Northeastern University

ACC1001- Financial Accounting

Instructor: Mike McKinney

Week 3- Chapter 4 and 5

Lecture Notes

I. Accrual Accounting
a. The accrual accounting concept is about timing
i. Accountants should book things as soon as they are known
ii. However, in some cases, the events have not yet occurred
iii. Enter the concept of accrual accounting; booking an event that has
not yet happened
1. For instance, we may know what rent is going to cost us
next month and for the next 12 months
2. Since the rent is not due to be paid for future months, we
can accrue the expense so the BS shows future obligations
and management can plan knowing those expenses
b. Revenue Recognition
i. See discussion on pages 164-165
ii. Example in book is about dry cleaning service
1. Cleaning service is performed in June but not customer
does not pay until July
2. See the journal entries on page 165
c. Expense Recognition Principle
i. Rule is “let the expenses follow the revenue
ii. In the dry cleaning example, the expenses should booked in June
when the revenue was booked
iii. As another example, think of an annual service contract
1. Note example about a service agreement
a. Performing the service has not yet occurred but the
obligation exists
b. For instance, warranty for 50,000 miles or three
years on a new car
i. The new car may not have any miles yet but
the manufacturer knows from experience a
certain percentage of new cars have repair
needs
ii. Manufacturer books a warranty reserve for
the expected expense
 c. For instance, if a customer pays for a one year
service agreement for a piece of production
equipment and pays in advance
i. The manufacturer books the revenue as
Deferred Revenue, a BS liability account
(because the manufacturer owes the service
to the customer),at the beginning of the year
ii. Each month, Deferred Revenue is relieved
of one-twelfth of the service contract and
Revenue is booked (recognized) for that
month
iv. See illustration 4-1 on page 165 for Matching Principle (match the
expense with the revenue)
d. Accrual versus cash
i. Some businesses, especially smaller, less sophisticated business,
use the cash principle of accounting
1. when the cash event occurs, that is the time period the
event is booked
2. for instance, for IRS purposes, all of us are independent
businesses
a. we pay our taxes on a cash basis
b. when the cash is received or dispensed, that is the
time period (year) we report that event for taxes
3. cash does not comply with GAAP
ii. accrual accounting
1. as mentioned before, the purpose of accrual accounting is
to recognize the appropriate timing of the event for
reporting
2. note on pages 166-167 and illustration 4-2 how accrual
versus cash accounting can change the apparent results
e. adjusting entries
i. adjusting entries ensure revenue and expenses are matched and
recognized in the same period
ii. adjusting entries are necessary because the trial balance may not
reflect all events because:
1. not all events are recorded as they happen
a. for instance, use of supplies
2. some expenses expire with passage of time
a. for instance, the warranty on a car or an annual
insurance policy
3. some events are not known yet
iii. types of adjusting entries
1. deferrals
a. prepaid expense
b. unearned revenues (see previous example)
2. accruals
 a. revenues where the work has been performed but
payment has not been made
b. accrued expenses
i. expenses have been incurred ( have
happened) but not yet paid
1. for example, consider your paycheck
at work
2. you have worked the week but not
yet been paid
3. the payroll expense is accrued until
the payment is made
3. see illustration 4-4 on page 168 to see examples of accruals
and deferrals on a trial balance
a. prepaid expenses
i. supplies
1. purchased and housed before they
are used
ii. insurance
1. insurance carriers require businesses
pay in advance for their insurance
coverage
2. Why? Because it is hard to collect
monies owed on something you can
not repossess
iii. Depreciation
1. A long-lived asset may last for years
2. Life of the asset gradually passes
3. GAAP requires current financial
statements reflect the true value of
the business
a. Which requires the BS reflect
the depreciated value of the
asset
4. See illustration 4-8 on page 172
5. See illustration 4-9 on page 172 for
treatment of accumulated
depreciation
iv. Unearned revenues
