Accrual Accounting & Adjusting Entries

Accrual-Basis Accounting and Adjusting Entries

• Accrual-basis accounting records transactions when they occur, regardless of cash exchange.
• Cash-basis accounting records revenue when cash is received and expenses when cash is paid.
• Adjusting entries are made to ensure revenue recognition and expense recognition principles are followed.
• Adjusting entries are needed because trial balances might not contain up-to-date data.
• Each adjusting entry affects one income statement account and one balance sheet account.
• Adjusting entries are classified as deferrals or accruals

Revenue Recognition Principle

• Revenue is recognized in the period when the performance obligation is satisfied
• Performance obligation is satisfied by performing a service or providing a good to a customer.

Expense Recognition Principle

• Expenses are recognized in the period when they contribute to revenue generation.
• Expense recognition ties to revenue recognition, following the rule, "Let the expenses follow the revenues."
• Also referred to as matching, showing relationship between effort and revenue.

Accrual vs Cash Basis

• Accrual basis: Transactions recorded when events occur, irrespective of cash flow.
• Accrual basis recognizes revenues when services are performed and expenses when incurred.
• Cash basis: Revenue recorded upon cash receipt, and expense recorded upon cash payment.
• Cash basis can be misleading as it might not reflect revenue in the period when the performance obligation is satisfied.

Types of Adjusting Entries

• Deferrals:
  • Prepaid expenses: Expenses paid in cash before use or consumption.
  • Unearned revenues: Cash received before services are performed.
• Accruals:
  • Accrued revenues: Revenues for services performed but not yet received in cash or recorded.
  • Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

Adjusting Entries for Deferrals

• Deferrals postpone expense or revenue recognition to a later date than the initial cash exchange.
• Adjusting entries for deferred expenses record the portion incurred during the period.
• Adjusting entries for deferred revenues record services performed during the period.
• Prepaid expenses and unearned revenues are the two deferral types.

Prepaid Expenses

• Prepaid expenses benefit more than one accounting period and are recorded as assets.
• Prepayments increase an asset account when cash is paid before use or consumption.
• Common prepayments include insurance, supplies, advertising, and rent.
• Adjusting entries for prepaid expenses increase an expense account and decrease an asset account.
• Before adjustment, assets are overstated, and expenses are understated.
• Accumulated Depreciation is a contra asset account offsetting the asset account on the balance sheet.

Unearned Revenues

• Cash received before services are performed increases a liability account called unearned revenues.
• Unearned revenues represent a company's obligation to provide a service.
• Unearned revenue for one company is usually a prepaid expense for the other.

Adjusting Entries for Accruals

• Accruals recognize expenses or revenues earlier than when cash changes hands.
• Accrual adjustments increase both a balance sheet and an income statement account.
• Before accrual adjustments, revenue and asset accounts or expense and liability accounts may be understated.

Accrued Revenues

• Accrued revenues are for services performed but not yet recorded.
• Accrued revenues accumulate with time.
• Unrecorded because the earning of interest does not involve daily transactions.

Accrued Expenses

• Accrued expenses are incurred but not yet paid or recorded.
• Interest, taxes, utilities, and salaries exemplify accrued expenses.
• Adjustments for accrued expenses record existing obligations and recognize expenses for the current period.
• Before adjustment, there will be an understatement of both liabilities and expenses.
• Interest recorded relies on the face value of the note, interest rate, and outstanding time.

The Adjusted Trial Balance and Closing Entries

• An adjusted trial balance is prepared after journalizing and posting adjusting entries.
• The adjusted trial balance proves the equality of debit and credit balances after adjustments.
• The adjusted trial balance is the basis for preparing financial statements.
• Earnings management involves timing revenues, expenses, gains, and losses to reduce net income volatility.
• Quality of earnings diminishes when earnings are managed to meet targets.

Quality of Earnings

• High-quality earnings come from full, transparent information.
• Questionable quality of earnings can mislead investors and creditors.

Closing the Books

• Temporary accounts (revenues, expenses, dividends) relate to a single accounting period
• Permanent accounts (balance sheet accounts) carry forward into future periods.
• Temporary accounts are closed to Retained Earnings at the end of the period
• Permanent accounts are not closed
• Closing entries transfer net income/loss and dividends to Retained Earnings.
• Closing entries produce a zero balance in each temporary account.
• Revenue and expense accounts close to Income Summary, a temporary account.
• Income Summary's balance is the net income or loss for the accounting period.
• A post-closing trial balance lists permanent accounts and their balances after closing entries.
• It proves the equality of debit and credit balances for accounts carried into the next period.
• Temporary accounts will all have zero balances in the post-closing trial balance.

