©2008 Pearson Prentice Hall. All rights reserved. 3-1 Accrual Accounting & Income Chapter 3.
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Transcript of ©2008 Pearson Prentice Hall. All rights reserved. 3-1 Accrual Accounting & Income Chapter 3.
©2008 Pearson Prentice Hall. All rights reserved.
3-1
Accrual Accounting & Income
Chapter 3
©2008 Pearson Prentice Hall. All rights reserved.
3-2
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
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3-3
Learning Objective 1
Relate accrual accounting and cash flows
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3-4
Accrual Accounting and Cash Flows
• Accrual accounting records both cash and non-cash transactions
Cash
Collecting from customers
Paying for expenses
Borrowing money
Issuing Stock
Non-cash
Sales on account
Purchases on account
Using prepaid expenses, such as supplies
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3-5
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
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3-6
Learning Objective 2
Apply the revenue and matching principles
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3-7
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
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3-8
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
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3-9
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
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3-10
Learning Objective 3
Adjust the accounts
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3-11
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
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3-123-12
Categories of Adjusting Entries
• Deferrals
• Depreciation
• Accruals
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3-13
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
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3-14
Prepaid Expenses
• Expenses paid in advance
• Include prepaid rent and supplies
• Asset is recorded when purchased
• Adjustment needed to record amount used
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3-15
Prepaid Rent Example
• Suppose on April 1 on a company paid $12,000 for one year’s rent in advance
JOURNAL
Date Accounts Debit Credit
1-Apr Prepaid rent $12,000
Cash $12,000
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3-16
Prepaid Rent Example
• Now, it’s December 31, the company’s year-end
• 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
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3-17
April 1, current year
December 31 April 1, following year
$12,000 Prepaid Rent
April 1 to December 31 = 9 months
9 out of 12 months of rent has expired
9/12 x $12,000 = $9,000
3 out of 12 months of rent remains
3/12 x $12,000 = $3,000
$9,000 $3,000
3-17
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3-18
Prepaid Rent Example
• Dec 31 – Adjust Prepaid Rent account for amount expired
JOURNAL
Date Accounts Debit Credit
12-31 Rent Expense $9,000
Prepaid Rent $9,000
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3-19
Prepaid Rent Rent Expense
Apr 1 $12,000 Dec 31 $9,000 Dec 31 $9,000
$3,000
End-of-year balance
Represents amount expired
Represents amount remaining
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3-20
Supplies Example
• Suppose a company purchased $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 $500 of supplies on hand
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3-21
Supplies Example
Supplies
$3,200Balance per ledger
$500Balance per physical count
What amount of supplies was used?
Subtract the balance per count from the balance per ledger
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3-22
Supplies Example
• Dec 31 – Adjust Supplies account for amount used
JOURNAL
Date Accounts Debit Credit
12-31 Supplies Expense $1,700
Supplies $1,700
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3-23
Supplies Supplies Expense
$3,200 Dec 31 $1,700 Dec 31 $1,700
$500
End-of-year balance
Represents amount used
Represents amount on hand
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3-24
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
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3-25
Accumulated Depreciation
• Account that shows the sum of depreciation expense of the plant asset
• Contra-asset Always has a companion account Normal credit balance
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3-26
Depreciation Example
• A company purchases equipment for $50,000
• The estimated useful life of the equipment is five years
=$5,000 annual depreciation
50,000/5 years
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3-27
Depreciation Example
• Dec 31 – Adjusting entry to record depreciation of equipment
JOURNAL
Date Accounts Debit Credit
12-31 Depreciation Expense $5,000
Accumulated Depreciation $5,000
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3-28
Depreciation – Balance Sheet
Balance Sheet
Plant assets:
Equipment $50,000
Less: Accum. Depr. (5,000) $45,000
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3-29
Accrued Expenses
• Expense incurred before cash is paid
• Result in a liability
• Common accrued expenses: Salaries Interest Taxes
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3-30
Accrued Salary Expense Example
• A company pays its employees a weekly salary each Friday
• Salaries for each week total $10,000
• December 31, the company’s year-end, falls on a Wednesday
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3-31
Monday, December 29
Wednesday, December 31 year end
Friday, January 2 pay day
$10,000 Salaries
Monday through Wednesday = 3 days
3 out of 5 days of salaries expense has been incurred
3/5 x $10,000 = $6,000
$6,000 $4,000
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3-32
Accrued Salary Expense Example
• Dec 31 – Record accrued salary expense
JOURNAL
Date Accounts Debit Credit
12-31 Salary expense $6,000
Salary payable $6,000
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3-33
Accrued Revenues
