Accounts, Accountants and Accruals Understanding : Accrual Accounting Matching Concept Assets vs Expenses Balance Sheet Income Statement Profit = Performance Cash Flow = Viability

1. Accrual Accounting Cash Accounting is simple – it works on cash Cash coming in is revenue Cash out is an expense But cash accounting is too simple to be useful What about equipment purchases or debt?

1. Accrual Accounting As an example, we will buy some equipment for $1 million, it will last 4 years and have $200,000 residual value. Under cash accounting, we will have the $1 million expense, in the first year, when the cash goes out. Then no more expense for the next 3 years and in the last year, we pick up $200,000 in revenue. The manager who buys the equipment is sacked after the first year for making a big loss. The replacement manager is a hero!

1. Accrual Accounting So we instead use accrual accounting It is not simple! The basis of accrual accounting is the Matching Concept

2. Matching Concept We want to measure performance, which cash accounting cannot do. The Matching Concept matches revenues with their expenses in a certain time period. Regardless of (has nothing to do with) the cash flows. X This psychologically difficult for real world people to accept.

2. Matching Concept In our example, we bought some equipment for $1 million, it will last 4 years and have $200,000 residual value. Under accrual accounting, the $1 million is not an expense. It is an asset. Each year, we use up ¼ of the machine = $200,000. We will match this using up or expense against the revenue earned from the equipment each year. This accrued or accrual expense is depreciation.

2. Matching Concept There are many other accrual concepts. What if we deliver some goods or services this month but we do not get paid for several more months. Is it a sale if we have not been paid yet? What if we get paid before we deliver the goods or service e.g. insurance, magazine subscriptions, airline tickets. Is it a sale? What if we employ staff and they are entitled to annual leave and long service leave. Are these expenses?

2. Matching Concept Why do we go to all this trouble with matching revenues with their expenses? For one major reason: we want to know how you are performing financially. Revenues – expenses = profit Profit is our accounting measure of performance We also get a better measure of what we owe: our liabilities.

3. Assets vs Expenses It is starting to get complex. Basically, it is all about time. We are trying to match revenues with their expenses in a set period of time. If it has gone and been used up, it is an expense. Examples include wages, interest, electricity.

3. Assets vs Expenses If we still have it, it is an asset. Examples include equipment, stock, buildings, accounts receivable and even pre-paid expenses. The same applies to other accounts. If we have earned it is a revenue. If we still owe it back, it is a liability.

4. Balance Sheet Because of accrual accounting, we now need another accounting statement on top of the Income Statement. This is the Balance Sheet. We need the Balance Sheet to show where all the assets are and the liabilities: the things that have not been used up yet or we still owe.

L I A B I L I T I E S S H A R E H O L D E R S' F U N D S A S S E T S SOURCES OF FUNDS USES OF FUNDS Balance Sheet Current Non Current Trade Credit Accruals Secured Debt: Overdraft Debentures Convertible Notes Subordinated Debt Preference Shares: Redeemable Cumulative Issued Capital Retained Earnings Cash Accounts Receivable Inventory Prepayments Plant Buildings Vehicles Investments Goodwill Intangibles Reserves Convertible

4. Balance Sheet Whenever it becomes too complicated just remember that business is about money coming in and going out. In bookkeeping, we call money coming in a credit entry and money going out a debit entry. Assets and expenses are very similar: they are both money going out. It is just that one has been used up (expenses) and one we still have (assets). Since money goes out in both cases, they are both debit entries to create them.

The Balance Sheet Equation Money In Liabilities + Equity Money Out Assets = Assets = Liabilities + Paid in Capital + Retained Earnings Assets = Liabilities + Paid in Capital + Revenues - Expenses Assets + Expenses = Liabilities + Paid in Capital + Revenues still got used up “Used up” is Income Statement Revenues - Expenses = Profit “Still got” is Balance Sheet Assets = Liabilities + Equity

4. Balance Sheet 1. Snapshot of the business at a point in time. 2. It balances! 3. Assets = Liabilities + Owners’ Equity 4. Company is legally liable to pay liabilities. 5. Shareholders are entitled to the net assets. 6. Double entry accounting ensures it balances. 7. Assets valued at economic value. 8. Most fixed assets are depreciated.

5. Income Statement 1. Summarises revenues and expenses over time. 2. Revenues are sales, rents, interest received. 3. Expenses are costs incurred. 4. Revenues increase Owners’ Equity. Expenses decrease Owners’ Equity. 5. Profit is the measure of performance. 6. Accrual accounting means profit and cash flow no longer match up.

6. Profit Measures Performance All of our accrual accounting treatment was to match revenues with their expenses. The net figure is profit. Profit is our financial measure of performance. It is measured in a unit of currency (dollars) and the profit figure has a dollar ($) sign in front of it. But the dollar sign does NOT mean it is cash. Because of accrual accounting, profit and cash flow are very different. X

6. Cash Flow Measures Viability It is cash that pays the bills. Profitable companies do go bust by not having the cash when needed. So in addition to the Balance Sheet and Income Statement, we have a third statement: The Statement of Cash Flows. It uses cash accounting.

Simplified Cash Flow for a Firm

Path to Enlightenment 1. Cash Accounting 2. Accrual Financial Accounting 3. Management Accounting 4. Investment Evaluation 5. Activity Based Management Simple but inadequate. No true measure of performance. No measure of liabilities incurred. Matches revenues and expenses regardless of when cash flows. Good measure of performance and reasonable measure of liabilities and assets. But poor measure of viability. So historic and forecast cash flows are also needed.. Accrual accounting is historic. It is good for assessing past performance but poor for decisions. Looks at costs, budgets, etc. So management accounting is added. Accounting systems do NOT pick up risk and returns. So other methods used like cost-benefit analysis, payback and discounted cash flows used. Tries to most accurately measure the cost of some activity. Expensive and difficult ? 6. Economic Value Added? Does the return justify the investment by equity investors?