Download - Ch-4, Accrual Accounting
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Chapter 4
Accrual Accounting
and
Financial Statements
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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.
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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.
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Based on how obvious transactions are,
they can be classified into two categories:
Explicit Transactions
Implicit
Transactions
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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.
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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
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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
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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
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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.
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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.
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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
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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
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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
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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
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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
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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.
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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
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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.
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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
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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.
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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
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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
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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.
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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.
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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
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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
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The Adjusting Process in Perspective
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
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The Adjusting Process in Perspective
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
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The Adjusting Process in Perspective
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
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The Adjusting Process in Perspective
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
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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.
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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 ============= =============
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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
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Current Assets and Liabilities
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.
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Current Assets and Liabilities
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
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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
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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
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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.
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Quick Ratio/ Acid Test Ratio
Quick Ratio
= Current Assets Inventory - Prepaid Expenses
Current Liabilities
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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.
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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.
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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
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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 ================
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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
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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
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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
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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
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Profitability Evaluation Ratios
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
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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
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Four popular profitability ratios
4. Return on Assets
= Net Income *100
Average Total Assets
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Profitability Evaluation Ratios
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
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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.
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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
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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.