Chapter 3 Using Accrual Accounting to Masure IncomeLearning objectivesRelate accrual accounting and cash flowsApply the revenue and matching principlesUpdate the financial statements by adjusting the accountsPrepare the financial statements Close the books Use the current ratio and the debt ratio to evaluate a businessAccrual Accounting Versus Cash-Basis AccountingIn Accrual Accounting, an accountant records the impact of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the accountant records the transaction even if it receives or pays no cash.In Cash-Basis Accounting, the accountant records a transaction only when it receives or pays cash. Cash receives are treated as revenues, and cash payments are handled as expenses.Accrual vs. Cash-Basis AccountingACCRUALRecords business transactions when they occurWhen sale is madeWhen bill is receivedComplies with GAAPPresents accurate financial pictureCASHRecords transactions only when cash is received or paidWhen customer pays for product or serviceWhen bills are paidOnly used by very small businessesOmits important infoAccrual Accounting and Cash FlowsAccrual Accounting records cash transactions, includingCollecting from customers; Borrowing money; receiving cash from interest earned; paying off loans; paying salaries, rent, and other expenses; Issuing stock.Accrual Accounting also records noncash transactions, such as Sales on account; Depreciation expense; Usage of prepaid rent, insurance, and supplies; Accrual of expenses incurred but not yet paid.accrual accounting and cash flowsAccrual accounting records both cash and non-cash transactionsCash Collecting from customersPaying for expensesBorrowing moneyIssuing StockNon-cash Sales on accountPurchases on accountUsing prepaid expenses, such as suppliesAccounting ConceptsTime period concept (periodicity) Ensures that accounting information is reported at regular intervals. A Month, a quarter, a semiannual periodRecognition issueRevenue principle1.when to record revenue (after it has been earned)2.the amount of revenue to record (the cash value of the goods transferred to the customer)The matching principlematching principle and accrual accountingThe matching principlematching principle is the basis for recording expenses.1.Identify all the expenses incurred during the accounting period.Measure the expenses, and match expenses against the revenue earned.Time-Period ConceptBusinesses do not stop operations to measure financial transactionsAccountants prepare financial statements at regular intervals to measure performanceCompanies select a twelve-month period for reporting purposes:Calendar yearFiscal yearThe Revenue PrincipleRevenue is recorded when earnedWhen product or service is delivered to customerCash may come before, at the same time, or after deliveryRevenue is recorded at the cash value of goods or services providedThe Matching PrincipleExpenses are incurred to help produce revenueExpenses should be recorded in the time period in which they are incurredExpenses should be matched to the revenues they help produceREVENUESEXPENSESExpensesMay be paid in cashPaying monthly rentMay arise from using up an assetUsing supplies previously purchasedMay arise from creating a liabilityReceive a bill from a supplierStop and Think1.A customer pays Callaway Golf $900 on March 15 for golf clubs to be delivered in April. Has Callaway earned revenue on March 15? When will Callaway earn the revenue?No. Callaway has received the cash but will not deliver the merchandise until later. Callaway earns the revenue when it gives the goods to the customer. Until that time, Callaway has a liability to the customer.Stop and Think2. Callaway pays $4,500 on July 31 for office rent for the next 3 months. Has the company incurred an expense on July 31?No. Callaway has paid cash for rent in advance. This prepaid rent is an asset because Callaway has the use of an office in the future.The Adjustment ProcessAt the end of the period, a business prepares financial statementsEnsures that:All revenue that has been earned has been recordedAll expenses that have been incurred are matched to revenuesAsset and liability accounts are up-to-date3-17Categories of Adjusting EntriesDeferralsDepreciationAccrualsAdjustments TypesAdjusting entries are required when there is no source document to trigger a transactionDeferred Revenue and ExpensesCash changes handsAccrued Revenue and ExpensesCash does not change handsDepreciationWear and tear of long-lived assetExercises D & EDeferrals Cash has already been received or paidRelated expense or revenue has not yet been recordedPrepaid expensesCompany has paid for expense in advanceAdjustment needed to record amount usedUnearned revenuesCustomer pays in advance for good or serviceAdjustment needed to record amount of revenue earnedPrepaid ExpensesExpenses paid in advanceInclude prepaid rent and suppliesAsset is recorded when purchasedAdjustment needed to record amount usedPrepaid ExpensePrepaid RentSuppose Air & Sea Travel prepays 3 months office rent($3,000) on April 1, 20*3.1. Paid 