Accrual Accounting

and
Financial Statements
 Make adjustments for the expiration or consumption of assets.
 Make adjustments for the earning of unearned revenues.
 Make adjustments for the accrual of unrecorded expenses.
 Make adjustments for the accrual of unrecorded revenues.
 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
solvency.
 Prepare single- and multiple-step income statements and use
ratios to asses profitability.
 Most transactions are recorded when they
occur.

 Some transactions might not even seem

like transactions and are recognized only
at the end of the accounting period.
 The difference in these transactions depends
on how obvious or explicit they are.
 Explicit Implicit
Transactions Transactions
 Explicit transactions - events
such as cash receipts and
disbursements, credit purchases, and credit sales
that trigger nearly all day-to-day routine entries

 Entries are usually

supported by
source documents.

 These transactions involve

events that have actually
happened.
 However, some explicit transactions might not involve
actual exchange of goods or services between the firm and
another party………………………….still they are
transactions

 E.g.- Loss of assets due to theft

 Implicit transactions - events such as the passage
of time that do not generate evidence that the
transaction happened and are recognized via
end-of-period adjustments
 Examples include depreciation
expense and the expiration of
prepaid rent.
June 2023
 Adjustments (adjusting entries) - end-of-period
entries that assign the financial effects of implicit
transactions to the appropriate time periods

 Adjustments are usually made when the financial

statements are about to be prepared.

 They are made in the form of journal entries that

are posted to the general ledger.
 Most entities use accrual accounting. Ledger
 Adjusting entries are at the heart of accrual accounting.

 Accrue - to accumulate a receivable or payable during a given

period even though no explicit transaction occurs.

 The receivable or payable grows with time, but nothing changes

hands.
ADJUSTMENTS OR ADJUSTING
ENTRIES
 Arise from four types of implicit
transactions:
1. Expiration or consumption of unexpired
costs
2. Earning of revenues received in advance
3. Accrual of unrecorded expenses
4. Accrual of unrecorded revenues

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1. EXPIRATION OR CONSUMPTION
OF UNEXPIRED COSTS
 Costs expire due to passage of time
 Characteristics of unexpired costs
 An explicit transaction in the past creates an
asset
 Subsequent implicit transactions recognize
the consumption of this asset as an expense

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

AN EXAMPLE OF EXPIRATION OR
CONSUMPTION OF UNEXPIRED
COSTS
 A company pays $6,000 rent in advance for
the months of January, February, and March
 Transaction initially recorded as an asset
(a) Prepaid rent 6,000
Cash 6,000

 End of January, asset declines in value as rent

for one month has been consumed

(b) Rent expense 2,000

Prepaid rent 2,000

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

AN EXAMPLE OF EXPIRATION OR
CONSUMPTION OF UNEXPIRED COSTS

 Failing to record the adjusting entry

causes:
 Assets to be overstated by $2,000
 Expenses to be understated by $2,000
 Net income and stockholders’ equity are
overstated

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

2.EARNING OF REVENUES RECEIVED
IN ADVANCE
 Unearned revenue
 Cash received from customers who pay in
advance for goods or services to be delivered
at a future date
 Also known as revenue received in advance
or deferred revenue
 Requires recording both the receipt of cash
and the liability for future goods or services

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

EARNING OF REVENUES RECEIVED
IN ADVANCE
 Characteristics of unearned revenue
 An explicit transaction (receipt of cash) in the
past creates a liability
 Subsequent implicit transactions recognize
the earning of revenues and the reduction in
the liability over time

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

AN EXAMPLE OF EARNING OF
REVENUES RECEIVED IN ADVANCE
 A company receives $6,000 in cash for rent in
advance for the months of January, February,
and March
 Transaction initially recorded as a liability
(a) Cash 6,000
Unearned rent revenue 6,000

 End of January, liability decreases as revenue

for one month has been earned

(b) Unearned rent revenue 2,000

Rent revenue 2,000

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

EARNING OF REVENUES RECEIVED
IN ADVANCE
 Failing to record adjusting entry causes:
 Liabilities to be overstated by $2,000
 Revenues to be understated by $2,000
 Net income and stockholders’ equity are
understated

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

3. ACCRUAL OF UNRECORDED
EXPENSES
 Some liabilities and the related expenses
increase with the passage of time
 Examples: wages, interest and income taxes

 Characteristics of unrecorded expenses

 An implicit transaction recognizes a liability
and an expense
 Adjustments to bring each accrued expense and
related liability account up to date are made at the
end of the accounting period when financial
statements are prepared
Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
ACCRUAL OF UNRECORDED
EXPENSES
 Adjustments are necessary to accurately match
the expense to the period in which it helps
generate revenues
 Subsequent explicit transaction records cash
disbursement for liability

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

AN EXAMPLE OF ACCOUNTING FOR
ACCRUAL OF WAGES
 A company makes routine entries for the
explicit payment of $500,000 in wages to
employees during January
(a) Wages expense 500,000
Cash 500,000

 Adjusting entry to accrue $75,000 in wages

for the last three days wages in January
(b) Wages expense 75,000
Accrued wages payable 75,000

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.

