3-1 The Accrual Basis of Accounting Chapter 3 Electronic Presentation by Douglas Cloud Pepperdine University

3-2 1.Describe the accrual basis of accounting. 2.Use the accrual basis of accounting to analyze, record, and summarize transactions. 3.Describe and illustrate the end-of-the-period adjustment process. 4.Prepare accrual-basis financial statements, including a classified balance sheet. Learning Goals After studying this chapter, you should be able to: ContinuedContinued

3-3 5.Describe how the accrual basis of accounting enhances the interpretation of financial statements. 6.Describe the accounting cycle for the accrual basis of accounting. 7.Describe and illustrate how common-sized financial statements can be used to analyze and evaluate a company’s performance. Learning Goals

3-4 1 Learning Goal Describe the accrual basis of accounting.

3-5 Under the cash basis, the matching concept is not emphasized. Under the cash basis, the receipt or payment of cash governs the recording process. The cash basis does not work well for large businesses. Under the accrual accounting basis, transactions are recorded even though cash is not received or paid unit a later point. Under the accrual accounting, revenue is normally recognized when it is earned.

3-6 Use the accrual basis of accounting to analyze, record, and summarize transactions. 2 Learning Goal

3-7 a. On November 1, received $1,800 from H.S. Company as rent for the use of Family Health Care’s land as a temporary parking lot from November 2003 through March 2004.

3-8 Cash + Land Assets a.1,800 Bal.7,32012,000 Bal.9,12012,000 Left Side of the Accounting Equation

3-9 Capital Stock Stockholders’ Equity Liabilities + Notes Payable a.1,800 Bal. 10,0006,0003,320 Retained Earnings Bal.10,0001,8006,0003,320 Right Side of the Accounting Equation + Unearned Revenue +

3-10 b. On November 1, paid $2,400 for an insurance premium on a two-year, general business policy.

3-11 Prepaid Cash + Insurance + Land Assets b.–2,4002,400 Bal.9,12012,000 Bal.6,7202,40012,000 Left Side of the Accounting Equation No effect on right side Prepaid Insurance

3-12 c. On November 1, paid $6,000 for an insurance premium on a six-month medical malpractice insurance policy.

3-13 Prepaid Cash + Insurance + Land Assets c.–6,0006,000 Bal.6,7202,40012,000 Bal.7208,40012,000 Left Side of the Accounting Equation No effect on right side

3-14 d. Dr. Landry invested an additional $5,000 in the business in exchange for capital stock.

3-15 Prepaid Cash + Insurance + Land Assets d.5,000 Bal.7208,40012,000 Bal.5,7208,40012,000 Left Side of the Accounting Equation

3-16 Capital Stock Stockholders’ Equity Liabilities + Notes Payable d.5,000 Bal. 10,0001,8006,0003,320 Retained Earnings Bal.10,0001,80011,0003,320 Right Side of the Accounting Equation + Unearn. Rev. ++

3-17 e. Purchased supplies for $240 on account.

3-18 Prepaid Cash + Insurance + + Land Assets e.240 Bal.5,7208,40012,000 Bal.5,7208, ,000 Left Side of the Accounting Equation Supplies

3-19 Capital Stock Stockholders’ Equity Liabilities + Notes Payable e.240 Bal. 10,0001,80011,0003,320 Retained Earnings Bal.10, ,80011,0003,320 Right Side of the Accounting Equation + Unearn. Rev. +++ Accts. Pay.

3-20 f. Purchased $8,500 of office equipment. Paid $1,700 cash as a down payment with the remainder due in five monthly installments of $1,360 beginning December 1.

3-21 Prepaid Cash + Insurance + + Land Assets f.-1,7008,500 Bal.5,7208, ,000 Bal.4,0208, ,50012,000 Left Side of the Accounting Equation Supplies + Office Equip.

3-22 Capital Stock Stockholders’ Equity Liabilities + Notes Payable f.6,800 Bal. 10, ,80011,0003,320 Retained Earnings Bal.16, ,80011,0003,320 Right Side of the Accounting Equation + Unearn. Rev Accts. Pay.

3-23 g. Provided services of $6,100 to patients on account.