• Companies often earn revenue before cash is received
• Results in an accrued revenue Receivable recorded
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3-34
Accrued Revenue Example
• A company performed services for customers during the last week of the year totaling $5,000
• The revenue has not yet been recorded because the customers won’t be billed until January
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3-35
Accrued Salary Expense Example
• Dec 31 – Record accrued revenue
JOURNAL
Date Accounts Debit Credit
12-31 Accounts Receivable $5,000
Service Revenue $5,000
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3-36
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
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3-37
Unearned Revenue Example
• On November 1, a company receives a customer payment of $18,000 for services to be performed during the next three months
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3-38
Unearned Revenue Example
• Nov 1 – Record advance payment received by customer
JOURNAL
Date Accounts Debit Credit
11-1 Cash $18,000
Unearned revenue $18,000
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3-39
November 1, current year
December 31 January 31, following year
$18,000
November 1 to December 31 = 3 months
2 out of 3 months of revenue has been earned
2/3 x $18,000 = $12,000
1 out of 3 months remains unearned
1/3 x $18,000 = $6,000
$12,000 $6,000
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3-40
Unearned Revenue Example
• Dec 31 – Record portion of unearned revenue that has been earned
JOURNAL
Date Accounts Debit Credit
12-31 Unearned revenue $12,000
Service revenue $12,000
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3-41
Unearned Revenue Service Revenue
Dec 31 $12,000 Nov 1 $18,000 Dec 31 $12,000
$6,000
End-of-year balance
Represents amount earned
Represents amount unearned
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3-42
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
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3-43
Adjusted Trial Balance
• Trial balance prepared after adjusting entries are made and posted
• These amounts are used to prepare the financial statements: Income Statement Statement of Retained Earnings Balance Sheet
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3-44
Learning Objective 4
Prepare the financial statements
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3-45
Income Statement
• Reports net income or loss
• Revenues minus expenses
• Net income flows to Retained Earnings Statement
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3-46
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
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3-47
Balance Sheet
• Reports assets, liabilities and equity
• Shows that the accounting equation is in balance
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3-48
INCOME STATEMENT
RETAINED EARNINGS STATEMENT
BALANCE SHEET
NET INCOME
ENDING RETAINED EARNINGS
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3-49
Learning Objective 5
Close the books
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3-50
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
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3-51
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
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3-52
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
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3-53
E3-29
• Dec 31 – Close Revenues
JOURNAL
Date Accounts Debit Credit
12-31 Service Revenue $23,600
Other revenue 600
Retained earnings $24,200
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3-54
E3-29
• Dec 31 – Close expenses
JOURNAL
Date Accounts Debit Credit
31-Dec ________________________ _________
Cost of services sold $11,600
Selling, general & admin exp $6,900
Depreciation expense $4,100
Income tax expense $500
Which account would be
debited? Total the expenses
for the amount
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3-55
E3-29
• Dec 31 – Close Dividends
JOURNAL
Date Accounts Debit Credit
12-31 Retained earnings $400
Dividends $400
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3-56
E3-29
Retained earningsBalance 12-31-X1
Balance 12-31-X2
$1,900
$24,200$400
$23,100
Revenues
Expenses
Dividends
$2,600Determine net income.
Remember revenuesminus expenses
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3-57
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
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3-58
Classified Balance Sheet
• Places assets into meaningful categories
• Categories: Current assets Long-term investments Property, plant and equipment Intangible assets Other assets
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3-59
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
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3-60
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
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3-61
Learning Objective 6
Use two new ratios to evaluate a business
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3-62
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
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3-63
Debt Ratio
• Proportion of assets that is financed with debt
• High debt ratio indicates more risk
Total liabilities
Total assets
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3-64
S3-14
Current ratio:Current assets = Cash + Accounts Receivable + Inventories + Other current assets
$900 + $27,700 + $33,000 = $4,800 = $66,400
Total Current liabilities = $53,600
Current ratio = 66,400 / 53,600
Current ratio = ______
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3-65
S3-14
Debt ratio:Total liabilities = Current liabilities + Long-term liabilities
$53,600 + $13,500 = $67,100
Total assets = Current assets + Property & Equipment, net + Other assets
$66,400 + $7,200 + $24,300 = 97,900
Debt ratio = $67,100 / $97,900
Debt ratio = .69
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3-66
End of Chapter Three