chapter 6 refining the accounting database. contents accruals and deferrals of expenses and...

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

CHAPTER 6Refining the accounting

database


Contents

Accruals and deferrals of expenses and revenues

Provisions Asset impairment Bad debts and doubtful debts Hidden reserves Capital structure


Accruals and deferrals of expenses and revenues

Timing differences between occurrence and notification of economic events Regular accounting entries are triggered

by notifications received in advance or after the fact

Period matching requires adjustments when preparing financial statements

Time-based expenses and revenues


Accruals and deferrals of expenses and revenues (cont.)

Accruals are previously unrecorded expenses and revenues that need to be adjusted at the end of the accounting period to reflect the amount of expenses incurred or revenues earned during the accounting period

Deferrals are previously recorded (and probably paid / received) expenses and revenues that have to be adjusted at the end of the accounting period by deferring part of them to the following accounting period


Accrued expenses – example

Gas bill for 1,200 received in February 20X0 for period of November 20X0 through January 20X1 Expenses relate to 20X0 (800) and to 20X1 (400) No regular accounting entry yet on 31/12/20X0

Adjustment on 31/12/20X0: Operating expense of 800 in the income statement (-

Equity) ‘Accrued expense’ on financing side of BS (+ Liability)


Example – Accrued expenses

AssetsEnd of

20X0 20X1

Cash 0 -1,200

Total 0 -1,200

Financing

Short-term liabilitiesAccrued expensesEquity

+800 -800

Profit 20X0Profit 20X1

-800-400

Total 0 -1,200


Deferred expenses – example

Annual insurance premium of 2,400 paid on 1 April 20X0 for period extending to end of March 20X1 Expenses relate to 20X0 (1,800) and to 20X1

(600) Regular accounting entry for the full amount on

01/04/20X0 Adjustment on 31/12/20X0:

Expense of 600 deferred to the following year (+ Equity)

‘Deferred expense’ on asset side of BS (+ Asset)


Example – Deferred expenses

Arrival of notification

End of

20X020X1

Assets

CashDeferred expenses/ Prepayments

-2,400+600 -600

Total -2,400 +600 -600

Financing

Equity Profit 20X0 -2,400 +600

Profit 20X1 -600

Total -2,400 +600 -600


Deferred revenues – example

Annual subscription fee of 1,400 received by a publishing company at the start of the annual subscription period (1 April 20X0) Revenues relate to 20X0 (1,050) and to 20X1

(350) Regular accounting entry for the full amount on

01/04/20X0 Adjustment on 31/12/20X0:

Revenue of 350 deferred to the following year (- Equity)

‘Deferred revenue’ on financing side of BS (+ Liability)


Example – Deferred revenues

Time of notification

End of20X0 20X1

Assets

Cash +1,400

Total +1,400 0 0

Financing

Short-term liabilitiesDeferred revenue +350 -350

Equity Profit 20X0 +1,400 -350

Profit 20X1 +350

Total +1,400 0 0


Accrued revenues – example Annual interest income of 9 per cent on a

loan of 100,000 granted on 1 September 20X0 and to be received at the end of the one-year term Interest income relates to 20X0 (3,000) and to

20X1 (6,000) No regular accounting entry yet on 31/12/20X0

Adjustment on 31/12/20X0: Interest income of 3,000 in the income statement (+

Equity) ‘Accrued income’ on asset side of BS (+ Asset)


Example – Accrued revenues

AssetsEnd of

20X0 20X1

Accrued incomeCash

+3,000 -3,000+9,000

Total +3,000 +6,000

Financing

Equity


+3,000+6,000

Total +3,000 +6,000


Provisions A provision is a present obligation as a result

of a past event, whereby It is probable that settlement of the obligation will

lead to a future outflow of company resources The amount or timing of future outflow is

uncertain A reliable estimate of the amount of the

obligation is feasible Creation of the provision:

Assets 0 = Equity + Liabilities IAS 37 Provisions, Contingent Liabilities and

Contingent Assets


IAS 37 - Provisions, Contingent Liabilities and Contingent Assets

(Extract)

14. A provision shall be recognised when: (a) an entity has a present obligation (legal or constructive) as a result of a past event;(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and(c) a reliable estimate can be made of the amount of the obligation.

