What Does The Term ‘True Up’ Mean In Accounting?

Accounting has evolved a lot over time, and it has become a lot more than credit, debit, journal, ledger, and financial reporting.

When we define the purpose of accounting for any business entity, the emphasis is put on ‘True representation of the financial position of an entity and real picture of the profitability.’

Every step the accounting professionals go through during the preparation of financial statements and day-to-day accounting is directed toward that bigger objective. We often heard of the term truing up the financial records.

It is a term that accountants often use, but a layman or an accounting student is often unfamiliar with the term. The generic meaning of the term true-up is ‘to reconcile or match the balance of two or more items.’ The accounting perspective of the term is more or less the same.

This blog is intended to have an in-depth understanding of the term true-up in the accounting field. And why does accounting data needs a true-up will also be part of our effort of explaining the term.

What Is True up?

The literal meaning of the term ‘true up’ says to make level, balance, or align something.

But, if we understand the term true up for the accounting procedures, it has almost the same meaning. The term true up means reconciling or matching two and more than two accounts’ balances.

Further breaking down of the definition explains that the reconciliation or matching is done by making adjustments in accounts.

Therefore, the entries made in books of accounts for this purpose are called adjustment entries or true up journal entries.

The adjustments are usually made after the end of a financial period once the accounts have been closed. The difference between actual and estimated amounts is adjusted by employing the process of truing up your financial data.

Why is adjustment necessary for the accounts? We will see it in the coming section. 

Why Is True up Necessary? Matching Principle And Accrual Basis

There are two systems of accounting. One is cash-based accounting, whereas the other one is accrual-based accounting.

If we look in-depth, cash-based accounting treats the expenses and revenues based on when the cash was received or paid.

On the other hand, the accrual basis accounting system works on certain accounting principles. The accrual system’s main concept is that expenses and revenues related to a certain financial period should be recorded in the same period, irrespective of payments made and cash received.

The accrual system is based on the matching principle of accounting. The matching principle says that revenues and expenses for a certain period should match.

In other words, expenses related to certain revenues should be recorded in the same period when revenue was generated.

As an example, we can consider the salaries of the employees. Let’s suppose employees are paid on an accrual basis, which means that January’s salary will be paid in February.

In this case, if the salaries paid to employees in January are charged as an expense of January and not of December, it will overstate the profit for the month of December. As a result, the objective of true profitability will be violated.

Therefore, the truing up of financial statements, data, and figures is critical to the objectives and requirements of fair financial reporting.

Is True up Another Name For Adjustment Journal Entries?

In the official language of accounting, you would rarely end up finding a clause of IFRS or IAS having the term ‘true-up.’ Another confusion I often faced was if the term true-up synonymous to what we generally call adjustment entries.

So here we are, answering the question.

Adjustment entries are made for the true representation of financial statements. The adjustment entries encompass correction of any erroneous transaction, inappropriate recording of a transaction, difference in estimates and actual values, accruals, and deferrals.

The principle behind adjusting entries is also the matching principle to ensure that all revenues or expenses of a specific financial year are recorded properly.

The purpose of truing up is also compliance with the matching principle, and accountants often use this lingo slang for the same concept of adjustments.

The only difference between the two is that the term truing up is mostly used when Budget variances are concerned. However, adjustment entries are more focused when correction of errors is concerned.

However, in most cases, both terms are interchangeably used, and the entries made for adjustments of balances can be called Adjustment Journal Entries or True-Up Journal Entries.

When Does An Entity Need True Up Of Financial Records?

We have understood that accounting records and the truing up of accounting records are almost the same concepts. But, the real question is when an entity needs to true up its financial records?

The general answer to this question is that truing up or adjustments are necessary at the closing of every financial period.

But to give a better idea of which scenarios require adjustment and truing up, we have listed the events when a need to true up financial records arises.

Budgeting Variances

The operational budget of the entities is all about the estimations of the recurring expenses. These budgets are often made for one financial year, a quarter, and even a month.

According to the International Financial Reporting Standards, an entity can estimate or provide the expected expenses or revenues.

