about the classification of VAT – whether receivable or payable – as a financial instrument or something else, for example, a statutory receivable. The question arises for the classification of VAT on transaction date and subsequently, as well as whether the accounting answer differs between VAT vendors on the invoice (accrual) or payments (cash) basis of VAT.

A scenario is used to illustrate the issue.

The discussion is organised into the following headings:

• What do the Standards say?
• How do you know which Standard to apply?
• Classification on initial recognition
• Classification after initial recognition
• Application to the payments for goods and services (payables) and input VAT
• Presentation in the financial statements
• Classification – Sales of Goods and/or Services
• Classification – Purchase of Goods and Services

This Fact Sheet explains the Secretariat’s views on the classification of VAT based on the principles in GRAP 104 on Financial Instruments (2019) and GRAP 108 on Statutory Receivables. This Fact Sheet accompanies, and is not a replacement for, the complete text of GRAP 104 and GRAP 108. This Fact Sheet has not been reviewed, approved or otherwise acted on by the ASB.

Click here to download the Factsheet:

https://www.asb.co.za/wp-content/uploads/2022/07/Fact-Sheet-11-Classification-of-VAT.pdf

Relevance to Auditors, Independent Reviewers & Accountants:

• You need to assess fair presentation and compliance with the Standards of GRAP. 
• This factsheet discusses some important aspects around the classification of VAT.
• Non-compliance with GRAP standards may lead to a modified audit opinion.

Relevance to Your clients:

• GRAP is applicable to all entities preparing their financial statements (and where applicable, consolidated and separate financial statements) on the accrual basis of accounting in accordance with the Standards of GRAP.

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Do Tax Liabilities Appear in the Financial Statements?

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

Taxes appear in some form in all three of the major financial statements: the balance sheet, the income statement, and the cash flow statement. Deferred income tax liabilities can be included in the long-term liabilities section of the balance sheet . Deferred tax liability is a liability that is due in the future. Specifically, the company has already earned the income, but it will not pay taxes on that income until the end of the tax year. Long-term liabilities are payable in more than 12 months.

Sales tax and use tax are usually listed on the balance sheet as current liabilities. They are both paid directly to the government and depend on the amount of product or services sold because the tax is a percentage of total sales. The sales tax and use tax depend on the jurisdiction and the type of product sold. These taxes are generally accrued on a monthly basis. Any expense that is payable in less than 12 months is a current liability.

Income and Cash Flow Statements

The income statement , or profit and loss statement, also lists expenses related to taxes. The statement will determine pre-tax income and subtract any tax payments to determine the net income after taxes. Using this method also allows companies to estimate their income tax liabilities.

The cash flow statement also includes information on tax expenses. It is listed as "taxes payable" and includes both long-term and short-term tax liabilities. When taxes are paid during the cash flow period reflected in the statement, then this change is shown as a decrease in taxes payable.

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• IFRS Interpretations Committee meeting — 17 September 2019
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IAS 1 Presentation of Financial Statements—Presentation of liabilities or assets related to uncertain tax treatments (Agenda Paper 10)

• Administrative session

In its June 2019 meeting, the Committee discussed a submission on whether an entity, in its statement of financial position, presents a liability related to uncertain tax treatments as a current (or deferred) tax liability or as a provision.  The Committee published a tentative agenda decision.

Some respondents disagreed with the technical analysis of the Committee and expressed their concerns over the relevance of the financial information presented.

Staff analysis

In response to the concerns from respondents, the staff reiterate that uncertain tax liabilities/assets are liabilities/assets for income tax as defined in IAS 12 and so an entity should adhere to the presentation requirements in IAS 1 in respect of income tax-related items and disaggregation criteria. The entity could disclose uncertain tax liabilities or assets separately if it provided relevant financial information.

Staff recommendation

The staff recommend finalising the agenda decision with no changes.

While some Committee members were supportive of the agenda decision, there were some (mainly representatives from preparers) who did not agree with the technical analysis and the agenda decision because they did not believe that the Standard is clear and explicit enough to derive this conclusion. This would result in diversity in practice. They did not disagree that the recognition and measurement of uncertain tax positions should follow IAS 12 but they struggled with the presentation. Those Committee members who were supportive of the agenda decision reminded the Committee of the core principle of IFRIC 23—it puts uncertain tax positions within the scope of IAS 12 rather than IAS 37 and consequently, the presentation should follow the requirements of IAS 12 and IAS 1. They further considered that aggregating the uncertain income tax and other tax together in the line 'provisions' may reduce transparency of financial information presented because they are measured using different accounting methods. The Chair acknowledged that a possibility of standard-setting would be explored.

The Committee decided, by a majority of votes, to finalise the agenda decision.

