Chapter 3 Using Accrual Accounting to Measure Income

Learning Objectives Relate accrual accounting and cash flows Apply the revenue and matching principles Update the financial statements by adjusting the accounts Prepare the financial statements Close the books Use the current ratio and the debt ratio to evaluate a business

Relate accrual accounting and cash flows

Apply the revenue and matching principles

Update the financial statements by adjusting the accounts

Prepare the financial statements

Close the books

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

Accrual vs Cash Accounting Accrual Accounting Impact of business transactions are recorded when the transaction occurs Revenues are recognized when earned . Expenses are recognized when incurred. Cash Accounting Transactions are recorded when cash is received or paid. Revenues are recorded when cash is received . Expenses are recorded when cash is paid .

Accrual Accounting

Impact of business transactions are recorded when the transaction occurs

Revenues are recognized when earned .

Expenses are recognized when incurred.

Cash Accounting

Transactions are recorded when cash is received or paid.

Revenues are recorded when cash is received .

Expenses are recorded when cash is paid .

Accrual vs Cash Accounting Generally accepted accounting principles (GAAP) require that business use accrual accounting.

Generally accepted accounting principles (GAAP) require that business use accrual accounting.

Accrual vs Cash Accounting Under accrual accounting, cash transactions are recorded as well as noncash transactions such as: Purchases of inventory on account Sales on account Depreciation expense Accrual of expenses incurred but not yet paid Usage of prepaid rent, insurance, and supplies

Under accrual accounting, cash transactions are recorded as well as noncash transactions such as:

Purchases of inventory on account

Sales on account

Depreciation expense

Accrual of expenses incurred but not yet paid

Usage of prepaid rent, insurance, and supplies

Time-Period Concept The time-period concept ensures that accounting information is reported at regular intervals. Basic accounting period is 1 year A fiscal year ends on a date other than December 31. Interim financial statements are usually prepared for periods such as a month, a quarter, or semiannual period.

The time-period concept ensures that accounting information is reported at regular intervals.

Basic accounting period is 1 year

A fiscal year ends on a date other than December 31.

Interim financial statements are usually prepared for periods such as a month, a quarter, or semiannual period.

Revenue Principle When should revenue be recorded? What amount of revenue should be recorded?

When should revenue be recorded?

What amount of revenue should be recorded?

Revenue Recognition Revenue should be recorded when it has been earned. The amount of revenue recorded is the cash value of the goods transferred to the customer.

Revenue should be recorded when it has been earned.

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

Matching Principle Expenses are costs of assets used up and of liabilities created in earning revenue. Matching involves two steps: Identify all expenses incurred during the period. Measure the expenses and match the expenses against revenues earned. Expenses may be paid in cash. result from using up an asset such as supplies result from creating a liability (payable)

Expenses are costs of assets used up and of liabilities created in earning revenue.

Matching involves two steps:

Identify all expenses incurred during the period.

Measure the expenses and match the expenses against revenues earned.

Expenses may

be paid in cash.

result from using up an asset such as supplies

result from creating a liability (payable)

Ethical Issues in Accrual Accounting Accruals require the use of judgment to determine which period should reflect revenues earned. Managers should no use accruals to “smooth” income by delaying or accelerating recognition of either revenues or expenses.

Accruals require the use of judgment to determine which period should reflect revenues earned.

Managers should no use accruals to “smooth” income by delaying or accelerating recognition of either revenues or expenses.

The Adjustment Process Examine the trial balance for accounts that may need to be adjusted. Basic categories of adjusting entries: Deferrals Depreciation Accruals

Examine the trial balance for accounts that may need to be adjusted.

Basic categories of adjusting entries:

Deferrals

Depreciation

Accruals

Adjusting Prepaid Expenses A prepaid expense is an expense paid in advance. Because they provide future economic benefit, prepaid expenses are classified as assets. Before financial statements are prepared, prepaid expenses are adjusted to reflect the amount used during the period of the statements.

A prepaid expense is an expense paid in advance.

Because they provide future economic benefit, prepaid expenses are classified as assets.