AN EXAMPLE OF ACCOUNTING FOR
ACCRUAL OF WAGES
 Failing to record the adjusting entry
causes:
 Liabilities to be understated by $75,000
 Expenses to be understated by $75,000
 Net income and stockholders’ equity are
overstated

On the next payroll date, the company will pay off

the $75,000 liability for the work performed during
the last 3 days of January, together with any wage
expense for the first days of February
Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
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

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Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
AN EXAMPLE OF ACCOUNTING FOR
THE ACCRUAL OF INTEREST
 A company borrows $100,000 on
December 31, 2020, and the terms of the
loan require repayment of the loan amount
of $100,000 plus 6% interest on December
31, 2021
 The calculation of interest for the full year is as
follows:

$100,000 x .06 x 1 = $6,000

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AN EXAMPLE OF ACCOUNTING FOR
THE ACCRUAL OF INTEREST
 As of January 31, 2021, the company has
had use of the money for one month.
 The amount of interest owed is (1/12 x .06 x
$100,000) = $500
 Adjusting entry needed to accrue $500 in
interest owed, but not yet paid, for the month
of January

Interest expense 500

Accrued interest payable 500

4-23
Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
AN EXAMPLE OF ACCOUNTING FOR
THE ACCRUAL OF INTEREST
 Failing to record the adjusting entry
causes:
 Liabilities to be understated by $500
 Expenses to be understated by $500
 Net income and stockholders’ equity are
overstated

4-24
Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
ACCRUAL OF INCOME TAXES

 Just like the accrual of wages and interest,

income tax expense and an income tax
liability accrue over the accounting period
as income is generated
 An adjusting entry is needed at the end of the
accounting period

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Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
4. ACCRUAL OF UNRECORDED
REVENUES
 Mirror image of the accrual of unrecorded
expenses
 Characteristics of unrecorded revenues
 An implicit transaction recognizes an asset
and a revenue
 Subsequent explicit transaction records the
receipt of cash and reduction of previously
recorded asset

4-26
Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
AN EXAMPLE OF ACCRUAL OF
UNRECORDED REVENUES
 Suppose the bank made a $100,000 loan to
a customer on December 31, 2021. The
terms of the loan require repayment of the
loan amount of $100,000 plus 6% interest
on December 31, 2022

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Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
AN EXAMPLE OF ACCRUAL OF
UNRECORDED REVENUES
 As of January 31, 2022, the bank has earned
interest for one month
 The amount of interest earned is (1/12 x .06 x
$100,000) = $500
 Adjusting entry need to accrue $500 in interest
revenue earned, but not yet received, for the
month of January 2022:

Accrued interest receivable 500

Interest revenue 500
4-28
Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
ACCRUAL OF UNRECORDED
REVENUES
 Failing to record the adjusting entry causes:
 Assets to be understated by $500
 Revenues to be understated by $500
 Net income and stockholders’ equity will be
understated

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Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall.
THE ADJUSTING PROCESS IN
PERSPECTIVE
 Steps in recording process:

 Considering adjustments, the fourth step

can be further divided as:

4-30
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THE ADJUSTING PROCESS IN
PERSPECTIVE

4-31
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THE ADJUSTING PROCESS IN
PERSPECTIVE

4-32
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 Classified balance sheet - a balance sheet that
groups the accounts into subcategories to help
readers quickly gain a perspective on the
company’s financial position

 Assets are usually classified as current assets/ short term assets and
long-term assets.

 Liabilities are usually classified as current liabilities and long-term

liabilities.
 STEVENS COMPANY
Balance Sheet
December 31, 2022
Assets Liabilities and Owners Equity

Current assets Current liabilities

Cash $ 4,525 Accounts payable $ 9,800
Accounts receivable 2,040 Wages payable 3,765
Total current assets 6,565 Total liabilities 13,565
Long-term assets
Land 9,755
Equipment 6,500 Owner’s Equity
Total plant assets 16,255 Stevens, capital 9,255
Total liabilities and
Total assets $22,820 owners' equity $22,820
============= =============
 Current assets - include cash plus assets that are
expected to be converted to cash, sold, or
consumed during the next 12 months or within
the normal operating cycle if longer than a year.

