1. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 1 Accrual Accounting and the Financial Statements Chapter 3

2. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 2 Learning Objective 1 Relate accrual accounting and cash flows.

3. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 3 1 Entity has cash The Business Cycle 2 Entity holds inventory Purchase of inventory 3 Entity has a receivable Sale of inventory on account Collection of the receivable

4. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 4 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.

5. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 5 Accrual Accounting and Cash Flows Income statement reports for year ended: Service revenue (when earned); £24 × 3 / 12 £ 6 Balance sheet reports: Liabilities: Unearned service revenue (company still owes £24 × 9 / 12 ) £18 Statement of cash flows reports for year ended: Collections from customers (when cash was received)£24 December 31, 2005

6. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 6 The Time-Period Concept Businesses need regular progress reports, so accountants prepare financial statements for specific periods and at regular intervals. Monthly Quarterly

7. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 7 Learning Objective 2 Apply the revenue and matching principles.

8. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 8 Revenue Principle The revenue principle governs two things: When to record revenue and… the amount of revenue to record.

9. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 9 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.

10. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 10 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.

11. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 11 The Matching Principle Revenue – Expense = Net income

12. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 12 The Matching Principle Revenue – Expense = (Net loss)

13. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 13 Learning Objective 3 Update the financial statements by adjusting the accounts.

14. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 14 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.

15. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 15 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

16. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 16 Deferrals Accruals Categories of Accounting Adjustments Depreciation

17. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 17 Prepaid Expenses: Rent 3,000 Prepaid Rent 3,000 Cash On April 1, 20x3, Air & Sea Travel prepays three months office rent.

18. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 18 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

19. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 19 Prepaid Expenses: Supplies On April 2, 20x3, Air & Sea Travel paid cash of $700 for office supplies. 700 Supplies 700 Cash

20. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 20 Prepaid Expenses: Supplies An inventory at month end indicated that $400 in office supplies remained. 4/2700 Supplies 4/30 300 Bal.400 Supplies Expense 4/30300 Bal.300

21. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 21 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 FurnitureAccounts Payable 16,500

22. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 22 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

23. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 23 Depreciation of Plant Assets What is the adjusting entry on April 30? April 30 Depreciation Expense – Furniture275 Accumulated Depreciation – Furniture275 To record depreciation on furniture

24. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 24 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 Book value of plant assets$64,025

25. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 25 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.

26. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 26 April 15 30 Accrued Expenses Assume that if a payday falls on the weekend, Air & Sea pays the employee on the following Monday. 1

27. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 27 Accrued Expenses Salary Payable 4/30 950 Bal.950 Salary Expense 4/15950 Bal. 1,900 4/30950 Salary Expense 4/15 950 Cash 4/15950

28. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 28 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 payment on May 15.

29. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 29 Accrued Revenues April 30 Accounts Receivable ($500 × ½)250 Service Revenue250 To accrue service revenue

30. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 30 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.

31. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 31 Unearned Revenues April 20 Cash450 Unearned Revenue450 Received cash for revenue in advance April 30 Unearned Revenue ($450 × 1 / 3 )150 Revenue150 To record unearned revenue earned

32. Adjusting the Accounts ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 32 Accounts receivable Supplies Prepaid rent Accumulated dep. Salary payable Unearned revenue Income tax payable Service revenue Rent expense Salary expense Supplies expenses Depreciation expense Income tax expense Totals 2,250 700 3,000 950 450 7,000 Accounts Needing Adjustments Partial Trial Balance Dr. Cr. 2,500 400 2,000 1,000 1,900 300 275 540 275 950 300 540 7,400 Partial Adjusted Trial Balance Dr. Cr. e) 250 f) 150 a)1,000 d) 950 b) 300 c) 275 g) 540 3,465 b) 300 a)1,000 c) 275 d) 950 g) 540 e) 250 f) 150 3,465 Adjustments Dr. Cr.

33. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 33 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

34. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 34 Air & Sea Adjusted Trial Balance April 30, 20x3 1,000 1,900 300 275 400 540 4,415 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

35. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 35 Learning Objective 4 Prepare the financial statements.

36. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 36 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 Net income$2,985 Month Ended April 30, 20x3

37. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 37 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

38. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 38 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 Total assets$45,925 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 stockholders’ equity$45,925 April 30, 20x3

39. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 39 Ethical Issues in Accrual Accounting “Managing” earnings to meet established goals or budgets. Misrepresenting company assets, liabilities, revenues, and expenses to financial statement users.

40. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 40 Learning Objective 5 Close the books.

41. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 41 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.

42. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 42 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.

43. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 43 Journalizing the Closing Entries April 30Service Revenue7,400 Retained Earnings7,400 April 30Retained Earnings4,415 Rent Expense1,000 Salary Expense1,900 Supplies Expense 300 Depreciation Expense 275 Utilities Expense 400 Income Tax Expense 540 April 30Retained Earnings3,200 Dividends3,200

44. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 44 Posting the Closing Entries Retained Earnings 4,415 3,200 11,250 7,400 11,035 Rent Expense 1,000 Other Expenses 1,515 Service Revenue 7,400 7,000 250 150 7,400 Dividends 3,200 Salary Expense 950 1,900

45. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 45 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.

46. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 46 Classifying Assets and Liabilities Current assets Long-term assets Current liabilities Long-term liabilities

47. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 47 Balance Sheet Format Account FormatReport Format

48. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 48 Income Statement Format RevenuesNet income –= Expenses Single-Step Income Statement

49. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 49 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

50. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 50 Income Statement Format Earnings before taxes Net earnings –= Income taxes Multi-Step Income Statement

51. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 51 Learning Objective 6 Use the current ratio and the debt ratio to evaluate a business.

52. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 52 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 Rule of thumb: A strong current ratio is 2.00.

53. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 53 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.

54. ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 3 - 54 End of Chapter 3