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FIN 335 Topic 2 GAPP & Accruals Accounting

1. GAPP

a. The SEC & FASB

2. The Sarbanes Oxley Act

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a.
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b.
3. Earnings Quality and Managerial Discretion
a. Choices of accounting policies, discretionary estimates and changes in estimates --The
choice of accounting policies affects the timing of revenue and expense recognition
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i. Policies that accelerate revenue recognition tend to increase current earnings

while those that delay it reduce current earnings.
ii. Policies that accelerate expense recognition tend to reduce current earnings
while those that delay it tend to raise current earnings.
iii. Choice b/w accelerated and straight-line depreciation, and impact in early
years of asset’s life:
1. Accelerated: decrease current earnings (CE)
2. Straight-line: increase current earnings
3. Example: Cost of the fixed asset = $60,000, asset life=10 yrs, salvage
value=0. Using accelerated (double-declining balance method), and SL
depreciation what’s the depreciation cost in year 1? Impact on NI?
a. SL method: Dep =60,000/10=$6000
b. Accelerated: Dep = 60,000/10*2=$12000
i. Year 2 Accel Dept = (60,000 – 12,000)/9 years (how
many years left) *2 = $10,667
c. Net Income (Straight Line) > Net Income (Accelerated)
d. Managers will use SL to increase net income during the first
year
b. Choice of inventory valuation methods
i. LIFO (last in first out): Assumes that the newest units in the inventory are the
first units sold.
ii. FIFO (first in first out): Assumes that the oldest unites in the inventory are the
first units sold.
iii. In periods of rising prices (inflation)
1. LIFO - Accelerate expense, decrease CE
2. FIFO - Delays expense, increase CE
iv. In periods of decreasing prices (deflation)
1. LIFO – increase CE
2. FIFO – decrease CE
v. In periods of rising prices, gross profit under FIFO is higher than that under LIFO
c. Choice of inventory valuation methods
i. Example: In 2018, Goodyear has 6 tires in inventory, 4 of which were sold for
$100 each. What’s the gross profit for 2018?
1. 2017 Tires #1 40, #2 40
2. 2018 Tires #3 50, #4 50, #5 60, #6 60
a. LIFO
i. COGS = 50*2+60*2 = 200
ii. Gross = 4*100-220 = $180
b. FIFO
i. COGS = 40*2+50*2 = 180
ii. Gross = 4*100 – 180 = 220
d. The choice of revenue recognition methods for long-term projects/contracts
i. The percentage of completion method
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1. Recognize revenue as it is earned gradually during the construction

