CHAPTER 6 Refining the accounting database

1. CHAPTER 6Refining the accounting database

2. Contents • Accruals and deferrals of expenses and revenues • Provisions • Asset impairment • Bad debts and doubtful debts • Hidden reserves • Capital structure

3. Accruals and deferrals of expenses and revenues • Timing differences between occurrence and notification of economic events • Regular accounting entries are triggered by notifications received in advance or after the fact • Period matching requires adjustments when preparing financial statements • Time-based expenses and revenues

4. Accruals and deferrals of expenses and revenues (cont.) • Accruals are previously unrecorded expenses and revenues that need to be adjusted at the end of the accounting period to reflect the amount of expenses incurred or revenues earned during the accounting period • Deferrals are previously recorded (and probably paid / received) expenses and revenues that have to be adjusted at the end of the accounting period by deferring part of them to the following accounting period

5. Accrued expenses – example • Gas bill for 1,200 received in February 20X0 for period of November 20X0 through January 20X1 • Expenses relate to 20X0 (800) and to 20X1 (400) • No regular accounting entry yet on 31/12/20X0 • Adjustment on 31/12/20X0: • Operating expense of 800 in the income statement (- Equity) • ‘Accrued expense’ on financing side of BS (+ Liability)

6. Example – Accrued expenses

7. Deferred expenses – example • Annual insurance premium of 2,400 paid on 1 April 20X0 for period extending to end of March 20X1 • Expenses relate to 20X0 (1,800) and to 20X1 (600) • Regular accounting entry for the full amount on 01/04/20X0 • Adjustment on 31/12/20X0: • Expense of 600 deferred to the following year (+ Equity) • ‘Deferred expense’ on asset side of BS (+ Asset)

8. Example – Deferred expenses

9. Deferred revenues – example • Annual subscription fee of 1,400 received by a publishing company at the start of the annual subscription period (1 April 20X0) • Revenues relate to 20X0 (1,050) and to 20X1 (350) • Regular accounting entry for the full amount on 01/04/20X0 • Adjustment on 31/12/20X0: • Revenue of 350 deferred to the following year (- Equity) • ‘Deferred revenue’ on financing side of BS (+ Liability)

10. Example – Deferred revenues

11. Accrued revenues – example • Annual interest income of 9 per cent on a loan of 100,000 granted on 1 September 20X0 and to be received at the end of the one-year term • Interest income relates to 20X0 (3,000) and to 20X1 (6,000) • No regular accounting entry yet on 31/12/20X0 • Adjustment on 31/12/20X0: • Interest income of 3,000 in the income statement (+ Equity) • ‘Accrued income’ on asset side of BS (+ Asset)

12. Example – Accrued revenues

13. Provisions • A provision is a present obligation as a result of a past event, whereby • It is probable that settlement of the obligation will lead to a future outflow of company resources • The amount or timing of future outflow is uncertain • A reliable estimate of the amount of the obligation is feasible • Creation of the provision: • Assets 0 = Equity  + Liabilities  • IAS 37 Provisions, Contingent Liabilities and Contingent Assets

14. IAS 37 - Provisions, Contingent Liabilities and Contingent Assets (Extract) 14. A provision shall be recognised when: (a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. Source: IAS 37 - Provisions, Contingent Liabilities and Contingent Assets

15. Figure 6.1 Decision tree - Recognising a provision Start Present obligation as a result of an obligating event Possible obligation ? No No Yes Probable outflow ? Remote? No Yes No Yes Reliable estimate ? No (rare) Yes Provide Disclose contingent liability Do nothing Source: IAS 37 – Provisions, Contingent Liabilities and Contingent Assets

16. Contingent liability • A contingent liability refers to • A possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the company, or • A present obligation that is not recognised because the future expenditure is not probable or the obligation cannot be measured with sufficient reliability • Not recognised in the balance sheet, but disclosure in the notes to the accounts

17. Applying the decision tree- Product warranty A manufacturer of domestic appliances sells its products with a three-year product warranty. If the product breaks down within a 3-years period, the manufacturer will fix or replace the product on its own expenses. Questions: 1) Present obligation as a result of a past event? 2) Future outflow of company resources probable? 3) Reliable estimate possible?

18. Applying the decision tree- Litigation During 20X1 six people have died after a banquet, supposedly of food poisoning. The catering company has been summoned. At the end of the 20X1 fiscal year the company’s legal advisors assume that the firm will probably win the case. However, new evidence that surfaces during 20X2 makes the legal advisors change their mind and at the end of that year they expect that the catering company will probably lose the case. Questions: 1) Present obligation as a result of a past event? 2) Future outflow of company resources probable? 3) Reliable estimation possible?