Using a Worksheet

• A worksheet is a multiple-column spreadsheet used in the adjustment process and in preparing financial statements.
• Not a permanent accounting record.
• It simplifies the preparation of adjusting entries and financial statements.

Depreciation Expenses

• Prepaid expenses (like prepaid rent) are now a completed benefit
• Unearned revenue is now earned

Closing Entries

• Closing entries are used to close all temporary accounts (revenue and expenses) (Income Statements accounts)
• Permanent accounts (A,L,E) (Balance sheet accounts) are not closed

Post-Closing Trial Balance

• Will show accounts like Interest Payable, Equipment, Unearned Service Revenue, and Accumulated Depreciation of Equipment

Financial statement inclusions

Balance Sheet:

• AP
• Accum Dep
• Supplies Income Statement:
• Service revenue
• Depreciation exp Retained Earnings Statement:
• Retained earning (beginning)
• Dividends

Appendix F: Time Value of Money

• Interest is payment for the use of money.
• Interest is the difference between the amount borrowed/invested (principal) and the amount repaid/collected.

Three elements to consider when calculating an amount of interest

• Principal (p): The original amount borrowed or invested.
• Interest rate (i): An annual percentage of the principal.
• Time (n): The number of periods over which the principal is borrowed or invested.

F.1 Interest and Future Values

• Simple interest is computed only on the principal amount.
• Compound interest computes on the principal and accumulated interest.
• Future value of a single amount is its value at a future date with compound interest.
• Annuity: Series of equal payments or receipts.
• Future value of an annuity: Sum of all payments/receipts plus accumulated interest.

Formula for Future Value (FV)

• FV = p × (1 + i)^n
  • FV = Future value
  • p = Principal (present value)
  • i = Interest rate per period
  • n = Number of periods

F.2 Present Values

• Present value is the current worth of a future payment or receipt, considering compound interest.

Present Value Variables:

• The dollar amount to be received (future amount).

• The length of time until the amount is received (number of periods).

• The interest rate (the discount rate).

• Discounting determines present value.

Present Value of an Annuity

• The present value of an annuity is the value now of a series of future receipts or payments, discounted assuming compound interest
• Interest on interest (and principal) (continued payment over a period of time)

Factors to know when computing annuity

• The discount rate
• Number of payments or receipts.
• Amount of periodic receipts or payments

Time Periods and Discounting

• Discounting can be annual or over shorter periods (monthly, quarterly, etc).
• Present value of a long-term note or bond is based on payment amounts, time to payment, and discount rate.

Computing Value of Bond payment

• A series of interest payments (an annuity)
• The principal amount ( a single sum)

F.3 Capital Budgeting Situations

• Long-term capital investments are evaluated using discounting techniques.
• Companies calculate the present value of cash flows involved in a capital investment.
• Computing the present value of net operating cash flows ($40,000 at the end of each year) is discounting an annuity
• Computing the present value of the $35,000 salvage value is discounting a single sum

F.4 Using Technological Tools

• Excel is a useful tool for accountants, allowing them to quickly solve a variety of accounting problems
• Excel and financial calculators can quickly solve accounting problems.

Excel Function Inputs

• Rate: Interest rate per period.
• Nper: Number of periods.
• Pmt: Payment amount each period.
• PV or FV: Present or future value.
• Type: 0 for payments at the end of the period, 1 for payments at the beginning.
• Financial calculators: Enter time value of money variables

Plus and Minus usage

• Excel: Cash inflows are positive, outflows negative.
• Financial calculators usually offset positive and negative flows.

Potential Issues in Calculators

• Compounding period has to be determined as some financial calculators may have preset values.
• Excel and financial calculators may differ slightly in answers due to rounding.
• Tables and charts may only contain up to a certain decimal place

Chapter 5 - Merchandising Operations and the Multiple-Step Income Statement

• The primary source of revenue for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales.
• A merchandising company has two categories of expenses: cost of goods sold and operating expenses.
• Cost of goods sold is the total cost of merchandise sold during the period. This expense is directly related to the revenue recognized from the sale of goods.
• Operating expenses are incurred in the process of earning sales revenue. Examples include advertising expense and rent expense. Note that operating expenses are a category of expenses, not a single line item on the income statement.
• The difference between sales revenue and cost of goods sold is called gross profit.
• Cost of goods sold and gross profit are unique to a merchandising company; they are not used by a service company.

