Accrual Accounting & Income Chapter 3 Chapter 3 addresses Accrual Accounting and Income. ©2008 Pearson Prentice Hall. All rights reserved.

Accrual vs. Cash-Basis Accounting Records business transactions when they occur When sale is made When bill is received Complies with GAAP Presents accurate financial picture CASH Records transactions only when cash is received or paid When customer pays for product or service When bills are paid Only used by very small businesses Omits important info Accrual accounting records the impact of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the accountant records the transaction even if it receives or pays no cash. Cash-basis accounting records only cash transactions cash — cash receipts and cash payments. Cash receipts are treated as revenues, and cash payments are handled as expenses. Generally accepted accounting principles (GAAP) require accrual accounting. The business records revenues as the revenues are earned and expenses as the expenses are incurred—not necessarily when cash changes hands. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 1 Relate accrual accounting and cash flows The first learning objective is to relate accrual accounting and cash flows. ©2008 Pearson Prentice Hall. All rights reserved.

Accrual Accounting and Cash Flows Accrual accounting records both cash and non-cash transactions Cash Collecting from customers Paying for expenses Borrowing money Issuing Stock Non-cash Sales on account Purchases on account Using prepaid expenses, such as supplies Accrual accounting is more complex—and more complete—than cash-basis accounting. Accrual accounting records cash transactions, such as: ■ Collecting cash from customers ■ Borrowing money ■ Receiving cash from interest earned ■ Paying off loans ■ Paying salaries, rent, and other expenses ■ Issuing stock Accrual accounting also records noncash transactions, such as: ■ Sales on account ■ Depreciation expense ■ Purchases of inventory on account ■ Usage of prepaid rent, insurance, and supplies ■ Accrual of expenses incurred but not yet paid ■ Earning of revenue when cash was collected in advance ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Time-Period Concept Businesses do not stop operations to measure financial transactions Accountants prepare financial statements at regular intervals to measure performance Companies select a twelve-month period for reporting purposes: Calendar year Fiscal year Accountants prepare financial statements for specific periods. The time-period concept ensures that accounting information is reported at regular intervals. The basic accounting period is one year, and virtually all businesses prepare annual financial statements. Over half of large companies use the calendar year from January 1 through December 31. A fiscal year ends on a date other than December 31. Most retailers use a fiscal year that ends on January 31 because the low point in their business activity falls, after Christmas. Companies also prepare financial statements for interim periods of less than a year, such as a month, a quarter (3 months), or a semiannual period (6 months) ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 2 Apply the revenue and matching principles The second learning objective is to apply the revenue and matching principles ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. The Revenue Principle Revenue is recorded when earned When product or service is delivered to customer Cash may come before, at the same time, or after delivery Revenue is recorded at the cash value of goods or services provided When should you record revenue? After it has been earned—and not before. In most cases, revenue is earned when the business has delivered a good or service to a customer. It has done everything required to earn the revenue by transferring the good or service to the customer. When the company is paid for the revenue varies. Sometimes customers pay before the product or service is provided. Other times, customers pay after the product or services is provided (accounts receivable). Regardless of the timing of the cash receipt, revenue should be recognized when earned. ©2008 Pearson Prentice Hall. All rights reserved.

The Matching Principle Expenses are incurred to help produce revenue Expenses should be recorded in the time period in which they are incurred Expenses should be matched to the revenues they help produce The matching principle is the basis for recording expenses. Expenses are the costs of assets used up, and of liabilities created, in the earning of revenue. While expenses have no future benefit to the company, they are necessary costs of running a business and help generate revenue. The matching principle includes two steps: 1. Identify all the expenses incurred during the accounting period. 2. Measure the expenses, and match expenses against the revenues earned. To match expenses against revenues means to subtract expenses from revenues to compute net income or net loss. EXPENSES REVENUES ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Expenses May be paid in cash Paying monthly rent May arise from using up an asset Using supplies previously purchased May arise from creating a liability Receive a bill from a supplier Some expenses are paid in cash, such as paying monthly rent. Other expenses arise from using up an asset such as supplies. Still other expenses occur when a company creates a liability. For example, a company uses electricity continuously. When the company receives the bill from the electric company, it records the expense and a liability. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Learning Objective 3 Adjust the accounts The third learning objective is to adjust the accounts. ©2008 Pearson Prentice Hall. All rights reserved.

