Accrual basis of accounting Chapter 3 Accrual basis of accounting © Cambridge Business Publishers

Accrual basis of accounting and contrasted with the cash basis with reference to revenue and expense recognition. © Cambridge Business Publishers

Accrual Accounting Required by GAAP Requires companies to measure and report accounting transactions without the necessity that cash has been received or paid Based on two primary principles: Revenue recognition Expense recognition (matching) Note: Cash Basis (Non-GAAP method used by individuals or some small businesses)– Revenues are recognized when cash is received and expenses are recorded when cash is paid © Cambridge Business Publishers

Revenue Recognition Principle Revenue is recognized when earned. Cash may be received at the same time revenue is recognized. Cash may be received after revenue is recognized. Cash may be received before revenue is recognized. Cash 100 Sales revenue Accounts receivable 100 Sales revenue Cash 100 Unearned revenue © Cambridge Business Publishers

Expense Recognition (Matching) Expenses incurred to generate revenue are recognized (matched) in the same time period. As with revenues, cash payment may occur at the same time, before, or after expense recognition. Wages Expense 75 Wages payable 75 Wages Payable 75 Cash 75 **Baking Supplies example © Cambridge Business Publishers

Select the correct answer. Which of the following is a primary principle underlying accrual accounting? Materiality Cash flows .Revenue recognition Income statement © Cambridge Business Publishers

The adjusting process. © Cambridge Business Publishers

The Unadjusted Trial Balance Mike’s Bikes Unadjusted Trial Balance December 31, 2016 Debit Credit Cash $40,000 Merch. inventory 3,000 Prepaid rent 6,000 Equipment 15,000 Accounts payable $3,000 Notes payable 20,000 Common stock 30,000 Sales revenue 12,000 Wages expense 1,000 ______ Totals $65,000 © Cambridge Business Publishers

Types of Adjustments Prepaid Expenses Unearned Revenue Allocating previously recorded assets to expense Prepaid Expenses Allocating previously recorded unearned revenue to earned revenue Unearned Revenue Recording operating expenses that have not yet been paid or recorded Accrued Expenses Recording revenue that has been earned, but not yet been received or recorded Accrued Revenues © Cambridge Business Publishers

deferral (prepaid) adjustments. © Cambridge Business Publishers

Allocating Previously Recorded Assets to Expenses (1) Mike’s Bikes determined the end-of-year merchandise inventory to be $500. This represents that amount of the $3,000 purchase that has not been used up, to generate December sales. Dec. 31 Cost of goods sold 2,500 Merch. inventory To record expense of merch. inventory used up. © Cambridge Business Publishers

Allocating Previously Recorded Assets to Expenses (2) Mike’s bikes prepaid one year of its $500 per month building rent. Dec. 31 Rent expense 500 Prepaid rent To record December building rent expense. © Cambridge Business Publishers

Allocating Previously Recorded Assets to Expenses (3) Mike’s Bikes purchased equipment for $15,000. The equipment is expected to have a useful life of five years, at which time is will be completely worthless. Monthly depreciation expense is computed as $15,000/60 months. Dec. 31 Depreciation expense 250 Accumulated depreciation—Equip. To record December depreciation expense on the equipment. © Cambridge Business Publishers

Allocating Previously Recorded Unearned Revenue to Earned Revenue When cash is received before it is earned, the liability account Unearned Revenue is credited. When the revenue is ultimately earned, the Unearned Revenue account is debited and an earned revenue account is credited. Assume the $100 was received in advance for bikes to be picked up the following week. Dec. 7 Cash 100 Unearned revenue To record cash received in advance. Dec. 14 Unearned revenue 100 Sales revenue To record sales revenue from an advanced payment. © Cambridge Business Publishers

accrual adjustments. © Cambridge Business Publishers

Recording Previously Unrecorded Expenses (4) Mike’s Bikes received a $20,000 bank loan with annual interest of six percent. The first annual interest payment is due November 30, 2017. Monthly interest expense is calculated as $20,000 x 0.06 x 1/12 Dec. 31 Interest expense 100 Interest payable To record December interest expense. © Cambridge Business Publishers

