Income Statements» What s Behind?» Income Statements» Scenic Video www.navigatingaccounting.com/video/scenic-end-period-accounting-and-business-decisions Scenic Video Transcript End-of-Period Accounting and Business Decisions Topics Accounting decisions: o Accrual systems o Accrual entries o Deferral entries o Accounting cycle o Adjusting entries: Accruals, deferrals, and judgments Business decisions: o Aligned with owners o Conflicting with owners Take-aways Transcript Introduction Welcome to the End of Period Accounting and Business Decisions scenic route video where you re going to learn that many of the entries you have studied in this module and especially those requiring significant judgment are actually recorded after the end of the reporting period when management has heightened opportunities and incentives to influence performance measures for better or for worse. You re also going to learn that management has heightened opportunities and incentives to influence performance measures during the last few days of the reporting period through business rather than accounting decisions. Along the way you re going to learn the difference between cash and accrual accounting systems and related concepts including accrual and deferral entries and the accounting cycle. Here s our agenda: accounting decisions, business decisions and then some takeaways. So let s get started. ACCOUNTING DECISIONS Accrual Entries We begin with the difference between a cash accounting system and accrual accounting system. So what is a cash accounting system? Well, first of all only transactions that affect cash are recorded. Sometimes they re used by small businesses but they are not You may translate this work into your local language, as long as you credit G. Peter & Carolyn R. Wilson and respect the Creative Commons Attribution-Noncommercial-Share Alike United States license. 1991 2011 NavAcc LLC. www.navigatingaccounting.com
consistent with either IFRS or U.S. GAAP. So when companies start out they re generally on a cash basis but overtime they have to go to an accrual accounting system. In this system transactions that don t affect as well as those that do affect cash are recorded. Here s a definition by IFRS of an accrual accounting system: When the accrual basis of accounting is used an entity recognizes items as assets, liabilities, equity, income and expenses that is the elements of the financial statements when they satisfy the definitions and recognition criteria for those elements in the Framework. And of course all these criteria and definitions are intended to capture the underlying economics. So when something significant happens in the company, you want to record it whether or not there s a cash flow that s the essence of an accrual accounting system. It can be a little confusing at first because when you look at an accrual accounting system, the word accrual is used and yet we re going to also use the same word, accrual to describe a certain set of entries. So you re going to have to get used to the fact that those are two different uses of the same word. Here, accrual entry is what we want to focus on and that s going to be part of but not all of, an accrual accounting system. So what s the essence of an accrual entry? And we ve been recording several accrual entries throughout the chapter, we just didn t make a point of it. Well accrual entries ensure income elements, revenues and expenses, gains and losses, are recognized before related cash flows occur. So here s a little picture over here here s our income elements recognized, and here s our cash flow over here. Now we have several of these throughout the chapter, let s look at some. For example, expense is recognized before cash is paid, here s some examples. Expense is recognized when a company is invoiced by accruing expenses to accounts payable, we did several examples where we had that. Expense is recognized when a company becomes obligated to pay because they ve already received the benefits of a resource but is never invoiced or has yet to be invoiced by accruing expenses to accrual liability. Here s the general characteristic of expenses that are accrued: a liability is recognized when the expense is recognized and the liability is de-recognized later when the cash outflow occurs. Now let s look at revenue, here s an example: Revenue is recognized when a credit-sell occurs. If we recognize revenue and a credit-sell occurs, the entry is accounts receivable that goes up and revenue goes up but the cash does not come till later, that s why it s called accrual. Now form away we say that revenue is accrued but in practice accrued generally refers to accruing expenses not revenue. That is you don t hear someone say, I accrued some revenue but you often hear them say, I accrued an expense. So what s the general description of what happens when we accrue revenue? An asset is recognized as accounts receivable when the revenue is recognized and derecognized later when the cash inflows; we should remember receivables would go down, cash goes up. Deferral Entries What are deferral entries? Well they re kind of the opposite of accrual entries and they re part of an accrual accounting system. In this case the cash inflow or outflow occurs before the income element is recognized. Let s look at examples for expenses. Expense is recognized when an asset is partially or fully used up or impaired. When the asset is acquired, expenses are deferred by recognizing 2
