© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-1 CHAPTER 3 Investment Banking Basics: Accrual Accounting and.

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-2 THE BUSINESS CYCLE Businesses pay cash to buy goods and services Businesses sell goods and services, receiving cash to complete the cycle

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-3 THE BUSINESS CYCLE 1 Entity has cash 1 Entity has cash 2 Entity holds inventory 2 Entity holds inventory 3 Entity has a receivable 3 Entity has a receivable Purchase of inventory Collection of the receivable Sale of inventory on account

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-4 ACCRUAL-BASIS ACCOUNTING VS. CASH-BASIS ACCOUNTING Accrual accounting –Recognizes the impact of a business event as it occurs Revenues are recorded as they are earned Expenses are recorded as they are incurred –Is based on a conceptual framework that includes a number of accounting concepts and principles –Is required by GAAP

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-5 THE TIME-PERIOD CONCEPT Accountants slice time into small segments and prepare financial statements to show progress for specific time periods –The most basic accounting period is one year –Companies prepare financial statements for interim periods of less than one year

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-6 THE REVENUE PRINCIPLE The revenue principle tells accountants –When to record revenue with a journal entry Revenue is recorded when it is earned It is earned when the business has delivered a completed good or service to the customer –The amount of revenue to record The amount is equal to the cash value of the goods or services transferred to the customer

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-7 I plan to have you make my travel arrangements March 12 March 12 Air & Sea Travel, Inc. April 2 April 2 Air & Sea Travel, Inc. No transaction has occurred Situation 1 - Do Not Record Revenue No transaction has occurred Situation 1 - Do Not Record Revenue The client has taken a trip arranged by Air & Sea Travel Situation 2 - Record Revenue The client has taken a trip arranged by Air & Sea Travel Situation 2 - Record Revenue photos Disney World

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-8 THE MATCHING PRINCIPLE The matching principle –Is the basis for recording expenses –Directs accountants to Identify all expenses incurred during the accounting period Measure the expenses Match expenses against revenues during the same period

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-9 THE MATCHING PRINCIPLE Revenue Expense Net income = Revenue Expense (Net loss) = Net income The matching principle matches the expense of a period against the revenue earned during the period. To match an expense means to subtract the expense from the revenue in order to measure net income or net loss or Net loss

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-10 THE MATCHING PRINCIPLE A natural link (cause and effect) exists between revenues and some types of expenses –Sales commissions –Cost of goods sold Some expenses are not linked with sales but with a particular time period –Rent expense –Salary expense

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-12 THE ADJUSTMENT PROCESS The adjustment process begins with the trial balance The unadjusted trial balance lists the accounts and their balances after the period’s transactions have been recorded

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-13 These trial balance accounts are incomplete because they omit certain revenue and expense transactions that affect more than one accounting period The accrual basis requires adjustment at the end of the period to produce correct balances for the financial statements THE ADJUSTMENT PROCESS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-15 Consider the Supplies account –Supplies is adjusted once a month –The amount on the trial balance represents the cost of supplies available for use during the month –The supplies on hand at the end of the month must be counted to determine the correct amount to report on the balance sheet THE ADJUSTMENT PROCESS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-16 THE ADJUSTMENT PROCESS March 31April 30 Supplies available for use during April Supplies on hand at April 30 Supplies expense for April = TOTAL COSTASSETEXPENSE $700$400$300 = = The adjustment of Supplies (and Supplies Expense) at the end of the accounting period The adjusting entry updates both the Supplies asset account and the Supplies Expense account

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-17 Accountants make adjusting entries in the journal at the end of the period to enter adjustments into the accounting records Adjusting entries –Assign revenues to the period in which they are earned and expenses to the period in which they are incurred –Update the asset and liability accounts THE ADJUSTMENT PROCESS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-18 THE ADJUSTMENT PROCESS Summary of the Accounting Cycle January 1December 31 Adjustments are made at the end of the period, but before the financial statements are prepared Transactions are recorded all during the period

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-19 Adjusting entries can be grouped into three basic categories: –Deferrals An adjustment of an asset or a liability for which the business paid or received cash in advance –Depreciation The systematic allocation of the cost of a plant asset to expense over the asset’s useful life –Accruals The recording of an expense or a revenue before paying or receiving cash THE ADJUSTMENT PROCESS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-20 PREPAID EXPENSES PREPAID RENT Suppose Air & Sea Travel prepays three months’ rent on April 1, 20X1. If the lease specifies a monthly rental amount of $1,000, the entry to record the payment for three months debits Prepaid Rent as follows: Apr. 1 Prepaid Rent (1,000 x 3) 3,000 Cash 3,000 Paid three months’ rent in advance Apr. 1 Prepaid Rent (1,000 x 3) 3,000 Cash 3,000 Paid three months’ rent in advance

