CONSTRUCTING FINANCIAL STATEMENTS 73
the month of March, even if the bill has not yet been received. If the prior year’s
bill was £2,400 for the same quarter (allowing for seasonal fluctuations in usage)
then the business will accrue £800 (1/3 of £2,400).
The effect of prepayments and accruals on profit, the Balance Sheet and cash
flow is shown in Table 6.4.
A further example of the matching principle is in the creation of provisions.
Provisionsare estimates of possible liabilities that may arise. An example of a
possible future liability is a provision for warranty claims that may be payable on
sales of products. The estimate will be based on the likely costs to be incurred in
the future.
Other types of provisions cover reductions in asset values. The main
examples are:
žDoubtful debts: customers may experience difficulty in paying their accounts
and a provision may be made based on experience that a proportion of debtors
will never pay.
žInventory: some stock may be obsolete but still held in the store. A provision
reduces the value of the obsolete stock to its sale or scrap value (if any).
žDepreciation: this is a charge against profits, intended to write off the value of
each fixed asset over its useful life.
Provisions for likely future liabilities are shown in the Balance Sheet as liabilities,
while provisions that reduce asset values are shown as deductions from the cost
of the asset. The most important provision, because it typically involves a large
amount of money, is for depreciation.
Depreciation..........................................
Fixed assets arecapitalizedin the Balance Sheet so that the purchase of fixed
assets does not affect profit. However, depreciation is an expense that spreads the
cost of the asset over its useful life. The following example illustrates the matching
principle in relation to depreciation.
An asset costs £100,000. It is expected to have a life of four years and have a
resale value of £20,000 at the end of that time. The depreciation charge is:
asset cost−resale value
expected life100 , 000 − 20 , 000
4
= 20 ,000 p.a.Table 6.4 Prepayments and accruals
Profit effect Balance Sheet Cash flowPrepayment Expense of £3,000 Prepayment (current
asset) of £9,000
Cash outflow of £12,000Accrual Expense of £800 Accrual (creditor) of
£800
No cash flow until quarterly
bill received and paid