Accrual
Accounting and
Financial
Statements
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CHAPTER
Introduction to Financial Accounting, 9/e
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Learning Objectives
After studying this chapter, you should be able to
1. Understand the role of adjustments in accrual
accounting
2. Make adjustments for the expiration or consumption
of assets
3. Make adjustments for the recognition of unearned
revenues
4. Make adjustments for accrual of unrecorded
expenses
5. Make adjustments for the accrual of unrecorded
revenues
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Learning Objectives
After studying this chapter, you should be able to
6. Describe the sequence of the final steps in the
recording process and relate cash flows to adjusting
entries
7. Prepare a classified balance sheet and use it to
assess short-term liquidity
8. Prepare single- and multiple-step income
statements
9. Use ratios to assess profitability
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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
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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
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Adjustments to the Accounts
• Adjustments arise from four basic types of
implicit transactions:
–
–
–
–
Expiration of unexpired costs
Earning of revenues received in advance
Accrual of unrecorded expenses
Accrual of unrecorded revenues
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Expiration of Unexpired Costs
• An explicit transaction in the past creates an
asset, and subsequent implicit transactions
serve to adjust the value of the asset
• Suppose a company purchases $10,000 of
Office Supplies Inventory on March 1, 2005.
The journal entry to record this explicit
transaction is:
Office Supplies Inventory
Cash
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$10,000
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$10,000
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Expiration of Unexpired Costs
• The company uses $1,500 of the Office Supplies
Inventory during the month. The following
adjusting entry is required to increase Office
Supplies Expense (debit) and reduce Office
Supplies Inventory (credit):
Office Supplies Expense
Office Supplies Inventory
$1,500
$1,500
• Failure to make this adjusting entry will overstate
assets and understate expenses
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Expiration of Unexpired Costs
Buyer
Assets
(Prepaid
Expense)
Adjustments
Appear in the
Balance Sheet
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Expenses
Incurred
Appear in the
Income Statement
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Earning of Revenues
Received in Advance
• Unearned revenue (revenue received in
advance or deferred revenue)
– Represents payments from customers who pay in
advance for goods or services that the company
promises to deliver at a future date
– Requires recording both the receipt of cash and the
liability for future services
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Earning of Revenues
Received in Advance
•
A company receives rent for 3 months in
advance, $6,000
•
The journal entries below represent
a) An explicit transaction that recognizes the receipt of
unearned revenue
b) A transaction showing the adjustment for one
month’s rent earned
(a) Cash
6,000
Unearned rent revenue
(b) Unearned rent revenue
2,000
Rent revenue
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6,000
2,000
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Earning of Revenues
Received in Advance
• The revenue is recognized (earned) only when
the owner makes the adjusting entries in
transaction (b)
• The liability Unearned Rent Revenue is
decreased (debited), the stockholders’ equity
account Rent Revenue is increased (credited)
• Failure to record the adjusting entry overstates
liabilities and understates revenues
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Earning of Revenues
Received in Advance
Seller
Liabilities
(Unearned
Revenue)
Adjustments
Appear in the
Balance Sheet
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Revenues
Earned
Appear in the
Income Statement
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Accrual of Unrecorded Expenses
• Some liabilities (and expenses) grow moment to moment
with the passage of time. Examples include:
– Wages
– Interest
– Income taxes
• Adjustments are made to bring each accrued expense
(and corresponding liability) account up to date at the
end of the period before preparation of the financial
statements
• Adjustments are necessary to accurately match the
expense to the period
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Accounting for Accrual of Wages
• Assume a company owes $30,000 for employee
services rendered during the last 3 days of the
month of January, but will not pay the employees
for these services until Friday, February 2
• The following transaction shows the entry to
accrue wages for Monday, January 29, through
Wednesday, January 31
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Accounting for Accrual of Wages
• The transaction recognizes both an expense
and a liability
Wages expense
Accrued wages payable
30,000
30,000
• Failure to record the adjustment understates
both expenses and liabilities
