Intermediate Accounting

Chapter 3: Accrual Accounting

Learning Objectives Overview

• L.O. 3-1: Explain the demand for periodic reporting and how accrual accounting meets it.

• L.O. 3-2: Explain why accrual accounting is inexact, the centrality of estimates, and the absence of "true" income; evaluate "quality of earnings."

• L.O. 3-3: Apply accrual accounting to periodicity, cut-off, and subsequent events.

• L.O. 3-4: Evaluate accounting changes (error, policy, estimate) and apply appropriate retrospective or prospective treatments.

• L.O. 3-5: Integrate the structure and connections among the four financial statements and their relation to accrual accounting.

CPA Competencies Addressed

• 1.1.1. Evaluates financial reporting needs (Level B): Focuses on financial statement users, standard setting, and accountability.

• 1.1.2. Evaluates the appropriateness of the basis of financial reporting (Level B): Distinguishes between accrual and cash accounting.

• 1.2.1. Develops or evaluates appropriate accounting policies and procedures – Ethical professional judgment (Level B).

• 1.2.2. Evaluates treatment for routine transactions (Level A): Covers changes in accounting policies and estimates, errors, and events after the reporting period.

• 1.3.1 Prepares financial statements (Level A): Emphasizes the accounting cycle.

Demand for Periodic Reporting and the Need for Accrual Accounting (L.O. 3-1)

Cash Cycle

A cash cycle is a set of transactions that converts a cash inflow to a cash outflow, or vice versa.

• Types of Cash Cycles:

  • Financing: Receiving funds from investors, using them to generate returns, and returning them.

  • Investing: Purchasing property, obtaining economic benefits, and disposing of property.

  • Operating: Purchasing inventory; production, sales, and delivery of goods or services; and receipts from customers.

Need for Accrual Accounting

Companies require financial information:

• Sooner: Typically annually and quarterly, rather than waiting for the completion of long cash cycles.

• Complete Information: To reflect economic events accurately, not just cash movements.

Accrual Versus Cash Accounting

• Accrual Accounting: Records economic events when they happen, regardless of when cash is exchanged.

• Cash Accounting: Records only when cash exchanges occur.

Example: Tradewinds Company

• Investors provide $20 ext{ million}$ in financing.

• Each ship costs $5 ext{ million}$ and completes $10$ voyages.

• Operating costs are $1 ext{ million}$, paid in advance.

• Each voyage typically ends within one year and generates $5 ext{ million}$ in goods sales.

Performance Measures Comparison (Tradewinds Company):

• Why the difference? The accrual basis reflects the economic loss of a ship in Year 2, which cash basis accounting does not capture until cash is affected.

Accrual and Deferral

• Accrual: An accounting entry that mirrors events or transactions in a period different from its corresponding cash flow (e.g., recording revenue earned but not yet received).

• Deferral: An accounting entry that mirrors events or transactions after the related cash flow (e.g., recognizing sales revenue after receiving cash in advance).

Factors Contributing to the Use of Accrual Accounting

• Significant Contributors:

  • Creation of indefinite-life entities (e.g., corporations).

  • Preparation of periodic financial reports.

  • Incomplete transactions at reporting dates.

  • The going concern assumption.

  • Accounting standards (e.g., IFRS) requiring accrual accounting (though these formalize existing practices).

• Not Significant Contributors:

  • Establishment of accounting standard setters (e.g., IASB) – standards formalize the need, don't create it.

  • Invention of the double-entry system – facilitates, but doesn't cause the demand.

  • Development of credit cards – affects cash timing but not the fundamental need for economic event reporting.

  • Financial reports using accrual accounting being simpler to understand – often they are more complex.

Demand for Periodic Reporting - IFRS Conceptual Framework OB2

• Objective: To provide financial information useful to existing and potential investors, lenders, and other creditors for decision-making regarding resource allocation (buying, selling, holding instruments, providing/settling loans).

• How periodic reports help: Investors need timely information to estimate investment value and evaluate management performance. Given many investors and varying needs, fixed reporting periods (e.g., annual, quarterly) are a practical response to this demand.

Role of the Going Concern Assumption

• The going concern assumption posits that a firm will continue operating into the foreseeable future, allowing incomplete transactions to conclude and their results to be known.

• Relevance to PPE Valuation:

  • PPE (property, plant, and equipment) are acquired for long-term use, not resale, to generate future earnings. They are recorded at depreciated net book value.

  • Depreciation aims to match the asset's cost to the periods when its benefits are realized. This allocation process is only meaningful if the firm remains a going concern for the asset's useful life.

• If Going Concern Assumption is Invalid:

  • Assets should be valued at their exit value (or net realizable value), typically resulting in a significant reduction in carrying value and a large loss on the income statement.

• Example: Machine Going into Bankruptcy

  • Purchased: $10,000,000$ on Jan 1, 2021. Useful life: $10$ years. Residual value: $1,000,000$. Straight-line depreciation.