Before financial statements are prepared, prepaid expenses are adjusted to reflect the amount used during the period of the statements.

Adjusting Prepaid Expenses To record $3,000 paid for 3 months rent on April 1, 20X3. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 1 Prepaid Rent (1,000 x 3) 3,000 Cash 3,000 Paid 3 months’ rent in advance Prepaid Rent 3,000 Cash 3,000

Adjusting Prepaid Expenses To adjust for one month’s rent expired at April 30. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Rent Expense (1,000/3) 1,000 Prepaid Rent 1,000 Expensed one month’s rent Rent Expense 1,000 Prepaid Rent 1,000

Adjusting Prepaid Expenses The following shows the effect of the adjustment. Apr 30 1,000 Bal. 2,000 Rent Expense Apr 30 1,000 Bal. 1,000 Prepaid Rent Apr 1 3,000

Adjusting Supplies To record the purchase of supplies. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 2 Supplies 700 Cash 700 Paid cash for supplies Supplies 700 Cash 700

Adjusting Supplies To adjust for supplies used during April. Calculate Supplies Expense: Supplies available during the period Less: Supplies on hand at end of period Equals: Supplies used during the period (expense) $700 - $400 = $300

Adjusting Supplies To adjust for supplies used during April. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Supplies Expense 300 Supplies 300 To record Supplies Expense Supplies Expense 300 Supplies 300

Adjusting Supplies The following shows the effect of the adjustment. Apr 30 300 Bal. 400 Supplies Expense Apr 30 300 Bal. 300 Supplies Apr 1 700

Depreciation Expense Plant assets are long-lived tangible assets. All plant assets except land decline in usefulness as they age. This decline in usefulness is an expense. The allocation of the cost of an asset to several periods is depreciation .

Plant assets are long-lived tangible assets.

All plant assets except land decline in usefulness as they age.

This decline in usefulness is an expense.

The allocation of the cost of an asset to several periods is depreciation .

Depreciation Expense The total depreciation recorded since the purchase of an asset is accumulated depreciation . Accumulated depreciation is a contra-asset account Cost less accumulated depreciation is the book value (or carrying amount) of the asset.

The total depreciation recorded since the purchase of an asset is accumulated depreciation .

Accumulated depreciation is a contra-asset account

Cost less accumulated depreciation is the book value (or carrying amount) of the asset.

Depreciation Expense Historical Cost – Salvage Value Useful Life ($16,500 – 0) 5 Years = $3,300 per year / 12 months = $275 per month

Depreciation Expense To record purchase of a long-lived asset. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 3 Furniture 16,500 Accounts Payable 16,500 Purchased office furniture on account Furniture 16,500 Accounts Payable 16,500

Depreciation Expense To recognize depreciation for April. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Depreciation Expense 275 Accumulated Depreciation 275 To record Depreciation Expense Depreciation Expense 275 Accumulated Depreciation 275

Depreciation Expense The following shows the effect of the adjustment. Furniture Apr 3 16,500 Bal. 16,500 Accumulated Depreciation - Furniture Apr 30 275 Depreciation Expense Apr 30 275 Bal. 275 Bal 275

Accrued Expenses Accrued expense refers to a liability that arises from an expense that has not yet been paid.

Accrued expense refers to a liability that arises from an expense that has not yet been paid.

Accrued Expenses To record salaries expense during the month. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 15 Salaries Expense 950 Cash 950 To pay salaries Salaries Expense 950 Cash 950

Accrued Expenses To adjust salaries expense at the end of the month. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 15 Salaries Expense 950 Salaries Payable 950 To accrue salaries expense Salaries Expense 950 Salaries Payable 950

Accrued Expenses The following shows the effect of the adjustment. Apr 30 950 Bal. 950 Salaries Expense Apr 30 950 Bal. 950 Salaries Payable

Accrued Revenues Accrued revenue is revenue that has been earned but cash has not been collected.

Accrued revenue is revenue that has been earned but cash has not been collected.

