On July 9, 2010, ABC Company provides legal service to a client, who agrees to pay $200 within one month.

On Aug 3, ABC Company receives a check of $200 from this client. When should you record revenue on the book?

Your company opens an electricity account with Amigo Energy which starts to supply energy on July 1, 2010. On August 4, you receive an electricity bill of $100 for the period July 1- 31. Does this expense belong to the month of July or August?

Chapter 3
Accrual Accounting and Income

1. 2. 3. 4. 5. 6.

Accrual accounting Revenue principle Matching principle Time period concept Adjusting entries Deferrals, accruals, depreciation Closing the book Current and long-term assets (liabilities) Current ratio and Debt ratio How to construct a simple Cash Flow statement using indirect method.
2

ACCRUAL ACCOUNTING
Records impact of transactions when they occur Records: Revenue when earned (e.g., sales on account) Expenses when incurred (e.g., purchase on account) No matter whether cash has been received or paid

In contrast, cash accounting records transactions when and only when cash payment or receipt is involved.
Which method provides more information?
3

Some of the transactions recorded in accrual accounting:

Cash transactions Collecting payments from customers Noncash transactions Sales on account

Borrowing money
Paying expenses

Depreciation expense
Purchases on account

Paying off loans

Issuing stock

Usage of prepaid expenses

Accrual of expenses not yet paid
Accrual accounting is more complex but also more complete and more informative.

Time Period Concept

Accounting information is reported at regular intervals-Year, quarter, month All businesses prepare annual financial statements The financial year (fiscal year) could be a calendar year or any other one year period (e.g. April 1 to March 31) In addition to annual reports, many companies produce interim financial reports as well (e.g. quarterly reports)

Revenue Principle
When to record

Amount to record

After revenue is earned:

When good or service has been delivered to customer

Cash value of goods or services transferred to customer

Matching Principle-align revenue with expenses

Expenses are matched against the revenue that was earned in a particular period Expenses incurred to generate revenues should be recorded in the same period. When revenues and expenses are properly matched, we get a reliable measure of net income (or net loss) Some expenses are paid in cash Others are not yet paid for (accruals) Certain other expenses arise from using up assets (e.g. supplies)
7

Question In which month should revenue be recorded?

A. In the month that cash is collected from the customer B. In the month the goods are shipped to the customer C. In the month that goods are ordered by the customer D. In the month that the invoice is mailed to the customer

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From trial balance to financial statements: The Adjusting Process

In chapter 2, we saw trial balances and used to them to create financial statements That was an over-simplification What to do with utility bills we have not received yet? Wages not paid yet? The wear and tear of machinery? And the money paid by customer in advance? In reality, several accounts in trial balance needs to be brought up-to-date before financial statements are created This updating process is termed the adjusting process

The Adjusting Process

Adjusting entries are at the heart of accrual accounting. Accrue - to accumulate a receivable or payable during a given period even though no explicit cash transaction occurs The receivable or payable grows with time, but nothing changes with cash. The goal of adjusting entries is to assure that assets, liabilities, and stockholders equity are properly stated.

Adjusting process is usually made when the financial statements are about to be prepared. They are made in the form of adjusting journal entries that are posted to the T account.

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Categories of Adjustments

Deferrals

Depreciation

Accruals
Lets do some necessary adjustments!

11

Five Types of Adjustments

Prepaid Expenses Accrued Expenses

Unearned Revenue

Accrued Revenue

Depreciation

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Deferrals
Business has paid or received cash in advance Prepaid expense
Recorded as an asset when purchased Expensed when used or expired

Unearned revenue
Recorded as a liability when payment is received Recorded as revenue when earned

13

How to record these transactions initially? June 1: pay $12,000 rent for 1 year from this June to next June. Aug 3: purchase $3,500 supplies that can last for years
JOURNAL Date Accounts and explanation Cash Debit 12,000 12,000 Credit June 1 Prepaid rent

