1 Accrual Accounting and the Financial Statements Chapter 3

2 Learning Objective 1 Relate accrual accounting and cash flows.

3 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

4 The Time-Period Concept Financial statements are prepared for specific periods and at regular intervals: –Monthly –Quarterly –Annually

5 Learning Objective 2 Apply the revenue and matching principles.

6 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?

7 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

8 Learning Objective 3 Adjusting the accounts at period end for Deferrals, Accruals, and Depreciation

9 Air & Sea Unadjusted Trial Balance April 30, 20x3

10 Categories of Accounting Adjustments  Deferrals  Depreciation  Accruals

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

12 Prepaid Expenses: Rent What is the adjusting entry on April 30, after one month? April 30 Rent Expense1,000 Prepaid Rent1,000 To record rent expense ($3,000 x 1/3)

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

14 Prepaid Expenses: Supplies An inventory at month end indicated that $400 of the original $700 in office supplies remained. ($300 of supplies were consumed): 4/2700 Supplies 4/ Bal.400 Supplies Expense 4/30300 Bal.300

15 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]

16 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 FurnitureAccounts Payable 16,500

17 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

18 Depreciation of Plant Assets What is the adjusting entry on April 30? April 30 Depreciation Expense, Furniture275 Accumulated Depreciation, Furniture275 To record depreciation at month end

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

20 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…

21 Accrued Expenses Salary Payable 4/ Bal.950 Bal. 1,900 4/ Salary Expense 4/ Cash 4/15950

22 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.

23 Accrued Revenues Adjusting entry: April 30 Accounts Receivable250 Service Revenue250 To accrue ½ month of service revenue

24 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.

25 Unearned Revenues April 20 Cash450 Unearned Revenue450 Received advance payment April 30 Unearned Revenue150 Revenue150 To record revenue earned ($450 x 1/3)

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

27 Learning Objective 4 Prepare the financial statements. The following income statement is in “single step form.” The following balance sheet is in “account form.”

28 Air & Sea Travel, Inc. Income Statement Month Ended April 30, 20x5 Revenue: Service revenue$7,400 Expenses: Salary expense$1,900 Rent expense1,000 Utilities expense400 Supplies expense300 Depreciation expense275 3,875 Income before tax$3,525 Income tax expense 540 Net income$2,985

29 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. Statement of Retained Earnings Month Ended April 30, 20x5

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

31 Learning Objective 5 Close the books.

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

33 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

Journalizing the Closing Entries April 30 Service Revenue7,400 Retained Earnings7,400 April 30 Retained Earnings4,415 Rent Expense1,000 Salary Expense1,900 Supplies Expense 300 Depreciation Expense275 Utilities Expense400 Income Tax Expense 540 April 30 Retained Earnings3,200 Dividends3,200

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

36 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.

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

38 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

39 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

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

41 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

42  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 Debt Ratio A low debt ratio is safer than a high debt ratio.