Accrual Accounting and the Financial Statements Chapter 3

Learning Objective 1 Relate accrual accounting and cash flows.

Accrual Accounting vs Cash Basis Accounting Accrual Accounting - records the impact of a business event as it occurs Cash Basis – records only transactions in which cash is received or paid

The Time-Period Concept Financial statements are prepared for specific periods and at regular intervals.

Learning Objective 2 Apply the revenue and matching principles.

Revenue Principle Revenue is recorded when it is earned. The amount of revenue to record is the cash value of goods transferred to customer.

The Matching Principle Record all expenses incurred during the accounting period Match expenses against revenues earned

Learning Objective 3 Update the financial statements by adjusting the accounts.

Air & Sea Unadjusted Trial Balance April 30, 20x3

Categories of Accounting Adjustments Deferrals Depreciation Accruals

Prepaid Expenses: Rent On April 1, 20x3, Air & Sea Travel prepays three months office rent. 3,000 Prepaid Rent Cash

Prepaid Expenses: Rent What is the adjusting entry on April 30? April 30 Rent Expense 1,000 Prepaid Rent 1,000 To record rent expense ($3,000 x 1/3)

Prepaid Expenses: Supplies On April 2, 20x3, Air & Sea Travel paid cash of $700 for office supplies. 700 Supplies Cash

Prepaid Expenses: Supplies An inventory at month end indicated that $400 in office supplies remained. 4/2 700 Supplies 4/30 300 Bal. 400 Supplies Expense 4/30 300 Bal. 300

Depreciation Allocation of the cost of a plant asset to expense over the asset’s useful life

Depreciation of Plant Assets On April 3, the business purchased furniture on account for $16,500. The furniture is expected to last 5 years. 16,500 Furniture Accounts Payable

Depreciation of Plant Assets Straight-line method of depreciation allocates equal amounts each accounting period. $16,000 ÷ 5 years = $3,300 per year $3,300 ÷12 months = $275 per month

Depreciation of Plant Assets What is the adjusting entry on April 30? April 30 Depreciation Expense, Furniture 275 Accumulated Depreciation, Furniture 275 To record depreciation

Book Value The net amount of a plant asset (cost minus accumulated depreciation)

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.

Accrued Expenses Salary Expense Cash 4/15 950 4/15 950 4/30 950 4/15 950 4/15 950 4/30 950 Bal. 1,900 Salary Payable 4/30 950 Bal. 950

Accrued Revenue A revenue that has been earned but not 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.

Accrued Revenues Adjusting entry: April 30 Accounts Receivable 250 Service Revenue 250 To accrue service revenue

Unearned Revenue An obligation arising from receiving cash before providing a service. Plantation Foods engages Air & Sea Travel agreeing to pay the agency $450 monthly, beginning immediately. Air & Sea Travel collects the first amount on April 20 and earns one-third the last 10 days.

Unearned Revenues April 20 Cash 450 Unearned Revenue 450 Received advanced payment April 30 Unearned Revenue 150 Revenue 150 To record revenue earned ($450 x 1/3)

Step 1 Prepare Unadjusted Trial Balance Step 2 Plan Adjustments Step 2 Prepare Adjusted Trial Balance

Learning Objective 4 Prepare the financial statements.

Air & Sea Travel, Inc. Income Statement Month Ended April 30, 20x5 Revenue: Service revenue $7,400 Expenses: Salary expense $1,900 Rent expense 1,000 Utilities expense 400 Supplies expense 300 Depreciation expense 275 3,875 Income before tax $3,525 Income tax expense 540 Net income $2,985

Air & Sea Travel, Inc. Statement of Retained Earnings Month Ended April 30, 20x5 Retained earnings, April 1, 20x5 $11,250 Add: Net income 2,958 $14,235 Less: Dividends ( 3,200) Retained earnings, April 30, 20x5 $11,035

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.

Closing Entries Prepare the accounts for the next period’s transactions. Transfer the revenue, expense, and dividends balances to Retained Earnings.

Which Accounts Need To Be Closed? Temporary accounts are closed Revenue Expense Dividends Permanent accounts are not closed Assets Liabilities Stockholders’ equity

Journalizing the Closing Entries April 30 Service Revenue 7,400 Retained Earnings 7,400 April 30 Retained Earnings 4,415 Rent Expense 1,000 Salary Expense 1,900 Supplies Expense 300 Depreciation Expense 275 Utilities Expense 400 Income Tax Expense 540 April 30 Retained Earnings 3,200 Dividends 3,200

Posting the Closing Entries Rent Expense 1,000 Service Revenue 7,400 7,000 250 150 7,400 Salary Expense 950 1,900 Retained Earnings 4,415 3,200 11,250 7,400 11,035 Other Expenses 1,515 Dividends 3,200

Classifying Assets and Liabilities List assets and liabilities in order of their relative liquidity. Liquidity - how quickly an item can be converted to cash.

Classifying Assets and Liabilities Current assets Long-term assets Current liabilities Long-term liabilities

Learning Objective 6 Use the current ratio and the debt ratio to evaluate a business.

Total current liabilities 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

A low debt ratio is safer than a high debt ratio. The proportion of assets that is financed with debt. Measures business’s ability to pay total liabilities Total liabilities Total assets A low debt ratio is safer than a high debt ratio.

End of Chapter 3