CHAPTER 4 Accruals accounting

1. CHAPTER 4Accruals accounting

2. Contents • Accruals basis of accounting • Credit transactions • Recognition of revenue • Period costs • Inventories and profit measurement • Accounting techniques • Manufacturing accounts • Net realisable value • Working capital

3. Accruals basis of accounting • Accruals are those costs and revenues which distinguish profit from net cash flow • Accounting needs to capture all the economic events when they take place, and the cash movement is usually only part of the picture of an economic event

4. Case 1 15/12 purchase (delivery) five washing machines (cost €300 each) 06/1 washing machines sold on credit for €400 each 18/1 receipt of customer 31/1 payment of supplier Case 2 15/12 purchase (delivery) five washing machines (cost €300 each) 20/12 washing machines sold on credit for €400 each 18/1 receipt of customer 31/1 payment of supplier Allocation of revenue and expenses - Example

5. IASB - Accruals “In order to meet their objectives, financial statements are prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions.” IASB, Framework for the Preparation and Presentation of Financial Statements, par.22

6. Accrual accounting • Two fundamentals: • Revenue recognition rules • Matching principle • Revenue and expenses relating to the same business transaction should be recognized in the same accounting period (the period when the transaction took place)

7. Credit transactions • Purchase and sale of goods frequently take place on credit, i.e. cash payment follows delivery often with a delay of 30 to 60 days • Suppliers and customers trading on ‘open account’ • Credit terms may lead to tension between financial management and procurement / marketing

8. Purchases on credit 1. Purchase inventory on credit Assets = Liabilities + Equity + Inventory 100 = + Debt to supplier 100 2. Settle debt to supplier - Cash 100 = - Debt settlement 100

9. Purchases on credit 1 2 Final Assets Cash –100 –100 Inventory +100 +100 Liabilities Suppliers +100 –100 0

10. Definition of creditor A creditor is an individual or another company to whom the firm owes money. Examples of creditors: • Trade creditors: Suppliers of raw materials, other inventories, equipment and services which are purchased in the course of business for resale, for which payment has not yet been made. • Other creditors: Amounts owing to outsiders for various other reasons, such as interest payable; usually routine recurring debts for services and supplies ancillary to trading operations.

11. Accounts payable ledger • General ledger carries an account which aggregates all the amounts owed to suppliers • Subsidiary ledger (‘accounts payable ledger’) duplicates all the movements on the total supplier account (a ‘control account’) but holds a separate account for each supplier with all details of purchases and payments • The sum of all individual balances in the subsidiary ledger should equal the amount in the corresponding general ledger control account

12. Sales on credit 1. Sale – recognition of revenue Assets = Liabilities + Equity + Receivable 200 = + Revenue 200 2. Receipt from customer - Receivable 200 + Cash 200 = 0

13. 1 2 Final Assets Cash +200 +200 Receivables +200 –200 0 Equity Profit or loss Sales +200 +200 Sales on credit

14. Accounts receivable ledger • General ledger carries an account which aggregates all the amounts due from customers • Subsidiary ledger (‘accounts receivable ledger’) duplicates all the movements on the total customer account (a ‘control account’) but holds a separate account for each customer with all details of sales and receipts • The sum of all individual balances in the subsidiary ledger should equal the amount in the corresponding general ledger control account

15. Revenue recognition • Definition of revenue • Revenue versus gains • Timing of revenue recognition • Long-term contracts

16. Defition of revenue • IAS 18 Revenue • "Revenue is the gross inflow of economic benefits in the period arising in the course of the ordinary activities of an entity when these inflows result in increases in equity, other than increases relating to contributions from equity participants "

17. Revenue versus gains • Income = an inflow of economic benefits during the period that result in increases in shareholders’ equity = Revenue + Gains • Revenue is income that arises in the course of the ordinary activities of the company • Revenues are reported as gross amounts, gains are reported net of related expenses

18. Timing of revenue recognition • Revenue is recognised in income statement when it is ‘earned’ • Implies a certain degree of performance on part of supplier • Critical event to decide that earning process is complete? • Timing of revenues becomes an issue

19. Typical revenue cycle for the sale of goods 1) Customer places order 2) Sales order is recognized after credit approval and inventory check 3) Goods ordered are shipped to customer 4) Customer accepts delivery of goods 5) Sales invoice is prepared and sent to customer 6) Customer pays invoice

20. IAS 18 - Revenue • Most critical event criteria: • the company has transferred the significant risks and rewards of ownership of the goods to the buyer • the company has neither managerial involvement nor effective control over the goods • In most cases fulfilment of these criteria coincides with • the transfer of legal title, or • the passing of possession to the buyer, which normally takes place at delivery

21. Sale of Goods – Complete list of recognition criteria (IAS 18) • The significant risks and rewards of ownership of the goods have been transferred to the buyer • The seller does not retain control over the goods, neither does he retain continuing managerial involvement incidental to ownership • The amount of revenue can be measured reliably • It is probable that the economic benefits associated with the transaction will flow to the seller, and • The costs incurred or to be incurred in respect of the transaction can be measured reliably

22. Long-term contracts • Recognise revenue by reference to the stage of completion of the transaction at the balance sheet date, provided that revenue, related costs and progress can be measured reliably. = ‘Percentage-of-completion method’ (in contrast to the ‘completed-contract method’). • This method uses the amount of services performed within the single accounting period as a percentage of total services to be performed as a base for allocating revenue, irrespective of cash payments

23. Period costs • Time-based expenses (associated with a certain accounting period) which are not traceable to any specific revenue generating transactions • Overhead costs of head office activities • Insurance costs • These costs should be allocated in a systematic way among the accounting periods in which the business benefits from these costs