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Accounting for VAT in the Philippines

By: Garry S. Pagaspas

Value Added Tax (VAT) is imposed upon any person who, in the ordinary course of trade or business, sells, barters, exchanges, leases goods or properties, renders services, and any person who imports goods. It is an indirect tax and the amount of VAT maybe shifted or passed on to the buyer, transferee or lessee of the goods, properties or services. The BIR has mandated under  Revenue Regulations No. 18-2011  that VAT shall be shown separately on the  sales invoice (SI)  for transactions involving goods, or on the  official receipts (OR)  for transactions involving services, and failure to follow the same is subject to penalties (say, P1,000.00 per SI/OR). This new mandate makes accounting for VAT a bit easier and fun. I should not say its boring, because some technical rules would thrill your brain cells. The VAT you pay on purchases is normally called  “input VAT” , while the VAT you add on sales is normally called  “output VAT”.  In computing the  VAT due and payable  to the Bureau of Internal Revenue (BIR), you simply compute as follows:

• Output tax from sales
• Less: Creditable input taxes
• Equals: VAT due and payable

The above formula is just a simple subtraction, but with the varying rules on output VAT, creditable input taxes, and other VAT rules on registration, filing of reports, makes the VAT system one-of-a-kind tax type for taxpayers. For purposes of accounting for VAT in the Philippines, you should note the following accounting areas that I wish to share sample entries. Of course, you can alter or change them to your desired account titles to fit your style for as long as they are comprehensible enough, because BIR did not prescribe the use of specific account titles. For better appreciation, I suggest you read further below with the  monthly – BIR Form No. 2550M , and  quarterly-BIR Form No, 2550Q.

For illustrative purposes, let us assume  the following transactions or figures, and to emphasize VAT journal entries, let us assume no withholding taxes applies, unless so stated.

Company Seller (VAT-registered) sold Company Buyer (VAT-registered) for P200,000, exclusive of 12% VAT, or a total of P224,000.00. Company Seller’s purchases amounted to P100,000.00, exclusive of 12% VAT or a total of P112,000.00.

I. Sales of goods or properties

In the monthly or quarterly VAT returns, sales of goods is classified into regular sales, zero-rated sales, exempt sales, and sales to government.  Sample accounting entries are as follows:

Regular sales and government sales:

• Debit: Cash or Account Receivable- P224,000.00
• Credit: Sales – P200,000.00
• Credit: Output VAT – P24,000.00

Zero-rated sales or VAT-exempt sales:

• Debit: Cash or Account Receivable- P200,000.00

Please note that VAT is shown separately through the Output VAT. In regular and government sales, VAT is added, while in zero-rated and exempt sales, not output VAT is imposed. The peculiar in government sales is the treatment of input taxes so we will deal with it later. Same is true with respect to zero-rated and exempt transaction because the difference lies in the treatment of input taxes.

II. Purchases of goods or properties, and services

Purchase of goods or properties, and services is a reciprocal of sale on the part of the seller. It could be with VAT for VATable, or without VAT for VAT-exempt or zero-rated transactions. Hereunder are sample entries.

Purchases with 12% VAT:

• Debit: Expense or Purchases or Asset account – P100,000.00
• Debit: Input VAT – P12,000.00
• Credit: Cash or Accounts payable – P112,000.00
• Credit: Cash or Accounts payable – P100,000.00

The only difference on the above sample entries lies on the recognition of the input taxes. For VATable purchases, input VAT is recognized separately because it represents an asset that has to be accounted for.

 III. Setting-up VAT payable or creditable input VAT

For monthly or quarterly filing of VAT returns, you may either have VAT payable or excess creditable input taxes.  For the first two (2) months of the quarter, you  use sales, purchases, and related VAT components for the monthly period only. For the quarterly return, you aggregate figures for the three (3) months of the quarter. Hereunder are the related sample entries:

Setting-up VAT payable:

• Debit: Output VAT  – P24,000.00
• Credit: Input VAT – P12,000.00
• Credit: VAT due and payable – P12,000.00

Setting-up VAT payable is simply closing the Input VAT and Output VAT accounts to VAT due and Payable account. The resulting difference would represent the VAT due and payable. This of course, presumes that the Input VAT are all creditable against output VAT and is not subject to deferred input VAT rules like on capital goods.

Setting-up Creditable input VAT:

• Debit: Output VAT  – P12,000.0
• Debit: Creditable input VAT –  12,000.00
• Credit: Input VAT – P24,000.00

In the above entry, the input VAT is more than the output VAT so the difference  is Creditable input Vat. It is a temporary asset account like input VAT and is used to refer to prior-period purchases with VAT.

Setting-up VAT payable applying prior-period creditable Input VAT:

• Credit: Creditable input VAT –  Px x x
• Credit: VAT due and payable – Px x x

IV.  Payment of VAT due and payable

Payment of VAT due and payable is the filing of the VAT returns within 2twenty (20) days from end of month for monthly returns using BIR Form No. 2550M, and within twenty-five (25) days from quarter-end for quarterly returns using BIR Form no. 2550Q.

Filing and Payment of VAT due and payable

• Debit: VAT due and payable – P12,000.00
• Credit: Cash – P12,000.00

The above entry is as simple as you pay a normal liability account.

