Just in Time Concept

Financial beS. Das Income measuring and Accrual Accounting realisation and Measurement in Financial financial statements DEFINITIONS receiptssinflows of assets or reductions in liabilities from selling goods and attend tos depreciatesoutflows of assets or increases in liabilities used up in generating tax grosss. Recognitionformal recording of an item in pecuniary statements, in words and numbers Measurementquantify the effects of economic events numbers unit is money dollars historical cost recorded for simplicity, verifiability, reliability Cur countercurrent cost-relevant but less(prenominal) reliableOnly an estimate until item is sold Net income= taxs-Expenses. Incomeamount of resources available for consumption at the end of a period and yet be as well withdraw as it was at the beginning of the period. CASH BASIS Versus ACCRUAL ACCOUNTING So if we DEFINE PERIOD to be lifetime of a solid (which dismiss only be defined for a firm with a finite life) then we are on ly interested in the wages of a firm over its lifetime. In that case a. just wait until the firm dissolves. b. Add up either the cash inflows over its lifetime new(prenominal) than those for deal of admit stock. c.Add up the cash outflows over its lifetime other those for stock repurchase or dividends. d. Find the difference between cash inflows and outflows and YOU HAVE NET INCOME. e. THE in a higher place IS ALWAYS TRUE. However, if you DEFINE PERIOD TO BE ANY INTERVAL SMALLER THAN THE LIFE TIME when you wish to get information on earnings as intermediate feedback, then there is the following problem -transactions may not be roll in the hay on a cash to cash priming because the earnings process is continuous Period1buy inventory for $5 Period2pay for inventory Period3sell and deliver inventory for $15Period4receive payment from customer. KEY QuestionWhen should revenues and expenses be recognised? One possibility is the cash tail recognize revenues at time of receiving cash and recognize expenses at the time of paying cash. Example A toy retail merchant starts business on January 1, 2000. The retailer Mr. XYZ pays two months rent in advance on his store for $2000. He also purchases and pays for toys worth $35,000. However, during the month of January, he sold no toys. During February, he sells all the toys he has for $45,000 but collects only $5000 of that in cash.He expects the neighborhood children to pay the remaining $40000 in March. JanFebruary Revenues Less Expenses Cost of toys Rent- Total Expense- Income Limitations of interchange land 1. expenses are not aligned in time with the revenue that they produce. 2. recognition of revenue is unduly postponed. A Second possibility is the use of Accrual basis depends upon when some critical event occurs. What happens to income (accrual basis) using same example? JanFebruary Revenues Less Expenses Cost of toysRent- Total Expense- Income Comparing the Cash And Accrual Bases of Accounting -Basic difference one of timing Recognize Revenue whenRecognize Expense when Cash Basis cash is received cash is paid Accrual Basisrevenue is get it is incurred testify 4-2 transparency Accrualmatching of expenses with the corresponding revenues OR match resources used (expired assets- expenses)to generate revenue. The accrual concept forces accountants and managers to focus on changes in bearers equity alternatively than merely reporting changes to the cash or other assets.The realization concept underlies the decision rules that accountants use in determining when revenues should be recognized and expenses matched to them. The Revenue Recognition formula RevenueIncrease in Asset Or Decrease in Liability from Delivery of Goods Or service RealizedGoods Or Services Exchanged for Cash Or Promise of Cash . EarnedRevenue get when realization is complete or no significant obligations left How are Revenues recorded? At the same time as cash is collected. Before the time cash is collected. After the time cash is collected. Possible Interpretations of Recognition PrinciplePercentage of CompletionFor long term projects, revenue recognized as stages are completed, based upon pro ploughshare of total cost incurred, Franchises sign fee recognized as revenue only FAS 45 substantial performance of its obligations B&J 32 Production MethodCommodities Traded at established price so revenue recognized when they are produced. Installment Methodopposite of mathematical production method no reasonable basis to estimate collectability, so revenue on sale recognized as cash is collected Continuouslysuch as rent and interestThe criteria used in accounting to decide the recognition of revenues is A firms has performed all, or a substantial portion, of the services it expects to provide. The firm has received cash, a receivable, or some other asset whose cash equivalent it can objectively measure. Expense Recognition and the Matching Principle The matching concept relates revenues a nd expenses so that owners equity is neither overstated nor understated at any points in the steam of events that constitutes trading operations. Expensewhen an Asset Has No Future Benefit i. e. It Is Used Up Or a Liability Is Incurred.MatchingAssociate Revenues with be (expenses) Necessary to Generate them UnexpiredSometimes not make with specific items of product sold, but with period in Assets which they were sold eg. sales clerks salaries are expensed in the period in which employees worked. Expired Some things neer go through asset stage, since benefit is seen to expire as soon Assets as costs expended (purchased) = Period Costs eg. utilities costs, telephone, fuel for vehicles (not asset) devil examples 1. Expired asset versus 2. Expensing of benefits/ resources