3-24 Prep. Office Cash + + Insur. + Supp. + Equip. + Land Assets g.6,100 Bal.4,0208, ,50012,000 Bal.4,0206,1008, ,50012,000 Left Side of the Accounting Equation Ac. Rec.

3-25 Capital Stock Stockholders’ Equity Liabilities + Notes Payable g.6,100 Bal. 16, ,80011,0003,320 Retained Earnings Bal.16, ,80011,0009,420 Right Side of the Accounting Equation + Unearn. Rev. +++ Accts. Pay. Fees Earned

3-26 h. Received $5,500 for services provided to patients who paid cash.

3-27 Prep. Office Cash + + Insur. + Supp. + Equip. + Land Assets h.5,500 Bal.4,0206,1008, ,50012,000 Bal.9,5206,1008, ,50012,000 Left Side of the Accounting Equation Ac. Rec.

3-28 Capital Stock Stockholders’ Equity Liabilities + Notes Payable h.5,500 Bal. 16, ,80011,0009,420 Retained Earnings Bal.16, ,80011,00014,920 Right Side of the Accounting Equation + Unearn. Rev Accts. Pay. Fees Earned

3-29 i. Received $4,200 from insurance companies, which paid on patients’ accounts for services that have been rendered.

3-30 Prep. Office Cash + + Insur. + Supp. + Equip. + Land Assets i.4,200–4,200 Bal.9,5206,1008, ,50012,000 Bal.13,7201,9008, ,50012,000 Left Side of the Accounting Equation Ac. Rec. No effect on right side

3-31 j. Paid $100 on account for supplies that had been purchased.

3-32 Prep. Office Cash + + Insur. + Supp. + Equip. + Land Assets j.–100 Bal.13,7201,9008, ,50012,000 Bal.13,6201,9008, ,50012,000 Left Side of the Accounting Equation Ac. Rec.

3-33 Capital Stock Stockholders’ Equity Liabilities + Notes Payable j.–100 Bal. 16, ,80011,00014,920 Retained Earnings Bal.16, ,80011,00014,920 Right Side of the Accounting Equation + Unearn. Rev Accts. Pay.

3-34 k. Expenses paid during November were as follows: wages, $2,790; rent, $800; utilities, $580; interest, $100; miscellaneous, $420.

3-35 Prep. Office Cash + + Insur. + Supp. + Equip. + Land Assets k.–4,690 Bal.13,6201,9008, ,50012,000 Bal.8,9301,9008, ,50012,000 Left Side of the Accounting Equation Ac. Rec.

3-36 Capital Stock Stockholders’ Equity Liabilities + Notes Payable k.–2,790 –800 –580 –100 –420 Bal. 16, ,80011,00014,920 Retained Earnings Bal.16, ,80011,00010,230 Right Side of the Accounting Equation + Unearn. Rev Accts. Pay. Wages Exp. Rent Exp. Utilities Exp. Interest Exp. Miscellaneous Exp.

3-37 l. Paid dividends of $1,200 to stockholder (Dr. Landry).

3-38 Prep. Office Cash + + Insur. + Supp. + Equip. + Land Assets l.–1,200 Bal.8,9301,9008, ,50012,000 Bal.7,7301,9008, ,50012,000 Left Side of the Accounting Equation Ac. Rec.

3-39 Capital Stock Stockholders’ Equity Liabilities + Notes Payable l.–1,200 Bal. 16, ,80011,00010,230 Retained Earnings Bal.16, ,80011,0009,030 Right Side of the Accounting Equation + Unearn. Rev Accts. Pay. DividendsDividends

3-40 Describe and illustrate the end- of-the-period adjustment process. 3 Learning Goal

3-41 The accrual basis of accounting requires the accounting records to be updated prior to preparing financial statements.

3-42 This updating process is called the adjustment process.

3-43 Deferrals are created by recording a transaction in a way that delays or defers the recognition of an expense or a revenue Accruals are created when a revenue or expense has not been recorded at the end of the accounting period. Deferrals and Accruals

3-44

3-45 Deferrals and Accruals a1.Earlier Family Health Care prepaid two policies—a general business policy for $2,400 and a malpractice policy for $6,000. The general business policy expires at a rate of $100 ($2,400 ÷ 24) per month and the malpractice policy expires at a rate of $1,100 ($6,000 ÷ 6) per month.

