Real world companies often face transactions or events longer than one period of account. This could be the case when a company renders longer services to its clients – such as building of ship or construction works at a large site and any other, let’s call them – long-term services. Any service that commences in one reporting period and ends in another, following period could be defined as a long-term service. These are not only service with large scope or value, nor only construction works, but also regular and common services such as subscriptions to magazines, domain and hosting, insurances, software licenses and etc. There is hardly a company that has never received such services. This ubiquitousness grounds the interest of the profession to the accounting treatment of such services.
We will herewith examine the accounting for regular long-term services whose value does not form the cost of an asset, or otherwise – those who are directly recognized as expenses. We will not examine revenues from long-term services that is set forth in standards 11 Construction Contracts and 18 Revenues.
The main principle for the accounting for long-term services is the accrual accounting of expenses. This principles requires that any expenses incurred in a period of account are recognized in the same period and not in the following one or the preceding one. The recognition of the expense does not depend on the payment to the supplier. It does not depend either on the presence of a document as an expense could have been incurred even if it were not properly documented and to the contrary – an expense may not have been incurred despite all documents have been properly collected. Therefore we believe that it is necessary for the company to select a reasonable method to allocate the expenses to each of the period of accounts they relate to.
The second principle that has to be observed when accounting for such expenses is that transactions and events expected to occur in the future do not in themselves give rise to assets, in other words – future period expenses shall not be recognized. This a long-known principle in the IFRS where it is explicitly stated in paragraph 4.13 of the Conceptual Framework. However, in Bulgaria the practice of recognizing future periods expenses and revenues is very popular. This used to be justified with the fact that there were no such a provision in any of the national standards or statutory acts. This gap was filled up by the General Provisions (promulgated in the State Gazette No.3 of 2016, hence a statutory act) which are almost copy-paste translation of Chapter 4 of the Conceptual Framework of IFRS. Section Assets of these General Provisions says:
„Transactions and events expected to occur in the future do not give rise to assets. The intention to purchase inventories or fixed assets does not meet the definition of an asset.“
The professional society in Bulgaria may not accept easily this change and get used to the accounting for long-term services without recognizing future periods expenses. It is difficult to overcome long-standing habits. Yet, we have to begin from somewhere. Therefore, we would like to suggest a method of accounting for long-term (i.e. in two periods of account) expense in compliance with the accrual accounting principle and without recognizing any future periods expense. We will not dig into theory but will present pure practical solution instead.
So, let us have the following case:
A company enters on 15.08.2016 into a one-year insurance, the premium being paid in two equal installments – the first on 15.08.2016 and the second on 15.02.2017. The total insurance premium due is BGN 400.
The company uses the following accounts in its Chart of Account:
432 Prepaid expenses
602 Expenses for services
The first step is to apply the accrual accounting principle, i.e. to allocate the cost of the insurance premium between the two period of accounts – 2016 and 2017. We believe that the most logical, grounded and reasonable approach is to allocate the cost pro-rata the numbers of days in 2016 and 2017 which the expense relates to, or:
It is very easy to calculate the number of days in each of the periods as Excel provides for mathematical calculations with dates. We show how to use Excel to calculate the days below:
Please note that the date shown in column B is not included in the period of account in order not to reduce it with one day.
The next step is to allocate the expense between the two periods of account as follows:
Remark: The pro-rata allocation is computed under the following formula:
So, we now know – the expense for 2016 is BGN 152.33. We may recognize it by recording the following in the accounts:
Meanwhile, on 15 August the company pays to the insurance agent the amount of BGN 200. We record the following:
It is clear that in 2016 the company has prepaid BGN 47.67 out of the premium related to 2017. This has to be recorded as a prepaid expense and recognized as an asset in the balance as of the end of 2016:
On 1 January 2017 the company has to recognize the prepaid expense as a current expense for 2017 or:
On 15 February 2017 the company may pay the second installment on the insurance premium and then the insurance will remain valid until 15 August 2017. This will give grounds to the recognition of current expense as follows:
We have often been told that the above-suggested method could result in expenses been “forgotten”. We cannot accept this argument for reasonable. The company will anyway not forget to pay the insurance premium installment as will otherwise lose its insurance coverage, so the payment will “remind” us for the necessity of recognizing the expense.
On the other hand, from the perspective of 2016 the second installment is a future transaction. The insurance coverage depends on the payment of the premium, i.e. should the company decide not to pay the second installment, it will not be insured for the period after 15 February 2017 and will not consume the benefits. It is completely feasible that company never incurs this part of the expense. In fact from the perspective of 15 August 2016 the company only declares its intention to pay those additional BGN 200 against which the insurer promises to maintain the insurance valid upon such a payment. As we already know, intentions and future events do not give rise to assets; hence any recognition of a future period expense, i.e. an asset is wrong and shall not be carried out.
We are aware that this separation of the accounting for such expenses in both periods of account creates some difficulties – documents must be found, computations must be recalled, records must be checked. Therefore we recommend all documents to be prepared when the expense was first recorded, including those that will be processed in the following period of account. It is a good practice to maintain a folder called for example “For the following period” and to keep such documents therein until their processing becomes grounded. In the above case two documents “For the following period” may be prepared:
- A memo dated 01.01.2017 for the recognition of the prepaid expense as a current expense for 2017; and
- A memo dated 15.02.2017 for the recognition of the second part of the installment as a current expense for 2017.
It is proper to attach copies of the insurance police and the expense allocation computations to these memos.
We hope that the suggested method of accounting for long-term services will be of help to all colleagues wishing to observe the generally accepted accounting principles and open to change and overcoming old habits.