Accrual Accounting and Financial Statements

CHAPTER 
4
Learning Objectives
After studying this chapter, you should be able to
•	Understand the role of adjustments in accrual accounting
•	Make adjustments for the expiration or consumption of assets
•	Make adjustments for the recognition of unearned revenues
•	Make adjustments for accrual of unrecorded expenses
•	Make adjustments for the accrual of unrecorded revenues
Learning Objectives
After studying this chapter, you should be able to
•	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 short-term liquidity
•	Prepare single- and multiple-step income statements
•	Use ratios to assess profitability
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
Adjustments to the Accounts
•	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
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
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:
Expiration of Unexpired Costs
•	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):

•	Failure to make this adjusting entry will overstate assets and understate expenses
Expiration of Unexpired Costs
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
Earning of Revenues 
Received in Advance
•	A company receives rent for 3 months in advance, $6,000
•	The journal entries below represent
•	An explicit transaction that recognizes the receipt of unearned revenue
•	A transaction showing the adjustment for one month’s rent earned
Earning of Revenues 
Received in Advance
•	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
Earning of Revenues 
Received in Advance
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
Accounting for Accrual of Wages
•	The transaction recognizes both an expense and a liability

•	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

Accrual of Interest
•	Calculation of interest for any part of a year is as follows:

•	For the full year, the interest is:
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:

•	Failure to record the adjustment understates both liabilities and expenses
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
Accrual of Unrecorded Revenues
•	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

•	Failure to make this adjustment understates both assets and revenues

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
The Adjusting Process in Perspective
•	The complete accounting cycle now becomes
The Adjusting Process in Perspective
•	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
 
The Adjusting Process in Perspective
The Adjusting Process in Perspective
The Adjusting Process in Perspective
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

Classified Balance Sheet
•	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
Classified Balance Sheet
•	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:
Classified Balance Sheet
Current Ratio
•	Liquidity is a company’s ability to pay its immediate financial obligations with cash and near-cash assets 
•	The current ratio evaluates a company’s liquidity

•	Chan Audio’s current ratio is

Current Ratio
•	The quick ratio removes Inventory (and other less liquid assets such as Prepaid Expenses) from the numerator of the calculation
•	Chan Audio’s quick ratio is

•	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

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

Single-Step Income Statement
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 firm’s routine, ongoing operations (wages, rent, depreciation, telephone, heat, advertising, etc.)
–	Operating income
•	The remainder of gross profit after the deduction of operating expenses

Multiple-Step Income Statements
–	Nonoperating revenues and expenses
•	Revenues and expenses not directly related to the mainstream of a firm’s 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
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
Gross Profit Margin
•	The Chan Audio Company’s gross profit percentage is presented below:

•	Gross profit percentages vary greatly by industry
Return on Sales or Net Profit Margin
•	The return on sales ratio (also known as the net profit margin ratio) gauges a company’s 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
Return on Sales or Net Profit Margin
•	Chan Audio’s return on sales ratio is
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 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