The Adjustment Process At the end of the period, a business prepares financial statements Ensures that: All revenue that has been earned has been recorded All expenses that have been incurred are matched to revenues Asset and liability accounts are up-to-date At the end of an accounting period (month, quarter or year), a company prepares financial statements. Adjustments are made to several account to make sure that all revenue earned has been recorded. Also, all expenses that have been incurred must be recorded and matched to revenues. Further, certain asset and liability accounts must be adjusted so their balances are up-to-date. ©2008 Pearson Prentice Hall. All rights reserved.

Categories of Adjusting Entries Deferrals Depreciation Accruals Adjusting entries fall into three major categories – deferrals, depreciation and accruals. 3-12 ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Deferrals Cash has already been received or paid Related expense or revenue has not yet been recorded Prepaid expenses Company has paid for expense in advance Adjustment needed to record amount used Unearned revenues Customer pays in advance for good or service Adjustment needed to record amount of revenue earned Deferrals are transactions where the cash has already been received or paid. However, the related expense or revenue has not yet been recorded. Prepaid expenses are when a company pays in advance for an expense, such as rent or insurance. When the cash was paid, a prepaid asset account was debited. At the end of the period, an adjustment is need to record the amount of the prepaid asset that has expired or been used. Conversely, unearned revenues occur when a customer prepays for a good or service. When the cash was received, an unearned revenue (a liability) account was credited. At the end of the period, an adjustment is need to record the amount of revenue earned. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Prepaid Expenses Expenses paid in advance Include prepaid rent and supplies Asset is recorded when purchased Adjustment needed to record amount used Let’s look closer at prepaid expenses. Some common accounts are “prepaid rent” and “supplies”. When these items are paid for and asset is recorded. An adjustment is needed at the end of the period to reflect the amount used or expired. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Prepaid Rent Example Suppose on April 1 on a company paid $12,000 for one year’s rent in advance JOURNAL Date   Accounts Debit Credit 1-Apr Prepaid rent $12,000 Cash Let’s say a company paid $12,000 for one year’s rent in advance on April 1. The entry on April 1 to record this transaction would include a debit to “prepaid rent”, an asset. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Prepaid Rent Example Now, it’s December 31, the company’s year-end The amount of rent that has expired must be recorded This amount is recorded as rent expense Prepaid rent (asset) needs to be reduced so it reflects the amount of rent remaining On December 31, the company’s year-end, an adjustment is need to record the amount of rent that has expired. This amount will be recorded as rent expense. In addition, the prepaid rent account needs to be reduced so its balance reflects the amount of rent remaining. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. $12,000 Prepaid Rent $9,000 $3,000 December 31 April 1, following year April 1, current year April 1 to December 31 = 9 months 3 out of 12 months of rent remains The line on this diagram represents the twelve-month period that the prepaid rent covers. December 31 falls nine months after the $12,000 of prepaid rent was recorded. Therefore, 9 months of the prepaid rent account has expired. 9/12 of $12,000 is $9,000. This amount will be recorded as rent expense. Three months of prepaid rent remains - January through March of the next year. After adjustment, prepaid rent should equal three months or $3,000. 9 out of 12 months of rent has expired 3/12 x $12,000 = $3,000 9/12 x $12,000 = $9,000 3-17 ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Prepaid Rent Example Dec 31 – Adjust Prepaid Rent account for amount expired JOURNAL Date   Accounts Debit Credit 12-31 Rent Expense $9,000 Prepaid Rent The adjusting entry needed has a debit to rent expense and a credit to prepaid rent for $9,000. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Prepaid Rent Rent Expense Apr 1 $12,000 Dec 31 $9,000 Dec 31 $9,000 Represents amount expired $3,000 Represents amount remaining End-of-year balance T-Accounts show the result of the adjusting entry. Originally, when the company paid for the rent, prepaid rent was debited for $12,000. When this adjusting entry is posted, $9,000 is recorded in rent expense and prepaid rent is decreased by the same amount. The ending balances show that rent expense equals the amount of rent expired (April 1 – December 31) and that prepaid rent equals the amount remaining – $3,000 – for the first three months of the next calendar year. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Supplies Example Suppose a company purchased $3,200 of supplies during the year The asset “supplies” was debited for each purchase At the end of the year, a physical count reveals $500 of supplies on hand Supplies is another common type of prepaid expense. The supplies account, an asset, is debited each time a company buys supplies. However, companies usually do not make entries to record each time a supply is used. Instead, a physical count of supplies is taken at year end. In the example above, a company purchased $3,200 of supplies during the year. At the end of the year, $500 of supplies remained. ©2008 Pearson Prentice Hall. All rights reserved.

