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ACCOUNTING ACCOUNTING FUNDAMENTALS FOR FUNDAMENTALS FOR

MANAGERSMANAGERS

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Chapter 3Chapter 3

The Accrual Basis of The Accrual Basis of AccountingAccounting

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinuedContinuedContinued

Learning ObjectivesLearning Objectives

1. Describe the accrual basis of accounting.

2. Use the accrual basis of accounting to analyze, record, and summarize transactions.

3. Describe and illustrate the end-of-the-period adjustment process.

4. Prepare accrual-basis financial statements, including a classified balance sheet.

Learning ObjectivesLearning Objectives

5. Describe how the accrual basis of accounting enhances the interpretation of financial statements.

6. Describe the accounting cycle for the accrual basis of accounting.

7. Describe and illustrate how common-sized financial statements can be used to analyze and evaluate a company’s performance.

1Describe the accrual basis of accounting.

Learning ObjectiveLearning Objective

Under the cash basis, the matching concept is not

emphasized.

Under the cash basis, the matching concept is not

emphasized.Under the cash basis, the receipt or payment

of cash governs the recording process.

Under the cash basis, the receipt or payment

of cash governs the recording process.The cash basis does

not work well for large businesses.

The cash basis does not work well for large

businesses.

Under the accrual accounting basis, transactions are

recorded even though cash is not received or paid unit a later point.

Under the accrual accounting basis, transactions are

recorded even though cash is not received or paid unit a later point.

Under accrual accounting, revenue is normally recognized

when it is earned.

Under accrual accounting, revenue is normally recognized

when it is earned.

Use the accrual basis of accounting to analyze, record, and summarize transactions.

2Learning ObjectiveLearning Objective

a. On November 1, received $1,800 from a. On November 1, received $1,800 from H.S. Company as rent for the use of H.S. Company as rent for the use of Family Health Care’s land as a Family Health Care’s land as a temporary parking lot from November temporary parking lot from November 2003 through March 2004.2003 through March 2004.

Cash + Land

Assets

a. 1,800 Bal. 7,320 12,000

Bal. 9,120 12,000

Left Side of the Accounting Left Side of the Accounting EquationEquation

Capital Stock

Stockholders’

EquityLiabilities + Notes Payable

a. 1,800 Bal. 10,000 6,000 3,320

Retained Earnings

Bal. 10,000 1,800 6,000 3,320

+Unearned Revenue

Right Side of the Accounting Right Side of the Accounting EquationEquation

b. On November 1, paid $2,400 for an b. On November 1, paid $2,400 for an insurance premium on a two-year, insurance premium on a two-year, general business policy.general business policy.

PrepaidCash + Insurance + Land

Assets

b. –2,400 2,400 Bal. 9,120 12,000

Bal. 6,720 2,400 12,000

No effect on right sideNo effect on right side

Prepaid Insurance

c. On November 1, paid $6,000 for an c. On November 1, paid $6,000 for an insurance premium on a six-month insurance premium on a six-month medical malpractice insurance policy.medical malpractice insurance policy.

Prepaid Cash + Insurance + Land

Assets

c. –6,000 6,000 Bal. 6,720 2,400 12,000

Bal. 720 8,400 12,000

d. Dr. Landry invested an d. Dr. Landry invested an additional $5,000 in the business additional $5,000 in the business in exchange for capital stock.in exchange for capital stock.

PrepaidCash + Insurance + Land

Assets

d. 5,000 Bal. 720 8,400 12,000

Bal. 5,720 8,400 12,000

Capital Stock

Stockholders’

d. 5,000 Bal. 10,000 1,800 6,000 3,320

Retained Earnings

Bal. 10,000 1,800 11,000 3,320

+Unearn.

Rev.++

e. Purchased supplies for e. Purchased supplies for $240 on account.$240 on account.

