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Expense or Revenue beforeCash

Expense incurred today, but cash paid tomorrow.

Salary earned by employees but not paid at the end of accounting period.

Employees earn salary when they perform their duties, not when they receive payment.

Unpaid salary is a Salary Payable liability

Revenue earnedtoday, but cash received tomorrow

Interest earned today, but cash received tomorrow.

Interest is a reward for lending money, so it is earned with passage of time

Interest receivable asset

Cash beforeaccruing Revenue or Expense (Cost Expirations or Revenue Expirations)

Cash paid yesterday, Expense incurredtoday.

1998 rent paid in advance in 1997

Rent paid in advance asseCash received yesterday, revenue earned today

Cash advance from customer for services not yet performed

Cash advance is Unearned Revenue liability

Matchingis the guiding principle in periodic adjustments.

Cash flow accounting

Measures performance by comparing the cash inflows of a certain time period to the cash outflows of that period (e.g., cash flow from operations).

Accrual accounting

Measures performance by comparing revenues (which are recognized when the earning process is complete) with expenses (which are recognized when assets are consumed or liabilities are created).

Geared toward periodic performance measurement that is not skewed by investment, financing, and long-horizon operational activities

Accrual accounting

Based not only on cash transactions but also on credit transactions, barter exchanges, changes in prices, changes in form of assets or liabilities, and other transactions.

records events that have cash consequences for an enterprise

but does not require a concurrent cash movement in order to record a transaction.

Over the entire life of a corporation, total “income” under cash flow and accrual accounting is the same.

However, cash receipts in a particular period may largely reflect the effects of activities of the enterprise in earlier periods.

Similarly, many of the cash outlays may relate to activities and efforts to be undertaken in future periods.

Accountants record exchange transactions.

But this does not capture all economic activities.

Top management’s incentive compensation is usually linked to stock prices and accounting earnings.

Why not link it to stock prices alone?

Stock prices are affected by economic factors that are outside of a manager’s control (e.g., macroeconomic, political factors).

Consequently, stock prices may be a poor indicator of managerial performance.

Combining both mitigates this problem

A second reason for using accounting earnings

Expected versus delivered performance

Firm X hires manager Y on December 31, 1997.

Stock price of X jumps by 10%! Why?

Market’s expectationsregarding the company’s future performance improve.

Accounting earnings of 1998 increases by 10%!

Why?

Manager Y’s actions produce an actualimprovement in the financial performance of X in 1998. Stock prices anticipated this improvement in 1997 at the time of the earnings announcement.

By combining stock prices and earnings to reward managers, a firm can reward a manager for his/her strategic planning and operational execution.

Of course, stock prices do reflect the delivered performance of the manager as well.

But if payment is on the basis of expected performance, then what do you do if the manager shirks subsequently? (Moral hazard problem)

Understand how events are translated into accounting reports via the BSE.

Understand the differences between accrual accounting numbers and cash flows

Revenue vs. cash collected

COGS vs. purchases vs. cash paid for purchases

Revenue recognition principles: Service has been provided by the company, customer has been billed and there is reasonable certainty of cash collectio

Issues in revenue recognition

Credit sales

Warranties and returns

In inflationary economies, in general LIFO COGS will be higher than FIFO.

There are tax benefits to using LIFO

Of course, for companies that face declining costs FIFO COGS will be higher: Intel was an example

If input prices do not change, LIFO COGS = FIFO COGS

Relevant for firms that report LIFO

Occurs when production < sale

You are selling out of beginning inventory

Under LIFO, beginning inventory is at older costs

Firms disclose LIFO liquidation profits in the footnotes

Watch out for: whether LIFO liquidation profits are disclosed post-tax or pretax

LIFO COGS without LIFO liquidation – LIFO costs reported after

LIFO liquidation =

Pre-tax LIFO liquidation profits =

Assets = Liabilities + Owner’s Equity

 Increases in assets are debits

Increases in liabilities are credits

Increases in Owner’s Equity (Capital Stock, RE) are credits

Revenues increase Retained Earnings – Credits

Contra asset accounts act like liability accounts – increases are recorded as credits

Their existence is tied to specific asset accounts

For example

Allowance for Doubtful Accounts (existence tied to Accounts Receivables, a current asset)

Accumulated Depreciation (existence tied to depreciable longterm assets like PP&E)

On the balance sheet, Accounts Receivables is reported net of ADA and PP&E is reported net of Accumulated Depreciation

Thus, contra-asset balances are not reported on the liabilities side, but as negative numbers on the asset side

Assets = Liabilities + Owner’s Equity

Key: Every economic event that leads to an accounting entry has two sides 

Determine what net income has been earned during a period, not just what cash has been generated during the period from operations

Why? To capture the economic events that have occurred during the period

Determine revenues applying the revenuerecognition principles

Not all accounts receivables will be collected in cash

The balance in Allowance for Doubtful Accounts at the end of the year reflects estimated defaults.