Aug 3

Supplies
Cash

3,500
3,500 Do we have the same amount of prepaid rent and assets by the year end?
1-14

Use T-accounts to analyze the balances and prepare the adjusted journal entries: First: decide what ending balances should appear in the asset (Prepaid Rent) and expense (Rent Expense) accounts. In this example, 7 months expense had been used, therefore $7,000 should be shown in Rent Expense ($1,2000/12 months x 7 months). Also, at December 31, there are still 5 months remaining (unused), and $5,000 should be shown in Prepaid Rent.
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Lets look at the T-accounts

ASSET

Prepaid rent
June 1

Rent expense
Dec 31 Dec 31

$12,000 $7,000
$5,000

$7,000

Balance Sheet

Income Statement

16

Adjustments made at year end:

JOURNAL Date Accounts and explanation Prepaid rent Dec 31 Supplies expense 2,900 Debit 7,000 7,000 Credit Dec 31 Rent expense

Supplies

2,900

Aug 3rd, purchase 3,500 supplies. On Dec 31th, $600 supplies at hand. Supplies are expensed when they are used

17

Lets look at the T-accounts

ASSET

Supplies
Aug 3

Supplies expense
Dec 31 Dec 31

$3,500 $2,900
$600
Amount on hand Balance Sheet

$2,900

Amount used Income Statement

18

Question

On January 1, Bambi Company paid $1,200 rent to cover six months, the adjusting entry at the end of January should include

1. A credit to Prepaid Rent for $1,000 2. A credit to Prepaid Rent for $200 3. A debit to Prepaid Rent for $1,000 4. A debit to Prepaid Rent for $200
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Question Garcia Company purchased a one-year insurance policy on April 1, Year 1, for $6,000. After year-end adjustments, the amount of prepaid insurance and the amount of insurance expense at December 31, Year 1, are, respectively

1. 2. 3. 4.

$1,500, $4,500. $4500, $1,500. $2,000, $4,000. $4,000, $2,000.

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What happens to receipt in advance?

Sept 1: you receive $12,000 cash from client for legal service of next 12 months. $1,000 per month.
JOURNAL
Date Sept 1 Accounts and explanation Cash Debit 12,000 Credit

Unearned service revenue

Receive client payment in advance

12,000

No free lunch in the world with money accepted now you have an obligation to deliver service in the future.
21

Any adjustment at the year end for the EARNED portion? Use T-accounts to analyze the balances and prepare the adjusting entry: First: decide what ending balances should appear in the liability (Unearned Service Revenue) and revenue (Service Revenue) accounts. In this example, 4 months revenue had been earned by 12/31, therefore $4,000 should be shown in Service Revenue ($12,000/12 months x 4 months). Also, at December 31, there are still 8 months remaining (unearned), and $8,000 should be shown in Unearned Service Revenue.
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Lets look at the T-accounts

LIABILITY

Unearned Service Revenue

Dec 31

Service Revenue $4,000

Dec 31

$4,000

$12,000 $8,000

June 1

Balance Sheet

Income Statement

23

Adjusting Entry at the year end:

JOURNAL Date Accounts and explanation Debit Credit 12,000

Sept 1

Cash
Unearned service revenue Receive client payment in advance

12,000

Dec 31

Unearned service revenue

Service revenue

4,000
4,000

How do these adjustments affect balance sheet and income statement?

24

Question On October 1, River Place Apartment received $5,200 from a tenant for four months rent. The Receipt was credited to Unearned Rent Revenue. What adjusting entry is needed on Dec 31th?

A. Unearned Rent Revenue 1,300 Rent Revenue 1,300 B. Cash 1,300 Rent Revenue 1,300 C. Rent Revenue 1,300 Unearned Rent Revenue 1,300 D. Unearned Rent Revenue 3,900 Rent Revenue 3,900
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Question Rodenko, Inc., publishes a monthly sports magazine. On July 1, Year 1, the company sold 1,000 two-year subscriptions for $100 each. On December 31, Year 1, the amount reported as a liability on the balance sheet and the amount reported as revenue on the income statement are, respectively

1. 2. 3. 4.

