ch_04 accrual accounting & financial statements

8/12/2019 Ch_04 Accrual Accounting & Financial Statements

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2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick

Accrual

Accounting and

FinancialStatements

CHAPTER

4


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2006 Prentice Hall Business Publishing Introduction to Financial Accounting, 9/e Horngren/Sundem/Elliott/Philbrick 3 of 45

Learning Objectives

After studying this chapter, you should be able to

6. Describe the sequence of the final steps in therecording process and relate cash flows to adjusting

entries7. Prepare a classified balance sheet and use it to

assess short-term liquidity

8. Prepare single- and multiple-step income

statements9. Use ratios to assess profitability


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Adjustments to the Accounts

Explicit transactionsare

Observable events that trigger nearly all day-to-dayroutine entries

Supported by source documents

Implicit transactions

Do not generate source documents or any visibleevidence that the event actually occurred

Are recorded in end-of-period entries calledadjustments


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Adjustmentshelp assign the financial effects ofimplicit transactions to the appropriate timeperiods

Accruemeans to accumulate a receivable(asset) or payable (liability) during a given periodeven though no explicit transaction occurs


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Adjustments arise from four basic types ofimplicit 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 anasset, and subsequent implicit transactionsserve to adjust the value of the asset

Suppose a company purchases $10,000 ofOffice Supplies Inventory on March 1, 2005.The journal entry to record this explicittransaction is:

Office Supplies Inventory $10,000Cash $10,000




The company uses $1,500 of the Office SuppliesInventory during the month. The followingadjusting entry is required to increase Office

Supplies Expense (debit) and reduce OfficeSupplies Inventory (credit):

Failure to make this adjusting entry will overstateassets and understate expenses

Office Supplies Expense $1,500

Office Supplies Inventory $1,500




Assets(PrepaidExpense)

ExpensesIncurred

Adjustments

Appear in the

Balance Sheet

Appear in the

Income Statement

Buyer


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Earning of Revenues

Received in Advance

A company receives rent for 3 months inadvance, $6,000

The journal entries below represent

a) An explicit transaction that recognizes the receipt ofunearned revenue

b) A transaction showing the adjustment for onemonths rent earned

(a)Cash 6,000Unearned rent revenue 6,000

(b) Unearned rent revenue 2,000Rent revenue 2,000



Earning of Revenues

Received in Advance

The revenue is recognized (earned) only whenthe owner makes the adjusting entries intransaction (b)

The liability Unearned Rent Revenue isdecreased (debited), the stockholders equity

account Rent Revenue is increased (credited)

Failure to record the adjusting entry overstatesliabilities and understates revenues



Earning of Revenues

Received in Advance

Liabilities(UnearnedRevenue)

RevenuesEarned

Adjustments

Appear in the

Balance Sheet

Appear in the

Income Statement

Seller



Accrual of Unrecorded Expenses

Some liabilities (and expenses) grow moment to momentwith 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 theend of the period before preparation of the financial

statements

Adjustments are necessary to accurately match theexpense to the period



Accounting for Accrual of Wages

Assume a company owes $30,000 for employeeservices rendered during the last 3 days of themonth of January, but will not pay the

employees for these services until Friday,February 2

The following transaction shows the entry toaccrue wages for Monday, January 29, throughWednesday, January 31



The transaction recognizes both an expenseand a liability

Failure to record the adjustment understatesboth expenses and liabilities

Accounting for Accrual of Wages

Wages expense 30,000Accrued wages payable 30,000


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Accrual of Interest

Calculation of interest for any part of a year is asfollows:

For the full year, the interest is:

Principal x Interest rate x Fraction of a year = Interest

$100,000 x .09 x 1 = $9,000



Accrual of Interest

As of January 31, the amount of interest owed is1/12 x .09 x $100,000 = $750

The adjusting journal entry is:

Failure to record the adjustment understatesboth liabilities and expenses

Interest expense 750Accrued interest payable 750



Accrual of Unrecorded Revenues

The accrual of unrecorded revenues is themirror image of the accrual of unrecordedexpenses

An adjustment is required to recognize revenuesearned but not received in cash



Accrual of Unrecorded Revenues

Assume a law firm renders $10,000 of servicesduring January, but does not bill for theseservices until March 31

The following adjustment is made forunrecorded revenues for the month of January

Failure to make this adjustment understates bothassets and revenues

Accrued (Unbilled) Fees Receivable 10,000Fee Revenue 10,000



Ethics, Unearned Revenue

and Revenue Recognition

Conservatism means selecting methods ofmeasurement that yield

Lower net income

Lower assets Lower stockholders equity

It is unethical to knowingly overstate revenueand net income



The Adjusting Process in Perspective

The complete accounting cycle now becomes

FinancialStatements

AdjustedTrial Balance

Journalize andPost Adjustments

UnadjustedTrial Balance

Transactions Documentation Journal Ledger




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 isreserved for implicit transactions, which anchor

the accrual basis of accounting




Revenues inthe IncomeStatement

Liabilities in theBalance Sheet

Advance CashCollections for

FutureServices to be

Rendered

Advance CashPayments for

FutureServices to be

Received

Expenses inthe IncomeStatement

NoncashAssets in theBalance Sheet

Transformedby

Expiration of

Unexpired

Costs

Create

Earnings of

Revenues

Received in

Advance

Create

TransformedBy Adjustments

into


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Liabilities in theBalance Sheet

