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Accrual Accounting and Financial Statements

CHAPTER

2006 Prentice Hall Business Publishing

Introduction to Financial Accounting, 9/e

Horngren/Sundem/Elliott/Philbrick

Learning Objectives
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 recognition 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
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

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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

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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

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

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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):
Office Supplies Expense Office Supplies Inventory $1,500 $1,500

Failure to make this adjusting entry will overstate assets and understate expenses
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Expiration of Unexpired Costs


Buyer

Assets (Prepaid Expense) Appear in the Balance Sheet

Adjustments

Expenses Incurred

Appear in the Income Statement

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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

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Earning of Revenues Received in Advance


A company receives rent for 3 months in advance, $6,000 The journal entries below represent
a) An explicit transaction that recognizes the receipt of unearned revenue b) A transaction showing the adjustment for one months rent earned
(a) Cash 6,000 Unearned rent revenue (b) Unearned rent revenue 2,000 Rent revenue
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6,000 2,000
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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

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Earning of Revenues Received in Advance


Seller

Liabilities (Unearned Revenue) Appear in the Balance Sheet

Adjustments

Revenues Earned

Appear in the Income Statement

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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
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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

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Accounting for Accrual of Wages


The transaction recognizes both an expense and a liability

Wages expense Accrued wages payable

30,000
30,000

Failure to record the adjustment understates both expenses and liabilities


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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

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Accrual of Interest
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 1 = $9,000

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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:
Interest expense Accrued interest payable 750
750

Failure to record the adjustment understates both liabilities and expenses

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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

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

Failure to make this adjustment understates both assets and revenues

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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

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The Adjusting Process in Perspective


The complete accounting cycle now becomes
Transactions Documentation Journal Ledger

Unadjusted Trial Balance

Journalize and Post Adjustments

Adjusted Trial Balance

Financial Statements

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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

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The Adjusting Process in Perspective

Advance Cash Payments for Future Services to be Received

Create

Noncash Assets in the Balance Sheet

Transformed by

Expenses in the Income Statement

Expiration of Unexpired Costs

Advance Cash Collections for Future Services to be Rendered

Create

Liabilities in the Balance Sheet

Transformed By Adjustments into

Revenues in the Income Statement

Earnings of Revenues Received in Advance

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The Adjusting Process in Perspective

Passing of Time and the Continuous Use of Services

Recorded by Adjustments as Increases in

Expenses in the Income Statement

and

Liabilities in the Balance Sheet

Decreased by

Later Cash Payments

Accrual of Unrecorded Expenses

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The Adjusting Process in Perspective

Passing of Time and the Continuous Rendering of Services

Recorded by Adjustments as Increases in

Revenues in the Income Statement

and

Noncash Assets In the Balance Sheet

Decreased by

Later Cash Collections

Accrual of Unrecorded Revenues

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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
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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

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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:
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Classified Balance Sheet


Chan Audio Company Balance Sheet January 31, 20X2 Assets Current assets: Cash $ 71,700 Accounts receivable 160,300 Note receivable 40,000 Accrued interest receivable 400 Merchandise inventory 250,200 Prepaid rent 10,000 Total current assets $532,600 Long-term asset: Store equipment $114,900 Accumulated depreciation 1,000 113,900 Total $646,500 Liabilities and Owners Equity Current liabilities: Accounts payable $117,100 Unearned rent revenue 2,500 Accrued wages payable 3,750 Accrued interest payable 750 Accrued income taxes payable 11,200 Note payable 100,000 Total current liabilities $235,300 Stockholders Equity: Paid-in capital $400,000 Retained earnings 11,200 411,200 Total $646,500

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Current Ratio
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

Chan Audios current ratio is $532,600 = 2.3


$235,300

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Current Ratio
The quick ratio removes Inventory (and other less liquid assets such as Prepaid Expenses) from the numerator of the calculation Chan Audios quick ratio is
$532,600 - $250,200 = 1.2 $235,300

The current ratio should be greater than 2.0


The quick ratio should be greater than 1.0
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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

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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

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Single-Step Income Statement


Chan Audio Company Income Statement For the Month Ended January 31, 20X2 Sales $160,000 Rent revenue 500 Interest revenue 400 Total sales and other revenues $160,900 Expenses: Cost of goods sold $100,000 Wages 31,750 Depreciation 1,000 Rent 5,000 Interest 750 Income taxes 11,200 Total Expenses 149,700 Net income $ 11,200

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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 firms 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 the mainstream of a firms 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
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Multiple-Step Income Statement


Chan Audio Company Income Statement For the Month Ended January 31, 20X2 Sales $160,000 Cost of goods sold 100,000 Gross profit 60,000 Operating expenses: Wages $ 31,750 Depreciation 1,000 Rent 5,000 37,750 Operating income $ 22,250 Other revenues and expenses: Rent revenue $ 500 Interest revenue 400 Total other revenue $ 900 Deduct: Interest expense 750 150 Income before income taxes $ 22,400 Income taxes (at 50%) 11,200 Net income $ 11,200

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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

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Gross Profit Margin


The Chan Audio Companys gross profit percentage is presented below:
Gross profit percentage = Gross profit / Sales = $60,000 / $160,000 = 37.5%

Gross profit percentages vary greatly by industry

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Return on Sales or Net Profit Margin


The return on sales ratio (also known as the net 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 (ROE or ROCE) compares net income with invested capital The return on common stockholders equity for Chan 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 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
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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