Supplies Example Supplies $3,200 $500 Balance per ledger What amount of supplies was used? Balance per ledger Balance per physical count $500 One of the purposes of adjusting entry is to ensure that asset accounts are reported at their proper balances. The supplies account should equal the actual amount of supplies on hand. Before adjustment, the supplies account has $3,200 in it. The correct balance is $500. We can “back into” the amount of supplies used by subtracting the amount on hand ($500) from the amount in the accounting records ($3,200). The company used $1,700 of supplies. Subtract the balance per count from the balance per ledger ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Supplies Example Dec 31 – Adjust Supplies account for amount used JOURNAL Date   Accounts Debit Credit 12-31 Supplies Expense $1,700 Supplies The adjusting entry need has a debit to supplies expense and a credit to supplies for $1,700. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Supplies Supplies Expense $3,200 Dec 31 $1,700 Dec 31 $1,700 Represents amount used $500 Represents amount on hand End-of-year balance T-Accounts show the impact of the adjusting entry. After it’s posted, supplies expense equals the amount of supplies used during the year and supplies (asset) equals the amount of supplies on hand at the end of the year. ©2008 Pearson Prentice Hall. All rights reserved.

Depreciation of Plant Assets Allocation of plant assets cost over their useful lives Results in a debit to an expense Depreciation Expense Corresponding credit Accumulated Depreciation Most companies own plant asset, such as buildings, furniture, equipment and vehicles. The cost of these plant assets is allocated over their useful lives to expense. This process is called depreciation. To record depreciation, depreciation expense is debited and accumulated depreciation is credited. ©2008 Pearson Prentice Hall. All rights reserved.

Accumulated Depreciation Account that shows the sum of depreciation expense of the plant asset Contra-asset Always has a companion account Normal credit balance Accumulated depreciation represents the cumulative total of depreciation expense recoded. It is a contra-asset. Contra-asset accounts never “stand alone”. They are always paired with a companion account. The contra account is subtracted from its companion account. Therefore, its normal balance is opposite of the companion account. So, accumulated depreciation has a normal credit balance. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Depreciation Example A company purchases equipment for $50,000 The estimated useful life of the equipment is five years The simplest way to compute depreciation is to divide the asset’s cost by its estimated life. This is called straight-line depreciation. For example, let’s say a company purchases equipment for $50,000 and assigns it a useful life of five years. Annual depreciation expense would be $5,000 – the $50,000 cost of the equipment divided by the five year life. $5,000 annual depreciation 50,000/5 years = ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Depreciation Example Dec 31 – Adjusting entry to record depreciation of equipment JOURNAL Date   Accounts Debit Credit 12-31 Depreciation Expense $5,000 Accumulated Depreciation The adjusting entry to record depreciation of the equipment would include a debit to depreciation expense and a credit to accumulated depreciation of $5,000. ©2008 Pearson Prentice Hall. All rights reserved.