V.  Special VAT rules

As I have mentioned above, special VAT rules makes it more challenging to account for VAT. These rules are mostly applicable on input VAT as to its availability for deduction or credit against output VAT such as in input VAT on capital goods costing P1M having a useful life of more than five years, final withholding of VAT on sales to government, refund of input VAT attributable to zero-rated sales, and expenses, and recording as expense of input VAT attributable to VAT-exempt sales transactions.

The special rules would be a more technical topic to deal with and may just ruin your basic understanding of the above simple sample accounting entries. I intend to discuss more of the special entries in my succeeding article on accounting for VAT. Of course, the above are sample illustrative entries only, and you are free to make enhancements. Account titles may vary depending on the chart of accounts adopted by your company.

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(Garry S. Pagaspas is a Resource Speaker with Tax and Accounting Center, Inc. He is a Certified Public Accountant and a degree holder in Bachelor of Laws engaged in active tax practice for more than seven (7) years now and a professor of taxation for more than four (4) years now. He had assisted various taxpayers in ensuring tax compliance and tax management resulting to tax savings rendering tax studies, opinions, consultancies and other related services. For comments, you may please send mail at ga************@ta************.ph .

Disclaimer : This article is for general conceptual guidance only and is not a substitute for an expert opinion. Please consult your preferred tax and/or legal consultant for the specific details applicable to your circumstances. For comments, you may also please send mail at info(@)taxacctgcenter.ph, or you may post a question at Tax and Accounting Center Forum  and participate therein.

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IFRS: the impact of IFRS 15 on your financial statements prepared under the Swiss Code of Obligations

Stefan Haag Director, Assurance, PwC Switzerland

David Baur Director, Assurance, PwC Switzerland

International Financial Reporting Standard (IFRS) 15 introduces fundamentally new rules on revenue recognition. The ramifications of implementing the new standard may be complex. Besides compliant presentation in IFRS financial statements, it raises questions regarding the design of contracts with customers, how to capture such contracts in IT systems – and the knock-on implications of IFRS 15 for companies reporting under the Swiss Code of Obligations, the focus of this article.

FRS 15 “Revenue from Contracts with Customers” contains fundamentally new rules on revenue recognition. Application of the standard is mandatory for annual reporting periods starting from 1 January 2018 onwards. The standard requires entities reporting under IFRS to provide useful information on the nature, amount, timing and uncertainty of revenue and cash flows from a contract with a customer. The idea is that revenue recognition should represent the economic reality of contracts with customers as closely as possible. The key principle is that an entity should recognise revenues corresponding to the amount of the expected consideration at the point-in-time, or over the period (“over-time”) during which, control of the agreed goods or services is transferred. IFRS 15 provides extensive guidance. By contrast, the Swiss Code of Obligations (Swiss CO) does not contain any provisions on revenue recognition which are directly applicable to an entity’s financial statements. It does, however, require the economic situation of the entity to be presented in such a way that a third party can form a reliable opinion.

In our view, revenue recognition in line with IFRS 15 is fundamentally compatible with the provisions of Swiss CO. Transactions would only have to be treated differently between the two frameworks if a specific IFRS 15 rule contradicts the overriding Swiss CO objective. IFRS and Swiss CO financial statements are based on two independent sets of accounting framework, so there is no requirement to apply the IFRS 15 guidance to Swiss CO financial statements. However, it would seem to contradict the principle of prudence stipulated in the Code of Obligations if in its Swiss CO financial statements an entity producing IFRS-consolidated financial statements recognises revenues earlier than under IFRS when it has not yet met its performance obligations.

Harmonisation sought – and possible

Since most IFRS users in Switzerland must additionally prepare Swiss CO financial statements, for reasons of practicality they may want to align their revenue recognition between both ledgers. If an entity now switches its revenue recognition from the old rules to IFRS 15, transition entries may be required as the total amount and timing of revenues from contracts with clients under IFRS 15 may be different.

If an entity now also wants to recognise revenue in its Swiss CO financial statements in accordance with the same principles as IFRS 15, it will have to address how it will deal with these transition effects under the Swiss CO and Swiss tax law – especially in the case of contracts that are still running at the transition date. One straightforward approach would be not to change the treatment of any ongoing contracts and only apply the new IFRS 15 guidance for contracts entered into after the transition. This would mean, however, that two different revenue recognition models are used over this transition period in the Swiss CO financial statements.

Handling transition effects in Swiss CO financial statements

Under the IFRS 15 transitional rules there is a choice available to preparers. Either they can opt to apply the standard retrospectively in full and then adjust the opening balance and comparative information accordingly, or they can opt for “modified retrospective application”. Under this second option the opening balance as of 1 January 2018 will be adjusted rather than the earliest period presented. Regardless of the method chosen, transition effects will occur for contracts with customers that have not yet been fulfilled, and these effects will have to be recognised in the opening balance sheet in the IFRS financial statements and adjusted via retained earnings. Regarding the Swiss CO financial statements the question arises what justifies a change in revenue recognition. Considering the adoption of IFRS 15 for the consolidated financial statements an entity may argue that it has reassessed the presentation of ongoing contracts with customers for its Swiss CO financial statements to present revenue more adequately.