PrepaidCash + Insurance + + Land

Assets

e. 240 Bal. 5,720 8,400 12,000

Bal. 5,720 8,400 240 12,000

Supplies

Capital Stock

Stockholders’

e. 240 Bal. 10,000 1,800 11,000 3,320

Retained Earnings

Bal. 10,000 240 1,800 11,000 3,320

+Unearn.

Rev.+ ++

Accts. Pay.

f. Purchased $8,500 of office equipment. Paid f. Purchased $8,500 of office equipment. Paid $1,700 cash as a down payment with the $1,700 cash as a down payment with the remainder due in five monthly installments of remainder due in five monthly installments of $1,360 beginning December 1.$1,360 beginning December 1.

PrepaidCash + Insurance + + Land

Assets

f. -1,700 8,500 Bal. 5,720 8,400 240 12,000

Bal. 4,020 8,400 240 8,500 12,000

Supplies +

OfficeEquip.

Capital Stock

Stockholders’

f. 6,800 Bal. 10,000 240 1,800 11,000 3,320

Retained Earnings

Bal. 16,800 240 1,800 11,000 3,320

+Unearn.

Rev.+ ++Accts. Pay.

g. Provided services of $6,100 to g. Provided services of $6,100 to patients on account.patients on account.

Prep. OfficeCash + + Insur. + Supp. + Equip. + Land

Assets

g. 6,100 Bal. 4,020 8,400 240 8,500 12,000

Bal. 4,020 6,100 8,400 240 8,500 12,000

Ac. Rec.

Capital Stock

Stockholders’

g. 6,100

Bal. 16,800 240 1,800 11,000 3,320

Retained Earnings

Bal. 16,800 240 1,800 11,000 9,420

+Unearn.

Rev.+ ++Accts. Pay.

Fees Fees EarnedEarnedFees Fees

EarnedEarned

h. Received $5,500 for h. Received $5,500 for services provided to services provided to patients who paid cash.patients who paid cash.

Assets

h. 5,500 Bal. 4,020 6,100 8,400 240 8,500 12,000

Bal. 9,520 6,100 8,400 240 8,500 12,000

Ac. Rec.

Capital Stock

Stockholders’

h. 5,500 Bal. 16,800 240 1,800 11,000 9,420

Retained Earnings

Bal. 16,800 240 1,800 11,000 14,920

+Unearn.

Rev.+ ++

Accts. Pay.

Fees Fees EarnedEarnedFees Fees

EarnedEarned

i. Received $4,200 from insurance i. Received $4,200 from insurance companies, which paid on companies, which paid on patients’ accounts for services patients’ accounts for services that have been rendered.that have been rendered.

Assets

i. 4,200 –4,200 Bal. 9,520 6,100 8,400 240 8,500 12,000

Bal. 13,720 1,900 8,400 240 8,500 12,000

Ac. Rec.

j. Paid $100 on account for supplies j. Paid $100 on account for supplies that had been purchased.that had been purchased.

Assets

j. –100 Bal. 13,720 1,900 8,400 240 8,500 12,000

Bal. 13,620 1,900 8,400 240 8,500 12,000

Ac. Rec.

Capital Stock

Stockholders’

j. –100 Bal. 16,800 240 1,800 11,000 14,920

Retained Earnings

Bal. 16,800 140 1,800 11,000 14,920

+Unearn.

Rev.+ ++Accts. Pay.

k. Expenses paid during November k. Expenses paid during November were as follows: wages, $2,790; were as follows: wages, $2,790; rent, $800; utilities, $580; interest, rent, $800; utilities, $580; interest, $100; miscellaneous, $420.$100; miscellaneous, $420.

Assets

k. –4,690 Bal. 13,620 1,900 8,400 240 8,500 12,000

Bal. 8,930 1,900 8,400 240 8,500 12,000

Ac. Rec.

Capital Stock

Stockholders’

k. –2,790–800–580–100 –420

Bal. 16,800 140 1,800 11,000 14,920

Retained Earnings

Bal. 16,800 140 1,800 11,000 10,230

+Unearn.