$0, $25,000, $50,000, $75,000,

$100,000. $75,000. $50,000. $25,000.

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Depreciation
How to record a transaction like this? Jan 1: purchase a machine with $50,000 cash, which is expected to be used for five years Do we have the same amount of asset at year end? How to adjust?
JOURNAL Accounts and explanation Equipment Cash Debit 50,000 50,000 Credit

1-27

Depreciation
Allocates cost of plant assets to expense over useful lives Represents wear-and-tear and obsolescence Examples of plant assets: Buildings Equipment Furniture With depreciation, a new account, Accumulated Depreciation, is introduced. Accumulated depreciation - the cumulative sum of all depreciation recognized over the life of a particular asset. Asset Cost Straight-Line Depreciation Expense = Useful Life
28

Depreciation
Equipment Depreciation Expense
Dec 31

$50,000
Jan 2

$10,000

Both numbers enter the Balance Sheet

Income Statement

Accumulated Depreciation $10,000

Dec 31

Depreciation on Dec 31 One year depreciation = 50,000 / 5 = 10,000

29

Depreciation initial and adjusting journal entries

JOURNAL Date Jan 2 Accounts and explanation Equipment Cash Dec 31 Depreciation expense Accumulated depreciation 10,000 10,000 Debit 50,000 50,000 Credit

Q: without the year-end adjustment, do we get a complete picture about this asset?

A contra asset account

30

More about Accumulated Depreciation

Sum of all depreciation expenses Increases over plant assets life Contra-asset: a separate but related account that offsets or is a deduction from a companion account. Normal credit balance Always has a companion account Appear on Balance Sheet along with certain assets Book value of plant asset = Cost of plant asset - accumulated depreciation

Book value is also called carrying value.

31

Lets see how that equipment is carried on the book

Balance Sheet December 31, 2010 Equipment Less: Accumulated Depreciation Book value $50,000 (10,000) $40,000

More on depreciation - See chapter 7

32

Question What is the effect on the financial statements of recording depreciation on equipment?

1. Net income is not affected, but assets and stockholders equity are decreased. 2. Net income and assets are decreased, but stockholders equity is not affected. 3. Net income, assets, and stockholders equity are all decreased. 4. Assets are decreased, but net income and stockholders equity are not affected.
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Accruals
No cash has changed hands yet, but youve owed or earned something:

Accrued expenses Record expense before paying cash Salaries, interest, and income taxes

Accrued revenues Record revenue before collecting cash Earned and will collect next period

34

Accrued Salaries
$15,000 weekly salaries
$6,000 $9,000

12-30

12-31

1-1

1-2

1-3

How to present this picture at 12/31? Costs incurred in a period, that are both unpaid and unrecorded. Match the expenses to the periods revenues! Accrued expenses are recorded for amounts that are owed at the end of an accounting period but have not been paid in that accounting period. In the accrual accounting, a liability (salary payable) is recorded and increased (Credit).

35

Accrued Salaries
JOURNAL Date Dec 31 Accounts and explanation Salaries expense Salaries payable Debit 6,000 6,000 Credit

Later:
JOURNAL

Date
Jan 3

Accounts and explanation

Salaries payable Salaries expenses Cash

Debit
6,000 9,000

Credit

15,000

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Accrued Interest
Interest is much like rent paid for the use of borrowed money. Interest accumulates (accrues) as time goes on, regardless of when the interest is actually paid. Interest = Principal x Interest rate x Fraction of a year The entry to record the accrual of interest expense is very similar to the entry to record the accrual of wage expense.
JOURNAL Date Dec 31 Accounts and explanation Interest expense Interest payable Debit xxxx xxxx Credit

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Accrued Income Tax

As income is generated, income tax expense is accrued rather than paid by the company each time a dollar comes in.

The entry to record accrued income taxes is similar to the accrual of other expenses.