that never went through asset stage.A. Depreciation Expense estimated useful life and eventual salvage or resale value Manipulation to increase or decrease income palliate deducted before calculating periodic exp ense because it is expected to be recovered and will remain an asset. B. Research DevelopmentDell Computer in its 1995 yearly spread over enumerate Research, development and engineering of $65,361,00 as operating expense on Income Statement. an expense is an asset whose usefulness to the company is complete it is deemed that RD has no approaching benefit left hence out right expense without going through asset stage.For an accrual based company, Statement of Cash Flows provides information on Sources and Uses of Cash. Accrual basis necessary because we divide the earning of income, a process that takes place over a period of time, into artificial segments (reporting periods). Example In the 1995, Income Statement Maytag passel had a net loss of $20,476,000. Their Statement of Cash Flows showed an increase in cash equivalents of $30,811,000. Cash provided by operating activities was $319,979,000. How can a company with a net loss rescue a gain in cash?This is possible if expe nses exceeded revenues since Income statement is on accrual basis. It contains revenue amounts that may not have been realized in cash (still in accounts receivable) and expenses that may not have been paid for such as derogation, and unpaid purchases. Also look for income from continuing operations versus loss due to extraordinary items and disposal of existing business. (As was the case in Maytag 1995) Accrual Accounting and Adjusting Entries at end of period Four Types 1. Deferred Expense Cash Paid before Expense Is IncurredAsset created as asset expires it becomes an expense, via adjusting entry Entry DuringAsset End of Expense period Cash period Asset eg. * prepaid rent becomes rent expense, a month at a time * Depreciation allocates cost of asset over its useful life does not measure sort out in value ? Based on estimates of salvage value and life of asset ?Periodic expense= actual cost est. salvage value/estimated life ? debit is depreciation expense ?credit is not to as set account, which will always reflect cost, ? but to accumulated depreciation- contra account that is, an asset account with a credit equaliser 2. Deferred RevenueCash Received before Revenue Is Earned Liability Created Because Goods Or Services Still Owed EntryDuringCashEnd of Liability period Liability period Revenue ?Eg. unearned the other company from deferred expense entries ? for example, The landlord who received the prepaid rent has a deferred revenue ? liability is reduced, revenue increased, as time passes ?magazine subscriptions received in advance, earned as magazines mailed 3. Accrued LiabilityExpense incurred before Cash Is PaidOpposite of deferred expense EntryDuring-End of Expense period- period Liability Eg. taxes, payroll, utilities interest for short term loan paid at maturity with principal 4. Accrued AssetRevenue Earned before Cash Is Received Opposite of deferred revenue EntryDuring-End of Asset period-periodRevenue ?both rent and interest are earned as time goes by, regardless of when cash received ? need adjusting entry if payment is not received. Exhibit 4-5 (text pp. 165) Example P4-2 REVISITING THE ACCOUNTING CYCLE Steps taken to collect the necessary information to prepare financial statements (Exhibit 4-8) . Collect and Analyze 2. Journalize Events 3. Post to Ledger Accounts(Results in Unadjusted Trial equilibrium) 4. Journalize and Post adjustments(Results in alter Trial Balance) 5. Prepare Financial Statements 6. Journalize and Post Closing Entries(Results in Post-Closing Trial Balance) 7. Post Closing Trial Balance 8. Optional Reversing Entries The Closing Process Two types of accountsBalance Sheet= real accounts = permanent Income Statement= nominal accounts = temporary (Includes Dividend account) Purpose of closing entries-Close temporary accounts -transfer net income (loss) to retained earningsProcess of closing debit apiece Revenue Account Sum Up a Single Credit to Income Summary. Credit Each Expense Account, Sum Up a Single Debit to Income Summary. Debit Income Summary If It Has a Credit Balance ( gild Had Net Income) ORCredit Income Summary If It Has a Debit Balance (Company Had Net Loss) Credit Dividend Account, Debit Retained cyberspace Exhibit 4-9 (text pp. 171) Example 1E4-23. Ben Jerrys Example 2Let us look at McDonalds Corporations 1998 Statement of Income shown on Page 139 of your text. Notea. Retained Earnings at the beginning and end of 1998 were $12,569 and $13,879. million respectively. b. Total dividends paid to common and preferred shareholders were $239. 5 Use the numbers from the Income Statement to Reconstruct the relevant account balances. Then Close them to Income Summary and from there to Retained Earnings. EXAMPLE P4-10 Post-closing Trial Balance will only contain Balance Sheet accounts.When is a sale a sale? In an article concerning troubled MiniScribe Corporation (The Wall Street Journal September 12, 1989 MiniScribes Investigators arrest That Massive Fraud Was Perpetr ated. ) it was stated that he company dramatically increased shipments to three warehouses, booking $56. 4 in sales and gross profit of $5. 4 million. (Note that the warehouses being shipped to belonged to MiniScribe) The volume of shipments only called attention to the problem it was not the problem. Problem is it is not Customers warehouse but MiniScribes shipping goods to ones? own warehouse is not a sale but a relocation of inventory must be an arms length transaction.This was one among numerous violations MiniScribe was also shipping bricks to an fictitious company, and recording them as sales revenue. 