ACG2021 Financial Accounting Chapter 3 Using Accrual Accounting to Measure Income

Learning Objectives Relate accrual accounting and cash accounting Apply the revenue and matching principles Update the financial statements by adjusting the accounts Close the books Use the current ratio and the debt ratio to evaluate a business

GAAP “In the United States, generally accepted accounting principles, commonly abbreviated as US GAAP or simply GAAP, are accounting rules used to prepare, present, and report financial statements for publicly-traded companies and many privately-held companies.” (Wikipedia)United Statesfinancial statementscompanies

Accrual vs Cash Accounting Generally accepted accounting principles (GAAP) require that business use accrual accounting.

Time-Period Concept The time-period concept ensures that accounting information is reported at regular intervals.  Basic accounting period is 1 year  A fiscal year ends on a date other than December 31.  Interim financial statements are usually prepared for periods such as a month, a quarter, or semiannual period.

Revenue Principle When should revenue be recorded?  Revenue should be recorded when it has been earned. Delivered Good or Service to a Customer What amount of revenue should be recorded?  The amount of revenue recorded is the cash value of the goods transferred to the customer.

Matching Principle Expenses are costs of assets used up and/or liabilities created in earning revenue. Matching involves two steps:  Identify all expenses incurred during the period.  Measure the expenses and match the expenses against revenues earned. Expenses may  be paid in cash.  result from using up an asset such as supplies  result from creating a liability (payable)

Accrual vs Cash Accounting Accrual Accounting  Impact of business transactions are recorded when the transaction occurs  Revenues are recognized when earned.  Expenses are recognized when incurred. Cash Accounting  Transactions are recorded when cash is received or paid.  Revenues are recorded when cash is received.  Expenses are recorded when cash is paid.

Accrual vs Cash Accounting Under accrual accounting, cash transactions are recorded as well as noncash transactions such as:  Purchases of inventory on account  Sales on account  Depreciation expense  Accrual of expenses incurred but not yet paid  Usage of prepaid rent, insurance, and supplies

Ethical Issues in Accrual Accounting Accruals require the use of judgment to determine which period should reflect revenues earned. Managers should not use accruals to “smooth” income by delaying or accelerating recognition of either revenues or expenses.

ACG2021 Financial Accounting Recording Accruals and Deferrals and Adjusting Accounts for Accruals and Deferrals

The Adjustment Process Examine the trial balance for accounts that may need to be adjusted. Basic categories of adjusting entries:  Deferrals Paid Cash in Advance for resource that will be used up in the future Supplies, Insurance, Rent, Plant assets, etc. Received Cash BEFORE performing Service Collected subscription revenue, paid for class Depreciation Special type of Deferral for Plant Assets  Accruals Provided Service or sold product before receiving Cash “on account” An Expense has occurred before paying Cash

Adjusting Deferred Assets Prepaid Expense  A prepaid expense is an expense paid for in advance.  Because they provide future economic benefit, prepaid expenses are classified as assets. Insurance, Rent, etc. Before financial statements are prepared, prepaid expenses are adjusted to reflect the amount of the asset used up during the period of the statements.

Deferred Asset Adjustment Adjustment records the effect of using up an Asset  “Using Up” an Asset the Asset value has been reduced We need to Credit the Asset  Debits must Equal Credits If Assets create economic benefits, Using them up leads to a Cost/Expense We need to Debit an Expense Account  Deferred Asset Rule Debit Expense and Credit Asset Assets Debit + Credit - Expenses Debit + Credit -

Adjusting Prepaid Expenses To record $3,000 paid for 3 months rent on April 1, 20X3. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 1Prepaid Rent (1,000 x 3)3,000 Cash3,000 Paid 3 months’ rent in advance Prepaid Rent 3,000 Cash 3,000

Adjusting Prepaid Expenses To adjust for one month’s rent expired at April 30. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 30Rent Expense (1,000/3)1,000 Prepaid Rent1,000 Expensed one month’s rent Rent Expense 1,000 Prepaid Rent 1,000

Adjusting Prepaid Expenses The following shows the effect of the adjustment. Prepaid Rent Apr 1 3,000 Apr 30 1,000 Bal. 2,000 Rent Expense Apr 30 1,000 Bal. 1,000

Adjusting Supplies To record the purchase of supplies. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 2Supplies700 Cash700 Paid cash for supplies Supplies 700 Cash 700

Adjusting Supplies To adjust for supplies used during April. Calculate Supplies Expense: Supplies available during the period Less: Supplies on hand at end of period Equals: Supplies used during the period (expense) $700 - $400 = $300

Adjusting Supplies To adjust for supplies used during April. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 30Supplies Expense 300 Supplies300 To record Supplies Expense Supplies Expense 300 Supplies 300

Adjusting Supplies The following shows the effect of the adjustment. Supplies Apr Apr Bal. 400 Supplies Expense Apr Bal. 300

