Accrual Accounting - Pearson
CHAPTER 3Accrual AccountingLEARNING OBJECTIVESAfter studying this chapter,you should be able to:In the late 16th century, the Dutch were at the forefront of trade with the restof the known world, sailing as far as modern-day Indonesia to bring back spicesthat were in high demand in Europe. The large profits from this lucrative tradeovercame the significant risks involved in traversing the oceans to the other sideof the globe.These voyages were also very expensive, requiring significant investmentupfront to fund the construction and purchase of ships, as well as the hiring ofcrews for the long journeys, which lasted anywhere from several months up tomore than a year. At the time, it was common for a company to be set up for eachindividual voyage then dissolved when the ship returned to port (or sank) and thegoods were sold. There was little in the way of financial accounting, other thanto record the amount of funds initially invested and the amount at the end of thevoyage for disbursement to the investors.In 1602, the Dutch government sponsored the creation of the Dutch EastIndia Company (Verenigde Oost-Indische Compagnie). The new company hadmonopoly powers to trade with Asia as far as the Dutch were concerned (althoughother European countries had their own ideas about the monopoly). For this company, accounting no longer centred on each voyage as was previously the case.Rather, the company reported its accounts periodically, which resulted in thedevelopment of accrual accounting.Why did the Dutch companies before 1602 not report on a periodic basis,and why did the formation of the Dutch East India Company change that practice?What is accrual accounting and why is it a consequence of periodic reporting?03 ch03 lo fish I.indd 69L.O. 3-1. Explain the sourceof demand for periodic reporting and how accrual accountingsatisfies that demand.L.O. 3-2. Explain why accrualaccounting is fundamentallyinexact, why estimates are centralto accrual accounting, and whythere is no “true” income fortypical situations; evaluate the“quality of earnings.”L.O. 3-3. Apply accrualaccounting in relation to issuesof timing: periodicity, cut-off, andsubsequent events.L.O. 3-4. Evaluate whetheran accounting change is an error,a change in accounting policy,or a change in estimate, andapply the retrospective andprospective treatmentsappropriate to that type ofaccounting change.L.O. 3-5. Integrate thestructure and connections amongthe four financial statements andexplain how this structure relatesto accrual accounting.9/28/12 4:05 PM
3CONTENTSA. DEMAND FOR PERIODIC REPORTING AND THE NEED FOR ACCRUAL ACCOUNTING71B. ACCRUAL VERSUS CASH ACCOUNTING74C. UNCERTAINTY AND THE ESSENTIAL ROLE OF ESTIMATES IN ACCRUAL ACCOUNTING76D. QUALITY OF EARNINGS AND EARNINGS MANAGEMENT77E. PERIODICITY, CUT-OFF, AND SUBSEQUENT EVENTS1. Periodicity2. Cut-Off797980F. ACCOUNTING CHANGES: ERRORS, CHANGES IN ACCOUNTING POLICY, AND CHANGES IN ESTIMATES1. Correction of Errors2. Changes in Accounting Policy3. Changes in Accounting Estimates4. Illustrative Example for Practice5. Summary818181838385G. THE STRUCTURE OF FINANCIAL REPORTS AND THEIR RELATIONSHIPS1. Overview of Financial Statement Presentation and Interrelationships2. Balance Sheet (Statement of Financial Position)868689a. Assetsb. Liabilitiesc. Equity3. Statement of Changes in Equity4. Income Statement (Statement of Comprehensive Income)5. Statement of Cash Flows6. Note Disclosures7. Discontinued Operations and Other Non-Current Assets held for Sale8. Comparative Figures9. Putting it All Together: An Illustrative Example10. A Practical Illustration: Thomson Reuters Corporation9192939395979899100100100H. SUBSTANTIVE DIFFERENCES BETWEEN RELEVANT IFRS AND ASPE109I. APPENDIX: REVIEW OF THE ACCOUNTING CYCLE1. Journalizing2. Posting3. Adjustments4. Preparing the Financial Statements5. Journalizing Closing Entries6. Posting of Closing Entries7. Summary109110111112114114115115J. SUMMARY116K. ANSWERS TO CHECKPOINT QUESTIONS117L. REFERENCES118M. GLOSSARY118N. PROBLEMS119O. MINI-CASES140In modern times, we take for granted that companies produce financial statements every year, or even more frequently. While much of this practice is due toregulation, the regulations themselves reflect the economic demands for periodicreporting. This chapter will first discuss the demand for and supply of periodicreporting. We will also see why periodic reporting naturally leads away fromcash accounting toward accrual accounting (i.e., the way we currently presentaccounting reports; a formal definition of accrual accounting will follow). Thechapter will then revisit the concept of uncertainty from Chapter 1 and how it03 ch03 lo fish I.indd 709/28/12 4:05 PM
