1. Accrual basis of accounting
Chapter 3
Accrual basis of accounting
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2. Accrual basis of accounting and contrasted with the cash basis with reference to revenue and expense recognition.
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3. Accrual Accounting Required by GAAP
Requires companies to measure and report accounting transactions without the necessity that cash has been received or paid
Based on two primary principles:
Revenue recognition
Expense recognition (matching)
Note: Cash Basis (Non-GAAP method used by individuals or some small businesses)– Revenues are recognized when cash is received and expenses are recorded when cash is paid
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4. Revenue Recognition Principle
Revenue is recognized when earned.
Cash may be received at the same time revenue is recognized.
Cash may be received after revenue is recognized.
Cash may be received before revenue is recognized.
Cash
100
Sales revenue
Accounts receivable
100
Sales revenue
Cash
100
Unearned revenue
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5. Expense Recognition (Matching)
Expenses incurred to generate revenue are recognized (matched) in the same time period.
As with revenues, cash payment may occur at the same time, before, or after expense recognition.
Wages Expense
Wages payable 75
Wages Payable
Cash 75
**Baking Supplies example
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6. Select the correct answer.
Which of the following is a primary principle underlying accrual accounting?
Materiality
Cash flows
.Revenue recognition
Income statement
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7. The adjusting process.
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8. The Unadjusted Trial Balance
Mike’s Bikes
Unadjusted Trial Balance
December 31, 2016
Debit
Credit
Cash
$40,000
Merch. inventory
3,000
Prepaid rent
6,000
Equipment
15,000
Accounts payable
$3,000
Notes payable
20,000
Common stock
30,000
Sales revenue
12,000
Wages expense
1,000
______
Totals
$65,000
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9. Types of Adjustments Prepaid Expenses Unearned Revenue
Allocating previously recorded assets to expense
Prepaid Expenses
Allocating previously recorded unearned revenue to earned revenue
Unearned Revenue
Recording operating expenses that have not yet been paid or recorded
Accrued Expenses
Recording revenue that has been earned, but not yet been received or recorded
Accrued Revenues
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10. deferral (prepaid) adjustments.
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11. Allocating Previously Recorded Assets to Expenses
(1) Mike’s Bikes determined the end-of-year merchandise inventory to be $500. This represents that amount of the $3,000 purchase that has not been used up, to generate December sales.
Dec. 31
Cost of goods sold
2,500
Merch. inventory
To record expense of merch. inventory used up.
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12. Allocating Previously Recorded Assets to Expenses
(2) Mike’s bikes prepaid one year of its $500 per month building rent.
Dec. 31
Rent expense
500
Prepaid rent
To record December building rent expense.
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13. Allocating Previously Recorded Assets to Expenses
(3) Mike’s Bikes purchased equipment for $15,000. The equipment is expected to have a useful life of five years, at which time is will be completely worthless. Monthly depreciation expense is computed as $15,000/60 months.
Dec. 31
Depreciation expense
250
Accumulated depreciation—Equip.
To record December depreciation expense
on the equipment.
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14. Allocating Previously Recorded Unearned Revenue to Earned Revenue
When cash is received before it is earned, the liability account Unearned Revenue is credited. When the revenue is ultimately earned, the Unearned Revenue account is debited and an earned revenue account is credited. Assume the $100 was received in advance for bikes to be picked up the following week.
Dec. 7
Cash
100
Unearned revenue
To record cash received in advance.
Dec. 14
Unearned revenue
100
Sales revenue
To record sales revenue from an advanced payment.
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15. accrual adjustments.
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16. Recording Previously Unrecorded Expenses
(4) Mike’s Bikes received a $20,000 bank loan with annual interest of six percent. The first annual interest payment is due November 30, Monthly interest expense is calculated as $20,000 x 0.06 x 1/12
Dec. 31
Interest expense
100
Interest payable
To record December interest expense.
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17. Recording Previously Unrecorded Revenue
(5) Mike’s Bikes delivered an order for a $200 bike on December 31. The customer will not be paying for the bike until January 7th of the next year.
Dec. 31
Accounts receivable
200
Sales revenue
To record sales revenue for bike delivered but not paid for.
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18. (1) Adjust Ending Merchandise Inventory
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Unadjusted Trail Balance
Adjustments
Debit
Credit
Cash
$40,000
Accounts receivable
(5) $200
200
Merchandise inventory
3,000
(1) $2,500
500
Prepaid rent
6,000
(2)
5,500
Equipment
15,000
Accumulated depreciation – Equip.
