Accrual Accounting and the

Financial Statements

Chapter 3

Relate accrual accounting

and cash flows.

1Entity

hascash

The Business Cycle

2Entityholds

inventory

Purchase ofinventory

3Entityhas a

receivable

Sale of inventory on account

Collection ofthe receivable

Suppose that on September 30, 2005,Vodafone receives £24 for a one-yearconnection to wireless phone service.

Accrual Accountingand Cash Flows

By December 31, Vodafone hasearned the revenue for three months.

Accrual Accountingand Cash Flows

Income statement reports for year ended:Service revenue (when earned); £24 × 3/12 £ 6

Balance sheet reports:Liabilities:

Unearned service revenue (company still owes £24 × 9/12) £18

Statement of cash flows reports for year ended:Collections from customers (when cash was received) £24

December 31, 2005

Apply the revenue and

matching principles.

Revenue Principle

The revenue principle governs two things:

When to record revenue and…

the amount of revenue to record.

Revenue Principle

photos

Disney

World

Situation 2The client has taken a trip arranged by

Air & Sea Travel. – Record Revenue

Situation 2The client has taken a trip arranged by

Air & Sea Travel. – Record Revenue

Air & SeaTravel, Inc.

April 2

Air & SeaTravel, Inc.

Situation 1No transaction has occurred.

– Do Not Record Revenue

Situation 1No transaction has occurred.

– Do Not Record Revenue

March 12I plan to have youmake my travelarrangements.

The Matching Principle

It is the basis for recordingexpenses and includes two steps:

Identify all the expenses incurredduring the accounting period.

Measure the expenses and matchexpenses against revenues earned.

Update the financial statements

by adjusting the accounts.

Updating the Accounts:The Adjustment Process

The adjustment process beginswith the trial balance.

The unadjusted trial balance lists theaccounts and their balances after the

period’s transactions have been recorded.

Air & Sea Unadjusted Trial Balance April 30, 20x3

$24,800 2,250 700 3,000 16,500

3,200

950 400$51,800

13,100 450 20,000 11,250

7,000

$51,800

CashAccounts receivableSuppliesPrepaid rentFurnitureAccounts payableUnearned service revenueCommon stockRetained earningsDividendsService revenueSalary expenseUtilities expenseTotal

Deferrals

Accruals

Categories ofAccounting Adjustments

Depreciation

Prepaid Expenses: Rent

3,000Prepaid Rent

3,000Cash

On April 1, 20x3, Air & Sea Travelprepays three months office rent.

Prepaid Expenses: Rent

What is the adjusting entry on April 30?

April 30Rent Expense ($3,000 × /3) 1,000

Prepaid Rent 1,000To record rent expense

Prepaid Expenses: Supplies

On April 2, 20x3, Air & Sea Travelpaid cash of $700 for office supplies.

700Supplies

700Cash

Prepaid Expenses: Supplies

An inventory at month end indicatedthat $400 in office supplies remained.

4/2 700Supplies

4/30 300Bal. 400

Supplies Expense4/30 300Bal. 300

Depreciation of Plant Assets

On April 3, the business purchasedfurniture on account for $16,500.

The furniture is expected to last 5 years.

16,500Furniture Accounts Payable

16,500

Depreciation of Plant Assets

The straight-line method of depreciation givesan annual depreciation expense of $3,300.

$16,000 ÷ 5 years = $3,300 per year

$3,300 ÷12 months = $275 per month

Depreciation of Plant Assets

What is the adjusting entry on April 30?

April 30Depreciation Expense – Furniture 275

Accumulated Depreciation – Furniture 275To record depreciation on furniture

Book Value

The net amount of a plant asset (cost minusaccumulated depreciation) is the book value.

Plant Assets of Air & Sea at April 30Furniture $16,500

Less Accumulated Depreciation – 275 $16,225Building $48,000

Less Accumulated Depreciation – 200 47,800Book value of plant assets $64,025

Accrued Expenses

The term accrued expense refers to a liability thatarises from an expense that has not yet been paid.

