1. ©2008 Pearson Prentice Hall. All rights reserved. 3-1 Accrual Accounting & Income Chapter 3

2. ©2008 Pearson Prentice Hall. All rights reserved. 3-2 Accrual vs. Cash-Basis Accounting ACCRUAL Records business transactions when they occur  When sale is made  When bill is received Complies with GAAP Presents accurate financial picture CASH Records transactions only when cash is received or paid  When customer pays for product or service  When bills are paid Only used by very small businesses Omits important info

3. ©2008 Pearson Prentice Hall. All rights reserved. 3-3 Learning Objective 1 Relate accrual accounting and cash flows

4. ©2008 Pearson Prentice Hall. All rights reserved. 3-4 Accrual Accounting and Cash Flows Accrual accounting records both cash and non-cash transactions Cash Collecting from customers Paying for expenses Borrowing money Issuing Stock Non-cash Sales on account Purchases on account Using prepaid expenses, such as supplies

5. ©2008 Pearson Prentice Hall. All rights reserved. 3-5 Time-Period Concept Businesses do not stop operations to measure financial transactions Accountants prepare financial statements at regular intervals to measure performance Companies select a twelve-month period for reporting purposes:  Calendar year  Fiscal year

6. ©2008 Pearson Prentice Hall. All rights reserved. 3-6 Learning Objective 2 Apply the revenue and matching principles

7. ©2008 Pearson Prentice Hall. All rights reserved. 3-7 The Revenue Principle Revenue is recorded when earned  When product or service is delivered to customer  Cash may come before, at the same time, or after delivery Revenue is recorded at the cash value of goods or services provided

8. ©2008 Pearson Prentice Hall. All rights reserved. 3-8 The Matching Principle Expenses are incurred to help produce revenue Expenses should be recorded in the time period in which they are incurred Expenses should be matched to the revenues they help produce REVENUESEXPENSES

9. ©2008 Pearson Prentice Hall. All rights reserved. 3-9 Expenses May be paid in cash  Paying monthly rent May arise from using up an asset  Using supplies previously purchased May arise from creating a liability  Receive a bill from a supplier

10. ©2008 Pearson Prentice Hall. All rights reserved. 3-10 Learning Objective 3 Adjust the accounts

11. ©2008 Pearson Prentice Hall. All rights reserved. 3-11 The Adjustment Process At the end of the period, a business prepares financial statements Ensures that:  All revenue that has been earned has been recorded  All expenses that have been incurred are matched to revenues  Asset and liability accounts are up-to-date

12. ©2008 Pearson Prentice Hall. All rights reserved. 3-12 Categories of Adjusting Entries Deferrals Depreciation Accruals

13. ©2008 Pearson Prentice Hall. All rights reserved. 3-13 Deferrals Cash has already been received or paid  Related expense or revenue has not yet been recorded Prepaid expenses  Company has paid for expense in advance  Adjustment needed to record amount used Unearned revenues  Customer pays in advance for good or service  Adjustment needed to record amount of revenue earned

14. ©2008 Pearson Prentice Hall. All rights reserved. 3-14 Prepaid Expenses Expenses paid in advance Include prepaid rent and supplies Asset is recorded when purchased Adjustment needed to record amount used

15. ©2008 Pearson Prentice Hall. All rights reserved. 3-15 Prepaid Rent Example Suppose on April 1 on a company paid $12,000 for one year’s rent in advance JOURNAL Date Accounts Debit Credit 1-Apr Prepaid rent $12,000 Cash $12,000

16. ©2008 Pearson Prentice Hall. All rights reserved. 3-16 Prepaid Rent Example Now, it’s December 31, the company’s year-end The amount of rent that has expired must be recorded This amount is recorded as rent expense Prepaid rent (asset) needs to be reduced so it reflects the amount of rent remaining

17. ©2008 Pearson Prentice Hall. All rights reserved. 3-17 April 1, current year December 31April 1, following year $12,000 Prepaid Rent April 1 to December 31 = 9 months 9 out of 12 months of rent has expired 9/12 x $12,000 = $9,000 3 out of 12 months of rent remains 3/12 x $12,000 = $3,000 $9,000$3,000 3-17

