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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

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 endof-period adjustments
Examples include depreciation
expense and the expiration of
prepaid rent.
June 2002

Adjustments to the Accounts

Adjustments (adjusting entries) - end-ofperiod 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.
2.
3.

4.

Expiration of unexpired costs


Earning of revenues received in advance
Accrual of unrecorded expenses
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.
Seller

Liabilities
(Unearned
Revenues)

Buyer
Revenues
Earned

Assets
(Prepaid
Expenses)

Adjustments

Appear in
Balance Sheet

Appear in
Income Statement

Expenses
Incurred
Adjustments

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.
Wages expense
Cash

cr.

20,000
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
Accrued Wages Payable

3,000
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
Accrued interest payable

xxx
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

Financial
Statements

Adjusted
Trial Balance

The Adjusting Process in Perspective

The expiration of unexpired costs

Adjustments are made AFTER the cash


flow.
Create

Advance Cash
Payments for
Future Services
to be Rendered

Transformed by
Adjustments
Into

Noncash
Assets in the
Balance Sheet

Expenses in
the Income
Statement

The Adjusting Process in Perspective

Earning of revenues received in advance

Adjustments are made AFTER the cash flow.


Transformed by
Adjustments
Into

Create

Advance Cash
Collections for
Future Services
to be Rendered

Liabilities in
the Balance
Sheet

Revenues in
the Income
Statement

The Adjusting Process in Perspective

Accrual of unrecorded expenses

Adjustments are made BEFORE cash flows.


Recorded by
Adjustments as
Increases in

Passing of Time
and Continuous
Use of Services

Expenses in
the Income
Statement
and
Liabilities in
the Balance
Sheet

Decreased
by

Later Cash
Payments

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

Decreased
by

Later Cash
Collections

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

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


Assets
Current assets:
Cash
Accounts receivable
Total current assets
Long-term assets:
Land
Equipment
Total plant assets
Total assets

STEVENS COMPANY
Balance Sheet
December 31, 2002
Liabilities and Owners Equity
$ 4,525
2,040

Current liabilities:
Accounts payable
Wages payable

6,565

Total liabilities

9,755
6,500
16,255
$22,820
=============

Owners Equity
Stevens, capital
Total liabilities and
owners' equity

$ 9,800
3,765
13,565

9,255
$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 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.

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

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
Rent revenue
Total revenues
Expenses:
Wages expense
Rent expense
Depreciation expense
Total expenses
Net Income

$ 98,600
4,000
$102,600
$45,800
12,000
5,000
62,800

$ 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 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.

2.
3.
4.

Gross profit percentage (gross margin


percentage)
Return on sales ratio
Return on stockholders equity ratio
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

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

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.