Recording Previously Unrecorded Revenue (5) Mike’s Bikes delivered an order for a $200 bike on December 31. The customer will not be paying for the bike until January 7th of the next year. Dec. 31 Accounts receivable 200 Sales revenue To record sales revenue for bike delivered but not paid for. © Cambridge Business Publishers

(1) Adjust Ending Merchandise Inventory Mike’s Bikes Adjusted Trial Balance December 31, 2016 Unadjusted Trail Balance Adjustments Debit Credit Cash $40,000 Accounts receivable (5) $200 200 Merchandise inventory 3,000 (1) $2,500 500 Prepaid rent 6,000 (2) 500 5,500 Equipment 15,000 Accumulated depreciation – Equip. (3) 250 $250 Accounts payable $3,000 Interest payable (4) 100 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,000 (5) 200 12,200 Cost of goods sold (1) 2,500 2,500 Wages expense 1,000 Rent expense (2) 500 Depreciation expense (3) 250 250 Interest expense ______ (4) 100 _____ Totals $65,000 $3,550 $65,550 © Cambridge Business Publishers

Adjusted Trial Balance (2) Record Rent Expense Mike’s Bikes Adjusted Trial Balance December 31, 2016 Unadjusted Trail Balance Adjustments Debit Credit Cash $40,000 Accounts receivable (5) $200 200 Merchandise inventory 3,000 (1) $2,500 500 Prepaid rent 6,000 (2) 500 5,500 Equipment 15,000 Accumulated depreciation – Equip (3) 250 $250 Accounts payable $3,000 Interest payable (4) 100 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,000 (5) 200 12,200 Cost of goods sold (1) 2,500 2,500 Wages expense 1,000 Rent expense (2) 500 Depreciation expense (3) 250 250 Interest expense ______ (4) 100 _____ Totals $65,000 $3,550 $65,550 © Cambridge Business Publishers

(3) Record Depreciation Expense Mike’s Bikes Adjusted Trial Balance December 31, 2016 Unadjusted Trail Balance Adjustments Debit Credit Cash $40,000 Accounts receivable (5) $200 200 Merchandise inventory 3,000 (1) $2,500 500 Prepaid rent 6,000 (2) 500 5,500 Equipment 15,000 Accumulated depreciation – Equip. (3) 250 $250 Accounts payable $3,000 Interest payable (4) 100 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,000 (5) 200 12,200 Cost of goods sold (1) 2,500 2,500 Wages expense 1,000 Rent expense (2) 500 Depreciation expense (3) 250 250 Interest expense ______ (4) 100 _____ Totals $65,000 $3,550 $65,550 © Cambridge Business Publishers

(4) Record Interest Expense Mike’s Bikes Adjusted Trial Balance December 31, 2016 Unadjusted Trail Balance Adjustments Debit Credit Cash $40,000 Accounts receivable (5) $200 200 Merchandise inventory 3,000 (1) $2,500 500 Prepaid rent 6,000 (2) 500 5,500 Equipment 15,000 Accumulated depreciation – Equip. (3) 250 $250 Accounts payable $3,000 Interest payable (4) 100 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,000 (5) 200 12,200 Cost of goods sold (1) 2,500 2,500 Wages expense 1,000 Rent expense (2) 500 Depreciation expense (3) 250 250 Interest expense ______ (4) 100 _____ Totals $65,000 $3,550 $65,550 © Cambridge Business Publishers

(4) Record Sales on Account Mike’s Bikes Adjusted Trial Balance December 31, 2016 Unadjusted Trail Balance Adjustments Debit Credit Cash $40,000 Accounts receivable (5) $200 200 Merchandise inventory 3,000 (1) $2,500 500 Prepaid rent 6,000 (2) 500 5,500 Equipment 15,000 Accumulated depreciation – Equip. (3) 250 $250 Accounts payable $3,000 Interest payable (4) 100 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,000 (5) 200 12,200 Cost of goods sold (1) 2,500 2,500 Wages expense 1,000 Rent expense (2) 500 Depreciation expense (3) 250 250 Interest expense ______ (4) 100 _____ Totals $65,000 $3,550 $65,550 © Cambridge Business Publishers

