accrual accounting & income

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

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Accrual Accounting and IncomeChapter 3


Explain how accrual accounting differs from cash-basis accounting


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ACCRUAL ACCOUNTING CASH-BASIS ACCOUNTING

• 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

Accrual vs. Cash-Basis Accounting


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Accrual Accounting

•Records both cash and noncash transactions


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Cash transactions Noncash transactions

Collecting payments from customers

Sales on account

Receiving interest earned Purchases on account

Borrowing money Accrual of expenses not yet paid

Paying expenses Depreciation expense

Paying off loans Usage of prepaid expenses

Issuing stock Earning of revenue when cash was collected in advance

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 quarterCopyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

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Apply the revenue and expense recognition principles


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Revenue Principle


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Expense Recognition Principle


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Adjust the accounts


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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


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Categories of Adjustments


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Deferrals

•Business has paid or received cash in advance


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Depreciation

•Allocates cost of plant assets to expense over useful lives

•Represents wear-and-tear and obsolescence

•Examples of plant assets:▫Buildings▫Equipment▫Furniture


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Accruals


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Prepaid Expenses

•Recorded as assets when paid in advance


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JOURNAL

Date Accounts Debit Credit

Jun 1 Prepaid rent 3,000

Cash 3,000

Jun 2 Supplies 700

Cash 700

Prepaid Expenses

•Expensed when expired or used


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JOURNAL


Jun 30 Rent expense 1,000

Prepaid rent 1,000

Jun 30 Supplies expense 300

Supplies 300

Prepaid Rent


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Prepaid rent

Jun 1 3,000 Jun 301,000

2,000

Rent expense

1,000Jun 30

Amount expiredAmount expired

Amount remainingAmount

remaining

Balance Sheet

Balance Sheet

Income Statemen

t

Income Statemen

t

Supplies


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Supplies

Jun 2 700 Jun 30300

400

Supplies expense

Amount usedAmount usedAmount on hand

Amount on hand

Balance Sheet

Balance Sheet

Income Statemen

t

Income Statemen

t

Jun 30 300

Depreciation


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JOURNAL


Jun 3 Equipment 24,000

Accounts payable 24,000

Jun 30

Depreciation expense 400

Accumulated depreciation 400

$24,000/5 = $4,800 annual depreciation $4,800/12 = $400 monthly depreciation

Depreciation


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Equipment

Jun 3 24,000

Depreciation Expense

400Jun 30

Balance Sheet

Balance Sheet Income

Statement

Income Statemen

tAccumulated Depreciation

Jun 30400

Accumulated Depreciation

•Sum of all depreciation expense▫Increases over asset’s life

•Contra-asset▫Normal credit balance▫Companion account is asset

•Book value▫Cost of plant asset less accumulated

depreciation


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Book Value

Partial Balance SheetJune 30, 2012

Equipment $24,000

Less: Accumulated Depreciation

(400)

Book value $23,600


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Accrued Expenses

•Expenses incurred before cash is paid•Results in a liability•Examples:

▫Salaries▫Interest


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Accrued Salaries

June

Sun. Mon. Tues. Wed. Thur.

Fri. Sat.