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-21 PREPAID EXPENSES PREPAID RENT At April 30, Prepaid Rent is adjusted to remove one month’s expense from the asset account. The adjustment transfers one-third of the asset balance from Prepaid Rent to Rent Expense as follows: Apr. 30 Rent Expense (3000 x1/3) 1,000 Prepaid Rent 1,000 To record rent expense Apr. 30 Rent Expense (3000 x1/3) 1,000 Prepaid Rent 1,000 To record rent expense

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-22 PREPAID EXPENSES PREPAID RENT After posting, Prepaid Rent and Rent Expense appear as follows: Prepaid RentRent Expense Apr 1. 3,000 Apr. 30 1,000 Bal. 2,000 Apr. 30 1,000 Bal. 1,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-23 PREPAID EXPENSES SUPPLIES On April 2, Air & Sea Travel paid cash of $700 for office supplies Apr. 2 Supplies 700 Cash 700 Paid cash for supplies Apr. 2 Supplies 700 Cash 700 Paid cash for supplies

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-24 PREPAID EXPENSES SUPPLIES To measure the business’s supplies expense during April, the owners count the supplies on hand at the end of the month. The count indicates that supplies costing $400 remain. Subtracting the entity’s $400 supplies on hand at the end of April from the cost of supplies available during April ($700) measures supplies expense during the month ($300).

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-25 PREPAID EXPENSES SUPPLIES The April 30 adjusting entry to update the Supplies account and to record the Supplies Expense for the month is as follows: Apr 30 Supplies Expense ( $700 - $400) 300 Supplies 300 To record supplies expense Apr 30 Supplies Expense ( $700 - $400) 300 Supplies 300 To record supplies expense

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-26 PREPAID EXPENSES SUPPLIES SuppliesSupplies Expense Apr 2. 700 Apr. 30 300 Bal. 400 Apr. 30 300 Bal. 300 After posting the accounts appear as follows:

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-27 DEPRECIATION OF PLANT ASSETS Plant assets are –Long-lived tangible assets, such as land, buildings, furniture, machinery, and equipment used in the operations of the business Depreciation is –The process of allocating the cost of the decline in value of a plant asset to expense

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-28 DEPRECIATION OF PLANT ASSETS On April 3, Air & Sea Travel purchased furniture on account for $16,500 and made the following entry: Apr. 3 Furniture 16,500 Accounts Payable 16,500 Purchased office furniture on account Apr. 3 Furniture 16,500 Accounts Payable 16,500 Purchased office furniture on account

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-29 DEPRECIATION OF PLANT ASSETS The straight-line method of depreciation gives an annual depreciation expense of $3,300 $16,000/5 years = $3,300 per year Depreciation for the month of April is $275 $3,300/12 months = $275 per month

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-30 DEPRECIATION OF PLANT ASSETS Depreciation expense for April is recorded as follows: Apr 30 Depreciation Expense - Furniture 275 Accumulated Depreciation - Furniture 275 To record depreciation on furniture Apr 30 Depreciation Expense - Furniture 275 Accumulated Depreciation - Furniture 275 To record depreciation on furniture

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-31 The Accumulated Depreciation account –Shows the cumulative sum of all depreciation expense from the date of acquiring the asset –Is a contra asset account An asset account with a normal credit balance A contra account –Always has a companion account –Always has a normal balance that is opposite that of the companion account DEPRECIATION OF PLANT ASSETS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-32 DEPRECIATION OF PLANT ASSETS After posting, the Furniture, Accumulated Depreciation - Furniture, and Depreciation Expense - Furniture accounts appear as follows: Furniture Apr. 3 16,500 Bal. 16,500 Accumulated Depreciation Furniture Apr. 30 275 Bal. 275 Depreciation Expense Furniture Apr. 30 275 Bal. 275

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-33 DEPRECIATION OF PLANT ASSETS Book value is the net amount of a plant asset (cost minus accumulated depreciation) Plant Assets: Furniture $16,500 Less Accumulated Depreciation (275) Book value $16,225 Plant Assets: Furniture $16,500 Less Accumulated Depreciation (275) Book value $16,225

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-34 ACCRUED EXPENSES An accrued expense is a liability that arises from an expense that the business has incurred but has not yet paid

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-35 ACCRUED EXPENSES SALARY EXPENSE Air & Sea Travel pays its employee a monthly salary of $1,900, half on the 15th and half on the last day of the month. During April, the agency paid the employee’s first half-month salary of $950 and made the following entry: Apr. 15 Salary Expense 950 Cash 950 To pay salary Apr. 15 Salary Expense 950 Cash 950 To pay salary