Complete Adjusted Trial Balance Mike’s Bikes Adjusted Trial Balance December 31, 2016 Unadjusted Trail Balance Adjustments Debit Credit Cash $40,000 Accounts receivable (5) $200 200 Merchandise inventory 3,000 (1) $2,500 500 Prepaid rent 6,000 (2) 500 5,500 Equipment 15,000 Accumulated depreciation – Equip. (3) 250 $250 Accounts payable $3,000 Interest payable (4) 100 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,000 (5) 200 12,200 Cost of goods sold (1) 2,500 2,500 Wages expense 1,000 Rent expense (2) 500 Depreciation expense (3) 250 250 Interest expense ______ (4) 100 _____ Totals $65,000 $3,550 $65,550 Total Adjustment Debits and Credits Complete Adjusted Trial Balance © Cambridge Business Publishers

Select the correct answer. The following is not a type of accrual adjustment? .Common stock Accrued expenses Prepaid expenses Unearned revenue © Cambridge Business Publishers

The adjusted trial balance and use it to prepare financial statements. © Cambridge Business Publishers

Prepare Financial Statements The adjusted trial balance provides the necessary information. Prepare the statements in the following order: Income Statement Statement of Stockholders’ Equity Balance Sheet Statement of Cash Flows © Cambridge Business Publishers

Prepare the Income Statement Mike’s Bikes Adjusted Trial Balance December 31, 2016 Debit Credit Cash $40,000 Accounts receivable 200 Merchandise inventory 500 Prepaid rent 5,500 Equipment 15,000 Accumulated depr. – Equip $250 Accounts payable 3,000 Interest payable 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,200 Cost of goods sold 2,500 Wages expense 1,000 Rent expense Depreciation expense 250 Interest expense Totals $65,550 Mike’s Bikes Income Statement For Month Ended December 31, 2016 Sales revenue $12,200 Expenses Cost of goods sold $2,500 Wages expense 1,000 Rent expense 500 Depreciation expense 250 Interest expense 100 Total expense 4,350 Net income $7,850 Net income will be an input for the statement of stockholders’ equity prepared next. © Cambridge Business Publishers

Prepare the Statement of Stockholders’ Equity Mike’s Bikes Adjusted Trial Balance December 31, 2016 Debit Credit Cash $40,000 Accounts receivable 200 Merchandise inventory 500 Prepaid rent 5,500 Equipment 15,000 Accumulated depr.– Equip. $250 Accounts payable 3,000 Interest payable 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,200 Cost of goods sold 2,500 Wages expense 1,000 Rent expense Depreciation expense 250 Interest expense Totals $65,550 Mike’s Bikes Statement of Stockholders’ Equity For Month Ended December 31, 2016 Common Stock Retained Earnings Total Balance, December 1, 2013 $0 Add: Common stock issued in December 30,000 Net income for December 7,850 Less: Dividends in December Balance, December 31, 2013 $30,000 $7,850 $37,850 From Income Statement Retained earnings will be an input on the balance sheet prepared next. © Cambridge Business Publishers

Prepare the Balance Sheet Mike’s Bikes Adjusted Trial Balance December 31, 2016 Debit Credit Cash $40,000 Accounts receivable 200 Merchandise inventory 500 Prepaid rent 5,500 Equipment 15,000 Accumulated depr. – Equip. $250 Accounts payable 3,000 Interest payable 100 Notes payable 20,000 Common stock 30,000 Sales revenue 12,200 Cost of goods sold 2,500 Wages expense 1,000 Rent expense Depreciation expense 250 Interest expense Totals $65,550 Mike’s Bikes Balance Sheet December 31, 2016 Assets Cash $40,000 Accounts receivable 200 Supplies inventory 500 Prepaid rent 5,500 Total current assets $46,200 Equipment 15,000 Accumulated depr. – Equip. (250) Equip. – net 14,750 Total assets $60,950 Liabilities Accounts payable $3,000 Interest payable 100 Total current liabilities $3,100 Notes payable 20,000 Total liabilities 23,100 Stockholders’ Equity Common stock 30,000 Retained earnings 7,850 Total stockholders’ equity 37,850 Total liabilities and stockholders’ equity © Cambridge Business Publishers

