Accrual Accounting and Financial Statements

1. AccrualAccounting and Financial Statements Lecture 9 (CHAPTER 4)

2. Learning Objectives (LO) After studying this chapter, you should be able to • Understand the role of adjustments in accrual accounting • Make adjustments for the expiration or consumption of assets • Make adjustments for the earning of unearned revenues • Make adjustments for accrual of unrecorded expenses • Make adjustments for the accrual of unrecorded revenues

3. Learning Objectives (LO) After studying this chapter, you should be able to • Describe the sequence of the final steps in the recording process and relate cash flows to adjusting entries • Prepare a classified balance sheet and use it to assess short-term liquidity • Prepare single- and multiple-step income statements • Use ratios to assess profitability

4. LO 6 - The Adjusting Process in Perspective Transactions Documentation Journal Ledger Unadjusted Trial Balance Journalize and Post Adjustments Adjusted Trial Balance Financial Statements The complete accounting cycle now becomes

5. LO 6 - The Adjusting Process in Perspective • Each adjusting entry affects at least • One income statement account • 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

6. LO 6 - The Adjusting Process in Perspective Advance Cash Payments for Future Services to be Received Noncash Assets in the Balance Sheet Expenses in the Income Statement Transformed by adjustments into When unexpired costs expire Create Liabilities in the Balance Sheet Revenues in the Income Statement When revenues received in advance are earned Advance Cash Collections in advance for future Services Transformed by adjustments into Create

7. LO 6 - The Adjusting Process in Perspective Passing of time and the continuous use of services before paying for them Should be recorded by adjustments as increases in Expenses in the Income Statement and Liabilities in the Balance Sheet Cash Payments Until decreased later by

8. LO 6 - The Adjusting Process in Perspective Passing of time and the continuous rendering of services Should be recorded by adjustments as increases in Revenues in the Income Statement and Noncash assets In the Balance Sheet Cash Collections Until decreased later by

9. LO 7 - Classified Balance Sheet • A classified balance sheet 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

10. LO 7 - Classified Balance Sheet

11. LO 7 - Classified Balance Sheet • Current assets = assets expected to be converted to cash, sold, or consumed during the next 12 months (or within an operating cycle if longer) • Current liabilities = liabilities expected to be paid within the next year (or operating cycle if longer) • Both are generally listed in the order in which they are likely to be converted/consumed or paid during the coming year

12. LO 7 - Classified Balance Sheet Current assets Current liabilities Current Ratio $532,500 $232,870 = 2.3 • 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 • Chan Audio’s current ratio is

13. LO 7 - Classified Balance Sheet $532,500 – $260,200 $232,870 = 1.2 • Working capital is the excess of current assets over current liabilities • Chan Audio’s working capital is $532,500 - $232,870 = $299,630 • The quick (acid test) ratio removes Inventory (and other less liquid assets such as Prepaid Expenses) from the numerator of the calculation • Chan Audio’s quick ratio is

14. LO 7 Classified Balance Sheet • A balance sheet may be presented in • Condensed format - just totals of current and long-term categories • Detailed format - the accounts that make up current and long-term categories • Report format - presents all the accounts vertically • Account format - lists assets to the left and liabilities and owners’ equity to the right

15. LO 8 - Income Statement FormatsSingle step - lists revenues and deducts expenses without drawing any intermediate subtotals

16. LO 8 - Income Statement FormatsMultiple step - lists revenues and deducts expenses while drawing intermediate informative subtotals

17. LO 8 - Income Statement Formats • In a multiple-step income statement, Intermediate and informative subtotals usually include the following: • Gross profit (gross margin) - excess of sales revenue over the cost of the inventory that was sold • Operating expenses - recurring expenses that pertain to the firm’s routine, ongoing operations • Operating income - the difference between the usual and frequent in- and outflows • Other (Nonoperating) items – not related to the firm’s principal operations, i.e., the unusual and/or infrequent flows

18. Prepare Adjustment Entries

19. Journal Entries

20. LO 9 - Profitability Evaluation Ratios • Profitability measures affect the investment decisions of investors, creditors, and managers • The four basic profitability ratios are • Gross profit percentage • Return on sales • Return on common stockholders’ investment • Return on assets • Ratios vary greatly by industry • Meaning is derived by comparison to others

21. LO 9 - Profitability Evaluation RatiosThe Chan Audio Company Gross profit percentage = Gross profit / Sales = $60,000 / $160,000 = 37.5% Return on sales = Net income / sales = $13,530 / $160,000 = 8.5% • Gross profit percentage - profitability just from selling goods; other expenses/losses are not considered • Return on sales ratio (AKA: Net Profit Margin) - profitability after all expense, gains, and losses

22. LO 9 - Profitability Evaluation RatiosThe Chan Audio Company Return on common = Net income/Average common stockholders’ equity stockholders’ equity = $13,530 / ½ ($400,000 + $413,530) = $13,530 / $406,765 = 3.3% (for 1 month) • Return on assets - measures the return produced by the average available assets (effectiveness) Return on assets = Net income / Average total assets = $13,530 / ½ ($620,000 + $646,400) = $13,520 / $633,200 = 2.1% (for 1 month) Return on common stockholders’ equity (ROE or ROCE) - amount of income produced by average invested capital