1

2 3 4 5 6 7 8

9 10 11 12 13 14 15

16 17 18 19 20 21 22

23 24 25 26 27 28 29

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Pay day

Pay day

Accrued Salaries


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JOURNAL


Jun 15 Salary expense 900

Cash 900

Jun 30 Salary expense 900

Salary payable 900

Accrued Salaries


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Salary Payable

Jun 30900

900

Salary Expense

900Jun 15

June’s salaryJune’s salaryAmount owed

Amount owed

Balance Sheet

Balance Sheet

Income Statemen

t

Income Statemen

t

900

1,800

Jun 30

Accrued Revenue

•Revenue earned but not yet received•Increases receivables and revenue


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JOURNAL


Jun 30 Accounts receivable 300

Service revenue 300

Unearned Revenue

•Receive cash before revenue is earned•Creates a liability


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JOURNAL


Jun 15 Cash 400

Unearned revenue 400

Unearned Revenue

•When revenue is earned▫Liability is reduced▫Revenue is increased


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JOURNAL

Date Accounts and explanation Debit Credit

Jun 30 Unearned revenue 200

Service revenue 200

Prepaids and Accruals

PREPAIDS –CASH FIRST

FIRST LATER

Prepaid expenses

Prepaid expense Expense

Cash Prepaid expense

Unearned revenues

Cash Unearned revenue

Unearned revenue Revenue

ACCRUALS – CASH LATER

FIRST LATER

Accrued expenses

Expense Payable

Payable Cash

Accrued revenues

Receivable Cash

Revenue Receivable


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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


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Summary of Adjusting Entries

Type of Account

Category of Adjustment Debit Credit

Prepaid expense Expense Asset

Depreciation Expense Contra asset

Accrued expense Expense Liability

Accrued revenue Asset Revenue

Unearned revenue Liability Revenue


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Exercise 3-24A


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JOURNAL


(a) Interest expense 9,600

Interest payable 9,600

(b) Interest receivable 4,900

Interest revenue 4,900

(c) Unearned rent revenue 3,000

Rent revenue 3,000

Exercise 3-24A


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JOURNAL


(d) Salary expense 7,600

Salary payable 7,600

(e) Supplies expense 1,800

Supplies 1,800

(f) Depreciation expense 16,000

Accumulated depreciation 16,000

Exercise 3-24A


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Partial Balance SheetDecember 31, 2012

Equipment $ 80,000

Less: Accumulated Depreciation

(16,000)

Book value $64,000

The Adjusted Trial Balance

•Prepared after adjustments are journalized and posted

•Useful step in preparing financial statements


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Construct the financial statements


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The Financial Statements


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Flow of Data in Financial Statements


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Income Statement

Revenues $$,$$$

Less: Expenses ($$,$$$)

Net Income $$,$$$

Statement of Retained Earnings

Retained earnings, beginning balance

$$,$$$

Plus: Net income $$,$$$

Less: Dividends ($,$$$)

Retained earnings, ending balance

$$,$$$

Flow of Data in Financial Statements


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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 $$$,$$$

Close the books


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Closing the Books

•Prepares the accounts for next period•Sets revenues, expenses, and dividends to

zero


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Closing the Books


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Closing Entries


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Exercise 3-29A


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JOURNAL


Service revenue 23,900

Other revenue 400

Retained earnings 24,300

Retained earnings 22,000

Cost of services sold 11,000

Selling, general, & admin. expenses

6,400

Depreciation expense 4,100

Income tax expense 500

Exercise 3-29A


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JOURNAL


Retained earnings 300

Dividends 300

Revenues ExpensesNet

Income$24,300 $22,000 $2,300

Exercise 3-29A


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Retained Earnings

2,600 Beginning Balance

24,300 Revenues300

22,000

Dividends

Expenses

4,600Ending Balance

Classifying Assets & Liabilities

•Classified as current or long-term based on liquidity▫How quickly an item can be converted to

cash


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Cash Most liquid

Accounts receivable Very liquid

Inventory Somewhat liquid

Plant assets Not liquid


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Classified Balance Sheet

•Categorizes and subtotals assets and liabilities


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Assets Liabilities

Current assets Current liabilities

Long-term investments Long-term liabilities

Property, plant, and equipment

Intangible assets

Other assets

Report Format Account Format

• Assets listed at the top• Liabilities and equity

beneath

• Assets on the left• Liabilities and equity on

the right

Balance Sheet Formats


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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

Income Statement Formats


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Analyze and evaluate a company’s debt-paying ability

Net Working Capital


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Current assets

Current liabilitie

s

Current Ratio


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Current assets

Current liabilities

Measures ability to pay current liabilities

Strong current ratio = 1.50

Debt Ratio


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Total assets

Total liabilities

Measures ability to pay all liabilities

Low debt ratio is safer than high debt ratio

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


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accrual accounting & income

Business

pearson education

prentice hall

depreciation expensejun

accrued expenses expenses

annual depreciation

monthly depreciation

accrual accounting records

accumulated depreciation