an asset. You might recall when the asset is acquired, its cost is said to be capitalized rather than expensed immediately. We don t hear someone say, We deferred an expense very often in practice but formally that s what where we think of it in accounting. So what s the general description of what happens when we have a deferred expense? An asset is recognized when the cash is paid and is derecognized later when the expense is recognized. Now let s look at a revenue example of a deferral entry. Revenue is deferred when cash sales occur and subsequently recognize when the company meets its performance obligations. The value card example that we looked at the liability is recognized when the cash is collected and is derecognized later when the revenue is recognized because the performance obligations are met. So most of this is a review for you, all we re doing is we re looking at the entries you ve already learned how to record and we re saying, Well, are those accrual entries or are those deferral entries? Those are terms that are widely used so we want to make sure that you understand them. Accounting Cycle Now we want to introduce what is called the accounting cycle. What is the accounting cycle? Well, there s two big parts to it, there s entries recorded during the period and then there s entries that are recorded during the closing period. So this is called the closing period over here and this is called the reporting period over here. Closing period is a new concept to us so let s talk about it a little bit. First of all it has two types of entries: adjusting entries and closing entries. Adjusting entries recognize the events and circumstances that occurred during the period; they happen during the periods that were not recognized during the period. So some things happened over here during the accounting period some economic events, things that are important for investors to know but we never got around to recording them. And so now after the period is over, we re going to record adjusting entries. It s important to realize and students sometimes miss this that adjusting entries never involve cash flows or more generally transactions with outsiders. Someone gives you cash, you have to record that at that point or more generally if you have a transaction with an outsider, that has to be recorded at that point well it s generally recorded at that point. What are closing entries? Well, we re going to briefly give you an introduction in here and when we go behind the numbers for the statement of changes in shareholders equity, we ll actually do closing entries they re a really important part of the accounting cycle. So what do they do? Well they transfer income account balances to permanent owners equity accounts. You might recall that income accounts are temporary accounts so we have to close out their balances, get them to zero balances, so that at the end of the year there ll be zero and therefore at the start of the next period there ll be zero. For example they transfer a net income into retained earnings but we saw that that happens when we studied the statement of shareholders equity and we indeed saw it in the retained earnings column of those statements, there was net income being transferred in but we will have to learn the entries for that. 3
So here s the accounting cycle and why is it an accounting cycle? Because it happens over and over and over again. And some important observations, the adjusting entries actually happen after the end of the period so we haven t made that distinction. We ve been saying, Well we record this at the end of the year. Well actually it s going to be recorded during the weeks thereafter. Closing periods are amazingly intense periods for accountants; if you know some accountants well this is not the best time to look to have fun because they are pretty busy during the closing period. ADJUSTING ENTRIES Accruals Now we want to tie together a few things. We talked about accrual entries now we want to talk about accrual adjusting entries that is accrual entries that are at the end of the period. And again this is just more of a review than anything else. We begin with accrued expenses. An adjusting entry is recorded to accrue expense to an accrued liability, remember that, when the company became obligated during the current period to make a future period payment but had not recognized this obligation prior to the adjusting entry. So let s look at some examples that we ve already seen. We accrue an expense that will never be invoiced. We accrue compensation because the employees work for us; we accrue taxes because we owe money to the government, neither one of those sends us a bill. And then we accrue expense that has yet to be invoiced accrued advertising, accrued internet services. Now let s look at an example of accrued revenue. An adjusting entry is recorded to accrue revenue to accounts receivable, when a revenue recognition criteria associated with a credit sale were met during the period but not recorded prior to the adjusting entry. A little example here. You make a sale during the period here, all the criteria aren t met for revenue recognition, but they get met somewhere during the period and perhaps the company doesn t record the entry to recognize the revenue when all the criteria are met. So we get to the end of the period and they look back and they say, Have we missed some revenue that we actually earned? and if the answer is yes, then they are going to record an entry that s an adjusting entry. So for example, if we are back here at the start, let s suppose that the company made a sale to a customer but they weren t quite sure yet about the customer s credit that is why the customer would pay the receivable. They run some credit checks during the period, they found out indeed that the customer is good for their promise, and so what they re going to do is recognize the revenue at the end of the period. They couldn t recognize it back here because it wasn t reliably measureable at that point but it became reliably measurable during the period. Well all that s described in the example right here and you can download that and read that. Deferrals Now let s look at an example of a deferral adjusting entry and in particular deferred expenses. So an adjusting entry is recorded to recognize a previously deferred expense when an asset was partially or fully used up during the current period but that usage or impairment was not recorded prior to the adjusting entry. So, economic events happened 4