period rather than after it’s completed
a. Can only be used if:
i. Contract clearly specifies the price and payment options
ii. Buyer is expected to pay the whole amount
iii. Seller is expected to complete the project
b. Formula= (cost incurred to date/total estimated cost)
*contract price
i. Find revenue in Year 2 = Year 2 – Year 1
c. Tends to accelerate revenues and increase CE
ii. The completed contract method
1. Recognize revenue only when the project is complete
a. Tends to delay revenue recognition and decrease CE
e. Example for long-term projects
i. Contract price = $5 bill
ii. Total estimate cost = $4 bill
1. Year 1: Cost incurred to date = $1 bill
a. Cumulated revenue = 1/4*5 = $1.25 bill
b. Revenue in year 1 = $1.25 bill
2. Year 2: Cost incurred to date = 3 bill
a. Cumulated Revenue = 3/4*5 = $3.75 bill
b. Revenue in year 2 = 3.75 – 1.25 = $2.5 bill
f. Managers also have discretion in making accounting estimates. Decide which of the
following discretions affect revenue recognition and which affect expense recognition.
i. The cost of warranty plans (Expense)
ii. The amount of bad debt in the firm’s receivables (Expense)
iii. The degree of completion of long-term projects (Revenue)
iv. The amount of assets that are impaired and that need to be written off
(Expense)
g. The timing of revenue and expense recognition
i. When to write off bad debts
ii. When to write down the value of obsolete inventory or other impaired assets
iii. Whether or not to capitalize certain costs in the current year
1. Example
a. Equipment cost $50,00 assets life = 5 years
b. If you capitalize in 2020 – Only capitalize if it brings the firm a
benefit in the next 5 years (justified)
i. On Balance Sheet: long term asset = $50,000
ii. On Income statement: Depreciation = $10,000
c. If you expense in 2020,
i. On income statement: expense = $50,000
h. The recognition and the magnitude of certain discretionary expenditures – when and by
how much to recognize
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i. R&D expenditures – (GAPP) R&D expenses have to be expensed in the year they
occur
ii. Repairs and maintenance expenditures
iii. Advertising expenditures
iv. Expenditures on new plant and equipment
1. These expenditures have both immediate and long-term impact on
profitability in opposite direction:
a. Immediate impact: Increase in Net Income
b. Long-term: lower Net Income for a few years in the future
i. The timing and magnitude of non-recurring and non-operating expense or income
items, such as: (usually only 1 time)
i. Restructuring charges
1. Gain or loss on sale of an asset or business segment
ii. Other special charges
1. Write down for the impairment of assets, accounting changes,
extraordinary items
j. Financial Statement Footnotes
i. Financial statement footnotes provide information on management
discretionary choices
ii. The analysts cannot properly interpret a company’s financial statements
without understanding the footnotes to the financial statements
4. Cash and Accrual-basis Accounting
a. The separation of a company’s economic life into small accounting periods, e.g. years
and quarter, causes measurement problems in financial accounting, and leads to the use
of what are called accruals.
i. Example: You and your two friends decide to start a software company. You
each contribute $5,000 (a total of $15,000) to buy computer equipment and
develop an application that you sell by mail. You operate the business for 3
years, at which time you decide the market for the product has dried up, so you
pay off all of the bills and liquidate the company. The company ends up with
$37,500 cash in the bank. If you divide up the cash at the end of year 3, how
much do each of you get?
1. You each get= (37,500 – 15,000) / 3 = 22,500 / 3 = $7,500
ii. But what if you can’t wait 3 years to compute net income?
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1. The need for timely financial accounting information, produced for

discrete accounting periods makes financial reporting much more
complex than it would be if financial statements were prepared just
once at the end of a firm’s life.

2. Net/gain loss = 13,000 – 15,000 = -2,000

iii. GAAP requires that the net incomes to be measured using accrual-basis
accounting.
iv. Under accrual method
1. Revenue is recognized in the accounting period in which is it earned,
rather than when it is received in cash.
2. Expense is recognized in the same period as the revenue it relates to or
in the period to which it is attributable.
v. Note
1. If we could simply wait and compute one net income number when the
business is wrapped up and liquidated, there would be no need for
accrual accounting.
2. Accrual accounting modifies cash receipts and disbursements to arrive
at net income.
vi. Compare the NI under accrual and cash methods
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a. Sales rev - Cash received for units not shipped = $3000 for
(accrual method)
b. Computer exp – cost of computers relating to years 2 and 3 =
(6,000)
c. Rent exp – additional rent exp owed at years end = 900
d. Blank CD exp – cost of blank CDs used in year 2 = (350)
e. Shipping box exp – cost of shipping boxes used in year 2 =
(1,200)
vii. Accruals are necessary because:
a. Companies enter transactions that affect more than one
accounting period
b. In many transactions, the economic effect of the transaction
takes place in a different accounting period from the cash flow
effect
2. Calculate accruals
a. Net income = Cash flow from operations + Accruals
b. Cash flows are better for predicting NI
3. Therefore,
a. If a manager increases accruals estimate, net income will
INCREASE
b. If a manager decreases accruals estimate, net income will
DECREASE
4. Accruals-related accounts include:
a. Accounts receivable, prepaid expenses, accrued taxes
depreciable assets accounts, account payable, accrued wages