Source: IAS 37 - Provisions, Contingent Liabilities and Contingent Assets


Figure 6.1 Decision tree - Recognising a provision

Start

Present obligation as a

result of an obligating

event

Provide Do nothingDisclose

contingent liability

Possible obligation ?

Reliable estimate ?

Probable outflow ?

Remote?

No

No

No (rare)

No

No

Yes

Yes

Yes

Yes

Source: IAS 37 – Provisions, Contingent Liabilities and Contingent Assets


Contingent liability A contingent liability refers to

1. A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the company, or

2. A present obligation that is not recognised because the future expenditure is not probable or the obligation cannot be measured with sufficient reliability

Not recognised in the balance sheet, but disclosure in the notes to the accounts


Applying the decision tree- Product warranty

A manufacturer of domestic appliances sells its products with a three-year product warranty. If the product breaks down within a 3-years period, the manufacturer will fix or replace the product on its own expenses.

Questions:1) Present obligation as a result of a past event?2) Future outflow of company resources probable?3) Reliable estimate possible?


Applying the decision tree- Litigation

During 20X1 six people have died after a banquet, supposedly of food poisoning. The catering company has been summoned.At the end of the 20X1 fiscal year the company’s legal advisors assume that the firm will probably win the case.However, new evidence that surfaces during 20X2 makes the legal advisors change their mind and at the end of that year they expect that the catering company will probably lose the case.

Questions:1) Present obligation as a result of a past event?2) Future outflow of company resources probable?3) Reliable estimation possible?


Applying the decision tree- Major repairs and overhaul

Some tangible assets require not only routine maintenance, but also major periodic ‘refits’ and replacement of major components.E.g. an electric power station – a 30-year useful life – replacement of the steam generator is normally required after 10 years + Major maintenance every 5 years

Questions:1) Present obligation as a result of a past event?

2) Future outflow of company resources probable?3) Reliable estimation possible?


Applying the decision tree- Financial guarantee

In 20X1 company A decides to guarantee part of company B’s borrowings. At the end of 20X1 company B may be described as financially healthy. However, by the end of 20X2 company B has gone into receivership.

Questions:1) Present obligation as a result of a past event?

2) Future outflow of company resources probable?3) Reliable estimation possible?


Provision accounting

Reverse provision

EquityProfit for the year +15,000LiabilitiesProvisions -15,000

Create provision

EquityProfit for the year -15,000LiabilitiesProvisions +15,000

1. Provision accounting – create provision

2. Provision accounting – use provision

3. Provision accounting – reverse provision

Use provisionAssetsCash -15,000LiabilitiesProvisions -15,000


Accounting for provisions -Example

1) At the end of 20X1 a provision is created for €20,000

2) During 20X2 costs covered by the provision are expensed for a total amount of €8,000

3) At the end of 20X3 further expenditure relating to the provision is no longer expected and the outstanding balance of the provision is reversed


Accounting for provisions (2)

Assets20X1 20X2 20X3 Accumul

Cash

Total 0 0

Liab./Equity

Provisions +20,000 +20,000

Equity -20,000


-20,000

Profit 20X3

Total 0 0




Cash -8,000 (1)

-8,000

Total 0 -8,000 -8,000

Liab./Equity

Provisions +20,000 -8,000 (2)

+12,000

Equity -20,000


-20,000-8,000

(1)+8,000(

2)

Profit 20X3

Total 0 -8,000 -8,000




Cash -8,000 (1)

-8,000

Total 0 -8,000 0 -8,000

Liab./Equity

Provisions +20,000 -8,000 (2)

-12,000 0

Equity -8,000


-20,000-8,000

(1)+8,000(

2)

Profit 20X3+12,000

Total 0 -8,000 0 -8,000


Asset impairment

An asset is considered to have become impaired if its remaining expected future benefits drop below its net carrying value

If so, the carrying value of the asset will be adjusted for an impairment loss

IAS 36 Impairment of assets


Impairment testing

At each balance sheet date, assets have to be reviewed for indications of possible impairment

If there is an indication of impairment, an impairment test will be carried out Compare net carrying amount and

