Chapter Three Accrual Accounting

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Chapter Three Accrual Accounting
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Accrual Accounting vs. Cash-Basis Accounting

• Two alternative methods may be used for
  calculating a businesss net income
• Accrual Basis of Accounting
• Cash Basis of Accounting
• Cash Basis of Accounting
• Revenues are recorded when cash is received
• Expenses are recorded when cash is paid
• No notion of Accounts Receivable (A/R) or
  Accounts Payable (A/P)
• Not a GAAP method

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Accrual Accounting vs. Cash-Basis Accounting

• Two alternative methods may be used for
  calculating a businesss net income
• Accrual Basis of Accounting
• Cash Basis of Accounting
• Accrual Basis of Accounting
• Revenues are recorded when they are earned
  i.e., when the service is performed or the goods
  are delivered
• Expenses are recorded when resources are utilized
  to use revenue i.e., when used or consumed
• GAAP Method

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Accrual Accounting Concepts

• Revenue Principle governs that revenue should
  be recognized when it is earned (i.e., when
  performance has occurred).
• Matching Principle governs the recognition of
  expenses (i.e., that expenses should be
  recognized when they are incurred).
• Time-Period Concept (Periodicity) governs the
  reporting of accounting information and/or
  financial statements at regular intervals.

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Adjustment Process

• The calculation of Net Income (Revenues
  Expenses) at the end of a period is critical.
• Accountants make certain adjustments at the end
  of the period in order to update records and
  accurately reflect all revenues and expenses.
• The adjustment process involves recording all
  revenues and expenses that have been earned or
  incurred in the current period.

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Rules of Thumb on Adjusting Entries

• Each adjusting entry will affect one Revenue or
  Expense account and one Asset or Liability
  account.
• The key to figuring out the necessary adjusting
  entries is to
• (1) Identify the revenue/expense that needs to be
  updated or asset/liability
• (2) Identify the corresponding account affected
  by the transaction.
• Adjusting entries never affect cash.

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Adjusting Entries Deferrals

• Deferrals are when cash has been received or paid
  in advance of actually recognizing an expense or
  revenue.
• Supplies (Asset) purchased 500 worth of office
  supplies.
• Prepaid Insurance (Asset) paid 10,000 for a
  6-month insurance premium.
• Prepaid Rent (Asset) paid 10,000 for 1 year of
  rent.
• Unearned Revenue (Liability) received 2,000 to
  paint two houses in the future.

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Deferrals Initial Journal Entry

• Since cash has been received or paid in advance,
  it may be helpful to think of the original
  journal entry. This is not required unless the
  problem specifies it, but can be a helpful first
  step.
• Supplies
  500
• Cash
  500
• Prepaid Insurance/Prepaid Rent 10,000
• Cash
  10,000
• Cash
  2,000
• Unearned Revenue
  2,000

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Adjustments Deferrals

• Example of the adjustment process for Prepaid
  Expenses (deferrals) Prepaid Rent, Prepaid
  Insurance, and Supplies
• These are expenses recorded in advance, in an
  asset account.
• Must properly allocate the expenses to the period
  during the adjustment process.
• Example On December 1, 2005, Shilling
  Construction, Inc. pre-pays 12 months of rent
  expense in the amount of 10,000.

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Adjustments Deferrals

• What is the adjusting entry on December 31, 2005
  to record the proper amount of Rent Expense for
  the period?

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Adjustments Deferrals

• Example of the adjustment process for Unearned
  Revenue, in which Revenues (Cash) are received
  before they are earned. Unearned Revenue is a
  liability account.
• Example On December 1, 2005, Georgetown Painters
  received 2,000 to paint two houses. At the time
  of receiving the cash, Georgetown planned to
  perform the work in the future.

Unearned Revenue
Cash
2,000
2,000
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Adjustments Deferrals

• As of December 31, 2005, Georgetown had painted 1
  of the two houses.
• What is the adjusting entry on December 31, 2005
  to record the proper amount of revenue for the
  month?

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Adjustments Depreciation

• Depreciation is the allocation of the cost of a
  plant asset to expense over the plants useful
  life.
• Long-lived plant assets (buildings, equipment,
  etc.) are not expensed when purchased rather,
  such assets are expensed as they are used or
  consumed.
• Depreciation expense is recorded in each
  accounting period in which the asset is used.

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Adjusting Entry Depreciation Expense

• Calculating depreciation expense
• Using the straight-line depreciation method,
  allocate an equal amount each accounting period
  in which the asset is expected to benefit (the
  useful life).
• Land is never depreciated.
• Depreciation expense Cost of the Asset
• 
  Useful Life

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Adjusting Entry Depreciation Expense

• Accumulated Depreciation
• The cumulative total of all depreciation expense
  relating to a particular plant asset.
• It is a contra asset. This means it is an
  anti-asset, meaning it is presented with a
  companion asset account, but it has a normal
  balance that is opposite the companion account.
• Accumulated Depreciation has a credit balance and
  increases with a credit.
• Book Value
• Asset Accumulated Depreciation Book Value

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Adjustments Depreciation

• Example of the adjustment process for
  depreciation
• On December 1, 2005, Shilling Construction
  purchases new office furniture on account for
  20,000. The furniture is expected to last 5
  years.

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Adjustments Depreciation

• Depreciation Expense Cost of the Asset
• 
  Useful Life
• Depreciation Expense20,0004,000/year
• 
  5 years
• Depreciation Expense4,000/yr333/month
• 12
  months

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Adjustments Depreciation

• What is the adjusting entry on December 31, 2005
  to record the proper amount of Depreciation
  Expense for the period?

