CH - 04 Accrual Accounting & Financial Statements

Accrual Accounting and Financial Statements
CHAPTER
2006 Prentice Hall Business Publishing
Introduction to Financial Accounting, 9/e
Horngren/Sundem/Elliott/Philbrick
Learning Objectives
After studying this chapter, you should be able to
1. Understand the role of adjustments in accrual accounting 2. Make adjustments for the expiration or consumption of assets 3. Make adjustments for the recognition of unearned revenues 4. Make adjustments for accrual of unrecorded expenses 5. Make adjustments for the accrual of unrecorded revenues
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Learning Objectives
After studying this chapter, you should be able to
6. Describe the sequence of the final steps in the recording process and relate cash flows to adjusting entries 7. Prepare a classified balance sheet and use it to assess short-term liquidity 8. Prepare single- and multiple-step income statements 9. Use ratios to assess profitability
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Adjustments to the Accounts

Explicit transactions are
Observable events that trigger nearly all day-to-day routine entries Supported by source documents
Implicit transactions
Do not generate source documents or any visible evidence that the event actually occurred Are recorded in end-of-period entries called adjustments
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Adjustments help assign the financial effects of implicit transactions to the appropriate time periods Accrue means to accumulate a receivable (asset) or payable (liability) during a given period even though no explicit transaction occurs
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Adjustments arise from four basic types of implicit transactions:
Expiration of unexpired costs Earning of revenues received in advance Accrual of unrecorded expenses Accrual of unrecorded revenues
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Expiration of Unexpired Costs

An explicit transaction in the past creates an asset, and subsequent implicit transactions serve to adjust the value of the asset Suppose a company purchases $10,000 of Office Supplies Inventory on March 1, 2005. The journal entry to record this explicit transaction is:
Office Supplies Inventory Cash $10,000 $10,000
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The company uses $1,500 of the Office Supplies Inventory during the month. The following adjusting entry is required to increase Office Supplies Expense (debit) and reduce Office Supplies Inventory (credit):
Office Supplies Expense Office Supplies Inventory $1,500 $1,500
Failure to make this adjusting entry will overstate assets and understate expenses
2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 8 of 45

Buyer
Assets (Prepaid Expense) Appear in the Balance Sheet
Adjustments
Expenses Incurred
Appear in the Income Statement
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Earning of Revenues Received in Advance

Unearned revenue (revenue received in advance or deferred revenue)
Represents payments from customers who pay in advance for goods or services that the company promises to deliver at a future date Requires recording both the receipt of cash and the liability for future services
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A company receives rent for 3 months in advance, $6,000 The journal entries below represent
a) An explicit transaction that recognizes the receipt of unearned revenue b) A transaction showing the adjustment for one months rent earned
(a) Cash 6,000 Unearned rent revenue (b) Unearned rent revenue 2,000 Rent revenue
2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e
6,000 2,000
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The revenue is recognized (earned) only when the owner makes the adjusting entries in transaction (b) The liability Unearned Rent Revenue is decreased (debited), the stockholders equity account Rent Revenue is increased (credited) Failure to record the adjusting entry overstates liabilities and understates revenues
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Seller
Liabilities (Unearned Revenue) Appear in the Balance Sheet
Adjustments
Revenues Earned
Appear in the Income Statement
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Accrual of Unrecorded Expenses

Some liabilities (and expenses) grow moment to moment with the passage of time. Examples include:
Wages Interest Income taxes
Adjustments are made to bring each accrued expense (and corresponding liability) account up to date at the end of the period before preparation of the financial statements
Adjustments are necessary to accurately match the expense to the period
Accounting for Accrual of Wages

Assume a company owes $30,000 for employee services rendered during the last 3 days of the month of January, but will not pay the employees for these services until Friday, February 2 The following transaction shows the entry to accrue wages for Monday, January 29, through Wednesday, January 31
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Accounting for Accrual of Wages

The transaction recognizes both an expense and a liability
Wages expense Accrued wages payable
30,000
30,000
Failure to record the adjustment understates both expenses and liabilities

Accrual of Interest
Interest is the rent paid for the use of money Interest accumulates (accrues) as time passes, regardless of when a company actually pays cash for interest Assume a company borrows $100,000 on December 31, 2005, and the terms of the loan require repayment of the loan amount of $100,000 plus interest on December 31, 2006
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Accrual of Interest
Calculation of interest for any part of a year is as follows:
Principal x Interest rate x Fraction of a year = Interest
For the full year, the interest is:

