hhtfa10_ch03_inst_ppt.pptx

3-1
Prepared by
Coby Harmon
University of California, Santa Barbara
Westmont College
Copyright ©2015 Pearson Education Inc. All rights reserved.

3-2
3
1. Explain how accrual accounting differs from cash-
basis accounting
Learning Objective

3-3 LO 1
Accrual Accounting Cash-Basis Accounting
 Records impact of
transactions when they occur
 Required by Generally
Accepted Accounting
Principles (GAAP)
 Records:
► Revenue when earned
► Expenses when incurred
 Records only cash
transactions
► Cash receipts
► Cash payments
 Ignores important information
 Results in incomplete
financial statements
 Only used by the smallest
businesses
EXPLAIN HOW ACCRUAL ACCOUNTING
DIFFERS FROM CASH-BASIS ACCOUNTING

3-4 LO 1
Accrual Accounting and Cash Flows
Accrual accounting records cash transactions, such as the
following:
■ Collecting cash from customers
■ Receiving cash from interest earned
■ Paying salaries, rent, and other expenses
■ Borrowing money
■ Paying off loans
■ Issuing stock

3-5 LO 1
Accrual Accounting and Cash Flow
Accrual accounting also records noncash transactions,
such as the following:
■ Sales on account
■ Purchases of inventory on account
■ Accrual of expenses incurred but not yet paid
■ Depreciation expense
■ Usage of prepaid rent, insurance, and supplies
■ Earning of revenue when cash was collected in advance

3-6
3
Learning Objective
2. Apply the revenue and expense recognition
principles

3-7
The Revenue Principle
Deals with two issues:
1. When to record (recognize) revenue
2. What amount of revenue to record
LO 2
Revenue is recognized when the business transfers promised
goods or services to a customer in an amount that reflects the cash
(or fair market value of other consideration) that the entity expects
to receive in exchange for those goods or services.
APPLY THE REVENUE AND EXPENSE
RECOGNITION PRINCIPLES

3-8 LO 2
The FASB and IASB have issued a joint standard that
provides a consistent, converged, and simplified way to
recognize revenue. The selling entity must:
(1) identify the contract with the customer;
(2) identify the separate performance obligations in the
contract;
(3) determine the transaction price;
(4) allocate the transaction price to the separate performance
obligations in the contract; and
(5) recognize revenue when (or as) the entity satisfies the
performance obligation.

3-9 LO 2
Exhibit 3-1 shows two situations that provide guidance on when to
record revenue for Starbucks Corporation.
Exhibit 3-1 | When to Record Revenue

3-10
The Expense Recognition Principle
Includes two steps:
1. Identify all the expenses incurred during the accounting
period.
2. Measure the expenses and recognize them in the same
period in which any related revenues are earned.
LO 2

3-11 LO 2
Advance slide in presentation mode to reveal answers
(1) A customer pays Starbucks $250 on March 15 for coffee to be served at a
party in April. Has Starbucks earned revenue on March 15? When will
Starbucks earn the revenue?
(2) Starbucks pays $6,000 on July 1 for store rent for the next three months.
Has Starbucks incurred an expense on July 1?
(1) No. Starbucks has received the cash but will not deliver the coffee until later.
Starbucks earns the revenue when it delivers the product to the customer and the
customer assumes control over it.
(2) No. Starbucks has paid cash for rent in advance. No expense has yet been
incurred because the company has not yet occupied the space. This prepaid rent is
an asset because Starbucks has acquired the use of a store location in the future.
Answers:

3-12
3
Learning Objective
3. Adjust the accounts

3-13
Adjusting entries:
 Journal entries made to ensure that revenues and
expenses are recognized in the proper accounting
period.
 Generally made at the end of the accounting period.
 Include at least one income statement account and one
balance sheet account.
LO 3
ADJUST THE ACCOUNTS

3-14 LO 3
A deferral is an
adjustment for payment of
an item or receipt of cash
in advance.
Deferrals are prepaid
expenses or unearned
revenue.
ADJUST THE ACCOUNTS
Categories of Adjusting Entries
Three basic categories:
 Deferrals,
 Depreciation, and
 Accruals

3-15 LO 3
 Deferrals,
 Accruals
Depreciation allocates
the cost of a plant asset to
expense over the asset’s
useful life.
ADJUST THE ACCOUNTS

