Transcript Accrual Accounting and the Financial Statements Chapter 3 1

Accrual Accounting and the
Financial Statements
Chapter 3
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Learning Objective 1
Relate accrual accounting and cash flows.
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Accrual Accounting vs Cash
Basis of Accounting
 Cash Basis – records transactions only as
cash is received or paid
 Accrual Accounting - records the impact of a
business event as it occurs
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The Time-Period Concept
Financial statements are prepared for specific
periods and at regular intervals:
–
–
–
Monthly
Quarterly
Annually
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Learning Objective 2
Apply the revenue and matching principles.
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Revenue Principle
 Revenue is recorded when it is earned,
rather than when cash is received.
 The amount of revenue to record is the cash
value of goods transferred to the customer.
 What do you think we would do if revenue
had been earned, but it’s collectability was
uncertain?
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The Matching Principle
 Record all expenses when incurred during
the accounting period, rather than when
paid
 Match incurred expenses for the accounting
period against revenues earned
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Learning Objective 3
Adjusting the accounts at period end for
Deferrals, Accruals, and Depreciation
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Air & Sea Unadjusted Trial
Balance April 30, 20x3
Account
Cash
Accounts receivable
Supplies
Prepaid rent
Furniture
Accounts payable
Unearned service revenue
Common stock
Retained earnings
Dividends
Service revenue
Salary expense
Utilities expense
Total
Debit
$24,800
2,250
700
3,000
16,500
Credit
13,100
450
20,000
11,250
3200
$7,000
950
400
$51,800
$51,800
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Categories of Accounting
Adjustments
 Deferrals
 Depreciation
 Accruals
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Prepaid Expenses: Rent
On April 1, 20x3, Air & Sea Travel prepays
three months office rent, creating an asset.
Prepaid Rent
3,000
Cash
3,000
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Prepaid Expenses: Rent
What is the adjusting entry on April 30, after
one month?
Date
General Journal
Accounts and Explanations
PR
April 30 Rent Expense
Prepaid Rent
To record rent expense
($3,000 x 1/3)
Debit
Credit
1,000
1,000
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Prepaid Expenses: Supplies
On April 2, 20x3, Air & Sea Travel paid cash of
$700 for office supplies, creating an asset.
Supplies
700
Cash
700
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Prepaid Expenses: Supplies
An inventory at month end indicated that $400
of the original $700 in office supplies
remained. ($300 of supplies were
consumed):
Supplies
4/2 700 4/30 300
Bal. 400
Supplies Expense
4/30 300
Bal. 300
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Depreciation
 Allocation of the cost of a plant asset to
expense over the asset’s useful life
 On balance sheet, original cost less
accumulated depreciation over the years is
called the asset’s book value
 Depreciation is not a valuation process:
book value is not likely to equal fair market
value [what asset could be sold for]
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Depreciation of Plant Assets
On April 3, the business purchased furniture
on account for $16,500. The furniture is
expected to last 5 years.
Furniture
16,500
Accounts Payable
16,500
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Depreciation of Plant Assets
 Straight-line method of depreciation
allocates equal amounts of the asset cost to
each accounting period:
 $16,000 ÷ 5 years = $3,300 per year
 $3,300 ÷12 months = $275 per month
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Depreciation of Plant Assets
What is the adjusting entry on April 30?
Date
General Journal
Accounts and Explanations
PR
April 30 Depreciation Expense, Furniture
Accumulated Depreciation,
Furniture
To record depreciation at month end
Debit
Credit
275
275
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Book Value
The net amount of a plant asset (cost minus
accumulated depreciation)
Plant Assets of Air & Sea at April 30, 20x5
Furniture
$
16,500
Less Accumulated Depreciation
(275) $
Building
$
48,000
Less Accumulated Depreciation
(200)
Book value of plant assets
$
16,225
47,800
64,025
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Accrued Expense
 A liability that arises from an expense that has not
yet been paid.
 Air & Sea Travel pays its employees a monthly
salary of $1,900, half on the 15th and half on the
last day of the month. If a payday falls on the
weekend, Air & Sea pays the employee on the
following Monday.
 Assume that April 30 is a Saturday in the following
example…
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Accrued Expenses
Salary Expense
4/15 950
4/30 950
Bal. 1,900
Cash
4/15 950
Salary Payable
4/30 950
Bal. 950
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Accrued Revenue
 A revenue that has been earned but not yet
received in cash.
 Bank One hires Air & Sea Travel on April 15
to arrange travel services on a monthly
basis. Bank One will pay the travel agency
$500 monthly, with the first payment on May
15.
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Accrued Revenues
Adjusting entry:
Date
General Journal
Accounts and Explanations
PR
April 30 Accounts Receivable
Service Revenue
To accrue ½ month of service revenue
Debit
Credit
250
250
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Unearned Revenue
 An obligation arising from receiving cash before
providing a service.
 This creates a liability—an obligation to provide
services in the future.
 Plantation Foods engages Air & Sea Travel
agreeing to pay the agency $450 monthly,
beginning immediately. Air & Sea Travel collects
the first $450 on April 20 and earns one-third of
the first cash payment in the last 10 days.
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Unearned Revenues
Date
General Journal
Accounts and Explanations
PR
April 20 Cash
Unearned Revenue
Received advance payment
Date
General Journal
Accounts and Explanations
PR
April 30 Unearned Revenue
Revenue
To record revenue earned
($450 x 1/3)
Debit
Credit
450
450
Debit
Credit
150
150
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Air & Sea Travel
Work Sheet
For the Month Ended April 30, 20x5
Unadjusted Trial
Account
Balance
Adjustments
Title
Debit
Credit
Debit
Credit
Cash
24,800
Accounts receivable
2,250
e.