$100,000 x .09 x 1 = $9,000
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Accrual of Interest
As of January 31, the amount of interest owed is 1/12 x .09 x $100,000 = $750 The adjusting journal entry is:
Interest expense Accrued interest payable 750
750
Failure to record the adjustment understates both liabilities and expenses
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Accrual of Unrecorded Revenues

The accrual of unrecorded revenues is the mirror image of the accrual of unrecorded expenses An adjustment is required to recognize revenues earned but not received in cash
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Assume a law firm renders $10,000 of services during January, but does not bill for these services until March 31 The following adjustment is made for unrecorded revenues for the month of January
Accrued (Unbilled) Fees Receivable Fee Revenue 10,000 10,000
Failure to make this adjustment understates both assets and revenues
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Ethics, Unearned Revenue and Revenue Recognition

Conservatism means selecting methods of measurement that yield
Lower net income Lower assets Lower stockholders equity
It is unethical to knowingly overstate revenue and net income
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The Adjusting Process in Perspective

The complete accounting cycle now becomes
Transactions Documentation Journal Ledger
Unadjusted Trial Balance
Journalize and Post Adjustments
Adjusted Trial Balance
Financial Statements
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Each adjusting entry affects at least
One income statement account and One balance sheet account
The Cash account is not adjusted The end-of-period adjustment process is reserved for implicit transactions, which anchor the accrual basis of accounting
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Advance Cash Payments for Future Services to be Received
Create
Noncash Assets in the Balance Sheet
Transformed by
Expenses in the Income Statement
Advance Cash Collections for Future Services to be Rendered
Create
Liabilities in the Balance Sheet
Transformed By Adjustments into
Revenues in the Income Statement
Earnings of Revenues Received in Advance
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Passing of Time and the Continuous Use of Services
Recorded by Adjustments as Increases in
Expenses in the Income Statement
and
Liabilities in the Balance Sheet
Decreased by
Later Cash Payments
Accrual of Unrecorded Expenses
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Passing of Time and the 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
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Classified Balance Sheet

A classified balance sheet further groups asset, liability, and owners equity accounts into subcategories Assets are classified into two groups:
Current assets Noncurrent (or long-term) assets
Liabilities are classified into

Current liabilities Noncurrent (or long-term) liabilities

Current assets are cash and other assets that a company expects to convert to cash, sell, or consume during the next 12 months (or within the normal operating cycle if longer)
Current assets are listed in the order in which they are likely to be converted to cash during the coming year
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Current liabilities are those that come due within the next year (or within the operating cycle if longer) Current liabilities are listed in the order in which they will decrease cash during the coming year Working capital is the excess of current assets over current liabilities The following slide shows the classified balance sheet for Chan Audio Company:

Chan Audio Company Balance Sheet January 31, 20X2 Assets Current assets: Cash $ 71,700 Accounts receivable 160,300 Note receivable 40,000 Accrued interest receivable 400 Merchandise inventory 250,200 Prepaid rent 10,000 Total current assets $532,600 Long-term asset: Store equipment $114,900 Accumulated depreciation 1,000 113,900 Total $646,500 Liabilities and Owners Equity Current liabilities: Accounts payable $117,100 Unearned rent revenue 2,500 Accrued wages payable 3,750 Accrued interest payable 750 Accrued income taxes payable 11,200 Note payable 100,000 Total current liabilities $235,300 Stockholders Equity: Paid-in capital $400,000 Retained earnings 11,200 411,200 Total $646,500
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Current Ratio
Liquidity is a companys ability to pay its immediate financial obligations with cash and near-cash assets The current ratio evaluates a companys liquidity
Current Ratio = Current assets Current liabilities
Chan Audios current ratio is $532,600 = 2.3

$235,300
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Current Ratio
The quick ratio removes Inventory (and other less liquid assets such as Prepaid Expenses) from the numerator of the calculation Chan Audios quick ratio is
$532,600 - $250,200 = 1.2 $235,300
The current ratio should be greater than 2.0

The quick ratio should be greater than 1.0
Formats of Balance Sheets

A balance sheet may be presented in the
Report format Account format
The report format presents the accounts vertically The account format puts the assets at the left and liabilities and owners equity at the right Either format is acceptable
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Income Statement Formats

Two commonly used formats for income statements are the
Single-step income statement Multiple-step income statement
The next slide presents a single-step income statement for Chan Audio Company
It groups all types of revenue together It lists and deducts all expenses without drawing any intermediate subtotals
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Single-Step Income Statement