18. ©2008 Pearson Prentice Hall. All rights reserved. 3-18 Prepaid Rent Example Dec 31 – Adjust Prepaid Rent account for amount expired JOURNAL Date Accounts Debit Credit 12-31 Rent Expense $9,000 Prepaid Rent $9,000

19. ©2008 Pearson Prentice Hall. All rights reserved. 3-19 Prepaid RentRent Expense Apr 1 $12,000Dec 31 $9,000 $3,000 End-of-year balance Represents amount expired Represents amount remaining

20. ©2008 Pearson Prentice Hall. All rights reserved. 3-20 Supplies Example Suppose a company purchased $3,200 of supplies during the year  The asset “supplies” was debited for each purchase At the end of the year, a physical count reveals $500 of supplies on hand

21. ©2008 Pearson Prentice Hall. All rights reserved. 3-21 Supplies Example Supplies $3,200 Balance per ledger $500 Balance per physical count What amount of supplies was used? Subtract the balance per count from the balance per ledger

22. ©2008 Pearson Prentice Hall. All rights reserved. 3-22 Supplies Example Dec 31 – Adjust Supplies account for amount used JOURNAL Date Accounts Debit Credit 12-31 Supplies Expense $1,700 Supplies $1,700

23. ©2008 Pearson Prentice Hall. All rights reserved. 3-23 SuppliesSupplies Expense $3,200Dec 31 $1,700 $500 End-of-year balance Represents amount used Represents amount on hand

24. ©2008 Pearson Prentice Hall. All rights reserved. 3-24 Depreciation of Plant Assets Allocation of plant assets cost over their useful lives Results in a debit to an expense  Depreciation Expense Corresponding credit  Accumulated Depreciation

25. ©2008 Pearson Prentice Hall. All rights reserved. 3-25 Accumulated Depreciation Account that shows the sum of depreciation expense of the plant asset Contra-asset  Always has a companion account  Normal credit balance

26. ©2008 Pearson Prentice Hall. All rights reserved. 3-26 Depreciation Example A company purchases equipment for $50,000 The estimated useful life of the equipment is five years = $5,000 annual depreciation 50,000/5 years

27. ©2008 Pearson Prentice Hall. All rights reserved. 3-27 Depreciation Example Dec 31 – Adjusting entry to record depreciation of equipment JOURNAL Date Accounts Debit Credit 12-31 Depreciation Expense $5,000 Accumulated Depreciation $5,000

28. ©2008 Pearson Prentice Hall. All rights reserved. 3-28 Depreciation – Balance Sheet Balance Sheet Plant assets: Equipment$50,000 Less: Accum. Depr.(5,000)$45,000

29. ©2008 Pearson Prentice Hall. All rights reserved. 3-29 Accrued Expenses Expense incurred before cash is paid Result in a liability Common accrued expenses:  Salaries  Interest  Taxes

30. ©2008 Pearson Prentice Hall. All rights reserved. 3-30 Accrued Salary Expense Example A company pays its employees a weekly salary each Friday Salaries for each week total $10,000 December 31, the company’s year-end, falls on a Wednesday

31. ©2008 Pearson Prentice Hall. All rights reserved. 3-31 Monday, December 29 Wednesday, December 31 year end Friday, January 2 pay day $10,000 Salaries Monday through Wednesday = 3 days 3 out of 5 days of salaries expense has been incurred 3/5 x $10,000 = $6,000 $6,000$4,000

32. ©2008 Pearson Prentice Hall. All rights reserved. 3-32 Accrued Salary Expense Example Dec 31 – Record accrued salary expense JOURNAL Date Accounts Debit Credit 12-31 Salary expense $6,000 Salary payable $6,000

33. ©2008 Pearson Prentice Hall. All rights reserved. 3-33 Accrued Revenues Companies often earn revenue before cash is received Results in an accrued revenue  Receivable recorded