Rev.+ ++

Accts. Pay.

Wages Exp.Wages Exp.Wages Exp.Wages Exp.Rent Exp.Rent Exp.Rent Exp.Rent Exp.

Utilities Exp.Utilities Exp.Utilities Exp.Utilities Exp.Interest Exp.Interest Exp.Interest Exp.Interest Exp.

Miscellaneous Exp.Miscellaneous Exp.Miscellaneous Exp.Miscellaneous Exp.

l. Paid dividends of $1,200 to l. Paid dividends of $1,200 to stockholder (Dr. Landry).stockholder (Dr. Landry).

Assets

l. –1,200 Bal. 8,930 1,900 8,400 240 8,500 12,000

Bal. 7,730 1,900 8,400 240 8,500 12,000

Ac. Rec.

Capital Stock

Stockholders’

l. –1,200 Bal. 16,800 140 1,800 11,000 10,230

Retained Earnings

Bal. 16,800 140 1,800 11,000 9,030

+Unearn.

Rev.+ ++Accts. Pay.

DividendsDividendsDividendsDividends

Describe and illustrate the end-of-the-period adjustment process.3

The accrual basis of accounting requires the accounting records to be

updated prior to preparing financial statements.

The accrual basis of accounting requires the accounting records to be

updated prior to preparing financial statements.

This updating process is called the

adjustment process.

This updating process is called the

adjustment process.

Deferrals are created by recording a

transaction in a way that delays or defers the recognition of an expense or a revenue

Deferrals are created by recording a

transaction in a way that delays or defers the recognition of an expense or a revenue

Accruals are created when a revenue or

expense has not been recorded at the end of the accounting period.

Accruals are created when a revenue or

expense has not been recorded at the end of the accounting period.

Deferrals and AccrualsDeferrals and Accruals

a1. Earlier Family Health Care prepaid two policies—a general business policy for $2,400 and a malpractice policy for $6,000. The general business policy expires at a rate of $100 ($2,400 ÷ 24) per month and the malpractice policy expires at a rate of $1,000 ($6,000 ÷ 6) per month.

Assets

Prepaid Insurance

Stockholder’ Equity

Retained Earnings

Balance 8,400 9,030

a1 –1,100 –1,100 Balance 7,300 7,930

Insurance Exp.Insurance Exp.

a2. For November, $150 of the supplies were used, leaving $90 of supplies for use during the coming months.

Assets

Supplies

Stockholder’ EquityRetained Earnings

Balance 240 7,930

a2 –150 –150 Balance 90 7,780

Supplies Exp.Supplies Exp.

Fixed assets such as drilling equipment lose their ability to

provide service over time. This reduction

in ability is called depreciation.

Fixed assets such as drilling equipment lose their ability to

provide service over time. This reduction

in ability is called depreciation.

The fixed asset account is not reduced directly by depreciation. Instead, an

offsetting account, called Accumulated Depreciation, is used.

The fixed asset account is not reduced directly by depreciation. Instead, an

offsetting account, called Accumulated Depreciation, is used.

a3. Assume that the amount of depreciation for November is $160.

AssetsOffice

Equipment

Balance 8,500 7,930

a3 160 –160 Balance 8,500 160 7,620

Accumulated– Depreciation

Depreciation Exp.Depreciation Exp.

a4. Of the $1,800 received for five-months’ rent, $360 ($1,800 ÷ 5) has been earned.

LiabilitiesUnearned

Balance 1,800 7,620

a4 –360 360 Balance 1,440 7,980

Rental Rev.Rental Rev.

a5. As of November 30, employees are owed $220 for accrued wages.

LiabilitiesWages Payable

Balance 7,980

a5 220 –220 Balance 220 7,760

Wages Exp.Wages Exp.

a6. Family Health Care provided $750 in services to patients that have not yet been billed.

