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ACCRUAL ACCOUNTING

TIMELINE

EXPLICIT VS IMPLICIT ACCOUNTING

Explicit transactions are events that trigger nearly all day-to-day entries Implicit transactions are events that are temporarily ignored in day-to-day recording procedures and are recognized only at the end of an accounting period (e.g., depreciation expense, expiration of prepaid rent).

Explicit / implicit transaction? payment of one year's rent in advance payment of dividends to stockholders recording monthly depreciation on equipment expiration of prepaid rent

THE ROLE OF ADJUSTMENTS IN ACCRUAL ACCOUNTING Making adjustments (adjusting entries) is the key final process Accrue means to accumulate a receivable or payable during a given period even though no explicit transaction occurs Overstated / understated Assets End of the period .based on reality .

b.accrual of unrecorded revenues .expiration or consumption of assets (unexpired costs). c. and d.realization (earning) of unearned revenues (revenues received in advance). accrual of unrecorded expenses.There are four types of adjusting entries a.

. Asset expirations are written off to expense (e. Lease Expense Prepaid Rent Dr Cr This entails computing the portion of an asset used up as expense in the current period. Assets can be considered unexpired costs.20X8. equipment) . which are consumed over time.g. inventory. prepaid rent.HOW MUCH YOU USED OR CONSUMED YOUR ASSETS? The warehouse 12-month lease has expired on September 1.

Supplies over time are used : Supplies Expense Dr Supplies Cr Depreciation Depreciation Expense Dr Accumulated Depreciation Cr .

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understatement of liabilities. d.understatement of assets.A company recorded cash purchases of equipment in the Depreciation Expense account when purchased. The result would be an: a. c. . b.overstatement of liabilities. overstatement of assets.

Example : y Kavya Caterering Service are paid Rs 50000 for the service they would offer on 20th Feb (few days from now) Dr Cr Cash Unearned Revenue .UNEARNED REVENUE Revenue that is received and recorded before it is earned.

e end of month say you want to make the financial statements. We had Cash Unearned Revenue y Dr Cr Now we need to realize the unearned revenue Unearned Revenue Dr Service Revenue Cr . On 28th feb i.

Liability Balance sheet .

employees) up to the end of an accounting period. The entity has an expense not previously recognized and a liability in the form of a legal obligation to pay. .ACCRUAL OF UNRECORDED EXPENSES This entails computing the amount owed for goods and services rendered to the entity by the outside parties (suppliers.

EXAMPLES Wages paid for every 10 days and statement is made on the 5th day. Adjustment would be : accrued wages. Wages Expense Accrued Wages Payable xxx xxx .

Tax Expense xxx Accrued Tax Payable xxx Accrued interest (principal x interest rate x fraction of year). Interest Expense xxx Accrued Interest Payable xxx .Accrued income tax.

ABC borrowed Rs 100000 on March 31st 2008 and needs to repay with 12% interest March 31st 2008 March 31st 2009 Interest Expense 12000 Accrued Interest Payable 12000 March 31st 2008 Dec 31st 2008 Interest Expense 9000 Accrued Interest Payable 9000 .

.CONT« ABC borrowed from XYZ bank Accrued Receivable Interest Revenue xxx xxx ‡ Accrual of Unrecorded Revenues ‡ The adjusting entries show the recognition of revenues that have been earned but not yet shown in the accounts.

Ledger Unadjusted Trial balance Journalize and post adjustment Adjusted Trial Balance Prepare Financial .

Adjusting entry Type of account Debited Type of account Credited Prepaids or Accumulated Depreciation Expiration of unexpired costs Expense Realization (earning) of unearned revenue Unearned Revenue Accrual of unrecorded expenses Accrual of unrecorded revenue Revenue Expense Payable Receivable Revenue .

The company's December 31 trial balance follows.000 $700 . ANDREW CORPORATION TRIAL BALANCE DECEMBER 31.Andrew Corporation began operation on January 1 of the current year.800 $1. 20x2 Ending office supplies on hand: Prepaid insurance expired during the period: Depreciation expense on furniture: Accrued salaries owned to employees: $100 $1.

FORMATS BALANCE SHEET Balance sheet Report Format Assets Liabilities Stockholder·s Equity Assets Liabilities Stockholder·s Equity Account Format .

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or classifications. categories. The asset classifications and their order of appearance on the balance sheet are: Current Assets Investments Fixed Assets Intangible Assets Other Assets .CLASSIFIED BALANCE SHEET "Classified" means that the balance sheet accounts are presented in distinct groupings.

If a company's operating cycle is longer than one year. supplies. accounts receivable. prepaid insurance. an item is a current asset if it will turn to cash or be used up within the operating cycle. temporary investments. cash. Current assets are presented in the order of liquidity. . i.. inventory.CURRENT ASSETS Cash and other resources that are expected to turn to cash or to be used up within one year of the balance sheet date.e.