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Accrual of 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
• Assume a company borrows $100,000 on
December 31, 2005, and the terms of the loan
require repayment of the loan amount of
$100,000 plus interest on December 31, 2006
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Accrual of Interest
• Calculation of interest for any part of a year is as
follows:
Principal x Interest rate x Fraction of a year = Interest
• For the full year, the interest is:
$100,000 x .09 x 1 = $9,000
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Accrual of Interest
• As of January 31, the amount of interest owed is
1/12 x .09 x $100,000 = $750
• The adjusting journal entry is:
Interest expense
Accrued interest payable
750
750
• Failure to record the adjustment understates
both liabilities and expenses
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Accrual of Unrecorded Revenues
• The accrual of unrecorded revenues is the
mirror image of the accrual of unrecorded
expenses
• An adjustment is required to recognize revenues
earned but not received in cash
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Accrual of Unrecorded Revenues
• Assume a law firm renders $10,000 of services
during January, but does not bill for these
services until March 31
• The following adjustment is made for
unrecorded revenues for the month of January
Accrued (Unbilled) Fees Receivable
Fee Revenue
10,000
10,000
• Failure to make this adjustment understates both
assets and revenues
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Ethics, Unearned Revenue
and Revenue Recognition
• Conservatism means selecting methods of
measurement that yield
– Lower net income
– Lower assets
– Lower stockholders’ equity
• It is unethical to knowingly overstate revenue
and net income
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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
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The Adjusting Process in Perspective
• Each adjusting entry affects at least
– One income statement account and
– 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
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The Adjusting Process in Perspective
Advance Cash
Payments for
Future
Services to be
Received
Advance Cash
Collections for
Future
Services to be
Rendered
Create
Create
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Noncash
Assets in the
Balance Sheet
Liabilities in the
Balance Sheet
Transformed
by
Transformed
By Adjustments
into
Introduction to Financial Accounting, 9/e
Expenses in
the Income
Statement
Expiration of
Unexpired
Costs
Revenues in
the Income
Statement
Earnings of
Revenues
Received in
Advance
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The Adjusting Process in Perspective
Passing of Time
and the
Continuous Use
of Services
Recorded by
Adjustments
as Increases
in
Expenses in the
Income
Statement
and
Liabilities in the
Balance Sheet
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Decreased by
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Later Cash
Payments
Accrual of
Unrecorded
Expenses
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The Adjusting Process in Perspective
Passing of Time
and the
Continuous
Rendering of
Services
Recorded by
Adjustments
as Increases
in
Revenues in the
Income
Statement
and
Noncash Assets
In the Balance
Sheet
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Decreased by
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Later Cash
Collections
Accrual of
Unrecorded
Revenues
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Classified Balance Sheet
• A classified balance sheet further 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
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Classified Balance Sheet
• Current assets are cash and other assets that
a company expects to convert to cash, sell, or
consume during the next 12 months (or within
the normal operating cycle if longer)
• Current assets are listed in the order in which
they are likely to be converted to cash during the
coming year
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Classified Balance Sheet
• Current liabilities are those that come due
within the next year (or within the operating cycle
if longer)
• Current liabilities are listed in the order in which
they will decrease cash during the coming year
• Working capital is the excess of current assets
over current liabilities
• The following slide shows the classified balance
sheet for Chan Audio Company:
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Classified Balance Sheet
Chan Audio Company
Balance Sheet
January 31, 20X2
Assets
Current assets:
Cash
$ 71,700
Accounts receivable
160,300
Note receivable
40,000
Accrued interest receivable
400
Merchandise inventory
250,200
Prepaid rent
10,000
Total current assets
$532,600
Long-term asset:
Store equipment $114,900
Accumulated
depreciation
1,000 113,900
Total
$646,500
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Liabilities and Owners’ Equity
Current liabilities:
Accounts payable
$117,100
Unearned rent revenue
2,500
Accrued wages payable
3,750
Accrued interest payable
750
Accrued income taxes payable 11,200
Note payable
100,000
Total current liabilities
$235,300
Stockholders’ Equity:
Paid-in capital
$400,000
Retained earnings
11,200 411,200
Total
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$646,500