AssetsAccounts

Receivable

Balance 1,900 7,760

a6 750 750 Balance 2,650 8,510

Fees EarnedFees Earned

Prepare accrual-basis financial statements, including a classified balance sheet.4

Fees earned $12,350Operating expenses:

Wages expense $3,010Insurance expense 1,100Rent expense 800Utilities expense 580Depreciation expense 160Supplies expense 150Interest expense 100Miscellaneous expense 420 Total operating expenses 6,320

Operating income: $ 6,030Other income:

Rent revenue 360Net income $ 6,390

Family Health Care, P.C.Income Statement

For the Month Ended November 30, 2003

Retained earnings, November 1, 2003 $3,320Net income for November $6,390Less dividends 1,200 5,190Retained earning, November 30, 2003 $8,510

Family Health Care, P.C.Retained Earnings Statement

From the From the income income

statementstatement(Slide 3-55)(Slide 3-55)

From the From the income income

statementstatement(Slide 3-55)(Slide 3-55)

AssetsCurrent assets:

Cash $ 7,730Accounts receivable 2,650Prepaid insurance 7,300Supplies 90 Total current assets$17,770

Fixed assets:Office equipment $8,500Less accumulated depreciation 160 $ 8,340Land 12,000 Total fixed assets 20,340

Total assets$38,110

Family Health Care, P.C.Balance Sheet

November 30, 2003

LiabilitiesCurrent liabilities:

Accounts payable $ 140Wages payable 220Notes payable 6,800Unearned revenue 1,440 Total current liabilities$ 8,600

Long-term liabilities:Notes payable 10,000

Total liabilities$18,600

Stockholders’ equityCapital stock $11,000Retained earnings 8,510

19,510Total liabilities and stockholders’ equity

$38,110

From the retained From the retained earnings statementearnings statementFrom the retained From the retained earnings statementearnings statement

Cash flows from operating activities:Cash received from patients $ 9,700Cash received from rental of land 1,800

$11,500Deduct cash payments for expenses:

Insurance premiums $(8,400)Supplies (100)Wages (2,790)Rent (800)Utilities (580)Interest (100)Miscellaneous expense (420) (13,190)

Net cash flow used in operating activities$ (1,690)

Family Health Care, P.C.Statement of Cash Flows

Net cash flow used in operating activities$ (1,690)

Cash flows from investing activities:Purchase of office equipment(1,700)

Cash flows from financing activities:Additional issuance of capital stock $ 5,000Deduct cash dividends (1,200)Net cash flow from financing activities 3,800

Net increase in cash$ 410

November 1, 2003 cash balance 7,320

November 30, 2003 cash balance$ 7,730

Assets are resources such as physical items or rights that are owned by the business.

AssetsAssets

Physical assets of a long-term nature are referred to as

fixed assets.

Physical assets of a long-term nature are referred to as

fixed assets.

Buildings Equipment Land Fixtures

AssetsAssets

Rights that are long-term in

nature are called intangible assets.

Rights that are long-term in

nature are called intangible assets.

Patents Copyrights Trademarks Leasehold

improvements

AssetsAssets

Cash and other assets that are expected to be converted

to cash or sold or used up within one year or less,

through the normal operations of the business, are called current assets.

Cash and other assets that are expected to be converted

to cash or sold or used up within one year or less,

through the normal operations of the business, are called current assets.

Accounts receivable

Notes receivable Supplies Other prepaid

expenses

AssetsAssets

Liabilities are amounts owed to outsiders… normally referred to as creditors.

LiabilitiesLiabilities

Liabilities that will be due within a short time (usually

one year or less) and that are paid out of current assets

are called current liabilities.

Liabilities that will be due within a short time (usually

one year or less) and that are paid out of current assets

are called current liabilities.

Accounts payable Wages payable Interest payable Taxes payable

A sizable number A sizable number of liabilities end in of liabilities end in

the word the word “payable.”“payable.”

A sizable number A sizable number of liabilities end in of liabilities end in

the word the word “payable.”“payable.”