Depreciation – Balance Sheet Plant assets: Equipment $50,000 Less: Accum. Depr. (5,000) $45,000 On the balance sheet, accumulated depreciation would be listed below the equipment as a reduction. The $5,000 accumulated depreciation balance is subtracted from the $50,000 cost. The result is net equipment of $45,000. Each year the accumulated depreciation account would increase by $5,000 until the net amount of equipment would be zero. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Accrued Expenses Expense incurred before cash is paid Result in a liability Common accrued expenses: Salaries Interest Taxes Another type of adjusting entry is accrued expenses. These occur when an expense is incurred before it is paid. Contrast this to prepaid expenses, when the company pays an expense before it is incurred. Accrued expense result in a liability – a payable account. Some common accrued expense are salaries, interest and taxes. ©2008 Pearson Prentice Hall. All rights reserved.

Accrued Salary Expense Example A company pays its employees a weekly salary each Friday Salaries for each week total $10,000 December 31, the company’s year-end, falls on a Wednesday An example of accrued salaries will show how the adjustment works. Let’ say a company pays its employees each Friday and weekly salaries total $10,000. This year, December 31 falls on a Wednesday. Pay day won’t occur until Friday, which would be in the next calendar year. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. $10,000 Salaries $6,000 $4,000 Friday, January 2 pay day Monday, December 29 Wednesday, December 31 year end Monday through Wednesday = 3 days The line above represents the five-day work week. The $10,000 of salaries needs to be allocated between the current year and the upcoming year. A vertical line is drawn on December 31. For accounting purposes, everything stops on this day. All expenses incurred before “the line” must be recorded. Three out of the five days of salaries expense needs to be recorded. This amounts to $6,000. 3 out of 5 days of salaries expense has been incurred 3/5 x $10,000 = $6,000 ©2008 Pearson Prentice Hall. All rights reserved.

Accrued Salary Expense Example Dec 31 – Record accrued salary expense JOURNAL Date   Accounts Debit Credit 12-31 Salary expense $6,000 Salary payable The adjusting entry to record the accrued salaries has a debit to salary expense and a credit to salary payable. The company owes employees for the work they have provided. On January 2, pay day, the company will satisfy this liability. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Accrued Revenues Companies often earn revenue before cash is received Results in an accrued revenue Receivable recorded Companies also have accrued revenues. Like accrued expenses, the cash portion of the transactions has not yet occurred. With accrued revenues, the company has earned the revenue, but has not yet received the cash. Therefore, an adjustment is needed to record the revenue earned and the future collection of cash – a receivable. ©2008 Pearson Prentice Hall. All rights reserved.

Accrued Revenue Example A company performed services for customers during the last week of the year totaling $5,000 The revenue has not yet been recorded because the customers won’t be billed until January An example will demonstrate how to account for accrued revenues. A company performed services for customers during the last week of the year. The amount of revenue earned was $5,000. Since the clients won’t be billed until the following year, no revenue has yet been recorded. ©2008 Pearson Prentice Hall. All rights reserved.

Accrued Salary Expense Example Dec 31 – Record accrued revenue JOURNAL Date   Accounts Debit Credit 12-31 Accounts Receivable $5,000 Service Revenue To record the accrued revenue, an adjusting entry is prepared debiting accounts receivable and crediting service revenue. Note that this is the same entry that is made during the year to record revenue on account. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Unearned Revenues Recorded as a liability when company receives payment Company owes customer product or service Revenue is not recorded until earned When company provides product or service An adjusting entry is made to transfer amount from unearned revenue to revenue While accrued revenues record revenue earned but not yet received, unearned revenues are when the company receives cash before the revenue has been earned. When the company receives cash, a liability is recorded – called unearned revenue. This liability is different than many payables. The company does not owe money, it owes a product or service to the customer who prepaid. At the end of the period, an adjustment is necessary to record the amount of revenue that has been earned. The amount earned is transferred from the unearned revenue account to a revenue account. ©2008 Pearson Prentice Hall. All rights reserved.

Unearned Revenue Example On November 1, a company receives a customer payment of $18,000 for services to be performed during the next three months An example will show how to account for unearned revenues. On November 1 a company received $18,000 from a customer for services to be performed for the next three months. In other words, the customer prepaid for the service. The cash came before the revenue. ©2008 Pearson Prentice Hall. All rights reserved.