during the period, we either used an asset or it got impaired but now we re going to record it at the end of the period because we ve yet to record it. So here s some examples. Depreciation expense equipment is used up all during the period but accountants don t continually monitor the machine and then decide, Well we got to record with a little depreciation everyday nah they wait until the end of the reporting period and then record all of the depreciation. And the same for amortization of intangibles and the same for impairments of PP&E or intangible assets. So now let s look at deferral entries related to revenue. An adjusting entry is recorded to recognize previously deferred revenue when the criteria for revenue recognition were met during the period but revenue is not recorded prior to the adjusting entry. Here s an example for you. The buyer met the performance obligation at the time of the sale by paying cash. So the buyer they did their part way back here but revenue was deferred because the sale occurred in a new market where the seller couldn t reliably estimate product returns. So there was a product return period here, you can bring back the product if you want and we re just not sure how many are going to come back at this point so when we make the sale can t recognize revenue because there is too much uncertainty. Now the product return period ended during the current reporting period, so the seller met the criteria. So at this point the product return period ended and we met the criteria. Now a company could have recognized the revenue at that point but there s no real benefit to doing so because the reports aren t going to go out till the end of the period so many companies will wait and do that as an adjusting entry at this point. Judgments Now, it turns out that a good deal of the judgment that happens in accounting happens during the closing period and in particular during adjusting entries. So what we want to do now is go back and briefly review some judgment concepts that we re going to introduce in the balance sheet chapter. Judgments associated with revenues and expenses, gains and losses are inextricably linked to judgments associated with assets and liabilities that s a central lesson of this chapter and thus related lessons from the balance sheet chapter apply here. Preparers and users both make judgments associated with the reported numbers. Prepares determine how financial items should be measured, recognized, classified and disclosed and users asses the credibility and more genuinely the usefulness of reported numbers. You might recall that judgment refers to situations where experts come to reasonably different estimates of a measure or reasonably different decisions on how something should be accounted for or disclosed. For good reasons they disagree, well that s a judgment and we see that those come up in recognition decisions, classification decisions and disclosure decisions all the time. But users have their judgment, they re over here and they are looking at their numbers and they are trying to figure out how good they are. So these decisions on both sides well they require proportional judgment. The more judgment required by insiders over here, the more judgment required by outsiders when trying to interpret the numbers. So if you re looking at a company and you know there s a lot of uncertainty going on in terms of measurement, well you re going to have a more difficult judgment because you know there was more difficult judgment behind the numbers you re looking at. So trying to assess the quality of the 5
numbers which is what you re trying to do over here, that s your judgment, that s more challenging. So here was our three-decision framework that we looked at in the balance sheet chapter and now let s take a closer look at one of the most important parts of it. Judgment is a two edge sword this is a really important concept. The consequences of users decisions create insiders incentives that are aligned with outsiders interest. Now that s really important because often we think of judgment on the part of preparers of accounting reports and we think of bad things that are happening for example they re manipulating the income but that misses a really important point. Judgment is also the source of many good things and that s when the incentives of the insiders are aligned with the incentive of the outsiders. How does that happen? Well anticipating the reward for performing well anticipating so you re working over here and making business decisions maybe in marketing, maybe in operations insiders have incentives to work more effectively and more efficiently. You know you re going to get a reward based on accounting numbers so if you work really hard say you re in the sales department and you make lots of sales which would end up in the accounting reports, you ll get a bonus. Well that s a consequence back on you that comes from the accounting numbers namely the revenues that are going to get recognized. Well knowing that s going to happen that you re going to get that bonus that gives you an incentive to work harder and more efficiently and more effectively. So accounting metrics are used to motivate people to work more effectively and more efficiently. Managers also have incentives to report honestly when they perform well. If you do really well you want to tell the world about it and you want resources to be allocated to your company because you re doing so well. So this is all the good from judgment but judgment is a two edge sword, the consequences of users decisions also create insider incentives that conflict with outsiders. So up here they were aligned, down here they conflict that is the incentive. Insiders have incentives to fraudulently misrepresent their performance when they perform poorly. Again this consequence connection which ties together users decisions, back to business decisions because users decisions are determined to varying degrees based on accounting reports. Well those accounting reports affects users decisions but business decisions are reflected in accounting reports so this connection between the user and the business decision it s got good consequences and it has bad consequences in terms of incentives. And both are really important and of course what we try to do in accounting is make sure the good incentives win out. Another really important concept has to do with accounting and economics is called adverse selection. Adverse selection occurs when sellers of products know more than buyers about the quality of an asset. It also occurs when investors can t distinguish reliable numbers from misleading ones. In these situations, investors attribute the same level of confidence to reliable and misleading numbers. So you can t tell a good number from a bad number, you re looking at two companies one is good and one is bad you can t tell them apart. Of the amount of confidence that an investor attributes to their numbers affect their decisions. When you can t tell a good number from a bad number then you put less confidence on the good numbers and that s just an outcome of not being able to separate or distinguish a good company from a bad company. 6
