1. Accrual Accounting Concepts
Chapter 3
Accrual Accounting Concepts

2. Learning Objectives
After studying this chapter, you should be able to…
Describe basic accrual accounting concepts, including the matching concept
Use accrual concepts of accounting to analyze, record, and summarize transactions
Describe and illustrate the end-of-period adjustment process
Prepare financial statements using accrual concepts of accounting, including a classified balance sheet
Describe how the accrual basis of accounting enhances the interpretation of financial statements

3. Learning Objective 1
Describe the basic accrual accounting concepts, including the matching concept

4. Why is Accrual Accounting Needed?
Cash received or paid
Revenue earned
Expense incurred
Transactions recorded in Chapter 2 examples were structured so cash was received or paid at the time of the transaction.
In real world, cash may be received or paid at a different time than when the revenue is earned or expense incurred.
If revenue would only be recorded when it is received in cash, an income statement could show a loss during a period when significant earning activities are taking place.
If expenses would only be recorded when they are paid in cash, an income statement for a period could show more income than is correct.
Accrual accounting is designed to avoid misleading information arising from the timing of cash receipts and payments.
Transactions are recorded as they are incurred
Accrual accounting transactions affect the accounting equation.
Transactions will be recorded even though cash is not received or paid until a later point.

5. Accruing Revenue Service provided Customer invoiced Cash received
Revenue is recognized (recorded) when earned
When services are provided with cash to be received at a later date, services are said to be provided on account.
When services are provided on account, an asset called account receivable is recorded to represent the amount that is expected to be received in cash in the future.
Revenue is said to be recognized when the service is provided, the earnings process is complete, and the customer is legally obligated to pay for the product or service.
Revenue
Recognized

6. Receive invoice for purchase
Accruing Revenue
Materials purchased
Receive invoice for purchase
Invoice paid
A company may purchase goods and services with terms which allow payment at a later time.
These transactions represent purchases made on account.
When purchases are made on account, a liability account called Accounts Payable is recorded in the amount to be paid at a later time.
Liabilities are recognized when the obligation is incurred
Expense
Recognized

7. Matching Principle Expenses incurred to generate revenue
When revenues are earned and recorded, all expenses incurred in generating the revenues must also be recorded.
Matching subtracts expenses incurred from revenues earned to arrive at Net Income or Net Loss.

8. Learning Objective 2
Use accrual concepts of accounting to analyze, record, and summarize transactions

9. Accrual Concepts – Family Health Care Transactions
Services are provided to patients
Insurance is filed, payment to be received in the future
Revenue is earned when the service is provided to the patient
Expenses are incurred for items such as supplies where payment may be made in the future
Expenses are recorded as they are incurred, not as they are paid
Family Health Care may provide services to patients covered by health insurance whereby payment will not be received until a point in time after the service was provided.
Family Health Care earns revenue when services are provided to patients because when the service is provided, the earnings process is complete.
Revenue is recognized at the point of service because the earnings process is complete and the patient is obligated to pay.
Family Health Care may incur expenses, such as medical supplies purchases, where payment will be made at a point in the future.
Family Health Care also incurs expenses to generate revenue and will recognize those expenses according to the Matching Principle.

10. Family Health Care – Rent Received in Advance
Family Health Care, P.C. receives a rent payment of $1,800 in cash from ILS for use of its land.
Family Health Care, P.C. receives a rent payment of $1,800 in cash from ILS for use of its land.
ILS will be using the land for a temporary parking lot until March of 2012.
Since cash is received in the amount of $1,800, cash is increased by that amount.
This increases cash flows from operating activities under the Statement of Cash Flows column.
Since Family Health entered the agreement and accepted the $1,800, they have an obligation to make the land available. Therefore, a liability called Unearned Revenue is also recorded at the time cash is received.
As time passes, Family Health will earn the rental revenue. That transaction will be recorded later in the example.
Amount received reported as a liability until the revenue is actually earned.

11. Family Health Care – Prepaid Expenses
Family Health Care, P.C. buys a 2-year business insurance policy and pays $2,400 in cash.
By paying the premium in advance, Family Health as purchased an asset – prepaid insurance coverage.
The mix of assets has changed; cash decreases by $2,400 and prepaid insurance increases by $2,400.
The payment of cash also decreases cash flows from Operating activities under the Statement of Cash flows column.
Prepaid insurance expires with the passage of time; that expense is matched or recorded as the time passes. That transaction will be recorded later in the example.
Amount paid is reported as a prepaid expense until the insurance is actually used up.

12. Family Health Care – Prepaid Expenses
Family Health Care, P.C. buys a 6-month medical malpractice insurance policy and pays a premium in cash of $6,000.
This transaction is recorded in a similar manner as the general business insurance transaction and has the same impacts.
Amount paid is reported as a prepaid expense until the insurance is actually used up.