Examples: interest payable. .LIABILITIES Current Liabilities y Obligations of the enterprise that are payable within one year of the balance sheet date. Two examples are bonds payable and long term notes payable. wages payable Fixed Liabilities y Obligations of the enterprise that are not payable within one year of the balance sheet date.

LETS IDENTIFY Patent Building Prepaid rent Wages payable Notes payable in 5 yrs Inventory Prepaid Insurance A/R Unearned revenue Short term investment Building to be sold at later point in time Accumulated depreciation .

FINANCIAL ANALYSIS .

WORKING CAPITAL Current asset ² Current liability An indicator of whether the company will be able to meet its current obligations (pay its bills. The greater the amount of working capital the more likely it will be able to make its payments on time. make a loan payment. Industry dependent .) If a company has current assets exactly equal to current liabilities. meet its payroll. it has no working capital. etc.

Reveals the financial position of the company Greater Working capital implies less financial strain Foresee financial difficulties Lower working capital Increased borrowing Late payment to creditors Lower credit rating .

It is wise to compare a company·s current ratio to that of other companies in the same industry .CURRENT RATIO The current ratio is used as an indicator of a company·s liquidity. Current asset / Current liability A ratio of 3:1 is better than 2:1. A 1:1 ratio means there is no working capital.

.HOW DO WE ASSESS ? Below 1 implies negative working capital Greater than 1 implies can easily meet the short term obligations Very high implies too much of unmanaged liquid cash.

QUICK TEST RATIO The Quick Test Ratio (also called the Acid Test or Liquidity Ratio) is test of a company's financial strength and liquidity. Current Assets ² Inventory Current liabilities It is a reflection of the liquidity of a business. The Quick Test ratio does not apply to the handful of companies where inventory is almost immediately convertible into cash . Removal of less liquid assets form numerator.

000 What is Donald's current ratio? a.0 d. 3. 20x2 includes: Current assets Current liabilities Total assets Total liabilities $ $ $ $ 60.2.0 . 31.0 b.000 90.000 45.Donald Corp.000 15.6.'s balance sheet as of Dec.0 c.4.

Calculate Working capital current ratio and acid test ratio .

The single-step format uses only one subtraction to arrive at net income. A single-step income statement is one of two commonly used formats for the income statement or profit and loss statement. Net Income = (Revenues + Gains) ² (Expenses + Losses) An extremely condensed income statement in the single-step format would look like this: .

The multiple-step profit and loss statement segregates the operating revenues and operating expenses from the nonoperating revenues. nonoperating expenses. and losses. . gains. The multiple-step income statement also shows the gross profit (net sales minus the cost of goods sold).

Profitability comparisons through time and within industries are used as a basis for predictions and decisions by both internal and external users of financial statements. Rate of return is the return per dollar invested.PROFITABILITY RATIOS Profitability ratios show a company's overall efficiency and performance. .

This ratio looks at how well a company controls the cost of its inventory and the manufacturing of its products and subsequently pass on the costs to its customers. The calculation is: Gross Profit/Net Sales .GROSS PROFIT The gross profit margin looks at cost of goods sold as a percentage of sales.

and depreciation . The net profit margin measures profitability after consideration of all expenses including taxes. interest.NET PROFIT MARGIN Return on sales ratio (net profit margin ratio): Net income Sales Return on sales = Shows how much of each sales dollar shows up as net income after all expenses are paid.

Net Income/Total Assets ROE measures the return on the money the investors have put into the company.RETURN ON ASSETS AND RETURN ON EQUITY RATIO ROA measures the efficiency with which the company is managing its investment in assets and using them to generate profit. Net Income/Stockholder's Equity This is the ratio potential investors look at when deciding whether or not to invest in the company .

SUMMARY The role of adjustments in accrual accounting. Single. A classified balance sheet and use it to assess short-term liquidity. .and multiple-step income statements Use ratios to assess profitability.

working capital c. current ratio d.Which of the following is not used in solvency determination? a.return on sales ratio b.none of the above .

5% b. 25% d.000 $ 25. has the following income statement items for the year 20x2: Sales Gross profit Operating expenses Net income $ 100.Morton Corp.000 $ 47.000 $ 72. 40% . 10% c.000 What is Morton's return on sales? a.

000 for the year 2007. Calculate ROE . It does not have any preferred stock outstanding and its stockholders· equity was $950.000 at the beginning of 2007 and was $1.A corporation·s net income after tax was $100.000 at the end of 2007. The increase was at a uniform rate throughout the year.050.

PROBLEM Sales COGS Depreciation Expense Rent Revenue 1800 1000 60 20 Interest Expense Utilities Expense Interest Revenue Wage Expense 138 110 28 400 Income tax rate 40% .

SOLUTION .

END OF CHAPTER .