3-16 LO 3
An accrual is the opposite
of a deferral. For an
accrued expense, the
company records
the expense before paying
cash. For an accrued
revenue, the company
records the revenue
before collecting cash.
ADJUST THE ACCOUNTS
 Deferrals,
 Accruals

3-17
Prepaid Expenses
An expense paid in advance. Prepaid expenses are assets
because they provide a future benefit for the owner.
Cash Payment Expense Recorded
BEFORE
 Insurance
 Advertising
Prepayments often occur in regard to:
ADJUST THE ACCOUNTS
 Rent
 Supplies
LO 3

3-18
Prepaid Expenses
Prepaid Rent. Suppose Freddy’s Auto Service, Inc. prepays
three months’ store rent ($3,000) on June 1. The entry for the
prepayment of three months’ rent is as follows:
LO 3
A B C D
1 Jun 1
2
3
Prepaid Rent ($1,000 x 3)
Cash
3,000
3,000
Prepaid Rent Cash
Jun 1 3,000 Jun 1 3,000

3-19
Prepaid Expenses
Prepaid Rent. Throughout June, Prepaid Rent carries the
balance of $3,000. At June 30, an adjusting entry is required to
transfer $1,000 ($3,000 ÷ 3) from Prepaid Rent to Rent Expense.
LO 3
A B C D
1 Jun 30
2
3
Rent Expense
Prepaid Rent
1,000
1,000
Prepaid Rent Rent Expense
Jun 1 3,000 Jun 30 1,000
Jun 30 1,000
Bal 2,000

3-20
Prepaid Expenses
Supplies. On June 2, Freddy’s Auto Service paid cash of $700
for cleaning supplies:
LO 3
A B C D
1 Jun 2
2
3
Supplies
Cash
700
700
Supplies Cash
Jun 2 700 Jun 2 700

3-21
Prepaid Expenses
Supplies. A count at June 30 indicates that $400 of supplies
remain on hand. Freddy makes the following adjusting entry.
LO 3
A B C D
1 Jun 30
2
3
Supplies Expense
Supplies
300
300
Supplies Supplies Expense
Jun 2 700 Jun 30 300
Jun 30 300
Bal 400

3-22 LO 3
Advance slide in presentation mode to reveal answers
At the beginning of the month, supplies were $5,000. During the
month, $7,000 of supplies were purchased. At month’s end, $3,000 of
supplies are still on hand. What is the
■ adjusting entry?
■ ending balance in the Supplies account?
Answer:

3-23
Depreciation of Plant Assets
Plant assets
 Long-lived tangible assets, such as land, buildings,
furniture, and equipment.
 Recorded as an asset when purchased.
 With the exception of land
► Decline in usefulness.
► Record depreciation expense over the asset’s useful life.
► Depreciation is the process of allocating cost to expense
for a long-term plant asset.
LO 3

3-24
To illustrate, suppose that on June 3 Freddy’s Auto Service
purchased equipment on account for $24,000:
LO 3
A B C D
1 Jun 3
2
3
Equipment
Accounts Payable
24,000
24,000
Equipment Accounts Payable
Jun 3 24,000 Jun 3 24,000

3-25
Freddy’s equipment will remain useful for five years and then be
worthless. One way to compute the amount of depreciation for
each year is to divide the cost of the asset ($24,000 in our
example) by its expected useful life (five years). This procedure—
called the straight-line depreciation method—gives annual
depreciation and monthly depreciation as follows:
LO 3
Annual Depreciation
$24,000 ÷ 5 years =
$4,800 per year
Monthly depreciation
$4,800 ÷ 12 months =
$400 per month

3-26
Depreciation expense for June is recorded as follows:
LO 3
A B C D
1 Jun 30
2
3
Depreciation Expense-Equipment
Accumulated Depreciation-Equipment
400
400
Equipment
Accumulated Depreciation-
Equipment
Jun 3 24,000
Jun 30 400
Depreciation Expense-Equipment
Jun 30 400

3-27
The Accumulated Depreciation account
 Shows the sum of all depreciation expense.
 The balance increases over the asset’s life.
 Is a contra asset account, a normal credit balance.
 A contra account has two distinguishing characteristics:
1. It always has a companion account.
2. Its normal balance is opposite that of the companion
account.
LO 3

3-28
Book Value. Cost of the asset minus accumulated depreciation,
also known as carrying amount.
LO 3
Exhibit 3-4 | Plant Assets on the Balance Sheet of Freddy’s Auto Service

3-29 LO 3
Exhibit 3-4 | Plant Assets on the Balance Sheet of Freddy’s Auto Service
Advance slide in presentation mode to reveal answer.
What will be the book value of Freddy’s equipment at the end of July?
Answer: $24,000 – $400 – $400 = $23,200.