19. Applying the decision tree- Major repairs and overhaul Some tangible assets require not only routine maintenance, but also major periodic ‘refits’ and replacement of major components. E.g. an electric power station – a 30-year useful life – replacement of the steam generator is normally required after 10 years + Major maintenance every 5 years Questions: 1) Present obligation as a result of a past event? 2) Future outflow of company resources probable? 3) Reliable estimation possible?

20. Applying the decision tree- Financial guarantee In 20X1 company A decides to guarantee part of company B’s borrowings. At the end of 20X1 company B may be described as financially healthy. However, by the end of 20X2 company B has gone into receivership. Questions: 1) Present obligation as a result of a past event? 2) Future outflow of company resources probable? 3) Reliable estimation possible?

21. Provision accounting 1. Provision accounting – createprovision 2. Provision accounting – use provision 3. Provision accounting –reverseprovision

22. Accounting for provisions -Example • At the end of 20X1 a provision is created for €20,000 • During 20X2 costs covered by the provision are expensed for a total amount of €8,000 • At the end of 20X3 further expenditure relating to the provision is no longer expected and the outstanding balance of the provision is reversed

23. Accounting for provisions (2)

24. Accounting for provisions (3)

25. Accounting for provisions (4)

26. Asset impairment • An asset is considered to have become impaired if its remaining expected future benefits drop below its net carrying value • If so, the carrying value of the asset will be adjusted for an impairment loss • IAS 36 Impairment of assets

27. Impairment testing • At each balance sheet date, assets have to be reviewed for indications of possible impairment • If there is an indication of impairment, an impairment test will be carried out • Compare net carrying amount and ‘recoverable amount’ • Recoverable amount = value recoverable through use or sale

28. Recoverable amount • The recoverable amount is the higher of an asset’s fair value less coststo sell and its value in use • Fair value of an asset is the amount for which the asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction • Value in use is the present value of estimated future cash flows from continued use of the asset and eventual disposal at the end of its useful life

29. Figure 6.2 Recoverable amount Carrying value Recoverable amount < is higher of > compare Fair value less costs to sell Value in use

30. Figure 6.3 - Impairment test Are there indications of potential impair-ment of the asset ? FV = Fair Value CA = Carrying amount VIU = Value in use No Yes Can one determine the fair value (FV) of the asset ? Yes No Calculate VIU Is FV less costs to sell > CA ? Yes No IS VIU > CA ? No Impairment No Yes Impairment loss

31. Accounting for impairment • If an impairment test shows that the recoverable amount of an asset is lower than its net carrying amount, the asset value is written down to the lower value • The asset write-down is expensed as an impairment loss • Assets  = Equity  + Liabilities 0

32. Accounting for impairment (cont.) • Impairment rationale • If impairment and the asset value were left unadjusted => overestimation of future economic benefits and current profit • In case of subsequent increase of the recoverable amount => Reversal of impairment loss

33. Impairment of a fixed asset - Illustration Assume a company acquired on 2 January 20X1 a specialized machine for €1,500,000, expecting to use it to produce a specific item for 12 years. The equipment was depreciated on a straight-line basis. By the end of 20X4 demand for the specific product has dropped so much that the company expects that the net cash flows the item would generate over the remainder of its product life cycle would be less than the machine’s net carrying value (€1,000,000). The value in use was estimated at €800,000, while the estimated net selling price on 1 January 20X5 was €750,000. The equipment is therefore written down to €800,000, its estimated value in use, and the impairment loss is recognised in the 20X4 income statement

34. Cash-generating units • Impairment testing is done at the individual or aggregate asset level • A cash-generating unit is the smallest identifiable group of assets that generate cash flows that are largely independent of the cash flows from other (groups of) assets • The existence of an active market for the output produced by a group of assets constitutes primary evidence that cash flows are independent

35. Individual assets versus cash-generating units - Example 1 A mining entity owns a private railway to support its mining activities. The private railway could be sold only for scrap value and it does not generate cash inflows that are largely independent of the cash inflows from the other assets of the mine. It is not possible to estimate the recoverable amount of the private railway because its value in use cannot be determined and is probably different from scrap value. Therefore, the entity estimates the recoverable amount of the cash-generating unit to which the private railway belongs, i.e. the mine as a whole. Source: IAS 36 - Impairment of Assets, par. 67 & 68

36. Individual assets versus cash-generating units - Example 2 A bus company provides services under contract with a muni-cipality that requires minimum service on each of five separate routes. Assets devoted to each route and the cash flows from each route can be identified separately. One of the routes operates at a significant loss. Because the entity does not have the option to curtail any one bus route, the lowest level of identifiable cash inflows that are largely independent of the cash inflows from other assets or groups of assets is the cash inflows generated by the five routes together. The cash-generating unit for each route is the bus company as a whole. Source: IAS 36 - Impairment of Assets, par. 67 & 68

