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Accrual method of accounting is used to measure a company’s financial performance/position by taking into account economic transactions, without considering the time for cash transaction occurrence. In this regard, the accrual accounting borrows from the idea that economic transactions are taken into account by matching expenses and revenue at the time of occurrence, but not when payments are finalised (Weygandt 2008, p. 52). Therefore, this method does not recognise revenue/expenses when payments are made or received. The accrual method of accounting gives more accurate picture of a company by combining both the current and the expected future cash inflows and outflows, and this provides more accurate and current financial health of a company (Glautier, Underdown & Morris 2010, p. 42).
The Purposes and Methods of the Accruals Concept of Accounting
Accrual methods of accounting are widely used in several companies since it is regarded as the standard practice. However, its application can be ignored in small business operation. Even though accrual accounting is complex and more expensive for a company to implement, it is more accurate, because it gives a more accurate financial position for a firm/business (Bebbington, Gray & Laughlin 2001, p. 412). Indeed, this is contrary to the cash method that does not recognise transactions before cash exchange occurs.
Accrual accounting is also used for recognising credit transactions. For example, when a customer purchases an item on credit, accrual accounting recognises the revenue as an ‘account receivable’, immediately the client takes the ownership of the item purchased. To this end, the seller’s revenue is increased, but the actual cash for the sale has not yet reached his/her bank account (Bennett 2010, p. 15). As a result, a company’s income statement and balance sheet are affected by the credit sale. Accounts receivable in the balance sheet is increased, but the unearned revenue is decreased when the seller has made the payment in advance. This is contrary to the cash method where such anticipated revenue from credit sale cannot be recognised, until the actual money is received by the seller.
Methods of the Accruals Concept of Accounting Application
Accrual accounting can be used for calculating a company’s trade receivables. For example, British Airways Company’s trade receivable stood at £448 million in 2011 (“British Airways 2012”, p. 47). British Airways trade/other receivables were presented at cost minus doubtful receivable allowances. Therefore, the company’s net trade receivables for 2011 were calculated as:
Net trade receivables = trade receivable less provision for doubtful receivables
= £ (458 – 10) million
Net trade receivables for the British Airways Plc. = £448 million.
The company’s net receivables (£448) million represented the accrued revenue income, which was recognised in the 2011 financial year. £448 million net trade receivables increased the amount of current assets of the British Airways Company.
The company’s £ 707 million sale in advance of carriage for 2011 was recorded under the trade payables, because the actual delivery of the service had not been done, but the money had been received by the British Airways Plc. (“British Airways 2012”, p. 49 ). This amount of money increased the company’s creditors at the end of the 2011 financial year. This is presented as the company’s current liability since it can be paid back to the creditors, if the British Airways Company fails to deliver the carriage services, which has been paid for in advance.
Based on the above analysis, accrual accounting can also used in calculating/interpreting financial accounting ratios. This has been done using relevant calculations to facilitate understanding and interpretation of financial data. In this regard, British Airways Company’s 2010 and 2011 financial reports have been used.
A significant increase in sales was realised that is, from 4.59% in 2010 to 5.94% in 2011. This can be attributed to better sales strategies and reduction in the cost of goods sold.
The mark-up increased slightly from 5.40% in 2010 to 5.47% in 2011. This can be contributed to high sales turnover, coupled with a reduction in the costs of sales.
The overall profitability of the firm increased because the net profit ratio improved from 2.54% in 2010 to 6.73% in 2011.
Significant increase on ROCE was realised when it rose from 1.48% in 2010 to 8.83% in 2011 (“British Airways” 2012, p.18). However, it is necessary to note that the rate of capital employed should always be higher than the company’s rate of borrowing, otherwise proportionate increase in the borrowings would result into proportionate reductions in earnings of the company’s shareholders.
This is a ratio between the current Assets and Current Liabilities, and ‘current’ means the assets and liabilities that need to be paid within one year’s time. This ratio shows how well the assets can repay the amount of liabilities on the company, and it also assesses the liquidity of the company’s assets. In British Airway' case, the current ratio appears lower than it should be. Even, though, the assets are not even enough to pay the liabilities, the company is doing pretty well (Dobbs, Huyett & Koller 2009, p.54).
British Airways’ quick ratio is 0.715:1 and 0.763:1 in the years 2011 and 2010 respectively. Given that a quick ratio of 1:1 is considered as a satisfactory financial condition; British Airways is, thus, sufficiently liquid (“British Airways” 2012, p.16). The ratio of 0.715:1 shows that even if the company’s inventories are sold, British Airways will still be able to meet its current liabilities if they need to be paid immediately. Furthermore, the ratio indicates some significant improvement from the results of the previous year, and this indicates operational excellence within the company in the current year.
In the year 2011, an average of one pound that is invested in inventory (stock) turns into 6.27 times in the sales. There was a significant increase in the stock turn over since 4.80 times sales turn over was realised in 2010.