A . Dem and f o r Pe r io dic R e po r t ing and t he N e e d f o r Ac c r ua l A c c o u n t i n g71impacts the preparation of accrual accounting reports through the use of estimates. This conceptual background will help explain the structure of the incomestatement (the main report measuring periodic performance) and the idea of“quality of earnings,” a concept that is used frequently in the press but oftenpoorly understood.After showing that periodic reports using accrual accounting are necessary to satisfy users’ information needs, this chapter proceeds to explore several issues that surface as a consequence. First, what kinds of financial statements (balance sheet, incomestatement, etc.) are necessary under an accrual accounting regime? How do we definethe reporting periods, and which events should be included in a particular period?Given the need to make accounting estimates and the need to change accountingpolicies from time to time, how do we deal with changes in these estimates and policies? How do we address errors in accounting reports that were previously issued?While this range of issues may seem diverse, they all are addressed in thischapter because they all are connected by the idea of timing: when do events,transactions, and accounting occur relative to each other. In accrual accounting,as you will see, timing is everything.A. DEMAND FOR PERIODIC REPORTING ANDTHE NEED FOR ACCRUAL ACCOUNTINGRecall from Chapter 1 that a ccounting involves the production and transmission of information about an enterprise from those who have it to those whoneed it. In the context of financial reporting to external users, accounting can bevery simple for businesses like the Dutch trading ships before 1602. Accountantsneeded only to record how much each investor contributed to the voyage; then,when the ship returned, the accountant tallied up how much the ship’s goodsfetched on the market and disbursed the funds to the investors according to theirshare of investment. In other words, the accounting was on a cash basis: track howmuch money comes into the enterprise at the beginning and how much goesback to each investor. This approach was efficient and practical because the cashcycles had all been completed.L.O. 3-1. Explain the sourceof demand for periodic reportingand how accrual accountingsatisfies that demand.TYPES OF CASH CYCLESA cash cycle is a set of transactions that converts a cash inflow toa cash outflow or vice versa. We can categorize cash cycles intothree types: financing, investing, and operating. A financing cash cycle is thereceipt of funding from investors, using those funds to generate returns frominvestments and operations, and returning the funds to investors. An investingcash cycle begins with the use of funds to purchase property that has longterm future benefits for the enterprise (e.g., equipment), using that propertyto obtain economic benefits that ultimately result in cash inflows, and disposing of the property. An operating cash cycle involves the purchase of itemssuch as inventory; production, sales, and delivery of goods or provision of services; and receipts from customers. The distinction between financing and theother two cycles is quite clear because of the direction of cash flows: financinginvolves inflows to the enterprise followed by outflows, while investment/operations involve outflows then inflows. The distinction between the investing and(Continued)03 ch03 lo fish I.indd 71cash cycle: A set of transactionsthat converts a cash inflow to a cashoutflow, or vice versa. A financingcash cycle is the receipt of fundingfrom investors, using those funds togenerate returns from investmentsand operations, and returning thefunds to investors. An investing cashcycle is the purchase of propertythat has long-term future benefitsfor the enterprise, using that propertyto obtain economic benefits thatultimately result in cash inflows, anddisposing of the property. An operating cash cycle involves the purchaseof items such as inventory; production, sales, and delivery of goods orprovision of services; and receiptsfrom customers.9/28/12 4:05 PM
