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Accrual Accounting and the Accrual Accounting and the Financial StatementsFinancial Statements

Chapter 3Chapter 3

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Learning Objective 1Learning Objective 1

Relate accrual accounting and cash flows.Relate accrual accounting and cash flows.

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Accrual Accounting vs Cash Accrual Accounting vs Cash Basis of AccountingBasis of Accounting

Cash Basis – records transactions only as Cash Basis – records transactions only as cash is received or paidcash is received or paid

Accrual Accounting - records the impact of a Accrual Accounting - records the impact of a business event as it occursbusiness event as it occurs

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The Time-Period ConceptThe Time-Period Concept

Financial statements are prepared for specific Financial statements are prepared for specific periods and at regular intervals:periods and at regular intervals:– MonthlyMonthly– QuarterlyQuarterly– Annually Annually

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Learning Objective 2Learning Objective 2

Apply the revenue and matching principles.Apply the revenue and matching principles.

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Revenue PrincipleRevenue Principle

Revenue is recorded when it is earned, Revenue is recorded when it is earned, rather than when cash is received.rather than when cash is received.

The amount of revenue to record is the cash The amount of revenue to record is the cash value of goods transferred to the customer.value of goods transferred to the customer.

What do you think we would do if revenue What do you think we would do if revenue had been earned, but it’s collectability was had been earned, but it’s collectability was uncertain?uncertain?

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The Matching PrincipleThe Matching Principle

Record all expenses when incurred during Record all expenses when incurred during the accounting period, rather than when the accounting period, rather than when paidpaid

Match incurred expenses for the accounting Match incurred expenses for the accounting period against revenues earnedperiod against revenues earned

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Learning Objective 3Learning Objective 3

Adjusting the accounts at period end for Adjusting the accounts at period end for Deferrals, Accruals, and DepreciationDeferrals, Accruals, and Depreciation

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Air & Sea Unadjusted Trial Air & Sea Unadjusted Trial Balance April 30, 20x3Balance April 30, 20x3

Account Debit CreditCash $24,800Accounts receivable 2,250Supplies 700Prepaid rent 3,000Furniture 16,500Accounts payable 13,100Unearned service revenue 450Common stock 20,000Retained earnings 11,250Dividends 3200 Service revenue $7,000Salary expense 950Utilities expense 400Total $51,800 $51,800

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Categories of Accounting Categories of Accounting AdjustmentsAdjustments

DeferralsDeferrals DepreciationDepreciation AccrualsAccruals

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Prepaid Expenses: RentPrepaid Expenses: Rent

On April 1, 20x3, Air & Sea Travel prepays On April 1, 20x3, Air & Sea Travel prepays three months office rent, creating an asset.three months office rent, creating an asset.

3,000Prepaid Rent

3,000Cash

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Prepaid Expenses: RentPrepaid Expenses: Rent

What is the adjusting entry on April 30, after What is the adjusting entry on April 30, after one month?one month?

General Journal

Date Accounts and Explanations PR Debit Credit

April 30 Rent Expense 1,000Prepaid Rent 1,000

To record rent expense ($3,000 x 1/3)

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Prepaid Expenses: SuppliesPrepaid Expenses: Supplies

On April 2, 20x3, Air & Sea Travel paid cash On April 2, 20x3, Air & Sea Travel paid cash of $700 for office supplies, creating an of $700 for office supplies, creating an asset.asset.