Debtor collection period indicates how well the receivables are being collected from the credit customers. The rate of 0.11 or 39.7 days in the year 2011 indicates that the company is capable of converting about two times the value of the receivables into cash, within one year (Libby & Short 2005, p.63). This shows that British Airways has not put into place proper policies, so as to help in the collection of the receivables. The lower rate of slightly below two implies that the management of the company is not sufficient vigilant in collecting receivables, and this works to corroborates the high amount of outstanding receivables.
Creditors Collection Period
The creditors’ collection period of the British Airways for the year 2011 records a decrease, as compared to the previous years. The value 39.7 days indicates that British Airways Company does not have sufficient liquid assets that could finance its operations for 39.7 days without receiving any cash from the outside sources (“British Airways” 2012, p.18). The lack of improvement in the creditors’ collection period could be attributed to the efforts of the company to cut its cost bases. The company is currently implementing strategic policies that are cost driven. They focused on strategies that would ensure efficiency improvement and these have proven beneficial.
Gearing Debt Equity Ratio
As it can be understood from its name, it is simply a ratio between the total liabilities of the company compared to the stockholders equity. In other words, it shows how much the company owes compared to what it owns. In this regard, in every company the aim will be to reach a level of 1:1 where they can repay all what they owe with what they already have. In this case, they are way far from this figure where they are 5.13: 1 which is an extremely high figure and acceptable (Brealey & Myers 2008, p.47).
Interest Cover Ratio
Similar to its name, it can be simply calculated by dividing the EBITDA over the interest, which is done to give reasonable results, in this case, as follows. Interest Coverage Ratio measures the extent to which EBITDA covers interest payments, and since most companies borrows money from banks with interests, it is truly essential in order to know whether it can be paid back or not.
Interest coverage ratio for the British Airways company was established to be 547.58 % and 218.06% in the years 2011 and 2010 respectively (“British Airways” 2012, p.17). This ratio shows the number of times the charged interest is covered with the ordinarily available cash that could be used for their payment. Thus, the positive 547.58% indicates that the company is sufficiently capable of paying the interest since it has much of comparable ordinarily available cash. Moreover, the ability of the company to cover its interest charges should be associated with the increasing values in the revenues of the company and the resultant increase in cash and cash equivalent components of British Airways Company. The increase in revenue should also be attributed to the improved efficiency and effectively with which the company operates to serve its clients (Pandey 2008, p.56).
The Environment and Regulatory Framework of Financial Reporting Analysis
Accrual accounting operates under the regulatory framework, governed by IFRS and IAS accounting standards. In addition, companies must also embrace corporate social responsibility to conserve the environment. The initial provision of the globally recognised financial standards regarding leases in general and lease class categories in specific, the accrual accounting’s computations could be considered correct. The reason for this is that the case presents a conditional situation where the ultimate ownership of the equipment under the lease agreement between the two parties eventually goes back to the person who leased out the equipment. This is a sufficient condition for one to consider the lease agreement in the category of operational class. The international standards regarding leases provides that if the ownership of the leased item finally does not transfer to the individual getting the service, then the lease arrangement is classified in the operational class. In this regard, and in principle of the part assertions of the international standards concerning leases, the accrual accounting would be correct in his class analysis. This implies that the accrual accounting employed part analysis of the standard and made an overall assumption about the prevailing economic usefulness time difference of the equipment under the lease in the case.
However, in view of the supporting assertions of the standards guiding the classification and reporting on lease arrangements, the accrual accounting’s research and classification of the lease agreement in the case is substantially mistaken. This is in light of the fact that the case presents lease equipment with an economic viability of four years and the lease agreement is for the first three years. In this connection, the subsequent provisions concerning the lifespan of the leased items and the lease duration is significant in changing the decision of the accrual accounting and therefore providing an opportunity for him to make the right judgment. This section of the standards asserts that in cases where the lease period in substantial over and above the whole economic usefulness of the leased item, then the lease contract qualifies to be considered in the finance category of leases (Marshall 2010, p. 11).
This implies that the accrual accounting ought to have considered this assertion before concluding that the lease agreement presented in the case is of operational nature. In considering the period of three years within which the lease contract will prevail and the overall four years as the useful economic viability of the equipment in the case, it is evident to conclude that the lease period covers a substantial time period within the remaining economic consideration in terms of years over the leased asset.
Further, the components that the accrual accounting considered in computing the obligatory payments under the lease arrangement presented in the case makes his research significantly in violation of the provisions of the globally recognised overruling standards guiding recognition and measurement, and/or presentation of lease transactional arrangements. In this regard, the accrual accounting’s research was substantially mistaken because; the identification of lease payments in an operating lease as an expense on a straight-line method above the lease term other than another systematic basis, is more representative of the time arrangement of the user’s convenience. Apart from that, in operating leases, lease payments, which exclude identification of service costs such as insurance, tax and maintenance, as an expense on a straight-line form, which comprises next time alignment of the user’s worth even though the payments are not on that method (Taylor, Taylor & Coulton 2005, p. 562). According to the analysis by the accrual accounting, this was not significant in the required computation. On the other hand, the accrual accounting did not disclose most of the significant details required in preparation of financial statements of British Airways Company including the consideration of the prevailing economic values of the leased item.