JOURNAL Date Dec 31 Accounts and explanation Income Tax Expense Income Tax Payable Debit xxxx xxxx Credit

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Accrued Revenue

Revenue earned but not yet received The adjusting entries show the recognition of revenues that have been earned, but the entity has not received cash. Increases receivables and revenue

JOURNAL Date Dec 31 Accounts and explanation Accounts receivable Service revenue Accrued Revenue Debit 1,500 1,500 Credit

Later:
JOURNAL
Date Jan 5 Accounts and explanation Cash Accounts receivable Debit 1,500 1,500 Credit

Collect cash from customer

How accrued revenue is different from unearned revenue?

39

Question If a real estate company fails to accrue commission revenue,

1. Revenue are understated and net income is overstate. 2. Assets are understated and net income is understated. 3. Net income is understated and stockholders equity is overstated. 4. Liabilities are overstated and owners equity is understated.

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Prepaids and Accruals a summary

Deferral CASH FIRST FIRST Prepaid expenses Unearned revenues Prepaid expense (Assets) Cash Cash Unearned revenue (Liability) FIRST Accrued expenses Accrued revenues Expense Accounts Payable Accounts Receivable Revenue Cash Accounts Receivable LATER Accounts Payable Cash LATER Expense Prepaid expense Unearned revenue Revenue

ACCRUALS CASH LATER

41

Summary of the Adjusting Process

Two purposes
Measure income Update balance sheet

Every adjusting entry affects at least one:

Revenue or expense Asset or liability

42

Exercise: Journalize adjusting entries on Dec 31 for each situation

a. The business has interest expense of $9,500 incurred during 2010 that it must pay early in January 2011.
JOURNAL Date (a) Accounts and explanation Interest expense Interest payable Debit 9,500 9,500 Credit

b. Interest revenue of $4,500 has been earned but not yet received.
(b) Interest receivable
Interest revenue

4,500
4,500

1-43

Exercise : journal entries of Dec 31

c. On July 1, when we collected $13,600 rent in advance, we debited Cash and credited Unearned Rent Revenue. The tenant was paying us for 2 years rent.
(c) Unearned rent revenue Rent revenue 3,400 3,400

d. Salary expense is $1,800 per dayMonday through Fridayand the business pays employees each Friday. This year, December 31 falls on a Wednesday.
(d) Salary expense Salary payable 5,400 5,400

44

As the Exercise continues:

e. The unadjusted balance of the Supplies account is $3,300. The total cost of supplies on hand is $1,200.
(e) Supplies expense Supplies 2,100 2,100

f. Equipment was purchased at the beginning of this year at a cost of $100,000. The equipments useful life is 5 years.
(f) Depreciation expense
Accumulated depreciation

20,000
20,000

1-45

Exercise:

Balance Sheet December 31, 2010 Equipment Less: Accumulated Depreciation $100,000 (20,000)

Book value

$80,000

46

The Adjusted Trial Balance

Prepared after adjustments are journalized and posted Useful step in preparing financial statements

47

ExerciseShineBrite Cash Wash Company Preparation of Adjusted Trial Balance Dec 31th, 2010
Unadjusted Debit Cash Accounts Receivable Supplies Accounts Payable Unearned Revenues Common Stock Retained Earnings Dividends Service Revenues Salaries Expense Supplies Expense 6 0 56 56 8 4 14 6 6 8 56 56 10 12 24 12 22 6 2 4 20 6 8 Credit Debit Adjusting JE Credit Adjusted Debit 10 12 16 12 16 6 2 Credit

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ExerciseShineBrite Cash Wash Company Preparation of Adjusted Trial Balance Dec 31th, 2010

(a) A physical count made at the end of the period revealed that there were supplies on hand with a cost of $16. AJE:
(a) Supplies expenses 8

Supplies

(b) The unearned revenues account shows $16 had still not been earned as of year-end. AJE: (b) Unearned Revenue 6
Service Revenue 6

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Recall
Income Statement
Lists revenues & expenses Reports net income

Statement of Retained Earnings

Shows changes in retained earnings

Balance Sheet
Reports assets, liabilities and stockholders equity
Should be able to construct financial statements based on the adjusted trial balance

50 50

Closing the books

Prepared after the financial statements have been prepared. Prepares the accounts for next period Temporary accounts are set to zero and closed into Retained earnings Can you guess what are the temporary accounts?