Liabilities that will not be due within a short time

(usually more than a year) or are not paid out of

current assets are called long-term liabilities.

Liabilities that will not be due within a short time

(usually more than a year) or are not paid out of

current assets are called long-term liabilities.

Mortgage payable Bonds payable

Stockholders’ equity is the stockholders’ right to the assets of the business.

Capital stock Retained earnings

Stockholders’ EquityStockholders’ Equity

Describe how the accrual basis of accounting enhances the interpretation of financial statements.

5Learning GoalLearning Goal

Family Health Care, P.C.Cash Basis Income StatementFor the Month Ended November 30, 2003

Fee earned$ 9,700

Operating expenses:Wages expense $2,790Insurance expense 8,400Rent expense 800Utilities expense 580Supplies expense 100Interest expense 100Miscellaneous expense 420 Total operating expenses 13,190

Operating loss$ 3,490

Rental revenue 1,800

Net loss$ 1,690

Note that this Note that this is a cash basis is a cash basis

income income statementstatement

Note that this Note that this is a cash basis is a cash basis

income income statementstatement

Using the accrual basis, net income for November was $6,390. However, if we

followed the cash basis, the firm shows a loss of $1,690.

Using the accrual basis, net income for November was $6,390. However, if we

followed the cash basis, the firm shows a loss of $1,690.

Describe the accounting cycle for the accrual basis of accounting.6

1. Identifying, analyzing and recording the effects of transactions on the accounting equation.

2. Identifying, analyzing, and recording adjustment data.

3. Preparing financial statements.

4. Preparing the accounting records for the next accounting period.

The Accounting CycleThe Accounting Cycle

After the financial statements are prepared, the balances in

the revenue, expense, and dividend accounts are closed

by the closing process.

After the financial statements are prepared, the balances in

the revenue, expense, and dividend accounts are closed

by the closing process.

In this way, the revenue, expense, and dividend accounts begin each period with a zero balance, and the

transactions of each period are kept separate from one another.

In this way, the revenue, expense, and dividend accounts begin each period with a zero balance, and the

transactions of each period are kept separate from one another.

Describe and illustrate how common-size financial statements can be used to analyze and evaluate a company’s performance.

7Learning ObjectiveLearning Objective

Income Statements for the Year Ending December 31, 2001

Revenues 100.0% 100.0%Operating expenses 86.2% 81.8%Operating income 13.8% 18.2%Other expenses 0.9% 2.5%Income before taxes 12.9% 15.7%Income taxes 4.8% 4.7%Net income 8.1% 11.0%

Wendy’s McDonald’sNote Wendy’s Note Wendy’s

higher proportion of higher proportion of operating expenses operating expenses

to revenue.to revenue.

Note Wendy’s Note Wendy’s higher proportion of higher proportion of operating expenses operating expenses

to revenue.to revenue.

Which is probably the Which is probably the reason for Wendy’s reason for Wendy’s lesser percentage of lesser percentage of

net income.net income.

Which is probably the Which is probably the reason for Wendy’s reason for Wendy’s lesser percentage of lesser percentage of

net income.net income.

Common-Size Financial Common-Size Financial StatementsStatements

Balance Sheets as of December 31, 2001

Current assets:Cash 5.4% 1.9%Accounts receivable 4.0% 3.9%Inventories and other assets 3.4% 2.3%

Total current assets 12.8% 8.1%Property, plant, and equipment 79.0% 76.7%Other long-term assets 8.2% 15.2%Total assets 100.0% 100.0%

Wendy’s McDonald’s

Balance Sheets as of December 31, 2001

Current liabilities:Accounts payable 5.4% 3.1%Other liabilities 8.9% 6.9%

Total current liabilities 14.3% 10.0%Long-term liabilities 36.1% 47.9%Stockholders’ equity 49.6% 42.1%Total assets 100.0% 100.0%

Wendy’s McDonald’s

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