After the closing of a financial period, the comparison of actual expenses and revenues is made with the estimations. The budget variances are either favorable or unfavorable.

However, the true-up entries’ purpose is to adjust the balance to match the actual value. Expenses and revenues are adjusted for the budget differences to their respective credit or debit accounts.

Errors And Omissions

Errors and omissions are a big reality of not just the corporate world but everyday life. In the recording, sorting, analyzing, posting balances, and making financial statements, there is a high probability of errors and omissions.

As a result, frustrating unequal trial balances and, therefore, misappropriation of profit and balance sheet are waiting.

As the audit progresses, the errors and omissions are identified, which need to be adjusted for an accurate financial position representation.

The journal entries are made to record the omitted entries or some aspects of a transaction. The errors of balance, incorrect value, overstating, or understating are also adjusted accordingly by the mean of true-up entries.

Timing Difference

Timing difference is also more relatable to budgeting, but it is not the budgeting variance. The best example of the timing difference can be given as an electricity bill is received once the electricity has been consumed.

Now, when closing financial statements, the bill has not yet been charged, but according to previous consumption patterns, the entity can estimate.

Mostly, the companies post these estimates to the related expense account. Now when the bill was received, it was either more than estimate or less than the estimate.

This difference has to be adjusted for a true representation of financial position and profitability. Therefore, the true-up entry will be posted for adjustment.

Quantification

According to the International Financial Reporting Standards, some expenses cannot be ascertained with complete accuracy due to unexpected events.

In that case, the company will have to make adjustments for the actual values once the financial period has been completed. The best example of this is the insurance of the employees in an entity.

It can not be estimated with certainty that how many new employees will be hired and how many of them will quit. Therefore, once the year is completed, actual figures can be calculated by the facts. The entities will pass the true-up journal entries in this case too.

True Up Journal Entries

Here are some examples of the true up entries for different scenarios present in an entity.

Example 1(Budgeting Variance)

A company estimated the cost of refreshment to be 3,000$ per quarter for the year of 2017. In the last quarter, it was found out that the actual cost incurred per quarter was 4,000$.

There was a total difference of 3,000$ that required to be adjusted for the year’s profit and loss statement.

The journal entry for the cost of refreshment in the 4th quarter will be made as:

DescriptionL.FDebit($)Credit($)
Refreshment Expense Account   7,000 
  Cash/Bank Account      7,000
Cost of refreshment incurred in last quarter plus an adjustment for cost of last 3 quarters.

Example 2

Another example of the timing difference can be illustrated as the payment of electricity bills as discussed above. From the previous estimations, the company has debited $15,000 as the electricity bill for the month.

However, when the actual bill was charged, it was of amount $12,000. Now, this scenario shows that the profit has been understated due to more charging of electricity bill.

An adjustment entry would be made to reconcile the balance. The entry will be such as

DescriptionL.FDebit($)Credit($)
Electricity Bill Payable Account  3,000 
  Electricity Bill Expense Account      3,000
Cost of electricity bill being charged to the month

Conclusion

We have tried to sum up the concept of truing up in a comprehensive way so that no ambiguity is left in the readers’ minds.

The truing up concept is just like the adjustment journal entries for any accounting period. We hope our effort will help you have a better and clear understanding of the concept.

Accounting for Warranty – Definition, Types, Journal Entry, And More

When we are buying different products, there is a whole back science going on in our minds. Product design, specifications, durability, reliability, color, utility, space management, and God knows what.

But, whenever choosing a product, our biggest concern is longevity, durability, and security.

What aspect of a product gives you security?

We all know without a doubt that’s a warranty -Warranty of repair, replacement, discounted repairs, etc.

But, what does a warranty means for the vendor or a manufacturer?

For a vendor or manufacturer, the warranty has different purposes, being the most important one as the marketing tool to promote their product by providing support.

By giving different types of warranties, the brands and manufacturers convey a message that their products are up to the mark, and they are so confident about it that they won’t mind giving a replacement.

Every action of an entity has a process. Everything needs to be logged in records for an accurate view of the profitability. That means, when a company is giving warranties, it will have to be recorded in one way or the other.

