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Accrual Accounting Process:
Part II
15
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P
...
g
...


ƒ Accrual accounting
ƒ

ƒ

Measures performance by comparing revenues (which are
recognized when the earning process is complete) with
expenses (which are recognized when assets are
consumed or liabilities are created)
...

Records events that have cash consequences for an
enterprise
But does not require a concurrent cash movement in
order to record a transaction
...

However, cash receipts in a particular period may
largely reflect the effects of activities of the
enterprise in earlier periods
...

The matching principle in accrual accounting
addresses this limitation of cash flow accounting
...


ƒ

What is “Present Value?”

ƒ Changes in stock prices = f(changes in
expectations about future cash flows)
...

ƒ Earnings are superior indicators of expected
future cash flows
...

ƒ Why not link it to stock prices alone?

ƒ
ƒ
ƒ

Stock prices are affected by economic factors that are
outside of a manager’s control (e
...
, macroeconomic,
political factors)
...

Combining both mitigates this problem
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Accounting Earnings versus
Stock Prices
ƒ A second reason for using accounting earnings
ƒ Expected versus delivered performance
ƒ
ƒ
ƒ
ƒ

Firm X hires manager Y on December 31, 1997
...

Accounting earnings of 1998 increases by 10%!
ƒ Why?
ƒ Manager Y’s actions produce an actual improvement in the
financial performance of X in 1998
...

9

Accounting Earnings versus
Stock Prices

ƒ By combining stock prices and earnings to
reward managers, a firm can reward a manager
for his/her strategic planning and operational
execution
...


ƒ
ƒ

But if payment is on the basis of expected
performance, then what do you do if the manager
shirks subsequently? (Moral hazard problem)
Earnings provide a straightforward measure of
delivered performance
...

ƒ But this does not capture all economic activities
...

To reduce accounting costs
ƒ Some economic activities may be continuous in nature
...
g
...


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Accrual Accounting and
Periodic Adjustments

ƒ In many cases, assets and liabilities are
created or discharged without the occurrence
of a visible, documented exchange
transaction

ƒ
ƒ

Interest is earned continually on a bank savings
account as time passes
Machinery depreciates as it is used in a
company's operations
...


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Accrual Accounting and Periodic
Adjustments

ƒ Adjusting entries
ƒ
ƒ

Made whenever financial statements are
prepared
...

never involves the cash account

14

s

Four ways that recognition and
cash do not coincide
Pay Cash

Recognize Expense
Time

Balance Sheet Date

Recognize Expense

Pay Cash
Time

Balance Sheet Date
15

s

Four ways that recognition
and cash do not coincide
Receive Cash

Recognize Revenue
Time

Balance Sheet Date

Recognize Revenue

Receive Cash
Time

Balance Sheet Date

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Types of Periodic Adjustments

ƒ Expense or Revenue before Cash

ƒ Expense incurred today, but cash paid tomorrow
...

Employees earn salary when they perform their duties,
not when they receive payment
...

Interest is a reward for lending money, so it is earned
with passage of time
Interest receivable asset

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Types of Periodic Adjustments

ƒ Cash before accruing Revenue or Expense
ƒ
ƒ
ƒ
ƒ

(Cost Expirations or Revenue Expirations)
Cash paid yesterday, Expense incurred today
...

Objective: To match the revenue earned in a period (whether
received in that period in cash or not) with all the expenses
incurred to earn that revenue (whether paid in that period in
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cash or not)
...

The total weekly payroll is $10,000, which is earned at a
rate of $2,000 per day for each of the five working days
...


ƒ On December 31
ƒ
ƒ

Sloan Enterprises has incurred wage expense for two days
But will not pay it in cash until January 3rd of the next fiscal
year
...

Expense would have been understated
Net income overstated

ƒ Without the adjusting entry

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Accruals (Accrue Today, Cash
Tomorrow)

ƒ $10,000 paid on Jan
...

ƒ Assets =
Liabilities + Owners’ Equity
ƒ Cash
Wages Payable Retained Earnings
ƒ -10,000
-4,000
-6,000
ƒ Dr Wage Expense (-RE)
6,000
ƒ Dr Wages Payable (-L)
4,000
ƒ Cr Cash (-A)
10,000
ƒ What would be the balance in the T-account for
Wage Expense on January 3rd?

ƒ

$6,000

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Accruals (Accrue Today, Cash
Tomorrow)

ƒ Consider the $10,000 paid to the employees
...
S
...

Books are closed on December 31
Stone Corp
...
S
...


Assets
Cash
Loan Receivable
-24,000
+24,000
Dr Loan Receivable
(+A)
Cr Cash (-A)

=

L

+

OE

24,000
24,000

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Accruals (Accrue Today, Cash
Tomorrow)

ƒ Where would you see this in the cash flow
statement of U
...
S
...