34. ©2008 Pearson Prentice Hall. All rights reserved. 3-34 Accrued Revenue Example A company performed services for customers during the last week of the year totaling $5,000 The revenue has not yet been recorded because the customers won’t be billed until January

35. ©2008 Pearson Prentice Hall. All rights reserved. 3-35 Accrued Salary Expense Example Dec 31 – Record accrued revenue JOURNAL Date Accounts Debit Credit 12-31 Accounts Receivable $5,000 Service Revenue $5,000

36. ©2008 Pearson Prentice Hall. All rights reserved. 3-36 Unearned Revenues Recorded as a liability when company receives payment  Company owes customer product or service Revenue is not recorded until earned  When company provides product or service An adjusting entry is made to transfer amount from unearned revenue to revenue

37. ©2008 Pearson Prentice Hall. All rights reserved. 3-37 Unearned Revenue Example On November 1, a company receives a customer payment of $18,000 for services to be performed during the next three months

38. ©2008 Pearson Prentice Hall. All rights reserved. 3-38 Unearned Revenue Example Nov 1 – Record advance payment received by customer JOURNAL Date Accounts Debit Credit 11-1 Cash $18,000 Unearned revenue $18,000

39. ©2008 Pearson Prentice Hall. All rights reserved. 3-39 November 1, current year December 31January 31, following year $18,000 November 1 to December 31 = 3 months 2 out of 3 months of revenue has been earned 2/3 x $18,000 = $12,000 1 out of 3 months remains unearned 1/3 x $18,000 = $6,000 $12,000$6,000

40. ©2008 Pearson Prentice Hall. All rights reserved. 3-40 Unearned Revenue Example Dec 31 – Record portion of unearned revenue that has been earned JOURNAL Date Accounts Debit Credit 12-31 Unearned revenue $12,000 Service revenue $12,000

41. ©2008 Pearson Prentice Hall. All rights reserved. 3-41 Unearned RevenueService Revenue Dec 31 $12,000Nov 1 $18,000Dec 31 $12,000 $6,000 End-of-year balance Represents amount earned Represents amount unearned

42. ©2008 Pearson Prentice Hall. All rights reserved. 3-42 Summary of Adjusting Entries Purpose of adjusting entries  Measure income  Update balance sheet Each adjusting entry affects  One income statement account Revenue or Expense  One balance sheet account Asset or liability

43. ©2008 Pearson Prentice Hall. All rights reserved. 3-43 Adjusted Trial Balance Trial balance prepared after adjusting entries are made and posted These amounts are used to prepare the financial statements:  Income Statement  Statement of Retained Earnings  Balance Sheet

44. ©2008 Pearson Prentice Hall. All rights reserved. 3-44 Learning Objective 4 Prepare the financial statements

45. ©2008 Pearson Prentice Hall. All rights reserved. 3-45 Income Statement Reports net income or loss Revenues minus expenses Net income flows to Retained Earnings Statement

46. ©2008 Pearson Prentice Hall. All rights reserved. 3-46 Statement of Retained Earnings Shows changes to the Retained Earnings account Net Income is added to beginning balance Dividends are subtracted Ending Retained Earnings flows to the Balance Sheet

47. ©2008 Pearson Prentice Hall. All rights reserved. 3-47 Balance Sheet Reports assets, liabilities and equity Shows that the accounting equation is in balance

48. ©2008 Pearson Prentice Hall. All rights reserved. 3-48 INCOME STATEMENT RETAINED EARNINGS STATEMENT BALANCE SHEET NET INCOME ENDING RETAINED EARNINGS

49. ©2008 Pearson Prentice Hall. All rights reserved. 3-49 Learning Objective 5 Close the books

50. ©2008 Pearson Prentice Hall. All rights reserved. 3-50 Closing the Books Done after financial statements are prepared Set temporary accounts to zero Transfers balances to retained earnings account Journalizes activity in Statement of Retained Earnings

51. ©2008 Pearson Prentice Hall. All rights reserved. 3-51 Temporary and Permanent Accounts Temporary Revenues, Expenses and Dividends Closed Balances represent a period of time Permanent Asset, liability and equity accounts Not closed Ending balance of one period carries over to following period

