Accrual Accounting Process: Part II

15.511 Corporate Accounting Summer 2003

Professor S.P. Kothari

Sloan School of Management Massachusetts Institute of Technology

June 14, 2003

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Agenda for Today

Continue with the accrual process Too many slides and a lot of details! Some of these are for self-study and for
recitations

Intuition Mechanics

Cash Flow Versus Accrual Accounting Cash flow accounting

Measures performance by comparing the cash inflows of a certain time period to the cash outflows of that period (e.g., cash flow from operations). 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). Geared toward periodic performance measurement that is not skewed by investment, financing, and long-horizon operational activities

Accrual accounting

Cash Flow Versus Accrual Accounting Accrual accounting

Based not only on cash transactions but also on credit transactions, barter exchanges, changes in prices, changes in form of assets or liabilities, and other transactions. Records events that have cash consequences for an enterprise But does not require a concurrent cash movement in order to record a transaction.

Cash Flow Versus Accrual Accounting Over the entire life of a corporation, total income
under cash flow and accrual accounting is the same. However, cash receipts in a particular period may largely reflect the effects of activities of the enterprise in earlier periods. Similarly, many of the cash outlays may relate to activities and efforts to be undertaken in future periods. The matching principle in accrual accounting addresses this limitation of cash flow accounting.

Cash Flow Versus Accrual Accounting

Isnt cash flow more important than

earnings? What cash flows are important?

When compared to current cash flows,

current earnings are more highly associated with future cash flows

Future cash flows!

Cash Flow Versus Accrual Accounting

Stock price = Present value of expected

future cash flows.

Changes in stock prices = f(changes in

expectations about future cash flows). When compared to cash flows, earnings have a stronger association with stock prices. Earnings are superior indicators of expected future cash flows.
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What is Present Value?

Accounting Earnings versus Stock Prices

Top managements incentive compensation is

usually linked to stock prices and accounting earnings. Why not link it to stock prices alone?

Stock prices are affected by economic factors that are outside of a managers control (e.g., macroeconomic, political factors). Consequently, stock prices may be a poor indicator of managerial performance. Combining both mitigates this problem
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Accounting Earnings versus Stock Prices A second reason for using accounting earnings Expected versus delivered performance

Firm X hires manager Y on December 31, 1997. Stock price of X jumps by 10%! Why? Markets expectations regarding the companys future performance improve. Accounting earnings of 1998 increases by 10%! Why? Manager Ys actions produce an actual improvement in the financial performance of X in 1998. Stock prices anticipated this improvement in 1997 at the time of the earnings announcement.
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Accounting Earnings versus Stock Prices

By combining stock prices and earnings to

reward managers, a firm can reward a manager for his/her strategic planning and operational execution. Of course, stock prices do reflect the delivered performance of the manager as well.

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.

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Accrual Accounting and Periodic Adjustments Accountants record exchange transactions. But this does not capture all economic activities. Periodic adjusting

Required to record activities that have taken place, but which have not yet been recorded. To reduce accounting costs Some economic activities may be continuous in nature. The effect of such activities are accumulated over a period and then recorded periodically rather than continuously, e.g., consumption of stationary.

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Accrual Accounting and Periodic Adjustments

In many cases, assets and liabilities are

created or discharged without the occurrence of a visible, documented exchange transaction

Periodically, adjusting journal entries are

made to record these effects.

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

Adjusting entries

Made whenever financial statements are prepared. Why? Adjusting entries are designed to
Correctly compute periodic income Correctly show balances of assets and liabilities at the end of the period

Will there be a need for adjusting entries if a corporation prepares only one income statement for the period covering its whole life?
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Periodic Adjustments

Characteristics of an adjusting journal entry:

matching of expenses and revenues involves at least one temporary (revenue, expense, or dividend) account and at least one permanent (asset or liability) account. never involves the cash account

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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

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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

Expense or Revenue before Cash

Expense incurred today, but cash paid tomorrow.

Salary earned by employees but not paid at the end of accounting period. Employees earn salary when they perform their duties, not when they receive payment. Unpaid salary is a Salary Payable liability

Revenue earned today, but cash received

tomorrow

Interest earned today, but cash received tomorrow. 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

Cash before accruing Revenue or Expense

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

1998 rent paid in advance in 1997 Rent paid in advance asset

Cash received yesterday, revenue earned today

Cash advance from customer for services not yet performed Cash advance is Unearned Revenue liability
Matching is the guiding principle in periodic adjustments. 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 18 cash or not).

Accruals (Accrue Today, Cash Tomorrow)

Accrued Wages

Employees of Sloan Enterprises are paid at the end of each week. 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. Assume December 31 falls on a Tuesday Books are closed (financial statements are prepared) on that December 31. Sloan Enterprises has incurred wage expense for two days But will not pay it in cash until January 3rd of the next fiscal year. 19

On December 31

Accruals (Accrue Today, Cash Tomorrow)

Periodic adjustment on December 31 Assets = Liabilities + Owners Equity Wages Payable Retained +4,000 -4,000 Dr Wage Expense (-RE) 4,000 Cr Wages Payable (+L) 4,000 Effect of omitting this journal entry?

