4/9/2012. Accrual Accounting and Financial Statements. Learning Objectives (LO) LO 1 - Adjustments to the Accounts. Learning Objectives (LO)

Size: px

Start display at page:

Download "4/9/2012. Accrual Accounting and Financial Statements. Learning Objectives (LO) LO 1 - Adjustments to the Accounts. Learning Objectives (LO)"

Brandon Lambert
5 years ago
Views:

Accrual Accounting and Financial s CHAPTER 4 Learning Objectives (LO) After studying this chapter, you should be able to 1. Understand the role of adjustments in accrual accounting 2.

Make adjustments for the accrual of unrecorded revenues 1of 35 2of 35 Learning Objectives (LO) LO 1 - Adjustments to the Accounts After studying this chapter, you should be able to 6.

1 Accrual Accounting and Financial s CHAPTER 4 Learning Objectives (LO) 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 earning of unearned revenues 4. Make adjustments for accrual of unrecorded expenses 5. Make adjustments for the accrual of unrecorded revenues 1of 35 2of 35 Learning Objectives (LO) LO 1 - Adjustments to the Accounts After studying this chapter, you should be able to 6. Describe the sequence of the final steps 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 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 3of 35 4of 35 LO 1 - Adjustments to the Accounts 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 (asset) or payable (liability) during a given period even though no explicit transaction occurs. For example, interest receivable or payable builds with the passage of time. Adjustments arise from four basic types of implicit transactions: Accrual of unrecorded expenses Expiration of unexpired (deferred) costs Accrual of unrecorded revenues Earning of revenues received in advance 5of 35 6of 35 1

2 LO 2 - Expiration of Unexpired Costs Assets (Prepaid- unexpired- Expense) Appear Need adjustments to reflect consumption Incurred Appear Income 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 2,000 Cash 2,000 Adjustment required: Office Supplies Expense 1,500 Office Supplies Inventory 1,500 How would assets and equity be affected if this adjustment is not made? 7of 35 8of 35 LO 3 - Earning of Revenues Received in Advance (Funds received but not earned) Appear Adjustments to reflect earning Revenues (When funds have been earned) Appear Income LO 3 - Earning of Revenues Received in Advance Situation: Receive $6,000 for 3 months rent on July 1 (explicit event) Cash 6,000 Unearned Rent Revenue 6,000 Adjustment required after 1 month passes: Unearned Rent Revenue 2,000 Rent Revenue 2,000 How would liabilities and equity be affected if this adjustment is not made? 9of of 35 LO 4 - Accrual of Unrecorded are incurred but are not yet recorded Need to appear Income Need adjustments to reflect consumption and debt need to be shown for the unrecorded d expenses Need to appear in the 11 of 35 LO 4 - Accrual of Unrecorded Situation: Payment for last week s wages (explicit event) Wage Expense 200,000 Cash 200,000 Adjustment required for last 3 days of the fiscal year (payday is next Friday) (implicit event): Wage Expense 120,000 Accrued wages payable 120,000 How would liabilities and equity be affected if this adjustment is not made? 12 of 35 2

3 LO 4 - Accrual of Unrecorded Other examples where expenses liabilities arise but are unrecorded include Wages Income taxes Utilities Interest Adjustments are necessary to accurately Match expense to the period books of the entity that will have to pay Record revenue books of the provider or recipient of those services when earned 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 Situation: A company borrows $100,000 on December 31, Terms of the loan require repayment of the loan amount of $100,000 plus interest on December 31, of of 35 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 12/12 = $9,000 As of January 31, 2011, the amount of interest owed is 1/12 x.09 x $100,000 = $750 Adjustment on borrower s books required after 1 month passes: Interest expense 750 Accrued interest payable 750 How would liabilities and equity be affected if this adjustment is not made? 15 of of 35 As of January 31, 2011, the amount of interest owed is 1/12 x.09 x $100,000 = $750 Adjustment on lender s books required after 1 month passes: Accrued Interest Receivable 750 Interest Revenue 750 How would assets and equity be affected if this adjustment is not made? 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 It is unethical to knowingly overstate assets or equity (net income) 17 of of 35 3

