1. 1 Accrual Accounting By P. Raghava Narayana Chartered Accountant

2. . 2 Accrual vs. Cash-Basis Accounting ACCRUAL Records business transactions when they occur  When sale is made  When bill is received Complies with GAAP Presents accurate financial picture CASH Records transactions only when cash is received or paid  When customer pays for product or service  When bills are paid Only used by very small businesses Omits important info

3. 3 Accrual Accounting and Cash Flows Accrual accounting records both cash and non-cash transactions Cash Collecting from customers Paying for expenses Borrowing money Issuing Shares Non-cash Sales on credit Purchases on credit Using prepaid expenses, such as supplies

4. 4 Time-Period Concept Businesses do not stop operations to measure financial transactions Accountants prepare financial statements at regular intervals to measure performance Companies select a twelve-month period for reporting purposes:  Calendar year  Fiscal year

5. 5 The Revenue Principle Revenue is recorded when earned  When product or service is delivered to customer  Cash may come before, at the same time, or after delivery Revenue is recorded at the cash value of goods or services provided

6. 6 The Matching Principle Expenses are incurred to help produce revenue Expenses should be recorded in the time period in which they are incurred Expenses should be matched to the revenues they help produce REVENUESEXPENSES

7. 7 Expenses May be paid in cash  Paying monthly rent May arise from using up an asset  Using supplies previously purchased May arise from creating a liability  Receive a bill from a supplier

8. ILLUSTRATION During the financial year 2010-11, Ashok had cash sales of Rs. 3,90,000 and credit sales of Rs. 1,60,000. His expenses for the year were Rs. 2,70,000 out of which Rs. 80,000 is still to be paid. Find out Ashok's income for 2010-11 following the Cash Basis of Accounting. 8

9. 9 The Adjustment Process At the end of the period, a business prepares financial statements Ensures that:  All revenue that has been earned has been recorded  All expenses that have been incurred are matched to revenues  Asset and liability accounts are up-to-date

10. 3-10 Categories of Adjusting Entries Deferrals Depreciation Accruals

11. 11 Deferrals Cash has already been received or paid  Related expense or revenue has not yet been recorded Prepaid expenses  Company has paid for expense in advance  Adjustment needed to record amount used Unearned revenues  Customer pays in advance for good or service  Adjustment needed to record amount of revenue earned

12. 12 Prepaid Expenses Expenses paid in advance Include prepaid rent and supplies Asset is recorded when purchased Adjustment needed to record amount used

13. 13 Prepaid Rent Example Suppose on April 1 on a company paid Rs.12,000 for one year’s rent in advance JOURNAL Date Accounts Debit Credit 1-Apr Prepaid rent Rs.12,000 Cash Rs.12,000

14. 14 Prepaid Rent Example Now, it’s December 31 and assume that the company is closing its book on December 31. The amount of rent that has expired must be recorded This amount is recorded as rent expense Prepaid rent (asset) needs to be reduced so it reflects the amount of rent remaining

15. April 1, current year December 31April 1, following year Rs. 12,000 Prepaid Rent April 1 to December 31 = 9 months 9 out of 12 months of rent has expired 9/12 x Rs. 12,000 = Rs. 9,000 3 out of 12 months of rent remains 3/12 x Rs. 12,000 = Rs. 3,000 Rs.9,000Rs. 3,000 15

16. 16 Prepaid Rent Example Dec 31 – Adjust Prepaid Rent account for amount expired JOURNAL Date Accounts Debit Credit 31/12 Rent Expense Rs. 9,000 Prepaid Rent Rs. 9,000

17. 17 Prepaid RentRent Expense Apr 1 Rs.12,000Dec 31 Rs.9,000 Rs.3,000 End-of-year balance Represents amount expired Represents amount remaining

18. 18 Supplies Example Suppose a company purchased Rs. 3,200 of supplies during the year  The asset “supplies” was debited for each purchase At the end of the year, a physical count reveals Rs. 500 of supplies on hand

19. 19 Supplies Example Supplies Rs.3,200 Balance per ledger Rs. 500 Balance per physical count What amount of supplies was used? Subtract the balance per count from the balance per ledger

