Accounting #5 - Accrual accounting and bad debts

[samvara]

Brain so much better that last week, did readings and enjoyed them - or accrual accounting is fundamentally more interesting.

Cash accounting: so much easier to work with!

• Revenue and expense pattern duplicates cash flow pattern
• Revenue recognised when cash received
• Expenses recognised when cash outlay is made

Alas, this means if you are the Chief Finance Officer for five years and you buy a vital piece of machinery in year 1 (let us say, a yacht) under Cash accounting you have to record a MASSIVE debt in year one which may impact on people's ability to a) trust you and b) trust the entity you are CFO for. Table below for zebra who likes numbers ;)

Observe my theoretical yacht being paid for in Year 1against my income of 35k/year and ask yourself if, based on the financial report for Year 1, you want me managing your finances.

Cash Accounting

Item	Year 1 ($)	Year 2 ($)	Year 3 ($)	Year 4 ($)	Year 5 ($)	5 year term ($)
Cash revenue	35,000	35,000	35,000	35,000	35,000	175,000
Cash expenses	(100,000)	0	0	0	0	(100,000)
Surplus/(Deficit)	(65,000)	35,000	35,000	35,000	35,000	75,000
Cumulative result	(65,000)	(30,000)	5,000	45,000	75,000	75,000

Accrual Accounting: revenue and expenses are identified without regard to timing of cash flow.

• All about timing - record transaction when services supplied or rendered
• will look the same as cash accounting over life of organisation (overall totals still the same)
• v. different for periods within org. life

In the case of my yacht, I'm going to record the expense against the 'useful life' of said yacht and spread the cost over the years I get to use it (for a higher degree for realism we could record it as most valuable in year 1 and least valuable in year 5 and show it getting proportionately less valuable over the five years). Observe the 5 year term ($) remains the same, but my financial reports aren't going to freak people out in year 1 or year 2.

Accrual Accounting

Item	Year 1 ($)	Year 2 ($)	Year 3 ($)	Year 4 ($)	Year 5 ($)	5 year term ($)
Cash revenue	35,000	35,000	35,000	35,000	35,000	175,000
Cash expenses	(20,000)	(20,000)	(20,000)	(20,000)	(20,000)	(100,000)
Surplus/(Deficit)	15,000)	15,000	15,000	15,000	15,000	75,000
Cumulative result	15,000	30,000	45,000	60,000	75,000	75,000

*sails away*

The public sector made the shift to accrual accounting relatively recently

• Reveals full cost of services. Important when charging a fee for a service and the agency is expected to recover full cost of service.
• Improves performance measurement - closer to true cost
• Increases sustainability of operations *cough* planning for Annual Leave and Long Service Leave payouts.

Prepayments: criteria for recognising a prepayment suspiciously similar to asset

• Future benefits will exist
• Control - we will get said benefits
• Past Event - something happened to create future benefit
i.e Insurance Policy

Debtors or Accounts Receivable: recognition criteria also familiar - see above. Managing debts is a big deal, there's a risk some will not be paid (bad debts) and accounting for them has two main approaches.

• Direct write-off - maybe...maybe...oh bugger where 'maybe = asset on the books and oh bugger = expense. Advantage, it looks like you're going to get paid right to when you don't - higher reportable revenue!
Results in decrease in assets and corresponding decrease in equity

Observe my Statement of Financial Performance says my balance is $37,000. The $500 of bad debt won't kick in from an accounting POV until I write it off. My balance looks higher but given I know I'll have a few bad debts (based on past experience) my balance is artificially high.

Direct write off method

Item	Cash	Debtors	Saving	SOCI
Sales	15,000		column	15,000
Sales (on credit)		30,000	for	30,000
Expenses	(8,000)		later	(8,000)
Balance	7,000	30,000	use	37,000
Bad debt		(500)		(500)

• Allowance for doubtful debts (also called 'provision') - eh... eh... oh bugger where eh... = estimate % of bad debts and stash $ in advance and oh bugger = time to use that allowance. Advantage, more reliable and conservative.
Doubtful debt planned for until it turns into bad debt and is written off but at least it doesn't come as a surprise

Observe my cunning accounting trick (well obviously it's not *mine*) of assuming I'll have $1,500 worth of bad debt, my balance is $35,500 and slightly harder to brag about, but is also more trustworthy. If I only have $500 in bad debts this year, well I have $1,000 stashed that I could use in my provision next year.

Allowance for doubtful debts method

Item	Cash	Debtors	Allowance for Doubtful Debts	SOCI
Sales	15,000			15,000
Sales (on credit)		30,000		30,000
Expenses	(8,000)			(8,000)
Create Allowance			(1,500)	(1,500)
Balance	7,000	30,000		35,500
Bad debt		(500)	500

For some perspective: Australia's four major banks recently reported bad debts of $6.5 billion and have provisions for $16.3 billion. When one went out on a limb and didn't increase the provision for bad debt at the rate the others did, it quickly got peer pressured into revising it. Mmmm high finance peer pressure, that sounds so much cooler than having an angry goth chick offer you a smoke in the girl's toilets.

Things to remember about the Provisioning method;

• Provision is deducted from debtors balance
• Not a liability; is a type of valuation account

Estimating doubtful debts

• % of sales for the period (out of fashion/favour now)
• Age of debt / accounts receivable (30 days, 60 days, 90 days)

Does not take into account status of customer of credit policies of organisation.

NB: This is an opportunity for Earnings Management - you can adjust your policies in (non-fraudulent) ways to make your financial reports look just a little bit sexier.

Pause to do a practice exercise and look at:

• the impact of changing the allowance for doubtful debt (assume 1.5% will go bad instead of 2%)  - less $ stashed in allowance, more revenue!
• relaxing your credit restrictions - more people can buy stuff, more revenue! (and quite probably more bad debts)
• ethics of above choices (was your initial accounting choice good - are you improving your reporting or cooking the books?)

Creditors are amounts owing at a point in time, the amounts of which are known.

• Accounts payable
• Wages

Accruals are amounts owing at a point in time, the amounts of which are not known with any certainty.

• Electricity
• Telephone

You can allocate an allowance for all sorts of stuff and a lot of us already do it. I have a spreadsheet that records my annual expenses and helps me predict how much I should put aside. I acknowledge that I love spreadsheets more than most people :p

Break for 2nd Team Exercise, we spent a cheerful hour discussing and writing up our responses and wrangling them. Bit of a tussle over writing styles but resolved reasonably amicably (I hope) and higher degree of confidence in answers this time around.

Comments

[zebra363.livejournal.com]

Good to see some numbers in there!

I love spreadsheets.

[black-samvara.livejournal.com]

So do I!