700Supplies

700Cash

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Prepaid Expenses: SuppliesPrepaid Expenses: Supplies

An inventory at month end indicated that $400 An inventory at month end indicated that $400 of the original $700 in office supplies of the original $700 in office supplies remained. ($300 of supplies were remained. ($300 of supplies were consumed):consumed):

4/2 700Supplies

4/30 300Bal. 400

Supplies Expense4/30 300Bal. 300

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DepreciationDepreciation

Allocation of the cost of a plant asset to Allocation of the cost of a plant asset to expense over the asset’s useful lifeexpense over the asset’s useful life

On balance sheet, original cost less On balance sheet, original cost less accumulated depreciation over the years is accumulated depreciation over the years is called the asset’s book valuecalled the asset’s book value

Depreciation is not a valuation process: Depreciation is not a valuation process: book value is not likely to equal fair market book value is not likely to equal fair market value [what asset could be sold for]value [what asset could be sold for]

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Depreciation of Plant AssetsDepreciation of Plant Assets

On April 3, the business purchased furniture On April 3, the business purchased furniture on account for $16,500. The furniture is on account for $16,500. The furniture is expected to last 5 years.expected to last 5 years.

16,500Furniture Accounts Payable

16,500

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Depreciation of Plant AssetsDepreciation of Plant Assets

Straight-line method of depreciation Straight-line method of depreciation allocates equal amounts of the asset cost to allocates equal amounts of the asset cost to each accounting period:each accounting period:

$16,000 ÷ 5 years = $3,300 per year$16,000 ÷ 5 years = $3,300 per year $3,300 ÷12 months = $275 per month$3,300 ÷12 months = $275 per month

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Depreciation of Plant AssetsDepreciation of Plant Assets

What is the adjusting entry on April 30?What is the adjusting entry on April 30?

General Journal

Date Accounts and Explanations PR Debit Credit

April 30 Depreciation Expense, Furniture 275Accumulated Depreciation,Furniture 275

To record depreciation at month end

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Book ValueBook Value

The net amount of a plant asset (cost minus The net amount of a plant asset (cost minus accumulated depreciation)accumulated depreciation)

Furniture 16,500$ Less Accumulated Depreciation (275) 16,225$ Building 48,000$ Less Accumulated Depreciation (200) 47,800 Book value of plant assets 64,025$

Plant Assets of Air & Sea at April 30, 20x5

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Accrued Expense Accrued Expense

A liability that arises from an expense that has not A liability that arises from an expense that has not yet been paid.yet been paid.

Air & Sea Travel pays its employees a monthly Air & Sea Travel pays its employees a monthly salary of $1,900, half on the 15th and half on the salary of $1,900, half on the 15th and half on the last day of the month. If a payday falls on the last day of the month. If a payday falls on the weekend, Air & Sea pays the employee on the weekend, Air & Sea pays the employee on the following Monday. following Monday.

Assume that April 30 is a Saturday in the following Assume that April 30 is a Saturday in the following example…example…

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Accrued ExpensesAccrued Expenses

Salary Payable4/30 950Bal. 950

Bal. 1,9004/30 950

Salary Expense4/15 950

Cash4/15 950

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Accrued RevenueAccrued Revenue

A revenue that has been earned but not yet A revenue that has been earned but not yet received in cash.received in cash.

Bank One hires Air & Sea Travel on April 15 Bank One hires Air & Sea Travel on April 15 to arrange travel services on a monthly to arrange travel services on a monthly basis. Bank One will pay the travel agency basis. Bank One will pay the travel agency $500 monthly, with the first payment on May $500 monthly, with the first payment on May 15.15.

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Accrued RevenuesAccrued Revenues

Adjusting entry:Adjusting entry:

General Journal

Date Accounts and Explanations PR Debit Credit

April 30 Accounts Receivable 250Service Revenue 250

To accrue ½ month of service revenue

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Unearned RevenueUnearned Revenue

An obligation arising from receiving cash before An obligation arising from receiving cash before providing a service. providing a service.

This creates a liability—an obligation to provide This creates a liability—an obligation to provide services in the future.services in the future.

Plantation Foods engages Air & Sea Travel Plantation Foods engages Air & Sea Travel agreeing to pay the agency $450 monthly, agreeing to pay the agency $450 monthly, beginning immediately. Air & Sea Travel collects beginning immediately. Air & Sea Travel collects the first $450 on April 20 and earns one-third of the first $450 on April 20 and earns one-third of the first cash payment in the last 10 days.the first cash payment in the last 10 days.

