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Chapter 2 accrual accounting
Chapter 2- Accrual Accounting and Income
Determination
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Accrual accounting- revenues are recognized when the seller has transferred control over
goods or services to a buyer. Expenses are the expired costs or assets that are used to
produce those revenues. Expense recognition is tied to revenue recognition.
Accrual accounting is a more useful measure of a firm’s performance
Accrual accounting revenue for a period often does NOT correspond to cash receipts
from the same period
Accrual-basis expenses in a period do NOT correspond to cash outflows in the period
Accrual accounting decouples earnings measurement from operating cash flows
accrual accounting better matches economic benefit with economic effort, thereby
producing a measure of operating performance- accrual earnings- that provides a more
realistic picture of economic activities
Retained earnings represents the accumulation of all the company’s earnings since its
inception- net of dividends
Book value/carrying value = amount at which an account is reported on a company’s
balance sheet
Net income is the change in owner’s equity not due to transactions with owners
Net asset valuation and net income determination are intertwined
The point at which revenue is to be recognized = the point at which the entity has
satisfied its contractual obligation to provide goods or services to a customer by
transferring control over those goods or services to the customer
Traceable costs = costs that are easily traced to the revenue earned
Period costs = costs that are important for generating revenue but their contribution to a
specific sale is difficult to trace
Traceable costs are recognized in the same period as the corresponding revenue is
recognized (matching)
Product costs = costs of physically producing a good (subset of traceable costs)
Financial reporting seeks to satisfy users needs for assessing future cash flows by
providing financial information based on past and current events in a format that gives
financial statement users reliable and representative baseline numbers for generating
their own forecasts of future cash flows
Gross profit is a key number for assessing the performance of an enterprise and for
predicting future profitability
Gross margin is useful for understanding how competitive pressures affect profit margins
Including unusual or infrequently occurring items as a component of income from
continuing operations complicates financial forecasting and analysis
Component of an entity = operations and cash flows that can be clearly distinguished,
both operationally and for financial reporting purposes, from the rest of the entity
A thing is considered ‘held for sale’ if:::: management has committed to sell it, it is
available for immediate sale, a buyer is in the process of being located, the sale is
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Chapter 2 accrual accounting
probable and expected to be completed in one year, it is being actively marketed at a
reasonable price, and it is unlikely to not be disposed of.
When a discontinued component is sold before the end of the reporting period, companies
must report:::: operating income or loss from operating the component from the
beginning of the reporting period to the disposal date, and gain or loss on disposal (net
sale – book value [net of tax])
If a component becomes a discontinued operation in a reporting period but has not been
sold by the end of the period- it is reported in two elements: operating income or loss
from operating the component (net of tax effects), and an impairment loss if the book
value of the net assets in the disposal group is more than the net assets fair value minus
cost to sell
Intraperiod income tax allocation- when stuff is treated net of tax effects in order to
match the income tax burden or benefit with the item giving rise to it
Separating the stuff into continuing and discontinued operations helps financial statement
users forecast future earnings more easily
Extraordinary items are no longer allowed
Some fraud or fudging of numbers occurs in order to meet expectations or future
expected cash flow reports
A few ways in which some employees can cook the books: overstating restructuring
charges in order to ‘clean up’ the financial statements (called big bath, often done because
creditors may overlook one time restructuring charges), overstating declines in asset
value or bad debts or sales returns (called cookie jar reserves, done for income smoothing
because they can overstate in good times and reverse in bad times), intentional errors
(usually small and hope that, even if caught by an auditor, it would be deemed as
immaterial even though it may just raise income or ratios to their targets), intentional
misstatement of estimates, and/or premature or aggressive revenue recognition
all publicly traded companies must report EPS numbers on the face of their income
statements
basic eps = income attributable to common shareholders (net income – dividends to preferred
shareholders and net income attributable to noncontrolling interests) / weighted average number
of common shares outstanding for the period
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diluted EPS reflects what basic Eps would have been if all potentially EPS reducing
(dilutive) securities were converted into common shares
comprehensive income = a change in equity (net assets) of a business entity that occurs
during a reporting period from transactions or events from nonowner sources
in other words- comprehensive income comprises all changes in equity except those
resulting from investments by owners (common stock) and distribution to owners
(dividends) (basically net income plus OCI)
closed/completed transactions = ultimate payoffs result from events that have already
occurred and whose dollar flows can be predicted fairly accurately
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Chapter 2 accrual accounting
net income is closed into retained earnings at the end of each reporting period- OCI is
closed into accumulated other comprehensive income (AOCI) at the end of each
reporting period
stuff goes into net income unless otherwise stated (in which it would go to OCI)
comprehensive income can be separated in a statement of other comprehensive income or
reported on the income statement at the end
revenues result in owners equity increases and expenses result in owners equity decreases
Debit = left.
Credit = right
Adjusting entries must be made before financial statements are prepared
Four categories of adjusting entries::: adjustments for…. Prepayments, deferred revenues,
accrued expenses, and accrued revenues.
Contra asset account = account that is subtracted from another account to which it relates.
Contra-asset accounts carry credit balances because they are subtracted from asset
accounts that carry debit balances
Closing entries = revenue and expense accounts are closed (zeroed out)
Differences between accrual-basis income and cash flow are related to changes in asset
and liability accounts
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