Contrary to IFRS, retrospective recognition of transition effects is not permitted in Swiss CO financial statements; instead, transitions are made prospectively. The corresponding effects are recognised in profit or loss for the current period, typically as extraordinary and explained in the notes. Figure 1 provides an example to illustrate how the effects of a change in revenue recognition can be presented in Swiss CO accounts.

Example: contract with multiple components (sale and maintenance of equipment)

At the end of Year X1 a company sells a piece of equipment (retail price 70) and an accompanying three-year maintenance deal (retail price 30). The margin on each component is 20 %. The entire selling price is paid in Year X1. On 1 January of Year X3, the entity adopts the new revenue recognition method. On this date, the remaining deferred maintenance expenses of 16 are expensed, and deferred maintenance revenue of 16 is recognised for the next two years.

How is the 1.1.X3 transition in revenue recognition presented in the Swiss CO statements?

Adjustment via extraordinary expense or income.

Accrued expense or deferred income (cost) / exceptional expense or income 16 Extraordinary expense or income / accrued expense or deferred income (revenue) 20

Recognition of net proceeds from sales of goods and services

Revenues from transactions with customers involving both the sale and maintenance of equipment are recognised on the basis of the retail prices of the equipment and maintenance as the company fulfils each performance obligation. …

Changes in the financial statements

Following the introduction of IFRS 15 for the purposes of the consolidated financial statements, the company has reviewed the recognition of revenues from transactions with multiple performance obligations. With effect from 1.1.X3, revenues from contracts with customers will be recognised in the financial statements under the Swiss CO in accordance with the same principles as in the consolidated financial statements. For contracts that involve both the sale of equipment and a period of maintenance support at a price set in advance, from 1.1.X3 onwards, revenue will be recognised on the basis of the relative retail selling prices of the equipment and maintenance. Under the previous policy, the revenue was recognised in its entirety on the date of shipment of the equipment and future maintenance expenses were accrued. The release of the accrued maintenance expense and the deferral of revenue on 1.1.X3 are presented in profit and loss as extraordinary income of 16 and extraordinary expense of 20.

Adjustment via sales revenue and service expense

Accrued expense or deferred income (cost) / service expense or income 16 Sales revenue / accrued expense or deferred income (revenue) 20

Following the introduction of IFRS 15 for the purposes of the consolidated financial statements, the company has reviewed the recognition of revenues from transactions with multiple performance obligations. With effect from 1.1.X3, revenues from contracts with customers will be recognised in the financial statements under the Swiss CO in accordance with the same principles as in the consolidated financial statements. For contracts that involve both the sale of equipment and a period of maintenance support at a price set in advance, from 1.1.X3 onwards, revenue will be recognised on the basis of the relative retail selling prices of the equipment and maintenance. Under the previous policy, the revenue was recognised in its entirety on the date of shipment of the equipment and future maintenance expenses were accrued. At transition, the release of the accrued maintenance expense and the deferral of the maintenance revenue at 1.1.X3 are recognised separately in profit and loss as service expense of 16 and as net proceeds from sales of goods and services of 20.

An evaluation of the options

The transition on 1.1.X3 involves changing from an accrued expense mode to the modalities of the new revenue recognition method. Since these effects bear no relation to sales revenues and/or (service) costs for the current period, Option 1 (recognition as an extraordinary item) is preferable to Option 2.

Important in terms of corporate income tax

Changes in commercial law accounting occurring on the basis of changes in the consolidated reporting standard rather than changes in the law are unusual. However, in our view the key principle that the taxation of a Swiss entity is based on the Swiss CO financial statements also applies in instances where changes have been made to an entity’s accounting policies provided such changes are sufficiently justified. This means that transition effects would in principle also have an effect on taxable net profit.

In practice, it would always be appropriate to seek a dialogue with the tax authorities and explain the background of these changes. Significant extraordinary income or expenses in particular are often challenged. It also makes sense from a tax point of view to include a detailed description of transition effects and the background to them in the notes to the financial statements.

If the decision is made not to align the Swiss CO financial statements to the IFRS 15 guidance, this will likely give rise to temporary differences between the Swiss CO and IFRS balance sheets with associated deferred tax impacts.

A word on value-added tax (VAT)

VAT follows its own principles which differ from the revenues principles for Swiss CO and IFRS. Basically, VAT is calculated on the basis of agreed compensation. If the entity pays on the basis of collected compensation, VAT is calculated on the payments made by the customer. So from a VAT point of view there can be uncertainty, especially concerning the date on which revenues are taxed. The VAT on the revenues for the three-year maintenance contract in (Figure 1) has to be paid in the first year, because the cash has already flowed. Transition effects may lead to difficulties in reconciling VAT statements. Under the terms of the Value-Added Tax Act (VAT Act), an entity must reconcile VAT to sales and demonstrate that its VAT returns tally with its financial statements. Transition effects will inevitably lead to discrepancies. The entity should provide these details to the Federal Tax Administration.

