Accrual Accounting and the Financial Statements

Accrual Accounting and the

Financial Statements

Learning Objective 1

Relate accrual accounting

and cash flows.

Entity 1 cash has

The Business Cycle

Entity 2 holds inventory Purchase of

inventory

Entity 3 has a receivable

Sale of inventory on account Collection of

the receivable

Suppose that on September 30, 2005, Vodafone receives £24 for a one-year

connection to wireless phone service.

Accrual Accounting and Cash Flows

By December 31, Vodafone has

earned the revenue for three months.

Accrual Accounting and Cash Flows

Income statement reports for year ended:

Service revenue (when earned); £24 ×

/

^{£ 6}

Balance sheet reports:

Liabilities:

Unearned service revenue

(company still owes £24 ×

/

^{) £18}

Statement of cash flows reports for year ended:

Collections from customers

(when cash was received) £24

December 31, 2005

The Time-Period Concept

Businesses need regular progress reports, so accountants prepare financial statements for specific periods and at regular intervals.

Monthly

Quarterly

Learning Objective 2 Apply the revenue and

matching principles.

Revenue Principle

The revenue principle governs two things:

When to record revenue and…

the amount of revenue to record.

Revenue Principle

photos

Disney World

Situation 2

The client has taken a trip arranged by Air & Sea Travel. – Record Revenue

Situation 2

The client has taken a trip arranged by Air & Sea Travel. – Record Revenue

Air & Sea Travel, Inc.

April 2 Air & Sea

Travel, Inc.

Situation 1

No transaction has occurred.

– Do Not Record Revenue Situation 1

No transaction has occurred.

– Do Not Record Revenue

March 12 I plan to have you

make my travel

arrangements.

The Matching Principle

It is the basis for recording

expenses and includes two steps:

Identify all the expenses incurred during the accounting period.

Measure the expenses and match

expenses against revenues earned.

The Matching Principle

Revenue Revenue – ^{Expense Expense} = ^{Net income Net income}

The Matching Principle

Revenue Revenue – ^{Expense Expense} = ^{(Net loss) (Net loss)}

Learning Objective 3

Update the financial statements

by adjusting the accounts.

Updating the Accounts:

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.

Air & Sea Unadjusted Trial Balance April 30, 20x3

$24,800 2,250 700 3,000 16,500

3,200 950 400

$51,800

13,100 450 20,000 11,250 7,000

$51,800 Cash Accounts receivable

Supplies

Prepaid rent Furniture

Accounts payable

Unearned service revenue Common stock

Retained earnings Dividends

Service revenue

Salary expense

Utilities expense

Total

Deferrals

Accruals

Categories of

Accounting Adjustments

Depreciation

Prepaid Expenses: Rent

3,000

Prepaid Rent

3,000 Cash

On April 1, 20x3, Air & Sea Travel

prepays three months office rent.

Prepaid Expenses: Rent

What is the adjusting entry on April 30?

April 30

Rent Expense ($3,000 × ^ / ₃ ) 1,000

Prepaid Rent 1,000

To record rent expense

Prepaid Expenses: Supplies

On April 2, 20x3, Air & Sea Travel paid cash of $700 for office supplies.

700

Supplies

700

Cash

Prepaid Expenses: Supplies

An inventory at month end indicated that $400 in office supplies remained.

4/2 700

Supplies

4/30 300 Bal. 400

Supplies Expense 4/30 300

Bal. 300

Depreciation of Plant Assets

On April 3, the business purchased furniture on account for $16,500.

The furniture is expected to last 5 years.

16,500

Furniture Accounts Payable

16,500

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

$3,300 ÷12 months = $275 per month

Depreciation of Plant Assets

What is the adjusting entry on April 30?

April 30

Depreciation Expense – Furniture 275

Accumulated Depreciation – Furniture 275

To record depreciation on furniture

Book Value

The net amount of a plant asset (cost minus accumulated depreciation) is the book value.

Plant Assets of Air & Sea at April 30

Furniture $16,500

Less Accumulated Depreciation – 275 $16,225

Building $48,000

Less Accumulated Depreciation – 200 47,800

Accrued Expenses

The term accrued expense refers to a liability that arises from an expense that has not yet been paid.

Suppose Air & Sea Travel pays its

employees a monthly salary of $1,900, half

on the 15th and half on the last day of the month.

April

15

Accrued Expenses

Assume that if a payday falls on the weekend,

Air & Sea pays the employee on the following Monday.

1

Accrued Expenses

Salary Payable 4/30 950

Bal. 950 Salary Expense

4/15 950 Bal. 1,900 4/30 950

Salary Expense 4/15 950

Cash

4/15 950

Accrued Revenues

An accrued revenue is a revenue that has been earned but not received in cash.

Bank One hires Air & Sea Travel on April 15 to arrange travel

services on a monthly basis.

Bank One will pay the travel agency

$500 monthly, with the first

Accrued Revenues

April 30

Accounts Receivable ($500 × ½) 250

Service Revenue 250

To accrue service revenue

Unearned Revenues

An unearned revenue is an obligation arising from receiving cash before providing a service.

Plantation Foods engages Air & Sea Travel agreeing to pay the agency $450 monthly,

beginning immediately.

Air & Sea Travel collects the first amount on

April 20 and earns one-third the last 10 days.