51

Temporary accounts
Revenues expenses dividends
Note: the post-closing Trial Balance consists only of balance sheet accounts. All of the temporary accounts have been closed to Retained Earnings, and we are now ready to start a new year, and accumulate new balances for revenues, expenses, and dividends.

52

Closing Entries
Closing means you transfer the balances to Retained Earnings.

Close Revenues
Debit each revenue account Credit Retained earnings

Close Expenses
Debit Retained earnings Credit each expense account

Close Dividends
Debit Retained earnings Credit Dividends
Note: To close an account you need to Debit (Credit) it if it has a Credit (Debit) balance and Credit (Debit) Retained Earnings.
53

P3-75A
Spa View Service, Inc., with fiscal year end March 31, has following accounts balance:
Service revenue: 95,000 Dividends: 31,200 Advertising expense: 10,900 Depreciation expense: 1,700 Interest expense: 900 Salary expense: 17,800 Supplies expense: 4,400

How to close the accounts? How does retained earnings change?

1-54

P3-75A journal entries to close revenue and expenses accounts

JOURNAL Date 3/31 Accounts and explanation Sales revenue Retained earnings Debit 95,000 95,000 Credit

3/31

Retained earnings Advertising expense Depreciation expense Interest expense Salary expense Supplies expense

35,700 10,900 1,700 900 17,800 4,400

55

P3-75A journal entries to close Dividends

JOURNAL
Date Accounts and explanation Retained earnings Dividends Debit 31,200 31,200 Credit

56

Changes to Retained Earnings

Retained Earnings
Expenses

$35,700 $31,200

$22,000 $95,000 $50,100

Beginning Balance Revenues Ending Balance

Dividends

57

Question A major purpose of preparing closing entries is to

A. Zero out the liability accounts B. Close out the supplies account C. Adjust the asset accounts to their correct current balances D. Update the Retained Earnings account.

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Question Which of the following accounts would not be included in the closing entries?

A. Depreciation Expense B. Retained Earnings C. Accumulated Depreciation D. Service Revenue

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Current or Long-term
Current assets: Can be turned into Cash cash within one year or one operating cycle. Short-term investments Accounts receivable Merchandise inventory Prepaid expenses are the current assets Assets are classified as current or long-term term based on liquidity, or how quickly an item can be converted to cash.

60

Current Liabilities
Debts that must be paid within 1 year or within the entitys operating cycle if longer than a year: Accounts payable Notes payable due within 1 year Salary payable Unearned revenue Interest payable Income tax payable

61

Current assets Long-term assets Current liabilities

Converted to cash, sold or consumed in the next year Held for longer than one year Includes plant assets Must be paid within one year Due date more than one year from balance sheet date

Long-term liabilities

Classified Balance Sheet

Categorizes and subtotals assets and liabilities
Assets Liabilities

Current assets
Long-term investments Property, plant and equipment Other assets

Current liabilities
Long-term liabilities

63

Financial Statement Formats

Balance Sheet
Report Format Assets listed at the top Liabilities and equity beneath Account format Assets on the left Liabilities and equity on the right

Income Statement
Single-Step All revenues grouped together All expenses grouped together Multi-step Shows subtotals to emphasize relationships Includes Gross profit Income from operations

64

Use two new ratios to evaluate a business

Current Ratio Debt Ratio Enhance users ability to analyze companys past performance From the names, how do you think the ratios should be computed? And what do they tell you?

65

Current Ratio
Current assets Current liabilities
It measures ability of a business to pay current liabilities with its current assets Whats the implication if this current ratio is less than one?

