Financial Accounting SESSION 1

Financial Accounting - Helena Isidro

Revision of basic concepts

Concepts of asset, liability, revenue, expense and income Record accounting transactions such as: sales, purchases,
acquisitions of equipment, payment of services and interests, etc.

Understand double-bookkeeping Prepare financial statements: income statement and balance sheet Revise intro material and exercises

Financial Accounting - Helena Isidro

Accounting principles
In order to achieve the financial reporting objectives of providing useful information for economic decision, financial statements must be prepared in accordance with fundamental accounting principles (IASB framework) Going Concern

Assumes that business will continue to operate for the foreseeable future Otherwise, if we expect business to close down in the near future we may use
market values, may need to record additional liabilities (e.g. redundancy costs) and to write down/up assets for their realisable value

Financial Accounting - Helena Isidro

Accounting principles
Accrual Basis

Revenues and expenses are recognised when earned/incurred, not

when money is received/paid

In most cases this will be achieved through matching revenues with

corresponding expenses These principles give rise to the following characteristics of financial information:
Financial Accounting - Helena Isidro

Matching
Revenues earned by the business are matched with the expense
incurred in earning those revenues

Expenses can be deferred until revenues are recognized (in a future

period) only if satisfy the definition of an asset
Example: sale on credit Sale revenue is recognised in I/S when goods are transferred to client, not only when cash is received from client Cost of sale is recognized in I/S when sale is recognized to match the revenue with expense
Financial Accounting - Helena Isidro

Prudence (Conservatism)
A degree of caution should be applied in exercising judgment and
making the necessary estimates

In particular, gains should be treated as realized only when realized

in the form of cash. Losses are recognized faster (in profit) than gains

Examples:
Doubts about the capability of a client to pay Reduce profit immediately as if the client would not pay Stocks bought for 1,000 have now a market value of 1,500 Do not recognize the gain until stock is actually sold
Financial Accounting - Helena Isidro

Accrual principle: Cash and Profit

Why is Cash different from Profit ?
BP Profit = (3.324) Cash = 18.556

Accounting numbers focus on the concept of economic profit Income statement provides information on generation and consumption of economic resources rather than on cash generation and expenditure Timing of receipt/payment of income/expense is irrelevant - what matters is when revenue (income) and expenses are recognised
In one reporting period: PROFITS AND CASH ARE NOT THE SAME
Financial Accounting - Helena Isidro

Cash and Accounting Profit

Example:
Period 1 purchase of merchandise worth 10,000 on cash Period 2 sale of all merchandise on credit for 15,000 Period 3 receipt of 15,000 from client

Financial Accounting - Helena Isidro

Cash and Accounting Profit

Period 1 Period 2 Sale Purchase merchandise merchandise on cash on credit Revenue Expense 15,000 10,000 5,000 15,000 10,000 (10,000) 15,000 Period 3 End of business Receipt from client 15,000 10,000 5,000 15,000 10,000 5,000
Financial Accounting - Helena Isidro

Profit = Cash At end of the business At end of the business

Profit
Cash inflow Cash outflow

Net cash

In individual periods cash is not equal to profit

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Deferrals and accruals

Four major transactions create differences between cash and profits: 1. Expenses paid but not consumed Prepayment or deferred expense 2. Expenses consumed but not paid Accrued expense 3. Revenues/income received in cash but not earned Unearned revenue/income or deferred revenue/income 4. Revenues/income earned but not received in cash Accrued revenue/income
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Prepayments (deferred expenses)

Prepayment is generated when a cash payment is made (or any other
asset given up) for an expense, which relates to a future accounting period

Example:
Suppose that on 1 September 2008, a company pays an insurance premium of 1,200 for the year ending 30 August 2009. If the company produces accounts with a year-end of 31 December, how should this item be treated?
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Prepayments
1 Sept 31 Dec 2008 Insurance usage/expense 1,200/12 months x 4 = 400 Payment = 1,200 1 Jan 30 Aug 2009 Insurance usage/expense 1,200/12 months x 8 = 800 Payment Cancel prepayment = -

Prepayment/deferred = 800 expense

= 800

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Accounting for prepayments

In the B/S worksheet

current assets
2008 Payment of insurance Defer to 2008 Transfer to retained profit Closing balance 2008 2009 Opening balance Insurance expense Transfer to retained profit Closing balance 2009

Assets Deferred Cash expenses (1,200) 800 800 800 (800) 0 (1,200) (1,200)

Equity Profit (I/S) (1,200) 800 400 0 Retained profit

(400) (400) (400)

(1,200)

(800) 800 0

(800) (1,200)
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Financial Accounting - Helena Isidro

Accounting for prepayments

In the journal (excl. profit appropriation) Year 2008 Dr insurance expense 1,200 Cr cash 1,200

Dr deferred expense Cr insurance expense

Year 2009 Dr insurance expense Cr deferred expense

800 800 800 800

Financial Accounting - Helena Isidro

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Accrued expenses
The accrual principle requires that we record a liability for all expenses which have been incurred but not paid

Example: Company A pays annual interests in a bank loan of 2.400 in 30 Nov 2009. The loan was obtained in 1 Dec 2008 and pays interests annually.