The essence of the matter

Revenue recognition as per IFRS 15 is also appropriate for accounting and reporting under the terms of the Swiss Code of Obligations (Swiss CO). For more complex sales transactions, we recommend disclosing the revenue recognition principles applied, also in Swiss CO financial statements. Under Swiss CO, revenues from contracts with customers can be recognised later than under IFRS 15, but not earlier. Since switching revenue recognition methods can lead to significant extraordinary effects, entities should provide appropriate explanations in the notes to the financial statements. These disclosures should be accompanied by relevant explanation which is also essential to ensure acceptance for VAT and tax purposes.

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Explaining Financial Statements

Apr 10, 2018 · Here's a detailed look at consolidated financial statements, how to understand them, and the role they play in financial projections.

Taylor Davidson

CEO / Founder

Following up on the introduction to finance and accounting , here's a deeper dive into the three statements of the consolidated financial statements.

Income Statement #

The income statement is usually the report that draws the most attention, and since each component of the statement shines light into different parts of the business's performance, it's worth explaining the details of the statement to understand what the different terms mean. Here's an overview of the basic structure of the income statement.

Revenues measure the money that is brought into a company from its business activities, often called sales. Revenues can be reported divided up into different business activities, or by different departments or regions, in the effort to provide more information and transparency into how a business operates.

The calculation of revenues often distinguishes between Gross Revenues and Net Revenues, net revenues reflected the revenues after accounting for discounts, returns, chargebacks, affiliates, or other contra-revenues.

Revenue can be recognized in different periods than the cash or payment for the revenues are received (under accural accounting), so it's important to distinguish in our forecasts when revenue is recognized and when cash or payments are received. If cash is received in advance of the revenues being recognized (for example, 12 months upfront payment for a SaaS service), then the balance goes to a balance sheet account for deferred revenue liabilities, and you decrease the revenue liability over time as you recognize the revenues. If cash is received after revenues are recognized, it's usually recorded as an accounts receivable.

For modeling purposes, if the cash is generally received within the same time period as the recognition of revenues (say 30 days for monthly forecasting), you can generally assume that revenues equals cash receipts.

The Foresight models - Standard and above - are prebuilt to handle a wide variety of revenue recognition and cash receipts scenarios, and will automatically handle the revenue recognition, cash, and balance sheet impacts of many different scenarios.

Cost of Goods Sold (COGS) #

Cost of goods sold (or cost of sales, or cost of revenues, or COGS) reflect the direct costs to produce the goods sold that earned the revenues during that period.

The rules for what costs are included into COGS can vary by business and how revenues are earned, but always true back to that basic principle. Production does not involve distribution or sales, but can include support, if the support is a function that is involved in providing the product, rather than selling the product.

For most costs it's fairly straightforward to figure out which costs are allocated to COGS and which ones to SG&A, but it can get a little complicated. GAAP and IFRS provides rules and guidance on how to handle certain costs, and for specific questions, best to consultant an accountant with experience with your types of businesses (or simply send me an email ).

The Foresight Standard and Starter Models handle the allocation of costs to COGS and SG&A in a very flexible way. You can specify a COGS margin or amount - relating to revenues - and additionally type in a number of costs into the Expenses section, and allocate them to COGS simply by selecting COGS in the dropdown, and the correct accounting treatment is handled automatically. This way, you have two methods to forecast COGS that provide flexibility to change it over time, and the edits required to shift a cost between COGS and SG&A is trivial.

Gross Margin #

Gross Margin reflects the amount of revenue that the company retains after incurring the direct costs associated with providing the products and services that earned the revenues.

Or, more simply:

Gross Margin = Revenue - Cost of Goods Sold

And for gross margin %:

Gross Margin % = ( Revenue - Cost of Goods Sold ) / Revenue

Gross margin is an important concept since it is one measure of operations and profitability, and helps a company think about the costs related to produce the products and services it sells. It also helps a company think about how much money is left over to pay for the costs to operate the business.

Selling, General and Administrative (SG&A) #

Selling, general and administrative (SG&A) costs are the costs associated with operating the business, and not in producing the products or services. SG&A costs encompass many different types of costs and can be broken down into direct and indirect selling costs, fixed and variable overhead, operating expenses. Essentially, it's all the costs related to the business that are not COGS.

The Foresight models handle the allocation of costs to SG&A in a very flexible way, and allow you to assign the costs to a set of dynamic categories to help in reporting the components of SG&A. Just input the costs in each row, select SG&A in the dropdown, select the reporting category in the dropdown, and the model handles the accounting treatment automatically. The reporting is not a formal part of the income statement but provides valuable additional insight into the major cost areas.

The models use one repoting category to represent selling costs (e.g. acquisition costs, marketing costs), which is then used for calculating customer acquisition cost (CAC). It's not a formal part of the income statement but an important additional metric for business analysis that the models handle automatically.