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Unearned RevenuesUnearned Revenues

General Journal

Date Accounts and Explanations PR Debit Credit

April 20 Cash 450Unearned Revenue 450

Received advance payment

General Journal

Date Accounts and Explanations PR Debit Credit

April 30 Unearned Revenue 150Revenue 150

To record revenue earned($450 x 1/3)

Air & Sea TravelWork Sheet

For the Month Ended April 30, 20x5

AccountUnadjusted Trial

Balance AdjustmentsAdjusted Trial

Balance Title Debit Credit Debit Credit Debit Credit

Cash 24,800 24,800 Accounts receivable 2,250 e. 250 2,500 Supplies 700 b. 300 400 Prepaid rent 3,000 a. 1000 2,000 Furniture 16,500 16,500 Accum depr, furn c. 275 275 Accounts payable 13,100 13,100 Salary payable d. 950 950 Income tax payable g. 540 540 Unearned svc rev. 450 f. 150 300 Common stock 20,000 20,000 Retained earnings 11,250 11,250

Dividends 3200 3,200 Service revenue $7,000 e. 250 $7,400

f. 150Salary expense 950 d. 950 1,900 Rent expense a. 1000 1,000 Supplies expense b. 300 300 Depr. Exp, furn. c. 275 275 Utilities expense 400 400 Income tax expense g. 540 540

Total $51,800 $51,800 3,465 3,465 53,815 53,815

Step 1Prepare

Unadjusted Trial BalanceStep 2

Plan Adjustments

Step 2Prepare Adjusted

Trial Balance

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Learning Objective 4Learning Objective 4

Prepare the financial statements.Prepare the financial statements.

The following income statement is in “single The following income statement is in “single step form.”step form.”

The following balance sheet is in “account The following balance sheet is in “account form.”form.”

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Air & Sea Travel, Inc.Air & Sea Travel, Inc.Income StatementIncome Statement

Month Ended April 30, 20x5Month Ended April 30, 20x5Revenue:

Service revenue $7,400Expenses:

Salary expense $1,900Rent expense 1,000Utilities expense 400Supplies expense 300Depreciation expense 275 3,875

Income before tax $3,525Income tax expense 540Net income $2,985

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Retained earnings, April 1, 20x5 $11,250Add: Net income 2,958

$14,235Less: Dividends ( 3,200)Retained earnings, April 30, 20x5 $11,035

Air & Sea Travel, Inc.Air & Sea Travel, Inc.Statement of Retained EarningsStatement of Retained Earnings

Month Ended April 30, 20x5Month Ended April 30, 20x5

Air & Sea Travel, Inc.Air & Sea Travel, Inc.Balance SheetBalance SheetApril 30, 20x5April 30, 20x5

AssetsCash $24,800Accounts receivable 2,500Supplies 400Prepaid rent 2,000Furniture $16,500 Less: Accumulated depreciation ( 275) 16,225

Total assets $45,925

LiabilitiesAccounts payable $13,100Salary payable 950Unearned revenue 300Income tax payable 540Total liabilities $14,890 Stockholders’ EquityCommon stock $20,000Retained earnings 11,035Total $31,031Total liabilities and stockholders’ equity $45,925

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Learning Objective 5Learning Objective 5

Close the books.Close the books.

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Closing EntriesClosing Entries

Prepare the accounts for the next period’s Prepare the accounts for the next period’s transactions.transactions.

Transfer the revenue, expense, and Transfer the revenue, expense, and dividends balances to Retained Earnings.dividends balances to Retained Earnings.

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Which AccountsWhich AccountsNeed To Be Closed?Need To Be Closed?