Components of the MULTIPLE STEP Income Statement:

• Revenue (X)
• COGS (Y)
• Gross Profit (X - Y = GP)
• Operating Expenses (A)
• Income before taxes GP - A = IBT
• Taxes - Tax Rate*IBT = T --------------------------------
• Income From continuing Operations (ICO = IBT -T)
• Discontinued Op’s (Net of Tax) (D)
• Net Income (ICO + – D)

5.1 Merchandising Operations and Inventory Systems

• Operating Cycle of merchandizing longer than service due to purchasing process.
• Added asset is Inventory
• Merchandise Inventory- all purchases of merch for resale to customers to get it ready

Systems for Inventory

• Perpetual: Detailed records of the cost of each inventory purchase and sale.
• Periodic: Determine the cost of goods sold only at the end of the accounting period

Flow of Costs

• Beginning inventory plus goods purchased determines the goods available for sale.
• Those goods that are not sold by the end of the accounting period represent ending inventory.
• Goods that are sold are assigned to cost of goods sold

Perpetual System

• Detailed records of the cost of each inventory purchase and sale.
• Continuously show the inventory and should be on hand for every item.
• Determines the cost of goods sold each time a sale occurs.
• Uses computers and electronic scanning equipment to make perpetual inventory cost effective!
• When recording the sale of goods for cash in a perpetual inventory system, you enter two journal entries. One to record the receipt of cash and sales revenue, and one to record the cost of goods sold and to reduce inventory.
• A payment of freight costs for goods shipped to a customer does not result in an inventory account.

Periodic System

• Does not keep detailed inventory records.
• Determine the cost of goods sold only at the end of the accounting period.
• When using periodic inventory, you don’t debit inventory when you buy it, you debit purchases.

Steps necessary to determine the cost of goods

• Determine the cost of goods on hand at the beginning of the accounting period.
• Add the cost of goods purchased.
• Subtract the cost of goods on hand as determined by the physical inventory count at the end of the accounting period.

Advantages of the Perpetual System

• Shows the quantity and cost of the inventory that should be on hand at any time.
• Provides better control over inventories than a periodic system.
• Computerized system can minimize this cost.

Difference between Perpetual and Periodic

• Perpetual:match COGS with every sale
• Periodic: solve for COGS after physical inventory count

5.2 Recording Purchases Under a Perpetual System

• A purchase invoice should support each credit purchase.
• Indicates the total purchase price and other relevant information.
• A purchase invoice to a buyer is a sales invoice to a seller.
• Under the perpetual inventory system, companies record purchases of merchandise for resale in the Inventory account.
• Not all purchases are debited to Inventory.

Freight Costs

• Indicate who is responsible for paying the freight charges (shipping costs) and who is responsible for the risk of loss or damage to the merchandise during transport.

FOB Shipping Point

• Ownership of goods passes to the buyer when the public carrier accepts the goods from the seller.
• Buyer responsible for the freight costs from the shipping point to the buyer’s destination.
• Buyer responsible for any loss or damage that occurs along the way.
• Buyer pays freight only when the shipping terms are FOB shipping point.

FOB Destination

• Ownership of goods remains with the seller until the goods reach the buyer.
• Seller is responsible for delivering the goods to the destination.
• As such, the goods would be included in the seller’s inventory until they are delivered.
• Freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller and go in the expense account titled Freight-Out (sometimes called Delivery Expense).

Purchase Returns and Allowances

Purchase Return

• A return of the goods from the buyer or seller for cash or credit.

Purchase Allowance

• A reduction made in the selling price of the merchandise, granted by the seller so that the buyer will keep the goods.

Purchase Discounts

• The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment.
• Net method - the payment will be made within the discount period.
• Credit terms specify the amount of the cash discount and time period in which it is offered.
• 2/10, n/30 Credit Terms: 2% cash discount if payment is within 10 days, otherwise net due within 30 days.
• Companies should take all available discounts.

5.3 Recording Sales Under a Perpetual System

• Sales-returns and allowances is a contra-revenue account
• The revenue recognition principle, requires that companies record sales revenue when the performance obligation is satisfied.
• Sales may be made on credit or for cash
• A sales invoice provides support for a credit sale.
• The seller makes two entries for each sale
  • Increase Cash or Accounts Receivable, and increase Sales Revenue
  • Increase Cost of Goods Sold and decrease Inventory

Sales Discounts

• A cash discount—called by the seller a sales discount—issued for the prompt payment of the balance due.
• The seller increases (debits) the Sales Discounts account for discounts that are taken.