Therefore, we will talk about the process of warranty, issuing warranties, and accounting for warranties by an entity. Before that, we should look at what a warranty is, different types of warranties, and when a company accounts for warranty expenses.

Definition

In the books of business law, you will find the definition of the warranty as something like,

Warranty is an implied or expressed promise of a manufacturer/vendor to a buyer, assuring that the product’s specifications, facts, and conditions are true and valid.

The warranty is implied by conditions or even implied by law. The buyers can go to the consumer court in case of any violation.

Since we are discussing the accounting treatment of the warranty, so we will look into that.

If we look into the GAAP standards, we will find a similar definition of warranty, saying,

A warranty is accounted for as a deliverable—a concept similar to a performance obligation— only if it is a “separately priced extended warranty” or a “product maintenance” contract.

We will further look into the nature of warranties, extended warranties, or product maintenance contract

Accounting Nature of Warranty

Warranty is the promise of the manufacturer or vendor with the buyer; therefore, it will be an expense for the company if a warranty is claimed.

So, the warranty’s accounting nature is an expense for the entity that will be debited to the company’s accounts at the time of sale against the warranty provision account. If the warranty is claimed, the provision account will be debited against the repairs, replacement inventory account.

Types of Warranty

A warranty issued by the manufacturer is generally for 1 year, 2 years, or it might be 5 years in some cases.

But, it is bound with different conditions like warranty can only be claimed if there has been no alteration, repair, changing of any parts with sub-standard substitutes, etc.

For instance, you will often find on the warranty card for a mobile warranty that the warranty cannot be claimed if the device has been exposed to water. So let’s have a look at some different types of warranties.

The most general types of warranties are two:

Implied Warranty

A buyer is entitled to the implied warranty for a specific product at the time of purchase. It is that type of warranty that is exercisable regardless of whether the seller or manufacturer has explicitly expressed the assurance.

However, one type of implied warranty requires oral or written assurance, that is the merchantable warranty. 

In terms of accounting, such a warranty is called assurance-kind of warranties regulated under the IFRS 15 and IAS 37. such warranties do not give rise to a special obligatory clause, and these are considered as a provision for expense in books of accounts.

In the implied warranty, there are two types of warranties: merchantable warranty and fitness warranty.

Implied warranty of merchantability confirms that the products meet the reasonable buyer’s expectations and merchantable.

In other words, the warranty of merchantability means that the product will fulfill the intended purpose of the buyer. The implied warranty of merchantability applies to new as well as used products.

Implied warranty of fitness assures that the product is fit for a specific purpose it is made for. For instance, the purpose of a knife can be cutting a vegetable, fruit, thread, rope, etc., but cutting is the specific purpose.

If a buyer of a knife finds that the knife is blunt and not fit for cutting, the implied warranty of fitness is applicable for replacing such a product.

Extended Warranty

We already discussed that the manufacturers’ warranty is mostly a standard of 1 year or 2 years. Many vendors go for an extended warranty to ensure that their customers are satisfied.

The extended warranty is a service agreement for repairs, maintenance, and service of the products.

The extended warranties are called service-type warranties and regulated under IFRS 15. These are giving an additional assurance to the buyer for service and maintenance of the product. Hence, giving rise to a separate obligation clause for the issuer.

Such service-type warranties are revenue for the seller, and they will be recorded at the time of sale. We will talk about the accounting treatment in detail in the following sections.

How Does An Entity Accounts For Different Kinds Of Warranties?

Depending on the type of the warranty, the accounting treatment also varies. We will look into each in detail.

To undergo an accounting treatment for a warranty, the first thing to question is what kind of warranty your customers have? To understand this, you can answer 2 questions to make the picture clear.

  1. Do the local state laws require the warranty? It is a general practice that the warranties are regulated by local state laws, and laws vary across the globe. If the answer to this question is yes, it is most likely that the type of warranty is assurance-type, and you will not be obligated for separate services.
  2. Is the warranty time period longer than what state laws have prescribed? If the answer is yes, it is most probable that the warranty is more likely to be a service-type warranty.