Deferred Revenue Unearned revenue exists when customers have paid in advance for services that have not yet been provided.  The organization “owes” the customer the service in the future  Thus, Unearned Revenue is a liability (an obligation) Liability Increases, thus Credit Unearned Revenue Received Cash, thus Debit Cash Revenue is recognized when the services are provided.  Reduces the organizations obligation Thus Liability is reduced, Debit Unearned Revenue Revenue is increased, Credit Service Revenue

Unearned Revenue To record cash received in advance from customers. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 20Cash450 Unearned Service Revenue450 Received cash for revenue in advance Cash 450 Unearned Service Revenue 450

Unearned Revenue To record revenues earned at the end of the month. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 30Unearned Service Revenue (450/3)150 Service Revenue150 To record unearned service revenue that has been earned Unearned Service Revenue 150 Service Revenue 150

Unearned Revenue The following shows the effect of the adjustment. Service Revenue Apr Bal. 7,400 Unearned Service Revenue Apr Bal. 300 Apr ,000 Apr

Adjusting Accrued Expenses Accrued Expense  An expense of an Organization that hasn’t been paid for by Cash  Matching Principle requires that we determine all Costs associated with Revenue, even if cash hasn’t been paid Taxes owed, Salaries owed, Interest owed, etc. Before financial statements are prepared, expenses are adjusted to reflect the cost to the organization for the period of the statements.

Accrued Expenses Accrued expense refers to a liability that arises from an expense that has not yet been paid.  An Expense that has not been paid The Expense value has increased We need to Debit the Expense account Leads to a liability that the organization owes Liability value has increased We need to Credit the Liability  Accrued Expense Rule: Debit Expense, Credit Liability Expenses Debit + Credit - Liability Debit - Credit +

Accrued Expenses To record salaries expense during the month. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 15Salaries Expense950 Cash950 To pay salaries Salaries Expense 950 Cash 950

Accrued Expenses To adjust salaries expense at the end of the month. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 30Salaries Expense950 Salaries Payable950 To accrue salaries expense Salaries Expense 950 Salaries Payable 950

Accrued Expenses The following shows the effect of the adjustment. Salaries Payable Apr Bal. 950 Salaries Expense Apr Bal. 950

Accrued Revenues Accrued revenue is revenue that has been earned but cash has not been collected.  “On Account”

Accrued Revenue To accrue revenues at the end of the month. DATEACCOUNTS AND EXPLANATIONDEBITCREDIT Apr 30Accounts Receivable250 Service Revenue250 To accrue service revenue Accounts Receivable 250 Service Revenue 250

Accrued Revenue The following shows the effect of the adjustment. Service Revenue Apr Bal. 7,250 Accounts Receivable 2,250 Bal. 2,500 Apr ,000

Summary of Adjusting Process Prepare a trial balance. Review trial balance and other records for adjustments that should be made:  Accruals  Deferrals  Depreciation Prepare and post adjusting entries. Prepare an adjusted trial balance to ensure accuracy of debits and credits after posting. Prepare financial statements.

Summary of Adjusting Entries

ACG2021 Financial Accounting Closing the Books

Adjusted Trial Balance

Stockholders’ Equity Accounts Expanded Accounting Equation Assets Liabilities Stockholders’ Equity Common Stock + Retained Earnings - Dividends + Revenues - Expenses =

Closing the Books Temporary accounts are closed  Revenues (are Debited) Retained Earnings is Credited  Expenses (are Credited) Retained Earnings is Debited  Dividends (are Credited) Retained Earnings are Debited Permanent accounts are not closed  Assets  Liabilities  Stockholders’ Equity

Journalizing Closing Entries Apr 30Service Revenue7,400 Retained Earnings7,400 Apr 30Retained Earnings4,415 Rent Expense1,000 Salary Expense1,900 Supplies Expense300 Depreciation Expense275 Utilities Expense400 Income Tax Expense540 Apr 30Retained Earnings3,200 Dividends3,200

Closing Accounts Retained Earnings after closing entries: Retained Earnings Beg. Bal11,250 Revenues7,400Expenses4,415 Dividends3,200 End Bal11,035

ACG 2021 Financial Accounting Financial Statement Formats

Formats for Financial Statements Balance sheet formats  Report format  Account format Income statement formats  Single-step income statement  Multi-step income statement

Classified Balance Sheet Current assets Long-term assets Current liabilities Long-term liabilities

Balance Sheet – Account Format

Balance Sheet – Report Format

Income Statement – Single Step

Income Statement – Multi Step

ACG 2021 Financial Accounting Accounting Ratios

Current Ratio Total Current Assets Total Current Liabilities = Debt Ratio Total Liabilities Total Assets =

Current Ratio Ability to pay current liabilities with current assets Rule of Thumb  1.5 or greater is a strong current ratio What does this mean?  Avg. between 1.2 and 1.5  1.0 or below is considered low What does this mean?

Debt Ratio Proportion of Assets financed with Debt Ability of a company to pay liabilities Lower ratio is safer then higher  Why?

End of Chapter 3