1. See illustration 4-11 on page 173 for
entry
2. See illustrations 4-12 and -13 on
page 174
b. Second type of adjusting entries: accruals
i. Accrued revenue
1. Services performed but not yet
recorded
 a. See illustration 4-14 for the
adjusting entry and 4-15 for a
full discussion
ii. Accrued expenses
1. See illustration 4-17 on page 177
iii. Accrued expenses
1. See illustration 4-18 on page 177 and
4-19 on page 178
iv. Accrued salaries
1. See illustration 4-20 on page 178 and
4-21 on page 179
4. Summary of adjusting entries
a. Illustration 4-23 on page 181 summarizes the types
of adjusting entries
b. Illustrations 4-24 and 25 provide the GL and entries
for adjusting entries
iv. The adjusted trial balance and financial statements
1. See illustration 4-26 on page 183
a. Provides the adjusted trial balance for the entries
made on illustration 4-25
b. Entries are shown in red
2. See illustration 4-27 and 28 on pages 184-185
a. Shows how the accounting flows from the trial
balance to the IS and BS
f. Why accrual accounting is important
i. Accrual accounting ensures the honest presentation of the financial
statements
ii. Attempts to ensure unethical accountants do not “cook the books”
meaning present the financials to tell a story that does not
accurately reflect the position of the business
iii. Prepares management to plan for events that have been obligated
or have occurred but for which the cash event has not yet happened
g. Closing the books
i. Revenue accounts are considered temporary
1. Because they related a specific period
ii. BS accounts are considered permanent
1. Because they are never closed but entries cause them to
change in value
iii. Note illustration 4-30 which graphically illustrates how the
revenue accounts flow to and are captured for permanent
consideration on the BS in the Retained earnings account
iv. Post closing trial balance
1. Prepared after all closing entries are completed
2. Proves the equality (balancing) of all permanent accounts
that will be carried into the next time period
h. Summary of accounting cycle
 i. See illustration 4-33for a summary of the accounting cycle as we
have studied so far
II. Multiple step IS
a. Merchandizing Operations
i. Merchandizers are retailors
ii. They buy and sell product rather than perform services
iii. See illustration 5-1 on page 230
1. Shows income measurement
2. Cost of Goods Sold (COS)
a. Identifies the cost of the product
3. Operating expenses
a. Overhead such as
i. Salesmen salaries & expenses
ii. Rent for office
iii. Transportation and handling of product
iv. Lights in the office
v. Accountants salaries and expenses
iv. Operating cycle
1. See illustration 5-2 on page 231
a. Shows difference between the operations of a
service company and a merchandizing company
v. Flow of costs
1. See illustration 5-3 on page 231
a. Begins to introduce inventory controls and
management
b. Businesses use an inventory control system either…
i. Perpetual
1. Updated by every transaction
2. Many retailers have a perpetual
system based off the entry at the cash
register
3. As cashier rings up sale a bar code is
scanned or an inventory number
entered
4. System records the use of an item in
inventory (in accounting terms the
inventory is relieved)
5. Manufacturing companies use a
formal request and approval form to
obtain inventory which creates a
document flow and updates the
perpetual inventory
ii. Periodic
1. Count inventory on an interval basis,
every month, for instance
 a. Determine the amount of
inventory at the beginning of
the inventory period
b. Count the inventory at the
end of the period
c. The difference plus any
inventory received in from
outside suppliers must be the
inventory used during the
period
vi. The perpetual inventory in detail
1. Recording purchases of inventory
a. Inventory can be purchased for cash
b. Another purchase option is a purchase on payment
terms from suppliers
i. Also called buying on credit
ii. Inventory is ordered and received and paid
for at a later date
iii. Thus the need for accrual accounting (see
last chapter)
c. See illustration 5-5 on page234
i. Shows document when inventory is received
in
ii. Called an invoice
iii. Order for inventory is made on a purchase
request to document order
1. Used to ensure the appropriate
employee has approved the order of
the inventory
iv. When received, an invoice is received from
