 Accrual accounting  Revenue  Earned when company delivers a product or performs a service  Expenses  Incurred when company uses resources or services to help generate revenue  Receipt or payment of cash does not affect revenue or expense recognition  Time period assumption  Business activities evaluated using specific time periods  E.g., months, quarters, years

 Difference between when item is recognized and actual cash flow  Cash received/paid before revenue/expense recognized  Recognition deferred (postponed)  Cash received/paid after revenue/expense recognized  Recognition accrued  No timing difference when cash received/paid at same time revenue/expense is recognized  The accounting cycle The accounting cycle  Adjusting entries Adjusting entries  Financial statements Financial statements

Adjusting Entries  Accrued revenues – revenue earned but not yet received in cash or previously recorded Accrued revenues  Accrued expenses – expense incurred but not yet paid in cash or previously recorded Accrued expenses  Deferred revenues – a liability resulting from the receipt of cash before the recognition of revenue; unearned revenue – liability that company owes customers Deferred revenues  Deferred expenses – an asset resulting from the payment of cash before the actual incurrence of the expense, ‘an asset is just an expense waiting to happen’ Deferred expenses

Accrued Revenues  Types of accrued revenue adjustments  Interest Revenue - Income earned from letting someone else use your money Interest Revenue  Time passing is the action related to interest income  Interest = Principal x Rate x Time  Principal - amount loaned  Rate - annual interest rate  Time - portion of year loan outstanding  Receivables with interest Receivables with interest  Other accrued revenue Other accrued revenue

Accrued Expenses  Expenses incurred but not yet  Paid in cash  Previously recorded  Types of accrued expense adjustments  Interest Expense Interest Expense  Other accrued expenses Other accrued expenses  Some expenses are recorded at the end of the year because the accounting period ends after the expense was incurred and before it has been paid  Salary expense is one of the most common year-end accrued expenses

Deferred Revenues  Deferred revenues  Dollars have been received in a prior transaction  Adjustment made for revenue earned related to cash previously received  Often called unearned revenue  Deferred expenses  Dollars were paid in a prior transaction  Adjustment made for expense incurred in current accounting period related to cash previously received  Often called prepaid expenses

 Purchase of supplies is an asset exchange  Supplies Expense should reflect only supplies used up during the period  Supplies on hand at the end of the period should be recorded as an asset  Are supplies a current or non-current asset?  Supplies Expense computation Beginning Balance +Purchases -Ending Balance _ Supplies Used (expense)

Depreciation  Equipment that lasts longer than one year should be treated like any other prepaid expense  We should allocate the cost of the asset to the periods that benefit from the use of the asset  This is called depreciation  Depreciation has NOTHING to do with the FAIR MARKET VALUE of an asset  A separate account is used to accumulate all depreciation related to an asset  Accumulated Depreciation is a contra-asset because it reduces the value of the asset on the books  Book value is the cost of an asset less Accumulated Depreciation

Depreciation  Straight-line depreciation  Allocates an equal amount of the cost of the asset to each accounting period.  Annual depreciation formula Asset cost _ useful life (in years)  Accumulate depreciation – the total amount of depreciation that has been recorded during an asset’s life – contra-asset  Residual value – the estimated value of an asset at the end of its useful life, deducted in the calculation of depreciation expense  Book value – the cost of an asset minus the total accumulated depreciation recorded for the asset

Preparing Financial Statements  Prior to preparing financial statements, the steps below in the accounting cycle are performed 1. Record transactions 2. Posting transactions to the general ledger 3. Prepare an unadjusted trial balance 4. Prepare and post adjusting entries 5. Prepare an adjusted trial balance  Adjusting entries – 5 basic types  Prepaid expense  Depreciation expense  Accrued expense  Accrued receivable  Unearned revenue

Closing Revenue and Expense Accounts  Revenue and expense, and dividend accounts – temporary accounts  Permanent or real accounts – balances carry over  After preparing the financial statements, revenues and expenses as well as dividends have to be transferred from those temporary accounts to retained earnings.  After this process, the income stmt. and dividend. accounts are reset to zero.  Revenue accounts are reset to zero.  Since they have credit balances, we use a DEBIT to decrease the accounts to zero (a zero balance).  The retained earnings account is CREDITED because revenues increase retained earnings.

Closing Revenue and Expense Accounts  Expense accounts are reset to zero.  Since they have DEBIT balances, we use a CREDIT to decrease the accounts to zero (a zero balance).  The retained earnings account is DEBITED because expenses decrease retained earnings.  Dividends account is reset to zero.  Since it has a DEBIT balance, we use a CREDIT to decrease the account to zero (a zero balance).  The retained earnings account is DEBITED because dividends decrease retained earnings.  A post-closing trial balance is prepared, showing only permanent accounts

Closing Revenue and Expense Accounts  Prepare closing entries for the following accounts. Retained Earnings Dr. Cr. 500 beg bal Service Revenue Dr. Cr. 100 Rent Expense Dr. Cr. 20 Wage Expense Dr. Cr. 40 Dividends Dr. Cr. 10

Financial Statement Analysis  Debt-to-assets ratio  Measure of long-term liquidity  What are two measures of short-term liquidity?  Also called a solvency ratio Total Liabilities Total Assets

Business Risk, Control, and Ethics  Controls that help a firm make sure all of its transactions are recorded  Pre-numbered documents  Segregation of duties  The person who does the record-keeping for an asset does not have control of the asset  How can the segregation of duties control be circumvented?

 Assign #7, pg. 200, E4-3A, E4-6A, E4- 7A (due 2/12)  Assign #8, pg. 210, P4-10A (due 2/12)