3-30 LO 3
Exhibit 3-5 | Starbucks Corporation’s
Reporting of Property, Plant, and
Equipment (Adapted, in millions)

3-31
Expense Recorded
Accrued Expenses
Expenses incurred but not yet paid in cash.
BEFORE
 Taxes
 Rent
Accrued expenses often occur in regard to:
ADJUST THE ACCOUNTS
 Salaries
 Interest
LO 3
Recorded at the end of the period using an adjusting entry.
Cash Payment

3-32
Accrued Expenses
To illustrate, suppose Freddy’s Auto Service, Inc. pays its employee a
monthly salary of $1,800, half on the 15th and half on the last day of
the month. The following calendar for June has the paydays circled:
LO 3
Assume that if a payday falls on a Sunday, Freddy’s pays the employee
on the following Monday.

3-33 LO 3
Accrued Expenses
During June, Freddy’s paid
its employees the first half-
A B C D
1 Jun 15
2
3
Salary Expense
Cash
900
900
Salary Expense
Jun 15 900
Cash
Jun 15 900
month salary of $900 and made the following entry:

3-34 LO 3
Accrued Expenses
Since the second half-month
amount of $900 will be paid
A B C D
1 Jun 30
2
3
Salary Expense
Salaries Payable
900
900
Salary Expense
Jun 15 900
Salary Payable
Jun 30 900
on July 1, Freddy makes an adjusting entry on June 30 as follows:
Jun 30 900

3-35
Accrued Revenues
Revenue that has been earned but not yet collected is called an
accrued revenue.
ADJUST THE ACCOUNTS
LO 3
 Services performed
 Rent
 Interest
BEFORE
Accrued revenues often occur in regard to:
Cash Receipt
Revenue Recorded

3-36
Accrued Revenues
Assume that FedEx hires Freddy’s on June 15. FedEx will pay
Freddy’s $600 monthly, with the first payment on July 15. During June,
Freddy’s will earn half a month’s fee for work done June 15 through
June 30. On June 30, Freddy’s makes the following adjusting entry:
LO 3
Accounts Receivable
2,200
Service Revenue
7,000
Jun 30 300 Jun 30 300
A B C D
1 Jun 30
2
Accounts Receivable
Service Revenue
300
300

3-37 LO 3
Advance slide in presentation mode to reveal answer
Suppose Freddy’s Auto Service, Inc. holds a note receivable
as an investment. At the end of June, $100 of interest revenue
has been earned. Journalize the accrued revenue adjustment
at June 30.
Answer:

3-38
Unearned Revenues
Receipt of cash before earning the revenue is recorded as a
liability called unearned revenues.
ADJUST THE ACCOUNTS
LO 3
 Customer deposits
 Airline tickets
Cash Receipt Revenue Recorded
BEFORE
 Magazine subscriptions
 Rent
Unearned revenues often occur in regard to:

3-39
Unearned Revenues
Suppose Home Depot engages Freddy’s Auto Service, Inc. to perform
routine oil changes on Home Depot trucks, agreeing to pay Freddy’s
$400 monthly, beginning immediately. If Freddy’s collects the first
amount on June 15, then Freddy’s records this transaction as follows:
LO 3
Cash
Jun 15 400
Unearned Service Revenue
Jun 15 400
A B C D
1 Jun 15
2
Cash
400
400

3-40
Unearned Revenues
The June 30 unadjusted trial balance lists Unearned Service Revenue
with a $400 credit balance. During the last 15 days of the month,
Freddy’s will earn one-half of the $400, or $200. On June 30, Freddy’s
makes the following adjustment:
LO 3
Service Revenue
7,000
Jun 15 400
A B C D
1 Jun 30
2
Service Revenue
200
200
Jun 30 200
Bal 200
Jun 30 300
Jun 30 200