72CHA PTER 3A ccru al A ccou nt ingoperating cash cycles is less clear as it requires subjective judgments aboutlong versus short term: investing cycles tend to be longer than operating cashcycles.Exhibit 3-1 summarizes each of these three cash cycles as well as theirtendency to be nested: financing provides cash flows for investment and operations, investment provides benefits for operations, and operations generatescash flows to fund more investments and payments to investors.Exhibit 3-1Conceptual depictions of cash cycles2. Use funds for investmentsand operations3. Dispose ofproperty1. Receive fundsfrom investorsInvestingcycleFinancingcycle2. Obtainbenefitsfrom usingproperty1. Acquireproperty3. Return fundsto investors1. Purchasese.g., inventory2. Production,sales, delivery4. Receive cashfrom customersOperatingcycle3. ProvideservicesWhy was there no reporting in between departure and return of the ships?The reason is simple: there were no credible and timely ways to obtain information about a voyage until the ship returned to port. (Credibility is importanthere, as there could be unverifiable rumours from other ships that happen tocross paths with the ship of interest.) Without such information, no one was inany mood to buy or sell investments in the voyage once the ship had started itsjourney. It was only practical to wait until each ship returned to port. In otherwords, there was an inability to supply the information during the voyage, even ifpeople demanded it. Given the limited duration of each company/voyage, investors were willing to wait for the ship’s return.The formation of corporations like the Dutch East India Company changedall that. These corporations, and other types of entities, had indefinite lives.They were intended to continue operating until the owners at a future date collectively decided to dissolve the entity. With the uncertain length of time untildissolution, which could be a very long time in the future, it is clearly not practical for investors to wait until the dissolution of the company to find out if theymade any money!The rise of entities with indefinite lives meant that investors in such entities needed to sell their investments at some point before the dissolution of theentity. These sellers and any potential buyers needed information to help themvalue the investment. Given a multitude of investors, it only made sense thatenterprises report at pre-specified intervals rather than respond to information requests coming from each investor or potential investor. In the case of the03 ch03 lo fish I.indd 729/28/12 4:05 PM
A . Dem and f o r Pe r io dic R e po r t ing and t he N e e d f o r Ac c r ua l A c c o u n t i n g73STILL WAITING In 1670, an incorporation under the British royal charter created“The Governor and Company of Adventurers of England trading intoHudson’s Bay.” The charter gave the company exclusive rights to the fur tradein the watershed flowing into Hudson Bay. The company continues to operate today as The Hudson’s Bay Company. It was publicly traded until January2006, when it was purchased by private equity firm NRDC Equity Partners. Ifinvestors had to wait until dissolution to find out what happened to their investments, they would have been waiting for almost three and a half centuries—and counting!Dutch East India Company, this interval was 10 years.1 Today the interval is typically a year or a quarter according to incorporation laws, securities regulations,and securities exchange rules.Except for coincidental occasions, the end of a reporting period such as ayear will not correspond with the completion of transactions. For instance, consider the hypothetical series of trading voyages for Tradewinds Company shownin Exhibit 3-2.Exhibit 3-2Timeline with voyages for Tradewinds CompanyYear 1Ship:AmsterdamBataviaHollandiaVoyage AYear 2Year 3Year 4Voyage DVoyage BSunkVoyage EVoyage CVoyage GVoyage FAt the end of the first year, Voyage A will have been completed. However,Voyages B and C also began in Year 1, but the ships had not returned by the end ofthe year. Should Tradewinds Company report only the results of Voyage A? Whatshould Tradewinds report regarding the investments it made for Voyages B and C?As you can gather from this example, reporting only information for completed voyages using cash basis accounting provides incomplete information toinvestors. (Recall the concept of completeness in the conceptual frameworks ofChapter 2.) Investors need to know that Tradewinds has invested in other voyages that are in progress at the end of the year—and, if the information is available, the status of those voyages. The