Liabilities are understated by $4,000 Retained earnings & Net income overstated by $4,000
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Earnings

Accruals (Accrue Today, Cash Tomorrow)

What would you see on the balance sheet as of

12/31?

What would you see on the income statement for

the year ended 12/31?

Wages Payable $4,000 under Liabilities

Without the adjusting entry

Wage Expense of $520,000 52 Weeks x $10,000 per week Wage expense would have been $4,000 less. Expense would have been understated Net income overstated

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Accruals (Accrue Today, Cash Tomorrow)

$10,000 paid on Jan. 3 of next year. Assets = Liabilities + Owners Equity Cash Wages Payable Retained Earnings -10,000 -4,000 -6,000 Dr Wage Expense (-RE) 6,000 Dr Wages Payable (-L) 4,000 Cr Cash (-A) 10,000 What would be the balance in the T-account for
Wage Expense on January 3rd?

$6,000

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Accruals (Accrue Today, Cash Tomorrow)

Consider the $10,000 paid to the employees. Where and How would it show up in the
financial statements?
Period 1 Cash Flow Statement Operating cash flow Income Statement Wage expense (-RE) Period 2 -10,000 -4,000 -6,000
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Accruals (Accrue Today, Cash Tomorrow)

Accrued Interest

On December 1, U.S. Bank loans $24,000 to Stone Corporation at an annual interest rate of 10%. Books are closed on December 31 Stone Corp. pays U.S. Bank in full (principal and interest) on January 31 of the next year.

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

OE

24,000 24,000
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Accruals (Accrue Today, Cash Tomorrow)

Where would you see this in the cash flow

statement of U.S Bank? Investing out flow of $24,000 On December 31, U.S. Bank has earned one months interest on the loan given to Stone Corp.

Interest earned = 24,000 x 10% x 1/12 = $200.

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Accruals (Accrue Today, Cash Tomorrow)

Periodic adjustment on December 31 Assets = L + Owners Equity Interest Receivable Retained Earnings +200 +200 Dr Interest Receivable (+A) 200 Cr Interest Revenue (+RE) 200 Effect of omitting this journal entry?

Assets are understated by $200 Retained earnings & Net income each understated by $200

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Accruals (Accrue Today, Cash Tomorrow)

How much cash will U.S. Bank receive on January

31 of the next year?

Although a single check may be issued, let us

consider it as two transactions. Assets Cash Loan Receivable +24,000 -24,000 = L + OE

$24,000 -- amount lent to Stone Corp. (principal) Plus $400 as interest for 2 months

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Accruals (Accrue Today, Cash Tomorrow)

Assets = L + Owners Equity Cash Int. Receivable Retained Earnings +400 -200 +200 Dr Cash (+A) 400 Cr Interest Receivable (-A) 200 Cr Interest Revenue (+RE) 200 Two elements to the journal entry

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

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

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Cost Expirations (Cash Yesterday, Accrual Today)

Supplies Inventory

During 2000, Greener Pastures, Ltd. purchases (for cash) supplies in the form of spare parts to support the manufacture of farm machinery at a total cost of $700. The company began the year with $500 in the supplies account.

Assets Cash -700

= Liabilities Supplies +700

OE

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Cost Expirations (Cash Yesterday, Accrual Today)

On December 31, a count reveals that supplies in the

amount of $300 remain on hand.
Supplies Used = Beg. Inv. + Purchases - Ending Inventory

= $500 + $700 - $300 = $900 Assets = L + Supplies -900 Dr Supplies Expense (-RE) 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 500 700 300 900 Supplies expense

Supplies expense of $900 is the adjusting entry and the corresponding debit is to Retained Earnings (i.e., expense on the income statement that affects retained earnings). The Ending Inventory of $300 appears on the balance sheet (and it serves as the ending inventory for the current fiscal period and beginning inventory for the following fiscal period).

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Cost Expirations (Cash Yesterday, Accrual Today)

What shows up in the cash flow statement? What shows up in the income statement? What shows up in the balance sheet?

Ending balance in Supplies of $300

The cash paid during the year for purchase of supplies Operating outflow = $700 The cost of supplies consumed during the year Supplies expense = $900

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Cost Expirations (Cash Yesterday, Accrual Today)

Prepaid Expenses

On January 1, 1999, Crimson Inc. purchased a

$1,000 insurance premium for a two-year period January 1, 1999 Assets = L + OE Cash Prepaid Insurance -1,000 +1,000 Dr Prepaid Insurance (+A) 1,000 Cr Cash (-A) 1,000
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Cost Expirations (Cash Yesterday, Accrual Today)

What happens during 1999? How to record this in financial statements?

One-years worth of insurance protection expires Assets = L + Owners Equity Prepaid Insurance Retained Earnings -500 -500 Dr Insurance Expense (-RE) 500 Cr Prepaid Insurance (-A) 500

Effect of omitting this journal entry?

