The Periodicity Assumption
Recall that in Chapter Two you were introduced to the Generally Accepted Accounting Principle Periodicity Assumption that financial reports are prepared at yearend, regardless of an economic entity’s operating cycle[1]. An organization’s operating cycle describes how quickly it turns its cash (used to buy or manufacture Inventory) into cash it receives from its customers (including any time to collect Accounts receivable). To illustrate this concept, consider two companies described in Table 4.1.
Table 4 1
Getya drunk is a distiller of rotgut whiskey based in Fayette, MO. It is a small company with a hardcore following of dedicated customers. Sooper Dooper is a retailer based in nearby Columbia, MO. It is one of the largest companies in the world with retail stores located throughout the world. When Getya purchases supplies from its suppliers, it accepts the same terms that they offer all of their customers, namely thirty days. At the end of this credit period, Getya pays cash, starting its operating cycle. Getya’s product is concocted with an old family recipe that calls for it to be aged in a smelly boot for a decade. When the product is ready, Getya ships it to liquor stores (the kind with dirt floors and cinder block walls) who are extended thirty-day credit terms. The operating cycle ends when Getya receives cash from its customers. Sooper on the other hand is very powerful in vendor negotiations. It dictates favorable terms that include 180 day credit terms which begin when Sooper receives its merchandise. Inventory doesn’t sit very long at Sooper, on average only seven days and its customers pay cash when they leave the store. While the operations of these two organizations are very different (Getya has a ten year operating cycle while Sooper’s is a negative 173 days), they are both required by GAAP to produce an annual financial report enabling investors to compare the financial reports of the two companies.Getya’s fiscal year corresponds with the calendar year while Sooper Dooper adopted a January 31 yearend. A fiscal yearend is selected based on industry standards. Retailers generally choose a January 31 yearend because a December 31 yearend would not allow them to capture the entire Christmas selling/return season. Even though financial reports can have different yearends, this does not materially damage comparability between different industries. What facilitates the comparability is the application of GAAP, including the Periodicity Assumption. Rules related to timing issues, or what period transactions are properly recorded in, are related to the Accrual Basis Assumption, the subject of this Chapter.
The Revenue Recognition and Matching Principles
Recall that in Chapter One (Table 1.2) we defined Revenues as inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations while Expenses were defined as outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations. All of the adjusting and accrual transactions introduced in Chapter Four will relate to either the Revenue Recognition or Matching Principles.
Recording Adjusting and Accrual Transactions
The spreadsheet workbook used in this Chapter is available on Google Docs at https://spreadsheets.google.com/spreadsheet/ccc?key=0AgmH5rG6dzTmdGhwSE1HMjdEbzRXamc2UFZvbjlISVE&hl=en_US. The companion YouTube lecture is available at http://www.youtube.com/watch?v=YdDKBZFEv0g. Please replicate the work demonstrated in this Chapter using paper and pencil, on columnar paper[2]. Use the proper form you learned in Chapter Three! Record transactions in the General Journal then post them to the General Ledger. This Chapter will cover the identification, analysis and recording of transactions in their proper period according to the Revenue Recognition Principle and Matching Principle.
Adjusting Balances and the Roll Forward: Accountant’s Toolbox Tables 4.2 and 4.3
This YouTube video details a handy tool for calculating the adjusting journal entry balance that is required to state balance sheet accounts at their correct balance http://www.youtube.com/watch?v=c24kcO3L8Sc . This approach is based on the assumption that the beginning balance is correct and all of the transactions related to the account in question have been recorded properly during the period. If these assumptions are correct, and the calculation of the ending balance is correct then the adjusting entry will record the related revenue or expense in the proper period. In the real world, this approach, called the “Balance Sheet approach” doesn’t always work because the data is not always complete. However, in your academic work the Balance Sheet approach works great. It is especially handy when you have a question that requires you to work backwards (you are given an ending balance and need to calculate the adjusting entry). This tool comes in handy when you are provided with the unadjusted ending balance.