3 months rent in advancePrepaid Rent 3,000 Cash 3,000 2.adjusted(to record rent expense)Rent Expense 1,000 Prepaid Cash 1,000 SuppliesOn April 2, Air & Sea Travel paid cash of $700 for office supplies.1.Paid cash for suppliesSupplies 700 Cash 7002.To record supplies expense($400 remain)Supplies expense 300(700-400) Supplies 300Depreciation of Plant AssetsAllocation of plant assets cost over their useful livesResults in a debit to an expenseDepreciation ExpenseCorresponding creditAccumulated DepreciationAccumulated DepreciationAccount that shows the sum of depreciation expense of the plant assetContra-assetAlways has a companion accountNormal credit balanceDepreciation of Plant AssetsSuppose Air & Sea Travel purchased furniture on account for $16,500 on April 3.1. purchased furniture on account Furniture 16,500 Accounts Payable 16,5002.To record depreciation on furnitureDepreciation Expense-Furniture 275Accumulate Depreciation-Furniture 275Accrued ExpensesExpense incurred before cash is paidResult in a liabilityCommon accrued expenses:SalariesInterestTaxesAccrued ExpensesAir & Sea Travel pays its employee a monthly salary of $1,900,half on the 15th and half on the last day of the month.1.April 15, to pay salarySalary Expense 950 Cash 950 2.Because April 30 falls on a Saturday, therefore ,Air & Sea adjusts for additional salary expense and salary payable of $950 as follows (to accrue salary expense)Salary Expense 950 Salary payable 950Accrued RevenuesCompanies often earn revenue before cash is receivedResults in an accrued revenueReceivable recordedAccrued RevenuesBank One employees must travel in their work. Assume that Bank One employees must travel in their work. Assume that Bank One hires Air & Sea Travel on April 15 to arrange travel Bank One hires Air & Sea Travel on April 15 to arrange travel services on a monthly basis. Suppose Bank One will pay the services on a monthly basis. Suppose Bank One will pay the travel agency $500 monthly, with the first payment on MAY travel agency $500 monthly, with the first payment on MAY 15.During April, Air & Sea will earn half a months fee, 15.During April, Air & Sea will earn half a months fee, &250, for work done April 15 through April 30. On April 30, &250, for work done April 15 through April 30. On April 30, Air & Sea Travel makes the following adjusting entry:Air & Sea Travel makes the following adjusting entry:April 30 To accrue service revenueApril 30 To accrue service revenueAccounts Receivable 250Accounts Receivable 250 Service Revenue 250 Service Revenue 250 Unearned RevenuesRecorded as a liability when company receives paymentCompany owes customer product or serviceRevenue is not recorded until earnedWhen company provides product or serviceAn adjusting entry is made to transfer amount from unearned revenue to revenueUnearned RevenuesSuppose Plantation Foods, a major producer of turkey food Suppose Plantation Foods, a major producer of turkey food products, engages Air & Sea Travel, agreeting to pay the products, engages Air & Sea Travel, agreeting to pay the travel agency $450 monthly, beginning immediately. If Air & travel agency $450 monthly, beginning immediately. If Air & Sea collects the first amount on April 20,it records this Sea collects the first amount on April 20,it records this transaction as follows:transaction as follows:1. April 20. Received cash for revenue in advance1. April 20. Received cash for revenue in advanceCash 450Cash 450 Unearned Service Revenue 450 Unearned Service Revenue 4502. April 30. To record unearned service revenue that has 2. April 30. To record unearned service revenue that has been earnedbeen earnedUnearned Service Revenue 150(450/3)Unearned Service Revenue 150(450/3) Service Revenue 150 Service Revenue 150Summary of the adjusting processAssets:Assets:1. 1. Consumable AssetsConsumable Assets Assets that get used up over timeAssets that get used up over timeE.g. Supplies, Pre-Paid Rent, Pre-Paid E.g. Supplies, Pre-Paid Rent, Pre-Paid InsuranceInsuranceTo adjust:To adjust:DEBITDEBIT the expense account associated with the expense account associated with the assetthe assetCREDITCREDIT the asset account for the amount the asset account for the amount that has been usedthat has been used2. Assets that Depreciate Over Assets that Depreciate Over TimeTimeE.g. Automobiles, Land, Buildings, EquipmentTo adjust:To adjust: DEBITDEBIT Amortization Expense Account for the assetCREDITCREDIT Accumulated Amortization Account for the assetRevenues:Revenues:1. Unearned RevenuesUnearned Revenues unearned revenues occur when a company is paid up front for work that has not yet been completed at this time, the full amount would have been posted into the UNEARNED REVENUE account (Credit) and CASH (Debit) as work is completed, the revenue must be recognized during the accounting period in which it was done and amount earned must come out of Unearned account and into Earned accountAccrued Revenues and Accrued Revenues and xpenses:xpenses:1. Accrued RevenuesAccrued Revenues occurs when work has been