Accrual Accounting and the Financial Statements Chapter 3

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Accrual Accounting and the Financial Statements
Chapter 3

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

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The Time-Period Concept

• Financial statements are prepared for specific
  periods and at regular intervals.

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Revenue Principle

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

4
The Matching Principle

• Record all expenses incurred during the
  accounting period
• Match expenses against revenues earned

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Learning Objective 3

• Update the financial statements by adjusting the
  accounts.

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Air Sea Unadjusted Trial Balance April 30, 20x3
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Categories of Accounting Adjustments

• Deferrals
• Depreciation
• Accruals

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Prepaid Expenses Rent

• On April 1, 20x3, Air Sea Travel prepays three
  months office rent.

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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)
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Prepaid Expenses Supplies

• On April 2, 20x3, Air Sea Travel paid cash of
  700 for office supplies.

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Prepaid Expenses Supplies

• An inventory at month end indicated that 400 in
  office supplies remained.

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Depreciation

• Allocation of the cost of a plant asset to
  expense over the assets useful life

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Depreciation of Plant Assets

• On April 3, the business purchased furniture on
  account for 16,500. The furniture is expected to
  last 5 years.

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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

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Depreciation of Plant Assets

• What is the adjusting entry on April 30?

April 30 Depreciation Expense,
Furniture 275 Accumulated Depreciation, Furni
ture 275 To record depreciation
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Book Value

• The net amount of a plant asset (cost minus
  accumulated depreciation)

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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.

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

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Accrued Revenues

• Adjusting entry

April 30 Accounts Receivable 250 Service
Revenue 250 To accrue service revenue
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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.

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Unearned Revenues
April 20 Cash 450 Unearned Revenue 450 Receiv
ed advanced payment
April 30 Unearned Revenue 150 Revenue 150 To
record revenue earned (450 x 1/3)
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Step 1 Prepare Unadjusted Trial Balance
Step 2 Plan Adjustments
Step 2 Prepare Adjusted Trial Balance
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• Transactions are entered.
• End of period adjustments are made.
• Prepare the financial statements.

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Air Sea Travel, Inc.Income StatementMonth
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 275 3,875 Income before
tax 3,525 Income tax expense 540 Net
income 2,985
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Air Sea Travel, Inc.Statement of Retained
EarningsMonth Ended April 30, 20x5
Retained earnings, April 1, 20x5 11,250 Add
Net income 2,958 14,235 Less
Dividends ( 3,200) Retained earnings, April
30, 20x5 11,035
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Air Sea Travel, Inc.Balance SheetApril 30,
20x5
Assets Cash 24,800 Accounts receivable
2,500 Supplies 400 Prepaid rent
2,000 Furniture 16,500 Less
Accumulated depreciation ( 275)
16,225 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
stockholders equity 31,031 Total liabilities
and stockholders equity 45,925
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Closing Entries

• Prepare the accounts for the next periods
  transactions.
• Transfer the revenue, expense, and dividends
  balances to Retained Earnings.
• Their balances are zeroed out so they are ready
  to accumulate again in the next period.

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Which AccountsNeed To Be Closed?

• Temporary accounts are closed
• Revenue
• Expense
• Dividends
• Permanent accounts are not closed
• Assets
• Liabilities
• Stockholders equity

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Journalizing the Closing Entries
April 30 Service Revenue 7,400 Retained
Earnings 7,400 April 30 Retained
Earnings 4,415 Rent Expense 1,000 Salary
Expense 1,900 Supplies Expense
300 Depreciation Expense 275 Utilities
Expense 400 Income Tax Expense 540 April 30
Retained Earnings 3,200 Dividends 3,200
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Posting the Closing Entries
Service Revenue
7,400
7,000 250 150 7,400
Retained Earnings
4,415 3,200
11,250 7,400 11,035
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Classifying Assets and Liabilities

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

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Classifying Assets and Liabilities
Current assets
Long-term assets
Current liabilities
Long-term liabilities
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• Use the current ratio and the debt ratio to
  evaluate a business.

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Current Ratio

• Measures companys ability to pay current
  liabilities with current assets

Total current assets Total current liabilities
Rule of thumb A strong current ratio is 2.00
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Debt Ratio

• The proportion of assets that is financed with
  debt.
• Measures businesss ability to pay total
  liabilities

Total liabilities Total assets
A low debt ratio is safer than a high debt ratio.