What is financial cost? Definition, classification and effective management

In today's competitive economic environment, financial cost management plays a key role in determining the survival and development of a business. This article will help businesses understand financial costs, classify them and develop effective management strategies, thereby optimizing financial resources.

1. Concept of financial costs

1.1. Definition of financial costs

Financial costs are expenses related to the financial activities of an enterprise, arising in the process of capital mobilization, financial investment and other financial transactions.

According to Circular 200/2014/TT-BTC of the Ministry of Finance, financial expenses are defined as " expenses related to financial activities such as loan interest expenses, exchange rate losses, payment discounts, losses from liquidation of financial investments, provisions for devaluation of trading securities, provisions for losses on investments in other entities and other financial expenses ".

For example, ABC Company borrows VND 1 billion from the bank at an interest rate of 10% per year to expand its business. The interest of VND 100 million per year will be recorded as the financial expense of the enterprise. Similarly, if the company conducts export transactions and incurs losses due to exchange rates, this loss will also be recorded as financial expense.

1.2. Characteristics of financial costs

Financial costs have the following main characteristics:

• Not directly creating products : Unlike production costs, financial costs do not directly participate in the process of creating products or services of the business.
• Monetary policy fluctuations : Financial costs are often greatly influenced by the monetary policies of the State Bank and fluctuations in the financial market.
• No ending balance : The financial expense account (account 635) has no ending balance because all amounts incurred during the period will be transferred to the business results determination account (account 911) at the end of the accounting period.
• Direct impact on profits : Financial costs directly impact business profits, reducing business performance.

Finance costs do not have an ending balance because they are essentially income accounts, and according to accounting principles, all income and expenses must be transferred to the income statement at the end of the accounting period. This is different from manufacturing costs that can be capitalized into inventory value.

1.3. The role of financial costs in business operations

Financial costs play an important role in the business operations of an enterprise:

• Importance to businesses : Financial costs reflect the efficiency in mobilizing and using capital. Good financial cost management helps businesses optimize financial resources, ensure stable cash flow and improve competitiveness.
• Impact on profits : Financial costs are one of the factors that directly reduce business profits. When financial costs increase, profits will decrease accordingly if other factors remain unchanged. Especially for businesses with high debt capital structure, financial costs can account for a large proportion of total costs.
• Role in financial strategy : Effective financial cost management is an important part of a business's overall financial strategy. Good control of these costs contributes to building a reasonable capital structure, minimizing financial risks and creating favorable conditions for the sustainable development of the business.

2. Classification of financial costs

2.1. Debt finance costs

Financial expenses on the debt side include expenses incurred during the accounting period related to the financial activities of the enterprise. Below is a summary table of the main types of financial expenses on the debt side:

2.2. Creditor financial costs

Credit finance expenses typically involve the reversal of provisions, reductions in finance expenses, or adjustments to previously recorded finance expenses. Below is a summary of credit finance expenses:

2.3. Items not included in financial expenses

Some expenses are often confused with financial expenses but are not actually recorded in this account:

• Business management costs related to finance : Salaries of finance and accounting department staff and office supplies costs of the finance department are not included in financial costs but are recorded in business management costs (account 642).
• Borrowing costs are capitalized : According to accounting standard No. 16, borrowing costs directly related to the investment in construction or production of unfinished assets are capitalized into the original cost of the assets, not accounted for in financial expenses.
• Loss from liquidation of fixed assets : Loss arising from liquidation and sale of fixed assets is recorded in other expenses (account 811), not financial expenses.
• Financial expenses are not deductible when calculating corporate income tax : Some financial expenses that do not meet the conditions prescribed by the Law on Corporate Income Tax will not be deductible when calculating tax, such as expenses without valid invoices and documents, and loan interest exceeding the prescribed level.

Example: XYZ Company has an interest expense of VND 500 million to build a new factory. According to accounting standards, this expense is capitalized into the original cost of assets, not recorded in account 635 - Financial expenses.

3. Common forms of financial costs

3.1. Interest expense and deferred purchase interest

Interest expense is the interest that a business must pay on loans from banks, credit institutions or individuals. This is the most common form of financial expense and often accounts for a large proportion of a business's total financial expenses.

Factors affecting interest costs include:

• Interest Rate : The higher the interest rate, the greater the interest cost. Interest rates can be fixed or floating according to market fluctuations.
• Loan term : The longer the loan term, the greater the total cumulative interest cost.
• Repayment method : Equal principal repayment or principal repayment at the end of the period will affect the way interest is calculated.
• Creditworthiness : Businesses with good credit histories often enjoy preferential interest rates, helping to reduce interest costs.

Example of calculating interest expenses: Company A borrows 2 billion VND with an interest rate of 9%/year, loan term of 3 years, interest paid periodically every 3 months, principal paid at the end of the term.

Interest expense per quarter = 2,000,000,000 × 9% ÷ 4 = 45,000,000 VND Total interest expense in 3 years = 45,000,000 × 12 = 540,000,000 VND

For deferred purchase interest, this is the interest that arises when a business purchases goods but does not pay immediately and must pay interest for the late payment period. For example, Company B buys raw materials worth 500 million VND, pays after 2 months with an interest rate of 1%/month. The deferred purchase interest is: 500,000,000 × 1% × 2 = 10,000,000 VND.