24. Inventories and profit measurement • Treatment of inventories • Cost of goods sold • Calculation of inventory value • Relevant costs

25. Treatment of inventories • The treatment of inventories in the accounting system is one of the most straightforward applications of the matching-principle of revenue and expenses • Inventories (assets) are ‘expensed’ when the goods are actually sold and revenue is recognised • IAS 2 Inventories

26. Inventory categories • Categories of inventory • Goods purchased for resale • Raw materials and consumables • Work in progress • Finished goods • We will first treat “goods purchased for resale” and extend to other categories later

27. Cost of goods sold • The cost of goods sold is the amount paid by the company for the goods it sold to customers in the accounting period • Gross profit = Sales – Cost of goods sold

28. Cost of goods sold (cont.)

29. Calculation of inventory value • Periodical inventory measurement (valuation) as a pragmatic approach Opening inventory + Purchases during the period - Closing inventoryto be determined = Cost of goods sold • How to attach individual costs to inventory items?

30. Relevant costs • Purchase price as appropriate reflection of the inventory asset – two considerations: • Inventory measure should not overstate the value of the inventory • Risk of overstating inventory values when prices fluctuate rapidly • Net realizable value • Value increments in addition to purchase price • IAS 2 Inventories specifies the notions of “purchase cost” and “cost of inventory”

31. Purchase cost • Purchase cost = Purchase price + import duties / other non-recoverable taxes + transport / handling costs + other costs directly attributable to acquisition • trade discounts / rebates

32. Cost of inventory • Cost of inventory = Cost of purchases + costs of conversion + other costs incurred in bringing the inventory to the present location and condition • Does not include wastage, administrative overheads and selling costs • Conversion costs relate to manufacturing processes

33. Accounting techniques • Continuous inventory • Measurement methods that rely on assumptions about inventory movements (but do not increase inventory value by adding in any associated costs) • Methods used where the inventory value of goods for resale includes costs other than the initial purchase price

34. Continuous inventory • Individual goods are valued at the actual cost of acquiring them • Used in a business dealing in a small volume of high-value items which are not homogeneous

35. Accounting assumptions • Inventory value is determined on the basis of assumptions about inventory movements • Assumptions are used to allocate the costs of inventory items between the cost of goods sold (expense) and the inventory asset carried forward to the next year • Not necessarily identical to actual physical inventory movements • Three generally accepted systems within a historical cost framework • FIFO, LIFO, weighted average • Principle of consistency!

36. FIFO • First In First Out • Assumes that the first item to be sold will be the first item delivered to the stores • Inventory is measured at the most recent prices • Consistent with good housekeeping

37. LIFO • Last In First Out • Assumes that the first item to be sold will be the last item delivered to the stores • Inventory is measured at the oldest prices • Banned by IAS 2 as from January 1, 2005

38. Weighted average • Cost of goods sold is measured based on the average cost of all the items of that type which are on hand at the time of sale • A new average is computed each time a sale takes place

39. Example inventory valuation rules (1) Inventory of video cameras 01/1 Number of items in inventory = 0 07/1 Purchase of 20 items at 1000 15/1 Purchase of 30 items at 1200 27/1 Sale of 40 items at 1500 31/1 Inventory valuation and profit calculation

40. Example inventory valuation rules (2) 31/1 Closing inventory = 10 items Number sold = 40 items Weighted average20 x 1000 + 30 x 1200 = 1120/ item 50 40 items sold 40 x 1120 10 items in closing inventory 10 x 1120 FIFO 40 items sold 20 x 1000 20 x 1200 10 items in closing inventory 10 x 1200 LIFO 40 items sold 30 x 1200 10 x 1000 10 items in closing inventory 10 x 1000

41. Manufacturing accounts • Matching principle: all costs of manufacturing a product should be recorded as an asset until the moment the product is sold • Distinction between direct costs and overhead (indirect costs) • Direct costs: raw material, labour cost,… • Overhead: supervisory production staff, cost of factory building, cost of general management,… • IAS 2: Cost of inventory includes a systematic allocation of production overheads that are incurred in converting materials into finished goods

42. Net realisable value • Inventory is valued at historical cost unless its net realisable value (NRV) is lower • NRV = net amount that a company expects to realise from the sale of inventory in the ordinary course of business • Inventory value is written down to NRV, if NRV < historical cost

43. Net realisable value (cont.) • The amount of any write-down of inventories to net realisable value will be recognised as an expense in the period the write-down occurs • Net realisable value is an entity-specific value • Takes into account the specific purpose for which the inventory is held by the company (specific sales contracts, expected use in the production of finished goods)

44. IAS 2 – Net realisable value 6. Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. 9. Inventories shall be measured at the lower of cost and net realisable value. 34. When inventories are sold, the carrying amount of those inventories shall be recognised as an expense in the period in which the related revenue is recognised. The amount of any write-down of inventories to net realisable value and all losses of inventories shall be recognised as an expense in the period the write-down or loss occurs. The amount of any reversal of any write-down of inventories, arising from an increase in net realisable value, shall be recognised as a reduction in the amount of inventories recognised as an expense in the period in which the reversal occurs. Source: IAS 2 - Inventories

45. Working capital • Accrual accounting leads to a number of short-term assets and liabilities which are linked to the operating cycle (or working capital cycle): trade payables, trade receivables, inventories, ... • The working capital cycle is the average time it takes to acquire materials, services and labour, manufacture the product, sell it and collect the proceeds from the customers • It stresses the economic link between current assets and current liabilities

46. Figure 4.1 - The working capital cycle Inventory Production Purchases Sales Trade receivables Trade payables Inventory Payments Receipts Cash