ACCRUAL

ACCOUNTING
TIMELINE
EXPLICIT VS IMPLICIT ACCOUNTING
 Explicit transactions are events that trigger nearly all
day-to-day entries

 Implicit transactions are events that are temporarily

ignored in day-to-day recording procedures and are
recognized only at the end of an accounting period (e.g.,
depreciation expense, expiration of prepaid rent).
Explicit / implicit transaction?

 payment of one year's rent in advance

 payment of dividends to stockholders

 recording monthly depreciation on equipment

 expiration of prepaid rent

THE ROLE OF ADJUSTMENTS IN
ACCRUAL ACCOUNTING
 Making adjustments (adjusting entries) is the key final
process
 Accrue means to accumulate a receivable or payable
during a given period even though no explicit transaction
occurs
 Overstated / understated Assets

 End of the period - based on reality

There are four types of adjusting entries
 
a. expiration or consumption of assets (unexpired costs);
 
b. realization (earning) of unearned revenues (revenues received
in advance);
 
c. accrual of unrecorded expenses; and
 
d. accrual of unrecorded revenues
HOW MUCH YOU USED OR CONSUMED
YOUR ASSETS?
The warehouse 12-month lease has expired on September
1,20X8.

Lease Expense Dr
Prepaid Rent Cr

This entails computing the portion of an asset used up as expense in the

current period.
 
Assets can be considered unexpired costs, which are consumed over
time. Asset expirations are written off to expense (e.g., inventory,
prepaid rent, equipment)
Supplies over time are used :
 Supplies Expense Dr
 Supplies Cr

Depreciation

 Depreciation Expense Dr
 Accumulated Depreciation Cr
A company recorded cash purchases of equipment in the
Depreciation Expense account when purchased. The result
would be an:
 
a. understatement of assets.
b. overstatement of liabilities.
c. overstatement of assets.
d. understatement of liabilities.
UNEARNED REVENUE
 Revenue that is received and recorded before it is earned.
 Example :
 Kavya Caterering Service are paid Rs 50000 for the service they
would offer on 20th Feb (few days from now)

Cash Dr
Unearned Revenue Cr
 On 28th feb i.e end of month say you want to make the financial
statements.
We had
Cash Dr
Unearned Revenue Cr

 Now we need to realize the unearned revenue

Unearned Revenue Dr
Service Revenue Cr
 Liability
Balance sheet
 ACCRUAL OF UNRECORDED EXPENSES
 
 This entails computing the amount owed for goods and
services rendered to the entity by the outside parties (suppliers,
employees) up to the end of an accounting period.

 The entity has an expense not previously recognized and a

liability in the form of a legal obligation to pay.
 
 EXAMPLES
 Wages paid for every 10 days and statement is made on the 5th
day.

 Adjustment would be : accrued wages.

 

Wages Expense xxx

Accrued Wages Payable xxx
Accrued income tax.
 
Tax Expense xxx
Accrued Tax Payable xxx

Accrued interest (principal x interest rate x fraction of year).

 Interest Expense xxx

Accrued Interest Payable xxx
ABC borrowed Rs 100000 on March 31st 2008 and needs to
repay with 12% interest

March 31st March 31st

2008 2009

Interest Expense 12000

Accrued Interest Payable 12000

March 31st 2008 Dec 31st 2008

Interest Expense 9000

Accrued Interest Payable 9000
CONT…
 ABC borrowed from XYZ bank

Accrued Receivable xxx

Interest Revenue xxx

• Accrual of Unrecorded Revenues

• The adjusting entries show the recognition
of revenues that have been earned but not
yet shown in the accounts.
 Unadjusted Journalize Adjusted
Prepare
Ledger Trial and post Trial
Financial
balance adjustment Balance
Adjusting entry Type of account Type of account
Debited Credited

Expiration of Prepaids or
unexpired costs Expense Accumulated Depreciation

Realization (earning) of
unearned revenue Unearned Revenue Revenue

Accrual of unrecorded
expenses Expense Payable

Accrual of unrecorded
revenue Receivable Revenue
Andrew Corporation began operation on January 1 of the current year. The company's December 31
trial balance follows.
 
ANDREW CORPORATION TRIAL BALANCE DECEMBER 31, 20x2
 

Ending office supplies on hand: $100

Prepaid insurance expired during the period: $1,800
Depreciation expense on furniture: $1,000
Accrued salaries owned to employees: $700
FORMATS BALANCE SHEET

Balance sheet

Report Format Account Format

Assets
Assets Liabilities
Liabilities Stockholder’s Equity
Stockholder’s Equity
CLASSIFIED BALANCE SHEET
 "Classified" means that the balance sheet accounts are
presented in distinct groupings, categories, or
classifications.
 The asset classifications and their order of appearance
on the balance sheet are:

Current Investment
Assets s

Fixed Intangible
CURRENT ASSETS

 Cash and other resources that are expected to turn to

cash or to be used up within one year of the balance
sheet date.
 If a company's operating cycle is longer than one year,
an item is a current asset if it will turn to cash or be used
up within the operating cycle.
 Current assets are presented in the order of liquidity, i.e.,
cash, temporary investments, accounts receivable,
inventory, supplies, prepaid insurance.
LIABILITIES
 Current Liabilities
 Obligations of the enterprise that are payable within one year
of the balance sheet date. Examples: interest payable, wages
payable