Accounting Treatment For Warranties

Now let’s look at the accounting treatment for assurance-type warranties and service-type warranties.

Assurance-Type Warranties

The matching principle of accounting requires the business entities to record the expenses related to the revenue at the time of revenue generation.

Under this principle, the assurance-type warranties are treated as an expense related to the sale of goods.

At the time of the sales, the warranty expenses are debited. A provision for the warranties is credited, which goes under the liabilities in the balance sheet.

The journal entry for the recording of warranty expense is as under:

Later on, if a certain warranty is claimed, the liability for warranty expense will be debited, and cash, inventory, or spare parts account will be credited depending on the scenario. The entry for the exercise of warranty is as follow:

Service-type Warranties

The service-type warranties are purchased by the buyer along with the price of the product. As a result, the unearned warranty revenue is credited while cash is debited. The journal entry for the service type warranty will be:

DateDescriptionL.FDebit($)Credit($)
 Cash/Bank Account Xxx 
              Unearned Warranty Revenue Account  Xxx
(Service-Type Warranty Sold Along With the product)

When the customer comes for repair or maintenance of the product, the revenue is realized, and the revenue earned is made.

The revenue earned account is credited, and the liability as unearned warranty revenue is decreased, therefore, debited.

The journal entry is as follow:

DateDescriptionL.FDebit($)Credit($)
  Unearned Warranty Revenue Account Xxx 
                                 Warranty Revenue Account  Xxx
(Revenue recognized on the service-type warranty)

Is Warranty Expense Or An Asset?

For the business entities that are purchasing the products having warranties, one of the most staggering questions is to treat warranty as an operating expense or add it to the asset’s value.

So here is the answer to this question.

According to the International Accounting Standards, IAS 16 Property, Plant and Equipment regulate the costs to be incurred as the asset costs and capitalized. It states that:

Any cost can be added to the asset value that:

  • Cost adjusted for duties, taxes, and discounts
  • The cost incurred for the first-time installation
  • The cost incurred for dismantling and removing the asset

Besides, no cost should be capitalized and should be treated as operating cost.

The answer is that,

The extended warranties which are purchased separately do not relate to the functionality or intended-use of the asset.

The asset can work well regardless of the warranty. Besides, the extended warranties do not fit under the criteria of capitalization of asset cost under IAS.

Therefore, for the entities purchasing extended warranties, it will be recorded as a normal operating cost.

Conclusion

We have discussed all the aspects of warranties, types, nature, accounting treatment, and perspective of buyer and seller.

We hope that this comprehensive effort will help you understand accounting for the warranty to show the true profitability in the financial statements.

Provision Expense – Types, Recognition, Examples, Journal Entries and More

If you ever been to business school, having this equation proven in preparing financial statements would have been your dream! The equation, Assets= Liabilities+ Capital, is referred to as the accounting equation.

But, any accounting student will have panicked every other time while equating the assets with liabilities and capital in preparation of the balance sheet. There is no one reason why your balance sheet didn’t balance, but one nightmare accounting treatment is Provisions.

You never know where to put a provision. If it’s a bad debt provision, subtract it from the realized bad debts and balance it with last year’s provision, and still, you got to adjust it with debtors of the asset side.

One thing which needs to be ascertained is that provisions are created for assets as well as liabilities. The provision expenses are the contingent liabilities, and provision for incomes are contingent assets subject to happening of a certain event

If it’s a tax provision, then it will go to liabilities, and similarly, there are dozens of provisions requiring different accounting solutions.

Being an accounting student, I had faced this issue tons of times, and I understand most of the people either in the field or in school can get stuck with the provision’s treatment.

Therefore, we will do an in-depth analysis of provision expense, its types, accounting treatment, accounting nature, and recording.

So take a deep and let’s get solve this mystery of the provisions once and for all.

What is provision expense?

Sometimes, we confuse the provision expense with saving because we are putting aside an amount in anticipation.

But actually, provision is only made for the future expense that is expected to occur and is meant to occur, but timings and amounts might vary

We cannot just make a provision account based on gut feelings, but much financial analysis goes in before making a provision.