3-46 Deferrals and Accruals Assets Prepaid Insurance Stockholder’ Equity Retained Earnings Balance 8,400 9,030 a1–1,100 Balance 7,3007,930 Insurance Exp.

3-47 Deferrals and Accruals a2.For November, $150 of the supplies were used, leaving $90 of supplies for use during the coming months. Assets Supplies Stockholder’ Equity Retained Earnings Balance 2407,930 a2–150 Balance 907,780 Supplies Exp.

3-48 Deferrals and Accruals Fixed assets such as drilling equipment lose their ability to provide service over time. This reduction in ability is called depreciation.

3-49 Deferrals and Accruals The fixed asset account is not reduced directly by depreciation. Instead, an offsetting account, called Accumulated Depreciation, is used.

3-50 Deferrals and Accruals a3.Assume that the amount of depreciation for November is $160. Assets Office Equipment Stockholder’ Equity Retained Earnings Balance 8,5007,930 a3160 –160 Balance 8, ,620 Accumulated – Depreciation Depreciation Exp.

3-51 Deferrals and Accruals a4.Of the $1,800 received for five-months’ rent, $360 ($1,800 ÷ 5) has been earned. Liabilities Unearned Rent Stockholder’ Equity Retained Earnings Balance 1,8007,620 a4– Balance 1,4407,980 Rental Rev.

3-52 Deferrals and Accruals a5.As of November 30, employees are owed $220 for accrued wages. Liabilities Wages Payable Stockholder’ Equity Retained Earnings Balance 7,980 a5220 –220 Balance 2207,760 Wages Exp.

3-53 Deferrals and Accruals a6.Family Health Care provided $750 in services to patients that have not yet been billed. Assets Accounts Receivable Stockholder’ Equity Retained Earnings Balance 1,9007,760 a6750 Balance 2,6508,510 Fees Earned

3-54 Prepare accrual-basis financial statements, including a classified balance sheet. 4 Learning Goal

3-55 Fees earned$12,350 Operating expenses: Wages expense$3,010 Insurance expense1,100 Rent expense800 Utilities expense580 Depreciation expense160 Supplies expense150 Interest expense100 Miscellaneous expense 420 Total operating expenses 6,320 Operating income:$ 6,030 Other income: Rent revenue 360 Net income$ 6,390 Family Health Care, P.C. Income Statement For the Month Ended November 30, 2003

3-56 Retained earnings, November 1, 2003$3,320 Net income for November$6,390 Less dividends 1,200 5,190 Retained earning, November 30, 2003$8,510 Family Health Care, P.C. Retained Earnings Statement For the Month Ended November 30, 2003 From the income statement (Slide 3-55) From the income statement (Slide 3-55)

3-57 Assets Current assets: Cash$ 7,730 Accounts receivable2,650 Prepaid insurance7,300 Supplies 90 Total current assets$17,770 Fixed assets: Office equipment$8,500 Less accumulated depreciation 160$ 8,340 Land 12,000 Total fixed assets 20,340 Total assets$38,110 Family Health Care, P.C. Balance Sheet November 30, 2003 ContinuedContinued

3-58 Liabilities Current liabilities: Accounts payable$ 140 Wages payable220 Notes payable6,800 Unearned revenue 1,440 Total current liabilities$ 8,600 Long-term liabilities: Notes payable 10,000 Total liabilities$18,600 Stockholders’ equity Capital stock$11,000 Retained earnings 8,510 19,510 Total liabilities and stockholders’ equity$38,110 From the retained earnings statement

3-59 Cash flows from operating activities: Cash received from patients$ 9,700 Cash received from rental of land 1,800$11,500 Deduct cash payments for expenses: Insurance premiums$(8,400) Supplies(100) Wages(2,790) Rent(800) Utilities(580) Interest(100) Miscellaneous expense (420) (13,190) Net cash flow used in operating activities$ (1,690) Family Health Care, P.C. Statement of Cash Flows For the Month Ended November 30, 2003 ContinuedContinued

3-60 Net cash flow used in operating activities$ (1,690) Cash flows from investing activities: Purchase of office equipment(1,700) Cash flows from financing activities: Additional issuance of capital stock$ 5,000 Deduct cash dividends (1,200) Net cash flow from financing activities 3,800 Net increase in cash$ 410 November 1, 2003 cash balance 7,320 November 30, 2003 cash balance$ 7,730

3-61AssetsAssets Assets are resources such as physical items or rights that are owned by the business.