Unearned Revenues

April 20

Cash 450

Unearned Revenue 450

Received cash for revenue in advance April 30

Unearned Revenue ($450 ×

/

) 150

Revenue 150

To record unearned revenue earned

Adjusting the Accounts

Accounts receivable Supplies

Prepaid rent

Accumulated dep.

Salary payable Unearned revenue Income tax payable Service revenue Rent expense Salary expense Supplies expenses Depreciation expense

2,250 700 3,000

950

450 7,000 Accounts Needing

Adjustments

Partial Trial Balance Dr. Cr.

2,500 400 2,000

1,000 1,900 300 275

275 950 300 540 7,400 Partial Adjusted Trial Balance

Dr. Cr.

e) 250

f) 150

a) 1,000 d) 950 b) 300 c) 275

b) 300

a) 1,000

c) 275

d) 950

g) 540

e) 250

f) 150

Adjustments

Dr. Cr.

Air & Sea Adjusted Trial Balance April 30, 20x3

Balance Sheet

Retained Earnings Cash Accounts receivable

Supplies

Prepaid rent Furniture

Accumulated depreciation-furniture Accounts payable

Salary payable

Unearned service revenue Income tax payable

Common stock Retained earnings Dividends

Totals

Account Title

24,800 2,500 400 2,000 16,500

3,200 49,400

275 13,100 950 300 540 20,000 11,250 46,415 Adjusted Trial Balance

Debit Credit

Air & Sea Adjusted Trial Balance April 30, 20x3

1,000 1,900 300 275 400 540 4,415

7,400

7,400 Service revenue

Rent expense Salary expense Supplies expense

Depreciation expense Utilities expense

Income tax expense Totals

Account Title Adjusted Trial Balance Debit Credit

Income

Statement

Learning Objective 4 Prepare the financial

statements.

Air & Sea Travel, Inc.

Income Statement

Revenue:

Service revenue $7,400

Expenses:

Salary expense $1,900

Rent expense 1,000

Utilities expense 400 Supplies expense 300

Depreciation expense 275 3,875

Income before tax $3,525

Income tax expense 540

Month Ended April 30, 20x3

Retained earnings, April 1, 20x3 $11,250

Add: Net income 2,958

$14,235

Less: Dividends – 3,200

Retained earnings, April 30, 20x3 $11,035

Air & Sea Travel, Inc.

Statement of Retained Earnings

Month Ended April 30, 20x3

Air & Sea Travel, Inc.

Balance Sheet

Assets

Cash $24,800

Accounts receivable 2,500

Supplies 400

Prepaid rent 2,000 Furniture $16,500

Less:

Accumulated

depreciation – 275 16,225

Liabilities

Accounts payable $13,100 Salary payable 950 Unearned revenue 300 Income tax payable 540 Total liabilities $14,890 Stockholders’ Equity

Common stock $20,000

Retained earnings 11,035

Total $31,031

Total liabilities and

April 30, 20x3

Ethical Issues in Accrual Accounting

“Managing” earnings to meet established goals or budgets.

Misrepresenting company assets, liabilities, revenues, and expenses

to financial statement users.

Learning Objective 5

Close the books.

Which Accounts

Need To Be Closed?

Closing the books means to prepare the accounts for the next period’s transactions.

Temporary accounts (revenue, expense, and dividends) are closed at the end

of the accounting period.

Which Accounts

Need To Be Closed?

Permanent accounts (assets, liabilities, and stockholders’ equity) are not closed

at the end of the period because their balances are not used to measure income.

Closing entries transfer the revenue, expense,

and dividends balances to Retained Earnings.

Journalizing the Closing Entries

April 30 Service Revenue 7,400

Retained Earnings 7,400

April 30 Retained Earnings 4,415

Rent Expense 1,000

Salary Expense 1,900

Supplies Expense 300

Depreciation Expense 275

Utilities Expense 400

Income Tax Expense 540

April 30 Retained Earnings 3,200

Dividends 3,200

Posting the Closing Entries

Retained Earnings 4,415

3,200 11,250 7,400 11,035 Rent Expense

1,000 1,000

Other Expenses

Service Revenue

7,400

7,000 250 150 7,400

Dividends Salary Expense

950 950

1,900 1,900

Classifying Assets and Liabilities

Liquidity measures how quickly an item can be converted to cash.

A balance sheet lists assets and liabilities

in the order of their relative liquidity.

Classifying Assets and Liabilities

Current assets

Long-term assets

Current liabilities

Long-term liabilities

Balance Sheet Format

Account Format

Report Format

Income Statement Format

Revenues – Expenses = Net income

Single-Step Income Statement

Sales revenues

– Cost of goods sold Gross profit

Operating income Selling and

administrative expenses

– =

Multi-Step Income Statement

Income Statement Format

Add: Other revenues and gains

Less: Other expenses and losses

Income Statement Format

Earnings before taxes

Net earnings

– Income =

taxes

Multi-Step Income Statement

Learning Objective 6

Use the current ratio and the debt ratio to evaluate

a business.

Current ratio

= Total current assets

÷ Total current liabilities Current ratio

= Total current assets

÷ Total current liabilities The current ratio measures the company’s ability to pay

current liabilities with current assets.

The current ratio measures the company’s ability to pay

current liabilities with current assets.

Current Ratio

Debt ratio = Total liabilities ÷ Total assets

Debt Ratio

The debt ratio indicates the proportion of assets that is financed with debt.

This ratio measures a business’s ability to pay total liabilities

A low debt ratio is safer than a high debt ratio.

End of Chapter 3