dynamics of accrual accounting and balance sheet

Accrual vs. Cash AccountingAccrual vs. Cash Accounting

Accrual Accounting

Records Revenue as earned( regardless of when cash is paid)

Records Expense as incurred( regardless of when expense is paid)


Accrual Accounting Records Revenue as earned( regardless of when cash is paid)

Records Expense as incurred( regardless of when expense is paid)

Cash Accounting• Records revenue as cash is received

( regardless when the sale is made)• Records Expense when paid

( regardless when the sale is made)


Accrual Accounting •Records Revenue as earned• Records Expense as incurred

Cash Accounting• Records revenue as cash is received• Records Expense when paid

Cash Accounting is not accepted by GAAP hence not used by companies.

Operating Cycle of BusinessOperating Cycle of Business

• Operating cycle of a business starts from cash brought in by owners which is used to by inputs. These are converted into finished product or service and sold to customers. To create receivables. When receivables are collected, we get cash again, to buy inputs.

• The different phases of this cycle are shown in the next slide.


Purchases

Inventory

Cash

A/cs Payable

Production

Finished Goods

Sales

A/cs Receivables

Collections

The Balance Sheet shows where the funds are

i.e. Assets

and who has helped business to acquire them.

i.e. Liabilities.


Sound Financial Management of a company

involves

matching the sources and uses of cash,

so that

obligations become due as assets mature into cash.


With sound review of a company’s Balance Sheet , one can monitor the ability of that company to

collect revenues

manage its inventory

plus satisfy its creditors & shareholders.

Review of Balance SheetReview of Balance Sheet

Balance Sheet - TermsBalance Sheet - Terms

Assets

• Are anything of value that is owned or due to the business.

• Classified as

Non-currentCurrentOthers


Non-Current Assets

Consist of

Net Fixed Assets

Investments in subsidiaries

Intangibles

Others


Non-Current Assets

Consist of Net Fixed Assets

Include Land, Buildings, Machinery & Equipment, Furniture & Fixtures, Vehicles etc.

Are long term investments that enable the business to carry on its operations.

Stated at book their value which is calculated asGross Fixed Assets (cost) less

accumulated depreciation.


Non-Current Assets

Consist of Net Fixed AssetsInvestments

Common forms of investment of surplus funds, by the companies are

Government or Trust Securities.Shares, Debentures, or BondsImmovable properties.In capital of subsidiaries.


Non-Current Assets

Consist of Net Fixed AssetsInvestments in subsidiaries Intangibles

Represent the use of cash to purchase assets with an undetermined life and may never mature into cash.

Research & Development PatentsMarket Research Goodwill

Standard accounting principles require most intangibles to be expensed as purchased and not capitalized.


Non-Current Assets

Consist of Net Fixed AssetsInvestments in subsidiaries Intangibles

Standard accounting principles require most intangibles to be expensed as purchased and not capitalized.

except purchased patents that may be amortized over the life of the patent


Current Assets

Consist of CashAccounts ReceivablesInventoryNotes ReceivablesPrepaid ExpensesOthers

They are assets that mature in less than one year .


Current Assets

Consist of Cash

Cash pays bills and obligations.Other assets cannot pay bills unless they are converted into cash.Includes all bank accounts, money market and short-term savings accounts.


Current Assets

Consist of CashAccounts Receivables

are money due from customers.are third most liquid asset after cash & short term investmentssome receivables can become uncollectiblethis expense is termed ‘ bad debts’these can be recorded by two methods $ Allowance method $ Direct write off Method


Current Assets


these can be recorded by two methods$ Allowance method An estimate is prepared for bad debts for the period and expense is recorded by journal entry

Bad Debt drTo Allowance for Bad Debts cr


Current Assets


these can be recorded by two methods $ Allowance method An estimate is prepared for bad debts for the periodThe estimate is based on

- % of sales method – income statement approach or- aging of receivables – balance sheet method


Current Assets


these can be recorded by two methods $ Allowance method $ Direct write off Method

the expense is recorded when specific account goes bad.journal entry is passed to debit Bad Debt expense and credit Accounts Receivables- xxx company.


Current Assets


these can be recorded by two methods $ Allowance method $ Direct write off Method

the method does not comply with Matching Revenue principle, as expense is recorded much later when specific account is un-collectible and goes bad


Current Assets

Consist of CashAccounts ReceivablesInventory

consists of materials company purchases to covert and sell as finished products.

the level of inventory has to be managed in such a waythat required materials are always available for production and sale with minimum funds locked in it.


Current Assets

Consist of CashAccounts ReceivablesInventory

the correct level of inventory is a function of the length of the company’s inventory cycle.

Inventory Cycle in Days = Ordering phase in days+ Production phase in days+ Finished Goods and Delivery

Phase in days


Current AssetsConsist of Cash

Accounts ReceivablesInventory

Quality Measurement & Goals

Both Receivables and Inventory can be managed by controlling their quality which is measured in days as follows.

Receivables Days = Actual Receivables x 360Sales in a year

Inventory Days = Actual Inventory x 360Cost of Goods sold in a year




Quality Measurement & GoalsBoth Receivables and Inventory can be managed by controlling their quality which is measured in days

Ideal receivables days should be close to average days of credit allowed to customers.

Ideal inventory days should be just over inventory cycle days.




Quality Measurement & GoalsBoth Receivables and Inventory can be managed by controlling their quality which is measured in days

Investment in Inventory and Accounts receivableis a function of sales and days.Increase due to sales is healthy.

But due to increase in days is costly as it is an indication of overstocking and inefficient collections.


Liabilities

Consist of CurrentNon-CurrentContingentEquity

“ Liabilities and net worth are sources of cash listed in descending order from the soonest to mature obligations to never to mature obligations.”


Liabilities

Consist of Current Liabilities

Are those obligations that mature and must be paid within 12 months.

They include Accounts Payable, Accrued Expenses, Notes Payable ( both Bank& Other) and Current Portion of Long Term Debt ( that part payable in next 12 months)


Liabilities

Consist of CurrentNon-Current Liabilities

Are those obligations that are not due and payable in the coming year.

Include long term secured or non secured loans, funds received from associates and promoters.


Liabilities

Consist of CurrentNon-CurrentContingent Liabilities

Are those obligations that hopefully never become due. They are potential liabilities which are not due on the day of reporting, but may, depending upon results of pending law suits and warranties and cross guarantees issued.


Liabilities

Consist of CurrentNon-CurrentContingent Liabilities

Are those obligations that hopefully never become due. They are potential liabilities which are not due on the day of reporting, but may, depending upon results of pending law suits and warranties and cross guarantees issued.

These are indicated by a foot notein the Balance Sheet


LiabilitiesConsist of Current

Non-CurrentContingentEquity and Net Worth

Equity and net worth are last to mature source of funds. It has two parts :Purchased Equity – Paid up Equity Shares and Preference

SharesEarned Equity – retained earnings ( profits) shown as

Reserves and Earned Surplus.

“ Accrual accounting records revenues as earned and expense as incurred, ignoring when payments arranged.”

“ Operating cycle of business involves process of converting the raw material to cash’

“Matching principle demands that against revenue of a period all expenses in that period are included”

“Non-current assets are those that do not mature into cash in a year”

“contingent Liabilities are potential and not actual ones as of date”

dynamics of accrual accounting and balance sheet

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