CHAPTER 6
Refining the accounting database
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© 2005 Peter Walton and Walter Aerts
Contents






Accruals and deferrals of expenses and
revenues
Provisions
Asset impairment
Bad debts and doubtful debts
Hidden reserves
Capital structure
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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
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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
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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)

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Example – Accrued expenses
End of
20X0
20X1
Cash
0
-1,200
Total
Financing
Short-term liabilities
0
-1,200
+800
-800
Assets
Accrued expenses
Equity
Profit 20X0
Profit 20X1
Total
-800
-400
0
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-1,200
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)

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Example – Deferred expenses
Arrival of
notification
End of
20X0
20X1
+600
-600
-600
Assets
Cash
Deferred expenses/
Prepayments
-2,400
Total
Financing
Equity
-2,400
+600
Profit 20X0
-2,400
+600
Profit 20X1
Total
-600
-2,400
+600
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-600
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)

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Example – Deferred revenues
Time of
notification
End of
20X0
20X1
0
0
+350
-350
Assets
Cash
+1,400
Total
+1,400
Financing
Short-term liabilities
Deferred revenue
Equity
Profit 20X0
+1,400
-350
Profit 20X1
Total
+350
+1,400
0
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0
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)

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Example – Accrued revenues
End of
20X0
Assets
Accrued income
Cash
Total
Financing
20X1
+3,000
-3,000
+9,000
+3,000
+6,000
Equity
Profit 20X0
Profit 20X1
Total
+3,000
+6,000
+3,000
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+6,000
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
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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
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Figure 6.1 Decision tree - Recognising a
provision
Start
Present
obligation as a
result of an
obligating event
No
Possible
obligation ?
No
Yes
Probable
outflow ?
No
Remote?
Yes
No
Yes
Reliable
estimate ?
No (rare)
Yes
Provide
Disclose
contingent liability
Do nothing
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Source: IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
Contingent liability

A contingent liability refers to
1.
2.

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
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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?
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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?
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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?
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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?
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Provision accounting
1. Provision accounting – create provision
Create provision
Equity
Profit for the year
Liabilities
Provisions
-15,000
+15,000
2. Provision accounting – use provision
Use provision
Assets
Cash
-15,000
Provisions
-15,000
Liabilities
3. Provision accounting – reverse provision
Reverse provision
Equity
Profit for the year
Liabilities
Provisions
+15,000
-15,000
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Accounting for provisions -Example
1)
2)
3)
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
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Accounting for provisions (2)
20X1
20X2
20X3
Accumul
Assets
Cash
Total
0
0
+20,000
+20,000
Liab./Equity
Provisions
Equity
Profit 20X1
Profit 20X2
-20,000
-20,000
Profit 20X3
Total
0
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0
Accounting for provisions (3)
20X1
20X2
20X3
Accumul
Assets
Cash
Total
-8,000 (1)
-8,000
0
-8,000
-8,000
+20,000
-8,000 (2)
+12,000
Liab./Equity
Provisions
Equity
Profit 20X1
Profit 20X2
-20,000
-20,000
-8,000 (1)
+8,000(2)
Profit 20X3
Total
0
-8,000
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-8,000
Accounting for provisions (4)
20X1
20X2
20X3
Accumul
Assets
Cash
Total
-8,000 (1)
-8,000
0
-8,000
0
-8,000
+20,000
-8,000 (2)
-12,000
0
Liab./Equity
Provisions
Equity
Profit 20X1
Profit 20X2
-8,000
-20,000
-8,000 (1)
+8,000(2)
Profit 20X3
Total
+12,000
0
-8,000
0
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-8,000
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
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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
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Recoverable amount



The recoverable amount is the higher of an
asset’s fair value less costs to 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
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Figure 6.2 Recoverable amount
Carrying value
compare
Recoverable
amount
< is higher of >
Fair value
less costs to sell
Value in use
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Figure 6.3 - Impairment test
Are there indications
of potential impairment of the asset ?
No
Yes
FV = Fair Value
CA = Carrying amount
VIU = Value in use
Can one determine
the fair value (FV)
of the asset ?
Yes
Is FV less costs to
sell > CA ?
Yes
No
Calculate VIU
No
IS VIU > CA ?
No Impairment
Yes
No
Impairment loss
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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
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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
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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
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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
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Individual assets versus cashgenerating 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
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Individual assets versus cashgenerating units - Example 2
A bus company provides services under contract with a municipality 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
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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 storeby-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
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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.
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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
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Bad debts and doubtful debts


Impairment adjustments relating to the noncollection 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)
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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
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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)
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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:
Write off
bad debt
Create
allowance
Assets
Receivables
Valuation allowance
–1,000
–1,300
Equity
Profit for the year
–1,000
–1,300
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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

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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
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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
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Components of equity

Share capital

Ordinary shares




Preference shares
Share premium



Par or nominal value
Different categories may imply different voting rights
Difference of issue price and par value of shares
Issue costs are offset against share premium
Reserves


Capital reserves
Revenue reserves (retained profits)
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Preference shares

Characteristics of debt



But:



Fixed return
Holders do not routinely have voting rights
Preference dividend may not be paid if there are
no profits
Preference dividend is not tax deductible
Preference dividends are usually cumulative
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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)
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