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Adjustments Depreciation

• Book Value (or carrying amount) is the net amount
  of the plant asset, calculated by netting the
  cost of the asset minus the related accumulated
  depreciation.
• Book value is not the same as fair market value.
• Book value represents the amount left to be
  allocated to depreciation expense in future
  periods.

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Adjusting Entry Accrued Expenses

• Accrued Expenses are expenses that have not yet
  been paid in cash, and have not been recorded at
  the end of the month. Since cash has not been
  received or paid prior to recognizing a revenue
  or expense, this is a type of accrual.
• Salary Expense employees work, but have not yet
  been paid.
• Interest Expense accrue interest on a bank loan
  that you borrow, but have not paid the interest
  back yet.
• Interest Revenue earn interest on a CD, but
  have not received the cash yet.
• Service Revenue perform ongoing travel services
  to another corporation.

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Adjustments Accrued Expenses

• Example of the adjustment process for Accrued
  Expenses, which are liabilities that arise from
  expenses that have not yet been paid.
• Example Shilling Construction 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 a weekend, Shilling pays the employee on
  the following Monday.
• Note For these purposes, assume that December
  31st, the second payday of the month, falls on a
  Saturday, and so the second half-month amount of
  950 will be paid on Monday, January 2nd.
  Therefore, an adjustment entry is needed on 12/31
  for additional salary expense and salary payable.

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Adjustments Accrued Expenses
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Adjustments Accrued Revenues

• Example of the adjustment process for Accrued
  Revenues, which are revenues that have been
  earned but not yet paid in cash.
• Example Towne East hires Air Sea Travel on
  April 15th to provide travel services on a
  monthly basis. Towne East will pay Air Sea
  Travel 500 monthly, with the first payment on
  May 15th.

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Adjustments Accrued Revenues

• Adjusting Entry

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Summary of Adjusting Entries

• Adjusting entries always affect at least one
• One Revenue or Expense account which measure
  net income
• One Asset or Liability account which update the
  Balance Sheet
• Adjusting entries never involve cash.

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In-Class Exercise!

• Form groups of 2-3 with people around you.
• I will distribute in-class exercise, in which you
  will prepare the adjusting journal entries for a
  series of events.
• Nominate someone in your group to serve as a team
  spokesperson.
• We will then discuss as a larger group.

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Adjusted Trial Balance

• The Adjusted Trial Balance is a list of all of
  the ledger accounts (i.e., all of the T-accounts)
  with their adjusted balances.
• The Adjusted Trial Balance is used to prepare the
  financial statements.
• Trial Balance Adjustments Adjusted Trial
  Balance
• Debit Credit Debit Credit
  Debit Credit

Refer to Exhibit 3-9, page 123, for format.
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Preparation of Financial Statements

• Using the Adjusted Trial Balance, the financial
  statements must be prepared in the following
  order
• (1) Income Statement
• Single step All Revenues, followed by all
  Expenses
• Multi-step Subtotals (such as COGS and Gross
  Profit)
• (2) Statement of Retained Earnings
• (3) Balance Sheet
• Assets Current Assets first (in order to
  liquidity), followed by Long-Term Assets
• Liabilities Current Liabilities, then Long-Term
  Liabilities
• Note the Statement of Cash Flows does not need
  to be prepared in a particular order, but it is
  typically prepared last.

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Closing the Books

• Closing the books is the process at the end of
  the period that journalizes and posts the closing
  entries to set the balances of the temporary or
  nominal accounts to zero.
• Prepares the account for the next periods
  transaction.
• Transfer the temporary or nominal account
  balances to Retained Earnings.
• What are temporary or nominal accounts??

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Closing the Books

• Temporary or Nominal Accounts are closed
• Revenues
• Expenses
• Dividends
• Permanent Accounts are not closed
• Assets
• Liabilities
• Stockholders Equity
• Do you notice any patterns?

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Closing the Books

• Rules for closing Revenue accounts Debit Revenue
  accounts and Credit Retained Earnings
• 4/30 Service Revenue 2,500
• Retained Earnings
  2,500
• Rules for closing Expense accounts Debit
  Retained Earnings and Credit the Expense accounts
• 4/30 Retained Earnings 1,000
• Rent Expense
  1,000
• Rules for closing Dividend accounts Debit
  Retained Earnings and Credit Dividends
• 4/30 Retained Earnings 500
• Dividends
  500

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In-Class Exercise

• Determine which of the following accounts would
  be closed for Poyntz Hardware, Inc. at the end of
  the year on December 31, 2006. If the account
  would be closed, please prepare the appropriate
  closing journal entry using good form journal
  entry rules.
• CLOSED? JOURNAL ENTRY (if applicable)
• Unearned Revenue of 500
• Cost of Goods Sold of 20,000
• Interest Expense of 150
• Accumulated Depreciation of 2,000
• Sales Revenue of 30,000

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Current Ratio and Debt Ratio

• Current Ratio Measures a companys ability to
  pay current liabilities with current assets.
• Rule of thumb a strong current ratio is around
  1.50-2.00.
• High ratio can pay current debts as they come
  due, but too high may signify too many current
  assets that are low-earning.

Total Current Assets Total Current Liabilities
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Current Ratio and Debt Ratio

• Debt Ratio Measures a businesss ability to pay
  total liabilities. Signifies the proportion of
  assets that is financed with debt.
• Total Liabilities
• Total Assets
• A low debt ratio is safer than a high debt ratio
  this also signifies lower interest expense.

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Questions?

• Any questions or concerns?