20. 20 Supplies Example Dec 31 – Adjust Supplies account for amount used JOURNAL Date Accounts Debit Credit 31/12 Supplies Expense Rs.2,700 Supplies Rs.2,700

21. 21 SuppliesSupplies Expense Rs.3,200Dec 31 Rs.2,700 Rs.500 End-of-year balance Represents amount used Represents amount on hand

22. 22 Depreciation of Plant Assets Allocation of plant assets cost over their useful lives Results in a debit to an expense  Depreciation Expense Corresponding credit  Accumulated Depreciation

23. 23 Accumulated Depreciation Account that shows the sum of depreciation expense of the plant asset Contra-asset  Always has a companion account  Normal credit balance

24. 24 Depreciation Example A company purchases equipment for Rs. 50,000 The estimated useful life of the equipment is five years = Rs. 5,000 annual depreciation 50,000/5 years

25. 25 Depreciation Example Dec 31 – Adjusting entry to record depreciation of equipment JOURNAL Date Accounts Debit Credit 12-31 Depreciation Expense Rs. 5,000 Accumulated Depreciation Rs. 5,000

26. 26 Depreciation – Balance Sheet Balance Sheet Plant assets: EquipmentRs.50,000 Less: Accum. Depr.(5,000)Rs.45,000

27. 27 Accrued Expenses Expense incurred before cash is paid Result in a liability Common accrued expenses:  Salaries  Interest  Taxes

28. 28 Accrued Salary Expense Example A company pays its employees a weekly salary each Friday Salaries for each week total Rs. 10,000 December 31, the company’s year-end, falls on a Wednesday

29. 29 Monday, December 29 Wednesday, December 31 year end Friday, January 2 pay day Rs.10,000 Salaries Monday through Wednesday = 3 days 3 out of 5 days of salaries expense has been incurred 3/5 x Rs10,000 = Rs6,000 Rs6,000Rs4,000

30. 30 Accrued Salary Expense Example Dec 31 – Record accrued salary expense JOURNAL Date Accounts Debit Credit 12-31 Salary expense Rs.6,000 Salary payable Rs.6,000

31. 31 Accrued Revenues Companies often earn revenue before cash is received Results in an accrued revenue  Receivable recorded

32. 32 Accrued Revenue Example A company performed services for customers during the last week of the year totaling Rs. 5,000 The revenue has not yet been recorded because the customers won’t be billed until January

33. 33 Accrued Salary Expense Example Dec 31 – Record accrued revenue JOURNAL Date Accounts Debit Credit 31/12 Accounts Receivable Rs.5,000 Service Revenue Rs. 5,000

34. 34 Unearned Revenues Recorded as a liability when company receives payment  Company owes customer product or service Revenue is not recorded until earned  When company provides product or service An adjusting entry is made to transfer amount from unearned revenue to revenue

35. 35 Unearned Revenue Example On November 1, a company receives a customer payment of Rs. 18,000 for services to be performed during the next three months

36. 36 Unearned Revenue Example Nov 1 – Record advance payment received by customer JOURNAL Date Accounts Debit Credit 01/11 Cash Rs. 18,000 Unearned revenue Rs. 18,000

37. 37 November 1, current year December 31January 31, following year Rs.18,000 November 1 to December 31 = 2 months 2 out of 3 months of revenue has been earned 2/3 x Rs, 18,000 = Rs. 12,000 1 out of 3 months remains unearned 1/3 x Rs. 18,000 = Rs. 6,000 Rs.12,000Rs.6,000

38. 38 Unearned Revenue Example Dec 31 – Record portion of unearned revenue that has been earned JOURNAL Date Accounts Debit Credit 31/12 Unearned revenue Rs.12,000 Service revenue Rs.12,000

39. 39 Unearned RevenueService Revenue Dec 31 Rs. 12,000 Nov 1 Rs.18,000Dec 31 Rs.12,000 Rs.6,000 End-of-year balance Represents amount earned Represents amount unearned

40. 40 Summary of Adjusting Entries Purpose of adjusting entries  Measure income  Update balance sheet Each adjusting entry affects  One income statement account Revenue or Expense  One balance sheet account Asset or liability