So to formally define a provision expense, we can say,

In accounting, the provision means a set-aside fund in anticipation of a future expense or reduction in the assets’ value.

According to IAS 37 of International Financial Reporting Standards, 

A provision is a liability of uncertain timing or amount. The liability may be a legal obligation or a constructive obligation that arises from the entity’s actions. It has indicated to others that it will accept certain responsibilities and has created an expectation that it will discharge those responsibilities. 

From the definition of the provisions, we can establish that a provision:

  • Only arises in anticipation of expected obligation arising from entity’s action
  • Is a contingent liability
  • It might vary in amount and time of payment

Examples of Provisions

Some most common examples of provision we often come across during the preparation of financial statements are

  • Warranties
  • Bad debts
  • Any penalty for an on-going lawsuit
  • Customer Refunds
  • Tax Obligation

There are different types of provision expense, and we will look into each type separately

Types of Provisions

Here are the types of provision expenses we come across during studying or preparing the financial statements of an entity

1) Provisions For Doubtful Debts

Provision for doubtful debts that is often referred to as provision for bad debts is recorded in anticipation of probable bad debts that might arise in accounts receivable. There are two types of doubtful debt allowances. One is a specific allowance, and the other one is a general allowance.

The general allowance corresponds to the general estimation of bad debts that might arise due to any reason based on past years’ estimation.

However, specific allowance for doubtful debts relates to specific account receivables. They are related to the debtors about whom the entity knows that they face certain financial problems and might fail to pay their dues.

2) Provisions For Discounts To Debtors

Most of the businesses opt for a strategy of rewarding the early payers and encouraging the debtors to clear their dues earlier by offering a certain amount of discount on their bills. This is an expense for an entity if realized.

Therefore, a provision for discounts to debtors is made. So that in the future, if a debtors come and claim the discount, a business can accommodate him.

3) Deferred Tax Payments

The IAS 12 of International Financial Reporting Standards defines deferred tax payments as the future expense concerning the Taxable Temporary Differences. The amount of deferred tax liability is calculated by adjusting the income before taxes with the amount an entity claims as a tax deduction.

In the deferred tax liability, you can not fully understand the concept unless you know the meaning of Taxable Temporary Differences.

Temporary differences are defined as the difference between an asset’s carrying cost for financial reporting purposes and its value for the tax purpose.

4) Contingent Liability For A Law Suit

Another provision expense arises in the matters of lawsuits, social responsibility, and other legal obligations.

 For instance, a business has been accused of violating the community standards by a social responsibility organization. It is expected that the company might lose the lawsuit and will be obligated to pay the penalty or fine.

In such a case, the contingent liability will be created and recorded under the liabilities in a business’s balance sheet.

5) Warranties

Warranty provision arises at the time of sales of a product as a result of the entitled warranty. The warranty provision includes any replacement, repair, or amendment that a customer is entitled under a certain product warranty.

The recording of warranty provision is made concerning the matching principle of the accounting that says the expenses related to certain revenue must be recorded at the same time when revenue is realized.

Therefore, any entity that gives product warranties will record the payable warranty provision at the sale time.

6) Inventory Obsolescence

Now, the recording of inventory obsolescence varies from business to business. If your business’s nature is something where there are occasionally obsolescences of inventory, you can write off the obsolete inventory amount in the profit and loss account.

However, suppose your business relates to products that have high rates of obsolescence. In that case, a provision for inventory obsolescence will be created to write-off the amount in every financial year.

7) Provision For Depreciation In Assets

The purpose of creating depreciation provisions is to make a balance sheet more realistic and reflecting the true value of the fixed assets of an entity. The depreciation provision is calculated depending on the depreciation method used by the entity.

It can be a straight line method where an equal amount of depreciation is written off every year. Or it can be the declining balance method where depreciation value is calculated on the remaining value of the asset at the end of every year.

When To Recognize An Expense Provision?

Any business can not create an expense provision for anything. As earlier mentioned, much financial analysis goes into the creation of expense provisions or income provisions.

