M2L4V1: Accrual Accounting

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Financial Accounting: Foundations

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University of Illinois at Urbana-Champaign

Financial Accounting: Foundations

1118 classificações

Curso 1 de 7 em Specialization Financial Management

In this course, you will learn foundations of financial accounting information. You will start your journey with a general overview of what financial accounting information is and the main financial statements. You will then learn how to code financial transactions in financial accounting language. In the meantime, you will learn about the most important concept in contemporary financial accounting: accrual accounting. You will then critically analyze how firms recognize revenues. Finally, you will finish the course with an analysis of accounting for short-term assets where you will go into detail on how firms account for accounts receivables and inventories. Upon successful completion of this course, you will be able to: • Understand main financial statements and the financial information they provide • Write a financial transaction in financial accounting language and understand how this impacts main financial statements • Understand how accrual accounting and fundamental accounting concepts work • Understand revenue recognition principles and how they impact main financial statements • Account for accounts receivables and inventories. This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.

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Module 2: Recording Transactions and Financial Statement Preparation

The starting point of financial statements is individual financial transactions. In this module, you will learn how to code financial transactions in accounting language and how to build main financial statements from these coded financial transactions. This bottom-up approach will help you appreciate the impact of various financial transactions on main financial statements.

M2L4V1: Accrual Accounting5:27

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Oktay Urcan
Associate Professor of Accountancy
Department of Accountancy, College of Business

[SOUND]

Now is the perfect time to go through probably the most important concept in

current accountant practice, that is accrual accounting.

To understand accrual accounting, what I'm going to do is that

I'm going to remind you two individual financial transactions we went through for

Illinois Supermarket in year two.

These were payment of insurance premium of 1,000 and

payment of employee salaries of 5,000.

So let me change these questions a little bit.

Suppose that half of the insurance payment, which is 500 is prepayment for

next year's insurance.

Suppose also that employees earn $5,000, but they are not paid yet.

My question is, what happens?

So let's remember the original solution for year 2002.

There was an insurance payment of $1,000, cash goes down and

then it's going to record as insurance expense in income statement.

Similarly, if you pay employees $5,000 there's a cash reduction of $5,000 and

then it's also recorded as an breach expense on income statement, but

we change the questions.

We said, for example, out of insurance payment of $1,000, 500

is related to pre-payment of next year's insurance, how am I going to record this?

First of all, it is no wonder that cash will go down by $1,000 we paid.

Out of this 1,000 payment, half of this is this year's,

this year is 2017, insurance expense.

Therefore, it's going to be recorded as a reduction from income statement.

But what I'm going to do with the prepayment?

This prepayment will be recorded as a prepaid expense account under assets.

So how do we go through our updated questions?

The first one was there is an insurance payment of $1,000, but half of this

insurance payment is a prepayment for next year insurance, how will we record this?

First of all there is a reduction of $1,000 in cash because we pay this.

Out of this $1000, half of this is related to year 2017's insurance expense.

Therefore, it is recorded as reduction from income statement.

And the next remaining $500, which is the pre-payment for

next year insurance will be recorded as prepared expenses.

In accounting, then we prepare for example sum rents, some insurance.

We record this as a prepared expenses.

Note this is a prepared expense account, but it is recorded as an asset.

This is a resource that we are going to use next year.

How about the next one?

Our employees earn, but are not paid, $5,000 yet.

Since they earn it,

I'm going to record this $5,000 as an aging expense on the income statement.

On the other hand, I'm not paying them yet.

But I'm going to pay in the future,

therefore this $5,000 will be recorded as accounts payable.

In general, accounts like prepared expenses, accounts payable,

account receivable are called accruals.

What is accruals or accrual accounting?

Under accrual accounting we are going to use adjusting entries

to ensure that the account it reflects economic reality of the firm.

So what do I mean?

For example, look at the employees.

All the employees worked for us, they earned $5,000 but I'm not paying them yet.

Although I'm not paying them yet,

I'm still recording this in our transaction worksheet.

Whether you pay or not doesn't matter here.

As long as they earn this money, it's going to be recorded as a wage expense.

Under in general then, under accrual accounting,

we are going to record revenues whenever they are earned,

no matter whether you collect the money or not.

Similarly, on the accrual accounting,

we are going to record expenses when they are incurred.

And regardless of whether you are getting the money, or paying money,

it doesn't matter.

Therefore, under accrual accounting,

you are going to notice that profits are not necessarily equal to changes in cash.

For example, for our question in year 2017,

the net change in year 2017 is minus $20,000.

On the other hand if you look at the income statement the amount of net

income is 3,000.

They are not related to each other.

So what's the summary?

Cash accounting is very simple.

You record the financial transaction only when it involves cash, but

it has nothing to do with economic reality.

You can make lots of sales for example.

If you don't collect cash under cash accounting,

it's not going to show up on your revenues.

Accrual accounting will reflect business reality.

We are going to record revenues whenever they are earned.

We are going to record expenses whenever they are incurred.

But there is a big problem with accrual accounting.

What is this big problem?

Accruals require a lot of judgment and we are going to see a lot of examples on how

we are going to be making judgments in accrual accounting.

And sometimes,

managers make judgments to inflate earnings that they report to outsiders.

So here's a summary of what we have done in this class.

First, we went through how are we going to code individual financial transactions.

In other words, we worried about how

we can write individual financial transactions in accounting language.

And then we went through how we can prepare a balance sheet and income

statement, and then be able to indicate accrual accounting and cash accounting.

Our current practice is we are using accrual accounting but

we need to very worried about something, which is usage of managerial discretion.

In the next class, I'm going to go through a fundamental accounting concepts, and

then I will also go through revenue recognition principles.

If you are aware of financial scandals,

accounting scandals over the last ten years,

you are going to notice that most of them are because of revenue recognition.

It's going to be an interesting class so stay tuned.

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