 Current liabilities - include liabilities that fall

due within the coming year or within the normal
operating cycle if longer than a year.
 Current assets are listed in the order in which
they will be converted to cash.
 Cash is always listed first; then Accounts
Receivable, Notes Receivable, and Interest
Receivable are listed.
 Non-monetary assets (inventory, prepaid
expenses) are listed last in the current assets
section.

 Current liabilities are listed in the order in which

they will draw on, or decrease, cash during the
coming year.
 Working capital - the excess of current assets over current
liabilities
 It connects the assets and the liabilities of the company.

Working Total Current Assets -

Capital Total Current Liabilities
 Comparing the amount of cash a company
will have on hand and the amount of debt the
company will have to pay off with that cash
can help readers assess an entity’s liquidity.

 Liquidity - an entity’s ability

to meet its immediate financial
obligations with cash and near-cash
assets as they become due
 The current ratio (working capital ratio) is
used to evaluate liquidity.
 The higher the current ratio, the more assurance
creditors have that the entity can pay its bills on
time…………however this may not be true always!!!

Current Ratio = Current Assets

Current Liabilities
 An old rule of thumb was that an acceptable current ratio
would be greater than 2.0, but realistically, a current ratio
over 1.0 is acceptable.

 One way of assessing the current ratio is to compare it to

the average current ratio of the industry in which the
company operates.
 Quick Ratio
= Current Assets – Inventory - Prepaid Expenses
Current Liabilities
 Balance sheet formats:
 Report format - a classified balance sheet with
assets at the top and liabilities and equity below.

 Account format - a classified balance sheet with

assets at the left and liabilities and equity at the
right

 Regardless of format, balance sheets always

contain the same basic information.
 Most users of financial statements are
concerned about the entity’s ability to
produce long-run earnings and dividends.

 This information can be found in the income

statement.

 Income statements can be prepared with

subcategories to make them easier to read
and more informative.
 Income statement formats:
 Single-step income statement - groups all
revenues together and then lists and deducts all
expenses together without drawing any
intermediate subtotals

 Multiple-step income statement - contains one

or more subtotals that highlight significant
relationships
 A single-step income statement:
STEVENS COMPANY
Income Statement
for the Year Ended December 31, 2022
Sales Revenue $ 98,600
Rent revenue 4,000
Total revenues $102,600
Expenses:
Wages expense $45,800
Rent expense 12,000
Depreciation expense 5,000
Corporate Tax @ 30% 11,940
Total expenses 74,740
Net Income $ 27,860
================
 Sections and intermediate subtotals on multiple step
income statements:
 Gross profit (gross margin) - excess of sales revenue over
the cost of inventory that was sold.

 Operating expenses - a group of recurring expenses that

pertain to a firm’s routine operations.

 Operating income (operating profit) - gross profit less all

operating expenses.

 Other revenues and expenses - items not directly related

to the main operations of a firm.

 Earnings before Income Tax(EBIT)

 (Rs. In Lakhs)

Sales Revenue 1,00,000

Less: Cost of Goods sold 25,000

Gross Profit/ Gross Margin 75,000

Less: Operating Expenses 35,000

Operating Income/ Operating Profit 45,000

Add: Non-operating Revenues/ Profits 5,000

Less: Non-operating Expense/ Losses 6,000

Earnings Before Tax (EBT)/ Profit Before Tax (PBT) 44,000

Less: Tax @30% 13,200

Earnings After Tax (EAT) / Net Income/ Net Profits/ Profit 30,800
After Tax (PAT)
 Accountants generally regard interest revenue and interest
expense as OTHER revenue and expense items

 Operating income eases the comparison between years

and between companies by not considering the OTHER
revenue and expense items
 Income statements are most useful in
evaluating an entity’s profitability, which
is the ability of a company to provide
investors with a particular rate of return
on their investment.
 Return on investment - the amount
of money an investor receives
because of a prior investment
 Profitability comparisons are used to compare
one company over a period of time or to
compare several companies over the same
period of time.

 Four popular profitability ratios:

1. Gross profit percentage (gross margin
percentage)
2. Return on sales ratio
3. Return on stockholders’ equity ratio
4. Return on Assets
1. Gross Profit% Or Gross Margin %
= Gross Profit * 100 =75%
Sales Revenue

2. Return on Sales or Net Profit Margin

= Net Income *100 =30.8%
Sales revenue

3. Return on Common stockholders equity

= Net Income * 100 = 30,800 *100= 17.11%
Average Common Equity 180000
 4. Return on Assets
= Net Income *100 = 30800 *100=13.68%
Average Total Assets 225000

 Gross profit % varies greatly with the nature of the industry

 E.g.: Gross profit % would be generally high for software companies

and low for retail companies