The IAS 37.14  of International Financial Reporting Standards(IFRS) binds the entities to recognize the expense or income provisions in certain cases that are:

  • A present expense payable arose as a result of any legal or constructive obligation
  • A probable expense
  • The amount can be estimated reliably

The measurement for different provisions is regulated under different clauses of the IAS 37 of IFRS.

Journal Entries For Provisions

For the accounting treatment of the provision expenses, the treatment for every provision will be different.

We are making entries of provisional debts, discount provision, warranties provision, and deferred tax provisions for you.

Journal Entries For Provisions
Journal Entries For Provisions

Are Provisions Non-Cash Expenses?

Yes, provisions are non-cash expenses or accounting loss reservations that are being charged to the current period.

The element of probability that gives rise to uncertainty of either the event will occur or not makes the provisions from the regular accrual expenses.

For instance, there is no outflow of cash in the case of bad debts, discounts, or warranties. Therefore, the provisions are given an accounting treatment of non-cash expenses

Is Provision An Asset Or Liability?

Provisions generally represent the set-aside funds of an entity in anticipation of the expected losses. The expected losses are related to the events that had happened in the past. Therefore, if a loss arises in the future, it will have to be compensated by the entity.

So such a case leads to the creation of contingent liabilities. These are recorded under liabilities column in the balance sheet or adjusted against receivables in case of bad debt provisions.

Therefore, provision expenses are treated as a liability in financial reporting.

Final Words

Contingency planning is a very important function of the accounting department and financial reporting procedure. And provisions are the essence of contingency planning that help the entities and individuals estimate an expense or loss in anticipation.

Electricity Cost – Fixed or Variable?

What is a Fixed Costs?

Fixed Costs can be defined as the costs that do not vary with the level of output within the company. As a matter of fact, organizations have to incur this particular cost regardless of the level of output they are operating in.

Over the course of time, even if the level of production increases within the company, the total fixed costs still the same. However, fixed cost per unit tends to decrease with the increasing level of input within the company.

In the same manner, it is also important to consider the fact that fixed costs are also referred to as overheads.

They cannot directly be associated with individual units of output produced within the company. Some examples of fixed costs include office rent, and salaries for office, and other managerial staff.

What is a Variable Cost?

Variable Cost is the cost that changes with the level of output within the company. Factually, it is directly proportional to the level of output that the company produces. This means that the higher the total level of output within the company, the higher the variable cost.

Hence, at zero levels of output, the company has zero variable costs. However, it must be noted that with increasing levels of output, the variable cost per unit stays the same.

Some examples of variable costs for an organization include production related expenses, direct material, and direct labor for the company.

Furthermore, it can also be seen that the variable cost for the company is referred to as a direct cost because it can be directly traced down to one unit of goods produced within the company.

Nature of Electricity Bill

During the normal course of operations, there are numerous expenses that a business has to bear in order to stay operationally active. In this regard, they mainly categorize those expenses as either fixed, or variable.

However, in certain types of expenses, there is often ambiguity regarding how they should be classified in order to depict a clear picture to the users of the financial statements.

Electricity tends to be one of such expenses that are often treated with relative ambiguity, because of the reason that it is relatively harder to bifurcate electricity-related expenses into fixed and variable.

However, it can be seen that the categorization of electricity-related costs can be broken down into several different pieces, and then subsequently tied together to get a better insight.

The electricity bill, by its very nature, is often regarded as a mixed cost. This is essential because of the cos that includes both components, fixed, as well as variable.

It normally includes a flat service charge, after which the variable charge accumulates in accordance with the number of electricity units that are consumed within the company.

Therefore, the nature of the electricity expense can be regarded as fixed. This is because it normally involves a fixed component and a variable component.

Also, it is also regarded as a fixed cost, because even if the company is not producing any goods and services, they would still be paying some fixed amount for electricity every month.  

How to Classify Electricity Bill?

Firstly, electricity is considered to be a utility that is consumed across different departments within the company. Therefore, it is relatively harder to segregate electricity strictly into either fixed or variable.

However, this is something that can be dealt with by keeping production-related electricity costs as variable costs, and other miscellaneous costs as fixed electricity costs.

For production-related electricity expenses, it makes sense for those costs to be associated with variable costs, because they are directly proportional to the number of goods and services that are produced. Higher the production, higher the electricity costs.

