Chap 3 accrual accounting & income

©2008 Pearson Prentice Hall. All rights reserved.3-1

Accrual Accounting & Income

Lecture 4 & 5

Chapter 3


Accrual vs. Cash-Basis Accounting

ACCRUAL• Records business

transactions when they occur When sale is made When bill is received

• Complies with GAAP• Presents accurate

financial picture

CASH• Records transactions

only when cash is received or paid When customer pays

for product or service When bills are paid

• Only used by very small businesses

• Omits important info


Learning Objective 1

Relate accrual accounting and cash flows


Accrual Accounting and Cash Flows

• Accrual accounting records both cash and non-cash transactions

Cash

Collecting from customers

Paying for expenses

Borrowing money

Issuing Stock

Non-cash

Sales on account

Purchases on account

Using prepaid expenses, such as supplies


Time-Period Concept

• Businesses do not stop operations to measure financial transactions

• Accountants prepare financial statements at regular intervals to measure performance

• Companies select a twelve-month period for reporting purposes: Calendar year Fiscal year



Apply the revenue and matching principles


The Revenue Principle

• Revenue is recorded when earned When product or service is delivered to

customer Cash may come before, at the same time, or

after delivery

• Revenue is recorded at the cash value of goods or services provided


The Matching Principle

• Expenses are incurred to help produce revenue

• Expenses should be recorded in the time period in which they are incurred

• Expenses should be matched to the revenues they help produce

REVENUESEXPENSES


Expenses

• May be paid in cash Paying monthly rent

• May arise from using up an asset Using supplies previously

purchased

• May arise from creating a liability Receive a bill from a

supplier



Adjust the accounts


The Adjustment Process

• At the end of the period, a business prepares financial statements

• Ensures that: All revenue that has been earned has been

recorded All expenses that have been incurred are

matched to revenues Asset and liability accounts are up-to-date

©2008 Pearson Prentice Hall. All rights reserved.3-123-12

Categories of Adjusting Entries

• Deferrals

• Depreciation

• Accruals


Deferrals

• Cash has already been received or paid Related expense or revenue has not yet been

recorded

• Prepaid expenses Company has paid for expense in advance Adjustment needed to record amount used

• Unearned revenues Customer pays in advance for good or service Adjustment needed to record amount of revenue

earned


Prepaid Expenses

• Expenses paid in advance

• Include prepaid rent and supplies

• Asset is recorded when purchased

• Adjustment needed to record amount used


Prepaid Rent Example

• Suppose on April 1 on a company paid $12,000 for one year’s rent in advance

JOURNAL

Date Accounts Debit Credit

1-Apr Prepaid rent $12,000

Cash $12,000



• Now, it’s December 31, the company’s year-end

• The amount of rent that has expired must be recorded

• This amount is recorded as rent expense

• Prepaid rent (asset) needs to be reduced so it reflects the amount of rent remaining


April 1, current year

December 31 April 1, following year

$12,000 Prepaid Rent

April 1 to December 31 = 9 months

9 out of 12 months of rent has expired

9/12 x $12,000 = $9,000

3 out of 12 months of rent remains

3/12 x $12,000 = $3,000

$9,000 $3,000

3-17



• Dec 31 – Adjust Prepaid Rent account for amount expired

JOURNAL


12-31 Rent Expense $9,000

Prepaid Rent $9,000


Prepaid Rent Rent Expense

Apr 1 $12,000 Dec 31 $9,000 Dec 31 $9,000

$3,000

End-of-year balance

Represents amount expired

Represents amount remaining


Supplies Example

• Suppose a company purchased $3,200 of supplies during the year The asset “supplies” was debited for each

purchase

• At the end of the year, a physical count reveals $500 of supplies on hand


Supplies Example

Supplies

$3,200Balance per ledger

$500Balance per physical count

What amount of supplies was used?

Subtract the balance per count from the balance per ledger


Supplies Example

• Dec 31 – Adjust Supplies account for amount used

JOURNAL


12-31 Supplies Expense $1,700

Supplies $1,700


Supplies Supplies Expense

$3,200 Dec 31 $1,700 Dec 31 $1,700

$500

End-of-year balance

Represents amount used

Represents amount on hand


Depreciation of Plant Assets

• Allocation of plant assets cost over their useful lives

• Results in a debit to an expense Depreciation Expense

• Corresponding credit Accumulated Depreciation


Accumulated Depreciation

• Account that shows the sum of depreciation expense of the plant asset

• Contra-asset Always has a companion account Normal credit balance


Depreciation Example

• A company purchases equipment for $50,000

• The estimated useful life of the equipment is five years

=$5,000 annual depreciation

50,000/5 years


Depreciation Example

• Dec 31 – Adjusting entry to record depreciation of equipment

JOURNAL


12-31 Depreciation Expense $5,000

Accumulated Depreciation $5,000


Depreciation – Balance Sheet

Balance Sheet

Plant assets:

Equipment $50,000

Less: Accum. Depr. (5,000) $45,000


Accrued Expenses

• Expense incurred before cash is paid

• Result in a liability

• Common accrued expenses: Salaries Interest Taxes


Accrued Salary Expense Example

• A company pays its employees a weekly salary each Friday

• Salaries for each week total $10,000

• December 31, the company’s year-end, falls on a Wednesday


Monday, December 29

Wednesday, December 31 year end

Friday, January 2 pay day

$10,000 Salaries

Monday through Wednesday = 3 days

3 out of 5 days of salaries expense has been incurred

3/5 x $10,000 = $6,000

$6,000 $4,000



• Dec 31 – Record accrued salary expense

JOURNAL


12-31 Salary expense $6,000

Salary payable $6,000


Accrued Revenues

• Companies often earn revenue before cash is received

• Results in an accrued revenue Receivable recorded


Accrued Revenue Example

• A company performed services for customers during the last week of the year totaling $5,000