‘recoverable amount’ Recoverable amount = value recoverable

through use or sale


Recoverable amount The recoverable amount is the higher of

an asset’s fair value less costs to sell and its value in use

Fair value of an asset is the amount for which the asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction

Value in use is the present value of estimated future cash flows from continued use of the asset and eventual disposal at the end of its useful life


Figure 6.2 Recoverable amount

Carrying value

Value in useFair value

less costs to sell

Recoverable amount

< is higher of >

compare


FV = Fair ValueCA = Carrying amountVIU = Value in use

Figure 6.3 - Impairment testAre there

indications of potential impair-

ment of the asset ?

Can one determine the

fair value (FV) of the asset ?

Is FV less costs to sell > CA ?

Calculate VIU

IS VIU > CA ?

Impairment loss

No Impairment

No Yes

No

No

No

Yes

Yes

Yes


Accounting for impairment

If an impairment test shows that the recoverable amount of an asset is lower than its net carrying amount, the asset value is written down to the lower value

The asset write-down is expensed as an impairment loss

Assets = Equity + Liabilities 0


Accounting for impairment (cont.)

Impairment rationale If impairment and the asset value

were left unadjusted => overestimation of future economic benefits and current profit

In case of subsequent increase of the recoverable amount => Reversal of impairment loss


Impairment of a fixed asset - Illustration

Assume a company acquired on 2 January 20X1 a specialized machine for €1,500,000, expecting to use it to produce a specific item for 12 years. The equipment was depreciated on a straight-line basis. By the end of 20X4 demand for the specific product has dropped so much that the company expects that the net cash flows the item would generate over the remainder of its product life cycle would be less than the machine’s net carrying value (€1,000,000). The value in use was estimated at €800,000, while the estimated net selling price on 1 January 20X5 was €750,000. The equipment is therefore written down to €800,000, its estimated value in use, and the impairment loss is recognised in the 20X4 income statement


Cash-generating units Impairment testing is done at the

individual or aggregate asset level A cash-generating unit is the smallest

identifiable group of assets that generate cash flows that are largely independent of the cash flows from other (groups of) assets

The existence of an active market for the output produced by a group of assets constitutes primary evidence that cash flows are independent


Individual assets versus cash-generating units - Example 1

A mining entity owns a private railway to support its mining activities. The private railway could be sold only for scrap value and it does not generate cash inflows that are largely independent of the cash inflows from the other assets of the mine. It is not possible to estimate the recoverable amount of the private railway because its value in use cannot be determined and is probably different from scrap value. Therefore, the entity estimates the recoverable amount of the cash-generating unit to which the private railway belongs, i.e. the mine as a whole.

Source: IAS 36 - Impairment of Assets, par. 67 & 68


Individual assets versus cash-generating units - Example 2

A bus company provides services under contract with a muni-cipality that requires minimum service on each of five separate routes. Assets devoted to each route and the cash flows from each route can be identified separately. One of the routes operates at a significant loss. Because the entity does not have the option to curtail any one bus route, the lowest level of identifiable cash inflows that are largely independent of the cash inflows from other assets or groups of assets is the cash inflows generated by the five routes together. The cash-generating unit for each route is the bus company as a whole.

Source: IAS 36 - Impairment of Assets, par. 67 & 68


Identification of a CGU in a retail store chain -Illustration

Store Downtown belongs to Alphaline, a retail store chain. Downtown makes all its retail purchases through the central purchasing centre of Alphaline.Pricing, marketing, advertising and human resources policies (except for hiring X’s cashiers and sales staff) are decided at corporate level. Alphaline also owns five other stores in the same city as Downtown (although in different neighbourhoods) and 20 other stores in other cities. All stores are managed uniformly. In identifying a cash-generating unit in this context, one should consider, for example, whether internal management reporting is organised to measure performance on a store-by-store basis and whether the business is run on a store-by-store profit basis or on a region/city basis. Although the stores of Alphaline are managed at a corporate level, they are all located in different neighbourhoods and probably have different customer bases. Downtown generates cash inflows that are largely independent of those of the other sores of the retail chain and, therefore, it is likely that Downtown is a cash-generating unit.

