Financial Accounting Chapter 3 Summary PDF

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Financial Accounting Chapter 3 – Accrual Accounting This chapter will be supported by examples from the company “Richemont” First the financial statements for the year 2011:

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Accrual Accounting Versus Cash Basis Accounting Shareholders want to earn a profit. Investors search for companies whose share prices will increase. Banks seek borrowers who will service and pay their debts. Accounting provides the information these people use for decision making. Accounting can be based on either the: ▪ accrual basis ▪ cash basis Accrual accounting records the impact of business transactions and events on an entity’s assets and liabilities in the period in which those transactions and events occur, even if the resulting cash receipts or payments occur in a prior or future period. Cash basis accounting records only cash transactions—cash receipts and cash payments. Cash receipts are treated as revenues, and cash payments are handled as expenses. ▪ Virtually all businesses use the accrual basis of accounting as required by financial reporting standards. ▪ Entities that use the cash basis of accounting do not follow accounting standards. Their financial statements omit important information and thus are less relevant to users of financial statements.

Accrual Accounting and Cash Flows accrual accounting records cash transactions, such as:  collecting cash from customers  receiving cash from interest earned  paying salaries, rent, and other expenses  borrowing money  paying off loans Financial Accounting Chapter 3 – Accrual Accounting

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 issuing shares But accrual accounting also records non-cash transactions, such as:  sales on account  purchases of inventory on account  accrual of expenses incurred but not yet paid  depreciation expense  usage of prepaid rent, insurance, and supplies  earning of revenue when cash was collected in advance To use accrual accounting, we need to understand a few more concepts. We turn now to the time-period concept, the revenue recognition principle, and the matching concept.

The Time-Period Concept The time-period concept ensures that accounting information is reported at regular intervals. IAS 1 – Presentation of Financial Statements requires an entity to present a complete set of financial statements (including comparative information, as appropriate) at least annually.

The Revenue Recognition Principle When should you recognize revenue? In short, when you “earn” the revenue. It sounds simple, but revenue recognition can be a very contentious topic. Think about the things you buy, the services you consume, when do the companies that provide you with these goods earn your money? The basic guidance on the revenue recognition principle comes from IAS 18 – Revenue. In general, for the sale of goods, revenue is recognized when: ▪ the entity has transferred to the buyer the significant risks and rewards of ownership of the goods; ▪ the entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold; ▪ the amount of revenue can be measured reliably; ▪ it is probable that the economic benefits associated with the transaction will flow to the entity; and ▪ the costs incurred or to be incurred in respect of the transaction can be measured reliably. Thus, for consumer sales transactions, it is usually at the point of sale, when you hand over your cash in return for the goods. Think about how such over the counter purchases would meet the IAS 18 criteria above. For services, similar principles apply. The only difference is the services you engage may not be consumed at the same time. Revenue is thus earned by reference to a “stage of completion” of the transaction at the balance sheet date. The amount of revenue to record is the fair value of the consideration received or receivable taking into account the amount of any trade discounts and volume rebates allowed by the entity. Example:

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So, to conclude, you should record revenue after it has been earned— and not before. Revenue is earned when there is an increase in or reduction in liability that results in an increase in equity (excluding transactions with owners). In most cases, revenue is earned when the business delivers goods or services to its customer. Every reporting entity must disclose its revenue recognition policy. You would find this in the notes to the accounts that accompany the financial statements.

The Matching Concept Matching is a concept used to explain the relationship between expenses and revenues. Matching includes two steps: ▪ Identify decreases in assets or increases in liabilities that result in reduction in equity (excluding transactions with owners) during the period. These are expenses. ▪ Measure these expenses, and subtract expenses from revenues to compute profit or loss. Remember that the change in assets and liabilities determines profit or loss, not the application of a matching concept.

Ethics in Business and Accounting Decisions The Deloitte Forensic Center published a report on financial statement fraud schemes alleged by the United States’ Securities and Exchange Commission (SEC) in enforcement releases issued from 2000 to 2008. Revenue recognition was the most susceptible area to fraud, accounting for almost 40% of the financial statement frauds alleged during the period.

Updating the Accounts: The Adjusting Process At the end of the period, a reporting entity presents its financial statements to its users. This process begins with the trial balance introduced in Chapter 2. We refer to this trial balance as unadjusted because the accounts are not yet ready for the financial statements. We continue with our ShineBrite CarWash example.

Which Accounts Need to Be Updated (Adjusted)? Shareholders need to know how well a company is performing. The financial statements report this information, and all accounts must be up-to-date. That means some accounts must be adjusted. This is the trial balance of ShineBrite. This trial balance is unadjusted. That means it’s not completely up-to-date. It’s not ready to be used as the basis for preparing the financial statements. Cash, Equipment, Accounts Payable, Share Capital, and Dividends are up-todate and need no adjustment at the end of the period. The day-to-day transactions provide all the data for these accounts. Accounts Receivable, Supplies, Prepaid Rent, and the other accounts are another Financial Accounting Chapter 3 – Accrual Accounting

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story. These accounts are not yet up-to-date on June 30, certain transactions have not yet been recorded.