Chan Audio Company Income Statement For the Month Ended January 31, 20X2 Sales $160,000 Rent revenue 500 Interest revenue 400 Total sales and other revenues $160,900 Expenses: Cost of goods sold $100,000 Wages 31,750 Depreciation 1,000 Rent 5,000 Interest 750 Income taxes 11,200 Total Expenses 149,700 Net income $ 11,200
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Multiple-Step Income Statements

Most multiple-step income statements disclose
Gross profit (gross margin) The excess of sales revenue over the cost of the inventory that was sold Operating expenses A group of recurring expenses that pertain to the firms routine, ongoing operations (wages, rent, depreciation, telephone, heat, advertising, etc.) Operating income The remainder of gross profit after the deduction of operating expenses
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Multiple-Step Income Statements

Nonoperating revenues and expenses Revenues and expenses not directly related to the mainstream of a firms operation Other (nonoperating) revenue and expenses Revenues and expenses that are not part of the ordinary operations of selling goods or services; i.e., interest revenue and interest expense
Income taxes appear in both income statement formats The next slide presents a multiple-step income statement for Chan Audio Company
Multiple-Step Income Statement

Chan Audio Company Income Statement For the Month Ended January 31, 20X2 Sales $160,000 Cost of goods sold 100,000 Gross profit 60,000 Operating expenses: Wages $ 31,750 Depreciation 1,000 Rent 5,000 37,750 Operating income $ 22,250 Other revenues and expenses: Rent revenue $ 500 Interest revenue 400 Total other revenue $ 900 Deduct: Interest expense 750 150 Income before income taxes $ 22,400 Income taxes (at 50%) 11,200 Net income $ 11,200
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Profitability Evaluation Ratios

Profitability measures affect the investment decisions of investors, creditors, and managers The four basic profitability ratios are
Gross profit margin Return on sales Return on common stockholders investment Return on assets
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Gross Profit Margin

The Chan Audio Companys gross profit percentage is presented below:
Gross profit percentage = Gross profit / Sales = $60,000 / $160,000 = 37.5%
Gross profit percentages vary greatly by industry
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Return on Sales or Net Profit Margin

The return on sales ratio (also known as the net profit margin ratio) gauges a companys ability to control the level of all its expenses relative to the level of its sales
The return on sales percentage tends to vary by industry
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Return on Sales or Net Profit Margin

Chan Audios return on sales ratio is
Return on sales = Net income / sales = $11,200 / $160,000 = 7%
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Return on Common Stockholders Equity

Return on common stockholders equity ratio (ROE or ROCE) compares net income with invested capital The return on common stockholders equity for Chan Audio is
Return on common stockholders equity = = = = Net income / Average common stockholders equity $11,200 / ($400,000 + $411,200) $11,200 / $405,600 2.8% (for 1 month)
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Return on Assets
The return on assets ratio
Compares net income with invested capital as measured by average total assets Measures how effectively those assets generate profits
The return on assets ratio for Chan Audio for the month of January is
Return on assets = = = = Net income / Average total assets $11,200 / ($620,000 + $646,500) $11,200 / $633,250 1.8% (for 1 month)
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Accrual Accounting and Financial Statements

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Adjustments to the Accounts

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Adjustments to the Accounts

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Adjustments to the Accounts

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Expiration of Unexpired Costs

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Expiration of Unexpired Costs

Expiration of Unexpired Costs

Assets (Prepaid Expense) Appear in the Balance Sheet

Appear in the Income Statement

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Earning of Revenues Received in Advance

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Earning of Revenues Received in Advance

Earning of Revenues Received in Advance

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Earning of Revenues Received in Advance

Liabilities (Unearned Revenue) Appear in the Balance Sheet

Appear in the Income Statement

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Accrual of Unrecorded Expenses

Accounting for Accrual of Wages

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Accounting for Accrual of Wages

Wages expense Accrued wages payable

Failure to record the adjustment understates both expenses and liabilities

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

For the full year, the interest is:

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Failure to record the adjustment understates both liabilities and expenses

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Accrual of Unrecorded Revenues

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Accrual of Unrecorded Revenues

Failure to make this adjustment understates both assets and revenues

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Ethics, Unearned Revenue and Revenue Recognition

It is unethical to knowingly overstate revenue and net income

2006 Prentice Hall Business Publishing