 Fixed Liabilities
 Obligations of the enterprise that are not payable within one
year of the balance sheet date. Two examples are bonds
payable and long term notes payable.
LETS IDENTIFY
 Patent
 Building

 Prepaid rent

 Wages payable

 Notes payable in 5 yrs

 Inventory

 Prepaid Insurance

 A/R

 Unearned revenue

 Short term investment

 Building to be sold at later point in time

 Accumulated depreciation
FINANCIAL ANALYSIS
WORKING CAPITAL
 Current asset – Current liability
 An indicator of whether the company will be able to
meet its current obligations (pay its bills, meet its
payroll, make a loan payment, etc.)
 If a company has current assets exactly equal to current
liabilities, it has no working capital.
 The greater the amount of working capital the more
likely it will be able to make its payments on time.
 Industry dependent
 Reveals the financial position of the company

 Greater Working capital implies less financial strain

 Foresee financial difficulties

Lower Incre Late Lowe

payme
worki ased r
nt to
ng borro credito credit
capital wing rs rating
CURRENT RATIO
 The current ratio is used as an indicator of a company’s
liquidity.

 Current asset / Current liability

 A ratio of 3:1 is better than 2:1. A 1:1 ratio means there

is no working capital.

 It is wise to compare a company’s current ratio to that of

other companies in the same industry
HOW DO WE ASSESS ?

 Below 1 implies negative working capital

 Greater than 1 implies can easily meet the short term

obligations

 Very high implies too much of unmanaged liquid cash.

QUICK TEST RATIO
 The Quick Test Ratio (also called the Acid Test or Liquidity
Ratio) is test of a company's financial strength and liquidity.

 Removal of less liquid assets form numerator.

 Current Assets – Inventory

Current liabilities

 It is a reflection of the liquidity of a business.

 The Quick Test ratio does not apply to the handful of
companies where inventory is almost immediately
convertible into cash
Donald Corp.'s balance sheet as of Dec. 31, 20x2 includes:
 
Current assets $ 60,000
Current liabilities $ 15,000
Total assets $ 90,000
Total liabilities $ 45,000
 
What is Donald's current ratio?
 
a. 2.0
b. 4.0
c. 3.0
d. 6.0
Calculate
Working capital
current ratio and
acid test ratio
 A single-step income statement
is one of two commonly used
formats for the income statement
or profit and loss statement. The
single-step format uses only one
subtraction to arrive at net income.


Net Income = (Revenues +
Gains) – (Expenses + Losses)

An extremely condensed income

statement in the single-step format
would look like this:
 The multiple-step profit and
loss statement segregates
the operating revenues and
operating expenses from the
nonoperating revenues,
nonoperating expenses,
gains, and losses.
 The multiple-step income
statement also shows the
gross profit (net sales
minus the cost of goods
sold).
PROFITABILITY RATIOS
 Profitability ratios show a company's overall efficiency
and performance.

 Rate of return is the return per dollar invested.

 Profitability comparisons through time and within

industries are used as a basis for predictions and
decisions by both internal and external users of financial
statements.
GROSS PROFIT
 The gross profit margin looks at cost of goods sold as a
percentage of sales.

 This ratio looks at how well a company controls the cost

of its inventory and the manufacturing of its products
and subsequently pass on the costs to its customers.

 The calculation is: Gross Profit/Net Sales

NET PROFIT MARGIN
 Return on sales ratio (net profit margin ratio):

Net
income
Re turnon =
sales
Sales
 Shows how much of each sales dollar shows up as net
income after all expenses are paid.
 The net profit margin measures profitability after
consideration of all expenses including taxes, interest,
and depreciation
RETURN ON ASSETS AND RETURN ON
EQUITY RATIO

 ROA measures the efficiency with which the company is

managing its investment in assets and using them to generate
profit.
 Net Income/Total Assets

 ROE measures the return on the money the investors have put
into the company.
Net Income/Stockholder's Equity
 This is the ratio potential investors look at when deciding
whether or not to invest in the company
SUMMARY
 The role of adjustments in accrual accounting.

 A classified balance sheet and use it to assess short-term

liquidity.

 Single- and multiple-step income statements

 Use ratios to assess profitability.

Which of the following is not used in solvency
determination?
 
a. return on sales ratio
b. working capital
c. current ratio
d. none of the above
Morton Corp. has the following income statement items for the year
20x2:
 
Sales $ 100,000
Gross profit $ 72,000
Operating expenses $ 47,000
Net income $ 25,000
 
What is Morton's return on sales?
 
a. 5%
b. 10%
c. 25%
d. 40%
 A corporation’s net income after tax was $100,000 for
the year 2007.
 It does not have any preferred stock outstanding and its
stockholders’ equity was $950,000 at the beginning of
2007 and was $1,050,000 at the end of 2007.
 The increase was at a uniform rate throughout the year.

 Calculate ROE
PROBLEM

Sales 1800 Interest Expense 138

COGS 1000 Utilities Expense 110
Depreciation 60 Interest Revenue 28
Expense
Rent Revenue 20 Wage Expense 400
Income tax rate 40%
SOLUTION
END OF CHAPTER