Table 4 2
A variation of this tool is the accounting roll forward, presented in the following YouTube video http://www.youtube.com/watch?v=MBtyiJE_PTU. You have already used this same “tool” when you learned the Statement of Retained Earnings in Chapter Two. Learning to use standard tools is an important step in learning the language of a paradigm, in this case, the language of financial accounting. Throughout this textbook I will refer to these standardized tools and demonstrate how to use them on a variety of subject areas. For an example of how this tool is used in financial markets, Google “Net Subscriber Additions” to see how closely analysts track this “KPI” (Key Performance Indicator) in the telecom industry.
Table 4 3
Expiring Assets
In Chapter Three you learned in journal entries #1 through #5 how to record the acquisition of assets that will benefit Lizzie Inc. in future periods. If any portions of these assets expire in the current period, then the asset balance must be reduced with a credit and a corresponding debit to an expense account. Examples of expiring assets include: Inventory that has been sold, Supplies that have been used, Prepaid insurance premiums that have expired and Equipment that was used in the period. All of these expired assets helped generate Revenue in the period and therefore must be MATCHED against the Revenue on the Income Statement. Lizzie Incorporated had three different assets that expired in the period.
Please prepare a roll forward worksheet for Lizzie Inc.’s Inventory. Since this was the company’s first year of operations, the beginning balance was $0. During the year (June 30) it purchased $18,839, its only purchase of the year. Therefore, the Cost of Goods Available for Sale during 2010 was $18,839, which is also the General Ledger balance before adjustment. At yearend, Lizzie Inc. determined that no inventory remained. Using the roll forward we can see that the Cost of Goods Sold was $18,839.
Table 4 4
Lizzie's equipment that she purchased on July 1 was used for 6 months helping her generate revenue. Therefore, a portion of this asset expired in the period. The term to describe the expiration of fixed assets is depreciation. Unlike other assets, the fixed asset account balance is not directly adjusted. It will remain at its historical cost until the asset is disposed of. To reduce the net[3] book value of the asset to its proper balance, a contra-asset account, Accumulated depreciation, is used. We will study different GAAP depreciation methodologies later in this text. For now, I will provide you with the Depreciation expense for the period of $580.
Table 4 5
Recall that on July 1 (je #5) Lizzie Inc. purchased a one-year insurance policy. The company properly recorded this as an asset because when purchased, the policy was going to benefit future periods. Prepare a roll forward for this insurance policy. The beginning balance (Jan 1) was $0, the one-year policy was purchased on July 1 (addition) and the proper balance in the Prepaid insurance account at yearend should be $375, ($750 * 6/12).
Table 4 6
Failure to record this type of adjusting entry will result in Assets and Owners’ Equity being overstated at yearend.
Expiring Liabilities
Liabilities that expire in the period require the account balance to be reduced by debiting the account with a corresponding credit to a revenue account. Lizzie Inc. did not have any liabilities expire in the example, so I am creating a scenario that is NOT in the Google Docs worksheet[4]. For illustration sake, lets assume that on November 1, 2010, Lizzie Incorporated received a $500 deposit from its customer for the future delivery of product. According the terms of the sales contract, Lizzie Inc. must return the Cash if it does not deliver the goods. This transaction would have resulted in an increase in Cash (debit) and an increase in Unearned revenue, a current liability (credit). The balance in Unearned revenue at December 31 would be $500 before adjustment. When it closed its books, the company determined that it had in fact shipped the product required under the sales contract and therefore, the proper balance in Unearned revenue should be $0. The appropriate entry in this case would be to decrease the current liability by debiting it and a corresponding entry to Sales (credit).
Failure to record this type of adjustment will result in overstated Liabilities and understated Owners’ Equity.
Accruing Assets
Accruing is a legal term used in financial accounting to describe the arising of a legal claim. In this case, Lizzie Inc. recognizes a new claim on an asset that arose in the period. When closing the books at yearend, the accountant of Lizzie Inc. realized that the company had shipped some product to a customer, but she had not yet prepared the invoice. Even though the invoice has not yet been sent to the customer, Lizzie Inc. has a legal claim for money that it is owed… an Account receivable. In some cases a company may wish to set up a separate Unbilled accounts receivable account, in this case we will use the regular old Accounts receivable.
