CHAPTER 3Accrual Accounting
CPA competencies addressed in this chapter1.1.1 / Evaluates financial reporting needs (Level B)
b.Financial statement users and their broad needs, standard setting, and requirement for accountability
1.1.2 / Evaluates the appropriateness of the basis of financial reporting (Level B)
c.Difference between accrual accounting compared to cash accounting
1.2.1 / Develops or evaluates appropriate accounting policies and procedures—Ethical professional judgement (Level B)
1.2.2 / Evaluates treatment for routine transactions (Level A)
o.Changes in accounting policies and estimates, and errors
1.2.2 / Evaluates treatment for routine transactions (Level A)
r.Events after the reporting period
1.3.1 / Prepares financial statements (Level A)
a.The accounting cycle
Learning objectives3-1. / Explain the source of demand for periodic reporting and how accrual accounting satisfies that demand.
3-2. / Explain why accrual accounting is fundamentally inexact, why estimates are central to accrual accounting, and why there is no “true” income for typical situations; evaluate the “quality of earnings.”
3-3. / Apply accrual accounting in relation to issues of timing: periodicity, cut-off, and subsequent events.
3-4. / Evaluate whether an accounting change is an error, a change in accounting policy, or a change in estimate, and apply the retrospective and prospective treatments appropriate to that type of accounting change.
3-5. / Integrate the structure and connections among the four financial statements and explain how this structure relates to accrual accounting.
Chapter 3 plays a crucial role in this textbook—it is the transition between the more theoretical and conceptual ideas in the first two chapters and the practical implementation of those ideas in the form of financial statements prepared under the accrual basis. As a transition, the chapter begins with the conceptual understanding of accrual accounting and the consequences of using accrual accounting (approximation and the need for estimates), followed by important practical issues related to the use of reporting periods: cut-off, subsequent events, and accounting changes. Finally, the chapter provides an overview of the periodic financial statements that result from the accrual accounting system. The presentation requirements of IFRS are the focus of this discussion.
From introductory accounting, students know that the accepted basis of accounting is the accrual basis; however, many students may not know why. The conceptual framework refers to the accrual basis and asserts that this basis is superior to the cash basis of accounting, but the framework does not elaborate on the reasons for this assertion. The first part of this chapter does so by going through a brief history of accrual accounting and the role played by the creation of indefinite-life corporations such as the Dutch East India Company. The example of the Hudson’s Bay Company solidifies the point with a company that is widely known in Canada.
The threshold concept that relates to accrual accounting is timing of recognition. As stated on page 79, “timing is everything” in accrual accounting because accruals are deviations from the timing of cash flows, so the key judgment in accrual accounting is when to recognize a transaction in the accounting system.
Following the discussion of the Dutch East India Company, Section B of the chapter uses an example of Tradewinds Company to compare and contrast the results of accrual and cash accounting. Intentionally, this is not the easiest example to illustrate the differences between the two accounting systems; the moderate level of complexity serves to review some of the basic accruals that students should have learned in introductory accounting.
Section C of the chapter makes the important point that accrual accounting involves incomplete cash cycles, and therefore accruals involve judgments about what will happen later in the cash cycles. Future cash flows are inherently uncertain, so accountants need to make estimates to determine the amount of accruals. Professional judgment is a key skill that accounting students should develop, and Section C of this chapter describes why this skill is so important.
Section D of the chapter looks at Quality of earnings and earnings management. A consequence of accrual accounting is that there is no “true” accounting income number. However, this does not mean that any number is as good as any other. Some accounting estimates are better than others, so it is more useful to think in terms of quality of earnings on a continuum from high to low.
To make the quality of earnings assessment, there needs to be a benchmark. The benchmark is unbiased earnings: which would be the average amount reported by accountants who are disinterested in the accounting outcome.
With the benchmark in place, students are prepared to think about whether accruals are unbiased or excessive. The threshold concept of economic consequences of accounting choice introduced in Chapter 1 resurfaces here in the form of earnings management and the source of excessive accruals.
As noted above, the use of accrual accounting is related to the demand for periodic reports. Section E addresses issues that result from periodicity: cut-off, subsequent events, and accounting changes. While other textbooks choose to address these issues much later, we believe this chapter is the appropriate place for them because they all flow from periodicity and the timing of recognition. Furthermore, proper coverage of the later chapters requires these ideas (e.g., change in depreciation methods), so students are encouraged to learn these concepts earlier rather than later.
Section F focuses on Accounting changes:errors, changes in accounting policy, and changes in estimates. Note that the example of an accounting policy change illustrated in Exhibit 3-9 (page 82) is just an example. Depending on the circumstances, changes in depreciation methods can be considered to be changes in estimates (see Chapter 8).
One point of confusion that students seem to have is to mix up subsequent events with accounting changes. It is sometimes difficult for them to identify when they should be using one or the other. It will be helpful to use a timeline for this purpose. Starting with the timeline illustrated in Exhibit 3-8, then extending this timeline forward (to the right) we can then show that subsequent events occur before the issuance of the financial statements, while accounting changes are relevant after that point in time.
Timeline from Exhibit 3-8 from text with extension for accounting changes
The final learning objective in this chapter is to understand the structure and connections among the four financial statements. As a result, this chapter discusses all of the financial statements in a succinct and integrated manner. This integrated approach also opens up the possibility of discussing the threshold concept of articulation. This concept is important for students to grasp in order for them to appreciate the full implications of various accounting treatments on all of the financial statements.
Use of end-of-chapter problems and cases
In addition to lectures, discussion of some of the end-of-chapter problems and cases will help students apply the concepts. The following table identifies all of the problems and cases that can be used in class and problems and cases that can be used for homework assignments. (Depending on the time allocation between lectures and examples, it may not be feasible to cover all of the suggested items.)
Summary of learning objectives, chapter content, and suggested problems and cases
3-1. / Explain the source of demand for periodic reporting and how accrual accounting satisfies that demand. / 71-76 / P3-2
P3-4 / P3-1
3-2. / Explain why accrual accounting is fundamentally inexact, why estimates are central to accrual accounting, and why there is no “true” income for typical situations; evaluate the “quality of earnings.” / 76-79 / P3-8
P3-11 / P3-7
3-3. / Apply accrual accounting in relation to issues of timing: periodicity, cut-off, and subsequent events. / 79-81 / P3-9
P3-18 / P3-14
3-4. / Evaluate whether an accounting change is an error, a change in accounting policy, or a change in estimate, and apply the retrospective and prospective treatments appropriate to that type of accounting change. / 81-86 / P3-19
P3-25 / P3-20
3-5. / Integrate the structure and connections among the four financial statements and explain how this structure relates to accrual accounting. / 86-107 / P3-30
P3-42 / P3-27
-- / Integrative / Case 2
/ Case 1
Case 2 is a difficult case intended for guided classroom discussion. A good analysis and discussion of this case does not require technical knowledge specific to redeemable preferred shares. Students are asked to discuss the relevant accounting issues while paying particular attention to the timing of events while applying the IFRS Framework.
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