13. Family Health Care – Additional Capital Investment
Dr. Landry invests an additional $5,000 in the business and receives capital stock.
This transaction is recorded in the same manner as Dr. Landry’s initial investment.

14. Family Health Care – Purchase on Account
Family Health Care, P.C. purchases $240 of supplies on account.
This transaction is similar to the insurance transactions in that purchased supplies are assets until they are used.
The promise to pay for supplies in the future is liability incurred called Accounts Payable.
Since no cash is paid or received, there is no impact on the Statement of Cash Flows.
Amount purchased is reported as an asset until the supplies are used in operations.
Amount purchased is reported as a liability.

15. Family Health Care – Purchase of Equipment
Family Health Care, P.C. purchases office equipment by making a $1,700 cash down payment and having five additional monthly installments of $1,360.
Since a cash payment was made, cash must decrease on the Balance Sheet by $1,700.
Cash flows from Investing activities is also decreased by $1,700 under the Statement of Cash flows column.
The remaining five payments represent an obligation to Family Health in the amount of $6,800. This is recorded on the balance sheet as a Note Payable.
The equipment has a value of $8,500; the $1,700 cash down payment plus the remaining five payments worth $6,800. The asset is recorded for the total value.
Cash down payment
Remaining balance due
Total Asset Value

16. Family Health Care – Services Provided on Account
Family Health Care, P.C. performed services to patients on account in the amount of $6,100.
Family Health Care, P.C. performed services to patients on account in the amount of $6,100; this means Family Health will collect cash from the patients’ insurance companies in the future.
Services provided represent Fees Earned, which is a Revenue account that increases Retained Earnings and also is recorded in the Income Statement column.
The amount to be collected in the future is called an Account Receivable and is recorded as an asset on the Balance Sheet.
Revenue is recorded when service is earned and invoiced

17. Family Health Care – Services Provided for Cash
Family Health Care, P.C. performed services to patients who paid with cash in the amount of $5,500.
This transaction is similar to the September and October revenue transactions for Family Health Care.

18. Family Health Care – Collection of Accounts Receivable
Family Health Care, P.C. received $4,200 in cash payments from patients’ insurance companies for prior services performed.
Cash on the Balance Sheet is increased by $4,200 while Accounts Receivable decreases in the same amount.
The cash received is also shown as an increase to Operating activities on the Statement of Cash Flows column.

19. Family Health Care – Payment of Accounts Payable
Family Health Care, P.C. paid $100 for supplies previously purchased on account.
Cash decreases by $100 on the Balance Sheet. Since Supplies are used in the normal operations of Family Health Care, cash flows from Operating activities is also decreased in the Statement of Cash Flows column.
This transaction decreases the amount owed by $100, so there is also a decrease in Accounts Payable recorded of $100.

20. Family Health Care – Expenses Paid in Cash
Family Health Care, P.C. incurred expenses for the month of November and paid cash for a total of $4,690.
This transaction is similar to the September and October expense transaction.

21. Family Health Care – Dividends Paid in Cash
Family Health Care, P.C. paid dividends of $1,200.
This transaction is similar to the dividend transaction of September and October.

22. Describe and illustrate the end-of-period adjustment process
Learning Objective 3
Describe and illustrate the end-of-period adjustment process

23. Summary of Accruals and Deferrals
Adjustments are necessary because, at any point in time, some elements of the accounting equation are not up to date. Adjustments are necessary to match revenues and expenses; it is the application of the matching concept.
The Adjustment process completes the information necessary for financial statement preparation.
If all of a company’s transactions are in cash, no adjustments are necessary.

24. Deferrals Accruals Revenue earned Cash received or paid or expense
incurred
Deferrals
Accruals
Cash received
or paid
Revenue earned
or expense
incurred
Accruals
Deferrals are created by recording a transaction in a way that delays the recognition of an expense or a revenue.
Common examples include prepaid/deferred expenses or unearned/deferred revenues.
Prepaid or deferred expenses are items such as prepaid insurance; the amount is initially recorded as an asset, but become expenses over time.
Unearned or deferred revenues are items such as unearned revenue; cash is collected in advance of revenue actually being earned so a liability is recorded until the revenue is earned.
Accruals are created when a revenue or expense has been earned or incurred, but has not been recorded at the end of an accounting period.
Common examples include accrued expenses/liabilities or accrued revenues/assets.
Accrued expenses or liabilities are expenses that have been incurred but are not recorded in the accounts; an example would be wages incurred during a month which are unpaid on the last day of the month.
Accrued revenues or assets are revenues earned but not yet recorded; an example would be revenue for patient services earned but not yet billed to the insurance companies.