Data Analytics and Credit Sales

• Effectively analyzing data regarding current, as well as potential, customers can help a company expand its sales base while minimizing the risk of unpaid receivables.
• To achieve the optimal cost-benefit balance on sales discounts, companies statistically analyze past discount practices to determine how large the discount should be, how long the payment period should be, and other factors.

5.4 Preparing the Multiple-Step Income Statement

Single-Step Income Statement

• Only one step, subtracting total expenses from total revenues, is required in determining net income (or net loss).
• Data are classified into two categories: -Revenues -Expenses

Multiple-Step Income Statement

• Has three important line items: gross profit, income from operations, and net income.
  • Subtract cost of goods sold from net sales to determine gross profit.
  • Deduct operating expenses from gross profit to determine income from operations.
  • Add or subtract the results of activities not related to operations to income from operations to determine net income.

Sales

• The income statement for a merchandising company typically presents gross sales for the period.
• The company deducts sales returns and allowances and sales discounts from sales revenue to arrive at net sales.

Gross Profit

• The excess of net sales over cost of goods sold is gross profit.
• Deducting cost of goods sold from net sales indicates Gross profit.

Nonoperating Activities and Income Tax Expense

• Activities that are unrelated which include:
  • Other revenues and gains
  • Other Expenses and Losses

5.5 Cost of Goods Sold Under a Periodic System

• End of period inventory balances are counted.
• B+P-E=COGS
• Gross Profit = Net Revenue - COGS
• Net Income = Gross Profit - Operating Expenses
• Gross Profit Rate : Gross Profit/Net sales Shows % profit after production costs
• Profit Margin Ratio: Net Income/Net Sales Shows % profit after all expenses

5.6 Gross Profit Rate and Profit Margin

• Analysts often express gross profit as a percentage by dividing the amount of gross profit by net sales.
• Gross Profit Rate Formula: Gross Profit/Net Sales
• The higher the gross profit amount, the more impressive the sales are!

Profit Margin Formula: Net Income/Net Sales

• The higher the profit margin the more the company is making!

Recording Merchandise Transactions

• Companies record revenues from the sale of merchandise when sales are made, just as in a perpetual system.
• Purchases of merchandise are recorded in the Purchases account rather than the Inventory account.

Section 2/19/25

• Annual percentage rate = i
• Simple Interest: Only computed on the principal amount
• Tot Interest = pin
• Not used very much Compound Interest Formula: PV =FV/(1+i)^n
• Ordinary Annuity - payments made at the end of the payment interval
• Annuity Due- payments made at the beginning of the payment interval
• Includes gross profit subtotal
• Separates operating transactions from non-operating
• Includes “income from operations” subtotal

Chapter 12: Statement of Cash Flows

• The statement of cash flows reports the cash receipts, cash payments, and net change in cash resulting from operating, investing, and financing activities during a period.
• Help investors and creditors asses and entities ability to generate future cash flows.
• The entity’s ability to pay dividends and meet obligations.
• Show the reasons for the difference between net income and net cash provided
• Cash investing and financing transactions during.

Classification of Cash Flows

• Operating activities involve income statement items.Operating activities include the cash effects of transactions that generate revenues and expenses. They thus enter into the determination of net income.
• Investing activities involve cash flows resulting from changes in investments and long-term asset items.Investing activities include (a) acquiring and disposing of investments and property, plant, and equipment, and (b) lending money and collecting the loans.
• Financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items.Financing activities include (a) obtaining cash from issuing debt and repaying the amounts borrowed, and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends.
• The operating activities are a main section

Statement of Cash Flows

• There are direct and indirect methods
• The direct methods involve reconciliation of net income
• The general format of the statement of cash flows presents the results of the three activities
• operating
• Investing
• Financing

Section 12.2 Indirect Method

• *Indirect method and Direct Method
• Under the indirect method, companies must adjust net income to convert certain items to the cash basis.
• The direct method shows operating cash receipts and payments

Statement of Cash Flows

• Under generally accepted accounting principles (GAAP), most companies use the accrual basis of accounting.This basis requires that companies record revenue when a performance obligation is satisfied and record expenses when incurred.
• The indirect method (or reconciliation method) starts with net income and converts it to net cash provided by operating activities. (Decrease in inventory and increases in accrued liabilities are added)
• When using the indirect method, the statement of cash flows starts with net income from the income statement and then adjusts for noncash expenses and changes in current asset and current liability accounts.
• The first line is net income…an accrual-basis number Summary of Conversion to Net Cash Provided by Operating Activities—Indirect Method Noncash charges such as depreciation and amortization. Gains and losses on the disposal of plant assets. Changes in noncash current asset and current liability accounts. Payment of the dividends (not the declaration) is a cash outflow that the company reports as a financing activity.

