Principles of Accrual Accounting

Objectives and Game Plan - - - - Understand some key concepts of Financial Accounting Appreciate the differences between cash basis and accrual accounting Develop a mental model for classifying types of accruals Practice the basic bookkeeping model Important Financial Accounting Concepts - Conservatism: not the same as pessimism Materiality: Benefit/cost trade-off Consistency: Contrast with uniformity Comparability Verifiability Revenue Recognition Matching Principle: Matching Efforts (costs) with Benefits (revenue) • Further, we will make assumptions about the Economic Entity, its ability to survive as a Going Concern, and the Fiscal Period (which need not be the calendar year) Key Conflict: Relevance v. Reliability - Example: How should we value one-of-a-kind assets, like one of Intel’s wafer fabrication plants? Key Conflict: Relevance v. Reliability - Example: How to value one-of-a-kind assets? • Financial accounting stresses Objectivity: Verifiable and reliable information. • Does not mean accounting is “cut and dried.” • Still ample room for managerial judgment when estimating future effects under “objective rules.” The Balance Sheet Equation Assets = Liabilities + Shareholders’ Equity Assets - Liabilities = Shareholders’ Equity “own” “owe” “owners’ share of the business” (book value, residual claim) Accounting in a Single-Period Word is “Easy” - Cash Invested 0 - + Cash Returned 1 Example: Shipping Expeditions in the 15th Century • Ship sold at end of voyage: finite project life • No information available until ship returns • Income is simply difference between cash out and cash in Accounting in a Multiperiod World is “Difficult” Cash Invested 0 1 2 3 4 5 6 … Cash Returned - - No pre-determined end to firm's life - going concern Cash invested and generated at multiple points in time Subsequent actions affected by prior results - feedback Monitoring by external investors: evaluate investment, retain/reward management Accrual accounting: focus on measuring performance in a given time period, independent of cash effects. Principals of Accrual Accounting - - - An attempt to measure firm performance regardless of when cash is exchanged Revenue Recognition: • Earnings process substantially complete • Cash collection reasonably assured The Matching Principle for Expenses: • Match efforts to the benefits generated • Capitalize expenditures that will benefit future periods, expense as benefits are realized • Recognize liabilities when efforts benefiting the current period require cash payment in the future Cash Collection v. Revenue Recognition Prior Period Cash received concurrent with earning revenue Cash received before earning revenue Cash received after earning revenue Current Period Subsequent Period + Cash (A) = + Revenue (SE) � Income Statement + Cash (A) = + Deferred Revenue (L) 0= - Deferred Revenue (L) + Revenue (SE) � Income Statement + Accounts Receivable (A) = + Revenue (SE) � Income Statement + Cash (A) - A/R (A) = 0 Note: Deferred Revenue can also be called Advances from Customers. Both names signify that cash has been received for a service or product that hasn't been delivered. Cash Payment v Expense Recognition Prior Period Cash paid concurrent with using resource to generate revenue Cash paid before using resource to generate revenue Cash paid after using resource to generate revenue Current Period Subsequent Period - Cash (-A) = + Expense (-SE) � Income Statement - Cash (-A) + Productive Asset (A) = 0 - Productive Asset (-A) = + Expense (-SE) � Income Statement 0= + Accrued Liability (L) + Expense (-SE) � Income Statement - Cash (-A) = - - Accrued Liability (-L) Note: The "Productive Asset" could be inventory, Prepaid Insurance, PP&E, etc. In the case of PP&E, we would reduce the value of the asset through the contra-asset Accumulated Depreciation. The"Accrued Liability" could be Accounts Payable, Accrued Wage Expense, Interest Payable, etc Temporary v Permanent Accounts - - Permanent Accounts: • Appear on the Balance Sheet • Start each period with the ending balance from the prior period Temporary Accounts: • Appear on the Income Statement • Start each period with a balance of $0 • Are closed at the end of the period to the Income Summary to compute Net Income for the period Handling Temporary Accounts in the Balance Sheet Equation (BSE) Format Net Income = Revenues - Expenses + Gains - Losses End. Ret. Earn. = Beg. Ret. Earn. + NI - Div Therefore... Revenues and Gains ultimately Increase Ret. Earn. Expenses and Losses ultimately Decrease Ret. Earn. We’ll record Income Statement components directly to the Permanent Account, Retained Earnings, with a note about the reason and recognize that this is a short-cut around the use of Temporary Accounts Exercise E5-18: Peters Company, Year 1 Cash + AR + PPRent + INV = AP + WgsPble + CC + RE BB 1 Total Assets = Liab + SE = Exercise E5-18: Peters Company, Year 2 Balance Sheet BB 1 Cash + AR + PPRent + INV = AP + WgsPble + CC + RE 26 4 6 5 10 4 24 3 Exercise E5-18: Peters Company (continued) Performance Measure Net Income…………… Net Cash Flow from Operations……………. Year 1 Year 2 Total Key Points - - - - Relevance of Accounting Measures depends on the decision context Most relevant measures are sometimes the least reliable: a major trade-off in accounting Accrual Accounting attempts to measure performance, regardless of when cash is affected • Tables on slides 8 and 9 provide a framework for thinking about the accrual process Balance Sheet Equation (BSE) as a tool for understanding events' impacts on the Financial Statements