Accrual accounting in the senior position must have employed his experience in the use and application of the international standards dictating the lease recognition constraints and provisional supporting clauses concerning lease categories and classes. This is evident in the conclusive way that he approaches the classification requirements. In addition the accrual accounting was mathematically correct in computing the necessary obligatory financial payments that the person receiving the financial services of the leased equipment must make good with the other party to the lease (“IFRS Foundation” 2011, p.36). Moreover, his allocation of both the initial and the subsequent financial components of the lease arrangements were significantly correct at least in the application of the relevant reporting principle. However, it is important to note that the accrual accounting made a material deviation from these standards in his choice of the applicable discounting rate relevant in determining the mathematical computations as discussed below (“IFRS Foundation” 2011, p.74).
In paragraph 10 of IAS 17, the global standards covering the recognition and accounting requirement on lease transactional arrangement, the standards assert that leases only fall under two categories; those which enable both the eventual transfer of owning the leased item to the person receiving the economic value of the leased transaction and /or which have substantial time of their remaining economic lifespan spent under the lease arrangement otherwise referred to as lease under the finance category and the vice versa, which are conventionally referred to as leases under the operation category (IFRS Foundation, 2011).
The application of both the substantial equipment ownership transfer either in terms of the economic lifespan or in terms of the eventual ownership change at the legal conclusion of the leas period, enables one to make an informed decision on whether the case present a finance class of lease or an operational lease class. In this regard, and in consideration of the reporting principle covering the substantial value against the legal form of the transaction, the lease duration of three years is significantly substantial as compared to the remaining life in economic terms of the leased equipment in the case of four years. Therefore, even though the leased equipment eventually retains its ownership with the person leasing it out, it is not straightforward to consider the lease in the finance category as the accrual accounting did in the previous section. Instead, one must go further into the provisions of the standard and bring in the component of economic substance of the time difference between the lease period and the period after the lease concludes.
Thus, the case presents in accounting terms a finance class of lease since the time remaining after the lease is concluded is less substantial as compared to the three years the equipment will take under the lease contract. Therefore, the accrual accounting was financially and economically correct in categorizing the lease in the case as a finance type of lease.
In computing the leased asset obligation at the inception of the lease otherwise referred to as initial lease obligation recognition, one must determine the appropriate discounting rate to employ. Conventionally, there are two discounting rate bases; the rate of incremental borrowing normally within the easy reach of the person obliged to pay the lease finance obligations, and the implicit rate that can only be determined on the basis of its viability. The later rate is always pegged on the person leasing the equipment out.
The case presents both and the task of the accrual accounting is to employ the provisions of the globally recognised standards to determine the correct discounting rate to use. In paragraph 20, IAS 17, the standards provide that the correct discounting rate to be used in computing the leased asset obligation is the implicit rate unless it is impracticable to establish. The cases presents a situation that discounts the caveat since it says that the implicit rate of 10% was reliably and practicably easy to calculate (“IFRS Foundation” 2011, p. 81). Therefore, this is the point of deviation from the provisions of the globally recognised standards covering leases referred to earlier. The accrual accounting utilized the incremental rate of borrowing despite the fact that the implicit discounting rate was easy to determine as documented in the case.
Therefore the following section will document the correct mathematical and financial calculations and reporting provisions as concerns the details, using hypothetical data.
Minimum initial obligations considering the implicit discounting rate of 10%
= £100,000 x 2.4868
= £ 248,690.
According to the U.K. GAAP, both answers would require a different direction only in terms of disclosing other items as stipulated in the U.K. GAAP. Whereas the answers of both the senior and accrual accountings were significantly different only in reference to the lease analysis as described above, both cases omitted some key details that need to be disclosed in preparation of the financial statements of British Airways Company (ASC 2010, p.1). Therefore, the section below explores those pertinent details that were omitted especially considering that the lease was falling under the operation class of leases (“IFRS Foundation” 2011, p.57).
In conclusion, according to ASC-80-05, the requirement in disclosing items, particularly in the case of a finance lease involves the British Airways Company in disclosing the following information; the future value of minimum lease payment in regard to operating leases that cannot be cancelled, in this position for four years (ASC 2011, p.1), the future value of minimum sublease income intended to be attained in non-cancellable sublease at the conclusion of the reporting period, both rental and sublease income identified as an expense at the time, with different amounts of minimum lease payments (ASC-840-10-25 (d)), contingent rents as well as sublease payment and a detailed explanation of the lessee’s significant leasing agreements which include the grounds on which there is the establishment of contingent rent payable (“IFRS Foundation” 2011, p.63); the reality of conditions of renewing or buying opportunities and escalating clauses; as well as limitations set by lease arrangements including the ones relating to dividends, additional indebtedness and other leasing (“FASB Accounting Standards Codification” 2011, p.1). In this regard, accrual accounting is also relevant in accounting for leases.