1. Accrual Accounting and the Financial Statements
Chapter 3

2. Learning Objective 1
Relate accrual accounting and cash flows.

3. Accrual Accounting vs Cash Basis Accounting
Accrual Accounting - records the impact of a business event as it occurs
Cash Basis – records only transactions in which cash is received or paid

4. The Time-Period Concept
Financial statements are prepared for specific periods and at regular intervals.

5. Learning Objective 2
Apply the revenue and matching principles.

6. Revenue Principle Revenue is recorded when it is earned.
The amount of revenue to record is the cash value of goods transferred to customer.

7. The Matching Principle
Record all expenses incurred during the accounting period
Match expenses against revenues earned

8. Learning Objective 3
Update the financial statements by adjusting the accounts.

9. Air & Sea Unadjusted Trial Balance April 30, 20x3

10. Categories of Accounting Adjustments
Deferrals
Depreciation
Accruals

11. Prepaid Expenses: Rent
On April 1, 20x3, Air & Sea Travel prepays three months office rent.
3,000
Prepaid Rent
Cash

12. Prepaid Expenses: Rent
What is the adjusting entry on April 30?
April 30 Rent Expense 1,000
Prepaid Rent 1,000
To record rent expense ($3,000 x 1/3)

13. Prepaid Expenses: Supplies
On April 2, 20x3, Air & Sea Travel paid cash of $700 for office supplies.
700
Supplies
Cash

14. Prepaid Expenses: Supplies
An inventory at month end indicated that $400 in office supplies remained.
4/2 700
Supplies 4/
Bal. 400
Supplies Expense
4/30 300
Bal. 300

15. Depreciation
Allocation of the cost of a plant asset to expense over the asset’s useful life

16. 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
Furniture
Accounts Payable

17. Depreciation of Plant Assets
Straight-line method of depreciation allocates equal amounts each accounting period.
$16,000 ÷ 5 years = $3,300 per year
$3,300 ÷12 months = $275 per month

18. Depreciation of Plant Assets
What is the adjusting entry on April 30?
April 30 Depreciation Expense, Furniture 275
Accumulated Depreciation, Furniture 275
To record depreciation

19. Book Value
The net amount of a plant asset (cost minus accumulated depreciation)

20. Accrued Expense
A liability that arises from an expense that has not yet been paid.
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. If a payday falls on the weekend, Air & Sea pays the employee on the following Monday.

21. Accrued Expenses Salary Expense Cash 4/15 950 4/15 950 4/30 9504/
4/15 950 4/
Bal. 1,900
Salary Payable 4/
Bal. 950

22. Accrued Revenue
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.

23. Accrued Revenues Adjusting entry: April 30 Accounts Receivable 250
Service Revenue 250
To accrue service revenue

24. Unearned Revenue
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.

25. Unearned Revenues April 20 Cash 450 Unearned Revenue 450
Received advanced payment
April 30 Unearned Revenue 150
Revenue 150
To record revenue earned
($450 x 1/3)

26. Step 1
Prepare
Unadjusted
Trial Balance
Step 2
Plan
Adjustments
Step 2
Prepare Adjusted
Trial Balance

27. Learning Objective 4
Prepare the financial statements.

28. Air & Sea Travel, Inc. Income Statement Month Ended April 30, 20x5
Revenue:
Service revenue $7,400
Expenses:
Salary expense $1,900
Rent expense 1,000
Utilities expense 400
Supplies expense 300
Depreciation expense ,875
Income before tax $3,525
Income tax expense
Net income $2,985

29. Air & Sea Travel, Inc. Statement of Retained Earnings Month Ended April 30, 20x5
Retained earnings, April 1, 20x5 $11,250
Add: Net income ,958
$14,235
Less: Dividends ( 3,200)
Retained earnings, April 30, 20x5 $11,035

30. Air & Sea Travel, Inc. Balance Sheet April 30, 20x5
Assets
Cash $24,800
Accounts receivable ,500
Supplies
Prepaid rent ,000
Furniture $16,500
Less:
Accumulated
depreciation ( ) 16,225
Total assets $45,925
Liabilities
Accounts payable $13,100
Salary payable
Unearned revenue
Income tax payable
Total liabilities $14,890
Stockholders’ Equity
Common stock $20,000
Retained earnings 11,035
Total $31,031
Total liabilities and
stockholders’ equity $45,925

31. Learning Objective 5
Close the books.

32. Closing Entries
Prepare the accounts for the next period’s transactions.
Transfer the revenue, expense, and dividends balances to Retained Earnings.

33. Which Accounts Need To Be Closed?
Temporary accounts are closed
Revenue
Expense
Dividends
Permanent accounts are not closed
Assets
Liabilities
Stockholders’ equity

34. Journalizing the Closing Entries
April Service Revenue 7,400
Retained Earnings 7,400
April Retained Earnings 4,415
Rent Expense 1,000
Salary Expense 1,900
Supplies Expense
Depreciation Expense 275
Utilities Expense 400
Income Tax Expense 540
April Retained Earnings 3,200
Dividends 3,200

35. Posting the Closing Entries
Rent Expense
1,000
Service Revenue
7,400
7,000
250
150
7,400
Salary Expense
950
1,900
Retained Earnings
4,415
3,200
11,250
7,400
11,035
Other Expenses
1,515
Dividends
3,200

36. Classifying Assets and Liabilities
List assets and liabilities in order of their relative liquidity.
Liquidity - how quickly an item can be converted to cash.

37. Classifying Assets and Liabilities
Current assets
Long-term assets
Current liabilities
Long-term liabilities

38. Learning Objective 6
Use the current ratio and the debt ratio to evaluate a business.

39. Total current liabilities
Current Ratio
Measures company’s ability to pay current liabilities with current assets
Total current assets
Total current liabilities
Rule of thumb: A strong current ratio is 2.00

40. A low debt ratio is safer than a high debt ratio.
The proportion of assets that is financed with debt.
Measures business’s ability to pay total liabilities
Total liabilities
Total assets
A low debt ratio is safer than a high debt ratio.

41. End of Chapter 3