37. Identification of a CGU in a retail store chain -Illustration Store Downtown belongs to Alphaline, a retail store chain. Downtown makes all its retail purchases through the central purchasing centre of Alphaline.Pricing, marketing, advertising and human resources policies (except for hiring X’s cashiers and sales staff) are decided at corporate level. Alphaline also owns five other stores in the same city as Downtown (although in different neighbourhoods) and 20 other stores in other cities. All stores are managed uniformly. In identifying a cash-generating unit in this context, one should consider, for example, whether internal management reporting is organised to measure performance on a store-by-store basis and whether the business is run on a store-by-store profit basis or on a region/city basis. Although the stores of Alphaline are managed at a corporate level, they are all located in different neighbourhoods and probably have different customer bases. Downtown generates cash inflows that are largely independent of those of the other sores of the retail chain and, therefore, it is likely that Downtown is a cash-generating unit. Source: Adapted from IAS 36 – Illustrative Examples

38. Identification of a CGU in a single product company - Illustration Company Unique produces a single product and owns plants A, B and C. Each plant is located in a different continent. Plant A produces a component that is assembled in either B or C. Alternatively, plant A’s products can be sold in an active market. The combined capacity of B and C is not fully utilised. Unique’s products are sold worldwide from either plant B or C. For example, plant B’s production can be sold in plant C’s continent if the products can be delivered faster from plant B than from plant C. Utilisation levels of plants B and C depend on the allocation of sales between the two sites.

39. Identification of a CGU in a single product company – Illustration (cont.) As there is an active market for plant A’s products, A could sell its product in that market and so, generate cash inflows that would be largely independent of the cash inflows from plants B or C. Therefore, it is likely that plant A is a separate cash-generating unit, although part of its output is used by plants B and C. Although there is an active market for the products assembled by plants B and C, cash inflows for B and C depend on the allocation of production across the two plants. It is unlikely that the future cash inflows for plants B and C can be determined individually. This brings us to conclude that plant B and plant C together are the smallest identifiable group of assets that generates cash inflows that are largely independent. Source: Adapted from IAS 36 – Illustrative Examples

40. Bad debts and doubtful debts • Impairment adjustments relating to the non-collection of company receivables • Two separate aspects to take into account the collectability risk of receivables: • On the evidence available, specific receivables are not likely ever to be paid (bad debts) • A more general assessment of the collectability of all receivables (doubtful debts)

41. Bad debt expense • If it is decided that the amount of a receivable is not recoverable, it will be categorised as a bad debt and removed from the receivables’ total • The amount outstanding of the receivable (asset) is cancelled and a corresponding bad debt expense is entered in the income statement

42. Allowance for doubtful debts • An allowance for doubtful debts is an adjustment to take a prudent view of the likely value to be received from the current receivables’ balance at the balance sheet date • The allowance is expensed in the income statement, while a credit balance is entered in the balance sheet accounts (5 valuation allowance account as a negative asset)

43. Example – Adjusting receivables The company decides to treat a receivable of £1,000 as definitely bad and to set aside a further £1,300 as an allowance for doubtful debts. Within the company’s accounting records, the entries would be:

44. Hidden reserves • Hidden reserves refers to the conservative tendency to reduce current profits and store them for less profitable (future) accounting periods • Instruments: • Creation of excessive provisions or provisions for non-existing obligations • Excessive asset write-downs/impairments • Adjustments of accrued/deferred expenses/revenues

45. Hidden reserves (cont.) Structural sources of hidden reserves: • Rapid depreciation and amortisation • Low capitalization of costs • Inventory valuation • LIFO in an environment characterized by rising prices • Historical cost principle

46. Capital structure • Companies are externally financed either with equity or debt • Equity participates fully in the risks and rewards of ownership • No guaranteed return, but no upper limit either • Downside risk is limited to the amount of the investment • Debt is usually advanced for a fixed period, earns a fixed return and must be repaid at end of period • Short, medium or long term • In different currencies • From a variety of sources • Return may be a floating rate

47. Components of equity • Share capital • Ordinary shares • Par or nominal value • Different categories may imply different voting rights • Preference shares • Share premium • Difference of issue price and par value of shares • Issue costs are offset against share premium • Reserves • Capital reserves • Revenue reserves (retained profits)

48. Preference shares • Characteristics of debt • Fixed return • Holders do not routinely have voting rights • But: • Preference dividend may not be paid if there are no profits • Preference dividend is not tax deductible • Preference dividends are usually cumulative

49. Convertibles • Convertible securities are either preference shares or debt (convertible debentures) which can be converted at some point in the future into ordinary shares • Other types of complex financial instruments which combine elements of debt and of equity (mezzanine debt, capital bonds and perpetual loan notes)