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Current Ratio
• 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
Current Ratio =
Current assets
Current liabilities
• Chan Audio’s current ratio is $532,600 = 2.3
$235,300
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Current Ratio
• The quick ratio removes Inventory (and other
less liquid assets such as Prepaid Expenses)
from the numerator of the calculation
• Chan Audio’s quick ratio is
$532,600 - $250,200 = 1.2
$235,300
• The current ratio should be greater than 2.0
• The quick ratio should be greater than 1.0
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Formats of Balance Sheets
• A balance sheet may be presented in the
– Report format
– Account format
• The report format presents the accounts
vertically
• The account format puts the assets at the left
and liabilities and owners’ equity at the right
• Either format is acceptable
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Income Statement Formats
• Two commonly used formats for income
statements are the
– Single-step income statement
– Multiple-step income statement
• The next slide presents a single-step income
statement for Chan Audio Company
– It groups all types of revenue together
– It lists and deducts all expenses without drawing any
intermediate subtotals
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Single-Step Income Statement
Chan Audio Company
Income Statement
For the Month Ended January 31, 20X2
Sales
$160,000
Rent revenue
500
Interest revenue
400
Total sales and other revenues
$160,900
Expenses:
Cost of goods sold
$100,000
Wages
31,750
Depreciation
1,000
Rent
5,000
Interest
750
Income taxes
11,200
Total Expenses
149,700
Net income
$ 11,200
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Multiple-Step Income Statements
• Most multiple-step income statements disclose
– Gross profit (gross margin)
• The excess of sales revenue over the cost of the
inventory that was sold
– Operating expenses
• A group of recurring expenses that pertain to the
firm’s routine, ongoing operations (wages, rent,
depreciation, telephone, heat, advertising, etc.)
– Operating income
• The remainder of gross profit after the deduction of
operating expenses
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Multiple-Step Income Statements
– Nonoperating revenues and expenses
• Revenues and expenses not directly related to the
mainstream of a firm’s operation
– Other (nonoperating) revenue and expenses
• Revenues and expenses that are not part of the
ordinary operations of selling goods or services;
i.e., interest revenue and interest expense
• Income taxes appear in both income statement
formats
• The next slide presents a multiple-step income
statement for Chan Audio Company
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Multiple-Step Income Statement
Chan Audio Company
Income Statement
For the Month Ended January 31, 20X2
Sales
$160,000
Cost of goods sold
100,000
Gross profit
60,000
Operating expenses:
Wages
$ 31,750
Depreciation
1,000
Rent
5,000 37,750
Operating income
$ 22,250
Other revenues and expenses:
Rent revenue
$
500
Interest revenue
400
Total other revenue
$
900
Deduct: Interest expense
750
150
Income before income taxes
$ 22,400
Income taxes (at 50%)
11,200
Net income
$ 11,200
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Profitability Evaluation Ratios
• Profitability measures affect the investment
decisions of investors, creditors, and managers
• The four basic profitability ratios are
–
–
–
–
Gross profit margin
Return on sales
Return on common stockholders’ investment
Return on assets
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Gross Profit Margin
• The Chan Audio Company’s gross profit
percentage is presented below:
Gross profit percentage = Gross profit / Sales
= $60,000 / $160,000
= 37.5%
• Gross profit percentages vary greatly by industry
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Return on Sales or Net Profit Margin
• The return on sales ratio (also known as the
net profit margin ratio) gauges a company’s
ability to control the level of all its expenses
relative to the level of its sales
• The return on sales percentage tends to vary by
industry
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Return on Sales or Net Profit Margin
• Chan Audio’s return on sales ratio is
Return on sales = Net income / sales
= $11,200 / $160,000
= 7%
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Return on Common Stockholders’ Equity
• Return on common stockholders’ equity ratio
(ROE or ROCE) compares net income with
invested capital
• The return on common stockholders’ equity for
Chan Audio is
Return on common stockholders’ equity =
=
=
=
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Net income / Average common stockholders’ equity
$11,200 / ½ ($400,000 + $411,200)
$11,200 / $405,600
2.8% (for 1 month)
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Return on Assets
• The return on assets ratio
– Compares net income with invested capital as
measured by average total assets
– Measures how effectively those assets generate
profits
• The return on assets ratio for Chan Audio for the
month of January is
Return on assets =
=
=
=
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Net income / Average total assets
$11,200 / ½ ($620,000 + $646,500)
$11,200 / $633,250
1.8% (for 1 month)
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