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Types of Periodic Adjustments
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.
Objective: To match the revenue earned in a period (whether received in that period in cash or not) with all the expenses incurred to earn that revenue (whether paid in that period in cash or not).

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Cash Flow Versus Accrual Accounting
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.
The matching principle in accrual accounting addresses this limitation of cash flow accounting.
Accrual Accounting and Periodic Adjustments
Accountants record exchange transactions.
But this does not capture all economic activities.
Accounting Earnings versus Stock Prices
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)
Earnings provide a straightforward measure of deliveredperformance.
Summary
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
Reconciliation net income and cash flow from operations
Revenue Recognition
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
Bill & hold sales, SAB 101

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LIFO versus FIFO COGS
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
(LIFO COGS excluding the effects of any LIFO liquidation – FIFO COGS) is a measure of difference in COGS under the two methods that is driven solely by changes in input prices
LIFO Liquidation
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 =
(Post-tax LIFO liquidation profits)/(1-tax rate)
Debits and Credits
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
Expenses reduce Retained Earnings - DebitsÂ
Contra-Asset Accounts
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 – Contra-Assets (if any) = Liabilities + Stockholders’ Equity
Balance Sheet Equation
Assets = Liabilities + Owner’s Equity
Key: Every economic event that leads to an accounting entry has two sidesÂ
Given an event and an accounting entry, you should be able to identify the two sidesÂ

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Basic Principles of Accrual Accounting
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
Report as expenses those costs that have been or will be incurred to generate those revenues
Accounts Receivable
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.
Bad debt expense is recorded at the end of every period to adjust the balance in ADA to the desired amount