Later CashPayments

Passing of Timeand the

Continuous Useof Services

Expenses in theIncome

Statement

Recorded byAdjustmentsas Increases

in

Accrual of

Unrecorded

ExpensesDecreased by

and


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Noncash AssetsIn the Balance

Sheet

Later CashCollections

Passing of Timeand the

ContinuousRendering of

Services

Revenues in theIncome

Statement

Recorded byAdjustmentsas Increases

in

Accrual of

Unrecorded

RevenuesDecreased by

and


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Classified Balance Sheet

A classified balance sheetfurther groupsasset, 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


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Current assetsare cash and other assets thata company expects to convert to cash, sell, orconsume 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 thecoming year


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Current liabilitiesare those that come duewithin the next year (or within the operating cycleif longer)

Current liabilities are listed in the order in whichthey will decrease cash during the coming year

Working capitalis the excess of current assets

over current liabilities The following slide shows the classified balance

sheet for Chan Audio Company:


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Chan Audio CompanyBalance Sheet

January 31, 20X2

Assets Liabilities and Owners EquityCurrent assets: Current liabilities:

Cash $ 71,700 Accounts payable $117,100Accounts receivable 160,300 Unearned rent revenue 2,500Note receivable 40,000 Accrued wages payable 3,750

Accrued interest receivable 400 Accrued interest payable 750Merchandise inventory 250,200 Accrued income taxes payable 11,200Prepaid rent 10,000 Note payable 100,000

Total current assets $532,600 Total current liabilities $235,300Long-term asset: Stockholders Equity:

Store equipment $114,900 Paid-in capital $400,000Accumulated Retained earnings 11,200 411,200depreciation 1,000 113,900

Total $646,500 Total $646,500


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Current Ratio

Liquidityis a companys ability to pay itsimmediate financial obligations with cash andnear-cash assets

The current ratioevaluates a companysliquidity

Chan Audios current ratio is

Current Ratio = Current assetsCurrent liabilities

$532,600$235,300

= 2.3


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Current Ratio

Thequick ratioremoves Inventory (and otherless liquid assets such as Prepaid Expenses)from the numerator of the calculation

Chan Audios quick ratio is

The current ratio should be greater than 2.0

The quick ratio should be greater than 1.0

$532,600 - $250,200$235,300

= 1.2


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Income Statement Formats

Two commonly used formats for incomestatements are the

Single-step income statement

Multiple-step income statement The next slide presents a single-stepincome

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 CompanyIncome Statement

For the Month Ended January 31, 20X2

Sales $160,000Rent revenue 500

Interest revenue 400Total sales and other revenues $160,900

Expenses:Cost of goods sold $100,000Wages 31,750Depreciation 1,000Rent 5,000

Interest 750Income taxes 11,200

Total Expenses 149,700Net income $ 11,200


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Multiple-Step Income Statements

Most multiple-stepincome statements disclose

Gross profit(gross margin)

The excess of sales revenue over the cost of theinventory that was sold

Operating expenses

A group of recurring expenses that pertain to thefirms 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 themainstream of a firms operation

Other (nonoperating) revenue and expenses

Revenues and expenses that are not part of theordinary 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-stepincome

statement for Chan Audio Company


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Multiple-Step Income Statement

Chan Audio CompanyIncome Statement

For the Month Ended January 31, 20X2

Sales $160,000Cost of goods sold 100,000Gross profit 60,000

Operating expenses:Wages $ 31,750Depreciation 1,000Rent 5,000 37,750

Operating income $ 22,250Other revenues and expenses:

Rent revenue $ 500Interest revenue 400

Total other revenue $ 900Deduct: Interest expense 750 150

Income before income taxes $ 22,400Income taxes (at 50%) 11,200Net income $ 11,200


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Profitability Evaluation Ratios

Profitability measures affect the investmentdecisions 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

percentageis presented below:

Gross profit percentages vary greatly by industry

Gross profit percentage = Gross profit / Sales= $60,000 / $160,000= 37.5%


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Return on Sales or Net Profit Margin

The return on sales ratio(also known as thenet 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(ROEor ROCE) compares net income withinvested capital

The return on common stockholders equity forChan 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 assetsratio

Compares net income with invested capital asmeasured by average total assets

Measures how effectively those assets generateprofits

The return on assets ratio for Chan Audio for themonth 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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