Accrued Revenue To accrue revenues at the end of the month. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Accounts Receivable 250 Service Revenue 250 To accrue service revenue Accounts Receivable 250 Service Revenue 250

Accrued Revenue The following shows the effect of the adjustment. Service Revenue Apr 30 250 Bal. 7,250 Accounts Receivable 2,250 Bal. 2,500 Apr 30 250 7,000

Unearned Revenue Unearned revenue exists when customers have paid in advance for services not yet provided. Revenue is recognized when the services are provided. An unearned revenue is a liability, not a revenue.

Unearned revenue exists when customers have paid in advance for services not yet provided.

Revenue is recognized when the services are provided.

An unearned revenue is a liability, not a revenue.

Unearned Revenue To record cash received in advance from customers. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 20 Cash 450 Unearned Service Revenue 450 Received cash for revenue in advance Cash 450 Unearned Service Revenue 450

Unearned Revenue To record revenues earned at the end of the month. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Unearned Service Revenue (450/3) 150 Service Revenue 150 To record unearned service revenue that has been earned Unearned Service Revenue 150 Service Revenue 150

Unearned Revenue The following shows the effect of the adjustment. Service Revenue Apr 30 250 Bal. 7,400 Unearned Service Revenue Apr 30 150 Bal. 300 Apr 20 450 7,000 Apr 30 150

Summary of Adjusting Process Prepare a trial balance. Review trial balance and other records for adjustments that should be made: Accruals Deferrals Depreciation Prepare and post adjusting entries. Prepare an adjusted trial balance to ensure accuracy of debits and credits after posting. Prepare financial statements.

Prepare a trial balance.

Review trial balance and other records for adjustments that should be made:

Accruals

Deferrals

Depreciation

Prepare and post adjusting entries.

Prepare an adjusted trial balance to ensure accuracy of debits and credits after posting.

Prepare financial statements.

Preparing Financial Statements Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows

Income Statement

Statement of Retained Earnings

Balance Sheet

Statement of Cash Flows

Closing the Books Temporary accounts are closed Revenues Expenses Dividends Permanent accounts are not closed Assets Liabilities Stockholders’ Equity

Temporary accounts are closed

Revenues

Expenses

Dividends

Permanent accounts are not closed

Assets

Liabilities

Stockholders’ Equity

Closing accounts Debit each revenue account for its credit balance and credit Retained Earnings for the sum of the revenues. Credit each expense account for its debit balance. Debit retained earnings for the sum of the expenses. Credit the dividends account for its debit balance. Debit Retained Earnings.

Debit each revenue account for its credit balance and credit Retained Earnings for the sum of the revenues.

Credit each expense account for its debit balance. Debit retained earnings for the sum of the expenses.

Credit the dividends account for its debit balance. Debit Retained Earnings.

Journalizing Closing Entries Apr 30 Service Revenue 7,400 Retained Earnings 7,400 Apr 30 Retained Earnings 4,415 Rent Expense 1,000 Salary Expense 1,900 Supplies Expense 300 Depreciation Expense 275 Utilities Expense 400 Income Tax Expense 540 Apr 30 Retained Earnings 3,200 Dividends 3,200

Closing Accounts Retained Earnings after closing entries: Retained Earnings Beg. Bal 11,250 Revenues 7,400 Expenses 4,415 Dividends 3,200 End Bal 11,035

Classified Balance Sheet Current assets Long-term assets Current liabilities Long-term liabilities

Current assets

Long-term assets

Current liabilities

Long-term liabilities

Formats for Financial Statements Balance sheet formats Report format Account format Income statement formats Single-step income statement Multi-step income statement

Balance sheet formats

Report format

Account format

Income statement formats

Single-step income statement

Multi-step income statement

Accounting Ratios Current Ratio Total Current Assets Total Current Liabilities = Debt Ratio Total Liabilities Total Assets =

Using Ratios Current ratio measures a company’s ability to pay current liabilities with current assets. Debt ratio measures a company’s ability to pay total liabilities.

Current ratio measures a company’s ability to pay current liabilities with current assets.

Debt ratio measures a company’s ability to pay total liabilities.

End of Chapter 3