completed for a client, but, as of the end of the month (or accounting period), the client has not yet paidTo adjust: To adjust: DEBITDEBIT Accounts ReceivableCREDITCREDIT Revenue accountAccrued ExpensesAccrued Expenses occurs when a bill for an expense comes occurs when a bill for an expense comes after the end of the month in which it after the end of the month in which it occurredoccurredE.G. Telephone bill for January arrives E.G. Telephone bill for January arrives February 10.expense must be posted to February 10.expense must be posted to January in this caseJanuary in this caseTo adjust:To adjust:DEBITDEBIT Expense AccountExpense AccountCREDITCREDIT Accounts Payable Accounts Payable It is necessary at this stage to carefully read the problems that are assigned. Dates are important to note (particularly when dealing with pre-paid assets), as are terms such as accrued, expired, on hand, unearned, and unrecorded. Each of these terms dictates a different type of adjustment.Summary of Adjusting EntriesPurpose of adjusting entriesMeasure incomeUpdate balance sheetEach adjusting entry affectsOne income statement accountRevenue or ExpenseOne balance sheet accountAsset or liabilityAdjusted Trial BalanceTrial balance prepared after adjusting entries are made and postedThese amounts are used to prepare the financial statements:Income StatementStatement of Retained EarningsBalance SheetLearning Objective 4Prepare the financial statementsIncome StatementReports net income or lossRevenues minus expensesNet income flows to Retained Earnings StatementStatement of Retained EarningsShows changes to the Retained Earnings accountNet Income is added to beginning balanceDividends are subtractedEnding Retained Earnings flows to the Balance SheetBalance SheetReports assets, liabilities and equityShows that the accounting equation is in balanceINCOME STATEMENTRETAINED EARNINGS STATEMENTBALANCE SHEETNET INCOMEENDING RETAINED EARNINGSLearning Objective 5Close the booksAccounting CycleStep 1: Identify transactionStep 2: Record transaction in journalStep 3: Post journal entries to general ledgerStep 4: Prepare a trial balanceStep 5: Journalize and post adjustmentsStep 6: Prepare adjusted trial balanceStep 7: Prepare financial statementsStep 8: Record and post closing entriesExercise EClassifying Assets and LiabilitiesIncome Statement FormatsSingle-stepAll revenues and gains grouped togetherAll expenses and losses grouped togetherMulti-stepIncludes useful subtotalsGross profitNet revenues minus cost of goods soldIncome from operationsNet incomeIncome Statement FormatsSingle-Step Income StatementMulti-Step Income StatementClosing the booksClosing the books means to prepare the accounts for the next periods transactions.Temporary accounts are closed at the end of the accounting period.Permanent accounts are not used to measure net income.Closing entries move the balances from the temporary accounts to Retained Earnings.Temporary and Permanent AccountsTemporaryRevenues, Expenses and DividendsClosedBalances represent a period of timePermanentAsset, liability and equity accounts Not closedEnding balance of one period carries over to following periodThree Closing Entries1.Close the revenue accountsSales XXOther RevenueXX Retained EarningsXX2.Close the expense accountsRetained EarningsXX Rent ExpenseXX Salary ExpenseXX Other ExpensesXX3.Close the dividends accountRetained EarningsXX DividendsXXEXAMPLEOn 30, April. the balance of the accountsservice revenue 7400salary expense 1900rent expense 1000utility expense 400supplies expense 300depreciation expense 275income tax expense 540dividends 3200Journalizing the Closing EntriesApril 30 Service Revenue7,400Retained Earnings7,400April 30 Retained Earnings4,415Rent Expense1,000Salary Expense1,900Supplies Expense 300Depreciation Expense 275Utilities Expense 400Income Tax Expense 540April 30 Retained Earnings3,200Dividends3,200Posting the Closing EntriesRetained Earnings4,4153,20011,250 7,40011,035Rent Expense1,0001,000Other Expenses1,5151,515Service Revenue7,4007,000 250 1507,400Dividends3,2003,200Salary Expense 950 9501,9001,900Exercise ELearning Objective 6Use two new ratios to evaluate a businessCurrent RatioCurrent ratio measures the companys ability to pay current liabilities with current assets.Rule of thumb: Strong ratio is 2.0 times but depends on industry norms.http:/edgarscan.pwcglobal.com/servlets/edgarscan Debt RatioDebt ratio indicates the proportionproportion of assets financed by debt.It measures the companys ability to pay its debt.Low debt ratio is less risky than a high debt ratio.The Income Statement and ProfitabilityGross Profit Margin (aka Gross Margin)Profit Margin (aka Return on Sales)Ethical Issues in Financial AccountingManaging earnings to meet established goals or budgets.Misrepresenting company assets, liabilities, revenues or expenses to financial statement users.Accounting Profession (continued)Auditors Report (aka Audit Opinion)Sarbanes-OxleyManagements Report vs. MD&APCAOBInternal Auditors and Audit CommitteesInternal Controls Report