Table 4 7
Failure to record this type of accrual will result in both Assets and Owners’ Equity being understated.
Accruing Liabilities
Recall that on July 1 (je #4), Lizzie Inc. sold its Note payable with a face value of $20,000 and a term of two years. Even though the first interest payment is not due for another six months, Lizzie Inc. has a legal obligation that has arisen over the last six months of 2010 that it needs to record. Using your business math skills you calculate the liability to be $1,000 at December 31(P*R*T $20,000*10%*(6/12)=$1,000).
Table 4 8
Failure to record this type of accrual will result in understated Liabilities and overstated Owners’ Equity.
Accounting in the Real World: Accrual and Adjusting Entry Closing Checklist
In order to ensure that all possible types of adjusting and accrual entries are recorded, it is a good idea to work from a checklist so that no material entries are overlooked. This is not an exhaustive checklist, but it will give you a good idea of the types of adjusting and accrual entries that we will cover in Financial Accounting 1.
1. Expiring Assets
a. Prepaid expenses (including insurance, rent, etc)
b. Inventory
c. Supplies
d. Equipment (depreciation)
e. Accounts receivable (allowance for doubtful accounts)
f. Bonds or Notes receivable (premium of discount)
2. Expiring Liabilities
a. Unearned revenue
b. Bonds or Notes payable (premium or discount)
3. Accruing Assets
a. Accounts receivable (services or goods provided but not yet billed)
b. Interest receivable
4. Accruing Liabilities
a. Interest payable
b. Goods and services received but not yet invoiced (utility bills, etc)
c. Legal claims from civil suits, whether a lawsuit has been filed or not
d. Wages earned by employees but not yet paid or recorded in Wages payable (earnings since last payroll before period end)
This checklist is part of an accounting system that helps people work in a consistent manner every period. This consistency promotes comparability between periods and is one of the enhancing qualities of useful information described in Chapter Two.
Kuhn Paradigm Science… The Importance of PRACTICE
This section is a repeat from Chapter Three, but it is important for you to understand what is required of you to learn this material. Kuhn’s observations can be extrapolated to society at large because a scientific community is a social system organized around a single paradigm just as society is organized around an economic paradigm. The framework is the foundation upon which the community is built, providing its rules for communication and social interaction. Without the framework the community does not exist. Understanding the framework, how it was established, its rules, terms of communication, tools, boundaries and even its known flaws is invaluable in understanding its product. Kuhn (1996) declared that the paradigm is not theoretical for its members, rather, it is part of their life and each member has personally observed evidence of its accuracy.
If, for example, the student of Newtonian dynamics ever discovers the meaning of terms like force, mass, space, and time, he does so less from the incomplete though sometimes helpful definitions in this text then by observing and participating in the application of these concepts to problem-solving (p. 46-47).
What this means to you is that this practice is NOT a waste of your time or merely busy work. It is HOW you learn the function of the financial accounting paradigm. Practice the work in Chapter Four at least three full times using the same numbers. Work through an entire accounting cycle, from the General Journal through to financial statement presentation. Compare the financial statements for Lizzie Incorporated that you prepared in Chapter Three to the statements you prepare in Chapter Four. Ponder how the revenue recognition and matching principles changed what these financial statements are communicating.
Next, experiment with different types of adjusting and accrual entries. Try to do entries that are listed in the checklist. Compare financial statements (with your changes) to understand the impact of various decisions. This chapter is instrumental in learning accounting, if you practice hard, the remainder of this course will be easy!
[1] The SEC requires quarterly financial reports and organizations customarily close their books at the end of each month.
[2] http://www.printablepaper.net/category/columnar
[3] “Net” in Financial Accounting means combining or offsetting different accounts. For example, Net Income combines revenues and expenses.
[4] I am too lazy to update the video… I will get to it later and add the Unearned revenue transaction.
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