250
Supplies
700
b. 300
Prepaid rent
3,000
a. 1000
Furniture
16,500
Accum depr, furn
c. 275
Accounts payable
13,100
Salary payable
d. 950
Income tax payable
g. 540
Unearned svc rev.
450 f.
150
Common stock
20,000
Retained earnings
11,250
Dividends
3200
Service revenue
$7,000
e. 250
f. 150
Salary expense
950
d.
950
Rent expense
a.
1000
Supplies expense
b.
300
Depr. Exp, furn.
c.
275
Utilities expense
400
Income tax expense
g.
540
Total
$51,800 $51,800
3,465
3,465
Step 2
Plan
Adjustments
Step 2
Prepare Adjusted
Trial Balance
Adjusted Trial
Balance
Debit
Credit
24,800
2,500
400
2,000
16,500
275
13,100
950
540
300
20,000
11,250
3,200
$7,400
Step 1
Prepare
Unadjusted
Trial Balance
1,900
1,000
300
275
400
540
53,815
53,815
Learning Objective 4
Prepare the financial statements.
The following income statement is in “single
step form.”
The following balance sheet is in “account
form.”
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Air & Sea Travel, Inc.
Income Statement
Month Ended April 30, 20x5
Revenue:
Service revenue
Expenses:
Salary expense
$1,900
Rent expense
1,000
Utilities expense
400
Supplies expense
300
Depreciation expense
275
Income before tax
Income tax expense
Net income
$7,400
3,875
$3,525
540
$2,985
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Air & Sea Travel, Inc.
Statement of Retained Earnings
Month Ended April 30, 20x5
Retained earnings, April 1, 20x5
Add: Net income
Less: Dividends
Retained earnings, April 30, 20x5
$11,250
2,958
$14,235
( 3,200)
$11,035
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Air & Sea Travel, Inc.
Balance Sheet
April 30, 20x5
Assets
Cash
$24,800
Accounts receivable
2,500
Supplies
400
Prepaid rent
2,000
Furniture
$16,500
Less:
Accumulated
depreciation ( 275) 16,225
Total assets
$45,925
Liabilities
Accounts payable
$13,100
Salary payable
950
Unearned revenue
300
Income tax payable
540
Total liabilities
$14,890
Stockholders’ Equity
Common stock
$20,000
Retained earnings
11,035
Total
$31,031
Total liabilities and
stockholders’ equity $45,925
Learning Objective 5
Close the books.
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Closing Entries
 Prepare the accounts for the next period’s
transactions.
 Transfer the revenue, expense, and
dividends balances to Retained Earnings.
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Which Accounts
Need To Be Closed?
 Temporary (nominal) accounts are closed to
retained earnings.
– Revenue
– Expense
– Dividends, but dividends are not an expense; rather
they are a distribution of earnings
 Permanent (real) accounts are not closed, but are
carried forward to future periods
– Assets
– Liabilities
– Stockholders’ equity
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Journalizing the Closing Entries
General Journal
Date
April 30
April 30
April 30
Accounts and Explanations
PR
Debit
Service Revenue
Retained Earnings
7,400
Retained Earnings
Rent Expense
Salary Expense
Supplies Expense
Depreciation Expense
Utilities Expense
Income Tax Expense
4,415
Retained Earnings
Dividends
3,200
Credit
7,400
1,000
1,900
300
275
400
540
3,200
Posting the Closing Entries
Rent Expense
1,000 1,000
Salary Expense
950
950
1,900 1,900
Other Expenses
1,515 1,515
Retained Earnings
4,415 11,250
3,200
7,400
11,035
Service Revenue
7,000
250
150
7,400 7,400
Dividends
3,200 3,200
Classifying Assets and Liabilities
 The balance sheet should list assets and
liabilities in order of their relative liquidity.
 Liquidity –
– How quickly an asset can be converted to cash.
– How quickly a liability will require payment of
cash.
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Classifying Assets and Liabilities
Current assets
Long-term assets
Current liabilities
Long-term liabilities
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Balance Sheet Formats
 Report format lists assets in comparative form,
followed by liabilities and equity in comparative
form (see text Exhibit 3-14)
– Most widely used in practice
– Allows trend analysis of accounts
– e.g. Callaway Golf’s cash can readily be seen (Ex 3-14)
to have decreased from $108m to $47m in 2003
 Account format
– Exemplified in text Exhibit 3-12
– Note this is a “T account” format
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Income Statement Formats
 Multi-step (Exhibit 3-15)
– Reports sub totals
– e.g. gross profit, income from continuing operations,
income pre tax, tax expense, net income.
 Single step (Exhibit 3-10)
– Lists all pre tax revenues under a heading
– Lists all pre tax expenses under a heading
– One subtraction of total revenues from total expenses to
arrive at income pre tax
– This is followed by tax expense, and net income
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Learning Objective 6
Use the current ratio and the debt ratio to
evaluate a business.
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Current Ratio
 Measures company’s ability to pay current
liabilities with current assets
Total current assets
Total current liabilities
Rule of thumb: A strong current ratio is 2.00
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Debt Ratio
 The percentage of total assets financed with
debt.
 Measures business’s ability to pay total
liabilities
 A company with a high percentage of debt to
assets is said to be highly leveraged.
Total liabilities
Total assets
A low debt ratio is safer than a high debt ratio.
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