52. ©2008 Pearson Prentice Hall. All rights reserved. 3-52 Closing Entries Debit each Revenue account for the amount in its credit balance  Retained earnings is credited Credit each Expense account for the amount in its debit balance  Retained earnings is debited Credit Dividends for the amount in its debit balance  Retained earnings is debited R E D

53. ©2008 Pearson Prentice Hall. All rights reserved. 3-53 E3-29 Dec 31 – Close Revenues JOURNAL Date Accounts Debit Credit 12-31 Service Revenue $23,600 Other revenue 600 Retained earnings $24,200

54. ©2008 Pearson Prentice Hall. All rights reserved. 3-54 E3-29 Dec 31 – Close expenses JOURNAL DateAccountsDebitCredit 31-Dec ________________________ ________ _ Cost of services sold $11,600 Selling, general & admin exp $6,900 Depreciation expense $4,100 Income tax expense $500 Which account would be debited? Total the expenses for the amount

55. ©2008 Pearson Prentice Hall. All rights reserved. 3-55 E3-29 Dec 31 – Close Dividends JOURNAL Date Accounts Debit Credit 12-31 Retained earnings $400 Dividends $400

56. ©2008 Pearson Prentice Hall. All rights reserved. 3-56 E3-29 Retained earnings Balance 12-31-X1 Balance 12-31-X2 $1,900 $24,200$400 $23,100 Revenues Expenses Dividends $2,600 Determine net income. Remember revenues minus expenses

57. ©2008 Pearson Prentice Hall. All rights reserved. 3-57 Classifying Assets & Liabilities Current and long-term classifications are based on liquidity  How quickly item is converted to in cash Current assets will be converted to cash, sold or used during the next year Long-term assets include plant assets Current liabilities must be paid in the next 12 months Long-term liabilities have due dates more than one year from balance sheet date

58. ©2008 Pearson Prentice Hall. All rights reserved. 3-58 Classified Balance Sheet Places assets into meaningful categories Categories:  Current assets  Long-term investments  Property, plant and equipment  Intangible assets  Other assets

59. ©2008 Pearson Prentice Hall. All rights reserved. 3-59 Balance Sheet Formats Report format  Assets at the top  Followed by liabilities and stockholders’ equity Account format  Assets on the left  Liabilities and stockholders’ equity on the right

60. ©2008 Pearson Prentice Hall. All rights reserved. 3-60 Income Statement Formats Single-step  All revenues and gains grouped together  All expenses and losses grouped together Multi-step  Includes useful subtotals  Gross profit Net revenues minus cost of goods sold  Income from operations  Net income

61. ©2008 Pearson Prentice Hall. All rights reserved. 3-61 Learning Objective 6 Use two new ratios to evaluate a business

62. ©2008 Pearson Prentice Hall. All rights reserved. 3-62 Current ratio Measure company’s ability to pay current liabilities with current assets Rule of thumb:  Strong current ratio is 1.50 Current assets Current liabilities

63. ©2008 Pearson Prentice Hall. All rights reserved. 3-63 Debt Ratio Proportion of assets that is financed with debt High debt ratio indicates more risk Total liabilities Total assets

64. ©2008 Pearson Prentice Hall. All rights reserved. 3-64 S3-14 Current ratio: Current assets = Cash + Accounts Receivable + Inventories + Other current assets $900 + $27,700 + $33,000 = $4,800 = $66,400 Total Current liabilities = $53,600 Current ratio = 66,400 / 53,600 Current ratio = ______

65. ©2008 Pearson Prentice Hall. All rights reserved. 3-65 S3-14 Debt ratio: Total liabilities = Current liabilities + Long-term liabilities $53,600 + $13,500 = $67,100 Total assets = Current assets + Property & Equipment, net + Other assets $66,400 + $7,200 + $24,300 = 97,900 Debt ratio = $67,100 / $97,900 Debt ratio =.69

66. ©2008 Pearson Prentice Hall. All rights reserved. 3-66 End of Chapter Three