ch-4, accrual accounting

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 - 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.


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 (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


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.


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 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


Earning of revenues received in advance

Adjustments are made AFTER the cash flow.

Advance Cash

Collections for

Future Services

to be Rendered

Liabilities in

the Balance

Sheet

Revenues in

the Income

Statement

Create

Transformed by

Adjustments

Into


Accrual of unrecorded expenses

Adjustments are made BEFORE cash flows.

Passing of Time

and Continuous

Use of Services

Recorded by

Adjustments as

Increases in

Expenses in

the Income

Statement

and

Liabilities in

the Balance

Sheet

Later Cash

Payments

Decreased

by


Accrual of unrecorded revenues

Adjustments are made BEFORE cash flows.

Passing of Time

and Continuous

Rendering of

Services

Recorded by

Adjustments as

Increases in

Revenues in

the Income

Statement

and

Noncash Assets

in the Balance

Sheet

Later Cash

Collections

Decreased

by


Each adjusting entry affects at least one income

statement account (revenue or expense) and one

balance sheet account (asset or liability).

Never debit or credit Cash in an adjusting entry.

Adjust Cash

Classified Balance Sheet

Classified balance sheet - a balance sheet

that groups the accounts into subcategories

to help readers quickly gain a perspective on

the companys financial position

Assets are usually classified as current

assets and long-term assets.

Liabilities are usually classified as current

liabilities and long-term liabilities.

Classified Balance Sheet STEVENS COMPANY

Balance Sheet

December 31, 2002

Assets Liabilities and Owners Equity

Current assets: Current liabilities:

Cash $ 4,525 Accounts payable $ 9,800

Accounts receivable 2,040 Wages payable 3,765

Total current assets 6,565 Total liabilities 13,565

Long-term assets:

Land 9,755

Equipment 6,500 Owners Equity Total plant assets 16,255 Stevens, capital 9,255

Total liabilities and

Total assets $22,820 owners' equity $22,820 ============= =============

Current Assets and Liabilities

Current assets - include cash plus assets that are

expected to be converted to cash, sold, or

consumed during the next 12 months or within the

normal operating cycle if longer than a year

Current liabilities - include liabilities that fall due

within the coming year or within the normal

operating cycle if longer than a year


Current assets are listed in the order in which they will be converted to cash.

Cash is always listed first; then Accounts Receivable, Notes Receivable, and Interest Receivable are listed.

Non monetary assets (inventory, prepaid expenses) are listed last in the current assets section.

- Tangible Vs Non-Tangible Assets

Current liabilities are listed in the order in which they will draw on, or decrease, cash during the coming year.


Working capital - the excess of current

assets over current liabilities

It connects the assets and the liabilities of

the company.

Working

Capital Current assets-Current Liabilities

Current Ratio/

Working Capital Ratio

Comparing the amount of cash a company

will have on hand and the amount of debt the

company will have to pay off with that cash

can help readers assess an entitys liquidity.

Liquidity - an entitys ability to meet its immediate financial

obligations with cash and near-cash

assets as they become due

Current Ratio

The current ratio (working capital ratio) is used

to evaluate liquidity.

The higher the current ratio, the more assurance

creditors have that the entity can pay its bills on

timehowever this may not be true always!!!

Current Ratio = Current Assets

Current Liabilities

Current Ratio

An old rule of thumb was that an

acceptable current ratio would be

greater than 2.0, but realistically, a

current ratio over 1.0 is acceptable.

One way of assessing the current ratio

is to compare it to the average current

ratio of the industry in which the

company operates.

Quick Ratio/ Acid Test Ratio

Quick Ratio

= Current Assets Inventory - Prepaid Expenses

Current Liabilities

Formats of Balance Sheets

Balance sheet formats:

Report format - a classified balance sheet with

assets at the top and liabilities and equity below

Account format - a classified balance sheet with

assets at the left and liabilities and equity at the

right

Regardless of format, balance sheets always

contain the same basic information.

Income Statements

Most users of financial statements are

concerned about the entitys ability to produce long-run earnings and dividends.

This information can be found in the income

statement.

Income statements can be prepared with

subcategories to make them easier to read

and more informative.

Single- and Multiple-Step Income

Statements

Income statement formats:

Single-step income statement - groups all

revenues together and then lists and deducts all

expenses together without drawing any

intermediate subtotals

Multiple-step income statement - contains one or

more subtotals that highlight significant

relationships

A single-step income statement:

STEVENS COMPANY

Income Statement

for the Year Ended December 31, 2002

Sales $ 98,600

Rent revenue 4,000

Total revenues $102,600

Expenses:

Wages expense $45,800

Rent expense 12,000

Depreciation expense 5,000

Total expenses 62,800

Net Income $ 39,800 ================

Multiple-Step Income Statements

Sections and intermediate subtotals on multiple step income statements:

Gross profit (gross margin) - excess of sales revenue over the cost of inventory that was sold

Operating expenses - a group of recurring expenses that pertain to a firms routine operations

Operating income (operating profit) - gross profit less all operating expenses

Other revenues and expenses - items not directly related to the main operations of a firm

Multiple-Step Income Statement Format

(Rs. In Lakhs)

Sales Revenue

Less: Cost of Goods sold

Gross Profit/ Gross Margin

Less: Operating Expenses

Operating Income/ Operating Profit

Add: Non-operating Revenues

Less: Non-operating Expense

Profit Before Tax

Less: Tax

Profit After Tax/ Net Income

Multiple-Step Income Statements

Accountants generally regard interest revenue and interest expense as OTHER revenue and expense items

Operating income eases the comparison between years and between companies by not considering the OTHER revenue and expense items

Profitability Evaluation Ratios

Income statements are most useful in

evaluating an entitys profitability, which is the ability of a company to provide investors

with a particular rate of return on their

investment.

Return on investment - the amount

of money an investor receives

because of a prior investment


Profitability comparisons are used to compare one

company over a period of time or to compare

several companies over the same period of time.

Four popular profitability ratios: 1. Gross profit percentage (gross margin

percentage)

2. Return on sales ratio

3. Return on stockholders equity ratio

4. Return on Assets

Four popular profitability ratios

1. Gross Profit% Or Gross Margin %

= Gross Profit * 100

Sales

2. Return on Sales OR Net Profit Margin

= Net Income *100

Sales

3. Return on Common stockholders equity

= Net Income * 100

Average Common equity

Four popular profitability ratios

4. Return on Assets

= Net Income *100

Average Total Assets


Gross profit % varies greatly with the

nature of industry

E.g.: Gross profit % would be generally

high for software companies and low for

retail companies

Generally Accepted Accounting

Principles (GAAP)

If every accountant used his or her own rules for

recording transactions, the financial statements

would be useless in making comparisons.

Therefore, accountants have agreed to apply a

common set of measurement principles (a common

language) to record information on financial

statements. Otherwise, decision makers could not

use or compare financial statements.

Generally Accepted Accounting Principles

(GAAP)

Generally accepted accounting principles

(GAAP) - a term that applies to the broad

concepts or guidelines and detailed

practices in accounting, including all the

conventions, rules, and procedures that

make up accepted accounting practice at a

given time

Generally Accepted Accounting

Principles and Basic Concepts

Accounting principles become generally accepted by agreement.

Experience, custom, usage, and practical

necessity contribute to a set of principles.

Accounting conventions

might be a better way to

describe these rules

because GAAP are not

the result of airtight logic.

ch-4, accrual accounting

Documents

obvious transactions

accounts adjustments

period entries

ledger adjustments

basic types of transactions

entries end

period adjustments examples

accrual of unrecorded