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A Brief Guide to…. Accruals Accounting November 2005 DRAFT v.1.0 v. 1.0 - Novem

A Brief Guide to…. Accruals Accounting November 2005 DRAFT v.1.0 v. 1.0 - November 2005 Document: briefguide_accruals.doc A brief guide to…. Accruals Accounting Page 2 Accruals Accounting Accruals Accounting is about ensuring that all income and charges relating to a financial period are actually recorded as being part of that period – and that assets and liabilities are appropriately disclosed. This means amounts are recognised when they are incurred, or when the right to receive them arrives – regardless of the actual date of any cash receipt or payment. It also requires that ‘non-cash’ transactions and events are recognised in the accounts to give ‘the complete picture’ – this includes concepts such as depreciation and provisions - as covered in the table opposite. Cash Accounting - An Alternative? In terms of conveying a ‘true and fair view’, there isn’t really any alternative to accruals accounting. Worldwide accounting standards are clear in that accruals accounting is “part of the bedrock of accounting” “An entity shall prepare its financial statements, except for cash flow information, using the accrual basis of accounting.” International Accounting Standards, IAS1 s.25 & Financial Reporting Standards, FRS 18 s.26 The old approach of ‘Cash Accounting’ shows just cash receipts and cash payments when they occur. There are no adjustments made to reflect amounts owed or owing – or the ownership and use of assets. Whilst this has simplicity to offer, it does not provide the complete picture and is only appropriate today for the very smallest of organisations – typically very small-scale voluntary groups with low levels of stakeholder interest. The Cash Flow Statement With Accruals Accounting comes the need for a Cash Flow Statement which takes equal importance alongside the income statement and balance sheet in the accounts. This is necessary because a focus on cash remains an important measure of business health and operation. v. 1.0 - November 2005 Document: briefguide_accruals.doc A brief guide to…. Accruals Accounting Page 3 To achieve this, the Cash Flow Statement follows a standard format to show cash flows during the period - analysing them between operating, investing and financing activities – and providing a reconciliation of the change in cash balances during the period to the difference between income and expenditure in the income statement. Fundamental Concepts Accruals Accounting brings with it the need to consider and include; Accrued Expenses Anticipation of future payment requests whereby you have received goods or services – but have not yet been charged for them. These show as the type of expense they are (e.g. Electricity) on the Income Statement and as an ‘Accrued Expense’ Liability on the Balance Sheet. Creditors A Balance Sheet liability showing amounts you owe for goods and services received that have been invoiced, but not yet paid. Debtors A Balance Sheet asset showing amounts owed to you for goods and services delivered but not yet been paid for. Depreciation Assets don’t last forever. Depreciation is a prudent estimate of the cost of tangible fixed assets that you have used in the period – a valid (but ‘non-cash’) expense charged to the Income Statement – and a reduction in asset value in the Balance Sheet. Prepayments An asset in the Balance Sheet recognising that you have paid for something that relates to the next accounting period (and therefore is not shown in the Income Statement). For example, if an annual software licence is paid in January for the calendar year, there would be a ‘prepayment’ in the March 31st Balance Sheet for 9 months worth of the total cost – and the Income Statement would only show the 3 month ‘true cost for the period’. Provisions Typically relating to ‘bad debts’ – It is prudent to assume not all debts owed will be collected – and a ‘Provision for Bad Debts’ charge to the Income Statement may be appropriate to present a ‘true and fair’ view – with a corresponding liability balance on the Balance Sheet. There is also the possibility of a contingent asset or liability – where at the Balance Sheet date, a potential asset or liability exists – but materialization of such is out of Management’s control – for example, the outcome of legal action where, on the balance of probability Management may need to pay a damage settlement – would call for a contingent liability on the Balance Sheet. v. 1.0 - November 2005 Document: briefguide_accruals.doc A brief guide to…. Accruals Accounting Page 4 Accepted reasons behind Accruals Accounting Gives the complete ‘true and fair’ picture with all income and costs related to a period being put to that period – & all assets and liabilities recognised. Performance easier to measure with revenues earned compared to resources consumed in a period – rather than simply cash in and cash out. Improves comparability from one period to the next. Enables long-term financial management and decision making. Makes clear the true cost of goods / services provided. Forces full records of assets & liabilities – improving management of them and showing the cost of using up assets and planning for their replacement. Reveals if current activities are funded by running down net worth. Recognises cost of future payments – e.g. pension commitments. Reduces potential for manipulation of accounts. Cash vs. Accruals Accounting – A Simple Example Imagine you’ve built and sold a house during the year. It cost you £10,000 to build – and you’ve done all the hard work to get a legally agreed sale for £30,000 – which at the accounting period end remains due but unpaid. On a cash accounting basis, your Income Statement would say you’ve lost £10,000 over the period. On an accruals basis, your Income Statement would say you’ve made £20,000. A fundamental and worrying difference! Which is the ‘true and fair’ view?? Still unconvinced? Try and answer these questions with ‘cash accounting’; • You had a £10,000 budget for the year. Have you kept within it? • How much does the organisation owe? • What are its main assets – and how much value is left in them? • Is the organisation a viable ‘going concern’ to survive in the future? The simple answer is that, with ‘cash accounting’ you can’t. This should be a grave concern and warning to all those interested in organisations that still use ‘cash accounting’ instead of ‘accruals accounting’. Document Prepared By: St Helena Government Audit Department chief.auditor@sainthelena.gov.sh (00 290) 2111 uploads/Management/ accruals-guide.pdf