(3)
$250
Accounts payable
$3,000
Interest payable
(4)
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,000
(5)
12,200
Cost of goods sold
(1) 2,500
2,500
Wages expense
1,000
Rent expense
(2)
Depreciation expense
(3)
250
Interest expense
______
(4)
_____
Totals
$65,000
$3,550
$65,550
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19. Adjusted Trial Balance
(2) Record Rent Expense
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Unadjusted Trail Balance
Adjustments
Debit
Credit
Cash
$40,000
Accounts receivable
(5) $200
200
Merchandise inventory
3,000
(1) $2,500
500
Prepaid rent
6,000
(2)
5,500
Equipment
15,000
Accumulated depreciation – Equip
(3)
$250
Accounts payable
$3,000
Interest payable
(4)
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,000
(5)
12,200
Cost of goods sold
(1) 2,500
2,500
Wages expense
1,000
Rent expense
(2)
Depreciation expense
(3)
250
Interest expense
______
(4)
_____
Totals
$65,000
$3,550
$65,550
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20. (3) Record Depreciation Expense
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Unadjusted Trail Balance
Adjustments
Debit
Credit
Cash
$40,000
Accounts receivable
(5) $200
200
Merchandise inventory
3,000
(1) $2,500
500
Prepaid rent
6,000
(2)
5,500
Equipment
15,000
Accumulated depreciation – Equip.
(3)
$250
Accounts payable
$3,000
Interest payable
(4)
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,000
(5)
12,200
Cost of goods sold
(1) 2,500
2,500
Wages expense
1,000
Rent expense
(2)
Depreciation expense
(3)
250
Interest expense
______
(4)
_____
Totals
$65,000
$3,550
$65,550
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21. (4) Record Interest Expense
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Unadjusted Trail Balance
Adjustments
Debit
Credit
Cash
$40,000
Accounts receivable
(5) $200
200
Merchandise inventory
3,000
(1) $2,500
500
Prepaid rent
6,000
(2)
5,500
Equipment
15,000
Accumulated depreciation – Equip.
(3)
$250
Accounts payable
$3,000
Interest payable
(4)
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,000
(5)
12,200
Cost of goods sold
(1) 2,500
2,500
Wages expense
1,000
Rent expense
(2)
Depreciation expense
(3)
250
Interest expense
______
(4)
_____
Totals
$65,000
$3,550
$65,550
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22. (4) Record Sales on Account
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Unadjusted Trail Balance
Adjustments
Debit
Credit
Cash
$40,000
Accounts receivable
(5) $200
200
Merchandise inventory
3,000
(1) $2,500
500
Prepaid rent
6,000
(2)
5,500
Equipment
15,000
Accumulated depreciation – Equip.
(3)
$250
Accounts payable
$3,000
Interest payable
(4)
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,000
(5)
12,200
Cost of goods sold
(1) 2,500
2,500
Wages expense
1,000
Rent expense
(2)
Depreciation expense
(3)
250
Interest expense
______
(4)
_____
Totals
$65,000
$3,550
$65,550
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23. Complete Adjusted Trial Balance
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Unadjusted Trail Balance
Adjustments
Debit
Credit
Cash
$40,000
Accounts receivable
(5) $200
200
Merchandise inventory
3,000
(1) $2,500
500
Prepaid rent
6,000
(2)
5,500
Equipment
15,000
Accumulated depreciation – Equip.
(3)
$250
Accounts payable
$3,000
Interest payable
(4)
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,000
(5)
12,200
Cost of goods sold
(1) 2,500
2,500
Wages expense
1,000
Rent expense
(2)
Depreciation expense
(3)
250
Interest expense
______
(4)
_____
Totals
$65,000
$3,550
$65,550
Total Adjustment Debits and Credits
Complete Adjusted Trial Balance
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24. Select the correct answer.
The following is not a type of accrual adjustment?
.Common stock
Accrued expenses
Prepaid expenses
Unearned revenue
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25. The adjusted trial balance and use it to prepare financial statements.
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26. Prepare Financial Statements
The adjusted trial balance provides the necessary information.
Prepare the statements in the following order:
Income Statement
Statement of Stockholders’ Equity
Balance Sheet
Statement of Cash Flows
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27. Prepare the Income Statement
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Debit
Credit
Cash
$40,000
Accounts receivable
200
Merchandise inventory
500
Prepaid rent
5,500
Equipment
15,000
Accumulated depr. – Equip
$250
Accounts payable
3,000
Interest payable
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,200
Cost of goods sold
2,500
Wages expense
1,000
Rent expense
Depreciation expense
250
Interest expense
Totals
$65,550
Mike’s Bikes
Income Statement
For Month Ended December 31, 2016
Sales revenue
$12,200
Expenses
Cost of goods sold
$2,500
Wages expense
1,000
Rent expense
500
Depreciation expense
250
Interest expense
100
Total expense
4,350
Net income
$7,850
Net income will be an input for the statement of stockholders’ equity prepared next.
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28. Prepare the Statement of Stockholders’ Equity
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Debit
Credit
Cash
$40,000
Accounts receivable
200
Merchandise inventory
500
Prepaid rent
5,500
Equipment
15,000
Accumulated depr.– Equip.
$250
Accounts payable
3,000
Interest payable
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,200
Cost of goods sold
2,500
Wages expense
1,000
Rent expense
Depreciation expense
250
Interest expense
Totals
$65,550
Mike’s Bikes
Statement of Stockholders’ Equity
For Month Ended December 31, 2016
Common Stock
Retained Earnings
Total
Balance, December 1, 2013 $0
Add: Common stock issued in
December
30,000
Net income for December
7,850
Less: Dividends in December
Balance, December 31, 2013
$30,000
$7,850
$37,850
From
Income Statement
Retained earnings will be an input on the balance sheet prepared next.