accrual basis of accounting would try tocapture the voyages in progress.Formally, accrual accounting is a basis of accounting that reflects economic events when they happen rather than only when cash exchanges occur.For instance, for Year 1 accrual accounting would include information relating toTHRESHOLDCONCEPTaccrual accounting A basis ofaccounting that records economicevents when they happen rather thanonly when cash exchanges occur;contrast with cash accounting.1. The reports were required every 10 years. While this seems like a long time in current times, bear inmind that each voyage could last for more than a year. Given the nature of the Dutch East India Company’s operations, 10 years is perhaps not such an unreasonable reporting period.03 ch03 lo fish I.indd 739/28/12 4:05 PM
74CHA PTER 3A ccru al A ccou nt ingthe one completed voyage (A) as well as the two that are in progress at year-end(voyages B and C). Investors would find all of this information useful. Indeed,the financial report would be misleading were it to omit information about thetwo unfinished voyages. As you can see, accrual accounting arises naturally whenenterprises report periodically.CHECKPOINT CP3-1Explain the historical and logical reasons why we prepare periodic financial reports.B. ACCRUAL VERSUS CASH ACCOUNTINGcash accounting A method ofaccounting that records only cashexchanges; contrast with accrualaccounting.We can use Exhibit 3-2 to illustrate the differences between accrual and cashaccounting by applying some simple numbers to the voyages.2 Investors provide 20 million in financing to start up the company.Each ship costs 5 million and on average can complete 10 voyages, unless itis sunk by storms, hazards, or pirates.Operating costs for each voyage are 1 million to pay for the crew’s wagesand to stock the ship with inventories and supplies. The company must paythese costs in advance because the goods and the crew may perish at sea.A successful voyage usually returns within a year (sometimes longer, depending on weather conditions) with goods that can be sold for 5 million.The cash basis accounting report for Years 1 and 2 would look as shown inExhibit 3-3 (Years 3 and 4 will be left as an exercise).Exhibit 3-3Cash basis financial report for Tradewinds CompanyYear 1Voyages mYear 2Voyages mOperationsInflow from sale of goods ( 5m/arrival)Outflow for operating costs( 1m/departure)Cash flow from operationsCash flow from investing activities( 5m/ship)Cash flow from financing activitiesNet cash flow for the yearCash at beginning of yearCash at end of yearaccrual An accounting entry thatrefliects events or transactions in aperiod different from its corresponding cash flow.AA, B, C 5(3)BD, E 5(2)2(15)30207030 77 10Note that the cash financial report is a statement of flows, with the balanceof cash reported at the bottom. We can also produce a balance sheet, but it wouldbe very short and redundant: it would show only cash of 7 million and 10 million for Year 1 and 2, respectively, and equity equal to those amounts. The cashbasis balance sheet has only cash and equity in equal amounts; there are no other itemsbecause all non-cash items are accruals.Accruals are accounting entries that record events in a period different from thecorresponding cash flows. Accruals encompass both instances where the accounting2. We use “dollars” and “ ” for convenience. The actual Dutch currency since the 13th century had beenthe guilder, until the Netherlands adopted the euro.03 ch03 lo fish I.indd 749/28/12 4:05 PM
B . Ac c r ual Ve r s us C as h A c c o u n t i n grecord reflects (i) events before cash flows and (ii) events after cash flows. Sometimes accountants will refer to the latter more specifically as deferrals. For example,recognizing sales revenue after the receipt of cash is a deferral of revenue.To prepare the accrual basis financial report, we need to provide some additional guidance on Tradewinds Company’s accrual policies: 75deferral An accounting entry thatreflects events or transactions afterthe related cash flow.Record the cost of products shipped out and traded in exchange for productsfrom Asia when the Asian products are sold at the home port. Similarly,record the cost of supplies and wages as well as depreciation when the shipreturns home. This is a reasonable but arbitrary allocation rule that maintains the logical relationship between revenues and related costs (conventionally called “matching” of costs to revenues).When the company receives