University of Pretoria eTD - van der Poll, HM, 2004 Chapter 4: Book entries and their relationship to accrual accounting and accounting assumptions 4 Book entries and their relationship to accrual accounting and accounting assumptions 4.1 Introduction Cash accounting has the disadvantage that deferred and expected revenues as well as deferred and expected expenses are not taken into account in a company’s financial information, thereby affecting the relevance of the information because information which may affect future financial statements is recorded in the current financial statements. When information is not relevant for the current decisions, the integrity of the information may be influenced. Accrual accounting overcame this problem through the use of the matching assumption. The matching assumption is used to match revenues and expenses in the same period, the balance, being either an expense or a revenue, is then reflected in the balance sheet as a deferred or expected expense or revenue. Companies may also have to make provision for an uncertain future happening called a contingency, in the financial statements. An asbestos mining company may face a lawsuit because of miners who fell ill and the company may somehow have to budget for these. These uncertain future happenings may have an influence on the integrity of information. The classification of items in the balance sheet may have different effects on the information portrayed in the financial statements of a company, for example when deferred taxation is classified as debt versus being classified as part of equity. A company may also need to make provisions for normal future costs, for instance the depreciation provision and deferred taxation provision in order to adhere to the matching assumption. In times of uncertainty a company may decide to make use of the assumption of conservatism by understating its assets, once again influencing the integrity of the information of the company. This chapter considers the role of transactions in accrual accounting, definitions and 51 University of Pretoria eTD - van der Poll, HM, 2004 Chapter 4: Book entries and their relationship to accrual accounting and accounting assumptions discussions of each of the accounting assumptions of matching, contingencies, classification, provisions and conservatism. Ratios are also discussed since these are used to portray the financial health of a company. Towards the end of a brief discussion is presented on accumulated depreciation and deferred taxation as examples of book entries which may affect the integrity of information. A summary concludes this chapter. 4.2 The role of transactions in accrual accounting Accrual accounting probably originated from the Industrial Revolution which revealed inadequacies in purely cash recording, given the complexities of trade, commerce and industry. Cash recording failed to accurately measure the “net financial result” of periodical business activities. Accrual accounting provided a remedy by bringing into account deferred or expected elements of revenue or cash outlays. These elements could be viewed as appropriate to the period under review even though the cash impact would only be seen at a later period. When a period of volatility is experienced in the financial unit of measurement (e.g. R, $, £, ¥, etc.) it follows that the assets of a company must be revalued. There is currently no system proposed by any of government, tax legislatures or academics that can be used as a guideline in this revaluation process (Goldberg 2001). However, when a company decides to revalue its assets, the bottom line of that company may be affected considerably. Book entries are used to revalue assets and increase or decrease the depreciation provision, which in turn decreases or increases the profit or loss, the dividend payout and the distributable reserve. The difference between cash accounting and accrual accounting is one of timing and matching (Wild et al. 2001). Accrual accounting has a number of benefits as well as some drawbacks. One of the benefits is that accrual accounting reduces timing and matching problems. The credit economy necessitates accrual accounting where a transaction is recorded when the goods are delivered, although there is no immediate 52 University of Pretoria eTD - van der Poll, HM, 2004 Chapter 4: Book entries and their relationship to accrual accounting and accounting assumptions transfer of cash involved. An important benefit of accrual accounting over cash accounting coincides with a main goal of accrual accounting as described by Wild et al. (2001:115) “... to make adjustments for transactions that have future cash flow implications, even when no cash inflows or cash outflows occur contemporaneously – an example is a credit sale”. A well-known problem with a credit sale is that the debtor might never pay in which case the transaction has to be ‘reversed’ when a provision for the doubtful debt is made. (It may even be said that no transaction occurred.) According to Glautier and Underdown (1997) the accountant must make sure at a financial year- end that all the income the company is legally entitled to, is recorded. This happens even if no cash was received and no economic event took place. Referring back to the credit sale, book entries are used to make provision for doubtful debts, which in turn may influence the integrity of the information portrayed in the financial statements. A number of problems arise when cash accounting (ordinary accounting) is used. Table 4.1 below lists some of the problems encountered in (ordinary) accounting but solved by accrual accounting. Table 4.1: Problems solved by accrual accounting Transaction Accrual accounting Problem solved Cash purchase of Increase in inventory Matching inventory Credit sale Revenue when goods are delivered Timing Cash purchase of Increase in assets Matching machine Depreciation of assets (Adapted from Wild et al. (2001). Table 4.1 effectively shows the mechanisms used by accrual accounting in solving 53 University of Pretoria eTD - van der Poll, HM, 2004 Chapter 4: Book entries and their relationship to accrual accounting and accounting assumptions either the matching or timing problems. When dealing with accrual accounting, it is important to note that accrual accounting is based on a number of assumptions (Wild et al. 2001): • Going-concern: the entity will continue its business activities into the foreseeable future. This assumption allows accrual accounting to recognise business activity before cash inflow or outflow. • Enforceability of contracts: most accrual entries are based on source documents, usually a contract. • Stable monetary unit: assumes stable prices. • Time value of money: assumes present value concepts. Assumptions, estimates and judgements are used in accrual accounting to introduce softness or uncertainty into accounting numbers. Whenever uncertainty, estimates or judgements are involved, it follows that the integrity of information is influenced by these and may be different to information based on reality. However, despite numerous criticisms, accrual accounting is useful for financial analysis but an accountant has to be aware of its shortcomings. 4.3 The relationship of book entries with certain accounting assumptions and the use of ratios 4.3.1 The matching assumption The matching principle was introduced in 1940 (Most 1982). Matching is one of the accounting principles that directly influences book entries and is based on an assumption made by accountants that there is a cause and effect relationship between expenses and revenue over time (Kam 1990). Items in accounting that are based on the 54 University of Pretoria eTD - van der Poll, HM, 2004 Chapter 4: Book entries and their relationship to accrual accounting and accounting assumptions matching principle include deferred taxation, research and development costs, contingencies, and provision for depreciation and pensions. These are all created by book entries and may influence the integrity of information. Matching may be described as a way to tie expense recognition to revenue recognition at a time when it is practicable to do so (Mulford and Comiskey 2002). The matching of revenues with expenses may be difficult, since some costs have a benefit for the future. As Kam (1990:283) puts it: “Proper matching is difficult. It implies not only that the actual using up of assets and services is for the period identified, but also that the value of the used assets and services is computed correctly”. When time is taken into account, matching becomes difficult because it is often hard to determine the time span of an entry. Furthermore, the allocation of a value to a particular period is also a non-trivial task. Matching is based on a person’s (subjective) perception and may therefore, influence the integrity of information supplied in the financial statements. Kam (1990) lists three basic issues an accountant considers when matching revenues with expenses: • association of cause and effect; • systematic and rational allocation; and • immediate recognition. Ideally, for every expense (cause) that takes place, a revenue (effect) must be created. However, not all expenses can be matched this way. In some cases time plays a crucial role and this calls for the allocation of costs, either immediately or over a period. Immediate recognition takes place if an expense is not covered by either of the first two bulleted items above. This method of allocating costs is well known in the accounting world, but once again allocation is also based upon the perception of management, and 55 University of Pretoria eTD - van der Poll, HM, 2004 Chapter 4: Book entries and their relationship to accrual accounting and accounting assumptions may therefore give rise to information of a different integrity than the information created by real transactions. The application of the matching principle often has the unfortunate effect of using the balance sheet as a sink for unexpired costs (i.e. costs incurred in the past that may be matched with future revenues) as they await their time of expiry on some future income statement.