Unearned Revenue Example Nov 1 – Record advance payment received by customer JOURNAL Date   Accounts Debit Credit 11-1 Cash $18,000 Unearned revenue On November 1, the company would debit cash to record the prepayment. The credit would be to unearned revenue – a liability. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. $18,000 $12,000 $6,000 December 31 January 31, following year November 1, current year November 1 to December 31 = 3 months 1 out of 3 months remains unearned The line above represents the three months for which the customer paid in advance. December 31 falls two months after the receipt of cash. Therefore, two out of three months of the unearned revenue is now earned. Two-thirds of 18,000 equals $12,000. $6,000 of the payment remains unearned. 2 out of 3 months of revenue has been earned 1/3 x $18,000 = $6,000 2/3 x $18,000 = $12,000 ©2008 Pearson Prentice Hall. All rights reserved.

Unearned Revenue Example Dec 31 – Record portion of unearned revenue that has been earned JOURNAL Date   Accounts Debit Credit 12-31 Unearned revenue $12,000 Service revenue The adjusting entry to record the portion earned would debit unearned revenue for $12,000. This reduces the liability. The credit is to service revenue. Until this point, no revenue had been recorded. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Unearned Revenue Service Revenue Dec 31 $12,000 Nov 1 $18,000 Dec 31 $12,000 Represents amount earned $6,000 Represents amount unearned End-of-year balance T-accounts illustrate how the adjustment impacted the accounts. On November 1, $18,000 was credited to the liability account unearned revenue. There was no amount in service revenue related to this receipt. After the adjustment is posted, service revenue has a balance of $12,000 representing the two month of revenue earned. Unearned revenue has an ending balance of $6000, representing the portion still unearned at December 31. ©2008 Pearson Prentice Hall. All rights reserved.

Summary of Adjusting Entries Purpose of adjusting entries Measure income Update balance sheet Each adjusting entry affects One income statement account Revenue or Expense One balance sheet account Asset or liability You have learned about three categories (deferrals, accruals and depreciation) and five types (prepaid expense, depreciation, accrued expenses, accrued revenues and unearned revenues) of adjusting entries. Recall that the purpose of adjusting entries is to measure income (both revenue and expenses) and update the balance sheet accounts. Note that each type of adjusting entry impacts an income statement account (either a revenue or an expense) and a balance sheet account (either an asset or a liability). Also, note that the “cash” account is never used in an adjusting entry. ©2008 Pearson Prentice Hall. All rights reserved.

Adjusted Trial Balance Trial balance prepared after adjusting entries are made and posted These amounts are used to prepare the financial statements: Income Statement Statement of Retained Earnings Balance Sheet An adjusted trial balance is, as its name implies, a trial balance prepared after adjusting entries are prepared and posted. The account balances on the adjusted trial balance are the amounts used to prepare the financial statements. The financial statements include the income statement, the statement of retained earnings and the balance sheet. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 4 Prepare the financial statements The fourth learning objective is to prepare the financial statements. Prepare the financial statements ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Income Statement Reports net income or loss Revenues minus expenses Net income flows to Retained Earnings Statement The first financial statement prepared in the income statement, which shows the net income or loss earned by the company. Net income is computed by subtracting revenues from expenses. The amount of net income flows to the Statement of Retained Earnings. Therefore, a company should prepare the income statement before the retained earnings statement. ©2008 Pearson Prentice Hall. All rights reserved.

Statement of Retained Earnings Shows changes to the Retained Earnings account Net Income is added to beginning balance Dividends are subtracted Ending Retained Earnings flows to the Balance Sheet The second statement prepared is the Statement of Retained Earnings. This report shows the changes to the retained earnings account. It starts with the beginning balance, net income (from the Income Statement) is added and dividends are subtracted to determine the ending balance in retained earnings. The ending balance flows to the Balance Sheet in the Stockholders’ Equity section. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Balance Sheet Reports assets, liabilities and equity Shows that the accounting equation is in balance The third financial statement prepared is the balance sheet. This report lists the asset, liability and equity accounts of a company. It demonstrates that the accounting equation is in balance. ©2008 Pearson Prentice Hall. All rights reserved.