information about the sinking of one of itsships, the company writes off the recorded value of that ship and expensesany inventories, prepaid wages, and prepaid supplies on the books.Based on the previous information and these two accrual accounting policies,the accrual basis financial report would look like the one shown in Exhibit 3-4:Exhibit 3-4Accrual basis financial report for Tradewinds CompanyYear 1VoyagesYear 2 mVoyages mStatement of income and retained earningsRevenue ( 5m/arrival)AOperating expenses ( 1m/arrival)A(1.0)Depreciation ( 0.5m/arrival)A(0.5)B(0.5)0.0D(4.5)*Write-off of operating costs due to sunkenship ( 1m/ship)0.0DNet income (loss)3.5Write-off of sunken shipRetained earnings at beginning of yearRetained earnings at end of yearBalance sheetCash (see Exhibit 3-3)Prepaid expenses ( 1m/voyage in progress)Total assetsContributed capitalRetained earningsTotal equityBB(1.0)(1.0)0.03.5 3.5 1.52.0 10.0C, E2.0B(0.5)15.0A 5.0(2.0) 7.0B, CShips at cost ( 5m/ship)Less: accumulated depreciation 5.0(0.5)10.0 23.5 21.520.020.03.51.5 23.5 21.5Cash flow statement(same as cash basis report—see Exhibit 3-3)*The Amsterdam sank in Voyage D. After depreciation of 0.5m for Voyage A, it had a book value of 4.5m, so this is the amount written off.Let’s compare and contrast the differences in the two sets of reports. Whatcan we say about the complexity of the reports? It is evident that the cash basisreport is much simpler. Tradewinds’ cash balance increased from 7 million to 10 million, and we can see the sources of that change. In contrast, the accrualreports are more complex; there are many more items in the accrual accountingreports. Observe that all the items other than cash in the balance sheet resultfrom accrual accounting.03 ch03 lo fish I.indd 759/28/12 4:05 PM
76CHA PTER 3A ccru al A ccou nt ingSecond, which set of reports provides more useful information about performance? The cash basis report shows operating cash flows of 2 million in Year
F. ACCOUNTING CHANGES: ERRORS, CHANGES IN ACCOUNTING POLICY, AND CHANGES IN ESTIMATES 81 1. Correction of Errors 81 2. Changes in Accounting Policy 81 3. Changes in Accounting Estimates 83 4. Illustrative Example for Practice 83 5. Summary 85 G. THE STRUCTUR
3. Supplies expense . 4. Expense . Exercises . 1. Determine if each of the following descriptions relates to an accrual or a cash basis of accounting. a. Cash . b. Accrual . c. Accrual . 2. Determine whether each of the following is a characteristic of an accrual or a cash basis of accounting. a. Accrual . b. Cash . c. Cash . 3.
FINANCIAL ACCOUNTING : MEANING, NATURE AND ROLE OF ACCOUNTING STRUCTURE 1.0 Objective 1.1 Introduction 1.2 Origin and Growth of Accounting 1.3 Meaning of Accounting 1.4 Distinction between Book-Keeping and Accounting 1.5 Distinction between Accounting and Accountancy 1.6 Nature of Accounting 1.7 Objectives of Accounting 1.8 Users of Accounting Information 1.9 Branches of Accounting 1.10 Role .
between accrual and cash basis accounting in an effort to demystify the process and underscore the importance of your accounting methods. Let’s start with the basics. When you entered the Medicare system, you agreed to abide by the Conditions of Participation. One of these conditions is to use the accrual
Theoretical Basis. 2. Budgeting. Accounting. Audit. . International Public Sector Accounting Standards 38 accrual basis standards, thereof 4 withdrawn/replaced 34 accrual basis standards, plus 1 cash basis standard as a temporary solution only, when implementing accrual IPSAS Conceptual framework since 2014: solid and stable basis .
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Pearson Education LTD. Pearson Education Australia PTY, Limited. Pearson Education Singapore, Pte. Ltd. Pearson Education North Asia, Ltd. Pearson Education Canada, Ltd. Pearson Educatión de Mexico, S.A. de C.V. Pearson Education—Japan Pearson Education Malaysia, Pte. Ltd. Library of Co
based international accounting standards call for financial statements which consolidate all entities under government control4 (such as extra-budgetary funds, arms-length agencies, and public corporations).5 Accrual accounting therefore offers a number of benefits over traditional cash accounting
Summary This report introduces two general methods of accounting—the cash basis method and accrual basis method. The choice of accounting method determines the timing of the recognition of revenue and expenses. Under cash basis accounting, revenue and expe
