1. Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 1

2. Accrual Accounting and Income Chapter 3 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 2

3. Explain how accrual accounting differs from cash-basis accounting Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 3

4. Accrual vs. Cash-Basis Accounting ACCRUAL ACCOUNTING CASH BASIS Records impact of transactions when they occur Required by Generally Accepted Accounting Principles (GAAP) Records: ▫Revenue when earned ▫Expenses when incurred Records only cash transactions ▫Cash receipts ▫Cash payments Ignores important information Results in incomplete financial statements Only used by the smallest businesses Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 4

5. Accrual Accounting Records both cash and noncash transactions Cash transactionsNoncash transactions Collecting payments from customers Sales on account Receiving interest earnedPurchases on account Borrowing moneyAccrual of expenses not yet paid Paying expensesDepreciation expense Paying off loansUsage of prepaid expenses Issuing stockEarning of revenue when cash was collected in advance Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 5

6. Time Period Concept Accounting information is reported at regular intervals ▫Basic accounting period is one year Calendar year ▫January 1 – December 31 Fiscal year ▫12-month period ending on a date other than December 31 Interim periods ▫Month or quarter Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 6

7. Apply the revenue and expense recognition principles Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 7

8. Revenue Principle When to record After revenue is earned: When good or service has been delivered to customer Amount to record Cash value of goods or services transferred to customer Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 8

9. Expense Recognition Principle Identify expenses incurred Measure the expenses Recognize along with related revenues Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 9

10. Adjust the accounts Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 10

11. Adjusting the Accounts Financial statements issued at end of period Several accounts on trial balance need to be brought up-to-date ▫Certain transactions have not been recorded Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 11

12. Categories of Adjustments DeferralsDepreciation Accruals Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 12

13. Deferrals Business has paid or received cash in advance Prepaid expense Recorded as an asset when purchased Expensed when used or expired Unearned revenue Recorded as a liability when payment is received Recorded as revenue when earned Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 13

14. Depreciation Allocates cost of plant assets to expense over useful lives Represents wear-and-tear and obsolescence Examples of plant assets: ▫Buildings ▫Equipment ▫Furniture Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 14

15. Accruals Accrued expenses Record expense before paying cash Salaries, interest, and income taxes Accrued revenues Record revenue before collecting cash Earned and will collect next period Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 15

16. Prepaid Expenses Recorded as assets when purchased JOURNAL DateAccounts and explanationDebitCredit June 1Prepaid rent3,000 Cash3,000 Aug 3Supplies700 Cash700 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 16

17. Prepaid Expenses Expensed when expired or used JOURNAL DateAccounts and explanationDebitCredit Jun 30 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 17

18. Prepaid Rent Prepaid rent June 1 $3,000 Dec 31 $1,000 $5,000 Rent expense $1,000 Dec 31 Amount expired Amount remaining Balance Sheet Income Statement Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 18

19. Supplies Jun 2 $700 Jun 30 $300 $400 Supplies expense Amount used Amount on hand Balance Sheet Income Statement Jun 30 $300 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 19

20. Depreciation JOURNAL DateAccounts and explanationDebitCredit Jun 3Equipment24,000 Accounts payable24,000 Dec 31Depreciation expense400 Accumulated depreciation400 $24,000/4 = $4,800 annual depreciation $4,800/12 = $400 monthly depreciation Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 20

21. Depreciation Equipment Jun 3 $24,000 Depreciation Expense $400 Jun 3 Balance Sheet Income Statement Accumulated Depreciation Dec 31 $400 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 21

22. Accumulated Depreciation Sum of all depreciation expense ▫Increases over plant asset’s life Contra-asset ▫Normal credit balance ▫Always has a companion account Book value ▫Cost of plant asset less accumulated depreciation Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 22

23. Book Value Balance Sheet June 30, 2012 Equipment Less: Accumulated Depreciation Book value Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 23

24. Accrued Expenses Expenses incurred before cash is paid Results in a liability Examples: ▫Salaries ▫Interest Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 24

25. Accrued Salaries June Sun.Mon.Tues.Wed.Thrs.Fri.Sat. 1 2345678 9101112131415 16171819202122 23242526272829 30 Pay day Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 25

26. Accrued Salaries JOURNAL DateAccounts and explanationDebitCredit Jun 15Salary expense900 Cash900 Jun 30 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 26

27. Accrued Salaries Salary Payable Jun 30 $900 Salary Expense $900 Jun 15 June’s salary Amount owed Balance Sheet Income Statement $900 $1,800 Jun 30 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 27

28. Accrued Revenue Revenue earned but not yet received Increases receivables and revenue JOURNAL DateAccounts and explanationDebitCredit Dec 31 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 28

29. Unearned Revenue Receive cash before revenue is earned Creates a liability JOURNAL DateAccounts and explanationDebitCredit Jun 15Cash400 Unearned revenue400 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 29