41. 41 Adjusted Trial Balance Trial balance prepared after adjusting entries are made and posted These amounts are used to prepare the financial statements:  Income Statement – Profit and Loss account  Balance Sheet

42. 42 Income Statement Reports net income or loss Revenues minus expenses Net income flows to Retained Earnings Statement (a.k.a Reserves & Surplus)

43. 43 Statement of Retained Earnings Shows changes to the Retained Earnings account Net Income is added to beginning balance Dividends are subtracted Ending Retained Earnings flows to the Balance Sheet

44. 44 Balance Sheet Reports assets, liabilities and equity Shows that the accounting equation is in balance

45. 45 INCOME STATEMENT RETAINED EARNINGS STATEMENT BALANCE SHEET NET INCOME ENDING RETAINED EARNINGS

46. 46 Closing the Books Done after financial statements are prepared Set temporary accounts to zero Transfers balances to retained earnings account Journalizes activity in Statement of Retained Earnings

47. 47 Temporary and Permanent Accounts Temporary Revenues, Expenses and Dividends Closed Balances represent a period of time Permanent Asset, liability and equity accounts Not closed Ending balance of one period carries over to following period

48. 48 Closing Entries Debit each Revenue account for the amount in its credit balance  Retained earnings is credited Credit each Expense account for the amount in its debit balance  Retained earnings is debited Credit Dividends for the amount in its debit balance  Retained earnings is debited R E D

49. 49 Dec 31 – Close Revenues JOURNAL Date Accounts Debit Credit 31/12 Service Revenue Rs.23,600 Other revenue 600 Retained earnings Rs. 24,200

50. 50 Dec 31 – Close expenses JOURNAL DateAccountsDebitCredit 31-Dec Retained Earnings Rs. 23,100 Cost of services sold Rs. 11,600 Selling, general & admin exp Rs. 6,900 Depreciation expense Rs.4,100 Income tax expense Rs. 500 Which account would be debited? Total the expenses for the amount

51. 51 Dec 31 – Close Dividends JOURNAL Date Accounts Debit Credit 12-31 Retained earnings Rs. 400 Dividends Rs. 400

52. 52 Retained earnings Opening balance Closing balance 1,900 24,200400 23,100 Revenues Expenses Dividends Rs. 2,600 Determine net income. Remember revenues minus expenses

53. 53 Classifying Assets & Liabilities Current and long-term classifications are based on liquidity  How quickly item is converted to in cash Current assets will be converted to cash, sold or used during the next year Long-term assets include plant assets Current liabilities must be paid in the next 12 months Long-term liabilities have due dates more than one year from balance sheet date

54. 54 Classified Balance Sheet Places assets into meaningful categories Categories:  Current assets  Long-term investments  Property, plant and equipment  Intangible assets  Other assets

55. 55 Balance Sheet Formats Report format  Assets at the top  Followed by liabilities and stockholders’ equity Account format  Assets on the left  Liabilities and stockholders’ equity on the right

56. 56 Income Statement Formats Single-step  All revenues and gains grouped together  All expenses and losses grouped together Multi-step  Includes useful subtotals  Gross profit Net revenues minus cost of goods sold  Income from operations  Net income

57. 57 Current ratio Measure company’s ability to pay current liabilities with current assets Rule of thumb:  Strong current ratio is 1.50 Current assets Current liabilities

58. 58 Debt Ratio Proportion of assets that is financed with debt High debt ratio indicates more risk Total liabilities Total assets

59. 59 S3-14 Current ratio: Current assets = Cash + Accounts Receivable + Inventories + Other current assets 900 + 27,700 + 33,000 + 4,800 = Rs. 66,400 Total Current liabilities = Rs. 53,600 Current ratio = 66,400 / 53,600 Current ratio = 1.24

60. 60 Debt ratio: Total liabilities = Current liabilities + Long-term liabilities Rs. 53,600 + Rs. 13,500 = Rs. 67,100 Total assets = Current assets + Property & Equipment, net + Other assets Rs.66,400 + Rs.7,200 + Rs. 24,300 = Rs. 97,900 Debt ratio = Rs.67,100 / Rs.97,900 Debt ratio =.69

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