Categories of Adjusting Entries Deferrals: A deferral is an adjustment for an item for which the business paid or received cash in advance. Richemont purchases supplies for use in its operations. During the period, some supplies (assets) are used up and become expenses. At the end of the period, an adjustment is needed to decrease the supplies account for the supplies used up and to record the supplies expense. Prepaid rent, prepaid insurance, and all other prepaid expenses require deferral adjustments. There are also deferral adjustments for liabilities. Companies may collect cash from its customers in advance of earning the revenue. When they receive cash up front, they have an obligation (i.e. a liability) to provide port and shipping services for its customer. This liability is called Unearned Revenue or Deferred Income. When the company delivers the goods to the customer, the obligation is reduced and it recognizes an increase in Sales Revenue. Depreciation: Depreciation allocates the cost of an item of Property, Plant and Equipment (PPE) to expense over the asset’s useful life. It’s the most common long-term deferral. The accounting adjustment records Depreciation Expense and decreases the asset’s carrying amount over its life. The process is identical to a deferral-type adjustment; the only difference is the type of asset involved. Accruals: An accrual is the opposite of a deferral. For an accrued expense, a company records the expense before (eventually) paying for it. For an accrued revenue, a company records the revenue before (eventually) collecting cash. Salary Expense is an example of an accrual adjustment. As employees work for Richemont, the company’s salary expense accrues with the passage of time. At March 31, 2011, Richemont owed employees some salaries to be paid after year-end, so Richemont recorded Salary Expense and Salary Payable for the amount owed. Other examples of expense accruals include interest expense and income tax expense. An accrued revenue is a revenue that the business has earned and will collect next year. At year-end, Richemont must accrue such revenue. The adjustment debits a receivable and credits a revenue. For example, accrual of interest revenue debits Interest Receivable and credits Interest Revenue. How the adjusting process actually works 

Prepaid Expenses A prepaid expense (or prepayment) is an expense paid in advance. Therefore, prepaid expenses are assets because they provide a future benefit for the owner. Prepaid Rent Companies pay rent in advance. This prepayment creates an asset for the renter, who can then use the rented item in the future. Suppose ShineBrite Car Wash prepays three months’ store rent ($3,000) on June 1.

These are both Assets so the accounting equation stays equal (3000-3000=0). Financial Accounting Chapter 3 – Accrual Accounting

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After posting, the Prepaid Rent account appears as follows: Throughout June, the Prepaid Rent account carries this beginning balance. The adjustment transfers $1,000 from Prepaid Rent to Rent Expense:

Assets decrease by 1000 and Shareholders Equity decreases by 1000 After posting, Prepaid Rent and Rent Expense appear as follows:

Supplies  another type of prepaid expense. On June 2, ShineBrite Car Wash paid cash of $700 for cleaning supplies:

The cost of the supplies ShineBrite used is supplies expense. To measure June’s supplies expense, the business counts the supplies on hand at the end of the month. The count shows that $400 of supplies remains.

After posting, the Supplies and Supplies Expense accounts appear as follows:

At the start of July, Supplies has this $400 balance, and the adjustment process is repeated each month.

Depreciation of Property, Plant and Equipment All PPE (except for freehold land) has finite useful lives, and the passage of time reduces their usefulness, this decline is an expense. Accountants allocate the cost of each PPE item over its useful life. Depreciation is the process of allocating cost to expense for PPE. Note that in some countries, land titles are not issued in perpetuity, so in such cases you may see “leasehold land” (as opposed to freehold land) that is depreciated over the period of the leasehold. To illustrate depreciation, suppose that on June 2, ShineBrite purchased car-washing equipment on account for $24,000.

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ShineBrite records an asset when it purchases equipment. Then, as the asset is used, a portion of the asset’s cost is transferred to Depreciation Expense. ShineBrite estimates that equipment will remain useful for five years. One simple way to allocate the amount of depreciation for each year is to divide the cost of the asset ($24,000 in our example) by its expected useful life (five years). This procedure —called the straightline depreciation method—gives annual depreciation of $4,800 and monthly depreciation of 4,800$/12= 400$ The Accumulated Depreciation Account Depreciation expense for June is recorded as follows:

The Accumulated Depreciation account shows the sum of all depreciation expense from using the asset. Therefore, the balance in the Accumulated Depreciation account increases over the asset’s life. Accumulated Depreciation is a contra asset account—an asset account with a normal credit balance. A contra account has two distinguishing characteristics: 1. It always has a companion account. 2. Its normal balance is opposite that of the companion account. In this case, Accumulated Depreciation is the contra account to Equipment, so Accumulated Depreciation appears directly after Equipment on the balance sheet. After posting, the PPE accounts of ShineBrite Car Wash are as follows—with the adjustment highlighted:

Carrying amount The net amount of a PPE (cost minus accumulated depreciation) is called that asset’s carrying amount (of a PPE). Sometimes carrying amount is also referred to as “book value”

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Example for Carrying amount (the building data are assumed for this illustration)

You will find that different companies categorize their PPE differently. Lines 1 to 4 list the four asset categories and their costs, accumulated depreciation and carrying amounts. Line 5 shows that the total cost of PPE is €2,539 million, with accumulated depreciation of €1,272 million, resulting in a carrying amount of €1,267 million. Note that assets under construction are also not depreciated until they are ready for use. 

