Accounting and Reporting on an Accrual Accounting Basis Chapter 2 Accounting and Reporting on an Accrual Accounting Basis

By the end of this chapter, you should be able to: explain historical cost 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.

Objective of financial statements To provide information about The financial position The financial performance Capability of an enterprise to adapt Changes in the amount due to equity owners That is useful to a wide range of users in making economic decisions (IASB)

Common information needs for decision making All the information needs of all users cannot be met Some needs are common to all users, eg. interest in the financial position, performance and adaptability of the enterprise as a whole. Which user is the primary target? Investors are providers of risk capital, so financial statements that meet their needs would also meet the needs of other users.

Decision makers need to assess the ability to generate cash Economic decisions require an evaluation of A business’s ability to generate cash and The timing and certainty of its generation To make the evaluation, users need information that focuses on: the financial position, financial performance cash flows

Financial information to evaluate the ability to generate cash differs from financial information on actual cash flows . . . in that, in addition to the cash flows and statement of financial position it includes within its definition of performance a reference to profit This information is required to assess changes in the economic resources that the business is likely to control in the future – i.e predicting the ability of the business to generate cash flows from its existing resource base.

A complete set of financial statements includes A statement of financial position as at the end of the period - Balance Sheet A statement of comprehensive income for the period - Income Statement 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.

HCA = Historical cost accounting HCA Accounting HCA = Historical cost accounting HCA is useful for stewardship purposes Transactions reported are the amount at the date transaction occurred Amounts are objective and verifiable Basis for determining outcome of agency agreements, for example loan covenants However, may not be as useful as inflation adjusted data for decision making.

Accrual accounting Includes transactions affecting the current accounting period that have not yet involved the movement of cash – Revenue earned replaces cash receipts Expenses incurred replaces cash payments Sacrifice of non-current assets – depreciation IAS16

Accrual accounting When to recognize transaction within the accrual period? Suppliers : Payables Customers: Receivables Employees: Payables Insurance, taxes, interest: Payables/Receivables Revenue earned, if unrealized (unearned Expenses incurred or not incurred.

Subjective judgements – the matching principle Financial statements must include costs related to the achievement of the reported income Payments made this period for expenses that relate to the next period are deducted from the cash paid to arrive at the expense for the period eg. rent Payments to be made in the next period for expenses incurred in the current period are added to the cash paid to arrive at the expense for the period eg. electricity.

illustration

Illustration – first 6 months actual cash flows for monthly sales Figure 1.7 Monthly sales, purchases and expenses for 6 months ended 30 June 20X1

Illustration – income statement adjusted refer to Fig 1.7 earned incurred Incurred, 6 months Figure 2.3 Statement of income for the 6 months ended 30 June 20X1

Financial position applying IASB 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

Financial position applying IASB definitions A liability is defined as a present obligation Arising from a past event Whose settlement is expected to result in an outflow of resources

Treatment of non-current assets The Matching Principle approach is to: Estimate how much of initial cost of the asset has been consumed in the period – this is known as depreciation Apply IAS 16 Depreciation – this IAS will be discussed in detail in the PPE chapter.

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 (value remaining at the end of the asset’s useful life) The depreciation method used should follow the pattern in which the asset’s economic benefits are used, and assumes the business will continue in operational existence for foreseeable future – i.e. the going concern assumption is applied.

References Elliott, Barry, Elliott Jamie, Financial Accounting and Reporting 18th Edition chapter 2