EBITDA - Earnings before interest, taxes, depreciation, and amortization #

Fairly self-explanatory, EBITDA is a popular metric that can be used to understand the core operating earnings of a company, and it's often used for valuation ratios and evaluating the company without the impact of accounting choices.

By definition, EBITDA is:

EBITDA = Net income + interest + taxes + depreciation + amortization

I usually report EBITDA on a forecasted income statement, although it's not necessary in formal corporate accounting, as it would usually be something that is calculated as an additional information point outside of the income statement. I do it that way because it's a fairly popular metric to help understand a company's profitability and it's easy to see the flow of the revenues and expenses that way.

For the Foresight models, that means that EBITDA is calculated as:

EBITDA = Gross Margin - SG&A

By definition, that means that the SG&A does not include the "ITDA", which are reported separately below EBITDA on the income statement. The Foresight models let you input interest, depreciation, and amortization as expenses, but select the appropriate category (interest and depreciation/amortization) so that the model separates the expenses into the appropriate accounting treatment.

Depreciation and Amortization #

Depreciation is a difficult thing for most beginners to financial modeling to understand, but it need not be too hard: it is an accounting method for a company to spread the cost of purchasing an asset over it's useful life. It attempts to help correct for large one-time expenses by effectively allowing you to account for the expense over the time period where the asset will contribute to the business's operations (the useful life). It also holds with the general accounting goal of matching expenses to the time periods in which they contribute to earning revenues.

Depreciation does not impact cash, which is often the trip up for beginning financial modelers. It is one of the ways in which the income statement deviates from the statement of cash flows, and which causes net income during a period to not equal net change in cash flows during the same period.

Depreciation is recorded on the income statement, and also recorded on the balance sheet as it decreases the value of the asset on the balance sheet. When you "capitalize" an expense (recording it as a capital expenditure instead of an ordinary operating expense), you record the value of the expense on the balance sheet, and then in future periods depreciate the asset on the income statement, reduce the value of the asset on the balance sheet (typically through an accumulated depreciation account), and add it back to net income on the statement of cash flows under the cash flow from operations section.

Amortization refers broadly to the spreading of expenses over a period of time, such as a mortgage, loan, or purchase of asset, but for the context of the income statement refers strictly to the spreading of costs of purchasing intangible assets over their useful life. The rationale and concept is similar to depreciation, but applies to the purchase of intangible assets such as patents or the goodwill created by purchasing another company for a premium over it's valuation

For many companies, depreciation and amortization could be minor issues in financial models. If a company is not making significant investments in hard assets, or it not capitalizing software development costs, then depreciation may irrelevant or minor and is often ignored in very basic financial reports and analysis. Amortization will be nonexistent unless the company has purchased intangible assets.

The Foresight models handle the depreciation for all capital expenditures - all expenses categorized as CAPEX in the expenses section - using a straight-line method, and using a time period that can be input in the Get Started or Settings sheets. Straight-line is the easiest method of depreciation, and effectively spreads the cost of purchasing the asset equally over a time period, which is intended to be the asset's useful life, or time period where the asset can be used productively in the business. Depreciation and it's impact on the assets accounts are automatically handled by the model on the income statement, balance sheet, and statement of cash flows.

There are many different methods for depreciation than straight-line, and you may find yourself wanting to create depreciation schedules that depreciate different assets over different periods of time and using different depreciation methods. This is not prebuilt into the models, but can be added by expanding the depreciation schedule on the Forecast sheet.

Interest expenses (and income) are generally recorded separately from revenues, COGS and SG&A (i.e. above EBITDA) as they generally are not associated with a company's core operations, and represent the costs (and earnings) from financing the company.

For some companies, earning income from interest may be a core part of their revenues, and should be treated appropriately as revenue.

The Foresight models (Starter, Standard, and above) have automatic schedules that calculate funding from debt instruments - loans - and their payback schedules, including interest expenses, using a set of user inputs around loan terms and interest rates. If you input new debt into one of the months under the cashflow forecast, the models will automatically handle all accounting impacts, and you can enter new debt into any month with different terms and interest rates, each month's debt is handled separately.

Other Income and Other Expenses #

Other income and expenses are earnings or expenses that are not related to a company's core business operations, and thus are recorded separately from revenues and expenses.

For most early-stage companies or users of the Foresight models, this will generally be insignificant and can be ignored and left as zeros, but the model structure allows you to input these into the income statement if they occur.

EBT - Earnings before Taxes #

EBT represents earnings before taxes, and is simply:

EBT = Net Income + Taxes

EBT may not be recorded on all income statements, but I break it out on the Foresight models so that corporate taxes may be calculated accurately. Thus, similar to EBITDA, I build down to EBT, thus EBT is calculated as:

EBT = EBITDA - depreciation - amortization - interest expenses + interest income - other income + other expenses

Taxes reflect corporate taxes paid on the earnings from the business (EBT). Business taxes, excise taxes, and other non-income related taxes are operating expenses and not reflected here.

