1-accruals and provisions

7/31/2019 1-Accruals and Provisions

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Financial AccountingFinancial AccountingFinancial AccountingFinancial Accounting

1Financial Accounting - Helena Isidro ©

SESSION 1SESSION 1SESSION 1SESSION 1



Revision of basic concepts• Concepts of asset, liability, revenue, expense and income

• Record accounting transactions such as: sales, purchases,acquisitions of equipment, payment of services and interests, etc.


n erstan ou e- oo eep ng

• Prepare financial statements: income statement and balance sheet

• Revise intro material and exercises



Accounting principlesIn order to achieve the financial reporting objectives of providing useful

information for economic decision, financial statements must be prepared in

accordance with fundamental accounting principles (IASB framework)

Going Concern


• Assumes that business will continue to operate for the foreseeable future

• Otherwise, if we expect business to close down in the near future we may use

market values, may need to record additional liabilities (e.g. redundancy costs)

and to “write down/up” assets for their realisable value



Accounting principles

Accrual Basis

• Revenues and expenses are recognised when earned/incurred, not

when mone is received/ aid


• In most cases this will be achieved through matchingmatchingmatchingmatching revenues with

corresponding expenses

These principles give rise to the following characteristics of financial

information:



Matching• Revenues earned by the business are matched with the expense

incurred in earning those revenues

• Expenses can be deferred until revenues are recognized (in a future

period) only if satisfy the definition of an asset


• Example: sale on credit

– Sale revenue is recognised in I/S when goods are transferred to client, not

only when cash is received from client

– Cost of sale is recognized in I/S when sale is recognized to match the

revenue with expense



Prudence (Conservatism)• A degree of caution should be applied in exercising judgment and

making the necessary estimates

• In particular, gains should be treated as realized only when realized

in the form of cash. Losses are recognized faster (in profit) than gains


• Examples :

Doubts about the capability of a client to pay

Reduce profit immediately “as if” “as if” “as if” “as if” the client would not pay

Stocks bought for 1,000 have now a market value of 1,500

Do not recognize the gain until stock is actually sold



Accrual principle: Cash and Profit Why is CashCashCashCash different from ProfitProfitProfitProfit ?

• Accounting numbers focus on the concept of economic profit

• Income statement provides information on generation and

BP

Profit = (3.324)

Cash = 18.556

BP

Profit = (3.324)

Cash = 18.556


and expenditure

• Timing of receipt/payment of income/expense is irrelevant - what

matters is when revenue (income) and expenses are recognised

In one reporting period:

PROFITS AND CASH ARE NOT THE SAME

In one reporting period:

PROFITS AND CASH ARE NOT THE SAME



Cash and Accounting ProfitExample:

• Period 1 – purchase of merchandise worth 10,000 on cash

• Period 2 – sale of all merchandise on credit for 15,000


• Period 3 – receipt of 15,000 from client



Cash and Accounting ProfitPeriod 1 Period 2 Period 3 End of business

PurchasePurchasePurchasePurchase

merchandisemerchandisemerchandisemerchandise

on cashon cashon cashon cash

SaleSaleSaleSale

merchandisemerchandisemerchandisemerchandise

on crediton crediton crediton credit

ReceiptReceiptReceiptReceipt

from clientfrom clientfrom clientfrom client

Revenue 15,000 15,000 A t


Expense 10,000 10,000

Profit Profit Profit Profit - 5,000 - 5,000

Cash inflow 15,000 15,000

Cash outflow 10,000 10,000

Net cash Net cash Net cash Net cash (10,000) - 15,000 5,000

P r of i t = C a s h

en d of t h e b u s i n e s s

In individual periods cash is not equal to profit



Prepayments (deferred expenses)• Prepayment is generated when a cash payment is made (or any other

asset given up) for an expense, which relates to a future accounting

period

• Example :


Suppose that on 1 September 2008, a company pays an insurance

premium of 1,200 for the year ending 30 August 2009. If the

company produces accounts with a year-end of 31 December, how

should this item be treated?



Prepayments1 Sept1 Sept1 Sept1 Sept –––– 31 Dec 200831 Dec 200831 Dec 200831 Dec 2008 1 Jan1 Jan1 Jan1 Jan –––– 30 Aug 200930 Aug 200930 Aug 200930 Aug 2009

Insurance “usage”/expense

1,200/12 months x 4 = 400

Insurance “usage”/expense

1,200/12 months x 8 = 800


Payment = 1,200

Prepayment/deferred = 800

expense

Payment = -

Cancel prepayment = 800



Accounting for prepayments Assets Equity

Deferred

expenses

Cash Profit

(I/S)

Retained

profit

2008200820082008

Payment of insurance (1,200) (1,200)

In the B/S worksheetIn the B/S worksheetIn the B/S worksheetIn the B/S worksheet

current assets


Defer to 2008 800 800Transfer to retained profit 400 (400)

Closing balance 2008 800 (1,200) 0 (400)

2009200920092009

Opening balance 800 (1,200) (400)

Insurance expense (800) (800)

Transfer to retained profit 800 (800)

Closing balance 2009 0 (1,200) 0 (1,200)



Accounting for prepaymentsIn the journal (excl. profit appropriation)In the journal (excl. profit appropriation)In the journal (excl. profit appropriation)In the journal (excl. profit appropriation)

Dr insurance expense 1,200

Cr cash 1,200

Year 2008 Year 2008 Year 2008 Year 2008


Dr deferred expense 800Cr insurance expense 800

Dr insurance expense 800

Cr deferred expense 800

Year 2009 Year 2009 Year 2009 Year 2009



Accrued expenses• The accrual principle requires that we record a liability for all

expenses which have been incurred but not paid


xamp e:

– Company A pays annual interests in a bank loan of 2.400 in

30 Nov 2009. The loan was obtained in 1 Dec 2008 and pays

interests annually.