Source: Adapted from IAS 36 – Illustrative Examples


Identification of a CGU in a single product company - Illustration

Company Unique produces a single product and owns plants A, B and C. Each plant is located in a different continent. Plant A produces a component that is assembled in either B or C. Alternatively, plant A’s products can be sold in an active market. The combined capacity of B and C is not fully utilised. Unique’s products are sold worldwide from either plant B or C. For example, plant B’s production can be sold in plant C’s continent if the products can be delivered faster from plant B than from plant C. Utilisation levels of plants B and C depend on the allocation of sales between the two sites.


Identification of a CGU in a single product company – Illustration (cont.)

As there is an active market for plant A’s products, A could sell its product in that market and so, generate cash inflows that would be largely independent of the cash inflows from plants B or C. Therefore, it is likely that plant A is a separate cash-generating unit, although part of its output is used by plants B and C.

Although there is an active market for the products assembled by plants B and C, cash inflows for B and C depend on the allocation of production across the two plants. It is unlikely that the future cash inflows for plants B and C can be determined individually. This brings us to conclude that plant B and plant C together are the smallest identifiable group of assets that generates cash inflows that are largely independent.

Source: Adapted from IAS 36 – Illustrative Examples


Bad debts and doubtful debts

Impairment adjustments relating to the non-collection of company receivables

Two separate aspects to take into account the collectability risk of receivables: On the evidence available, specific receivables

are not likely ever to be paid (bad debts) A more general assessment of the collectability

of all receivables (doubtful debts)


Bad debt expense

If it is decided that the amount of a receivable is not recoverable, it will be categorised as a bad debt and removed from the receivables’ total

The amount outstanding of the receivable (asset) is cancelled and a corresponding bad debt expense is entered in the income statement


Allowance for doubtful debts An allowance for doubtful debts is an

adjustment to take a prudent view of the likely value to be received from the current receivables’ balance at the balance sheet date

The allowance is expensed in the income statement, while a credit balance is entered in the balance sheet accounts (5 valuation allowance account as a negative asset)


Example – Adjusting receivables

The company decides to treat a receivable of £1,000 as definitely bad and to set aside a further £1,300 as an allowance for doubtful debts. Within the company’s accounting records, the entries would be:

Write offbad debt

Create allowanc

eAssetsReceivables –1,000Valuation

allowance –1,300EquityProfit for the year –1,000 –1,300


Hidden reserves Hidden reserves refers to the

conservative tendency to reduce current profits and store them for less profitable (future) accounting periods

Instruments: Creation of excessive provisions or

provisions for non-existing obligations Excessive asset write-downs/impairments Adjustments of accrued/deferred

expenses/revenues


Hidden reserves (cont.)

Structural sources of hidden reserves: Rapid depreciation and amortisation Low capitalization of costs Inventory valuation

LIFO in an environment characterized by rising prices

Historical cost principle


Capital structure Companies are externally financed either with

equity or debt Equity participates fully in the risks and rewards

of ownership No guaranteed return, but no upper limit either Downside risk is limited to the amount of the investment

Debt is usually advanced for a fixed period, earns a fixed return and must be repaid at end of period Short, medium or long term In different currencies From a variety of sources Return may be a floating rate


Components of equity Share capital

Ordinary shares Par or nominal value Different categories may imply different voting rights

Preference shares Share premium

Difference of issue price and par value of shares Issue costs are offset against share premium

Reserves Capital reserves Revenue reserves (retained profits)


Preference shares

Characteristics of debt Fixed return Holders do not routinely have voting rights

But: Preference dividend may not be paid if there

are no profits Preference dividend is not tax deductible

Preference dividends are usually cumulative


Convertibles

Convertible securities are either preference shares or debt (convertible debentures) which can be converted at some point in the future into ordinary shares

Other types of complex financial instruments which combine elements of debt and of equity (mezzanine debt, capital bonds and perpetual loan notes)

chapter 6 refining the accounting database. contents accruals and deferrals of expenses and...

Documents

20x1 expenses

20x0 revenues

expenses equity

deferrals of expenses

profit 20x0 profit 20x1

revenues assets end

unrecorded expenses

accounting database