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29. Prepare the Balance Sheet
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Debit
Credit
Cash
$40,000
Accounts receivable
200
Merchandise inventory
500
Prepaid rent
5,500
Equipment
15,000
Accumulated depr. – Equip.
$250
Accounts payable
3,000
Interest payable
100
Notes payable
20,000
Common stock
30,000
Sales revenue
12,200
Cost of goods sold
2,500
Wages expense
1,000
Rent expense
Depreciation expense
250
Interest expense
Totals
$65,550
Mike’s Bikes
Balance Sheet
December 31, 2016
Assets
Cash
$40,000
Accounts receivable
200
Supplies inventory
500
Prepaid rent
5,500
Total current assets
$46,200
Equipment
15,000
Accumulated depr. – Equip.
(250)
Equip. – net
14,750
Total assets
$60,950
Liabilities
Accounts payable
$3,000
Interest payable
100
Total current liabilities
$3,100
Notes payable
20,000
Total liabilities
23,100
Stockholders’ Equity
Common stock
30,000
Retained earnings
7,850
Total stockholders’ equity
37,850
Total liabilities and stockholders’ equity
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30. Select the correct answer.
The first financial statement to be prepared is:
.Income statement
Balance sheet
Statement of cash flows
Statement of stockholders’ equity
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31. The closing process and the accounting cycle.
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32. Permanent and Temporary Accounts
Permanent accounts are accounts whose balances carry over from one accounting period to the next.
Accounts on the balance sheet
Temporary accounts are used to gather information for a particular accounting period and then reset to zero by transferring the balance to a permanent account.
Permanent Accounts
Temporary Accounts
Assets
Revenues
Liabilities
Expenses
Common Stock
Dividends
Retained Earnings
Income Summary
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33. Closing Process
Temporary accounts are zeroed out at the close of the accounting period in order to “start fresh” in the next period.
The balances in these accounts are transferred to Retained Earnings—a permanent account.
Dividends are also closed to Retained Earnings
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34. Closing Process Illustrated
Dec. 31
Sales revenue
12,200
Retained earnings
To close the revenue accounts.
4,350
Cost of goods sold
2,500
Wages expense
1,000
Rent expense
500
Depreciation expense
250
Interest expense
100
To close the expense accounts.
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35. Post-Closing Trial Balance
A post-closing trial balance is prepared once the temporary accounts have been closed to Retained Earnings.
Mike’s Bikes
Adjusted Trial Balance
December 31, 2016
Debit
Credit
Cash
$40,000
Accounts receivable
200
Merchandise inventory
500
Prepaid rent
5,500
Equipment
15,000
Accumulated depreciation—Equipment $
Accounts payable
3,000
Interest payable
100
Notes payable
20,000
Common stock
30,000
Retained earnings
______
7,850
Totals
$61,200
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36. Select the correct answer.
The following is a true statement regarding the closing process:
Dividends are closed to retained earnings by crediting retained earnings.
.Revenues are closed to retained earnings by crediting retained earnings.
Expenses are closed to retained earnings by crediting retained earnings.
Revenues are closed to retained earnings by debiting retained earnings.
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37. Quality of Accounting Numbers
The degree to which a company’s financial statements reflect its true financial condition and performance.
Accrual accounting involves many estimates and judgments.
Analyst judge how conservative or aggressive the estimates are.
The more conservative the estimates, the higher the company’s quality of earnings is judged to be.
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38. Appendix 3A Learning Objective 7
The process of closing to the Income Summary account and summarizing the accounting cycle.
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39. Closing Using Income Summary
Temporary accounts are zeroed out at the close of the accounting period in order to “start fresh” in the next period.
The balances in these accounts are ultimately transferred to Retained Earnings—a permanent account.
A summary account, such as Income Summary, can be used to help in the closing process
Any temporary account with a debit balance is credited with the offsetting debit to Income Summary
Any temporary account with a credit balance is debited with the offsetting credit to Income Summary
Income Summary is then closed to Retained Earnings
Dividends are also closed to Retained Earnings
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40. Closing Process Using Income Summary —Illustration—
Dec. 31
Sales revenue
12,200
Income summary
To close the revenue accounts.
4,350
Cost of goods sold
2,500
Wages expense
1,000
Rent expense
500
Depreciation expense
250
Interest expense
100
To close the expense accounts.
7,850
Retained earnings
To close the Income Summary account.
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41. Appendix 3B Learning Objective 8
how to use a worksheet in the adjusting and closing process.
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42. Using a Worksheet
A worksheet using a program such as Microsoft Excel may be used to facilitate the adjusting and closing process.
The worksheet is a tool; it is not part of the formal accounting records.
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43. Corporate Social Responsibility
Investors appear to care about more than just reported income.
Company’s with higher quality of earnings and higher perceived corporate social responsibility outperformed the Standard and Poor’s 500 Index.
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