Therefore, it is best to classify production-related electricity expenses as variable costs, and other miscellaneous electricity-related expenses as fixed expenses.

Regardless of the fact that holistically electricity-related costs are considered as mixed costs, yet they are normally classified as fixed costs, in the Income Statements. This is because of the fact that electricity expense in itself includes both fixed, as well as variable components.

Hence, it is regarded as a cost that cannot be individually attributed to one particular unit of product. Even though production-related electricity expenses are directly proportional to the amount that is produced within the company, yet it still cannot be attributed to one particular unit in an accurate manner. Hence, in most cases, it is classified as fixed costs only.

Net Open Position: Definition, Example, Formula, and Importance

Definition

Net Open Position is defined as the exposure of companies towards foreign exchange risk that the company is exposed towards. The exposure of the foreign exchange risk is defined as the difference between total assets and total liabilities in the foreign currency.

This particular risk element describes the extent to which the company can see volatility in the financials as a result of the foreign exchange risk.

In this regard, it can be seen companies are often exposed to foreign exchange risk because when they are dealing with foreign exchange transactions.

This is because of the fact that currency rates keep on fluctuating because, and hence this makes the financials of the company vulnerable to uncalled for instability in profitability.

The foreign exchange risk is always inherent within companies particularly in cases where there is more than one currency in operation.

Therefore, this is the exposure that needs to be accounted for by companies in order to identify the element of risk that the organization has undertaken as a result of the foreign exchange-related transactions.

Formula

Net Open Position is calculated using three main parameters. These parameters include total assets in the foreign currency, total liabilities in the foreign currency, and the equity or the net worth of the company. Using these parameters, the following formula is then used:

Net Open Position = (Total Assets in the foreign currency – total liabilities in the foreign currency) / (Equity or Net Worth of the company)

However, in order to represent all currencies as one single currency, it is important to convert the international currencies into the functional currency of the organization. This is done using the prevalent spot rate at that point in time. 

Example of Net Open Position

Net Open Position can further be explained using the illustration provided below:

Multinational Inc. is a trading concern sending goods from the US to the UK. They also import some of their raw materials from the UK. As of 31st December 2019, they had the following balances on their balance sheet:

Total Assets (Local Currency) = $ 500,000

Total Assets (Foreign Currency) = £ 200,000

Total Liabilities (Local Currency) = $300,000

Total Liabilities (Foreign Currency) = £ 100,000

 Equity or Net worth of the company -= $ 200,000

As of 31st December 2019, the spot rate between USD and GBP was $0.9 = £ 1

In order to calculate the Net Open Position of Multinational Inc, the following calculations need to be made:

Total Assets (Foreign Currency) = £ 200,000

Total Foreign Assets (local currency) = $ 180,000

Total Liabilities (Foreign Currency) = £ 100,000

Total Foreign Liabilities (local currency) = $ 80,000

Therefore, after these conversions, the net open position of Multinational Inc. can be calculated as the following:

Net Open Position = (Total Assets in the foreign currency – total liabilities in the foreign currency) / (Equity or Net Worth of the company)

Net Open Position = ($180,000 – $80,000) / 300,000

Net Open Position = 100,000 / 300,000 = 33.33%

Importance of Assessing Net Open Position

There are numerous different advantages of calculating net open positions. Firstly, it can be seen that net open positions can greatly help companies to assess their inherent risk.

This is important for companies, and their stakeholders because it gives them a much-needed insight and overview regarding the existing risk position and how can this risk position be altered for the overall position of the company.

In the same manner, the net open position can also be used for business strategies, and in terms of devising a protocol that companies can follow in terms of minimizing and mitigating that risk in the coming years.

Limitations of Net Open Position

However, it can be seen that the net open position has certain limitations, which need to be included in the analysis too. Net Open Position is the risk exposure at a certain point in time. It provides a snapshot, which is based on the existing exchange rates.

However, it does not provide a longitudinal view. It does not incorporate the fact that foreign currency rates might constantly change from time to time, and hence, this is something that might change the net open position of the organization too.