RETAINED EARNINGS STATEMENT INCOME STATEMENT NET INCOME RETAINED EARNINGS STATEMENT ENDING RETAINED EARNINGS The order in which the statements are prepared is important. Net Income from the Income Statement flows to the Retained Earnings Statement. The ending balance of the Retained Earnings Statement flows to the Balance Sheet. BALANCE SHEET ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Learning Objective 5 Close the books The fifth learning objective is to close the books. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Closing the Books Done after financial statements are prepared Set temporary accounts to zero Transfers balances to retained earnings account Journalizes activity in Statement of Retained Earnings The final step in the accounting cycle is to close the books. This is done after financial statements are prepared. Closing entries “zero out” temporary accounts and transfer their balances to retained earnings. Closing entries mirror the Retained Earnings Statement. ©2008 Pearson Prentice Hall. All rights reserved.

Temporary and Permanent Accounts Revenues, Expenses and Dividends Closed Balances represent a period of time Permanent Asset, liability and equity accounts Not closed Ending balance of one period carries over to following period Temporary accounts are revenue, expenses and dividends. These accounts are closed at the end of the year and begin the following year with a zero balance. Their balances represent a period of time. For example, the service revenue account shows the amount of revenue earned for the year. Permanent accounts are the asset, liability and equity accounts. These accounts are not closed. Their year-end balances carry forward to the next year. If a company has cash of $10,000 at the end of one year, it begins the next year with $10,000. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Closing Entries Debit each Revenue account for the amount in its credit balance Retained earnings is credited Credit each Expense account for the amount in its debit balance Retained earnings is debited Credit Dividends for the amount in its debit balance R E D There are three closing entries. First, each revenue account is debited for its balance. Retained Earnings is credited, which increases the account. Second, each expense account is credited for its balance. Retained earnings is debited, which decreases it. Now, Retained Earnings has been increased by revenues and decreased by expenses. Revenues minus expenses equals net income. Net income has been added to Retained Earnings, just like in the Statement of Retained Earnings. The third closing entry credits the Dividends account and debits Retained Earnings. This zeros out Dividends and decreases retained earnings. This mirrors the R.E. Statement where dividends is subtracted. The acronym RED can help you remember the closing entries. R for revenues, E for expenses and D for Dividends. Note, Retained Earnings is a permanent account and is not closed. It is, however, increased and decreased by the closing entries. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Dec 31 – Close Revenues JOURNAL Date   Accounts Debit Credit 12-31 Service Revenue $23,600 Other revenue   600   Retained earnings  $24,200 E3-29 demonstrates the closing process. Above is the entry to close the two revenue accounts. ©2008 Pearson Prentice Hall. All rights reserved.

Which account would be debited? Total the expenses for the amount Dec 31 – Close expenses JOURNAL Date Accounts Debit Credit 31-Dec ________________________ _________   Cost of services sold $11,600 Selling, general & admin exp $6,900 Depreciation expense $4,100 Income tax expense $500 Each expense account is credited for its balance and retained earnings is debited for the total. At this point, retained earnings has been increased by the amount of net income earned by the company. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Dec 31 – Close Dividends JOURNAL Date   Accounts Debit Credit 12-31 Retained earnings $400 Dividends The last closing entry zeros out the dividends account. Retained earnings is debited and Dividends is credited for the amount of Dividends (not the retained earnings balance). ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Retained earnings $1,900 Balance 12-31-X1 Expenses $23,100 $400 $24,200 Revenues Dividends $2,600 Balance 12-31-X2 Determine net income. Remember revenues minus expenses A T-account is a good way to determine the ending balance of retained earnings. The beginning balance comes from the amount provided in the text. The first closing entry increases the account by the amount of revenue. The second closing entry decreases it by the amount of expenses. The third closing entry decrease it by the amount of dividends. The result is an ending balance of $2,600. Remember, retained earnings isn’t closed. It is used in the closing process, but not closed. Net income equals the revenues minus the expenses. ©2008 Pearson Prentice Hall. All rights reserved.

