ACG2021Financial Accounting Chapter 3Using Accrual Accounting to Measure Income
Learning Objectives • Relate accrual accounting and cash accounting • Apply the revenue and matching principles • Update the financial statements by adjusting the accounts • Close the books • Use the current ratio and the debt ratio to evaluate a business
GAAP • “In the United States, generally accepted accounting principles, commonly abbreviated as US GAAP or simply GAAP, are accounting rules used to prepare, present, and report financial statements for publicly-traded companies and many privately-held companies.” (Wikipedia)
Accrual vs Cash Accounting • Generally accepted accounting principles (GAAP) require that business use accrual accounting.
Time-Period Concept • The time-period concept ensures that accounting information is reported at regular intervals. • Basic accounting period is 1 year • A fiscal year ends on a date other than December 31. • Interim financial statements are usually prepared for periods such as a month, a quarter, or semiannual period.
Revenue Principle • When should revenue be recorded? • Revenue should be recorded when it has been earned. • Delivered Good or Service to a Customer • What amount of revenue should be recorded? • The amount of revenue recorded is the cash value of the goods transferred to the customer.
Matching Principle • Expenses are costs of assets used up and/or liabilities created in earning revenue. • Matching involves two steps: • Identify all expenses incurred during the period. • Measure the expenses and match the expenses against revenues earned. • Expenses may • be paid in cash. • result from using up an asset such as supplies • result from creating a liability (payable)
Accrual vs Cash Accounting • Accrual Accounting • Impact of business transactions are recorded when the transaction occurs • Revenues are recognized when earned. • Expenses are recognized when incurred. • Cash Accounting • Transactions are recorded when cash is received or paid. • Revenues are recorded when cash is received. • Expenses are recorded when cash is paid.
Accrual vs Cash Accounting • Under accrual accounting, cash transactions are recorded as well as noncash transactions such as: • Purchases of inventory on account • Sales on account • Depreciation expense • Accrual of expenses incurred but not yet paid • Usage of prepaid rent, insurance, and supplies
Ethical Issues in Accrual Accounting • Accruals require the use of judgment to determine which period should reflect revenues earned. • Managers should not use accruals to “smooth” income by delaying or accelerating recognition of either revenues or expenses.
ACG2021Financial Accounting Recording Accruals and Deferrals and Adjusting Accounts for Accruals and Deferrals
The Adjustment Process • Examine the trial balance for accounts that may need to be adjusted. • Basic categories of adjusting entries: • Deferrals • Paid Cash in Advance for resource that will be used up in the future • Supplies, Insurance, Rent, Plant assets, etc. • Received Cash BEFORE performing Service • Collected subscription revenue, paid for class • Depreciation • Special type of Deferral for Plant Assets • Accruals • Provided Service or sold product before receiving Cash • “on account” • An Expense has occurred before paying Cash
Adjusting Deferred Assets • Prepaid Expense • A prepaid expense is an expense paid for in advance. • Because they provide future economic benefit, prepaid expenses are classified as assets. • Insurance, Rent, etc. • Before financial statements are prepared, prepaid expenses are adjusted to reflect the amount of the asset used up during the period of the statements.
Assets Expenses Debit + Debit + Credit - Credit - Deferred Asset Adjustment • Adjustment records the effect of using up an Asset • “Using Up” an Asset • the Asset value has been reduced • We need to Credit the Asset • Debits must Equal Credits • If Assets create economic benefits, • Using them up leads to a Cost/Expense • We need to Debit an Expense Account • Deferred Asset Rule • Debit Expense and Credit Asset
Adjusting Prepaid Expenses To record $3,000 paid for 3 months rent on April 1, 20X3. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 1 Prepaid Rent (1,000 x 3) 3,000 Cash 3,000 Paid 3 months’ rent in advance Cash Prepaid Rent 3,000 3,000
Adjusting Prepaid Expenses To adjust for one month’s rent expired at April 30. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Rent Expense (1,000/3) 1,000 Prepaid Rent 1,000 Expensed one month’s rent Prepaid Rent Rent Expense 1,000 1,000
Prepaid Rent Apr 1 3,000 Adjusting Prepaid Expenses The following shows the effect of the adjustment. Rent Expense Apr 30 1,000 Apr 30 1,000 Bal. 1,000 Bal. 2,000
Adjusting Supplies To record the purchase of supplies. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 2 Supplies 700 Cash 700 Paid cash for supplies Cash Supplies 700 700
Adjusting Supplies To adjust for supplies used during April. Calculate Supplies Expense: Supplies available during the period Less: Supplies on hand at end of period Equals: Supplies used during the period (expense) $700 - $400 = $300
