1. Accrual Accounting and Financial Statements
Lecture 9
(CHAPTER 4)

2. 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

3. 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

4. LO 6 - The Adjusting Process in Perspective
The complete accounting cycle now becomes
Transactions
Documentation
Journal
Ledger
Unadjusted
Trial Balance
Journalize and
Post Adjustments
Adjusted
Trial Balance
Financial
Statements

5. LO 6 - The Adjusting Process in Perspective
Each adjusting entry affects at least
One income statement account
One balance sheet account
The Cash account is not adjusted
The end-of-period adjustment process is reserved for implicit transactions, which anchor the accrual basis of accounting

6. LO 6 - The Adjusting Process in Perspective
Advance Cash
Payments for
Future
Services to be
Received
Noncash
Assets in the
Balance Sheet
Expenses in
the Income
Statement
Transformed
by adjustments
into
When unexpired costs expire
Create
Liabilities
in the
Balance Sheet
Revenues in
the Income
Statement
When revenues received in advance are earned
Advance Cash
Collections in
advance for
future
Services
Transformed
by adjustments into
Create

7. LO 6 - The Adjusting Process in Perspective
Passing of time
and the
continuous use
of services
before paying
for them
Should be recorded by adjustments as increases in
Expenses
in the
Income
Statement
and
Liabilities
in the
Balance Sheet
Cash
Payments
Until decreased later by

8. LO 6 - The Adjusting Process in Perspective
Passing of time
and the
continuous
rendering of
services
Should be recorded by adjustments as increases in
Revenues
in the
Income
Statement
and
Noncash
assets
In the Balance
Sheet
Cash
Collections
Until decreased later by

9. LO 7 - Classified Balance Sheet
A classified balance sheet groups asset, liability, and owners’ equity accounts into subcategories
Assets are classified into two groups:
Current assets
Noncurrent (or long-term) assets
Liabilities are classified into
Current liabilities
Noncurrent (or long-term) liabilities

10. LO 7 - Classified Balance Sheet

11. LO 7 - Classified Balance Sheet
Current assets = assets expected to be converted to cash, sold, or consumed during the next 12 months (or within an operating cycle if longer)
Current liabilities = liabilities expected to be paid within the next year (or operating cycle if longer)
Both are generally listed in the order in which they are likely to be converted/consumed or paid during the coming year

12. LO 7 - Classified Balance Sheet
Liquidity is a company’s ability to pay its immediate financial obligations with cash and near-cash assets
The current ratio evaluates a company’s liquidity
Chan Audio’s current ratio is
Current assets
Current liabilities
Current Ratio
$532,500
$232,870
= 2.3

13. LO 7 - Classified Balance Sheet
Working capital is the excess of current assets over current liabilities
Chan Audio’s working capital is
$532,500 - $232,870 = $299,630
The quick (acid test) ratio removes Inventory (and other less liquid assets such as Prepaid Expenses) from the numerator of the calculation
Chan Audio’s quick ratio is
$532,500 – $260,200
$232,870
= 1.2

14. LO 7 Classified Balance Sheet
A balance sheet may be presented in
Condensed format - just totals of current and long-term categories
Detailed format - the accounts that make up current and long-term categories
Report format - presents all the accounts vertically
Account format - lists assets to the left and liabilities and owners’ equity to the right

15. LO 8 - Income Statement Formats Single step - lists revenues and deducts expenses without drawing any intermediate subtotals

16. LO 8 - Income Statement Formats Multiple step - lists revenues and deducts expenses while drawing intermediate informative subtotals

17. LO 8 - Income Statement Formats
In a multiple-step income statement, Intermediate and informative subtotals usually include the following:
Gross profit (gross margin) - excess of sales revenue over the cost of the inventory that was sold
Operating expenses - recurring expenses that pertain to the firm’s routine, ongoing operations
Operating income - the difference between the usual and frequent in- and outflows
Other (Nonoperating) items – not related to the firm’s principal operations, i.e., the unusual and/or infrequent flows

18. Prepare Adjustment Entries

19. Journal Entries

20. LO 9 - Profitability Evaluation Ratios
Profitability measures affect the investment decisions of investors, creditors, and managers
The four basic profitability ratios are
Gross profit percentage
Return on sales
Return on common stockholders’ investment
Return on assets
Ratios vary greatly by industry
Meaning is derived by comparison to others

21. LO 9 - Profitability Evaluation Ratios The Chan Audio Company
Gross profit percentage - profitability just from selling goods; other expenses/losses are not considered
Return on sales ratio (AKA: Net Profit Margin) -
profitability after all expense, gains, and losses
Gross profit percentage = Gross profit / Sales
= $60,000 / $160,000
= 37.5%
Return on sales = Net income / sales
= $13,530 / $160,000
= 8.5%

22. LO 9 - Profitability Evaluation Ratios The Chan Audio Company
Return on common stockholders’ equity (ROE or ROCE) - amount of income produced by average invested capital
Return on common = Net income/Average common stockholders’ equity stockholders’ equity
= $13,530 / ½ ($400,000 + $413,530)
= $13,530 / $406,765
= 3.3% (for 1 month)
Return on assets - measures the return produced by the average available assets (effectiveness)
Return on assets = Net income / Average total assets
= $13,530 / ½ ($620, $646,400)
= $13,520 / $633,200
= 2.1% (for 1 month)