Financial Accounting - Helena Isidro

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Accounting for accrued expenses

Interest expense
Assets Cash 2008 Interest expense 2009 Payment of interests
current liabilities

Liab Accrued expense 200

Equity Profit (I/S) (200) 2.200

2.400

(200)

Financial Accounting - Helena Isidro

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Unearned or deferred revenue

Cash received prior to the goods/service have been provided We need to record the cash receipt but not the revenue in the I/S, as the accrual principle requires revenue to be recognised when earned not when receipt occurs The way to do this is to set up a category of liability called unearned or deferred revenue (income) Example: Homes plc, a letting agency, closes accounts on 31 Dec. At end of December 2008, the company received rents of Jan and Feb 2009 in the amount of 2,000
Financial Accounting - Helena Isidro

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Accounting for deferred revenue

Assets Cash 2008 Receipt of 2009 rents 2009 Rents revenue of 2009 Liabilities Deferred revenue 2,000 Equity Profit (I/S)

2,000

(2,000)

2,000

Financial Accounting - Helena Isidro

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Impairment
Recall the prudence concept: A degree of caution/conservantism should be applied in exercising judgment and making the necessary estimates An asset is impaired and impairment losses are incurred if there is objective evidence of a loss event that has an impact on the estimated future cash flows

Financial Accounting - Helena Isidro

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Impairment of receivables
For receivables, consider the following events:

(a) significant financial difficulty of borrower (b) breach of contract, such as a default or delinquency in interest or
principal payments

(c) the lender granted to the borrower a concession that the lender
would not otherwise consider

(d) becomes probable that the borrower will enter bankruptcy or other
financial re-organisation
Financial Accounting - Helena Isidro

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Impairment of receivables
Consider the following example: In period X1, company Zett plc sold goods to a client in the amount of 15,000, giving the client three-month credit During X1, the client paid only 14,000. Despite being contacted several times by the company the client did not to pay the remaining 1,000 At X2, the client reported financial difficulties and the debt was declared difficult to collect When should the loss be recognised in Zett plc accounts? In X2 only? Recognition of the expense only in X2 and doing nothing in X1 is not a prudent attitude. As a consequence, accounts in period X1 would reflect: - Overstatement of assets (accounts receivable) by 1,000 - Overstatement of profit (no recognition of the loss) by 1,000
Financial Accounting - Helena Isidro

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Impairment of receivables
The accounting entries are:
Cash Assets Impairment of receivables(*) Equity Acc receivable Profit (I/S)

Period X1 Sale Receipt from sales Impairment

14,000 (1,000)

15,000 (14,000)

15,000 (1,000)

(*) also referred to as provision for doubtful debts

Financial Accounting - Helena Isidro

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Impairment of receivables
Note that in the B/S the impairment reduces the accounts receivable
account. Sometimes is referred to as adjustment to asset or contra-asset. In B/S receivables is reported net
Accounts receivable 0

Note also that in the I/S the impairment loss is a separate operational
expense and is not deducted from sales revenue
Sales revenue Impairment loss 15,000 (1,000)
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Impairment of receivables
What happens in period X2?

Client financial troubles are resolved and he agrees to pay 60% of the
debt. The remaining 40% will not be collected (becoming a bad debt)

The credit is solved and there no need to keep the impairment in the
B/S: reverse the impairment loss

Financial Accounting - Helena Isidro

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Reverse impairment loss

Part of the credit is collected (600), part is transferred to bad debt expense (400), the B/S allowance for impairment is cancelled (1,000) against the I/S (revenue)
Cash Period X2 Opening balance Cash received Reversion impair. Assets Impairment Acc receivable 1,000 (1,000) Equity Profit (I/S) Retained profit 14,000 (400) 1,000
Bad debt expense Operational revenue

14,000 600

(1,000) 1,000

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Provisions for other events

The provision for doubtful debts reduces the value of an asset (receivables) Other provisions are represented in B/S as liabilities. These include: Restructuring provisions (e.g. future termination of a line of business, a
business in a country)

Onerous contracts provisions (e.g. closed leasehold properties that the

company cannot use but is liable to fulfill rent)

Environmental provisions (e.g. environmental liabilities, such as remediation

costs, related to past mining activities)

Litigation and other legal claims

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Summary
In this session we:

Understood accounting principles of matching and prudence Explained the accounting accruals and deferrals Learned how to value receivables and recognize impairment for
receivables

Understood the concept of provisions

Financial Accounting - Helena Isidro

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