Temporary (nominal) accounts are closed to retained Temporary (nominal) accounts are closed to retained earnings.earnings.– RevenueRevenue– ExpenseExpense– Dividends, but dividends are not an expense; rather they are Dividends, but dividends are not an expense; rather they are

a distribution of earningsa distribution of earnings

Permanent (real) accounts are not closed, but are Permanent (real) accounts are not closed, but are carried forward to future periodscarried forward to future periods– Assets Assets – LiabilitiesLiabilities– Stockholders’ equityStockholders’ equity

Journalizing the Closing EntriesJournalizing the Closing EntriesGeneral Journal

Date Accounts and Explanations PR Debit Credit

April 30 Service Revenue 7,400Retained Earnings 7,400

April 30 Retained Earnings 4,415Rent Expense 1,000Salary Expense 1,900Supplies Expense 300Depreciation Expense 275Utilities Expense 400Income Tax Expense 540

April 30 Retained Earnings 3,200Dividends 3,200

Posting the Closing EntriesPosting the Closing Entries

Retained Earnings4,4153,200

11,250 7,40011,035

Rent Expense1,000 1,000

Other Expenses1,515 1,515

Service Revenue

7,400

7,000 250 1507,400

Dividends3,200 3,200

Salary Expense 950 9501,900 1,900

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Classifying Assets and LiabilitiesClassifying Assets and Liabilities

The balance sheet should list assets and The balance sheet should list assets and liabilities in order of their relative liquidity.liabilities in order of their relative liquidity.

Liquidity – Liquidity – – How quickly an asset can be converted to cash.How quickly an asset can be converted to cash.– How quickly a liability will require payment of How quickly a liability will require payment of

cash.cash.

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Classifying Assets and LiabilitiesClassifying Assets and Liabilities

Current assets

Long-term assets

Current liabilities

Long-term liabilities

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Balance Sheet FormatsBalance Sheet Formats

Report format lists assets in comparative form, Report format lists assets in comparative form, followed by liabilities and equity in comparative followed by liabilities and equity in comparative form (see text Exhibit 3-14)form (see text Exhibit 3-14)– Most widely used in practiceMost widely used in practice– Allows trend analysis of accountsAllows trend analysis of accounts– e.g. Callaway Golf’s cash can readily be seen (Ex 3-14) e.g. Callaway Golf’s cash can readily be seen (Ex 3-14)

to have decreased from $108m to $47m in 2003to have decreased from $108m to $47m in 2003

Account format Account format – Exemplified in text Exhibit 3-12Exemplified in text Exhibit 3-12– Note this is a “T account” formatNote this is a “T account” format

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Income Statement FormatsIncome Statement Formats

Multi-step (Exhibit 3-15)Multi-step (Exhibit 3-15)– Reports sub totalsReports sub totals– e.g. gross profit, income from continuing operations, e.g. gross profit, income from continuing operations,

income pre tax, tax expense, net income.income pre tax, tax expense, net income.

Single step (Exhibit 3-10)Single step (Exhibit 3-10)– Lists all pre tax revenues under a headingLists all pre tax revenues under a heading– Lists all pre tax expenses under a headingLists all pre tax expenses under a heading– One subtraction of total revenues from total expenses to One subtraction of total revenues from total expenses to

arrive at income pre taxarrive at income pre tax– This is followed by tax expense, and net incomeThis is followed by tax expense, and net income

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Learning Objective 6Learning Objective 6

Use the current ratio and the debt ratio to Use the current ratio and the debt ratio to evaluate a business.evaluate a business.

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Current RatioCurrent Ratio

Measures company’s ability to pay current Measures company’s ability to pay current liabilities with current assetsliabilities with current assets

Total current assetsTotal current liabilities

Rule of thumb: A strong current ratio is 2.00

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The percentage of total assets financed with The percentage of total assets financed with debt.debt.

Measures business’s ability to pay total Measures business’s ability to pay total liabilitiesliabilities

A company with a high percentage of debt A company with a high percentage of debt to assets is said to be highly leveraged.to assets is said to be highly leveraged.

Total liabilitiesTotal assets

Debt RatioDebt Ratio

A low debt ratio is safer than a high debt ratio.