ch4.ppt accounting for acural basis best

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
CHAPTER 4
Accruals 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 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

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
+100
Suppliers
Liabilities
+100
+100
Inventory
–100
–100
Cash
Assets
Final
2
1

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 loss
Equity
0
–200
+200
Receivables
+200
+200
Cash
Assets
Final
2
1
+200
+200
Sales

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 reliably
4. It is probable that the economic benefits associated with
the transaction will flow to the seller, and
5. 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 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

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 1120
10 items in closing inventory 10 x 1120
FIFO
20 x 1200
LIFO
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
Receipts
Payments
Purchases
Trade
payables
Inventory
Trade
receivables
Cash

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