• The revenue has not yet been recorded because the customers won’t be billed until January



• Dec 31 – Record accrued revenue

JOURNAL


12-31 Accounts Receivable $5,000

Service Revenue $5,000


Unearned Revenues

• Recorded as a liability when company receives payment Company owes customer product or service

• Revenue is not recorded until earned When company provides product or service

• An adjusting entry is made to transfer amount from unearned revenue to revenue


Unearned Revenue Example

• On November 1, a company receives a customer payment of $18,000 for services to be performed during the next three months



• Nov 1 – Record advance payment received by customer

JOURNAL


11-1 Cash $18,000

Unearned revenue $18,000


November 1, current year

December 31 January 31, following year

$18,000

November 1 to December 31 = 3 months

2 out of 3 months of revenue has been earned

2/3 x $18,000 = $12,000

1 out of 3 months remains unearned

1/3 x $18,000 = $6,000

$12,000 $6,000



• Dec 31 – Record portion of unearned revenue that has been earned

JOURNAL


12-31 Unearned revenue $12,000

Service revenue $12,000


Unearned Revenue Service Revenue

Dec 31 $12,000 Nov 1 $18,000 Dec 31 $12,000

$6,000

End-of-year balance

Represents amount earned

Represents amount unearned


Summary of Adjusting Entries

• Purpose of adjusting entries Measure income Update balance sheet

• Each adjusting entry affects One income statement account

• Revenue or Expense

One balance sheet account• Asset or liability


Adjusted Trial Balance

• Trial balance prepared after adjusting entries are made and posted

• These amounts are used to prepare the financial statements: Income Statement Statement of Retained Earnings Balance Sheet



Prepare the financial statements


Income Statement

• Reports net income or loss

• Revenues minus expenses

• Net income flows to Retained Earnings Statement


Statement of Retained Earnings

• Shows changes to the Retained Earnings account

• Net Income is added to beginning balance

• Dividends are subtracted

• Ending Retained Earnings flows to the Balance Sheet


Balance Sheet

• Reports assets, liabilities and equity

• Shows that the accounting equation is in balance


INCOME STATEMENT

RETAINED EARNINGS STATEMENT

BALANCE SHEET

NET INCOME

ENDING RETAINED EARNINGS



Close the books


Closing the Books

• Done after financial statements are prepared

• Set temporary accounts to zero

• Transfers balances to retained earnings account

• Journalizes activity in Statement of Retained Earnings


Temporary and Permanent Accounts

Temporary• Revenues, Expenses

and Dividends• Closed• Balances represent a

period of time

Permanent• Asset, liability and

equity accounts • Not closed• Ending balance of

one period carries over to following period


Closing Entries

• Debit each Revenue account for the amount in its credit balance Retained earnings is credited

• Credit each Expense account for the amount in its debit balance Retained earnings is debited

• Credit Dividends for the amount in its debit balance Retained earnings is debited

R E D


E3-29

• Dec 31 – Close Revenues

JOURNAL


12-31 Service Revenue $23,600

Other revenue 600

Retained earnings $24,200


E3-29

• Dec 31 – Close expenses

JOURNAL


31-Dec ________________________ _________

Cost of services sold $11,600

Selling, general & admin exp $6,900

Depreciation expense $4,100

Income tax expense $500

Which account would be

debited? Total the expenses

for the amount


E3-29

• Dec 31 – Close Dividends

JOURNAL


12-31 Retained earnings $400

Dividends $400


E3-29

Retained earningsBalance 12-31-X1

Balance 12-31-X2

$1,900

$24,200$400

$23,100

Revenues

Expenses

Dividends

$2,600Determine net income.

Remember revenuesminus expenses


Classifying Assets & Liabilities

• Current and long-term classifications are based on liquidity How quickly item is converted to in cash

• Current assets will be converted to cash, sold or used during the next year

• Long-term assets include plant assets• Current liabilities must be paid in the next 12

months• Long-term liabilities have due dates more than

one year from balance sheet date


Classified Balance Sheet

• Places assets into meaningful categories

• Categories: Current assets Long-term investments Property, plant and equipment Intangible assets Other assets


Balance Sheet Formats

• Report format Assets at the top Followed by liabilities and stockholders’ equity

• Account format Assets on the left Liabilities and stockholders’ equity on the right


Income Statement Formats

• Single-step All revenues and gains grouped together All expenses and losses grouped together

• Multi-step Includes useful subtotals Gross profit

• Net revenues minus cost of goods sold Income from operations Net income



Use two new ratios to evaluate a business


Current ratio

• Measure company’s ability to pay current liabilities with current assets

• Rule of thumb: Strong current ratio is 1.50

Current assets Current liabilities


Debt Ratio

• Proportion of assets that is financed with debt

• High debt ratio indicates more risk

Total liabilities

Total assets


S3-14

Current ratio:Current assets = Cash + Accounts Receivable + Inventories + Other current assets

$900 + $27,700 + $33,000 = $4,800 = $66,400

Total Current liabilities = $53,600

Current ratio = 66,400 / 53,600

Current ratio = ______


S3-14

Debt ratio:Total liabilities = Current liabilities + Long-term liabilities

$53,600 + $13,500 = $67,100

Total assets = Current assets + Property & Equipment, net + Other assets

$66,400 + $7,200 + $24,300 = 97,900

Debt ratio = $67,100 / $97,900

Debt ratio = .69


End of Chapter Three

Chap 3 accrual accounting & income

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