In the same manner, a higher net open position is also perceived as a cause of higher risk for the company. However, it must be kept in mind that a lot of companies solely rely on international trade, and therefore, their net open position might be higher.

This does not necessarily mean that the company is a high-risk entity. In fact, this risk can be minimized over the course of time using techniques and strategies that can reduce the element of risk.

Repair and Maintenance Expense – Overview, Accounting Treatment, Journal Entries, and Example

Overview

During the normal course of business, there are certain routine expenses that are considered unavoidable. They are part and parcel of the operations of the company, and therefore, need to be paid by the company in order to ensure that there are no bottlenecks that hinder the performance of the company.

Repairs and maintenance expense are one such expense that is incurred by the company on a regular basis.

Repairs and maintenance expenses basically include expenses that are incurred as a result of the machinery or other equipment within the company that needs to be kept in proper running condition with the company.

These expenses are considered to be unavoidable and are necessary to ensure smooth functioning of operations without any machine breakdowns, and any relevant hiccups.

In this regard, these expenses are mainly categorized as periodic costs. They cannot be associated with one particular product, and the expense for repairs and maintenance highly varies from one year to another.

By the nature of repairs and maintenance-related expenses, it is seen that it is normally considered to be an expense that is a routine expenditure, and it cannot be predicted before it actually happens.

With routine maintenance, the amount is still predictable, but with unforeseen machine breakdowns, predicting the amount for these expenses is relatively hard.

Therefore, this is the amount that is normally deducted from the petty cash of the company, since it is mostly not very substantial. However, it still needs to be accounted for in order to record those expenses in a proper manner.

Accounting Treatment for Repairs and Maintenance Expense

Repairs and maintenance expense is considered to be one of the operational expenses of the company, and therefore, it is categorized as a normal expense.

Repairs and Maintenance expenses can either be planned or unplanned. Planned repairs and maintenance expense means that companies now need to be incurred and carried out over the coming year.

On the other hand, unplanned repairs and maintenance expenses are expenses that occur on an unforeseen basis. For both of these types of repairs and maintenance-related expenses, they are treated and categorized in the same manner.

Therefore, repairs and maintenance expense is mainly categorized as an expense account. The expenses are debit in nature, and therefore, as the amount increases, the relevant amount is debited in the Profit and Loss Account.

Normally, organizations settle this amount in cash, and therefore, they barely have any prepaid or accrual balance at the year-end. However, in certain cases, organizations do end up having either prepaid or accruing repairs and maintenance expenses.

In the case where there are prepaid repairs and maintenance expenses, it means that the company has paid in advance, or has paid an excess amount to the supplier. In that particular case, it is treated as a Current Asset in the Balance Sheet.

On the contrary, it can further be seen that in the case where there is a pending balance of Repairs and Maintenance that needs to be settled before the year-end, there is a need to include that as Current Liabilities in the final year statements.

Double Entry for Repairs and Maintenance Expense

In order to record the repair and maintenance expense when it is incurred, the following journal entry is made:

ParticularDrCr
Repairs and Maintenance Expensexxx
    Cash xxx

Since the repairs and maintenance account is paid in the year where it is due, it is supposed to be expensed and written off at the end of the year.

Therefore, in order to settle the amount that has been carried out as an expense at the end of the year, the following journal entry is made:

ParticularDrCr
Income Statementxxx
       Repairs and Maintenance Expense    xxx

Example

In order to explain and further classify the treatment of repairs and maintenance expense, the following illustration is provided:

Kemp Co. is a manufacturing concern. Over the course of the year, they incurred $25,000 as repairs and maintenance expenses.

However, they got into an agreement with the supplier that they would pay $15,000 as repairs and expense cost upfront, and the remaining amount would be settled in the next year.

In order to record the above transaction in the financial statements, the following transactions need to be made:

ParticularDrCr
Repairs and Maintenance Expense25,000
    Cash 15,000
Current Liability 10,000

In the same manner, it can be seen that at the year end, the following journal entries need to be made:

ParticularDrCr
Income Statement25,000
Repairs and Maintenance Expense 25,000