72 ACCOUNTING FOR MANAGERS
(capital). This is called the accounting equation:
assets=liabilities+capital
or
assets−liabilities=capitalHowever, the capital of the business does not represent the value of the business – it
is the result of the application of a number of accounting principles. In addition
to the Financial Reporting Standards and Statements of Standard Accounting
Practice referred to earlier, there are some basic accounting principles that are
generally accepted by the accounting profession as being important in preparing
accounting reports. These were described in Chapter 3. However, an important
principle that is particularly relevant to the interpretation of accounting reports is
the matching principle.
Thematching (or accruals) principlerecognizes income when it is earned
and recognizes expenses when they are incurred (accrual accounting), not when
money is received or paid out (cash accounting). While cash is very important in
business, the accruals method provides a more meaningful picture of the financial
performance of a business from year to year.
Accruals accounting.....................................
Unlike a system ofcash accounting, where receipts are treated as income and
payments as expenses (which is common in not-for-profit organizations), the
matching principle requires a system ofaccrual accounting, which takes account of
the timing differences between receipts and payments and when those cash flows
are treated as income earned and expenses incurred for the calculation of profit.
Accruals accounting makes adjustments for:
žprepayments;
žaccruals; and
žprovisions.
The matching principle requires that certain cash payments made in advance are
treated asprepayments, i.e. made in advance of when they are treated as an
expense for profit purposes. Other expenses areaccrued, i.e. treated as expenses
for profit purposes even though no cash payment has yet been made.
A good example of a prepayment is insurance, which is paid 12 months in
advance. Assume that a business which has a financial year ending 31 March pays
its 12 months insurance premium of £12,000 in advance on 1 January. At its year
end, the business will only treat £3,000 (3/12 of £12,000) as an expense and will
treat the remaining £9,000 as a prepayment (a current asset in the Balance Sheet).
A good example of an accrual is electricity, which like most utilities is paid
(often quarterly) in arrears. If the same business usually receives its electricity bill
in May (covering the period March to May) it will need to accrue an expense for