Suppose Air & Sea Travel pays itsemployees a monthly salary of $1,900, half

on the 15th and half on the last day of the month.

April

15

30

Accrued Expenses

Assume that if a paydayfalls on the weekend,Air & Sea pays theemployee on the

following Monday.

1

Accrued Expenses

Salary Payable4/30 950Bal. 950

Salary Expense4/15 950

Bal. 1,9004/30 950

Salary Expense4/15 950

Cash4/15 950

Accrued Revenues

An accrued revenue is a revenue that hasbeen earned but not received in cash.

Bank One hires Air & Sea Travelon April 15 to arrange travelservices on a monthly basis.

Bank One will pay the travel agency$500 monthly, with the first

payment on May 15.

Accrued Revenues

April 30Accounts Receivable ($500 × ½) 250

Service Revenue 250To accrue service revenue

Unearned Revenues

An unearned revenue is an obligation arisingfrom receiving cash before providing a service.

Plantation Foods engages Air & Sea Travelagreeing to pay the agency $450 monthly,

beginning immediately.

Air & Sea Travel collects the first amount onApril 20 and earns one-third the last 10 days.

Unearned Revenues

April 20Cash 450

Unearned Revenue 450Received cash for revenue in advance

April 30Unearned Revenue ($450 × 1/3) 150

Revenue 150To record unearned revenue earned

Adjusting the Accounts

©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 29

Accounts receivableSuppliesPrepaid rentAccumulated dep.Salary payable Unearned revenueIncome tax payableService revenue

Rent expenseSalary expenseSupplies expensesDepreciation expenseIncome tax expense Totals

2,250 7003,000

950

450

7,000

Accounts NeedingAdjustments

Partial TrialBalance

Dr. Cr.2,500 4002,000

1,0001,900 300 275 540

275 950 300 5407,400

PartialAdjusted

Trial BalanceDr. Cr.

e) 250

f) 150

a) 1,000d) 950b) 300c) 275g) 540

3,465

b) 300a) 1,000c) 275d) 950

g) 540e) 250f) 150

3,465

AdjustmentsDr. Cr.

Prepare the financial

statements.

Air & Sea Travel, Inc.Income Statement

Revenue:Service revenue $7,400

Expenses: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

Month Ended April 30, 20x3

Retained earnings, April 1, 20x3 $11,250Add: Net income 2,985

$14,235Less: Dividends – 3,200Retained earnings, April 30, 20x3 $11,035

Air & Sea Travel, Inc.Statement of Retained Earnings

Month Ended April 30, 20x3

Air & Sea Travel, Inc.Balance Sheet

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

April 30, 20x3

Close the books.

Which AccountsNeed To Be Closed?

Closing the books means to prepare theaccounts for the next period’s transactions.

Temporary accounts (revenue, expense,and dividends) are closed at the end

of the accounting period.

Which AccountsNeed To Be Closed?

Permanent accounts (assets, liabilities,and stockholders’ equity) are not closed

at the end of the period because theirbalances are not used to measure income.

Closing entries transfer the revenue, expense,and dividends balances to Retained Earnings.

Journalizing the Closing Entries

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 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

Income Statement Format

Revenues Net income– =Expenses

Single-Step Income Statement

Sales revenues– Cost of goods sold Gross profit

Operatingincome

Selling andadministrative

expenses– =

Multi-Step Income Statement

Income Statement Format

Add: Other revenues and gainsLess: Other expenses and losses

Income Statement Format

Earningsbefore taxes

Netearnings

– =Incometaxes

Multi-Step Income Statement

Use the current ratio and

the debt ratio to evaluate

a business.

Current ratio= Total current assets

÷ Total current liabilities

Current ratio= Total current assets

÷ Total current liabilities

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

Current Ratio

Rule of thumb: A strong current ratio is 2.00.Rule of thumb: A strong current ratio is 2.00.

Debt ratio = Total liabilities ÷ Total assets

Debt Ratio

The debt ratio indicates the proportionof assets that is financed with debt.

This ratio measures a business’sability to pay total liabilities

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