Accrual Accounting and Financial Statements Lecture 8 (CHAPTER 4)

Learning Objectives (LO) After studying this chapter, you should be able to Understand the role of adjustments in accrual accounting Make adjustments for the expiration or consumption of assets Make adjustments for the earning of unearned revenues Make adjustments for accrual of unrecorded expenses Make adjustments for the accrual of unrecorded revenues

Learning Objectives (LO) After studying this chapter, you should be able to 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 short-term liquidity Prepare single- and multiple-step income statements Use ratios to assess profitability

LO 1 - 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

LO 1 - 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. For example, interest receivable or payable builds with the passage of time.

LO 1 - Adjustments to the Accounts Adjustments arise from four basic types of implicit transactions: Accrual of unrecorded expenses Expiration of unexpired (deferred) costs Accrual of unrecorded revenues Earning of revenues received in advance

LO 2 - Expiration of Unexpired Costs Assets (Prepaid- unexpired- Expense) Expenses Incurred Need adjustments to reflect consumption Appear in the Balance Sheet Appear in the Income Statement

LO 2 - Expiration of Unexpired Costs Situation: After purchasing $2,000 of office supplies, (explicit event) the company determines that at month-end $1,500 were used. Adjustment required: How would assets and equity be affected if this adjustment is not made? Office Supplies Inventory 2,000 Cash 2,000 Office Supplies Expense 1,500 Office Supplies Inventory 1,500

LO 3 - Earning of Revenues Received in Advance Liabilities (Funds received but not earned) Revenues (When funds have been earned) Adjustments to reflect earning Appear in the Balance Sheet Appear in the Income Statement

LO 3 - Earning of Revenues Received in Advance Situation: Receive $6,000 for 3 months’ rent on July 1 (explicit event) Adjustment required after 1 month passes: How would liabilities and equity be affected if this adjustment is not made? Cash 6,000 Unearned Rent Revenue 6,000 Unearned Rent Revenue 2,000 Rent Revenue 2,000

LO 4 - Accrual of Unrecorded Expenses Need adjustments to reflect consumption and debt Expenses are incurred but are not yet recorded Liabilities need to be shown for the unrecorded expenses Need to appear in the Income Statement Need to appear in the Balance Sheet

LO 4 - Accrual of Unrecorded Expenses Situation: Payment for last week’s wages (explicit event) Adjustment required for last 3 days of the fiscal year (payday is next Friday) (implicit event): How would liabilities and equity be affected if this adjustment is not made? Wage Expense 200,000 Cash 200,000 Wage Expense 120,000 Accrued wages payable 120,000

LO 4 - Accrual of Unrecorded Expenses Other examples where expenses liabilities arise but are unrecorded include Wages Income taxes Utilities Interest Adjustments are necessary to accurately Match expense to the period in the books of the entity that will have to pay Record revenue in the books of the provider or recipient of those services when earned

LO 4 and LO5 - Accrual of Unrecorded Expenses and Revenues (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 Situation: A company borrows $100,000 on December 31, 2010. Terms of the loan require repayment of the loan amount of $100,000 plus interest on December 31, 2011

LO 4 and LO5 - Accrual of Unrecorded Expenses and Revenues (interest) Calculation of interest for any part of a year is as follows: For the full year, the interest is: Principal x Interest rate x Fraction of a year = Interest $100,000 x .09 x 12/12 = $9,000

LO 4 and LO5 - Accrual of Unrecorded Expenses and Revenues (interest) As of January 31, 2011, the amount of interest owed is 1/12 x .09 x $100,000 = $750 Adjustment on borrower’s books required after 1 month passes: How would liabilities and equity be affected if this adjustment is not made? Interest expense 750 Accrued interest payable 750

LO 4 and LO5 - Accrual of Unrecorded Expenses and Revenues (interest) As of January 31, 2011, the amount of interest owed is 1/12 x .09 x $100,000 = $750 Adjustment on lender’s books required after 1 month passes: How would assets and equity be affected if this adjustment is not made? Accrued Interest Receivable 750 Interest Revenue 750