ch-4, accrual accounting

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  • Chapter 4

    Accrual Accounting

    and

    Financial Statements

  • Learning Objectives

    Make adjustments for the expiration or consumption of assets.

    Make adjustments for the earning of unearned revenues.

    Make adjustments for the accrual of unrecorded expenses.

    Make adjustments for the accrual of unrecorded revenues.

    Describe the sequence of the final steps in the recording process and relate cash flows to adjusting entries.

    Prepare a classified balance sheet and use it to assess solvency.

    Prepare single- and multiple-step income statements and use ratios to asses profitability.

  • Adjustments to the Accounts

    Most transactions are recorded when they

    occur.

    Some transactions might not even seem like

    transactions and are recognized only at the

    end of the accounting period.

    The difference in these transactions depends on

    how obvious or explicit they are.

  • Based on how obvious transactions are,

    they can be classified into two categories:

    Explicit Transactions

    Implicit

    Transactions

  • Explicit Transactions

    Explicit transactions - events such as cash receipts and disbursements, credit purchases, and

    credit sales that trigger nearly all day-to-day routine

    entries

    Entries are usually

    supported by

    source documents.

    These transactions involve

    events that have actually

    happened.

  • Explicit Transactions

    However, some explicit transactions

    might not involve actual exchange of

    goods or services between the firm and

    another party.still they are transactions

    E.g.- Loss of assets due to theft

  • Implicit Transactions

    Implicit transactions - events such as the passage of

    time that do not generate evidence that the

    transaction happened and are recognized via end-

    of-period adjustments

    Examples include depreciation

    expense and the expiration of

    prepaid rent. June 2002

  • Adjustments to the Accounts

    Adjustments (adjusting entries) - end-of-

    period entries that assign the financial

    effects of implicit transactions to the

    appropriate time periods

    Adjustments are usually made when

    the financial statements are about to

    be prepared.

    They are made in the form of journal

    entries that are posted to the general

    ledger.

    Ledger

  • Adjustments to the Accounts

    Most entities use accrual accounting.

    Adjusting entries are at the heart of

    accrual accounting.

    Accrue - to accumulate a receivable or

    payable during a given period even

    though no explicit transaction occurs.

    The receivable or payable grows with time,

    but nothing changes hands.

  • Section 209 of Companies Act,1956

    As per this section, accounts are not deemed to

    be properly kept unless they are maintained

    under double entry system and as per accrual

    method of accounting.

    Also, the matching principle may require that all

    expenses related to earning income should be

    booked irrespective of their being paid and VICE

    VERSA.

  • Adjustments to the Accounts

    The goal of adjusting entries is to assure that

    assets, liabilities, and owners equity are properly stated.

    Four basic types of transactions that trigger

    adjusting entries:

    1. Expiration of unexpired costs

    2. Earning of revenues received in advance

    3. Accrual of unrecorded expenses

    4. Accrual of unrecorded revenues

  • 1. Expiration of Unexpired Costs

    Originally cash is paid and an asset is created.

    An adjustment recognizes an expense and reduces

    the corresponding asset.

    The cost is expired because of the passage of time.

    An explicit transaction has created an asset, and

    an implicit transaction adjusts the value of the

    asset.

    Examples include prepaid rent, depreciation

    expense, etc

  • 2. Earning of Revenues Received

    in Advance

    Unearned revenue/ deferred revenue/ Revenue received in

    advance - revenue received and recorded before it is

    earned

    Payment is received in exchange for a commitment to

    provide services or goods at a later date.

    This commitment is a liability the service or goods are owed to someone.

    For example, when a magazine publisher receives cash

    for a subscription, revenue is not earned until the

    publisher provides the subscriber with an issue of the

    magazine even though cash has been received

  • Earning of Revenues Received

    in Advance

    The transactions regarding prepaid expenses and

    unearned revenues are really mirror images of each

    other.

    Liabilities

    (Unearned

    Revenues)

    Revenues

    Earned

    Seller

    Adjustments

    Buyer

    Assets

    (Prepaid

    Expenses)

    Expenses

    Incurred

    Adjustments

    Appear in

    Balance Sheet

    Appear in

    Income Statement

    Appear in

    Balance Sheet

    Appear in

    Income Statement

  • 3.Accrual of Unrecorded Expenses

    Some expenses grow moment to

    momentit is awkward and unnecessary to make hourly, daily

    or even weekly formal recording of

    these expenses

  • 3.Accrual of Unrecorded Expenses

    The balances of accrued expenses are

    only important when financial

    statements are prepared.

    Consequently, adjustments to bring these

    accounts up to date are made at the end of

    an accounting period to match the

    expenses to the period.

  • a. Accounting for Payment of Wages

    Paying wages is an explicit transaction

    driven by writing a payroll check.

    As wages are paid, wage expense is

    recorded while cash is decreased.

    dr. cr.

    Wages expense 20,000

    Cash 20,000

  • a. Accounting for Accrual of Wages

    With accrued expenses, the accountant must

    determine if something additional should

    appear in the financial statements but as yet

    does not.

    Accrued expenses are recorded for amounts

    that are owed at the end of an

    accounting period but have not been

    paid in that accounting period.

  • Accounting for Accrual of Wages

    Calvin Corporation pays its employees $20,000 during the month of January. Calvin also owes its employees $3,000 for services rendered during the last three days of January, but the employees will not be paid until February 2.

    To ensure that all wages for the month of January are recorded, an adjustment must be made.

    31/1 Wages expense 3,000

    Accrued Wages Payable 3,000

  • Accounting for Accrual of Wages

    In both the actual payment and in the accrual

    of wages, an expense is created.

    In the payment, an asset (cash)

    is decreased.

    But in the accrual, a liability

    (accrued wages payable) is

    recorded and increased.

  • b. Accrual of Interest

    Interest is much like rent paid for the use of money.

    Interest accumulates (accrues) as time

    goes on, regardless of when the interest is

    actually paid.

    Interest = Principal x Interest rate x Fraction of a year

  • Accrual of Interest

    The entry to record the accrual of

    interest expense is very similar to the

    entry to record the accrual of wage

    expense.

    Interest expense xxx

    Accrued interest payable xxx

  • c. Accrual of Income Taxes

    As income is generated, income tax

    expense is accrued rather than paid by

    the company each time a dollar comes

    in.

    The entry to record accrued income

    taxes is similar to the accrual of other

    expenses.

  • 4. Accrual of Unrecorded Revenues

    The accrual of unrecorded revenues is the

    mirror image of the accrual of unrecorded

    expenses.

    The adjusting entries show the recognition

    of revenues that have been earned, but the

    entity has not received cash.

  • The Adjusting Process in Perspective

    The recording process has a final goal - the

    preparation of accurate financial statements

    prepared on the accrual basis.

    The final steps of the process can be shown as:

    Ledger Unadjusted

    Trial Balance

    Journalize &

    Post Adjustments

    Adjusted

    Trial Balance

    Financial

    Statements

  • The Adjusting Process in Perspective

    The expiration of unexpired costs

    Adjustments are made AFTER the cash

    flow.

    Advance Cash

    Payments for

    Future Services

    to be Rendered

    Noncash

    Assets in the

    Balance Sheet

    Expenses in

    the Income

    Statement

    Create

    Transformed by

    Adjustments

    Into

  • The Adjusting Process in Perspective

    Earning of revenues received in advance