Select the correct answer. The first financial statement to be prepared is: .Income statement Balance sheet Statement of cash flows Statement of stockholders’ equity © Cambridge Business Publishers

The closing process and the accounting cycle. © Cambridge Business Publishers

Permanent and Temporary Accounts Permanent accounts are accounts whose balances carry over from one accounting period to the next. Accounts on the balance sheet Temporary accounts are used to gather information for a particular accounting period and then reset to zero by transferring the balance to a permanent account. Permanent Accounts Temporary Accounts Assets Revenues Liabilities Expenses Common Stock Dividends Retained Earnings Income Summary © Cambridge Business Publishers

Closing Process Temporary accounts are zeroed out at the close of the accounting period in order to “start fresh” in the next period. The balances in these accounts are transferred to Retained Earnings—a permanent account. Dividends are also closed to Retained Earnings © Cambridge Business Publishers

Closing Process Illustrated Dec. 31 Sales revenue 12,200 Retained earnings To close the revenue accounts. 4,350 Cost of goods sold 2,500 Wages expense 1,000 Rent expense 500 Depreciation expense 250 Interest expense 100 To close the expense accounts. © Cambridge Business Publishers

Post-Closing Trial Balance A post-closing trial balance is prepared once the temporary accounts have been closed to Retained Earnings. Mike’s Bikes Adjusted Trial Balance December 31, 2016 Debit Credit Cash $40,000 Accounts receivable 200 Merchandise inventory 500 Prepaid rent 5,500 Equipment 15,000 Accumulated depreciation—Equipment $ 250 Accounts payable 3,000 Interest payable 100 Notes payable 20,000 Common stock 30,000 Retained earnings ______ 7,850 Totals $61,200 © Cambridge Business Publishers

Select the correct answer. The following is a true statement regarding the closing process: Dividends are closed to retained earnings by crediting retained earnings. .Revenues are closed to retained earnings by crediting retained earnings. Expenses are closed to retained earnings by crediting retained earnings. Revenues are closed to retained earnings by debiting retained earnings. © Cambridge Business Publishers

Quality of Accounting Numbers The degree to which a company’s financial statements reflect its true financial condition and performance. Accrual accounting involves many estimates and judgments. Analyst judge how conservative or aggressive the estimates are. The more conservative the estimates, the higher the company’s quality of earnings is judged to be. © Cambridge Business Publishers

Appendix 3A Learning Objective 7 The process of closing to the Income Summary account and summarizing the accounting cycle. © Cambridge Business Publishers

Closing Using Income Summary Temporary accounts are zeroed out at the close of the accounting period in order to “start fresh” in the next period. The balances in these accounts are ultimately transferred to Retained Earnings—a permanent account. A summary account, such as Income Summary, can be used to help in the closing process Any temporary account with a debit balance is credited with the offsetting debit to Income Summary Any temporary account with a credit balance is debited with the offsetting credit to Income Summary Income Summary is then closed to Retained Earnings Dividends are also closed to Retained Earnings © Cambridge Business Publishers

Closing Process Using Income Summary —Illustration— Dec. 31 Sales revenue 12,200 Income summary To close the revenue accounts. 4,350 Cost of goods sold 2,500 Wages expense 1,000 Rent expense 500 Depreciation expense 250 Interest expense 100 To close the expense accounts. 7,850 Retained earnings To close the Income Summary account. © Cambridge Business Publishers

Appendix 3B Learning Objective 8 how to use a worksheet in the adjusting and closing process. © Cambridge Business Publishers

Using a Worksheet A worksheet using a program such as Microsoft Excel may be used to facilitate the adjusting and closing process. The worksheet is a tool; it is not part of the formal accounting records. © Cambridge Business Publishers

Corporate Social Responsibility Investors appear to care about more than just reported income. Company’s with higher quality of earnings and higher perceived corporate social responsibility outperformed the Standard and Poor’s 500 Index. © Cambridge Business Publishers

© Cambridge Business Publishers