25. Deferred Expenses – Prepaid Insurance
As prepaid insurance expires, the asset Prepaid Insurance decreases.
On November 1, Family Health paid a $2,400 premium for a 2-year business insurance policy and a $6,000 premium for a 6 month malpractice policy.
During November, a portion of the prepaid insurance purchased has expired.
Since the business insurance is a two year policy, it is expiring at a rate of $100 per month ($2,400 / 24 months). The malpractice premium expires at a rate of $1,000 per month ($6,000 / 6 months). A total of $1,100 of prepaid insurance has expired during November.
Adjustments affect both a balance sheet account and an income statement account

26. Deferred Expenses – Supplies
During November, $150 of supplies was used in operations leaving a balance of $90.
During November, $150 of supplies was used in operations leaving a balance of $90.
The asset Supplies decreases by $150 and Retained Earnings also decreases to reflect the use of supplies in operations.
In addition, supplies expense under the Income Statement column is recorded as -$150.

27. Fixed Assets and Depreciation
Equipment used to
generate revenue over time
Equipment
purchased
Depreciation
Fixed assets such as office equipment lose their ability to provide service and, ultimately generate revenue, over time.
The reduction in an asset’s ability to provide service is called depreciation.
Depreciation is estimated based on the asset’s useful life.
A record of the original cost of the asset must be maintained for tax and other purposes; a contra asset account is used to accumulate depreciation on an asset over time.
Accumulated Depreciation is subtracted from the cost of the asset on the Balance Sheet.

28. Deferred Expenses – Depreciation
The depreciation on Office Equipment for Family Health Care is assumed to be $160 per month.
Depreciation is recorded by entering a -$160 in the Accumulated Depreciation column and the Retained Earnings column; depreciation expense is also recorded in the Income Statement column with a -$160.
Land is not depreciated, because it usually does not lose its ability to provide service.
The cost of the equipment is a type of deferred expense that is recognized as an expense over the fixed asset’s useful life.
The cost of the fixed asset less the balance of it accumulated depreciation is called the asset’s book value or carrying value.

29. Deferred Revenue – Unearned Rent
On November 1, Family Health Care received $1,800 from ILS for rental of land for five months.
1/5 of $1,800 or $360 is considered earned as of November 30.
Unearned Revenue decreases and Retained Earnings increases $360; in addition, Rent revenue increases by $360 under the Income Statement column.

30. Accrued Expenses – Wages Owed
Wages earned
End of month
Pay Day
Accrued expenses or liabilities are expenses that have been incurred but are not recorded in the accounts; an example would be wages incurred during a month which are unpaid on the last day of the month.
Normally, employees are not paid on the same day an accounting period ends.
Assume that Family Health Care employees have not been paid at the end of the month for work performed equating to $220.

31. Accrued Expenses – Wages Owed
The amount owed for wages not paid is $220.
The amount owed for wages not paid increases the liability account Wages Payable for $220.
Retained Earnings decreases and Wages expense is recorded under the Income Statement column as -$220.

32. Accrued Revenues – Patient Services
Family Health Care provides services worth $750 to patients and have not billed for these services at the end of the month.
Accrued revenues or assets are revenues earned but not yet recorded; an example would be revenue for patient services earned but not yet billed to the insurance companies.
Normally, accrued revenue adjustments are used to account for services provided near month end.
Assume that Family Health Care provided services of $750 to patients who have not yet been billed.
This adjustment is recorded by increasing Accounts Receivable to represent the $750 which will be billed.
Retained Earnings increases and Fees earned is recorded under the Income Statement column as $750.

33. Learning Objective 4
Prepare financial statements using accrual concepts of accounting, including a classified balance sheet

34. Summary of Transactions for Family Health Care
Family Health Care, P.C. prepares the four required financial statements to summarize November activity after adjustments.
The Income Statement is still prepared by summarizing the transactions listed under the Income Statement column of the Exhibit 2 worksheet from the text. Then, the Statement of Retained earning will be prepared. The Balance Sheet will be prepared from the worksheet by reporting the balances of the asset, liability and equity columns. Finally, the Statement of Cash Flows will be prepared.

35. Income Statement after Adjustments
Revenues are a result of providing services or selling products to customers. Fees earned represents services provided for cash, on account, and those accrued at the end of the month. Family Health Care has revenues from patient services and rental revenue. Revenues from the primary operations of the business are reported separately from other revenue; since the primary operation of the business is providing services to patients, rental revenue is reported under “Other Income”.
Expenses are matched against revenues to determine Net Income.
Expenses now include depreciation expense of $160.
Wage expense of $3,010 includes the $2,790 of wages paid plus the accrual of $220 at the end of the month.
Expenses not related to the primary operation of the business are reported as “Other Expenses”.
Operating income is determined by deducting operating expenses from fees earned; Family Health Care reports operating income of $6,030.
Other income of $360 from rental revenue is then added to operating income to determine the net income for November of $6,390.