Classifying Assets & Liabilities Current and long-term classifications are based on liquidity How quickly item is converted to in cash Current assets will be converted to cash, sold or used during the next year Long-term assets include plant assets Current liabilities must be paid in the next 12 months Long-term liabilities have due dates more than one year from balance sheet date Balance sheet accounts are often classified. The classification is based on length of time. One year is a guideline in this process. Assets are often listed in order of liquidity – how quickly an item turns to cash. Current assets are those that will be converted to cash, sold or used within one year. Long-term assets are all those that don’t meet the criteria for current. A common category of long-term assets is plant assets. Liabilities are also split into to current and long-term. Again one year is the guideline. Those liabilities that must be paid (or satisfied) within one year are current. Those that are due more than one year from balance sheet date are long-term. ©2008 Pearson Prentice Hall. All rights reserved.

Classified Balance Sheet Places assets into meaningful categories Categories: Current assets Long-term investments Property, plant and equipment Intangible assets Other assets The classified balance uses these categories. In addition to current assets, companies have sections for long-term investments; property, plant and equipment; intangible assets and other assets. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Balance Sheet Formats Report format Assets at the top Followed by liabilities and stockholders’ equity Account format Assets on the left Liabilities and stockholders’ equity on the right The balance sheet can be prepared in one of two formats. The report format lists assets at the top, followed by liabilities and equity. The account format shows assets on the left and liabilities and equity on the right. Either format is acceptable. ©2008 Pearson Prentice Hall. All rights reserved.

Income Statement Formats Single-step All revenues and gains grouped together All expenses and losses grouped together Multi-step Includes useful subtotals Gross profit Net revenues minus cost of goods sold Income from operations Net income The income statement also has two formats. The single step lumps all revenues and gains together and all expenses and losses. The multi-step income statement incorporates categories and subtotals. Cost of goods sold is subtracted from net revenues to determine gross profit. Gross profit minus operating expenses equals income from operations. Other expenses and revenues are subtracted to determine net income. ©2008 Pearson Prentice Hall. All rights reserved.

Learning Objective 6 Use two new ratios to evaluate a business The sixth learning objective is to use two new ratios to evaluate a business. Use two new ratios to evaluate a business ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Current ratio Measure company’s ability to pay current liabilities with current assets Rule of thumb: Strong current ratio is 1.50 The current ratio is computed by dividing current assets by current liabilities. It measures a company’s ability to pay current liabilities. A rule of thumb is that a current ratio should be 1.5 or higher. Current assets Current liabilities ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Debt Ratio Proportion of assets that is financed with debt High debt ratio indicates more risk Total liabilities Total assets The debt ratio is computed by dividing total liabilities by total assets. Note, totals are used, not just current. This ratio shows the proportion of assets that is financed by debt. The higher the debt ratio, the riskier the company. ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Current ratio: Current assets = Cash + Accounts Receivable + Inventories + Other current assets $900 + $27,700 + $33,000 = $4,800 = $66,400 Total Current liabilities = $53,600 S3-14 demonstrates how to compute these two ratios. First, pick out the assets that are current. These are cash, accounts receivable, inventories and other current assets. These total to $66,400. Total current liabilities is given as $53,600. Divide the current assets by current liabilities to get a current ratio of 1.24. This means the company has approximately one-and-one-quarter as many current assets as current liabilities. Current ratio = 66,400 / 53,600 Current ratio = ______ ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. Debt ratio: Total liabilities = Current liabilities + Long-term liabilities $53,600 + $13,500 = $67,100 Total assets = Current assets + Property & Equipment, net + Other assets For the debt ratio, compute total liabilities. This equals the current liabilities plus the long-term - $67,100. Total assets are the current assets computed for the current ratio, plus property & equipment, net and other assets. These amount to $97,900. This gives us a debt ratio of .69. $66,400 + $7,200 + $24,300 = 97,900 Debt ratio = $67,100 / $97,900 Debt ratio = .69 ©2008 Pearson Prentice Hall. All rights reserved.

©2008 Pearson Prentice Hall. All rights reserved. End of Chapter Three Are there any questions? ©2008 Pearson Prentice Hall. All rights reserved.