3.2. Exchange rate difference loss

Exchange rate differences arise when an enterprise conducts transactions in foreign currencies and there is a difference between the recorded exchange rate and the actual exchange rate at the time of payment or end-of-period revaluation.

Causes of exchange rate differences include:

• Exchange rate fluctuations in the market : When the domestic currency depreciates against foreign currencies, businesses with foreign currency debts will incur exchange rate losses.
• Different timing of recording and payment : Difference between exchange rate at the time of recording transaction and actual payment time.
• Revaluation of monetary items at the end of the period : According to regulations, monetary items with foreign currency origin must be revalued at the interbank exchange rate at the end of the accounting period.

Specific example of how to calculate exchange rate difference loss: Company X imports equipment worth 100,000 USD on January 1, 2023 with a book exchange rate of 23,000 VND/USD. By February 15, 2023, when paying, the exchange rate is 23,500 VND/USD.

Book value: 100,000 × 23,000 = 2,300,000,000 VND Actual payment value: 100,000 × 23,500 = 2,350,000,000 VND Exchange rate difference loss: 2,350,000,000 - 2,300,000,000 = 50,000,000 VND

3.3. Payment discount costs

Cash discount is a discount that a business (seller) gives to customers when they pay for goods before the specified time. This is a measure to encourage customers to pay early, helping businesses improve cash flow.

Cash discounts are usually calculated as a percentage of the value of the goods and depend on the time of payment. A common example is the term "2/10, n/30", which means that the customer will receive a 2% discount on the invoice value if payment is made within 10 days, otherwise the full payment must be made within 30 days.

How to calculate and account for discount costs:

• When selling, the business records full revenue.
• When a customer pays early and receives a discount, the business records the discount as a financial expense.

For example: Company Y sells goods to a customer for VND500 million, applying a 2% discount policy if payment is made within 15 days. The customer pays after 10 days and enjoys the discount. The payment discount is: VND500,000,000 × 2% = VND10,000,000, which is recorded as financial expenses.

3.4. Provision for decline in value of trading securities

Provision for devaluation of trading securities is an amount set aside to compensate for the loss in value when the market price of securities falls below the original price. Setting up a provision helps businesses accurately reflect the real value of their securities portfolio.

According to Circular 200/2014/TT-BTC, the calculation of provision for devaluation of trading securities is as follows:

Provision level = (Quantity of securities with reduced value at the time of preparing financial statements × Securities price recorded in accounting books) - (Quantity of securities with reduced value at the time of preparing financial statements × Actual securities price on the market)

Example: Company Z buys 10,000 shares of Company ABC at VND 25,000/share. At the time of preparing the financial statement, the market price of ABC shares has decreased to VND 20,000/share.

Book value: 10,000 × 25,000 = 250,000,000 VND Market value: 10,000 × 20,000 = 200,000,000 VND Provision level: 250,000,000 - 200,000,000 = 50,000,000 VND

3.5. Cost of liquidation of financial investments

Liquidation costs of financial investments arise when a business sells financial investments (such as stocks, bonds, capital contributions to other entities) at a price lower than the original cost of the investment.

The process of liquidating a financial investment usually includes the following steps:

1. Determine the carrying amount of the investment
2. Determine actual selling price
3. Calculating the profit/loss from liquidation
4. Post to appropriate accounts

Cases of loss arising during liquidation:

• When liquidating securities in a bear market
• When the partner company is in trouble, forced to withdraw capital at a low price
• When investment strategy changes, portfolio restructuring is required.

Specific example of accounting: Company M invested in buying 50,000 shares of Company XYZ at VND 30,000/share. After 2 years, due to capital needs, Company M decided to sell all of these shares at VND 28,000/share.

Book value: 50,000 × 30,000 = 1,500,000,000 VND Liquidation value: 50,000 × 28,000 = 1,400,000,000 VND Loss from liquidation of investment: 1,500,000,000 - 1,400,000,000 = 100,000,000 VND

This loss of 100 million VND is recorded in the company's financial expenses.

4. Accounting for financial costs

4.1. Accounting principles for account 635

Account 635 - Financial expenses is used to reflect the financial operating expenses and expenses for financial investment activities of the enterprise. When accounting for account 635, the following basic principles must be followed:

• Matching principle : Financial expenses must be recorded in the accounting period in which they arise, regardless of whether the money has actually been spent or not.
• Principle of prudence : When there are signs of a decline in the value of financial investments, enterprises must make full provisions.
• Consistency principle : The method of accounting for financial costs must be applied consistently between accounting periods, unless there is an approved change in accounting policy.
• Offset principle : Financial revenue cannot be offset against financial expenses, except in some special cases as prescribed.