the supplier
1. The invoice is recorded in the system
to add inventory (Db. To Inventory
account which increases the assets;
Cr. To Accounts Payable which
increases the liability side of the BS)
2. See entry at the bottom of page 233
d. Freight costs
i. Terms for the delivery of product from a
supplier are very specific and determined by
legally based on hundreds of years of
experience
ii. Think of all the choices when ordering a
product
1. When do I own the item
 a. When it leaves the supplier’s
dock?
b. When arrives at my sight?
c. Who is responsible if the
item is lost or damaged while
in the truck on its way to me?
d. Who insures while in
shipment?
e. These are all determined by
the shipping terms
f. Your text talks about Free on
Board (FOB) which still must
be defined by other terms
such as…
i. FOB shipping point
ii. FOB destination
g. Terms also determine who
pays for the shipping
h. Read the discussion on pages
233-235 to get an idea of how
freight costs are determined
e. Returns and allowances
i. Not all product arrives as ordered
1. Sometimes the supplier ships the
wrong thing
2. Sometimes the order clerk makes a
mistake and orders the wrong thing
3. Sometimes the item or items are
broken when they arrive
4. All these problems result in the
request to return the product to the
supplier for an allowance on the
invoice (reduction or “credit” against
the AP
5. see discussion on pages 235-236
with entry to accounts
f. purchase discounts
i. sometimes the supplier wants to invite their
customer to pay quickly
ii. offers a discount if paid promptly
iii. the most common discount business to
business is 2%, net 10
1. means the ordering business can pay
2% less than the invoice if they pay
within 10 days
 iv. sometimes the discount is offered off a
volume of purchase
1. for instance, once 10 items have
been purchased the price decreases
by a percentage or a flat amount
v. see discussion on pages 236-237 and the
entries for a purchase discount
g. see discussion on pages 237 that summarize the
purchasing transaction
vii. recording the merchandizing sale
1. see discussion on pages 238-241
a. provides the detail of the merchandizing version of
the sale, returns and allowances and discounts
viii. Income statement presentation
ix. Two types of presentation
1. Single-step IS
a. See illustration 5-7 on page 241
b. All revenues and all expenses are presented as
single line items
c. The form is simple and easy to read
d. Usually used by very uncomplicated businesses
2. Multiple-step IS
a. Contains a more defined presentation of
components of the income process
b. Provides a greater ability to identify and analyze
those things going well and those things that need
attention
c. See illustration 5-8 on page 242
i. Important line items to recognize are…
1. Gross Profit
a. Profit before operating
expenses are counted
b. Allows ability to separate the
sales revenue and expenses
from the expenses created by
overhead
2. Income from operations
a. Before taxes
3. Net income
a. After everything income and
expense has been considered
3. On page 243 the merchandizing company is high-lighted
x. Nonoperating activities
1. Usually defined as revenues received not part of sales
operations
a. Interest from investments
 b. Dividends from investments in other businesses
c. Rent
d. Extraordinary gain from sale of an asset not product
2. On expense side
a. Interest expense
b. Lost due to casualty
c. Sale of an asset that created a loss
xi. Determining the costs under a periodic system
1. Discussed earlier in notes
2. See illustration5-13 on page 247
xii. Gross profit
1. We have discussed in an earlier chapter the use of ratios
a. Ratios allow different sized businesses to be
compared for performance
b. Gross profit can be expressed as a percentage of
various business items
i. Gross profit as a percentage of sales
ii. Gross profit by employee
iii. Gross profit as a percentage of fixed assets
iv. Gross profit as a percentage of debt
c. Different industries have different standards and
different ratios that best describe the performance of
the business
i. For instance, software companies typically
expect higher profit margins because the
investment in people and operating
equipment is minimal when compared a
heavy manufacturer like automobiles
ii. See illustration5-14 thru 5-16 to get an idea
what different industries approach ratio
analysis