Adjusting Supplies To adjust for supplies used during April. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Supplies Expense 300 Supplies 300 To record Supplies Expense Supplies Supplies Expense 300 300
Supplies Apr 1 700 Adjusting Supplies The following shows the effect of the adjustment. Supplies Expense Apr 30 300 Apr 30 300 Bal. 300 Bal. 400
Deferred Revenue • Unearned revenue exists when customers have paid in advance for services that have not yet been provided. • The organization “owes” the customer the service in the future • Thus, Unearned Revenue is a liability (an obligation) • Liability Increases, thus Credit Unearned Revenue • Received Cash, thus Debit Cash • Revenue is recognized when the services are provided. • Reduces the organizations obligation • Thus Liability is reduced, Debit Unearned Revenue • Revenue is increased, Credit Service Revenue
Unearned Revenue To record cash received in advance from customers. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 20 Cash 450 Unearned Service Revenue 450 Received cash for revenue in advance Cash Unearned Service Revenue 450 450
Unearned Revenue To record revenues earned at the end of the month. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Unearned Service Revenue (450/3) 150 Service Revenue 150 To record unearned service revenue that has been earned Unearned Service Revenue Service Revenue 150 150
Unearned Revenue The following shows the effect of the adjustment. Unearned Service Revenue Service Revenue 7,000 Apr 30 150 Apr 20 450 Apr 30 250 Apr 30 150 Bal. 300 Bal. 7,400
Adjusting Accrued Expenses • Accrued Expense • An expense of an Organization that hasn’t been paid for by Cash • Matching Principle requires that we determine all Costs associated with Revenue, even if cash hasn’t been paid • Taxes owed, Salaries owed, Interest owed, etc. • Before financial statements are prepared, expenses are adjusted to reflect the cost to the organization for the period of the statements.
Accrued Expenses • Accrued expense refers to a liability that arises from an expense that has not yet been paid. • An Expense that has not been paid • The Expense value has increased • We need to Debit the Expense account • Leads to a liability that the organization owes • Liability value has increased • We need to Credit the Liability • Accrued Expense Rule: • Debit Expense, Credit Liability Expenses Debit + Credit - Liability Debit - Credit +
Accrued Expenses To record salaries expense during the month. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 15 Salaries Expense 950 Cash 950 To pay salaries Salaries Expense Cash 950 950
Accrued Expenses To adjust salaries expense at the end of the month. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Salaries Expense 950 Salaries Payable 950 To accrue salaries expense Salaries Expense Salaries Payable 950 950
Salaries Payable Accrued Expenses The following shows the effect of the adjustment. Salaries Expense Apr 30 950 Apr 30 950 Bal. 950 Bal. 950
Accrued Revenues • Accrued revenue is revenue that has been earned but cash has not been collected. • “On Account”
Accrued Revenue To accrue revenues at the end of the month. DATE ACCOUNTS AND EXPLANATION DEBIT CREDIT Apr 30 Accounts Receivable 250 Service Revenue 250 To accrue service revenue Accounts Receivable Service Revenue 250 250
Accrued Revenue The following shows the effect of the adjustment. Accounts Receivable Service Revenue 7,000 2,250 Apr 30 250 Apr 30 250 Bal. 2,500 Bal. 7,250
Summary of Adjusting Process • Prepare a trial balance. • Review trial balance and other records for adjustments that should be made: • Accruals • Deferrals • Depreciation • Prepare and post adjusting entries. • Prepare an adjusted trial balance to ensure accuracy of debits and credits after posting. • Prepare financial statements.
ACG2021Financial Accounting Closing the Books
Common Stock + Retained Earnings - Dividends + Revenues - Expenses Stockholders’ Equity Accounts Expanded Accounting Equation Assets Liabilities = Stockholders’ Equity
Closing the Books • Temporary accounts are closed • Revenues (are Debited) • Retained Earnings is Credited • Expenses (are Credited) • Retained Earnings is Debited • Dividends (are Credited) • Retained Earnings are Debited • Permanent accounts are not closed • Assets • Liabilities • Stockholders’ Equity
Journalizing Closing Entries Apr 30 Service Revenue 7,400 Retained Earnings 7,400 Apr 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 Apr 30 Retained Earnings 3,200 Dividends 3,200
Closing Accounts Retained Earnings after closing entries: Retained Earnings Beg. Bal 11,250 Expenses 4,415 Revenues 7,400 Dividends 3,200 End Bal 11,035
ACG 2021Financial Accounting Financial Statement Formats
Formats for Financial Statements • Balance sheet formats • Report format • Account format • Income statement formats • Single-step income statement • Multi-step income statement
Classified Balance Sheet • Current assets • Long-term assets • Current liabilities • Long-term liabilities
ACG 2021Financial Accounting Accounting Ratios
Accounting Ratios Total Current Assets Current Ratio = Total Current Liabilities Total Liabilities Debt Ratio = Total Assets