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-36 ACCRUED EXPENSES SALARY EXPENSE Because April 30, the second payday of the month, falls on a Saturday, the second half-month amount of $950 will be paid on Monday, May 2. At April 30, Air & Sea’s accountant adjusts for additional salary expense and salary payable of $950 by recording an increase in each account as follows: Apr. 30 Salary Expense 950 Salary Payable 950 To accrue salary expense Apr. 30 Salary Expense 950 Salary Payable 950 To accrue salary expense

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-37 ACCRUED EXPENSES SALARY EXPENSE After posting, the Salary Payable and Salary Expense accounts appear as follows: Salary PayableSalary Expense Apr. 30 950 Bal. 950 Apr. 15 950 Apr. 30 950 Bal. 1,900

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-39 ACCRUED REVENUES Guerrero Tours hires Air & Sea Travel on April 15 to perform services on a monthly basis. Guerrero will pay the travel agency $500 monthly, with the first payment on May 15. On April 30, Air & Sea Travel makes the following adjusting entry for half a month’s fee: Apr. 30 Accounts Receivable ($500 x 1/2) 250 Service Revenue 250 To accrue service revenue Apr. 30 Accounts Receivable ($500 x 1/2) 250 Service Revenue 250 To accrue service revenue

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-40 ACCRUED REVENUES Posting this adjusting entry has the following effects on these two accounts: Accounts Receivable 2,250 Apr. 30 250 Service Revenue 7,000 Apr. 30 250 Bal. 2,500Bal. 7,250

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-41 UNEARNED REVENUES An unearned revenue is an obligation arising from receiving cash in advance of providing a product or a service

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-42 UNEARNED REVENUES Baldwin Investment Bankers agrees to pay the travel agency $450 monthly. If Air & Sea Travel collects the first amount on April 20, the increases in assets and liabilities are recorded as follows: Apr. 20 Cash 450 Unearned Service Revenue 450 Received revenue in advance Apr. 20 Cash 450 Unearned Service Revenue 450 Received revenue in advance Unearned Service Revenue is a liability because it represents Air & Sea’s obligation to perform service for the client

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-43 UNEARNED REVENUES During the last 10 days of the month, the travel agency will earn one-third of the $450. The accountant makes the following adjustment: Apr. 30 Unearned Service Revenue (450 x 1/3) 150 Service Revenue 150 To record unearned service revenue that has been earned Apr. 30 Unearned Service Revenue (450 x 1/3) 150 Service Revenue 150 To record unearned service revenue that has been earned

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-44 UNEARNED REVENUES After posting, the balance of these two accounts appears as follows: Unearned Service Revenue Apr. 30 150 Apr. 20 450 Bal. 300 Service Revenue 7,000 Apr. 30 250 Apr. 30 150 Bal. 7,400

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-48 THE ADJUSTED TRIAL BALANCE The adjusted trial balance lists the accounts, along with their adjusted balances Trial Balance

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-50 PREPARING THE FINANCIAL STATEMENTS FROM THE ADJUSTED TRIAL BALANCE The April financial statements of Air & Sea Travel can be prepared from the adjusted trial balance

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-53 ETHICAL ISSUES IN ACCRUAL ACCOUNTING Ethical issues include –“Managing” earnings to meet established goals or budgets –Misrepresenting company assets, liabilities, revenues, and expenses to financial statement users

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-54 CLOSING THE BOOKS Temporary (nominal) accounts are –Revenue, expense, and dividends accounts –Closed at the end of the accounting period Permanent (real) accounts are –Assets, liabilities, and stockholders’ equity accounts –Are not closed at the end of the period because their balances are not used to measure income

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-55 CLOSING THE BOOKS Closing entries transfer revenue, expense, and dividends balances from their respective accounts to the Retained Earnings account

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-56 CLOSING THE BOOKS The following are the steps in closing the accounts of a corporation: ÀDebit each revenue account for the amount of its credit balance. Credit Retained Earnings for the sum of the revenues This entry transfers the sum of the revenues to the credit side of Retained Earnings ÁCredit each expense account for the amount of its debit balance. Debit Retained Earnings for the sum of the expenses This entry transfers the sum of the expenses to the debit side of Retained Earnings

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-57 CLOSING THE BOOKS ÂCredit the Dividends account for the amount of its debit balance. Debit the Retained Earnings account This entry transfers the dividends amount to the debit side of the Retained Earnings account If Air & Sea Travel closes the books at the end of April, the following slides present the complete closing process for the business

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-58 Journalizing Closing Entries  Apr. 30Service Revenue7,400 Retained Earnings 7,400  30Retained Earnings4,415 Rent Expense 1,000 Salary Expense 1,900 Supplies Expense 300 Depreciation Expense 275 Utilities Expense 400 Income Tax Expense 540  30Retained Earnings3,200 Dividends 3,200  Apr. 30Service Revenue7,400 Retained Earnings 7,400  30Retained Earnings4,415 Rent Expense 1,000 Salary Expense 1,900 Supplies Expense 300 Depreciation Expense 275 Utilities Expense 400 Income Tax Expense 540  30Retained Earnings3,200 Dividends 3,200

