Accrual Accounting and the Financial Statements Chapter 3

Relate accrual accounting and cash flows.

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

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 × 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

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.

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, ,000 16,500 3, $51,800 13, ,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. 4/2700 Supplies 4/ Bal.400 Supplies Expense 4/30300 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 FurnitureAccounts 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 – Furniture275 Accumulated Depreciation – Furniture275 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 – ,800 Book value of plant assets$64,025

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 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/ Bal.950 Salary Expense 4/15950 Bal. 1,900 4/30950 Salary Expense 4/ Cash 4/15950

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.

Accrued Revenues April 30 Accounts Receivable ($500 × ½)250 Service Revenue250 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 Cash450 Unearned Revenue450 Received cash for revenue in advance April 30 Unearned Revenue ($450 × 1 / 3 )150 Revenue150 To record unearned revenue earned

Adjusting the Accounts ©2004 Prentice Hall Business Publishing Financial Accounting, 5/e Harrison/Horngren 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, , ,000 Accounts Needing Adjustments Partial Trial Balance Dr. Cr. 2, ,000 1,000 1, ,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.

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 Net income$2,985 Month Ended April 30, 20x3

Retained earnings, April 1, 20x3$11,250 Add: Net income 2,985 $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 – ,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

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 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

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, ,400 Dividends 3,200 Salary Expense 950 1,900

Income Statement Format RevenuesNet income –= Expenses 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

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 Rule of thumb: A strong current ratio is 2.00.

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.