Here s a picture down here that tells the whole story. Now suppose that we ask a bunch of experts to value two companies and here s our distribution of the values for the company that was a poor investment and here s our distribution of the values for the company who was a good investment. These are experts who are objective; they re trying to do the best job they can but our problem is we can t tell a good investment from a bad investment. So if a value comes in right in here, well that could be the value of good investment but it can also be a value of a bad investment. So when outsiders can t tell a good investment from a bad investment well then there s a real problem because we can t allocate resources effectively and efficiently to the good companies and distinguish them from the bad companies. Investors challenge is to distinguish companies that report honestly and correctly from those that report fraudulently or otherwise mislead investors. The key to meeting this challenge is to separate the measurement distributions of competent, honest preparers from the distributions of preparers who intentionally or inadvertently mislead users all analysts are trying to do that. They are trying to figure out who are the good companies and who are the companies that aren t so good in terms of their integrity, in terms of what the numbers represent. Users are more challenged that challenge is more severe to the extent insiders incentives conflict with outsiders interests. If the insiders have conflicting incentives, well they are more likely to mislead and it s also more challenging to the extent objective experts measures are dispersed. So when there is a good deal of dispersion down here, well then there is more overlap between the bad investments and the good investments hence difficult to tell a good one from a bad one. As we get out here well there s no errors; here are our distribution of the values of the poor company and the good company so if you see a company is valued more highly in that type of marketplace, you know it s a better company and you re willing to pay more for it than you would for a poor company. So this is a perfect outcome over here. The third factor that affects the extent of the challenge is to the degree to which the internal controls auditors, regulators and other mechanisms that mitigate honest errors and opportunistic behaviors are not effective. There s often times when people have an incentive to do bad things but they don t do bad things because there s mechanisms that curb their behavior and these mechanisms were introduced in the balance sheet chapter and you can go study about them but the big ones are internal controls, auditors, regulators, and of course the integrity of the preparers of the numbers. So when we look at a system we need to understand the incentives of the insiders, the degree to which it is very difficult to measure something but also the mechanisms that are in place to curb up opportunistic behavior. This is an overview of what accounting is all about. You see what accountants are trying to do is move the system in this direction to where we get more efficient outcomes. What does this have to do with adjusting entries? Let s go look at that next. Here s the thing that is critical to understand, when you re looking at the closing period which actually takes place, remember, after the end of the accounting period you have intensified incentives. Management sees how close they are to the performance metrics that they are trying to meet before recording adjusted entries. You had to make earnings of a dollar twenty-four and you re a dollar twenty-two real close to a dollar twenty-four well you know that here and you don t know that back at the start of the period. So your incentives are much higher to do good and bad during the adjusting period because you have all these information now which heightens your incentives. So when managers are close to making their targets, managers have an incentive to accelerate revenue recognition and delay 7
expense recognition. Remember this is after the period, everything s already happened. We re talking about accounting measures not real activities that happen back here. Now that doesn t mean that they act on that incentive, that s where those mitigating mechanisms like internal controls come into play but the incentive is very intensified at the end of the period. So when they re close to making their targets not quite there, they have the incentive to push income up by either taking more revenue or taking lesser expense. But the opposite is also true, when they have more than enough income to make their targets managers actually have the opposite incentive; they have incentive to shift income to the next period by delaying revenue recognition and accelerating expense recognition and thus increase the likelihood they will meet next period s targets. Not only does management have intensified incentives to misrepresent numbers, when they are doing adjusting entries, but they also have intensified opportunities. The vast majority of recognition and measurement judgments companies make involve adjusting entries, this is where significant portion of the judgment takes place. The dispersion of objective experts estimates of measures associated with adjusting entries tend to be more widely dispersed than the measures recorded during the period because they re often based on uncertain forecasts. Now, we ll learn more about that throughout the book but it s really important to understand that. Remember when we have more dispersion in the measurements of objective experts which happens a good deal on these adjusting entries, that s when we have more opportunities to misrepresent numbers. BUSINESS DECISIONS Aligned with Owners Now we want to look at business decisions and now we re not going to be focusing on the adjusting entries which are out here, but instead we re going to be looking in the current reporting