Accrued Expenses The term accrued expense refers to a liability that arises from an expense that has not yet been paid. Let’s look at salary expense. Most companies pay their employees at set times. Suppose ShineBrite pays its employee a monthly salary of $1,800, half on the 15th and half on the last day of the month. Assume that if a payday falls on a Sunday, ShineBrite pays the employee on the following Monday. First at the 15th of June this transaction occurs:

The trial balance at June 30 includes Salary Expense with its debit balance of $900. Because June 30, the second payday of the month, falls on a Sunday, the second half-month amount of $900 will be paid on Monday, July 1. At June 30, therefore, ShineBrite adjusts for additional salary expense and salary payable of $900

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The accounts now hold all of June’s salary information. Salary Expense has a full month’s salary, and Salary Payable shows the amount owed at June 30. All accrued expenses are recorded this way—debit the expense and credit the liability.

Accrued Revenues A revenue that has been earned but not yet collected is called an accrued revenue. Assume that FedEx hires ShineBrite on June 15 to wash FedEx delivery trucks each month. FedEx will pay $600 monthly, with the first payment on July 15. During June, ShineBrite will earn half a month’s fee, $300, for work done June 15 through June 30. On June 30, ShineBrite makes the following adjusting entry:

Unearned Revenues Some businesses collect cash from customers before earning the revenue. This creates a liability called unearned revenue or deferred income. When the job is completed, the business earns the revenue. Suppose UPS engages ShineBrite to wash vehicles, agreeing to pay $400 monthly, beginning immediately. If ShineBrite collects the first amount on June 15, they record this as follows:

Unearned Service Revenue is a liability because ShineBrite is obligated to perform services for UPS.

During the last 15 days of the month, ShineBrite will earn one-half of the $400, or $200. On June 30, ShineBrite makes the following adjustment:

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An unearned revenue represents an obligation to perform and, as such, is a liability, not a revenue. One company’s prepaid expense is the other company’s unearned revenue.

Summary of the Adjusting Process Two purposes of the adjusting process are to: ▪ update the balance sheet, and ▪ measure income. Therefore, every adjusting entry affects at least one of the following: ▪ asset or liability—to update the balance sheet; ▪ revenue or expense—to measure income.

The Adjusted Trial Balance

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The Account Title and the Trial Balance data come from the trial balance. The two Adjustments columns summarize the adjusting entries. The Adjusted Trial Balance columns then give the final account balances.

Preparing the Financial Statement The June financial statements of ShineBrite can be prepared from the adjusted trial balance.

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Which Accounts Need to be Closed? At the end of each accounting period, it is necessary to close the books. Closing the books means to prepare the accounts for the next period’s transactions. The closing entries set the revenue, expense, and dividends balances back to zero at the end of the period. Closing is easily handled by computers. Recall that the income statement for a particular year reports only one year’s income. Temporary Accounts: Because income and expenses relate to a limited period, they are called temporary accounts. The Dividends account is also temporary because it is used to record the amount of distributions to owners during the period. The closing process applies only to temporary accounts (income, expenses, and dividends). Permanent Accounts: Let’s contrast the temporary accounts with the permanent accounts: assets, liabilities, and shareholders’ equity. The permanent accounts are not closed at the end of the period because they carry over to the next period. Consider Cash, Receivables, Equipment, Accounts Payable, Share Capital, and Retained Earnings. Their ending balances at the end of one period become the beginning balances of the next period. Closing entries transfer the revenue, expense, and dividends balances to Retained Earnings. Here are the steps to close the books of a company: 1. Debit each income account for the amount of its credit balance. Credit Retained Earnings for the sum of the revenues. Now the sum of the revenues is in Retained Earnings. 2. Credit each expense account for the amount of its debit balance. Debit Retained Earnings for the sum of the expenses. The sum of the expenses is now in Retained Earnings. 3. Credit the Dividends account for the amount of its debit balance. Debit Retained Earnings. This entry places the dividends amount in the debit side of Retained Earnings. Remember that dividends are not expenses. Dividends never affect net income. After closing the books, the retained earnings account of ShineBrite appears as follows:

Assume that ShineBrite Car Wash closes the books at the end of June.

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Thise are the closing journal entries:

This are the accounts after closing:

Instead of closing the revenue and expense account directly to retained earnings, some accountants prefer to use a temporary account (usually called Income Summary). After closing all income and expense accounts to the Income Summary account, the balance of Income Summary (i.e. the profit or loss for the period) is, in turn, closed to the retained earnings account.

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