Showing posts with label accruals. Show all posts
Showing posts with label accruals. Show all posts

Monday 10 April 2017

Accounting for a Major Project Lasting 4 Years in the Construction Sector

In accounting, costs must be fairly matched to sales.

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.

  1. The full $60 m revenue will not be credited until the work is completed.
  2. In fact, there will probably be a retention and it will be necessary to make a reserve for retention work.
  3. The final cost and profit may not be known for some years.
  4. Conventions of prudent accounting should ensure that profits are only recognized when they have clearly been earned.
  5. 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.




Additional Notes:

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.
The prudent accountant will make reserves to cover these eventualities, either a bad debt reserve or sales ledger reserve.  Sales (and profit) will be reduced by an appropriate amount.

Time will tell whether the reserves have been fixed at a level that was too high, too low, or just right.  If the reserves were too cautious there will be an extra profit to bring into a later Profit Statement.  If the reserves were not cautious enough there will be a further cost (and loss) to bring into a later Profit Statement.

Wednesday 13 January 2016

Accruals, prepayments, accrued income and deferred income.

The accruals or matching concept states that we recognize an income or expense in the income statement in the period in which it is earned or incurred, not in the period in which payment is received or made.

In order to ensure that costs (and revenues) are allocated to the correct period, we use prepayments, accruals, accrued income and deferred income.

An accrual is where you have received a service, but not yet paid.

A prepayment is where you have paid for a service, but not yet received that service.

Deferred income is where you have been paid, but have not yet provided the service.

Accrued income is where you have provided a service, but not yet been paid.



Accrual =  liability
Accrued Income = Asset

Prepayment = Asset
Deferred Income = Liability


Balance Sheet

Assets
     Cash
     Prepayments
     Accrued income


Liabilities
     Accruals
     Deferred income



Saturday 6 February 2010

Investing decision: Focus on Cash Flows (FCF & Dividends) rather than Accruals (Earnings)

Investing Decisions

How much should you invest and what assets should you invest in?

Criterion:  To maximise the returns to and wealth of the investors.

The value of the firm is increased by
  • cash flows generated by the firm which support the price of the stock or 
  • the dividend returned to the owners.

An important characteristic of investing decision is how you approach this problem:  You should focus on the cash flows instead of accruals.

- Expenses vs. Cash Outflows
  • Purchase of capital asset
- is not expense
- is cash outflow
  • Recognition of depreciation expense
- is expense
- is not cash outflow

-Revenues vs Cash Inflows
  • Borrowing funds
-is not revenue
- is cash inflow


Focus of cash flows:  Free Cash Flows and Dividend

rather than

Focus on accruals:  Earnings


The investing decisions by the firm typically have long term consequences to the firm over many years (3 years to 100 years). 

When investing, the investors have a projection of what the future cash inflows and future cash outflows of the firms might be but the investors cannot be certain of these future cash flows.

Therefore, the investors also need to focus on the significant risks associated with this projections of future cash flows when making their investing decision..

Tuesday 8 September 2009

Do Sophisticated Investors Understand Accounting Quality?

Do Sophisticated Investors Understand Accounting Quality?

Evidence from Bank Loans

Since banks significantly rely upon financial statements to assess and monitor borrowers’ accounting quality, we measure accounting quality as the magnitude of abnormal operating accruals, after controlling for industry and the firm’s normal level of activity. Operating accruals represent the difference between the reported earnings and the operating cash flows of a firm. Large deviations between earnings and operating cash flows make it harder for the bank to assess the ability of borrowers to generate cash flows in the future. Differentiating between earnings and cash flows is crucial for the bank because the payments by borrowers in the form of interest or principal will be serviced out of cash flows.


IV. Conclusion

We examine if banks have the ability to understand the relationship between operating accruals, future earnings and cash flows. Differentiating between earnings and cash flows is crucial for the bank because, the payments to the loan contracts in the form of interest or principal will be serviced out of cash flows and not earnings of the borrower.

This issue is important since various papers have documented that stock market investors (Sloan (1996); Xie (2001)) as well as sophisticated bond market investors (Bhojraj and Swaminathan (2004)) do not seem to price poor accounting quality as reflected in accruals.

In sharp contrast to these studies we find evidence in support of (Working Capital/ Total Assets) + 0.076 (Current Liabilities/ Current Assets) – 1.72 (1 if Total Liabilities >Total Assets, 0 otherwise) – 0.521 ((Net Incomet - Net Incomet-1)/( Net Incomet + Net Incomet-1)) the banks being able to discern the true accounting quality of borrowers and incorporate loan terms, price and non-price terms, appropriately.

Our paper makes four contributions to the literature.
  • First, by showing that banks consider the deviations between cash flows and earnings in pricing and structuring their contracts, we provide direct evidence supporting the specialness of financial intermediation. The financial intermediation literature has hitherto relied on indirect evidence supporting the specialness of banks.
  • Second, we add to the growing body of evidence that investors misprice information in financial statements, by showing that some sophisticated investors (banks, in our case) properly use this information while structuring financial contracts.
  • Third, we advance the explanation that our results support, and are consistent with, the notion of limited information as a source of risk – a view increasingly gaining currency in the asset pricing literature.
  • Finally, we show how accounting quality has a direct and measurable impact on a firm’s cost of capital.


http://www.bis.org/bcbs/events/rtf04sunder.pdf