Relationship of account 635 with other accounts:

• Account 111, 112 (Cash, Bank deposits): When paying financial expenses
• Account 334 (Payable to employees): When deducting interest payable to employees
• Account 341 (Borrowings and financial lease debts): When deducting interest payable
• Account 911 (Determining business results): When transferring financial expenses at the end of the period

Important notes when accounting:

• Only record into account 635 expenses directly related to financial activities.
• For interest expenses used for investment in construction and purchase of fixed assets, capitalize them into the original cost of the asset.
• Do not record losses due to liquidation of fixed assets in account 635 (record in account 811)

4.2. Structure of account 635 - Financial expenses

Account 635 - Financial expenses has the following structure:

ACCOUNT 635 - FINANCIAL EXPENSES

Debit side:

• Reflects financial expenses incurred during the period.
• Financial investment losses, exchange rate losses
• Interest expense, payment discount
• Provision for devaluation of trading securities, provision for investment losses

Creditor:

• Reflects the amounts recorded as reductions in financial expenses
• Reversal of provision for devaluation of trading securities, provision for investment losses
• Transfer financial expenses to account 911 at the end of the period

Closing balance: None

The structure diagram of account 635 - Financial expenses can be illustrated as follows:

ACCOUNT 635 - FINANCIAL EXPENSES

Meaning of each part in the structure:

• Debit : Reflects the total financial expenses incurred during the period, showing the level of capital usage and efficiency of financial activities.
• Credit side : Reflects the amounts recorded as reductions in financial expenses and the transfer to the end-of-period business results.
• No ending balance : Reflects the nature of the expense account, which is fully transferred to the business results at the end of the accounting period.

4.3. Financial cost accounting process

The process of accounting for financial costs can be carried out in the following steps:

Step 1: Identify and record financial expenses incurred

• Determine the financial expenses incurred during the accounting period
• Check original documents (loan agreement, interest calculation sheet, bank notice, etc.)
• Record in detailed accounting book account 635

Step 2: Classify financial expenses by type

• Classify interest expenses, exchange rate losses, payment discounts, etc.
• Record in detail each type of financial expense

Step 3: Record financial expense reductions

• Record any provision reversals.
• Record adjustments to reduce financial expenses

Step 4: Transfer final financial expenses

• At the end of the accounting period, transfer all the arising amounts on the Debit side of Account 635 (after deducting the Credit side) to Account 911.
• Make entry: Debit account 911 / Credit account 635

Example of accounting entries:

ABC Company has the following transactions related to financial expenses in May 2023:

1. May 10: Pay bank loan interest of 30 million VND Debit account 635 / Credit account 112: 30,000,000 VND
   
2. May 15: Advance payment of interest payable of 15 million VND Debit account 635 / Credit account 335: 15,000,000 VND
   
3. May 20: Exchange rate difference loss occurred when paying foreign currency debt of 25 million VND Debit account 635 / Credit account 112: 25,000,000 VND
   
4. May 31: Transfer financial expenses to business results Debit account 911 / Credit account 635: 70,000,000 VND

Illustrative statement of accounts:

4.4. Special accounting cases

In addition to the usual accounting cases, accountants need to pay attention to some special accounting cases related to financial costs:

1. Accounting for provision for devaluation of trading securities

When making provisions:

• Debit account 635 / Credit account 229 (Provision for asset loss)

When reversing provision:

• Debit account 229 / Credit account 635

For example: XYZ Company bought 10,000 shares at 50,000 VND/share. At the end of the year, the market price decreased to 45,000 VND/share. Provision: 10,000 × (50,000 - 45,000) = 50,000,000 VND.

• Debit account 635 / Credit account 229: 50,000,000 VND

2. Accounting for exchange rate differences at the end of the period

For foreign currency denominated monetary items, upon end-of-period revaluation:

• If a loss occurs: Debit account 635 / Credit related accounts (111, 112, 131...)
• If interest arises: Debit related account / Credit account 515 (Financial activity revenue)

For example: The company has a debt of 10,000 USD, the recorded exchange rate is 23,000 VND/USD. When revaluated at the end of the period, the exchange rate is 23,500 VND/USD. Exchange rate difference loss: 10,000 × (23,500 - 23,000) = 5,000,000 VND.

• Debit account 635 / Credit account 331: 5,000,000 VND

3. Accounting for bond issuance costs

When bond issuance costs arise:

• Debit account 635 / Credit account 111, 112, 331...

For example: Consulting and brokerage fees when issuing bonds are 20 million VND, paid by bank transfer.

• Debit account 635 / Credit account 112: 20,000,000 VND

4. Accounting for payment discounts for buyers

When payment discount arises:

• Debit account 635 / Credit account 131 (Receivables from customers)

For example: Customers get a 2% discount for early payment, order value is 1 billion VND. Discount: 1,000,000,000 × 2% = 20,000,000 VND.

• Debit account 635 / Credit account 131: 20,000,000 VND

Financial costs play an important role in assessing the business performance and financial management ability of an enterprise. Controlling and optimizing these costs not only helps enterprises maintain a stable cash flow but also enhances their competitiveness in the market. Therefore, understanding the nature, components and management of financial costs will be the key to helping enterprises develop sustainably and achieve long-term business goals.