ƒ
ƒ

Interest earned = 24,000 x 10% x 1/12
= $200
...
S
...
(principal)
Plus $400 as interest for 2 months

ƒ Although a single check may be issued, let us
ƒ
ƒ
ƒ

consider it as two transactions
...
Receivable
Retained Earnings
ƒ +400
-200
+200
ƒ Dr Cash (+A)
400
ƒ Cr Interest Receivable (-A)
200
ƒ Cr Interest Revenue (+RE)
200
ƒ Two elements to the journal entry
ƒ
ƒ

Exchange of one asset for another asset
Record revenue earned and cash received
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Accruals (Accrue Today, Cash
Tomorrow)

ƒ Effect on cash flow and income statements
ƒ
Period 1
Period 2
ƒ Cash Flow Statement
ƒ Investing cash flow
-24,000
+24,000
ƒ Operating cash flow
+400
ƒ Income Statement
ƒ Interest Revenue
+200
+200

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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ Supplies Inventory
ƒ
ƒ

During 2000, Greener Pastures, Ltd
...

The company began the year with $500 in the supplies
account
...

Supplies Used = Beg
...
+ Purchases - Ending Inventory

ƒ = $500 + $700 - $300
ƒ = $900
ƒ Assets
=
L
+
ƒ Supplies
ƒ -900
ƒ Dr Supplies Expense (-RE)
ƒ Cr Supplies Inventory (-A)

Owners’ Equity
Retained Earnings
-900
900
900
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Cost Expirations (Cash
Yesterday, Accrual Today)
Supplies Account
Beg bal
Purchases
Ending Inv

ƒ
ƒ

500

900

Supplies expense

700
300

Supplies expense of $900 is the adjusting entry and the
corresponding debit is to Retained Earnings (i
...
, expense
on the income statement that affects retained earnings)
...


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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ What shows up in the cash flow statement?
ƒ
ƒ

The cash paid during the year for purchase of supplies
Operating outflow = $700

ƒ
ƒ

The cost of supplies consumed during the year
Supplies expense = $900

ƒ

Ending balance in Supplies of $300

ƒ What shows up in the income statement?
ƒ What shows up in the balance sheet?

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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ Prepaid Expenses

ƒ On January 1, 1999, Crimson Inc
...

The adjusting entries may be recorded more
frequently
...


ƒ Magazines Unlimited receives $5,000 during 2000
for magazine subscriptions to be fulfilled during
2000 and 2001
...


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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ $5,000 received during 2000
ƒ Assets
=
Liabilities
+ OE
ƒ Cash
Unearned Revenue
ƒ +5,000
+5,000
ƒ Dr Cash (+A)
5,000
ƒ Cr Unearned Revenue (+L)
5,000
ƒ What happens to this liability at the end of 2000?
ƒ

Decreases by 60% because Magazines Unlimited delivers
magazines in 2000
...


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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ Depreciation
ƒ

Dewey, Inc
...
Dewey’s management estimates
initially that the equipment would last for ten years and
would be scrapped thereafter
...

What does matching principle suggest?

ƒ
ƒ

Apportion the $10,000 as an expense over the 10 year
period
Depreciation expense

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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ Depreciation is allocating (or expensing) the cost of
ƒ

a long-lived asset over its estimated useful life
...


ƒ One common method is straight line
ƒ

Equal apportionment of the cost over useful life

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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ Depreciation expense for each year = $1,000
ƒ At the end of each year, what do we do?
ƒ Assets
= L
+ Owners’ Equity
ƒ Equipment
Retained Earnings
ƒ -1,000
-1,000
ƒ If we repeat this ten times over the next ten years,
what would be the balance in the T-account for
Equipment

ƒ

Zero
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Cost Expirations (Cash
Yesterday, Accrual Today)
ƒ
ƒ
ƒ
ƒ
ƒ
ƒ

How does the $10,000 show up in the cash flow and income
statements?
Periods
1
2
3
...
(-RE) 1,000 1,000 1,000
...

ƒ What might be the potential limitations of this
approach?
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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ Consider two Companies
ƒ
Company A Company B
ƒ Equipment
10,000
10,000
ƒ Instead of this disclosure, let us consider an
ƒ
ƒ
ƒ
ƒ

alternative approach
Equipment (cost)
100,000
20,000
(-) Depreciation to date (90,000)
(10,000)
Net Book Value
10,000
10,000
What do you learn from the second approach?
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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ How do accountants record depreciation?
ƒ Dr Depreciation Expense (-RE) 1,000
ƒ Cr Accumulated Depreciation (-A)
1,000
ƒ Acc
...
is a contra (negative) asset account
ƒ Decreases in assets are credits
ƒ So, Acc
...
has a credit balance
ƒ
ƒ

Represents the cumulative depreciation on an asset
Informs the user about the age of the asset

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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ Balance sheet presentation after one year
...

ƒ Equipment (original cost)
10,000
ƒ (-) Accumulated Depreciation
(10,000)
ƒ Net Book Value
0
ƒ Does this make sense?
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Cost Expirations (Cash
Yesterday, Accrual Today)

ƒ Yes, if the asset remains in use
...


ƒ However, if the equipment is scrapped after ten
years, how do we record it?

ƒ

Eliminate it from the books

ƒ Dr Acc
...


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