period but just during the last few days during the last few days of the reporting period when managers are close to making their targets so once again they know pretty much how they re doing and they certainly know a lot more here than you back here. They have an incentive to modify real activities. Real activities, business decisions and thus financial results in ways that are aligned with owners interest they can do good during these last five days and that s important. Well, you will see shortly that they can be bad too but they can do good and that s really important to understand. They can increase revenues by working more diligently to increased market share so that last four, five days everyone s out there working as hard as they can and trying to make their numbers and they are doing it in ways that are honest. Well that s good, that means the metric is really having a heightened effect on them and the incentive is very positive. They can decrease expenses by working diligently to cut waste or otherwise control the cost without sacrificing shareholder s values true but more different. There are industries of what s called big ticket items, like medical imaging devices on those deals, the last six or seven days of the month are very important because you see the customers on the other end who had the entire reporting period to make a big ticket decision well they know that at the end of the period the sellers that is the buyers know that the sellers are trying to make their numbers and they will get sellers to compete with each other so that they will get two big companies to compete with each other to get the best deal they can as the pressure is heightened towards the end of the year. And there are industries where up to 50% of the sales come from the last week or so of the reporting quarter all because of that heightened 8
activity. That can put positive incentives into the system where everyone is trying to work their hardest to earn those sales. Conflicting with Owners But there can also be conflicts with the owners interests lots of conflicts with the owners interests and they happen on real activities within the current reporting period and these are distinct from the accounting decisions we looked at earlier. So managers also have incentives to modify real activities and thus financial results in ways that conflict with owners interests. So when they re close to making their targets again just about there, managers have an incentive to take actions that conflict with owners interest. They can accelerate shipments to increase current period revenues and by accelerate shipments that s not necessarily bad but they can do it in a high-cost way. So for example they can find shipping alternatives that might be more expensive to ensure that they get the product to the customer than they wouldn t have to pay if they just waited a couple more days into the next period. They can defer beneficial marketing or R&D activities to decrease expenses. They can sell assets that have unrealized gains and that will make their income look higher and in fact they will be revealing real gains but remember those are transient. They can lower product prices below those customers will be willing to pay early in the next period to entice them to accelerate purchases. This often happens and can be really dysfunctional wait two more days to make the sale and then you earn more for it. Well these are all dysfunctional and they happen frequently and that s why internal controllers and others within the company work diligently during that last five to seven days, maybe 10 days they re working diligently because they know that s when the tension is great and they re going to try to stop all these activities from taking place. So all those happen when we re just about to make our numbers and we re trying to boost our income but just as we said before the opposite can be true. What happens when you got more than enough income and you know you get to the end of the period and you re just doing great well management can delay shipments to decrease current period revenues, shift those revenues into the next quarter or they can accelerate marketing or research and development activities to increase current period expenses or they can sell assets that have unrealized losses. So these activities happen frequently but there is a good deal of controls in place to try to make sure that they re mitigated and companies distinguish themselves but how good their control systems are. Take-aways So what we would we have you take away from this module? Cash flow myths something we ve emphasized before. Revenue is only recognized when customers pay for products and expenses are only recognized when costs are paid. Students really believe that coming into accounting course but here s the accrual system realities that you should now understand. Revenues and expenses can be recognized before, at the same time or after the related cash flows that s the whole notion of an accrual accounting system. Accrual entries ensure income elements are recognized before the related cash flow; deferral entries are just the opposite. You should now understand the accounting cycle and its importance. Lots of things happen during the period but lots of things happen after the end of the reporting period, adjusting 9
entries are recorded and by the way we didn t mention it but they are pre-dated to the last day of the accounting report even though they are recorded out here after the period. Here s the picture of the accounting cycle we have entries during the period, adjusting entries, then closing entries which we ll talk about in the subsequent video. And we also learned in this video that there are two major end of the period control concerns management has heightened opportunities and heightened motives to manipulate the income and more generally financial measures and near the end of the period not after the end of the period but near the end of the period by manipulating real business activities and during the closing period by manipulating adjusting entries. So these are two major problems and of course there s plenty of mitigating devices but they re not always successful. Well, hope you enjoyed this video and I look forward to seeing you in the next one. 10