CHAPTER 4 Accruals accounting

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 4Accruals accounting


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


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


Allocation of revenue and expenses - Example

Case 115/12 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 215/12 purchase (delivery)

five washing machines (cost €300 each)

20/12 washing machines sold on credit for €400 each

18/1 receipt of customer31/1 payment of supplier


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


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)


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


Purchases on credit

1. Purchase inventory on credit

2. Settle debt to supplier

Assets = Liabilities + Equity

+ Inventory 100 = + Debt to supplier 100

- Cash 100 = - Debt settlement 100


Purchases on credit

0–100+100SuppliersLiabilities

+100+100Inventory–100–100Cash

AssetsFinal21


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.


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


Sales on credit

1. Sale – recognition of revenue

2. Receipt from customer

Assets = Liabilities + Equity

+ Receivable 200 = + Revenue 200

- Receivable 200 + Cash 200 = 0


Sales on credit

Profit or lossEquity

0 –200+200Receivables

+200+200CashAssets

Final21

+200+200Sales


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


Revenue recognition

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


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 "


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


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


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


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


Sale of Goods – Complete list of recognition criteria (IAS 18)

1. The significant risks and rewards of ownership of the goods have been transferred to the buyer

2. The seller does not retain control over the goods, neither does he retain continuing managerial involvement incidental to ownership

3. The amount of revenue can be measured reliably4. It is probable that the economic benefits associated

with the transaction will flow to the seller, and5. The costs incurred or to be incurred in respect of the

transaction can be measured reliably


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


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


Inventories and profit measurement

Treatment of inventories Cost of goods sold Calculation of inventory value Relevant costs


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


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


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


Cost of goods sold (cont.)

Inventory available at 1/1/X1 XXX

plus goods purchased during year XXX

Goods available for resale in 20X1 XXX

less cost of inventory on hand 31/12/X1 XXX

= Cost of goods sold during year XXX


Calculation of inventory value

Periodical inventory measurement (valuation) as a pragmatic approach

Opening inventory+ Purchases during the period- Closing inventory to be

determined= Cost of goods sold

How to attach individual costs to inventory items?


Relevant costs Purchase price as appropriate reflection of

the inventory asset – two considerations:1. Inventory measure should not overstate the

value of the inventory Risk of overstating inventory values when prices

fluctuate rapidly Net realizable value

2. Value increments in addition to purchase price IAS 2 Inventories specifies the notions of

“purchase cost” and “cost of inventory”


Purchase cost Purchase cost =

Purchase price+ import duties / other non-recoverable

taxes+ transport / handling costs+ other costs directly attributable to

acquisition- trade discounts / rebates


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


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


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


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!


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


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


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


Example inventory valuation rules (1)

Inventory of video cameras01/1 Number of items in inventory = 007/1 Purchase of 20 items at 100015/1 Purchase of 30 items at 120027/1 Sale of 40 items at 150031/1 Inventory valuation and profit

calculation


Example inventory valuation rules (2)

31/1 Closing inventory = 10 items Number sold = 40 items

Weighted average 20 x 1000 + 30 x 1200 = 1120/ item 50

40 items sold 40 x 112010 items in closing inventory 10 x 1120

FIFO40 items sold 20 x 1000

20 x 120010 items in closing inventory 10 x 1200

LIFO40 items sold 30 x 1200

10 x 100010 items in closing inventory 10 x 1000


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


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


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)


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


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


Figure 4.1 - The working capital cycle

Inventory

Production Sales

ReceiptsPayments

Purchases

Trade payables

InventoryTrade

receivables

Cash

Documents

CHAPTER 4 Accruals accounting