chap 3 accrual accounting & income

1. Accrual Accounting & Income Lecture 4 & 5 Chapter 3 ©2008 Pearson Prentice Hall. All rights reserved.

2. 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 Accrual vs. Cash-Basis Accounting ©2008 Pearson Prentice Hall. All rights reserved.

3. Learning Objective 1 Relate accrual accounting and cash flows ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

5. 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 Time-Period Concept ©2008 Pearson Prentice Hall. All rights reserved.

6. Learning Objective 2 Apply the revenue and matching principles ©2008 Pearson Prentice Hall. All rights reserved.

7. The Revenue Principle • Revenue is recordedwhen 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 ©2008 Pearson Prentice Hall. All rights reserved.

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 EXPENSES REVENUES ©2008 Pearson Prentice Hall. All rights reserved.

9. 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 Expenses ©2008 Pearson Prentice Hall. All rights reserved.

10. Adjust the accounts Learning Objective 3 ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

12. Categories of Adjusting Entries • Deferrals • Depreciation • Accruals 3-12 ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

14. Prepaid Expenses • Expenses paid in advance • Include prepaid rent and supplies • Asset is recorded when purchased • Adjustment needed to record amount used ©2008 Pearson Prentice Hall. All rights reserved.

15. Prepaid Rent Example • Suppose on April 1 on a company paid $12,000 for one year’s rent in advance ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

17. $12,000 Prepaid Rent $9,000 $3,000 December 31 April 1, following year April 1, current year April 1 to December 31 = 9 months 3 out of 12 months of rent remains 9 out of 12 months of rent has expired 3/12 x $12,000 = $3,000 9/12 x $12,000 = $9,000 3-17 ©2008 Pearson Prentice Hall. All rights reserved.

18. Prepaid Rent Example Dec 31 – Adjust Prepaid Rent account for amount expired ©2008 Pearson Prentice Hall. All rights reserved.

19. Prepaid Rent Rent Expense Apr 1 $12,000 Dec 31 $9,000 Dec 31 $9,000 Represents amount expired $3,000 Represents amount remaining End-of-year balance ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

21. Supplies Example Supplies $3,200 What amount of supplies was used? Balance per ledger Balance per physical count $500 Subtract the balance per count from the balance per ledger ©2008 Pearson Prentice Hall. All rights reserved.

22. Supplies Example • Dec 31 – Adjust Supplies account for amount used ©2008 Pearson Prentice Hall. All rights reserved.

23. Supplies Supplies Expense $3,200 Dec 31 $1,700 Dec 31 $1,700 Represents amount used $500 Represents amount on hand End-of-year balance ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

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 = ©2008 Pearson Prentice Hall. All rights reserved.

27. Depreciation Example • Dec 31 – Adjusting entry to record depreciation of equipment ©2008 Pearson Prentice Hall. All rights reserved.

28. Depreciation – Balance Sheet ©2008 Pearson Prentice Hall. All rights reserved.

29. Accrued Expenses • Expense incurred before cash is paid • Result in a liability • Common accrued expenses: • Salaries • Interest • Taxes ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

31. $10,000 Salaries $6,000 $4,000 Friday, January 2 pay day Monday, December 29 Wednesday, December 31 year end Monday through Wednesday = 3 days 3 out of 5 days of salaries expense has been incurred 3/5 x $10,000 = $6,000 ©2008 Pearson Prentice Hall. All rights reserved.

32. Accrued Salary Expense Example • Dec 31 – Record accrued salary expense ©2008 Pearson Prentice Hall. All rights reserved.

33. Accrued Revenues • Companies often earn revenue before cash is received • Results in an accrued revenue • Receivable recorded ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

35. Accrued Salary Expense Example • Dec 31 – Record accrued revenue ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

38. Unearned Revenue Example • Nov 1 – Record advance payment received by customer ©2008 Pearson Prentice Hall. All rights reserved.

39. $18,000 $12,000 $6,000 December 31 January 31, following year November 1, current year November 1 to December 31 = 3 months 1 out of 3 months remains unearned 2 out of 3 months of revenue has been earned 1/3 x $18,000 = $6,000 2/3 x $18,000 = $12,000 ©2008 Pearson Prentice Hall. All rights reserved.

40. Unearned Revenue Example • Dec 31 – Record portion of unearned revenue that has been earned ©2008 Pearson Prentice Hall. All rights reserved.

41. Unearned Revenue Service Revenue Dec 31 $12,000 Nov 1 $18,000 Dec 31 $12,000 Represents amount earned $6,000 Represents amount unearned End-of-year balance ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

44. Learning Objective 4 Prepare the financial statements ©2008 Pearson Prentice Hall. All rights reserved.

45. Income Statement • Reports net income or loss • Revenues minus expenses • Net income flows to Retained Earnings Statement ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.

47. Balance Sheet • Reports assets, liabilities and equity • Shows that the accounting equation is in balance ©2008 Pearson Prentice Hall. All rights reserved.

48. INCOME STATEMENT NET INCOME RETAINED EARNINGS STATEMENT ENDING RETAINED EARNINGS BALANCE SHEET ©2008 Pearson Prentice Hall. All rights reserved.

49. Learning Objective 5 Close the books ©2008 Pearson Prentice Hall. All rights reserved.

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 ©2008 Pearson Prentice Hall. All rights reserved.