In the Foresight models , the corporate tax rate is an input (for the % of EBT that is paid as tax). The calculations of tax look to model the tax situations for most companies. No tax is paid when there is a net loss (negative EBT, or more simply, expenses greater than revenues), and I track net losses over time to track the loss carryforward to apply the net losses against the net gains so that the company does not pay taxes until cumulative net profits are greater than cumulative net losses. This assumes that the losses can be carried forward in entirety over the three or five year time periods used in the models. All of this is done automatically, and the only user input required is the corporate tax rate, on the Get Started or Settings sheet. Consult a tax professional for any questions around specific tax treatment and rules around loss carryforwards applicable to your situation.

A note about value-added taxes:

I'm often asked about VAT (Value-Added Tax), for users outside of the USA. Technically, a business is collecting VAT and then disbursing it to governments, so it is not income, and the VAT you pay on expenses is recompensed by the government, so it is not an expense. Sales and expenses should be recorded net of VAT, and thus VAT does not show up on a company's income statement as revenues or expenses. VAT would be recorded on the balance sheet under VAT control accounts to track how much VAT has been collected and paid, and while this could have a balance sheet impact - and particularly an impact on cash balances - if there is a significant period between when VAT is collected and when it is paid, for the purposes of financial modeling the typical assumption is to assume that time period is within a month (or is consistent over time), and thus I generally ignore accounting for VAT in the Foresight models.

Net Income #

Typically the last item on an income statement is net income, the company's total earnings or profit.

In the Foresight models, net income is:

Net income = EBT - taxes

I typically report the net income %, which is a measure of the ability of the company to turn revenues into profit:

Net income % = Net Income / Revenues

While net income often the thing that people look at first, I hope the explanation of the income statement helps explain that in understanding a business's performance, it's just one measure of operational success.

When analayzing an income statement, often I'll look at gross margin %, EBITDA %, and net income % together to get a look at how successfully the business turns revenues into profits, to draw insights about the business model of a company, and compare it to other companies in its industry, to get a feel for whether the company is performing well or not. Different types of companies will have drastically different profitability profiles given the fundamental operations of the business and the realities of their industries.

Statement of Cash Flows #

The Statement of Cash Flows breaks down the cash flows of a business during a period into three main areas, separating out the changes in cash created from the operations of the business, investing in the business, and financing the business.

Typically, the statement of cash flows records the cash on hand at the beginning of the period, the increase or decrease in cash flow resulting from operations, investing, and financing, and the cash on hand at the end of the period.

In the Foresight models, I build a typical statement of cash flows and also generally include a fourth statement that provides an alternative look at the cashflows of a company, and is a core part of the automatic fundraising calculations. For more on that function, read about the funding round forecasting ›

Cash Flows from Operations #

The cash flow from operations details how the operations of the business creates an increase or decrease in the amount of cash held by the company. The methodology is to start with net income, and then adjust it by adding back non-cash expenses (depreciation, amortization), and then adding (or subtracting) the changes in cash flows from working capital.

Changes in working capital is the net change in many balance sheet accounts that reflect the differences in timing between then cash is received or disbursed and when the revenue or expense is recorded on the balance sheet. The impact of these timing differences are tracked on the balance sheets as assets and liabilties, and the net of the changes in these accounts during this time period is the net changes in working capital that is added or subtracted to net income to calculate cash flows from operations.

For the exact details on which balance sheet accounts are used to calculate changes in working capital, consult How to changes in working capital capital affect a company's cash flow? or review the Foresight financial model for exactly how I do it.

Cash Flows from Investing #

The cash flows from investing detail the net cash spent to invest in the business, generally through capital expenditures, investments in the financial markets, and investing in subsidiary companies not consolidated into the company's statements.

In the Foresight models, generally the only cash flow from investing are capital expenditures.

Cash Flows from Financing #

The cash flows from financing detail the aggregate changes in cash from financing the business. This will typically record equity investments, new debt, repayments of the principal on debt, dividends, changes in owner's capital, stock repurchases, and other financing-related impacts.

For the users of Foresight models, it is typically new equity investments, new debt, and any debt repayments that are important in this section. The models do allow for dividends to investors, but it is not commonly used. This section fits most usecases for private companies, but if you have specific areas that require changes to this section, feel free to add them in or contact me for any questions.

Balance Sheet #

The balance sheet reflects the financial condition of the firm at a specific date in time, usually at the end of an income statement period. The balance sheet reports the company’s assets, liabilities, and shareholder’s equity, and a correctly calculated balance sheet (and consolidated financial statements) will hold true to a basic accounting premise:

Assets = Liabilities + Sharedholder's Equity

Thus, the balance sheet is divided into three section:

Assets are resources that the company owns or controls with the expectation that they will derive future economic benefit from them. The most obvious asset is cash, but they include a variety of current (short-term) assets, fixed assets, investments, and intangible assets, and this section on the balance sheet is typically broken out into current and long-term assets.

Assets are valued at historical cost (also called book value), and adjusted for aging, use, or improvements, through depreciation and other methods. For more about assets, Investopedia has a good summary.