1. Claiming Tomorrows Profits Today, Forbes, October 17, 1988, p 78. Case 4-1Ben Jerrys Revenue Recognition Initial Franchise Fee Footnote on 147 of text. FASB SFAS 45 allows franchisor to recognize initial franchise fee as revenue only when substantial performance of its obligations and when accretion of the fee is reasonably assured. Revenue Recognition The Company recognizes franchise fee as .. when services required by the franchise agreement have been substantially performed. 1. Consistent with SFAS 45.The pen refers to certain mandatory services that the company promises to perform for the new stores. Performance of these services is the basis for recognizing the fee as revenue. Note that the footnote specifically uses the wording substantially performed. 2. The company recognizes the franchise fees as revenue in proportion to the stores for which the required services have been substantially performed. 3. Franchise fees are not large relative to net sales in any of the years. Franchise fees are less than 0. 4% of net sales in apiece of the three years. Unearned Revenue Realizability Vs.Earned criteria realized BUT has it been earned?. 1. Case 4-2Gateway- Revenue Recognition Refer to page 30 of Gateways Annual Report, under Summary of Significant Accounting Policies 1. Gateway recognizes revenue from product sales when products are shi pped. Revenue from separately priced extended warranty programs is deferred and recognized over the extended warranty period. 2. Extended warranty programs are contracts to service products for a period beyond the original warranty. These contracts are purchased for an additional amount above the product purchase price. . The revenue from the extended warranties is recognized over the warranty period because it is earned over the entire period, as coverage is provided. 2. Case 4-3 Sears, Roebuck, Company Revenue from Service Contracts. 1. Under the accrual basis, revenue should be recognized when it is earned, rather than when cash is received. Since the retailer incurs costs to repair damages over the life of the service contract, the revenue from the contract is also earned over the life of the contract. 2. Revenue to be recognized each year Year 1 Year 2Year 3Sales Revenue Service Contract Total revenue Typically, for service contract you receive cash or payment, for future ser vices, that creates a liability. Thus one has an unearned revenue account. In this particular example, the liability account would contain XXX at the end of year 1 and XX at the end of year 2 reported under current liability as unearned revenue on the balance sheet. Sears, Roebuck, Company 1998 Annual Report Footnotes to Revenue Recognition The Company sells extended service contracts with terms of coverage between 12 and 36 months.Revenue and incremental direct acquisition costs from the sale of these contracts are deferred and amortized over the lives of the contracts. Costs related to servicing the contracts are expensed as incurred. 3. American Airlines 1996 total revenues of $17,753 million. Balance sheet reported ? Air traffic Liability? of $1,889 million. unearned revenue (11%) from ticket sales. -when retired Retired when ticket holders are provided transportation. -Refundability a factor -What if carrier cannot provide service due to strike or storm. -When is revenue ear ned ? when ticket is bought when rider boards when plane takes off when the round trip is complete. AMERICAN AIRLINES 1998 Annual Report (Summary of Significant Accounting Policies) (Note 1) PASSENGER REVENUES Passenger ticket sales are initially recorded as a component of air traffic liability. Revenue derived from ticket sales is recognized at the time transportation is provided. However, due to sundry(a) factors, including the complex pricing structure and interline agreements throughout the industry, certain amounts are recognized in revenue using estimates regarding both the timing and the amount of revenue to be ecognized. Actual results could differ from those estimates.In 1998, American showed revenues of $17,449 million and recorded Air traffic liability of $2,163 million on its Balance Sheet. Time Warner Inc. According to Annual Report they publish 26 different magazines. At end of 19985 unearned subscription revenue was $741 million. -included in their is your paid su bscription to Time for issues that you have yet to receive. -magazines are sold at different rates depending on how you subscribed and for how long. how to keep track of when earned. when does the earnings process complete When subscription received if main source of revenue is advertising. When production is complete and delivery is made. A combination of these two. Note that Time does not have difficulty to keep track since subscription price variations and customer records are all unploughed by computers closely monitor the process from payment to through unearned revenue to delivery and revenue earned. Time Warner Inc. 1998 Annual Report (Note 1) The unearned portion of paid subscriptions is deferred until magazines are delivered to subscribers.Upon each delivery, a proportionate share of the gross subscription is included in revenues. E 4-81. sniffyCash Subscriptions Received in advance (Unearned Revenue) To record accretion of 900 subscriptions Assets =Liabilities+ Owner s Equity 2. August 31. Unearned revenue Subscription revenue To record subscriptions earned during August. Assets=Liabilities+Owners Equity 3. Net income for the month of August would be under stated / overstated by XXX if the accountant forgot to make the entry to recognize revenue earned. (Self Note Also see clipping Subscription case) E 4 -9