3-41
Unearned Revenues
Prepaid Expenses
ADJUST THE ACCOUNTS
LO 3
Exhibit 3-6 | Prepaid Adjustments
PREPAIDS—Cash First
First – Pay cash and record an
asset:
Prepaid Expense XXX
Cash XXX
Later – Record an expense and
decrease the asset:
Expense XXX
Prepaid Expense XXX
Later – Record revenue and
decrease unearned revenue:
Unearned Revenue XXX
Revenue XXX
First – Receive cash and record
unearned revenue:
Cash XXX
Unearned Revenue XXX

3-42
Accrued Expenses
ADJUST THE ACCOUNTS
LO 3
Exhibit 3-6 | Accrual Adjustments
ACCRUALS—Cash Later
First – Accrue expense and a
payable:
Expense XXX
Payable XXX
Later – Pay cash and decrease the
payable:
Payable XXX
Cash XXX
Later – Receive cash and decrease
the receivable:
Cash XXX
Receivable XXX
First – Accrue revenue and a
receivable:
Receivable XXX
Revenue XXX
Accrued Revenues

3-43
Summary of the Adjusting Process
Two purposes of the adjusting process are to
■ measure income, and
■ update the balance sheet.
Therefore, every adjusting entry affects both of the following:
■ Revenue or expense—to measure income
■ Asset or liability—to update the balance sheet
ADJUST THE ACCOUNTS
LO 3

3-44 LO 3
Summary of Adjusting Process
Exhibit 3-7 | Summary of Adjusting Entries

3-45 LO 3
A B C D
1 Jun 30
2
3
Income Tax Expense
Income Tax Payable
600
600
Summary of Adjusting Process
Freddy’s Auto Service, Inc. would make an additional adjusting entry to
accrue income tax expense and the related income tax payable as the
final adjusting entry of the period. Freddy’s Auto Service, Inc. accrues
income tax expense as follows:
The income tax accrual follows the pattern for accrued expenses.

3-46 LO 3
Exhibit 3-8 | The Adjusting Process of Freddy’s Auto Service, Inc.

3-47 LO 3

3-48
The Adjusted Trial Balance
 Summarizes all accounts and their final balances after
all adjusting entries have been journalized and posted.
 Source for the preparation of the financial statements.
► Income statement
► Balance sheet
► Statement of retained earnings
ADJUST THE ACCOUNTS
LO 3

3-49
Exhibit 3-9 | Trial Balance Worksheet

3-50
Phoenix Equipment Rentals Company faced the following
situations. Journalize the adjusting entry needed at December
31, 2014, for each situation.
a. The business has interest expense of $1,200 that it must
pay early in January 2015.
A B C D
1 Dec 31
2
3
Interest Expense
Interest Payable
1,200
1,200
Illustration
LO 3

3-51
Expense Recognized =
Journalize the adjusting entry needed at December 31, 2014,
for each situation.
b. The unadjusted balance of the Supplies account is $3,200.
The total cost of supplies on hand is $1,500.
A B C D
1 Dec 31
2
3
Supplies Expense
Supplies
1,700
1,700
LO 3
$3,200 - $1,500 = $1,700
Illustration

3-52
for each situation.
c. Salary expense is $7,000 per day—Monday through
Friday—and the business pays employees each Friday. This
year, December 31 falls on a Wednesday.
A B C D
1 Dec 31
2
3
Salary Expense
Salary Payable
21,000
21,000
LO 3
$7,000 x 3 days = $21,000
Illustration

3-53
Revenue Recognized =
for each situation.
d. On July 1, 2014, when the business collected $15,000 rent
in advance, it debited Cash and credited Unearned Rent
Revenue. The tenant was paying for one years’ rent.
A B C D
1 Dec 31
2
3
Unearned Rent Revenue
Rent Revenue
7,500
7,500
LO 3
$15,000 x ½ year = $7,500
Illustration

3-54
for each situation.
e. Interest revenue of $900 has been earned but not yet
received.
A B C D
1 Dec 31
2
3
Interest Receivable
Interest Revenue
900
900
LO 3
Illustration

3-55
for each situation.
f. Equipment was purchased at the beginning of this year at a
cost of $50,000. The equipment’s useful life is five years.
There is no residual value. Record depreciation for this year.
LO 3
$50,000 ÷ 5 years = $10,000
A B C D
1 Dec 31
2
3
Depreciation Expense
Accumulated Depreciation
10,000
10,000
Illustration