30. Unearned Revenue When revenue is earned ▫Liability is reduced ▫Revenue is increased JOURNAL DateAccounts and explanationDebitCredit Dec 31 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 30

31. Prepaids and Accruals PREPAIDS –CASH FIRST FIRSTLATER Prepaid expenses Prepaid expenseExpense CashPrepaid expense Unearned revenues CashUnearned revenue Revenue ACCRUALS – CASH LATER FIRSTLATER Accrued expenses ExpensePayable Cash Accrued revenues ReceivableCash RevenueReceivable Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 31

32. Summary of the Adjusting Process Two purposes of adjusting process ▫Measure income ▫Update balance sheet Every adjusting entry affects at least one: ▫Revenue or expense ▫Asset or liability Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 32

33. Summary of Adjusting Entries Type of Account Category of AdjustmentDebitCredit Prepaid expense Depreciation Accrued expense Accrued revenue Unearned revenue Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 33

34. Exercise 3-24A JOURNAL DateAccounts and explanationDebitCredit (a) (b) (c) Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 34

35. Exercise 3-24A JOURNAL DateAccounts and explanationDebitCredit (d) (e) (f) Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 35

36. Exercise 3-24A Balance Sheet December 31, 2012 Equipment Less: Accumulated Depreciation Book value Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 36

37. The Adjusted Trial Balance Prepared after adjustments are journalized and posted Useful step in preparing financial statements Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 37

38. Construct the financial statements Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 38

39. The Financial Statements Income Statement Lists revenues & expenses Reports net income Statement of Retained Earnings Shows changes in retained earnings Balance Sheet Reports assets, liabilities, and stockholders’ equity 39 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 39

40. Flow of Data in Financial Statements Income Statement Revenues $$,$$$ Less: Expenses($$,$$$) Net Income$$,$$$ Statement of Retained Earnings Retained earnings, beginning balance $$,$$$ Plus: Net income$$,$$$ Less: Dividends($,$$$) Retained earnings, ending balance$$,$$$ Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 40

41. Flow of Data in Financial Statements Statement of Retained Earnings Retained earnings, beginning balance $$,$$$ Plus: Net income$$,$$$ Less: Dividends($,$$$) Retained earnings, ending balance$$,$$$ Balance Sheet Current assets$$,$$$Liabilities $$,$$$ Plant assets$$,$$$ Common stock $$,$$$ Other assets$$,$$$ Retained earnings $$,$$$ Total assets $$$,$$$ Total liabilities & stockholders’ equity $$$,$$$ Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 41

42. Close the books Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 42

43. Closing the Books Prepares the accounts for next period Sets revenues, expenses, and dividends to zero Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 43

44. Temporary Closed Revenues, expenses, and dividends Permanent Not closed Assets, liabilities, and equity Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 44

45. Closing Entries Close Dividends Close Expenses Close Revenues Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 45

46. Exercise 3-29A JOURNAL DateAccounts and explanationDebitCredit Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 46

47. Exercise 3-29A JOURNAL DateAccounts and explanationDebitCredit RevenuesExpensesNet Income ? ? ? ? ? ? Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 47

48. Exercise 3-29A Retained Earnings $2,600 Beginning Balance Revenues Dividends Expenses Ending Balance Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 48

49. Classifying Assets & Liabilities Classified as current or long-term based on liquidity ▫How quickly an item can be converted to cash CashMost liquid Accounts receivableVery liquid InventorySomewhat liquid Plant assetsNot liquid Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 49

50. Converted to cash, sold or consumed in the next year Current assets Held for longer than one year Include plant assets Long-term assets Must be paid within one year Current liabilities Due date more than one year from balance sheet date Long-term liabilities 50 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 50

51. Classified Balance Sheet Categorizes and subtotals assets and liabilities AssetsLiabilities Current assetsCurrent liabilities Long-term investmentsLong-term liabilities Property, plant, and equipment Other assets Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 51

52. Balance Sheet Formats Report Format Account Format Assets listed at the top Liabilities and equity beneath Account format Assets on the left Liabilities and equity on the right Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 52

53. Income Statement Formats Single-Step Multi-Step All revenues grouped together All expenses grouped together Shows subtotals to emphasize relationships Includes ▫Gross profit ▫Income from operations ▫Income before taxes ▫Net income Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 53

54. Analyze and evaluate a company’s debt-paying ability Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 54

55. Net Working Capital ?? Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 55

56. Current Ratio ? ? ? ? Measures ability to pay current liabilities Strong current ratio = 1.50 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 56

57. Debt Ratio ? ? ? ? Measures ability to pay all liabilities Low debt ratio is safer than high debt ratio Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 57

58. Transactions Affect on Ratios Increase revenue and decrease costs ▫Results in increase in current assets and net income Sell stock ▫Increases cash and equity Borrow less money ▫Decreases liabilities Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 58

59. Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 59

60. Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 60