36. Retained Earnings Statement after Adjustments
November net income of $6,930 (from the income statement) is added to the retained earnings of $3,320 at November 1.
Dividends paid of $1,200 are deducted.
Ending retained earnings of $8,510 is included on Family Health Care’s balance sheet at November 30, 2011.

37. Balance Sheet after Adjustments
The balance sheet shown is a classified balance sheet which has various sections, subsections and captions.
ASSETS:
Assets on a classified balance sheet are normally reported as Current assets, Fixed assets, and Intangible assets.
Current assets are cash and other assets expected to be converted to cash or used up within one year through normal operations and include accounts receivable and inventory.
Fixed assets are physical assets of a long-term nature and, except for land, depreciate over time.
Accumulated depreciations, a contra account to property, plant and equipment, is included in the fixed asset section of the balance sheet.
Family Health Care reports $8,500 of office equipment net of $160 of accumulated depreciation, for a book value of $8,340.
Intangible assets represent rights that will provide a long-term benefit to a company but do not have physical presence; examples are patent rights, copyrights, and goodwill.
Family Health Care has no intangible assets.
LIABILITIES:
Liabilities on a classified balance sheet are also split into current liabilities and long-term liabilities.
Current liabilities are due within a short period of time, usually one year or less, and are to be paid for from current assets and include accounts payable and wages payable.
Long-term liabilities are not expected to come due for a period of more than one year; as long-term liabilities come due, they are reclassified to current liabilties.
Family Health Care has $16,800 of notes payable, $6,800 due next year and reported as a current liability, the remaining balance is reported as a long term liability.
EQUITY:
Capital stock represents amounts invested in the company by stockholders.
Family Health Care has $11,000 of capital stock which represents the initial investment of $6,000 made by Dr. Landry on September 1 and the additional $5,000 amount invested during November by Dr. Landry.
Retained earnings represents net income that has been retained in the company and not paid out through dividends.
The retained earnings of $8,510 is the ending balance reported on the statement of retained earnings for November 30, 2011.

38. Statement of Cash Flows after Adjustments
The statement of cash flows is still prepared by summarizing the transactions in the Statement of Cash Flows column of the Exhibit 2 worksheet.
The Cash flows from operating activities section summarizes all operating activity transactions; cash receipts from operations are added, cash payments for expenses subtracted.
The Cash flows from investing activities is prepared by summarizing all the investing activities from the Statement of Cash Flows column on Exhibit 2.
During November, Family Health Care invested in office equipment; only $1,700 of the purchase price was paid in cash and that is the only portion reported as an investing activity on the statement of cash flows.
The Cash flows from financing activities is prepared by summarizing all the financing activities from the Statement of Cash Flows column on Exhibit 2.
During November, Family Health Care received an additional cash investment from Dr. Landry of $5,000 and paid dividends of $1,200.

39. How the Financial Statements Integrate:

40. Learning Objective 5
Describe how the accrual basis of accounting enhances the interpretation of financial statements

41. Cash vs. Accrual Basis of Accounting
Accrual based accounting enhances interpretation of financial statements by following a standard set of rules (GAAP) for recording and reporting and is a better predictor of long-term profitability. Accrual based accounting is required for publicly held corporations.
Under cash basis accounting, transactions are recorded only when cash is paid or received and this could lead to misleading financial reporting due to timing issues.
Revenue earned in a period but collected in a future period is not reported and may understate net income.
Cash collected in advance for revenue that will not be earned until the future may overstate income for a period.
Cash basis is only used by individuals and small businesses.

42. Importance of Accrual Based Accounting
Accrual based accounting provides a more accurate measure of company performance.
Accrual based accounting reports important changes in revenue, regardless of cash collection, which is important in an expanding profitable business.
However, Cash from operations is important to the long-run solvency of a business; companies need cash to survive.
Family Health Care financial statements illustrate why financial statements should be analyzed together.

43. Accrual Accounting and the Accounting Cycle
Identify
Transactions
Prepare
Financial
Statements
Record
Adjustments
The accounting cycle is the process that begins with identifying transactions and ends with preparing financial statements.
Basic steps of the accounting cycle:
Identifying, analyzing, and recording the effects of transactions on the accounting equation
Identifying, analyzing, and recording adjustment data
Preparing financial statements
All steps were illustrated in this chapter!
The ending balances for the Balance Sheet columns become the beginning balances for the next period.

44. End of Chapter 3