1-Accruals and Provisions
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Transcript of 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
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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.
2Financial Accounting - Helena Isidro ©
n erstan ou e- oo eep ng
• Prepare financial statements: income statement and balance sheet
• Revise intro material and exercises
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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
3Financial Accounting - Helena Isidro ©
• 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
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Accounting principles
Accrual Basis
• Revenues and expenses are recognised when earned/incurred, not
when mone is received/ aid
4Financial Accounting - Helena Isidro ©
• In most cases this will be achieved through matchingmatchingmatchingmatching revenues with
corresponding expenses
These principles give rise to the following characteristics of financial
information:
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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
5Financial Accounting - Helena Isidro ©
• 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
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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
6Financial Accounting - Helena Isidro ©
• 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
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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
7Financial Accounting - Helena Isidro ©
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
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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
8Financial Accounting - Helena Isidro ©
• Period 3 – receipt of 15,000 from client
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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
9Financial Accounting - Helena Isidro ©
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
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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 :
11Financial Accounting - Helena Isidro ©
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?
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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
12Financial Accounting - Helena Isidro ©
Payment = 1,200
Prepayment/deferred = 800
expense
Payment = -
Cancel prepayment = 800
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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
13Financial Accounting - Helena Isidro ©
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)
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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
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Dr deferred expense 800Cr insurance expense 800
Dr insurance expense 800
Cr deferred expense 800
Year 2009 Year 2009 Year 2009 Year 2009
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Accrued expenses• The accrual principle requires that we record a liability for all
expenses which have been incurred but not paid
15Financial Accounting - Helena Isidro ©
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.
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Accounting for accrued expenses Assets Liab Equity
Cash Accrued
expense
Profit
(I/S)
2008200820082008
Interest expenseInterest expenseInterest expenseInterest expense current liabilities current liabilities
16Financial Accounting - Helena Isidro ©
Interest expense 200 (200)2009200920092009
Payment of interests 2.400 (200) 2.200
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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
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– 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
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Assets Liabilities Equity
Cash Deferredrevenue
Profit(I/S)
2008200820082008
Accounting for deferred revenue
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Receipt of 2009rents
2,000 2,000
2009200920092009
Rents revenue of
2009
(2,000) 2,000
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Impairment• Recall the prudence concept: A degree of caution/conservantism
should be applied in exercising judgment and making the necessary estimates
19Financial Accounting - Helena Isidro ©
• 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
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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
20Financial Accounting - Helena Isidro ©
(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
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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
21Financial Accounting - Helena Isidro ©
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
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Impairment of receivables Assets Equity
Cash Impairment
of
receivables(*)
Acc
receivable
Profit
(I/S)
The accounting entries are:
22Financial Accounting - Helena Isidro ©
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’
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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
23Financial Accounting - Helena Isidro ©
• 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)
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Impairment of receivables What happens in period X2?
• Client financial troubles are resolved and he agrees to pay 60% of the
debt.
“ ”
24Financial Accounting - Helena Isidro ©
• The credit is solved and there no need to keep the impairment in the
B/S: reverse the impairment loss
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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)
25Financial Accounting - Helena Isidro ©
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
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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)
26Financial Accounting - Helena Isidro ©
– 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
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Summary In this session we:
• Understood accounting principles of matching and prudence
• Explained the accounting accruals and deferrals
27Financial Accounting - Helena Isidro ©
z
receivables
• Understood the concept of provisions