Objective of Accrual Accounting

3.A - Accrual Accounting: An Overview

In these sessions, we look more closely at accrual accounting and review the notions introduced earlier regarding financial statement articulation. We discuss the idea of an "accrual" and a "deferral" and also analyze how to account for credit sales. Finally we discuss a few "mini-cases" that address some of the subtleties of accrual accounting.

Objective of Accrual Accounting

The objective of this course is to provide you with an understanding of accounting information and to begin to teach you how it can be used. When one mentions "financial accounting" one automatically thinks of accrual accounting, not cash accounting. True cash accounting is what you see in your checking account activity report each month (for those who still use checks). Anything more involved is a variant of accrual accounting. Accrual accounting provides a measure of wealth creation in any specific period, called income or earnings for that period, which is separate and distinct from the amount of cash flow for that period. The sole purpose of accrual accounting is to keep track of the difference between income and cash flow and to show how they are linked.

Understanding Accrual Accounting

Clorox had $1,089 million in Sales, and collected $1,097 million in cash from its customers. Which measure BEST reflects the physical activity of the business and the increase in wealth of the owners?

First, remember that BEST is defined in terms of the decision makers or users, the idea being that change in wealth is important to the F/S users. The sales amount has as its advantage that it (better?) represents current activity. The collections amount may be due to activity recorded in the past. On the other hand, if the sale is not collectible, it should not be included in our measure of increased wealth. With regard to physical activity, the sales amount again has advantages, since payments can be made independently of production or delivery of goods. The key overall is to makes certain that the sales amount reflects goods which have been or will be produced, delivered, accepted and for which payment eventually will be received.

Q: Which measure would you use to determine a performance-related bonus for the sales force?

A: does the sales force have responsibility for collection. Sales number may be inflated due to sales to customers with poor credit. Also does the company wish to reward finding customers and persuading them to buy or to reward collecting the money afterward. The argument is strong for using collections rather than sales to better measure the effort of the individuals involved.

Q: Which measure would you use to determine a performance-related bonus for the marketing department?

A: Similar questions apply here except that one may argue that the sales force has more control over the type of individual buyer while the marketing department increases sales over whole groups of buyers. For this reason, the sales amount may be argued as more preferred than collections for marketing.

Q: Which measure would you use to determine a performance-related bonus for the financial personnel?

A: Once again we should look to the area that the party we are trying to motivate controls. If we use sales, then the finance dept. we try to increase sales without regard to collections and vice versa, so the question to ask is whether the finance department's action can be detrimental to collection process? Do these people have control of collections and will using sales cause them to not spend suitable time and effort ensuring that the sale is collectible.

The presentation of the material follows this approach. First, the accounting for revenue is discussed, in particular the recording of the allowance for bad debts, and how to make inferences about collections and write-offs from F/S information. This discussion is followed by a discussion of identifying the benefits used to generate the revenues and matching the costs of these benefits against the revenues as expenses. Then we discuss the way changes in accounting policies and estimates are handled. Finally, we end the sessions with discussion of some cases.

Accounting for Revenue: Accounts Receivable

The most common point for recognizing revenue is at delivery, or once the good has been shipped or the service provided. Since credit is so often used, this means that the cash is received subsequent to delivery, that is, subsequent to the point at which revenue has bee recognized. Some customers who purchase on credit will not pay the bill. The matching principle requires managers to estimate the future cost of the receivables that will not be collected because it relates to the present revenues.

Methods for accounting for Bad Debts

There are basically two methods or approaches to estimating the cost of bad debts, although there are a number of variants of the second approach. These two are as follows:

a. The write-off method: This method recognizes the cost of bad debts as they are written off. This method does not rely as extensively on the judgement of management as accounts are usually written off only after more objective evidence of non-payment (such as bankruptcy) has been obtained.

b. The Allowance method: This method estimates the bad debt expense prior to actually writing it off. The expense may be estimated and the allowance calculated or the allowance may be estimated and the expense calculated. There are many possible ways to estimate the expense, but the most common are the following:

1. % of credit sales

2. % of receivables

3. Aging of accounts

To see how these methods are employed, consider the following simple exercise.

Simple example of accounting for bad debts: Assume for purposes of this example that credit sales were $100,000 in 1/91 and $80,000 was collected by 1/31. Credit sales in 2/91 were $200,000 from which $140,000 was collected by 2/28 and $10,000 was collected from 1/91 sales. In 2/91 a customer with a balance of 500 went bankrupt.

Required: Determine the bad debt expense and bad debt allowance under

a. The write off method

b. Assume the company uses 1% of sales

c. Assume,