This is so that the costs of the goods actually sold, and only those costs, are brought into the Profit and Loss Statement.
A Major Project lasting 4 years
Contractor will be paid $60 m
Costs over the 4 years are expected to be $55 m
Anticipated profit is $5 m.
It is almost certain the contractor will receive various stage payments over the 4 years.
This poses a multitude of accounting problems and there is more than one accounting treatment.
The aim must be to bring in both revenue and costs strictly as they are earned and incurred.
Accounting standards provide firm rules for the published accounts.
- The full $60 m revenue will not be credited until the work is completed.
- In fact, there will probably be a retention and it will be necessary to make a reserve for retention work.
- The final cost and profit may not be known for some years.
- Conventions of prudent accounting should ensure that profits are only recognized when they have clearly been earned.
- Losses on the other hand should be recognized as soon as they can be realistically foreseen.
Failure to act on this convention has led to scandals and nasty surprises for investors. The collapse of some big companies being examples.
Prudence and the matching of costs to income - the Principles:
- Accruals are costs incurred, but not yet in the books.
- Prepayments are costs in the books, but not yet incurred.
- Profit is reduced by expected bad debts.
- Depreciation is a book entry to reduce the value of fixed assets.
- Profit accounting may differ from cash accounting.
- Profit Statements should be prudent.
- Costs must be matched to income.
Accruals (costs not yet entered)
Invoices are submitted after the event and some will not have been entered into the books when they are closed off. This problem is overcome by adding in an allowance for these costs. The uninvoiced costs are called accruals.
An example is a company whose electricity bill is around $18,000 per quarter. Let us further assume that assume that accounts are made up to 31 December and that the last electricity bill was up to 30 November. The accountant will accrue $6,000 for electricity used but not billed. If electricity invoices in the period total $60,000 the added $6,000 will result in $66,000 being shown in in the Profit Statement.
Prepayments (cost entered in advance)
Costs may have been entered into the books for items where the benefit has not yet been received.
For example, consider an insurance premium of $12,000 paid on 1 December for 12 months's coer in advance. If the Profit Statement is made up to 31 December the costs will have been overstated by 11/12 x $12,000 = $11,000. The accountant will reduce the costs accordingly. These reductions are called prepayments.
Bad debt reserves and sales ledger reserves
Many businesses sell on credit and at the end of the period of the Profit Statement money will be owed by customers Unfortunately not all this money will necessarily be received. Among the possible reasons are:
- bad debts
- an agreement that customers may deduct a settlement discount if payment is made by a certain date.
- the customers may claim that there were shortages, or that they received faulty goods; perhaps goods were supplied on a sale-or-return basis.