As a rule of thumb, a strong current ratio is 1.50 Most successful businesses operate with current ratios between 1.20 and 1.50
66

Debt Ratio
Total liabilities Total assets
Measures the proportion of a businesss assets that are financed with debt. Measures businesss ability to pay both current and long-term debt Low debt ratio is safer than high debt ratio, though not necessarily better.

67

Question UPS earns service revenue of $800,000. How does this transaction affect UPS ratio?

A. Improves the current ratio and does not affect the debt ratio B. Hurts the current ratio and improves the debt ratio C. Hurts both ratio D. Improves both ratios

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Question Suppose Green Mountain Corporation borrows $20 million on a 20 year note payable. How does this transaction affect its ratios?

A. Hurts both ratio B. Improves both ratios C. Improves the current ratio and hurts the debt ratio D. Hurts the current ratio and improves the debt ratio

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The Statement of Cash Flows

Measures cash receipts and cash payments. Gives a direct picture of where cash came from (cash receipts) and where cash went (cash payment) during a period. Categorizes into three types of activities: operating (related to normal business activities, selling goods and services). investing (related to investments in long-term assets, selling or purchasing plants). financing (related to the business sources of fund, e.g. issuing stocks or debts).

70

Statement of Cash Flows For the year ended December 31, 2010 Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities Net cash flows 60 20 (30) 50

Cash balance, December 31, 2009

Cash balance, December 31, 2010

10
60

71

How to prepare a cash flow statement Part 1- Cash Flow from Operations*
Net Income + Depreciation expense Increases in accounts receivable + Decreases in accounts receivable + Increases in accounts payable Decreases in accounts payable = Cash flows from operating activities *The above is a simple version.
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Cash Flow from Operations Add back Depreciation

Depreciation is a non-cash expense that reduces net income. Therefore, it is added back to put net income on a cash basis.

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Cash Flow from Operations Increase in Accounts Receivable

An increase in accounts receivable increases net income because of the associated revenue. However, since no cash is provided, the increase is shown as a reduction to put net income on a cash basis.

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Cash Flow from Operations Decrease in accounts receivable

The reverse is true for a decrease in accounts receivable. A collection of accounts receivable provides cash but does not affect net income. Therefore, the decrease in this current asset is an addition to put net income on a cash basis.

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Cash Flow from OperationsIncrease in accounts payable

Consider accounts payable. An increase in accounts payable decreases net income because of the associated expense. However, since no cash is yet paid, the increase in this current liability is shown as an addition to put net income on a cash basis.

1-76

Cash Flow from Operations Decrease in accounts payable

The reverse is true for a decrease in accounts payable. A payment of accounts payable uses cash but does not affect net income. Therefore, the decrease in this current liability is a subtraction to put net income on a cash basis.

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Example- Indirect method - Cash Flows

Item Net Profit Depreciation, Amortization Amount $269 $188

Increase in accounts receivable ($179) Increase in notes receivable Increase in Accounts payable Net Cash provided by operations ($84) $89 $ 283

1-78

How to prepare a cash flow statement (Continued)

Remember there are three components for Cash Flow statements. We learnt how to construct the cash flow from operations. The two other components are:
Cash Flow from investments Cash Flow from financing

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Cash Flow from Investing

Investing activities include cash from buying and selling noncurrent assets. It also includes cash generated (lost) from investments in securities.

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Cash Flow from Financing Activities

Financing activities include
borrowing and repaying money, distributing dividends and issuing stock.

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SUMMARY

Compare accrual and cash basis accounting Apply the revenue and matching principles Adjust the accounts Prepare the financial statements Close the temporary accounts Use ratios to evaluate a business Understand how to construct a cashflow statement using the indirect method

82

SUMMARY

Compare accrual and cash basis accounting Apply the revenue and matching principles Adjust the accounts Prepare the financial statements Close the temporary accounts Use ratios to evaluate a business Cash Flow

83