Accounting for accrued expenses Assets Liab Equity

Cash Accrued

expense

Profit

(I/S)

2008200820082008

Interest expenseInterest expenseInterest expenseInterest expense current liabilities current liabilities


Interest expense 200 (200)2009200920092009

Payment of interests 2.400 (200) 2.200



Unearned or deferred revenue• Cash received prior to the goods/service have been provided

– We need to record the cash receipt but not the revenue in the I/S, as the

accrual principle requires revenue to be recognised when earned not

when receipt occurs


– The way to do this is to set up a category of liability called unearned or

deferred revenue (income)

• Example:

Homes plc, a letting agency, closes accounts on 31 Dec. At end of

December 2008, the company received rents of Jan and Feb 2009 in the

amount of €2,000



Assets Liabilities Equity

Cash Deferredrevenue

Profit(I/S)

2008200820082008

Accounting for deferred revenue


Receipt of 2009rents

2,000 2,000

2009200920092009

Rents revenue of

2009

(2,000) 2,000



Impairment• Recall the prudence concept: A degree of caution/conservantism

should be applied in exercising judgment and making the necessary estimates


• An asset is impaired and impairment losses are incurred if there is

objective evidence of a ‘loss event’ that has an impact on the

estimated future cash flows



Impairment of receivablesFor receivables, consider the following events:

(a) significant financial difficulty of borrower

(b) breach of contract, such as a default or delinquency in interest or


(c) the lender granted to the borrower a concession that the lender

would not otherwise consider

(d) becomes probable that the borrower will enter bankruptcy or other

financial re-organisation



Impairment of receivablesConsider the following example:Consider the following example:Consider the following example:Consider the following example:

In period X1, company Zett plc sold goods to a client in the amount of €15,000, giving the

client three-month credit

During X1, the client paid only €14,000. Despite being contacted several times by the company

the client did not to pay the remaining €1,000


At X2, the client reported financial difficulties and the debt was declared “difficult to collect”

When should the loss be recognised in Zett plc accounts? In X2 only? When should the loss be recognised in Zett plc accounts? In X2 only? When should the loss be recognised in Zett plc accounts? In X2 only? When should the loss be recognised in Zett plc accounts? In X2 only?

Recognition of the expense only in X2 and doing nothing in X1 is not a prudent attitude. As a

consequence, accounts in period X1 would reflect:

- Overstatement of assets (accounts receivable) by €1,000

- Overstatement of profit (no recognition of the loss) by €1,000



Impairment of receivables Assets Equity

Cash Impairment

of

receivables(*)

Acc

receivable

Profit

(I/S)

The accounting entries are:


Perio X1Perio X1Perio X1Perio X1

Sale 15,000 15,000

Receipt from sales 14,000 (14,000)

Impairment (1,000) (1,000)

(*) also referred to as ‘provision for doubtful debts’



Impairment of receivables• Note that in the B/S the “impairment” reduces the “accounts receivable”

account. Sometimes is referred to as “adjustment to asset” or “contra-asset”. In

B/S receivables is reported net Accounts receivable 0


• Note also that in the I/S the “impairment loss” is a separate operational

expense and is not deducted from sales revenue

Sales revenue 15,000

…………

Impairment loss (1,000)



Impairment of receivables What happens in period X2?

• Client financial troubles are resolved and he agrees to pay 60% of the

debt.

“ ”


• The credit is solved and there no need to keep the impairment in the

B/S: reverse the impairment loss



Reverse impairment loss

Assets Equity

Cash Impairment Acc Profit Retained

Part of the credit is collected (€600), part is transferred to bad debt expense

(€400), the B/S allowance for impairment is cancelled (€1,000) against the I/S

(revenue)


receivable

(I/S) profitPeriod X2Period X2Period X2Period X2

Opening balance 14,000 (1,000) 1,000 14,000

Cash received 600 (1,000) (400)

Reversion impair. 1,000 1,000

Bad debt expenseBad debt expenseBad debt expenseBad debt expense

Operational revenueOperational revenueOperational revenueOperational revenue



Provisions for other events• The provision for doubtful debts reduces the value of an asset (receivables)

• Other provisions are represented in B/S as liabilities. These include:

– Restructuring provisions (e.g. future termination of a line of business, a

business in a country)


– Onerous contracts provisions (e.g. closed leasehold properties that the

company cannot use but is liable to fulfill rent)

– Environmental provisions (e.g. environmental liabilities, such as remediation

costs, related to past mining activities)

– Litigation and other legal claims



Summary In this session we:

• Understood accounting principles of matching and prudence

• Explained the accounting accruals and deferrals


z

receivables

• Understood the concept of provisions

1-accruals and provisions

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