August 1999: The Humble Journal Entry
It would appear as if our educationalists are neglecting to impress on students the importance of journal entries. The basis of all financial accounting is the double-sided journal entry. Back in the late 50's, in my first year of CTA, our June holidays were taken up by a project requiring hundreds of journal entries to be passed manually and then requiring the books to be balanced. I can still remember the high I got on balancing the trial balance first time. To this day I still think in terms of journal entries.
Recently I was discussing a scheme with a bright newly qualified CA(SA). He told me that Propco sold a rental revenue stream to Newco. I asked him what the journal entry in Propco was and he said: "That's not the issue." I said that I could not understand the scheme unless the issue was cleared up. We then looked at the possibility of crediting revenue or a liability or deferred income (what!) or the fixed property itself with the cash received. Suddenly the consequences of this scheme started to take shape.
Another example I came across last year was an announcement by a large company that it was considering transferring its pension fund liability to a Special Purpose Entity (SPE). When I asked one of the accountants from the company what the debit in the SPE would be, he said that they were still working on it!
In the 1994 South African Breweries (SAB) consolidated financial statements R550 million was written off directly to reserves being "adjustment on reconstruction of OK Bazaars". The explanation given for this write off was: "An amount of R550 million was injected by the parent company as equity capital and applied to eliminate existing loans from SAB (to OK Bazaars) of R200 million and reduce external borrowings. At SAB level, the injection of R550 million of new equity capital has been set aside in full against the group's retained surplus to cater for the negative impact of the comprehensive reassessment currently taking place in the OK of the fair value of all its assets and liabilities." Let’s try to work out the journal entries (millions):
In SAB's Books
Investment in OK / Dr. / 550Loans to OK / Cr. / 200
Cash / Cr. / 350
In OK's Books
Loans to SAB / Dr. / 200Cash / Dr. / 350
Share capital and share premium / Cr. / 550
Equity issued by company.
On Consolidation
Share capital and share premium / Dr. / 550Investment in OK / Cr. / 550
Contra entry.
Loss (debited directly to reserves) / Dr. / 550
Help! / Cr. / 550
This credit, from a group point of view, must have gone to write down OK’s receivables, inventories and/or other operating assets. Statements of GAAP do not permit such write-downs to be charged directly to reserves (AC 103.06). Without following through the journal entries, an analyst would not have realised that there was a GAAP problem here.
In the recently published financial statements of Plate Glass an exceptional item of R190 million (presented where one would normally show an extraordinary item) was excluded from headline earnings. The explanation for this item was that a subsidiary was sold at the end of the year and that the loans to the subsidiaries were written down during the year. How can a loan in a subsidiary be written down in consolidated financial statements? There is no loan! Where did the credit go to?
[Note: I subsequently discovered that the credit was lying in a provision account.]
If you think in terms of journal entries you will be in a far better position to audit and analyse financial statements. Unfortunately, you will also be in a far better position to manipulate financial statements. During my lecturing days here are some of the journal entries I was given by students from practice:
- Debit expenses and credit shareholders' loan
- Debit goodwill and credit shareholders' loan
- Debit plant and equipment and credit operating profit
- Debit brand name and credit shareholders' loan
- Debit goodwill and credit operating profit and then debit reserves and credit goodwill
- Debit dividends, credit share capital and credit share premium