Learning Objectives (LO)

Accrual Accounting and Financial Statements

After studying this chapter, you should be able to CHAPTER

1. Understand the role of adjustments in accrual accounting 2. Make adjustments for the expiration or consumption of assets 3. Make adjustments for the earning 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 (LO)

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

LO 1 - Adjustments to the Accounts

At the end of an accounting period, adjustments are needed because some transactions are implicit rather than explicit.

Explicit transactions
Observable events that trigger the majority of day -to-day routine journal entries Prompted by an economic event Supported by source documents Examples cash or credit sales, wage payments, etc.

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 Examples prepaid rent, depreciation, etc.
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LO 1 - Adjustments to the Accounts

Adjustments help assign the financial effects of implicit transactions to the appropriate time periods Accrue means to accumulate a receivable or payable during a given period of time, even though no physical assets change hands. As receivables and payables are accumulated on the balance sheet, revenues or expenses must be recognized on the income statement, to maintain the equity of the equation. Adjusting entries never affect cash, as any entry with a cash impact is the result of an explicit transaction. Adjustments help match revenues and expenses to a particular period and ensure the balance sheet correctly states assets and liabilities.
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LO 1 - Adjustments to the Accounts

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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LO 2 - Expiration of Unexpired Costs

Assets (PrepaidunexpiredExpense) Appear in the Balance Sheet Need adjustments to reflect consumption Expenses Incurred

LO 2 - Expiration of Unexpired Costs

Situation: After purchasing $2,000 of office supplies, (explicit event) the company determines that at month-end $1,500 were used.
Office Supplies Inventory Cash 2,000 2,000

Appear in the Income Statement

Adjustment required:
Office Supplies Expense Office Supplies Inventory 1,500 1,500

Explicit transaction in the past created an asset. Subsequent implicit transactions are necessary to recognize its consumption during the period. Examples Expensing prepaid rent, depreciating an asset
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How would assets and equity be affected if this adjustment is not made?
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LO 3 - Earning of Revenues Received in Advance

Liabilities (Funds received but not earned) Appear in the Balance Sheet Revenues (When funds have been earned) Appear in the Income Statement

LO 3 - Earning of Revenues Received in Advance

Situation: Receive $6,000 for 3 months rent on July 1 (explicit event)
Cash Unearned Rent Revenue 6,000 6,000

Adjustments to reflect earning

Adjustment required after 1 month passes:

Unearned Rent Revenue Rent Revenue 2,000 2,000

Unearned Revenue - Cash received from customers who pay in advance for goods and services to be delivered at a future date. Cash is received but the revenue is not earned.
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How would liabilities and equity be affected if this adjustment is not made?
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LO 4 - Accrual of Unrecorded Expenses

Need Expenses Liabilities are adjustments to need incurred reflect to be shown but are consumption and for the not debt unrecorded yet expenses recorded Need to appear in the Need to appear in Income Statement the Balance Sheet
The event is the passage of time; no other economic event involv ed. Employees earn their wages with the passage of time. Accountants record this only at the end of reporting period.
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LO 4 - Accrual of Unrecorded Expenses

Situation: Payment for last weeks wages (explicit event)
Wage Expense Cash 200,000 200,000

Adjustment required for last 3 days of the fiscal year (payday is next Friday) (implicit event):
Wage Expense Accrued wages payable 120,000 120,000

How would liabilities and equity be affected if this adjustment is not made?
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LO5 - Accrual of Unrecorded Revenues

Adjustments are required to recognize revenues earned but not yet received. Examples:
Interest revenue, hourly fees for professional services, commission charges, utility services.

LO5 - Accrual of Unrecorded Revenues

Situation: A company borrows $100,000 on December 31, 2010 at 9%. Terms of the loan require repayment of the loan amount of $100,000 plus interest on December 31, 2011. As of January 31, 2011, the amount of interest owed is $100,000 x .09 x 1/12 = $750 Adjustment on lenders books required after 1 month: Accrued Interest Receivable Interest Revenue 750 750

How would assets and equity be affected if this adjustment is not made?
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LO 5 - Ethics, Unearned Revenue and Revenue Recognition

When uncertainty prevails, conservatism suggests selecting measurement methods that
Understate assets Overstate liabilities Understate Equity (and net income) by Understating revenue and gains Overstating expenses and losses
Transactions

LO 6 Adjusted Trial balance

Documentation

Journal

Ledger

The complete accounting cycle now becomes

It is unethical to knowingly overstate assets or equity (net income)

Unadjusted Trial Balance

Journalize and Post Adjustments

Adjusted Trial Balance

Financial Statements

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LO 7 - Classified Balance Sheet

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

LO 7 - Classified Balance Sheet

Liabilities are classified into

Current liabilities Noncurrent (or long-term) liabilities

Balance Sheet formats

Account format Report format Sequencing of balance sheet accounts under US GAAP and IFRS
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LO 7 - Classified Balance Sheet

Current assets assets expected to be converted to cash, sold, or consumed during the next 12 months (or within an operating cycle if longer) Current liabilities liabilities expected to be paid within the next year (or operating cycle if longer) Working capital the excess of current assets over current liabilities
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LO 7 - Classified Balance Sheet

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

If the ratio is too low difficulty in meeting shortterm obligations If the ratio is too high excessive holdings of current assets, inefficient use of resources
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LO 8 - Income Statement Formats LO 7 - Classified Balance Sheet

Quick ratio (acid test) removes Inventory (and other less liquid assets such as Prepaid Expenses) from the numerator of the calculation Current ratios normally vary between 1.0 and 2.0, but this is very industry-specific.
Single step - lists revenues and deducts expenses without drawing any intermediate subtotals

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LO 8 - Income Statement Formats

Multiple step - lists revenues and deducts expenses while drawing intermediate informative subtotals

LO 8 - Income Statement Formats

In a multiple-step income statement, Intermediate and informative subtotals usually include the following:

Gross profit (gross margin) - excess of sales revenue over the cost of the inventory that was sold Operating expenses - recurring expenses that pertain to the firms routine, ongoing operations Operating income gross profit less operating expenses (income from operations) Other (Non-operating) items not related to the firms principal operations, i.e., the unusual and/or infrequent flows
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LO 9 - Profitability Evaluation Ratios

Profitability company s ability to generate earnings and pay dividends to its investors; to provide them with a particular rate of return on their investment The four basic profitability ratios are
Gross profit percentage Return on sales Return on common stockholders investment Return on assets

LO 9 - Profitability Evaluation Ratios

Gross profit percentage - profitability just from selling goods; other expenses/losses are not considered Gross profit percentage = Gross profit / Sales = $60,000 / $160,000 = 37.5% Return on sales ratio (Net Profit Margin) profitability after all expense, gains, and losses Return on sales = Net income / sales = $13,530 / $160,000 = 8.5%
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Ratios vary greatly by industry Meaning is derived by comparison to others

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LO 9 - Profitability Evaluation Ratios

Return on common stockholders equity (ROE or ROCE) - amount of income produced by average invested capital
Return on common = Net income/Average common stockholders equity stockholders equity = $13,530 / ($400,000 + $413,530) = $13,530 / $406,765 = 3.3% (for 1 month)

Return on assets (ROA) - measures how effectively assets generate profits

Return on assets = = = = Net income / Average total assets $13,530 / ($620,000 + $646,400) $13,520 / $633,200 2.1% (for 1 month)
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