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-59 Posting Closing Entries: Depreciation Expense Adj. 275 Bal. 275Clo. 275 Income Tax Expense Bal. 540 Utilities Expense Bal. 400 Supplies Expense Bal. 300 Salary Expense Bal. 1,900 Rent Expense Bal. 1,000 Adj. 1,000 950 Adj. 950 Adj. 300 Adj. 400 Adj. 540 Clo. 1,000 Clo. 1,900 Clo. 300 Clo. 400 Clo. 540 Service Revenue 7,000 Adj. 250 Adj. 150 Clo, 7,400Bal. 7,400 Retained Earnings Clo. 4,415 Clo. 3,200 11,250 Clo. 7,400 Bal 11,035 Dividends Bal. 3,200Clo. 3,200 Adj. = Amount posted from an adjusting entry; Clo. = Amount posted from a closing entry; Bal. = Balance As arrow  shows, it is not necessary to make a separate closing entry for each expense. In one closing entry, record one debit to Retained Earnings and a separate credit to each expense account   

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-61 Liquidity is a measure of how quickly an item can be converted to cash Balance sheets list assets and liabilities in the order of their relative liquidity

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-62 ASSETS Current assets –Are assets that are expected to be converted to cash, sold, or consumed during the next 12 months or within the business’s normal operating cycle if longer than a year –Include Cash, Accounts Receivable, Notes Receivable, and Prepaid Expenses - merchandising entities include Inventory in current assets

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-63 ASSETS Long-term assets –Are all assets that are not classified as current assets. They are not held for sale, but rather are used to operate the business –Include plant assets (Property, Plant, and Equipment), Land, Buildings, Furniture and Fixtures, and Equipment –Include investments in Available-for-Sale Securities, investments in Held-to-Maturity Securities, and Other Assets

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-64 LIABILITIES Current liabilities –Are debts that are due to be paid within one year or within the entity’s operating cycle if longer than a year –Include Accounts Payable, Notes Payable due within one year, Salary Payable, Unearned Revenue, Interest Payable, and Income Tax Payable

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-65 LIABILITIES Long-term liabilities –Are all liabilities that are not classified as current –Include Notes Payable - Long Term

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-66 DIFFERENT FORMATS FOR THE FINANCIAL STATEMENTS Balance sheet formats –The account format Lists the assets at left and the liabilities and stockholders’ equity at right –The report format Lists the assets at the top, followed by the liabilities and stockholders’ equity below

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-67 Income statement formats –A single-step income statement Lists all the revenues together under a heading such as Revenues or Revenues and Gains. The expenses appear in a separate category titled Expenses, Costs and Expenses, or Expenses and Losses –A multi-step income statement Contains a number of subtotals to highlight important relationships among revenues and expenses DIFFERENT FORMATS FOR THE FINANCIAL STATEMENTS

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-68 MULTI-STEP INCOME STATEMENT Net sales revenue$150,000 Cost of goods sold 80,000 Gross margin 70,000 Operating expenses (listed individually) 40,000 Income from operations 30,000 Other income (expense): Interest revenue$2,000 Interest expense (9,000) Gain on sale of equipment 3,000 (4,000) Income before tax 26,000 Income tax expense 10,000 Net income $ 16,000 Net sales revenue$150,000 Cost of goods sold 80,000 Gross margin 70,000 Operating expenses (listed individually) 40,000 Income from operations 30,000 Other income (expense): Interest revenue$2,000 Interest expense (9,000) Gain on sale of equipment 3,000 (4,000) Income before tax 26,000 Income tax expense 10,000 Net income $ 16,000

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-70 CURRENT RATIO The current ratio –Is the ratio of any entity's current assets to its current liabilities –Measures the company’s ability to pay current liabilities with current assets Current ratio = Total current assets Total current liabilities A rule of thumb: A strong current ratio is 2.00

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-71 DEBT RATIO The debt ratio –Is the ratio of total liabilities to total assets –Indicates the proportion of a company’s assets that is financed with debt –Measures a business’s ability to pay both current and long-term debts - total liabilities Debt ratio = Total liabilities Total assets A low debt ratio is safer than a high debt ratio

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-1 CHAPTER 3 Investment Banking Basics: Accrual Accounting and.

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© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-1 CHAPTER 3 Investment Banking Basics: Accrual Accounting and.

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Presentation on theme: "© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren 3-1 CHAPTER 3 Investment Banking Basics: Accrual Accounting and."— Presentation transcript:

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