3-62 Physical assets of a long-term nature referred to as fixed assets. AssetsAssets  Buildings  Equipment  Land  Fixtures

3-63 Rights that are long-term in nature are called intangible assets. AssetsAssets  Patents  Copyrights  Trademarks  Leasehold improvements

3-64AssetsAssets Cash and other assets that are expected to be converted to cash or sold or used up within one year or less, through the normal operations of the business, are called current assets.  Accounts receivable  Notes receivable  Supplies  Other prepaid expenses

3-65LiabilitiesLiabilities Liabilities are amounts owed to outsiders… normally referred to as creditors.

3-66LiabilitiesLiabilities Liabilities that will be due within a short time (usually one year or less) and that are paid out of current assets are called current liabilities.  Accounts payable  Wages payable  Interest payable  Taxes payable A sizable number of liabilities end in the word “payable.”

3-67LiabilitiesLiabilities Liabilities that will not be due within a short time (usually more than a year) or are not paid out of current assets are called long-term liabilities.  Mortgage payable  Bonds payable

3-68 Stockholders’ Equity Stockholders’ equity is the stockholders’ right to the assets of the business.  Capital stock  Retained earnings

3-69 Describe how the accrual basis of accounting enhances the interpretation of financial statements. 5 Learning Goal

3-70 Family Health Care, P.C. Cash Basis Income Statement For the Month Ended November 30, 2003 Fee earned$ 9,700 Operating expenses: Wages expense$2,790 Insurance expense8,400 Rent expense800 Utilities expense580 Supplies expense100 Interest expense100 Miscellaneous expense 420 Total operating expenses 13,190 Operating loss$ 3,490 Rental revenue 1,800 Net loss$ 1,690 Note that this is a cash basis income statement

3-71 Using the accrual basis, net income for November was $6,390. However, if we followed the cash basis, the firm shows a loss of $1,690. Cash Accrual

3-72 Describe the accounting cycle for the accrual basis of accounting. 6 Learning Goal

3-73 The Accounting Cycle 1.Identifying, analyzing and recording the effects of transactions on the accounting equation. 2.Identifying, analyzing, and recording adjustment data. 3.Preparing financial statements. 4.Preparing the accounting records for the next accounting period.

3-74 After the financial statements are prepared, the balances in the revenue, expense, and dividend accounts are closed by the closing process.

3-75 In this way, the revenue, expense, and dividend accounts begin each period with a zero balance, and the transactions of each period are kept separate from one another.

3-76 Describe and illustrate how common-sized financial statements can be used to analyze and evaluate a company’s performance. 7 Learning Goal

3-77 Income Statements for the Year Ending December 31, 2001 Revenues 100.0%100.0% Operating expenses 86.2% 81.8% Operating income13.8%18.2% Other expenses 0.9% 2.5% Income before taxes12.9%15.7% Income taxes 4.8% 4.7% Net income8.1%11.0% Common-Sized Financial Statements Wendy’s McDonald’s Note Wendy’s higher proportion of operating expenses to revenue. Which is probably the reason for Wendy’s lesser percentage of net income.

3-78 Balance Sheets as of December 31, 2001 Current assets: Cash5.4%1.9% Accounts receivable4.0%3.9% Inventories and other assets 3.4% 2.3% Total current assets12.8%8.1% Property, plant, and equipment79.0%76.7% Other long-term assets 8.2% 15.2% Total assets100.0%100.0% Common-Sized Financial Statements Wendy’s McDonald’s ContinuedContinued

3-79 Balance Sheets as of December 31, 2001 Current liabilities: Accounts payable5.4%3.1% Other liabilities 8.9% 6.9% Total current liabilities14.3%10.0% Long-term liabilities36.1%47.9% Stockholders’ equity 49.6% 42.1% Total assets100.0%100.0% Common-Sized Financial Statements Wendy’s McDonald’s

3-80 The End Chapter 3

3-81