In the Foresight models the default assets section consists of: Current Assets Cash Accounts Receivable, or money due in the future for services or products already delivered Inventory (if applicable), the value of products currently available for sale Work in Progress (if appplicable, and only for the Standard models and above), the value of products currently in manufacturing process but not yet available to sell Prepaid Expenses Long Term Assets Property, Plant and Equipment, the value of the cumulative capital expenditures over time Accumulated Depreciation, the cumulative of the depreciation expense to date Other Assets Other assets, not calculated but left as an input to use if relevant for your company The user inputs are on the Get Started or Settings sheets, and differ depending on the forecast method. Accounts Receivable's input is for Days Accounts Receivable, the average number of days between delivery of a product or service and when cash is received. Prepaid expenses is for the % of non-salary SG&A expenses. Inventory (and if using a Standard Model or above, Work in Progress) is calculated based on a number of assumptions around inventory purchasing behavior and desired stock levels. Depreciation is handled using the depreciation schedule and an input for # of months to depreciate an asset purchase over (using the straight-line depreciation method). All of these assumptions are 0 by default and can in many cases be left at 0. The exact balance sheet accounts for your company may differ, for example if you hold some cash in short-term investments, or other things specific to your business, and the model can be edited to fit your exact balance sheet accounts.

Liabilities #

Liabilities are financial obligations that have resulted from the business's operations. Liabilities are typically broken out into current and noncurrent (long-term) liabilities, and include things like loans, accounts payable, credit cards payable, mortgages, accrued expenses, and deferred revenues.

In the Foresight models, the typical balance sheet consists of: Current Liabilities

Accounts Payable, bills that have been received but not yet paid. This input is a percentage of current period SG&A. Accrued Liabilties (or accrued expenses), expenses that have been incurred, not billed, and not yet paid. This input is a percentage of current period SG&A. Deferred Revenues Liability, a liability created when cash has been received for services not yet provided. This is explained in the context of revenues under the income statement description above. Inventory Accounts Payable, or payments due for inventory (and work in progress, if applicable) that have been received but not yet paid for. Bad Debt Allowance, an allowance for accounts receivable that may not be collected, based on the company's historical percentage of accounts receivable that is written off and not collected. This is an input as the percentage of accounts receivable expected to be bad debt. Noncurrent Liabilties Long-term debt, which represents any debt that has been taken out, and is reduced over time by any debt repayments. This is calculated from the debt fundraising forecast and the debt repayment schedule.

Shareholder's Equity #

The shareholder's equity represents the financial value of the firm, measured only by the assets and liabilities on the balance sheet. The accounts here will typically consist of any equity investments, retained earnings, current period net income (or loss), and any owner's equity, if applicable.

The Foresight models use a fairly simple shareholder's equity section:

Owner's Equity, value of cash or equity put into the company by the owner, with a default input of zero Equity Investment, which is calculated from the fundraising and cash forecast Retained earnings, the cumulative value of net income (loss) to date. Many companies reset retained earnings every year and use net income (loss) for year to date; for simplicity's sake I use current period net income and let retained earnings grow over time Current period net income (loss), which is calculated from the income statement

As a note, I do not use "plugs" to force balance sheets to balance (meaning, to make assets = liabilities + shareholder's equity), and there is a check at the bottom of the balance sheet to make sure that the balance sheet balances according to that equation.

If the result of that check is anything other than zero, then the user should look at their statements to see what is not being reflected appropriately. Often the balance sheet fails to balance on the initial period if there is a beginning cash balance and no other accounts are recorded for the opening balance sheet, since that means there are liabilities or shareholder's equity values not being reflected. Usually the edit is to increase the retained earnings for the value of the cash, if no other opening balance sheet information is supplied.

Why build financial statements for your financial projections? #

Financial statements are critical for running a business, but not terribly meaningful until you have a business to run. And even then, for early-stage startups, the problem with financial statements is that they surface the wrong metrics for startups.

"Large companies need financial tools to monitor how well the are executing a known business model. Startups need metrics to evaluate how well their search for a business model is going." - Steve Blank

But while you can build a basic understanding of your business without creating a set of statements, you'll need financial statements when you're raising capital or once have a business to run. Investors will often want to see your projected statements so they can understand the business deeper and make sure you know the impacts of business strategies on the financial condition of a company.

The important thing to me about financial statements is not about creating them, but about using them, and knowing what they inform about a business and what they hide. For SaaS businesses, for example, the classic income statement is a start, but a deeper look at marginal recurring revenue (MRR) and its components are critical to understand the current state and future of the business.

To me, financial statements are important because they are a standard and accepted way of presenting your projections to people, but you can't stop there. There are many metrics to use to explain how your business operates that don't show up on a set of financial statements. LTV, CAC, website traffic, average order size, churn, cohort performance, MRR, any many other metrics are important operational metrics that explain how a business is performing in way that aren't captured by financial statements.

That's why I advocate a way of presenting your financials to investors that isn't just about a summarized income statement. Read more at How to pitch your financial projections ›

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