Assets are overstated by $500 Retained earnings (income) overstated by $500

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Cost Expirations (Cash Yesterday, Accrual Today)

Reporting in Financial Statements? 1999 Operating cash out flow (-) 1,000 Insurance expense (-RE) 500

2000 500

What shows up in the balance sheet as of 12/31/99?

Assets: Prepaid Insurance $500 Why is this an asset? Represents one-years worth of insurance protection for 2000
available to the company
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Cost Expirations (Cash Yesterday, Accrual Today)

Are we not getting insurance protection every

day? Why wait till December 31 to record the expense?

Cost-benefit trade off Financial statements are prepared quarterly for investors and monthly for firms management. The adjusting entries may be recorded more frequently.

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Cost Expirations (Cash Yesterday, Accrual Today)

Pre-received revenues

Unearned revenue Fees received in advance Customer advances Subscription received in advance, etc.

Magazines Unlimited receives $5,000 during 2000

for magazine subscriptions to be fulfilled during 2000 and 2001. Assume that as of the end of 2000 Time had fulfilled 60% of the subscriptions.

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Cost Expirations (Cash Yesterday, Accrual Today)

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

Decreases by 60% because Magazines Unlimited delivers magazines in 2000.
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Cost Expirations (Cash Yesterday, Accrual Today)

Assets = Liabilities + Owners Equity Unearned Revenue Retained Earnings -3,000 +3,000 Dr Unearned Revenue (-L) 3,000 Cr Subscription Revenue (+RE) 3,000 Effect of omitting this entry?

Liabilities are overstated by $3,000 Retained earnings (income) understated by $3,000

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Cost Expirations (Cash Yesterday, Accrual Today)

Effect on financial statements? 2000 2001 Operating cash inflow (+) +5,000 Subscription revenue (+RE) +3,000 +2,000 What do you see in the balance sheet as of
12/31/2000?

Liabilities: Unearned Revenue = $2,000 Represents the obligation for unfulfilled journal subscriptions.

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Cost Expirations (Cash Yesterday, Accrual Today)

Depreciation

Dewey, Inc. invests $10,000 in a quality control equipment on January 1, 1990. Deweys management estimates initially that the equipment would last for ten years and would be scrapped thereafter.

Assets = Cash Equipment -10,000 +10,000 Dr Equipment (+A) Cr Cash (-A)

+ OE

10,000 10,000
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Cost Expirations (Cash Yesterday, Accrual Today)

Where and when would you see the $10,000

cash flow statement?

in the

Dewey paid for the equipment in 1990, but the

equipment provides benefits for 10 years. What does matching principle suggest?

Investing cash outflow of $10,000 in the year of payment

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

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Cost Expirations (Cash Yesterday, Accrual Today)

Depreciation is allocating (or expensing) the cost of

a long-lived asset over its estimated useful life. How much to allocate to a given period as depreciation expense?

One common method is straight line

Several methods are allowed under GAAP (Discussed later in the course). Equal apportionment of the cost over useful life

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Cost Expirations (Cash Yesterday, Accrual Today)

Depreciation expense for each year = $1,000 At the end of each year, what do we do? Assets = L + Owners Equity Equipment Retained Earnings -1,000 -1,000 If we repeat this ten times over the next ten years,
what would be the balance in the T-account for Equipment

Zero
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Cost Expirations (Cash Yesterday, Accrual Today)

How does the $10,000 show up in the cash flow and income statements? Periods 1 2 3 ...... 10 Investing outflow (-) 10,000 0 0 0 Depreciation Exp. (-RE) 1,000 1,000 1,000 ... 1,000 Over a firms entire life, would net income be equal to its operating cash flows?

No, operating cash flow does not include the outflow for equipment whereas net income is computed after subtracting depreciation expense
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Cost Expirations (Cash Yesterday, Accrual Today)

How to record depreciation expense? Equipment Retained Earnings -1,000 -1,000 One possibility is Dr Depreciation Expense (-RE) 1,000 Cr Equipment (-A) 1,000 However, this is not GAAP. What might be the potential limitations of this
approach?
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Cost Expirations (Cash Yesterday, Accrual Today)

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

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

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)

Balance sheet presentation after one year. Equipment (original cost) 10,000 (-) Accumulated Depreciation (1,000) Net Book Value 9,000 Balance sheet presentation after ten years. Equipment (original cost) 10,000 (-) Accumulated Depreciation (10,000) Net Book Value 0 Does this make sense?
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Cost Expirations (Cash Yesterday, Accrual Today)

Yes, if the asset remains in use. However, if the equipment is scrapped after ten
years, how do we record it?

Sometimes fully depreciated asset may still be used.

Dr Acc. Depreciation (+A) 10,000 Cr Equipment (-A) What remains on the books? Equipment (-) Accumulated Depreciation Net Book Value

Eliminate it from the books

10,000 0 0 0

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Summary

Accrual accounting can be confusing! Understand the logic behind it and it will be
clear.

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