Accrual Accounting ProcessWhat is Cost of Goods Sold?What is Cost of Goods Sold?What is Cost of Goods Sold?What is Gross Profit or Margin?Components of IncomeComponents of Income - StaplesCash Flow StatementCash Flow Versus Accrual AccountingCash Flow Versus Accrual AccountingCash Flow Versus Accrual AccountingCash Flow Versus Accrual AccountingCash Flow Versus Accrual AccountingAccounting Earnings versus Stock PricesAccounting Earnings versus Stock PricesAccounting Earnings versus Stock PricesAccrual Accounting and Periodic AdjustmentsRecall Joe’s Landscaping ServiceRecall Blockbuster - MatchingRecording video expensesAccrual Accounting and Periodic AdjustmentsAccrual Accounting and Periodic AdjustmentsPeriodic AdjustmentsTypes of Periodic AdjustmentsTypes of Periodic Adjustments1Accrual Accounting Process15.501/516 AccountingSpring 2004Professor S. RoychowdhurySloan School of ManagementMassachusetts Institute of TechnologyFeb 17/18, 20042What is Cost of Goods Sold? Q Mart buys $10,000 worth of cereals from Special Foods for cash. Assets = L + OE Cash Inventory -10,000 +10,000 Exchange of one asset for another asset Operating outflow = $10,0003What is Cost of Goods Sold? Q Mart sold one-half of the cereals for $8,000 cash Assets = L + Owners’ Equity Cash Retained Earnings +8,000 +8,000 What is the most significant matching expense?4What is Cost of Goods Sold? The cost to Q Mart of buying the cereal that was sold for $8,000 one-half of $10,000 = $5,000 = Cost of Goods Sold or Cost of Sales Assets = L + Owners’ Equity Inventory Retained Earnings -5,000 -5,0005What is Gross Profit or Margin? Assets = L + Owners’ Equity Cash Inventory Retained Earnings -10,000 +10,000 +8,000 +8,000 -5,000 -5,000 Increase in retained earnings +3,000 Gross Profit or Margin = Sales Revenue (-) Cost of Goods Sold = $3,000 GM rate = $3,000/$8,000 = 37.5%6Components of Income Sales or Service Revenue (-) Cost of Goods Sold (-) Operating Expenses (-) Unusual or Infrequent items (-) Income Tax Expense = Income from Continuing Operations (ICO) All items disclosed below ICO are referred to as “below the line” items. The below-the-line items are each shown net of income tax.7Components of Income - Staples Sales 11,596,075 Cost of goods sold&Occupancy costs 08,652,593 Gross Profit 02,943,482 Operating expenses Operating &selling 01,795,428 Pre-opening 00,008,746 General & administrative 00,454,501 Amortization on intangibles 00,002,135 Amortization on goodwill 0 Asset impairment charges 0 Store closure charge 0 Interest & other expenses 00,020,609 Total operating & other expenses 02,281,419 Income before taxes 00,662,063 Income taxes 00,215,963 Net income 00,446,1008Cash Flow Statement Operating Activities Net income 0,446,100 Adjustments,  Depreciation and amortization(+) 0,267,209 ------ Cash flow from operating 0,468,250 Investing activities Acquisition of property & equip (-) (0,264,692) Acquisitions of businesses (-) (1,171,187) ------- Net cash from investing (1,436,226) Financing activities Proceeds from sale of capital stock (+) 0,078,895 Proceeds from borrowings (+) 0,730,897 Payments on borrowings (-) (0,95,235) ------? Net cash from financing 0,714,083 Net increase/(decrease) 0,201,2409Cash 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 activitiesCash Flow Versus Accrual Accounting10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.Cash Flow Versus Accrual Accounting11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.12Cash Flow Versus Accrual Accounting Stock price = Present value of expectedfuture cash flows. Changes in stock prices = f(changes in expectations about future cash flows). Isn’t cash flow more important than earnings?13Cash Flow Versus Accrual Accounting What cash flows are important? Future cash flows! When compared to current cash flows, current earnings more highly associated with future cash flows When compared to cash flows, earnings have a stronger association with stock prices. Earnings are superior indicators of expected future cash flows.14Accounting 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 problem15Accounting Earnings versus Stock Prices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 expectations regarding the company’s future performance improve. Accounting earnings of 1998 increases by 10%!  Why? Manager Y’s actions produce an actual