4 Each adjusting entry affects at least Transactions Documentation Journal Ledger Unadjusted Trial Balance The complete accounting cycle now becomes Journalize and Post Adjustments Adjusted Trial Balance Financial s One income statement account 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 19 of of 35 Advance Cash Payments for Future Services to be Received Create Noncash Assets Transformed by adjustments into in the Income When unexpired costs expire Passing of time and the continuous use of services before paying for them Should be recorded by adjustments as increases in Income and Advance Cash Collections in advance for future Services Create Transformed by adjustments into Revenues in the Income When revenues received in advance are earned Until decreased later by Cash Payments 21 of of 35 Passing of time and the continuous rendering of services Should be recorded by adjustments as increases in Revenues Income A classified balance sheet groups asset, liability, and owners equity accounts into subcategories and Noncash assets In the Balance Sheet Until decreased later by Cash Collections Assets are classified into two groups: Current assets Noncurrent (or long-term) assets are classified into Current liabilities Noncurrent (or long-term) liabilities 23 of of 35 4

5 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 with next year (or operating cycle if longer) Both are generally listed order in which they are likely to be converted/consumed or paid during the coming year 25 of of 35 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 Current Ratio Chan Audio s current ratio is Current assets Current liabilities $532,500 $232,870 = 2.3 Working capital is the excess of current assets over current liabilities Chan Audio s working capital is $532,500 - $232,870 = $299,630 The quick (acid test) ratio removes Inventory (and other less liquid assets such as Prepaid ) from the numerator of the calculation $532,500 $260,200 Chan Audio s quick ratio is = 1.2 $232, of of 35 LO 7 Classified A balance sheet may be presented in Condensed format - just totals of current and longterm categories LO 8 - Income Formats Single step - lists revenues and deducts expenses without drawing any intermediate subtotals Detailed format - the accounts that t make up current and long-term categories Report format - presents all the accounts vertically Account format - lists assets to the left and liabilities and owners equity to the right 29 of of 35 5

6 LO 8 - Income Formats Multiple step - lists revenues and deducts expenses while drawing intermediate informative subtotals LO 8 - Income 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 firm s routine, ongoing operations Operating income - the difference between the usual and frequent in- and outflows Other (Nonoperating) items not related to the firm s principal operations, i.e., the unusual and/or infrequent flows 31 of of 35 LO 9 - Profitability Evaluation Ratios Profitability measures affect the investment decisions of investors, creditors, and managers The four basic profitability ratios are Gross profit percentage Return on sales Return on common stockholders investment Return on assets Ratios vary greatly by industry Meaning is derived by comparison to others LO 9 - Profitability Evaluation Ratios The Chan Audio Company Gross profit percentage - profitability just from selling goods; other expenses/losses are not considered Gross profit percentage = Gross profit / Sales = $60,000 / $160,000 =375% 37.5% Return on sales ratio (AKA: Net Profit Margin) - profitability after all expense, gains, and losses Return on sales = Net income / sales = $13,530 / $160,000 = 8.5% 33 of of 35 LO 9 - Profitability Evaluation Ratios The Chan Audio Company 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 / ½ ($400, $413,530) = $13,530 / $406,765 = 3.3% (for 1 month) Return on assets - measures the return produced by the average available assets (effectiveness) Return on assets = Net income / Average total assets = $13,530 / ½ ($620,000 + $646,400) = $13,520 / $633,200 = 2.1% (for 1 month) 35 of 35 6

Chapter 5 Accrual Adjustments and Financial Statement Preparation. Revenue recognition Matching expenses to revenues Expenses related to periods

Chapter 5 Accrual Adjustments and Financial Statement Preparation Revenue recognition Matching expenses to revenues Expenses related to periods 1 The Measurement of Income major function of accounting