  • i. Depreciation Expense (2021 & 2022, if going concern): $(10,000,000 - 1,000,000) / 10 ext{ years} = 900,000$

  • ii. Should 2022 depreciation be the same as 2021? No, because the firm is going into bankruptcy. The asset should be valued at its net realizable value.

  • iii. Value of machine on Dec 31, 2022: $5,500,000$ (resale value).

  • iv. Adjustment to carrying value in 2022:

    • Book value at Dec 31, 2022 (assuming going concern): $10,000,000 - (2 imes 900,000) = 8,200,000$

    • Resale value: $5,500,000$

    • Downward adjustment: $8,200,000 - 5,500,000 = 2,700,000$

    • This $2,700,000$ is an additional expense/loss beyond normal depreciation, to write down the machine to its net realizable value.

• Valuation of Prepaid Rent:

  • Going Concern: Reported as an asset at the unexpired value ($100,000$).

  • Not Going Concern: Valued at net realizable value, likely $0$ unless it can be sub-leased for a recoverable amount.

• Valuation of Inventory in Bankruptcy:

  • Valued at net realizable value (e.g., auction price), which is likely less than FIFO or average-cost values. FIFO (First-In, First-Out) or average cost methods are not applicable.

Uncertainty and the Essential Role of Estimates in Accrual Accounting (L.O. 3-2)

• Accrual accounting reports inherently require the use of estimates.

• A range of acceptable alternatives often exists.

• Unbiased accounting: A conceptual outcome representing an average or consensus from disinterested accountants.

• True and fair (IFRS concept): An overall evaluation that financial statements fairly represent an enterprise's economic conditions and performance.

Quality of Earnings and Earnings Management

• Quality of earnings: How closely reported earnings correspond to the earnings that would be reported in the absence of management bias.

• It's important to distinguish between unbiased accruals and excessive accruals.

Beyond the Income Statement

• The concept of quality of earnings also applies to other financial statements.

• Excessive accruals on the income statement have implications for other financial statements (e.g., overstated/understated assets and liabilities on the balance sheet).

Unbiased Versus Excessive Accruals

• Unbiased Accruals: Reflect economic conditions and accounting standards, applying professional judgment and ethics.

• Excessive Accruals: Result from contractual incentives for the firm or management, as well as unethical managerial opportunism, leading to over- or under-accruing.

Example: Quantum Company

• Cash flows: $500$

• Reported earnings: $800$

• Total accruals: $800 - 500 = 300$

• Unbiased accruals: $200$

• Excessive accruals: $300 - 200 = 100$

• Unbiased earnings (not observed): Cash flows + Unbiased accruals = $500 + 200 = 700$

Why Estimates are Essential and Can Be Biased

• Estimates are unavoidable because cash cycles are often incomplete at reporting dates, requiring forecasts of future events.

• Since future events are uncertain, estimates are necessary but cannot be fully verified, only evaluated for reasonableness.

• Example (Accounts Receivable): Reporting the balance requires estimating the collectible amount. If management has incentives to manipulate receivables or income, this estimate can be biased upwards or downwards.

Assessing Earnings Quality by Comparing Earnings and Cash Flows

• Finance professionals often assess earnings quality by looking at the difference between net income and cash flow from operations.

• This difference (accruals) includes factors reflecting economic circumstances, standards, judgment, ethics (unbiased portion), and management bias (from incentives/opportunism).

• Merits: Helps uncover management bias.

• Limitations: Accruals also include unbiased components reflecting economic conditions. The fundamental role of accrual accounting is to provide more useful information than cash basis alone. Attributing all differences to low quality implies cash flows are always superior, which contradicts the demand for balance sheet and income statement information.

Pros and Cons of Government Adopting GAAP Accrual Accounting

• Pros:

  • Relevance: Information becomes more relevant to taxpayers for evaluating the use of tax dollars.

  • Financial Position: Provides better, more complete information on assets and liabilities.

  • Capital Investments: Budget balance is not adversely affected by large capital investments, increasing willingness to invest in long-term benefits like infrastructure.

  • Reduced Incentives: Decreases incentives to sell assets just for cash flow (even if it's a bad deal).

  • Performance Measurement: Accrual numbers better measure performance than cash surplus/deficit.

  • Agency Problems: Reduces agency problems by providing a better performance measure for politicians (agents) managing taxpayers' money.

• Cons:

  • Judgment: Accrual accounting uses more judgments, offering politicians more latitude to affect reported numbers.

  • Reliability: Numbers may be less reliable due to increased subjectivity.

  • Understanding: Accrual numbers can be more difficult for the average citizen to understand.

  • Evaluation Difficulty: More subjective numbers make governmental performance evaluation harder.

  • Asset Qualification: Skeptics argue some government spending (e.g.,