Accounting and reporting on an accrual accounting basis

1. Chapter 2 Accounting and reporting on an accrual accounting basis

2. Main purpose • This chapter is a simple revision of introductory accounting. • It uses all of the information already met in cash accounting. • Then increases the information that is recorded and reported. • Adjusting for the effect of transactions that have not been completedby the end of an accounting period gives us accrual accounting.

3. Objectives By the end of this chapter, you should be able to: • explain the historical cost convention and accrual concept; • adjust cash receipts and payments in accordance with IAS 18 Revenue; • account for the amount of non-current assets used during the accounting period; • prepare a statement of income and a statement of financial position; • reconcile cash flow accounting and accrual accounting data.

4. Chapter 2 covers • Historical cost convention • Accrual basis of accounting • Mechanics of accrual accounting – adjusting cash receipts and payments • Subjective judgements required in accrual accounting • Mechanics of accrual accounting – the statement of financial position • Reformatting the statement of financial position • Accounting for the sacrifice of non-current assets • Reconciliation of cash flow and accrual accounting data

5. Objective of financial statements To provide information about: • the financial position; • the financial performance; • capability of an enterprise to adapt; and • changes in the amount due to equity owners. General purpose: useful to a wide range of users in making economic decisions (IASC).

6. Common information needs for decision making • All the information needs of all users cannot be met, but: – some needs are common to all users, e.g. some interest in the financial position, performance and adaptability of the enterprise as a whole. • So, which user is the primary target? • The IASC states that, as investors are providers of risk capital, financial statements that meet their needs would also meet the needs of other users.

7. Decision makers need to assess the ability to generate cash • The IASC considers that economic decisions require an evaluation of: • an enterprise’s ability to generate cash; and • the timing and certainty of its generation. • It believes that users are better able to make the evaluation if they are provided with information that focuses on the financial position, performance and cash flow of an enterprise.

8. Financial information to evaluate theability to generate cash differs from financial information on actual cash flows • The IASC approach differs from the cash flow model used in Chapter 1, in that, • in addition to the cash flows and statement of financial position it includes within its definition of performance a reference to profit.

9. Financial information to evaluate the ability to generate cash differs from financial information on actual cash flows (Continued) • It states that this information is required to assess changes in the economic resources that the enterprise is likely to control in the future. • This is useful in predicting the capacity of the enterprise to generate cash flows from its existing resource base.

10. A complete set of financial statements – IASB • A statement of financial position as at the end of the period. • A statement of comprehensive income for the period. • A statement of changes in equity for the period. • A statement of cash flows for the period. • Notes, comprising a summary of significant accounting policies and other explanatory information.

11. HCA accounting • HCA is useful for stewardship purposes • Transactions reported at amount at date transaction occurred. • Amounts are objective and verifiable. • Basis for determining outcome of agency agreements, e.g. loan covenants. • However, may not be as useful as inflation adjusted data for decision making.

12. Accrual accounting • Adjusts the realised operating cash flows for transactions still not converted into cash at the end of the period. • Includes in period’s income, invoices issued but cash still not received. • Includes in the period’s expenses invoices received but cash still not paid out. • Was regarded by the IASC as more useful than cash accounting in making economic decisions.

13. Subjective judgements – the matching principle • Financial statements must include costs related to the achievement of the reported income. • Payments made relating to the next period are deducted from the cash paid to arrive at the expense for the period. • Payments to be made in the next period but incurred in the current period are added to the cash paid to arrive at the expense for the period.

14. Illustration– income statement adjusted Figure 2.1 Statement of income for the six months ended 30 June 20X1

15. Illustration – financial position adjusted Figure 2.2 Statement of financial position adjusted to an accrual basis

16. Financial position applying IASC definitions • An asset is defined as a resource: • controlled by the enterprise; • as a result of a past event; • from which future economic benefits are expected to flow. Note that this definition is important and will be met throughout later chapters.

17. Financial position applying IASC definitions (Continued) • A liability is defined as a present obligation: • arising from a past event • whose settlement is expected to result in an outflow of resources. Note that this definition will also be met throughout the text.

18. Statement of financial position applying the IASC definitions Figure 2.3 Reframed statement as at 30 June

19. Statement of financial position applying the IASC definitions (Continued) Figure 2.3 Reframed statement as at 30 June (Continued)

20. Treatment of non-current assets • The matching principle approach is to: • estimate as revenue expenditure how much of initial outlay has been consumed in the period – this is depreciation. • Apply IAS 16 depreciation – this IAS will be discussed in detail in the PPE chapter.

21. IAS 16 states • Depreciation is the systematic allocation of the depreciable amount over useful economic life. • Depreciable amount is the cost of an asset less its residual value. • The depreciation method used should reflect the pattern in which the asset’s economic benefits are consumed.

22. Non-current asset treatment in accrual accounting – the going concern assumption • Assumes business will continue in operational existence for foreseeable future. • More relevant to use loss of service potential rather than change in net realisable value. • Service potential means the number of products that can be produced over life of the asset. • Necessary to assess financial capital maintenance.

23. Income statement adjusted Figure 2.4 Statement of income for the six months ending 30 June

24. Statement of financial position Figure 2.5 Statement of financial position as at 30 June

25. Statement of financial position (Continued) Figure 2.5 Statement of financial position as at 30 June (Continued)

26. Reconciliation in accordance withaccounting standards Figure 2.6 Statement of cash flows in accordance with IAS 7 Statement of Cash Flows

27. Reconciliation in accordance with accounting standards (Continued) Figure 2.6 Statement of cash flows in accordance with IAS 7 Statement of Cash Flows (Continued)

28. Review questions • ‘Cash flow accounting and accrual accounting information are both required by a potential shareholder’. Discuss. • ‘The asset measurement basis applied in accrual accounting can lead to financial difficulties when assets are due for replacement’. Discuss.

29. Review questions (Continued) • ‘Accrual accounting is preferable to cash flow accounting because the information is more relevant to all users of financial statements’. Discuss. • ‘Information contained in a statement of income and a statement of financial position prepared under accrual accounting concepts is factual and objective’. Discuss.

30. Review questions (Continued) The Conceptual Framework for Financial Reporting identifies seven user groups: investors, employees, lenders, suppliers and other trade creditors, customers, government and the public. Discuss which of the financial statements illustrated in Chapters 1 and 2 would be most useful to each of these seven groups if they could only receive one statement. 5.

31. Review questions (Continued) • The annual financial statements of companies are used by various parties for a wide variety of purposes. Discuss which of the three statements of income, financial position and cash flows would be of most interest to (a) a loan creditor and (b) a trade creditor. 7. Discuss how amounts are reported in a statement of financial position if the accounts are not prepared on a going concern basis.