3-56
for each situation.
f. Equipment was purchased at the beginning of this year at a
cost of $50,000. Determine the equipment’s book value.
Equipment $ 50,000
LO 3
Less: Accumulated Depreciation 10,000
Book value of equipment $ 40,000
Phoenix Equipment Rental Equipment at December 31, 2014
Illustration

3-57
3
Learning Objective
4. Construct the financial statements

3-58
The June
financial
statements of
Freddy’s Auto
Service, Inc. can
be prepared from
the adjusted trial
balance.
CONSTRUCT
THE
FINANCIAL
STATEMENTS
Exhibit 3-10 | Income Statement
Exhibit 3-11 | Statement of
Retained Earnings

3-59
CONSTRUCT THE FINANCIAL STATEMENTS
Exhibit 3-11 | Statement of
Retained Earnings
Exhibit 3-12 | Balance Sheet
LO 4

3-60
Classifying Assets and Liabilities Based on
Their Liquidity
 Cash is the most liquid asset.
 Accounts receivable are relatively liquid because cash
collections usually follow quickly.
 Inventory is less liquid because inventory must be sold.
 Equipment and buildings are even less liquid because
these assets are not for sale.
 Assets and liabilities are presented in order of liquidity.
LO 5

3-61
Their Liquidity
 Currents Assets
 Long-Term Assets
 Current Liabilities
 Long-Term Liabilities
LO 5
► Converted to cash, sold,
or consumed during the
next 12 months or within
the business’s normal
operating cycle if longer
than a year.

3-62
Their Liquidity
 Currents Assets
LO 5
► Land, Buildings, Furniture
and Fixtures, and
Equipment are plant
assets.
► Long-Term Investments,
Intangible Assets, and
Other Assets are also
long-term.

3-63
Their Liquidity
 Currents Assets
LO 5
► Debts that must be paid
within one year or within
the operating cycle if
longer than a year.
► Accounts Payable, Notes
Payable due within one
year, Salary Payable,
Unearned Revenue,
Interest Payable, and
Income Tax Payable are
current liabilities.

3-64
Their Liquidity
 Currents Assets
LO 5
► All liabilities that are not
current are classified as
long-term liabilities.
► Many notes payable are
long term.

3-65
Format for the Financial Statements
 Balance Sheet Formats
► Report
► Account
 Income Statement Formats
► Single-step
► Multi-step
LO 5

3-66 LO 5
Balance
Sheet
Report
Format

3-67 LO 5
Balance Sheet Account Format

3-68 LO 5
Income Statement Single-Step Format
Income tax expense may also be included with the expenses thus
eliminating the income before tax line.

3-69
Income Statement Multiple-Step Format

3-70
3
Learning Objective
6. Analyze and evaluate a company’s debt-paying
ability

3-71
Analyze and Evaluate a Company’s
Debt-Paying Ability
LO 6
Net Working Capital
 Total current assets - Total current liabilities
 To be considered sufficiently liquid, entities should
have a sufficient excess of current assets over
current liabilities.

3-72
Debt-Paying Ability
LO 6
Current Ratio
 Total current assets ÷ Total current liabilities
 Measures the company’s ability to pay current
liabilities with current assets.
 Most successful businesses operate with current
ratios between 1.20 and 1.50.

3-73
How Do Transactions Affect the Ratios?
LO 6
Current Ratio
a. Issued stock and received cash of $50 million.
A B C D
1
2
Cash
Common Stock
50
50
Cash, a current asset, affects the current ratio as follows:
After
Before

3-74
Debt-Paying Ability
LO 6
Debt Ratio
 Total liabilities ÷ Total assets
 Indicates the proportion of a company’s assets that is
financed with debt.
 Measures a business’s ability to pay both current and
long-term debts (total liabilities).
 A low debt ratio is safer than a high debt ratio.

3-75
How Do Transactions Affect the Ratios?
LO 6
Debt Ratio
a. Issued stock and received cash of $50 million.
A B C D
1
2
Cash
Common Stock
50
50
Cash, a current asset, affects the debt ratio as follows:
After
Before

3-76
Debt-Paying Ability
LO 6
Do These Transactions Affect the Ratios?
b. Paid cash to purchase buildings for $20 million.
c. Made a $30 million sale on account to a grocery chain.
d. Collected the account receivable, $30 million.
e. Accrued expenses at year end, $40 million.
f. Recorded depreciation, $80 million.
g. Earned interest revenue and collected cash, $40
million.

3-77
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