Corporate Life Cycle

• All products will go through all product life cycles phases.
• Introductory -When a company purchases product sell plants and equipment. Growth -The company will try to sell and expand its business.
• Maturity- level off the sales
• Decline -sales decreasing because of weakness in consumer demand. The company sells excess assets
• During the growth phase, we expect to see the company start to generate small amounts of cash from operations. During this phase, net cash provided by operating activities on the statement of cash flows is less than net income.
• During the maturity phase, net cash provided by operating activities and net income are approximately the same. Cash generated from operations exceeds investing needs.
• Finally, during the decline phase, net cash provided by operating activities decreases. Cash from investing activities might actually become positive as the company sells off excess assets.

Free Cash Flow

• Net cash provided by operating activities after adjustment for capital expenditure-and dividends
• Free Cash Flow Formula = Net Cash Provided by operating Activities (Cash Sales) - Capital Expenditures - Cash Dividends

Statement of Cash Flow- Direct Method

• The direct method, companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis.
• Adjustments are made for prepaid expenses and accrued expenses.
• *Payment of the dividends (not the declaration) is a cash outflow that the company reports as a financing activity
• *Indicates that the net change in cash during the period was an increase of this agrees with the change in balances in the Cash account reported on the balance sheets in.

Section 2/26/25 SCF SECTIONS

Operating Section

• Shows changes in cash from operating activities
• Adjustments to reconcile net income to net cash from operations (indirect method)
• Includes: Current Assets, Current Liabilities, activities that affect net income(gains & losses and non-cash expenses)
• Inflow: customer payments, interest income
• Outflow: salary payments, income tax paid

Investing Section

• Shows changes in cash from investing activities
• Includes: Long-term assets
• Inflow: sale of PP&E, sale of debt or equity securities of other entities
• Outflow: purchase of PP&E, loans to other entities

Financing Section

• Shows changes in cash from financing activities
• Includes: long-term liabilities, equity
• Inflow: issuance of equity securities and debt
• Outflow: payment of dividends, redemption of debt

Direct Method

• Uses cash receipts and payments to sow cash flow
• Directly shows inflows and outflows of cash rather than indirectly showing net cash by reconciling net income.

Chapter 13: Financial Analysis - The Big Picture

Section 13.1 - Sustainable Income and Quality of Earnings

• Sustainable Income- The average level of income to be obtained by a company in the future.
• To assess analysts need to understand discontinued operations, comprehensive income, and changes in accounting principle.

Discontinued Operations

• A company should report income from continuing operations and income(loss) from discontinued operations.

Comprehensive Income

• Comprehensive income can be the sum of net income and other comprehensive income items.
• Available-for-sale securities are held with the intent of selling them sometime in the future. Companies do not include unrealized gains or losses on available-for-sale securities in net income, Instead, they report them as part of “Other comprehensive income,” which is not included in net income.

Changes in Accounting Principle

• Occurs when the principle used in the current year is different from the used in the preceding year
• Accounting rules permit a change when management can show that the new principle is preferable to the old principle
• Quality of Earnings
• Provides transparent financial records. If a company has a high quality of earnings.
• Horizontal Analysis and Vertical Analysis
• Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends.
• Intercompany basis. Comparisons with other companies provide insight into a company’s competitive position
• Industry averages. Comparisons with industry averages provide information about a company’s relative position within the industry

Ratio Analysis

• Expresses the relationship among selected items of financial statement data
• Liquidity/ Solvency/ Profitability

Solvency Ratios

• Debt to Assets Ratio = Total Liabilities/Total Assets
• Times Interest Earned = (Net Income + Interest Expense + Income Tax Expense) / Interest Expense
• Free Cash Flow = Net cash provided by operating activities - Capital Expenditures - Cash Dividends

Profitability Ratios

• Return on common stockholders’ equity = (Net Income - Preferred Dividends)/Average Common Stockholders equity
• Return on assets = Net Income/Average total assets
• Profit margin = Net Income/Net Sales
• Asset turnover = Net Sales/Average Total Assets
• Gross profit rate = Gross Profit/Net Sales
• Earnings per share = (Net Income - Preferred Dividends)/Weight-average common shares outstanding
• Price-earnings ratio = Market prices per share/Earnings per share
• Payout ratio = Cash dividends paid on common stock/Net Income